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AJG | 1 | 2,025 | 2025-05-01 17:30:00 | Operator: Good afternoon, and welcome to Arthur J. Gallagher & Company’s First Quarter 2025 Earnings Conference Call. Participants have been placed on a listen-only mode. The lines will be open for questions following the presentation. Today’s call is being recorded. If you have any objections, you may disconnect at this time. Some of the comments made during this conference call, including answers given in response to questions, may constitute forward-looking statements within the meaning of the securities laws. The company does not assume any obligation to update information or forward-looking statements provided on this call. These forward-looking statements are subject to risks and uncertainties that can cause actual results to differ materially. Please refer to the information concerning forward-looking statements and Risk Factors sections contained in the company’s most recent 10-K, 10-Q and 8-K filings for more details on such risks and uncertainties. In addition, for reconciliations of non-GAAP measures discussed on this call as well as other information regarding these measures, please refer to the earnings release and other materials in the Investor Relations section of the company’s website. It is now my pleasure to introduce J. Patrick Gallagher, Jr., Chairman and CEO of Arthur J. Gallagher & Company. Mr. Gallagher, you may begin.
J. Patrick Gallagher, Jr.: Thank you. Good afternoon and thank you for joining us for our first quarter 2025 earnings call. On the call with me today is Doug Howell, our CFO; and other members of our management team. We had a fantastic first quarter. For our combined Brokerage and Risk Management segments, we posted 14% growth in revenue, 9% organic growth, reported net earnings margin of 23%, adjusted EBITDAC margin of 41.1%, up 338 basis points year-over-year, adjusted EBITDAC growth of 26%, our 20th consecutive quarter of double-digit growth, GAAP earnings per share of $3.29 and adjusted earnings per share of $4.16. Another excellent quarter by the team. Moving to results on a segment basis, starting with the Brokerage segment. Reported revenue growth was 16%. Organic growth was 9.5%, which included about 1 point of favorable timing. Even without the timing impact, all-in organic was right in line with our expectations. Adjusted EBITDAC margin expanded 359 basis points to 43.4%, with underlying margins up a full percentage point. Doug will unpack this in his comments. Let me provide you with some insights behind our Brokerage segment organic. Within our retail P/C operations, we delivered 5% organic overall. U.S. organic was north of 5%, while our international operations, primarily in the UK, Canada, Australia and New Zealand, were closer to 4%. Our global employee benefit brokerage and consulting business posted organic of more than 7%. Shifting to our reinsurance, wholesale and specialty businesses, in total, organic of 13%. This includes 20% organic from Gallagher Re and 8% organic from our wholesale and specialty businesses. So we continue to report strong growth across retail P/C, wholesale, reinsurance and benefits. Next, let me provide some thoughts on the P/C insurance pricing environment, starting with the primary insurance market. Overall, the global P/C insurance market continues to behave rationally with carriers looking to grow in lines and geographies where there’s an acceptable return, and seeking rate increases where it’s needed to generate an appropriate underwriting profit. Breaking down first quarter global renewal premium changes by product line, we saw the following: property down 2%, D&O down 3%, workers’ comp up 5%, personal lines up 8%, casualty lines up 8% overall, including general liability up 5%, commercial auto up 6% and umbrella up 11%. Breaking down renewal premiums by client size, we continue to see a divergence between small to midsize accounts and large accounts. For small to midsize accounts, which we define as accounts generating less than $100,000 of revenue, renewal premiums were up 5%. For large accounts, our clients generating more than $100,000 of revenue, renewal premiums were up 1%. All that said, pricing is ultimately driven by client loss experience. Good accounts are getting some premium relief in certain lines. However, accounts with poor experience are seeing greater increases. Having a trusted adviser like Gallagher can help businesses navigate a complex insurance and economic backdrop by finding the best coverage for our clients while mitigating price increases, today’s environment is the ideal market for us to show our expertise, product knowledge and our data-driven capabilities. Let me move to the reinsurance market. First quarter dynamics, which is mostly influenced by January 1 renewals, reflected an environment that generally favored reinsurance buyers. Overall, reinsurers were able to meet increased client demand with sufficient capacity while remaining disciplined on terms. The Gallagher Re team shined with excellent retention and some fantastic new business wins. April renewals experienced similar trading conditions as earlier in the year, and as expected, saw a bit more downward pricing pressure. The January wildfire losses and continued casualty reserve increases remain a focus for the industry. But neither caused much upward movement in pricing given the large proportion of Japanese buyers in April. With that said, U.S. severe convective storm season is here, which then leads us to U.S. wind season. Time will tell how the year plays out. Regardless, Gallagher Re should continue to excel in this environment. Moving to some comments on our customers’ business activity. During the first quarter, our daily revenue indications from audits, endorsements and cancellations continued to be a net positive. While the upward revenue adjustments are not quite as high as last year, we continue to see solid client business activity and no signs of a meaningful global economic slowdown. Our daily revenue indications through the end of April are not showing any significant changes in our customers’ business activity from the prospect of tariffs. Our daily indications have historically given us some early insights into our clients’ business activity, so we will continue to watch these very carefully. We are also closely watching the U.S. labor market. And there continues to be a strong demand for new workers. The number of open jobs in the U.S. stood at more than 7 million, still at a level that is well above the number of unemployed people looking for work. We’ve also seen recent health insurance carry results show continued increases in the utilization and cost of health care. With these two trends as the backdrop, we are seeing more and more employers looking for ways to grow their workforce and control their benefit costs. Our experts can provide creative solutions to solve these challenges. Regardless of market and economic conditions, I believe we are well positioned to compete and to win. From our niche expertise, outstanding service or extensive data and analytics offerings, we have the resources and know-how to service any account of any size, of any complexity anywhere around the globe. So with a fantastic first quarter behind us, we continue to see full year 2025 Brokerage segment organic in the 6% to 8% range. Moving on to our Risk Management segment, Gallagher Bassett. First quarter revenue growth was 6%, including organic of about 4%. We continue to see excellent client retention and strong new business production. However, sold new business within the Risk Management segment typically takes longer to materialize into revenue. As these new client contracts incept and begin to generate revenue in the coming months, we are confident we will see stronger revenue growth in the second half of the year. Adjusted EBITDAC margin was 20.5%, in line with our March expectations. Looking ahead, we still see full year 2025 organic in that 6% to 8% range and margins around 20.5%. Shifting to mergers and acquisitions. During the first quarter, we completed 11 new tuck-in mergers, representing around $100 million of estimated annualized revenue. We also announced the acquisition of Woodruff Sawyer during the quarter and completed that in early April. That means through today, we already are at $400 million of acquired revenue. For those new partners joining us, I’d like to extend a very warm welcome to the Gallagher family of professionals. As for the pending AssuredPartners acquisition, not much to update relative to our March IR Day comments, we are working to respond to the second request. And we still expect to close in the second half of 2025. Looking at our pipeline, we have more than 40 term sheets signed or being prepared, representing north of $450 million of annualized revenue. Good firms always have a choice, and it would be terrific if they chose to partner with Gallagher. I’ll conclude with some comments about our bedrock Gallagher culture. During our Global Sales Award meeting in early March, our unique Gallagher culture was on full display. It was inspiring to watch the interactions among thousands of our colleagues across geographies, business units and product lines. I came away even more convinced that our greatest asset is our people and our biggest differentiator is our culture. And that is the Gallagher way. Okay. I’ll stop now and turn it over to Doug. Doug?
Doug Howell: Thanks, Pat, and hello, everyone. Today I’ll walk you through our earnings release, starting with some comments on first quarter organic growth and margins by segment, including how we are seeing these shape up for the full year 2025. Next, I’ll move to the CFO commentary document that we posted on our IR website and walk you through our typical modeling helpers. And then I’ll conclude my prepared remarks with my usual comments on cash, M&A and capital management. Okay. Let’s flip to Page 2 of the earnings release. Headline, Brokerage segment organic growth of 9.5% was a great quarter and it helps our – and it helps bolster our view that full year organic will be in that 6% to 8% range. And that range is in line with what we’ve been saying all year. As Pat mentioned, first quarter did have some favorable timing of about 1 point. So looking forward, we see some favorable timing again in the second quarter, but not to the same magnitude. And then all of the first half timing will reverse itself in the third and fourth quarters with no impact on full year 2025. So as we look through to the rest of the year, second quarter might be more like 6% to 7%. Then we will see the timing slip in the third and fourth quarters might mean third and fourth quarter organic of about 5% each. Causes a low noise across the quarters, but with a 9.5% first quarter, the math gets us back to a full year 2025 organic in that 6% to 8% range. That would be a terrific year. So flipping now to Page 4 of the earnings release, to the Brokerage segment adjusted EBITDAC table. First quarter adjusted EBITDAC margin was 43.4%, up 359 basis points year-over-year and above our March IR Day expectations. So let me walk you through a bridge from last year as we typically do. First, if we pull out last year’s 2024 first quarter earnings release, you would see we reported back then adjusted EBITDAC margin of 39.9%. But now I’m using current period FX rates that would have been 39.8%. Then organic growth of 9.5% gave us about 120 basis points of expansion this quarter. The roll-in impact of M&A and lower interest rates each used about 10 basis points of margin this quarter. Finally, as the footnote at the bottom of that table notes, the impact of interest income from the cash that we’re holding for the AssuredPartners acquisition adds us about 260 basis points of margin this quarter. Follow that bridge and it will get you to first quarter 2025 margin of 43.4%. That is really, really great work by the team. As for second quarter headline margin expansion, it’s still looking like we will be pushing around 300 basis points, again, driven by strong underlying margin expansion of approximately 60 to 80 basis points assuming organic in that 6% to 7% range and also interest income related to the cash we’re holding for AP plus a small offset by the roll-in of M&A and lower interest rates. Looking out towards the third quarter, we would still expect underlying margin expansion, and then we’ll also have the impact of investment income on the funds we’re holding for AP. So in total, think – we’re thinking expansion could be 250 to 280 basis points. This, of course, would change if we get AP closed before September 30. As for fourth quarter, we would hope we’d have AP closed, so we would have underlying margin expansion still, but lose the extra investment income, yet have AP’s fourth quarter results in our books. The punch line here is there’s nothing we’re seeing that causes us to change how we view underlying margin expansion potential. We believe at organic greater than 4%, we should see some underlying margin expansion. At 6% organic, maybe 60 basis points of expansion and at 8% organic, perhaps around 100 basis points of expansion. So again, there’s no new news here. We still believe we are positioned to expand underlying full year margins by about 60 to 100 basis points. Sticking on Page 4. Risk Management segment organic was 3.9%. That’s a bit below our 5% expectation due to lower new business revenue. As Pat mentioned, we expect this to improve in the second half of the year as we have already sold new contracts, but these have yet to start generating revenue. So we see organic moving back towards 6% to 8% throughout the year. Adjusted EBITDAC margin of 20.5% was in line with our March IR Day expectations. And looking forward, we still see full year margins again around 20.5%. Turning now to Page 6 of the earnings release and the Corporate segment shortcut table. For the adjusted interest in banking, clean energy and acquisition lines, all were very close to our March IR Day expectations. The corporate line was better than our March expectations due to some expense timing, a few favorable tax items, including the tax benefit from stock-based compensation, somewhat offset by an unrealized FX remeasurement loss. So now let’s move from the earnings release to the CFO commentary document that we posted on our website. First, as an overall statement, please read the headers and footnotes carefully on how these numbers in this document include or exclude the impact of AssuredPartners. That said, let’s flip to Page 3 and our modeling helpers across the board. First quarter 2025 actual numbers were fairly close to what we provided back in March. One thing to call out in our 2025 outlook are changes from FX for both the Brokerage and Risk Management segments. With the dollar weakening since mid-March, we have provided updated estimates for revenue and EPS impacts for the remainder of the year. Just take a look at the disclosures and refine your models. Turning now to Page 4 and the Corporate segment outlook for 2025. Within the corporate line of the Corporate segment, like I mentioned earlier, we had some favorable expense timing in the first quarter. So you’ll see some of that comes back over the rest of the year. We’ve increased after-tax expense by about $1 million per quarter for the remainder of 2025. However, the rest of our outlook for the Corporate segment is unchanged from six weeks ago. Flipping to Page 5 to our tax credit carryovers. A reminder – this is a reminder page, as of March 31, we have about $710 million of tax credits. We continue to expect additional cash flow of more than $180 million this year and even more in 2026 and later years. And don’t forget, this benefit will show up in our cash flow statement rather than our P&L. So it’s still a nice sweetener to fund a future M&A. Turning now to Page 6, the investment income table. We’ve updated our forecast to reflect current FX rates and changes in fiduciary cash balances. And you’ll see here that we’re still assuming two 25 basis point rate cuts during 2025. You’ll also see that we provided a separate line to show our estimates of interest income associated with the funds that we’re holding to pay for AssuredPartners. Shifting down on that page of the rollover revenue table. First quarter 2025 column subtotal is around $80 million and $92 million before divestitures. These numbers are consistent with our March IR Day expectations. Looking forward, the pinkish columns to the right include estimated revenues for brokerage M&A closed through yesterday. And just a reminder, you’ll make a pick – that you’ll need to make a pick for future M&A. Then below that table, we have a separate section for AssuredPartners. We show you what we expect for monthly pro forma revenues in purple. And then finally, continuing down on the page, you’ll see the Risk Management segment rollover revenues too. So moving to cash, capital management and M&A funding. We had no outstanding borrowings on our line of credit at March 31. And you might have seen that in early April, we amended our credit agreement. We extended the maturity date to April of 2030 and also increased our borrowing capacity from $1.7 billion to $2.5 billion. Our current cash position, potential borrowing capacity and strong expected free cash flow position us well for our pipeline of M&A opportunities. So even after the $13.5 billion for Assured paying for Woodruff and paying for the Willis Re earn-out, and after the other 11 deals we’ve already done through Q1, we still have over $2 billion of M&A capacity here in 2025 and another $5 billion of capacity in 2026 before using any stock. So our M&A strategy has a tremendous runway. So another excellent quarter in the books. As we look ahead, we see strong organic growth, a terrific M&A pipeline. We continue to see opportunities to improve our productivity and quality. And as Pat said, we have a winning culture. So it looks like we’re well on track for another great year. Back to you, Pat.
J. Patrick Gallagher, Jr.: Thanks, Doug. Operator, I think we’re ready to go to questions-and-answers.
Operator: Thank you. [Operator Instructions] Our first questions come from the line of Elyse Greenspan with Wells Fargo. Please proceed with your question.
Elyse Greenspan: Hi. Thanks. Good evening. My first question, I wanted to start with the pretty impressive 20% growth that you guys saw in reinsurance. Can you just try to break that down between what’s coming from pricing, retention, new demand? And then if you could give us a sense like if it’s new-new or if it’s business that you’re taking from peers? Because it’s a pretty strong number.
J. Patrick Gallagher, Jr.: Well, thanks, Elyse. And let me try to break down some of the 20% organic. First, the reinsurance folks, they’re just on fire. They had a great quarter and a lot of it came with the January 1 renewals. So let me break down three pieces. Our new business spread was responsible for more than half the organic this quarter. In fact, we had about 15 new client wins with more than $1 million each. These are big chunky deals. This is not similar to what we do on the retail side. Increased renewal premiums from carrier growth was another 5% or so, inflation, people buying more cover, as you see some rates come down, people have some room for additional cover, et cetera. And the remainder was some favorable timing. We have now better insights into it. And as I noted, it will reverse itself in the latter half of the year. But let me be clear, we said from the very beginning that we thought this was a group of folks that when working with our overall company when we integrated them into working with retail and our wholesale and specialty people, that it would be a good match. And that’s what we’re seeing. These guys and gals are just doing a tremendous job, and the new business was outstanding. Congratulations to them.
Elyse Greenspan: That’s great. And then my second question, so it sounds like you guys are still working, I guess, not a lot to update, as you said, like working on a response to the DOJ. So is that something, I guess, you guys would expect to respond? I think there’s like a 30-day clock once that happens. Is that something that, based on the timeline of a Q4 close, Doug, is that – would you expect to just respond to comments, I guess, that would be something that would happen in the Q2? Is that your expectation?
Doug Howell: All right. We’re obviously putting together all the information that’s been requested. And we’re working hard on it both on our side and then the AP team is doing the same thing. We’ll get that over to them sometime in mid-third quarter. And then it does start a clock tick, you may have the right to ask some questions. But there is a process here. First, getting that over, certifying to it and then they’ll have 30 days to get back to us on that.
Elyse Greenspan: Okay. And then I just – you mentioned that there was, I guess, some timing that impacted on the first quarter, some kind of – was it a pull forward from other quarters? I think it was 1% and then there was also going to be an impact in Q2.
Doug Howell: Yes. All right. So let’s go through that a little bit because I think it’s a good question. First, it doesn’t do anything to full year. Second, we’re just getting some better insights into the development of revenues. We’ve implemented our new reinsurance system last fall. So that’s up and running. We’ve got a new benefit system. So those systems help us look into the treaties and then to the expected headcount in our benefits business. So while the timing this quarter was mostly in reinsurance, let’s call that about two thirds, and the other one third is across our benefits business and a little bit in the specialty business. But without this timing, the first quarter for reinsurance was still in the upper teens, and it impacted specialty and benefits each about a point. But we’re going to have a little bit of that again in the second quarter, but to a lesser magnitude. And then again, the timing will reverse itself compared to last year in the third and fourth quarters. So no impact for full year organic. And we would say that this is the result of just putting in new systems and be able to make better estimates earlier on in the year.
Elyse Greenspan: Thank you.
Doug Howell: Thanks, Elyse.
Operator: Thank you. Our next questions come from the line of Greg Peters with Raymond James. Please proceed with your question.
Greg Peters: Good afternoon.
J. Patrick Gallagher, Jr.: Hi, Greg.
Greg Peters: Hi. So Pat, in your comments, I think it was – yes, Pat, it was you, that talked about the bifurcation of renewal pricing in the small to mid accounts, which was you defined as less than $100,000, and then the mid to large account. Just wondering if you could provide some more color, because the commentary we’re hearing in the marketplace around that seems to suggest that the larger account business might be under a little bit more rate pressure, specifically in the property areas.
J. Patrick Gallagher, Jr.: Well, that’s exactly what I said, Greg. I mean, I think we’re seeing in the large account area, and it’s the typical economics. You’ve got a bigger account, you got more swag, right? You can get a better deal. Especially if you’ve got good results. And these larger accounts are better managed from a risk management standpoint, and they’re seeing the results of that. Our people are clearly helping with that. You get down into the smaller accounts, all the way down to your personal lines, you don’t have the negotiating power. And at the same time, they don’t have the great results. So it’s a fluid market, but it makes sense to me that, if you’re bigger, you get a little bit better deal than if you’re smaller.
Doug Howell: Yes, it’s pretty linear too, Greg. If you look at, let’s say, over 100, we said it’s up a point or so or something like that. But when you go to like $25,000 to $100,000, maybe it’s 3.5%, 4%, you get a little lower than that $10,000 to $25,000 account, maybe you’re getting in the mid-4s. And then when you get less than $10,000 as that account size, now this is for premiums, you’re seeing it being up in the mid-5s. So it’s consistent even within that under $100,000 million, that the smaller it gets, the higher the rate increases. We saw that not going up as fast on the other side too, when rates were going up. So I don’t know if it’s as much they’re just a reversion to the mean, also that the smaller accounts are catching up.
Greg Peters: That makes sense. For my second question, my follow-up question, I’m going to pivot back to the pending acquisition of AssuredPartners. This has been – you’ve obviously been working very closely with them for the last several months now and trying to get this to the finish line. And I know you were pretty forthcoming with details about how you expected margin improvement to materialize and retention and organic revenue growth to develop. And I’m just curious, now that we’re here in May, if you have a different perspective or if there’s any different changes you have on the views on the opportunity with AssuredPartners for all of the areas I mentioned.
J. Patrick Gallagher, Jr.: Well, thank you for the question, Greg. But I’ll tell you, it’s actually gotten stronger. I mean we did our Board meeting this week, and that was, of course, one of the key questions. Their turnover is actually better than ours, not by a lot, by maybe 0.5 point to a point. So they’re staying very consistent with what they’ve had in the past. And that’s after bonuses have been paid, so we’re not seeing an uptick. I said, when we did the deal, I didn’t expect any breakage. We’ve seen a producer here or there depart, but that’s common business across all of our platforms. In terms of the people, we’ve had to be careful given the request for another bit of information, but there are certain work streams that have been allowed to continue. And I’ll tell you what, just every single day, our people are more affirmed than the fact that they’re dealing with folks that they really like. They understand the business. They love the business. And they can’t wait to get the two organizations together. There’s no waffling, there’s no momma crying. It’s people that just want to go out and sell a lot of insurance. And we’re very, very – more excited than we were in January.
Greg Peters: Got it. Just a detail question on that. Is the organic profile at Assured based on what you’ve seen just similar to what you’re seeing inside your retail business?
Doug Howell: Yes.
Greg Peters: Perfect.
Doug Howell: Yes. I mean they account for 606 [ph] differently, but let’s just say it is. You can throw a hat over them.
Greg Peters: Perfect. Thank you.
J. Patrick Gallagher, Jr.: Thanks, Greg.
Operator: Thank you. Our next questions come from the line of Mike Zaremski with BMO Capital Markets. Please proceed with your questions.
Mike Zaremski: Thanks. Good evening. Doug, the – or I think Pat might pull this too, the one point of timing benefit in Brokerage organic, is that in addition to the $26 million reversal on Page 6 of the CFO commentary, which I’ll admit is kind of over my head, in terms of its explanation?
Doug Howell: Yes. I think you’re calling out the fact last year – and we highlighted it last year, there was a gross up of revenues and a gross up of expenses as we implemented our conforming accounting policies on some historical acquisitions that caused the gross up. So we didn’t take credit for the $26 million as revenue last year and so we shouldn’t be measured by that again this year. So it’s just if you gross up the revenues, you gross up the comp on the revenues and a lot of those revenues triggered some extra earn-outs on it, it all washed to nothing. And we did talk about it last year, but it kind of sticks out a little bit more now, you can see that we repeated the note about that, on Page 6, I think it’s in the third footnote – or second or third footnote there. So it’s – we’re levelizing for a change in purchase accounting, which I think is 100% appropriate.
Mike Zaremski: Okay. Got it. I’ll make sure to go through that. Switching gears a bit, a question on also Brokerage organic. The RPC stat that you began giving out in recent years, which is helpful, I think it was 4% this past quarter. And organic, obviously tremendous, five-plus points above that. But if we look kind of going back a few years that you disclosed RPC – it’s much – the gap between organic and RPC is much narrower. Curious, should the gap stay wider than historical kind of implied by your guidance? And maybe part of the reason is reinsurance isn’t included in RPC. But any – am I asking a question you think is fair?
J. Patrick Gallagher, Jr.: It’s a fair question, Mike, but here are a couple of things. We were a different company than we were then. And number one, we’ve got many more large accounts. Our large account penetration continues to grow every month, and a lot of that business is on fees. Then also, when you take a look at the business and how we’re selling it, I think that we’re better sellers today. We’ve got tools that are just unbelievable in terms of helping our producers get out and drive new business, whether it be what we call Gallagher Win [ph], which is sales force, and then you’ve got the data analytics and Gallagher Drive, which I think most of you have seen these tools, we presented them to you. And they’re maturing now. They’re in the hands of solid producers that have got – any time the market is in flux. That’s great news for our producers up and down. And frankly, right now, it’s a great time and it’s a great message for our client base and our prospect base work with Gallagher. And we think we’ve got an opportunity to really do a great job on your pricing as well as your coverage and your terms. So we’re a different company, better opportunities, more fee business, larger platform, stronger players.
Mike Zaremski: Okay. That makes sense. If I could just sneak one last one, a follow-up in. You said that you’ll respond to the, I guess, government about the Assured data request in a number of months. Any color on why this data request would take such a long time to...
J. Patrick Gallagher, Jr.: I’ll give you one bit of color, Mike. We’re not talking a lot about this. That’s intentional. It’s a lot of data from both parties.
Mike Zaremski: Appreciate it, Pat.
J. Patrick Gallagher, Jr.: Sure, Mike.
Operator: Thank you. Our next questions come from the line of Mark Hughes with Truist Securities. Please proceed with your questions.
Mark Hughes: Yes, thank you. Good afternoon.
J. Patrick Gallagher, Jr.: Hey, Mark.
Mark Hughes: Pat, if I heard you properly, you said the workers’ comp up 5% versus I think it was up 1% last quarter. Is there something going on there or?
J. Patrick Gallagher, Jr.: Not really. I mean, we did actually plum for that among our Gallagher Bassett’s biggest line of covers, of course, is comp. We were asking ourselves, is there any systemic change there? We don’t see it most of comp is fee scheduled stuff. So I think it’s underlying comp costs are up with medical. But I also do think it’s a better economy than I think people are writing about. Our daily check-in on the economy is that our middle market accounts, in particular, are pretty robust.
Doug Howell: Yes. We’re still seeing good employment growth in those folks. We are – I think there is starting to be more chatter around medical inflation. So there could be some proactiveness there by the carriers on that in order to make sure they stay ahead of it. So it’s not a huge portion of our book really, but it is an interesting uptick that is – remember, that’s both rate and exposure. So it’s moving north and our educated guess is more exposure and higher medical inflation.
Mark Hughes: And then on the property market, Pat, what’s your sense of how this thing plays out? Obviously, it’s sensitive to cat losses. So a lot of it depends. But in your experience where you’ve had kind of a run-up and then you start to see it turn back a little bit, how is this going to work over the next few quarters, couple of years?
J. Patrick Gallagher, Jr.: Well, again, Mark, let me go back in my history, which is a long one now. The property markets, I would define it as fragile, right? When you’re minting money, it’s a great place to be. And of course, you’re going to give customers back some of the money you’ve made. But boy, the bill comes hard when it comes, and it’s not gradual. And so it just seems that we’re all concerned. In fact, you might recall a year ago or so, we surveyed over 1,000 of our customers, middle market customers, their number one concern was weather-related, climate change. And I think we all see it. We never had tornadoes in the fall. These convective storms have got every scratching their head. The prediction for the hurricane season is more storms than normal. Last year, there was that prediction as well, and it wasn’t as severe. But I’ll tell you, whoever saw California wildfire is coming, you combine those with some storms, both in California and around the world – well, the thing about property is it can change on a dime. Now we certainly hope that doesn’t happen because our customers have been shocked. You know how I feel about hard markets. I’d much rather have a market that’s pretty stable, lets us show our tools, help us contain the cost for our clients. It’s hard to explain to people why rates are jumping. You can do it in property because you can show them the losses. But I think you’re right to ask the question. It’s all well and good now. I think customers deserve a bit of a decrease. Carriers are on a little bit of an edge, if you will. They know they’ve got to give some money back. The market is competitive, but if the wind blows, the story could change very quickly.
Mark Hughes: Very good. Well, everything – it’s definitely crazy out there with the Cubs [ph] in first place. I’m with you.
J. Patrick Gallagher, Jr.: No, Mark. That’s the new normal.
Mark Hughes: Okay. All right. Thank you.
J. Patrick Gallagher, Jr.: We waited 100 years. Some people have a bad decade. We had a bad century. We’re back for good.
Mark Hughes: All right.
J. Patrick Gallagher, Jr.: Thanks, Mark.
Operator: Thank you. Thank you. Our next questions come from the line of David Motemaden with Evercore ISI. Please proceed with your questions.
David Motemaden: Hey, good evening.
J. Patrick Gallagher, Jr.: Hey, David.
David Motemaden: My question, I missed it, just on the RPC for this quarter. I think you had said it was 5% last quarter. It was trending around 4% in the first two months of the quarter, this 1Q. Where did that end up for 1Q? And within your outlook, what are you guys assuming for the rest of the year?
Doug Howell: So let me see if I can break that apart. What’s your question? You want to know what the renewal premium change was in the first quarter and what our outlook is for the rest of the year? Is that the question?
David Motemaden: Yes. What’s embedded in the outlook that you gave – the organic cadence that you gave?
Doug Howell: Basically about the same. We don’t see a further – property down 2%, call it flat. The casualty rates, we’ve had a lot of quarters on casualty rates as I look across the grid here, consistently in that 8% – 7%, 8%, 10%, 9%, 9%, 9%, 10% as I look at casualty rates coming across. So I think there’s still some concerns over casualty on that. So our outlook as we shape our organic for the rest of the year is assuming similar to what we saw right now, or this quarter.
J. Patrick Gallagher, Jr.: David, back to Mark’s comments before about a long time to look back. In my past experience, when markets became a little squishy, you’d see them fall quite dramatically across all lines. That is not what we’re seeing today. Umbrella cover up this past quarter 11%. Continuing push up of casualty. A little bit down on property. As we said in our opening remarks, this is a pretty logical market. So I don’t think you’re going to see any major change. And if we do, we’ll give it to you at our IR Day updates.
David Motemaden: Got it. Thank you. And then I guess I’m also wondering that difference between the middle market and large account. I guess I’m wondering just I know that there’s typically, the large account business is more cyclical and you guys are underweight that. But outside of that, when you look at your middle-market property book and small market property book, would you say that’s more SCS exposed and, therefore, the pricing might be a little bit more durable there? Or is that just – is that not the right way to think about it?
J. Patrick Gallagher, Jr.: I don’t like to think about it that way. And I’ll tell you why. Convective storms are – they seem to be localized in the Midwest. You got fire risk in lots of states I never thought of before, like New Jersey. But I don’t think that’s necessarily something you’d say is more akin to hurting those accounts, although you have to say there are a heck of a lot more small accounts than there are large accounts. There was 1,000 Fortune 1000 accounts. There’s 1,000 small accounts in Schaumburg. So I guess, in one sense, I’d argue, no, I don’t think those storms fall necessarily harder on one book of business than another, except by virtue of the fact that the numbers are just greater. I think it’s buying power. That’s what I’d say, David. It’s just real simple. If I get an account that’s going to pay me $100,000 or an account that’s going to pay me $100 million, who gets a better deal? $100 million.
David Motemaden: Yes. No, that makes sense. And then lastly so I might be nitpicking here, but I think you guys have called out 5% organic in U.S. retail and it sounds like that was maybe a little bit lighter than what you guys were talking about in March. I think you guys were saying 6%. Was there anything behind that outside of just the general RPC trends that we spoke about?
Doug Howell: Listen, I think that when you get down to a point one way or another on the organic, I would say they’re almost the same number. There could be a mix difference in there. When something moves a point, I’ll be honest, we don’t dig into it as deeply if something moves five points. So the point is consider it mix, but still, the point is on this is it’s still going up. And if you look across everything that we’ve said is we still have a market that is arguably flat in a couple of spots and going up in a lot of spots, right? So I think that the fact is there still is a need for rate. The carriers see that, you’ve seen that in the releases that they’ve had. And so I think that you blend all that together, we’re selling more than we’re losing, and we feel pretty good about a 6% to 8% year, that would be a terrific five- or six-year run on that.
David Motemaden: No, I definitely agree. Thank you.
J. Patrick Gallagher, Jr.: Thanks David.
Operator: Thank you. [Operator Instructions] Our next questions come from the line of Katie Sakys with Autonomous Research. Please proceed with your questions.
Katie Sakys: Hi, thank you. I guess my first question, I wanted to go back to Doug’s comments on the cadence of Brokerage organic growth that you expect to see for 2Q, 3Q and 4Q? Back-of-the-envelope math, I’m kind of getting to the midpoint of the 6% to 8% full year guide. Which of those quarters, Doug, do you kind of see the most potential to upside versus your current estimates right now? And how does seasonality perhaps inform that view?
Doug Howell: I think the upside could come in the fourth quarter. I think if we have a storm season, and like Pat said, the property shifts, I also still believe that there’s going to be development issues, as you get into your third quarter actuarial reserves as they start to do their third quarter views of how they feel their development is. When it goes from a – into a paid loss triangle versus an incurred loss triangle, you kind of wake up to that when you do your actuarial reviews in the third quarter. So fourth quarter is probably the quarter where there’s the most upside.
Katie Sakys: Great. Super helpful. And then I apologize if this next question is a little bit nitpicky, but I noticed in the CFO commentary that the average EBITDAC multiple that you guys paid for your tuck-ins this quarter was slightly elevated at 11.5x versus the 10x to 11x guide. Is that just a result of some noise from one-off transactions? Or is there any additional color that we should be aware of there?
Doug Howell: If I peel apart the 11 that we closed in the quarter, I don’t see anybody really off the map on that. So being 10x to 11x is still pretty close, so.
Katie Sakys: Thank you.
J. Patrick Gallagher, Jr.: Thanks, Katie.
Operator: Thank you. Our next questions come from the line of Andrew Andersen with Jefferies. Please proceed with your questions.
Andrew Andersen: Hey, good afternoon. The supplemental commissions within Brokerage were pretty strong. Was there any timing benefit there? And just maybe more broadly, could you talk about how you’re thinking about that those line items, the contingents and supplementals?
Doug Howell: All right. So supplementals in the first quarter. We’ve had some pretty good work as we start to negotiate contracts for the coming year. I think the team has done a good job of getting more carrier relationships under our supplemental. So I wouldn’t say that there’s anything systemic there. Maybe there’s a couple of million flip between contingent and supplemental, but that carriers switch back and forth between those.
J. Patrick Gallagher, Jr.: They’re still, by and large, volume-based. Volumes up, things are good.
Andrew Andersen: Got it. And then just within specialty, could you maybe talk about the growth difference between open brokerage and MGA? And I suppose where I’m going with this is, I’m not sure if the MGAs are kind of weighted to property. But if we’re seeing some compression in property rate, could that impact your MGA growth in the back half of the year?
Doug Howell: Our binding business had a terrific quarter. I think they’re in the mid-teens. The Brokerage business was probably 5% to 6%, something like that. So I think between the two, Brokerage and binding, our affinity business had a terrific quarter. Captives were a little slow this quarter. But by and large, the binding business did a really great job. And the open brokerage is still continuing to show really, really nice mid-single-digit growth.
Andrew Andersen: Thank you.
J. Patrick Gallagher, Jr.: Thanks, Andrew.
Operator: Thank you. Our next questions come from the line of Meyer Shields with KBW. Please proceed with your questions.
Meyer Shields: Great. Thanks so much. Two big picture questions, if I can. First, if my memory is correct then, one of the benefits you were talking about when you bought Gallagher Re was that you could introduce reinsurance brokerage capabilities to all of the carriers that you place business with. And I’m wondering whether the 20% organic growth that you had in the first quarter, does any – is that still a factor? Or has that played out and this is just the execution of the current team?
J. Patrick Gallagher, Jr.: No, that’s a big factor. And that’s 15 deals. Again, we’re not getting granular as to who, what, where and when. But that’s exactly what we talked about. It’s coming out the way we dreamed it. These people are working together. We’ve introduced them to some other players that they didn’t know. They’ve introduced us to plenty of players we didn’t know. The cross-pollinization both in what we’re doing in retail and things like pools and what they’re doing with carriers that we didn’t know about has been very good for our retail team. And of course, we’ve got deep relations with carriers across the board that all of us at this table have traded with for years. And it’s not – it’s just really been a very positive development in our repertoire.
Doug Howell: Listen, in our culture, the fact that people run together to help each other, we’re really seeing that. We’re seeing a lot of joint meetings between our retail folks, our wholesale folks, our reinsurers. I just spent a week in London, and all the opportunities that we have with MGAs and capital formation using the reinsurance opportunities, I think we’re just scratching the surface of what Gallagher Re will bring to us.
Meyer Shields: Okay. That’s very helpful. The second question, I’m just trying to put this together in my head. You’ve got more leverage with the big accounts because they’ve got more swag, I think that’s the way Pat put it. On the other hand, there’s a higher propensity towards fees there. So overall, is the larger account business more or less sensitive, from your perspective, the revenue growth more or less sensitive to the cycle than in small and mid?
J. Patrick Gallagher, Jr.: It’s probably less because we’re on fees. I mean, that’s – there’s no question about that. And the nice thing about a fee account in a softening market is that you don’t get asked to take a pay cut for doing a better job.
Meyer Shields: Okay. Thank you.
J. Patrick Gallagher, Jr.: Thanks, Meyer.
Operator: Thank you. Our last question will come from the line of Cave Montazeri with Deutsche Bank. Please proceed with your questions.
Cave Montazeri: Thank you. I know you guys have a pretty good real-time pulse on the economy. Earlier in your prepared remarks, you mentioned the U.S. labor market was still strong. But just wondering in your conversations with clients, especially the middle market clients, what are they staying on the impact of tariffs on their business?
J. Patrick Gallagher, Jr.: I think that you’ve read all the stuff, Cave, that there is out there. I mean everybody’s got questions, and it’s too – it’s very client specific. What business are you in? Where does your product mix come from? What’s your supply chain? Is it something that you can change one way or another? How do your clients feel about it? The good news for us is that any time there’s consternation, anytime there’s change, anytime there’s concern, we’re there to help them through it. So if, in fact, tariffs create some additional loss costs or some additional value increases, there’s ways to mitigate that, whether we move towards a captive, higher retentions, change the language, et cetera, et cetera. But there’s concern as to what it means to them as individuals. And I’d say that’s much more pronounced in the middle and small cap market.
Cave Montazeri: Makes sense. My follow-up is on your international organic growth. I think you mentioned 4% if I remember correctly, I guess it’s not a bad number in absolute terms, but it is a bit of a drag on the overall brokerage organic. Could you give us a bit of maybe regional color on what you’re seeing internationally? Maybe like some regions being better than others?
Doug Howell: Yes. Cave, it’s a flat market. Australia and New Zealand first quarter is very slow because of their heavy periods are in the summer. The UK retail is hanging in there, kind of similar to our retail. So if you’re thinking about maybe a – call Canada flat and the rest of them maybe 5% to 6%...
J. Patrick Gallagher, Jr.: And remember, nowhere in the world has our casualty book. Nobody’s got our tort system. So we are seeing pressure on casualty rates and carriers are seeing pressure on their past casualty years.
Cave Montazeri: Yes, that makes sense. And if I could squeeze one more in on the topic of international, like from an M&A inorganic growth point of view, internationally, like where is your appetite geographically, where you think there’s going to be good opportunities to grow in the future?
J. Patrick Gallagher, Jr.: Well, first of all, we now trade extensively throughout the world. As we said in our prepared comments, there’s not an account anywhere in the world we can’t do, of any size. But if you take a look at premium, written premium, that’s the ball we’re following.
Cave Montazeri: Thank you.
J. Patrick Gallagher, Jr.: Thanks, Cave. Well, thank you, everyone, for joining us this afternoon. We had a great first quarter and a great kickoff to 2025. It’s important that we think the 57,000 colleagues around the globe for doing the work that creates these results. Their creativity, dedication and unwavering client focus is what really makes these results. Thank you all, and have a great evening.
Operator: Thank you. This does conclude today’s teleconference. We appreciate your participation. You may disconnect your lines at this time. Enjoy the rest of your night. | [
{
"speaker": "Operator",
"text": "Good afternoon, and welcome to Arthur J. Gallagher & Company’s First Quarter 2025 Earnings Conference Call. Participants have been placed on a listen-only mode. The lines will be open for questions following the presentation. Today’s call is being recorded. If you have any objections, you may disconnect at this time. Some of the comments made during this conference call, including answers given in response to questions, may constitute forward-looking statements within the meaning of the securities laws. The company does not assume any obligation to update information or forward-looking statements provided on this call. These forward-looking statements are subject to risks and uncertainties that can cause actual results to differ materially. Please refer to the information concerning forward-looking statements and Risk Factors sections contained in the company’s most recent 10-K, 10-Q and 8-K filings for more details on such risks and uncertainties. In addition, for reconciliations of non-GAAP measures discussed on this call as well as other information regarding these measures, please refer to the earnings release and other materials in the Investor Relations section of the company’s website. It is now my pleasure to introduce J. Patrick Gallagher, Jr., Chairman and CEO of Arthur J. Gallagher & Company. Mr. Gallagher, you may begin."
},
{
"speaker": "J. Patrick Gallagher, Jr.",
"text": "Thank you. Good afternoon and thank you for joining us for our first quarter 2025 earnings call. On the call with me today is Doug Howell, our CFO; and other members of our management team. We had a fantastic first quarter. For our combined Brokerage and Risk Management segments, we posted 14% growth in revenue, 9% organic growth, reported net earnings margin of 23%, adjusted EBITDAC margin of 41.1%, up 338 basis points year-over-year, adjusted EBITDAC growth of 26%, our 20th consecutive quarter of double-digit growth, GAAP earnings per share of $3.29 and adjusted earnings per share of $4.16. Another excellent quarter by the team. Moving to results on a segment basis, starting with the Brokerage segment. Reported revenue growth was 16%. Organic growth was 9.5%, which included about 1 point of favorable timing. Even without the timing impact, all-in organic was right in line with our expectations. Adjusted EBITDAC margin expanded 359 basis points to 43.4%, with underlying margins up a full percentage point. Doug will unpack this in his comments. Let me provide you with some insights behind our Brokerage segment organic. Within our retail P/C operations, we delivered 5% organic overall. U.S. organic was north of 5%, while our international operations, primarily in the UK, Canada, Australia and New Zealand, were closer to 4%. Our global employee benefit brokerage and consulting business posted organic of more than 7%. Shifting to our reinsurance, wholesale and specialty businesses, in total, organic of 13%. This includes 20% organic from Gallagher Re and 8% organic from our wholesale and specialty businesses. So we continue to report strong growth across retail P/C, wholesale, reinsurance and benefits. Next, let me provide some thoughts on the P/C insurance pricing environment, starting with the primary insurance market. Overall, the global P/C insurance market continues to behave rationally with carriers looking to grow in lines and geographies where there’s an acceptable return, and seeking rate increases where it’s needed to generate an appropriate underwriting profit. Breaking down first quarter global renewal premium changes by product line, we saw the following: property down 2%, D&O down 3%, workers’ comp up 5%, personal lines up 8%, casualty lines up 8% overall, including general liability up 5%, commercial auto up 6% and umbrella up 11%. Breaking down renewal premiums by client size, we continue to see a divergence between small to midsize accounts and large accounts. For small to midsize accounts, which we define as accounts generating less than $100,000 of revenue, renewal premiums were up 5%. For large accounts, our clients generating more than $100,000 of revenue, renewal premiums were up 1%. All that said, pricing is ultimately driven by client loss experience. Good accounts are getting some premium relief in certain lines. However, accounts with poor experience are seeing greater increases. Having a trusted adviser like Gallagher can help businesses navigate a complex insurance and economic backdrop by finding the best coverage for our clients while mitigating price increases, today’s environment is the ideal market for us to show our expertise, product knowledge and our data-driven capabilities. Let me move to the reinsurance market. First quarter dynamics, which is mostly influenced by January 1 renewals, reflected an environment that generally favored reinsurance buyers. Overall, reinsurers were able to meet increased client demand with sufficient capacity while remaining disciplined on terms. The Gallagher Re team shined with excellent retention and some fantastic new business wins. April renewals experienced similar trading conditions as earlier in the year, and as expected, saw a bit more downward pricing pressure. The January wildfire losses and continued casualty reserve increases remain a focus for the industry. But neither caused much upward movement in pricing given the large proportion of Japanese buyers in April. With that said, U.S. severe convective storm season is here, which then leads us to U.S. wind season. Time will tell how the year plays out. Regardless, Gallagher Re should continue to excel in this environment. Moving to some comments on our customers’ business activity. During the first quarter, our daily revenue indications from audits, endorsements and cancellations continued to be a net positive. While the upward revenue adjustments are not quite as high as last year, we continue to see solid client business activity and no signs of a meaningful global economic slowdown. Our daily revenue indications through the end of April are not showing any significant changes in our customers’ business activity from the prospect of tariffs. Our daily indications have historically given us some early insights into our clients’ business activity, so we will continue to watch these very carefully. We are also closely watching the U.S. labor market. And there continues to be a strong demand for new workers. The number of open jobs in the U.S. stood at more than 7 million, still at a level that is well above the number of unemployed people looking for work. We’ve also seen recent health insurance carry results show continued increases in the utilization and cost of health care. With these two trends as the backdrop, we are seeing more and more employers looking for ways to grow their workforce and control their benefit costs. Our experts can provide creative solutions to solve these challenges. Regardless of market and economic conditions, I believe we are well positioned to compete and to win. From our niche expertise, outstanding service or extensive data and analytics offerings, we have the resources and know-how to service any account of any size, of any complexity anywhere around the globe. So with a fantastic first quarter behind us, we continue to see full year 2025 Brokerage segment organic in the 6% to 8% range. Moving on to our Risk Management segment, Gallagher Bassett. First quarter revenue growth was 6%, including organic of about 4%. We continue to see excellent client retention and strong new business production. However, sold new business within the Risk Management segment typically takes longer to materialize into revenue. As these new client contracts incept and begin to generate revenue in the coming months, we are confident we will see stronger revenue growth in the second half of the year. Adjusted EBITDAC margin was 20.5%, in line with our March expectations. Looking ahead, we still see full year 2025 organic in that 6% to 8% range and margins around 20.5%. Shifting to mergers and acquisitions. During the first quarter, we completed 11 new tuck-in mergers, representing around $100 million of estimated annualized revenue. We also announced the acquisition of Woodruff Sawyer during the quarter and completed that in early April. That means through today, we already are at $400 million of acquired revenue. For those new partners joining us, I’d like to extend a very warm welcome to the Gallagher family of professionals. As for the pending AssuredPartners acquisition, not much to update relative to our March IR Day comments, we are working to respond to the second request. And we still expect to close in the second half of 2025. Looking at our pipeline, we have more than 40 term sheets signed or being prepared, representing north of $450 million of annualized revenue. Good firms always have a choice, and it would be terrific if they chose to partner with Gallagher. I’ll conclude with some comments about our bedrock Gallagher culture. During our Global Sales Award meeting in early March, our unique Gallagher culture was on full display. It was inspiring to watch the interactions among thousands of our colleagues across geographies, business units and product lines. I came away even more convinced that our greatest asset is our people and our biggest differentiator is our culture. And that is the Gallagher way. Okay. I’ll stop now and turn it over to Doug. Doug?"
},
{
"speaker": "Doug Howell",
"text": "Thanks, Pat, and hello, everyone. Today I’ll walk you through our earnings release, starting with some comments on first quarter organic growth and margins by segment, including how we are seeing these shape up for the full year 2025. Next, I’ll move to the CFO commentary document that we posted on our IR website and walk you through our typical modeling helpers. And then I’ll conclude my prepared remarks with my usual comments on cash, M&A and capital management. Okay. Let’s flip to Page 2 of the earnings release. Headline, Brokerage segment organic growth of 9.5% was a great quarter and it helps our – and it helps bolster our view that full year organic will be in that 6% to 8% range. And that range is in line with what we’ve been saying all year. As Pat mentioned, first quarter did have some favorable timing of about 1 point. So looking forward, we see some favorable timing again in the second quarter, but not to the same magnitude. And then all of the first half timing will reverse itself in the third and fourth quarters with no impact on full year 2025. So as we look through to the rest of the year, second quarter might be more like 6% to 7%. Then we will see the timing slip in the third and fourth quarters might mean third and fourth quarter organic of about 5% each. Causes a low noise across the quarters, but with a 9.5% first quarter, the math gets us back to a full year 2025 organic in that 6% to 8% range. That would be a terrific year. So flipping now to Page 4 of the earnings release, to the Brokerage segment adjusted EBITDAC table. First quarter adjusted EBITDAC margin was 43.4%, up 359 basis points year-over-year and above our March IR Day expectations. So let me walk you through a bridge from last year as we typically do. First, if we pull out last year’s 2024 first quarter earnings release, you would see we reported back then adjusted EBITDAC margin of 39.9%. But now I’m using current period FX rates that would have been 39.8%. Then organic growth of 9.5% gave us about 120 basis points of expansion this quarter. The roll-in impact of M&A and lower interest rates each used about 10 basis points of margin this quarter. Finally, as the footnote at the bottom of that table notes, the impact of interest income from the cash that we’re holding for the AssuredPartners acquisition adds us about 260 basis points of margin this quarter. Follow that bridge and it will get you to first quarter 2025 margin of 43.4%. That is really, really great work by the team. As for second quarter headline margin expansion, it’s still looking like we will be pushing around 300 basis points, again, driven by strong underlying margin expansion of approximately 60 to 80 basis points assuming organic in that 6% to 7% range and also interest income related to the cash we’re holding for AP plus a small offset by the roll-in of M&A and lower interest rates. Looking out towards the third quarter, we would still expect underlying margin expansion, and then we’ll also have the impact of investment income on the funds we’re holding for AP. So in total, think – we’re thinking expansion could be 250 to 280 basis points. This, of course, would change if we get AP closed before September 30. As for fourth quarter, we would hope we’d have AP closed, so we would have underlying margin expansion still, but lose the extra investment income, yet have AP’s fourth quarter results in our books. The punch line here is there’s nothing we’re seeing that causes us to change how we view underlying margin expansion potential. We believe at organic greater than 4%, we should see some underlying margin expansion. At 6% organic, maybe 60 basis points of expansion and at 8% organic, perhaps around 100 basis points of expansion. So again, there’s no new news here. We still believe we are positioned to expand underlying full year margins by about 60 to 100 basis points. Sticking on Page 4. Risk Management segment organic was 3.9%. That’s a bit below our 5% expectation due to lower new business revenue. As Pat mentioned, we expect this to improve in the second half of the year as we have already sold new contracts, but these have yet to start generating revenue. So we see organic moving back towards 6% to 8% throughout the year. Adjusted EBITDAC margin of 20.5% was in line with our March IR Day expectations. And looking forward, we still see full year margins again around 20.5%. Turning now to Page 6 of the earnings release and the Corporate segment shortcut table. For the adjusted interest in banking, clean energy and acquisition lines, all were very close to our March IR Day expectations. The corporate line was better than our March expectations due to some expense timing, a few favorable tax items, including the tax benefit from stock-based compensation, somewhat offset by an unrealized FX remeasurement loss. So now let’s move from the earnings release to the CFO commentary document that we posted on our website. First, as an overall statement, please read the headers and footnotes carefully on how these numbers in this document include or exclude the impact of AssuredPartners. That said, let’s flip to Page 3 and our modeling helpers across the board. First quarter 2025 actual numbers were fairly close to what we provided back in March. One thing to call out in our 2025 outlook are changes from FX for both the Brokerage and Risk Management segments. With the dollar weakening since mid-March, we have provided updated estimates for revenue and EPS impacts for the remainder of the year. Just take a look at the disclosures and refine your models. Turning now to Page 4 and the Corporate segment outlook for 2025. Within the corporate line of the Corporate segment, like I mentioned earlier, we had some favorable expense timing in the first quarter. So you’ll see some of that comes back over the rest of the year. We’ve increased after-tax expense by about $1 million per quarter for the remainder of 2025. However, the rest of our outlook for the Corporate segment is unchanged from six weeks ago. Flipping to Page 5 to our tax credit carryovers. A reminder – this is a reminder page, as of March 31, we have about $710 million of tax credits. We continue to expect additional cash flow of more than $180 million this year and even more in 2026 and later years. And don’t forget, this benefit will show up in our cash flow statement rather than our P&L. So it’s still a nice sweetener to fund a future M&A. Turning now to Page 6, the investment income table. We’ve updated our forecast to reflect current FX rates and changes in fiduciary cash balances. And you’ll see here that we’re still assuming two 25 basis point rate cuts during 2025. You’ll also see that we provided a separate line to show our estimates of interest income associated with the funds that we’re holding to pay for AssuredPartners. Shifting down on that page of the rollover revenue table. First quarter 2025 column subtotal is around $80 million and $92 million before divestitures. These numbers are consistent with our March IR Day expectations. Looking forward, the pinkish columns to the right include estimated revenues for brokerage M&A closed through yesterday. And just a reminder, you’ll make a pick – that you’ll need to make a pick for future M&A. Then below that table, we have a separate section for AssuredPartners. We show you what we expect for monthly pro forma revenues in purple. And then finally, continuing down on the page, you’ll see the Risk Management segment rollover revenues too. So moving to cash, capital management and M&A funding. We had no outstanding borrowings on our line of credit at March 31. And you might have seen that in early April, we amended our credit agreement. We extended the maturity date to April of 2030 and also increased our borrowing capacity from $1.7 billion to $2.5 billion. Our current cash position, potential borrowing capacity and strong expected free cash flow position us well for our pipeline of M&A opportunities. So even after the $13.5 billion for Assured paying for Woodruff and paying for the Willis Re earn-out, and after the other 11 deals we’ve already done through Q1, we still have over $2 billion of M&A capacity here in 2025 and another $5 billion of capacity in 2026 before using any stock. So our M&A strategy has a tremendous runway. So another excellent quarter in the books. As we look ahead, we see strong organic growth, a terrific M&A pipeline. We continue to see opportunities to improve our productivity and quality. And as Pat said, we have a winning culture. So it looks like we’re well on track for another great year. Back to you, Pat."
},
{
"speaker": "J. Patrick Gallagher, Jr.",
"text": "Thanks, Doug. Operator, I think we’re ready to go to questions-and-answers."
},
{
"speaker": "Operator",
"text": "Thank you. [Operator Instructions] Our first questions come from the line of Elyse Greenspan with Wells Fargo. Please proceed with your question."
},
{
"speaker": "Elyse Greenspan",
"text": "Hi. Thanks. Good evening. My first question, I wanted to start with the pretty impressive 20% growth that you guys saw in reinsurance. Can you just try to break that down between what’s coming from pricing, retention, new demand? And then if you could give us a sense like if it’s new-new or if it’s business that you’re taking from peers? Because it’s a pretty strong number."
},
{
"speaker": "J. Patrick Gallagher, Jr.",
"text": "Well, thanks, Elyse. And let me try to break down some of the 20% organic. First, the reinsurance folks, they’re just on fire. They had a great quarter and a lot of it came with the January 1 renewals. So let me break down three pieces. Our new business spread was responsible for more than half the organic this quarter. In fact, we had about 15 new client wins with more than $1 million each. These are big chunky deals. This is not similar to what we do on the retail side. Increased renewal premiums from carrier growth was another 5% or so, inflation, people buying more cover, as you see some rates come down, people have some room for additional cover, et cetera. And the remainder was some favorable timing. We have now better insights into it. And as I noted, it will reverse itself in the latter half of the year. But let me be clear, we said from the very beginning that we thought this was a group of folks that when working with our overall company when we integrated them into working with retail and our wholesale and specialty people, that it would be a good match. And that’s what we’re seeing. These guys and gals are just doing a tremendous job, and the new business was outstanding. Congratulations to them."
},
{
"speaker": "Elyse Greenspan",
"text": "That’s great. And then my second question, so it sounds like you guys are still working, I guess, not a lot to update, as you said, like working on a response to the DOJ. So is that something, I guess, you guys would expect to respond? I think there’s like a 30-day clock once that happens. Is that something that, based on the timeline of a Q4 close, Doug, is that – would you expect to just respond to comments, I guess, that would be something that would happen in the Q2? Is that your expectation?"
},
{
"speaker": "Doug Howell",
"text": "All right. We’re obviously putting together all the information that’s been requested. And we’re working hard on it both on our side and then the AP team is doing the same thing. We’ll get that over to them sometime in mid-third quarter. And then it does start a clock tick, you may have the right to ask some questions. But there is a process here. First, getting that over, certifying to it and then they’ll have 30 days to get back to us on that."
},
{
"speaker": "Elyse Greenspan",
"text": "Okay. And then I just – you mentioned that there was, I guess, some timing that impacted on the first quarter, some kind of – was it a pull forward from other quarters? I think it was 1% and then there was also going to be an impact in Q2."
},
{
"speaker": "Doug Howell",
"text": "Yes. All right. So let’s go through that a little bit because I think it’s a good question. First, it doesn’t do anything to full year. Second, we’re just getting some better insights into the development of revenues. We’ve implemented our new reinsurance system last fall. So that’s up and running. We’ve got a new benefit system. So those systems help us look into the treaties and then to the expected headcount in our benefits business. So while the timing this quarter was mostly in reinsurance, let’s call that about two thirds, and the other one third is across our benefits business and a little bit in the specialty business. But without this timing, the first quarter for reinsurance was still in the upper teens, and it impacted specialty and benefits each about a point. But we’re going to have a little bit of that again in the second quarter, but to a lesser magnitude. And then again, the timing will reverse itself compared to last year in the third and fourth quarters. So no impact for full year organic. And we would say that this is the result of just putting in new systems and be able to make better estimates earlier on in the year."
},
{
"speaker": "Elyse Greenspan",
"text": "Thank you."
},
{
"speaker": "Doug Howell",
"text": "Thanks, Elyse."
},
{
"speaker": "Operator",
"text": "Thank you. Our next questions come from the line of Greg Peters with Raymond James. Please proceed with your question."
},
{
"speaker": "Greg Peters",
"text": "Good afternoon."
},
{
"speaker": "J. Patrick Gallagher, Jr.",
"text": "Hi, Greg."
},
{
"speaker": "Greg Peters",
"text": "Hi. So Pat, in your comments, I think it was – yes, Pat, it was you, that talked about the bifurcation of renewal pricing in the small to mid accounts, which was you defined as less than $100,000, and then the mid to large account. Just wondering if you could provide some more color, because the commentary we’re hearing in the marketplace around that seems to suggest that the larger account business might be under a little bit more rate pressure, specifically in the property areas."
},
{
"speaker": "J. Patrick Gallagher, Jr.",
"text": "Well, that’s exactly what I said, Greg. I mean, I think we’re seeing in the large account area, and it’s the typical economics. You’ve got a bigger account, you got more swag, right? You can get a better deal. Especially if you’ve got good results. And these larger accounts are better managed from a risk management standpoint, and they’re seeing the results of that. Our people are clearly helping with that. You get down into the smaller accounts, all the way down to your personal lines, you don’t have the negotiating power. And at the same time, they don’t have the great results. So it’s a fluid market, but it makes sense to me that, if you’re bigger, you get a little bit better deal than if you’re smaller."
},
{
"speaker": "Doug Howell",
"text": "Yes, it’s pretty linear too, Greg. If you look at, let’s say, over 100, we said it’s up a point or so or something like that. But when you go to like $25,000 to $100,000, maybe it’s 3.5%, 4%, you get a little lower than that $10,000 to $25,000 account, maybe you’re getting in the mid-4s. And then when you get less than $10,000 as that account size, now this is for premiums, you’re seeing it being up in the mid-5s. So it’s consistent even within that under $100,000 million, that the smaller it gets, the higher the rate increases. We saw that not going up as fast on the other side too, when rates were going up. So I don’t know if it’s as much they’re just a reversion to the mean, also that the smaller accounts are catching up."
},
{
"speaker": "Greg Peters",
"text": "That makes sense. For my second question, my follow-up question, I’m going to pivot back to the pending acquisition of AssuredPartners. This has been – you’ve obviously been working very closely with them for the last several months now and trying to get this to the finish line. And I know you were pretty forthcoming with details about how you expected margin improvement to materialize and retention and organic revenue growth to develop. And I’m just curious, now that we’re here in May, if you have a different perspective or if there’s any different changes you have on the views on the opportunity with AssuredPartners for all of the areas I mentioned."
},
{
"speaker": "J. Patrick Gallagher, Jr.",
"text": "Well, thank you for the question, Greg. But I’ll tell you, it’s actually gotten stronger. I mean we did our Board meeting this week, and that was, of course, one of the key questions. Their turnover is actually better than ours, not by a lot, by maybe 0.5 point to a point. So they’re staying very consistent with what they’ve had in the past. And that’s after bonuses have been paid, so we’re not seeing an uptick. I said, when we did the deal, I didn’t expect any breakage. We’ve seen a producer here or there depart, but that’s common business across all of our platforms. In terms of the people, we’ve had to be careful given the request for another bit of information, but there are certain work streams that have been allowed to continue. And I’ll tell you what, just every single day, our people are more affirmed than the fact that they’re dealing with folks that they really like. They understand the business. They love the business. And they can’t wait to get the two organizations together. There’s no waffling, there’s no momma crying. It’s people that just want to go out and sell a lot of insurance. And we’re very, very – more excited than we were in January."
},
{
"speaker": "Greg Peters",
"text": "Got it. Just a detail question on that. Is the organic profile at Assured based on what you’ve seen just similar to what you’re seeing inside your retail business?"
},
{
"speaker": "Doug Howell",
"text": "Yes."
},
{
"speaker": "Greg Peters",
"text": "Perfect."
},
{
"speaker": "Doug Howell",
"text": "Yes. I mean they account for 606 [ph] differently, but let’s just say it is. You can throw a hat over them."
},
{
"speaker": "Greg Peters",
"text": "Perfect. Thank you."
},
{
"speaker": "J. Patrick Gallagher, Jr.",
"text": "Thanks, Greg."
},
{
"speaker": "Operator",
"text": "Thank you. Our next questions come from the line of Mike Zaremski with BMO Capital Markets. Please proceed with your questions."
},
{
"speaker": "Mike Zaremski",
"text": "Thanks. Good evening. Doug, the – or I think Pat might pull this too, the one point of timing benefit in Brokerage organic, is that in addition to the $26 million reversal on Page 6 of the CFO commentary, which I’ll admit is kind of over my head, in terms of its explanation?"
},
{
"speaker": "Doug Howell",
"text": "Yes. I think you’re calling out the fact last year – and we highlighted it last year, there was a gross up of revenues and a gross up of expenses as we implemented our conforming accounting policies on some historical acquisitions that caused the gross up. So we didn’t take credit for the $26 million as revenue last year and so we shouldn’t be measured by that again this year. So it’s just if you gross up the revenues, you gross up the comp on the revenues and a lot of those revenues triggered some extra earn-outs on it, it all washed to nothing. And we did talk about it last year, but it kind of sticks out a little bit more now, you can see that we repeated the note about that, on Page 6, I think it’s in the third footnote – or second or third footnote there. So it’s – we’re levelizing for a change in purchase accounting, which I think is 100% appropriate."
},
{
"speaker": "Mike Zaremski",
"text": "Okay. Got it. I’ll make sure to go through that. Switching gears a bit, a question on also Brokerage organic. The RPC stat that you began giving out in recent years, which is helpful, I think it was 4% this past quarter. And organic, obviously tremendous, five-plus points above that. But if we look kind of going back a few years that you disclosed RPC – it’s much – the gap between organic and RPC is much narrower. Curious, should the gap stay wider than historical kind of implied by your guidance? And maybe part of the reason is reinsurance isn’t included in RPC. But any – am I asking a question you think is fair?"
},
{
"speaker": "J. Patrick Gallagher, Jr.",
"text": "It’s a fair question, Mike, but here are a couple of things. We were a different company than we were then. And number one, we’ve got many more large accounts. Our large account penetration continues to grow every month, and a lot of that business is on fees. Then also, when you take a look at the business and how we’re selling it, I think that we’re better sellers today. We’ve got tools that are just unbelievable in terms of helping our producers get out and drive new business, whether it be what we call Gallagher Win [ph], which is sales force, and then you’ve got the data analytics and Gallagher Drive, which I think most of you have seen these tools, we presented them to you. And they’re maturing now. They’re in the hands of solid producers that have got – any time the market is in flux. That’s great news for our producers up and down. And frankly, right now, it’s a great time and it’s a great message for our client base and our prospect base work with Gallagher. And we think we’ve got an opportunity to really do a great job on your pricing as well as your coverage and your terms. So we’re a different company, better opportunities, more fee business, larger platform, stronger players."
},
{
"speaker": "Mike Zaremski",
"text": "Okay. That makes sense. If I could just sneak one last one, a follow-up in. You said that you’ll respond to the, I guess, government about the Assured data request in a number of months. Any color on why this data request would take such a long time to..."
},
{
"speaker": "J. Patrick Gallagher, Jr.",
"text": "I’ll give you one bit of color, Mike. We’re not talking a lot about this. That’s intentional. It’s a lot of data from both parties."
},
{
"speaker": "Mike Zaremski",
"text": "Appreciate it, Pat."
},
{
"speaker": "J. Patrick Gallagher, Jr.",
"text": "Sure, Mike."
},
{
"speaker": "Operator",
"text": "Thank you. Our next questions come from the line of Mark Hughes with Truist Securities. Please proceed with your questions."
},
{
"speaker": "Mark Hughes",
"text": "Yes, thank you. Good afternoon."
},
{
"speaker": "J. Patrick Gallagher, Jr.",
"text": "Hey, Mark."
},
{
"speaker": "Mark Hughes",
"text": "Pat, if I heard you properly, you said the workers’ comp up 5% versus I think it was up 1% last quarter. Is there something going on there or?"
},
{
"speaker": "J. Patrick Gallagher, Jr.",
"text": "Not really. I mean, we did actually plum for that among our Gallagher Bassett’s biggest line of covers, of course, is comp. We were asking ourselves, is there any systemic change there? We don’t see it most of comp is fee scheduled stuff. So I think it’s underlying comp costs are up with medical. But I also do think it’s a better economy than I think people are writing about. Our daily check-in on the economy is that our middle market accounts, in particular, are pretty robust."
},
{
"speaker": "Doug Howell",
"text": "Yes. We’re still seeing good employment growth in those folks. We are – I think there is starting to be more chatter around medical inflation. So there could be some proactiveness there by the carriers on that in order to make sure they stay ahead of it. So it’s not a huge portion of our book really, but it is an interesting uptick that is – remember, that’s both rate and exposure. So it’s moving north and our educated guess is more exposure and higher medical inflation."
},
{
"speaker": "Mark Hughes",
"text": "And then on the property market, Pat, what’s your sense of how this thing plays out? Obviously, it’s sensitive to cat losses. So a lot of it depends. But in your experience where you’ve had kind of a run-up and then you start to see it turn back a little bit, how is this going to work over the next few quarters, couple of years?"
},
{
"speaker": "J. Patrick Gallagher, Jr.",
"text": "Well, again, Mark, let me go back in my history, which is a long one now. The property markets, I would define it as fragile, right? When you’re minting money, it’s a great place to be. And of course, you’re going to give customers back some of the money you’ve made. But boy, the bill comes hard when it comes, and it’s not gradual. And so it just seems that we’re all concerned. In fact, you might recall a year ago or so, we surveyed over 1,000 of our customers, middle market customers, their number one concern was weather-related, climate change. And I think we all see it. We never had tornadoes in the fall. These convective storms have got every scratching their head. The prediction for the hurricane season is more storms than normal. Last year, there was that prediction as well, and it wasn’t as severe. But I’ll tell you, whoever saw California wildfire is coming, you combine those with some storms, both in California and around the world – well, the thing about property is it can change on a dime. Now we certainly hope that doesn’t happen because our customers have been shocked. You know how I feel about hard markets. I’d much rather have a market that’s pretty stable, lets us show our tools, help us contain the cost for our clients. It’s hard to explain to people why rates are jumping. You can do it in property because you can show them the losses. But I think you’re right to ask the question. It’s all well and good now. I think customers deserve a bit of a decrease. Carriers are on a little bit of an edge, if you will. They know they’ve got to give some money back. The market is competitive, but if the wind blows, the story could change very quickly."
},
{
"speaker": "Mark Hughes",
"text": "Very good. Well, everything – it’s definitely crazy out there with the Cubs [ph] in first place. I’m with you."
},
{
"speaker": "J. Patrick Gallagher, Jr.",
"text": "No, Mark. That’s the new normal."
},
{
"speaker": "Mark Hughes",
"text": "Okay. All right. Thank you."
},
{
"speaker": "J. Patrick Gallagher, Jr.",
"text": "We waited 100 years. Some people have a bad decade. We had a bad century. We’re back for good."
},
{
"speaker": "Mark Hughes",
"text": "All right."
},
{
"speaker": "J. Patrick Gallagher, Jr.",
"text": "Thanks, Mark."
},
{
"speaker": "Operator",
"text": "Thank you. Thank you. Our next questions come from the line of David Motemaden with Evercore ISI. Please proceed with your questions."
},
{
"speaker": "David Motemaden",
"text": "Hey, good evening."
},
{
"speaker": "J. Patrick Gallagher, Jr.",
"text": "Hey, David."
},
{
"speaker": "David Motemaden",
"text": "My question, I missed it, just on the RPC for this quarter. I think you had said it was 5% last quarter. It was trending around 4% in the first two months of the quarter, this 1Q. Where did that end up for 1Q? And within your outlook, what are you guys assuming for the rest of the year?"
},
{
"speaker": "Doug Howell",
"text": "So let me see if I can break that apart. What’s your question? You want to know what the renewal premium change was in the first quarter and what our outlook is for the rest of the year? Is that the question?"
},
{
"speaker": "David Motemaden",
"text": "Yes. What’s embedded in the outlook that you gave – the organic cadence that you gave?"
},
{
"speaker": "Doug Howell",
"text": "Basically about the same. We don’t see a further – property down 2%, call it flat. The casualty rates, we’ve had a lot of quarters on casualty rates as I look across the grid here, consistently in that 8% – 7%, 8%, 10%, 9%, 9%, 9%, 10% as I look at casualty rates coming across. So I think there’s still some concerns over casualty on that. So our outlook as we shape our organic for the rest of the year is assuming similar to what we saw right now, or this quarter."
},
{
"speaker": "J. Patrick Gallagher, Jr.",
"text": "David, back to Mark’s comments before about a long time to look back. In my past experience, when markets became a little squishy, you’d see them fall quite dramatically across all lines. That is not what we’re seeing today. Umbrella cover up this past quarter 11%. Continuing push up of casualty. A little bit down on property. As we said in our opening remarks, this is a pretty logical market. So I don’t think you’re going to see any major change. And if we do, we’ll give it to you at our IR Day updates."
},
{
"speaker": "David Motemaden",
"text": "Got it. Thank you. And then I guess I’m also wondering that difference between the middle market and large account. I guess I’m wondering just I know that there’s typically, the large account business is more cyclical and you guys are underweight that. But outside of that, when you look at your middle-market property book and small market property book, would you say that’s more SCS exposed and, therefore, the pricing might be a little bit more durable there? Or is that just – is that not the right way to think about it?"
},
{
"speaker": "J. Patrick Gallagher, Jr.",
"text": "I don’t like to think about it that way. And I’ll tell you why. Convective storms are – they seem to be localized in the Midwest. You got fire risk in lots of states I never thought of before, like New Jersey. But I don’t think that’s necessarily something you’d say is more akin to hurting those accounts, although you have to say there are a heck of a lot more small accounts than there are large accounts. There was 1,000 Fortune 1000 accounts. There’s 1,000 small accounts in Schaumburg. So I guess, in one sense, I’d argue, no, I don’t think those storms fall necessarily harder on one book of business than another, except by virtue of the fact that the numbers are just greater. I think it’s buying power. That’s what I’d say, David. It’s just real simple. If I get an account that’s going to pay me $100,000 or an account that’s going to pay me $100 million, who gets a better deal? $100 million."
},
{
"speaker": "David Motemaden",
"text": "Yes. No, that makes sense. And then lastly so I might be nitpicking here, but I think you guys have called out 5% organic in U.S. retail and it sounds like that was maybe a little bit lighter than what you guys were talking about in March. I think you guys were saying 6%. Was there anything behind that outside of just the general RPC trends that we spoke about?"
},
{
"speaker": "Doug Howell",
"text": "Listen, I think that when you get down to a point one way or another on the organic, I would say they’re almost the same number. There could be a mix difference in there. When something moves a point, I’ll be honest, we don’t dig into it as deeply if something moves five points. So the point is consider it mix, but still, the point is on this is it’s still going up. And if you look across everything that we’ve said is we still have a market that is arguably flat in a couple of spots and going up in a lot of spots, right? So I think that the fact is there still is a need for rate. The carriers see that, you’ve seen that in the releases that they’ve had. And so I think that you blend all that together, we’re selling more than we’re losing, and we feel pretty good about a 6% to 8% year, that would be a terrific five- or six-year run on that."
},
{
"speaker": "David Motemaden",
"text": "No, I definitely agree. Thank you."
},
{
"speaker": "J. Patrick Gallagher, Jr.",
"text": "Thanks David."
},
{
"speaker": "Operator",
"text": "Thank you. [Operator Instructions] Our next questions come from the line of Katie Sakys with Autonomous Research. Please proceed with your questions."
},
{
"speaker": "Katie Sakys",
"text": "Hi, thank you. I guess my first question, I wanted to go back to Doug’s comments on the cadence of Brokerage organic growth that you expect to see for 2Q, 3Q and 4Q? Back-of-the-envelope math, I’m kind of getting to the midpoint of the 6% to 8% full year guide. Which of those quarters, Doug, do you kind of see the most potential to upside versus your current estimates right now? And how does seasonality perhaps inform that view?"
},
{
"speaker": "Doug Howell",
"text": "I think the upside could come in the fourth quarter. I think if we have a storm season, and like Pat said, the property shifts, I also still believe that there’s going to be development issues, as you get into your third quarter actuarial reserves as they start to do their third quarter views of how they feel their development is. When it goes from a – into a paid loss triangle versus an incurred loss triangle, you kind of wake up to that when you do your actuarial reviews in the third quarter. So fourth quarter is probably the quarter where there’s the most upside."
},
{
"speaker": "Katie Sakys",
"text": "Great. Super helpful. And then I apologize if this next question is a little bit nitpicky, but I noticed in the CFO commentary that the average EBITDAC multiple that you guys paid for your tuck-ins this quarter was slightly elevated at 11.5x versus the 10x to 11x guide. Is that just a result of some noise from one-off transactions? Or is there any additional color that we should be aware of there?"
},
{
"speaker": "Doug Howell",
"text": "If I peel apart the 11 that we closed in the quarter, I don’t see anybody really off the map on that. So being 10x to 11x is still pretty close, so."
},
{
"speaker": "Katie Sakys",
"text": "Thank you."
},
{
"speaker": "J. Patrick Gallagher, Jr.",
"text": "Thanks, Katie."
},
{
"speaker": "Operator",
"text": "Thank you. Our next questions come from the line of Andrew Andersen with Jefferies. Please proceed with your questions."
},
{
"speaker": "Andrew Andersen",
"text": "Hey, good afternoon. The supplemental commissions within Brokerage were pretty strong. Was there any timing benefit there? And just maybe more broadly, could you talk about how you’re thinking about that those line items, the contingents and supplementals?"
},
{
"speaker": "Doug Howell",
"text": "All right. So supplementals in the first quarter. We’ve had some pretty good work as we start to negotiate contracts for the coming year. I think the team has done a good job of getting more carrier relationships under our supplemental. So I wouldn’t say that there’s anything systemic there. Maybe there’s a couple of million flip between contingent and supplemental, but that carriers switch back and forth between those."
},
{
"speaker": "J. Patrick Gallagher, Jr.",
"text": "They’re still, by and large, volume-based. Volumes up, things are good."
},
{
"speaker": "Andrew Andersen",
"text": "Got it. And then just within specialty, could you maybe talk about the growth difference between open brokerage and MGA? And I suppose where I’m going with this is, I’m not sure if the MGAs are kind of weighted to property. But if we’re seeing some compression in property rate, could that impact your MGA growth in the back half of the year?"
},
{
"speaker": "Doug Howell",
"text": "Our binding business had a terrific quarter. I think they’re in the mid-teens. The Brokerage business was probably 5% to 6%, something like that. So I think between the two, Brokerage and binding, our affinity business had a terrific quarter. Captives were a little slow this quarter. But by and large, the binding business did a really great job. And the open brokerage is still continuing to show really, really nice mid-single-digit growth."
},
{
"speaker": "Andrew Andersen",
"text": "Thank you."
},
{
"speaker": "J. Patrick Gallagher, Jr.",
"text": "Thanks, Andrew."
},
{
"speaker": "Operator",
"text": "Thank you. Our next questions come from the line of Meyer Shields with KBW. Please proceed with your questions."
},
{
"speaker": "Meyer Shields",
"text": "Great. Thanks so much. Two big picture questions, if I can. First, if my memory is correct then, one of the benefits you were talking about when you bought Gallagher Re was that you could introduce reinsurance brokerage capabilities to all of the carriers that you place business with. And I’m wondering whether the 20% organic growth that you had in the first quarter, does any – is that still a factor? Or has that played out and this is just the execution of the current team?"
},
{
"speaker": "J. Patrick Gallagher, Jr.",
"text": "No, that’s a big factor. And that’s 15 deals. Again, we’re not getting granular as to who, what, where and when. But that’s exactly what we talked about. It’s coming out the way we dreamed it. These people are working together. We’ve introduced them to some other players that they didn’t know. They’ve introduced us to plenty of players we didn’t know. The cross-pollinization both in what we’re doing in retail and things like pools and what they’re doing with carriers that we didn’t know about has been very good for our retail team. And of course, we’ve got deep relations with carriers across the board that all of us at this table have traded with for years. And it’s not – it’s just really been a very positive development in our repertoire."
},
{
"speaker": "Doug Howell",
"text": "Listen, in our culture, the fact that people run together to help each other, we’re really seeing that. We’re seeing a lot of joint meetings between our retail folks, our wholesale folks, our reinsurers. I just spent a week in London, and all the opportunities that we have with MGAs and capital formation using the reinsurance opportunities, I think we’re just scratching the surface of what Gallagher Re will bring to us."
},
{
"speaker": "Meyer Shields",
"text": "Okay. That’s very helpful. The second question, I’m just trying to put this together in my head. You’ve got more leverage with the big accounts because they’ve got more swag, I think that’s the way Pat put it. On the other hand, there’s a higher propensity towards fees there. So overall, is the larger account business more or less sensitive, from your perspective, the revenue growth more or less sensitive to the cycle than in small and mid?"
},
{
"speaker": "J. Patrick Gallagher, Jr.",
"text": "It’s probably less because we’re on fees. I mean, that’s – there’s no question about that. And the nice thing about a fee account in a softening market is that you don’t get asked to take a pay cut for doing a better job."
},
{
"speaker": "Meyer Shields",
"text": "Okay. Thank you."
},
{
"speaker": "J. Patrick Gallagher, Jr.",
"text": "Thanks, Meyer."
},
{
"speaker": "Operator",
"text": "Thank you. Our last question will come from the line of Cave Montazeri with Deutsche Bank. Please proceed with your questions."
},
{
"speaker": "Cave Montazeri",
"text": "Thank you. I know you guys have a pretty good real-time pulse on the economy. Earlier in your prepared remarks, you mentioned the U.S. labor market was still strong. But just wondering in your conversations with clients, especially the middle market clients, what are they staying on the impact of tariffs on their business?"
},
{
"speaker": "J. Patrick Gallagher, Jr.",
"text": "I think that you’ve read all the stuff, Cave, that there is out there. I mean everybody’s got questions, and it’s too – it’s very client specific. What business are you in? Where does your product mix come from? What’s your supply chain? Is it something that you can change one way or another? How do your clients feel about it? The good news for us is that any time there’s consternation, anytime there’s change, anytime there’s concern, we’re there to help them through it. So if, in fact, tariffs create some additional loss costs or some additional value increases, there’s ways to mitigate that, whether we move towards a captive, higher retentions, change the language, et cetera, et cetera. But there’s concern as to what it means to them as individuals. And I’d say that’s much more pronounced in the middle and small cap market."
},
{
"speaker": "Cave Montazeri",
"text": "Makes sense. My follow-up is on your international organic growth. I think you mentioned 4% if I remember correctly, I guess it’s not a bad number in absolute terms, but it is a bit of a drag on the overall brokerage organic. Could you give us a bit of maybe regional color on what you’re seeing internationally? Maybe like some regions being better than others?"
},
{
"speaker": "Doug Howell",
"text": "Yes. Cave, it’s a flat market. Australia and New Zealand first quarter is very slow because of their heavy periods are in the summer. The UK retail is hanging in there, kind of similar to our retail. So if you’re thinking about maybe a – call Canada flat and the rest of them maybe 5% to 6%..."
},
{
"speaker": "J. Patrick Gallagher, Jr.",
"text": "And remember, nowhere in the world has our casualty book. Nobody’s got our tort system. So we are seeing pressure on casualty rates and carriers are seeing pressure on their past casualty years."
},
{
"speaker": "Cave Montazeri",
"text": "Yes, that makes sense. And if I could squeeze one more in on the topic of international, like from an M&A inorganic growth point of view, internationally, like where is your appetite geographically, where you think there’s going to be good opportunities to grow in the future?"
},
{
"speaker": "J. Patrick Gallagher, Jr.",
"text": "Well, first of all, we now trade extensively throughout the world. As we said in our prepared comments, there’s not an account anywhere in the world we can’t do, of any size. But if you take a look at premium, written premium, that’s the ball we’re following."
},
{
"speaker": "Cave Montazeri",
"text": "Thank you."
},
{
"speaker": "J. Patrick Gallagher, Jr.",
"text": "Thanks, Cave. Well, thank you, everyone, for joining us this afternoon. We had a great first quarter and a great kickoff to 2025. It’s important that we think the 57,000 colleagues around the globe for doing the work that creates these results. Their creativity, dedication and unwavering client focus is what really makes these results. Thank you all, and have a great evening."
},
{
"speaker": "Operator",
"text": "Thank you. This does conclude today’s teleconference. We appreciate your participation. You may disconnect your lines at this time. Enjoy the rest of your night."
}
] | Arthur J. Gallagher & Co. | 252,186 |
AKAM | 4 | 2,020 | 2021-02-09 16:30:00 | Operator: Ladies and gentlemen, thank you for standing by, and welcome to the Q4 2020 Akamai Technologies, Inc. Earnings Conference Call. At this time, all participant lines are in a listen-only mode. After the speakers’ presentation, there will be a question-and-answer session. [Operator Instructions] Please be advised that today’s conference is being recorded. [Operator Instructions] I would now like to hand the conference over to your speaker today, Tom Barth, Head of Investor Relations. Thank you Please go ahead, Sir.
Tom Barth: Thank you, operator. Good afternoon, everyone, and thank you for joining Akamai’s fourth quarter and fiscal year 2020 earnings conference call. Speaking today will be Tom Leighton, Akamai’s Chief Executive Officer; and Ed McGowan, Akamai’s Chief Financial Officer. Before we get started, please note that today’s comments include forward-looking statements including statements regarding revenue and earnings guidance. These forward-looking statements are subject to risks and uncertainties and involve a number of factors that could cause actual results to differ materially from those expressed or implied by such statements. The factors include uncertainty stemming from COVID-19 pandemic and any impact from unexpected geopolitical developments. Additional information concerning these factors is contained in Akamai’s filings with the SEC, including our annual report on Form 10-K and quarterly reports on Form 10-Q. The forward-looking statements included in this call represent the company’s view on February 09, 2020. Akamai disclaims any obligation to update these statements to reflect future events or circumstances. As a reminder, we will be referring to some non-GAAP financial metrics during today's call. A detailed reconciliation of GAAP and non-GAAP metrics can be found under the financial portion of the Investor Relations section of akamai.com. And with that, let me turn the call over to Tom.
Tom Leighton: Thanks, Tom. And thank you all for joining us today. I am pleased to report that Akamai delivered excellent results for both the both the fourth quarter and the full year in spite of the extraordinary challenges that we all faced in 2020. Q4 revenue was $846 million up 10% over Q4 2019 and up 8% in constant currency. This strong result was driven by the continued rapid growth of our security business and continued high traffic on our intelligent Edge platform. Non-GAAP operating margin in Q4 was 30% up one point over Q4 2019 and Q4 non-GAAP EPS was $1.33 per diluted share, up 8% year-over-year and up 6% in constant currency. For the full year we surpassed our expectations for the top -- setting new records for our business and positioning us well for our future. Full-year 2020 revenue was $3.2 billion up 11% over the prior year in constant currency and topping that $3 billion mark in the first time in our history. We're especially pleased to report that we expanded non-GAAP operating margin to 31% in 2020 overachieving our targeted 30%. This is up dramatically from 24% in 2017. I think it's worth noting that we achieve this expansion over the past three years while also investing for future growth. Non-GAAP EPS for 2020 was $5.22 per share up 16% over 2019 and exceeding $5 per share for the first time. We also generated $1.2 billion in cash from operations last year, up 15% over 2019 and representing 38% of revenue. Our securities portfolio continued to be the fastest growing part of our business in Q4, generating revenue of $296 million, up 23$ year-over-year in constant currency. For the full-year, security revenue exceeded $1 billion and grew 25% over 2019. This puts Akamai, a rare company as few firms generated more than $1 billion in annual revenue from Cyber Security solutions and fewer scale grew at 25% last year. Security represented one third of our revenue last year, which was up from 29% in 2019 and 24% in 2018. Looking to our especially strong Prolexic services Q4 as we helped dozens of major enterprises that span against a wave of ransom DDoS attacks that began in Q3. DDoS production has been the main stay of our portfolio for years and has never been more relevant for customers. We also saw strong bookings for our Bot Manager solution. Bot Manager helps defend against prudential of these attacks which were about four times greater in 2020 than the year before. 2020 was also a strong year for innovation with the release of Page Integrity Manager and Secure Web Gateway. Bookings for both are off to an excellent start as enterprises increasingly need to deal with malware and third-party software and applications and the addition of Secure Web Gateway to our enterprise Enterprise Threat Protector service better positions us to compete in the fast-growing enterprise security market. We were also pleased to close our acquisition of Asavie in Q4, which helps advance our security capabilities for cellular devices and networks. New customers signed Asavie integration including National Health Agency, which adopted Asavie to secure it's COVID vaccination application and Digital Comps, a nonprofit organization that works to close the digital learning gap for students to equitable access and technology. Our media and carrier division also delivered a strong fourth quarter as a result of continued high levels of traffic for OTT video services and downloads of e-gaming software. On November 10, traffic on the Akamai platform reached an all-time of 181 terabits per second, 50% greater than 2019. Nobody in the marketplace comes anywhere close to our capacity to serve customers at the edge on a global scale. In fact, we already exceeded last year's traffic feet just last week. On the application performance side of the business, Q4 was a crucial quarter for e-commerce with major buying events such as Black Friday and Single Day. The unmatched reliability, scale, global reach and security of our Intelligent Edge platform is a major reason why 40 of the world's top 50 retailers and 23 of the top 25 in the US use Akamai to accelerate their commerce applications. Overall, we're very pleased with our performance last year on both the top and bottom lines and I want to thank our employees for enabling Akamai to achieve such strong results as they cope with the challenges of the pandemic. As we look to the future, we see substantial opportunity for enterprises to increase their use of the Akamai Intelligent Edge platform. We believe the Edge is where new applications and new business models will come to life, where intelligence will be built and collected and analyzed, where the promise of 5G and IoT will be realized and where security will provide the online world's first and most important line of defense. To better take advantage of these opportunities and to better serve our customers, we announced today that we'll be realigning our organization around two major groups of products, products that enable business online and products that protect business online. Both product groups will be supported with a single unified sales organization. Products that enable business online will be the focus of our new Edge technology group, which will be led by Adam Karon as COO and General Manager. This group will be responsible for our media delivery, web performance and Edge computing solutions as well the Edge platform that underpins everything we do. These products generate about two thirds of our total revenue today and strong margins and tax generation that fuel our innovation power. The group's mission is twofold; first to ensure that our Edge platform remains the unparalleled market leader for scale, performance, reliability, ease-of-use, agility and cost and second, to generate additional growth of the innovation of new products and services for emerging customer needs in areas such as IoT, 5G and serverless computing. The products that protect business online will come together as a new security technology group to be led by Rick McConnell as President and General Manager. This new group will be responsible for all our security solutions, including our market-leading web security products such Kona Site Defender, Bot Manager and Prolexic. Our enterprise security products such as Enterprise and Application Access and Enterprise Threat Protector and our carrier security products such as our DNS space secure business offering and our new secure mobile service from Azioni. In 2021 with go to market with a unified mobile sales organization that better serve our customers, deepen our channel relationships and provide our customers and partners with easier access to the full breadth of our portfolio. PJ Joseph who previously led our sales for media and carrier, will lead global sales reporting to me. As part of the new alignment, Bobby Blumofe will become our Chief Technology Officer to guide innovation and be an evangelist for our technology vision and leadership in the market place. Kim Salem-Jackson who has successfully led Akamai field marketing and global indications for the last three years will become our new Chief Marketing Officer as part of our planned transition. Kim will succeed Monique Bonner who has done a fabulous job at transforming our marketing organization over the last four and years. Mo will stay on with Akamai in senior advisory role, which will allow her to devote time to her family while still ensuring the success of key market initiatives currently underway. You can read more about our organizational announcement in the press release issued today and you'll be able to see directly from our leadership team at our Investor Summit on February 25 and we'll outline our strategy and plans drive Anamai's next phase of growth. Akamai name amazing contributions to the world in 2020, but we believe the best is yet to come. Looking ahead, we have the potential to greatly expand our business and enterprise and carrier security as we strive to further grow our leadership position in web website. We plan to growth the capacity of our unparalleled intelligent Edge platform by another order of magnitude as we continue to improve our market-leading performance and reliability. We seek to bring innovative new services to market to support emerging IoT and serverless computing applications. We want to help enable the world to take advantage of the incredible potential of 5G and we'll continue our efforts to build value for our shareholders with our world-class counter technology leadership, strong profitability and cash generation that fuel our future growth. Now I'll turn the call over to Ed to provide further details on our 2020 results and the Outlook for 2021. Ed?
Ed McGowan: Thank you, Tom. As Tom outlined, Akamai delivered another excellent quarter in Q4. We were very pleased to exceed the high end of our guidance range on revenue and earnings. Q4 revenue was $846 million up 10% year-over-year or 8% in constant currency, driven by another quarter of very strong security growth, higher-than-expected gaming traffic and the weaker US dollar. Revenue from our Web Division was $438 million, up 5% year-over-year or 4% in constant currency. Revenue growth for this group of customers was again, led by our Security business. And while we saw a stronger than expected seasonal traffic growth from some of our retail and commerce customers, other customers in this vertical and in our travel and hospitality vertical continue to be negatively impacted by the pandemic. Revenue from our Media and Carrier Division was $408 million, up 15% year-over-year or 14% in constant currency. As noted, we benefited from higher than expected gaming and video traffic along with continued momentum in security. Revenue from the Internet platform customers was $58 million, up 11% from the prior year and above our expectations due to higher-than-expected traffic. Security revenue for the fourth quarter was $296 million, up 24% year-over-year and 23% in constant currency driven by continued global demand across our web security product portfolio and higher-than-expected revenue from our recently closed Asavie acquisition. Asavie we contributed approximately $8 million in Q4, driven by a combination of much-better-than-expected strength in the educational vertical and a faster-than-expected revenue ramp for a recently added carrier in the U.S. Foreign exchange fluctuations had a positive impact on revenue of $6 million on a sequential basis and positive $9 million on a year-over-year basis. International revenue was $379 million, up 16% year-over-year or 13% in constant currency. Sales in our international markets represented 45% of total revenue in Q4, up 3 points from Q4 2019 and consistent with Q3 levels. Finally, revenue from our U.S. market was $467 million up 5% year-over-year. Moving now to costs; cash gross margin was 76% in line with our expectations. GAAP gross margin, which includes both depreciation and stock-based compensation was 64%, non-GAAP cash operating expenses were $280 million, slightly above our guidance in part due to higher sales commissions given the revenue outperformance we saw in Q4. Moving on to profitability. Adjusted EBITDA was $364 million, a $45 million or 14% from the same period in 2019. Our adjusted EBITDA margin was 43%, up 2 points from Q4 2019. Non-GAAP operating income was $256 million, up $34 million or 15% in the same period last year. Non-GAAP operating margin came in at 30%, up 1 point from last year and in line with our guidance. Capital expenditures in Q4 excluding equity compensation and capitalized interest expense were $195 million. GAAP net income for the fourth quarter was $113 million or $0.68 of earnings per diluted share. It is worth noting that our Q4 GAAP results include two one-time items, a $27 million restructuring charge primarily related to the company realignment as Tom mentioned and a $20 million additional endowment to the Akamai Foundation. Non-GAAP net income was $220 million or $1.33 of earnings per diluted share, up 8% year-over-year, up 6% in constant currency, and $0.01 above the high-end of our guidance range due to higher-than-expected revenues. Taxes included in our non-GAAP earnings were $39 million based on a Q4 effective tax rate of approximately 15%. Now, I will discuss some balance sheet items. As of December 31st, our cash, cash equivalents, and marketable securities totaled approximately $2.5 billion. After accounting for the $2.3 billion of combined principal amounts of our two convertible notes, net cash was approximately $197 million as of December 31st. Now, I'll review our use of capital. During the fourth quarter, we spent $73 million to repurchase shares, buying back approximately 700,000 shares. We ended Q4 with approximately $572 million remaining on our previously announced share repurchase authorization. Our long-term plan remains to leverage our share buyback program to offset dilution resulting from equity compensation over time. I'm very proud of all of our employees who delivered these outstanding Q4 and 2020 results, especially during a very challenging year for us all. Now before I provide guidance, I thought it would be helpful to talk about how we see the year unfolding and highlight some key items you may want to consider as you build your models. Our revenue outlook assumes that the pandemic-related impacts to areas like work-from-home and travel will last at least for the first half of 2021. As a result, we expect to see continued challenges in our retail and travel verticals. From a traffic perspective, as life returns to a more normalized pre-pandemic state, we do not expect to see our traffic on our platform decrease. We believe the pandemic has accelerated consumer usage of the Internet in areas like OTT video, gaming, and e-commerce and we believe this usage pattern will likely persist going forward. However, we expect to see traffic continue to grow in 2021, but at a rate more in line with pre-2020 historical levels. In addition to revenue, there are some other items we expect in 2021 that are worth calling out. First, in 2020, our travel and related expenses were much lower than normal. Our guidance assumes that these expenses begin to return to a more normalized level beginning in the second half of 2021. Second, in light of the recent decline in interest rates, we expect our interest income to decline on a year-over-year basis. Specifically, we expect interest income to be about $8 million lower year-over-year, which will have a negative impact of about $0.05 on our non-GAAP earnings per share compared with 2020. Third, I wanted to remind you of the typical seasonality that we experience on the top and bottom lines. In the first quarter, we usually see a revenue step-down sequentially from Q4, our strong seasonal quarter. Also in Q1, remember that our employee payroll taxes and 401(k) matching programs reset. These costs will decline throughout the year as employees begin to max out. Finally, as Tom mentioned earlier, we are reorganizing the company around a product-driven group structure and moving away from the current vertically aligned division structure. In Q1, we will report revenue results under the new edge technology and security technology groups as Tom outlined. The revenue splits will look familiar to you as they align to our current CDN on other and cloud security revenue reporting that we have historically provided. To assist with the transition, we will continue to report web and Media and Carrier Division results on our website for the balance of 2021. And finally, as a result of the reorganization, we expect to record an additional restructuring charge of approximately $7 million in Q1. Looking ahead to full-year, we expect revenue of $3.37 billion to $3.42 billion, which is up 4% to 6% year-over-year in constant currency. This outlook assumes that foreign exchange contributes about $45 million on a year-over-year basis. We expect security revenue growth in the range of 18% to 20% over 2020 levels. We also expect non-GAAP operating margin of approximately 30%, we expect non-GAAP earnings per diluted share of $5.33 to $5.46. And this non-GAAP earnings guidance is based on a non-GAAP effective tax rate of approximately 15% and a fully diluted share count of approximately 165 million shares. And finally, full-year CapEx is expected to be approximately 16% of revenue. This is down 7 points year-over-year as we expect to leverage the significant network capacity investment we made in 2019 and 2020. Moving on to Q1 guidance. We are projecting Q1 revenue in the range of $822 million to $836 million, or up 5% to 7% in constant currency over Q1 2020. The current spot rates, foreign exchange fluctuations are expected to have a positive $4 million impact on Q1 revenue compared to Q4 levels and a positive $16 million impact year-over-year. At these revenue levels, we expect cash gross margins of approximately 76%. Q1 non-GAAP operating expenses are projected to be $265 million to $270 million. We anticipate Q1 EBITDA margins of approximately 44%. And now, moving on to depreciation. We expect non-GAAP depreciation expense to be between $111 million to $112 million. Factoring in this guidance, we expect non-GAAP operating margin of approximately 30% for Q1. Moving on to CapEx; we expect to spend approximately $150 million to $155 million excluding equity compensation in the first quarter. And with the overall revenue and spend configuration I just outlined, we expect Q1 non-GAAP EPS in the range of $1.28 to $1.31. This EPS guidance assumes taxes of approximately $37 million to $38 million based on an estimated quarterly non-GAAP tax rate of approximately 15%. It also reflects a fully diluted share count of approximately 165 million shares. In summary, as you heard Tom highlight, we achieved several significant milestones in 2020 including delivering 11% top-line revenue growth with total revenue exceeding $3 billion for the first time in company history. Growing security revenue 25% and surpassing $1 billion, exceeding our 30% operating margin target, and generating non-GAAP EPS of more than $5 a share. We are very pleased with our performance in 2020 and we believe we're well-positioned for 2021. We look forward to provide any of a deeper look into our business and our plans for the future at our upcoming Investor Summit on February 25th. Thank you. Tom and I would be happy to take your questions. Operator?
Operator: [Operator Instructions] Our first question comes from the line of Sterling Auty from JPMorgan. Your line is now open.
Sterling Auty: Yes, thanks. Hi, guys. So I guess the big item that crosses my mind is the comment that you're expecting traffic to continue to grow, not really fall off, but at pre-pandemic levels. And given that security is now a bigger part of the mix, I'm kind of curious why the level of deceleration that's factored into the guidance for 2021.
Ed McGowan: Hey, Sterling, this is Ed. So I think there's a couple of things you need to think about there. So obviously 2020 was an unusually high traffic year for us. And the point I was trying to make there is that we're not seeing that decline but what we're expecting going into this year is what I'd call, more and more normal traffic year. So you start to get into some tougher compares as you get into Q2 and throughout the rest of the year. And you still have the normal dynamics in the Media business, most of the traffic is coming from media obviously, so there'll be a series of renewals and that's sort of thing which is pretty normal. And then the second thing that we called out is that we are starting to see a bit more pressure in travel and hospitality and retail. The first wave was customers coming to us asking us for extended payment terms, some credits, or some help within a quarter. Now, we're getting into a renewal cycle so we're expecting to see some pressure from that area. And keep in mind that's about 20% of our total business, about 40% of our Web Division, our prior Web Division business, so that's going to going to have a little bit of an impact on us as well.
Sterling Auty: That makes a lot of sense. And then, Tom, hey, one for you. The structural changes that you're making to the business, what's the motivation of doing that now?
Tom Leighton: Well, I think the time has come to bring all of our security teams together. When we created the current structure five years ago, we didn't really have a Security business to speak of a few million dollars, now it's over $1 billion and we had -- the products there were split among three different groups, the web security group which is most of it, enterprise security, which we've talked a lot about, and carrier security, which is very closely tied to enterprise. And enterprise and carrier getting to a real scale now that we can bring them out of incubation and bring all of our security teams together in a division that just focuses on security. And I think that I'll provide even stronger growth going forward. Also, unifying sales makes sense now. Before we had media sales force that we're selling to customers who are buying media products. We had a web sales force selling to verticals that we're buying web products. So splitting made sense then but now all of our customers buy security. In fact, some of the big media customers are our biggest buyers of security products. And so I think it makes sense to bring the field force together and it's more efficient. So I think the end result is that we will operate more efficiently, we will have a stronger innovation, and continue very strong growth in our security product group. And also on the CDN side of the house, as Ed talked about, we've got some tailwinds there, also some challenges in the commerce and travel vertical. But I think very interesting future growth with areas like IoT, 5G and, serverless computing. And bringing those teams together I think, again will enable us to be more efficient moving forward.
Operator: Thank you. Our next question comes from the line of Keith Weiss from Morgan Stanley. Your line is now open.
Keith Weiss: Excellent. Thank you, guys, for taking the question. I wanted to dig into the restructuring a little bit as well. So the restructuring charge, does that imply that there were some headcount reductions associated with this, and given that sort of the operating margins stay relatively stable for the full year, maybe down a little bit, it seems like you're hiring to offset that. So if you could talk us kind of through -- kind of where are you taking sort of investment away and where are you adding investment, that would be helpful. And then the second part of the question from like a go-to-market or from a customer-facing perspective, what are the customers going to see differently here, are the salespeople going to go in with like a bigger toolset or like what changes from that dynamic?
Ed McGowan: Yes, sure, Keith, this is Ed, I'll take the first part. So, yes, we had about a 2% reduction in heads and most of that was due to overlap primarily in the go-to-market area. Obviously, we had two leaders in different regions and things like that. In terms of investments, we added over 500 heads this year, investing in security R&D as a percentage has gone. So I think we've done a really good job of cutting costs and scaling. But it would be invested back into the business. So this is really wasn't about the cost savings initiatives, it was more about better efficiency in tuck-in alignment. So we're keeping margins in that 30% and investing a bit in the business moving forward as well. And as we've said in the past, we think 30% is a pretty good place to be running the business.
Tom Leighton: Yes. In terms of the areas we're investing in more because we are and net headcount went up quite a bit last year and will grow again this year despite the current reduction taking place. We're investing in innovation, new products, particularly in the security area, also in our platform, making it more of a programmable platform for our customers with projects such as EdgeWorkers and making it easier for customers to just deploy their code straight on to Akamai. In terms of what the customer sees, they're going to see the same rep they saw before by and large. When we had split the sales force before, it was by vertical, and so when we bring it together, it doesn't mean that there is account breakage per se or that you're going to have a different rep. Now that said, it will be a more efficient management structure. We will have a deeper focus on channel, so it's especially important for our growing security products, particularly in the enterprise and carrier security products. And it will be easier I think for a rep to sell everything than maybe it was before. Now, I think reps were, for example, in media, as I mentioned, selling security products and they were versed in the whole product set. But I think that becomes even easier now.
Operator: Thank you. Our next question comes from the line of James Fish from Piper Sandler. Your line is now open.
James Fish: Hey, guys, thanks for the question. I want to pick on a couple of questions that were already asked and get into it in greater detail. So maybe first, the last couple of weeks we've been hearing a little bit tougher pricing on the media delivery side. I mean what can you say about some of the larger renewals took place in the back half of '20 as well as that take place in the first half of '21, especially on the streaming side in some of those new streaming services?
Ed McGowan: Yes, sure. So I would say in terms of pricing, there is -- in the media side I'm not seeing anything unusual. There's one or two accounts where we've had some competitors get a little bit more aggressive than normal but -- and just as far as '21 goes from a medias perspective, not a ton of renewals, nothing worth calling out that's outside the norm. In the past, I've mentioned when we've had items that I thought was worth calling out, I don't see anything here. Our average contract lengths are between one and two years, so you'll always have a mix, I would say. For the ones that occurred in Q4 in the back half of the year came in where we expected. So no real surprises there.
James Fish: Got it. And then obviously a few weeks ago, you announced that updated channel partnerships, specifically on the security side and now today, you're talking about this unified sales organization. Can you guys give us a little bit more color as to how much of the business, especially on security is actually coming from the channel already? And then additionally, how does the greater investment around channel impact the P&L versus the consolidation of the sales structure?
Ed McGowan: Yes. So right now, about a third of the business in total goes through the channel. In terms of breaking it down a little bit further, if you think about the six -- for example, Asavie, 100% of that goes through the channel. We believe the enterprise business, more and more of that's going to go through the channel. As far as the split goes between security and content delivery, there'd be a bit more on the content delivery side because we've been in the business a lot longer, it's a bigger percentage of our revenue. But the way to think about it is as we move forward, especially in enterprise, channels will be a much bigger part of our go-to-market strategy.
Operator: Thank you. Our next question comes from the line of James Breen from William Blair. Your line is now open.
James Breen: Thanks for taking the question. Just for a spread, I think you said that the EBITDA margin in the first quarter guide were up 44%, but you also talked about some of the payroll expenses and some of the expenses in the year-end being higher in the first quarter. If that's the case, where are you seeing better margins to sort of offset some of this increase in expenses? And then secondly, I think, Tom, you talked about some of your media customers taking more security products. Can you just talk about your total customer base and what you're seeing in terms of customers taking multiple products from you guys across the base? Thanks.
Ed McGowan: Yes. So the -- yes, the EBITDA margin was 44%. I think just in general, we've done a good job of scaling our back office and getting leverage out of most of our G&A functions plus we're doing all the stuff we do on the server-side making our servers more efficient, etc. So I just called that out because Q1, we typically have vesting of stock, bonus payouts, etc., so we do tend to see a bit uptick in our operating expenses. But also it's -- you had a very high quarter in Q4 from a commissions perspective. So that sort of normalizes out. So the two kind of offset each other but as you kind of think about your model in Q1, it tends to be a bit high on the OpEx side. As you go forward, then obviously Q4, if we're having a good year, it tends to be a high quarter as well as we head into accelerators from the commission side.
Tom Leighton: Yes, and in terms of media customers buying security. Our media customers are the biggest brands out there and they very much need their content stay secure and not have sites deface. They're worried about accounts being taken over, that media accounts, gaming accounts from the account hijackers and that's where our bot management and account protection capabilities are very important. And since these are such large enterprises, they tend to be very large security customers. When we get together on the 25th, we'll give really a much deeper breakdown into our various security products, how we think about them, their growth rates, and what we are projecting over the next several years in terms of growth. We will also give you updated counts on how many buy how many security products.
Operator: Thank you. Our next question comes from the line of Tim Horan from Oppenheimer. Your line is now open.
Tim Horan: Thanks, guys. Can you give us a sense of last year, how much were volumes on the different business above trend? Do you estimate -- I mean there's a lot of moving parts, any color on that would be helpful.
Ed McGowan: Yes, sure. So on the traffic side, I would say last year was probably about double what we normally see from a traffic-growth perspective. And then as far as other volumes, obviously, those -- our bookings were pretty much in line with what we expected. And outside of the traffic, there was really nothing that was unusual or worth calling out.
Tim Horan: And looking at...
Tom Leighton: And one thing is that the attack traffic, the bad guys out there, their volumes were way up across the board. Malicious login attempts, attempts to embed malware, those kinds of things -- DDoS attacks, huge increases really across the board last year. And so that course makes a big difference for Akamai to be able to help our customers because we're unique at being able to stop the largest denial of service attacks and being able to stop the account hijacking attacks.
Tim Horan: And did term and volume or didn't, sorry, did volume price discounts kick-in as a result of volumes being so strong?
Ed McGowan: So it depends on the contract. A lot of big media companies do have tiered pricing, so that would have kicked in but again, nothing unusual other than the fact that just traffic was just much higher than we had expected.
Operator: Thank you. Our next question comes from the line of Colby Synesael from Cowen. Your line is now open.
Colby Synesael: Great, thank you. Two questions, one is, we're getting a lot of questions just in terms of what the company is likely to guide to at the upcoming Analyst Day. Obviously not asking for the numbers themselves, but what are, from a financial perspective, your intentions in terms of what you're going to provide at the Analyst Day? And then secondly, as it relates to your guidance for 2021, your security growth of 18% to 20%, I think it's below to I think what had been message more of a go for a plus 20%. Is there anything to kind of flag there, is that just typical conservatism, is this simply the law of large numbers as we now breach that $1 billion, or do you think if there is an opportunity to kind of accelerate that or re-accelerate that growth again? Thank you.
Ed McGowan: Yes, So I'll take the second part first. It is a bit of the law of large numbers I guess, we're getting much bigger. We do have a lot of newer products that are ramping fast but it just takes a while on a recurring revenue business. I think if you go back and look in the past, we've talked about last year getting to $1 billion, we exceeded that the year before that, mid-20s, we did high-20s. So there is always a possibility to overachieve but I think that's a reasonable guide. The other question was on the intentions of what we are going to talk about at the Analyst Day. As far as 2021 guidance, so it's only a two-week, so I'm not going to see anything different that I haven't seen yet. So I don't anticipate updating guidance from what we just talked about now. But what we will do is get into a lot more detail, you'll hear from all the leaders talking about what's the different groups and what they're going to be working on some of the growth dynamics, we'll be exposing a lot more about what's going on within the security buckets. We'll be showing you different growth rates and different products, so I think there's a lot of good information that will come out. But in terms of updating guidance, there won't be any [indiscernible], just given that it's two weeks from today.
Colby Synesael: So, no, I think of -- I'll go back to your Analyst Day I think, it might have been in 2018, there was a talk about that 30% operating margin. No expectation to give a new bogey, if you will, for a few years out from there.
Ed McGowan: No, we're not going to give a new bogey for new operating margin. What I will do is talk about the dynamics of the different businesses and how over time, you can see margins expand if we get to the -- a greater percentage of our business comes from security.
Operator: Thank you. Our next question comes from the line of Brad Zelnick from Credit Suisse. Your line is now open.
Brad Zelnick: Great, thanks so much for taking the questions. If there has been some -- so much pent-up demand on the gaming side, and it seems like gaming was a strong contributor again this quarter, how should we think about the impact the gaming vertical might have in 2021 versus maybe other console launches in the past?
Ed McGowan: Yes, you're right, it was a very strong quarter for gaming. And for us again, just as a reminder we work with the publishers, as well as the major platform. So the upside coming from a variety of different customers. It's, -- we're seeing more interest in gaming the console releases drove a lot of upside in the quarter. It's always hard to predict what games are going to be popular and there is a bit of seasonality in gaming depending on a quarter that has many releases versus one that may not have as many. But it's a very fast-growing vertical for us and we expect that with these new consoles, there should be some new demand throughout the year.
Brad Zelnick: Great, that's very helpful, and maybe just a follow-up on a different topic, Ed. As we think about the zero-overage plans you put in place within the Web Division and the strong e-commerce holiday season, what might the impact have been, and is this a model, which you might expect to be more pervasive throughout your customer base as we move into 2021 and beyond?
Ed McGowan: Yes, good question. So, as you know, we introduced this probably about 20 months ago is that the number of our customer conference back in and I think it was June of '19, and we have gotten a lot of traction mostly in retail, that's where we're seeing most of the requests for that type of structure. We're right now -- we've got over half of our customers in the commerce vertical are adopting that structure and it makes a lot of sense. It's actually a good strategy when you're faced with a customer base to discuss the macroeconomic challenges when you're looking at ways of getting -- saving money or getting more predictable spend. So it's been well received by the customer base, I would imagine that will continue to tick up. It's not for everyone and like I said, we've seen the primary adopter of that is in the retail space.
Brad Zelnick: Awesome. Thanks so much.
Operator: Thank you. Our next question comes from the line of Will Power from Baird. Your line is now open.
Will Power: Okay, great. Yes, thanks for taking the question. Maybe just to come back to security, I'd love to try to get a little more color on Page Integrity. I know you've been seeing strong trends there for a while, is that on path to be $100 million product and anything else you can share there? And I guess the second piece that ties into that, just wanted to get an update on what you're seeing in terms of revenue, bookings, etc. for some of that enterprise products?
Tom Leighton: Yes, I'll take those. Page Integrity Manager is off to a great start. We had really very good bookings. Now, of course, we just got launched middle of last year, so it will take time to grow into a $100 million business, but that's very exciting for us. And in terms of bookings for the enterprise business, again, very strong. And as you know, we've been looking forward to getting our enterprise and carrier security products to the point where they are $100 million revenue and we think that we can do that this year, at least get on that run rate so that combined with the enterprise and carrier security now that we have Asavie on-board, and we're going to talk a lot more about that at the upcoming Analyst Day.
Will Power: Are there any particular areas within the enterprise component where you're seeing particular strength?
Tom Leighton: It's across the board, Enterprise Application Access, really important because of all the malicious login attempts. Enterprise Threat Protector with SolarWinds becomes more important than ever to know what employee devices and enterprise devices are talking to, are they trying to contact command and control outside the enterprise, that's something that we can help catch and stop. Asavie has done incredibly well, much better than we'd expected post-acquisition. And, for example, things like students that need to gain access for remote learning, to protect them to make sure that their environment is secure, there is a -- been a lot of development, of course, we have carriers there. They sell this product and we're behind the scenes, but a very strong pickup there to secure the enterprise cellular networks. And then you think about IoT, in the future, all those devices have to be secured and probably all going to be connected with 5G. So I think a lot of potential upside there. And our secure business solution that's resolved by major carriers under their brands for small and media business -- medium business, again doing very well. So I would say across the board with the enterprise and carrier products, very strong growth and we might have a good chance of doubling revenue this year and reaching $100 million.
Operator: Thank you. Our next question comes from the line of Jeff Van Rhee from Craig-Hallum. Your line is now open.
Jeff Van Rhee: Great, thanks, two from me. Tom, just in terms of restructuring, I'm just curious sort of the thought process or the history of the thought process there. How long this has been percolating and if there were, as you think about it, kind of one or two key triggers that really made this the time? And then secondly, very high level. You look at the 11% annual growth, a lot of puts and takes as it relates to COVID but to the extent you can dial it in, what do you think growth would have been ex-COVID impacts, so obviously pro and con, but any color there?
Tom Leighton: Yes, we've been thinking about rework along these lines for really an extended period. It's something the senior management team would discuss at least on an annual basis. And in terms of the trigger, now our security business has reached $1 billion and that's an important milestone. We are also seeing really strong growth for the enterprise and carrier security products, as I mentioned, and they were both in incubation phase and in different parts of the company. We have the enterprise group had the enterprise security products and for the carrier products that was done in the Media and Carrier Division. And of course, most of security revenue was in the Web Division. And increasingly as the smaller product areas grew, you start to have overlap, for example, anybody the buys Asavie, we want to sell them Kona Site Defender, makes perfect sense. Same thing for enterprise security, if you buy EAA, we want Kona. And so I think it really makes sense now, they've reached critical mass to bring them together into one team focused on security. And as I mentioned, with the sales organization is something we have thought about over the last couple of years, certainly more efficient to have a single sales organization and the advantage of having them be split had disappeared really once all our customers are buying really all our products, but certainly security. So again, the time is right to do it and you don't like doing something in the middle of the pandemic, but at the same time, you can't wait. At Akamai, we always had a sense of urgency, we want to get this done because I think it will help our growth going forward. Now in terms of 11%, we are very pleased to see that this year. We definitely got some tailwinds for overall traffic levels and so the Media and Carrier Division did well, we also deployed a ton of capacity for, as Ed mentioned, increased growth this year and next year, just the rate of growth probably less this year and next year, more like normal traffic increases as opposed to twice that, that we experienced this year. I think we got hurt in revenue in our web performance products, as Ed talked about. A big part of their revenue comes from commerce which has gotten -- most commerce companies have really been pounded with COVID. There's a few big names that have done very well, probably picked up business. The amount of commerce going online has increased dramatically but when the parent company is hurting, that creates a more difficult environment to negotiate a contract. And in many cases, as we've talked about, we worked with the customer to give them some relief and on pricing as well, we've gone to zero-overage so they can plan better and that hurt I think, revenue with this past Q4, we don't get a lot of bursting. On the other hand, it preserves that business more for us in long term and we're in this for the long haul. And it means we aren't going to share that business with the many competitors out there, who would like to have just a tiny piece of our commerce business. And so it seems a little paradoxical that on the one hand, it probably hurt us on revenue on the other, as we talked about, we serve 40 of the global 50 leaders in commerce and retail and 23 of 25 in the U.S. and we're working very hard to maintain that business over the long-term and grow it, particularly with our security products.
Operator: Thank you. Our next question comes from the line of Brandon Nispel from KeyBanc Capital. Your line is now open.
Brandon Nispel: Great, thank you. Two questions for Ed. Ed, could you provide the contribution from acquired businesses included in the revenue outlook for 2021, I think in particular around Asavie and then Inverse? And then secondly, how should we think about IPC revenue contribution in 2021 versus 2020? Thanks.
Ed McGowan: Yes, sure. So as far as Inverse goes, there's really no revenue, that was a very small company. It was more of a tech tuck-in some of the others that we've done in the past. So there is no real contribution from that directly. As we integrated and it will help accelerate some of our other products. Asavie, probably about $30 million incremental, if you look kind of year-over-year, we had about $8 million this quarter. So somewhere in that range, so call it a little less than a point. And then as far as the Internet platform customers, I'm not going to tip my cap for the team that's been working on those, they have done a fantastic job not only maintaining that business but growing it. I haven't provided specific guidance, but I'd expect kind of a similar year where you're kind of maintain where you're kind of, maintaining where you are at, maybe a little upside. Q4 was particularly strong, so maybe it's in that $50 million range, plus or minus a few million bucks depending on what's going on in a particular quarter.
Brandon Nispel: Great. Thank you.
Operator: Thank you. Our next question comes from the line of Rishi Jaluria from D.A. Davidson. Your line is now open.
Rishi Jaluria: Hey, guys. Thanks so much for taking my questions, and nice to see continued strong execution. I wanted to go back to an earlier comment that was made with reference to SolarWinds bridge. I wanted to get a sense, what are you seeing out there in terms of any changes in demand or pipeline or inbound interest as a result of that breach, especially given your kind of leadership in the zero-trust area that's becoming increasingly important for CSO. And then I've got a follow-up.
Tom Leighton: Yes, obviously it illustrates the importance of zero-trust. It's -- it was obviously a devastating attack and it highlights the need for products, for example, like our Enterprise Threat Protector. It's one thing to try to stop the malware from getting inside, that's hard, you look at an example like this, but once it inside, it has to go out and contact command to control. And that's something that you can pick up in detect and block in many cases and then alert the CSO that they got a problem. And that's what our Enterprise Threat Protector product is meant to do and has done in many, many cases. So I think in the long run, it just heightens the need for products that we provide and the need for zero-trust in general. Stepping up a level, with third party malware showing up everywhere, that's the same problem you have with page integrity and why our Page Integrity Manager service is so important. Because today so many websites linked to third parties or use third-party or open-source code, it has malware. And what that means is when a client or one of our users goes to their website or uses their app, the client gets infected and their personal information's exposed. And it's just another example of a third-party malware that's become infected that the enterprise is using. A different particular use case, one is the web side the others internal enterprise apps, same problem and same devastating result and Akamai has solutions to help stop that.
Rishi Jaluria: Got it, that's helpful. And then I wanted to go back to the reorg. Look, I think it makes a lot of sense why you're doing the reorg, maybe philosophically, want to understand what steps are you taking or how are you thinking about avoiding disruption because in enterprise software, every time there is a reorg, there's always a worry of it's going to disrupt the business, especially when you're running on such a hot hand like you are right now and you've done reorgs in the past. So maybe kind of a thought process on just how do you avoid that from really disrupting our business would be helpful. Thanks.
Tom Leighton: Yes, that's a great question, something we've put a lot of time and effort into. This is a kind of thing we would plan for, really for six months. It's important to know we're doing it from a position of strength. I think the last thing you want to do is a reorg when you're in a position of weakness because that's where you can get the disruption in the problems. And as you can see, we're as strong as we've ever been. And so I think that is a good time to do a reorg. As we mentioned before, I don't see a lot of account disruption, not a lot of account breakage. You do worry whenever you change, the go-to-market operation, that you could have some disruption that way. I don't think that's likely here because as we mentioned, a lot of the accounts have the same person they had before that they're dealing with. So I don't think that will be a problem for us. And as you mentioned, we do have experience at doing this and we have great employees and I would say morale in the company is very high. And so I don't anticipate serious disruptions in the business here.
Operator: Thank you. Our next question comes from the line of Robert Majek from Raymond James. Your line is now open.
Robert Majek: Great, thanks. I think investors appreciate the sales synergies between your web performance offerings in your cloud security offerings and the sales force consolidation there makes perfect sense but would be great to get your thoughts on whether or not it still makes sense to build a dedicated sales force to help accelerate your enterprise security adoption.
Tom Leighton: Yes, we do have a sales specialist already and that has been maintained with the new organization. So there'll be no change there in terms of the specialist for not only the enterprise security products but the carrier security products, which are very close. Also, Prolexic has sales specialists there, so that won't change.
Robert Majek: Great, thanks and one more if I can, just building up Brad's questions. The year-over-year CDN growth rate decelerated 4 points from last quarter. So just wondering what we should make that dynamic. We know that overall traffic especially around gaming with strong, up -- perhaps it was offset by the introduction Zero Overage Fixed Fee pricing. So any additional clarification there would be helpful as we think about CDN and growth rate going forward.
Ed McGowan: Yes, I think you pretty much nailed it. I just remember last Q4 was an exceptionally strong quarter from a traffic growth perspective. So you've got a bit of a tougher compare and like I said earlier, starting in Q2, when we saw the big ramp in traffic, you're going to start to see a little bit tougher compare on the media side and then the dynamics that we've talked about really over last couple of quarters on the retail and commerce vertical, make it a bit more of a challenging year from a CDN perspective, but we still think we're in a great position and we've got some really good tailwinds going on. We were just talking a minute ago, OTT video is also growing very strongly. So there's a lot of puts and takes in there, but in general, I think that's kind of the key driver is just a bit of a tougher compare and then that challenge with retail and travel.
Tom Barth: Okay, well, this is Tom Barth. We want to thank everyone in closing. As Tom and Ed mentioned, we would look forward to you joining us virtually for our Investor Relations Summit on February 25th. Additionally, we will be presenting at several investor conferences and events throughout the rest of the quarter. Details of these can be found on the Investor Relations section of akamai.com. Thank you for joining us, and all of us here at Akamai wish continued good health to you and yours and have a wonderful evening.
Operator: Ladies and gentlemen, this concludes today's conference call. Thank you for participating. You may now disconnect. | [
{
"speaker": "Operator",
"text": "Ladies and gentlemen, thank you for standing by, and welcome to the Q4 2020 Akamai Technologies, Inc. Earnings Conference Call. At this time, all participant lines are in a listen-only mode. After the speakers’ presentation, there will be a question-and-answer session. [Operator Instructions] Please be advised that today’s conference is being recorded. [Operator Instructions] I would now like to hand the conference over to your speaker today, Tom Barth, Head of Investor Relations. Thank you Please go ahead, Sir."
},
{
"speaker": "Tom Barth",
"text": "Thank you, operator. Good afternoon, everyone, and thank you for joining Akamai’s fourth quarter and fiscal year 2020 earnings conference call. Speaking today will be Tom Leighton, Akamai’s Chief Executive Officer; and Ed McGowan, Akamai’s Chief Financial Officer. Before we get started, please note that today’s comments include forward-looking statements including statements regarding revenue and earnings guidance. These forward-looking statements are subject to risks and uncertainties and involve a number of factors that could cause actual results to differ materially from those expressed or implied by such statements. The factors include uncertainty stemming from COVID-19 pandemic and any impact from unexpected geopolitical developments. Additional information concerning these factors is contained in Akamai’s filings with the SEC, including our annual report on Form 10-K and quarterly reports on Form 10-Q. The forward-looking statements included in this call represent the company’s view on February 09, 2020. Akamai disclaims any obligation to update these statements to reflect future events or circumstances. As a reminder, we will be referring to some non-GAAP financial metrics during today's call. A detailed reconciliation of GAAP and non-GAAP metrics can be found under the financial portion of the Investor Relations section of akamai.com. And with that, let me turn the call over to Tom."
},
{
"speaker": "Tom Leighton",
"text": "Thanks, Tom. And thank you all for joining us today. I am pleased to report that Akamai delivered excellent results for both the both the fourth quarter and the full year in spite of the extraordinary challenges that we all faced in 2020. Q4 revenue was $846 million up 10% over Q4 2019 and up 8% in constant currency. This strong result was driven by the continued rapid growth of our security business and continued high traffic on our intelligent Edge platform. Non-GAAP operating margin in Q4 was 30% up one point over Q4 2019 and Q4 non-GAAP EPS was $1.33 per diluted share, up 8% year-over-year and up 6% in constant currency. For the full year we surpassed our expectations for the top -- setting new records for our business and positioning us well for our future. Full-year 2020 revenue was $3.2 billion up 11% over the prior year in constant currency and topping that $3 billion mark in the first time in our history. We're especially pleased to report that we expanded non-GAAP operating margin to 31% in 2020 overachieving our targeted 30%. This is up dramatically from 24% in 2017. I think it's worth noting that we achieve this expansion over the past three years while also investing for future growth. Non-GAAP EPS for 2020 was $5.22 per share up 16% over 2019 and exceeding $5 per share for the first time. We also generated $1.2 billion in cash from operations last year, up 15% over 2019 and representing 38% of revenue. Our securities portfolio continued to be the fastest growing part of our business in Q4, generating revenue of $296 million, up 23$ year-over-year in constant currency. For the full-year, security revenue exceeded $1 billion and grew 25% over 2019. This puts Akamai, a rare company as few firms generated more than $1 billion in annual revenue from Cyber Security solutions and fewer scale grew at 25% last year. Security represented one third of our revenue last year, which was up from 29% in 2019 and 24% in 2018. Looking to our especially strong Prolexic services Q4 as we helped dozens of major enterprises that span against a wave of ransom DDoS attacks that began in Q3. DDoS production has been the main stay of our portfolio for years and has never been more relevant for customers. We also saw strong bookings for our Bot Manager solution. Bot Manager helps defend against prudential of these attacks which were about four times greater in 2020 than the year before. 2020 was also a strong year for innovation with the release of Page Integrity Manager and Secure Web Gateway. Bookings for both are off to an excellent start as enterprises increasingly need to deal with malware and third-party software and applications and the addition of Secure Web Gateway to our enterprise Enterprise Threat Protector service better positions us to compete in the fast-growing enterprise security market. We were also pleased to close our acquisition of Asavie in Q4, which helps advance our security capabilities for cellular devices and networks. New customers signed Asavie integration including National Health Agency, which adopted Asavie to secure it's COVID vaccination application and Digital Comps, a nonprofit organization that works to close the digital learning gap for students to equitable access and technology. Our media and carrier division also delivered a strong fourth quarter as a result of continued high levels of traffic for OTT video services and downloads of e-gaming software. On November 10, traffic on the Akamai platform reached an all-time of 181 terabits per second, 50% greater than 2019. Nobody in the marketplace comes anywhere close to our capacity to serve customers at the edge on a global scale. In fact, we already exceeded last year's traffic feet just last week. On the application performance side of the business, Q4 was a crucial quarter for e-commerce with major buying events such as Black Friday and Single Day. The unmatched reliability, scale, global reach and security of our Intelligent Edge platform is a major reason why 40 of the world's top 50 retailers and 23 of the top 25 in the US use Akamai to accelerate their commerce applications. Overall, we're very pleased with our performance last year on both the top and bottom lines and I want to thank our employees for enabling Akamai to achieve such strong results as they cope with the challenges of the pandemic. As we look to the future, we see substantial opportunity for enterprises to increase their use of the Akamai Intelligent Edge platform. We believe the Edge is where new applications and new business models will come to life, where intelligence will be built and collected and analyzed, where the promise of 5G and IoT will be realized and where security will provide the online world's first and most important line of defense. To better take advantage of these opportunities and to better serve our customers, we announced today that we'll be realigning our organization around two major groups of products, products that enable business online and products that protect business online. Both product groups will be supported with a single unified sales organization. Products that enable business online will be the focus of our new Edge technology group, which will be led by Adam Karon as COO and General Manager. This group will be responsible for our media delivery, web performance and Edge computing solutions as well the Edge platform that underpins everything we do. These products generate about two thirds of our total revenue today and strong margins and tax generation that fuel our innovation power. The group's mission is twofold; first to ensure that our Edge platform remains the unparalleled market leader for scale, performance, reliability, ease-of-use, agility and cost and second, to generate additional growth of the innovation of new products and services for emerging customer needs in areas such as IoT, 5G and serverless computing. The products that protect business online will come together as a new security technology group to be led by Rick McConnell as President and General Manager. This new group will be responsible for all our security solutions, including our market-leading web security products such Kona Site Defender, Bot Manager and Prolexic. Our enterprise security products such as Enterprise and Application Access and Enterprise Threat Protector and our carrier security products such as our DNS space secure business offering and our new secure mobile service from Azioni. In 2021 with go to market with a unified mobile sales organization that better serve our customers, deepen our channel relationships and provide our customers and partners with easier access to the full breadth of our portfolio. PJ Joseph who previously led our sales for media and carrier, will lead global sales reporting to me. As part of the new alignment, Bobby Blumofe will become our Chief Technology Officer to guide innovation and be an evangelist for our technology vision and leadership in the market place. Kim Salem-Jackson who has successfully led Akamai field marketing and global indications for the last three years will become our new Chief Marketing Officer as part of our planned transition. Kim will succeed Monique Bonner who has done a fabulous job at transforming our marketing organization over the last four and years. Mo will stay on with Akamai in senior advisory role, which will allow her to devote time to her family while still ensuring the success of key market initiatives currently underway. You can read more about our organizational announcement in the press release issued today and you'll be able to see directly from our leadership team at our Investor Summit on February 25 and we'll outline our strategy and plans drive Anamai's next phase of growth. Akamai name amazing contributions to the world in 2020, but we believe the best is yet to come. Looking ahead, we have the potential to greatly expand our business and enterprise and carrier security as we strive to further grow our leadership position in web website. We plan to growth the capacity of our unparalleled intelligent Edge platform by another order of magnitude as we continue to improve our market-leading performance and reliability. We seek to bring innovative new services to market to support emerging IoT and serverless computing applications. We want to help enable the world to take advantage of the incredible potential of 5G and we'll continue our efforts to build value for our shareholders with our world-class counter technology leadership, strong profitability and cash generation that fuel our future growth. Now I'll turn the call over to Ed to provide further details on our 2020 results and the Outlook for 2021. Ed?"
},
{
"speaker": "Ed McGowan",
"text": "Thank you, Tom. As Tom outlined, Akamai delivered another excellent quarter in Q4. We were very pleased to exceed the high end of our guidance range on revenue and earnings. Q4 revenue was $846 million up 10% year-over-year or 8% in constant currency, driven by another quarter of very strong security growth, higher-than-expected gaming traffic and the weaker US dollar. Revenue from our Web Division was $438 million, up 5% year-over-year or 4% in constant currency. Revenue growth for this group of customers was again, led by our Security business. And while we saw a stronger than expected seasonal traffic growth from some of our retail and commerce customers, other customers in this vertical and in our travel and hospitality vertical continue to be negatively impacted by the pandemic. Revenue from our Media and Carrier Division was $408 million, up 15% year-over-year or 14% in constant currency. As noted, we benefited from higher than expected gaming and video traffic along with continued momentum in security. Revenue from the Internet platform customers was $58 million, up 11% from the prior year and above our expectations due to higher-than-expected traffic. Security revenue for the fourth quarter was $296 million, up 24% year-over-year and 23% in constant currency driven by continued global demand across our web security product portfolio and higher-than-expected revenue from our recently closed Asavie acquisition. Asavie we contributed approximately $8 million in Q4, driven by a combination of much-better-than-expected strength in the educational vertical and a faster-than-expected revenue ramp for a recently added carrier in the U.S. Foreign exchange fluctuations had a positive impact on revenue of $6 million on a sequential basis and positive $9 million on a year-over-year basis. International revenue was $379 million, up 16% year-over-year or 13% in constant currency. Sales in our international markets represented 45% of total revenue in Q4, up 3 points from Q4 2019 and consistent with Q3 levels. Finally, revenue from our U.S. market was $467 million up 5% year-over-year. Moving now to costs; cash gross margin was 76% in line with our expectations. GAAP gross margin, which includes both depreciation and stock-based compensation was 64%, non-GAAP cash operating expenses were $280 million, slightly above our guidance in part due to higher sales commissions given the revenue outperformance we saw in Q4. Moving on to profitability. Adjusted EBITDA was $364 million, a $45 million or 14% from the same period in 2019. Our adjusted EBITDA margin was 43%, up 2 points from Q4 2019. Non-GAAP operating income was $256 million, up $34 million or 15% in the same period last year. Non-GAAP operating margin came in at 30%, up 1 point from last year and in line with our guidance. Capital expenditures in Q4 excluding equity compensation and capitalized interest expense were $195 million. GAAP net income for the fourth quarter was $113 million or $0.68 of earnings per diluted share. It is worth noting that our Q4 GAAP results include two one-time items, a $27 million restructuring charge primarily related to the company realignment as Tom mentioned and a $20 million additional endowment to the Akamai Foundation. Non-GAAP net income was $220 million or $1.33 of earnings per diluted share, up 8% year-over-year, up 6% in constant currency, and $0.01 above the high-end of our guidance range due to higher-than-expected revenues. Taxes included in our non-GAAP earnings were $39 million based on a Q4 effective tax rate of approximately 15%. Now, I will discuss some balance sheet items. As of December 31st, our cash, cash equivalents, and marketable securities totaled approximately $2.5 billion. After accounting for the $2.3 billion of combined principal amounts of our two convertible notes, net cash was approximately $197 million as of December 31st. Now, I'll review our use of capital. During the fourth quarter, we spent $73 million to repurchase shares, buying back approximately 700,000 shares. We ended Q4 with approximately $572 million remaining on our previously announced share repurchase authorization. Our long-term plan remains to leverage our share buyback program to offset dilution resulting from equity compensation over time. I'm very proud of all of our employees who delivered these outstanding Q4 and 2020 results, especially during a very challenging year for us all. Now before I provide guidance, I thought it would be helpful to talk about how we see the year unfolding and highlight some key items you may want to consider as you build your models. Our revenue outlook assumes that the pandemic-related impacts to areas like work-from-home and travel will last at least for the first half of 2021. As a result, we expect to see continued challenges in our retail and travel verticals. From a traffic perspective, as life returns to a more normalized pre-pandemic state, we do not expect to see our traffic on our platform decrease. We believe the pandemic has accelerated consumer usage of the Internet in areas like OTT video, gaming, and e-commerce and we believe this usage pattern will likely persist going forward. However, we expect to see traffic continue to grow in 2021, but at a rate more in line with pre-2020 historical levels. In addition to revenue, there are some other items we expect in 2021 that are worth calling out. First, in 2020, our travel and related expenses were much lower than normal. Our guidance assumes that these expenses begin to return to a more normalized level beginning in the second half of 2021. Second, in light of the recent decline in interest rates, we expect our interest income to decline on a year-over-year basis. Specifically, we expect interest income to be about $8 million lower year-over-year, which will have a negative impact of about $0.05 on our non-GAAP earnings per share compared with 2020. Third, I wanted to remind you of the typical seasonality that we experience on the top and bottom lines. In the first quarter, we usually see a revenue step-down sequentially from Q4, our strong seasonal quarter. Also in Q1, remember that our employee payroll taxes and 401(k) matching programs reset. These costs will decline throughout the year as employees begin to max out. Finally, as Tom mentioned earlier, we are reorganizing the company around a product-driven group structure and moving away from the current vertically aligned division structure. In Q1, we will report revenue results under the new edge technology and security technology groups as Tom outlined. The revenue splits will look familiar to you as they align to our current CDN on other and cloud security revenue reporting that we have historically provided. To assist with the transition, we will continue to report web and Media and Carrier Division results on our website for the balance of 2021. And finally, as a result of the reorganization, we expect to record an additional restructuring charge of approximately $7 million in Q1. Looking ahead to full-year, we expect revenue of $3.37 billion to $3.42 billion, which is up 4% to 6% year-over-year in constant currency. This outlook assumes that foreign exchange contributes about $45 million on a year-over-year basis. We expect security revenue growth in the range of 18% to 20% over 2020 levels. We also expect non-GAAP operating margin of approximately 30%, we expect non-GAAP earnings per diluted share of $5.33 to $5.46. And this non-GAAP earnings guidance is based on a non-GAAP effective tax rate of approximately 15% and a fully diluted share count of approximately 165 million shares. And finally, full-year CapEx is expected to be approximately 16% of revenue. This is down 7 points year-over-year as we expect to leverage the significant network capacity investment we made in 2019 and 2020. Moving on to Q1 guidance. We are projecting Q1 revenue in the range of $822 million to $836 million, or up 5% to 7% in constant currency over Q1 2020. The current spot rates, foreign exchange fluctuations are expected to have a positive $4 million impact on Q1 revenue compared to Q4 levels and a positive $16 million impact year-over-year. At these revenue levels, we expect cash gross margins of approximately 76%. Q1 non-GAAP operating expenses are projected to be $265 million to $270 million. We anticipate Q1 EBITDA margins of approximately 44%. And now, moving on to depreciation. We expect non-GAAP depreciation expense to be between $111 million to $112 million. Factoring in this guidance, we expect non-GAAP operating margin of approximately 30% for Q1. Moving on to CapEx; we expect to spend approximately $150 million to $155 million excluding equity compensation in the first quarter. And with the overall revenue and spend configuration I just outlined, we expect Q1 non-GAAP EPS in the range of $1.28 to $1.31. This EPS guidance assumes taxes of approximately $37 million to $38 million based on an estimated quarterly non-GAAP tax rate of approximately 15%. It also reflects a fully diluted share count of approximately 165 million shares. In summary, as you heard Tom highlight, we achieved several significant milestones in 2020 including delivering 11% top-line revenue growth with total revenue exceeding $3 billion for the first time in company history. Growing security revenue 25% and surpassing $1 billion, exceeding our 30% operating margin target, and generating non-GAAP EPS of more than $5 a share. We are very pleased with our performance in 2020 and we believe we're well-positioned for 2021. We look forward to provide any of a deeper look into our business and our plans for the future at our upcoming Investor Summit on February 25th. Thank you. Tom and I would be happy to take your questions. Operator?"
},
{
"speaker": "Operator",
"text": "[Operator Instructions] Our first question comes from the line of Sterling Auty from JPMorgan. Your line is now open."
},
{
"speaker": "Sterling Auty",
"text": "Yes, thanks. Hi, guys. So I guess the big item that crosses my mind is the comment that you're expecting traffic to continue to grow, not really fall off, but at pre-pandemic levels. And given that security is now a bigger part of the mix, I'm kind of curious why the level of deceleration that's factored into the guidance for 2021."
},
{
"speaker": "Ed McGowan",
"text": "Hey, Sterling, this is Ed. So I think there's a couple of things you need to think about there. So obviously 2020 was an unusually high traffic year for us. And the point I was trying to make there is that we're not seeing that decline but what we're expecting going into this year is what I'd call, more and more normal traffic year. So you start to get into some tougher compares as you get into Q2 and throughout the rest of the year. And you still have the normal dynamics in the Media business, most of the traffic is coming from media obviously, so there'll be a series of renewals and that's sort of thing which is pretty normal. And then the second thing that we called out is that we are starting to see a bit more pressure in travel and hospitality and retail. The first wave was customers coming to us asking us for extended payment terms, some credits, or some help within a quarter. Now, we're getting into a renewal cycle so we're expecting to see some pressure from that area. And keep in mind that's about 20% of our total business, about 40% of our Web Division, our prior Web Division business, so that's going to going to have a little bit of an impact on us as well."
},
{
"speaker": "Sterling Auty",
"text": "That makes a lot of sense. And then, Tom, hey, one for you. The structural changes that you're making to the business, what's the motivation of doing that now?"
},
{
"speaker": "Tom Leighton",
"text": "Well, I think the time has come to bring all of our security teams together. When we created the current structure five years ago, we didn't really have a Security business to speak of a few million dollars, now it's over $1 billion and we had -- the products there were split among three different groups, the web security group which is most of it, enterprise security, which we've talked a lot about, and carrier security, which is very closely tied to enterprise. And enterprise and carrier getting to a real scale now that we can bring them out of incubation and bring all of our security teams together in a division that just focuses on security. And I think that I'll provide even stronger growth going forward. Also, unifying sales makes sense now. Before we had media sales force that we're selling to customers who are buying media products. We had a web sales force selling to verticals that we're buying web products. So splitting made sense then but now all of our customers buy security. In fact, some of the big media customers are our biggest buyers of security products. And so I think it makes sense to bring the field force together and it's more efficient. So I think the end result is that we will operate more efficiently, we will have a stronger innovation, and continue very strong growth in our security product group. And also on the CDN side of the house, as Ed talked about, we've got some tailwinds there, also some challenges in the commerce and travel vertical. But I think very interesting future growth with areas like IoT, 5G and, serverless computing. And bringing those teams together I think, again will enable us to be more efficient moving forward."
},
{
"speaker": "Operator",
"text": "Thank you. Our next question comes from the line of Keith Weiss from Morgan Stanley. Your line is now open."
},
{
"speaker": "Keith Weiss",
"text": "Excellent. Thank you, guys, for taking the question. I wanted to dig into the restructuring a little bit as well. So the restructuring charge, does that imply that there were some headcount reductions associated with this, and given that sort of the operating margins stay relatively stable for the full year, maybe down a little bit, it seems like you're hiring to offset that. So if you could talk us kind of through -- kind of where are you taking sort of investment away and where are you adding investment, that would be helpful. And then the second part of the question from like a go-to-market or from a customer-facing perspective, what are the customers going to see differently here, are the salespeople going to go in with like a bigger toolset or like what changes from that dynamic?"
},
{
"speaker": "Ed McGowan",
"text": "Yes, sure, Keith, this is Ed, I'll take the first part. So, yes, we had about a 2% reduction in heads and most of that was due to overlap primarily in the go-to-market area. Obviously, we had two leaders in different regions and things like that. In terms of investments, we added over 500 heads this year, investing in security R&D as a percentage has gone. So I think we've done a really good job of cutting costs and scaling. But it would be invested back into the business. So this is really wasn't about the cost savings initiatives, it was more about better efficiency in tuck-in alignment. So we're keeping margins in that 30% and investing a bit in the business moving forward as well. And as we've said in the past, we think 30% is a pretty good place to be running the business."
},
{
"speaker": "Tom Leighton",
"text": "Yes. In terms of the areas we're investing in more because we are and net headcount went up quite a bit last year and will grow again this year despite the current reduction taking place. We're investing in innovation, new products, particularly in the security area, also in our platform, making it more of a programmable platform for our customers with projects such as EdgeWorkers and making it easier for customers to just deploy their code straight on to Akamai. In terms of what the customer sees, they're going to see the same rep they saw before by and large. When we had split the sales force before, it was by vertical, and so when we bring it together, it doesn't mean that there is account breakage per se or that you're going to have a different rep. Now that said, it will be a more efficient management structure. We will have a deeper focus on channel, so it's especially important for our growing security products, particularly in the enterprise and carrier security products. And it will be easier I think for a rep to sell everything than maybe it was before. Now, I think reps were, for example, in media, as I mentioned, selling security products and they were versed in the whole product set. But I think that becomes even easier now."
},
{
"speaker": "Operator",
"text": "Thank you. Our next question comes from the line of James Fish from Piper Sandler. Your line is now open."
},
{
"speaker": "James Fish",
"text": "Hey, guys, thanks for the question. I want to pick on a couple of questions that were already asked and get into it in greater detail. So maybe first, the last couple of weeks we've been hearing a little bit tougher pricing on the media delivery side. I mean what can you say about some of the larger renewals took place in the back half of '20 as well as that take place in the first half of '21, especially on the streaming side in some of those new streaming services?"
},
{
"speaker": "Ed McGowan",
"text": "Yes, sure. So I would say in terms of pricing, there is -- in the media side I'm not seeing anything unusual. There's one or two accounts where we've had some competitors get a little bit more aggressive than normal but -- and just as far as '21 goes from a medias perspective, not a ton of renewals, nothing worth calling out that's outside the norm. In the past, I've mentioned when we've had items that I thought was worth calling out, I don't see anything here. Our average contract lengths are between one and two years, so you'll always have a mix, I would say. For the ones that occurred in Q4 in the back half of the year came in where we expected. So no real surprises there."
},
{
"speaker": "James Fish",
"text": "Got it. And then obviously a few weeks ago, you announced that updated channel partnerships, specifically on the security side and now today, you're talking about this unified sales organization. Can you guys give us a little bit more color as to how much of the business, especially on security is actually coming from the channel already? And then additionally, how does the greater investment around channel impact the P&L versus the consolidation of the sales structure?"
},
{
"speaker": "Ed McGowan",
"text": "Yes. So right now, about a third of the business in total goes through the channel. In terms of breaking it down a little bit further, if you think about the six -- for example, Asavie, 100% of that goes through the channel. We believe the enterprise business, more and more of that's going to go through the channel. As far as the split goes between security and content delivery, there'd be a bit more on the content delivery side because we've been in the business a lot longer, it's a bigger percentage of our revenue. But the way to think about it is as we move forward, especially in enterprise, channels will be a much bigger part of our go-to-market strategy."
},
{
"speaker": "Operator",
"text": "Thank you. Our next question comes from the line of James Breen from William Blair. Your line is now open."
},
{
"speaker": "James Breen",
"text": "Thanks for taking the question. Just for a spread, I think you said that the EBITDA margin in the first quarter guide were up 44%, but you also talked about some of the payroll expenses and some of the expenses in the year-end being higher in the first quarter. If that's the case, where are you seeing better margins to sort of offset some of this increase in expenses? And then secondly, I think, Tom, you talked about some of your media customers taking more security products. Can you just talk about your total customer base and what you're seeing in terms of customers taking multiple products from you guys across the base? Thanks."
},
{
"speaker": "Ed McGowan",
"text": "Yes. So the -- yes, the EBITDA margin was 44%. I think just in general, we've done a good job of scaling our back office and getting leverage out of most of our G&A functions plus we're doing all the stuff we do on the server-side making our servers more efficient, etc. So I just called that out because Q1, we typically have vesting of stock, bonus payouts, etc., so we do tend to see a bit uptick in our operating expenses. But also it's -- you had a very high quarter in Q4 from a commissions perspective. So that sort of normalizes out. So the two kind of offset each other but as you kind of think about your model in Q1, it tends to be a bit high on the OpEx side. As you go forward, then obviously Q4, if we're having a good year, it tends to be a high quarter as well as we head into accelerators from the commission side."
},
{
"speaker": "Tom Leighton",
"text": "Yes, and in terms of media customers buying security. Our media customers are the biggest brands out there and they very much need their content stay secure and not have sites deface. They're worried about accounts being taken over, that media accounts, gaming accounts from the account hijackers and that's where our bot management and account protection capabilities are very important. And since these are such large enterprises, they tend to be very large security customers. When we get together on the 25th, we'll give really a much deeper breakdown into our various security products, how we think about them, their growth rates, and what we are projecting over the next several years in terms of growth. We will also give you updated counts on how many buy how many security products."
},
{
"speaker": "Operator",
"text": "Thank you. Our next question comes from the line of Tim Horan from Oppenheimer. Your line is now open."
},
{
"speaker": "Tim Horan",
"text": "Thanks, guys. Can you give us a sense of last year, how much were volumes on the different business above trend? Do you estimate -- I mean there's a lot of moving parts, any color on that would be helpful."
},
{
"speaker": "Ed McGowan",
"text": "Yes, sure. So on the traffic side, I would say last year was probably about double what we normally see from a traffic-growth perspective. And then as far as other volumes, obviously, those -- our bookings were pretty much in line with what we expected. And outside of the traffic, there was really nothing that was unusual or worth calling out."
},
{
"speaker": "Tim Horan",
"text": "And looking at..."
},
{
"speaker": "Tom Leighton",
"text": "And one thing is that the attack traffic, the bad guys out there, their volumes were way up across the board. Malicious login attempts, attempts to embed malware, those kinds of things -- DDoS attacks, huge increases really across the board last year. And so that course makes a big difference for Akamai to be able to help our customers because we're unique at being able to stop the largest denial of service attacks and being able to stop the account hijacking attacks."
},
{
"speaker": "Tim Horan",
"text": "And did term and volume or didn't, sorry, did volume price discounts kick-in as a result of volumes being so strong?"
},
{
"speaker": "Ed McGowan",
"text": "So it depends on the contract. A lot of big media companies do have tiered pricing, so that would have kicked in but again, nothing unusual other than the fact that just traffic was just much higher than we had expected."
},
{
"speaker": "Operator",
"text": "Thank you. Our next question comes from the line of Colby Synesael from Cowen. Your line is now open."
},
{
"speaker": "Colby Synesael",
"text": "Great, thank you. Two questions, one is, we're getting a lot of questions just in terms of what the company is likely to guide to at the upcoming Analyst Day. Obviously not asking for the numbers themselves, but what are, from a financial perspective, your intentions in terms of what you're going to provide at the Analyst Day? And then secondly, as it relates to your guidance for 2021, your security growth of 18% to 20%, I think it's below to I think what had been message more of a go for a plus 20%. Is there anything to kind of flag there, is that just typical conservatism, is this simply the law of large numbers as we now breach that $1 billion, or do you think if there is an opportunity to kind of accelerate that or re-accelerate that growth again? Thank you."
},
{
"speaker": "Ed McGowan",
"text": "Yes, So I'll take the second part first. It is a bit of the law of large numbers I guess, we're getting much bigger. We do have a lot of newer products that are ramping fast but it just takes a while on a recurring revenue business. I think if you go back and look in the past, we've talked about last year getting to $1 billion, we exceeded that the year before that, mid-20s, we did high-20s. So there is always a possibility to overachieve but I think that's a reasonable guide. The other question was on the intentions of what we are going to talk about at the Analyst Day. As far as 2021 guidance, so it's only a two-week, so I'm not going to see anything different that I haven't seen yet. So I don't anticipate updating guidance from what we just talked about now. But what we will do is get into a lot more detail, you'll hear from all the leaders talking about what's the different groups and what they're going to be working on some of the growth dynamics, we'll be exposing a lot more about what's going on within the security buckets. We'll be showing you different growth rates and different products, so I think there's a lot of good information that will come out. But in terms of updating guidance, there won't be any [indiscernible], just given that it's two weeks from today."
},
{
"speaker": "Colby Synesael",
"text": "So, no, I think of -- I'll go back to your Analyst Day I think, it might have been in 2018, there was a talk about that 30% operating margin. No expectation to give a new bogey, if you will, for a few years out from there."
},
{
"speaker": "Ed McGowan",
"text": "No, we're not going to give a new bogey for new operating margin. What I will do is talk about the dynamics of the different businesses and how over time, you can see margins expand if we get to the -- a greater percentage of our business comes from security."
},
{
"speaker": "Operator",
"text": "Thank you. Our next question comes from the line of Brad Zelnick from Credit Suisse. Your line is now open."
},
{
"speaker": "Brad Zelnick",
"text": "Great, thanks so much for taking the questions. If there has been some -- so much pent-up demand on the gaming side, and it seems like gaming was a strong contributor again this quarter, how should we think about the impact the gaming vertical might have in 2021 versus maybe other console launches in the past?"
},
{
"speaker": "Ed McGowan",
"text": "Yes, you're right, it was a very strong quarter for gaming. And for us again, just as a reminder we work with the publishers, as well as the major platform. So the upside coming from a variety of different customers. It's, -- we're seeing more interest in gaming the console releases drove a lot of upside in the quarter. It's always hard to predict what games are going to be popular and there is a bit of seasonality in gaming depending on a quarter that has many releases versus one that may not have as many. But it's a very fast-growing vertical for us and we expect that with these new consoles, there should be some new demand throughout the year."
},
{
"speaker": "Brad Zelnick",
"text": "Great, that's very helpful, and maybe just a follow-up on a different topic, Ed. As we think about the zero-overage plans you put in place within the Web Division and the strong e-commerce holiday season, what might the impact have been, and is this a model, which you might expect to be more pervasive throughout your customer base as we move into 2021 and beyond?"
},
{
"speaker": "Ed McGowan",
"text": "Yes, good question. So, as you know, we introduced this probably about 20 months ago is that the number of our customer conference back in and I think it was June of '19, and we have gotten a lot of traction mostly in retail, that's where we're seeing most of the requests for that type of structure. We're right now -- we've got over half of our customers in the commerce vertical are adopting that structure and it makes a lot of sense. It's actually a good strategy when you're faced with a customer base to discuss the macroeconomic challenges when you're looking at ways of getting -- saving money or getting more predictable spend. So it's been well received by the customer base, I would imagine that will continue to tick up. It's not for everyone and like I said, we've seen the primary adopter of that is in the retail space."
},
{
"speaker": "Brad Zelnick",
"text": "Awesome. Thanks so much."
},
{
"speaker": "Operator",
"text": "Thank you. Our next question comes from the line of Will Power from Baird. Your line is now open."
},
{
"speaker": "Will Power",
"text": "Okay, great. Yes, thanks for taking the question. Maybe just to come back to security, I'd love to try to get a little more color on Page Integrity. I know you've been seeing strong trends there for a while, is that on path to be $100 million product and anything else you can share there? And I guess the second piece that ties into that, just wanted to get an update on what you're seeing in terms of revenue, bookings, etc. for some of that enterprise products?"
},
{
"speaker": "Tom Leighton",
"text": "Yes, I'll take those. Page Integrity Manager is off to a great start. We had really very good bookings. Now, of course, we just got launched middle of last year, so it will take time to grow into a $100 million business, but that's very exciting for us. And in terms of bookings for the enterprise business, again, very strong. And as you know, we've been looking forward to getting our enterprise and carrier security products to the point where they are $100 million revenue and we think that we can do that this year, at least get on that run rate so that combined with the enterprise and carrier security now that we have Asavie on-board, and we're going to talk a lot more about that at the upcoming Analyst Day."
},
{
"speaker": "Will Power",
"text": "Are there any particular areas within the enterprise component where you're seeing particular strength?"
},
{
"speaker": "Tom Leighton",
"text": "It's across the board, Enterprise Application Access, really important because of all the malicious login attempts. Enterprise Threat Protector with SolarWinds becomes more important than ever to know what employee devices and enterprise devices are talking to, are they trying to contact command and control outside the enterprise, that's something that we can help catch and stop. Asavie has done incredibly well, much better than we'd expected post-acquisition. And, for example, things like students that need to gain access for remote learning, to protect them to make sure that their environment is secure, there is a -- been a lot of development, of course, we have carriers there. They sell this product and we're behind the scenes, but a very strong pickup there to secure the enterprise cellular networks. And then you think about IoT, in the future, all those devices have to be secured and probably all going to be connected with 5G. So I think a lot of potential upside there. And our secure business solution that's resolved by major carriers under their brands for small and media business -- medium business, again doing very well. So I would say across the board with the enterprise and carrier products, very strong growth and we might have a good chance of doubling revenue this year and reaching $100 million."
},
{
"speaker": "Operator",
"text": "Thank you. Our next question comes from the line of Jeff Van Rhee from Craig-Hallum. Your line is now open."
},
{
"speaker": "Jeff Van Rhee",
"text": "Great, thanks, two from me. Tom, just in terms of restructuring, I'm just curious sort of the thought process or the history of the thought process there. How long this has been percolating and if there were, as you think about it, kind of one or two key triggers that really made this the time? And then secondly, very high level. You look at the 11% annual growth, a lot of puts and takes as it relates to COVID but to the extent you can dial it in, what do you think growth would have been ex-COVID impacts, so obviously pro and con, but any color there?"
},
{
"speaker": "Tom Leighton",
"text": "Yes, we've been thinking about rework along these lines for really an extended period. It's something the senior management team would discuss at least on an annual basis. And in terms of the trigger, now our security business has reached $1 billion and that's an important milestone. We are also seeing really strong growth for the enterprise and carrier security products, as I mentioned, and they were both in incubation phase and in different parts of the company. We have the enterprise group had the enterprise security products and for the carrier products that was done in the Media and Carrier Division. And of course, most of security revenue was in the Web Division. And increasingly as the smaller product areas grew, you start to have overlap, for example, anybody the buys Asavie, we want to sell them Kona Site Defender, makes perfect sense. Same thing for enterprise security, if you buy EAA, we want Kona. And so I think it really makes sense now, they've reached critical mass to bring them together into one team focused on security. And as I mentioned, with the sales organization is something we have thought about over the last couple of years, certainly more efficient to have a single sales organization and the advantage of having them be split had disappeared really once all our customers are buying really all our products, but certainly security. So again, the time is right to do it and you don't like doing something in the middle of the pandemic, but at the same time, you can't wait. At Akamai, we always had a sense of urgency, we want to get this done because I think it will help our growth going forward. Now in terms of 11%, we are very pleased to see that this year. We definitely got some tailwinds for overall traffic levels and so the Media and Carrier Division did well, we also deployed a ton of capacity for, as Ed mentioned, increased growth this year and next year, just the rate of growth probably less this year and next year, more like normal traffic increases as opposed to twice that, that we experienced this year. I think we got hurt in revenue in our web performance products, as Ed talked about. A big part of their revenue comes from commerce which has gotten -- most commerce companies have really been pounded with COVID. There's a few big names that have done very well, probably picked up business. The amount of commerce going online has increased dramatically but when the parent company is hurting, that creates a more difficult environment to negotiate a contract. And in many cases, as we've talked about, we worked with the customer to give them some relief and on pricing as well, we've gone to zero-overage so they can plan better and that hurt I think, revenue with this past Q4, we don't get a lot of bursting. On the other hand, it preserves that business more for us in long term and we're in this for the long haul. And it means we aren't going to share that business with the many competitors out there, who would like to have just a tiny piece of our commerce business. And so it seems a little paradoxical that on the one hand, it probably hurt us on revenue on the other, as we talked about, we serve 40 of the global 50 leaders in commerce and retail and 23 of 25 in the U.S. and we're working very hard to maintain that business over the long-term and grow it, particularly with our security products."
},
{
"speaker": "Operator",
"text": "Thank you. Our next question comes from the line of Brandon Nispel from KeyBanc Capital. Your line is now open."
},
{
"speaker": "Brandon Nispel",
"text": "Great, thank you. Two questions for Ed. Ed, could you provide the contribution from acquired businesses included in the revenue outlook for 2021, I think in particular around Asavie and then Inverse? And then secondly, how should we think about IPC revenue contribution in 2021 versus 2020? Thanks."
},
{
"speaker": "Ed McGowan",
"text": "Yes, sure. So as far as Inverse goes, there's really no revenue, that was a very small company. It was more of a tech tuck-in some of the others that we've done in the past. So there is no real contribution from that directly. As we integrated and it will help accelerate some of our other products. Asavie, probably about $30 million incremental, if you look kind of year-over-year, we had about $8 million this quarter. So somewhere in that range, so call it a little less than a point. And then as far as the Internet platform customers, I'm not going to tip my cap for the team that's been working on those, they have done a fantastic job not only maintaining that business but growing it. I haven't provided specific guidance, but I'd expect kind of a similar year where you're kind of maintain where you're kind of, maintaining where you are at, maybe a little upside. Q4 was particularly strong, so maybe it's in that $50 million range, plus or minus a few million bucks depending on what's going on in a particular quarter."
},
{
"speaker": "Brandon Nispel",
"text": "Great. Thank you."
},
{
"speaker": "Operator",
"text": "Thank you. Our next question comes from the line of Rishi Jaluria from D.A. Davidson. Your line is now open."
},
{
"speaker": "Rishi Jaluria",
"text": "Hey, guys. Thanks so much for taking my questions, and nice to see continued strong execution. I wanted to go back to an earlier comment that was made with reference to SolarWinds bridge. I wanted to get a sense, what are you seeing out there in terms of any changes in demand or pipeline or inbound interest as a result of that breach, especially given your kind of leadership in the zero-trust area that's becoming increasingly important for CSO. And then I've got a follow-up."
},
{
"speaker": "Tom Leighton",
"text": "Yes, obviously it illustrates the importance of zero-trust. It's -- it was obviously a devastating attack and it highlights the need for products, for example, like our Enterprise Threat Protector. It's one thing to try to stop the malware from getting inside, that's hard, you look at an example like this, but once it inside, it has to go out and contact command to control. And that's something that you can pick up in detect and block in many cases and then alert the CSO that they got a problem. And that's what our Enterprise Threat Protector product is meant to do and has done in many, many cases. So I think in the long run, it just heightens the need for products that we provide and the need for zero-trust in general. Stepping up a level, with third party malware showing up everywhere, that's the same problem you have with page integrity and why our Page Integrity Manager service is so important. Because today so many websites linked to third parties or use third-party or open-source code, it has malware. And what that means is when a client or one of our users goes to their website or uses their app, the client gets infected and their personal information's exposed. And it's just another example of a third-party malware that's become infected that the enterprise is using. A different particular use case, one is the web side the others internal enterprise apps, same problem and same devastating result and Akamai has solutions to help stop that."
},
{
"speaker": "Rishi Jaluria",
"text": "Got it, that's helpful. And then I wanted to go back to the reorg. Look, I think it makes a lot of sense why you're doing the reorg, maybe philosophically, want to understand what steps are you taking or how are you thinking about avoiding disruption because in enterprise software, every time there is a reorg, there's always a worry of it's going to disrupt the business, especially when you're running on such a hot hand like you are right now and you've done reorgs in the past. So maybe kind of a thought process on just how do you avoid that from really disrupting our business would be helpful. Thanks."
},
{
"speaker": "Tom Leighton",
"text": "Yes, that's a great question, something we've put a lot of time and effort into. This is a kind of thing we would plan for, really for six months. It's important to know we're doing it from a position of strength. I think the last thing you want to do is a reorg when you're in a position of weakness because that's where you can get the disruption in the problems. And as you can see, we're as strong as we've ever been. And so I think that is a good time to do a reorg. As we mentioned before, I don't see a lot of account disruption, not a lot of account breakage. You do worry whenever you change, the go-to-market operation, that you could have some disruption that way. I don't think that's likely here because as we mentioned, a lot of the accounts have the same person they had before that they're dealing with. So I don't think that will be a problem for us. And as you mentioned, we do have experience at doing this and we have great employees and I would say morale in the company is very high. And so I don't anticipate serious disruptions in the business here."
},
{
"speaker": "Operator",
"text": "Thank you. Our next question comes from the line of Robert Majek from Raymond James. Your line is now open."
},
{
"speaker": "Robert Majek",
"text": "Great, thanks. I think investors appreciate the sales synergies between your web performance offerings in your cloud security offerings and the sales force consolidation there makes perfect sense but would be great to get your thoughts on whether or not it still makes sense to build a dedicated sales force to help accelerate your enterprise security adoption."
},
{
"speaker": "Tom Leighton",
"text": "Yes, we do have a sales specialist already and that has been maintained with the new organization. So there'll be no change there in terms of the specialist for not only the enterprise security products but the carrier security products, which are very close. Also, Prolexic has sales specialists there, so that won't change."
},
{
"speaker": "Robert Majek",
"text": "Great, thanks and one more if I can, just building up Brad's questions. The year-over-year CDN growth rate decelerated 4 points from last quarter. So just wondering what we should make that dynamic. We know that overall traffic especially around gaming with strong, up -- perhaps it was offset by the introduction Zero Overage Fixed Fee pricing. So any additional clarification there would be helpful as we think about CDN and growth rate going forward."
},
{
"speaker": "Ed McGowan",
"text": "Yes, I think you pretty much nailed it. I just remember last Q4 was an exceptionally strong quarter from a traffic growth perspective. So you've got a bit of a tougher compare and like I said earlier, starting in Q2, when we saw the big ramp in traffic, you're going to start to see a little bit tougher compare on the media side and then the dynamics that we've talked about really over last couple of quarters on the retail and commerce vertical, make it a bit more of a challenging year from a CDN perspective, but we still think we're in a great position and we've got some really good tailwinds going on. We were just talking a minute ago, OTT video is also growing very strongly. So there's a lot of puts and takes in there, but in general, I think that's kind of the key driver is just a bit of a tougher compare and then that challenge with retail and travel."
},
{
"speaker": "Tom Barth",
"text": "Okay, well, this is Tom Barth. We want to thank everyone in closing. As Tom and Ed mentioned, we would look forward to you joining us virtually for our Investor Relations Summit on February 25th. Additionally, we will be presenting at several investor conferences and events throughout the rest of the quarter. Details of these can be found on the Investor Relations section of akamai.com. Thank you for joining us, and all of us here at Akamai wish continued good health to you and yours and have a wonderful evening."
},
{
"speaker": "Operator",
"text": "Ladies and gentlemen, this concludes today's conference call. Thank you for participating. You may now disconnect."
}
] | Akamai Technologies, Inc. | 24,522 |
AKAM | 3 | 2,020 | 2020-10-27 16:30:00 | Operator: Ladies and gentlemen, thank you for standing by, and welcome to the Third Quarter 2020 Akamai Technologies, Inc. Earnings Conference Call. At this time, all participant lines are in a listen-only mode. After the speakers’ presentation, there will be a question-and-answer session. [Operator Instructions] Please be advised that today’s conference is being recorded. [Operator Instructions] I would now like to hand the conference over to your speaker today, Tom Barth. Please go ahead.
Tom Barth: Thank you, operator. Good afternoon, everyone, and thank you for joining Akamai’s third quarter 2020 earnings conference call. Speaking today will be Tom Leighton, Akamai’s Chief Executive Officer; and Ed McGowan, Akamai’s Chief Financial Officer. Before we get started, please note that today’s comments include forward-looking statements including statements regarding revenue and earnings guidance. These forward-looking statements are subject to risks and uncertainties and involve a number of factors that could cause actual results to differ materially from those expressed or implied by such statements. The factors include uncertainty stemming from COVID-19 pandemic and any impact from unexpected geopolitical developments. Additional information concerning these factors is contained in Akamai’s filings with the SEC, including our annual report on Form 10-K and quarterly reports on Form 10-Q. The forward-looking statements included in this call represent the company’s view on October 27, 2020. Akamai disclaims any obligation to update these statements to reflect future events or circumstances. As a reminder, we will be referring to some non-GAAP financial metrics during today's call. A detailed reconciliation of GAAP and non-GAAP metrics can be found under the financial portion of the Investor Relations section of akamai.com. And with that, let me turn the call over to Tom.
Tom Leighton: Thanks, Tom. And thank you all for joining us today. I'm pleased to report that Akamai achieved excellent results in the third quarter. Revenue was $793 million, up 12% year-over-year and up 11% in constant currency. Non-GAAP operating margin was 32%, up 3 points from Q3 of last year. Non-GAAP EPS was $1.31 per diluted share, up 19% year-over-year, and up 18% in constant currency. These very strong results were driven primarily by the continued strong performance of our security products, and high traffic levels on our Edge platform. We're very proud of how Akamai has continued to deliver fast, intelligent and secure online experiences for billions of users around the world as we support our customers during these challenging times. We're also very pleased that our hard work to improve operating efficiency and profitability has put us in an excellent position to exceed our goal of 30% operating margins for the year. Our Media and Carrier business continued to perform very well in Q3, benefiting from high traffic levels for video streaming and gaming software downloads. In fact, one giant video-on-demand service increased the traffic on our platform by a factor of 4 last quarter. As more entertainment moves online, Akamai has continued to prove that our unique Edge platform scales to meet the unprecedented demand for streaming video, popular gaming releases, and complex API transactions. We can do this in part because we’ve positioned more than 325,000 servers in more than 4,000 locations in over 1,000 cities. At Akamai, we’ve positioned content very close to end users, and we make sure it's available when and where it's needed. In addition, our highly advanced Internet mapping algorithms route traffic around congestion to maintain excellent application performance for our customers. Our unique Edge platform also allows our customers to perform a wide variety of computational tasks close to end users, resulting in faster performance, instant scalability and lower cost. For example, a leading social networking company uses Akamai's Edge platform to manage API requests for their recommendation engine, a leading apparel company uses our platform to supply health information to users based on their fitness tracker. Several major companies use Akamai to provide critical weather updates based on local conditions, as well as geographic information such as nearby points of interest, or locations of desired services. Many of the world's largest OTT companies use Akamai to help manage the critical components of their architecture on the edge, including functionality for user authentication, content recommendations, and payment processing. Some of the world's largest credit card companies use our platform to assist with authentication and authorization of payments via digital gateways. Several of the world's largest gaming companies use Akamai's Edge to assist in managing user profiles and registration, as well as event leaderboards. And the ad tech ecosystem uses applications running on the Akamai Edge to assist with ad calls, bidding, and placing consent cookies to remain in compliant with data privacy regulations. It's important to note that while some CDNs are talking about edge computing or serverless computing, as if they're somehow new technologies, Akamai has been providing these services to thousands of customers for well over a decade. And already this year, we've handled well over 100 trillion API requests on our Edge platform. The vast capacity of our platform, combined with our unparalleled security intelligence and machine learning algorithms, has also enabled Akamai to defend many of the world's most important enterprises against the largest and most sophisticated cyber attacks. This capability has proved to be especially important during the recent wave of ransom DDoS attacks. Since August, we've been approached by dozens of major businesses around the world that had received extortion letters, threatening them with massive DDoS attacks, if they didn't pay a ransom. In response, our security experts performed emergency integrations of our Prolexic service, which enabled these enterprises to continue or resume business operations without experiencing any service disruptions from the attacks. As a result, we've added many new enterprises to our Prolexic customer base, including several global banks and insurance companies, a leading travel website, and two national stock exchanges. In addition to Prolexic, we also continue to see strong growth from our market leading Kona Site Defender and Bot Manager services. Bot Manager has been especially valuable in stopping account takeover attacks, which have greatly increased in scale and sophistication. In fact, the number of malicious login attempts by bots that we blocked in Q3 was more than double the number we handled in Q2. I'm also pleased to report that our recently launched Page Integrity Manager solution, which is designed to identify and forward Magecart attacks and malware in third-party scripts is off to an excellent start with strong customer interest and bookings. In another sign of our leadership in cyber security, Forrester recently named Akamai as a Leader in Zero Trust, with the highest possible scores for network security, workload security, APIs, zero trust advocacy and market approach. And just last week, Gartner recognized Akamai as a leader in its 2020 Magic Quadrant for Web Application Firewalls for the fourth year in a row. Overall, Q3 revenue from our Cloud Security Solutions was $266 million, up 23% year-over-year in constant currency and accounting for 34% of Akamai’s total revenue. To further build on our growth in security, we were pleased to announce today that Akamai has acquired Asavie, a leader in securing mobile access for enterprises. Asavie partners with some of the world's largest mobile network operators to enable enterprises to connect, manage and secure communication among cellphones, and other IoT devices, without the need for client software on the device. These capabilities are critical for organizations with mobile workforces or large numbers of connected devices. By integrating Asavie solution with Akamai's unique Edge platform, and arming it with Akamai's vast array of real time security data, we plan to enable enterprises to greatly improve the security of their operations, while also improving the performance of their internal applications. Asavie will complement our security product lines with a cellular-specific security offering, which is an important step in our strategy to capture the emerging opportunity in 5G. It is also synergistic with our Enterprise Application Access product, and complements our IoT Edge cloud solution, allowing enterprises to improve the reliability and consistency of real time communications with IoT devices, and to easily secure those endpoints to avoid compromise. As we look to the future, we believe that the deployment of 5G and IoT applications can provide significant opportunities for Akamai. 5G technology improves the performance of the last mile, providing higher throughput and lower latency, and the potential to connect a lot more people and things. And that could spawn the creation of new applications, such as ultra-low latency video, augmented reality, IoT applications and analytics at a massive scale, deep threat intelligence for attack mitigation, and much more that we can't even imagine yet. The impact of 5G on innovation to be similar to the way broadband enabled new social networking apps that few could have imagined before. As 5G networks come online, we believe that end users and connected devices will demand faster performance and greater scale than cloud data centers can provide. And thus, that our Edge architecture will become more important than ever. In fact, Gartner estimates that by 2022, more than half of enterprise generated data will be created and processed outside of traditional cloud data centers. The breadth of our Edge platform means that we're incredibly close to billions of end users. And being so close means that Akamai is in a unique position to provide the near instant response times, very high quality video experiences, serverless computing capabilities, and the market-leading security services that our customers are demanding. In summary, we're very pleased with our performance so far this year. We believe that our strong growth, profitability and cash generation provides us with a financial firepower to continue investing in the innovation, network capacity, novel products, and world class talent needed to fuel our future growth. Now, I'll turn the call over to Ed for more on Q3, and our outlook for the fourth quarter. Ed?
Ed McGowan : Thank you, Tom. As Tom outlined, Akamai delivered another excellent quarter from Q3. We were very pleased to exceed the high end of our guidance range on revenue, operating margin and earnings. Q3 revenue was $793 million, up 12% year-over-year for 11% in constant currency, driven by another quarter of robust security growth, continued strong performance from our Media and Carrier Division and a weaker U.S. dollar. Revenue from our Web Division was $418 million, up 8% year-over-year, or 7% in constant currency. Revenue growth for this group of customers was again led by our security business and to a lesser extent we also benefited from lower-than-expected COVID-related credits to customers. Revenue from our Media and Carrier Division was $375 million, up 16% year-over-year. The overachievement in Q3 came from higher-than-expected OTT video and gaming traffic, along with continued momentum in security. We were pleased to see traffic remain at elevated levels, which helped offset the approximately $15 million negative impact from India's ban of 59 Chinese apps that we discussed on our last quarter's call. Revenue from the Internet Platform Customers was $51 million, up 15% from the prior year, and above our expectations due to higher traffic. Security revenue for the third quarter was $266 million, up 23% year-over-year, driven by continued global demand for our Web and Enterprise Security Solutions. And as Tom mentioned earlier, we also saw strong demand for DDoS protection from our Prolexic products in Q3. Foreign exchange fluctuations had a positive impact on revenue of $10 million on a sequential basis and positive $4 million on a year-over-year basis. International revenue was $355 million of 20% year-over-year or 18% in constant currency. We had strong performance internationally despite the sequential headwinds in India that I previously mentioned. Sales in our international markets represent 45% of total revenue in Q3, up 3 points from Q3 2019 and up 1 point from Q2 levels. Finally, revenue from our U.S. market was $437 million, up 6% year-over-year. Now moving to costs. Cash gross margin was 76%, in line with our expectations. GAAP gross margin which includes both depreciation and stock-based compensation was 64%. Non-GAAP cash operating expenses were $252 million roughly flat with Q2 levels, and in line with our guidance. Now moving on to profitability, adjusted EBITDA was $351 million, up $51 million or 17% from the same period in 2019. Our adjusted EBITDA margin was 44%, up 2 points from Q3 2019. Non-GAAP operating income was $251 million, up $43 million or 20% from the same period last year. Non-GAAP operating margin came in at 32%, up 3 points from Q3 last year. Capital expenditures in Q3, excluding equity compensation and capitalized interest expense, were $200 million, in line with our guidance range. GAAP net income for the third quarter was $159 million or $0.95 of earnings per diluted share. Non-GAAP net income was $216 million, or $1.31 of earnings per diluted share, up 19% year-over-year, up 18% in constant currency and $0.07 above the high end of our guidance range due to higher-than-expected revenue. Taxes included in our non-GAAP earnings were $37 million based on a Q3 effective tax rate of approximately 15%. Now, I will discuss some balance sheet items. We continue to have a very strong balance sheet. As of September 30th, our cash, cash equivalents and marketable securities totaled approximately $2.6 billion, up approximately $163 million from the end of Q2. After accounting for the $2.3 billion of combined principal amounts of our two convertible notes, net cash was approximately $254 million as of September 30th. This increase was driven by a number of factors that include an exceptionally strong cash collections quarter. Now, I will review our use of capital. During the third quarter, we spent $13 million to repurchase shares, buying back approximately 120,000 shares. We ended Q3 with approximately $644 million remaining on our previously announced share repurchase authorization. Our long-term plan remains to leverage our share buyback program to offset dilution resulting from equity compensation over time. In summary, we're very pleased with our Q3 results. Before I provide guidance, I wanted to take a moment to remind everyone of several factors that will impact Q4. First, seasonality plays a large role in determining our fourth quarter financial performance. We typically see higher-than-normal traffic for our large media customers, and from seasonal online retail activity for our e-commerce customers, which are both difficult to predict, especially in the current economic environment. Also, as Tom mentioned earlier, today, we announced the acquisition of Asavie. In the fourth quarter, we expect the acquisition to add approximately $4 million of revenue and to be dilutive by approximately $0.01 of non-GAAP EPS. It’s also worth noting, as I mentioned earlier, that our Q3 revenue was negatively impacted by approximately $15 million due to the actions taken by the Indian government to ban 59 Chinese based web applications in India. Our Q4 guidance as soon as the ban in India remains in place for the balance of 2020. In addition, the U.S. government has taken a similar stance with respect to some of these applications. And absent court action or change in policy, those bans are scheduled to take effect in mid-November. As a result, our Q4 guidance assumes an additional $4 million to $5 million negative impact to revenue sequentially based on the U.S. ban going into effect mid-November. In the unanticipated events, these 59 applications were subject to a total global ban, the total additional negative impact to our revenue would only be approximately 3%. To be clear, this represents an extreme assumption that we do not currently expect to occur, and we are not modeling in our current outlook. However, I wanted to provide you with additional color for added transparency, and to make the point that our customer base remains well-diversified across many customers, industries, products and geographies. Finally, at current spot rates, foreign exchange fluctuations are expected to have a positive $2 million impact on Q4 revenue compared to Q3 revenue -- Q3 levels and a positive $6 million impact year-over-year. Taking all these factors into consideration, we're projecting Q4 revenue in the range of $812 million to $837 million or up 4% to 8% in constant currency over Q4 2019. To frame our guidance further, we would expect to be towards the lower end of the range if we see a more modest quarter for OTT and gaming traffic, if e-commerce activity is weaker than expected, the impact of the COVID pandemic leads to an inability of our customers to pay for our services and the U.S. dollar strengthens and creates foreign exchange headwinds. Conversely, we'd expect to be at the higher end of the range if we see -- if we experience a more robust than normal online holiday shopping season, and we see stronger than expected demand for OTT video and gaming traffic, including potential upside from two highly publicized new game console releases expected later this quarter. At these revenue levels, we expect cash gross margin of approximately 76%. Q4 non-GAAP operating expenses are projected to be $268 million to $279 million, with a sequential increase primarily due to higher commissions-related expenses from sales compensation accelerators kicking in during the fourth quarter, given our very strong performance this year relative to our plan. Factoring in the gross margin and operating expense expectations I just provided, we anticipate Q4 EBITDA margins of approximately 43%. Moving now to depreciation, we expect non-GAAP depreciation expense to be between $106 million to $108 million, reflecting our accelerated server deployment in Q3. Factoring in this guidance, we expect non-GAAP operating margin of approximately 30% for Q4. Moving on to CapEx, we expect to spend approximately $193 million to $199 million excluding equity compensation in the fourth quarter. And with the overall revenue spend configuration I just outlined, we expect Q4 non-GAAP EPS in the range of $1.28 to $1.32, or up 2% to 5% in constant currency. This EPS guidance assumes taxes of $36 million to $37 million, based on an estimated quarterly non-GAAP tax rate of approximately 15%. And it also reflects a fully diluted share count of approximately 165 million shares. In light of the Q4 guidance I've just provided and our strong performance for the third quarter, for the full year 2020, we now expect revenue of $3.164 billion to $3.189 billion, which is up 10% year-over-year in constant currency. We expect non-GAAP operating margins of approximately 31%. And we expect non-GAAP earnings per diluted share of $5.16 to $5.20, which is up 15% to 16% year-over-year. In summary, we are very pleased with how our business has continued to perform during a very challenging time. Thank you. Tom and I would be happy to take your questions. Operator?
Operator: [Operator Instructions] Our first question comes from the line of Tim Horan with Oppenheimer. Your line is open. Please go ahead.
Tim Horan: Can you talk about Edge a little bit more, maybe on how your service offers compare with your peers? And what do you think your win rate is on pitches for Edge?
Tom Leighton: Well, Edge refers to our platform, which really is unique in the sense that -- we're in 4,000 locations. We're in 1,000 cities. We are uniquely close to the end users out there, the billions of end users around the world. Other companies talk about edge, and they might be in a couple of dozen locations, a factor of 100 or less. And because we're close, that's really important, because we're going to give better performance. If you're closer, the latency is less, and it's going to be faster. Also, if you're close, you got access to the bandwidth and the scale. And that's why we have so much more scale than the other CDNs. And that's really important to customers that have a lot of traffic, the big OTT providers and the big software downloaders. And that's why so much of their business comes to Akamai. Also, being in those locations gives us a huge advantage on cost, because in the large fraction of those 4,000 locations, we don't pay for bandwidth and colo and power. And so it's free for us with the infrastructure. We pay for our CapEx. But our competitors aren't there. There our competitors are in big data centers, and that is the most expensive real estate in the world. And so we're in a position that we can provide compelling pricing to the major enterprises out there. And our competitors, if they're going to do that, they have to do it losing money, and that's not sustainable. Now any one of the many competitors we have out there, all, generally speaking, much, much smaller, at any given time, they could take on some traffic and show some high percentage growth on very small numbers. But it's hard to sustain that when you don't really have a sustainable advantage. And then you see that happen as the traffic -- some of the traffic share moves around among the smaller players. Now in addition, it's not just about CDN and delivering traffic, it's accelerating the traffic. It's providing functionality on the edge close to the end user. And I talked about a lot of examples that where we're doing that today. And of course, processing a lot of the API transactions, which are tied to functionality, over 100 trillion so far this year. And then you have the security aspect, which our CDN competitors, by and large, don't have. They make partner with other companies or start-ups to have some security story. But that's now $1 billion business for Akamai and growing at over 20%. And security is just really vital for our customers and it works in tandem with the application acceleration, with the Edge computing, all is one service, all on one platform. And if you're not on the edge, there's no hope to withstand the large attacks that we're seeing today.
Operator: And our next question comes from the line of Colby Synesael with Cowen. Your line is open. Please go ahead.
Colby Synesael : Just going back to security. I'm just curious, would the security results thus far this year have been much different had COVID-19 not had happened? I'm just curious how you would quantify the impact that COVID-19 has had on the security business, whether good or bad? And then secondly, the long-term operating margin of 30%, I think you've messaged that, that should remain flat target. But can you just remind us why that is and why we won't continue to see increased operating margin leverage?
Tom Leighton: Sure. I think we'd see strong security growth with or without COVID. There are some of our products that are really helpful for enterprises as they have more of a remote workforce. And so we did see uptick in bookings there. So I think there's some help. The attack rates have gone way up. And I do think some of that has tied to COVID. Now whether we see the ransom DDoS attacks that are widespread just in the last couple of months, we might have seen that anyway. Maybe there's an increase because the price is bigger now. If you're attacking a commerce company that has 90% of their business in brick-and-mortar, well, they care about the 10% for sure, but when all of their business is online, now they really really care. So there is a bigger price, and maybe that's incented the attackers to up the attack level or maybe that's just the world we're living in, where we're going to be seeing more and more attacks, even if we get COVID under control. And I can tell you, we see a lot of attacks in Asia Pacific just like we do here and in Europe. Even though in APJ, COVID is largely under control there and operations are largely returned to normal. And yet the attacks -- the ransom DDoS attacks are just as -- increasing just as fast over there. In fact, one of the national stock exchanges that was taken offline that is now an Akamai customer was in Asia Pacific. In terms of the 30%, we do think that's a good place to operate the company over the longer term. And we're -- that said, we're going to do everything we can to operate as efficiently as possible and you see that this year. This year, we've been doing over 30%. And so if we can do that and continue to make the investments we want to make to achieve long-term growth in the business, then we will. But I think the right way to think about it is 30% is a good baseline and when we can overachieve that, we're going to do that.
Colby Synesael : And I guess just one quick follow-up to the security question. I mean given what sounds like some upside, arguably, do you think that you're in a position to sustain that 20%-plus growth rate over the next few years?
Tom Leighton : Certainly, we'd like to do that. We're seeing very strong growth in Kona Site Defender and Prolexic. And Kona Site defender is our web app firewall product. Bot Manager doing very well, and the next-generation of that will be even stronger at preventing account takeover. Security services business we talked about is doing very well. And I think with the increase in attacks and the sophistication of attacks, we're seeing even more demand for our security services. It's just too hard for even major enterprises to keep up. And then you have the newer solutions, our enterprise services, Enterprise Application Access, Enterprise Threat Protector, now equipped with the first version of our Secure Web Gateway. We're going into beta with our multifactor authentication service next month. As we talked about, our Page Integrity Manager, which sits on top of Kona, off to a great start. We'd like to see that track the way that Bot Manager did getting out of the gate. And of course, we announced today -- and I'm really excited about the Asavie acquisition. I think that opens up a whole new category for us that we'll see accelerated growth as we get more 5G deployments as you see more IoT applications out there. And what that does is it sends all the cellular traffic safely and directly to Akamai before it gets on to the Internet. And in that way, we can really protect enterprises and their cellular devices. And I think that's a market that is very exciting for the future.
Operator: And our next question comes from the line of Sterling Auty with JPMorgan. Your line is open. Please go ahead.
Sterling Auty : So wondering, you made the comment that one of the big video providers, you saw 4x increase in traffic, that would seem to be more than just a COVID related. I'm just wondering what else you saw in that particular account? And is that something is happening in other accounts as well?
Tom Leighton : Yes. As we talked about and we're continuing to gain share, if you exclude the 59 Chinese apps where obviously government regulation has lessened the traffic we're delivering there. And that's based on our scale and performance and ability to offer market competitive prices for our customers. And so I think you've seen that trend over the last couple of years, we've talked about it. We put a lot of effort into continuing to improve performance, continuing to improve our scale and on a global basis. And that puts us in a great position against the competition in the market. And you're right, the 4x is obviously not COVID. COVID did improve traffic, there's no question about that, but nothing like 4x.
Sterling Auty : That's great. And then one follow-up. You touched upon it in your prepared remarks and your guidance, which is e-commerce heading into the holiday season. It's been a little while since you've updated us. Can you give us a sense of where do you sit in terms of your customer base within like that e-tailing 100 or that 100 largest e-commerce sites and vendors that are out there?
Tom Leighton : Very, very strong. Well north of 90% of the top commerce companies rely on Akamai for application acceleration, and also importantly, increasingly importantly, security. And as I mentioned before, now that these companies, a lot of them, most all of their business is online. And so security really, really matters now, and we're obviously the go-to supplier there.
Operator: And our next question comes from the line of James Fish with Piper Sandler. Your line is open. Please go ahead.
James Fish : Tom, you sound really excited here on these new security solutions again. I guess, how are you thinking about the web security gateway market? And do you need more investment in an enterprise security sales team to get this product more penetrated and beyond just the CDN installed base?
James Fish : Yes. In fact, a lot of our customers for the enterprise products are new to Akamai and hadn't bought our pre-existing product line. And that's because our web products, delivery and web app firewall were primarily to a subset of the Fortune 500, maybe a third of the verticals to half of the verticals. But enterprise security is something that pretty much all the Fortune 500 would need. And so that has increased our market, and we have put effort into our specialist teams that help the sales force. I would say that all of our sales force now is very adept at selling the traditional Akamai security products. And most of them are actually pretty good now at the newer products with enterprise security, Page Integrity Manager. SWG is just new out there. So very early on. But I think we're in good shape there. And Asavie of course, that's sold by carriers as is our SPS solution. And so we would sell to the world’s -- or Asavie -- now Akamai sell to the world's major carriers and provide a solution that they then take to enterprises. And I think that's a model that we're very excited about. And increasingly, you'll see with our enterprise security products, will be led by channel partners and carriers being the majority of that.
Sterling Auty : Just as my follow-up, we're starting to see a new wave of applications, get the size again like we did last decade with Netflix and YouTube being 2 examples. I guess, what are you guys hearing from customers regarding their own potential CDN build-outs for some of the applications that they have? One of your customers, for example, hit their 5-year goal within 1 year.
Tom Leighton : Wait, so are you asking about what are we seeing in terms of DIY? Or what are we seeing in terms of big OTT players and their market penetration success?
Sterling Auty : Both. I'll take both.
Tom Leighton : Okay. Well, yes, OTT is certainly increasing, and a lot of the offers are seeing substantial success. Obviously, some are doing better than others. But I do think OTT is here to stay. Obviously, got tailwinds from the pandemic. But I think people are -- as they view more online, that becomes more of the pattern and that will outlive the pandemic. Of course, I think we'd all like to get back to a world when you can go out and see a movie, probably not going to be anytime soon here in the Americas or in EMEA. And I think more and more of the movie watching and TV shows will be watched online. DIY is something that you know that we exist in a few of the largest content providers. And I don't think we've seen a huge shift there. You can sort of track that with our -- the cloud giant customers, which has been fairly steady over the last year or so. It's really hard to build out something like that for yourself. It costs hundreds and hundreds of millions of dollars, if not more, you end up spending more than you would with Akamai, and you don't get the quality you get with Akamai. And not only that, if you're a global company, you got to do it all around the world, that's just -- it doesn't make sense. Now some of the biggest companies do it, and I think you'll continue to see that. But there's not been a real fundamental shift there.
Operator: And our next question comes from the line of Brad Zelnick with Credit Suisse. Your line is open. Please go ahead.
Ray McDonough : This is Ray McDonough on for Brad. First, Tom, if I could, I wanted to ask about gaming. And as you mentioned, we're approaching a new console cycle with both Sony and Microsoft coming out with new consoles. And from what I understand, they've made some changes to how games will be downloaded. With the caveat that downloads and gaming files are becoming larger and more ubiquitous, how should investors think about the contribution of gaming? How much does it represent today? And how big of a growth driver do you think it can be into next year?
Tom Leighton: I'm going to hand that one over to Ed.
Ed McGowan : Yes. So obviously, gaming has been a business that's changed for us quite a bit over the last couple of years. You see the multi-player gaming has changed the dynamics. And if you think about the consoles that are coming online, obviously, 2 major players, it's been say, 4, 5 years since we've had a major upgrade cycle. So I would say you can kind of throw history out, this is sort of a new chapter. I think it could be a good source of upside for us. In terms of its contribution, we don't break it out specifically, but I would say it's probably the second largest contributor in our media business next to video. So as I talked about in the guidance section that this could be a source of upside. And it's hard to tell, we'll know when we get there, but this could last into the early part of next year as some of the publishers come up with new games and the consumers are buying the new consoles, they have to update the system with firmware and then catchup with all the old games that they had. So I think this is a pretty good trend for us. It's hard to predict whenever you have something that's large. And as you rightly pointed out, the game downloads, the frequency and the size are only increasing.
Ray McDonough : Yes. That makes a ton of sense. I appreciate that color. And if I could, just a quick follow-up. Coming out of the first half of the year, there seems to be some supply constraints industry-wide. Understanding that every region is a bit different, how is capacity industry-wide trending? And how should investors think about your capital expenditure plans into next year?
Ed McGowan : Yes. Great question. So obviously, this year was a pretty big year for CapEx. And we've really been on the journey here for the last, call it, 18 months, where we've increased the capacity of the network. And I'm glad we did. I think Tom and the team made a great decision to do this. Obviously, we couldn't have predicted the pandemic, but we had a lot of new OTT launches coming. And as we talked about just a few minutes ago on gaming, that's becoming more and more challenging because customers want to get their games at the same time. And that requires a lot more capacity. And so we spent quite a bit on CapEx. We actually took advantage of some bulk purchases here at the end of the year. We've added a tremendous amount to our capacity. So I would expect next year to be back in sort of the normal level of CapEx and down several points from what we're seeing today.
Operator: And our next question comes from the line of Will Power with Baird. Your line is open. Please go ahead.
Will Power : Okay. Great. I'll ask just a couple here. Maybe first, I'd love to get some perspective on what you're seeing in international arena. And I guess, really, despite the challenges you were facing in India, you continue to see strong growth. So maybe just if you can just touch on what the sources of the strength were kind of outside of India?
Tom Leighton : Yes, sure. So, yes, you are right to point out, it’s actually not India that was impacted, it was actually China because the customers that were impacted, the 59 Chinese apps, we serve about 30 of them. Those were actually customers in China. So China revenue, obviously, was a bit more challenged this quarter. Actually, India was actually one of the areas of strength. What I was encouraged by is I saw in many different countries, in all different geographies, so Latin America, Brazil and Mexico, over in Europe, we saw strength in the UK, Germany in the Netherlands. And then over in Asia, we saw strength in Australia, Indonesia and continued strength in Japan. So it's really across the board. We're very pleased with international growth. And if you think about coming into a quarter where you're losing $15 million of revenue from your international customer base and to be able to still grow sequentially and grow 20% year-over-year, it's very impressive. And as I've talked about in other calls, I think we have a unique advantage in the industry from an international perspective. We made the investments early on in sales and building out our network and our capabilities that I think it's a huge advantage for us, and we’ve done remarkably well, not only in just delivering media but also in security.
Will Power : Is that international strength concentrated in any particular products or solutions or is it more broad-based?
Tom Leighton: I'd say it's more broad-based. Certainly, the early days, it was all about media delivery and application acceleration. The U.S. market was the first to adopt the security solutions. But now security is becoming a really nice growth engine for us internationally.
Will Power : Okay. And then kind of my second core question, just around M&A, notwithstanding the acquisition announced this morning. Maybe you can just update us on appetite for M&A as we exit this year and into 2021. Maybe any color around areas of focus and potential size, kind of what you're seeing out there in the market?
Tom Leighton: Yes, we continue to be very active in looking at potential deals. Obviously, it's a little trickier with the pandemic because travel is restricted, but that's not preventing us from doing transactions, as you saw from today's announcement. I would say so far the pandemic really hasn't impacted market caps very much, that may happen at some point depending on what happens with the global economy. So, I would say it's business as usual right now.
Operator: And our next question comes from the line of Keith Weiss with Morgan Stanley. Your line is open. Please go ahead.
Keith Weiss : A lot of the questions I had were covered. So a couple of kind of more detailed questions, if you will. One, on that gaming theme, a lot of what people were talking about for gaming on a go forward basis is shifting to more streaming to game subscriptions. And it's not just Microsoft, there are like other vendors have their platform for game streaming. Can you talk to us about how optimized or positioned for that potential shift towards more of a game streaming? It sounds like something that would be kind of right up your alley.
Tom Leighton: Yes, so it depends exactly what you're referring to. But if it's a gaming tournament, where a lot of people are watching, yes, we do that already. And that creates a fair amount of traffic. If it's a situation where an individual's game and their screen is being streamed, we don't do that very much. We will handle the metadata and the security around that. The economics around streaming individuals, what they would see on their screen, that's pretty challenging. People have been working at that, the big gaming companies for well over a decade and haven't really gotten the economics to work. But we would handle the metadata, the security, the log-ins, the leader board, all that kind of stuff, we handle. It's just the individual stream is not so economical.
Keith Weiss : And then one detailed question on the security solutions. In particular, Access is a solution that you guys have rolled out. And it's something that we hear a lot from a lot of different vendors across the spectrum, whether it's guys coming from like a security perspective, like a Zscaler or Citrix as their access solutions. Can you talk to us about sort of how the competitive environment in there is shaking out for you guys? Where do you guys see yourselves doing well? And who do you run-up against most often?
Tom Leighton: Yes. We compete well with Zscaler there. I would say that the vast majority of the competition is the traditional CPE vendors and the traditional ways of doing things. And our value proposition is that we can do it in the cloud. That's a lot easier and more secure. And we can -- once we have it and we're providing the access, we can layer in Kona Site Defender and our other technologies, which the other companies don't have. And that makes it a superior service. So I'm optimistic about the future growth there, and even though we compete with Zscaler and we compete well, really, the 2 of us are out there competing against the traditional way of doing things.
Operator: And our next question comes from the line of Amit Daryanani with Evercore. Your line is open. Please go ahead
Lexi Curnin : This is Lexi on for Amit. So I guess, the December quarter guide implies that sales were up around 7% year-over-year, and that's kind of a strong deceleration versus the 12% to 13% range we've seen over the last few quarters. I guess the India and U.S. then account for $20 million or 200 basis points of drag. But beyond that, what do you see as kind of the headwinds there?
Tom Leighton: Yes. So I think if you look the last couple of quarters, certainly, Q2 was -- we saw a big jump due to the pandemic and the additional traffic that we've got on. The good news is we've been able to maintain the traffic and even fill in the divot that was caused by the $15 million in Q4. And you're right to point out the fact that, that revenue was gone and I talked about an additional $4 million if this U.S. ban goes into effect here coming up in mid-November. Last Q4 was an exceptionally strong quarter-over-quarter. There's a few things if you want to look at kind of comparing the jump that we normally see from Q3 to Q4. We just talked about the -- those applications, the Chinese applications is one piece. As you recall, in Q2, I talked about some license revenue, it was about $7 million that we saw from our carrier business. That traditionally we see in Q4 and we saw in Q4 last year, we're not expecting that again. So that's a piece of it. And then the other thing that is a little bit different this year. If you recall, back in Q2 of 2019, we had our customer conference, and we introduced our zero overage offering to our Web Division customers. And that was really a response to customers who are looking for more predictable spend with Akamai. You can imagine retailers are the ones who mostly go for this offering. And again, it's web, it's not for media customers. And that's to smooth out some of the different holidays and various peaks that they have in their business. Now that's been in the market now for about 18 months. So we're starting to see some pretty good uptake on that. And what that means is you just see a little bit of a flattening out your seasonality.
Operator: And our next question comes from the line of James Breen with William Blair. Your line is open. Please go ahead.
James Breen : Just one on security. Can you just give us a little color around the 23% growth? And how much of that came from existing customers taking new products? And maybe on that point, if you have security customers taking 3 of your products and they take a fourth, I believe most of that business is contractual. How does that manifest itself into the relationship or the contract with the company at the time? And then just secondly on CDN and media, traditionally, we see a little bit of a step down in volumes in the third quarter as more people are outside in July and August. We didn't see as much last year this timeframe. It doesn't seem like you saw it this year. Just your overall thoughts on that and OTT sort of overtaking some of the linear television, et cetera?
Tom Leighton: Yes, great question. So I'll start with the second one. We didn't -- you're right, we didn't see as much of a seasonal dip. I did see a little bit in Europe towards the end of the quarter. You got to remember that we also have been in kind of a partial lockdown for most of the summer. So I would say that, that probably adds to it. We do typically see a seasonal dip here in Q3. But again, outside of a little bit in Europe, I didn't really see much across the world. So that was a good trend for us. And your first question was around security growth of 23%. What's making it up? I think the question was around new versus existing. Primarily, the biggest growth is from existing customers. Today, we have about 61% roughly of our customers buy security from us. And our new customer acquisition is led by security, but in the recurring revenue business in any given quarter new customers aren't going to add a ton to the revenue pile. So it's typically your existing customers. And then the other question on as customers contract with us for multiple services. It tends to be -- sometimes it could be demand driven. So if you have something like a ransomware attack, you have an emergency integration, you just add that to your contract. In other times, it can be upon renewal where you're adding functionality, so somebody might be Kona Site Defender customer they want to add Bot Manager. We're seeing some really good early uptake with customers, that our Kona Site Defender customers that are adding Page Integrity. And that could be done mid contract, if we go in and just add it to your contract. Typically, you have some form of an MSA with your customer and you can just add that product fairly easily.
James Breen : And just a follow-up to that, as you look across your entire revenue base right now, in terms of total revenue, how much of that is contractual versus more volume driven like your traditional CDN business?
Tom Leighton: In that business, I'd say a majority of it is contractual. There is some volumetric components to security. But really, when you think about the business in total, the big variable in terms of volumes is in the media business.
James Breen : And in terms of total revenue, as you look at media and security combined, how much of your total revenue you think is more volume driven?
Tom Leighton : That's a good question, probably a quarter, maybe a third at the most. It depends on the quarter. In a quarter like this, Q4, where you have stronger seasonality, you'll see a little bit more than normal. But the majority of the business is contractual.
Operator: And our next question comes from the line of Jeff Van Rhee with Craig-Hallum Capital Group. Your line is open. Please go ahead.
Jeff Van Rhee : Most of what I had has been answered. Just a few on the managed security services. I remember a while back, you had referenced that I believe is 1,000 customers and a $100 million in revenue. I don't know that we've gotten an update. Just curious if you could update that? And then any commentary around verticals that stood out for AKAM in the quarter?
Tom Leighton: Sure. So in terms of managed security services, I don't have a customer number here for you. We'll probably give you a more fulsome security update later when we get to next year. But it's still growing at double-digits, which is great. So managed security services has been actually really a key differentiator for us. What we're finding is while we've built tools for customers to be able to manage their security products on their own, a lot of times, they want us to do it for them. For example, Bot Manager, we're finding that there's a lot of demand for managed Bot Manager. It doesn't sound like the greatest product name, but it’s descriptive of what's happening. And then on the Kona Site Defender side, managing firewall rules can be complicated, and oftentimes, customers would like us to do that as well.
Ed McGowan : Yes. In terms of the verticals, obviously, the financial vertical is huge, as you can imagine, for security. Commerce, increasingly important as more of their business moves online. And interestingly enough, big media, gaming sites are now seeing a lot of attacks, new sites, obviously, especially during an election cycle, are big targets. And OTT sites and protecting accounts there is really important. So pretty much any big brand name is a big buyer of our security services.
Operator: And our next question comes from the line of Rishi Jaluria with D.A. Davidson. Your line is open. Please go ahead.
Hannah Rudoff : This is Hannah Rudoff on for Rishi. So on the Asavie acquisition, could you just talk about what overlap there is between you and them, both in terms of the actual technology today and then the customer bases?
Tom Leighton: I didn't catch that question. Can you repeat it, please?
Hannah Rudoff : Yes. On the Asavie acquisition, could you just talk about what overlap there is between you and Asavie in terms of actual technology and the customer bases?
Tom Leighton: Great. No, really good question. There is not a lot of overlap there. Their primary capability is to take the traffic from a cellular device and vector it through the carrier into what today is their platform. Now we are going to take that in vector it into the Akamai platform, and then we can layer in our enterprise security capabilities, our application firewall capabilities, Secure Web Gateway, make sure that traffic stays secure, so that the device doesn't end up going to a site with malware, or -- and if it does, to make sure that malware doesn't get back on the device. And so there's a very little overlap in capabilities, but very strong synergy. And the really nice thing is that their technology doesn't need to make use of a client. And a lot of the devices out there, especially in IoT, may not be equipped with that kind of capability. They'll just go straight with a cellular connection. And also, there's no way around it because it's handled with the SIM card layer So it's not a situation like with a normal device where the user can sort of get around any corporate security and go where they want and then get malware on the device and bring it back into the enterprise.
Hannah Rudoff : And then is there anything to call out on this quarter with regard to the Internet Platform Customers aside from the higher traffic? I know you guys expected a greater sequential decline due to repricing. And then how should we think about growth of this cohort for the remainder of the year?
Ed McGowan: Yes, great question. So yes, definitely a nice upside surprise for us. As I mentioned on the last call, we did do repricing with 2 large customers in that cohort. And typically, it takes, call it, 6 to 9 months to get back to traffic levels where your revenue sort of gets back to where it started from. We were able to do that and more here in Q3. So that was great, and it was a big jump in traffic from a couple of customers. So really good news there. And I would say, in terms of this year -- remainder of this year, Q4 tends to be a pretty strong quarter. So I'd expect something in this range, maybe a touch higher.
Operator: And our next question comes from the line of Brandon Nispel with KeyBanc Capital Markets. Your line is open. Please go ahead.
Brandon Nispel : Two, if I could. What are you guys seeing from a traffic perspective thus far in the fourth quarter versus really the third quarter? And taking a step back, how should we think about the higher traffic growth in 2020 translating into some contract repricing situation into 2021? Then on the acquisition, you called out $4 million in revenue. Is it safe to assume that, that acquisition you've closed today, and it's a 2-month benefit for this year, roughly. And can we annualize that in terms of modeling purposes for next year with some growth expectation?
Ed McGowan: Yes. So why don't I start with the last one and my way back. So as far as the acquisition goes, yes, I mean, that's the way the math would work out for this quarter. Just keep in mind that when you go through purchase accounting and you do your integration costs and things like that, there's some movement there. We'll give you an update on how much revenue contribution this will be for next year when we do our next call. But yes, you're thinking about it in a way. But in terms of like how much growth add-on and things like that, we'll update you as we get few months into the integration and have a plan fully built out. For 2020, '21, you talked about pricing and volumes. It's just a standard part of the business. We'll always have some number of customers that are up for renewal at any given time, average contract length is typically 18 months and from a year to 2, sometimes you get a little longer. So at any given time, you're going to have renewals. I think we've done a good job of calling out when there's anything that's unusual, meaning you have a big group of customers that are all coming up at once or we talked about last year when we had some big acquisitions with some of our customers acquiring each other. We'll continue to do that, but there's really nothing to call out at this point, and we'll be giving you a full update on '21 in the February call. And then I think your third question was on traffic for the fourth quarter. Are we seeing anything relative to Q3? Obviously, in back-to-school fall season, we do see a slight pickup in traffic. We included that in our guidance. I think the only thing to call out is weekends, we do see elevated traffic sports, they’ve been a nice source of traffic for us and that certainly continues this year.
Operator: And our next question comes from the line of Lee Krowl with B. Riley Securities. Your line I open. Please go ahead.
Lee Krowl : Two quick questions. I think you mentioned the Web Division saw some upside from customer credits. Curious if you could quantify that upside? And then if there is a similar contribution in Q4?
Ed McGowan: Yes, sure. So I wouldn't necessarily call the contribution. I think the way I would describe it is, if you recall on the Q1 call, we talked about how the negative impact was around $5 million. And in Q2, we talked about it being $14 million. So going into the quarter, we had modeled that we would have a further negative impact. It's really hard to predict what's never been in one of these before. So it's really hard to predict what customers are going to request and ask for. So the good news there is we had very less than [$1 million] impact. As a matter of fact, we had a little bit of a positive impact in our bad debt assumptions as we had assumed with some customers that had filed for bankruptcy that have come back post-bankruptcy, were a little bit higher up on the chain there. So we were able to recover some of that money that we had to write-off. So in general, that was a positive surprise. So I wouldn't say that it was a pickup of any kind that we would expect in this quarter. I think what I outlined in the guidance section was there's a potential that if we get into a second wave, and we see customers get under a lot of stress that you could see something similar to what we've seen in prior quarters. We're not anticipating that right now. But that's obviously something as you kind of build your models and handicap that you'd want to think about. The worst the pandemic gets, the more stress the retailers are under, the more stress to travel and hospitality. Customers are under -- there's a potential that you could see a little bit of headwind there, if we have to do some things on the restructuring or credit side.
Lee Krowl : Got it. And then just another question. You guys added a lot of capacity in '19 and certainly significant capacity in 2020 in response to both streaming media as well as kind of the pandemic-related uptick in traffic. As we lap those comparisons for both capacity as well as traffic growth and we kind of hit some of the slower quarters with that added capacity, maybe just talk about the puts and takes between margins and keeping the servers running hard to offset cost? One of your competitors kind of indicated a little bit of a margin headwind as server capacity overstretched a pullback in demand. As we lap some difficult comps over the coming quarters, how do you kind of think about capacity versus the margin standpoint?
Ed McGowan: Yes. Good question. So mix is obviously something that you have to take into consideration. The good news for us, if you think about the 20 plus years we've been in this business, we've always seen unit economics where volumes go up, prices go down. We've been able to do a phenomenal job of driving down costs in our network. And the fact that we're at such a scale, there's a mix between fixed contracts versus variable contracts. We get -- as Tom mentioned, a lot of our traffic is free, and that sometimes going to include both space, power and bandwidth. So we have a whole team that is maniacally focused on that, and we continue to make improvements in our server capacity to be able to get more throughput per machine. So obviously, as mix changes, you can have a point here or there move. But in general, I think we've done a phenomenal job maintaining margins despite the realities of the high-volume media business. So I don't know the specifics of what you're talking about with our competitor, but we don't see any significant declines in margins as a result of adding all this capacity. If anything, I think it gives us a tremendous advantage. One of the interesting things that we saw this quarter, well, I saw -- we lost a lot of traffic in India. We actually picked up a lot of traffic in India from other customers as a result of having additional capacity, you get better performance, the more capacity you have and we were able to benefit and fill in some of that gap of the $15 million we lost and some of it was released in the India region.
Operator: And our next question comes from the line of Mark Mahaney with RBC. Your line is open. Please go ahead.
Mark Mahaney : Okay, thanks. All my business questions were asked. So I'll just ask, in the event of a change in administration next week and you think about the implications for your business in terms of everything from R&D tax credit policies, I don’t know immigration issues, corporate tax rates, what do you think will be the biggest impacts on your business? Were there to be a change in administration?
Tom Leighton : Well, maybe the -- just settling down the overall environment out there would be good. Stress levels are obviously pretty high in the country -- in this country right now. And it'd be good to get past that. Obviously, taxes might rise. I don't think that changes the operation of the business in any way. Obviously, there'll be a one-time reset on EPS if tax rate were to go up. And Ed can talk more to that. But I don't see the fundamentals of our business changing one way or another depending on who wins. Ed, what thoughts do you have about that?
Ed McGowan : Yes. It’s a good question, Mark. So I would say, in terms of taxes, obviously, a lot of our earnings come from outside the U.S. So it's rumored that there's a 7% increase or whatever may come at some point. And who knows if it comes in '21 or they wait a year to put it in ‘22. It would have some impact on us. But like I said, a lot of our earnings are outside the U.S. A couple of other things to keep an eye on, though, interest rates. So with the Fed being very accommodative and interest rates at near zero, think about our reinvestment of our marketable securities. So you're going to get a lower interest rate in terms of returns. So that's going to impact your [geared view as such]. And then the last thing would be around foreign exchange. So depending on what type of stimulus you have, if the dollar gets weaker because as a result of us printing more money, then obviously, that could be a benefit for us because the way to think about our international business is we've got -- we're profitable outside the U.S. and nearly half of our business is outside the U.S. So that can be a benefit potentially if the dollar were to get weaker. So those would be sort of the 3 areas financially that sort of jump off the page at me.
Tom Barth : Well, thank you, everyone. In closing, we will be presenting at a number of virtual investor conferences and events throughout the rest of the fourth quarter. Details of these can be found in the Investor Relations section of akamai.com. Thank you for joining us. All of us here at Akamai wish you continued health to you and yours, and I have a very nice evening.
Operator: Ladies and gentlemen, thank you for participating in today's conference. This does conclude the program. And you may all disconnect. Everyone, have a great day. | [
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"speaker": "Operator",
"text": "Ladies and gentlemen, thank you for standing by, and welcome to the Third Quarter 2020 Akamai Technologies, Inc. Earnings Conference Call. At this time, all participant lines are in a listen-only mode. After the speakers’ presentation, there will be a question-and-answer session. [Operator Instructions] Please be advised that today’s conference is being recorded. [Operator Instructions] I would now like to hand the conference over to your speaker today, Tom Barth. Please go ahead."
},
{
"speaker": "Tom Barth",
"text": "Thank you, operator. Good afternoon, everyone, and thank you for joining Akamai’s third quarter 2020 earnings conference call. Speaking today will be Tom Leighton, Akamai’s Chief Executive Officer; and Ed McGowan, Akamai’s Chief Financial Officer. Before we get started, please note that today’s comments include forward-looking statements including statements regarding revenue and earnings guidance. These forward-looking statements are subject to risks and uncertainties and involve a number of factors that could cause actual results to differ materially from those expressed or implied by such statements. The factors include uncertainty stemming from COVID-19 pandemic and any impact from unexpected geopolitical developments. Additional information concerning these factors is contained in Akamai’s filings with the SEC, including our annual report on Form 10-K and quarterly reports on Form 10-Q. The forward-looking statements included in this call represent the company’s view on October 27, 2020. Akamai disclaims any obligation to update these statements to reflect future events or circumstances. As a reminder, we will be referring to some non-GAAP financial metrics during today's call. A detailed reconciliation of GAAP and non-GAAP metrics can be found under the financial portion of the Investor Relations section of akamai.com. And with that, let me turn the call over to Tom."
},
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"speaker": "Tom Leighton",
"text": "Thanks, Tom. And thank you all for joining us today. I'm pleased to report that Akamai achieved excellent results in the third quarter. Revenue was $793 million, up 12% year-over-year and up 11% in constant currency. Non-GAAP operating margin was 32%, up 3 points from Q3 of last year. Non-GAAP EPS was $1.31 per diluted share, up 19% year-over-year, and up 18% in constant currency. These very strong results were driven primarily by the continued strong performance of our security products, and high traffic levels on our Edge platform. We're very proud of how Akamai has continued to deliver fast, intelligent and secure online experiences for billions of users around the world as we support our customers during these challenging times. We're also very pleased that our hard work to improve operating efficiency and profitability has put us in an excellent position to exceed our goal of 30% operating margins for the year. Our Media and Carrier business continued to perform very well in Q3, benefiting from high traffic levels for video streaming and gaming software downloads. In fact, one giant video-on-demand service increased the traffic on our platform by a factor of 4 last quarter. As more entertainment moves online, Akamai has continued to prove that our unique Edge platform scales to meet the unprecedented demand for streaming video, popular gaming releases, and complex API transactions. We can do this in part because we’ve positioned more than 325,000 servers in more than 4,000 locations in over 1,000 cities. At Akamai, we’ve positioned content very close to end users, and we make sure it's available when and where it's needed. In addition, our highly advanced Internet mapping algorithms route traffic around congestion to maintain excellent application performance for our customers. Our unique Edge platform also allows our customers to perform a wide variety of computational tasks close to end users, resulting in faster performance, instant scalability and lower cost. For example, a leading social networking company uses Akamai's Edge platform to manage API requests for their recommendation engine, a leading apparel company uses our platform to supply health information to users based on their fitness tracker. Several major companies use Akamai to provide critical weather updates based on local conditions, as well as geographic information such as nearby points of interest, or locations of desired services. Many of the world's largest OTT companies use Akamai to help manage the critical components of their architecture on the edge, including functionality for user authentication, content recommendations, and payment processing. Some of the world's largest credit card companies use our platform to assist with authentication and authorization of payments via digital gateways. Several of the world's largest gaming companies use Akamai's Edge to assist in managing user profiles and registration, as well as event leaderboards. And the ad tech ecosystem uses applications running on the Akamai Edge to assist with ad calls, bidding, and placing consent cookies to remain in compliant with data privacy regulations. It's important to note that while some CDNs are talking about edge computing or serverless computing, as if they're somehow new technologies, Akamai has been providing these services to thousands of customers for well over a decade. And already this year, we've handled well over 100 trillion API requests on our Edge platform. The vast capacity of our platform, combined with our unparalleled security intelligence and machine learning algorithms, has also enabled Akamai to defend many of the world's most important enterprises against the largest and most sophisticated cyber attacks. This capability has proved to be especially important during the recent wave of ransom DDoS attacks. Since August, we've been approached by dozens of major businesses around the world that had received extortion letters, threatening them with massive DDoS attacks, if they didn't pay a ransom. In response, our security experts performed emergency integrations of our Prolexic service, which enabled these enterprises to continue or resume business operations without experiencing any service disruptions from the attacks. As a result, we've added many new enterprises to our Prolexic customer base, including several global banks and insurance companies, a leading travel website, and two national stock exchanges. In addition to Prolexic, we also continue to see strong growth from our market leading Kona Site Defender and Bot Manager services. Bot Manager has been especially valuable in stopping account takeover attacks, which have greatly increased in scale and sophistication. In fact, the number of malicious login attempts by bots that we blocked in Q3 was more than double the number we handled in Q2. I'm also pleased to report that our recently launched Page Integrity Manager solution, which is designed to identify and forward Magecart attacks and malware in third-party scripts is off to an excellent start with strong customer interest and bookings. In another sign of our leadership in cyber security, Forrester recently named Akamai as a Leader in Zero Trust, with the highest possible scores for network security, workload security, APIs, zero trust advocacy and market approach. And just last week, Gartner recognized Akamai as a leader in its 2020 Magic Quadrant for Web Application Firewalls for the fourth year in a row. Overall, Q3 revenue from our Cloud Security Solutions was $266 million, up 23% year-over-year in constant currency and accounting for 34% of Akamai’s total revenue. To further build on our growth in security, we were pleased to announce today that Akamai has acquired Asavie, a leader in securing mobile access for enterprises. Asavie partners with some of the world's largest mobile network operators to enable enterprises to connect, manage and secure communication among cellphones, and other IoT devices, without the need for client software on the device. These capabilities are critical for organizations with mobile workforces or large numbers of connected devices. By integrating Asavie solution with Akamai's unique Edge platform, and arming it with Akamai's vast array of real time security data, we plan to enable enterprises to greatly improve the security of their operations, while also improving the performance of their internal applications. Asavie will complement our security product lines with a cellular-specific security offering, which is an important step in our strategy to capture the emerging opportunity in 5G. It is also synergistic with our Enterprise Application Access product, and complements our IoT Edge cloud solution, allowing enterprises to improve the reliability and consistency of real time communications with IoT devices, and to easily secure those endpoints to avoid compromise. As we look to the future, we believe that the deployment of 5G and IoT applications can provide significant opportunities for Akamai. 5G technology improves the performance of the last mile, providing higher throughput and lower latency, and the potential to connect a lot more people and things. And that could spawn the creation of new applications, such as ultra-low latency video, augmented reality, IoT applications and analytics at a massive scale, deep threat intelligence for attack mitigation, and much more that we can't even imagine yet. The impact of 5G on innovation to be similar to the way broadband enabled new social networking apps that few could have imagined before. As 5G networks come online, we believe that end users and connected devices will demand faster performance and greater scale than cloud data centers can provide. And thus, that our Edge architecture will become more important than ever. In fact, Gartner estimates that by 2022, more than half of enterprise generated data will be created and processed outside of traditional cloud data centers. The breadth of our Edge platform means that we're incredibly close to billions of end users. And being so close means that Akamai is in a unique position to provide the near instant response times, very high quality video experiences, serverless computing capabilities, and the market-leading security services that our customers are demanding. In summary, we're very pleased with our performance so far this year. We believe that our strong growth, profitability and cash generation provides us with a financial firepower to continue investing in the innovation, network capacity, novel products, and world class talent needed to fuel our future growth. Now, I'll turn the call over to Ed for more on Q3, and our outlook for the fourth quarter. Ed?"
},
{
"speaker": "Ed McGowan",
"text": "Thank you, Tom. As Tom outlined, Akamai delivered another excellent quarter from Q3. We were very pleased to exceed the high end of our guidance range on revenue, operating margin and earnings. Q3 revenue was $793 million, up 12% year-over-year for 11% in constant currency, driven by another quarter of robust security growth, continued strong performance from our Media and Carrier Division and a weaker U.S. dollar. Revenue from our Web Division was $418 million, up 8% year-over-year, or 7% in constant currency. Revenue growth for this group of customers was again led by our security business and to a lesser extent we also benefited from lower-than-expected COVID-related credits to customers. Revenue from our Media and Carrier Division was $375 million, up 16% year-over-year. The overachievement in Q3 came from higher-than-expected OTT video and gaming traffic, along with continued momentum in security. We were pleased to see traffic remain at elevated levels, which helped offset the approximately $15 million negative impact from India's ban of 59 Chinese apps that we discussed on our last quarter's call. Revenue from the Internet Platform Customers was $51 million, up 15% from the prior year, and above our expectations due to higher traffic. Security revenue for the third quarter was $266 million, up 23% year-over-year, driven by continued global demand for our Web and Enterprise Security Solutions. And as Tom mentioned earlier, we also saw strong demand for DDoS protection from our Prolexic products in Q3. Foreign exchange fluctuations had a positive impact on revenue of $10 million on a sequential basis and positive $4 million on a year-over-year basis. International revenue was $355 million of 20% year-over-year or 18% in constant currency. We had strong performance internationally despite the sequential headwinds in India that I previously mentioned. Sales in our international markets represent 45% of total revenue in Q3, up 3 points from Q3 2019 and up 1 point from Q2 levels. Finally, revenue from our U.S. market was $437 million, up 6% year-over-year. Now moving to costs. Cash gross margin was 76%, in line with our expectations. GAAP gross margin which includes both depreciation and stock-based compensation was 64%. Non-GAAP cash operating expenses were $252 million roughly flat with Q2 levels, and in line with our guidance. Now moving on to profitability, adjusted EBITDA was $351 million, up $51 million or 17% from the same period in 2019. Our adjusted EBITDA margin was 44%, up 2 points from Q3 2019. Non-GAAP operating income was $251 million, up $43 million or 20% from the same period last year. Non-GAAP operating margin came in at 32%, up 3 points from Q3 last year. Capital expenditures in Q3, excluding equity compensation and capitalized interest expense, were $200 million, in line with our guidance range. GAAP net income for the third quarter was $159 million or $0.95 of earnings per diluted share. Non-GAAP net income was $216 million, or $1.31 of earnings per diluted share, up 19% year-over-year, up 18% in constant currency and $0.07 above the high end of our guidance range due to higher-than-expected revenue. Taxes included in our non-GAAP earnings were $37 million based on a Q3 effective tax rate of approximately 15%. Now, I will discuss some balance sheet items. We continue to have a very strong balance sheet. As of September 30th, our cash, cash equivalents and marketable securities totaled approximately $2.6 billion, up approximately $163 million from the end of Q2. After accounting for the $2.3 billion of combined principal amounts of our two convertible notes, net cash was approximately $254 million as of September 30th. This increase was driven by a number of factors that include an exceptionally strong cash collections quarter. Now, I will review our use of capital. During the third quarter, we spent $13 million to repurchase shares, buying back approximately 120,000 shares. We ended Q3 with approximately $644 million remaining on our previously announced share repurchase authorization. Our long-term plan remains to leverage our share buyback program to offset dilution resulting from equity compensation over time. In summary, we're very pleased with our Q3 results. Before I provide guidance, I wanted to take a moment to remind everyone of several factors that will impact Q4. First, seasonality plays a large role in determining our fourth quarter financial performance. We typically see higher-than-normal traffic for our large media customers, and from seasonal online retail activity for our e-commerce customers, which are both difficult to predict, especially in the current economic environment. Also, as Tom mentioned earlier, today, we announced the acquisition of Asavie. In the fourth quarter, we expect the acquisition to add approximately $4 million of revenue and to be dilutive by approximately $0.01 of non-GAAP EPS. It’s also worth noting, as I mentioned earlier, that our Q3 revenue was negatively impacted by approximately $15 million due to the actions taken by the Indian government to ban 59 Chinese based web applications in India. Our Q4 guidance as soon as the ban in India remains in place for the balance of 2020. In addition, the U.S. government has taken a similar stance with respect to some of these applications. And absent court action or change in policy, those bans are scheduled to take effect in mid-November. As a result, our Q4 guidance assumes an additional $4 million to $5 million negative impact to revenue sequentially based on the U.S. ban going into effect mid-November. In the unanticipated events, these 59 applications were subject to a total global ban, the total additional negative impact to our revenue would only be approximately 3%. To be clear, this represents an extreme assumption that we do not currently expect to occur, and we are not modeling in our current outlook. However, I wanted to provide you with additional color for added transparency, and to make the point that our customer base remains well-diversified across many customers, industries, products and geographies. Finally, at current spot rates, foreign exchange fluctuations are expected to have a positive $2 million impact on Q4 revenue compared to Q3 revenue -- Q3 levels and a positive $6 million impact year-over-year. Taking all these factors into consideration, we're projecting Q4 revenue in the range of $812 million to $837 million or up 4% to 8% in constant currency over Q4 2019. To frame our guidance further, we would expect to be towards the lower end of the range if we see a more modest quarter for OTT and gaming traffic, if e-commerce activity is weaker than expected, the impact of the COVID pandemic leads to an inability of our customers to pay for our services and the U.S. dollar strengthens and creates foreign exchange headwinds. Conversely, we'd expect to be at the higher end of the range if we see -- if we experience a more robust than normal online holiday shopping season, and we see stronger than expected demand for OTT video and gaming traffic, including potential upside from two highly publicized new game console releases expected later this quarter. At these revenue levels, we expect cash gross margin of approximately 76%. Q4 non-GAAP operating expenses are projected to be $268 million to $279 million, with a sequential increase primarily due to higher commissions-related expenses from sales compensation accelerators kicking in during the fourth quarter, given our very strong performance this year relative to our plan. Factoring in the gross margin and operating expense expectations I just provided, we anticipate Q4 EBITDA margins of approximately 43%. Moving now to depreciation, we expect non-GAAP depreciation expense to be between $106 million to $108 million, reflecting our accelerated server deployment in Q3. Factoring in this guidance, we expect non-GAAP operating margin of approximately 30% for Q4. Moving on to CapEx, we expect to spend approximately $193 million to $199 million excluding equity compensation in the fourth quarter. And with the overall revenue spend configuration I just outlined, we expect Q4 non-GAAP EPS in the range of $1.28 to $1.32, or up 2% to 5% in constant currency. This EPS guidance assumes taxes of $36 million to $37 million, based on an estimated quarterly non-GAAP tax rate of approximately 15%. And it also reflects a fully diluted share count of approximately 165 million shares. In light of the Q4 guidance I've just provided and our strong performance for the third quarter, for the full year 2020, we now expect revenue of $3.164 billion to $3.189 billion, which is up 10% year-over-year in constant currency. We expect non-GAAP operating margins of approximately 31%. And we expect non-GAAP earnings per diluted share of $5.16 to $5.20, which is up 15% to 16% year-over-year. In summary, we are very pleased with how our business has continued to perform during a very challenging time. Thank you. Tom and I would be happy to take your questions. Operator?"
},
{
"speaker": "Operator",
"text": "[Operator Instructions] Our first question comes from the line of Tim Horan with Oppenheimer. Your line is open. Please go ahead."
},
{
"speaker": "Tim Horan",
"text": "Can you talk about Edge a little bit more, maybe on how your service offers compare with your peers? And what do you think your win rate is on pitches for Edge?"
},
{
"speaker": "Tom Leighton",
"text": "Well, Edge refers to our platform, which really is unique in the sense that -- we're in 4,000 locations. We're in 1,000 cities. We are uniquely close to the end users out there, the billions of end users around the world. Other companies talk about edge, and they might be in a couple of dozen locations, a factor of 100 or less. And because we're close, that's really important, because we're going to give better performance. If you're closer, the latency is less, and it's going to be faster. Also, if you're close, you got access to the bandwidth and the scale. And that's why we have so much more scale than the other CDNs. And that's really important to customers that have a lot of traffic, the big OTT providers and the big software downloaders. And that's why so much of their business comes to Akamai. Also, being in those locations gives us a huge advantage on cost, because in the large fraction of those 4,000 locations, we don't pay for bandwidth and colo and power. And so it's free for us with the infrastructure. We pay for our CapEx. But our competitors aren't there. There our competitors are in big data centers, and that is the most expensive real estate in the world. And so we're in a position that we can provide compelling pricing to the major enterprises out there. And our competitors, if they're going to do that, they have to do it losing money, and that's not sustainable. Now any one of the many competitors we have out there, all, generally speaking, much, much smaller, at any given time, they could take on some traffic and show some high percentage growth on very small numbers. But it's hard to sustain that when you don't really have a sustainable advantage. And then you see that happen as the traffic -- some of the traffic share moves around among the smaller players. Now in addition, it's not just about CDN and delivering traffic, it's accelerating the traffic. It's providing functionality on the edge close to the end user. And I talked about a lot of examples that where we're doing that today. And of course, processing a lot of the API transactions, which are tied to functionality, over 100 trillion so far this year. And then you have the security aspect, which our CDN competitors, by and large, don't have. They make partner with other companies or start-ups to have some security story. But that's now $1 billion business for Akamai and growing at over 20%. And security is just really vital for our customers and it works in tandem with the application acceleration, with the Edge computing, all is one service, all on one platform. And if you're not on the edge, there's no hope to withstand the large attacks that we're seeing today."
},
{
"speaker": "Operator",
"text": "And our next question comes from the line of Colby Synesael with Cowen. Your line is open. Please go ahead."
},
{
"speaker": "Colby Synesael",
"text": "Just going back to security. I'm just curious, would the security results thus far this year have been much different had COVID-19 not had happened? I'm just curious how you would quantify the impact that COVID-19 has had on the security business, whether good or bad? And then secondly, the long-term operating margin of 30%, I think you've messaged that, that should remain flat target. But can you just remind us why that is and why we won't continue to see increased operating margin leverage?"
},
{
"speaker": "Tom Leighton",
"text": "Sure. I think we'd see strong security growth with or without COVID. There are some of our products that are really helpful for enterprises as they have more of a remote workforce. And so we did see uptick in bookings there. So I think there's some help. The attack rates have gone way up. And I do think some of that has tied to COVID. Now whether we see the ransom DDoS attacks that are widespread just in the last couple of months, we might have seen that anyway. Maybe there's an increase because the price is bigger now. If you're attacking a commerce company that has 90% of their business in brick-and-mortar, well, they care about the 10% for sure, but when all of their business is online, now they really really care. So there is a bigger price, and maybe that's incented the attackers to up the attack level or maybe that's just the world we're living in, where we're going to be seeing more and more attacks, even if we get COVID under control. And I can tell you, we see a lot of attacks in Asia Pacific just like we do here and in Europe. Even though in APJ, COVID is largely under control there and operations are largely returned to normal. And yet the attacks -- the ransom DDoS attacks are just as -- increasing just as fast over there. In fact, one of the national stock exchanges that was taken offline that is now an Akamai customer was in Asia Pacific. In terms of the 30%, we do think that's a good place to operate the company over the longer term. And we're -- that said, we're going to do everything we can to operate as efficiently as possible and you see that this year. This year, we've been doing over 30%. And so if we can do that and continue to make the investments we want to make to achieve long-term growth in the business, then we will. But I think the right way to think about it is 30% is a good baseline and when we can overachieve that, we're going to do that."
},
{
"speaker": "Colby Synesael",
"text": "And I guess just one quick follow-up to the security question. I mean given what sounds like some upside, arguably, do you think that you're in a position to sustain that 20%-plus growth rate over the next few years?"
},
{
"speaker": "Tom Leighton",
"text": "Certainly, we'd like to do that. We're seeing very strong growth in Kona Site Defender and Prolexic. And Kona Site defender is our web app firewall product. Bot Manager doing very well, and the next-generation of that will be even stronger at preventing account takeover. Security services business we talked about is doing very well. And I think with the increase in attacks and the sophistication of attacks, we're seeing even more demand for our security services. It's just too hard for even major enterprises to keep up. And then you have the newer solutions, our enterprise services, Enterprise Application Access, Enterprise Threat Protector, now equipped with the first version of our Secure Web Gateway. We're going into beta with our multifactor authentication service next month. As we talked about, our Page Integrity Manager, which sits on top of Kona, off to a great start. We'd like to see that track the way that Bot Manager did getting out of the gate. And of course, we announced today -- and I'm really excited about the Asavie acquisition. I think that opens up a whole new category for us that we'll see accelerated growth as we get more 5G deployments as you see more IoT applications out there. And what that does is it sends all the cellular traffic safely and directly to Akamai before it gets on to the Internet. And in that way, we can really protect enterprises and their cellular devices. And I think that's a market that is very exciting for the future."
},
{
"speaker": "Operator",
"text": "And our next question comes from the line of Sterling Auty with JPMorgan. Your line is open. Please go ahead."
},
{
"speaker": "Sterling Auty",
"text": "So wondering, you made the comment that one of the big video providers, you saw 4x increase in traffic, that would seem to be more than just a COVID related. I'm just wondering what else you saw in that particular account? And is that something is happening in other accounts as well?"
},
{
"speaker": "Tom Leighton",
"text": "Yes. As we talked about and we're continuing to gain share, if you exclude the 59 Chinese apps where obviously government regulation has lessened the traffic we're delivering there. And that's based on our scale and performance and ability to offer market competitive prices for our customers. And so I think you've seen that trend over the last couple of years, we've talked about it. We put a lot of effort into continuing to improve performance, continuing to improve our scale and on a global basis. And that puts us in a great position against the competition in the market. And you're right, the 4x is obviously not COVID. COVID did improve traffic, there's no question about that, but nothing like 4x."
},
{
"speaker": "Sterling Auty",
"text": "That's great. And then one follow-up. You touched upon it in your prepared remarks and your guidance, which is e-commerce heading into the holiday season. It's been a little while since you've updated us. Can you give us a sense of where do you sit in terms of your customer base within like that e-tailing 100 or that 100 largest e-commerce sites and vendors that are out there?"
},
{
"speaker": "Tom Leighton",
"text": "Very, very strong. Well north of 90% of the top commerce companies rely on Akamai for application acceleration, and also importantly, increasingly importantly, security. And as I mentioned before, now that these companies, a lot of them, most all of their business is online. And so security really, really matters now, and we're obviously the go-to supplier there."
},
{
"speaker": "Operator",
"text": "And our next question comes from the line of James Fish with Piper Sandler. Your line is open. Please go ahead."
},
{
"speaker": "James Fish",
"text": "Tom, you sound really excited here on these new security solutions again. I guess, how are you thinking about the web security gateway market? And do you need more investment in an enterprise security sales team to get this product more penetrated and beyond just the CDN installed base?"
},
{
"speaker": "James Fish",
"text": "Yes. In fact, a lot of our customers for the enterprise products are new to Akamai and hadn't bought our pre-existing product line. And that's because our web products, delivery and web app firewall were primarily to a subset of the Fortune 500, maybe a third of the verticals to half of the verticals. But enterprise security is something that pretty much all the Fortune 500 would need. And so that has increased our market, and we have put effort into our specialist teams that help the sales force. I would say that all of our sales force now is very adept at selling the traditional Akamai security products. And most of them are actually pretty good now at the newer products with enterprise security, Page Integrity Manager. SWG is just new out there. So very early on. But I think we're in good shape there. And Asavie of course, that's sold by carriers as is our SPS solution. And so we would sell to the world’s -- or Asavie -- now Akamai sell to the world's major carriers and provide a solution that they then take to enterprises. And I think that's a model that we're very excited about. And increasingly, you'll see with our enterprise security products, will be led by channel partners and carriers being the majority of that."
},
{
"speaker": "Sterling Auty",
"text": "Just as my follow-up, we're starting to see a new wave of applications, get the size again like we did last decade with Netflix and YouTube being 2 examples. I guess, what are you guys hearing from customers regarding their own potential CDN build-outs for some of the applications that they have? One of your customers, for example, hit their 5-year goal within 1 year."
},
{
"speaker": "Tom Leighton",
"text": "Wait, so are you asking about what are we seeing in terms of DIY? Or what are we seeing in terms of big OTT players and their market penetration success?"
},
{
"speaker": "Sterling Auty",
"text": "Both. I'll take both."
},
{
"speaker": "Tom Leighton",
"text": "Okay. Well, yes, OTT is certainly increasing, and a lot of the offers are seeing substantial success. Obviously, some are doing better than others. But I do think OTT is here to stay. Obviously, got tailwinds from the pandemic. But I think people are -- as they view more online, that becomes more of the pattern and that will outlive the pandemic. Of course, I think we'd all like to get back to a world when you can go out and see a movie, probably not going to be anytime soon here in the Americas or in EMEA. And I think more and more of the movie watching and TV shows will be watched online. DIY is something that you know that we exist in a few of the largest content providers. And I don't think we've seen a huge shift there. You can sort of track that with our -- the cloud giant customers, which has been fairly steady over the last year or so. It's really hard to build out something like that for yourself. It costs hundreds and hundreds of millions of dollars, if not more, you end up spending more than you would with Akamai, and you don't get the quality you get with Akamai. And not only that, if you're a global company, you got to do it all around the world, that's just -- it doesn't make sense. Now some of the biggest companies do it, and I think you'll continue to see that. But there's not been a real fundamental shift there."
},
{
"speaker": "Operator",
"text": "And our next question comes from the line of Brad Zelnick with Credit Suisse. Your line is open. Please go ahead."
},
{
"speaker": "Ray McDonough",
"text": "This is Ray McDonough on for Brad. First, Tom, if I could, I wanted to ask about gaming. And as you mentioned, we're approaching a new console cycle with both Sony and Microsoft coming out with new consoles. And from what I understand, they've made some changes to how games will be downloaded. With the caveat that downloads and gaming files are becoming larger and more ubiquitous, how should investors think about the contribution of gaming? How much does it represent today? And how big of a growth driver do you think it can be into next year?"
},
{
"speaker": "Tom Leighton",
"text": "I'm going to hand that one over to Ed."
},
{
"speaker": "Ed McGowan",
"text": "Yes. So obviously, gaming has been a business that's changed for us quite a bit over the last couple of years. You see the multi-player gaming has changed the dynamics. And if you think about the consoles that are coming online, obviously, 2 major players, it's been say, 4, 5 years since we've had a major upgrade cycle. So I would say you can kind of throw history out, this is sort of a new chapter. I think it could be a good source of upside for us. In terms of its contribution, we don't break it out specifically, but I would say it's probably the second largest contributor in our media business next to video. So as I talked about in the guidance section that this could be a source of upside. And it's hard to tell, we'll know when we get there, but this could last into the early part of next year as some of the publishers come up with new games and the consumers are buying the new consoles, they have to update the system with firmware and then catchup with all the old games that they had. So I think this is a pretty good trend for us. It's hard to predict whenever you have something that's large. And as you rightly pointed out, the game downloads, the frequency and the size are only increasing."
},
{
"speaker": "Ray McDonough",
"text": "Yes. That makes a ton of sense. I appreciate that color. And if I could, just a quick follow-up. Coming out of the first half of the year, there seems to be some supply constraints industry-wide. Understanding that every region is a bit different, how is capacity industry-wide trending? And how should investors think about your capital expenditure plans into next year?"
},
{
"speaker": "Ed McGowan",
"text": "Yes. Great question. So obviously, this year was a pretty big year for CapEx. And we've really been on the journey here for the last, call it, 18 months, where we've increased the capacity of the network. And I'm glad we did. I think Tom and the team made a great decision to do this. Obviously, we couldn't have predicted the pandemic, but we had a lot of new OTT launches coming. And as we talked about just a few minutes ago on gaming, that's becoming more and more challenging because customers want to get their games at the same time. And that requires a lot more capacity. And so we spent quite a bit on CapEx. We actually took advantage of some bulk purchases here at the end of the year. We've added a tremendous amount to our capacity. So I would expect next year to be back in sort of the normal level of CapEx and down several points from what we're seeing today."
},
{
"speaker": "Operator",
"text": "And our next question comes from the line of Will Power with Baird. Your line is open. Please go ahead."
},
{
"speaker": "Will Power",
"text": "Okay. Great. I'll ask just a couple here. Maybe first, I'd love to get some perspective on what you're seeing in international arena. And I guess, really, despite the challenges you were facing in India, you continue to see strong growth. So maybe just if you can just touch on what the sources of the strength were kind of outside of India?"
},
{
"speaker": "Tom Leighton",
"text": "Yes, sure. So, yes, you are right to point out, it’s actually not India that was impacted, it was actually China because the customers that were impacted, the 59 Chinese apps, we serve about 30 of them. Those were actually customers in China. So China revenue, obviously, was a bit more challenged this quarter. Actually, India was actually one of the areas of strength. What I was encouraged by is I saw in many different countries, in all different geographies, so Latin America, Brazil and Mexico, over in Europe, we saw strength in the UK, Germany in the Netherlands. And then over in Asia, we saw strength in Australia, Indonesia and continued strength in Japan. So it's really across the board. We're very pleased with international growth. And if you think about coming into a quarter where you're losing $15 million of revenue from your international customer base and to be able to still grow sequentially and grow 20% year-over-year, it's very impressive. And as I've talked about in other calls, I think we have a unique advantage in the industry from an international perspective. We made the investments early on in sales and building out our network and our capabilities that I think it's a huge advantage for us, and we’ve done remarkably well, not only in just delivering media but also in security."
},
{
"speaker": "Will Power",
"text": "Is that international strength concentrated in any particular products or solutions or is it more broad-based?"
},
{
"speaker": "Tom Leighton",
"text": "I'd say it's more broad-based. Certainly, the early days, it was all about media delivery and application acceleration. The U.S. market was the first to adopt the security solutions. But now security is becoming a really nice growth engine for us internationally."
},
{
"speaker": "Will Power",
"text": "Okay. And then kind of my second core question, just around M&A, notwithstanding the acquisition announced this morning. Maybe you can just update us on appetite for M&A as we exit this year and into 2021. Maybe any color around areas of focus and potential size, kind of what you're seeing out there in the market?"
},
{
"speaker": "Tom Leighton",
"text": "Yes, we continue to be very active in looking at potential deals. Obviously, it's a little trickier with the pandemic because travel is restricted, but that's not preventing us from doing transactions, as you saw from today's announcement. I would say so far the pandemic really hasn't impacted market caps very much, that may happen at some point depending on what happens with the global economy. So, I would say it's business as usual right now."
},
{
"speaker": "Operator",
"text": "And our next question comes from the line of Keith Weiss with Morgan Stanley. Your line is open. Please go ahead."
},
{
"speaker": "Keith Weiss",
"text": "A lot of the questions I had were covered. So a couple of kind of more detailed questions, if you will. One, on that gaming theme, a lot of what people were talking about for gaming on a go forward basis is shifting to more streaming to game subscriptions. And it's not just Microsoft, there are like other vendors have their platform for game streaming. Can you talk to us about how optimized or positioned for that potential shift towards more of a game streaming? It sounds like something that would be kind of right up your alley."
},
{
"speaker": "Tom Leighton",
"text": "Yes, so it depends exactly what you're referring to. But if it's a gaming tournament, where a lot of people are watching, yes, we do that already. And that creates a fair amount of traffic. If it's a situation where an individual's game and their screen is being streamed, we don't do that very much. We will handle the metadata and the security around that. The economics around streaming individuals, what they would see on their screen, that's pretty challenging. People have been working at that, the big gaming companies for well over a decade and haven't really gotten the economics to work. But we would handle the metadata, the security, the log-ins, the leader board, all that kind of stuff, we handle. It's just the individual stream is not so economical."
},
{
"speaker": "Keith Weiss",
"text": "And then one detailed question on the security solutions. In particular, Access is a solution that you guys have rolled out. And it's something that we hear a lot from a lot of different vendors across the spectrum, whether it's guys coming from like a security perspective, like a Zscaler or Citrix as their access solutions. Can you talk to us about sort of how the competitive environment in there is shaking out for you guys? Where do you guys see yourselves doing well? And who do you run-up against most often?"
},
{
"speaker": "Tom Leighton",
"text": "Yes. We compete well with Zscaler there. I would say that the vast majority of the competition is the traditional CPE vendors and the traditional ways of doing things. And our value proposition is that we can do it in the cloud. That's a lot easier and more secure. And we can -- once we have it and we're providing the access, we can layer in Kona Site Defender and our other technologies, which the other companies don't have. And that makes it a superior service. So I'm optimistic about the future growth there, and even though we compete with Zscaler and we compete well, really, the 2 of us are out there competing against the traditional way of doing things."
},
{
"speaker": "Operator",
"text": "And our next question comes from the line of Amit Daryanani with Evercore. Your line is open. Please go ahead"
},
{
"speaker": "Lexi Curnin",
"text": "This is Lexi on for Amit. So I guess, the December quarter guide implies that sales were up around 7% year-over-year, and that's kind of a strong deceleration versus the 12% to 13% range we've seen over the last few quarters. I guess the India and U.S. then account for $20 million or 200 basis points of drag. But beyond that, what do you see as kind of the headwinds there?"
},
{
"speaker": "Tom Leighton",
"text": "Yes. So I think if you look the last couple of quarters, certainly, Q2 was -- we saw a big jump due to the pandemic and the additional traffic that we've got on. The good news is we've been able to maintain the traffic and even fill in the divot that was caused by the $15 million in Q4. And you're right to point out the fact that, that revenue was gone and I talked about an additional $4 million if this U.S. ban goes into effect here coming up in mid-November. Last Q4 was an exceptionally strong quarter-over-quarter. There's a few things if you want to look at kind of comparing the jump that we normally see from Q3 to Q4. We just talked about the -- those applications, the Chinese applications is one piece. As you recall, in Q2, I talked about some license revenue, it was about $7 million that we saw from our carrier business. That traditionally we see in Q4 and we saw in Q4 last year, we're not expecting that again. So that's a piece of it. And then the other thing that is a little bit different this year. If you recall, back in Q2 of 2019, we had our customer conference, and we introduced our zero overage offering to our Web Division customers. And that was really a response to customers who are looking for more predictable spend with Akamai. You can imagine retailers are the ones who mostly go for this offering. And again, it's web, it's not for media customers. And that's to smooth out some of the different holidays and various peaks that they have in their business. Now that's been in the market now for about 18 months. So we're starting to see some pretty good uptake on that. And what that means is you just see a little bit of a flattening out your seasonality."
},
{
"speaker": "Operator",
"text": "And our next question comes from the line of James Breen with William Blair. Your line is open. Please go ahead."
},
{
"speaker": "James Breen",
"text": "Just one on security. Can you just give us a little color around the 23% growth? And how much of that came from existing customers taking new products? And maybe on that point, if you have security customers taking 3 of your products and they take a fourth, I believe most of that business is contractual. How does that manifest itself into the relationship or the contract with the company at the time? And then just secondly on CDN and media, traditionally, we see a little bit of a step down in volumes in the third quarter as more people are outside in July and August. We didn't see as much last year this timeframe. It doesn't seem like you saw it this year. Just your overall thoughts on that and OTT sort of overtaking some of the linear television, et cetera?"
},
{
"speaker": "Tom Leighton",
"text": "Yes, great question. So I'll start with the second one. We didn't -- you're right, we didn't see as much of a seasonal dip. I did see a little bit in Europe towards the end of the quarter. You got to remember that we also have been in kind of a partial lockdown for most of the summer. So I would say that, that probably adds to it. We do typically see a seasonal dip here in Q3. But again, outside of a little bit in Europe, I didn't really see much across the world. So that was a good trend for us. And your first question was around security growth of 23%. What's making it up? I think the question was around new versus existing. Primarily, the biggest growth is from existing customers. Today, we have about 61% roughly of our customers buy security from us. And our new customer acquisition is led by security, but in the recurring revenue business in any given quarter new customers aren't going to add a ton to the revenue pile. So it's typically your existing customers. And then the other question on as customers contract with us for multiple services. It tends to be -- sometimes it could be demand driven. So if you have something like a ransomware attack, you have an emergency integration, you just add that to your contract. In other times, it can be upon renewal where you're adding functionality, so somebody might be Kona Site Defender customer they want to add Bot Manager. We're seeing some really good early uptake with customers, that our Kona Site Defender customers that are adding Page Integrity. And that could be done mid contract, if we go in and just add it to your contract. Typically, you have some form of an MSA with your customer and you can just add that product fairly easily."
},
{
"speaker": "James Breen",
"text": "And just a follow-up to that, as you look across your entire revenue base right now, in terms of total revenue, how much of that is contractual versus more volume driven like your traditional CDN business?"
},
{
"speaker": "Tom Leighton",
"text": "In that business, I'd say a majority of it is contractual. There is some volumetric components to security. But really, when you think about the business in total, the big variable in terms of volumes is in the media business."
},
{
"speaker": "James Breen",
"text": "And in terms of total revenue, as you look at media and security combined, how much of your total revenue you think is more volume driven?"
},
{
"speaker": "Tom Leighton",
"text": "That's a good question, probably a quarter, maybe a third at the most. It depends on the quarter. In a quarter like this, Q4, where you have stronger seasonality, you'll see a little bit more than normal. But the majority of the business is contractual."
},
{
"speaker": "Operator",
"text": "And our next question comes from the line of Jeff Van Rhee with Craig-Hallum Capital Group. Your line is open. Please go ahead."
},
{
"speaker": "Jeff Van Rhee",
"text": "Most of what I had has been answered. Just a few on the managed security services. I remember a while back, you had referenced that I believe is 1,000 customers and a $100 million in revenue. I don't know that we've gotten an update. Just curious if you could update that? And then any commentary around verticals that stood out for AKAM in the quarter?"
},
{
"speaker": "Tom Leighton",
"text": "Sure. So in terms of managed security services, I don't have a customer number here for you. We'll probably give you a more fulsome security update later when we get to next year. But it's still growing at double-digits, which is great. So managed security services has been actually really a key differentiator for us. What we're finding is while we've built tools for customers to be able to manage their security products on their own, a lot of times, they want us to do it for them. For example, Bot Manager, we're finding that there's a lot of demand for managed Bot Manager. It doesn't sound like the greatest product name, but it’s descriptive of what's happening. And then on the Kona Site Defender side, managing firewall rules can be complicated, and oftentimes, customers would like us to do that as well."
},
{
"speaker": "Ed McGowan",
"text": "Yes. In terms of the verticals, obviously, the financial vertical is huge, as you can imagine, for security. Commerce, increasingly important as more of their business moves online. And interestingly enough, big media, gaming sites are now seeing a lot of attacks, new sites, obviously, especially during an election cycle, are big targets. And OTT sites and protecting accounts there is really important. So pretty much any big brand name is a big buyer of our security services."
},
{
"speaker": "Operator",
"text": "And our next question comes from the line of Rishi Jaluria with D.A. Davidson. Your line is open. Please go ahead."
},
{
"speaker": "Hannah Rudoff",
"text": "This is Hannah Rudoff on for Rishi. So on the Asavie acquisition, could you just talk about what overlap there is between you and them, both in terms of the actual technology today and then the customer bases?"
},
{
"speaker": "Tom Leighton",
"text": "I didn't catch that question. Can you repeat it, please?"
},
{
"speaker": "Hannah Rudoff",
"text": "Yes. On the Asavie acquisition, could you just talk about what overlap there is between you and Asavie in terms of actual technology and the customer bases?"
},
{
"speaker": "Tom Leighton",
"text": "Great. No, really good question. There is not a lot of overlap there. Their primary capability is to take the traffic from a cellular device and vector it through the carrier into what today is their platform. Now we are going to take that in vector it into the Akamai platform, and then we can layer in our enterprise security capabilities, our application firewall capabilities, Secure Web Gateway, make sure that traffic stays secure, so that the device doesn't end up going to a site with malware, or -- and if it does, to make sure that malware doesn't get back on the device. And so there's a very little overlap in capabilities, but very strong synergy. And the really nice thing is that their technology doesn't need to make use of a client. And a lot of the devices out there, especially in IoT, may not be equipped with that kind of capability. They'll just go straight with a cellular connection. And also, there's no way around it because it's handled with the SIM card layer So it's not a situation like with a normal device where the user can sort of get around any corporate security and go where they want and then get malware on the device and bring it back into the enterprise."
},
{
"speaker": "Hannah Rudoff",
"text": "And then is there anything to call out on this quarter with regard to the Internet Platform Customers aside from the higher traffic? I know you guys expected a greater sequential decline due to repricing. And then how should we think about growth of this cohort for the remainder of the year?"
},
{
"speaker": "Ed McGowan",
"text": "Yes, great question. So yes, definitely a nice upside surprise for us. As I mentioned on the last call, we did do repricing with 2 large customers in that cohort. And typically, it takes, call it, 6 to 9 months to get back to traffic levels where your revenue sort of gets back to where it started from. We were able to do that and more here in Q3. So that was great, and it was a big jump in traffic from a couple of customers. So really good news there. And I would say, in terms of this year -- remainder of this year, Q4 tends to be a pretty strong quarter. So I'd expect something in this range, maybe a touch higher."
},
{
"speaker": "Operator",
"text": "And our next question comes from the line of Brandon Nispel with KeyBanc Capital Markets. Your line is open. Please go ahead."
},
{
"speaker": "Brandon Nispel",
"text": "Two, if I could. What are you guys seeing from a traffic perspective thus far in the fourth quarter versus really the third quarter? And taking a step back, how should we think about the higher traffic growth in 2020 translating into some contract repricing situation into 2021? Then on the acquisition, you called out $4 million in revenue. Is it safe to assume that, that acquisition you've closed today, and it's a 2-month benefit for this year, roughly. And can we annualize that in terms of modeling purposes for next year with some growth expectation?"
},
{
"speaker": "Ed McGowan",
"text": "Yes. So why don't I start with the last one and my way back. So as far as the acquisition goes, yes, I mean, that's the way the math would work out for this quarter. Just keep in mind that when you go through purchase accounting and you do your integration costs and things like that, there's some movement there. We'll give you an update on how much revenue contribution this will be for next year when we do our next call. But yes, you're thinking about it in a way. But in terms of like how much growth add-on and things like that, we'll update you as we get few months into the integration and have a plan fully built out. For 2020, '21, you talked about pricing and volumes. It's just a standard part of the business. We'll always have some number of customers that are up for renewal at any given time, average contract length is typically 18 months and from a year to 2, sometimes you get a little longer. So at any given time, you're going to have renewals. I think we've done a good job of calling out when there's anything that's unusual, meaning you have a big group of customers that are all coming up at once or we talked about last year when we had some big acquisitions with some of our customers acquiring each other. We'll continue to do that, but there's really nothing to call out at this point, and we'll be giving you a full update on '21 in the February call. And then I think your third question was on traffic for the fourth quarter. Are we seeing anything relative to Q3? Obviously, in back-to-school fall season, we do see a slight pickup in traffic. We included that in our guidance. I think the only thing to call out is weekends, we do see elevated traffic sports, they’ve been a nice source of traffic for us and that certainly continues this year."
},
{
"speaker": "Operator",
"text": "And our next question comes from the line of Lee Krowl with B. Riley Securities. Your line I open. Please go ahead."
},
{
"speaker": "Lee Krowl",
"text": "Two quick questions. I think you mentioned the Web Division saw some upside from customer credits. Curious if you could quantify that upside? And then if there is a similar contribution in Q4?"
},
{
"speaker": "Ed McGowan",
"text": "Yes, sure. So I wouldn't necessarily call the contribution. I think the way I would describe it is, if you recall on the Q1 call, we talked about how the negative impact was around $5 million. And in Q2, we talked about it being $14 million. So going into the quarter, we had modeled that we would have a further negative impact. It's really hard to predict what's never been in one of these before. So it's really hard to predict what customers are going to request and ask for. So the good news there is we had very less than [$1 million] impact. As a matter of fact, we had a little bit of a positive impact in our bad debt assumptions as we had assumed with some customers that had filed for bankruptcy that have come back post-bankruptcy, were a little bit higher up on the chain there. So we were able to recover some of that money that we had to write-off. So in general, that was a positive surprise. So I wouldn't say that it was a pickup of any kind that we would expect in this quarter. I think what I outlined in the guidance section was there's a potential that if we get into a second wave, and we see customers get under a lot of stress that you could see something similar to what we've seen in prior quarters. We're not anticipating that right now. But that's obviously something as you kind of build your models and handicap that you'd want to think about. The worst the pandemic gets, the more stress the retailers are under, the more stress to travel and hospitality. Customers are under -- there's a potential that you could see a little bit of headwind there, if we have to do some things on the restructuring or credit side."
},
{
"speaker": "Lee Krowl",
"text": "Got it. And then just another question. You guys added a lot of capacity in '19 and certainly significant capacity in 2020 in response to both streaming media as well as kind of the pandemic-related uptick in traffic. As we lap those comparisons for both capacity as well as traffic growth and we kind of hit some of the slower quarters with that added capacity, maybe just talk about the puts and takes between margins and keeping the servers running hard to offset cost? One of your competitors kind of indicated a little bit of a margin headwind as server capacity overstretched a pullback in demand. As we lap some difficult comps over the coming quarters, how do you kind of think about capacity versus the margin standpoint?"
},
{
"speaker": "Ed McGowan",
"text": "Yes. Good question. So mix is obviously something that you have to take into consideration. The good news for us, if you think about the 20 plus years we've been in this business, we've always seen unit economics where volumes go up, prices go down. We've been able to do a phenomenal job of driving down costs in our network. And the fact that we're at such a scale, there's a mix between fixed contracts versus variable contracts. We get -- as Tom mentioned, a lot of our traffic is free, and that sometimes going to include both space, power and bandwidth. So we have a whole team that is maniacally focused on that, and we continue to make improvements in our server capacity to be able to get more throughput per machine. So obviously, as mix changes, you can have a point here or there move. But in general, I think we've done a phenomenal job maintaining margins despite the realities of the high-volume media business. So I don't know the specifics of what you're talking about with our competitor, but we don't see any significant declines in margins as a result of adding all this capacity. If anything, I think it gives us a tremendous advantage. One of the interesting things that we saw this quarter, well, I saw -- we lost a lot of traffic in India. We actually picked up a lot of traffic in India from other customers as a result of having additional capacity, you get better performance, the more capacity you have and we were able to benefit and fill in some of that gap of the $15 million we lost and some of it was released in the India region."
},
{
"speaker": "Operator",
"text": "And our next question comes from the line of Mark Mahaney with RBC. Your line is open. Please go ahead."
},
{
"speaker": "Mark Mahaney",
"text": "Okay, thanks. All my business questions were asked. So I'll just ask, in the event of a change in administration next week and you think about the implications for your business in terms of everything from R&D tax credit policies, I don’t know immigration issues, corporate tax rates, what do you think will be the biggest impacts on your business? Were there to be a change in administration?"
},
{
"speaker": "Tom Leighton",
"text": "Well, maybe the -- just settling down the overall environment out there would be good. Stress levels are obviously pretty high in the country -- in this country right now. And it'd be good to get past that. Obviously, taxes might rise. I don't think that changes the operation of the business in any way. Obviously, there'll be a one-time reset on EPS if tax rate were to go up. And Ed can talk more to that. But I don't see the fundamentals of our business changing one way or another depending on who wins. Ed, what thoughts do you have about that?"
},
{
"speaker": "Ed McGowan",
"text": "Yes. It’s a good question, Mark. So I would say, in terms of taxes, obviously, a lot of our earnings come from outside the U.S. So it's rumored that there's a 7% increase or whatever may come at some point. And who knows if it comes in '21 or they wait a year to put it in ‘22. It would have some impact on us. But like I said, a lot of our earnings are outside the U.S. A couple of other things to keep an eye on, though, interest rates. So with the Fed being very accommodative and interest rates at near zero, think about our reinvestment of our marketable securities. So you're going to get a lower interest rate in terms of returns. So that's going to impact your [geared view as such]. And then the last thing would be around foreign exchange. So depending on what type of stimulus you have, if the dollar gets weaker because as a result of us printing more money, then obviously, that could be a benefit for us because the way to think about our international business is we've got -- we're profitable outside the U.S. and nearly half of our business is outside the U.S. So that can be a benefit potentially if the dollar were to get weaker. So those would be sort of the 3 areas financially that sort of jump off the page at me."
},
{
"speaker": "Tom Barth",
"text": "Well, thank you, everyone. In closing, we will be presenting at a number of virtual investor conferences and events throughout the rest of the fourth quarter. Details of these can be found in the Investor Relations section of akamai.com. Thank you for joining us. All of us here at Akamai wish you continued health to you and yours, and I have a very nice evening."
},
{
"speaker": "Operator",
"text": "Ladies and gentlemen, thank you for participating in today's conference. This does conclude the program. And you may all disconnect. Everyone, have a great day."
}
] | Akamai Technologies, Inc. | 24,522 |
AKAM | 2 | 2,020 | 2020-07-28 16:30:00 | Operator: Ladies and gentlemen, thank you for standing by, and welcome to the Akamai Technologies Q2 2020 Earnings Conference Call. Please be advised today’s conference call is being recorded. I would now like to turn the conference over to your host Mr. Tom Barth, Head of Investor Relations. Sir, you may begin.
Tom Barth: Thank you, operator. Good afternoon, everyone, and thank you for joining Akamai’s second quarter 2020 earnings conference call. Speaking today will be Tom Leighton, Akamai’s Chief Executive Officer; and Ed McGowan, Akamai’s Chief Financial Officer. Before we get started, please note that today’s comments include forward-looking statements including statements regarding revenue and earnings guidance. These forward-looking statements are subject to risks and uncertainties and involve a number of factors that could cause actual results differ materially from those expressed or implied by such statements. The factors include uncertainty stemming from COVID-19 pandemic and any impact on unexpected geopolitical developments. Additional information concerning these factors is contained in Akamai’s filings with the SEC, including our Annual Report on Form 10-K and quarterly reports on Form 10-Q. The forward-looking statements included in this call represent the company’s view on July 28, 2020. Akamai disclaims any obligation to update these statements to reflect future events or circumstances. As a reminder, we will be referring to some non-GAAP financial metrics during today’s call. A detailed reconciliation of GAAP and non-GAAP metrics can be found under the financial portion of the Investor Relations section of akamai.com. With that, let me turn the call over to Tom.
Tom Leighton: Thanks, Tom, and thank you all for joining us today. I’m pleased to report that Akamai achieved excellent results in the second quarter. Revenue was $795 million, up 13% year-over-year and up 14% in constant currency. Non-GAAP operating margin was 32%, up 3 points over Q2 of last year. And non-GAAP EPS was $1.38 per diluted share, up 29% year-over-year and up 30% in constant currency. These very strong results were driven by a continuation of the high traffic levels we’ve seen since the onset of the pandemic, very strong demand for our Cloud Security Solutions and by our ongoing focus on operational efficiency. Akamai was founded with the vision of enabling the internet to scale, so that it could support millions of enterprises and billions of people everywhere. Our mission has been to make all digital experiences be fast, reliable, and secure, a mission that is especially important now amid a devastating pandemic. In our 22-year history as a company, there’s never been a time when Akamai’s importance and value to daily life has been more evident. Due to the incredible work of our highly talented employees, we believe that Akamai has become an indispensable part of the internet, supporting remote work, home entertainment, the learning online banking, home deliveries, logistics, security systems, and commercial transactions of all kinds, for billions of people around the world as they cope with a pandemic. The Akamai Intelligent Edge Platform has grown to include over 300,000 servers in over 4,000 locations and nearly 1,500 network partners at the edge of the internet. The edge is where the end users are and where the content and applications need to be. The edge is where connected devices and the internet of things are located where 5G networks will become pervasive and increasingly where security needs to be to stop the many distributed attacks whose size and sophistication continued to increase. 4,000 locations spanning 135 countries is a powerful offering for global customers and goes far beyond the deployments of other CDNs, even if you were to somehow put them all together. Our unique edge platform has provided enormous capacity to meet the unprecedented demand due to the impact of the pandemic, the launch of several OTT services and the release of numerous electronic games. Peak traffic on the Akamai platform exceeded 100 terabits per second every day in the second quarter. That’s a lot of traffic. Of course, many CDNs claim to have lots of capacity, but none get close to Akamai when it comes to the actual delivery of content. As a result of our unparalleled scale and industry-leading performance and reliability, Akamai gained traffic share in Q2, on both an overall basis and at several of the world’s largest media companies. Akamai now works with more than 220 of the world’s largest OTT and broadcasting companies, as well as with 24 of the world’s 25 most popular video game publishers. The enormous capacity of our unique edge platform has also enabled Akamai to defend the world’s most important enterprises against the world’s largest and most sophisticated attacks. The size and sophistication of attacks has risen dramatically since the pandemic began. As threat actors take advantage of the distraction and vulnerabilities created by employees working remotely. Data from our Enterprise Threat Protector service shows that employee visits to sites with malware rose nearly five-fold in Q2. And just last month we defended a major bank and a major internet service provider against two of the largest attacks ever seen. In Q2, we released our new and highly innovative Akamai Page Integrity Manager, which is designed to protect websites and end users from malware infected content that resides on third-party sites. Nearly half of the content on a typical website originates from third-parties and attackers are embedding malware in this content to steal user’s credit cards and other personal data. Page Integrity Manager provides visibility and intelligence to help organizations stay ahead of this rapidly growing attack. And it has received strong positive feedback from early adopters. The well over 2000 customers who use our web application firewall products are perfect candidates for this new solution. Theft of login credentials is another growing problem that customers increasingly seek our help in stopping. We blocked more than 53 billion credential abuse attempts last quarter, more than four times the number we saw in Q2 of last year. This increase is one reason why our Bot Manager service is now used by more than 600 of the world’s major enterprises. Overall, Q2 revenue from our Cloud Security Solutions grew by 28% year-over-year in constant currency and achieved $1 billion run rate on an annualized basis. This is an important milestone that’s been reached by only a handful of cybersecurity businesses. Our Cloud Security Solutions are now relied upon by thousands of enterprises, including 30 of the world’s top 35 banks, 17 of the world’s top 20 e-commerce sites, 8 of the world’s top 10 asset managers and the majority of the world’s largest airlines, hotels, insurance firms, and consumer goods companies. The strong demand we saw in Q2 for our security and media services, more than offset the reduced revenue growth we saw from sectors of the economy that have been hit hardest by the pandemic, namely travel, hospitality [Technical Difficulty] by the pandemic. That’s one of many reasons why Akamai customer loyalty has remained very high and that our churn rate in the quarter stayed below 1% of annualized revenue. As we’ve grown our business over the last several years, we’ve worked hard to improve our operating efficiency and profitability. As a result, we were especially pleased to see our operating margins exceed our target of 30% in Q2. And also to see our non-GAAP earnings per share reach a $1.38 more than double what we achieved three years ago. Our profitability and cash generation is important, because it gives us the financial fire power to continue to invest in innovation, network capacity, go-to-market capabilities and world-class talent to fuel our future growth. Before turning the call over to Ed, I want to thank our nearly 8,000 employees for their very hard work on behalf of our many customers and the billions of internet users around the world. Despite the pandemic, Akamai employees have continued their can do attitude and customer first mindset, enabling our platform to manage more traffic, more web transactions and more cyber attacks than ever before. Their creativity, teamwork, and tenacity are key to what makes Akamai such a unique and strong company. Now I’ll turn the call over to Ed for more on Q2 and our outlook for the second half. Ed?
Ed McGowan: Thank you, Tom. Today, I plan to review our exceptional Q2 results, discuss the impact COVID-19 is having on our business and provide guidance for Q3 and the full year. As Tom mentioned, we delivered a great quarter on both the top and bottom line. Q2 revenue was $795 million, up 13% year-over-year or 14% in constant currency, driven by extremely robust traffic growth in media, and another quarter of very strong results from our Cloud Security Solutions. Revenue from our Media and Carrier Division was $390 million, up 19% year-over-year and 20% in constant currency. The outstanding performance of our Media and Carrier Division was a result of very strong traffic growth in OTT video, gaming and software downloads. This was a continuation of elevated traffic we saw in late March as shelter-in-place orders were issued in most countries around the world. Revenue from our Internet Platform Customers was $51 million, up 10% over Q2 of last year. Revenue from our Web Division was $404 million, up 7% year-over-year and 8% in constant currency. Revenue growth from web customers was driven once again by security. Revenue from our Cloud Security Solutions totaled $259 million, up 27% year-over-year and 28% in constant currency. Cloud security revenue represented 33% of total revenue in the quarter, compared to 29% in the same quarter a year ago. It is worth noting that approximately $7 million of security revenue in Q2 came from one-time license sales to several carrier customers. And we do not expect to see licensed sales at this level in Q3. Moving on to revenue by geography. International revenue was $351 million, up 22% year-over-year or 25% in constant currency. We are very pleased with our strong international performance, especially in APJ and Latin America. Foreign exchange fluctuations had a negative $1 million impact to revenue on a sequential basis and had a negative $8 million impact on a year-over-year basis. Sales in our international markets represented 44% of total revenue in Q2, up 3 points from Q2 2019 and consistent with Q1 levels. Revenue from our U.S. market was $444 million, up 6% year-over-year. Moving now to costs. Cash gross margin was 77% consistent with Q1 levels. GAAP gross margin, which includes both depreciation and stock-based compensation was 65%, also consistent with Q1 levels. Non-GAAP cash operating expenses were $253 million in line with expectations. Adjusted EBITDA was $355 million, up $29 million from Q1 and up $63 million or 21% from Q2 2019. Our adjusted EBITDA margin was 45%, up 2 points from Q1 and up 3 points from Q2 2019. Non-GAAP operating income was $258 million, up $29 million from Q1 levels and up $54 million or 26% from the same period last year. Non-GAAP operating margin was 32%, up 2 points from Q1 levels and up 3 points from Q2 of last year. Capital expenditures in Q2, excluding equity compensation and capitalized interest, were $196 million in line with our guidance range as we began to catch up on supply chain and travel disruptions that impacted our network build out in Q1. Moving on to earnings. GAAP net income for the second quarter was $162 million or $0.98 of earnings per diluted share. Non-GAAP net income was $227 million or $1.38 of earnings per diluted share, up 29% year-over-year, up 30% in constant currency and $0.14 above the high end of our guidance range. As Q2 results really demonstrated the leverage of our platform and operating model. Taxes included in our non-GAAP earnings were $38 million based on a Q2 effective tax rate of approximately 14%. Now I’ll turn to some balance sheet items. We continue to believe that our balance sheet is very strong. As of June 30, our cash, cash equivalents and marketable securities totaled $2.4 billion. During the second quarter, we spent $27 million to repurchase shares, buying back approximately 300,000 shares. We have approximately $658 million remaining on our previously announced share repurchase authorization. We plan to continue to leverage our share buyback program to offset dilution resulting from equity compensation over time. In summary, we’re very pleased with our performance in the second quarter. And before I turn to our Q3 and full year guidance, I wanted to provide you an update on some of the things I discussed last quarter regarding COVID-19. On our last call, I shared with you details about web verticals that were most impacted by the pandemic during the first quarter, specifically, travel and hospitality and commerce and retail. As you would expect, our customers within the travel and hospitality vertical continue to be challenged in Q2. And although some retail customers experienced notable increases in e-commerce activity, the uptick was tempered in some cases by bankruptcy and continued disruption to those customers that have a heavier reliance on brick and mortar. Many global brands in both of these verticals rely heavily on Akamai. We plan to continue to work closely with them as they cope with near-term financial pressures and look beyond into a post COVID-19 world. As a result, Q2 was negatively impacted by approximately $14 million related to a combination of contract restructurings and elevated bad debt reserves. This impact was in line with our expectations. I’d now like to provide our outlook for Q3 and for full year 2020. For Q3, we are projecting revenue in the range of $760 million to $785 million for up 7% to 11% in constant currency over Q3 2019. The sequential decline in revenue embedded in our Q3 guidance reflects three items. First, we expect the recent actions taken in India to band 59. Chinese based web applications will negatively impact Q3 revenue by approximately $15 million sequentially. We deliver traffic for approximately 30 of those applications in the second quarter. Our guidance assumes the ban will remain in place for the balance of 2020. Second, we expect to see our typical seasonal summer traffic moderation, because people begin to spend more time outside in a way from their devices. And third, we expect internet platform customer revenue to decline by approximately $4 million to $5 million in Q3, primarily due to two of our largest platform customers renewing at new pricing levels in June. At current spot rates, foreign exchange is expected to have a positive $6 million impact on Q3 revenue compared to Q2 levels and no impact on a year-over-year basis. At these revenue levels, we expect cash gross margins of approximately 76%. Q3 non-GAAP operating expenses are projected to be $249 million to $260 million up slightly from Q2 levels. Factoring in the cash gross margin and operating expense expectations I just provided. We anticipate Q3 EBITDA margins of approximately 43%. Moving now to depreciation, we expect non-GAAP depreciation expense to be between $99 million to $101 million. We expect non-GAAP operating margin of approximately 30% for Q3. Moving on to CapEx, we expect to spend approximately $193 million to $203 million, excluding equity compensation in the third quarter. And with the overall revenue and spend configuration, I just outlined, we expect Q3 three non-GAAP EPS in the range of $1.20 to $1.24 or up 8% to 12% in constant currency. This EPS guidance assumes taxes of approximately $34 million to $35 million based on an estimated quarterly non-GAAP tax rate of approximately 15%. It also reflects a fully diluted share count of approximately 164 million shares. Moving onto annual guidance, with increased visibility to Q3 and the remainder of the year, I’m very pleased to reinstate guidance for the full year 2020. While, our ranges are a bit wider than usual, we want it to be as transparent as possible about how we see the remainder of the year shaping up. We currently expect revenue of $3.125 billion to $3.175 billion, which assumes our security business contributes more than $1 billion. Adjusted EBITDA margins of approximately 43%. Non-GAAP operating margins of 30% to 31%. Non-GAAP earnings per diluted share of $50.2 to $5.12. This represents year-over-year growth of 12% to 14%. This non-GAAP earnings guidance is based on a non-GAAP effective tax rate of approximately 15% and the fully diluted share count of approximately 164 million shares. Finally, full year CapEx is expected to be 22% to 23% of revenue. In summary, we continue to be very pleased with the performance of our business. We believe our excellent Q2 results demonstrated the profitability of our business model and scalability of our platform, our revenue diversification, deep enterprise customer relationships in our strong balance sheet and cash flow. Thank you. Tom. And I would be happy to take your questions. Operator?
Operator: [Operator Instructions] Our first question comes from James Breen of William Blair. Your line is open.
James Breen: Great. Thanks for taking the questions. There’s a couple on the customer side, you talked about a couple of renewals this quarter. Can you just give us a little bit of color into how those contracts work going forward and/or is there any other anticipated renewals in the back half of the year. And then just commentary around the security side, obviously, it’s a large business and continue to see you continue to grow in the high 20% range. I think a lot of us have anticipated something in the lower 20% of the beginning of the year. So can you just talk about some of the products there, maybe some of the new products that are driving it and then just give a little more color on the overall picture? Thanks.
Ed McGowan: Hey, Jim. This is Ed. I’ll take the first one and then Tom, you can take the second one. So in terms of the renewals, in terms of major renewals for the back half of the year, I don’t – we don’t expect anything large for the internet platform customers. There will be no more renewals this year and in terms of the contracts pretty standard. The good news, I guess, is a couple of them are no longer term in nature, but not all of the – we will have some renewals next year, but very pleased with how those contracts turned out. Tom?
Tom Leighton: Yes. The revenue and security was driven by our flagship services, Kona Site Defender, which provides web application firewall capabilities, stops the attackers from taking over a website or corrupting it or stealing data. There are [indiscernible] service capabilities. That stops the big attacks. You have Bot Manager doing extremely well. And that keeps adversaries from taking over accounts from stealing customer information. We also have a very strong security services business, and those folks have been very busy, as you can imagine, with major IT shops now trying to support, remote work and work from home on a sudden basis, where they really need security help. Closely related, but a smaller business is our Enterprise Security offerings. And we do have new capabilities there. We now have a Secure Web Gateway that’s available. And coming up later this year, multifactor authentication. We also have a new service I talked about called Page Integrity Manager. And this works the – one of the latest attack vectors that’s becoming pretty rampant out there where the adversary puts malware into a third-party side or third-party code that’s used by the primary site. And what happens there is the user comes to the main site and the main site links to third parties for their apps and other things that are useful, usually. And the browser follows those links. And before you know what the browser is getting malware from one of those third-party sites. And that malware is designed to cause the browser to give up the user’s personal information like their credit card. There are some very famous breaches there resulting in large fines and Page Integrity Manager stops that and notifies our customer that they got a problem in terms of where they’re linking for their third-party content. Also we have Akamai Identity Cloud, which provides capabilities around the user and their profile and history, making sure that user data stays safe and compliant with local regulations. So really a lot going on in our security business, and we’re seeing very strong growth there, obviously.
James Breen: Great. Thank you.
Operator: Thank you. Our next question comes from Brad Zelnick of Credit Suisse. Your line is open.
Brad Zelnick: Great. Thank you so much and congrats on all the success. Tom, I wanted to ask you about the Edge Computing opportunity. There’s a lot of buzz out there around the Edge and what some are the use – I’d be curious to hear just from you, what are some of the use cases that convince you it’s very real? Over what time line does it materialize? And how is Akamai positioned to win in capturing this?
Tom Leighton: Yes. We’re the largest provider of edge computing services by far. We have been doing it for close to 20 years. And the idea that this is how somehow something new is just not true. It’s – most of our customers are using our edge computing capabilities for a variety of applications to A, B testing for how users like their site, to do things locally about what content actually gets delivered to the user, what ads get delivered to the user. Keeping track of how a user goes through a site. The security services use an extensive compute power at the Edge. We don’t break it out as a separate revenue item, but if you use the definitions, we see that a lot of folks in the analyst community are using, I would say already, it’s over a $2 billion business for us. We don’t report it that way. But most of our customers are using the computing in some form or another, and also when it comes to Edge, I think this is really important. We’ve been talking about the Edge and the importance of being at the Edge really again, 20 years, and recently it’s become popular as a buzzword. And that’s because the Edge is really important, but to be at the Edge, that means you got to be in thousands of places, close to the users, really close, and we’re in 4,000 points of presence now. A lot of the other CDNs, who talk about doing Edge or Edge Computing, maybe they’re in a couple of dozen cloud core data centers, which is really not the Edge. In fact, you could take probably about maybe even all of our CDN competitors put them together and they don’t get anywhere close to the Edge presence that Akamai has. And what’s the future of Edge Computing, I think it’s very large, you look at 5G coming and that’s going to utilize a lot of capabilities at the Edge. With 5G, you get a lot more devices connected. IoT becomes much more possible. You have much lower latencies in the last mile. And then that means it’s even more important to do the computer delivery from the last mile. If you’ve got a huge latency in the last mile, okay, the latency you’ve introduced going from the Edge of the core is not as bad, but you really now it becomes noticeable with 5G. Also you have a lot more bandwidth to 5G. So I think that’s an important driver, a future revenue for Akamai. Also with IoT, we already have an IoT Edge Connect platform that our customers are using. It’s unique among CDNs. It uses different protocols. Not ACTP, by and large, which is what powers a lot of the web today, but MQTT, it uses the pub sub model, which is a whole different communication paradigm. That’s a lot more efficient. And again, users not only compute at the Edge, but data stored at edge, key value pairs and databases at the Edge. And Akamai is in an unique position to provide that. But again, I just want to be really clear Edge Computing is not a new phenomenon. It’s got recent buzz with a couple of IPOs on the street, but we’ve been doing that at scale for a long, long time.
Brad Zelnick: Thank you so much, Tom. That’s it for me and congrats again.
Tom Leighton: Thank you.
Operator: Thank you. Our next question comes from Sterling Auty of JP Morgan. Your line is open.
Sterling Auty: Yes, thanks. Hi, guys. So, Ed, you kind of give us a couple of the parameters that will impact Q3, but as I think about the full year guidance, how have you layered in perhaps some of the positive impacts that we would see from a more full rollout of some of the new OTT solutions, as well as the presidential election?
Ed McGowan: Hey, Sterling, thanks for the question. So I’ll start with the presidential election. I’d say, this year – coming into the year, we’re expecting probably a bit more robust debate scheduled, where a lot of competitors going out to the democratic seat that sort of ended quickly. So I’d say it’s probably going to be a bit more muted this year. Just because there – I think there’s only three debates scheduled, it’s not as much activity as I would have expected at this time. So nothing outside of a little bit of revenue associated with that. So nothing really significant. On the OTT launches, obviously, we just had one go a couple of weeks ago. It’s still early days and I don’t want to go in May. So still pretty early there. I think we’ve got, you saw the media revenue, obviously, very, very strong expect to see another strong quarter. Despite the fact that I talked a bit about the dynamics in Q3 and for the rest of the year with those applications in India being banned. But we’re seeing good growth there and expect that to continue into the balance of the year.
Sterling Auty: All right, great. And then one follow-up. How should we think about the contract restructurings, and maybe in particular, excuse me, into the e-commerce vertical in the back half of the year, maybe in light of a question that I’m getting a lot right now is, probably not a lot of foot traffic going to the malls. Could we be setup for just a massive e-commerce holiday season this year and traditionally that’s been a big benefit for Akamai.
Ed McGowan: Yes. Good question. So you can imagine, there’s an awful lot of debate internally on that. What I would say with contract restructurings, I mentioned, that we had about a $14 million a headwind here in Q2. Most of that was in travel, retail we did see about 10 bankruptcies roughly this quarter. And you look at the economic data, it’s mixed, there are some, some numbers that are doing better than others. So as we go and look at the Q4, you’ve seen, we’ve given quite a wide range, and if you do some math on kind of the mid points, it’s kind of suggests a bit softer than we saw last year. Maybe we go to the high end, it could be a bit better, but it’s still tougher to call. I will say, when I talked about the web vertical or web division, excuse me, last quarter, I expected it to be flat to down a bit, probably a little bit better than I expected in Q2, mainly because we’ve seen a lot of our customers, both in retail and travel be able to access the capital markets and stabilize their businesses a bit. But I still think it’s going to be pretty rocky going into Q4 as we get into the fall season, who knows what happens with the pandemic. But the thesis is correct. There’s not a lot of people going to the stores, you could see a lot of online retail activity. We see a bit of a, kind of a mixed bag. We see some that are doing much better than expected, in terms of traffic growth and others that are kind of in line. And you’ve got some that are still struggling with just their legacy business and in financial difficulty. So we’ll see, but that’s why we provided a wide range. There’s a couple of different ways, different outcomes that could happen here in Q4.
Sterling Auty: Got it. Thank you.
Operator: Thank you. Our next question comes from Colby Synesael of Cowen. Your line is open.
Colby Synesael: Great, thank you. Two questions if I may. I guess, for Ed, I just wanted to follow-up on Jim’s question, regarding security. And Tom, appreciate the various sub-segments that you broke out. Can you help us just a bucket from a revenue perspective, some of the bigger drivers maybe either in dollars or percentage as we start to focus more on that security business. I think it’d be helpful just to give it more color on where the revenue is actually coming from. And then secondly, you guys haven’t really done any tuck in M&A in some time. Is that just a function of a disconnect with valuations? Or is it something else and trying to get a sense, if we should expect to see that kind of start to come back into the full, maybe the next few quarters. Thank you.
Ed McGowan: Yes, sure. So as far as security goes, I think it’s a bit more of the same. We saw good strength with Kona Site Defender, that’s obviously our largest product and drives the most revenue. We’re starting to see a nice uptick in Prolexic. That was a good surprise for the quarter. Bot Man continues to be probably our fastest growing product. Security services are going along pretty well. So it’s really sort of strength across the board. And I think as I look into the future, Tom talked a bit about Page Integrity. That’s the product that we’re really excited about. When you think about the KSD base as really good customer base to go and upsell that. We’re hoping that, that has very similar characteristics of Bot Man, which is a nice addition on to Kona Site Defender. And Bot Man got to 100 million pretty quickly. Hopefully we can see the same with Page Integrity.
Colby Synesael: Does Kona, for example, 50% of revenue, is it 60% of revenue of the security business, any color there?
Ed McGowan: So we haven’t broken it out yet. I’d say it is the largest percentage. We’ve got four products over 100 million. I don’t know that it’s over 50%, but it’s probably close to that. That’s a reasonable for proxy.
Tom Leighton: And on the M&A question, we’re continuing our efforts there, at the same pace is always. But we’re also very disciplined buyers. And when you’re in the midst of a pandemic, it is a little harder to conduct diligence. And if we were to close an acquisition, maybe a little harder to integrate it with the travel restrictions we have now. So probably that’s a damper. And I wouldn’t say, there’s huge bargains that have been created as a result of the pandemic, at least not yet. And we’re very careful about what we buy to make sure it makes good financial sense, but we’re continuing with our efforts there full speed ahead.
Colby Synesael: Great. Thank you.
Operator: Thank you. Our next question comes from Keith Weiss of Morgan Stanley. Your line is now open.
Josh Baer: Hi, this is Josh Baer on for Keith. Just wondering, if there’s any way to quantify the benefit to OpEx in Q2 and maybe in Q3 from more limited travel, entertainment and expenses related to COVID. And then more broadly, as it relates to margins, how should investors think about margin expansion in the years to come beyond the 30% to 31% for this year?
Ed McGowan: Yes, sure. I’ll take the first part and say a few words on the second part. Maybe Tom, you can chime in on that as well. In terms of the travel, it’s not a huge expenditure for us, using a couple million dollars a month. So we did see obviously a lot less travel this quarter. And we’ll see a little bit in Q3. So not a huge amount of savings there, but that did help operating margins. I think what really benefited the operating margin line was, obviously, extremely strong traffic, running the network at, probably hotter than we’d like. That’s why you see us building out a lot more CapEx. The network performed fantastically well, but you do want to make sure that you’ve got a lot more capacity to be able to handle big spikes and take advantage of opportunities when other competitors may have some struggles and it’s good to have that extra capacity. But when you do run the network, how do you see the drop to the operating line. In terms of margins, we’ve said in the past that we plan on operating at 30%, we want to continue to make investments in the business. We added a couple of hundred heads this quarter, and in the areas of research and development product and go to market, we think there’s still a lot of room for growth here. So we want to make sure we balance that appropriately.
Josh Baer: Got it. Thanks.
Operator: Thank you. Our next question comes from James Fish of Piper Sandler. Your line is open.
James Fish: Well, and appreciate the added color this quarter. I just have one, it’s on web proxy. It’s been in beta and been freely available to some customers out there, given your goodwill. Why not accelerate the modernization of the product and accelerate the investments and enterprise security to really step on the gas on a high profile area?
Tom Leighton: Well, yes, we are working very hard in terms of both product delivery and with a sales effort. And we were very pleased to see substantially increased bookings so far this year. And we very much would like to continue to accelerate the penetration in that business.
James Fish: Thanks.
Operator: Thank you. Our next question comes from Will Power of Baird. Your line is open.
Will Power: Great. Thanks. Let me – a couple of questions very quickly – here. I wonder if you could just comment broadly on what you’re seeing in terms of enterprise sales cycles, broader pipeline, are you continuously benefits from COVID. Or are you starting to see any potential headwinds economic pressures. And then my second question, just coming back to the media, is there any way to kind of help break apart the sources of upside there, obviously, really strong results. Any particular outliers between video, gaming, et cetera?
Tom Leighton: Yes, this is Tom. I’ll take the first question. I would say, it’s a mixed bag with COVID. On the one hand, there is a much greater need for our security products, not just enterprise products with remote workforces, but pretty much all the security products because the attack volumes and vectors have increased so much with the threat actors trying to take advantage of the situation. So that’s a good tailwind. And I think you saw the benefit of that so far this year. On the other hand, sales are a little harder, because you can’t visit customers. Everything is remote now. That said, I think our teams have done a very good job adapting with virtual conferences and meetings. And so I think we’re dealing with that situation very well. On balance, I think we’re in a much stronger position with our security offers, in terms of the customer’s need for our products. And I think Ed will take the question on media upside.
Ed McGowan: Yes. So the good news is, it was really strength across a number of areas. I’ll dig into a couple for you. I would say one area in particular that stands out in my mind is gaming. We saw a ton of gaming activity and so a lot of major publishers do some smart things, including running some promotions to promote their games and offer attractive incentives for folks to leverage their portfolio. During the time that you’ve got people locked up in a pandemic. So we saw not only just a more robust game release quarter, we just saw some really smart things by the game publishers and that drove a tremendous amount of traffic. So that was an area of particular strength. And then obviously no surprise video, OTT video from a lot of the existing providers, some of the newer providers added as well. And that was strength pretty much across the board. It was both here in the U.S. and internationally. Our internet platforms obviously provided some nice upside for the quarter. That’s been a theme we’ve talked about a lot, they’ve kind of been in that stabilization in the $45 million range. And every once in a while, we get some upside from those customers as well. And then also social media. We saw – we carry a number of social media platforms and it’s not much of a surprise that people are locked up in their homes and not traveling and going out to dinner and things like that spending more time online, including social media. So the good news is pretty much across the game, but if I had to point out one thing in particular that jumped out will be gaming.
Will Power: Okay. That’s great. Thank you.
Operator: Thank you. Our next question comes from Heather Bellini of Goldman Sachs. Your line is open.
Caroline Liu: Hi. This is Caroline on for Heather. And thank you for taking my question. My first one is really just on the security business. I was wondering if you could give more color on what is the split between new business from the existing customers versus like a completely new Akamai customers. And then if you are a new to Akamai, is there an opportunity to set upsell a CDN and other products to that security customer. And then I just have a quick follow-up.
Ed McGowan: Sure. No problem. So obviously, our business being a recurring revenue business, you don’t get a ton of revenue right off of that, when you sign up a new customer. So the majority of the business does come from our existing customer base right now about 59% of our customers buy a security product, which is up couple of points from last quarter. And then about 31% of our customer base is buying more than one security product. So that’s going to be a theme in terms of future growth that, whether it’s your ad, you buy Kona Site Defender, you’re adding Page Integrity or Bot Management or Security Services. So I’d say for the certainly for the near-term seeing most of our growth coming from our existing customers is where we’re going to see the majority of the growth is that customers take on more security products. And then as far as when you sign up as a new customer, we do tend to sell a lot of protect and perform bundle, so it’s not unusual to see somebody come in as both a security customer and as a CDN customer, but throughout our history, if you look at our strategy has always been to focus on the largest web properties, largest banks, largest travel, retail customers, et cetera. And to grow those accounts over time. We talk about how we’ve worked with some of our customers that have been challenged with COVID and restructuring contracts and offering some financial assistance that will pay off in the long run. And that’s always been our strategy. So our focus on acquiring new customers that have a lot of growth opportunity, this has paid off over the last 20 years. And that’s where we’re going to continue to focus.
Caroline Liu: Got it. And then – sorry, go ahead.
Ed McGowan: I said you had a second question.
Caroline Liu: Yes. So the other one is just on OTT, you talked about how you’re continuing to drive share gains. And last quarter, I remember you also said that as well. So I’m kind of curious, like what exactly is, kind of enabling you guys to gain more share in traffic. Is there something on the competitors? Or is it more so your guys is doing the product innovation side.
Ed McGowan: Yeah. I’d say there’s probably three key areas. The first one is around performance. So what a lot of the OTT providers or really any large scale media customer will do is they’ll have their own set of performance metrics. And pretty much now most large providers of media content will split with CDNs. And usually it’s the one with the best quality wins. Pricing is pretty efficient in the market. So it’s not as much about price anymore. Occasionally, you’ll see that, but it’s really about performance. That’s the one thing. I’d say the other thing is around the capacity that you have outside of the U.S. in particular, we tend to do much better in places that are harder to deliver. And then I say the last thing is just having, scale is another area that depending on the type of application, you can see, real big peak demands, whether that’s in gaming or live sporting events and such like that. So having capacity in the right places, the best performance and having the scale is really what drives the share gains.
Caroline Liu: Got it. Thank you so much.
Operator: Thank you. Our next question comes from Amit Daryanani of Evercore. Your line is open.
Amit Daryanani: Thanks for taking my question, guys. I have a two as well. First off, I guess when I think about the revenue performance this quarter on the CDN side, especially. I’m curious, did you see a normal drop-off in usage patterns in the month of June, the summer season kicked off. I’m asking that broadly, because given the fact that shelter in place remains broadly across the globe. Do you think that Q3 could not see a seasonal drop, because we’re all limited and not able to travel at this point?
Tom Leighton: Yes. So you do start to see a little bit of traffic, not accelerating as much, I would say, probably the best way to put it. Coming into the pandemic, something like that really accelerates a trend. So you saw a lot more internet users now adopting e-commerce, adopting – watching video online, cord cutting, et cetera. So we saw a nice bump from COVID in the pandemic, and we’ve seen that sustained. I’d say traffic was elevated probably longer than we had expected. We’ve never been through one of these, so it’s hard to always call it. But in terms of normal seasonality, I would expect to see, as the summer months come on, we do expect to see traffic certainly not grow as quickly as we saw the last quarter, but it’ll still be strong. But I would expect some seasonality that’s reflected in our guide.
Amit Daryanani: Got it. And then if I can just follow-up, how do we think about the security business performing in the back half of the year relative to the top line expectations you’ve given, especially some of the commentary you just had on the new customer part of the equation over here?
Tom Leighton: Yes, sure. So one thing I did call out on the call was that we had some license revenue. We do sell every quarter a couple million dollars of license, some of our Nominum products to our carrier business – our target customers, excuse me. And this quarter, in particular, was a bit unusual, just that we had that sort of performance. I talked about $7 million in the quarter. Typically, you see that purchase behavior in the back half of the year in Q4. It’s a little bit unusual to see that in Q2 or Q3. So I just wanted to call that out. It’s something we want to take into consideration. And also, as you look at sort of year-over-year growth rates, Q4 of last year, we had a massive sequential growth quarter-over-quarter. I think we were up about $22 million sequentially. So just kind of keep that in mind as you’re doing your modeling, think about kind of your year-over-year growth. We talked about being over $1 billion. At the beginning of the year when we gave guidance, we talked about doing $1 billion of revenue in security. So this implies sort of low 20% growth rate, which is better than we had expected coming into the year. And then again, as far as new customers are concerned, you’ve got a base this big. The revenue growth is going to come from that existing customer base. We continue to add new customers every quarter, but it won’t make a material impact on the year. That happens over time. So it’s – we continue to add customers over time, it will be more of an impact on the overall growth, but it’s going to be the existing customers that really drive the growth.
Amit Daryanani: Got it. Thank you very much.
Operator: Thank you. Our next question comes from Mark Mahaney of RBC. Your line is open.
Mark Mahaney: Okay, thanks. Two questions, then. Sports has been, I guess, a non-event. What are you assuming? What is a reasonable assumption for what kind of traffic you could get from sports? And I guess you’ve had such strong traffic the last couple of months because we’ve all been at home but without sports. And so as sports, hopefully, it comes back and MLB, NHL, et cetera, how material could that be like what if we just learned over the last couple of months, you can have really strong traffic growth without any sports at all? And then the other thing I wanted to ask is you talked about these apps banned in India. One of those apps could be banned in the U.S. Would that be a similarly material event for you if that app were to be banned in the U.S.? Thank you.
Ed McGowan: Hey Mark, yes, thanks for the question. I’ll take the second one first, and I’ll talk about sports right after. So the way to think about U.S., if the U.S. were to do something very similar to what happened in India, the number of Internet users in India is much greater than the U.S., it’s about 3 times the overall population. So you’ll have fewer users, assuming kind of like-for-like. And then also, we tend to have a bit more competition in the U.S. We tend to get outsized share in India. So I would not expect it to be as material. It would be an impact we do for those 30 apps that I talked about. We deliver traffic here in the U.S., but it would not be as material. In terms of sports, so yes, you’re right. We really haven’t had much sports. We had a little bit of the premier league in the Bundesliga over in Europe. One thing I was looking for was to see – where we see a much different traffic profile now that you don’t have spans in the stands? And while we have a limited subset, we get a couple of weeks now of major – a week of Major League Baseball and a couple of soccer leagues. We haven’t seen anything that suggests that the traffic patterns are materially different. I’d say it’s probably more normal and in line with what I would normally expect. So still early, we’ve got the NHL, NBA kicking off here at the end of the week. And then hopefully, the NFL coming on and Champions League and IPL and a bunch of other things. Now, I talked in the last call that for us, sports in general, is about a little over 1% of our revenue. Now if you get that all in a concentrated period of time, that could add some decent revenue. Still, like I said, early days to see how the behavior changes. I’ve watched a number of baseball games and seeing it without fans is not as exciting personally. But hopefully, it continues to drive a lot of folks to watch online. But I think about it in that sort of perspective, about over the course of a year, a little over 1% of revenue comes from live sports. Certainly, the bigger ones being NFL, Champions League, IPL, some of the other sports, not quite as big.
Mark Mahaney: Okay. Thanks a lot, Ed.
Operator: Thank you. Our next question comes from Tim Horan of Oppenheimer. Your line is open.
Tim Horan: Thanks, guys. Tom, back to the Edge. In the past, I think you were a little skeptical about being able to do kind of gaming as a cloud service just because of the cost of the compute and the latency. Maybe just any more updates on what you’re seeing from that perspective. And maybe any other applications that you think are perfect for your infrastructure that’s already in place that are new or more Edge based.
Tom Leighton: Yes. I don’t think there’s any change in the gaming landscape, if anything. I think the thesis that it is less efficient to do all the compute in the cloud probably getting proved out. Companies have been working on that for over a decade. Now we do a lot of business with the gaming companies. So we’re a go-to player for them to distribute software. And there are things that we can do to optimize the performance as well. But I think doing all the compute in the cloud, it’s not as efficient, just economically. With Edge Computing applications, pretty much all of our customers’ applications that run on Akamai are doing some kinds of compute, personalization, the selection of the content that goes to the end user, the format it goes in, the images, which image goes, depends on the device, the connectivity in the last mile, all optimized for performance. So it’s pervasive today, I would say, Edge Computing on our platform, which is a reason why we don’t separate it out. I don’t think you can. And also on the Security side, we are inspecting the details of every single request that comes in and also the content that goes back out. We’re placing software on the client for all sorts of purposes, most recently for Page Integrity Manager. As you go to a website that’s protected by Page Integrity Manager, we have our script on the client itself that is looking at everything the browser is being asked to do, to see – for example, is it being asked to access your credit card or stuff that we believe is personal information and send it to a place that we think is bad. And I can’t tell you how much we’ve already discovered is going on out there. So I would say Edge Computing is just pervasive today. And the Edge being our edge servers in 4,000 locations, which is the real edge. And also on the client, we’re doing a lot of computing there as well. And I do think that is the future. And as you have richer applications, there’s more use of that. I think the big opportunity going forward is in the IoT arena. I think 5G helps to enable that. And as I mentioned before, that’s a whole different paradigm, uses different protocols and different structures like the pub-sub model and data stores. And again, being at the Edge helps a lot to reduce the latencies there. Edge Computing is not a new phenomenon. And I think that’s really important to understand.
Tim Horan: And just a quick follow-up on security. Ed, I’m assuming the vast, vast majority of Security revenue is kind of recurring or not usage based, but just any clarification there. And can you give us some color, how does it compare to your gross margins of Security versus your consolidated gross margins? Thank you.
Ed McGowan: Yes, sure. So I’d say the majority is recurring. There is – as I talked about, we do some bundling. So you have a bundle of Protect and Perform. So that can drive a little bit of variability in usage. Sometimes you see that kind of play out in Q4 to Q1, but the majority is recurring in nature. And then your second question was on gross margins. Yes. So the gross margin on security would be greater than what you would typically see on CDN. And it’s an interesting debate, right, because you’re using the same servers that are delivering a video to one home might be blocking an attack from another home. And it just kind of shows the power of the model and the leverage that we have that as we build out this Edge, we can build on new capabilities on top. And those incremental capabilities have much higher incremental gross margin and Security certainly falls into that category.
Tim Horan: Thank you.
Operator: Thank you. Our next question comes from Rishi Jaluria of D.A. Davidson. Your line is open.
Hannah Rudoff: Hi guys, this is Hannah Rudoff on for Rishi. Thanks for taking my question. Just one for me here. Could you talk about how your customer conversations, especially around Enterprise Security Solutions have shifted from when you last talked about three months ago, especially organizations have maybe moved out of triage mode at this point and are thinking more about medium and long-term planning?
Tom Leighton: Yes. I think at a high level, the conversations are very similar. But with much more urgency in some cases, I can just give you an anecdote with a conversation with a CEO of a very large company. And the CEO was both happy and worried about how quickly his IT team had enabled the workforce to be remote. And he was happy because within a week, the entire workforce was remote because basically a shelter in place rules are put in place. On the other hand, he was worried because he always wanted a remote workforce, but was always told by his Chief Security Officer it would take two years to make it be secure. And all of a sudden, their workforce is remote in a week. And that led to a really good conversation about, okay, how can we really secure it for them. And that’s where our Enterprise Application Access product and our Zero Trust suite of solutions really makes a big difference. It’s a service on our platform. It does it security at the application layer, not at the network layer. So never mind the pandemic and remote work, it’s just a lot more secure to start with. But now you’re in a position where very quickly we can enable them to have security for a remote workforce that employees can only access apps that they’re allowed to. And even then, the employee device can’t directly touch the app or the data, it just touches us. And we’re scouring every communication to make sure that malware isn’t being spread and data is not being exfiltrated. And of course, that’s not possible with the traditional approach. So I think the COVID situation with remote work has certainly enhanced the interest in EAA. The attack rising in general have enhanced interest in Akamai Security Solutions. And of course, you’re right that there’s a lot of scrambling going on out there. And so it is a little more complicated in terms of the sales process. But on balance, I would say we’re doing better than we expected. And on balance, there’s more tailwinds associated with the pandemic for our business because customers need our help even more than before.
Hannah Rudoff: Great, super helpful. Thank you.
Operator: Thank you. Our next question comes from Lee Krowl of B. Riley FBR. Your line is open.
Lee Krowl: Great. Thanks for taking my questions, and congrats on a very solid quarter. Two questions. First, on the impact of the Indian app ban. You quantified the impact, a little bit more detail. I’m curious if that makes an assumption for a backfill from apps that are still available to consumers as an offset? Or is that just a complete loss of business? And then secondly, can you just maybe talk about CapEx leverage? I assume as we start to lap some of these OTT launches from a year-over-year perspective, is there an ability to see leverage now that you’ve built in some of the capacity? Or is there a working assumption that as we continue to see proliferation of these products, that CapEx will need to kind of match the growth in traffic?
Ed McGowan: Yes, sure. So in terms of the India ban, we assume that there’s a complete loss there. Obviously, there’s – users move to other applications to the extent that there’s other options in the market. We’re obviously having conversations with all those customers. In some cases, we were – some of them are customers now, some of them we’re trying to acquire. So yes, we’re just assuming that there’s really no material impact right now just because it’s an unknown. We haven’t seen any major shift or anything like that. That’s just sort of traffic has disappeared for lack of a better term. This is something we’ve never dealt with before. So we’re kind of in unchartered territory. So what we did is just wanted to call it out for you guys. And so you could think about it in your models because, obviously, while the Q2 guidance is very, very strong and above where the consensus was, it is a step down, and that is a material reason why. Obviously, if that traffic comes back, that would be great. I wouldn’t expect it to all come back at once. I think it’d be some kind of a ramp. But to the extent that other players in the market pick up some of this behavior or some of the various things that folks are doing with those apps, we’re going to be right there trying to acquire those customers. And with our scale and capacity and performance, we should be in great shape to get it. But there’s no assumption that there’s a shift from one to another. As far as CapEx goes, this quarter should be the high watermark for the year. Obviously, we weren’t expecting a pandemic starting off the year. Or Tom had mentioned doing 100 terabits every day of the quarter. Obviously, it came with a lot more revenue. So what we’re doing now is just kind of retooling and building up more capacity just in anticipation that there could be a second wave of COVID here and maybe another big splice. We want to be prepared for that. In our capacity planning, we’re going to assume that, that traffic comes back in India. We’re not making the assumption here on the revenue side. If we’re wrong, we’ll grow into it. But as I think about sort of a normal CapEx range, the network CapEx is really wide focused on. I know you kind of look at that headline number and I sort of look at the software cap being in sort of that 7% to 8% range. We have got a full gross expense in the P&L for R&D. So R&D running at 13%, 14% of revenue is about the right way to look at it. I think that’s a healthy spend. And then if you look at network CapEx in the 7% to 10% range, it’s kind of a normal range with this year, obviously, being closer to 14% because of the pandemic. I think this is probably the right way to think about it, to the extent that we see the opportunity for significant growth or accelerated core cutting or whatever. We’re going to go after it pretty aggressively.
Lee Krowl: Got it. Thank you for the details.
Operator: Thank you. Our next question comes from Jeff Van Rhee of Craig-Hallum. Your line is open.
Jeff Van Rhee: [Indiscernible] surge in Zero Trust bookings, forgive me if I missed it, but just any comparable comment this quarter in terms of bookings on Zero Trust. And then the other related to Security as well. I think you had said a year ago that the demand for security services was about 1,000 users and a bit over $100 million in revenue. Is there any update there?
Tom Leighton: I missed the first part of the question, but I think it had to do with our enterprise Zero Trust Solutions, and we had a very strong quarter there. We don’t break out the individual numbers for that solution set yet, but we saw very strong growth and we were very pleased with that. With the Managed Security Services, as you can imagine, this is a time when our customers need us more than ever with that. You have the range of attacks increasing, their sophistication, and now our customers really busy trying to figure out how to securely support a remote workforce. So very pleased with the results there and the continued very strong growth of our Security Solutions.
Jeff Van Rhee: Got it, thank you.
Operator: Thank you. Our next question comes from Brandon Nispel of KeyBanc Capital. Your line is open.
Brandon Nispel: Great. Thank you for taking the questions. I wanted to get you guys’ thoughts on the CDN business. That business hasn’t grown as fast in over five years and really exceeding where it has the last couple of years. I guess, is it your view that growth can get – be sustained at these levels? It doesn’t seem like it from your guidance, but how should we think about the target growth rate for the CDN business over the next, call it, 18 to 36 months? Secondly, you made it a point, Ed, to call the balance sheet quick asset for the company. I was hoping you could outline some of your capital allocation priorities and share your thoughts on potentially any return to capital to shareholders beyond the share repurchase program, which you guys didn’t repurchase that many shares this quarter. But hoping you could share some more details. Thanks.
Ed McGowan: Sure. I’ll take a step. So just in terms of the CDN business, on several calls ago, we were asked the question of what would it take to get the CDN business to get back to a healthy growth rate like what we have today. I think, well, no one would have predicted the pandemic would be the reason that, that would happen. I think to sort of kind of step back behind that, you think what behavior did it drive, it was significant adoption of Internet, video, gaming, e-commerce, online banking, just people using the Internet a lot more. And I would say that to the extent that anything drives that acceleration of any of those trends, we stand to gain. And I think the CDN business is going to always be a little bit lumpy in terms of its growth rate. I don’t think we could sort of go up into the right, just given the dynamics in the business. We obviously have several verticals now that are challenged, travel and hospitality and retail, which has been kind of a challenged vertical for a while. When you get into the high-volume CDN business, you always have to deal with volume and pricing. I’ve been with the company for 20 years, and that sort of rule has been in place since I started. That as companies grow volumes, unit prices go down. Our economics work the same way with our vendors and the way we build our network and design our technology to drive costs out. So you always have a little bit of lumpiness. But really, what you’d have to look at is what are some of the macro trends? How successful are these OTT offerings? What’s the next big trend in something like gaming? Do you get stabilization in your retail and travel vertical? So it’s possible. I think this was a good test case in showing that it is possible to get back to a healthy growth rate in CDN. But there’s a lot of things to consider with different dynamics, some that are out of our control. The other question was on capital allocation. Yes. So we don’t – we talk about offsetting dilution. We’ve done that in the past. And over time, if you look at our share count, opportunistically, we’ve used our share buyback program to reduce the number of shares. Back in 2018, we did a large $750 million buyback. We don’t have any intentions of doing that at this time. But it’s something that we always talk to our Board about and always something that we look at. But right now, as I said in the prepared remarks, we’re looking at just offsetting dilution over time. And we’d love to be able to find some good strategic acquisitions. We’re always looking. We’re very disciplined buyers, active shoppers. Valuations in some of the spaces that we’re in, in security, in particular, started to correct a bit as we went into the beginning of the pandemic, but they certainly come out of that probably even a bit more stretched than when we went in. So we’re going to be patient, look for the right opportunity, but M&A will certainly be an area that we look to utilize our capital that for.
Brandon Nispel: Thank you.
Tom Barth: Operator, we have time for one more call.
Operator: Thank you. Our next question comes from Alex Henderson of Needham & Company. Your line is open.
Roger Boyd: Hey, thanks for taking my question. This is Roger Boyd on for Alex. Just a quick question on e-commerce. Acknowledging that the broader retail market remains pressured, there’s been a lot of opportunities in that space. I’m just wondering, to the extent Akamai has been able to win new e-commerce logos in the current environment. And then secondly, given your investments in Botnet and Page Integrity, is it fair to say that is vertical value security a little more than the average customer, and that might be a differentiator for Akamai?
Tom Leighton: Yes. So the first one, I didn’t quite catch all the second one, so I’ll ask you to repeat that after I hit the e-commerce question. I think the question was, does this enable us to – does this environment enable us to acquire new customers? Yes, sure. I mean I think it’s an area where we, today, work with many of the large e-commerce customers today. But certainly, the way I look at it is, as companies are shifting from more brick-and-mortar to online, one of the conversations we’re having with our customers is about that shift and what else, what other products do they need? And how are they planning on making more of a push towards online. So, I think that’s a good trend for us. And I’d say pretty much every retailer is – get some presence online. But certainly, there are some opportunities there. But for the flip side, there’s also a lot of challenges in that market as well as we’ve talked about. And I’m sorry, can you just repeat your second question?
Ed McGowan: I can answer that. Go ahead. Yes, the second question – with security, that is a huge differentiator for us. We’re the market leader by far with Cloud Security Solutions. And as I mentioned, the vast majority of the world’s biggest e-commerce sites make use of our security solutions. Today, I would say, in that vertical, sales are led by security, and then delivering acceleration would be an add-on. In fact, we include the basic DSA, Dynamic Site Accelerator services, part of Kona Site Defender. Thought manager is critical today for any commerce site, and we’re really uniquely differentiated with our capabilities there. So security is very important across not only e-commerce but many verticals today.
Roger Boyd: That’s perfect, thank you.
Tom Barth: Well, again, thank you, Tom and Ed. That wraps up, I think, our questions. So I want to thank everyone for joining us. In closing, we will be presenting at a number of virtual investor conferences and events throughout the rest of the third quarter, and details of those can be found on the Investor Relations section of akamai.com. Thank you again for joining us. And all of us here at Akamai wish you continued health to you and yours. So have a nice evening.
Operator: Thank you. Ladies and gentlemen, this does conclude today’s conference. You may all disconnect. Have a great day. | [
{
"speaker": "Operator",
"text": "Ladies and gentlemen, thank you for standing by, and welcome to the Akamai Technologies Q2 2020 Earnings Conference Call. Please be advised today’s conference call is being recorded. I would now like to turn the conference over to your host Mr. Tom Barth, Head of Investor Relations. Sir, you may begin."
},
{
"speaker": "Tom Barth",
"text": "Thank you, operator. Good afternoon, everyone, and thank you for joining Akamai’s second quarter 2020 earnings conference call. Speaking today will be Tom Leighton, Akamai’s Chief Executive Officer; and Ed McGowan, Akamai’s Chief Financial Officer. Before we get started, please note that today’s comments include forward-looking statements including statements regarding revenue and earnings guidance. These forward-looking statements are subject to risks and uncertainties and involve a number of factors that could cause actual results differ materially from those expressed or implied by such statements. The factors include uncertainty stemming from COVID-19 pandemic and any impact on unexpected geopolitical developments. Additional information concerning these factors is contained in Akamai’s filings with the SEC, including our Annual Report on Form 10-K and quarterly reports on Form 10-Q. The forward-looking statements included in this call represent the company’s view on July 28, 2020. Akamai disclaims any obligation to update these statements to reflect future events or circumstances. As a reminder, we will be referring to some non-GAAP financial metrics during today’s call. A detailed reconciliation of GAAP and non-GAAP metrics can be found under the financial portion of the Investor Relations section of akamai.com. With that, let me turn the call over to Tom."
},
{
"speaker": "Tom Leighton",
"text": "Thanks, Tom, and thank you all for joining us today. I’m pleased to report that Akamai achieved excellent results in the second quarter. Revenue was $795 million, up 13% year-over-year and up 14% in constant currency. Non-GAAP operating margin was 32%, up 3 points over Q2 of last year. And non-GAAP EPS was $1.38 per diluted share, up 29% year-over-year and up 30% in constant currency. These very strong results were driven by a continuation of the high traffic levels we’ve seen since the onset of the pandemic, very strong demand for our Cloud Security Solutions and by our ongoing focus on operational efficiency. Akamai was founded with the vision of enabling the internet to scale, so that it could support millions of enterprises and billions of people everywhere. Our mission has been to make all digital experiences be fast, reliable, and secure, a mission that is especially important now amid a devastating pandemic. In our 22-year history as a company, there’s never been a time when Akamai’s importance and value to daily life has been more evident. Due to the incredible work of our highly talented employees, we believe that Akamai has become an indispensable part of the internet, supporting remote work, home entertainment, the learning online banking, home deliveries, logistics, security systems, and commercial transactions of all kinds, for billions of people around the world as they cope with a pandemic. The Akamai Intelligent Edge Platform has grown to include over 300,000 servers in over 4,000 locations and nearly 1,500 network partners at the edge of the internet. The edge is where the end users are and where the content and applications need to be. The edge is where connected devices and the internet of things are located where 5G networks will become pervasive and increasingly where security needs to be to stop the many distributed attacks whose size and sophistication continued to increase. 4,000 locations spanning 135 countries is a powerful offering for global customers and goes far beyond the deployments of other CDNs, even if you were to somehow put them all together. Our unique edge platform has provided enormous capacity to meet the unprecedented demand due to the impact of the pandemic, the launch of several OTT services and the release of numerous electronic games. Peak traffic on the Akamai platform exceeded 100 terabits per second every day in the second quarter. That’s a lot of traffic. Of course, many CDNs claim to have lots of capacity, but none get close to Akamai when it comes to the actual delivery of content. As a result of our unparalleled scale and industry-leading performance and reliability, Akamai gained traffic share in Q2, on both an overall basis and at several of the world’s largest media companies. Akamai now works with more than 220 of the world’s largest OTT and broadcasting companies, as well as with 24 of the world’s 25 most popular video game publishers. The enormous capacity of our unique edge platform has also enabled Akamai to defend the world’s most important enterprises against the world’s largest and most sophisticated attacks. The size and sophistication of attacks has risen dramatically since the pandemic began. As threat actors take advantage of the distraction and vulnerabilities created by employees working remotely. Data from our Enterprise Threat Protector service shows that employee visits to sites with malware rose nearly five-fold in Q2. And just last month we defended a major bank and a major internet service provider against two of the largest attacks ever seen. In Q2, we released our new and highly innovative Akamai Page Integrity Manager, which is designed to protect websites and end users from malware infected content that resides on third-party sites. Nearly half of the content on a typical website originates from third-parties and attackers are embedding malware in this content to steal user’s credit cards and other personal data. Page Integrity Manager provides visibility and intelligence to help organizations stay ahead of this rapidly growing attack. And it has received strong positive feedback from early adopters. The well over 2000 customers who use our web application firewall products are perfect candidates for this new solution. Theft of login credentials is another growing problem that customers increasingly seek our help in stopping. We blocked more than 53 billion credential abuse attempts last quarter, more than four times the number we saw in Q2 of last year. This increase is one reason why our Bot Manager service is now used by more than 600 of the world’s major enterprises. Overall, Q2 revenue from our Cloud Security Solutions grew by 28% year-over-year in constant currency and achieved $1 billion run rate on an annualized basis. This is an important milestone that’s been reached by only a handful of cybersecurity businesses. Our Cloud Security Solutions are now relied upon by thousands of enterprises, including 30 of the world’s top 35 banks, 17 of the world’s top 20 e-commerce sites, 8 of the world’s top 10 asset managers and the majority of the world’s largest airlines, hotels, insurance firms, and consumer goods companies. The strong demand we saw in Q2 for our security and media services, more than offset the reduced revenue growth we saw from sectors of the economy that have been hit hardest by the pandemic, namely travel, hospitality [Technical Difficulty] by the pandemic. That’s one of many reasons why Akamai customer loyalty has remained very high and that our churn rate in the quarter stayed below 1% of annualized revenue. As we’ve grown our business over the last several years, we’ve worked hard to improve our operating efficiency and profitability. As a result, we were especially pleased to see our operating margins exceed our target of 30% in Q2. And also to see our non-GAAP earnings per share reach a $1.38 more than double what we achieved three years ago. Our profitability and cash generation is important, because it gives us the financial fire power to continue to invest in innovation, network capacity, go-to-market capabilities and world-class talent to fuel our future growth. Before turning the call over to Ed, I want to thank our nearly 8,000 employees for their very hard work on behalf of our many customers and the billions of internet users around the world. Despite the pandemic, Akamai employees have continued their can do attitude and customer first mindset, enabling our platform to manage more traffic, more web transactions and more cyber attacks than ever before. Their creativity, teamwork, and tenacity are key to what makes Akamai such a unique and strong company. Now I’ll turn the call over to Ed for more on Q2 and our outlook for the second half. Ed?"
},
{
"speaker": "Ed McGowan",
"text": "Thank you, Tom. Today, I plan to review our exceptional Q2 results, discuss the impact COVID-19 is having on our business and provide guidance for Q3 and the full year. As Tom mentioned, we delivered a great quarter on both the top and bottom line. Q2 revenue was $795 million, up 13% year-over-year or 14% in constant currency, driven by extremely robust traffic growth in media, and another quarter of very strong results from our Cloud Security Solutions. Revenue from our Media and Carrier Division was $390 million, up 19% year-over-year and 20% in constant currency. The outstanding performance of our Media and Carrier Division was a result of very strong traffic growth in OTT video, gaming and software downloads. This was a continuation of elevated traffic we saw in late March as shelter-in-place orders were issued in most countries around the world. Revenue from our Internet Platform Customers was $51 million, up 10% over Q2 of last year. Revenue from our Web Division was $404 million, up 7% year-over-year and 8% in constant currency. Revenue growth from web customers was driven once again by security. Revenue from our Cloud Security Solutions totaled $259 million, up 27% year-over-year and 28% in constant currency. Cloud security revenue represented 33% of total revenue in the quarter, compared to 29% in the same quarter a year ago. It is worth noting that approximately $7 million of security revenue in Q2 came from one-time license sales to several carrier customers. And we do not expect to see licensed sales at this level in Q3. Moving on to revenue by geography. International revenue was $351 million, up 22% year-over-year or 25% in constant currency. We are very pleased with our strong international performance, especially in APJ and Latin America. Foreign exchange fluctuations had a negative $1 million impact to revenue on a sequential basis and had a negative $8 million impact on a year-over-year basis. Sales in our international markets represented 44% of total revenue in Q2, up 3 points from Q2 2019 and consistent with Q1 levels. Revenue from our U.S. market was $444 million, up 6% year-over-year. Moving now to costs. Cash gross margin was 77% consistent with Q1 levels. GAAP gross margin, which includes both depreciation and stock-based compensation was 65%, also consistent with Q1 levels. Non-GAAP cash operating expenses were $253 million in line with expectations. Adjusted EBITDA was $355 million, up $29 million from Q1 and up $63 million or 21% from Q2 2019. Our adjusted EBITDA margin was 45%, up 2 points from Q1 and up 3 points from Q2 2019. Non-GAAP operating income was $258 million, up $29 million from Q1 levels and up $54 million or 26% from the same period last year. Non-GAAP operating margin was 32%, up 2 points from Q1 levels and up 3 points from Q2 of last year. Capital expenditures in Q2, excluding equity compensation and capitalized interest, were $196 million in line with our guidance range as we began to catch up on supply chain and travel disruptions that impacted our network build out in Q1. Moving on to earnings. GAAP net income for the second quarter was $162 million or $0.98 of earnings per diluted share. Non-GAAP net income was $227 million or $1.38 of earnings per diluted share, up 29% year-over-year, up 30% in constant currency and $0.14 above the high end of our guidance range. As Q2 results really demonstrated the leverage of our platform and operating model. Taxes included in our non-GAAP earnings were $38 million based on a Q2 effective tax rate of approximately 14%. Now I’ll turn to some balance sheet items. We continue to believe that our balance sheet is very strong. As of June 30, our cash, cash equivalents and marketable securities totaled $2.4 billion. During the second quarter, we spent $27 million to repurchase shares, buying back approximately 300,000 shares. We have approximately $658 million remaining on our previously announced share repurchase authorization. We plan to continue to leverage our share buyback program to offset dilution resulting from equity compensation over time. In summary, we’re very pleased with our performance in the second quarter. And before I turn to our Q3 and full year guidance, I wanted to provide you an update on some of the things I discussed last quarter regarding COVID-19. On our last call, I shared with you details about web verticals that were most impacted by the pandemic during the first quarter, specifically, travel and hospitality and commerce and retail. As you would expect, our customers within the travel and hospitality vertical continue to be challenged in Q2. And although some retail customers experienced notable increases in e-commerce activity, the uptick was tempered in some cases by bankruptcy and continued disruption to those customers that have a heavier reliance on brick and mortar. Many global brands in both of these verticals rely heavily on Akamai. We plan to continue to work closely with them as they cope with near-term financial pressures and look beyond into a post COVID-19 world. As a result, Q2 was negatively impacted by approximately $14 million related to a combination of contract restructurings and elevated bad debt reserves. This impact was in line with our expectations. I’d now like to provide our outlook for Q3 and for full year 2020. For Q3, we are projecting revenue in the range of $760 million to $785 million for up 7% to 11% in constant currency over Q3 2019. The sequential decline in revenue embedded in our Q3 guidance reflects three items. First, we expect the recent actions taken in India to band 59. Chinese based web applications will negatively impact Q3 revenue by approximately $15 million sequentially. We deliver traffic for approximately 30 of those applications in the second quarter. Our guidance assumes the ban will remain in place for the balance of 2020. Second, we expect to see our typical seasonal summer traffic moderation, because people begin to spend more time outside in a way from their devices. And third, we expect internet platform customer revenue to decline by approximately $4 million to $5 million in Q3, primarily due to two of our largest platform customers renewing at new pricing levels in June. At current spot rates, foreign exchange is expected to have a positive $6 million impact on Q3 revenue compared to Q2 levels and no impact on a year-over-year basis. At these revenue levels, we expect cash gross margins of approximately 76%. Q3 non-GAAP operating expenses are projected to be $249 million to $260 million up slightly from Q2 levels. Factoring in the cash gross margin and operating expense expectations I just provided. We anticipate Q3 EBITDA margins of approximately 43%. Moving now to depreciation, we expect non-GAAP depreciation expense to be between $99 million to $101 million. We expect non-GAAP operating margin of approximately 30% for Q3. Moving on to CapEx, we expect to spend approximately $193 million to $203 million, excluding equity compensation in the third quarter. And with the overall revenue and spend configuration, I just outlined, we expect Q3 three non-GAAP EPS in the range of $1.20 to $1.24 or up 8% to 12% in constant currency. This EPS guidance assumes taxes of approximately $34 million to $35 million based on an estimated quarterly non-GAAP tax rate of approximately 15%. It also reflects a fully diluted share count of approximately 164 million shares. Moving onto annual guidance, with increased visibility to Q3 and the remainder of the year, I’m very pleased to reinstate guidance for the full year 2020. While, our ranges are a bit wider than usual, we want it to be as transparent as possible about how we see the remainder of the year shaping up. We currently expect revenue of $3.125 billion to $3.175 billion, which assumes our security business contributes more than $1 billion. Adjusted EBITDA margins of approximately 43%. Non-GAAP operating margins of 30% to 31%. Non-GAAP earnings per diluted share of $50.2 to $5.12. This represents year-over-year growth of 12% to 14%. This non-GAAP earnings guidance is based on a non-GAAP effective tax rate of approximately 15% and the fully diluted share count of approximately 164 million shares. Finally, full year CapEx is expected to be 22% to 23% of revenue. In summary, we continue to be very pleased with the performance of our business. We believe our excellent Q2 results demonstrated the profitability of our business model and scalability of our platform, our revenue diversification, deep enterprise customer relationships in our strong balance sheet and cash flow. Thank you. Tom. And I would be happy to take your questions. Operator?"
},
{
"speaker": "Operator",
"text": "[Operator Instructions] Our first question comes from James Breen of William Blair. Your line is open."
},
{
"speaker": "James Breen",
"text": "Great. Thanks for taking the questions. There’s a couple on the customer side, you talked about a couple of renewals this quarter. Can you just give us a little bit of color into how those contracts work going forward and/or is there any other anticipated renewals in the back half of the year. And then just commentary around the security side, obviously, it’s a large business and continue to see you continue to grow in the high 20% range. I think a lot of us have anticipated something in the lower 20% of the beginning of the year. So can you just talk about some of the products there, maybe some of the new products that are driving it and then just give a little more color on the overall picture? Thanks."
},
{
"speaker": "Ed McGowan",
"text": "Hey, Jim. This is Ed. I’ll take the first one and then Tom, you can take the second one. So in terms of the renewals, in terms of major renewals for the back half of the year, I don’t – we don’t expect anything large for the internet platform customers. There will be no more renewals this year and in terms of the contracts pretty standard. The good news, I guess, is a couple of them are no longer term in nature, but not all of the – we will have some renewals next year, but very pleased with how those contracts turned out. Tom?"
},
{
"speaker": "Tom Leighton",
"text": "Yes. The revenue and security was driven by our flagship services, Kona Site Defender, which provides web application firewall capabilities, stops the attackers from taking over a website or corrupting it or stealing data. There are [indiscernible] service capabilities. That stops the big attacks. You have Bot Manager doing extremely well. And that keeps adversaries from taking over accounts from stealing customer information. We also have a very strong security services business, and those folks have been very busy, as you can imagine, with major IT shops now trying to support, remote work and work from home on a sudden basis, where they really need security help. Closely related, but a smaller business is our Enterprise Security offerings. And we do have new capabilities there. We now have a Secure Web Gateway that’s available. And coming up later this year, multifactor authentication. We also have a new service I talked about called Page Integrity Manager. And this works the – one of the latest attack vectors that’s becoming pretty rampant out there where the adversary puts malware into a third-party side or third-party code that’s used by the primary site. And what happens there is the user comes to the main site and the main site links to third parties for their apps and other things that are useful, usually. And the browser follows those links. And before you know what the browser is getting malware from one of those third-party sites. And that malware is designed to cause the browser to give up the user’s personal information like their credit card. There are some very famous breaches there resulting in large fines and Page Integrity Manager stops that and notifies our customer that they got a problem in terms of where they’re linking for their third-party content. Also we have Akamai Identity Cloud, which provides capabilities around the user and their profile and history, making sure that user data stays safe and compliant with local regulations. So really a lot going on in our security business, and we’re seeing very strong growth there, obviously."
},
{
"speaker": "James Breen",
"text": "Great. Thank you."
},
{
"speaker": "Operator",
"text": "Thank you. Our next question comes from Brad Zelnick of Credit Suisse. Your line is open."
},
{
"speaker": "Brad Zelnick",
"text": "Great. Thank you so much and congrats on all the success. Tom, I wanted to ask you about the Edge Computing opportunity. There’s a lot of buzz out there around the Edge and what some are the use – I’d be curious to hear just from you, what are some of the use cases that convince you it’s very real? Over what time line does it materialize? And how is Akamai positioned to win in capturing this?"
},
{
"speaker": "Tom Leighton",
"text": "Yes. We’re the largest provider of edge computing services by far. We have been doing it for close to 20 years. And the idea that this is how somehow something new is just not true. It’s – most of our customers are using our edge computing capabilities for a variety of applications to A, B testing for how users like their site, to do things locally about what content actually gets delivered to the user, what ads get delivered to the user. Keeping track of how a user goes through a site. The security services use an extensive compute power at the Edge. We don’t break it out as a separate revenue item, but if you use the definitions, we see that a lot of folks in the analyst community are using, I would say already, it’s over a $2 billion business for us. We don’t report it that way. But most of our customers are using the computing in some form or another, and also when it comes to Edge, I think this is really important. We’ve been talking about the Edge and the importance of being at the Edge really again, 20 years, and recently it’s become popular as a buzzword. And that’s because the Edge is really important, but to be at the Edge, that means you got to be in thousands of places, close to the users, really close, and we’re in 4,000 points of presence now. A lot of the other CDNs, who talk about doing Edge or Edge Computing, maybe they’re in a couple of dozen cloud core data centers, which is really not the Edge. In fact, you could take probably about maybe even all of our CDN competitors put them together and they don’t get anywhere close to the Edge presence that Akamai has. And what’s the future of Edge Computing, I think it’s very large, you look at 5G coming and that’s going to utilize a lot of capabilities at the Edge. With 5G, you get a lot more devices connected. IoT becomes much more possible. You have much lower latencies in the last mile. And then that means it’s even more important to do the computer delivery from the last mile. If you’ve got a huge latency in the last mile, okay, the latency you’ve introduced going from the Edge of the core is not as bad, but you really now it becomes noticeable with 5G. Also you have a lot more bandwidth to 5G. So I think that’s an important driver, a future revenue for Akamai. Also with IoT, we already have an IoT Edge Connect platform that our customers are using. It’s unique among CDNs. It uses different protocols. Not ACTP, by and large, which is what powers a lot of the web today, but MQTT, it uses the pub sub model, which is a whole different communication paradigm. That’s a lot more efficient. And again, users not only compute at the Edge, but data stored at edge, key value pairs and databases at the Edge. And Akamai is in an unique position to provide that. But again, I just want to be really clear Edge Computing is not a new phenomenon. It’s got recent buzz with a couple of IPOs on the street, but we’ve been doing that at scale for a long, long time."
},
{
"speaker": "Brad Zelnick",
"text": "Thank you so much, Tom. That’s it for me and congrats again."
},
{
"speaker": "Tom Leighton",
"text": "Thank you."
},
{
"speaker": "Operator",
"text": "Thank you. Our next question comes from Sterling Auty of JP Morgan. Your line is open."
},
{
"speaker": "Sterling Auty",
"text": "Yes, thanks. Hi, guys. So, Ed, you kind of give us a couple of the parameters that will impact Q3, but as I think about the full year guidance, how have you layered in perhaps some of the positive impacts that we would see from a more full rollout of some of the new OTT solutions, as well as the presidential election?"
},
{
"speaker": "Ed McGowan",
"text": "Hey, Sterling, thanks for the question. So I’ll start with the presidential election. I’d say, this year – coming into the year, we’re expecting probably a bit more robust debate scheduled, where a lot of competitors going out to the democratic seat that sort of ended quickly. So I’d say it’s probably going to be a bit more muted this year. Just because there – I think there’s only three debates scheduled, it’s not as much activity as I would have expected at this time. So nothing outside of a little bit of revenue associated with that. So nothing really significant. On the OTT launches, obviously, we just had one go a couple of weeks ago. It’s still early days and I don’t want to go in May. So still pretty early there. I think we’ve got, you saw the media revenue, obviously, very, very strong expect to see another strong quarter. Despite the fact that I talked a bit about the dynamics in Q3 and for the rest of the year with those applications in India being banned. But we’re seeing good growth there and expect that to continue into the balance of the year."
},
{
"speaker": "Sterling Auty",
"text": "All right, great. And then one follow-up. How should we think about the contract restructurings, and maybe in particular, excuse me, into the e-commerce vertical in the back half of the year, maybe in light of a question that I’m getting a lot right now is, probably not a lot of foot traffic going to the malls. Could we be setup for just a massive e-commerce holiday season this year and traditionally that’s been a big benefit for Akamai."
},
{
"speaker": "Ed McGowan",
"text": "Yes. Good question. So you can imagine, there’s an awful lot of debate internally on that. What I would say with contract restructurings, I mentioned, that we had about a $14 million a headwind here in Q2. Most of that was in travel, retail we did see about 10 bankruptcies roughly this quarter. And you look at the economic data, it’s mixed, there are some, some numbers that are doing better than others. So as we go and look at the Q4, you’ve seen, we’ve given quite a wide range, and if you do some math on kind of the mid points, it’s kind of suggests a bit softer than we saw last year. Maybe we go to the high end, it could be a bit better, but it’s still tougher to call. I will say, when I talked about the web vertical or web division, excuse me, last quarter, I expected it to be flat to down a bit, probably a little bit better than I expected in Q2, mainly because we’ve seen a lot of our customers, both in retail and travel be able to access the capital markets and stabilize their businesses a bit. But I still think it’s going to be pretty rocky going into Q4 as we get into the fall season, who knows what happens with the pandemic. But the thesis is correct. There’s not a lot of people going to the stores, you could see a lot of online retail activity. We see a bit of a, kind of a mixed bag. We see some that are doing much better than expected, in terms of traffic growth and others that are kind of in line. And you’ve got some that are still struggling with just their legacy business and in financial difficulty. So we’ll see, but that’s why we provided a wide range. There’s a couple of different ways, different outcomes that could happen here in Q4."
},
{
"speaker": "Sterling Auty",
"text": "Got it. Thank you."
},
{
"speaker": "Operator",
"text": "Thank you. Our next question comes from Colby Synesael of Cowen. Your line is open."
},
{
"speaker": "Colby Synesael",
"text": "Great, thank you. Two questions if I may. I guess, for Ed, I just wanted to follow-up on Jim’s question, regarding security. And Tom, appreciate the various sub-segments that you broke out. Can you help us just a bucket from a revenue perspective, some of the bigger drivers maybe either in dollars or percentage as we start to focus more on that security business. I think it’d be helpful just to give it more color on where the revenue is actually coming from. And then secondly, you guys haven’t really done any tuck in M&A in some time. Is that just a function of a disconnect with valuations? Or is it something else and trying to get a sense, if we should expect to see that kind of start to come back into the full, maybe the next few quarters. Thank you."
},
{
"speaker": "Ed McGowan",
"text": "Yes, sure. So as far as security goes, I think it’s a bit more of the same. We saw good strength with Kona Site Defender, that’s obviously our largest product and drives the most revenue. We’re starting to see a nice uptick in Prolexic. That was a good surprise for the quarter. Bot Man continues to be probably our fastest growing product. Security services are going along pretty well. So it’s really sort of strength across the board. And I think as I look into the future, Tom talked a bit about Page Integrity. That’s the product that we’re really excited about. When you think about the KSD base as really good customer base to go and upsell that. We’re hoping that, that has very similar characteristics of Bot Man, which is a nice addition on to Kona Site Defender. And Bot Man got to 100 million pretty quickly. Hopefully we can see the same with Page Integrity."
},
{
"speaker": "Colby Synesael",
"text": "Does Kona, for example, 50% of revenue, is it 60% of revenue of the security business, any color there?"
},
{
"speaker": "Ed McGowan",
"text": "So we haven’t broken it out yet. I’d say it is the largest percentage. We’ve got four products over 100 million. I don’t know that it’s over 50%, but it’s probably close to that. That’s a reasonable for proxy."
},
{
"speaker": "Tom Leighton",
"text": "And on the M&A question, we’re continuing our efforts there, at the same pace is always. But we’re also very disciplined buyers. And when you’re in the midst of a pandemic, it is a little harder to conduct diligence. And if we were to close an acquisition, maybe a little harder to integrate it with the travel restrictions we have now. So probably that’s a damper. And I wouldn’t say, there’s huge bargains that have been created as a result of the pandemic, at least not yet. And we’re very careful about what we buy to make sure it makes good financial sense, but we’re continuing with our efforts there full speed ahead."
},
{
"speaker": "Colby Synesael",
"text": "Great. Thank you."
},
{
"speaker": "Operator",
"text": "Thank you. Our next question comes from Keith Weiss of Morgan Stanley. Your line is now open."
},
{
"speaker": "Josh Baer",
"text": "Hi, this is Josh Baer on for Keith. Just wondering, if there’s any way to quantify the benefit to OpEx in Q2 and maybe in Q3 from more limited travel, entertainment and expenses related to COVID. And then more broadly, as it relates to margins, how should investors think about margin expansion in the years to come beyond the 30% to 31% for this year?"
},
{
"speaker": "Ed McGowan",
"text": "Yes, sure. I’ll take the first part and say a few words on the second part. Maybe Tom, you can chime in on that as well. In terms of the travel, it’s not a huge expenditure for us, using a couple million dollars a month. So we did see obviously a lot less travel this quarter. And we’ll see a little bit in Q3. So not a huge amount of savings there, but that did help operating margins. I think what really benefited the operating margin line was, obviously, extremely strong traffic, running the network at, probably hotter than we’d like. That’s why you see us building out a lot more CapEx. The network performed fantastically well, but you do want to make sure that you’ve got a lot more capacity to be able to handle big spikes and take advantage of opportunities when other competitors may have some struggles and it’s good to have that extra capacity. But when you do run the network, how do you see the drop to the operating line. In terms of margins, we’ve said in the past that we plan on operating at 30%, we want to continue to make investments in the business. We added a couple of hundred heads this quarter, and in the areas of research and development product and go to market, we think there’s still a lot of room for growth here. So we want to make sure we balance that appropriately."
},
{
"speaker": "Josh Baer",
"text": "Got it. Thanks."
},
{
"speaker": "Operator",
"text": "Thank you. Our next question comes from James Fish of Piper Sandler. Your line is open."
},
{
"speaker": "James Fish",
"text": "Well, and appreciate the added color this quarter. I just have one, it’s on web proxy. It’s been in beta and been freely available to some customers out there, given your goodwill. Why not accelerate the modernization of the product and accelerate the investments and enterprise security to really step on the gas on a high profile area?"
},
{
"speaker": "Tom Leighton",
"text": "Well, yes, we are working very hard in terms of both product delivery and with a sales effort. And we were very pleased to see substantially increased bookings so far this year. And we very much would like to continue to accelerate the penetration in that business."
},
{
"speaker": "James Fish",
"text": "Thanks."
},
{
"speaker": "Operator",
"text": "Thank you. Our next question comes from Will Power of Baird. Your line is open."
},
{
"speaker": "Will Power",
"text": "Great. Thanks. Let me – a couple of questions very quickly – here. I wonder if you could just comment broadly on what you’re seeing in terms of enterprise sales cycles, broader pipeline, are you continuously benefits from COVID. Or are you starting to see any potential headwinds economic pressures. And then my second question, just coming back to the media, is there any way to kind of help break apart the sources of upside there, obviously, really strong results. Any particular outliers between video, gaming, et cetera?"
},
{
"speaker": "Tom Leighton",
"text": "Yes, this is Tom. I’ll take the first question. I would say, it’s a mixed bag with COVID. On the one hand, there is a much greater need for our security products, not just enterprise products with remote workforces, but pretty much all the security products because the attack volumes and vectors have increased so much with the threat actors trying to take advantage of the situation. So that’s a good tailwind. And I think you saw the benefit of that so far this year. On the other hand, sales are a little harder, because you can’t visit customers. Everything is remote now. That said, I think our teams have done a very good job adapting with virtual conferences and meetings. And so I think we’re dealing with that situation very well. On balance, I think we’re in a much stronger position with our security offers, in terms of the customer’s need for our products. And I think Ed will take the question on media upside."
},
{
"speaker": "Ed McGowan",
"text": "Yes. So the good news is, it was really strength across a number of areas. I’ll dig into a couple for you. I would say one area in particular that stands out in my mind is gaming. We saw a ton of gaming activity and so a lot of major publishers do some smart things, including running some promotions to promote their games and offer attractive incentives for folks to leverage their portfolio. During the time that you’ve got people locked up in a pandemic. So we saw not only just a more robust game release quarter, we just saw some really smart things by the game publishers and that drove a tremendous amount of traffic. So that was an area of particular strength. And then obviously no surprise video, OTT video from a lot of the existing providers, some of the newer providers added as well. And that was strength pretty much across the board. It was both here in the U.S. and internationally. Our internet platforms obviously provided some nice upside for the quarter. That’s been a theme we’ve talked about a lot, they’ve kind of been in that stabilization in the $45 million range. And every once in a while, we get some upside from those customers as well. And then also social media. We saw – we carry a number of social media platforms and it’s not much of a surprise that people are locked up in their homes and not traveling and going out to dinner and things like that spending more time online, including social media. So the good news is pretty much across the game, but if I had to point out one thing in particular that jumped out will be gaming."
},
{
"speaker": "Will Power",
"text": "Okay. That’s great. Thank you."
},
{
"speaker": "Operator",
"text": "Thank you. Our next question comes from Heather Bellini of Goldman Sachs. Your line is open."
},
{
"speaker": "Caroline Liu",
"text": "Hi. This is Caroline on for Heather. And thank you for taking my question. My first one is really just on the security business. I was wondering if you could give more color on what is the split between new business from the existing customers versus like a completely new Akamai customers. And then if you are a new to Akamai, is there an opportunity to set upsell a CDN and other products to that security customer. And then I just have a quick follow-up."
},
{
"speaker": "Ed McGowan",
"text": "Sure. No problem. So obviously, our business being a recurring revenue business, you don’t get a ton of revenue right off of that, when you sign up a new customer. So the majority of the business does come from our existing customer base right now about 59% of our customers buy a security product, which is up couple of points from last quarter. And then about 31% of our customer base is buying more than one security product. So that’s going to be a theme in terms of future growth that, whether it’s your ad, you buy Kona Site Defender, you’re adding Page Integrity or Bot Management or Security Services. So I’d say for the certainly for the near-term seeing most of our growth coming from our existing customers is where we’re going to see the majority of the growth is that customers take on more security products. And then as far as when you sign up as a new customer, we do tend to sell a lot of protect and perform bundle, so it’s not unusual to see somebody come in as both a security customer and as a CDN customer, but throughout our history, if you look at our strategy has always been to focus on the largest web properties, largest banks, largest travel, retail customers, et cetera. And to grow those accounts over time. We talk about how we’ve worked with some of our customers that have been challenged with COVID and restructuring contracts and offering some financial assistance that will pay off in the long run. And that’s always been our strategy. So our focus on acquiring new customers that have a lot of growth opportunity, this has paid off over the last 20 years. And that’s where we’re going to continue to focus."
},
{
"speaker": "Caroline Liu",
"text": "Got it. And then – sorry, go ahead."
},
{
"speaker": "Ed McGowan",
"text": "I said you had a second question."
},
{
"speaker": "Caroline Liu",
"text": "Yes. So the other one is just on OTT, you talked about how you’re continuing to drive share gains. And last quarter, I remember you also said that as well. So I’m kind of curious, like what exactly is, kind of enabling you guys to gain more share in traffic. Is there something on the competitors? Or is it more so your guys is doing the product innovation side."
},
{
"speaker": "Ed McGowan",
"text": "Yeah. I’d say there’s probably three key areas. The first one is around performance. So what a lot of the OTT providers or really any large scale media customer will do is they’ll have their own set of performance metrics. And pretty much now most large providers of media content will split with CDNs. And usually it’s the one with the best quality wins. Pricing is pretty efficient in the market. So it’s not as much about price anymore. Occasionally, you’ll see that, but it’s really about performance. That’s the one thing. I’d say the other thing is around the capacity that you have outside of the U.S. in particular, we tend to do much better in places that are harder to deliver. And then I say the last thing is just having, scale is another area that depending on the type of application, you can see, real big peak demands, whether that’s in gaming or live sporting events and such like that. So having capacity in the right places, the best performance and having the scale is really what drives the share gains."
},
{
"speaker": "Caroline Liu",
"text": "Got it. Thank you so much."
},
{
"speaker": "Operator",
"text": "Thank you. Our next question comes from Amit Daryanani of Evercore. Your line is open."
},
{
"speaker": "Amit Daryanani",
"text": "Thanks for taking my question, guys. I have a two as well. First off, I guess when I think about the revenue performance this quarter on the CDN side, especially. I’m curious, did you see a normal drop-off in usage patterns in the month of June, the summer season kicked off. I’m asking that broadly, because given the fact that shelter in place remains broadly across the globe. Do you think that Q3 could not see a seasonal drop, because we’re all limited and not able to travel at this point?"
},
{
"speaker": "Tom Leighton",
"text": "Yes. So you do start to see a little bit of traffic, not accelerating as much, I would say, probably the best way to put it. Coming into the pandemic, something like that really accelerates a trend. So you saw a lot more internet users now adopting e-commerce, adopting – watching video online, cord cutting, et cetera. So we saw a nice bump from COVID in the pandemic, and we’ve seen that sustained. I’d say traffic was elevated probably longer than we had expected. We’ve never been through one of these, so it’s hard to always call it. But in terms of normal seasonality, I would expect to see, as the summer months come on, we do expect to see traffic certainly not grow as quickly as we saw the last quarter, but it’ll still be strong. But I would expect some seasonality that’s reflected in our guide."
},
{
"speaker": "Amit Daryanani",
"text": "Got it. And then if I can just follow-up, how do we think about the security business performing in the back half of the year relative to the top line expectations you’ve given, especially some of the commentary you just had on the new customer part of the equation over here?"
},
{
"speaker": "Tom Leighton",
"text": "Yes, sure. So one thing I did call out on the call was that we had some license revenue. We do sell every quarter a couple million dollars of license, some of our Nominum products to our carrier business – our target customers, excuse me. And this quarter, in particular, was a bit unusual, just that we had that sort of performance. I talked about $7 million in the quarter. Typically, you see that purchase behavior in the back half of the year in Q4. It’s a little bit unusual to see that in Q2 or Q3. So I just wanted to call that out. It’s something we want to take into consideration. And also, as you look at sort of year-over-year growth rates, Q4 of last year, we had a massive sequential growth quarter-over-quarter. I think we were up about $22 million sequentially. So just kind of keep that in mind as you’re doing your modeling, think about kind of your year-over-year growth. We talked about being over $1 billion. At the beginning of the year when we gave guidance, we talked about doing $1 billion of revenue in security. So this implies sort of low 20% growth rate, which is better than we had expected coming into the year. And then again, as far as new customers are concerned, you’ve got a base this big. The revenue growth is going to come from that existing customer base. We continue to add new customers every quarter, but it won’t make a material impact on the year. That happens over time. So it’s – we continue to add customers over time, it will be more of an impact on the overall growth, but it’s going to be the existing customers that really drive the growth."
},
{
"speaker": "Amit Daryanani",
"text": "Got it. Thank you very much."
},
{
"speaker": "Operator",
"text": "Thank you. Our next question comes from Mark Mahaney of RBC. Your line is open."
},
{
"speaker": "Mark Mahaney",
"text": "Okay, thanks. Two questions, then. Sports has been, I guess, a non-event. What are you assuming? What is a reasonable assumption for what kind of traffic you could get from sports? And I guess you’ve had such strong traffic the last couple of months because we’ve all been at home but without sports. And so as sports, hopefully, it comes back and MLB, NHL, et cetera, how material could that be like what if we just learned over the last couple of months, you can have really strong traffic growth without any sports at all? And then the other thing I wanted to ask is you talked about these apps banned in India. One of those apps could be banned in the U.S. Would that be a similarly material event for you if that app were to be banned in the U.S.? Thank you."
},
{
"speaker": "Ed McGowan",
"text": "Hey Mark, yes, thanks for the question. I’ll take the second one first, and I’ll talk about sports right after. So the way to think about U.S., if the U.S. were to do something very similar to what happened in India, the number of Internet users in India is much greater than the U.S., it’s about 3 times the overall population. So you’ll have fewer users, assuming kind of like-for-like. And then also, we tend to have a bit more competition in the U.S. We tend to get outsized share in India. So I would not expect it to be as material. It would be an impact we do for those 30 apps that I talked about. We deliver traffic here in the U.S., but it would not be as material. In terms of sports, so yes, you’re right. We really haven’t had much sports. We had a little bit of the premier league in the Bundesliga over in Europe. One thing I was looking for was to see – where we see a much different traffic profile now that you don’t have spans in the stands? And while we have a limited subset, we get a couple of weeks now of major – a week of Major League Baseball and a couple of soccer leagues. We haven’t seen anything that suggests that the traffic patterns are materially different. I’d say it’s probably more normal and in line with what I would normally expect. So still early, we’ve got the NHL, NBA kicking off here at the end of the week. And then hopefully, the NFL coming on and Champions League and IPL and a bunch of other things. Now, I talked in the last call that for us, sports in general, is about a little over 1% of our revenue. Now if you get that all in a concentrated period of time, that could add some decent revenue. Still, like I said, early days to see how the behavior changes. I’ve watched a number of baseball games and seeing it without fans is not as exciting personally. But hopefully, it continues to drive a lot of folks to watch online. But I think about it in that sort of perspective, about over the course of a year, a little over 1% of revenue comes from live sports. Certainly, the bigger ones being NFL, Champions League, IPL, some of the other sports, not quite as big."
},
{
"speaker": "Mark Mahaney",
"text": "Okay. Thanks a lot, Ed."
},
{
"speaker": "Operator",
"text": "Thank you. Our next question comes from Tim Horan of Oppenheimer. Your line is open."
},
{
"speaker": "Tim Horan",
"text": "Thanks, guys. Tom, back to the Edge. In the past, I think you were a little skeptical about being able to do kind of gaming as a cloud service just because of the cost of the compute and the latency. Maybe just any more updates on what you’re seeing from that perspective. And maybe any other applications that you think are perfect for your infrastructure that’s already in place that are new or more Edge based."
},
{
"speaker": "Tom Leighton",
"text": "Yes. I don’t think there’s any change in the gaming landscape, if anything. I think the thesis that it is less efficient to do all the compute in the cloud probably getting proved out. Companies have been working on that for over a decade. Now we do a lot of business with the gaming companies. So we’re a go-to player for them to distribute software. And there are things that we can do to optimize the performance as well. But I think doing all the compute in the cloud, it’s not as efficient, just economically. With Edge Computing applications, pretty much all of our customers’ applications that run on Akamai are doing some kinds of compute, personalization, the selection of the content that goes to the end user, the format it goes in, the images, which image goes, depends on the device, the connectivity in the last mile, all optimized for performance. So it’s pervasive today, I would say, Edge Computing on our platform, which is a reason why we don’t separate it out. I don’t think you can. And also on the Security side, we are inspecting the details of every single request that comes in and also the content that goes back out. We’re placing software on the client for all sorts of purposes, most recently for Page Integrity Manager. As you go to a website that’s protected by Page Integrity Manager, we have our script on the client itself that is looking at everything the browser is being asked to do, to see – for example, is it being asked to access your credit card or stuff that we believe is personal information and send it to a place that we think is bad. And I can’t tell you how much we’ve already discovered is going on out there. So I would say Edge Computing is just pervasive today. And the Edge being our edge servers in 4,000 locations, which is the real edge. And also on the client, we’re doing a lot of computing there as well. And I do think that is the future. And as you have richer applications, there’s more use of that. I think the big opportunity going forward is in the IoT arena. I think 5G helps to enable that. And as I mentioned before, that’s a whole different paradigm, uses different protocols and different structures like the pub-sub model and data stores. And again, being at the Edge helps a lot to reduce the latencies there. Edge Computing is not a new phenomenon. And I think that’s really important to understand."
},
{
"speaker": "Tim Horan",
"text": "And just a quick follow-up on security. Ed, I’m assuming the vast, vast majority of Security revenue is kind of recurring or not usage based, but just any clarification there. And can you give us some color, how does it compare to your gross margins of Security versus your consolidated gross margins? Thank you."
},
{
"speaker": "Ed McGowan",
"text": "Yes, sure. So I’d say the majority is recurring. There is – as I talked about, we do some bundling. So you have a bundle of Protect and Perform. So that can drive a little bit of variability in usage. Sometimes you see that kind of play out in Q4 to Q1, but the majority is recurring in nature. And then your second question was on gross margins. Yes. So the gross margin on security would be greater than what you would typically see on CDN. And it’s an interesting debate, right, because you’re using the same servers that are delivering a video to one home might be blocking an attack from another home. And it just kind of shows the power of the model and the leverage that we have that as we build out this Edge, we can build on new capabilities on top. And those incremental capabilities have much higher incremental gross margin and Security certainly falls into that category."
},
{
"speaker": "Tim Horan",
"text": "Thank you."
},
{
"speaker": "Operator",
"text": "Thank you. Our next question comes from Rishi Jaluria of D.A. Davidson. Your line is open."
},
{
"speaker": "Hannah Rudoff",
"text": "Hi guys, this is Hannah Rudoff on for Rishi. Thanks for taking my question. Just one for me here. Could you talk about how your customer conversations, especially around Enterprise Security Solutions have shifted from when you last talked about three months ago, especially organizations have maybe moved out of triage mode at this point and are thinking more about medium and long-term planning?"
},
{
"speaker": "Tom Leighton",
"text": "Yes. I think at a high level, the conversations are very similar. But with much more urgency in some cases, I can just give you an anecdote with a conversation with a CEO of a very large company. And the CEO was both happy and worried about how quickly his IT team had enabled the workforce to be remote. And he was happy because within a week, the entire workforce was remote because basically a shelter in place rules are put in place. On the other hand, he was worried because he always wanted a remote workforce, but was always told by his Chief Security Officer it would take two years to make it be secure. And all of a sudden, their workforce is remote in a week. And that led to a really good conversation about, okay, how can we really secure it for them. And that’s where our Enterprise Application Access product and our Zero Trust suite of solutions really makes a big difference. It’s a service on our platform. It does it security at the application layer, not at the network layer. So never mind the pandemic and remote work, it’s just a lot more secure to start with. But now you’re in a position where very quickly we can enable them to have security for a remote workforce that employees can only access apps that they’re allowed to. And even then, the employee device can’t directly touch the app or the data, it just touches us. And we’re scouring every communication to make sure that malware isn’t being spread and data is not being exfiltrated. And of course, that’s not possible with the traditional approach. So I think the COVID situation with remote work has certainly enhanced the interest in EAA. The attack rising in general have enhanced interest in Akamai Security Solutions. And of course, you’re right that there’s a lot of scrambling going on out there. And so it is a little more complicated in terms of the sales process. But on balance, I would say we’re doing better than we expected. And on balance, there’s more tailwinds associated with the pandemic for our business because customers need our help even more than before."
},
{
"speaker": "Hannah Rudoff",
"text": "Great, super helpful. Thank you."
},
{
"speaker": "Operator",
"text": "Thank you. Our next question comes from Lee Krowl of B. Riley FBR. Your line is open."
},
{
"speaker": "Lee Krowl",
"text": "Great. Thanks for taking my questions, and congrats on a very solid quarter. Two questions. First, on the impact of the Indian app ban. You quantified the impact, a little bit more detail. I’m curious if that makes an assumption for a backfill from apps that are still available to consumers as an offset? Or is that just a complete loss of business? And then secondly, can you just maybe talk about CapEx leverage? I assume as we start to lap some of these OTT launches from a year-over-year perspective, is there an ability to see leverage now that you’ve built in some of the capacity? Or is there a working assumption that as we continue to see proliferation of these products, that CapEx will need to kind of match the growth in traffic?"
},
{
"speaker": "Ed McGowan",
"text": "Yes, sure. So in terms of the India ban, we assume that there’s a complete loss there. Obviously, there’s – users move to other applications to the extent that there’s other options in the market. We’re obviously having conversations with all those customers. In some cases, we were – some of them are customers now, some of them we’re trying to acquire. So yes, we’re just assuming that there’s really no material impact right now just because it’s an unknown. We haven’t seen any major shift or anything like that. That’s just sort of traffic has disappeared for lack of a better term. This is something we’ve never dealt with before. So we’re kind of in unchartered territory. So what we did is just wanted to call it out for you guys. And so you could think about it in your models because, obviously, while the Q2 guidance is very, very strong and above where the consensus was, it is a step down, and that is a material reason why. Obviously, if that traffic comes back, that would be great. I wouldn’t expect it to all come back at once. I think it’d be some kind of a ramp. But to the extent that other players in the market pick up some of this behavior or some of the various things that folks are doing with those apps, we’re going to be right there trying to acquire those customers. And with our scale and capacity and performance, we should be in great shape to get it. But there’s no assumption that there’s a shift from one to another. As far as CapEx goes, this quarter should be the high watermark for the year. Obviously, we weren’t expecting a pandemic starting off the year. Or Tom had mentioned doing 100 terabits every day of the quarter. Obviously, it came with a lot more revenue. So what we’re doing now is just kind of retooling and building up more capacity just in anticipation that there could be a second wave of COVID here and maybe another big splice. We want to be prepared for that. In our capacity planning, we’re going to assume that, that traffic comes back in India. We’re not making the assumption here on the revenue side. If we’re wrong, we’ll grow into it. But as I think about sort of a normal CapEx range, the network CapEx is really wide focused on. I know you kind of look at that headline number and I sort of look at the software cap being in sort of that 7% to 8% range. We have got a full gross expense in the P&L for R&D. So R&D running at 13%, 14% of revenue is about the right way to look at it. I think that’s a healthy spend. And then if you look at network CapEx in the 7% to 10% range, it’s kind of a normal range with this year, obviously, being closer to 14% because of the pandemic. I think this is probably the right way to think about it, to the extent that we see the opportunity for significant growth or accelerated core cutting or whatever. We’re going to go after it pretty aggressively."
},
{
"speaker": "Lee Krowl",
"text": "Got it. Thank you for the details."
},
{
"speaker": "Operator",
"text": "Thank you. Our next question comes from Jeff Van Rhee of Craig-Hallum. Your line is open."
},
{
"speaker": "Jeff Van Rhee",
"text": "[Indiscernible] surge in Zero Trust bookings, forgive me if I missed it, but just any comparable comment this quarter in terms of bookings on Zero Trust. And then the other related to Security as well. I think you had said a year ago that the demand for security services was about 1,000 users and a bit over $100 million in revenue. Is there any update there?"
},
{
"speaker": "Tom Leighton",
"text": "I missed the first part of the question, but I think it had to do with our enterprise Zero Trust Solutions, and we had a very strong quarter there. We don’t break out the individual numbers for that solution set yet, but we saw very strong growth and we were very pleased with that. With the Managed Security Services, as you can imagine, this is a time when our customers need us more than ever with that. You have the range of attacks increasing, their sophistication, and now our customers really busy trying to figure out how to securely support a remote workforce. So very pleased with the results there and the continued very strong growth of our Security Solutions."
},
{
"speaker": "Jeff Van Rhee",
"text": "Got it, thank you."
},
{
"speaker": "Operator",
"text": "Thank you. Our next question comes from Brandon Nispel of KeyBanc Capital. Your line is open."
},
{
"speaker": "Brandon Nispel",
"text": "Great. Thank you for taking the questions. I wanted to get you guys’ thoughts on the CDN business. That business hasn’t grown as fast in over five years and really exceeding where it has the last couple of years. I guess, is it your view that growth can get – be sustained at these levels? It doesn’t seem like it from your guidance, but how should we think about the target growth rate for the CDN business over the next, call it, 18 to 36 months? Secondly, you made it a point, Ed, to call the balance sheet quick asset for the company. I was hoping you could outline some of your capital allocation priorities and share your thoughts on potentially any return to capital to shareholders beyond the share repurchase program, which you guys didn’t repurchase that many shares this quarter. But hoping you could share some more details. Thanks."
},
{
"speaker": "Ed McGowan",
"text": "Sure. I’ll take a step. So just in terms of the CDN business, on several calls ago, we were asked the question of what would it take to get the CDN business to get back to a healthy growth rate like what we have today. I think, well, no one would have predicted the pandemic would be the reason that, that would happen. I think to sort of kind of step back behind that, you think what behavior did it drive, it was significant adoption of Internet, video, gaming, e-commerce, online banking, just people using the Internet a lot more. And I would say that to the extent that anything drives that acceleration of any of those trends, we stand to gain. And I think the CDN business is going to always be a little bit lumpy in terms of its growth rate. I don’t think we could sort of go up into the right, just given the dynamics in the business. We obviously have several verticals now that are challenged, travel and hospitality and retail, which has been kind of a challenged vertical for a while. When you get into the high-volume CDN business, you always have to deal with volume and pricing. I’ve been with the company for 20 years, and that sort of rule has been in place since I started. That as companies grow volumes, unit prices go down. Our economics work the same way with our vendors and the way we build our network and design our technology to drive costs out. So you always have a little bit of lumpiness. But really, what you’d have to look at is what are some of the macro trends? How successful are these OTT offerings? What’s the next big trend in something like gaming? Do you get stabilization in your retail and travel vertical? So it’s possible. I think this was a good test case in showing that it is possible to get back to a healthy growth rate in CDN. But there’s a lot of things to consider with different dynamics, some that are out of our control. The other question was on capital allocation. Yes. So we don’t – we talk about offsetting dilution. We’ve done that in the past. And over time, if you look at our share count, opportunistically, we’ve used our share buyback program to reduce the number of shares. Back in 2018, we did a large $750 million buyback. We don’t have any intentions of doing that at this time. But it’s something that we always talk to our Board about and always something that we look at. But right now, as I said in the prepared remarks, we’re looking at just offsetting dilution over time. And we’d love to be able to find some good strategic acquisitions. We’re always looking. We’re very disciplined buyers, active shoppers. Valuations in some of the spaces that we’re in, in security, in particular, started to correct a bit as we went into the beginning of the pandemic, but they certainly come out of that probably even a bit more stretched than when we went in. So we’re going to be patient, look for the right opportunity, but M&A will certainly be an area that we look to utilize our capital that for."
},
{
"speaker": "Brandon Nispel",
"text": "Thank you."
},
{
"speaker": "Tom Barth",
"text": "Operator, we have time for one more call."
},
{
"speaker": "Operator",
"text": "Thank you. Our next question comes from Alex Henderson of Needham & Company. Your line is open."
},
{
"speaker": "Roger Boyd",
"text": "Hey, thanks for taking my question. This is Roger Boyd on for Alex. Just a quick question on e-commerce. Acknowledging that the broader retail market remains pressured, there’s been a lot of opportunities in that space. I’m just wondering, to the extent Akamai has been able to win new e-commerce logos in the current environment. And then secondly, given your investments in Botnet and Page Integrity, is it fair to say that is vertical value security a little more than the average customer, and that might be a differentiator for Akamai?"
},
{
"speaker": "Tom Leighton",
"text": "Yes. So the first one, I didn’t quite catch all the second one, so I’ll ask you to repeat that after I hit the e-commerce question. I think the question was, does this enable us to – does this environment enable us to acquire new customers? Yes, sure. I mean I think it’s an area where we, today, work with many of the large e-commerce customers today. But certainly, the way I look at it is, as companies are shifting from more brick-and-mortar to online, one of the conversations we’re having with our customers is about that shift and what else, what other products do they need? And how are they planning on making more of a push towards online. So, I think that’s a good trend for us. And I’d say pretty much every retailer is – get some presence online. But certainly, there are some opportunities there. But for the flip side, there’s also a lot of challenges in that market as well as we’ve talked about. And I’m sorry, can you just repeat your second question?"
},
{
"speaker": "Ed McGowan",
"text": "I can answer that. Go ahead. Yes, the second question – with security, that is a huge differentiator for us. We’re the market leader by far with Cloud Security Solutions. And as I mentioned, the vast majority of the world’s biggest e-commerce sites make use of our security solutions. Today, I would say, in that vertical, sales are led by security, and then delivering acceleration would be an add-on. In fact, we include the basic DSA, Dynamic Site Accelerator services, part of Kona Site Defender. Thought manager is critical today for any commerce site, and we’re really uniquely differentiated with our capabilities there. So security is very important across not only e-commerce but many verticals today."
},
{
"speaker": "Roger Boyd",
"text": "That’s perfect, thank you."
},
{
"speaker": "Tom Barth",
"text": "Well, again, thank you, Tom and Ed. That wraps up, I think, our questions. So I want to thank everyone for joining us. In closing, we will be presenting at a number of virtual investor conferences and events throughout the rest of the third quarter, and details of those can be found on the Investor Relations section of akamai.com. Thank you again for joining us. And all of us here at Akamai wish you continued health to you and yours. So have a nice evening."
},
{
"speaker": "Operator",
"text": "Thank you. Ladies and gentlemen, this does conclude today’s conference. You may all disconnect. Have a great day."
}
] | Akamai Technologies, Inc. | 24,522 |
AKAM | 1 | 2,020 | 2020-04-28 16:30:00 | Operator: Ladies and gentlemen, thank you for standing by. Welcome to the First Quarter 2020 Akamai Technologies, Inc. Earnings Conference Call. At this time, all participants are in a listen-only mode. After the speakers’ presentation, there will be a question-and-answer session. [Operator Instructions] Please be advised that today's conference is being recorded. [Operator Instructions] It is now my pleasure to introduce Head of Investor Relations, Tom Barth.
Tom Barth: Thank you, operator. Good afternoon, everyone. And thank you for joining Akamai’s First Quarter 2020 Earnings Conference Call. Speaking today will be Tom Leighton, Akamai's Chief Executive Officer; and Ed McGowan, Akamai's Chief Financial Officer. Before we get started, please note that today's comments include forward-looking statements including statements regarding revenue and earnings guidance. These forward-looking statements are subject to risks and uncertainties and involve a number of factors that could cause actual results to differ material from those expressed or implied by such statements. Additional information concerning these factors is contained in Akamai’s filings with the SEC, including our annual report on Form 10-K and quarterly reports on Form 10-Q. The forward-looking statements included in this call represent the Company's view on April 28, 2020. Akamai disclaims any obligation to update these statements to reflect future events or circumstances. As a reminder, we will be referring to some non-GAAP financial metrics during today's call. A detailed reconciliation of GAAP and non-GAAP metrics can be found under the financial portion of the Investor Relations section at akamai.com. And with that, let me turn the call over to Tom.
Tom Leighton: Thanks, Tom. And thank you all for joining us today. Before I get into the numbers, I want to acknowledge how much the world has been disrupted by the COVID-19 pandemic. All of our lives have been impacted in ways that would have been hard to imagine only a short while ago. At Akamai, our primary concern is for the health and safety of our employees, their loved ones, our customers and partners, and the communities where we work and live. Fortunately, we're in a position where almost all of our employees can work remotely, and we've been doing that successfully for the last two months. We've also implemented special measures to protect employees who need to travel, for example, to a data or operation center. And we're doing what we can to help employees to face especially challenging situations as a result of the pandemic. As businesses and consumers around the globe adjust their routines in the interest of public health, the internet is being used at a scale that the world has never experienced. In addition to the hundreds of millions of people who've been working from home, governments are leveraging the internet to keep citizens informed and to provide economic assistance. Houses of worship are streaming services and communities are engaging online to relieve the social isolation felt by many. And of course, education, commerce and entertainment are now almost entirely online. As much of the world hunkers down in place, Akamai is continuing to work behind the scenes to keep the internet functioning as a lifeline for organizations and people everywhere. I'll talk more in a minute about Akamai’s unique role during the pandemic and the impact of the pandemic on our business. But first, I'll review our Q1 financial performance. I'm pleased to report that Akamai had a very strong first quarter on both the top and bottom lines. Revenue was $764 million, up 8% year-over-year and up 9% in constant currency. Non-GAAP operating margin in Q1 was 30%, up 1 point over Q4 and consistent with Q1 of last year. Non-GAAP EPS in Q1 was $1.20 per diluted share, up 9% year-over-year and up 11% in constant currency. These excellent results were driven by the continued strong performance of our security solutions, greater than expected traffic levels, and by our continued focus on operational efficiency. As more business is conducted over the internet, the ability to scale becomes critical. And when it comes to scale, Akamai is the clear leader. Traffic on our platform increased dramatically in March as enterprises turned to Akamai to move more of their operations online. Despite the cancellation or postponement of major sporting events, like March Madness, and Champions League Soccer, our traffic increased by about 30% over a four-week period at the end of Q1. Traffic reached a peak of 167 terabits per second, which was more than double the peak of the first quarter of 2019. We're very pleased that the capacity we added to the platform last year has enabled us to help our customers, when they need us most. We're also making a big difference when it comes to helping the major carriers handle the explosion in demand. That's because we've deployed our infrastructure deep into carrier networks and close to end users, thereby offloading an enormous amount of traffic that would otherwise congest core backbones and routers. Of course, performance is also critical as businesses move the majority of their operations online. Although some other companies have experienced cases of performance degradation and even extended outages in recent months, I'm very happy to report that Akamai's performance has remained consistent and strong over the past quarter. In fact, our measurements indicate that the page download times provided by our industry leading Ion service has significantly improved over the past year. This is in spite of the large increase in traffic, and is a direct result of our relentless efforts to improve the performance of our services. Akamai is also helping to protect many of the world's major enterprises as more employees work from home and as IT departments increase their focus on business continuity. We believe that Akamai’s market leading security services are needed now more than ever, as attackers take advantage of the pandemic to ramp up their exploits on enterprises across all verticals. In Q1, our cloud-based security portfolio generated $240 million in revenue, up 28% year-over-year in constant currency. Sales continue to be led by our flagship services for DDoS prevention, application-layer firewall and bot management. We also saw a strong surge in bookings for our next-gen Zero Trust enterprise security solutions. The strong demand we saw in Q1 for our security and media services more than offset the reduced revenue we received from companies that have been hit hardest by the pandemic, especially in the travel and hospitality vertical. Where appropriate, we are modifying the terms of these customers’ contracts to provide them some relief and flexibility, often in return for extended contract line. We value our customers and want them to think of Akamai as a supportive and reliable partner for the long run. We are fortunate that our financial strength enables us to provide assistance to customers in need, which we believe will benefit our shareholders and the global economy over the long term. We've also played an important role in helping to support websites and applications associated with response to the pandemic. And the Akamai Foundation is providing sustainable financial assistance for numerous relief efforts around the world. Most of all today, I want to recognize and thank our nearly 7,800 employees for working so hard to serve the thousands of organizations and billions of internet users who rely on us during these very-challenging times. I couldn't be proud of the way that our people have stepped up and of what they're managing to accomplish, despite their own personal challenges and dealing with a pandemic. Their spirit and leadership during a time of crisis is a key part of what makes Akamai such a unique and strong company. Lastly, I want to offer a warm welcome to our Board's newest member, Marianne Brown. Marianne joined Akamai's Board last month and brings with her extensive financial and operational expertise, as well as valuable leadership experience with global technology-driven companies. I'll now turn the call over to Ed for more details on our Q1 performance and our outlook for Q2. Ed?
Ed McGowan: Thank you, Tom. Before I begin, I would also like to thank our fellow employees for their amazing work and dedication. And I would like to acknowledge our customers and partners, especially those who have been hardest hit by the global pandemic. Today, I plan to review our Q1 results, discuss the impact the pandemic is having on our business and provide Q2 guidance and an update on the full year. As Tom mentioned, we delivered a very strong quarter on both the top and bottom line. Q1 revenue was $764 million, up 8% year-over-year or 9% in constant currency, driven by a significant increase of global traffic, as well as continued strong growth across our security portfolio. Revenue from our Media and Carrier division was $358 million, up 8% year-over-year and 9% in constant currency. The outperformance in media was primarily due to the surge in traffic from OTT video, gaming, social media and news and information sites as more and more people around the world began to shelter in place. Revenue from our internet platform customers was $45 million, in line with our expectations. Revenue from our Web division was $406 million, up 8% year-over-year and 10% in constant currency. Revenue growth for this group of customers was again driven by our security business. Moving on to revenue by geography. International revenue was $335 million, up 16% year-over-year or 19% in constant currency. We continue to see very strong international growth, especially in APJ. Foreign exchange fluctuations had a negative $3 million impact to revenue on a sequential basis and had a negative $7 million impact on a year-over-year basis. Sales in our international markets represented 44% of total revenue in Q1, up 3 points from Q1 2019 and up 2 points from Q4 level. Revenue from our U.S. markets was $429 million, up 3% year-over-year. Moving on to costs. Cash gross margin was 77%, consistent with our expectations. GAAP gross margins, which includes both depreciation and stock-based compensation, was 65%, down a point from Q1 of last year. Non-GAAP cash operating expenses were $260 million, in line with expectations. Adjusted EBITDA was $327 million, up $8 million from Q4 and up 9% in the same period in 2019. Our adjusted EBITDA margin was 43%, up 2 points from Q4 and up 1 point from Q1 of 2019. Non-GAAP operating income was $230 million, up $8 million from Q4 levels and up $20 million or 9% from the same period last year. Non-GAAP operating margin was 30%, up 1 point from Q4 levels and consistent with Q1 of last year. Capital expenditures in Q1, excluding equity compensation and capitalized interest expense were $136 million. This was lower than our guidance range, given some pandemic-related supply chain disruptions and travel restrictions that delayed some planned network buildup. However, thanks in part to the capacity work we undertook in 2019, we are very pleased that we've been able to maintain network resiliency during this virus outbreak. Moving on to earnings. GAAP net income for the first quarter was $123 million or $0.75 cents of earnings per diluted share. This included a restructuring charge of about $11 million associated with the prior actions I mentioned on our last quarterly call. We did not take any new restructuring actions during Q1. Non-GAAP net income was $196 million or $1.20 of earnings per diluted share, up 9% year-over-year, up 11% in constant currency, and $0.02 above the high end of our guidance range, due to higher than expected revenue in the quarter. Taxes included in our non-GAAP earnings were $35 million based on a Q1 effective tax rate of 15%. This was slightly better than we expected, due to stronger than expected growth outside the U.S. Now, I will turn to some balance sheet items. We believe that our balance sheet is strong. We anticipate that we can maintain this position in the face of the current economic uncertainty. As of March 31st, our cash, cash equivalents and marketable securities totaled $2.2 billion. Our total debt at the end of Q1 remained unchanged at $2.3 billion. As a reminder, our debt is comprised of two convertible notes with par values of $1.15 billion each and maturity in 2025 and 2027, respectively. Now, I will review our use of capital. During the first quarter, we spent $81 million to repurchase shares, buying back approximately 900,000 shares. We have approximately $750 million remaining on our previously announced share repurchase authorization. We plan to continue to leverage our share buyback program to offset dilution, resulting from equity compensation over time and subject to global financial conditions. In summary, we are very pleased with our Q1 results. Given these uncertain times and with the increased volatility we are seeing in global markets, I thought it would be helpful to provide some additional context on the impact that the recent elevated traffic levels may have on our media division and the negative impact the pandemic may have on some key verticals in our Web division. First, as Tom mentioned, with many countries around the world issuing shelter-in-place orders, we have seen a dramatic increase in media traffic across our platform. We expect this elevated traffic to continue to have a positive impact on our Q2 results. However, we anticipate that traffic levels may start to moderate if life begins return to normal, and as the warmer summer months get underway in our larger markets. As an aside, some of you may be wondering about live sports. As a reminder, no individual live event has a significant impact on our results. And to-date, the stronger traffic from shelter-in-place orders has more than offset the impact of live sports cancellations and postponements. Moving now to our Web division. There are two verticals notably impacted by the global pandemic, travel and hospitality, and commerce and retail. Travel and hospitality vertical accounted for roughly 4% of total Akamai revenue in Q1. This vertical is comprised of over 200 customers globally, including some of the largest airlines, hotels, cruise lines and travel-related sites. Most of these customers have seen sharp declines in demand. The trend is expected to continue throughout 2020. Our commerce and retail vertical is an area we have highlighted for some time as being under financial pressure. This vertical includes more than 900 customers globally and represents approximately 16% of Akamai's total revenue. So, while we have seen a recent traffic uptick with some customers, other customers are struggling, especially those that rely heavily on brick and mortar operations. We believe they could become increasingly challenged, the longer the shelter-in-place orders continue. As Tom mentioned, we have already begun to work with many of our customers whose businesses have been impacted by the pandemic. Q1 was negatively impacted by approximately $5 million due to a combination of contract restructurings and elevated bad debt reserves. Although it is difficult for us to project the total impact, we do expect to incur additional charges in the coming quarters, if the economy continues to suffer. I'd now like to provide our outlook for the second quarter. We are projecting Q2 revenue in the range of $752 million to $778 million, or up 6% to 12% in constant currency over Q2 2019. Given the COVID-related impacts on the business I just discussed, we expect to see continued sequential growth in our media division and a slight decline sequentially on our Web division is Q2. At current spot rates, foreign exchange is expected to have a negative $7 million impact on Q2 revenue compared to Q1 levels and have a negative $11 million impact on a year-over-year basis. At these revenue levels, we expect cash gross margins of approximately 76%. Q2 non-GAAP operating expenses are projected to be $252 million to $260 million. Factoring in the cash gross margin and operating expense expectations I just provided, we anticipate Q2 EBITDA margins of approximately 43%. Moving now to depreciation. We expect non-GAAP depreciation expense to be between $98 million to $101 million. We expect non-GAAP operating margins of approximately 30% for Q2. Moving on to CapEx. We expect to spend approximately $186 million to $206 million, excluding equity compensation in the second quarter. This assumes there's not a significant change in the overall economic environment and that we will catch up on our CapEx spend for the first half of 2020 in Q2. With the overall revenue and spend configuration I just outlined, we expect Q2 non-GAAP EPS in the range of $1.18 to $1.24, or up 14% to 20% in constant currency. This EPS guidance assumes taxes of approximately $34 million to $36 million, based on an estimated quarterly non-GAAP tax rate of approximately 15%. It also reflects a fully diluted share count of proximately 164 million shares. As our Q1 results and Q2 guidance demonstrate, we are optimistic about the continued strength of our business, even in the light of the pandemic. As you're seeing from other companies reporting, however, it has become much more challenging to predict economic conditions, resulting customer impacts in the second half of the year. As a result of this uncertainty, especially as it relates to the holiday shopping season in Q4, we are withdrawing full year 2020 guidance at this time. We plan to reassess providing annual guidance next quarter as we gain additional insights into the direction of the global economy. We're very thankful for the resiliency of our employees, the diversification of our revenue, the strength of our customer relationships and our strong balance sheet. We believe we are well-positioned to continue to help our customers during this very difficult time by providing them with the best and most secure digital experiences around the world. Thank you. Tom and I would be happy to take your questions. Operator?
Operator: Thank you. [Operator Instructions] Our first question comes from the line of Will Power with Baird.
Will Power: Great. Okay. Thank you for taking the question. Well, I guess first, I hope everyone in Akamai team is staying as a healthy and safe as possible. Maybe two quick questions, if I can. First, would love to get more granularity if possible on the sources of strength in media? Maybe just trying to understand, the strength in OTT video versus gaming, if there's any way to kind of rank order what you're seeing there? Then, the second question is on security, given the uncertain climate and questions on IT budgets. Maybe just talk about how you're thinking about security growth going forward and what you're seeing in terms of potential lengthened sales cycles versus the need for work-at-home capabilities.
Ed McGowan: Yes, sure. I'll take the first one, Tom, and maybe you take the second one. So, the strength in media really came, like I mentioned in the earlier remarks, we really saw strength across several different sub verticals in media, probably the largest would be in OTT video. It also was a very, very strong gaming quarter, especially in March. And really, we saw a significant uptake in traffic over the last couple of weeks of March. And as the shelter-in-place orders came around the world as we got to places like Europe, India, and the U.S., we really saw a dramatic increase. So, there's pretty much strength across the board and really across the globe as well.
Tom Leighton: Yes. And first, thanks for the concern about Akamai employees. And I'm happy to report that by and large, we're all doing well. In terms of the question on security growth, it’s looking very strong. And partly, that's because the attackers aren't held back by the pandemic or working remotely. In fact, we've seen a substantial increase in attack activity. And, perhaps -- that perhaps they're doing that because they know IT managers have a lot of other things that they got to worry about in terms of supporting their workforce remotely that increases vulnerabilities. And so, it's really a perfect storm for the attackers to run their exploits. And we have products that are really well-designed to help major enterprises deal with that, both for securing their websites and apps and also for securing access for their employees who are now remote, all of a sudden. And so, we've seen a very strong uptick in bookings for enterprise security products. And I guess, the last point there is, our customer base is the world's major enterprises. And they're going to fare better than most through the pandemic. And we have very good relationships. And so, we're in a better position to provide them with the new security capabilities or the increased capacity that they're going to need for the security products. So, on balance, I think the security business is looking very strong. And of course, we're all hoping that the global recession doesn’t really deepen or persist for a long time.
Will Power: Great, thank you.
Operator: Thank you. And our next question comes from line of Keith Weiss with Morgan Stanley.
Keith Weiss: Thank you, guys, for taking the question and very nice quarter. So, two questions, one on -- as we think about Q2, any quantification you could give us in terms of kind of the puts and takes, and particularly on sort of the drags of having to reprice some of those contracts -- or I’m assuming reprice, having to amend some of those contracts on the performance side of the equation? Any sense you could give us and just like what kind of impact that has on Q2? And then, on the flip side of the equation, is it possible to quantify kind of the -- your expectation for how well this sort of up traffic is going sustain into Q2, like how much of that did you actually put into the guide on a go forward basis?
Ed McGowan: Sure. Hey, Keith. It’s Ed. So, let’s start with the Web division. Obviously, what I tried to do was call on a couple of verticals that our customers are experiencing some significant challenges. So, we're dealing with those on a case by case basis. And in the prepared remarks, I talked a little bit about how we expect to see a slight -- sequential decline in the web business. And really what that's all about is a couple of things that we have to take into consideration. In some cases, the customers will come direct to us and ask us if there's anything we can do to help them during this period of time where there's a lot of uncertainty. In some cases, we'll amend contracts and we'll get something in exchange for that. In other cases, we have to assess the ability of the customer to pay us. And so, there's some customers in particular in certain geographic areas of the country that we're more concerned about. And if you don't have -- if you have any concern about the customers’ ability to pay, you have to reserve that revenue. So, the combination of that is going on. I am encouraged to see that the capital markets have been open. And we've seen a number of customers that have been able to secure funding. There's obviously availability with certain government bailout programs and things like that. But, it is an area that we're keeping a close eye on. And then, obviously, bankruptcies are another possibility. So, what we did is, we did -- ran a number of different scenarios. And we assumed that we would continue to see additional pressure in the web business and we would see a slight decline. Obviously, this is out of control -- out of our control, in terms of what's going to happen with this pandemic and also out of the control of our customers in many ways. So, then, on the media side, we assume that this continued strong traffic growth that we saw in March to continue throughout most of the quarter. We made an assumption that in June that we may see a slight decline in the traffic as things hopefully start to get back to normal and the warmer months start to hit. We've seen a pretty strong traffic growth here in April.
Keith Weiss: Got it. And just in terms of the nature of the contract negotiations, is it more on billing terms, or does actual pricing change? Give us some color on to what you're willing to give to your customers and is there anything kind of out of bounds in what you're not willing to do in terms of contract amendments?
Ed McGowan: Yes, sure. I mean, you take it case by case, we always take the long term view a lot of these customers have been with us for 15 or 20 years. And they certainly take the travel and hospitality vertical. That was a vertical that I never worried about. It's a -- made up of fantastic, amazing companies. They have been always pay on time. They're usually folks that are early adopters of our new solutions, et cetera. But obviously, they just saw demand evaporate here in the second quarter -- excuse me, in the first quarter. So, we work with them. Sometimes it could be you enter into a zero overage contract. A lot of customers are asking for extended terms and payments. So, we have to take that into consideration. Sometimes it's some credit relief, but we do it case-by-case. So, far the customers have been pretty reasonable in terms of their RASK. There haven't been things that have been completely outrageous so far.
Operator: And our next question comes from the line of James Fish with Piper Sandler.
James Fish: I just want to double click on Will’s question. What are you guys seeing thus far with the security solutions with work-from-home, specifically more about that new cloud, web gateway or security solution and the EAA product?
Tom Leighton: Yes. So, strong bookings there. Now, the secure web gateway is just now available in beta and as part of our Enterprise Threat Protector solution, version 3.0. And I think that really increases the strength of the offer. Where we're seeing a lot of the bookings now is an Enterprise Application Access. And you think of that as the VPN replacement, think of that as a thing that lets all your employees who used to just log in, in a physical building now have to do it from home and you need to secure them and you need to scale that overnight. And so, I think that's why we're seeing a real uptake there. And in general, I think, these are the solutions of the future for enterprise security. They enable the zero trust model, they are much more secure within the traditional solutions that enterprises have been using now for decades and can put a big dent in enterprise data breaches in the future.
James Fish: And then, on the media side, I mean, one of your peers and in that space get the share loss of some of the streaming services. Were you guys able to capture some of that share, given the Akamai network size or did you see any specific media share gains with some of newer OTT services?
Ed McGowan: Yes. So, that's a great question. We did -- one of the things that has been a bit of a challenge in the industry is that there's been a surge of demand, so capacity becomes a bigger component of the equation. And along with that comes performance. So, in some cases, we've seen pretty nice share gains across the board. So, we've been very happy with that in Q1.
Operator: Thank you. And our next question comes from the line of Sterling Auty with JP Morgan.
Sterling Auty: You mentioned in your prepared remarks that no single live sporting event is a meaningful part of revenue. But, I think you've talked in the past that things like the Olympics and World Cup that span a couple of weeks are more meaningful. So, I'm wondering how you quantified or how you gauged the potential for a fade off in traffic in June, versus the loss of the Olympics this year, within the guide and what we should be thinking as we go into the back half of the year?
Ed McGowan: So, I'll get into a little bit of detail on this one, just to try to help you guys out. So, we did talk about there's no individual events is material. Take the Olympics for example. When you think about the Olympics, there's obviously the direct right holders, there's the web traffic that can sometimes go along with an event of that size, the travel and news, and things like that. And then there's also live television. We've got several folks that show live television. And then obviously, the duration of the streaming is what really matters. We do web delivery, we do services, we do security, et cetera. But it's really the length of the streaming. An event like that could be, let’s call it, the $3 million to $5 million range, maybe a few million on a really good year. If I think about live sports in general, it’s probably a little over 1% of our total revenue throughout the year. So, right now, you see in Q1, we certainly more than offset the lack of live sports, and we expect that to happen in Q2. So, in terms of what we've built into our guides, we're assuming that live sports is not fully back up and running and that what we're seeing from the OTT and other gaming and other sub verticals will more than offset that in Q2.
Sterling Auty: That's great transparency. Thank you for that. And then, on the security side, can you give us a sense of where the strength is coming from, from this aspect? How much of that strength in spending is new customers coming onto the platform versus existing customers, either taking more product, or existing customers just paying more because of either some sort of volume commitment on any of this or just help peel back the onion a bit on the contributions from the growth in security?
Ed McGowan: Yes, sure. Good question, Sterling. So, first of all, I'll take it from a couple of lenses. I'll start off with the product side. So, we saw great strength with strength with Bot Man, KSD services, and EAA and ETP, albeit a bit smaller, good uptake of multiple solutions. And I've provided this metric before in terms of the number of customers that have purchased a security product for up to 57% now, up from 55% last quarter. So, we're seeing good uptake in the installed base and growing there. And also, customers taking on more than one product, customer buying two or more, up to about 29%, that's up 1 point from last quarter as well. So, doing well with the installed base. In terms of bookings, we're seeing new customer bookings, again being led by security. And, again, so you see this stuff in your installed base. And we're also very excited about page integrity. We came up with our limited availability page integrity. We signed a number of customers this quarter and expect to continue to do that throughout the year. Tom mentioned secure web gateway, which is up in beta now and then obviously enterprise has got a long way to go there.
Operator: Thank you. And our next question comes from the line of Heather Bellini with Goldman Sachs.
Caroline Liu: Hi. This is Caroline on for Heather. First off, I do want to echo the comments that my colleagues on the line have already made. I do hope that you and your families are staying safe and healthy. First off, I wanted to dive a little bit more into the comments that you made about OTT. I'm curious, how has the OTT demand environment trended relative to your expectations, or I guess, put another way, how much of the OTT strength would you characterize as due to the new launches, the share gains versus the general increase in user traffic that was driven by the shelter-in-place orders?
Ed McGowan: Yes. Good question. And this is one that I challenged my team to come up with a number. And it's a little difficult. Times like this tend to self-accelerate trends you see in the market and OTT growth being one and obviously cord-cutting being another. And in March is when we really saw a big uptick in traffic. So, there's no doubt that the shelter-in-place really drove a lot of traffic. But we also had a major customer launch a new service over in EMEA. And we had our own models about what we expected. And I would say, we did a little bit better, could be because of the shelter-in-place. But, I’d say, it’s kind of a combination of both the shelter-in-place, but also, we had -- we took some share in some places as well, like I talked about earlier, we have capacity in a lot of places where it really matters, we’re able to outperform some of our competitors in certain areas. So, it's sort of a combination of everything, but I would say that, shelter-in-place certainly did help accelerate the trend that we're seeing in the market.
Caroline Liu: Got it. And can you talk through what the demand was like, sort of in the last two weeks of March? And what are you seeing now, especially in areas like APJ where some of the countries have sort of relaxed the shelter-in-place orders and people are starting to return back to their workplaces?
Tom Leighton: Yes. The demand increased steadily through March and total traffic increasing from March to April. And you can see, as countries went into shelter-in-place, you see the traffic increased. And I think most of the world is, at least the traffic wise is still in that condition of being high. And as we look forward, we may see more normal growth from here, depending, as Ed said, on live events and OTT launches and so forth. So, APJ, I would say also very strong. And as you know, a lot of our -- got a lot of strong growth there.
Caroline Liu: Got it. Thank you so much.
Operator: Thank you. And our next question comes from the line of James Breen with William Blair.
James Breen: Thanks for taking the questions. Just on the CapEx side, you talked about a little bit delay and sort of the expansion that you had, you were prepared for just because some of the build out you did at the end of last year. Is there any concern about those delays continuing and the ability to sort of meet demand from a customer side, as we go forward here?
Tom Leighton: Yes. We think we're past the delays. We did have about 90 days of delay on delivery of a bunch of servers, but we've had plenty of capacity. And as you can tell by hitting a peak, which is really what the CapEx governs of doubling year-over-year. And at this point, we think we're in very good shape, with the supply lines and getting the full capacity we want for the rest of the year. We have the tax in all the cities where we need to do that. We do the installation. And we have the approvals from pretty much all the major governments that our folks can move around, even where it’s a very strict lockdown, just because we're such a critical resource in countries around the world. So, we're optimistic, as Ed said, on being able to continue to deploy capacity and to stay ahead of the demand.
James Breen: Great. Thank you.
Operator: Thank you. And our next question comes from the line of Michael Turits with Raymond James.
Michael Turits: With you guys withdrawing guidance, as I think through your different segments, I’d like to just try to focus on which are the ones that provide that uncertainty. Because it sounds like CDN is strong now. And really, it worst, at least on the media side at worst, come back to the level it was at. Security, it doesn't sound like you think there's some uncertainty that's macro related, but perhaps there isn’t. And you can tell me if you think there is. So, we're left with ecommerce and around travel and retail. So, am I right, Ed that that’s really the reason why we have an uncertainty that caused you to pull guidance in that segment?
Ed McGowan: Yes. I mean, obviously, we hated to do that, as we ran our scenarios, there is so much that's out of our control and really impacts our customers. For example, if you run into a second flare-up against in the fall and get into another round of shelter-in-place, how does that impact our customers business, especially in the Web division? Obviously we would be bullish for the media division because we’d see those elevated traffic levels. But on the website, it could be considerable. And what's the consumer going to do, how is the consumer going to behave? And with Q4 being a very strong seasonal quarter for us, you can imagine, as you run through a number of scenarios, your range just gets really wide. And we just didn't think it would be helpful. And that's why we provided some additional color, so, you guys can run your models by giving you some size, relative size and number of customers, et cetera. That's really what's driving, Michael, is just the uncertainty around those Web division customers and more, in particular to what's happening with the virus. There's just so much that's out of all of our controls, and including capital markets. Who knows in the second round right now, it's good to see some of our customers getting funding, but that may close down at the second round happens, and elevated bankruptcies, consumers may not be spending, may not be travelling. So, it's not something that we're experts in and we wanted to give it more time to get some more color rather than providing something we thought was unhelpful.
Michael Turits: And then, if I think about CDN as a division, obviously the only thing you’ve guided to is 2Q. But, CDN is made up of both the media side as well as the website. So, do you think that it is enough in traffic to give you an offset to both, live sports and to web that you can see growth in the CDN business year-over-year next quarter?
Ed McGowan: So, in Q2, yes, I would say right now there's a good chance that we could see the strength medium, no more than offset live sports and potentially the impact on Web. Right now, we have 60 days to go. And you never know what's going to happen here in the last 60 days, whether it gives you a larger than normal range, but it is possible and I wouldn't be surprised if we saw CDN growth here in Q2.
Operator: Thank you. And your next question comes from the line of Tim Horan with Oppenheimer.
Tim Horan: Tom, could you maybe step back a second and I can talk about what you kind of expect for a secular shifts in internet usage and trends and maybe how COVID here might change what you guys are doing, your strategy, if at all or, maybe other areas that you might want to invest in as a result of all this? And then, just a quick follow up on security. On the bookings, can you give us maybe just some comparisons of past quarter? Is it like well -- 10 points and above trend that you've seen the last few years or any kind of color around that would be great? Thanks.
Tom Leighton: Yes. In terms of the secular shift, I think there's a reasonable prospect that there will be much more use of the internet coming out of this permanently than there was going in. And in many areas, you look at ecommerce and traditionally that was -- the penetration of ecommerce and commerce as a whole has grown about 2% of the year and low to mid teens and pretty much now the large majority of commerce is online. And after people get used to doing that for an extended period, a lot of that share gain may become permanent. That's really good for Akamai. If you look at media, and movie releases being done online, a lot of consumption now moving online. And that may become permanent, a lot of that as well. You look at work from home, there wasn't a lot of that before. But now there's just a ton of it. And after you've done it for a while, I think you may see a lot of that become permanent. And so, just across the board, it's not so much new users of the internet that weren't done a little bit before. But now they're being done at massive scale. And there's a prospect that the scale will be very large coming out. And so, when we look at the secular tailwinds here, obviously, we're worried about a global recession, as Ed talked about. We just have no idea how long or deep that will be. We're hoping we get out of this pandemic situation by the end of the year and things are looking better. That's beyond our control. But once we do emerge, it does seem like there's a lot of strong tailwinds for Akamai. Because the things I described are all the things that we're really good at and the market leaders at. And so, I would say long term view, very bullish about Akamai. It's not a major product shift for us. Obviously, go to market now. We're changing how we do that, because we're not traveling. So, the go-to-market motions are all virtual and digital now. And we've gotten off to a great start there and how many of you came to our virtual edge live event but tremendous attendance there and really good feedback. And so, how we approach customers, how we talk to them physically is changing. And that's fine. We're in good shape there. In terms of the security bookings, yes, for the enterprise security products, very substantial increase year-over-year in Q1.And that seems to be continuing into Q2. So, that is good news. Now, it takes a while for that to turn into revenue, of course. But, that's a very positive development. And I do think that again in the long term, with more employees working from home, and already the need to stop data breaches and protect enterprise applications and data that there is a bright future for our Zero Trust enterprise security products.
Tim Horan: Thank you.
Operator: Thank you. Your next question comes from the line of Colby Synesael with Cowen.
Colby Synesael: Great. Thank you. Two questions, if I may. I guess, first I just want to drill a bit further down on bad debt. Wondering if you could provide any more color as it relates to -- as a percentage of revenue or what the actual step up was in the quarter. And what should we be looking for that could suggest that you might have to take it up a little bit further potentially in the second quarter. And then just real quickly on pricing. I'm just curious with the incremental volume that you're seeing tied to the CDN business, whether it's just the broader OTT trend or CD-19 related, if we're seeing any significant material shift in pricing trends. Thank you.
Ed McGowan: Sure. I'll take those. Bad debt was up a couple of million this quarter. There's a new accounting standard that we adopted at the beginning of January ASC 326, which basically in the past used to look at -- sorry to get wonky here, but in fact, you had to look at the historic and anything that happens within a quarter. Now you have to look at potential future credit losses. So, think of it almost like you're a bank where you're evaluating your trade receivables and having to put up a reserve for potential future credit losses. And I mentioned earlier, we'll be extending out, in some cases, some payment terms to folks. In some cases, as they are just asking for some time. In other cases, like in places like India, they physically can't get into the office and are not set up to do electronic payments. So, we'll be evaluating that as every company that adopts this standard will be doing the same. So, I do expect that debt expenses will go higher, and we did plan for that in our guidance. So, you’ll see in G&A line that that will start to tick up a bit. On the pricing side, pricing in the CDN market, I didn't see anything this quarter that was out of the ordinary. I will say, though, that we are seeing, as I talked about capacity, the push for capacity reservation fees, which essentially is just getting a little on top of what you'd normally get for the cost of this delivery. Capacity is at a premium at this point. So, we are seeing a little bit of a benefit there. But, in terms of the normal pricing environment, it's still volume-based and I don't see a lot of difference in the market at this point.
Colby Synesael: Thank you very much.
Operator: Thank you. And our next question comes from the line of Jane Lee [ph] with RBC Capital Markets.
UnidentifiedAnalyst: Hi. Thank you. This is Jane for Mark Mahaney. Thanks for taking the question. So, maybe just a couple of points, one on the guidance. You mentioned the vertical weaknesses in your hospitality, travel, commerce. Can you give perhaps ballpark the magnitude of the impact? And maybe just like, do you bake in a similar impact in Q2, or do you expect that in your Q2 guide -- or do you expect that to kind of be a worsening scenario, just given how much of that has just happened in the last month of the quarter? And then, I have a follow-up. Thank you.
Ed McGowan: Yes, sure. So, in the guide, we did expect that we see additional pressure in those verticals and in my prepared remarks I talked about how we expected the Web division to decline slightly. It’s not usually a division that grows very steadily obviously with the exception of a seasonally strong Q4 going to Q1. So, we are anticipating that. So, I did bake in some of that and then included in the range as a various set of scenarios in terms of good, better, best in terms of how we will land. So far in the first 30 days -- or the 28 days of the quarter, I would say, we're trending about what I would have expected, but see how things go here in the next 60 days as we finish up the quarter. Hopefully as some of these countries and states start to come back out of shelter-in-place, we don't see a panic back to things getting worse. And there's more consumer confidence, we don't see as much pressure. But that's how we thought about it.
Unidentified Analyst: Got it. And another question just on security, maybe pre and post COVID. Maybe parsing out the COVID impact before that really hit and you see a surge in booking. How the growth has been trending versus your expectations and what's kind of the cadence of transition to Zero Trust? And maybe after the COVID impact, you mentioned a few new launches and it has obviously page integrity being one, SWG as well that will be a more material revenue driver in the out years. Now, do you see any of these new product launches actually becoming more meaningful revenue drivers in perhaps this year or next year, sooner than projected?
Tom Leighton: Yes. Good question. I would say, the security growth remains very strong. It's been in the high 20s for some time, and we saw that in Q1 as well, and that's going into COVID. I think, the pandemic as we talked about, the rate of attacks is increased as bad as that is, during the pandemic, as the attackers try to take advantage of it, I would say. Now ,the new services like page integrity and secure web gateway and enterprise security and the increased bookings around enterprise, security, those are things that will drive revenue in the future. So, there's some time between bookings and growth. I would say that the pandemic and the stuff that’s happening there helps Zero Trust because in our enterprise security, because there is even more need for it. And in some cases, it's an urgent need. Whereas before there was -- I think it was early days of a trend towards moving to Zero Trust. So, there's an accelerant because of the pandemic. I don't think the pandemic yet you've seen any change in revenue because of it, the same way you would for traffic. Traffic, you monetize that immediately, as soon as you're delivering more, you get the revenue for it. With security products, that more is the bookings and the recurring revenue that's generated as customers find new services or increase the services they have. And so, there -- I think there is benefit, in the future, but we haven't experienced that yet in the same way we have the traffic.
Operator: Thank you. And our next question comes from the line of Rishi Jaluria with D.A. Davidson.
Rishi Jaluria: First, I wanted to go back to retail and commerce as a vertical. Look at -- I know it's been under pressure, even pre-COVID. It feels like certain parts of that vertical though might be doing better than others in this environment, right, especially those like a Walmart that are selling essential goods and services, and we're seeing pockets of ecommerce. So, I wanted to get a sense for what are you seeing within that vertical. And if you think you're withdrawing of guidance and one of the factors being uncertainty around the holiday shopping season. Is that a function of the impact from the fact that we're in a recession, it might take time for recovery. So, discretionary spending might be down or maybe some more detail around that? And then, the second question I wanted to ask, you talked a little bit about the payment terms and restructuring your deals. One of your competitors or peers talked about some customers deferring minimum traffic commitments in this environment. Just wanted to get a sense, is that something that you are seeing as well. Thanks.
Ed McGowan: All right. So, I’ll start with the second one. So, in terms of deferring minimum traffic commitments, we haven't got into that. As a matter of fact, traffic is up significantly. So, it hasn't been an issue for us. There are some customers in the Web division that have opted for the zero overage, but that's been a normal sales motion. So, I wouldn't say -- I wouldn't really call of anything there. On your question about retail and what we’re worried about there. You're correct. There's winners and losers. Some folks have done very well and we’ve seen traffic go higher, and their underlying businesses are doing well. But there's an awful lot of them that are stressed. And I talked about the size of the vertical, 16% of revenue over 900 customers. That's global. So, the really the big thing that we're concerned with and I think you hit it on the head with this, the depth of this reception and how do consumers behave, are they going to go out and spend, are they going to go back into stores, what's the ability of our customers to be able to raise enough capital to get through this issue. In some cases, we're going to see unfortunately some customers go bankrupt. I hate to see it, it does happen. Some liquidate, some come out on the other side. But whenever that happens, it's a disruption for us. We have to stop taking revenue, write-off revenue in the quarter, take a bad debt hit for some of the older receivables. So, it just becomes very disruptive. And it's hard for us to really call out what's going to happen, because I think what's going to drive the depth of this reception is going to be what happens with the virus and do people feel comfortable coming out, as we've never dealt with this before. So, it's really hard for us to make the call. And, just given the size of that vertical, it can swing around quite a bit. So, that's what our -- that's why we decided to withdraw our guidance.
Rishi Jaluria: That's helpful. Thank you.
Operator: Thank you. And our next question comes from the line of Lee Krowl with B. Riley.
Lee Krowl: Great. Thanks for taking my questions. And congrats on a solid quarter, all things considered. I wanted to focus first on the security business. I think, last call, you guys kind of highlighted 20% growth as the baseline for the year. Obviously Q1 is tracking kind of ahead of that, and you're speaking to some momentum with bookings. Is it reasonable to say that that 20% or possibly higher is still reasonable? And then, second question, I just wanted to focus on international. Maybe could you parse out contribution of security versus media delivery, especially with the context of new launches on the OTT side? Thanks for taking my questions.
Ed McGowan: Sure. So, I'll start with the security question. Obviously, we’re off to a great start here. 28%, constant currency growth. Feeling pretty good about Q2. Obviously, Q1’s bookings were strong. We signed one of our largest security deals in our in our history with one of our large media companies. So, good to see that and we see the benefit of that in Q2. So, I think Q2, we’ll see really strong growth. And we did call out 20%. It's possible we could do better than that. Obviously, the verticals we call out that are challenged, do have big security customers. So, to the extent that there's bankruptcies and things like that can bump you around a little bit. But, feeling pretty good here in the first half., certainly that will be growing greater than 20%. And it's possible for the year, really just depends on how things go, some of the comments I made earlier. And your second question on international in terms of the strength, I’d say, there it’s similar to what we see in the U.S. probably a bit more security adoption, quite more greenfield internationally, especially in places like Latin America, pretty low penetration there, which is good. That’s part of the reason we did the exceeded transaction that gives us a good basis to grow the security business there. We are seeing similar trends that we saw in the U.S. there where you see security and verticals like financial services and commerce and travel first and then you’re seeing media start to catch up. We've done some pretty good deals on the media side as well. So, I'd say there's probably more greenfield in outside the U.S., but we are seeing very similar trends.
Lee Krowl: Got it. Thanks for taking my questions, guys.
Operator: Thank you. And our next question comes from the line of Jeff Van Rhee with Craig-Hallum.
Jeff Van Rhee: Great, thanks. I think most might have been answered. Just one remaining. I think as you look at the enterprise sales effort, and this is a little outside of sort of the COVID environment currently, but I know long term, tremendous growth opportunity. When you look at the sales process and where you are at this point, can you just talk to your satisfaction with win rates, with process, with just the overall execution effort in sales within enterprise and things that are yet to be done to really get that running where you wanted, it if it isn’t.
Tom Leighton: Yes. We're pretty happy with where that is now, with pretty much everything you mentioned, the people, the process, the execution. As you could imagine, this is a difficult time to go out and get bookings. You can't physically meet with your accounts, the buyers out there, the IT folks are just swamped with adjusting to the new reality. And yet, we had a great bookings quarter, better than expectation on our enterprise security products, much -- big improvement over last year, and that's -- we're starting off the second quarter very well. So, I think that's an area where we're very happy. You don't see that in generating revenue today. But that will certainly help us going forward.
Jeff Van Rhee: Got it. Great. Thank you.
Operator: Thank you. And our next question comes from the line of Brandon Nispel with KeyBanc Capital Markets.
Brandon Nispel: Okay, great. Thanks for taking the question. I'm wondering if - one for Ed -- maybe both for Ed. Can you give us a sense of -- again, we've talked about some customers doing well in e-commerce, some not. Can you give us a sense of, as you look at your customer base, what could be a worst case scenario if we’re going into the global recession throughout 2020? What percentage of revenue would be at risk? Second, I'm curious, with customers hitting increased traffic during the quarter, how does the pricing change? Is it dynamic during the quarter, where they hit sort of a new threshold for traffic and they reprice to a lower level? I'm just curious how that works. Thanks.
Tom Leighton: Yes. I'll take the first and Ed will probably take the second. As Ed talked about, I think, barring some kind of deep and long lasting recession that wipes out major customers and a lot of them or just totally wipes out consumer buying, which of course hurts the commerce vertical, I think we're in good position. We have a really diverse customer base. Our largest vertical is media which is cranking and actually benefiting in many ways from the new reality of what the pandemic has caused. Our customer base tends to be the biggest names in the business. And generally speaking, they're the ones that are going to thrive the best, even if the global recession deepens and is lengthy. And it's just that I think no one really knows what the future holds through the global recession. And if it really is deep at the end of the year, and it's going persist into 2021, that could put our commerce customers and companies pretty much everywhere under pressure. And it's hard to really know what the impact of that could be. And that impacts the potential downside of any guidance we can give. And on the other side, we've got, as you know, substantial upsides in the media business and in security above where we were thinking. And as Ed talked about, just we want to be careful that we don't know for sure that just persists and grows from there all year long. And as Ed talked about, in June, he even -- we put in a dampening there in June on that. And so, that's really what's going on in our thinking that there's the potential for large upside and the potential for downsides that are hard for us to really quantify. And it's beyond our control at this point. I would say at a high level, business is very strong, as you can tell with the strong Q1 and I think a strong guide, albeit with a wider range in Q2. And Ed, do you want to talk about pricing with increased traffic?
Ed McGowan: Yes, sure. So, obviously, customers know one size fits all for customer pricing. But, what I would say is that typically we do have tiered pricing in most of our contracts, especially the ones with very large volume, so that as you do clip into new tiers, you do get typically a lower rate for that tier. But again, it does vary from customer-to-customer, but we do in most cases have some kind of a tiered pricing structure.
Brandon Nispel: And I guess, just as a follow-up, you guys gave the travel hospitality exposure and sort of talked about live events, but could you give us what percentage of revenue is coming from what you would call SMB? Thanks.
Ed McGowan: Oh, it's very small. Yes, we do very little with SMB. We have a couple of partners that work with SMB. Like, for example our carriers will sell some security offerings to small, medium business. It’s such a small part of our business. We have a few OVP partners and other partners. But, it’s not a significant part of our business at all.
Tom Barth: Okay. Well, thank you, everyone. In closing, we will be presenting at several virtual investor conferences and events throughout the rest of the second quarter. Details of these can be found in the Investor Relations section of akamai.com. I want to thank you for joining us. And all of us at Akamai wish you continued health, and I wish you a very nice evening. So, thank you.
Operator: Ladies and gentlemen, this concludes today's conference call. Thank you for participating. You may now disconnect. | [
{
"speaker": "Operator",
"text": "Ladies and gentlemen, thank you for standing by. Welcome to the First Quarter 2020 Akamai Technologies, Inc. Earnings Conference Call. At this time, all participants are in a listen-only mode. After the speakers’ presentation, there will be a question-and-answer session. [Operator Instructions] Please be advised that today's conference is being recorded. [Operator Instructions] It is now my pleasure to introduce Head of Investor Relations, Tom Barth."
},
{
"speaker": "Tom Barth",
"text": "Thank you, operator. Good afternoon, everyone. And thank you for joining Akamai’s First Quarter 2020 Earnings Conference Call. Speaking today will be Tom Leighton, Akamai's Chief Executive Officer; and Ed McGowan, Akamai's Chief Financial Officer. Before we get started, please note that today's comments include forward-looking statements including statements regarding revenue and earnings guidance. These forward-looking statements are subject to risks and uncertainties and involve a number of factors that could cause actual results to differ material from those expressed or implied by such statements. Additional information concerning these factors is contained in Akamai’s filings with the SEC, including our annual report on Form 10-K and quarterly reports on Form 10-Q. The forward-looking statements included in this call represent the Company's view on April 28, 2020. Akamai disclaims any obligation to update these statements to reflect future events or circumstances. As a reminder, we will be referring to some non-GAAP financial metrics during today's call. A detailed reconciliation of GAAP and non-GAAP metrics can be found under the financial portion of the Investor Relations section at akamai.com. And with that, let me turn the call over to Tom."
},
{
"speaker": "Tom Leighton",
"text": "Thanks, Tom. And thank you all for joining us today. Before I get into the numbers, I want to acknowledge how much the world has been disrupted by the COVID-19 pandemic. All of our lives have been impacted in ways that would have been hard to imagine only a short while ago. At Akamai, our primary concern is for the health and safety of our employees, their loved ones, our customers and partners, and the communities where we work and live. Fortunately, we're in a position where almost all of our employees can work remotely, and we've been doing that successfully for the last two months. We've also implemented special measures to protect employees who need to travel, for example, to a data or operation center. And we're doing what we can to help employees to face especially challenging situations as a result of the pandemic. As businesses and consumers around the globe adjust their routines in the interest of public health, the internet is being used at a scale that the world has never experienced. In addition to the hundreds of millions of people who've been working from home, governments are leveraging the internet to keep citizens informed and to provide economic assistance. Houses of worship are streaming services and communities are engaging online to relieve the social isolation felt by many. And of course, education, commerce and entertainment are now almost entirely online. As much of the world hunkers down in place, Akamai is continuing to work behind the scenes to keep the internet functioning as a lifeline for organizations and people everywhere. I'll talk more in a minute about Akamai’s unique role during the pandemic and the impact of the pandemic on our business. But first, I'll review our Q1 financial performance. I'm pleased to report that Akamai had a very strong first quarter on both the top and bottom lines. Revenue was $764 million, up 8% year-over-year and up 9% in constant currency. Non-GAAP operating margin in Q1 was 30%, up 1 point over Q4 and consistent with Q1 of last year. Non-GAAP EPS in Q1 was $1.20 per diluted share, up 9% year-over-year and up 11% in constant currency. These excellent results were driven by the continued strong performance of our security solutions, greater than expected traffic levels, and by our continued focus on operational efficiency. As more business is conducted over the internet, the ability to scale becomes critical. And when it comes to scale, Akamai is the clear leader. Traffic on our platform increased dramatically in March as enterprises turned to Akamai to move more of their operations online. Despite the cancellation or postponement of major sporting events, like March Madness, and Champions League Soccer, our traffic increased by about 30% over a four-week period at the end of Q1. Traffic reached a peak of 167 terabits per second, which was more than double the peak of the first quarter of 2019. We're very pleased that the capacity we added to the platform last year has enabled us to help our customers, when they need us most. We're also making a big difference when it comes to helping the major carriers handle the explosion in demand. That's because we've deployed our infrastructure deep into carrier networks and close to end users, thereby offloading an enormous amount of traffic that would otherwise congest core backbones and routers. Of course, performance is also critical as businesses move the majority of their operations online. Although some other companies have experienced cases of performance degradation and even extended outages in recent months, I'm very happy to report that Akamai's performance has remained consistent and strong over the past quarter. In fact, our measurements indicate that the page download times provided by our industry leading Ion service has significantly improved over the past year. This is in spite of the large increase in traffic, and is a direct result of our relentless efforts to improve the performance of our services. Akamai is also helping to protect many of the world's major enterprises as more employees work from home and as IT departments increase their focus on business continuity. We believe that Akamai’s market leading security services are needed now more than ever, as attackers take advantage of the pandemic to ramp up their exploits on enterprises across all verticals. In Q1, our cloud-based security portfolio generated $240 million in revenue, up 28% year-over-year in constant currency. Sales continue to be led by our flagship services for DDoS prevention, application-layer firewall and bot management. We also saw a strong surge in bookings for our next-gen Zero Trust enterprise security solutions. The strong demand we saw in Q1 for our security and media services more than offset the reduced revenue we received from companies that have been hit hardest by the pandemic, especially in the travel and hospitality vertical. Where appropriate, we are modifying the terms of these customers’ contracts to provide them some relief and flexibility, often in return for extended contract line. We value our customers and want them to think of Akamai as a supportive and reliable partner for the long run. We are fortunate that our financial strength enables us to provide assistance to customers in need, which we believe will benefit our shareholders and the global economy over the long term. We've also played an important role in helping to support websites and applications associated with response to the pandemic. And the Akamai Foundation is providing sustainable financial assistance for numerous relief efforts around the world. Most of all today, I want to recognize and thank our nearly 7,800 employees for working so hard to serve the thousands of organizations and billions of internet users who rely on us during these very-challenging times. I couldn't be proud of the way that our people have stepped up and of what they're managing to accomplish, despite their own personal challenges and dealing with a pandemic. Their spirit and leadership during a time of crisis is a key part of what makes Akamai such a unique and strong company. Lastly, I want to offer a warm welcome to our Board's newest member, Marianne Brown. Marianne joined Akamai's Board last month and brings with her extensive financial and operational expertise, as well as valuable leadership experience with global technology-driven companies. I'll now turn the call over to Ed for more details on our Q1 performance and our outlook for Q2. Ed?"
},
{
"speaker": "Ed McGowan",
"text": "Thank you, Tom. Before I begin, I would also like to thank our fellow employees for their amazing work and dedication. And I would like to acknowledge our customers and partners, especially those who have been hardest hit by the global pandemic. Today, I plan to review our Q1 results, discuss the impact the pandemic is having on our business and provide Q2 guidance and an update on the full year. As Tom mentioned, we delivered a very strong quarter on both the top and bottom line. Q1 revenue was $764 million, up 8% year-over-year or 9% in constant currency, driven by a significant increase of global traffic, as well as continued strong growth across our security portfolio. Revenue from our Media and Carrier division was $358 million, up 8% year-over-year and 9% in constant currency. The outperformance in media was primarily due to the surge in traffic from OTT video, gaming, social media and news and information sites as more and more people around the world began to shelter in place. Revenue from our internet platform customers was $45 million, in line with our expectations. Revenue from our Web division was $406 million, up 8% year-over-year and 10% in constant currency. Revenue growth for this group of customers was again driven by our security business. Moving on to revenue by geography. International revenue was $335 million, up 16% year-over-year or 19% in constant currency. We continue to see very strong international growth, especially in APJ. Foreign exchange fluctuations had a negative $3 million impact to revenue on a sequential basis and had a negative $7 million impact on a year-over-year basis. Sales in our international markets represented 44% of total revenue in Q1, up 3 points from Q1 2019 and up 2 points from Q4 level. Revenue from our U.S. markets was $429 million, up 3% year-over-year. Moving on to costs. Cash gross margin was 77%, consistent with our expectations. GAAP gross margins, which includes both depreciation and stock-based compensation, was 65%, down a point from Q1 of last year. Non-GAAP cash operating expenses were $260 million, in line with expectations. Adjusted EBITDA was $327 million, up $8 million from Q4 and up 9% in the same period in 2019. Our adjusted EBITDA margin was 43%, up 2 points from Q4 and up 1 point from Q1 of 2019. Non-GAAP operating income was $230 million, up $8 million from Q4 levels and up $20 million or 9% from the same period last year. Non-GAAP operating margin was 30%, up 1 point from Q4 levels and consistent with Q1 of last year. Capital expenditures in Q1, excluding equity compensation and capitalized interest expense were $136 million. This was lower than our guidance range, given some pandemic-related supply chain disruptions and travel restrictions that delayed some planned network buildup. However, thanks in part to the capacity work we undertook in 2019, we are very pleased that we've been able to maintain network resiliency during this virus outbreak. Moving on to earnings. GAAP net income for the first quarter was $123 million or $0.75 cents of earnings per diluted share. This included a restructuring charge of about $11 million associated with the prior actions I mentioned on our last quarterly call. We did not take any new restructuring actions during Q1. Non-GAAP net income was $196 million or $1.20 of earnings per diluted share, up 9% year-over-year, up 11% in constant currency, and $0.02 above the high end of our guidance range, due to higher than expected revenue in the quarter. Taxes included in our non-GAAP earnings were $35 million based on a Q1 effective tax rate of 15%. This was slightly better than we expected, due to stronger than expected growth outside the U.S. Now, I will turn to some balance sheet items. We believe that our balance sheet is strong. We anticipate that we can maintain this position in the face of the current economic uncertainty. As of March 31st, our cash, cash equivalents and marketable securities totaled $2.2 billion. Our total debt at the end of Q1 remained unchanged at $2.3 billion. As a reminder, our debt is comprised of two convertible notes with par values of $1.15 billion each and maturity in 2025 and 2027, respectively. Now, I will review our use of capital. During the first quarter, we spent $81 million to repurchase shares, buying back approximately 900,000 shares. We have approximately $750 million remaining on our previously announced share repurchase authorization. We plan to continue to leverage our share buyback program to offset dilution, resulting from equity compensation over time and subject to global financial conditions. In summary, we are very pleased with our Q1 results. Given these uncertain times and with the increased volatility we are seeing in global markets, I thought it would be helpful to provide some additional context on the impact that the recent elevated traffic levels may have on our media division and the negative impact the pandemic may have on some key verticals in our Web division. First, as Tom mentioned, with many countries around the world issuing shelter-in-place orders, we have seen a dramatic increase in media traffic across our platform. We expect this elevated traffic to continue to have a positive impact on our Q2 results. However, we anticipate that traffic levels may start to moderate if life begins return to normal, and as the warmer summer months get underway in our larger markets. As an aside, some of you may be wondering about live sports. As a reminder, no individual live event has a significant impact on our results. And to-date, the stronger traffic from shelter-in-place orders has more than offset the impact of live sports cancellations and postponements. Moving now to our Web division. There are two verticals notably impacted by the global pandemic, travel and hospitality, and commerce and retail. Travel and hospitality vertical accounted for roughly 4% of total Akamai revenue in Q1. This vertical is comprised of over 200 customers globally, including some of the largest airlines, hotels, cruise lines and travel-related sites. Most of these customers have seen sharp declines in demand. The trend is expected to continue throughout 2020. Our commerce and retail vertical is an area we have highlighted for some time as being under financial pressure. This vertical includes more than 900 customers globally and represents approximately 16% of Akamai's total revenue. So, while we have seen a recent traffic uptick with some customers, other customers are struggling, especially those that rely heavily on brick and mortar operations. We believe they could become increasingly challenged, the longer the shelter-in-place orders continue. As Tom mentioned, we have already begun to work with many of our customers whose businesses have been impacted by the pandemic. Q1 was negatively impacted by approximately $5 million due to a combination of contract restructurings and elevated bad debt reserves. Although it is difficult for us to project the total impact, we do expect to incur additional charges in the coming quarters, if the economy continues to suffer. I'd now like to provide our outlook for the second quarter. We are projecting Q2 revenue in the range of $752 million to $778 million, or up 6% to 12% in constant currency over Q2 2019. Given the COVID-related impacts on the business I just discussed, we expect to see continued sequential growth in our media division and a slight decline sequentially on our Web division is Q2. At current spot rates, foreign exchange is expected to have a negative $7 million impact on Q2 revenue compared to Q1 levels and have a negative $11 million impact on a year-over-year basis. At these revenue levels, we expect cash gross margins of approximately 76%. Q2 non-GAAP operating expenses are projected to be $252 million to $260 million. Factoring in the cash gross margin and operating expense expectations I just provided, we anticipate Q2 EBITDA margins of approximately 43%. Moving now to depreciation. We expect non-GAAP depreciation expense to be between $98 million to $101 million. We expect non-GAAP operating margins of approximately 30% for Q2. Moving on to CapEx. We expect to spend approximately $186 million to $206 million, excluding equity compensation in the second quarter. This assumes there's not a significant change in the overall economic environment and that we will catch up on our CapEx spend for the first half of 2020 in Q2. With the overall revenue and spend configuration I just outlined, we expect Q2 non-GAAP EPS in the range of $1.18 to $1.24, or up 14% to 20% in constant currency. This EPS guidance assumes taxes of approximately $34 million to $36 million, based on an estimated quarterly non-GAAP tax rate of approximately 15%. It also reflects a fully diluted share count of proximately 164 million shares. As our Q1 results and Q2 guidance demonstrate, we are optimistic about the continued strength of our business, even in the light of the pandemic. As you're seeing from other companies reporting, however, it has become much more challenging to predict economic conditions, resulting customer impacts in the second half of the year. As a result of this uncertainty, especially as it relates to the holiday shopping season in Q4, we are withdrawing full year 2020 guidance at this time. We plan to reassess providing annual guidance next quarter as we gain additional insights into the direction of the global economy. We're very thankful for the resiliency of our employees, the diversification of our revenue, the strength of our customer relationships and our strong balance sheet. We believe we are well-positioned to continue to help our customers during this very difficult time by providing them with the best and most secure digital experiences around the world. Thank you. Tom and I would be happy to take your questions. Operator?"
},
{
"speaker": "Operator",
"text": "Thank you. [Operator Instructions] Our first question comes from the line of Will Power with Baird."
},
{
"speaker": "Will Power",
"text": "Great. Okay. Thank you for taking the question. Well, I guess first, I hope everyone in Akamai team is staying as a healthy and safe as possible. Maybe two quick questions, if I can. First, would love to get more granularity if possible on the sources of strength in media? Maybe just trying to understand, the strength in OTT video versus gaming, if there's any way to kind of rank order what you're seeing there? Then, the second question is on security, given the uncertain climate and questions on IT budgets. Maybe just talk about how you're thinking about security growth going forward and what you're seeing in terms of potential lengthened sales cycles versus the need for work-at-home capabilities."
},
{
"speaker": "Ed McGowan",
"text": "Yes, sure. I'll take the first one, Tom, and maybe you take the second one. So, the strength in media really came, like I mentioned in the earlier remarks, we really saw strength across several different sub verticals in media, probably the largest would be in OTT video. It also was a very, very strong gaming quarter, especially in March. And really, we saw a significant uptake in traffic over the last couple of weeks of March. And as the shelter-in-place orders came around the world as we got to places like Europe, India, and the U.S., we really saw a dramatic increase. So, there's pretty much strength across the board and really across the globe as well."
},
{
"speaker": "Tom Leighton",
"text": "Yes. And first, thanks for the concern about Akamai employees. And I'm happy to report that by and large, we're all doing well. In terms of the question on security growth, it’s looking very strong. And partly, that's because the attackers aren't held back by the pandemic or working remotely. In fact, we've seen a substantial increase in attack activity. And, perhaps -- that perhaps they're doing that because they know IT managers have a lot of other things that they got to worry about in terms of supporting their workforce remotely that increases vulnerabilities. And so, it's really a perfect storm for the attackers to run their exploits. And we have products that are really well-designed to help major enterprises deal with that, both for securing their websites and apps and also for securing access for their employees who are now remote, all of a sudden. And so, we've seen a very strong uptick in bookings for enterprise security products. And I guess, the last point there is, our customer base is the world's major enterprises. And they're going to fare better than most through the pandemic. And we have very good relationships. And so, we're in a better position to provide them with the new security capabilities or the increased capacity that they're going to need for the security products. So, on balance, I think the security business is looking very strong. And of course, we're all hoping that the global recession doesn’t really deepen or persist for a long time."
},
{
"speaker": "Will Power",
"text": "Great, thank you."
},
{
"speaker": "Operator",
"text": "Thank you. And our next question comes from line of Keith Weiss with Morgan Stanley."
},
{
"speaker": "Keith Weiss",
"text": "Thank you, guys, for taking the question and very nice quarter. So, two questions, one on -- as we think about Q2, any quantification you could give us in terms of kind of the puts and takes, and particularly on sort of the drags of having to reprice some of those contracts -- or I’m assuming reprice, having to amend some of those contracts on the performance side of the equation? Any sense you could give us and just like what kind of impact that has on Q2? And then, on the flip side of the equation, is it possible to quantify kind of the -- your expectation for how well this sort of up traffic is going sustain into Q2, like how much of that did you actually put into the guide on a go forward basis?"
},
{
"speaker": "Ed McGowan",
"text": "Sure. Hey, Keith. It’s Ed. So, let’s start with the Web division. Obviously, what I tried to do was call on a couple of verticals that our customers are experiencing some significant challenges. So, we're dealing with those on a case by case basis. And in the prepared remarks, I talked a little bit about how we expect to see a slight -- sequential decline in the web business. And really what that's all about is a couple of things that we have to take into consideration. In some cases, the customers will come direct to us and ask us if there's anything we can do to help them during this period of time where there's a lot of uncertainty. In some cases, we'll amend contracts and we'll get something in exchange for that. In other cases, we have to assess the ability of the customer to pay us. And so, there's some customers in particular in certain geographic areas of the country that we're more concerned about. And if you don't have -- if you have any concern about the customers’ ability to pay, you have to reserve that revenue. So, the combination of that is going on. I am encouraged to see that the capital markets have been open. And we've seen a number of customers that have been able to secure funding. There's obviously availability with certain government bailout programs and things like that. But, it is an area that we're keeping a close eye on. And then, obviously, bankruptcies are another possibility. So, what we did is, we did -- ran a number of different scenarios. And we assumed that we would continue to see additional pressure in the web business and we would see a slight decline. Obviously, this is out of control -- out of our control, in terms of what's going to happen with this pandemic and also out of the control of our customers in many ways. So, then, on the media side, we assume that this continued strong traffic growth that we saw in March to continue throughout most of the quarter. We made an assumption that in June that we may see a slight decline in the traffic as things hopefully start to get back to normal and the warmer months start to hit. We've seen a pretty strong traffic growth here in April."
},
{
"speaker": "Keith Weiss",
"text": "Got it. And just in terms of the nature of the contract negotiations, is it more on billing terms, or does actual pricing change? Give us some color on to what you're willing to give to your customers and is there anything kind of out of bounds in what you're not willing to do in terms of contract amendments?"
},
{
"speaker": "Ed McGowan",
"text": "Yes, sure. I mean, you take it case by case, we always take the long term view a lot of these customers have been with us for 15 or 20 years. And they certainly take the travel and hospitality vertical. That was a vertical that I never worried about. It's a -- made up of fantastic, amazing companies. They have been always pay on time. They're usually folks that are early adopters of our new solutions, et cetera. But obviously, they just saw demand evaporate here in the second quarter -- excuse me, in the first quarter. So, we work with them. Sometimes it could be you enter into a zero overage contract. A lot of customers are asking for extended terms and payments. So, we have to take that into consideration. Sometimes it's some credit relief, but we do it case-by-case. So, far the customers have been pretty reasonable in terms of their RASK. There haven't been things that have been completely outrageous so far."
},
{
"speaker": "Operator",
"text": "And our next question comes from the line of James Fish with Piper Sandler."
},
{
"speaker": "James Fish",
"text": "I just want to double click on Will’s question. What are you guys seeing thus far with the security solutions with work-from-home, specifically more about that new cloud, web gateway or security solution and the EAA product?"
},
{
"speaker": "Tom Leighton",
"text": "Yes. So, strong bookings there. Now, the secure web gateway is just now available in beta and as part of our Enterprise Threat Protector solution, version 3.0. And I think that really increases the strength of the offer. Where we're seeing a lot of the bookings now is an Enterprise Application Access. And you think of that as the VPN replacement, think of that as a thing that lets all your employees who used to just log in, in a physical building now have to do it from home and you need to secure them and you need to scale that overnight. And so, I think that's why we're seeing a real uptake there. And in general, I think, these are the solutions of the future for enterprise security. They enable the zero trust model, they are much more secure within the traditional solutions that enterprises have been using now for decades and can put a big dent in enterprise data breaches in the future."
},
{
"speaker": "James Fish",
"text": "And then, on the media side, I mean, one of your peers and in that space get the share loss of some of the streaming services. Were you guys able to capture some of that share, given the Akamai network size or did you see any specific media share gains with some of newer OTT services?"
},
{
"speaker": "Ed McGowan",
"text": "Yes. So, that's a great question. We did -- one of the things that has been a bit of a challenge in the industry is that there's been a surge of demand, so capacity becomes a bigger component of the equation. And along with that comes performance. So, in some cases, we've seen pretty nice share gains across the board. So, we've been very happy with that in Q1."
},
{
"speaker": "Operator",
"text": "Thank you. And our next question comes from the line of Sterling Auty with JP Morgan."
},
{
"speaker": "Sterling Auty",
"text": "You mentioned in your prepared remarks that no single live sporting event is a meaningful part of revenue. But, I think you've talked in the past that things like the Olympics and World Cup that span a couple of weeks are more meaningful. So, I'm wondering how you quantified or how you gauged the potential for a fade off in traffic in June, versus the loss of the Olympics this year, within the guide and what we should be thinking as we go into the back half of the year?"
},
{
"speaker": "Ed McGowan",
"text": "So, I'll get into a little bit of detail on this one, just to try to help you guys out. So, we did talk about there's no individual events is material. Take the Olympics for example. When you think about the Olympics, there's obviously the direct right holders, there's the web traffic that can sometimes go along with an event of that size, the travel and news, and things like that. And then there's also live television. We've got several folks that show live television. And then obviously, the duration of the streaming is what really matters. We do web delivery, we do services, we do security, et cetera. But it's really the length of the streaming. An event like that could be, let’s call it, the $3 million to $5 million range, maybe a few million on a really good year. If I think about live sports in general, it’s probably a little over 1% of our total revenue throughout the year. So, right now, you see in Q1, we certainly more than offset the lack of live sports, and we expect that to happen in Q2. So, in terms of what we've built into our guides, we're assuming that live sports is not fully back up and running and that what we're seeing from the OTT and other gaming and other sub verticals will more than offset that in Q2."
},
{
"speaker": "Sterling Auty",
"text": "That's great transparency. Thank you for that. And then, on the security side, can you give us a sense of where the strength is coming from, from this aspect? How much of that strength in spending is new customers coming onto the platform versus existing customers, either taking more product, or existing customers just paying more because of either some sort of volume commitment on any of this or just help peel back the onion a bit on the contributions from the growth in security?"
},
{
"speaker": "Ed McGowan",
"text": "Yes, sure. Good question, Sterling. So, first of all, I'll take it from a couple of lenses. I'll start off with the product side. So, we saw great strength with strength with Bot Man, KSD services, and EAA and ETP, albeit a bit smaller, good uptake of multiple solutions. And I've provided this metric before in terms of the number of customers that have purchased a security product for up to 57% now, up from 55% last quarter. So, we're seeing good uptake in the installed base and growing there. And also, customers taking on more than one product, customer buying two or more, up to about 29%, that's up 1 point from last quarter as well. So, doing well with the installed base. In terms of bookings, we're seeing new customer bookings, again being led by security. And, again, so you see this stuff in your installed base. And we're also very excited about page integrity. We came up with our limited availability page integrity. We signed a number of customers this quarter and expect to continue to do that throughout the year. Tom mentioned secure web gateway, which is up in beta now and then obviously enterprise has got a long way to go there."
},
{
"speaker": "Operator",
"text": "Thank you. And our next question comes from the line of Heather Bellini with Goldman Sachs."
},
{
"speaker": "Caroline Liu",
"text": "Hi. This is Caroline on for Heather. First off, I do want to echo the comments that my colleagues on the line have already made. I do hope that you and your families are staying safe and healthy. First off, I wanted to dive a little bit more into the comments that you made about OTT. I'm curious, how has the OTT demand environment trended relative to your expectations, or I guess, put another way, how much of the OTT strength would you characterize as due to the new launches, the share gains versus the general increase in user traffic that was driven by the shelter-in-place orders?"
},
{
"speaker": "Ed McGowan",
"text": "Yes. Good question. And this is one that I challenged my team to come up with a number. And it's a little difficult. Times like this tend to self-accelerate trends you see in the market and OTT growth being one and obviously cord-cutting being another. And in March is when we really saw a big uptick in traffic. So, there's no doubt that the shelter-in-place really drove a lot of traffic. But we also had a major customer launch a new service over in EMEA. And we had our own models about what we expected. And I would say, we did a little bit better, could be because of the shelter-in-place. But, I’d say, it’s kind of a combination of both the shelter-in-place, but also, we had -- we took some share in some places as well, like I talked about earlier, we have capacity in a lot of places where it really matters, we’re able to outperform some of our competitors in certain areas. So, it's sort of a combination of everything, but I would say that, shelter-in-place certainly did help accelerate the trend that we're seeing in the market."
},
{
"speaker": "Caroline Liu",
"text": "Got it. And can you talk through what the demand was like, sort of in the last two weeks of March? And what are you seeing now, especially in areas like APJ where some of the countries have sort of relaxed the shelter-in-place orders and people are starting to return back to their workplaces?"
},
{
"speaker": "Tom Leighton",
"text": "Yes. The demand increased steadily through March and total traffic increasing from March to April. And you can see, as countries went into shelter-in-place, you see the traffic increased. And I think most of the world is, at least the traffic wise is still in that condition of being high. And as we look forward, we may see more normal growth from here, depending, as Ed said, on live events and OTT launches and so forth. So, APJ, I would say also very strong. And as you know, a lot of our -- got a lot of strong growth there."
},
{
"speaker": "Caroline Liu",
"text": "Got it. Thank you so much."
},
{
"speaker": "Operator",
"text": "Thank you. And our next question comes from the line of James Breen with William Blair."
},
{
"speaker": "James Breen",
"text": "Thanks for taking the questions. Just on the CapEx side, you talked about a little bit delay and sort of the expansion that you had, you were prepared for just because some of the build out you did at the end of last year. Is there any concern about those delays continuing and the ability to sort of meet demand from a customer side, as we go forward here?"
},
{
"speaker": "Tom Leighton",
"text": "Yes. We think we're past the delays. We did have about 90 days of delay on delivery of a bunch of servers, but we've had plenty of capacity. And as you can tell by hitting a peak, which is really what the CapEx governs of doubling year-over-year. And at this point, we think we're in very good shape, with the supply lines and getting the full capacity we want for the rest of the year. We have the tax in all the cities where we need to do that. We do the installation. And we have the approvals from pretty much all the major governments that our folks can move around, even where it’s a very strict lockdown, just because we're such a critical resource in countries around the world. So, we're optimistic, as Ed said, on being able to continue to deploy capacity and to stay ahead of the demand."
},
{
"speaker": "James Breen",
"text": "Great. Thank you."
},
{
"speaker": "Operator",
"text": "Thank you. And our next question comes from the line of Michael Turits with Raymond James."
},
{
"speaker": "Michael Turits",
"text": "With you guys withdrawing guidance, as I think through your different segments, I’d like to just try to focus on which are the ones that provide that uncertainty. Because it sounds like CDN is strong now. And really, it worst, at least on the media side at worst, come back to the level it was at. Security, it doesn't sound like you think there's some uncertainty that's macro related, but perhaps there isn’t. And you can tell me if you think there is. So, we're left with ecommerce and around travel and retail. So, am I right, Ed that that’s really the reason why we have an uncertainty that caused you to pull guidance in that segment?"
},
{
"speaker": "Ed McGowan",
"text": "Yes. I mean, obviously, we hated to do that, as we ran our scenarios, there is so much that's out of our control and really impacts our customers. For example, if you run into a second flare-up against in the fall and get into another round of shelter-in-place, how does that impact our customers business, especially in the Web division? Obviously we would be bullish for the media division because we’d see those elevated traffic levels. But on the website, it could be considerable. And what's the consumer going to do, how is the consumer going to behave? And with Q4 being a very strong seasonal quarter for us, you can imagine, as you run through a number of scenarios, your range just gets really wide. And we just didn't think it would be helpful. And that's why we provided some additional color, so, you guys can run your models by giving you some size, relative size and number of customers, et cetera. That's really what's driving, Michael, is just the uncertainty around those Web division customers and more, in particular to what's happening with the virus. There's just so much that's out of all of our controls, and including capital markets. Who knows in the second round right now, it's good to see some of our customers getting funding, but that may close down at the second round happens, and elevated bankruptcies, consumers may not be spending, may not be travelling. So, it's not something that we're experts in and we wanted to give it more time to get some more color rather than providing something we thought was unhelpful."
},
{
"speaker": "Michael Turits",
"text": "And then, if I think about CDN as a division, obviously the only thing you’ve guided to is 2Q. But, CDN is made up of both the media side as well as the website. So, do you think that it is enough in traffic to give you an offset to both, live sports and to web that you can see growth in the CDN business year-over-year next quarter?"
},
{
"speaker": "Ed McGowan",
"text": "So, in Q2, yes, I would say right now there's a good chance that we could see the strength medium, no more than offset live sports and potentially the impact on Web. Right now, we have 60 days to go. And you never know what's going to happen here in the last 60 days, whether it gives you a larger than normal range, but it is possible and I wouldn't be surprised if we saw CDN growth here in Q2."
},
{
"speaker": "Operator",
"text": "Thank you. And your next question comes from the line of Tim Horan with Oppenheimer."
},
{
"speaker": "Tim Horan",
"text": "Tom, could you maybe step back a second and I can talk about what you kind of expect for a secular shifts in internet usage and trends and maybe how COVID here might change what you guys are doing, your strategy, if at all or, maybe other areas that you might want to invest in as a result of all this? And then, just a quick follow up on security. On the bookings, can you give us maybe just some comparisons of past quarter? Is it like well -- 10 points and above trend that you've seen the last few years or any kind of color around that would be great? Thanks."
},
{
"speaker": "Tom Leighton",
"text": "Yes. In terms of the secular shift, I think there's a reasonable prospect that there will be much more use of the internet coming out of this permanently than there was going in. And in many areas, you look at ecommerce and traditionally that was -- the penetration of ecommerce and commerce as a whole has grown about 2% of the year and low to mid teens and pretty much now the large majority of commerce is online. And after people get used to doing that for an extended period, a lot of that share gain may become permanent. That's really good for Akamai. If you look at media, and movie releases being done online, a lot of consumption now moving online. And that may become permanent, a lot of that as well. You look at work from home, there wasn't a lot of that before. But now there's just a ton of it. And after you've done it for a while, I think you may see a lot of that become permanent. And so, just across the board, it's not so much new users of the internet that weren't done a little bit before. But now they're being done at massive scale. And there's a prospect that the scale will be very large coming out. And so, when we look at the secular tailwinds here, obviously, we're worried about a global recession, as Ed talked about. We just have no idea how long or deep that will be. We're hoping we get out of this pandemic situation by the end of the year and things are looking better. That's beyond our control. But once we do emerge, it does seem like there's a lot of strong tailwinds for Akamai. Because the things I described are all the things that we're really good at and the market leaders at. And so, I would say long term view, very bullish about Akamai. It's not a major product shift for us. Obviously, go to market now. We're changing how we do that, because we're not traveling. So, the go-to-market motions are all virtual and digital now. And we've gotten off to a great start there and how many of you came to our virtual edge live event but tremendous attendance there and really good feedback. And so, how we approach customers, how we talk to them physically is changing. And that's fine. We're in good shape there. In terms of the security bookings, yes, for the enterprise security products, very substantial increase year-over-year in Q1.And that seems to be continuing into Q2. So, that is good news. Now, it takes a while for that to turn into revenue, of course. But, that's a very positive development. And I do think that again in the long term, with more employees working from home, and already the need to stop data breaches and protect enterprise applications and data that there is a bright future for our Zero Trust enterprise security products."
},
{
"speaker": "Tim Horan",
"text": "Thank you."
},
{
"speaker": "Operator",
"text": "Thank you. Your next question comes from the line of Colby Synesael with Cowen."
},
{
"speaker": "Colby Synesael",
"text": "Great. Thank you. Two questions, if I may. I guess, first I just want to drill a bit further down on bad debt. Wondering if you could provide any more color as it relates to -- as a percentage of revenue or what the actual step up was in the quarter. And what should we be looking for that could suggest that you might have to take it up a little bit further potentially in the second quarter. And then just real quickly on pricing. I'm just curious with the incremental volume that you're seeing tied to the CDN business, whether it's just the broader OTT trend or CD-19 related, if we're seeing any significant material shift in pricing trends. Thank you."
},
{
"speaker": "Ed McGowan",
"text": "Sure. I'll take those. Bad debt was up a couple of million this quarter. There's a new accounting standard that we adopted at the beginning of January ASC 326, which basically in the past used to look at -- sorry to get wonky here, but in fact, you had to look at the historic and anything that happens within a quarter. Now you have to look at potential future credit losses. So, think of it almost like you're a bank where you're evaluating your trade receivables and having to put up a reserve for potential future credit losses. And I mentioned earlier, we'll be extending out, in some cases, some payment terms to folks. In some cases, as they are just asking for some time. In other cases, like in places like India, they physically can't get into the office and are not set up to do electronic payments. So, we'll be evaluating that as every company that adopts this standard will be doing the same. So, I do expect that debt expenses will go higher, and we did plan for that in our guidance. So, you’ll see in G&A line that that will start to tick up a bit. On the pricing side, pricing in the CDN market, I didn't see anything this quarter that was out of the ordinary. I will say, though, that we are seeing, as I talked about capacity, the push for capacity reservation fees, which essentially is just getting a little on top of what you'd normally get for the cost of this delivery. Capacity is at a premium at this point. So, we are seeing a little bit of a benefit there. But, in terms of the normal pricing environment, it's still volume-based and I don't see a lot of difference in the market at this point."
},
{
"speaker": "Colby Synesael",
"text": "Thank you very much."
},
{
"speaker": "Operator",
"text": "Thank you. And our next question comes from the line of Jane Lee [ph] with RBC Capital Markets."
},
{
"speaker": "UnidentifiedAnalyst",
"text": "Hi. Thank you. This is Jane for Mark Mahaney. Thanks for taking the question. So, maybe just a couple of points, one on the guidance. You mentioned the vertical weaknesses in your hospitality, travel, commerce. Can you give perhaps ballpark the magnitude of the impact? And maybe just like, do you bake in a similar impact in Q2, or do you expect that in your Q2 guide -- or do you expect that to kind of be a worsening scenario, just given how much of that has just happened in the last month of the quarter? And then, I have a follow-up. Thank you."
},
{
"speaker": "Ed McGowan",
"text": "Yes, sure. So, in the guide, we did expect that we see additional pressure in those verticals and in my prepared remarks I talked about how we expected the Web division to decline slightly. It’s not usually a division that grows very steadily obviously with the exception of a seasonally strong Q4 going to Q1. So, we are anticipating that. So, I did bake in some of that and then included in the range as a various set of scenarios in terms of good, better, best in terms of how we will land. So far in the first 30 days -- or the 28 days of the quarter, I would say, we're trending about what I would have expected, but see how things go here in the next 60 days as we finish up the quarter. Hopefully as some of these countries and states start to come back out of shelter-in-place, we don't see a panic back to things getting worse. And there's more consumer confidence, we don't see as much pressure. But that's how we thought about it."
},
{
"speaker": "Unidentified Analyst",
"text": "Got it. And another question just on security, maybe pre and post COVID. Maybe parsing out the COVID impact before that really hit and you see a surge in booking. How the growth has been trending versus your expectations and what's kind of the cadence of transition to Zero Trust? And maybe after the COVID impact, you mentioned a few new launches and it has obviously page integrity being one, SWG as well that will be a more material revenue driver in the out years. Now, do you see any of these new product launches actually becoming more meaningful revenue drivers in perhaps this year or next year, sooner than projected?"
},
{
"speaker": "Tom Leighton",
"text": "Yes. Good question. I would say, the security growth remains very strong. It's been in the high 20s for some time, and we saw that in Q1 as well, and that's going into COVID. I think, the pandemic as we talked about, the rate of attacks is increased as bad as that is, during the pandemic, as the attackers try to take advantage of it, I would say. Now ,the new services like page integrity and secure web gateway and enterprise security and the increased bookings around enterprise, security, those are things that will drive revenue in the future. So, there's some time between bookings and growth. I would say that the pandemic and the stuff that’s happening there helps Zero Trust because in our enterprise security, because there is even more need for it. And in some cases, it's an urgent need. Whereas before there was -- I think it was early days of a trend towards moving to Zero Trust. So, there's an accelerant because of the pandemic. I don't think the pandemic yet you've seen any change in revenue because of it, the same way you would for traffic. Traffic, you monetize that immediately, as soon as you're delivering more, you get the revenue for it. With security products, that more is the bookings and the recurring revenue that's generated as customers find new services or increase the services they have. And so, there -- I think there is benefit, in the future, but we haven't experienced that yet in the same way we have the traffic."
},
{
"speaker": "Operator",
"text": "Thank you. And our next question comes from the line of Rishi Jaluria with D.A. Davidson."
},
{
"speaker": "Rishi Jaluria",
"text": "First, I wanted to go back to retail and commerce as a vertical. Look at -- I know it's been under pressure, even pre-COVID. It feels like certain parts of that vertical though might be doing better than others in this environment, right, especially those like a Walmart that are selling essential goods and services, and we're seeing pockets of ecommerce. So, I wanted to get a sense for what are you seeing within that vertical. And if you think you're withdrawing of guidance and one of the factors being uncertainty around the holiday shopping season. Is that a function of the impact from the fact that we're in a recession, it might take time for recovery. So, discretionary spending might be down or maybe some more detail around that? And then, the second question I wanted to ask, you talked a little bit about the payment terms and restructuring your deals. One of your competitors or peers talked about some customers deferring minimum traffic commitments in this environment. Just wanted to get a sense, is that something that you are seeing as well. Thanks."
},
{
"speaker": "Ed McGowan",
"text": "All right. So, I’ll start with the second one. So, in terms of deferring minimum traffic commitments, we haven't got into that. As a matter of fact, traffic is up significantly. So, it hasn't been an issue for us. There are some customers in the Web division that have opted for the zero overage, but that's been a normal sales motion. So, I wouldn't say -- I wouldn't really call of anything there. On your question about retail and what we’re worried about there. You're correct. There's winners and losers. Some folks have done very well and we’ve seen traffic go higher, and their underlying businesses are doing well. But there's an awful lot of them that are stressed. And I talked about the size of the vertical, 16% of revenue over 900 customers. That's global. So, the really the big thing that we're concerned with and I think you hit it on the head with this, the depth of this reception and how do consumers behave, are they going to go out and spend, are they going to go back into stores, what's the ability of our customers to be able to raise enough capital to get through this issue. In some cases, we're going to see unfortunately some customers go bankrupt. I hate to see it, it does happen. Some liquidate, some come out on the other side. But whenever that happens, it's a disruption for us. We have to stop taking revenue, write-off revenue in the quarter, take a bad debt hit for some of the older receivables. So, it just becomes very disruptive. And it's hard for us to really call out what's going to happen, because I think what's going to drive the depth of this reception is going to be what happens with the virus and do people feel comfortable coming out, as we've never dealt with this before. So, it's really hard for us to make the call. And, just given the size of that vertical, it can swing around quite a bit. So, that's what our -- that's why we decided to withdraw our guidance."
},
{
"speaker": "Rishi Jaluria",
"text": "That's helpful. Thank you."
},
{
"speaker": "Operator",
"text": "Thank you. And our next question comes from the line of Lee Krowl with B. Riley."
},
{
"speaker": "Lee Krowl",
"text": "Great. Thanks for taking my questions. And congrats on a solid quarter, all things considered. I wanted to focus first on the security business. I think, last call, you guys kind of highlighted 20% growth as the baseline for the year. Obviously Q1 is tracking kind of ahead of that, and you're speaking to some momentum with bookings. Is it reasonable to say that that 20% or possibly higher is still reasonable? And then, second question, I just wanted to focus on international. Maybe could you parse out contribution of security versus media delivery, especially with the context of new launches on the OTT side? Thanks for taking my questions."
},
{
"speaker": "Ed McGowan",
"text": "Sure. So, I'll start with the security question. Obviously, we’re off to a great start here. 28%, constant currency growth. Feeling pretty good about Q2. Obviously, Q1’s bookings were strong. We signed one of our largest security deals in our in our history with one of our large media companies. So, good to see that and we see the benefit of that in Q2. So, I think Q2, we’ll see really strong growth. And we did call out 20%. It's possible we could do better than that. Obviously, the verticals we call out that are challenged, do have big security customers. So, to the extent that there's bankruptcies and things like that can bump you around a little bit. But, feeling pretty good here in the first half., certainly that will be growing greater than 20%. And it's possible for the year, really just depends on how things go, some of the comments I made earlier. And your second question on international in terms of the strength, I’d say, there it’s similar to what we see in the U.S. probably a bit more security adoption, quite more greenfield internationally, especially in places like Latin America, pretty low penetration there, which is good. That’s part of the reason we did the exceeded transaction that gives us a good basis to grow the security business there. We are seeing similar trends that we saw in the U.S. there where you see security and verticals like financial services and commerce and travel first and then you’re seeing media start to catch up. We've done some pretty good deals on the media side as well. So, I'd say there's probably more greenfield in outside the U.S., but we are seeing very similar trends."
},
{
"speaker": "Lee Krowl",
"text": "Got it. Thanks for taking my questions, guys."
},
{
"speaker": "Operator",
"text": "Thank you. And our next question comes from the line of Jeff Van Rhee with Craig-Hallum."
},
{
"speaker": "Jeff Van Rhee",
"text": "Great, thanks. I think most might have been answered. Just one remaining. I think as you look at the enterprise sales effort, and this is a little outside of sort of the COVID environment currently, but I know long term, tremendous growth opportunity. When you look at the sales process and where you are at this point, can you just talk to your satisfaction with win rates, with process, with just the overall execution effort in sales within enterprise and things that are yet to be done to really get that running where you wanted, it if it isn’t."
},
{
"speaker": "Tom Leighton",
"text": "Yes. We're pretty happy with where that is now, with pretty much everything you mentioned, the people, the process, the execution. As you could imagine, this is a difficult time to go out and get bookings. You can't physically meet with your accounts, the buyers out there, the IT folks are just swamped with adjusting to the new reality. And yet, we had a great bookings quarter, better than expectation on our enterprise security products, much -- big improvement over last year, and that's -- we're starting off the second quarter very well. So, I think that's an area where we're very happy. You don't see that in generating revenue today. But that will certainly help us going forward."
},
{
"speaker": "Jeff Van Rhee",
"text": "Got it. Great. Thank you."
},
{
"speaker": "Operator",
"text": "Thank you. And our next question comes from the line of Brandon Nispel with KeyBanc Capital Markets."
},
{
"speaker": "Brandon Nispel",
"text": "Okay, great. Thanks for taking the question. I'm wondering if - one for Ed -- maybe both for Ed. Can you give us a sense of -- again, we've talked about some customers doing well in e-commerce, some not. Can you give us a sense of, as you look at your customer base, what could be a worst case scenario if we’re going into the global recession throughout 2020? What percentage of revenue would be at risk? Second, I'm curious, with customers hitting increased traffic during the quarter, how does the pricing change? Is it dynamic during the quarter, where they hit sort of a new threshold for traffic and they reprice to a lower level? I'm just curious how that works. Thanks."
},
{
"speaker": "Tom Leighton",
"text": "Yes. I'll take the first and Ed will probably take the second. As Ed talked about, I think, barring some kind of deep and long lasting recession that wipes out major customers and a lot of them or just totally wipes out consumer buying, which of course hurts the commerce vertical, I think we're in good position. We have a really diverse customer base. Our largest vertical is media which is cranking and actually benefiting in many ways from the new reality of what the pandemic has caused. Our customer base tends to be the biggest names in the business. And generally speaking, they're the ones that are going to thrive the best, even if the global recession deepens and is lengthy. And it's just that I think no one really knows what the future holds through the global recession. And if it really is deep at the end of the year, and it's going persist into 2021, that could put our commerce customers and companies pretty much everywhere under pressure. And it's hard to really know what the impact of that could be. And that impacts the potential downside of any guidance we can give. And on the other side, we've got, as you know, substantial upsides in the media business and in security above where we were thinking. And as Ed talked about, just we want to be careful that we don't know for sure that just persists and grows from there all year long. And as Ed talked about, in June, he even -- we put in a dampening there in June on that. And so, that's really what's going on in our thinking that there's the potential for large upside and the potential for downsides that are hard for us to really quantify. And it's beyond our control at this point. I would say at a high level, business is very strong, as you can tell with the strong Q1 and I think a strong guide, albeit with a wider range in Q2. And Ed, do you want to talk about pricing with increased traffic?"
},
{
"speaker": "Ed McGowan",
"text": "Yes, sure. So, obviously, customers know one size fits all for customer pricing. But, what I would say is that typically we do have tiered pricing in most of our contracts, especially the ones with very large volume, so that as you do clip into new tiers, you do get typically a lower rate for that tier. But again, it does vary from customer-to-customer, but we do in most cases have some kind of a tiered pricing structure."
},
{
"speaker": "Brandon Nispel",
"text": "And I guess, just as a follow-up, you guys gave the travel hospitality exposure and sort of talked about live events, but could you give us what percentage of revenue is coming from what you would call SMB? Thanks."
},
{
"speaker": "Ed McGowan",
"text": "Oh, it's very small. Yes, we do very little with SMB. We have a couple of partners that work with SMB. Like, for example our carriers will sell some security offerings to small, medium business. It’s such a small part of our business. We have a few OVP partners and other partners. But, it’s not a significant part of our business at all."
},
{
"speaker": "Tom Barth",
"text": "Okay. Well, thank you, everyone. In closing, we will be presenting at several virtual investor conferences and events throughout the rest of the second quarter. Details of these can be found in the Investor Relations section of akamai.com. I want to thank you for joining us. And all of us at Akamai wish you continued health, and I wish you a very nice evening. So, thank you."
},
{
"speaker": "Operator",
"text": "Ladies and gentlemen, this concludes today's conference call. Thank you for participating. You may now disconnect."
}
] | Akamai Technologies, Inc. | 24,522 |
AKAM | 4 | 2,021 | 2022-02-15 16:30:00 | Operator: Good day and thank you for standing by. Welcome to the Fourth Quarter 2021 Akamai Technologies Earnings and Acquisition of Linode Conference Call. [Operator Instructions] Please be advised today's conference may be recorded. [Operator Instructions] I'd now like to hand the conference over to Tom Barth, Head of Investor Relations. Please go ahead.
Tom Barth: Thank you, operator. Good afternoon, everyone, and thank you for joining Akamai's Fourth Quarter 2021 and Acquisition of Linode Conference Call. Before we get started with the Linode acquisition that we just announced, today's earnings call format will be a bit different than normal. We will be presenting slides and associated content, and the link to the webcast can be found in the Events section of our Investor Relations website. We plan to post the full slide deck following the call, and I am now on Slide 2. As you can see from our agenda, speaking today will be Tom Leighton, Akamai's Chief Executive Officer; Adam Karon, Akamai's Chief Operating Officer and General Manager of the Edge Technology Group; and Ed McGowan, Akamai's Chief Financial Officer. Moving to Slide 3. Please note that today's comments include forward-looking statements, including statements regarding revenue and earnings guidance. While I don’t intend to read this slide, these forward-looking statements are subject to risks and uncertainties and then involve a number of factors that could cause actual results to differ materially from those expressed or implied by such statements. These factors include uncertainty stemming from the COVID-19 pandemic, the integration of any acquisitions and any impact from unexpected geopolitical developments. Additional information concerning these factors is contained in Akamai's filings with the SEC, including our annual report on Form 10-K and quarterly reports on Form 10-Q. The forward-looking statements included in this call represent company's view on February 15, 2022. Akamai disclaims any obligation to update these statements to reflect future events or circumstances. As a reminder, we will be referring to some non-GAAP financial metrics during today's call. A detailed reconciliation of GAAP and non-GAAP metrics can be found under the financial portion of the Investor Relations section at akamai.com. And with that, let me turn the call over to Tom, and he'll start on Slide 4.
Tom Leighton: Thanks, Tom, and thank you all for joining us today. Today is a very exciting day for Akamai. This afternoon, we announced that we've signed a definitive agreement to acquire Linode. We see this as a tremendous opportunity for Akamai and we believe that it will be transformational as we expand our business into adjacent markets, become more strategic for our customers and accelerate our growth and evolution as a company. We'll talk more about Linode in a few minutes. But first, I'd like to review some of the highlights from a very strong Q4 and 2021. Turning to Slide 5. Q4 revenue was $905 million, up 7% year-over-year. Our revenue growth was driven by the continued strong demand for our security products as well as our fast-growing Edge applications business. Non-GAAP operating margin in Q4 was 31%, up 1 point over Q4 in 2020. Q4 non-GAAP EPS was $1.49 per diluted share, up 12% year-over-year. For the full year, revenue was $3.46 billion, up 8% over 2020. We expanded non-GAAP operating margin to 32% last year, and we achieved this result while investing for future growth. Non-GAAP EPS last year was $5.74, up 10% over 2020. 2021 was also a very strong year for cash generation at Akamai. We generated $859 million in free cash flow last year, an increase of 78% over 2020. I think it's important to note that our excellent cash generation has allowed us to make strategic acquisitions like Guardicore in Q4 and now Linode to fuel our future growth while also returning capital to shareholders. In Q4, we spent $271 million to buy back just over 2.4 million shares of stock. Over the course of the full year, we spent $522 million to buy back approximately 4.7 million shares. Our primary use of cash is for M&A and offsetting the dilution from our equity compensation programs. Over the past 10 years, Akamai has also engaged in opportunistic buybacks that have resulted in a reduction of our fully diluted share count by about 12%. Last quarter, security products continued their rapid growth, generating revenue of $365 million, up 23% year-over-year. For the full year, security revenue reached $1.33 billion and grew 26% over 2020. Security represented 39% of our revenue last year, up from 33% in 2020. In recent years, Akamai has built one of the world's leading cloud security businesses. Our security solutions are highly differentiated and recognized as best in class by our customers, who rely on Akamai to protect their most important digital assets from very determined and highly capable attackers. Results in Q4 were especially strong for our Bot Manager solution, which helps to defend against a wide range of automated attacks. Our new Account Protector solution, which provides account takeover protection, also performed very well in Q4 in only its second quarter of availability. Our web app firewall offerings also posted excellent results in Q4. And Akamai was recognized as a leader in Gartner's 2021 Magic Quadrant for web application and API protection, scoring the highest of 11 vendors in ability to execute. In October, we acquired Guardicore to extend our Zero Trust solutions to help stop the spread of ransomware. As a part of Akamai, Guardicore has continued its strong growth momentum and closed major deals last quarter at one of the largest freight railways in the U.S. and at one of the largest telecommunication companies in South America. We're very excited about the value that Guardicore's micro-segmentation capabilities bring to our customers. And as Ed will talk about shortly, we now believe that Guardicore will drive significantly more revenue this year than we'd initially forecast when we announced the transaction last fall. Our CDN business generated revenue of $541 million in Q4, down 2% from Q4 in 2020. Traffic on our platform continued to be strong in Q4, peaking at over 200 terabits per second. Our Edge application solutions had a great Q4, exiting the year with an annualized revenue run rate of more than $200 million and growing 30% for the full year. Our Akamai EdgeWorkers solution was adopted by a top sporting equipment company, a global business travel service and one of the largest banks in the U.S. Overall, we're very pleased with our performance last year on both the top and bottom lines. We achieved our goals in 2021 and then some. And I want to thank our employees for delivering such strong results as they continue to cope with the challenges of the pandemic. I'll now move on to Slide 6. As many of you know, Akamai's mission is to power and protect life online. And our purpose in dong that is to make life better for billions of people, billions of times a day. Akamai has been doing this for more than 20 years, enabled in part by a series of market-defining innovations, starting with the invention of content delivery networks in the late 1990s. As you can see on the next slide, #7, we follow this breakthrough in Internet technology with fundamental advances in video streaming, application acceleration and web security. In each of these areas, Akamai was a major pioneer in enabling new capabilities. And in each of these areas, we're still the market leader today by far. Throughout the past 20 years, we've also been a pioneer and a leader in edge computing, beginning with the invention of Edge Side Includes in the early 2000s, a technology that's still used by thousands of our customers today. And now turning to Slide 8. We're taking the next major step in our evolution by creating the world's most distributed compute platform from cloud to edge, making it easier for developers and businesses to build, run and secure their applications online. As you can see in this afternoon's press release, we've entered into a definitive agreement to acquire Linode, it’s a privately held company that makes cloud computing simple, affordable and accessible. Linode is known for its developer-friendly services, the quality of their support and as a trusted Infrastructure-as a-Service platform provider. By combining Linode's developer-centric cloud advantages with Akamai's deep enterprise strengths, we believe that we can provide tremendous value to developers and enterprises as they build cloud applications on Akamai. We see plenty of opportunity for a differentiated offering among customers who desire ease of use, wider reach beyond just a few POPs, lower latency, stronger security and greater resiliency, all from a single platform and all at an affordable price point. Akamai's highly distributed edge platform has the global reach to enable any cloud application to deliver the best end-user experience anywhere that users or services consume apps, from the cloud to the edge, where more compute services will live as 5G and IoT take hold and expand. The Akamai platform is uniquely suited for workloads that require high throughput, low latency and instant scalability on demand. Akamai has been perfecting this capability for many years, and it's very hard to do. Akamai also has the capabilities needed to integrate seamlessly with both DIY cloud apps and third-party cloud vendors as part of the larger cloud ecosystem. We believe that this flexibility will appeal to enterprises that want a multi-vendor cloud strategy to mitigate their vendor concentration risk and to ensure resiliency and seamless availability in case one vendor service experiences an outage. And with Akamai's category-leading security solutions, customers will be able to secure their apps from their point of origin to the edge, all under Akamai's protective umbrella. Security delivered at the edge offers unique advantages since it enables customers to manage security policies across all their apps and infrastructure wherever they're located. We believe that such an end-to-end security approach will appeal to customers who want increased efficiency and greater resiliency along with lower security risk. The net of all this is that we believe that Akamai and Linode can solve customers' needs in ways that are not addressed in the market today, forming a powerful winning combination that will enable customers to build, deliver and secure their apps on the platform that powers and protects life online. Moving to Slide 9. We see the acquisition of Linode as a transformational opportunity for Akamai. This slide shows the way that we presented our business at our Investor Day last year. With Linode, Akamai will expand beyond security and delivery into the world's most distributed cloud services provider with leading solutions for security, delivery and compute, as shown here on Slide 10. We'll offer customers a breadth and depth of services uncommon in the cloud space today, a massive content delivery platform, the best application performance, easy-to-use cloud and edge compute and category-leading security solutions, all backed by expert services and support professionals to help power and protect life online. Given that we're announcing this acquisition at the same time as our earnings, I thought it would be helpful to have Adam Karon join us on the call today to talk more about Linode. Adam is our COO, and he's responsible for running our compute and delivery businesses. Later this year, we'll also plan to hold an Investor Day, when you'll be able to hear from Mani Sundaram, who leads our security business, as well as from other Akamai executives. After Adam speaks, Ed will cover the financial aspects of the acquisition and provide our outlook for 2022. Adam?
Adam Karon: Thanks, Tom. I'll start on Slide 12. Tom just spoke about the 3 core product pillars we have at Akamai: security, delivery and compute. I’m going focus a bit deeper into the compute portfolio and what we think it will look like after the integration of Linode. Turning to Slide 13. I'll start with the existing Linode product portfolio, which is split into 4 product groupings, the first being compute, which has offerings like dedicated and shared CPUs, BareMetal, GPUs and Kubernetes; the next being storage, which provides services like block storage, object storage and a managed database service in beta; next, cloud orchestration; and finally, an award-winning set of developer tools that make it really easy for developers to use their platform. Their products are sold in traditional cloud models using online trials and online purchases. Turning to Slide 14. After the acquisition closes, the Akamai compute product portfolio we envision would consist of 5 product groupings: the first being compute inherited from Linode, containing shared and dedicated CPUs, GPUs, Kubernetes; storage, which would contain the block and object storage that came from Linode but would also now include Akamai's net storage; we have cloud optimization that would include Akamai's Global Traffic Manager, Cloud Wrapper and Direct Connect solutions; next, the developer tools we get from Linode as well as the existing Akamai developer tools now make the Akamai compute platform easy and accessible to developers all over the world; and last, but certainly not least, our Edge applications, which contain our EdgeWorkers and EdgeKV products that execute compute right at our edge. It will also include our Cloudlet's image and video manager and, of course, our API acceleration product. One of the exciting synergies would be in go-to-market. Akamai's compute products would not only be sold online, but because our current globally located enterprise sales force works closely with the buyers for cloud compute, they have the right relationships, and we would not need to create an overlay sales force. Another exciting go-to-market synergy would be our existing robust and global channel ecosystem that could also take these cloud compute offerings to market. And in both cases, new wallet share within the customer base could be open for future growth. Turning to Slide 15. Now let's talk about how we think about compute. Now computing at the edge or near end users and devices brings unique benefits for critical use cases that are in many locations and where data is in motion or ephemeral, whereas computing in the cloud brings other benefits that are usually for applications running in a smaller number of locations and where data is stored and persistent. Our combined platform would have both edge and cloud computing. And since modern applications are built as a collection of services, each with differing compute needs and data needs, only by combining the edge and cloud can we fulfill the varied needs of our customer base like data localization and low-latency containerized compute as well as more typical compute needs that are persistent and in fewer locations. The unique capabilities can come together when we are able to combine Akamai's Edge platform with Linode's cloud computing capabilities and then add in our Global Traffic Manager product to route across multiple clouds and cloud locations our global large private network that efficiently connects cloud and edge locations and messaging, bringing it all together, coordinating cloud and edge services. You end up with the world's most distributed compute platform from cloud to edge making it easier for developers and businesses to build, run and secure applications. Now on Slide 16. While Linode and Akamai can solve a number of customer use cases separately, I thought it would be useful to cover just a few examples of the use cases we believe we can help fulfill for our customers with this unique combination of products. In the sports vertical, you could imagine a sports league could leverage the new Akamai platform to deploy WebRTC services to enable a watch-along app that allows a group of friends to watch a game in sync while communicating with each other in real time. And they would be able to do that using our distributed VMs, load balancing and high-throughput egress. When you think of IoT and fleet management, you could see a shipping company building a distributed app to collect and parts video and telemetry data from trucks and route before backhauling the data to their data warehouse. And they'd be able to do that using our support of MQTT, our distributed VMs and direct connect capabilities. An e-commerce site can leverage Akamai to dynamically personalize their site based on the user's previous and current browsing activity without having to go back to their data lake, all using our managed database services, Kubernetes and Functions as a Service. In the metaverse, we can help create a persistent virtual experience when a game studio needs to connect users from across the globe in a fully immersive VR experience from any console, mobile device or browser, all using our distributed GPUs, low-latency and private backbone. And in health care, a hospital could leverage Akamai to create a platform that captures and archives videos of surgical procedures to help train doctors on new and emerging techniques using Bare Metal and our Object Storage. Now turning to Slide 17. The combination of Akamai and Linode can be a truly unique offering in the market. We plan to combine the ease of use and developer-friendliness Linode is known for with the wider reach, lower latency, strong security and greater resiliency that are Akamai's hallmarks. We expect our new combined offering to appeal to developers by offering core cloud compute functionality, ease of use and tools they need appeal to enterprises with security, uptime and reliability and drive future use cases as new applications can take advantage of the throughput performance and distribution of a market-leading global network. Turning to Slide 18. So with Akamai and Linode, we can have highly secure, elastic compute along with storage capabilities on the world's largest edge network, category-leading security, an edge computing platform for latency-sensitive workloads, all on Akamai's large global private network with a globally located enterprise sales force and robust channel ecosystem, all setting us up to win in the marketplace. And now I'll pass it to Ed to discuss the transaction details.
Ed McGowan: Thank you, Adam. I will start my remarks with brief highlights of our very strong Q4 results, then provide some insight into the financial aspects of the Linode acquisition and then close with our Q1 and full year 2022 guidance. So moving to Slide 20. Starting with the Q4 highlights. We are very pleased with our strong Q4 results, capping off an excellent year for Akamai. Q4 revenue was $905 million, up 7% year-over-year or 8% in constant currency. Revenue was led by another quarter of very strong growth in security as well as strength in our edge applications business. Security revenue growth in Q4 was 23% year-over-year or 25% in constant currency, with Guardicore contributing revenue of approximately $10 million. We are very pleased with the initial momentum we've seen from Guardicore as well as the continued growth of the pipeline. It is also worth noting that our Edge Applications business surpassed a $200 million annual revenue run rate in Q4 and grew 30% for the full year in 2021. International revenue growth was another bright spot with revenue increasing 13% year-over-year or 16% in constant currency. Sales in our international markets represented 47% of total revenue in Q4, up 2 points from Q4 2020. These strong results were despite foreign exchange fluctuations, which had a negative impact [Technical Difficulty] basis and negative $10 million on a year-over-year basis. Non-GAAP net income was $243 million or $1.49 of earnings per diluted share, up 12% year-over-year, up 14% in constant currency and $0.05 above the high end of our guidance range. Finally, as Tom mentioned, we had an exceptional year from a cash flow perspective. Moving to capital deployment. During the fourth quarter, we spent approximately $271 million to buy back approximately 2.4 million shares. Our intention is to continue to buy back shares to offset dilution from employee equity programs over time and to be opportunistic, both M&A and share repurchases. Turning now to Linode on Slide 21. As you heard from Tom and Adam, we believe the combination of Akamai and Linode will create the world's most distributed platform for developers and businesses to build, run and secure their applications. Under the terms of the agreement, Akamai has agreed to acquire Linode in exchange for approximately $900 million of cash. The transaction will be treated as an asset purchase for tax purposes. And as a result, we anticipate significant cash income tax savings over the next 15 years. While this benefit will not impact our non-GAAP effective tax rate, we estimate the present value of these savings to be approximately $120 million. Turning to Slide 22. We believe that Linode currently has a very attractive financial profile and that there are considerable revenue and cost synergy opportunities in the future. Assuming a late Q1 close, in 2022, we expect the acquisition to: add revenue of approximately $100 million, have no material impact to our non-GAAP operating margin and be accretive to non-GAAP EPS by $0.05 to $0.06 per share. Looking beyond this year, we expect Linode to be additive to our non-GAAP operating margin as we continue to capitalize on revenue and cost synergies, including leveraging our go-to-market channel and marketing organizations to accelerate revenue from enterprise customers, realizing significant cost savings by utilizing our very large global private network that Adam previously talked about as well as leveraging our significant scale and supply chain along with our network deployment expertise. From a CapEx perspective, we expect Linode to add approximately 2 points to CapEx as a percentage of revenue in 2022 as we plan to expand Linode's capacity and locations to meet anticipated customer demand. However, over the long term, we do not expect the acquisition to meaningfully change our previously communicated goal of CapEx being in the mid-teens as a percentage of revenue. Turning to Slide 23. As Tom and Adam previously mentioned, upon closing the acquisition, we plan to update our revenue reporting to reflect 3 separate business groups: security, delivery and compute. The first revenue grouping, security, will remain unchanged from the existing reporting of our Security Technologies Group. The second revenue group will be delivery. Delivery will be comprised of edge delivery and services portion of our existing ETG organization but will exclude our net storage and Edge application businesses that were previously included as part of ETG revenue. For context, our Edge applications business, which had revenue of approximately $196 million in 2021 and our net storage business, which had revenue of approximately $57 million in 2021, will move to our new compute business. The third and final revenue group will be called compute. Compute will include Linode, plus our Edge Applications and Net Storage businesses I just mentioned. We believe that with strong execution, we can deliver more than $500 million of annual compute revenue in 2023. Turning to Slide 24. Before I provide our Q1 and 2022 guidance, I wanted to highlight a couple of factors to consider for your models. First, the Q1 and full year 2022 guidance I am about to provide does not reflect the revenue and non-GAAP EPS contribution we anticipate from Linode that I previously mentioned, since the acquisition has not yet closed. We plan to update our full year guidance to include Linode on the first earnings conference call after the deal has closed. Second, international revenue now represents nearly half of our total revenue. And the dollar has continued to strengthen since we reported in early November. Therefore, we currently expect a meaningful foreign exchange headwind in 2022. At current spot rates, our guidance assumes that foreign exchange will have a negative $45 million impact on revenue on a year-over-year basis. Finally, similar to 2019, we have 8 of our top 10 customers renewing in the first half of the year. As a reminder, we define our top customers as anyone contributing revenue of 1% or more. And that customer -- that group of customers contributed approximately 19% of total revenue in 2021. Although we expect to see a negative impact to revenue growth in the near term, we expect to see incremental revenue over time as these customers' traffic grows with us. I'd also note that while the cluster timing of these renewals is unusual, the pricing, contract terms are consistent with the broader trends in the market, and these renewals have been factored into our guidance. So with all that in mind, turning to our Q1 guidance on Slide 25. We are projecting revenue in the range of $896 million to $910 million or up 6% to 8% as reported or 8% to 10% in constant currency over Q1 2021. Foreign exchange fluctuations are expected to have a negative $2 million impact on Q1 revenue compared to Q4 levels and a negative $17 million impact year-over-year. At these revenue levels, we expect cash gross margins of approximately 76%. Q1 non-GAAP operating expenses are projected to be $292 million to $296 million. We anticipate Q1 EBITDA margins of approximately 43%. We expect non-GAAP depreciation expense to be between $123 million to $124 million, and we expect non-GAAP operating margin of approximately 30% for Q1. Moving on to CapEx. We expect to spend approximately $120 million to $124 million, excluding equity compensation and capitalized interest in the first quarter. This represents approximately 13% to 14% of anticipated total revenue, which is down approximately 4 points from Q1 2021 levels. And with the overall revenue and spend configuration I just outlined, we expect Q1 non-GAAP EPS in the range of $1.39 to $1.43. This EPS guidance assumes guidance taxes of $38 million to $39 million based on an estimated quarterly non-GAAP tax rate of approximately 14.5%. It also reflects a fully diluted share count of approximately 162 million shares. Moving to Slide 26. Looking ahead to the full year, we expect revenue of $3.673 billion to $3.728 billion, which is up 6% to 8% year over year as reported or 7% to 9% in constant currency. We security revenue growth to be at least 20% for the full year 2022. This includes an expected Guardicore contribution of approximately $50 million to $55 million. We are estimating non-GAAP operating margin of approximately 29% to 30% and non-GAAP earnings per diluted share of $5.82 to $5.97. And this non-GAAP earnings guidance is based on a non-GAAP effective tax rate of approximately 14.5%, a fully diluted share count of approximately 162 million shares. Finally, full year CapEx is anticipated to be approximately 13% to 14% of revenue. In closing, we are very pleased with our 2021 performance and are excited to close on Linode and help customers build, run and secure their applications. Now I'd like to turn the call back over to Tom to say a few words before we take your questions. Tom?
Tom Leighton: Thanks, Ed. I'll wrap up now on Slide 28. As I mentioned earlier, Akamai has had a rich and exciting history of innovation that has fundamentally enabled the Internet to provide enormous benefit to billions of people around the world. We are truly making life better for billions of people, billions of times a day. As incredible as Akamai's contributions to the Internet have been, I want you to know that I couldn't be more excited about Akamai's potential for the future as we expand our business with Linode and Guardicore, provide even greater value for our customers and shareholders and make life even better for Internet users everywhere. Ed, Adam and I will now be happy to take your questions.
Operator: [Operator Instructions] Our first question comes from Sterling Auty with JPMorgan.
Sterling Auty: I wondered if you could give us some context in terms of what kind of growth was Linode experiencing before the acquisition? And then when you talked about kind of 2023 and beyond, I want to make sure I understand that new compute area, the $500 million, what kind of growth rate do you expect out of that segment?
Ed McGowan: Sterling, this is Ed. Thanks for the question. So before the acquisition, they were growing at about 15%, give or take. The bigger customers were growing faster. And they were sort of containing their growth a bit. It was a very closely held company. So they were holding back a bit on their investment in go-to-market and their build-out. So obviously, that's one of the major synergies we bring. So we think we can accelerate that business pretty considerably. Now when I talked about the different components of the business, if you take the net storage business plus the edge applications business plus where Linode is, assume I talked about how we grew the edge applications business 30%. And if you remember back on Investor Day, that was our long-term target. Our net storage business, as it is today, is kind of a flattish business, kind of grows like the CDN. We expect that to obviously accelerate as we add new capabilities. And then the Linode business should accelerate quite a bit. So if you were to put those pieces together, and I talked about in '23 that I expected that we would be above $500 million in revenue, that sort of gets you to that 30% to 35% kind of growth rate in that business once you get through the acquisition.
Sterling Auty: Right. And then -- but given those pieces, would you expect that growth to be durable at that level or kind of settle back into more of a 15% to 20%, just so we understand the longer-term context? And that's all for me.
Ed McGowan: Yes. That's a great question, and I'll ask Adam to chime in a little bit here as well. Obviously, we're getting into a very, very big market. And what pushed us into this market was our customers. We were getting more and more requests for folks to -- continue to come with different use cases. Ourselves, we're spending quite a bit on third-party cloud today, whether it's through acquisitions or through IT projects. Just the overall growth of this market is so significant that we think there's certainly the market there to do that. I'll let Adam talk a little bit about some of these plans in terms of future integration and the growth prospects going forward. But it's quite possible that, that could be a durable growth rate going forward for that business.
Adam Karon: Yes. I agree, Ed. I think we see that market growing very rapidly outside of what Akamai had before, and we see that with our customers in demand of our edge applications and asking us for this type of cloud computing as well. So we do expect it to be durable as that market continues to grow quite rapidly.
Operator: Our next question comes from Keith Weiss with Morgan Stanley.
Keith Weiss: Maybe 2 questions. One on the Linode acquisition. I just want to kind of better understand kind of like the buy versus like a partner decision. Can you help us understand what's interesting about sort of buying this asset, what you could do owning sort of Linode versus partnering with Linode or other type of cloud computing platforms out there, number one? And then number two, for Ed, just in looking at FY '22 and the margins coming down. Nice margin performance in Q4 and all throughout 2021. Can you talk to us a little what's going to be pressuring margins into 2022?
Tom Leighton: Yes. By owning Linode, we can really scale up that business. We have a lot of expertise in network deployment and doing that in a cost-effective way to get enormous scale. Also, we've got a large enterprise sales force and a customer base that is hungry for us to bring them this kind of capability. We know how to make large-scale systems be reliable and perform well. And we can bring it all together as part of an end-to-end solution so that our customers can take their major applications, build them easily on Akamai, and that's where Linode comes in, run them. Of course, we have the world's largest and best content delivery platform to deliver it, and then wrap it all together under our security umbrella to make sure it stays secure. And so that's a compelling reason for us to make the acquisition here and provide the end-to-end service versus just partnering with the various cloud providers. Ed, do you want to take the margin question?
Ed McGowan: Yes. Sure, Keith. And just to add on that, if I just look at the financial profile of the business we just acquired, think about getting up to that sort of scale of revenue, the type of investment you need to make, how long it will take you to get there. It's rare that you find companies that have profitability margins like we do. So to be able to bolt that on, it's immediately accretive, gets us to market much faster, there's a brilliance to the simplicity in terms of how they approach and how simple it is to use their system. That's an expertise that we're acquiring as well. So there's a lot to like about that. Now in terms of the margins. So there's a couple of things going on there. One of the points that I made in my prepared remarks was about foreign exchange. That's a big headwind for us, and we're very profitable outside the U.S. So that does put a little bit of pressure on margins for us. But also, we're making investments. And keep in mind, you have the full Guardicore business. We only had about 2 -- a little over 2 months in the first -- in the fourth quarter. So in the first quarter, we have full Guardicore and we -- cost in the business. And you've got, in the middle of the year is when we do our merit increase. That said, 2 things to point out. Number one, we're going to be -- I said we do about 30% in Q1. We've done very well managing costs. And then we also told you when we did the acquisition of Guardicore that in '23, we'd expect to get above 30% margins again. So will it be expanding margins? Might be slightly under 30% this year. As I said, somewhere between 29% and 30%, but we anticipate to get back above that in '23.
Operator: Our next question comes from James Breen with William Blair.
James Breen: Just looking at the Edge Technology Group, growth this year has been flattish off of some pretty high numbers from 2020 as a result of the pandemic. As you think about that going forward and with some of the repricing this year, can you just talk about some of the puts and takes relative to repricing some of those contracts as well as some of the sectors that were hit most by the pandemic potentially improving?
Ed McGowan: This is Ed. I'll take that one. So yes, as far as the renewals go, as we've talked in the past, whenever we have a combination of renewals, we'll always call it out for you guys. Here's what I would expect with that group of customers: typical renewal pricing, nothing unusual in terms of anything in the market to call out there. I'd expect that group of customers to decline a bit in Q1, decline a bit in Q2 because like about half of the renewals already done. I got about half coming up here in April. And then I would expect that revenue to start to grow again. It's pretty typical of what you see in the CDN business when you have a cluster of renewals. Now those customers have varying contracts. Some of them are 1 year, some of them are 2, some of them are 3, and some of them have revenue commitments that will be used up before the contract is over. So it's very unusual to have this sort of a cluster. So that will put some pressure on growth here for the next couple of quarters, but then I expect that customer group to grow. They've been very busy buying up our security products, our compute product. I expect now they're great targets for the new acquisition we just picked up here. So I expect to expand the wallet share within those group of accounts. And this is just something that's pretty typical in the CDN business. And where we're seeing the pricing pressure is on the delivery side. We're not seeing it in the Security side, not seeing it at Edge. We're seeing it just in delivery. As far as the pandemic, we are starting to see a little bit of improvement in travel and hospitality. And as a reminder, that group was about 4% of our total revenue. I think that will sort of ebb and flow with how the pandemic goes. As we start to have these waves of new variants, travel slows down, as it goes away, travel picks up. Retail is still a bit sluggish, not really seeing a significant improvement. And just remember, we had set up a 0 overage, and the biggest acquirers of that type of contract are the retailers, especially in the U.S. So you see a little bit of a muted seasonality here in Q4 related to retail. But still some way to go here on retail. Travel is improving a bit. And in general, as we get past these renewals, you'll start to see the delivery business improve a bit.
Operator: Our next question comes from Colby Syneseal with Cowen.
Michael Elias: This is Michael on for Colby. Two questions, if I may. First, following this acquisition, you also did Guardicore. How would you describe the appetite for additional M&A? And as part of that, how does this acquisition impact the way that you're thinking about additional buybacks? I thought there was a pretty notable step up in the fourth quarter. And then on one other question, if I can squeeze it in. With this acquisition, $100 million of revenue coming in and you talked about 15% growth that seems durable, how does this change the way you're thinking about the long-term revenue growth profile for the company?
Tom Leighton: Yes. Good questions. Obviously, we've done 2 large deals, the largest deals we've done in about 20 years over the last several months. I wouldn't expect to see us continue at that rate, certainly. We probably will do more tech tuck-ins and smaller acquisitions. In terms of the buyback, our primary use of cash is for M&A and to buy back equity to offset the dilution from compensation programs. Now as I mentioned, that said, we do also opportunistically buy back additional stock. And if you look over the last 10 years, it's averaged a little more than 1% a year. And so I think our general approach to use of capital is not changing here. Just we saw 2 exceptional opportunities, first with Guardicore and now with Linode. Guardicore really is a huge boost to our enterprise security business, Zero Trust capabilities. We believe they have the best solution to stop the impact of ransomware. And that's a huge, huge deal. And you see that in the improved guidance we've given. And just we closed the deal a few months ago, and we're looking at this year then of doing $30 million to $35 million and now, as you heard from Ed, substantially more than that. And I can tell you from talking to many of our customers, many of the world's major banks, they are very interested in what Guardicore can do, both the visibility it gives customers into their own networks and the ability to mitigate the impacts of ransomware. Now in terms of the durability of revenue growth from Linode, in the past, they were doing 15%. I think Ed and Adam talked about, we think we can do a lot more than that. Just consider that Linode doesn't really have a sales force, never mind a sales force like Akamai has going after major enterprises. And you combine that with the fact that our major enterprise customers have wanted us to have this capability for them. So we think we can really accelerate their growth and that it could well be that the 30% is sustainable. We're certainly going to try to do that. And if we're successful there, you can see Akamai as a whole back in double-digit revenue growth on a more sustainable basis, and that's certainly our goal.
Operator: Next question comes from James Fish with Piper Sandler.
James Fish: So curious, grew 22% -- actually, I'm sorry, 25% constant currency. But seem like new business slowed and the normalized security number was slightly down versus last quarter. So really, why aren't we growing faster in the segment when the market has come directly towards SASE, and it's been as healthy of a security market as we've probably seen since 2014. And have we seen a pickup at all in selling security outside of the existing CDN installed base? And just was squeezing in another one here, but what was the growth of our annual customer metrics you guys typically give in Q4 regarding the individual products and subsegments like in access control?
Tom Leighton: I'll start with that and then hand it over to Ed. We're very pleased to see our security business grow 25% in constant currency. You talk about SASE, and that is a very small portion of our business today. In fact, SASE technically wouldn't even include micro-segmentation. I would imagine that's going to change in the near future because it's so important and it's going to become a requirement, I believe, for many of the world's major enterprises, certainly in the financial vertical. So the SASE framework is a small amount of Akamai revenue. And with Guardicore growing rapidly, the vast majority of our security revenue is the web security area, where we're protecting, think of it as B2C apps, from denial of service, from content corruption, from account theft, from data exfiltration, those kinds of attacks, which technically isn't part of the SASE framework. And so what you would think of is maybe more towards a SASE. We're getting very good growth on a small number. And of course the lion’s share of our security business is in the web security, API protection, where we're the market leaders and growing at a very fast clip on a good size number for us. And Ed, maybe you want to take the rest of the question.
Ed McGowan: Yes. So Jim, we don't break this out every quarter, but I'll just go back to the IR Day. We set targets for application security, network security and security services. And as a reminder, those goals were for application security, 20% to 25%, 20% to 25% in network security and then security services of 10% to 15%. I can tell you that we achieved all of those and exceeded, in many cases, those metrics. Are there any other metrics that you were looking for? I think you mentioned something about customers?
James Fish: Yes. I mean we used to kind of talk about penetration of number of customers that are on your WAF solution at this point. And I thought at the Analyst Day, we were going to get the annual update on those subsegments. Maybe you're saving that for the Analyst Day.
Ed McGowan: Yes. That's what we're going to do. On Analyst Day, we'll have a deep dive on that. What I'll do is I'll provide -- I provided this metric before in terms of the number of customers that buy a security product, that's up to 68.5%. So that's up about 6% year-over-year. 2 or more is up to 34.5%. That's up about 3%. 3 or more is up to 20%. And we increased our customer base by about 6% for the year. Our total customer base is up about 6%. Security penetration is up about 6% year-over-year.
James Fish: Helpful. If I can squeeze in one more. One now, we've heard on some of the smaller developer-focused solutions like Linode is that organizations tend to kind of graduate from these solutions to an AWS or Azure. What investments are you looking to make or event this sort of graduation and make it more enterprise-grade for the Akamai installed base? Or is it more about taking Akamai downmarket and be that developer focus that we've been looking for?
Tom Leighton: I'll hand this over to Adam in just a minute, but we're interested in the developer base for sure because our large enterprise customers, their apps are built and, in many cases, managed by the developers. So we really care about a developer-friendly solution. But we are going to take this to our large enterprise customers. And Adam has a robust road map of added capabilities. And Adam, why don't you talk a little bit about that?
Adam Karon: Sure, Tom. I think Tom mentioned earlier, our -- some of our expertise is just building and deploying larger network presence all over the globe. So that would be our first area to go and make those locations that Linode has just more robust and available to our customers. But building in things like availability zones, BPC, identity access management and then building in compliance like SOC2 and PCI are really on the core parts of our road map so that customers can not only bring their apps onto the platform but graduate and continue to grow and scale globally as they build, run and secure the application right on the Akamai platform.
Tom Leighton: And I just would add, our customers have been pretty explicit with us that they are very interested in us having this capability. And putting it together with the world's best content delivery capabilities, the world's best application performance and the world's best security solutions to provide an end-to-end solution. So I think you will not see this be a situation where they migrate from, say, a Linode to a Hyperscaler. But our customers are interested in alternatives and end-to-end solutions that -- maybe there are some functions on hyperscalers today that I think would migrate to Akamai's new cloud platform. We'll be the world's most distributed cloud platform with now market-leading solutions in not just delivery and security but also compute.
Operator: Our next question comes from Rishi Jaluria with RBC.
Rishi Jaluria: Just 2. One on Linode and maybe an inverse of the last question. Obviously, they have a great traction of Akamai to cross-sell into that Linode base. You're obviously very, very strong in the larger enterprises with both security as well as the core delivery and Edge Applications business. Can you talk about your ability to actually take some of your more enterprise-grade products and actually sell them successfully downmarket once the Linode acquisition closes? And then I wanted to drill a little bit more into Q4 and what you saw from the e-commerce season. I know you talked a little bit about retail bounce-back being sluggish. But I know when we were on this call 3 months ago, one of the concerns was just with supply seeing concerns and the tough comps, e-commerce was going to be a little bit challenged in Q4. Just wanted to get a sense for what did you see specifically on the e-commerce side in Q4.
Tom Leighton: I'll take the first question. Ed will take the second. Yes, we certainly can cross-sell into the Linode base. That's not our primary objective here. The primary objective is to take Linode and really scale that up and sell it into the large enterprise base. I think that's far more lucrative for us than taking our existing solutions and selling into the large number of small customers. And the focus will be moving Linode's capabilities into our platform and having a comprehensive solution for large enterprise customers. And Ed, you want to take the next one?
Ed McGowan: Yes. I got it. So Rishi, on the commerce, you're right, when we had the Q3 call, we did talk about sort of a variety of commerce. I would say that we pretty much landed where we expected. We didn't really bake in a ton of upside really for 2 reasons. One was just uncertainty around supply chain, people potentially ordering earlier in the year. But the bigger factor was around the 0 overage. We've been in market now for over 2 years, and we've got a pretty high penetration so that you don't see as much of a bursting in Q4 as you do from the commerce customers. And as I've said, it's been a mixed bag. Some companies are doing pretty well, some aren’t doing so great. So again, I'd say it's kind of as expected, but we weren't going in expecting a ton out of our retail vertical this Q4.
Operator: Our next question comes from Fatima Boolani with Citi.
Fatima Boolani: Maybe a jump ball for you all just with respect to some of the new revenue classifications that we're going to be expecting in the next couple of months here. As I think back to your last Analyst Day, what was certainly helpful for us is to get a sense of what type of traffic mix you're expecting in the delivery franchise. So I'm curious with Linode in the family or soon to be, how you expect that mix of traffic to change relative to some of your expectations within the long and medium-term guide. And then I had a quick follow-up, if I could.
Tom Leighton: Well, the traffic measured by bytes delivered is 95-plus percent big media and software downloads, gaming downloads. That's the vast majority of the traffic. That won't change with Linode. In fact, I would expect we'd be selling compute services to those same big media customers. In fact, several of them have expressed interest in that capability. So Linode won't change our traffic mix. And when we get together at IR Day, we'll do the deep dive in each of these categories to get a better feel of how the revenue is breaking down.
Fatima Boolani: That's very helpful. And for Ed, I wanted to talk a little bit about the margin upside in the quarter. With the media business having some nice outperformance, we were still able to see a nice leverage fall through the model. So I'm just curious if you can walk us through some of the puts and takes within the cost-control elements of the business in the quarter. That would be helpful.
Ed McGowan: Yes. Sure. Good question. So a couple of things to note on that. One is just a mix issue. So we obviously had a strong security quarter. I did a little bit better on security. So that drives very high incremental margins in the business. The other thing on the cost of goods sold line, the margins came in on the gross margin line a little bit better. Team has done a phenomenal job on driving down our bandwidth costs. As I look out towards next year, we expect traffic to grow sort of at normal rates. And my bandwidth costs are not really going up very much. So able to drive down bandwidth costs, that would be the big thing. We're getting good efficiencies, starting to see CapEx come down quite a bit. We won't see the depreciation fall off. You have to get a peak in, say, the next 1.5 years or so, then it will start to come off. But just around the -- around all the different organizations, which is doing -- really focused on efficiency. And we've seen good flow through when we get a little bit of a revenue upside.
Operator: Our next question comes from Alex Henderson with Needham & Company.
AlexHenderson: I was hoping we could talk a little bit about the architecture that you're anticipating as we go forward, whether you're planning on integrating the platforms at the Edge or whether you're -- as described in the slide deck, whether the Linode nodes are, in fact, relatively separate from your edge compute platform. Do you anticipate moving to a single software stack within each node? Or will these be separate nodes in that context?
Tom Leighton: I'll start with that and then turn it over to Adam. You want to think of Akamai's platform is hierarchical. There's a core where functions such as storage would live, where there's dozens of locations for archive storage, migrating out all the way to the edge, where there's 4,000 PoPs, where most of our capabilities live today. Something else that's closer to the core in dozens of locations would be the Prolexic service. But things like delivering video, delivering software, accelerating your bank statement and most of all, the security other than Prolexic all live on the very edge out in 4,000 locations. EdgeWorkers lives out there too. EdgeKV lives out there. And Linode starts in the core in 11 locations, and we'll be expanding that quite a bit, and it will all be integrated together as part of one hierarchical platform. And then maybe, Adam, you could get a little bit deeper into that in terms of the software stack and so forth.
Adam Karon: Yes. I think you covered most of it, but I think the way you can think about it is that the Linode stack itself can be segmented into multiple components. Just like Tom just described, you might have storage or databases that might exist closer to the core. And as you have more ephemeral-type instantiations of applications, you push those components further out towards our edge, ultimately culminating in our deep edge, where you'd have our Chrome V8 engines that can be instantiated on demand right on the edge itself. So that's our EdgeWorkers solution. But you can see kind of a Linode kind of stack like spanning the entire span and what Tom just described as the core all the way out to the edge.
Alex Henderson: If I could follow up. You talked about the coder-centric capabilities of Linode. Can you talk about the degree to which coders are riding to this platform? And for that matter, to the Akamai platform, how many coders do you have right into your platform at this point?
Tom Leighton: Adam, why don't you take that one?
Adam Karon: Yes. On the Linode platform, they have over 150,000 customers today on their platform writing and deploying applications. On our -- was that the question?
Alex Henderson: The degree to which the coders are writing to the platform, yes. I suppose they're not necessarily customers. I assume that customers have to do some writing.
Adam Karon: The customers -- yes, they're primarily developers, which is 1 of the reasons for the benefit of bringing the developer-centric community that Linode brings to the Akamai community. And then those developers, as Tom described, a lot of them are the decision-makers inside of our enterprise customer base developing and deploying and, in some cases, managing those applications. And thus, that developer community becomes appealing -- appeals through those enterprise customers right back to Akamai. So it's kind of a great system that they have.
Alex Henderson: Can you give us the Akamai-related data point relative to how many coders are writing to your edge compute capabilities?
Adam Karon: I don't think I have that stat on hand right now.
Operator: Our next question comes from Tim Horan with Oppenheimer.
TimHoran: Will it take much investment to consolidate any of the great Linode both from a software and hardware perspective? And will you be operating on relatively similar hardware? And I guess same thing for the go-to-market strategy and I guess, customer care just a little bit about the overall investment. And then I just had a quick follow-up.
Tom Leighton: Sure. So we are looking at the ways we can drive synergy between the hardware that the Linode platform runs on today and the Akamai platform. And you can imagine, we have a significant deep expertise in our network group and hardware engineering organizations that spend all of their time optimizing for that, which gives us our great COGS and Capex benefits inside of Akamai. So we'll look to do that as we integrate Linode. And then can you repeat the second half of the question? I think it was on go-to-market?
Tim Horan: Yes. Just same thing for like customer care and go-to-market? Will you have to invest much to integrate?
Adam Karon: Yes. No, the great thing about the platform is it is very self-service, very frictionless for developers to come on board. They have amazing documentation that make developers use of their platform easy. And they have a great customer care group inside of Linode that we've worked very closely with our -- and build up to the signing of this. And so we expect to have them operate more as a Tier 2 to our existing Akamai customer care organization. And of course, our existing enterprise sales force will be the sales force that goes to market, selling those products along with their existing self-service model they have today.
Tim Horan: And you mentioned you have a very large network, obviously. Do you think you can get into the enterprise private line or global WAN market or just overall enterprise network indirectly?
Adam Karon: Well, can you ask -- I think in terms of enterprise win or whatnot, we do partner very closely with our telco partners, and that's something that we work very closely with them when they have opportunities. We use our network in combination with theirs, where it makes synergy with those customers that want to use both our telco partners and Akamai. I'm not sure if that's what you were getting at or something that --
Tom Leighton: Think of Akamai as providing Internet connectivity to enterprises. That's not our business. We -- that's our partners' business. Now we do provide clean access so that an enterprise can sort of hide behind Akamai. And only Akamai can come through so that they maintain safety and security for their data centers. So we do that, but we're not -- we don't provide base connectivity. That would be our partners, which would be the carriers.
Operator: Our next question comes from Franklin Louthan with Raymond James.
Franklin Louthan: You mentioned earlier bringing scale to the business here. And I'm just curious what the strategy is for bringing scale to compete increasingly with large cloud companies that have some of the biggest scale in the world. And why the strategic decision to move in that direction and not bolster more of the security or the core CDN business?
Tom Leighton: Yes. When you think of scale, there's a it. One is just how many servers do you have. Obviously, we have a lot. But the way we think about scale is more in terms of being distributed. And none of the hyperscalers come anywhere close to us in terms of being in 4,000 PoPs and having a real edge network. Now what we haven't had before is the managed VM, managed container services. And our customers have asked for that. That's been the one missing piece on our platform. Because customers for many of their apps would like to take the entire app, build it on Akamai, run it on Akamai, deliver it through us, where they know they get fabulous performance, instant scalability, where it becomes relevant to do so to have the edge computing really done on the edge and then to have it all be secure so that we can provide the end-to-end service. And so that's why we're doing this. And in some cases, there may be some -- of course, we've been competing with the hyperscalers for 15 years, and I think that will continue. And I think the hyperscalers themselves, several of them are our largest customers. And several of them are already using us for our compute capabilities, and I expect that to increase with the acquisition of Linode. And so it's an environment where we compete, of course, have and for many years and successfully. And what we do, we do really well. And that will be taking an application, making it easy to build and deploy on Akamai and then to have the world's best performance, scalability, global reach and security. And that's where Akamai excels. And that's the goal in making this acquisition is really to complete that story to be able to have the end-to-end capability to handle their applications.
Adam Karon: Yes. And just to add, I think that -- I was going to -- this doesn't take away from our investment in security. And another way to think about it is you've now got 2 very exciting, fast-growing businesses inside of Akamai, led by 2 different leaders in the company. And the scale that we can bring -- turn the question around and think about if you're a $100-plus million company trying to scale to $1 billion, what would you need? You'd need an enterprise sales force. You'd need a global private network. You'd want to have a low-cost deployment model. You'd want to have access to customers and channel, and we bring all that. So this, to me, was a very natural adjacency for us. And I look at ourselves and what we're spending in third-party cloud, looking at bringing that in-house driving some additional synergies and savings there, it's just a natural extension of what we're doing and entering a really, really big, exciting market. And again, it doesn't take away from our ability to invest in security. As you saw, we did 2 very large acquisitions: one in security, one here in cloud. And we're very fortunate with our profitability and our cash flow generation to be able to do that.
Franklin Louthan: So is the end goal to be able to provide some of these cloud computing functions on yourself that would -- that the large cloud companies would white label? Or are you going to be providing aspects that they just can't do themselves in their larger server farm requirements?
Tom Leighton: I think both. There's things that we do today at a level that the hyperscalers don't do. I mean they have competing services, but in many cases, the hyperscalers use us and use our services for their own properties even though we compete with them. I do expect us to be partnering with, well, certainly many of the world's major carriers and white labeling our services. Of course, the carriers are major channel partners with us today, and I think that will increase through the acquisition of Linode because they've had an interest in being able to offer that kind of capability, and now it comes hand-in-hand with, well, the whole solution all put together.
Operator: Our next question comes from Rudy Kessinger with D.A. Davidson.
Rudy Kessinger: I want to go -- 2 things here. Starting off, going back to the customers that are going to have the repricing. You said basically declined in first half and then returned to growth in the second half. For the year in '22 over '21, what's your expectation for that group? Are they going to be slightly down or about breakeven on a growth basis?
Ed McGowan: Yes. Good question. So I would expect those customers to be slightly up year-over-year. So as you decline in the first 2 quarters, you start growing the back half. Now there's also significant upside with the Linode products as well. You can imagine these guys have -- they spend tons of money in this area. So there's a potential there that you could continue to grow that base of customers. So not expecting that this year, but it's possible that we could start to tap into that. Obviously, we're going to have to build a pipeline, get customers lined up, but that's obviously, certainly a very target-rich group of customers.
Rudy Kessinger: Got it. And then secondly, going back to Guardicore, a pretty substantial outperformance thus far. I think you said $10 million in the quarter. Initial expectation in Q4 was 6 to 7 and then obviously, 50 to 55 expected versus 30 to 35 originally. Just what's really driving that upside? What's really resonating well with this product, both with new customers and those that you're cross-selling?
Tom Leighton: Well, obviously, ransomware is a big problem. And we believe that Guardicore has the best solution. It is easier to use than competing solutions, and micro-segmentation has a reputation for being really hard to implement and inflexible. It gives you great visibility in terms of what's going on in your network. Customers have really appreciated that. It's really important with security. And they have a solution that works with legacy systems that the competition doesn't have. They have built their own custom firewall. And the competing services will have to rely on the existing firewalls and whatever operating systems being used by a particular application and, in some cases, doesn't even exist and so they can't cover it. So it's the best solution and to a big problem that's rapidly growing. And so we've seen very strong interest in our customer base. And of course, we have a very large enterprise sales force that now can bring Guardicore into the large banks and the large enterprises, and the initial reception has been very strong. So yes, I'm very excited by their performance this year, and I'm looking forward to substantial growth in the future.
Operator: This question comes from Jeff Van Rhee with Craig-Hallum.
JeffVan Rhee: So 2 quick ones for me. First, I guess, on the cross-sell back into your base of Linode product. How critical is it to win over the developers in your base? I mean, obviously, you've got the relationship. Maybe you can come in and try to make the cross-sell, but there's a lot of power sitting in those developers. What is it about these tools that the developers will see as their best option? And how do you win them over?
Tom Leighton: Adam, why don't you take that one?
Adam Karon: of the most attractive things to the Linode platform is that their developer-centric tools make it really easy for customers who use their Kubernetes engine, use their managed VMs. It's just very simple to configure. Onboard comes with a ton of documentation, makes it very simple for somebody to learn how to use, and Onboard themselves and try their applications very quickly on their platform. We heard from developers inside of our own company as well as developers inside of our customers that they love to use the Linode tools, they're simple, easy. And that's really why we think we're going to win over the developers using that type of platform, something that's simple, easy to use and has great documentation.
Jeff Van Rhee: Yes. And you may have missed it -- mentioned it. If I missed it, apologies, but in terms of the customer base, how many customers, what's an average spend per year for the Linode base? And any particular concentrations in the base from vertical or other segmentation that matters?
Adam Karon: So the Linode customer base is around 150,000 customers. We don't break them down like that, at least not yet. But we can tell you, I think Ed mentioned this earlier on the call, that the larger segment of their customer base is growing much faster than the very, very small developers. But we don't give out the ARPU yet on the customer base.
Ed McGowan: Yes. Just to add, there's no customer concentration risk in terms of any significant customers making up a large percentage of the revenue. And earlier, it was Adam who mentioned that from a go-to-market perspective, they didn't focus on selling into large enterprises. That's where we can bring in that synergy. So I would expect that over time, that customer base could change and look a lot more like our customer base. And obviously, that small developer base will just continue to grow as we continue to market and that sort of thing. But it also opens up opportunities in some of our underserved verticals that you think about the spend in certain places that may not have as large websites or web presence, but they're spending an awful lot in this area. So I do expect that customer base to change. When we get to Analyst Day, we'll try to break that down a little bit for you, give you some views in terms of how we're thinking about growth in the future. And then as we get some months under our belt of operating the company, as we come up with new metrics that we think are helpful, we'll obviously bring them to the table and disclose them for you.
Tom Barth: Okay. Well, thank you, everyone. In closing, we will be presenting at several investor conferences and road shows throughout the rest of the first quarter. Details of these can be found in the Investor Relations section of akamai.com. Thank you for joining us, and all of us here at Akamai wish you continued good health, and we wish you a happy evening. Thank you.
Operator: This concludes today's conference call. Thank you for participating. You may now disconnect. | [
{
"speaker": "Operator",
"text": "Good day and thank you for standing by. Welcome to the Fourth Quarter 2021 Akamai Technologies Earnings and Acquisition of Linode Conference Call. [Operator Instructions] Please be advised today's conference may be recorded. [Operator Instructions] I'd now like to hand the conference over to Tom Barth, Head of Investor Relations. Please go ahead."
},
{
"speaker": "Tom Barth",
"text": "Thank you, operator. Good afternoon, everyone, and thank you for joining Akamai's Fourth Quarter 2021 and Acquisition of Linode Conference Call. Before we get started with the Linode acquisition that we just announced, today's earnings call format will be a bit different than normal. We will be presenting slides and associated content, and the link to the webcast can be found in the Events section of our Investor Relations website. We plan to post the full slide deck following the call, and I am now on Slide 2. As you can see from our agenda, speaking today will be Tom Leighton, Akamai's Chief Executive Officer; Adam Karon, Akamai's Chief Operating Officer and General Manager of the Edge Technology Group; and Ed McGowan, Akamai's Chief Financial Officer. Moving to Slide 3. Please note that today's comments include forward-looking statements, including statements regarding revenue and earnings guidance. While I don’t intend to read this slide, these forward-looking statements are subject to risks and uncertainties and then involve a number of factors that could cause actual results to differ materially from those expressed or implied by such statements. These factors include uncertainty stemming from the COVID-19 pandemic, the integration of any acquisitions and any impact from unexpected geopolitical developments. Additional information concerning these factors is contained in Akamai's filings with the SEC, including our annual report on Form 10-K and quarterly reports on Form 10-Q. The forward-looking statements included in this call represent company's view on February 15, 2022. Akamai disclaims any obligation to update these statements to reflect future events or circumstances. As a reminder, we will be referring to some non-GAAP financial metrics during today's call. A detailed reconciliation of GAAP and non-GAAP metrics can be found under the financial portion of the Investor Relations section at akamai.com. And with that, let me turn the call over to Tom, and he'll start on Slide 4."
},
{
"speaker": "Tom Leighton",
"text": "Thanks, Tom, and thank you all for joining us today. Today is a very exciting day for Akamai. This afternoon, we announced that we've signed a definitive agreement to acquire Linode. We see this as a tremendous opportunity for Akamai and we believe that it will be transformational as we expand our business into adjacent markets, become more strategic for our customers and accelerate our growth and evolution as a company. We'll talk more about Linode in a few minutes. But first, I'd like to review some of the highlights from a very strong Q4 and 2021. Turning to Slide 5. Q4 revenue was $905 million, up 7% year-over-year. Our revenue growth was driven by the continued strong demand for our security products as well as our fast-growing Edge applications business. Non-GAAP operating margin in Q4 was 31%, up 1 point over Q4 in 2020. Q4 non-GAAP EPS was $1.49 per diluted share, up 12% year-over-year. For the full year, revenue was $3.46 billion, up 8% over 2020. We expanded non-GAAP operating margin to 32% last year, and we achieved this result while investing for future growth. Non-GAAP EPS last year was $5.74, up 10% over 2020. 2021 was also a very strong year for cash generation at Akamai. We generated $859 million in free cash flow last year, an increase of 78% over 2020. I think it's important to note that our excellent cash generation has allowed us to make strategic acquisitions like Guardicore in Q4 and now Linode to fuel our future growth while also returning capital to shareholders. In Q4, we spent $271 million to buy back just over 2.4 million shares of stock. Over the course of the full year, we spent $522 million to buy back approximately 4.7 million shares. Our primary use of cash is for M&A and offsetting the dilution from our equity compensation programs. Over the past 10 years, Akamai has also engaged in opportunistic buybacks that have resulted in a reduction of our fully diluted share count by about 12%. Last quarter, security products continued their rapid growth, generating revenue of $365 million, up 23% year-over-year. For the full year, security revenue reached $1.33 billion and grew 26% over 2020. Security represented 39% of our revenue last year, up from 33% in 2020. In recent years, Akamai has built one of the world's leading cloud security businesses. Our security solutions are highly differentiated and recognized as best in class by our customers, who rely on Akamai to protect their most important digital assets from very determined and highly capable attackers. Results in Q4 were especially strong for our Bot Manager solution, which helps to defend against a wide range of automated attacks. Our new Account Protector solution, which provides account takeover protection, also performed very well in Q4 in only its second quarter of availability. Our web app firewall offerings also posted excellent results in Q4. And Akamai was recognized as a leader in Gartner's 2021 Magic Quadrant for web application and API protection, scoring the highest of 11 vendors in ability to execute. In October, we acquired Guardicore to extend our Zero Trust solutions to help stop the spread of ransomware. As a part of Akamai, Guardicore has continued its strong growth momentum and closed major deals last quarter at one of the largest freight railways in the U.S. and at one of the largest telecommunication companies in South America. We're very excited about the value that Guardicore's micro-segmentation capabilities bring to our customers. And as Ed will talk about shortly, we now believe that Guardicore will drive significantly more revenue this year than we'd initially forecast when we announced the transaction last fall. Our CDN business generated revenue of $541 million in Q4, down 2% from Q4 in 2020. Traffic on our platform continued to be strong in Q4, peaking at over 200 terabits per second. Our Edge application solutions had a great Q4, exiting the year with an annualized revenue run rate of more than $200 million and growing 30% for the full year. Our Akamai EdgeWorkers solution was adopted by a top sporting equipment company, a global business travel service and one of the largest banks in the U.S. Overall, we're very pleased with our performance last year on both the top and bottom lines. We achieved our goals in 2021 and then some. And I want to thank our employees for delivering such strong results as they continue to cope with the challenges of the pandemic. I'll now move on to Slide 6. As many of you know, Akamai's mission is to power and protect life online. And our purpose in dong that is to make life better for billions of people, billions of times a day. Akamai has been doing this for more than 20 years, enabled in part by a series of market-defining innovations, starting with the invention of content delivery networks in the late 1990s. As you can see on the next slide, #7, we follow this breakthrough in Internet technology with fundamental advances in video streaming, application acceleration and web security. In each of these areas, Akamai was a major pioneer in enabling new capabilities. And in each of these areas, we're still the market leader today by far. Throughout the past 20 years, we've also been a pioneer and a leader in edge computing, beginning with the invention of Edge Side Includes in the early 2000s, a technology that's still used by thousands of our customers today. And now turning to Slide 8. We're taking the next major step in our evolution by creating the world's most distributed compute platform from cloud to edge, making it easier for developers and businesses to build, run and secure their applications online. As you can see in this afternoon's press release, we've entered into a definitive agreement to acquire Linode, it’s a privately held company that makes cloud computing simple, affordable and accessible. Linode is known for its developer-friendly services, the quality of their support and as a trusted Infrastructure-as a-Service platform provider. By combining Linode's developer-centric cloud advantages with Akamai's deep enterprise strengths, we believe that we can provide tremendous value to developers and enterprises as they build cloud applications on Akamai. We see plenty of opportunity for a differentiated offering among customers who desire ease of use, wider reach beyond just a few POPs, lower latency, stronger security and greater resiliency, all from a single platform and all at an affordable price point. Akamai's highly distributed edge platform has the global reach to enable any cloud application to deliver the best end-user experience anywhere that users or services consume apps, from the cloud to the edge, where more compute services will live as 5G and IoT take hold and expand. The Akamai platform is uniquely suited for workloads that require high throughput, low latency and instant scalability on demand. Akamai has been perfecting this capability for many years, and it's very hard to do. Akamai also has the capabilities needed to integrate seamlessly with both DIY cloud apps and third-party cloud vendors as part of the larger cloud ecosystem. We believe that this flexibility will appeal to enterprises that want a multi-vendor cloud strategy to mitigate their vendor concentration risk and to ensure resiliency and seamless availability in case one vendor service experiences an outage. And with Akamai's category-leading security solutions, customers will be able to secure their apps from their point of origin to the edge, all under Akamai's protective umbrella. Security delivered at the edge offers unique advantages since it enables customers to manage security policies across all their apps and infrastructure wherever they're located. We believe that such an end-to-end security approach will appeal to customers who want increased efficiency and greater resiliency along with lower security risk. The net of all this is that we believe that Akamai and Linode can solve customers' needs in ways that are not addressed in the market today, forming a powerful winning combination that will enable customers to build, deliver and secure their apps on the platform that powers and protects life online. Moving to Slide 9. We see the acquisition of Linode as a transformational opportunity for Akamai. This slide shows the way that we presented our business at our Investor Day last year. With Linode, Akamai will expand beyond security and delivery into the world's most distributed cloud services provider with leading solutions for security, delivery and compute, as shown here on Slide 10. We'll offer customers a breadth and depth of services uncommon in the cloud space today, a massive content delivery platform, the best application performance, easy-to-use cloud and edge compute and category-leading security solutions, all backed by expert services and support professionals to help power and protect life online. Given that we're announcing this acquisition at the same time as our earnings, I thought it would be helpful to have Adam Karon join us on the call today to talk more about Linode. Adam is our COO, and he's responsible for running our compute and delivery businesses. Later this year, we'll also plan to hold an Investor Day, when you'll be able to hear from Mani Sundaram, who leads our security business, as well as from other Akamai executives. After Adam speaks, Ed will cover the financial aspects of the acquisition and provide our outlook for 2022. Adam?"
},
{
"speaker": "Adam Karon",
"text": "Thanks, Tom. I'll start on Slide 12. Tom just spoke about the 3 core product pillars we have at Akamai: security, delivery and compute. I’m going focus a bit deeper into the compute portfolio and what we think it will look like after the integration of Linode. Turning to Slide 13. I'll start with the existing Linode product portfolio, which is split into 4 product groupings, the first being compute, which has offerings like dedicated and shared CPUs, BareMetal, GPUs and Kubernetes; the next being storage, which provides services like block storage, object storage and a managed database service in beta; next, cloud orchestration; and finally, an award-winning set of developer tools that make it really easy for developers to use their platform. Their products are sold in traditional cloud models using online trials and online purchases. Turning to Slide 14. After the acquisition closes, the Akamai compute product portfolio we envision would consist of 5 product groupings: the first being compute inherited from Linode, containing shared and dedicated CPUs, GPUs, Kubernetes; storage, which would contain the block and object storage that came from Linode but would also now include Akamai's net storage; we have cloud optimization that would include Akamai's Global Traffic Manager, Cloud Wrapper and Direct Connect solutions; next, the developer tools we get from Linode as well as the existing Akamai developer tools now make the Akamai compute platform easy and accessible to developers all over the world; and last, but certainly not least, our Edge applications, which contain our EdgeWorkers and EdgeKV products that execute compute right at our edge. It will also include our Cloudlet's image and video manager and, of course, our API acceleration product. One of the exciting synergies would be in go-to-market. Akamai's compute products would not only be sold online, but because our current globally located enterprise sales force works closely with the buyers for cloud compute, they have the right relationships, and we would not need to create an overlay sales force. Another exciting go-to-market synergy would be our existing robust and global channel ecosystem that could also take these cloud compute offerings to market. And in both cases, new wallet share within the customer base could be open for future growth. Turning to Slide 15. Now let's talk about how we think about compute. Now computing at the edge or near end users and devices brings unique benefits for critical use cases that are in many locations and where data is in motion or ephemeral, whereas computing in the cloud brings other benefits that are usually for applications running in a smaller number of locations and where data is stored and persistent. Our combined platform would have both edge and cloud computing. And since modern applications are built as a collection of services, each with differing compute needs and data needs, only by combining the edge and cloud can we fulfill the varied needs of our customer base like data localization and low-latency containerized compute as well as more typical compute needs that are persistent and in fewer locations. The unique capabilities can come together when we are able to combine Akamai's Edge platform with Linode's cloud computing capabilities and then add in our Global Traffic Manager product to route across multiple clouds and cloud locations our global large private network that efficiently connects cloud and edge locations and messaging, bringing it all together, coordinating cloud and edge services. You end up with the world's most distributed compute platform from cloud to edge making it easier for developers and businesses to build, run and secure applications. Now on Slide 16. While Linode and Akamai can solve a number of customer use cases separately, I thought it would be useful to cover just a few examples of the use cases we believe we can help fulfill for our customers with this unique combination of products. In the sports vertical, you could imagine a sports league could leverage the new Akamai platform to deploy WebRTC services to enable a watch-along app that allows a group of friends to watch a game in sync while communicating with each other in real time. And they would be able to do that using our distributed VMs, load balancing and high-throughput egress. When you think of IoT and fleet management, you could see a shipping company building a distributed app to collect and parts video and telemetry data from trucks and route before backhauling the data to their data warehouse. And they'd be able to do that using our support of MQTT, our distributed VMs and direct connect capabilities. An e-commerce site can leverage Akamai to dynamically personalize their site based on the user's previous and current browsing activity without having to go back to their data lake, all using our managed database services, Kubernetes and Functions as a Service. In the metaverse, we can help create a persistent virtual experience when a game studio needs to connect users from across the globe in a fully immersive VR experience from any console, mobile device or browser, all using our distributed GPUs, low-latency and private backbone. And in health care, a hospital could leverage Akamai to create a platform that captures and archives videos of surgical procedures to help train doctors on new and emerging techniques using Bare Metal and our Object Storage. Now turning to Slide 17. The combination of Akamai and Linode can be a truly unique offering in the market. We plan to combine the ease of use and developer-friendliness Linode is known for with the wider reach, lower latency, strong security and greater resiliency that are Akamai's hallmarks. We expect our new combined offering to appeal to developers by offering core cloud compute functionality, ease of use and tools they need appeal to enterprises with security, uptime and reliability and drive future use cases as new applications can take advantage of the throughput performance and distribution of a market-leading global network. Turning to Slide 18. So with Akamai and Linode, we can have highly secure, elastic compute along with storage capabilities on the world's largest edge network, category-leading security, an edge computing platform for latency-sensitive workloads, all on Akamai's large global private network with a globally located enterprise sales force and robust channel ecosystem, all setting us up to win in the marketplace. And now I'll pass it to Ed to discuss the transaction details."
},
{
"speaker": "Ed McGowan",
"text": "Thank you, Adam. I will start my remarks with brief highlights of our very strong Q4 results, then provide some insight into the financial aspects of the Linode acquisition and then close with our Q1 and full year 2022 guidance. So moving to Slide 20. Starting with the Q4 highlights. We are very pleased with our strong Q4 results, capping off an excellent year for Akamai. Q4 revenue was $905 million, up 7% year-over-year or 8% in constant currency. Revenue was led by another quarter of very strong growth in security as well as strength in our edge applications business. Security revenue growth in Q4 was 23% year-over-year or 25% in constant currency, with Guardicore contributing revenue of approximately $10 million. We are very pleased with the initial momentum we've seen from Guardicore as well as the continued growth of the pipeline. It is also worth noting that our Edge Applications business surpassed a $200 million annual revenue run rate in Q4 and grew 30% for the full year in 2021. International revenue growth was another bright spot with revenue increasing 13% year-over-year or 16% in constant currency. Sales in our international markets represented 47% of total revenue in Q4, up 2 points from Q4 2020. These strong results were despite foreign exchange fluctuations, which had a negative impact [Technical Difficulty] basis and negative $10 million on a year-over-year basis. Non-GAAP net income was $243 million or $1.49 of earnings per diluted share, up 12% year-over-year, up 14% in constant currency and $0.05 above the high end of our guidance range. Finally, as Tom mentioned, we had an exceptional year from a cash flow perspective. Moving to capital deployment. During the fourth quarter, we spent approximately $271 million to buy back approximately 2.4 million shares. Our intention is to continue to buy back shares to offset dilution from employee equity programs over time and to be opportunistic, both M&A and share repurchases. Turning now to Linode on Slide 21. As you heard from Tom and Adam, we believe the combination of Akamai and Linode will create the world's most distributed platform for developers and businesses to build, run and secure their applications. Under the terms of the agreement, Akamai has agreed to acquire Linode in exchange for approximately $900 million of cash. The transaction will be treated as an asset purchase for tax purposes. And as a result, we anticipate significant cash income tax savings over the next 15 years. While this benefit will not impact our non-GAAP effective tax rate, we estimate the present value of these savings to be approximately $120 million. Turning to Slide 22. We believe that Linode currently has a very attractive financial profile and that there are considerable revenue and cost synergy opportunities in the future. Assuming a late Q1 close, in 2022, we expect the acquisition to: add revenue of approximately $100 million, have no material impact to our non-GAAP operating margin and be accretive to non-GAAP EPS by $0.05 to $0.06 per share. Looking beyond this year, we expect Linode to be additive to our non-GAAP operating margin as we continue to capitalize on revenue and cost synergies, including leveraging our go-to-market channel and marketing organizations to accelerate revenue from enterprise customers, realizing significant cost savings by utilizing our very large global private network that Adam previously talked about as well as leveraging our significant scale and supply chain along with our network deployment expertise. From a CapEx perspective, we expect Linode to add approximately 2 points to CapEx as a percentage of revenue in 2022 as we plan to expand Linode's capacity and locations to meet anticipated customer demand. However, over the long term, we do not expect the acquisition to meaningfully change our previously communicated goal of CapEx being in the mid-teens as a percentage of revenue. Turning to Slide 23. As Tom and Adam previously mentioned, upon closing the acquisition, we plan to update our revenue reporting to reflect 3 separate business groups: security, delivery and compute. The first revenue grouping, security, will remain unchanged from the existing reporting of our Security Technologies Group. The second revenue group will be delivery. Delivery will be comprised of edge delivery and services portion of our existing ETG organization but will exclude our net storage and Edge application businesses that were previously included as part of ETG revenue. For context, our Edge applications business, which had revenue of approximately $196 million in 2021 and our net storage business, which had revenue of approximately $57 million in 2021, will move to our new compute business. The third and final revenue group will be called compute. Compute will include Linode, plus our Edge Applications and Net Storage businesses I just mentioned. We believe that with strong execution, we can deliver more than $500 million of annual compute revenue in 2023. Turning to Slide 24. Before I provide our Q1 and 2022 guidance, I wanted to highlight a couple of factors to consider for your models. First, the Q1 and full year 2022 guidance I am about to provide does not reflect the revenue and non-GAAP EPS contribution we anticipate from Linode that I previously mentioned, since the acquisition has not yet closed. We plan to update our full year guidance to include Linode on the first earnings conference call after the deal has closed. Second, international revenue now represents nearly half of our total revenue. And the dollar has continued to strengthen since we reported in early November. Therefore, we currently expect a meaningful foreign exchange headwind in 2022. At current spot rates, our guidance assumes that foreign exchange will have a negative $45 million impact on revenue on a year-over-year basis. Finally, similar to 2019, we have 8 of our top 10 customers renewing in the first half of the year. As a reminder, we define our top customers as anyone contributing revenue of 1% or more. And that customer -- that group of customers contributed approximately 19% of total revenue in 2021. Although we expect to see a negative impact to revenue growth in the near term, we expect to see incremental revenue over time as these customers' traffic grows with us. I'd also note that while the cluster timing of these renewals is unusual, the pricing, contract terms are consistent with the broader trends in the market, and these renewals have been factored into our guidance. So with all that in mind, turning to our Q1 guidance on Slide 25. We are projecting revenue in the range of $896 million to $910 million or up 6% to 8% as reported or 8% to 10% in constant currency over Q1 2021. Foreign exchange fluctuations are expected to have a negative $2 million impact on Q1 revenue compared to Q4 levels and a negative $17 million impact year-over-year. At these revenue levels, we expect cash gross margins of approximately 76%. Q1 non-GAAP operating expenses are projected to be $292 million to $296 million. We anticipate Q1 EBITDA margins of approximately 43%. We expect non-GAAP depreciation expense to be between $123 million to $124 million, and we expect non-GAAP operating margin of approximately 30% for Q1. Moving on to CapEx. We expect to spend approximately $120 million to $124 million, excluding equity compensation and capitalized interest in the first quarter. This represents approximately 13% to 14% of anticipated total revenue, which is down approximately 4 points from Q1 2021 levels. And with the overall revenue and spend configuration I just outlined, we expect Q1 non-GAAP EPS in the range of $1.39 to $1.43. This EPS guidance assumes guidance taxes of $38 million to $39 million based on an estimated quarterly non-GAAP tax rate of approximately 14.5%. It also reflects a fully diluted share count of approximately 162 million shares. Moving to Slide 26. Looking ahead to the full year, we expect revenue of $3.673 billion to $3.728 billion, which is up 6% to 8% year over year as reported or 7% to 9% in constant currency. We security revenue growth to be at least 20% for the full year 2022. This includes an expected Guardicore contribution of approximately $50 million to $55 million. We are estimating non-GAAP operating margin of approximately 29% to 30% and non-GAAP earnings per diluted share of $5.82 to $5.97. And this non-GAAP earnings guidance is based on a non-GAAP effective tax rate of approximately 14.5%, a fully diluted share count of approximately 162 million shares. Finally, full year CapEx is anticipated to be approximately 13% to 14% of revenue. In closing, we are very pleased with our 2021 performance and are excited to close on Linode and help customers build, run and secure their applications. Now I'd like to turn the call back over to Tom to say a few words before we take your questions. Tom?"
},
{
"speaker": "Tom Leighton",
"text": "Thanks, Ed. I'll wrap up now on Slide 28. As I mentioned earlier, Akamai has had a rich and exciting history of innovation that has fundamentally enabled the Internet to provide enormous benefit to billions of people around the world. We are truly making life better for billions of people, billions of times a day. As incredible as Akamai's contributions to the Internet have been, I want you to know that I couldn't be more excited about Akamai's potential for the future as we expand our business with Linode and Guardicore, provide even greater value for our customers and shareholders and make life even better for Internet users everywhere. Ed, Adam and I will now be happy to take your questions."
},
{
"speaker": "Operator",
"text": "[Operator Instructions] Our first question comes from Sterling Auty with JPMorgan."
},
{
"speaker": "Sterling Auty",
"text": "I wondered if you could give us some context in terms of what kind of growth was Linode experiencing before the acquisition? And then when you talked about kind of 2023 and beyond, I want to make sure I understand that new compute area, the $500 million, what kind of growth rate do you expect out of that segment?"
},
{
"speaker": "Ed McGowan",
"text": "Sterling, this is Ed. Thanks for the question. So before the acquisition, they were growing at about 15%, give or take. The bigger customers were growing faster. And they were sort of containing their growth a bit. It was a very closely held company. So they were holding back a bit on their investment in go-to-market and their build-out. So obviously, that's one of the major synergies we bring. So we think we can accelerate that business pretty considerably. Now when I talked about the different components of the business, if you take the net storage business plus the edge applications business plus where Linode is, assume I talked about how we grew the edge applications business 30%. And if you remember back on Investor Day, that was our long-term target. Our net storage business, as it is today, is kind of a flattish business, kind of grows like the CDN. We expect that to obviously accelerate as we add new capabilities. And then the Linode business should accelerate quite a bit. So if you were to put those pieces together, and I talked about in '23 that I expected that we would be above $500 million in revenue, that sort of gets you to that 30% to 35% kind of growth rate in that business once you get through the acquisition."
},
{
"speaker": "Sterling Auty",
"text": "Right. And then -- but given those pieces, would you expect that growth to be durable at that level or kind of settle back into more of a 15% to 20%, just so we understand the longer-term context? And that's all for me."
},
{
"speaker": "Ed McGowan",
"text": "Yes. That's a great question, and I'll ask Adam to chime in a little bit here as well. Obviously, we're getting into a very, very big market. And what pushed us into this market was our customers. We were getting more and more requests for folks to -- continue to come with different use cases. Ourselves, we're spending quite a bit on third-party cloud today, whether it's through acquisitions or through IT projects. Just the overall growth of this market is so significant that we think there's certainly the market there to do that. I'll let Adam talk a little bit about some of these plans in terms of future integration and the growth prospects going forward. But it's quite possible that, that could be a durable growth rate going forward for that business."
},
{
"speaker": "Adam Karon",
"text": "Yes. I agree, Ed. I think we see that market growing very rapidly outside of what Akamai had before, and we see that with our customers in demand of our edge applications and asking us for this type of cloud computing as well. So we do expect it to be durable as that market continues to grow quite rapidly."
},
{
"speaker": "Operator",
"text": "Our next question comes from Keith Weiss with Morgan Stanley."
},
{
"speaker": "Keith Weiss",
"text": "Maybe 2 questions. One on the Linode acquisition. I just want to kind of better understand kind of like the buy versus like a partner decision. Can you help us understand what's interesting about sort of buying this asset, what you could do owning sort of Linode versus partnering with Linode or other type of cloud computing platforms out there, number one? And then number two, for Ed, just in looking at FY '22 and the margins coming down. Nice margin performance in Q4 and all throughout 2021. Can you talk to us a little what's going to be pressuring margins into 2022?"
},
{
"speaker": "Tom Leighton",
"text": "Yes. By owning Linode, we can really scale up that business. We have a lot of expertise in network deployment and doing that in a cost-effective way to get enormous scale. Also, we've got a large enterprise sales force and a customer base that is hungry for us to bring them this kind of capability. We know how to make large-scale systems be reliable and perform well. And we can bring it all together as part of an end-to-end solution so that our customers can take their major applications, build them easily on Akamai, and that's where Linode comes in, run them. Of course, we have the world's largest and best content delivery platform to deliver it, and then wrap it all together under our security umbrella to make sure it stays secure. And so that's a compelling reason for us to make the acquisition here and provide the end-to-end service versus just partnering with the various cloud providers. Ed, do you want to take the margin question?"
},
{
"speaker": "Ed McGowan",
"text": "Yes. Sure, Keith. And just to add on that, if I just look at the financial profile of the business we just acquired, think about getting up to that sort of scale of revenue, the type of investment you need to make, how long it will take you to get there. It's rare that you find companies that have profitability margins like we do. So to be able to bolt that on, it's immediately accretive, gets us to market much faster, there's a brilliance to the simplicity in terms of how they approach and how simple it is to use their system. That's an expertise that we're acquiring as well. So there's a lot to like about that. Now in terms of the margins. So there's a couple of things going on there. One of the points that I made in my prepared remarks was about foreign exchange. That's a big headwind for us, and we're very profitable outside the U.S. So that does put a little bit of pressure on margins for us. But also, we're making investments. And keep in mind, you have the full Guardicore business. We only had about 2 -- a little over 2 months in the first -- in the fourth quarter. So in the first quarter, we have full Guardicore and we -- cost in the business. And you've got, in the middle of the year is when we do our merit increase. That said, 2 things to point out. Number one, we're going to be -- I said we do about 30% in Q1. We've done very well managing costs. And then we also told you when we did the acquisition of Guardicore that in '23, we'd expect to get above 30% margins again. So will it be expanding margins? Might be slightly under 30% this year. As I said, somewhere between 29% and 30%, but we anticipate to get back above that in '23."
},
{
"speaker": "Operator",
"text": "Our next question comes from James Breen with William Blair."
},
{
"speaker": "James Breen",
"text": "Just looking at the Edge Technology Group, growth this year has been flattish off of some pretty high numbers from 2020 as a result of the pandemic. As you think about that going forward and with some of the repricing this year, can you just talk about some of the puts and takes relative to repricing some of those contracts as well as some of the sectors that were hit most by the pandemic potentially improving?"
},
{
"speaker": "Ed McGowan",
"text": "This is Ed. I'll take that one. So yes, as far as the renewals go, as we've talked in the past, whenever we have a combination of renewals, we'll always call it out for you guys. Here's what I would expect with that group of customers: typical renewal pricing, nothing unusual in terms of anything in the market to call out there. I'd expect that group of customers to decline a bit in Q1, decline a bit in Q2 because like about half of the renewals already done. I got about half coming up here in April. And then I would expect that revenue to start to grow again. It's pretty typical of what you see in the CDN business when you have a cluster of renewals. Now those customers have varying contracts. Some of them are 1 year, some of them are 2, some of them are 3, and some of them have revenue commitments that will be used up before the contract is over. So it's very unusual to have this sort of a cluster. So that will put some pressure on growth here for the next couple of quarters, but then I expect that customer group to grow. They've been very busy buying up our security products, our compute product. I expect now they're great targets for the new acquisition we just picked up here. So I expect to expand the wallet share within those group of accounts. And this is just something that's pretty typical in the CDN business. And where we're seeing the pricing pressure is on the delivery side. We're not seeing it in the Security side, not seeing it at Edge. We're seeing it just in delivery. As far as the pandemic, we are starting to see a little bit of improvement in travel and hospitality. And as a reminder, that group was about 4% of our total revenue. I think that will sort of ebb and flow with how the pandemic goes. As we start to have these waves of new variants, travel slows down, as it goes away, travel picks up. Retail is still a bit sluggish, not really seeing a significant improvement. And just remember, we had set up a 0 overage, and the biggest acquirers of that type of contract are the retailers, especially in the U.S. So you see a little bit of a muted seasonality here in Q4 related to retail. But still some way to go here on retail. Travel is improving a bit. And in general, as we get past these renewals, you'll start to see the delivery business improve a bit."
},
{
"speaker": "Operator",
"text": "Our next question comes from Colby Syneseal with Cowen."
},
{
"speaker": "Michael Elias",
"text": "This is Michael on for Colby. Two questions, if I may. First, following this acquisition, you also did Guardicore. How would you describe the appetite for additional M&A? And as part of that, how does this acquisition impact the way that you're thinking about additional buybacks? I thought there was a pretty notable step up in the fourth quarter. And then on one other question, if I can squeeze it in. With this acquisition, $100 million of revenue coming in and you talked about 15% growth that seems durable, how does this change the way you're thinking about the long-term revenue growth profile for the company?"
},
{
"speaker": "Tom Leighton",
"text": "Yes. Good questions. Obviously, we've done 2 large deals, the largest deals we've done in about 20 years over the last several months. I wouldn't expect to see us continue at that rate, certainly. We probably will do more tech tuck-ins and smaller acquisitions. In terms of the buyback, our primary use of cash is for M&A and to buy back equity to offset the dilution from compensation programs. Now as I mentioned, that said, we do also opportunistically buy back additional stock. And if you look over the last 10 years, it's averaged a little more than 1% a year. And so I think our general approach to use of capital is not changing here. Just we saw 2 exceptional opportunities, first with Guardicore and now with Linode. Guardicore really is a huge boost to our enterprise security business, Zero Trust capabilities. We believe they have the best solution to stop the impact of ransomware. And that's a huge, huge deal. And you see that in the improved guidance we've given. And just we closed the deal a few months ago, and we're looking at this year then of doing $30 million to $35 million and now, as you heard from Ed, substantially more than that. And I can tell you from talking to many of our customers, many of the world's major banks, they are very interested in what Guardicore can do, both the visibility it gives customers into their own networks and the ability to mitigate the impacts of ransomware. Now in terms of the durability of revenue growth from Linode, in the past, they were doing 15%. I think Ed and Adam talked about, we think we can do a lot more than that. Just consider that Linode doesn't really have a sales force, never mind a sales force like Akamai has going after major enterprises. And you combine that with the fact that our major enterprise customers have wanted us to have this capability for them. So we think we can really accelerate their growth and that it could well be that the 30% is sustainable. We're certainly going to try to do that. And if we're successful there, you can see Akamai as a whole back in double-digit revenue growth on a more sustainable basis, and that's certainly our goal."
},
{
"speaker": "Operator",
"text": "Next question comes from James Fish with Piper Sandler."
},
{
"speaker": "James Fish",
"text": "So curious, grew 22% -- actually, I'm sorry, 25% constant currency. But seem like new business slowed and the normalized security number was slightly down versus last quarter. So really, why aren't we growing faster in the segment when the market has come directly towards SASE, and it's been as healthy of a security market as we've probably seen since 2014. And have we seen a pickup at all in selling security outside of the existing CDN installed base? And just was squeezing in another one here, but what was the growth of our annual customer metrics you guys typically give in Q4 regarding the individual products and subsegments like in access control?"
},
{
"speaker": "Tom Leighton",
"text": "I'll start with that and then hand it over to Ed. We're very pleased to see our security business grow 25% in constant currency. You talk about SASE, and that is a very small portion of our business today. In fact, SASE technically wouldn't even include micro-segmentation. I would imagine that's going to change in the near future because it's so important and it's going to become a requirement, I believe, for many of the world's major enterprises, certainly in the financial vertical. So the SASE framework is a small amount of Akamai revenue. And with Guardicore growing rapidly, the vast majority of our security revenue is the web security area, where we're protecting, think of it as B2C apps, from denial of service, from content corruption, from account theft, from data exfiltration, those kinds of attacks, which technically isn't part of the SASE framework. And so what you would think of is maybe more towards a SASE. We're getting very good growth on a small number. And of course the lion’s share of our security business is in the web security, API protection, where we're the market leaders and growing at a very fast clip on a good size number for us. And Ed, maybe you want to take the rest of the question."
},
{
"speaker": "Ed McGowan",
"text": "Yes. So Jim, we don't break this out every quarter, but I'll just go back to the IR Day. We set targets for application security, network security and security services. And as a reminder, those goals were for application security, 20% to 25%, 20% to 25% in network security and then security services of 10% to 15%. I can tell you that we achieved all of those and exceeded, in many cases, those metrics. Are there any other metrics that you were looking for? I think you mentioned something about customers?"
},
{
"speaker": "James Fish",
"text": "Yes. I mean we used to kind of talk about penetration of number of customers that are on your WAF solution at this point. And I thought at the Analyst Day, we were going to get the annual update on those subsegments. Maybe you're saving that for the Analyst Day."
},
{
"speaker": "Ed McGowan",
"text": "Yes. That's what we're going to do. On Analyst Day, we'll have a deep dive on that. What I'll do is I'll provide -- I provided this metric before in terms of the number of customers that buy a security product, that's up to 68.5%. So that's up about 6% year-over-year. 2 or more is up to 34.5%. That's up about 3%. 3 or more is up to 20%. And we increased our customer base by about 6% for the year. Our total customer base is up about 6%. Security penetration is up about 6% year-over-year."
},
{
"speaker": "James Fish",
"text": "Helpful. If I can squeeze in one more. One now, we've heard on some of the smaller developer-focused solutions like Linode is that organizations tend to kind of graduate from these solutions to an AWS or Azure. What investments are you looking to make or event this sort of graduation and make it more enterprise-grade for the Akamai installed base? Or is it more about taking Akamai downmarket and be that developer focus that we've been looking for?"
},
{
"speaker": "Tom Leighton",
"text": "I'll hand this over to Adam in just a minute, but we're interested in the developer base for sure because our large enterprise customers, their apps are built and, in many cases, managed by the developers. So we really care about a developer-friendly solution. But we are going to take this to our large enterprise customers. And Adam has a robust road map of added capabilities. And Adam, why don't you talk a little bit about that?"
},
{
"speaker": "Adam Karon",
"text": "Sure, Tom. I think Tom mentioned earlier, our -- some of our expertise is just building and deploying larger network presence all over the globe. So that would be our first area to go and make those locations that Linode has just more robust and available to our customers. But building in things like availability zones, BPC, identity access management and then building in compliance like SOC2 and PCI are really on the core parts of our road map so that customers can not only bring their apps onto the platform but graduate and continue to grow and scale globally as they build, run and secure the application right on the Akamai platform."
},
{
"speaker": "Tom Leighton",
"text": "And I just would add, our customers have been pretty explicit with us that they are very interested in us having this capability. And putting it together with the world's best content delivery capabilities, the world's best application performance and the world's best security solutions to provide an end-to-end solution. So I think you will not see this be a situation where they migrate from, say, a Linode to a Hyperscaler. But our customers are interested in alternatives and end-to-end solutions that -- maybe there are some functions on hyperscalers today that I think would migrate to Akamai's new cloud platform. We'll be the world's most distributed cloud platform with now market-leading solutions in not just delivery and security but also compute."
},
{
"speaker": "Operator",
"text": "Our next question comes from Rishi Jaluria with RBC."
},
{
"speaker": "Rishi Jaluria",
"text": "Just 2. One on Linode and maybe an inverse of the last question. Obviously, they have a great traction of Akamai to cross-sell into that Linode base. You're obviously very, very strong in the larger enterprises with both security as well as the core delivery and Edge Applications business. Can you talk about your ability to actually take some of your more enterprise-grade products and actually sell them successfully downmarket once the Linode acquisition closes? And then I wanted to drill a little bit more into Q4 and what you saw from the e-commerce season. I know you talked a little bit about retail bounce-back being sluggish. But I know when we were on this call 3 months ago, one of the concerns was just with supply seeing concerns and the tough comps, e-commerce was going to be a little bit challenged in Q4. Just wanted to get a sense for what did you see specifically on the e-commerce side in Q4."
},
{
"speaker": "Tom Leighton",
"text": "I'll take the first question. Ed will take the second. Yes, we certainly can cross-sell into the Linode base. That's not our primary objective here. The primary objective is to take Linode and really scale that up and sell it into the large enterprise base. I think that's far more lucrative for us than taking our existing solutions and selling into the large number of small customers. And the focus will be moving Linode's capabilities into our platform and having a comprehensive solution for large enterprise customers. And Ed, you want to take the next one?"
},
{
"speaker": "Ed McGowan",
"text": "Yes. I got it. So Rishi, on the commerce, you're right, when we had the Q3 call, we did talk about sort of a variety of commerce. I would say that we pretty much landed where we expected. We didn't really bake in a ton of upside really for 2 reasons. One was just uncertainty around supply chain, people potentially ordering earlier in the year. But the bigger factor was around the 0 overage. We've been in market now for over 2 years, and we've got a pretty high penetration so that you don't see as much of a bursting in Q4 as you do from the commerce customers. And as I've said, it's been a mixed bag. Some companies are doing pretty well, some aren’t doing so great. So again, I'd say it's kind of as expected, but we weren't going in expecting a ton out of our retail vertical this Q4."
},
{
"speaker": "Operator",
"text": "Our next question comes from Fatima Boolani with Citi."
},
{
"speaker": "Fatima Boolani",
"text": "Maybe a jump ball for you all just with respect to some of the new revenue classifications that we're going to be expecting in the next couple of months here. As I think back to your last Analyst Day, what was certainly helpful for us is to get a sense of what type of traffic mix you're expecting in the delivery franchise. So I'm curious with Linode in the family or soon to be, how you expect that mix of traffic to change relative to some of your expectations within the long and medium-term guide. And then I had a quick follow-up, if I could."
},
{
"speaker": "Tom Leighton",
"text": "Well, the traffic measured by bytes delivered is 95-plus percent big media and software downloads, gaming downloads. That's the vast majority of the traffic. That won't change with Linode. In fact, I would expect we'd be selling compute services to those same big media customers. In fact, several of them have expressed interest in that capability. So Linode won't change our traffic mix. And when we get together at IR Day, we'll do the deep dive in each of these categories to get a better feel of how the revenue is breaking down."
},
{
"speaker": "Fatima Boolani",
"text": "That's very helpful. And for Ed, I wanted to talk a little bit about the margin upside in the quarter. With the media business having some nice outperformance, we were still able to see a nice leverage fall through the model. So I'm just curious if you can walk us through some of the puts and takes within the cost-control elements of the business in the quarter. That would be helpful."
},
{
"speaker": "Ed McGowan",
"text": "Yes. Sure. Good question. So a couple of things to note on that. One is just a mix issue. So we obviously had a strong security quarter. I did a little bit better on security. So that drives very high incremental margins in the business. The other thing on the cost of goods sold line, the margins came in on the gross margin line a little bit better. Team has done a phenomenal job on driving down our bandwidth costs. As I look out towards next year, we expect traffic to grow sort of at normal rates. And my bandwidth costs are not really going up very much. So able to drive down bandwidth costs, that would be the big thing. We're getting good efficiencies, starting to see CapEx come down quite a bit. We won't see the depreciation fall off. You have to get a peak in, say, the next 1.5 years or so, then it will start to come off. But just around the -- around all the different organizations, which is doing -- really focused on efficiency. And we've seen good flow through when we get a little bit of a revenue upside."
},
{
"speaker": "Operator",
"text": "Our next question comes from Alex Henderson with Needham & Company."
},
{
"speaker": "AlexHenderson",
"text": "I was hoping we could talk a little bit about the architecture that you're anticipating as we go forward, whether you're planning on integrating the platforms at the Edge or whether you're -- as described in the slide deck, whether the Linode nodes are, in fact, relatively separate from your edge compute platform. Do you anticipate moving to a single software stack within each node? Or will these be separate nodes in that context?"
},
{
"speaker": "Tom Leighton",
"text": "I'll start with that and then turn it over to Adam. You want to think of Akamai's platform is hierarchical. There's a core where functions such as storage would live, where there's dozens of locations for archive storage, migrating out all the way to the edge, where there's 4,000 PoPs, where most of our capabilities live today. Something else that's closer to the core in dozens of locations would be the Prolexic service. But things like delivering video, delivering software, accelerating your bank statement and most of all, the security other than Prolexic all live on the very edge out in 4,000 locations. EdgeWorkers lives out there too. EdgeKV lives out there. And Linode starts in the core in 11 locations, and we'll be expanding that quite a bit, and it will all be integrated together as part of one hierarchical platform. And then maybe, Adam, you could get a little bit deeper into that in terms of the software stack and so forth."
},
{
"speaker": "Adam Karon",
"text": "Yes. I think you covered most of it, but I think the way you can think about it is that the Linode stack itself can be segmented into multiple components. Just like Tom just described, you might have storage or databases that might exist closer to the core. And as you have more ephemeral-type instantiations of applications, you push those components further out towards our edge, ultimately culminating in our deep edge, where you'd have our Chrome V8 engines that can be instantiated on demand right on the edge itself. So that's our EdgeWorkers solution. But you can see kind of a Linode kind of stack like spanning the entire span and what Tom just described as the core all the way out to the edge."
},
{
"speaker": "Alex Henderson",
"text": "If I could follow up. You talked about the coder-centric capabilities of Linode. Can you talk about the degree to which coders are riding to this platform? And for that matter, to the Akamai platform, how many coders do you have right into your platform at this point?"
},
{
"speaker": "Tom Leighton",
"text": "Adam, why don't you take that one?"
},
{
"speaker": "Adam Karon",
"text": "Yes. On the Linode platform, they have over 150,000 customers today on their platform writing and deploying applications. On our -- was that the question?"
},
{
"speaker": "Alex Henderson",
"text": "The degree to which the coders are writing to the platform, yes. I suppose they're not necessarily customers. I assume that customers have to do some writing."
},
{
"speaker": "Adam Karon",
"text": "The customers -- yes, they're primarily developers, which is 1 of the reasons for the benefit of bringing the developer-centric community that Linode brings to the Akamai community. And then those developers, as Tom described, a lot of them are the decision-makers inside of our enterprise customer base developing and deploying and, in some cases, managing those applications. And thus, that developer community becomes appealing -- appeals through those enterprise customers right back to Akamai. So it's kind of a great system that they have."
},
{
"speaker": "Alex Henderson",
"text": "Can you give us the Akamai-related data point relative to how many coders are writing to your edge compute capabilities?"
},
{
"speaker": "Adam Karon",
"text": "I don't think I have that stat on hand right now."
},
{
"speaker": "Operator",
"text": "Our next question comes from Tim Horan with Oppenheimer."
},
{
"speaker": "TimHoran",
"text": "Will it take much investment to consolidate any of the great Linode both from a software and hardware perspective? And will you be operating on relatively similar hardware? And I guess same thing for the go-to-market strategy and I guess, customer care just a little bit about the overall investment. And then I just had a quick follow-up."
},
{
"speaker": "Tom Leighton",
"text": "Sure. So we are looking at the ways we can drive synergy between the hardware that the Linode platform runs on today and the Akamai platform. And you can imagine, we have a significant deep expertise in our network group and hardware engineering organizations that spend all of their time optimizing for that, which gives us our great COGS and Capex benefits inside of Akamai. So we'll look to do that as we integrate Linode. And then can you repeat the second half of the question? I think it was on go-to-market?"
},
{
"speaker": "Tim Horan",
"text": "Yes. Just same thing for like customer care and go-to-market? Will you have to invest much to integrate?"
},
{
"speaker": "Adam Karon",
"text": "Yes. No, the great thing about the platform is it is very self-service, very frictionless for developers to come on board. They have amazing documentation that make developers use of their platform easy. And they have a great customer care group inside of Linode that we've worked very closely with our -- and build up to the signing of this. And so we expect to have them operate more as a Tier 2 to our existing Akamai customer care organization. And of course, our existing enterprise sales force will be the sales force that goes to market, selling those products along with their existing self-service model they have today."
},
{
"speaker": "Tim Horan",
"text": "And you mentioned you have a very large network, obviously. Do you think you can get into the enterprise private line or global WAN market or just overall enterprise network indirectly?"
},
{
"speaker": "Adam Karon",
"text": "Well, can you ask -- I think in terms of enterprise win or whatnot, we do partner very closely with our telco partners, and that's something that we work very closely with them when they have opportunities. We use our network in combination with theirs, where it makes synergy with those customers that want to use both our telco partners and Akamai. I'm not sure if that's what you were getting at or something that --"
},
{
"speaker": "Tom Leighton",
"text": "Think of Akamai as providing Internet connectivity to enterprises. That's not our business. We -- that's our partners' business. Now we do provide clean access so that an enterprise can sort of hide behind Akamai. And only Akamai can come through so that they maintain safety and security for their data centers. So we do that, but we're not -- we don't provide base connectivity. That would be our partners, which would be the carriers."
},
{
"speaker": "Operator",
"text": "Our next question comes from Franklin Louthan with Raymond James."
},
{
"speaker": "Franklin Louthan",
"text": "You mentioned earlier bringing scale to the business here. And I'm just curious what the strategy is for bringing scale to compete increasingly with large cloud companies that have some of the biggest scale in the world. And why the strategic decision to move in that direction and not bolster more of the security or the core CDN business?"
},
{
"speaker": "Tom Leighton",
"text": "Yes. When you think of scale, there's a it. One is just how many servers do you have. Obviously, we have a lot. But the way we think about scale is more in terms of being distributed. And none of the hyperscalers come anywhere close to us in terms of being in 4,000 PoPs and having a real edge network. Now what we haven't had before is the managed VM, managed container services. And our customers have asked for that. That's been the one missing piece on our platform. Because customers for many of their apps would like to take the entire app, build it on Akamai, run it on Akamai, deliver it through us, where they know they get fabulous performance, instant scalability, where it becomes relevant to do so to have the edge computing really done on the edge and then to have it all be secure so that we can provide the end-to-end service. And so that's why we're doing this. And in some cases, there may be some -- of course, we've been competing with the hyperscalers for 15 years, and I think that will continue. And I think the hyperscalers themselves, several of them are our largest customers. And several of them are already using us for our compute capabilities, and I expect that to increase with the acquisition of Linode. And so it's an environment where we compete, of course, have and for many years and successfully. And what we do, we do really well. And that will be taking an application, making it easy to build and deploy on Akamai and then to have the world's best performance, scalability, global reach and security. And that's where Akamai excels. And that's the goal in making this acquisition is really to complete that story to be able to have the end-to-end capability to handle their applications."
},
{
"speaker": "Adam Karon",
"text": "Yes. And just to add, I think that -- I was going to -- this doesn't take away from our investment in security. And another way to think about it is you've now got 2 very exciting, fast-growing businesses inside of Akamai, led by 2 different leaders in the company. And the scale that we can bring -- turn the question around and think about if you're a $100-plus million company trying to scale to $1 billion, what would you need? You'd need an enterprise sales force. You'd need a global private network. You'd want to have a low-cost deployment model. You'd want to have access to customers and channel, and we bring all that. So this, to me, was a very natural adjacency for us. And I look at ourselves and what we're spending in third-party cloud, looking at bringing that in-house driving some additional synergies and savings there, it's just a natural extension of what we're doing and entering a really, really big, exciting market. And again, it doesn't take away from our ability to invest in security. As you saw, we did 2 very large acquisitions: one in security, one here in cloud. And we're very fortunate with our profitability and our cash flow generation to be able to do that."
},
{
"speaker": "Franklin Louthan",
"text": "So is the end goal to be able to provide some of these cloud computing functions on yourself that would -- that the large cloud companies would white label? Or are you going to be providing aspects that they just can't do themselves in their larger server farm requirements?"
},
{
"speaker": "Tom Leighton",
"text": "I think both. There's things that we do today at a level that the hyperscalers don't do. I mean they have competing services, but in many cases, the hyperscalers use us and use our services for their own properties even though we compete with them. I do expect us to be partnering with, well, certainly many of the world's major carriers and white labeling our services. Of course, the carriers are major channel partners with us today, and I think that will increase through the acquisition of Linode because they've had an interest in being able to offer that kind of capability, and now it comes hand-in-hand with, well, the whole solution all put together."
},
{
"speaker": "Operator",
"text": "Our next question comes from Rudy Kessinger with D.A. Davidson."
},
{
"speaker": "Rudy Kessinger",
"text": "I want to go -- 2 things here. Starting off, going back to the customers that are going to have the repricing. You said basically declined in first half and then returned to growth in the second half. For the year in '22 over '21, what's your expectation for that group? Are they going to be slightly down or about breakeven on a growth basis?"
},
{
"speaker": "Ed McGowan",
"text": "Yes. Good question. So I would expect those customers to be slightly up year-over-year. So as you decline in the first 2 quarters, you start growing the back half. Now there's also significant upside with the Linode products as well. You can imagine these guys have -- they spend tons of money in this area. So there's a potential there that you could continue to grow that base of customers. So not expecting that this year, but it's possible that we could start to tap into that. Obviously, we're going to have to build a pipeline, get customers lined up, but that's obviously, certainly a very target-rich group of customers."
},
{
"speaker": "Rudy Kessinger",
"text": "Got it. And then secondly, going back to Guardicore, a pretty substantial outperformance thus far. I think you said $10 million in the quarter. Initial expectation in Q4 was 6 to 7 and then obviously, 50 to 55 expected versus 30 to 35 originally. Just what's really driving that upside? What's really resonating well with this product, both with new customers and those that you're cross-selling?"
},
{
"speaker": "Tom Leighton",
"text": "Well, obviously, ransomware is a big problem. And we believe that Guardicore has the best solution. It is easier to use than competing solutions, and micro-segmentation has a reputation for being really hard to implement and inflexible. It gives you great visibility in terms of what's going on in your network. Customers have really appreciated that. It's really important with security. And they have a solution that works with legacy systems that the competition doesn't have. They have built their own custom firewall. And the competing services will have to rely on the existing firewalls and whatever operating systems being used by a particular application and, in some cases, doesn't even exist and so they can't cover it. So it's the best solution and to a big problem that's rapidly growing. And so we've seen very strong interest in our customer base. And of course, we have a very large enterprise sales force that now can bring Guardicore into the large banks and the large enterprises, and the initial reception has been very strong. So yes, I'm very excited by their performance this year, and I'm looking forward to substantial growth in the future."
},
{
"speaker": "Operator",
"text": "This question comes from Jeff Van Rhee with Craig-Hallum."
},
{
"speaker": "JeffVan Rhee",
"text": "So 2 quick ones for me. First, I guess, on the cross-sell back into your base of Linode product. How critical is it to win over the developers in your base? I mean, obviously, you've got the relationship. Maybe you can come in and try to make the cross-sell, but there's a lot of power sitting in those developers. What is it about these tools that the developers will see as their best option? And how do you win them over?"
},
{
"speaker": "Tom Leighton",
"text": "Adam, why don't you take that one?"
},
{
"speaker": "Adam Karon",
"text": "of the most attractive things to the Linode platform is that their developer-centric tools make it really easy for customers who use their Kubernetes engine, use their managed VMs. It's just very simple to configure. Onboard comes with a ton of documentation, makes it very simple for somebody to learn how to use, and Onboard themselves and try their applications very quickly on their platform. We heard from developers inside of our own company as well as developers inside of our customers that they love to use the Linode tools, they're simple, easy. And that's really why we think we're going to win over the developers using that type of platform, something that's simple, easy to use and has great documentation."
},
{
"speaker": "Jeff Van Rhee",
"text": "Yes. And you may have missed it -- mentioned it. If I missed it, apologies, but in terms of the customer base, how many customers, what's an average spend per year for the Linode base? And any particular concentrations in the base from vertical or other segmentation that matters?"
},
{
"speaker": "Adam Karon",
"text": "So the Linode customer base is around 150,000 customers. We don't break them down like that, at least not yet. But we can tell you, I think Ed mentioned this earlier on the call, that the larger segment of their customer base is growing much faster than the very, very small developers. But we don't give out the ARPU yet on the customer base."
},
{
"speaker": "Ed McGowan",
"text": "Yes. Just to add, there's no customer concentration risk in terms of any significant customers making up a large percentage of the revenue. And earlier, it was Adam who mentioned that from a go-to-market perspective, they didn't focus on selling into large enterprises. That's where we can bring in that synergy. So I would expect that over time, that customer base could change and look a lot more like our customer base. And obviously, that small developer base will just continue to grow as we continue to market and that sort of thing. But it also opens up opportunities in some of our underserved verticals that you think about the spend in certain places that may not have as large websites or web presence, but they're spending an awful lot in this area. So I do expect that customer base to change. When we get to Analyst Day, we'll try to break that down a little bit for you, give you some views in terms of how we're thinking about growth in the future. And then as we get some months under our belt of operating the company, as we come up with new metrics that we think are helpful, we'll obviously bring them to the table and disclose them for you."
},
{
"speaker": "Tom Barth",
"text": "Okay. Well, thank you, everyone. In closing, we will be presenting at several investor conferences and road shows throughout the rest of the first quarter. Details of these can be found in the Investor Relations section of akamai.com. Thank you for joining us, and all of us here at Akamai wish you continued good health, and we wish you a happy evening. Thank you."
},
{
"speaker": "Operator",
"text": "This concludes today's conference call. Thank you for participating. You may now disconnect."
}
] | Akamai Technologies, Inc. | 24,522 |
AKAM | 3 | 2,021 | 2021-11-02 16:30:00 | Operator: Good day, ladies and gentlemen, and welcome to Akamai Technologies, Inc. third quarter 2021 earnings conference call. At this time, all participants are in a listen-only mode. Later, we will conduct a question-and-answer session and instructions will follow at that time. If anyone should require assistance during the conference, [ Operator Instructions]. As a reminder, this conference call is being recorded. I will now like to turn the conference over to Tom Barton, Head of Investor Relations. Thank you. Please go ahead.
Tom Barth: Thank you, operator. Good afternoon, everyone. And thank you for joining Akamai's third quarter 2021 earnings conference call. Speaking today will be Tom Leighton, Akamai's Chief Executive Officer, and Ed McGowan, Akamai's Chief Financial Officer. Before we get started, please note that today's comments include forward-looking statements, including statements regarding revenue and earnings guidance. These forward-looking statements are subject to risks and uncertainties and then Involve a number of factors that could cause actual results to differ materially from those expressed or implied by such statements. These factors include uncertainty stemming from the COVID-19 pandemic, the integration of any acquisitions and any impact from unexpected geopolitical developments. Additional information concerning these factors is contained in Akamai's filings with the SCC, including our Annual Report on Form 10-K and quarterly reports on Form 10-Q. The forward-looking statements included in this call will represent the Company's view on November second, 2021, Akamai disclaims any obligation to update these statements to reflect future events or circumstances. As a reminder, we'll be referring to some non-GAAP financial metrics during today's call. A detailed reconciliation of GAAP and non-GAAP metrics can be found under the financial portion of the Investor Relations section of akamai.com. And with that, let me turn the call over to Tom.
Tom Leighton: Thanks, Tom. And thank you all for joining us today. I'm pleased to report that Akamai delivered excellent financial results in the third quarter, coming in at or above the high end of our guidance ranges for revenue, operating margin, and earnings per share. Q3 revenue was $860 million, up 9% year-over-year, and up 8% in constant-currency. Non-GAAP operating margin in Q3 was 32%, which reflects our continued focus on operational efficiency even as we've continued to invest for future growth. Q3 non-GAAP EPS was a $1.45 per diluted share, up 11% year-over-year. Akamai's strong performance in Q3 was largely driven by our security business, which is now one of our leading cloud security businesses in the world, with an annualized revenue run rate of more than $1.3 billion, up 26% year-over-year, and up 25% in constant currency. Over the last several years, we've grown our security portfolio from point solutions into a comprehensive platform that provides defense in depth to address our customers biggest threats. The unique breadth of our defenses is important to our customers who want more security capabilities from fewer vendors. Our security solutions are highly differentiated and recognized as best-in-class by our customers, who see us as a leading provider of services to protect our most critical assets, including enterprise websites, applications, data, and access. We routinely earned top rankings in multiple categories for major industry analysts. For example, Akamai disrupted the web apps security market when we launched Kona Site Defender in 2012. Since then we've continued to extend our leadership position and the web app firewall sector with Gartner recently naming Akamai as a market leader for the 5th year in a row. Akamai has been the market leader in DDoS protection since we acquired Prolexic in 2014, Forester recently said, ''Large enterprise clients that want an experienced, trusted vendor to make their DDoS problem go away, should look to Akamai. '' As new threat vectors have emerged, we've extended our platform to defend against them. For example, we created the first comprehensive bot management solution to protect our customers from sophisticated bot operators would try to steal content, disrupt operations are penetrate user accounts. According to Forester, Akamai is best for companies wanting to [Indiscernible] bots off the edge. Bloomberg Business Week even quoted a hacker calling Akamai's bot defense the hardest to crack. More recently, we released Akamai page integrity manager to identify malicious code of third-party scripts and websites that's designed to steal end-user data. Page integrity manager helps to address a major threat that's been costing businesses hundreds of millions of dollars and fines, as well as serious reputation damage. We plan to extend our web app protections further in the coming months with the release of Account Protector and Audience Hijacking Prevention. Account Protector is designed to reduce fraud by making sure that the entity logging into an account is the crew owner of that account. Audience Hijacking Prevention can help businesses protects sales by fording malware that diverts a customer just before the completion of a transaction. Since founding, Akamai over 20 years ago, our vision has always been to help our customers solve their toughest Internet challenges, and today that includes stopping ransomware. Ransomware is a huge problem for enterprises around the world, with a new attack striking every 11 seconds. The damage resulting from ransomware is expected to amount over $20 billion this year alone. Garda core (ph.) is critical to stopping the spread of ransomware, and that's a key reason why we acquired the Company. Akamai is already selling solutions such as Enterprise Application Access that help prevent attackers from gaining access to enterprise infrastructure and applications. But to be secure in today's world, you also need a second layer of defense to lock the spread of malware that has gained a foothold in the enterprise. And that's where Garda core comes in. Garda core helps detect when a breach occurred by identifying anomalous data flows within enterprise networks. Garda core also helps prevent the malware from spreading through a capability known as micro-segmentation. Garda core's, micro-segmentation solution limits access within the enterprise to only those applications that are authorized to communicate with one another. Denying communication as the default greatly limits the spread of malware and protects the flow of enterprise data across the network. And that's the key to stopping ransomware. We believe Guard core 's best-in-class micro-segmentation solution is the perfect addition to our Zero Trust portfolio, enabling Akamai to offer customers a comprehensive solution to stop the damage being caused by ransomware and malware. During the call we held on September 29, we spoke about the parallels between our acquisition of Guard core with our acquisition of Prolexic in 2014. Just as the acquisition of Prolexic propelled us to a leadership position in helping to stop DDoS attacks. We believe that the acquisition of Guard core will establish Akamai as a leader in helping to stop the damage caused by ransomware, as well as other forms of malware. Customers see, Akamai as a strategic partner in security, not only because of the strength and breadth of our solutions, but also because of the depth of our security expertise in threat intelligence and the scale of our platform. The same platform that underpins our world-leading CDN. Akamai CDN handles over 5 trillion requests every day. In addition, we resolve more than 3 trillion DNS queries each day. This gives us unmatched real-time insight into the world's Internet traffic, which we analyzed to provide best-in-class threat intelligence, protection, and support. We also have one of the industry's largest and most experienced teams of security professionals with thousands of engineers and consultants working on security for our customers. Our security solutions are tightly integrated into the world's largest and most distributed Edge platform. And that provides unmatched global scale to defend customers against not only the largest DDoS attacks, but also against the best spot armies that are waging attacks from the edge. The integration of our security solutions with our CDN solutions also provides benefits to our customers in terms of improved performance and ease of use. With Akamai, security and performance go hand in hand. You can buy them together as a single for tech and perform package, which makes purchasing and integration easy for the customer. And when you buy security from Akamai, your performance is automatically improved. That's because we apply the security layer as we're delivering the content from the world's true Edge platform. This means that the processing needed for security stays close to the end-user, which makes for much better performance. Akamai's unique combination of security and delivery provides a powerful offering in the market, which is one reason by we are the market leaders in both security CDN. Our CDN business also generates substantial cash that we can use to invest in future growth. As we've recently done with the Guard core acquisition. For example, our CDN business generated revenue of $526 million in Q3, and contributed substantially to our overall free cash flow of $273 million. Enough to cover almost half of what we spent to acquire Guard core. We believe that having the world's largest and most distributed Edge network also provides a great foundation for the growth of our Edge applications business. As 5G rolls out, as IOT applications proliferate, and as more data is created and processed at the edge. A kamai's Edge compute platform is very well-suited to support the high throughput and low latency applications that are not well served by traditional cloud providers today. From delivery and performance to compute and security, the world's leading brands want our help. That's because the internet is getting more complicated with more traffic, higher user expectations, and more cyber threats every day. And the world's leading enterprises know that, Akamai can help keep their digital experiences close to their end-users and the threats further away. They know that what we do makes life better for billions of people, billions of times a day, and that nobody powers and protects life online like Akamai. I will now turn the call over to Ed to provide further details on our Q3 results and our outlook for the rest of the year. Ed.
Ed Mc Gowan: Thank you, Tom. As Tom just outlined, Akamai delivered another excellent quarter. Q3 revenue was $860 million, up 9% year-over-year, or 8% in constant currency. Revenue was again driven by very strong results in our security business. Revenue from our security technology group was $335 million, up 26% year-over-year, or 25% in constant currency. Security now accounts for 39% of our total revenue. Revenue from our Edge technology group was $526 million flat year-over-year and down 1% in constant currency. Foreign exchange fluctuations heading negative impact on revenue of $5 million on a sequential basis in positive $4 million on a year-over-year basis. International revenue was $412 million up 16% year-over-year, or 15% in constant currency. Sales in our international markets represented 48% of total revenue in Q3, up 3 points from Q3, 2020, and up 1 point from Q2 levels. Finally, revenue from our U.S. market was $449 million up 3% year-over-year. Moving now to costs, cash gross margin was 76% in line with our expectations. GAAP gross margin, which includes both depreciation and stock-based compensation, was 63% non-GAAP cash operating expenses were $261 Million. Now moving on to profitability, adjusted EBITDA was $396 million. Our adjusted EBITDA margin was 46%, non-GAAP operating income was $277 million and Non-GAAP operating margin was 32%. Capital expenditures in Q3, excluding equity compensation and capitalized interest expense were $129 million. This was below our guidance range, primarily due to continued progress on network capex efficiency projects. GAAP Net Income for the third quarter was $179 million or $1.08 of earnings per diluted share. Non-GAAP net income was $239 million or $1.45 of earnings per diluted share, up 11% year-over-year, up 10% in constant currency, and $0.04 above the high-end of our guidance range. Taxes included in our non-GAAP earnings were $39 million based on a Q3 effective tax rate of approximately 14%. Moving now to cash in our use of capital. As of September 30th, our cash equivalents and marketable securities totaled approximately $2.8 billion after accounting for the $2.3 billion of combined principal amounts of our 2 convertible notes. Net cash was approximately $452 million as of September 30th. During the third quarter, we spent approximately $97 million to repurchase shares, buying back approximately 800 thousand shares. We ended Q3 with approximately $321 million remaining on our current repurchase authorization, which runs through the end of this year. As noted in today's press release, our Board authorized a new buyback program of up to $1.8 billion beginning January 1st, 2022, and running through the end of 2024. As we've previously discussed, our primary intention is to buy back shares to offset dilution from employee equity programs over time. However, our repurchase authorizations also allow us to opportunistically deploy capital if or when we believe there is a valuation disconnect in the market based on business or market conditions. Combining the two authorizations, we currently have more than $2 billion available for share repurchases through the end of 2024. We believe our strong Balance Sheet and significant free cash flow generation, which totaled $273 million or 32% of total revenue in Q3 also provides us with significant financial flexibility to pursue a balanced capital deployment strategy. As such, we plan to continue to invest organically in R&D and product development, expand our capabilities through M&A as you saw with our most recent acquisition of Guard core and return capital to shareholders via share repurchases. Moving onto Q4 guidance, there are two factors to consider as you update your models for the Fourth Quarter. First, we closed the acquisition Guard core on October 20th. Our guidance assumes Guard core will contribute approximately $6 to $7 million of revenue in Q4. It also assumes that Quadcore will be approximately $0.05 dilutive to our total non-GAAP earnings per share in Q4. Second, as in prior years, seasonality plays a large role in determining our Fourth Quarter financial performance. We typically see higher-than-normal traffic for our large media customers and from seasonal online retail activity for our e-commerce customers, which are both difficult to predict. With that in mind, we're projecting Q4 revenue in the range of $883 million to $908 million or up 4% to 7% as reported or 5% to 8% in constant currency over Q4 2020 Foreign exchange fluctuations are expected to have a negative $3 million impact on Q4 revenue compared to Q3 levels, and a negative $6 million impact year-over-year. At these revenue levels, we expect cash gross margins of approximately 76%. Q4 non-GAAP operating expenses are projected to be $290 to $297 million. We anticipate Q4 EBITDA margins of approximately 43% to 44%. We expect non-GAAP depreciation expense to be between $120 to $121 million. factoring in this guidance, we expect non-GAAP operating margin of approximately 30% for Q4. Moving on to capex, we expect to spend approximately $128 to $133 million excluding equity compensation in the fourth quarter. This represents less than 15% of anticipated total revenue. And with the overall revenue and spend configuration I just outlined, we expect Q4 non-GAAP EPS in a range of $1.37 to $1.44. The CPS guidance assumes taxes of $38 to $39 million based on an estimated quarterly non-GAAP tax rate of approximately 14.5%. That also reflects a fully diluted share count of approximately 164 million shares. Looking ahead to the full year, we are raising our guidance. We now expect revenue of $3.439 billion to $3.464 billion, which is up 8% year-over-year as reported, or up 7% in constant currency. We now expect security revenue growth to be in the mid-20% range for the full year 2021. We are estimating non-GAAP operating margin of approximately 31% and non-GAAP earnings per diluted share of $5.63 to $5.69. And this non-GAAP earnings guidance is based on a non-GAAP effective tax rate of approximately 14.5%. They fully diluted share count of approximately 164 million shares. Finally, full-year CapEx is anticipated to be approximately 16% of revenue, consistent with our prior guidance. We are very pleased to deliver another quarter of excellent financial results, and we look forward to closing out a strong 2021. Thank you. Tom and I will be happy to take your questions, Operator.
Operator: Thank you. [Operator Instructions]. Your first question comes from the line of James Fish from Piper Sandler. Your line is now open.
James Fish: Hey, guys, nice quarter. Thanks for the questions. A couple of your competitors are starting to get a little bit louder on the security side with getting a foot in the door with government and 0 trust architectures so, I guess my question is, how was the federal vertical for you this quarter, and what will it take for Akamai to become more a part of those conversations, especially when you guys already do service some government stuff?
Tom Leighton: Our government business is very strong, particularly in security. We defend most -- all the major agencies in the government, pretty much every branch of the military. So, I would say we have a very strong business there.
James Fish: All right. And then on Guard core, how long until the 100-plus reps are likely selling the entire security portfolio? And really also any update to the go-to-market onto security standalone sales with channel partners, as well as what you guys are doing to target developers better with Edge applications. Thanks, guys.
Ed Mc Gowan: Yeah, hey Jim, it's Ed. I'll take the first one and then maybe Tom can follow up on the developers. But in terms of the sales force, we're going to maintain the sales force that we acquired from Guard core. This is pretty typical what we do with our acquisitions. They will be primarily in an overlay function. It's a little bit different of a sale. Very similar to some of our enterprise sales and we just we'll build out that team a bit. Probably takes maybe a year or so as the rep start to introduce Guard core into their accounts that they begin to get comfortable with selling Guard core. That's been our typical model, so I think we've got a pretty good -- acquired a great team from Guard core and we just combine that with our existing enterprise sales team. And then as far as channels go, we did pick up a few channel partners as a result of Guard core and we're still actively out recruiting more and more channel partners.
Tom Leighton: And in terms of the developer focused question, we've done a lot of work to make our platform be very accessible to developers. A lot of efforts there and strong progress. And in fact, on a daily basis, we're now spinning up about 5 billion applications on Edge workers and that's every day. So strong adoption of our capabilities in terms of Edge computing.
Tom Barth: Operator, next question.
Operator: Yes, thank you. Next question comes the line of Sterling Auty from J.P. Morgan. Your line is now open.
Sterling Auty: Yes. Thanks. Hi, guys. You gave us the security growth on a constant currency. But can you give us a sense of what it was on an organic constant currency basis. And Tom, you had highlighted a number of different areas and strengthened DDoS, etc. What was the tip of the sphere that drove the growth, this quarter in particular?
Ed Mc Gowan: So, the organic security growth in constant currency should be about 22%, so odds will be added about 3 points of growth. Tom you want to take the other part?
Tom Leighton: Yeah. And the strength was really across all of our product categories. All of them growing at close to 20% or more. Infrastructure doing well, app and API protection. Fraud, well into close to 30% growth, and access, the best of all. And of course, that will get a lot stronger now, with Guard core and the ransomware solution. So, it's across-the-board in security.
Sterling Auty: That's great. And maybe one really quick one. Given the contribution you're expecting from Guard core in Q4, does that mean that the run rate in terms of what the contribution in '22 might actually be better than what you thought at the time of the acquisition?
Ed Mc Gowan: Yeah. Hey, Sterling, 2 points on that, so yes, I think we should see better contribution from Guard core and also, we've been off to a pretty good start here in the first couple of weeks since we closed the acquisition rate, they finished very strong. I was very impressed to see several multimillion-dollar deals, in several different verticals across the different GOs. We saw a couple in the U.S., a couple in EMEA and APJ, we saw deals and transportation which isn't really a huge vertical for Akamai as well as other verticals were strong in like insurance and finance. So off to a pretty good start, pretty optimistic so far, and I do think they'll contribute a bit more next year. We'll give you a full guidance on our next call for next year, but so far off to a pretty good start.
Sterling Auty: Excellent. Thank you.
Operator: Your next question comes from the line of Colby Synesael from Cowen and Company. Your line is now open.
Michael Elias: Hi, this is Michael on for Colby. 2 questions if I may. First, as you think about the incremental security offerings that could make sense to add via M&A moving forward, what comes to mind? And then the second, what are you seeing from the customer verticals that have been more heavily impacted by the pandemic as we go into the holiday season? Thank you.
Tom Leighton: Yes. We continue to look and invest in new capabilities and security, both organically and through M&A. As we talked about, tape integrity manager released in the last year, very exciting technology. Going forward we have account protector, there's a lot of customer interest there. And then early next year, audience hijacking protection. I think that's -- a lot of customers have asked for that and that stops malware plug-ins from stealing or hijacking their audience right before the point-of-sale or the transaction is executed. Obviously, in the Access segment, I think that's a huge area of future growth. Really excited about the Guard core acquisition that combines very nicely with our 0 trust solutions that combines with enterprise application access to give you the full combination of North Southeast, West will be compelling in the market. So, we're continuing to invest across the board and a portion of the existing solutions that -- we continually work on those to add features, stay ahead of the new attack vectors. So, it's not just like you building a web app firewall, you're constantly adding new capabilities to it to stay ahead of the attackers to keep our customers safe.
Ed Mc Gowan: And then on your second question? [Indiscernible] Yes. Sure. On the second question was around the verticals that were impacted and if you recall we out commerce and travel. I would say in travel we're starting to see a bit of improvement there, we're starting to see traffic pick up a little bit. As a reminder, that's above 4% of our total revenue, so it doesn't have a huge impact in terms of what we're seeing as far as an improvement, but it's good to see that that's starting to pick up a little bit. Commerce, I would say is pretty mixed. We're seeing good strength in security, still seeing some pressure, especially in the U.S. Commerce vertical. That's a much bigger vertical. That's around 15% of total revenue. So, we're not quite out of the woods yet with commerce, again, especially in the U.S. That's the area that we're probably seeing the most weakness, and that's still persisting from the pandemic.
Michael Elias: Thank you.
Operator: The next question comes from the line of Keith Weiss from Morgan Stanley. Your line is now open.
Keith Weiss: Just wanted to thank you guys for taking the question. Two areas that I was hoping to dig into. Could you talk to the disparity in growth between the U.S. and international? I thought it had more to do historically with platform customers in the U.S. under performing, but now the platform customers are actually doing really well and growing pretty well. So, I [Indiscernible] on why the U.S. is still under performing international regions. And then, a second question on the operating margin side of the equation, any guideline you could give us and how we should think about calendar year 22. Are there kind of a lot of companies are talking to us? Reiteration, if you will, or maybe more spending on travel and people come back to the office and marketing events, ramping back up. On the flip side of the equation, you’ve been kind of under-spending on CapEx versus the original target, and that's coming down as a percentage of revenue. So perhaps there's some gross margin benefit that you could see in calendar '22. It's a good offset that. So, any kind of sense you can give us on how to start thinking about calendar '22 margins?
Ed Mc Gowan: Sure. Well, I'll start with the second part on margin. So yes, you're correct. Next year, we'll be expecting that we should start traveling again, so it'll be a little bit more OpEx there. You're right to call it CapEx as I think the team is doing a fantastic job on a lot of CapEx efficiency projects that we've got going with both software and hardware. Being able to drive that down you would expect that CapEx to be back to those normal levels that we've seen, maybe even a touch lower. So that impacts your depreciation, but it takes a while for that to flow through the model. I'm sure you won't get a ton of benefit of that right away, but certainly down the road you will. I have given some prior guidance when we had the Guardicore call about operating in the 29% to 30% range for next year. And then hopefully getting back, or we will get back to over 30% in '23. Obviously, we'll update you. I mentioned earlier to Sterling that Guardicore contribution probably a bit better than what we said earlier on. I don't have a number to call out yet, so that'll obviously help out the operating margins a touch there. And then you asked about U.S. and international and the disparity between the two. I sort of flip it around and say that it's not so much the U.S. being weak, but really just strong international growth. U.S. is low single-digit. I mentioned on the previous question that's where we're having the most trouble with our U.S. commerce vertical, which are pretty significant vertical in the U.S. and then we also have a lot of large media customers that are in the U.S. and that's where you tend to see more of the splitting of traffic and pricing pressure. So those things combined sort of put a little bit of pressure in terms of the growth rate in the U.S. but, really the strength outside the U.S. is something that I think is a significant advantage for us. We made a lot of investments both in the network and the sales teams, etc. and we've been able to drive pretty significant growth. Very happy with what I'm seeing in terms of participation, or as strong growth in countries like Korea, Spain, Brazil, Mexico, Hong Kong, Singapore, Taiwan, I mean across-the-board, we're seeing very strong growth. Latin America, in particular has been very strong. We made an acquisition there a couple of years ago, start to get some good scale out of that. A little bit of a mixed picture in the U.S. with some challenges in commerce. But really, I have looked at it as just very strong international presence and growth.
Keith Weiss: Got it. I mean, should the take away be that like -- if we just looked at the security side of the equation. The growth in U.S. and international be more even on the security side of equation than it would on the Edge Tech side?
Ed Mc Gowan: Yes, I think that's a good way to look at the key. If I look at in the web performance, especially in commerce, that's where the primary challenge is right now. But if I look at security, obviously the U.S. was the first to adopt. We're still seeing very, very strong growth, and as matter of fact, 67% of our customers are buying 1 security product, 34% are buying 2. If you put that into perspective in a year, we've gone up 6 points in terms of security adoption for the customer base. That's adding over 600 customers. So, we're seeing good broad-based strength in security, both here in the U.S. and also internationally. But I think you're thinking about it in the right way in terms of having strong security growth in both regions.
Keith Weiss: Got it. Excellent. That's very helpful. Thank you, guys.
Operator: Your next question comes from the line of James Breen from William Blair. Your line is now open.
James Breen: Thanks for taking the question. Just on the cash flow side, it seemed like strictly strong quarter given some of the improvements you've had, the network and just expense control in general. How do we -- how should we think about that cash flow going forward? Is this a particular strong quarter? And it can tend, tend to drift down over time or is it going to be lumpy or are we at a sort of a new run rate in terms of cash generation? Thanks.
Ed Mc Gowan: Yes, great question, Jim. Q1 tend be the lower quarter from a cash flow perspective just because of working capitals, when you say your bonus is off. But I think if you peg your CapEx to that 15% range, you're looking at pretty significant improvements. I think if you use that as your guide, working off the operating margins we gave you and think about Q1 as probably being a low point as you're modeling out your free cash flow. But yeah, very, very strong free cash flow generation this quarter for sure.
James Breen: Great, thanks. And then just one other one. As you look at the revenue growth, excluding the platform customers, the platform customers were down about 3 million sequentially. Is there a range now where you feel like in the sort of low 60's range where that revenue is going to hover for those companies given the amount of growth you've seen in the last 12 to 18 months from that?
Tom Leighton: Yeah, I think that's probably not a bad place to peg it Jim. Q4 always tends to be a bit of a stronger quarter and that verticals, a little bit of seasonality there. You always have renewals. So, whenever you have a renewal, you'll see it pull back a couple of million dollars depending on the timing and that sort of stuff. But I think [Indiscernible] it's been a low 60's, it's probably a decent place to peg it.
James Breen: Terrific. Thank you.
Operator: Your next question comes from the line of Frank Louthan from Raymond James. Your line is now open.
Frank Louthan: Yeah. Great. Just wanted to talk a little bit about the buybacks you said you'd opportunistically use that take advantage of the market valuation. What levels seem appropriate here. It's kind of the first question and I've got a follow-up.
Tom Leighton: Primarily, we've used the equity buyback to offset the equity dilution from employee grants. And from time-to-time, we do buy back additional shares and we've seen that over the years. And we use that approach such that as the stock price declines, we will buy back more.
Ed Mc Gowan: And I do feel that in this market, Akamai has a very strong presence, both in CDN and security. Our security business growing at 25% on a very big number. And I do feel that Akamai is worth lower in this market. And so, you may see us buyback additional shares, especially depending on how the stock price fluctuates.
Frank Louthan: Alright, great. And then, you've done a good job adding together some M&A for the secure -- on the security side, any other tools do you think you need to make yourself more competitive in the market? Do you feel like you've got kind of the right mix here to -- for that product set?
Tom Leighton: Yeah, we're always looking at new capabilities as I mentioned. And of course, the attackers are always innovating with new forms of attack. But I am very excited about the Guardicore acquisition and I think it really does fill out and complete our access story, our ability to stop ransomware and malware. As I mentioned, we already have capabilities that prevent the malware from getting in. Enterprise Application Access in particular governs what employees can touch and access and even then, it has to come through Akamai's application firewall, so we're making sure that malware doesn't come in. We also have multi-factor authentication which make sure that the employee is who they say they are. And now we're -- Guardicore, we stopped the spread of the malware if it does get in. And there are a lot of ways the into the enterprise today. It is really -- despite all the defenses you put in place, somebody for example, in the capital pipeline case, a password or potential gets out there. Now we still have ways of catching that somebody is using a stolen credential, but malware does get in still, and so the real key there is stopping the spread, and that's what Guardicore does. And so now I think it's really nice because you stopped the ransomware with Guardicore, but we've got the whole package in whole solution now. And I think that's really unique in the marketplace and very exciting.
Frank Louthan: Alright, great. Thank you very much.
Operator: Your next question comes from the line of Amit Daryanani from Evercore. Your line is now open.
Amit Daryanani: Thanks a lot. And good evening, everyone. I have two questions as well up near the first one I was hoping you could talk about. As I look at the midpoint of the guide for December of is there a way to think about how are you thinking about seasonality in Edge and security? In the bottom, are you going to get through the security numbers may imply a much more severe deceleration than what people are modeling. So, I just love to understand how are you assuming those two segments stacking up in the December quarter.
Ed Mc Gowan: Yeah. Sure, I'll take that. We'll start with the Edge. Obviously, Edge, is quite a busy quarter in Q4. As I talked about, seasonality from e-commerce, I think it's obviously a tougher quarter to call here with some supply chain disruptions and things like that. Does that drive more or less Internet traffic, and what does that holiday season look like? Typically, a very strong media quarter where you see new devices, and games coming online -- I'm sorry. Devices, consoles, etc. coming online. And then you also have a lot of sporting events in Q4, back-to-school, you've got lots of game releases, so it can be a pretty robust season for us and obviously challenging to call I looked at the events calendar, it's pretty full, so provided we can see some good traffic, you can see good upside we delivered that in the last couple of years. In terms of security, it’s not stopped as seasonal. Certainly, there are some bundles we have where there is -- traffic can impact that a bit but, I think to take our security guidance, we've been pretty conservative in the way that we've approached security, and we've been over-delivering every quarter. I think, with that obviously Guardicore is off to a good start so I wouldn't imply that as a seasonal down tick or anything like that in our security growth.
Amit Daryanani: Got it. And then if I could follow-up the CapEx number for September quarter and really for December as well. I mean, capex as a percent of sales, I think will be 14, 15% for the back half of the year, versus 19%, 20% of the last several quarters prior to that up. I'm curious. Is capex coming down because you feel like there's enough capacity you have out there and you can see that lower or is it more that you just can't get your hands on the supply chain and the products and need to drive capex. I'm trying to understand what's taking capex lower, and then how do I think about this as we go into 2022?
Ed Mc Gowan: Yes. I would say it's good execution. And if anything, with the supply chain, we're not seeing supply chain disruptions in terms of the fact that we actually, if you remember a few calls ago, we talked about in the pandemic, we took capex up and we were pretty cautious in terms of making sure that we had plenty of extra capacity available for -- if you see the pandemic continue and see traffic growth, etc. So, we learned in, we built up our inventory a bit, we fund a lot of small equipment so that we're not concerned right now anyway with the supply chain. So, I'd say that's part of what's driving it as we built out ahead of demand, we're pretty smart in the way we did that. But also, I mentioned there's a number of CapEx efficiencies that Adam and his team are working on. Not only just software, but network design, deployment optimization, looking at different hardware improvements, and just to anyway to drive a good focus on lowering our need for capex and also keep in mind we have great relationships with the networks and ISP. So, in terms of doing optimization inside of their networks, are able to do that as well. So, I'd say it's really a great execution on the team's part, and CapEx has come down pretty significantly, you see that in our free cash flow results.
Amit Daryanani: Does that sustain next year? This mid-teens CapEx as a percent of sales, is that the right way to model this out?
Ed Mc Gowan: Yes. Right now [Indiscernible] you see another pandemic or some major events and we see some crazy unexpected traffic growth, yeah, I think it's a sustainable number, certainly going into next year. I don't want to get into giving guidance, but I think that I talked about in the past that we'd be getting back to this level and we're actually operating a little bit better than that.
Amit Daryanani: Perfect. Thank you.
Operator: Your next question comes from the line of Rishi Jaluria from RBC. Your line is now open.
Rishi Jaluria: Hey, guys. Thanks so much for taking my questions. And nice to see security growth hold up and actually accelerate with this quarter. 2 questions. First, I wanted to go a little bit deeper on the supply chain issues. I appreciate you've obviously over invested capacity with the OTT launches and the pandemic last year. You seem pretty well insulated from the rising cost, but at what point that this continues dragging out, does it begin to become a worry, and you might have to overspend in order to keep capacity and not have to turn away business? And maybe related to that. As we think about the environment heading into Q4, how do we expect that to shake out, especially given Q4 is such a -- traditionally such a strong commerce season? A lot of companies are telling us they're not going to able to meet demand. especially when it comes to electronic goods. So, is that a worry that you have, and maybe how are you thinking about embedding that in your guidance? Thank you.
Ed Mc Gowan: Yes. So, I'll take the second part first. You know, that's why we give a pretty wide range. I just mentioned on the last question that, it's hard to predict what the commerce season looks like. And obviously, when you are in the business of delivering Internet traffic, one model could suggest that, well, shelves are not stocked. People are doing more surfing to find things. Another model would suggest that there's not as much shopping and people are giving cash and gift cards. Hard to tell, but we did put out a pretty big range there. Also keep in mind that a lot of our Commerce customers, about half of our Commerce customers have taken, we call our 0 overage, so you've kind of flattened out that first thing. So, the bursting for commerce is not as big of an impact if we're still has an impact. In terms of the device cycle, that's an interesting one. We do expect and we have seen over the last several years, especially in the last couple of weeks of the year, as new devices come online as a lot of firmware updates and things like that, I still expect to see that, but there's other things that are not as dependent on that, for example, gaming releases, new video content that comes out if you don't have a new machine, you're watching it on your old machine. So, I still think that we'll have a pretty big immediate quarter for sure. That's why I've given a pretty wide range to try to take those things into consideration. And then on your supply chain question you had asked about, when does this become a problem? That's funny. I asked the same questions to my team as we go through our capex build-out. We've done a nice job of building out several quarters’ worth of inventory here, and we've diversified our supply chain. And the team's done a good job of ensuring that we're not seeing any significant increase in price or anything like that. A little bit on the freight side, but it's not really material and I think that should start to work itself out. But if we do see another massive growth and traffic, maybe we should start to run into some problems, but so far so good. And like I said, the team did a really good job preparing, not expecting this type of a disruption in the supply chain, but expecting that the result from the pandemic would last a lot longer. So, we did some scenario planning, so we're in pretty good shape at the moment.
Rishi Jaluria: That's really helpful. Thank you so much.
Operator: Your next question comes from the line of Alex Henderson from Needham. Your line is now open.
Alex Henderson: Thanks. Looking at the guidance and the commentary, it does sound like your security businesses exp - if I add in some of the inorganic, that would imply even lower growth. Is it reasonable to think that the security business can sustain a 20% growth rate organically in '22 or is that too aggressive of an expectation for a billion three business?
Ed Mc Gowan: Yes, I think one thing to keep in mind, Alex, is you've got the anniversary of [Indiscernible] Southern Europe, your growth rate lapse in Q4 for [Indiscernible] and then we got in Guardicore. We've said in the -- when we did our analyst data that we expected to be able to grow 20% [Indiscernible] 3 to 5 years with acquisitions being part of the strategy. And you can see that the Guardicore acquisition with the prior guidance, and a couple of points of growth. We obviously did much better this year than we expected going into the year. Security has over performed every single quarter. We still feel pretty comfortable with our 20% growth rate as we talked about, as a matter of fact coming out of this year we're doing a bit better than that. So, I think, if you're taking the super all end of the range, maybe you could come up with that formula, but we're expecting pretty solid growth here over the security in Q4.
Tom Leighton: Yes. Our strategy in security is to combine organic development, we have intelligence, and timely acquisitions. And we'll continue to do that. And of course, when you buy a Company after a year, its growth becomes organic and it's no longer counted as an acquisition growth per se, and I think we've had a really great track record of doing that in security, going back all the way to Prolexic acquisition in 2014. And as I mentioned, I think Guardicore is fundamentally like that in terms of really transforming our enterprise security business, just like Prolexic transformed our DDoS business, which of course today is very, very successful. We're the market leader by far and our goal is to do that on the Enterprise Security side to things like stopping ransomware and stopping malware. And as we -- as Ed said, as we continue to want to grow our security business over the longer term at 20+% that we'll include acquisitions, and I think acquisitions are a good thing. It gives you a jump start on technology, an important area. Guardicore has been working for a long time to develop their micro-segmentation approach. I believe it is market getting what they do. They're the best folks out there, and now we have the benefit of all of the years of effort that they put into that at a perfect time. Because a lot of companies are rightly worried about stopping ransomware and now Akamai's in a position to help them do that. And of course, it sits with a lot of our organic development on technology around EAA. It's an ideal combination. So, we'll continue to do both and in working hard to continue to our security growth that
Alex Henderson: Okay. I get it. Thanks. That's helpful. Can you talk a little bit about the pricing environment, whether there's been any change in competitive landscape, have you seen more competition or less competition? How should we think about the environment? I think we're also seeing enterprise is spending more this year. Do you think that that sustains into 2022 given the first half of spike in an attack caused a flurry of spending intentions?
Ed Mc Gowan: I think the competitive environment is very similar to what it's been in the past. It's -- it is a very competitive environment. Across-the-board from Cloud giants who are also our largest customers, all the way down to startups. Obviously, CDN is a mature environment. competitively, and so I don't see there's any fundamental change there. Security is really a great environment for us. We're the market leader by far in the core areas of defending and protecting websites, applications, and APIs, The leader by far and DDoS prevention. And those are areas that have a lot of attacks taking place. And now, the new category for us where we're going to encounter new competition because we're moving into that space in a big way would be
Tom Leighton: enterprise security. We already have a very strong access solution there. And now we have what we believe is the best solution to stop ransomware for with micro-segmentation. And by adding that to Akamai, we now have a new set of competitors there, because we're entering their space and we think there's a lot of potential gain for Akamai there, and ability to help major enterprises.
Alex Henderson: Great. Thank you very much.
Operator: Your last question comes from the line of Brandon Nispel from KeyBanc Capital Markets. Your line is now open.
Brandon Nispel: Awesome. Thank you for taking the question. Could you unpack the growth in the Edge Technology Group, please? What was the growth in the quarter for Edge applications, and what does that imply for the growth in the Edge delivery business? And then how do you expect these two segments within that larger group to trend exiting the year? Thanks.
Ed Mc Gowan: So, Brian, we're not going to breakout Edge apps every quarter. We talked about it last time growing at over 30%, and we think that business can continue to sustain that. I think we'll exit the year on a run rate over $200 million, which is a pretty good healthy growth rate there. And then just the -- again, we're not breaking out the Edge delivery business this quarter, we'll do it at the end of the year.
Brandon Nispel: If I could just follow up on that when you back out some of the one-time items that are affecting comparability and the Edge technology business specifically, I think India apps and you're still lapping. Is that business growing? And what's going to cause that business to return to growth next year? Thanks.
Ed Mc Gowan: Yes. So, it's obviously a just a tougher compare. This is the First Quarter that we don't have that compare and you saw that we were roughly flat in terms of total Edge Tech. I think as we get into next year, it's an easier compare. I think we're comfortable with our longer-term growth, a low single-digits for the Edge business over time, obviously. With the Edge applications business much faster growing as that becomes more material that could change the growth rate. I think it's just continued execution and traffic growth going into next year on a much easier to compare, I think you'll start to see a bit of growth rate pick up a little bit there.
Tom Leighton: Okay, thank you, everyone. In closing we'll be presenting at a number of investor conferences and road shows throughout the rest of the fourth quarter. And details of these can be found in the Investor Relations section of akamai.com. We appreciate you joining us, and all of us here at Akamai wish continued good health to you and yours, and have a great evening. Thank you.
Operator: This concludes today's conference call. Thank you for participating and have a wonderful day. You may all disconnect. | [
{
"speaker": "Operator",
"text": "Good day, ladies and gentlemen, and welcome to Akamai Technologies, Inc. third quarter 2021 earnings conference call. At this time, all participants are in a listen-only mode. Later, we will conduct a question-and-answer session and instructions will follow at that time. If anyone should require assistance during the conference, [ Operator Instructions]. As a reminder, this conference call is being recorded. I will now like to turn the conference over to Tom Barton, Head of Investor Relations. Thank you. Please go ahead."
},
{
"speaker": "Tom Barth",
"text": "Thank you, operator. Good afternoon, everyone. And thank you for joining Akamai's third quarter 2021 earnings conference call. Speaking today will be Tom Leighton, Akamai's Chief Executive Officer, and Ed McGowan, Akamai's Chief Financial Officer. Before we get started, please note that today's comments include forward-looking statements, including statements regarding revenue and earnings guidance. These forward-looking statements are subject to risks and uncertainties and then Involve a number of factors that could cause actual results to differ materially from those expressed or implied by such statements. These factors include uncertainty stemming from the COVID-19 pandemic, the integration of any acquisitions and any impact from unexpected geopolitical developments. Additional information concerning these factors is contained in Akamai's filings with the SCC, including our Annual Report on Form 10-K and quarterly reports on Form 10-Q. The forward-looking statements included in this call will represent the Company's view on November second, 2021, Akamai disclaims any obligation to update these statements to reflect future events or circumstances. As a reminder, we'll be referring to some non-GAAP financial metrics during today's call. A detailed reconciliation of GAAP and non-GAAP metrics can be found under the financial portion of the Investor Relations section of akamai.com. And with that, let me turn the call over to Tom."
},
{
"speaker": "Tom Leighton",
"text": "Thanks, Tom. And thank you all for joining us today. I'm pleased to report that Akamai delivered excellent financial results in the third quarter, coming in at or above the high end of our guidance ranges for revenue, operating margin, and earnings per share. Q3 revenue was $860 million, up 9% year-over-year, and up 8% in constant-currency. Non-GAAP operating margin in Q3 was 32%, which reflects our continued focus on operational efficiency even as we've continued to invest for future growth. Q3 non-GAAP EPS was a $1.45 per diluted share, up 11% year-over-year. Akamai's strong performance in Q3 was largely driven by our security business, which is now one of our leading cloud security businesses in the world, with an annualized revenue run rate of more than $1.3 billion, up 26% year-over-year, and up 25% in constant currency. Over the last several years, we've grown our security portfolio from point solutions into a comprehensive platform that provides defense in depth to address our customers biggest threats. The unique breadth of our defenses is important to our customers who want more security capabilities from fewer vendors. Our security solutions are highly differentiated and recognized as best-in-class by our customers, who see us as a leading provider of services to protect our most critical assets, including enterprise websites, applications, data, and access. We routinely earned top rankings in multiple categories for major industry analysts. For example, Akamai disrupted the web apps security market when we launched Kona Site Defender in 2012. Since then we've continued to extend our leadership position and the web app firewall sector with Gartner recently naming Akamai as a market leader for the 5th year in a row. Akamai has been the market leader in DDoS protection since we acquired Prolexic in 2014, Forester recently said, ''Large enterprise clients that want an experienced, trusted vendor to make their DDoS problem go away, should look to Akamai. '' As new threat vectors have emerged, we've extended our platform to defend against them. For example, we created the first comprehensive bot management solution to protect our customers from sophisticated bot operators would try to steal content, disrupt operations are penetrate user accounts. According to Forester, Akamai is best for companies wanting to [Indiscernible] bots off the edge. Bloomberg Business Week even quoted a hacker calling Akamai's bot defense the hardest to crack. More recently, we released Akamai page integrity manager to identify malicious code of third-party scripts and websites that's designed to steal end-user data. Page integrity manager helps to address a major threat that's been costing businesses hundreds of millions of dollars and fines, as well as serious reputation damage. We plan to extend our web app protections further in the coming months with the release of Account Protector and Audience Hijacking Prevention. Account Protector is designed to reduce fraud by making sure that the entity logging into an account is the crew owner of that account. Audience Hijacking Prevention can help businesses protects sales by fording malware that diverts a customer just before the completion of a transaction. Since founding, Akamai over 20 years ago, our vision has always been to help our customers solve their toughest Internet challenges, and today that includes stopping ransomware. Ransomware is a huge problem for enterprises around the world, with a new attack striking every 11 seconds. The damage resulting from ransomware is expected to amount over $20 billion this year alone. Garda core (ph.) is critical to stopping the spread of ransomware, and that's a key reason why we acquired the Company. Akamai is already selling solutions such as Enterprise Application Access that help prevent attackers from gaining access to enterprise infrastructure and applications. But to be secure in today's world, you also need a second layer of defense to lock the spread of malware that has gained a foothold in the enterprise. And that's where Garda core comes in. Garda core helps detect when a breach occurred by identifying anomalous data flows within enterprise networks. Garda core also helps prevent the malware from spreading through a capability known as micro-segmentation. Garda core's, micro-segmentation solution limits access within the enterprise to only those applications that are authorized to communicate with one another. Denying communication as the default greatly limits the spread of malware and protects the flow of enterprise data across the network. And that's the key to stopping ransomware. We believe Guard core 's best-in-class micro-segmentation solution is the perfect addition to our Zero Trust portfolio, enabling Akamai to offer customers a comprehensive solution to stop the damage being caused by ransomware and malware. During the call we held on September 29, we spoke about the parallels between our acquisition of Guard core with our acquisition of Prolexic in 2014. Just as the acquisition of Prolexic propelled us to a leadership position in helping to stop DDoS attacks. We believe that the acquisition of Guard core will establish Akamai as a leader in helping to stop the damage caused by ransomware, as well as other forms of malware. Customers see, Akamai as a strategic partner in security, not only because of the strength and breadth of our solutions, but also because of the depth of our security expertise in threat intelligence and the scale of our platform. The same platform that underpins our world-leading CDN. Akamai CDN handles over 5 trillion requests every day. In addition, we resolve more than 3 trillion DNS queries each day. This gives us unmatched real-time insight into the world's Internet traffic, which we analyzed to provide best-in-class threat intelligence, protection, and support. We also have one of the industry's largest and most experienced teams of security professionals with thousands of engineers and consultants working on security for our customers. Our security solutions are tightly integrated into the world's largest and most distributed Edge platform. And that provides unmatched global scale to defend customers against not only the largest DDoS attacks, but also against the best spot armies that are waging attacks from the edge. The integration of our security solutions with our CDN solutions also provides benefits to our customers in terms of improved performance and ease of use. With Akamai, security and performance go hand in hand. You can buy them together as a single for tech and perform package, which makes purchasing and integration easy for the customer. And when you buy security from Akamai, your performance is automatically improved. That's because we apply the security layer as we're delivering the content from the world's true Edge platform. This means that the processing needed for security stays close to the end-user, which makes for much better performance. Akamai's unique combination of security and delivery provides a powerful offering in the market, which is one reason by we are the market leaders in both security CDN. Our CDN business also generates substantial cash that we can use to invest in future growth. As we've recently done with the Guard core acquisition. For example, our CDN business generated revenue of $526 million in Q3, and contributed substantially to our overall free cash flow of $273 million. Enough to cover almost half of what we spent to acquire Guard core. We believe that having the world's largest and most distributed Edge network also provides a great foundation for the growth of our Edge applications business. As 5G rolls out, as IOT applications proliferate, and as more data is created and processed at the edge. A kamai's Edge compute platform is very well-suited to support the high throughput and low latency applications that are not well served by traditional cloud providers today. From delivery and performance to compute and security, the world's leading brands want our help. That's because the internet is getting more complicated with more traffic, higher user expectations, and more cyber threats every day. And the world's leading enterprises know that, Akamai can help keep their digital experiences close to their end-users and the threats further away. They know that what we do makes life better for billions of people, billions of times a day, and that nobody powers and protects life online like Akamai. I will now turn the call over to Ed to provide further details on our Q3 results and our outlook for the rest of the year. Ed."
},
{
"speaker": "Ed Mc Gowan",
"text": "Thank you, Tom. As Tom just outlined, Akamai delivered another excellent quarter. Q3 revenue was $860 million, up 9% year-over-year, or 8% in constant currency. Revenue was again driven by very strong results in our security business. Revenue from our security technology group was $335 million, up 26% year-over-year, or 25% in constant currency. Security now accounts for 39% of our total revenue. Revenue from our Edge technology group was $526 million flat year-over-year and down 1% in constant currency. Foreign exchange fluctuations heading negative impact on revenue of $5 million on a sequential basis in positive $4 million on a year-over-year basis. International revenue was $412 million up 16% year-over-year, or 15% in constant currency. Sales in our international markets represented 48% of total revenue in Q3, up 3 points from Q3, 2020, and up 1 point from Q2 levels. Finally, revenue from our U.S. market was $449 million up 3% year-over-year. Moving now to costs, cash gross margin was 76% in line with our expectations. GAAP gross margin, which includes both depreciation and stock-based compensation, was 63% non-GAAP cash operating expenses were $261 Million. Now moving on to profitability, adjusted EBITDA was $396 million. Our adjusted EBITDA margin was 46%, non-GAAP operating income was $277 million and Non-GAAP operating margin was 32%. Capital expenditures in Q3, excluding equity compensation and capitalized interest expense were $129 million. This was below our guidance range, primarily due to continued progress on network capex efficiency projects. GAAP Net Income for the third quarter was $179 million or $1.08 of earnings per diluted share. Non-GAAP net income was $239 million or $1.45 of earnings per diluted share, up 11% year-over-year, up 10% in constant currency, and $0.04 above the high-end of our guidance range. Taxes included in our non-GAAP earnings were $39 million based on a Q3 effective tax rate of approximately 14%. Moving now to cash in our use of capital. As of September 30th, our cash equivalents and marketable securities totaled approximately $2.8 billion after accounting for the $2.3 billion of combined principal amounts of our 2 convertible notes. Net cash was approximately $452 million as of September 30th. During the third quarter, we spent approximately $97 million to repurchase shares, buying back approximately 800 thousand shares. We ended Q3 with approximately $321 million remaining on our current repurchase authorization, which runs through the end of this year. As noted in today's press release, our Board authorized a new buyback program of up to $1.8 billion beginning January 1st, 2022, and running through the end of 2024. As we've previously discussed, our primary intention is to buy back shares to offset dilution from employee equity programs over time. However, our repurchase authorizations also allow us to opportunistically deploy capital if or when we believe there is a valuation disconnect in the market based on business or market conditions. Combining the two authorizations, we currently have more than $2 billion available for share repurchases through the end of 2024. We believe our strong Balance Sheet and significant free cash flow generation, which totaled $273 million or 32% of total revenue in Q3 also provides us with significant financial flexibility to pursue a balanced capital deployment strategy. As such, we plan to continue to invest organically in R&D and product development, expand our capabilities through M&A as you saw with our most recent acquisition of Guard core and return capital to shareholders via share repurchases. Moving onto Q4 guidance, there are two factors to consider as you update your models for the Fourth Quarter. First, we closed the acquisition Guard core on October 20th. Our guidance assumes Guard core will contribute approximately $6 to $7 million of revenue in Q4. It also assumes that Quadcore will be approximately $0.05 dilutive to our total non-GAAP earnings per share in Q4. Second, as in prior years, seasonality plays a large role in determining our Fourth Quarter financial performance. We typically see higher-than-normal traffic for our large media customers and from seasonal online retail activity for our e-commerce customers, which are both difficult to predict. With that in mind, we're projecting Q4 revenue in the range of $883 million to $908 million or up 4% to 7% as reported or 5% to 8% in constant currency over Q4 2020 Foreign exchange fluctuations are expected to have a negative $3 million impact on Q4 revenue compared to Q3 levels, and a negative $6 million impact year-over-year. At these revenue levels, we expect cash gross margins of approximately 76%. Q4 non-GAAP operating expenses are projected to be $290 to $297 million. We anticipate Q4 EBITDA margins of approximately 43% to 44%. We expect non-GAAP depreciation expense to be between $120 to $121 million. factoring in this guidance, we expect non-GAAP operating margin of approximately 30% for Q4. Moving on to capex, we expect to spend approximately $128 to $133 million excluding equity compensation in the fourth quarter. This represents less than 15% of anticipated total revenue. And with the overall revenue and spend configuration I just outlined, we expect Q4 non-GAAP EPS in a range of $1.37 to $1.44. The CPS guidance assumes taxes of $38 to $39 million based on an estimated quarterly non-GAAP tax rate of approximately 14.5%. That also reflects a fully diluted share count of approximately 164 million shares. Looking ahead to the full year, we are raising our guidance. We now expect revenue of $3.439 billion to $3.464 billion, which is up 8% year-over-year as reported, or up 7% in constant currency. We now expect security revenue growth to be in the mid-20% range for the full year 2021. We are estimating non-GAAP operating margin of approximately 31% and non-GAAP earnings per diluted share of $5.63 to $5.69. And this non-GAAP earnings guidance is based on a non-GAAP effective tax rate of approximately 14.5%. They fully diluted share count of approximately 164 million shares. Finally, full-year CapEx is anticipated to be approximately 16% of revenue, consistent with our prior guidance. We are very pleased to deliver another quarter of excellent financial results, and we look forward to closing out a strong 2021. Thank you. Tom and I will be happy to take your questions, Operator."
},
{
"speaker": "Operator",
"text": "Thank you. [Operator Instructions]. Your first question comes from the line of James Fish from Piper Sandler. Your line is now open."
},
{
"speaker": "James Fish",
"text": "Hey, guys, nice quarter. Thanks for the questions. A couple of your competitors are starting to get a little bit louder on the security side with getting a foot in the door with government and 0 trust architectures so, I guess my question is, how was the federal vertical for you this quarter, and what will it take for Akamai to become more a part of those conversations, especially when you guys already do service some government stuff?"
},
{
"speaker": "Tom Leighton",
"text": "Our government business is very strong, particularly in security. We defend most -- all the major agencies in the government, pretty much every branch of the military. So, I would say we have a very strong business there."
},
{
"speaker": "James Fish",
"text": "All right. And then on Guard core, how long until the 100-plus reps are likely selling the entire security portfolio? And really also any update to the go-to-market onto security standalone sales with channel partners, as well as what you guys are doing to target developers better with Edge applications. Thanks, guys."
},
{
"speaker": "Ed Mc Gowan",
"text": "Yeah, hey Jim, it's Ed. I'll take the first one and then maybe Tom can follow up on the developers. But in terms of the sales force, we're going to maintain the sales force that we acquired from Guard core. This is pretty typical what we do with our acquisitions. They will be primarily in an overlay function. It's a little bit different of a sale. Very similar to some of our enterprise sales and we just we'll build out that team a bit. Probably takes maybe a year or so as the rep start to introduce Guard core into their accounts that they begin to get comfortable with selling Guard core. That's been our typical model, so I think we've got a pretty good -- acquired a great team from Guard core and we just combine that with our existing enterprise sales team. And then as far as channels go, we did pick up a few channel partners as a result of Guard core and we're still actively out recruiting more and more channel partners."
},
{
"speaker": "Tom Leighton",
"text": "And in terms of the developer focused question, we've done a lot of work to make our platform be very accessible to developers. A lot of efforts there and strong progress. And in fact, on a daily basis, we're now spinning up about 5 billion applications on Edge workers and that's every day. So strong adoption of our capabilities in terms of Edge computing."
},
{
"speaker": "Tom Barth",
"text": "Operator, next question."
},
{
"speaker": "Operator",
"text": "Yes, thank you. Next question comes the line of Sterling Auty from J.P. Morgan. Your line is now open."
},
{
"speaker": "Sterling Auty",
"text": "Yes. Thanks. Hi, guys. You gave us the security growth on a constant currency. But can you give us a sense of what it was on an organic constant currency basis. And Tom, you had highlighted a number of different areas and strengthened DDoS, etc. What was the tip of the sphere that drove the growth, this quarter in particular?"
},
{
"speaker": "Ed Mc Gowan",
"text": "So, the organic security growth in constant currency should be about 22%, so odds will be added about 3 points of growth. Tom you want to take the other part?"
},
{
"speaker": "Tom Leighton",
"text": "Yeah. And the strength was really across all of our product categories. All of them growing at close to 20% or more. Infrastructure doing well, app and API protection. Fraud, well into close to 30% growth, and access, the best of all. And of course, that will get a lot stronger now, with Guard core and the ransomware solution. So, it's across-the-board in security."
},
{
"speaker": "Sterling Auty",
"text": "That's great. And maybe one really quick one. Given the contribution you're expecting from Guard core in Q4, does that mean that the run rate in terms of what the contribution in '22 might actually be better than what you thought at the time of the acquisition?"
},
{
"speaker": "Ed Mc Gowan",
"text": "Yeah. Hey, Sterling, 2 points on that, so yes, I think we should see better contribution from Guard core and also, we've been off to a pretty good start here in the first couple of weeks since we closed the acquisition rate, they finished very strong. I was very impressed to see several multimillion-dollar deals, in several different verticals across the different GOs. We saw a couple in the U.S., a couple in EMEA and APJ, we saw deals and transportation which isn't really a huge vertical for Akamai as well as other verticals were strong in like insurance and finance. So off to a pretty good start, pretty optimistic so far, and I do think they'll contribute a bit more next year. We'll give you a full guidance on our next call for next year, but so far off to a pretty good start."
},
{
"speaker": "Sterling Auty",
"text": "Excellent. Thank you."
},
{
"speaker": "Operator",
"text": "Your next question comes from the line of Colby Synesael from Cowen and Company. Your line is now open."
},
{
"speaker": "Michael Elias",
"text": "Hi, this is Michael on for Colby. 2 questions if I may. First, as you think about the incremental security offerings that could make sense to add via M&A moving forward, what comes to mind? And then the second, what are you seeing from the customer verticals that have been more heavily impacted by the pandemic as we go into the holiday season? Thank you."
},
{
"speaker": "Tom Leighton",
"text": "Yes. We continue to look and invest in new capabilities and security, both organically and through M&A. As we talked about, tape integrity manager released in the last year, very exciting technology. Going forward we have account protector, there's a lot of customer interest there. And then early next year, audience hijacking protection. I think that's -- a lot of customers have asked for that and that stops malware plug-ins from stealing or hijacking their audience right before the point-of-sale or the transaction is executed. Obviously, in the Access segment, I think that's a huge area of future growth. Really excited about the Guard core acquisition that combines very nicely with our 0 trust solutions that combines with enterprise application access to give you the full combination of North Southeast, West will be compelling in the market. So, we're continuing to invest across the board and a portion of the existing solutions that -- we continually work on those to add features, stay ahead of the new attack vectors. So, it's not just like you building a web app firewall, you're constantly adding new capabilities to it to stay ahead of the attackers to keep our customers safe."
},
{
"speaker": "Ed Mc Gowan",
"text": "And then on your second question? [Indiscernible] Yes. Sure. On the second question was around the verticals that were impacted and if you recall we out commerce and travel. I would say in travel we're starting to see a bit of improvement there, we're starting to see traffic pick up a little bit. As a reminder, that's above 4% of our total revenue, so it doesn't have a huge impact in terms of what we're seeing as far as an improvement, but it's good to see that that's starting to pick up a little bit. Commerce, I would say is pretty mixed. We're seeing good strength in security, still seeing some pressure, especially in the U.S. Commerce vertical. That's a much bigger vertical. That's around 15% of total revenue. So, we're not quite out of the woods yet with commerce, again, especially in the U.S. That's the area that we're probably seeing the most weakness, and that's still persisting from the pandemic."
},
{
"speaker": "Michael Elias",
"text": "Thank you."
},
{
"speaker": "Operator",
"text": "The next question comes from the line of Keith Weiss from Morgan Stanley. Your line is now open."
},
{
"speaker": "Keith Weiss",
"text": "Just wanted to thank you guys for taking the question. Two areas that I was hoping to dig into. Could you talk to the disparity in growth between the U.S. and international? I thought it had more to do historically with platform customers in the U.S. under performing, but now the platform customers are actually doing really well and growing pretty well. So, I [Indiscernible] on why the U.S. is still under performing international regions. And then, a second question on the operating margin side of the equation, any guideline you could give us and how we should think about calendar year 22. Are there kind of a lot of companies are talking to us? Reiteration, if you will, or maybe more spending on travel and people come back to the office and marketing events, ramping back up. On the flip side of the equation, you’ve been kind of under-spending on CapEx versus the original target, and that's coming down as a percentage of revenue. So perhaps there's some gross margin benefit that you could see in calendar '22. It's a good offset that. So, any kind of sense you can give us on how to start thinking about calendar '22 margins?"
},
{
"speaker": "Ed Mc Gowan",
"text": "Sure. Well, I'll start with the second part on margin. So yes, you're correct. Next year, we'll be expecting that we should start traveling again, so it'll be a little bit more OpEx there. You're right to call it CapEx as I think the team is doing a fantastic job on a lot of CapEx efficiency projects that we've got going with both software and hardware. Being able to drive that down you would expect that CapEx to be back to those normal levels that we've seen, maybe even a touch lower. So that impacts your depreciation, but it takes a while for that to flow through the model. I'm sure you won't get a ton of benefit of that right away, but certainly down the road you will. I have given some prior guidance when we had the Guardicore call about operating in the 29% to 30% range for next year. And then hopefully getting back, or we will get back to over 30% in '23. Obviously, we'll update you. I mentioned earlier to Sterling that Guardicore contribution probably a bit better than what we said earlier on. I don't have a number to call out yet, so that'll obviously help out the operating margins a touch there. And then you asked about U.S. and international and the disparity between the two. I sort of flip it around and say that it's not so much the U.S. being weak, but really just strong international growth. U.S. is low single-digit. I mentioned on the previous question that's where we're having the most trouble with our U.S. commerce vertical, which are pretty significant vertical in the U.S. and then we also have a lot of large media customers that are in the U.S. and that's where you tend to see more of the splitting of traffic and pricing pressure. So those things combined sort of put a little bit of pressure in terms of the growth rate in the U.S. but, really the strength outside the U.S. is something that I think is a significant advantage for us. We made a lot of investments both in the network and the sales teams, etc. and we've been able to drive pretty significant growth. Very happy with what I'm seeing in terms of participation, or as strong growth in countries like Korea, Spain, Brazil, Mexico, Hong Kong, Singapore, Taiwan, I mean across-the-board, we're seeing very strong growth. Latin America, in particular has been very strong. We made an acquisition there a couple of years ago, start to get some good scale out of that. A little bit of a mixed picture in the U.S. with some challenges in commerce. But really, I have looked at it as just very strong international presence and growth."
},
{
"speaker": "Keith Weiss",
"text": "Got it. I mean, should the take away be that like -- if we just looked at the security side of the equation. The growth in U.S. and international be more even on the security side of equation than it would on the Edge Tech side?"
},
{
"speaker": "Ed Mc Gowan",
"text": "Yes, I think that's a good way to look at the key. If I look at in the web performance, especially in commerce, that's where the primary challenge is right now. But if I look at security, obviously the U.S. was the first to adopt. We're still seeing very, very strong growth, and as matter of fact, 67% of our customers are buying 1 security product, 34% are buying 2. If you put that into perspective in a year, we've gone up 6 points in terms of security adoption for the customer base. That's adding over 600 customers. So, we're seeing good broad-based strength in security, both here in the U.S. and also internationally. But I think you're thinking about it in the right way in terms of having strong security growth in both regions."
},
{
"speaker": "Keith Weiss",
"text": "Got it. Excellent. That's very helpful. Thank you, guys."
},
{
"speaker": "Operator",
"text": "Your next question comes from the line of James Breen from William Blair. Your line is now open."
},
{
"speaker": "James Breen",
"text": "Thanks for taking the question. Just on the cash flow side, it seemed like strictly strong quarter given some of the improvements you've had, the network and just expense control in general. How do we -- how should we think about that cash flow going forward? Is this a particular strong quarter? And it can tend, tend to drift down over time or is it going to be lumpy or are we at a sort of a new run rate in terms of cash generation? Thanks."
},
{
"speaker": "Ed Mc Gowan",
"text": "Yes, great question, Jim. Q1 tend be the lower quarter from a cash flow perspective just because of working capitals, when you say your bonus is off. But I think if you peg your CapEx to that 15% range, you're looking at pretty significant improvements. I think if you use that as your guide, working off the operating margins we gave you and think about Q1 as probably being a low point as you're modeling out your free cash flow. But yeah, very, very strong free cash flow generation this quarter for sure."
},
{
"speaker": "James Breen",
"text": "Great, thanks. And then just one other one. As you look at the revenue growth, excluding the platform customers, the platform customers were down about 3 million sequentially. Is there a range now where you feel like in the sort of low 60's range where that revenue is going to hover for those companies given the amount of growth you've seen in the last 12 to 18 months from that?"
},
{
"speaker": "Tom Leighton",
"text": "Yeah, I think that's probably not a bad place to peg it Jim. Q4 always tends to be a bit of a stronger quarter and that verticals, a little bit of seasonality there. You always have renewals. So, whenever you have a renewal, you'll see it pull back a couple of million dollars depending on the timing and that sort of stuff. But I think [Indiscernible] it's been a low 60's, it's probably a decent place to peg it."
},
{
"speaker": "James Breen",
"text": "Terrific. Thank you."
},
{
"speaker": "Operator",
"text": "Your next question comes from the line of Frank Louthan from Raymond James. Your line is now open."
},
{
"speaker": "Frank Louthan",
"text": "Yeah. Great. Just wanted to talk a little bit about the buybacks you said you'd opportunistically use that take advantage of the market valuation. What levels seem appropriate here. It's kind of the first question and I've got a follow-up."
},
{
"speaker": "Tom Leighton",
"text": "Primarily, we've used the equity buyback to offset the equity dilution from employee grants. And from time-to-time, we do buy back additional shares and we've seen that over the years. And we use that approach such that as the stock price declines, we will buy back more."
},
{
"speaker": "Ed Mc Gowan",
"text": "And I do feel that in this market, Akamai has a very strong presence, both in CDN and security. Our security business growing at 25% on a very big number. And I do feel that Akamai is worth lower in this market. And so, you may see us buyback additional shares, especially depending on how the stock price fluctuates."
},
{
"speaker": "Frank Louthan",
"text": "Alright, great. And then, you've done a good job adding together some M&A for the secure -- on the security side, any other tools do you think you need to make yourself more competitive in the market? Do you feel like you've got kind of the right mix here to -- for that product set?"
},
{
"speaker": "Tom Leighton",
"text": "Yeah, we're always looking at new capabilities as I mentioned. And of course, the attackers are always innovating with new forms of attack. But I am very excited about the Guardicore acquisition and I think it really does fill out and complete our access story, our ability to stop ransomware and malware. As I mentioned, we already have capabilities that prevent the malware from getting in. Enterprise Application Access in particular governs what employees can touch and access and even then, it has to come through Akamai's application firewall, so we're making sure that malware doesn't come in. We also have multi-factor authentication which make sure that the employee is who they say they are. And now we're -- Guardicore, we stopped the spread of the malware if it does get in. And there are a lot of ways the into the enterprise today. It is really -- despite all the defenses you put in place, somebody for example, in the capital pipeline case, a password or potential gets out there. Now we still have ways of catching that somebody is using a stolen credential, but malware does get in still, and so the real key there is stopping the spread, and that's what Guardicore does. And so now I think it's really nice because you stopped the ransomware with Guardicore, but we've got the whole package in whole solution now. And I think that's really unique in the marketplace and very exciting."
},
{
"speaker": "Frank Louthan",
"text": "Alright, great. Thank you very much."
},
{
"speaker": "Operator",
"text": "Your next question comes from the line of Amit Daryanani from Evercore. Your line is now open."
},
{
"speaker": "Amit Daryanani",
"text": "Thanks a lot. And good evening, everyone. I have two questions as well up near the first one I was hoping you could talk about. As I look at the midpoint of the guide for December of is there a way to think about how are you thinking about seasonality in Edge and security? In the bottom, are you going to get through the security numbers may imply a much more severe deceleration than what people are modeling. So, I just love to understand how are you assuming those two segments stacking up in the December quarter."
},
{
"speaker": "Ed Mc Gowan",
"text": "Yeah. Sure, I'll take that. We'll start with the Edge. Obviously, Edge, is quite a busy quarter in Q4. As I talked about, seasonality from e-commerce, I think it's obviously a tougher quarter to call here with some supply chain disruptions and things like that. Does that drive more or less Internet traffic, and what does that holiday season look like? Typically, a very strong media quarter where you see new devices, and games coming online -- I'm sorry. Devices, consoles, etc. coming online. And then you also have a lot of sporting events in Q4, back-to-school, you've got lots of game releases, so it can be a pretty robust season for us and obviously challenging to call I looked at the events calendar, it's pretty full, so provided we can see some good traffic, you can see good upside we delivered that in the last couple of years. In terms of security, it’s not stopped as seasonal. Certainly, there are some bundles we have where there is -- traffic can impact that a bit but, I think to take our security guidance, we've been pretty conservative in the way that we've approached security, and we've been over-delivering every quarter. I think, with that obviously Guardicore is off to a good start so I wouldn't imply that as a seasonal down tick or anything like that in our security growth."
},
{
"speaker": "Amit Daryanani",
"text": "Got it. And then if I could follow-up the CapEx number for September quarter and really for December as well. I mean, capex as a percent of sales, I think will be 14, 15% for the back half of the year, versus 19%, 20% of the last several quarters prior to that up. I'm curious. Is capex coming down because you feel like there's enough capacity you have out there and you can see that lower or is it more that you just can't get your hands on the supply chain and the products and need to drive capex. I'm trying to understand what's taking capex lower, and then how do I think about this as we go into 2022?"
},
{
"speaker": "Ed Mc Gowan",
"text": "Yes. I would say it's good execution. And if anything, with the supply chain, we're not seeing supply chain disruptions in terms of the fact that we actually, if you remember a few calls ago, we talked about in the pandemic, we took capex up and we were pretty cautious in terms of making sure that we had plenty of extra capacity available for -- if you see the pandemic continue and see traffic growth, etc. So, we learned in, we built up our inventory a bit, we fund a lot of small equipment so that we're not concerned right now anyway with the supply chain. So, I'd say that's part of what's driving it as we built out ahead of demand, we're pretty smart in the way we did that. But also, I mentioned there's a number of CapEx efficiencies that Adam and his team are working on. Not only just software, but network design, deployment optimization, looking at different hardware improvements, and just to anyway to drive a good focus on lowering our need for capex and also keep in mind we have great relationships with the networks and ISP. So, in terms of doing optimization inside of their networks, are able to do that as well. So, I'd say it's really a great execution on the team's part, and CapEx has come down pretty significantly, you see that in our free cash flow results."
},
{
"speaker": "Amit Daryanani",
"text": "Does that sustain next year? This mid-teens CapEx as a percent of sales, is that the right way to model this out?"
},
{
"speaker": "Ed Mc Gowan",
"text": "Yes. Right now [Indiscernible] you see another pandemic or some major events and we see some crazy unexpected traffic growth, yeah, I think it's a sustainable number, certainly going into next year. I don't want to get into giving guidance, but I think that I talked about in the past that we'd be getting back to this level and we're actually operating a little bit better than that."
},
{
"speaker": "Amit Daryanani",
"text": "Perfect. Thank you."
},
{
"speaker": "Operator",
"text": "Your next question comes from the line of Rishi Jaluria from RBC. Your line is now open."
},
{
"speaker": "Rishi Jaluria",
"text": "Hey, guys. Thanks so much for taking my questions. And nice to see security growth hold up and actually accelerate with this quarter. 2 questions. First, I wanted to go a little bit deeper on the supply chain issues. I appreciate you've obviously over invested capacity with the OTT launches and the pandemic last year. You seem pretty well insulated from the rising cost, but at what point that this continues dragging out, does it begin to become a worry, and you might have to overspend in order to keep capacity and not have to turn away business? And maybe related to that. As we think about the environment heading into Q4, how do we expect that to shake out, especially given Q4 is such a -- traditionally such a strong commerce season? A lot of companies are telling us they're not going to able to meet demand. especially when it comes to electronic goods. So, is that a worry that you have, and maybe how are you thinking about embedding that in your guidance? Thank you."
},
{
"speaker": "Ed Mc Gowan",
"text": "Yes. So, I'll take the second part first. You know, that's why we give a pretty wide range. I just mentioned on the last question that, it's hard to predict what the commerce season looks like. And obviously, when you are in the business of delivering Internet traffic, one model could suggest that, well, shelves are not stocked. People are doing more surfing to find things. Another model would suggest that there's not as much shopping and people are giving cash and gift cards. Hard to tell, but we did put out a pretty big range there. Also keep in mind that a lot of our Commerce customers, about half of our Commerce customers have taken, we call our 0 overage, so you've kind of flattened out that first thing. So, the bursting for commerce is not as big of an impact if we're still has an impact. In terms of the device cycle, that's an interesting one. We do expect and we have seen over the last several years, especially in the last couple of weeks of the year, as new devices come online as a lot of firmware updates and things like that, I still expect to see that, but there's other things that are not as dependent on that, for example, gaming releases, new video content that comes out if you don't have a new machine, you're watching it on your old machine. So, I still think that we'll have a pretty big immediate quarter for sure. That's why I've given a pretty wide range to try to take those things into consideration. And then on your supply chain question you had asked about, when does this become a problem? That's funny. I asked the same questions to my team as we go through our capex build-out. We've done a nice job of building out several quarters’ worth of inventory here, and we've diversified our supply chain. And the team's done a good job of ensuring that we're not seeing any significant increase in price or anything like that. A little bit on the freight side, but it's not really material and I think that should start to work itself out. But if we do see another massive growth and traffic, maybe we should start to run into some problems, but so far so good. And like I said, the team did a really good job preparing, not expecting this type of a disruption in the supply chain, but expecting that the result from the pandemic would last a lot longer. So, we did some scenario planning, so we're in pretty good shape at the moment."
},
{
"speaker": "Rishi Jaluria",
"text": "That's really helpful. Thank you so much."
},
{
"speaker": "Operator",
"text": "Your next question comes from the line of Alex Henderson from Needham. Your line is now open."
},
{
"speaker": "Alex Henderson",
"text": "Thanks. Looking at the guidance and the commentary, it does sound like your security businesses exp - if I add in some of the inorganic, that would imply even lower growth. Is it reasonable to think that the security business can sustain a 20% growth rate organically in '22 or is that too aggressive of an expectation for a billion three business?"
},
{
"speaker": "Ed Mc Gowan",
"text": "Yes, I think one thing to keep in mind, Alex, is you've got the anniversary of [Indiscernible] Southern Europe, your growth rate lapse in Q4 for [Indiscernible] and then we got in Guardicore. We've said in the -- when we did our analyst data that we expected to be able to grow 20% [Indiscernible] 3 to 5 years with acquisitions being part of the strategy. And you can see that the Guardicore acquisition with the prior guidance, and a couple of points of growth. We obviously did much better this year than we expected going into the year. Security has over performed every single quarter. We still feel pretty comfortable with our 20% growth rate as we talked about, as a matter of fact coming out of this year we're doing a bit better than that. So, I think, if you're taking the super all end of the range, maybe you could come up with that formula, but we're expecting pretty solid growth here over the security in Q4."
},
{
"speaker": "Tom Leighton",
"text": "Yes. Our strategy in security is to combine organic development, we have intelligence, and timely acquisitions. And we'll continue to do that. And of course, when you buy a Company after a year, its growth becomes organic and it's no longer counted as an acquisition growth per se, and I think we've had a really great track record of doing that in security, going back all the way to Prolexic acquisition in 2014. And as I mentioned, I think Guardicore is fundamentally like that in terms of really transforming our enterprise security business, just like Prolexic transformed our DDoS business, which of course today is very, very successful. We're the market leader by far and our goal is to do that on the Enterprise Security side to things like stopping ransomware and stopping malware. And as we -- as Ed said, as we continue to want to grow our security business over the longer term at 20+% that we'll include acquisitions, and I think acquisitions are a good thing. It gives you a jump start on technology, an important area. Guardicore has been working for a long time to develop their micro-segmentation approach. I believe it is market getting what they do. They're the best folks out there, and now we have the benefit of all of the years of effort that they put into that at a perfect time. Because a lot of companies are rightly worried about stopping ransomware and now Akamai's in a position to help them do that. And of course, it sits with a lot of our organic development on technology around EAA. It's an ideal combination. So, we'll continue to do both and in working hard to continue to our security growth that"
},
{
"speaker": "Alex Henderson",
"text": "Okay. I get it. Thanks. That's helpful. Can you talk a little bit about the pricing environment, whether there's been any change in competitive landscape, have you seen more competition or less competition? How should we think about the environment? I think we're also seeing enterprise is spending more this year. Do you think that that sustains into 2022 given the first half of spike in an attack caused a flurry of spending intentions?"
},
{
"speaker": "Ed Mc Gowan",
"text": "I think the competitive environment is very similar to what it's been in the past. It's -- it is a very competitive environment. Across-the-board from Cloud giants who are also our largest customers, all the way down to startups. Obviously, CDN is a mature environment. competitively, and so I don't see there's any fundamental change there. Security is really a great environment for us. We're the market leader by far in the core areas of defending and protecting websites, applications, and APIs, The leader by far and DDoS prevention. And those are areas that have a lot of attacks taking place. And now, the new category for us where we're going to encounter new competition because we're moving into that space in a big way would be"
},
{
"speaker": "Tom Leighton",
"text": "enterprise security. We already have a very strong access solution there. And now we have what we believe is the best solution to stop ransomware for with micro-segmentation. And by adding that to Akamai, we now have a new set of competitors there, because we're entering their space and we think there's a lot of potential gain for Akamai there, and ability to help major enterprises."
},
{
"speaker": "Alex Henderson",
"text": "Great. Thank you very much."
},
{
"speaker": "Operator",
"text": "Your last question comes from the line of Brandon Nispel from KeyBanc Capital Markets. Your line is now open."
},
{
"speaker": "Brandon Nispel",
"text": "Awesome. Thank you for taking the question. Could you unpack the growth in the Edge Technology Group, please? What was the growth in the quarter for Edge applications, and what does that imply for the growth in the Edge delivery business? And then how do you expect these two segments within that larger group to trend exiting the year? Thanks."
},
{
"speaker": "Ed Mc Gowan",
"text": "So, Brian, we're not going to breakout Edge apps every quarter. We talked about it last time growing at over 30%, and we think that business can continue to sustain that. I think we'll exit the year on a run rate over $200 million, which is a pretty good healthy growth rate there. And then just the -- again, we're not breaking out the Edge delivery business this quarter, we'll do it at the end of the year."
},
{
"speaker": "Brandon Nispel",
"text": "If I could just follow up on that when you back out some of the one-time items that are affecting comparability and the Edge technology business specifically, I think India apps and you're still lapping. Is that business growing? And what's going to cause that business to return to growth next year? Thanks."
},
{
"speaker": "Ed Mc Gowan",
"text": "Yes. So, it's obviously a just a tougher compare. This is the First Quarter that we don't have that compare and you saw that we were roughly flat in terms of total Edge Tech. I think as we get into next year, it's an easier compare. I think we're comfortable with our longer-term growth, a low single-digits for the Edge business over time, obviously. With the Edge applications business much faster growing as that becomes more material that could change the growth rate. I think it's just continued execution and traffic growth going into next year on a much easier to compare, I think you'll start to see a bit of growth rate pick up a little bit there."
},
{
"speaker": "Tom Leighton",
"text": "Okay, thank you, everyone. In closing we'll be presenting at a number of investor conferences and road shows throughout the rest of the fourth quarter. And details of these can be found in the Investor Relations section of akamai.com. We appreciate you joining us, and all of us here at Akamai wish continued good health to you and yours, and have a great evening. Thank you."
},
{
"speaker": "Operator",
"text": "This concludes today's conference call. Thank you for participating and have a wonderful day. You may all disconnect."
}
] | Akamai Technologies, Inc. | 24,522 |
AKAM | 2 | 2,021 | 2021-08-03 16:30:00 | Operator: Good day, and thank you for standing by. Welcome to the Q2 2021 Akamai Technologies Inc. Earnings Conference Call. At this time, all participants are in listen-only mode. After the speaker’s presentation, there will be a question-and-answer session. [Operator Instructions] Please be advised that today’s conference is being recorded. [Operator Instructions] I would now like to hand the conference over to your speaker today, Tom Barth, Investor Relations for Akamai Technologies. Please go ahead.
Tom Barth: Thank you, operator. Good afternoon, everyone, and thank you for joining Akamai’s second quarter 2021 earnings conference call. Speaking today will be Tom Leighton, Akamai’s Chief Executive Officer, and Ed McGowan, Akamai’s Chief Financial Officer. Before we get started, please note that today’s comments include forward-looking statements, including statements regarding revenue and earnings guidance. These forward-looking statements are subject to risks and uncertainties and involve a number of factors that could cause actual results to differ materially from those expressed or implied by such statements; the factors include uncertainty stemming from COVID-19 pandemic and any impact from unexpected geopolitical developments. Additional information concerning these factors is contained in Akamai’s filings with the SEC, including our Annual Report on Form 10-K and Quarterly Reports on Form 10-Q. The forward-looking statements included in this call represent the company’s view on August 3, 2021. Akamai disclaims any obligation to update these statements to reflect future events or circumstances. As a reminder, we will be referring to some non-GAAP financial metrics during today’s call. A detailed reconciliation of GAAP and non-GAAP metrics can be found under the financial portion of the Investor Relations section at akamai.com. And with that, let me turn the call over to Tom.
Tom Leighton: Thanks, Tom, and thank you all for joining us today. I'm pleased to report that Akamai delivered excellent financial results in the second quarter, coming in at/or above the high end of our guidance range for both revenue and EPS. Q2 revenue was $853 million, up 7% year-over-year and up 5% in constant currency. Non-GAAP operating margin in Q2 was 32%, which reflects our continued focus on operational efficiency, even as we've continued to invest for future growth. Q2 non-GAAP EPS was $1.42 per diluted share, up 3% year-over-year. Akamai Security Solutions continued to perform especially well in Q2, generating revenue of $325 million, up 25% year-over-year, and up 22% in constant currency. Cyberattacks generated headlines throughout the first half of the year, and our strong growth reflects the criticality of security to organizations in every sector and geography of the world. Akamai is increasingly recognized as a security leader that offers not just innovative and market leading solutions, but also insights into an enormous amount of Internet data and threat intelligence, a massive distributed platform at the edge of the Internet where most attacks originate. And the technical expertise of one of the industry's largest and most experienced teams of security professionals. The strong growth of our security portfolio was driven by several product lines, including our market leading solutions for web app firewall, bot management, DDoS prevention and Access Control. Our recently released Akamai Page Integrity Manager continued to have rapid adoption in Q2. Page Integrity Manager helps businesses protect their users from having credit card data or other personal information stolen by malware embedded in third-party content. It's also designed to prevent user data from being intentionally or inadvertently sent to third parties such as advertisers or social networks, which can result in a violation of privacy laws and steep fines. As an example, one of our customers is a leading furniture retailer. Page Integrity Manager detected that one of their partners, a major social media platform, was taking their shoppers' e-mail addresses in violation of their data privacy rules. Page Integrity Manager blocks such transfers of personal data and immediately notifies our customers so that appropriate business actions can be taken. In June, we entered beta with a related solution that we call; Audience Hijacking Protection. Audience Hijacking Protection is designed to detect and block malicious or unwanted activity from client side plug-ins, browser extensions and malware. For example, it can quickly identify vulnerable resources, detect suspicious behavior and block unwanted ads, pop-ups, affiliate fraud and other malicious activities that attempt to hijack a retailer's audience. Initial customer interest in this new capability is very strong. Akamai Bot Manager also continued to perform very well in Q2, with revenue growing 40% year-over-year. Bot Manager now has nearly 800 customers with an annualized revenue run rate of nearly $200 million. Our customers use Bot Manager to fort a variety of unwanted activities and attacks such as price scraping, inventory manipulation, credential stuffing and account takeover. Recently, we enhanced our ability to defend against account takeover attempts with the beta launch of Akamai Account Protector. It's designed to proactively identify and block human fraudulent activity using advanced machine learning, behavioral analytics and reputation heuristics. Account Protector intelligently evaluates every login request to determine, if it's coming from a legitimate user or an impersonator. Q2 bookings were also strong for our Prolexic service, which helps organizations defend against the surge of ransom DDOS attacks that began in Q3 of last year. As an example, a leading financial analytics company recently adopted Prolexic to protect them from this growing threat. Prior to that, the company faced operational and technical challenges from needing to manage multiple security technologies from various niche vendors and cloud service providers. Since consolidating with Akamai, they have greatly benefited from reduced complexity, improved security and greater consistency for compliance and risk management across their many business units. As you all likely know, there have been widespread ransomware, data theft and other malware attacks against major enterprises this year. Included were well-publicized attacks on critical infrastructure at a major pipeline company, the world's largest meat packer and a freight operator that serves as the lifeline for 2 popular island destinations in New England. The need to stop these kinds of attacks is driving organizations to adopt new Zero Trust and Secure Access Service Edge, or SASE Solutions, such as those offered by Akamai. For example, when the exchange server attack hit thousands of organizations in March, Akamai's e-mail wasn't compromised, because our IT department uses Akamai's Enterprise Application Access solution, which prevented unauthorized access to our exchange server. Our Access Control suite of products continue to be Akamai's fastest-growing security segment in Q2, with revenue up 161% year-over-year, including the acquisition of Asavie, and up 57% on an organic basis. As one example of a new customer, we closed a large security contract in Q2 with a company that helps maritime operators manage risk. This company has thousands of employees and hundreds of offices throughout the world. They adopted our Enterprise Application Access and Kona Site Defender solutions to secure the access to their applications and to protect their internal systems from malware and other threats. I'll now turn to our CDN portfolio, which generated revenue of $528 million in Q2, down 1% year-over-year and 4% in constant currency. This result was in line with our expectations and reflects the challenging comparison against last year's pandemic-related jump in traffic and the loss of revenue from Chinese applications that were banned from India in July of 2020. Traffic on our platform remained strong in Q2, with peaks exceeding 130 terabits per second every day throughout the quarter. This enormous amount of traffic provides strong evidence of how much customers were live on our platform's unparalleled scale and reach, which is enabled by more than 4,200 points of presence at the edge, in 135 countries around the world. Our tremendous global presence is especially important to the world's major broadcasters, who continue to look to Akamai to deliver the world's most significant events. For example, during the recent European football tournament, the peak traffic that we delivered globally for more than 30 broadcasters was 35 terabits per second, nearly 5 times the peak observed in 2016. Our fast-growing Edge Applications segment delivered $47 million in Q2, up 35% year-over-year and up 32% in constant currency. This rapid growth rate reflects the shift of compute workloads from core data centers, on-prem or in the cloud to our edge platform for offload, improved performance, security and global scale. For example, each time a user accesses one of our retailer customer sites, the retailer's geo location code is executed on an Akamai edge server to identify the user's location and then deliver content tailored for that location. Overall, we're now supporting an average of 5 billion such edge computing instantiations per day on our platform. In summary, I'm pleased to report that we've executed according to the plan we outlined for investors during our February Analyst Day. In particular, we continued to achieve strong demand from customers for our security and edge computing solutions, diversification of our business across products, geographies and sales channels, and strong financial performance on both the top and bottom lines. Before turning the call over to Ed, I'd like to formally welcome Sharon Bowen to our Board of Directors. Sharon's had extensive experience in financial and securities transactions for large global companies and we're very much looking forward to benefiting from her engagement and counsel. In addition, as many of you know, our Board is now chaired by Dan Hesse, who succeeded Fred Salerno in June. Dan has held senior management positions in the telco industry for many years, including as CEO of Sprint. He's also recognized as a leader in ESG and is providing valuable advice and oversight to our senior management team. Of course, we all deeply appreciate Fred's many years of outstanding leadership and service to Akamai, and we wish him the very best in his future endeavors. I'll now turn the call over to Ed to provide further details on our Q2 results and our outlook for next quarter and the full year. Ed?
Ed McGowan: Thank you, Tom. As Tom outlined, Akamai delivered another excellent quarter. Q2 revenue was $853 million, at the high end of our guidance range and up 7% year-over-year or 5% in constant currency. Revenue growth was led by broad-based strength across our Security business globally. Revenue from our Security Technology Group was $325 million, up 25% year-over-year or 22% in constant currency. Security now accounts for 38% of our total revenue. We saw strong performance across our major security products, including Bot Manager, Prolexic, and our Access Control product suite. Revenue from our Edge Technology Group was $528 million, down 1% year-over-year or 4% in constant currency. These results were in line with our internal expectations, which factored in challenging comparisons from our outstanding CDN results in Q2 a year ago. The tough year-over-year compares within our Edge delivery business offset the continued strong growth in our edge applications business. Foreign exchange fluctuations had a negative impact on revenue of $2 million on a sequential basis and a positive $19 million on a year-over-year basis, largely in line with our expectations. International revenue was $403 million, up 15% year-over-year or 9% in constant currency. Sales in our international markets represented 47% of total revenue in Q2, up three points from Q2 2020 and up two points from Q1 levels. As a reminder, our Q2 results last year included approximately $15 million of revenue from China-based apps that were banned in India from Q3 2020 onwards. Adjusting for this impact, international growth would have been approximately 20% year-over-year and 14% in constant currency. Finally, revenue from our US market was $450 million, up 1% year-over-year. Moving now to costs. Cash gross margin was 76%, in line with our expectations. GAAP gross margin, which includes both depreciation and stock-based compensation, was 62%. Non-GAAP cash operating expenses were $259 million, slightly below our guidance range due to lower-than-expected hiring during the quarter. Now, moving on to profitability. Adjusted EBITDA was $386 million. Our adjusted EBITDA margin was 45%, in line with our guidance. Non-GAAP operating income was $270 million, and our non-GAAP operating margin was 32%, slightly favorable to our guidance due to lower operating expenses I just mentioned. Capital expenditures in Q2, excluding equity compensation and capitalized interest expense were $138 million, consistent with our guidance range. GAAP net income for the second quarter was $156 million or $0.94 of earnings per diluted share. Non-GAAP net income was $233 million or $1.42 of earnings per diluted share, up 3% year-over-year, down 1% in constant currency and $0.02 above the high end of our guidance range. Taxes included in our non-GAAP earnings were $39 million, based on a Q2 effective tax rate of approximately 14.5%. Now I will discuss some balance sheet items. As of June 30th, our cash, cash equivalents and marketable securities totaled approximately $2.6 billion. After accounting for the $2.3 billion of combined principal amounts of our two convertible notes, net cash was approximately $281 million as of June 30th. Now I will review our use of capital. During the second quarter, we spent approximately $96 million to repurchase shares, buying back approximately 900,000 shares. We ended Q2 with approximately $417 million remaining on our previously announced share repurchase authorization. Our plan remains to leverage our share buyback program to offset dilution, resulting from equity compensation over time. Moving on to Q3 guidance. We are projecting Q3 revenue in the range of $845 million to $860 million or up 7% to 9% as reported or 6% to 8% in constant currency over Q3 2020. Foreign exchange fluctuations are expected to have a negative $3 million impact on Q3 revenue compared to Q2 levels and a positive $5 million impact year-over-year. At these revenue levels, we expect cash gross margins of approximately 76%. Q3 non-GAAP operating expenses are projected to be $257 million to $262 million, and we anticipate Q3 EBITDA margins of approximately 45%. Moving now to depreciation. We expect non-GAAP depreciation expense to be between $120 million to $121 million. Factoring in this guidance, we expect non-GAAP operating margin of approximately 31% for Q3. Moving on to CapEx. We expect to spend approximately $135 million to $140 million excluding equity compensation in the third quarter. And with the overall revenue and spend configuration I just outlined, we expect Q3 non-GAAP EPS in the range of $1.37 to $1.41. This EPS guidance assumes taxes of $38 million to $39 million based on an estimated quarterly non-GAAP tax rate of approximately 14.5%. It also reflects a fully diluted share count of approximately 165 million shares. Looking ahead to the full year, we are raising our guidance for both revenue and EPS. We now expect revenue of $3.42 billion to $3.45 billion, which is up 7% to 8% year-over-year as reported, or up 6% to 7% in constant currency. We now expect Security revenue growth to be in the low to mid-20% range for the full year 2021. We are estimating non-GAAP operating margin of approximately 31% and non-GAAP earnings per diluted share of $5.54 to $5.65. And this non-GAAP earnings guidance is based on a non-GAAP effective tax rate of approximately 14.5% and a fully diluted share count of approximately 164 million shares. Finally, full year CapEx is anticipated to be approximately 16% of revenue, consistent with our prior guidance. We are very pleased with our excellent financial results in the first half, and we look forward to delivering a strong second half. Thank you. Tom and I would be happy to take your questions. Operator?
Operator: [Operator Instructions] Our first question comes from the line of James Breen from William Blair. Your line is now open.
James Breen: Thanks for taking the question. Can you talk about some of the seasonality around the business, second, third quarter? Obviously, the Olympics is happening right now and sort of how you see the impact in the business, given how the traffic patterns have been so far. And then it seems like operating income 31% is moving up a little bit. Can you just talk about some of the dynamics and where you see that going as security maybe becomes a bigger part of the business?
Ed McGowan: Jim, thanks for the question. This is Ed. In terms of seasonality, Q3, typically, we tend to see a little bit of slowdown in traffic over the summer months, we were calling for sort of a flattish quarter to Q2 here with the guide. We'll see a little bit of slowdown in August. I would expect -- I've got the Olympics in there. Not expecting a ton from the Olympics this year, it's a couple of million bucks that we have in the quarter. We did see in terms of seasonality in Q2, we did see a bit of a lighter gaming quarter in Q2. We would expect to see that probably pick up a bit here in the back half of the year. And then obviously, in Q4, that's our most challenging quarter to call, which you've got really 2 seasons there. You've got the commerce season and then the -- we typically see a large media season as well. So we're expecting that in Q4. And we'll update you as we go and we'll get more information as the year goes on. And for the next call, we'll update you on what we're seeing for the Q4 seasonality. The margin question, yes, we had a better quarter from an operating margin perspective. Hiring was a little bit lighter than normal. Just a couple of things to keep in mind on the margin front. July is when we have our annual merit increase or our salary increases, so that comes into effect beginning in Q3. Then also, we do expect that we'll see some travel expenses and some costs related to offices reopening in the back half of the year as well. Tom and I have talked about, we plan on operating the business in the 30% range. This year, we'll do a little bit better, but we do want to continue to invest for the opportunities we see in front of us in Security.
James Breen: Great. Thanks.
Operator: Thank you. Our next question comes from the line of Sterling Auty from JPMorgan. Your line is now open.
Sterling Auty: Yes, thanks. Hi, guys. I'm curious to understand, how you're thinking about the investment on the go-to-market, specifically sales headcount in the security side of the business, given the strength that you're seeing?
Tom Leighton: We do have a specialist team for our newest security products. And that's very helpful until the field can get up to speed. But our entire go-to-market operation is now well versed in selling security products. So they really only need the assist for the newly released products. And so we don't have a bifurcated sales force now.
Sterling Auty: Understood. And then just one follow-up in terms of the security competitive landscape, especially on the newer solutions like Page Integrity Manager. Who is the point person you're selling into? And are these uncontested, or what other solutions do they tend to consider when they're looking at it?
Tom Leighton: Yes. For our new solutions, you might see a start-up out there with something similar. Our normal competition doesn't have these capabilities. And it's a big advantage to be able to offer these capabilities with the existing platform because once you're on Akamai, for example, you're using our Web App Firewall, which is a market-leading solution, it's very easy to add Page Integrity Manager on top. We just take care of that. The customer says they want it and we turn it on. And the request – the data flow is not changed. The same will be true with Audience Hijacking Protection, same thing, built right on top of the Web App Firewall, and our other solutions. So it really is very convenient for customers to buy from us. And there really isn't something that's comparable in the marketplace. And these are adding great value. In terms of the buyer, Audience Hijacking Protection, that could really go the range. Probably it ends up more towards the marketing side of the house because literally, their audience is being hijack today. Any retailer has a problem where – because of malware that's on the user's browser or plug-ins or extensions they have, that malware and those plug-ins are looking for somebody about to do a transaction. And what they'll do is put some pop-up over at saying, wait a minute, go here instead. Or even worse, it will be some fraud, where they'll change the refer header and claim credit for this buyer and our customer now has to pay more. So if for products like that, it could be anywhere from the security side all the way through the website and through the marketing side of the house because it provides so much value, it reduces cost, increases revenue and provides greater security. Really, it's very nice to see that because it's a very good blend between our delivery and performance solutions and our security solutions all wrapped up in one package.
Sterling Auty: Makes sense. Thank you.
Operator: Thank you. Our next question comes from the line of Will Tyler from Baird. Your line is now open.
Charlie Erlikh: This is Charlie Erlikh on for Will. Thanks for taking my question. I had a sort of a sort of a two-part question on contract renegotiations. I guess, first, are there any big contracts coming up that we should be aware of, or is it pretty spread out over the back half of the year and into next year? And then part two, for the contract renegotiations that you've already had, kind of curious what you're hearing in terms of sort of the health of the customers? And are they still asking for price concessions, or are we closer to back to pre-pandemic levels in that respect? Thanks.
Ed McGowan: Yes. So on the -- in terms of the big contracts up for renewal, we had a few that we did this quarter. And then, I'd say, the rest are sort of spread out fairly evenly. If there's ever anything that is major, I tend to try to call that out. But as we disclosed in our IR day, we don't have significant customer concentration risk. But sometimes you can get a few of them all together that can make a little bit of noise in the quarter, but they're pretty much spread out. And in terms of the health of the customers, it really varies by vertical. We do see, I would say, pretty standard pricing discussions. This industry traditionally has had deflationary pricing when it comes to -- especially volumes, but it's being driven by volume. And I don't see any major change there. Really nothing to call out. I think it's still too early to call an end to the pandemic, obviously. So we've got some significant business with commerce and retailers, and that's still kind of playing itself out at this point. We've seen some pickup in volume, but we're not out of the woods yet there. But in terms of overall pricing, really nothing to call out in terms of any major changes.
Charlie Erlikh: Great. Thanks, Ed. And just if I can just squeeze in another one. You used to give this helpful metric on the percentage of customers that are taking one security product and the percentage that are taking multiple security products. Is that something that you could provide us now or you're not giving that metric anymore?
Ed McGowan: Yeah, sure. I can give you that number. So right now, we've got about 55% of our customers that are buying one security product and about 32% that are buying more than one. But just keep in mind that our customer base has grown over the last year, it's up probably by 5% or 6% over the last year. So we're doing a pretty good job of getting penetration into the base. But the base is also growing. If I go back a year ago, Q2 of 2020, that number for folks that have acquired a security product was around 59%. So we're seeing really healthy growth in terms of the overall number of customers, both from penetration of the base, but also just the size of the customer base is growing as well.
Charlie Erlikh: Great. Thanks very much.
Operator: Thank you. Our next question comes from the line of Keith Weiss for Morgan Stanley. Your line is now open.
Mike Wilson: Hi. It's Mike Wilson on for Keith Weiss. Thank you for taking our question. I'd like to dig a little bit deeper into the Edge Applications. What type of use cases you're seeing? And what other verticals you're kind of seeing traction in besides retail? You gave a nice example in your prepared remarks, but anything additional would be helpful.
Tom Leighton: Sure. It really is useful, I think, across all verticals. Gaming is another example of the big -- our big gaming customers had interest there. They want to get local decisions made in terms of who's playing who, what master server maybe they go back to for the gaming instructions. Another great example is the COVID vaccine registration sites. In this case, it was a third-party company unrelated to us, built a queuing application on top of our EdgeWorkers solution that is used today by, I think, dozens now, governments and pharmaceutical companies to assist in getting vaccine registrations. And of course, in the early days in the U.S. and still in many countries, there's a lot more people that want to get a vaccine than you have capacity for and so you want to be fair. So if somebody comes into the website, they get into the queue, and they know how long the queue is and that whole process is managed. And again, that's an ideal application to run with our edge computing service. And also handles all the excess load and the flash crowd around the site when you announced, okay, we got a lot of vaccines available in a certain period of time. A lot of people come at once. So maybe they know when that's going to happen, and so we provide the overflow capacity for that. But really, anything you could imagine that involves locality, the need to rapidly scale would be a suitable use for our EdgeWorkers solutions. IoT applications, I think, in the future is a big driver of demand there. And I think that gets enabled by 5G as that gets deployed, and you get a lot more devices connected. But there, you've got a lot of devices with a lot of communication back and forth, very chatty protocols, data being sent in and you need to aggregate that and make decisions quickly locally on the fly, edge computing, edge applications is a good example for that. Tailoring the content based on the device type and the local connectivity is another example. We do that with our image and video manager applications, where if you're on a, say, a cellular device, you don't have a big screen and maybe you don't have great connectivity, we will automatically, at the edge with the edge computing, put in a smaller – a lower resolution version of the image. And on your device, it will look the same. So there's no real reduction in quality, but the less traffic needed to convey the image means you get better performance for the end user. So there's just all sorts of applications that people are using. And now we're doing those, kinds of, things five billion times a day on our edge platform using Edge Java.
Mike Wilson: That's really great color. And then pivoting to the CDN solutions within the Edge Technology Group, anything to call out in terms of pricing? And then how should we think about revenue from the Internet platform customers and the second half of 2021?
Ed McGowan: Yes. I'll take that one, Tom. So the -- in terms of pricing, as I just mentioned, really nothing to call out on the pricing side. As far as Internet platform customers go, the team's doing a great job executing there, we continue to grow that group of customer’s obviously very highly innovative customer base, a lot of them have their own CDN, but we're doing a good job of growing that business and very happy with the performance there. I expect that revenue stream to continue to run along about the same pace that it's going now for the rest of the year, maybe see a little bit of upside in this fourth quarter.
Mike Wilson: All right. Thanks guys.
Operator: Thank you. Our next question comes from the line of James Fish from Piper Sandler. Your line is now open.
James Fish: Hey guys, thanks for the questions. First, on the external and internal-based cloud access solutions, what one is really leading the charge at this point? And what has been the pushback from customers that are evaluating other solutions that may pick a competitor? And do you plan on building or acquiring into the rest of that SASE stack like in DLP or CASB?
Tom Leighton: So yes, we're interested in the entire SASE stack. I would say we're really focused though on stopping malware, stopping these ransom DDoS, ransomware attacks, stopping data exfiltration. And that puts us in the direction of a focus on access to make sure that we do the access control of the application layer, not as it's traditionally done at the network layer, and that makes a huge difference in terms of the malware getting inside in the first place. Also, we have Secure Web Gateway capabilities, probably market-leading DNS capabilities, which makes a big difference in terms of data exfiltration. And we do have some DLP capabilities today with our newest version of Enterprise Threat Protector. CASB, less capabilities there today, potentially of interest, but not the primary mission in terms of stopping the data exfiltration, the ransomware attacks, the malware attacks on enterprises. And of course, ransom DDoS, which our Prolexic solution helps a lot with -- along with Kona. So good traction there. As you see the growth on the access side of the house now, well over 50% organically. And of course, if you account the Asavie acquisition, over 160% year-over-year. We plan to continue investing there organically, also through potentially M&A, we're always looking there. And I think that has a lot of future potential for us.
James Fish: That's helpful, Tom. And I guess I'll be the one to take the bait. Obviously, 2 outages during the last couple of months here. Can you just walk us through, maybe add what the financial impact could be in terms of any SLA refunds or what you heard back in terms of feedback from customers regarding the DNS and the DDoS issues? Thanks?
Tom Leighton: Yes. In terms of financial impact, de minimis. We lost, at the peak, about 2% of our traffic for up to 1 hour. So not any financial impact per se. That said, we care a lot about reliability at Akamai. It is core to everything we want to do. And we've put a ton of effort into making our solutions be reliable over the last 10-plus years. In fact, you have to go back to 2004 to find anything comparable in terms of what's happened on our platform. In 2004, we actually took the entire platform down for about an hour, which was disastrous. That didn't happen in this case, but we did hurt hundreds of our customers, and we deeply regret that. We impacted them and their users, and that's unacceptable. In both cases, there was an update that caused a problem. And we have invested a lot in infrastructure to make sure that updates are done safely. In this case, the updates were totally different and totally different systems at Akamai. But as a result of this, we are taking a fresh look at how we release updates to make sure that something like this won't happen again. And meanwhile, we've locked down all update channels as we do a thorough investigation of each one. People don't often realize it, but we are constantly doing updates. We have a platform with dozens of services. We have many, many thousands of customers. Any given customers maybe wanted to make an update to their site on an hourly basis or more. And so it's just thousands and thousands a day of updates that are taking place in the platform. And because of the really very intense work that we've done over the last decade, we have had an excellent track record of keeping any problem with an update from spreading. Humans making updates will make mistakes. And our goal is to prevent -- to catch them early and prevent them from spreading. And in this case, there were 2 different channels where that didn't happen the way we want it to. And so we are putting in a lot of effort to look at every possible channel and make sure it is working the way we want to. And not only do we not want to have any more incidents this year, we don't want to be having this happen in the next 10 years. And so there's a lot of effort going into making sure that's the case.
Operator: Thank you. Our next question comes from the line of Tim Horan from Oppenheimer. Your line is now open.
Tim Horan: Thanks. Tom, just maybe two really higher level questions. Can you just talk about how important edge compute do you think is going to be in the cloud in terms of -- for specific applications? What percentage will have some edge component to it? And how do you think your infrastructure holds up compares to competitors for providing that edge? And then on the security front, another just really high-level question. Do customers understand how much better cloud-based security is than on-prem? And where are we with that process?
Tom Leighton: Yes, good questions. I think edge computing is really important in the future. And when I say edge, I really mean edge, and that's a big difference with the competition, none of whom really have an edge platform. Of course, for the last couple of years, everybody says they have edge everything. It's just -- it's not true. We're in over 4,000 locations, in about 1,000 cities and 135 countries, and nobody is anywhere, anywhere close to that. And we offer native Javascript support now, which a lot of the folks that talk about edge computing don't. And we spin up our apps in a few milliseconds, and that's a factor of 1,000 better than some of the folks that talk a lot about edge computing out there. So, I think we stack up very well against the competition there. And I think you see that reflected in our very strong growth. That segment now well over 30% growth year-over-year. We think we can maintain that. And on a reasonable size number, last year, $150 million, we're now almost up to a $200 million annual revenue run rate for our edge applications business. So, I think very strong future potential. And as you grow in your 30% a year on a number that's about $200 million now, after a few years, that starts really being meaningful. And I think that drives accelerated growth for the CDN business. And remind me again of the security question you had.
Tim Horan: Well, it seems like security is rapidly moving to the cloud. I guess the customers understand how much better that is, where do you think we are in the process?
Tom Leighton: Yes, that's a good question. It's interesting because we started with application firewall. And if you go back five or six years, pretty much everybody bought a device and managed it in their data set. And today, there's still a few enterprises that do that. But pretty much all the major B2C companies on large -- majority of them are now using Akamai for that as a cloud service. And we're the market leader by far in application firewall. You look at DDoS. And again, go back five-plus years, that was managed either in the data center or with a single carrier. And that just doesn't work anymore. You can't handle the volume. And so now Akamai is the market leader by far with a cloud service there. I think you will see the same thing happen with enterprise security. Today, it is done, you get your VPN and you get your boxes and you manage them in your data center. That is not a good way to do it. That's why you have all these breaches. When you're providing network layer access, it's a disaster. You look at the big pipeline company that had a problem. It's just one of many thousands of enterprises. Credentials to the BPM are stolen, put on the dark web, somebody gets them. And that just gives them access to the entire network. And you can't do it that way. And that's why our solutions are so important with application layer access. Now sure you can steal somebody's credentials, but of course, you want multifactor authentication. And then you only get access to the app. And if you're using Akamai, you don't even get access to the app directly. You got to come through us, and we'll make sure there's no malware going to that app or you're not exploiting vulnerabilities, and then you don't have those kind of situations. So I think if you look at the exchange server situation, which I talked about a few minutes ago. Again, by having Akamai in front with our Enterprise Application Access, our e-mail wasn't stolen, even though we had the vulnerable software like everybody else did. So it will take some time. We're at the beginnings of, I'd say, Zero Trust approach and moving to the cloud, in particular to the edge – My Edge platform for enterprise security, but I do think there's a tremendous future there because we're in a position to really stop those breaches.
Tim Horan: Thank you.
Operator: Thank you. Our next question comes from the line of Colby Synesael from Cowen. Your line is now open.
Colby Synesael: Thank you. Two modeling questions, if I might. The first one, just looking at the guide increase for 2021. Just curious if you're going to agree with how I'm thinking about it, which is it seems like it reflects a 2Q upside, maybe a little bit of upside in terms of your expectations for 3Q, but really no change as it relates to your assumptions for 4Q. And it sounds like that's more a function of just lack of visibility opposed to some type of step-down or negative impact, if you will, that you're now anticipating? Just curious, if I'm thinking about that correctly. And then secondly, it sounds like in response to one of questions, regarding M&A it may have been suggesting that you guys obviously continue to look and may even be close to something. Are you guys still holding a line where M&A is expected to be accretive within some short period of time, or are valuations getting to a point now, where if you were, in fact, to do something of materiality, it could actually be relatively meaningfully dilutive just given what you'd have today? Thank you.
Ed McGowan: All right. So I'll take the first question, Colby. So in terms of Q4, I think you're thinking about it correctly, we always talk on Q4 being the hardest quarter to call. And then obviously, there's been a bit of a flare-up here with the Delta virus. So we're going with what we see now, as I said earlier in the call, we'll update you as we get more visibility. There's two seasons to call. There's the commerce season, and commerce is a very important vertical for us. And then also, as we've seen in the last several years, there tends to be a big jump step-up in media. So we'll get some more information as we go. But I think you're thinking about it correctly.
Tom Leighton: Yes. And in terms of the M&A question, we're always looking for companies that have novel capabilities that we can use to build products for our customers that are synergistic with our platform and our solutions we have today. And you're right, there are areas, particularly in security and also edge computing that have very high valuations to that. And that makes it harder to do acquisitions that make sense because we're not going to do something that's crazy. Now when you're looking at acquisition, we look at it over the long-term and so that we want it to be accretive, certainly over the long-term. In addition to the purchase price, we also worry about the hit margins, especially when you do an acquisition, often as you know, the first year, you have revenue recognition issues where you don't get to recognize all the revenue right away. And so in the first year, you can take a hit to your margins. And if we find the right acquisition that is really helpful to us in growth over the long-term and it will be accretive to margins over the long-term, there may be a situation where we would take a short-term hit to margins, and then we would improve them from there.
Colby Synesael: Okay, great. Thank you.
Operator: Thank you. Our next question comes from the line of Brandon Nispel from KeyBanc Capital. Your line is now open.
Brandon Nispel: Great. Thanks for taking the question. Ed, I'm curious about, you mentioned headcount growth slowed and actually was down sequentially. Can you update us on your hiring plans for the rest of the year? And do you believe the company needs another phase of investment in headcount in order to sustain the current growth trajectory? Thanks.
Ed McGowan: Yeah, sure. So I talked about headcount being a little bit behind hiring. Obviously, last year, we had record low attrition. And we're still not back to the attrition levels that we saw pre-pandemic. But we're just a little bit behind on our hiring. I expect that will catch up. We're scaling the company very well. As you can see, our margins have improved quite a bit. But we still want to make investments in security. You've seen some of our newer products have grown to a pretty material size. We've got some very fast and exciting growing businesses with our edge computing business along with very deep product bench for security. So we're going to continue to invest there. There will be some investments in go-to-market. And then, obviously, as we continue to grow, there'll be some scaling heads that we have to add. But nothing in terms of like a major investment cycle or anything like that that we anticipate coming.
Operator: Thank you. Our next question comes from the line of Mike Cikos from Needham & Company. Your line is now open.
Mike Cikos: Hi team. Thanks for taking the questions. I wanted to focus on the security and the improved outlook you guys provided today. It seems like the security, in general is facing broad-based demand, but are there any solutions specifically that are driving this improved outlook? And then I guess a follow-on, with the current threat environment, the headlines we're seeing, is this driving a material change in customer interest? Are you seeing any noticeable impact on sales cycles or budget flowing into this space as a result of that?
Tom Leighton: The good news is we're seeing strong demand across all of our major security product lines. And also the new security products are obviously not contributing a lot of revenue yet, but we're seeing strong interest in those as well. So it's just a -- it's a good picture across the board. The threat environment certainly increases the awareness and need for our solutions. In terms of sales cycle, obviously, if a customer is under attack, the sales cycle can be very short. In many cases, we'll integrate the customer within a matter of hours or days and often a follow-up with all the details of the contract later, and we've seen a lot of that. With these ransom DDoS attacks, dozens and dozens of major enterprises in that situation that very quickly become happy Akamai customers. So it's a good environment, I would say, in terms of security sales for all of our security products right now.
Mike Cikos: Thanks for that. And if I'm just thinking about the traffic trends, trying to parse out between the typical seasonality where there's a slower leg, if you will, in the summer months. And I'm matching that up against what we have with COVID and this Delta variant we're seeing, trying to -- can you guys better comment on that? I'm just trying to put those two pieces together to see what's baked into the guidance as we stand today, or how you see that traffic playing out over the last month, now that we're in Q3? Thank you.
Ed McGowan: Yeah, good question. So what we've assumed here is that there really isn't going to be a major step-up in demand like we saw last year. So not anticipating major lockdowns or anything like that. So then, obviously, if something like that were to happen, it could increase our traffic in the quarter. We do see typical seasonality in the summer months, typically August in, hopefully Europe, in particular, tends to be lighter than expected. So we're anticipating that. It's offset a little bit by the Olympics. Again, I told you not a ton there, a few million bucks for the Olympics. But security growth is also not necessarily impacted by traffic. So we could see if we do see lockdowns, you could see traffic accelerate a bit. And we're not really anticipating that, it's not in our guide at this point. We are expecting to see a strong seasonal Q4. And like I said a couple of times now, we'll update when we talk to you again, when we get more visibility. But traffic has got back to, what I would call, more normal growth rates. Obviously, we went through a year-and-a-half of accelerated traffic growth with the launch of some major OTT platforms along with the pandemic. So we’re modeling what I would consider to be sort of a more normal CDN outlook.
Operator: Thank you. Our next question comes from the line of Ben Rose from Battle Road Research. Your line is now open.
Ben Rose: Yes. Good afternoon. A question for Tom and then a question for Ed. For Tom, you mentioned at the outset, the Akamai Account Protector that you're working on in beta. I was curious to know if you could provide a little bit more information on the kind of benefits to customers that would come from this product that may not be available in Akamai's security portfolio currently.
Tom Leighton: Sure. Account Protector is sort of the next step beyond Bot Manager. Bot Manager detects whether it's a human being that's trying to, for example, to log into an account. And as you probably know, there's a ton of account stuffing going on. We see every day now about 1 billion illegitimate attempts to log into an account of some kind, a bank account, gaming account, a commerce account. And the vast, vast majority of that is bot traffic. Credentials have been stolen somewhere and a Bot network is used to check out those credentials against a lot of websites to see if you get a hit. Now the adversaries have evolved, the attackers have evolved. And now I will use humans to attempt to log in and steal accounts. Now you can't do that at the same scale as you can with a bot army. But you use things that you think may well get in and now the human will do it. And so we need to decide, well, okay, it's human, but is it the right human? And that's what Account Protector is all about. And it will use information about the human that's been using that account before with a variety of inputs and trust scores and then using machine learning to the side on the fly based on everything we can see here, is this the right human for this account? And we give a score that is used to decide, are we going to provide access directly? Do you go to some other security mechanism, like you get asked questions or a capture test of some kind, or do you just block? And that's what Account Protector does. So it is one-step deeper analysis that will now deal with human-based fraud and then specifically around the log-in function. Now of course, Bot Manager covers a lot of other things, too, like price scraping, inventory stealing, inventory – reserving all the seats in a hotel or an airline by a competitor, that kind of thing. So, this is really focused on fraud and log-in that's being done by humans.
Tom Barth: Ben, you had a question for Ed, maybe you could restate it.
Tom Leighton: I don't think it was stated.
Tom Barth: Ben, what was your question for Ed? Thank you, everyone. In closing, we will be presenting at several investor conferences and road shows throughout the rest of the third quarter. Details of these can be found on the Investor Relations section of akamai.com. Thank you for joining us, and all of us here at Akamai wish have a wonderful evening.
Operator: This concludes today's conference call. Thank you for participating. You may now disconnect. | [
{
"speaker": "Operator",
"text": "Good day, and thank you for standing by. Welcome to the Q2 2021 Akamai Technologies Inc. Earnings Conference Call. At this time, all participants are in listen-only mode. After the speaker’s presentation, there will be a question-and-answer session. [Operator Instructions] Please be advised that today’s conference is being recorded. [Operator Instructions] I would now like to hand the conference over to your speaker today, Tom Barth, Investor Relations for Akamai Technologies. Please go ahead."
},
{
"speaker": "Tom Barth",
"text": "Thank you, operator. Good afternoon, everyone, and thank you for joining Akamai’s second quarter 2021 earnings conference call. Speaking today will be Tom Leighton, Akamai’s Chief Executive Officer, and Ed McGowan, Akamai’s Chief Financial Officer. Before we get started, please note that today’s comments include forward-looking statements, including statements regarding revenue and earnings guidance. These forward-looking statements are subject to risks and uncertainties and involve a number of factors that could cause actual results to differ materially from those expressed or implied by such statements; the factors include uncertainty stemming from COVID-19 pandemic and any impact from unexpected geopolitical developments. Additional information concerning these factors is contained in Akamai’s filings with the SEC, including our Annual Report on Form 10-K and Quarterly Reports on Form 10-Q. The forward-looking statements included in this call represent the company’s view on August 3, 2021. Akamai disclaims any obligation to update these statements to reflect future events or circumstances. As a reminder, we will be referring to some non-GAAP financial metrics during today’s call. A detailed reconciliation of GAAP and non-GAAP metrics can be found under the financial portion of the Investor Relations section at akamai.com. And with that, let me turn the call over to Tom."
},
{
"speaker": "Tom Leighton",
"text": "Thanks, Tom, and thank you all for joining us today. I'm pleased to report that Akamai delivered excellent financial results in the second quarter, coming in at/or above the high end of our guidance range for both revenue and EPS. Q2 revenue was $853 million, up 7% year-over-year and up 5% in constant currency. Non-GAAP operating margin in Q2 was 32%, which reflects our continued focus on operational efficiency, even as we've continued to invest for future growth. Q2 non-GAAP EPS was $1.42 per diluted share, up 3% year-over-year. Akamai Security Solutions continued to perform especially well in Q2, generating revenue of $325 million, up 25% year-over-year, and up 22% in constant currency. Cyberattacks generated headlines throughout the first half of the year, and our strong growth reflects the criticality of security to organizations in every sector and geography of the world. Akamai is increasingly recognized as a security leader that offers not just innovative and market leading solutions, but also insights into an enormous amount of Internet data and threat intelligence, a massive distributed platform at the edge of the Internet where most attacks originate. And the technical expertise of one of the industry's largest and most experienced teams of security professionals. The strong growth of our security portfolio was driven by several product lines, including our market leading solutions for web app firewall, bot management, DDoS prevention and Access Control. Our recently released Akamai Page Integrity Manager continued to have rapid adoption in Q2. Page Integrity Manager helps businesses protect their users from having credit card data or other personal information stolen by malware embedded in third-party content. It's also designed to prevent user data from being intentionally or inadvertently sent to third parties such as advertisers or social networks, which can result in a violation of privacy laws and steep fines. As an example, one of our customers is a leading furniture retailer. Page Integrity Manager detected that one of their partners, a major social media platform, was taking their shoppers' e-mail addresses in violation of their data privacy rules. Page Integrity Manager blocks such transfers of personal data and immediately notifies our customers so that appropriate business actions can be taken. In June, we entered beta with a related solution that we call; Audience Hijacking Protection. Audience Hijacking Protection is designed to detect and block malicious or unwanted activity from client side plug-ins, browser extensions and malware. For example, it can quickly identify vulnerable resources, detect suspicious behavior and block unwanted ads, pop-ups, affiliate fraud and other malicious activities that attempt to hijack a retailer's audience. Initial customer interest in this new capability is very strong. Akamai Bot Manager also continued to perform very well in Q2, with revenue growing 40% year-over-year. Bot Manager now has nearly 800 customers with an annualized revenue run rate of nearly $200 million. Our customers use Bot Manager to fort a variety of unwanted activities and attacks such as price scraping, inventory manipulation, credential stuffing and account takeover. Recently, we enhanced our ability to defend against account takeover attempts with the beta launch of Akamai Account Protector. It's designed to proactively identify and block human fraudulent activity using advanced machine learning, behavioral analytics and reputation heuristics. Account Protector intelligently evaluates every login request to determine, if it's coming from a legitimate user or an impersonator. Q2 bookings were also strong for our Prolexic service, which helps organizations defend against the surge of ransom DDOS attacks that began in Q3 of last year. As an example, a leading financial analytics company recently adopted Prolexic to protect them from this growing threat. Prior to that, the company faced operational and technical challenges from needing to manage multiple security technologies from various niche vendors and cloud service providers. Since consolidating with Akamai, they have greatly benefited from reduced complexity, improved security and greater consistency for compliance and risk management across their many business units. As you all likely know, there have been widespread ransomware, data theft and other malware attacks against major enterprises this year. Included were well-publicized attacks on critical infrastructure at a major pipeline company, the world's largest meat packer and a freight operator that serves as the lifeline for 2 popular island destinations in New England. The need to stop these kinds of attacks is driving organizations to adopt new Zero Trust and Secure Access Service Edge, or SASE Solutions, such as those offered by Akamai. For example, when the exchange server attack hit thousands of organizations in March, Akamai's e-mail wasn't compromised, because our IT department uses Akamai's Enterprise Application Access solution, which prevented unauthorized access to our exchange server. Our Access Control suite of products continue to be Akamai's fastest-growing security segment in Q2, with revenue up 161% year-over-year, including the acquisition of Asavie, and up 57% on an organic basis. As one example of a new customer, we closed a large security contract in Q2 with a company that helps maritime operators manage risk. This company has thousands of employees and hundreds of offices throughout the world. They adopted our Enterprise Application Access and Kona Site Defender solutions to secure the access to their applications and to protect their internal systems from malware and other threats. I'll now turn to our CDN portfolio, which generated revenue of $528 million in Q2, down 1% year-over-year and 4% in constant currency. This result was in line with our expectations and reflects the challenging comparison against last year's pandemic-related jump in traffic and the loss of revenue from Chinese applications that were banned from India in July of 2020. Traffic on our platform remained strong in Q2, with peaks exceeding 130 terabits per second every day throughout the quarter. This enormous amount of traffic provides strong evidence of how much customers were live on our platform's unparalleled scale and reach, which is enabled by more than 4,200 points of presence at the edge, in 135 countries around the world. Our tremendous global presence is especially important to the world's major broadcasters, who continue to look to Akamai to deliver the world's most significant events. For example, during the recent European football tournament, the peak traffic that we delivered globally for more than 30 broadcasters was 35 terabits per second, nearly 5 times the peak observed in 2016. Our fast-growing Edge Applications segment delivered $47 million in Q2, up 35% year-over-year and up 32% in constant currency. This rapid growth rate reflects the shift of compute workloads from core data centers, on-prem or in the cloud to our edge platform for offload, improved performance, security and global scale. For example, each time a user accesses one of our retailer customer sites, the retailer's geo location code is executed on an Akamai edge server to identify the user's location and then deliver content tailored for that location. Overall, we're now supporting an average of 5 billion such edge computing instantiations per day on our platform. In summary, I'm pleased to report that we've executed according to the plan we outlined for investors during our February Analyst Day. In particular, we continued to achieve strong demand from customers for our security and edge computing solutions, diversification of our business across products, geographies and sales channels, and strong financial performance on both the top and bottom lines. Before turning the call over to Ed, I'd like to formally welcome Sharon Bowen to our Board of Directors. Sharon's had extensive experience in financial and securities transactions for large global companies and we're very much looking forward to benefiting from her engagement and counsel. In addition, as many of you know, our Board is now chaired by Dan Hesse, who succeeded Fred Salerno in June. Dan has held senior management positions in the telco industry for many years, including as CEO of Sprint. He's also recognized as a leader in ESG and is providing valuable advice and oversight to our senior management team. Of course, we all deeply appreciate Fred's many years of outstanding leadership and service to Akamai, and we wish him the very best in his future endeavors. I'll now turn the call over to Ed to provide further details on our Q2 results and our outlook for next quarter and the full year. Ed?"
},
{
"speaker": "Ed McGowan",
"text": "Thank you, Tom. As Tom outlined, Akamai delivered another excellent quarter. Q2 revenue was $853 million, at the high end of our guidance range and up 7% year-over-year or 5% in constant currency. Revenue growth was led by broad-based strength across our Security business globally. Revenue from our Security Technology Group was $325 million, up 25% year-over-year or 22% in constant currency. Security now accounts for 38% of our total revenue. We saw strong performance across our major security products, including Bot Manager, Prolexic, and our Access Control product suite. Revenue from our Edge Technology Group was $528 million, down 1% year-over-year or 4% in constant currency. These results were in line with our internal expectations, which factored in challenging comparisons from our outstanding CDN results in Q2 a year ago. The tough year-over-year compares within our Edge delivery business offset the continued strong growth in our edge applications business. Foreign exchange fluctuations had a negative impact on revenue of $2 million on a sequential basis and a positive $19 million on a year-over-year basis, largely in line with our expectations. International revenue was $403 million, up 15% year-over-year or 9% in constant currency. Sales in our international markets represented 47% of total revenue in Q2, up three points from Q2 2020 and up two points from Q1 levels. As a reminder, our Q2 results last year included approximately $15 million of revenue from China-based apps that were banned in India from Q3 2020 onwards. Adjusting for this impact, international growth would have been approximately 20% year-over-year and 14% in constant currency. Finally, revenue from our US market was $450 million, up 1% year-over-year. Moving now to costs. Cash gross margin was 76%, in line with our expectations. GAAP gross margin, which includes both depreciation and stock-based compensation, was 62%. Non-GAAP cash operating expenses were $259 million, slightly below our guidance range due to lower-than-expected hiring during the quarter. Now, moving on to profitability. Adjusted EBITDA was $386 million. Our adjusted EBITDA margin was 45%, in line with our guidance. Non-GAAP operating income was $270 million, and our non-GAAP operating margin was 32%, slightly favorable to our guidance due to lower operating expenses I just mentioned. Capital expenditures in Q2, excluding equity compensation and capitalized interest expense were $138 million, consistent with our guidance range. GAAP net income for the second quarter was $156 million or $0.94 of earnings per diluted share. Non-GAAP net income was $233 million or $1.42 of earnings per diluted share, up 3% year-over-year, down 1% in constant currency and $0.02 above the high end of our guidance range. Taxes included in our non-GAAP earnings were $39 million, based on a Q2 effective tax rate of approximately 14.5%. Now I will discuss some balance sheet items. As of June 30th, our cash, cash equivalents and marketable securities totaled approximately $2.6 billion. After accounting for the $2.3 billion of combined principal amounts of our two convertible notes, net cash was approximately $281 million as of June 30th. Now I will review our use of capital. During the second quarter, we spent approximately $96 million to repurchase shares, buying back approximately 900,000 shares. We ended Q2 with approximately $417 million remaining on our previously announced share repurchase authorization. Our plan remains to leverage our share buyback program to offset dilution, resulting from equity compensation over time. Moving on to Q3 guidance. We are projecting Q3 revenue in the range of $845 million to $860 million or up 7% to 9% as reported or 6% to 8% in constant currency over Q3 2020. Foreign exchange fluctuations are expected to have a negative $3 million impact on Q3 revenue compared to Q2 levels and a positive $5 million impact year-over-year. At these revenue levels, we expect cash gross margins of approximately 76%. Q3 non-GAAP operating expenses are projected to be $257 million to $262 million, and we anticipate Q3 EBITDA margins of approximately 45%. Moving now to depreciation. We expect non-GAAP depreciation expense to be between $120 million to $121 million. Factoring in this guidance, we expect non-GAAP operating margin of approximately 31% for Q3. Moving on to CapEx. We expect to spend approximately $135 million to $140 million excluding equity compensation in the third quarter. And with the overall revenue and spend configuration I just outlined, we expect Q3 non-GAAP EPS in the range of $1.37 to $1.41. This EPS guidance assumes taxes of $38 million to $39 million based on an estimated quarterly non-GAAP tax rate of approximately 14.5%. It also reflects a fully diluted share count of approximately 165 million shares. Looking ahead to the full year, we are raising our guidance for both revenue and EPS. We now expect revenue of $3.42 billion to $3.45 billion, which is up 7% to 8% year-over-year as reported, or up 6% to 7% in constant currency. We now expect Security revenue growth to be in the low to mid-20% range for the full year 2021. We are estimating non-GAAP operating margin of approximately 31% and non-GAAP earnings per diluted share of $5.54 to $5.65. And this non-GAAP earnings guidance is based on a non-GAAP effective tax rate of approximately 14.5% and a fully diluted share count of approximately 164 million shares. Finally, full year CapEx is anticipated to be approximately 16% of revenue, consistent with our prior guidance. We are very pleased with our excellent financial results in the first half, and we look forward to delivering a strong second half. Thank you. Tom and I would be happy to take your questions. Operator?"
},
{
"speaker": "Operator",
"text": "[Operator Instructions] Our first question comes from the line of James Breen from William Blair. Your line is now open."
},
{
"speaker": "James Breen",
"text": "Thanks for taking the question. Can you talk about some of the seasonality around the business, second, third quarter? Obviously, the Olympics is happening right now and sort of how you see the impact in the business, given how the traffic patterns have been so far. And then it seems like operating income 31% is moving up a little bit. Can you just talk about some of the dynamics and where you see that going as security maybe becomes a bigger part of the business?"
},
{
"speaker": "Ed McGowan",
"text": "Jim, thanks for the question. This is Ed. In terms of seasonality, Q3, typically, we tend to see a little bit of slowdown in traffic over the summer months, we were calling for sort of a flattish quarter to Q2 here with the guide. We'll see a little bit of slowdown in August. I would expect -- I've got the Olympics in there. Not expecting a ton from the Olympics this year, it's a couple of million bucks that we have in the quarter. We did see in terms of seasonality in Q2, we did see a bit of a lighter gaming quarter in Q2. We would expect to see that probably pick up a bit here in the back half of the year. And then obviously, in Q4, that's our most challenging quarter to call, which you've got really 2 seasons there. You've got the commerce season and then the -- we typically see a large media season as well. So we're expecting that in Q4. And we'll update you as we go and we'll get more information as the year goes on. And for the next call, we'll update you on what we're seeing for the Q4 seasonality. The margin question, yes, we had a better quarter from an operating margin perspective. Hiring was a little bit lighter than normal. Just a couple of things to keep in mind on the margin front. July is when we have our annual merit increase or our salary increases, so that comes into effect beginning in Q3. Then also, we do expect that we'll see some travel expenses and some costs related to offices reopening in the back half of the year as well. Tom and I have talked about, we plan on operating the business in the 30% range. This year, we'll do a little bit better, but we do want to continue to invest for the opportunities we see in front of us in Security."
},
{
"speaker": "James Breen",
"text": "Great. Thanks."
},
{
"speaker": "Operator",
"text": "Thank you. Our next question comes from the line of Sterling Auty from JPMorgan. Your line is now open."
},
{
"speaker": "Sterling Auty",
"text": "Yes, thanks. Hi, guys. I'm curious to understand, how you're thinking about the investment on the go-to-market, specifically sales headcount in the security side of the business, given the strength that you're seeing?"
},
{
"speaker": "Tom Leighton",
"text": "We do have a specialist team for our newest security products. And that's very helpful until the field can get up to speed. But our entire go-to-market operation is now well versed in selling security products. So they really only need the assist for the newly released products. And so we don't have a bifurcated sales force now."
},
{
"speaker": "Sterling Auty",
"text": "Understood. And then just one follow-up in terms of the security competitive landscape, especially on the newer solutions like Page Integrity Manager. Who is the point person you're selling into? And are these uncontested, or what other solutions do they tend to consider when they're looking at it?"
},
{
"speaker": "Tom Leighton",
"text": "Yes. For our new solutions, you might see a start-up out there with something similar. Our normal competition doesn't have these capabilities. And it's a big advantage to be able to offer these capabilities with the existing platform because once you're on Akamai, for example, you're using our Web App Firewall, which is a market-leading solution, it's very easy to add Page Integrity Manager on top. We just take care of that. The customer says they want it and we turn it on. And the request – the data flow is not changed. The same will be true with Audience Hijacking Protection, same thing, built right on top of the Web App Firewall, and our other solutions. So it really is very convenient for customers to buy from us. And there really isn't something that's comparable in the marketplace. And these are adding great value. In terms of the buyer, Audience Hijacking Protection, that could really go the range. Probably it ends up more towards the marketing side of the house because literally, their audience is being hijack today. Any retailer has a problem where – because of malware that's on the user's browser or plug-ins or extensions they have, that malware and those plug-ins are looking for somebody about to do a transaction. And what they'll do is put some pop-up over at saying, wait a minute, go here instead. Or even worse, it will be some fraud, where they'll change the refer header and claim credit for this buyer and our customer now has to pay more. So if for products like that, it could be anywhere from the security side all the way through the website and through the marketing side of the house because it provides so much value, it reduces cost, increases revenue and provides greater security. Really, it's very nice to see that because it's a very good blend between our delivery and performance solutions and our security solutions all wrapped up in one package."
},
{
"speaker": "Sterling Auty",
"text": "Makes sense. Thank you."
},
{
"speaker": "Operator",
"text": "Thank you. Our next question comes from the line of Will Tyler from Baird. Your line is now open."
},
{
"speaker": "Charlie Erlikh",
"text": "This is Charlie Erlikh on for Will. Thanks for taking my question. I had a sort of a sort of a two-part question on contract renegotiations. I guess, first, are there any big contracts coming up that we should be aware of, or is it pretty spread out over the back half of the year and into next year? And then part two, for the contract renegotiations that you've already had, kind of curious what you're hearing in terms of sort of the health of the customers? And are they still asking for price concessions, or are we closer to back to pre-pandemic levels in that respect? Thanks."
},
{
"speaker": "Ed McGowan",
"text": "Yes. So on the -- in terms of the big contracts up for renewal, we had a few that we did this quarter. And then, I'd say, the rest are sort of spread out fairly evenly. If there's ever anything that is major, I tend to try to call that out. But as we disclosed in our IR day, we don't have significant customer concentration risk. But sometimes you can get a few of them all together that can make a little bit of noise in the quarter, but they're pretty much spread out. And in terms of the health of the customers, it really varies by vertical. We do see, I would say, pretty standard pricing discussions. This industry traditionally has had deflationary pricing when it comes to -- especially volumes, but it's being driven by volume. And I don't see any major change there. Really nothing to call out. I think it's still too early to call an end to the pandemic, obviously. So we've got some significant business with commerce and retailers, and that's still kind of playing itself out at this point. We've seen some pickup in volume, but we're not out of the woods yet there. But in terms of overall pricing, really nothing to call out in terms of any major changes."
},
{
"speaker": "Charlie Erlikh",
"text": "Great. Thanks, Ed. And just if I can just squeeze in another one. You used to give this helpful metric on the percentage of customers that are taking one security product and the percentage that are taking multiple security products. Is that something that you could provide us now or you're not giving that metric anymore?"
},
{
"speaker": "Ed McGowan",
"text": "Yeah, sure. I can give you that number. So right now, we've got about 55% of our customers that are buying one security product and about 32% that are buying more than one. But just keep in mind that our customer base has grown over the last year, it's up probably by 5% or 6% over the last year. So we're doing a pretty good job of getting penetration into the base. But the base is also growing. If I go back a year ago, Q2 of 2020, that number for folks that have acquired a security product was around 59%. So we're seeing really healthy growth in terms of the overall number of customers, both from penetration of the base, but also just the size of the customer base is growing as well."
},
{
"speaker": "Charlie Erlikh",
"text": "Great. Thanks very much."
},
{
"speaker": "Operator",
"text": "Thank you. Our next question comes from the line of Keith Weiss for Morgan Stanley. Your line is now open."
},
{
"speaker": "Mike Wilson",
"text": "Hi. It's Mike Wilson on for Keith Weiss. Thank you for taking our question. I'd like to dig a little bit deeper into the Edge Applications. What type of use cases you're seeing? And what other verticals you're kind of seeing traction in besides retail? You gave a nice example in your prepared remarks, but anything additional would be helpful."
},
{
"speaker": "Tom Leighton",
"text": "Sure. It really is useful, I think, across all verticals. Gaming is another example of the big -- our big gaming customers had interest there. They want to get local decisions made in terms of who's playing who, what master server maybe they go back to for the gaming instructions. Another great example is the COVID vaccine registration sites. In this case, it was a third-party company unrelated to us, built a queuing application on top of our EdgeWorkers solution that is used today by, I think, dozens now, governments and pharmaceutical companies to assist in getting vaccine registrations. And of course, in the early days in the U.S. and still in many countries, there's a lot more people that want to get a vaccine than you have capacity for and so you want to be fair. So if somebody comes into the website, they get into the queue, and they know how long the queue is and that whole process is managed. And again, that's an ideal application to run with our edge computing service. And also handles all the excess load and the flash crowd around the site when you announced, okay, we got a lot of vaccines available in a certain period of time. A lot of people come at once. So maybe they know when that's going to happen, and so we provide the overflow capacity for that. But really, anything you could imagine that involves locality, the need to rapidly scale would be a suitable use for our EdgeWorkers solutions. IoT applications, I think, in the future is a big driver of demand there. And I think that gets enabled by 5G as that gets deployed, and you get a lot more devices connected. But there, you've got a lot of devices with a lot of communication back and forth, very chatty protocols, data being sent in and you need to aggregate that and make decisions quickly locally on the fly, edge computing, edge applications is a good example for that. Tailoring the content based on the device type and the local connectivity is another example. We do that with our image and video manager applications, where if you're on a, say, a cellular device, you don't have a big screen and maybe you don't have great connectivity, we will automatically, at the edge with the edge computing, put in a smaller – a lower resolution version of the image. And on your device, it will look the same. So there's no real reduction in quality, but the less traffic needed to convey the image means you get better performance for the end user. So there's just all sorts of applications that people are using. And now we're doing those, kinds of, things five billion times a day on our edge platform using Edge Java."
},
{
"speaker": "Mike Wilson",
"text": "That's really great color. And then pivoting to the CDN solutions within the Edge Technology Group, anything to call out in terms of pricing? And then how should we think about revenue from the Internet platform customers and the second half of 2021?"
},
{
"speaker": "Ed McGowan",
"text": "Yes. I'll take that one, Tom. So the -- in terms of pricing, as I just mentioned, really nothing to call out on the pricing side. As far as Internet platform customers go, the team's doing a great job executing there, we continue to grow that group of customer’s obviously very highly innovative customer base, a lot of them have their own CDN, but we're doing a good job of growing that business and very happy with the performance there. I expect that revenue stream to continue to run along about the same pace that it's going now for the rest of the year, maybe see a little bit of upside in this fourth quarter."
},
{
"speaker": "Mike Wilson",
"text": "All right. Thanks guys."
},
{
"speaker": "Operator",
"text": "Thank you. Our next question comes from the line of James Fish from Piper Sandler. Your line is now open."
},
{
"speaker": "James Fish",
"text": "Hey guys, thanks for the questions. First, on the external and internal-based cloud access solutions, what one is really leading the charge at this point? And what has been the pushback from customers that are evaluating other solutions that may pick a competitor? And do you plan on building or acquiring into the rest of that SASE stack like in DLP or CASB?"
},
{
"speaker": "Tom Leighton",
"text": "So yes, we're interested in the entire SASE stack. I would say we're really focused though on stopping malware, stopping these ransom DDoS, ransomware attacks, stopping data exfiltration. And that puts us in the direction of a focus on access to make sure that we do the access control of the application layer, not as it's traditionally done at the network layer, and that makes a huge difference in terms of the malware getting inside in the first place. Also, we have Secure Web Gateway capabilities, probably market-leading DNS capabilities, which makes a big difference in terms of data exfiltration. And we do have some DLP capabilities today with our newest version of Enterprise Threat Protector. CASB, less capabilities there today, potentially of interest, but not the primary mission in terms of stopping the data exfiltration, the ransomware attacks, the malware attacks on enterprises. And of course, ransom DDoS, which our Prolexic solution helps a lot with -- along with Kona. So good traction there. As you see the growth on the access side of the house now, well over 50% organically. And of course, if you account the Asavie acquisition, over 160% year-over-year. We plan to continue investing there organically, also through potentially M&A, we're always looking there. And I think that has a lot of future potential for us."
},
{
"speaker": "James Fish",
"text": "That's helpful, Tom. And I guess I'll be the one to take the bait. Obviously, 2 outages during the last couple of months here. Can you just walk us through, maybe add what the financial impact could be in terms of any SLA refunds or what you heard back in terms of feedback from customers regarding the DNS and the DDoS issues? Thanks?"
},
{
"speaker": "Tom Leighton",
"text": "Yes. In terms of financial impact, de minimis. We lost, at the peak, about 2% of our traffic for up to 1 hour. So not any financial impact per se. That said, we care a lot about reliability at Akamai. It is core to everything we want to do. And we've put a ton of effort into making our solutions be reliable over the last 10-plus years. In fact, you have to go back to 2004 to find anything comparable in terms of what's happened on our platform. In 2004, we actually took the entire platform down for about an hour, which was disastrous. That didn't happen in this case, but we did hurt hundreds of our customers, and we deeply regret that. We impacted them and their users, and that's unacceptable. In both cases, there was an update that caused a problem. And we have invested a lot in infrastructure to make sure that updates are done safely. In this case, the updates were totally different and totally different systems at Akamai. But as a result of this, we are taking a fresh look at how we release updates to make sure that something like this won't happen again. And meanwhile, we've locked down all update channels as we do a thorough investigation of each one. People don't often realize it, but we are constantly doing updates. We have a platform with dozens of services. We have many, many thousands of customers. Any given customers maybe wanted to make an update to their site on an hourly basis or more. And so it's just thousands and thousands a day of updates that are taking place in the platform. And because of the really very intense work that we've done over the last decade, we have had an excellent track record of keeping any problem with an update from spreading. Humans making updates will make mistakes. And our goal is to prevent -- to catch them early and prevent them from spreading. And in this case, there were 2 different channels where that didn't happen the way we want it to. And so we are putting in a lot of effort to look at every possible channel and make sure it is working the way we want to. And not only do we not want to have any more incidents this year, we don't want to be having this happen in the next 10 years. And so there's a lot of effort going into making sure that's the case."
},
{
"speaker": "Operator",
"text": "Thank you. Our next question comes from the line of Tim Horan from Oppenheimer. Your line is now open."
},
{
"speaker": "Tim Horan",
"text": "Thanks. Tom, just maybe two really higher level questions. Can you just talk about how important edge compute do you think is going to be in the cloud in terms of -- for specific applications? What percentage will have some edge component to it? And how do you think your infrastructure holds up compares to competitors for providing that edge? And then on the security front, another just really high-level question. Do customers understand how much better cloud-based security is than on-prem? And where are we with that process?"
},
{
"speaker": "Tom Leighton",
"text": "Yes, good questions. I think edge computing is really important in the future. And when I say edge, I really mean edge, and that's a big difference with the competition, none of whom really have an edge platform. Of course, for the last couple of years, everybody says they have edge everything. It's just -- it's not true. We're in over 4,000 locations, in about 1,000 cities and 135 countries, and nobody is anywhere, anywhere close to that. And we offer native Javascript support now, which a lot of the folks that talk about edge computing don't. And we spin up our apps in a few milliseconds, and that's a factor of 1,000 better than some of the folks that talk a lot about edge computing out there. So, I think we stack up very well against the competition there. And I think you see that reflected in our very strong growth. That segment now well over 30% growth year-over-year. We think we can maintain that. And on a reasonable size number, last year, $150 million, we're now almost up to a $200 million annual revenue run rate for our edge applications business. So, I think very strong future potential. And as you grow in your 30% a year on a number that's about $200 million now, after a few years, that starts really being meaningful. And I think that drives accelerated growth for the CDN business. And remind me again of the security question you had."
},
{
"speaker": "Tim Horan",
"text": "Well, it seems like security is rapidly moving to the cloud. I guess the customers understand how much better that is, where do you think we are in the process?"
},
{
"speaker": "Tom Leighton",
"text": "Yes, that's a good question. It's interesting because we started with application firewall. And if you go back five or six years, pretty much everybody bought a device and managed it in their data set. And today, there's still a few enterprises that do that. But pretty much all the major B2C companies on large -- majority of them are now using Akamai for that as a cloud service. And we're the market leader by far in application firewall. You look at DDoS. And again, go back five-plus years, that was managed either in the data center or with a single carrier. And that just doesn't work anymore. You can't handle the volume. And so now Akamai is the market leader by far with a cloud service there. I think you will see the same thing happen with enterprise security. Today, it is done, you get your VPN and you get your boxes and you manage them in your data center. That is not a good way to do it. That's why you have all these breaches. When you're providing network layer access, it's a disaster. You look at the big pipeline company that had a problem. It's just one of many thousands of enterprises. Credentials to the BPM are stolen, put on the dark web, somebody gets them. And that just gives them access to the entire network. And you can't do it that way. And that's why our solutions are so important with application layer access. Now sure you can steal somebody's credentials, but of course, you want multifactor authentication. And then you only get access to the app. And if you're using Akamai, you don't even get access to the app directly. You got to come through us, and we'll make sure there's no malware going to that app or you're not exploiting vulnerabilities, and then you don't have those kind of situations. So I think if you look at the exchange server situation, which I talked about a few minutes ago. Again, by having Akamai in front with our Enterprise Application Access, our e-mail wasn't stolen, even though we had the vulnerable software like everybody else did. So it will take some time. We're at the beginnings of, I'd say, Zero Trust approach and moving to the cloud, in particular to the edge – My Edge platform for enterprise security, but I do think there's a tremendous future there because we're in a position to really stop those breaches."
},
{
"speaker": "Tim Horan",
"text": "Thank you."
},
{
"speaker": "Operator",
"text": "Thank you. Our next question comes from the line of Colby Synesael from Cowen. Your line is now open."
},
{
"speaker": "Colby Synesael",
"text": "Thank you. Two modeling questions, if I might. The first one, just looking at the guide increase for 2021. Just curious if you're going to agree with how I'm thinking about it, which is it seems like it reflects a 2Q upside, maybe a little bit of upside in terms of your expectations for 3Q, but really no change as it relates to your assumptions for 4Q. And it sounds like that's more a function of just lack of visibility opposed to some type of step-down or negative impact, if you will, that you're now anticipating? Just curious, if I'm thinking about that correctly. And then secondly, it sounds like in response to one of questions, regarding M&A it may have been suggesting that you guys obviously continue to look and may even be close to something. Are you guys still holding a line where M&A is expected to be accretive within some short period of time, or are valuations getting to a point now, where if you were, in fact, to do something of materiality, it could actually be relatively meaningfully dilutive just given what you'd have today? Thank you."
},
{
"speaker": "Ed McGowan",
"text": "All right. So I'll take the first question, Colby. So in terms of Q4, I think you're thinking about it correctly, we always talk on Q4 being the hardest quarter to call. And then obviously, there's been a bit of a flare-up here with the Delta virus. So we're going with what we see now, as I said earlier in the call, we'll update you as we get more visibility. There's two seasons to call. There's the commerce season, and commerce is a very important vertical for us. And then also, as we've seen in the last several years, there tends to be a big jump step-up in media. So we'll get some more information as we go. But I think you're thinking about it correctly."
},
{
"speaker": "Tom Leighton",
"text": "Yes. And in terms of the M&A question, we're always looking for companies that have novel capabilities that we can use to build products for our customers that are synergistic with our platform and our solutions we have today. And you're right, there are areas, particularly in security and also edge computing that have very high valuations to that. And that makes it harder to do acquisitions that make sense because we're not going to do something that's crazy. Now when you're looking at acquisition, we look at it over the long-term and so that we want it to be accretive, certainly over the long-term. In addition to the purchase price, we also worry about the hit margins, especially when you do an acquisition, often as you know, the first year, you have revenue recognition issues where you don't get to recognize all the revenue right away. And so in the first year, you can take a hit to your margins. And if we find the right acquisition that is really helpful to us in growth over the long-term and it will be accretive to margins over the long-term, there may be a situation where we would take a short-term hit to margins, and then we would improve them from there."
},
{
"speaker": "Colby Synesael",
"text": "Okay, great. Thank you."
},
{
"speaker": "Operator",
"text": "Thank you. Our next question comes from the line of Brandon Nispel from KeyBanc Capital. Your line is now open."
},
{
"speaker": "Brandon Nispel",
"text": "Great. Thanks for taking the question. Ed, I'm curious about, you mentioned headcount growth slowed and actually was down sequentially. Can you update us on your hiring plans for the rest of the year? And do you believe the company needs another phase of investment in headcount in order to sustain the current growth trajectory? Thanks."
},
{
"speaker": "Ed McGowan",
"text": "Yeah, sure. So I talked about headcount being a little bit behind hiring. Obviously, last year, we had record low attrition. And we're still not back to the attrition levels that we saw pre-pandemic. But we're just a little bit behind on our hiring. I expect that will catch up. We're scaling the company very well. As you can see, our margins have improved quite a bit. But we still want to make investments in security. You've seen some of our newer products have grown to a pretty material size. We've got some very fast and exciting growing businesses with our edge computing business along with very deep product bench for security. So we're going to continue to invest there. There will be some investments in go-to-market. And then, obviously, as we continue to grow, there'll be some scaling heads that we have to add. But nothing in terms of like a major investment cycle or anything like that that we anticipate coming."
},
{
"speaker": "Operator",
"text": "Thank you. Our next question comes from the line of Mike Cikos from Needham & Company. Your line is now open."
},
{
"speaker": "Mike Cikos",
"text": "Hi team. Thanks for taking the questions. I wanted to focus on the security and the improved outlook you guys provided today. It seems like the security, in general is facing broad-based demand, but are there any solutions specifically that are driving this improved outlook? And then I guess a follow-on, with the current threat environment, the headlines we're seeing, is this driving a material change in customer interest? Are you seeing any noticeable impact on sales cycles or budget flowing into this space as a result of that?"
},
{
"speaker": "Tom Leighton",
"text": "The good news is we're seeing strong demand across all of our major security product lines. And also the new security products are obviously not contributing a lot of revenue yet, but we're seeing strong interest in those as well. So it's just a -- it's a good picture across the board. The threat environment certainly increases the awareness and need for our solutions. In terms of sales cycle, obviously, if a customer is under attack, the sales cycle can be very short. In many cases, we'll integrate the customer within a matter of hours or days and often a follow-up with all the details of the contract later, and we've seen a lot of that. With these ransom DDoS attacks, dozens and dozens of major enterprises in that situation that very quickly become happy Akamai customers. So it's a good environment, I would say, in terms of security sales for all of our security products right now."
},
{
"speaker": "Mike Cikos",
"text": "Thanks for that. And if I'm just thinking about the traffic trends, trying to parse out between the typical seasonality where there's a slower leg, if you will, in the summer months. And I'm matching that up against what we have with COVID and this Delta variant we're seeing, trying to -- can you guys better comment on that? I'm just trying to put those two pieces together to see what's baked into the guidance as we stand today, or how you see that traffic playing out over the last month, now that we're in Q3? Thank you."
},
{
"speaker": "Ed McGowan",
"text": "Yeah, good question. So what we've assumed here is that there really isn't going to be a major step-up in demand like we saw last year. So not anticipating major lockdowns or anything like that. So then, obviously, if something like that were to happen, it could increase our traffic in the quarter. We do see typical seasonality in the summer months, typically August in, hopefully Europe, in particular, tends to be lighter than expected. So we're anticipating that. It's offset a little bit by the Olympics. Again, I told you not a ton there, a few million bucks for the Olympics. But security growth is also not necessarily impacted by traffic. So we could see if we do see lockdowns, you could see traffic accelerate a bit. And we're not really anticipating that, it's not in our guide at this point. We are expecting to see a strong seasonal Q4. And like I said a couple of times now, we'll update when we talk to you again, when we get more visibility. But traffic has got back to, what I would call, more normal growth rates. Obviously, we went through a year-and-a-half of accelerated traffic growth with the launch of some major OTT platforms along with the pandemic. So we’re modeling what I would consider to be sort of a more normal CDN outlook."
},
{
"speaker": "Operator",
"text": "Thank you. Our next question comes from the line of Ben Rose from Battle Road Research. Your line is now open."
},
{
"speaker": "Ben Rose",
"text": "Yes. Good afternoon. A question for Tom and then a question for Ed. For Tom, you mentioned at the outset, the Akamai Account Protector that you're working on in beta. I was curious to know if you could provide a little bit more information on the kind of benefits to customers that would come from this product that may not be available in Akamai's security portfolio currently."
},
{
"speaker": "Tom Leighton",
"text": "Sure. Account Protector is sort of the next step beyond Bot Manager. Bot Manager detects whether it's a human being that's trying to, for example, to log into an account. And as you probably know, there's a ton of account stuffing going on. We see every day now about 1 billion illegitimate attempts to log into an account of some kind, a bank account, gaming account, a commerce account. And the vast, vast majority of that is bot traffic. Credentials have been stolen somewhere and a Bot network is used to check out those credentials against a lot of websites to see if you get a hit. Now the adversaries have evolved, the attackers have evolved. And now I will use humans to attempt to log in and steal accounts. Now you can't do that at the same scale as you can with a bot army. But you use things that you think may well get in and now the human will do it. And so we need to decide, well, okay, it's human, but is it the right human? And that's what Account Protector is all about. And it will use information about the human that's been using that account before with a variety of inputs and trust scores and then using machine learning to the side on the fly based on everything we can see here, is this the right human for this account? And we give a score that is used to decide, are we going to provide access directly? Do you go to some other security mechanism, like you get asked questions or a capture test of some kind, or do you just block? And that's what Account Protector does. So it is one-step deeper analysis that will now deal with human-based fraud and then specifically around the log-in function. Now of course, Bot Manager covers a lot of other things, too, like price scraping, inventory stealing, inventory – reserving all the seats in a hotel or an airline by a competitor, that kind of thing. So, this is really focused on fraud and log-in that's being done by humans."
},
{
"speaker": "Tom Barth",
"text": "Ben, you had a question for Ed, maybe you could restate it."
},
{
"speaker": "Tom Leighton",
"text": "I don't think it was stated."
},
{
"speaker": "Tom Barth",
"text": "Ben, what was your question for Ed? Thank you, everyone. In closing, we will be presenting at several investor conferences and road shows throughout the rest of the third quarter. Details of these can be found on the Investor Relations section of akamai.com. Thank you for joining us, and all of us here at Akamai wish have a wonderful evening."
},
{
"speaker": "Operator",
"text": "This concludes today's conference call. Thank you for participating. You may now disconnect."
}
] | Akamai Technologies, Inc. | 24,522 |
AKAM | 1 | 2,021 | 2021-05-04 16:30:00 | Operator: Good day and thank you for standing by. Welcome to the Akamai Technologies First Quarter 2021 Earnings Call. At this time, all participant lines are in a listen-only mode. After the speakers' presentation, there will be a question-and-answer session. [Operator Instructions] Please be advised that today's conference is being recorded. [Operator Instructions] I would now like to hand the conference over to your host today, Tom Barth, Head of Investor Relations. Thank you Please go ahead, Sir.
Tom Barth: Thank you, operator. Good afternoon everyone and thank you for joining Akamai's first quarter 2021 earnings conference call. Speaking today will be Tom Leighton, Akamai's Chief Executive Officer; and Ed McGowan, Akamai's Chief Financial Officer. Before we get started, please note that today's comments include forward-looking statements including statements regarding revenue and earnings guidance. These forward-looking statements are subject to risks and uncertainties and involve a number of factors that could cause actual results to differ materially from those expressed or implied in such statements. The factors include uncertainty stemming from COVID-19 pandemic and any impact from unexpected geopolitical developments. Additional information concerning these factors is contained in Akamai's filings with the SEC, including our annual report on Form 10-K and quarterly reports on Form 10-Q. The forward-looking statements included in this call represent the company's view on May 4, 2021. Akamai disclaims any obligation to update these statements to reflect future events or circumstances. As a reminder, we will be referring to some non-GAAP financial metrics during today's call. A detailed reconciliation of GAAP and non-GAAP metrics can be found under the financial portion of the Investor Relations section of akamai.com. And with that, let me turn the call over to Tom.
Tom Leighton: Thanks Tom. And thank you all for joining us today. I'm pleased to report that Akamai delivered excellent results in the first quarter. Q1 revenue was $843 million, up 10% year-over-year and up 8% in constant currency. This strong result was driven by the continued rapid growth of our security business, accelerated growth in our edge applications business and continued high traffic levels on our intelligent edge platform. Non-GAAP operating margin in Q1 was 31% and Q1 non-GAAP EPS was $1.38 per diluted share, up 15% year-over-year and up 11% in constant currency. With a strong start to 2021, we're proud that Akamai has continued to enable and to protect, remote work, homeschooling, ecommerce and online entertainment for billions of people around the world amidst very challenging circumstances. Our security solutions portfolio performed especially well in Q1 generating revenue of $310 million, up 29% year-over-year and up 27% in constant currency. A very strong growth was experienced across most of our security products, including our new Page Integrity Manager solution. Page Integrity Manager helps enterprises defend against malware and third-party software and applications. Customers that adopted Page Integrity Manager in Q1 included Maersk, the world's largest container shipping operator, and Groupon, the global e commerce marketplace. Maersk uses more than 4000 scripts, half of which are third party scripts to drive millions of dollars of online business every hour. Managing this complex and dynamic environment had become an increasingly difficult security challenge for Maersk and so they now use Page Integrity Manager to improve visibility into security threats and to prevent the loss of critical data. Our Bot Manager solution also continued to perform very well in Q1. Bot Manager is designed to mitigate a wide variety of automated attacks, including account stuffing attacks where credentials stolen from one website are checked for validity at 1000s of other websites. When valid credentials are found a manual attack is then often used to extract value from the compromised accounts. Losses from account takeovers and new account fraud are estimated at over $10 billion annually in the US. In order to afford such manual attacks. We launched the beta for our new account protector solution in Q1. Account protector shields organizations from account takeover and other kinds of fraudulent human activity without increasing friction for legitimate customers. Account protector works by detecting in real time whether a user logging into an application is the legitimate account owner or an imposter in possession of stolen credentials. One of our beta customers for this new solution is a well-known restaurant franchise that was under attack by cyber criminals who were compromising the loyalty accounts of their diners. The criminals were stealing loyalty reward points and then reselling them on the dark web. The digital theft outraged the diners whose points were stolen and angered restaurant owners who unknowingly provided meals to fraudsters. With help from Akamai, the franchise can now identify the situations where humans are impersonating valid diners, and take action to stop the illicit transfer of loyalty points, thereby stopping the fraud and enabling the franchise to focus on accelerating sales. We're also excited about the success of Akamai's fastest growing security segment Access Control, which reached an annualized revenue run rate of $100 million in Q1, up more than 170% over Q1 of 2020 and up over 60% organically. Our Access Control segment provides secure connectivity for users, applications, workloads and IoT systems, regardless of their location. Products in this area include enterprise application access, enterprise threat protector, and our new secure mobile and secure IoT solutions that we acquired from Asavie in October. Our secure mobile and secure IoT products provide security, visibility and control for mobile devices at the edge. These services determine malicious activity and support acceptable use policies without needing to install a client on the device. The solutions are sold to our carrier partners such as AT&T, where it forms the basis for their AccessMyLAN solution. These capabilities have been especially important in helping school districts secure student devices during the pandemic so that students can learn from home safely. Our security solutions also continued to gain recognition from the leading analyst firms in Q1. Our market leading web application firewall capabilities, earned Gartner peer insights customers choice distinction, and Forrester named Akamai as a leader in DDoS protection for the third time, saying large enterprise clients that want an experienced trusted vendor to make their DDoS problem go away should look to Akamai. Turning to our CDN portfolio, Q1 marked another quarter of very strong traffic growth for Akamai, led by OTT video services and downloads of e-gaming software. On March 16, traffic on the Akamai platform reached an all-time high of 200 terabits per second. This is 19% higher than the peak and Q1 of last year, and two and a half times the traffic peak in Q1 of 2019. Daily peaks were also high in Q1, averaging 143 terabits per second. In fact, traffic on our platform exceeded 110 terabits per second, pretty much around the clock in Q1. Overall, our CDN products and services generated revenue of $532 million in Q1 of 2% year-over-year and flat in constant currency. The Edge application segment generated 45 million in revenue last quarter, up more than 30% over Q1 of 2020. As you may recall from the discussion at our Investor Summit in February, this revenue amount includes edge computing solutions, such as EdgeWorkers that we build discreetly, but does not include the wide array of services that use our computing capabilities at the edge. As we discussed during our recent Investor Summit, we believe that there's the potential for substantial future growth in the area of edge computing, as we anticipate more enterprises moving their compute workloads to our edge platform for offload, improved performance, security and global scale. A timely example of such a shift is manifested in our new Vaccine Edge solution, which is enabling over two dozen public health agencies and pharmacy chains around the world to deliver and secure COVID vaccine registration sites in the face of extraordinary flash crowds. In multiple instances, Akamai was called in to rescue government agencies whose websites had crashed under load, resulting in frustrated citizens who waited for long times before getting kicked out without a reservation. In some cases, these websites have been using solutions provided by competitors that were not able to handle the load. We're pleased to partner on Vaccine Edge with salesforce.com. And we're proud that our EdgeWorkers solution has made a real difference to the many millions of citizens trying to get the vaccine as quickly as possible. Our customers are now using EdgeWorkers for a wide range of applications. For example, a leading theme park operator is using EdgeWorkers to help manage demand as they plan to reopen parks. A publicly traded sports and entertainment company has implemented GEO fencing, using our EdgeKV data store together with EdgeWorkers to ensure that users access only relevant broadcast content for their location. A nationwide home improvement retailer and a global credit card company are using AB Testing logic at the edge to deliver fast and personalized user experiences. We're enabling DevOps workflows for a global sportswear brand by managing canary releases, where only a targeted group of users can see a new experience. And we're enabling a leading global manufacturer of devices to authenticate their users at the edge, which improves performance and reduces their cloud costs. We're also proud of the progress that we're making with our sustainability efforts. In the past year, we doubled our platform capacity, with no increase at all in our platform's carbon footprint. And just two weeks ago on Earth Day, we announced that by 2030, Akamai intends to power 100% of our global operations with renewable energy, improve the energy efficiency of our platform by an additional 50%, mitigate 100% of our platform emissions and continue to recycle 100% of our electronic waste. These goals reflect optimized commitment to be a responsible, efficient and forward-looking company. In summary, we're very excited about the innovative technology that we're developing, the strong demand from customers for our security and edge computing solutions and our Q1 financial performance on both the top and bottom lines. The growth strategy and goals that we outlined to you in our Investor Summit on February 25 set our direction for the future. And we believe that our strong Q1 results show that we've been executing according to plan. Now I'll turn the call over to Ed to provide further details on our Q1 results, and the outlook for next quarter and 2021. Ed?
Ed McGowan: Thank you, Tom. Before I provide additional details on our Q1 performance, I'd like to remind everyone that as a result of the reorganization we announced last quarter, we've refocused the company from a vertical aligned divisional structure to a product-oriented lens. I will therefore be focusing my discussion today on our security technology group and our edge technology group. The security group, as you might imagine, encompasses all of our security solution. The edge group includes our media delivery, and web performance CDN business, along with our edge compute solutions. We plan to provide additional revenue detail for the different product lines within our security technology group and edge technology group on an annual basis. However, we might highlight specific subgroup details from time to time on our quarterly earnings calls if we feel it will help provide greater context on our results. Finally, as I mentioned on our last call, we will continue to report both web division and media and carrier division results along with our internet platform customer results on our website for the balance of 2021 to assist with this reporting transition. So with all that said, as Tom outlined, Akamai delivered another excellent quarter in Q1. We were very pleased to exceed the high end of our guidance range on both revenue and earnings. Q1 revenue was $843 million, up 10% year-over-year, or 8% in constant currency, driven by continued strength across most major product areas in our security business, better than expected traffic from OTT video and gaming customers and very strong performance in our edge applications business. Revenue from our security technology group was $310 million, up 29% year-over-year, or 27% in constant currency, driven by broad based strength across most of our security products. Revenue from our edge technology group was $532 million, up 2% year-over-year, or flat and constant currency. We benefited from strong traffic growth driven by OTT video and gaming, as well as strong growth in our edge applications business as Tom mentioned earlier. As expected, foreign exchange fluctuations had a positive impact on revenue of $3 million on a sequential basis, and positive $16 million on a year-over-year basis. International revenue was $380 million, up 13% year-over-year, or 8% in constant currency. Sales in our international markets represented 45% of total revenue in Q1 up one point from Q1 2020 and consistent with Q4 levels. Finally, revenue from our US market was $463 million, up 8% year-over-year. Moving now to costs, cash gross margin was 76%, in line with our expectations. GAAP gross margin, which includes both depreciation and stock-based compensation, was 64%. Non-GAAP cash operating expenses were $267 million in line with our expectations. Now moving on to profitability, adjusted EBITDA was $375 million, up $49 million, or 15% from the same period in 2020. Our adjusted EBITDA margin was 45%, up two points from Q1 2020. Non-GAAP operating income was $264 million, up $34 million, or 15% from the same period last year. Non-GAAP operating margin came in at 31%, up one point from Q1 last year and above our guidance range due to leverage from our revenue out performance. Capital expenditures in Q1 excluding equity compensation and capitalized interest expense were $150 million, consistent with our guidance range. We continue to expect Q1 CapEx to represent the high watermark for quarterly CapEx spending in 2021. GAAP net income for the first quarter was $156 million or $0.94 of earnings per diluted share. Our Q1 GAAP results include a $7 million restructuring charge related to the company realignment we announced last quarter, which was in line with our expectations. Non-GAAP net income was $228 million, or $1.38 of earnings per diluted share, up 15% year-over-year, up 11% in constant currency and $0.07 above the high end of our guidance range due to our revenue outperformance. Taxes included in our non-GAAP earnings were $38 million based on a Q1 effective tax rate of approximately 14%. Now, I will discuss some balance sheet items. As of March 31, our cash, cash equivalents and marketable securities totaled approximately $2.5 billion. After accounting for the $2.3 billion of combined principal amounts of our two convertible notes, net cash was approximately $154 million as of March 31. Now I will review our use of capital. During the first quarter we spent $58 million to repurchase shares, buying back approximately 600,000 shares. We ended Q1 with approximately $514 million remaining on our previously announced share repurchase authorization. Our plan remains to leverage our share buyback program to offset dilution resulting from equity compensation over time. As a result based on current market conditions, we expect to spend at least $350 million for the full year 2021. Moving on to Q2 guidance, we are projecting Q2 revenue in the range of $839 million to $853 million, or up 6% to 7% as reported or 3% to 5% in constant currency over Q2 2020. There are two factors to consider, as you think about year-over-year comparisons for Q2. First, in 2020, we saw a significant uptick in traffic on our network starting at the end of March and continuing through the remainder of the year as a result of global lock downs. As our excellent Q1 results demonstrate traffic has continued to grow on our network this year. But we don't expect to see the same traffic growth rates from a year ago going forward. This creates more challenging year-over-year comparisons for our edge delivery business starting in Q2 and continuing for the remainder of 2021. Second, the Q2 year-over-year growth comparison also reflects the continuing ban of some Chinese based apps in India. As a reminder, these apps which were banned in Q3 of last year contributed revenue of approximately $15 million in Q2 2020. Foreign exchange fluctuations are expected to have a negative $3 million impact on Q2 revenue compared to Q1 levels and a positive $18 million impact year-over-year. At these revenue levels, we expect cash gross margins of approximately 76%. Q2 non-GAAP operating expenses are projected to be $261 million to $266 million. We anticipate Q2 EBITDA margins of approximately 45%. Moving now to depreciation, we expect non-GAAP depreciation expense to be between $116 million to $117 million. Factoring in this guidance, we expect non-GAAP operating margin of approximately 31% for Q2. Moving on to CapEx, we expect to spend approximately $133 million to $138 million, excluding equity compensation in the second quarter. And with the overall revenue and spend configuration I just outlined, we expect Q2 non-GAAP EPS in the range of $1.35 to $1.40. This EPS guidance assumes taxes of $37 million to $39 million based on an estimated quarterly non-GAAP tax rate of approximately 14%. It also reflects a fully diluted share count of approximately 165 million shares. Looking ahead to the full year, we are raising our guidance for both revenue and EPS. We now expect revenue of $3.4 billion to $3.435 billion, which is up 6% to 7% year-over-year as reported or up 5% to 6% in constant currency. We now expect security growth to be in the low 20s for the full year 2021. We are estimating non-GAAP operating margin of approximately 30% to 31% and non-GAAP earnings per diluted share of $5.45 and $5.52. And this non-GAAP earnings guidance is based on a non-GAAP effective tax rate of approximately 14% and a fully diluted share count of approximately 164 million shares. Moving on to CapEx, full year CapEx is expected to be approximately 16% of revenue, unchanged from our prior outlook. We are very pleased to have delivered such strong results in Q1 and to be able to increase our outlook for the full year. Thank you. Tom and I would be happy to take your questions. Operator?
Operator: [Operator Instructions] Our first question comes from Colby Synesael with Cowen. Your line is now open.
Unidentified Analyst: Hi, this is Michael on for Colby. Two questions, if I may. First, can you give us an update on your M&A pipeline for security and how the number of opportunities you're seeing compares to this time last year? And secondly one of your CDN peers flagged that they saw loss of market share due to performance. Is there anything that you can flag related to market share gains, or potentially losses during the quarter? That'd be helpful. Thank you.
Tom Leighton: Sure, I would say the M&A pipeline is comparable to last year. There's a lot of companies for sale and the pricing for typical companies in the security area remains very high. And I think in many cases unrealistic. So I think overall, the dynamics there are pretty comparable to where they were last year. As you know, Akamai is always looking for opportunities. We're also very disciplined in terms of actually what we end up buying. In terms of CDN market share the very large media companies do compare the CDN vendors in terms of their traffic share. And if a vendor is doing better than others, they tend to get more share. And that's why Akamai has such a large share when it comes to delivery of media traffic. And if a vendor has outages or is performing poorly, which we see a fair amount out there among our competition, they can lose share. And so that's a very typical dynamic, nothing new there. It's been that way for several years. And that's why Akamai such an effort to have the world's best performance hence why we have so much of the traffic.
Unidentified Analyst: Perfect. Thank you very much.
Operator: Our next question comes from James Fish with Piper Sandler.
James Fish: Hey, guys, congrats on the quarter. First, can you just give us more color behind the media CDN business in terms of especially the gaming verticals specifically? Just really trying to understand how fast either revenue or traffic from gaming itself is growing and what the exposure to gaming overall, given what we're seeing with the console cycle, as well. And then normally Ed, you don't typically raising Q - following Q1, I guess what gives you the confidence at this point of the year versus normal?
Ed McGowan: Yeah. Hey Jim, so first, I'll take the first question, which was around the media, the gaming growth in particular. So we don't break out specific growth rates. But I can say that gaming in particular was one of the stronger verticals in terms of growth, very pleased with what we saw. And the other thing is, I'd say, the names of the number of customers that we saw growing, it wasn't just your normal handful of gaming customers. So we saw some benefit from the continuation of the gaming console releases we saw in Q4, but we also saw a lot of publishers have some pretty significant releases during the quarter. So in general, it's a really good gaming quarter. We're off to a pretty good start here in Q2. And as you know, this the gaming release can be a bit seasonal, but so far, it's been a pretty good start for the year. Like I said, I'm pretty happy with the performance across many different customers. In terms of guidance, yeah, we just started off having a great year. Traffic has been very strong. You saw the security performance, it's a little bit - we get a lot of exposure on the FX side. So having one quarter down and having the first month of the quarter of the - or second quarter down, gives a little bit more confidence going into the year. So we felt that we had enough visibility at this point to raise guidance. As you know, the second half of the year is always a little bit more challenging where Q3 is embassy summer seasonality, we didn't see that last year, because of the pandemic, we'll probably see a little bit of that on the media side. And then Q4 obviously, tends to be our strongest seasonal quarter where you have strong ecommerce and strong media. So we're feeling pretty confident at this point. So we thought it was appropriate to take the guidance up a touch.
James Fish: Thanks, congrats again.
Operator: Our next question comes from Keith Weiss with Morgan Stanley.
Keith Weiss: Excellent, thank you guys for taking the question and very nice quarter. On the last question and this kind of increased confidence in the year, is it more on the like CDN side or more on the security side, because it does sound like you feel good about some of those new products ramping pretty nicely on the security portfolio, and you're talking about the low 20s growth for the year. So I was hoping you could clarify that and then have a follow up question on margins if we have time.
Tom Leighton: Yeah, we had a very strong start to the year. It's great to see the security business growing at 29%. And as we talked about, it's really across the board. It's not a single product doing well, but just strength everywhere in security. And when you see that kind of performance and we look ahead to the back part of the year, we are confident that we're going to do better than we had thought coming into the year, just great performance. There's also good performance on the CDN side, happy to see that up 2%. As I'd talked about you do worry about FX there and what can happen, but on balance business very strong and off to a great start. Ed, do you want to add any color to that?
Ed McGowan: No, I think you covered it, Tom. I think seeing the strength of security to be able to take that up a touch and last quarter we were in the 18% to 20% range. Now we're in the low 20s. And then on the CDN side, we do have some tougher compares. But we're seeing really strong traffic and not seeing any decrease from what we've seen over the last year. So we're feeling pretty good about that.
Keith Weiss: Got it, that sounds great. And then on the margin side of the equation, we're past the peak in terms of CapEx, sort of spending or CapEx intensity. But it's going to take some time for that to flow through to gross margins, so there's probably more like a calendar '22 impact. But you did come in a little bit ahead on operating margins this quarter and next quarter, we're looking for 31%. The expectation that you're going to try to sort of take that up with increased investment in the business or is there potential for kind of more flow through upside into better margins for the year.
Ed McGowan: Yeah. So Keith, two things to think about there, the first one is, we have our - biggest expense lies our payroll, and we have our annual, what we call our merit increase cycle that kicks in July 1. So you'll see a little bit of increase in our operating expenses for carrying our current employees, but we will be investing in security. So we plan - we've got some planned investments in the back half of the year. But we took the guidance range up from what we said approximately 30 last time to 31. So running a 31 here would be to touch under and in Q3 as we go through our merit cycle and then Q4 is always a little bit of a wild card in terms of how strong the revenue performance is. But we want to make sure we're investing back in the business, we see really good growth in security, but also in our edge applications business as well.
Keith Weiss: Is there a potential for gross margins to start to become a little bit of a tailwind into the back half of the year?
Ed McGowan: Yeah, I mean, you got to keep in mind, the mix there. Overtime, I think, as you get into - as we talked about, in the Investor Relations Day, where you saw our security margins, gross margins are higher, you've got your media margins are lower. So it really is a mix. And while we're exceeding our plan so far on security, it's going to take a bit for that to really manifest itself in higher gross margins. You see we get a bigger percentage of the business coming from security. And if you look at the part of the business in media that's growing primarily the high-volume video, high volume media, that tends to be where you have the most competition and pricing pressure. So you kind of balance those two out and you kind of keep the margin - gross margins, flattish here for the year and then I'd say overtime there's a chance that we could see some expansion there, but we're not going to call that out right now.
Keith Weiss: Got it. Excellent. Thank you so much for the color guys.
Operator: Our next question comes from Sterling Auty with JP Morgan.
Unidentified Analyst: Hi, this is Rajat on for Sterling Auty. Can you give colors on the organic growth in the security for the quarter?
Ed McGowan: Yeah. Sure. This is Ed. We had about $10 million of contribution from Asavie, which would be about four percentage points. I would say though, that when we acquired Asavie, our plan was to do roughly 30 million in revenue in the first year. And we're obviously exceeding that. So we've been able to take that asset and really start to scale it. So while it's technically inorganic, I'd say we deserve some credit for being able to significantly accelerate that growth rate. So you back out the 4%, you'd be - it's at 29 to be 25 and 22% on a constant currency basis.
Unidentified Analyst: Okay, and then just a follow-up on that, like the gross margins in sales and marketing are down seasonally, so can you give colors on that also?
Ed McGowan: Yeah, so on the sales and marketing, what you'll find is Q4 tends to be our highest quarter for sales and marketing expenses where you have - especially last year when we were exceeding our plan to get into accelerator, so you get a reset on the compensation and you'll see it spike up again in Q4 of this year.
Unidentified Analyst: Cool and on gross margins.
Ed McGowan: Yeah, so gross margins were flat quarter-over-quarter. That's in line with what we expected. So really, there's nothing to call out there.
Unidentified Analyst: Cool, thanks.
Operator: Our next question comes from Tim Horan with Oppenheimer.
Tim Horan: Thanks guys, great, security quarter. Was there any one-time items, any license deals or anything else that would suggest why the growth has slowed down so much after an acceleration like this? And can you comment on how enterprise security is doing? Is it meeting your expectations at this point?
Ed McGowan: Yeah. Sure. Tim, I'll take the first one and Tom if you want to talk about enterprise afterwards. So yeah, there's - there was really nothing to call out in terms of license revenue. But I'm glad you reminded me because when you guys are building your model, if you remember last year in Q2, we did have an unusually strong license quarter. So as you kind of build your models and look at your competitors, just remember last year, we had 7 million of license revenue in Q2. We don't expect that again in Q2 of this year. And in Q1, there was really nothing unusual. As Tom said, there's really strength across many different products in security. It's been easy for us to just call out one thing, but the good news for us as we've seen strength everywhere. And Tom I don't know if you want to talk a bit about the enterprise.
Tom Leighton: Yeah, the access segment performed very well. As we noted, we're now at $100 million revenue run rate. So it's great to start the year in Q1 there, very strong growth, over 170% over last year. Now of course that includes Asavie. If you take that out, organic growth still over 60% in that segment, so very pleased. And as Ed noted, we're pretty excited about the Asavie acquisition, especially as you get the emergence of 5G and you get IoT applications, but the ability to secure enterprise devices across the board, I think is very exciting for the future. And we're really in a unique position to do that. And we have great relationships with the carrier. So we think we'll really be able to scale that business to a global basis.
Tim Horan: And just following up on the M&A question, with new security products, do you think you can shift more to internal development from your own R&D as opposed to acquisitions? Or how has that been trending the last few years?
Tom Leighton: I think it's a good healthy mix. As you know, we've made several acquisitions, mostly tech tuck ins, occasionally something a little bit larger. And we do a lot of organic investment in research and development, very active, they're very innovative. Maybe a good example is Page Integrity Manager, which we launched last year, and doing really well in the marketplace. And we did - that was a blend of a tech tuck in about seven to 10 employees in the company we acquired and a lot of organic development at the same time to make a very successful product quickly bring it to market and very strong adoption in early days.
Tim Horan: Thank you.
Operator: Our next question comes from Alex Henderson with Needham.
Mike Cikos: Hey, guys. Here's Mike Cikos on the line here for Alex Henderson. Could you comment on the security growth you're experiencing? I'm just trying to, I guess, think about this demand and the increased expectations you guys have now. Is any of this at all related to, I guess budges finally coming to market following the headlines that we saw earlier in the year round SolarWinds and the Microsoft Exchange Server hack? And then there's the second comment on that would be the improved outlook that you have for security, is it also expected to be broad based on a go forward basis?
Tom Leighton: Yeah, let me take the first question there. And that's a yeah, really good question. The attack landscape is just breathtaking. You think you've seen it all and then next week, you read the next headline, the in the attackers are very powerful. You have nation states, large scale, organized crime just - and what they're doing is pretty scary. Now, the great news for Akamai and our customers is that we have solutions that can protect enterprises for a large majority of those attacks. A great example is the recent Exchange Server hack, where many 1000s of enterprises got hacked, lost their emails, which is really bad. Akamai, our IT department was running an Exchange Server, just like all those other companies. And the difference is we didn't get hacked because we use our own enterprise security solutions. And we had enterprise application access, sitting in front of our Exchange Server. And that meant that the vulnerability couldn't be exploited. Because the employee doesn't just get to go contact the Exchange Server they did, then somebody can come in and before you're authenticated by the Exchange Server, you can exploit the vulnerability. Instead, they got to get to Akamai –they come to Akamai's enterprise application access product, we authenticate them. And if it's a bad guy outside trying to do something, no way they get in and not only that, they don't get directly to the Exchange Server, because they have to pass through our security. So if they're trying to do bad things, we'll stop it. And it's all about our approach to zero trust. And yes, we can protect enterprises from these sorts of things. And even in zero-day attacks, we didn't know about the exchange hack before other enterprises or Microsoft did, and yet we were protected at zero-day because of our solutions. So I think as the attacks increase that does increase awareness and that does help drive our security business. And I see no end to the attacks coming. There's more on the way and we're in a great position to be able to help the leading enterprises stay safe against those attacks.
Mike Cikos: Great and then just following up that broad based strength that we're talking to Q1, is that expected on a go forward basis with the updated outlook we have today?
Tom Leighton: Yes, we're strong across the board and we're anticipating that through the rest of this year. And of course at our Investor Day, we talked about the three-to-five-year CAGR goals and as you go back to that material, you'll see it's pretty strong across the board there in terms of our anticipated growth over the longer term.
Mike Cikos: Great, thank you.
Operator: Our next question comes from James Breen with William Blair.
James Breen: Thanks. Thanks for taking the question. Just wondering if you can give us some color on the US versus the international mix? It seemed like US had a pretty good acceleration on a year-over-year basis this quarter. Is this pandemic driven? Or is it more around the products that's getting sold? And then just secondly, in the margin for Ed, EBITDA margins 45%, you've guided to that to the next quarter. Given the business mix now, is that sort of the starting point in terms of margin structure given CapEx coming down and investments et cetera? Thanks.
Ed McGowan: Yeah. Hey, Jim. So on the - I'll take the EBITDA margin question first. Yeah, so 45 is a good spot for this quarter. Obviously, we've got a little bit of expense coming in Q3. So 44, 45-ish, but I think you're thinking about it in the right range. On the US versus international, yeah, US was pretty strong. We've been having pretty decent US growth. If you remember, go back a year or so, a little over a year ago, we were kind of flattish and we started to turn things around there. Lot of it has to do with the strength that we're seeing in media, a lot of the companies are in the US. But in terms of international still having very strong growth internationally, we do come up against some tougher compares. There's pretty strong media business outside the US. So you'll see some tougher compares on the media delivery side, and as I called out from an international perspective, there's - we're still laughing that $15 million of lost revenue associated with the banned apps in India.
James Breen: And then, just one other question, are there any sectors that you're seeing that were particularly hit hard by the pandemics that are maybe starting to come back a little bit more as the vaccine has gotten rolled out? Thanks.
Ed McGowan: Yeah, I would - yeah, it's a good question, Jim. So I would say the hotel and travel is probably stabilizing a little bit, I wouldn't say we're in the growth phase yet. Maybe starting to see some early signs, it's probably still few quarters before we start to see that business return to a growth engine for us. On retail, it's still a mixed bag. You've got some that are doing well, some that aren't doing well. And just keep in mind that that's 20% of our total business, 40% of your old legacy web business. But it's - I'd say we're optimistic, but still ways to go before we declare a victory there.
James Breen: Great, thanks.
Operator: Our next question comes from Brandon Nispel with KeyBanc.
Brandon Nispel: Great, two questions for Ed and one for Tom. Ed, could you just outline how we should be thinking about working capital for the year? And then for the full year '21, what's embedded in your outlook for FX versus your prior expectations? And for Tom, how should we think about the growth in edge applications sequentially as we move throughout the year? I think you mentioned it was about $45 million this quarter. Thanks.
Ed McGowan: Hey, Brandon, yeah, I'll take the second one first in terms of FX. So the FX rates we do is at the beginning of the quarter, we sort of take a look at where the FX rates are assuming that's going to stay for the balance of the year. In terms of how it was relative to the beginning of the last quarter, we gave guidance, some currencies are up, some are down that's roughly somewhat in line. I talked about in the prepared remarks that FX sort of came in as expected. We get a little bit of a headwind here quarter-over-quarter, mostly with this in the yen. But I would say just keep an eye on it though. It's just - if you kind of just step back and do the math, we get a little over a $1 billion worth of non-USs denominated revenue. So to the extent that you get a 1%, swing that can swing to $10 million on an annual basis and the major currencies for us a euro, yen, pound and then it kind of drops off from there and the other currencies aren't as impactful. But those are the three to keep an eye on. And then working capital, I'd say, like any other year, you'll see nothing unusual in terms of working capital. This year in Q1, you see us, from a cash flow perspective, we pay out our bonuses early in Q1 and you see cash - working capital, pick up a touch. To call out in terms of collections, we've actually been fantastic. Nothing on the payable side, it's unusual. As we've talked about CapEx is already hit its high point, so nothing really unusual to call on working capital.
Tom Leighton: Yeah, and in terms of the edge applications question, you're right about 45 million in Q1. We don't guide separately on an annual basis for that. You just saw over 30% growth in Q1 and at IR Day we did talk about into the three-to-five-year CAGR. Goal there is over 30%. So at a high level, I'd expect to see us continue with very strong growth through the rest of the year in edge applications.
Brandon Nispel: That thanks for taking the questions.
Operator: Our next question comes from Robert Majek with Raymond James.
Robert Majek: Great, thanks. Just two questions for me, one, good to see the guide up on the security business to a low 20s rate, but you did just report security growth at 29%. So just how should we read into that? Why should we expect that growth rate to decelerate materially? And then two, just what are you seeing on CDN per unit pricing? Is the level of price decline getting more steeper than usual as larger customers renegotiate their now larger CDN contracts in a COVID boosted traffic environment?
Ed McGowan: Yeah, so I'll take both of those. So on the low 20s, the way to think about it is - I just called out when Tim asked the question about license revenue. You got a tougher compare in Q2. With 7 million of license revenue, we don't anticipate repeating in Q2. You also have the Asavie acquisition that will anniversary in Q4. So when you take those two factors into consideration, you'll see the growth rate come down a touch as those sort of work themselves out. On the CDN pricing environment, nothing really to call out there, I've been in this business for a little over 20 years and I've sort of gotten numb to pricing at this point and I don't see anything that is unusual. And also, if there was anything in our top - we in our Earnings Day - Analyst Day we called out our top eight customers, anyone who's over 1% as a metric. And if there's anything in that group of customers worth calling out, I'd certainly do that. And there's really nothing at this point to call out. And as far as renewals are going, we do a pretty good job of anticipating what to expect and it hasn't been negative surprises so far. Thanks Rob.
Operator: [Operator Instructions] Our next question comes from Jeff Van Rhee with Craig Hallum.
Unidentified Analyst: Hey, guys. This is Rudy on for Jeff. Thanks for taking my questions. I know in security you've said there's broad based strength in the quarter expect that to continue. Were there any products in there maybe one or two that were just a little bit weaker or saw some challenges or slowdowns, just anything you'd call out?
Tom Leighton: I don't think there's anything to call out there, just really was outstanding quarter across the board. We're very pleased with how the security business is doing.
Unidentified Analyst: Got it and then the sustainability goals by 2030, is there any boundary you can put around maybe how much expense for those investments there you're factoring in for 21? Or just what the expected impact of margins might be from investments there may be on the longer term.
Tom Leighton: Yeah, so, I'll tell the team went through this and there's really not any significant expenses that we anticipate for several years. And even then, the cost that the team has rolled up is not all that significant. We've actually been able to do some pretty creative deals with certain projects on renewable energy that have worked out to be - from a pricing perspective, and no overall net economics have been neutral to even favorable in some cases, so nothing really there to note. Team's doing a fabulous job on it. And if it's - if time goes on, if there's anything we need to call out, we'll certainly let you know.
Unidentified Analyst: Got it. Great. Thank you. That's it for me.
Operator: Our next question comes from Charlie Ehrlich with Baird
Charlie Ehrlich: Hey, thanks for taking the question. It's Chuck Ehrlich on for Will Power. I was hoping to dig in a little bit more into the legacy web division. Can you maybe talk a little bit more about maybe the puts and takes in that segment and the declines we're seeing there? And then what it might take to stabilize that segment?
Tom Leighton: Yeah, so I would say similar to what we've talked about in the past, right. You've got, obviously strong security growth, you've got from a verticals perspective, you have two verticals, retail and travel, which make up 40% of the legacy web division, vertical division, excuse me. And we're still, like I said, a few questions ago, we're not quite out of the woods there yet. And we're starting to see some stability, but we're not seeing that type of growth yet there. So it's going to take a bit for that to recover. We're doing a nice job of dealing with certain pricing pressure in those verticals with opening up other shares of the wallet, whether it's additional security products or really starting to see a lot of interest in our edge computing and edge applications business as well. So we'll see dollars potentially ship delivery into that category as we go through pricing negotiations, but that's pretty normal. And once we start to see probably in a couple of quarters, hopefully the travel and retail business get back to normal if these vaccines hold and life returns to normal, hopefully start to see that segment of the business growing again.
Charlie Ehrlich: Okay. And then on the internet platform customers, we're continuing to see some growth there, which is great. Is there anything specific where that's driving that growth and what we expect for the rest of the year from that cohort?
Tom Leighton: Yeah, so it's becoming less impactful. So that's why we're kind of going away from that metric. You didn't hear me talk about in our prepared remarks. I think years ago, people were concerned that that may go to zero. And we talked a couple of years ago about stabilizing that and getting it back to growth. And the team has just done a phenomenal job. So I first tip my hat to the team that's managing those accounts. They've done a nice job of finding areas for us to add value to incredibly innovative technology companies that have their own CDN. And we found a nice spot to pick up this, whether it's adding security or delivering traffic for video and gaming for big scale events, or for live video or even on demand video, we're just finding a nice niche there and that continues to grow. It's up about a $1 million quarter over quarter, very impressive growth rate. I'd say stability is probably a good way to think about that going through the year. There's always upside with these accounts and team's identifying new areas of opportunity all the time. So very pleased with where we are with those customers and expect to see probably similar numbers, what you're seeing now down a little bit, quarter to quarter, depending on certain things that are going on in those accounts.
Charlie Ehrlich: Got it. Thank you.
Operator: Our next question comes from Alex Henderson with Needham.
Mike Cikos: Hey, guys, Mike Chico's here again and thanks for getting me on the line. I did just want to follow up. Just looking at my model versus where you guys came in the sales and marketing expense. This quarter was much slower than what we had anticipated, even if I'm removing the accelerators from 4Q and even just looking at Q1 '21 versus Q1 '20, the amount of leverage in the model. Can you talk to how we should expect the sales and marketing to play out over the course of the years? Are there savings being realized from the realigned division? Or the reorganizations you guys had talked to earlier this year?
Tom Leighton: Yeah, that's a good point, Mike. So as part of the reorganization, right, some shift between sales and marketing, research and development, a few million bucks, if I remember correctly. And then there was some savings as we moved from the divisional model to one as there was some synergy mostly at the management level. So you'll see some of those costs go away as well.
Mike Cikos: Great, thank you for clarifying that.
Tom Barth: Okay, well, thank you everyone. In closing, we will be presenting at several investor conferences and roadshows throughout the rest of the second quarter. Details of these can be found in the investor relations section at akamai.com. Thank you for joining us. And all of us here at Akamai wish you continued good health to yourself as well as to your families. Have a nice evening.
Tom Leighton: Thank you.
Operator: This concludes today's conference call. Thank you for participating. You may now disconnect. | [
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{
"speaker": "Tom Barth",
"text": "Thank you, operator. Good afternoon everyone and thank you for joining Akamai's first quarter 2021 earnings conference call. Speaking today will be Tom Leighton, Akamai's Chief Executive Officer; and Ed McGowan, Akamai's Chief Financial Officer. Before we get started, please note that today's comments include forward-looking statements including statements regarding revenue and earnings guidance. These forward-looking statements are subject to risks and uncertainties and involve a number of factors that could cause actual results to differ materially from those expressed or implied in such statements. The factors include uncertainty stemming from COVID-19 pandemic and any impact from unexpected geopolitical developments. Additional information concerning these factors is contained in Akamai's filings with the SEC, including our annual report on Form 10-K and quarterly reports on Form 10-Q. The forward-looking statements included in this call represent the company's view on May 4, 2021. Akamai disclaims any obligation to update these statements to reflect future events or circumstances. As a reminder, we will be referring to some non-GAAP financial metrics during today's call. A detailed reconciliation of GAAP and non-GAAP metrics can be found under the financial portion of the Investor Relations section of akamai.com. And with that, let me turn the call over to Tom."
},
{
"speaker": "Tom Leighton",
"text": "Thanks Tom. And thank you all for joining us today. I'm pleased to report that Akamai delivered excellent results in the first quarter. Q1 revenue was $843 million, up 10% year-over-year and up 8% in constant currency. This strong result was driven by the continued rapid growth of our security business, accelerated growth in our edge applications business and continued high traffic levels on our intelligent edge platform. Non-GAAP operating margin in Q1 was 31% and Q1 non-GAAP EPS was $1.38 per diluted share, up 15% year-over-year and up 11% in constant currency. With a strong start to 2021, we're proud that Akamai has continued to enable and to protect, remote work, homeschooling, ecommerce and online entertainment for billions of people around the world amidst very challenging circumstances. Our security solutions portfolio performed especially well in Q1 generating revenue of $310 million, up 29% year-over-year and up 27% in constant currency. A very strong growth was experienced across most of our security products, including our new Page Integrity Manager solution. Page Integrity Manager helps enterprises defend against malware and third-party software and applications. Customers that adopted Page Integrity Manager in Q1 included Maersk, the world's largest container shipping operator, and Groupon, the global e commerce marketplace. Maersk uses more than 4000 scripts, half of which are third party scripts to drive millions of dollars of online business every hour. Managing this complex and dynamic environment had become an increasingly difficult security challenge for Maersk and so they now use Page Integrity Manager to improve visibility into security threats and to prevent the loss of critical data. Our Bot Manager solution also continued to perform very well in Q1. Bot Manager is designed to mitigate a wide variety of automated attacks, including account stuffing attacks where credentials stolen from one website are checked for validity at 1000s of other websites. When valid credentials are found a manual attack is then often used to extract value from the compromised accounts. Losses from account takeovers and new account fraud are estimated at over $10 billion annually in the US. In order to afford such manual attacks. We launched the beta for our new account protector solution in Q1. Account protector shields organizations from account takeover and other kinds of fraudulent human activity without increasing friction for legitimate customers. Account protector works by detecting in real time whether a user logging into an application is the legitimate account owner or an imposter in possession of stolen credentials. One of our beta customers for this new solution is a well-known restaurant franchise that was under attack by cyber criminals who were compromising the loyalty accounts of their diners. The criminals were stealing loyalty reward points and then reselling them on the dark web. The digital theft outraged the diners whose points were stolen and angered restaurant owners who unknowingly provided meals to fraudsters. With help from Akamai, the franchise can now identify the situations where humans are impersonating valid diners, and take action to stop the illicit transfer of loyalty points, thereby stopping the fraud and enabling the franchise to focus on accelerating sales. We're also excited about the success of Akamai's fastest growing security segment Access Control, which reached an annualized revenue run rate of $100 million in Q1, up more than 170% over Q1 of 2020 and up over 60% organically. Our Access Control segment provides secure connectivity for users, applications, workloads and IoT systems, regardless of their location. Products in this area include enterprise application access, enterprise threat protector, and our new secure mobile and secure IoT solutions that we acquired from Asavie in October. Our secure mobile and secure IoT products provide security, visibility and control for mobile devices at the edge. These services determine malicious activity and support acceptable use policies without needing to install a client on the device. The solutions are sold to our carrier partners such as AT&T, where it forms the basis for their AccessMyLAN solution. These capabilities have been especially important in helping school districts secure student devices during the pandemic so that students can learn from home safely. Our security solutions also continued to gain recognition from the leading analyst firms in Q1. Our market leading web application firewall capabilities, earned Gartner peer insights customers choice distinction, and Forrester named Akamai as a leader in DDoS protection for the third time, saying large enterprise clients that want an experienced trusted vendor to make their DDoS problem go away should look to Akamai. Turning to our CDN portfolio, Q1 marked another quarter of very strong traffic growth for Akamai, led by OTT video services and downloads of e-gaming software. On March 16, traffic on the Akamai platform reached an all-time high of 200 terabits per second. This is 19% higher than the peak and Q1 of last year, and two and a half times the traffic peak in Q1 of 2019. Daily peaks were also high in Q1, averaging 143 terabits per second. In fact, traffic on our platform exceeded 110 terabits per second, pretty much around the clock in Q1. Overall, our CDN products and services generated revenue of $532 million in Q1 of 2% year-over-year and flat in constant currency. The Edge application segment generated 45 million in revenue last quarter, up more than 30% over Q1 of 2020. As you may recall from the discussion at our Investor Summit in February, this revenue amount includes edge computing solutions, such as EdgeWorkers that we build discreetly, but does not include the wide array of services that use our computing capabilities at the edge. As we discussed during our recent Investor Summit, we believe that there's the potential for substantial future growth in the area of edge computing, as we anticipate more enterprises moving their compute workloads to our edge platform for offload, improved performance, security and global scale. A timely example of such a shift is manifested in our new Vaccine Edge solution, which is enabling over two dozen public health agencies and pharmacy chains around the world to deliver and secure COVID vaccine registration sites in the face of extraordinary flash crowds. In multiple instances, Akamai was called in to rescue government agencies whose websites had crashed under load, resulting in frustrated citizens who waited for long times before getting kicked out without a reservation. In some cases, these websites have been using solutions provided by competitors that were not able to handle the load. We're pleased to partner on Vaccine Edge with salesforce.com. And we're proud that our EdgeWorkers solution has made a real difference to the many millions of citizens trying to get the vaccine as quickly as possible. Our customers are now using EdgeWorkers for a wide range of applications. For example, a leading theme park operator is using EdgeWorkers to help manage demand as they plan to reopen parks. A publicly traded sports and entertainment company has implemented GEO fencing, using our EdgeKV data store together with EdgeWorkers to ensure that users access only relevant broadcast content for their location. A nationwide home improvement retailer and a global credit card company are using AB Testing logic at the edge to deliver fast and personalized user experiences. We're enabling DevOps workflows for a global sportswear brand by managing canary releases, where only a targeted group of users can see a new experience. And we're enabling a leading global manufacturer of devices to authenticate their users at the edge, which improves performance and reduces their cloud costs. We're also proud of the progress that we're making with our sustainability efforts. In the past year, we doubled our platform capacity, with no increase at all in our platform's carbon footprint. And just two weeks ago on Earth Day, we announced that by 2030, Akamai intends to power 100% of our global operations with renewable energy, improve the energy efficiency of our platform by an additional 50%, mitigate 100% of our platform emissions and continue to recycle 100% of our electronic waste. These goals reflect optimized commitment to be a responsible, efficient and forward-looking company. In summary, we're very excited about the innovative technology that we're developing, the strong demand from customers for our security and edge computing solutions and our Q1 financial performance on both the top and bottom lines. The growth strategy and goals that we outlined to you in our Investor Summit on February 25 set our direction for the future. And we believe that our strong Q1 results show that we've been executing according to plan. Now I'll turn the call over to Ed to provide further details on our Q1 results, and the outlook for next quarter and 2021. Ed?"
},
{
"speaker": "Ed McGowan",
"text": "Thank you, Tom. Before I provide additional details on our Q1 performance, I'd like to remind everyone that as a result of the reorganization we announced last quarter, we've refocused the company from a vertical aligned divisional structure to a product-oriented lens. I will therefore be focusing my discussion today on our security technology group and our edge technology group. The security group, as you might imagine, encompasses all of our security solution. The edge group includes our media delivery, and web performance CDN business, along with our edge compute solutions. We plan to provide additional revenue detail for the different product lines within our security technology group and edge technology group on an annual basis. However, we might highlight specific subgroup details from time to time on our quarterly earnings calls if we feel it will help provide greater context on our results. Finally, as I mentioned on our last call, we will continue to report both web division and media and carrier division results along with our internet platform customer results on our website for the balance of 2021 to assist with this reporting transition. So with all that said, as Tom outlined, Akamai delivered another excellent quarter in Q1. We were very pleased to exceed the high end of our guidance range on both revenue and earnings. Q1 revenue was $843 million, up 10% year-over-year, or 8% in constant currency, driven by continued strength across most major product areas in our security business, better than expected traffic from OTT video and gaming customers and very strong performance in our edge applications business. Revenue from our security technology group was $310 million, up 29% year-over-year, or 27% in constant currency, driven by broad based strength across most of our security products. Revenue from our edge technology group was $532 million, up 2% year-over-year, or flat and constant currency. We benefited from strong traffic growth driven by OTT video and gaming, as well as strong growth in our edge applications business as Tom mentioned earlier. As expected, foreign exchange fluctuations had a positive impact on revenue of $3 million on a sequential basis, and positive $16 million on a year-over-year basis. International revenue was $380 million, up 13% year-over-year, or 8% in constant currency. Sales in our international markets represented 45% of total revenue in Q1 up one point from Q1 2020 and consistent with Q4 levels. Finally, revenue from our US market was $463 million, up 8% year-over-year. Moving now to costs, cash gross margin was 76%, in line with our expectations. GAAP gross margin, which includes both depreciation and stock-based compensation, was 64%. Non-GAAP cash operating expenses were $267 million in line with our expectations. Now moving on to profitability, adjusted EBITDA was $375 million, up $49 million, or 15% from the same period in 2020. Our adjusted EBITDA margin was 45%, up two points from Q1 2020. Non-GAAP operating income was $264 million, up $34 million, or 15% from the same period last year. Non-GAAP operating margin came in at 31%, up one point from Q1 last year and above our guidance range due to leverage from our revenue out performance. Capital expenditures in Q1 excluding equity compensation and capitalized interest expense were $150 million, consistent with our guidance range. We continue to expect Q1 CapEx to represent the high watermark for quarterly CapEx spending in 2021. GAAP net income for the first quarter was $156 million or $0.94 of earnings per diluted share. Our Q1 GAAP results include a $7 million restructuring charge related to the company realignment we announced last quarter, which was in line with our expectations. Non-GAAP net income was $228 million, or $1.38 of earnings per diluted share, up 15% year-over-year, up 11% in constant currency and $0.07 above the high end of our guidance range due to our revenue outperformance. Taxes included in our non-GAAP earnings were $38 million based on a Q1 effective tax rate of approximately 14%. Now, I will discuss some balance sheet items. As of March 31, our cash, cash equivalents and marketable securities totaled approximately $2.5 billion. After accounting for the $2.3 billion of combined principal amounts of our two convertible notes, net cash was approximately $154 million as of March 31. Now I will review our use of capital. During the first quarter we spent $58 million to repurchase shares, buying back approximately 600,000 shares. We ended Q1 with approximately $514 million remaining on our previously announced share repurchase authorization. Our plan remains to leverage our share buyback program to offset dilution resulting from equity compensation over time. As a result based on current market conditions, we expect to spend at least $350 million for the full year 2021. Moving on to Q2 guidance, we are projecting Q2 revenue in the range of $839 million to $853 million, or up 6% to 7% as reported or 3% to 5% in constant currency over Q2 2020. There are two factors to consider, as you think about year-over-year comparisons for Q2. First, in 2020, we saw a significant uptick in traffic on our network starting at the end of March and continuing through the remainder of the year as a result of global lock downs. As our excellent Q1 results demonstrate traffic has continued to grow on our network this year. But we don't expect to see the same traffic growth rates from a year ago going forward. This creates more challenging year-over-year comparisons for our edge delivery business starting in Q2 and continuing for the remainder of 2021. Second, the Q2 year-over-year growth comparison also reflects the continuing ban of some Chinese based apps in India. As a reminder, these apps which were banned in Q3 of last year contributed revenue of approximately $15 million in Q2 2020. Foreign exchange fluctuations are expected to have a negative $3 million impact on Q2 revenue compared to Q1 levels and a positive $18 million impact year-over-year. At these revenue levels, we expect cash gross margins of approximately 76%. Q2 non-GAAP operating expenses are projected to be $261 million to $266 million. We anticipate Q2 EBITDA margins of approximately 45%. Moving now to depreciation, we expect non-GAAP depreciation expense to be between $116 million to $117 million. Factoring in this guidance, we expect non-GAAP operating margin of approximately 31% for Q2. Moving on to CapEx, we expect to spend approximately $133 million to $138 million, excluding equity compensation in the second quarter. And with the overall revenue and spend configuration I just outlined, we expect Q2 non-GAAP EPS in the range of $1.35 to $1.40. This EPS guidance assumes taxes of $37 million to $39 million based on an estimated quarterly non-GAAP tax rate of approximately 14%. It also reflects a fully diluted share count of approximately 165 million shares. Looking ahead to the full year, we are raising our guidance for both revenue and EPS. We now expect revenue of $3.4 billion to $3.435 billion, which is up 6% to 7% year-over-year as reported or up 5% to 6% in constant currency. We now expect security growth to be in the low 20s for the full year 2021. We are estimating non-GAAP operating margin of approximately 30% to 31% and non-GAAP earnings per diluted share of $5.45 and $5.52. And this non-GAAP earnings guidance is based on a non-GAAP effective tax rate of approximately 14% and a fully diluted share count of approximately 164 million shares. Moving on to CapEx, full year CapEx is expected to be approximately 16% of revenue, unchanged from our prior outlook. We are very pleased to have delivered such strong results in Q1 and to be able to increase our outlook for the full year. Thank you. Tom and I would be happy to take your questions. Operator?"
},
{
"speaker": "Operator",
"text": "[Operator Instructions] Our first question comes from Colby Synesael with Cowen. Your line is now open."
},
{
"speaker": "Unidentified Analyst",
"text": "Hi, this is Michael on for Colby. Two questions, if I may. First, can you give us an update on your M&A pipeline for security and how the number of opportunities you're seeing compares to this time last year? And secondly one of your CDN peers flagged that they saw loss of market share due to performance. Is there anything that you can flag related to market share gains, or potentially losses during the quarter? That'd be helpful. Thank you."
},
{
"speaker": "Tom Leighton",
"text": "Sure, I would say the M&A pipeline is comparable to last year. There's a lot of companies for sale and the pricing for typical companies in the security area remains very high. And I think in many cases unrealistic. So I think overall, the dynamics there are pretty comparable to where they were last year. As you know, Akamai is always looking for opportunities. We're also very disciplined in terms of actually what we end up buying. In terms of CDN market share the very large media companies do compare the CDN vendors in terms of their traffic share. And if a vendor is doing better than others, they tend to get more share. And that's why Akamai has such a large share when it comes to delivery of media traffic. And if a vendor has outages or is performing poorly, which we see a fair amount out there among our competition, they can lose share. And so that's a very typical dynamic, nothing new there. It's been that way for several years. And that's why Akamai such an effort to have the world's best performance hence why we have so much of the traffic."
},
{
"speaker": "Unidentified Analyst",
"text": "Perfect. Thank you very much."
},
{
"speaker": "Operator",
"text": "Our next question comes from James Fish with Piper Sandler."
},
{
"speaker": "James Fish",
"text": "Hey, guys, congrats on the quarter. First, can you just give us more color behind the media CDN business in terms of especially the gaming verticals specifically? Just really trying to understand how fast either revenue or traffic from gaming itself is growing and what the exposure to gaming overall, given what we're seeing with the console cycle, as well. And then normally Ed, you don't typically raising Q - following Q1, I guess what gives you the confidence at this point of the year versus normal?"
},
{
"speaker": "Ed McGowan",
"text": "Yeah. Hey Jim, so first, I'll take the first question, which was around the media, the gaming growth in particular. So we don't break out specific growth rates. But I can say that gaming in particular was one of the stronger verticals in terms of growth, very pleased with what we saw. And the other thing is, I'd say, the names of the number of customers that we saw growing, it wasn't just your normal handful of gaming customers. So we saw some benefit from the continuation of the gaming console releases we saw in Q4, but we also saw a lot of publishers have some pretty significant releases during the quarter. So in general, it's a really good gaming quarter. We're off to a pretty good start here in Q2. And as you know, this the gaming release can be a bit seasonal, but so far, it's been a pretty good start for the year. Like I said, I'm pretty happy with the performance across many different customers. In terms of guidance, yeah, we just started off having a great year. Traffic has been very strong. You saw the security performance, it's a little bit - we get a lot of exposure on the FX side. So having one quarter down and having the first month of the quarter of the - or second quarter down, gives a little bit more confidence going into the year. So we felt that we had enough visibility at this point to raise guidance. As you know, the second half of the year is always a little bit more challenging where Q3 is embassy summer seasonality, we didn't see that last year, because of the pandemic, we'll probably see a little bit of that on the media side. And then Q4 obviously, tends to be our strongest seasonal quarter where you have strong ecommerce and strong media. So we're feeling pretty confident at this point. So we thought it was appropriate to take the guidance up a touch."
},
{
"speaker": "James Fish",
"text": "Thanks, congrats again."
},
{
"speaker": "Operator",
"text": "Our next question comes from Keith Weiss with Morgan Stanley."
},
{
"speaker": "Keith Weiss",
"text": "Excellent, thank you guys for taking the question and very nice quarter. On the last question and this kind of increased confidence in the year, is it more on the like CDN side or more on the security side, because it does sound like you feel good about some of those new products ramping pretty nicely on the security portfolio, and you're talking about the low 20s growth for the year. So I was hoping you could clarify that and then have a follow up question on margins if we have time."
},
{
"speaker": "Tom Leighton",
"text": "Yeah, we had a very strong start to the year. It's great to see the security business growing at 29%. And as we talked about, it's really across the board. It's not a single product doing well, but just strength everywhere in security. And when you see that kind of performance and we look ahead to the back part of the year, we are confident that we're going to do better than we had thought coming into the year, just great performance. There's also good performance on the CDN side, happy to see that up 2%. As I'd talked about you do worry about FX there and what can happen, but on balance business very strong and off to a great start. Ed, do you want to add any color to that?"
},
{
"speaker": "Ed McGowan",
"text": "No, I think you covered it, Tom. I think seeing the strength of security to be able to take that up a touch and last quarter we were in the 18% to 20% range. Now we're in the low 20s. And then on the CDN side, we do have some tougher compares. But we're seeing really strong traffic and not seeing any decrease from what we've seen over the last year. So we're feeling pretty good about that."
},
{
"speaker": "Keith Weiss",
"text": "Got it, that sounds great. And then on the margin side of the equation, we're past the peak in terms of CapEx, sort of spending or CapEx intensity. But it's going to take some time for that to flow through to gross margins, so there's probably more like a calendar '22 impact. But you did come in a little bit ahead on operating margins this quarter and next quarter, we're looking for 31%. The expectation that you're going to try to sort of take that up with increased investment in the business or is there potential for kind of more flow through upside into better margins for the year."
},
{
"speaker": "Ed McGowan",
"text": "Yeah. So Keith, two things to think about there, the first one is, we have our - biggest expense lies our payroll, and we have our annual, what we call our merit increase cycle that kicks in July 1. So you'll see a little bit of increase in our operating expenses for carrying our current employees, but we will be investing in security. So we plan - we've got some planned investments in the back half of the year. But we took the guidance range up from what we said approximately 30 last time to 31. So running a 31 here would be to touch under and in Q3 as we go through our merit cycle and then Q4 is always a little bit of a wild card in terms of how strong the revenue performance is. But we want to make sure we're investing back in the business, we see really good growth in security, but also in our edge applications business as well."
},
{
"speaker": "Keith Weiss",
"text": "Is there a potential for gross margins to start to become a little bit of a tailwind into the back half of the year?"
},
{
"speaker": "Ed McGowan",
"text": "Yeah, I mean, you got to keep in mind, the mix there. Overtime, I think, as you get into - as we talked about, in the Investor Relations Day, where you saw our security margins, gross margins are higher, you've got your media margins are lower. So it really is a mix. And while we're exceeding our plan so far on security, it's going to take a bit for that to really manifest itself in higher gross margins. You see we get a bigger percentage of the business coming from security. And if you look at the part of the business in media that's growing primarily the high-volume video, high volume media, that tends to be where you have the most competition and pricing pressure. So you kind of balance those two out and you kind of keep the margin - gross margins, flattish here for the year and then I'd say overtime there's a chance that we could see some expansion there, but we're not going to call that out right now."
},
{
"speaker": "Keith Weiss",
"text": "Got it. Excellent. Thank you so much for the color guys."
},
{
"speaker": "Operator",
"text": "Our next question comes from Sterling Auty with JP Morgan."
},
{
"speaker": "Unidentified Analyst",
"text": "Hi, this is Rajat on for Sterling Auty. Can you give colors on the organic growth in the security for the quarter?"
},
{
"speaker": "Ed McGowan",
"text": "Yeah. Sure. This is Ed. We had about $10 million of contribution from Asavie, which would be about four percentage points. I would say though, that when we acquired Asavie, our plan was to do roughly 30 million in revenue in the first year. And we're obviously exceeding that. So we've been able to take that asset and really start to scale it. So while it's technically inorganic, I'd say we deserve some credit for being able to significantly accelerate that growth rate. So you back out the 4%, you'd be - it's at 29 to be 25 and 22% on a constant currency basis."
},
{
"speaker": "Unidentified Analyst",
"text": "Okay, and then just a follow-up on that, like the gross margins in sales and marketing are down seasonally, so can you give colors on that also?"
},
{
"speaker": "Ed McGowan",
"text": "Yeah, so on the sales and marketing, what you'll find is Q4 tends to be our highest quarter for sales and marketing expenses where you have - especially last year when we were exceeding our plan to get into accelerator, so you get a reset on the compensation and you'll see it spike up again in Q4 of this year."
},
{
"speaker": "Unidentified Analyst",
"text": "Cool and on gross margins."
},
{
"speaker": "Ed McGowan",
"text": "Yeah, so gross margins were flat quarter-over-quarter. That's in line with what we expected. So really, there's nothing to call out there."
},
{
"speaker": "Unidentified Analyst",
"text": "Cool, thanks."
},
{
"speaker": "Operator",
"text": "Our next question comes from Tim Horan with Oppenheimer."
},
{
"speaker": "Tim Horan",
"text": "Thanks guys, great, security quarter. Was there any one-time items, any license deals or anything else that would suggest why the growth has slowed down so much after an acceleration like this? And can you comment on how enterprise security is doing? Is it meeting your expectations at this point?"
},
{
"speaker": "Ed McGowan",
"text": "Yeah. Sure. Tim, I'll take the first one and Tom if you want to talk about enterprise afterwards. So yeah, there's - there was really nothing to call out in terms of license revenue. But I'm glad you reminded me because when you guys are building your model, if you remember last year in Q2, we did have an unusually strong license quarter. So as you kind of build your models and look at your competitors, just remember last year, we had 7 million of license revenue in Q2. We don't expect that again in Q2 of this year. And in Q1, there was really nothing unusual. As Tom said, there's really strength across many different products in security. It's been easy for us to just call out one thing, but the good news for us as we've seen strength everywhere. And Tom I don't know if you want to talk a bit about the enterprise."
},
{
"speaker": "Tom Leighton",
"text": "Yeah, the access segment performed very well. As we noted, we're now at $100 million revenue run rate. So it's great to start the year in Q1 there, very strong growth, over 170% over last year. Now of course that includes Asavie. If you take that out, organic growth still over 60% in that segment, so very pleased. And as Ed noted, we're pretty excited about the Asavie acquisition, especially as you get the emergence of 5G and you get IoT applications, but the ability to secure enterprise devices across the board, I think is very exciting for the future. And we're really in a unique position to do that. And we have great relationships with the carrier. So we think we'll really be able to scale that business to a global basis."
},
{
"speaker": "Tim Horan",
"text": "And just following up on the M&A question, with new security products, do you think you can shift more to internal development from your own R&D as opposed to acquisitions? Or how has that been trending the last few years?"
},
{
"speaker": "Tom Leighton",
"text": "I think it's a good healthy mix. As you know, we've made several acquisitions, mostly tech tuck ins, occasionally something a little bit larger. And we do a lot of organic investment in research and development, very active, they're very innovative. Maybe a good example is Page Integrity Manager, which we launched last year, and doing really well in the marketplace. And we did - that was a blend of a tech tuck in about seven to 10 employees in the company we acquired and a lot of organic development at the same time to make a very successful product quickly bring it to market and very strong adoption in early days."
},
{
"speaker": "Tim Horan",
"text": "Thank you."
},
{
"speaker": "Operator",
"text": "Our next question comes from Alex Henderson with Needham."
},
{
"speaker": "Mike Cikos",
"text": "Hey, guys. Here's Mike Cikos on the line here for Alex Henderson. Could you comment on the security growth you're experiencing? I'm just trying to, I guess, think about this demand and the increased expectations you guys have now. Is any of this at all related to, I guess budges finally coming to market following the headlines that we saw earlier in the year round SolarWinds and the Microsoft Exchange Server hack? And then there's the second comment on that would be the improved outlook that you have for security, is it also expected to be broad based on a go forward basis?"
},
{
"speaker": "Tom Leighton",
"text": "Yeah, let me take the first question there. And that's a yeah, really good question. The attack landscape is just breathtaking. You think you've seen it all and then next week, you read the next headline, the in the attackers are very powerful. You have nation states, large scale, organized crime just - and what they're doing is pretty scary. Now, the great news for Akamai and our customers is that we have solutions that can protect enterprises for a large majority of those attacks. A great example is the recent Exchange Server hack, where many 1000s of enterprises got hacked, lost their emails, which is really bad. Akamai, our IT department was running an Exchange Server, just like all those other companies. And the difference is we didn't get hacked because we use our own enterprise security solutions. And we had enterprise application access, sitting in front of our Exchange Server. And that meant that the vulnerability couldn't be exploited. Because the employee doesn't just get to go contact the Exchange Server they did, then somebody can come in and before you're authenticated by the Exchange Server, you can exploit the vulnerability. Instead, they got to get to Akamai –they come to Akamai's enterprise application access product, we authenticate them. And if it's a bad guy outside trying to do something, no way they get in and not only that, they don't get directly to the Exchange Server, because they have to pass through our security. So if they're trying to do bad things, we'll stop it. And it's all about our approach to zero trust. And yes, we can protect enterprises from these sorts of things. And even in zero-day attacks, we didn't know about the exchange hack before other enterprises or Microsoft did, and yet we were protected at zero-day because of our solutions. So I think as the attacks increase that does increase awareness and that does help drive our security business. And I see no end to the attacks coming. There's more on the way and we're in a great position to be able to help the leading enterprises stay safe against those attacks."
},
{
"speaker": "Mike Cikos",
"text": "Great and then just following up that broad based strength that we're talking to Q1, is that expected on a go forward basis with the updated outlook we have today?"
},
{
"speaker": "Tom Leighton",
"text": "Yes, we're strong across the board and we're anticipating that through the rest of this year. And of course at our Investor Day, we talked about the three-to-five-year CAGR goals and as you go back to that material, you'll see it's pretty strong across the board there in terms of our anticipated growth over the longer term."
},
{
"speaker": "Mike Cikos",
"text": "Great, thank you."
},
{
"speaker": "Operator",
"text": "Our next question comes from James Breen with William Blair."
},
{
"speaker": "James Breen",
"text": "Thanks. Thanks for taking the question. Just wondering if you can give us some color on the US versus the international mix? It seemed like US had a pretty good acceleration on a year-over-year basis this quarter. Is this pandemic driven? Or is it more around the products that's getting sold? And then just secondly, in the margin for Ed, EBITDA margins 45%, you've guided to that to the next quarter. Given the business mix now, is that sort of the starting point in terms of margin structure given CapEx coming down and investments et cetera? Thanks."
},
{
"speaker": "Ed McGowan",
"text": "Yeah. Hey, Jim. So on the - I'll take the EBITDA margin question first. Yeah, so 45 is a good spot for this quarter. Obviously, we've got a little bit of expense coming in Q3. So 44, 45-ish, but I think you're thinking about it in the right range. On the US versus international, yeah, US was pretty strong. We've been having pretty decent US growth. If you remember, go back a year or so, a little over a year ago, we were kind of flattish and we started to turn things around there. Lot of it has to do with the strength that we're seeing in media, a lot of the companies are in the US. But in terms of international still having very strong growth internationally, we do come up against some tougher compares. There's pretty strong media business outside the US. So you'll see some tougher compares on the media delivery side, and as I called out from an international perspective, there's - we're still laughing that $15 million of lost revenue associated with the banned apps in India."
},
{
"speaker": "James Breen",
"text": "And then, just one other question, are there any sectors that you're seeing that were particularly hit hard by the pandemics that are maybe starting to come back a little bit more as the vaccine has gotten rolled out? Thanks."
},
{
"speaker": "Ed McGowan",
"text": "Yeah, I would - yeah, it's a good question, Jim. So I would say the hotel and travel is probably stabilizing a little bit, I wouldn't say we're in the growth phase yet. Maybe starting to see some early signs, it's probably still few quarters before we start to see that business return to a growth engine for us. On retail, it's still a mixed bag. You've got some that are doing well, some that aren't doing well. And just keep in mind that that's 20% of our total business, 40% of your old legacy web business. But it's - I'd say we're optimistic, but still ways to go before we declare a victory there."
},
{
"speaker": "James Breen",
"text": "Great, thanks."
},
{
"speaker": "Operator",
"text": "Our next question comes from Brandon Nispel with KeyBanc."
},
{
"speaker": "Brandon Nispel",
"text": "Great, two questions for Ed and one for Tom. Ed, could you just outline how we should be thinking about working capital for the year? And then for the full year '21, what's embedded in your outlook for FX versus your prior expectations? And for Tom, how should we think about the growth in edge applications sequentially as we move throughout the year? I think you mentioned it was about $45 million this quarter. Thanks."
},
{
"speaker": "Ed McGowan",
"text": "Hey, Brandon, yeah, I'll take the second one first in terms of FX. So the FX rates we do is at the beginning of the quarter, we sort of take a look at where the FX rates are assuming that's going to stay for the balance of the year. In terms of how it was relative to the beginning of the last quarter, we gave guidance, some currencies are up, some are down that's roughly somewhat in line. I talked about in the prepared remarks that FX sort of came in as expected. We get a little bit of a headwind here quarter-over-quarter, mostly with this in the yen. But I would say just keep an eye on it though. It's just - if you kind of just step back and do the math, we get a little over a $1 billion worth of non-USs denominated revenue. So to the extent that you get a 1%, swing that can swing to $10 million on an annual basis and the major currencies for us a euro, yen, pound and then it kind of drops off from there and the other currencies aren't as impactful. But those are the three to keep an eye on. And then working capital, I'd say, like any other year, you'll see nothing unusual in terms of working capital. This year in Q1, you see us, from a cash flow perspective, we pay out our bonuses early in Q1 and you see cash - working capital, pick up a touch. To call out in terms of collections, we've actually been fantastic. Nothing on the payable side, it's unusual. As we've talked about CapEx is already hit its high point, so nothing really unusual to call on working capital."
},
{
"speaker": "Tom Leighton",
"text": "Yeah, and in terms of the edge applications question, you're right about 45 million in Q1. We don't guide separately on an annual basis for that. You just saw over 30% growth in Q1 and at IR Day we did talk about into the three-to-five-year CAGR. Goal there is over 30%. So at a high level, I'd expect to see us continue with very strong growth through the rest of the year in edge applications."
},
{
"speaker": "Brandon Nispel",
"text": "That thanks for taking the questions."
},
{
"speaker": "Operator",
"text": "Our next question comes from Robert Majek with Raymond James."
},
{
"speaker": "Robert Majek",
"text": "Great, thanks. Just two questions for me, one, good to see the guide up on the security business to a low 20s rate, but you did just report security growth at 29%. So just how should we read into that? Why should we expect that growth rate to decelerate materially? And then two, just what are you seeing on CDN per unit pricing? Is the level of price decline getting more steeper than usual as larger customers renegotiate their now larger CDN contracts in a COVID boosted traffic environment?"
},
{
"speaker": "Ed McGowan",
"text": "Yeah, so I'll take both of those. So on the low 20s, the way to think about it is - I just called out when Tim asked the question about license revenue. You got a tougher compare in Q2. With 7 million of license revenue, we don't anticipate repeating in Q2. You also have the Asavie acquisition that will anniversary in Q4. So when you take those two factors into consideration, you'll see the growth rate come down a touch as those sort of work themselves out. On the CDN pricing environment, nothing really to call out there, I've been in this business for a little over 20 years and I've sort of gotten numb to pricing at this point and I don't see anything that is unusual. And also, if there was anything in our top - we in our Earnings Day - Analyst Day we called out our top eight customers, anyone who's over 1% as a metric. And if there's anything in that group of customers worth calling out, I'd certainly do that. And there's really nothing at this point to call out. And as far as renewals are going, we do a pretty good job of anticipating what to expect and it hasn't been negative surprises so far. Thanks Rob."
},
{
"speaker": "Operator",
"text": "[Operator Instructions] Our next question comes from Jeff Van Rhee with Craig Hallum."
},
{
"speaker": "Unidentified Analyst",
"text": "Hey, guys. This is Rudy on for Jeff. Thanks for taking my questions. I know in security you've said there's broad based strength in the quarter expect that to continue. Were there any products in there maybe one or two that were just a little bit weaker or saw some challenges or slowdowns, just anything you'd call out?"
},
{
"speaker": "Tom Leighton",
"text": "I don't think there's anything to call out there, just really was outstanding quarter across the board. We're very pleased with how the security business is doing."
},
{
"speaker": "Unidentified Analyst",
"text": "Got it and then the sustainability goals by 2030, is there any boundary you can put around maybe how much expense for those investments there you're factoring in for 21? Or just what the expected impact of margins might be from investments there may be on the longer term."
},
{
"speaker": "Tom Leighton",
"text": "Yeah, so, I'll tell the team went through this and there's really not any significant expenses that we anticipate for several years. And even then, the cost that the team has rolled up is not all that significant. We've actually been able to do some pretty creative deals with certain projects on renewable energy that have worked out to be - from a pricing perspective, and no overall net economics have been neutral to even favorable in some cases, so nothing really there to note. Team's doing a fabulous job on it. And if it's - if time goes on, if there's anything we need to call out, we'll certainly let you know."
},
{
"speaker": "Unidentified Analyst",
"text": "Got it. Great. Thank you. That's it for me."
},
{
"speaker": "Operator",
"text": "Our next question comes from Charlie Ehrlich with Baird"
},
{
"speaker": "Charlie Ehrlich",
"text": "Hey, thanks for taking the question. It's Chuck Ehrlich on for Will Power. I was hoping to dig in a little bit more into the legacy web division. Can you maybe talk a little bit more about maybe the puts and takes in that segment and the declines we're seeing there? And then what it might take to stabilize that segment?"
},
{
"speaker": "Tom Leighton",
"text": "Yeah, so I would say similar to what we've talked about in the past, right. You've got, obviously strong security growth, you've got from a verticals perspective, you have two verticals, retail and travel, which make up 40% of the legacy web division, vertical division, excuse me. And we're still, like I said, a few questions ago, we're not quite out of the woods there yet. And we're starting to see some stability, but we're not seeing that type of growth yet there. So it's going to take a bit for that to recover. We're doing a nice job of dealing with certain pricing pressure in those verticals with opening up other shares of the wallet, whether it's additional security products or really starting to see a lot of interest in our edge computing and edge applications business as well. So we'll see dollars potentially ship delivery into that category as we go through pricing negotiations, but that's pretty normal. And once we start to see probably in a couple of quarters, hopefully the travel and retail business get back to normal if these vaccines hold and life returns to normal, hopefully start to see that segment of the business growing again."
},
{
"speaker": "Charlie Ehrlich",
"text": "Okay. And then on the internet platform customers, we're continuing to see some growth there, which is great. Is there anything specific where that's driving that growth and what we expect for the rest of the year from that cohort?"
},
{
"speaker": "Tom Leighton",
"text": "Yeah, so it's becoming less impactful. So that's why we're kind of going away from that metric. You didn't hear me talk about in our prepared remarks. I think years ago, people were concerned that that may go to zero. And we talked a couple of years ago about stabilizing that and getting it back to growth. And the team has just done a phenomenal job. So I first tip my hat to the team that's managing those accounts. They've done a nice job of finding areas for us to add value to incredibly innovative technology companies that have their own CDN. And we found a nice spot to pick up this, whether it's adding security or delivering traffic for video and gaming for big scale events, or for live video or even on demand video, we're just finding a nice niche there and that continues to grow. It's up about a $1 million quarter over quarter, very impressive growth rate. I'd say stability is probably a good way to think about that going through the year. There's always upside with these accounts and team's identifying new areas of opportunity all the time. So very pleased with where we are with those customers and expect to see probably similar numbers, what you're seeing now down a little bit, quarter to quarter, depending on certain things that are going on in those accounts."
},
{
"speaker": "Charlie Ehrlich",
"text": "Got it. Thank you."
},
{
"speaker": "Operator",
"text": "Our next question comes from Alex Henderson with Needham."
},
{
"speaker": "Mike Cikos",
"text": "Hey, guys, Mike Chico's here again and thanks for getting me on the line. I did just want to follow up. Just looking at my model versus where you guys came in the sales and marketing expense. This quarter was much slower than what we had anticipated, even if I'm removing the accelerators from 4Q and even just looking at Q1 '21 versus Q1 '20, the amount of leverage in the model. Can you talk to how we should expect the sales and marketing to play out over the course of the years? Are there savings being realized from the realigned division? Or the reorganizations you guys had talked to earlier this year?"
},
{
"speaker": "Tom Leighton",
"text": "Yeah, that's a good point, Mike. So as part of the reorganization, right, some shift between sales and marketing, research and development, a few million bucks, if I remember correctly. And then there was some savings as we moved from the divisional model to one as there was some synergy mostly at the management level. So you'll see some of those costs go away as well."
},
{
"speaker": "Mike Cikos",
"text": "Great, thank you for clarifying that."
},
{
"speaker": "Tom Barth",
"text": "Okay, well, thank you everyone. In closing, we will be presenting at several investor conferences and roadshows throughout the rest of the second quarter. Details of these can be found in the investor relations section at akamai.com. Thank you for joining us. And all of us here at Akamai wish you continued good health to yourself as well as to your families. Have a nice evening."
},
{
"speaker": "Tom Leighton",
"text": "Thank you."
},
{
"speaker": "Operator",
"text": "This concludes today's conference call. Thank you for participating. You may now disconnect."
}
] | Akamai Technologies, Inc. | 24,522 |
AKAM | 4 | 2,022 | 2023-02-14 16:30:00 | Operator: Good afternoon, and welcome to the Akamai Technologies, Inc. Earnings Q4 Fiscal Year 2022 Earnings Conference Call. [Operator Instructions] Please note that this conference is being recorded. I'd now like to turn the conference over to Tom Barth, Head of Investor Relations. Please go ahead.
Tom Barth: Thank you, operator. Good afternoon, everyone, and thank you for joining Akamai's fourth quarter 2022 earnings call. Speaking today will be Tom Leighton, Akamai's Chief Executive Officer; and Ed McGowan, Akamai's Chief Financial Officer. Please note that today's comments include forward-looking statements, including statements regarding revenue and earnings guidance. These forward-looking statements are subject to risks and uncertainties and involve a number of factors that could cause actual results to differ materially from those expressed or implied by such statements. The factors include any impact from macroeconomic trends, the integration of any acquisitions and any impact from geopolitical developments. Additional information concerning these factors is contained in Akamai's filings with the SEC, including our annual report on Form 10-K and quarterly reports Form 10-Q. The forward-looking statements included in this call represent the company's view on February 14, 2023. Akamai disclaims any obligation to update these statements to reflect new information, future events or circumstances, except as required by law. As a reminder, we will be referring to some non-GAAP financial metrics during today's call. A detailed reconciliation of GAAP and non-GAAP metrics can be found under the financial portion of the Investor Relations section at akamai.com. And with that, let me turn the call over to Tom.
Tom Leighton : Thanks, Tom, and thank you all for joining us today. I'm pleased to report that Akamai delivered strong results in the fourth quarter, exceeding the high end of our guidance range on both the top and bottom lines, despite ongoing challenges with the global economic environment. Q4 revenue was $928 million, up 6% year-over-year in constant currency. Our revenue growth was driven by continued strong demand for our security products, our fast-growing compute business and by higher-than-expected delivery traffic. Security and compute accounted for 55% of our overall revenue in the fourth quarter and grew a combined 22% year-over-year in constant currency. Non-GAAP operating margin in Q4 was 28%. Q4 non-GAAP EPS was $1.37 per diluted share, down 2% year-over-year in constant currency. For the full year, revenue was $3.62 billion up 8% over 2021 in constant currency. Non-GAAP operating margin was 29%, down from 32% in 2021 and slightly below our goal of 30%. The decline last year was due to the impact of foreign exchange, the challenging macroeconomic environment, the investments we made to grow Guardicore's segmentation product and the rising cost of third-party cloud services. As Ed will describe in a few minutes, we're taking several actions to reduce costs and to shift resources to areas with the strongest potential for growth, such as cybersecurity and especially cloud computing. Going forward, we anticipate that our margins will likely remain slightly under 30% in the near term, and our goal is to grow margins back over 30% during the medium to long term. Non-GAAP EPS last year was $5.37, down 1% over 2021 in constant currency. 2022 was another strong year for cash generation at Akamai, with $816 million in free cash flow, representing 23% of revenue. Akamai's strong cash generation enables us to make strategic acquisitions while also returning value to shareholders. In 2022, we spent $608 million to buy back 6.4 million shares. Over the last 10 years, we've reduced the number of Akamai shares outstanding by approximately $21 million or 12%. I'll now say a few words about each of our three main lines of business, starting with security. Our security products generated revenue of $400 million in Q4, up 14% year-over-year in constant currency. For the full year, security revenue reached $1.54 billion and grew 20% over 2021 in constant currency. We saw especially strong growth through our market-leading Guardicore Segmentation product with revenue reaching $68 million for the full year. New segmentation customers in Q4 included one of the largest insurance companies in the U.S., a leading Internet services conglomerate in Japan and one of the largest banks in Scandinavia. Enterprises are choosing our segmentation solution because of its ability to protect against ransomware and data exfiltration attacks and also for the visibility it provides into their internal infrastructure. These are also among the reasons that Akamai was named as the Leader in The Forrester New Wave for Microsegmentation last year. We also saw large wins for our market-leading application security solutions in Q4, including at one of the UK's largest multinational energy companies, one of the big three multinational banks in Singapore and two of the largest tech hardware companies in the U.S. Overall, security accounted for 43% of our revenue last year, up from 39% in 2021. In 2023, we expect security to become our largest line of business. This represents a significant milestone in our evolution since we pioneered the CDN marketplace 25 years ago. That said, and as the security business becomes larger and with customers becoming more cost conscious due to the challenging macroeconomic environment, the growth rate of our security business has slowed, a trend that we anticipate will continue over the coming year. As you might expect, we're working hard to realize the full potential of our security business, both in terms of growth and efficiency. For example, we're in the process of moving the compute components of our security products from third-party cloud providers to our new Akamai connected cloud platform a transformation that will save us a substantial amount of OpEx over the next several years. We're redeploying resources within security from lower growth areas to high-growth areas such as segmentation. And we're redeploying go-to-market resources to achieve stronger cross-sell and penetration within our existing base. We're also working more closely with partners to drive better adoption among new customers. And we're continuing to innovate new capabilities, such as our recently released Account Protector and our new Brand Protector solutions to keep our customers safe amidst a rapidly evolving attack landscape. While we believe that our security business will continue to generate strong returns for our shareholders, we foresee an even bigger opportunity in cloud computing and its potential to return Akamai to double-digit top line growth over the longer term. Our compute business performed well in Q4 with revenue of $112 million up 65% year-over-year in constant currency. For the full year, compute revenue was $405 million and grew 64% over 2021 in constant currency. Earlier today, we unveiled Akamai Connected Cloud, our massively distributed platform for cloud computing, security and content delivery. Akamai Connected Cloud links Linode's 11 core data centers with Akamai's 4,100 edge computing locations. In addition, we're in the process of building out 14 more core enterprise scale data centers with at least 3 expected to come online in the next few months. We believe integrating these core cloud computing data centers with our unique edge platform will allow us to offer customers better performance, greater scale and lower cost for enterprise workloads. We also plan to have our new virtual private cloud capability and the first of more than 50 distributed cloud computing sites available in the second half of the year. The distributed sites will enable us to bring cloud computing much closer to end users around the world, which will further enhance the performance benefits of Akamai Connected Cloud. Of course, and as Ed will describe shortly, we'll be incurring substantial CapEx and colocation costs associated with the build-out of our compute infrastructure over the near term. We're also in the process of recasting approximately 1,000 positions or about 10% of our workforce to spend the majority of their time working on the development, deployment, support and go-to-market efforts associated with Akamai Connected Cloud. Because of the natural synergy and close integration between cloud computing and our existing edge platform, we believe we can accomplish this transformation without adding significant headcount to the business. This shift will also further enhance the efficiency of our delivery business. We're undertaking this ambitious investment in Akamai Connected Cloud because we believe it will create substantial value for shareholders in the medium and long term. We expect to achieve nearly $0.5 billion in revenue from compute in 2023, and the investment we're making this year should help drive that number substantially higher in 2024 and beyond as we use the new capabilities and capacity to support mission-critical enterprise workloads. I think it's worth noting that Akamai is taking a fundamentally different approach to the cloud computing market than providers who base their platforms solely on core data centers. Our strategy is to offer the world's most distributed platform placing compute, storage, data base and other cloud services closer to end users and enterprise data centers. As IDC’s VP of Research Dave McCarthy says “The cloud’s next phase requires a shift in how developers and enterprises think about getting applications and data closer to their customers. It redefines how the industry looks at things like performance, scale, cost and security as workloads are no longer built for one place but are delivered across a wide spectrum of compute and geography.” IDC adds that “Akamai's innovative rethinking of how this gets done and how it is architecting the Akamai Connected Cloud, puts it in a unique position to usher in an exciting new era for technology and to help enterprises build, deploy, and secure distributed applications.” We couldn’t agree more, distributed applications require a distributed architecture. Akamai’s leadership positioned at the edge of the Internet enables us to scale just about everything we touch. We scale content putting digital experiences closer to users than anyone. We scale cybersecurity, keeping threats father away from business and people. And now, we are building on Akamai’s 25 years of experience with scaling and securing the Internet for the world’s largest enterprises, so we can scale cloud computing and provide better performance at lower cost. Although we still have much work to do, we are encouraged by the reaction from customers who want to realize the value of our approach. Last quarter, a well-known digital fitness platform brought business to us that they previously did with a major cloud provider. They chose Akamai Connected Cloud because we can optimize their performance and provide better economics. When a gaming company suffered a DDoS attack that took out their Internet relay chat servers, they turned to Akamai Connected Cloud to get back on line. After utilizing connected cloud for a few weeks, they also migrated their peer-to-peer match making servers to Akamai. This is what they say to other gaming businesses with similar use cases: “Our adoption of Akamai’s cloud computing services was painless and turnkey. Akamai has a great backbone network and the connected layer between our global servers has been rock solid. With Akamai’s extensive global network we provide a better experience to our gamers by delivering from the edge and reducing latency. With Akamai, there is no reason to go anywhere else.” As you can see from this example, there's a strong synergy between our emerging cloud computing business and our delivery and security businesses, especially for customers in the gaming, media and commerce verticals. Turning now to content delivery. Our CDN business generated revenue of $415 million in Q4, down 8% from Q4 and 2021 in constant currency. For the full year, delivery revenue was $1.67 billion, also down 8% year-over-year. Traffic on the network was better than expected in Q4, reaching a new peak record of 261 terabits per second on December 14 as we supported more than 50 customers globally in delivering the World Cup, along with other streaming, gaming and software download businesses. This World Cup was the first time in Akamai's 25-year history when we delivered more than an exabyte of data for an event. How much is an exabyte? It's 1,000 petabytes. That's 1 billion gigabytes. For the person transcribing this call, that's 1 byte with 18 zeros after it. That's a lot of zeros and a lot of traffic. I doubt if anyone has managed such a feat before. Once again, Akamai finished the year as the CDN market leader by far, as we continue to support the world's leading brands by delivering reliable, secure, high-performing online experiences. Looking back at 2022, we're pleased that we continue to grow the business and add significant new capabilities in the face of serious global macroeconomic challenges. Today, we're redefining our future with Akamai Connected Cloud to become the world's most distributed cloud platform with leading solutions for delivery, security and cloud computing. With our expanded strategy and business model, we believe that we're on a path to provide even greater value for shareholders and to make Akamai the cloud company that powers and protects life online. Now I'll turn the call over to Ed for more on our Q4 and full year results and our outlook for 2023. Ed?
Ed McGowan: Thank you, Tom. Today, I plan to provide brief highlights of our strong Q4 results, some color on 2023 and touch on some items to help you with your models and then close with our Q1 and full year 2023 guidance. Starting with Q4 highlights. We were very pleased with our strong Q4 results despite continued difficult macroeconomic conditions. Q4 revenue was $928 million, up 2% year-over-year or 6% in constant currency. We saw very strong growth in both our compute and security businesses as well as better-than-expected traffic in our delivery business during the fourth quarter. As Tom mentioned, our compute business was $112 million, growing 61% year-over-year as reported and 65% in constant currency. We continue to be very pleased with the initial feedback from our customers on our future compute capabilities, and we are very optimistic about capturing a meaningful share of our customers' cloud spend in the years to come. Our security revenue was $400 million, up 10% year-over-year and up 14% in constant currency. Our delivery revenue was $415 million, which declined 12% year-over-year and 8% in constant currency. Traffic exceeded our expectations during the quarter, led by higher video traffic, stronger-than-expected commerce traffic and record-setting World Cup online viewership. International revenue was $445 million, up 4% year-over-year or up 12% in constant currency, representing 48% of our total revenue in Q4. Foreign exchange fluctuations had a negative impact on revenue of $2 million on a sequential basis and negative $36 million on a year-over-year basis. Non-GAAP net income was $216 million or $1.37 of earnings per diluted share, down 8% year-over-year and down 2% in constant currency, but $0.07 above the high end of our guidance range. Moving to our capital allocation strategy. During the fourth quarter, we spent approximately $178 million to buy back approximately 2.1 million shares. For the full year, we spent approximately $608 million to buy back approximately 6.4 million shares. We ended 2022 with approximately $1.2 billion remaining on our current repurchase authorization. Our intention is to continue to buy back shares to offset dilution from employee equity programs over time and to be opportunistic in both M&A and share repurchases. It's worth noting that in addition to offsetting dilution, we have reduced shares outstanding by approximately 21.2 million shares or 12% since January 1, 2013. Before I move on to guidance, there are several items that I want to highlight to help you with your 2023 models. The first relates to a change in our network server useful lives. As some of you may recall, we announced on our Q4 2018 earnings call that we were required to extend the useful life of our network servers from 4 years to 5 years based on the actual server useful life trends. We carefully monitor the useful lives of all of our capital assets annually. And based on the outcome of our most recent review, we now are extending the useful lives of our servers from 5 years to 6 years. Similar to when we made the change 4 years ago, this extended useful life is a direct result of the continued software and hardware initiatives that we have put in place to manage our global network more efficiently. Because we are now using the servers in our network for an average of 6 years we are required under GAAP accounting to adjust our useful life policy to 6 years beginning in Q1 of 2023. Please keep in mind that this change has no impact on cash flow, but will result in a depreciation benefit of roughly $56 million in 2023 and approximately $31 million in 2024. We have provided a supplemental table in the Investor Relations section of our website that details the impact of this change. Second, we are expecting non-GAAP gross margins to decline by approximately 2 points in 2023 due to two primary items. First, as we build out our new compute locations, we are required to account for our colocation leases under GAAP accounting standard ASC 842. In order to achieve more favourable unit economics, we often sign longer term colocation agreements that include certain financial commitments. ASC 842 requires we straight line the cost of those future financial commitments over the life of the agreement. As a result, we expect to record approximately $40 million of noncash colocation costs related to this accounting standard in 2023. The second item impacting gross margin is our third-party cloud costs, as we've mentioned in the past, we expect to migrate the majority of our third-party cloud spend on to our own cloud infrastructure over the next 12 to 18 months. That said, we expect the majority of the migration effort to impact the back half of the year. We expect we will incur just over a $100 million of third-party cloud costs and cost of goods sold in 2023. We do, however, expect we will exit the year on a path to significantly lower our third-party cloud costs from 2024. Third, we expect international sales will represent nearly half of our total revenue in 2023 and the currency markets remain incredibly volatile. I will provide more detail on the impact of currency on each quarter's earnings call, but it's important to note that the strengthening or weakening of the U.S. dollar can have a material impact on our reported results and guidance. As a reminder, the currencies that have the largest impact on our business are the euro, the yen and the Great British pound. Fourth, I want to remind you of the typical seasonality that we experienced on the top and bottom lines throughout the year. Regarding revenue, the fourth quarter is usually our strongest quarter, and we typically see a step down in Q1 revenue from Q4 levels. Regarding profitability, as a reminder, in Q3, we have the annual company-wide merit increase; and in Q4, we typically see higher sales commission expense. And one final thought before we move on to guidance. Tom mentioned that we will be investing in what we believe will be two areas of higher growth for the company for years to come: security and compute. While we expect to manage the business below our target operating margin of 30% in 2023 and we expect 2023 to be a higher-than-normal year for CapEx, we will continue to reduce costs and drive efficiency gains in key areas such as third-party cloud savings. We expect to save over $100 million in annual cost as we migrate workloads from the hyperscalers to our own platform over the next 12 to 18 months. Real estate rationalization. As our employees have largely elected to work remotely, we expect to reduce our real estate costs by approximately $20 million in 2023 and achieve further savings in 2024. Shifting resources. As Tom mentioned, we'll be incurring substantial CapEx and colocation costs associated with the build-out of our compute infrastructure over the near term. As a result, we are prioritizing certain actions and retasking approximately 1,000 positions from other parts of the business to our compute business. In addition, during the fourth quarter, we closed approximately 500 open positions and we will continue to be very prudent with any headcount additions during the year. Finally, we are lowering CapEx related to delivery. We expect to reduce our CapEx related to the delivery business to 4% of revenue in 2023. Now moving on to guidance. Our guidance for 2023 assumes no material changes, good or bad, in the current macroeconomic landscape which we view as challenging, but navigable. For the first quarter of 2023, we are projecting revenue in the range of million to $900 million to $915 million or up 0% to 1% as reported or 2% to 3% in constant currency over Q1 2022. Foreign exchange fluctuations are expected to have a positive $13 million impact on Q1 revenue compared to Q4 levels, but a negative $19 million impact year-over-year. At these revenue levels, we expect cash gross margins of approximately 73%. Q1 non-GAAP operating expenses are projected to be $299 million to $303 million. We anticipate Q1 EBITDA margins of approximately 39% to 40%. We expect non-GAAP depreciation expense to be between $109 million to $111 million, and we expect non-GAAP operating margin of approximately 27% to 28% for Q1. And with the overall revenue and spend configuration I just outlined, we expect Q1 non-GAAP EPS in the range of $1.30 to $1.34. This EPS guidance assumes taxes of $43 million to $44 million, based on an estimated quarterly non-GAAP tax rate of approximately 17.5%. It also reflects a fully diluted share count of approximately 157 million shares. Moving on to CapEx. We expect to spend approximately $220 million to $228 million, excluding equity compensation and capitalized interest in the first quarter. This represents approximately 24% to 25% of anticipated total revenue. Looking ahead to the full year, we expect revenue of $3.7 billion to $3.78 billion, which is up 2% to 4% year-over-year, both in as reported and in constant currency. We expect security revenue growth to be in the low double digits for the full year 2023. We are estimating non-GAAP operating margin of approximately 27% to 28% and full year CapEx is expected to be approximately 21% of total revenue. We expect our CapEx to be roughly broken down as follows: approximately 4% of revenue for our delivery business; approximately 9% of revenue for our compute business, of which roughly $100 million of that will be for internal workloads moving in-house and the remainder for future revenue growth; approximately 7% of revenue for capitalized software; and the remaining about 1% for IT and facility-related spend. We expect non-GAAP earnings per diluted share of $5.40 to $5.60. And this non-GAAP earnings guidance is based on a non-GAAP effective tax rate of approximately 17.5% and a fully diluted share count of approximately 157 million shares. In closing, we are very pleased with the strong finish to 2022, and we are excited about our growth prospects in both security and cloud computing. Now, Tom and I would be happy to take your questions. Operator?
Operator: [Operator Instructions] Our first question will come from James Fish with Piper Sandler.
James Fish: I appreciate all those details on the moving part. Ed, I know there's a lot there. I actually want to dive into the security business here. Tom, you had mentioned thinking about go-to-market investments and looking to prioritize on how to better address the market. Are you guys changing at all how you're approaching the market, especially on the network security side with Zero Trust as it seems to be a little bit of a disconnect? And, Ed, is it possible we can actually get an update on what that access control Zero Trust kind of business finished at for 2022?
Tom Leighton: Yes. No, good question. And we are increasing the allocation of our go-to-market investments around the enterprise side and Zero Trust. We have specialist teams there really focused on Guardicore and now the other enterprise products as we integrate them in with the Guardicore solution. And we've had a lot of success with that team, as you can see from the really good growth in the Guardicore product. And so we're doubling down there. And over the course of this year, you'll see, I think, more cross-sell with our Enterprise Application Access product in Guardicore and ETP. And then I'll turn the other question over to Ed.
Ed McGowan: Jim. Yes. So what I'd say about Zero Trust is we ended the year on a run rate of about $200 million in Zero Trust. And we had a very strong finish to Guardicore. In Guardicore, we'd expect this year to be on a run rate of $100 million. So a very, very strong finish to the year with Guardicore.
James Fish: Helpful. And just a follow-up on the compute side. A big question we've been getting is whether the compute business could get traction really outside the media vertical? Or is that really going to be the focus in terms of gaming and streaming kind of storage and compute on the back end? And kind of what's the confidence level that you're not going to see an erosion in that more traditional windows that's SMB based?
Tom Leighton: I think media is the big first set of adopters. In fact, as you know, one of the world's largest, if not the largest social media company is already using it. And I think that's because media really is concerned about performance. And so we're doing things like transcoding, much closer to the end user. And that's a key thesis of our architecture and our approach to compute is to be much more distributed with the compute, have containers and VMs much closer to the end users. Gaming, another example, what that makes a lot of sense. Things like leaderboards, manage groups of users as they play the game, you need low latency, there's a lot of back and forth with the clients and you want that to be close to the end user. That said, this is not limited to media. Commerce is also very sensitive to performance, and we've already signed up commerce companies. And commerce companies, of course, especially with these macroeconomic challenges. Akamai Connected Cloud, better performance at a more competitive price point. So I think you'll see penetration in the commerce vertical as well. And of course, Akamai is really close to the big companies in media and commerce. I have the opportunity to talk to the most senior executives in many of these companies, and they're very interested in what we can do for them. And they've been asking us to do this. And I think they're excited about the potential Akamai Connected Cloud. I think down the road, take a little bit longer. The financial vertical is another vertical that's very strong for Akamai because of our work in security and our market-leading products there. There, we have a little bit more work to do on the certifications. The bar is a little bit higher for financial institutions, but I think that would follow media and commerce in terms of adoption of Akamai Connected Cloud.
Operator: Our next question will come from James Breen with William Blair.
James Breen: Can you just talk a little bit about sort of the internal decision-making around shifting resources to the security and cloud side and maybe a little bit on the delivery side of market share to some extent, giving up some market share within that business sort of better for the overall profitability in the long term?
Tom Leighton: Well, yes, I think it makes good sense to be shifting resources towards the higher growth areas both security but especially in cloud computing. I think we'll see a lot stronger return on the investment. We still have the market-leading delivery business. We haven't lost share, to the best of my knowledge. We have turned away some -- a small amount of the business that's very spiky. And that doesn't make as much sense for us to take that business at the price point isn't right today. And that's because traffic growth rates are lower than they used to be. So you have to spend money to build out for the spike. And if your traffic growth rates are lower, it takes longer to fill that capacity on a daily basis. With delivery, your cost is associated with your peak and your revenue more associated with the daily usage or total aggregate usage. And so we have, as we've talked about, turned down some deals there just because the ROI doesn't make us much sense in this environment, and we get a lot better ROI from investing in compute and I think, obviously, security. And then within security, we're reallocating investment decisions there to focus more resources on the fastest-growing security products. So I think it just makes good sense. And for now with compute, it's something our customers are really asking us to do. And even in this challenging macroeconomic environment, it's something that I think the timing may be even a little bit better there because of that.
Operator: Our next question will come from Keith Weiss with Morgan Stanley.
Keith Weiss: Excellent. A couple of questions, I have a ton of questions, but I'll try to limit it to two or three. On the cloud computing side of the equation, the word of the year amongst investors has been optimization, and we've heard it from AWS, we've heard it from Azure. I'm really interested to hear how that impacted Linode. Given kind of being a lower cost provider in the marketplace, did you guys -- did you see optimization of people trying to sort of reduce the amount of consumption on your platform? Are you guys like more of a net beneficiary because of, people are ultimately seeking just kind of lower cost overall? And then also on cloud, I don't know, did you guys mention what the contribution was from Linode this quarter? I believe you guys have been given the kind of inorganic contribution over the past couple of quarters. And then I have one for Ed on the margin side of the equation.
Tom Leighton: All right. I'll take the first part of that and let Ed take the second part. I think Linode is a much smaller company and really sort of a different market than the giant cloud companies that are maybe referring to optimization. So I didn't see -- we don't see a big impact on Linode. Now what we're doing is making Linode so it can be used by the big enterprises for mission-critical applications. And that, in part, is building out scale. It's making it be more distributed, available in more cities, integrating it with the Akamai platform and our Edge regions and increasing the functionality. So a lot of work taking place on the Linode platform so we can sell it at a much higher scale to major enterprises. And we're in the stage now with early adopters there. And I think as we get towards the end of this year, we'll be in a position to take on a lot more business there. And I think the value proposition is that we would have better performance will be more distributed, closer to end users at a more competitive price point. And I think in this environment, yes, pricing matters, especially if you look at -- as we talked about, big media, big commerce, they care. And they are spending a lot in the cloud today. So I think that's the phenomenon you'll see take effect as we're in a position to take on more large-scale business for large enterprises. And then Ed, you can take the second part of that question.
Ed McGowan: Yes, sure. So Linode, it will get more difficult to break up sort of merging in with everything, but it was about $34 million, a little over $34 million. We did see a slight increase in the growth rate as the year went on, and we haven't seen any change in the consumption around optimization, meaning folks are using less of the cloud at this point.
Keith Weiss: Perfect. Perfect. And then on the expense side of the equation. I just want to make sure I understanding this correctly. It sounds like you're slowing down or pausing hiring and I'm assuming you close those positions that could be hired into them, but you just like tick it off of the job board, if you will, and then repositioning employees rather than any like restructuring or headcount reduction. So should the way that we should be thinking about it is you're aiming towards relatively flat headcount in 2023?
Ed McGowan: Yes, Keith. So the way to think it will probably go up a little bit. It won't be up as much as it's been up certainly last year. But I mean, you're thinking about it in the right way. And one of the things that we're fortunate enough to do is if you think about what we would -- the typical company would do if you didn't have the skill sets and how it should have to do a layoff, that's expensive and then you have to go hire new talent. We're fortunate enough in the areas that Tom talked about, whether it's development or build out of the network, the sales functions that we can shift those resources over. So if you think about the cost to build out what we're doing, would cause somebody else a significant amount of money, but we're able to shift those resources. And as far as the new headcount going forward, we're going to be pretty judicious with where we're hiring, but it's going to be primarily in the areas of cloud and security and maybe a few on the go-to-market side.
Keith Weiss: Got it. And the shift take place both in terms of development as well as go-to-market? Or is it more so like the development resources are being shifted?
Tom Leighton: There's a lot of resources being shifted within our platform and delivery organizations. Think of the hundreds of people that are managing our network deployment that build out our 4,100 regions today and the tremendous scale we have, and they are now heavily focused on building out compute resources. Think of the people that manage the operations, the automatic deployment of software, the payload or the load balancing, the resiliency, they are heavily focused on incorporating those capabilities for compute, building on top of the Linode framework. So I would say the large majority of the resources are of that nature that we're retasking.
Operator: Our next question will come from Tim Horan with Oppenheimer.
Tim Horan: Also on the cloud, can you talk a little bit about your improvement in price and performance versus the comments? Can you give us some metrics there? And then can you talk a little bit about what type of cloud you're building out for? I know, Tom, in the past, you were a little skeptical that we could do kind of gaming as a service over cloud infrastructure. Is that changing? And you could optimize your cloud for AI or blockchain or more networking or very, very low latency? Just any color there? And then lastly, have you contemplated maybe partnering with some of the larger cloud providers with AI really starting to take off? Can you be a partner to a few of them or one of them that would really accelerate things?
Tom Leighton: Yes, good questions. We'll be the most distributed cloud services provider. And of course, we start with 4,100 POPs for function as a service, JavaScript at the edge. And we're building out the core cloud capabilities. And then this notion of the -- of a more distributed containers closer to the edge, VMs closer to the edge. Now that will give you better performance for things where you want to be close to the end user because it will be closer to more end users will be in some cases, countries where you don't have a presence from the hyperscalers. And our pricing will be less already. You can look at the list pricing and see that it's less than what the hyperscalers charge. And we're -- because we're integrating it with our backbone and with our edge platform, that gives us great economics on the delivery, taking the data in and out of storage or compute and getting it to end users. We're in a position to do that at a lower cost and to give consumers a better price point. Yes, this works not for all gaming functions, but for a lot of the things you want to do with gaming. It's a great use case, streaming, obviously, transcoding, APIs, chatting APIs, people communicating during a sporting event. That's all -- is very relevant to having a more distributed model. AI, I think elementary stuff you can put in a container or VM yes, that makes perfect sense. If you want to have the monolithic storage associated with that, that's more cloud, core cloud compute, I would say. I think in terms of partnering, yes, we have a lot of customers that obviously use Akamai services today as well as the cloud giants. In fact, the cloud giants themselves, a couple of them are very large Akamai customers. And so they also use their own services. So I think it's an ecosystem where, yes, I think there'll be customers that would use us and use the hyperscalers depending on the application and what they're looking to do. And we very much believe in a multi-cloud approach.
Operator: Our next question will come from Mark Murphy with JPMorgan.
Mark Murphy: Is it possible to ballpark the revenue contribution that was driven by this huge scale of the World Cup so that we could then remove that from our models for the next 3 years and then, I guess, presumably included back in year four?
Ed McGowan: Yes. Mark, it's Ed. There's about $5 million, roughly.
Mark Murphy: Okay. Got it. And then as a follow-up, just to clarify, during Q4, were you able to capture some of the business that Amazon is losing either due to the lower pricing structure that you have for Linode or because you have this advantage of broader points of presence? I guess I'm just interested in -- it sounds like from what you're describing, that potential is there. I'm just wondering if there was a material benefit or tailwind from that in Q4?
Tom Leighton: Not in compute in Q4. Obviously, we compete very successfully in delivery and security with the hyperscalers. We're the market leader there. Now in compute, they are the market leaders by far. And so nothing that we would do in compute is going to make any difference to them. I mean we're looking to get to a 1% market share in a market that's $100 billion to $200 billion a year. So it will take us a while in compute before I think a hyperscaler would even really, really notice. And of course, a 1% or 2% market share means a lot to us in compute, that's several billion dollars means less, obviously, to folks at the scale of those guys.
Operator: Our next question will come from Rishi Jaluria with RBC.
Rishi Jaluria: Wonderful. I've got two. First, I wanted to start on the compute side of the equation. I appreciate all the color around CapEx. And please forgive me if my math is shouty over here. But if I just do a rough back of the envelope numbers, right, with 9% of total revenue being CapEx, specifically for the compute business and then I strip out $100 million of nonrecurring, that's still telling me that CapEx -- compute CapEx this year in 2023 is going to be 45% of compute revenue, which, again, it's a growing business and everything. Number one, am I directionally thinking about this? And maybe number -- piece number 2 to that is, how should we be thinking about steady state CapEx for the compute business once we get through maybe the next year or 1.5 years? And then I've got a follow-up.
Ed McGowan: Yes, sure. So you're doing the math right. So the way to think about the $100 million, that will enable us for our internal use, that will enable us to save lot more than $100 million. So think of it -- you think about it right in terms of as a onetime sort of burst of a charge. Obviously, if we continue to use our own compute capabilities over time down the road. We will be adding a little bit from time to time there. But you're thinking about that correctly. In terms of what does the steady state look like? We talked at the Analyst Day about how you can approximate sort of future growth percentage with what you would spend. So for example, if we are -- of the $1 billion we're spending 30% in CapEx, our growth rate would be probably around 30%. It's not quite dollar for dollar, but it’s sort of a rough approximation. So think of us spending roughly $100 million this year on internal use another, say, call it, 225 to 250 depending on where you are on your models. That enables you to get that type of revenue scale potentially. Obviously, it's going to have to play out in the market to be a little bit more if we get a little bit less. That's a pretty decent rule of thumb. And then obviously, as we're growing out these locations, we're pretty ambitious in terms of the core locations that we're putting online also distributed locations are putting online. We're going to be investing ahead of revenue. So I would expect for the next 1.5 years or 2 years to have elevated CapEx related to the compute business, and we'll start to scale into it.
Rishi Jaluria: Okay. Got it. That's helpful. And then just maybe going back to the security business. Going past this year, longer term, what needs to happen to see security overall reaccelerate growth rate that you'd be happy with? Is that primarily going to be driven by a continued Guardicore mix shift? Is that going to be more on the Zero Trust portfolio ex Guardicore? Maybe walk us through kind of what needs to happen to get security up to kind of an organic growth rate that you'd be happy with?
Tom Leighton: Yes. No, I think you characterized it well, and it is more the mix shift to the newer products for us that are growing at a rapid rate, but are still relatively small. We've got a substantial return from Bot Manager now. That's a great example, starting to really help. Next is Guardicore, which, as Ed mentioned, we want to -- as we exit should be at over $100 million run rate. And once you start getting to that size and it's rapidly growing, it starts making a difference for the big security number. And of course, as that number gets bigger, it obviously gets more challenging to maintain the higher growth rates. We're continuing to invest in new capabilities there. Account Protector is off to a very good start, really excited about that. But it will take time to do that. And we're continuing to look for potential acquisitions that can help jump start growth. I don't think anything huge. It gets you the return right away, but areas that we think are really important that we can become market leaders in like we've done for application firewall, bot management, for segmentation and that over then a period of years can drive significant growth for us.
Operator: Next question will come from Amit Daryanani with Evercore.
Amit Daryanani: Two questions for me as well. I guess the first one, when we think about 2% to 4% kind of top line growth in '23 in constant currency, I think you talked about security growing double digits. Is there a way to think about how do you think growth stacks up on the compute and delivery side as well for the year?
Ed McGowan: Yes, sure. So well, we didn't give specific guidance for either delivery or compute. Tom did talk about us achieving $0.5 billion or so in compute revenue. So depending on where you put your models, you decide the $0.5 billion for compute and just solve for the delivery. I think if you were to be on the higher end of the business, delivery might do a little bit better as we saw in Q4, potentially get security going. If the macroeconomic conditions improve and then obviously there really is just a timing issue in terms of when we can start moving major workloads on compute.
Amit Daryanani: Got it. And then as we think about sort of the path from, let's just say, 27.5% operating margins that you'll be at in '23, towards just 30% kind of target you folks have had in the -- you have now actually, what do you think takes to achieve that target? Is there a revenue number that you need to get there or a mix or the cost reduction? If you could just maybe provide a bit of a bridge on how do you get from 27.5% to 30% EBIT margins, that would be really helpful?
Ed McGowan: Yes. So it's a little bit of everything, right? But I think as we laid out about five or six different things that we're doing, probably the biggest near-term item would be the third-party cloud costs. So as we migrate that our own cloud, we're going to save about $100 million or so. Think about that as some of that will happen this year, a lot more of it in '24 and then by '25, we should have almost the majority of our internal cloud or third-party cloud on our eternal system. So that's 2 points to 3 points right there. Colocation, I talked a bit about the audit of the ASC 842 in lease accounting. We have a little bit more of a burden that we have to take at the beginning of some of these longer-term agreements. But also, we're spending on colocation that we haven't quite scaled into yet. So there's your question about revenue. As revenue scales, you'll get scale with your margins. And then just through some of the depreciation savings that we're getting on delivery and the real estate savings. We're spending, call it, before this year around $100 million in real estate, we're going to save about $20 million this year. Probably room to get maybe another $20 million or $30 million out of that as well. So it's really a combination of getting the compute revenue to scale into our investments in mostly our colocation facilities and third-party cloud savings, those are probably the two biggest areas for margin expansion.
Amit Daryanani: Perfect. It sounds like most of the ramp to margins is going to be driven by self-help levers versus revenue tailwinds. I mean, it seems like the skew might be a bit more on self-help. Is that a fair way to characterize it?
Ed McGowan: Yes. I mean I think that's -- when you look at the size of those numbers, certainly, I mean, obviously, revenue cures all your rails, right? We've got a pretty scalable model. So if we see acceleration in revenue, especially on the compute side, you're going to see a pretty good flow-through. But yes, there's a lot in our control here. And I think we're doing the responsible things as far as hiring goes, shifting resources, focusing on reducing our real estate costs and really focusing on driving down that third-party cloud cost, which is really taken a pretty big chunk out of our gross margin.
Operator: Our next question will come from Fatima Boolani with Citi.
Fatima Boolani: Two for me. On the delivery segment, the last couple of years for you have been maybe a little bit more erratic just by way of lapping some of the benefits from the pandemic, some of the dynamics you saw in the gaming area where trends are moderating. So at a high level for you, when we think about the underlying cadence from a volume perspective, what are you assuming that's maybe different the same, better or worse versus the trends you saw this year? And I'm considering the renewal cohort what you've mentioned around holding on pricing. So any sort of color commentary you can give us for the delivery segment in terms of traffic trends and then pricing trends under the hood? And then I have a follow-up, please.
Ed McGowan: Yes, sure. Great question. So let me see if I can pick that all at once here. So in terms of the major renewals, we don't have nearly as many major renewals as we had last year. So that's going to be one thing that works in our favor. We are not anticipating in our guidance any significant increase in traffic in terms of levels of growth that we saw last year. We're anticipating a slight increase, but nothing significant. We're anticipating that and we're starting to see that price declines are moderating a bit. They're not nearly as steep as they've been in the past. And then we will continue our posture in terms of being a little bit more selective with some of the spiky traffic. Once we start seeing volumes get back to the historical Internet growth rates and beyond, then maybe that posture may change, but that's the way we're going to play it for now.
Fatima Boolani: I appreciate that. And just the delineation between your U.S. business and the international business, anything you can point to by way of geographical differences in procurement? Is there more sensitivity on budgets in the U.S. versus international? Any characterization there because international continues to be a stronghold for you versus some of the -- maybe some of the malaise on the U.S. side, but would love to get a little bit more granular on what's continuing to drive that strength and if some of that budgetary pressure that you alluded to on the security side is maybe showing up more pronouncedly in U.S. versus international? That's it for me.
Ed McGowan: Sure. Yes, I would say just kind of general macro across all regions. I'd say new customer acquisition is more challenging in an environment like this. And I think you hear a lot of companies talk about that. We're seeing that as well. In terms of geographic, obviously, the European economy is struggling a bit more than we are in the U.S., slightly higher inflation, et cetera. So I expect that area to be a bit more weaker than what I'm seeing in the U.S. Asia is still been pretty strong. Latin America has been pretty strong. U.S. has been kind of holding firm here. But I would expect the European business, in particular, is to be the most impacted by the macroeconomic factors.
Operator: Our next question will come from Frank Louthan with Raymond James.
Frank Louthan: So with the significant number of POPs that you have already, what is it about the cloud platform that you need to expand these sites? What is about the location and the capabilities that they bring for expanding the compute platform that you generally have? And then you touched on a possibility for M&A. What do you consider significant? And what are the -- what size M&A do you think you might be looking at if you do any in the next 12 months?
Tom Leighton: Yes. So on the Akamai Connected Cloud architecture, we already have 4,100 edge regions. And these regions do delivery and security. They're the first line of defense. They also do what we call edge computing, which is function as a service, JavaScript at the edge. Now in the core, where Linode had 11 data centers, and we're going to more than double that, you have very large-scale storage object and block storage. You've got VM as a service, Container as a Service, Kubernetes, core cloud compute. Now we're adding also an intermediate layer, we call those sort of the distributed compute layer. And this would have not the monolithic storage, but you'd have containers as a service. Kubernetes, VMs as a service, so you could do compute there. And so what you do and where you want to do it depends on the application, things that are a lot of back and forth with the end user that are lighter weight, that could be handled in JavaScript. You want to be doing that in the 4,100 edge regions, something like transcoding, you're doing some data processing, you got an app in a container, but performance matters, you want to be close to the end user or say a gaming application that you'll want to do in our distributed edge platform. And the reason we have that is there's a lot of cities and places in the world that don't have a giant cloud data center there. And they can't really take advantage of the cloud for applications that have -- where the proximity to the user is important, and so that's something that we want to be able to provide. So there's three sort of levels here of compute and you want to be actually using generally all three for a major company, but the specific application dictates where you want to be doing it and what combination that you want to use.
Frank Louthan: Okay. Potential for M&A and thoughts on what you would consider significant versus more tuck-in?
Tom Leighton: Yes, good. So I think tuck-ins are a team that has the beginnings of a product or technology that we can scale on behalf of our customers. We've done a lot of acquisitions like that. More substantial would be something like Guardicore that had, at that time, the #2 product in the marketplace, and we've invested around that. They're now #1, which is great to see and a more significant cost associated with that. And they had a developed product already. Go back farther Prolexic is another example of that where they had a developed product, they already had $40 million, $50 million in ARR. And those are -- we do occasionally, and we're always looking. But we do those occasionally. But more you'll see the tech tuck-ins and then we develop from there.
Operator: Our next question will come from Rudy Kessinger with D.A. Davidson.
Rudy Kessinger: I guess I'm curious, how did the macro trend in the quarter just with deals lengthening? And how many deals did you see push, I guess, relative to Q3? And the guide assumes no positive or negative change in the macro. Just why make that assumption, why not be a bit more conservative, maybe assuming it gets a little worse?
Ed McGowan: Yes. So this is Ed. So in terms of the biggest impact on the quarter, I would say coming in, we're expecting potentially a weak commerce season. We actually saw a pretty decent commerce season. We saw a decent video traffic. We saw obviously, we talked about the World Cup being better than our expectations. I would say gaming was noticeably weak. We didn't see as much activities you typically see. And then from the sales side, a couple of deals pushed a few large Guardicore deals we track that push and then also new customer acquisitions are slower than we'd like to see. Those are really the big things. Then as far as the macroeconomic conditions, it's tough when you sit in the seat to try to play economist. And with us, obviously, exit has probably the biggest impact on us more than anything, given we've got longer-term contracts. But it's hard to say that, look, things can change and get dramatically worse. I'm just expecting what I see right now in front of us in terms of the macroeconomic environment is challenging, but I think we can navigate it pretty well. So that's what we based our guidance on. If things change, we'll obviously update the guidance. But I was just trying to -- a lot of times people asked me what was what we were thinking as you put your guidance that are you expecting things to get dramatically worse. In this case, no, I expect things to be dramatically better not kind of roughly the end if things do change, we'll obviously update you as we get more information.
Rudy Kessinger: Yes. Okay. That's fair. And then at a higher level, I mean, obviously, it sounds like compute has kind of slotted into growth priority one, if you will, kind of ahead of security. And just at the high level, I'm curious what really is giving you conviction to invest so much in compute. Is it the early customers that you've signed? Is it just conversations? Is it the pipeline growth you've seen over the last few quarters since you made the acquisition? What's giving you so much conviction to make such a large investment go-on on compute?
Tom Leighton: Well, it's all of the above plus the compelling logic of the situation. As I mentioned, I do have the opportunity to meet with the senior most executives that a lot of the world's largest companies, especially you think media, commerce, gaming and so forth. And there is a lot of interest there in our ability to help them. They're in a situation where they're spending a ton on third-party cloud. It's growing rapidly. Many of them describe it as being out of control. and it's even hard to know how big it will get. In some cases, they're spending this with a competitor. And on top of it, they've got major company initiatives to cut cost because of the challenging global economic conditions. And so when we can offer them a service with at least as good, better performance, at a lower price point, that's very attractive. Now on top of it, these companies, they know us well. They already trust us with scale and performance and security because we provide the vast majority of their delivery and security. So we are a very logical choice. It's not like we're just somebody coming along here saying, hey, we got a cloud service. It's not like that at all. We've got a lot of credibility with these companies and they are pretty clear that they think this could be very attractive for them. In fact, I think one of the analysts on this call did a survey of 50 of our larger customers have found the same thing. The same thing was reported to them. So we see that our customers need that and would like to shift business to us, but we want to get ready for that and help them. And that means building out the capacity building out the new distributed architecture and getting the functionality to the level that they're going to be comfortable putting mission-critical applications at very large scale on our platform. And of course, Akamai will be one of the first examples of that. We're going to place our services that are used by pretty much all the major enterprises, a lot of the major enterprises out there for, for example, security onto our platform. And that will be another great proof point that Akamai Connected Cloud is really going to work for them.
Operator: Our next question will come from Ray McDonough with Guggenheim.
Ray McDonough: Tom, maybe just to ask the M&A question in a slightly different way. As we think about the strategic plan going forward, do you feel the organization has enough operational capacity to continue to expand Linode right now and do another acquisition in security at this point to help you reaccelerate growth? And is 20% long-term growth including acquisitions in the security business, something you are still targeting after this year?
Tom Leighton: Yes, good question. First, the work on Linode which is extensive is use different teams by and large than our security technology group. And so yes, we are in a position that we can continue that work and also do security acquisition. I don’t think there’s any challenge there. Now we have, as we talked about, retask a lot of the positions, either people or positions from our platform and delivery organizations to the compute effort. So there is a lot of effort there, and that will be increasing throughout the year. Now in terms of the 20%, what we're talking about is we're guiding this year into the low double digits and then we'll see where we are. Obviously, we'd like to be growing faster than that, but there are very challenging conditions out there, as we've talked about, and we'll have to see. So we'll update that guidance as we -- maybe we get to an Investor Day or get into next year. But right now, we're just guiding for this year in security in the low double digits.
Ray McDonough: Great. And one more, if I could. The work we've done on Land does suggest your customer base is interested in leveraging Linode. And when I think about sort of the lead times for capacity additions in the data center space that you've already leased, how long are the lead times to fill that data center space? And at what point would you expect it at least to get to a somewhat full utilization of just the space that you've already contracted for?
Tom Leighton: Yes. So good question. There's the contracting, there's the build-out, there's getting it all turned on. And the way you want to think of it is we would be doing the core data center build-out. The focus of that is in the first half, and we'll have a lot of that done then, and we should finish that early in the second half or get substantially more than we have today. And then late in the second half, taking on the distributed architecture, we should have a bunch of those regions turned on live later in the year. And at that point and also, at the same time, getting the certifications in place, virtual private cloud, other capabilities that the big enterprises need so that when we get to the later part of the year, we're in a position that we can take on this business, and it will just happen all at once. A major enterprise will try it, use some applications and then some of the big ones, you port some of the traffic over. And so I think the major feeling of it and use of it really comes more in '24, not so much this year. We expect, as we talked about this year to do about $0.5 billion in compute. But the real growth, I think and the monetization of what we are building out now comes in '24 and '25. And also for our own use. This year, we are in the process of porting our own applications. And as Ed talked about we are going to save some this year but really the big savings for us comes in '24. So that's the way I think to think about it.
Tom Barth: Well, it is Valentine's Day. So we're in a little bit over. But operator, why don't we take one more question? I know there's probably a few more, but let's just take one more and we'll end the call.
Operator: Okay. Our last question will come from Michael Elias with Cowen & Company.
Michael Elias: Just two questions for you. The first is you talked about some Guardicore deals slipping. And last quarter, there was commentary around longating sales cycles. Just wondering if you could give us some color on how sales cycles have evolved for not only Guardicore but the broader portfolio? And then my second question for you is maybe to phrase it a different or frame it a different way, is there a rule of thumb that we should use to think about the correlation between incremental revenue and incremental megawatts of data center capacity that you need, i.e., to support an incremental $100 million in compute revenue, you would need x amount of megawatts?
Ed McGowan: All right. I'll try, the second one is going to be a little bit more challenging and maybe I'll come back with a metric on that one. I don't have exact metric down to the megawatt, but I'm sure somewhere in the business, I can find somebody who does. But I've sort of used sort of a rule of thumb of $1 of CapEx is $1 of revenue roughly speaking, that may change a bit, but sort of a good rule of thumb. In terms of sales cycles, the good news with the deals slipping is they're not going away. This is typically a big purchase that you make, especially with Guardicore that it could be something where the decision-maker is just pushing it off a quarter or two. And it's not that the deals are losing. It just becomes a longer sales cycle and a fight for budget. In terms of just overall sales cycles, like I said, the biggest impact is new customers, right? It's a lot easier with your existing customers, you're going through renewal cycles, you're having upgrade conversations and things like that, getting new customers to open up a new buying pattern is challenging. I do think one thing that will work in our advantage in all of this, though, is as we talk about compute and the need to find a cheaper alternative go multi-cloud. I think that's going to work in our favor. So I think one thing this -- all the negatives that come with the macroeconomic backdrop that we have. I think that's one positive that will work in our favor, and we are starting to see our pipeline grow pretty dramatically in that area. And as Tom talked about, we should start to see deals close towards the back half of the year and then really set ourselves up for '24.
Tom Barth: Okay. Well, thank you, Michael. Thank you, everyone. And in closing, we'll be presenting at several investor conferences and events throughout the rest of the first quarter. Details of these can be found in the Investor Relations section at akamai.com. We want to thank all of you for joining us, and we wish you a very good health and good health to your family. So have a nice evening. Take care.
Operator: The conference has now concluded. Thank you for attending today's presentation. You may now disconnect. | [
{
"speaker": "Operator",
"text": "Good afternoon, and welcome to the Akamai Technologies, Inc. Earnings Q4 Fiscal Year 2022 Earnings Conference Call. [Operator Instructions] Please note that this conference is being recorded. I'd now like to turn the conference over to Tom Barth, Head of Investor Relations. Please go ahead."
},
{
"speaker": "Tom Barth",
"text": "Thank you, operator. Good afternoon, everyone, and thank you for joining Akamai's fourth quarter 2022 earnings call. Speaking today will be Tom Leighton, Akamai's Chief Executive Officer; and Ed McGowan, Akamai's Chief Financial Officer. Please note that today's comments include forward-looking statements, including statements regarding revenue and earnings guidance. These forward-looking statements are subject to risks and uncertainties and involve a number of factors that could cause actual results to differ materially from those expressed or implied by such statements. The factors include any impact from macroeconomic trends, the integration of any acquisitions and any impact from geopolitical developments. Additional information concerning these factors is contained in Akamai's filings with the SEC, including our annual report on Form 10-K and quarterly reports Form 10-Q. The forward-looking statements included in this call represent the company's view on February 14, 2023. Akamai disclaims any obligation to update these statements to reflect new information, future events or circumstances, except as required by law. As a reminder, we will be referring to some non-GAAP financial metrics during today's call. A detailed reconciliation of GAAP and non-GAAP metrics can be found under the financial portion of the Investor Relations section at akamai.com. And with that, let me turn the call over to Tom."
},
{
"speaker": "Tom Leighton",
"text": "Thanks, Tom, and thank you all for joining us today. I'm pleased to report that Akamai delivered strong results in the fourth quarter, exceeding the high end of our guidance range on both the top and bottom lines, despite ongoing challenges with the global economic environment. Q4 revenue was $928 million, up 6% year-over-year in constant currency. Our revenue growth was driven by continued strong demand for our security products, our fast-growing compute business and by higher-than-expected delivery traffic. Security and compute accounted for 55% of our overall revenue in the fourth quarter and grew a combined 22% year-over-year in constant currency. Non-GAAP operating margin in Q4 was 28%. Q4 non-GAAP EPS was $1.37 per diluted share, down 2% year-over-year in constant currency. For the full year, revenue was $3.62 billion up 8% over 2021 in constant currency. Non-GAAP operating margin was 29%, down from 32% in 2021 and slightly below our goal of 30%. The decline last year was due to the impact of foreign exchange, the challenging macroeconomic environment, the investments we made to grow Guardicore's segmentation product and the rising cost of third-party cloud services. As Ed will describe in a few minutes, we're taking several actions to reduce costs and to shift resources to areas with the strongest potential for growth, such as cybersecurity and especially cloud computing. Going forward, we anticipate that our margins will likely remain slightly under 30% in the near term, and our goal is to grow margins back over 30% during the medium to long term. Non-GAAP EPS last year was $5.37, down 1% over 2021 in constant currency. 2022 was another strong year for cash generation at Akamai, with $816 million in free cash flow, representing 23% of revenue. Akamai's strong cash generation enables us to make strategic acquisitions while also returning value to shareholders. In 2022, we spent $608 million to buy back 6.4 million shares. Over the last 10 years, we've reduced the number of Akamai shares outstanding by approximately $21 million or 12%. I'll now say a few words about each of our three main lines of business, starting with security. Our security products generated revenue of $400 million in Q4, up 14% year-over-year in constant currency. For the full year, security revenue reached $1.54 billion and grew 20% over 2021 in constant currency. We saw especially strong growth through our market-leading Guardicore Segmentation product with revenue reaching $68 million for the full year. New segmentation customers in Q4 included one of the largest insurance companies in the U.S., a leading Internet services conglomerate in Japan and one of the largest banks in Scandinavia. Enterprises are choosing our segmentation solution because of its ability to protect against ransomware and data exfiltration attacks and also for the visibility it provides into their internal infrastructure. These are also among the reasons that Akamai was named as the Leader in The Forrester New Wave for Microsegmentation last year. We also saw large wins for our market-leading application security solutions in Q4, including at one of the UK's largest multinational energy companies, one of the big three multinational banks in Singapore and two of the largest tech hardware companies in the U.S. Overall, security accounted for 43% of our revenue last year, up from 39% in 2021. In 2023, we expect security to become our largest line of business. This represents a significant milestone in our evolution since we pioneered the CDN marketplace 25 years ago. That said, and as the security business becomes larger and with customers becoming more cost conscious due to the challenging macroeconomic environment, the growth rate of our security business has slowed, a trend that we anticipate will continue over the coming year. As you might expect, we're working hard to realize the full potential of our security business, both in terms of growth and efficiency. For example, we're in the process of moving the compute components of our security products from third-party cloud providers to our new Akamai connected cloud platform a transformation that will save us a substantial amount of OpEx over the next several years. We're redeploying resources within security from lower growth areas to high-growth areas such as segmentation. And we're redeploying go-to-market resources to achieve stronger cross-sell and penetration within our existing base. We're also working more closely with partners to drive better adoption among new customers. And we're continuing to innovate new capabilities, such as our recently released Account Protector and our new Brand Protector solutions to keep our customers safe amidst a rapidly evolving attack landscape. While we believe that our security business will continue to generate strong returns for our shareholders, we foresee an even bigger opportunity in cloud computing and its potential to return Akamai to double-digit top line growth over the longer term. Our compute business performed well in Q4 with revenue of $112 million up 65% year-over-year in constant currency. For the full year, compute revenue was $405 million and grew 64% over 2021 in constant currency. Earlier today, we unveiled Akamai Connected Cloud, our massively distributed platform for cloud computing, security and content delivery. Akamai Connected Cloud links Linode's 11 core data centers with Akamai's 4,100 edge computing locations. In addition, we're in the process of building out 14 more core enterprise scale data centers with at least 3 expected to come online in the next few months. We believe integrating these core cloud computing data centers with our unique edge platform will allow us to offer customers better performance, greater scale and lower cost for enterprise workloads. We also plan to have our new virtual private cloud capability and the first of more than 50 distributed cloud computing sites available in the second half of the year. The distributed sites will enable us to bring cloud computing much closer to end users around the world, which will further enhance the performance benefits of Akamai Connected Cloud. Of course, and as Ed will describe shortly, we'll be incurring substantial CapEx and colocation costs associated with the build-out of our compute infrastructure over the near term. We're also in the process of recasting approximately 1,000 positions or about 10% of our workforce to spend the majority of their time working on the development, deployment, support and go-to-market efforts associated with Akamai Connected Cloud. Because of the natural synergy and close integration between cloud computing and our existing edge platform, we believe we can accomplish this transformation without adding significant headcount to the business. This shift will also further enhance the efficiency of our delivery business. We're undertaking this ambitious investment in Akamai Connected Cloud because we believe it will create substantial value for shareholders in the medium and long term. We expect to achieve nearly $0.5 billion in revenue from compute in 2023, and the investment we're making this year should help drive that number substantially higher in 2024 and beyond as we use the new capabilities and capacity to support mission-critical enterprise workloads. I think it's worth noting that Akamai is taking a fundamentally different approach to the cloud computing market than providers who base their platforms solely on core data centers. Our strategy is to offer the world's most distributed platform placing compute, storage, data base and other cloud services closer to end users and enterprise data centers. As IDC’s VP of Research Dave McCarthy says “The cloud’s next phase requires a shift in how developers and enterprises think about getting applications and data closer to their customers. It redefines how the industry looks at things like performance, scale, cost and security as workloads are no longer built for one place but are delivered across a wide spectrum of compute and geography.” IDC adds that “Akamai's innovative rethinking of how this gets done and how it is architecting the Akamai Connected Cloud, puts it in a unique position to usher in an exciting new era for technology and to help enterprises build, deploy, and secure distributed applications.” We couldn’t agree more, distributed applications require a distributed architecture. Akamai’s leadership positioned at the edge of the Internet enables us to scale just about everything we touch. We scale content putting digital experiences closer to users than anyone. We scale cybersecurity, keeping threats father away from business and people. And now, we are building on Akamai’s 25 years of experience with scaling and securing the Internet for the world’s largest enterprises, so we can scale cloud computing and provide better performance at lower cost. Although we still have much work to do, we are encouraged by the reaction from customers who want to realize the value of our approach. Last quarter, a well-known digital fitness platform brought business to us that they previously did with a major cloud provider. They chose Akamai Connected Cloud because we can optimize their performance and provide better economics. When a gaming company suffered a DDoS attack that took out their Internet relay chat servers, they turned to Akamai Connected Cloud to get back on line. After utilizing connected cloud for a few weeks, they also migrated their peer-to-peer match making servers to Akamai. This is what they say to other gaming businesses with similar use cases: “Our adoption of Akamai’s cloud computing services was painless and turnkey. Akamai has a great backbone network and the connected layer between our global servers has been rock solid. With Akamai’s extensive global network we provide a better experience to our gamers by delivering from the edge and reducing latency. With Akamai, there is no reason to go anywhere else.” As you can see from this example, there's a strong synergy between our emerging cloud computing business and our delivery and security businesses, especially for customers in the gaming, media and commerce verticals. Turning now to content delivery. Our CDN business generated revenue of $415 million in Q4, down 8% from Q4 and 2021 in constant currency. For the full year, delivery revenue was $1.67 billion, also down 8% year-over-year. Traffic on the network was better than expected in Q4, reaching a new peak record of 261 terabits per second on December 14 as we supported more than 50 customers globally in delivering the World Cup, along with other streaming, gaming and software download businesses. This World Cup was the first time in Akamai's 25-year history when we delivered more than an exabyte of data for an event. How much is an exabyte? It's 1,000 petabytes. That's 1 billion gigabytes. For the person transcribing this call, that's 1 byte with 18 zeros after it. That's a lot of zeros and a lot of traffic. I doubt if anyone has managed such a feat before. Once again, Akamai finished the year as the CDN market leader by far, as we continue to support the world's leading brands by delivering reliable, secure, high-performing online experiences. Looking back at 2022, we're pleased that we continue to grow the business and add significant new capabilities in the face of serious global macroeconomic challenges. Today, we're redefining our future with Akamai Connected Cloud to become the world's most distributed cloud platform with leading solutions for delivery, security and cloud computing. With our expanded strategy and business model, we believe that we're on a path to provide even greater value for shareholders and to make Akamai the cloud company that powers and protects life online. Now I'll turn the call over to Ed for more on our Q4 and full year results and our outlook for 2023. Ed?"
},
{
"speaker": "Ed McGowan",
"text": "Thank you, Tom. Today, I plan to provide brief highlights of our strong Q4 results, some color on 2023 and touch on some items to help you with your models and then close with our Q1 and full year 2023 guidance. Starting with Q4 highlights. We were very pleased with our strong Q4 results despite continued difficult macroeconomic conditions. Q4 revenue was $928 million, up 2% year-over-year or 6% in constant currency. We saw very strong growth in both our compute and security businesses as well as better-than-expected traffic in our delivery business during the fourth quarter. As Tom mentioned, our compute business was $112 million, growing 61% year-over-year as reported and 65% in constant currency. We continue to be very pleased with the initial feedback from our customers on our future compute capabilities, and we are very optimistic about capturing a meaningful share of our customers' cloud spend in the years to come. Our security revenue was $400 million, up 10% year-over-year and up 14% in constant currency. Our delivery revenue was $415 million, which declined 12% year-over-year and 8% in constant currency. Traffic exceeded our expectations during the quarter, led by higher video traffic, stronger-than-expected commerce traffic and record-setting World Cup online viewership. International revenue was $445 million, up 4% year-over-year or up 12% in constant currency, representing 48% of our total revenue in Q4. Foreign exchange fluctuations had a negative impact on revenue of $2 million on a sequential basis and negative $36 million on a year-over-year basis. Non-GAAP net income was $216 million or $1.37 of earnings per diluted share, down 8% year-over-year and down 2% in constant currency, but $0.07 above the high end of our guidance range. Moving to our capital allocation strategy. During the fourth quarter, we spent approximately $178 million to buy back approximately 2.1 million shares. For the full year, we spent approximately $608 million to buy back approximately 6.4 million shares. We ended 2022 with approximately $1.2 billion remaining on our current repurchase authorization. Our intention is to continue to buy back shares to offset dilution from employee equity programs over time and to be opportunistic in both M&A and share repurchases. It's worth noting that in addition to offsetting dilution, we have reduced shares outstanding by approximately 21.2 million shares or 12% since January 1, 2013. Before I move on to guidance, there are several items that I want to highlight to help you with your 2023 models. The first relates to a change in our network server useful lives. As some of you may recall, we announced on our Q4 2018 earnings call that we were required to extend the useful life of our network servers from 4 years to 5 years based on the actual server useful life trends. We carefully monitor the useful lives of all of our capital assets annually. And based on the outcome of our most recent review, we now are extending the useful lives of our servers from 5 years to 6 years. Similar to when we made the change 4 years ago, this extended useful life is a direct result of the continued software and hardware initiatives that we have put in place to manage our global network more efficiently. Because we are now using the servers in our network for an average of 6 years we are required under GAAP accounting to adjust our useful life policy to 6 years beginning in Q1 of 2023. Please keep in mind that this change has no impact on cash flow, but will result in a depreciation benefit of roughly $56 million in 2023 and approximately $31 million in 2024. We have provided a supplemental table in the Investor Relations section of our website that details the impact of this change. Second, we are expecting non-GAAP gross margins to decline by approximately 2 points in 2023 due to two primary items. First, as we build out our new compute locations, we are required to account for our colocation leases under GAAP accounting standard ASC 842. In order to achieve more favourable unit economics, we often sign longer term colocation agreements that include certain financial commitments. ASC 842 requires we straight line the cost of those future financial commitments over the life of the agreement. As a result, we expect to record approximately $40 million of noncash colocation costs related to this accounting standard in 2023. The second item impacting gross margin is our third-party cloud costs, as we've mentioned in the past, we expect to migrate the majority of our third-party cloud spend on to our own cloud infrastructure over the next 12 to 18 months. That said, we expect the majority of the migration effort to impact the back half of the year. We expect we will incur just over a $100 million of third-party cloud costs and cost of goods sold in 2023. We do, however, expect we will exit the year on a path to significantly lower our third-party cloud costs from 2024. Third, we expect international sales will represent nearly half of our total revenue in 2023 and the currency markets remain incredibly volatile. I will provide more detail on the impact of currency on each quarter's earnings call, but it's important to note that the strengthening or weakening of the U.S. dollar can have a material impact on our reported results and guidance. As a reminder, the currencies that have the largest impact on our business are the euro, the yen and the Great British pound. Fourth, I want to remind you of the typical seasonality that we experienced on the top and bottom lines throughout the year. Regarding revenue, the fourth quarter is usually our strongest quarter, and we typically see a step down in Q1 revenue from Q4 levels. Regarding profitability, as a reminder, in Q3, we have the annual company-wide merit increase; and in Q4, we typically see higher sales commission expense. And one final thought before we move on to guidance. Tom mentioned that we will be investing in what we believe will be two areas of higher growth for the company for years to come: security and compute. While we expect to manage the business below our target operating margin of 30% in 2023 and we expect 2023 to be a higher-than-normal year for CapEx, we will continue to reduce costs and drive efficiency gains in key areas such as third-party cloud savings. We expect to save over $100 million in annual cost as we migrate workloads from the hyperscalers to our own platform over the next 12 to 18 months. Real estate rationalization. As our employees have largely elected to work remotely, we expect to reduce our real estate costs by approximately $20 million in 2023 and achieve further savings in 2024. Shifting resources. As Tom mentioned, we'll be incurring substantial CapEx and colocation costs associated with the build-out of our compute infrastructure over the near term. As a result, we are prioritizing certain actions and retasking approximately 1,000 positions from other parts of the business to our compute business. In addition, during the fourth quarter, we closed approximately 500 open positions and we will continue to be very prudent with any headcount additions during the year. Finally, we are lowering CapEx related to delivery. We expect to reduce our CapEx related to the delivery business to 4% of revenue in 2023. Now moving on to guidance. Our guidance for 2023 assumes no material changes, good or bad, in the current macroeconomic landscape which we view as challenging, but navigable. For the first quarter of 2023, we are projecting revenue in the range of million to $900 million to $915 million or up 0% to 1% as reported or 2% to 3% in constant currency over Q1 2022. Foreign exchange fluctuations are expected to have a positive $13 million impact on Q1 revenue compared to Q4 levels, but a negative $19 million impact year-over-year. At these revenue levels, we expect cash gross margins of approximately 73%. Q1 non-GAAP operating expenses are projected to be $299 million to $303 million. We anticipate Q1 EBITDA margins of approximately 39% to 40%. We expect non-GAAP depreciation expense to be between $109 million to $111 million, and we expect non-GAAP operating margin of approximately 27% to 28% for Q1. And with the overall revenue and spend configuration I just outlined, we expect Q1 non-GAAP EPS in the range of $1.30 to $1.34. This EPS guidance assumes taxes of $43 million to $44 million, based on an estimated quarterly non-GAAP tax rate of approximately 17.5%. It also reflects a fully diluted share count of approximately 157 million shares. Moving on to CapEx. We expect to spend approximately $220 million to $228 million, excluding equity compensation and capitalized interest in the first quarter. This represents approximately 24% to 25% of anticipated total revenue. Looking ahead to the full year, we expect revenue of $3.7 billion to $3.78 billion, which is up 2% to 4% year-over-year, both in as reported and in constant currency. We expect security revenue growth to be in the low double digits for the full year 2023. We are estimating non-GAAP operating margin of approximately 27% to 28% and full year CapEx is expected to be approximately 21% of total revenue. We expect our CapEx to be roughly broken down as follows: approximately 4% of revenue for our delivery business; approximately 9% of revenue for our compute business, of which roughly $100 million of that will be for internal workloads moving in-house and the remainder for future revenue growth; approximately 7% of revenue for capitalized software; and the remaining about 1% for IT and facility-related spend. We expect non-GAAP earnings per diluted share of $5.40 to $5.60. And this non-GAAP earnings guidance is based on a non-GAAP effective tax rate of approximately 17.5% and a fully diluted share count of approximately 157 million shares. In closing, we are very pleased with the strong finish to 2022, and we are excited about our growth prospects in both security and cloud computing. Now, Tom and I would be happy to take your questions. Operator?"
},
{
"speaker": "Operator",
"text": "[Operator Instructions] Our first question will come from James Fish with Piper Sandler."
},
{
"speaker": "James Fish",
"text": "I appreciate all those details on the moving part. Ed, I know there's a lot there. I actually want to dive into the security business here. Tom, you had mentioned thinking about go-to-market investments and looking to prioritize on how to better address the market. Are you guys changing at all how you're approaching the market, especially on the network security side with Zero Trust as it seems to be a little bit of a disconnect? And, Ed, is it possible we can actually get an update on what that access control Zero Trust kind of business finished at for 2022?"
},
{
"speaker": "Tom Leighton",
"text": "Yes. No, good question. And we are increasing the allocation of our go-to-market investments around the enterprise side and Zero Trust. We have specialist teams there really focused on Guardicore and now the other enterprise products as we integrate them in with the Guardicore solution. And we've had a lot of success with that team, as you can see from the really good growth in the Guardicore product. And so we're doubling down there. And over the course of this year, you'll see, I think, more cross-sell with our Enterprise Application Access product in Guardicore and ETP. And then I'll turn the other question over to Ed."
},
{
"speaker": "Ed McGowan",
"text": "Jim. Yes. So what I'd say about Zero Trust is we ended the year on a run rate of about $200 million in Zero Trust. And we had a very strong finish to Guardicore. In Guardicore, we'd expect this year to be on a run rate of $100 million. So a very, very strong finish to the year with Guardicore."
},
{
"speaker": "James Fish",
"text": "Helpful. And just a follow-up on the compute side. A big question we've been getting is whether the compute business could get traction really outside the media vertical? Or is that really going to be the focus in terms of gaming and streaming kind of storage and compute on the back end? And kind of what's the confidence level that you're not going to see an erosion in that more traditional windows that's SMB based?"
},
{
"speaker": "Tom Leighton",
"text": "I think media is the big first set of adopters. In fact, as you know, one of the world's largest, if not the largest social media company is already using it. And I think that's because media really is concerned about performance. And so we're doing things like transcoding, much closer to the end user. And that's a key thesis of our architecture and our approach to compute is to be much more distributed with the compute, have containers and VMs much closer to the end users. Gaming, another example, what that makes a lot of sense. Things like leaderboards, manage groups of users as they play the game, you need low latency, there's a lot of back and forth with the clients and you want that to be close to the end user. That said, this is not limited to media. Commerce is also very sensitive to performance, and we've already signed up commerce companies. And commerce companies, of course, especially with these macroeconomic challenges. Akamai Connected Cloud, better performance at a more competitive price point. So I think you'll see penetration in the commerce vertical as well. And of course, Akamai is really close to the big companies in media and commerce. I have the opportunity to talk to the most senior executives in many of these companies, and they're very interested in what we can do for them. And they've been asking us to do this. And I think they're excited about the potential Akamai Connected Cloud. I think down the road, take a little bit longer. The financial vertical is another vertical that's very strong for Akamai because of our work in security and our market-leading products there. There, we have a little bit more work to do on the certifications. The bar is a little bit higher for financial institutions, but I think that would follow media and commerce in terms of adoption of Akamai Connected Cloud."
},
{
"speaker": "Operator",
"text": "Our next question will come from James Breen with William Blair."
},
{
"speaker": "James Breen",
"text": "Can you just talk a little bit about sort of the internal decision-making around shifting resources to the security and cloud side and maybe a little bit on the delivery side of market share to some extent, giving up some market share within that business sort of better for the overall profitability in the long term?"
},
{
"speaker": "Tom Leighton",
"text": "Well, yes, I think it makes good sense to be shifting resources towards the higher growth areas both security but especially in cloud computing. I think we'll see a lot stronger return on the investment. We still have the market-leading delivery business. We haven't lost share, to the best of my knowledge. We have turned away some -- a small amount of the business that's very spiky. And that doesn't make as much sense for us to take that business at the price point isn't right today. And that's because traffic growth rates are lower than they used to be. So you have to spend money to build out for the spike. And if your traffic growth rates are lower, it takes longer to fill that capacity on a daily basis. With delivery, your cost is associated with your peak and your revenue more associated with the daily usage or total aggregate usage. And so we have, as we've talked about, turned down some deals there just because the ROI doesn't make us much sense in this environment, and we get a lot better ROI from investing in compute and I think, obviously, security. And then within security, we're reallocating investment decisions there to focus more resources on the fastest-growing security products. So I think it just makes good sense. And for now with compute, it's something our customers are really asking us to do. And even in this challenging macroeconomic environment, it's something that I think the timing may be even a little bit better there because of that."
},
{
"speaker": "Operator",
"text": "Our next question will come from Keith Weiss with Morgan Stanley."
},
{
"speaker": "Keith Weiss",
"text": "Excellent. A couple of questions, I have a ton of questions, but I'll try to limit it to two or three. On the cloud computing side of the equation, the word of the year amongst investors has been optimization, and we've heard it from AWS, we've heard it from Azure. I'm really interested to hear how that impacted Linode. Given kind of being a lower cost provider in the marketplace, did you guys -- did you see optimization of people trying to sort of reduce the amount of consumption on your platform? Are you guys like more of a net beneficiary because of, people are ultimately seeking just kind of lower cost overall? And then also on cloud, I don't know, did you guys mention what the contribution was from Linode this quarter? I believe you guys have been given the kind of inorganic contribution over the past couple of quarters. And then I have one for Ed on the margin side of the equation."
},
{
"speaker": "Tom Leighton",
"text": "All right. I'll take the first part of that and let Ed take the second part. I think Linode is a much smaller company and really sort of a different market than the giant cloud companies that are maybe referring to optimization. So I didn't see -- we don't see a big impact on Linode. Now what we're doing is making Linode so it can be used by the big enterprises for mission-critical applications. And that, in part, is building out scale. It's making it be more distributed, available in more cities, integrating it with the Akamai platform and our Edge regions and increasing the functionality. So a lot of work taking place on the Linode platform so we can sell it at a much higher scale to major enterprises. And we're in the stage now with early adopters there. And I think as we get towards the end of this year, we'll be in a position to take on a lot more business there. And I think the value proposition is that we would have better performance will be more distributed, closer to end users at a more competitive price point. And I think in this environment, yes, pricing matters, especially if you look at -- as we talked about, big media, big commerce, they care. And they are spending a lot in the cloud today. So I think that's the phenomenon you'll see take effect as we're in a position to take on more large-scale business for large enterprises. And then Ed, you can take the second part of that question."
},
{
"speaker": "Ed McGowan",
"text": "Yes, sure. So Linode, it will get more difficult to break up sort of merging in with everything, but it was about $34 million, a little over $34 million. We did see a slight increase in the growth rate as the year went on, and we haven't seen any change in the consumption around optimization, meaning folks are using less of the cloud at this point."
},
{
"speaker": "Keith Weiss",
"text": "Perfect. Perfect. And then on the expense side of the equation. I just want to make sure I understanding this correctly. It sounds like you're slowing down or pausing hiring and I'm assuming you close those positions that could be hired into them, but you just like tick it off of the job board, if you will, and then repositioning employees rather than any like restructuring or headcount reduction. So should the way that we should be thinking about it is you're aiming towards relatively flat headcount in 2023?"
},
{
"speaker": "Ed McGowan",
"text": "Yes, Keith. So the way to think it will probably go up a little bit. It won't be up as much as it's been up certainly last year. But I mean, you're thinking about it in the right way. And one of the things that we're fortunate enough to do is if you think about what we would -- the typical company would do if you didn't have the skill sets and how it should have to do a layoff, that's expensive and then you have to go hire new talent. We're fortunate enough in the areas that Tom talked about, whether it's development or build out of the network, the sales functions that we can shift those resources over. So if you think about the cost to build out what we're doing, would cause somebody else a significant amount of money, but we're able to shift those resources. And as far as the new headcount going forward, we're going to be pretty judicious with where we're hiring, but it's going to be primarily in the areas of cloud and security and maybe a few on the go-to-market side."
},
{
"speaker": "Keith Weiss",
"text": "Got it. And the shift take place both in terms of development as well as go-to-market? Or is it more so like the development resources are being shifted?"
},
{
"speaker": "Tom Leighton",
"text": "There's a lot of resources being shifted within our platform and delivery organizations. Think of the hundreds of people that are managing our network deployment that build out our 4,100 regions today and the tremendous scale we have, and they are now heavily focused on building out compute resources. Think of the people that manage the operations, the automatic deployment of software, the payload or the load balancing, the resiliency, they are heavily focused on incorporating those capabilities for compute, building on top of the Linode framework. So I would say the large majority of the resources are of that nature that we're retasking."
},
{
"speaker": "Operator",
"text": "Our next question will come from Tim Horan with Oppenheimer."
},
{
"speaker": "Tim Horan",
"text": "Also on the cloud, can you talk a little bit about your improvement in price and performance versus the comments? Can you give us some metrics there? And then can you talk a little bit about what type of cloud you're building out for? I know, Tom, in the past, you were a little skeptical that we could do kind of gaming as a service over cloud infrastructure. Is that changing? And you could optimize your cloud for AI or blockchain or more networking or very, very low latency? Just any color there? And then lastly, have you contemplated maybe partnering with some of the larger cloud providers with AI really starting to take off? Can you be a partner to a few of them or one of them that would really accelerate things?"
},
{
"speaker": "Tom Leighton",
"text": "Yes, good questions. We'll be the most distributed cloud services provider. And of course, we start with 4,100 POPs for function as a service, JavaScript at the edge. And we're building out the core cloud capabilities. And then this notion of the -- of a more distributed containers closer to the edge, VMs closer to the edge. Now that will give you better performance for things where you want to be close to the end user because it will be closer to more end users will be in some cases, countries where you don't have a presence from the hyperscalers. And our pricing will be less already. You can look at the list pricing and see that it's less than what the hyperscalers charge. And we're -- because we're integrating it with our backbone and with our edge platform, that gives us great economics on the delivery, taking the data in and out of storage or compute and getting it to end users. We're in a position to do that at a lower cost and to give consumers a better price point. Yes, this works not for all gaming functions, but for a lot of the things you want to do with gaming. It's a great use case, streaming, obviously, transcoding, APIs, chatting APIs, people communicating during a sporting event. That's all -- is very relevant to having a more distributed model. AI, I think elementary stuff you can put in a container or VM yes, that makes perfect sense. If you want to have the monolithic storage associated with that, that's more cloud, core cloud compute, I would say. I think in terms of partnering, yes, we have a lot of customers that obviously use Akamai services today as well as the cloud giants. In fact, the cloud giants themselves, a couple of them are very large Akamai customers. And so they also use their own services. So I think it's an ecosystem where, yes, I think there'll be customers that would use us and use the hyperscalers depending on the application and what they're looking to do. And we very much believe in a multi-cloud approach."
},
{
"speaker": "Operator",
"text": "Our next question will come from Mark Murphy with JPMorgan."
},
{
"speaker": "Mark Murphy",
"text": "Is it possible to ballpark the revenue contribution that was driven by this huge scale of the World Cup so that we could then remove that from our models for the next 3 years and then, I guess, presumably included back in year four?"
},
{
"speaker": "Ed McGowan",
"text": "Yes. Mark, it's Ed. There's about $5 million, roughly."
},
{
"speaker": "Mark Murphy",
"text": "Okay. Got it. And then as a follow-up, just to clarify, during Q4, were you able to capture some of the business that Amazon is losing either due to the lower pricing structure that you have for Linode or because you have this advantage of broader points of presence? I guess I'm just interested in -- it sounds like from what you're describing, that potential is there. I'm just wondering if there was a material benefit or tailwind from that in Q4?"
},
{
"speaker": "Tom Leighton",
"text": "Not in compute in Q4. Obviously, we compete very successfully in delivery and security with the hyperscalers. We're the market leader there. Now in compute, they are the market leaders by far. And so nothing that we would do in compute is going to make any difference to them. I mean we're looking to get to a 1% market share in a market that's $100 billion to $200 billion a year. So it will take us a while in compute before I think a hyperscaler would even really, really notice. And of course, a 1% or 2% market share means a lot to us in compute, that's several billion dollars means less, obviously, to folks at the scale of those guys."
},
{
"speaker": "Operator",
"text": "Our next question will come from Rishi Jaluria with RBC."
},
{
"speaker": "Rishi Jaluria",
"text": "Wonderful. I've got two. First, I wanted to start on the compute side of the equation. I appreciate all the color around CapEx. And please forgive me if my math is shouty over here. But if I just do a rough back of the envelope numbers, right, with 9% of total revenue being CapEx, specifically for the compute business and then I strip out $100 million of nonrecurring, that's still telling me that CapEx -- compute CapEx this year in 2023 is going to be 45% of compute revenue, which, again, it's a growing business and everything. Number one, am I directionally thinking about this? And maybe number -- piece number 2 to that is, how should we be thinking about steady state CapEx for the compute business once we get through maybe the next year or 1.5 years? And then I've got a follow-up."
},
{
"speaker": "Ed McGowan",
"text": "Yes, sure. So you're doing the math right. So the way to think about the $100 million, that will enable us for our internal use, that will enable us to save lot more than $100 million. So think of it -- you think about it right in terms of as a onetime sort of burst of a charge. Obviously, if we continue to use our own compute capabilities over time down the road. We will be adding a little bit from time to time there. But you're thinking about that correctly. In terms of what does the steady state look like? We talked at the Analyst Day about how you can approximate sort of future growth percentage with what you would spend. So for example, if we are -- of the $1 billion we're spending 30% in CapEx, our growth rate would be probably around 30%. It's not quite dollar for dollar, but it’s sort of a rough approximation. So think of us spending roughly $100 million this year on internal use another, say, call it, 225 to 250 depending on where you are on your models. That enables you to get that type of revenue scale potentially. Obviously, it's going to have to play out in the market to be a little bit more if we get a little bit less. That's a pretty decent rule of thumb. And then obviously, as we're growing out these locations, we're pretty ambitious in terms of the core locations that we're putting online also distributed locations are putting online. We're going to be investing ahead of revenue. So I would expect for the next 1.5 years or 2 years to have elevated CapEx related to the compute business, and we'll start to scale into it."
},
{
"speaker": "Rishi Jaluria",
"text": "Okay. Got it. That's helpful. And then just maybe going back to the security business. Going past this year, longer term, what needs to happen to see security overall reaccelerate growth rate that you'd be happy with? Is that primarily going to be driven by a continued Guardicore mix shift? Is that going to be more on the Zero Trust portfolio ex Guardicore? Maybe walk us through kind of what needs to happen to get security up to kind of an organic growth rate that you'd be happy with?"
},
{
"speaker": "Tom Leighton",
"text": "Yes. No, I think you characterized it well, and it is more the mix shift to the newer products for us that are growing at a rapid rate, but are still relatively small. We've got a substantial return from Bot Manager now. That's a great example, starting to really help. Next is Guardicore, which, as Ed mentioned, we want to -- as we exit should be at over $100 million run rate. And once you start getting to that size and it's rapidly growing, it starts making a difference for the big security number. And of course, as that number gets bigger, it obviously gets more challenging to maintain the higher growth rates. We're continuing to invest in new capabilities there. Account Protector is off to a very good start, really excited about that. But it will take time to do that. And we're continuing to look for potential acquisitions that can help jump start growth. I don't think anything huge. It gets you the return right away, but areas that we think are really important that we can become market leaders in like we've done for application firewall, bot management, for segmentation and that over then a period of years can drive significant growth for us."
},
{
"speaker": "Operator",
"text": "Next question will come from Amit Daryanani with Evercore."
},
{
"speaker": "Amit Daryanani",
"text": "Two questions for me as well. I guess the first one, when we think about 2% to 4% kind of top line growth in '23 in constant currency, I think you talked about security growing double digits. Is there a way to think about how do you think growth stacks up on the compute and delivery side as well for the year?"
},
{
"speaker": "Ed McGowan",
"text": "Yes, sure. So well, we didn't give specific guidance for either delivery or compute. Tom did talk about us achieving $0.5 billion or so in compute revenue. So depending on where you put your models, you decide the $0.5 billion for compute and just solve for the delivery. I think if you were to be on the higher end of the business, delivery might do a little bit better as we saw in Q4, potentially get security going. If the macroeconomic conditions improve and then obviously there really is just a timing issue in terms of when we can start moving major workloads on compute."
},
{
"speaker": "Amit Daryanani",
"text": "Got it. And then as we think about sort of the path from, let's just say, 27.5% operating margins that you'll be at in '23, towards just 30% kind of target you folks have had in the -- you have now actually, what do you think takes to achieve that target? Is there a revenue number that you need to get there or a mix or the cost reduction? If you could just maybe provide a bit of a bridge on how do you get from 27.5% to 30% EBIT margins, that would be really helpful?"
},
{
"speaker": "Ed McGowan",
"text": "Yes. So it's a little bit of everything, right? But I think as we laid out about five or six different things that we're doing, probably the biggest near-term item would be the third-party cloud costs. So as we migrate that our own cloud, we're going to save about $100 million or so. Think about that as some of that will happen this year, a lot more of it in '24 and then by '25, we should have almost the majority of our internal cloud or third-party cloud on our eternal system. So that's 2 points to 3 points right there. Colocation, I talked a bit about the audit of the ASC 842 in lease accounting. We have a little bit more of a burden that we have to take at the beginning of some of these longer-term agreements. But also, we're spending on colocation that we haven't quite scaled into yet. So there's your question about revenue. As revenue scales, you'll get scale with your margins. And then just through some of the depreciation savings that we're getting on delivery and the real estate savings. We're spending, call it, before this year around $100 million in real estate, we're going to save about $20 million this year. Probably room to get maybe another $20 million or $30 million out of that as well. So it's really a combination of getting the compute revenue to scale into our investments in mostly our colocation facilities and third-party cloud savings, those are probably the two biggest areas for margin expansion."
},
{
"speaker": "Amit Daryanani",
"text": "Perfect. It sounds like most of the ramp to margins is going to be driven by self-help levers versus revenue tailwinds. I mean, it seems like the skew might be a bit more on self-help. Is that a fair way to characterize it?"
},
{
"speaker": "Ed McGowan",
"text": "Yes. I mean I think that's -- when you look at the size of those numbers, certainly, I mean, obviously, revenue cures all your rails, right? We've got a pretty scalable model. So if we see acceleration in revenue, especially on the compute side, you're going to see a pretty good flow-through. But yes, there's a lot in our control here. And I think we're doing the responsible things as far as hiring goes, shifting resources, focusing on reducing our real estate costs and really focusing on driving down that third-party cloud cost, which is really taken a pretty big chunk out of our gross margin."
},
{
"speaker": "Operator",
"text": "Our next question will come from Fatima Boolani with Citi."
},
{
"speaker": "Fatima Boolani",
"text": "Two for me. On the delivery segment, the last couple of years for you have been maybe a little bit more erratic just by way of lapping some of the benefits from the pandemic, some of the dynamics you saw in the gaming area where trends are moderating. So at a high level for you, when we think about the underlying cadence from a volume perspective, what are you assuming that's maybe different the same, better or worse versus the trends you saw this year? And I'm considering the renewal cohort what you've mentioned around holding on pricing. So any sort of color commentary you can give us for the delivery segment in terms of traffic trends and then pricing trends under the hood? And then I have a follow-up, please."
},
{
"speaker": "Ed McGowan",
"text": "Yes, sure. Great question. So let me see if I can pick that all at once here. So in terms of the major renewals, we don't have nearly as many major renewals as we had last year. So that's going to be one thing that works in our favor. We are not anticipating in our guidance any significant increase in traffic in terms of levels of growth that we saw last year. We're anticipating a slight increase, but nothing significant. We're anticipating that and we're starting to see that price declines are moderating a bit. They're not nearly as steep as they've been in the past. And then we will continue our posture in terms of being a little bit more selective with some of the spiky traffic. Once we start seeing volumes get back to the historical Internet growth rates and beyond, then maybe that posture may change, but that's the way we're going to play it for now."
},
{
"speaker": "Fatima Boolani",
"text": "I appreciate that. And just the delineation between your U.S. business and the international business, anything you can point to by way of geographical differences in procurement? Is there more sensitivity on budgets in the U.S. versus international? Any characterization there because international continues to be a stronghold for you versus some of the -- maybe some of the malaise on the U.S. side, but would love to get a little bit more granular on what's continuing to drive that strength and if some of that budgetary pressure that you alluded to on the security side is maybe showing up more pronouncedly in U.S. versus international? That's it for me."
},
{
"speaker": "Ed McGowan",
"text": "Sure. Yes, I would say just kind of general macro across all regions. I'd say new customer acquisition is more challenging in an environment like this. And I think you hear a lot of companies talk about that. We're seeing that as well. In terms of geographic, obviously, the European economy is struggling a bit more than we are in the U.S., slightly higher inflation, et cetera. So I expect that area to be a bit more weaker than what I'm seeing in the U.S. Asia is still been pretty strong. Latin America has been pretty strong. U.S. has been kind of holding firm here. But I would expect the European business, in particular, is to be the most impacted by the macroeconomic factors."
},
{
"speaker": "Operator",
"text": "Our next question will come from Frank Louthan with Raymond James."
},
{
"speaker": "Frank Louthan",
"text": "So with the significant number of POPs that you have already, what is it about the cloud platform that you need to expand these sites? What is about the location and the capabilities that they bring for expanding the compute platform that you generally have? And then you touched on a possibility for M&A. What do you consider significant? And what are the -- what size M&A do you think you might be looking at if you do any in the next 12 months?"
},
{
"speaker": "Tom Leighton",
"text": "Yes. So on the Akamai Connected Cloud architecture, we already have 4,100 edge regions. And these regions do delivery and security. They're the first line of defense. They also do what we call edge computing, which is function as a service, JavaScript at the edge. Now in the core, where Linode had 11 data centers, and we're going to more than double that, you have very large-scale storage object and block storage. You've got VM as a service, Container as a Service, Kubernetes, core cloud compute. Now we're adding also an intermediate layer, we call those sort of the distributed compute layer. And this would have not the monolithic storage, but you'd have containers as a service. Kubernetes, VMs as a service, so you could do compute there. And so what you do and where you want to do it depends on the application, things that are a lot of back and forth with the end user that are lighter weight, that could be handled in JavaScript. You want to be doing that in the 4,100 edge regions, something like transcoding, you're doing some data processing, you got an app in a container, but performance matters, you want to be close to the end user or say a gaming application that you'll want to do in our distributed edge platform. And the reason we have that is there's a lot of cities and places in the world that don't have a giant cloud data center there. And they can't really take advantage of the cloud for applications that have -- where the proximity to the user is important, and so that's something that we want to be able to provide. So there's three sort of levels here of compute and you want to be actually using generally all three for a major company, but the specific application dictates where you want to be doing it and what combination that you want to use."
},
{
"speaker": "Frank Louthan",
"text": "Okay. Potential for M&A and thoughts on what you would consider significant versus more tuck-in?"
},
{
"speaker": "Tom Leighton",
"text": "Yes, good. So I think tuck-ins are a team that has the beginnings of a product or technology that we can scale on behalf of our customers. We've done a lot of acquisitions like that. More substantial would be something like Guardicore that had, at that time, the #2 product in the marketplace, and we've invested around that. They're now #1, which is great to see and a more significant cost associated with that. And they had a developed product already. Go back farther Prolexic is another example of that where they had a developed product, they already had $40 million, $50 million in ARR. And those are -- we do occasionally, and we're always looking. But we do those occasionally. But more you'll see the tech tuck-ins and then we develop from there."
},
{
"speaker": "Operator",
"text": "Our next question will come from Rudy Kessinger with D.A. Davidson."
},
{
"speaker": "Rudy Kessinger",
"text": "I guess I'm curious, how did the macro trend in the quarter just with deals lengthening? And how many deals did you see push, I guess, relative to Q3? And the guide assumes no positive or negative change in the macro. Just why make that assumption, why not be a bit more conservative, maybe assuming it gets a little worse?"
},
{
"speaker": "Ed McGowan",
"text": "Yes. So this is Ed. So in terms of the biggest impact on the quarter, I would say coming in, we're expecting potentially a weak commerce season. We actually saw a pretty decent commerce season. We saw a decent video traffic. We saw obviously, we talked about the World Cup being better than our expectations. I would say gaming was noticeably weak. We didn't see as much activities you typically see. And then from the sales side, a couple of deals pushed a few large Guardicore deals we track that push and then also new customer acquisitions are slower than we'd like to see. Those are really the big things. Then as far as the macroeconomic conditions, it's tough when you sit in the seat to try to play economist. And with us, obviously, exit has probably the biggest impact on us more than anything, given we've got longer-term contracts. But it's hard to say that, look, things can change and get dramatically worse. I'm just expecting what I see right now in front of us in terms of the macroeconomic environment is challenging, but I think we can navigate it pretty well. So that's what we based our guidance on. If things change, we'll obviously update the guidance. But I was just trying to -- a lot of times people asked me what was what we were thinking as you put your guidance that are you expecting things to get dramatically worse. In this case, no, I expect things to be dramatically better not kind of roughly the end if things do change, we'll obviously update you as we get more information."
},
{
"speaker": "Rudy Kessinger",
"text": "Yes. Okay. That's fair. And then at a higher level, I mean, obviously, it sounds like compute has kind of slotted into growth priority one, if you will, kind of ahead of security. And just at the high level, I'm curious what really is giving you conviction to invest so much in compute. Is it the early customers that you've signed? Is it just conversations? Is it the pipeline growth you've seen over the last few quarters since you made the acquisition? What's giving you so much conviction to make such a large investment go-on on compute?"
},
{
"speaker": "Tom Leighton",
"text": "Well, it's all of the above plus the compelling logic of the situation. As I mentioned, I do have the opportunity to meet with the senior most executives that a lot of the world's largest companies, especially you think media, commerce, gaming and so forth. And there is a lot of interest there in our ability to help them. They're in a situation where they're spending a ton on third-party cloud. It's growing rapidly. Many of them describe it as being out of control. and it's even hard to know how big it will get. In some cases, they're spending this with a competitor. And on top of it, they've got major company initiatives to cut cost because of the challenging global economic conditions. And so when we can offer them a service with at least as good, better performance, at a lower price point, that's very attractive. Now on top of it, these companies, they know us well. They already trust us with scale and performance and security because we provide the vast majority of their delivery and security. So we are a very logical choice. It's not like we're just somebody coming along here saying, hey, we got a cloud service. It's not like that at all. We've got a lot of credibility with these companies and they are pretty clear that they think this could be very attractive for them. In fact, I think one of the analysts on this call did a survey of 50 of our larger customers have found the same thing. The same thing was reported to them. So we see that our customers need that and would like to shift business to us, but we want to get ready for that and help them. And that means building out the capacity building out the new distributed architecture and getting the functionality to the level that they're going to be comfortable putting mission-critical applications at very large scale on our platform. And of course, Akamai will be one of the first examples of that. We're going to place our services that are used by pretty much all the major enterprises, a lot of the major enterprises out there for, for example, security onto our platform. And that will be another great proof point that Akamai Connected Cloud is really going to work for them."
},
{
"speaker": "Operator",
"text": "Our next question will come from Ray McDonough with Guggenheim."
},
{
"speaker": "Ray McDonough",
"text": "Tom, maybe just to ask the M&A question in a slightly different way. As we think about the strategic plan going forward, do you feel the organization has enough operational capacity to continue to expand Linode right now and do another acquisition in security at this point to help you reaccelerate growth? And is 20% long-term growth including acquisitions in the security business, something you are still targeting after this year?"
},
{
"speaker": "Tom Leighton",
"text": "Yes, good question. First, the work on Linode which is extensive is use different teams by and large than our security technology group. And so yes, we are in a position that we can continue that work and also do security acquisition. I don’t think there’s any challenge there. Now we have, as we talked about, retask a lot of the positions, either people or positions from our platform and delivery organizations to the compute effort. So there is a lot of effort there, and that will be increasing throughout the year. Now in terms of the 20%, what we're talking about is we're guiding this year into the low double digits and then we'll see where we are. Obviously, we'd like to be growing faster than that, but there are very challenging conditions out there, as we've talked about, and we'll have to see. So we'll update that guidance as we -- maybe we get to an Investor Day or get into next year. But right now, we're just guiding for this year in security in the low double digits."
},
{
"speaker": "Ray McDonough",
"text": "Great. And one more, if I could. The work we've done on Land does suggest your customer base is interested in leveraging Linode. And when I think about sort of the lead times for capacity additions in the data center space that you've already leased, how long are the lead times to fill that data center space? And at what point would you expect it at least to get to a somewhat full utilization of just the space that you've already contracted for?"
},
{
"speaker": "Tom Leighton",
"text": "Yes. So good question. There's the contracting, there's the build-out, there's getting it all turned on. And the way you want to think of it is we would be doing the core data center build-out. The focus of that is in the first half, and we'll have a lot of that done then, and we should finish that early in the second half or get substantially more than we have today. And then late in the second half, taking on the distributed architecture, we should have a bunch of those regions turned on live later in the year. And at that point and also, at the same time, getting the certifications in place, virtual private cloud, other capabilities that the big enterprises need so that when we get to the later part of the year, we're in a position that we can take on this business, and it will just happen all at once. A major enterprise will try it, use some applications and then some of the big ones, you port some of the traffic over. And so I think the major feeling of it and use of it really comes more in '24, not so much this year. We expect, as we talked about this year to do about $0.5 billion in compute. But the real growth, I think and the monetization of what we are building out now comes in '24 and '25. And also for our own use. This year, we are in the process of porting our own applications. And as Ed talked about we are going to save some this year but really the big savings for us comes in '24. So that's the way I think to think about it."
},
{
"speaker": "Tom Barth",
"text": "Well, it is Valentine's Day. So we're in a little bit over. But operator, why don't we take one more question? I know there's probably a few more, but let's just take one more and we'll end the call."
},
{
"speaker": "Operator",
"text": "Okay. Our last question will come from Michael Elias with Cowen & Company."
},
{
"speaker": "Michael Elias",
"text": "Just two questions for you. The first is you talked about some Guardicore deals slipping. And last quarter, there was commentary around longating sales cycles. Just wondering if you could give us some color on how sales cycles have evolved for not only Guardicore but the broader portfolio? And then my second question for you is maybe to phrase it a different or frame it a different way, is there a rule of thumb that we should use to think about the correlation between incremental revenue and incremental megawatts of data center capacity that you need, i.e., to support an incremental $100 million in compute revenue, you would need x amount of megawatts?"
},
{
"speaker": "Ed McGowan",
"text": "All right. I'll try, the second one is going to be a little bit more challenging and maybe I'll come back with a metric on that one. I don't have exact metric down to the megawatt, but I'm sure somewhere in the business, I can find somebody who does. But I've sort of used sort of a rule of thumb of $1 of CapEx is $1 of revenue roughly speaking, that may change a bit, but sort of a good rule of thumb. In terms of sales cycles, the good news with the deals slipping is they're not going away. This is typically a big purchase that you make, especially with Guardicore that it could be something where the decision-maker is just pushing it off a quarter or two. And it's not that the deals are losing. It just becomes a longer sales cycle and a fight for budget. In terms of just overall sales cycles, like I said, the biggest impact is new customers, right? It's a lot easier with your existing customers, you're going through renewal cycles, you're having upgrade conversations and things like that, getting new customers to open up a new buying pattern is challenging. I do think one thing that will work in our advantage in all of this, though, is as we talk about compute and the need to find a cheaper alternative go multi-cloud. I think that's going to work in our favor. So I think one thing this -- all the negatives that come with the macroeconomic backdrop that we have. I think that's one positive that will work in our favor, and we are starting to see our pipeline grow pretty dramatically in that area. And as Tom talked about, we should start to see deals close towards the back half of the year and then really set ourselves up for '24."
},
{
"speaker": "Tom Barth",
"text": "Okay. Well, thank you, Michael. Thank you, everyone. And in closing, we'll be presenting at several investor conferences and events throughout the rest of the first quarter. Details of these can be found in the Investor Relations section at akamai.com. We want to thank all of you for joining us, and we wish you a very good health and good health to your family. So have a nice evening. Take care."
},
{
"speaker": "Operator",
"text": "The conference has now concluded. Thank you for attending today's presentation. You may now disconnect."
}
] | Akamai Technologies, Inc. | 24,522 |
AKAM | 3 | 2,022 | 2022-11-08 16:30:00 | Operator: Good day, and welcome to the Akamai Technologies Third Quarter 2022 Earnings Conference Call. [Operator Instructions]. I would now like to turn the conference over to Tom Barth, Head of Investor Relations. Please go ahead, sir.
Tom Barth: Thank you, operator. Good afternoon, everyone, and thank you for joining Akamai's Third Quarter 2022 Earnings Call. Speaking today will be Tom Leighton, Akamai's Chief Executive Officer; and Ed McGowan, Akamai's Chief Financial Officer. Please note that today's comments include forward-looking statements, including statements regarding revenue and earnings guidance. These forward-looking statements are subject to risks and uncertainties and involve a number of factors that could cause actual results to differ materially from those expressed or implied by such statements. The factors include any impact from macroeconomic trends, the integration of any acquisitions and any impact from geopolitical developments. Additional information concerning these factors is contained in Akamai's filings with the SEC, including our annual report on Form 10-K and quarterly reports on Form 10-Q. The forward-looking statements included in this call represent the company's view on November 8, 2022. Akamai disclaims any obligation to update these statements to reflect new information, future events or circumstances, except as required by law. As a reminder, we'll be referring to some non-GAAP financial metrics during today's call. A detailed reconciliation of GAAP and non-GAAP metrics can be found under the financial portion of the Investor Relations section of akamai.com. And with that, let me turn the call over to Tom.
Thomson Leighton: Thanks, Tom, and thank you all for joining us today. I'm pleased to report that Akamai delivered strong results in the third quarter despite the ongoing challenges with the global economic environment and the effects of a strong U.S. dollar. Q3 revenue was $882 million, up 3% year-over-year and up 7% in constant currency. This result was driven by the continued strong growth of our security and compute businesses, which collectively grew 23% year-over-year and 28% in constant currency. These 2 business lines accounted for 55% of our overall revenue in the quarter. Q3 non-GAAP operating margin was 28%. And non-GAAP EPS was $1.26 per diluted share, down 13% year-over-year or down 7% in constant currency. EPS was negatively impacted once again by foreign exchange rates and a higher effective tax rate compared to last year. Free cash flow was very strong at $271 million in Q3, and it amounted to 31% of our revenue. I'll now say a few words about each of our 3 main lines of business, starting with security. Our Security solutions generated revenue of $380 million in Q3, up 13% year-over-year and up 19% in constant currency. The growth was particularly strong for our enterprise Zero Trust products, which were up 51% year-over-year in constant currency. Our Guardicore Segmentation solution continued to lead the way with several major customer wins. For example, one of the largest energy companies in the world adopted Guardicore to help protect against SolarWinds types of ransomware attacks. A leading global developer of dietary supplements adopted our Segmentation solution to help meet European regulations and limit cybersecurity risk. And a major South American broadcaster deployed Guardicore to protect their reporting of election results. Our market-leading app and API protection products also performed well in Q3, with many wins against the competition. For example, the largest bank in Southeast Asia came to Akamai last quarter after suffering repeated outages by a competitor that had lured them in with low pricing. When the bank faced large fines from regulators for the extended outages, they saw more value in being back on Akamai's platform. One of the top banks in North America is in the process of bringing all of their traffic back to Akamai after struggling with outages at another competitor who would also lure them in with lower pricing, but couldn't deliver the performance and reliability needed by a major enterprise. After testing our capabilities against competitors, one of the world's largest financial services companies expanded their relationship with us, contracting for 10 of our products and services, including Bot Manager and Page Integrity Manager. A Fortune 100 food processor and commodities trader became a new Akamai customer last quarter after an anonymous threat drove them to seek better DDoS and web app protection than they were getting from a competitor. And in Germany, an online advertising business with one of the country's busiest websites suffered severe account takeover attacks, load problems and reputation damage before coming to Akamai for bot management and app and API protection. Given such examples, it's not surprising that Akamai's web app and API protection was named a leader in both Gartner's Magic Quadrant and in Forrester's Wave report last quarter. Our compute product group also performed well in Q3 with revenue of $109 million, up 72% year-over-year and up 77% in constant currency. We're continuing to make good progress on integrating Linode into our edge platform and on adding the capabilities and scale needed to support mission-critical applications for major enterprises. In particular, we've connected all of Linode's 11 existing locations into our private backbone, enabling us to provide lower latency, higher throughput and improved egress economics. We've also expanded the capacity of these facilities and are in the process of adding 13 additional sites, 5 of which are expected to go live in Q1 with 8 more planned for Q2. As we discussed at our Analyst Day in May, we're also developing a lighter-weight deployment model that is suitable for distribution at a broad scale. This will enable us to get compute much closer to end users around the world. We plan to deploy several dozen of these lighter-weight sites next year, at which point we expect to compare well with the hyperscalers in terms of points of presence and proximity to both enterprise data centers and end users. Of course, we plan to have all of our compute sites integrated into Akamai's unique edge platform, which has over 4,000 locations for edge computing. As a result, we expect to be able to offer superior performance as well as lower total cost of ownership for enterprise computing needs. We've also made significant progress on adding new and improved enterprise capabilities to our compute platform. We launched Database-as-a-Service with managed MySQL in May and managed Postgres in June. We released the next generation of our Kubernetes platform in Q3 to enhance performance and reliability. We expect to launch early versions of an enhanced object storage product as well as next-gen serverless capabilities next quarter. And we expect to become SOC 2 and ISO 27001 compliant this quarter with PCI compliance expected to follow in the first half of 2023. Although we still have much work to do, we're encouraged by the customer use cases that our compute platform began serving in Q3. One of the world's top development studios for gaming moved their matchmaking service to Akamai to help them with data processing and analysis. A large online legal services platform in India chose Akamai as part of their multi-cloud strategy after they concluded that we could help them optimize their cloud computing budget. And a large media workflow company in Germany is planning to migrate their apps from a hyperscaler to Akamai, calling our new capabilities a great addition, especially with the plans for a high number of distributed sites and the tight integration with Akamai content delivery. Over the past few months, I've spoken with many of the world's leading enterprises about our plans for cloud computing. Most tell me that they want more choice in cloud computing, and they often express concern about being locked into contracts with cloud giants that are consuming larger portions of their IT budgets, especially in cases when their cloud vendor is also a direct competitor. Customers also understand the value of leveraging a more widely distributed cloud platform and one that directly connects to Akamai's unique edge platform with over 4,000 points of presence. Turning now to our CDN business. Our delivery products generated revenue of $393 million in Q3, down 15% year-over-year and down 11% in constant currency. These results reflect continued deceleration in traffic growth among our largest customers and the impact of some large renewals that we completed in the first half of the year. As we said at our Analyst Day in May, we've aligned our pricing strategy with the slower traffic growth rates we've experienced this year. In addition to scaling back discounts upon renewal, we're continuing to decline business from a very small number of customers who have extreme traffic peaks compared to their daily usage patterns. While this resulted in less revenue in Q3, it's enabled us to meaningfully lower our delivery network CapEx as we direct cash flow from our delivery business to our compute and security businesses where we have a higher ROI. As Ed will detail shortly, we're also taking several steps to reduce OpEx, including reducing our real estate footprint and limiting hiring to our most critical areas. Although we're facing the same challenging macroeconomic environment as other companies, I believe that Akamai is on the right path to long-term growth and success with our disciplined management of expenses and strong focus on opportunities for future growth such as cloud computing. Becoming a force in the enormous cloud computing market won't be easy, but I believe that it's something that Akamai can accomplish. Akamai has a strong track record of continuous innovation and business expansion. Along the way, we've achieved significant milestones that many thought were impossible. In our first decade, we pioneered the CDN industry. a multibillion dollar market, where we remain the leader by far. In our second decade, we created the industry for app and API protection as a cloud service, our second multibillion dollar market, where we are the leader by a wide margin. Looking ahead, Akamai is on the cusp of another major phase of expansion with our foray into cloud computing. Having already scaled content delivery and cloud security into billion dollar businesses, we now have an opportunity to do it again with cloud computing. In fact, I believe our opportunity in cloud computing is even larger than it's been for delivery and security. Cloud computing is a $100 billion market growing at a very rapid rate. We believe we're in an excellent position to capture a share of this business, particularly from companies that value our market-leading delivery and security solutions and that don't want to be locked in to more expensive options with a cloud giant that competes against them. Akamai is a company that enterprises can trust to be their partner, to scale with their business and to provide the best when it comes to security, reliability and performance. By adding compute to our unique edge platform, we can provide a full suite of cloud services that will help lower our customers' cost to build, run, deliver and secure their applications. In summary, my confidence in Akamai's future prospects for growth and success has never been higher. In fact, my confidence in what I see ahead for Akamai has led me to take steps to put in place a 10b5-1 trading plan, not to sell, but to buy $3 million in Akamai stock over the next 6 months. We expect to announce the adoption of my plan in a formal filing later this week. Now I'll turn the call over to Ed for more on Q3 and our outlook. Ed?
Edward McGowan: Thank you, Tom. As Tom mentioned, Akamai delivered a solid quarter in Q3 despite a very challenging macroeconomic environment. Q3 revenue was $882 million, up 3% year-over-year or 7% in constant currency. The stronger U.S. dollar negatively impacted our year-over-year growth rate by approximately 4 points or about $39 million of revenue year-over-year and $14 million on a sequential basis. On a combined basis, our security and compute businesses represented 55% of total revenue, up 23% year-over-year and 28% in constant currency. Security revenue was $380 million and grew 13% year-over-year and 19% in constant currency, led by another strong contribution from Guardicore. Guardicore delivered approximately $14 million of revenue in Q3. Security represented 43% of total revenue in Q3, which is up 4 points from Q3 a year ago. Compute revenue was $109 million in Q3, up 72% year-over-year and 77% in constant currency. As Tom mentioned, while we are in the early innings of our cloud computing journey, we are very excited about initial feedback from customers and the significant growth opportunity ahead. Delivery revenue was $393 million, down 15% year-over-year and down 11% in constant currency. Sales in our international markets were $421 million and represented 48% of total revenue in Q3, up 1 point from Q2. International revenue was up 2% year-over-year or 12% in constant currency. Finally, revenue from our U.S. market was $461 million, up 3% year-over-year. Moving now to costs and profitability. Cash gross margin was 75%. GAAP gross margin, which includes both depreciation and stock-based compensation, was 61%. Non-GAAP cash operating expenses were $291 million. Adjusted EBITDA was $368 million, and our adjusted EBITDA margin was 42%. Non-GAAP operating income was $243 million, and our non-GAAP operating margin was 28%. It is worth noting that on a year-over-year basis, our non-GAAP operating margin was negatively impacted by approximately 1 point due to unfavorable foreign exchange rates. Capital expenditures in Q3, excluding equity compensation and capitalized interest expense, were $111 million. As we mentioned on our Q2 earnings call, our strategy in our delivery business is to be more selective on the peak traffic levels we will take on our network. As a result, delivery network CapEx, excluding Linode, was just under 4% of revenue in Q3. GAAP net income for the third quarter was $108 million or $0.68 of earnings per diluted share. Non-GAAP net income was $200 million or $1.26 of earnings per diluted share, down 13% year-over-year and down 7% in constant currency. It's worth noting that on a year-over-year basis, foreign exchange rates negatively impacted our non-GAAP EPS by approximately $0.10 in Q3. Taxes included in our non-GAAP earnings were $41 million based on a Q3 effective tax rate of approximately 17%. This was about 1 point higher than our guidance due to a more unfavorable mix between U.S. and foreign earnings. Now moving to cash and our use of capital. As of September 30, our cash, cash equivalents and marketable securities totaled approximately $1.4 billion. During the third quarter, we spent approximately $163 million to repurchase shares, buying back approximately 1.8 million shares. Our ongoing share repurchase activity has resulted in a net reduction in our non-GAAP fully diluted shares outstanding of approximately 5 million shares or roughly 3% on a year-over-year basis. We ended Q3 with approximately $1.4 billion remaining on our current repurchase authorization. Our intention is to continue to buy back shares to offset dilution from employee equity programs over time and to be opportunistic in both M&A and share repurchases. Before I provide our Q4 outlook and an update to our 2022 guidance, I want to highlight several factors. First, with nearly half of our revenue coming from outside the U.S., the strong U.S. dollar continues to be a significant headwind to our reported results. At current spot rates, our guidance now assumes foreign exchange will have a negative $130 million impact to revenue in 2022 on a year-over-year basis. As I mentioned previously, the strong dollar also impacts our margins and earnings. We estimate FX will negatively impact our non-GAAP operating margin by approximately 1 point year-over-year and non-GAAP earnings by approximately $0.34 for the full year 2022. Second, we have seen a lengthening in some of our sales cycles. We believe that is -- this primarily reflects the uncertain macroeconomic conditions that our customers are experiencing, and it is visible in many parts of our business. Finally, we continue to closely monitor our costs in light of ongoing inflationary and macroeconomic pressures across the globe. We have made good initial progress on our cost-cutting measures that we mentioned on our last call, which include real estate costs, where we sublease some of our underutilized office space in Q3, and we'll continue to look for additional savings going forward. Reducing our third-party cloud expense in 2023, where we look forward to making significant progress on shifting workloads to Linode. And lowering network CapEx associated with our delivery business, where I noted our continued progress on reducing spend significantly related to traffic delivery. In addition to these items, as Tom mentioned, we plan to be very disciplined with headcount and focus our investments on higher growth areas like cloud computing and security. In particular, we are closing over 500 open positions and re-tasking many other employees to work on compute. These closures went into effect today. And just a quick reminder about our typical fourth quarter dynamics before I turn to our Q4 guidance. As in prior years, seasonality plays a large role in determining our fourth quarter financial performance. We typically see higher-than-normal traffic for our large media customers and from seasonal online retail activity from our e-commerce customers, which are both difficult to predict, especially during this more challenging macroeconomic environment. With that in mind, we are projecting Q4 revenue in the range of $890 million to $915 million or down 2% to up 1% as reported or up 3% to 6% in constant currency over Q4 2021. Foreign exchange fluctuations are expected to have a negative $11 million impact on Q4 revenue compared to Q3 levels and a negative $44 million impact year-over-year. At these revenue levels, we expect cash gross margins of approximately 74%. This roughly 1 point sequential decline is primarily driven by increased third-party cloud costs and some compute-related data center build-out costs. Q4 non-GAAP operating expenses are projected to be $298 million to $306 million. We anticipate Q4 EBITDA margins of approximately 40% to 41%. We expect non-GAAP depreciation expense to be between $125 million to $126 million, and we expect non-GAAP operating margin to be approximately 27% for Q4. Moving on to CapEx. We expect to spend approximately $122 million to $127 million, excluding equity compensation and capitalized interest in the fourth quarter. This represents approximately 14% of projected total revenue. And with the overall revenue and spend configuration I just outlined, we expect Q4 non-GAAP EPS in the range of $1.23 to $1.30. This EPS guidance assumes taxes of $38 million to $40 million based on an estimated quarterly non-GAAP tax rate of approximately 16%. It also reflects a fully diluted share count of approximately 158 million shares. And finally, for the full year 2022, we now expect revenue of $3.58 billion to $3.6 billion, which is up 3% to 4% year-over-year as reported or up 7% to 8% in constant currency. We continue to expect security growth of approximately 20% in constant currency for the full year 2022. We now estimate non-GAAP operating margin to be approximately 28% and non-GAAP earnings per diluted share of $5.23 to $5.30. And this non-GAAP earnings guidance is based on a non-GAAP effective tax rate of approximately 16.5%, a fully diluted share count of approximately 116 million shares. Finally, full year CapEx is anticipated to be approximately 13% of revenue. In closing, we are very pleased with how the business is continuing to perform despite a very challenging macroeconomic backdrop. We are very excited about our future growth opportunities ahead. Thank you. Tom and I would be happy to take your questions. Operator?
Operator: [Operator Instructions]. Today's first question comes from Keith Weiss at Morgan Stanley.
Keith Weiss: Excellent. Nice quarter in a difficult environment. On that difficult environment point, I was hoping you could help with a little bit more specificity in terms of where you guys are seeing the macro impacts. It sounds like security is still holding up relatively well. And on the delivery side of the equation, there's some Akamai-specific impacts there. Could you give us some kind of detail in terms of where the risk factors are, sort of where the macro lies on a product and geographic perspective? I think that would be helpful. And then I guess on the CapEx side of the equation, you talked a little bit about types of business that you guys are not looking to take onboard on a go-forward basis, the very peaky workloads that perhaps were overly taxed in the system, if you will. Can that lead to a fundamental different kind of CapEx intensity for the business on a go-forward basis? Or is it just too small to make a difference?
Edward McGowan: Keith, this is Ed. I'll take those. I'll start with the second question first. So from a CapEx perspective, the way to think about it is in the delivery business, we had -- if you go back to our May Analyst Day, we talked about CapEx and delivery being in sort of the high single digits. We've been running in the lower single digits. We're just under 4%. So certainly, in the near term, it will have an impact in the delivery business. As the compute business gets larger, obviously, that's going to be the main driver for CapEx. But certainly, you saw that in Q3, the impact of overall CapEx down at around 13%, and for the year, it's around 13%. So it is less capital-intensive. But as we look at our cloud compute business, obviously, there's going to be some -- Tom talked about building out in more locations. So there'll be some more CapEx associated with that. But we are seeing a pretty healthy decline in our delivery business, which is as anticipated. On your first question, you asked about the macroeconomic environment where we're seeing some challenges. I mentioned in my prepared remarks that we are seeing some of our sales cycles lengthening, seeing customers pushing off upgrades for certain products and things like that, which is pretty typical. Most companies are doing that. I know we're -- we're doing something similar as we go through our budget cycles. We think it's temporary in nature. Also seeing a little bit of pressure in some of the advertising-related businesses, a little bit of pressure there. And then Europe is something that we're keeping a pretty close eye on, that's about geographically where we're worried. Obviously, with what's going on with energy costs and things like that in Europe, that's something that we're keeping a very close eye on and have been a little bit cautious on our guidance, I would say, in Q4, just relative to seasonality. Just trying to take that into consideration.
Keith Weiss: Got it. And on the energy cost, is that a top line concern in terms of you're worried about your -- what your customers are experiencing? Or is that more of a gross margin concern that you guys are worried that those energy costs can impact your gross margins on a go-forward basis?
Edward McGowan: Yes, I'd say it's more on our customers and their customers, so how does the consumer behave. Obviously, retail is a driver of seasonality as is spending for media. So those 2 things could be impacted. And then obviously, with our customers, if you see shutdown in manufacturing and things like that, that's obviously going to have a ripple effect on GDP across Europe. So that's from that perspective. As far as our risk with energy, we do a pretty good job. The team has done a nice job with our colo negotiations. If you think about our costs, our server costs were pretty insulated from costs there on the bandwidth side that tends to be deflationary. Colo, there is some energy exposure, but the team has done a really good job of trying to lock in longer-term deals. We're not seeing that. It's possible that may start to affect us later into next year. But right now, we've got it pretty well under control.
Operator: And our next question today comes from James Breen at William Blair.
James Breen: Can you just talk a little bit about the compute business? I recognize it was up a lot year-over-year after you closed Linode. It was up a few million quarter-to-quarter. What do you have to do to accelerate that business? Is it building out more resources? Is it just you're getting some larger customers? And sort of what are the thoughts there on what that could ultimately grow? It seems like with the opportunity, it could grow faster than the security business.
Thomson Leighton: Yes. Great question. The compute business, even before Linode, was on a pretty strong trajectory of growth. And with Linode, that accelerates it a lot. As you look to the future, the big growth comes when we're tapping into the core cloud compute market, a market that's over $100 billion today and growing rapidly. And that's something that we're working really hard on now to -- so we can exploit that next year. And that involves increasing scale, having a lot more core compute regions and then introducing the lighter-weight distributed computing regions. So that we'll be in a position to offer at least as good or better performance integration into the Akamai platform, which has great delivery, great security and, of course, edge computing at a lower total cost of ownership. And for a lot of our customers, especially you think of the media vertical and the commerce vertical, they spend a lot more on compute than they do with delivery and security. Moreover, they compete pretty heavily with the hyperscalers. So the big growth for us, what we're really going after over the next several years is in that core cloud compute market, mission-critical applications for major enterprises because that's a very big potential market for us. And that's what will drive our -- the major growth in compute, and ultimately, I think the company going forward.
Operator: And our next question today comes from James Fish at Piper Sandler.
James Fish: I appreciate the questions. Obviously, I agree with you on deceleration in traffic overall, especially on the media side. But what makes you guys confident that you aren't losing traffic share of some of the media customers, especially as you're purposely not doing some of these large events, for example, or kind of the gaming peak traffic? And any sense to how much that's kind of impacting the media business this quarter in this year overall that we should kind of normalize as we start to think about for next year?
Edward McGowan: Jim, this is Ed. Good question. So actually with traffic, we are starting to see a little bit of a recovery in September. It continued a bit in October as well. But in general, it is, as we talked about, a much lower year relative to what we typically see. As far as the specific customers, you're talking about only a handful of big customers that can drive this kind of peak. And these particular customers all have multi-CDN. So in this particular case, we did lose a couple of million dollars. It's not significant in terms of the impact on the year. But as you can see, it saved us about, call it, 4 points on CapEx. So it's pretty meaningful from an overall economic standpoint. Now that said, we still -- these still are big -- very big customers of ours. They've just sort of flattened out the peak a bit. So as their daily average traffic is not growing as quickly, the economics just don't work for us anymore. So we just -- they're still good customers of ours, but just decided we weren't going to allow them to peak as much as they did in the past. It just makes sense for us. But it's not an overly material number. A few million dollars is the way to think about it.
James Fish: That's helpful. I appreciate that. Maybe following up a little bit on Keith's prior question around more specifically on the security growth, which slowed to about 15% when I normalize everything. What makes you guys confident that we're going to see an acceleration of this business back to that 20% all-in constant currency growth rate over the next couple of years? And is the impact today being more felt on the new business side, given kind of your comments along elongating sales cycles? Or is it you're seeing a slowdown in existing customers' expansion as well?
Thomson Leighton: Yes. Good question. The 20% goal, of course, includes M&A, and we're about to do the year-over-year lapping on Guardicore, which is a very successful acquisition. And we haven't announced any other acquisitions in security to sort of fill that gap. In terms of increasing the security growth rate over time, obviously, the global economic conditions are important there. Also, we've got several of the newer products that are growing very rapidly. Aside from Guardicore, bot management doing extremely well. The new Account Protector solution doing very well. Page integrity management, which will be, I think, really important for companies that want to be PCI compliant beginning in 2025, and they're already working towards that. Those areas are doing very well in terms of growth, but they're still small enough in revenue that they can't swing the whole number as much. The vast majority of our security revenue today is in the app and the API protection area. And the large majority of that is in our web app firewall, where we're the market leader by far and continuing to grow that faster than the market and our competitors there. But that market is -- as a whole, is slower growing. So what we'll need to see is better economic environment, continued growth in the rapidly growing products that are -- as they get bigger, their rapid growth can drive security as a whole, and ultimately, M&A, which is a key part of the 20% goal.
Operator: And ladies and gentlemen, our next question today comes from Frank Louthan at Raymond James.
Frank Louthan: Great. With the sales cycle more elongated, can you give us a little more detail there? Is that across the board? Is it concentrated in any verticals? And give us a little bit more color on what's driving that. Is it more economic? Or is there anything to do with the mix with Linode and compute that's sort of making the suite of services take a little longer for folks to make a decision?
Edward McGowan: Frank, good question. So actually, I'll start with Linode. Actually, Linode in an environment like this, given what Tom talked about, we will be able to provide comparable services at a much better set of economics and actually think is an opportunity for us. So I would expect that as we go into next year, that should be a tailwind for us. On the headwind side, we are seeing across the board, certainly from a geographic perspective, that sales cycles are elongating. We've seen some deals push. Probably the easiest place to identify it is in Guardicore. Guardicore, as Tom mentioned, is still doing really well, but we have a dedicated sales team. So it's a little bit easier to track those deals as they're going through the pipeline. Those deals also sometimes tend to be a little bit larger. So it's a little bit easier to follow that. With our business, given it's a SaaS business and we've got recurring revenue contracts are constantly going through and renewing contracts, what you're seeing is some customers that are talking about, say, adding Page Integrity Manager or a Bot Manager or Account Protector, just pushing that off into the future as they go through their budget cycle. So we're not seeing as much on the renewal side from an upgrade perspective. So a little bit of slowness there. And then from the new customer acquisition perspective, I think pretty much every tech company you talk to these days is seeing it a little bit harder to attract new customers. So it's a little bit of a combination of everything as we've just been impacted by this economic impact here.
Operator: And our next question today comes from Fatima Boolani with Citigroup.
Unidentified Analyst: This is on for Fatima. So just maybe a follow-up in regards to the September and October recovery on the delivery side you're starting to see. Can you maybe give a sense of which end market cohort is really driving that momentum? And then when you're going to negotiating tables in regards to pricing and other contract terms, can you also give us a sense of how that has been developing?
Edward McGowan: Sure. Yes. So in terms of the traffic sort of getting a little bit healthier, I would say, coming out of the summer months, media is probably the vertical that it's most obvious in. So we're starting to see that across video, a little bit in gaming. Gaming is still overall very, very weak compared to what it's been in the future, but a little bit of an uptick here in the gaming vertical over the last couple of months. And then your other question, can you just remind me again? I forget.
Unidentified Analyst: Sorry, just in terms of pricing and other contract terms as you guys go to the negotiation table.
Edward McGowan: Yes. So one of the things we talked about is, obviously, like in the media division in particular, media verticals in particular, as we see traffic levels decline or not grow as quickly, I should say, we typically would give a discount commensurate with what you see in the traffic growth rate. So obviously, as traffic growth rates are not growing as quickly, we are lowering our discounts that we're providing to our customers, and we're starting to see that make its way through the system. It will take a while for it to really impact the growth as we go through our renewal cycles, but I am seeing that the pricing declines are certainly moderating a bit.
Unidentified Analyst: Okay. Got it. And then maybe just a follow-on, on the lighter-weight development. Any sense of how the customers -- are there any #1 customers in the beta testing phase? And also, I guess, where -- what are sort of the milestones we should look out there -- look out for there?
Thomson Leighton: I didn't catch the question. Can you repeat the question, please?
Unidentified Analyst: Sorry, just in terms of the lighter-weight deployment on, I guess, the cloud side? Yes.
Thomson Leighton: Yes. And what's the question about the lighter-weight deployment?
Unidentified Analyst: Yes. Just in terms of, are there any customers currently in the beta phase or testing out the product and how has that feedback been? And then are there any milestones we should look out for?
Thomson Leighton: Good. Okay. So there are customers on the platform today and a key reason that they are using Linode and plan to grow their use of Linode is because of these deployments. And the advantage of the lighter-weight deployments is we can get into markets, into regions where it's hard to build out a massive core compute data center so that we're going to have before -- next year more than double by having over a couple of dozen of the core compute data centers, but several dozen more of these lighter-weight distributed locations, where you can do the compute. You wouldn't have huge monolithic storage there, but you don't need that. That can be in the core regions. And that is a key consideration to some of our larger customers that are working with Linode today, doing proofs-of-concept, so in some cases, already running mission-critical applications. Because those lighter weight regions being closer to enterprise data centers in many parts of the world and to end users gives you better performance. And I think that will put Akamai in a great position to have equal or better performance than the hyperscalers. Of course, we have already our edge deployment with 4,000 locations, which also supports edge computing on top of delivery. And for a total -- lower total cost of ownership. So yes, the lightweight distributed regions are important for a lot of our customers and prospects with among the major enterprises on Linode.
Operator: And our next question today comes from Michael Elias at Cowen and Company.
Michael Elias: The first one, you mentioned it a bit ago relating to your long-term guidance and M&A on the security front. Just a question around how would you describe the pipeline of opportunities for M&A in the security market? And as part of that, maybe any capabilities which are top of mind as you think about adding to the platform?
Thomson Leighton: Yes, we have a large pipeline, and we generally do. We're constantly looking for appropriate acquisitions. As Ed said, we're very disciplined buyers, though. And the market as a whole is still highly priced. I think the realities of what's going on in the global economy haven't fully set in yet. That may take another year. And so because we're very careful buyers, we're being very selective there. I think there's a variety of capabilities that would be interesting as tech tuck-ins. And occasionally, we'll make an acquisition with a product adjacency. I think Guardicore has been a fabulous acquisition. They're the market leaders now in segmentation, making Akamai the market leader there. And I think that's the most important defense an enterprise can have. You can buy every company's Zero Trust offer, and malware is still getting into enterprises. And the real key is to identify it quickly and proactively block it from spreading. And that's how you limit the damage caused by ransomware and data exfiltration attacks. And that's what Guardicore does. And so I think very important strategic product with enterprise security and Zero Trust. But over time, I think there'll be other capabilities that we'll be interested in, in terms of broadening the portfolio.
Michael Elias: Got it. Now just a philosophical question for you, Tom. Over the years, you've taken steps to continue to grow the business and expand Akamai into new verticals. But the stock really hasn't responded in the way that I think you would have liked, just given some of your prior comments. My question for you is, as you think about executing the long-term vision for Akamai, do you believe being a public company is the right setting for you to achieve that long-term vision?
Thomson Leighton: Yes, sure. I think it's great being a public company. And yes, I do think the stock is undervalued where we are today in this market. And that's why I'm going to buy more shares. It's -- and over time, the stock has grown. And I think there's excellent prospects for future growth as we continue to grow Akamai. And I'm really excited about what we can do in the compute landscape. That's an enormous market. You just look at Akamai, next year, probably security will be our biggest product line. That's a big step forward, given that we started as a CDN company. And I think if you look 3 to 5 years down the road, well, maybe in that time frame, compute could be our largest product line. So I think there's lots of opportunity for continued growth. We're very disciplined when it comes to cost, and that means there's a lot of opportunity for bottom line growth in earnings per share. We've continued to buy back our equity to reduce the number of shares outstanding. So I think there's a great value proposition for public Akamai shareholders.
Operator: And our next question today comes from Tim Horan with Oppenheimer.
Tim Horan: I hate to harp on it, but the sales slowdown, can you just give us a little more color maybe when you started to see it? Is it continuing? Maybe what the lag is in terms of sales and revenue showing up? Just I'm trying to get a sense of what next year's revenue growth could be. I guess, at a high level, are we looking at 2 or 3 more quarters of flat from what we know now? Or at a high level, can growth be better next year than this year at this point?
Edward McGowan: Jim, let me take a stab at that. So I would say we started to see it really in this quarter and continue -- sorry, this quarter, meaning Q3, sorry, we're reporting Q3, continuing here in Q4. Hard to say how long this economic slowdown lasts. Now keep in mind, most of our business is under contract. The impact of the new signings doesn't have an overly material impact on the business, especially in any one given quarter. Obviously, over a prolonged period of time, it can slow growth down a bit. I think the bigger thing to think about as you build your models is the impact that foreign exchange has had. I've been trying to call it out as we go. Obviously, the dollar has gotten stronger throughout the year. So when you think about from an as-reported perspective, that's going to be a pretty big headwind. If you annualized at a point we went back all the way to the beginning of the year, you're talking a couple of hundred million dollars of revenue or $0.40 of EPS, a couple of points of operating margin. But that's a much bigger issue in terms of growth. And given our strong growth internationally, FX, assuming the dollar continues to get stronger, is something that I'd be more concerned about from a growth perspective. But we'll give you an update on guidance next year when we have our Q1 call -- or excuse me, our Q4 earnings call in Q1. So I'm not going to provide any guidance right now, but hopefully that gives you enough color to think about it.
Tim Horan: On FX, some of your largest competitors, particularly in cloud, but even on the kind of CDN security space, people had a bundling kind of charge in dollars pretty regularly. And some of your other smaller, one in main competitors in Linode has raised prices quite a bit here lately. Have you thought about maybe switching over the pricing in dollars? Or do you do much of that? And have you taken any pricing steps to increase prices?
Edward McGowan: Yes. So we tend to price most of our -- not all of our international business is in the local currency, most of it is, though. So you can see that's why we have such a big impact. Generally speaking, it's hard to switch with a customer who has been paying in one currency and then switching to another one. Then you also -- the -- in terms of price increases, too, that's not something that we're considering at this point. Obviously, it's kind of a risky thing to do, when you see companies raise prices. Part of the reason we're actively looking to move our cloud spend is for the reason that we're seeing the suppliers in that area either increase price or not give any commensurate declines with volume increases. So I think the long-term strategy of introducing price increases can come back and backfire on you. So we're not planning on -- we're not going to be making any changes in terms of changing customers out from paying in local currency to dollars.
Tim Horan: In the U.K., you're 20% below your peers in the last 9 months of price reduction effectively. But my last question is, Linode, is your OpEx and CapEx run rate enough to transition Linode and grow Linode?
Edward McGowan: Yes. So if you think about where the investments are going to be, and that's where we're primarily investing our headcount is in Linode and also in security. And Tom also mentioned that we'll be moving some of the people that have skills that are transferable. If you think about building out, scaling up a CDN, there's a lot of transferable skills. So we'll be able to move some folks that have talent into that group as well. So that won't put any pressure on the bottom line, but we will be spending some money and continuing to grow because we think the opportunity is significant. And then on a CapEx perspective, we will be building out to take in the consideration, moving our own workloads as well as the future demand, and we'll give you an update on that at the next call.
Operator: And the next question comes from Amit Daryanani with Evercore.
Amit Daryanani: I have two as well. I guess maybe on the first one, if you could just talk about the edge business, the Linode asset. And I guess, maybe the question I struggled with a fair bit is, can you grow this business on the cloud infrastructure side without sacrificing operating margins over the next several years? Or is that growth in Linode on the edge side going to come at lower margins inherently?
Edward McGowan: Yes. So good question. I think we bring some pretty interesting synergy. I just mentioned on the last question how we've got a lot of skill sets in-house that can do, say, network build-outs, for example. We don't have to build out a separate team to do network build-outs. We've got engineering talent in-house. We also have a big enterprise sales force in place that Tom talked earlier in one of the earlier questions about the spending of some of our larger verticals and the relationships we have with those customers who are spending probably 10 to 15x more on cloud computing than they are on CDN. So there's a significant synergy that you get there. And then also with our network infrastructure that we have built out, Tom talked about connecting our backbone to the existing Linode centers. That drives a significant cost benefit. So I think that actually, we could have very attractive operating margins, similar to what I showed on the IR Day. We get pretty good operating leverage, just like we did with the security business. So long term, our goal is to get back to 30% or higher in operating margin. And I think as we scale that business, we should be able to do it.
Amit Daryanani: Got it. And then, I guess, maybe I'd just stick to that theme around Linode. Are there certain use cases that make Linode more attractive more so the top 3 cloud providers that are out there? I guess I'd just love to understand, when you folks walk into a customer pitch, what are the reasons want to use Linode versus some of the peers that might provide a cloud solution at least cheaper? Maybe that would be really helpful. Like what are the 2, 3 reasons that you think stands out?
Thomson Leighton: Yes. Let me answer that question in the context of where we'll be next year. Because as you know, we're doing a lot of the build-out now. We're doing -- adding a lot of the functionality now. But if you look at where we'll be this time next year, I think, first, our footprint will be better than that of the hyperscalers. We'll be closer to a lot more enterprise data centers' end users. So that means better performance. I think we'll be hooked in now then to the Akamai platform with 4,000 POPs to do delivery, to do the outer layer of security, to do edge computing. So that's a big advantage. As Ed noted, that also lowers our costs substantially for egress. And so lower total cost of ownership is another, I think, very attractive feature that Akamai would have. Akamai is known for scalability, for reliability in addition. And there's been some pretty well-publicized issues with some of the hyperscalers in terms of reliability, extended issues. And I think that's an area where we can be very competitive. Really the only area where we wouldn't be as competitive as in the large number of third-party apps in the ecosystem that are available as managed services on the hyperscalers. And that's a key way that you get vendor lock-in. And so customers that want -- enterprises that want to have that, fine, okay? But if you don't want lock-in and you do want better performance at a lower cost, I think Akamai will be very competitive. And also, it's good to keep in mind just relative scale. Those hyperscalers are giant companies. If we can go get 1%, 2% market share in a multi-hundred billion dollar business, that will be very meaningful for us. And I think we're in a position that we can go do that. One other issue is that in the sectors where we're very strong like media and commerce, those companies, they compete heavily with at least some of the hyperscalers. And with the cost of the hyperscalers rising, that's becoming more of an issue for those companies. You're paying a large bill to a company that's buying out the media rights from underneath you. And that's sort of tough for some of them to take. So I think that also gives us a competitive advantage. We don't compete with our customers. We will help them grow with their business and be good partners to them and they can trust us.
Operator: And our next question today comes from Mark Murphy at JPMorgan.
Sonak Kolar: Sonak Kolar here on for Mark Murphy. Tom, can you get a bit deeper on the new pricing strategy, particularly around delivery? Have you noted any incremental changes in customer retention or churn levels as a result of some of these pricing adjustments, specifically around some of the inflationary environment pressures driving price sensitivity in the market?
Edward McGowan: Yes. This is Ed. No, we haven't seen anything notable. Like if anything, we're actually starting, like I said, to see some bit of a moderation in the pricing declines. So we haven't seen anything on the churn side.
Sonak Kolar: Got it. That's very helpful. And then a quick follow-up. Would you say some of the macro pressures that you've called out have intensified in Q3 relative to Q2? Or has it remained fairly in line with some of the pressures that you called out during the last earnings call?
Edward McGowan: Yes, I'd say it's intensified a bit in Q3.
Operator: And our next question today comes from Rudy Kessinger with D.A. Davidson.
Rudy Kessinger: I don't want to belabor the point on security growth. But again, when we exclude Guardicore and look at it at constant currency, it looks like organic has come down about 5 points from Q1 to Q3. And so if you were to look at it, could you maybe break out like what's been the impact in your assessment from the macro and -- versus just maybe some of the larger products maturing and growing slower that's led to that roughly 5-point deceleration in the last couple of quarters?
Edward McGowan: Yes, I'd say it's a tough one to really figure out what the impact is on the macro. I'd say that's probably -- maybe that's a point or 2. But I think it's really the issue of what Tom talked about, where if you look at the biggest product, we're the market leader in web app firewalls growing faster than the market, but that market isn't growing as fast as some of the other markets that we're in, and it's just not at scale yet. So I'd say that's the bigger issue, except those newer products are growing faster at the scale that we're at, just isn't offsetting the slower growth in those -- in the bigger products.
Rudy Kessinger: Okay. And then on Linode, I don't know if you gave it. Could you share how much revenue Linode did in the quarter? And then last quarter, given the commentary today about the increase in cost of the hyperscalers, last quarter, you talked about moving your hyperscaler spend over to Linode internally. Have you started that process yet? And if not, when do you plan to do so?
Edward McGowan: Yes, I'll take the first one.
Thomson Leighton: Go ahead, Ed. You take the first part and I'll...
Edward McGowan: I'll do -- mine is pretty simple. So Linode added about $33 million this quarter. Tom, why don't you talk about the movement?
Thomson Leighton: Yes. So that's well -- the migration of our cloud spend to Linode is well underway. We've already done some. The lion's share of that work or the migration will take place, I would say, over Q1 to Q3 next year. And by the end of next year, we ought to have the vast, vast majority migrated.
Operator: And ladies and gentlemen, our next question today comes from Tom Blakey with Truist Securities.
Tom Blakey: I think it's been touched on a couple of times by my peers here. Just wanted to get -- go back to that. Some sort of normalized CapEx level, from my estimation, we're clearly overspending on Linode as a percentage of Linode revenue, anyway, right, if you do the percentage of total revenue. And you've made great strides in terms of lowering the CapEx from a delivery perspective down to this kind of 3% to 4% range. But as things kind of normalize, Tom, when you look out, and we're at , maybe 2/3 of revenue coming from compute security, CapEx is nil. You're just riding the rails of what already exists. What does the CapEx kind of bridge or normalized structure of this company look like a few years from now?
Edward McGowan: Yes. So I'll take a stab at that. Tom, if you want to add anything, feel free to jump in. So obviously, with the -- what we're talking about here, where Linode was primarily focused on small, medium business, and we're moving towards the enterprise workloads, you're talking about much larger workloads. Even with our own spend and what we're moving, Tom talked about on the last call, we had that we're spending roughly $100 million, that's growing pretty fast. That's a much bigger scale than what Linode was doing. So looking at CapEx as a percentage of existing Linode business isn't the right metric to look at, at this point. But think of it as we're in the build phase. So you can see CapEx is starting to creep up a bit as we're building out, as we see better visibility into demand and also as we start to build out our plans to migrate the workloads that we do have on the hyperscalers on to us. So you're going to see a bit of a disjoint. So if you're looking at that as a metric, it doesn't send the right signal. I'd say look at that as more of a bullish signal in terms of how we feel about our customer -- pending customer demand and also how we think we'll be very successful in being able to migrate those workloads. So for the next, say, several quarters, you're going to see more CapEx going into Linode and then the revenue and the cost savings will follow. But then if we get -- it really depends on the growth, right? So as you're growing revenue at significant rates, and so you're doubling revenue, you're going to obviously have a higher percentage of CapEx. But then at some point, it will normalize out to approximate what the future revenue growth would be. And so, let's say, for example, we get to 20% growth as a run rate in the long term, your CapEx will probably be somewhere in that range.
Tom Blakey: I'm sorry, I didn't understand the last comment of 20% growth in Linode, the CapEx was...
Edward McGowan: No, no, no. So I was using that as an example. What I was saying is we'll give you detailed guidance on what we're going to do next year, but we're in a building phase now where Tom talked about getting into many new centers we're building out for our own demand and also what we're hearing from our customers. So what I was saying is if you're looking at CapEx as a percentage of Linode, it's not the right way to be thinking about it because we're going after a much different business, right? We're going after big enterprise workloads. So there's a build phase where you have to build out ahead of the demand. And then you'll start to see the revenue come our way. And as you get to scale, like many years out when you get to scale, you can start thinking about as a proxy that roughly speaking, your CapEx would approximate what your future demand is. So if you, say, have a long-term run rate of 20% or 30%, your CapEx will be somewhere in that range. But in the near term, it'll be higher than...
Tom Blakey: That's exactly what I was asking. I understand, obviously, you're overspending today. And that comment was just a structural comment for the question on what CapEx would be as a total percentage of revenue, total revenue in the -- again, when you're at scale for Linode? Will it be structurally lower or higher than delivery?
Edward McGowan: We'll know when we get there. There'll probably be -- certainly higher than what we're seeing in delivery now, but it is a more capital-intensive business by nature.
Tom Blakey: It's a more capital-intensive business with compute, okay.
Operator: And our next question today comes from Will Power at Baird.
Charles Erlikh: This is Charlie Erlikh on for Will. I just wanted to ask a 2-parter on the comment that you guys are going to basically take some resources from delivery and put them into security and compute headcount-wise and hiring-wise. So the first part is, how do you feel about competition for talent in the security business and the compute business maybe relative to a few months ago? Kind of what does that hiring environment look like in those 2 businesses? And then part 2 on the delivery side, how should we interpret that comment as far as trying to turn around that delivery business and just sort of what should we expect from that business as far as trends going forward?
Thomson Leighton: I'll take the first question. It's still a competitive market for hiring. We've been very pleased to see our attrition rates take a major drop over the last quarter. We had stayed at low attrition rates through COVID, well better than market, ticked up a little bit in the first half of the year, but now again down to, over the last 3 months, very low attrition. We have very successful recruiting. Akamai is considered to be a great place to work as measured by the various studies that are done and also employee satisfaction surveys that we do. So people really like working at Akamai. We have really great employees, very smart. We set a high bar for who we recruit. And of course, everybody wants to hire those people. And pretty much everybody wants to hire Akamai employees. But our retention rates are good. I would say our success in hiring is good, but it's a competitive market out there. And Ed, do you want to talk about the delivery business?
Edward McGowan: Yes, sure. So the way to think about the delivery business, I'll call on 4 factors in terms of thinking about, as you called it, a turnaround. Obviously, one is renewal. So we went through a very heavy phase of renewals. So we're not going to have that next year. We'll always have some renewals, but it's very unusual to see 8 of your top 10 customers renewing at the same time. Number two is pricing. So we're -- as we talked about several times on the call, we are moderating the discounts that we provide on pricing. And then the third thing is traffic. Traffic, we're starting to see some encouraging signs, albeit early, that the Internet has been growing at 30% a year for many, many years. This year is a sub-30% year, but it's reasonable to think that we should start to get back to more traditional growth rates. And then the fourth thing I would say is I think we get a tailwind in our delivery business from being in the compute space. We actually do see some customers that are on hyperscalers get to a certain size that they -- even though they offer their own CDNs, come to us for better performance. So as we add customers, get into new verticals, et cetera, we do have the opportunity to just grow the delivery business by being a proxy of being in the compute business.
Operator: And our final question today comes from Alex Henderson at Needham & Company.
Alexander Henderson: Sliding in before the final. Nice. So I wanted to go back to the commentary that you've made about the outlook for the upcoming quarter, particularly in the security space. If I adjust the numbers for the contribution from the acquisition of Guardicore, I'm getting an as-reported growth rate of around 9%. And I'm wondering, given your commentary about more difficult conditions and a little larger currency translation year-over-year in the fourth quarter, whether in fact you're expecting the security business to slow to that level in your guidance?
Edward McGowan: Yes. Alex, this is Ed here. I'll give that one a try. Obviously, we don't break out specific guidance for individual products like that in the quarter. But right now, the FX impact, as you quoted an as-reported number, is about 6%. So as-reported was 13%, constant currency was 19%. So if you assume that, you're getting to about -- if you're using 9%, you get to about 15%. Since we're lapping, in constant currency that is -- since you're lapping the Guardicore acquisition at this point, and we just came off a 15% organic growth rate, if you back up the contribution from Guardicore in Q3, that's probably a reasonable number. If you're solving for what we gave you in terms of 20% constant currency, somewhere in that 14% to 16% constant currency. Obviously, I can't predict where FX is going to be. But if you just kind of keep it what it was this quarter, that's -- you're doing roughly the right math.
Alexander Henderson: So a similar kind of question. If I take the Linode comments, it looks like that actually accelerated from about a 15% baseline growth rate to around 20%, making the adjustment for the Linode acquisition. On an as-reported basis, that's actually pretty good, considering the currency. Can you talk a little bit about the geographic play between -- in the Linode business and how much currency would have impacted that side of it? And then again, as we look into the baseline growth rate, it does seem like it's accelerating. Can you talk a little bit about whether that's a function of the investments you're making in marketing and like? Or whether that's something that's sustainable in the guide?
Edward McGowan: Sure. So I'll start with the currency with Linode. So not -- they -- when we acquired Linode, most if not all of their revenue was in U.S. dollars. So they were not billing in local currency. So there's not as much currency headwinds associated with the Linode portion of the business. Obviously, with the non-Linode compute business, we have the normal dynamics in our business. On the investments in terms of marketing, et cetera, I think we can maintain the current levels, and I'm not expecting a significant increase in marketing spend next year. We are increasing it a bit, but nothing significant. From a sales perspective, we are adding some sales folks, some specialists, especially on the technical side, to help our sales force, but it's not going to be a significant investment there. We believe our sales force can be trained, and we're also changing our comp plans to have an added incentive for compute. So all of that, I think, can fit into sort of a normal run rate expense level that we've been sort of operating, and I don't see any major investments in that part of the business.
Alexander Henderson: If I could slide in one last one, since I'm the last guy here. As the mix shifts here, how do you expect the mix shift between the segments to start impacting the overall margins?
Edward McGowan: Yes. So obviously, if you go back to the IR Day slides, and there was a question earlier about the leverage that we get on the compute business, as the faster-growing parts of the business security and compute become a bigger part of the business, we should get some operating leverage. It won't happen right away, but over time. Then obviously, there's the dynamic that we talked about with some accelerated CapEx ahead of revenue. So that's another thing to keep in mind. The other thing you notice -- I talked a bit about having a bit of a pressure on the gross margin line. That also, I would say, is more of a temporary thing. We will be reducing the gross margin line as we move our third-party costs over, but also with some of the build-out costs, including some of our colocation agreements, network build costs, a little bit that's front-loaded. So as revenue scales, we should start to see some scale in the gross margin line as well. So as Tom talked about, security should be our biggest product line. It's got higher gross margins, higher operating margin. So we should start to see that flow through as the mix changes to those 2 product lines over time.
Thomson Leighton: And thank you, everyone. In closing, we will be presenting at a number of investor conferences and presenting at events, road shows and other things throughout the rest of the fourth quarter. Details of these can be found in the Investor Relations section of akamai.com. So thank you for joining us. And all of us here at Akamai wish continued good health to you and yours, and have a nice evening.
Operator: Thank you, sir. This concludes today's conference call. We thank you all for attending today's presentation. You may now disconnect your lines, and have a wonderful day. | [
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"speaker": "Operator",
"text": "Good day, and welcome to the Akamai Technologies Third Quarter 2022 Earnings Conference Call. [Operator Instructions]. I would now like to turn the conference over to Tom Barth, Head of Investor Relations. Please go ahead, sir."
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"speaker": "Tom Barth",
"text": "Thank you, operator. Good afternoon, everyone, and thank you for joining Akamai's Third Quarter 2022 Earnings Call. Speaking today will be Tom Leighton, Akamai's Chief Executive Officer; and Ed McGowan, Akamai's Chief Financial Officer. Please note that today's comments include forward-looking statements, including statements regarding revenue and earnings guidance. These forward-looking statements are subject to risks and uncertainties and involve a number of factors that could cause actual results to differ materially from those expressed or implied by such statements. The factors include any impact from macroeconomic trends, the integration of any acquisitions and any impact from geopolitical developments. Additional information concerning these factors is contained in Akamai's filings with the SEC, including our annual report on Form 10-K and quarterly reports on Form 10-Q. The forward-looking statements included in this call represent the company's view on November 8, 2022. Akamai disclaims any obligation to update these statements to reflect new information, future events or circumstances, except as required by law. As a reminder, we'll be referring to some non-GAAP financial metrics during today's call. A detailed reconciliation of GAAP and non-GAAP metrics can be found under the financial portion of the Investor Relations section of akamai.com. And with that, let me turn the call over to Tom."
},
{
"speaker": "Thomson Leighton",
"text": "Thanks, Tom, and thank you all for joining us today. I'm pleased to report that Akamai delivered strong results in the third quarter despite the ongoing challenges with the global economic environment and the effects of a strong U.S. dollar. Q3 revenue was $882 million, up 3% year-over-year and up 7% in constant currency. This result was driven by the continued strong growth of our security and compute businesses, which collectively grew 23% year-over-year and 28% in constant currency. These 2 business lines accounted for 55% of our overall revenue in the quarter. Q3 non-GAAP operating margin was 28%. And non-GAAP EPS was $1.26 per diluted share, down 13% year-over-year or down 7% in constant currency. EPS was negatively impacted once again by foreign exchange rates and a higher effective tax rate compared to last year. Free cash flow was very strong at $271 million in Q3, and it amounted to 31% of our revenue. I'll now say a few words about each of our 3 main lines of business, starting with security. Our Security solutions generated revenue of $380 million in Q3, up 13% year-over-year and up 19% in constant currency. The growth was particularly strong for our enterprise Zero Trust products, which were up 51% year-over-year in constant currency. Our Guardicore Segmentation solution continued to lead the way with several major customer wins. For example, one of the largest energy companies in the world adopted Guardicore to help protect against SolarWinds types of ransomware attacks. A leading global developer of dietary supplements adopted our Segmentation solution to help meet European regulations and limit cybersecurity risk. And a major South American broadcaster deployed Guardicore to protect their reporting of election results. Our market-leading app and API protection products also performed well in Q3, with many wins against the competition. For example, the largest bank in Southeast Asia came to Akamai last quarter after suffering repeated outages by a competitor that had lured them in with low pricing. When the bank faced large fines from regulators for the extended outages, they saw more value in being back on Akamai's platform. One of the top banks in North America is in the process of bringing all of their traffic back to Akamai after struggling with outages at another competitor who would also lure them in with lower pricing, but couldn't deliver the performance and reliability needed by a major enterprise. After testing our capabilities against competitors, one of the world's largest financial services companies expanded their relationship with us, contracting for 10 of our products and services, including Bot Manager and Page Integrity Manager. A Fortune 100 food processor and commodities trader became a new Akamai customer last quarter after an anonymous threat drove them to seek better DDoS and web app protection than they were getting from a competitor. And in Germany, an online advertising business with one of the country's busiest websites suffered severe account takeover attacks, load problems and reputation damage before coming to Akamai for bot management and app and API protection. Given such examples, it's not surprising that Akamai's web app and API protection was named a leader in both Gartner's Magic Quadrant and in Forrester's Wave report last quarter. Our compute product group also performed well in Q3 with revenue of $109 million, up 72% year-over-year and up 77% in constant currency. We're continuing to make good progress on integrating Linode into our edge platform and on adding the capabilities and scale needed to support mission-critical applications for major enterprises. In particular, we've connected all of Linode's 11 existing locations into our private backbone, enabling us to provide lower latency, higher throughput and improved egress economics. We've also expanded the capacity of these facilities and are in the process of adding 13 additional sites, 5 of which are expected to go live in Q1 with 8 more planned for Q2. As we discussed at our Analyst Day in May, we're also developing a lighter-weight deployment model that is suitable for distribution at a broad scale. This will enable us to get compute much closer to end users around the world. We plan to deploy several dozen of these lighter-weight sites next year, at which point we expect to compare well with the hyperscalers in terms of points of presence and proximity to both enterprise data centers and end users. Of course, we plan to have all of our compute sites integrated into Akamai's unique edge platform, which has over 4,000 locations for edge computing. As a result, we expect to be able to offer superior performance as well as lower total cost of ownership for enterprise computing needs. We've also made significant progress on adding new and improved enterprise capabilities to our compute platform. We launched Database-as-a-Service with managed MySQL in May and managed Postgres in June. We released the next generation of our Kubernetes platform in Q3 to enhance performance and reliability. We expect to launch early versions of an enhanced object storage product as well as next-gen serverless capabilities next quarter. And we expect to become SOC 2 and ISO 27001 compliant this quarter with PCI compliance expected to follow in the first half of 2023. Although we still have much work to do, we're encouraged by the customer use cases that our compute platform began serving in Q3. One of the world's top development studios for gaming moved their matchmaking service to Akamai to help them with data processing and analysis. A large online legal services platform in India chose Akamai as part of their multi-cloud strategy after they concluded that we could help them optimize their cloud computing budget. And a large media workflow company in Germany is planning to migrate their apps from a hyperscaler to Akamai, calling our new capabilities a great addition, especially with the plans for a high number of distributed sites and the tight integration with Akamai content delivery. Over the past few months, I've spoken with many of the world's leading enterprises about our plans for cloud computing. Most tell me that they want more choice in cloud computing, and they often express concern about being locked into contracts with cloud giants that are consuming larger portions of their IT budgets, especially in cases when their cloud vendor is also a direct competitor. Customers also understand the value of leveraging a more widely distributed cloud platform and one that directly connects to Akamai's unique edge platform with over 4,000 points of presence. Turning now to our CDN business. Our delivery products generated revenue of $393 million in Q3, down 15% year-over-year and down 11% in constant currency. These results reflect continued deceleration in traffic growth among our largest customers and the impact of some large renewals that we completed in the first half of the year. As we said at our Analyst Day in May, we've aligned our pricing strategy with the slower traffic growth rates we've experienced this year. In addition to scaling back discounts upon renewal, we're continuing to decline business from a very small number of customers who have extreme traffic peaks compared to their daily usage patterns. While this resulted in less revenue in Q3, it's enabled us to meaningfully lower our delivery network CapEx as we direct cash flow from our delivery business to our compute and security businesses where we have a higher ROI. As Ed will detail shortly, we're also taking several steps to reduce OpEx, including reducing our real estate footprint and limiting hiring to our most critical areas. Although we're facing the same challenging macroeconomic environment as other companies, I believe that Akamai is on the right path to long-term growth and success with our disciplined management of expenses and strong focus on opportunities for future growth such as cloud computing. Becoming a force in the enormous cloud computing market won't be easy, but I believe that it's something that Akamai can accomplish. Akamai has a strong track record of continuous innovation and business expansion. Along the way, we've achieved significant milestones that many thought were impossible. In our first decade, we pioneered the CDN industry. a multibillion dollar market, where we remain the leader by far. In our second decade, we created the industry for app and API protection as a cloud service, our second multibillion dollar market, where we are the leader by a wide margin. Looking ahead, Akamai is on the cusp of another major phase of expansion with our foray into cloud computing. Having already scaled content delivery and cloud security into billion dollar businesses, we now have an opportunity to do it again with cloud computing. In fact, I believe our opportunity in cloud computing is even larger than it's been for delivery and security. Cloud computing is a $100 billion market growing at a very rapid rate. We believe we're in an excellent position to capture a share of this business, particularly from companies that value our market-leading delivery and security solutions and that don't want to be locked in to more expensive options with a cloud giant that competes against them. Akamai is a company that enterprises can trust to be their partner, to scale with their business and to provide the best when it comes to security, reliability and performance. By adding compute to our unique edge platform, we can provide a full suite of cloud services that will help lower our customers' cost to build, run, deliver and secure their applications. In summary, my confidence in Akamai's future prospects for growth and success has never been higher. In fact, my confidence in what I see ahead for Akamai has led me to take steps to put in place a 10b5-1 trading plan, not to sell, but to buy $3 million in Akamai stock over the next 6 months. We expect to announce the adoption of my plan in a formal filing later this week. Now I'll turn the call over to Ed for more on Q3 and our outlook. Ed?"
},
{
"speaker": "Edward McGowan",
"text": "Thank you, Tom. As Tom mentioned, Akamai delivered a solid quarter in Q3 despite a very challenging macroeconomic environment. Q3 revenue was $882 million, up 3% year-over-year or 7% in constant currency. The stronger U.S. dollar negatively impacted our year-over-year growth rate by approximately 4 points or about $39 million of revenue year-over-year and $14 million on a sequential basis. On a combined basis, our security and compute businesses represented 55% of total revenue, up 23% year-over-year and 28% in constant currency. Security revenue was $380 million and grew 13% year-over-year and 19% in constant currency, led by another strong contribution from Guardicore. Guardicore delivered approximately $14 million of revenue in Q3. Security represented 43% of total revenue in Q3, which is up 4 points from Q3 a year ago. Compute revenue was $109 million in Q3, up 72% year-over-year and 77% in constant currency. As Tom mentioned, while we are in the early innings of our cloud computing journey, we are very excited about initial feedback from customers and the significant growth opportunity ahead. Delivery revenue was $393 million, down 15% year-over-year and down 11% in constant currency. Sales in our international markets were $421 million and represented 48% of total revenue in Q3, up 1 point from Q2. International revenue was up 2% year-over-year or 12% in constant currency. Finally, revenue from our U.S. market was $461 million, up 3% year-over-year. Moving now to costs and profitability. Cash gross margin was 75%. GAAP gross margin, which includes both depreciation and stock-based compensation, was 61%. Non-GAAP cash operating expenses were $291 million. Adjusted EBITDA was $368 million, and our adjusted EBITDA margin was 42%. Non-GAAP operating income was $243 million, and our non-GAAP operating margin was 28%. It is worth noting that on a year-over-year basis, our non-GAAP operating margin was negatively impacted by approximately 1 point due to unfavorable foreign exchange rates. Capital expenditures in Q3, excluding equity compensation and capitalized interest expense, were $111 million. As we mentioned on our Q2 earnings call, our strategy in our delivery business is to be more selective on the peak traffic levels we will take on our network. As a result, delivery network CapEx, excluding Linode, was just under 4% of revenue in Q3. GAAP net income for the third quarter was $108 million or $0.68 of earnings per diluted share. Non-GAAP net income was $200 million or $1.26 of earnings per diluted share, down 13% year-over-year and down 7% in constant currency. It's worth noting that on a year-over-year basis, foreign exchange rates negatively impacted our non-GAAP EPS by approximately $0.10 in Q3. Taxes included in our non-GAAP earnings were $41 million based on a Q3 effective tax rate of approximately 17%. This was about 1 point higher than our guidance due to a more unfavorable mix between U.S. and foreign earnings. Now moving to cash and our use of capital. As of September 30, our cash, cash equivalents and marketable securities totaled approximately $1.4 billion. During the third quarter, we spent approximately $163 million to repurchase shares, buying back approximately 1.8 million shares. Our ongoing share repurchase activity has resulted in a net reduction in our non-GAAP fully diluted shares outstanding of approximately 5 million shares or roughly 3% on a year-over-year basis. We ended Q3 with approximately $1.4 billion remaining on our current repurchase authorization. Our intention is to continue to buy back shares to offset dilution from employee equity programs over time and to be opportunistic in both M&A and share repurchases. Before I provide our Q4 outlook and an update to our 2022 guidance, I want to highlight several factors. First, with nearly half of our revenue coming from outside the U.S., the strong U.S. dollar continues to be a significant headwind to our reported results. At current spot rates, our guidance now assumes foreign exchange will have a negative $130 million impact to revenue in 2022 on a year-over-year basis. As I mentioned previously, the strong dollar also impacts our margins and earnings. We estimate FX will negatively impact our non-GAAP operating margin by approximately 1 point year-over-year and non-GAAP earnings by approximately $0.34 for the full year 2022. Second, we have seen a lengthening in some of our sales cycles. We believe that is -- this primarily reflects the uncertain macroeconomic conditions that our customers are experiencing, and it is visible in many parts of our business. Finally, we continue to closely monitor our costs in light of ongoing inflationary and macroeconomic pressures across the globe. We have made good initial progress on our cost-cutting measures that we mentioned on our last call, which include real estate costs, where we sublease some of our underutilized office space in Q3, and we'll continue to look for additional savings going forward. Reducing our third-party cloud expense in 2023, where we look forward to making significant progress on shifting workloads to Linode. And lowering network CapEx associated with our delivery business, where I noted our continued progress on reducing spend significantly related to traffic delivery. In addition to these items, as Tom mentioned, we plan to be very disciplined with headcount and focus our investments on higher growth areas like cloud computing and security. In particular, we are closing over 500 open positions and re-tasking many other employees to work on compute. These closures went into effect today. And just a quick reminder about our typical fourth quarter dynamics before I turn to our Q4 guidance. As in prior years, seasonality plays a large role in determining our fourth quarter financial performance. We typically see higher-than-normal traffic for our large media customers and from seasonal online retail activity from our e-commerce customers, which are both difficult to predict, especially during this more challenging macroeconomic environment. With that in mind, we are projecting Q4 revenue in the range of $890 million to $915 million or down 2% to up 1% as reported or up 3% to 6% in constant currency over Q4 2021. Foreign exchange fluctuations are expected to have a negative $11 million impact on Q4 revenue compared to Q3 levels and a negative $44 million impact year-over-year. At these revenue levels, we expect cash gross margins of approximately 74%. This roughly 1 point sequential decline is primarily driven by increased third-party cloud costs and some compute-related data center build-out costs. Q4 non-GAAP operating expenses are projected to be $298 million to $306 million. We anticipate Q4 EBITDA margins of approximately 40% to 41%. We expect non-GAAP depreciation expense to be between $125 million to $126 million, and we expect non-GAAP operating margin to be approximately 27% for Q4. Moving on to CapEx. We expect to spend approximately $122 million to $127 million, excluding equity compensation and capitalized interest in the fourth quarter. This represents approximately 14% of projected total revenue. And with the overall revenue and spend configuration I just outlined, we expect Q4 non-GAAP EPS in the range of $1.23 to $1.30. This EPS guidance assumes taxes of $38 million to $40 million based on an estimated quarterly non-GAAP tax rate of approximately 16%. It also reflects a fully diluted share count of approximately 158 million shares. And finally, for the full year 2022, we now expect revenue of $3.58 billion to $3.6 billion, which is up 3% to 4% year-over-year as reported or up 7% to 8% in constant currency. We continue to expect security growth of approximately 20% in constant currency for the full year 2022. We now estimate non-GAAP operating margin to be approximately 28% and non-GAAP earnings per diluted share of $5.23 to $5.30. And this non-GAAP earnings guidance is based on a non-GAAP effective tax rate of approximately 16.5%, a fully diluted share count of approximately 116 million shares. Finally, full year CapEx is anticipated to be approximately 13% of revenue. In closing, we are very pleased with how the business is continuing to perform despite a very challenging macroeconomic backdrop. We are very excited about our future growth opportunities ahead. Thank you. Tom and I would be happy to take your questions. Operator?"
},
{
"speaker": "Operator",
"text": "[Operator Instructions]. Today's first question comes from Keith Weiss at Morgan Stanley."
},
{
"speaker": "Keith Weiss",
"text": "Excellent. Nice quarter in a difficult environment. On that difficult environment point, I was hoping you could help with a little bit more specificity in terms of where you guys are seeing the macro impacts. It sounds like security is still holding up relatively well. And on the delivery side of the equation, there's some Akamai-specific impacts there. Could you give us some kind of detail in terms of where the risk factors are, sort of where the macro lies on a product and geographic perspective? I think that would be helpful. And then I guess on the CapEx side of the equation, you talked a little bit about types of business that you guys are not looking to take onboard on a go-forward basis, the very peaky workloads that perhaps were overly taxed in the system, if you will. Can that lead to a fundamental different kind of CapEx intensity for the business on a go-forward basis? Or is it just too small to make a difference?"
},
{
"speaker": "Edward McGowan",
"text": "Keith, this is Ed. I'll take those. I'll start with the second question first. So from a CapEx perspective, the way to think about it is in the delivery business, we had -- if you go back to our May Analyst Day, we talked about CapEx and delivery being in sort of the high single digits. We've been running in the lower single digits. We're just under 4%. So certainly, in the near term, it will have an impact in the delivery business. As the compute business gets larger, obviously, that's going to be the main driver for CapEx. But certainly, you saw that in Q3, the impact of overall CapEx down at around 13%, and for the year, it's around 13%. So it is less capital-intensive. But as we look at our cloud compute business, obviously, there's going to be some -- Tom talked about building out in more locations. So there'll be some more CapEx associated with that. But we are seeing a pretty healthy decline in our delivery business, which is as anticipated. On your first question, you asked about the macroeconomic environment where we're seeing some challenges. I mentioned in my prepared remarks that we are seeing some of our sales cycles lengthening, seeing customers pushing off upgrades for certain products and things like that, which is pretty typical. Most companies are doing that. I know we're -- we're doing something similar as we go through our budget cycles. We think it's temporary in nature. Also seeing a little bit of pressure in some of the advertising-related businesses, a little bit of pressure there. And then Europe is something that we're keeping a pretty close eye on, that's about geographically where we're worried. Obviously, with what's going on with energy costs and things like that in Europe, that's something that we're keeping a very close eye on and have been a little bit cautious on our guidance, I would say, in Q4, just relative to seasonality. Just trying to take that into consideration."
},
{
"speaker": "Keith Weiss",
"text": "Got it. And on the energy cost, is that a top line concern in terms of you're worried about your -- what your customers are experiencing? Or is that more of a gross margin concern that you guys are worried that those energy costs can impact your gross margins on a go-forward basis?"
},
{
"speaker": "Edward McGowan",
"text": "Yes, I'd say it's more on our customers and their customers, so how does the consumer behave. Obviously, retail is a driver of seasonality as is spending for media. So those 2 things could be impacted. And then obviously, with our customers, if you see shutdown in manufacturing and things like that, that's obviously going to have a ripple effect on GDP across Europe. So that's from that perspective. As far as our risk with energy, we do a pretty good job. The team has done a nice job with our colo negotiations. If you think about our costs, our server costs were pretty insulated from costs there on the bandwidth side that tends to be deflationary. Colo, there is some energy exposure, but the team has done a really good job of trying to lock in longer-term deals. We're not seeing that. It's possible that may start to affect us later into next year. But right now, we've got it pretty well under control."
},
{
"speaker": "Operator",
"text": "And our next question today comes from James Breen at William Blair."
},
{
"speaker": "James Breen",
"text": "Can you just talk a little bit about the compute business? I recognize it was up a lot year-over-year after you closed Linode. It was up a few million quarter-to-quarter. What do you have to do to accelerate that business? Is it building out more resources? Is it just you're getting some larger customers? And sort of what are the thoughts there on what that could ultimately grow? It seems like with the opportunity, it could grow faster than the security business."
},
{
"speaker": "Thomson Leighton",
"text": "Yes. Great question. The compute business, even before Linode, was on a pretty strong trajectory of growth. And with Linode, that accelerates it a lot. As you look to the future, the big growth comes when we're tapping into the core cloud compute market, a market that's over $100 billion today and growing rapidly. And that's something that we're working really hard on now to -- so we can exploit that next year. And that involves increasing scale, having a lot more core compute regions and then introducing the lighter-weight distributed computing regions. So that we'll be in a position to offer at least as good or better performance integration into the Akamai platform, which has great delivery, great security and, of course, edge computing at a lower total cost of ownership. And for a lot of our customers, especially you think of the media vertical and the commerce vertical, they spend a lot more on compute than they do with delivery and security. Moreover, they compete pretty heavily with the hyperscalers. So the big growth for us, what we're really going after over the next several years is in that core cloud compute market, mission-critical applications for major enterprises because that's a very big potential market for us. And that's what will drive our -- the major growth in compute, and ultimately, I think the company going forward."
},
{
"speaker": "Operator",
"text": "And our next question today comes from James Fish at Piper Sandler."
},
{
"speaker": "James Fish",
"text": "I appreciate the questions. Obviously, I agree with you on deceleration in traffic overall, especially on the media side. But what makes you guys confident that you aren't losing traffic share of some of the media customers, especially as you're purposely not doing some of these large events, for example, or kind of the gaming peak traffic? And any sense to how much that's kind of impacting the media business this quarter in this year overall that we should kind of normalize as we start to think about for next year?"
},
{
"speaker": "Edward McGowan",
"text": "Jim, this is Ed. Good question. So actually with traffic, we are starting to see a little bit of a recovery in September. It continued a bit in October as well. But in general, it is, as we talked about, a much lower year relative to what we typically see. As far as the specific customers, you're talking about only a handful of big customers that can drive this kind of peak. And these particular customers all have multi-CDN. So in this particular case, we did lose a couple of million dollars. It's not significant in terms of the impact on the year. But as you can see, it saved us about, call it, 4 points on CapEx. So it's pretty meaningful from an overall economic standpoint. Now that said, we still -- these still are big -- very big customers of ours. They've just sort of flattened out the peak a bit. So as their daily average traffic is not growing as quickly, the economics just don't work for us anymore. So we just -- they're still good customers of ours, but just decided we weren't going to allow them to peak as much as they did in the past. It just makes sense for us. But it's not an overly material number. A few million dollars is the way to think about it."
},
{
"speaker": "James Fish",
"text": "That's helpful. I appreciate that. Maybe following up a little bit on Keith's prior question around more specifically on the security growth, which slowed to about 15% when I normalize everything. What makes you guys confident that we're going to see an acceleration of this business back to that 20% all-in constant currency growth rate over the next couple of years? And is the impact today being more felt on the new business side, given kind of your comments along elongating sales cycles? Or is it you're seeing a slowdown in existing customers' expansion as well?"
},
{
"speaker": "Thomson Leighton",
"text": "Yes. Good question. The 20% goal, of course, includes M&A, and we're about to do the year-over-year lapping on Guardicore, which is a very successful acquisition. And we haven't announced any other acquisitions in security to sort of fill that gap. In terms of increasing the security growth rate over time, obviously, the global economic conditions are important there. Also, we've got several of the newer products that are growing very rapidly. Aside from Guardicore, bot management doing extremely well. The new Account Protector solution doing very well. Page integrity management, which will be, I think, really important for companies that want to be PCI compliant beginning in 2025, and they're already working towards that. Those areas are doing very well in terms of growth, but they're still small enough in revenue that they can't swing the whole number as much. The vast majority of our security revenue today is in the app and the API protection area. And the large majority of that is in our web app firewall, where we're the market leader by far and continuing to grow that faster than the market and our competitors there. But that market is -- as a whole, is slower growing. So what we'll need to see is better economic environment, continued growth in the rapidly growing products that are -- as they get bigger, their rapid growth can drive security as a whole, and ultimately, M&A, which is a key part of the 20% goal."
},
{
"speaker": "Operator",
"text": "And ladies and gentlemen, our next question today comes from Frank Louthan at Raymond James."
},
{
"speaker": "Frank Louthan",
"text": "Great. With the sales cycle more elongated, can you give us a little more detail there? Is that across the board? Is it concentrated in any verticals? And give us a little bit more color on what's driving that. Is it more economic? Or is there anything to do with the mix with Linode and compute that's sort of making the suite of services take a little longer for folks to make a decision?"
},
{
"speaker": "Edward McGowan",
"text": "Frank, good question. So actually, I'll start with Linode. Actually, Linode in an environment like this, given what Tom talked about, we will be able to provide comparable services at a much better set of economics and actually think is an opportunity for us. So I would expect that as we go into next year, that should be a tailwind for us. On the headwind side, we are seeing across the board, certainly from a geographic perspective, that sales cycles are elongating. We've seen some deals push. Probably the easiest place to identify it is in Guardicore. Guardicore, as Tom mentioned, is still doing really well, but we have a dedicated sales team. So it's a little bit easier to track those deals as they're going through the pipeline. Those deals also sometimes tend to be a little bit larger. So it's a little bit easier to follow that. With our business, given it's a SaaS business and we've got recurring revenue contracts are constantly going through and renewing contracts, what you're seeing is some customers that are talking about, say, adding Page Integrity Manager or a Bot Manager or Account Protector, just pushing that off into the future as they go through their budget cycle. So we're not seeing as much on the renewal side from an upgrade perspective. So a little bit of slowness there. And then from the new customer acquisition perspective, I think pretty much every tech company you talk to these days is seeing it a little bit harder to attract new customers. So it's a little bit of a combination of everything as we've just been impacted by this economic impact here."
},
{
"speaker": "Operator",
"text": "And our next question today comes from Fatima Boolani with Citigroup."
},
{
"speaker": "Unidentified Analyst",
"text": "This is on for Fatima. So just maybe a follow-up in regards to the September and October recovery on the delivery side you're starting to see. Can you maybe give a sense of which end market cohort is really driving that momentum? And then when you're going to negotiating tables in regards to pricing and other contract terms, can you also give us a sense of how that has been developing?"
},
{
"speaker": "Edward McGowan",
"text": "Sure. Yes. So in terms of the traffic sort of getting a little bit healthier, I would say, coming out of the summer months, media is probably the vertical that it's most obvious in. So we're starting to see that across video, a little bit in gaming. Gaming is still overall very, very weak compared to what it's been in the future, but a little bit of an uptick here in the gaming vertical over the last couple of months. And then your other question, can you just remind me again? I forget."
},
{
"speaker": "Unidentified Analyst",
"text": "Sorry, just in terms of pricing and other contract terms as you guys go to the negotiation table."
},
{
"speaker": "Edward McGowan",
"text": "Yes. So one of the things we talked about is, obviously, like in the media division in particular, media verticals in particular, as we see traffic levels decline or not grow as quickly, I should say, we typically would give a discount commensurate with what you see in the traffic growth rate. So obviously, as traffic growth rates are not growing as quickly, we are lowering our discounts that we're providing to our customers, and we're starting to see that make its way through the system. It will take a while for it to really impact the growth as we go through our renewal cycles, but I am seeing that the pricing declines are certainly moderating a bit."
},
{
"speaker": "Unidentified Analyst",
"text": "Okay. Got it. And then maybe just a follow-on, on the lighter-weight development. Any sense of how the customers -- are there any #1 customers in the beta testing phase? And also, I guess, where -- what are sort of the milestones we should look out there -- look out for there?"
},
{
"speaker": "Thomson Leighton",
"text": "I didn't catch the question. Can you repeat the question, please?"
},
{
"speaker": "Unidentified Analyst",
"text": "Sorry, just in terms of the lighter-weight deployment on, I guess, the cloud side? Yes."
},
{
"speaker": "Thomson Leighton",
"text": "Yes. And what's the question about the lighter-weight deployment?"
},
{
"speaker": "Unidentified Analyst",
"text": "Yes. Just in terms of, are there any customers currently in the beta phase or testing out the product and how has that feedback been? And then are there any milestones we should look out for?"
},
{
"speaker": "Thomson Leighton",
"text": "Good. Okay. So there are customers on the platform today and a key reason that they are using Linode and plan to grow their use of Linode is because of these deployments. And the advantage of the lighter-weight deployments is we can get into markets, into regions where it's hard to build out a massive core compute data center so that we're going to have before -- next year more than double by having over a couple of dozen of the core compute data centers, but several dozen more of these lighter-weight distributed locations, where you can do the compute. You wouldn't have huge monolithic storage there, but you don't need that. That can be in the core regions. And that is a key consideration to some of our larger customers that are working with Linode today, doing proofs-of-concept, so in some cases, already running mission-critical applications. Because those lighter weight regions being closer to enterprise data centers in many parts of the world and to end users gives you better performance. And I think that will put Akamai in a great position to have equal or better performance than the hyperscalers. Of course, we have already our edge deployment with 4,000 locations, which also supports edge computing on top of delivery. And for a total -- lower total cost of ownership. So yes, the lightweight distributed regions are important for a lot of our customers and prospects with among the major enterprises on Linode."
},
{
"speaker": "Operator",
"text": "And our next question today comes from Michael Elias at Cowen and Company."
},
{
"speaker": "Michael Elias",
"text": "The first one, you mentioned it a bit ago relating to your long-term guidance and M&A on the security front. Just a question around how would you describe the pipeline of opportunities for M&A in the security market? And as part of that, maybe any capabilities which are top of mind as you think about adding to the platform?"
},
{
"speaker": "Thomson Leighton",
"text": "Yes, we have a large pipeline, and we generally do. We're constantly looking for appropriate acquisitions. As Ed said, we're very disciplined buyers, though. And the market as a whole is still highly priced. I think the realities of what's going on in the global economy haven't fully set in yet. That may take another year. And so because we're very careful buyers, we're being very selective there. I think there's a variety of capabilities that would be interesting as tech tuck-ins. And occasionally, we'll make an acquisition with a product adjacency. I think Guardicore has been a fabulous acquisition. They're the market leaders now in segmentation, making Akamai the market leader there. And I think that's the most important defense an enterprise can have. You can buy every company's Zero Trust offer, and malware is still getting into enterprises. And the real key is to identify it quickly and proactively block it from spreading. And that's how you limit the damage caused by ransomware and data exfiltration attacks. And that's what Guardicore does. And so I think very important strategic product with enterprise security and Zero Trust. But over time, I think there'll be other capabilities that we'll be interested in, in terms of broadening the portfolio."
},
{
"speaker": "Michael Elias",
"text": "Got it. Now just a philosophical question for you, Tom. Over the years, you've taken steps to continue to grow the business and expand Akamai into new verticals. But the stock really hasn't responded in the way that I think you would have liked, just given some of your prior comments. My question for you is, as you think about executing the long-term vision for Akamai, do you believe being a public company is the right setting for you to achieve that long-term vision?"
},
{
"speaker": "Thomson Leighton",
"text": "Yes, sure. I think it's great being a public company. And yes, I do think the stock is undervalued where we are today in this market. And that's why I'm going to buy more shares. It's -- and over time, the stock has grown. And I think there's excellent prospects for future growth as we continue to grow Akamai. And I'm really excited about what we can do in the compute landscape. That's an enormous market. You just look at Akamai, next year, probably security will be our biggest product line. That's a big step forward, given that we started as a CDN company. And I think if you look 3 to 5 years down the road, well, maybe in that time frame, compute could be our largest product line. So I think there's lots of opportunity for continued growth. We're very disciplined when it comes to cost, and that means there's a lot of opportunity for bottom line growth in earnings per share. We've continued to buy back our equity to reduce the number of shares outstanding. So I think there's a great value proposition for public Akamai shareholders."
},
{
"speaker": "Operator",
"text": "And our next question today comes from Tim Horan with Oppenheimer."
},
{
"speaker": "Tim Horan",
"text": "I hate to harp on it, but the sales slowdown, can you just give us a little more color maybe when you started to see it? Is it continuing? Maybe what the lag is in terms of sales and revenue showing up? Just I'm trying to get a sense of what next year's revenue growth could be. I guess, at a high level, are we looking at 2 or 3 more quarters of flat from what we know now? Or at a high level, can growth be better next year than this year at this point?"
},
{
"speaker": "Edward McGowan",
"text": "Jim, let me take a stab at that. So I would say we started to see it really in this quarter and continue -- sorry, this quarter, meaning Q3, sorry, we're reporting Q3, continuing here in Q4. Hard to say how long this economic slowdown lasts. Now keep in mind, most of our business is under contract. The impact of the new signings doesn't have an overly material impact on the business, especially in any one given quarter. Obviously, over a prolonged period of time, it can slow growth down a bit. I think the bigger thing to think about as you build your models is the impact that foreign exchange has had. I've been trying to call it out as we go. Obviously, the dollar has gotten stronger throughout the year. So when you think about from an as-reported perspective, that's going to be a pretty big headwind. If you annualized at a point we went back all the way to the beginning of the year, you're talking a couple of hundred million dollars of revenue or $0.40 of EPS, a couple of points of operating margin. But that's a much bigger issue in terms of growth. And given our strong growth internationally, FX, assuming the dollar continues to get stronger, is something that I'd be more concerned about from a growth perspective. But we'll give you an update on guidance next year when we have our Q1 call -- or excuse me, our Q4 earnings call in Q1. So I'm not going to provide any guidance right now, but hopefully that gives you enough color to think about it."
},
{
"speaker": "Tim Horan",
"text": "On FX, some of your largest competitors, particularly in cloud, but even on the kind of CDN security space, people had a bundling kind of charge in dollars pretty regularly. And some of your other smaller, one in main competitors in Linode has raised prices quite a bit here lately. Have you thought about maybe switching over the pricing in dollars? Or do you do much of that? And have you taken any pricing steps to increase prices?"
},
{
"speaker": "Edward McGowan",
"text": "Yes. So we tend to price most of our -- not all of our international business is in the local currency, most of it is, though. So you can see that's why we have such a big impact. Generally speaking, it's hard to switch with a customer who has been paying in one currency and then switching to another one. Then you also -- the -- in terms of price increases, too, that's not something that we're considering at this point. Obviously, it's kind of a risky thing to do, when you see companies raise prices. Part of the reason we're actively looking to move our cloud spend is for the reason that we're seeing the suppliers in that area either increase price or not give any commensurate declines with volume increases. So I think the long-term strategy of introducing price increases can come back and backfire on you. So we're not planning on -- we're not going to be making any changes in terms of changing customers out from paying in local currency to dollars."
},
{
"speaker": "Tim Horan",
"text": "In the U.K., you're 20% below your peers in the last 9 months of price reduction effectively. But my last question is, Linode, is your OpEx and CapEx run rate enough to transition Linode and grow Linode?"
},
{
"speaker": "Edward McGowan",
"text": "Yes. So if you think about where the investments are going to be, and that's where we're primarily investing our headcount is in Linode and also in security. And Tom also mentioned that we'll be moving some of the people that have skills that are transferable. If you think about building out, scaling up a CDN, there's a lot of transferable skills. So we'll be able to move some folks that have talent into that group as well. So that won't put any pressure on the bottom line, but we will be spending some money and continuing to grow because we think the opportunity is significant. And then on a CapEx perspective, we will be building out to take in the consideration, moving our own workloads as well as the future demand, and we'll give you an update on that at the next call."
},
{
"speaker": "Operator",
"text": "And the next question comes from Amit Daryanani with Evercore."
},
{
"speaker": "Amit Daryanani",
"text": "I have two as well. I guess maybe on the first one, if you could just talk about the edge business, the Linode asset. And I guess, maybe the question I struggled with a fair bit is, can you grow this business on the cloud infrastructure side without sacrificing operating margins over the next several years? Or is that growth in Linode on the edge side going to come at lower margins inherently?"
},
{
"speaker": "Edward McGowan",
"text": "Yes. So good question. I think we bring some pretty interesting synergy. I just mentioned on the last question how we've got a lot of skill sets in-house that can do, say, network build-outs, for example. We don't have to build out a separate team to do network build-outs. We've got engineering talent in-house. We also have a big enterprise sales force in place that Tom talked earlier in one of the earlier questions about the spending of some of our larger verticals and the relationships we have with those customers who are spending probably 10 to 15x more on cloud computing than they are on CDN. So there's a significant synergy that you get there. And then also with our network infrastructure that we have built out, Tom talked about connecting our backbone to the existing Linode centers. That drives a significant cost benefit. So I think that actually, we could have very attractive operating margins, similar to what I showed on the IR Day. We get pretty good operating leverage, just like we did with the security business. So long term, our goal is to get back to 30% or higher in operating margin. And I think as we scale that business, we should be able to do it."
},
{
"speaker": "Amit Daryanani",
"text": "Got it. And then, I guess, maybe I'd just stick to that theme around Linode. Are there certain use cases that make Linode more attractive more so the top 3 cloud providers that are out there? I guess I'd just love to understand, when you folks walk into a customer pitch, what are the reasons want to use Linode versus some of the peers that might provide a cloud solution at least cheaper? Maybe that would be really helpful. Like what are the 2, 3 reasons that you think stands out?"
},
{
"speaker": "Thomson Leighton",
"text": "Yes. Let me answer that question in the context of where we'll be next year. Because as you know, we're doing a lot of the build-out now. We're doing -- adding a lot of the functionality now. But if you look at where we'll be this time next year, I think, first, our footprint will be better than that of the hyperscalers. We'll be closer to a lot more enterprise data centers' end users. So that means better performance. I think we'll be hooked in now then to the Akamai platform with 4,000 POPs to do delivery, to do the outer layer of security, to do edge computing. So that's a big advantage. As Ed noted, that also lowers our costs substantially for egress. And so lower total cost of ownership is another, I think, very attractive feature that Akamai would have. Akamai is known for scalability, for reliability in addition. And there's been some pretty well-publicized issues with some of the hyperscalers in terms of reliability, extended issues. And I think that's an area where we can be very competitive. Really the only area where we wouldn't be as competitive as in the large number of third-party apps in the ecosystem that are available as managed services on the hyperscalers. And that's a key way that you get vendor lock-in. And so customers that want -- enterprises that want to have that, fine, okay? But if you don't want lock-in and you do want better performance at a lower cost, I think Akamai will be very competitive. And also, it's good to keep in mind just relative scale. Those hyperscalers are giant companies. If we can go get 1%, 2% market share in a multi-hundred billion dollar business, that will be very meaningful for us. And I think we're in a position that we can go do that. One other issue is that in the sectors where we're very strong like media and commerce, those companies, they compete heavily with at least some of the hyperscalers. And with the cost of the hyperscalers rising, that's becoming more of an issue for those companies. You're paying a large bill to a company that's buying out the media rights from underneath you. And that's sort of tough for some of them to take. So I think that also gives us a competitive advantage. We don't compete with our customers. We will help them grow with their business and be good partners to them and they can trust us."
},
{
"speaker": "Operator",
"text": "And our next question today comes from Mark Murphy at JPMorgan."
},
{
"speaker": "Sonak Kolar",
"text": "Sonak Kolar here on for Mark Murphy. Tom, can you get a bit deeper on the new pricing strategy, particularly around delivery? Have you noted any incremental changes in customer retention or churn levels as a result of some of these pricing adjustments, specifically around some of the inflationary environment pressures driving price sensitivity in the market?"
},
{
"speaker": "Edward McGowan",
"text": "Yes. This is Ed. No, we haven't seen anything notable. Like if anything, we're actually starting, like I said, to see some bit of a moderation in the pricing declines. So we haven't seen anything on the churn side."
},
{
"speaker": "Sonak Kolar",
"text": "Got it. That's very helpful. And then a quick follow-up. Would you say some of the macro pressures that you've called out have intensified in Q3 relative to Q2? Or has it remained fairly in line with some of the pressures that you called out during the last earnings call?"
},
{
"speaker": "Edward McGowan",
"text": "Yes, I'd say it's intensified a bit in Q3."
},
{
"speaker": "Operator",
"text": "And our next question today comes from Rudy Kessinger with D.A. Davidson."
},
{
"speaker": "Rudy Kessinger",
"text": "I don't want to belabor the point on security growth. But again, when we exclude Guardicore and look at it at constant currency, it looks like organic has come down about 5 points from Q1 to Q3. And so if you were to look at it, could you maybe break out like what's been the impact in your assessment from the macro and -- versus just maybe some of the larger products maturing and growing slower that's led to that roughly 5-point deceleration in the last couple of quarters?"
},
{
"speaker": "Edward McGowan",
"text": "Yes, I'd say it's a tough one to really figure out what the impact is on the macro. I'd say that's probably -- maybe that's a point or 2. But I think it's really the issue of what Tom talked about, where if you look at the biggest product, we're the market leader in web app firewalls growing faster than the market, but that market isn't growing as fast as some of the other markets that we're in, and it's just not at scale yet. So I'd say that's the bigger issue, except those newer products are growing faster at the scale that we're at, just isn't offsetting the slower growth in those -- in the bigger products."
},
{
"speaker": "Rudy Kessinger",
"text": "Okay. And then on Linode, I don't know if you gave it. Could you share how much revenue Linode did in the quarter? And then last quarter, given the commentary today about the increase in cost of the hyperscalers, last quarter, you talked about moving your hyperscaler spend over to Linode internally. Have you started that process yet? And if not, when do you plan to do so?"
},
{
"speaker": "Edward McGowan",
"text": "Yes, I'll take the first one."
},
{
"speaker": "Thomson Leighton",
"text": "Go ahead, Ed. You take the first part and I'll..."
},
{
"speaker": "Edward McGowan",
"text": "I'll do -- mine is pretty simple. So Linode added about $33 million this quarter. Tom, why don't you talk about the movement?"
},
{
"speaker": "Thomson Leighton",
"text": "Yes. So that's well -- the migration of our cloud spend to Linode is well underway. We've already done some. The lion's share of that work or the migration will take place, I would say, over Q1 to Q3 next year. And by the end of next year, we ought to have the vast, vast majority migrated."
},
{
"speaker": "Operator",
"text": "And ladies and gentlemen, our next question today comes from Tom Blakey with Truist Securities."
},
{
"speaker": "Tom Blakey",
"text": "I think it's been touched on a couple of times by my peers here. Just wanted to get -- go back to that. Some sort of normalized CapEx level, from my estimation, we're clearly overspending on Linode as a percentage of Linode revenue, anyway, right, if you do the percentage of total revenue. And you've made great strides in terms of lowering the CapEx from a delivery perspective down to this kind of 3% to 4% range. But as things kind of normalize, Tom, when you look out, and we're at , maybe 2/3 of revenue coming from compute security, CapEx is nil. You're just riding the rails of what already exists. What does the CapEx kind of bridge or normalized structure of this company look like a few years from now?"
},
{
"speaker": "Edward McGowan",
"text": "Yes. So I'll take a stab at that. Tom, if you want to add anything, feel free to jump in. So obviously, with the -- what we're talking about here, where Linode was primarily focused on small, medium business, and we're moving towards the enterprise workloads, you're talking about much larger workloads. Even with our own spend and what we're moving, Tom talked about on the last call, we had that we're spending roughly $100 million, that's growing pretty fast. That's a much bigger scale than what Linode was doing. So looking at CapEx as a percentage of existing Linode business isn't the right metric to look at, at this point. But think of it as we're in the build phase. So you can see CapEx is starting to creep up a bit as we're building out, as we see better visibility into demand and also as we start to build out our plans to migrate the workloads that we do have on the hyperscalers on to us. So you're going to see a bit of a disjoint. So if you're looking at that as a metric, it doesn't send the right signal. I'd say look at that as more of a bullish signal in terms of how we feel about our customer -- pending customer demand and also how we think we'll be very successful in being able to migrate those workloads. So for the next, say, several quarters, you're going to see more CapEx going into Linode and then the revenue and the cost savings will follow. But then if we get -- it really depends on the growth, right? So as you're growing revenue at significant rates, and so you're doubling revenue, you're going to obviously have a higher percentage of CapEx. But then at some point, it will normalize out to approximate what the future revenue growth would be. And so, let's say, for example, we get to 20% growth as a run rate in the long term, your CapEx will probably be somewhere in that range."
},
{
"speaker": "Tom Blakey",
"text": "I'm sorry, I didn't understand the last comment of 20% growth in Linode, the CapEx was..."
},
{
"speaker": "Edward McGowan",
"text": "No, no, no. So I was using that as an example. What I was saying is we'll give you detailed guidance on what we're going to do next year, but we're in a building phase now where Tom talked about getting into many new centers we're building out for our own demand and also what we're hearing from our customers. So what I was saying is if you're looking at CapEx as a percentage of Linode, it's not the right way to be thinking about it because we're going after a much different business, right? We're going after big enterprise workloads. So there's a build phase where you have to build out ahead of the demand. And then you'll start to see the revenue come our way. And as you get to scale, like many years out when you get to scale, you can start thinking about as a proxy that roughly speaking, your CapEx would approximate what your future demand is. So if you, say, have a long-term run rate of 20% or 30%, your CapEx will be somewhere in that range. But in the near term, it'll be higher than..."
},
{
"speaker": "Tom Blakey",
"text": "That's exactly what I was asking. I understand, obviously, you're overspending today. And that comment was just a structural comment for the question on what CapEx would be as a total percentage of revenue, total revenue in the -- again, when you're at scale for Linode? Will it be structurally lower or higher than delivery?"
},
{
"speaker": "Edward McGowan",
"text": "We'll know when we get there. There'll probably be -- certainly higher than what we're seeing in delivery now, but it is a more capital-intensive business by nature."
},
{
"speaker": "Tom Blakey",
"text": "It's a more capital-intensive business with compute, okay."
},
{
"speaker": "Operator",
"text": "And our next question today comes from Will Power at Baird."
},
{
"speaker": "Charles Erlikh",
"text": "This is Charlie Erlikh on for Will. I just wanted to ask a 2-parter on the comment that you guys are going to basically take some resources from delivery and put them into security and compute headcount-wise and hiring-wise. So the first part is, how do you feel about competition for talent in the security business and the compute business maybe relative to a few months ago? Kind of what does that hiring environment look like in those 2 businesses? And then part 2 on the delivery side, how should we interpret that comment as far as trying to turn around that delivery business and just sort of what should we expect from that business as far as trends going forward?"
},
{
"speaker": "Thomson Leighton",
"text": "I'll take the first question. It's still a competitive market for hiring. We've been very pleased to see our attrition rates take a major drop over the last quarter. We had stayed at low attrition rates through COVID, well better than market, ticked up a little bit in the first half of the year, but now again down to, over the last 3 months, very low attrition. We have very successful recruiting. Akamai is considered to be a great place to work as measured by the various studies that are done and also employee satisfaction surveys that we do. So people really like working at Akamai. We have really great employees, very smart. We set a high bar for who we recruit. And of course, everybody wants to hire those people. And pretty much everybody wants to hire Akamai employees. But our retention rates are good. I would say our success in hiring is good, but it's a competitive market out there. And Ed, do you want to talk about the delivery business?"
},
{
"speaker": "Edward McGowan",
"text": "Yes, sure. So the way to think about the delivery business, I'll call on 4 factors in terms of thinking about, as you called it, a turnaround. Obviously, one is renewal. So we went through a very heavy phase of renewals. So we're not going to have that next year. We'll always have some renewals, but it's very unusual to see 8 of your top 10 customers renewing at the same time. Number two is pricing. So we're -- as we talked about several times on the call, we are moderating the discounts that we provide on pricing. And then the third thing is traffic. Traffic, we're starting to see some encouraging signs, albeit early, that the Internet has been growing at 30% a year for many, many years. This year is a sub-30% year, but it's reasonable to think that we should start to get back to more traditional growth rates. And then the fourth thing I would say is I think we get a tailwind in our delivery business from being in the compute space. We actually do see some customers that are on hyperscalers get to a certain size that they -- even though they offer their own CDNs, come to us for better performance. So as we add customers, get into new verticals, et cetera, we do have the opportunity to just grow the delivery business by being a proxy of being in the compute business."
},
{
"speaker": "Operator",
"text": "And our final question today comes from Alex Henderson at Needham & Company."
},
{
"speaker": "Alexander Henderson",
"text": "Sliding in before the final. Nice. So I wanted to go back to the commentary that you've made about the outlook for the upcoming quarter, particularly in the security space. If I adjust the numbers for the contribution from the acquisition of Guardicore, I'm getting an as-reported growth rate of around 9%. And I'm wondering, given your commentary about more difficult conditions and a little larger currency translation year-over-year in the fourth quarter, whether in fact you're expecting the security business to slow to that level in your guidance?"
},
{
"speaker": "Edward McGowan",
"text": "Yes. Alex, this is Ed here. I'll give that one a try. Obviously, we don't break out specific guidance for individual products like that in the quarter. But right now, the FX impact, as you quoted an as-reported number, is about 6%. So as-reported was 13%, constant currency was 19%. So if you assume that, you're getting to about -- if you're using 9%, you get to about 15%. Since we're lapping, in constant currency that is -- since you're lapping the Guardicore acquisition at this point, and we just came off a 15% organic growth rate, if you back up the contribution from Guardicore in Q3, that's probably a reasonable number. If you're solving for what we gave you in terms of 20% constant currency, somewhere in that 14% to 16% constant currency. Obviously, I can't predict where FX is going to be. But if you just kind of keep it what it was this quarter, that's -- you're doing roughly the right math."
},
{
"speaker": "Alexander Henderson",
"text": "So a similar kind of question. If I take the Linode comments, it looks like that actually accelerated from about a 15% baseline growth rate to around 20%, making the adjustment for the Linode acquisition. On an as-reported basis, that's actually pretty good, considering the currency. Can you talk a little bit about the geographic play between -- in the Linode business and how much currency would have impacted that side of it? And then again, as we look into the baseline growth rate, it does seem like it's accelerating. Can you talk a little bit about whether that's a function of the investments you're making in marketing and like? Or whether that's something that's sustainable in the guide?"
},
{
"speaker": "Edward McGowan",
"text": "Sure. So I'll start with the currency with Linode. So not -- they -- when we acquired Linode, most if not all of their revenue was in U.S. dollars. So they were not billing in local currency. So there's not as much currency headwinds associated with the Linode portion of the business. Obviously, with the non-Linode compute business, we have the normal dynamics in our business. On the investments in terms of marketing, et cetera, I think we can maintain the current levels, and I'm not expecting a significant increase in marketing spend next year. We are increasing it a bit, but nothing significant. From a sales perspective, we are adding some sales folks, some specialists, especially on the technical side, to help our sales force, but it's not going to be a significant investment there. We believe our sales force can be trained, and we're also changing our comp plans to have an added incentive for compute. So all of that, I think, can fit into sort of a normal run rate expense level that we've been sort of operating, and I don't see any major investments in that part of the business."
},
{
"speaker": "Alexander Henderson",
"text": "If I could slide in one last one, since I'm the last guy here. As the mix shifts here, how do you expect the mix shift between the segments to start impacting the overall margins?"
},
{
"speaker": "Edward McGowan",
"text": "Yes. So obviously, if you go back to the IR Day slides, and there was a question earlier about the leverage that we get on the compute business, as the faster-growing parts of the business security and compute become a bigger part of the business, we should get some operating leverage. It won't happen right away, but over time. Then obviously, there's the dynamic that we talked about with some accelerated CapEx ahead of revenue. So that's another thing to keep in mind. The other thing you notice -- I talked a bit about having a bit of a pressure on the gross margin line. That also, I would say, is more of a temporary thing. We will be reducing the gross margin line as we move our third-party costs over, but also with some of the build-out costs, including some of our colocation agreements, network build costs, a little bit that's front-loaded. So as revenue scales, we should start to see some scale in the gross margin line as well. So as Tom talked about, security should be our biggest product line. It's got higher gross margins, higher operating margin. So we should start to see that flow through as the mix changes to those 2 product lines over time."
},
{
"speaker": "Thomson Leighton",
"text": "And thank you, everyone. In closing, we will be presenting at a number of investor conferences and presenting at events, road shows and other things throughout the rest of the fourth quarter. Details of these can be found in the Investor Relations section of akamai.com. So thank you for joining us. And all of us here at Akamai wish continued good health to you and yours, and have a nice evening."
},
{
"speaker": "Operator",
"text": "Thank you, sir. This concludes today's conference call. We thank you all for attending today's presentation. You may now disconnect your lines, and have a wonderful day."
}
] | Akamai Technologies, Inc. | 24,522 |
AKAM | 2 | 2,022 | 2022-08-09 16:30:00 | Operator: Good day, and welcome to the Akamai Technologies Second Quarter 2022 Conference Call. [Operator Instructions]. Please note this event is being recorded. I would now like to turn the conference over to Tom Barth, Head of Investor Relations. Please go ahead.
Tom Barth: Thank you, operator. Good afternoon, everyone, and thank you for joining Akamai's Second Quarter 2022 Earnings Call. Speaking today will be Tom Leighton, Akamai's Chief Executive Officer; and Ed McGowan, Akamai's Chief Financial Officer. Please note that today's comments include forward-looking statements, including statements regarding revenue and earnings guidance. These forward-looking statements are subject to risks and uncertainties and involve a number of factors that could cause actual results to differ materially from those expressed or implied by such statements. The factors include any impact from macroeconomic trends, the integration of any acquisitions and any impact from geopolitical developments. Additional information concerning these factors is contained in Akamai's filings with the SEC, including our annual report on Form 10-K and quarterly reports on Form 10-Q. The forward-looking statements included in this call represent Akamai's view on August 9, 2022. Akamai disclaims any obligation to update these statements to reflect new information, future events or circumstances, except as required by law. As a reminder, we will be referring to some non-GAAP financial metrics during today's call. A detailed reconciliation of GAAP and non-GAAP metrics can be found under the financial portion of the Investor Relations section of akamai.com. And with that, let me turn the call over to Tom.
Thomson Leighton: Thanks, Tom, and thank you all for joining us today. I'm pleased to report that Akamai delivered strong results in the second quarter despite the ongoing challenges with the global economic environment and slower Internet traffic growth. Q2 revenue was $903 million, up 6% year-over-year and up 9% in constant currency. This result was driven by the continued rapid growth of our Security and Compute businesses, which when taken together, were up 30% in constant currency. These 2 business lines now account for 54% of our overall revenue. Q2 non-GAAP operating margin was 29%. Q2 non-GAAP EPS was $1.35 per diluted share, down 5% year-over-year, but up 0.5% in constant currency. As Ed will discuss later, EPS was negatively impacted by foreign exchange rates and a higher effective tax rate compared to last year. Free cash flow was very strong at $223 million in Q2 and it accounted for 25% of revenue. We've been leveraging our financial strength to make substantial investments in enterprise security and cloud computing. We've also used some of this cash to buy back additional stock. In the first half of the year, we spent $268 million to repurchase 2.6 million shares. This puts us on track to go beyond what's needed to offset dilution from employee equity programs this year. I'll now say a few words about each of our 3 main lines of business: Security, Compute and Delivery, starting with Security. Our Security Solutions generated revenue of $381 million in Q2, up 17% year-over-year and up 21% in constant currency. Growth in security was driven primarily by our app and API security portfolio, which includes our market-leading web app firewall, Bot Manager, Account Protector and Page Integrity Manager solutions. Our Zero Trust enterprise security portfolio, led by Guardicore, also performed well in Q2, with numerous significant customer wins. A leading global provider of financial data concerned about ransomware, added Guardicore segmentation solution to the 7 security products they already buy from Akamai. A major insurance company in France became a new customer for Akamai when they adopted our Guardicore solution to help meet European financial regulations. The sale, led by one of our carrier partners, is indicative of the excitement we're seeing for our Zero Trust solutions among our partners. In Australia's largest telecom provider, Telstra, expanded their business with us by adding our Secure Web Gateway solution to their portfolio of Akamai products. They told us, "As part of Telstra's journey in delivering fit-for-purpose solutions, Akamai has been a key industry partner with network-based anti-phishing malware protection and content filtering. Telstra blocks millions of threats every single day, and Akamai is a key partner in that protection." Overall, our Zero Trust solutions delivered $43 million of revenue in Q2, up 59% year-over-year in constant currency. This is an area where we're making -- continuing to make major investments and where we anticipate significant future growth. Turning now to Compute. I'm very pleased to report that the revenue for our Compute product group was $106 million in Q2, up 74% year-over-year and up 78% in constant currency. As a reminder, the Compute product group includes Linode and Akamai solutions for Edge computing, storage cloud optimization and Edge applications. A common theme that I heard when I met with executives from around the world in Q2 was their growing concern about being locked into contracts with cloud giants that are consuming large and rapidly increasing shares of their IT budgets. They want more choice in compute and are open to alternative clouds like Linode as a more efficient way to build, run and secure their applications. As a result, many large enterprises have begun testing the Linode platform, including a major U.S. airline, one of the world's top gaming companies and a global provider of weather data. Major media companies, in particular, expressed significant concerns with their growing use of the giant clouds. Not only are the cost high, in part because of the fees from moving data from cloud storage to a CDN for delivery, but they're also concerned about their increasing reliance on a direct competitor. As an example, I'm very pleased to announce that we recently signed a contract with one of the world's largest media companies to run a critical new workload on Linode. The service is live today, and we anticipate that it will generate millions of dollars of annual revenue as their usage grows over time. This is just the tip of the iceberg when it comes to our potential for future revenue growth in Compute. Cloud computing is a fast-growing, multi-hundred billion dollar market. And as we scale Linode to be enterprise grade with pops and hundreds of locations around the world, we should be in an excellent position to capture a share of this market, particularly from companies that value our industry-leading security and delivery solutions and that don't want to be locked in to more expensive options with a cloud giant that competes against them. Our Delivery products generated revenue of $417 million in Q2, down 11% year-over-year and down 8% in constant currency. These results were clearly impacted by a continued deceleration in traffic growth among our largest media customers and by the lower unit pricing we provided as part of their recent contract renewals. It's important to note that Akamai remains the market leader in delivery by far. Moreover, customer churn in the first half of this year remained at record lows, and lost annual revenue from churned accounts in Q2 was even less than in Q1. We also saw some notable delivery customers move business to our platform in Q2 after trying out competing solutions. No matter which competitor they've been working with, they chose Akamai because of our superior performance and reliability. Like many companies, we're managing through a time of substantial economic headwinds and uncertainty with escalating inflation, the strengthening U.S. dollar, growing concerns about a global recession, escalating geopolitical tensions and conflicts, and a slowing of Internet traffic growth as the world tries to return to normal in the midst of a pandemic. As Ed will talk about shortly, I think it's prudent to assume that these headwinds will dampen our growth rates and profitability over the next several quarters, particularly in our Delivery business, which is being impacted by the challenges that many major media companies have recently reported. Given the enormous market opportunity in front of us, we will continue to focus our investment on Zero Trust enterprise security led by Guardicore, and cloud computing, led by Linode. These investments, combined with the economic headwinds I just mentioned, will likely result in our operating margin remaining below 30% in the near term. We expect our margins to improve over time as our Security and Compute businesses continue to grow and account for a larger share of total revenue. In addition, we're embarking on several major initiatives to reduce cost and improve operational efficiency that should help return our margins to 30% or better in the medium to longer term. As Ed will discuss further, these initiatives include leveraging Linode to significantly reduce our cloud spend with hyperscalers, slowing the capital expenditures for our delivery platform and optimizing our real estate footprint. While these are challenging times to be sure, I believe that Akamai is on the right track for long-term growth and success and that we're well positioned because of our unique global-edge platform, our market-leading security and delivery solutions, our new compute capabilities which provide great performance at an affordable cost, our premier enterprise customer base and our strong financial position and profitable business model. Now I'll turn the call over to Ed for more on Q2 and our outlook going forward. Ed?
Edward McGowan: Thank you, Tom. As Tom mentioned, Akamai delivered another solid quarter in Q2. Q2 revenue was $903 million, up 6% year-over-year or 9% in constant currency. Revenue was in line with our guidance and was led by our Security and Compute businesses. As we mentioned on our last call, we expected significant foreign exchange headwinds to impact our revenue in Q2. The much stronger U.S. dollar negatively impacted our year-over-year growth rate by 3 points or approximately $29 million of revenue year-over-year and $14 million on a sequential basis. On a combined basis, our Security and Compute businesses represented 54% of total revenue, growing 26% year-over-year and 30% in constant currency. Security revenue was $381 million and grew 17% year-over-year and 21% in constant currency, with continued strength from our Zero Trust business led by Guardicore. Guardicore delivered approximately $14 million of revenue in Q2. Security represented 42% of total revenue in Q2, which is up 4 points from Q2 a year ago. Compute revenue was $106 million in Q2, growing 74% year-over-year and 78% in constant currency. Linode contributed revenue of approximately $32 million in the second quarter. Delivery revenue was $417 million, down 11% year-over-year and 8% in constant currency. It's worth noting that while traffic on our network continued to grow, the rate of that traffic growth declined sequentially in Q2. As Tom mentioned, we believe that the current macroeconomic environment has had the greatest impact on customers in our media vertical, most notably in advertising and gaming. These challenges are most apparent in our delivery results. Also, as we talked about at our Analyst Day in May, we started to align our pricing strategy with the new traffic growth rates we have seen on our network over the last 2 quarters. In addition to scaling back discounts provided upon renewal, we decided to turn away some business from a very small number of customers who have extreme traffic peaks compared to their daily usage patterns. While this will result in slightly less revenue, it will enable us to significantly lower our network CapEx as we focus on cash flow from our Delivery business to help accelerate our investments in faster-growing areas like Compute and Security. Sales in our international markets represented 47% of total revenue in Q2, unchanged from Q1. International revenue grew 6% year-over-year or 13% in constant currency. Finally, revenue from our U.S. market was $477 million and grew 6% year-over-year. Going now to costs and profitability. Cash gross margin was 75%. GAAP gross margin, which includes both depreciation and stock-based compensation, was 62%. Non-GAAP cash operating expenses were $292 million. Adjusted EBITDA was $388 million and our adjusted EBITDA margin was 43%. Non-GAAP operating income was $262 million, and non-GAAP operating margin was 29%. It is worth noting that our non-GAAP operating margin was negatively impacted by approximately 1 point due to unfavorable foreign exchange. Capital expenditures in Q2, excluding equity compensation and capitalized interest expense, were $104 million. This was much better than we expected, partly due to some Linode specific CapEx that pushed from Q2 into Q3 as well as some savings from our strategy of being more selective on certain types of customer traffic. These savings were most apparent in our network CapEx, excluding Linode, which was only about 3% of revenue. GAAP net income for the second quarter was $120 million or $0.74 of earnings per diluted share. Non-GAAP net income was $216 million or $1.35 of earnings per diluted share, down 5% year-over-year and up 1/2 of 1% in constant currency. It's worth noting that foreign exchange negatively impacted our non-GAAP EPS by approximately $0.07. Taxes included in our non-GAAP earnings were $42 million based on a Q2 effective tax rate of approximately 16%. This was about 1.5 points higher than last year. Moving now to cash and our use of capital. As of June 30, our cash, cash equivalents and marketable securities totaled approximately $1.3 billion. During the second quarter, we spent approximately $165 million to repurchase shares, buying back approximately 1.6 million shares. Our ongoing share repurchase activity has resulted in a net reduction in our non-GAAP fully diluted shares outstanding of approximately 4 million shares or roughly 2% on a year-over-year basis. We ended Q2 with approximately $1.5 billion remaining on our current repurchase authorization. Our intention is to continue to buy back shares to offset dilution from employee equity programs over time and to be opportunistic in both M&A and share repurchases. Before I provide our Q3 outlook and an update to our 2022 guidance, I want to highlight several factors. First, with nearly 50% of our revenue coming from outside the U.S., foreign exchange continues to be a significant headwind to our reported results. At current spot rates, our guidance now assumes foreign exchange will have a negative $114 million impact to revenue in 2022 on a year-over-year basis. As I mentioned previously, foreign exchange also impacts our margins and earnings. We estimate FX will negatively impact non-GAAP operating margin by approximately 1 point year-over-year and non-GAAP earnings by approximately $0.31 for the full year 2022. Second, we are incrementally more cautious on the outlook for traffic growth in Q3 and Q4. Based on our year-to-date trend, plus what we are hearing from other large Internet companies, we are anticipating a slower than usual traffic growth rate for the remainder of 2022. Third, as a result of the expected slower traffic growth rate and our updating pricing strategy that we noted earlier, we anticipate CapEx to be significantly below our previous outlook. Finally, as Tom mentioned, we expect the more challenging macroeconomic environment to dampen our revenue growth and margins in the near term. When combined with the impact of renewing 8 of our top 10 customers in the first half of the year, we expect Delivery revenue to decline at a slightly higher rate on a year-over-year basis for the next 2 quarters. As a result of these factors, we also expect margins to decline over the near term as well. We believe strongly in the long-term opportunities in front of us, especially in Security and Compute, and therefore, planned to continue to invest to exploit the market opportunity in these areas. That said, as Tom highlighted, we are embarking on several major initiatives to reduce costs and improve operational efficiency. Potential savings for each of these areas is in the tens of millions of dollars. Specifically, we are planning to do the following 3 things. First, significantly reduce our cloud spend with hyperscalers as we migrate internal Akamai workloads to Linode. Second, realized savings from our strategy of being more selective on certain types of customer traffic, which we expect will result in both lower capital expenditures and depreciation expense. And third, optimize our real estate footprint as the hybrid work experience becomes more permanent. Now turning to our Q3 guidance. We are projecting revenue in the range of $868 million to $883 million or up 1% to 3% as reported or 5% to 7% in constant currency over Q3 2021. Foreign exchange fluctuations are expected to have a negative $11 million impact on Q3 revenue compared to Q2 levels and a negative $36 million impact year-over-year. At these revenue levels, we expect cash gross margins of approximately 74%. In the short term, our gross margin is negatively impacted by our continued investment in Guardicore and the Linode-related headcount as well as higher third-party cloud costs. However, we are confident that this is a short-term impact only. We expect our gross margin to expand to the high 70% long-term target model as we see continued strong growth from both Guardicore and Linode as we reduce our third-party cloud costs over time. Q3 non-GAAP operating expenses are projected to be $283 million to $291 million. We anticipate Q3 EBITDA margins of approximately 41%. We expect non-GAAP depreciation expense to be between $125 million to $128 million, and we expect non-GAAP operating margin to be approximately 27% for Q3. As mentioned previously, the near-term decline in operating margin is due to slower traffic and revenue growth, our annual merit-based wage increase, which become effective July 1, the negative impact from foreign exchange, investments associated with Guardicore and Linode and increased third-party cloud costs. As our Security and Compute business continue to grow and we reap the benefits of the cost savings actions I described earlier, we are confident that our operating margins will return to 30% and then grow from there. Moving on to CapEx. We expect to spend approximately $109 million to $119 million, excluding equity compensation and capitalized interest in the third quarter. This represents approximately 13% of projected total revenue. And with the overall revenue and spend configuration I just outlined, we expect Q3 non-GAAP EPS in the range of $1.21 to $1.26. This EPS guidance assumes taxes of $37 million to $38 million based on an estimated quarterly non-GAAP effective tax rate of approximately 16%. It also reflects a fully diluted share count of approximately 160 million shares. Looking ahead to the full year, we now expect revenue of $3.57 billion to $3.61 billion, which is up 3% to 4% year-over-year as reported or up 6% to 8% in constant currency. We continue to expect Security growth of approximately 20% in constant currency for the full year 2022. We now estimate non-GAAP operating margins to be approximately 28% to 29% and non-GAAP earnings per diluted share of $5.19 to $5.37. And this non-GAAP earnings guidance is based on a non-GAAP effective tax rate of approximately 16% and a fully diluted share count of approximately 160 million shares. Finally, full year CapEx is anticipated to be approximately 12% to 13% of revenue. In closing, while the macroeconomic backdrop has become more uncertain, we believe that we are in the right markets with differentiated products that remain highly valued by our customers. Thank you. Tom and I would be happy to take your questions. Operator?
Operator: [Operator Instructions]. The first question is from James Breen of William Blair.
James Breen: Can you just talk about, obviously, the revenue guidance for the third quarter is lower than where consensus by about $10 million? Can you talk about the trade-off between margins and going after some of this delivery traffic in general because it's -- the EBITDA margins are about the same, but obviously, the growth is slowing at the top line.
Edward McGowan: Jim, this is Ed. So in terms of the guide, there's really 2 pieces to it. The first one is obviously FX has gotten incrementally worse. That's probably about half of the delta. The rest of it is the slower traffic that we talked about. I think your question was specific to the trade-off that we're making. The first immediate impact that you get on that trade-off from taking less of that peak traffic as you save on CapEx. So that will make its way through the P&L through lower depreciation and obviously immediately through cash flow. And so the decision that we've made is obviously, as we talked about in May, as traffic levels have come down, the discounts that we offer upon renewal are lower. And in some cases, we've seen a small handful of customers that have the traffic. Their peaks are still growing at pretty significant rates, but their day-to-day traffic is not. So there's a formula that we go through in a trade-off that we made that I think makes a lot of sense for us, especially as I look at the types of returns we can get from the faster-growing areas like security and compute.
James Breen: So the shift in general just to a more -- a little bit more of an asset-light business and focusing on some of these other areas?
Edward McGowan: Yes. I mean, I would say, obviously, compute can be, I wouldn't call it an asset-heavy business, but it does have a fair bit of CapEx. We talked about our CapEx for Linode being about 2% of revenue in total. And obviously, it's going to be a little bit front-end loaded. We actually took the advantage to try to spend a little bit more for Linode. Based on some of the conversations we're having, we're starting to see some good demand. And obviously, Tom talked about signing a pretty significant customer in the quarter. So what we're doing though, on the Akamai, of course, I call it the legacy Akamai delivery business is we are being a bit more selective in reducing CapEx. I made a comment that our network CapEx excluding Linode was 3%. That's typically around, call it, 8% to 10%, at least where it's been running over the last couple of years. So I think it's just a question of being more selective with certain types of traffic. It's really a handful of customers that have that type of traffic pattern. It's generally event-driven. And what we're seeing is it's just a better return to shift some of that investment in other places.
James Breen: Great. And then just maybe just one for Tom. On Linode, can you just talk about some of the success you're having sort of selling that product into your existing customer base?
Thomson Leighton: Yes. Obviously, very early days. We've got a lot of work ahead of us with Linode, as we've talked about. But it's great to land our first very large customer, putting a critical app. Actually, it's for transcoding, user content onto the Linode platform. As I mentioned, that's just that app alone as it scales is worth several million dollars a year of revenue for us. And tip of the iceberg, this is a customer that spends many hundreds of millions of dollars a year on cloud computing. And that's just 1 customer. So a lot of good opportunity ahead, and we're making good progress on our road map for Linode.
Operator: The next question is from James Fish of Piper Sandler.
James Fish: We've seen some security vendors report here and Security is going through kind of actually still a strong environment despite the macro. And when I look at your normalized rate of about 17%, it's a bit lighter than what we saw in Q1 in the last couple of years really. What's going on, especially on the core WAF and DDoS and in Bot management in terms of the sizing and growth against some of the newer solutions like EAA and PIM here? And is there a way to think about if you guys are seeing any higher net churn overall or how to balance net new business versus the expansion that you're seeing with your existing customers and security?
Thomson Leighton: I'll start with that and then maybe Ed will add some comments. Security is very strong. We have the market-leading WAF by far. In fact, you look at their most recent Magic Quadrants and analyst ratings, and we've widened the gap with competition. Bot Manager also the market leader by far. Now we have Account Protector built on top, growing very well. EAA is small today, good opportunity for growth, particularly coming on the following Guardicore. Guardicore, very exciting. You think about the enterprise security landscape, and our segmentation, I think, has been something that historically was overlooked mainly because it wasn't done very well. But I think as you look to the future, it's probably the most important thing an enterprise can do. You could buy everybody's security products today, a company could buy everything. And now we're still going to find a way in somewhere. And the real key is to identify when the malware has gotten inside, where it is and block it from spreading. And that's why Guardicore is the best defense against malware and ransomware, and they have the best solution as rated by analysts, and we see really good traction there, but still on relatively small numbers. Page Integrity Manager, a relatively new product but a very bright future. Again, it's new, so it's still small today, but that's going to allow companies to satisfy the new PCI requirement, something that's hard for a company to do on their own. The new requirements say that a company has to have safeguards against malware that gets into the digital supply chain and winds up on their users' browser. And that's just very hard for any enterprise to do. But when Akamai is delivering that content, we can place our scripts on the page to make sure that the user experience is safe and to make sure that if the user has ingested malware somewhere in the supply chain that we can identify and block it so the user is not compromised. So I think when you look at our security product portfolio really doing very well, and we're in early days with some of the most exciting products that have a lot of future runway.
James Fish: Got it. And maybe for Ed, on the delivery side, Ed, you alluded to a handful of customers that you guys essentially don't really want to deal with going forward just in terms of the type of traffic that you're delivering for them versus obviously the peaks versus the average. Taking a step back, what are you seeing in terms of this new pricing strategy versus kind of the churn as well as how to think about this removal of customers on the second half guide and if it really impacts the Security business going forward?
Edward McGowan: Yes. Great question, Jim. So let me just clarify that we're not doing business with these customers, just kind of taking a step back, like I say, it's a handful of customers. And typically, what you look at is these are multi-CDN customers that use many different vendors and tend to have big peaks for events. And the way you look at those customers is, there's a certain amount of day-to-day traffic you get, a certain price point that you're willing to sell at and there's a certain peak to average ratio that you're looking at. So as we go and renew some of these customers, we're being a lot more disciplined in terms of the -- taking a different approach as far as the level of discount that we're willing to provide. So therefore, the customer has to make a decision about still using us, but how are they going to handle those peaks? then going to straighten them out over a longer period of time, try to find additional peak in the market, et cetera. So they're still very big customers of ours, but we are pushing back a bit in terms of how much peak we're willing to take on the network. And as a result, we may lose a little bit of that day-to-day traffic, but we're still a significant vendor. As far as the impact on security and other products, we have not seen any impact on that. We're not losing these customers. They're not leaving the platform. It's just -- we are holding the line a bit more on price, and we may lose a little bit of the delivery as a result. But we're also losing a lot of that big peak and that ratio is getting more in line with what makes more economic sense.
Operator: The next question is from Rishi Jaluria of RBC.
Rishi Jaluria: Wonderful. Maybe first, I want to touch on Security. So you've obviously been talking a lot about the Delivery business. But we've seen a pretty decent decel in Security this quarter relative to last quarter, even looking on a constant currency basis. And look, on a constant currency basis, you saw only less than $6 million added sequentially from Q1 to Q2. And what should be a pretty strong security spending environment, at least based on what others in the space are saying. Can you maybe just help us understand what's going on in the security business and just how we should be thinking about that going forward? And then I have a follow-up.
Edward McGowan: Yes, Rishi, sure. So I'll take that. Keep in mind, if you remember last quarter, we talked about Guardicore revenue having about $7 million of onetime license revenue, which was a pull forward of about 1% or so of growth into that quarter. So that impacted it as well. We are -- one other thing to keep in mind, too, if you recall, with our [indiscernible] business during 2020 and 2021, we had a pretty strong uptick from the educational vertical. And there, that was when kids were working from -- sorry, working from home, doing school from home. And there was some government funding that was enabling folks to be able to work or go to school remotely and that funding has gone away. So we've seen a little bit of a decline there. I think it's a combination of those 2 factors that led to a little bit lighter of a sort of a sequential growth quarter-over-quarter. But some of the other things that we're seeing underlying our business, we're seeing very strong demand in Bot Manager. Account Protector is a newer version of that product or an add-on. That's going pretty well, but it's still pretty early days. It takes a while for that to -- good to add to growth. But those are some factors that you need to consider as you think about the slowdown in the growth there.
Rishi Jaluria: Got it. That's really helpful. And then just maybe I want to be explicit about macro in the guidance. When we think about your guidance, you talked about all the moving pieces between customers and turning [indiscernible] piece of the business and all that kind of stuff. But I want to be explicit, what are you assuming in terms of the macro environment? Are you assuming it kind of stays as it is today? Or are you seeing some sort of macro degradation? And maybe to really round that out, right? If I think about your last true recession that you are around for, right, '08,'09, even though traffic continued to grow at a nice rate during those years. Pricing compression led to a pretty big decel, I know this is obviously a very different business than it was 15 years ago. But maybe I just want to understand your macro assumptions and maybe tied into the macro assumptions, what you're assuming for the pricing environment. Again, consistent with what you're seeing, worse, better? Any color there would be helpful.
Edward McGowan: Sure. Yes. So let's see, I'll start with pricing. So one of the things -- the biggest area where you see pricing impact the business is on delivery. We don't see the typical price declines that you would expect to see in the Security business. The business just doesn't work that way. And I don't anticipate that being a significant problem for us. Obviously, we're anticipating that traffic is not going to recover to growth rates like we've seen in the past. We said that in our prepared remarks. So kind of a muted -- more muted Q4 than we typically see. Q4 tends to be a strong quarter for us. We anticipate that the macroeconomic environment is not going to get any better. One of the areas that I'm keeping a close eye on is Europe. We're seeing a lot of challenges in Europe, seeing energy prices, for example, are really, really high over in Europe. We're coming into the winter session. So you could see potentially less graphic related to people cutting subscriptions or doing things like that, less shopping online. So that's one of the things that I'm concerned about. And then also the recession and the impact that it could have on our customers potentially delaying buying decisions and things like that. But obviously, we're producing a tremendous amount of cash. The business is in great shape. It's much more well diversified than in the past. So I think we'll weather the storm pretty well. But I do think, as Tom and I both mentioned in our prepared remarks that it is going to dampen our revenue growth a bit here and also our margins for a short period of time.
Operator: The next question is from Keith Weiss of Morgan Stanley.
Joshua Baer: This is Josh Baer on for Keith. I wanted to ask about Linode. Are these enterprises that are testing out the platform? Are they considering Linode as primary cloud vendor? And I guess assuming it's a multi-cloud strategy approach, what are some use cases that enterprises are testing with Linode? What types of workloads or products do you expect to be popular with enterprises?
Thomson Leighton: Well, really, any kind of cloud compute application is suitable for Linode. Obviously, we support containers as a service, VM as a service. So anything you do in the cloud you could do on the Linode. I think the use cases initially and how the customers are viewing it as trying it out with some new applications, and in the one case of the media company we talked about, it's a critical application. They're running their new transcoding app for user-generated content on us. It's about as critical as it gets. And as I mentioned, that may become worth millions of dollars as it scales up, but this is a company that's spending many hundreds of millions of dollars in the cloud. So it's not a situation where we think you're just going to switch all that on to Akamai right away. But it is a business that I think we can really grow and that we're in an excellent position to tap into a very large cloud computing market. That market is a couple of hundred billion dollars growing at a very rapid clip. And Akamai is a trusted partner for many major enterprises that are looking for some diversification, that want a reliable partner, has great performance which we do with our distributor platform, knows how to handle scale and at an affordable price point, which we're in an excellent position to provide. So I'm really optimistic about the future of our Compute business.
Joshua Baer: Great. And it sounds like a lot of the focus is on the hyperscalers and the enterprise opportunity. Just also wanted to ask if you're seeing any changes in the competitive landscape around some of the other alternative cloud providers serving SMB just in regard to any pricing changes or any other moving pieces in the market.
Thomson Leighton: Well, as you know, one of our competitors there raised pricing. And I would say, so far, there's not a big change in the competitive landscape in the SMB market. We do intend to offer other services such as security to that customer base. But I think the real focus for us is bringing -- upscaling Linode to make it really enterprise -- major enterprise grade and scaling it out and making it be much more distributed, which will obviously improve performance. And going after the large enterprises, many of our customers spend 10 or more times as much with the major clouds than they do with us for delivery and security. And so that's a great opportunity for Akamai to be able to now provide them with compute as well, so that they can build their apps on Akamai, run them obviously deliver and secure them on Akamai. Really an incredible opportunity.
Operator: The next question is from Frank Louthan of Raymond James.
Frank Louthan: Can you just be a little bit more clear, some of the -- you mentioned the media companies and the issues with some of the traffic slowing down. Do you think this is more of a near-term issue or seasonal? And then how long do you think before some of that traffic begins to come back a bit?
Thomson Leighton: Yes. As we mentioned, there's a variety of factors that are impacting the media companies and hence traffic. You've sort of got a year -- I mean we still got COVID, but this is more like a non-COVID year lapping a COVID year. And so people are out and about more, and so there's less traffic growth due to that. You've got impacts of what, in some places is a recession. And you've seen some of the media companies report that they've got their own challenges with usage. And so that tends to reduce traffic. Obviously, we've got foreign exchange headwinds, which impacts the revenue we get from media companies overseas. And so all of that is impacting traffic in the media business for Akamai. I don't see those as being permanent. And we do expect over the long term that the traffic returns to more normal growth rates and that the revenue for the Delivery business stabilizes. May take a little while, several quarters at this point, but I don't think it's a long-term phenomenon.
Frank Louthan: Okay. Great. And can you quantify how much CapEx you might be saving annually from sort of the pushing out some of the higher volume folks?
Edward McGowan: Yes. So probably the best way to think about that, if you remember, coming into the year, we were sort of guiding that 15% to 16% range. We said, Linode will be a couple of points. We're now down to 12% to 13%. So that's somewhere in the 3% to 4% range is probably a good number to be working with. I also gave the data point out that our network-only sort of legacy Akamai Delivery business or Akamai network CapEx is around 3% where typically it had run around 8%. Now we'll, obviously, you still have to invest in the network, and we expect traffic to grow, et cetera. But I think we can remain in a lower than sort of long-term trend model here for a while. Obviously, if we see significant increase in traffic, we'll obviously have better delivery results and deal with it at the time. But kind of looking out over the next several quarters and into next year, I'd expect to see the CapEx levels at sort of levels you're seeing here.
Operator: Next question is from Fatima Boolani of Citi.
Fatima Boolani: Ed, this was for you, just with respect to a lot of the detailed commentary on your expectation of the delivery franchise for the second half. So a number of moving pieces here. But what I want to focus on is maybe doubling back to some of your comments from the last earnings call with respect to the observations around gaming, traffic slowing down. So I am inferring up the bulk of the pain that you're talking about from a delivery standpoint is purely coming from the OTT side, but I'd love to kind of get a confirmation and maybe get more of an in-depth under the hooded view of where you're seeing the most, I guess, elasticity or volatility from a traffic type standpoint? And how you're thinking about those trends in maybe a more granular fashion in the back half, especially on the back of the renewals that are now behind you?
Edward McGowan: Yes, good question. So let me just try to answer it this way. Obviously, our largest source of traffic is video traffic. And we are seeing video traffic, the growth rate of that is slower than we had expected. Still growing but slower than we expected. Probably the more noticeable areas would be gaming, software and then advertising-related, so some of the portal, news portals, et cetera, that sort of stuff that are impacted by advertising that's the area. But if you have a slowdown in video, it's such a significant portion of traffic that can tend to be the biggest driver. Now will that recover? What we typically see in Q4 is we do see somewhat of a device cycle where you see new devices coming online, oftentimes you see new content that comes on in Q4. There's back-to-school. There is the start of the fall sports season that we typically see a big increase in traffic. What we're looking at this year is we're being more cautious. We're still expecting it to increase like we see in Q4, but just not at the levels that we've seen in the past just based on the trends that we're seeing in the market today, what we're hearing from other companies, what we're getting from our customers. But that's probably the best way to think about it.
Fatima Boolani: I appreciate that. And just really quickly, on the macro commentary that you shared especially with some of the key observations in Europe. I'm curious about any concerns or observations with respect to sales cycle elongation, deal decision -- delays in deal decision and deal making from a procurement standpoint, anything tangible that you can share with us just with respect to those dynamics, just as the broader economy sort of softened.
Edward McGowan: It's a good question. I'd say it's still kind of early days, but that's certainly something that we're looking at. Security tends to be one of the places that you wouldn't delay a purchase, especially if you're under an attack. If you're not under attack, sometimes you might elongate that a little bit. But we haven't seen anything yet that's worth calling out in terms of elongating the sales cycles. I think I'm more concerned with what happens going into the winter, and there's talk of cutting back use of natural gas and the impact on GDP, that obviously would have an impact on not just Akamai, but on many, many companies. So that's something you look out for. And then also just as you get into a situation like that, keeping a close eye on receivables and making sure that you not -- your customers are in good financial health. So far, no issues there, but that's again something that we'd be looking out for.
Operator: The next question is from Tim Horan of Oppenheimer.
Timothy Horan: Questions on Linode. How much can you save enterprises do you think on their compute bill with Linode? Secondly, is this a good run rate for the Compute segment or maybe any color on what the growth rates you're kind of looking for there?
Thomson Leighton: Yes, the savings can be substantial. The list pricing that we offer for Linode is substantially less than when you see the hyperscalers offering, that's public information. And for major enterprises, obviously, you can have some discount to that. And the really good news is that we believe we can do this at substantial margins. So as we grow the business, actually, they'll improve our margins overall. And Ed, do you want to take the second part of that?
Edward McGowan: Yes. So in terms of the run rate and the growth expectations, yes, I mean, I think in terms of the near-term run rate, that's probably a reasonable place to peg it. What Tom and Adam talked about in May at our Analyst Day is we're making some substantial upgrades to the capabilities that Linode has, that doesn't happen overnight. So really, we will start to see -- the big enterprise growth will be into '23 and the back half of '23 '24, et cetera. But we do expect pretty substantial growth here, obviously, grew 74-plus percent in Compute, but a good place to put it for now, but it will take some time to build out the capacity as well as the added features. We're going, as Tom said, at a pretty good pace here, but that's when you really start to see the exciting growth is once all that capability is up and available.
Operator: The next question is from Rudy Kessinger of D.A. Davidson.
Rudy Kessinger: Great. So for the balance of the year, you're taking the revenue guide down by $55 million. You said FX headwinds for the year now at $114 million versus $100 million previously. So ex that FX headwind, you're taking it down by $41 million. I'm curious if you could kind of bucket it out that $41 million reduction between lower traffic growth outlook or macro challenges versus maybe some of the revenue you're losing from potentially taking less traffic from some of those customers with high peaks or other areas where you're reducing the guide.
Edward McGowan: Yes. I'd say the majority of it comes from the slower traffic. That's going to be the biggest component of it. The impact for some of the traffic we're turning away isn't all that significant, but does contribute to it. I don't have an exact percentage for you, but that's not a significant part of it. And then the macroeconomic would be the remainder. So if you were to stack rank it would be slower traffic macroeconomic and then the impact from turning away some of the traffic that we talked about in terms of the peaky traffic.
Rudy Kessinger: Okay. And then on Linode, I guess I'm curious, like what is your total internal spend with the hyperscales currently? What percent do you think you could move to Linode over time? And what's the kind of expected cost savings you think you can get from that?
Thomson Leighton: Yes, we're spending about $100 million a year annually now with the cloud companies. And over the next year or 2, ultimately, we would migrate pretty much -- most all of that on to Linode. And substantial savings. So that's why it's one of our several initiatives we're taking to improve margins. Also, it's great to be using our own services, and it will help us as we do the work with Linode to make it enterprise-ready, to be using it across the spectrum of applications at Akamai. We're very much like our customers and looking for ways to save on cost and get great performance out of our cloud compute platform.
Operator: The next question is from Jeff Van Rhee of Craig-Hallum.
Jeff Van Rhee: Just a couple for me. I think on the Security side, I just want to clarify, I know you said you're comfortable at 24% revenue growth. To be clear, as reported or constant currency and then just kind of the puts and takes of being able to sustain that 20% in the outyear, given kind of the deceleration we're seeing right now?
Edward McGowan: Sure. I'll take the first part, Tom, you can take the second part in terms of the future. That's in constant currency. And just remember, Jeff, that the Guardicore acquisition anniversary is in the fourth quarter.
Thomson Leighton: Yes. And in terms of the longer range, obviously, we're seeing very good growth in our flagship products, Web App Firewall and Bot Manager. They're the largest contribution of revenue. Really good growth, but on smaller numbers, obviously, for Zero Trust enterprise computing. In the longer time frame, I think that's what drives a lot of the growth in security. The infrastructure category growing more slowly today, also on a moderate size number. But I think in the long term, you see the enterprise Zero Trust security group grow, led by Guardicore as the market leader in stopping ransomware. .
Jeff Van Rhee: So I guess as a bucket, no clear sort of things you would call out that should drive acceleration or deceleration, maybe a different way to look at it.
Thomson Leighton: Well, there's the three categories we have today. The biggest is app in API security, very strong growth. I think we get continued strong growth there. A lot of innovation going on with Account Protector, Page Integrity Manager we talked about being really important for PCI compliance. We have a new audience hijacking prevention capability that looks really cool. Infrastructure is moderate size today, and that's not growing as fast. That's your DDoS protection and your D&S defenses. And then the really high-growth area, Zero Trust enterprise security led by Guardicore, but it's the smallest of the 3. And so you sort of have 3 different comps with a little bit different dynamic in each.
Jeff Van Rhee: Okay. And one last, if I could, on delivery. Obviously, you're making some changes around the peaking traffic. What about pricing disciplines just in traffic in general? I think you had commented last quarter you were taking a much more sort of across-the-board conservative approach to pricing. Just pricing outside that peaking, how has your approach changed this quarter and likely to change the rest of year?
Edward McGowan: Yes. So we've been instituting that now for the last several months. And as Tom talked about, we have not seen a lot of churn. We've been fairly successful in the renewals that we've had. We are still offering discounts to customers who have traffic growth. It's just not at the same levels that we've done historically.
Operator: The next question is from Will Power of Baird.
Charles Erlikh: It's Charlie Erlikh on for Will. Just one question for me on the pricing and contract renegotiations kind of building on your response. Any big contracts coming up for renewal that we should be aware of in the second half? And then for the 8 that you mentioned you had in the first half, any more color on just the tone and the overall discussions like pricing compression, you mentioned a little bit, but just the health of the customers you're talking to and just any more color on that would be great.
Edward McGowan: Yes, sure. So there's no big ones coming up in the second half. Like I said, if we ever have a big clump in the -- we'll call it out for it. I think it's just helpful to provide commentary and get you guys aware of what's happening. In terms of the dynamics outside of pushing back a little bit on sort of the peak to average, which is part of the normal discussion that we have, I would say we're kind of came in line with what we had expected. We did try to apply our strategy of being a bit more disciplined. I don't know if that's the right word, but more attuned to what's going on with volumes and having conversations with customers about expected volume growth, et cetera. So pleased with where we landed. And obviously, renewing large customers and this -- and the delivery segment is never a fun thing. But kind of came out as expected. And then your other question was on -- just remind me again?
Charles Erlikh: I think you actually hit all the questions, yes, just the overall tone of the conversations. But yes, I think you answered it pretty well.
Edward McGowan: Yes. So overall, I mean the customers are still in great shape. There are some very large brands and still very healthy. We added services to most of them. So not only are we just dealing with delivery, but we're also adding on additional capabilities as well.
Operator: The next question is from Alex Henderson of Needham.
Alexander Henderson: So given both Guardicore and Linode have not been in the full for over a year, I was wondering if you could look at them from the perspective of apples-to-apples, if they had been in the fold for the entire year, what their internal growth rates look like so that we have some gauge of the rate of growth at those 2 acquisitions.
Edward McGowan: Yes, it's a good question, Alex. I'll take this one, Tom. So Linode, so Linode will end up being in for most of the year. But just prior to acquisition, we had said in our commentary, they're growing around 15%. Obviously, we'll accelerate that as we start to add enterprise customers. So I'd expect that to increase. With Guardicore, if you remember our first call, we're taking our guidance up quite a bit, but if you look at where our kind of internal -- where our run rate is now, we're looking at over $60 million. That would be almost a doubling of where they were when we acquired them even slightly higher than that. So Guardicore growing extremely fast, I would say, sort of if it was a standalone on its own would be more than a double. And Linode, we just picked it up and its starting to add that functionality and expect to accelerate that growth rate, but they were about 15% prior to acquisition.
Alexander Henderson: There was a comment earlier in the call that adjusting for acquisitions, the underlying growth rate was 17%. Would you confirm that, that's an accurate calculus?
Edward McGowan: Yes. That's about the right math. 21% constant currency. Guardicore was about $14 million. So that's roughly 4%. So that's about right.
Alexander Henderson: Perfect. And then just looking at the international markets, how are you handling the FX swings that are going on? In terms of pricing, are you offsetting and look the effective price reduction that implies in dollars, if you're in local currency and where you're not in local currency, are you pricing down to lower the burden? How are you handling the customer pressures around that?
Edward McGowan: Yes. So most of the customers outside the U.S. are paying us in local currency. So they're billed in local currency. There are several that are not certain countries, for example, will be in U.S. dollar. So far, it has not been a big issue with our customers pushing back. We do some hedging on balance sheet, but not from an operational perspective, not cash flow hedging. And then in terms of pricing, we do take that into consideration as we're going through with customers that are outside the U.S. And also just in general, depending on where their traffic is, that also comes into effect. If we're delivering in countries that are more expensive, we take that into effect as well.
Tom Barth: Okay. Thank you, Alex, and thank you, everyone. So in closing, we will be presenting at a number of investor conferences and events throughout the rest of the third quarter. Details of these can be found in the Investor Relations section of akamai.com. Thank you for joining us, and all of us here at Akamai wish continued good health to you and yours. Have a nice evening.
Operator: The conference has now concluded. Thank you for attending today's presentation. You may now disconnect. | [
{
"speaker": "Operator",
"text": "Good day, and welcome to the Akamai Technologies Second Quarter 2022 Conference Call. [Operator Instructions]. Please note this event is being recorded. I would now like to turn the conference over to Tom Barth, Head of Investor Relations. Please go ahead."
},
{
"speaker": "Tom Barth",
"text": "Thank you, operator. Good afternoon, everyone, and thank you for joining Akamai's Second Quarter 2022 Earnings Call. Speaking today will be Tom Leighton, Akamai's Chief Executive Officer; and Ed McGowan, Akamai's Chief Financial Officer. Please note that today's comments include forward-looking statements, including statements regarding revenue and earnings guidance. These forward-looking statements are subject to risks and uncertainties and involve a number of factors that could cause actual results to differ materially from those expressed or implied by such statements. The factors include any impact from macroeconomic trends, the integration of any acquisitions and any impact from geopolitical developments. Additional information concerning these factors is contained in Akamai's filings with the SEC, including our annual report on Form 10-K and quarterly reports on Form 10-Q. The forward-looking statements included in this call represent Akamai's view on August 9, 2022. Akamai disclaims any obligation to update these statements to reflect new information, future events or circumstances, except as required by law. As a reminder, we will be referring to some non-GAAP financial metrics during today's call. A detailed reconciliation of GAAP and non-GAAP metrics can be found under the financial portion of the Investor Relations section of akamai.com. And with that, let me turn the call over to Tom."
},
{
"speaker": "Thomson Leighton",
"text": "Thanks, Tom, and thank you all for joining us today. I'm pleased to report that Akamai delivered strong results in the second quarter despite the ongoing challenges with the global economic environment and slower Internet traffic growth. Q2 revenue was $903 million, up 6% year-over-year and up 9% in constant currency. This result was driven by the continued rapid growth of our Security and Compute businesses, which when taken together, were up 30% in constant currency. These 2 business lines now account for 54% of our overall revenue. Q2 non-GAAP operating margin was 29%. Q2 non-GAAP EPS was $1.35 per diluted share, down 5% year-over-year, but up 0.5% in constant currency. As Ed will discuss later, EPS was negatively impacted by foreign exchange rates and a higher effective tax rate compared to last year. Free cash flow was very strong at $223 million in Q2 and it accounted for 25% of revenue. We've been leveraging our financial strength to make substantial investments in enterprise security and cloud computing. We've also used some of this cash to buy back additional stock. In the first half of the year, we spent $268 million to repurchase 2.6 million shares. This puts us on track to go beyond what's needed to offset dilution from employee equity programs this year. I'll now say a few words about each of our 3 main lines of business: Security, Compute and Delivery, starting with Security. Our Security Solutions generated revenue of $381 million in Q2, up 17% year-over-year and up 21% in constant currency. Growth in security was driven primarily by our app and API security portfolio, which includes our market-leading web app firewall, Bot Manager, Account Protector and Page Integrity Manager solutions. Our Zero Trust enterprise security portfolio, led by Guardicore, also performed well in Q2, with numerous significant customer wins. A leading global provider of financial data concerned about ransomware, added Guardicore segmentation solution to the 7 security products they already buy from Akamai. A major insurance company in France became a new customer for Akamai when they adopted our Guardicore solution to help meet European financial regulations. The sale, led by one of our carrier partners, is indicative of the excitement we're seeing for our Zero Trust solutions among our partners. In Australia's largest telecom provider, Telstra, expanded their business with us by adding our Secure Web Gateway solution to their portfolio of Akamai products. They told us, \"As part of Telstra's journey in delivering fit-for-purpose solutions, Akamai has been a key industry partner with network-based anti-phishing malware protection and content filtering. Telstra blocks millions of threats every single day, and Akamai is a key partner in that protection.\" Overall, our Zero Trust solutions delivered $43 million of revenue in Q2, up 59% year-over-year in constant currency. This is an area where we're making -- continuing to make major investments and where we anticipate significant future growth. Turning now to Compute. I'm very pleased to report that the revenue for our Compute product group was $106 million in Q2, up 74% year-over-year and up 78% in constant currency. As a reminder, the Compute product group includes Linode and Akamai solutions for Edge computing, storage cloud optimization and Edge applications. A common theme that I heard when I met with executives from around the world in Q2 was their growing concern about being locked into contracts with cloud giants that are consuming large and rapidly increasing shares of their IT budgets. They want more choice in compute and are open to alternative clouds like Linode as a more efficient way to build, run and secure their applications. As a result, many large enterprises have begun testing the Linode platform, including a major U.S. airline, one of the world's top gaming companies and a global provider of weather data. Major media companies, in particular, expressed significant concerns with their growing use of the giant clouds. Not only are the cost high, in part because of the fees from moving data from cloud storage to a CDN for delivery, but they're also concerned about their increasing reliance on a direct competitor. As an example, I'm very pleased to announce that we recently signed a contract with one of the world's largest media companies to run a critical new workload on Linode. The service is live today, and we anticipate that it will generate millions of dollars of annual revenue as their usage grows over time. This is just the tip of the iceberg when it comes to our potential for future revenue growth in Compute. Cloud computing is a fast-growing, multi-hundred billion dollar market. And as we scale Linode to be enterprise grade with pops and hundreds of locations around the world, we should be in an excellent position to capture a share of this market, particularly from companies that value our industry-leading security and delivery solutions and that don't want to be locked in to more expensive options with a cloud giant that competes against them. Our Delivery products generated revenue of $417 million in Q2, down 11% year-over-year and down 8% in constant currency. These results were clearly impacted by a continued deceleration in traffic growth among our largest media customers and by the lower unit pricing we provided as part of their recent contract renewals. It's important to note that Akamai remains the market leader in delivery by far. Moreover, customer churn in the first half of this year remained at record lows, and lost annual revenue from churned accounts in Q2 was even less than in Q1. We also saw some notable delivery customers move business to our platform in Q2 after trying out competing solutions. No matter which competitor they've been working with, they chose Akamai because of our superior performance and reliability. Like many companies, we're managing through a time of substantial economic headwinds and uncertainty with escalating inflation, the strengthening U.S. dollar, growing concerns about a global recession, escalating geopolitical tensions and conflicts, and a slowing of Internet traffic growth as the world tries to return to normal in the midst of a pandemic. As Ed will talk about shortly, I think it's prudent to assume that these headwinds will dampen our growth rates and profitability over the next several quarters, particularly in our Delivery business, which is being impacted by the challenges that many major media companies have recently reported. Given the enormous market opportunity in front of us, we will continue to focus our investment on Zero Trust enterprise security led by Guardicore, and cloud computing, led by Linode. These investments, combined with the economic headwinds I just mentioned, will likely result in our operating margin remaining below 30% in the near term. We expect our margins to improve over time as our Security and Compute businesses continue to grow and account for a larger share of total revenue. In addition, we're embarking on several major initiatives to reduce cost and improve operational efficiency that should help return our margins to 30% or better in the medium to longer term. As Ed will discuss further, these initiatives include leveraging Linode to significantly reduce our cloud spend with hyperscalers, slowing the capital expenditures for our delivery platform and optimizing our real estate footprint. While these are challenging times to be sure, I believe that Akamai is on the right track for long-term growth and success and that we're well positioned because of our unique global-edge platform, our market-leading security and delivery solutions, our new compute capabilities which provide great performance at an affordable cost, our premier enterprise customer base and our strong financial position and profitable business model. Now I'll turn the call over to Ed for more on Q2 and our outlook going forward. Ed?"
},
{
"speaker": "Edward McGowan",
"text": "Thank you, Tom. As Tom mentioned, Akamai delivered another solid quarter in Q2. Q2 revenue was $903 million, up 6% year-over-year or 9% in constant currency. Revenue was in line with our guidance and was led by our Security and Compute businesses. As we mentioned on our last call, we expected significant foreign exchange headwinds to impact our revenue in Q2. The much stronger U.S. dollar negatively impacted our year-over-year growth rate by 3 points or approximately $29 million of revenue year-over-year and $14 million on a sequential basis. On a combined basis, our Security and Compute businesses represented 54% of total revenue, growing 26% year-over-year and 30% in constant currency. Security revenue was $381 million and grew 17% year-over-year and 21% in constant currency, with continued strength from our Zero Trust business led by Guardicore. Guardicore delivered approximately $14 million of revenue in Q2. Security represented 42% of total revenue in Q2, which is up 4 points from Q2 a year ago. Compute revenue was $106 million in Q2, growing 74% year-over-year and 78% in constant currency. Linode contributed revenue of approximately $32 million in the second quarter. Delivery revenue was $417 million, down 11% year-over-year and 8% in constant currency. It's worth noting that while traffic on our network continued to grow, the rate of that traffic growth declined sequentially in Q2. As Tom mentioned, we believe that the current macroeconomic environment has had the greatest impact on customers in our media vertical, most notably in advertising and gaming. These challenges are most apparent in our delivery results. Also, as we talked about at our Analyst Day in May, we started to align our pricing strategy with the new traffic growth rates we have seen on our network over the last 2 quarters. In addition to scaling back discounts provided upon renewal, we decided to turn away some business from a very small number of customers who have extreme traffic peaks compared to their daily usage patterns. While this will result in slightly less revenue, it will enable us to significantly lower our network CapEx as we focus on cash flow from our Delivery business to help accelerate our investments in faster-growing areas like Compute and Security. Sales in our international markets represented 47% of total revenue in Q2, unchanged from Q1. International revenue grew 6% year-over-year or 13% in constant currency. Finally, revenue from our U.S. market was $477 million and grew 6% year-over-year. Going now to costs and profitability. Cash gross margin was 75%. GAAP gross margin, which includes both depreciation and stock-based compensation, was 62%. Non-GAAP cash operating expenses were $292 million. Adjusted EBITDA was $388 million and our adjusted EBITDA margin was 43%. Non-GAAP operating income was $262 million, and non-GAAP operating margin was 29%. It is worth noting that our non-GAAP operating margin was negatively impacted by approximately 1 point due to unfavorable foreign exchange. Capital expenditures in Q2, excluding equity compensation and capitalized interest expense, were $104 million. This was much better than we expected, partly due to some Linode specific CapEx that pushed from Q2 into Q3 as well as some savings from our strategy of being more selective on certain types of customer traffic. These savings were most apparent in our network CapEx, excluding Linode, which was only about 3% of revenue. GAAP net income for the second quarter was $120 million or $0.74 of earnings per diluted share. Non-GAAP net income was $216 million or $1.35 of earnings per diluted share, down 5% year-over-year and up 1/2 of 1% in constant currency. It's worth noting that foreign exchange negatively impacted our non-GAAP EPS by approximately $0.07. Taxes included in our non-GAAP earnings were $42 million based on a Q2 effective tax rate of approximately 16%. This was about 1.5 points higher than last year. Moving now to cash and our use of capital. As of June 30, our cash, cash equivalents and marketable securities totaled approximately $1.3 billion. During the second quarter, we spent approximately $165 million to repurchase shares, buying back approximately 1.6 million shares. Our ongoing share repurchase activity has resulted in a net reduction in our non-GAAP fully diluted shares outstanding of approximately 4 million shares or roughly 2% on a year-over-year basis. We ended Q2 with approximately $1.5 billion remaining on our current repurchase authorization. Our intention is to continue to buy back shares to offset dilution from employee equity programs over time and to be opportunistic in both M&A and share repurchases. Before I provide our Q3 outlook and an update to our 2022 guidance, I want to highlight several factors. First, with nearly 50% of our revenue coming from outside the U.S., foreign exchange continues to be a significant headwind to our reported results. At current spot rates, our guidance now assumes foreign exchange will have a negative $114 million impact to revenue in 2022 on a year-over-year basis. As I mentioned previously, foreign exchange also impacts our margins and earnings. We estimate FX will negatively impact non-GAAP operating margin by approximately 1 point year-over-year and non-GAAP earnings by approximately $0.31 for the full year 2022. Second, we are incrementally more cautious on the outlook for traffic growth in Q3 and Q4. Based on our year-to-date trend, plus what we are hearing from other large Internet companies, we are anticipating a slower than usual traffic growth rate for the remainder of 2022. Third, as a result of the expected slower traffic growth rate and our updating pricing strategy that we noted earlier, we anticipate CapEx to be significantly below our previous outlook. Finally, as Tom mentioned, we expect the more challenging macroeconomic environment to dampen our revenue growth and margins in the near term. When combined with the impact of renewing 8 of our top 10 customers in the first half of the year, we expect Delivery revenue to decline at a slightly higher rate on a year-over-year basis for the next 2 quarters. As a result of these factors, we also expect margins to decline over the near term as well. We believe strongly in the long-term opportunities in front of us, especially in Security and Compute, and therefore, planned to continue to invest to exploit the market opportunity in these areas. That said, as Tom highlighted, we are embarking on several major initiatives to reduce costs and improve operational efficiency. Potential savings for each of these areas is in the tens of millions of dollars. Specifically, we are planning to do the following 3 things. First, significantly reduce our cloud spend with hyperscalers as we migrate internal Akamai workloads to Linode. Second, realized savings from our strategy of being more selective on certain types of customer traffic, which we expect will result in both lower capital expenditures and depreciation expense. And third, optimize our real estate footprint as the hybrid work experience becomes more permanent. Now turning to our Q3 guidance. We are projecting revenue in the range of $868 million to $883 million or up 1% to 3% as reported or 5% to 7% in constant currency over Q3 2021. Foreign exchange fluctuations are expected to have a negative $11 million impact on Q3 revenue compared to Q2 levels and a negative $36 million impact year-over-year. At these revenue levels, we expect cash gross margins of approximately 74%. In the short term, our gross margin is negatively impacted by our continued investment in Guardicore and the Linode-related headcount as well as higher third-party cloud costs. However, we are confident that this is a short-term impact only. We expect our gross margin to expand to the high 70% long-term target model as we see continued strong growth from both Guardicore and Linode as we reduce our third-party cloud costs over time. Q3 non-GAAP operating expenses are projected to be $283 million to $291 million. We anticipate Q3 EBITDA margins of approximately 41%. We expect non-GAAP depreciation expense to be between $125 million to $128 million, and we expect non-GAAP operating margin to be approximately 27% for Q3. As mentioned previously, the near-term decline in operating margin is due to slower traffic and revenue growth, our annual merit-based wage increase, which become effective July 1, the negative impact from foreign exchange, investments associated with Guardicore and Linode and increased third-party cloud costs. As our Security and Compute business continue to grow and we reap the benefits of the cost savings actions I described earlier, we are confident that our operating margins will return to 30% and then grow from there. Moving on to CapEx. We expect to spend approximately $109 million to $119 million, excluding equity compensation and capitalized interest in the third quarter. This represents approximately 13% of projected total revenue. And with the overall revenue and spend configuration I just outlined, we expect Q3 non-GAAP EPS in the range of $1.21 to $1.26. This EPS guidance assumes taxes of $37 million to $38 million based on an estimated quarterly non-GAAP effective tax rate of approximately 16%. It also reflects a fully diluted share count of approximately 160 million shares. Looking ahead to the full year, we now expect revenue of $3.57 billion to $3.61 billion, which is up 3% to 4% year-over-year as reported or up 6% to 8% in constant currency. We continue to expect Security growth of approximately 20% in constant currency for the full year 2022. We now estimate non-GAAP operating margins to be approximately 28% to 29% and non-GAAP earnings per diluted share of $5.19 to $5.37. And this non-GAAP earnings guidance is based on a non-GAAP effective tax rate of approximately 16% and a fully diluted share count of approximately 160 million shares. Finally, full year CapEx is anticipated to be approximately 12% to 13% of revenue. In closing, while the macroeconomic backdrop has become more uncertain, we believe that we are in the right markets with differentiated products that remain highly valued by our customers. Thank you. Tom and I would be happy to take your questions. Operator?"
},
{
"speaker": "Operator",
"text": "[Operator Instructions]. The first question is from James Breen of William Blair."
},
{
"speaker": "James Breen",
"text": "Can you just talk about, obviously, the revenue guidance for the third quarter is lower than where consensus by about $10 million? Can you talk about the trade-off between margins and going after some of this delivery traffic in general because it's -- the EBITDA margins are about the same, but obviously, the growth is slowing at the top line."
},
{
"speaker": "Edward McGowan",
"text": "Jim, this is Ed. So in terms of the guide, there's really 2 pieces to it. The first one is obviously FX has gotten incrementally worse. That's probably about half of the delta. The rest of it is the slower traffic that we talked about. I think your question was specific to the trade-off that we're making. The first immediate impact that you get on that trade-off from taking less of that peak traffic as you save on CapEx. So that will make its way through the P&L through lower depreciation and obviously immediately through cash flow. And so the decision that we've made is obviously, as we talked about in May, as traffic levels have come down, the discounts that we offer upon renewal are lower. And in some cases, we've seen a small handful of customers that have the traffic. Their peaks are still growing at pretty significant rates, but their day-to-day traffic is not. So there's a formula that we go through in a trade-off that we made that I think makes a lot of sense for us, especially as I look at the types of returns we can get from the faster-growing areas like security and compute."
},
{
"speaker": "James Breen",
"text": "So the shift in general just to a more -- a little bit more of an asset-light business and focusing on some of these other areas?"
},
{
"speaker": "Edward McGowan",
"text": "Yes. I mean, I would say, obviously, compute can be, I wouldn't call it an asset-heavy business, but it does have a fair bit of CapEx. We talked about our CapEx for Linode being about 2% of revenue in total. And obviously, it's going to be a little bit front-end loaded. We actually took the advantage to try to spend a little bit more for Linode. Based on some of the conversations we're having, we're starting to see some good demand. And obviously, Tom talked about signing a pretty significant customer in the quarter. So what we're doing though, on the Akamai, of course, I call it the legacy Akamai delivery business is we are being a bit more selective in reducing CapEx. I made a comment that our network CapEx excluding Linode was 3%. That's typically around, call it, 8% to 10%, at least where it's been running over the last couple of years. So I think it's just a question of being more selective with certain types of traffic. It's really a handful of customers that have that type of traffic pattern. It's generally event-driven. And what we're seeing is it's just a better return to shift some of that investment in other places."
},
{
"speaker": "James Breen",
"text": "Great. And then just maybe just one for Tom. On Linode, can you just talk about some of the success you're having sort of selling that product into your existing customer base?"
},
{
"speaker": "Thomson Leighton",
"text": "Yes. Obviously, very early days. We've got a lot of work ahead of us with Linode, as we've talked about. But it's great to land our first very large customer, putting a critical app. Actually, it's for transcoding, user content onto the Linode platform. As I mentioned, that's just that app alone as it scales is worth several million dollars a year of revenue for us. And tip of the iceberg, this is a customer that spends many hundreds of millions of dollars a year on cloud computing. And that's just 1 customer. So a lot of good opportunity ahead, and we're making good progress on our road map for Linode."
},
{
"speaker": "Operator",
"text": "The next question is from James Fish of Piper Sandler."
},
{
"speaker": "James Fish",
"text": "We've seen some security vendors report here and Security is going through kind of actually still a strong environment despite the macro. And when I look at your normalized rate of about 17%, it's a bit lighter than what we saw in Q1 in the last couple of years really. What's going on, especially on the core WAF and DDoS and in Bot management in terms of the sizing and growth against some of the newer solutions like EAA and PIM here? And is there a way to think about if you guys are seeing any higher net churn overall or how to balance net new business versus the expansion that you're seeing with your existing customers and security?"
},
{
"speaker": "Thomson Leighton",
"text": "I'll start with that and then maybe Ed will add some comments. Security is very strong. We have the market-leading WAF by far. In fact, you look at their most recent Magic Quadrants and analyst ratings, and we've widened the gap with competition. Bot Manager also the market leader by far. Now we have Account Protector built on top, growing very well. EAA is small today, good opportunity for growth, particularly coming on the following Guardicore. Guardicore, very exciting. You think about the enterprise security landscape, and our segmentation, I think, has been something that historically was overlooked mainly because it wasn't done very well. But I think as you look to the future, it's probably the most important thing an enterprise can do. You could buy everybody's security products today, a company could buy everything. And now we're still going to find a way in somewhere. And the real key is to identify when the malware has gotten inside, where it is and block it from spreading. And that's why Guardicore is the best defense against malware and ransomware, and they have the best solution as rated by analysts, and we see really good traction there, but still on relatively small numbers. Page Integrity Manager, a relatively new product but a very bright future. Again, it's new, so it's still small today, but that's going to allow companies to satisfy the new PCI requirement, something that's hard for a company to do on their own. The new requirements say that a company has to have safeguards against malware that gets into the digital supply chain and winds up on their users' browser. And that's just very hard for any enterprise to do. But when Akamai is delivering that content, we can place our scripts on the page to make sure that the user experience is safe and to make sure that if the user has ingested malware somewhere in the supply chain that we can identify and block it so the user is not compromised. So I think when you look at our security product portfolio really doing very well, and we're in early days with some of the most exciting products that have a lot of future runway."
},
{
"speaker": "James Fish",
"text": "Got it. And maybe for Ed, on the delivery side, Ed, you alluded to a handful of customers that you guys essentially don't really want to deal with going forward just in terms of the type of traffic that you're delivering for them versus obviously the peaks versus the average. Taking a step back, what are you seeing in terms of this new pricing strategy versus kind of the churn as well as how to think about this removal of customers on the second half guide and if it really impacts the Security business going forward?"
},
{
"speaker": "Edward McGowan",
"text": "Yes. Great question, Jim. So let me just clarify that we're not doing business with these customers, just kind of taking a step back, like I say, it's a handful of customers. And typically, what you look at is these are multi-CDN customers that use many different vendors and tend to have big peaks for events. And the way you look at those customers is, there's a certain amount of day-to-day traffic you get, a certain price point that you're willing to sell at and there's a certain peak to average ratio that you're looking at. So as we go and renew some of these customers, we're being a lot more disciplined in terms of the -- taking a different approach as far as the level of discount that we're willing to provide. So therefore, the customer has to make a decision about still using us, but how are they going to handle those peaks? then going to straighten them out over a longer period of time, try to find additional peak in the market, et cetera. So they're still very big customers of ours, but we are pushing back a bit in terms of how much peak we're willing to take on the network. And as a result, we may lose a little bit of that day-to-day traffic, but we're still a significant vendor. As far as the impact on security and other products, we have not seen any impact on that. We're not losing these customers. They're not leaving the platform. It's just -- we are holding the line a bit more on price, and we may lose a little bit of the delivery as a result. But we're also losing a lot of that big peak and that ratio is getting more in line with what makes more economic sense."
},
{
"speaker": "Operator",
"text": "The next question is from Rishi Jaluria of RBC."
},
{
"speaker": "Rishi Jaluria",
"text": "Wonderful. Maybe first, I want to touch on Security. So you've obviously been talking a lot about the Delivery business. But we've seen a pretty decent decel in Security this quarter relative to last quarter, even looking on a constant currency basis. And look, on a constant currency basis, you saw only less than $6 million added sequentially from Q1 to Q2. And what should be a pretty strong security spending environment, at least based on what others in the space are saying. Can you maybe just help us understand what's going on in the security business and just how we should be thinking about that going forward? And then I have a follow-up."
},
{
"speaker": "Edward McGowan",
"text": "Yes, Rishi, sure. So I'll take that. Keep in mind, if you remember last quarter, we talked about Guardicore revenue having about $7 million of onetime license revenue, which was a pull forward of about 1% or so of growth into that quarter. So that impacted it as well. We are -- one other thing to keep in mind, too, if you recall, with our [indiscernible] business during 2020 and 2021, we had a pretty strong uptick from the educational vertical. And there, that was when kids were working from -- sorry, working from home, doing school from home. And there was some government funding that was enabling folks to be able to work or go to school remotely and that funding has gone away. So we've seen a little bit of a decline there. I think it's a combination of those 2 factors that led to a little bit lighter of a sort of a sequential growth quarter-over-quarter. But some of the other things that we're seeing underlying our business, we're seeing very strong demand in Bot Manager. Account Protector is a newer version of that product or an add-on. That's going pretty well, but it's still pretty early days. It takes a while for that to -- good to add to growth. But those are some factors that you need to consider as you think about the slowdown in the growth there."
},
{
"speaker": "Rishi Jaluria",
"text": "Got it. That's really helpful. And then just maybe I want to be explicit about macro in the guidance. When we think about your guidance, you talked about all the moving pieces between customers and turning [indiscernible] piece of the business and all that kind of stuff. But I want to be explicit, what are you assuming in terms of the macro environment? Are you assuming it kind of stays as it is today? Or are you seeing some sort of macro degradation? And maybe to really round that out, right? If I think about your last true recession that you are around for, right, '08,'09, even though traffic continued to grow at a nice rate during those years. Pricing compression led to a pretty big decel, I know this is obviously a very different business than it was 15 years ago. But maybe I just want to understand your macro assumptions and maybe tied into the macro assumptions, what you're assuming for the pricing environment. Again, consistent with what you're seeing, worse, better? Any color there would be helpful."
},
{
"speaker": "Edward McGowan",
"text": "Sure. Yes. So let's see, I'll start with pricing. So one of the things -- the biggest area where you see pricing impact the business is on delivery. We don't see the typical price declines that you would expect to see in the Security business. The business just doesn't work that way. And I don't anticipate that being a significant problem for us. Obviously, we're anticipating that traffic is not going to recover to growth rates like we've seen in the past. We said that in our prepared remarks. So kind of a muted -- more muted Q4 than we typically see. Q4 tends to be a strong quarter for us. We anticipate that the macroeconomic environment is not going to get any better. One of the areas that I'm keeping a close eye on is Europe. We're seeing a lot of challenges in Europe, seeing energy prices, for example, are really, really high over in Europe. We're coming into the winter session. So you could see potentially less graphic related to people cutting subscriptions or doing things like that, less shopping online. So that's one of the things that I'm concerned about. And then also the recession and the impact that it could have on our customers potentially delaying buying decisions and things like that. But obviously, we're producing a tremendous amount of cash. The business is in great shape. It's much more well diversified than in the past. So I think we'll weather the storm pretty well. But I do think, as Tom and I both mentioned in our prepared remarks that it is going to dampen our revenue growth a bit here and also our margins for a short period of time."
},
{
"speaker": "Operator",
"text": "The next question is from Keith Weiss of Morgan Stanley."
},
{
"speaker": "Joshua Baer",
"text": "This is Josh Baer on for Keith. I wanted to ask about Linode. Are these enterprises that are testing out the platform? Are they considering Linode as primary cloud vendor? And I guess assuming it's a multi-cloud strategy approach, what are some use cases that enterprises are testing with Linode? What types of workloads or products do you expect to be popular with enterprises?"
},
{
"speaker": "Thomson Leighton",
"text": "Well, really, any kind of cloud compute application is suitable for Linode. Obviously, we support containers as a service, VM as a service. So anything you do in the cloud you could do on the Linode. I think the use cases initially and how the customers are viewing it as trying it out with some new applications, and in the one case of the media company we talked about, it's a critical application. They're running their new transcoding app for user-generated content on us. It's about as critical as it gets. And as I mentioned, that may become worth millions of dollars as it scales up, but this is a company that's spending many hundreds of millions of dollars in the cloud. So it's not a situation where we think you're just going to switch all that on to Akamai right away. But it is a business that I think we can really grow and that we're in an excellent position to tap into a very large cloud computing market. That market is a couple of hundred billion dollars growing at a very rapid clip. And Akamai is a trusted partner for many major enterprises that are looking for some diversification, that want a reliable partner, has great performance which we do with our distributor platform, knows how to handle scale and at an affordable price point, which we're in an excellent position to provide. So I'm really optimistic about the future of our Compute business."
},
{
"speaker": "Joshua Baer",
"text": "Great. And it sounds like a lot of the focus is on the hyperscalers and the enterprise opportunity. Just also wanted to ask if you're seeing any changes in the competitive landscape around some of the other alternative cloud providers serving SMB just in regard to any pricing changes or any other moving pieces in the market."
},
{
"speaker": "Thomson Leighton",
"text": "Well, as you know, one of our competitors there raised pricing. And I would say, so far, there's not a big change in the competitive landscape in the SMB market. We do intend to offer other services such as security to that customer base. But I think the real focus for us is bringing -- upscaling Linode to make it really enterprise -- major enterprise grade and scaling it out and making it be much more distributed, which will obviously improve performance. And going after the large enterprises, many of our customers spend 10 or more times as much with the major clouds than they do with us for delivery and security. And so that's a great opportunity for Akamai to be able to now provide them with compute as well, so that they can build their apps on Akamai, run them obviously deliver and secure them on Akamai. Really an incredible opportunity."
},
{
"speaker": "Operator",
"text": "The next question is from Frank Louthan of Raymond James."
},
{
"speaker": "Frank Louthan",
"text": "Can you just be a little bit more clear, some of the -- you mentioned the media companies and the issues with some of the traffic slowing down. Do you think this is more of a near-term issue or seasonal? And then how long do you think before some of that traffic begins to come back a bit?"
},
{
"speaker": "Thomson Leighton",
"text": "Yes. As we mentioned, there's a variety of factors that are impacting the media companies and hence traffic. You've sort of got a year -- I mean we still got COVID, but this is more like a non-COVID year lapping a COVID year. And so people are out and about more, and so there's less traffic growth due to that. You've got impacts of what, in some places is a recession. And you've seen some of the media companies report that they've got their own challenges with usage. And so that tends to reduce traffic. Obviously, we've got foreign exchange headwinds, which impacts the revenue we get from media companies overseas. And so all of that is impacting traffic in the media business for Akamai. I don't see those as being permanent. And we do expect over the long term that the traffic returns to more normal growth rates and that the revenue for the Delivery business stabilizes. May take a little while, several quarters at this point, but I don't think it's a long-term phenomenon."
},
{
"speaker": "Frank Louthan",
"text": "Okay. Great. And can you quantify how much CapEx you might be saving annually from sort of the pushing out some of the higher volume folks?"
},
{
"speaker": "Edward McGowan",
"text": "Yes. So probably the best way to think about that, if you remember, coming into the year, we were sort of guiding that 15% to 16% range. We said, Linode will be a couple of points. We're now down to 12% to 13%. So that's somewhere in the 3% to 4% range is probably a good number to be working with. I also gave the data point out that our network-only sort of legacy Akamai Delivery business or Akamai network CapEx is around 3% where typically it had run around 8%. Now we'll, obviously, you still have to invest in the network, and we expect traffic to grow, et cetera. But I think we can remain in a lower than sort of long-term trend model here for a while. Obviously, if we see significant increase in traffic, we'll obviously have better delivery results and deal with it at the time. But kind of looking out over the next several quarters and into next year, I'd expect to see the CapEx levels at sort of levels you're seeing here."
},
{
"speaker": "Operator",
"text": "Next question is from Fatima Boolani of Citi."
},
{
"speaker": "Fatima Boolani",
"text": "Ed, this was for you, just with respect to a lot of the detailed commentary on your expectation of the delivery franchise for the second half. So a number of moving pieces here. But what I want to focus on is maybe doubling back to some of your comments from the last earnings call with respect to the observations around gaming, traffic slowing down. So I am inferring up the bulk of the pain that you're talking about from a delivery standpoint is purely coming from the OTT side, but I'd love to kind of get a confirmation and maybe get more of an in-depth under the hooded view of where you're seeing the most, I guess, elasticity or volatility from a traffic type standpoint? And how you're thinking about those trends in maybe a more granular fashion in the back half, especially on the back of the renewals that are now behind you?"
},
{
"speaker": "Edward McGowan",
"text": "Yes, good question. So let me just try to answer it this way. Obviously, our largest source of traffic is video traffic. And we are seeing video traffic, the growth rate of that is slower than we had expected. Still growing but slower than we expected. Probably the more noticeable areas would be gaming, software and then advertising-related, so some of the portal, news portals, et cetera, that sort of stuff that are impacted by advertising that's the area. But if you have a slowdown in video, it's such a significant portion of traffic that can tend to be the biggest driver. Now will that recover? What we typically see in Q4 is we do see somewhat of a device cycle where you see new devices coming online, oftentimes you see new content that comes on in Q4. There's back-to-school. There is the start of the fall sports season that we typically see a big increase in traffic. What we're looking at this year is we're being more cautious. We're still expecting it to increase like we see in Q4, but just not at the levels that we've seen in the past just based on the trends that we're seeing in the market today, what we're hearing from other companies, what we're getting from our customers. But that's probably the best way to think about it."
},
{
"speaker": "Fatima Boolani",
"text": "I appreciate that. And just really quickly, on the macro commentary that you shared especially with some of the key observations in Europe. I'm curious about any concerns or observations with respect to sales cycle elongation, deal decision -- delays in deal decision and deal making from a procurement standpoint, anything tangible that you can share with us just with respect to those dynamics, just as the broader economy sort of softened."
},
{
"speaker": "Edward McGowan",
"text": "It's a good question. I'd say it's still kind of early days, but that's certainly something that we're looking at. Security tends to be one of the places that you wouldn't delay a purchase, especially if you're under an attack. If you're not under attack, sometimes you might elongate that a little bit. But we haven't seen anything yet that's worth calling out in terms of elongating the sales cycles. I think I'm more concerned with what happens going into the winter, and there's talk of cutting back use of natural gas and the impact on GDP, that obviously would have an impact on not just Akamai, but on many, many companies. So that's something you look out for. And then also just as you get into a situation like that, keeping a close eye on receivables and making sure that you not -- your customers are in good financial health. So far, no issues there, but that's again something that we'd be looking out for."
},
{
"speaker": "Operator",
"text": "The next question is from Tim Horan of Oppenheimer."
},
{
"speaker": "Timothy Horan",
"text": "Questions on Linode. How much can you save enterprises do you think on their compute bill with Linode? Secondly, is this a good run rate for the Compute segment or maybe any color on what the growth rates you're kind of looking for there?"
},
{
"speaker": "Thomson Leighton",
"text": "Yes, the savings can be substantial. The list pricing that we offer for Linode is substantially less than when you see the hyperscalers offering, that's public information. And for major enterprises, obviously, you can have some discount to that. And the really good news is that we believe we can do this at substantial margins. So as we grow the business, actually, they'll improve our margins overall. And Ed, do you want to take the second part of that?"
},
{
"speaker": "Edward McGowan",
"text": "Yes. So in terms of the run rate and the growth expectations, yes, I mean, I think in terms of the near-term run rate, that's probably a reasonable place to peg it. What Tom and Adam talked about in May at our Analyst Day is we're making some substantial upgrades to the capabilities that Linode has, that doesn't happen overnight. So really, we will start to see -- the big enterprise growth will be into '23 and the back half of '23 '24, et cetera. But we do expect pretty substantial growth here, obviously, grew 74-plus percent in Compute, but a good place to put it for now, but it will take some time to build out the capacity as well as the added features. We're going, as Tom said, at a pretty good pace here, but that's when you really start to see the exciting growth is once all that capability is up and available."
},
{
"speaker": "Operator",
"text": "The next question is from Rudy Kessinger of D.A. Davidson."
},
{
"speaker": "Rudy Kessinger",
"text": "Great. So for the balance of the year, you're taking the revenue guide down by $55 million. You said FX headwinds for the year now at $114 million versus $100 million previously. So ex that FX headwind, you're taking it down by $41 million. I'm curious if you could kind of bucket it out that $41 million reduction between lower traffic growth outlook or macro challenges versus maybe some of the revenue you're losing from potentially taking less traffic from some of those customers with high peaks or other areas where you're reducing the guide."
},
{
"speaker": "Edward McGowan",
"text": "Yes. I'd say the majority of it comes from the slower traffic. That's going to be the biggest component of it. The impact for some of the traffic we're turning away isn't all that significant, but does contribute to it. I don't have an exact percentage for you, but that's not a significant part of it. And then the macroeconomic would be the remainder. So if you were to stack rank it would be slower traffic macroeconomic and then the impact from turning away some of the traffic that we talked about in terms of the peaky traffic."
},
{
"speaker": "Rudy Kessinger",
"text": "Okay. And then on Linode, I guess I'm curious, like what is your total internal spend with the hyperscales currently? What percent do you think you could move to Linode over time? And what's the kind of expected cost savings you think you can get from that?"
},
{
"speaker": "Thomson Leighton",
"text": "Yes, we're spending about $100 million a year annually now with the cloud companies. And over the next year or 2, ultimately, we would migrate pretty much -- most all of that on to Linode. And substantial savings. So that's why it's one of our several initiatives we're taking to improve margins. Also, it's great to be using our own services, and it will help us as we do the work with Linode to make it enterprise-ready, to be using it across the spectrum of applications at Akamai. We're very much like our customers and looking for ways to save on cost and get great performance out of our cloud compute platform."
},
{
"speaker": "Operator",
"text": "The next question is from Jeff Van Rhee of Craig-Hallum."
},
{
"speaker": "Jeff Van Rhee",
"text": "Just a couple for me. I think on the Security side, I just want to clarify, I know you said you're comfortable at 24% revenue growth. To be clear, as reported or constant currency and then just kind of the puts and takes of being able to sustain that 20% in the outyear, given kind of the deceleration we're seeing right now?"
},
{
"speaker": "Edward McGowan",
"text": "Sure. I'll take the first part, Tom, you can take the second part in terms of the future. That's in constant currency. And just remember, Jeff, that the Guardicore acquisition anniversary is in the fourth quarter."
},
{
"speaker": "Thomson Leighton",
"text": "Yes. And in terms of the longer range, obviously, we're seeing very good growth in our flagship products, Web App Firewall and Bot Manager. They're the largest contribution of revenue. Really good growth, but on smaller numbers, obviously, for Zero Trust enterprise computing. In the longer time frame, I think that's what drives a lot of the growth in security. The infrastructure category growing more slowly today, also on a moderate size number. But I think in the long term, you see the enterprise Zero Trust security group grow, led by Guardicore as the market leader in stopping ransomware. ."
},
{
"speaker": "Jeff Van Rhee",
"text": "So I guess as a bucket, no clear sort of things you would call out that should drive acceleration or deceleration, maybe a different way to look at it."
},
{
"speaker": "Thomson Leighton",
"text": "Well, there's the three categories we have today. The biggest is app in API security, very strong growth. I think we get continued strong growth there. A lot of innovation going on with Account Protector, Page Integrity Manager we talked about being really important for PCI compliance. We have a new audience hijacking prevention capability that looks really cool. Infrastructure is moderate size today, and that's not growing as fast. That's your DDoS protection and your D&S defenses. And then the really high-growth area, Zero Trust enterprise security led by Guardicore, but it's the smallest of the 3. And so you sort of have 3 different comps with a little bit different dynamic in each."
},
{
"speaker": "Jeff Van Rhee",
"text": "Okay. And one last, if I could, on delivery. Obviously, you're making some changes around the peaking traffic. What about pricing disciplines just in traffic in general? I think you had commented last quarter you were taking a much more sort of across-the-board conservative approach to pricing. Just pricing outside that peaking, how has your approach changed this quarter and likely to change the rest of year?"
},
{
"speaker": "Edward McGowan",
"text": "Yes. So we've been instituting that now for the last several months. And as Tom talked about, we have not seen a lot of churn. We've been fairly successful in the renewals that we've had. We are still offering discounts to customers who have traffic growth. It's just not at the same levels that we've done historically."
},
{
"speaker": "Operator",
"text": "The next question is from Will Power of Baird."
},
{
"speaker": "Charles Erlikh",
"text": "It's Charlie Erlikh on for Will. Just one question for me on the pricing and contract renegotiations kind of building on your response. Any big contracts coming up for renewal that we should be aware of in the second half? And then for the 8 that you mentioned you had in the first half, any more color on just the tone and the overall discussions like pricing compression, you mentioned a little bit, but just the health of the customers you're talking to and just any more color on that would be great."
},
{
"speaker": "Edward McGowan",
"text": "Yes, sure. So there's no big ones coming up in the second half. Like I said, if we ever have a big clump in the -- we'll call it out for it. I think it's just helpful to provide commentary and get you guys aware of what's happening. In terms of the dynamics outside of pushing back a little bit on sort of the peak to average, which is part of the normal discussion that we have, I would say we're kind of came in line with what we had expected. We did try to apply our strategy of being a bit more disciplined. I don't know if that's the right word, but more attuned to what's going on with volumes and having conversations with customers about expected volume growth, et cetera. So pleased with where we landed. And obviously, renewing large customers and this -- and the delivery segment is never a fun thing. But kind of came out as expected. And then your other question was on -- just remind me again?"
},
{
"speaker": "Charles Erlikh",
"text": "I think you actually hit all the questions, yes, just the overall tone of the conversations. But yes, I think you answered it pretty well."
},
{
"speaker": "Edward McGowan",
"text": "Yes. So overall, I mean the customers are still in great shape. There are some very large brands and still very healthy. We added services to most of them. So not only are we just dealing with delivery, but we're also adding on additional capabilities as well."
},
{
"speaker": "Operator",
"text": "The next question is from Alex Henderson of Needham."
},
{
"speaker": "Alexander Henderson",
"text": "So given both Guardicore and Linode have not been in the full for over a year, I was wondering if you could look at them from the perspective of apples-to-apples, if they had been in the fold for the entire year, what their internal growth rates look like so that we have some gauge of the rate of growth at those 2 acquisitions."
},
{
"speaker": "Edward McGowan",
"text": "Yes, it's a good question, Alex. I'll take this one, Tom. So Linode, so Linode will end up being in for most of the year. But just prior to acquisition, we had said in our commentary, they're growing around 15%. Obviously, we'll accelerate that as we start to add enterprise customers. So I'd expect that to increase. With Guardicore, if you remember our first call, we're taking our guidance up quite a bit, but if you look at where our kind of internal -- where our run rate is now, we're looking at over $60 million. That would be almost a doubling of where they were when we acquired them even slightly higher than that. So Guardicore growing extremely fast, I would say, sort of if it was a standalone on its own would be more than a double. And Linode, we just picked it up and its starting to add that functionality and expect to accelerate that growth rate, but they were about 15% prior to acquisition."
},
{
"speaker": "Alexander Henderson",
"text": "There was a comment earlier in the call that adjusting for acquisitions, the underlying growth rate was 17%. Would you confirm that, that's an accurate calculus?"
},
{
"speaker": "Edward McGowan",
"text": "Yes. That's about the right math. 21% constant currency. Guardicore was about $14 million. So that's roughly 4%. So that's about right."
},
{
"speaker": "Alexander Henderson",
"text": "Perfect. And then just looking at the international markets, how are you handling the FX swings that are going on? In terms of pricing, are you offsetting and look the effective price reduction that implies in dollars, if you're in local currency and where you're not in local currency, are you pricing down to lower the burden? How are you handling the customer pressures around that?"
},
{
"speaker": "Edward McGowan",
"text": "Yes. So most of the customers outside the U.S. are paying us in local currency. So they're billed in local currency. There are several that are not certain countries, for example, will be in U.S. dollar. So far, it has not been a big issue with our customers pushing back. We do some hedging on balance sheet, but not from an operational perspective, not cash flow hedging. And then in terms of pricing, we do take that into consideration as we're going through with customers that are outside the U.S. And also just in general, depending on where their traffic is, that also comes into effect. If we're delivering in countries that are more expensive, we take that into effect as well."
},
{
"speaker": "Tom Barth",
"text": "Okay. Thank you, Alex, and thank you, everyone. So in closing, we will be presenting at a number of investor conferences and events throughout the rest of the third quarter. Details of these can be found in the Investor Relations section of akamai.com. Thank you for joining us, and all of us here at Akamai wish continued good health to you and yours. Have a nice evening."
},
{
"speaker": "Operator",
"text": "The conference has now concluded. Thank you for attending today's presentation. You may now disconnect."
}
] | Akamai Technologies, Inc. | 24,522 |
AKAM | 1 | 2,022 | 2022-05-03 16:30:00 | Operator: Good day, and thank you for standing by. Welcome to the First Quarter 2022 Akamai Technologies Earnings Conference Call. [Operator instructions] I'd now like to hand the conference over to your speaker today, Tom Barth, Head of Investor Relations. Please go ahead.
Tom Barth: Thank you, operator. Good afternoon, everyone, and thank you for joining Akamai's first quarter 2022 earnings call. Speaking today will be Tom Leighton, Akamai's Chief Executive Officer; and Ed McGowan, Akamai’s Chief Financial Officer. Please note that today's comments include forward-looking statements, including statements regarding revenue and earnings guidance. These forward-looking statements are subject to risks and uncertainties and involve a number of factors that could cause actual results to differ materially from those expressed or implied by such statements. These factors include any impact from macroeconomic trends, uncertainty stemming from the COVID-19 pandemic, the integration of any acquisitions and any impact from geopolitical developments. Additional information concerning these factors is contained in Akamai's filings with the SEC, including our annual report on Form 10-K and quarterly reports on Form 10-Q. The forward-looking statements included in this call represent company's view on May 3, 2022. Akamai disclaims any obligation to update these statements to reflect new information, future events or circumstances except as required by law. As a reminder, we will be referring to some non-GAAP financial metrics during today's call. A detailed reconciliation of GAAP and non-GAAP metrics can be found under the financial portion of the Investor Relations section at akamai.com. And with that, let me turn the call over to Tom.
Tom Leighton: Thanks, Tom. And thank you all for joining us today. Our Q1 revenue was $904 million, up 7% year-over-year and up 9% in constant currency. This solid result was driven by the continued rapid growth of our Security and Compute businesses. Q1 non-GAAP operating margin was 30%. Q1 non-GAAP EPS was a $1.39 per diluted share, up 1% year-over-year and up 4% in constant currency. As Ed will discuss later, EPS came in at the low end of our guidance range, primarily due to an adverse tax impact of $0.03. Since our last call with you on February 15, we've seen the development of several major global events and financial headwinds. It’s remarkable how quickly the world has changed with the war in Ukraine, the significant strengthening of the U.S. dollar, escalating inflation, increasing concerns about a recession and a moderation of internet traffic growth, as many countries remove mask mandates. Since these developments are all fairly recent, they had a relatively small impact on our Q1 results, but it's prudent to assume that they'll impact our results more meaningfully for the rest of the year. For example, at current spot rates, the strengthening dollar will adversely impact full year 2022 revenue by about a $100 million. About $55 million of that impact has come since we issued guidance on February 15. As we disclosed in our 8-K filing on March 7, about 1% of our revenue comes from Russian companies or is derived from delivering traffic into Russia. We have since terminated our business with several majority state-owned Russian companies and our traffic delivered into Russia and Ukraine on behalf of other global customers has declined dramatically since the war began. As a result, it's reasonable to assume that we will no longer generate most of the revenue that had been associated with Russian and Ukraine. Lastly, data from some of our large customers in the media and commerce verticals suggest that they may be transitioning from an environment of above normal online consumption, fueled by COVID-related restrictions to an environment with more macroeconomic uncertainty, which could moderate their traffic growth in the near term. Discussions with many of our large carrier partners across the world have reinforced the view that traffic growth rates may be moderating across the internet as a whole. In particular, they've told us that they've recently seen a moderation in their year-over-year traffic growth, and that the current levels of traffic on their network are less than what they'd expected. This is consistent with what we've recently seen. Traffic is still growing at a fast pace on the Akamai platform, but at a more moderate pace than we've observed over the last few years. As a result of these largely external factors and to be conservative in our outlook, we feel it’s prudent to lower our expectations for the full year. Ed will provide more detail shortly. That said, and this is important to emphasize, Akamai’s business continues to be very strong and highly profitable. Traffic growth on our platform remains substantial. And the data we've received from customers and carrier partners indicates that our market share remains stable or is modestly increasing. In addition, our customer churn levels continue to be at record lows. Lost annual revenue from churned accounts in Q1 amounted to less than one half of 1% of total annual revenue. And churn due to competitors was much less than half of that already small amount. As a result, our market leading delivery business continues to generate substantial cash and to power our unique edge platform. Our security business has reached an annual revenue run rate of over $1 billion and continues to grow over 20% annually in constant currency. And we believe that our Compute business is poised to achieve about $400 million in revenue this year with a growth rate of over 60%. And perhaps most important of all the combination of our security and compute businesses now represents the majority of our revenue. We expect these businesses to generate about $2 billion of revenue this year with a growth rate of about 27% in constant currency. I'll now talk about each of our three major business lines, starting with Security, which we believe will soon become our largest business line. Our security solutions generated revenue of $382 million in Q1, one up 23% year-over-year and up 26% in constant currency. This very strong growth was driven primarily by our flagship security products, Kona Site Defender and Bot Manager. And also by our new Guardicore micro-segmentation solution to stop ransomware. In Q1, we finalized the largest deal in Guardicore’s history, valued it more than $10 million over the next three years, expanding our longtime relationship with one of the largest banks in the world. The size and scope of the deal illustrates why we're so excited about our opportunity in micro segmentation. Financial services firms in particular are frequent targets of ransomware and malware and large banks with security risks, face financial penalties from regulators if they fail to address them. So from a compliance perspective, adopting micro segmentation can reduce risk and prevent large fines in the process. By reducing spending on their legacy static firewalls, the bank that's adopting our micro segmentation solution will free up resources to implement stronger defenses as they move to a new zero trust security architecture. And by converting to our more flexible software-based solution, they can achieve greater agility to compete with fast moving FinTech services. This example demonstrates how Guardicore can help Akamai expand longtime relationships with customers to become a more valuable strategic partner in the future. Guardicore is also helping us win new accounts and verticals such as critical infrastructure. For example, one of the largest railroads in the world recently became a multimillion dollar Guardicore customer. On April 20, cybersecurity authorities in the U.S. and other major countries warned that the war in Ukraine raises the risk of cyber attacks. Their recommended defenses aligned well to Akamai security solutions from microsegmentation, DDoS protection and web app firewall. Web application attacks experienced by customers grew by nearly 200% year-over-year in Q1. The largest increase we've seen in several years, web app attacks are a critical vulnerability for any company moving to the cloud, building microservices or integrating third parties via APIs, which is why app and API protection is a critical priority for major enterprises. Akamai is a leader in Gartner's Magic Quadrant for Web App and API Protection. And in Q1, Akamai’s web app and API protection on Gartner Peer Insights Customers Choice Distinction for the third year in a row, also in Q1, Forrester named Akamai a leader in its New Wave for Microsegmentation. As we discussed during our last call with investors in February, we will be reporting on our delivery and compute product lines separately, going forward. In Q1, our delivery products generated revenue of $444 million, down 6% year-over-year and down 4% in constant currency. Revenue for our compute product group was $78 million in Q1, up 32% year-over-year and up 35% in constant currency. As I mentioned earlier, traffic on our platform has been growing at a substantial rate. In fact, just last week, we set another record when we delivered over 250 terabits per second of peak traffic, more than 20% higher than our previous peak reached in February. The Akamai Edge platform continues to be the top choice for large media companies worldwide due to its unique scale and performance. In a recent review of CDN vendors worldwide, IDC said Akamai's balanced and comprehensive portfolio spanning media and web delivery, emerging edge applications, extensive security capabilities, and programmable edge addresses the needs of all enterprise segments and the developer community. The report also noted how Akamai's appetite for innovation is showcased by the fact that it continues to expand its services and capabilities beyond CDN to address new areas. Akamai is the market leader in delivery by far, and the income generated by our delivery business helps to fund our investments in the fast growing areas of security and compute, including our game changing acquisitions of Guardicore and Linode. Our compute product group includes Akamai’s capabilities in compute, storage, cloud optimization, developer tools, edge applications, and now Linode, which joined Akamai on March 21. We are encouraged by how customers and industry analysts have responded to our acquisition of Linode. In fact, several of used the word transformational to sum up the potential impact of our combination of the marketplace, the CEO and Co-Founder of Macrometa, Linode partner that enables web and cloud developers to run and scale data heavy real-time cloud applications has called Akamai’s acquisition of Linode, a watershed moment for the cloud because it fundamentally reconfigures the landscape in many ways. Those are his words and he says that Akamai provides that layer of reach and distribution in a way that cloud providers are very challenged to be able to do. I'm excited about that he said. Of course, we're excited too. Linode was an early pioneer in creating the market for alternative clouds, offering developers a platform to build new applications in ways that are simple to use and affordable. With high performance, a competitive, transparent, and predictable price points and backed by strong customer support after the sale. Today, nearly three quarters of enterprises are pursuing multi-cloud strategies, which means that new workloads will be cloud agnostic and portable, free to move and choose the best place to be. In fact, IDC just issued a report on workload deployment optimization that urges buyers to consider suppliers of Infrastructure-as-a-Service beyond the hyperscalers. Our acquisition of Linode was the first alternative IDC highlighted as an example that can offer better cost and performance while retaining the level of redundancy and coverage demanded by enterprises. In the coming years, we expect that customers will have a growing need for a continuum of compute from the cloud to the edge, to be closer where billions of end users are and where tens of billions of connected devices will be, especially as 5G and IoT take hold and grow. Building the bridge that enables developers to move from the cloud to the edge and have one place to build, run and secure apps is a key reason why we're expanding our offering with Linode. At our Analyst Day, coming up on May 18, we'll talk more about the potential for substantial future growth in this new and exciting part of Akamai's portfolio. As we become the cloud company that powers and protects life online. The soundness of our overall strategy was validated in visits I had with dozens of Akamai customers across EMEA and APJ last month. Common concerns expressed by customers and prospects included the war in Ukraine, the heightened level of cyber attacks, as well as risk to trade and supply chains, energy costs, and currency evaluations. Customers express very strong interest in our security strategy and Guardicore, in particular. As you can imagine, their boards are asking them how they can prevent a crippling ransomware attack. And Guardicore is the perfect solution. They know that malware always finds a way in, the key is identifying it and stopping it spread before it can cause serious damage. And that's exactly what Guardicore is designed to do. Most of the customers I met with, were also interested in exploring our cloud compute offering as a more affordable and easier way to build, run, and secure their new applications. The tight labor market, employee attrition, and the desire of employees to work remotely were also top of mind for customers in every location. Several companies that I met with are reducing their real estate footprint. And one of them told me they could only do this because they secured their remote work environments with Akamai's enterprise application access. Here at Akamai, we face the same macro trends as our customers, but in spite of the headwinds, we feel good about the growing demand from customers for our security and compute solutions, the expertise of our team in the addition of capabilities and talent from Guardicore and Linode. And how all of this gives Akamai not one, but two, rapidly growing and highly synergistic businesses, further diversifying our revenue, we've also performed well on the retention of our talent, employees appreciate our flexible workplace policy and culture of teamwork. Akamai scores very high on third-party rankings of the Best Places to Work. I'm proud of the way that our employees have managed. And I want to thank our extended team around the world for doing such a great job for our customers. They are truly making life better for billions of people, billions of times a day. Now over to Ed for more on Q1 and our outlook for Q2 and the rest of the year. Ed?
Ed McGowan: Thank you, Tom. As Tom mentioned, Akamai delivered a solid quarter in Q1. Q1 revenue is $904 million, up 7% year-over-year, or 9% in constant current currency. Revenue was led by continued strong growth in security and compute. The strength was partially offset by a significant strengthening U.S. dollar and a slight moderation in traffic growth rate in our delivery business during the last month of the quarter. Security revenue grew 23% year-over-year and 26% in constant currency, led by a reacceleration of growth in our application Security business and continued very strong performance from Guardicore. Security represented 42% of total revenue in Q1, which is up 5 points from Q1 a year ago. Guardicore delivered revenue of $19 million in the quarter, included in our Guardicore results was approximately $7 million of term license deals from four customers. As a reminder, while the majority of Guardicore deals are Software as a Service and revenue is recognized monthly under ASC 606, some customers specifically financial services and healthcare due from time to time require on-premise deployments. These deployments result in term license accounting treatment, where we are required to recognize a significant portion of the revenue upfront when the product is delivered for spreading the revenue over the contract term. It’s worth noting the impact of these deals resulted in a pull forward from Q2 to Q4 into Q1 of approximately 1 percentage point of revenue growth. Compute revenue in Q1 was $78 million and grew 32% year-over-year and 35% in constant currency. As Tom mentioned, we were very pleased with the initial performance of our Linode acquisition, which closed in late March and contributed revenue of approximately $3.5 million in Q1. Delivery revenue was $444 million in Q1 and decline 6% year-over-year and 4% in constant currency. As discussed last quarter, several of our top customers are expected to renew in the first half of 2022. Our first quarter revenue was impacted by the renewals of half of these customers, we expect the remaining customers to renew by July 1. So far, the pricing for the renewals has been in line with our expectations. Additionally, we started to notice the growth rate of traffic on our network moderate a bit in March, specifically in gaming and OTT verticals. As some pandemic related restrictions were lifted in countries throughout the world. Sales in our international markets represented 47% of total revenue in Q1. International revenue grew 11% year-over-year or 16% in constant currency. The negative impact of foreign exchange on our Q1 results increased by approximately $2 million from our February earnings call as a U.S. dollar continued to strengthened significantly in March. Foreign exchange fluctuations had a negative impact on revenue of $4 million on a sequential basis and negative $18 million on a year-over-year basis. Finally, revenue from our U.S. market was $481 million and grew 4% year-over-year. Now moving on to costs. Cash gross margin was 76% in line with our expectations. GAAP gross margin, which includes both depreciation and stock-based compensation was 63%. Non-GAAP cash operating expenses were $295 million. Now moving on to profitability. Adjusted EBITDA was $391 million. Our adjusted EBITDA margin was 43% in line with our guidance. Non-GAAP operating income was $270 million and non-GAAP operating margin was 30%. Capital expenditures in Q1, excluding equity compensation and capitalized interest expense were $116 million. This was slightly better than our guidance range as we continued to see greater efficiency on our network. GAAP net income for the first quarter was $119 million or $0.73 of earning per diluted share. Non-GAAP net income was $225 million or $1.39 of earnings per diluted share, up 1% year-over-year and up 4% in constant currency. Non-GAAP earnings per share was negatively impacted by approximately $0.03 in Q1 due to a higher than expected non-GAAP effective tax rate. Taxes included in our non-GAAP earnings were $43 million based on a Q1 effective tax rate of approximately 16%. This was approximately 1.5 points higher than we had expected in due primarily to three reasons. First, a higher than expected mix of U.S. revenue with foreign exchange rate fluctuations, a significant contributing factor along with the addition of Linode revenue. Second, an unfavorable change to foreign tax credits in Q1 based on the most recent treasury guidance. And third, a refinement of our previous assumptions related to R&D tax launching changes from the 2017 U.S. tax reform that became effective in Q1 2022. Moving now to cash in our use of capital. As of March our cash, cash equivalents and marketable securities totaled approximately $1.3 billion. During the first quarter, we spent approximately $103 million repurchase shares, buying back approximately 900,000 shares. In addition to share repurchases in March, we spent approximately $900 million to complete our acquisition of Linode. We ended Q1 with approximately $1.7 billion remaining on our current repurchase authorization. Our intention is to continue to buy back shares to offset dilution from employee equity programs over time, and to be opportunistic in both M&A and share repurchases. Before I provide our Q2 and 2022 guidance, I want to highlight several factors. First, our guidance now includes Linode. We expect Linode to contribute revenue of approximately $100 million and add approximately $0.05 to $0.06 to non-GAAP EPS in 2022. This is unchanged from the assumptions we shared on our last call. Second, the dollar has continued to strengthen meaningfully since we reported in mid-February. As a result, we currently expect a much greater foreign exchange headwind for the remainder of 2022. At current spot rates, our guidance assumes that foreign exchange will have a negative $100 million impact on revenue on a year-over-year basis. This compares to our prior guidance of a negative $45 million impact to revenue. This change in FX from our prior guide will also negatively impact non-GAAP EPS by approximately $0.16 for the a full year 2022. It’s worth emphasizing that currency markets have been extremely unsettled and about as volatile as I have ever seen, as a result, it is impossible to predict whether and how the impact could change going forward. Third, we now expect our non-GAAP effective tax rate for 2022 to be approximately 16%, which is a approximately 1.5 points higher than our prior assumption. Based on the items I mentioned before, the change in tax rate will also negatively impact the full year 2022 non-GAAP EPS by approximately $0.11. Fourth, as Tom discussed, regarding our business in Russia and Ukraine is reasonable to assume that most of that revenue goes away. Finally, as mentioned earlier, our traffic growth rate moderated a bit in March, and we’ve seen that trend continue in April. While traffic continues to grow at a strong rate and as at record levels, the growth rate is lower than we originally expected. Therefore, we are taking a more conservative approach to forecasting our traffic and corresponding revenue for the remainder of the year. That said, we do not believe this trend is a permanent consumer shift or due to us losing share, but rather is likely driven by some of the significant external factors we are seeing in the marketplace and geopolitically. Said another way, we believe that traffic growth and online activity return to more historical norms at some point. So with all those factors in mind, turning to our Q2 guidance. We are now projecting revenue in the range of $890 million to $905 million or up 4% to 6% as reported or 8% to 10% in constant currency over Q2 2021. Foreign exchange fluctuations are expected to have a negative $14 million impact on Q2 revenue compared to Q1 levels and a negative $30 million impact year-over-year. At these revenue levels, we expect cash gross margins of approximately 75%. Q2 non-GAAP operating expenses are projected to be $282 million to $289 million. We anticipate Q2 EBITDA margins of approximately 43%. We expect non-GAAP depreciation expense to be between $129 million to $130 million. And we expect non-GAAP operating margin to decline to approximately 29% for Q2 to largely to the change in FX and some node integration costs. Moving now to CapEx, we expect to spend approximately $150 million to $155 million, excluding equity compensation and capitalized interest in the second quarter. This represents approximately 17% of projected total revenue. A significant portion of the increase in the spend this quarter is related to Linode, an anticipation of significant demand. With the overall revenue and spend configuration I just outlined, we expect Q2 non-GAAP EPS from the range of $1.28 to $1.33. This EPS guidance assumes taxes, the $40 million to $41 million based on an estimated quarterly non-GAAP tax rate of approximately 16%. It also reflects a fully diluted share count of approximately 162 million shares. Looking ahead to the full year, we now expect revenue of $3.62 billion to $3.67 billion, which is up 5% to 6% year-over-year as reported, we’re up 7% to 9% in constant currency. We expect security revenue to grow at least 20% or greater for full year 2022 in constant currency. We now estimate non-GAAP operating margin to be approximately 29% based primarily on the impact of FX and some of the internet traffic dynamics I previously discussed. We now estimate non-GAAP earnings per diluted share of $5.32 to $5.44. This non-GAAP earnings guidance is based on a non-GAAP effective tax rate of approximately 16%, a fully diluted share count of approximately 161 million shares. Finally, full year CapEx is anticipated to be approximately 14% of revenue. It is worth noting, our CapEx assumption now includes Linode that we talked about on our last quarter, partially offset by lower network CapEx, given the slower traffic growth rate that we now project. In closing, while the macroeconomic environment has become more challenging since our last earnings call and the U.S. dollar continues to be a major headwind for us. We remain very optimistic about the opportunities in front of us, especially in Security and Compute. As Tom mentioned, I look forward to seeing you at our Analyst Day in New York City on May 18. Thank you. Tom and I would be happy to take your questions. Operator?
Operator: Thank you. [Operator Instructions] Our first question comes from Keith Weiss with Morgan Stanley. Your line is open.
Keith Weiss: Excellent. Thank you guys for taking the call and a lot of great kind of information in there for us to kind of better understand kind of what’s going on with a lot of moving pieces in the environment. Of course, I’m going to ask you about more on that. So in particular, when you see like the slowing network traffic and some of these increasing pressures, is there any kind of geographic specificity to it? Is it more in Europe than the U.S. or is it more evenly spread number one. And number two, on the security side of the equation, is there any counterforce if you will, meaning, it sounds like, it’s a pretty bad threat environment out there. You guys have a great solution portfolio for those types of threats. Are you seeing any sort of increasing demand on that side of the equation that can offset some of those potential headwinds on the delivering compute side of the equation? Thank you.
Tom Leighton: Yes, this is Tom. Great questions. The traffic, I would say, growth moderation seems to be pretty much global and that coincides with a pretty much global reduction in things like mask mandates and quarantines and so forth, except for China. And we don’t do domestic to domestic delivery in China, so we wouldn’t be able to see that. So there’s no particular geographic dependence there and you’re on a great point about counterbalance through security. Obviously, we’re negatively impacted in terms of traffic and a few customers, because of the war and Ukraine. On the other hand, attacks have gone way up, the volume of attacks. And that’s an area where we can really help our customers. And so there could have some counterbalance in terms of the security business. And obviously, as I mentioned, customers are really worried about ransomware attacks and malware, and we’ve got a great solution for that with Guardicore. And as we talk about the macroeconomic challenges, the fears of a recession, the inflation – customers probably increasingly concerned about saving cost going forward and that could provide some counterbalance as well, with our Linode solution, we’re in a really good position to help major enterprises decrease their cloud spend. We find that many of them have seen that spend increase dramatically. And now they can use Linode for applications, especially, enterprises that are already set up in a multi-cloud environment. They’ve got their applications and containers or VMs, and they could easily move those to Linode and save money. So there could be some counterbalance here as we go forward. That’s a very good observation.
Keith Weiss: Got it. And if I could sneak one in for Ed on the other side of the equation. You talked to us about how sort of CapEx is coming down a little bit versus kind of what we were talking about immediately after Linode based on lower network traffic. Are there any adjustments that you guys are making to your OpEx side of the equation? So the level of investment that you guys are going to be making throughout the year given a more kind of difficult environment. Or is it – it’s kind of steady investment as you goes, if you will.
Tom Leighton: We’re not able to hear, Ed. So I guess, we’re having a trouble with the operator with Ed maybe – okay. Could you ask the question again, please?
Keith Weiss: Sure. Thanks. So I was just on the call, Ed, you had talked about CapEx coming down a little bit because of sort of lower network traffic. I was just wondering if you guys are making any adjustment to the OpEx for FY2022 given the more volatile macro. Any limitation in any kind of your investments throughout the year, or do the investments stay relatively stable?
Tom Leighton: No, that’s a great question. And yes, CapEx is much more efficient. Of course, we’re investing heavily to grow the Linode footprint. In terms of OpEx, we’re always working to be more efficient with our OpEx to deliver traffic. And we’re seeing the benefits of that even now. You look at the impact that FX for example is having on our operating margin and then, having less traffic and yet still we were at 29% to 30% with op margin for this year. And now we’ll be, I think really closer to the low end of that range. But it’s because that we’ve been able to be much more efficient on OpEx that we can hold it there and not be lower than that. And of course, we are – also it’s important that we are going to continue to invest certainly in security and compute. We don’t want to be a very temporary solution with FX to induce us to do something that would hurt us long-term with our growth and security and compute. And if you look at our business today and I think it’s pretty important to note that the majority of our revenue is now security and compute, and that is growing currently at over 25% as reported. And so the last thing we want to do is somehow scale back investment there when it’s just a fabulous a couple of businesses just because there’s stuff going on with FX and the macroeconomic environment. And Ed is trying to get back on, but we can keep going and I’ll do my best Ed invitation in the meantime.
Ed McGowan: Yeah. So Tom, I’m back, could you guys hear me now?
Tom Leighton: We can, very good.
Ed McGowan: Okay, great. I’m sorry about that. I don’t know what happened little technical difficulties there, Keith. But I’m not sure if Tom got to your question about some of the things we’re doing on the cost. Okay, if there’s anything else I’m happy to take an additional question.
Keith Weiss: Yes. No, Tom did a great job. You might have to worry about job security now.
Operator: Thank you. Our next question comes from James Breen with William Blair. Your line is open.
James Breen: Thanks. Just a couple. One, when you look at the old guidance that you gave on the fourth quarter call relative today down kind of $5 million at the – $50 million below and in the high end. Given some of the puts and takes you gave, it seems like the rush impact sort of mid $30 million, and then the incremental FX of sort of in the mid 50s sort of kind of offsets basically the upside from Linode and close that deal. I’m just trying to think about to quantify it. So is that sort of incremental kind of $15 million difference, really what you’re seeing from the lower traffic on the delivery side. And can you just remind us of the delivery revenue this quarter the $444 million? How we want to think about it annually? How much of that is more volume driven versus subscription based? Thanks.
Ed McGowan: Yes. Jim, it Ed. Yes, I think you’ve got the pieces right there in terms of the different components, FX being about $55 million, Russia, you could say is about 1%, so call at about $30 million give or take. But the rest of it is the delivery. I think one of the things we tried to make clear in our prepared remarks was the Compute business is going great. We don’t have any – we’ve only owned the business for a little while, so there’s no change there in terms of our outlook. But certainly good early returns and then security is going great, did better than we expected this quarter. So it is limited to a delivery issue and is, I would say primarily, almost all volume driven that we’re seeing. So what we did basically is just adjust the growth rate that we expected for the remainder of the year. And then obviously, things can change over time. But based on what we’ve seen so far in the last couple weeks of March and the beginning of April, we just thought it was prudent to adjust that. So you’re thinking about it right in terms of the different pieces.
James Breen: Great. And then just maybe one for Tom, just the strategy. Linode, you’ve owned it now for a little over a month. They were folks a lot on sort of the small midsize business space in terms of the computing storage. Have you seen any traction with that product that some of your larger customers now that it’s starting to get integrated?
Tom Leighton: Yes, obviously very early days, but we’re really excited about the potential for that traction. I give you just, one anecdote, I was in Europe meeting customers last month and met with one of our major media workflow partners. And I was going to go to talk to them about Linode because they have a big cloud spend and we feel that could be really relevant for moving to Linode. They’re very happy Akamai partners and customers. And I was going to tell them about the acquisition, but I get there, we shake hands. First thing he says is, wow, great acquisition. And he’s is the CEO, but turns out he has a pass as a developer knew about Linode, loves them and he’s into multi-cloud and he said, look, what we did is we already have our workflow apps and containers. And so we thought, what the heck let’s try it. And so they moved him over to Linode and he said, it worked great. And he said, we’re going to save money to boot. And it’s really easy to use. And we didn’t even know because Linode really is easy to use that we didn’t know this was even taking place. So I do think we’re in an excellent position to not only increase the existing Linode customer base, but provide Linode capabilities to major enterprises. And of course, Linode really appeals the developers and increasingly developers are making the decisions or heavily influencing the decisions that have major enterprises as was an example in this case.
James Breen: Great. Thanks a lot.
Operator: Thank you. Our next question comes from Rishi Jaluria with RBC. Your line is open.
Rishi Jaluria: Wonderful guys. Thanks for taking my questions and appreciate all the details around the moving pieces. First, I wanted to start with maybe better understanding some of the macro factors. I think look, the FX well understood, Russia as well, the moderating traffic with reopenings. But Tom, at the beginning you had mentioned kind of the inflation side, as well as fears of recession being in Western Europe or globally. Can you talk a little bit more about how those macro factors are impacting your business? Is this resulting in longer sales cycles, smaller initial deals, just more hesitation around new deals? Any color there that you can give would be helpful and then have a follow-up.
Ed McGowan: Yes. This is Ed. I’ll take that and Tom, if you want to add some color if I missed something here. So, in terms of the inflation and the impact on our business today, we’re not seeing a significant impact from inflation, whether that’s with labor costs or with our costs of our network and that sort of thing. We’re seeing a little bit of higher energy prices in Europe and that sort of thing. But our team does a pretty good job of trying to bake that into their deals when they sign colo deals and that sort of thing. That could obviously change, obviously the labor markets are pretty tight and that sort of thing. But I think the biggest macro impact from our business in terms of our change in outlook is really around the change in behavior where we’re seeing mask mandates lifted and people going out more shopping, more in-stores and that sort of stuff. And the impact on the traffic growth rate is probably the biggest impact. Obviously if we get a major recession that could potentially have a greater impact, but we’re not seeing that certainly in the security business, we’re not seeing customers pulling back. We’re not seeing deals size, the deals getting elongated or anything along those lines. It’s really more that, that impact on the traffic business.
Tom Leighton: Yes. And to Ed’s point, it’s not direct on us, but there is some concern among our media customers in terms of subscriptions and how their business is doing. And so we just keeping an eye on that in terms of the end users reacting in cutting cost and consuming less online. So, I don’t think that’s a major factor yet, but it’s something we’re keeping an eye on.
Rishi Jaluria: Got it. That that’s really helpful. Thanks. And then just going back to Linode, I guess number one, if we do the math back of the envelope, it’s about a $4 million contribution in Q1 is that directionally a correct, number one. And I think number two, when you made the acquisition; you talked about incremental investment opportunities to accelerate the growth rate. Can you maybe remind us about where you find those opportunities, especially where there’s low hanging fruit? And what would be an ideal growth rate for the Linode asset? Thanks.
Ed McGowan: Yes. So, I’ll start off with the question first, just the housekeeping item. We had about $3.5 million of revenue we see in the quarter from Linode. And then as far as the growth rate’s concerned, we’ll get into a lot more details when we see you in New York in a couple of weeks, but, obviously this is a very, very fast growing business, and Linode’s growth rate before we acquire them was at 15%. We think we can accelerate that pretty significantly as we introduce more features, more locations, more capabilities, and we start to tap into our enterprise customer base. So, we think that growth rate can accelerate pretty significantly.
Tom Leighton: Yes. Just to add to that in terms of investment and opportunities, obviously scale is something we’re really good at and distribution, which we’re putting a lot of effort into, and our customer base, which Linode really hadn’t tapped into and being a smaller company, probably a little harder for them to go after major enterprises in terms of the credibility and so forth. But that’s really easy for us to do. And just as I talked about with examples before you take Linode ease of use, and our customer base and those customers that are multi-cloud, and have their apps and containers, they can move them over and save money when they do it. And bring it closer to their delivery and security, which has been occupy where the market leaders at. So, I think there’s a really great opportunity to jumpstart a significant growth among major enterprises for Linode.
Rishi Jaluria: Got it. That’s really helpful. Thank you so much, guys.
Operator: Thank you. Our next question comes from Tim Horan with Oppenheimer. Your line is open.
Tim Horan: Thank you. Tom, on that point with apps and containers is it, have we seen many apps kind of poured over to other clouds at this point, and if they are tying into other value-added products and other software products that the cloud guys have, does it make it harder to do? Or can they still do it relatively easily?
Tom Leighton: Yes, that’s another great point. The hyperscalers have a lot of managed services and added functionality on their platform, which Linode doesn’t. Now, if you’re the kind of company that likes to do those things yourself well, that’s easy to do on Linode. If you’re the kind of company that wants that done by your cloud provider, well, Linode doesn’t do that today. Now, over time, we will be adding more and more capabilities there. So it really, so today I wouldn’t say that that every customer would be in a position to move everything over to Linode. That is certainly not the case. But I think there is a pretty significant segment where it can be done and does make sense to do. And over time we want to grow the kinds of the number, in the types of applications that will make sense to move on to Linode. And it is helpful that, certainly our customer base is already using us for market leading delivery, market leading app acceleration or market leading security. So there’s a lot of synergy there. And I think the combination of that synergy ease of use and cost savings, it’s a pretty exciting combination.
Tim Horan: And just on the traffic volumes, could you give us a sense, the last two years in COVID were we like 25% above trend, 50% above trend, and do you think it kind of reverses however much it was above trend? I’m not looking for exact numbers, but just some color.
Tom Leighton: Yes, it was way above, certainly the first year and very strong the second year. And I would say comparison a small decreasing growth rates, still growing very strong, but less than I think have been expected. And we’re seeing that the same for the internet as a whole. Now, and we’re also seeing our growth be stronger than the internet as a whole, which is good. That’s what we want to keep seeing, because it means we’re – taking more of the internet traffic when that happens. So, I would say the step down, we’ve seen so far is less than the step ups that we’ve seen. And I think that’s because a lot of the increased use of the internet for everything, for video, for gaming, for commerce, remote work, I think a lot of that is here to stay. But right now with all the restrictions coming off except for China, I think that’s a big part of why we’re seeing a little bit of a decrease in traffic growth rates right now.
Tim Horan: Thank you.
Operator: Thank you. Our next question comes from James Fish with Piper Sandler. Your line is open.
James Fish: Hey guys, thanks for the questions. Wanted to first start on the delivery side where frankly, we’re not surprised to see slowing traffic given our tracking of what’s going on in space, but it seems like it was a little bit worse for you guys. Can you just help break down where the main weakness was between web delivery versus media delivery this quarter? It sounds like media was a bit more of a surprise for you guys as it was a former growth driver. It slowing and you guys had a bunch of renewals there while we didn’t have the recovery and web despite travel and hospitality traffic coming back. Can you just help us kind of triangulate where we are between some of the underlying verticals?
Ed McGowan: Hey Jim, this is Ed, I’ll take that one. So yes, the bigger impact was definitely on the media side. So, I called out that we had renewals and when you have renewals, big renewals concentrated in a short period of time and you have a slowdown in your traffic rate; it does accentuate the impact to revenue. Typically we see in a normal year, you’d start to get back to flat line after several quarters and that sort of thing. We just think it might take a little bit longer based on the type of traffic growth rates we’re seeing. In terms of the hospitality and retail, two things to think about there. We are seeing a bit of traffic increase specifically in travel, small vertical for us about 4% give or take, but remember both travel and the media – sorry, the commerce vertical tend to buy our zero overage. So it’s a little bit traffic. It doesn’t have as much of an impact on revenue, but in terms of the biggest impact, that’s really on the media side in terms of the change in traffic. And also in terms of a percentage of overall traffic media represents us a significant portion greater than 90% of our total traffic.
James Fish: Got it. And switching over to security side, how are you guys thinking about the current balance of terms subscription versus SaaS for Guardicore now that you've had it for about one and a half quarters? How do you think this settles down given certain verticals like financial services, want those term subscriptions. And lastly, any sense to what other large deals for Guardicore could be in the pipeline over the next few quarters that can swing? I think it was 50 million to 55 million for expectations for Guardicore this year.
Ed McGowan: Yes. Good question. So I called out on the call that there was about four customers that had term licenses and what I'll do going forward to the extent that there's anything material we'll call it out. I'd say the majority of customers have the more traditional subscription based model, but there are our customers, especially financial services that do like to have the management controller on premise. And that's what really drives the term license aspect of it and what requires us to take the revenue up front. But again, I think the majority will be in that category. Now, keep in mind with the term license, you do have to renew that subscription when the term goes up. The typical term one to three years, Tom mentioned that we did sign a fairly large three-year term deal. So there'll be some of that maintenance and whatnot that could spread out, but you are required to take a fair chunk of that upfront. But in general, I would say that the majority would be the SaaS type deals. And as far as the pipeline goes, it's always hard to call when a deal's going to hit in any particular quarter. I don't see anything significant here in Q2, I'm expecting more of a normal quarter, but to the extent there's anything we'll certainly let you know.
James Fish: Thanks, Ed.
Operator: Thank you. Our next question comes from Amit Daryanani with Evercore ISI. Your line is open.
Amit Daryanani: Thanks for taking my question. I guess I have two as well. Maybe just to ask a little bit more on the core delivery business, the CDM business. I guess, do you think this business just sort of declines 4% or 5% a year for the rest of calendar 2022? Or do you think to see sort of a bottom and the decline rate should improve as you go through the year?
Ed McGowan: Yes, so, I think for the rest of the year, you'll see the business in decline because of the renewals that we have, we had half of them hit so far in the first quarter, the other half will hit in the second quarter. So you'll probably see a little bit of a step down in Q3 and then in Q4 tends to be your seasonally strong quarter. But you do have a tough compare. So I would expect it to be negative for the rest of this year. And obviously it'll fluctuate depending on the specific traffic levels. But Q4, we do typically see a strong season both with commerce and media, commerce has a less muted impact these days with a lot of customers, I think it's about 65% or greater have a zero overage contract. So commerce doesn't have as big of an impact, but media we've typically seen a pretty strong traffic in Q4. We expect to see a pickup in traffic probably a little less. So this year that's what we've modeled in.
Amit Daryanani: Got it. And then, hopefully I have all these numbers correctly if not, please correct them. But as I think about the revisions to the calendar 2022 guide that you folks provided, it looks like sales versus the streets was with all the adjustments is coming down by about 100 million give or take, 2.5%, 3% of initial expectations. But the EPS numbers, I think are coming down much more severely closer to 8%, 9% versus what the prior expectations were. Maybe just walk me through, there's a much more outside EPS adjustment to the full year numbers versus revenue. Is that just a tax rate or one of the moving pieces that are magnifying the correction on the bottom line on the EPS line versus the top line?
Ed McGowan: Yes, sure. So let me try to walk you through that, Rishi. So first of all, the tax impact is about $0.11. And that obviously has no – that's outside of any sort of change in the revenue. Then you get the FX impact is about $0.16. And then the Russia impact is call it another $0.09-ish give or take. So you've got about 60% of it is related to sort of those external factors and the remainder of it is related to just the revisions that we see in delivery.
Amit Daryanani: Got it. Thank you.
Operator: Thank you. Our next question comes from Frank Louthan with Raymond James. Your line is open.
Frank Louthan: All right. Great. Great, thank you. So, on the traffic thing, just to be clear, this is an end user slowing down with the pie shrinking. It's just more of the pie is growing more slowly and or is some of this traffic going elsewhere? And if that's the case, who are you losing share to?
Tom Leighton: No, you're right. It's the – it's just the pie is not growing as fast. The pie is not shrinking; the pie is just not growing as fast. And we believe based on talking to our customers and our carrier partners and what we see that our share of the pie is stable or growing and that we are not on balance losing share of the pie.
Frank Louthan: Okay, great. Thank you. And then what sales investments do you need to make for the rest of the year to sell more with through, sell through with Linode and to sell more Guardicore, et cetera, where are you on that?
Tom Leighton: Yes, so the nice thing with the Linode acquisition is we're not required to make any additional investments in sales, per se. We're going to be obviously bringing this to our channel partners and our sales reps can sell it as a matter of fact, a lot of our customers, if you look at their CDN spend to cloud spend, it's orders of magnitude, larger on the cloud side. So we're talking to the same people that are spending money there. Our teams are will be trained up and ready to go for being able to sell Linode. On the security side, you do tend to hire more specialists. And if I look at sort of where PJ is investing in sales, we are invest a lot in Guardicore not only just with sales reps, but also with technical specialists that help the sales team and professional services folks as well. So you're seeing the investment more leaning in towards the sales side, and you're getting a lot of leverage from the Linode standpoint.
Frank Louthan: All right, great. Thank you.
Operator: Thank you. We have a question from Rudy Kessinger with D.A. Davidson. Your line is open.
Rudy Kessinger: Great guys. Thanks for taking my questions. On the OTT or media, just how are your OTT customers attributing that slower traffic growth maybe between end users, eliminating or reducing the number of OTT services, they subscribe to a shortage of new content or just people getting out more with COVID mandates lifted?
Tom Leighton: Well, as best we're hearing as sort of the first and third there's fewer subscriptions, in some cases, some cases subscriptions reversing. Some cases when the subscriptions are okay, there's traffic growth, but slower traffic growth, and they had anticipated and that they had seen before. And so I think, part of that is that people are just out more right now. Also on the commerce side, and there's been public reports about this, that more brick and mortar sales than there have been, and a little bit less on the online side, which is understandable I think. Given that people are apparently out and about more with less restrictions. So I think there's sort of a variety of factors and it's early days here and probably we'll learn a lot more over the next couple of months.
Rudy Kessinger: Got it. And then just on delivery, you said the pricing on those large customers that renewed this quarter was about as expected. But just as you look more broadly in delivery, how is pricing pressure faring versus years past. I guess, just as I piece it together, understanding traffic growth growing more slowly, but still growing and your guys, position that you're still gaining share of that growing pie, but delivery revenue being down several points. Just how is pricing pressure faring in the broader market?
Tom Leighton: Yes, good question. So I would say a couple things to respond to that. So the renewals like I said are coming in largely as expected. The big change is the rate of growth. So that also impacts your conversations going forward. So we've talked for years about how the pricing and the market is fairly efficient in terms, especially with the high volume media environment and it's really driven by volume. So to the extent that customers have less volume, the discounts rates will start to come down going forward. So I would expect to see over time if customers aren't growing at the same type of rate, they're not going to get the same kind of discount. So we may see that take hold over the next several quarters as we go through more renewals and that sort of thing.
Rudy Kessinger: Got it. That's helpful. Thanks guys.
Operator: Thank you. We have a question from Fatima Boolani with Citi. Your line is open.
Fatima Boolani: Hey, good afternoon. Thank you for squeezing me in. Just a really quick one for you in the security business, I think we – you spent a lot of time sort of flushing out the Guardicore performance in the corridor, which was pretty substantial. I think you also kicked your hat on the recovery or re-acceleration on the application security side of the security portfolio. But I'm curious if you have any comments or observations around what the network security side of the funds within that business segment is doing. Just any color there with respect to sort of competitive dynamics, sales dynamics that would be really helpful? Thank you.
Tom Leighton: Yes, this is Tom. On the network side that would be [indiscernible] which is our DDoS mitigation service doing very well. And that we've seen a lot of attacks over the last year, especially around ransom or extortion DDoS attacks. And we've been in a great position to; I had a lot of customers, major enterprises that were going to be potential victims of those attacks. Also we have DNS capabilities, which are widely used as part of the network security product lines, and I would say doing, doing very well.
Fatima Boolani: One other thing I would add, Tom, just that if I – if I look at the product portfolio, Bot Manager continues to do extremely well and growing at a very, very healthy clip, and we introduced our account protector this quarter and saw very, very high uptake with that in early returns on that look great. Obviously it's a newer product, so it'll take time for that to become a material contributed to revenue, but so far the early returns on that have been very good?
Tom Leighton: Yes. And those are all part of our app and API protection group, which is where we're seeing the re-acceleration Ed talked about.
Fatima Boolani: Got it. And just a quick one for you in terms of the housekeeping around free cash flow. So appreciate some of the puts and takes on the margin side of things. Mostly stable but curious about how we should think about free cash flow kind of given the near-term step up in CapEx, which is expected to moderate based on your guidance over the course of the year. But anything you can help us from the free cash flow margin side given the FX movements as well, and that's it for me?
Tom Leighton: Sure. Yes, sure. So the – on the free cash flow side, you'll notice that Q1 tends to be a little bit lighter on the free cash flow side. And a lot of it has to do with when the timing of when bonuses get paid and you can look, if you look kind of year over year, it's sort of in line, Q1-to-Q1 it will expand as we go out throughout the year, but I think one big key takeaway. If you go to the CapEx section, which obviously impacts free cash flow quite a bit. We had originally talked about the sort of call it, Akamai excluding Linode being 13% to 14% from a CapEx perspective. And that Linode would add about two points. One of the things that we're able to do is take advantage of the slow down and growth rate of traffic to be able to pull in some of the CapEx associated with Linode and build out a little bit faster. But in addition to that, we've taken down our total CapEx. So I gave guidance for about 14% of total revenue for the year, which is about 2% better than what we had expected. So think of it as sort of folding in the Linode CapEx under the original umbrella. So that'll obviously help our free cash flow.
Operator: Thank you. Our next question comes from Michael Elias with Cowen and Company. Your line is open.
Michael Elias: Great. Thanks for taking the questions. Two, if I may. So you're expecting to hold an Analyst Day later this month. Any color on what we should expect to hear and as part of that, should we expect similar long-term guidance to what you gave. Your last Analyst Day just including the new compute segment? It's my first question. And the second is, you highlighted at the beginning of the call the inflation and you said that you aren't seeing the impacts of that. I'm just wondering as you think of the business and to the extent that did become a bigger issue. What are the levers that you could pull vis-à-vis pricing in order to combat inflation to be something that manifested itself? Thank you.
Tom Leighton: Yes. On the first question I think Analyst Day structurally it look a lot like it did last year. So we will look at long-term, CAGR is what we're trying to achieve. We'll talk lot about the compute business and our overall strategy. So high level similar to what you saw last year in terms of the structure. Obviously we've got a cool new things to talk about with our new products, the acquisitions, Guardicore, Linode and the compute product line where we're pretty excited about.
Ed McGowan: Yes. On the inflation front, a couple of things there, obviously you could, I guess you could argue that inflation is causing rates to go higher, which is impacting the U.S. dollar. So there's the FX impact of that, so that's one thing to keep in mind, I guess. But one of the advantages of sort of the hybrid work environment is it enables you to look at acquiring talent from all over the place, instead of just on the couch [ph], you can look in the middle of the country and look at other lower cost areas. So that's one tool in our toolkit. The team's done a great job on the network side with our supply chain in terms of you negotiating and leverage power. A lot of our traffic on our network today is free in terms of bandwidth, so we're somewhat insulated from that. Obviously we'll keep a close eye on the labor markets, but as Tom mentioned there could be some impact to some of our customers and the decisions that they make in terms of their spending. Already we're spending on subscriptions or video or buying the next title for gaming or the gaming console and that sort of things. So that could have an impact on traffic. So what we're doing there is obviously pulling back a little bit on our CapEx for the core network. We're actually able to redeploy some of those resources that we have that know how to build out and scale the network and just go faster in Linode, which is great. So we're sort of taking advantage of some of the opportunities that this gives us and trying to insulate ourselves from any significant impact that inflation may have on the business.
Tom Leighton: Yes. And that's one of the really nice things about our business now as we really are diversified. The majority of our revenue is now security and compute, not delivery, which is a pretty big milestone for a company that not too long ago was known as a CDN or a delivery company. And so when you do have these external factors that can hurt one side of the business, they might help other sides of the business, they might help other sides of the business. For example, security being tied to the war in Ukraine, or inflation driving a need to cut costs and now we have a really good answer for our customers with Linode. So it puts our business in a much stronger position, and we're much more diversified than we've ever been.
Michael Elias: Great. Thank you.
Operator: Thank you. We have a question from Jeff Van Rhee with Craig-Hallum. Your line is open.
Jeff Van Rhee: Great. Thanks. Just a couple of cleanups for me. On the – on Guardicore in terms of the term licenses, were there any terms in Q4?
Ed McGowan: Nothing material. There may have been about $1 million or so, but nothing really material there.
Jeff Van Rhee: Okay. And then as it relates to Linode, how should we think about sales cycles there? As obviously we're going to try to blow out the sales effort and take that into the enterprise base. Just how do we think about two things there. One, the sales cycles? And then two, to date, for Linode, what was a large customer? I mean if you take a look at kind of the – maybe their top 10 customers, what would it take for somebody to crack that large customer criteria sort of into the top 10, obviously, thinking to being able to measure your success in bringing that product to your enterprise base?
Ed McGowan: Yes. Good question. So the sales cycles will vary. As Tom mentioned, there are certain workloads that are built in a container that's easy to move, so those can move relatively quickly. We've started our training, rolled out our compensation plan, so our sales team is starting to build the funnel. We're having good conversations with customers. We're starting to build out additional functionality. We put out a press release about our managed database capabilities the other day. We're be building out more locations. You'll hear a lot more from Adam when we get to the Analyst Day about specifically what we're doing and where we're heading. I would say you start – in terms of how I'm looking at success, which we should start to see some of that materialize towards the back half of the year and really looking at what is our exit run rate going into next year and then what does that funnel look like. But we should start to see a lot of this materialize towards the back half of the year. It's probably a normal sales cycle. You got some early wins. You've got developers from customers that can start playing around adding new applications and that sort of stuff. But I think in terms of the more meaningful, impactful deal sizes, those should happen towards the back half of the year and into next year.
Jeff Van Rhee: Okay. That's helpful. Last one for me. I think on the traffic side, you mentioned OTT as well as gaming and in particular, in general, being most visible in the most recent quarter. I mean, anything notable difference in the trends of those two traffic types? Or is it just generally, behavior you or expect from people getting outside and unlocking? Any differences there?
Ed McGowan: Yes. Good question. I'd say sort of the latter, what you just said there that is probably more of that people getting out. That's – you see that more on the video side in terms of less hours streamed, if you're watching 10 hours a day, you're maybe doing eight or six or whatever. But gaming is more of a seasonal issue. I'd say we saw more of an impact on gaming, not as many releases that had probably a bit weaker than we would have expected. I think in terms of the trends, it depends on what the cycle looks like going into the back half of the year in terms of major gaming releases. But the video side, I think, is a lot more behavioral.
Jeff Van Rhee: Yes. Okay, all right. Thank you.
Tom Barth: Operator – time for one more question.
Operator: Thank you. Our last question comes from Will Power with Baird. Your line is open.
Will Power: Okay. Great. Thanks for sneaking me in. Maybe, Tom, I'd love to get a little more color on the strength within compute. Anything else you could provide with respect to key drivers in the quarter would be great.
Tom Leighton: Yes. We've been working on edge computing, doing edge computing services for close to 20 years. We have the edge worker solution that has function as a service and thousands of POPs around the world, EdgeKV database capability and more and more applications having – our customers having an interest in having them work at the edge. You get tremendous scalability, instant scalability, you can spin up your edge worker app a few milliseconds and be really close to the end user. And I think we get more business there as you go forward, more and more of our customers are using it as they move to the – an API model and as you get 5G and as you get IoT and you have more demand for lower latency and scalability at the edge. And of course, Linode is really exciting because now you get the core cloud compute capability. So you can just take your container, your app and the container and move it over to Akamai, and have the whole thing end-to-end from the core of the cloud to the edge. You can build your app on Akamai. You can run it on Akamai. You could deliver it on Akamai. You can do the compute you need at the real edge in thousands of places. And of course, we'll wrap it all in security for you. So I think compute is strong on its own from what we had. Now you get more strength with Linode and then you wrap it all together in the Akamai platform, which is really unique in terms of having 4,000 POPs. There is nothing like it in terms of having a true edge network, the scalability you get and the performance you get from that.
Will Power: Okay. Great. Thanks. And then maybe just a quick question on thoughts around potential M&A from here given valuation compressions in the market. How does that change the landscape for you? How you look at things and maybe appetite here, particularly coming on the heels of the Linode deal?
Tom Leighton: Yes. We're continuing to look at possible acquisitions. Obviously, we've done two large ones in a short period of time. I don't expect that to be the norm. We're generating a lot of cash, and we're going to use that to reinvest in the business, particularly in security and compute. So it's not impossible over time. You'll see other acquisitions like that. And probably, several smaller acquisitions like we've always done. Tech tuck-ins, adjacent products. So I think what you've seen is what you'll get, but not two big ones right away. That's not the norm. But we saw a real chance to have a game changer in enterprise security with Guardicore. Really, the right product to stop ransomware and a game changer in Linode, a leading alternative cloud that gives us – really completes the Akamai picture, I would say, in terms of powering and protecting life online, being able to build, run, deliver, accelerate and secure your app all in 1 platform is really exciting for us.
Will Power: Great. Thank you.
Tom Barth: Thank you, everyone, for joining us tonight. I know we ran a little long, so we appreciate your patience. And in closing, we will be presenting at several investor conferences and road shows throughout the rest of the second quarter, including our Analyst Day in New York City on May 18. Details of all these events can be found in the Investor Relations section of akamai.com. Thanks for joining us and all of us here at Akamai wish you and yours continue good out. Have a great evening.
Operator: This concludes today's conference call. Thank you for participating. You may now disconnect. | [
{
"speaker": "Operator",
"text": "Good day, and thank you for standing by. Welcome to the First Quarter 2022 Akamai Technologies Earnings Conference Call. [Operator instructions] I'd now like to hand the conference over to your speaker today, Tom Barth, Head of Investor Relations. Please go ahead."
},
{
"speaker": "Tom Barth",
"text": "Thank you, operator. Good afternoon, everyone, and thank you for joining Akamai's first quarter 2022 earnings call. Speaking today will be Tom Leighton, Akamai's Chief Executive Officer; and Ed McGowan, Akamai’s Chief Financial Officer. Please note that today's comments include forward-looking statements, including statements regarding revenue and earnings guidance. These forward-looking statements are subject to risks and uncertainties and involve a number of factors that could cause actual results to differ materially from those expressed or implied by such statements. These factors include any impact from macroeconomic trends, uncertainty stemming from the COVID-19 pandemic, the integration of any acquisitions and any impact from geopolitical developments. Additional information concerning these factors is contained in Akamai's filings with the SEC, including our annual report on Form 10-K and quarterly reports on Form 10-Q. The forward-looking statements included in this call represent company's view on May 3, 2022. Akamai disclaims any obligation to update these statements to reflect new information, future events or circumstances except as required by law. As a reminder, we will be referring to some non-GAAP financial metrics during today's call. A detailed reconciliation of GAAP and non-GAAP metrics can be found under the financial portion of the Investor Relations section at akamai.com. And with that, let me turn the call over to Tom."
},
{
"speaker": "Tom Leighton",
"text": "Thanks, Tom. And thank you all for joining us today. Our Q1 revenue was $904 million, up 7% year-over-year and up 9% in constant currency. This solid result was driven by the continued rapid growth of our Security and Compute businesses. Q1 non-GAAP operating margin was 30%. Q1 non-GAAP EPS was a $1.39 per diluted share, up 1% year-over-year and up 4% in constant currency. As Ed will discuss later, EPS came in at the low end of our guidance range, primarily due to an adverse tax impact of $0.03. Since our last call with you on February 15, we've seen the development of several major global events and financial headwinds. It’s remarkable how quickly the world has changed with the war in Ukraine, the significant strengthening of the U.S. dollar, escalating inflation, increasing concerns about a recession and a moderation of internet traffic growth, as many countries remove mask mandates. Since these developments are all fairly recent, they had a relatively small impact on our Q1 results, but it's prudent to assume that they'll impact our results more meaningfully for the rest of the year. For example, at current spot rates, the strengthening dollar will adversely impact full year 2022 revenue by about a $100 million. About $55 million of that impact has come since we issued guidance on February 15. As we disclosed in our 8-K filing on March 7, about 1% of our revenue comes from Russian companies or is derived from delivering traffic into Russia. We have since terminated our business with several majority state-owned Russian companies and our traffic delivered into Russia and Ukraine on behalf of other global customers has declined dramatically since the war began. As a result, it's reasonable to assume that we will no longer generate most of the revenue that had been associated with Russian and Ukraine. Lastly, data from some of our large customers in the media and commerce verticals suggest that they may be transitioning from an environment of above normal online consumption, fueled by COVID-related restrictions to an environment with more macroeconomic uncertainty, which could moderate their traffic growth in the near term. Discussions with many of our large carrier partners across the world have reinforced the view that traffic growth rates may be moderating across the internet as a whole. In particular, they've told us that they've recently seen a moderation in their year-over-year traffic growth, and that the current levels of traffic on their network are less than what they'd expected. This is consistent with what we've recently seen. Traffic is still growing at a fast pace on the Akamai platform, but at a more moderate pace than we've observed over the last few years. As a result of these largely external factors and to be conservative in our outlook, we feel it’s prudent to lower our expectations for the full year. Ed will provide more detail shortly. That said, and this is important to emphasize, Akamai’s business continues to be very strong and highly profitable. Traffic growth on our platform remains substantial. And the data we've received from customers and carrier partners indicates that our market share remains stable or is modestly increasing. In addition, our customer churn levels continue to be at record lows. Lost annual revenue from churned accounts in Q1 amounted to less than one half of 1% of total annual revenue. And churn due to competitors was much less than half of that already small amount. As a result, our market leading delivery business continues to generate substantial cash and to power our unique edge platform. Our security business has reached an annual revenue run rate of over $1 billion and continues to grow over 20% annually in constant currency. And we believe that our Compute business is poised to achieve about $400 million in revenue this year with a growth rate of over 60%. And perhaps most important of all the combination of our security and compute businesses now represents the majority of our revenue. We expect these businesses to generate about $2 billion of revenue this year with a growth rate of about 27% in constant currency. I'll now talk about each of our three major business lines, starting with Security, which we believe will soon become our largest business line. Our security solutions generated revenue of $382 million in Q1, one up 23% year-over-year and up 26% in constant currency. This very strong growth was driven primarily by our flagship security products, Kona Site Defender and Bot Manager. And also by our new Guardicore micro-segmentation solution to stop ransomware. In Q1, we finalized the largest deal in Guardicore’s history, valued it more than $10 million over the next three years, expanding our longtime relationship with one of the largest banks in the world. The size and scope of the deal illustrates why we're so excited about our opportunity in micro segmentation. Financial services firms in particular are frequent targets of ransomware and malware and large banks with security risks, face financial penalties from regulators if they fail to address them. So from a compliance perspective, adopting micro segmentation can reduce risk and prevent large fines in the process. By reducing spending on their legacy static firewalls, the bank that's adopting our micro segmentation solution will free up resources to implement stronger defenses as they move to a new zero trust security architecture. And by converting to our more flexible software-based solution, they can achieve greater agility to compete with fast moving FinTech services. This example demonstrates how Guardicore can help Akamai expand longtime relationships with customers to become a more valuable strategic partner in the future. Guardicore is also helping us win new accounts and verticals such as critical infrastructure. For example, one of the largest railroads in the world recently became a multimillion dollar Guardicore customer. On April 20, cybersecurity authorities in the U.S. and other major countries warned that the war in Ukraine raises the risk of cyber attacks. Their recommended defenses aligned well to Akamai security solutions from microsegmentation, DDoS protection and web app firewall. Web application attacks experienced by customers grew by nearly 200% year-over-year in Q1. The largest increase we've seen in several years, web app attacks are a critical vulnerability for any company moving to the cloud, building microservices or integrating third parties via APIs, which is why app and API protection is a critical priority for major enterprises. Akamai is a leader in Gartner's Magic Quadrant for Web App and API Protection. And in Q1, Akamai’s web app and API protection on Gartner Peer Insights Customers Choice Distinction for the third year in a row, also in Q1, Forrester named Akamai a leader in its New Wave for Microsegmentation. As we discussed during our last call with investors in February, we will be reporting on our delivery and compute product lines separately, going forward. In Q1, our delivery products generated revenue of $444 million, down 6% year-over-year and down 4% in constant currency. Revenue for our compute product group was $78 million in Q1, up 32% year-over-year and up 35% in constant currency. As I mentioned earlier, traffic on our platform has been growing at a substantial rate. In fact, just last week, we set another record when we delivered over 250 terabits per second of peak traffic, more than 20% higher than our previous peak reached in February. The Akamai Edge platform continues to be the top choice for large media companies worldwide due to its unique scale and performance. In a recent review of CDN vendors worldwide, IDC said Akamai's balanced and comprehensive portfolio spanning media and web delivery, emerging edge applications, extensive security capabilities, and programmable edge addresses the needs of all enterprise segments and the developer community. The report also noted how Akamai's appetite for innovation is showcased by the fact that it continues to expand its services and capabilities beyond CDN to address new areas. Akamai is the market leader in delivery by far, and the income generated by our delivery business helps to fund our investments in the fast growing areas of security and compute, including our game changing acquisitions of Guardicore and Linode. Our compute product group includes Akamai’s capabilities in compute, storage, cloud optimization, developer tools, edge applications, and now Linode, which joined Akamai on March 21. We are encouraged by how customers and industry analysts have responded to our acquisition of Linode. In fact, several of used the word transformational to sum up the potential impact of our combination of the marketplace, the CEO and Co-Founder of Macrometa, Linode partner that enables web and cloud developers to run and scale data heavy real-time cloud applications has called Akamai’s acquisition of Linode, a watershed moment for the cloud because it fundamentally reconfigures the landscape in many ways. Those are his words and he says that Akamai provides that layer of reach and distribution in a way that cloud providers are very challenged to be able to do. I'm excited about that he said. Of course, we're excited too. Linode was an early pioneer in creating the market for alternative clouds, offering developers a platform to build new applications in ways that are simple to use and affordable. With high performance, a competitive, transparent, and predictable price points and backed by strong customer support after the sale. Today, nearly three quarters of enterprises are pursuing multi-cloud strategies, which means that new workloads will be cloud agnostic and portable, free to move and choose the best place to be. In fact, IDC just issued a report on workload deployment optimization that urges buyers to consider suppliers of Infrastructure-as-a-Service beyond the hyperscalers. Our acquisition of Linode was the first alternative IDC highlighted as an example that can offer better cost and performance while retaining the level of redundancy and coverage demanded by enterprises. In the coming years, we expect that customers will have a growing need for a continuum of compute from the cloud to the edge, to be closer where billions of end users are and where tens of billions of connected devices will be, especially as 5G and IoT take hold and grow. Building the bridge that enables developers to move from the cloud to the edge and have one place to build, run and secure apps is a key reason why we're expanding our offering with Linode. At our Analyst Day, coming up on May 18, we'll talk more about the potential for substantial future growth in this new and exciting part of Akamai's portfolio. As we become the cloud company that powers and protects life online. The soundness of our overall strategy was validated in visits I had with dozens of Akamai customers across EMEA and APJ last month. Common concerns expressed by customers and prospects included the war in Ukraine, the heightened level of cyber attacks, as well as risk to trade and supply chains, energy costs, and currency evaluations. Customers express very strong interest in our security strategy and Guardicore, in particular. As you can imagine, their boards are asking them how they can prevent a crippling ransomware attack. And Guardicore is the perfect solution. They know that malware always finds a way in, the key is identifying it and stopping it spread before it can cause serious damage. And that's exactly what Guardicore is designed to do. Most of the customers I met with, were also interested in exploring our cloud compute offering as a more affordable and easier way to build, run, and secure their new applications. The tight labor market, employee attrition, and the desire of employees to work remotely were also top of mind for customers in every location. Several companies that I met with are reducing their real estate footprint. And one of them told me they could only do this because they secured their remote work environments with Akamai's enterprise application access. Here at Akamai, we face the same macro trends as our customers, but in spite of the headwinds, we feel good about the growing demand from customers for our security and compute solutions, the expertise of our team in the addition of capabilities and talent from Guardicore and Linode. And how all of this gives Akamai not one, but two, rapidly growing and highly synergistic businesses, further diversifying our revenue, we've also performed well on the retention of our talent, employees appreciate our flexible workplace policy and culture of teamwork. Akamai scores very high on third-party rankings of the Best Places to Work. I'm proud of the way that our employees have managed. And I want to thank our extended team around the world for doing such a great job for our customers. They are truly making life better for billions of people, billions of times a day. Now over to Ed for more on Q1 and our outlook for Q2 and the rest of the year. Ed?"
},
{
"speaker": "Ed McGowan",
"text": "Thank you, Tom. As Tom mentioned, Akamai delivered a solid quarter in Q1. Q1 revenue is $904 million, up 7% year-over-year, or 9% in constant current currency. Revenue was led by continued strong growth in security and compute. The strength was partially offset by a significant strengthening U.S. dollar and a slight moderation in traffic growth rate in our delivery business during the last month of the quarter. Security revenue grew 23% year-over-year and 26% in constant currency, led by a reacceleration of growth in our application Security business and continued very strong performance from Guardicore. Security represented 42% of total revenue in Q1, which is up 5 points from Q1 a year ago. Guardicore delivered revenue of $19 million in the quarter, included in our Guardicore results was approximately $7 million of term license deals from four customers. As a reminder, while the majority of Guardicore deals are Software as a Service and revenue is recognized monthly under ASC 606, some customers specifically financial services and healthcare due from time to time require on-premise deployments. These deployments result in term license accounting treatment, where we are required to recognize a significant portion of the revenue upfront when the product is delivered for spreading the revenue over the contract term. It’s worth noting the impact of these deals resulted in a pull forward from Q2 to Q4 into Q1 of approximately 1 percentage point of revenue growth. Compute revenue in Q1 was $78 million and grew 32% year-over-year and 35% in constant currency. As Tom mentioned, we were very pleased with the initial performance of our Linode acquisition, which closed in late March and contributed revenue of approximately $3.5 million in Q1. Delivery revenue was $444 million in Q1 and decline 6% year-over-year and 4% in constant currency. As discussed last quarter, several of our top customers are expected to renew in the first half of 2022. Our first quarter revenue was impacted by the renewals of half of these customers, we expect the remaining customers to renew by July 1. So far, the pricing for the renewals has been in line with our expectations. Additionally, we started to notice the growth rate of traffic on our network moderate a bit in March, specifically in gaming and OTT verticals. As some pandemic related restrictions were lifted in countries throughout the world. Sales in our international markets represented 47% of total revenue in Q1. International revenue grew 11% year-over-year or 16% in constant currency. The negative impact of foreign exchange on our Q1 results increased by approximately $2 million from our February earnings call as a U.S. dollar continued to strengthened significantly in March. Foreign exchange fluctuations had a negative impact on revenue of $4 million on a sequential basis and negative $18 million on a year-over-year basis. Finally, revenue from our U.S. market was $481 million and grew 4% year-over-year. Now moving on to costs. Cash gross margin was 76% in line with our expectations. GAAP gross margin, which includes both depreciation and stock-based compensation was 63%. Non-GAAP cash operating expenses were $295 million. Now moving on to profitability. Adjusted EBITDA was $391 million. Our adjusted EBITDA margin was 43% in line with our guidance. Non-GAAP operating income was $270 million and non-GAAP operating margin was 30%. Capital expenditures in Q1, excluding equity compensation and capitalized interest expense were $116 million. This was slightly better than our guidance range as we continued to see greater efficiency on our network. GAAP net income for the first quarter was $119 million or $0.73 of earning per diluted share. Non-GAAP net income was $225 million or $1.39 of earnings per diluted share, up 1% year-over-year and up 4% in constant currency. Non-GAAP earnings per share was negatively impacted by approximately $0.03 in Q1 due to a higher than expected non-GAAP effective tax rate. Taxes included in our non-GAAP earnings were $43 million based on a Q1 effective tax rate of approximately 16%. This was approximately 1.5 points higher than we had expected in due primarily to three reasons. First, a higher than expected mix of U.S. revenue with foreign exchange rate fluctuations, a significant contributing factor along with the addition of Linode revenue. Second, an unfavorable change to foreign tax credits in Q1 based on the most recent treasury guidance. And third, a refinement of our previous assumptions related to R&D tax launching changes from the 2017 U.S. tax reform that became effective in Q1 2022. Moving now to cash in our use of capital. As of March our cash, cash equivalents and marketable securities totaled approximately $1.3 billion. During the first quarter, we spent approximately $103 million repurchase shares, buying back approximately 900,000 shares. In addition to share repurchases in March, we spent approximately $900 million to complete our acquisition of Linode. We ended Q1 with approximately $1.7 billion remaining on our current repurchase authorization. Our intention is to continue to buy back shares to offset dilution from employee equity programs over time, and to be opportunistic in both M&A and share repurchases. Before I provide our Q2 and 2022 guidance, I want to highlight several factors. First, our guidance now includes Linode. We expect Linode to contribute revenue of approximately $100 million and add approximately $0.05 to $0.06 to non-GAAP EPS in 2022. This is unchanged from the assumptions we shared on our last call. Second, the dollar has continued to strengthen meaningfully since we reported in mid-February. As a result, we currently expect a much greater foreign exchange headwind for the remainder of 2022. At current spot rates, our guidance assumes that foreign exchange will have a negative $100 million impact on revenue on a year-over-year basis. This compares to our prior guidance of a negative $45 million impact to revenue. This change in FX from our prior guide will also negatively impact non-GAAP EPS by approximately $0.16 for the a full year 2022. It’s worth emphasizing that currency markets have been extremely unsettled and about as volatile as I have ever seen, as a result, it is impossible to predict whether and how the impact could change going forward. Third, we now expect our non-GAAP effective tax rate for 2022 to be approximately 16%, which is a approximately 1.5 points higher than our prior assumption. Based on the items I mentioned before, the change in tax rate will also negatively impact the full year 2022 non-GAAP EPS by approximately $0.11. Fourth, as Tom discussed, regarding our business in Russia and Ukraine is reasonable to assume that most of that revenue goes away. Finally, as mentioned earlier, our traffic growth rate moderated a bit in March, and we’ve seen that trend continue in April. While traffic continues to grow at a strong rate and as at record levels, the growth rate is lower than we originally expected. Therefore, we are taking a more conservative approach to forecasting our traffic and corresponding revenue for the remainder of the year. That said, we do not believe this trend is a permanent consumer shift or due to us losing share, but rather is likely driven by some of the significant external factors we are seeing in the marketplace and geopolitically. Said another way, we believe that traffic growth and online activity return to more historical norms at some point. So with all those factors in mind, turning to our Q2 guidance. We are now projecting revenue in the range of $890 million to $905 million or up 4% to 6% as reported or 8% to 10% in constant currency over Q2 2021. Foreign exchange fluctuations are expected to have a negative $14 million impact on Q2 revenue compared to Q1 levels and a negative $30 million impact year-over-year. At these revenue levels, we expect cash gross margins of approximately 75%. Q2 non-GAAP operating expenses are projected to be $282 million to $289 million. We anticipate Q2 EBITDA margins of approximately 43%. We expect non-GAAP depreciation expense to be between $129 million to $130 million. And we expect non-GAAP operating margin to decline to approximately 29% for Q2 to largely to the change in FX and some node integration costs. Moving now to CapEx, we expect to spend approximately $150 million to $155 million, excluding equity compensation and capitalized interest in the second quarter. This represents approximately 17% of projected total revenue. A significant portion of the increase in the spend this quarter is related to Linode, an anticipation of significant demand. With the overall revenue and spend configuration I just outlined, we expect Q2 non-GAAP EPS from the range of $1.28 to $1.33. This EPS guidance assumes taxes, the $40 million to $41 million based on an estimated quarterly non-GAAP tax rate of approximately 16%. It also reflects a fully diluted share count of approximately 162 million shares. Looking ahead to the full year, we now expect revenue of $3.62 billion to $3.67 billion, which is up 5% to 6% year-over-year as reported, we’re up 7% to 9% in constant currency. We expect security revenue to grow at least 20% or greater for full year 2022 in constant currency. We now estimate non-GAAP operating margin to be approximately 29% based primarily on the impact of FX and some of the internet traffic dynamics I previously discussed. We now estimate non-GAAP earnings per diluted share of $5.32 to $5.44. This non-GAAP earnings guidance is based on a non-GAAP effective tax rate of approximately 16%, a fully diluted share count of approximately 161 million shares. Finally, full year CapEx is anticipated to be approximately 14% of revenue. It is worth noting, our CapEx assumption now includes Linode that we talked about on our last quarter, partially offset by lower network CapEx, given the slower traffic growth rate that we now project. In closing, while the macroeconomic environment has become more challenging since our last earnings call and the U.S. dollar continues to be a major headwind for us. We remain very optimistic about the opportunities in front of us, especially in Security and Compute. As Tom mentioned, I look forward to seeing you at our Analyst Day in New York City on May 18. Thank you. Tom and I would be happy to take your questions. Operator?"
},
{
"speaker": "Operator",
"text": "Thank you. [Operator Instructions] Our first question comes from Keith Weiss with Morgan Stanley. Your line is open."
},
{
"speaker": "Keith Weiss",
"text": "Excellent. Thank you guys for taking the call and a lot of great kind of information in there for us to kind of better understand kind of what’s going on with a lot of moving pieces in the environment. Of course, I’m going to ask you about more on that. So in particular, when you see like the slowing network traffic and some of these increasing pressures, is there any kind of geographic specificity to it? Is it more in Europe than the U.S. or is it more evenly spread number one. And number two, on the security side of the equation, is there any counterforce if you will, meaning, it sounds like, it’s a pretty bad threat environment out there. You guys have a great solution portfolio for those types of threats. Are you seeing any sort of increasing demand on that side of the equation that can offset some of those potential headwinds on the delivering compute side of the equation? Thank you."
},
{
"speaker": "Tom Leighton",
"text": "Yes, this is Tom. Great questions. The traffic, I would say, growth moderation seems to be pretty much global and that coincides with a pretty much global reduction in things like mask mandates and quarantines and so forth, except for China. And we don’t do domestic to domestic delivery in China, so we wouldn’t be able to see that. So there’s no particular geographic dependence there and you’re on a great point about counterbalance through security. Obviously, we’re negatively impacted in terms of traffic and a few customers, because of the war and Ukraine. On the other hand, attacks have gone way up, the volume of attacks. And that’s an area where we can really help our customers. And so there could have some counterbalance in terms of the security business. And obviously, as I mentioned, customers are really worried about ransomware attacks and malware, and we’ve got a great solution for that with Guardicore. And as we talk about the macroeconomic challenges, the fears of a recession, the inflation – customers probably increasingly concerned about saving cost going forward and that could provide some counterbalance as well, with our Linode solution, we’re in a really good position to help major enterprises decrease their cloud spend. We find that many of them have seen that spend increase dramatically. And now they can use Linode for applications, especially, enterprises that are already set up in a multi-cloud environment. They’ve got their applications and containers or VMs, and they could easily move those to Linode and save money. So there could be some counterbalance here as we go forward. That’s a very good observation."
},
{
"speaker": "Keith Weiss",
"text": "Got it. And if I could sneak one in for Ed on the other side of the equation. You talked to us about how sort of CapEx is coming down a little bit versus kind of what we were talking about immediately after Linode based on lower network traffic. Are there any adjustments that you guys are making to your OpEx side of the equation? So the level of investment that you guys are going to be making throughout the year given a more kind of difficult environment. Or is it – it’s kind of steady investment as you goes, if you will."
},
{
"speaker": "Tom Leighton",
"text": "We’re not able to hear, Ed. So I guess, we’re having a trouble with the operator with Ed maybe – okay. Could you ask the question again, please?"
},
{
"speaker": "Keith Weiss",
"text": "Sure. Thanks. So I was just on the call, Ed, you had talked about CapEx coming down a little bit because of sort of lower network traffic. I was just wondering if you guys are making any adjustment to the OpEx for FY2022 given the more volatile macro. Any limitation in any kind of your investments throughout the year, or do the investments stay relatively stable?"
},
{
"speaker": "Tom Leighton",
"text": "No, that’s a great question. And yes, CapEx is much more efficient. Of course, we’re investing heavily to grow the Linode footprint. In terms of OpEx, we’re always working to be more efficient with our OpEx to deliver traffic. And we’re seeing the benefits of that even now. You look at the impact that FX for example is having on our operating margin and then, having less traffic and yet still we were at 29% to 30% with op margin for this year. And now we’ll be, I think really closer to the low end of that range. But it’s because that we’ve been able to be much more efficient on OpEx that we can hold it there and not be lower than that. And of course, we are – also it’s important that we are going to continue to invest certainly in security and compute. We don’t want to be a very temporary solution with FX to induce us to do something that would hurt us long-term with our growth and security and compute. And if you look at our business today and I think it’s pretty important to note that the majority of our revenue is now security and compute, and that is growing currently at over 25% as reported. And so the last thing we want to do is somehow scale back investment there when it’s just a fabulous a couple of businesses just because there’s stuff going on with FX and the macroeconomic environment. And Ed is trying to get back on, but we can keep going and I’ll do my best Ed invitation in the meantime."
},
{
"speaker": "Ed McGowan",
"text": "Yeah. So Tom, I’m back, could you guys hear me now?"
},
{
"speaker": "Tom Leighton",
"text": "We can, very good."
},
{
"speaker": "Ed McGowan",
"text": "Okay, great. I’m sorry about that. I don’t know what happened little technical difficulties there, Keith. But I’m not sure if Tom got to your question about some of the things we’re doing on the cost. Okay, if there’s anything else I’m happy to take an additional question."
},
{
"speaker": "Keith Weiss",
"text": "Yes. No, Tom did a great job. You might have to worry about job security now."
},
{
"speaker": "Operator",
"text": "Thank you. Our next question comes from James Breen with William Blair. Your line is open."
},
{
"speaker": "James Breen",
"text": "Thanks. Just a couple. One, when you look at the old guidance that you gave on the fourth quarter call relative today down kind of $5 million at the – $50 million below and in the high end. Given some of the puts and takes you gave, it seems like the rush impact sort of mid $30 million, and then the incremental FX of sort of in the mid 50s sort of kind of offsets basically the upside from Linode and close that deal. I’m just trying to think about to quantify it. So is that sort of incremental kind of $15 million difference, really what you’re seeing from the lower traffic on the delivery side. And can you just remind us of the delivery revenue this quarter the $444 million? How we want to think about it annually? How much of that is more volume driven versus subscription based? Thanks."
},
{
"speaker": "Ed McGowan",
"text": "Yes. Jim, it Ed. Yes, I think you’ve got the pieces right there in terms of the different components, FX being about $55 million, Russia, you could say is about 1%, so call at about $30 million give or take. But the rest of it is the delivery. I think one of the things we tried to make clear in our prepared remarks was the Compute business is going great. We don’t have any – we’ve only owned the business for a little while, so there’s no change there in terms of our outlook. But certainly good early returns and then security is going great, did better than we expected this quarter. So it is limited to a delivery issue and is, I would say primarily, almost all volume driven that we’re seeing. So what we did basically is just adjust the growth rate that we expected for the remainder of the year. And then obviously, things can change over time. But based on what we’ve seen so far in the last couple weeks of March and the beginning of April, we just thought it was prudent to adjust that. So you’re thinking about it right in terms of the different pieces."
},
{
"speaker": "James Breen",
"text": "Great. And then just maybe one for Tom, just the strategy. Linode, you’ve owned it now for a little over a month. They were folks a lot on sort of the small midsize business space in terms of the computing storage. Have you seen any traction with that product that some of your larger customers now that it’s starting to get integrated?"
},
{
"speaker": "Tom Leighton",
"text": "Yes, obviously very early days, but we’re really excited about the potential for that traction. I give you just, one anecdote, I was in Europe meeting customers last month and met with one of our major media workflow partners. And I was going to go to talk to them about Linode because they have a big cloud spend and we feel that could be really relevant for moving to Linode. They’re very happy Akamai partners and customers. And I was going to tell them about the acquisition, but I get there, we shake hands. First thing he says is, wow, great acquisition. And he’s is the CEO, but turns out he has a pass as a developer knew about Linode, loves them and he’s into multi-cloud and he said, look, what we did is we already have our workflow apps and containers. And so we thought, what the heck let’s try it. And so they moved him over to Linode and he said, it worked great. And he said, we’re going to save money to boot. And it’s really easy to use. And we didn’t even know because Linode really is easy to use that we didn’t know this was even taking place. So I do think we’re in an excellent position to not only increase the existing Linode customer base, but provide Linode capabilities to major enterprises. And of course, Linode really appeals the developers and increasingly developers are making the decisions or heavily influencing the decisions that have major enterprises as was an example in this case."
},
{
"speaker": "James Breen",
"text": "Great. Thanks a lot."
},
{
"speaker": "Operator",
"text": "Thank you. Our next question comes from Rishi Jaluria with RBC. Your line is open."
},
{
"speaker": "Rishi Jaluria",
"text": "Wonderful guys. Thanks for taking my questions and appreciate all the details around the moving pieces. First, I wanted to start with maybe better understanding some of the macro factors. I think look, the FX well understood, Russia as well, the moderating traffic with reopenings. But Tom, at the beginning you had mentioned kind of the inflation side, as well as fears of recession being in Western Europe or globally. Can you talk a little bit more about how those macro factors are impacting your business? Is this resulting in longer sales cycles, smaller initial deals, just more hesitation around new deals? Any color there that you can give would be helpful and then have a follow-up."
},
{
"speaker": "Ed McGowan",
"text": "Yes. This is Ed. I’ll take that and Tom, if you want to add some color if I missed something here. So, in terms of the inflation and the impact on our business today, we’re not seeing a significant impact from inflation, whether that’s with labor costs or with our costs of our network and that sort of thing. We’re seeing a little bit of higher energy prices in Europe and that sort of thing. But our team does a pretty good job of trying to bake that into their deals when they sign colo deals and that sort of thing. That could obviously change, obviously the labor markets are pretty tight and that sort of thing. But I think the biggest macro impact from our business in terms of our change in outlook is really around the change in behavior where we’re seeing mask mandates lifted and people going out more shopping, more in-stores and that sort of stuff. And the impact on the traffic growth rate is probably the biggest impact. Obviously if we get a major recession that could potentially have a greater impact, but we’re not seeing that certainly in the security business, we’re not seeing customers pulling back. We’re not seeing deals size, the deals getting elongated or anything along those lines. It’s really more that, that impact on the traffic business."
},
{
"speaker": "Tom Leighton",
"text": "Yes. And to Ed’s point, it’s not direct on us, but there is some concern among our media customers in terms of subscriptions and how their business is doing. And so we just keeping an eye on that in terms of the end users reacting in cutting cost and consuming less online. So, I don’t think that’s a major factor yet, but it’s something we’re keeping an eye on."
},
{
"speaker": "Rishi Jaluria",
"text": "Got it. That that’s really helpful. Thanks. And then just going back to Linode, I guess number one, if we do the math back of the envelope, it’s about a $4 million contribution in Q1 is that directionally a correct, number one. And I think number two, when you made the acquisition; you talked about incremental investment opportunities to accelerate the growth rate. Can you maybe remind us about where you find those opportunities, especially where there’s low hanging fruit? And what would be an ideal growth rate for the Linode asset? Thanks."
},
{
"speaker": "Ed McGowan",
"text": "Yes. So, I’ll start off with the question first, just the housekeeping item. We had about $3.5 million of revenue we see in the quarter from Linode. And then as far as the growth rate’s concerned, we’ll get into a lot more details when we see you in New York in a couple of weeks, but, obviously this is a very, very fast growing business, and Linode’s growth rate before we acquire them was at 15%. We think we can accelerate that pretty significantly as we introduce more features, more locations, more capabilities, and we start to tap into our enterprise customer base. So, we think that growth rate can accelerate pretty significantly."
},
{
"speaker": "Tom Leighton",
"text": "Yes. Just to add to that in terms of investment and opportunities, obviously scale is something we’re really good at and distribution, which we’re putting a lot of effort into, and our customer base, which Linode really hadn’t tapped into and being a smaller company, probably a little harder for them to go after major enterprises in terms of the credibility and so forth. But that’s really easy for us to do. And just as I talked about with examples before you take Linode ease of use, and our customer base and those customers that are multi-cloud, and have their apps and containers, they can move them over and save money when they do it. And bring it closer to their delivery and security, which has been occupy where the market leaders at. So, I think there’s a really great opportunity to jumpstart a significant growth among major enterprises for Linode."
},
{
"speaker": "Rishi Jaluria",
"text": "Got it. That’s really helpful. Thank you so much, guys."
},
{
"speaker": "Operator",
"text": "Thank you. Our next question comes from Tim Horan with Oppenheimer. Your line is open."
},
{
"speaker": "Tim Horan",
"text": "Thank you. Tom, on that point with apps and containers is it, have we seen many apps kind of poured over to other clouds at this point, and if they are tying into other value-added products and other software products that the cloud guys have, does it make it harder to do? Or can they still do it relatively easily?"
},
{
"speaker": "Tom Leighton",
"text": "Yes, that’s another great point. The hyperscalers have a lot of managed services and added functionality on their platform, which Linode doesn’t. Now, if you’re the kind of company that likes to do those things yourself well, that’s easy to do on Linode. If you’re the kind of company that wants that done by your cloud provider, well, Linode doesn’t do that today. Now, over time, we will be adding more and more capabilities there. So it really, so today I wouldn’t say that that every customer would be in a position to move everything over to Linode. That is certainly not the case. But I think there is a pretty significant segment where it can be done and does make sense to do. And over time we want to grow the kinds of the number, in the types of applications that will make sense to move on to Linode. And it is helpful that, certainly our customer base is already using us for market leading delivery, market leading app acceleration or market leading security. So there’s a lot of synergy there. And I think the combination of that synergy ease of use and cost savings, it’s a pretty exciting combination."
},
{
"speaker": "Tim Horan",
"text": "And just on the traffic volumes, could you give us a sense, the last two years in COVID were we like 25% above trend, 50% above trend, and do you think it kind of reverses however much it was above trend? I’m not looking for exact numbers, but just some color."
},
{
"speaker": "Tom Leighton",
"text": "Yes, it was way above, certainly the first year and very strong the second year. And I would say comparison a small decreasing growth rates, still growing very strong, but less than I think have been expected. And we’re seeing that the same for the internet as a whole. Now, and we’re also seeing our growth be stronger than the internet as a whole, which is good. That’s what we want to keep seeing, because it means we’re – taking more of the internet traffic when that happens. So, I would say the step down, we’ve seen so far is less than the step ups that we’ve seen. And I think that’s because a lot of the increased use of the internet for everything, for video, for gaming, for commerce, remote work, I think a lot of that is here to stay. But right now with all the restrictions coming off except for China, I think that’s a big part of why we’re seeing a little bit of a decrease in traffic growth rates right now."
},
{
"speaker": "Tim Horan",
"text": "Thank you."
},
{
"speaker": "Operator",
"text": "Thank you. Our next question comes from James Fish with Piper Sandler. Your line is open."
},
{
"speaker": "James Fish",
"text": "Hey guys, thanks for the questions. Wanted to first start on the delivery side where frankly, we’re not surprised to see slowing traffic given our tracking of what’s going on in space, but it seems like it was a little bit worse for you guys. Can you just help break down where the main weakness was between web delivery versus media delivery this quarter? It sounds like media was a bit more of a surprise for you guys as it was a former growth driver. It slowing and you guys had a bunch of renewals there while we didn’t have the recovery and web despite travel and hospitality traffic coming back. Can you just help us kind of triangulate where we are between some of the underlying verticals?"
},
{
"speaker": "Ed McGowan",
"text": "Hey Jim, this is Ed, I’ll take that one. So yes, the bigger impact was definitely on the media side. So, I called out that we had renewals and when you have renewals, big renewals concentrated in a short period of time and you have a slowdown in your traffic rate; it does accentuate the impact to revenue. Typically we see in a normal year, you’d start to get back to flat line after several quarters and that sort of thing. We just think it might take a little bit longer based on the type of traffic growth rates we’re seeing. In terms of the hospitality and retail, two things to think about there. We are seeing a bit of traffic increase specifically in travel, small vertical for us about 4% give or take, but remember both travel and the media – sorry, the commerce vertical tend to buy our zero overage. So it’s a little bit traffic. It doesn’t have as much of an impact on revenue, but in terms of the biggest impact, that’s really on the media side in terms of the change in traffic. And also in terms of a percentage of overall traffic media represents us a significant portion greater than 90% of our total traffic."
},
{
"speaker": "James Fish",
"text": "Got it. And switching over to security side, how are you guys thinking about the current balance of terms subscription versus SaaS for Guardicore now that you've had it for about one and a half quarters? How do you think this settles down given certain verticals like financial services, want those term subscriptions. And lastly, any sense to what other large deals for Guardicore could be in the pipeline over the next few quarters that can swing? I think it was 50 million to 55 million for expectations for Guardicore this year."
},
{
"speaker": "Ed McGowan",
"text": "Yes. Good question. So I called out on the call that there was about four customers that had term licenses and what I'll do going forward to the extent that there's anything material we'll call it out. I'd say the majority of customers have the more traditional subscription based model, but there are our customers, especially financial services that do like to have the management controller on premise. And that's what really drives the term license aspect of it and what requires us to take the revenue up front. But again, I think the majority will be in that category. Now, keep in mind with the term license, you do have to renew that subscription when the term goes up. The typical term one to three years, Tom mentioned that we did sign a fairly large three-year term deal. So there'll be some of that maintenance and whatnot that could spread out, but you are required to take a fair chunk of that upfront. But in general, I would say that the majority would be the SaaS type deals. And as far as the pipeline goes, it's always hard to call when a deal's going to hit in any particular quarter. I don't see anything significant here in Q2, I'm expecting more of a normal quarter, but to the extent there's anything we'll certainly let you know."
},
{
"speaker": "James Fish",
"text": "Thanks, Ed."
},
{
"speaker": "Operator",
"text": "Thank you. Our next question comes from Amit Daryanani with Evercore ISI. Your line is open."
},
{
"speaker": "Amit Daryanani",
"text": "Thanks for taking my question. I guess I have two as well. Maybe just to ask a little bit more on the core delivery business, the CDM business. I guess, do you think this business just sort of declines 4% or 5% a year for the rest of calendar 2022? Or do you think to see sort of a bottom and the decline rate should improve as you go through the year?"
},
{
"speaker": "Ed McGowan",
"text": "Yes, so, I think for the rest of the year, you'll see the business in decline because of the renewals that we have, we had half of them hit so far in the first quarter, the other half will hit in the second quarter. So you'll probably see a little bit of a step down in Q3 and then in Q4 tends to be your seasonally strong quarter. But you do have a tough compare. So I would expect it to be negative for the rest of this year. And obviously it'll fluctuate depending on the specific traffic levels. But Q4, we do typically see a strong season both with commerce and media, commerce has a less muted impact these days with a lot of customers, I think it's about 65% or greater have a zero overage contract. So commerce doesn't have as big of an impact, but media we've typically seen a pretty strong traffic in Q4. We expect to see a pickup in traffic probably a little less. So this year that's what we've modeled in."
},
{
"speaker": "Amit Daryanani",
"text": "Got it. And then, hopefully I have all these numbers correctly if not, please correct them. But as I think about the revisions to the calendar 2022 guide that you folks provided, it looks like sales versus the streets was with all the adjustments is coming down by about 100 million give or take, 2.5%, 3% of initial expectations. But the EPS numbers, I think are coming down much more severely closer to 8%, 9% versus what the prior expectations were. Maybe just walk me through, there's a much more outside EPS adjustment to the full year numbers versus revenue. Is that just a tax rate or one of the moving pieces that are magnifying the correction on the bottom line on the EPS line versus the top line?"
},
{
"speaker": "Ed McGowan",
"text": "Yes, sure. So let me try to walk you through that, Rishi. So first of all, the tax impact is about $0.11. And that obviously has no – that's outside of any sort of change in the revenue. Then you get the FX impact is about $0.16. And then the Russia impact is call it another $0.09-ish give or take. So you've got about 60% of it is related to sort of those external factors and the remainder of it is related to just the revisions that we see in delivery."
},
{
"speaker": "Amit Daryanani",
"text": "Got it. Thank you."
},
{
"speaker": "Operator",
"text": "Thank you. Our next question comes from Frank Louthan with Raymond James. Your line is open."
},
{
"speaker": "Frank Louthan",
"text": "All right. Great. Great, thank you. So, on the traffic thing, just to be clear, this is an end user slowing down with the pie shrinking. It's just more of the pie is growing more slowly and or is some of this traffic going elsewhere? And if that's the case, who are you losing share to?"
},
{
"speaker": "Tom Leighton",
"text": "No, you're right. It's the – it's just the pie is not growing as fast. The pie is not shrinking; the pie is just not growing as fast. And we believe based on talking to our customers and our carrier partners and what we see that our share of the pie is stable or growing and that we are not on balance losing share of the pie."
},
{
"speaker": "Frank Louthan",
"text": "Okay, great. Thank you. And then what sales investments do you need to make for the rest of the year to sell more with through, sell through with Linode and to sell more Guardicore, et cetera, where are you on that?"
},
{
"speaker": "Tom Leighton",
"text": "Yes, so the nice thing with the Linode acquisition is we're not required to make any additional investments in sales, per se. We're going to be obviously bringing this to our channel partners and our sales reps can sell it as a matter of fact, a lot of our customers, if you look at their CDN spend to cloud spend, it's orders of magnitude, larger on the cloud side. So we're talking to the same people that are spending money there. Our teams are will be trained up and ready to go for being able to sell Linode. On the security side, you do tend to hire more specialists. And if I look at sort of where PJ is investing in sales, we are invest a lot in Guardicore not only just with sales reps, but also with technical specialists that help the sales team and professional services folks as well. So you're seeing the investment more leaning in towards the sales side, and you're getting a lot of leverage from the Linode standpoint."
},
{
"speaker": "Frank Louthan",
"text": "All right, great. Thank you."
},
{
"speaker": "Operator",
"text": "Thank you. We have a question from Rudy Kessinger with D.A. Davidson. Your line is open."
},
{
"speaker": "Rudy Kessinger",
"text": "Great guys. Thanks for taking my questions. On the OTT or media, just how are your OTT customers attributing that slower traffic growth maybe between end users, eliminating or reducing the number of OTT services, they subscribe to a shortage of new content or just people getting out more with COVID mandates lifted?"
},
{
"speaker": "Tom Leighton",
"text": "Well, as best we're hearing as sort of the first and third there's fewer subscriptions, in some cases, some cases subscriptions reversing. Some cases when the subscriptions are okay, there's traffic growth, but slower traffic growth, and they had anticipated and that they had seen before. And so I think, part of that is that people are just out more right now. Also on the commerce side, and there's been public reports about this, that more brick and mortar sales than there have been, and a little bit less on the online side, which is understandable I think. Given that people are apparently out and about more with less restrictions. So I think there's sort of a variety of factors and it's early days here and probably we'll learn a lot more over the next couple of months."
},
{
"speaker": "Rudy Kessinger",
"text": "Got it. And then just on delivery, you said the pricing on those large customers that renewed this quarter was about as expected. But just as you look more broadly in delivery, how is pricing pressure faring versus years past. I guess, just as I piece it together, understanding traffic growth growing more slowly, but still growing and your guys, position that you're still gaining share of that growing pie, but delivery revenue being down several points. Just how is pricing pressure faring in the broader market?"
},
{
"speaker": "Tom Leighton",
"text": "Yes, good question. So I would say a couple things to respond to that. So the renewals like I said are coming in largely as expected. The big change is the rate of growth. So that also impacts your conversations going forward. So we've talked for years about how the pricing and the market is fairly efficient in terms, especially with the high volume media environment and it's really driven by volume. So to the extent that customers have less volume, the discounts rates will start to come down going forward. So I would expect to see over time if customers aren't growing at the same type of rate, they're not going to get the same kind of discount. So we may see that take hold over the next several quarters as we go through more renewals and that sort of thing."
},
{
"speaker": "Rudy Kessinger",
"text": "Got it. That's helpful. Thanks guys."
},
{
"speaker": "Operator",
"text": "Thank you. We have a question from Fatima Boolani with Citi. Your line is open."
},
{
"speaker": "Fatima Boolani",
"text": "Hey, good afternoon. Thank you for squeezing me in. Just a really quick one for you in the security business, I think we – you spent a lot of time sort of flushing out the Guardicore performance in the corridor, which was pretty substantial. I think you also kicked your hat on the recovery or re-acceleration on the application security side of the security portfolio. But I'm curious if you have any comments or observations around what the network security side of the funds within that business segment is doing. Just any color there with respect to sort of competitive dynamics, sales dynamics that would be really helpful? Thank you."
},
{
"speaker": "Tom Leighton",
"text": "Yes, this is Tom. On the network side that would be [indiscernible] which is our DDoS mitigation service doing very well. And that we've seen a lot of attacks over the last year, especially around ransom or extortion DDoS attacks. And we've been in a great position to; I had a lot of customers, major enterprises that were going to be potential victims of those attacks. Also we have DNS capabilities, which are widely used as part of the network security product lines, and I would say doing, doing very well."
},
{
"speaker": "Fatima Boolani",
"text": "One other thing I would add, Tom, just that if I – if I look at the product portfolio, Bot Manager continues to do extremely well and growing at a very, very healthy clip, and we introduced our account protector this quarter and saw very, very high uptake with that in early returns on that look great. Obviously it's a newer product, so it'll take time for that to become a material contributed to revenue, but so far the early returns on that have been very good?"
},
{
"speaker": "Tom Leighton",
"text": "Yes. And those are all part of our app and API protection group, which is where we're seeing the re-acceleration Ed talked about."
},
{
"speaker": "Fatima Boolani",
"text": "Got it. And just a quick one for you in terms of the housekeeping around free cash flow. So appreciate some of the puts and takes on the margin side of things. Mostly stable but curious about how we should think about free cash flow kind of given the near-term step up in CapEx, which is expected to moderate based on your guidance over the course of the year. But anything you can help us from the free cash flow margin side given the FX movements as well, and that's it for me?"
},
{
"speaker": "Tom Leighton",
"text": "Sure. Yes, sure. So the – on the free cash flow side, you'll notice that Q1 tends to be a little bit lighter on the free cash flow side. And a lot of it has to do with when the timing of when bonuses get paid and you can look, if you look kind of year over year, it's sort of in line, Q1-to-Q1 it will expand as we go out throughout the year, but I think one big key takeaway. If you go to the CapEx section, which obviously impacts free cash flow quite a bit. We had originally talked about the sort of call it, Akamai excluding Linode being 13% to 14% from a CapEx perspective. And that Linode would add about two points. One of the things that we're able to do is take advantage of the slow down and growth rate of traffic to be able to pull in some of the CapEx associated with Linode and build out a little bit faster. But in addition to that, we've taken down our total CapEx. So I gave guidance for about 14% of total revenue for the year, which is about 2% better than what we had expected. So think of it as sort of folding in the Linode CapEx under the original umbrella. So that'll obviously help our free cash flow."
},
{
"speaker": "Operator",
"text": "Thank you. Our next question comes from Michael Elias with Cowen and Company. Your line is open."
},
{
"speaker": "Michael Elias",
"text": "Great. Thanks for taking the questions. Two, if I may. So you're expecting to hold an Analyst Day later this month. Any color on what we should expect to hear and as part of that, should we expect similar long-term guidance to what you gave. Your last Analyst Day just including the new compute segment? It's my first question. And the second is, you highlighted at the beginning of the call the inflation and you said that you aren't seeing the impacts of that. I'm just wondering as you think of the business and to the extent that did become a bigger issue. What are the levers that you could pull vis-à-vis pricing in order to combat inflation to be something that manifested itself? Thank you."
},
{
"speaker": "Tom Leighton",
"text": "Yes. On the first question I think Analyst Day structurally it look a lot like it did last year. So we will look at long-term, CAGR is what we're trying to achieve. We'll talk lot about the compute business and our overall strategy. So high level similar to what you saw last year in terms of the structure. Obviously we've got a cool new things to talk about with our new products, the acquisitions, Guardicore, Linode and the compute product line where we're pretty excited about."
},
{
"speaker": "Ed McGowan",
"text": "Yes. On the inflation front, a couple of things there, obviously you could, I guess you could argue that inflation is causing rates to go higher, which is impacting the U.S. dollar. So there's the FX impact of that, so that's one thing to keep in mind, I guess. But one of the advantages of sort of the hybrid work environment is it enables you to look at acquiring talent from all over the place, instead of just on the couch [ph], you can look in the middle of the country and look at other lower cost areas. So that's one tool in our toolkit. The team's done a great job on the network side with our supply chain in terms of you negotiating and leverage power. A lot of our traffic on our network today is free in terms of bandwidth, so we're somewhat insulated from that. Obviously we'll keep a close eye on the labor markets, but as Tom mentioned there could be some impact to some of our customers and the decisions that they make in terms of their spending. Already we're spending on subscriptions or video or buying the next title for gaming or the gaming console and that sort of things. So that could have an impact on traffic. So what we're doing there is obviously pulling back a little bit on our CapEx for the core network. We're actually able to redeploy some of those resources that we have that know how to build out and scale the network and just go faster in Linode, which is great. So we're sort of taking advantage of some of the opportunities that this gives us and trying to insulate ourselves from any significant impact that inflation may have on the business."
},
{
"speaker": "Tom Leighton",
"text": "Yes. And that's one of the really nice things about our business now as we really are diversified. The majority of our revenue is now security and compute, not delivery, which is a pretty big milestone for a company that not too long ago was known as a CDN or a delivery company. And so when you do have these external factors that can hurt one side of the business, they might help other sides of the business, they might help other sides of the business. For example, security being tied to the war in Ukraine, or inflation driving a need to cut costs and now we have a really good answer for our customers with Linode. So it puts our business in a much stronger position, and we're much more diversified than we've ever been."
},
{
"speaker": "Michael Elias",
"text": "Great. Thank you."
},
{
"speaker": "Operator",
"text": "Thank you. We have a question from Jeff Van Rhee with Craig-Hallum. Your line is open."
},
{
"speaker": "Jeff Van Rhee",
"text": "Great. Thanks. Just a couple of cleanups for me. On the – on Guardicore in terms of the term licenses, were there any terms in Q4?"
},
{
"speaker": "Ed McGowan",
"text": "Nothing material. There may have been about $1 million or so, but nothing really material there."
},
{
"speaker": "Jeff Van Rhee",
"text": "Okay. And then as it relates to Linode, how should we think about sales cycles there? As obviously we're going to try to blow out the sales effort and take that into the enterprise base. Just how do we think about two things there. One, the sales cycles? And then two, to date, for Linode, what was a large customer? I mean if you take a look at kind of the – maybe their top 10 customers, what would it take for somebody to crack that large customer criteria sort of into the top 10, obviously, thinking to being able to measure your success in bringing that product to your enterprise base?"
},
{
"speaker": "Ed McGowan",
"text": "Yes. Good question. So the sales cycles will vary. As Tom mentioned, there are certain workloads that are built in a container that's easy to move, so those can move relatively quickly. We've started our training, rolled out our compensation plan, so our sales team is starting to build the funnel. We're having good conversations with customers. We're starting to build out additional functionality. We put out a press release about our managed database capabilities the other day. We're be building out more locations. You'll hear a lot more from Adam when we get to the Analyst Day about specifically what we're doing and where we're heading. I would say you start – in terms of how I'm looking at success, which we should start to see some of that materialize towards the back half of the year and really looking at what is our exit run rate going into next year and then what does that funnel look like. But we should start to see a lot of this materialize towards the back half of the year. It's probably a normal sales cycle. You got some early wins. You've got developers from customers that can start playing around adding new applications and that sort of stuff. But I think in terms of the more meaningful, impactful deal sizes, those should happen towards the back half of the year and into next year."
},
{
"speaker": "Jeff Van Rhee",
"text": "Okay. That's helpful. Last one for me. I think on the traffic side, you mentioned OTT as well as gaming and in particular, in general, being most visible in the most recent quarter. I mean, anything notable difference in the trends of those two traffic types? Or is it just generally, behavior you or expect from people getting outside and unlocking? Any differences there?"
},
{
"speaker": "Ed McGowan",
"text": "Yes. Good question. I'd say sort of the latter, what you just said there that is probably more of that people getting out. That's – you see that more on the video side in terms of less hours streamed, if you're watching 10 hours a day, you're maybe doing eight or six or whatever. But gaming is more of a seasonal issue. I'd say we saw more of an impact on gaming, not as many releases that had probably a bit weaker than we would have expected. I think in terms of the trends, it depends on what the cycle looks like going into the back half of the year in terms of major gaming releases. But the video side, I think, is a lot more behavioral."
},
{
"speaker": "Jeff Van Rhee",
"text": "Yes. Okay, all right. Thank you."
},
{
"speaker": "Tom Barth",
"text": "Operator – time for one more question."
},
{
"speaker": "Operator",
"text": "Thank you. Our last question comes from Will Power with Baird. Your line is open."
},
{
"speaker": "Will Power",
"text": "Okay. Great. Thanks for sneaking me in. Maybe, Tom, I'd love to get a little more color on the strength within compute. Anything else you could provide with respect to key drivers in the quarter would be great."
},
{
"speaker": "Tom Leighton",
"text": "Yes. We've been working on edge computing, doing edge computing services for close to 20 years. We have the edge worker solution that has function as a service and thousands of POPs around the world, EdgeKV database capability and more and more applications having – our customers having an interest in having them work at the edge. You get tremendous scalability, instant scalability, you can spin up your edge worker app a few milliseconds and be really close to the end user. And I think we get more business there as you go forward, more and more of our customers are using it as they move to the – an API model and as you get 5G and as you get IoT and you have more demand for lower latency and scalability at the edge. And of course, Linode is really exciting because now you get the core cloud compute capability. So you can just take your container, your app and the container and move it over to Akamai, and have the whole thing end-to-end from the core of the cloud to the edge. You can build your app on Akamai. You can run it on Akamai. You could deliver it on Akamai. You can do the compute you need at the real edge in thousands of places. And of course, we'll wrap it all in security for you. So I think compute is strong on its own from what we had. Now you get more strength with Linode and then you wrap it all together in the Akamai platform, which is really unique in terms of having 4,000 POPs. There is nothing like it in terms of having a true edge network, the scalability you get and the performance you get from that."
},
{
"speaker": "Will Power",
"text": "Okay. Great. Thanks. And then maybe just a quick question on thoughts around potential M&A from here given valuation compressions in the market. How does that change the landscape for you? How you look at things and maybe appetite here, particularly coming on the heels of the Linode deal?"
},
{
"speaker": "Tom Leighton",
"text": "Yes. We're continuing to look at possible acquisitions. Obviously, we've done two large ones in a short period of time. I don't expect that to be the norm. We're generating a lot of cash, and we're going to use that to reinvest in the business, particularly in security and compute. So it's not impossible over time. You'll see other acquisitions like that. And probably, several smaller acquisitions like we've always done. Tech tuck-ins, adjacent products. So I think what you've seen is what you'll get, but not two big ones right away. That's not the norm. But we saw a real chance to have a game changer in enterprise security with Guardicore. Really, the right product to stop ransomware and a game changer in Linode, a leading alternative cloud that gives us – really completes the Akamai picture, I would say, in terms of powering and protecting life online, being able to build, run, deliver, accelerate and secure your app all in 1 platform is really exciting for us."
},
{
"speaker": "Will Power",
"text": "Great. Thank you."
},
{
"speaker": "Tom Barth",
"text": "Thank you, everyone, for joining us tonight. I know we ran a little long, so we appreciate your patience. And in closing, we will be presenting at several investor conferences and road shows throughout the rest of the second quarter, including our Analyst Day in New York City on May 18. Details of all these events can be found in the Investor Relations section of akamai.com. Thanks for joining us and all of us here at Akamai wish you and yours continue good out. Have a great evening."
},
{
"speaker": "Operator",
"text": "This concludes today's conference call. Thank you for participating. You may now disconnect."
}
] | Akamai Technologies, Inc. | 24,522 |
AKAM | 4 | 2,023 | 2024-02-13 16:30:00 | Operator: Good afternoon, and welcome to the Akamai Technologies. Inc. Fourth Quarter 2023 Earnings Conference Call. [Operator Instructions] Please note, this event is being recorded. I would now like to turn the conference over to Tom Barth, Head of Investor Relations. Please go ahead.
Tom Barth: Thank you, operator. Good afternoon, everyone, and thank you for joining Akamai's fourth quarter 2023 earnings call. Speaking today will be Tom Leighton, Akamai's Chief Executive Officer; and Ed McGowan, Akamai's Chief Financial Officer. Please note that today's comments include forward-looking statements, including statements regarding revenue and earnings guidance. These forward-looking statements are subject to risks and uncertainties and involve a number of factors that could cause actual results to differ materially from those expressed or implied by such statements. The factors include any impact from macroeconomic trends, the integration of any acquisitions and any impact from geopolitical developments. Additional information concerning these factors is contained in Akamai's filings with the SEC, including our annual report on Form 10-K and quarterly reports on Form 10-Q. The forward-looking statements included in this call represent the company's view on February 13, 2024. Akamai disclaims any obligation to update these statements to reflect new information, future events or circumstances, except as required by law. As a reminder, we will be referring to some non-GAAP financial metrics during today's call. A detailed reconciliation of GAAP and non-GAAP metrics can be found under the financial portion of the Investor Relations section of akamai.com. Before I turn the call over to Tom, I’d like to let everyone know that I have transitioned to Head of Akamai’s investor roles to Mark Stoutenberg. Many of you have met Mark over the past year, and I'm confident you will find him extremely helpful about all things Akamai. I'll be moving into another role internally, and want to thank Tom personally for bringing me into the Akamai culture 10 years ago. It's been a privilege to work with so many wonderful people, both here at Akamai, and of course, all of you externally. I wish you all happiness and good fortune. And now I'd like to turn the call over to Tom.
Tom Leighton: Thanks, Tom. And thank you very much for the terrific job that you've done over the last 10 years at Akamai. It's truly been a pleasure working with you. And I'd like to join you in welcoming Mark as your successor. Turning now to our Q4 results, I'm pleased to report that ACMI delivered a strong finish to a very successful 2023. Fourth quarter revenue grew to $995 million, and non-GAAP operating margin was 30%. Non-GAAP earnings per share in Q4 was $1.69, up 23% year-over-year, and up 22% in constant currency. For the full year, revenue was $3.81 billion, and non-GAAP operating margin was 30%. Full year non-GAAP earnings per share was $6.20, up 15% year-over-year, and up 16% in constant currency. Security revenue in Q4 grew 17% year-over-year, and was up 18% in constant currency, contributing nearly half of our total revenue in the quarter. Security growth was driven in part by continued strong demand for our market-leading Guardicore Segmentation Solution, as more enterprises relied on Akamai to defend against malware and ransomware. Customers who purchased Segmentation in Q4 included one of the largest global tech firms in India, and a leading payment systems company based in Hong Kong that handles 15 million transactions a day. We've also seen strong interest in our new API Security Solution that we announced in August. Early adopters of this new solution include three major financial institutions, several major retail brands in Europe and North America, and a leading industrial automation company in Europe. Our customers are seeing the value of this new capability with several already paying over half $0.5 million per year for the service. Akamai’s API Security Solution also earned recognition from industry analysts in Q4. KuppingerCole named Akamai an overall industry leader in their API security and management leadership compass report. And Gartner validated our strong and expanded API capabilities in its market guide for cloud, web application and API protection. Turning now to cloud computing, I'm pleased to say that we accomplished what we set out to achieve last year in terms of infrastructure deployment, product development, jumpstarting our partner ecosystem, onboarding the first mission critical apps from some major enterprise customers, and achieving substantial cost savings as we moved our own applications from hyperscalers to the Akamai Connected Cloud. After launching Akamai Connected Cloud. After launching Akamai Connected Cloud last year, we rolled out 14 new core computing regions around the world, giving us a total of 25 overall. We also enhanced our cloud compute offering by doubling the capacity of our object storage solution and adding premium instances for large commercial workloads that are designed to deliver consistent performance with predictable resource and cost allocation. Also, our Akamai Global Load Balancer is now live. This integrated service is designed to route traffic requests to the optimal data center to minimize latency and ensure no single point of failure. Last year, we also amplified our go-to-market approach with our cloud computing partner program. The collaborative nature of the program provides a unique model for Akamai to engage with customers at a consultative level to deeply understand their requirements and pain points and to provide a complete solution leveraging the combined strength of the partner’s technology and Akamai's distributed compute platform. We've already partnered with several leading SaaS and PaaS providers and cloud data and processing platforms. We're very pleased with the progress that we've made thus far and are looking forward to adding more new partnerships in 2024. We've also begun to gain traction with some of our largest customers as they migrate mission-critical apps onto our cloud platform. For example, one of the world's best-known social media platforms spent approximately $5 million on computing services with us last year and they're already on a run rate to do more than double that this year. Two of the world's best-known software companies recently signed on and are already spending about a quarter of a million dollars per month on cloud computing with Akamai. In Q4, we also signed up a major global media measurement and analytics company and we displaced a hyperscaler when we signed Blu TV, the largest VOD streaming company in Turkey. The streaming customer told us that they found our platform to be simple to use, automated and intuitive, cloud agnostic for a smooth multi-cloud migration and affordable with very low egress cost, all backed by a trusted and reliable partner. In addition to exceeding our full-year cloud computing revenue goal of $500 million last year, we also derived significant cost savings by migrating several of our own applications from hyperscalers to Akamai Connected Cloud. Our bot manager and enterprise application access solutions were among the first to migrate. Together, these products are used by over 1,000 customers and they generate over $300 million in annual revenue for Akamai. But all that is just the beginning. Today, we're excited to announce the next phase of our multi-year strategy to transform the cloud marketplace, taking cloud computing to the edge by embedding cloud computing capabilities into Akamai's massively distributed edge network. Akamai's new initiative, codenamed Gecko which stands for “Generalized Edge Compute”, combines the computing power of our cloud platform with the proximity and efficiency of the edge to put workloads closer to users than any other cloud provider. Traditional cloud providers support virtual machines and containers in a relatively small number of core data centers. Gecko is designed to extend this capability to our edge pops, bringing full stack computing power to hundreds of previously hard-to-reach locations. Deploying our cloud computing capabilities into Akamai's worldwide edge platform will also enable us to take advantage of existing operational tools, processes, and observability, enabling developers to innovate across the entire continuum of compute and providing a consistent experience from centralized cloud to distributed edge. Nobody else in the marketplace does this today. In the latest implementation phase that we're announcing today, Akamai aims to embed compute with support for virtual machines into about 100 cities by the end of the year. We've deployed new Gecko-architected regions in four countries already, as well as in cities that lack a concentrated hyperscaler presence. These initial locations are listed in today's press release. Following that, we plan to add support for containers. And then, we plan to develop automated workload orchestration to make it easier for developers to build applications across hundreds of distributed locations. We've been conducting early trials of Gecko with several of our enterprise customers that are eager to deliver better experiences for their customers by running workloads closer to users, devices, and sources of data. Their early feedback has been very encouraging, as they evaluate Gecko for tasks such as AI inferencing, deep learning for recommendation engines, data analytics, multiplayer gaming, accelerating banking transactions, personalization for e-commerce, and a variety of media workflow applications, such as transcoding. In short, I'm incredibly excited for the prospects of Gecko as we move full stack compute to the edge. Turning now to content delivery, I'm pleased to report that Akamai remains the market leader by a wide margin, providing the scale and performance required by the world's top brands as we help them deliver reliable, secure, and near flawless online experiences. Our delivery business continues to be an important generator of profit that we use to develop new products to fuel Akamai's future growth. And it's an important driver of our security and cloud computing businesses, as we harvest the competitive and cost advantages of offering delivery, security, and compute on the same platform as a bundle. As we've noted in past calls, we're selective when it comes to less profitable delivery opportunities. And this is a discipline that we intend to maintain, and in some cases, increase in 2024. To be clear, we still aim to be the best in delivery for our customers. And we believe that our disciplined approach will benefit our business by allowing us to focus more of our investment in security and cloud computing, which are now approaching two thirds of Akamai's revenue and growing at a rapid rate. In summary, we're pleased to have accomplished what we said we would do in 2023. Our cloud computing plans are taking shape as we envisioned. Our expanded security portfolio is enabling us to deepen our relationships with customers. And we continue to invest in Akamai's future growth while also enhancing our profitability. Now I'll turn the call over to Ed for more on our results and our outlook for Q1 and 2024. Ed?
Ed McGowan: Thank you, Tom. I would also like to thank Tom Barth for his incredible service for 10 years as our head of investor relations. Now moving on to our results, let me start by saying that I'm very pleased with our fiscal 2023 year results, delivering $6.20 of non-GAAP earnings per share, capping off a year of double-digit earnings growth for our shareholders. Today I'll cover our Q4 results, provide some color regarding 2024, including some items to help investors better understand a few factors that will impact our upcoming results, and then close with our Q1 and full year 2024 guidance, starting with revenue. Q4 revenue was $995 million, up 7% year-over-year as reported and in cost and currency. We saw continued strong growth in our compute and security businesses during the fourth quarter. Our compute business grew to $135 million, up 20% year-over-year as reported and in constant currency. We continue to be very pleased with the feedback regarding our cloud compute offerings, and we are very optimistic about the early traction we are seeing from enterprise customers. Moving to security, revenue was $471 million, growing 18% year-over-year and up 17% in constant currency. Our security revenue continues to be driven by strong growth in our Guardicore Segmentation Solution, in our industry leading web app firewall, denial of service, and bot management solutions. In addition, and as Tom mentioned, we are encouraged by the early traction of our new API security solution. During the fourth quarter, we signed 17 API security customers, including 4 with annual contract values in excess of $500,000 per year. Our delivery revenue was $389 million, including approximately $20 million from the contracts we recently acquired from StackPath and Lumen. International revenue was $479 million, up 8% year-over-year, or up 6% in constant currency, representing 48% of total revenue in Q4. Finally, foreign exchange fluctuations had a negative impact on revenue of $4 million on a sequential basis and a positive $6 million benefit on a year-over-year basis. Moving to profitability. In Q4, we generated strong non-GAAP net income of $263 million, or $1.69 of earnings per diluted share, up 23% year-over-year or 22% in constant currency, and $0.07 above the high end of our guidance range. These stronger-than-expected EPS results were driven primarily by continued progress on the cost-saving initiatives we have previously outlined, and approximately $6 million in lower-than-expected transition services, or TSA costs, associated with the StackPath and Lumen contracts, as our services organization migrated the customers onto our platform much faster than we expected. Q4 CapEx was $143 million, or just below 15% of revenue. We were very pleased with our continued focus on lowering the capital intensity of our delivery business. This effort, along with our very strong profitability, enabled us to deliver very strong free cash flow results in Q4. Moving to our capital allocation strategy, during the fourth quarter, we spent approximately $55 million to buy back approximately 500,000 shares. For the full year, we spent approximately $654 million to buy back approximately 8 million shares. We ended 2023 with approximately $500 million remaining on our current repurchase authorization. Going forward, our intention is to continue buying back shares to offset dilution from employee equity programs over time, and to be opportunistic in both M&A and share repurchases. Before I move on to guidance, there are several items that I want to highlight in order to give investors some greater insight into the business. The first relates to our delivery revenue. In the first half of 2024, seven of our top 10 CDN customers' contracts come up for renewal. As we've discussed in the past, this type of renewal generally leads to an initial drop in revenue, and then we typically see revenue grow again as traffic increases over time. We have factored the expected outcome of these renewals into our Q1 and full year 2024 guidance. In addition, as Tom mentioned, we plan to continue to optimize our delivery business by focusing on how we charge certain high-volume traffic customers for their usage on our network, all with an eye on profitability. For example, we plan to start charging a premium for higher-cost delivery destinations. We expect to continue to optimize the ratio of peak to day-to-day traffic, and we plan to negotiate different pricing for API traffic versus download traffic. Choosing to shed some less profitable traffic will result in a more balanced and profitable approach to pricing, which we believe is the right strategy for the company. Second, OECD member countries continue to work toward the enactment of a 15% global minimum corporate tax rate. And in particular, in December 2023, the Swiss Federal Council declared the rules in effect for Switzerland beginning in 2024. As a result, we anticipate that our non-GAAP effective tax rate will increase by roughly 1.5 to 2 percentage points, to approximately 18.5% to 19%. We estimate this increase in our tax rate will have a negative impact on Q1 non-GAAP EPS of approximately $0.02 to $0.03 per diluted share, and a negative impact on full year non-GAAP EPS of approximately $0.12 to $0.15 per diluted share. The impact of this tax rate change has been factored into our Q1 and full year 2024 guidance. Third, we expect to generate significantly more free cash flow in 2024 compared to 2023 levels. This is primarily due to much lower capital expenditures in 2024, along with our continued focus on profitability. Please note that the full cost to build out our Gecko compute sites we announced earlier today is included in our Q1 and full year 2024 capital expenditure guidance. Fourth, I want to remind you of the typical seasonality we experience on the top and bottom lines throughout the year. Regarding revenue, the fourth quarter is usually our strongest quarter. Regarding profitability, in Q1 we incur much higher payroll taxes related to the reset of Social Security taxes for employees who maxed out during 2023, and from stock vesting for employee equity programs, which tend to be more heavily concentrated in the first quarter. It's also worth noting that in Q3, our annual company-wide merit-based salary increases go into effect, so we tend to see higher operating costs in Q3 compared to Q2 levels. Finally, for 2024, we anticipate heightened volatility in foreign currency markets, driven by the unpredictable timing and magnitude of Federal Reserve policy changes and their impact on interest rates. With this in mind, forecasting the trajectory of FX in the latter part of the year poses a formidable challenge. Thus, for the full year, we plan to provide annual revenue growth, security and compute revenue growth, non-GAAP EPS growth, non-GAAP operating margin, and CapEx only in constant currency based on 1231-2023 exchange rates. However, for the coming quarter, we will provide both as reported and constant currency guidance. As a reminder, we have approximately $1.2 billion of annual revenue that is generated from foreign currency with the Euro, Yen, and Great British Pound being the largest non-U.S. dollar sources of revenue. In addition, our costs in non-U.S. dollars tend to be significantly lower than our revenue and are primarily in Indian rupee, Israeli shekel, and Polish Zloty. Moving now to guidance. Our guidance for 2024 assumes no material changes, good or bad, in the current macroeconomic landscape. For the first quarter of 2024, we are projecting revenue in the range of $980 million to $1 billion, or up 7% to 9% as reported, or 8% to 10% in constant currency over Q1 2023. At current spot rates, foreign exchange fluctuations are expected to have a positive $2 million impact on Q1 revenue compared to Q4 levels and a negative $4 million impact year-over-year. At these revenue levels, we expect cash gross margin of approximately 73% as reported and in constant currency. Q1 non-GAAP operating expenses are projected to be $305 million to $310 million. We anticipate Q1 EBITDA margins of approximately 42% to 43% as reported and in constant currency. We expect non-GAAP depreciation expense of $127 million to $129 million. We expect non-GAAP operating margin of approximately 29% to 30% as reported and in constant currency for Q1. And with the overall revenue and spend configuration I just outlined, we expect Q1 non-GAAP EPS in the range of $1.59 to $1.64, or up 14% to 18% as reported, and 16% to 19% in constant currency. The EPS guidance assumes taxes of $56 million to $58 million based on an estimated quarterly non-GAAP tax rate of approximately 18.5% to 19%. It also reflects a fully diluted share count of approximately 155 million shares. Moving on to CapEx, we expect to spend approximately $146 million to $154 million excluding equity compensation and capitalized interest in the first quarter. This represents approximately 15% of total revenue. Looking ahead to the full year for 2024, we expect revenue growth of 6% to 8% in constant currency. We expect security revenue growth of approximately 14% to 16% in constant currency. We expect compute revenue growth to be approximately 20% in constant currency. And we're estimating non-GAAP operating margin of approximately 30% in constant currency. And full year CapEx is expected to be approximately 15% of total constant currency revenue, which again includes the Gecko compute buildup. We expect our CapEx to be roughly broken down as follows. Approximately 3% of revenue for our delivery and security business, approximately 4% of revenue for compute, approximately 7% of revenue for capitalized software, and the remainder for IT and facility related spend. We expect non-GAAP earnings per diluted share growth of 7% to 11% in constant currency. And as we mentioned earlier, this non-GAAP earnings guidance is based on a non-GAAP effective tax rate of approximately 18.5% to 19%, and a fully diluted share count of approximately 155 million shares. In closing, we are very pleased with a strong finish to 2023. We continue to be excited about our growth prospects and driving profitability across the business. Now Tom and I would like to take your questions. Operator?
Operator: [Operator Instructions] And our first question will come from Fatima Boolani of Citi. Please go ahead.
Fatima Boolani: Thank you for taking my questions. Ed, I wanted to drill into the delivery, the segment performance and the guidance and some of the modeling points that you shared with us. I was hoping you could parse out for us some of the organic traffic trends you saw on the platform, parsed away from the traffic, from the acquired contracts between StackPath and Lumen. And then to the extent you can talk about any timeframe you have with regards to absorbing some of this additional acquired traffic from these contracts. And the last piece of the question here is also the guidance that we calculated to be down 6% for delivery in 2024, implied by your guidance, full year guidance. Can you talk to what proportion of that traffic that you would have deemed lower quality being peeled off is maybe the reason why we're not seeing a more sharper improvement in the delivery franchise. And then I have a quick follow-up. Thank you.
Ed McGowan: All right, sure. Let me see if I can tackle all those for you. I'll start with the performance in Q4. So I'll break it down into a couple of buckets. So in Q4, we tend to see a stronger seasonal quarter for us. And we did see some of that. So from the retail customer perspective, we saw bursting roughly to the tune of about half of what we saw last year. And I think that has to do mostly with the zero overage. As that's become more popular, we are seeing less bursting. If I look back a few years, that's down above 50%, 22 compared to 21, and again, 23 compared to 22. Some of it could be macro factors, hard to tell. We're not really the best gauge for folks' consumption, but more they're surfing. If I look at gaming, gaming was a better year. If I look last year, gaming was pretty weak. This year, it was pretty good. Gaming tends to be fairly lower priced delivery, so you don't get as much upside in revenue. Video was up quarter-over-quarter, but not as much as we saw the prior year. So I would say kind of an okay fourth quarter from delivery. The one area that was probably the weakest was more in sort of high tech. So think about that as new connected devices, maybe it's connected TV or a new, say an iPad or something like that, printer drivers, that sort of stuff. That was much weaker than what we saw last year. Last year was a pretty good bump up in that category. So that really sort of sums up what the dynamics are in terms of the delivery business in Q4. And I looked at that, not including the acquisition traffic. The second question you asked, if I wrote it down correctly, was the absorption of the traffic from the acquisitions. We've largely done that. The services team did a phenomenal job migrating over the customers. We did it in probably about a third of the time that we had expected to be able to do that. There's still a few stragglers, but the transition services costs are immaterial. So that's why we didn't call that out. But that's largely been done. In terms of this year, why are we seeing a down 6% if that's the math you're using for delivery? A lot of it has to do with the renewals. Unfortunately, these larger customers, as we've talked in the past, we only have about eight customers that are greater than 1% of revenue. And unfortunately, seven of them are renewing in the first half of the year. That does have a bit of an impact on the delivery business. The majority of the revenue from those customers comes from delivery. We've seen this in the past. It seems like every two years, we kind of bump into this. Even though we try to sign staggered contracts, what happens often is someone might sign a two or three year deal with a revenue commit. They'll spend that in a shorter period of time. And we just get a combination of renewals here. And then the other thing was on the shedding of traffic. So let me just get a little bit more specific with what we're doing. So last year, if you remember, we talked about being a bit more stringent with the peak to average ratios. And we're going to continue to do that. We did a pretty good job. There's still a few customers we need to adjust. And that generally happens where customers will split and they have lots of day-to-day traffic and they might split that among three or four CDNs. And then they'll have peak events, whether that's a big video event or a big download event. And we get the disproportionate size of that peak. So you want to make sure you're compensated for that. So the way to do that is you get a higher percentage of the day-to-day or you just limit the peak. So we'll continue doing that. And sometimes that may mean we lose a little bit of traffic, but that's okay because you can see the results in CapEx. The new thing that we're doing now is we've worked with product and IT to enable us to be able to build for very granular level on destinations. In the past, we generally would build based on large geos, say for example, a large geos, say for example, the U.S. or Europe or Asia. Now we're able to get one level deeper. And so we can go after some of the areas where our costs are a bit higher to deliver. It's unclear. We're assuming that customers have choice. They may decide to take that traffic somewhere else. Some of our competitors don't really focus as much on profit as we do. If that's the case, then that's okay with us. So I think as we tried to factor all that in, those are the two driving factors as to why we're not seeing a better delivery performance in 2024. I think I hit all your questions.
Fatima Boolani: You did. Super comprehensive. Thank you. And an easy one, just on gross margins, you gave us the guidance for cash gross margins on the first quarter. But just qualitatively, if you can talk to us about some of the puts and takes at a full year level as we think about the mix of business changing, your focus on pricing discipline, and just even a U.S. international mix, any sort of puts and takes in terms of the dynamics we should be thinking about COGS and cash gross margins for the full year. And that's it for me. Thank you.
Ed McGowan: Sure. No problem. In terms of the cost of goods sold, I'll start with the good stuff that's going on in cost of goods sold. Obviously, you touched on the mix. So as we get a higher degree of security business, that obviously helps our gross margin line. And the second thing is the movement of our third-party cloud costs onto our own platform. We did a great job so far this year. Tom talked a bit about that in his prepared remarks. And we have more to go, and we have a roadmap to get that. So that'll drive some significant savings. The downside or what's sort of contracting them or not expanding the margins as much, I should say, we could be going a bit higher, is that with the build of the Gecko sites, we'll incur some additional co-location costs. So as we start to build out those facilities, you don't have revenue to go against it. But also, as I talked about last year, when we built out some of the bigger sites, with the accounting rules, when you do long-term Colo commitments or any kind of a commitment for long-term leases, you have to straight line any commitment. So we end up with a bit of a disconnect between what we're paying in cash and what we're actually expensing. So we're able to offset that with the savings we get from the third-party cloud in the mix, but those are the underlying dynamics.
Fatima Boolani: Thank you so much.
Operator: The next question comes from Frank Louthan of Raymond James. Please go ahead.
Frank Louthan: Great. Thank you. How different is Gecko from what you're doing now with Compute? Is this a new packaging of some of your products, or is it something a little different? And then secondly, of the CDN business that you acquired last year, how much are you expecting that to fall off? I think the goal was to try and get it out to some other services, but what are you factoring in there at that time?
Tom Leighton: Yes, I'll take the first question. Yeah, Gecko is not packaging. Gecko is a new capability where we're going to be offering full-stack compute in 100 cities by the end of the year, and ultimately in hundreds of cities. We're actually taking full-stack compute, the kinds of services you get in Linode or a hyperscaler, and making that available in our edge pops. Now today, the edge pops, we have 4,000, and they run function as a service. We'll spin up JavaScript apps in 4,000 locations in over 700 cities in milliseconds based on user demand, but that's not full-stack compute. Now we're going to be taking virtual machines and containers and supporting those in our Edge platform, and that enables our customers to get much better performance and scalability, also lower cost because of the financial benefits we get from our edge platform. So it really becomes, I think, a very compelling cloud computing offering that just doesn't exist in the marketplace today. It's not a packaging thing at all. This is a new capability, and of course, ultimately, after we get the support for VMs and containers, we want to make it work just as we do function as a service, so that we'll be spinning up containers and VMs on demand where and when they're needed, and that capability doesn't exist today in the market. Ed, you want to take the CDN question, the acquisition?
Ed McGowan: Yes. Sure, happy to do that. Hey, Frank. Yes, I would say, just as a reminder, when we acquired the businesses, we actually acquired selected customers. What we mean by that is we actually went through and we left some customers that we weren't going to take. For example, if someone violated our acceptable use policy, really small customers, and then, believe it or not, some that had pricing that we just didn't want to take. So we had already gone through sort of a selection process. If you recall, I had given guidance last quarter of about $18 million to $20 million for this quarter, and we hit the high end of that range, which I'm happy that we did. So we've largely been able to migrate over everything that we had hoped to. There's a few customers that churned, but by and large, we've gotten everything out of that acquisition or those acquisitions, I should say. There were two of them that we had hoped to.
Frank Louthan: Okay, great. Thank you very much.
Operator: The next question comes from James Fish of Piper Sandler. Please go ahead.
James Fish: Hey, guys. First, just Tom Barth. Look, you've been a class actor and appreciate all the help over the years, and just wanted to echo Tom Leighton and Ed's sentiment there. I really appreciate the help over the years. I want to circle over to security, actually. Look, security was a little bit lower than I think we were all anticipating for Q4. I get that we have some drivers underneath that are helping the business, but did you see any push out of deals and maybe that's contributing to your confidence around mid-teens growth for 2024? Help us on the confidence for sustained mid-teens growth, and really how is that selling outside the install base and penetration of those new security packages going?
Ed McGowan: Hey, Jim. This is Ed. Yes, I was actually pretty pleased with our performance and didn't see many deals push out. We didn't have any large license deals like we did in Q3, so that might be -- that always skews some of the results, so we didn't have any of that. But no deals that really pushed out from a security perspective. Very pleased with what we're seeing with Guardicore continued great growth there. That's been phenomenal, and that's a lot of customers are being driven new verticals and things like that. The channel's been doing phenomenally well there. We talked a lot about in our prepared remarks, API security. I don't get surprised often, but I've been surprised with the ARPUs there. I've been very pleased with that. That's been very, very good to see. And the strength in – we talked about the bundles that we had done a lot on the last call. That's continued to go very well, and we're seeing very strong growth in our WAF and our fraud products, too, bot management and our fraud protector. So really strength across the board. Nothing so far from macroeconomic challenges. That always can change. You never know what can happen, but nothing that we saw in Q4. As far as the projections for this year, we feel pretty confident. We've generally been relatively conservative with our approach to security growth. We don't factor in any major type of attacks where sometimes we'll see a spike in demand or anything like that. So we feel pretty good with how security's going.
Tom Leighton: Maybe just to click down one level into Fatima's earlier question on the CDN side, and something that Tom said as well in his prepared remarks, is there any way to understand how much on the CDN side of the base you plan to essentially -- I don't want to say give away for free, but give away for free to get that compute revenue or help us understand kind of the dynamic between what we should expect between CDN and compute kind of dollar shifting. Thanks, guys.
Tom Leighton: Yes. I think you can't factor in any percentage there at this point. We have been in some discussions with some very large media companies where we would offer discounted or free delivery in return for a significant portion of the compute business. On balance, that would be a great trade for us, much more profitable and much more revenue, because at the end of the day, big media companies will spend 10x on compute what they'll spend on delivery and even security. This is something that we see the hyperscalers do. They will sometimes give away the delivery in return for getting the compute business, because that's where the vast majority of the revenue is and very profitable. We'll keep you advised as we go if that starts to make a material difference.
Operator: The next question comes from Keith Weiss of Morgan Stanley. Please go ahead.
Keith Weiss: Excellent. Thank you, guys, for taking the question. This is one for Ed. Throughout 2020, we talked a lot about savings initiatives. We talked a lot about migrating workloads to internal cloud and that yields savings. I got to say, just to put it bluntly, it kind of disappointing about the lack of margin expansion in the sky. Is there something holding that back or is there some incremental investments perhaps behind Gecko that we're making instead of that? Or meeting a bunch of questions like, why not more margin? Given all the efficiency sort of improvements that you guys have been putting in for the past year?
Tom Leighton: Yes, I'll take this one, Tom. You broke up a little bit there, Keith, but I think I got the genesis of the question. So yes, we've done, I thought, a great job of making some acquisitions over the last few years, investing in a compute business, spending an awful lot to build out our compute facilities, adding a lot of functionality, growing our security business, doing acquisitions there as well. And got back to 30% margin last year and continuing this year. We've always said that's been a pretty healthy spot to run the business. We're investing because we see opportunity for growth and there's always a balance. You can't cut your way to greatness. Perhaps we could cut a few more points, but then what are we leaving on the table? I think we've been pretty disciplined and balanced with our approach in terms of investing for growth and returning to margin. We've got some pretty exciting areas. We're seeing great growth in API security. It's still early days there. The product will continue to get better. We've seen good ARPUs there, so I'm very excited about what we're doing there. We've made investments in go-to-market and Guardicore, and that certainly has paid off. And the investments in Computer Stein has shown some early returns. So again, it's a balanced approach. We're in this for the long-term, and I think we don't want to shoot ourselves in the foot and not go after some of these big opportunities that we have in front of us.
Keith Weiss: Got it. That's clear.
Tom Leighton: Thank you.
Operator: The next question comes from Mark Murphy of JPMorgan. Please go ahead.
Mark Murphy: Thank you very much. So, Tom, you've done a very solid job with the compute business. And in the prepared comments, you mentioned onboarding of submission-critical apps. I'm wondering if you could shed a little light on the pipeline of that kind of critical app that you see coming to you in 2024 and thus far. How well is your infrastructure handling the intensity of those larger workloads in terms of stability, reliability, uptime, etc? And then I have a quick follow-up.
Tom Leighton: Yes. So, signing on compute customers is a big focus for us this year. We have the basic infrastructure in place. Of course, now we're building out Gecko. But just with the basic infrastructure already in 25 cities, we'll be looking to add on many more mission-critical apps from major enterprises. And some examples, you look at social media, live transcoding. We now have two giant companies using that on the platform, one for live sports broadcasting, another for live user-generated content. Another customer, we're hosting e-commerce sites for them in a way that performs better because closer to the end-user and less expensive. AI inferencing for ad targeting, personalizing content. And again, you want to do that really fast. And you just don't have time to backhaul that up into a centralized location. You want to be in a lot of locations around the world to get better performance. And again, we can do it at a lower cost. We've even got a large, one of the world's largest banks now using us, our edge compute, to register credit cards, their user credit cards with Apple Pay because Apple Pay requires you do the registration in 60 milliseconds. And the only way they can get that done fast is to do it on Akamai Connected Cloud. So really, a lot of different applications already on the platform, doing proofs of concept now. So the focus this year, and I think it's a good pipeline, is to be taking on many more mission-critical apps for major enterprises. And of course, we're the first big one. We've got enormous applications already running on the platform and very successfully. And we do it in a multi-cloud way. And as I talked about earlier, now we have the global load balancing built in, the failover capability, so that it does make for a reliable service that's high-performing. So really excited about what's coming this year.
Mark Murphy: Yes. It's great to hear the tie-in with the inferencing and Apple Pay as well. So I appreciate the color of that. Ed, I wanted to ask you, you're providing the fiscal year guidance in constant currency and, of course, we all understand it's going to be very difficult to predict the actual fluctuations in the spot market, but if we looked at it at current FX levels, do you think it would skew that 6% to 8% revenue growth level higher or lower? If we were to try to translate it into reported U.S. dollars in our models right now today?
Ed McGowan: Yes, good question. I think the CPI report today gave you a good view of how things can change so quickly. The market originally had thought there'd be a lot of rate cuts and now all of a sudden that doesn't look like it's going to happen and obviously currencies and interest rates are very closely aligned. So if you look, I gave you the 1231 number, so obviously the dollar has gotten a bit stronger. I gave you the numbers in terms of the total non-U.S. dollars, so you can kind of do some math. It would still be in that range. Obviously, it'd be a little bit of a headwind just given that the dollar's gotten stronger since 1231, but I think you can take our Q1 guidance and sort of fold that in and think about the normal seasonality that you have and come up with an answer. But it would still be in that range, though.
Mark Murphy: And just to clarify, so it's still in that 68% range if we put it into USD or are you saying it's still kind of mid-single-digit, but maybe some like a point lower?
Ed McGowan: Well, no, I mean, if you're using spot rates as of today, the simple math would suggest that it is, yes. If you looked at, just take the midpoint of the guide, right? Just say if I just use that and what the impact of the dollar has been, it's still in that range. Now, you would ask, could it be higher? Obviously, the dollar was at 101 back at 1231. It was at 106 in November, and so it's bouncing all over the place. Obviously, if it were to move, you can do the math, five or six points lower, you could potentially get on the other side of that. So, again, it's just I'd be end up giving you guys a massive range that wouldn't be helpful. So what I'd rather do is just give you guys the tools that you can do it yourself and look at, really get an understanding of the core business underneath that. How is that? I think it's much more important to understand.
Mark Murphy: Understood. Thank you very much. And I want to also thank Tom Barth for a lot of great interactions over the years.
Operator: The next question comes from Madeline Brooks of Bank of America. Please go ahead.
Madeline Brooks: Hi, team. Thanks so much for taking my question tonight. Just one on security. Outside of Guardicore, I just want to touch on this year, the rest of the Zero Trust portfolio trends that you've seen and maybe if you're feeling any additional competitive pressure now that the market has really expanded there? And then I have one follow-up.
Tom Leighton: Yes. In Web App Firewall, we've been the market leader there, for 10 years since we started that marketplace with Web App Firewall as a service. And after 10 years, you do get, competition. But we're still the market leader by a good margin. And that's a good growth business for us. We've added a lot of capabilities on top, bot management and more recently, account protector, client side protection so that customers of commerce sites can stay safe by going to the site. You need going to need that now for compliance. There's a brand protector. So that's identifying the phishing sites and keeping them from stealing, user information. Of course, we've been doing, denial of service protection for a long, long time now. Market leadership position there. And then you have on the enterprise side, of course, Guardicore we talked about doing very well. And I'm really excited about API security. I think over the longer term, that becomes as big a marketplace and just as important as Web App Firewall has become. And our goal there is to become the market leader. And already in the go-to-market motion, there's a strong synergy between Web App Firewall and API security. We built a very easy way to do a proof-of-concept for our Web App Firewall customers. And that's where we're getting a lot of early traction. Also, we've integrated with a lot of the load balancers and other firewalls out there so that we can sign on new customers who are, not using my CDN or Web App Firewall. So I think, there's a variety of areas in security that are working very well for us.
Madeline Brooks: Thanks so much, Tom. And then just one quick one on compute, too. I think if we think about earnings that have happened so far, especially with hyperscalers like AWS, Microsoft, Meta, we've kind of heard of this theme of the optimization inflection in terms of cloud computing, meaning maybe this year we're going to see a little bit more investment in new workloads. I'm just wondering if you've heard of any of those trends among your customers who are thinking about compute for the first time, or maybe if you're seeing increased appetite for compute for this coming year versus 2023. Thanks so much.
Tom Leighton: Yes, compute is an enormous marketplace and growing rapidly, and there's always new applications that are being created, and not just migrating from a data center into the cloud, but just brand new applications. So that's where we're seeing a lot of traction. Also, in some cases, lift and shift out of a data center or out of a hyperscaler. But it's just an enormous marketplace and a great place for us to operate. And even those that are optimizing, that's sort of, I guess, not such a great thing for the hyperscalers, but we're part of that trend. It's great for us, because we can help customers reduce cloud spend. And we've gotten very good feedback from our early adopters of Akamai Connected Cloud that they're saving a lot of money. So the trend to optimization is a positive thing for Akamai.
Operator: The next question comes from Rishi Jaluria of RBC. Please go ahead.
Rishi Jaluria: Wonderful. Thanks so much for taking my questions. And let me echo my colleagues in thanking Tom Barth. It's been a great decade working with you, and I'm really excited for your next chapter. I wanted to drill on to maybe going back to Gecko. I guess, number one, can you talk a little bit about edge inferencing and what those use cases look like? It's one of those things that we hear a lot of talk about in theory, but maybe in practicality as you're talking with your customers and having those conversations, what can that look like? And what positions Gecko uniquely for that? And then maybe financially, to the extent I know it's still early, are you assuming real Gecko contribution on the compute line in your guidance for the year? Or is that something that as it gets traction could lead to more upside beyond what you model? Thank you.
Tom Leighton: Great. So let me start with edge inferencing. And so some of the examples I gave, that's exactly what's happening for commerce sites in figuring out in real time what content you're actually going to give to the user that's coming to the site. Ad targeting, what ad do they get? Anything that involves personalization. On the security side, a ton of inferencing is used to analyze real-time data. For example, even our own bot management solution. Is that entity that's coming to the site, is it a bot or is it a human? And even if it's a human and they have the right credentials, is it the right human? And you use AI and inferencing for that, and you've got to do it really fast. You can't afford to send it back to the centralized data center because you've got a massive number of people that you've got to process in real time, especially if you're doing some kind of live event. And so being at the edge matters, because you can be scalable, you can handle it locally, you get great performance, you can make it be real time. And Akamai's unique value proposition with Gecko is that we're going to be able to now support this, not in a few cities, but in a hundred cities by the end of this year. So anything you can put in a VM, virtual machine, which is most things, you're going to be able to do that in a hundred cities. And then ultimately in hundreds of cities, because we can put this in general Akamai Edge pods. And then next will be containers, which is pretty much the rest of what you do in cloud computing. And then to be able to spin it all up automatically. It's a whole new concept for compute that I think is very powerful, and there's a high overlap of wanting to do that with inferencing engines, where you're trying to do something intelligent based on that end user or that end entity that's interacting with the application. Now, in terms of Gecko, we're just now in the early stages of getting it deployed. We're in nine cities, we'll get the 10th new city up in another month or so. By the end of the year, we'll be in a total of a hundred cities supporting compute. So not a lot of revenue is factored into the guidance based on Gecko for this year. That would come more next year. So this year's revenue guidance is based on the original 25 core compute regions that we've set up by the end of last year. Now we will deploy this, of course, just as fast as we can and as customers want to adopt it. And hopefully we have the situation where we want to build out more, get more compute capacity because there's so much demand for compute on Akamai. Ed, do you have any color you want to add around the guidance there?
Ed McGowan: No, I think you captured it right, Tom. We don't, we're not really anticipating anything. I mean, one thing we are doing this year is we are making changes to our comp plan with our reps so that they're all, all have to sell compute this year. So you could see things, reps get very creative. I learned in sales that comp drives behavior. So by leaning in here and making it something that all reps have to do, we should see a lot more use cases, a lot more opportunities, etcetera. So there's always a chance that we could be surprised here with the creativity of our field bringing us opportunities, but we did not factor in anything material as it relates to Gecko.
Rishi Jaluria: All right, wonderful. Thank you so much, guys.
Operator: The next question comes from Michael Elias of TD Cowen. Please go ahead.
Michael Elias: Great. Thanks for taking the questions. Two, if I may. Just first on Gecko, presumably the pops that you have, they're already supporting security and delivery workloads. So from an architecture perspective, can you help us think about what expanding the compute platform into these pops means? Is it just additional co-location deployments and on the CapEx side, networking gear and servers? Any color that you could give there in terms of the mechanics of what the expansion would look like? And then second, Ed, last year you were talking about elongation of enterprise sales cycles. Just curious what you're seeing in terms of the buying behavior of your customer base. Any notable call-outs there? Thank you.
Tom Leighton: All right. So I'll take the first one. With Gecko, that is generally speaking an existing Akamai Edge pops. And in particular, they tend to be the larger ones where we already have a lot of equipment. It's already connected into our backbone. And what we'd be doing is adding additional servers. And for compute, it would be a beefier server and additional COLO for those servers. But all the other infrastructure is generally already there. And it's already connected in and we already have delivery and security operating there. So it does become a very efficient way for us to deploy Gecko. And Ed, you want to take the second one there?
Ed McGowan: Sure. Yes. So I think the trend, obviously, acquiring new customers is always challenging in an environment like this. The one probably exception to that is in the security space. That tends to be something that obviously, now with the requirements with the SEC reporting and I added a disclosure with CISOs being now potentially criminally charged for breaches and things like that. Audit Committee is spending more and more time on cybersecurity as a topic. That tends to be a budget that, one, you don't typically cut and, two, you're generally adding to. But yes, new customers are challenging. I do think this kind of environment helps us what we were just talking about in the last few questions, around optimizing cloud spend. Certainly, if you've seen what we've done, we've spent [ph] a tremendous amount of money. So I think that can also help us in this particular environment. But definitely, new customer acquisition is a bit more challenging, but we're still doing pretty well. Obviously, the environment can change. But it hasn't been a major factor for us yet.
Michael Elias: Great. Thank you
Operator: The next question comes from Ray McDonough of Guggenheim Securities. Please go ahead.
Raymond McDonough: Great, thanks for sneaking me in. Maybe, Tom, just a follow-up to a prior question. As we think about Gecko and you mentioned that your edge sites right now don't have full stack compute. But how much work is done to be to converge what you already have at your edge sites and what you've done in terms of building out the nodes capabilities? Should we expect there to be a common software stack across both edge and centralized sites? And if so, is the plan to have that in place by year-end?
Tom Leighton: Yes. Great question. So what we're doing now is, as I mentioned in the last question, deploying more hardware in existing edge region and generally the larger edge regions. We already have network there. We already have delivery security located there. So there's some additional color and servers. And yes, the goal is to put it all on one common software stack. Now initially, we have the Linode stack is moving into these edge pops for Gecko. But as we once we get the support for virtual machines and containers, then next, we want to add the software stack that we have for delivery and for security and for function as a service that automatically, for example, spins up JavaScript apps and milliseconds based on end-user demand, we want all of that to be operating on containers and VMs. So that you don't have to think ahead of time about how many VMs do you want in each of these hundreds of cities? It just happens based on end user demand. You automatically get new ones spun up, load balancing, fail over, really a very compelling concept. And that doesn't exist in the cloud marketplace today. That is the vision -- I think you really nailed it when you talked about the common software stack because only Akamai has that full edge platform today, that software stack around delivery and security that will be now including compute.
Raymond McDonough: Appreciate that color. And maybe as a quick follow-up, as we think about the expansion of the Linode footprint last year, can you help us understand as much as you can, how much of the space currently built out was for internal use purposes to help with that third-party cloud savings versus space that's online now that's revenue generating? And I know we've talked about this in the past, but any color around what we should expect from a customer utilization perspective that might be embedded in your guidance as we move through year-end? That would be helpful.
Ed McGowan: Yes, sure. So the majority of the growth in the compute guidance is going to come from enterprise compute. So the stuff that we built out for the last year. So if you kind of go back and look at the math in terms of -- we've kind of said roughly speaking, $1 of CapEx is $1 of revenue. You can kind of look at what we're doing for compute build-out now what we did last year. We said we got about $100 million roughly for our -- all in for our internal use. So that leaves a pretty significant amount left for customer demand. Now obviously, the way people buy today, they pick a location, etcetera. So it's not going to be exactly a dollar for dollar right now, but it's a general rule of thumb. So I would say the majority of what we built out is for customer usage.
Raymond McDonough: Great. Thanks for sneaking me in. Appreciate it.
Operator: The next question comes from Tim Horan of Oppenheimer. Please go ahead.
Timothy Horan: Thanks guys. Following up on Ray's question. So I'm assuming the goal here is to get to one single platform where customers can access the full range of services relatively easily on, I guess, one on ramp up. When do you think you'll get there? And secondly, the Gecko product, it sounds like is this completely serverless? And is it a development platform also? Thanks.
Tom Leighton: Yes. So I think one platform really in terms of being able to do everything together and all the same software so that we have our Edge software running with the Linode software to spin up VMs and containers that's not until 2025. We are, first, combining the infrastructure and of course, customers can buy the services as a package. We have common reporting now in many cases. But in terms of doing all the automatic spinning up and truly serverless used for VMs and containers, think 2025 for that. And let's see. So -- and what was the other question you had?
Timothy Horan: So the new product, Gecko, it is primarily a serverless product, it sounds like. And do you have all the support there for developers to completely run their applications on this new platform?
Tom Leighton: Yes. And it's -- it depends how you define serverless, initially with Gecko, you would operate it the same way you would Linode. You decide how many VMs and containers you want in the various cities. And it is very developer-friendly, works just like Linode. So if you're familiar there, that would now work in -- well, at the end of the year, 100 cities for your virtual machines. Now if you define serverless to be -- which doesn't exist today out in the marketplace for VMs and containers, they just spin up automatically like we do today for Function as a Service and for JavaScript, that's what comes 2025.
Timothy Horan: If you don't mind me asking me, it sounds a lot like what Cloudflare is doing, but you're saying it doesn't exist today. Tom, can you maybe talk about a little bit what's different, what you're doing?
Tom Leighton: Yes, that's a great question. They don't support VMs or containers at all, never mind serverless or anything else, just -- they don't have support for that. They don't do this full stack cloud computing.
Timothy Horan: Got it. Thanks a lot.
Operator: The next question comes from Alex Henderson of Needham. Please go ahead.
Alex Henderson: Great. So it seems pretty clear that Guardicore is a critical piece of your security growth. And obviously is perturbing the overall growth rate. I was hoping you could give us some sense of what the security product lines, excluding Guardicore look like in terms of their growth rates. Any sizing of that growth would be even a ballpark would be quite helpful. And then second, I was hoping you could talk a little bit about your -- you mentioned inferencing, but I think it came in kind of as an afterthought as opposed to the primary focus. Can you talk about your involvement in AI inferencing at the edge and to what extent that requires either the 2025 kind of structure or what needs you have there and whether you're putting GPUs out of the edge in order to facilitate that?
Tom Leighton: Ed, do you want to go with the first one, and I'll take the second one?
Ed McGowan: Sure. Why don't I go to the first one? On the spirit of it being a year-end call, I'll break out these numbers at a high level for you, but won't be doing it every quarter. So if I look at the -- what we used to -- what we call the Appen API security bucket, that's our largest bucket, that includes bot management, our fraud products, our web app firewall, our new API security product. That's actually in Q4 growing over 20%. So that's been incredible. Guardicore itself, if I normalize for the onetime software that we did last Q4 is growing at about 6%. And infrastructure and services are growing sub-10%.
Alex Henderson: Just to be clear, is this the full year growth rate? Or is this the fourth quarter growth rate?
Ed McGowan: This is the fourth quarter growth rate. The full year I don't have [indiscernible].
Alex Henderson: That's sufficient. I just needed to know what it was.
Tom Leighton: Okay. Yes, in terms of the question around inferencing and AI and so forth, yes, we're building full stack compute to have great performance at a lower price point and have that available in hundreds of cities. And one of the many things that you would do with that is AI inferencing and that's not an afterthought. In fact, we've been using AI in our products for, well, 10 years, bot management, for example, runs on Akamai connected cloud. It's one of many things that run on it. So not an afterthought. There is an enormous amount of buzz now about AI. And I think a lot of that is justified. And I think there's a lot more compute going to be consumed because of AI. And it is a strong use case among our customers that are using Akamai connected cloud. That said, it's not all AI. In fact, our biggest customers are doing media workflow, doing live transcoding. And that's not using AI. So I think AI is an important use case, one of several use cases. Now in particular, you asked 2024 versus 2025 it's being done already on our platforms. There's no need to wait until the end of the year unless you want to do it in 100 cities, then that comes at the end of the year. No need to wait to 2025 when the instances are spun up automatically instead of by design ahead of time the way compute works today. So you talked about GPUs. Akamai has GPUs deployed, we're deploying more. We've used them in the past for graphics. And going forward, probably use them for Gen AI uses. We're not really deploying them right now in the edge pops. And that's not -- it just because you don't need to. It's not cost-effective. And the edge pops, you're going to be doing the inferencing. And for the inferencing, you can use GPUs, but we're also using CPUs. And right now, we get a better ROI on the CPUs. So I guess there's a lot of confusion there as well. Now GPUs are critical for doing training for especially large language models and that's going to be done in the core and we're not supporting that as a key use case today. We could, in theory, right, we have all the technology to do it, but that's not where we're focused in terms of getting the best ROI for our platform. And for that matter, most of the work with these models, most of the compute is done when you're using them for the inferencing. You do the training, and then you spend -- just so it learns you get it ready to go, and then you operate it. And it's the operation where most the vast majority of the cycles are and that can be done on CPUs. And in many cases, the cases I mentioned, for a personalization for security, for data analytics, that's done on the edge more as good reason to be done there using CPU-based hardware.
Alex Henderson: Great. Thanks for the complete answer.
Operator: The next question comes from Jonathan Ho of William Blair. Please go ahead.
Jonathan Ho: Hi, good afternoon. Just one question from me. How important is the global load balancing capability? And what does that maybe mean for your ability to either attract more customers or to drive revenue from that product? Thank you.
Tom Leighton: Yes, that's very helpful because it makes it much more scalable. You have failover, so much more reliable. And I think it's the basic capability, of course, we've had forever, it seems in delivery of security, and now that's available for compute. So I think that's important and that greatly increases the market we can go after for compute.
Jonathan Ho: Thank you.
Tom Leighton: And operator, we have time for one last question.
Operator: Our last question will come from Rudy Kessinger of D.A. Davidson. Please go ahead.
Rudy Kessinger: Hey thanks for squeezing me in guys. Ed if my math is correct, even if I exclude the $100 million in CapEx and compute last year, intended for moving over internal workloads between last year and this year, it looks to be about $400 million in compute CapEx. And going back to that kind of $1 in CapEx equals $1 of revenue capacity, $400 million in CapEx, roughly $200 million of compute growth 2024 versus 2022. Do you feel like you guys are maybe over building at all? Or what gives you the confidence, I guess, in the pipeline and the ramping usage to spend so much on another round of build-out this year when we're not yet seeing growth accelerate, right? You're guiding to 20% growth next year that's flat with Q4.
Tom Leighton: Yes. So I'll just -- let me address that part first. So I would say if you look at the underlying components of what's growing, it's actually that enterprise compute opportunity that's growing very, very, very fast, like those numbers, the percentages would be kind of foolish to break out because they're going off of small numbers and adding to them very big numbers. Now also part of our strategy is to be competitive and have big core centers in many cities, and that does require a larger build out. So there's a lot of capacity that we have to sell. And then also, we're seeing demand in certain cities, you have to build out more capacity where you're getting demand. And then the Gecko sites that we're building out, it's not a significant -- I mean it's a decent amount of capital. But I think that is another big key differentiator for us. And as Tom mentioned, we think there's a big opportunity there. So I know a lot of people have been questioning us being able to take on large workloads, etcetera. We clearly have a lot of capacity out there. As I talked about earlier, we've made the change with our compensation plans where our reps now have to sell compute. So we're going to see a lot more of that. We've done a tremendous amount with the platform in terms of adding functionality. We built out the platform, connected it to our backbone, and we have a lot of new compute partners. The platform is ready to be sold so we're pretty optimistic about it. And I think we're building in a pretty responsible manner. As I talked about, our CapEx is relatively modest for this business right now. So I think we're in pretty good shape.
Tom Leighton: And with that, that will end today's call. I want to thank everyone for joining, and have a great evening.
Operator: The conference has now concluded. Thank you for attending today's presentation, and you may now disconnect. | [
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{
"speaker": "Tom Barth",
"text": "Thank you, operator. Good afternoon, everyone, and thank you for joining Akamai's fourth quarter 2023 earnings call. Speaking today will be Tom Leighton, Akamai's Chief Executive Officer; and Ed McGowan, Akamai's Chief Financial Officer. Please note that today's comments include forward-looking statements, including statements regarding revenue and earnings guidance. These forward-looking statements are subject to risks and uncertainties and involve a number of factors that could cause actual results to differ materially from those expressed or implied by such statements. The factors include any impact from macroeconomic trends, the integration of any acquisitions and any impact from geopolitical developments. Additional information concerning these factors is contained in Akamai's filings with the SEC, including our annual report on Form 10-K and quarterly reports on Form 10-Q. The forward-looking statements included in this call represent the company's view on February 13, 2024. Akamai disclaims any obligation to update these statements to reflect new information, future events or circumstances, except as required by law. As a reminder, we will be referring to some non-GAAP financial metrics during today's call. A detailed reconciliation of GAAP and non-GAAP metrics can be found under the financial portion of the Investor Relations section of akamai.com. Before I turn the call over to Tom, I’d like to let everyone know that I have transitioned to Head of Akamai’s investor roles to Mark Stoutenberg. Many of you have met Mark over the past year, and I'm confident you will find him extremely helpful about all things Akamai. I'll be moving into another role internally, and want to thank Tom personally for bringing me into the Akamai culture 10 years ago. It's been a privilege to work with so many wonderful people, both here at Akamai, and of course, all of you externally. I wish you all happiness and good fortune. And now I'd like to turn the call over to Tom."
},
{
"speaker": "Tom Leighton",
"text": "Thanks, Tom. And thank you very much for the terrific job that you've done over the last 10 years at Akamai. It's truly been a pleasure working with you. And I'd like to join you in welcoming Mark as your successor. Turning now to our Q4 results, I'm pleased to report that ACMI delivered a strong finish to a very successful 2023. Fourth quarter revenue grew to $995 million, and non-GAAP operating margin was 30%. Non-GAAP earnings per share in Q4 was $1.69, up 23% year-over-year, and up 22% in constant currency. For the full year, revenue was $3.81 billion, and non-GAAP operating margin was 30%. Full year non-GAAP earnings per share was $6.20, up 15% year-over-year, and up 16% in constant currency. Security revenue in Q4 grew 17% year-over-year, and was up 18% in constant currency, contributing nearly half of our total revenue in the quarter. Security growth was driven in part by continued strong demand for our market-leading Guardicore Segmentation Solution, as more enterprises relied on Akamai to defend against malware and ransomware. Customers who purchased Segmentation in Q4 included one of the largest global tech firms in India, and a leading payment systems company based in Hong Kong that handles 15 million transactions a day. We've also seen strong interest in our new API Security Solution that we announced in August. Early adopters of this new solution include three major financial institutions, several major retail brands in Europe and North America, and a leading industrial automation company in Europe. Our customers are seeing the value of this new capability with several already paying over half $0.5 million per year for the service. Akamai’s API Security Solution also earned recognition from industry analysts in Q4. KuppingerCole named Akamai an overall industry leader in their API security and management leadership compass report. And Gartner validated our strong and expanded API capabilities in its market guide for cloud, web application and API protection. Turning now to cloud computing, I'm pleased to say that we accomplished what we set out to achieve last year in terms of infrastructure deployment, product development, jumpstarting our partner ecosystem, onboarding the first mission critical apps from some major enterprise customers, and achieving substantial cost savings as we moved our own applications from hyperscalers to the Akamai Connected Cloud. After launching Akamai Connected Cloud. After launching Akamai Connected Cloud last year, we rolled out 14 new core computing regions around the world, giving us a total of 25 overall. We also enhanced our cloud compute offering by doubling the capacity of our object storage solution and adding premium instances for large commercial workloads that are designed to deliver consistent performance with predictable resource and cost allocation. Also, our Akamai Global Load Balancer is now live. This integrated service is designed to route traffic requests to the optimal data center to minimize latency and ensure no single point of failure. Last year, we also amplified our go-to-market approach with our cloud computing partner program. The collaborative nature of the program provides a unique model for Akamai to engage with customers at a consultative level to deeply understand their requirements and pain points and to provide a complete solution leveraging the combined strength of the partner’s technology and Akamai's distributed compute platform. We've already partnered with several leading SaaS and PaaS providers and cloud data and processing platforms. We're very pleased with the progress that we've made thus far and are looking forward to adding more new partnerships in 2024. We've also begun to gain traction with some of our largest customers as they migrate mission-critical apps onto our cloud platform. For example, one of the world's best-known social media platforms spent approximately $5 million on computing services with us last year and they're already on a run rate to do more than double that this year. Two of the world's best-known software companies recently signed on and are already spending about a quarter of a million dollars per month on cloud computing with Akamai. In Q4, we also signed up a major global media measurement and analytics company and we displaced a hyperscaler when we signed Blu TV, the largest VOD streaming company in Turkey. The streaming customer told us that they found our platform to be simple to use, automated and intuitive, cloud agnostic for a smooth multi-cloud migration and affordable with very low egress cost, all backed by a trusted and reliable partner. In addition to exceeding our full-year cloud computing revenue goal of $500 million last year, we also derived significant cost savings by migrating several of our own applications from hyperscalers to Akamai Connected Cloud. Our bot manager and enterprise application access solutions were among the first to migrate. Together, these products are used by over 1,000 customers and they generate over $300 million in annual revenue for Akamai. But all that is just the beginning. Today, we're excited to announce the next phase of our multi-year strategy to transform the cloud marketplace, taking cloud computing to the edge by embedding cloud computing capabilities into Akamai's massively distributed edge network. Akamai's new initiative, codenamed Gecko which stands for “Generalized Edge Compute”, combines the computing power of our cloud platform with the proximity and efficiency of the edge to put workloads closer to users than any other cloud provider. Traditional cloud providers support virtual machines and containers in a relatively small number of core data centers. Gecko is designed to extend this capability to our edge pops, bringing full stack computing power to hundreds of previously hard-to-reach locations. Deploying our cloud computing capabilities into Akamai's worldwide edge platform will also enable us to take advantage of existing operational tools, processes, and observability, enabling developers to innovate across the entire continuum of compute and providing a consistent experience from centralized cloud to distributed edge. Nobody else in the marketplace does this today. In the latest implementation phase that we're announcing today, Akamai aims to embed compute with support for virtual machines into about 100 cities by the end of the year. We've deployed new Gecko-architected regions in four countries already, as well as in cities that lack a concentrated hyperscaler presence. These initial locations are listed in today's press release. Following that, we plan to add support for containers. And then, we plan to develop automated workload orchestration to make it easier for developers to build applications across hundreds of distributed locations. We've been conducting early trials of Gecko with several of our enterprise customers that are eager to deliver better experiences for their customers by running workloads closer to users, devices, and sources of data. Their early feedback has been very encouraging, as they evaluate Gecko for tasks such as AI inferencing, deep learning for recommendation engines, data analytics, multiplayer gaming, accelerating banking transactions, personalization for e-commerce, and a variety of media workflow applications, such as transcoding. In short, I'm incredibly excited for the prospects of Gecko as we move full stack compute to the edge. Turning now to content delivery, I'm pleased to report that Akamai remains the market leader by a wide margin, providing the scale and performance required by the world's top brands as we help them deliver reliable, secure, and near flawless online experiences. Our delivery business continues to be an important generator of profit that we use to develop new products to fuel Akamai's future growth. And it's an important driver of our security and cloud computing businesses, as we harvest the competitive and cost advantages of offering delivery, security, and compute on the same platform as a bundle. As we've noted in past calls, we're selective when it comes to less profitable delivery opportunities. And this is a discipline that we intend to maintain, and in some cases, increase in 2024. To be clear, we still aim to be the best in delivery for our customers. And we believe that our disciplined approach will benefit our business by allowing us to focus more of our investment in security and cloud computing, which are now approaching two thirds of Akamai's revenue and growing at a rapid rate. In summary, we're pleased to have accomplished what we said we would do in 2023. Our cloud computing plans are taking shape as we envisioned. Our expanded security portfolio is enabling us to deepen our relationships with customers. And we continue to invest in Akamai's future growth while also enhancing our profitability. Now I'll turn the call over to Ed for more on our results and our outlook for Q1 and 2024. Ed?"
},
{
"speaker": "Ed McGowan",
"text": "Thank you, Tom. I would also like to thank Tom Barth for his incredible service for 10 years as our head of investor relations. Now moving on to our results, let me start by saying that I'm very pleased with our fiscal 2023 year results, delivering $6.20 of non-GAAP earnings per share, capping off a year of double-digit earnings growth for our shareholders. Today I'll cover our Q4 results, provide some color regarding 2024, including some items to help investors better understand a few factors that will impact our upcoming results, and then close with our Q1 and full year 2024 guidance, starting with revenue. Q4 revenue was $995 million, up 7% year-over-year as reported and in cost and currency. We saw continued strong growth in our compute and security businesses during the fourth quarter. Our compute business grew to $135 million, up 20% year-over-year as reported and in constant currency. We continue to be very pleased with the feedback regarding our cloud compute offerings, and we are very optimistic about the early traction we are seeing from enterprise customers. Moving to security, revenue was $471 million, growing 18% year-over-year and up 17% in constant currency. Our security revenue continues to be driven by strong growth in our Guardicore Segmentation Solution, in our industry leading web app firewall, denial of service, and bot management solutions. In addition, and as Tom mentioned, we are encouraged by the early traction of our new API security solution. During the fourth quarter, we signed 17 API security customers, including 4 with annual contract values in excess of $500,000 per year. Our delivery revenue was $389 million, including approximately $20 million from the contracts we recently acquired from StackPath and Lumen. International revenue was $479 million, up 8% year-over-year, or up 6% in constant currency, representing 48% of total revenue in Q4. Finally, foreign exchange fluctuations had a negative impact on revenue of $4 million on a sequential basis and a positive $6 million benefit on a year-over-year basis. Moving to profitability. In Q4, we generated strong non-GAAP net income of $263 million, or $1.69 of earnings per diluted share, up 23% year-over-year or 22% in constant currency, and $0.07 above the high end of our guidance range. These stronger-than-expected EPS results were driven primarily by continued progress on the cost-saving initiatives we have previously outlined, and approximately $6 million in lower-than-expected transition services, or TSA costs, associated with the StackPath and Lumen contracts, as our services organization migrated the customers onto our platform much faster than we expected. Q4 CapEx was $143 million, or just below 15% of revenue. We were very pleased with our continued focus on lowering the capital intensity of our delivery business. This effort, along with our very strong profitability, enabled us to deliver very strong free cash flow results in Q4. Moving to our capital allocation strategy, during the fourth quarter, we spent approximately $55 million to buy back approximately 500,000 shares. For the full year, we spent approximately $654 million to buy back approximately 8 million shares. We ended 2023 with approximately $500 million remaining on our current repurchase authorization. Going forward, our intention is to continue buying back shares to offset dilution from employee equity programs over time, and to be opportunistic in both M&A and share repurchases. Before I move on to guidance, there are several items that I want to highlight in order to give investors some greater insight into the business. The first relates to our delivery revenue. In the first half of 2024, seven of our top 10 CDN customers' contracts come up for renewal. As we've discussed in the past, this type of renewal generally leads to an initial drop in revenue, and then we typically see revenue grow again as traffic increases over time. We have factored the expected outcome of these renewals into our Q1 and full year 2024 guidance. In addition, as Tom mentioned, we plan to continue to optimize our delivery business by focusing on how we charge certain high-volume traffic customers for their usage on our network, all with an eye on profitability. For example, we plan to start charging a premium for higher-cost delivery destinations. We expect to continue to optimize the ratio of peak to day-to-day traffic, and we plan to negotiate different pricing for API traffic versus download traffic. Choosing to shed some less profitable traffic will result in a more balanced and profitable approach to pricing, which we believe is the right strategy for the company. Second, OECD member countries continue to work toward the enactment of a 15% global minimum corporate tax rate. And in particular, in December 2023, the Swiss Federal Council declared the rules in effect for Switzerland beginning in 2024. As a result, we anticipate that our non-GAAP effective tax rate will increase by roughly 1.5 to 2 percentage points, to approximately 18.5% to 19%. We estimate this increase in our tax rate will have a negative impact on Q1 non-GAAP EPS of approximately $0.02 to $0.03 per diluted share, and a negative impact on full year non-GAAP EPS of approximately $0.12 to $0.15 per diluted share. The impact of this tax rate change has been factored into our Q1 and full year 2024 guidance. Third, we expect to generate significantly more free cash flow in 2024 compared to 2023 levels. This is primarily due to much lower capital expenditures in 2024, along with our continued focus on profitability. Please note that the full cost to build out our Gecko compute sites we announced earlier today is included in our Q1 and full year 2024 capital expenditure guidance. Fourth, I want to remind you of the typical seasonality we experience on the top and bottom lines throughout the year. Regarding revenue, the fourth quarter is usually our strongest quarter. Regarding profitability, in Q1 we incur much higher payroll taxes related to the reset of Social Security taxes for employees who maxed out during 2023, and from stock vesting for employee equity programs, which tend to be more heavily concentrated in the first quarter. It's also worth noting that in Q3, our annual company-wide merit-based salary increases go into effect, so we tend to see higher operating costs in Q3 compared to Q2 levels. Finally, for 2024, we anticipate heightened volatility in foreign currency markets, driven by the unpredictable timing and magnitude of Federal Reserve policy changes and their impact on interest rates. With this in mind, forecasting the trajectory of FX in the latter part of the year poses a formidable challenge. Thus, for the full year, we plan to provide annual revenue growth, security and compute revenue growth, non-GAAP EPS growth, non-GAAP operating margin, and CapEx only in constant currency based on 1231-2023 exchange rates. However, for the coming quarter, we will provide both as reported and constant currency guidance. As a reminder, we have approximately $1.2 billion of annual revenue that is generated from foreign currency with the Euro, Yen, and Great British Pound being the largest non-U.S. dollar sources of revenue. In addition, our costs in non-U.S. dollars tend to be significantly lower than our revenue and are primarily in Indian rupee, Israeli shekel, and Polish Zloty. Moving now to guidance. Our guidance for 2024 assumes no material changes, good or bad, in the current macroeconomic landscape. For the first quarter of 2024, we are projecting revenue in the range of $980 million to $1 billion, or up 7% to 9% as reported, or 8% to 10% in constant currency over Q1 2023. At current spot rates, foreign exchange fluctuations are expected to have a positive $2 million impact on Q1 revenue compared to Q4 levels and a negative $4 million impact year-over-year. At these revenue levels, we expect cash gross margin of approximately 73% as reported and in constant currency. Q1 non-GAAP operating expenses are projected to be $305 million to $310 million. We anticipate Q1 EBITDA margins of approximately 42% to 43% as reported and in constant currency. We expect non-GAAP depreciation expense of $127 million to $129 million. We expect non-GAAP operating margin of approximately 29% to 30% as reported and in constant currency for Q1. And with the overall revenue and spend configuration I just outlined, we expect Q1 non-GAAP EPS in the range of $1.59 to $1.64, or up 14% to 18% as reported, and 16% to 19% in constant currency. The EPS guidance assumes taxes of $56 million to $58 million based on an estimated quarterly non-GAAP tax rate of approximately 18.5% to 19%. It also reflects a fully diluted share count of approximately 155 million shares. Moving on to CapEx, we expect to spend approximately $146 million to $154 million excluding equity compensation and capitalized interest in the first quarter. This represents approximately 15% of total revenue. Looking ahead to the full year for 2024, we expect revenue growth of 6% to 8% in constant currency. We expect security revenue growth of approximately 14% to 16% in constant currency. We expect compute revenue growth to be approximately 20% in constant currency. And we're estimating non-GAAP operating margin of approximately 30% in constant currency. And full year CapEx is expected to be approximately 15% of total constant currency revenue, which again includes the Gecko compute buildup. We expect our CapEx to be roughly broken down as follows. Approximately 3% of revenue for our delivery and security business, approximately 4% of revenue for compute, approximately 7% of revenue for capitalized software, and the remainder for IT and facility related spend. We expect non-GAAP earnings per diluted share growth of 7% to 11% in constant currency. And as we mentioned earlier, this non-GAAP earnings guidance is based on a non-GAAP effective tax rate of approximately 18.5% to 19%, and a fully diluted share count of approximately 155 million shares. In closing, we are very pleased with a strong finish to 2023. We continue to be excited about our growth prospects and driving profitability across the business. Now Tom and I would like to take your questions. Operator?"
},
{
"speaker": "Operator",
"text": "[Operator Instructions] And our first question will come from Fatima Boolani of Citi. Please go ahead."
},
{
"speaker": "Fatima Boolani",
"text": "Thank you for taking my questions. Ed, I wanted to drill into the delivery, the segment performance and the guidance and some of the modeling points that you shared with us. I was hoping you could parse out for us some of the organic traffic trends you saw on the platform, parsed away from the traffic, from the acquired contracts between StackPath and Lumen. And then to the extent you can talk about any timeframe you have with regards to absorbing some of this additional acquired traffic from these contracts. And the last piece of the question here is also the guidance that we calculated to be down 6% for delivery in 2024, implied by your guidance, full year guidance. Can you talk to what proportion of that traffic that you would have deemed lower quality being peeled off is maybe the reason why we're not seeing a more sharper improvement in the delivery franchise. And then I have a quick follow-up. Thank you."
},
{
"speaker": "Ed McGowan",
"text": "All right, sure. Let me see if I can tackle all those for you. I'll start with the performance in Q4. So I'll break it down into a couple of buckets. So in Q4, we tend to see a stronger seasonal quarter for us. And we did see some of that. So from the retail customer perspective, we saw bursting roughly to the tune of about half of what we saw last year. And I think that has to do mostly with the zero overage. As that's become more popular, we are seeing less bursting. If I look back a few years, that's down above 50%, 22 compared to 21, and again, 23 compared to 22. Some of it could be macro factors, hard to tell. We're not really the best gauge for folks' consumption, but more they're surfing. If I look at gaming, gaming was a better year. If I look last year, gaming was pretty weak. This year, it was pretty good. Gaming tends to be fairly lower priced delivery, so you don't get as much upside in revenue. Video was up quarter-over-quarter, but not as much as we saw the prior year. So I would say kind of an okay fourth quarter from delivery. The one area that was probably the weakest was more in sort of high tech. So think about that as new connected devices, maybe it's connected TV or a new, say an iPad or something like that, printer drivers, that sort of stuff. That was much weaker than what we saw last year. Last year was a pretty good bump up in that category. So that really sort of sums up what the dynamics are in terms of the delivery business in Q4. And I looked at that, not including the acquisition traffic. The second question you asked, if I wrote it down correctly, was the absorption of the traffic from the acquisitions. We've largely done that. The services team did a phenomenal job migrating over the customers. We did it in probably about a third of the time that we had expected to be able to do that. There's still a few stragglers, but the transition services costs are immaterial. So that's why we didn't call that out. But that's largely been done. In terms of this year, why are we seeing a down 6% if that's the math you're using for delivery? A lot of it has to do with the renewals. Unfortunately, these larger customers, as we've talked in the past, we only have about eight customers that are greater than 1% of revenue. And unfortunately, seven of them are renewing in the first half of the year. That does have a bit of an impact on the delivery business. The majority of the revenue from those customers comes from delivery. We've seen this in the past. It seems like every two years, we kind of bump into this. Even though we try to sign staggered contracts, what happens often is someone might sign a two or three year deal with a revenue commit. They'll spend that in a shorter period of time. And we just get a combination of renewals here. And then the other thing was on the shedding of traffic. So let me just get a little bit more specific with what we're doing. So last year, if you remember, we talked about being a bit more stringent with the peak to average ratios. And we're going to continue to do that. We did a pretty good job. There's still a few customers we need to adjust. And that generally happens where customers will split and they have lots of day-to-day traffic and they might split that among three or four CDNs. And then they'll have peak events, whether that's a big video event or a big download event. And we get the disproportionate size of that peak. So you want to make sure you're compensated for that. So the way to do that is you get a higher percentage of the day-to-day or you just limit the peak. So we'll continue doing that. And sometimes that may mean we lose a little bit of traffic, but that's okay because you can see the results in CapEx. The new thing that we're doing now is we've worked with product and IT to enable us to be able to build for very granular level on destinations. In the past, we generally would build based on large geos, say for example, a large geos, say for example, the U.S. or Europe or Asia. Now we're able to get one level deeper. And so we can go after some of the areas where our costs are a bit higher to deliver. It's unclear. We're assuming that customers have choice. They may decide to take that traffic somewhere else. Some of our competitors don't really focus as much on profit as we do. If that's the case, then that's okay with us. So I think as we tried to factor all that in, those are the two driving factors as to why we're not seeing a better delivery performance in 2024. I think I hit all your questions."
},
{
"speaker": "Fatima Boolani",
"text": "You did. Super comprehensive. Thank you. And an easy one, just on gross margins, you gave us the guidance for cash gross margins on the first quarter. But just qualitatively, if you can talk to us about some of the puts and takes at a full year level as we think about the mix of business changing, your focus on pricing discipline, and just even a U.S. international mix, any sort of puts and takes in terms of the dynamics we should be thinking about COGS and cash gross margins for the full year. And that's it for me. Thank you."
},
{
"speaker": "Ed McGowan",
"text": "Sure. No problem. In terms of the cost of goods sold, I'll start with the good stuff that's going on in cost of goods sold. Obviously, you touched on the mix. So as we get a higher degree of security business, that obviously helps our gross margin line. And the second thing is the movement of our third-party cloud costs onto our own platform. We did a great job so far this year. Tom talked a bit about that in his prepared remarks. And we have more to go, and we have a roadmap to get that. So that'll drive some significant savings. The downside or what's sort of contracting them or not expanding the margins as much, I should say, we could be going a bit higher, is that with the build of the Gecko sites, we'll incur some additional co-location costs. So as we start to build out those facilities, you don't have revenue to go against it. But also, as I talked about last year, when we built out some of the bigger sites, with the accounting rules, when you do long-term Colo commitments or any kind of a commitment for long-term leases, you have to straight line any commitment. So we end up with a bit of a disconnect between what we're paying in cash and what we're actually expensing. So we're able to offset that with the savings we get from the third-party cloud in the mix, but those are the underlying dynamics."
},
{
"speaker": "Fatima Boolani",
"text": "Thank you so much."
},
{
"speaker": "Operator",
"text": "The next question comes from Frank Louthan of Raymond James. Please go ahead."
},
{
"speaker": "Frank Louthan",
"text": "Great. Thank you. How different is Gecko from what you're doing now with Compute? Is this a new packaging of some of your products, or is it something a little different? And then secondly, of the CDN business that you acquired last year, how much are you expecting that to fall off? I think the goal was to try and get it out to some other services, but what are you factoring in there at that time?"
},
{
"speaker": "Tom Leighton",
"text": "Yes, I'll take the first question. Yeah, Gecko is not packaging. Gecko is a new capability where we're going to be offering full-stack compute in 100 cities by the end of the year, and ultimately in hundreds of cities. We're actually taking full-stack compute, the kinds of services you get in Linode or a hyperscaler, and making that available in our edge pops. Now today, the edge pops, we have 4,000, and they run function as a service. We'll spin up JavaScript apps in 4,000 locations in over 700 cities in milliseconds based on user demand, but that's not full-stack compute. Now we're going to be taking virtual machines and containers and supporting those in our Edge platform, and that enables our customers to get much better performance and scalability, also lower cost because of the financial benefits we get from our edge platform. So it really becomes, I think, a very compelling cloud computing offering that just doesn't exist in the marketplace today. It's not a packaging thing at all. This is a new capability, and of course, ultimately, after we get the support for VMs and containers, we want to make it work just as we do function as a service, so that we'll be spinning up containers and VMs on demand where and when they're needed, and that capability doesn't exist today in the market. Ed, you want to take the CDN question, the acquisition?"
},
{
"speaker": "Ed McGowan",
"text": "Yes. Sure, happy to do that. Hey, Frank. Yes, I would say, just as a reminder, when we acquired the businesses, we actually acquired selected customers. What we mean by that is we actually went through and we left some customers that we weren't going to take. For example, if someone violated our acceptable use policy, really small customers, and then, believe it or not, some that had pricing that we just didn't want to take. So we had already gone through sort of a selection process. If you recall, I had given guidance last quarter of about $18 million to $20 million for this quarter, and we hit the high end of that range, which I'm happy that we did. So we've largely been able to migrate over everything that we had hoped to. There's a few customers that churned, but by and large, we've gotten everything out of that acquisition or those acquisitions, I should say. There were two of them that we had hoped to."
},
{
"speaker": "Frank Louthan",
"text": "Okay, great. Thank you very much."
},
{
"speaker": "Operator",
"text": "The next question comes from James Fish of Piper Sandler. Please go ahead."
},
{
"speaker": "James Fish",
"text": "Hey, guys. First, just Tom Barth. Look, you've been a class actor and appreciate all the help over the years, and just wanted to echo Tom Leighton and Ed's sentiment there. I really appreciate the help over the years. I want to circle over to security, actually. Look, security was a little bit lower than I think we were all anticipating for Q4. I get that we have some drivers underneath that are helping the business, but did you see any push out of deals and maybe that's contributing to your confidence around mid-teens growth for 2024? Help us on the confidence for sustained mid-teens growth, and really how is that selling outside the install base and penetration of those new security packages going?"
},
{
"speaker": "Ed McGowan",
"text": "Hey, Jim. This is Ed. Yes, I was actually pretty pleased with our performance and didn't see many deals push out. We didn't have any large license deals like we did in Q3, so that might be -- that always skews some of the results, so we didn't have any of that. But no deals that really pushed out from a security perspective. Very pleased with what we're seeing with Guardicore continued great growth there. That's been phenomenal, and that's a lot of customers are being driven new verticals and things like that. The channel's been doing phenomenally well there. We talked a lot about in our prepared remarks, API security. I don't get surprised often, but I've been surprised with the ARPUs there. I've been very pleased with that. That's been very, very good to see. And the strength in – we talked about the bundles that we had done a lot on the last call. That's continued to go very well, and we're seeing very strong growth in our WAF and our fraud products, too, bot management and our fraud protector. So really strength across the board. Nothing so far from macroeconomic challenges. That always can change. You never know what can happen, but nothing that we saw in Q4. As far as the projections for this year, we feel pretty confident. We've generally been relatively conservative with our approach to security growth. We don't factor in any major type of attacks where sometimes we'll see a spike in demand or anything like that. So we feel pretty good with how security's going."
},
{
"speaker": "Tom Leighton",
"text": "Maybe just to click down one level into Fatima's earlier question on the CDN side, and something that Tom said as well in his prepared remarks, is there any way to understand how much on the CDN side of the base you plan to essentially -- I don't want to say give away for free, but give away for free to get that compute revenue or help us understand kind of the dynamic between what we should expect between CDN and compute kind of dollar shifting. Thanks, guys."
},
{
"speaker": "Tom Leighton",
"text": "Yes. I think you can't factor in any percentage there at this point. We have been in some discussions with some very large media companies where we would offer discounted or free delivery in return for a significant portion of the compute business. On balance, that would be a great trade for us, much more profitable and much more revenue, because at the end of the day, big media companies will spend 10x on compute what they'll spend on delivery and even security. This is something that we see the hyperscalers do. They will sometimes give away the delivery in return for getting the compute business, because that's where the vast majority of the revenue is and very profitable. We'll keep you advised as we go if that starts to make a material difference."
},
{
"speaker": "Operator",
"text": "The next question comes from Keith Weiss of Morgan Stanley. Please go ahead."
},
{
"speaker": "Keith Weiss",
"text": "Excellent. Thank you, guys, for taking the question. This is one for Ed. Throughout 2020, we talked a lot about savings initiatives. We talked a lot about migrating workloads to internal cloud and that yields savings. I got to say, just to put it bluntly, it kind of disappointing about the lack of margin expansion in the sky. Is there something holding that back or is there some incremental investments perhaps behind Gecko that we're making instead of that? Or meeting a bunch of questions like, why not more margin? Given all the efficiency sort of improvements that you guys have been putting in for the past year?"
},
{
"speaker": "Tom Leighton",
"text": "Yes, I'll take this one, Tom. You broke up a little bit there, Keith, but I think I got the genesis of the question. So yes, we've done, I thought, a great job of making some acquisitions over the last few years, investing in a compute business, spending an awful lot to build out our compute facilities, adding a lot of functionality, growing our security business, doing acquisitions there as well. And got back to 30% margin last year and continuing this year. We've always said that's been a pretty healthy spot to run the business. We're investing because we see opportunity for growth and there's always a balance. You can't cut your way to greatness. Perhaps we could cut a few more points, but then what are we leaving on the table? I think we've been pretty disciplined and balanced with our approach in terms of investing for growth and returning to margin. We've got some pretty exciting areas. We're seeing great growth in API security. It's still early days there. The product will continue to get better. We've seen good ARPUs there, so I'm very excited about what we're doing there. We've made investments in go-to-market and Guardicore, and that certainly has paid off. And the investments in Computer Stein has shown some early returns. So again, it's a balanced approach. We're in this for the long-term, and I think we don't want to shoot ourselves in the foot and not go after some of these big opportunities that we have in front of us."
},
{
"speaker": "Keith Weiss",
"text": "Got it. That's clear."
},
{
"speaker": "Tom Leighton",
"text": "Thank you."
},
{
"speaker": "Operator",
"text": "The next question comes from Mark Murphy of JPMorgan. Please go ahead."
},
{
"speaker": "Mark Murphy",
"text": "Thank you very much. So, Tom, you've done a very solid job with the compute business. And in the prepared comments, you mentioned onboarding of submission-critical apps. I'm wondering if you could shed a little light on the pipeline of that kind of critical app that you see coming to you in 2024 and thus far. How well is your infrastructure handling the intensity of those larger workloads in terms of stability, reliability, uptime, etc? And then I have a quick follow-up."
},
{
"speaker": "Tom Leighton",
"text": "Yes. So, signing on compute customers is a big focus for us this year. We have the basic infrastructure in place. Of course, now we're building out Gecko. But just with the basic infrastructure already in 25 cities, we'll be looking to add on many more mission-critical apps from major enterprises. And some examples, you look at social media, live transcoding. We now have two giant companies using that on the platform, one for live sports broadcasting, another for live user-generated content. Another customer, we're hosting e-commerce sites for them in a way that performs better because closer to the end-user and less expensive. AI inferencing for ad targeting, personalizing content. And again, you want to do that really fast. And you just don't have time to backhaul that up into a centralized location. You want to be in a lot of locations around the world to get better performance. And again, we can do it at a lower cost. We've even got a large, one of the world's largest banks now using us, our edge compute, to register credit cards, their user credit cards with Apple Pay because Apple Pay requires you do the registration in 60 milliseconds. And the only way they can get that done fast is to do it on Akamai Connected Cloud. So really, a lot of different applications already on the platform, doing proofs of concept now. So the focus this year, and I think it's a good pipeline, is to be taking on many more mission-critical apps for major enterprises. And of course, we're the first big one. We've got enormous applications already running on the platform and very successfully. And we do it in a multi-cloud way. And as I talked about earlier, now we have the global load balancing built in, the failover capability, so that it does make for a reliable service that's high-performing. So really excited about what's coming this year."
},
{
"speaker": "Mark Murphy",
"text": "Yes. It's great to hear the tie-in with the inferencing and Apple Pay as well. So I appreciate the color of that. Ed, I wanted to ask you, you're providing the fiscal year guidance in constant currency and, of course, we all understand it's going to be very difficult to predict the actual fluctuations in the spot market, but if we looked at it at current FX levels, do you think it would skew that 6% to 8% revenue growth level higher or lower? If we were to try to translate it into reported U.S. dollars in our models right now today?"
},
{
"speaker": "Ed McGowan",
"text": "Yes, good question. I think the CPI report today gave you a good view of how things can change so quickly. The market originally had thought there'd be a lot of rate cuts and now all of a sudden that doesn't look like it's going to happen and obviously currencies and interest rates are very closely aligned. So if you look, I gave you the 1231 number, so obviously the dollar has gotten a bit stronger. I gave you the numbers in terms of the total non-U.S. dollars, so you can kind of do some math. It would still be in that range. Obviously, it'd be a little bit of a headwind just given that the dollar's gotten stronger since 1231, but I think you can take our Q1 guidance and sort of fold that in and think about the normal seasonality that you have and come up with an answer. But it would still be in that range, though."
},
{
"speaker": "Mark Murphy",
"text": "And just to clarify, so it's still in that 68% range if we put it into USD or are you saying it's still kind of mid-single-digit, but maybe some like a point lower?"
},
{
"speaker": "Ed McGowan",
"text": "Well, no, I mean, if you're using spot rates as of today, the simple math would suggest that it is, yes. If you looked at, just take the midpoint of the guide, right? Just say if I just use that and what the impact of the dollar has been, it's still in that range. Now, you would ask, could it be higher? Obviously, the dollar was at 101 back at 1231. It was at 106 in November, and so it's bouncing all over the place. Obviously, if it were to move, you can do the math, five or six points lower, you could potentially get on the other side of that. So, again, it's just I'd be end up giving you guys a massive range that wouldn't be helpful. So what I'd rather do is just give you guys the tools that you can do it yourself and look at, really get an understanding of the core business underneath that. How is that? I think it's much more important to understand."
},
{
"speaker": "Mark Murphy",
"text": "Understood. Thank you very much. And I want to also thank Tom Barth for a lot of great interactions over the years."
},
{
"speaker": "Operator",
"text": "The next question comes from Madeline Brooks of Bank of America. Please go ahead."
},
{
"speaker": "Madeline Brooks",
"text": "Hi, team. Thanks so much for taking my question tonight. Just one on security. Outside of Guardicore, I just want to touch on this year, the rest of the Zero Trust portfolio trends that you've seen and maybe if you're feeling any additional competitive pressure now that the market has really expanded there? And then I have one follow-up."
},
{
"speaker": "Tom Leighton",
"text": "Yes. In Web App Firewall, we've been the market leader there, for 10 years since we started that marketplace with Web App Firewall as a service. And after 10 years, you do get, competition. But we're still the market leader by a good margin. And that's a good growth business for us. We've added a lot of capabilities on top, bot management and more recently, account protector, client side protection so that customers of commerce sites can stay safe by going to the site. You need going to need that now for compliance. There's a brand protector. So that's identifying the phishing sites and keeping them from stealing, user information. Of course, we've been doing, denial of service protection for a long, long time now. Market leadership position there. And then you have on the enterprise side, of course, Guardicore we talked about doing very well. And I'm really excited about API security. I think over the longer term, that becomes as big a marketplace and just as important as Web App Firewall has become. And our goal there is to become the market leader. And already in the go-to-market motion, there's a strong synergy between Web App Firewall and API security. We built a very easy way to do a proof-of-concept for our Web App Firewall customers. And that's where we're getting a lot of early traction. Also, we've integrated with a lot of the load balancers and other firewalls out there so that we can sign on new customers who are, not using my CDN or Web App Firewall. So I think, there's a variety of areas in security that are working very well for us."
},
{
"speaker": "Madeline Brooks",
"text": "Thanks so much, Tom. And then just one quick one on compute, too. I think if we think about earnings that have happened so far, especially with hyperscalers like AWS, Microsoft, Meta, we've kind of heard of this theme of the optimization inflection in terms of cloud computing, meaning maybe this year we're going to see a little bit more investment in new workloads. I'm just wondering if you've heard of any of those trends among your customers who are thinking about compute for the first time, or maybe if you're seeing increased appetite for compute for this coming year versus 2023. Thanks so much."
},
{
"speaker": "Tom Leighton",
"text": "Yes, compute is an enormous marketplace and growing rapidly, and there's always new applications that are being created, and not just migrating from a data center into the cloud, but just brand new applications. So that's where we're seeing a lot of traction. Also, in some cases, lift and shift out of a data center or out of a hyperscaler. But it's just an enormous marketplace and a great place for us to operate. And even those that are optimizing, that's sort of, I guess, not such a great thing for the hyperscalers, but we're part of that trend. It's great for us, because we can help customers reduce cloud spend. And we've gotten very good feedback from our early adopters of Akamai Connected Cloud that they're saving a lot of money. So the trend to optimization is a positive thing for Akamai."
},
{
"speaker": "Operator",
"text": "The next question comes from Rishi Jaluria of RBC. Please go ahead."
},
{
"speaker": "Rishi Jaluria",
"text": "Wonderful. Thanks so much for taking my questions. And let me echo my colleagues in thanking Tom Barth. It's been a great decade working with you, and I'm really excited for your next chapter. I wanted to drill on to maybe going back to Gecko. I guess, number one, can you talk a little bit about edge inferencing and what those use cases look like? It's one of those things that we hear a lot of talk about in theory, but maybe in practicality as you're talking with your customers and having those conversations, what can that look like? And what positions Gecko uniquely for that? And then maybe financially, to the extent I know it's still early, are you assuming real Gecko contribution on the compute line in your guidance for the year? Or is that something that as it gets traction could lead to more upside beyond what you model? Thank you."
},
{
"speaker": "Tom Leighton",
"text": "Great. So let me start with edge inferencing. And so some of the examples I gave, that's exactly what's happening for commerce sites in figuring out in real time what content you're actually going to give to the user that's coming to the site. Ad targeting, what ad do they get? Anything that involves personalization. On the security side, a ton of inferencing is used to analyze real-time data. For example, even our own bot management solution. Is that entity that's coming to the site, is it a bot or is it a human? And even if it's a human and they have the right credentials, is it the right human? And you use AI and inferencing for that, and you've got to do it really fast. You can't afford to send it back to the centralized data center because you've got a massive number of people that you've got to process in real time, especially if you're doing some kind of live event. And so being at the edge matters, because you can be scalable, you can handle it locally, you get great performance, you can make it be real time. And Akamai's unique value proposition with Gecko is that we're going to be able to now support this, not in a few cities, but in a hundred cities by the end of this year. So anything you can put in a VM, virtual machine, which is most things, you're going to be able to do that in a hundred cities. And then ultimately in hundreds of cities, because we can put this in general Akamai Edge pods. And then next will be containers, which is pretty much the rest of what you do in cloud computing. And then to be able to spin it all up automatically. It's a whole new concept for compute that I think is very powerful, and there's a high overlap of wanting to do that with inferencing engines, where you're trying to do something intelligent based on that end user or that end entity that's interacting with the application. Now, in terms of Gecko, we're just now in the early stages of getting it deployed. We're in nine cities, we'll get the 10th new city up in another month or so. By the end of the year, we'll be in a total of a hundred cities supporting compute. So not a lot of revenue is factored into the guidance based on Gecko for this year. That would come more next year. So this year's revenue guidance is based on the original 25 core compute regions that we've set up by the end of last year. Now we will deploy this, of course, just as fast as we can and as customers want to adopt it. And hopefully we have the situation where we want to build out more, get more compute capacity because there's so much demand for compute on Akamai. Ed, do you have any color you want to add around the guidance there?"
},
{
"speaker": "Ed McGowan",
"text": "No, I think you captured it right, Tom. We don't, we're not really anticipating anything. I mean, one thing we are doing this year is we are making changes to our comp plan with our reps so that they're all, all have to sell compute this year. So you could see things, reps get very creative. I learned in sales that comp drives behavior. So by leaning in here and making it something that all reps have to do, we should see a lot more use cases, a lot more opportunities, etcetera. So there's always a chance that we could be surprised here with the creativity of our field bringing us opportunities, but we did not factor in anything material as it relates to Gecko."
},
{
"speaker": "Rishi Jaluria",
"text": "All right, wonderful. Thank you so much, guys."
},
{
"speaker": "Operator",
"text": "The next question comes from Michael Elias of TD Cowen. Please go ahead."
},
{
"speaker": "Michael Elias",
"text": "Great. Thanks for taking the questions. Two, if I may. Just first on Gecko, presumably the pops that you have, they're already supporting security and delivery workloads. So from an architecture perspective, can you help us think about what expanding the compute platform into these pops means? Is it just additional co-location deployments and on the CapEx side, networking gear and servers? Any color that you could give there in terms of the mechanics of what the expansion would look like? And then second, Ed, last year you were talking about elongation of enterprise sales cycles. Just curious what you're seeing in terms of the buying behavior of your customer base. Any notable call-outs there? Thank you."
},
{
"speaker": "Tom Leighton",
"text": "All right. So I'll take the first one. With Gecko, that is generally speaking an existing Akamai Edge pops. And in particular, they tend to be the larger ones where we already have a lot of equipment. It's already connected into our backbone. And what we'd be doing is adding additional servers. And for compute, it would be a beefier server and additional COLO for those servers. But all the other infrastructure is generally already there. And it's already connected in and we already have delivery and security operating there. So it does become a very efficient way for us to deploy Gecko. And Ed, you want to take the second one there?"
},
{
"speaker": "Ed McGowan",
"text": "Sure. Yes. So I think the trend, obviously, acquiring new customers is always challenging in an environment like this. The one probably exception to that is in the security space. That tends to be something that obviously, now with the requirements with the SEC reporting and I added a disclosure with CISOs being now potentially criminally charged for breaches and things like that. Audit Committee is spending more and more time on cybersecurity as a topic. That tends to be a budget that, one, you don't typically cut and, two, you're generally adding to. But yes, new customers are challenging. I do think this kind of environment helps us what we were just talking about in the last few questions, around optimizing cloud spend. Certainly, if you've seen what we've done, we've spent [ph] a tremendous amount of money. So I think that can also help us in this particular environment. But definitely, new customer acquisition is a bit more challenging, but we're still doing pretty well. Obviously, the environment can change. But it hasn't been a major factor for us yet."
},
{
"speaker": "Michael Elias",
"text": "Great. Thank you"
},
{
"speaker": "Operator",
"text": "The next question comes from Ray McDonough of Guggenheim Securities. Please go ahead."
},
{
"speaker": "Raymond McDonough",
"text": "Great, thanks for sneaking me in. Maybe, Tom, just a follow-up to a prior question. As we think about Gecko and you mentioned that your edge sites right now don't have full stack compute. But how much work is done to be to converge what you already have at your edge sites and what you've done in terms of building out the nodes capabilities? Should we expect there to be a common software stack across both edge and centralized sites? And if so, is the plan to have that in place by year-end?"
},
{
"speaker": "Tom Leighton",
"text": "Yes. Great question. So what we're doing now is, as I mentioned in the last question, deploying more hardware in existing edge region and generally the larger edge regions. We already have network there. We already have delivery security located there. So there's some additional color and servers. And yes, the goal is to put it all on one common software stack. Now initially, we have the Linode stack is moving into these edge pops for Gecko. But as we once we get the support for virtual machines and containers, then next, we want to add the software stack that we have for delivery and for security and for function as a service that automatically, for example, spins up JavaScript apps and milliseconds based on end-user demand, we want all of that to be operating on containers and VMs. So that you don't have to think ahead of time about how many VMs do you want in each of these hundreds of cities? It just happens based on end user demand. You automatically get new ones spun up, load balancing, fail over, really a very compelling concept. And that doesn't exist in the cloud marketplace today. That is the vision -- I think you really nailed it when you talked about the common software stack because only Akamai has that full edge platform today, that software stack around delivery and security that will be now including compute."
},
{
"speaker": "Raymond McDonough",
"text": "Appreciate that color. And maybe as a quick follow-up, as we think about the expansion of the Linode footprint last year, can you help us understand as much as you can, how much of the space currently built out was for internal use purposes to help with that third-party cloud savings versus space that's online now that's revenue generating? And I know we've talked about this in the past, but any color around what we should expect from a customer utilization perspective that might be embedded in your guidance as we move through year-end? That would be helpful."
},
{
"speaker": "Ed McGowan",
"text": "Yes, sure. So the majority of the growth in the compute guidance is going to come from enterprise compute. So the stuff that we built out for the last year. So if you kind of go back and look at the math in terms of -- we've kind of said roughly speaking, $1 of CapEx is $1 of revenue. You can kind of look at what we're doing for compute build-out now what we did last year. We said we got about $100 million roughly for our -- all in for our internal use. So that leaves a pretty significant amount left for customer demand. Now obviously, the way people buy today, they pick a location, etcetera. So it's not going to be exactly a dollar for dollar right now, but it's a general rule of thumb. So I would say the majority of what we built out is for customer usage."
},
{
"speaker": "Raymond McDonough",
"text": "Great. Thanks for sneaking me in. Appreciate it."
},
{
"speaker": "Operator",
"text": "The next question comes from Tim Horan of Oppenheimer. Please go ahead."
},
{
"speaker": "Timothy Horan",
"text": "Thanks guys. Following up on Ray's question. So I'm assuming the goal here is to get to one single platform where customers can access the full range of services relatively easily on, I guess, one on ramp up. When do you think you'll get there? And secondly, the Gecko product, it sounds like is this completely serverless? And is it a development platform also? Thanks."
},
{
"speaker": "Tom Leighton",
"text": "Yes. So I think one platform really in terms of being able to do everything together and all the same software so that we have our Edge software running with the Linode software to spin up VMs and containers that's not until 2025. We are, first, combining the infrastructure and of course, customers can buy the services as a package. We have common reporting now in many cases. But in terms of doing all the automatic spinning up and truly serverless used for VMs and containers, think 2025 for that. And let's see. So -- and what was the other question you had?"
},
{
"speaker": "Timothy Horan",
"text": "So the new product, Gecko, it is primarily a serverless product, it sounds like. And do you have all the support there for developers to completely run their applications on this new platform?"
},
{
"speaker": "Tom Leighton",
"text": "Yes. And it's -- it depends how you define serverless, initially with Gecko, you would operate it the same way you would Linode. You decide how many VMs and containers you want in the various cities. And it is very developer-friendly, works just like Linode. So if you're familiar there, that would now work in -- well, at the end of the year, 100 cities for your virtual machines. Now if you define serverless to be -- which doesn't exist today out in the marketplace for VMs and containers, they just spin up automatically like we do today for Function as a Service and for JavaScript, that's what comes 2025."
},
{
"speaker": "Timothy Horan",
"text": "If you don't mind me asking me, it sounds a lot like what Cloudflare is doing, but you're saying it doesn't exist today. Tom, can you maybe talk about a little bit what's different, what you're doing?"
},
{
"speaker": "Tom Leighton",
"text": "Yes, that's a great question. They don't support VMs or containers at all, never mind serverless or anything else, just -- they don't have support for that. They don't do this full stack cloud computing."
},
{
"speaker": "Timothy Horan",
"text": "Got it. Thanks a lot."
},
{
"speaker": "Operator",
"text": "The next question comes from Alex Henderson of Needham. Please go ahead."
},
{
"speaker": "Alex Henderson",
"text": "Great. So it seems pretty clear that Guardicore is a critical piece of your security growth. And obviously is perturbing the overall growth rate. I was hoping you could give us some sense of what the security product lines, excluding Guardicore look like in terms of their growth rates. Any sizing of that growth would be even a ballpark would be quite helpful. And then second, I was hoping you could talk a little bit about your -- you mentioned inferencing, but I think it came in kind of as an afterthought as opposed to the primary focus. Can you talk about your involvement in AI inferencing at the edge and to what extent that requires either the 2025 kind of structure or what needs you have there and whether you're putting GPUs out of the edge in order to facilitate that?"
},
{
"speaker": "Tom Leighton",
"text": "Ed, do you want to go with the first one, and I'll take the second one?"
},
{
"speaker": "Ed McGowan",
"text": "Sure. Why don't I go to the first one? On the spirit of it being a year-end call, I'll break out these numbers at a high level for you, but won't be doing it every quarter. So if I look at the -- what we used to -- what we call the Appen API security bucket, that's our largest bucket, that includes bot management, our fraud products, our web app firewall, our new API security product. That's actually in Q4 growing over 20%. So that's been incredible. Guardicore itself, if I normalize for the onetime software that we did last Q4 is growing at about 6%. And infrastructure and services are growing sub-10%."
},
{
"speaker": "Alex Henderson",
"text": "Just to be clear, is this the full year growth rate? Or is this the fourth quarter growth rate?"
},
{
"speaker": "Ed McGowan",
"text": "This is the fourth quarter growth rate. The full year I don't have [indiscernible]."
},
{
"speaker": "Alex Henderson",
"text": "That's sufficient. I just needed to know what it was."
},
{
"speaker": "Tom Leighton",
"text": "Okay. Yes, in terms of the question around inferencing and AI and so forth, yes, we're building full stack compute to have great performance at a lower price point and have that available in hundreds of cities. And one of the many things that you would do with that is AI inferencing and that's not an afterthought. In fact, we've been using AI in our products for, well, 10 years, bot management, for example, runs on Akamai connected cloud. It's one of many things that run on it. So not an afterthought. There is an enormous amount of buzz now about AI. And I think a lot of that is justified. And I think there's a lot more compute going to be consumed because of AI. And it is a strong use case among our customers that are using Akamai connected cloud. That said, it's not all AI. In fact, our biggest customers are doing media workflow, doing live transcoding. And that's not using AI. So I think AI is an important use case, one of several use cases. Now in particular, you asked 2024 versus 2025 it's being done already on our platforms. There's no need to wait until the end of the year unless you want to do it in 100 cities, then that comes at the end of the year. No need to wait to 2025 when the instances are spun up automatically instead of by design ahead of time the way compute works today. So you talked about GPUs. Akamai has GPUs deployed, we're deploying more. We've used them in the past for graphics. And going forward, probably use them for Gen AI uses. We're not really deploying them right now in the edge pops. And that's not -- it just because you don't need to. It's not cost-effective. And the edge pops, you're going to be doing the inferencing. And for the inferencing, you can use GPUs, but we're also using CPUs. And right now, we get a better ROI on the CPUs. So I guess there's a lot of confusion there as well. Now GPUs are critical for doing training for especially large language models and that's going to be done in the core and we're not supporting that as a key use case today. We could, in theory, right, we have all the technology to do it, but that's not where we're focused in terms of getting the best ROI for our platform. And for that matter, most of the work with these models, most of the compute is done when you're using them for the inferencing. You do the training, and then you spend -- just so it learns you get it ready to go, and then you operate it. And it's the operation where most the vast majority of the cycles are and that can be done on CPUs. And in many cases, the cases I mentioned, for a personalization for security, for data analytics, that's done on the edge more as good reason to be done there using CPU-based hardware."
},
{
"speaker": "Alex Henderson",
"text": "Great. Thanks for the complete answer."
},
{
"speaker": "Operator",
"text": "The next question comes from Jonathan Ho of William Blair. Please go ahead."
},
{
"speaker": "Jonathan Ho",
"text": "Hi, good afternoon. Just one question from me. How important is the global load balancing capability? And what does that maybe mean for your ability to either attract more customers or to drive revenue from that product? Thank you."
},
{
"speaker": "Tom Leighton",
"text": "Yes, that's very helpful because it makes it much more scalable. You have failover, so much more reliable. And I think it's the basic capability, of course, we've had forever, it seems in delivery of security, and now that's available for compute. So I think that's important and that greatly increases the market we can go after for compute."
},
{
"speaker": "Jonathan Ho",
"text": "Thank you."
},
{
"speaker": "Tom Leighton",
"text": "And operator, we have time for one last question."
},
{
"speaker": "Operator",
"text": "Our last question will come from Rudy Kessinger of D.A. Davidson. Please go ahead."
},
{
"speaker": "Rudy Kessinger",
"text": "Hey thanks for squeezing me in guys. Ed if my math is correct, even if I exclude the $100 million in CapEx and compute last year, intended for moving over internal workloads between last year and this year, it looks to be about $400 million in compute CapEx. And going back to that kind of $1 in CapEx equals $1 of revenue capacity, $400 million in CapEx, roughly $200 million of compute growth 2024 versus 2022. Do you feel like you guys are maybe over building at all? Or what gives you the confidence, I guess, in the pipeline and the ramping usage to spend so much on another round of build-out this year when we're not yet seeing growth accelerate, right? You're guiding to 20% growth next year that's flat with Q4."
},
{
"speaker": "Tom Leighton",
"text": "Yes. So I'll just -- let me address that part first. So I would say if you look at the underlying components of what's growing, it's actually that enterprise compute opportunity that's growing very, very, very fast, like those numbers, the percentages would be kind of foolish to break out because they're going off of small numbers and adding to them very big numbers. Now also part of our strategy is to be competitive and have big core centers in many cities, and that does require a larger build out. So there's a lot of capacity that we have to sell. And then also, we're seeing demand in certain cities, you have to build out more capacity where you're getting demand. And then the Gecko sites that we're building out, it's not a significant -- I mean it's a decent amount of capital. But I think that is another big key differentiator for us. And as Tom mentioned, we think there's a big opportunity there. So I know a lot of people have been questioning us being able to take on large workloads, etcetera. We clearly have a lot of capacity out there. As I talked about earlier, we've made the change with our compensation plans where our reps now have to sell compute. So we're going to see a lot more of that. We've done a tremendous amount with the platform in terms of adding functionality. We built out the platform, connected it to our backbone, and we have a lot of new compute partners. The platform is ready to be sold so we're pretty optimistic about it. And I think we're building in a pretty responsible manner. As I talked about, our CapEx is relatively modest for this business right now. So I think we're in pretty good shape."
},
{
"speaker": "Tom Leighton",
"text": "And with that, that will end today's call. I want to thank everyone for joining, and have a great evening."
},
{
"speaker": "Operator",
"text": "The conference has now concluded. Thank you for attending today's presentation, and you may now disconnect."
}
] | Akamai Technologies, Inc. | 24,522 |
AKAM | 3 | 2,023 | 2023-11-07 16:30:00 | Operator: Good afternoon, and welcome to the Akamai Technology Third Quarter 2023 Earnings Conference Call. [Operator Instructions] Please note, this event is being recorded. I would now like to turn the conference over to Tom Barth, Head of Investor Relations. Please go ahead.
Tom Barth: Thank you, operator. Good afternoon, everyone, and thank you for joining Akamai's third quarter 2023 earnings call. Speaking today will be Tom Leighton, Akamai's Chief Executive Officer; and Ed McGowan, Akamai's Chief Financial Officer. Please note that today's comments include forward-looking statements, including statements regarding revenue and earnings guidance. These forward-looking statements are subject to risks and uncertainties and involve a number of factors that could cause actual results to differ materially from those expressed or implied by such statements. The factors include any impact from macroeconomic trends, the integration of any acquisitions and any impact from geopolitical developments. Additional information concerning these factors is contained in Akamai's filings with the SEC, including our annual report on Form 10-K and quarterly reports on Form 10-Q. The forward-looking statements included in this call represent the company's view on November 7, 2023. Akamai disclaims any obligation to update these statements to reflect new information, future events or circumstances, except as required by law. As a reminder, we will be referring to some non-GAAP financial metrics during today's call. A detailed reconciliation of GAAP and non-GAAP metrics can be found under the financial portion of the Investor Relations section of akamai.com. And with that, I'll turn the call over to Tom.
Tom Leighton: Thanks, Tom, and thank you all for joining us today. I'm pleased to report that Akamai delivered excellent results in the third quarter with revenue, operating margin and earnings all exceeding the high end of our guidance range. Revenue grew to $965 million in Q3, up 9% year-over-year. Non-GAAP operating margin was 31%, and non-GAAP earnings per share was $1.63, up 29% year-over-year. Ed will cover the key factors that drove our bottom line performance in his portion of the call. I'll now say a few words about each of our 3 main product areas, starting with security, our largest source of revenue. Security revenue grew 20% year-over-year in Q3. The acceleration in security growth was driven in part by especially strong demand for our market-leading Guardicor segmentation solution as enterprises confront the ever-present threats from malware and especially ransomware. CISOs and corporate Boards everywhere have seen the recent headlines about devastating ransomware attacks, including at 2 casino hotels in Las Vegas, a major manufacturer of cleaning products in the U.S. and at a multinational provider of systems for smart buildings. One of them reportedly paid $15 million to get ransomware out of their systems. Another is reportedly spending $25 million to deal with the after effects and a third has reported more than $100 million in losses from the attack. Customers who purchased our segmentation solution last quarter include a major global services provider, one of the world's most recognized entertainment brands and a leading bank in Switzerland that renewed their segmentation protection with a significant upgrade. We also saw strong demand for our market-leading web app firewall solutions in Q3, where we continue to win against competitors who are challenged to provide the levels of reliability and performance required by major enterprises. Customers who switched to Akamai, including a nationwide retail chain in the U.S. and a leading global manufacturer based in India, also told us that our competitors simply can't provide the level of support and professional services that they need and have come to depend on from Akamai. Customers also value being able to purchase an entire suite of integrated security products from Akamai, a provider who they trust to keep them safe against a wide variety of attacks. For example, we're seeing very strong interest in our new API security solution that we announced last quarter. This new product is in its very early days, but we've already integrated it with our market-leading web app firewall solution to make it even easier for customers to implement. At the Black Hat security conference last quarter, Akamai API Security was named one of the 20 hottest new cybersecurity tools by CRN, a major trade publication for channel resellers. And as with Guardicore, you don't need to be a CDN customer to benefit from this new solution. Turning now to cloud computing. I'm pleased to say that we're on track with our product development, infrastructure deployment and conversations with customers about use cases well suited for the Akamai connected cloud. Since our last call, we've gone live with 7 more core compute regions in Amsterdam, Jakarta, Los Angeles, Miami, Milan, Osaka and Sao Paulo. In addition to the 6 that we opened earlier this year and the 11 that we acquired from Linode, this brings our total to 24 core compute regions to serve Akamai connected cloud customers. Of course, there are other cloud companies with a few dozen data centers. But Akamai is unique in having these data centers interconnected to the world's most distributed edge platform with more than 4100 points of presence across 750 cities and 130 countries. As one trade pub block and files recently wrote, Akamai is focusing on a future where scale becomes more about the size of the network versus the size of its data centers, more effectively powering modern applications. We agree. Akamai's massively distributed edge network, 25 years in the making and managed by Akamai's team of experts around the world is a key differentiator in our strategy. We believe that next-generation applications will need next-generation cloud infrastructure, and we intend to chart the course for the next decade of cloud computing when more of the compute will be done closer to the end user and where we believe our platform will have an important edge over more centralized models. As IDC put it in July, Akamai brings the simplicity, affordability and accessibility of its cloud computing services to larger commercial customers on an architecture built for the next decade, not the last. The Akamai Connected Cloud will put containers and VMs closer to end users and bring enterprise workloads to locations around the world that are otherwise difficult for organizations to reach. Customers are responding to Akamai's unique offering, and we've already gained cloud computing business across multiple verticals in every major geography, including a European streaming media company, a digital advertising company in Japan, a large financial institution in Indonesia, and e-commerce platform in Korea, major carriers in EMEA and Central America and a television network in South America. In addition to direct sales, we're seeing good traction in our cloud computing partner ecosystem, where we're acquiring new customers by selling with cloud service providers and managed service providers. We've also partnered successfully with independent software vendors and SaaS and PaaS providers. In fact, we recently signed one of the world's best-known SaaS providers and our second largest cloud computing deal since we acquired Lanone [ph] Turning now to content delivery. I'm pleased to report that we saw an acceleration of traffic growth in Q3. In addition, we acquired enterprise customer contracts from StackPath and Lumen Technologies following their decisions to exit the CDN market. As Ed will talk about shortly, the financial terms of the acquisitions were very attractive for Akamai shareholders. In addition to the delivery business that we acquired, we're planning to introduce these customers to our full portfolio of security and cloud computing solutions to help them power and protect their businesses online. In summary, we are very pleased by our performance in Q3. Our expanded security portfolio is deepening our relationships with customers. Our cloud computing plans are executing on schedule, and we continue to invest in Akamai's future growth while also enhancing our profitability. Now I'll turn the call over to Ed for more on our Q3 results and our outlook for Q4 and the full year. Ed?
Ed McGowan: Thank you, Tom. As Tom mentioned, Akamai delivered a strong and very profitable quarter in Q3. In my remarks today, I'll cover our Q3 results and then provide some perspective on Q4, share some details on our recent customer contract acquisitions and closed with our increased full year 2023 guidance. First, let's discuss revenue. Total revenue for the third quarter was $965 million, up 9% year-over-year as reported and in constant currency. In the third quarter, Security revenue was $456 million, growing 20% year-over-year as reported and 19% in constant currency. Security revenue growth was primarily driven by continued strength in our segmentation product, which is now over $100 million on an annualized run rate basis and up 97% year-over-year. I'll note that during the quarter, we had approximately $6 million of onetime segmentation license revenue. Adjusting for that onetime license revenue, total security growth for the third quarter would have been 18% year-over-year as reported and 17% in constant currency. And segmentation revenue growth would have been approximately 62% year-over-year and 60% in constant currency. In addition to strength and segmentation, we also saw very strong growth in our flagship Web Application Firewall or WAF product family. This growth was primarily driven by stronger-than-expected adoption of new security bundles offered to new and existing customers that we introduced this year. The new security bundles include additional security entitlements such as more security policies, additional security configurations and more advanced rate control policies. Many existing customers are seeing greater value in these new bundles and as a result, are spending more with us. Moving to compute. Revenue was $130 million, growing 19% year-over-year as reported and in constant currency. On a combined basis, our securities and compute business product lines represented 61% of total revenue, growing 20% year-over-year and 19% in constant currency. Shifting to delivery. Revenue was $379 million, declining 4% year-over-year as reported and in constant currency. It's worth noting that delivery was aided by approximately $4 million in revenue from the selected CDN customer contracts we acquired from StackPath. International revenue was $467 million, up 11% year-over-year and up 9% in constant currency. Foreign exchange fluctuations had a negative impact on revenue of $3 million on a sequential basis and a positive $7 million benefit on a year-over-year basis. Moving now to company profitability. Non-GAAP net income was $251 million or $1.63 of earnings per diluted share, up 29% year-over-year and up 28% in constant currency. These especially strong EPS results exceeded the high end of our guidance range by $0.11. -- were driven primarily by higher revenues and continued progress on the cost savings initiatives we outlined over the last few quarters. As an example, we continue to reduce our third-party cloud spend by migrating internal workloads to our connected cloud platform. In Q3, our third-party cloud spend declined 26% year-over-year. Moving to margins. Our cash gross margin was 73%. Included in our Q3 cost of goods sold was approximately $5 million of transition services agreement or TSA costs paid to StackPath. With customer contract acquisitions, TSA payments are used to cover the seller's customer-related network and support costs during the migration period.\ I'll provide further detail on expected TSA costs going forward in the guidance section in a few moments. Adjusted EBITDA margin was 43%, and our non-GAAP operating margin was 31%, 2 points ahead of our guidance, driven by our revenue outperformance and continued focus on driving down costs across the business. Moving now to cash and our use of capital. As of September 30, our cash, cash equivalents and marketable securities totaled approximately $2.1 billion, which includes the proceeds from the convertible debt raise we did during the quarter. As a reminder, in August, we issued $1.65 billion of senior unsecured convertible debt that will mature on February 15, 2029. The notes will bear interest at a rate of 1.125% per year payable semiannually. Finally, the net proceeds of approximately $1 billion from this offering have been invested in highly liquid marketable securities. These securities yield approximately 5.25% on a weighted average basis with maturities close to May 2025 as we intend to use these proceeds to pay off approximately $1.15 billion of convertible notes that mature in May 2025. We -- for the third quarter, we spent roughly $113 million to repurchase approximately 1.1 million shares. We now have roughly $600 million remaining on our previously announced share buyback authorization. Our approach to capital allocation remains the same to opportunistically buy back shares to offset dilution from employee equity programs over time while maintaining sufficient capital to deploy when strategic M&A presents itself. Before I cover Q4 guidance, I want to provide a quick reminder about our typical fourth quarter dynamics and add some color to our 2 recent transactions with StackPath and Lumen. As in prior year, seasonality plays a significant role in determining our financial performance for the fourth quarter. Typically, we see higher-than-normal traffic from large media customers and they pick up in seasonal online retail activity from our e-commerce customers. Both of these traffic patterns are difficult to predict. Q4 also tends to have higher operating expenses than in Q3, driven by higher sales commissions due to accelerator payments for sales reps who overachieved their annual quotas. As it relates to the transactions with StackPath and women's, first, both transactions were acquisitions of selected CDN customer contracts, including over 200 net new customers to Akamai. We did not acquire any other assets or liabilities at either company. Second, we expect the 2 transactions combined will add approximately $17 million to $20 million of revenue in Q4. Third, we expect to record approximately $13 million to $14 million of StackPath and lumen TSA costs in Q4. These costs will be recorded in our cost of goods sold and will have a negative impact of approximately 1 percentage point on gross margin, adjusted EBITDA margin and non-GAAP operating margin. Combined, the stack path of lumen TSAs will negatively impact our Q4 EPS by approximately $0.06 to $0.07. We do not expect to incur any material TSA costs in 2024. And finally, our expectations for these customer acquisitions remain the same as we disclosed previously for the full year 2024. As a reminder, we expect the customer contracts acquired from StackPath to add approximately $20 million of revenue in 2024 and to be accretive to non-GAAP earnings per share by $0.03 to $0.05. And we expect the customer contracts acquired from women to add approximately $40 million to $50 million of revenue in 2024 and to be $0.08 to $0.12 accretive to non-GAAP EPS. With all that in mind, we are now projecting fourth quarter revenue in the range of $985 million to $1.005 billion or up 6% to 8% as reported and in constant currency over Q4 2022. We -- at current spot rates, foreign exchange fluctuations are expected to have a negative $8 million impact on Q4 revenue compared to Q3 levels and a positive $2 million impact year-over-year. Taking into account the impact of the StackPath and Lumen TSAs for the fourth quarter, we expect cash gross margins of approximately 72%. Q4 non-GAAP operating expenses are projected to be $305 million to $311 million. We expect Q4 adjusted EBITDA margin of approximately 41%. We expect non-GAAP depreciation expense to be between $123 million to $125 million, and we expect a non-GAAP operating margin of approximately 29% for Q4. Moving on to CapEx. We expect to spend approximately $143 million to $153 million, excluding equity compensation and capitalized interest in the fourth quarter. This represents approximately 15% of our projected total revenue for the fourth quarter. Additionally, our CapEx guidance includes the integration requirements to support the traffic for both CDN customer contract acquisitions. Based on our expectations for revenue and costs, we expect Q4 non-GAAP EPS to be $1.57 to $1.62. This EPS guidance assumes taxes of $50 million to $52 million based on an estimated quarterly non-GAAP tax rate of approximately 17%. It also reflects a fully diluted share count of approximately 155 million shares. Looking ahead to the full year, we have increased revenue to a range of $3.802billion to $3.22 billion, which is up 5% to 6% year-over-year as reported and 6% in constant currency. At current spot rates, our guidance assumes foreign exchange will have a negative $18 million impact on revenue in 2023 on a year-over-year basis. We are raising our security revenue growth expectations to approximately 15% for the full year 2023, and we continue to expect to achieve approximately $0.5 billion in revenue from compute in 2023. And despite a year of significant investment, we are estimating non-GAAP operating margin of approximately 29%. With all that in mind, we have raised our estimated non-GAAP earnings per diluted share to a range of $6.08 to $6.13. Our non-GAAP earnings guidance is based on a non-GAAP effective tax rate of approximately 17%, and a fully diluted share count of approximately 155 million shares. Finally, our full year CapEx is expected to be 19% of total revenue. In closing, we are very pleased with how the business is performing in 2023 as we continue to invest for revenue growth and improve our profitability. With that, we now look forward to your questions. Operator?
Operator: [Operator Instructions] The first question is from James Fish of Piper Sandler. Please go ahead.
James Fish: Really nice quarter there. Understanding you're selling Guardicore to the installed base primarily. But what are you seeing with selling outside of the installed base with security and compute and specifically within security. Is there a way to think about that drag along effect or how the Guardicore enterprise sales team are really dragging along the rest of the security or even compute portfolios into any net new customer wins. Really, the crux of the question is how is the sales process going outside of the CDN installed base?
Ed McGowan: Jim, this is Ed. I'll start. Tom, you can jump in if there's anything you want to add. So actually, it's interesting, you started off by saying Guardicore is mostly to the installed base. Actually, we've done a really nice job of selling to new customers. One of the things that came over as part of the Guardicore acquisition is a pretty robust channel and pretty much every deal is done through the channel. As a matter of fact, I think we can do a better job of selling in the installed base and probably come up with some new incentives to incentivize the sales force to do that. So there's a ton of room in the installed base because most of the growth in Guardicore has come from outside the installed base.
Tom Leighton: Yes. And I would just add to that, that there is good drag along with Guardicore and for example, Enterprise Application Access, one is considered north-south, the other East West, both are really important in terms of keeping malware out and identifying when it gets in and really blocking the spread. So it's good that way, too.
James Fish: Helpful, guys. And just a follow-up, Tom, you had actually started to allude to it a little bit. But as we think about those lumen and Exacto [ph] contracts, I guess how much wallet share do you have in aggregate of these new customers? Or what's the overall opportunity for those specific customers beyond just that CDN revenue that you bought?
Tom Leighton: Yes. Well, obviously, there's a CDN revenue, which is what transfers, but we're going to be looking to sell our security and compute solutions into those 200-plus new customers. And I think there's some good opportunity there.
Operator: The next question is from Fatima Boolani of Citi.
Fatima Boolani: Good afternoon. Thank you for taking my question. Tom, maybe I'll start with you. I want to have a broader conversation with regards to some of these contracts that you've been acquiring, it's setting up to be a little bit of a pattern. So look, you've been doing delivery for the better part of 2 decades here. So I wanted to get your kind of longitudinal perspective on what you're seeing in the marketplace and the market backdrop that's sort of pointing more and more towards consolidation in the delivery here. And then ultimately, I wanted to get your perspective on how you think this is going to impact some of the pricing dynamics and ultimately, your pricing power in the delivery space. And then I have a follow-up for Ed, if I may.
Tom Leighton: Yes, I wouldn't call it a pattern. It's been a long time, really since we've acquired a competitor or a competitor contracts. This is a situation where 2 of the many CDNs out there decided to discontinue their operations. And they wanted -- now they're still remaining as companies, obviously, and they wanted to have their customers have the best possible experience as they exited the CDN space. And so they approached Akamai as the leader by far in CDN and made very compelling financial terms for the transaction. So it makes a lot of sense for our shareholders that we take on these customers. And also, it's a good opportunity as we mentioned, to sell them security and compute. So really good for shareholders. It's not something that we're actively doing trying to go buy other CDMs. But every once in a while, there is an opportunity that is compelling for shareholders. I don't see any fundamental change in the marketplace the hyperscalers and a dozen - 2 dozen other companies are selling delivery services. So I don't think there'll be any fundamental change there or change with pricing. Separately from this, of course, you know that we talked about Akamai as being more conservative with pricing, as we talked about, we're not taking some of the spiky traffic, if the pricing doesn't make sense because we've been focusing more on the capital deployment into our compute offering, which we see enormous potential future growth for...
Fatima Boolani: Perfect. Thank you. Ed, I was hoping I could parse out some of your prepared remarks with respect to the third-party cloud spend that you're effectively in-sourcing. I believe a couple of quarters ago, you may have ballpark that figure at about $100 million. So please correct me if that recollection is correct. And also just wanted to get a sense of how far down the path you are in this in-sourcing of third-party cloud spend on your Connected Cloud platform. Thank you.
Ed McGowan: Yes, sure. That's a great recollection, thought me you're correct. That's about $100 million or actually north of $100 million. So we are still in the earlier innings of the journey. However, we've made a lot of progress, and the team is doing a great job. So we expect to see that the savings continue to ramp. I'm very happy to say that we're slightly ahead of where we expected to be, and we have a lot of confidence that we'll be able to drive the type of savings that we expect to throughout next year.
Fatima Boolani: Thank you.
Operator: The next question is from Magellan Brooks [ph] of Bank of America. Please go ahead.
Q – Unidentified Analyst: Thanks for taking my question. Just want to dive into security a bit and see are the trends differing between international and domestic in terms of what products are getting better versus not? And then one follow-up question after that. Thanks.
Tom Leighton: I don't think there's a fundamental difference. The attacks are global in nature and the same attacks we see here domestically. We see in pretty much all of the major geos. And yes, you do see a little bit more attacks where there's hotspots wars taking place or political tensions, there'll be more attacks, but the nature of the attacks is similar. You got a denial of service attacks, you got ransomware. You've got application layer attacks, more recently, AI attacks. So -- and that happens everywhere because there's no reason it should be in one geography versus another.
Q – Unidentified Analyst: Got it. And then for the Connected Cloud and just the compute segment as well, you guys talked about a lot of really nice international deals, but also just wanted to get a pulse on what's happening domestically and appetite for the products here.
Tom Leighton: Again, I think that is universal as well. We'll have special advantages in locations where the hyperscalers aren't. But that kind of compute capability can be accessed by customers anywhere. Big U.S. companies care a lot about being able to give really good performance for their users all around the world. So again, I think that's -- there's not a fundamental difference between the U.S. or other regions. We have gotten off to a really good start, and I would say APJ, but it's across the board. We're deep in conversations with major enterprises across all the major geos.
Q – Unidentified Analyst: Got it. Congrats.
Operator: The next question is from Ray McDonough of Guggenheim Securities. Please go ahead.
Ray McDonough: Thanks for taking the questions. And Ed, I appreciate the color on the additional bundles of security and the additional services you added to those bundles. And then in our conversations, we did pick up a decent price up with when those services are added. So can you help us understand what sort of pricing uplift, if any, there might be there? And what the penetration rate is in your installed base currently of those services and what the opportunity is going forward?
Ed McGowan: Yes. So I'll start and then Tom, if there's anything you want to add. So this is a pretty targeted program that we identified customers in selected verticals primarily in commerce, manufacturing, health care, pharma, financial services, what we traditionally call sort of our legacy web customers. And as we have talked about, included a lot more services and functionality into the bundles. And upon renewal, we're able to upsell. And we're about -- this is probably 2,000 to 3,000 customers that fit into this sort of targeted group. We're probably about halfway through in terms of the customers that come up for renewal. If you remember, our customer -- average customer contract length is about 18 months. So this probably runs about 18 months to 2 years kind of a program, but we're very happy with what we're seeing with the average uplift on the average sale price.
Ray McDonough: Great. And then maybe if I could, just on compute. Now that the majority of those core data centers are online. Can you talk about how much of the contracted space you filled out and what sort of utilization you're hoping to achieve as you enter 2024? I know you're not going to provide any sort of guidance here, but any sort of guidepost in terms of the actual capacity that will be online in '24 and what the compute pipeline looks like heading into next year to fill that capacity, it would be helpful just to understand kind of the capital needs of that business as we think about '24.
Ed McGowan: Yes. In terms of the capital, we pretty much now done the major buildout. And of course, we're big consumers of that ourselves as we move our own applications in-house to Akamai Connected Cloud. And we've also got plenty of room to take on major enterprise business. So I don't think you'll see a lot of CapEx associated with the big core data centers until we start generating a lot more revenue from that. And then we would build out further. There'll probably be another couple that we do. What you will see is a relatively smaller amount of CapEx as we do build out into our existing Edge pops. And our goal is to start equipping them with compute so that you can run containers, VMs, Kubernetes and many more cities around the world. And so that -- and more cities than you can do that with, for example, the hyperscalers. And so that will be taking place over the course of the next year, but it's not a large amount of CapEx, so much smaller than what you saw this year. And then going from there, it will depend on how fast the revenue grows. So it will be a good news story if we're back next year saying that, okay, great, we fill that up, and now we're going to be building out some more. So it's a much better situation than we were in this year where there was a lot of build out getting ready and no revenue yet.
Operator: The next question is from Frank Louthan from Raymond James.
Frank Louthan: Great. Thank you. Can you give us some color on sort of the nature of the compute deals that you're getting now versus maybe 6 to 12 months ago? And then what have you learned by putting some of your own enterprise-level workloads on the compute platform that you've maybe been able to utilize as you sell to customers? And how has that process benefited the product?
Tom Leighton: Yes. Good question. I would say you start going back 6-plus months ago, there really wasn't a lot of compute deals at that time because the Linode infrastructure really wasn't ready for it. There was some early experimentation. Now we're in a position where we really can take on mission-critical applications from big enterprises. We're starting to do that. Some are starting to grow very nicely. In terms of the learnings, we've learned a lot. I would say on the good news side, we're saving a lot of money. And we're going to help our customers save a lot of money. We're also seeing really good performance and better in many cases than we can get with the hyperscalers. And as we go forward, we'll get -- we, of course, have better scalability in terms of faster scalability. And for Akamai, that's really important because we have a lot of customers that have flash crowds, peak events and so forth, Hard to predict how big they'll be. And with our deployed platform, we're really good at that, of course, with security and with delivery. And now we're applying those capabilities to compute so that we can spin up more compute instances in a faster, more responsive way. So we're very happy consumers of our own cloud. Now on the other side, we've learned that it's not just flip a switch. And you just don't flip a switch and suddenly you're off the hyperscaler and you're on to Akamai. And of course, that's true when you move from any cloud environment into another one, it does take some effort to do it, but it is well, well worth it. And we're so a great reference, and we can now help our customers and our partners. We're working with many partners in cloud so that they can take their customers and get them on to Akamai Connected Cloud.
Operator: Next question is from Tim Horan of Oppenheimer.
Tim Horan: Staying on that point, can you maybe just talk about the backlog and customer interest at this point? Just any update, it sounds like it's going well. Also, where are you kind of all the value-added services and tools? And I just -- maybe just a complete cloud portfolio at this point? And then lastly, could you just remind us what the margins of this business will look like longer term? And I guess we do get asked a lot like why can you sell this cheaper than the cloud providers, I guess, at the end of the day? And will that impact your margins?
Tom Leighton: Okay. A lot of components there. I'll start with some of them and then probably Ed will fill in with some. Yes, we're in a lot of really good conversations, as you can imagine, because the world's major media companies, gaming companies, commerce companies all use Akamai. They had for many, many years. They trust us for scale, reliability, performance, they trust us with security. They trust us not to compete with them. And as they see what we're building in terms of compute, they like the idea of getting better performance, more distributed compute capabilities. And some of those folks really like the idea of a much lower price point. And as an extra benefit, especially if you're in media or commerce, it's getting to be a bigger problem that they're cutting such giant checks to their leading competitor and sharing all the crown jewels of their data with their leading competitor. So they're taking the Akamai solution with great interest, I would say. Now in terms of being cheaper, Akamai has been for a long time, the world's most distributed platform. We run one of the world's largest backbones. We have worked for many, many years to be incredibly efficient in terms of moving data around and doing the delivery. And that gives us a real advantage of being able to do this now for compute in a very cost-effective way. Now that said, I am sure that the hyperscalers pay a little bit less for their hardware than we do, probably not a lot less, maybe a little less. But when it comes to everything else, I think Akamai is in an excellent position. And what we're seeing in the marketplace is that they'll get their best offer from the hyperscalers, and we can be a lot lower than that and be very profitable at doing it. And the good news, I think, for Akamai is that here you've got a $10-plus billion market growing at 20% a year. And we're a tiny guy there compared to the hyperscalers. So we can operate at a level that is not threatening to them in any way. They got to worry about each other. And there's plenty of room for us to take on a lot of revenue at lower price points and very good margins for Akamai. Now in terms of the marketplace, that's an area, obviously, with the hyperscalers are way ahead some of those folks, every application ever made is available in the marketplace. -- as a managed service, we are growing our marketplace. We are growing the tools that are available on Akamai Connected Cloud. And the first applications that we're targeting are applications that are more easily able to be cloud agnostic, that are not locked in, that aren't using 20 other applications in the marketplace. And so that we are much easier to port onto Akamai Connected Cloud. And so there are some applications that won't be able to report in the near term. But we don't need all those applications. All we need is to get going as a tiny share of that market. And we've identified just, for example, in the media vertical alone, there's a lot of applications that are amenable to moving to our platform. And of course, a lot of our partners in our marketplace to begin with our media-related companies, for that reason because they're also threatened by the hyperscalers, and they're very excited about having media applications beyond Akamai. Ed, do you want to add anything there?
Ed McGowan: Yes. Just a couple of things. Yes, Tom talked a little bit about the leverage we have with the backbone, but we also have a lot of other leverage in the company with our go-to-market, where the focus is going to be initially with our installed base. As Tom talked about in media to start, there's a tremendous amount. We pretty much work with every major brands. So there's a lot of leverage from that perspective. Also the people that build and deploy the network are the same people who are building and deploying our CDN network. -- and we're getting leverage with our co-location vendors and things like that. So we -- I've seen some pretty large proposals go out that get us margins that are pretty similar to the company margins in terms of gross margins that are somewhere between security and delivery and operating margins that potentially could be even greater as we get scale to the bottom line. So there's an enormous amount of margins. If you think of the math that we're doing with how much we're saving, the amount of capital that we're deploying and the cost, we're going to be saving a tremendous amount of money on moving our own applications, and we'll be able to offer some of that to our customers as well.
Operator: The next question is from Alex Henderson of Needham & Company.
Alex Henderson: Great. I'm rather than astounded that we haven't heard the word AI, so far in this conference call, at least I don't think we have. So can you talk a little bit about the impact of AI in terms of your opportunity to bring it to compute? Is it something that you think you can bring to the edge piece? Or is to run on your security -- our CDN Edge. And alternatively, is at a risk in the sense that InferenceI is going to be distributed, but a lot of the compute process might be more centralized in that context, diminish the willingness of people to move applications to your compute. So how do I think about the - the infant AI opportunity and the risk of customers being more challenges in moving.
Tom Leighton: Okay. Great question. In fact, there's a lot of components to this one, too. At a high level, there's a lot of potential opportunity, I would say. But let me step back just a minute. Akamai has been using AI and machine learning in our products for a long, long time. Obviously, useful for anomaly detection, bot detection, when an entity is accessing their bank account with the right credentials. Is it the right person or not detecting that malware has infected an application inside an enterprise. Lots of ways that we've been using AI and machine learning. Now with Gen AI, I think it helps some, but it really helps the attack. It's much easier now to morph malware into a lot of different forms, makes it harder to detect. Our teams have created some very nasty bots very quickly using Gen AI. And I think we're already seeing more penetration as a result of Gen AI. That's one area where really it is being actively used today. Now on that side of the house, the implications are -- there's more risk in terms of cybersecurity for enterprises. They're going to get penetrated more. And so you really have to double down on your defense and depth. I think it makes products like [indiscernible] segmentation even more critical because you're going to get penetrated, the key is to identify it quickly and proactively block the spread. And that -- I think when you look at our growth rate there, very, very hot with a market-leading solution. Now you also asked about what about compute and the impact of Gen AI there? I do think over time, it will suck up a lot more compute. And that's good for vendors selling compute, like Akamai sales compute. And you're right, there's a difference between the generation of the model, which is -- if they're large models, very heavy, and that will be done in core compute and storage data centers. inference engines can run at the edge and will make sense to run at the edge for many applications. And we already have several partners that are porting their AI models on to Akamai for inference engines -- and so -- and I expect that they will be selling that in our marketplace to other companies. And so in fact, we're already in a sense, using AI as we put our internal applications on to Akamai Connected Cloud. So I think you will see, over time, a lot of revenue generated there because of all the uses that I think will come about through AI. Now you ask about risk. I think you will need -- you do the model generation in the big data centers. That's not a risk for Akamai because we've got 2 dozen of those today. So that's -- it's just to be done in a different place. It won't be done at the edge. But inference engines, yes, a lot of that work will be done at the edge, and we're in a great place there because other companies don't have an edge, anything like Akamai..
Operator: Next question is from Abdul Khan of Evercore.
Q – Unidentified Analyst: This is Dua speaking for Abdul. And I just wanted to ask for you broadly on the enterprise spend environment. And I know we've previously we've noted elongating sales cycles. And I was just generally curious whether there's any change there. And if you had to characterize it, is enterprise IT spend incrementally worse or better or about the same versus, let's say, 90 days ago?
Tom Leighton: Yes. Good question. I would say, I think there's a lot of companies that are being cautious. We have seen a slight uptick in bankruptcies as you typically would see in cycle like this. But we're not seeing a significant impact certainly in our security business. If anything, we've seen better-than-expected results there. So I think security is not as impacted, at least at the moment. Obviously, there's a lot of speculation out there that we're heading towards a recession and things can change pretty quickly. But so far, we fared very well. And also, if you think about our messaging around compute, one of the biggest challenges a lot of companies have is the runaway cost of compute, and we offer a very compelling option for people to look to save money and increase their performance by moving to us. So I think that will play into our favor in an environment like this.
Operator: Next question is from Mark Murphy of JPMorgan.
Mark Murphy: Ed, how noticeable or how sudden is the increase that you're seeing and the sophistication of all these mallware and ransomware attacks. The part of why I was asking is we noticed that you're launching some scrubbing centers in Canada. And I'm wondering if that's driving CapEx a little higher to help make sure that you're able to address all these attacks. And then I have a quick follow-up.
Tom Leighton: Yes, let me just start on the product side, and then Ed will pick up your questions. So ransomware isn't related to scrubbing centers. scrubbing centers are just restricting the flow of packets and screening out or scrubbing out the packets that are trying to flood any particular resource. And that's nothing really per se to do with malware and ransomware to filter that out, you need application layer defenses where the scrubbing centers are routing layer defenses. And putting the scrubbing centers in Canada, and we're actually putting scrubbing centers in many more cities around the world and greatly increasing our capacity so that with local customers there, we can do the scrubbing for them locally. And that gives them better performance while we're giving them the defense against the volumetric attacks. For ransomware, you need Gardicor for malware, you need app and API security. And those are different products where they're done at our edge network in the 4,000 POPs, EdgePops we have around the world. And then, Ed, do you want to pick up the other part of that?
Tom Leighton: Yes, sure. Usually, the -- as Tom mentioned, the building of the scrubbing center generally will follow where we see significant demand from customers. And one of the other reasons security is up a bit this year as we have seen an increase in some of these volumetric attacks in the health care sector, a little bit in the financial sector as well. So this is pretty ordinary course for us. So in terms of like the CapEx needs or builds going forward, I'd say this is just ordinary course -- there's really nothing unusual to call out there, but we have seen a bit of a pickup in DDoS, in particular, tends to be a bit more episodic as you see big headline grabbing attacks. We do tend to see a pickup in business. And oftentimes, that will include a scrubbing center build. But they're pretty well informed with where we're seeing increased demand.
Mark Murphy: Okay. Understood. And then, Ed, just as a follow-up, did you mention what was the total consideration paid for the acquired contracts from StackPath in Lumin? I'm wondering, I believe those are expected to contribute something like $60 million to $70 million next year in aggregate. Is that -- are you taking -- like are you assuming a similar ongoing run rate that those contracts had with the prior providers and extrapolating that into next year? Or are you contemplating into that any kind of expansion, contraction, right, or pricing that up or pricing that lower?
Tom Leighton: Sure. Let me start -- I'll take it in different pieces here. So in terms of anticipating any upsell or anything like that with the 200-plus customers, I haven't factored anything in for that. So that would be upside to the extent that we can do that. Remember, we purchased selected contracts. There are certain contracts that we did not take. There's, for example, adult content and some of the small medium business customer contracts we didn't take. So that's not included. So if you're looking at other numbers that you may have heard about these companies are private, I'd just caution anybody with private company numbers and other is accurate. We just looked at the contracts that we're acquiring, what we think will -- how many will onboard, what will happen with pricing, how much traffic we'll keep some of these customers are splitters, so we anticipate some of that traffic may go away. But we've tried to factor all that in. So what we're trying to do effectively is look at the other side of the integration in terms of the contracts that we acquired, what is that run rate of business that we acquired taking into consideration the best we can, volume and pricing dynamics. In terms of consideration, we'll file our 10-Q tomorrow, and you'll see that for STACK PAT, that contract has got an upfront fee of about $35 million, and there's a small earnout. Also with the TSA agreement, a little wonky accounting here for you, but you have to fair value the TSA and to the extent that there's excess cost there that goes to the purchase price. So when you see the final 10-K once it's filed and the cash flow, the numbers may be slightly higher. On the lumen, it's about $75 million. There is no earnout there. Same comments on the TSA. There is a fair value analysis you do in purchase accounting. So that might be slightly higher. But that's the extent of the agreements.
Operator: The next question is from Rishi Jaluria of RBC.
Rishi Jaluria: One wanted to follow up on 2 earlier questions that were asked, one on AI and then one on the contracts. Thinking specifically around AI, Tom, I appreciate your answer earlier. If we think about the opportunity to do inferencing at the edge, especially for cases like connecting devices or med tech or financial services now that people are increasingly worried about data and data residency. Can you speak to a little bit of your opportunity for that? And maybe alongside that, what investments do you need to make both in the software stack as well as in hardware infrastructure, be it GPUs or anything else to really capitalize and get your fair share of that opportunity? And then I've got a quick follow-up.
Tom Leighton: Great. Yes, the data residency, data sovereignty issues are increasingly important, as I imagine you know, -- and that's where Akamai has a great opportunity because we're in 130 different countries with our infrastructure. And as we move compute into our edge pops, that enables us to do the work locally, keep the data local, which is an exciting opportunity for us. And I think in the not-too-distant future, we'll be in locations and countries that even the hyperscalers aren't there. Now in terms of the work on the software stack to be able to do that, that is ongoing work now. We are actually already in beta with a few customers -- so we're pretty far along. And then next year, as I mentioned, there'll be relatively small amount of CapEx as we do build out in a nontrivial number of our edge pops to be able to support compute. Now today, at the edge, I don't -- we support GPUs today, but that would be more in the core data centers. I think for the inference engines, we're running that just fine on CPUs. And so as we look at the edge, where you'd be running the inference engines, I don't, I think, run on CPUs and be much more cost-effective than trying to buy GPUs or custom hardware there. I think where you might see that as more if you're working with large-scale model development. And then that would be in the core data centers. That wouldn't be at the edge. The edge is where you want to do the inferencing. And that's -- it seems like that's going to be working very well on our edge platform with CPUs.
Rishi Jaluria: Got it. That's really helpful. And then just in terms of the StackPath and Lumen contracts, again, I appreciate the color in terms of your set of assumptions. Can you walk us through what you can do on your part to ensure those customers, whether they're net new or existing Akamai customers that maybe we're trying to use a multi-CDN approach, what you can do to get those customers to stay and to not turn off on to other competitors or even just kind of figure out how to reduce the peaty.
Tom Leighton: Yes. Good question. I think first is the approach that we took, right? We got an inbound request from these 2 companies, and some of them are customers we know and have had a long relationship with. And providing an orderly transition is step 1 in the relationship, right? So now you get a warm relationship and introduction to it's a new customer, and certainly, for the customers that we have. They obviously know us -- and you get -- instead of having a jump ball in the open market, you have a chance to sit down with the customer and understand what their needs are, understand what's going on with their contracts, length of contracts, pricing, et cetera. And you could just set up a relationship and just go through a normal sales cycle effectively. I think we've got a pretty good track record, and I'm certainly understanding the customers. And if I think about sort of the weighted average of where the revenue is, we've obviously gone and talked to a lot of those customers. We obviously have had a long-term relationship with a lot of these folks. So I think we have a fairly high degree of confidence in the numbers that we've put out. Obviously, things can change. But based on our experience with a lot of these folks and with some of these new folks that we have not worked with us in the past, we have an awful lot of other services to offer that they didn't have before. And especially with security being such a big topic these days. We're hearing from some of these customers that they're glad that they have a relationship with us now.
Operator: The next question is from Ruby Kessinger of D.A. Davidson.
Ruby Kessinger: Ed, I just want to quantify the TSA impact. It seems to be about 1.5 points impact cash gross margins in Q4. Is that accurate? And just to be clear, it sounds like that, that TSA ends at year-end? Or when exactly does that TSA add?
Tom Leighton: Yes. So there might be just a tiny bit that goes into Q1 just depending on how the migration goes. Hopefully, we can be done with it by the next couple of months. Yes, it's just under 1.5 points. I rounded down to a point, but you're right. If you just take the amount divided by the revenue, it's about 1.3%, 1.4%.
Ruby Kessinger: Okay. Got it. And then if I just look at your delivery guidance, which, I guess, is implied by your compute security revenue guidance, and then I back out the expected $17 million to $20 million of revenue from Lumin and StackPath in Q4, it implies delivery revenue flat to down in Q4 versus Q3. So is any extra conservatism in the Q4 delivery guide just based on what you're seeing from traffic trends or any pricing pressure to call out? Or why not -- why aren't we seeing a typical seasonal Q4 uplift in delivery revenue ex those acquisitions.
Tom Leighton: Yes. That's a good question. First of all, there's $4 million of delivery in the Q4 number so that you have to look at the net delta between the 2. Also, there's about an $8 million headwind from FX. So there is some implied growth in the delivery number. As I talked about there's a high degree of uncertainty in Q4 as it relates to traffic, right? You've got -- typically, we see a big seasonality in terms of retail and the media side of the business. Retail as we've gone to 0 overage is less impactful. We do still see some bursting. I think we're being probably a bit more cautious, especially on the commerce side of the equation for now. But there is some implied growth in there as you factor in those other 2 items I just mentioned.
Ruby Kessinger: Okay. That's helpful.
Operator: The next question is from William Power of Baird.
Q – Unidentified Analyst: This is Yan Simoes on for Will. So first of all, just looking at delivery, how are you thinking about Q4 delivery trends this year versus normal seasonality given all the questions around the consumer and media activity in general? Any color there would be great.
Tom Leighton: Yes. As I just mentioned on the last question that we're probably a bit more cautious in terms of our outlook certainly with retail. I mentioned earlier in an earlier question that we've seen an uptick in bankruptcies. We do have a lot of customers that are on the 0 overage for commerce. So we're going into disease. We haven't seen it yet. It usually starts right after Thanksgiving. We're just being a bit more cautious. And in terms of the media cycle, -- we did see a little bit of gaming activity. Gaming has been light for the last 1.5 years. A couple of years ago, we saw a big console refresh cycle. We don't -- not expected to see that. So I'd say we're going into this quarter, probably a bit more cautious than we normally have in Q4 and certainly what we've seen in the past.
Operator: The next question is from Michael Elias of TD Cowen.
Michael Elias: First, earlier you talked about portability, particularly for cloud-agnostic workloads. I guess my question for you is, as you think about moving and garnering more share here, what are the steps that you could do to pretty much increase the ease of portability of workloads? And as part of that, through your data center deployments, do you have essentially direct cross connect into the cloud on ramps of the major cloud providers to essentially help facilitate the movement of workloads to your platform? And then I have a quick follow-up.
Tom Leighton: Yes. Great question. I think partners are really helpful there because they do a lot of the work in the first place to get into the third-party cloud provider. And today, some of them move between third-party cloud providers. And so there is a natural partner ecosystem that can be helpful porting that to Akamai. And I think they're finding that the terms are even more favorable for them as well as for the partners. Also, as we grow the ecosystem of third-party capabilities, which with our qualified compute partner program we're doing early focus on media there, which is our initial focus in terms of applications to move to Akamai. And yes, what it depends on the data center and the third-party cloud provider, but we do have direct connections in many cases. And of course, we operate, as I mentioned, one of the world's largest backbones and in a position to also make direct connections to major enterprises, which can help quite a bit. And then just as a quick follow-up. Just curious if you could talk a little bit about the M&A environment that you're seeing. I know you have that your security growth guidance that you gave at your Analyst Day, which includes some M&A. Just curious, any thoughts around the M&A environment, particularly for security? And maybe as part of that, just comments on valuation. Yes, valuations in the companies that we're most interested in are still extremely high. And you see some of the recent acquisitions that have been done at very high revenue multiples. So not a lot of change yet. Probably at the fringes, it's getting harder. But for companies that we have an interest in, I'd not say it's made a lot of improvement yet. That may change with time. We just have to see. It's something we keep a close eye on. Of course, we're always looking, but we're very disciplined buyers. So it really has to make very good sense for our customers and for our shareholders. Operator, we have time for one more, please.
Operator: The last question is from Jeff Van Rhee of Craig Hallum.
Jeff Van Rhee: Just one quick one on compute, Kind of getting to the inflection or the acceleration in growth. I have a couple of questions. Just on sales cycles there, refractory, what is the typical sales cycle for a compute deal? And then secondly, with the bulk of the build-out done, and it sounds like functionality isn't the limiter, then it's really just getting to maturity of these sales cycles. The sales force has trained the functionalities there, the infrastructure is there. So it looks like Q4 builds in organic growth roughly similar to Q3. So just trying to get a sense of timing of acceleration there.
Tom Leighton: Yes. Good question. There is the sales cycle. But when you close the deal, then there's the effort to actually port it and then the time to grow it. And so it's not like maybe one of a normal service or sell delivery were very quick to to port the business and turn it up. It can -- that can happen in a period of days to weeks. Here, probably it's more months to actually get the app corded. And then all the traffic or all the compute won't move over all at once. You wouldn't be growing it over time. So it will -- this is something you'll see, I think, throughout next year as we close customers and then we grow their revenue. And the early signings we did this year, that's exactly what we're seeing, initially very small amounts of revenue, relatively speaking, and then grows over time.
Jeff Van Rhee: Okay. Well, thank you, everyone. In closing, we will be presenting at a number of investor conferences and events throughout the rest of the year. Details of these can be found in the Investor Relations section of Rockmy.con. Again, thank you for joining us, and all of us here at Akamai wish you and yours a wonderful rest of the year. Have a nice evening.
Operator: The conference has now concluded. Thank you for attending today's presentation. You may now disconnect.+ | [
{
"speaker": "Operator",
"text": "Good afternoon, and welcome to the Akamai Technology Third Quarter 2023 Earnings Conference Call. [Operator Instructions] Please note, this event is being recorded. I would now like to turn the conference over to Tom Barth, Head of Investor Relations. Please go ahead."
},
{
"speaker": "Tom Barth",
"text": "Thank you, operator. Good afternoon, everyone, and thank you for joining Akamai's third quarter 2023 earnings call. Speaking today will be Tom Leighton, Akamai's Chief Executive Officer; and Ed McGowan, Akamai's Chief Financial Officer. Please note that today's comments include forward-looking statements, including statements regarding revenue and earnings guidance. These forward-looking statements are subject to risks and uncertainties and involve a number of factors that could cause actual results to differ materially from those expressed or implied by such statements. The factors include any impact from macroeconomic trends, the integration of any acquisitions and any impact from geopolitical developments. Additional information concerning these factors is contained in Akamai's filings with the SEC, including our annual report on Form 10-K and quarterly reports on Form 10-Q. The forward-looking statements included in this call represent the company's view on November 7, 2023. Akamai disclaims any obligation to update these statements to reflect new information, future events or circumstances, except as required by law. As a reminder, we will be referring to some non-GAAP financial metrics during today's call. A detailed reconciliation of GAAP and non-GAAP metrics can be found under the financial portion of the Investor Relations section of akamai.com. And with that, I'll turn the call over to Tom."
},
{
"speaker": "Tom Leighton",
"text": "Thanks, Tom, and thank you all for joining us today. I'm pleased to report that Akamai delivered excellent results in the third quarter with revenue, operating margin and earnings all exceeding the high end of our guidance range. Revenue grew to $965 million in Q3, up 9% year-over-year. Non-GAAP operating margin was 31%, and non-GAAP earnings per share was $1.63, up 29% year-over-year. Ed will cover the key factors that drove our bottom line performance in his portion of the call. I'll now say a few words about each of our 3 main product areas, starting with security, our largest source of revenue. Security revenue grew 20% year-over-year in Q3. The acceleration in security growth was driven in part by especially strong demand for our market-leading Guardicor segmentation solution as enterprises confront the ever-present threats from malware and especially ransomware. CISOs and corporate Boards everywhere have seen the recent headlines about devastating ransomware attacks, including at 2 casino hotels in Las Vegas, a major manufacturer of cleaning products in the U.S. and at a multinational provider of systems for smart buildings. One of them reportedly paid $15 million to get ransomware out of their systems. Another is reportedly spending $25 million to deal with the after effects and a third has reported more than $100 million in losses from the attack. Customers who purchased our segmentation solution last quarter include a major global services provider, one of the world's most recognized entertainment brands and a leading bank in Switzerland that renewed their segmentation protection with a significant upgrade. We also saw strong demand for our market-leading web app firewall solutions in Q3, where we continue to win against competitors who are challenged to provide the levels of reliability and performance required by major enterprises. Customers who switched to Akamai, including a nationwide retail chain in the U.S. and a leading global manufacturer based in India, also told us that our competitors simply can't provide the level of support and professional services that they need and have come to depend on from Akamai. Customers also value being able to purchase an entire suite of integrated security products from Akamai, a provider who they trust to keep them safe against a wide variety of attacks. For example, we're seeing very strong interest in our new API security solution that we announced last quarter. This new product is in its very early days, but we've already integrated it with our market-leading web app firewall solution to make it even easier for customers to implement. At the Black Hat security conference last quarter, Akamai API Security was named one of the 20 hottest new cybersecurity tools by CRN, a major trade publication for channel resellers. And as with Guardicore, you don't need to be a CDN customer to benefit from this new solution. Turning now to cloud computing. I'm pleased to say that we're on track with our product development, infrastructure deployment and conversations with customers about use cases well suited for the Akamai connected cloud. Since our last call, we've gone live with 7 more core compute regions in Amsterdam, Jakarta, Los Angeles, Miami, Milan, Osaka and Sao Paulo. In addition to the 6 that we opened earlier this year and the 11 that we acquired from Linode, this brings our total to 24 core compute regions to serve Akamai connected cloud customers. Of course, there are other cloud companies with a few dozen data centers. But Akamai is unique in having these data centers interconnected to the world's most distributed edge platform with more than 4100 points of presence across 750 cities and 130 countries. As one trade pub block and files recently wrote, Akamai is focusing on a future where scale becomes more about the size of the network versus the size of its data centers, more effectively powering modern applications. We agree. Akamai's massively distributed edge network, 25 years in the making and managed by Akamai's team of experts around the world is a key differentiator in our strategy. We believe that next-generation applications will need next-generation cloud infrastructure, and we intend to chart the course for the next decade of cloud computing when more of the compute will be done closer to the end user and where we believe our platform will have an important edge over more centralized models. As IDC put it in July, Akamai brings the simplicity, affordability and accessibility of its cloud computing services to larger commercial customers on an architecture built for the next decade, not the last. The Akamai Connected Cloud will put containers and VMs closer to end users and bring enterprise workloads to locations around the world that are otherwise difficult for organizations to reach. Customers are responding to Akamai's unique offering, and we've already gained cloud computing business across multiple verticals in every major geography, including a European streaming media company, a digital advertising company in Japan, a large financial institution in Indonesia, and e-commerce platform in Korea, major carriers in EMEA and Central America and a television network in South America. In addition to direct sales, we're seeing good traction in our cloud computing partner ecosystem, where we're acquiring new customers by selling with cloud service providers and managed service providers. We've also partnered successfully with independent software vendors and SaaS and PaaS providers. In fact, we recently signed one of the world's best-known SaaS providers and our second largest cloud computing deal since we acquired Lanone [ph] Turning now to content delivery. I'm pleased to report that we saw an acceleration of traffic growth in Q3. In addition, we acquired enterprise customer contracts from StackPath and Lumen Technologies following their decisions to exit the CDN market. As Ed will talk about shortly, the financial terms of the acquisitions were very attractive for Akamai shareholders. In addition to the delivery business that we acquired, we're planning to introduce these customers to our full portfolio of security and cloud computing solutions to help them power and protect their businesses online. In summary, we are very pleased by our performance in Q3. Our expanded security portfolio is deepening our relationships with customers. Our cloud computing plans are executing on schedule, and we continue to invest in Akamai's future growth while also enhancing our profitability. Now I'll turn the call over to Ed for more on our Q3 results and our outlook for Q4 and the full year. Ed?"
},
{
"speaker": "Ed McGowan",
"text": "Thank you, Tom. As Tom mentioned, Akamai delivered a strong and very profitable quarter in Q3. In my remarks today, I'll cover our Q3 results and then provide some perspective on Q4, share some details on our recent customer contract acquisitions and closed with our increased full year 2023 guidance. First, let's discuss revenue. Total revenue for the third quarter was $965 million, up 9% year-over-year as reported and in constant currency. In the third quarter, Security revenue was $456 million, growing 20% year-over-year as reported and 19% in constant currency. Security revenue growth was primarily driven by continued strength in our segmentation product, which is now over $100 million on an annualized run rate basis and up 97% year-over-year. I'll note that during the quarter, we had approximately $6 million of onetime segmentation license revenue. Adjusting for that onetime license revenue, total security growth for the third quarter would have been 18% year-over-year as reported and 17% in constant currency. And segmentation revenue growth would have been approximately 62% year-over-year and 60% in constant currency. In addition to strength and segmentation, we also saw very strong growth in our flagship Web Application Firewall or WAF product family. This growth was primarily driven by stronger-than-expected adoption of new security bundles offered to new and existing customers that we introduced this year. The new security bundles include additional security entitlements such as more security policies, additional security configurations and more advanced rate control policies. Many existing customers are seeing greater value in these new bundles and as a result, are spending more with us. Moving to compute. Revenue was $130 million, growing 19% year-over-year as reported and in constant currency. On a combined basis, our securities and compute business product lines represented 61% of total revenue, growing 20% year-over-year and 19% in constant currency. Shifting to delivery. Revenue was $379 million, declining 4% year-over-year as reported and in constant currency. It's worth noting that delivery was aided by approximately $4 million in revenue from the selected CDN customer contracts we acquired from StackPath. International revenue was $467 million, up 11% year-over-year and up 9% in constant currency. Foreign exchange fluctuations had a negative impact on revenue of $3 million on a sequential basis and a positive $7 million benefit on a year-over-year basis. Moving now to company profitability. Non-GAAP net income was $251 million or $1.63 of earnings per diluted share, up 29% year-over-year and up 28% in constant currency. These especially strong EPS results exceeded the high end of our guidance range by $0.11. -- were driven primarily by higher revenues and continued progress on the cost savings initiatives we outlined over the last few quarters. As an example, we continue to reduce our third-party cloud spend by migrating internal workloads to our connected cloud platform. In Q3, our third-party cloud spend declined 26% year-over-year. Moving to margins. Our cash gross margin was 73%. Included in our Q3 cost of goods sold was approximately $5 million of transition services agreement or TSA costs paid to StackPath. With customer contract acquisitions, TSA payments are used to cover the seller's customer-related network and support costs during the migration period.\\ I'll provide further detail on expected TSA costs going forward in the guidance section in a few moments. Adjusted EBITDA margin was 43%, and our non-GAAP operating margin was 31%, 2 points ahead of our guidance, driven by our revenue outperformance and continued focus on driving down costs across the business. Moving now to cash and our use of capital. As of September 30, our cash, cash equivalents and marketable securities totaled approximately $2.1 billion, which includes the proceeds from the convertible debt raise we did during the quarter. As a reminder, in August, we issued $1.65 billion of senior unsecured convertible debt that will mature on February 15, 2029. The notes will bear interest at a rate of 1.125% per year payable semiannually. Finally, the net proceeds of approximately $1 billion from this offering have been invested in highly liquid marketable securities. These securities yield approximately 5.25% on a weighted average basis with maturities close to May 2025 as we intend to use these proceeds to pay off approximately $1.15 billion of convertible notes that mature in May 2025. We -- for the third quarter, we spent roughly $113 million to repurchase approximately 1.1 million shares. We now have roughly $600 million remaining on our previously announced share buyback authorization. Our approach to capital allocation remains the same to opportunistically buy back shares to offset dilution from employee equity programs over time while maintaining sufficient capital to deploy when strategic M&A presents itself. Before I cover Q4 guidance, I want to provide a quick reminder about our typical fourth quarter dynamics and add some color to our 2 recent transactions with StackPath and Lumen. As in prior year, seasonality plays a significant role in determining our financial performance for the fourth quarter. Typically, we see higher-than-normal traffic from large media customers and they pick up in seasonal online retail activity from our e-commerce customers. Both of these traffic patterns are difficult to predict. Q4 also tends to have higher operating expenses than in Q3, driven by higher sales commissions due to accelerator payments for sales reps who overachieved their annual quotas. As it relates to the transactions with StackPath and women's, first, both transactions were acquisitions of selected CDN customer contracts, including over 200 net new customers to Akamai. We did not acquire any other assets or liabilities at either company. Second, we expect the 2 transactions combined will add approximately $17 million to $20 million of revenue in Q4. Third, we expect to record approximately $13 million to $14 million of StackPath and lumen TSA costs in Q4. These costs will be recorded in our cost of goods sold and will have a negative impact of approximately 1 percentage point on gross margin, adjusted EBITDA margin and non-GAAP operating margin. Combined, the stack path of lumen TSAs will negatively impact our Q4 EPS by approximately $0.06 to $0.07. We do not expect to incur any material TSA costs in 2024. And finally, our expectations for these customer acquisitions remain the same as we disclosed previously for the full year 2024. As a reminder, we expect the customer contracts acquired from StackPath to add approximately $20 million of revenue in 2024 and to be accretive to non-GAAP earnings per share by $0.03 to $0.05. And we expect the customer contracts acquired from women to add approximately $40 million to $50 million of revenue in 2024 and to be $0.08 to $0.12 accretive to non-GAAP EPS. With all that in mind, we are now projecting fourth quarter revenue in the range of $985 million to $1.005 billion or up 6% to 8% as reported and in constant currency over Q4 2022. We -- at current spot rates, foreign exchange fluctuations are expected to have a negative $8 million impact on Q4 revenue compared to Q3 levels and a positive $2 million impact year-over-year. Taking into account the impact of the StackPath and Lumen TSAs for the fourth quarter, we expect cash gross margins of approximately 72%. Q4 non-GAAP operating expenses are projected to be $305 million to $311 million. We expect Q4 adjusted EBITDA margin of approximately 41%. We expect non-GAAP depreciation expense to be between $123 million to $125 million, and we expect a non-GAAP operating margin of approximately 29% for Q4. Moving on to CapEx. We expect to spend approximately $143 million to $153 million, excluding equity compensation and capitalized interest in the fourth quarter. This represents approximately 15% of our projected total revenue for the fourth quarter. Additionally, our CapEx guidance includes the integration requirements to support the traffic for both CDN customer contract acquisitions. Based on our expectations for revenue and costs, we expect Q4 non-GAAP EPS to be $1.57 to $1.62. This EPS guidance assumes taxes of $50 million to $52 million based on an estimated quarterly non-GAAP tax rate of approximately 17%. It also reflects a fully diluted share count of approximately 155 million shares. Looking ahead to the full year, we have increased revenue to a range of $3.802billion to $3.22 billion, which is up 5% to 6% year-over-year as reported and 6% in constant currency. At current spot rates, our guidance assumes foreign exchange will have a negative $18 million impact on revenue in 2023 on a year-over-year basis. We are raising our security revenue growth expectations to approximately 15% for the full year 2023, and we continue to expect to achieve approximately $0.5 billion in revenue from compute in 2023. And despite a year of significant investment, we are estimating non-GAAP operating margin of approximately 29%. With all that in mind, we have raised our estimated non-GAAP earnings per diluted share to a range of $6.08 to $6.13. Our non-GAAP earnings guidance is based on a non-GAAP effective tax rate of approximately 17%, and a fully diluted share count of approximately 155 million shares. Finally, our full year CapEx is expected to be 19% of total revenue. In closing, we are very pleased with how the business is performing in 2023 as we continue to invest for revenue growth and improve our profitability. With that, we now look forward to your questions. Operator?"
},
{
"speaker": "Operator",
"text": "[Operator Instructions] The first question is from James Fish of Piper Sandler. Please go ahead."
},
{
"speaker": "James Fish",
"text": "Really nice quarter there. Understanding you're selling Guardicore to the installed base primarily. But what are you seeing with selling outside of the installed base with security and compute and specifically within security. Is there a way to think about that drag along effect or how the Guardicore enterprise sales team are really dragging along the rest of the security or even compute portfolios into any net new customer wins. Really, the crux of the question is how is the sales process going outside of the CDN installed base?"
},
{
"speaker": "Ed McGowan",
"text": "Jim, this is Ed. I'll start. Tom, you can jump in if there's anything you want to add. So actually, it's interesting, you started off by saying Guardicore is mostly to the installed base. Actually, we've done a really nice job of selling to new customers. One of the things that came over as part of the Guardicore acquisition is a pretty robust channel and pretty much every deal is done through the channel. As a matter of fact, I think we can do a better job of selling in the installed base and probably come up with some new incentives to incentivize the sales force to do that. So there's a ton of room in the installed base because most of the growth in Guardicore has come from outside the installed base."
},
{
"speaker": "Tom Leighton",
"text": "Yes. And I would just add to that, that there is good drag along with Guardicore and for example, Enterprise Application Access, one is considered north-south, the other East West, both are really important in terms of keeping malware out and identifying when it gets in and really blocking the spread. So it's good that way, too."
},
{
"speaker": "James Fish",
"text": "Helpful, guys. And just a follow-up, Tom, you had actually started to allude to it a little bit. But as we think about those lumen and Exacto [ph] contracts, I guess how much wallet share do you have in aggregate of these new customers? Or what's the overall opportunity for those specific customers beyond just that CDN revenue that you bought?"
},
{
"speaker": "Tom Leighton",
"text": "Yes. Well, obviously, there's a CDN revenue, which is what transfers, but we're going to be looking to sell our security and compute solutions into those 200-plus new customers. And I think there's some good opportunity there."
},
{
"speaker": "Operator",
"text": "The next question is from Fatima Boolani of Citi."
},
{
"speaker": "Fatima Boolani",
"text": "Good afternoon. Thank you for taking my question. Tom, maybe I'll start with you. I want to have a broader conversation with regards to some of these contracts that you've been acquiring, it's setting up to be a little bit of a pattern. So look, you've been doing delivery for the better part of 2 decades here. So I wanted to get your kind of longitudinal perspective on what you're seeing in the marketplace and the market backdrop that's sort of pointing more and more towards consolidation in the delivery here. And then ultimately, I wanted to get your perspective on how you think this is going to impact some of the pricing dynamics and ultimately, your pricing power in the delivery space. And then I have a follow-up for Ed, if I may."
},
{
"speaker": "Tom Leighton",
"text": "Yes, I wouldn't call it a pattern. It's been a long time, really since we've acquired a competitor or a competitor contracts. This is a situation where 2 of the many CDNs out there decided to discontinue their operations. And they wanted -- now they're still remaining as companies, obviously, and they wanted to have their customers have the best possible experience as they exited the CDN space. And so they approached Akamai as the leader by far in CDN and made very compelling financial terms for the transaction. So it makes a lot of sense for our shareholders that we take on these customers. And also, it's a good opportunity as we mentioned, to sell them security and compute. So really good for shareholders. It's not something that we're actively doing trying to go buy other CDMs. But every once in a while, there is an opportunity that is compelling for shareholders. I don't see any fundamental change in the marketplace the hyperscalers and a dozen - 2 dozen other companies are selling delivery services. So I don't think there'll be any fundamental change there or change with pricing. Separately from this, of course, you know that we talked about Akamai as being more conservative with pricing, as we talked about, we're not taking some of the spiky traffic, if the pricing doesn't make sense because we've been focusing more on the capital deployment into our compute offering, which we see enormous potential future growth for..."
},
{
"speaker": "Fatima Boolani",
"text": "Perfect. Thank you. Ed, I was hoping I could parse out some of your prepared remarks with respect to the third-party cloud spend that you're effectively in-sourcing. I believe a couple of quarters ago, you may have ballpark that figure at about $100 million. So please correct me if that recollection is correct. And also just wanted to get a sense of how far down the path you are in this in-sourcing of third-party cloud spend on your Connected Cloud platform. Thank you."
},
{
"speaker": "Ed McGowan",
"text": "Yes, sure. That's a great recollection, thought me you're correct. That's about $100 million or actually north of $100 million. So we are still in the earlier innings of the journey. However, we've made a lot of progress, and the team is doing a great job. So we expect to see that the savings continue to ramp. I'm very happy to say that we're slightly ahead of where we expected to be, and we have a lot of confidence that we'll be able to drive the type of savings that we expect to throughout next year."
},
{
"speaker": "Fatima Boolani",
"text": "Thank you."
},
{
"speaker": "Operator",
"text": "The next question is from Magellan Brooks [ph] of Bank of America. Please go ahead."
},
{
"speaker": "Q – Unidentified Analyst",
"text": "Thanks for taking my question. Just want to dive into security a bit and see are the trends differing between international and domestic in terms of what products are getting better versus not? And then one follow-up question after that. Thanks."
},
{
"speaker": "Tom Leighton",
"text": "I don't think there's a fundamental difference. The attacks are global in nature and the same attacks we see here domestically. We see in pretty much all of the major geos. And yes, you do see a little bit more attacks where there's hotspots wars taking place or political tensions, there'll be more attacks, but the nature of the attacks is similar. You got a denial of service attacks, you got ransomware. You've got application layer attacks, more recently, AI attacks. So -- and that happens everywhere because there's no reason it should be in one geography versus another."
},
{
"speaker": "Q – Unidentified Analyst",
"text": "Got it. And then for the Connected Cloud and just the compute segment as well, you guys talked about a lot of really nice international deals, but also just wanted to get a pulse on what's happening domestically and appetite for the products here."
},
{
"speaker": "Tom Leighton",
"text": "Again, I think that is universal as well. We'll have special advantages in locations where the hyperscalers aren't. But that kind of compute capability can be accessed by customers anywhere. Big U.S. companies care a lot about being able to give really good performance for their users all around the world. So again, I think that's -- there's not a fundamental difference between the U.S. or other regions. We have gotten off to a really good start, and I would say APJ, but it's across the board. We're deep in conversations with major enterprises across all the major geos."
},
{
"speaker": "Q – Unidentified Analyst",
"text": "Got it. Congrats."
},
{
"speaker": "Operator",
"text": "The next question is from Ray McDonough of Guggenheim Securities. Please go ahead."
},
{
"speaker": "Ray McDonough",
"text": "Thanks for taking the questions. And Ed, I appreciate the color on the additional bundles of security and the additional services you added to those bundles. And then in our conversations, we did pick up a decent price up with when those services are added. So can you help us understand what sort of pricing uplift, if any, there might be there? And what the penetration rate is in your installed base currently of those services and what the opportunity is going forward?"
},
{
"speaker": "Ed McGowan",
"text": "Yes. So I'll start and then Tom, if there's anything you want to add. So this is a pretty targeted program that we identified customers in selected verticals primarily in commerce, manufacturing, health care, pharma, financial services, what we traditionally call sort of our legacy web customers. And as we have talked about, included a lot more services and functionality into the bundles. And upon renewal, we're able to upsell. And we're about -- this is probably 2,000 to 3,000 customers that fit into this sort of targeted group. We're probably about halfway through in terms of the customers that come up for renewal. If you remember, our customer -- average customer contract length is about 18 months. So this probably runs about 18 months to 2 years kind of a program, but we're very happy with what we're seeing with the average uplift on the average sale price."
},
{
"speaker": "Ray McDonough",
"text": "Great. And then maybe if I could, just on compute. Now that the majority of those core data centers are online. Can you talk about how much of the contracted space you filled out and what sort of utilization you're hoping to achieve as you enter 2024? I know you're not going to provide any sort of guidance here, but any sort of guidepost in terms of the actual capacity that will be online in '24 and what the compute pipeline looks like heading into next year to fill that capacity, it would be helpful just to understand kind of the capital needs of that business as we think about '24."
},
{
"speaker": "Ed McGowan",
"text": "Yes. In terms of the capital, we pretty much now done the major buildout. And of course, we're big consumers of that ourselves as we move our own applications in-house to Akamai Connected Cloud. And we've also got plenty of room to take on major enterprise business. So I don't think you'll see a lot of CapEx associated with the big core data centers until we start generating a lot more revenue from that. And then we would build out further. There'll probably be another couple that we do. What you will see is a relatively smaller amount of CapEx as we do build out into our existing Edge pops. And our goal is to start equipping them with compute so that you can run containers, VMs, Kubernetes and many more cities around the world. And so that -- and more cities than you can do that with, for example, the hyperscalers. And so that will be taking place over the course of the next year, but it's not a large amount of CapEx, so much smaller than what you saw this year. And then going from there, it will depend on how fast the revenue grows. So it will be a good news story if we're back next year saying that, okay, great, we fill that up, and now we're going to be building out some more. So it's a much better situation than we were in this year where there was a lot of build out getting ready and no revenue yet."
},
{
"speaker": "Operator",
"text": "The next question is from Frank Louthan from Raymond James."
},
{
"speaker": "Frank Louthan",
"text": "Great. Thank you. Can you give us some color on sort of the nature of the compute deals that you're getting now versus maybe 6 to 12 months ago? And then what have you learned by putting some of your own enterprise-level workloads on the compute platform that you've maybe been able to utilize as you sell to customers? And how has that process benefited the product?"
},
{
"speaker": "Tom Leighton",
"text": "Yes. Good question. I would say you start going back 6-plus months ago, there really wasn't a lot of compute deals at that time because the Linode infrastructure really wasn't ready for it. There was some early experimentation. Now we're in a position where we really can take on mission-critical applications from big enterprises. We're starting to do that. Some are starting to grow very nicely. In terms of the learnings, we've learned a lot. I would say on the good news side, we're saving a lot of money. And we're going to help our customers save a lot of money. We're also seeing really good performance and better in many cases than we can get with the hyperscalers. And as we go forward, we'll get -- we, of course, have better scalability in terms of faster scalability. And for Akamai, that's really important because we have a lot of customers that have flash crowds, peak events and so forth, Hard to predict how big they'll be. And with our deployed platform, we're really good at that, of course, with security and with delivery. And now we're applying those capabilities to compute so that we can spin up more compute instances in a faster, more responsive way. So we're very happy consumers of our own cloud. Now on the other side, we've learned that it's not just flip a switch. And you just don't flip a switch and suddenly you're off the hyperscaler and you're on to Akamai. And of course, that's true when you move from any cloud environment into another one, it does take some effort to do it, but it is well, well worth it. And we're so a great reference, and we can now help our customers and our partners. We're working with many partners in cloud so that they can take their customers and get them on to Akamai Connected Cloud."
},
{
"speaker": "Operator",
"text": "Next question is from Tim Horan of Oppenheimer."
},
{
"speaker": "Tim Horan",
"text": "Staying on that point, can you maybe just talk about the backlog and customer interest at this point? Just any update, it sounds like it's going well. Also, where are you kind of all the value-added services and tools? And I just -- maybe just a complete cloud portfolio at this point? And then lastly, could you just remind us what the margins of this business will look like longer term? And I guess we do get asked a lot like why can you sell this cheaper than the cloud providers, I guess, at the end of the day? And will that impact your margins?"
},
{
"speaker": "Tom Leighton",
"text": "Okay. A lot of components there. I'll start with some of them and then probably Ed will fill in with some. Yes, we're in a lot of really good conversations, as you can imagine, because the world's major media companies, gaming companies, commerce companies all use Akamai. They had for many, many years. They trust us for scale, reliability, performance, they trust us with security. They trust us not to compete with them. And as they see what we're building in terms of compute, they like the idea of getting better performance, more distributed compute capabilities. And some of those folks really like the idea of a much lower price point. And as an extra benefit, especially if you're in media or commerce, it's getting to be a bigger problem that they're cutting such giant checks to their leading competitor and sharing all the crown jewels of their data with their leading competitor. So they're taking the Akamai solution with great interest, I would say. Now in terms of being cheaper, Akamai has been for a long time, the world's most distributed platform. We run one of the world's largest backbones. We have worked for many, many years to be incredibly efficient in terms of moving data around and doing the delivery. And that gives us a real advantage of being able to do this now for compute in a very cost-effective way. Now that said, I am sure that the hyperscalers pay a little bit less for their hardware than we do, probably not a lot less, maybe a little less. But when it comes to everything else, I think Akamai is in an excellent position. And what we're seeing in the marketplace is that they'll get their best offer from the hyperscalers, and we can be a lot lower than that and be very profitable at doing it. And the good news, I think, for Akamai is that here you've got a $10-plus billion market growing at 20% a year. And we're a tiny guy there compared to the hyperscalers. So we can operate at a level that is not threatening to them in any way. They got to worry about each other. And there's plenty of room for us to take on a lot of revenue at lower price points and very good margins for Akamai. Now in terms of the marketplace, that's an area, obviously, with the hyperscalers are way ahead some of those folks, every application ever made is available in the marketplace. -- as a managed service, we are growing our marketplace. We are growing the tools that are available on Akamai Connected Cloud. And the first applications that we're targeting are applications that are more easily able to be cloud agnostic, that are not locked in, that aren't using 20 other applications in the marketplace. And so that we are much easier to port onto Akamai Connected Cloud. And so there are some applications that won't be able to report in the near term. But we don't need all those applications. All we need is to get going as a tiny share of that market. And we've identified just, for example, in the media vertical alone, there's a lot of applications that are amenable to moving to our platform. And of course, a lot of our partners in our marketplace to begin with our media-related companies, for that reason because they're also threatened by the hyperscalers, and they're very excited about having media applications beyond Akamai. Ed, do you want to add anything there?"
},
{
"speaker": "Ed McGowan",
"text": "Yes. Just a couple of things. Yes, Tom talked a little bit about the leverage we have with the backbone, but we also have a lot of other leverage in the company with our go-to-market, where the focus is going to be initially with our installed base. As Tom talked about in media to start, there's a tremendous amount. We pretty much work with every major brands. So there's a lot of leverage from that perspective. Also the people that build and deploy the network are the same people who are building and deploying our CDN network. -- and we're getting leverage with our co-location vendors and things like that. So we -- I've seen some pretty large proposals go out that get us margins that are pretty similar to the company margins in terms of gross margins that are somewhere between security and delivery and operating margins that potentially could be even greater as we get scale to the bottom line. So there's an enormous amount of margins. If you think of the math that we're doing with how much we're saving, the amount of capital that we're deploying and the cost, we're going to be saving a tremendous amount of money on moving our own applications, and we'll be able to offer some of that to our customers as well."
},
{
"speaker": "Operator",
"text": "The next question is from Alex Henderson of Needham & Company."
},
{
"speaker": "Alex Henderson",
"text": "Great. I'm rather than astounded that we haven't heard the word AI, so far in this conference call, at least I don't think we have. So can you talk a little bit about the impact of AI in terms of your opportunity to bring it to compute? Is it something that you think you can bring to the edge piece? Or is to run on your security -- our CDN Edge. And alternatively, is at a risk in the sense that InferenceI is going to be distributed, but a lot of the compute process might be more centralized in that context, diminish the willingness of people to move applications to your compute. So how do I think about the - the infant AI opportunity and the risk of customers being more challenges in moving."
},
{
"speaker": "Tom Leighton",
"text": "Okay. Great question. In fact, there's a lot of components to this one, too. At a high level, there's a lot of potential opportunity, I would say. But let me step back just a minute. Akamai has been using AI and machine learning in our products for a long, long time. Obviously, useful for anomaly detection, bot detection, when an entity is accessing their bank account with the right credentials. Is it the right person or not detecting that malware has infected an application inside an enterprise. Lots of ways that we've been using AI and machine learning. Now with Gen AI, I think it helps some, but it really helps the attack. It's much easier now to morph malware into a lot of different forms, makes it harder to detect. Our teams have created some very nasty bots very quickly using Gen AI. And I think we're already seeing more penetration as a result of Gen AI. That's one area where really it is being actively used today. Now on that side of the house, the implications are -- there's more risk in terms of cybersecurity for enterprises. They're going to get penetrated more. And so you really have to double down on your defense and depth. I think it makes products like [indiscernible] segmentation even more critical because you're going to get penetrated, the key is to identify it quickly and proactively block the spread. And that -- I think when you look at our growth rate there, very, very hot with a market-leading solution. Now you also asked about what about compute and the impact of Gen AI there? I do think over time, it will suck up a lot more compute. And that's good for vendors selling compute, like Akamai sales compute. And you're right, there's a difference between the generation of the model, which is -- if they're large models, very heavy, and that will be done in core compute and storage data centers. inference engines can run at the edge and will make sense to run at the edge for many applications. And we already have several partners that are porting their AI models on to Akamai for inference engines -- and so -- and I expect that they will be selling that in our marketplace to other companies. And so in fact, we're already in a sense, using AI as we put our internal applications on to Akamai Connected Cloud. So I think you will see, over time, a lot of revenue generated there because of all the uses that I think will come about through AI. Now you ask about risk. I think you will need -- you do the model generation in the big data centers. That's not a risk for Akamai because we've got 2 dozen of those today. So that's -- it's just to be done in a different place. It won't be done at the edge. But inference engines, yes, a lot of that work will be done at the edge, and we're in a great place there because other companies don't have an edge, anything like Akamai.."
},
{
"speaker": "Operator",
"text": "Next question is from Abdul Khan of Evercore."
},
{
"speaker": "Q – Unidentified Analyst",
"text": "This is Dua speaking for Abdul. And I just wanted to ask for you broadly on the enterprise spend environment. And I know we've previously we've noted elongating sales cycles. And I was just generally curious whether there's any change there. And if you had to characterize it, is enterprise IT spend incrementally worse or better or about the same versus, let's say, 90 days ago?"
},
{
"speaker": "Tom Leighton",
"text": "Yes. Good question. I would say, I think there's a lot of companies that are being cautious. We have seen a slight uptick in bankruptcies as you typically would see in cycle like this. But we're not seeing a significant impact certainly in our security business. If anything, we've seen better-than-expected results there. So I think security is not as impacted, at least at the moment. Obviously, there's a lot of speculation out there that we're heading towards a recession and things can change pretty quickly. But so far, we fared very well. And also, if you think about our messaging around compute, one of the biggest challenges a lot of companies have is the runaway cost of compute, and we offer a very compelling option for people to look to save money and increase their performance by moving to us. So I think that will play into our favor in an environment like this."
},
{
"speaker": "Operator",
"text": "Next question is from Mark Murphy of JPMorgan."
},
{
"speaker": "Mark Murphy",
"text": "Ed, how noticeable or how sudden is the increase that you're seeing and the sophistication of all these mallware and ransomware attacks. The part of why I was asking is we noticed that you're launching some scrubbing centers in Canada. And I'm wondering if that's driving CapEx a little higher to help make sure that you're able to address all these attacks. And then I have a quick follow-up."
},
{
"speaker": "Tom Leighton",
"text": "Yes, let me just start on the product side, and then Ed will pick up your questions. So ransomware isn't related to scrubbing centers. scrubbing centers are just restricting the flow of packets and screening out or scrubbing out the packets that are trying to flood any particular resource. And that's nothing really per se to do with malware and ransomware to filter that out, you need application layer defenses where the scrubbing centers are routing layer defenses. And putting the scrubbing centers in Canada, and we're actually putting scrubbing centers in many more cities around the world and greatly increasing our capacity so that with local customers there, we can do the scrubbing for them locally. And that gives them better performance while we're giving them the defense against the volumetric attacks. For ransomware, you need Gardicor for malware, you need app and API security. And those are different products where they're done at our edge network in the 4,000 POPs, EdgePops we have around the world. And then, Ed, do you want to pick up the other part of that?"
},
{
"speaker": "Tom Leighton",
"text": "Yes, sure. Usually, the -- as Tom mentioned, the building of the scrubbing center generally will follow where we see significant demand from customers. And one of the other reasons security is up a bit this year as we have seen an increase in some of these volumetric attacks in the health care sector, a little bit in the financial sector as well. So this is pretty ordinary course for us. So in terms of like the CapEx needs or builds going forward, I'd say this is just ordinary course -- there's really nothing unusual to call out there, but we have seen a bit of a pickup in DDoS, in particular, tends to be a bit more episodic as you see big headline grabbing attacks. We do tend to see a pickup in business. And oftentimes, that will include a scrubbing center build. But they're pretty well informed with where we're seeing increased demand."
},
{
"speaker": "Mark Murphy",
"text": "Okay. Understood. And then, Ed, just as a follow-up, did you mention what was the total consideration paid for the acquired contracts from StackPath in Lumin? I'm wondering, I believe those are expected to contribute something like $60 million to $70 million next year in aggregate. Is that -- are you taking -- like are you assuming a similar ongoing run rate that those contracts had with the prior providers and extrapolating that into next year? Or are you contemplating into that any kind of expansion, contraction, right, or pricing that up or pricing that lower?"
},
{
"speaker": "Tom Leighton",
"text": "Sure. Let me start -- I'll take it in different pieces here. So in terms of anticipating any upsell or anything like that with the 200-plus customers, I haven't factored anything in for that. So that would be upside to the extent that we can do that. Remember, we purchased selected contracts. There are certain contracts that we did not take. There's, for example, adult content and some of the small medium business customer contracts we didn't take. So that's not included. So if you're looking at other numbers that you may have heard about these companies are private, I'd just caution anybody with private company numbers and other is accurate. We just looked at the contracts that we're acquiring, what we think will -- how many will onboard, what will happen with pricing, how much traffic we'll keep some of these customers are splitters, so we anticipate some of that traffic may go away. But we've tried to factor all that in. So what we're trying to do effectively is look at the other side of the integration in terms of the contracts that we acquired, what is that run rate of business that we acquired taking into consideration the best we can, volume and pricing dynamics. In terms of consideration, we'll file our 10-Q tomorrow, and you'll see that for STACK PAT, that contract has got an upfront fee of about $35 million, and there's a small earnout. Also with the TSA agreement, a little wonky accounting here for you, but you have to fair value the TSA and to the extent that there's excess cost there that goes to the purchase price. So when you see the final 10-K once it's filed and the cash flow, the numbers may be slightly higher. On the lumen, it's about $75 million. There is no earnout there. Same comments on the TSA. There is a fair value analysis you do in purchase accounting. So that might be slightly higher. But that's the extent of the agreements."
},
{
"speaker": "Operator",
"text": "The next question is from Rishi Jaluria of RBC."
},
{
"speaker": "Rishi Jaluria",
"text": "One wanted to follow up on 2 earlier questions that were asked, one on AI and then one on the contracts. Thinking specifically around AI, Tom, I appreciate your answer earlier. If we think about the opportunity to do inferencing at the edge, especially for cases like connecting devices or med tech or financial services now that people are increasingly worried about data and data residency. Can you speak to a little bit of your opportunity for that? And maybe alongside that, what investments do you need to make both in the software stack as well as in hardware infrastructure, be it GPUs or anything else to really capitalize and get your fair share of that opportunity? And then I've got a quick follow-up."
},
{
"speaker": "Tom Leighton",
"text": "Great. Yes, the data residency, data sovereignty issues are increasingly important, as I imagine you know, -- and that's where Akamai has a great opportunity because we're in 130 different countries with our infrastructure. And as we move compute into our edge pops, that enables us to do the work locally, keep the data local, which is an exciting opportunity for us. And I think in the not-too-distant future, we'll be in locations and countries that even the hyperscalers aren't there. Now in terms of the work on the software stack to be able to do that, that is ongoing work now. We are actually already in beta with a few customers -- so we're pretty far along. And then next year, as I mentioned, there'll be relatively small amount of CapEx as we do build out in a nontrivial number of our edge pops to be able to support compute. Now today, at the edge, I don't -- we support GPUs today, but that would be more in the core data centers. I think for the inference engines, we're running that just fine on CPUs. And so as we look at the edge, where you'd be running the inference engines, I don't, I think, run on CPUs and be much more cost-effective than trying to buy GPUs or custom hardware there. I think where you might see that as more if you're working with large-scale model development. And then that would be in the core data centers. That wouldn't be at the edge. The edge is where you want to do the inferencing. And that's -- it seems like that's going to be working very well on our edge platform with CPUs."
},
{
"speaker": "Rishi Jaluria",
"text": "Got it. That's really helpful. And then just in terms of the StackPath and Lumen contracts, again, I appreciate the color in terms of your set of assumptions. Can you walk us through what you can do on your part to ensure those customers, whether they're net new or existing Akamai customers that maybe we're trying to use a multi-CDN approach, what you can do to get those customers to stay and to not turn off on to other competitors or even just kind of figure out how to reduce the peaty."
},
{
"speaker": "Tom Leighton",
"text": "Yes. Good question. I think first is the approach that we took, right? We got an inbound request from these 2 companies, and some of them are customers we know and have had a long relationship with. And providing an orderly transition is step 1 in the relationship, right? So now you get a warm relationship and introduction to it's a new customer, and certainly, for the customers that we have. They obviously know us -- and you get -- instead of having a jump ball in the open market, you have a chance to sit down with the customer and understand what their needs are, understand what's going on with their contracts, length of contracts, pricing, et cetera. And you could just set up a relationship and just go through a normal sales cycle effectively. I think we've got a pretty good track record, and I'm certainly understanding the customers. And if I think about sort of the weighted average of where the revenue is, we've obviously gone and talked to a lot of those customers. We obviously have had a long-term relationship with a lot of these folks. So I think we have a fairly high degree of confidence in the numbers that we've put out. Obviously, things can change. But based on our experience with a lot of these folks and with some of these new folks that we have not worked with us in the past, we have an awful lot of other services to offer that they didn't have before. And especially with security being such a big topic these days. We're hearing from some of these customers that they're glad that they have a relationship with us now."
},
{
"speaker": "Operator",
"text": "The next question is from Ruby Kessinger of D.A. Davidson."
},
{
"speaker": "Ruby Kessinger",
"text": "Ed, I just want to quantify the TSA impact. It seems to be about 1.5 points impact cash gross margins in Q4. Is that accurate? And just to be clear, it sounds like that, that TSA ends at year-end? Or when exactly does that TSA add?"
},
{
"speaker": "Tom Leighton",
"text": "Yes. So there might be just a tiny bit that goes into Q1 just depending on how the migration goes. Hopefully, we can be done with it by the next couple of months. Yes, it's just under 1.5 points. I rounded down to a point, but you're right. If you just take the amount divided by the revenue, it's about 1.3%, 1.4%."
},
{
"speaker": "Ruby Kessinger",
"text": "Okay. Got it. And then if I just look at your delivery guidance, which, I guess, is implied by your compute security revenue guidance, and then I back out the expected $17 million to $20 million of revenue from Lumin and StackPath in Q4, it implies delivery revenue flat to down in Q4 versus Q3. So is any extra conservatism in the Q4 delivery guide just based on what you're seeing from traffic trends or any pricing pressure to call out? Or why not -- why aren't we seeing a typical seasonal Q4 uplift in delivery revenue ex those acquisitions."
},
{
"speaker": "Tom Leighton",
"text": "Yes. That's a good question. First of all, there's $4 million of delivery in the Q4 number so that you have to look at the net delta between the 2. Also, there's about an $8 million headwind from FX. So there is some implied growth in the delivery number. As I talked about there's a high degree of uncertainty in Q4 as it relates to traffic, right? You've got -- typically, we see a big seasonality in terms of retail and the media side of the business. Retail as we've gone to 0 overage is less impactful. We do still see some bursting. I think we're being probably a bit more cautious, especially on the commerce side of the equation for now. But there is some implied growth in there as you factor in those other 2 items I just mentioned."
},
{
"speaker": "Ruby Kessinger",
"text": "Okay. That's helpful."
},
{
"speaker": "Operator",
"text": "The next question is from William Power of Baird."
},
{
"speaker": "Q – Unidentified Analyst",
"text": "This is Yan Simoes on for Will. So first of all, just looking at delivery, how are you thinking about Q4 delivery trends this year versus normal seasonality given all the questions around the consumer and media activity in general? Any color there would be great."
},
{
"speaker": "Tom Leighton",
"text": "Yes. As I just mentioned on the last question that we're probably a bit more cautious in terms of our outlook certainly with retail. I mentioned earlier in an earlier question that we've seen an uptick in bankruptcies. We do have a lot of customers that are on the 0 overage for commerce. So we're going into disease. We haven't seen it yet. It usually starts right after Thanksgiving. We're just being a bit more cautious. And in terms of the media cycle, -- we did see a little bit of gaming activity. Gaming has been light for the last 1.5 years. A couple of years ago, we saw a big console refresh cycle. We don't -- not expected to see that. So I'd say we're going into this quarter, probably a bit more cautious than we normally have in Q4 and certainly what we've seen in the past."
},
{
"speaker": "Operator",
"text": "The next question is from Michael Elias of TD Cowen."
},
{
"speaker": "Michael Elias",
"text": "First, earlier you talked about portability, particularly for cloud-agnostic workloads. I guess my question for you is, as you think about moving and garnering more share here, what are the steps that you could do to pretty much increase the ease of portability of workloads? And as part of that, through your data center deployments, do you have essentially direct cross connect into the cloud on ramps of the major cloud providers to essentially help facilitate the movement of workloads to your platform? And then I have a quick follow-up."
},
{
"speaker": "Tom Leighton",
"text": "Yes. Great question. I think partners are really helpful there because they do a lot of the work in the first place to get into the third-party cloud provider. And today, some of them move between third-party cloud providers. And so there is a natural partner ecosystem that can be helpful porting that to Akamai. And I think they're finding that the terms are even more favorable for them as well as for the partners. Also, as we grow the ecosystem of third-party capabilities, which with our qualified compute partner program we're doing early focus on media there, which is our initial focus in terms of applications to move to Akamai. And yes, what it depends on the data center and the third-party cloud provider, but we do have direct connections in many cases. And of course, we operate, as I mentioned, one of the world's largest backbones and in a position to also make direct connections to major enterprises, which can help quite a bit. And then just as a quick follow-up. Just curious if you could talk a little bit about the M&A environment that you're seeing. I know you have that your security growth guidance that you gave at your Analyst Day, which includes some M&A. Just curious, any thoughts around the M&A environment, particularly for security? And maybe as part of that, just comments on valuation. Yes, valuations in the companies that we're most interested in are still extremely high. And you see some of the recent acquisitions that have been done at very high revenue multiples. So not a lot of change yet. Probably at the fringes, it's getting harder. But for companies that we have an interest in, I'd not say it's made a lot of improvement yet. That may change with time. We just have to see. It's something we keep a close eye on. Of course, we're always looking, but we're very disciplined buyers. So it really has to make very good sense for our customers and for our shareholders. Operator, we have time for one more, please."
},
{
"speaker": "Operator",
"text": "The last question is from Jeff Van Rhee of Craig Hallum."
},
{
"speaker": "Jeff Van Rhee",
"text": "Just one quick one on compute, Kind of getting to the inflection or the acceleration in growth. I have a couple of questions. Just on sales cycles there, refractory, what is the typical sales cycle for a compute deal? And then secondly, with the bulk of the build-out done, and it sounds like functionality isn't the limiter, then it's really just getting to maturity of these sales cycles. The sales force has trained the functionalities there, the infrastructure is there. So it looks like Q4 builds in organic growth roughly similar to Q3. So just trying to get a sense of timing of acceleration there."
},
{
"speaker": "Tom Leighton",
"text": "Yes. Good question. There is the sales cycle. But when you close the deal, then there's the effort to actually port it and then the time to grow it. And so it's not like maybe one of a normal service or sell delivery were very quick to to port the business and turn it up. It can -- that can happen in a period of days to weeks. Here, probably it's more months to actually get the app corded. And then all the traffic or all the compute won't move over all at once. You wouldn't be growing it over time. So it will -- this is something you'll see, I think, throughout next year as we close customers and then we grow their revenue. And the early signings we did this year, that's exactly what we're seeing, initially very small amounts of revenue, relatively speaking, and then grows over time."
},
{
"speaker": "Jeff Van Rhee",
"text": "Okay. Well, thank you, everyone. In closing, we will be presenting at a number of investor conferences and events throughout the rest of the year. Details of these can be found in the Investor Relations section of Rockmy.con. Again, thank you for joining us, and all of us here at Akamai wish you and yours a wonderful rest of the year. Have a nice evening."
},
{
"speaker": "Operator",
"text": "The conference has now concluded. Thank you for attending today's presentation. You may now disconnect.+"
}
] | Akamai Technologies, Inc. | 24,522 |
AKAM | 2 | 2,023 | 2023-08-08 16:30:00 | Operator: Good day and welcome to the Akamai Technologies Second Quarter 2023 Earnings Conference Call. All participants will be in listen-only mode. [Operator Instructions] Please note that this event is being recorded. Now I’d like to turn the call over to Mr. Tom Barth, Head of Investor Relations. Please go ahead, sir.
Tom Barth: Thank you, operator. Good afternoon, everyone and thank you for joining Akamai’s second quarter 2022 earnings call. Speaking today will be Tom Leighton, Akamai’s Chief Executive Officer and Ed McGowan, Akamai’s Chief Financial Officer. Please note that today’s comments include forward-looking statements, including statements regarding revenue and earnings guidance. These forward-looking statements are subject to risks and uncertainties and involve a number of factors that could cause actual results to differ materially from those expressed or implied by such statements. The factors include any impact from macroeconomic trends, the integration of any acquisitions and any impact from geopolitical developments. Additional information concerning these factors is contained in Akamai’s filings with the SEC, including our annual report on Form 10-K and quarterly reports on Form 10-Q. The forward-looking statements included in this call represent Akamai’s view on August 9, 2022. Akamai disclaims any obligation to update these statements to reflect new information, future events or circumstances, except as required by law. As a reminder, we will be referring to some non-GAAP financial metrics during today’s call. A detailed reconciliation of GAAP and non-GAAP metrics can be found under the financial portion of the Investor Relations section of akamai.com. And with that, let me turn the call over to Tom.
Tom Leighton: Thanks, Tom, and thank you all for joining us today. I’m pleased to report that Akamai delivered strong results in the second quarter despite the ongoing challenges with the global economic environment and slower Internet traffic growth. Q2 revenue was $903 million, up 6% year-over-year and up 9% in constant currency. This result was driven by the continued rapid growth of our security and compute businesses, which when taken together were up 30% in constant currency. These two business lines now account for 54% of our overall revenue. Q2 non-GAAP operating margin was 29%. Q2 non-GAAP EPS was $1.35 per diluted share, down 5% year-over-year, but up 0.5% in constant currency. As Ed will discuss later, EPS was negatively impacted by foreign exchange rates and a higher effective tax rate compared to last year. Free cash flow was very strong at $223 million in Q2 and it accounted for 25% of revenue. We have been leveraging our financial strength to make substantial investments in enterprise security and cloud computing. We have also used some of this cash to buyback additional stock. In the first half of the year, we spent $268 million to repurchase 2.6 million shares. This puts us on track to go beyond what’s needed to offset dilution from employee equity programs this year. I’ll now say a few words about each of our three main lines of business: security, compute and delivery, starting with security. Our Security Solutions generated revenue of $381 million in Q2, up 17% year-over-year and up 21% in constant currency. Growth in security was driven primarily by our app and API security portfolio, which includes our market-leading web app firewall, bot manager, account protector and page integrity manager solutions. Our Zero Trust enterprise security portfolio, led by Guardicore, also performed well in Q2 with numerous significant customer wins. A leading global provider of financial data concerned about ransomware, added Guardicore segmentation solution to the 7 security products they already buy from Akamai. A major insurance company in France became a new customer for Akamai when they adopted our Guardicore solution to help meet European financial regulations. The sale led by one of our carrier partners is indicative of the excitement we are seeing for our Zero Trust Solutions among our partners. An Australia’s largest telecom provider, Telstra, expanded their business with us by adding our secure web gateway solution to their portfolio of Akamai products. They told us “as part of Telstra’s journey in delivering fit-for-purpose solutions, Akamai has been a key industry partner with network-based anti-phishing malware protection and content filtering. Telstra blocks millions of threats every single day and Akamai is a key partner in that protection.” Overall, our Zero Trust Solutions delivered $43 million of revenue in Q2, up 59% year-over-year in constant currency. This is an area where we are making – continuing to make major investments and where we anticipate significant future growth. Turning now to compute. I am very pleased to report that the revenue for our Compute Product Group was $106 million in Q2, up 74% year-over-year and up 78% in constant currency. As a reminder, the Compute Product Group includes Linode and Akamai Solutions for edge computing, storage, cloud optimization and edge applications. A common theme that I heard when I met with executives from around the world in Q2 was their growing concern about being locked into contracts with cloud giants that are consuming large and rapidly increasing shares of their IT budgets. They want more choice in compute and are open to alternative clouds like Linode as a more efficient way to build, run and secure their applications. As a result, many large enterprises have begun testing the Linode platform, including a major U.S. airline, one of the world’s top gaming companies and a global provider of weather data. Major media companies, in particular, expressed significant concerns with their growing use of the giant clouds. Not only are the costs high in part because of the fees from moving data [Technical Difficulty]
Operator: Pardon, ladies and gentlemen, we have to interrupt the call at this time. One moment, please.
Tom Barth: Okay. Sorry about that, everyone. We are ready to begin the real call. That was the warm up. I apologize again. And what I’d like to do is introduce our CEO, Dr. Tom Leighton. Just standby for a minute. Operator, could you put the call on hold for me? We just had a little trouble with technical difficulties on the phone here.
Operator: Yes. Thank you, everyone. We’ll be on hold while you gather your information and get going again. Thank you, everyone. This is the operator. Thank you for holding standing by. We have Mr. Tom Barth, ready to take over again for the call. Please go ahead, sir.
Tom Barth: Okay. Thank you, everyone, for your patience today. We’re – again, I apologize for the technical glitch, but we are ready to go. And I’d like to reintroduce our CEO, Dr. Tom Leighton. Tom?
Tom Leighton: Thanks, Tom and thank you all for joining us today. Sorry about the production snafu there. Anyway, I am very pleased to report that Akamai delivered strong results in the second quarter, with revenue coming in near the high-end of our guidance range and earnings exceeding the high-end of our guidance range by $0.07. Revenue grew to $936 million in Q2, up 4% year-over-year, both as reported and in constant currency. Non-GAAP operating margin was 29% and non-GAAP earnings per share was $1.49, up 10% as reported and up 11% in constant currency. As you can see, and as Ed will explain in his portion of the call, our actions to increase profitability are delivering good results. I’ll now say a few words about each of our three main product areas, starting with security, which is our largest source of revenue. Security revenue grew to $433 million in Q2, up 14% year-over-year, both as reported and in constant currency. The improvement in our security growth rate was driven by multiple products, with especially strong growth for our market-leading segmentation solution. We entered the segmentation market with our acquisition of Guardicore in Q4 of 2021 and we are nearing an annualized revenue run-rate of $100 million. At this scale, segmentation is having a bigger impact on our overall security growth rate. Customers are adopting our segmentation solution to help defend against ransomware and data exfiltration attacks, which have become more frequent and damaging. For example, last quarter, we signed a 3-year $8 million segmentation deal with one of the world’s largest carriers. Large carriers and banks want to protect their consumer data from losses that can damage their brands and trigger large fines from regulators. They also appreciate spending less on legacy firewalls that no longer provide adequate protection. We also saw strong growth in Q2 for our market-leading web app firewall and bot management solutions, where we continue to fare well against the competition due in part to their challenges with reliability and performance. For example, we recently took business away from a competitor, 1 of the world’s largest micro blocking platforms. outages on their former providers platform made the customers seek a more reliable partner. So they switched to Akamai for their global expansion plan in Europe and Asia. In another example, a leading Asian financial institution recently returned to Akamai, also because of reliability challenges with this competitor’s platform. As we look to the future, we’re also excited about our new API security solution that we announced last week, enabled in part by our acquisition of NeoSec in May. API security is rapidly emerging as a critical need for major enterprises. That’s because as enterprises modernize their infrastructure to create better digital experiences. They’re making increasing use of APIs to improve developer agility and end user performance. The problem is that these APIs are often not adequately secured, and they open up new vectors for attack. Our new API security product leverages AI-based analytics and threat hunting capabilities to discover APIs, analyze their behavior, identify vulnerabilities and help customers defend against attacks. Customers who thought they had 1,000 APIs might turn on API security and Discover hundreds more they never knew they had, with vulnerabilities lurking within legacy infrastructure or new applications. This is why banks are establishing API governance group today, and it helps to explain why IDC and Gartner project that the API security market will surpass $1 billion by 2027. Like our segmentation solution, customers can buy our API security product without being an Akamai CDN customer. These security solutions are CDN agnostic demonstrating how we can go to market as a security provider first. We also continue to make good progress on the cloud computing front. Akamai is taking a fundamentally new approach to cloud computing making it fully distributed with many more points of presence that are available with traditional solutions. By leveraging Akamai’s unique platform and capabilities, we believe that we can offer enterprises better latency, better performance, automated scalability and portability and reduce costs, especially for applications that incur high egress fees with the hyperscalers. Since our call with you in May, we’ve gone live with three new cloud computing sites in Washington, D.C., Chicago and Paris, and we plan to open 10 more later this year. These new sites are part of our plan to connect compute, storage, database and other services into the same platform that powers our edge network today, a massively distributed footprint that spans more than 4,100 locations and 130 countries. Last month, we also announced a doubling of the capacity of our object storage solution a new premium instances for large commercial workloads that are designed to deliver consistent performance with predictable resource and cost allocation and our plan to launch in beta the Akamai Global load balancer later this quarter. This new integrated service is designed to route traffic request to the optimal data center to minimize latency and ensure no single point of failure. We believe that the Akamai connected cloud will be ideally suited for applications that benefit from being closer to end users. For example, in e-commerce, our customers want to tailor their online shopping experience to the individual user. They also want the better performance you get by being closer to the end user. That’s because better performance translates into higher conversion rates. In video and gaming, our customers want the game engine closer to the end user to reduce latency. And to tailor experiences based on the user’s device type and connectivity. In AI, the basic models will be generated and trained in the core. But the inference engines, which generate alerts and responses to queries will be more efficient to run at the edge, where and when they’re needed. And the cyber attackers exploit advances in AI to create more forms of malware and more dangerous bots, more security will be deployed at the edge to intercept attacks before they can reach and swap a customer’s data center in the core. In all these areas, our customers also want the ability to spin up instances to handle flash crowds on demand, something that’s very hard to do with competing cloud solutions. In summary, we believe that next-generation applications will need next-generation cloud infrastructure and Akamai is charting the course for this next decade of cloud computing. When more of the compute will be done closer to the end user and where we believe our platform will have an important edge over more centralized models. Turning now to content delivery, I am pleased to report that we continue to be the market leader, providing industry-leading performance and scale as we continue to support the world’s top brands by delivering reliable, secure and near flawless online experiences. We enjoy a strong synergy between our delivery, security and cloud computing offerings as we power and protect life online. The synergy is both on the top line as long-time delivery customers buy our security and cloud computing products and also on the bottom line as we realize the cost benefits of using a single infrastructure to provide security and compute services as well as delivery. Overall, I am pleased to see that Akamai performed well in the first half of the year. Despite the macroeconomic challenges, we continue to invest in the key areas that we expect to drive our future growth while also taking actions to improve our profitability. Now I will turn the call over to Ed for more on our Q2 results and our outlook for Q3 and the full year. Ed?
Ed McGowan: Thank you, Tom. Today, I plan to review our Q2 results and provide some color on Q3, along with our increased full year 2023 guidance. I’m pleased that Q2 was another strong and very profitable quarter. I’ll have more to say about our double-digit EPS growth in a moment. First, let’s discuss revenue. Total revenue for the second quarter was $936 million, up 4% year-over-year. In the second quarter, Security revenue was $433 million, growing 14% year-over-year. As Tom mentioned, security revenue was driven by strong demand for our WAC, slot management and segmentation solutions. Moving to compute. Revenue was $123 million, growing 16% year-over-year as reported and 17% in constant currency. On a combined basis, our security and compute product lines represented 59% of total revenue growing 14% year-over-year and 15% in constant currency. Shifting to delivery. Revenue was $380 million, declining 9% year-over-year as reported and 8% in constant currency. International revenue was $456 million, up 7% year-over-year and 8% in constant currency and now represents approximately half of our total revenue. Foreign exchange fluctuations were flat on a sequential basis and negative $6 million on a year-over-year basis. Moving now to profitability. Non-GAAP net income was $228 million or $1.49 of earnings per diluted share, up 10% year-over-year and up 11% in constant currency. The strong EPS results exceeded the high end of our guidance range by $0.07 and were driven primarily by higher revenues, saving from savings from the head count actions we took earlier in the second quarter and continued progress on our cost savings initiatives. As a reminder, those cost savings initiatives include third-party cloud savings, rationalization of our real estate costs, depreciation expense and other operating costs associated with lower CapEx related to our delivery business, disciplined spending with vendors and tighter travel and expense policy management. With respect to third-party cloud spend, I’m pleased to report that for as long as we attract this expense, Q2 was the first quarter where total third-party cloud spend declined year-over-year. While the decline was relatively modest, it reflects disciplined vendor management as well as the beginning of savings related to the migration of our workloads onto our own cloud platform. This migration effort to move away from third-party clouds is in the early stages, and we are seeing promising signs. For example, our bot management solution is now running production workloads for hundreds of customers on our own cloud computing platform. As a reminder, we anticipate that the amount of savings we will be able to achieve will start to ramp through the end of 2023 and into 2024 as we bring online the needed capacity and features. Moving to margins. Our cash gross margin was 73%. Adjusted EBITDA margin was 41%, and our non-GAAP operating margin was 29%, slightly ahead of our guidance. Moving now to cash and our use of capital, as of June 30, our cash, cash equivalents and marketable securities totaled approximately $1 billion. During the second quarter, we spent roughly $137 million to repurchase approximately 1.6 million shares. We now have about $700 million remaining in our previously announced share buyback authorization. Our approach to capital allocation remains the same to opportunistically buyback shares to offset dilution from employee equity programs over time while maintaining sufficient capital to deploy when strategic M&A presents itself. Finally, I am pleased to announce that Akamai has obtained investment-grade credit ratings from Moody’s and S&P. These ratings are part of a broader financial policy to further reinforce our business and financial strength, not only with investors but also with customers, vendors and other parties that we engage with from a commercial perspective. The credit rating also broadens our financial toolkit, allowing us to evaluate all available financing instruments to determine what’s best suited for our financial goals. Finally, as a reminder, Akamai currently has two convertible debt instruments outstanding, $1.15 billion due in May 2025 and $1.15 billion due in September 2027. Before I provide our Q3 and full year 2023 guidance, I want to touch on some housekeeping items. First, our annual merit-based wage increases became effective July 1. This will result in an additional net operating cost of approximately $12 million per quarter. Second, in late July, the IRS released a notice that granted temporary relief for determining eligibility of foreign tax credits. This will result in a lower-than-expected non-GAAP effective tax rate in Q3 and for the full year. And finally, the guidance I will provide assumes no change, good or bad to the current macroeconomic environment. So with those factors in mind, I’ll turn to our Q3 guidance. We are now projecting revenue in the range of $937 million to $952 million or up 6% to 8% as reported and 5% to 7% in constant currency over Q3 2022. The current spot rates foreign exchange fluctuations are expected to have a positive $1 million impact on Q3 revenue compared to Q2 levels and a positive $10 million impact year-over-year. At these revenue levels, we expect cash gross margins of approximately 74%. Q3 non-GAAP operating expenses are projected to be $297 million to $302 million. We expect Q3 EBITDA margin of approximately 42%. We expect non-GAAP depreciation expense to be between $121 million to $123 million, and we expect non-GAAP operating margin of approximately 29% for Q3. Moving on to CapEx. We expect to spend approximately $162 million to $170 million, excluding equity compensation and capitalized interest in the third quarter. This represents approximately 17% to 18% of our projected total revenue for the third quarter. Based on our expectations for revenue and costs, we expect Q3 non-GAAP EPS to be $1.48 to $1.52. The CPS guidance assumes taxes of $42 million to $45 million based on an estimated quarterly non-GAAP tax rate of approximately 16%. It also reflects a fully diluted share count of approximately 155 million shares. Looking ahead to the full year, we have increased revenue to a range of $3.765 million to $3.795 billion, which is up 4% to 5% year-over-year as reported and in constant currency. At current spot rates, our guidance assumes foreign exchange will have a negative $4 million impact to revenue in 2023 on a year-over-year basis. We are also raising our security revenue growth expectations to 12% to 14% for the full year 2023 and we continue to expect to achieve approximately $0.5 billion in revenue from compute in 2023. And despite a significant year of investments, we are estimating non-GAAP operating margin of approximately 29%. With all that in mind, we have raised our estimated non-GAAP earnings per diluted share to a range of $5.87 to $5.95. Our non-GAAP earnings guidance is based on a non-GAAP effective tax rate of approximately 17% and a fully diluted share count of approximately 155 million shares. Finally, our full year CapEx is expected to be approximately 19% of total revenue. In closing, we are very pleased with our financial achievements for the first half of the year, in our ability to increase our overall revenue, security revenue and non-GAAP EPS guidance for the full year. We believe that Akamai is a special class of businesses that have the ability and discipline to invest in future revenue growth while continuing to be extremely profitable and generate significant cash flows. With that, we now look forward to your questions. Operator?
Operator: Thank you. [Operator Instructions] First question will be from James Fish, Piper Sandler. Please go ahead.
James Fish: Hi, guys. Congrats on the quarter and the security [indiscernible]. And speaking of security, how should we think about the bookings heading into Q3 for this segment or the bookings related to us? And really, the crux of my question is – just trying to understand the sustainability here and understanding we’re raising by 2 points for the full year. Just kind of give some color around the confidence for the year is really what I’m asking.
Ed McGowan: Hey, Jim, thanks for the question. This is Ed. I’ll take that one. So I would say we had two back-to-back very strong quarters of bookings. So that was very encouraging. And we also saw strength and if I look at my sequential growth quarter-over-quarter, we actually saw all three major product lines accelerate. So we saw growth in API and protection segmentation was very strong. Guardicore was extremely strong in the quarter. And even the infrastructure business still has some hangover effect from the Kilmet attacks we saw earlier on. So all those product lines grew sequentially quarter-over-quarter. In terms of the customer penetration, if I go back to Q4 and look at where we are now, we saw about a 2.5% increase in customers buying a security product up to about 75.5%. So we’re seeing great penetration in the installed base. just one other sound by for you. We now have about 700 customers who are buying four or more products in security. So we’re seeing really good strength with new customer additions, bookings across all product lines. And then just another thing on segmentation. When we’re seeing renewals with segmentation, we’re seeing those renew very favorably and generally with expansion orders included.
James Fish: Helpful. And then, Tom, maybe for you on the compute side. How are you guys looking to invest behind the GPU as a service side of Linode. Is this something your customers, particularly your large media customers are looking to deploy with you or do you see that as more reserve for the hyperscalers and so you’re going to be more focused on that AI inference opportunity. Thanks, guys.
Tom Leighton: Yes. We do support GPUs today. It’s not our primary focus and that’s just a financial decision. I would say gaming is more where you’d see that with our big media customers doing video and media workflow, CPUs are just fine. And much more economical and attractive there. In terms of AI, I think over time, probably that migrates – at least in terms of the inference engines, migrates to CPU as well. And I think that, over time, as we talked about, probably something you want to be doing at the edge. But we’re fully capable of supporting GPUs. We do that some today, really based on demand from our customer base and financials.
Operator: Thank you. Next question will be from Keith Weiss, Morgan Stanley. Please go ahead.
Keith Weiss: I wanted to follow-up on the security question in the security business. We got a reacceleration this quarter. And I just want to understand like some of the drivers behind that, whether you’re seeing a better spend environment. It sounded like the bookings were pretty solid. Is it sort of sales execution? Or are you seeing sort of like newer offerings like Guardicore sort of reach material scale to drive that sort of dollar growth on a year-over-year basis. I was wondering if you could sort of unpack the strength in security and what it could portend for future quarters.
Tom Leighton: Yes. Ed talked to that somewhat. Let me just give some additional color there. It’s still a challenging spend environment in general. So that – I would have said that’s changed a lot. We are getting strong sales execution. And security is really important. And as we’ve talked about before, in this environment, financial institutions, they just can’t afford to have a glitch. And this is where our reliability really helps and stands out against the competition. They can’t afford to get hacked. And again, we stand out there because we have the market-leading solutions for web app, firewall and for bot management. And with Guardicore, really seeing strong growth, as Ed talked about. And I think what we’re seeing in the marketplace is there’s good tailwinds there. Particularly now you have Gen AI and already the tools are out there, the variance of that to produce more malignant bots to morph malware so it’s harder to detect. You can train the bots pretty easily to get around a lot of the firewall defenses. And so I think what you’re going to see is even more penetration of the traditional defenses. And at that point, what you really need is Guardicore to identify when you are penetrated and where and to proactively block the spread. So I think you’re going to see more demand for segmentation is really the critical defense going forward. So strong – as Ed talked about, strong execution and performance across all three pillars. And then you look to the future, API security is going to be, I think, a very important market for us. Very early days but I think really critical. So it’s really pleasing to see the momentum that we’ve been building in the first half of the year with security and that can, I think, help drive us forward.
Keith Weiss: I appreciate the thoughts, Tom. And just as a follow-up, sort of toggling to the delivery business. Just want to get an update, and you guys have talked about this before, but I just want to get an update on sort of the operating principles and the operating philosophy around the delivery business with respect to sort of managing for sort of revenue share versus harvesting for profit to fund investments in the compute business given the ambitious road map you have there? What sort of the right way we think that you guys are going to strike that balance between those two objectives?
Tom Leighton: Yes. It really comes down to price and profitability. And as we’ve talked about, we have turned down business that is very spiky, and we don’t get what we think paid enough to do it. And so we’ve left that to others to take. And meanwhile, growing the highly profitable delivery business, the core business there. And I think we are starting to see some positive signs there. Traffic growth is not where it was before the pandemic, but getting better. We’re seeing some acceleration there, which is good. Price declines, I’d say, softening a little bit here. And so I’m optimistic that over the next 1 to 2 years, we should see more of a stabilization of that business. Still price pressure, but I’m pleased with the progress we’re making there and strong cash generation.
Keith Weiss: Thank you for the details, Tom. I appreciate it.
Operator: Thank you. Next question will be from Ray McDonough of Guggenheim Securities. Please go ahead.
Ray McDonough: Great. Thanks for taking my question. Tom, maybe just to stay on the security side of things. Last quarter, you mentioned actions you were taking on the go-to-market side in security. And you mentioned execution as part of the driver of security reacceleration. But I’m wondering if you could provide more color on the sort of go-to-market changes that might be working here. And we’ve been hearing that Akamai has been more successful in engaging traditional security resellers recently. Has that helped drive an acceleration of growth here at all? Or is that still too early and maybe a contributor into the future?
Tom Leighton: Our partners are very important for security sales. In fact, some of our products are partner only, for example, segmentation. And very pleased to just recently announced a partnership with WWT, that will be bundling in our solutions for segmentation and API security. And that kind of partnership is obviously very helpful for us in driving a lot of the improved execution. We also have dedicated resources for some of the newer and more advanced security services like segmentation. And I think that helps with sales. And we’re seeing customers – new customers to Akamai, which is great and also upselling our solutions into the existing base. And as Ed noted, now 700 customers buying four different security solutions. And Ed, do you want to add anything to that?
Ed McGowan: No, I think you covered it. We’ve made a lot of the investments already. So there’s not a big investment needed in the sales overlay functions. Very happy with that. As a matter of fact, lot of the new customer acquisition is coming from Guardicore. And they’re actually getting penetration in some verticals that aren’t traditionally strong. Like this quarter, we saw some wins in education, state and local government, manufacturing and pharmaceutical places that typically are a very big web properties that are typical CDN customers. So I think we’re seeing really good execution across all the parts of security, direct sales, the overlay teams in the channel.
Ray McDonough: Great. That makes sense. Maybe as a follow-up, Ed, I know Guardicore and some of your other businesses, there could be some upfront license deals that could contribute in any given quarter. Was there anything to call out from an upfront license recognition in the quarter in security, in particular, that might not be repeatable that we should just know about? And is there any renewals that might be coming up in the back half of the year that we should be aware of?
Ed McGowan: Yes. So nothing material this quarter, a couple of million bucks, but nothing material. It’s over a couple of points, I call it out, so nothing there to call out. One thing I will say, though, with the licensing we do with Guardicore in particular. It’s term licenses, so it’s generally 2 to 3 years typically. And those license deals were new and one of the comments I made earlier is that we are seeing very strong renewals. So when those license deals come up, we are seeing renewals typically with expansion orders, which is really encouraging. So you have somebody who’s renewing and then adding on more protection across their internal infrastructure. But nothing to call out this quarter.
Ray McDonough: Great. Thanks for the color.
Operator: Thank you. Next question will be from Frank Louthan, Raymond James. Please go ahead.
Frank Louthan: Great. Thank you. On the delivery business, can you talk to us about any impact you think you might see from the writer strike. Do you think is that factoring any of that in the decline? And then just comment on the sort of the sequential change in the business there. What’s sort of the outlook there for the rest of the year? Thanks.
Ed McGowan: Hey, Brian, this is Ed. From the registry, I wouldn’t anticipate any major impact from that, certainly not hearing anything from our customers there. Obviously, that potentially impact new releases, which you could take a couple of years to get out. But not seeing anything there. And in terms of the second part of the question, what are some of the fundamentals and what we’re seeing. As Tom talked about, we are seeing traffic growth rates improve. It’s going up a couple of points a quarter. Pricing is still a bit challenging and some of the old web performance verticals in commerce and a little bit in travel as well. But we are seeing with the larger customers, big media, traditional media customers pricing starting to abate a bit there still pricing declines were not nearly as steep. So, I think its profit continues to improve and we obviously have Q4 coming up in a few months, will be in Q4, and that always tends to be a generally strong quarter for the Internet as kids go back to school and new gaming consoles are sold and connected devices and all that stuff, and it also tends to be pretty popular with new TV series and sports and whatnot that we are optimistic that traffic should continue to improve. And as Tom talked about, hopefully, we get this business back to stable in the next year or so.
Frank Louthan: Alright. Great. Are you seeing any more vendor consolidation like we saw earlier this year with some of the larger media companies?
Ed McGowan: There is one probably, real notable one that went from five vendors down to two, and we were a leading provider there and did pick up some additional shares. So, we want the ones who won there, but nothing really notable this quarter. That happened, I think at the end of last quarter.
Frank Louthan: Okay. Great. Thank you.
Operator: Thank you. Next question will be from Mark Murphy, JPMorgan. Please go ahead.
Unidentified Analyst: Hi. This is RD on for Mark Murphy. Thanks for taking the question and congrats on the quarter. Start off, you mentioned earlier that you expect to see stabilization in the delivery market over the next couple of years. Can you just describe what trends you are seeing that kind of leads you to think that?
Ed McGowan: Sure, I will take this Tom, if you want to add something. So, I think it’s really in the delivery business, it comes down to pricing and traffic growth rates. Now, we are starting to see traffic growth rates improve and also comps become a little bit easier. The other thing is we talked about moving away from some of the peak year business, what that will do is improve the profitability. So, the delivery business to us is a really strategic asset for us, right. It enables us to get really great economics, which will help our cloud business delivery function of cloud in a lot of ways. Also for our security business, which enables us to get the reach and the scale and the data for security. So, it’s obviously a very strategic business. But in terms of like the stabilization, I would say we are seeing pricing moderate, especially with the larger customers, which is a good sign, traffic improving a bit, and if that continues, we should be back to hopefully a stable plus or minus a couple of points would be great. But I think one thing that the macroeconomic environment is causing a little bit of churn, if you will, or challenges in some of the traditional web verticals like commerce. So, that’s going to have to work itself out as well. So, that may take a year or so for that to work its way out. But I think as we see traffic growth and pricing stabilize a bit more, we should be in pretty good shape.
Tom Leighton: Yes. And the only thing I would add is that in this environment with higher interest rates and money is harder to get, there is a little less enthusiasm for investment in the lots of CDNs out there that are losing money. And as Ed noted, Akamai is a unique position that we generate a lot of cash from our delivery business. We are the market leader, we do it better than anybody. And the smaller companies that were okay losing money before, well, that’s not so easy to do now. And so I think that does help maybe the overall environment a little bit, and we will see how that plays out over the next year or 2 years.
Unidentified Analyst: That’s very insightful. Thank you. And then with regards to Guardicore, it seems like you guys are having a bit of momentum on that front. Any changes in the competitive landscape win rates, anything along those lines?
Tom Leighton: Yes, it’s gotten more favorable for us. Our lead over the competition has widened as we’ve made a lot of investments in Guardicore to improve its capabilities. And so now we are recognized by the analyst community is the market leader by a wide margin. And that’s very good timing because that capability is an increasing need with major institutions. So, I think the competitive environment has become more favorable for us because of the work we have done to make it a great product.
Unidentified Analyst: Got it. Thank you. I will step back in the queue.
Operator: Thank you. Next question will be coming from Rishi Jaluria of RBC. Please go ahead.
Rishi Jaluria: Hi. Wonderful. Thanks so much for taking my questions guys. Nice to see the security reacceleration this quarter. I had a two-part question I wanted to ask about the compute business. First, can you talk a little bit about how some of your product investment in terms of getting Linode to be enterprise scale and to be truly competitive with the likes of either AWS and Azure, I think it got features and functionality like Kubernetes, for example, how those efforts are going? And maybe what learnings you have had as you have been migrating your own cloud spend onto that platform. And the second part, and Tom, you kind of hinted a little bit at this earlier, right? But let me look at what the hyperscale cloud vendors are saying, they are seeing a big uptick in demand right now as a result of generative AI workloads. And how do you think about your ability to capture some of those generative AI workloads as companies are thinking increasingly about adopting their generative AI strategy? And maybe are there additional investments you need to make in Linode to be able to capture some sort of some share of it? Thank you.
Tom Leighton: Yes. Great questions. And we are making really good progress with Linode, Kubernetes. And really, it’s about scale, and we talked about that. The build-out will be up to a couple of dozen core locations by the end of the year with a ton more capacity than we had before. Object storage and the new architecture there, much more capacity and capability. The certifications, we now have PCI compliance for our use, so we can run bot manager on it with market-leading bot management solution. We have 300 customers now using that solution on Akamai connected cloud instead of a third-party cloud. And that does take advantage of deep learning technology. So already, we have those capabilities, you have to support that on Akamai’s cloud. I think overall, with the timeline, the way we think about it, by the end of this year, we should be in a position to start taking on more serious bookings or bookings with large customers for really important applications. We have a couple already using it and then start generating more revenue next year from major applications. Now, in terms of competing with the hyperscalers, we are not going to be fully competitive for every application. And we don’t have to be. It’s a $200 billion a year market, growing 15%. And we are targeting a subset of that market, primarily initially vertical media and gaming, followed by commerce after that, where in particular applications where performance matters. So, the application is being used in some way by end users or business partners, where you maybe want to have that application running closer, so it has better performance. Where scalability, rapid scalability matters and cost, especially for the applications that involve moving data around or have a lot of hits. And you see that in media, gaming and commerce. So, that’s really what we are targeting, which is a pretty reasonable subset of the $200 billion. Now, within that subset, if you are an enterprise that uses a lot of the third-party apps that are available as managed services on the existing platforms, probably it’s harder to migrate, and that’s not where we would go first. Fortunately, if you look at media workflow and the areas where we are targeting, often that’s not the case. And it’s easier for us to manage the porting. Now, you don’t just flip a switch, so it’s not that easy, unfortunately. And we have learned that. But at Akamai, pretty much all of our applications are in the process of migrating from third-party cloud onto our compute platform. And so it does take some effort, but it is eminently doable, and we are going to save a lot by doing that. And we are not the biggest company out there. Our big media customers spend, well, hundreds and hundreds of millions of dollars a year in the cloud with often case, their primary competitor. And so I think we are in a position that we can now help them based on our experience, migrate a bunch of those applications to Akamai. Good for us, good for them.
Rishi Jaluria: Wonderful. Really helpful. Thank you so much.
Operator: Thank you. Next question will be from Rudy Kessinger, D.A. Davidson. Please go ahead.
Rudy Kessinger: Hey great. Thanks for taking the questions. Just – I know a lot of questions have been asked on security. Can you share the Guardicore growth rate? What kind of growth are you seeing in that business?
Ed McGowan: Hey, Rudy, this is Ed. About 60% year-over-year. And as Tom talked about, we should be at a $100 million run rate very, very soon. I would be surprised if we don’t get there next quarter.
Rudy Kessinger: Great. That is very impressive. As it relates to compute, 17% year-over-year constant currency that’s fully organic figure this quarter as you have lapped that acquisition. The guide implies depending how you model the sequential is maybe 1 to 2 points of acceleration by year-end. I guess just how is the pipeline building for Linode as you get some of these sites online? And when should we expect to see more material growth acceleration? Just what are your growth aspirations there in terms of maybe 2024?
Tom Leighton: Yes. So when you talk about Linode, almost all of the revenue there is in their traditional business, developers, small, medium enterprises, low-ARPU customers. That business was a little over $100 million a year when we bought it growing in the teens. It’s growing a little bit faster now, but it’s not – that’s not the game changer. And why we bought Linode was to be able to use it as the base to create a service for major enterprises with mission-critical applications, very high ARPU accounts. And today, the revenue there, we have actually signed up a few important cases, customers. And so we do have revenue there now, but it’s small in the millions of dollars. And so but that’s where the growth comes from and that’s – we are trying to get 1% of the $200 billion market, so over a period of time to go from a few million to a couple of billions. We don’t have a timeframe on that yet, but we are trying to do that as quickly as we can. But that’s where the real growth comes from and it starts from a very small portion of our roughly $0.5 billion compute business today.
Rudy Kessinger: That’s helpful. Thank you.
Tom Barth: Operator, this is Tom Barth and it’s time for one more question.
Operator: Thank you. Our last question will be from Amit Daryanani of Evercore. Please go ahead.
Amit Daryanani: Yes. Thanks for taking my question. I guess maybe to start on the security side, can you just touch about – as you see the acceleration that’s happening there, is that skewing more from new customers or expansion of existing customers, just any clear that would be helpful and then was there any licensing revenues that help you with Guardicore in June?
Ed McGowan: Hey, Amit, this is Ed. So as I talked about earlier, there was really no material license revenue in the quarter. And as I said, I’d call it anything, if it’s a couple of points of growth or anything like that. So nothing to report there. In terms of the new customers and existing we are seeing, as I talked about, a pretty good expansion in the existing installed base, both with just pure penetration rates up a couple of points in the last two quarters to – as I look at customers buying multiple products. I mentioned earlier, we have over 700 customers now buying four products. So the majority of the revenue growth is coming from the installed base buying more, but I’m very encouraged with the new logo acquisition, especially with what we’re seeing in Guardicore. Very encouraging to see them be able to attract new customers and verticals that were typically not very strong in. So again, mostly from the installed base in terms of buying more products, which is great, but it’s very encouraging on the new logo acquisition as well.
Amit Daryanani: Got it. And then if I can just follow-up on one thing. I think you talked about full year operating margins being around 29%. That’s about what you have in the first half of the year as well. But that would imply that sales will accelerate in H2 versus H1 from a dollar basis, but operating margins don’t go up. So maybe I am missing this, but what’s the offset? Is it the merit increases or is there other offers to consider in terms of why aren’t we seeing better operating leverage in the back half of the year?
Ed McGowan: Yes. So two things there, one is the merit increases you called out. But also the depreciation picks up quite a bit because of the CapEx in the first half of the year. So those are really the two main drivers. But I’m pretty pleased with what we’ve been able to accomplish on the margin front, making huge investments in the business and acquisition, the big investments we’re making in compute and to be able to deliver 29% operating margin for the year is pretty impressive and then to deliver – be able to raise EPS guidance. Very pleased with the team. I think everybody has pitched in and done a great job. So happy with that and pleased to see – is able to maintain the 29% margin despite the fact that there’s increased depreciation and merit increases. .
Amit Daryanani: Perfect. That’s helpful. Thank you.
Tom Barth: Thank you, Amit and thank you everyone. In closing, we will be presenting at several investor conferences and road shows throughout the rest of the third quarter. Details of these can be found on the Investor Relations section at akamai.com. Thank you for joining us and all of us here at Akamai wish you and yours a wonderful rest of the summer. Have a nice evening.
Operator: Conference has now concluded. Thank you for attending today’s presentation. You may now disconnect. | [
{
"speaker": "Operator",
"text": "Good day and welcome to the Akamai Technologies Second Quarter 2023 Earnings Conference Call. All participants will be in listen-only mode. [Operator Instructions] Please note that this event is being recorded. Now I’d like to turn the call over to Mr. Tom Barth, Head of Investor Relations. Please go ahead, sir."
},
{
"speaker": "Tom Barth",
"text": "Thank you, operator. Good afternoon, everyone and thank you for joining Akamai’s second quarter 2022 earnings call. Speaking today will be Tom Leighton, Akamai’s Chief Executive Officer and Ed McGowan, Akamai’s Chief Financial Officer. Please note that today’s comments include forward-looking statements, including statements regarding revenue and earnings guidance. These forward-looking statements are subject to risks and uncertainties and involve a number of factors that could cause actual results to differ materially from those expressed or implied by such statements. The factors include any impact from macroeconomic trends, the integration of any acquisitions and any impact from geopolitical developments. Additional information concerning these factors is contained in Akamai’s filings with the SEC, including our annual report on Form 10-K and quarterly reports on Form 10-Q. The forward-looking statements included in this call represent Akamai’s view on August 9, 2022. Akamai disclaims any obligation to update these statements to reflect new information, future events or circumstances, except as required by law. As a reminder, we will be referring to some non-GAAP financial metrics during today’s call. A detailed reconciliation of GAAP and non-GAAP metrics can be found under the financial portion of the Investor Relations section of akamai.com. And with that, let me turn the call over to Tom."
},
{
"speaker": "Tom Leighton",
"text": "Thanks, Tom, and thank you all for joining us today. I’m pleased to report that Akamai delivered strong results in the second quarter despite the ongoing challenges with the global economic environment and slower Internet traffic growth. Q2 revenue was $903 million, up 6% year-over-year and up 9% in constant currency. This result was driven by the continued rapid growth of our security and compute businesses, which when taken together were up 30% in constant currency. These two business lines now account for 54% of our overall revenue. Q2 non-GAAP operating margin was 29%. Q2 non-GAAP EPS was $1.35 per diluted share, down 5% year-over-year, but up 0.5% in constant currency. As Ed will discuss later, EPS was negatively impacted by foreign exchange rates and a higher effective tax rate compared to last year. Free cash flow was very strong at $223 million in Q2 and it accounted for 25% of revenue. We have been leveraging our financial strength to make substantial investments in enterprise security and cloud computing. We have also used some of this cash to buyback additional stock. In the first half of the year, we spent $268 million to repurchase 2.6 million shares. This puts us on track to go beyond what’s needed to offset dilution from employee equity programs this year. I’ll now say a few words about each of our three main lines of business: security, compute and delivery, starting with security. Our Security Solutions generated revenue of $381 million in Q2, up 17% year-over-year and up 21% in constant currency. Growth in security was driven primarily by our app and API security portfolio, which includes our market-leading web app firewall, bot manager, account protector and page integrity manager solutions. Our Zero Trust enterprise security portfolio, led by Guardicore, also performed well in Q2 with numerous significant customer wins. A leading global provider of financial data concerned about ransomware, added Guardicore segmentation solution to the 7 security products they already buy from Akamai. A major insurance company in France became a new customer for Akamai when they adopted our Guardicore solution to help meet European financial regulations. The sale led by one of our carrier partners is indicative of the excitement we are seeing for our Zero Trust Solutions among our partners. An Australia’s largest telecom provider, Telstra, expanded their business with us by adding our secure web gateway solution to their portfolio of Akamai products. They told us “as part of Telstra’s journey in delivering fit-for-purpose solutions, Akamai has been a key industry partner with network-based anti-phishing malware protection and content filtering. Telstra blocks millions of threats every single day and Akamai is a key partner in that protection.” Overall, our Zero Trust Solutions delivered $43 million of revenue in Q2, up 59% year-over-year in constant currency. This is an area where we are making – continuing to make major investments and where we anticipate significant future growth. Turning now to compute. I am very pleased to report that the revenue for our Compute Product Group was $106 million in Q2, up 74% year-over-year and up 78% in constant currency. As a reminder, the Compute Product Group includes Linode and Akamai Solutions for edge computing, storage, cloud optimization and edge applications. A common theme that I heard when I met with executives from around the world in Q2 was their growing concern about being locked into contracts with cloud giants that are consuming large and rapidly increasing shares of their IT budgets. They want more choice in compute and are open to alternative clouds like Linode as a more efficient way to build, run and secure their applications. As a result, many large enterprises have begun testing the Linode platform, including a major U.S. airline, one of the world’s top gaming companies and a global provider of weather data. Major media companies, in particular, expressed significant concerns with their growing use of the giant clouds. Not only are the costs high in part because of the fees from moving data [Technical Difficulty]"
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"speaker": "Operator",
"text": "Pardon, ladies and gentlemen, we have to interrupt the call at this time. One moment, please."
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"speaker": "Tom Barth",
"text": "Okay. Sorry about that, everyone. We are ready to begin the real call. That was the warm up. I apologize again. And what I’d like to do is introduce our CEO, Dr. Tom Leighton. Just standby for a minute. Operator, could you put the call on hold for me? We just had a little trouble with technical difficulties on the phone here."
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"speaker": "Operator",
"text": "Yes. Thank you, everyone. We’ll be on hold while you gather your information and get going again. Thank you, everyone. This is the operator. Thank you for holding standing by. We have Mr. Tom Barth, ready to take over again for the call. Please go ahead, sir."
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"speaker": "Tom Barth",
"text": "Okay. Thank you, everyone, for your patience today. We’re – again, I apologize for the technical glitch, but we are ready to go. And I’d like to reintroduce our CEO, Dr. Tom Leighton. Tom?"
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"speaker": "Tom Leighton",
"text": "Thanks, Tom and thank you all for joining us today. Sorry about the production snafu there. Anyway, I am very pleased to report that Akamai delivered strong results in the second quarter, with revenue coming in near the high-end of our guidance range and earnings exceeding the high-end of our guidance range by $0.07. Revenue grew to $936 million in Q2, up 4% year-over-year, both as reported and in constant currency. Non-GAAP operating margin was 29% and non-GAAP earnings per share was $1.49, up 10% as reported and up 11% in constant currency. As you can see, and as Ed will explain in his portion of the call, our actions to increase profitability are delivering good results. I’ll now say a few words about each of our three main product areas, starting with security, which is our largest source of revenue. Security revenue grew to $433 million in Q2, up 14% year-over-year, both as reported and in constant currency. The improvement in our security growth rate was driven by multiple products, with especially strong growth for our market-leading segmentation solution. We entered the segmentation market with our acquisition of Guardicore in Q4 of 2021 and we are nearing an annualized revenue run-rate of $100 million. At this scale, segmentation is having a bigger impact on our overall security growth rate. Customers are adopting our segmentation solution to help defend against ransomware and data exfiltration attacks, which have become more frequent and damaging. For example, last quarter, we signed a 3-year $8 million segmentation deal with one of the world’s largest carriers. Large carriers and banks want to protect their consumer data from losses that can damage their brands and trigger large fines from regulators. They also appreciate spending less on legacy firewalls that no longer provide adequate protection. We also saw strong growth in Q2 for our market-leading web app firewall and bot management solutions, where we continue to fare well against the competition due in part to their challenges with reliability and performance. For example, we recently took business away from a competitor, 1 of the world’s largest micro blocking platforms. outages on their former providers platform made the customers seek a more reliable partner. So they switched to Akamai for their global expansion plan in Europe and Asia. In another example, a leading Asian financial institution recently returned to Akamai, also because of reliability challenges with this competitor’s platform. As we look to the future, we’re also excited about our new API security solution that we announced last week, enabled in part by our acquisition of NeoSec in May. API security is rapidly emerging as a critical need for major enterprises. That’s because as enterprises modernize their infrastructure to create better digital experiences. They’re making increasing use of APIs to improve developer agility and end user performance. The problem is that these APIs are often not adequately secured, and they open up new vectors for attack. Our new API security product leverages AI-based analytics and threat hunting capabilities to discover APIs, analyze their behavior, identify vulnerabilities and help customers defend against attacks. Customers who thought they had 1,000 APIs might turn on API security and Discover hundreds more they never knew they had, with vulnerabilities lurking within legacy infrastructure or new applications. This is why banks are establishing API governance group today, and it helps to explain why IDC and Gartner project that the API security market will surpass $1 billion by 2027. Like our segmentation solution, customers can buy our API security product without being an Akamai CDN customer. These security solutions are CDN agnostic demonstrating how we can go to market as a security provider first. We also continue to make good progress on the cloud computing front. Akamai is taking a fundamentally new approach to cloud computing making it fully distributed with many more points of presence that are available with traditional solutions. By leveraging Akamai’s unique platform and capabilities, we believe that we can offer enterprises better latency, better performance, automated scalability and portability and reduce costs, especially for applications that incur high egress fees with the hyperscalers. Since our call with you in May, we’ve gone live with three new cloud computing sites in Washington, D.C., Chicago and Paris, and we plan to open 10 more later this year. These new sites are part of our plan to connect compute, storage, database and other services into the same platform that powers our edge network today, a massively distributed footprint that spans more than 4,100 locations and 130 countries. Last month, we also announced a doubling of the capacity of our object storage solution a new premium instances for large commercial workloads that are designed to deliver consistent performance with predictable resource and cost allocation and our plan to launch in beta the Akamai Global load balancer later this quarter. This new integrated service is designed to route traffic request to the optimal data center to minimize latency and ensure no single point of failure. We believe that the Akamai connected cloud will be ideally suited for applications that benefit from being closer to end users. For example, in e-commerce, our customers want to tailor their online shopping experience to the individual user. They also want the better performance you get by being closer to the end user. That’s because better performance translates into higher conversion rates. In video and gaming, our customers want the game engine closer to the end user to reduce latency. And to tailor experiences based on the user’s device type and connectivity. In AI, the basic models will be generated and trained in the core. But the inference engines, which generate alerts and responses to queries will be more efficient to run at the edge, where and when they’re needed. And the cyber attackers exploit advances in AI to create more forms of malware and more dangerous bots, more security will be deployed at the edge to intercept attacks before they can reach and swap a customer’s data center in the core. In all these areas, our customers also want the ability to spin up instances to handle flash crowds on demand, something that’s very hard to do with competing cloud solutions. In summary, we believe that next-generation applications will need next-generation cloud infrastructure and Akamai is charting the course for this next decade of cloud computing. When more of the compute will be done closer to the end user and where we believe our platform will have an important edge over more centralized models. Turning now to content delivery, I am pleased to report that we continue to be the market leader, providing industry-leading performance and scale as we continue to support the world’s top brands by delivering reliable, secure and near flawless online experiences. We enjoy a strong synergy between our delivery, security and cloud computing offerings as we power and protect life online. The synergy is both on the top line as long-time delivery customers buy our security and cloud computing products and also on the bottom line as we realize the cost benefits of using a single infrastructure to provide security and compute services as well as delivery. Overall, I am pleased to see that Akamai performed well in the first half of the year. Despite the macroeconomic challenges, we continue to invest in the key areas that we expect to drive our future growth while also taking actions to improve our profitability. Now I will turn the call over to Ed for more on our Q2 results and our outlook for Q3 and the full year. Ed?"
},
{
"speaker": "Ed McGowan",
"text": "Thank you, Tom. Today, I plan to review our Q2 results and provide some color on Q3, along with our increased full year 2023 guidance. I’m pleased that Q2 was another strong and very profitable quarter. I’ll have more to say about our double-digit EPS growth in a moment. First, let’s discuss revenue. Total revenue for the second quarter was $936 million, up 4% year-over-year. In the second quarter, Security revenue was $433 million, growing 14% year-over-year. As Tom mentioned, security revenue was driven by strong demand for our WAC, slot management and segmentation solutions. Moving to compute. Revenue was $123 million, growing 16% year-over-year as reported and 17% in constant currency. On a combined basis, our security and compute product lines represented 59% of total revenue growing 14% year-over-year and 15% in constant currency. Shifting to delivery. Revenue was $380 million, declining 9% year-over-year as reported and 8% in constant currency. International revenue was $456 million, up 7% year-over-year and 8% in constant currency and now represents approximately half of our total revenue. Foreign exchange fluctuations were flat on a sequential basis and negative $6 million on a year-over-year basis. Moving now to profitability. Non-GAAP net income was $228 million or $1.49 of earnings per diluted share, up 10% year-over-year and up 11% in constant currency. The strong EPS results exceeded the high end of our guidance range by $0.07 and were driven primarily by higher revenues, saving from savings from the head count actions we took earlier in the second quarter and continued progress on our cost savings initiatives. As a reminder, those cost savings initiatives include third-party cloud savings, rationalization of our real estate costs, depreciation expense and other operating costs associated with lower CapEx related to our delivery business, disciplined spending with vendors and tighter travel and expense policy management. With respect to third-party cloud spend, I’m pleased to report that for as long as we attract this expense, Q2 was the first quarter where total third-party cloud spend declined year-over-year. While the decline was relatively modest, it reflects disciplined vendor management as well as the beginning of savings related to the migration of our workloads onto our own cloud platform. This migration effort to move away from third-party clouds is in the early stages, and we are seeing promising signs. For example, our bot management solution is now running production workloads for hundreds of customers on our own cloud computing platform. As a reminder, we anticipate that the amount of savings we will be able to achieve will start to ramp through the end of 2023 and into 2024 as we bring online the needed capacity and features. Moving to margins. Our cash gross margin was 73%. Adjusted EBITDA margin was 41%, and our non-GAAP operating margin was 29%, slightly ahead of our guidance. Moving now to cash and our use of capital, as of June 30, our cash, cash equivalents and marketable securities totaled approximately $1 billion. During the second quarter, we spent roughly $137 million to repurchase approximately 1.6 million shares. We now have about $700 million remaining in our previously announced share buyback authorization. Our approach to capital allocation remains the same to opportunistically buyback shares to offset dilution from employee equity programs over time while maintaining sufficient capital to deploy when strategic M&A presents itself. Finally, I am pleased to announce that Akamai has obtained investment-grade credit ratings from Moody’s and S&P. These ratings are part of a broader financial policy to further reinforce our business and financial strength, not only with investors but also with customers, vendors and other parties that we engage with from a commercial perspective. The credit rating also broadens our financial toolkit, allowing us to evaluate all available financing instruments to determine what’s best suited for our financial goals. Finally, as a reminder, Akamai currently has two convertible debt instruments outstanding, $1.15 billion due in May 2025 and $1.15 billion due in September 2027. Before I provide our Q3 and full year 2023 guidance, I want to touch on some housekeeping items. First, our annual merit-based wage increases became effective July 1. This will result in an additional net operating cost of approximately $12 million per quarter. Second, in late July, the IRS released a notice that granted temporary relief for determining eligibility of foreign tax credits. This will result in a lower-than-expected non-GAAP effective tax rate in Q3 and for the full year. And finally, the guidance I will provide assumes no change, good or bad to the current macroeconomic environment. So with those factors in mind, I’ll turn to our Q3 guidance. We are now projecting revenue in the range of $937 million to $952 million or up 6% to 8% as reported and 5% to 7% in constant currency over Q3 2022. The current spot rates foreign exchange fluctuations are expected to have a positive $1 million impact on Q3 revenue compared to Q2 levels and a positive $10 million impact year-over-year. At these revenue levels, we expect cash gross margins of approximately 74%. Q3 non-GAAP operating expenses are projected to be $297 million to $302 million. We expect Q3 EBITDA margin of approximately 42%. We expect non-GAAP depreciation expense to be between $121 million to $123 million, and we expect non-GAAP operating margin of approximately 29% for Q3. Moving on to CapEx. We expect to spend approximately $162 million to $170 million, excluding equity compensation and capitalized interest in the third quarter. This represents approximately 17% to 18% of our projected total revenue for the third quarter. Based on our expectations for revenue and costs, we expect Q3 non-GAAP EPS to be $1.48 to $1.52. The CPS guidance assumes taxes of $42 million to $45 million based on an estimated quarterly non-GAAP tax rate of approximately 16%. It also reflects a fully diluted share count of approximately 155 million shares. Looking ahead to the full year, we have increased revenue to a range of $3.765 million to $3.795 billion, which is up 4% to 5% year-over-year as reported and in constant currency. At current spot rates, our guidance assumes foreign exchange will have a negative $4 million impact to revenue in 2023 on a year-over-year basis. We are also raising our security revenue growth expectations to 12% to 14% for the full year 2023 and we continue to expect to achieve approximately $0.5 billion in revenue from compute in 2023. And despite a significant year of investments, we are estimating non-GAAP operating margin of approximately 29%. With all that in mind, we have raised our estimated non-GAAP earnings per diluted share to a range of $5.87 to $5.95. Our non-GAAP earnings guidance is based on a non-GAAP effective tax rate of approximately 17% and a fully diluted share count of approximately 155 million shares. Finally, our full year CapEx is expected to be approximately 19% of total revenue. In closing, we are very pleased with our financial achievements for the first half of the year, in our ability to increase our overall revenue, security revenue and non-GAAP EPS guidance for the full year. We believe that Akamai is a special class of businesses that have the ability and discipline to invest in future revenue growth while continuing to be extremely profitable and generate significant cash flows. With that, we now look forward to your questions. Operator?"
},
{
"speaker": "Operator",
"text": "Thank you. [Operator Instructions] First question will be from James Fish, Piper Sandler. Please go ahead."
},
{
"speaker": "James Fish",
"text": "Hi, guys. Congrats on the quarter and the security [indiscernible]. And speaking of security, how should we think about the bookings heading into Q3 for this segment or the bookings related to us? And really, the crux of my question is – just trying to understand the sustainability here and understanding we’re raising by 2 points for the full year. Just kind of give some color around the confidence for the year is really what I’m asking."
},
{
"speaker": "Ed McGowan",
"text": "Hey, Jim, thanks for the question. This is Ed. I’ll take that one. So I would say we had two back-to-back very strong quarters of bookings. So that was very encouraging. And we also saw strength and if I look at my sequential growth quarter-over-quarter, we actually saw all three major product lines accelerate. So we saw growth in API and protection segmentation was very strong. Guardicore was extremely strong in the quarter. And even the infrastructure business still has some hangover effect from the Kilmet attacks we saw earlier on. So all those product lines grew sequentially quarter-over-quarter. In terms of the customer penetration, if I go back to Q4 and look at where we are now, we saw about a 2.5% increase in customers buying a security product up to about 75.5%. So we’re seeing great penetration in the installed base. just one other sound by for you. We now have about 700 customers who are buying four or more products in security. So we’re seeing really good strength with new customer additions, bookings across all product lines. And then just another thing on segmentation. When we’re seeing renewals with segmentation, we’re seeing those renew very favorably and generally with expansion orders included."
},
{
"speaker": "James Fish",
"text": "Helpful. And then, Tom, maybe for you on the compute side. How are you guys looking to invest behind the GPU as a service side of Linode. Is this something your customers, particularly your large media customers are looking to deploy with you or do you see that as more reserve for the hyperscalers and so you’re going to be more focused on that AI inference opportunity. Thanks, guys."
},
{
"speaker": "Tom Leighton",
"text": "Yes. We do support GPUs today. It’s not our primary focus and that’s just a financial decision. I would say gaming is more where you’d see that with our big media customers doing video and media workflow, CPUs are just fine. And much more economical and attractive there. In terms of AI, I think over time, probably that migrates – at least in terms of the inference engines, migrates to CPU as well. And I think that, over time, as we talked about, probably something you want to be doing at the edge. But we’re fully capable of supporting GPUs. We do that some today, really based on demand from our customer base and financials."
},
{
"speaker": "Operator",
"text": "Thank you. Next question will be from Keith Weiss, Morgan Stanley. Please go ahead."
},
{
"speaker": "Keith Weiss",
"text": "I wanted to follow-up on the security question in the security business. We got a reacceleration this quarter. And I just want to understand like some of the drivers behind that, whether you’re seeing a better spend environment. It sounded like the bookings were pretty solid. Is it sort of sales execution? Or are you seeing sort of like newer offerings like Guardicore sort of reach material scale to drive that sort of dollar growth on a year-over-year basis. I was wondering if you could sort of unpack the strength in security and what it could portend for future quarters."
},
{
"speaker": "Tom Leighton",
"text": "Yes. Ed talked to that somewhat. Let me just give some additional color there. It’s still a challenging spend environment in general. So that – I would have said that’s changed a lot. We are getting strong sales execution. And security is really important. And as we’ve talked about before, in this environment, financial institutions, they just can’t afford to have a glitch. And this is where our reliability really helps and stands out against the competition. They can’t afford to get hacked. And again, we stand out there because we have the market-leading solutions for web app, firewall and for bot management. And with Guardicore, really seeing strong growth, as Ed talked about. And I think what we’re seeing in the marketplace is there’s good tailwinds there. Particularly now you have Gen AI and already the tools are out there, the variance of that to produce more malignant bots to morph malware so it’s harder to detect. You can train the bots pretty easily to get around a lot of the firewall defenses. And so I think what you’re going to see is even more penetration of the traditional defenses. And at that point, what you really need is Guardicore to identify when you are penetrated and where and to proactively block the spread. So I think you’re going to see more demand for segmentation is really the critical defense going forward. So strong – as Ed talked about, strong execution and performance across all three pillars. And then you look to the future, API security is going to be, I think, a very important market for us. Very early days but I think really critical. So it’s really pleasing to see the momentum that we’ve been building in the first half of the year with security and that can, I think, help drive us forward."
},
{
"speaker": "Keith Weiss",
"text": "I appreciate the thoughts, Tom. And just as a follow-up, sort of toggling to the delivery business. Just want to get an update, and you guys have talked about this before, but I just want to get an update on sort of the operating principles and the operating philosophy around the delivery business with respect to sort of managing for sort of revenue share versus harvesting for profit to fund investments in the compute business given the ambitious road map you have there? What sort of the right way we think that you guys are going to strike that balance between those two objectives?"
},
{
"speaker": "Tom Leighton",
"text": "Yes. It really comes down to price and profitability. And as we’ve talked about, we have turned down business that is very spiky, and we don’t get what we think paid enough to do it. And so we’ve left that to others to take. And meanwhile, growing the highly profitable delivery business, the core business there. And I think we are starting to see some positive signs there. Traffic growth is not where it was before the pandemic, but getting better. We’re seeing some acceleration there, which is good. Price declines, I’d say, softening a little bit here. And so I’m optimistic that over the next 1 to 2 years, we should see more of a stabilization of that business. Still price pressure, but I’m pleased with the progress we’re making there and strong cash generation."
},
{
"speaker": "Keith Weiss",
"text": "Thank you for the details, Tom. I appreciate it."
},
{
"speaker": "Operator",
"text": "Thank you. Next question will be from Ray McDonough of Guggenheim Securities. Please go ahead."
},
{
"speaker": "Ray McDonough",
"text": "Great. Thanks for taking my question. Tom, maybe just to stay on the security side of things. Last quarter, you mentioned actions you were taking on the go-to-market side in security. And you mentioned execution as part of the driver of security reacceleration. But I’m wondering if you could provide more color on the sort of go-to-market changes that might be working here. And we’ve been hearing that Akamai has been more successful in engaging traditional security resellers recently. Has that helped drive an acceleration of growth here at all? Or is that still too early and maybe a contributor into the future?"
},
{
"speaker": "Tom Leighton",
"text": "Our partners are very important for security sales. In fact, some of our products are partner only, for example, segmentation. And very pleased to just recently announced a partnership with WWT, that will be bundling in our solutions for segmentation and API security. And that kind of partnership is obviously very helpful for us in driving a lot of the improved execution. We also have dedicated resources for some of the newer and more advanced security services like segmentation. And I think that helps with sales. And we’re seeing customers – new customers to Akamai, which is great and also upselling our solutions into the existing base. And as Ed noted, now 700 customers buying four different security solutions. And Ed, do you want to add anything to that?"
},
{
"speaker": "Ed McGowan",
"text": "No, I think you covered it. We’ve made a lot of the investments already. So there’s not a big investment needed in the sales overlay functions. Very happy with that. As a matter of fact, lot of the new customer acquisition is coming from Guardicore. And they’re actually getting penetration in some verticals that aren’t traditionally strong. Like this quarter, we saw some wins in education, state and local government, manufacturing and pharmaceutical places that typically are a very big web properties that are typical CDN customers. So I think we’re seeing really good execution across all the parts of security, direct sales, the overlay teams in the channel."
},
{
"speaker": "Ray McDonough",
"text": "Great. That makes sense. Maybe as a follow-up, Ed, I know Guardicore and some of your other businesses, there could be some upfront license deals that could contribute in any given quarter. Was there anything to call out from an upfront license recognition in the quarter in security, in particular, that might not be repeatable that we should just know about? And is there any renewals that might be coming up in the back half of the year that we should be aware of?"
},
{
"speaker": "Ed McGowan",
"text": "Yes. So nothing material this quarter, a couple of million bucks, but nothing material. It’s over a couple of points, I call it out, so nothing there to call out. One thing I will say, though, with the licensing we do with Guardicore in particular. It’s term licenses, so it’s generally 2 to 3 years typically. And those license deals were new and one of the comments I made earlier is that we are seeing very strong renewals. So when those license deals come up, we are seeing renewals typically with expansion orders, which is really encouraging. So you have somebody who’s renewing and then adding on more protection across their internal infrastructure. But nothing to call out this quarter."
},
{
"speaker": "Ray McDonough",
"text": "Great. Thanks for the color."
},
{
"speaker": "Operator",
"text": "Thank you. Next question will be from Frank Louthan, Raymond James. Please go ahead."
},
{
"speaker": "Frank Louthan",
"text": "Great. Thank you. On the delivery business, can you talk to us about any impact you think you might see from the writer strike. Do you think is that factoring any of that in the decline? And then just comment on the sort of the sequential change in the business there. What’s sort of the outlook there for the rest of the year? Thanks."
},
{
"speaker": "Ed McGowan",
"text": "Hey, Brian, this is Ed. From the registry, I wouldn’t anticipate any major impact from that, certainly not hearing anything from our customers there. Obviously, that potentially impact new releases, which you could take a couple of years to get out. But not seeing anything there. And in terms of the second part of the question, what are some of the fundamentals and what we’re seeing. As Tom talked about, we are seeing traffic growth rates improve. It’s going up a couple of points a quarter. Pricing is still a bit challenging and some of the old web performance verticals in commerce and a little bit in travel as well. But we are seeing with the larger customers, big media, traditional media customers pricing starting to abate a bit there still pricing declines were not nearly as steep. So, I think its profit continues to improve and we obviously have Q4 coming up in a few months, will be in Q4, and that always tends to be a generally strong quarter for the Internet as kids go back to school and new gaming consoles are sold and connected devices and all that stuff, and it also tends to be pretty popular with new TV series and sports and whatnot that we are optimistic that traffic should continue to improve. And as Tom talked about, hopefully, we get this business back to stable in the next year or so."
},
{
"speaker": "Frank Louthan",
"text": "Alright. Great. Are you seeing any more vendor consolidation like we saw earlier this year with some of the larger media companies?"
},
{
"speaker": "Ed McGowan",
"text": "There is one probably, real notable one that went from five vendors down to two, and we were a leading provider there and did pick up some additional shares. So, we want the ones who won there, but nothing really notable this quarter. That happened, I think at the end of last quarter."
},
{
"speaker": "Frank Louthan",
"text": "Okay. Great. Thank you."
},
{
"speaker": "Operator",
"text": "Thank you. Next question will be from Mark Murphy, JPMorgan. Please go ahead."
},
{
"speaker": "Unidentified Analyst",
"text": "Hi. This is RD on for Mark Murphy. Thanks for taking the question and congrats on the quarter. Start off, you mentioned earlier that you expect to see stabilization in the delivery market over the next couple of years. Can you just describe what trends you are seeing that kind of leads you to think that?"
},
{
"speaker": "Ed McGowan",
"text": "Sure, I will take this Tom, if you want to add something. So, I think it’s really in the delivery business, it comes down to pricing and traffic growth rates. Now, we are starting to see traffic growth rates improve and also comps become a little bit easier. The other thing is we talked about moving away from some of the peak year business, what that will do is improve the profitability. So, the delivery business to us is a really strategic asset for us, right. It enables us to get really great economics, which will help our cloud business delivery function of cloud in a lot of ways. Also for our security business, which enables us to get the reach and the scale and the data for security. So, it’s obviously a very strategic business. But in terms of like the stabilization, I would say we are seeing pricing moderate, especially with the larger customers, which is a good sign, traffic improving a bit, and if that continues, we should be back to hopefully a stable plus or minus a couple of points would be great. But I think one thing that the macroeconomic environment is causing a little bit of churn, if you will, or challenges in some of the traditional web verticals like commerce. So, that’s going to have to work itself out as well. So, that may take a year or so for that to work its way out. But I think as we see traffic growth and pricing stabilize a bit more, we should be in pretty good shape."
},
{
"speaker": "Tom Leighton",
"text": "Yes. And the only thing I would add is that in this environment with higher interest rates and money is harder to get, there is a little less enthusiasm for investment in the lots of CDNs out there that are losing money. And as Ed noted, Akamai is a unique position that we generate a lot of cash from our delivery business. We are the market leader, we do it better than anybody. And the smaller companies that were okay losing money before, well, that’s not so easy to do now. And so I think that does help maybe the overall environment a little bit, and we will see how that plays out over the next year or 2 years."
},
{
"speaker": "Unidentified Analyst",
"text": "That’s very insightful. Thank you. And then with regards to Guardicore, it seems like you guys are having a bit of momentum on that front. Any changes in the competitive landscape win rates, anything along those lines?"
},
{
"speaker": "Tom Leighton",
"text": "Yes, it’s gotten more favorable for us. Our lead over the competition has widened as we’ve made a lot of investments in Guardicore to improve its capabilities. And so now we are recognized by the analyst community is the market leader by a wide margin. And that’s very good timing because that capability is an increasing need with major institutions. So, I think the competitive environment has become more favorable for us because of the work we have done to make it a great product."
},
{
"speaker": "Unidentified Analyst",
"text": "Got it. Thank you. I will step back in the queue."
},
{
"speaker": "Operator",
"text": "Thank you. Next question will be coming from Rishi Jaluria of RBC. Please go ahead."
},
{
"speaker": "Rishi Jaluria",
"text": "Hi. Wonderful. Thanks so much for taking my questions guys. Nice to see the security reacceleration this quarter. I had a two-part question I wanted to ask about the compute business. First, can you talk a little bit about how some of your product investment in terms of getting Linode to be enterprise scale and to be truly competitive with the likes of either AWS and Azure, I think it got features and functionality like Kubernetes, for example, how those efforts are going? And maybe what learnings you have had as you have been migrating your own cloud spend onto that platform. And the second part, and Tom, you kind of hinted a little bit at this earlier, right? But let me look at what the hyperscale cloud vendors are saying, they are seeing a big uptick in demand right now as a result of generative AI workloads. And how do you think about your ability to capture some of those generative AI workloads as companies are thinking increasingly about adopting their generative AI strategy? And maybe are there additional investments you need to make in Linode to be able to capture some sort of some share of it? Thank you."
},
{
"speaker": "Tom Leighton",
"text": "Yes. Great questions. And we are making really good progress with Linode, Kubernetes. And really, it’s about scale, and we talked about that. The build-out will be up to a couple of dozen core locations by the end of the year with a ton more capacity than we had before. Object storage and the new architecture there, much more capacity and capability. The certifications, we now have PCI compliance for our use, so we can run bot manager on it with market-leading bot management solution. We have 300 customers now using that solution on Akamai connected cloud instead of a third-party cloud. And that does take advantage of deep learning technology. So already, we have those capabilities, you have to support that on Akamai’s cloud. I think overall, with the timeline, the way we think about it, by the end of this year, we should be in a position to start taking on more serious bookings or bookings with large customers for really important applications. We have a couple already using it and then start generating more revenue next year from major applications. Now, in terms of competing with the hyperscalers, we are not going to be fully competitive for every application. And we don’t have to be. It’s a $200 billion a year market, growing 15%. And we are targeting a subset of that market, primarily initially vertical media and gaming, followed by commerce after that, where in particular applications where performance matters. So, the application is being used in some way by end users or business partners, where you maybe want to have that application running closer, so it has better performance. Where scalability, rapid scalability matters and cost, especially for the applications that involve moving data around or have a lot of hits. And you see that in media, gaming and commerce. So, that’s really what we are targeting, which is a pretty reasonable subset of the $200 billion. Now, within that subset, if you are an enterprise that uses a lot of the third-party apps that are available as managed services on the existing platforms, probably it’s harder to migrate, and that’s not where we would go first. Fortunately, if you look at media workflow and the areas where we are targeting, often that’s not the case. And it’s easier for us to manage the porting. Now, you don’t just flip a switch, so it’s not that easy, unfortunately. And we have learned that. But at Akamai, pretty much all of our applications are in the process of migrating from third-party cloud onto our compute platform. And so it does take some effort, but it is eminently doable, and we are going to save a lot by doing that. And we are not the biggest company out there. Our big media customers spend, well, hundreds and hundreds of millions of dollars a year in the cloud with often case, their primary competitor. And so I think we are in a position that we can now help them based on our experience, migrate a bunch of those applications to Akamai. Good for us, good for them."
},
{
"speaker": "Rishi Jaluria",
"text": "Wonderful. Really helpful. Thank you so much."
},
{
"speaker": "Operator",
"text": "Thank you. Next question will be from Rudy Kessinger, D.A. Davidson. Please go ahead."
},
{
"speaker": "Rudy Kessinger",
"text": "Hey great. Thanks for taking the questions. Just – I know a lot of questions have been asked on security. Can you share the Guardicore growth rate? What kind of growth are you seeing in that business?"
},
{
"speaker": "Ed McGowan",
"text": "Hey, Rudy, this is Ed. About 60% year-over-year. And as Tom talked about, we should be at a $100 million run rate very, very soon. I would be surprised if we don’t get there next quarter."
},
{
"speaker": "Rudy Kessinger",
"text": "Great. That is very impressive. As it relates to compute, 17% year-over-year constant currency that’s fully organic figure this quarter as you have lapped that acquisition. The guide implies depending how you model the sequential is maybe 1 to 2 points of acceleration by year-end. I guess just how is the pipeline building for Linode as you get some of these sites online? And when should we expect to see more material growth acceleration? Just what are your growth aspirations there in terms of maybe 2024?"
},
{
"speaker": "Tom Leighton",
"text": "Yes. So when you talk about Linode, almost all of the revenue there is in their traditional business, developers, small, medium enterprises, low-ARPU customers. That business was a little over $100 million a year when we bought it growing in the teens. It’s growing a little bit faster now, but it’s not – that’s not the game changer. And why we bought Linode was to be able to use it as the base to create a service for major enterprises with mission-critical applications, very high ARPU accounts. And today, the revenue there, we have actually signed up a few important cases, customers. And so we do have revenue there now, but it’s small in the millions of dollars. And so but that’s where the growth comes from and that’s – we are trying to get 1% of the $200 billion market, so over a period of time to go from a few million to a couple of billions. We don’t have a timeframe on that yet, but we are trying to do that as quickly as we can. But that’s where the real growth comes from and it starts from a very small portion of our roughly $0.5 billion compute business today."
},
{
"speaker": "Rudy Kessinger",
"text": "That’s helpful. Thank you."
},
{
"speaker": "Tom Barth",
"text": "Operator, this is Tom Barth and it’s time for one more question."
},
{
"speaker": "Operator",
"text": "Thank you. Our last question will be from Amit Daryanani of Evercore. Please go ahead."
},
{
"speaker": "Amit Daryanani",
"text": "Yes. Thanks for taking my question. I guess maybe to start on the security side, can you just touch about – as you see the acceleration that’s happening there, is that skewing more from new customers or expansion of existing customers, just any clear that would be helpful and then was there any licensing revenues that help you with Guardicore in June?"
},
{
"speaker": "Ed McGowan",
"text": "Hey, Amit, this is Ed. So as I talked about earlier, there was really no material license revenue in the quarter. And as I said, I’d call it anything, if it’s a couple of points of growth or anything like that. So nothing to report there. In terms of the new customers and existing we are seeing, as I talked about, a pretty good expansion in the existing installed base, both with just pure penetration rates up a couple of points in the last two quarters to – as I look at customers buying multiple products. I mentioned earlier, we have over 700 customers now buying four products. So the majority of the revenue growth is coming from the installed base buying more, but I’m very encouraged with the new logo acquisition, especially with what we’re seeing in Guardicore. Very encouraging to see them be able to attract new customers and verticals that were typically not very strong in. So again, mostly from the installed base in terms of buying more products, which is great, but it’s very encouraging on the new logo acquisition as well."
},
{
"speaker": "Amit Daryanani",
"text": "Got it. And then if I can just follow-up on one thing. I think you talked about full year operating margins being around 29%. That’s about what you have in the first half of the year as well. But that would imply that sales will accelerate in H2 versus H1 from a dollar basis, but operating margins don’t go up. So maybe I am missing this, but what’s the offset? Is it the merit increases or is there other offers to consider in terms of why aren’t we seeing better operating leverage in the back half of the year?"
},
{
"speaker": "Ed McGowan",
"text": "Yes. So two things there, one is the merit increases you called out. But also the depreciation picks up quite a bit because of the CapEx in the first half of the year. So those are really the two main drivers. But I’m pretty pleased with what we’ve been able to accomplish on the margin front, making huge investments in the business and acquisition, the big investments we’re making in compute and to be able to deliver 29% operating margin for the year is pretty impressive and then to deliver – be able to raise EPS guidance. Very pleased with the team. I think everybody has pitched in and done a great job. So happy with that and pleased to see – is able to maintain the 29% margin despite the fact that there’s increased depreciation and merit increases. ."
},
{
"speaker": "Amit Daryanani",
"text": "Perfect. That’s helpful. Thank you."
},
{
"speaker": "Tom Barth",
"text": "Thank you, Amit and thank you everyone. In closing, we will be presenting at several investor conferences and road shows throughout the rest of the third quarter. Details of these can be found on the Investor Relations section at akamai.com. Thank you for joining us and all of us here at Akamai wish you and yours a wonderful rest of the summer. Have a nice evening."
},
{
"speaker": "Operator",
"text": "Conference has now concluded. Thank you for attending today’s presentation. You may now disconnect."
}
] | Akamai Technologies, Inc. | 24,522 |
AKAM | 1 | 2,023 | 2023-05-09 17:20:00 | Operator: Good day. And welcome to the Akamai Technologies First Quarter 2023 Earnings Conference Call. All participants are in listen-only mode. [Operator Instructions] After today's presentation, there will be an opportunity to ask questions. [Operator Instructions] Please note, today's event is being recorded. I would now like to turn the conference over to Tom Barth, Head of Investor Relations. Please go ahead.
Tom Barth: Thank you. Good afternoon, everyone, and thank you for joining Akamai's first quarter 2023 earnings call. Speaking today will be Tom Leighton, Akamai's Chief Executive Officer; and Ed McGowan, Akamai's Chief Financial Officer. Please note that today's comments include forward-looking statements, including statements regarding revenue and earnings guidance. These forward-looking statements are subject to risks and uncertainties and involve a number of factors that could cause actual results to differ materially from those expressed or implied by such statements. The factors include any impact from macroeconomic trends, the integration of any acquisitions and any impact from geopolitical developments. Additional information concerning these factors is contained in Akamai's filings with the SEC, including our annual report on Form 10-K and quarterly reports on Form 10-Q. The forward-looking statements included in this call represent the company's view on May 9, 2023. Akamai disclaims any obligation to update these statements to reflect new information, future events or circumstances, except as required by law. As a reminder, we will be referring to some non-GAAP financial metrics during today's call. A detailed reconciliation of GAAP and non-GAAP metrics can be found under the financial portion of the Investor Relations section of akamai.com. And with that, let me turn the call over to Tom.
Tom Leighton : Thanks, Tom, and thank you all for joining us today. I'm pleased to report that despite the challenging macroeconomic environment, Akamai delivered strong results in the first quarter, with both revenue and earnings exceeding the high end of our guidance range. Revenue grew to $916 million, and non-GAAP operating margin expanded to 29% in Q1. Non-GAAP earnings per share was $1.40. In what has been a good start to the year for Akamai, we've continued to invest in the key areas that we expect to drive our future growth while also taking actions to improve margins. As Ed will explain in his portion of the call, we remain focused on returning to our operating margin target of at least 30% as we work to accelerate growth. I'll now say a few words about each of our three main product areas, starting with security. For the first time in Akamai's 25-year history, security represented the largest share of Akamai's revenue in Q1. This marks a significant milestone for Akamai since our expansion into security a decade ago. While we take pride in this achievement, we're focused on accelerating our security revenue growth rate from here, both organically and through disciplined M&A. For example, this past week, we closed our acquisition of Neosec, which complements Akamai's market-leading app and API security portfolio by extending our capabilities in the rapidly growing API security market. Last year saw a record number of web app and API attacks more than double the number in 2021. The rapid rise in API attacks is becoming a critical challenge for enterprises across all verticals and with IDC and Gartner now projecting the API security market to exceed $1 billion by 2027. The company we acquired, Neosec, is a powerful SaaS security platform that leverages AI-based behavioral analytics, unmatched visibility and threat hunting capabilities to discover APIs, analyze their behavior, identify vulnerabilities and help customers defend against attacks. We plan to take Neosec to market immediately while our combined teams work together on product innovation with the majority of its engineers located in Tel Aviv, where we already have a significant security engineering presence, we expect Neosec will be an excellent fit with our culture. And like our Guardicore acquisition, we can sell Neosec to customers that don't use our CDM. Speaking of Guardicore our segmentation solution to protect against ransomware continued to achieve strong traction with new customers in Q1, including with one of the largest banking groups in Europe and one of the largest airlines in the UK. We're also continuing our organic investment in innovative new products to help protect major enterprises. For example, at the RSA conference two weeks ago, our new Brand Protector Solution was named 1 of the 20 hottest security products by CRM. Another trade publication, CSO, listed both Brand Protector and our new Prolexic Network Cloud Firewall among the most interesting products to see at RSA this year. At RSA, we also featured a new managed security service called Akamai Hunt, Akamai agentless segmentation and multiple enhancements to our market-leading bot management solution. In addition to our investments in new products, we're focused on accelerating security growth by winning new customers and expanding our relationships with existing customers. For example, one of the biggest security threats in the news last quarter was Kill net's coordinated series of DDoS attacks against some of the top medical centers in the U.S. In response, some very prominent health care institutions adopted Akamai's industry-leading solution for DDoS protection. In recognition of the value Akamai provides, the CIO of a world famous clinic e-mailed us afterward, thanking Akamai for enabling him to sleep well at night. We're also making good progress on the cloud computing front. Last quarter, we acquired the cloud storage company -- Ondat. Storage is a key component of cloud computing -- and we expect that Ondat's technology and considerable expertise will further enhance our enterprise-grade storage solution for Akamai Connected Cloud. Akamai intends to offer the world's most distributed platform placing compute, storage, databases and other cloud services closer to end users and enterprise datacenters. As a result, we believe that Akamai will be able to offer customers better performance, more points of presence and lower cost for many mission-critical enterprise workloads. That's the fundamental difference in our approach compared to other providers. We already have partners working with Akamai to run globally distributed databases with very low latency for synchronization. We have partners utilizing our cloud platform to provide customers with real-time visibility into telemetry from their end users around the world. We're working with customers in e-commerce, travel, hospitality, software as a service, media and entertainment to improve their ability to personalize experiences monetize content, accelerate data processing, facilitate collaboration, simplify management, improve performance and reduce costs, in some cases, by large amounts. And we're having early discussions about potentially leveraging Akamai Connected Cloud for AI inference engines. Each of these use cases plays to Akamai's advantage in terms of numbers of POPs, global reach performance and cost. Another advantage that we hear repeatedly from customers, including those I met with last month at the NAB conference is that they trust us. They value the years of highly reliable service that we provided in delivery and security, and they trust us not to use their data to compete with them. I'll now say a few words about our delivery business, which experienced an encouraging uptick in traffic growth late in Q1. Akamai continues to be the market leader in delivery, providing industry-leading performance and scale as we continue to support the world's top brands by delivering reliable, secure and near flawless online experiences. And we continue to see a strong synergy between our delivery business and our security and compute offerings, especially for customers in the gaming, media and commerce verticals. The synergy is both on the top-line, as long-time delivery customers buy our security and compute products and also on the bottom line as we realize the cost benefits of using a single infrastructure to provide security and compute services as well as delivery. We plan to pass some of the cost savings on to our customers, which is especially valuable for customers who are paying exorbitant egress fees to the hyperscalers to access or move their data. The synergy of having a single cloud platform will also help us in our ongoing effort to improve profitability. Not only can we leverage existing infrastructure, but we can also leverage existing talent as we shift resources and focus from delivery to compute. As Ed will explain shortly, we are very focused on managing costs and deploying resources where they generate the best long-term returns. As one part of this effort, we plan to reduce our worldwide workforce by a little less than 3% this quarter. This was a difficult decision, but it was necessary for us to prioritize investments in the areas with the greatest potential for future growth as we strive to deliver greater value for shareholders. I'd like to take this opportunity to thank all of our employees for their hard work on behalf of our customers and shareholders. From our developers and engineers who build and operate the services that power and protect life online, to our sales, services and marketing teams who do such a great job helping our customers in this challenging environment, and our back office and administrative support teams who help make Akamai be such a great place to work. It really is a privilege for me to be able to work with such an outstanding group of people as we make life better for billions of people, billions of times a day. While this is a time of substantial macroeconomic uncertainty, I believe that it is also a time of great future opportunity for Akamai as we bring new security and compute capabilities to market and as we deploy Akamai Connected Cloud. As you may know, I continue to be a personal buyer of Akamai stock under the 10b5-1 plan that I filed last year. And I'm pleased to let you know that Akamai repurchased 4.6 million shares of Akamai stock in Q1 for a total of $349 million. Now I'll turn the call over to Ed for more on our Q1 results and our outlook for Q2 and the full year. Ed?
Ed McGowan : Thank you, Tom. Today, I plan to review our Q1 results and provide some color on Q2 and our updated full year 2023 guidance where we increased our expectations for revenue, non-GAAP operating margin and non-GAAP EPS while decreasing our planned CapEx spend for the year. We were very pleased with our strong Q1 results in light of the continued difficult macroeconomic landscape. Total revenue for the first quarter was $916 million, up 1% year-over-year and 4% in constant currency. Security revenue was $406 million and is now our largest business representing 44% of total revenue. In the first quarter, Security revenue grew 6% year-over-year and 9% in constant currency. As a reminder, last year, we had roughly $7 million of upfront license revenue in Q1. If you normalize for this onetime impact, the security growth rate would have been approximately 11% in constant currency. Finally, I was also pleased to see we had a very strong bookings quarter in securities, specifically with our Guardicore segmentation and Lab Solutions. Moving on to Compute. Revenue was $116 million, growing 49% year-over-year as reported and 51% in constant currency. On a combined basis, our Security and Compute product lines represented 57% of total revenue, growing 13% year-over-year and 16% in constant currency. Now on to Delivery. Revenue was $394 million, which declined 11% year-over-year and 9% in constant currency. Delivery continues to provide strategic value in its customer base and generate strong cash flows. I'm optimistic about improving traffic volumes over the past two months and to a lesser extent, the slightly better pricing dynamics we've recently seen in the market. International revenue was $442 million, up 5% year-year and 9% in constant currency, representing 48% of total revenue in Q1. Foreign exchange fluctuations had a positive impact on revenue of $11 million on a sequential basis and a negative $21 million impact on a year-over-year basis. Non-GAAP net income was $218 million or $1.40 of earnings per diluted share, up 1% year-over-year and 4% in constant currency and $0.06 above the high end of our guidance range. Turning now to margins. Our non-GAAP operating margin in Q1 was 29%. This was slightly above our plan, primarily due to higher-than-expected revenue and continued focus on operational efficiencies. During the first quarter, we recorded a $45 million restructuring charge, primarily related to severance costs, along with facility-related charges as we continue to reduce our real estate footprint. The impact of these charges has been incorporated into our second quarter and full year 2023 guidance. In addition to these specific actions, we also continue to be very focused on cost savings initiatives I described last quarter, which include third-party cloud savings, continued real estate rationalization, depreciation expense and other operating costs associated with lower CapEx related to our delivery business, disciplined spending with vendors and tighter travel and expense policy management. I'm pleased with our progress on these initiatives, which helped drive improvements to our margins in Q1 compared to our expectations coming into the year. Moving now to cash and our use of capital. As of March 31, our cash, cash equivalents and marketable securities totaled approximately $1.1 billion. During the first quarter, we have spent approximately $349 million to repurchase approximately 4.6 million shares. We now have just under $850 million remaining on our previously announced buyback authorization. In addition to being aggressive with our buyback program, we have made two acquisitions since our last earnings call that will help drive revenue growth with Ondat in the first quarter and Neosec in the second quarter. We believe this demonstrates our continued balanced approach to capital allocation, opportunistically buying back shares to offset dilution from employee equity programs over time while maintaining sufficient capital to deploy when strategic M&A presents itself. Before I provide our Q2 and full year 2023 guidance, I want to touch on some housekeeping items. Regarding our two acquisitions, while neither was material to revenue, both are expected to be dilutive to non-GAAP EPS in 2023, with Ondat dilutive by $0.02 to $0.04 and Neosec dilutive by $0.04 to $0.06. Finally, as you build out your models, I'd like to remind you our annual merit-based wage increases become effective in Q3. From a seasonality perspective, Q4 is typically our strongest financial performance quarter and the guidance I will provide assumes no change, good or bad to the current macroeconomic environment. So with those factors in mind, turning to our Q2 guidance. We are now projecting revenue in the range of $923 million to $937 million, up 2% to 4% as reported and 3% to 4% in constant currency over Q2, 2022. At current spot rates, foreign exchange fluctuations are expected to have a positive $2 million impact on Q2 revenue compared to Q1 levels and a negative $3 million impact year-over-year. At these revenue levels, we expect cash gross margins of approximately 73%. Q2 non-GAAP operating expenses are projected to be $300 million to $305 million. We expect Q2 EBITDA margins of approximately 41%. We expect non-GAAP depreciation expense to be between $116 million to $118 million and we expect non-GAAP operating margin of approximately 28.5% for Q2. Moving on to CapEx. We expect to spend approximately $195 million to $202 million, excluding equity compensation and capitalized interest in the second quarter. This represents approximately 21% to 22% of our projected total revenue. Based on our expectations for revenue and costs, we expect Q2 non-GAAP EPS in the range of $1.38 to $1.42. This EPS guidance assumes taxes of $45 million to $47 million based on an estimated quarterly non-GAAP tax rate of approximately 17.5% to 18%. It also reflects a fully diluted share count of approximately 153 million shares. Looking ahead to the full year, we now expect revenue of $3.740 billion to $3.785 billion, which is up 3% to 5% year-over-year as reported and in constant currency. At current spot rates, our guidance assumes foreign exchange fluctuations will have a positive $3 million impact on revenue in 2023 on a year-over-year basis. We continue to expect Security revenue growth to be in the low-double-digits for the full year 2023, and we continue to expect to achieve approximately $0.5 billion in revenue from Compute in 2023. We are estimating non-GAAP operating margin of approximately 28% to 29%, and we now estimate non-GAAP earnings per diluted share of $5.69 to $5.84. Our non-GAAP earnings guidance is based on a non-GAAP effective tax rate of approximately 17.5% to 18% and a fully diluted share count of approximately 153 million shares. Finally, our updated full year CapEx is expected to be approximately 18.5% to 19% of total revenue. This CapEx is lower than our original expectations outlined last quarter due to strong pricing negotiations, resulting in better-than-anticipated server pricing, along with improved efficiencies, integrating Linode with Akamai's existing supply chain earlier than expected. In closing, we are very pleased with the strong start to 2023, and we look forward to your questions. Operator?
Operator: Thank you, we will now begin the question-and-answer session. [Operator Instructions] Today's first question comes from Keith Weiss with Morgan Stanley.
Keith Weiss : Thank you guys for taking the question. And nice quarter. Maybe one top line, on bottom line question. On the top-line side of the equation, you talked to strong bookings performance in the quarter, particularly with Guardicore. Is that a broader security kind of commentary? And maybe part of what kind of sustains kind of your confidence in the double-digit growth throughout the year, perhaps maybe even sort of do we see some acceleration on a go-forward basis based upon that booking. So one is kind of like a perspective on real time what's going on in Security? And then on the better operating margins on a go-forward basis. Can you give us some sense of where the headcount reductions are coming from in that 3% headcount reduction? And when we think about the better margins that you guys are projecting, how much of that comes from this recent round of headcount reductions, how much is just better OpEx controls that you guys exhibited thus far in the year? Thank you.
Tom Leighton: Great. I'll take a first pass on these and then turn it over to Ed, and I'll get into more of the details. Yeah, we saw strong bookings and security across the board. It is a challenging environment out there for sure, especially with commits on larger deals. On the other hand, we do see a little bit of a silver lining, especially in the financial vertical, which is large for us. With everything that's going on in the banking sector, there is more concern than ever around security and reliability. And I think the last thing a major financial institution wants to see is some kind of problem now. An outage or some kind of half be successful. And I think that helps us. Akamai is widely recognized as the best when it comes to reliability and in terms of security. And so I think that is also helping us, especially vis-a-vis the competition. We're also pretty excited about Neosec, A lot of very positive conversations early on with customers on top of Guardicore and of course, the whole suite of security products. In terms of margins, the focus of the reduction in force, on the go-to-market side, was really in the management layers and so that we can actually get more feet on the street in services, we can get more people helping customers, particularly in the areas of expertise with Security and Compute. And in some cases, in geographies that we feel are untapped and that we can get more leverage. And with -- I think probably I'll turn it over to Ed now in terms of how this shapes up with all the other things we're doing to improve operational efficiency, Ed?
Ed McGowan : Yeah, Keith. So we talked about taking a restructuring charge. About half of that was severance related so that the headcount savings and then the other half was -- or roughly half was related to real estate. In terms of thinking about the headcount savings, our payroll is a little over $1 billion. We reduced a little less than 3%. So on an annualized basis, think of that as kind of in the $40 million range, give or take. We'll get about three quarters of the benefit of that this year. In terms of the real estate, we probably saved about 25% to 30% of our current spend. More to go there. I expect we can reduce that probably by a similar amount next year. The big savings to come is going to be in third-party cloud. We did see a reduction this quarter, which was nice. We reduced our spend as we start to optimize and start to move some things over. But that's a big one. That's about $100 million in total spend or a little bit more, and we'll start to see that benefit next year, a little bit more this year, but mostly into next year and into 2025. Team is doing a great job with vendor management, including being able to engineer out certain functions that we may be using a third party for. So I would say it's a combination of things, but just to sort of put it in perspective, that headcount savings is, call it, roughly a little over a point of margin on an annualized basis. That also gives you giving you that sort of kind of run rate payroll number will give you the math necessary to build your models to factor in that annual increase that we give every year in the third quarter.
Tom Leighton: Also, in terms of the reductions, obviously, we're directing a lot of resources that were on the delivery side of the house into compute. And that, in many cases, is the same person changing what they're doing, but also in this reduction that we're taking, you'll see that effect as well.
Keith Weiss : Got it. And just to be clear, the lower CapEx intensity, it sounds like that's more efficient sourcing, not any change in the scope of build-out that you guys are expecting for the cloud side of the business?
Ed McGowan : Yeah. So the way to think about that, Keith, is two things. One, we were able to benefit pretty significantly actually with the pricing reductions in the server pricing. My understanding is that's somewhat of an industry phenomenon, but also just given our buying power, a big chunk of that decline in CapEx was related to that. The other thing that I find pretty exciting is we envisioned when we sort of built the models that we'll be able to integrate with our supply chain to be really tight with our demand and build, meaning not having to overbuild for demand. We've been able to knock down the time that it takes for us to deploy. So the initial builds that we're building out will be a little bit smaller than we originally anticipated because we expected a longer lead time with our supply chain. So now that we've been able to shrink that down we can tighten that up a bit. So those are really the main factors, a little bit of push in terms of a couple of sites that can push into '24, but those two factors are pretty significant. And we're very happy that we're able to deliver that this quickly.
Keith Weiss : Excellent. That's super helpful, guys. Thank you.
Operator: Thank you. And our next question today comes from James Fish of Piper Sandler. Please go ahead.
James Fish : Hey, guys. Thanks for the question guys. Wanting to build off of Keith a little bit here. Now that you rolled out your objectives for 2023 here, how are you thinking about not just the CapEx intensity for this year as you're starting to kind of get the savings greater than you expected. Is this the right way to think about next year's capital spending? And I think, Tom, you actually had alluded to getting into that long-term 30%. Is there an update on the time frame there?
Tom Leighton: Yeah. Let me take a first pass at this. This year is when we're doing the initial build-out for compute and obviously very substantial. And future years will depend on how fast we sell the capacity that we're building out now. And so if we're able to sell that quickly, then there would be more CapEx spend next year. If it takes us longer to fill that capacity, then you would see CapEx be much less next year. So it really depends on how rapidly we get uptake on the initial build-out that we're doing. And on the 30%, we're not issuing a specific time line there. But obviously, we're having, I think, really good success in our efficiency and we're taking actions to improve margins. And so we'd like to get back to 30% and beyond just as quickly as we can, subject to making the investments for future growth. And I'm very optimistic about our ability to do that. Ed, was there something you'd like to add there?
Ed McGowan : No, I think that covered it, Tom.
James Fish : Great. And just a follow-up on the security side as well. It sounds like you guys are pointing to this being the kind of trough in growth. But as you think about network security offerings, in particular, including the Zero Trust overall portfolio not just Guardicore, how do you feel about your go-to-market -- how your go-to-market is aligned with selling these types of solutions that tend to go through indirect sources that really are MSPs that you guys have historically been lined up with? Thanks, guys.
Ed McGowan : Yeah, I do think we should see improvement in security growth from here. And particularly now that we're adding API security into the mix, I think the channel is really important for us and it's something we're putting a lot of effort into it, especially on the enterprise security side. For example, Guardicore is all through the channel, very successful partnerships, and it's something we'll be focused on with API security as well.
Operator: Thank you. And our next question today comes from Jonathan Ho with William Blair. Please go ahead.
Jonathan Ho : Hi, there. I just wanted to understand a little bit better about maybe your confidence level around the macro environment, what you're seeing out there? And why you're not potentially taking a more conservative stance. I think you said that your expected macro to remain consistent.
Tom Leighton: Well, I think our guidance does reflect or the current situation and our view, we're not assuming that the macro environment will improve. And so I do think we are taking a reasonably conservative view going forward. We are very happy with the strong start to the year on several fronts as we talked about. Ed, would you like to say a little bit more about that?
Ed McGowan : Yeah, sure. I mean in terms of some of the negatives that you're seeing, obviously, sales cycles are a little bit longer. We are seeing difficulty with adding new customers with the exception of Guardicore. Tom alluded to the fact that Guardicore brought a pretty good channel organization with them, and we're seeing pretty good new logo acquisition there. So that's probably the exception to that rule. We're seeing some pricing pressure from some verticals, we are seeing, I mentioned, better pricing environment for some of the higher media delivery business. Inflation obviously causes some challenges. We've seen some bankruptcies in the retail space and a couple in the financial services. None that's overly material. And as I said, we're not anticipating things to get worse. If things did get worse, potentially we'd see a little bit more of that. On the Pro side, we are seeing lower turnover of employees, faster time to hire, which isn't much of a surprise. With rates going up and we have cash interest rates are better for us from a reinvestment perspective, the dollar is slightly weaker. That may -- as the dollar gets weaker that helps our benefits. And then also just from the vendor side, just continued focus on pushing vendors for better pricing and things like that. So it's a mixed environment, obviously, a challenging environment. I think we're navigating through it pretty well. And we've built in what we thought we could achieve based on what we see today.
Tom Leighton: On the silver lining side, as we get our compute offering, prepared to take on major mission-critical enterprise workloads, there is the potential that because we can do it less expensively, particularly for applications involving large amounts of data and delivery of data that, that could be a net benefit for us competitively in a time when companies are looking to cut costs. And is something a lot of our customers have told us, particularly customers with large volumes of data that they need to cut the cloud expense. And I think we'll be in a position to help them do that. And as I mentioned earlier, at a time like this when there's a lot of concern in the financial sector, Akamai's reliability and security, it really becomes paramount. And that's helpful to help mitigate the impacts of a difficult macroeconomic environment.
Jonathan Ho : Excellent. And then just as a quick follow-up. In terms of the delivery business, I think you talked about some favorable trends around the traffic side. Can you talk about what you're seeing in terms of those improvements and maybe the sustainability of that as we think about, again, the delivery traffic? Thank you.
Tom Leighton: Yes. About March, really of last year is when we really saw traffic growth take a hit, part because of the economy as a whole, part because of the war in Ukraine, and now we're lapping that. And so when you look at the year-over-year rates, indeed, they did start improving in March. And so we're optimistic about that and hope to see that be more sustainable just because you have a more reasonable compare. Ed, do you want to add more color on that?
Ed McGowan : Yeah. The only thing I would add, I did touch a little bit on just slightly better pricing environment, which makes sense given the volumes. They're still not back to pre-pandemic levels, better than what we saw last year. Also, we've seen in some accounts, some larger accounts, some vendor consolidation, and we've been a benefactor of that, which makes sense. Some customers will have four or five CDNs that can get to be pretty expensive. Sometimes they build up teams. They have technology they use for load balancing and things like that. So as they consolidate vendors. And a lot of us have volume-based tiered pricing, so you can take advantage of lower unit economics as you consolidate to one or two vendors. So that's been a positive trend for us. It's another reason why we've seen a little bit of an uptick in traffic.
Jonathan Ho : Thank you.
Operator: Thank you. And our next question comes from Frank Louthan with Raymond James. Please go ahead.
Unidentified Analyst: Hey, guys. This is Rob on for Frank. So who do you run into in the marketplace now for compute specifically? And how would you guys evaluate the outlook for that business in particular going forward? And what's driving that outlook primarily?
Tom Leighton: Yes, the hyperscalers and also do it yourselves. And I think the outlook for us is positive. We're not trying to take 30% market share. It's a $100 billion, $200 billion market. But we do think we can be very competitive for certain kinds of applications, particularly in the verticals where we do a lot of business, the media vertical, entertainment obviously, video, gaming, commerce. And that's because those customers, they know us, they like us, they use us for the delivery and security. And I think we're in a position to offer them a very compelling capability in terms of better performance and a lower price point. So we'll see. But so far, I think we're very pleased with what we've been hearing for customers, making good progress, getting our connected cloud platform built out, upgrading Lino to really take on large-scale mission-critical enterprise workloads.
Unidentified Analyst: Great. Thank you.
Operator: Thank you. And our next question today comes from Rudy Kessinger with D.A. Davidson. Please go ahead.
Rudy Kessinger : Hey, great. Thanks for taking my questions. Just want to double click maybe on security. You said Guardicore $7 million of license revenue Q1 last year. Was there any license revenue for Guardicore this Q1 this year?
Ed McGowan : Yeah. No, nothing material. No.
Rudy Kessinger : Yeah. Okay. Got it. And then maybe just a follow-up on delivery, certainly stronger revenue performance than we expected. Is there -- I guess, was there anything in the quarter you talked about maybe some customers consolidating from four or five vendors, maybe to three. Anything in particular in the quarter that would give you hope that delivery maybe you could potentially turn that back to a, I don't know, say, a flat or maybe only a 3%-5% decline in business as opposed to a 10%-ish decline in business as we've seen over the last few quarters?
Ed McGowan : Yeah. That's obviously continued traffic growth. I think if we get back to kind of pre-pandemic levels, that's certainly going to help. We've done a pretty good job on pricing, especially with the larger customers in the old web verticals, especially commerce, we're still seeing some pricing pressure there. So really, it's a combination. But I'd say the stronger traffic growth is going to be the main thing. As we get into Q2 and Q3, we've got slightly easier compare you recall last year, we had significant renewals in our top-10. We have renewals all the time, but that was an unusual year for that. So the double-digit declines, I wouldn't expect that certainly next quarter or the quarter after that. And in Q4 is always the toughest quarter to call, but things will get -- should get a little bit better from a year-over-year compare standpoint. But in terms of getting to sort of flat or even plus or minus a point, you're going to need to see stronger traffic growth than what we're seeing now.
Rudy Kessinger : Got it. Fair enough. Thank you.
Operator: Thank you. And our next question today comes from Ray McDonough with Guggenheim. Please go ahead.
Ray McDonough : Great, thanks for taking the questions. Tom, maybe first for you. Another question around security go-to-market. I know you touched on the focus on the channel. But you did mention you were also redeploying go-to-market resources within the security group as well. Can you talk more specifically to the changes made in that organization? And is there any early results to point to from those changes that give you confidence that you will be able to reaccelerate growth here in the rest of 2023?
Tom Leighton: Well, we're just taking the actions as we speak. So nothing to see directly from that yet. I would say they're in three areas. One is less investment in management and more in, say, feet on the street. The next would be more focused on security and compute and getting the right expertise in front of the customer, and that would be in presales and also in services. And then the third is a shift in resources to some of the, I would say, undertapped geographies, where we think there's the potential for a lot of growth. So I think all three are very helpful. And then, of course, channels, particularly for our enterprise security solutions, where that's, I think, a much -- a better way of doing it. For our established web app firewall, we do have a significant channel's presence but also a significant direct presence. And we expect to start seeing the benefits here towards the end of the year as we hire the new resources in these areas.
Ray McDonough : That makes sense. And then maybe just a follow-up for you on Linode. I believe you've kind of outlined an expansion of 14 core datacenters by the end of the year and 50 distributed sites, I believe. Is that still the case? And maybe just following up on one of your comments earlier, can you talk about how much smaller the Compute footprints are this year, if it's a magnitude of size? And how comfortable you feel in terms of the lead times to add capacity if the macro environment or demand turns more quickly than you expect?
Ed McGowan : Yeah. Why don't I start with the last part first. So in terms of the timing, I think we've got it down to probably 60 to 90 days, I think we can add capacity pretty quickly. We're building up -- working with our suppliers. We've had long-term relationships, structuring deals with them to be able to very quickly get our hands on equipment and building up some inventory and that sort of thing. So we feel pretty good about that. So I think -- and also these sales cycles are not immediate, right? So there's usually a trial period and that sort of thing, starting the conversations now. So it's not like CDNs where you can shift overnight, just move traffic within a day or two. So we will have good lead times there. In terms of the actual size, I just say they're small, I don't have a specific number to throw out. We're on track to deliver all of our core sites. There's a couple coming online in Q2 and a bunch coming online in Q3, no change there. As far as the distributed sites, we will be building out a bunch of those. I don't have an updated figure for you. Some of them may push. Those are much smaller in terms of of CapEx. So that really doesn't have a major impact on CapEx. Each one of those sites are relatively small, so it's not going to have a material impact. But in terms of what we're seeing with the supply chain, we feel pretty good. We've done a lot of work, great hats off to the team. They've done a fantastic job working with our suppliers to be able to really tighten things up, and you can see that in the updated guidance.
Ray McDonough : Great. Appreciate the color.
Operator: Our next question today comes from Amit Daryanani with Evercore. Please go ahead.
Unidentified Analyst: Hi, this is Lauren on for Amit. So just to kind of double-click into buybacks and how you guys are thinking about the second half of the year after a fairly aggressive first quarter? That would be great.
Tom Leighton: Yeah. Our policy and strategy really hasn't changed. And that includes -- there's times when we do buyback more shares that are needed to offset dilution from employee equity programs. And those are opportunistic. And in Q1, we felt there was a substantial opportunity to buyback more than the usual allotment. And of course, we have a programmatic buyback that buys back more when the stock price is lower and buys back less when the stock price is higher. And so when the stock goes lower, the programmatic or automatic buying also increases. And as you know, the stock price was lower through a lot of Q1. So there's really no fundamental change in strategy. Prior to this year, over the last 10 years, we've bought back an extra 1% a year over and above the equity program dilution offset. Obviously, Q1 was more than that. So there's not a specific change in strategy that would say we're going to buyback what we did in Q1 every quarter. So no change in strategy.
Unidentified Analyst: Got it. Thank you.
Operator: Thank you. And our next question today comes from Mark Murphy at JPMorgan. Please go ahead.
Unidentified Analyst: This is [Indiscernible] on for Mark Murphy. Thanks for taking the call, and congrats on the quarter. Maybe just on compute. I think in the past, you've mentioned that the node hasn't faced the same optimization headwinds that the hyperscalers have. Curious if anything's changed on that front?
Tom Leighton: Sorry, as in faced what headwinds?
Unidentified Analyst: Sorry, the same optimization headwinds that the hyperscalers have been calling out the last few quarters?
Tom Leighton: Yes, I think Linode is really in a very traditional, Linode a very different market and much more affordable and really not servicing the major enterprises. Major enterprises, at least the customers that we talk to are very worried about the rapidly growing cloud costs. And that's something that I think we're in a position to help them with as we get our infrastructure built out and get it ready to take on mission-critical workloads.
Unidentified Analyst: Great. Thank you so much for that additional color. I'll leave then and pass back to the operator.
Operator: Thank you. And ladies and gentlemen, we have no further questions at this time.
Tom Barth: Okay. Well, thank you, operator, and thank you, everyone. In closing, we will be presenting at several investor conferences and road shows throughout the rest of the second quarter. Details of these can be found in the Investor Relations section of akamai.com. Thank you for joining us, and all of us here at Akamai wish continued good health to you and yours. Have a nice evening.
Operator: Thank you. Ladies and gentlemen, this concludes today's conference call. And we thank you all for attending today's presentation. You may now disconnect your lines. And have a wonderful day. | [
{
"speaker": "Operator",
"text": "Good day. And welcome to the Akamai Technologies First Quarter 2023 Earnings Conference Call. All participants are in listen-only mode. [Operator Instructions] After today's presentation, there will be an opportunity to ask questions. [Operator Instructions] Please note, today's event is being recorded. I would now like to turn the conference over to Tom Barth, Head of Investor Relations. Please go ahead."
},
{
"speaker": "Tom Barth",
"text": "Thank you. Good afternoon, everyone, and thank you for joining Akamai's first quarter 2023 earnings call. Speaking today will be Tom Leighton, Akamai's Chief Executive Officer; and Ed McGowan, Akamai's Chief Financial Officer. Please note that today's comments include forward-looking statements, including statements regarding revenue and earnings guidance. These forward-looking statements are subject to risks and uncertainties and involve a number of factors that could cause actual results to differ materially from those expressed or implied by such statements. The factors include any impact from macroeconomic trends, the integration of any acquisitions and any impact from geopolitical developments. Additional information concerning these factors is contained in Akamai's filings with the SEC, including our annual report on Form 10-K and quarterly reports on Form 10-Q. The forward-looking statements included in this call represent the company's view on May 9, 2023. Akamai disclaims any obligation to update these statements to reflect new information, future events or circumstances, except as required by law. As a reminder, we will be referring to some non-GAAP financial metrics during today's call. A detailed reconciliation of GAAP and non-GAAP metrics can be found under the financial portion of the Investor Relations section of akamai.com. And with that, let me turn the call over to Tom."
},
{
"speaker": "Tom Leighton",
"text": "Thanks, Tom, and thank you all for joining us today. I'm pleased to report that despite the challenging macroeconomic environment, Akamai delivered strong results in the first quarter, with both revenue and earnings exceeding the high end of our guidance range. Revenue grew to $916 million, and non-GAAP operating margin expanded to 29% in Q1. Non-GAAP earnings per share was $1.40. In what has been a good start to the year for Akamai, we've continued to invest in the key areas that we expect to drive our future growth while also taking actions to improve margins. As Ed will explain in his portion of the call, we remain focused on returning to our operating margin target of at least 30% as we work to accelerate growth. I'll now say a few words about each of our three main product areas, starting with security. For the first time in Akamai's 25-year history, security represented the largest share of Akamai's revenue in Q1. This marks a significant milestone for Akamai since our expansion into security a decade ago. While we take pride in this achievement, we're focused on accelerating our security revenue growth rate from here, both organically and through disciplined M&A. For example, this past week, we closed our acquisition of Neosec, which complements Akamai's market-leading app and API security portfolio by extending our capabilities in the rapidly growing API security market. Last year saw a record number of web app and API attacks more than double the number in 2021. The rapid rise in API attacks is becoming a critical challenge for enterprises across all verticals and with IDC and Gartner now projecting the API security market to exceed $1 billion by 2027. The company we acquired, Neosec, is a powerful SaaS security platform that leverages AI-based behavioral analytics, unmatched visibility and threat hunting capabilities to discover APIs, analyze their behavior, identify vulnerabilities and help customers defend against attacks. We plan to take Neosec to market immediately while our combined teams work together on product innovation with the majority of its engineers located in Tel Aviv, where we already have a significant security engineering presence, we expect Neosec will be an excellent fit with our culture. And like our Guardicore acquisition, we can sell Neosec to customers that don't use our CDM. Speaking of Guardicore our segmentation solution to protect against ransomware continued to achieve strong traction with new customers in Q1, including with one of the largest banking groups in Europe and one of the largest airlines in the UK. We're also continuing our organic investment in innovative new products to help protect major enterprises. For example, at the RSA conference two weeks ago, our new Brand Protector Solution was named 1 of the 20 hottest security products by CRM. Another trade publication, CSO, listed both Brand Protector and our new Prolexic Network Cloud Firewall among the most interesting products to see at RSA this year. At RSA, we also featured a new managed security service called Akamai Hunt, Akamai agentless segmentation and multiple enhancements to our market-leading bot management solution. In addition to our investments in new products, we're focused on accelerating security growth by winning new customers and expanding our relationships with existing customers. For example, one of the biggest security threats in the news last quarter was Kill net's coordinated series of DDoS attacks against some of the top medical centers in the U.S. In response, some very prominent health care institutions adopted Akamai's industry-leading solution for DDoS protection. In recognition of the value Akamai provides, the CIO of a world famous clinic e-mailed us afterward, thanking Akamai for enabling him to sleep well at night. We're also making good progress on the cloud computing front. Last quarter, we acquired the cloud storage company -- Ondat. Storage is a key component of cloud computing -- and we expect that Ondat's technology and considerable expertise will further enhance our enterprise-grade storage solution for Akamai Connected Cloud. Akamai intends to offer the world's most distributed platform placing compute, storage, databases and other cloud services closer to end users and enterprise datacenters. As a result, we believe that Akamai will be able to offer customers better performance, more points of presence and lower cost for many mission-critical enterprise workloads. That's the fundamental difference in our approach compared to other providers. We already have partners working with Akamai to run globally distributed databases with very low latency for synchronization. We have partners utilizing our cloud platform to provide customers with real-time visibility into telemetry from their end users around the world. We're working with customers in e-commerce, travel, hospitality, software as a service, media and entertainment to improve their ability to personalize experiences monetize content, accelerate data processing, facilitate collaboration, simplify management, improve performance and reduce costs, in some cases, by large amounts. And we're having early discussions about potentially leveraging Akamai Connected Cloud for AI inference engines. Each of these use cases plays to Akamai's advantage in terms of numbers of POPs, global reach performance and cost. Another advantage that we hear repeatedly from customers, including those I met with last month at the NAB conference is that they trust us. They value the years of highly reliable service that we provided in delivery and security, and they trust us not to use their data to compete with them. I'll now say a few words about our delivery business, which experienced an encouraging uptick in traffic growth late in Q1. Akamai continues to be the market leader in delivery, providing industry-leading performance and scale as we continue to support the world's top brands by delivering reliable, secure and near flawless online experiences. And we continue to see a strong synergy between our delivery business and our security and compute offerings, especially for customers in the gaming, media and commerce verticals. The synergy is both on the top-line, as long-time delivery customers buy our security and compute products and also on the bottom line as we realize the cost benefits of using a single infrastructure to provide security and compute services as well as delivery. We plan to pass some of the cost savings on to our customers, which is especially valuable for customers who are paying exorbitant egress fees to the hyperscalers to access or move their data. The synergy of having a single cloud platform will also help us in our ongoing effort to improve profitability. Not only can we leverage existing infrastructure, but we can also leverage existing talent as we shift resources and focus from delivery to compute. As Ed will explain shortly, we are very focused on managing costs and deploying resources where they generate the best long-term returns. As one part of this effort, we plan to reduce our worldwide workforce by a little less than 3% this quarter. This was a difficult decision, but it was necessary for us to prioritize investments in the areas with the greatest potential for future growth as we strive to deliver greater value for shareholders. I'd like to take this opportunity to thank all of our employees for their hard work on behalf of our customers and shareholders. From our developers and engineers who build and operate the services that power and protect life online, to our sales, services and marketing teams who do such a great job helping our customers in this challenging environment, and our back office and administrative support teams who help make Akamai be such a great place to work. It really is a privilege for me to be able to work with such an outstanding group of people as we make life better for billions of people, billions of times a day. While this is a time of substantial macroeconomic uncertainty, I believe that it is also a time of great future opportunity for Akamai as we bring new security and compute capabilities to market and as we deploy Akamai Connected Cloud. As you may know, I continue to be a personal buyer of Akamai stock under the 10b5-1 plan that I filed last year. And I'm pleased to let you know that Akamai repurchased 4.6 million shares of Akamai stock in Q1 for a total of $349 million. Now I'll turn the call over to Ed for more on our Q1 results and our outlook for Q2 and the full year. Ed?"
},
{
"speaker": "Ed McGowan",
"text": "Thank you, Tom. Today, I plan to review our Q1 results and provide some color on Q2 and our updated full year 2023 guidance where we increased our expectations for revenue, non-GAAP operating margin and non-GAAP EPS while decreasing our planned CapEx spend for the year. We were very pleased with our strong Q1 results in light of the continued difficult macroeconomic landscape. Total revenue for the first quarter was $916 million, up 1% year-over-year and 4% in constant currency. Security revenue was $406 million and is now our largest business representing 44% of total revenue. In the first quarter, Security revenue grew 6% year-over-year and 9% in constant currency. As a reminder, last year, we had roughly $7 million of upfront license revenue in Q1. If you normalize for this onetime impact, the security growth rate would have been approximately 11% in constant currency. Finally, I was also pleased to see we had a very strong bookings quarter in securities, specifically with our Guardicore segmentation and Lab Solutions. Moving on to Compute. Revenue was $116 million, growing 49% year-over-year as reported and 51% in constant currency. On a combined basis, our Security and Compute product lines represented 57% of total revenue, growing 13% year-over-year and 16% in constant currency. Now on to Delivery. Revenue was $394 million, which declined 11% year-over-year and 9% in constant currency. Delivery continues to provide strategic value in its customer base and generate strong cash flows. I'm optimistic about improving traffic volumes over the past two months and to a lesser extent, the slightly better pricing dynamics we've recently seen in the market. International revenue was $442 million, up 5% year-year and 9% in constant currency, representing 48% of total revenue in Q1. Foreign exchange fluctuations had a positive impact on revenue of $11 million on a sequential basis and a negative $21 million impact on a year-over-year basis. Non-GAAP net income was $218 million or $1.40 of earnings per diluted share, up 1% year-over-year and 4% in constant currency and $0.06 above the high end of our guidance range. Turning now to margins. Our non-GAAP operating margin in Q1 was 29%. This was slightly above our plan, primarily due to higher-than-expected revenue and continued focus on operational efficiencies. During the first quarter, we recorded a $45 million restructuring charge, primarily related to severance costs, along with facility-related charges as we continue to reduce our real estate footprint. The impact of these charges has been incorporated into our second quarter and full year 2023 guidance. In addition to these specific actions, we also continue to be very focused on cost savings initiatives I described last quarter, which include third-party cloud savings, continued real estate rationalization, depreciation expense and other operating costs associated with lower CapEx related to our delivery business, disciplined spending with vendors and tighter travel and expense policy management. I'm pleased with our progress on these initiatives, which helped drive improvements to our margins in Q1 compared to our expectations coming into the year. Moving now to cash and our use of capital. As of March 31, our cash, cash equivalents and marketable securities totaled approximately $1.1 billion. During the first quarter, we have spent approximately $349 million to repurchase approximately 4.6 million shares. We now have just under $850 million remaining on our previously announced buyback authorization. In addition to being aggressive with our buyback program, we have made two acquisitions since our last earnings call that will help drive revenue growth with Ondat in the first quarter and Neosec in the second quarter. We believe this demonstrates our continued balanced approach to capital allocation, opportunistically buying back shares to offset dilution from employee equity programs over time while maintaining sufficient capital to deploy when strategic M&A presents itself. Before I provide our Q2 and full year 2023 guidance, I want to touch on some housekeeping items. Regarding our two acquisitions, while neither was material to revenue, both are expected to be dilutive to non-GAAP EPS in 2023, with Ondat dilutive by $0.02 to $0.04 and Neosec dilutive by $0.04 to $0.06. Finally, as you build out your models, I'd like to remind you our annual merit-based wage increases become effective in Q3. From a seasonality perspective, Q4 is typically our strongest financial performance quarter and the guidance I will provide assumes no change, good or bad to the current macroeconomic environment. So with those factors in mind, turning to our Q2 guidance. We are now projecting revenue in the range of $923 million to $937 million, up 2% to 4% as reported and 3% to 4% in constant currency over Q2, 2022. At current spot rates, foreign exchange fluctuations are expected to have a positive $2 million impact on Q2 revenue compared to Q1 levels and a negative $3 million impact year-over-year. At these revenue levels, we expect cash gross margins of approximately 73%. Q2 non-GAAP operating expenses are projected to be $300 million to $305 million. We expect Q2 EBITDA margins of approximately 41%. We expect non-GAAP depreciation expense to be between $116 million to $118 million and we expect non-GAAP operating margin of approximately 28.5% for Q2. Moving on to CapEx. We expect to spend approximately $195 million to $202 million, excluding equity compensation and capitalized interest in the second quarter. This represents approximately 21% to 22% of our projected total revenue. Based on our expectations for revenue and costs, we expect Q2 non-GAAP EPS in the range of $1.38 to $1.42. This EPS guidance assumes taxes of $45 million to $47 million based on an estimated quarterly non-GAAP tax rate of approximately 17.5% to 18%. It also reflects a fully diluted share count of approximately 153 million shares. Looking ahead to the full year, we now expect revenue of $3.740 billion to $3.785 billion, which is up 3% to 5% year-over-year as reported and in constant currency. At current spot rates, our guidance assumes foreign exchange fluctuations will have a positive $3 million impact on revenue in 2023 on a year-over-year basis. We continue to expect Security revenue growth to be in the low-double-digits for the full year 2023, and we continue to expect to achieve approximately $0.5 billion in revenue from Compute in 2023. We are estimating non-GAAP operating margin of approximately 28% to 29%, and we now estimate non-GAAP earnings per diluted share of $5.69 to $5.84. Our non-GAAP earnings guidance is based on a non-GAAP effective tax rate of approximately 17.5% to 18% and a fully diluted share count of approximately 153 million shares. Finally, our updated full year CapEx is expected to be approximately 18.5% to 19% of total revenue. This CapEx is lower than our original expectations outlined last quarter due to strong pricing negotiations, resulting in better-than-anticipated server pricing, along with improved efficiencies, integrating Linode with Akamai's existing supply chain earlier than expected. In closing, we are very pleased with the strong start to 2023, and we look forward to your questions. Operator?"
},
{
"speaker": "Operator",
"text": "Thank you, we will now begin the question-and-answer session. [Operator Instructions] Today's first question comes from Keith Weiss with Morgan Stanley."
},
{
"speaker": "Keith Weiss",
"text": "Thank you guys for taking the question. And nice quarter. Maybe one top line, on bottom line question. On the top-line side of the equation, you talked to strong bookings performance in the quarter, particularly with Guardicore. Is that a broader security kind of commentary? And maybe part of what kind of sustains kind of your confidence in the double-digit growth throughout the year, perhaps maybe even sort of do we see some acceleration on a go-forward basis based upon that booking. So one is kind of like a perspective on real time what's going on in Security? And then on the better operating margins on a go-forward basis. Can you give us some sense of where the headcount reductions are coming from in that 3% headcount reduction? And when we think about the better margins that you guys are projecting, how much of that comes from this recent round of headcount reductions, how much is just better OpEx controls that you guys exhibited thus far in the year? Thank you."
},
{
"speaker": "Tom Leighton",
"text": "Great. I'll take a first pass on these and then turn it over to Ed, and I'll get into more of the details. Yeah, we saw strong bookings and security across the board. It is a challenging environment out there for sure, especially with commits on larger deals. On the other hand, we do see a little bit of a silver lining, especially in the financial vertical, which is large for us. With everything that's going on in the banking sector, there is more concern than ever around security and reliability. And I think the last thing a major financial institution wants to see is some kind of problem now. An outage or some kind of half be successful. And I think that helps us. Akamai is widely recognized as the best when it comes to reliability and in terms of security. And so I think that is also helping us, especially vis-a-vis the competition. We're also pretty excited about Neosec, A lot of very positive conversations early on with customers on top of Guardicore and of course, the whole suite of security products. In terms of margins, the focus of the reduction in force, on the go-to-market side, was really in the management layers and so that we can actually get more feet on the street in services, we can get more people helping customers, particularly in the areas of expertise with Security and Compute. And in some cases, in geographies that we feel are untapped and that we can get more leverage. And with -- I think probably I'll turn it over to Ed now in terms of how this shapes up with all the other things we're doing to improve operational efficiency, Ed?"
},
{
"speaker": "Ed McGowan",
"text": "Yeah, Keith. So we talked about taking a restructuring charge. About half of that was severance related so that the headcount savings and then the other half was -- or roughly half was related to real estate. In terms of thinking about the headcount savings, our payroll is a little over $1 billion. We reduced a little less than 3%. So on an annualized basis, think of that as kind of in the $40 million range, give or take. We'll get about three quarters of the benefit of that this year. In terms of the real estate, we probably saved about 25% to 30% of our current spend. More to go there. I expect we can reduce that probably by a similar amount next year. The big savings to come is going to be in third-party cloud. We did see a reduction this quarter, which was nice. We reduced our spend as we start to optimize and start to move some things over. But that's a big one. That's about $100 million in total spend or a little bit more, and we'll start to see that benefit next year, a little bit more this year, but mostly into next year and into 2025. Team is doing a great job with vendor management, including being able to engineer out certain functions that we may be using a third party for. So I would say it's a combination of things, but just to sort of put it in perspective, that headcount savings is, call it, roughly a little over a point of margin on an annualized basis. That also gives you giving you that sort of kind of run rate payroll number will give you the math necessary to build your models to factor in that annual increase that we give every year in the third quarter."
},
{
"speaker": "Tom Leighton",
"text": "Also, in terms of the reductions, obviously, we're directing a lot of resources that were on the delivery side of the house into compute. And that, in many cases, is the same person changing what they're doing, but also in this reduction that we're taking, you'll see that effect as well."
},
{
"speaker": "Keith Weiss",
"text": "Got it. And just to be clear, the lower CapEx intensity, it sounds like that's more efficient sourcing, not any change in the scope of build-out that you guys are expecting for the cloud side of the business?"
},
{
"speaker": "Ed McGowan",
"text": "Yeah. So the way to think about that, Keith, is two things. One, we were able to benefit pretty significantly actually with the pricing reductions in the server pricing. My understanding is that's somewhat of an industry phenomenon, but also just given our buying power, a big chunk of that decline in CapEx was related to that. The other thing that I find pretty exciting is we envisioned when we sort of built the models that we'll be able to integrate with our supply chain to be really tight with our demand and build, meaning not having to overbuild for demand. We've been able to knock down the time that it takes for us to deploy. So the initial builds that we're building out will be a little bit smaller than we originally anticipated because we expected a longer lead time with our supply chain. So now that we've been able to shrink that down we can tighten that up a bit. So those are really the main factors, a little bit of push in terms of a couple of sites that can push into '24, but those two factors are pretty significant. And we're very happy that we're able to deliver that this quickly."
},
{
"speaker": "Keith Weiss",
"text": "Excellent. That's super helpful, guys. Thank you."
},
{
"speaker": "Operator",
"text": "Thank you. And our next question today comes from James Fish of Piper Sandler. Please go ahead."
},
{
"speaker": "James Fish",
"text": "Hey, guys. Thanks for the question guys. Wanting to build off of Keith a little bit here. Now that you rolled out your objectives for 2023 here, how are you thinking about not just the CapEx intensity for this year as you're starting to kind of get the savings greater than you expected. Is this the right way to think about next year's capital spending? And I think, Tom, you actually had alluded to getting into that long-term 30%. Is there an update on the time frame there?"
},
{
"speaker": "Tom Leighton",
"text": "Yeah. Let me take a first pass at this. This year is when we're doing the initial build-out for compute and obviously very substantial. And future years will depend on how fast we sell the capacity that we're building out now. And so if we're able to sell that quickly, then there would be more CapEx spend next year. If it takes us longer to fill that capacity, then you would see CapEx be much less next year. So it really depends on how rapidly we get uptake on the initial build-out that we're doing. And on the 30%, we're not issuing a specific time line there. But obviously, we're having, I think, really good success in our efficiency and we're taking actions to improve margins. And so we'd like to get back to 30% and beyond just as quickly as we can, subject to making the investments for future growth. And I'm very optimistic about our ability to do that. Ed, was there something you'd like to add there?"
},
{
"speaker": "Ed McGowan",
"text": "No, I think that covered it, Tom."
},
{
"speaker": "James Fish",
"text": "Great. And just a follow-up on the security side as well. It sounds like you guys are pointing to this being the kind of trough in growth. But as you think about network security offerings, in particular, including the Zero Trust overall portfolio not just Guardicore, how do you feel about your go-to-market -- how your go-to-market is aligned with selling these types of solutions that tend to go through indirect sources that really are MSPs that you guys have historically been lined up with? Thanks, guys."
},
{
"speaker": "Ed McGowan",
"text": "Yeah, I do think we should see improvement in security growth from here. And particularly now that we're adding API security into the mix, I think the channel is really important for us and it's something we're putting a lot of effort into it, especially on the enterprise security side. For example, Guardicore is all through the channel, very successful partnerships, and it's something we'll be focused on with API security as well."
},
{
"speaker": "Operator",
"text": "Thank you. And our next question today comes from Jonathan Ho with William Blair. Please go ahead."
},
{
"speaker": "Jonathan Ho",
"text": "Hi, there. I just wanted to understand a little bit better about maybe your confidence level around the macro environment, what you're seeing out there? And why you're not potentially taking a more conservative stance. I think you said that your expected macro to remain consistent."
},
{
"speaker": "Tom Leighton",
"text": "Well, I think our guidance does reflect or the current situation and our view, we're not assuming that the macro environment will improve. And so I do think we are taking a reasonably conservative view going forward. We are very happy with the strong start to the year on several fronts as we talked about. Ed, would you like to say a little bit more about that?"
},
{
"speaker": "Ed McGowan",
"text": "Yeah, sure. I mean in terms of some of the negatives that you're seeing, obviously, sales cycles are a little bit longer. We are seeing difficulty with adding new customers with the exception of Guardicore. Tom alluded to the fact that Guardicore brought a pretty good channel organization with them, and we're seeing pretty good new logo acquisition there. So that's probably the exception to that rule. We're seeing some pricing pressure from some verticals, we are seeing, I mentioned, better pricing environment for some of the higher media delivery business. Inflation obviously causes some challenges. We've seen some bankruptcies in the retail space and a couple in the financial services. None that's overly material. And as I said, we're not anticipating things to get worse. If things did get worse, potentially we'd see a little bit more of that. On the Pro side, we are seeing lower turnover of employees, faster time to hire, which isn't much of a surprise. With rates going up and we have cash interest rates are better for us from a reinvestment perspective, the dollar is slightly weaker. That may -- as the dollar gets weaker that helps our benefits. And then also just from the vendor side, just continued focus on pushing vendors for better pricing and things like that. So it's a mixed environment, obviously, a challenging environment. I think we're navigating through it pretty well. And we've built in what we thought we could achieve based on what we see today."
},
{
"speaker": "Tom Leighton",
"text": "On the silver lining side, as we get our compute offering, prepared to take on major mission-critical enterprise workloads, there is the potential that because we can do it less expensively, particularly for applications involving large amounts of data and delivery of data that, that could be a net benefit for us competitively in a time when companies are looking to cut costs. And is something a lot of our customers have told us, particularly customers with large volumes of data that they need to cut the cloud expense. And I think we'll be in a position to help them do that. And as I mentioned earlier, at a time like this when there's a lot of concern in the financial sector, Akamai's reliability and security, it really becomes paramount. And that's helpful to help mitigate the impacts of a difficult macroeconomic environment."
},
{
"speaker": "Jonathan Ho",
"text": "Excellent. And then just as a quick follow-up. In terms of the delivery business, I think you talked about some favorable trends around the traffic side. Can you talk about what you're seeing in terms of those improvements and maybe the sustainability of that as we think about, again, the delivery traffic? Thank you."
},
{
"speaker": "Tom Leighton",
"text": "Yes. About March, really of last year is when we really saw traffic growth take a hit, part because of the economy as a whole, part because of the war in Ukraine, and now we're lapping that. And so when you look at the year-over-year rates, indeed, they did start improving in March. And so we're optimistic about that and hope to see that be more sustainable just because you have a more reasonable compare. Ed, do you want to add more color on that?"
},
{
"speaker": "Ed McGowan",
"text": "Yeah. The only thing I would add, I did touch a little bit on just slightly better pricing environment, which makes sense given the volumes. They're still not back to pre-pandemic levels, better than what we saw last year. Also, we've seen in some accounts, some larger accounts, some vendor consolidation, and we've been a benefactor of that, which makes sense. Some customers will have four or five CDNs that can get to be pretty expensive. Sometimes they build up teams. They have technology they use for load balancing and things like that. So as they consolidate vendors. And a lot of us have volume-based tiered pricing, so you can take advantage of lower unit economics as you consolidate to one or two vendors. So that's been a positive trend for us. It's another reason why we've seen a little bit of an uptick in traffic."
},
{
"speaker": "Jonathan Ho",
"text": "Thank you."
},
{
"speaker": "Operator",
"text": "Thank you. And our next question comes from Frank Louthan with Raymond James. Please go ahead."
},
{
"speaker": "Unidentified Analyst",
"text": "Hey, guys. This is Rob on for Frank. So who do you run into in the marketplace now for compute specifically? And how would you guys evaluate the outlook for that business in particular going forward? And what's driving that outlook primarily?"
},
{
"speaker": "Tom Leighton",
"text": "Yes, the hyperscalers and also do it yourselves. And I think the outlook for us is positive. We're not trying to take 30% market share. It's a $100 billion, $200 billion market. But we do think we can be very competitive for certain kinds of applications, particularly in the verticals where we do a lot of business, the media vertical, entertainment obviously, video, gaming, commerce. And that's because those customers, they know us, they like us, they use us for the delivery and security. And I think we're in a position to offer them a very compelling capability in terms of better performance and a lower price point. So we'll see. But so far, I think we're very pleased with what we've been hearing for customers, making good progress, getting our connected cloud platform built out, upgrading Lino to really take on large-scale mission-critical enterprise workloads."
},
{
"speaker": "Unidentified Analyst",
"text": "Great. Thank you."
},
{
"speaker": "Operator",
"text": "Thank you. And our next question today comes from Rudy Kessinger with D.A. Davidson. Please go ahead."
},
{
"speaker": "Rudy Kessinger",
"text": "Hey, great. Thanks for taking my questions. Just want to double click maybe on security. You said Guardicore $7 million of license revenue Q1 last year. Was there any license revenue for Guardicore this Q1 this year?"
},
{
"speaker": "Ed McGowan",
"text": "Yeah. No, nothing material. No."
},
{
"speaker": "Rudy Kessinger",
"text": "Yeah. Okay. Got it. And then maybe just a follow-up on delivery, certainly stronger revenue performance than we expected. Is there -- I guess, was there anything in the quarter you talked about maybe some customers consolidating from four or five vendors, maybe to three. Anything in particular in the quarter that would give you hope that delivery maybe you could potentially turn that back to a, I don't know, say, a flat or maybe only a 3%-5% decline in business as opposed to a 10%-ish decline in business as we've seen over the last few quarters?"
},
{
"speaker": "Ed McGowan",
"text": "Yeah. That's obviously continued traffic growth. I think if we get back to kind of pre-pandemic levels, that's certainly going to help. We've done a pretty good job on pricing, especially with the larger customers in the old web verticals, especially commerce, we're still seeing some pricing pressure there. So really, it's a combination. But I'd say the stronger traffic growth is going to be the main thing. As we get into Q2 and Q3, we've got slightly easier compare you recall last year, we had significant renewals in our top-10. We have renewals all the time, but that was an unusual year for that. So the double-digit declines, I wouldn't expect that certainly next quarter or the quarter after that. And in Q4 is always the toughest quarter to call, but things will get -- should get a little bit better from a year-over-year compare standpoint. But in terms of getting to sort of flat or even plus or minus a point, you're going to need to see stronger traffic growth than what we're seeing now."
},
{
"speaker": "Rudy Kessinger",
"text": "Got it. Fair enough. Thank you."
},
{
"speaker": "Operator",
"text": "Thank you. And our next question today comes from Ray McDonough with Guggenheim. Please go ahead."
},
{
"speaker": "Ray McDonough",
"text": "Great, thanks for taking the questions. Tom, maybe first for you. Another question around security go-to-market. I know you touched on the focus on the channel. But you did mention you were also redeploying go-to-market resources within the security group as well. Can you talk more specifically to the changes made in that organization? And is there any early results to point to from those changes that give you confidence that you will be able to reaccelerate growth here in the rest of 2023?"
},
{
"speaker": "Tom Leighton",
"text": "Well, we're just taking the actions as we speak. So nothing to see directly from that yet. I would say they're in three areas. One is less investment in management and more in, say, feet on the street. The next would be more focused on security and compute and getting the right expertise in front of the customer, and that would be in presales and also in services. And then the third is a shift in resources to some of the, I would say, undertapped geographies, where we think there's the potential for a lot of growth. So I think all three are very helpful. And then, of course, channels, particularly for our enterprise security solutions, where that's, I think, a much -- a better way of doing it. For our established web app firewall, we do have a significant channel's presence but also a significant direct presence. And we expect to start seeing the benefits here towards the end of the year as we hire the new resources in these areas."
},
{
"speaker": "Ray McDonough",
"text": "That makes sense. And then maybe just a follow-up for you on Linode. I believe you've kind of outlined an expansion of 14 core datacenters by the end of the year and 50 distributed sites, I believe. Is that still the case? And maybe just following up on one of your comments earlier, can you talk about how much smaller the Compute footprints are this year, if it's a magnitude of size? And how comfortable you feel in terms of the lead times to add capacity if the macro environment or demand turns more quickly than you expect?"
},
{
"speaker": "Ed McGowan",
"text": "Yeah. Why don't I start with the last part first. So in terms of the timing, I think we've got it down to probably 60 to 90 days, I think we can add capacity pretty quickly. We're building up -- working with our suppliers. We've had long-term relationships, structuring deals with them to be able to very quickly get our hands on equipment and building up some inventory and that sort of thing. So we feel pretty good about that. So I think -- and also these sales cycles are not immediate, right? So there's usually a trial period and that sort of thing, starting the conversations now. So it's not like CDNs where you can shift overnight, just move traffic within a day or two. So we will have good lead times there. In terms of the actual size, I just say they're small, I don't have a specific number to throw out. We're on track to deliver all of our core sites. There's a couple coming online in Q2 and a bunch coming online in Q3, no change there. As far as the distributed sites, we will be building out a bunch of those. I don't have an updated figure for you. Some of them may push. Those are much smaller in terms of of CapEx. So that really doesn't have a major impact on CapEx. Each one of those sites are relatively small, so it's not going to have a material impact. But in terms of what we're seeing with the supply chain, we feel pretty good. We've done a lot of work, great hats off to the team. They've done a fantastic job working with our suppliers to be able to really tighten things up, and you can see that in the updated guidance."
},
{
"speaker": "Ray McDonough",
"text": "Great. Appreciate the color."
},
{
"speaker": "Operator",
"text": "Our next question today comes from Amit Daryanani with Evercore. Please go ahead."
},
{
"speaker": "Unidentified Analyst",
"text": "Hi, this is Lauren on for Amit. So just to kind of double-click into buybacks and how you guys are thinking about the second half of the year after a fairly aggressive first quarter? That would be great."
},
{
"speaker": "Tom Leighton",
"text": "Yeah. Our policy and strategy really hasn't changed. And that includes -- there's times when we do buyback more shares that are needed to offset dilution from employee equity programs. And those are opportunistic. And in Q1, we felt there was a substantial opportunity to buyback more than the usual allotment. And of course, we have a programmatic buyback that buys back more when the stock price is lower and buys back less when the stock price is higher. And so when the stock goes lower, the programmatic or automatic buying also increases. And as you know, the stock price was lower through a lot of Q1. So there's really no fundamental change in strategy. Prior to this year, over the last 10 years, we've bought back an extra 1% a year over and above the equity program dilution offset. Obviously, Q1 was more than that. So there's not a specific change in strategy that would say we're going to buyback what we did in Q1 every quarter. So no change in strategy."
},
{
"speaker": "Unidentified Analyst",
"text": "Got it. Thank you."
},
{
"speaker": "Operator",
"text": "Thank you. And our next question today comes from Mark Murphy at JPMorgan. Please go ahead."
},
{
"speaker": "Unidentified Analyst",
"text": "This is [Indiscernible] on for Mark Murphy. Thanks for taking the call, and congrats on the quarter. Maybe just on compute. I think in the past, you've mentioned that the node hasn't faced the same optimization headwinds that the hyperscalers have. Curious if anything's changed on that front?"
},
{
"speaker": "Tom Leighton",
"text": "Sorry, as in faced what headwinds?"
},
{
"speaker": "Unidentified Analyst",
"text": "Sorry, the same optimization headwinds that the hyperscalers have been calling out the last few quarters?"
},
{
"speaker": "Tom Leighton",
"text": "Yes, I think Linode is really in a very traditional, Linode a very different market and much more affordable and really not servicing the major enterprises. Major enterprises, at least the customers that we talk to are very worried about the rapidly growing cloud costs. And that's something that I think we're in a position to help them with as we get our infrastructure built out and get it ready to take on mission-critical workloads."
},
{
"speaker": "Unidentified Analyst",
"text": "Great. Thank you so much for that additional color. I'll leave then and pass back to the operator."
},
{
"speaker": "Operator",
"text": "Thank you. And ladies and gentlemen, we have no further questions at this time."
},
{
"speaker": "Tom Barth",
"text": "Okay. Well, thank you, operator, and thank you, everyone. In closing, we will be presenting at several investor conferences and road shows throughout the rest of the second quarter. Details of these can be found in the Investor Relations section of akamai.com. Thank you for joining us, and all of us here at Akamai wish continued good health to you and yours. Have a nice evening."
},
{
"speaker": "Operator",
"text": "Thank you. Ladies and gentlemen, this concludes today's conference call. And we thank you all for attending today's presentation. You may now disconnect your lines. And have a wonderful day."
}
] | Akamai Technologies, Inc. | 24,522 |
AKAM | 4 | 2,024 | 2025-02-20 16:30:00 | Operator: Good day, and welcome to the Fourth Quarter 2024 Akamai Technologies, Inc. Earnings Conference Call. All participants will be in listen-only mode. [Operator Instructions]. Please note this event is being recorded. I would now like to turn the conference over to Mark Stoutenberg, Head of Investor Relations. Please go ahead.
Mark Stoutenberg: Good afternoon, everyone, and thank you for joining Akamai's fourth quarter 2024 earnings call. Speaking today will be Tom Leighton, Akamai's Chief Executive Officer; and Ed McGowan, Akamai's Chief Financial Officer. Please note that today's comments include forward-looking statements, including those regarding revenue and earnings guidance, along with our business outlook, three to five year goals and longer-term targets. These forward-looking statements are based on current expectations and assumptions that are subject to certain risks and uncertainties and involve a number of factors that could cause actual results to differ materially from those expressed or implied by such statements. The factors include but are not limited to any impact from macroeconomic trends, the integration of any acquisition, geopolitical developments, and any other risk factors identified in our filings with the SEC. The forward-looking statements included in this call represent the company's views on February 20, 2025. Akamai undertakes no obligation to update any forward-looking statements, which speak only as of the date they are made. As a reminder, we will be referring to certain non-GAAP financial metrics during today's call. A detailed reconciliation of GAAP to non-GAAP metrics can be found under the financial portion of the Investor Relations section of akamai.com. Also, as part of our ongoing commitment to transparency, we've enhanced our disclosures to provide investors with a more comprehensive understanding of our business. This quarter, we've created a new presentation available in the Investor Relations section of our website, offering a bit more information on our product portfolios, financials, and performance goals. This presentation supplements the information in our earnings release and annual filings, and we encourage you to review it. Within the presentation, you'll find an overview of select revenue and year-over-year revenue growth rates. Please note, all growth rate percentages are reported on a constant currency basis. With that, I'll now hand the call off to our CEO, Dr. Tom Leighton.
Tom Leighton: Thanks, Mark. As you can see in today's press release, Akamai delivered solid performance in the fourth quarter with revenue coming in at $1.02 billion and non-GAAP earnings per share coming in well above our guidance range at $1.66. I'm also pleased to report that we made excellent progress on our multi-year journey to transform Akamai from a CDN pioneer into the cybersecurity and cloud computing company that powers and protects business online. For the first time in Akamai's history, Security delivered the majority of our annual revenue in 2024, surpassing the $2 billion threshold and growing at 16% year-over-year. Our cloud computing portfolio recorded $630 million in revenue last year, growing 25% over 2023. The portion of this revenue derived from our cloud infrastructure services was $230 million, up 32% over 2023. Our cloud infrastructure services primarily consists of the compute and storage solutions that we've developed based on Linode. They also include our edge workers product and ISV solutions running on our cloud platform. Combined, security and compute accounted for two-thirds of Akamai revenue in 2024, growing 18% year-over-year. And we exceeded all our year-end annualized revenue run rate or ARR goals for the fastest-growing areas of the business, namely for our Guardicore platform, our API security solution, and enterprise revenue for our cloud infrastructure services. These are three of the key areas that we anticipate will drive revenue acceleration for our overall business in 2026 and beyond. In the area of security, Akamai has expanded into new adjacent markets, growing beyond point solutions to provide a more holistic and comprehensive security offering. This has enabled us to expand our customer base and to better serve enterprises with a broader portfolio for protecting infrastructure, applications, APIs and user interactions in both cloud and on-prem environments. Security growth in Q4 was driven by continued strong demand for our market-leading Guardicore segmentation solution as more enterprises relied on Akamai to defend against malware and ransomware. The Guardicore platform ended the year with an ARR of $190 million up 31% year-over-year and surpassing our goal of $180 million. In Q4, we signed our largest deployment to date for Guardicore with a leading IT services company in India. The solution covers 30,000 servers and nearly 300,000 endpoints. We also displaced a competitor segmentation offering that was falling short at major banks, both Hong Kong and in the U.S. More than 80% of our segmentation revenue in 2024 came through channel partners, including one of the world's leading SIs, Deloitte, which wraps its services and implementation expertise around our segmentation and API security products to create value for customers that Deloitte knows well. Together, in Q4, we won a $5.8 million contract with Petrobras in Brazil to reduce the risk of a breach and ransomware attacks. We also partnered with Deloitte to help defend two large European banks from API risks. In Q4, Akamai also signed a large contract for API security with one of the biggest asset managers and brokerage firms in the U.S. Our API security solution ended 2024 with an ARR of $57 million, up from just $1 million at the end of 2023 and exceeding our goal of $50 million. Taken together, our API security solution and Guardicore platform ended 2024 with $247 million of ARR. As we look ahead, we expect to generate continued strong growth for these products with a goal of increasing their combined ARR by 30% to 35% during the year. We also anticipate that over the next several years, the rapid growth and more meaningful amount of revenue from these new products will help offset the slower growth of our more widely adopted and market-leading web app firewall and DDoS mitigation products. As a result and as noted in our supplemental disclosure that Mark mentioned a few minutes ago, we believe that we can maintain a CAGR of about 10% in constant currency for our security products over the next three to five years with typical M&A. This would bring us to more than $3 billion in security revenue by the end of the decade. While our security product line is performing very well, our compute product line is growing even faster and has a much larger addressable market. We've come a long way since we expanded into the cloud computing market in 2022 with the acquisition of Linode. And we made a lot of progress last year, achieving what we set out to do in revenue growth, signing new enterprise customers, infrastructure deployment, product development, partner ecosystem expansion and migrating our own applications from hyperscalers to the Akamai cloud. We continue to sign compute customers at a rapid pace in Q4 and including two financial software companies in the U.S., two of the largest retailers in the U.S., a cybersecurity provider in Europe, an enterprise software company in Asia, one of the largest banks in Southeast Asia and an intelligent transportation system provider in Latin America. When we measure the progress of our cloud infrastructure services, we've been looking at the results through two lenses. Our primary lens is the uptake of these solutions by larger enterprise customers, such as those doing over $100,000 in ARR. The second lens is looking at the performance of these products across customers of all sizes. At year-end, approximately 300 enterprises were spending at least $100,000 in ARR for our cloud infrastructure services, up significantly from the year before. Collectively, these customers finished the year with an ARR of $115 million for our cloud infrastructure services, far exceeding our goal of $100 million. When you include all customers, the ARR for our cloud infrastructure services finished 2024 at $259 million, up 35% year-over-year. This is a substantial improvement from when we acquired Linode in 2022 when the ARR from these services was approximately $127 million and was growing in the mid-teens. In addition to enabling customer growth, our work to make Linode be enterprise grade has allowed us to move some of our most important products from hyperscalers to Akamai's Cloud. This has resulted in improved performance and savings of well over $100 million per year. Many of our customers have also significantly expanded their use of our cloud infrastructure services over the last year, some by a factor of 4x or more. By year-end, 15 customers were spending over $1 million in ARR for our cloud infrastructure services, more than triple the number from 2023. And today, we announced our first customer to sign a contract committing to spend more than $100 million for our cloud infrastructure services over the next several years. We believe this is a remarkable validation of our new cloud capabilities, signaling that an extremely sophisticated buyer of cloud services is confident in our ability to execute and provide a level of service and performance comparable to or better than the hyperscalers. The recent improvements that we've made to our cloud platform will enable us to do even more for enterprise customers in 2025. For example, in the last year, we expanded Akamai's core data center footprint to 41 locations in 36 cities around the world. Next week, we plan to announce that we've enabled our new managed container service in our 4,300-plus points of presence in more than 700 cities around the world. We're currently testing this service with customer workloads in over 100 cities. We've significantly upgraded our object storage solution with a 5x increase in scalability and a 10x increase in performance, making it comparable to the hyperscalers but with much lower egress fees due to the efficiencies of our unique edge platform. We added GPUs for a variety of AI and media use cases. One customer ran a proof of concept between Akamai and a hyperscaler and then chose Akamai for text to image AI inferencing workloads. Another customer uses our cloud for AI-powered speech recognition for its in-vehicle voice assistant. And an OTT provider switched from a hyperscaler to Akamai to provide a more cost-effective platform for its ad-supported streaming TV service. We enhanced the scale and security of our Linode Kubernetes engine product. Traditional cloud providers run Kubernetes platforms from a relatively small number of core data centers. Akamai's differentiated approach will combine the computing power of our cloud platform with the proximity and efficiency of our edge to put workloads closer to users than any other cloud provider. Building on technology that we acquired from Red Kubes last year, we released the Akamai app platform to enable developers to build and deploy highly distributed applications in just a few clicks. And we added nine compute ISV partners last year, bringing our total to 23. Our ISV partners accounted for $36 million of cloud infrastructure services ARR at year-end. We're very excited about our opportunity for continued strong growth as we bring the power of compute to the edge with our broadly deployed network getting compute instances closer to end users with an open platform that ensures flexibility and portability, orchestrated resource deployment to ensure efficient scaling and operations and predictable pricing with an unmatched ability to minimize egress costs. I think our rapid progress in cloud computing has summed up well in an evaluation of public cloud platforms released last month by IDC. Their worldwide public cloud marketscape for IaaS identified Akamai as a major player relative to industry peers, saying "Akamai has accelerated its journey into the public cloud IaaS space, transforming from a pure-play CDN provider into a formidable public cloud competitor." In addition, Gartner positioned Akamai as an emerging leader for Gen AI specialized infrastructure in their recent innovation guide for generative AI technologies. As we noted in the supplemental materials Mark mentioned, we're supporting a growing number of AI use cases with a special focus on inferencing. While it's still early days, we're excited about the long-term revenue opportunity, and we believe that the unique properties of Akamai's Cloud position us to be a major player in AI inferencing in the years to come. As we look forward to the rest of 2025, our goal is to grow our total cloud infrastructure services ARR by 40% to 45% in constant currency. We believe that the accelerating growth of our cloud infrastructure services revenue will be driven primarily by enterprise customers. Given the great success that we're having with our cloud infrastructure services, we plan to focus more of our compute investments in this area. In particular, we're in the process of migrating some of our older cloud applications for tasks such as visitor prioritization, image and video management, and live streaming workflow to ISV partners who specialize in these areas, and we plan to move some or all of their workloads to Akamai's cloud. In addition to converting former competitors into important ISV partners for our cloud, we believe this transition will enable us to focus more of our internal resources on further development and expansion of our cloud infrastructure services. The transition also means that we expect that the revenue from some of our cloud applications will decline in 2025. And as Ed will discuss shortly that we're projecting about 15% growth for our cloud computing solutions as a whole in 2025. As our cloud infrastructure services revenue continues to rapidly increase, we believe that we can reaccelerate the overall cloud computing revenue growth rate to achieve a CAGR of at least 20% on over the next three to five years in constant currency. This would make cloud computing our third $1 billion product line by 2027. I'll next talk about content delivery, which continues to be an important generator of profit that we use to develop new products to fuel our future growth. Our unique edge platform with over 4,300 points of presence in over 700 cities continues to be a major differentiator in terms of lowering our costs, enabling massive scale and providing superior performance. And this is true not only for delivery, but also for security and compute. In security, we use the platform to provide a massive shield against all sorts of attacks without impacting performance or raising costs. And in compute, we use the platform to provide function as a service with our edge workers product. And as we'll announce next week, we'll also use the same platform to run our new managed container service in thousands of pops across hundreds of cities. This capability is unique in the market, and it will enable our customers to get their compute workloads much closer to users. Akamai achieved substantial cost synergies by using the same physical server to support our delivery, security and now compute services in over 4,300 POPs in 700 cities. It's a unique capability and a key reason why Akamai has been so profitable, while many of our competitors have struggled. Our installed base of delivery customers also continues to be a key contributor to our growth in security and cloud computing. As we harvest the competitive and performance advantages of offering delivery, security, and compute as a bundle on the same platform. That synergy works especially well for our security and compute customers that want delivery as a feature and see it as critical to their relationship with us over other vendors. In Q4, we signed many deals that included security and compute solutions alongside our best-in-class delivery. And we won back delivery business for competitors at one of the leading tech players in AI and as a leading player in streaming media. And in December, we acquired select customer contracts from Edgio to offer their customers our market-leading delivery services and the opportunity to take advantage of Akamai's full range of security and cloud solutions. I'm pleased to report that we're beginning to see signs of improvement in the delivery marketplace with more customers willing to sign multi-year contracts with predictable pricing, a more stable pricing environment generally and early signs of stabilizing traffic growth. As a result, and as Ed will discuss in a few minutes, we now expect to see the year-over-year decline in delivery revenue shrink to about 10% this year. If the favorable trends hold, we should see the decline in delivery revenue continued to lessen in 2026 and beyond. As we noted in our call last May, our largest customer is navigating political challenges and is pursuing a DIY strategy. As a result, we expect that the revenue from this customer will produce a headwind of about 1% to 2% per year on our overall revenue growth rate for the next couple of years before stabilizing at a level similar to some of our hyperscaler customers, which would be about 2% to 3% of our total revenue. That said, I'm pleased to report that we entered into a five-year committed relationship with this customer in Q4, that includes a substantial minimum annual spend, which provides greater predictability and which reduces our exposure to their political situation in the U.S. While we're pleased with the progress that we made last year on our multiyear transformation journey, we still have work to do to reach more new customers and to cross-sell our new capabilities in security and cloud computing to our installed base. To drive greater top line growth over the next three to five years, we're transforming our go-to-market strategy to align more resources with the higher growth segments of our business and to accelerate the pace at which we add new customers. In particular, we've already begun to raise the ratio of hunters to farmers and sales and to increase the number of specialized sellers and presales resources that support sales of our Guardicore platform, API security and cloud infrastructure services. We're also investing more in partner enablement as the channel has become a major source of revenue growth for us. Based on advice from one of the world's top consulting firms, we're also embarking on a major project to optimize our sales operating model, account coverage framework, compensation structure, pricing strategy and the way that we leverage our channel partner ecosystem. As we disclosed in the supplemental forecast posted on Akamai's Investor Relations website, we believe that the combination of double-digit security growth, very fast growth in cloud computing, a stabilizing delivery business and a constantly improving product mix should enable us to accelerate revenue growth in the years ahead and to achieve double-digit revenue growth by the end of the decade, if not sooner. In fact, if you remove the impact of foreign exchange headwinds in the large customer I mentioned earlier, you can see that the acceleration is already underway. Excluding these two factors, revenue growth accelerated in 2024 over 2023. And as Ed will describe shortly, we anticipate further acceleration in 2025. We believe that improving our top line growth and product mix, combined with our continued efforts to improve efficiency, will help to improve operating margins so that we can meet and then exceed our goal of 30% over the next several years. We also believe that we can resume growing our non-GAAP EPS in 2026. While we still have much to do, we're very optimistic about the future. Our cloud computing strategy is taking hold as we envisioned. Our expanded security portfolio is enabling us to deepen and expand our relationships with customers and partners. And we continue to invest in Akamai's future growth while also maintaining strong profitability. Now I'll turn the call over to Ed for more on our results and our outlook. Ed?
Ed McGowan: Thank you, Tom. Before I begin, I want to reiterate what Mark mentioned at the start of the call, and highlight some of the new disclosures we issued earlier today. The materials we posted to the IR section of our website include a bit more detail than what we will cover in today's prepared remarks. Our aim is to provide deeper insights into our business and present our updated long-term goals. While we do not intend to provide this level of disclosure every quarter, we will occasionally offer additional context if we believe it will be helpful. Today, I plan to cover our Q4 results, provide some color on 2025, including a few new disclosures and then cover our Q1 and full-year 2025 guidance and I will close with our long-term thoughts on revenue and profitability goals. Now let's cover our Q4 results, starting with revenue. Total revenue was $1.020 billion, up 3% year-over-year as reported and in constant currency. We continue to see solid growth in our compute and security portfolios during the fourth quarter. Edgio contributed approximately $9 million of revenue in the quarter, which was in line with our expectations. Compute revenue grew to $167 million, a 24% year-over-year increase as reported and 25% in constant currency. In the fourth quarter, Compute revenue was comprised of $65 million from our cloud infrastructure services and $102 million from our other cloud applications. As Tom pointed out, one of our largest customers has committed to spending at least $100 million on our cloud infrastructure services over the next few years. We expect that their workloads will begin ramping up by the end of 2025. Moving to security revenue. Security revenue was $535 million, growing 14% year-over-year as reported and in constant currency. During Q4, we had approximately $12 million of onetime license revenue compared to $5 million in Q4 of last year. As noted in our added disclosure, our security revenue was comprised of $205 million from Zero Trust Enterprise plus API security, which grew 51% in constant currency year-over-year and $1.84 billion from all other security products, which grew 14% in constant currency year-over-year. Combined, compute and security revenue grew 16% year-over-year as reported and 17% in constant currency in Q4 and now represents 69% of total revenue. Our delivery revenue was $318 million, slightly ahead of our expectations and down 18% year-over-year as reported and in constant currency. We anticipate an improvement in delivery revenue in 2025 driven by a more positive outlook on delivery, as Tom discussed earlier. International revenue was $490 million, up 2% year-over-year or 4% in constant currency, representing 48% of total revenue in Q4. Finally, foreign exchange fluctuations had a negative impact on revenue of $8 million on a sequential basis and a negative $6 million impact on a year-over-year basis. Moving to profitability. In Q4, we generated non-GAAP net income of $254 million or $1.66 of earnings per diluted share, down 2% year-over-year, flat in constant currency and well above the high end of our guidance range. These EPS results exceeded our guidance driven primarily by slightly higher-than-expected revenue, lower-than-expected transition services or TSA costs related to the Edgio transaction, greater savings from the head count actions we announced in Q3 and lower payroll costs due to some hiring pushing from Q4 into Q1. Finally, our Q4 CapEx was $193 million or 19% of revenue. Moving to our capital allocation strategy. During the fourth quarter, we spent approximately $138 million to buy back approximately 1.4 million shares. For the full-year, we spent $557 million to buy back approximately 5.6 million shares. We ended 2024 with approximately $2 billion remaining on our current repurchase authorization. It's worth noting that over the past decade, we have not only met our objective of buying back shares to offset dilution from our employee equity programs, but we have also decreased our shares outstanding by approximately 16% over that time frame. Going forward, our capital allocation strategy remains the same: to continue buying back shares over time, to offset dilution from employee equity programs and to be opportunistic in both M&A and share repurchases. Before I move to guidance, there are several items that I want to highlight to help with your 2025 models. The first relates to revenue from the Edgio transaction. we now expect approximately $85 million to $105 million in Edgio revenue for 2025. In addition, we expect to have approximately $6 million of TSA costs in Q1 related to Edgio. Approximately $4 million of those costs will be included in cost of goods sold and the remainder in operating expense. We do not anticipate any TSA costs beyond Q1. Second, we expect our CapEx to be approximately 2 percentage points higher than last year for the following reasons. First, we plan to increase spend by about 1% of revenue to accommodate the increased traffic resulting from the Edgio transaction. Second, we anticipate approximately another 1% of revenue will be used for a geo-specific infrastructure builds to support the recently signed $100 million cloud infrastructure services contract we announced earlier today. Additionally, we expect our CapEx spend will be heavily front-end loaded with the first quarter seeing significantly higher expenditures compared to the rest of the year. This is due in part to the items I mentioned above in our plans to pull forward approximately $10 million to $15 million of CapEx into the first quarter to help mitigate the risk of potential tariffs that may be announced later this year. Third, we expect interest income to decline in 2025 due to lower cash balances resulting from recent acquisitions and our plan to retire our $1.15 billion convertible debt instrument that matures on May 1, 2025 along with expected lower investment yields as interest rates come down throughout the year. Fourth, for 2025 we anticipate continued heightened volatility in foreign currency markets driven by unpredictable timing and magnitude of Federal Reserve policy changes and their impact on interest rates. As an example of how impactful FX can be to our results. Since our last earnings call in early November, the strength of the U.S. dollar has negatively impacted our 2025 expectations by approximately $18 million in revenue on an annual basis and negatively impacted our non-GAAP operating margin by approximately 30 basis points and negatively impacted our non-GAAP EPS expectations by approximately $0.09 per share. As a reminder, related to currency, we have approximately $1.2 billion of annual revenue that is generated from foreign currency with the euro, yen and great British pound being the largest non-U.S. dollar sources of revenue. In addition, our costs in non-U.S. dollars tend to be significantly lower than revenue and are primarily in Indian rupee, Israeli Shekel and Polish Zloty. Fifth and finally, as Tom mentioned and illustrated in our supplemental disclosure, the traction that we are seeing in our business is being obscured by the challenges facing our largest customer and the significant FX fluctuations. If we exclude the effect of this customer in FX, our revenue growth rate would have accelerated year-over-year in 2024 compared to 2023. Now moving to guidance. For the first quarter of 2025, we are projecting revenue in the range of $1 billion to $1.02 billion, up 1% to 3% as reported or up 3% to 5% in constant currency over Q1 2024. We anticipate that Q1 revenue levels will be slightly lower than Q4 due to the following: lower revenue from our largest customer, as we discussed earlier, the negative impact of foreign exchange, reduced onetime license revenue in Q1 from Q4 levels. Two, fewer calendar days in Q1 compared to Q4, that's two less days of usage revenue. And finally, a significant number of delivery customers have calendar year-end dates on their contracts. Therefore, the aggregate impact of all those renewals tends to have a negative impact on Q1 revenue compared to Q4 levels. Note that we expect these items will be partially offset by a full quarter's benefit from Edgio. At current spot rates, foreign exchange fluctuations are expected to have a negative $7 million impact on Q1 compared to Q4 levels and a negative $15 million impact year-over-year. At these revenue levels, we expect cash gross margin of approximately 72%. Q1 non-GAAP operating expenses are projected to be $310 million to $316 million. We anticipate Q1 EBITDA margin of approximately 41%. We expect non-GAAP depreciation expense of $132 million to $134 million. We expect non-GAAP operating margin of approximately 28%. And with this overall revenue and spend configuration I just outlined, we expect Q1 non-GAAP EPS in the range of $1.54 to $1.59, we are down 6% to 3% as reported and down 2% to up 1% in constant currency. This EPS guidance assumes taxes of $57 million to $59 million based on an estimated quarterly non-GAAP tax rate of approximately 19.5%. It also reflects a fully diluted share count of approximately 152 million shares. Moving on to CapEx. We expect to spend approximately $237 million to $245 million, excluding equity compensation and capitalized interest in the first quarter. This represents approximately 24% of total revenue. As noted earlier, we anticipate that our CapEx spending will be heavily front-end loaded with the first quarter seeing significantly high expenditures compared to the rest of the year. Looking ahead to the full-year. We expect revenue of $4 billion to $4.2 billion, which is flat to up 5% as reported and up 1% to 6% in constant currency. We are providing a wider range than past practice due to the larger scale of our business, the uncertainty around our largest customer and continuing macroeconomic and geopolitical factors. We would expect to come in at the higher end of that range if we see significant weakening of the U.S. dollar, traffic growth materially exceeds our current levels and there is no ban in the U.S. for our largest customer. We would expect to come in at the lower end of this range if we see significant strengthening of the U.S. dollar. Traffic materially slows from current levels, and our largest customer is banned in the U.S. Moving on to security. We expect security revenue growth of approximately 10% in constant currency in 2025. In Q4 included in security of the combined ARR for our Zero Trust Enterprise and API security solutions was approximately $247 million. We expect the combined ARR of these two products to increase by 30% to 35% year-over-year in constant currency for 2025. For compute, we expect revenue growth to be approximately 15% in constant currency. Included in compute, our cloud infrastructure services delivered $259 million in ARR exiting 2024. We expect Cloud Infrastructure Services ARR year-over-year growth in the range of 40% to 45% in constant currency for 2025. At current spot rates, our guidance assumed foreign exchange will have a negative $38 million impact to revenue in 2025 on a year-over-year basis. Moving to operating margins. For 2025, we're estimating a non-GAAP operating margin of approximately 28% as measured in today's FX rates. Decline in operating margin for the full-year '25 is due mainly to depreciation expense being approximately 90 basis points higher than last year and the negative impact of foreign exchange year-over-year. We anticipate that our full-year capital expenditures will be approximately 19% of total revenue, up approximately 2 points from 2024 due to the items that I listed earlier. As a percentage of total revenue, our 2025 CapEx is expected to be roughly broken down as follows: approximately 4% for delivery and security, approximately 6% for compute, approximately 8% for capitalized software and the remainder is for IT and facilities related spending. Moving to EPS. For the full-year 2025, we expect non-GAAP earnings per diluted share in the range of $6 to $6.40. This non-GAAP earnings guidance is based on a non-GAAP effective tax rate of approximately 19.5% and a fully diluted share count of approximately 152 million shares. Before closing, I want to comment on our revenue and profitability goals for the next three to five years. Cloud Infrastructure Services is experiencing significant growth, which we believe will be the main driver of our total compute revenue in the near to medium term. Our goal is to grow total compute revenue at a compounded annual growth rate of approximately 20% over the next three to five years. Moving to security. Given the size and scale in our security business, it is natural that we will see some products reach maturity and experience slowing growth rates, while other products in emerging areas will see more rapid growth. As a result, we expect security growth over the next three to five years to be led mainly by our newer Guardicore platform and API security products. However, some of our largest security products like Web Application Firewall or WAF and Prolexic, are examples of some of our more mature products. We've been offering these products for over a decade and have reached a very high penetration rate within our customer base. As a result, we expect the growth rate for these products to begin slowing in 2025 and continue to moderate throughout the remainder of the decade. Given these dynamics in our security portfolio, our goal is to grow total security revenue at an overall compounded annual growth rate of about 10% over the next three to five years, including our typical level of M&A. We anticipate delivery revenue declines will moderate in 2025 with increasing stabilization expected over the next few years. In summary, we anticipate that the combination of double-digit growth of our security products, the rapid expansion in our compute services, a stabilizing delivery business and a continuously improving product mix away from delivery will allow us to achieve double-digit top line revenue growth by the end of the decade, if not sooner. As for profitability, we expect operating margins to reach 30% plus by the end of the decade. And with accelerating top line and expanding operating margins, our goal would be to deliver strong growth in non-GAAP EPS over the next few years. Finally, while we're not providing specific guidance for 2026, we do anticipate revenue acceleration and margin expansion compared to 2025 levels. With that, I'll wrap things up, and Tom and I are happy to take your questions. Operator?
Operator: We will now begin the question-and-answer session. [Operator Instructions]. The first question comes from Roger Boyd with UBS. Please go ahead.
Roger Boyd: Great, thank you for taking my question. And congrats on the quarter. And congrats on the large cloud deal. Tom, I love if you could maybe expand a little bit on that, provide any more details on the nature of workloads as customers bringing over, and it sounds like it's probably coming off a hyperscaler, but any additional info you can provide on the competitive environment there as it relates to pricing performance edge presence. I think Ed noted there's some geo-specific conditions the customer is looking for. I know that's a lot, but thanks.
Tom Leighton: Yes. They already have been using substantial cloud infrastructure services at Akamai for a variety of media applications. And we'll increase that usage. In addition, they have some special needs in Scandinavia and we are building out a data center there for them to handle substantial applications for them throughout Europe. So they're using the services in a normal way, plus we have a special situation that we're doing a build-out for them and development for them. But ultimately, we think many of our customers will use.
Roger Boyd: Super helpful. Appreciate the color.
Operator: The next question comes from Madeline Brooks with Bank of America. Please go ahead.
Madeline Brooks: Hi, team. Thanks so much for taking my question. First is for housekeeping. I just want to clarify that the $100 million compute deal is not the same as the five year deal that you signed with your largest delivery customer? And then I have a quick follow-up to that.
Tom Leighton: They are the same customer.
Madeline Brooks: Got it. Okay. Thank you. And then the other one would be, can you just give us more details outside of just the geo location and why they chose Akamai. Is it -- does it have anything to do with maybe newer products that you have work on AI or intelligence, things of that nature would be helpful. Thank you.
Tom Leighton: Yes, they chose Akamai for superior performance and improve better pricing. We are very well connected throughout Europe. Nobody has the points of presence that we do. And so we can handle requests for this customer throughout the continent and get it into the data center facility they'd like to have in Scandinavia and do that very efficiently at a favorable price point, because of our existing platform and capabilities.
Operator: The next question comes from Amit Daryanani with Evercore. Please go ahead.
Amit Daryanani: Thanks a lot. And thanks for taking my question. I guess I have two quick ones, hopefully. The first one, with your largest customer, the $60 million headwind that you talked about. I'm hoping you just maybe expand a little bit on that is that headwind going to happen irrespective of what happens with the recent executive order around their operations? I'm just trying to understand like is this more about them intending to move some of the CDN in-house? Or is it more of an executive order that $6 million headwind does it happen in respective? And it sounds like it's another $60 million in '26. Maybe just level set that kind of what's happening there and how to ring-fence that would be helpful. And then just to operating margins. What do you think it takes for Akamai to get back to a 30% operating margin number over time? Any kind of help on revenue or cost control, that would be helpful? Thank you.
Tom Leighton: Yes. So the headwind is, by and large, because of their DIY build-out, as we've talked about. So they'll be taking on more of the services themselves. And there are political challenges, obviously, in the U.S. as a result of the five year agreement. Our exposure there is mitigated quite a bit. As we talked about in the disclosure last year, we had about $50 million, I have about $50 million of U.S. business with this customer that obviously would be taken away if they are banned in the U.S. However, as a result of the minimum commitments made, our exposure there is less. As Ed pointed out, if they are banned in the U.S. then we would have less revenue from them than if they continue to operate. And if they continue to operate, there would be upside to the upper end of the range. And Ed, do you want to talk about the margins?
Ed McGowan: Sure. Yes. So most of the expansion is going to come through two things. One, the mix is going to move more towards security and compute. And then just from an operating leverage perspective, with the revenue growth, we just believe we can scale the business accordingly. And a lot of that additional growth will drop to the bottom line. The changes that Tom is talking about or mentioned on the call about go-to-market, some of that has already been funded by the action that we took before, and we're very responsible with future investments. So we expect to see some scale as we grow top line.
Amit Daryanani: Great. Thank you very much.
Operator: The next question comes from Fatima Boolani with Citi. Please go ahead.
Fatima Boolani: Good afternoon. Thank you for taking my questions. Tom or Ed feel free to chime in on this. With regards to TikTok, you talked specifically about the delivery business and some of the minimal commitment minimum commitments they've made to you to protect you. But I was actually curious if you can opine or comment on if that is a customer that has adopted other solutions in your portfolio, i.e., specifically anything in the security realm that we have to be mindful of eroding away. And then I have a quick follow-up on the good market as well.
Tom Leighton: Yes. Like any large customer, they pretty much use all our services. So they're a large delivery customer. They use a lot of our security services and actually a growing amount of our compute our cloud infrastructure services. And we have factored that in to the guidance we've given, both the guidance for this year and the three to five year guidance.
Fatima Boolani: Great. And just from a go-to-market perspective, Tom, you were very explicit in that there's been a lot of thoughtful change and maybe a little bit of an overhaul in the go-to-market organization by way of account segmentation, price strategy, et cetera. I'm wondering how far along are you in the process of ironing out or cementing a lot of these changes, because it does seem like there might be a couple of things that blocks from an aggregate go-to-market strategy perspective. So would love to hear kind of where you are on the journey to kind of overhaul the go-to-market organization and how we should think about you coming out the other end of that? Thank you.
Tom Leighton: Yes. Great question. I think of this as sort of a two year process, roughly speaking. And we're in the beginning stages. We've already increased the number of our hunters and as I said, the ratio of hunting to farming. We've already increased and we'll do further increases in the specialized sales team. We are working now, thinking through pricing structure changes, contracts, potential contract structure changes, making progress in segmentation for the field. So a lot of work still underway. And you want to, I think, position this in the context that we're transforming the company. And you look at our product set and we're evolving substantially from what was a delivery company and then a delivery and stadium web-firewall company, where most of our revenue has been and you look at the products that are really growing and driving us forward to the future. And you're looking at some intake are core segmentation and enterprise Zero Trust security, you're looking at API security, huge greenfield there for us. And best of all, you're looking at our cloud infrastructure services, which has just really taken off. It's remarkable. I think when you see what's happened. We bought Linode about three years ago, had about $127 million ARR, growing mid-teens at best. And today, more than double now growing at 35% last year, and we're forecasting 40% to 45% this year. And I think what's really exciting about that is the addressable market for us is literally over $100 billion. And that's probably just in our current customer base. So tremendous potential, and it's really taking off now. So that changes the company. And it changes what we need from the sales force, what they need to be doing. Obviously, we want to protect and grow the revenue in our existing base, but we want to be out there selling those new products, both in the existing base and to a lot of new customers. And so in response to that, we're in the process of transforming the sales force to get the capabilities that we need to continue the very strong growth we're seeing in these new areas.
Fatima Boolani: Thank you.
Operator: The next question comes from Frank Louthan with Raymond James. Please go ahead.
Frank Louthan: Great. Thank you. Can you give us -- let's say, can you give us an idea of what the -- of what logo growth was in the quarter? That would be great. And is there any particular group security, compute, et cetera, that saw a better or a worse growth from new logos? Thanks.
Ed McGowan: Hey, Frank, this is Ed. Actually, logo gross, obviously was probably most positively impacted from the Edgio contracts that we acquired. We added a few hundred logos there, over 100 of those were new to the company. So that was the biggest addition. As far as where the new logos are coming from, it's mostly in security in the two new areas that Tom talked about, Guardicore and API security, and also in the compute side as well. So I would say it's probably stronger than normal new acquisition quarter in Q4, just normal course and then obviously Edgio helped quite a bit as well.
Frank Louthan: And what's your outlook for being able to retain those Edgio contracts? Do you think some of those will churn off? Or what's the likelihood of those converting into more permanent customers?
Ed McGowan: Yes. So we've gone through the migration at this point. So we've moved everybody off. The Edgio network has closed so or shut down at this point. So we have a good idea of who's coming over at this point. We don't anticipate significant churn from what we have today. We are very selective on what we took. We didn't take all customers. There were certain things, certain small customers that didn't make sense for us to take. There's some acceptable use policy violations that we wouldn't take and there are some economics with certain customers that we didn't want. So factoring into our guidance is what we think we'll do with that customer base. I think there's probably some upside there with upsell generally speaking, you want to land the customer, make sure they're happy and then start developing a pipeline with them. I want to just attack them right away with the sales pitch. So pretty happy with what we were able to retain. It was pretty much right in line, maybe a little bit better than we expected.
Frank Louthan: Okay. Great. Thank you.
Operator: The next question comes from Rishi Jaluria with RBC. Please go ahead.
Rishi Jaluria: Wonderful. Thanks so much for taking my questions. Just two quick ones. First, going back to some of the changes in go-to-market and changes in sales, what can you do on your end to minimize the disruption from that. What are you assuming when you think about your 2025 guide. And I ask because in the history of software, we see sales regards changes to go-to-market and they always end up being a lot more disruptive than anticipated. So maybe if you could walk us through your assumptions and what you can do to minimize that disruption. That would be helpful. And I have a quick follow-up.
Tom Leighton: Well, the first key is to avoid an account breakage. And so we're not doing it all at once. As I mentioned, this is a two year journey. And of course, we're adding resources with specialization on the new products. And so those folks are helping do the cross-sell and have a chance to hunt for new customers. So the key really, I think is we will minimize the breakage of the rep associations with customers in the accounts. And Ed, is there anything you'd like to add to that?
Ed McGowan: Yes, I'd just say that as a mentioned, we're working with one of the large consulting firms and bringing some expertise in to help us think through that. But absolutely, we want to be very careful with how we think about the movement from hunting to farming and how we support customers going forward. The less breakage, the better.
Rishi Jaluria: Got it. No, that's helpful. And then just really quickly on Edgio. I appreciate the color and the detailed guide. As we think maybe a little bit more longer term, given Edgio's out of the fold now, and you have those contracts and assets, how should we be thinking about the pricing environment for the delivery? And can just having fewer players in the space help maybe lead to a less aggressive pricing environment? Thanks.
Ed McGowan: Yes. That really comes down to the different buckets of customers. I'd say with some of the larger high volume customers, we are seeing some rationalization to some extent, longer contract terms, which is helpful. Obviously, if you have less players, you do potentially have some better pricing, but we're already starting to see that in the market. So I'd say it's getting a little bit better, but it's always been a volume driven business. So to the extent that volumes continue to drive -- go higher, we'll still see the general trend in pricing to go down, but hopefully, we'll see it moderate a little bit more in the future.
Rishi Jaluria: Wonderful. Thank you.
Operator: The next question comes from John DiFucci with Guggenheim. Please go ahead.
John DiFucci: Thank you. So Tom and Ed, I think this applies both you. Business looks to be going as planned, and we appreciate the three to five year goals and actually all the information that you gave us, this is great. But the guidance for next year implies 3% growth. And I think there's a 1% of FX headwind, so that's about 4%. I get the large customer issues, but there's always issues, right? That aside for now, how do we get comfort that growth is going to accelerate to 10%. Is it just math, because I haven't gone through it at all yet to faster growing portions of the business will more than offset the delivery business. And are you -- and/or, I guess, are you expecting improved macro backdrop in the forecast? Or does it -- I guess, also related to this, does that 10% eventual 10% exclude any impacts from that large customer?
Ed McGowan: All right. So I'll take this one, Tom. So I'll start with the back part. The large cost, what we've done is we've modeled out what their minimum spend would be for that five year contract. So Think of that as being the bottom of the potential there for that customer. So there's more upside there potentially. But in terms of what we're seeing for growth, I think you have to kind of break the business down into the buckets and why we showed you all that data. We'll start with delivery first. So delivery, obviously, has been a pretty big drag. It's starting to improve. We expect it to improve this year, continue to improve. So you should start to see some stabilization in delivery over that period of time. So that you think of that as a big drag sort of moderating significantly, so you don't have as much of a drag. So then when you take the businesses that we have, we look at security, the bigger franchises are slowing a bit, but they're still growing. So we're still getting some growth out of that. And underneath that, say, for example, in our security products, we have new fraud products and be introducing new products. So that franchise will still grow, just won't be growing as fast as it was. But the -- between Guardicore and APIs, those are very large markets. We have market-leading products we think we'll be able to -- that included with the -- some of the changes we're making in go-to-market and the investments we're making in hunting, we'll get more productivity out of the sales force. And there's still a long way to go there. So we think that that growth as it gets bigger, you get 10% growth out of security, that we think is pretty durable given those factors. And then there's compute. So with compute, we're going through a little bit of a transformation that Tom talked about with the sort of [indiscernible], I don't want to say the legacy, but some of the other older products in the other applications bucket where we're partnering with some of the ISV partners, which has a little bit of a near-term flattening of revenue in that bucket, but it gives us a much bigger opportunity to grow the market by partnering with those folks getting some of their own business, but also getting a product that's being invested in, et cetera. So we have a much more robust offering. And then again, with the go-to-market investments we're making in compute, not only just with the hunters, but also with the overlay specialists. We think that will also help drive more productivity in the field. So hopefully, that answers your question.
John DiFucci: That was really good. That's really helpful. It makes you think we need to do a lot more work around, especially compute, but it's exciting to think about Guardicore and API. I guess just one thing, one last question on the compute business. And one of the things that I can help think about here is profitability. And it's always a question at anybody that's coming into this business. But you alluded to having some advantages entering this business given the delivery business. I guess, can you describe that in a little more detail? I mean, I kind of get the high level. Is it as simple as you're utilizing underutilized assets across your network? Or is there something more to it?
Tom Leighton: There are several reasons. First, we probably move around more data than pretty much anybody. And we've figured out how to do that very efficiently. And so for customers of our cloud infrastructure platform, when they compare our pricing to the hyperscalers, we're a lot less. At least for the applications where they're moving around data, they got a lot of hits. And that's a lot of the applications out there today. And so in head-to-head competition now with the hyperscalers, we can offer a much better price. Second is performance. And as we've talked about, we have the world's most distributed platform. We are in a position to get our customers' compute instances a lot closer to end users. And not only is that good for scalability, it's great for performance, because the business logic is running close to the users. And so when we do head-to-head trials now against the hyperscalers for a lot of the applications, we perform better. So we're able to offer better performance at a lower price point. And now with the managed container service, that's super exciting. We can actually support our customers' containers in hundreds of cities. Nobody is doing that today. And so again -- and those are the locations we've had already for the delivery business and the security business. So we're already there. So you get better performance and scalability at a lower price point. And then you combine that with the enormous market that we have a chance to tap into. And I think probably really important as you make the models to look at our cloud infrastructure services revenue and what's happening there. We only really started selling that to enterprises last year and went from very little revenue to $115 million ARR in the total for our cloud infrastructure services, $259 million. And we're projecting that total number to grow by 40%. At least 40% to 45% this year. So I would encourage you to keep a close eye on that because that drives a lot of growth and profitability for us going forward.
Ed McGowan: John, just to add on the profitability, there's four main synergies One is the backbone. So we obviously can leverage that. Obviously, we don't kind of track that we serve there. Number two is with operations. So a lot of the folks that build out the CDN, also build out the data centers for our compute business, so we didn't have to go hire a big team. Number three is engineering. We talked earlier in the year that we moved about 1,000 people out of the engineering organization in our delivery business into the compute business, both in operations and engineering. And then the fourth thing is on go-to-market. So we can leverage our existing customer relationships and our reps. We're augmenting that a bit with some of our specialists, but we don't have to go out and hire a whole new team. So there's an awful lot of operating expenses that we can take advantage of in terms of driving profitability.
John DiFucci: Thank you guys. This all makes sense. Now it's the easy part. You just have to execute. That was a joke. It's not easy.
Ed McGowan: Exactly.
John DiFucci: Thanks guys.
Operator: The next question comes from Patrick Colville with Scotiabank. Please go ahead.
Patrick Colville: Thanks for squeezing me in guys. So I guess this one is for probably Dr. Tom and Ed. I mean, in the prepared remarks, you touched on the reasons why compute slow. But I just -- I'm going to my model now and the year-on-year delta is pretty stark. And so I just want to make sure I've got them completely nailed down. So I guess just to start off, this year, 25% growth in compute next year guidance of 15%. Can you just double [indiscernible] what is driving that?
Ed McGowan: Yes, sure. So there's the two pieces. There's the caught infrastructure security, which will continue to grow and actually accelerate. So that piece, it's the smaller piece of the two businesses, but that's going to accelerate pretty significantly. When you look under the covers of the other, the application services, there's a number of things in there. For example, we have some of our legacy net storage business, which will be end of lifing that soon in the next year or two. And some customers will migrate to our cloud offering, some may decide to do something else, but that's going to be in a bit of a decline. And then we've got a lot of revenue that comes from some of these potential ISV partners. For example, we've got some of our transcoding. We announced something with a partner called Harmonic, we're partnering with them, and we're migrating some of that business over there. They're using us now for their compute. So that's going to be shifting over time. And there's probably four or five different buckets, whether it's image manager, video manager, our waiting room application or visitor prioritization. Those things were going to be moving towards ISV partners and focusing more of our efforts on the infrastructure services. So you're going to see flattening to maybe slightly down in that bucket, and you'll see most of the growth coming from cloud and infrastructure services.
Patrick Colville: Okay. Okay. Helpful. And then I guess as a quick one because I've been getting this a lot from investors. In terms of Akamai's exposure to the U.S. Fed. How should we think about that? And in 2024, is there any expectations for that business embedded into guidance for 2025?
Ed McGowan: So when you say the U.S. study, you talked about the Federal Reserve interest rate policy or you're talking about the federal government slightly?
Patrick Colville: The latter.
Ed McGowan: Okay. Yes. So we obviously do sell to the government. It's not a huge portion of our business. It's way too early to tell with what the cost-cutting efforts that are going on, how that would impact us. But it's not an overly material part of the business. I wouldn't expect anything material out of that. We haven't modeled anything material, just kind of regular way business for now. So I'm not anticipating anything.
Patrick Colville: Crystal clear. All right, thank you so much guys. I really appreciate it.
Operator: The next question comes from James Fish with Piper Sandler. Please go ahead.
James Fish: Hey guys. I appreciate all the details here, and increased disclosures, I think investors will as well. Maybe just following up on something you just said first, Ed. Can you just walk us through some of that transition impact on the compute side and which of the products you plan to sort of be transitioning off and how to think about the utilization of the compute network today that we need to invest this much after two years of investing as much behind the compute business?
Ed McGowan: Yes, I mean I gave you in terms of the investment percentage of revenue that we're spending for that. 1% of that of the six that we're using compute will be specifically for that big customer. And I've always talked about how from time-to-time, if we do get large customers, you do tend to sometimes get outsized demand in a particular geo. We added an awful lot of investment this year in terms of bulking up a number of locations, et cetera. We're going to continue to add to those. We're also seeing very strong demand. So we're continuing to invest with that. But also keep in mind we did migrate over $100 million worth of our own applications. It's running well over $0.5 billion of our revenue today, and that business continues to grow. So we're still having to provide some investment to support that, which is significantly less than what we would be paying if we were to continue to use third-party cloud providers. Now in terms of the two different components of revenue, I think I discussed the cloud infrastructure service. So I think you guys get that. That's the real fast-growing stuff. And inside that other bucket is where you'll see that flattening out to declining. And it's really just the items I mentioned. We've got video management, image management, visitor prioritization and some various workflow components like transcoding that we have built from time-to-time for customers. There's not a ton of demand for it. It's grown decently, but it's not a specialty of ours. So we want to make sure that we're investing in the right areas. So as we're migrating that to partners and we shift our investment into the faster-growing infrastructure cloud services, you'll see a bottoming out here this year and then the growth will reaccelerate to 20%, led by cloud infrastructure services. And also keep in mind, I've got about -- last time we broke it out, it was about $50 million of legacy storage. So think of that as like the media companies storing like a backup origin for their video files and music file and that sort of stuff, images, et cetera. That's -- that business will be winding down over the next year or so. So that's going to have a bit of a drag on revenue as well.
James Fish: Understood. And I think a lot of investors here you guys are sitting here on an earnings call, giving a three to five year framework. The last time we got this type of framework from you guys was many years ago. And I think in that framework, we had talked about a 20% constant currency security growth, for example, and we didn't hit that. So you're talking about a 10% CAGR that includes M&A from here within security. Just what's going to drive the reason that we actually achieve these results and that this is a reasonable expectation that, that actually might be conservative as opposed to hoping that we hit that number? Thanks guys.
Ed McGowan: Well, I mean, to be fair, there were several years during that period of time when we did grow 20%. We always said 20% would include acquisitions. So we did some acquisitions along the way. We've -- look we just did -- put up 16%. So that business has been very healthy. We've been adding a couple of hundred million of high-margin security revenue for years now. And if you do the math, we'll continue to do that. In terms of the impact of acquisitions going forward, we're not anticipating doing significantly large acquisitions, more of what we've done in the past, whether it's tuck-ins or smaller companies that are -- got a product that's in market that's about to scale like API security, where the company is looking at making a big investment in go-to-market or raising a route or looking to exit buy something like that or like Guardicore and we scale that up, and we've shown that we've got success there. So I think we've got confidence in our M&A strategy. It's not going to be a significant portion, but maybe over time, it might be one of the faster-growing products as we exit the decade. And what we've been -- why we broke these businesses out for, you can see how well we're scaling a business now that's a couple of hundred million growing extremely fast. So I think we have pretty good confidence. And again, yes, you can -- we can quibble over the 20% and maybe a couple of years, we're in high teens. But as we said, that would have included acquisitions we've been always doing. But I thought we did pretty well over that period of time. And we just thought now that we're getting to a scale of a couple of billion it made sense to update expectations as we see some of our products that we've been in the market for over a decade, slowing down.
Operator: The next question comes from Will Power with Baird. Please go ahead.
William Power: Okay, great. Tom, you provided some good examples in the prepared remarks, I think of some of the applications that are being used in your network. I mean it seemed for some time that you should be well positioned for inference at the edge. And I just I wonder if you maybe update on this, just as along the lines of the tone of conversations you're having, what kind of the pipeline looks like, just kind of the activity level you're seeing in terms of taking advantage of particularly some of these generative AI applications and inference that maybe is starting to develop or you just think it's going to start to develop?
Tom Leighton: Yes, I think there's a lot AI-powered at image normalization so that the various images have the same consistent size, quality image classification even for things like detecting disease in crops. AI-powered speech recognition in cars, AI-powered chatbots, sentiment analysis, tactic image inferencing for a variety of applications. All sorts of applications already using Gen AI on the platform. And we have partners, our ISV partners. Some of them doing AI on the platform, web assembly, AI inferencing. So I would say it's early days, but all sorts of things being done on our cloud infrastructure services today.
William Power: Okay. And then I mean as we look at the cloud infrastructure assumed acceleration, I think you're looking for 40% to 45% ARR growth, any further breakdown, how much is inferencing influencing that? Or is that still early? And if not, what are kind of the key drivers of the acceleration there including impact of the $100 million deal, how does that factor in?
Tom Leighton: Yes, the $100 million deal doesn't do a lot this year. That doesn't really ramp up until the end of the year. So I don't think that's a material impact on our 40% to 45% projection. That will certainly help us in '26 and beyond. And I don't think AI inferencing is a big part of the growth this year either. There could be some, but I think that will fall more into the upside category. I think it's just more of the traditional uses of compute on the platform. And keep in mind, that's a $100 billion market today, plus without getting into AI or the new large deal that we've done. And just as examples, with our ISV partners, database at the edge, observability for all sorts of applications, media workflow, things like file transcoding and live encoding, video packaging, interactive WebRTC. These are what our ISV partners have their applications doing on our cloud infrastructure platform, digital asset management, video optimization, game orchestration, fleet management, DRM, Kubernetes activity and auto scaling ad insertion, service side ad insertion. So there's just a bunch of stuff that is just good old regular compute that's running on the platform. I would say we're -- as you can see from the examples we've given, we're selling it into pretty much all the verticals. A lot of financial companies are starting to use it now. Media broadly construed is still, I think, the sweet spot and partly that's by design because those customers need to get great performance. They need to cut cost. They don't like writing a huge check to their biggest competitor. And they're big Akamai customers, and they like Akamai a lot. So that's sort of the center of mass, but it goes across verticals and across a lot of use cases. And I'd say we're excited about AI. That's upside and probably comes down the road.
William Power: That's helpful. Thank you.
Operator: The next question comes from Mark Murphy with JPMorgan. Please go ahead.
Mark Murphy: Thank you very much. Tom, interested to get your view of the ramifications for Akamai of all of the technological advancements and efficiencies that we've seen with the Deep Seek model? And whether you see any signs of that opening up kind of a broader wave of experimentation for doing edge inferencing on Akamai compute. Maybe some of these AI applications are going to become more economically viable. And then I had a quick follow-up for Ed.
Tom Leighton: Yes. I think the Deep Seek phenomenon or announcement or whatever you want to call it, is very consistent with what we've been saying is going to happen. I think you'll see further improvements. It's great for us because it validates what we've been saying and how we've designed our cloud infrastructure platform. In fact, there's already entities running Deep Seek on our cloud infrastructure platform along with other models. And it does mean that it is a lot less expensive. It doesn't need the giant core GPUs. It can be run on lighter weight GPUs. There'll be a lot of use cases where you want that on the edge. And I think it's great and very much what we expected to happen. And I think you'll see more developments along those lines.
Mark Murphy: Okay. That's great to hear. And Ed, as a follow-up on the security CAGR where you're expecting about 10% in the next three to five years, that's fairly close, I believe to the overall market growing something like 12% to 14%. And you said that it includes a typical level of M&A. If we think about it organically, should we pencil out something like maybe mid- to high-single-digits organically? And then if you're able to find some of these tuck-ins, you've done an incredible job picking those out and executing on those recently and they're growing like a weed. And then maybe the inorganic piece gives you a couple of few points there over the next three to five years. Is that a decent framework?
Ed McGowan: Yes, I think that's a good way to think about it, Mark. I mean obviously, at the scale we're at now over $2 billion, and we talk about even the bigger revenue companies we've acquired have been $20 million to $30 million. That's insignificance about a point in total from inorganic. In terms of the near term, there's going to be mostly from organic. But yes, probably maybe one point, something like that as you get out a couple of years. And then obviously, if we picked a good company like we did with Noname or we did with Guardicore, as you get out further, we consider that organic growth at that point that might be contributing because it's a faster-growing area if we get into a hot space that's growing quickly. But in terms of like the -- to make a number in any given year, we don't anticipate getting much more than maybe 1% from an acquisition inorganically.
Mark Murphy: Okay, understood. Thank you so much.
Operator: I understand that we have time for one last questioner and that will come from Jonathan Ho with William Blair & Company. Please go ahead.
Jonathan Ho: Excellent. And let me echo the thank you for the additional disclosure. Just one question from me. How concerned should we be with potential tariff impacts. And can you maybe pass through higher costs that are associated with that? I know you're trying to maybe accelerate some investment ahead of time particularly given your need to invest on the compute side over the long run, it does seem like there's may be some exposure here. So I just wanted to understand the implications there. Thank you.
Ed McGowan: Yes. I mean it's obviously tough to call, just given we don't know what the ultimate end game is here in terms of towers. But to the extent we do have the ability to move supply chains around. And we're looking at obviously doing that. There was some talk about Canada and Mexico. We do get some server builds out of the there. But -- so we fast forward it so. I gave you the number, $10 million to $15 million. So it's not significant. In terms of can we pass some of these pricing costs along, we're certainly exploring that as part of the work we're doing with the consulting firm we hired overall pricing strategy is part of it. And to the extent that it becomes somewhat immaterial in any way, we certainly would have to bake that into our pricing. But it's tough to say at this point because we just don't know what the final end state is.
Jonathan Ho: Thank you.
Operator: This concludes our question-and-answer session. I would like to turn the conference back over to Mark Stoutenberg for any closing remarks.
Mark Stoutenberg: Thank you, everyone. As usual, we will be attending investor conferences throughout the rest of the quarter. We look forward to seeing you there and discussing everything that we talked about today. So thanks again for joining us tonight. I know it's a long call. We hope that you have a rest nice evening. Operator, you can end the call now.
Operator: The conference has now concluded. Thank you for attending today's presentation. You may now disconnect. | [
{
"speaker": "Operator",
"text": "Good day, and welcome to the Fourth Quarter 2024 Akamai Technologies, Inc. Earnings Conference Call. All participants will be in listen-only mode. [Operator Instructions]. Please note this event is being recorded. I would now like to turn the conference over to Mark Stoutenberg, Head of Investor Relations. Please go ahead."
},
{
"speaker": "Mark Stoutenberg",
"text": "Good afternoon, everyone, and thank you for joining Akamai's fourth quarter 2024 earnings call. Speaking today will be Tom Leighton, Akamai's Chief Executive Officer; and Ed McGowan, Akamai's Chief Financial Officer. Please note that today's comments include forward-looking statements, including those regarding revenue and earnings guidance, along with our business outlook, three to five year goals and longer-term targets. These forward-looking statements are based on current expectations and assumptions that are subject to certain risks and uncertainties and involve a number of factors that could cause actual results to differ materially from those expressed or implied by such statements. The factors include but are not limited to any impact from macroeconomic trends, the integration of any acquisition, geopolitical developments, and any other risk factors identified in our filings with the SEC. The forward-looking statements included in this call represent the company's views on February 20, 2025. Akamai undertakes no obligation to update any forward-looking statements, which speak only as of the date they are made. As a reminder, we will be referring to certain non-GAAP financial metrics during today's call. A detailed reconciliation of GAAP to non-GAAP metrics can be found under the financial portion of the Investor Relations section of akamai.com. Also, as part of our ongoing commitment to transparency, we've enhanced our disclosures to provide investors with a more comprehensive understanding of our business. This quarter, we've created a new presentation available in the Investor Relations section of our website, offering a bit more information on our product portfolios, financials, and performance goals. This presentation supplements the information in our earnings release and annual filings, and we encourage you to review it. Within the presentation, you'll find an overview of select revenue and year-over-year revenue growth rates. Please note, all growth rate percentages are reported on a constant currency basis. With that, I'll now hand the call off to our CEO, Dr. Tom Leighton."
},
{
"speaker": "Tom Leighton",
"text": "Thanks, Mark. As you can see in today's press release, Akamai delivered solid performance in the fourth quarter with revenue coming in at $1.02 billion and non-GAAP earnings per share coming in well above our guidance range at $1.66. I'm also pleased to report that we made excellent progress on our multi-year journey to transform Akamai from a CDN pioneer into the cybersecurity and cloud computing company that powers and protects business online. For the first time in Akamai's history, Security delivered the majority of our annual revenue in 2024, surpassing the $2 billion threshold and growing at 16% year-over-year. Our cloud computing portfolio recorded $630 million in revenue last year, growing 25% over 2023. The portion of this revenue derived from our cloud infrastructure services was $230 million, up 32% over 2023. Our cloud infrastructure services primarily consists of the compute and storage solutions that we've developed based on Linode. They also include our edge workers product and ISV solutions running on our cloud platform. Combined, security and compute accounted for two-thirds of Akamai revenue in 2024, growing 18% year-over-year. And we exceeded all our year-end annualized revenue run rate or ARR goals for the fastest-growing areas of the business, namely for our Guardicore platform, our API security solution, and enterprise revenue for our cloud infrastructure services. These are three of the key areas that we anticipate will drive revenue acceleration for our overall business in 2026 and beyond. In the area of security, Akamai has expanded into new adjacent markets, growing beyond point solutions to provide a more holistic and comprehensive security offering. This has enabled us to expand our customer base and to better serve enterprises with a broader portfolio for protecting infrastructure, applications, APIs and user interactions in both cloud and on-prem environments. Security growth in Q4 was driven by continued strong demand for our market-leading Guardicore segmentation solution as more enterprises relied on Akamai to defend against malware and ransomware. The Guardicore platform ended the year with an ARR of $190 million up 31% year-over-year and surpassing our goal of $180 million. In Q4, we signed our largest deployment to date for Guardicore with a leading IT services company in India. The solution covers 30,000 servers and nearly 300,000 endpoints. We also displaced a competitor segmentation offering that was falling short at major banks, both Hong Kong and in the U.S. More than 80% of our segmentation revenue in 2024 came through channel partners, including one of the world's leading SIs, Deloitte, which wraps its services and implementation expertise around our segmentation and API security products to create value for customers that Deloitte knows well. Together, in Q4, we won a $5.8 million contract with Petrobras in Brazil to reduce the risk of a breach and ransomware attacks. We also partnered with Deloitte to help defend two large European banks from API risks. In Q4, Akamai also signed a large contract for API security with one of the biggest asset managers and brokerage firms in the U.S. Our API security solution ended 2024 with an ARR of $57 million, up from just $1 million at the end of 2023 and exceeding our goal of $50 million. Taken together, our API security solution and Guardicore platform ended 2024 with $247 million of ARR. As we look ahead, we expect to generate continued strong growth for these products with a goal of increasing their combined ARR by 30% to 35% during the year. We also anticipate that over the next several years, the rapid growth and more meaningful amount of revenue from these new products will help offset the slower growth of our more widely adopted and market-leading web app firewall and DDoS mitigation products. As a result and as noted in our supplemental disclosure that Mark mentioned a few minutes ago, we believe that we can maintain a CAGR of about 10% in constant currency for our security products over the next three to five years with typical M&A. This would bring us to more than $3 billion in security revenue by the end of the decade. While our security product line is performing very well, our compute product line is growing even faster and has a much larger addressable market. We've come a long way since we expanded into the cloud computing market in 2022 with the acquisition of Linode. And we made a lot of progress last year, achieving what we set out to do in revenue growth, signing new enterprise customers, infrastructure deployment, product development, partner ecosystem expansion and migrating our own applications from hyperscalers to the Akamai cloud. We continue to sign compute customers at a rapid pace in Q4 and including two financial software companies in the U.S., two of the largest retailers in the U.S., a cybersecurity provider in Europe, an enterprise software company in Asia, one of the largest banks in Southeast Asia and an intelligent transportation system provider in Latin America. When we measure the progress of our cloud infrastructure services, we've been looking at the results through two lenses. Our primary lens is the uptake of these solutions by larger enterprise customers, such as those doing over $100,000 in ARR. The second lens is looking at the performance of these products across customers of all sizes. At year-end, approximately 300 enterprises were spending at least $100,000 in ARR for our cloud infrastructure services, up significantly from the year before. Collectively, these customers finished the year with an ARR of $115 million for our cloud infrastructure services, far exceeding our goal of $100 million. When you include all customers, the ARR for our cloud infrastructure services finished 2024 at $259 million, up 35% year-over-year. This is a substantial improvement from when we acquired Linode in 2022 when the ARR from these services was approximately $127 million and was growing in the mid-teens. In addition to enabling customer growth, our work to make Linode be enterprise grade has allowed us to move some of our most important products from hyperscalers to Akamai's Cloud. This has resulted in improved performance and savings of well over $100 million per year. Many of our customers have also significantly expanded their use of our cloud infrastructure services over the last year, some by a factor of 4x or more. By year-end, 15 customers were spending over $1 million in ARR for our cloud infrastructure services, more than triple the number from 2023. And today, we announced our first customer to sign a contract committing to spend more than $100 million for our cloud infrastructure services over the next several years. We believe this is a remarkable validation of our new cloud capabilities, signaling that an extremely sophisticated buyer of cloud services is confident in our ability to execute and provide a level of service and performance comparable to or better than the hyperscalers. The recent improvements that we've made to our cloud platform will enable us to do even more for enterprise customers in 2025. For example, in the last year, we expanded Akamai's core data center footprint to 41 locations in 36 cities around the world. Next week, we plan to announce that we've enabled our new managed container service in our 4,300-plus points of presence in more than 700 cities around the world. We're currently testing this service with customer workloads in over 100 cities. We've significantly upgraded our object storage solution with a 5x increase in scalability and a 10x increase in performance, making it comparable to the hyperscalers but with much lower egress fees due to the efficiencies of our unique edge platform. We added GPUs for a variety of AI and media use cases. One customer ran a proof of concept between Akamai and a hyperscaler and then chose Akamai for text to image AI inferencing workloads. Another customer uses our cloud for AI-powered speech recognition for its in-vehicle voice assistant. And an OTT provider switched from a hyperscaler to Akamai to provide a more cost-effective platform for its ad-supported streaming TV service. We enhanced the scale and security of our Linode Kubernetes engine product. Traditional cloud providers run Kubernetes platforms from a relatively small number of core data centers. Akamai's differentiated approach will combine the computing power of our cloud platform with the proximity and efficiency of our edge to put workloads closer to users than any other cloud provider. Building on technology that we acquired from Red Kubes last year, we released the Akamai app platform to enable developers to build and deploy highly distributed applications in just a few clicks. And we added nine compute ISV partners last year, bringing our total to 23. Our ISV partners accounted for $36 million of cloud infrastructure services ARR at year-end. We're very excited about our opportunity for continued strong growth as we bring the power of compute to the edge with our broadly deployed network getting compute instances closer to end users with an open platform that ensures flexibility and portability, orchestrated resource deployment to ensure efficient scaling and operations and predictable pricing with an unmatched ability to minimize egress costs. I think our rapid progress in cloud computing has summed up well in an evaluation of public cloud platforms released last month by IDC. Their worldwide public cloud marketscape for IaaS identified Akamai as a major player relative to industry peers, saying \"Akamai has accelerated its journey into the public cloud IaaS space, transforming from a pure-play CDN provider into a formidable public cloud competitor.\" In addition, Gartner positioned Akamai as an emerging leader for Gen AI specialized infrastructure in their recent innovation guide for generative AI technologies. As we noted in the supplemental materials Mark mentioned, we're supporting a growing number of AI use cases with a special focus on inferencing. While it's still early days, we're excited about the long-term revenue opportunity, and we believe that the unique properties of Akamai's Cloud position us to be a major player in AI inferencing in the years to come. As we look forward to the rest of 2025, our goal is to grow our total cloud infrastructure services ARR by 40% to 45% in constant currency. We believe that the accelerating growth of our cloud infrastructure services revenue will be driven primarily by enterprise customers. Given the great success that we're having with our cloud infrastructure services, we plan to focus more of our compute investments in this area. In particular, we're in the process of migrating some of our older cloud applications for tasks such as visitor prioritization, image and video management, and live streaming workflow to ISV partners who specialize in these areas, and we plan to move some or all of their workloads to Akamai's cloud. In addition to converting former competitors into important ISV partners for our cloud, we believe this transition will enable us to focus more of our internal resources on further development and expansion of our cloud infrastructure services. The transition also means that we expect that the revenue from some of our cloud applications will decline in 2025. And as Ed will discuss shortly that we're projecting about 15% growth for our cloud computing solutions as a whole in 2025. As our cloud infrastructure services revenue continues to rapidly increase, we believe that we can reaccelerate the overall cloud computing revenue growth rate to achieve a CAGR of at least 20% on over the next three to five years in constant currency. This would make cloud computing our third $1 billion product line by 2027. I'll next talk about content delivery, which continues to be an important generator of profit that we use to develop new products to fuel our future growth. Our unique edge platform with over 4,300 points of presence in over 700 cities continues to be a major differentiator in terms of lowering our costs, enabling massive scale and providing superior performance. And this is true not only for delivery, but also for security and compute. In security, we use the platform to provide a massive shield against all sorts of attacks without impacting performance or raising costs. And in compute, we use the platform to provide function as a service with our edge workers product. And as we'll announce next week, we'll also use the same platform to run our new managed container service in thousands of pops across hundreds of cities. This capability is unique in the market, and it will enable our customers to get their compute workloads much closer to users. Akamai achieved substantial cost synergies by using the same physical server to support our delivery, security and now compute services in over 4,300 POPs in 700 cities. It's a unique capability and a key reason why Akamai has been so profitable, while many of our competitors have struggled. Our installed base of delivery customers also continues to be a key contributor to our growth in security and cloud computing. As we harvest the competitive and performance advantages of offering delivery, security, and compute as a bundle on the same platform. That synergy works especially well for our security and compute customers that want delivery as a feature and see it as critical to their relationship with us over other vendors. In Q4, we signed many deals that included security and compute solutions alongside our best-in-class delivery. And we won back delivery business for competitors at one of the leading tech players in AI and as a leading player in streaming media. And in December, we acquired select customer contracts from Edgio to offer their customers our market-leading delivery services and the opportunity to take advantage of Akamai's full range of security and cloud solutions. I'm pleased to report that we're beginning to see signs of improvement in the delivery marketplace with more customers willing to sign multi-year contracts with predictable pricing, a more stable pricing environment generally and early signs of stabilizing traffic growth. As a result, and as Ed will discuss in a few minutes, we now expect to see the year-over-year decline in delivery revenue shrink to about 10% this year. If the favorable trends hold, we should see the decline in delivery revenue continued to lessen in 2026 and beyond. As we noted in our call last May, our largest customer is navigating political challenges and is pursuing a DIY strategy. As a result, we expect that the revenue from this customer will produce a headwind of about 1% to 2% per year on our overall revenue growth rate for the next couple of years before stabilizing at a level similar to some of our hyperscaler customers, which would be about 2% to 3% of our total revenue. That said, I'm pleased to report that we entered into a five-year committed relationship with this customer in Q4, that includes a substantial minimum annual spend, which provides greater predictability and which reduces our exposure to their political situation in the U.S. While we're pleased with the progress that we made last year on our multiyear transformation journey, we still have work to do to reach more new customers and to cross-sell our new capabilities in security and cloud computing to our installed base. To drive greater top line growth over the next three to five years, we're transforming our go-to-market strategy to align more resources with the higher growth segments of our business and to accelerate the pace at which we add new customers. In particular, we've already begun to raise the ratio of hunters to farmers and sales and to increase the number of specialized sellers and presales resources that support sales of our Guardicore platform, API security and cloud infrastructure services. We're also investing more in partner enablement as the channel has become a major source of revenue growth for us. Based on advice from one of the world's top consulting firms, we're also embarking on a major project to optimize our sales operating model, account coverage framework, compensation structure, pricing strategy and the way that we leverage our channel partner ecosystem. As we disclosed in the supplemental forecast posted on Akamai's Investor Relations website, we believe that the combination of double-digit security growth, very fast growth in cloud computing, a stabilizing delivery business and a constantly improving product mix should enable us to accelerate revenue growth in the years ahead and to achieve double-digit revenue growth by the end of the decade, if not sooner. In fact, if you remove the impact of foreign exchange headwinds in the large customer I mentioned earlier, you can see that the acceleration is already underway. Excluding these two factors, revenue growth accelerated in 2024 over 2023. And as Ed will describe shortly, we anticipate further acceleration in 2025. We believe that improving our top line growth and product mix, combined with our continued efforts to improve efficiency, will help to improve operating margins so that we can meet and then exceed our goal of 30% over the next several years. We also believe that we can resume growing our non-GAAP EPS in 2026. While we still have much to do, we're very optimistic about the future. Our cloud computing strategy is taking hold as we envisioned. Our expanded security portfolio is enabling us to deepen and expand our relationships with customers and partners. And we continue to invest in Akamai's future growth while also maintaining strong profitability. Now I'll turn the call over to Ed for more on our results and our outlook. Ed?"
},
{
"speaker": "Ed McGowan",
"text": "Thank you, Tom. Before I begin, I want to reiterate what Mark mentioned at the start of the call, and highlight some of the new disclosures we issued earlier today. The materials we posted to the IR section of our website include a bit more detail than what we will cover in today's prepared remarks. Our aim is to provide deeper insights into our business and present our updated long-term goals. While we do not intend to provide this level of disclosure every quarter, we will occasionally offer additional context if we believe it will be helpful. Today, I plan to cover our Q4 results, provide some color on 2025, including a few new disclosures and then cover our Q1 and full-year 2025 guidance and I will close with our long-term thoughts on revenue and profitability goals. Now let's cover our Q4 results, starting with revenue. Total revenue was $1.020 billion, up 3% year-over-year as reported and in constant currency. We continue to see solid growth in our compute and security portfolios during the fourth quarter. Edgio contributed approximately $9 million of revenue in the quarter, which was in line with our expectations. Compute revenue grew to $167 million, a 24% year-over-year increase as reported and 25% in constant currency. In the fourth quarter, Compute revenue was comprised of $65 million from our cloud infrastructure services and $102 million from our other cloud applications. As Tom pointed out, one of our largest customers has committed to spending at least $100 million on our cloud infrastructure services over the next few years. We expect that their workloads will begin ramping up by the end of 2025. Moving to security revenue. Security revenue was $535 million, growing 14% year-over-year as reported and in constant currency. During Q4, we had approximately $12 million of onetime license revenue compared to $5 million in Q4 of last year. As noted in our added disclosure, our security revenue was comprised of $205 million from Zero Trust Enterprise plus API security, which grew 51% in constant currency year-over-year and $1.84 billion from all other security products, which grew 14% in constant currency year-over-year. Combined, compute and security revenue grew 16% year-over-year as reported and 17% in constant currency in Q4 and now represents 69% of total revenue. Our delivery revenue was $318 million, slightly ahead of our expectations and down 18% year-over-year as reported and in constant currency. We anticipate an improvement in delivery revenue in 2025 driven by a more positive outlook on delivery, as Tom discussed earlier. International revenue was $490 million, up 2% year-over-year or 4% in constant currency, representing 48% of total revenue in Q4. Finally, foreign exchange fluctuations had a negative impact on revenue of $8 million on a sequential basis and a negative $6 million impact on a year-over-year basis. Moving to profitability. In Q4, we generated non-GAAP net income of $254 million or $1.66 of earnings per diluted share, down 2% year-over-year, flat in constant currency and well above the high end of our guidance range. These EPS results exceeded our guidance driven primarily by slightly higher-than-expected revenue, lower-than-expected transition services or TSA costs related to the Edgio transaction, greater savings from the head count actions we announced in Q3 and lower payroll costs due to some hiring pushing from Q4 into Q1. Finally, our Q4 CapEx was $193 million or 19% of revenue. Moving to our capital allocation strategy. During the fourth quarter, we spent approximately $138 million to buy back approximately 1.4 million shares. For the full-year, we spent $557 million to buy back approximately 5.6 million shares. We ended 2024 with approximately $2 billion remaining on our current repurchase authorization. It's worth noting that over the past decade, we have not only met our objective of buying back shares to offset dilution from our employee equity programs, but we have also decreased our shares outstanding by approximately 16% over that time frame. Going forward, our capital allocation strategy remains the same: to continue buying back shares over time, to offset dilution from employee equity programs and to be opportunistic in both M&A and share repurchases. Before I move to guidance, there are several items that I want to highlight to help with your 2025 models. The first relates to revenue from the Edgio transaction. we now expect approximately $85 million to $105 million in Edgio revenue for 2025. In addition, we expect to have approximately $6 million of TSA costs in Q1 related to Edgio. Approximately $4 million of those costs will be included in cost of goods sold and the remainder in operating expense. We do not anticipate any TSA costs beyond Q1. Second, we expect our CapEx to be approximately 2 percentage points higher than last year for the following reasons. First, we plan to increase spend by about 1% of revenue to accommodate the increased traffic resulting from the Edgio transaction. Second, we anticipate approximately another 1% of revenue will be used for a geo-specific infrastructure builds to support the recently signed $100 million cloud infrastructure services contract we announced earlier today. Additionally, we expect our CapEx spend will be heavily front-end loaded with the first quarter seeing significantly higher expenditures compared to the rest of the year. This is due in part to the items I mentioned above in our plans to pull forward approximately $10 million to $15 million of CapEx into the first quarter to help mitigate the risk of potential tariffs that may be announced later this year. Third, we expect interest income to decline in 2025 due to lower cash balances resulting from recent acquisitions and our plan to retire our $1.15 billion convertible debt instrument that matures on May 1, 2025 along with expected lower investment yields as interest rates come down throughout the year. Fourth, for 2025 we anticipate continued heightened volatility in foreign currency markets driven by unpredictable timing and magnitude of Federal Reserve policy changes and their impact on interest rates. As an example of how impactful FX can be to our results. Since our last earnings call in early November, the strength of the U.S. dollar has negatively impacted our 2025 expectations by approximately $18 million in revenue on an annual basis and negatively impacted our non-GAAP operating margin by approximately 30 basis points and negatively impacted our non-GAAP EPS expectations by approximately $0.09 per share. As a reminder, related to currency, we have approximately $1.2 billion of annual revenue that is generated from foreign currency with the euro, yen and great British pound being the largest non-U.S. dollar sources of revenue. In addition, our costs in non-U.S. dollars tend to be significantly lower than revenue and are primarily in Indian rupee, Israeli Shekel and Polish Zloty. Fifth and finally, as Tom mentioned and illustrated in our supplemental disclosure, the traction that we are seeing in our business is being obscured by the challenges facing our largest customer and the significant FX fluctuations. If we exclude the effect of this customer in FX, our revenue growth rate would have accelerated year-over-year in 2024 compared to 2023. Now moving to guidance. For the first quarter of 2025, we are projecting revenue in the range of $1 billion to $1.02 billion, up 1% to 3% as reported or up 3% to 5% in constant currency over Q1 2024. We anticipate that Q1 revenue levels will be slightly lower than Q4 due to the following: lower revenue from our largest customer, as we discussed earlier, the negative impact of foreign exchange, reduced onetime license revenue in Q1 from Q4 levels. Two, fewer calendar days in Q1 compared to Q4, that's two less days of usage revenue. And finally, a significant number of delivery customers have calendar year-end dates on their contracts. Therefore, the aggregate impact of all those renewals tends to have a negative impact on Q1 revenue compared to Q4 levels. Note that we expect these items will be partially offset by a full quarter's benefit from Edgio. At current spot rates, foreign exchange fluctuations are expected to have a negative $7 million impact on Q1 compared to Q4 levels and a negative $15 million impact year-over-year. At these revenue levels, we expect cash gross margin of approximately 72%. Q1 non-GAAP operating expenses are projected to be $310 million to $316 million. We anticipate Q1 EBITDA margin of approximately 41%. We expect non-GAAP depreciation expense of $132 million to $134 million. We expect non-GAAP operating margin of approximately 28%. And with this overall revenue and spend configuration I just outlined, we expect Q1 non-GAAP EPS in the range of $1.54 to $1.59, we are down 6% to 3% as reported and down 2% to up 1% in constant currency. This EPS guidance assumes taxes of $57 million to $59 million based on an estimated quarterly non-GAAP tax rate of approximately 19.5%. It also reflects a fully diluted share count of approximately 152 million shares. Moving on to CapEx. We expect to spend approximately $237 million to $245 million, excluding equity compensation and capitalized interest in the first quarter. This represents approximately 24% of total revenue. As noted earlier, we anticipate that our CapEx spending will be heavily front-end loaded with the first quarter seeing significantly high expenditures compared to the rest of the year. Looking ahead to the full-year. We expect revenue of $4 billion to $4.2 billion, which is flat to up 5% as reported and up 1% to 6% in constant currency. We are providing a wider range than past practice due to the larger scale of our business, the uncertainty around our largest customer and continuing macroeconomic and geopolitical factors. We would expect to come in at the higher end of that range if we see significant weakening of the U.S. dollar, traffic growth materially exceeds our current levels and there is no ban in the U.S. for our largest customer. We would expect to come in at the lower end of this range if we see significant strengthening of the U.S. dollar. Traffic materially slows from current levels, and our largest customer is banned in the U.S. Moving on to security. We expect security revenue growth of approximately 10% in constant currency in 2025. In Q4 included in security of the combined ARR for our Zero Trust Enterprise and API security solutions was approximately $247 million. We expect the combined ARR of these two products to increase by 30% to 35% year-over-year in constant currency for 2025. For compute, we expect revenue growth to be approximately 15% in constant currency. Included in compute, our cloud infrastructure services delivered $259 million in ARR exiting 2024. We expect Cloud Infrastructure Services ARR year-over-year growth in the range of 40% to 45% in constant currency for 2025. At current spot rates, our guidance assumed foreign exchange will have a negative $38 million impact to revenue in 2025 on a year-over-year basis. Moving to operating margins. For 2025, we're estimating a non-GAAP operating margin of approximately 28% as measured in today's FX rates. Decline in operating margin for the full-year '25 is due mainly to depreciation expense being approximately 90 basis points higher than last year and the negative impact of foreign exchange year-over-year. We anticipate that our full-year capital expenditures will be approximately 19% of total revenue, up approximately 2 points from 2024 due to the items that I listed earlier. As a percentage of total revenue, our 2025 CapEx is expected to be roughly broken down as follows: approximately 4% for delivery and security, approximately 6% for compute, approximately 8% for capitalized software and the remainder is for IT and facilities related spending. Moving to EPS. For the full-year 2025, we expect non-GAAP earnings per diluted share in the range of $6 to $6.40. This non-GAAP earnings guidance is based on a non-GAAP effective tax rate of approximately 19.5% and a fully diluted share count of approximately 152 million shares. Before closing, I want to comment on our revenue and profitability goals for the next three to five years. Cloud Infrastructure Services is experiencing significant growth, which we believe will be the main driver of our total compute revenue in the near to medium term. Our goal is to grow total compute revenue at a compounded annual growth rate of approximately 20% over the next three to five years. Moving to security. Given the size and scale in our security business, it is natural that we will see some products reach maturity and experience slowing growth rates, while other products in emerging areas will see more rapid growth. As a result, we expect security growth over the next three to five years to be led mainly by our newer Guardicore platform and API security products. However, some of our largest security products like Web Application Firewall or WAF and Prolexic, are examples of some of our more mature products. We've been offering these products for over a decade and have reached a very high penetration rate within our customer base. As a result, we expect the growth rate for these products to begin slowing in 2025 and continue to moderate throughout the remainder of the decade. Given these dynamics in our security portfolio, our goal is to grow total security revenue at an overall compounded annual growth rate of about 10% over the next three to five years, including our typical level of M&A. We anticipate delivery revenue declines will moderate in 2025 with increasing stabilization expected over the next few years. In summary, we anticipate that the combination of double-digit growth of our security products, the rapid expansion in our compute services, a stabilizing delivery business and a continuously improving product mix away from delivery will allow us to achieve double-digit top line revenue growth by the end of the decade, if not sooner. As for profitability, we expect operating margins to reach 30% plus by the end of the decade. And with accelerating top line and expanding operating margins, our goal would be to deliver strong growth in non-GAAP EPS over the next few years. Finally, while we're not providing specific guidance for 2026, we do anticipate revenue acceleration and margin expansion compared to 2025 levels. With that, I'll wrap things up, and Tom and I are happy to take your questions. Operator?"
},
{
"speaker": "Operator",
"text": "We will now begin the question-and-answer session. [Operator Instructions]. The first question comes from Roger Boyd with UBS. Please go ahead."
},
{
"speaker": "Roger Boyd",
"text": "Great, thank you for taking my question. And congrats on the quarter. And congrats on the large cloud deal. Tom, I love if you could maybe expand a little bit on that, provide any more details on the nature of workloads as customers bringing over, and it sounds like it's probably coming off a hyperscaler, but any additional info you can provide on the competitive environment there as it relates to pricing performance edge presence. I think Ed noted there's some geo-specific conditions the customer is looking for. I know that's a lot, but thanks."
},
{
"speaker": "Tom Leighton",
"text": "Yes. They already have been using substantial cloud infrastructure services at Akamai for a variety of media applications. And we'll increase that usage. In addition, they have some special needs in Scandinavia and we are building out a data center there for them to handle substantial applications for them throughout Europe. So they're using the services in a normal way, plus we have a special situation that we're doing a build-out for them and development for them. But ultimately, we think many of our customers will use."
},
{
"speaker": "Roger Boyd",
"text": "Super helpful. Appreciate the color."
},
{
"speaker": "Operator",
"text": "The next question comes from Madeline Brooks with Bank of America. Please go ahead."
},
{
"speaker": "Madeline Brooks",
"text": "Hi, team. Thanks so much for taking my question. First is for housekeeping. I just want to clarify that the $100 million compute deal is not the same as the five year deal that you signed with your largest delivery customer? And then I have a quick follow-up to that."
},
{
"speaker": "Tom Leighton",
"text": "They are the same customer."
},
{
"speaker": "Madeline Brooks",
"text": "Got it. Okay. Thank you. And then the other one would be, can you just give us more details outside of just the geo location and why they chose Akamai. Is it -- does it have anything to do with maybe newer products that you have work on AI or intelligence, things of that nature would be helpful. Thank you."
},
{
"speaker": "Tom Leighton",
"text": "Yes, they chose Akamai for superior performance and improve better pricing. We are very well connected throughout Europe. Nobody has the points of presence that we do. And so we can handle requests for this customer throughout the continent and get it into the data center facility they'd like to have in Scandinavia and do that very efficiently at a favorable price point, because of our existing platform and capabilities."
},
{
"speaker": "Operator",
"text": "The next question comes from Amit Daryanani with Evercore. Please go ahead."
},
{
"speaker": "Amit Daryanani",
"text": "Thanks a lot. And thanks for taking my question. I guess I have two quick ones, hopefully. The first one, with your largest customer, the $60 million headwind that you talked about. I'm hoping you just maybe expand a little bit on that is that headwind going to happen irrespective of what happens with the recent executive order around their operations? I'm just trying to understand like is this more about them intending to move some of the CDN in-house? Or is it more of an executive order that $6 million headwind does it happen in respective? And it sounds like it's another $60 million in '26. Maybe just level set that kind of what's happening there and how to ring-fence that would be helpful. And then just to operating margins. What do you think it takes for Akamai to get back to a 30% operating margin number over time? Any kind of help on revenue or cost control, that would be helpful? Thank you."
},
{
"speaker": "Tom Leighton",
"text": "Yes. So the headwind is, by and large, because of their DIY build-out, as we've talked about. So they'll be taking on more of the services themselves. And there are political challenges, obviously, in the U.S. as a result of the five year agreement. Our exposure there is mitigated quite a bit. As we talked about in the disclosure last year, we had about $50 million, I have about $50 million of U.S. business with this customer that obviously would be taken away if they are banned in the U.S. However, as a result of the minimum commitments made, our exposure there is less. As Ed pointed out, if they are banned in the U.S. then we would have less revenue from them than if they continue to operate. And if they continue to operate, there would be upside to the upper end of the range. And Ed, do you want to talk about the margins?"
},
{
"speaker": "Ed McGowan",
"text": "Sure. Yes. So most of the expansion is going to come through two things. One, the mix is going to move more towards security and compute. And then just from an operating leverage perspective, with the revenue growth, we just believe we can scale the business accordingly. And a lot of that additional growth will drop to the bottom line. The changes that Tom is talking about or mentioned on the call about go-to-market, some of that has already been funded by the action that we took before, and we're very responsible with future investments. So we expect to see some scale as we grow top line."
},
{
"speaker": "Amit Daryanani",
"text": "Great. Thank you very much."
},
{
"speaker": "Operator",
"text": "The next question comes from Fatima Boolani with Citi. Please go ahead."
},
{
"speaker": "Fatima Boolani",
"text": "Good afternoon. Thank you for taking my questions. Tom or Ed feel free to chime in on this. With regards to TikTok, you talked specifically about the delivery business and some of the minimal commitment minimum commitments they've made to you to protect you. But I was actually curious if you can opine or comment on if that is a customer that has adopted other solutions in your portfolio, i.e., specifically anything in the security realm that we have to be mindful of eroding away. And then I have a quick follow-up on the good market as well."
},
{
"speaker": "Tom Leighton",
"text": "Yes. Like any large customer, they pretty much use all our services. So they're a large delivery customer. They use a lot of our security services and actually a growing amount of our compute our cloud infrastructure services. And we have factored that in to the guidance we've given, both the guidance for this year and the three to five year guidance."
},
{
"speaker": "Fatima Boolani",
"text": "Great. And just from a go-to-market perspective, Tom, you were very explicit in that there's been a lot of thoughtful change and maybe a little bit of an overhaul in the go-to-market organization by way of account segmentation, price strategy, et cetera. I'm wondering how far along are you in the process of ironing out or cementing a lot of these changes, because it does seem like there might be a couple of things that blocks from an aggregate go-to-market strategy perspective. So would love to hear kind of where you are on the journey to kind of overhaul the go-to-market organization and how we should think about you coming out the other end of that? Thank you."
},
{
"speaker": "Tom Leighton",
"text": "Yes. Great question. I think of this as sort of a two year process, roughly speaking. And we're in the beginning stages. We've already increased the number of our hunters and as I said, the ratio of hunting to farming. We've already increased and we'll do further increases in the specialized sales team. We are working now, thinking through pricing structure changes, contracts, potential contract structure changes, making progress in segmentation for the field. So a lot of work still underway. And you want to, I think, position this in the context that we're transforming the company. And you look at our product set and we're evolving substantially from what was a delivery company and then a delivery and stadium web-firewall company, where most of our revenue has been and you look at the products that are really growing and driving us forward to the future. And you're looking at some intake are core segmentation and enterprise Zero Trust security, you're looking at API security, huge greenfield there for us. And best of all, you're looking at our cloud infrastructure services, which has just really taken off. It's remarkable. I think when you see what's happened. We bought Linode about three years ago, had about $127 million ARR, growing mid-teens at best. And today, more than double now growing at 35% last year, and we're forecasting 40% to 45% this year. And I think what's really exciting about that is the addressable market for us is literally over $100 billion. And that's probably just in our current customer base. So tremendous potential, and it's really taking off now. So that changes the company. And it changes what we need from the sales force, what they need to be doing. Obviously, we want to protect and grow the revenue in our existing base, but we want to be out there selling those new products, both in the existing base and to a lot of new customers. And so in response to that, we're in the process of transforming the sales force to get the capabilities that we need to continue the very strong growth we're seeing in these new areas."
},
{
"speaker": "Fatima Boolani",
"text": "Thank you."
},
{
"speaker": "Operator",
"text": "The next question comes from Frank Louthan with Raymond James. Please go ahead."
},
{
"speaker": "Frank Louthan",
"text": "Great. Thank you. Can you give us -- let's say, can you give us an idea of what the -- of what logo growth was in the quarter? That would be great. And is there any particular group security, compute, et cetera, that saw a better or a worse growth from new logos? Thanks."
},
{
"speaker": "Ed McGowan",
"text": "Hey, Frank, this is Ed. Actually, logo gross, obviously was probably most positively impacted from the Edgio contracts that we acquired. We added a few hundred logos there, over 100 of those were new to the company. So that was the biggest addition. As far as where the new logos are coming from, it's mostly in security in the two new areas that Tom talked about, Guardicore and API security, and also in the compute side as well. So I would say it's probably stronger than normal new acquisition quarter in Q4, just normal course and then obviously Edgio helped quite a bit as well."
},
{
"speaker": "Frank Louthan",
"text": "And what's your outlook for being able to retain those Edgio contracts? Do you think some of those will churn off? Or what's the likelihood of those converting into more permanent customers?"
},
{
"speaker": "Ed McGowan",
"text": "Yes. So we've gone through the migration at this point. So we've moved everybody off. The Edgio network has closed so or shut down at this point. So we have a good idea of who's coming over at this point. We don't anticipate significant churn from what we have today. We are very selective on what we took. We didn't take all customers. There were certain things, certain small customers that didn't make sense for us to take. There's some acceptable use policy violations that we wouldn't take and there are some economics with certain customers that we didn't want. So factoring into our guidance is what we think we'll do with that customer base. I think there's probably some upside there with upsell generally speaking, you want to land the customer, make sure they're happy and then start developing a pipeline with them. I want to just attack them right away with the sales pitch. So pretty happy with what we were able to retain. It was pretty much right in line, maybe a little bit better than we expected."
},
{
"speaker": "Frank Louthan",
"text": "Okay. Great. Thank you."
},
{
"speaker": "Operator",
"text": "The next question comes from Rishi Jaluria with RBC. Please go ahead."
},
{
"speaker": "Rishi Jaluria",
"text": "Wonderful. Thanks so much for taking my questions. Just two quick ones. First, going back to some of the changes in go-to-market and changes in sales, what can you do on your end to minimize the disruption from that. What are you assuming when you think about your 2025 guide. And I ask because in the history of software, we see sales regards changes to go-to-market and they always end up being a lot more disruptive than anticipated. So maybe if you could walk us through your assumptions and what you can do to minimize that disruption. That would be helpful. And I have a quick follow-up."
},
{
"speaker": "Tom Leighton",
"text": "Well, the first key is to avoid an account breakage. And so we're not doing it all at once. As I mentioned, this is a two year journey. And of course, we're adding resources with specialization on the new products. And so those folks are helping do the cross-sell and have a chance to hunt for new customers. So the key really, I think is we will minimize the breakage of the rep associations with customers in the accounts. And Ed, is there anything you'd like to add to that?"
},
{
"speaker": "Ed McGowan",
"text": "Yes, I'd just say that as a mentioned, we're working with one of the large consulting firms and bringing some expertise in to help us think through that. But absolutely, we want to be very careful with how we think about the movement from hunting to farming and how we support customers going forward. The less breakage, the better."
},
{
"speaker": "Rishi Jaluria",
"text": "Got it. No, that's helpful. And then just really quickly on Edgio. I appreciate the color and the detailed guide. As we think maybe a little bit more longer term, given Edgio's out of the fold now, and you have those contracts and assets, how should we be thinking about the pricing environment for the delivery? And can just having fewer players in the space help maybe lead to a less aggressive pricing environment? Thanks."
},
{
"speaker": "Ed McGowan",
"text": "Yes. That really comes down to the different buckets of customers. I'd say with some of the larger high volume customers, we are seeing some rationalization to some extent, longer contract terms, which is helpful. Obviously, if you have less players, you do potentially have some better pricing, but we're already starting to see that in the market. So I'd say it's getting a little bit better, but it's always been a volume driven business. So to the extent that volumes continue to drive -- go higher, we'll still see the general trend in pricing to go down, but hopefully, we'll see it moderate a little bit more in the future."
},
{
"speaker": "Rishi Jaluria",
"text": "Wonderful. Thank you."
},
{
"speaker": "Operator",
"text": "The next question comes from John DiFucci with Guggenheim. Please go ahead."
},
{
"speaker": "John DiFucci",
"text": "Thank you. So Tom and Ed, I think this applies both you. Business looks to be going as planned, and we appreciate the three to five year goals and actually all the information that you gave us, this is great. But the guidance for next year implies 3% growth. And I think there's a 1% of FX headwind, so that's about 4%. I get the large customer issues, but there's always issues, right? That aside for now, how do we get comfort that growth is going to accelerate to 10%. Is it just math, because I haven't gone through it at all yet to faster growing portions of the business will more than offset the delivery business. And are you -- and/or, I guess, are you expecting improved macro backdrop in the forecast? Or does it -- I guess, also related to this, does that 10% eventual 10% exclude any impacts from that large customer?"
},
{
"speaker": "Ed McGowan",
"text": "All right. So I'll take this one, Tom. So I'll start with the back part. The large cost, what we've done is we've modeled out what their minimum spend would be for that five year contract. So Think of that as being the bottom of the potential there for that customer. So there's more upside there potentially. But in terms of what we're seeing for growth, I think you have to kind of break the business down into the buckets and why we showed you all that data. We'll start with delivery first. So delivery, obviously, has been a pretty big drag. It's starting to improve. We expect it to improve this year, continue to improve. So you should start to see some stabilization in delivery over that period of time. So that you think of that as a big drag sort of moderating significantly, so you don't have as much of a drag. So then when you take the businesses that we have, we look at security, the bigger franchises are slowing a bit, but they're still growing. So we're still getting some growth out of that. And underneath that, say, for example, in our security products, we have new fraud products and be introducing new products. So that franchise will still grow, just won't be growing as fast as it was. But the -- between Guardicore and APIs, those are very large markets. We have market-leading products we think we'll be able to -- that included with the -- some of the changes we're making in go-to-market and the investments we're making in hunting, we'll get more productivity out of the sales force. And there's still a long way to go there. So we think that that growth as it gets bigger, you get 10% growth out of security, that we think is pretty durable given those factors. And then there's compute. So with compute, we're going through a little bit of a transformation that Tom talked about with the sort of [indiscernible], I don't want to say the legacy, but some of the other older products in the other applications bucket where we're partnering with some of the ISV partners, which has a little bit of a near-term flattening of revenue in that bucket, but it gives us a much bigger opportunity to grow the market by partnering with those folks getting some of their own business, but also getting a product that's being invested in, et cetera. So we have a much more robust offering. And then again, with the go-to-market investments we're making in compute, not only just with the hunters, but also with the overlay specialists. We think that will also help drive more productivity in the field. So hopefully, that answers your question."
},
{
"speaker": "John DiFucci",
"text": "That was really good. That's really helpful. It makes you think we need to do a lot more work around, especially compute, but it's exciting to think about Guardicore and API. I guess just one thing, one last question on the compute business. And one of the things that I can help think about here is profitability. And it's always a question at anybody that's coming into this business. But you alluded to having some advantages entering this business given the delivery business. I guess, can you describe that in a little more detail? I mean, I kind of get the high level. Is it as simple as you're utilizing underutilized assets across your network? Or is there something more to it?"
},
{
"speaker": "Tom Leighton",
"text": "There are several reasons. First, we probably move around more data than pretty much anybody. And we've figured out how to do that very efficiently. And so for customers of our cloud infrastructure platform, when they compare our pricing to the hyperscalers, we're a lot less. At least for the applications where they're moving around data, they got a lot of hits. And that's a lot of the applications out there today. And so in head-to-head competition now with the hyperscalers, we can offer a much better price. Second is performance. And as we've talked about, we have the world's most distributed platform. We are in a position to get our customers' compute instances a lot closer to end users. And not only is that good for scalability, it's great for performance, because the business logic is running close to the users. And so when we do head-to-head trials now against the hyperscalers for a lot of the applications, we perform better. So we're able to offer better performance at a lower price point. And now with the managed container service, that's super exciting. We can actually support our customers' containers in hundreds of cities. Nobody is doing that today. And so again -- and those are the locations we've had already for the delivery business and the security business. So we're already there. So you get better performance and scalability at a lower price point. And then you combine that with the enormous market that we have a chance to tap into. And I think probably really important as you make the models to look at our cloud infrastructure services revenue and what's happening there. We only really started selling that to enterprises last year and went from very little revenue to $115 million ARR in the total for our cloud infrastructure services, $259 million. And we're projecting that total number to grow by 40%. At least 40% to 45% this year. So I would encourage you to keep a close eye on that because that drives a lot of growth and profitability for us going forward."
},
{
"speaker": "Ed McGowan",
"text": "John, just to add on the profitability, there's four main synergies One is the backbone. So we obviously can leverage that. Obviously, we don't kind of track that we serve there. Number two is with operations. So a lot of the folks that build out the CDN, also build out the data centers for our compute business, so we didn't have to go hire a big team. Number three is engineering. We talked earlier in the year that we moved about 1,000 people out of the engineering organization in our delivery business into the compute business, both in operations and engineering. And then the fourth thing is on go-to-market. So we can leverage our existing customer relationships and our reps. We're augmenting that a bit with some of our specialists, but we don't have to go out and hire a whole new team. So there's an awful lot of operating expenses that we can take advantage of in terms of driving profitability."
},
{
"speaker": "John DiFucci",
"text": "Thank you guys. This all makes sense. Now it's the easy part. You just have to execute. That was a joke. It's not easy."
},
{
"speaker": "Ed McGowan",
"text": "Exactly."
},
{
"speaker": "John DiFucci",
"text": "Thanks guys."
},
{
"speaker": "Operator",
"text": "The next question comes from Patrick Colville with Scotiabank. Please go ahead."
},
{
"speaker": "Patrick Colville",
"text": "Thanks for squeezing me in guys. So I guess this one is for probably Dr. Tom and Ed. I mean, in the prepared remarks, you touched on the reasons why compute slow. But I just -- I'm going to my model now and the year-on-year delta is pretty stark. And so I just want to make sure I've got them completely nailed down. So I guess just to start off, this year, 25% growth in compute next year guidance of 15%. Can you just double [indiscernible] what is driving that?"
},
{
"speaker": "Ed McGowan",
"text": "Yes, sure. So there's the two pieces. There's the caught infrastructure security, which will continue to grow and actually accelerate. So that piece, it's the smaller piece of the two businesses, but that's going to accelerate pretty significantly. When you look under the covers of the other, the application services, there's a number of things in there. For example, we have some of our legacy net storage business, which will be end of lifing that soon in the next year or two. And some customers will migrate to our cloud offering, some may decide to do something else, but that's going to be in a bit of a decline. And then we've got a lot of revenue that comes from some of these potential ISV partners. For example, we've got some of our transcoding. We announced something with a partner called Harmonic, we're partnering with them, and we're migrating some of that business over there. They're using us now for their compute. So that's going to be shifting over time. And there's probably four or five different buckets, whether it's image manager, video manager, our waiting room application or visitor prioritization. Those things were going to be moving towards ISV partners and focusing more of our efforts on the infrastructure services. So you're going to see flattening to maybe slightly down in that bucket, and you'll see most of the growth coming from cloud and infrastructure services."
},
{
"speaker": "Patrick Colville",
"text": "Okay. Okay. Helpful. And then I guess as a quick one because I've been getting this a lot from investors. In terms of Akamai's exposure to the U.S. Fed. How should we think about that? And in 2024, is there any expectations for that business embedded into guidance for 2025?"
},
{
"speaker": "Ed McGowan",
"text": "So when you say the U.S. study, you talked about the Federal Reserve interest rate policy or you're talking about the federal government slightly?"
},
{
"speaker": "Patrick Colville",
"text": "The latter."
},
{
"speaker": "Ed McGowan",
"text": "Okay. Yes. So we obviously do sell to the government. It's not a huge portion of our business. It's way too early to tell with what the cost-cutting efforts that are going on, how that would impact us. But it's not an overly material part of the business. I wouldn't expect anything material out of that. We haven't modeled anything material, just kind of regular way business for now. So I'm not anticipating anything."
},
{
"speaker": "Patrick Colville",
"text": "Crystal clear. All right, thank you so much guys. I really appreciate it."
},
{
"speaker": "Operator",
"text": "The next question comes from James Fish with Piper Sandler. Please go ahead."
},
{
"speaker": "James Fish",
"text": "Hey guys. I appreciate all the details here, and increased disclosures, I think investors will as well. Maybe just following up on something you just said first, Ed. Can you just walk us through some of that transition impact on the compute side and which of the products you plan to sort of be transitioning off and how to think about the utilization of the compute network today that we need to invest this much after two years of investing as much behind the compute business?"
},
{
"speaker": "Ed McGowan",
"text": "Yes, I mean I gave you in terms of the investment percentage of revenue that we're spending for that. 1% of that of the six that we're using compute will be specifically for that big customer. And I've always talked about how from time-to-time, if we do get large customers, you do tend to sometimes get outsized demand in a particular geo. We added an awful lot of investment this year in terms of bulking up a number of locations, et cetera. We're going to continue to add to those. We're also seeing very strong demand. So we're continuing to invest with that. But also keep in mind we did migrate over $100 million worth of our own applications. It's running well over $0.5 billion of our revenue today, and that business continues to grow. So we're still having to provide some investment to support that, which is significantly less than what we would be paying if we were to continue to use third-party cloud providers. Now in terms of the two different components of revenue, I think I discussed the cloud infrastructure service. So I think you guys get that. That's the real fast-growing stuff. And inside that other bucket is where you'll see that flattening out to declining. And it's really just the items I mentioned. We've got video management, image management, visitor prioritization and some various workflow components like transcoding that we have built from time-to-time for customers. There's not a ton of demand for it. It's grown decently, but it's not a specialty of ours. So we want to make sure that we're investing in the right areas. So as we're migrating that to partners and we shift our investment into the faster-growing infrastructure cloud services, you'll see a bottoming out here this year and then the growth will reaccelerate to 20%, led by cloud infrastructure services. And also keep in mind, I've got about -- last time we broke it out, it was about $50 million of legacy storage. So think of that as like the media companies storing like a backup origin for their video files and music file and that sort of stuff, images, et cetera. That's -- that business will be winding down over the next year or so. So that's going to have a bit of a drag on revenue as well."
},
{
"speaker": "James Fish",
"text": "Understood. And I think a lot of investors here you guys are sitting here on an earnings call, giving a three to five year framework. The last time we got this type of framework from you guys was many years ago. And I think in that framework, we had talked about a 20% constant currency security growth, for example, and we didn't hit that. So you're talking about a 10% CAGR that includes M&A from here within security. Just what's going to drive the reason that we actually achieve these results and that this is a reasonable expectation that, that actually might be conservative as opposed to hoping that we hit that number? Thanks guys."
},
{
"speaker": "Ed McGowan",
"text": "Well, I mean, to be fair, there were several years during that period of time when we did grow 20%. We always said 20% would include acquisitions. So we did some acquisitions along the way. We've -- look we just did -- put up 16%. So that business has been very healthy. We've been adding a couple of hundred million of high-margin security revenue for years now. And if you do the math, we'll continue to do that. In terms of the impact of acquisitions going forward, we're not anticipating doing significantly large acquisitions, more of what we've done in the past, whether it's tuck-ins or smaller companies that are -- got a product that's in market that's about to scale like API security, where the company is looking at making a big investment in go-to-market or raising a route or looking to exit buy something like that or like Guardicore and we scale that up, and we've shown that we've got success there. So I think we've got confidence in our M&A strategy. It's not going to be a significant portion, but maybe over time, it might be one of the faster-growing products as we exit the decade. And what we've been -- why we broke these businesses out for, you can see how well we're scaling a business now that's a couple of hundred million growing extremely fast. So I think we have pretty good confidence. And again, yes, you can -- we can quibble over the 20% and maybe a couple of years, we're in high teens. But as we said, that would have included acquisitions we've been always doing. But I thought we did pretty well over that period of time. And we just thought now that we're getting to a scale of a couple of billion it made sense to update expectations as we see some of our products that we've been in the market for over a decade, slowing down."
},
{
"speaker": "Operator",
"text": "The next question comes from Will Power with Baird. Please go ahead."
},
{
"speaker": "William Power",
"text": "Okay, great. Tom, you provided some good examples in the prepared remarks, I think of some of the applications that are being used in your network. I mean it seemed for some time that you should be well positioned for inference at the edge. And I just I wonder if you maybe update on this, just as along the lines of the tone of conversations you're having, what kind of the pipeline looks like, just kind of the activity level you're seeing in terms of taking advantage of particularly some of these generative AI applications and inference that maybe is starting to develop or you just think it's going to start to develop?"
},
{
"speaker": "Tom Leighton",
"text": "Yes, I think there's a lot AI-powered at image normalization so that the various images have the same consistent size, quality image classification even for things like detecting disease in crops. AI-powered speech recognition in cars, AI-powered chatbots, sentiment analysis, tactic image inferencing for a variety of applications. All sorts of applications already using Gen AI on the platform. And we have partners, our ISV partners. Some of them doing AI on the platform, web assembly, AI inferencing. So I would say it's early days, but all sorts of things being done on our cloud infrastructure services today."
},
{
"speaker": "William Power",
"text": "Okay. And then I mean as we look at the cloud infrastructure assumed acceleration, I think you're looking for 40% to 45% ARR growth, any further breakdown, how much is inferencing influencing that? Or is that still early? And if not, what are kind of the key drivers of the acceleration there including impact of the $100 million deal, how does that factor in?"
},
{
"speaker": "Tom Leighton",
"text": "Yes, the $100 million deal doesn't do a lot this year. That doesn't really ramp up until the end of the year. So I don't think that's a material impact on our 40% to 45% projection. That will certainly help us in '26 and beyond. And I don't think AI inferencing is a big part of the growth this year either. There could be some, but I think that will fall more into the upside category. I think it's just more of the traditional uses of compute on the platform. And keep in mind, that's a $100 billion market today, plus without getting into AI or the new large deal that we've done. And just as examples, with our ISV partners, database at the edge, observability for all sorts of applications, media workflow, things like file transcoding and live encoding, video packaging, interactive WebRTC. These are what our ISV partners have their applications doing on our cloud infrastructure platform, digital asset management, video optimization, game orchestration, fleet management, DRM, Kubernetes activity and auto scaling ad insertion, service side ad insertion. So there's just a bunch of stuff that is just good old regular compute that's running on the platform. I would say we're -- as you can see from the examples we've given, we're selling it into pretty much all the verticals. A lot of financial companies are starting to use it now. Media broadly construed is still, I think, the sweet spot and partly that's by design because those customers need to get great performance. They need to cut cost. They don't like writing a huge check to their biggest competitor. And they're big Akamai customers, and they like Akamai a lot. So that's sort of the center of mass, but it goes across verticals and across a lot of use cases. And I'd say we're excited about AI. That's upside and probably comes down the road."
},
{
"speaker": "William Power",
"text": "That's helpful. Thank you."
},
{
"speaker": "Operator",
"text": "The next question comes from Mark Murphy with JPMorgan. Please go ahead."
},
{
"speaker": "Mark Murphy",
"text": "Thank you very much. Tom, interested to get your view of the ramifications for Akamai of all of the technological advancements and efficiencies that we've seen with the Deep Seek model? And whether you see any signs of that opening up kind of a broader wave of experimentation for doing edge inferencing on Akamai compute. Maybe some of these AI applications are going to become more economically viable. And then I had a quick follow-up for Ed."
},
{
"speaker": "Tom Leighton",
"text": "Yes. I think the Deep Seek phenomenon or announcement or whatever you want to call it, is very consistent with what we've been saying is going to happen. I think you'll see further improvements. It's great for us because it validates what we've been saying and how we've designed our cloud infrastructure platform. In fact, there's already entities running Deep Seek on our cloud infrastructure platform along with other models. And it does mean that it is a lot less expensive. It doesn't need the giant core GPUs. It can be run on lighter weight GPUs. There'll be a lot of use cases where you want that on the edge. And I think it's great and very much what we expected to happen. And I think you'll see more developments along those lines."
},
{
"speaker": "Mark Murphy",
"text": "Okay. That's great to hear. And Ed, as a follow-up on the security CAGR where you're expecting about 10% in the next three to five years, that's fairly close, I believe to the overall market growing something like 12% to 14%. And you said that it includes a typical level of M&A. If we think about it organically, should we pencil out something like maybe mid- to high-single-digits organically? And then if you're able to find some of these tuck-ins, you've done an incredible job picking those out and executing on those recently and they're growing like a weed. And then maybe the inorganic piece gives you a couple of few points there over the next three to five years. Is that a decent framework?"
},
{
"speaker": "Ed McGowan",
"text": "Yes, I think that's a good way to think about it, Mark. I mean obviously, at the scale we're at now over $2 billion, and we talk about even the bigger revenue companies we've acquired have been $20 million to $30 million. That's insignificance about a point in total from inorganic. In terms of the near term, there's going to be mostly from organic. But yes, probably maybe one point, something like that as you get out a couple of years. And then obviously, if we picked a good company like we did with Noname or we did with Guardicore, as you get out further, we consider that organic growth at that point that might be contributing because it's a faster-growing area if we get into a hot space that's growing quickly. But in terms of like the -- to make a number in any given year, we don't anticipate getting much more than maybe 1% from an acquisition inorganically."
},
{
"speaker": "Mark Murphy",
"text": "Okay, understood. Thank you so much."
},
{
"speaker": "Operator",
"text": "I understand that we have time for one last questioner and that will come from Jonathan Ho with William Blair & Company. Please go ahead."
},
{
"speaker": "Jonathan Ho",
"text": "Excellent. And let me echo the thank you for the additional disclosure. Just one question from me. How concerned should we be with potential tariff impacts. And can you maybe pass through higher costs that are associated with that? I know you're trying to maybe accelerate some investment ahead of time particularly given your need to invest on the compute side over the long run, it does seem like there's may be some exposure here. So I just wanted to understand the implications there. Thank you."
},
{
"speaker": "Ed McGowan",
"text": "Yes. I mean it's obviously tough to call, just given we don't know what the ultimate end game is here in terms of towers. But to the extent we do have the ability to move supply chains around. And we're looking at obviously doing that. There was some talk about Canada and Mexico. We do get some server builds out of the there. But -- so we fast forward it so. I gave you the number, $10 million to $15 million. So it's not significant. In terms of can we pass some of these pricing costs along, we're certainly exploring that as part of the work we're doing with the consulting firm we hired overall pricing strategy is part of it. And to the extent that it becomes somewhat immaterial in any way, we certainly would have to bake that into our pricing. But it's tough to say at this point because we just don't know what the final end state is."
},
{
"speaker": "Jonathan Ho",
"text": "Thank you."
},
{
"speaker": "Operator",
"text": "This concludes our question-and-answer session. I would like to turn the conference back over to Mark Stoutenberg for any closing remarks."
},
{
"speaker": "Mark Stoutenberg",
"text": "Thank you, everyone. As usual, we will be attending investor conferences throughout the rest of the quarter. We look forward to seeing you there and discussing everything that we talked about today. So thanks again for joining us tonight. I know it's a long call. We hope that you have a rest nice evening. Operator, you can end the call now."
},
{
"speaker": "Operator",
"text": "The conference has now concluded. Thank you for attending today's presentation. You may now disconnect."
}
] | Akamai Technologies, Inc. | 24,522 |
AKAM | 3 | 2,024 | 2024-11-07 16:30:00 | Operator: Good day. And welcome to the Akamai Technologies Third Quarter 2024 Earnings Conference Call [Operator Instructions]. Please note that today's event is being recorded. I would now like to turn the conference over to Mr. Mark Stoutenberg, Head of Investor Relations. Please go ahead, sir.
Mark Stoutenberg: Good afternoon, everyone. And thank you for joining Akamai's third quarter 2024 earnings call. Speaking today will be Tom Leighton, Akamai's Chief Executive Officer; and Ed McGowan, Akamai's Chief Financial Officer. Please note that today's comments include forward-looking statements, including statements regarding revenue and earnings guidance. These forward-looking statements are subject to certain risks and uncertainties and involve a number of factors that could cause actual results to differ materially from those expressed or implied by such statements. The factors include any impact from macroeconomic trends, the integration of any acquisitions and any impact from geopolitical developments. Additional information concerning these factors is contained in Akamai's filings with the SEC, including our annual report on Form 10-K and our quarterly reports on Form 10-Q. These forward-looking statements included on this call represent the company's view on November 7, 2024. Akamai disclaims any obligation to update these statements to reflect new information or future events, except as required by law. As a reminder, we will be referring to certain non-GAAP financial metrics during today's call. A detailed reconciliation of GAAP and non-GAAP metrics can be found under the Financial portion of the Investor Relations section of akamai.com. I'll now hand the call off to our CEO, Dr. Tom Leighton.
Tom Leighton: Thanks, Mark. I'm pleased to report that Akamai delivered a solid third quarter in which we achieved two significant milestones. For the first time, Akamai's total annual revenue run rate exceeded $4 billion and our security annual revenue run rate exceeded $2 billion. Our compute results were also very strong, growing 28% year-over-year in constant currency. Non-GAAP operating margin was 29% and non-GAAP earnings per share was $1.59 in line with our guidance. On last quarter's earnings call, we reviewed how Akamai is undergoing a fundamental transformation from a content delivery pioneer into the cybersecurity and cloud computing company that powers and protects business online. Security now delivers the majority of Akamai revenue and compute and security combined account for more than two thirds of our revenue. Since entering the security market a little more than a decade ago with web app firewall as a cloud service, we greatly expanded our security product set into an impressive portfolio, covering infrastructure, application and enterprise network security. We now offer market leading solutions to help protect against DDoS and DNS attacks, application and API attacks, account abuse and fraud and ransomware and data exfiltration attacks. We're already leveraging generative AI to enhance the security and ease of use of our Guardicore and WAF solutions. And we set ourselves apart from the competition with our extensive threat visibility and intelligence and our expert managed services that customers rely upon to protect their businesses. Customer interest in our security solutions remained strong in Q3 and we signed many significant contracts, including a $70 million agreement with one of the world's largest financial institutions, which included our Guardicore segmentation solution, API Security and Prolexic DDoS protection; a $6 million upgrade at one of the world's leading chemical producers that included Guardicore to increase visibility and better protect against ransomware; a $3 million expansion with one of the world's leading auto manufacturers that included Guardicore to protect their critical high performance computing clusters; a $5 million upgrade from another of the world's largest financial institutions to protect their apps and APIs from malicious activity; and a competitive takeaway for our new API security solution at one of the world's largest multinational technology companies. As a result of the strong early momentum, our new API security solution is on track to achieve an annualized revenue run rate of more than $50 million by the end of the year. And our Zero Trust segment, led by Guardicore, is on track to achieve an annualized revenue run rate of more than $180 million by year end. We're also seeing strong interest in our Prolexic service as a result of the large DDoS attacks that have been raging across Asia. Our State of the Internet report in September warned of how geopolitical tensions are increasing the risks of attacks. And we recently thwarted two of the largest DDoS attacks ever seen, one against a leading financial institution in the Middle East and the other against a popular generative AI service. In both cases, our customers didn't see any impact, thanks to our protection. The GenAI customer, a well known hyperscaler, told us that the enterprise grade protection we provide to their business is a true differentiator and it's why they partner with Akamai over competing vendors who have struggled when confronted with large attacks. As another example, a major financial institution in Australia called on us last month for emergency assistance when the competitor they were using for security failed in the face of an attack, resulting in a significant disruption to their business and painful news headlines. We also signed up one of the leading financial institutions in India as they sought to defend themselves from the increasing scale of DDoS attacks. I think it's worth noting that enterprise grade security is not just about scale and reach, which Akamai has plenty of. It's also about having the right people and expertise to partner with and support the most demanding enterprise accounts. And it's about having five nines of platform reliability. These are critical areas where Akamai excels. And there are key reasons why customers trust Akamai to keep them operating normally during even the most challenging circumstances. We've also continued to advance our security capabilities through innovation. For example, last month, we announced the availability of our new behavioral DDoS engine for Akamai's app and API protector solution. It leverages machine learning and intelligence from our global platform to analyze data from multiple sources to provide automated protection against application layer attacks. Turning now to compute. The strong momentum that we achieved in the first half of the year accelerated in Q3 with compute revenue growing to $167 million, up 28% year-over-year. We continued to add new compute customers at a strong pace and we remain on track for our new enterprise compute solutions to exit the year with an annualized revenue run rate of more than $100 million. In Q3, we saw enterprise compute wins in the US at one of the largest retailers, one of the world's largest SaaS platforms, a large e-gaming platform, a large sports gaming platform, a nationwide passenger railroad and a global weather forecaster. In Europe, we saw a large compute win with a major German travel platform. And a major telco doubled their prior commit for our enterprise compute solutions. In Latin America, one of the largest private banks in Brazil expanded their reliance on Akamai to adopt an ISV observability solution that provides insights into data to help improve user experience. And in APJ, we signed up an international domain management platform that enables domain owners to optimize and manage their domains using our compute solutions. Across the world, we're seeing strong interest in our differentiated cloud computing platform for cloud native apps, observability, better performance and lower cost. Retailers in particular have told us that they've achieved better performance and conversion rates for their mobile apps running on Akamai Connected Cloud, with one reporting $160,000 in additional revenue per day. We're also seeing more opportunities for our platform to support the use of AI for tasks such as image generation and processing, speech recognition, consumer analytics and prediction and generation of short videos for advertising. In September, we introduced new video workflow capabilities from our ISV partners that integrate our compute and delivery platforms to give media customers unprecedented flexibility to tailor media experiences to meet their user demands. And over the past year, we've greatly expanded our object storage capabilities to help customers get reliable, scalable and low latency workload performance at a fraction of the cost charged by hyperscalers. Customers have responded. For example, French premium television channel Canal+ expanded their use of our services last quarter, adding Akamai cloud computing and migrating their video assets to Akamai's object store. This enabled them to significantly reduce their costs while improving performance and reliability. And just this month, Akamai entered into a multiyear strategic partnership with a large video workflow ISV that includes a $17 million commitment for Akamai's enterprise compute services. In an evaluation of public cloud platforms released last quarter, Forrester named Akamai a strong performer and noted that Akamai offers, a market leading edge platform that provides businesses with a distributed platform to build, run and secure applications. The vision to lead as an [IAS] alternative by offering compute at the edge of networks for low latency workloads and strengths in edge development with a significant global fabric of edge locations and robust computing platform that developers can utilize to deploy applications closer to users. In summary, we're pleased with the momentum that we've achieved in compute this year and we're very excited about the enormous opportunity ahead. Now turning to delivery. As we've noted on recent calls, our delivery solutions have been weathering macroeconomic headwinds that have been felt industry wide. In the 25 years that we've been in the delivery business, we've seen numerous swings in traffic levels, such as when traffic slowed as the largest Internet companies adopted DIY a decade ago and as when traffic boomed at the start of the pandemic. Most recently, we've seen traffic growth slow as the streaming and gaming verticals have faced their own headwinds. Looking forward, we expect that traffic growth will eventually rebound just as it has in the past. Catalysts for potential future traffic growth include the analysis by Nielsen that 59% of video consumption has yet to move online, along with a lot of advertising, which will presumably follow the audience. More advanced video games and the growth of online sports, which is still in the early innings, are also catalysts to watch. When traffic growth picks up, we believe that Akamai is in a much stronger position than competitors to capture it. Given our scale and cost structure, we can add traffic very profitably, while it appears that many of our competitors are struggling to even stay in business. In the meantime, and as I've said before, our plan for delivery is threefold. First, we'll remain disciplined when it comes to the profitability of traffic that we choose to serve. Second, we'll continue to leverage our market leadership position and installed base of major enterprises to generate cross selling opportunities. And third, we'll continue to take steps to retain our market leadership while also reinvesting most of the cash flow from our delivery product line into the fast growing areas of the business. It's important to note that Akamai realizes strong synergies and competitive advantages by offering customers delivery in addition to security and compute. These synergies and advantages include improved performance and seamless integration, bundling for cross selling and strong customer retention, increased margins for all of our services, unmatched visibility from seeing enormous volumes of traffic and the capacity to quickly detect and stop massive cyber attacks at the edge. As you can see from our results, Akamai has come a long way in our evolution from the leading content delivery company into the cybersecurity and cloud computing company that powers and protects business online. We're very pleased to see our security business exceed $2 billion in annual revenue run rate and we're very excited about the enormous potential for future growth in cloud computing. But we still have more work to do to fully realize the potential of the fast growing areas of our business. As our next step, we plan to shift more investment into the development of our cloud computing capabilities and new security products, as well as into the go-to-market resources and partner ecosystem to sell these services to a broader portion of the enterprise marketplace. With the success of our new solutions in API security, enterprise security and cloud computing, we're now selling to enterprises who were not in the sweet spot for our delivery or cloud WAF services. And so we plan to add go-to-market positions for hunting as well as experienced specialists to support sales of the new products. Our new offerings are also much more partner friendly than our traditional delivery and cloud WAF solutions. And so we're also continuing to strengthen our partner ecosystem. In order to help fund these investments in the fast growing areas of the business, we've made the difficult decision to eliminate about 2.5% of the current roles across the company. This was a painful decision because it impacts our people whose innovation and drive have been an important part of our success. We believe that redeploying these resources will enable us to grow while still maintaining our near term operating margin target of about 30% and then be in a better position to climb above 30% as the fast growing areas of our business expand our profitability. Now I'll turn the call over to Ed, who will review the Q3 results in more detail and provide our outlook on Q4. Ed?
Ed McGowan: Thank you, Tom. Today, I plan to review our Q3 results, provide some financial color on our restructuring charge and then discuss our expectations for Q4. I'll start with our third quarter results. Total revenue for the third quarter was $1.005 billion, up 4% year-over-year as reported and in constant currency, marking our first $1 billion quarter. Compute revenue was $167 million, up 28% year-over-year as reported and in constant currency. These results included a $7 million onetime benefit related to the release of some deferred revenue in conjunction with the expiration of a long term legacy compute contract. As Tom mentioned, we continue to see very positive market momentum with our enterprise compute solutions and remain on track to exit the year with an annualized revenue run rate of more than $100 million. Moving to security revenue. In the third quarter, security revenue was $519 million, a 14% year-over-year increase as reported and in constant currency. During Q3, we had $3 million of 1 time license revenue compared to $6 million in Q3 of last year. During Q3, revenue from Noname was approximately $8 million in line with our expectations. It's worth noting that similar to Guardicore, our partner and channel ecosystem is the driving force behind the majority of new customer wins for our new API security solutions. Combined, compute and security revenue grew 17% year-over-year as reported and in constant currency, representing 68% of total revenue. Delivery revenue was $319 million, a 16% year-over-year decline, both as reported and in constant currency. Sequentially, delivery revenue decreased 3%, which is an improvement compared to the 6% and 10% sequential declines in the previous two quarters. As Tom mentioned, delivery has been impacted by recent macroeconomic headwinds that have been felt industry wide. As a result, we have seen a significant slowdown in year-over-year traffic growth, most notably in video streaming and gaming. While it's difficult to predict exactly when the industry will recover and growth will resume, we believe our business will be uniquely positioned to capitalize on the recovery. Our scale and cost structure enables us to attract and retain customers very profitably and our delivery business continues to generate very desirable cash flows. International revenue was $480 million, up 3% year-over-year as reported and in constant currency, representing 48% of total revenue in Q3. Foreign exchange fluctuations had a positive impact on revenue of $5 million on a sequential basis and a negative $3 million impact on a year-over-year basis. Non-GAAP net income was $244 million or $1.59 of earnings per diluted share, down 2% year-over-year and down 1% in constant currency. As a reminder, included in our Q3 results is a full quarter's worth of Noname's revenue and expense. And finally, our non-GAAP operating margin in Q3 was 29%. Moving now to cash and our use of capital. As of September 30th, our cash, cash equivalents and marketable securities totaled approximately $2 billion. During the third quarter, we spent approximately $166 million, repurchasing approximately 1.7 million shares. We now have an aggregate of roughly $2.1 billion remaining in our share buyback authorizations. As it relates to the use of capital, our intentions remain the same: to continue buying back shares over time, to offset dilution from employee equity programs, and to be opportunistic in both M&A and share repurchases. Before I provide our Q4 guidance, I want to touch on some housekeeping items. First, as part of our new go-to-market approach and subsequent workforce realignment that Tom mentioned, we took an $82 million restructuring charge in Q3. This charge was primarily driven by our workforce reduction and related severance costs, along with the write down of intangible assets related to the Neosec acquisition. We estimate the workforce action will result in approximately $45 million of annualized savings going forward. We expect to reinvest most of those savings as part of the plan Tom discussed to refocus our go-to-market efforts around our fast growing compute and security offerings. Second, in previous years, seasonal factors significantly influenced our Q4 financial performance. This year, we are seeing weaker than normal traffic trends persisting into October. As a result, we do not anticipate an improvement in traffic growth for the remainder of 2024. Finally, Q4 operating expenses tend to be higher than Q3 due to increased sales commissions for reps who exceed their annual sales quotas. And this year, our annual employee merit cycle went into effect on October 1st. So with those factors in mind, I'll move to our Q4 guidance. We are projecting revenue in the range of $995 million to $1.020 billion, which is flat to up 3% as reported and in constant currency over Q4 of 2023. At current spot rates, including the significant volatility from yesterday, foreign exchange fluctuations are expected to have a negative $7 million impact on Q4 revenue compared to Q3 levels and a negative $5 million impact on a year-over-year basis. At these revenue levels, we expect cash gross margins of approximately 72% to 73%. Q4 non-GAAP operating expenses are projected to be $321 million to $327 million. We expect Q4 EBITDA margin of approximately 40% to 41%. We expect non-GAAP depreciation expense to be between $131 million to $133 million. And we expect non-GAAP operating margin of approximately 27% to 28% for Q4. Moving on to CapEx. We expect to spend $184 million to $192 million. This represents approximately 18% to 19% of our projected total revenue. The sequential increase in CapEx is primarily due to timing, as several projects were delayed from Q3 to Q4. Based on our expectations for revenue and costs, we expect Q4 non-GAAP EPS in the range of $1.49 to $1.56. This EPS guidance assumes taxes of $54 million to $57 million based on an estimated quarterly non-GAAP tax rate of approximately 19%. It also reflects a fully diluted share count of approximately 153 million shares. Looking ahead to the full year. We now expect revenue of $3.966 billion to $3.991 billion, which is up 4% to 5% year-over-year as reported and up 5% in constant currency. At current spot rates, our guidance assumes foreign exchange will have a negative $22 million impact on revenue in 2024 on a year-over-year basis. We expect security growth of approximately 15% to 17% in constant currency in 2024. Given the continued adoption of our enterprise compute solution, we are now increasing our overall expected compute revenue growth to the higher end of our prior guidance or approximately 25% in constant currency for the full year 2024. Moving to profitability. We are estimating non-GAAP operating margin of approximately 29% and non-GAAP earnings per diluted share of $6.31 to $6.38. Our non-GAAP earnings guidance is based on a non-GAAP effective tax rate of approximately 19% and a fully diluted share count of approximately 154 million shares. Finally, our full year CapEx is expected to be approximately 17% of total revenue. In conclusion, we are very pleased with our continued progress with our enterprise compute solutions and excited about the early returns for our recently introduced API solutions. Thank you. Tom and I are now happy to take your questions. Operator?
Operator: [Operator Instructions] And today's first question comes from Rishi Jaluria with RBC.
Rishi Jaluria: Maybe, Tom, in your prepared remarks, you talked a little bit about some of the traction that you're having on the AI side, including with AI companies. Can you help us understand philosophically, how you're thinking about the role that GenAI could play in security on both sides of the equation, both from what happens? How you can leverage GenAI to make security offerings better but maybe more significantly, what does that do to attack surfaces and attack vectors, especially if GenAI is going to get in the hands of nefarious actors? And then I've got a quick follow-up.
Tom Leighton: GenAI is already in the hands and being widely used by nefarious actors, and that's one reason why we're seeing a lot more attacks and penetrations. Probably, you've all seen the deepfakes very compelling but it's also used to generate the malware and train it to get around defenses. So it is increasing the need for defenses, defenses and depth. I think it's a big reason why you really need segmentation now and the Guardicore solution is doing so well. On our side of the house, we've been using AI and ML really forever in our security products. We use it for anomaly detection, bot detection. If it's a human logging into an account, making sure it's the right human and not somebody who stole credentials. We also use it to -- across the company really to be more efficient in the various operations we do. We're using it in -- already in two of our products, security products with GenAI as an interface. So it helps our customers manage their deployments of our security solution, gives them greater visibility. You can interface with your infrastructure and human language. Using our capabilities, you can ask what's that device there? Are the firewall rules up to date? You can ask questions like what do I need to do to bring my firewall rules within the last couple iterations so they're not too far out of date. And it answers and tells you. It's really very compelling and very interesting capabilities. So a lot of use of GenAI, I would say, at Akamai. Still early days. But unfortunately, the bad guys are using it too, very effectively.
Rishi Jaluria: And then just quickly, Tom, you alluded to this in your prepared remarks, but obviously, seeing some higher profile shakeouts, including a long awaited bankruptcy of one of your long time competitors. Maybe help us understand both near term, long term, how we should be thinking about the impact on your business from consolidation? Maybe is there an opportunity for you to gain share of wallet, especially as the kind of stable player and leader in the space? And then longer term, with one less player that had been maybe aggressive on pricing, how do you think this shakes out in the overall pricing environment, specifically on the delivery side?
Tom Leighton: Yes, I think consolidation in the delivery market is long overdue. And you've seen a lot of companies operating at losses in part funded by private equity or Wall Street. And it just didn't make sense. These companies were never going to make money. You still see some of it out there today with companies that are just really struggling, offering pricing which for them, loses money. And so I do think it makes sense to have some consolidation. And you're right, we've seen -- there was Instart Logic, StackPath, Lumen all gone. Edgio, which is the combination of EdgeCast and Limelight and Chapter 11, we'll see how that works out. But I do think this shake out makes sense. And I do think long run, it helps lead to a stabilization of the delivery market. As we talked about, we are very careful with our pricing. And we do turn away business that we don't think makes sense for us. And sometimes, other companies will step in and take that, they'll lose money in the hopes of showing some revenue growth. But I think it's not sustainable for them to do that. And I think the shakeout may be the beginning of something very positive and will help the delivery business over the medium to longer term.
Operator: And the next question comes from James Fish with Piper Sandler.
James Fish: You made a comment about shifting investments here on the go-to-market to investing behind hunters as well as sales specialists as well as the channel. Can you just talk about what caused you to make the shift now rather than at year end? How to think about the mix of that investment between the direct and specialists against kind of the indirect approach with the channel?
Tom Leighton: I think we are really seeing good traction now. We already had traction, I would say, in Guardicore. But now with API security, we talked about achieving an ARR of $50 million at year end versus near zero last year. So we really, I think, proved that out and we're very excited about the future. And with compute, last year, we really weren't even selling enterprise compute. The platform just wasn't at that level. And this year, as we talked about, we are now beginning to sell it and seeing great traction to the point where we think that will be a $100 million ARR by the end of the year. So we've now, I think, proved it certainly to ourselves that this is worthy of more investment. Now at the same time, the new product areas are attracted to a much broader market of enterprises than our traditional leading products, which would be delivery and cloud WAF. And so there's a lot of enterprises and verticals that do use cloud computing, do need API security, do need enterprise security that works in the sweet spot for our traditional services. And so that says we do need to invest more in hunting now. We got to go after those accounts. And in addition, I think it's very helpful for us to have specialists, people that are really familiar with selling cloud computing and that will help our traction as we accelerate the growth there. So that's why we're doing it now and we didn't do it last year and why we're growing the resources there. And of course, these new products are also very channel friendly in ways that our traditional services weren't. Delivery in cloud WAF weren't just -- we had channel partners, but they weren't as friendly and as attractive. The new products, very attractive to the channel, and there's a real role for our channel partners to play. And of course with cloud computing, we've got a lot of ISVs now getting on the platform. So that's why we're making this investment now.
James Fish: And maybe Ed, for you, as we think about the advanced security package changes that you guys made almost two years ago now. How penetrated is that across the security installed base, how much more room do we have to go with cross or upselling that unit? Trying to understand the year-to-date impact on security growth and anything as it pertains to the delivery impact as we think about those bundles.
Ed McGowan: So we talked last quarter a lot about this as we had anniversaried the introduction of the package and had a pretty high penetration, obviously, especially with the -- early on with the early adopters of it. We're sort of the end of that at this point. So the way to think about it is you've got year-over-year compares that have us selling in both quarters.
Operator: And our next question comes from Frank Louthan with Raymond James.
Frank Louthan: Since you acquired the Lumen CDN last year, you're a little over a year ago, did you get any network elements with that? And is there any aspect of their new networks that they're building to support their AI partners that they're having conversations with you about, about implementing your capabilities and layering them on top of that network to help maybe deliver some of that AI traffic?
Ed McGowan: So with the Lumen acquisition, there was no acquisition of any assets aside from the customer contracts. So there was no network acquisitions. And as far as any partnership discussions we have with Lumen, we're not prepared to talk about anything but there's nothing specific to what you mentioned there.
Operator: The next question comes from Fatima Boolani with Citigroup.
Unidentified Analyst: This is Mark on for Fatima. Maybe just -- great to hear the momentum that you guys are seeing on compute, but maybe just on profitability. Why aren't we seeing maybe greater evidence of operating leverage given the compute outperformance, especially since the segment commands better relative gross profit characteristics to delivery, which is declining?
Ed McGowan: So we're still in the scaling up factor within the compute business, so we haven't reached scale yet. And you're right to think that once we get to a much larger scale, we should start to see better flow through. You'll see, hopefully, gross margins expand a little bit and operating margin expand. But we're still in the investment phase of the business and haven't reached scale yet.
Unidentified Analyst: And maybe just a quick follow-on. How should we think about CapEx trajectory going through '25 from sort of the '24 70% level going forward?
Ed McGowan: So we're not going to provide guidance on this call for next year. But as we talked about -- last year was a pretty heavy investment year for CapEx related to building out some of the major data centers for compute. We don't anticipate anything like that going forward. But what I've said in the past is if we do see unusually large deals that come with more revenue, there may be some additional builds. But as we've talked about this CapEx level somewhere in this range is generally where we'd like to keep the business for now. Obviously, as compute gets bigger, that may change over time. But certainly, over the next couple of years, that's about the range we'd like to stay in.
Operator: And our next question is from Rudy Kessinger with D.A. Davidson.
Rudy Kessinger: Ed, I want to ask on delivery. It's basically implied in Q4 that delivery revenue is down 20%, 21% year-over-year by my math. I guess, it seems kind of hard to wrap my head around that if traffic is still growing. I know you're saying traffic growth is not as strong as you've seen in the past. But if traffic growth is still growing, just help us try to understand how delivery could be down over 20% year-over-year unless you're seeing much higher pricing pressure than you've seen in the past? And then as we think about going forward, maybe '25 is it fair to assume that delivery is at least a double digit decline going forward?
Ed McGowan: So a couple of things to think about here. So if you remember, last Q4 we had the Lumen and StackPath acquisitions. And during that time, when it entered into the transition services agreement, we had all of the contracts even though we had anticipated some of those would go away. So it's a really difficult compare, Q4. And in terms of traffic growth, it is growing very slowly. So at rates that we haven't seen in the 25 plus years we've been in this business, so it's growing very, very slow. Pricing is getting a little bit better. But even if you have 5%, 10% price declines and your traffic is growing in low single digits, you're not going to see growth, you're going to see contraction. So it's just been a weak traffic environment. Pricing, as I said, is getting a little bit better. But it takes a lot longer for that to work its way through the system and we get a tough compare. So those are the factors.
Rudy Kessinger: And then on compute, maybe it's a around in you CapEx. It looks like maybe at the midpoint, if you use the percent you're giving for the full year, up about $40 million for this year. Correct me if my math is wrong there. But if it is accurate, it seems like a little bit of a step up with not much of a raise in the compute guide for this year if I back out the $7 million in onetime that you had for Q3?
Ed McGowan: Yes, it's about that, maybe just a little bit less shade less than that. But it's a combination of a bunch of things. It's not all compute. There's some compute in there. There's some related to delivery in terms of some of the places where we have outsized demand. So unfortunately, delivery demand isn't all in one place. It's not just one number, you have to build out in certain geos as you get demand in certain places. And there's also infrastructure services, infrastructure that we use to run the platform. And there's always some timing between quarters so a little bit slipped out of Q3 and a little bit came in from Q1. So I wouldn't read too much into it.
Operator: And the next question is from Matt Dezort with Needham.
Matt Dezort: I guess within compute, could you touch on some of the early use cases and verticals and how those are performing? Any cohort metrics you can offer, especially behind some of the observability in security and media customers you guys have talked about? And any other newer tips that you guys are seeing as driving more workloads to Connected Cloud?
Tom Leighton: Yes, I would say the sweet spot early on by design in terms of revenue is media workflow but we are seeing compute sales across really all verticals and including new customers. And just to give you an idea of the range of our ISV partners who -- customers will buy solutions from them or from us on our platform. There's a couple of database partners, observability widely being sold, live encoding, transcoding, video packaging, WebRTC for interactive video, digital asset management, optimization of video, game orchestration, fleet management, DRM, Kubernetes, connectivity and auto scaling, server side ad insertion, AI inferencing and API performance and testing. And that's just the list of different ISV partners. So we really are seeing a lot of use cases across multiple verticals with a sweet spot in media workflow. And at this point, we really have a very good ecosystem media workflow partners, which is starting, as we talked about in the prepared remarks, really being well received in terms of our media customer base. They're looking for better performance, distributed compute at a lower price point and we're really in a good position to provide that today.
Matt Dezort: And as a quick follow-up. Can I ask about some of the security pieces excluding Guardicore and Noname? How did some of the larger pieces perform in 3Q across WAF? It sounds like DDoS was really strong, you touched on a number of wins there. Did that drive any incremental upside in the quarter? And how do you think about that triumvirate going forward?
Ed McGowan: So we saw pretty good strength across all different products, including -- you talked about Guardicore but even within the Zero Trust space, with our Enterprise Access product, we saw some pretty good growth there. We saw continued strong growth in WAF. We saw some acceleration in DDoS. You don't really get a big burst of revenue right away when you have attacks in a quarter. Typically, you sign up new customers and that revenue comes out over time. But it was pretty strong demand, pretty similar to what we saw in Q2 across the board.
Operator: And the next question comes from Mark Murphy with JP Morgan.
Unidentified Analyst: This is [Erdi Wu] on for Mark Murphy. I wanted to ask a question on compute as well. It's really good to see that momentum. I think you guys specifically called out adding customers at a strong rate and now kind of getting customers outside that sweet spot, which is very interesting to hear. So I guess my question is, is that kind of rate of addition of those customers a little bit more than you expected? And are you seeing these kind of non-sweet spot customers kind of come in earlier than you expected as well?
Tom Leighton: We're very encouraged with the adoption of our compute services, substantial increase in number of customers. And even though we planned and focused early on on the big media accounts that are already Akamai customers for using our platform, we're really seeing it across the base and a lot of new customers signing up, starting with compute that didn't use our pre-existing services. So we're very pleased to see the growth in compute. And of course, you've seen all year long as we've raised our targets for the year in terms of the enterprise compute revenue and the compute business as a whole.
Operator: And this does conclude our question-and-answer session for today. I would now like to turn the conference back over to Mr. Mark Stoutenberg for any closing remarks.
Mark Stoutenberg: Thank you, everyone. In closing, we will be attending several investor conferences throughout the rest of the quarter. We look forward to seeing you there. Again, thanks for joining us tonight. We hope you have a nice evening. Operator, you may now end the call.
Operator: Thank you. The conference has now concluded. Thank you for attending today's presentation, and you may now disconnect. | [
{
"speaker": "Operator",
"text": "Good day. And welcome to the Akamai Technologies Third Quarter 2024 Earnings Conference Call [Operator Instructions]. Please note that today's event is being recorded. I would now like to turn the conference over to Mr. Mark Stoutenberg, Head of Investor Relations. Please go ahead, sir."
},
{
"speaker": "Mark Stoutenberg",
"text": "Good afternoon, everyone. And thank you for joining Akamai's third quarter 2024 earnings call. Speaking today will be Tom Leighton, Akamai's Chief Executive Officer; and Ed McGowan, Akamai's Chief Financial Officer. Please note that today's comments include forward-looking statements, including statements regarding revenue and earnings guidance. These forward-looking statements are subject to certain risks and uncertainties and involve a number of factors that could cause actual results to differ materially from those expressed or implied by such statements. The factors include any impact from macroeconomic trends, the integration of any acquisitions and any impact from geopolitical developments. Additional information concerning these factors is contained in Akamai's filings with the SEC, including our annual report on Form 10-K and our quarterly reports on Form 10-Q. These forward-looking statements included on this call represent the company's view on November 7, 2024. Akamai disclaims any obligation to update these statements to reflect new information or future events, except as required by law. As a reminder, we will be referring to certain non-GAAP financial metrics during today's call. A detailed reconciliation of GAAP and non-GAAP metrics can be found under the Financial portion of the Investor Relations section of akamai.com. I'll now hand the call off to our CEO, Dr. Tom Leighton."
},
{
"speaker": "Tom Leighton",
"text": "Thanks, Mark. I'm pleased to report that Akamai delivered a solid third quarter in which we achieved two significant milestones. For the first time, Akamai's total annual revenue run rate exceeded $4 billion and our security annual revenue run rate exceeded $2 billion. Our compute results were also very strong, growing 28% year-over-year in constant currency. Non-GAAP operating margin was 29% and non-GAAP earnings per share was $1.59 in line with our guidance. On last quarter's earnings call, we reviewed how Akamai is undergoing a fundamental transformation from a content delivery pioneer into the cybersecurity and cloud computing company that powers and protects business online. Security now delivers the majority of Akamai revenue and compute and security combined account for more than two thirds of our revenue. Since entering the security market a little more than a decade ago with web app firewall as a cloud service, we greatly expanded our security product set into an impressive portfolio, covering infrastructure, application and enterprise network security. We now offer market leading solutions to help protect against DDoS and DNS attacks, application and API attacks, account abuse and fraud and ransomware and data exfiltration attacks. We're already leveraging generative AI to enhance the security and ease of use of our Guardicore and WAF solutions. And we set ourselves apart from the competition with our extensive threat visibility and intelligence and our expert managed services that customers rely upon to protect their businesses. Customer interest in our security solutions remained strong in Q3 and we signed many significant contracts, including a $70 million agreement with one of the world's largest financial institutions, which included our Guardicore segmentation solution, API Security and Prolexic DDoS protection; a $6 million upgrade at one of the world's leading chemical producers that included Guardicore to increase visibility and better protect against ransomware; a $3 million expansion with one of the world's leading auto manufacturers that included Guardicore to protect their critical high performance computing clusters; a $5 million upgrade from another of the world's largest financial institutions to protect their apps and APIs from malicious activity; and a competitive takeaway for our new API security solution at one of the world's largest multinational technology companies. As a result of the strong early momentum, our new API security solution is on track to achieve an annualized revenue run rate of more than $50 million by the end of the year. And our Zero Trust segment, led by Guardicore, is on track to achieve an annualized revenue run rate of more than $180 million by year end. We're also seeing strong interest in our Prolexic service as a result of the large DDoS attacks that have been raging across Asia. Our State of the Internet report in September warned of how geopolitical tensions are increasing the risks of attacks. And we recently thwarted two of the largest DDoS attacks ever seen, one against a leading financial institution in the Middle East and the other against a popular generative AI service. In both cases, our customers didn't see any impact, thanks to our protection. The GenAI customer, a well known hyperscaler, told us that the enterprise grade protection we provide to their business is a true differentiator and it's why they partner with Akamai over competing vendors who have struggled when confronted with large attacks. As another example, a major financial institution in Australia called on us last month for emergency assistance when the competitor they were using for security failed in the face of an attack, resulting in a significant disruption to their business and painful news headlines. We also signed up one of the leading financial institutions in India as they sought to defend themselves from the increasing scale of DDoS attacks. I think it's worth noting that enterprise grade security is not just about scale and reach, which Akamai has plenty of. It's also about having the right people and expertise to partner with and support the most demanding enterprise accounts. And it's about having five nines of platform reliability. These are critical areas where Akamai excels. And there are key reasons why customers trust Akamai to keep them operating normally during even the most challenging circumstances. We've also continued to advance our security capabilities through innovation. For example, last month, we announced the availability of our new behavioral DDoS engine for Akamai's app and API protector solution. It leverages machine learning and intelligence from our global platform to analyze data from multiple sources to provide automated protection against application layer attacks. Turning now to compute. The strong momentum that we achieved in the first half of the year accelerated in Q3 with compute revenue growing to $167 million, up 28% year-over-year. We continued to add new compute customers at a strong pace and we remain on track for our new enterprise compute solutions to exit the year with an annualized revenue run rate of more than $100 million. In Q3, we saw enterprise compute wins in the US at one of the largest retailers, one of the world's largest SaaS platforms, a large e-gaming platform, a large sports gaming platform, a nationwide passenger railroad and a global weather forecaster. In Europe, we saw a large compute win with a major German travel platform. And a major telco doubled their prior commit for our enterprise compute solutions. In Latin America, one of the largest private banks in Brazil expanded their reliance on Akamai to adopt an ISV observability solution that provides insights into data to help improve user experience. And in APJ, we signed up an international domain management platform that enables domain owners to optimize and manage their domains using our compute solutions. Across the world, we're seeing strong interest in our differentiated cloud computing platform for cloud native apps, observability, better performance and lower cost. Retailers in particular have told us that they've achieved better performance and conversion rates for their mobile apps running on Akamai Connected Cloud, with one reporting $160,000 in additional revenue per day. We're also seeing more opportunities for our platform to support the use of AI for tasks such as image generation and processing, speech recognition, consumer analytics and prediction and generation of short videos for advertising. In September, we introduced new video workflow capabilities from our ISV partners that integrate our compute and delivery platforms to give media customers unprecedented flexibility to tailor media experiences to meet their user demands. And over the past year, we've greatly expanded our object storage capabilities to help customers get reliable, scalable and low latency workload performance at a fraction of the cost charged by hyperscalers. Customers have responded. For example, French premium television channel Canal+ expanded their use of our services last quarter, adding Akamai cloud computing and migrating their video assets to Akamai's object store. This enabled them to significantly reduce their costs while improving performance and reliability. And just this month, Akamai entered into a multiyear strategic partnership with a large video workflow ISV that includes a $17 million commitment for Akamai's enterprise compute services. In an evaluation of public cloud platforms released last quarter, Forrester named Akamai a strong performer and noted that Akamai offers, a market leading edge platform that provides businesses with a distributed platform to build, run and secure applications. The vision to lead as an [IAS] alternative by offering compute at the edge of networks for low latency workloads and strengths in edge development with a significant global fabric of edge locations and robust computing platform that developers can utilize to deploy applications closer to users. In summary, we're pleased with the momentum that we've achieved in compute this year and we're very excited about the enormous opportunity ahead. Now turning to delivery. As we've noted on recent calls, our delivery solutions have been weathering macroeconomic headwinds that have been felt industry wide. In the 25 years that we've been in the delivery business, we've seen numerous swings in traffic levels, such as when traffic slowed as the largest Internet companies adopted DIY a decade ago and as when traffic boomed at the start of the pandemic. Most recently, we've seen traffic growth slow as the streaming and gaming verticals have faced their own headwinds. Looking forward, we expect that traffic growth will eventually rebound just as it has in the past. Catalysts for potential future traffic growth include the analysis by Nielsen that 59% of video consumption has yet to move online, along with a lot of advertising, which will presumably follow the audience. More advanced video games and the growth of online sports, which is still in the early innings, are also catalysts to watch. When traffic growth picks up, we believe that Akamai is in a much stronger position than competitors to capture it. Given our scale and cost structure, we can add traffic very profitably, while it appears that many of our competitors are struggling to even stay in business. In the meantime, and as I've said before, our plan for delivery is threefold. First, we'll remain disciplined when it comes to the profitability of traffic that we choose to serve. Second, we'll continue to leverage our market leadership position and installed base of major enterprises to generate cross selling opportunities. And third, we'll continue to take steps to retain our market leadership while also reinvesting most of the cash flow from our delivery product line into the fast growing areas of the business. It's important to note that Akamai realizes strong synergies and competitive advantages by offering customers delivery in addition to security and compute. These synergies and advantages include improved performance and seamless integration, bundling for cross selling and strong customer retention, increased margins for all of our services, unmatched visibility from seeing enormous volumes of traffic and the capacity to quickly detect and stop massive cyber attacks at the edge. As you can see from our results, Akamai has come a long way in our evolution from the leading content delivery company into the cybersecurity and cloud computing company that powers and protects business online. We're very pleased to see our security business exceed $2 billion in annual revenue run rate and we're very excited about the enormous potential for future growth in cloud computing. But we still have more work to do to fully realize the potential of the fast growing areas of our business. As our next step, we plan to shift more investment into the development of our cloud computing capabilities and new security products, as well as into the go-to-market resources and partner ecosystem to sell these services to a broader portion of the enterprise marketplace. With the success of our new solutions in API security, enterprise security and cloud computing, we're now selling to enterprises who were not in the sweet spot for our delivery or cloud WAF services. And so we plan to add go-to-market positions for hunting as well as experienced specialists to support sales of the new products. Our new offerings are also much more partner friendly than our traditional delivery and cloud WAF solutions. And so we're also continuing to strengthen our partner ecosystem. In order to help fund these investments in the fast growing areas of the business, we've made the difficult decision to eliminate about 2.5% of the current roles across the company. This was a painful decision because it impacts our people whose innovation and drive have been an important part of our success. We believe that redeploying these resources will enable us to grow while still maintaining our near term operating margin target of about 30% and then be in a better position to climb above 30% as the fast growing areas of our business expand our profitability. Now I'll turn the call over to Ed, who will review the Q3 results in more detail and provide our outlook on Q4. Ed?"
},
{
"speaker": "Ed McGowan",
"text": "Thank you, Tom. Today, I plan to review our Q3 results, provide some financial color on our restructuring charge and then discuss our expectations for Q4. I'll start with our third quarter results. Total revenue for the third quarter was $1.005 billion, up 4% year-over-year as reported and in constant currency, marking our first $1 billion quarter. Compute revenue was $167 million, up 28% year-over-year as reported and in constant currency. These results included a $7 million onetime benefit related to the release of some deferred revenue in conjunction with the expiration of a long term legacy compute contract. As Tom mentioned, we continue to see very positive market momentum with our enterprise compute solutions and remain on track to exit the year with an annualized revenue run rate of more than $100 million. Moving to security revenue. In the third quarter, security revenue was $519 million, a 14% year-over-year increase as reported and in constant currency. During Q3, we had $3 million of 1 time license revenue compared to $6 million in Q3 of last year. During Q3, revenue from Noname was approximately $8 million in line with our expectations. It's worth noting that similar to Guardicore, our partner and channel ecosystem is the driving force behind the majority of new customer wins for our new API security solutions. Combined, compute and security revenue grew 17% year-over-year as reported and in constant currency, representing 68% of total revenue. Delivery revenue was $319 million, a 16% year-over-year decline, both as reported and in constant currency. Sequentially, delivery revenue decreased 3%, which is an improvement compared to the 6% and 10% sequential declines in the previous two quarters. As Tom mentioned, delivery has been impacted by recent macroeconomic headwinds that have been felt industry wide. As a result, we have seen a significant slowdown in year-over-year traffic growth, most notably in video streaming and gaming. While it's difficult to predict exactly when the industry will recover and growth will resume, we believe our business will be uniquely positioned to capitalize on the recovery. Our scale and cost structure enables us to attract and retain customers very profitably and our delivery business continues to generate very desirable cash flows. International revenue was $480 million, up 3% year-over-year as reported and in constant currency, representing 48% of total revenue in Q3. Foreign exchange fluctuations had a positive impact on revenue of $5 million on a sequential basis and a negative $3 million impact on a year-over-year basis. Non-GAAP net income was $244 million or $1.59 of earnings per diluted share, down 2% year-over-year and down 1% in constant currency. As a reminder, included in our Q3 results is a full quarter's worth of Noname's revenue and expense. And finally, our non-GAAP operating margin in Q3 was 29%. Moving now to cash and our use of capital. As of September 30th, our cash, cash equivalents and marketable securities totaled approximately $2 billion. During the third quarter, we spent approximately $166 million, repurchasing approximately 1.7 million shares. We now have an aggregate of roughly $2.1 billion remaining in our share buyback authorizations. As it relates to the use of capital, our intentions remain the same: to continue buying back shares over time, to offset dilution from employee equity programs, and to be opportunistic in both M&A and share repurchases. Before I provide our Q4 guidance, I want to touch on some housekeeping items. First, as part of our new go-to-market approach and subsequent workforce realignment that Tom mentioned, we took an $82 million restructuring charge in Q3. This charge was primarily driven by our workforce reduction and related severance costs, along with the write down of intangible assets related to the Neosec acquisition. We estimate the workforce action will result in approximately $45 million of annualized savings going forward. We expect to reinvest most of those savings as part of the plan Tom discussed to refocus our go-to-market efforts around our fast growing compute and security offerings. Second, in previous years, seasonal factors significantly influenced our Q4 financial performance. This year, we are seeing weaker than normal traffic trends persisting into October. As a result, we do not anticipate an improvement in traffic growth for the remainder of 2024. Finally, Q4 operating expenses tend to be higher than Q3 due to increased sales commissions for reps who exceed their annual sales quotas. And this year, our annual employee merit cycle went into effect on October 1st. So with those factors in mind, I'll move to our Q4 guidance. We are projecting revenue in the range of $995 million to $1.020 billion, which is flat to up 3% as reported and in constant currency over Q4 of 2023. At current spot rates, including the significant volatility from yesterday, foreign exchange fluctuations are expected to have a negative $7 million impact on Q4 revenue compared to Q3 levels and a negative $5 million impact on a year-over-year basis. At these revenue levels, we expect cash gross margins of approximately 72% to 73%. Q4 non-GAAP operating expenses are projected to be $321 million to $327 million. We expect Q4 EBITDA margin of approximately 40% to 41%. We expect non-GAAP depreciation expense to be between $131 million to $133 million. And we expect non-GAAP operating margin of approximately 27% to 28% for Q4. Moving on to CapEx. We expect to spend $184 million to $192 million. This represents approximately 18% to 19% of our projected total revenue. The sequential increase in CapEx is primarily due to timing, as several projects were delayed from Q3 to Q4. Based on our expectations for revenue and costs, we expect Q4 non-GAAP EPS in the range of $1.49 to $1.56. This EPS guidance assumes taxes of $54 million to $57 million based on an estimated quarterly non-GAAP tax rate of approximately 19%. It also reflects a fully diluted share count of approximately 153 million shares. Looking ahead to the full year. We now expect revenue of $3.966 billion to $3.991 billion, which is up 4% to 5% year-over-year as reported and up 5% in constant currency. At current spot rates, our guidance assumes foreign exchange will have a negative $22 million impact on revenue in 2024 on a year-over-year basis. We expect security growth of approximately 15% to 17% in constant currency in 2024. Given the continued adoption of our enterprise compute solution, we are now increasing our overall expected compute revenue growth to the higher end of our prior guidance or approximately 25% in constant currency for the full year 2024. Moving to profitability. We are estimating non-GAAP operating margin of approximately 29% and non-GAAP earnings per diluted share of $6.31 to $6.38. Our non-GAAP earnings guidance is based on a non-GAAP effective tax rate of approximately 19% and a fully diluted share count of approximately 154 million shares. Finally, our full year CapEx is expected to be approximately 17% of total revenue. In conclusion, we are very pleased with our continued progress with our enterprise compute solutions and excited about the early returns for our recently introduced API solutions. Thank you. Tom and I are now happy to take your questions. Operator?"
},
{
"speaker": "Operator",
"text": "[Operator Instructions] And today's first question comes from Rishi Jaluria with RBC."
},
{
"speaker": "Rishi Jaluria",
"text": "Maybe, Tom, in your prepared remarks, you talked a little bit about some of the traction that you're having on the AI side, including with AI companies. Can you help us understand philosophically, how you're thinking about the role that GenAI could play in security on both sides of the equation, both from what happens? How you can leverage GenAI to make security offerings better but maybe more significantly, what does that do to attack surfaces and attack vectors, especially if GenAI is going to get in the hands of nefarious actors? And then I've got a quick follow-up."
},
{
"speaker": "Tom Leighton",
"text": "GenAI is already in the hands and being widely used by nefarious actors, and that's one reason why we're seeing a lot more attacks and penetrations. Probably, you've all seen the deepfakes very compelling but it's also used to generate the malware and train it to get around defenses. So it is increasing the need for defenses, defenses and depth. I think it's a big reason why you really need segmentation now and the Guardicore solution is doing so well. On our side of the house, we've been using AI and ML really forever in our security products. We use it for anomaly detection, bot detection. If it's a human logging into an account, making sure it's the right human and not somebody who stole credentials. We also use it to -- across the company really to be more efficient in the various operations we do. We're using it in -- already in two of our products, security products with GenAI as an interface. So it helps our customers manage their deployments of our security solution, gives them greater visibility. You can interface with your infrastructure and human language. Using our capabilities, you can ask what's that device there? Are the firewall rules up to date? You can ask questions like what do I need to do to bring my firewall rules within the last couple iterations so they're not too far out of date. And it answers and tells you. It's really very compelling and very interesting capabilities. So a lot of use of GenAI, I would say, at Akamai. Still early days. But unfortunately, the bad guys are using it too, very effectively."
},
{
"speaker": "Rishi Jaluria",
"text": "And then just quickly, Tom, you alluded to this in your prepared remarks, but obviously, seeing some higher profile shakeouts, including a long awaited bankruptcy of one of your long time competitors. Maybe help us understand both near term, long term, how we should be thinking about the impact on your business from consolidation? Maybe is there an opportunity for you to gain share of wallet, especially as the kind of stable player and leader in the space? And then longer term, with one less player that had been maybe aggressive on pricing, how do you think this shakes out in the overall pricing environment, specifically on the delivery side?"
},
{
"speaker": "Tom Leighton",
"text": "Yes, I think consolidation in the delivery market is long overdue. And you've seen a lot of companies operating at losses in part funded by private equity or Wall Street. And it just didn't make sense. These companies were never going to make money. You still see some of it out there today with companies that are just really struggling, offering pricing which for them, loses money. And so I do think it makes sense to have some consolidation. And you're right, we've seen -- there was Instart Logic, StackPath, Lumen all gone. Edgio, which is the combination of EdgeCast and Limelight and Chapter 11, we'll see how that works out. But I do think this shake out makes sense. And I do think long run, it helps lead to a stabilization of the delivery market. As we talked about, we are very careful with our pricing. And we do turn away business that we don't think makes sense for us. And sometimes, other companies will step in and take that, they'll lose money in the hopes of showing some revenue growth. But I think it's not sustainable for them to do that. And I think the shakeout may be the beginning of something very positive and will help the delivery business over the medium to longer term."
},
{
"speaker": "Operator",
"text": "And the next question comes from James Fish with Piper Sandler."
},
{
"speaker": "James Fish",
"text": "You made a comment about shifting investments here on the go-to-market to investing behind hunters as well as sales specialists as well as the channel. Can you just talk about what caused you to make the shift now rather than at year end? How to think about the mix of that investment between the direct and specialists against kind of the indirect approach with the channel?"
},
{
"speaker": "Tom Leighton",
"text": "I think we are really seeing good traction now. We already had traction, I would say, in Guardicore. But now with API security, we talked about achieving an ARR of $50 million at year end versus near zero last year. So we really, I think, proved that out and we're very excited about the future. And with compute, last year, we really weren't even selling enterprise compute. The platform just wasn't at that level. And this year, as we talked about, we are now beginning to sell it and seeing great traction to the point where we think that will be a $100 million ARR by the end of the year. So we've now, I think, proved it certainly to ourselves that this is worthy of more investment. Now at the same time, the new product areas are attracted to a much broader market of enterprises than our traditional leading products, which would be delivery and cloud WAF. And so there's a lot of enterprises and verticals that do use cloud computing, do need API security, do need enterprise security that works in the sweet spot for our traditional services. And so that says we do need to invest more in hunting now. We got to go after those accounts. And in addition, I think it's very helpful for us to have specialists, people that are really familiar with selling cloud computing and that will help our traction as we accelerate the growth there. So that's why we're doing it now and we didn't do it last year and why we're growing the resources there. And of course, these new products are also very channel friendly in ways that our traditional services weren't. Delivery in cloud WAF weren't just -- we had channel partners, but they weren't as friendly and as attractive. The new products, very attractive to the channel, and there's a real role for our channel partners to play. And of course with cloud computing, we've got a lot of ISVs now getting on the platform. So that's why we're making this investment now."
},
{
"speaker": "James Fish",
"text": "And maybe Ed, for you, as we think about the advanced security package changes that you guys made almost two years ago now. How penetrated is that across the security installed base, how much more room do we have to go with cross or upselling that unit? Trying to understand the year-to-date impact on security growth and anything as it pertains to the delivery impact as we think about those bundles."
},
{
"speaker": "Ed McGowan",
"text": "So we talked last quarter a lot about this as we had anniversaried the introduction of the package and had a pretty high penetration, obviously, especially with the -- early on with the early adopters of it. We're sort of the end of that at this point. So the way to think about it is you've got year-over-year compares that have us selling in both quarters."
},
{
"speaker": "Operator",
"text": "And our next question comes from Frank Louthan with Raymond James."
},
{
"speaker": "Frank Louthan",
"text": "Since you acquired the Lumen CDN last year, you're a little over a year ago, did you get any network elements with that? And is there any aspect of their new networks that they're building to support their AI partners that they're having conversations with you about, about implementing your capabilities and layering them on top of that network to help maybe deliver some of that AI traffic?"
},
{
"speaker": "Ed McGowan",
"text": "So with the Lumen acquisition, there was no acquisition of any assets aside from the customer contracts. So there was no network acquisitions. And as far as any partnership discussions we have with Lumen, we're not prepared to talk about anything but there's nothing specific to what you mentioned there."
},
{
"speaker": "Operator",
"text": "The next question comes from Fatima Boolani with Citigroup."
},
{
"speaker": "Unidentified Analyst",
"text": "This is Mark on for Fatima. Maybe just -- great to hear the momentum that you guys are seeing on compute, but maybe just on profitability. Why aren't we seeing maybe greater evidence of operating leverage given the compute outperformance, especially since the segment commands better relative gross profit characteristics to delivery, which is declining?"
},
{
"speaker": "Ed McGowan",
"text": "So we're still in the scaling up factor within the compute business, so we haven't reached scale yet. And you're right to think that once we get to a much larger scale, we should start to see better flow through. You'll see, hopefully, gross margins expand a little bit and operating margin expand. But we're still in the investment phase of the business and haven't reached scale yet."
},
{
"speaker": "Unidentified Analyst",
"text": "And maybe just a quick follow-on. How should we think about CapEx trajectory going through '25 from sort of the '24 70% level going forward?"
},
{
"speaker": "Ed McGowan",
"text": "So we're not going to provide guidance on this call for next year. But as we talked about -- last year was a pretty heavy investment year for CapEx related to building out some of the major data centers for compute. We don't anticipate anything like that going forward. But what I've said in the past is if we do see unusually large deals that come with more revenue, there may be some additional builds. But as we've talked about this CapEx level somewhere in this range is generally where we'd like to keep the business for now. Obviously, as compute gets bigger, that may change over time. But certainly, over the next couple of years, that's about the range we'd like to stay in."
},
{
"speaker": "Operator",
"text": "And our next question is from Rudy Kessinger with D.A. Davidson."
},
{
"speaker": "Rudy Kessinger",
"text": "Ed, I want to ask on delivery. It's basically implied in Q4 that delivery revenue is down 20%, 21% year-over-year by my math. I guess, it seems kind of hard to wrap my head around that if traffic is still growing. I know you're saying traffic growth is not as strong as you've seen in the past. But if traffic growth is still growing, just help us try to understand how delivery could be down over 20% year-over-year unless you're seeing much higher pricing pressure than you've seen in the past? And then as we think about going forward, maybe '25 is it fair to assume that delivery is at least a double digit decline going forward?"
},
{
"speaker": "Ed McGowan",
"text": "So a couple of things to think about here. So if you remember, last Q4 we had the Lumen and StackPath acquisitions. And during that time, when it entered into the transition services agreement, we had all of the contracts even though we had anticipated some of those would go away. So it's a really difficult compare, Q4. And in terms of traffic growth, it is growing very slowly. So at rates that we haven't seen in the 25 plus years we've been in this business, so it's growing very, very slow. Pricing is getting a little bit better. But even if you have 5%, 10% price declines and your traffic is growing in low single digits, you're not going to see growth, you're going to see contraction. So it's just been a weak traffic environment. Pricing, as I said, is getting a little bit better. But it takes a lot longer for that to work its way through the system and we get a tough compare. So those are the factors."
},
{
"speaker": "Rudy Kessinger",
"text": "And then on compute, maybe it's a around in you CapEx. It looks like maybe at the midpoint, if you use the percent you're giving for the full year, up about $40 million for this year. Correct me if my math is wrong there. But if it is accurate, it seems like a little bit of a step up with not much of a raise in the compute guide for this year if I back out the $7 million in onetime that you had for Q3?"
},
{
"speaker": "Ed McGowan",
"text": "Yes, it's about that, maybe just a little bit less shade less than that. But it's a combination of a bunch of things. It's not all compute. There's some compute in there. There's some related to delivery in terms of some of the places where we have outsized demand. So unfortunately, delivery demand isn't all in one place. It's not just one number, you have to build out in certain geos as you get demand in certain places. And there's also infrastructure services, infrastructure that we use to run the platform. And there's always some timing between quarters so a little bit slipped out of Q3 and a little bit came in from Q1. So I wouldn't read too much into it."
},
{
"speaker": "Operator",
"text": "And the next question is from Matt Dezort with Needham."
},
{
"speaker": "Matt Dezort",
"text": "I guess within compute, could you touch on some of the early use cases and verticals and how those are performing? Any cohort metrics you can offer, especially behind some of the observability in security and media customers you guys have talked about? And any other newer tips that you guys are seeing as driving more workloads to Connected Cloud?"
},
{
"speaker": "Tom Leighton",
"text": "Yes, I would say the sweet spot early on by design in terms of revenue is media workflow but we are seeing compute sales across really all verticals and including new customers. And just to give you an idea of the range of our ISV partners who -- customers will buy solutions from them or from us on our platform. There's a couple of database partners, observability widely being sold, live encoding, transcoding, video packaging, WebRTC for interactive video, digital asset management, optimization of video, game orchestration, fleet management, DRM, Kubernetes, connectivity and auto scaling, server side ad insertion, AI inferencing and API performance and testing. And that's just the list of different ISV partners. So we really are seeing a lot of use cases across multiple verticals with a sweet spot in media workflow. And at this point, we really have a very good ecosystem media workflow partners, which is starting, as we talked about in the prepared remarks, really being well received in terms of our media customer base. They're looking for better performance, distributed compute at a lower price point and we're really in a good position to provide that today."
},
{
"speaker": "Matt Dezort",
"text": "And as a quick follow-up. Can I ask about some of the security pieces excluding Guardicore and Noname? How did some of the larger pieces perform in 3Q across WAF? It sounds like DDoS was really strong, you touched on a number of wins there. Did that drive any incremental upside in the quarter? And how do you think about that triumvirate going forward?"
},
{
"speaker": "Ed McGowan",
"text": "So we saw pretty good strength across all different products, including -- you talked about Guardicore but even within the Zero Trust space, with our Enterprise Access product, we saw some pretty good growth there. We saw continued strong growth in WAF. We saw some acceleration in DDoS. You don't really get a big burst of revenue right away when you have attacks in a quarter. Typically, you sign up new customers and that revenue comes out over time. But it was pretty strong demand, pretty similar to what we saw in Q2 across the board."
},
{
"speaker": "Operator",
"text": "And the next question comes from Mark Murphy with JP Morgan."
},
{
"speaker": "Unidentified Analyst",
"text": "This is [Erdi Wu] on for Mark Murphy. I wanted to ask a question on compute as well. It's really good to see that momentum. I think you guys specifically called out adding customers at a strong rate and now kind of getting customers outside that sweet spot, which is very interesting to hear. So I guess my question is, is that kind of rate of addition of those customers a little bit more than you expected? And are you seeing these kind of non-sweet spot customers kind of come in earlier than you expected as well?"
},
{
"speaker": "Tom Leighton",
"text": "We're very encouraged with the adoption of our compute services, substantial increase in number of customers. And even though we planned and focused early on on the big media accounts that are already Akamai customers for using our platform, we're really seeing it across the base and a lot of new customers signing up, starting with compute that didn't use our pre-existing services. So we're very pleased to see the growth in compute. And of course, you've seen all year long as we've raised our targets for the year in terms of the enterprise compute revenue and the compute business as a whole."
},
{
"speaker": "Operator",
"text": "And this does conclude our question-and-answer session for today. I would now like to turn the conference back over to Mr. Mark Stoutenberg for any closing remarks."
},
{
"speaker": "Mark Stoutenberg",
"text": "Thank you, everyone. In closing, we will be attending several investor conferences throughout the rest of the quarter. We look forward to seeing you there. Again, thanks for joining us tonight. We hope you have a nice evening. Operator, you may now end the call."
},
{
"speaker": "Operator",
"text": "Thank you. The conference has now concluded. Thank you for attending today's presentation, and you may now disconnect."
}
] | Akamai Technologies, Inc. | 24,522 |
AKAM | 2 | 2,024 | 2024-08-08 16:30:00 | Operator: Good day and welcome to the Second Quarter 2024 Akamai Technologies Earnings Conference Call. All participants will be in listen-only mode. [Operator Instructions]. After today's presentation, there will be an opportunity to ask questions. [Operator instructions]. Please note this event is being recorded. I would now like to turn the conference over to Mark Stoutenberg, Head of Investor Relations. Please go ahead.
Mark Stoutenberg: Thank you, operator. Good afternoon, everyone, and thank you for joining Akamai's second quarter 2024 earnings call. Speaking today will be Tom Leighton, Akamai's Chief Executive Officer and Ed McGowan, Akamai's Chief Financial Officer. Please note that today's comments include forward-looking statements, including statements regarding revenue and earnings guidance. These forward-looking statements are subject to risks and uncertainties and involve a number of factors that could cause actual results to differ materially from those expressed or implied by such statements. The factors include any impact from macroeconomic trends, the integration of any acquisitions, and any impact from geopolitical developments. Additional information concerning these factors is contained in Akamai's filings with the SEC, including our Annual Report on Form 10-K and our Quarterly Reports on Form 10-Q. The forward-looking statements included in this call represent the company's view on August 8, 2024. Akamai disclaims any obligation to update these statements to reflect new information, future events, or circumstances, except as required by law. As a reminder, we will be referring to certain non-GAAP financial metrics today. A detailed reconciliation of GAAP and non-GAAP metrics can be found under the financial portion of the Investor Relations section of akamai.com. I will now hand the call off to our Co-Founder and CEO, Dr. Tom Leighton.
Tom Leighton: Thanks Mark. I'm pleased to report that in the second quarter, Akamai delivered continued strong momentum in compute, strong growth in our security portfolio, steady operating margins and healthy earnings growth on the bottom-line. Second quarter revenue grew to $980 million, up 5% year-over-year as reported and up 6% in constant currency. Non-GAAP operating margin was 29%. Non-GAAP earnings per share was $1.58, up 6% year-over-year and up 9% in constant currency. These results were in line with or above our guidance. Before I provide more color on our performance, I'd like to review how Akamai is evolving as we grow. As most of Akamai first made its name with the invention of content delivery services, and we're still the world's leader in that market today. We stand out for providing the scale and performance required by the world's top brands as we help them deliver reliable, secure and near flawless digital experiences. Recent examples include delivering the Euros football tournament and the summer games in Paris for top broadcasters around the world. As we've said in previous calls, our delivery business has been challenged in recent quarters by macroeconomic and geopolitical headwinds. Our plan for delivery is threefold. First, we will remain disciplined when it comes to the profitability of traffic that we choose to serve. Second, we will continue to leverage our market leadership position and installed base of major enterprises to generate cross selling opportunities. And third, we will continue to take steps to retain our market leadership while also reinvesting most of the cash flow from our delivery product line into the fast growing areas of the business. In Q2, delivery accounted for one third of our revenue, or $329 million. This is quite a change from five years ago when delivery accounted for two thirds of Akamai revenue. The diversification of our revenue across new markets through continuous innovation has long been a core part of Akamai's strategy for long-term profitable revenue growth. A little more than a decade ago, we expanded our business into security with the creation of web app firewall as a cloud service. We did this to meet what we recognized as a growing customer need in a way that was complementary to what Akamai was already doing for customers with delivery. The opportunity was clear to us because we listened to our customers. We created what has proved to be a very successful cloud service for web app firewall. And now, for the first time in Akamai history, security delivered the majority of Akamai's revenue, $499 million in Q2, up 15% year-over-year and up 16% in constant currency. This amounts to an annual run rate of about $2 billion per year. Of course, we greatly expanded our security product set over the years. We now offer market leading solutions for DDoS prevention, Bot management, account and content protection app and API security, and zero trust enterprise security led by our Guardicore segmentation solution. Customer interest in our security solutions is strong and we had many significant wins in Q2. One of the world's largest energy companies became a new zero trust customer with Akamai. One of the top three airlines in the US is moving from a Legacy VPN architecture to a zero trust architecture. With Akamai, we provided Akamai app and API protector to one of the largest providers of HR management software and services in the US and to German retailers Delife, Douglas, Wagner, and Zalando. EFAFLEX, the German maker of high speed industrial doors, purchased our segmentation solution, as did a major stock exchange and a leading cybersecurity company in Latin America. We provided DDoS protection to one of the largest banks in the world and to a government ministry in the Middle east and at one major electric utility in Southeast Asia. We replaced a well known competitor in a five year deal for our web app firewall, DDoS protection, Bot management, account, takeover prevention, and API security. We're especially excited about the most recent additions to our security portfolio. In Q2, we announced our new Akamai Guardicore platform, the first of its kind to enable zero trust security through a fully integrated combination of micro segmentation, zero trust network access, multi factor authentication, DNS firewall, and threat hunting. Its single agent and unified control console, powered by GenAI, are designed to strengthen and simplify enterprise security with broad visibility and granular controls. The new GenAI interface enables our customers operations teams to ask questions in a human language to gain information about their enterprise networks. The new Akamai Guardicore platform reflects our evolution as a security vendor, growing beyond point solutions to a broader and more comprehensive security offering. Customers tell us they want to consolidate security products and tools with vendors they can trust, and we think this will appeal to their needs. In Q2, we also closed the acquisition of no name security as we accelerate our momentum in the fast growing API security market. IDC forecasts this market will grow at a CAGR of 34% to nearly $1 billion by 2027. With no name, we believe that Akamai now has one of the most comprehensive API security solutions in the industry. Within two weeks of the close, Akamai offered no name customers our new Edge connector, an integration with Akamai web app and API protector that works with a click of a button. No name saw a significant increase in closed deals in Q2, including wins at some of the largest banks and insurance companies in North America and at leading software companies in Europe and Asia. We're also beginning to see a good up-sell motion with early no name adopters. For example, one of the largest US healthcare insurers more than doubled their no name contract in Q2 to over $1.7 million annually. About a decade after we entered the security market, we again expanded Akamai's future opportunity by developing a much broader offering in cloud computing. As many of Akamai has offered function as a service in our edge platform. For many years, this kind of edge computing has been used by thousands of our customers, and it is deeply integrated into our delivery and security services. But our customers asked for more. They wanted us to offer full stack cloud computing so that they could run their VMs and containers on the Akamai platform. And they wanted us to do it in a way that would be more efficient and less costly than comparable offerings provided by the hyperscalers. They wanted Akamai to do this because they were already delivering and securing their sites and apps on our platform. They liked our track record of reliability, and they knew they could trust Akamai to be a good partner. Many of them also liked the fact that we don't compete against them. Unlike the hyperscalers, adding cloud computing to our portfolio also makes good sense for Akamai. In addition to satisfying customer demand, we can reap the advantages from offering customers delivery, security and compute on the same platform. The synergies include improved performance, seamless integration and other operational efficiencies, bundling for cross selling and strong customer retention, increased margins for all of our services, deepening relationships with carrier networks, capacity to quickly detect and stop massive cyberattacks at the edge, unmatched visibility into enormous volumes of traffic and the security insights and threat intelligence that we gain as a result. If you step back and look at how the marketplace has evolved, you can see how the hyperscalers have worked to achieve a similar suite of offerings, although they've taken a different route to get there. They started with cloud computing and infrastructure as a service and then moved into security and delivery, validating our view that there is synergy in offering customers all three together. he hyperscalers also have a more centralized architecture, while Akamai has the world's most distributed cloud platform, with more than 4100 points of presence in over 700 cities across 130 countries. We believe that being more distributed provides customers with better performance, better economics and greater reliability. As we reported in our last earnings call, the initial response from customers to our new cloud offering has been very encouraging. The strong early momentum that we achieved in Q one continued in Q2, with compute revenue growing to $151 million, up 23% year-over-year and up 24% in constant currency. New compute customers added in Q2 include one of the world's best known media and entertainment brands based here in the US, the European cybersecurity company Sekoia.io, Clara Video, the video brand of the biggest Telco in Latin America, MwareTV, a technology platform for IPTV and OTT services and a cable satellite IPTV provider that reaches almost half the households in Australia. Customers are also leveraging our ISV partners, which we call qualified compute partners, to run low latency workloads on our compute platform. These include solutions for observability into workload behavior, cybersecurity and large scale events where the need to store very large sets of data makes Akamaya more attractive and cost effective option than competitors. Our media customers can now take advantage of a full suite of media workflow offerings on Akamai connected cloud, which provides valuable synergy with our delivery platform for more efficient image manipulation, decisioning and video transcoding. And with Akamai's latest qualified compute partner and customer Yospace, media companies around the globe can leverage their advanced ad tech and ad strategies at scale across the Akamai connected cloud. Customers are also building new apps on our platform where low latency data distribution and processing provides a better user experience for their customers at significantly reduced cost. One customer is training and testing the machine learning engines that power their security scanning product. Another is building an AI powered Chatbot application to improve their customer experience and streamline operations with intelligent, conversational customer engagement. Such AI powered applications are increasingly popular with recent advances in large language models. Akamai is also a very large user of our new cloud solution. As a result of migrating most of our own apps from the hyperscalers to Akamai connected cloud, we're seeing better performance and greatly reduce cost. In fact, we expect to reduce our spending on third party clouds to less than a third of what it would have been this year had we stayed on the hyperscalers, saving us well over $100 million in annual OpEx. It sure feels good not writing a nine figure check to your competitors every year, and this is a feeling that we look forward to providing to our large enterprise customers. In summary, Akamai has undergone a fundamental transformation. We transformed from a content delivery pioneer into the cloud company that powers and protects life online. Compute and security now generate two thirds of our revenue, and we believe that they provide Akamai with excellent potential for future growth and profitability. And we've achieved this transformation while successfully maintaining robust margins. Because both of our fast growing product areas, our large security portfolio, and our rapidly growing cloud computing portfolio, are built upon and enabled by the foundation of our business, our highly efficient and massively distributed delivery platform. Our near term operating margin goal remains 30%, and we see potential margin upside over time as the fast growing areas of the business expand our profitability. Looking back at the first half of 2024. We're pleased by our strong performance in security and compute. Looking ahead, we're very excited about our potential for future growth as we integrate noname and as our fast growing compute offerings continue to gain traction with customers. Now I'll turn the call over to Ed for more on our Q2 results and our outlook for Q3 and the full year. Ed?
Ed McGowan: Thank you Tom. Today I plan to review our Q2 results and then provide some color on our expectations for Q3 in the full year. Turning to our second quarter results, total revenue for the second quarter was $980 million, up 5% year-over-year as reported, and 6% in constant currency. Compute revenue was $151 million, up 23% year-over-year as reported, and 24% in constant currency. We continue to be very pleased with the level of enthusiasm in the market as more and more customers are leveraging our enterprise compute solutions. In particular, we are seeing a broad array of enterprise compute use cases including live transcoding, secure access, observability, object storage, real time log aggregation and insight spatial computing and deep learning AI models across many verticals including media, e-commerce, software and financial services. Moving to security revenue in the second quarter, security revenue was $499 million, up 15% year-over-year as reported, and 16% in constant currency. We're very pleased by the continued performance of our Guardicore Zero trust solution and highly encouraged by the traction we are seeing in our recently launched API security solution. It's worth noting that the no name transaction closed in late June and the revenue contribution in the second quarter was less than $1 million. Combined, compute and security revenue grew 17% year-over-year as reported, and 18% in constant currency, representing 66% of total revenue. Moving to delivery revenue was $329 million, which declined 13% year-over-year as reported, and 12% in constant currency. The decline in delivery revenue was primarily related to the revenue impacting items that I outlined last quarter and was in line with our expectations. International revenue was $471 million, up 3% year-over-year and up 5% in constant currency, representing 48% of total revenue in Q2, foreign exchange fluctuations had a negative impact on revenue of $5 million on a sequential basis and a negative $10 million impact on a year-over-year basis. Non-GAAP net income was $243 million, or $1.58 of earnings per diluted share, up 6% year-over-year and up 9% in constant currency, and our non-GAAP operating margin in Q2 was 29%. Moving now to cash and our use of capital as of June 30. Our cash, cash equivalents and marketable securities totaled approximately $1.9 billion during the second quarter. We spent approximately $128 million repurchasing approximately 1.4 million shares. We now have an aggregate of roughly $2.3 billion remaining in our share buyback authorizations. We also used approximately $450 million in cash in the second quarter for the acquisition of no name. As it relates to our use of capital, our intention remains the same to continue buying back shares over time, to offset dilution from employee equity programs, and to be opportunistic in both M&A and share repurchases. Before I provide our Q3 and updated full year 2024 guidance, I want to touch on some housekeeping items. First, regarding the close of the no name security acquisition, we expect this transaction to add approximately eight to $10 million of revenue in Q3, approximately $18 to $20 million in revenue for the full year 2024. We also expect it to be dilutive to non-GAAP EPS by approximately four to $0.05 for the full year 2024, and to be dilutive to non-GAAP operating margin by approximately 30 basis points to 40 basis points in 2024. As a reminder, our updated full year guidance includes the impact of the acquisition. Second, and specific to traffic, we expect a modest uptick in year-over-year traffic in Q3, primarily due to the Paris Summer Games. This event is expected to drive approximately three to $4 million of additional revenue in the third quarter, and while Q4 is typically our strongest quarter seasonally, we saw a more muted impact of that seasonality last year, and we expect to see a similar result this year. Third, the country of India recently announced plans to eliminate its digital service tax effective as of August 1, 2024. We are working with our tax advisors to determine the full impact of this tax change on our non-GAAP effective tax rate. Based on our initial assessment, we believe this could result in a small increase in our effective non-GAAP tax rate, and we have adjusted our guidance accordingly. Finally, the macroeconomic environment remains challenging and geopolitical tensions persist. Any negative developments could have a meaningful impact on our business. So with those factors in mind, I'll move to our Q3 guidance. For Q3, we're projecting revenue in the range of $988 million to $1.008 billion, or up 2% to 4% as reported, and 3% to 5% in constant currency over Q3 2023. At current spot rates, foreign exchange fluctuations are expected to have a positive $2 million impact on Q3 revenue compared to Q2 levels and a negative $5 million impact year-over-year. At these revenue levels, we expect cash gross margins of approximately 73%. Q3 non-GAAP operating expenses are projected to be $307 million to $312 billion. We expect Q3 EBITDA margin of approximately 42%. We expect non-GAAP depreciation expense to be between $129 million to $131 million and we expect non-GAAP operating margin of approximately 29% for Q3. Moving on to CapEx, we expect to spend $166 million to $174 million. This represents approximately 17% of our projected total revenue. Based on our expectations for revenue and costs, we expect Q3 non-GAAP EPs in the range of CPs. Guidance assumes taxes of $59 million to $60 million based on an estimated quarterly non-GAAP tax rate of approximately 19% to 20%. It also reflects a fully diluted share count of approximately 154 million shares. Looking ahead to the full year, we now expect revenue of which is up four to 5% year-over-year as reported, and up five to 6% in constant currency at current spot rates. Our guidance assumes foreign exchange will have a negative $20 million impact to revenue in 2024. On a year-over-year basis, we continue to expect security revenue growth of approximately 15% to 17% in constant currency in 2024, including the contribution from the acquisition of no name. And given the strong momentum and adoption from both new and existing enterprise compute customers, we now expect enterprise compute annualized revenue run rate to double from the $50 million we reported last quarter to over $100 million as we exit 2024. As a result, we are now increasing our overall expected compute revenue growth to approximately 23% to 25% in constant currency for the full year 2024. Moving to profitability, we estimate non-GAAP operating margin of approximately 29% and non-GAAP earnings per diluted share of our non-GAAP earnings guidance is based on non-GAAP effective tax rate of approximately 19% to 20% and a fully diluted share count of approximately 154 million shares. Finally, our full year CapEx is expected to be approximately 16% of total revenue. In closing, we are pleased with the traction we are seeing in enterprise compute and look forward to helping our customers migrate services to the Yakamai connected cloud. Thank you. Tom and I would now be happy to take your questions. Operator?
Operator: We will now begin the question-and-answer session. [Operator instructions]. The first question today comes from Patrick Colville with Scotiabank. Please go ahead.
Patrick Colville: Thank you so much for taking my question. Frank and Ed, really great to be part of the hack. My story I want to talk about the business makes shift. I mean, that's where you opened your prepared remarks. Specifically, I want to focus on compute. The $100 million revenue you just called out from Akamai connected cloud is really compelling and great to see that ramping. When might that hockey stick to become an even greater revenue base? What's the trajectory of Akamai connected cloud over the coming quarters? And if we think out beyond that?
Tom Leighton: Yes, great question. And I got to say, we were very pleased to see the rapid early adoption. that's a capability that we really just started selling in earnest this year. We had some very early adopters towards the end of last year. And, if we can get up to $100 million ARR by the end of the year, which we think we're going to do, that's great, for the first year of the product, and then we'll see where we are at the beginning. Next year, we'll give guidance in February for the year in compute, but we're very optimistic about strong growth in compute driven by the enterprise customers and our new capability. There's an enormous market there, obviously, and so we're really looking forward into tapping into that.
Patrick Colville: Very helpful. Thank you. I guess the second part of my question I want to ask about delivery this year. You've been very clear about the headwinds to the delivery business in 2024. I appreciate you might not want to give guidance beyond 2024, wondering whether the headwinds we're seeing right now are cyclical headwinds or are they structural in nature? Thank you.
Tom Leighton: Yes, I don't think what we're seeing today persists over the long term. traffic, I think, will grow, continue to grow maybe at a little bit of a slower rate, than it did certainly during the COVID times. But, delivery, I believe, is here to stay. We are intent on remaining the market leader by a good margin. It's a very profitable business for us. We're very careful about that. We're very efficient in what we do. And it's very synergistic, with our security web app firewall business and our emerging compute business. So I don't see these headwinds persisting over the long term. There are geopolitical considerations that we're worried about, for next year. But I don't think this is a long-term phenomenon. And in any case, given the very fast growth of our security and compute product lines, they've nearly trickled in revenue over the last five years. So now where they're two thirds of our revenue overall, I think the, what you see with delivery, with sometimes challenges, sometimes good, it has a lot less impact on the overall growth rate as we go forward. Ed, do you have anything you want to add to that?
Ed McGowan: No, I think you covered it well.
Operator: The next question comes from Keith Weiss with Morgan family. Please go ahead.
Keith Weiss: Excellent. Thank you guys for taking the question and congratulations on the solid quarter. And I wanted to ask you a little bit about kind of parsing out the guidance, particularly the full year guidance. If I'm doing my math right, the midpoint of the full year comes up by about $5 million for the full year. But we're adding or no names. It sounds like about $20 million in revenues for the full year. Is there a part of the equation that's coming down, a part of the business that you're getting more cautious on? That makes up that difference?
Ed McGowan: No, Keith? Yes. So we included no name in our guidance last quarter as well. So there's nothing that's changed. If anything, the business has gotten a little bit better. So our guidance has come up a bit to reflect that.
Keith Weiss: Got it, got it. And then on the expense side of the equation, the savings from moving sort of in house from the hyperscaler is $100 million is real savings. Congratulations on that. That's quite a feat. Tom, you talked about the ability to sort of start pushing that more into operating margins in the near future. Can you give us an indication of what near future means? 2025 near future, or are we thinking two or three years out or further?
Tom Leighton: Well, Yes, the saving, operating savings we're getting, as Ed said, we've been plowing that back into the business by and large so that we can invest in growth. There's more savings to come there, but we really get the upward pressure on margins, the beneficial tailwinds on margins as the mix shift continues. As we add compute customers, that is good margin for us. And it's accretive security as we add customers there, it's accretive. Now, as Ed noted that today with the new security products, initially they're dilutive, but as we grow the revenue there, every customer we add, every deal we sign improves margins. So that over time, 30% is our goal, we're very close to that today, but over time, we think we have good potential to grow beyond that.
Operator: The next question comes from John DiFucci with Guggenheim Securities. Please go ahead.
John DiFucci: Thank you. I have a question on Guardicore. So, segmentation broadly seems like it's becoming more relevant in the market. Customers are more accepting of it. It's no longer like a new thing, and it has been for a while, and you guys have been there, and you bought God of a couple of years ago, but frankly, it seems like an essential component to a zero trust environment. Not everybody has it. So can you talk a little bit more about how about this business, but really about your Akamai Guardicore Zero trust platform that you just launched a few months ago, and how that sort of fits in the ecosystem of some of an enterprise when they need to protect all their assets to establish that zero trust environment. Because it always seemed to me that this was essential, like I said, for zero trust. I guess if you can also, in addition to the technologies and what else it fits in with, can you also hit on your channel efforts regarding this platform? Because I know this is sold through the channel. I think, Ed, you said this before, but it seems like a really sophisticated solution. It's not just you're buying a firewall for somebody or something like that. If you can just talk a little bit about how. I know it's only, it's early, but how that's working through the channel?
Tom Leighton: Yes. I think you characterized it very well. Segmentation is essential, I mean you got to lock the doors in the windows as best you can, but now we're still gets in. And I think really the most important thing an enterprise can do is lock down everything inside and that means Guardicore. It means having your agent on every application on every device. And you're right, most enterprises don't have it. When you go back a few years, and I think the community of large really disfavored segmentation. And that's because the way it was done back then was really crude. You did it in hardware, it's very inflexible, hard to do. And at the end of the day, if you did it at all, you had giant segments which defeated the whole purpose. You weren't very secure because the malware would get in and wipe out an entire giant segment and you had a big problem. And Guardicore solved that problem through software, very easy to manipulate, make updates much more secure, fine green controls. And so it's been an education process for us in the marketplace. We viewed it as something that was going to be essential and that, I think, is proving out, as you noted. And of course, with the ransomware headlines and disasters, it's not surprising to see why people are waking up to what they really do need this. So now the next question is with the platform. And there, what we've done is combine the Guardicore, which is protecting inside app-to-app device-to-device communication with the employee device to internal applications. And so we've combined what's called North, South and East, West. Now again, you go back a few years ago, they were different buyers and treated differently. But then we were thinking back then, boy, it's going to make sense to put this all together and sure enough, we're now seeing customers say, "Hey, we want that on the same platform. We want a single agent, not 2 different agents and we got to deal with a single control panel so that the business logic can be applied to employee devices at the same way and the same time as it is to internal applications." And so that's what the Guardicore platform is all about. We actually also combine it with DNS firewall, multifactor authentication, threat-hunting capabilities so that you can tell when you've got now where it is, what's going on into a platform which customers are excited about. And I think it's important not to underestimate the importance of a single agent to do this because that's really important real estate. And the new control panel powered by Gen AI, it's actually pretty cool. You can converse in a human language, if you will, with your network infrastructure. You get much greater visibility probably much better compliance as a result, which means better security. Now your channel question, yes, Guardicore is all channel. And you're right, it is a sophisticated integration and deployment. It's not just like throw a firewall out there. And that's where the partners can really add value. And so in some cases, in many cases, the partner will derive even more revenue than Akamai will. And it's ongoing because you're growing your Guardicore, your segmentation footprint to include more applications and devices, and it's great for partners when they can add value and generate revenue. So it's a really good channel-friendly product. And of course, not easy to do per se, but a lot easier than the way segmentation used to be.
John DiFucci: And if I could, Tom, because that all makes a ton of sense to me. But it also raises the question, like, what are people -- what do they do? What are the alternatives? Like I'm familiar with Illumio and as another company, I've seen called Truxport but like you said, like people don't lot of enterprises don't even have segmentation implemented. So a lot of do, but a lot don't. And so what are the -- are there other things that we're just -- that I'm just missing like I don't know, is Palo buy the whole Palo platform. Are they just saying, you don't need it? Or we have something that kind of does it? Like I'm just trying to -- because the opportunity is just seems really big here?
Tom Leighton: No, I think it is a big opportunity. And very few, relatively speaking, enterprises have it today, the early adopters are the critical infrastructure companies because they really, really have to have it. And we do compete with Illumio. They're probably our leading competitor. We believe the Guardicore solution is a lot better. We actually have our own mini firewall in the Asia. We don't have to rely on the firewall in the OS, which sometimes won't be there, it might not be consistent. We can cover a lot of the legacy systems which that's important to enterprises to get more universal coverage. I think there is a ton of greenfield. And I wouldn't be there when one of the other competitors is talking about their platforms. They probably don't spend a lot of time talking about segmentation because they don't really have a solution for it.
Operator: The next question comes from Mark Murphy with JPMorgan. Please go ahead. Thank you very much.
Mark Murphy: Ed, what is your latest thinking on the FX headwind to the full year revenue forecast. I'm just curious if there's been any movement there from, I think, previously, you've been looking at that as, I believe, $40 million headwind.
Ed McGowan: Mark, yes, not much of a change. The dollar moved around quite a bit during the quarter, up and down, but it's pretty much exactly the same. So for the full year, it's about $40. I gave the guidance already in the quarter in terms of the impact quarter-over-quarter and for year-over-year, but it's still about the same, just around 40 for the full year.
Mark Murphy: Okay. And then, Tom, as a quick follow-up, you mentioned a pretty wide array of the workload types that you're seeing on your cloud computing platform. And you mentioned toward the end, deep learning and AI models. I'm wondering if you can double-click on that, for instance. What are the types of model? Are you seeing LLM, the text models or image models or something else? And is it possible to estimate what percentage of your cloud ARR might be relating to those newer types of AI workloads?
Tom Leighton: Yes. Great question. I would say today, AI workload is probably a small fraction of the ARR. I think over time, potential for growth there. As we talked about useful in security, applications, chatbots, tailoring content for commerce companies, ad targeting, recommendation engines. I would say that the models are smaller because they're more focused. The giant models sort of are used to learn everything, your chat GPT, you can ask it any question at all, have it try to be knowledgeable about everything. Those are giant models and we're not really targeting that business. But for our customer base, they tend to be a lot more focused on what they're trying to do. Maybe it's a commerce site, maybe it's an ad site, maybe it's a security company. And they don't need to learn the whole world to really provide value. In fact, we see that with our own solution with the Akamai Guardicore platform with the control interface, powered by Gen AI. Really, it's a very specific application, which means that you don't need the gigantic model to really provide the value. And that means it doesn't have to run on this giant suite of GPUs, it can run just great on our platform, which has GPUs but primarily CPU-based, which gives us much better ROI. And that works great for what our customers are looking to do in terms of their AI applications.
Operator: The next question comes from Madeline Brooks with Bank of America. Please go ahead.
Madeline Brooks: Hi team, thanks for taking my questions. I want to continue on the discussion of Connected Cloud and you mentioned some nice wins in enterprise outside of your traditional CDN customers. But I guess I just wanted to double click on that and kind of get a little bit of color. What are those customers for nonmedia, non-e-commerce. What are the use cases that those customers are finding from Connected Cloud? And if you could just help us break out to growth of those customers maybe versus growth of your more traditional customers? Are they growing around the same in terms of their adoption of Connected Cloud?
Tom Leighton: Yes, we're seeing growth both within the base and outside the base. I think, for example, with our qualified compute partner program with observability, a lot of companies need that to know what's going on with their applications. Security companies would need that. Now we also have a lot of media customers. And I would say that's probably the biggest segment today. We have, by design, a full media workflow ecosystem now supported through our QCP program on the platform and so a lot of media customers starting to take advantage of that. Outside of that, for example, OS and firmware patch storage, personalized waiting room experience, improved page performance with hints and so forth. We talked about with AI tailoring the site for a user based on what they've been doing so far. Real-time log aggregation and insights into your logs, observability, kinds of things. We even have a PBX, a telephone switching system running on it, 5G Internet gateway running on it. So it does broaden the base which is, I think, exciting for us in the future. But today, probably the biggest segment would be media.
Operator: The next question comes from Alex Henderson with Needham. Please go ahead.
Alex Henderson: Great. First off, I think congratulations to an order on the great results out of both security and out of the compute. And I wanted to focus a little bit on the compute side of the business because I think, ultimately, that's the area that needs to be proven out to the Street more than anything else. Can you talk a little bit about the mechanics around what portion of the customer base that's converting to compute is coming from internal? What portion of the compute are true new customers? How many -- how much of the growth is coming from existing customers that are increasing their upsell? Just kind of look at it as if it was a traditional stand-alone business and give us some of those critical metrics that go into analyzing the success of that business?
Tom Leighton: Yes. I'll take our first half and turn it over to Ed. And the answer will be pretty similar to the last question. I would say our biggest users and the biggest segment for compute today is our large media customers. And that's by design. And our -- a lot of our QCP, our Quality Compute Partners are media workflow companies. So that's sort of the biggest segment. I would say observability as a capability, a very large one as well, and that spans across all verticals and would include new customers. So we do have a bunch of customers in nontraditional Akamai verticals that are using compute. And I think over the longer run, that opens up a whole new market verticals for us. But the biggest chunk today would be existing Akamai media companies is the biggest. And Ed, do you want to add some color on that?
Ed McGowan: Yes, sure. Alex, so as Tom mentioned, we're seeing growth in both existing applications for stuff that's been on the platform for a while, but the bulk of the growth is actually coming from new customers. The new customer additions is growing very, very quickly. We broke out some numbers for you last quarter, and that continues to ramp very nicely. And we're seeing a significant increase in the pipeline. We are seeing some new customers come to the platform. And what's interesting is we're probably seeing more workloads and repeatable workloads in areas even -- Tom talked about media, but outside of media. And we're seeing customers that may be relatively small CEM customers are fairly large compute customers. So I'd say it's across the board where we're seeing the growth, but it's mostly from adding new customers to the mix and then they start to ramp.
Operator: The next question comes from Fatima Boolani with Citi. Please go ahead
Fatima Boolani: I wanted to be in on the delivery guidance and the expected performance in the back half. So appreciate you experienced a lot of the traffic degradation patterns in the first half. But I'm just curious why the trajectory of the business is actually worsening in the back half? And then I have a follow-up for Tom, please.
Ed McGowan: Yes, sure. So I talked a little bit about the expectations for Q4. Just based on what we're seeing now in terms of traffic growth and what we saw last year, we're not expecting the normal hockey stick to any significant degree like we've seen in prior years. And also keep in mind, we closed the transaction with StackPath and Lumen last year, and that's all delivery revenue. So that makes sure Q4 tougher comparison if you're looking at sort of year-over-year growth rates, that's going to skew your perspective a bit. And as we talked about on the last call, there were some dynamics going on with one of our larger social media customers. The good news there is we've got a good handle on that. That's sort of playing out as we expected. But as we talked about, those are the factors that as you put that into your model, why it may look like it's deteriorating a little bit. But I'd say the biggest issue is the fact that you're anniversary-ing the StackPath and move contribution from Q4 last year.
Fatima Boolani: That makes sense. That's very fair. And Tom, for you, I think you've been very constructive around the compute opportunity. There are so many specific examples of the momentum you've been garnering in the compute franchise. But taking a step back as a broader strategy question for you, as you think about scaling that franchise and have it becoming an even bigger part of the overall revenue story. How are you straddling this notion of not using compute as -- or essentially ensuring compute ends up being wallet share accretive against your base as opposed to potentially managing a situation in which the delivery franchise sort of bumps along and compute sort of plugging the hole? Just what are some of the mechanisms you have in place to continue to drive the actual wallet share growth and accretion within existing delivery customers from where you are extracting a lot of net new compute demand for now?
Tom Leighton: Yes. Compute is different than delivery. So it's not a situation where delivery revenue was going into compute. That's not the case here. And that compute opportunity is orders of magnitude bigger than the delivery opportunity. And so I think, over time, it becomes a much bigger business than delivery. And I think delivery does its thing and it's a very good business for us in terms of cash generation, in terms of cross-selling. And in terms of actually of the economics of the platform, so we can go out there and offer compute at and especially for chatty applications and applications where data is moving around at a much lower price point than the hyperscalers because we have the delivery platform, but it doesn't -- it's not a situation where it's plugging a hole in delivery. I think compute is a huge revenue growth driver for us in the future, independent of anything in delivery.
Operator: The next question comes from Jim Fish with Piper Sandler. Please go ahead
Unidentified Analyst: This is Quinton on for Jim Fish. Maybe touching on that first question there. A competitor in the space recently talked about pricing pressures from some of the largest medium customers getting worse over the past couple of months. Are you seeing those pricing trends in the market that's maybe driving some of that second half weakness alongside, obviously, the StackPath and Lumen impact? Or are you not really seeing these pressures given your decision to move away from these kind of lower margin delivery opportunities?
Ed McGowan: Quinton, this is Ed. As we talked about, we had some large renewals this year. So obviously, those we've been through all those, and there is certain pricing pressure there. I'd say it's nothing different than what we've traditionally seen in the marketplace. I wouldn't say that it's significantly worse. I think the issue is just not as much traffic growth. So as you reprice a customer, you tend to see significant traffic growth. So the revenue declines don't persist as long as they have in a situation like this. So I wouldn't say if anything has changed in terms of the trajectory of the pricing. It's always been very competitive, it always will be. So that's really not the issue. The issue is just we're not seeing the type of traffic growth that we normally see.
Unidentified Analyst: Yes. That's really helpful. And then obviously, it's still really early here with the Noname acquisition. But any update you can provide on the integration between Noname and your kind of existing Neosec API opportunity? And maybe how you balance that go-to-market of those two platforms and how you can kind of leverage a full suite to kind of grow the wallet here within a customer.
Tom Leighton: Yes, we are now going to market with Noname. And as I mentioned, within 2 weeks of the close, we had a fully integrated with Akamai products, existing Akamai products, in particular, our web app firewall where a lot of the APIs would go through that. So I would say we're basically integrated today. We have some Neosec customers who we are maintaining over time, that will evolve into the Noname product with some of the capabilities from Neosec, so we get the best of both worlds.
Ed McGowan: Yes. Just to add the -- just add the Noname acquisition came with a pretty sophisticated channel as well as a number of specialists. So we have both of those, so that's going to help drive some sales. And actually, from the minute we announced the close to when we closed or announced the deal ultimately closed, we saw a nice pickup in deals closed. So not no impact on the funnel and the teams already out there selling. So very excited about that. I think we've just enhanced our go-to-market capability as part of the acquisition.
Operator: The next question comes from Jonathan Ho with William Blair & Company. Please go ahead.
Jonathan Ho: Hi. Good afternoon. As you listen to customers and what they need or want from the compute side of things. Are there any core services or capabilities that you feel like you're missing or you're going to add pretty soon that are maybe potentially catalyst for even faster adoption?
Tom Leighton: I think probably the biggest difference today would be the size of the marketplace. Obviously, the hyperscalers have an enormous marketplace and we're getting started there. We're really excited that I think now we have a very competitive media workflow marketplace. I think we've got a very competitive observability marketplace. And that's something that we're going to be continuing to grow. We're also building out, as you know, our distributed compute capabilities so that we'll be in more locations than in many locations where the hyperscalers don't have a presence, which will give us an advantage in performance and also in countries where you've got data sovereignty laws. We'll be in a better position to handle that. But it's yes, it's ongoing. We're continuing to develop and improve the platform, including with storage, a lot of effort going on there too. So that's going to be -- that will be ongoing for the foreseeable future. But if you can tell from the results, we're in a position now, we can get out there and be selling it. And it's great to see the rapid early adoption.
Jonathan Ho: That makes a ton of sense. Just in terms of the delivery business, as we continue to see this decline as a percentage of revenue, it seems to be carrying the business in terms of margins. How concerned are you over deleveraging effects and CapEx efficiency as we see sort of the two sides of the business move in opposite directions?
Ed McGowan: Yes, I said it's not a huge concern there. The margins of the new products are very high gross margin products, so that will be helpful. Sure the compute business is a bit more capital intensive. But we've been able to drive down the CapEx of the core business and delivery pretty dramatically. So you're down low single digits as a percentage of revenue for that business. That will maintain as long as the delivery, as long as traffic is not growing significantly. And part of our strategy and being more selective of the type of peak traffic to average that we're taking on the platform is by design, is to make sure that we do maintain that efficiency as we're spending more CapEx in the compute business, and we're not taking on that sort of not as profitable peak to average type traffic so that we can maintain a low CapEx posture in the delivery business.
Operator: The next question comes from Tim Horan with Oppenheimer. Please go ahead
Timothy Horan: Kind of a few part question on cloud. Can you use your own platform? It sounds like you're moving a lot of legacy services on there to create kind of, you think, unique services for yourself and new services or improve legacy services on that platform. And then secondly, if you look at Microsoft, Google Cloud flare, they're kind of growing cloud in the 30% range. Do you think you can kind of get there? And are you kind of maybe CapEx constrained to do that? Or just maybe talk about how you can kind of get up to your peers there. And what do you have to do in the SMB market to hit that type of 30% growth?
Tom Leighton: Yes. On the first question, we have built capabilities for ourselves as part of our migration. So we're off of Snowflake and Data bricks which we had big spends there. Looking at over time, making our capabilities available to customers, again, a service that is more efficient, which I think is really important for customers. In terms of the growth rate, I would say that you want to compare the enterprise compute number, which we've talked about was a $50 million ARR at the end of Q1. We think that will more than double by the end of the year. That's sort of the number you want to look at that's comparable. We've got more in the overall compute number, but those are -- have products like image and video manager, legacy Akamai net storage, other kinds of things. which aren't as comparable for what you're looking at in terms of the hyperscaler growth. So if you focus on the enterprise compute, which is really going to be the growth driver for us, that's going in a very fast percentage now and, of course, on a much, much smaller number than the hyperscalers. Ed, do you have -- want to add to that?
Ed McGowan: No, I think that's exactly right. And that's something that, over time, as that number becomes more material, we'll start to break that out for folks to make it easy for you to see where that growth is coming from. But Tom is absolutely right. That's where the big market is. That's where we're seeing the explosive growth, and we see that we think that can continue. Obviously, the pipeline is growing. We're seeing a lot more use cases than we expected. I see a great participation from all of our reps across the world. It's not just one geo. So we're very excited about it.
Timothy Horan: And do you think you're capital constrained at all or product constrained at all in the enterprise there?
Ed McGowan: No, I don't think there's a capital constraint problem. I mean you could envision perhaps as a customer that may come to us with a big task where you may have to do some build out if it's in a particular concentrated geography. But we got a very strong balance sheet. We produce a ton of free cash flow. So there's no issue from a capital constraint perspective. I think we can grow this business to a significant size over time, and I don't think capital is a problem right now.
Operator: The next question comes from Rudy Kessinger with D.A. Davidson. Please go ahead.
Rudy Kessinger: Hey, great. Thanks for taking my questions on security. I guess in the second half, if I look at it adjusting out Noname, it looks like organic growth at constant currency is just about 11% to 12%. Obviously, it's been a slowdown versus the last several quarters. And in general, the security growth rate has kind of been pretty volatile over the last 5 to 6 quarters. Could you just give us the puts and takes on maybe some tough compares in the second half. I think you had some spike in DDoS strength last year. But also just going forward, just what's the kind of right growth range that we should expect out of the security business?
Ed McGowan: Yes, sure. So just in terms of some of the puts and takes, just remember, last year, in Q3, we had little over $6 million of license revenue, that's a couple of percentage points. So that's going to make your Q3 compare a little bit more challenging. The other thing to keep in mind, too, last year, we introduced some new security bundles for web app firewall that did phenomenally well. So we've anniversaried that, so that makes sure our compare is a little bit more challenging. And then between Guardicore and API security as they start to ramp, we think APIs going to ramp very, very quickly. It's just a smaller number. So as you've talked about, the growth has bounced around a little bit over time. That happens as you bring new products into the market and they start to ramp up, think about when we brought [ Batman ] manager to the market. It was a small product and then go to hundreds of millions of dollars. I think the same thing you'll see with Guardicore and API security.
Rudy Kessinger: Yes. Okay. And then on the delivery outlook, I guess, your -- I mean, fastly, I'll say it more directly, I mean, they certainly seem to indicate that outside, it was broader than just one social media customer has several large media customers that seem to be shifting traffic to lower-cost providers. It sounds like you guys aren't really seeing that dynamic or maybe it's not the year and it was already factored into the guide. Any comment on that?
Ed McGowan: Yes. No, we're not seeing a phenomenon of someone moving to low-cost providers. As a matter of fact, there's two less of them in the market today. So we're not seeing that. As I talked about earlier, we have a tough compare with a [indiscernible] Q4. And then we've just seen just a lower traffic year. Gaming has been unusually weak, video traffic isn't as robust as it normally is. That stuff happens from time to time, but we're not seeing a shift to low-cost providers or any new low-cost providers in the market.
Operator: Okay. The last question today comes from William Power with Baird.
Unidentified Analyst: This is Yan Samilton for Will. Ed, just going back to that more muted Q4 seasonality you're expecting for delivery again this year. If I remember correctly, last year, you were pointing to weaker trends in retail, including an uptick in bankruptcies there and then also weaker in terms of gaming. And now I know it's probably still a little early to forecast though, but is it those same verticals where you're expecting weaker traffic again this year that you're informing your expectation? Or is it some others or maybe it's more broad-based?
Ed McGowan: Yes. I'd say it's a combination of those two verticals. We've seen sort of over time the retail seasonal or to be less and less. Some of that has to do with the Zero overage product that we offer in the market. But just in general, it just hasn't been as robust as have been, say, 4 or 5 years ago. And then from gaming, yes, still weak. I haven't seen any major launches or we're not hearing anything from our customers that we leave me to believe that Q4 will be strong from that perspective. And then also, as I just talked about several times here, just traffic in general has been a bit sluggish from a growth perspective in general. So I don't see anything that tells me that, that's going to change going into Q4. So obviously, we've got a few months to go here before we get there. We'll update you when we talk again in November. But based on what I'm seeing today, just out of this worthwhile calling that out to folks as they build out their models.
Operator: This concludes our question-and-answer session. I would like to turn the conference back over to Mark Stoutenberg for closing remarks.
Mark Stoutenberg: Thank you, everyone. In closing, we will be presenting at several investor conferences throughout the rest of the quarter and the rest of the year. We look forward to seeing you with those. We hope everyone has a nice evening tonight. Operator, you may now end the call.
Operator: The conference has now concluded. Thank you for attending today's presentation. You may now disconnect. | [
{
"speaker": "Operator",
"text": "Good day and welcome to the Second Quarter 2024 Akamai Technologies Earnings Conference Call. All participants will be in listen-only mode. [Operator Instructions]. After today's presentation, there will be an opportunity to ask questions. [Operator instructions]. Please note this event is being recorded. I would now like to turn the conference over to Mark Stoutenberg, Head of Investor Relations. Please go ahead."
},
{
"speaker": "Mark Stoutenberg",
"text": "Thank you, operator. Good afternoon, everyone, and thank you for joining Akamai's second quarter 2024 earnings call. Speaking today will be Tom Leighton, Akamai's Chief Executive Officer and Ed McGowan, Akamai's Chief Financial Officer. Please note that today's comments include forward-looking statements, including statements regarding revenue and earnings guidance. These forward-looking statements are subject to risks and uncertainties and involve a number of factors that could cause actual results to differ materially from those expressed or implied by such statements. The factors include any impact from macroeconomic trends, the integration of any acquisitions, and any impact from geopolitical developments. Additional information concerning these factors is contained in Akamai's filings with the SEC, including our Annual Report on Form 10-K and our Quarterly Reports on Form 10-Q. The forward-looking statements included in this call represent the company's view on August 8, 2024. Akamai disclaims any obligation to update these statements to reflect new information, future events, or circumstances, except as required by law. As a reminder, we will be referring to certain non-GAAP financial metrics today. A detailed reconciliation of GAAP and non-GAAP metrics can be found under the financial portion of the Investor Relations section of akamai.com. I will now hand the call off to our Co-Founder and CEO, Dr. Tom Leighton."
},
{
"speaker": "Tom Leighton",
"text": "Thanks Mark. I'm pleased to report that in the second quarter, Akamai delivered continued strong momentum in compute, strong growth in our security portfolio, steady operating margins and healthy earnings growth on the bottom-line. Second quarter revenue grew to $980 million, up 5% year-over-year as reported and up 6% in constant currency. Non-GAAP operating margin was 29%. Non-GAAP earnings per share was $1.58, up 6% year-over-year and up 9% in constant currency. These results were in line with or above our guidance. Before I provide more color on our performance, I'd like to review how Akamai is evolving as we grow. As most of Akamai first made its name with the invention of content delivery services, and we're still the world's leader in that market today. We stand out for providing the scale and performance required by the world's top brands as we help them deliver reliable, secure and near flawless digital experiences. Recent examples include delivering the Euros football tournament and the summer games in Paris for top broadcasters around the world. As we've said in previous calls, our delivery business has been challenged in recent quarters by macroeconomic and geopolitical headwinds. Our plan for delivery is threefold. First, we will remain disciplined when it comes to the profitability of traffic that we choose to serve. Second, we will continue to leverage our market leadership position and installed base of major enterprises to generate cross selling opportunities. And third, we will continue to take steps to retain our market leadership while also reinvesting most of the cash flow from our delivery product line into the fast growing areas of the business. In Q2, delivery accounted for one third of our revenue, or $329 million. This is quite a change from five years ago when delivery accounted for two thirds of Akamai revenue. The diversification of our revenue across new markets through continuous innovation has long been a core part of Akamai's strategy for long-term profitable revenue growth. A little more than a decade ago, we expanded our business into security with the creation of web app firewall as a cloud service. We did this to meet what we recognized as a growing customer need in a way that was complementary to what Akamai was already doing for customers with delivery. The opportunity was clear to us because we listened to our customers. We created what has proved to be a very successful cloud service for web app firewall. And now, for the first time in Akamai history, security delivered the majority of Akamai's revenue, $499 million in Q2, up 15% year-over-year and up 16% in constant currency. This amounts to an annual run rate of about $2 billion per year. Of course, we greatly expanded our security product set over the years. We now offer market leading solutions for DDoS prevention, Bot management, account and content protection app and API security, and zero trust enterprise security led by our Guardicore segmentation solution. Customer interest in our security solutions is strong and we had many significant wins in Q2. One of the world's largest energy companies became a new zero trust customer with Akamai. One of the top three airlines in the US is moving from a Legacy VPN architecture to a zero trust architecture. With Akamai, we provided Akamai app and API protector to one of the largest providers of HR management software and services in the US and to German retailers Delife, Douglas, Wagner, and Zalando. EFAFLEX, the German maker of high speed industrial doors, purchased our segmentation solution, as did a major stock exchange and a leading cybersecurity company in Latin America. We provided DDoS protection to one of the largest banks in the world and to a government ministry in the Middle east and at one major electric utility in Southeast Asia. We replaced a well known competitor in a five year deal for our web app firewall, DDoS protection, Bot management, account, takeover prevention, and API security. We're especially excited about the most recent additions to our security portfolio. In Q2, we announced our new Akamai Guardicore platform, the first of its kind to enable zero trust security through a fully integrated combination of micro segmentation, zero trust network access, multi factor authentication, DNS firewall, and threat hunting. Its single agent and unified control console, powered by GenAI, are designed to strengthen and simplify enterprise security with broad visibility and granular controls. The new GenAI interface enables our customers operations teams to ask questions in a human language to gain information about their enterprise networks. The new Akamai Guardicore platform reflects our evolution as a security vendor, growing beyond point solutions to a broader and more comprehensive security offering. Customers tell us they want to consolidate security products and tools with vendors they can trust, and we think this will appeal to their needs. In Q2, we also closed the acquisition of no name security as we accelerate our momentum in the fast growing API security market. IDC forecasts this market will grow at a CAGR of 34% to nearly $1 billion by 2027. With no name, we believe that Akamai now has one of the most comprehensive API security solutions in the industry. Within two weeks of the close, Akamai offered no name customers our new Edge connector, an integration with Akamai web app and API protector that works with a click of a button. No name saw a significant increase in closed deals in Q2, including wins at some of the largest banks and insurance companies in North America and at leading software companies in Europe and Asia. We're also beginning to see a good up-sell motion with early no name adopters. For example, one of the largest US healthcare insurers more than doubled their no name contract in Q2 to over $1.7 million annually. About a decade after we entered the security market, we again expanded Akamai's future opportunity by developing a much broader offering in cloud computing. As many of Akamai has offered function as a service in our edge platform. For many years, this kind of edge computing has been used by thousands of our customers, and it is deeply integrated into our delivery and security services. But our customers asked for more. They wanted us to offer full stack cloud computing so that they could run their VMs and containers on the Akamai platform. And they wanted us to do it in a way that would be more efficient and less costly than comparable offerings provided by the hyperscalers. They wanted Akamai to do this because they were already delivering and securing their sites and apps on our platform. They liked our track record of reliability, and they knew they could trust Akamai to be a good partner. Many of them also liked the fact that we don't compete against them. Unlike the hyperscalers, adding cloud computing to our portfolio also makes good sense for Akamai. In addition to satisfying customer demand, we can reap the advantages from offering customers delivery, security and compute on the same platform. The synergies include improved performance, seamless integration and other operational efficiencies, bundling for cross selling and strong customer retention, increased margins for all of our services, deepening relationships with carrier networks, capacity to quickly detect and stop massive cyberattacks at the edge, unmatched visibility into enormous volumes of traffic and the security insights and threat intelligence that we gain as a result. If you step back and look at how the marketplace has evolved, you can see how the hyperscalers have worked to achieve a similar suite of offerings, although they've taken a different route to get there. They started with cloud computing and infrastructure as a service and then moved into security and delivery, validating our view that there is synergy in offering customers all three together. he hyperscalers also have a more centralized architecture, while Akamai has the world's most distributed cloud platform, with more than 4100 points of presence in over 700 cities across 130 countries. We believe that being more distributed provides customers with better performance, better economics and greater reliability. As we reported in our last earnings call, the initial response from customers to our new cloud offering has been very encouraging. The strong early momentum that we achieved in Q one continued in Q2, with compute revenue growing to $151 million, up 23% year-over-year and up 24% in constant currency. New compute customers added in Q2 include one of the world's best known media and entertainment brands based here in the US, the European cybersecurity company Sekoia.io, Clara Video, the video brand of the biggest Telco in Latin America, MwareTV, a technology platform for IPTV and OTT services and a cable satellite IPTV provider that reaches almost half the households in Australia. Customers are also leveraging our ISV partners, which we call qualified compute partners, to run low latency workloads on our compute platform. These include solutions for observability into workload behavior, cybersecurity and large scale events where the need to store very large sets of data makes Akamaya more attractive and cost effective option than competitors. Our media customers can now take advantage of a full suite of media workflow offerings on Akamai connected cloud, which provides valuable synergy with our delivery platform for more efficient image manipulation, decisioning and video transcoding. And with Akamai's latest qualified compute partner and customer Yospace, media companies around the globe can leverage their advanced ad tech and ad strategies at scale across the Akamai connected cloud. Customers are also building new apps on our platform where low latency data distribution and processing provides a better user experience for their customers at significantly reduced cost. One customer is training and testing the machine learning engines that power their security scanning product. Another is building an AI powered Chatbot application to improve their customer experience and streamline operations with intelligent, conversational customer engagement. Such AI powered applications are increasingly popular with recent advances in large language models. Akamai is also a very large user of our new cloud solution. As a result of migrating most of our own apps from the hyperscalers to Akamai connected cloud, we're seeing better performance and greatly reduce cost. In fact, we expect to reduce our spending on third party clouds to less than a third of what it would have been this year had we stayed on the hyperscalers, saving us well over $100 million in annual OpEx. It sure feels good not writing a nine figure check to your competitors every year, and this is a feeling that we look forward to providing to our large enterprise customers. In summary, Akamai has undergone a fundamental transformation. We transformed from a content delivery pioneer into the cloud company that powers and protects life online. Compute and security now generate two thirds of our revenue, and we believe that they provide Akamai with excellent potential for future growth and profitability. And we've achieved this transformation while successfully maintaining robust margins. Because both of our fast growing product areas, our large security portfolio, and our rapidly growing cloud computing portfolio, are built upon and enabled by the foundation of our business, our highly efficient and massively distributed delivery platform. Our near term operating margin goal remains 30%, and we see potential margin upside over time as the fast growing areas of the business expand our profitability. Looking back at the first half of 2024. We're pleased by our strong performance in security and compute. Looking ahead, we're very excited about our potential for future growth as we integrate noname and as our fast growing compute offerings continue to gain traction with customers. Now I'll turn the call over to Ed for more on our Q2 results and our outlook for Q3 and the full year. Ed?"
},
{
"speaker": "Ed McGowan",
"text": "Thank you Tom. Today I plan to review our Q2 results and then provide some color on our expectations for Q3 in the full year. Turning to our second quarter results, total revenue for the second quarter was $980 million, up 5% year-over-year as reported, and 6% in constant currency. Compute revenue was $151 million, up 23% year-over-year as reported, and 24% in constant currency. We continue to be very pleased with the level of enthusiasm in the market as more and more customers are leveraging our enterprise compute solutions. In particular, we are seeing a broad array of enterprise compute use cases including live transcoding, secure access, observability, object storage, real time log aggregation and insight spatial computing and deep learning AI models across many verticals including media, e-commerce, software and financial services. Moving to security revenue in the second quarter, security revenue was $499 million, up 15% year-over-year as reported, and 16% in constant currency. We're very pleased by the continued performance of our Guardicore Zero trust solution and highly encouraged by the traction we are seeing in our recently launched API security solution. It's worth noting that the no name transaction closed in late June and the revenue contribution in the second quarter was less than $1 million. Combined, compute and security revenue grew 17% year-over-year as reported, and 18% in constant currency, representing 66% of total revenue. Moving to delivery revenue was $329 million, which declined 13% year-over-year as reported, and 12% in constant currency. The decline in delivery revenue was primarily related to the revenue impacting items that I outlined last quarter and was in line with our expectations. International revenue was $471 million, up 3% year-over-year and up 5% in constant currency, representing 48% of total revenue in Q2, foreign exchange fluctuations had a negative impact on revenue of $5 million on a sequential basis and a negative $10 million impact on a year-over-year basis. Non-GAAP net income was $243 million, or $1.58 of earnings per diluted share, up 6% year-over-year and up 9% in constant currency, and our non-GAAP operating margin in Q2 was 29%. Moving now to cash and our use of capital as of June 30. Our cash, cash equivalents and marketable securities totaled approximately $1.9 billion during the second quarter. We spent approximately $128 million repurchasing approximately 1.4 million shares. We now have an aggregate of roughly $2.3 billion remaining in our share buyback authorizations. We also used approximately $450 million in cash in the second quarter for the acquisition of no name. As it relates to our use of capital, our intention remains the same to continue buying back shares over time, to offset dilution from employee equity programs, and to be opportunistic in both M&A and share repurchases. Before I provide our Q3 and updated full year 2024 guidance, I want to touch on some housekeeping items. First, regarding the close of the no name security acquisition, we expect this transaction to add approximately eight to $10 million of revenue in Q3, approximately $18 to $20 million in revenue for the full year 2024. We also expect it to be dilutive to non-GAAP EPS by approximately four to $0.05 for the full year 2024, and to be dilutive to non-GAAP operating margin by approximately 30 basis points to 40 basis points in 2024. As a reminder, our updated full year guidance includes the impact of the acquisition. Second, and specific to traffic, we expect a modest uptick in year-over-year traffic in Q3, primarily due to the Paris Summer Games. This event is expected to drive approximately three to $4 million of additional revenue in the third quarter, and while Q4 is typically our strongest quarter seasonally, we saw a more muted impact of that seasonality last year, and we expect to see a similar result this year. Third, the country of India recently announced plans to eliminate its digital service tax effective as of August 1, 2024. We are working with our tax advisors to determine the full impact of this tax change on our non-GAAP effective tax rate. Based on our initial assessment, we believe this could result in a small increase in our effective non-GAAP tax rate, and we have adjusted our guidance accordingly. Finally, the macroeconomic environment remains challenging and geopolitical tensions persist. Any negative developments could have a meaningful impact on our business. So with those factors in mind, I'll move to our Q3 guidance. For Q3, we're projecting revenue in the range of $988 million to $1.008 billion, or up 2% to 4% as reported, and 3% to 5% in constant currency over Q3 2023. At current spot rates, foreign exchange fluctuations are expected to have a positive $2 million impact on Q3 revenue compared to Q2 levels and a negative $5 million impact year-over-year. At these revenue levels, we expect cash gross margins of approximately 73%. Q3 non-GAAP operating expenses are projected to be $307 million to $312 billion. We expect Q3 EBITDA margin of approximately 42%. We expect non-GAAP depreciation expense to be between $129 million to $131 million and we expect non-GAAP operating margin of approximately 29% for Q3. Moving on to CapEx, we expect to spend $166 million to $174 million. This represents approximately 17% of our projected total revenue. Based on our expectations for revenue and costs, we expect Q3 non-GAAP EPs in the range of CPs. Guidance assumes taxes of $59 million to $60 million based on an estimated quarterly non-GAAP tax rate of approximately 19% to 20%. It also reflects a fully diluted share count of approximately 154 million shares. Looking ahead to the full year, we now expect revenue of which is up four to 5% year-over-year as reported, and up five to 6% in constant currency at current spot rates. Our guidance assumes foreign exchange will have a negative $20 million impact to revenue in 2024. On a year-over-year basis, we continue to expect security revenue growth of approximately 15% to 17% in constant currency in 2024, including the contribution from the acquisition of no name. And given the strong momentum and adoption from both new and existing enterprise compute customers, we now expect enterprise compute annualized revenue run rate to double from the $50 million we reported last quarter to over $100 million as we exit 2024. As a result, we are now increasing our overall expected compute revenue growth to approximately 23% to 25% in constant currency for the full year 2024. Moving to profitability, we estimate non-GAAP operating margin of approximately 29% and non-GAAP earnings per diluted share of our non-GAAP earnings guidance is based on non-GAAP effective tax rate of approximately 19% to 20% and a fully diluted share count of approximately 154 million shares. Finally, our full year CapEx is expected to be approximately 16% of total revenue. In closing, we are pleased with the traction we are seeing in enterprise compute and look forward to helping our customers migrate services to the Yakamai connected cloud. Thank you. Tom and I would now be happy to take your questions. Operator?"
},
{
"speaker": "Operator",
"text": "We will now begin the question-and-answer session. [Operator instructions]. The first question today comes from Patrick Colville with Scotiabank. Please go ahead."
},
{
"speaker": "Patrick Colville",
"text": "Thank you so much for taking my question. Frank and Ed, really great to be part of the hack. My story I want to talk about the business makes shift. I mean, that's where you opened your prepared remarks. Specifically, I want to focus on compute. The $100 million revenue you just called out from Akamai connected cloud is really compelling and great to see that ramping. When might that hockey stick to become an even greater revenue base? What's the trajectory of Akamai connected cloud over the coming quarters? And if we think out beyond that?"
},
{
"speaker": "Tom Leighton",
"text": "Yes, great question. And I got to say, we were very pleased to see the rapid early adoption. that's a capability that we really just started selling in earnest this year. We had some very early adopters towards the end of last year. And, if we can get up to $100 million ARR by the end of the year, which we think we're going to do, that's great, for the first year of the product, and then we'll see where we are at the beginning. Next year, we'll give guidance in February for the year in compute, but we're very optimistic about strong growth in compute driven by the enterprise customers and our new capability. There's an enormous market there, obviously, and so we're really looking forward into tapping into that."
},
{
"speaker": "Patrick Colville",
"text": "Very helpful. Thank you. I guess the second part of my question I want to ask about delivery this year. You've been very clear about the headwinds to the delivery business in 2024. I appreciate you might not want to give guidance beyond 2024, wondering whether the headwinds we're seeing right now are cyclical headwinds or are they structural in nature? Thank you."
},
{
"speaker": "Tom Leighton",
"text": "Yes, I don't think what we're seeing today persists over the long term. traffic, I think, will grow, continue to grow maybe at a little bit of a slower rate, than it did certainly during the COVID times. But, delivery, I believe, is here to stay. We are intent on remaining the market leader by a good margin. It's a very profitable business for us. We're very careful about that. We're very efficient in what we do. And it's very synergistic, with our security web app firewall business and our emerging compute business. So I don't see these headwinds persisting over the long term. There are geopolitical considerations that we're worried about, for next year. But I don't think this is a long-term phenomenon. And in any case, given the very fast growth of our security and compute product lines, they've nearly trickled in revenue over the last five years. So now where they're two thirds of our revenue overall, I think the, what you see with delivery, with sometimes challenges, sometimes good, it has a lot less impact on the overall growth rate as we go forward. Ed, do you have anything you want to add to that?"
},
{
"speaker": "Ed McGowan",
"text": "No, I think you covered it well."
},
{
"speaker": "Operator",
"text": "The next question comes from Keith Weiss with Morgan family. Please go ahead."
},
{
"speaker": "Keith Weiss",
"text": "Excellent. Thank you guys for taking the question and congratulations on the solid quarter. And I wanted to ask you a little bit about kind of parsing out the guidance, particularly the full year guidance. If I'm doing my math right, the midpoint of the full year comes up by about $5 million for the full year. But we're adding or no names. It sounds like about $20 million in revenues for the full year. Is there a part of the equation that's coming down, a part of the business that you're getting more cautious on? That makes up that difference?"
},
{
"speaker": "Ed McGowan",
"text": "No, Keith? Yes. So we included no name in our guidance last quarter as well. So there's nothing that's changed. If anything, the business has gotten a little bit better. So our guidance has come up a bit to reflect that."
},
{
"speaker": "Keith Weiss",
"text": "Got it, got it. And then on the expense side of the equation, the savings from moving sort of in house from the hyperscaler is $100 million is real savings. Congratulations on that. That's quite a feat. Tom, you talked about the ability to sort of start pushing that more into operating margins in the near future. Can you give us an indication of what near future means? 2025 near future, or are we thinking two or three years out or further?"
},
{
"speaker": "Tom Leighton",
"text": "Well, Yes, the saving, operating savings we're getting, as Ed said, we've been plowing that back into the business by and large so that we can invest in growth. There's more savings to come there, but we really get the upward pressure on margins, the beneficial tailwinds on margins as the mix shift continues. As we add compute customers, that is good margin for us. And it's accretive security as we add customers there, it's accretive. Now, as Ed noted that today with the new security products, initially they're dilutive, but as we grow the revenue there, every customer we add, every deal we sign improves margins. So that over time, 30% is our goal, we're very close to that today, but over time, we think we have good potential to grow beyond that."
},
{
"speaker": "Operator",
"text": "The next question comes from John DiFucci with Guggenheim Securities. Please go ahead."
},
{
"speaker": "John DiFucci",
"text": "Thank you. I have a question on Guardicore. So, segmentation broadly seems like it's becoming more relevant in the market. Customers are more accepting of it. It's no longer like a new thing, and it has been for a while, and you guys have been there, and you bought God of a couple of years ago, but frankly, it seems like an essential component to a zero trust environment. Not everybody has it. So can you talk a little bit more about how about this business, but really about your Akamai Guardicore Zero trust platform that you just launched a few months ago, and how that sort of fits in the ecosystem of some of an enterprise when they need to protect all their assets to establish that zero trust environment. Because it always seemed to me that this was essential, like I said, for zero trust. I guess if you can also, in addition to the technologies and what else it fits in with, can you also hit on your channel efforts regarding this platform? Because I know this is sold through the channel. I think, Ed, you said this before, but it seems like a really sophisticated solution. It's not just you're buying a firewall for somebody or something like that. If you can just talk a little bit about how. I know it's only, it's early, but how that's working through the channel?"
},
{
"speaker": "Tom Leighton",
"text": "Yes. I think you characterized it very well. Segmentation is essential, I mean you got to lock the doors in the windows as best you can, but now we're still gets in. And I think really the most important thing an enterprise can do is lock down everything inside and that means Guardicore. It means having your agent on every application on every device. And you're right, most enterprises don't have it. When you go back a few years, and I think the community of large really disfavored segmentation. And that's because the way it was done back then was really crude. You did it in hardware, it's very inflexible, hard to do. And at the end of the day, if you did it at all, you had giant segments which defeated the whole purpose. You weren't very secure because the malware would get in and wipe out an entire giant segment and you had a big problem. And Guardicore solved that problem through software, very easy to manipulate, make updates much more secure, fine green controls. And so it's been an education process for us in the marketplace. We viewed it as something that was going to be essential and that, I think, is proving out, as you noted. And of course, with the ransomware headlines and disasters, it's not surprising to see why people are waking up to what they really do need this. So now the next question is with the platform. And there, what we've done is combine the Guardicore, which is protecting inside app-to-app device-to-device communication with the employee device to internal applications. And so we've combined what's called North, South and East, West. Now again, you go back a few years ago, they were different buyers and treated differently. But then we were thinking back then, boy, it's going to make sense to put this all together and sure enough, we're now seeing customers say, \"Hey, we want that on the same platform. We want a single agent, not 2 different agents and we got to deal with a single control panel so that the business logic can be applied to employee devices at the same way and the same time as it is to internal applications.\" And so that's what the Guardicore platform is all about. We actually also combine it with DNS firewall, multifactor authentication, threat-hunting capabilities so that you can tell when you've got now where it is, what's going on into a platform which customers are excited about. And I think it's important not to underestimate the importance of a single agent to do this because that's really important real estate. And the new control panel powered by Gen AI, it's actually pretty cool. You can converse in a human language, if you will, with your network infrastructure. You get much greater visibility probably much better compliance as a result, which means better security. Now your channel question, yes, Guardicore is all channel. And you're right, it is a sophisticated integration and deployment. It's not just like throw a firewall out there. And that's where the partners can really add value. And so in some cases, in many cases, the partner will derive even more revenue than Akamai will. And it's ongoing because you're growing your Guardicore, your segmentation footprint to include more applications and devices, and it's great for partners when they can add value and generate revenue. So it's a really good channel-friendly product. And of course, not easy to do per se, but a lot easier than the way segmentation used to be."
},
{
"speaker": "John DiFucci",
"text": "And if I could, Tom, because that all makes a ton of sense to me. But it also raises the question, like, what are people -- what do they do? What are the alternatives? Like I'm familiar with Illumio and as another company, I've seen called Truxport but like you said, like people don't lot of enterprises don't even have segmentation implemented. So a lot of do, but a lot don't. And so what are the -- are there other things that we're just -- that I'm just missing like I don't know, is Palo buy the whole Palo platform. Are they just saying, you don't need it? Or we have something that kind of does it? Like I'm just trying to -- because the opportunity is just seems really big here?"
},
{
"speaker": "Tom Leighton",
"text": "No, I think it is a big opportunity. And very few, relatively speaking, enterprises have it today, the early adopters are the critical infrastructure companies because they really, really have to have it. And we do compete with Illumio. They're probably our leading competitor. We believe the Guardicore solution is a lot better. We actually have our own mini firewall in the Asia. We don't have to rely on the firewall in the OS, which sometimes won't be there, it might not be consistent. We can cover a lot of the legacy systems which that's important to enterprises to get more universal coverage. I think there is a ton of greenfield. And I wouldn't be there when one of the other competitors is talking about their platforms. They probably don't spend a lot of time talking about segmentation because they don't really have a solution for it."
},
{
"speaker": "Operator",
"text": "The next question comes from Mark Murphy with JPMorgan. Please go ahead. Thank you very much."
},
{
"speaker": "Mark Murphy",
"text": "Ed, what is your latest thinking on the FX headwind to the full year revenue forecast. I'm just curious if there's been any movement there from, I think, previously, you've been looking at that as, I believe, $40 million headwind."
},
{
"speaker": "Ed McGowan",
"text": "Mark, yes, not much of a change. The dollar moved around quite a bit during the quarter, up and down, but it's pretty much exactly the same. So for the full year, it's about $40. I gave the guidance already in the quarter in terms of the impact quarter-over-quarter and for year-over-year, but it's still about the same, just around 40 for the full year."
},
{
"speaker": "Mark Murphy",
"text": "Okay. And then, Tom, as a quick follow-up, you mentioned a pretty wide array of the workload types that you're seeing on your cloud computing platform. And you mentioned toward the end, deep learning and AI models. I'm wondering if you can double-click on that, for instance. What are the types of model? Are you seeing LLM, the text models or image models or something else? And is it possible to estimate what percentage of your cloud ARR might be relating to those newer types of AI workloads?"
},
{
"speaker": "Tom Leighton",
"text": "Yes. Great question. I would say today, AI workload is probably a small fraction of the ARR. I think over time, potential for growth there. As we talked about useful in security, applications, chatbots, tailoring content for commerce companies, ad targeting, recommendation engines. I would say that the models are smaller because they're more focused. The giant models sort of are used to learn everything, your chat GPT, you can ask it any question at all, have it try to be knowledgeable about everything. Those are giant models and we're not really targeting that business. But for our customer base, they tend to be a lot more focused on what they're trying to do. Maybe it's a commerce site, maybe it's an ad site, maybe it's a security company. And they don't need to learn the whole world to really provide value. In fact, we see that with our own solution with the Akamai Guardicore platform with the control interface, powered by Gen AI. Really, it's a very specific application, which means that you don't need the gigantic model to really provide the value. And that means it doesn't have to run on this giant suite of GPUs, it can run just great on our platform, which has GPUs but primarily CPU-based, which gives us much better ROI. And that works great for what our customers are looking to do in terms of their AI applications."
},
{
"speaker": "Operator",
"text": "The next question comes from Madeline Brooks with Bank of America. Please go ahead."
},
{
"speaker": "Madeline Brooks",
"text": "Hi team, thanks for taking my questions. I want to continue on the discussion of Connected Cloud and you mentioned some nice wins in enterprise outside of your traditional CDN customers. But I guess I just wanted to double click on that and kind of get a little bit of color. What are those customers for nonmedia, non-e-commerce. What are the use cases that those customers are finding from Connected Cloud? And if you could just help us break out to growth of those customers maybe versus growth of your more traditional customers? Are they growing around the same in terms of their adoption of Connected Cloud?"
},
{
"speaker": "Tom Leighton",
"text": "Yes, we're seeing growth both within the base and outside the base. I think, for example, with our qualified compute partner program with observability, a lot of companies need that to know what's going on with their applications. Security companies would need that. Now we also have a lot of media customers. And I would say that's probably the biggest segment today. We have, by design, a full media workflow ecosystem now supported through our QCP program on the platform and so a lot of media customers starting to take advantage of that. Outside of that, for example, OS and firmware patch storage, personalized waiting room experience, improved page performance with hints and so forth. We talked about with AI tailoring the site for a user based on what they've been doing so far. Real-time log aggregation and insights into your logs, observability, kinds of things. We even have a PBX, a telephone switching system running on it, 5G Internet gateway running on it. So it does broaden the base which is, I think, exciting for us in the future. But today, probably the biggest segment would be media."
},
{
"speaker": "Operator",
"text": "The next question comes from Alex Henderson with Needham. Please go ahead."
},
{
"speaker": "Alex Henderson",
"text": "Great. First off, I think congratulations to an order on the great results out of both security and out of the compute. And I wanted to focus a little bit on the compute side of the business because I think, ultimately, that's the area that needs to be proven out to the Street more than anything else. Can you talk a little bit about the mechanics around what portion of the customer base that's converting to compute is coming from internal? What portion of the compute are true new customers? How many -- how much of the growth is coming from existing customers that are increasing their upsell? Just kind of look at it as if it was a traditional stand-alone business and give us some of those critical metrics that go into analyzing the success of that business?"
},
{
"speaker": "Tom Leighton",
"text": "Yes. I'll take our first half and turn it over to Ed. And the answer will be pretty similar to the last question. I would say our biggest users and the biggest segment for compute today is our large media customers. And that's by design. And our -- a lot of our QCP, our Quality Compute Partners are media workflow companies. So that's sort of the biggest segment. I would say observability as a capability, a very large one as well, and that spans across all verticals and would include new customers. So we do have a bunch of customers in nontraditional Akamai verticals that are using compute. And I think over the longer run, that opens up a whole new market verticals for us. But the biggest chunk today would be existing Akamai media companies is the biggest. And Ed, do you want to add some color on that?"
},
{
"speaker": "Ed McGowan",
"text": "Yes, sure. Alex, so as Tom mentioned, we're seeing growth in both existing applications for stuff that's been on the platform for a while, but the bulk of the growth is actually coming from new customers. The new customer additions is growing very, very quickly. We broke out some numbers for you last quarter, and that continues to ramp very nicely. And we're seeing a significant increase in the pipeline. We are seeing some new customers come to the platform. And what's interesting is we're probably seeing more workloads and repeatable workloads in areas even -- Tom talked about media, but outside of media. And we're seeing customers that may be relatively small CEM customers are fairly large compute customers. So I'd say it's across the board where we're seeing the growth, but it's mostly from adding new customers to the mix and then they start to ramp."
},
{
"speaker": "Operator",
"text": "The next question comes from Fatima Boolani with Citi. Please go ahead"
},
{
"speaker": "Fatima Boolani",
"text": "I wanted to be in on the delivery guidance and the expected performance in the back half. So appreciate you experienced a lot of the traffic degradation patterns in the first half. But I'm just curious why the trajectory of the business is actually worsening in the back half? And then I have a follow-up for Tom, please."
},
{
"speaker": "Ed McGowan",
"text": "Yes, sure. So I talked a little bit about the expectations for Q4. Just based on what we're seeing now in terms of traffic growth and what we saw last year, we're not expecting the normal hockey stick to any significant degree like we've seen in prior years. And also keep in mind, we closed the transaction with StackPath and Lumen last year, and that's all delivery revenue. So that makes sure Q4 tougher comparison if you're looking at sort of year-over-year growth rates, that's going to skew your perspective a bit. And as we talked about on the last call, there were some dynamics going on with one of our larger social media customers. The good news there is we've got a good handle on that. That's sort of playing out as we expected. But as we talked about, those are the factors that as you put that into your model, why it may look like it's deteriorating a little bit. But I'd say the biggest issue is the fact that you're anniversary-ing the StackPath and move contribution from Q4 last year."
},
{
"speaker": "Fatima Boolani",
"text": "That makes sense. That's very fair. And Tom, for you, I think you've been very constructive around the compute opportunity. There are so many specific examples of the momentum you've been garnering in the compute franchise. But taking a step back as a broader strategy question for you, as you think about scaling that franchise and have it becoming an even bigger part of the overall revenue story. How are you straddling this notion of not using compute as -- or essentially ensuring compute ends up being wallet share accretive against your base as opposed to potentially managing a situation in which the delivery franchise sort of bumps along and compute sort of plugging the hole? Just what are some of the mechanisms you have in place to continue to drive the actual wallet share growth and accretion within existing delivery customers from where you are extracting a lot of net new compute demand for now?"
},
{
"speaker": "Tom Leighton",
"text": "Yes. Compute is different than delivery. So it's not a situation where delivery revenue was going into compute. That's not the case here. And that compute opportunity is orders of magnitude bigger than the delivery opportunity. And so I think, over time, it becomes a much bigger business than delivery. And I think delivery does its thing and it's a very good business for us in terms of cash generation, in terms of cross-selling. And in terms of actually of the economics of the platform, so we can go out there and offer compute at and especially for chatty applications and applications where data is moving around at a much lower price point than the hyperscalers because we have the delivery platform, but it doesn't -- it's not a situation where it's plugging a hole in delivery. I think compute is a huge revenue growth driver for us in the future, independent of anything in delivery."
},
{
"speaker": "Operator",
"text": "The next question comes from Jim Fish with Piper Sandler. Please go ahead"
},
{
"speaker": "Unidentified Analyst",
"text": "This is Quinton on for Jim Fish. Maybe touching on that first question there. A competitor in the space recently talked about pricing pressures from some of the largest medium customers getting worse over the past couple of months. Are you seeing those pricing trends in the market that's maybe driving some of that second half weakness alongside, obviously, the StackPath and Lumen impact? Or are you not really seeing these pressures given your decision to move away from these kind of lower margin delivery opportunities?"
},
{
"speaker": "Ed McGowan",
"text": "Quinton, this is Ed. As we talked about, we had some large renewals this year. So obviously, those we've been through all those, and there is certain pricing pressure there. I'd say it's nothing different than what we've traditionally seen in the marketplace. I wouldn't say that it's significantly worse. I think the issue is just not as much traffic growth. So as you reprice a customer, you tend to see significant traffic growth. So the revenue declines don't persist as long as they have in a situation like this. So I wouldn't say if anything has changed in terms of the trajectory of the pricing. It's always been very competitive, it always will be. So that's really not the issue. The issue is just we're not seeing the type of traffic growth that we normally see."
},
{
"speaker": "Unidentified Analyst",
"text": "Yes. That's really helpful. And then obviously, it's still really early here with the Noname acquisition. But any update you can provide on the integration between Noname and your kind of existing Neosec API opportunity? And maybe how you balance that go-to-market of those two platforms and how you can kind of leverage a full suite to kind of grow the wallet here within a customer."
},
{
"speaker": "Tom Leighton",
"text": "Yes, we are now going to market with Noname. And as I mentioned, within 2 weeks of the close, we had a fully integrated with Akamai products, existing Akamai products, in particular, our web app firewall where a lot of the APIs would go through that. So I would say we're basically integrated today. We have some Neosec customers who we are maintaining over time, that will evolve into the Noname product with some of the capabilities from Neosec, so we get the best of both worlds."
},
{
"speaker": "Ed McGowan",
"text": "Yes. Just to add the -- just add the Noname acquisition came with a pretty sophisticated channel as well as a number of specialists. So we have both of those, so that's going to help drive some sales. And actually, from the minute we announced the close to when we closed or announced the deal ultimately closed, we saw a nice pickup in deals closed. So not no impact on the funnel and the teams already out there selling. So very excited about that. I think we've just enhanced our go-to-market capability as part of the acquisition."
},
{
"speaker": "Operator",
"text": "The next question comes from Jonathan Ho with William Blair & Company. Please go ahead."
},
{
"speaker": "Jonathan Ho",
"text": "Hi. Good afternoon. As you listen to customers and what they need or want from the compute side of things. Are there any core services or capabilities that you feel like you're missing or you're going to add pretty soon that are maybe potentially catalyst for even faster adoption?"
},
{
"speaker": "Tom Leighton",
"text": "I think probably the biggest difference today would be the size of the marketplace. Obviously, the hyperscalers have an enormous marketplace and we're getting started there. We're really excited that I think now we have a very competitive media workflow marketplace. I think we've got a very competitive observability marketplace. And that's something that we're going to be continuing to grow. We're also building out, as you know, our distributed compute capabilities so that we'll be in more locations than in many locations where the hyperscalers don't have a presence, which will give us an advantage in performance and also in countries where you've got data sovereignty laws. We'll be in a better position to handle that. But it's yes, it's ongoing. We're continuing to develop and improve the platform, including with storage, a lot of effort going on there too. So that's going to be -- that will be ongoing for the foreseeable future. But if you can tell from the results, we're in a position now, we can get out there and be selling it. And it's great to see the rapid early adoption."
},
{
"speaker": "Jonathan Ho",
"text": "That makes a ton of sense. Just in terms of the delivery business, as we continue to see this decline as a percentage of revenue, it seems to be carrying the business in terms of margins. How concerned are you over deleveraging effects and CapEx efficiency as we see sort of the two sides of the business move in opposite directions?"
},
{
"speaker": "Ed McGowan",
"text": "Yes, I said it's not a huge concern there. The margins of the new products are very high gross margin products, so that will be helpful. Sure the compute business is a bit more capital intensive. But we've been able to drive down the CapEx of the core business and delivery pretty dramatically. So you're down low single digits as a percentage of revenue for that business. That will maintain as long as the delivery, as long as traffic is not growing significantly. And part of our strategy and being more selective of the type of peak traffic to average that we're taking on the platform is by design, is to make sure that we do maintain that efficiency as we're spending more CapEx in the compute business, and we're not taking on that sort of not as profitable peak to average type traffic so that we can maintain a low CapEx posture in the delivery business."
},
{
"speaker": "Operator",
"text": "The next question comes from Tim Horan with Oppenheimer. Please go ahead"
},
{
"speaker": "Timothy Horan",
"text": "Kind of a few part question on cloud. Can you use your own platform? It sounds like you're moving a lot of legacy services on there to create kind of, you think, unique services for yourself and new services or improve legacy services on that platform. And then secondly, if you look at Microsoft, Google Cloud flare, they're kind of growing cloud in the 30% range. Do you think you can kind of get there? And are you kind of maybe CapEx constrained to do that? Or just maybe talk about how you can kind of get up to your peers there. And what do you have to do in the SMB market to hit that type of 30% growth?"
},
{
"speaker": "Tom Leighton",
"text": "Yes. On the first question, we have built capabilities for ourselves as part of our migration. So we're off of Snowflake and Data bricks which we had big spends there. Looking at over time, making our capabilities available to customers, again, a service that is more efficient, which I think is really important for customers. In terms of the growth rate, I would say that you want to compare the enterprise compute number, which we've talked about was a $50 million ARR at the end of Q1. We think that will more than double by the end of the year. That's sort of the number you want to look at that's comparable. We've got more in the overall compute number, but those are -- have products like image and video manager, legacy Akamai net storage, other kinds of things. which aren't as comparable for what you're looking at in terms of the hyperscaler growth. So if you focus on the enterprise compute, which is really going to be the growth driver for us, that's going in a very fast percentage now and, of course, on a much, much smaller number than the hyperscalers. Ed, do you have -- want to add to that?"
},
{
"speaker": "Ed McGowan",
"text": "No, I think that's exactly right. And that's something that, over time, as that number becomes more material, we'll start to break that out for folks to make it easy for you to see where that growth is coming from. But Tom is absolutely right. That's where the big market is. That's where we're seeing the explosive growth, and we see that we think that can continue. Obviously, the pipeline is growing. We're seeing a lot more use cases than we expected. I see a great participation from all of our reps across the world. It's not just one geo. So we're very excited about it."
},
{
"speaker": "Timothy Horan",
"text": "And do you think you're capital constrained at all or product constrained at all in the enterprise there?"
},
{
"speaker": "Ed McGowan",
"text": "No, I don't think there's a capital constraint problem. I mean you could envision perhaps as a customer that may come to us with a big task where you may have to do some build out if it's in a particular concentrated geography. But we got a very strong balance sheet. We produce a ton of free cash flow. So there's no issue from a capital constraint perspective. I think we can grow this business to a significant size over time, and I don't think capital is a problem right now."
},
{
"speaker": "Operator",
"text": "The next question comes from Rudy Kessinger with D.A. Davidson. Please go ahead."
},
{
"speaker": "Rudy Kessinger",
"text": "Hey, great. Thanks for taking my questions on security. I guess in the second half, if I look at it adjusting out Noname, it looks like organic growth at constant currency is just about 11% to 12%. Obviously, it's been a slowdown versus the last several quarters. And in general, the security growth rate has kind of been pretty volatile over the last 5 to 6 quarters. Could you just give us the puts and takes on maybe some tough compares in the second half. I think you had some spike in DDoS strength last year. But also just going forward, just what's the kind of right growth range that we should expect out of the security business?"
},
{
"speaker": "Ed McGowan",
"text": "Yes, sure. So just in terms of some of the puts and takes, just remember, last year, in Q3, we had little over $6 million of license revenue, that's a couple of percentage points. So that's going to make your Q3 compare a little bit more challenging. The other thing to keep in mind, too, last year, we introduced some new security bundles for web app firewall that did phenomenally well. So we've anniversaried that, so that makes sure our compare is a little bit more challenging. And then between Guardicore and API security as they start to ramp, we think APIs going to ramp very, very quickly. It's just a smaller number. So as you've talked about, the growth has bounced around a little bit over time. That happens as you bring new products into the market and they start to ramp up, think about when we brought [ Batman ] manager to the market. It was a small product and then go to hundreds of millions of dollars. I think the same thing you'll see with Guardicore and API security."
},
{
"speaker": "Rudy Kessinger",
"text": "Yes. Okay. And then on the delivery outlook, I guess, your -- I mean, fastly, I'll say it more directly, I mean, they certainly seem to indicate that outside, it was broader than just one social media customer has several large media customers that seem to be shifting traffic to lower-cost providers. It sounds like you guys aren't really seeing that dynamic or maybe it's not the year and it was already factored into the guide. Any comment on that?"
},
{
"speaker": "Ed McGowan",
"text": "Yes. No, we're not seeing a phenomenon of someone moving to low-cost providers. As a matter of fact, there's two less of them in the market today. So we're not seeing that. As I talked about earlier, we have a tough compare with a [indiscernible] Q4. And then we've just seen just a lower traffic year. Gaming has been unusually weak, video traffic isn't as robust as it normally is. That stuff happens from time to time, but we're not seeing a shift to low-cost providers or any new low-cost providers in the market."
},
{
"speaker": "Operator",
"text": "Okay. The last question today comes from William Power with Baird."
},
{
"speaker": "Unidentified Analyst",
"text": "This is Yan Samilton for Will. Ed, just going back to that more muted Q4 seasonality you're expecting for delivery again this year. If I remember correctly, last year, you were pointing to weaker trends in retail, including an uptick in bankruptcies there and then also weaker in terms of gaming. And now I know it's probably still a little early to forecast though, but is it those same verticals where you're expecting weaker traffic again this year that you're informing your expectation? Or is it some others or maybe it's more broad-based?"
},
{
"speaker": "Ed McGowan",
"text": "Yes. I'd say it's a combination of those two verticals. We've seen sort of over time the retail seasonal or to be less and less. Some of that has to do with the Zero overage product that we offer in the market. But just in general, it just hasn't been as robust as have been, say, 4 or 5 years ago. And then from gaming, yes, still weak. I haven't seen any major launches or we're not hearing anything from our customers that we leave me to believe that Q4 will be strong from that perspective. And then also, as I just talked about several times here, just traffic in general has been a bit sluggish from a growth perspective in general. So I don't see anything that tells me that, that's going to change going into Q4. So obviously, we've got a few months to go here before we get there. We'll update you when we talk again in November. But based on what I'm seeing today, just out of this worthwhile calling that out to folks as they build out their models."
},
{
"speaker": "Operator",
"text": "This concludes our question-and-answer session. I would like to turn the conference back over to Mark Stoutenberg for closing remarks."
},
{
"speaker": "Mark Stoutenberg",
"text": "Thank you, everyone. In closing, we will be presenting at several investor conferences throughout the rest of the quarter and the rest of the year. We look forward to seeing you with those. We hope everyone has a nice evening tonight. Operator, you may now end the call."
},
{
"speaker": "Operator",
"text": "The conference has now concluded. Thank you for attending today's presentation. You may now disconnect."
}
] | Akamai Technologies, Inc. | 24,522 |
AKAM | 1 | 2,024 | 2024-05-09 16:30:00 | Operator: Good day and welcome to the First Quarter 2024 Akamai Technologies Incorporated Earnings Conference Call. All participants will be in listen-only mode. [Operator Instructions] Please note this event is being recorded. I would now like to turn the conference over to Mark Stoutenberg, Head of Investor Relations. Please go ahead.
Mark Stoutenberg : Thank you, operator. Good afternoon, everyone, and thank you for joining Akamai's First Quarter 2024 Earnings Call. Speaking today will be Tom Leighton, Akamai's Chief Executive Officer and Ed McGowan, Akamai's Chief Financial Officer. Please note that today's comments include forward-looking statements, including statements regarding revenue and earnings guidance. These forward-looking statements are subject to risks and uncertainties and involve a number of factors that could cause actual results to differ materially from those expressed or implied by such statements. The factors include any impact from macroeconomic trends, the integration of any acquisitions, and any impact from geopolitical developments. Additional information concerning these factors is contained in Akamai's filings with the SEC, including our Annual Report on Form 10-K and our Quarterly Reports on Form 10-Q. The forward-looking statements included in this call represent the company's view on May 9th, 2024. Akamai disclaims any obligation to update these statements to reflect new information, future events, or circumstances, except as required by law. As a reminder, we will be referring to certain non-GAAP financial metrics during today's call. A detailed reconciliation of GAAP and non-GAAP metrics can be found under the financial portion of the Investor Relations section of akamai.com. I will now hand the call off to our CEO, Dr. Tom Leighton.
Tom Leighton : Thanks, Mark. Akamai got off to a strong start for the year with our Security and Compute portfolios. And we continued to experience industry headwinds with our delivery product-line. First quarter revenue grew to $987 million, up 8% year-over-year as reported and in constant currency. Non-GAAP operating margin was 30% and non-GAAP earnings per share was $1.64, up 17% year-over-year and up 18% in constant currency. The fast growing parts of our business, security and cloud computing, grew to represent almost two-thirds of total revenue in Q1, and combined they grew 22% over Q1 of 2023. The continued shift in Akamai's revenue mix towards security and compute, is a clear indicator that our growth strategy is achieving the intended results. We continue to successfully leverage the market leadership and cashflow of our delivery product line to invest in our faster growing and more profitable security and cloud computing portfolios. And we are excited about the opportunities we have ahead of us, especially with our planned acquisition of Noname Security, which we announced this week. I'll say more about Noname in a minute. But first, looking at our security portfolio more broadly, security revenue grew 21% year-over-year in Q1 to $491 million, driven in part by continued strong demand for our market-leading Guardicore Segmentation Solution. Customers who purchased Segmentation from Akamai in Q1 included one of the top telcos in the US, a supermarket chain with more than 1,500 stores across Canada, and a major business management software company in Latin America. Our Zero Trust Network Access Solution, is also seeing good traction. For example, the United States Army announced last month that it selected Akamai for Zero Trust Security in Battlefield Networks. After a competitive evaluation of more than 40 vendors, the Army will use Akamai for its tactical identity, credential, and access management to enhance defenses in high-risk operational environments and limit network access to authorized users, devices, applications, and services. In response to customer requests to bring our Enterprise Zero Trust solutions together into a single platform, we've integrated Guardicore with our other enterprise security solutions to form our recently announced Akamai Guardicore platform. This new platform is the first of its kind to enable Zero Trust Security through a fully integrated combination of micro segmentation, Zero Trust Network Access, multi-factor authentication, DNS firewall, and threat hunting. All designed to strengthen and simplify enterprise security with broad visibility and granular controls through a single console. We think it will appeal to customers looking to consolidate security vendors and integrate their security tools. We also continue to see strong customer interests in our app and API security solutions. Customers who purchased Akamai API Security in Q1, included a major consumer financial services company, a US supermarket chain with more than 1,200 stores, and a leading US manufacturer of electric vehicles. Last month, one of our largest customers, a well-known hyperscaler, was hit with a massive denial-of-service attack, 24 million requests per minute. Using our rate controls and custom web app firewall rules, the customer successfully forwarded 99.999% of the attack traffic. That's five nines of protection. The customer was delighted, telling us, “that's an A-plus by just about every calculation”. Unlike some of our competitors who struggled to defend against far smaller DDoS attacks in recent months, Akamai is capable of protecting even the hyperscalers. The scale of Akamai defenses and the depth of our expertise really matter for customers, who named Akamai a Customer's Choice for the fifth-year in a row in the new Gartner Peer Insights Voice of the Customers report for cloud web app and API protection. And soon, our suite of app and API security solutions will become even stronger with the planned acquisition of Noname Security. The use of APIs has exploded in nearly every industry, driven by digital transformation, the widespread adoption of mobile phones and IoT devices, and the increased sharing of data between third-party providers. The increasing use of APIs also opens up new threat vectors for attackers and the need for API security. For example, we saw API attacks on our platform more than double from January 2023 to January 2024. And IDC Research now predicts that the API security market will grow at a CAGR of 34% to nearly a $1 billion by 2027. That's one reason why we are so excited about our plan to acquire Noname, as we accelerate our momentum in this fast growing segment. As one of the market leading API security offerings, Noname delivers visibility into API business logic abuse and contextual awareness between API requests and responses to ensure that anomalous traffic is detected, inspected, and blocked when warranted. We believe that the addition of Noname to our API security solution will offer Akamai customers enhanced attack analysis, more flexible deployment options, and extensive vendor integrations. Ed will share some financial details about the acquisition shortly. Turning now to cloud computing, I'm pleased to say that 2024 is off to a great start, with strong early momentum across multiple verticals. Customers are excited about our differentiated cloud platform, which offers superior performance through a more distributed footprint, cloud diversification, and lower costs. Examples of major enterprises using our cloud computing platform now include one of the world's largest e-commerce platforms, several global auto manufacturers, several large direct-to-consumer and OTT providers, several global SaaS providers, numerous travel and hospitality companies, including one of the world's largest cruise lines and a large airline in Asia, one of the largest credit unions in the US. A multinational financial services company. An iconic global corporation that manufactures and sells consumer electronics, computer software, and online services. A European cyber security company, and a leading ad tech company. Just this week, we signed up one of the world's best known media companies to a two-year deal worth several million dollars per year for compute. Yet another great example of major enterprises using our new cloud computing platform is Sony Group. Sony is excited about Akamai's investment into Edge Compute and has multiple latency-sensitive compute workloads that are running on Akamai. Current use cases include PlayStation.com, leveraging Edge Compute to improve search engine optimization, and PlayStation Direct, leveraging Edge Compute to ensure a fair experience for customers purchasing PlayStation Hardware. We're also seeing strong early traction with our Independent Software Vendor, or ISV, partners. They offer solutions that run on our compute platform in which our go-to-market teams co-sell to help customers solve big challenges with a better together solution. For example, a media workflow provider, which powers OTT video, now offers its live encoder solution on Akamai Connected Cloud. The solution is designed to increase efficiency for large scale streaming while also lowering egress fees, by as much as 90% according to their calculations. Joint customers of the offering include OneFootball, one of the world's biggest digital soccer platforms, backed by clubs such as Real Madrid, Manchester City, and Bayern Munich. In partnership with an observability solution provider, we won cloud computing deals in Q1 with one of the world's leading gaming companies, a leading luxury goods brand in Europe and one of India's largest conglomerates. Their solution powers observability using Akamai Cloud computing and enables real-time data ingestion at scale, lightning fast query performance, and extensive data retention at a fraction of the cost of other platforms. Another ISV partner that is providing distributed database services, enabled a well-known online travel marketplace to go live in Q1, with a geolocation implementation that uses Akamai’s Edge Computing to execute code at the edge for optimal performance. The travel site invoked more than 68 billion Edge Compute instances in March alone. By the end of Q1, we had over 200 customers spending $36,000 or more in Annual Recurring Revenue for our new compute services, with about half spending $100,000 or more, and six spending over $1 million per year, all just for compute. All of these customer counts are triple what we had in Q1 of last year. Collectively, these customers are spending over $50 million annually coming out of Q1 for our new cloud computing solutions, which is up more than 4 times year-over-year. Beginning this quarter, our global enterprise cloud sales team is now led by Dan Lawrence, who joined us from AWS, where he ran data and analytics for its private equity segment. Before that, Dan ran the Americas analytics business for five customer segments, including gaming and high-tech SaaS. Dan joined Akamai for the potential he sees to combine Akamai's trusted brand and Edge Computing platform with the large market opportunity and distributed cloud. I'll now say a few words about content delivery, which represents a little over one-third of our overall revenue. Akamai remains the market leader in delivery by a wide margin, providing the scale and performance required by the world's top brands as we help them deliver reliable, secure, and near-flawless digital experiences. That said, our delivery revenue was less than expected in Q1, due to slowing traffic growth across the industry, and a large social media customer that is now optimizing their business to reduce costs. As a result, and as Ed will discuss shortly, we now expect our delivery revenue to decline at a higher rate this year. As we've noted before, delivery continues to generate profits that we use to fuel our future growth. It also helps our security and cloud computing portfolios, as we harvest the competitive and cost advantages of offering delivery, security, and compute on the same platform. Of course, we are not happy to see the declining revenue in our delivery portfolio. And while it remains difficult to predict exactly when that business will begin to stabilize, we believe that Akamai’s CDN remains a critical enabler of doing business on the internet. This has been the case for the past 25 years, and we remain convinced that businesses will continue to need Akamai's superior scale, reliability, and security in the future as they migrate more workloads to the cloud, seek to secure their internal and external applications, and look to unlock the promise of AI, often while also leveraging Akamai security and compute capabilities. Moreover, given the exciting growth we're seeing in our security and compute portfolios, we believe it is only a matter of time before these businesses drive accelerating revenue growth for Akamai as a whole. In summary, we are pleased by the strong performance of our security and compute portfolios to start the year. And we are very excited about our potential for future growth and profitability, as we add Noname to our security portfolio and as our fast-growing compute portfolio contributes a larger share of revenue. Now I'll turn the call over to Ed for more on our Q1 results and our outlook for Q2 in the full year. Ed?
Ed McGowan : Thank you, Tom. Today I plan to review our Q1 results and then provide some color on our Q2 expectations in our updated full year 2024 guidance, along with the financial impact of our recently announced acquisition of Noname Security. Before we get into that, I wanted to address a few items, including what Tom mentioned in his remarks, that have caused us to reduce our guidance for the remainder of the year. First, the US Dollar has strengthened significantly since the start of the year. As we have noted on many prior calls, foreign exchange fluctuations can significantly impact our top and bottom lines. Based on the strength of the US dollar, we now expect FX to have a negative impact of approximately $40 million on our top-line outlook for the full year 2024. That translates to a negative impact of approximately $0.12 to our expected non-GAAP EPS for 2024. In addition, we expect this will negatively impact our full year 2024 non-GAAP operating margin by approximately 30 basis points. Second, as Tom mentioned, a large social media customer has recently taken steps to lower its costs through a series of optimizations across its platform. As a result, they have reduced their overall traffic. Therefore, we now expect approximately $40 million to $60 million less revenue from this customer for the full year than we previously thought. This change will primarily impact our delivery product line. Finally, as Tom mentioned in his remarks, in addition to the large social media customer, we have seen lower than expected traffic in our delivery business over the past two months, most notably in gaming and video. This is in-line with similar patterns that were cited earlier this week in a research note from a leading Wall Street bank that stated, video streaming services were seeing a drop in downloads, in active users during April. The note also mentioned that weakness was coming from streaming service providers pushing for ad-supported versions and password sharing crackdowns to stay ahead in the streaming wars. As a result of these recent market conditions, it's prudent to assume that this traffic weakness will continue for the remainder of 2024. This lower traffic outlook would translate into approximately $20 million to $30 million less delivery revenue for the remainder of the year than we previously expected. The good news is that in contrast to some other competitors in the industry, both our delivery business and the overall company continue to be highly profitable. As a result, the significant cash flows we generate give us the financial flexibility to execute strategic acquisitions, return capital to shareholders, invest in our future growth, and further diversify our business away from delivery and into the faster growing and even more profitable areas of security and compute. Turning now to our first quarter results. Total revenue for the first quarter was $987 million, up 8% year-over-year as reported and in constant currency. Our two fastest growing offerings, Compute and Security, grew 22% year-over-year on a combined basis and now represent 64% of total revenue. Compute revenue was $145 million, up 25% year-over-year as reported and in constant currency. As Tom mentioned, we have more than 200 enterprise customers using our cloud computing solutions. Our offerings clearly resonate well with customers and we remain optimistic about the early traction we see from large enterprise businesses. It's worth noting that the annual run rate of our enterprise compute revenue is now over $50 million and is growing at over 300% year-over-year. Security revenue was $491 million. Security revenue grew 21% year-over-year as reported, and in constant currency. We are very pleased by our continued performance with our Guardicore Zero Trust Solution and highly encouraged by the traction we are seeing in our recently launched API security solution. Moving to delivery. Revenue was $352 million, which declined 11% year-over-year as reported and 10% in constant currency. International revenue was $475 million, up 7% year-over-year and up 8% in constant currency, representing 48% of total revenue in Q1. Foreign exchange fluctuations had a positive impact on revenue of $2 million on a sequential basis and a negative $4 million impact on a year-over-year basis. Non-GAAP net income was $225 million or $1.64 of earnings per diluted share, up 17% year-over-year and up 18% in constant currency. And finally, our non-GAAP operating margin in Q1 was 30%. Moving now to cash and our use of capital. As of March 31, our cash, cash equivalents, and marketable securities totaled approximately $2.3 billion. During the first quarter, we spent approximately $125 million to repurchase approximately 1.1 million shares. We now have roughly $400 million remaining on our previously announced share buyback authorization. As noted in today's press release, our board authorized a new buyback program of up to $2 billion effective today in running through the end of June, 2027. Combining the two authorizations, we currently have roughly $2.4 billion available for share repurchases. Our intention is to continue buying back shares to offset dilution from employee equity programs over time and to be opportunistic in both M&A and share repurchases. Earlier this week, we announced our intent to acquire Noname security for approximately $450 million. We believe this acquisition demonstrates our continued balance approach to capital allocation by opportunistically buying back shares over time, while maintaining sufficient capital to deploy when strategic M&A presents itself. Before I provide our Q2 and full year 2024 guidance, I wanted to touch on some housekeeping items. First, regarding our planned acquisition of Noname Security. We expect this transaction to add approximately $20 million in revenue for the full year, to be diluted to non-GAAP EPS by approximately $0.10, and to be diluted to non-GAAP operating margin by approximately 50 basis points in 2024. We expect that the acquisition will close sometime in June. We do not expect the acquisition to have a material impact on Q2 results. And as a reminder, our updated full-year guidance includes the impact of the acquisition. Finally, specific to traffic, we expect a modest uptick in media traffic in Q3, primarily due to the Olympics. This event is expected to drive approximately $3 million to $4 million of additional revenue in the third quarter. And while Q4 is typically our strongest quarter seasonally, we saw a more muted impact of that seasonality last year. We expect that we will see a similar result this year. So with those factors in mind, turning to our Q2 guidance. We are now projecting revenue in a range of $967 million to $986 million or up 3% to 5% as reported, and 4% to 6% in constant currency over Q2 2023. At current spot rates, foreign exchange fluctuations are expected to have a negative $5 million impact on Q2 revenue compared to Q1 levels and a negative $9 million impact year-over-year. At these revenue levels, we expect cash gross margins of approximately 72% to 73%. Q2 non-GAAP operating expenses are projected to be $302 million to $307 million. We expect Q2 EBITDA margins of approximately 41% to 42%. We expect non-GAAP depreciation expense to be between $126 million to $128 million. And we expect non-GAAP operating margin of approximately 28% to 29% for Q2. Moving on to CapEx, we expect to spend approximately $175 million to $183 million. This represents approximately 18% to 19% of our projected total revenue. Based on our expectations for revenue and cost, we expect Q2 non-GAAP EPS in the range of $1.51 to $1.56. The CPS guidance assumes taxes of $56 million to $59 million, based on an estimated quarterly non-GAAP tax rate of approximately 19% to 19.5%. It also reflects a fully diluted share count of approximately 155 million shares. Looking ahead to the full year, we now expect revenue of $3,950 million to $4,020 million, which is up 4% to 5% year-over-year as [reported now] (ph) 4% to 6% in constant currency. We now expect security revenue growth of approximately 15% to 17% in constant currency in 2024, including the contribution from the acquisition of Noname. With a strong start for our compute offerings in Q1, we now expect compute revenue growth to be approximately 21% to 23% in constant currency for the full year 2024. We are estimating non-GAAP operating margin of approximately 28% to 29%. We now estimate non-GAAP earnings per diluted share of $6.20 to $6.40. Our non-GAAP earnings guidance is based on the non-GAAP effective tax rate of approximately 19% to 19.5%, and fully diluted share count of approximately 155 million shares. Finally, our full year CapEx is expected to be approximately 16% of total revenue. This updated CapEx is higher than our original expectations outlined last quarter due to our lower revenue outlook, slightly higher software capitalization rates across the business as more work is being done on capitalized projects and higher than expected server component costs, driven primarily by NAND storage pricing in certain servers that support our cloud computing buildup. In closing, we are pleased with our progress in security and compute to start the year. Tom and I would be very happy to take your questions. Operator?
Operator: Thank you. We will now begin the question-and-answer session. [Operator Instructions] Our first question comes from Madeline Brooks from Bank of America. Please go ahead.
Madeline Brooks: Hi, team. Thanks so much for taking my question, and great to see compute kick up in terms of the guidance. One question for me on the delivery side of the house. Last quarter you had mentioned that first quarter and second quarter of this year we were going to see a few renewals. I just wanted to see how those renewals were going if there was any updated outlook in your guidance from the renewal side of the house. Thank you.
Ed McGowan: Hey, Madeline, this is Ed. Yeah, so the renewals are going as planned in terms of the pricing expectations. We've got a few of them done now. We'll have about five of the seven completed by the end of this quarter, and the other two will be done in early Q3. As far as expectations go, like I said, pricing is coming in-line. Volume a little bit lower than we expected normally when we do these large renewals. We tend to see an uptick in traffic. We just haven't seen that. So that's all been reflected in our guidance.
Madeline Brooks: Great. Thanks. Let me ask you one more question if I could. For those renewals [or financing] (ph) your larger deals, are you seeing any type of offsetting with compute growth for maybe some larger customers where you are seeing lower volume?
Ed McGowan: I'm sorry, could you just repeat that again?
Madeline Brooks: Are you seeing a lower customers, larger customers who are coming in maybe with lower volume than expected? Are you seeing that offset at all by any type of compute growth or growth in other areas of the business?
Tom Leighton: Yeah, they're not directly tied, but as we talked about, several of the world's largest media companies are starting to use our compute capabilities for a variety of tasks. So that's a good new story. It's not tied to the traffic levels in any way. Of course, these big media companies still use Akamai for a large fraction of their delivery needs, but traffic in the industry as a whole, especially media and gaming, is lower than we had initially expected.
Madeline Brooks: Great, thank you so much.
Operator: The next question comes from Keith Weiss from Morgan Stanley. Please go ahead.
Joshua Baer: Thank you, this is Josh Baer on for Keith. The Question was on margin guidance. It was lowered I think by 150 basis points at the midpoint, 50 from the Noname acquisition. You mentioned 30 base points from FX. I was hoping you could just walk through the rest of the move lower on the margin guidance?
Ed McGowan: Yeah, I think just the rest of that would just be due to the lower delivery revenue as a whole.
Joshua Baer: Okay, got it. I guess as a follow-up related to margins, is there any structural change in reaching, I guess, the low 30s type of long-term target and just asking given the lower guidance for this year but also because from a mixed perspective you've actually moved faster to the higher margin security and compute versus delivery. Thank you.
Ed McGowan: Yeah, sure. So there's really no structural change. Obviously, we're making some pretty big investments in R&D, and you can see that in the R&D line. And also just the acquisitions, we made an acquisition last year, made an acquisition now. So we're investing in growth. But there's also a fair bit of investment that goes into the cost of goods sold-line as we build out our compute platform. So you can see that in the higher co-location costs. And there is some accounting that you have to do when you enter into some of the long-term agreements for co-location. So we should start to see that, get some benefit of that as compute grows even faster.
Joshua Baer: Great, thank you.
Operator: The next question comes from James Fish from Piper Sandler. Please go ahead.
James Fish: Hey guys, just on the social media customer here, I think I may know what's going on, but you know, it does seem as though traffic has been slowing for the last, you know, two years or so from what we can tell. But on some of these renewals and specifically on the social media customer, I guess what's the confidence that this isn't just tied to kind of DIY efforts picking back up in the space?
Tom Leighton: Yeah, for the large social media customer we talked about, there's a few components generally tied to their efforts to reduce costs. You know, they are using less bits per transaction and end-user experience. They're optimizing their doing less prefetching. They do have a very large DIY component as well and we haven't seen the impact of that yet but we do think that they may use that more throughout the rest of the year and that's factored into our lower guidance for this particular customer. So we haven't seen that yet, but we anticipated at this point as part of their overall cost reduction efforts.
James Fish: Got it. And then on the security side of the house, I mean, what did Noname have that [sure] (ph) Neosec was smaller in scale, but that Neosec didn't. And so why isn't this just kind of a role of strategy of kind of the API space? And Ed, if you could just walk me through the security guidance? You guys had a pretty good beat here. And I get FX is kind of moving against you on this, but why wouldn't we see further upside given the strength you saw in Q1? Is it just because some of the security revenues tied to some of these delivery renewals or why the conservative security guide?
Tom Leighton: I'll take the first part and then let Ed to answer the second part. Yeah, Noname is a market leader. And they have a lot of capabilities that we don't have yet. And it's actually very synergistic with what we have. They have an on-prem and hybrid-solution. Our solution has been SaaS-only. They have a great channel partner ecosystem, market-leading presence, very easy to use and to integrate. And by the time we get the acquisition closed later this quarter, we anticipate we'll have full integration with Akamai Security Services, which is the piece they were really missing. And great user experience and console. So really strong capabilities and of course much bigger business. And with our solution, we can add to that I think stronger forensics and threat hunting with our data lake capabilities and by putting the pieces together, really a very compelling solution. I was just out at RSA earlier this week and I got to say the news was incredibly well received. A lot of customers, both ours and Noname customers, very happy about the acquisition and what we're going to be able to do for them. Also, the partner ecosystem, Noname is very partner friendly. That will really help our go-to-market motion and they were very excited about the news as well. And Ed, I'll turn it over to you for the second part there.
Ed McGowan: Yeah, sure. So first of all, just a great quarter for security, great sequential growth, strength across the board really in terms of pretty much all of our solutions, obviously seeing great growth with API security and expect that will accelerate now that we have Noname in the mix. But I think as you look at last year, we had very, very strong sequential growth, sort of unusually strong, including some license revenue in the back half of last year. So the compares get a little bit tougher. I don't think there's anything structurally that we're seeing that would cause us to be less bullish. I think one thing, just to keep in mind, we introduced some bundles last year. We had identified about 3,000 customers or so. Obviously, we had great success with that. That's going to have less of an impact this year as we start to anniversary that. But we are very excited about what we're seeing with Guardicore, which is starting to become more material, and the growth from API security. So we're very bullish with the growth going forward. I think just getting it to tougher comps in the back half, which is going to perhaps cause the percentages to be a little bit lower than what we saw here in Q1.
James Fish: Thanks Ed.
Operator: The next question comes from Fatima Boolani from Citi. Please go ahead.
Fatima Boolani: Good afternoon. Thank you for taking my question. Just one on delivery. You know, I can appreciate how difficult it is to sort of parameterize some of the trends that are playing out in the industry. I think both of you sort of laid that out in the prepared remarks. But how should we think about the floor in terms of declines in this business and what type of GuardRails you're anticipating and putting around this business? And essentially what I'm trying to get around is how confident are you that this recalibration lower does take into consideration everything that's happening in them? And then I have a follow-up.
Tom Leighton: Yeah, I'll start and then Ed will give us some more color on this. Of course, you know, when we give guidance, we do it based on the best available information we have at the time. Obviously, we don't like to see, the revenue decline and you never like to be in a position of taking down the guidance for one of your portfolios. We do believe that, you know, our delivery business is critical for major enterprises to operate on the Internet. That said, delivery is a very competitive environment And we are subject to overall traffic levels on the internet, which we now believe will be in a lower state than we had thought before. And you know, this is typical. We've been doing this as the market leader now for 25 years, and there's times, when traffic accelerates more than you might have thought and times when it doesn't. And I think we're in sort of the latter mode right now. Now we do believe the business will get back to par. I can't tell you exactly when that will be. It's important for us to do that. I should add though, it's not our top priority. We are not out there doing whatever price it takes to go grab all the business. In fact, I think we've been pretty clear that's not the case. There's traffic that we are not taking because we don't feel that it's profitable or really strategic for us. Our primary goal is using delivery for very strong cash flow that we can invest in security and compute, which we think are much more lucrative markets in the long run, offering much more growth. And also we use it with our customers to introduce, for example compute. The [big-bit] (ph) customers, big media, gaming, are big prospects in compute. And the largest customers there are over $1 billion in third-party cloud spend, typical large media customer, hundreds of millions. And we want to get a share of that business which is much more profitable and ultimately much larger than delivery. So that is our focus here. Obviously we want to get back to PAR. We don't like to see a declining business but it's a bigger picture. And of course we are competing with a lot of companies that are very desperate just to get a little bit more growth in delivery, and even if they are doing it at a very unprofitable level, and that makes it more challenging. And Ed, maybe you want to talk a little bit more on the details of the guidance and the confidence?
Ed McGowan: Yeah, as Tom talked about, we use the best information we possibly can. We obviously work with a lot of the big telcos. We try to get feedback from them to see what they're seeing. We talk to our large customers to get an understanding of what they have planned in terms of the big events or if they're doing downloads, how big the downloads are going to be, what sort of share we should expect as we go through things like our large renewals and that sort of stuff. When we see a trend like we saw in March where traffic was lower than we expected and then continued into April, it did cause us to go back and relook at our forecasts and be a little bit more cautious. But those forecasts, it's unusual to see traffic decline month over month. It doesn't generally happen. But there is a big pressure in the industry to save costs, especially in the streaming business. Gaming tends to be very seasonal and a little fickle in terms of different titles being popular and not. We're just sort of in the downtrend in gaming. But as Tom mentioned, we've seen these trends before. We're usually pretty good at predicting when things will turn around. But when we do see something that is concerning, we're going to call it out and reset our forecast.
Fatima Boolani: I appreciate that. And just with regards to the new go-to-market leadership on the compute side, I'm just curious if there are going to be any material changes or is this a deepening of the bench that's going to allow for an ongoing, ideally, acceleration of the compute business? We'd love to just get a little bit more detail on that go-to-market change for someone with a pretty excellent category. Thanks so much.
Tom Leighton: Yeah, it's more of the latter and getting really solid experience and expertise as we increase our investment in the go-to-market effort around compute. And we think Dan is an excellent addition to our leadership.
Operator: The next question comes from Mark Murphy from JP Morgan. Please go ahead.
Mark Murphy: Thank you very much. I wanted to congratulate you on the strength in the Compute and Security and the US Army win the Sony -- win, obviously good things happening there. Going back to the social media company that you referenced, is that a typical kind of [garden variety] (ph) case of cost optimization or is there perhaps anything unusual like a corner case where The clock might be ticking on legislative proposals and they are moving in advance of that. Could it be a social media company that is struggling and shrinking? Anything along those lines?
Tom Leighton: No, I think you described it pretty well in the first two descriptions you gave. And they just are a very large customer for Akamai, and a very good customer. They are looking to cut costs and they are looking at potential, geopolitical challenges. And so that, I think a lot of companies look to cut costs, particularly these days in media and maybe they have additional concerns.
Mark Murphy: I understand. Okay. And then Ed, the security company you're acquiring, I forget the name of it, can you provide any metrics on the headcount or their growth rate in the last 12 months or the gross margins? And I'm just wondering, does it focus on API security that aligns any more or less across any of the particular hyperscalers?
Ed McGowan: Yeah, I'll take the first part, Tom. You can take the second part about the product. Now in terms of growth rates and stuff like that, I hesitate to give growth rates because we obviously have to translate everything they're doing into GAAP revenue ASC 606. But needless to say, they were growing pretty quickly. We talked about we think it will contribute about $20 million of revenue, but again growing very fast as we introduce them into the mix. We think we can accelerate that growth rate quite a bit as we introduce them to our customer base. Gross margins I would say is pretty typical of what you see in a software company. It's called like high 70s, maybe low 80s. There are some people cost that go into your cost of goods sold. As far as people go, right around 250 people, give or take, 60% or so is in R&D, 30% in go-to-market and the rest is sort of mixed in kind of your back-office support.
Tom Leighton: Yeah, in terms of the question on the hyperscalers and API security, they don't offer API security. They have API gateways, which is something totally different. In our competition, in API security is more startups or younger companies smaller. It's an emerging field and really we feel Noname as a leader there.
Mark Murphy: Thank you.
Operator: The next question comes from Frank Louthan from Raymond James. Please go ahead.
Frank Louthan: Great, thank you. Just to go back on the delivery side, was there a price that they would have been willing to stick with? There was just pretty much a business decision there. And Tom, you mentioned get back to PAR. What do you mean by that? Is that a level of revenue? How should we think about what it would be to kind of getting back to PAR?
Tom Leighton: Well, PAR, we don't want to see revenue decline in our portfolio. We'd like to see it to grow. And we're declining, obviously, now in delivery. And in the particular case of the large social media company, I don't think, this is a price-related issue, really. And as Ed mentioned, I think pricing, obviously very competitive out there. And we don't go and chase the bottom stuff that's not really profitable for us. But you know, pricing is sort of as we expect and more of it's a traffic, overall traffic in the industry right now.
Frank Louthan: Okay, and at what level do you see the delivery business sort of bottoming it out that would be considered sort of flat for you.
Ed McGowan: Yeah, you know as Tom talked about, it's hard to predict. I mean, I think what you need to see for that to happen is traffic growth to improve, to see pricing rationalize a bit more than where it is now, and less concentration of big renewals. But that's really the formula that you would need to see a sort of a stabilized delivery business.
Frank Louthan: Okay, great. Thank you.
Operator: The next question comes from Amit Daryanani from Evercore. Please go ahead.
Unidentified Analyst: Hey, guys. Thanks for taking the question. This is [Chant] (ph) on for Amit. I just had a quick one on the delivery business. You know, given this is an election year, do you think we could see a step up in the delivery business, maybe in the back half? I think normally elections tend to drive some sort of benefit as well as kind of the Olympic benefits you mentioned earlier.
Tom Leighton: Yes, we talked about the Olympics as a decent event for us. Our estimate is $3 million to $4 million this year. As far as the election goes, really hard to tell. You know, we saw back in [2016] (ph) a bit more traffic, [2020] (ph) didn't really drive a ton of traffic. I'd say this is probably closer to what we saw in 2020, so we're not really anticipating a significant amount of traffic as a result of this year's election, but we'll see.
Unidentified Analyst: Got it. And then just as a follow-up, I think free cash flow is really strong during this quarter, but if I look back historically, Q1 is kind of the low, and then sequentially in the June and September quarter it's much greater. So could you talk about maybe any changes to your CapEx and free cash flow expectations for fiscal 2024?
Tom Leighton: Yeah, so I would think that next year should play out, or excuse me, 2024 should play out like it's done in the past. Q1 was a little bit stronger than normal. As we talked about on several calls back last year, we did move some folks to a stock-based bonus program. So we used to have a cash-based bonus program that would play out in Q1 that would drive cash flow down a little bit in Q1, but in terms of the progress throughout the year, it should look like the other years.
Unidentified Analyst: Great. Thanks for that.
Operator: The next question comes from Jonathan Ho from William Blair & Company. Please go ahead.
Jonathan Ho: Hi. Good afternoon. Just wanted to understand the Zero Trust platform that you announced today. Can you talk a little bit about how customers are thinking about purchasing the assembly of products that you're talking about and how that compares with maybe some of the other views on how SASE and other Zero Trust platforms will evolve over time.
Tom Leighton: Yeah, this is a really good platform for Zero Trust for enterprise applications. So you get your micro segmentation and your employees Zero Trust Network access which is your employee access. That's your North, South and East, West now combined. Same agents, you don't have to have two different agents, same console and [plane of class] (ph). And on top of it, you get your MFA, your DNS security, and your threat hunting service, all packaged in a platform. And that's something customers have been asking for. It makes their lives a lot easier than having what seem to be different products with different agents and different interfaces. On top of it, at RSA we demonstrated a very cool new capability that actually uses a GenAI, LLMs, to give a very nice human interface into your enterprise infrastructure. It identifies what your various applications and devices are, and you'd sort of think, oh, well people would know, but they don't. Enterprise, major enterprises just have zillions of applications and devices on the internal network and they don't even know what they all are. And this tells you, in actually a human language form, can actually tell you what is not sufficiently protected or if the firewall rules, the agent rules are out-of-date. We've got a lot of positive feedback about that at RSA. And it's something that over time we want to take to our entire suite of security services, which I think will be pretty exciting. So yeah, so this helps because customers want to see, really have a few basic platforms of which Akamai is one and simplification of interface and control, both for the control plane and for the agent that's on their applications and service.
Jonathan Ho: Excellent, excellent. And just in terms of a follow-up, with compute, you obviously spoke about a number of large wins here, large types of customers. Can you talk about the potential to take that larger share of the pie over time as you grow within these customers and help us understand, are you landing in sort of a small footprint to begin with and then growing from there? Are you just sort of taking everything up front? I'm just trying to understand what that net retention opportunity looks like over time. Thank you.
Tom Leighton: Yeah, great question. It very much is a land small. Somebody will try out a single app with a little of the traffic forward and then grow it, and then add more apps. And you see that with our profile of customers, starting with the ones that $3,000 a month, then half of them now up to [$100,000] (ph) a year, [$60 million] (ph), [$100 million] (ph) a year. And Akamai is actually our first $100 million a year customer on the platform. And that's the same progression we went through over the last year-and-a-half. And we expect, and that's what we're trying to do with all of our accounts. These customers I talked about I couldn't give you most of their names, but you would recognize them. And they are -- what they're spending now with us is a tiny fraction, even the big ones, of their overall cloud spend. And they are finding the platform is easy to use, performs very well, and is saving them a boatload of money. And I think that's why we're seeing such good early traction. And now the goal is to grow those accounts, both in terms of the number of use cases and the scale of a use case, and then to add more customers. And again, they will come in at the lower revenue volumes to start.
Operator: The next question comes from Alex Henderson from Needham. Please go ahead.
Alex Henderson: Great, thanks. First off, congratulations. Picking off Noname was a real coup for you. I think that's an outstanding acquisition. So congratulations on that. I wanted to ask some content around the compute piece. First, you moved a bunch of your internal apps from other compute platforms to internal. Where are you on that? What does that look like in terms of the cost savings? And what has been the variance relative to what you'd expected when you started it, I assume you probably got better results, not worse results. And I was hoping you could, within the context of the compute platform, talk about gross retention as opposed to net retention. Obviously your net retention looks very good with these upticks, but I was wondering if there was any churn of people who were on the platform before that may have fallen out of the equation?
Tom Leighton: Yeah, we're more than halfway through the migration of our third-party cloud spend onto Akamai Connected Cloud. And as I mentioned, seeing really dramatic savings and also performance improvements. So we're more than $100 million a year in on the platform now, which is really fabulous for us. And maybe, Ed you want to take the second part of that question?
Ed McGowan: Yeah, so if you think about where you see that, Alex, is there some absolute savings if you look at our – in our cost of goods sold line, you can see that on that network build and support sub-line, sub-category. It's offset a little bit by what you see in [colocation] (ph) fees. So you're not seeing a ton of margin expansion. But what doesn't show up there is that that line was growing at 30%, 40%, or 50% a year. Now, probably we'd be growing 30%, 40% if we hadn't done it. So the cost avoidance is pretty significant. As Tom said, we're finding this to be much better than we had expected. We should get the rest of the expected applications moved over here between now and the early part of next year, end of this year into the early part of next year. So I'm very, very pleased with that. And again, a lot of cost avoidance and some absolute cost savings, like I said, being a little bit [massive] (ph), investments we're making in the platform. And then you also asked a question on gross retention, I think was the term you used in terms of are we seeing any churn. On the enterprise side, we're not seeing any churn so far. We haven't seen any customers that have left the platform. We do see a little bit of churn in the legacy retail node business which was pretty common when you talked about the SMTs. But where we're really aiming to grow the business, we're not seeing any of that yet.
Alex Henderson: Okay, great. And just one last question on this subject. Can you talk about whether you're seeing any potential around inference AI on this platform because it hasn't been mentioned yet. Thanks.
Tom Leighton: Oh yeah, we already have several customers doing all sorts of AI, but inference AI on our platform, and we have partners, our ISV partners. Some of them, that's their product capability. So yeah, we foresee substantial use of the platform for inference.
Alex Henderson: Great. Thank you.
Operator: The next question comes from Rudy Kessinger from DA Davidson. Please go ahead.
Rudy Kessinger: Hey, Thanks for taking my questions. Ed, just given the quicker than expected mix shift of the higher gross margin revenue lines, why aren't we seeing gross margins at least hold steady, if not expand? It's been compressing for the last few years.
Ed McGowan: Yes, so if you look back a few years ago, they've been compressing a bit. We had some pricing pressure as we always do in the delivery business. But I talked a little bit about this a few questions ago, and even a little bit with Alex in the last question. As we invest in the platform to build out compute locations, we're doing the GECO build out. We built out 25 core locations last year. We entered into these long-term leases for colocation. And where there's underlying [commits] (ph), you have to straight line that. So there's some non-cash colocation expenses. So if you look at our [co-loc] (ph) cost line, that's been growing pretty substantially. So that's masking a lot of the savings that you're seeing from our third-party compute costs. There's also additional build out and support costs that go along with it as well. So that's why you're seeing that margin sort of holding flat to where they've been over let's say the last year or so, but I don't expect them to decline. Hopefully over time they should start to expand a bit, but as we're building out aggressively in the compute platform that does put a little bit of pressure on margins, but as we start to fill up those locations, we should start to see expansion in margin.
Rudy Kessinger: Yeah, okay. And then on delivery, could you just talk about where some of the repricings came in with some of those contracts? And if I look at kind of what's implied for delivery in the rest of the year on an organic basis adjusting for some of those contracts you acquired, it looks like it kind of probably gets down to down 20%-ish year-over-year on an organic basis. What is the mix of price compression versus traffic growth? Is it flat kind of traffic on the network given all the things you talked about and 20% price compression or what is the combination there?
Ed McGowan: Yeah, so we don't share those numbers for obvious reasons with the price compression because obviously there's customers that get certain discounts, others don't get as high discount because they don't have as much traffic. And also it's a competitive number. I'd want to know what my competitors are doing with that number as well. But if I think about sort of the mix of what's driving it. Pricing is always a factor. And if you don't get the commensurate traffic growth offset that, then you're going to decline. And that's what we're seeing. It's really the back-half story is a lower than expected traffic. Now, couple that with your, some of your largest customers renewing at the same time. You don't have that, that volume offset. It just exaggerates the impact at the back half of the year. So like I said, it's really more of a volume issue than it is an overall pricing issue.
Tom Leighton: Okay, operator, I think we've got time for one last question.
Operator: The next question comes from Tom Blakey from KeyBanc Capital Markets. Please go ahead.
Tom Blakey: Hey, Mark and guys, thanks for squeezing me in here. I just wanted to go back, I think maybe to dive a little deeper on Rudy's question about gross margins. You talk about moving to more profitable solutions longer-term and made some headway here in one queue. In the past, you've kind of given us a framework about lowering CapEx, as a percentage of revenue for CDN. Essentially, 0% CapEx is needed, theoretically anyway, for security. Can you just walk us through what the -- not the near-term manned price components are, but longer-term structurally, what does compute look like at scale for Akamai? And have a follow up.
Ed McGowan: Yeah, so good questions. What -- I'll start with what the components of CapEx are today. So we said 16%. About 8% of that is Software CAP, so that's probably going to be 7%, 8% sort of going forward. Don't expect much of a change there. That's kind of been historically in that range. Compute this year is about 4%. CDN and securities around 3%, and then there's always 1% call it first. You know, you're [back-off](ph) if there's your IT systems and your facility related stuff. So in terms of how that's going to go throughout the years, we've obviously driven down our CapEx on the CDN business pretty dramatically. That used to be sort of 8% to 10% is what we used to talk about. So we've more than cut that in half. And I expect that -- that kind of low single-digit range will probably be where we stay unless we see just a dramatic increase like we saw during the pandemic. But there's no reason to believe that is to happen with what we know about the industry right now. In terms of the compute business, it's really a question of growth. Now we're expanding in terms of the number of locations right now. Obviously, revenue is growing very fastly, we made a big investment last year, and we talked about having room for revenue growth. And obviously, that enterprise revenue growth is quite substantial in terms of year-over-year and getting to more material numbers. Tom and I talked about being on a $50 million run rate just for that and growing it over 300%. Now, we've used kind of a metric of about a $1 of CapEx for a dollar of revenue. Not a perfect metric, but it's not a bad one to use. I've actually looked at some of the hyperscalers and some of the other public information that's available. It's a fairly decent proxy, obviously, as you're making major investments like testing an AI now. But I think that's a fairly decent place to put it for now and then obviously as we get more experience we'll update you from there.
Tom Blakey: Okay thanks again for that review and update there. Back to Noname and the kind of setup here so we model it correctly and look at organic growth. Did that $20 million for the back half includes like a cross-sell or uplift from being on the Akamai platform? Is that just kind of annualizing what Noname's revenues are today? And maybe from a strategic perspective for Tom, like is with Noname also purchased to be more of a -- strategic asset in the context of not just API related posture management and bundling there, or is Noname going to be in -- its code base going be more of a hub for bundling more additional security services for Akamai?
Tom Leighton: Yeah, I'll just do a quick answer on the second part there. Yeah, Noname is strategic, API security is strategic, and we're looking forward to integrating that more deeply in the Akamai platform and then building on top of it with new capabilities. And Ed, I'll let you talk about the financial.
Ed McGowan: Yeah, so what we've baked in really is just essentially what we expect their contribution to be without a significant increase in sales from our revenue synergy. So there's an opportunity to drive additional revenue synergy throughout the back-half of the year. Assumption there is it closes sometime in June. Going to train our sales reps up. It always takes a little while for an acquisition to settle, and then you start opening up sales campaigns and we'll start closing some deals towards the latter part of the year. Hopefully we can do better than that but in terms of our thinking we just sort of layer in what that contribution will be and hopefully we can drive some revenue synergy in addition to that.
Tom Blakey: Thanks. Thank you.
Tom Leighton: Okay. Thank you, everyone. In closing, we'll be presenting at several investor conferences throughout the rest of the quarter. We look forward to seeing you at those. And thanks again for joining us tonight. We hope you have a nice evening. Operator you can now end the call.
Operator: Conference has now concluded. Thank you for attending today's presentation. You may now disconnect. | [
{
"speaker": "Operator",
"text": "Good day and welcome to the First Quarter 2024 Akamai Technologies Incorporated Earnings Conference Call. All participants will be in listen-only mode. [Operator Instructions] Please note this event is being recorded. I would now like to turn the conference over to Mark Stoutenberg, Head of Investor Relations. Please go ahead."
},
{
"speaker": "Mark Stoutenberg",
"text": "Thank you, operator. Good afternoon, everyone, and thank you for joining Akamai's First Quarter 2024 Earnings Call. Speaking today will be Tom Leighton, Akamai's Chief Executive Officer and Ed McGowan, Akamai's Chief Financial Officer. Please note that today's comments include forward-looking statements, including statements regarding revenue and earnings guidance. These forward-looking statements are subject to risks and uncertainties and involve a number of factors that could cause actual results to differ materially from those expressed or implied by such statements. The factors include any impact from macroeconomic trends, the integration of any acquisitions, and any impact from geopolitical developments. Additional information concerning these factors is contained in Akamai's filings with the SEC, including our Annual Report on Form 10-K and our Quarterly Reports on Form 10-Q. The forward-looking statements included in this call represent the company's view on May 9th, 2024. Akamai disclaims any obligation to update these statements to reflect new information, future events, or circumstances, except as required by law. As a reminder, we will be referring to certain non-GAAP financial metrics during today's call. A detailed reconciliation of GAAP and non-GAAP metrics can be found under the financial portion of the Investor Relations section of akamai.com. I will now hand the call off to our CEO, Dr. Tom Leighton."
},
{
"speaker": "Tom Leighton",
"text": "Thanks, Mark. Akamai got off to a strong start for the year with our Security and Compute portfolios. And we continued to experience industry headwinds with our delivery product-line. First quarter revenue grew to $987 million, up 8% year-over-year as reported and in constant currency. Non-GAAP operating margin was 30% and non-GAAP earnings per share was $1.64, up 17% year-over-year and up 18% in constant currency. The fast growing parts of our business, security and cloud computing, grew to represent almost two-thirds of total revenue in Q1, and combined they grew 22% over Q1 of 2023. The continued shift in Akamai's revenue mix towards security and compute, is a clear indicator that our growth strategy is achieving the intended results. We continue to successfully leverage the market leadership and cashflow of our delivery product line to invest in our faster growing and more profitable security and cloud computing portfolios. And we are excited about the opportunities we have ahead of us, especially with our planned acquisition of Noname Security, which we announced this week. I'll say more about Noname in a minute. But first, looking at our security portfolio more broadly, security revenue grew 21% year-over-year in Q1 to $491 million, driven in part by continued strong demand for our market-leading Guardicore Segmentation Solution. Customers who purchased Segmentation from Akamai in Q1 included one of the top telcos in the US, a supermarket chain with more than 1,500 stores across Canada, and a major business management software company in Latin America. Our Zero Trust Network Access Solution, is also seeing good traction. For example, the United States Army announced last month that it selected Akamai for Zero Trust Security in Battlefield Networks. After a competitive evaluation of more than 40 vendors, the Army will use Akamai for its tactical identity, credential, and access management to enhance defenses in high-risk operational environments and limit network access to authorized users, devices, applications, and services. In response to customer requests to bring our Enterprise Zero Trust solutions together into a single platform, we've integrated Guardicore with our other enterprise security solutions to form our recently announced Akamai Guardicore platform. This new platform is the first of its kind to enable Zero Trust Security through a fully integrated combination of micro segmentation, Zero Trust Network Access, multi-factor authentication, DNS firewall, and threat hunting. All designed to strengthen and simplify enterprise security with broad visibility and granular controls through a single console. We think it will appeal to customers looking to consolidate security vendors and integrate their security tools. We also continue to see strong customer interests in our app and API security solutions. Customers who purchased Akamai API Security in Q1, included a major consumer financial services company, a US supermarket chain with more than 1,200 stores, and a leading US manufacturer of electric vehicles. Last month, one of our largest customers, a well-known hyperscaler, was hit with a massive denial-of-service attack, 24 million requests per minute. Using our rate controls and custom web app firewall rules, the customer successfully forwarded 99.999% of the attack traffic. That's five nines of protection. The customer was delighted, telling us, “that's an A-plus by just about every calculation”. Unlike some of our competitors who struggled to defend against far smaller DDoS attacks in recent months, Akamai is capable of protecting even the hyperscalers. The scale of Akamai defenses and the depth of our expertise really matter for customers, who named Akamai a Customer's Choice for the fifth-year in a row in the new Gartner Peer Insights Voice of the Customers report for cloud web app and API protection. And soon, our suite of app and API security solutions will become even stronger with the planned acquisition of Noname Security. The use of APIs has exploded in nearly every industry, driven by digital transformation, the widespread adoption of mobile phones and IoT devices, and the increased sharing of data between third-party providers. The increasing use of APIs also opens up new threat vectors for attackers and the need for API security. For example, we saw API attacks on our platform more than double from January 2023 to January 2024. And IDC Research now predicts that the API security market will grow at a CAGR of 34% to nearly a $1 billion by 2027. That's one reason why we are so excited about our plan to acquire Noname, as we accelerate our momentum in this fast growing segment. As one of the market leading API security offerings, Noname delivers visibility into API business logic abuse and contextual awareness between API requests and responses to ensure that anomalous traffic is detected, inspected, and blocked when warranted. We believe that the addition of Noname to our API security solution will offer Akamai customers enhanced attack analysis, more flexible deployment options, and extensive vendor integrations. Ed will share some financial details about the acquisition shortly. Turning now to cloud computing, I'm pleased to say that 2024 is off to a great start, with strong early momentum across multiple verticals. Customers are excited about our differentiated cloud platform, which offers superior performance through a more distributed footprint, cloud diversification, and lower costs. Examples of major enterprises using our cloud computing platform now include one of the world's largest e-commerce platforms, several global auto manufacturers, several large direct-to-consumer and OTT providers, several global SaaS providers, numerous travel and hospitality companies, including one of the world's largest cruise lines and a large airline in Asia, one of the largest credit unions in the US. A multinational financial services company. An iconic global corporation that manufactures and sells consumer electronics, computer software, and online services. A European cyber security company, and a leading ad tech company. Just this week, we signed up one of the world's best known media companies to a two-year deal worth several million dollars per year for compute. Yet another great example of major enterprises using our new cloud computing platform is Sony Group. Sony is excited about Akamai's investment into Edge Compute and has multiple latency-sensitive compute workloads that are running on Akamai. Current use cases include PlayStation.com, leveraging Edge Compute to improve search engine optimization, and PlayStation Direct, leveraging Edge Compute to ensure a fair experience for customers purchasing PlayStation Hardware. We're also seeing strong early traction with our Independent Software Vendor, or ISV, partners. They offer solutions that run on our compute platform in which our go-to-market teams co-sell to help customers solve big challenges with a better together solution. For example, a media workflow provider, which powers OTT video, now offers its live encoder solution on Akamai Connected Cloud. The solution is designed to increase efficiency for large scale streaming while also lowering egress fees, by as much as 90% according to their calculations. Joint customers of the offering include OneFootball, one of the world's biggest digital soccer platforms, backed by clubs such as Real Madrid, Manchester City, and Bayern Munich. In partnership with an observability solution provider, we won cloud computing deals in Q1 with one of the world's leading gaming companies, a leading luxury goods brand in Europe and one of India's largest conglomerates. Their solution powers observability using Akamai Cloud computing and enables real-time data ingestion at scale, lightning fast query performance, and extensive data retention at a fraction of the cost of other platforms. Another ISV partner that is providing distributed database services, enabled a well-known online travel marketplace to go live in Q1, with a geolocation implementation that uses Akamai’s Edge Computing to execute code at the edge for optimal performance. The travel site invoked more than 68 billion Edge Compute instances in March alone. By the end of Q1, we had over 200 customers spending $36,000 or more in Annual Recurring Revenue for our new compute services, with about half spending $100,000 or more, and six spending over $1 million per year, all just for compute. All of these customer counts are triple what we had in Q1 of last year. Collectively, these customers are spending over $50 million annually coming out of Q1 for our new cloud computing solutions, which is up more than 4 times year-over-year. Beginning this quarter, our global enterprise cloud sales team is now led by Dan Lawrence, who joined us from AWS, where he ran data and analytics for its private equity segment. Before that, Dan ran the Americas analytics business for five customer segments, including gaming and high-tech SaaS. Dan joined Akamai for the potential he sees to combine Akamai's trusted brand and Edge Computing platform with the large market opportunity and distributed cloud. I'll now say a few words about content delivery, which represents a little over one-third of our overall revenue. Akamai remains the market leader in delivery by a wide margin, providing the scale and performance required by the world's top brands as we help them deliver reliable, secure, and near-flawless digital experiences. That said, our delivery revenue was less than expected in Q1, due to slowing traffic growth across the industry, and a large social media customer that is now optimizing their business to reduce costs. As a result, and as Ed will discuss shortly, we now expect our delivery revenue to decline at a higher rate this year. As we've noted before, delivery continues to generate profits that we use to fuel our future growth. It also helps our security and cloud computing portfolios, as we harvest the competitive and cost advantages of offering delivery, security, and compute on the same platform. Of course, we are not happy to see the declining revenue in our delivery portfolio. And while it remains difficult to predict exactly when that business will begin to stabilize, we believe that Akamai’s CDN remains a critical enabler of doing business on the internet. This has been the case for the past 25 years, and we remain convinced that businesses will continue to need Akamai's superior scale, reliability, and security in the future as they migrate more workloads to the cloud, seek to secure their internal and external applications, and look to unlock the promise of AI, often while also leveraging Akamai security and compute capabilities. Moreover, given the exciting growth we're seeing in our security and compute portfolios, we believe it is only a matter of time before these businesses drive accelerating revenue growth for Akamai as a whole. In summary, we are pleased by the strong performance of our security and compute portfolios to start the year. And we are very excited about our potential for future growth and profitability, as we add Noname to our security portfolio and as our fast-growing compute portfolio contributes a larger share of revenue. Now I'll turn the call over to Ed for more on our Q1 results and our outlook for Q2 in the full year. Ed?"
},
{
"speaker": "Ed McGowan",
"text": "Thank you, Tom. Today I plan to review our Q1 results and then provide some color on our Q2 expectations in our updated full year 2024 guidance, along with the financial impact of our recently announced acquisition of Noname Security. Before we get into that, I wanted to address a few items, including what Tom mentioned in his remarks, that have caused us to reduce our guidance for the remainder of the year. First, the US Dollar has strengthened significantly since the start of the year. As we have noted on many prior calls, foreign exchange fluctuations can significantly impact our top and bottom lines. Based on the strength of the US dollar, we now expect FX to have a negative impact of approximately $40 million on our top-line outlook for the full year 2024. That translates to a negative impact of approximately $0.12 to our expected non-GAAP EPS for 2024. In addition, we expect this will negatively impact our full year 2024 non-GAAP operating margin by approximately 30 basis points. Second, as Tom mentioned, a large social media customer has recently taken steps to lower its costs through a series of optimizations across its platform. As a result, they have reduced their overall traffic. Therefore, we now expect approximately $40 million to $60 million less revenue from this customer for the full year than we previously thought. This change will primarily impact our delivery product line. Finally, as Tom mentioned in his remarks, in addition to the large social media customer, we have seen lower than expected traffic in our delivery business over the past two months, most notably in gaming and video. This is in-line with similar patterns that were cited earlier this week in a research note from a leading Wall Street bank that stated, video streaming services were seeing a drop in downloads, in active users during April. The note also mentioned that weakness was coming from streaming service providers pushing for ad-supported versions and password sharing crackdowns to stay ahead in the streaming wars. As a result of these recent market conditions, it's prudent to assume that this traffic weakness will continue for the remainder of 2024. This lower traffic outlook would translate into approximately $20 million to $30 million less delivery revenue for the remainder of the year than we previously expected. The good news is that in contrast to some other competitors in the industry, both our delivery business and the overall company continue to be highly profitable. As a result, the significant cash flows we generate give us the financial flexibility to execute strategic acquisitions, return capital to shareholders, invest in our future growth, and further diversify our business away from delivery and into the faster growing and even more profitable areas of security and compute. Turning now to our first quarter results. Total revenue for the first quarter was $987 million, up 8% year-over-year as reported and in constant currency. Our two fastest growing offerings, Compute and Security, grew 22% year-over-year on a combined basis and now represent 64% of total revenue. Compute revenue was $145 million, up 25% year-over-year as reported and in constant currency. As Tom mentioned, we have more than 200 enterprise customers using our cloud computing solutions. Our offerings clearly resonate well with customers and we remain optimistic about the early traction we see from large enterprise businesses. It's worth noting that the annual run rate of our enterprise compute revenue is now over $50 million and is growing at over 300% year-over-year. Security revenue was $491 million. Security revenue grew 21% year-over-year as reported, and in constant currency. We are very pleased by our continued performance with our Guardicore Zero Trust Solution and highly encouraged by the traction we are seeing in our recently launched API security solution. Moving to delivery. Revenue was $352 million, which declined 11% year-over-year as reported and 10% in constant currency. International revenue was $475 million, up 7% year-over-year and up 8% in constant currency, representing 48% of total revenue in Q1. Foreign exchange fluctuations had a positive impact on revenue of $2 million on a sequential basis and a negative $4 million impact on a year-over-year basis. Non-GAAP net income was $225 million or $1.64 of earnings per diluted share, up 17% year-over-year and up 18% in constant currency. And finally, our non-GAAP operating margin in Q1 was 30%. Moving now to cash and our use of capital. As of March 31, our cash, cash equivalents, and marketable securities totaled approximately $2.3 billion. During the first quarter, we spent approximately $125 million to repurchase approximately 1.1 million shares. We now have roughly $400 million remaining on our previously announced share buyback authorization. As noted in today's press release, our board authorized a new buyback program of up to $2 billion effective today in running through the end of June, 2027. Combining the two authorizations, we currently have roughly $2.4 billion available for share repurchases. Our intention is to continue buying back shares to offset dilution from employee equity programs over time and to be opportunistic in both M&A and share repurchases. Earlier this week, we announced our intent to acquire Noname security for approximately $450 million. We believe this acquisition demonstrates our continued balance approach to capital allocation by opportunistically buying back shares over time, while maintaining sufficient capital to deploy when strategic M&A presents itself. Before I provide our Q2 and full year 2024 guidance, I wanted to touch on some housekeeping items. First, regarding our planned acquisition of Noname Security. We expect this transaction to add approximately $20 million in revenue for the full year, to be diluted to non-GAAP EPS by approximately $0.10, and to be diluted to non-GAAP operating margin by approximately 50 basis points in 2024. We expect that the acquisition will close sometime in June. We do not expect the acquisition to have a material impact on Q2 results. And as a reminder, our updated full-year guidance includes the impact of the acquisition. Finally, specific to traffic, we expect a modest uptick in media traffic in Q3, primarily due to the Olympics. This event is expected to drive approximately $3 million to $4 million of additional revenue in the third quarter. And while Q4 is typically our strongest quarter seasonally, we saw a more muted impact of that seasonality last year. We expect that we will see a similar result this year. So with those factors in mind, turning to our Q2 guidance. We are now projecting revenue in a range of $967 million to $986 million or up 3% to 5% as reported, and 4% to 6% in constant currency over Q2 2023. At current spot rates, foreign exchange fluctuations are expected to have a negative $5 million impact on Q2 revenue compared to Q1 levels and a negative $9 million impact year-over-year. At these revenue levels, we expect cash gross margins of approximately 72% to 73%. Q2 non-GAAP operating expenses are projected to be $302 million to $307 million. We expect Q2 EBITDA margins of approximately 41% to 42%. We expect non-GAAP depreciation expense to be between $126 million to $128 million. And we expect non-GAAP operating margin of approximately 28% to 29% for Q2. Moving on to CapEx, we expect to spend approximately $175 million to $183 million. This represents approximately 18% to 19% of our projected total revenue. Based on our expectations for revenue and cost, we expect Q2 non-GAAP EPS in the range of $1.51 to $1.56. The CPS guidance assumes taxes of $56 million to $59 million, based on an estimated quarterly non-GAAP tax rate of approximately 19% to 19.5%. It also reflects a fully diluted share count of approximately 155 million shares. Looking ahead to the full year, we now expect revenue of $3,950 million to $4,020 million, which is up 4% to 5% year-over-year as [reported now] (ph) 4% to 6% in constant currency. We now expect security revenue growth of approximately 15% to 17% in constant currency in 2024, including the contribution from the acquisition of Noname. With a strong start for our compute offerings in Q1, we now expect compute revenue growth to be approximately 21% to 23% in constant currency for the full year 2024. We are estimating non-GAAP operating margin of approximately 28% to 29%. We now estimate non-GAAP earnings per diluted share of $6.20 to $6.40. Our non-GAAP earnings guidance is based on the non-GAAP effective tax rate of approximately 19% to 19.5%, and fully diluted share count of approximately 155 million shares. Finally, our full year CapEx is expected to be approximately 16% of total revenue. This updated CapEx is higher than our original expectations outlined last quarter due to our lower revenue outlook, slightly higher software capitalization rates across the business as more work is being done on capitalized projects and higher than expected server component costs, driven primarily by NAND storage pricing in certain servers that support our cloud computing buildup. In closing, we are pleased with our progress in security and compute to start the year. Tom and I would be very happy to take your questions. Operator?"
},
{
"speaker": "Operator",
"text": "Thank you. We will now begin the question-and-answer session. [Operator Instructions] Our first question comes from Madeline Brooks from Bank of America. Please go ahead."
},
{
"speaker": "Madeline Brooks",
"text": "Hi, team. Thanks so much for taking my question, and great to see compute kick up in terms of the guidance. One question for me on the delivery side of the house. Last quarter you had mentioned that first quarter and second quarter of this year we were going to see a few renewals. I just wanted to see how those renewals were going if there was any updated outlook in your guidance from the renewal side of the house. Thank you."
},
{
"speaker": "Ed McGowan",
"text": "Hey, Madeline, this is Ed. Yeah, so the renewals are going as planned in terms of the pricing expectations. We've got a few of them done now. We'll have about five of the seven completed by the end of this quarter, and the other two will be done in early Q3. As far as expectations go, like I said, pricing is coming in-line. Volume a little bit lower than we expected normally when we do these large renewals. We tend to see an uptick in traffic. We just haven't seen that. So that's all been reflected in our guidance."
},
{
"speaker": "Madeline Brooks",
"text": "Great. Thanks. Let me ask you one more question if I could. For those renewals [or financing] (ph) your larger deals, are you seeing any type of offsetting with compute growth for maybe some larger customers where you are seeing lower volume?"
},
{
"speaker": "Ed McGowan",
"text": "I'm sorry, could you just repeat that again?"
},
{
"speaker": "Madeline Brooks",
"text": "Are you seeing a lower customers, larger customers who are coming in maybe with lower volume than expected? Are you seeing that offset at all by any type of compute growth or growth in other areas of the business?"
},
{
"speaker": "Tom Leighton",
"text": "Yeah, they're not directly tied, but as we talked about, several of the world's largest media companies are starting to use our compute capabilities for a variety of tasks. So that's a good new story. It's not tied to the traffic levels in any way. Of course, these big media companies still use Akamai for a large fraction of their delivery needs, but traffic in the industry as a whole, especially media and gaming, is lower than we had initially expected."
},
{
"speaker": "Madeline Brooks",
"text": "Great, thank you so much."
},
{
"speaker": "Operator",
"text": "The next question comes from Keith Weiss from Morgan Stanley. Please go ahead."
},
{
"speaker": "Joshua Baer",
"text": "Thank you, this is Josh Baer on for Keith. The Question was on margin guidance. It was lowered I think by 150 basis points at the midpoint, 50 from the Noname acquisition. You mentioned 30 base points from FX. I was hoping you could just walk through the rest of the move lower on the margin guidance?"
},
{
"speaker": "Ed McGowan",
"text": "Yeah, I think just the rest of that would just be due to the lower delivery revenue as a whole."
},
{
"speaker": "Joshua Baer",
"text": "Okay, got it. I guess as a follow-up related to margins, is there any structural change in reaching, I guess, the low 30s type of long-term target and just asking given the lower guidance for this year but also because from a mixed perspective you've actually moved faster to the higher margin security and compute versus delivery. Thank you."
},
{
"speaker": "Ed McGowan",
"text": "Yeah, sure. So there's really no structural change. Obviously, we're making some pretty big investments in R&D, and you can see that in the R&D line. And also just the acquisitions, we made an acquisition last year, made an acquisition now. So we're investing in growth. But there's also a fair bit of investment that goes into the cost of goods sold-line as we build out our compute platform. So you can see that in the higher co-location costs. And there is some accounting that you have to do when you enter into some of the long-term agreements for co-location. So we should start to see that, get some benefit of that as compute grows even faster."
},
{
"speaker": "Joshua Baer",
"text": "Great, thank you."
},
{
"speaker": "Operator",
"text": "The next question comes from James Fish from Piper Sandler. Please go ahead."
},
{
"speaker": "James Fish",
"text": "Hey guys, just on the social media customer here, I think I may know what's going on, but you know, it does seem as though traffic has been slowing for the last, you know, two years or so from what we can tell. But on some of these renewals and specifically on the social media customer, I guess what's the confidence that this isn't just tied to kind of DIY efforts picking back up in the space?"
},
{
"speaker": "Tom Leighton",
"text": "Yeah, for the large social media customer we talked about, there's a few components generally tied to their efforts to reduce costs. You know, they are using less bits per transaction and end-user experience. They're optimizing their doing less prefetching. They do have a very large DIY component as well and we haven't seen the impact of that yet but we do think that they may use that more throughout the rest of the year and that's factored into our lower guidance for this particular customer. So we haven't seen that yet, but we anticipated at this point as part of their overall cost reduction efforts."
},
{
"speaker": "James Fish",
"text": "Got it. And then on the security side of the house, I mean, what did Noname have that [sure] (ph) Neosec was smaller in scale, but that Neosec didn't. And so why isn't this just kind of a role of strategy of kind of the API space? And Ed, if you could just walk me through the security guidance? You guys had a pretty good beat here. And I get FX is kind of moving against you on this, but why wouldn't we see further upside given the strength you saw in Q1? Is it just because some of the security revenues tied to some of these delivery renewals or why the conservative security guide?"
},
{
"speaker": "Tom Leighton",
"text": "I'll take the first part and then let Ed to answer the second part. Yeah, Noname is a market leader. And they have a lot of capabilities that we don't have yet. And it's actually very synergistic with what we have. They have an on-prem and hybrid-solution. Our solution has been SaaS-only. They have a great channel partner ecosystem, market-leading presence, very easy to use and to integrate. And by the time we get the acquisition closed later this quarter, we anticipate we'll have full integration with Akamai Security Services, which is the piece they were really missing. And great user experience and console. So really strong capabilities and of course much bigger business. And with our solution, we can add to that I think stronger forensics and threat hunting with our data lake capabilities and by putting the pieces together, really a very compelling solution. I was just out at RSA earlier this week and I got to say the news was incredibly well received. A lot of customers, both ours and Noname customers, very happy about the acquisition and what we're going to be able to do for them. Also, the partner ecosystem, Noname is very partner friendly. That will really help our go-to-market motion and they were very excited about the news as well. And Ed, I'll turn it over to you for the second part there."
},
{
"speaker": "Ed McGowan",
"text": "Yeah, sure. So first of all, just a great quarter for security, great sequential growth, strength across the board really in terms of pretty much all of our solutions, obviously seeing great growth with API security and expect that will accelerate now that we have Noname in the mix. But I think as you look at last year, we had very, very strong sequential growth, sort of unusually strong, including some license revenue in the back half of last year. So the compares get a little bit tougher. I don't think there's anything structurally that we're seeing that would cause us to be less bullish. I think one thing, just to keep in mind, we introduced some bundles last year. We had identified about 3,000 customers or so. Obviously, we had great success with that. That's going to have less of an impact this year as we start to anniversary that. But we are very excited about what we're seeing with Guardicore, which is starting to become more material, and the growth from API security. So we're very bullish with the growth going forward. I think just getting it to tougher comps in the back half, which is going to perhaps cause the percentages to be a little bit lower than what we saw here in Q1."
},
{
"speaker": "James Fish",
"text": "Thanks Ed."
},
{
"speaker": "Operator",
"text": "The next question comes from Fatima Boolani from Citi. Please go ahead."
},
{
"speaker": "Fatima Boolani",
"text": "Good afternoon. Thank you for taking my question. Just one on delivery. You know, I can appreciate how difficult it is to sort of parameterize some of the trends that are playing out in the industry. I think both of you sort of laid that out in the prepared remarks. But how should we think about the floor in terms of declines in this business and what type of GuardRails you're anticipating and putting around this business? And essentially what I'm trying to get around is how confident are you that this recalibration lower does take into consideration everything that's happening in them? And then I have a follow-up."
},
{
"speaker": "Tom Leighton",
"text": "Yeah, I'll start and then Ed will give us some more color on this. Of course, you know, when we give guidance, we do it based on the best available information we have at the time. Obviously, we don't like to see, the revenue decline and you never like to be in a position of taking down the guidance for one of your portfolios. We do believe that, you know, our delivery business is critical for major enterprises to operate on the Internet. That said, delivery is a very competitive environment And we are subject to overall traffic levels on the internet, which we now believe will be in a lower state than we had thought before. And you know, this is typical. We've been doing this as the market leader now for 25 years, and there's times, when traffic accelerates more than you might have thought and times when it doesn't. And I think we're in sort of the latter mode right now. Now we do believe the business will get back to par. I can't tell you exactly when that will be. It's important for us to do that. I should add though, it's not our top priority. We are not out there doing whatever price it takes to go grab all the business. In fact, I think we've been pretty clear that's not the case. There's traffic that we are not taking because we don't feel that it's profitable or really strategic for us. Our primary goal is using delivery for very strong cash flow that we can invest in security and compute, which we think are much more lucrative markets in the long run, offering much more growth. And also we use it with our customers to introduce, for example compute. The [big-bit] (ph) customers, big media, gaming, are big prospects in compute. And the largest customers there are over $1 billion in third-party cloud spend, typical large media customer, hundreds of millions. And we want to get a share of that business which is much more profitable and ultimately much larger than delivery. So that is our focus here. Obviously we want to get back to PAR. We don't like to see a declining business but it's a bigger picture. And of course we are competing with a lot of companies that are very desperate just to get a little bit more growth in delivery, and even if they are doing it at a very unprofitable level, and that makes it more challenging. And Ed, maybe you want to talk a little bit more on the details of the guidance and the confidence?"
},
{
"speaker": "Ed McGowan",
"text": "Yeah, as Tom talked about, we use the best information we possibly can. We obviously work with a lot of the big telcos. We try to get feedback from them to see what they're seeing. We talk to our large customers to get an understanding of what they have planned in terms of the big events or if they're doing downloads, how big the downloads are going to be, what sort of share we should expect as we go through things like our large renewals and that sort of stuff. When we see a trend like we saw in March where traffic was lower than we expected and then continued into April, it did cause us to go back and relook at our forecasts and be a little bit more cautious. But those forecasts, it's unusual to see traffic decline month over month. It doesn't generally happen. But there is a big pressure in the industry to save costs, especially in the streaming business. Gaming tends to be very seasonal and a little fickle in terms of different titles being popular and not. We're just sort of in the downtrend in gaming. But as Tom mentioned, we've seen these trends before. We're usually pretty good at predicting when things will turn around. But when we do see something that is concerning, we're going to call it out and reset our forecast."
},
{
"speaker": "Fatima Boolani",
"text": "I appreciate that. And just with regards to the new go-to-market leadership on the compute side, I'm just curious if there are going to be any material changes or is this a deepening of the bench that's going to allow for an ongoing, ideally, acceleration of the compute business? We'd love to just get a little bit more detail on that go-to-market change for someone with a pretty excellent category. Thanks so much."
},
{
"speaker": "Tom Leighton",
"text": "Yeah, it's more of the latter and getting really solid experience and expertise as we increase our investment in the go-to-market effort around compute. And we think Dan is an excellent addition to our leadership."
},
{
"speaker": "Operator",
"text": "The next question comes from Mark Murphy from JP Morgan. Please go ahead."
},
{
"speaker": "Mark Murphy",
"text": "Thank you very much. I wanted to congratulate you on the strength in the Compute and Security and the US Army win the Sony -- win, obviously good things happening there. Going back to the social media company that you referenced, is that a typical kind of [garden variety] (ph) case of cost optimization or is there perhaps anything unusual like a corner case where The clock might be ticking on legislative proposals and they are moving in advance of that. Could it be a social media company that is struggling and shrinking? Anything along those lines?"
},
{
"speaker": "Tom Leighton",
"text": "No, I think you described it pretty well in the first two descriptions you gave. And they just are a very large customer for Akamai, and a very good customer. They are looking to cut costs and they are looking at potential, geopolitical challenges. And so that, I think a lot of companies look to cut costs, particularly these days in media and maybe they have additional concerns."
},
{
"speaker": "Mark Murphy",
"text": "I understand. Okay. And then Ed, the security company you're acquiring, I forget the name of it, can you provide any metrics on the headcount or their growth rate in the last 12 months or the gross margins? And I'm just wondering, does it focus on API security that aligns any more or less across any of the particular hyperscalers?"
},
{
"speaker": "Ed McGowan",
"text": "Yeah, I'll take the first part, Tom. You can take the second part about the product. Now in terms of growth rates and stuff like that, I hesitate to give growth rates because we obviously have to translate everything they're doing into GAAP revenue ASC 606. But needless to say, they were growing pretty quickly. We talked about we think it will contribute about $20 million of revenue, but again growing very fast as we introduce them into the mix. We think we can accelerate that growth rate quite a bit as we introduce them to our customer base. Gross margins I would say is pretty typical of what you see in a software company. It's called like high 70s, maybe low 80s. There are some people cost that go into your cost of goods sold. As far as people go, right around 250 people, give or take, 60% or so is in R&D, 30% in go-to-market and the rest is sort of mixed in kind of your back-office support."
},
{
"speaker": "Tom Leighton",
"text": "Yeah, in terms of the question on the hyperscalers and API security, they don't offer API security. They have API gateways, which is something totally different. In our competition, in API security is more startups or younger companies smaller. It's an emerging field and really we feel Noname as a leader there."
},
{
"speaker": "Mark Murphy",
"text": "Thank you."
},
{
"speaker": "Operator",
"text": "The next question comes from Frank Louthan from Raymond James. Please go ahead."
},
{
"speaker": "Frank Louthan",
"text": "Great, thank you. Just to go back on the delivery side, was there a price that they would have been willing to stick with? There was just pretty much a business decision there. And Tom, you mentioned get back to PAR. What do you mean by that? Is that a level of revenue? How should we think about what it would be to kind of getting back to PAR?"
},
{
"speaker": "Tom Leighton",
"text": "Well, PAR, we don't want to see revenue decline in our portfolio. We'd like to see it to grow. And we're declining, obviously, now in delivery. And in the particular case of the large social media company, I don't think, this is a price-related issue, really. And as Ed mentioned, I think pricing, obviously very competitive out there. And we don't go and chase the bottom stuff that's not really profitable for us. But you know, pricing is sort of as we expect and more of it's a traffic, overall traffic in the industry right now."
},
{
"speaker": "Frank Louthan",
"text": "Okay, and at what level do you see the delivery business sort of bottoming it out that would be considered sort of flat for you."
},
{
"speaker": "Ed McGowan",
"text": "Yeah, you know as Tom talked about, it's hard to predict. I mean, I think what you need to see for that to happen is traffic growth to improve, to see pricing rationalize a bit more than where it is now, and less concentration of big renewals. But that's really the formula that you would need to see a sort of a stabilized delivery business."
},
{
"speaker": "Frank Louthan",
"text": "Okay, great. Thank you."
},
{
"speaker": "Operator",
"text": "The next question comes from Amit Daryanani from Evercore. Please go ahead."
},
{
"speaker": "Unidentified Analyst",
"text": "Hey, guys. Thanks for taking the question. This is [Chant] (ph) on for Amit. I just had a quick one on the delivery business. You know, given this is an election year, do you think we could see a step up in the delivery business, maybe in the back half? I think normally elections tend to drive some sort of benefit as well as kind of the Olympic benefits you mentioned earlier."
},
{
"speaker": "Tom Leighton",
"text": "Yes, we talked about the Olympics as a decent event for us. Our estimate is $3 million to $4 million this year. As far as the election goes, really hard to tell. You know, we saw back in [2016] (ph) a bit more traffic, [2020] (ph) didn't really drive a ton of traffic. I'd say this is probably closer to what we saw in 2020, so we're not really anticipating a significant amount of traffic as a result of this year's election, but we'll see."
},
{
"speaker": "Unidentified Analyst",
"text": "Got it. And then just as a follow-up, I think free cash flow is really strong during this quarter, but if I look back historically, Q1 is kind of the low, and then sequentially in the June and September quarter it's much greater. So could you talk about maybe any changes to your CapEx and free cash flow expectations for fiscal 2024?"
},
{
"speaker": "Tom Leighton",
"text": "Yeah, so I would think that next year should play out, or excuse me, 2024 should play out like it's done in the past. Q1 was a little bit stronger than normal. As we talked about on several calls back last year, we did move some folks to a stock-based bonus program. So we used to have a cash-based bonus program that would play out in Q1 that would drive cash flow down a little bit in Q1, but in terms of the progress throughout the year, it should look like the other years."
},
{
"speaker": "Unidentified Analyst",
"text": "Great. Thanks for that."
},
{
"speaker": "Operator",
"text": "The next question comes from Jonathan Ho from William Blair & Company. Please go ahead."
},
{
"speaker": "Jonathan Ho",
"text": "Hi. Good afternoon. Just wanted to understand the Zero Trust platform that you announced today. Can you talk a little bit about how customers are thinking about purchasing the assembly of products that you're talking about and how that compares with maybe some of the other views on how SASE and other Zero Trust platforms will evolve over time."
},
{
"speaker": "Tom Leighton",
"text": "Yeah, this is a really good platform for Zero Trust for enterprise applications. So you get your micro segmentation and your employees Zero Trust Network access which is your employee access. That's your North, South and East, West now combined. Same agents, you don't have to have two different agents, same console and [plane of class] (ph). And on top of it, you get your MFA, your DNS security, and your threat hunting service, all packaged in a platform. And that's something customers have been asking for. It makes their lives a lot easier than having what seem to be different products with different agents and different interfaces. On top of it, at RSA we demonstrated a very cool new capability that actually uses a GenAI, LLMs, to give a very nice human interface into your enterprise infrastructure. It identifies what your various applications and devices are, and you'd sort of think, oh, well people would know, but they don't. Enterprise, major enterprises just have zillions of applications and devices on the internal network and they don't even know what they all are. And this tells you, in actually a human language form, can actually tell you what is not sufficiently protected or if the firewall rules, the agent rules are out-of-date. We've got a lot of positive feedback about that at RSA. And it's something that over time we want to take to our entire suite of security services, which I think will be pretty exciting. So yeah, so this helps because customers want to see, really have a few basic platforms of which Akamai is one and simplification of interface and control, both for the control plane and for the agent that's on their applications and service."
},
{
"speaker": "Jonathan Ho",
"text": "Excellent, excellent. And just in terms of a follow-up, with compute, you obviously spoke about a number of large wins here, large types of customers. Can you talk about the potential to take that larger share of the pie over time as you grow within these customers and help us understand, are you landing in sort of a small footprint to begin with and then growing from there? Are you just sort of taking everything up front? I'm just trying to understand what that net retention opportunity looks like over time. Thank you."
},
{
"speaker": "Tom Leighton",
"text": "Yeah, great question. It very much is a land small. Somebody will try out a single app with a little of the traffic forward and then grow it, and then add more apps. And you see that with our profile of customers, starting with the ones that $3,000 a month, then half of them now up to [$100,000] (ph) a year, [$60 million] (ph), [$100 million] (ph) a year. And Akamai is actually our first $100 million a year customer on the platform. And that's the same progression we went through over the last year-and-a-half. And we expect, and that's what we're trying to do with all of our accounts. These customers I talked about I couldn't give you most of their names, but you would recognize them. And they are -- what they're spending now with us is a tiny fraction, even the big ones, of their overall cloud spend. And they are finding the platform is easy to use, performs very well, and is saving them a boatload of money. And I think that's why we're seeing such good early traction. And now the goal is to grow those accounts, both in terms of the number of use cases and the scale of a use case, and then to add more customers. And again, they will come in at the lower revenue volumes to start."
},
{
"speaker": "Operator",
"text": "The next question comes from Alex Henderson from Needham. Please go ahead."
},
{
"speaker": "Alex Henderson",
"text": "Great, thanks. First off, congratulations. Picking off Noname was a real coup for you. I think that's an outstanding acquisition. So congratulations on that. I wanted to ask some content around the compute piece. First, you moved a bunch of your internal apps from other compute platforms to internal. Where are you on that? What does that look like in terms of the cost savings? And what has been the variance relative to what you'd expected when you started it, I assume you probably got better results, not worse results. And I was hoping you could, within the context of the compute platform, talk about gross retention as opposed to net retention. Obviously your net retention looks very good with these upticks, but I was wondering if there was any churn of people who were on the platform before that may have fallen out of the equation?"
},
{
"speaker": "Tom Leighton",
"text": "Yeah, we're more than halfway through the migration of our third-party cloud spend onto Akamai Connected Cloud. And as I mentioned, seeing really dramatic savings and also performance improvements. So we're more than $100 million a year in on the platform now, which is really fabulous for us. And maybe, Ed you want to take the second part of that question?"
},
{
"speaker": "Ed McGowan",
"text": "Yeah, so if you think about where you see that, Alex, is there some absolute savings if you look at our – in our cost of goods sold line, you can see that on that network build and support sub-line, sub-category. It's offset a little bit by what you see in [colocation] (ph) fees. So you're not seeing a ton of margin expansion. But what doesn't show up there is that that line was growing at 30%, 40%, or 50% a year. Now, probably we'd be growing 30%, 40% if we hadn't done it. So the cost avoidance is pretty significant. As Tom said, we're finding this to be much better than we had expected. We should get the rest of the expected applications moved over here between now and the early part of next year, end of this year into the early part of next year. So I'm very, very pleased with that. And again, a lot of cost avoidance and some absolute cost savings, like I said, being a little bit [massive] (ph), investments we're making in the platform. And then you also asked a question on gross retention, I think was the term you used in terms of are we seeing any churn. On the enterprise side, we're not seeing any churn so far. We haven't seen any customers that have left the platform. We do see a little bit of churn in the legacy retail node business which was pretty common when you talked about the SMTs. But where we're really aiming to grow the business, we're not seeing any of that yet."
},
{
"speaker": "Alex Henderson",
"text": "Okay, great. And just one last question on this subject. Can you talk about whether you're seeing any potential around inference AI on this platform because it hasn't been mentioned yet. Thanks."
},
{
"speaker": "Tom Leighton",
"text": "Oh yeah, we already have several customers doing all sorts of AI, but inference AI on our platform, and we have partners, our ISV partners. Some of them, that's their product capability. So yeah, we foresee substantial use of the platform for inference."
},
{
"speaker": "Alex Henderson",
"text": "Great. Thank you."
},
{
"speaker": "Operator",
"text": "The next question comes from Rudy Kessinger from DA Davidson. Please go ahead."
},
{
"speaker": "Rudy Kessinger",
"text": "Hey, Thanks for taking my questions. Ed, just given the quicker than expected mix shift of the higher gross margin revenue lines, why aren't we seeing gross margins at least hold steady, if not expand? It's been compressing for the last few years."
},
{
"speaker": "Ed McGowan",
"text": "Yes, so if you look back a few years ago, they've been compressing a bit. We had some pricing pressure as we always do in the delivery business. But I talked a little bit about this a few questions ago, and even a little bit with Alex in the last question. As we invest in the platform to build out compute locations, we're doing the GECO build out. We built out 25 core locations last year. We entered into these long-term leases for colocation. And where there's underlying [commits] (ph), you have to straight line that. So there's some non-cash colocation expenses. So if you look at our [co-loc] (ph) cost line, that's been growing pretty substantially. So that's masking a lot of the savings that you're seeing from our third-party compute costs. There's also additional build out and support costs that go along with it as well. So that's why you're seeing that margin sort of holding flat to where they've been over let's say the last year or so, but I don't expect them to decline. Hopefully over time they should start to expand a bit, but as we're building out aggressively in the compute platform that does put a little bit of pressure on margins, but as we start to fill up those locations, we should start to see expansion in margin."
},
{
"speaker": "Rudy Kessinger",
"text": "Yeah, okay. And then on delivery, could you just talk about where some of the repricings came in with some of those contracts? And if I look at kind of what's implied for delivery in the rest of the year on an organic basis adjusting for some of those contracts you acquired, it looks like it kind of probably gets down to down 20%-ish year-over-year on an organic basis. What is the mix of price compression versus traffic growth? Is it flat kind of traffic on the network given all the things you talked about and 20% price compression or what is the combination there?"
},
{
"speaker": "Ed McGowan",
"text": "Yeah, so we don't share those numbers for obvious reasons with the price compression because obviously there's customers that get certain discounts, others don't get as high discount because they don't have as much traffic. And also it's a competitive number. I'd want to know what my competitors are doing with that number as well. But if I think about sort of the mix of what's driving it. Pricing is always a factor. And if you don't get the commensurate traffic growth offset that, then you're going to decline. And that's what we're seeing. It's really the back-half story is a lower than expected traffic. Now, couple that with your, some of your largest customers renewing at the same time. You don't have that, that volume offset. It just exaggerates the impact at the back half of the year. So like I said, it's really more of a volume issue than it is an overall pricing issue."
},
{
"speaker": "Tom Leighton",
"text": "Okay, operator, I think we've got time for one last question."
},
{
"speaker": "Operator",
"text": "The next question comes from Tom Blakey from KeyBanc Capital Markets. Please go ahead."
},
{
"speaker": "Tom Blakey",
"text": "Hey, Mark and guys, thanks for squeezing me in here. I just wanted to go back, I think maybe to dive a little deeper on Rudy's question about gross margins. You talk about moving to more profitable solutions longer-term and made some headway here in one queue. In the past, you've kind of given us a framework about lowering CapEx, as a percentage of revenue for CDN. Essentially, 0% CapEx is needed, theoretically anyway, for security. Can you just walk us through what the -- not the near-term manned price components are, but longer-term structurally, what does compute look like at scale for Akamai? And have a follow up."
},
{
"speaker": "Ed McGowan",
"text": "Yeah, so good questions. What -- I'll start with what the components of CapEx are today. So we said 16%. About 8% of that is Software CAP, so that's probably going to be 7%, 8% sort of going forward. Don't expect much of a change there. That's kind of been historically in that range. Compute this year is about 4%. CDN and securities around 3%, and then there's always 1% call it first. You know, you're [back-off](ph) if there's your IT systems and your facility related stuff. So in terms of how that's going to go throughout the years, we've obviously driven down our CapEx on the CDN business pretty dramatically. That used to be sort of 8% to 10% is what we used to talk about. So we've more than cut that in half. And I expect that -- that kind of low single-digit range will probably be where we stay unless we see just a dramatic increase like we saw during the pandemic. But there's no reason to believe that is to happen with what we know about the industry right now. In terms of the compute business, it's really a question of growth. Now we're expanding in terms of the number of locations right now. Obviously, revenue is growing very fastly, we made a big investment last year, and we talked about having room for revenue growth. And obviously, that enterprise revenue growth is quite substantial in terms of year-over-year and getting to more material numbers. Tom and I talked about being on a $50 million run rate just for that and growing it over 300%. Now, we've used kind of a metric of about a $1 of CapEx for a dollar of revenue. Not a perfect metric, but it's not a bad one to use. I've actually looked at some of the hyperscalers and some of the other public information that's available. It's a fairly decent proxy, obviously, as you're making major investments like testing an AI now. But I think that's a fairly decent place to put it for now and then obviously as we get more experience we'll update you from there."
},
{
"speaker": "Tom Blakey",
"text": "Okay thanks again for that review and update there. Back to Noname and the kind of setup here so we model it correctly and look at organic growth. Did that $20 million for the back half includes like a cross-sell or uplift from being on the Akamai platform? Is that just kind of annualizing what Noname's revenues are today? And maybe from a strategic perspective for Tom, like is with Noname also purchased to be more of a -- strategic asset in the context of not just API related posture management and bundling there, or is Noname going to be in -- its code base going be more of a hub for bundling more additional security services for Akamai?"
},
{
"speaker": "Tom Leighton",
"text": "Yeah, I'll just do a quick answer on the second part there. Yeah, Noname is strategic, API security is strategic, and we're looking forward to integrating that more deeply in the Akamai platform and then building on top of it with new capabilities. And Ed, I'll let you talk about the financial."
},
{
"speaker": "Ed McGowan",
"text": "Yeah, so what we've baked in really is just essentially what we expect their contribution to be without a significant increase in sales from our revenue synergy. So there's an opportunity to drive additional revenue synergy throughout the back-half of the year. Assumption there is it closes sometime in June. Going to train our sales reps up. It always takes a little while for an acquisition to settle, and then you start opening up sales campaigns and we'll start closing some deals towards the latter part of the year. Hopefully we can do better than that but in terms of our thinking we just sort of layer in what that contribution will be and hopefully we can drive some revenue synergy in addition to that."
},
{
"speaker": "Tom Blakey",
"text": "Thanks. Thank you."
},
{
"speaker": "Tom Leighton",
"text": "Okay. Thank you, everyone. In closing, we'll be presenting at several investor conferences throughout the rest of the quarter. We look forward to seeing you at those. And thanks again for joining us tonight. We hope you have a nice evening. Operator you can now end the call."
},
{
"speaker": "Operator",
"text": "Conference has now concluded. Thank you for attending today's presentation. You may now disconnect."
}
] | Akamai Technologies, Inc. | 24,522 |
AKAM | 1 | 2,025 | 2025-05-08 16:30:00 | Operator: Hello and welcome to the Akamai Technologies First Quarter 2025 Earnings Conference Call. All participants will be in listen-only mode. [Operator Instructions] After today’s presentation, there will be an opportunity to ask questions. [Operator Instructions] Please note, this event is being recorded. I would now like to turn the conference over to Mark Stoutenberg, Head of Investor Relations. Please go ahead.
Mark Stoutenberg: Good afternoon everyone and thank you for joining Akamai's first quarter 2025 earnings call. Speaking today will be Tom Leighton, Akamai's Chief Executive Officer; and Ed McGowan, Akamai's Chief Financial Officer. Please note that today's comments include forward-looking statements, including those regarding revenue and earnings guidance. These forward-looking statements are based on current expectations, assumptions that are subject to certain risks and uncertainties and involve a number of factors that could cause actual results to differ materially from those expressed or implied. The factors include but are not limited to, any impact from macroeconomic trends, the integration of any acquisition, geopolitical developments and any other risk factors identified in our filings with the SEC. The statements included on today's call represent the company's views on May 8, 2025. And we assume no obligation to update any forward-looking statements. As a reminder, we will be referring to certain non-GAAP financial metrics during today's call. A detailed reconciliation of GAAP to non-GAAP metrics can be found under the financial portion of the Investor Relations section of akamai.com. With that, I'll now hand the call off to our CEO, Dr. Tom Leighton.
Tom Leighton: Thanks, Mark. I'm pleased to report that Akamai got off to a solid start on the year. First quarter revenue grew to $1.015 billion, up 3% year-over-year reported and up 4% in constant currency. Non-GAAP operating margin came in above guidance at 30% and non-GAAP earnings per share came in well above the high end of our guidance range at $1.07, up 4% year-over-year and up 6% in constant currency. Security and compute combined to account for 69% of our total revenue in Q1, growing 10% year-over-year as reported and 11% in constant currency, underscoring Akamai's ongoing transformation from a CDN pioneer into the cybersecurity and cloud computing company that powers and protects business online. Security growth in Q1 was driven in part by continued strong demand for our market-leading Guardicore segmentation solution as more enterprises relied on Akamai to meet compliance requirements and to defend against malware and ransomware. The FBI's Internet crime report at least last month called ransomware, the most pervasive threat to critical infrastructure and segmentation is the last and most important line of defense for an enterprise. Once an attack finds its way through the perimeter defenses, Guardicore is designed to spot it and proactively prevented from spreading and causing serious harm. In Q1, we achieved several large competitive takeaways for our Guardicore solution, including at a major bank in the U.S. and had a government revenue and customs authority in Europe. Both told us that they were not getting the help they needed from their incumbent provider. They also told us that their trust and confidence in Akamai were factors in switching from the competitor to us. We beat out another station competitor at a clinical research laboratory and at a major credit union which told us that our solution was easier for them to manage while offering unified control over their on-prem and hybrid environments. In addition, we expanded existing contracts for Guardicore at a well-known financial analytics company in the U.S., a global Fortune 500 manufacturer in Europe and a major telco in Latin America. We also continue to see strong interest in our market-leading API security solution in Q1. Almost everything online today leverages APIs, including attackers who know that APIs usually don't come with sufficient security and controls. Akamai stated the Internet security report issued last month showed that API has now cost organizations around $87 billion a year with shadow and Zombie APIs being especially vulnerable to attack. When we do proof of concept for our API security solution, most CISOs and CIOs are surprised to learn just how many APIs they have exposed. For example, at one of our customer events in Q1, the CISO of a major Korean company told attendees about how our solution detected numerous undocumented APIs, along with multiple vulnerabilities thinking about 40 security issues, ranging from exposure of sensitive data through unauthenticated and publicly accessible APIs to weak password policies and unencrypted passwords. In Q1, we signed contracts for API security with numerous companies, including a leading U.S. fintech provider, one of the largest banks in Canada, one of the largest pharmacy benefits managers in the U.S., 2 large U.S. insurance companies, a well-known auto manufacturer in the U.K., a global online fashion retailer in China and a multinational investment bank in Australia. And last week at the RSA Security Conference, our API security solution won a global Infosec Award from Cyber Defense Magazine. Also last week at RSA, we announced our newest security offering, firewall for AI which CISO Magazine highlighted as one of the top cybersecurity products at RSA and which CRN hailed as one of the coolest new cybersecurity products at the show. Many enterprises today are deploying LLMs to provide myriad services such as chatbots inference engines, content generation and cataloging. Some are beginning to go further and deploy Agentic AI, software agents with the ability to gather information, connect with other tools, reason, make decisions and then act autonomously. In fact, Deloitte forecast that 1/4 of the organizations using GenAI today will deploy AI agents this year and half will use them by 2027. As is often the case when enterprises adopt new technologies, cyber criminals quickly learn how to attack the new technology for nefarious purposes. GenAI and the use of AI apps and agents are just the latest examples with a Verion exploits already well publicized. Akamai's firewall for AI is designed to protect AI agents, AI-powered applications, LLMs and AI-driven APIs from these new threats. By securing inbound AI queries and outbound AI responses, it offers multilayered protection by detecting and blocking sensitive data leaks in AI-generated responses, defending against remote code execution, model back doors and data poisoning attacks, filtering inappropriate content, such as misinformation, hate speech and other offensive material and mitigating AI-driven denial of service attacks by controlling excessive carry usage and model overload. The new product is generating strong interest from customers. For example, a financial services firm told us, "Akamai's AI firewall has given us great insight into the interactions with our AI chat agent which helps paint a picture of the threat landscape unique to LLMs. This tool will allow us to save critical systems resources for real clients rather than being consumed by bad actor." In Q1, we also received accolades for our other security products. Akamai was named a leader in the Forrester Wave Web Application Firewall report and achieved the highest possible score for 11 criteria including detection models, Layer 7 DDoS protection, pricing transparency and flexibility, road map and vision. Our WAF continues to be an industry leader and serves as the bedrock for app security used by many of the world's largest enterprises. For example, in Q1, we signed multimillion-dollar contracts with a global bank based in India and the world's third largest railway with over 60 million daily users. As is often the case, these new WAF customers are also making use of our content delivery services to provide the best possible performance for their web applications. Turning now to delivery. I'm pleased to report that we saw better-than-expected results for our delivery products in Q1. This was due in part to improved overall traffic growth, our continued excellent performance for both enterprise web apps and large live events and incremental growth from new customer accounts that we acquired from Edgio in December. One of those new customer accounts led to a $16 million commitment over 3 years for Akamai to deliver 100% of their traffic along with Akamai API security, app and API Protector, professional services and 2 solutions from our compute ISV partners. That's a great example of the opportunity and competitive advantage we have by providing world-class delivery, security and compute together on a single platform, supported by the best in managed professional services. Turning now to cloud computing. In Q1, we continued our strong momentum in cloud computing, introducing new capabilities to serve customers, signing up new accounts and expanding our go-to-market reach, both in-house and with partners. In March, we introduced our new Akamai Cloud inference solution which provides what we believe is a better architecture for customers to build and run, AI applications, data-intensive workloads closer to end users. AI inference and agentic AI apps often require high throughput networking to manage large volumes of data and return accurate results with the milliseconds. By running these workloads at the edge, we can achieve better throughput, lower latency and significant cost savings compared to other cloud providers in the market. For example, in one proof of concept, a company's artificial intelligence application achieved 30% faster response times using our new Butte platform than they had with a hyperscaler. And another proof of concept, a publishing company saw a 2.5x faster response times with 3x higher throughput and significant cost savings compared to another hyperscaler. Customers who signed deals with us for cloud computing in Q1 included a global live streaming service with hundreds of millions of users, a major cybersecurity provider in the U.S., a European industrial products company and a global developer of immersive video games. We also saw numerous large deals in Q1 come through our growing roster of ISV partners, including at one of the largest retailers in the world, one of the large pharmacy benefits managers, a major European fashion retailer and a leading broadcasting company in Japan. As a result of our competitive advantages, Gartner named Akamai an emerging leader for GenAI specialized infrastructure. And it's one of the reasons why vast data the AI data platform company has partnered with Akamai to make data-intensive AI inferencing and more efficient for our joint customers. Our edge computing capabilities will be further enhanced by the introduction of our new managed Container Service, or MCS, that we announced in Q1. MCS will provide support for customer containers in any of our 4,000-plus pops around the world. That means we'll be able to run customer compute instances in over 700 cities. No other provider comes anywhere close to doing that today. Also in Q1, Akamai became the first and only provider to offer video processing units, or VPUs, in the cloud, with our new accelerated compute instances solution built on specialized processors from Net. A VPU architecture can offer up to 20x greater throughput than CPU solutions which results in greatly improved performance as well as significant savings for media companies. This gives Akamai another way to complement and cement our long-standing relationships with major media companies which include all of the top 10 media companies in the world. It's also very synergistic with the media workflow services provided by our ISV partners on Akamai Cloud. Overall, we believe that the combination of world-class delivery, compute the security available on our platform provides a low-cost, high-performance and massively scalable alternative to the hyperscalers for media and entertainment companies. And unlike the hyperscalers, we do compete with our customers. At the NAB Show in Las Vegas last month and in recent bits with customers across Europe and Asia, many executives told me how they see real value in what we're doing, in part because they're tired of writing huge checks to the hyperscalers who then use the funds to compete against them. On the go-to-market front, the sales transformation efforts that we outlined during our last call are on track as planned. We're making good progress in rebalancing our sales team to provide greater focus on new customer acquisition while maintaining strong customer relationships. We've implemented a better sales play methodology to improve our installed base penetration, especially for fast-growing security and cloud infrastructure offerings. And we're seeing good early success with changes to reward sellers and customers for longer multiyear contracts. Like all of you, we're keeping a close eye on global economic and political challenges. As we noted during the call, we've taken steps to minimize the ecto tariffs on our business. And as of now, we anticipate that the direct impact to Akamai from tariffs in 2025 will be about $10 million in CapEx which is amortized over 6 years. That said, there is concern among some of our customers in a possible recession which could impact later in the year. And some of our customers outside the U.S. have raised concerns about whether they should rely on American companies for critical infrastructure. Neither issue has impacted our business to date. And we're working to reassure customers that Akamai will continue to serve them as we always have. We're also staying very engaged with our U.S. federal sector customers. Overall, we arrived less than 5% of our revenue from the U.S. public sector, including state and federal. Based on our current line of sight, we had to lose a few million dollars of revenue in the back half of 2025 and related to federal cutbacks. There's also a possibility of increasing revenue in situations where our solutions can generate significant savings for federal agencies. Lastly, we were very pleased to see Akamai recognized last quarter as one of the most trustworthy companies in America by Newsweek Magazine which partnered with a market research firm to analyze more than 100,000 evaluations generated by customers, employees and investors. Trust and integrity are core values at Akamai and they really matter to customers who rely on us to be there for them. So I want to express thanks to our employees who work so hard to help Akamai earn the trust of our customers and shareholders. Now, I'll turn the call over to Ed to say more on our Q1 results and our outlook for the rest of the year. Ed?
Ed McGowan: Thank you, Tom. Today, I have to review our Q1 results and then provide some color on our Q2 expectations and our updated full year 2025 guidance. As Tom mentioned, we got off to a solid start to the year with total Q1 revenue of $1.015 billion which was up 3% year-over-year as reported and 4% in constant currency. We continue to see strong performance within our compute and security portfolios during the first quarter. Compute revenue grew to $165 million, a 14% year-over-year increase as reported and 15% in constant currency. Security revenue was $531 million, growing 8% year-over-year reported and 10% in constant currency. During Q1, we had approximately $6 million of onetime license revenue compared to $4 million in Q1 of last year and $12 million in Q4 2024. For the first quarter combined revenue from compute and security increased by 10% or 11% in constant currency, accounting for 69% of total revenue. Our delivery revenue was $319 million, down 9% as reported and down 1% [ph] in constant currency. Delivery revenue was stronger than expected in Q1. And while it's too early to call a bottom in delivery, we are encouraged by some improving trends in the delivery business to start 2025. International revenue was $486 million, up 2% year-over-year or 5% constant currency representing 48% of total revenue in Q1. Foreign exchange fluctuations had a negative impact on revenue of $5 million on a sequential basis and a negative $14 million impact on a year-over-year basis. Finally, it's worth noting that GEO contributed approximately $23 million of revenue in the quarter which was in line with our expectations. Moving to profitability. In Q1, we generated non-GAAP net income of $256 million or $1.70 of earnings per diluted share, up 4% year-over-year as reported up 6% in constant currency and well above the high end of our guidance range. Our EPS outperformance was driven by better-than-expected Q1 revenue, lower-than-expected transition services or TSA costs related to the traction, better-than-expected bandwidth costs, lower than payroll taxes primarily related to stock-based compensation as a result of a lower stock price. And lower employee medical claims related to our self-insured medical plan. Finally, our Q1 CapEx was $226 million or 22% of revenue. Our first quarter CapEx came in slightly lower than our guidance which was mostly due to timing as some CapEx has been pushed from Q1 into Q2. Moving to our capital allocation strategy. During the first quarter, we spent approximately $500 million to buy back approximately 6.2 million shares. We ended the first quarter with approximately $1.5 billion remaining on our current repurchase authorization. Our intention remains the same to continue buying back shares to offset dilution from employee equity programs over time and to be opportunistic in both M&A and share repurchases. As of March 31, we had approximately $1.3 billion of cash, cash equivalent securities. It's worth noting that subsequent to the end of the first quarter and prior to today's earnings announcement, we use cash on hand and funds available under our revolving credit facility fully repaid $1.15 billion of our outstanding convertible notes that matured on May 1 of this year. Before I provide our Q2 and full year 2025 guidance, I want to items. First, we have completed our migration ageo customers to the platform. As a result, we will not have any additional TSA costs moving forward and our revenue expectations from the transaction remain the same, approximately $85 million to $105 million of GO revenue contributions for 2025. Second, we expect an increase in operating expenses for the second quarter, partly due to a weaker U.S. dollar as well as higher marketing expenditures for Q2 events, our annual sales President's Club trip and the impact of our annual employee merit cycle which effect on April 1. Third, we continue to expect our CapEx to be heavily front-end loaded with significantly higher expenditures in the first half of the year compared to the second half of the year. This includes approximately $10 million of CapEx pulled forward to the first half of the year to help mitigate potential tariff risks. Fourth, we expect interest income to decline in 2025 due primarily to lower cash balances resulting from stock repurchases, recent acquisitions and the retirement of our $1.5 billion convertible debt. Additionally, we anticipate lower investment yields as interest rates are projected to come down throughout the year. As a result, we expect net interest income to decrease by approximately $5 million per month starting in May of 2025. Finally, we are maintaining our forecast ranges to effectively navigate increased volatility within the current economic environment, the volatility in the foreign exchange markets and the potential impact of the pending TikTok band. So with those factors in mind, I'll now move to our Q2 guidance. For Q2, we are projecting revenue in the range of $1.012 billion to $1.032 billion or up 3% to 5% as reported and in constant currency over Q2 2024. At current specs, foreign exchange fluctuations are expected to have a positive $15 million impact on Q2 revenue compared to Q1 levels and a positive $7 million impact year-over-year. At these revenue levels, we expect cash gross margins of approximately 72%. Q2 non-GAAP operating expenses are projected to be $315 million to $320 million. This is Q1 levels due to the items I just mentioned. We expect Q2 EBITDA margin of approximately 41% to 42%. We expect non-option expense to be between $135 million to $107 million and we expect non-GAAP operating margin of approximately 28% for Q2. Moving on to CapEx. We expect to spend approximately $226 million to $236 million. This represents approximately 22% to 23% of our projected total revenue. Based on our expectations for revenue and costs, we expect Q2 non-GAAP EPS in the range of $1.52 to $1.58. This EPS guidance assumes taxes of $54 million to $57 million based on an estimated quarterly non-GAAP tax rate of approximately 19% to 20%. It also reflects a fully diluted share count of approximately 148 million shares. Looking ahead to the full year for 2025, we expect revenue of $4.050 billion to $4.2 billion which is up 1% to 5% as reported and in constant currency. As a reminder, we would expect to come in at the higher end of that range -- if we see continued weakening of the U.S. dollar, traffic growth materially exceed levels and there is no ban in the U.S. for our largest customer. We would expect them at the mid to lower end of that range if we see significant strengthening of the U.S. dollar a significant downturn in the economy in the back half of the year. Traffic growth materially slows from current levels and our largest customer is band in the U.S. Moving on to security. We continue to expect security revenue growth of approximately 10% in constant currency for 2025. And we continue to expect the combined ARR from our Zero Trust rise and API security solutions to increase by 30% to 35% year-over-year in constant currency for 2025. For compute, we continue to expect row to be approximately 15% in concurrency. And as a reminder, included within our compute, we continue to expect cloud infrastructure ARR year-over-year growth in the range of 30% to 45% in currency for 2025. At current spot rates, our guidance assumes foreign exchange will have a positive $8 million impact to revenue in 2025 on a year-over-year basis. Moving on to operating margins. For 2025, we are estimating non-GAAP operating margin of approximately 8% as measured in today's FX rates. We anticipate that our full year capital expenditures will be approximately 19% to 20% of total revenue. Moving to EPS. For the full year '25, we expect non-GAAP earnings per diluted share in the range of $6.10 to $6.40. This non-GAAP earnings guidance is based on a non-GAAP effective tax rate of approximately 19% to 20% and a fully diluted share count of approximately 150 million shares. In summary, although we anticipate heightened economic volatility, we believe that Akamai is in a strong position to continue delivering revenue growth and maintaining healthy margins. This is by our newer security and cloud computing products a moderation in our content delivery revenue declines in commitment to disciplined cost management. With that, I'll wrap things up and Tom and I are happy to take your questions.
Operator: [Operator Instructions] Today's first question comes from Amit Daryanani with Evercore.
Amit Daryanani: I guess maybe to just start on the delivery side. Can you just talk about what really drove the upside for you folks in the quarter? Was it more pricing or traffic driven? And then what's reframe saying this can sustain into the out quarters? Just in what was the upside and why the hesitation about the sustaining?
Ed McGowan: Amit, this is Ed. Thanks for the question. Yes, so I'd say what drove it was really traffic. Pricing typically, unless you have large renewals, doesn't have a huge impact in any given quarter and we didn't have any significant concentration on renewal. So it was all about traffic growth. And it was pretty strong pretty much every sub vertical. So we saw strong video traffic, strong gaming traffic, strong software downloads and even across commerce and some of the other subverticals. So it's just a better improved environment. And just being cautious in terms of calling a bottom. This is the third quarter in a row here where revenue has kind of been flattish sequentially which is better than what it's been which has been declining. But we're seeing decent trends here in April and we're just being a bit more cautious and don't call the bottom quite yet.
Amit Daryanani: Got it. That's still fair. And if I just follow up on the security side, I'd love to hear how you would characterize your performance in the March. It looks a little bit lower, I think, like not $15 million from what the Street was modeling perhaps. I'd love to understand how that end up versus your internal expectations. And then as you think about this acceleration from 8% to call it 10% in security, what enables us for the year?
Ed McGowan: Yes. Good question. So I would say it came in, in line with what we had expected for the quarter. And as you heard A few minutes ago, I reiterated our guidance for 10% constant currency and we did deliver 10% constant currency this quarter. There's a little bit of noise in there with license revenue and I sort of called that out for you. We had about $12 million of license revenue last quarter, about $6 million less this quarter. So that can sometimes folks don't quite get the model right, going from Q4 to Q1. And also with some of the bundles, Q4 tends to have a little bit of volumetric revenue associated with some of our commerce customers and things like that, that you don't see repeat at such a level in Q2. So I would say it came in, in line with what we expected. Big drivers for growth is exactly what we had thought in terms of the bookings. We're seeing a very strong API security growth and very strong Guardicore growth as we expected. And things are playing out exactly how we had thought.
Operator: The next question is from Jonathan Ho with William Blair.
Jonathan Ho: Congrats on the strong quarter. Can you provide a little bit more detail on the role you can play with agentic AI with your AI firewall. And perhaps help us understand how you could potentially benefit AI utilization in the enterprise really begins to expand?
Tom Leighton: Yes. There's a lot of attacks now that have been published against AI apps of all kinds, including agentic AI. Attacks where the adversary is able to trick the agent, the AI agent into giving up sensitive data, code, PII, trick the agent into saying things that it should -- could be offensive content, could be deals, prices for things that aren't right. And so you got to protect the app, particularly if it's an agent making decisions and doing things. You got to protect it from the attackers that cause it to do bad things. Also, you've got to protect it from ingesting a bad information. A lot of these apps are learning as they go along. And the adversaries I've figured out how to submit information to it that causes it to learn bad things which can cause problems in the future. AI is a brand-new attack service and being rapidly deployed. In fact, a lot of enterprises are -- they're forming rules inside the enterprise, about what they can and can't do with AI. But on the other hand, they can't even keep track of all the AI applications that they are using and supposed. So another aspect of what we're doing, same as we do for API security. The first thing is letting our customers know what AI apps do they have exposed. And then making sure that they're protected. And I imagine this is going to be really a war of regulation. So the first attacks are being seen out there. We have the first line of defenses now with the OAS top 10 and additional capabilities tailored to particular customer use cases. And I think there'll be some back and forth there that more attacks will be figured out. And our job is to stay ahead of that and keep our customers safe.
Jonathan Ho: Excellent. And you mentioned some customers expressing worry over whether they could rely on U.S.-based services. Is there potential for diversification or multisourcing pressure from some of your customers internationally. Just wondering.
Tom Leighton: Today, I don't think there's good alternatives, especially when it comes to security, pretty much all the world's major banks, most of the major commerce companies rely on Akamai for their security because we're really the best and in terms of protecting them. There's not good alternatives for them today. I think over the long haul, our job is to make sure that they understand that continue to rely on Akamai. No matter what happens with the geopolitics and the rhetoric. But it's a topic that's come up in some accounts. And so we're being careful that they understand that Akamai is here for them over the long haul. And that we're not going away and that they can continue to on us.
Operator: The next question is from Will Power with Baird.
William Power: Okay, great. I come back to the Security segment. You called out a number of competitive takeaways for the segmentation products. I guess it would just be helpful if you can kind of just help distill down what's really setting you apart in that market, allowing you to take share? And then secondly, it'd be great to get any on the progress, trends within the kind of the rest of the broader 0 trust portfolio and where go-to-market since there?
Tom Leighton: Yes. I think scale sets us apart to the larger enterprises could have hundreds of thousands of applications and devices. They need to protect and we're unique in being able to do that. Ease of use has come up in several accounts and particularly with our new AI-enabled interface that can make the integration be a lot faster and simpler. Our new engine suggests the initial firewall rules that it should be set up for all the various devices in the enterprise actually tells our customer and their operator, what the various devices are notifies them. If firewall rules are out of date or not the most recent set of rules that they need to have. So ease of use is really important because if you think about installing hundreds of thousands of agents, you need really good automation to do that effectively. And trust, I think is really important. And we've been told that by our customers because these agents are running inside the company. And it's really important that they be reliable and Akamai has a great track record there. We're not the lowest cost provider. You know there's others out there with lower cost solutions. But when it comes to protecting critical infrastructure from the devastation of ransomware or data ex filtration with software that's running really in the inside the important applications, Akamai is pretty unique in being able to do that and being trusted for that. In terms of zero trust, Guardicore is our flagship solution. It's sort of the and we do have other capabilities. We've combined North, Southeast west protections built around Guardicore and our Enterprise Application Access solution, so that we can provide really a comprehensive set of solutions to protect the enterprise applications and data.
William Power: Okay, great. No, that's helpful. And maybe just to add quickly for you. Nice to see the better margins in the quarter, I mean it sounds like you expect to dip back down in Q2. So I guess I'm just trying to sort out what proportion of that upside in the quarter could be more sustainable versus some conservatism going forward?
Ed McGowan: Yes. I think for this quarter, in particular, I'd say you'd have to see some revenue upside to drive higher margins. We obviously have very good leverage. If you think about -- as I broke out in the prepared remarks, the items that drove the upside both in Q1 and then in Q2, what's driving the higher cost. Some of it is event driven. But there is the -- we did pull our merit cycle in a little bit earlier this year. We typically do it in the middle of the year, so we just brought it to April. So that has a recurring cost. So doing some hiring. So that has an impact as well. But we think over time, as the business grows will improve our margins. And maybe in the back half, there's a potential if we hit the upside to expand margins a bit as well.
Operator: The question comes from Frank Louthan with Raymond James.
Unidentified Analyst: Great. This is Rob [ph] on for Frank. So can you talk about the recent sales changes? Where are you as far as the new folks you need to hire moving people around within their different roles between the hunters and farmers? And then what are some other drivers of improvement that you see taking shape the rest of this year and into next year?
Tom Leighton: I'll start with that and then hand it off to Ed on the margin question. I'd say we're about 1/3 of the way there. We've made a lot of changes, seeing some very good progress. shifting for the forest towards hunting now that we have products that a lot of new to Akamai customers need, for example, API security segmentation cloud computing and they're going to need firewall for AI as well. Also hiring more of the specialists that have a lot of expertise that can help facilitate those sales. We've made shifts to incent both our sellers and customers to longer-term contracts starting to see some impact there which is good. And overall, over time, growing the overall presence in the marketplace. So I'd say we're about 1/3 of the way there and making good progress. And Ed, do you want to talk about the margins?
Ed McGowan: Yes, sure. So I'd say it's probably 3 main drivers. The first one would be just as we scale up our compute business. So right now, we are subscale. So if we look at some of the facilities as we start to sell those out and get to a bit of scale inside of some of the different -- we are seeing very attractive margins in line with what we talked about. But we do have a long way to go in terms of reaching scale. As we start to grow and compute, I do expect our margins to expand obviously there. And then as security continues to grow. It's a higher-margin product for us. API security is a very high-margin product for us, much lower CapEx associated with your securities. So that's going to help. And then as the stocks being such a big drain, that also helps as well. So if we get back to kind of low single-digit or even flat CDM growth. That obviously has a big help on margins. As far as other operating areas, we're always looking at efficiencies, we've run out a lot of costs. There's a little bit in the room potentially in real estate and we can find a la some of our unused space. And then with compute in terms of our own use of compute, we've migrated a lot of our stuff to the note. We'll look to do some more. But it's really going to come from scaling up of the business and as the mix shifts over time.
Operator: The next question comes from Jeffrey Van Rhee with Craig-Hallum.
Jeffrey Van Rhee: Just a couple maybe on the security front. Just high level, if I look at the organics and try to back out the acquisitions, it looks like it's fallen off fairly quickly from 15 to 10 to maybe now mid-single digits going sequentially last quarter was 10% year-over-year in this quarter, looks like mid-single digits. Just talk to me a little bit. I know you touched on it last quarter but I want to make sure I fully understand what's played out there on the security. And I think you had pointed to WAF but -- maybe if you could just start there.
Ed McGowan: Yes, sure. So yes, they're sort of inorganic in the number but it's not a significant portion of revenue for us. In terms of if you break out the business in the different subsegments, we are seeing WAF slowdown naturally a little bit. It's still growing but it's not growing nearly as fast as it was very high penetration which is expected. Obviously, API security is growing incredibly fast and we think can be a very, very significant grower for us over time. Infrastructure security business is a low single-digit growing business and is kind of in that range. Prolexic is growing in kind of in its normal range. We haven't had a lot of big attacks or anything like that, that tend to be kind of more, call it, episodic that drives spikes in demand there. So we haven't seen that in a while. So that's also slowing a bit revenue has been consistent in that sort of high single digit, low single digit -- or sorry, low double-digit growth area. So it's really just a mix shift right now as we talked about exactly what we're expecting with some of the products that have been in the market for a while, just naturally slowing down. And then the newer products like Guardicore and API taking off but just not at the scale yet to offset the slower growth in the other products.
Jeffrey Van Rhee: Got it. That's helpful. And on compute, you had commented last quarter around some exiting of some legacy revenue streams around video, I think transcoding, image management and some other things in there. How much -- how was the headwind from that this quarter in compute compared to what you were expecting when you gave the guide?
Ed McGowan: Yes, I'd say it's playing out exactly how we expected. And we're still seeing very strong growth in our CIS compute infrastructure services business and I reiterated our guidance there for very strong 40% to 45% growth in ARR. So playing out exactly as we expected -- we said it would take a while to -- for some of this to play out probably about 2 years or something like that but it came in exactly as we had thought. So...
Jeffrey Van Rhee: Perfect. Okay. And then just one last one -- to revisit the prior question on sales and the changes you're making in sales, it sounds like a little more focus on hunters. In terms of the metrics, we'll see, where do you think the impact of these sales changes will show up first? And presumably, if you're focused on Hunters maybe a new customer metric might be the place we would look for that. But just tell me kind of how we're going to see this play out in terms of the results and metrics that we might be able to observe?
Ed McGowan: Yes. So we haven't really provided any metrics in terms of sales productivity but it's something that we'll consider providing you some metrics in terms of how the -- number one, how the investments are going, where what stage are we in, in terms of adding the capacity. And it's both with hunters as well as some specialists for both compute and security. But I think you just see it by fest itself in stronger revenue growth but we'll consider breaking out some metrics that will be helpful. It's just sometimes a booking metric doesn't always translate to revenue cleanly, so that's not the most helpful thing to give. But we'll give us some consideration try to give you some metrics that might be helpful.
Operator: The next question comes from Patrick Colville with Scotiabank.
Unidentified Analyst: This is Sagar [ph] on for Patrick Colville. I wanted to better understand the non-delivery opportunity to cross-sell Edgio into the existing base and what you're seeing within that segment specifically?
Ed McGowan: This is Ed again. You added several hundred customers from Edgio. And there's a good opportunity there where Edgio did not have very many security products at all actually and they didn't offer compute, certainly not the robust compute solutions that we have. So right now, there's not a lot to report in terms of upsell. The first thing you want to do is just make sure the customers are migrated over. They understand who their rep is, get familiar with the services and working with Akamai and then we'll start to build campaigns. I'd expect that to take your normal 6 to 9 months to start to build a pipeline and then we should start to see some potential upsell into that base of additional customers over time.
Operator: The next question comes from Madeline Brooks with Bank of America.
Unidentified Analyst: This is Kevin [ph] on from Madeline Brooks for Bank of America. I want to talk to you about the compute trends. You've noted over time that you expect compute to be kind of a long-term 20% growth driver or grower. What is contributing to this current growth rate that we saw this quarter? And what needs to happen to bring it back up into the 20s?
Tom Leighton: Yes. So the real driver there is our cloud infrastructure services. And as we've talked about and as Ed said, we expect the ARR there to grow 40% to 45% this year. And that means -- and as that number gets a lot bigger, that drives the overall compute number. So that's the number to watch. We'll highlight that as we and -- that will be driving the bigger compute number. Ultimately, that becomes a large major compute number.
Unidentified Analyst: It sounds good. And then just as a follow-up on the securities -- if I look over the last 3 years or so, you've grown annually the 15% to 16% rate in the segment and then you just kind of listed some guidance for 10% for the year. And you've already given color as to why that is. But two questions. One, what gives you confidence in this 10%? And two, do you see any upside to this 10%? And what could drive that upside?
Tom Leighton: Yes, I'll start with that. The confidence is driven by the large interest big potential market and very strong growth for our segmentation in API security solutions. And as we talked about, we think the ARR of those solutions this year grow 30% to 35%. A lot of demand for that. We have the market-leading solutions. And now we are adding in firewall for AI just starting but a lot of customer interest there. And I think that has a long runway ahead, even though no revenue to speak of yet just signing the first customers now. So I think having leading solutions in large potential markets that today, fairly small revenue but growing at a food clip. That gives us confidence that we can be growing the larger security number in the 10% range. Upside would be in part based on products, how fast they get going; and if we can beat the 30% to 35% on these products. Ed, do you want to add anything to that?
Ed McGowan: Yes. The other thing I would say is the business is very highly recurring, mostly subscription-based business. I do break out from time to time if we have some license revenue. So you do have pretty good visibility in terms of the base there's not much price pricing in your security business is a very sticky product. You don't tend to have a lot of churn. So you have a lot of confidence in sort of the underlying business that you have and it really just comes that pace at which you're adding existing customers buying more product and acquiring new logos. But if you look at the size of the sales force, what we've produced over the years, we certainly have the capacity to add the type of revenue that we need. And obviously, as we add get more reps up to speed, we'll have more capacity to sell even more.
Operator: The next question is from Rudy Kessinger with D.A. Davidson.
Rudy Kessinger: Ed, could you -- just on the compute side, could you maybe quantify just what would compute growth have been if not for some of the lay compute stuff you shifted to partners relative to the 25% in constant currency in Q4?
Ed McGowan: Yes. Sure. Good question. So if you remember last time we broke out the sub number. So the cloud infrastructure service and the -- what we call our other computer, our legacy compute. There's like 4 or 5 different things that were in there, some legacy storage, some of the first customers that we had done some custom builds for some video optimization and optimization, that sort of stuff. That business has grown about 20% last year and the cloud infrastructure service grew at over 30%. So I'd say we're seeing very similar growth rates in the cloud infrastructure service and where the slowdown is coming as expected, is in that other legacy stuff where you've got a combination of some of the custom deals we did. We did a couple of big custom deals that have largely run their course and they're not growing anymore. Any new applications would go into cloud infrastructure service. Our legacy storage business is starting to decline. We've migrated a little bit of business to partners. So that's playing out exactly as we expected. So really, the decline from 20% to 15% or 25% to 15% is really all in that bucket as we had called out to you. But the Cellco infrastructure service is growing really, really fast.
Rudy Kessinger: Okay. And on the delivery front, what are you seeing from a pricing standpoint? And in particular, since the Edgio bankruptcy, have you started to see pricing improve on renewals? And do you think 6, 12 months from now, we might get to a point where price compression could be better than it has been historically, just given us that several low-cost providers a the space for the last few years?
Ed McGowan: Yes. Good question. So we're seeing kind of a mixed bag, as you would expect. I'd say we're seeing some somewhat encouraging signs of some of our larger media customers where the price declines aren't nearly what they used to be but you don't also have the same type of volume growth that we used to. So that sort of makes sense. But also this like you pointed out, fewer options there across some of the other -- the rest of the base or delivery, it's a mixed bag. It depends sometimes you have a little bit more price pressure in commerce, if there's pressure with the economy and that sort of thing. But -- yes, I think over time, it's possible we'll see a moderation. We are seeing it. It's definitely improved a bit over the last year or so. And there's still room to go there. But this business has always had some element of unit economics of higher volumes, lower unit prices. I expect that to continue. But that's certainly one of the drivers to getting this business back to flat and mid- to low single-digit growth or decline over time.
Operator: The next question comes from John DiFucci with Guggenheim Securities.
John DiFucci: I guess I think this question is for Ed. As you focus on the faster-growing parts of security, specifically API Security with no name and NeoSeand and Guardicore which I would think are largely channel focused but different channels than are the traditional Akamai channels? And probably sold through the channel like other traditional security products are sold. I mean, are you taking steps to really ramp that up to drive growth with new channel partners? And if so, because we do a lot of checks and trying to hear more -- we'd like to hear more about Akamai in those checks. Can this new path to market more focused path, if that's the case, also be used to sell more of your infrastructure and app security products?
Ed McGowan: Yes, I'll start...
Tom Leighton: I can start with some of the channel -- You're absolutely right. They are different than the traditional Akamai channel partners. And in fact, most of our large major article sales, API security sales and new customers to Akamai come through those channels. Examples of partners would be Presidio, WWT, Optiv, GuidePoint, Defense X, IBM and Deloitte Macnica, OCD, Accenture, Carso. So a variety of partners that are different than the by and large carrier partners we had in the CDN days from before. Ed, do you want to add to that?
Ed McGowan: Yes. I would say, John, in talking with PJ, 80% to 90% of our new logo acquisition does come through the channel. I would expect with some of our installed base where we have a strong direct relationship, I would imagine a lot of the API security sales and Guardicore sales will be led by our traditional reps. But about 1/3 -- a little over 1/3 of our business in general comes through the channel and a little over half of it comes in security comes to the channel. I expect that to increase over time. And as we acquired some of these companies, both NeoSec and Guardicore did come with some new channel relationships that we've obviously continue to grow and block on as a result. So I do expect a lot of our growth going forward to come through the channel.
John DiFucci: Ed and Tom, the -- sorry for my voice. But is -- is this an opportunity to -- through those new channel partners to also sell like your -- the slower-growing parts of security but they're still needed like DDoS protection and WAF, because others -- other partners or other of your competitors that sell those products are making a big push in the channel. So they're getting sort of used to selling that or the -- at least they're starting to talk about it.
Tom Leighton: Yes and we do that. Often, it will be the new customer sales would be led with Guardicore or API security but you're absolutely right. the whole platform, the whole security platform can be then included with that or grown to that. And those partners are very good at it. So I think you're absolutely right and we're seeing that.
Operator: We have time for one last question. It will come from James Fish with Piper Sandler.
Unidentified Analyst: This is Kate [ph] on for Fish. So just one on the -- for the security weakness, was that more on the new side of the -- was that more on the new side or the expansion side of existing customers?
Ed McGowan: Yes. I wouldn't refer to it as weakness. It came in as we expected it. So we're not viewing it as weakness so it was pretty much right in line. But in terms of the impact within a quarter, you got to remember a lot of the business is recurring. So the bulk of the revenue is already spoken for with existing commerce. Most of the growth, as I said, comes from the -- into newer sales is coming from API security and Guardicore as we expected. That doesn't have a huge revenue contribution in the quarter in which you sell it because it does take a maybe a month or so to get it up and running and revenue generating. So like I said, I think things turned out just as we expected and the normal mix of new customer versus upsell into the base was pretty similar to what we see in a typical quarter.
Operator: Thank you. That concludes our question-and-answer session. I would now like to turn the call back over to Mark Stoutenberg for closing remarks.
Mark Stoutenberg: MJ [ph], you can please end the call now.
Operator: All right. This concludes our presentation. Thank you for attending today's conference. You may now disconnect your lines. | [
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"speaker": "Operator",
"text": "Hello and welcome to the Akamai Technologies First Quarter 2025 Earnings Conference Call. All participants will be in listen-only mode. [Operator Instructions] After today’s presentation, there will be an opportunity to ask questions. [Operator Instructions] Please note, this event is being recorded. I would now like to turn the conference over to Mark Stoutenberg, Head of Investor Relations. Please go ahead."
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{
"speaker": "Mark Stoutenberg",
"text": "Good afternoon everyone and thank you for joining Akamai's first quarter 2025 earnings call. Speaking today will be Tom Leighton, Akamai's Chief Executive Officer; and Ed McGowan, Akamai's Chief Financial Officer. Please note that today's comments include forward-looking statements, including those regarding revenue and earnings guidance. These forward-looking statements are based on current expectations, assumptions that are subject to certain risks and uncertainties and involve a number of factors that could cause actual results to differ materially from those expressed or implied. The factors include but are not limited to, any impact from macroeconomic trends, the integration of any acquisition, geopolitical developments and any other risk factors identified in our filings with the SEC. The statements included on today's call represent the company's views on May 8, 2025. And we assume no obligation to update any forward-looking statements. As a reminder, we will be referring to certain non-GAAP financial metrics during today's call. A detailed reconciliation of GAAP to non-GAAP metrics can be found under the financial portion of the Investor Relations section of akamai.com. With that, I'll now hand the call off to our CEO, Dr. Tom Leighton."
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"speaker": "Tom Leighton",
"text": "Thanks, Mark. I'm pleased to report that Akamai got off to a solid start on the year. First quarter revenue grew to $1.015 billion, up 3% year-over-year reported and up 4% in constant currency. Non-GAAP operating margin came in above guidance at 30% and non-GAAP earnings per share came in well above the high end of our guidance range at $1.07, up 4% year-over-year and up 6% in constant currency. Security and compute combined to account for 69% of our total revenue in Q1, growing 10% year-over-year as reported and 11% in constant currency, underscoring Akamai's ongoing transformation from a CDN pioneer into the cybersecurity and cloud computing company that powers and protects business online. Security growth in Q1 was driven in part by continued strong demand for our market-leading Guardicore segmentation solution as more enterprises relied on Akamai to meet compliance requirements and to defend against malware and ransomware. The FBI's Internet crime report at least last month called ransomware, the most pervasive threat to critical infrastructure and segmentation is the last and most important line of defense for an enterprise. Once an attack finds its way through the perimeter defenses, Guardicore is designed to spot it and proactively prevented from spreading and causing serious harm. In Q1, we achieved several large competitive takeaways for our Guardicore solution, including at a major bank in the U.S. and had a government revenue and customs authority in Europe. Both told us that they were not getting the help they needed from their incumbent provider. They also told us that their trust and confidence in Akamai were factors in switching from the competitor to us. We beat out another station competitor at a clinical research laboratory and at a major credit union which told us that our solution was easier for them to manage while offering unified control over their on-prem and hybrid environments. In addition, we expanded existing contracts for Guardicore at a well-known financial analytics company in the U.S., a global Fortune 500 manufacturer in Europe and a major telco in Latin America. We also continue to see strong interest in our market-leading API security solution in Q1. Almost everything online today leverages APIs, including attackers who know that APIs usually don't come with sufficient security and controls. Akamai stated the Internet security report issued last month showed that API has now cost organizations around $87 billion a year with shadow and Zombie APIs being especially vulnerable to attack. When we do proof of concept for our API security solution, most CISOs and CIOs are surprised to learn just how many APIs they have exposed. For example, at one of our customer events in Q1, the CISO of a major Korean company told attendees about how our solution detected numerous undocumented APIs, along with multiple vulnerabilities thinking about 40 security issues, ranging from exposure of sensitive data through unauthenticated and publicly accessible APIs to weak password policies and unencrypted passwords. In Q1, we signed contracts for API security with numerous companies, including a leading U.S. fintech provider, one of the largest banks in Canada, one of the largest pharmacy benefits managers in the U.S., 2 large U.S. insurance companies, a well-known auto manufacturer in the U.K., a global online fashion retailer in China and a multinational investment bank in Australia. And last week at the RSA Security Conference, our API security solution won a global Infosec Award from Cyber Defense Magazine. Also last week at RSA, we announced our newest security offering, firewall for AI which CISO Magazine highlighted as one of the top cybersecurity products at RSA and which CRN hailed as one of the coolest new cybersecurity products at the show. Many enterprises today are deploying LLMs to provide myriad services such as chatbots inference engines, content generation and cataloging. Some are beginning to go further and deploy Agentic AI, software agents with the ability to gather information, connect with other tools, reason, make decisions and then act autonomously. In fact, Deloitte forecast that 1/4 of the organizations using GenAI today will deploy AI agents this year and half will use them by 2027. As is often the case when enterprises adopt new technologies, cyber criminals quickly learn how to attack the new technology for nefarious purposes. GenAI and the use of AI apps and agents are just the latest examples with a Verion exploits already well publicized. Akamai's firewall for AI is designed to protect AI agents, AI-powered applications, LLMs and AI-driven APIs from these new threats. By securing inbound AI queries and outbound AI responses, it offers multilayered protection by detecting and blocking sensitive data leaks in AI-generated responses, defending against remote code execution, model back doors and data poisoning attacks, filtering inappropriate content, such as misinformation, hate speech and other offensive material and mitigating AI-driven denial of service attacks by controlling excessive carry usage and model overload. The new product is generating strong interest from customers. For example, a financial services firm told us, \"Akamai's AI firewall has given us great insight into the interactions with our AI chat agent which helps paint a picture of the threat landscape unique to LLMs. This tool will allow us to save critical systems resources for real clients rather than being consumed by bad actor.\" In Q1, we also received accolades for our other security products. Akamai was named a leader in the Forrester Wave Web Application Firewall report and achieved the highest possible score for 11 criteria including detection models, Layer 7 DDoS protection, pricing transparency and flexibility, road map and vision. Our WAF continues to be an industry leader and serves as the bedrock for app security used by many of the world's largest enterprises. For example, in Q1, we signed multimillion-dollar contracts with a global bank based in India and the world's third largest railway with over 60 million daily users. As is often the case, these new WAF customers are also making use of our content delivery services to provide the best possible performance for their web applications. Turning now to delivery. I'm pleased to report that we saw better-than-expected results for our delivery products in Q1. This was due in part to improved overall traffic growth, our continued excellent performance for both enterprise web apps and large live events and incremental growth from new customer accounts that we acquired from Edgio in December. One of those new customer accounts led to a $16 million commitment over 3 years for Akamai to deliver 100% of their traffic along with Akamai API security, app and API Protector, professional services and 2 solutions from our compute ISV partners. That's a great example of the opportunity and competitive advantage we have by providing world-class delivery, security and compute together on a single platform, supported by the best in managed professional services. Turning now to cloud computing. In Q1, we continued our strong momentum in cloud computing, introducing new capabilities to serve customers, signing up new accounts and expanding our go-to-market reach, both in-house and with partners. In March, we introduced our new Akamai Cloud inference solution which provides what we believe is a better architecture for customers to build and run, AI applications, data-intensive workloads closer to end users. AI inference and agentic AI apps often require high throughput networking to manage large volumes of data and return accurate results with the milliseconds. By running these workloads at the edge, we can achieve better throughput, lower latency and significant cost savings compared to other cloud providers in the market. For example, in one proof of concept, a company's artificial intelligence application achieved 30% faster response times using our new Butte platform than they had with a hyperscaler. And another proof of concept, a publishing company saw a 2.5x faster response times with 3x higher throughput and significant cost savings compared to another hyperscaler. Customers who signed deals with us for cloud computing in Q1 included a global live streaming service with hundreds of millions of users, a major cybersecurity provider in the U.S., a European industrial products company and a global developer of immersive video games. We also saw numerous large deals in Q1 come through our growing roster of ISV partners, including at one of the largest retailers in the world, one of the large pharmacy benefits managers, a major European fashion retailer and a leading broadcasting company in Japan. As a result of our competitive advantages, Gartner named Akamai an emerging leader for GenAI specialized infrastructure. And it's one of the reasons why vast data the AI data platform company has partnered with Akamai to make data-intensive AI inferencing and more efficient for our joint customers. Our edge computing capabilities will be further enhanced by the introduction of our new managed Container Service, or MCS, that we announced in Q1. MCS will provide support for customer containers in any of our 4,000-plus pops around the world. That means we'll be able to run customer compute instances in over 700 cities. No other provider comes anywhere close to doing that today. Also in Q1, Akamai became the first and only provider to offer video processing units, or VPUs, in the cloud, with our new accelerated compute instances solution built on specialized processors from Net. A VPU architecture can offer up to 20x greater throughput than CPU solutions which results in greatly improved performance as well as significant savings for media companies. This gives Akamai another way to complement and cement our long-standing relationships with major media companies which include all of the top 10 media companies in the world. It's also very synergistic with the media workflow services provided by our ISV partners on Akamai Cloud. Overall, we believe that the combination of world-class delivery, compute the security available on our platform provides a low-cost, high-performance and massively scalable alternative to the hyperscalers for media and entertainment companies. And unlike the hyperscalers, we do compete with our customers. At the NAB Show in Las Vegas last month and in recent bits with customers across Europe and Asia, many executives told me how they see real value in what we're doing, in part because they're tired of writing huge checks to the hyperscalers who then use the funds to compete against them. On the go-to-market front, the sales transformation efforts that we outlined during our last call are on track as planned. We're making good progress in rebalancing our sales team to provide greater focus on new customer acquisition while maintaining strong customer relationships. We've implemented a better sales play methodology to improve our installed base penetration, especially for fast-growing security and cloud infrastructure offerings. And we're seeing good early success with changes to reward sellers and customers for longer multiyear contracts. Like all of you, we're keeping a close eye on global economic and political challenges. As we noted during the call, we've taken steps to minimize the ecto tariffs on our business. And as of now, we anticipate that the direct impact to Akamai from tariffs in 2025 will be about $10 million in CapEx which is amortized over 6 years. That said, there is concern among some of our customers in a possible recession which could impact later in the year. And some of our customers outside the U.S. have raised concerns about whether they should rely on American companies for critical infrastructure. Neither issue has impacted our business to date. And we're working to reassure customers that Akamai will continue to serve them as we always have. We're also staying very engaged with our U.S. federal sector customers. Overall, we arrived less than 5% of our revenue from the U.S. public sector, including state and federal. Based on our current line of sight, we had to lose a few million dollars of revenue in the back half of 2025 and related to federal cutbacks. There's also a possibility of increasing revenue in situations where our solutions can generate significant savings for federal agencies. Lastly, we were very pleased to see Akamai recognized last quarter as one of the most trustworthy companies in America by Newsweek Magazine which partnered with a market research firm to analyze more than 100,000 evaluations generated by customers, employees and investors. Trust and integrity are core values at Akamai and they really matter to customers who rely on us to be there for them. So I want to express thanks to our employees who work so hard to help Akamai earn the trust of our customers and shareholders. Now, I'll turn the call over to Ed to say more on our Q1 results and our outlook for the rest of the year. Ed?"
},
{
"speaker": "Ed McGowan",
"text": "Thank you, Tom. Today, I have to review our Q1 results and then provide some color on our Q2 expectations and our updated full year 2025 guidance. As Tom mentioned, we got off to a solid start to the year with total Q1 revenue of $1.015 billion which was up 3% year-over-year as reported and 4% in constant currency. We continue to see strong performance within our compute and security portfolios during the first quarter. Compute revenue grew to $165 million, a 14% year-over-year increase as reported and 15% in constant currency. Security revenue was $531 million, growing 8% year-over-year reported and 10% in constant currency. During Q1, we had approximately $6 million of onetime license revenue compared to $4 million in Q1 of last year and $12 million in Q4 2024. For the first quarter combined revenue from compute and security increased by 10% or 11% in constant currency, accounting for 69% of total revenue. Our delivery revenue was $319 million, down 9% as reported and down 1% [ph] in constant currency. Delivery revenue was stronger than expected in Q1. And while it's too early to call a bottom in delivery, we are encouraged by some improving trends in the delivery business to start 2025. International revenue was $486 million, up 2% year-over-year or 5% constant currency representing 48% of total revenue in Q1. Foreign exchange fluctuations had a negative impact on revenue of $5 million on a sequential basis and a negative $14 million impact on a year-over-year basis. Finally, it's worth noting that GEO contributed approximately $23 million of revenue in the quarter which was in line with our expectations. Moving to profitability. In Q1, we generated non-GAAP net income of $256 million or $1.70 of earnings per diluted share, up 4% year-over-year as reported up 6% in constant currency and well above the high end of our guidance range. Our EPS outperformance was driven by better-than-expected Q1 revenue, lower-than-expected transition services or TSA costs related to the traction, better-than-expected bandwidth costs, lower than payroll taxes primarily related to stock-based compensation as a result of a lower stock price. And lower employee medical claims related to our self-insured medical plan. Finally, our Q1 CapEx was $226 million or 22% of revenue. Our first quarter CapEx came in slightly lower than our guidance which was mostly due to timing as some CapEx has been pushed from Q1 into Q2. Moving to our capital allocation strategy. During the first quarter, we spent approximately $500 million to buy back approximately 6.2 million shares. We ended the first quarter with approximately $1.5 billion remaining on our current repurchase authorization. Our intention remains the same to continue buying back shares to offset dilution from employee equity programs over time and to be opportunistic in both M&A and share repurchases. As of March 31, we had approximately $1.3 billion of cash, cash equivalent securities. It's worth noting that subsequent to the end of the first quarter and prior to today's earnings announcement, we use cash on hand and funds available under our revolving credit facility fully repaid $1.15 billion of our outstanding convertible notes that matured on May 1 of this year. Before I provide our Q2 and full year 2025 guidance, I want to items. First, we have completed our migration ageo customers to the platform. As a result, we will not have any additional TSA costs moving forward and our revenue expectations from the transaction remain the same, approximately $85 million to $105 million of GO revenue contributions for 2025. Second, we expect an increase in operating expenses for the second quarter, partly due to a weaker U.S. dollar as well as higher marketing expenditures for Q2 events, our annual sales President's Club trip and the impact of our annual employee merit cycle which effect on April 1. Third, we continue to expect our CapEx to be heavily front-end loaded with significantly higher expenditures in the first half of the year compared to the second half of the year. This includes approximately $10 million of CapEx pulled forward to the first half of the year to help mitigate potential tariff risks. Fourth, we expect interest income to decline in 2025 due primarily to lower cash balances resulting from stock repurchases, recent acquisitions and the retirement of our $1.5 billion convertible debt. Additionally, we anticipate lower investment yields as interest rates are projected to come down throughout the year. As a result, we expect net interest income to decrease by approximately $5 million per month starting in May of 2025. Finally, we are maintaining our forecast ranges to effectively navigate increased volatility within the current economic environment, the volatility in the foreign exchange markets and the potential impact of the pending TikTok band. So with those factors in mind, I'll now move to our Q2 guidance. For Q2, we are projecting revenue in the range of $1.012 billion to $1.032 billion or up 3% to 5% as reported and in constant currency over Q2 2024. At current specs, foreign exchange fluctuations are expected to have a positive $15 million impact on Q2 revenue compared to Q1 levels and a positive $7 million impact year-over-year. At these revenue levels, we expect cash gross margins of approximately 72%. Q2 non-GAAP operating expenses are projected to be $315 million to $320 million. This is Q1 levels due to the items I just mentioned. We expect Q2 EBITDA margin of approximately 41% to 42%. We expect non-option expense to be between $135 million to $107 million and we expect non-GAAP operating margin of approximately 28% for Q2. Moving on to CapEx. We expect to spend approximately $226 million to $236 million. This represents approximately 22% to 23% of our projected total revenue. Based on our expectations for revenue and costs, we expect Q2 non-GAAP EPS in the range of $1.52 to $1.58. This EPS guidance assumes taxes of $54 million to $57 million based on an estimated quarterly non-GAAP tax rate of approximately 19% to 20%. It also reflects a fully diluted share count of approximately 148 million shares. Looking ahead to the full year for 2025, we expect revenue of $4.050 billion to $4.2 billion which is up 1% to 5% as reported and in constant currency. As a reminder, we would expect to come in at the higher end of that range -- if we see continued weakening of the U.S. dollar, traffic growth materially exceed levels and there is no ban in the U.S. for our largest customer. We would expect them at the mid to lower end of that range if we see significant strengthening of the U.S. dollar a significant downturn in the economy in the back half of the year. Traffic growth materially slows from current levels and our largest customer is band in the U.S. Moving on to security. We continue to expect security revenue growth of approximately 10% in constant currency for 2025. And we continue to expect the combined ARR from our Zero Trust rise and API security solutions to increase by 30% to 35% year-over-year in constant currency for 2025. For compute, we continue to expect row to be approximately 15% in concurrency. And as a reminder, included within our compute, we continue to expect cloud infrastructure ARR year-over-year growth in the range of 30% to 45% in currency for 2025. At current spot rates, our guidance assumes foreign exchange will have a positive $8 million impact to revenue in 2025 on a year-over-year basis. Moving on to operating margins. For 2025, we are estimating non-GAAP operating margin of approximately 8% as measured in today's FX rates. We anticipate that our full year capital expenditures will be approximately 19% to 20% of total revenue. Moving to EPS. For the full year '25, we expect non-GAAP earnings per diluted share in the range of $6.10 to $6.40. This non-GAAP earnings guidance is based on a non-GAAP effective tax rate of approximately 19% to 20% and a fully diluted share count of approximately 150 million shares. In summary, although we anticipate heightened economic volatility, we believe that Akamai is in a strong position to continue delivering revenue growth and maintaining healthy margins. This is by our newer security and cloud computing products a moderation in our content delivery revenue declines in commitment to disciplined cost management. With that, I'll wrap things up and Tom and I are happy to take your questions."
},
{
"speaker": "Operator",
"text": "[Operator Instructions] Today's first question comes from Amit Daryanani with Evercore."
},
{
"speaker": "Amit Daryanani",
"text": "I guess maybe to just start on the delivery side. Can you just talk about what really drove the upside for you folks in the quarter? Was it more pricing or traffic driven? And then what's reframe saying this can sustain into the out quarters? Just in what was the upside and why the hesitation about the sustaining?"
},
{
"speaker": "Ed McGowan",
"text": "Amit, this is Ed. Thanks for the question. Yes, so I'd say what drove it was really traffic. Pricing typically, unless you have large renewals, doesn't have a huge impact in any given quarter and we didn't have any significant concentration on renewal. So it was all about traffic growth. And it was pretty strong pretty much every sub vertical. So we saw strong video traffic, strong gaming traffic, strong software downloads and even across commerce and some of the other subverticals. So it's just a better improved environment. And just being cautious in terms of calling a bottom. This is the third quarter in a row here where revenue has kind of been flattish sequentially which is better than what it's been which has been declining. But we're seeing decent trends here in April and we're just being a bit more cautious and don't call the bottom quite yet."
},
{
"speaker": "Amit Daryanani",
"text": "Got it. That's still fair. And if I just follow up on the security side, I'd love to hear how you would characterize your performance in the March. It looks a little bit lower, I think, like not $15 million from what the Street was modeling perhaps. I'd love to understand how that end up versus your internal expectations. And then as you think about this acceleration from 8% to call it 10% in security, what enables us for the year?"
},
{
"speaker": "Ed McGowan",
"text": "Yes. Good question. So I would say it came in, in line with what we had expected for the quarter. And as you heard A few minutes ago, I reiterated our guidance for 10% constant currency and we did deliver 10% constant currency this quarter. There's a little bit of noise in there with license revenue and I sort of called that out for you. We had about $12 million of license revenue last quarter, about $6 million less this quarter. So that can sometimes folks don't quite get the model right, going from Q4 to Q1. And also with some of the bundles, Q4 tends to have a little bit of volumetric revenue associated with some of our commerce customers and things like that, that you don't see repeat at such a level in Q2. So I would say it came in, in line with what we expected. Big drivers for growth is exactly what we had thought in terms of the bookings. We're seeing a very strong API security growth and very strong Guardicore growth as we expected. And things are playing out exactly how we had thought."
},
{
"speaker": "Operator",
"text": "The next question is from Jonathan Ho with William Blair."
},
{
"speaker": "Jonathan Ho",
"text": "Congrats on the strong quarter. Can you provide a little bit more detail on the role you can play with agentic AI with your AI firewall. And perhaps help us understand how you could potentially benefit AI utilization in the enterprise really begins to expand?"
},
{
"speaker": "Tom Leighton",
"text": "Yes. There's a lot of attacks now that have been published against AI apps of all kinds, including agentic AI. Attacks where the adversary is able to trick the agent, the AI agent into giving up sensitive data, code, PII, trick the agent into saying things that it should -- could be offensive content, could be deals, prices for things that aren't right. And so you got to protect the app, particularly if it's an agent making decisions and doing things. You got to protect it from the attackers that cause it to do bad things. Also, you've got to protect it from ingesting a bad information. A lot of these apps are learning as they go along. And the adversaries I've figured out how to submit information to it that causes it to learn bad things which can cause problems in the future. AI is a brand-new attack service and being rapidly deployed. In fact, a lot of enterprises are -- they're forming rules inside the enterprise, about what they can and can't do with AI. But on the other hand, they can't even keep track of all the AI applications that they are using and supposed. So another aspect of what we're doing, same as we do for API security. The first thing is letting our customers know what AI apps do they have exposed. And then making sure that they're protected. And I imagine this is going to be really a war of regulation. So the first attacks are being seen out there. We have the first line of defenses now with the OAS top 10 and additional capabilities tailored to particular customer use cases. And I think there'll be some back and forth there that more attacks will be figured out. And our job is to stay ahead of that and keep our customers safe."
},
{
"speaker": "Jonathan Ho",
"text": "Excellent. And you mentioned some customers expressing worry over whether they could rely on U.S.-based services. Is there potential for diversification or multisourcing pressure from some of your customers internationally. Just wondering."
},
{
"speaker": "Tom Leighton",
"text": "Today, I don't think there's good alternatives, especially when it comes to security, pretty much all the world's major banks, most of the major commerce companies rely on Akamai for their security because we're really the best and in terms of protecting them. There's not good alternatives for them today. I think over the long haul, our job is to make sure that they understand that continue to rely on Akamai. No matter what happens with the geopolitics and the rhetoric. But it's a topic that's come up in some accounts. And so we're being careful that they understand that Akamai is here for them over the long haul. And that we're not going away and that they can continue to on us."
},
{
"speaker": "Operator",
"text": "The next question is from Will Power with Baird."
},
{
"speaker": "William Power",
"text": "Okay, great. I come back to the Security segment. You called out a number of competitive takeaways for the segmentation products. I guess it would just be helpful if you can kind of just help distill down what's really setting you apart in that market, allowing you to take share? And then secondly, it'd be great to get any on the progress, trends within the kind of the rest of the broader 0 trust portfolio and where go-to-market since there?"
},
{
"speaker": "Tom Leighton",
"text": "Yes. I think scale sets us apart to the larger enterprises could have hundreds of thousands of applications and devices. They need to protect and we're unique in being able to do that. Ease of use has come up in several accounts and particularly with our new AI-enabled interface that can make the integration be a lot faster and simpler. Our new engine suggests the initial firewall rules that it should be set up for all the various devices in the enterprise actually tells our customer and their operator, what the various devices are notifies them. If firewall rules are out of date or not the most recent set of rules that they need to have. So ease of use is really important because if you think about installing hundreds of thousands of agents, you need really good automation to do that effectively. And trust, I think is really important. And we've been told that by our customers because these agents are running inside the company. And it's really important that they be reliable and Akamai has a great track record there. We're not the lowest cost provider. You know there's others out there with lower cost solutions. But when it comes to protecting critical infrastructure from the devastation of ransomware or data ex filtration with software that's running really in the inside the important applications, Akamai is pretty unique in being able to do that and being trusted for that. In terms of zero trust, Guardicore is our flagship solution. It's sort of the and we do have other capabilities. We've combined North, Southeast west protections built around Guardicore and our Enterprise Application Access solution, so that we can provide really a comprehensive set of solutions to protect the enterprise applications and data."
},
{
"speaker": "William Power",
"text": "Okay, great. No, that's helpful. And maybe just to add quickly for you. Nice to see the better margins in the quarter, I mean it sounds like you expect to dip back down in Q2. So I guess I'm just trying to sort out what proportion of that upside in the quarter could be more sustainable versus some conservatism going forward?"
},
{
"speaker": "Ed McGowan",
"text": "Yes. I think for this quarter, in particular, I'd say you'd have to see some revenue upside to drive higher margins. We obviously have very good leverage. If you think about -- as I broke out in the prepared remarks, the items that drove the upside both in Q1 and then in Q2, what's driving the higher cost. Some of it is event driven. But there is the -- we did pull our merit cycle in a little bit earlier this year. We typically do it in the middle of the year, so we just brought it to April. So that has a recurring cost. So doing some hiring. So that has an impact as well. But we think over time, as the business grows will improve our margins. And maybe in the back half, there's a potential if we hit the upside to expand margins a bit as well."
},
{
"speaker": "Operator",
"text": "The question comes from Frank Louthan with Raymond James."
},
{
"speaker": "Unidentified Analyst",
"text": "Great. This is Rob [ph] on for Frank. So can you talk about the recent sales changes? Where are you as far as the new folks you need to hire moving people around within their different roles between the hunters and farmers? And then what are some other drivers of improvement that you see taking shape the rest of this year and into next year?"
},
{
"speaker": "Tom Leighton",
"text": "I'll start with that and then hand it off to Ed on the margin question. I'd say we're about 1/3 of the way there. We've made a lot of changes, seeing some very good progress. shifting for the forest towards hunting now that we have products that a lot of new to Akamai customers need, for example, API security segmentation cloud computing and they're going to need firewall for AI as well. Also hiring more of the specialists that have a lot of expertise that can help facilitate those sales. We've made shifts to incent both our sellers and customers to longer-term contracts starting to see some impact there which is good. And overall, over time, growing the overall presence in the marketplace. So I'd say we're about 1/3 of the way there and making good progress. And Ed, do you want to talk about the margins?"
},
{
"speaker": "Ed McGowan",
"text": "Yes, sure. So I'd say it's probably 3 main drivers. The first one would be just as we scale up our compute business. So right now, we are subscale. So if we look at some of the facilities as we start to sell those out and get to a bit of scale inside of some of the different -- we are seeing very attractive margins in line with what we talked about. But we do have a long way to go in terms of reaching scale. As we start to grow and compute, I do expect our margins to expand obviously there. And then as security continues to grow. It's a higher-margin product for us. API security is a very high-margin product for us, much lower CapEx associated with your securities. So that's going to help. And then as the stocks being such a big drain, that also helps as well. So if we get back to kind of low single-digit or even flat CDM growth. That obviously has a big help on margins. As far as other operating areas, we're always looking at efficiencies, we've run out a lot of costs. There's a little bit in the room potentially in real estate and we can find a la some of our unused space. And then with compute in terms of our own use of compute, we've migrated a lot of our stuff to the note. We'll look to do some more. But it's really going to come from scaling up of the business and as the mix shifts over time."
},
{
"speaker": "Operator",
"text": "The next question comes from Jeffrey Van Rhee with Craig-Hallum."
},
{
"speaker": "Jeffrey Van Rhee",
"text": "Just a couple maybe on the security front. Just high level, if I look at the organics and try to back out the acquisitions, it looks like it's fallen off fairly quickly from 15 to 10 to maybe now mid-single digits going sequentially last quarter was 10% year-over-year in this quarter, looks like mid-single digits. Just talk to me a little bit. I know you touched on it last quarter but I want to make sure I fully understand what's played out there on the security. And I think you had pointed to WAF but -- maybe if you could just start there."
},
{
"speaker": "Ed McGowan",
"text": "Yes, sure. So yes, they're sort of inorganic in the number but it's not a significant portion of revenue for us. In terms of if you break out the business in the different subsegments, we are seeing WAF slowdown naturally a little bit. It's still growing but it's not growing nearly as fast as it was very high penetration which is expected. Obviously, API security is growing incredibly fast and we think can be a very, very significant grower for us over time. Infrastructure security business is a low single-digit growing business and is kind of in that range. Prolexic is growing in kind of in its normal range. We haven't had a lot of big attacks or anything like that, that tend to be kind of more, call it, episodic that drives spikes in demand there. So we haven't seen that in a while. So that's also slowing a bit revenue has been consistent in that sort of high single digit, low single digit -- or sorry, low double-digit growth area. So it's really just a mix shift right now as we talked about exactly what we're expecting with some of the products that have been in the market for a while, just naturally slowing down. And then the newer products like Guardicore and API taking off but just not at the scale yet to offset the slower growth in the other products."
},
{
"speaker": "Jeffrey Van Rhee",
"text": "Got it. That's helpful. And on compute, you had commented last quarter around some exiting of some legacy revenue streams around video, I think transcoding, image management and some other things in there. How much -- how was the headwind from that this quarter in compute compared to what you were expecting when you gave the guide?"
},
{
"speaker": "Ed McGowan",
"text": "Yes, I'd say it's playing out exactly how we expected. And we're still seeing very strong growth in our CIS compute infrastructure services business and I reiterated our guidance there for very strong 40% to 45% growth in ARR. So playing out exactly as we expected -- we said it would take a while to -- for some of this to play out probably about 2 years or something like that but it came in exactly as we had thought. So..."
},
{
"speaker": "Jeffrey Van Rhee",
"text": "Perfect. Okay. And then just one last one -- to revisit the prior question on sales and the changes you're making in sales, it sounds like a little more focus on hunters. In terms of the metrics, we'll see, where do you think the impact of these sales changes will show up first? And presumably, if you're focused on Hunters maybe a new customer metric might be the place we would look for that. But just tell me kind of how we're going to see this play out in terms of the results and metrics that we might be able to observe?"
},
{
"speaker": "Ed McGowan",
"text": "Yes. So we haven't really provided any metrics in terms of sales productivity but it's something that we'll consider providing you some metrics in terms of how the -- number one, how the investments are going, where what stage are we in, in terms of adding the capacity. And it's both with hunters as well as some specialists for both compute and security. But I think you just see it by fest itself in stronger revenue growth but we'll consider breaking out some metrics that will be helpful. It's just sometimes a booking metric doesn't always translate to revenue cleanly, so that's not the most helpful thing to give. But we'll give us some consideration try to give you some metrics that might be helpful."
},
{
"speaker": "Operator",
"text": "The next question comes from Patrick Colville with Scotiabank."
},
{
"speaker": "Unidentified Analyst",
"text": "This is Sagar [ph] on for Patrick Colville. I wanted to better understand the non-delivery opportunity to cross-sell Edgio into the existing base and what you're seeing within that segment specifically?"
},
{
"speaker": "Ed McGowan",
"text": "This is Ed again. You added several hundred customers from Edgio. And there's a good opportunity there where Edgio did not have very many security products at all actually and they didn't offer compute, certainly not the robust compute solutions that we have. So right now, there's not a lot to report in terms of upsell. The first thing you want to do is just make sure the customers are migrated over. They understand who their rep is, get familiar with the services and working with Akamai and then we'll start to build campaigns. I'd expect that to take your normal 6 to 9 months to start to build a pipeline and then we should start to see some potential upsell into that base of additional customers over time."
},
{
"speaker": "Operator",
"text": "The next question comes from Madeline Brooks with Bank of America."
},
{
"speaker": "Unidentified Analyst",
"text": "This is Kevin [ph] on from Madeline Brooks for Bank of America. I want to talk to you about the compute trends. You've noted over time that you expect compute to be kind of a long-term 20% growth driver or grower. What is contributing to this current growth rate that we saw this quarter? And what needs to happen to bring it back up into the 20s?"
},
{
"speaker": "Tom Leighton",
"text": "Yes. So the real driver there is our cloud infrastructure services. And as we've talked about and as Ed said, we expect the ARR there to grow 40% to 45% this year. And that means -- and as that number gets a lot bigger, that drives the overall compute number. So that's the number to watch. We'll highlight that as we and -- that will be driving the bigger compute number. Ultimately, that becomes a large major compute number."
},
{
"speaker": "Unidentified Analyst",
"text": "It sounds good. And then just as a follow-up on the securities -- if I look over the last 3 years or so, you've grown annually the 15% to 16% rate in the segment and then you just kind of listed some guidance for 10% for the year. And you've already given color as to why that is. But two questions. One, what gives you confidence in this 10%? And two, do you see any upside to this 10%? And what could drive that upside?"
},
{
"speaker": "Tom Leighton",
"text": "Yes, I'll start with that. The confidence is driven by the large interest big potential market and very strong growth for our segmentation in API security solutions. And as we talked about, we think the ARR of those solutions this year grow 30% to 35%. A lot of demand for that. We have the market-leading solutions. And now we are adding in firewall for AI just starting but a lot of customer interest there. And I think that has a long runway ahead, even though no revenue to speak of yet just signing the first customers now. So I think having leading solutions in large potential markets that today, fairly small revenue but growing at a food clip. That gives us confidence that we can be growing the larger security number in the 10% range. Upside would be in part based on products, how fast they get going; and if we can beat the 30% to 35% on these products. Ed, do you want to add anything to that?"
},
{
"speaker": "Ed McGowan",
"text": "Yes. The other thing I would say is the business is very highly recurring, mostly subscription-based business. I do break out from time to time if we have some license revenue. So you do have pretty good visibility in terms of the base there's not much price pricing in your security business is a very sticky product. You don't tend to have a lot of churn. So you have a lot of confidence in sort of the underlying business that you have and it really just comes that pace at which you're adding existing customers buying more product and acquiring new logos. But if you look at the size of the sales force, what we've produced over the years, we certainly have the capacity to add the type of revenue that we need. And obviously, as we add get more reps up to speed, we'll have more capacity to sell even more."
},
{
"speaker": "Operator",
"text": "The next question is from Rudy Kessinger with D.A. Davidson."
},
{
"speaker": "Rudy Kessinger",
"text": "Ed, could you -- just on the compute side, could you maybe quantify just what would compute growth have been if not for some of the lay compute stuff you shifted to partners relative to the 25% in constant currency in Q4?"
},
{
"speaker": "Ed McGowan",
"text": "Yes. Sure. Good question. So if you remember last time we broke out the sub number. So the cloud infrastructure service and the -- what we call our other computer, our legacy compute. There's like 4 or 5 different things that were in there, some legacy storage, some of the first customers that we had done some custom builds for some video optimization and optimization, that sort of stuff. That business has grown about 20% last year and the cloud infrastructure service grew at over 30%. So I'd say we're seeing very similar growth rates in the cloud infrastructure service and where the slowdown is coming as expected, is in that other legacy stuff where you've got a combination of some of the custom deals we did. We did a couple of big custom deals that have largely run their course and they're not growing anymore. Any new applications would go into cloud infrastructure service. Our legacy storage business is starting to decline. We've migrated a little bit of business to partners. So that's playing out exactly as we expected. So really, the decline from 20% to 15% or 25% to 15% is really all in that bucket as we had called out to you. But the Cellco infrastructure service is growing really, really fast."
},
{
"speaker": "Rudy Kessinger",
"text": "Okay. And on the delivery front, what are you seeing from a pricing standpoint? And in particular, since the Edgio bankruptcy, have you started to see pricing improve on renewals? And do you think 6, 12 months from now, we might get to a point where price compression could be better than it has been historically, just given us that several low-cost providers a the space for the last few years?"
},
{
"speaker": "Ed McGowan",
"text": "Yes. Good question. So we're seeing kind of a mixed bag, as you would expect. I'd say we're seeing some somewhat encouraging signs of some of our larger media customers where the price declines aren't nearly what they used to be but you don't also have the same type of volume growth that we used to. So that sort of makes sense. But also this like you pointed out, fewer options there across some of the other -- the rest of the base or delivery, it's a mixed bag. It depends sometimes you have a little bit more price pressure in commerce, if there's pressure with the economy and that sort of thing. But -- yes, I think over time, it's possible we'll see a moderation. We are seeing it. It's definitely improved a bit over the last year or so. And there's still room to go there. But this business has always had some element of unit economics of higher volumes, lower unit prices. I expect that to continue. But that's certainly one of the drivers to getting this business back to flat and mid- to low single-digit growth or decline over time."
},
{
"speaker": "Operator",
"text": "The next question comes from John DiFucci with Guggenheim Securities."
},
{
"speaker": "John DiFucci",
"text": "I guess I think this question is for Ed. As you focus on the faster-growing parts of security, specifically API Security with no name and NeoSeand and Guardicore which I would think are largely channel focused but different channels than are the traditional Akamai channels? And probably sold through the channel like other traditional security products are sold. I mean, are you taking steps to really ramp that up to drive growth with new channel partners? And if so, because we do a lot of checks and trying to hear more -- we'd like to hear more about Akamai in those checks. Can this new path to market more focused path, if that's the case, also be used to sell more of your infrastructure and app security products?"
},
{
"speaker": "Ed McGowan",
"text": "Yes, I'll start..."
},
{
"speaker": "Tom Leighton",
"text": "I can start with some of the channel -- You're absolutely right. They are different than the traditional Akamai channel partners. And in fact, most of our large major article sales, API security sales and new customers to Akamai come through those channels. Examples of partners would be Presidio, WWT, Optiv, GuidePoint, Defense X, IBM and Deloitte Macnica, OCD, Accenture, Carso. So a variety of partners that are different than the by and large carrier partners we had in the CDN days from before. Ed, do you want to add to that?"
},
{
"speaker": "Ed McGowan",
"text": "Yes. I would say, John, in talking with PJ, 80% to 90% of our new logo acquisition does come through the channel. I would expect with some of our installed base where we have a strong direct relationship, I would imagine a lot of the API security sales and Guardicore sales will be led by our traditional reps. But about 1/3 -- a little over 1/3 of our business in general comes through the channel and a little over half of it comes in security comes to the channel. I expect that to increase over time. And as we acquired some of these companies, both NeoSec and Guardicore did come with some new channel relationships that we've obviously continue to grow and block on as a result. So I do expect a lot of our growth going forward to come through the channel."
},
{
"speaker": "John DiFucci",
"text": "Ed and Tom, the -- sorry for my voice. But is -- is this an opportunity to -- through those new channel partners to also sell like your -- the slower-growing parts of security but they're still needed like DDoS protection and WAF, because others -- other partners or other of your competitors that sell those products are making a big push in the channel. So they're getting sort of used to selling that or the -- at least they're starting to talk about it."
},
{
"speaker": "Tom Leighton",
"text": "Yes and we do that. Often, it will be the new customer sales would be led with Guardicore or API security but you're absolutely right. the whole platform, the whole security platform can be then included with that or grown to that. And those partners are very good at it. So I think you're absolutely right and we're seeing that."
},
{
"speaker": "Operator",
"text": "We have time for one last question. It will come from James Fish with Piper Sandler."
},
{
"speaker": "Unidentified Analyst",
"text": "This is Kate [ph] on for Fish. So just one on the -- for the security weakness, was that more on the new side of the -- was that more on the new side or the expansion side of existing customers?"
},
{
"speaker": "Ed McGowan",
"text": "Yes. I wouldn't refer to it as weakness. It came in as we expected it. So we're not viewing it as weakness so it was pretty much right in line. But in terms of the impact within a quarter, you got to remember a lot of the business is recurring. So the bulk of the revenue is already spoken for with existing commerce. Most of the growth, as I said, comes from the -- into newer sales is coming from API security and Guardicore as we expected. That doesn't have a huge revenue contribution in the quarter in which you sell it because it does take a maybe a month or so to get it up and running and revenue generating. So like I said, I think things turned out just as we expected and the normal mix of new customer versus upsell into the base was pretty similar to what we see in a typical quarter."
},
{
"speaker": "Operator",
"text": "Thank you. That concludes our question-and-answer session. I would now like to turn the call back over to Mark Stoutenberg for closing remarks."
},
{
"speaker": "Mark Stoutenberg",
"text": "MJ [ph], you can please end the call now."
},
{
"speaker": "Operator",
"text": "All right. This concludes our presentation. Thank you for attending today's conference. You may now disconnect your lines."
}
] | Akamai Technologies, Inc. | 24,522 |
ALB | 4 | 2,020 | 2021-02-18 09:00:00 | Operator: Ladies and gentlemen, thank you for standing by. And welcome to the Albemarle Corporation Q4 2020 Earnings Conference Call. At this time, all participants are in a listen-only mode. After the speaker presentation, there will be a question-and-answer session. [Operator Instructions]. Please be advised that today’s conference is being recorded. [Operator Instructions] I would now like to hand the conference to your speaker today, Meredith Bandy, VP of Investor Relations & Sustainability. Please go ahead, ma'am.
Meredith Bandy: All right. Thank you, Joelle. And welcome to Albemarle’s fourth quarter 2020 earnings conference call. Our earnings were released after the closing the market yesterday and you will find the material posted to our website under the Investor Relations section at albemarle.com. Joining me on the call today are Kent Masters, Chief Executive Officer; and Scott Tozier, Chief Financial Officer. Raphael Crawford, President, Catalysts; Netha Johnson, President, Bromine and Eric Norris, President, Lithium, are also available for Q&A. As a reminder, some of the statements made during this conference call including our outlooks, expected company performance, expected impacted impacts of the COVID-19 pandemic and proposed expansion projects may constitute forward-looking statements within the meaning of federal securities laws. Please note the cautionary language about forward-looking statements in our press release and that same language applies to this call. Please also note that some of our comments today refer to financial measures that are not prepared in accordance with GAAP, a reconciliation of these measures to GAAP financial measures can be found in our earnings release and the appendix of our presentation, both of which are on our website. Now, I will turn the call over to Kent.
Kent Masters: Thanks Meredith. And thank you all for joining us today. On today's call, I will highlight recent accomplishments and discuss our strategy to capitalize on the very attractive long-term growth trends we see for our businesses. Scott will give more detail on a result outlook and capital allocation. I'm pleased to say that Albemarle reported solid fourth quarter results including net sales of $879 million and adjusted EBITDA of $221 million, both of which were at or above the high end of our previous outlook. I'm also encouraged by the rebound we began to see in the second half of the year particularly for bromine and lithium. We expect to generate full-year 2021 net sales of between $3.2 billion and $3.3 billion and adjusted EBITDA of between $810 million and $860 million, both up from 2020 results. As I'm sure you're aware earlier this month we completed a $1.5 billion capital raise. The proceeds of this offering provide the financial flexibility to execute our long-term strategy including the acceleration of high return growth projects. Now, if we turn to slide five, we have a clear strategy to drive sustainable value for our shareholders. Albemarle has four primary strategic objectives. First, we will grow profitably. We have identified and planned a portfolio of low capital intensity high return projects. These projects lever our diverse world-class resources in both lithium and bromine. Over the past five years, we have built the internal team and capabilities to execute these projects on time and on budget. In addition, we have the long-term commercial relationship with customers that are required for these projects. We are working to ensure that we are aligning with their strategic requirements while achieving adequate returns for our shareholders. Of course, the majority of our growth will be lithium. But at the same time, we will be investing in our bromine projects. This will include highly efficient Brownfield projects with attractive returns and short paybacks. I'm sure, Netha will be happy to give you more detail when we get to Q&A. Second, we will maximize productivity. Over the past year, we have optimized earnings and cash flow generation across our business including our very successful, sustainable cost savings program. Operational discipline is essential for generating cash flow and supporting growth. And we will not take our eyes off the ball, even as we move into an accelerated growth phase. Third, we will invest with discipline, focusing our capital investments on our highest return opportunities, just as we have in the past, we will actively assess our portfolio for opportunities to unlock shareholder value. We will also continue to maintain our investment grade credit rating and support our dividend. Fourth, and finally, we will advance sustainability across our businesses, which is a core value for Albemarle. Our aim is to increase sustainability throughout the value chain from the resource to the end use of our products. Most recognizably, we develop lithium products that enable the reduction of greenhouse gas emissions through the adoption of battery electric vehicles. Our catalyst business contributes to sustainability by helping refiners produce cleaner transportation fuels. And our bromine products contribute to consumer safety by preventing fires and electronic equipment. With continued regulatory changes, advancements in technology and investments in infrastructure like charging stations, the current environment is ideal for a step-change in EV adoption. We are seeing this play out in the acceleration of global EV sales led by rebounding demand in China and new demand in Europe. Global EV sales increased 45% during 2020 and are expected to increase by over 70% in 2021. On the right hand side of the slide, you see demand projections for lithium over the next five to 10 years. Based on our internal estimates, we believe demand will reach more than 1.1 million tons by 2025, up from around 300,000 tons today. This is slightly higher than third party projections from industry analysts like Benchmark Minerals Roskill and the CRU Group. But as you can see, the consensus is that the industry expects to see significant growth in the coming years. As the industry leader in lithium, Albemarle is able to take these external estimates, internal forecast and discussions with our strategic customers and suppliers to generate a detailed demand forecast. On slide seven, you see other metrics we use to gauge the future of the lithium market. While Albemarle's demand outlook for lithium is above third party estimates. Our outlook is below some of the more ambitious targets from automotive OEMs. For example, Tesla's vision of three terawatt hours of battery production by 2030 would translate to roughly 2.3 million tons of lithium. That means that Tesla's demand alone would exceed estimates for the entire market. Additional regulatory impacts for example, if the U.S. decides to adopt more European like EV incentives would be incremental to our estimates. Total lithium demand is expected to grow by about 30% per year from 2020 to 2025, led by lithium consumption and electric vehicles, which is expected to grow by 47% per year. Two other trends support lithium demand, increased adoption of battery electric vehicles and larger battery size. Battery electric vehicles and larger battery size improve the consumer experience with longer driving ranges and innovation in batteries is also driving shorter charging times. It's important to note that this outlook does not assume a major shift in battery technologies over the next five years. Advanced battery technologies like solid state batteries could potentially increase lithium intensity later this decade. Since 2015, we've nearly tripled our nameplate conversion capacity to 85,000 tons per year. Later this year, we expect to complete two major projects, which we refer to as Wave 2. Wave 2 consists of La Negra III and IV project and Kemerton I and II projects, which will more than double our current capacity to 175,000 tons per year. Over the last five years, we engaged with our customers with long term volume commitment to execute this portfolio of projects. Now, with this new acceleration in demand, customers are asking us to repeat the model. Our next two waves of expansion could once again more than double our nameplate capacity. With lower capital intensity, we expect these projects to generate very attractive returns. The identified and planned Wave 3 projects would add 150,000 tons of annual capacity over the next three to five years. This third wave includes a conversion plan in China, which would be part of our MARBL joint venture, a smaller expansion at our silver peak asset in Nevada. Another plant in China on a new mega site, and Kemerton III and IV, a brownfield project in Australia. We also have identified opportunities for a fourth wave of projects. These could include further expansions in Australia, China and Southeast Asia, and the potential to restart the mine and expand our conversion facility at Kings Mountain in North Carolina. Wave 4 also includes options to support customers looking to localize supply, for example, by converting carbonate to hydroxide near the battery manufacturer. And before we continue, let me update you on our Wave 2 projects. So La Negra III and IV enables us to add lithium carbonate capacity at the very low end of the cost curve, the project remains on track for mechanical completion in mid 2021. Kemerton I and II, our new lithium hydroxide conversion plant in Western Australia is on track to reach mechanical completion late in 2021. Kemerton is core to our hydroxide capacity in line with expected strong long term market demand. Both of these projects will add significant commercial lithium sales beginning in 2022, following commissioning and customer qualification processes. As we move from Wave 2 to Wave 3 projects and beyond, we expect an estimated 40% reduction in capital intensity to support compelling economic returns. We can achieve these capital efficiencies and returns for three key reasons. First, we were able to leverage our experience in project execution by building standardized plants with economies of scale. For example, we expect new hydroxide plant would be a standard two trains or 50,000 tons per year, similar to what we are building at Kemerton today. Second, in many cases, we're moving from Greenfield to Brownfield economics, just as today we're moving from La Negra I and II to La Negra III and IV. Likewise, we'll move from Kemerton I and II to Kemerton III and IV and so on. As with Kemerton, the focus will be on building what we call mega sites, standardize large scale plants, able to support multiple trains for lithium conversion. Finally, we'll be buying or building additional facilities and low cost jurisdictions, as we did when we successively acquired and then expanded our Xinyu [ph] facility in China in 2016. Before I turn it over to Scott to review recent results, I'd like to acknowledge all the hard work by Albemarle team to continue to operate during the global pandemic, as well as their ability to achieve significant progress on our long term strategy. A year ago, when my predecessor laid out our 2020 strategic objectives, I don't think any of us can imagine how the year would play out. Despite all the challenges our team has delivered. We set ourselves up to grow profitably, keeping our major lithium capital projects on track for 2021 completion. We maximize productivity achieving $80 million of sustainable cost savings in 2020, 60%. above our initial targets. We demonstrated financial discipline, completing our 26th consecutive year of dividend increases and maintaining our investment grade credit rating throughout the pandemic related downturn. And finally, we improve the sustainability of our businesses by establishing baseline environmental data and improving our reporting and transparency. Now I'll now turn the call over to Scott for a detailed review of the 2020 financial results.
Scott Tozier: Thanks, Kent and good morning everyone. Albemarle generated fourth quarter net sales of over $879 million, a decrease of about 11% compared to the prior year. But at the high end of our previous outlook. This reduction was primarily due to reduce prices and lithium has expected coming into the year and reduced volumes in catalysts offset by improvements in bromine. GAAP net income was $85 million, adjusted EPS of $1.17, excludes a pension mark-to-market loss due to lower discount rates. As Kent stated, adjusted EBITDA was $221 million, above the high end of our previous outlook. Turning to slide 13 for a look at adjusted EBITDA by business segment. Lithium's EBITDA declined by $17 million versus the prior year. Pricing was down about 20% in the quarter due to contract pricing adjustments agreed in late 2019, as well as product mix. Volumes were higher than expected due to a combination of improving demand and customers fulfilling their full year contract commitments. Cost savings help offset the impact of lower prices. Bromine's EBITDA was up about $7 million, the increase was due to higher volumes and higher pricing. Bromine is overall a good news story. The business has essentially rebounded to pre-pandemic levels. In Q4 they benefited from higher demand, customer restocking and some short term supply demand imbalances for both raw materials and finished goods. Catalysts EBITDA declined by $53 million, primarily due to lower volumes. This business continues to be the most challenged of the three due to ongoing travel restrictions, as well as reduced refinery capacity utilization and margins. Fluid Catalytic Cracking or FCC volume improved sequentially, but remained down compared to the prior year quarter. Hydroprocessing catalyst or HPC volumes were also down with a tough comparable relative to an unusually strong Q4 2019. Our corporate and other category EBITDA decreased by $8 million, due to a mix of slightly lower fine chemistry services results and slightly higher corporate costs. The FCS business is contract driven and can vary quarter to quarter. Full year results were very strong compared to history. Comparing the full year to fourth quarter, you can see it and get a sense of the rebound we started to see in the second half of 2020, particularly for lithium and bromine. We are pivoting capital allocation to prioritize high return growth projects to align with strategic customer demand and maintain our leadership positions. We remain committed to preserving the financial flexibility necessary to fund growth and to maintain our investment grade credit rating. We'll also continue to support our dividend. Although dividend growth may be lower than the historical average, while we build out the next wave of growth projects that will enable higher return opportunities. Finally, we will pursue a disciplined and thoughtful approach to investments, including M&A and joint ventures. As we said in the past, the most likely M&A you'd see us do would be bolt on acquisitions of lithium conversion assets, in cases where buying allows us to grow more quickly and generate better returns than building. We are finalizing the sale of our Fine Chemistry Services and performance catalysts solutions businesses and expect to update you in the coming months. Let's turn to slide 15 for look at our balance sheet. The primary use of proceeds from our equity offering is to accelerate profitable growth. The 90% or about 90% of the proceeds are for lithium growth, with most of the remainder for enhancements to our bromine business. The returns on these projects are highly attractive, and we expect to generate returns at least two times our weighted average cost of capital at mid cycle pricing. These are large, long dated projects with a bulk of incremental spending in 2022 through 2025. In the meantime, instead of holding the proceeds as cash we plan to delever, which will reduce interest expense and cash drag on the balance sheet. This will enable us to use cash and debt capacity to fund investments as they are approved. Our long term target net leverage ratio remains two to two and a half times adjusted EBITDA. Pro forma for the offering, we're below that range, but expect to increase our leverage as needed to accelerate growth and deliver returns to shareholders. Overall, we expect 2021 results to improve year-over-year. For the total company we expect net sales to be higher year-over-year as our businesses continue to recover from the events of 2020. Adjusted EBITDA of between $810 million and $860 million also suggests potential upside compared to 2020, due to higher net sales and ongoing cost savings. We expect CapEx to be slightly higher year-over-year as we begin to execute our accelerated growth projects. However, as they I mentioned earlier the bulk of that spending for these projects will be in 2022 to 2025. Net cash from operations is expected to be lower due to higher cash taxes and higher inventories, as we start up the two new lithium plants. Expectations for adjusted diluted EPS of $3.25 to $3.65 is lower than last year due to higher taxes and depreciation, as well as the increased share count. Due to the recent severe winter weather, we have temporarily shut down four of our U.S. plants; Our Bayport, Pasadena, Magnolia and Baton Rouge plants have been down since Monday. Once it is safe to do so, we will restart these facilities. And this situation is still evolving. At this point, we expect some impact to Q1 results and potentially Q2. It's possible the weather will have more of an impact than what is currently included in this outlook. And we'll update you if there are any material changes. Let's turn to slide 17. Lithium results are expected to be relatively flat compared to 2020. We expect slightly higher volumes, with the restart of North American production late last year, as well as modest efficiency improvements. As usual, we expect volumes to be back half weighted for lithium. At this point, we still anticipate slightly lower pricing depending on full year average realized pricing for carbonate and technical grade products. Our new contracts structures provide increased flexibility to increase price in response to improving market prices. Lithium costs will be slightly higher year-over-year related to the startup cost associated with La Negra and Kemerton partially offset by continued cost and efficiency improvements. And as Kent discussed, the long term growth story for lithium is intact. In catalysts, we expect 2021 results to be flat year-over-year, including higher PCS earnings. We expect the decline in North American refining catalysts volume. This is primarily a result of one customer who recently indicated that they would de-select album as catalysts due to our public support for electric vehicles. Longer term, we are continuing to position the catalysts business to grow in emerging markets and capitalize on our strengths as a global specialty chemicals producer in the crude to chemicals market and the renew renewable fuels market. Raphael, can give more color on the challenges and opportunities we see for our catalysts business during Q&A. In bromine, we expect full year 2021 results to improve modestly, with continued economic recovery and a return to sold out plants. Our ongoing savings initiatives should offset the impact of inflation. Looking ahead, we see steady demand increases for our flagship fire safety products driven by new technology trends, like 5G and electric vehicles. I'll turn it back to Kent to review our strategic objectives for 2021.
Kent Masters: Thanks, Scott. Albemarle finished strong in 2020. And we are excited about the opportunities ahead of us in 2021. We will continue to execute our long term strategy. The successful completion of our Wave 2 projects and investment decisions on new expansion projects in lithium and bromine. We are also working with customers to reach commercial agreements for a majority of new capacity prior to investing. We will continue to maximize productivity with operational discipline across our businesses, including cost reduction, lean principles, continuous improvement and project execution excellence. We expect to achieve $75 million of productivity improvements in 2021. We will be disciplined stewards of capital investing in high return growth, maintaining our investment grade credit rating and supporting our dividend. Finally, we will continue to implement and improve sustainability across our company including setting near term goals to reduce greenhouse gas emissions at our existing operations and exploring science based target options for all three of our businesses. And with that, we'd like to open up the call for questions. So Joule, over to you.
Operator: Thank you. [Operator Instructions] Our first question comes from David Begleiter with Deutsche Bank. Your line is now open.
David Begleiter: Thank you. Good morning, Kent, on recycling in lithium, when do you expect it to become a bigger part of the market? And what will be Albemarle's role in lithium recycling going forward?
Kent Masters: So, let me -- I'll start with that, maybe Eric can give a little bit more details. So I mean, we've got activities around lithium, but we expect that to be a number of years out before it becomes a major business. So basically, there has to be enough lithium in the market to - for it to run its lifecycle in a vehicle and then come back for recycling. So -- and I think our roll in that. I mean, we'll have to look at those business options. But when you see lithium being recycled, there's a component of that that looks a lot like our conversion facility. So we would anticipate that we would play in that, but it's a number of years out before that comes to fruition. So Eric, anything you want to add there?
Eric Norris: Sure, Kent. David, I'd add that, we have a number of efforts already with existing customers, both in the U.S. and in Europe, who are very focused on investing in recycling capabilities. In some cases, in Europe, it's part of the EU battery directive. Those targets within the EU, for example, are still being set and being discussed. The industry is offering its views on technology as our way and when it will be ready. And as Kent pointed out, we're doing some novel process development and linking it into how we might run our conversion plants or adapt those plants and those designs for that capability. So it is early days. But Albemarle is really well-positioned with its customer base, and it's spread across the various cathode technologies and with our global footprint to really take advantage of that trend as it develops in the next decade.
David Begleiter: Thank you. And just on your Wave 3 projects you listed on slide eight. When should we see, expect a formal announcement, and which projects will be moving forward? And how do you rank order these projects, right now, in your mind as likelihood of moving forward first?
Kent Masters: Yes. I think the order that we listed them, that's kind of our order. So we expect to see a China facility would be the first thing that we would move on. We're working on that, investigating it, doing planning around it now. But it's still at a point where it could be an acquisition. And then, an acquisition use in has some element of work to it before it really becomes an Albemarle facility, or a Greenfield plant. But we're working on that now. And we'd probably come to a FID on that late 2021, depending on whether it's an acquisition or a Greenfield.
David Begleiter: Thank you very much.
Operator: Thank you. Our next question comes from Ben Kallo with Baird. Your line is now open.
Ben Kallo: Thanks for taking my question. Maybe I'm just taking a step back. Could you talk a bit about just visibility in your lithium sales as we move into next year? Like we see all these announcements from big auto OMS [ph] and then smaller start-ups. And can you talk about how your salespeople attack those companies and then your lead time to that? And then maybe meet -- weaving in next year going from I think the Streets are like $850 million this year to over $1 billion of EBITDA next year. Not to ask for guidance for 2022, but just can you give us some puts and takes for growth in 2022 with both volume and then how you think about pricing as well? Thank you.
Eric Norris: Good morning, Ben. This is Eric Norris. First in terms of the visibility, we see near term, which I think was your first question. We have two approaches we take, right? One is exactly what Kent described in the call, which is a macro to micro approach of modeling demand. And that has led us with some of the announcements you've referenced to increase our demand outlook on a macro basis. That -- a big part of that is what happens on the ground with our salespeople. Our strategy has been and will continue to be to use contracts to secure long term volumes. That requires a discussion with a customer to commit anywhere from three to five years. And a discussion that follows that into the details of what they are looking at from a specific chemistry, location and quantity point of view. So I'd characterize our visibility is quite reasonable and good in that regard, giving us the certainty we need to expand and positioning us well in the market to grow with the additional resources we have. Maybe you could repeat your second question.
Ben Kallo: My second question was just -- the Street is modeling about 20% growth, and it's mostly coming from lithium from 2021 to 2022. Can you talk about the puts and takes that we should think about without giving -- without having to give guidance, but the volume you're bringing on and then how we should think about that versus pricing that maybe rebounds as you move to new contracts?
Scott Tozier: Yes. Ben, this is Scott. I'll take that question. So as you look into 2022, the volumetric growth coming from lithium with the startup of La Negra III and IV and Kemerton I and II is clearly the highlight for that year. However, we do see continued recovery in refining catalysts as transportation fuels, and refinery utilization continues to improve. And potentially some additional growth in bromine, as some of those early growth projects come to fruition, and we're able to place that into the market. So, I think we're well-positioned going into 2022 to see very meaningful and high return growth in that year.
Ben Kallo: Great. Thank you, guys.
Operator: Thank you. Our next question comes from Chris Kapsch with Loop Capital Markets. Your line is open.
Chris Kapsch: Yes. Good morning. Thanks for taking my questions. So, on the upward revisions here, 2025 lithium demand forecast, you pointed to, obviously, to EV penetration and the mix of EVs larger batteries as the drivers. I'm just wondering if you could provide color on the outlook from hydroxide versus carbonate standpoint. I'm just curious if the upward revision is tied mostly to higher energy density EVs, and therefore more skewed towards hydroxide?
Kent Masters: Morning, Chris. So relative to the demand question in the mix, it is weighted towards hydroxide. If you look at the market today, we see it being sort of a 30/70 split. And by the -- 30% hydroxide, that would bring that value. And if you look out to 2025. And there's going to be some error bars on this, of course. But it's about 60/40, 60% hydroxide. So the large part of the growth is in hydroxide high nickel chemistries. It's not to say there isn't growth in carbonate for more conventional technologies like LSP. But to enable the growth targets of the Western OEMs in particular, and the range they're looking for energy density is going to be hydroxide. And that's true even in 2021. The rate of growth we see for demand in 2021 is incrementally higher for hydroxide that it is for carbonate. And as you know, Albemarle is well-positioned no matter which way it goes. Because we have capacity coming on and we're doubling our capacity in both product lines. As we roll forward, look at Wave 3, the predominance of that is going to go towards hydroxide for the reasons I just referenced.
Chris Kapsch: Got it. That's helpful. And the follow-up is regarding your comments about your contracts, which sort of are seemingly kind of sort of a perpetual renegotiation right now. But what you mentioned the ability to lift prices higher. I'm curious if there's also a floor in the renegotiated contracts and if it applies to both EV supply chain customers and industrial grade customers also. And then just any color on just as the tone of the conversations given that the world kind of has changed over the last three to six months. If they feels like the leverage has shifted back from them to the suppliers given maybe concerns about security of supply? Thanks.
Kent Masters: Yes. So I'll start with that, and then maybe Eric gives some color. We're not sure. But I think for the industrial customers, I mean, the long term contracts are mostly in the EV market. So when we talk about our long term contracts, that's about the EV market less so on the industrial side. And I don't know, the leverage really has shifted, but it is changed the tone of the discussions. And it's -- we still sit with our long term prices above the spot market even with the moves that we've seen, but there's less pressure on those contracts. There's not that there's no pressure on those contracts, but there's -- I would say less pressure. If that trend continues, it will kind of move in the same direction. Eric, you want to top that off.
Eric Norris: The only thing I would add Kent and Chris is that these contracts, you've characterized them, Kent, as if or Chris, as if they have been perpetually negotiated and that they may be one size fits all, that's the change. We did make an adjustment, a concession as the market pricing collapsed a year ago. And now, we're moving into restructuring these contracts based on customer needs. And there are going to be some that are going to look like spot. And that's going to be, as Kent pointed out, some of those contracts in the TG area and perhaps in the China market. There's others are going to be like the old variety, but the vast majority is going to be variable based pricing that reflects some market index, global index, not necessarily just China. And that's positioning us well as we go into an improving market from a price standpoint to benefit from a growth standpoint.
Chris Kapsch: Very helpful. Thanks.
Operator: Thank you. Our next question comes from Lawrence Alexander with Jefferies. Your line is open.
Laurence Alexander: Good morning. So, I guess two questions. First, on the recycling comments earlier, is the message that you'll engage in significant recycling, when the returns are double your whack? Or is it that you are engaging in a significant amount of R&D, to try and position yourself for when that market develops? I mean, like, are you subsidizing the market to some development to some extent? And secondly, can you speak to the trends in conversion costs, as specs change at the automotive OEMs? Are the costs rising or falling over the next few years?
Kent Masters: Yes. So on recycling, I think, I would say it's really we're investing R&D process. But we're talking to customers about what a business model might look like. But it's really an early phase of that. And we're investing at this point, and trying to figure out what the business model would look like and what our role would be in that. But we're also investing in R&D to kind of get us there. So, I don't think -- we're, we're not sitting and waiting till we get the returns that we expect. And the kind of the biggest driver for that is there's not going to be no lithium that's coming through the lifecycle to feed recycling processes for another number of years. And I'm sorry, the second question?
Laurence Alexander: Just with respect, as auto OEM or as the battery specs are evolving, as the conversion costs rising or falling, is it becoming tougher to meet those specs?
Kent Masters: Yes. So, I mean, the specs are evolving. And but I don't know the processing costs are really going up. So we're driving hard on productivity to try and drive those costs down. There are in some cases, some steps that we've modified in order to meet some of the specs around crystallization. I don't think it's driving the cost up at this point. But it's probably offsetting some of our productivity gains. But as it gets more sophisticated, but we get better at making it. A lot of that's about process control. We are looking at one step in the process that we have to add in, which would add a little bit of cost, but I think we would at a minimum we'd offset that with our productivity.
Laurence Alexander: Thank you.
Operator: Thank you. Our next question comes from Mike Harrison with Seaport Global Securities. Your line is now open.
Mike Harrison: Hi, good morning. Wanted to ask about the lithium business, your pricing and mix you said was down 20%. Typically, I think about pricing is flowing through pretty directly to the bottom line. And so that 20% decline would have been something like $80 million of an EBITDA headwind. Yet your EBITDA was only down $18 million. So how did you make up that fairly significant difference? It doesn't look like volume would have been big enough to make that up on its own.
Scott Tozier: Yes. This is Scott. I would I would point to. There is volume growth in the quarter on a year-over-year basis. But also we're seeing the results of our productivity actions from a cost perspective. And so, that's been a big focus that we started in 2019 as we're trying to maximize the productivity, and not only have the world-class resources that give us low costs, but also have low cost operations. And we're seeing the benefits of that very clearly in the fourth quarter. And we'll see benefit of that in 2021 as well, both on the cost basis, but also we're seeing some volumetric growth just from the yield enhancements and improvements that the engineers are able to get out of our plants. So all pointing in the right direction for us.
Eric Norris: And I would add to that. That mean those productivity improvements, that mean, they flow through, it's much more difficult to get them in flat volumes. As we get volume growth, those really start to show up. But there'll be new facilities, which will then kind of redo the playbook on productivity again. But I think as volume grows, those really show up more.
Mike Harrison: Understood. Okay. And then over on the catalysts side, you mentioned the changing customer order patterns affecting maybe the cadence of the year. But I wanted to dig in a little bit on this customer that de-selected you guys, because of your support for electric vehicles. Do you see that as kind of a one-off happening with a specific customer? Or are there other customers where you see this coming into play going forward?
Kent Masters: Yes. So difficult to predict the future, but we kind of see it as kind of one customer took exception. And we're going to work pretty hard to gain their confidence and get that customer back. But they've kind of taken a different view at the moment.
Mike Harrison: All right. Thanks very much.
Operator: Thank you. Our next question comes from Arun Viswanathan with RBC Capital Markets. Your line is open.
Arun Viswanathan: Great. Thanks for taking my question. Just curious on the pricing outlook, you commented that maybe, your overall pricing would be down a little bit year-on-year in 2021 versus 2020. And we have seen some initial improvement in pricing, I guess, in certain markets. So, maybe you can just give us your thoughts on how price and both carbon and hydroxide evolves through the year as you see it. And maybe if there's any regional differences between China and North America, that'd be helpful? Thanks.
Kent Masters: So I'll make a comment and Eric can add some color. But I mean, I think we see the same numbers that you're seeing around spot prices. So they have moved China spot prices. So we sell little-to-no volume in China on a spot basis. So it's not directly applicable, but it is indicative of the market. But we've not really seen prices change outside of China for the contract prices we haven't really seen. But as I'd said earlier, it lessens the pressure on our discussions with customers. So it's not as much downward pressure, as we had seen, say, second quarter, third quarter of last year, because of spot prices have turned up. But we'll just have to see how it plays out during the year. At the moment, the spot prices are still below our contract prices. So it's not like a sea change. If it continues to move, that could give us some upside. But at the moment those prices are still below our contract prices.
Eric Norris: And so I'd add to that. The prices in China that you're seeing are largely carbonate, and have largely inflected in the past two months. It's a bit early. It's an encouraging sign, but a bit early to extrapolate that to the world. And as Kent pointed out, our business is biased to more world, or ex China prices and in China prices. And most of our outlook is around carbonate and TG products, not around necessarily battery grade hydroxide, which is relatively flat in its outlook. So it's an encouraging sign. And the way we've got our contracts structured, should it continue broaden and deepen over time that trend, then we're in extremely good position to benefit from that going forward. And we'll just continue to watch it. I would say it's a matter of from where we are today. It's not a matter of if prices inflect -- inflect upwards, broadly, it's just a matter of when. And 2021 is a transition year. I think as we go forward in the future years is going to get pretty tight.
Arun Viswanathan: Great. Thanks for that detail. And maybe you could also offer your thoughts on maybe a little bit longer term, you noted that it is going to get pretty tight. Would you expect pricing to kind of head back towards prior peaks that we saw in 2017 and 2018? And also maybe you can just comment on that as it relates to spodumene as well? Thanks.
Kent Masters: Yes. So I would say I mean, we're predicting the future, right? And this industry is really only been through one down cycle, so we're coming off that. We don't anticipate that prices move back to the peaks that they were before, but we don't know that. So I think I'll leave it at that.
Eric Norris: Yes. On spodumene, we are -- because of what's happened in China, what's really -- the reason we believe prices have spikes in China is a fundamental shortage now -- available carbonate inventory and available spodumene supply and inventory. So what's that meant is now prices have started to inflect upward for chemical grades spodumene, which should that trend continue, will provide more supply into that market to meet that need. What that all means from a future standpoint, as Kent said, the calculus too hard to say, given the maturity of this market, and we'll continue to watch.
Operator: Thank you. Our next question comes from Vincent Andrews with Morgan Stanley. Your line is now open.
Vincent Andrews: Thank you. Thank you for taking my question. I just wanted to bridge the Wave 3 on slide eight with sort of the plans from when you did the MARBL JV. And just looking back at that slide, you were going to build two stages of 50,000 tons of LCE at Wodgina, and it was going to be $1.6 billion split between the two parties. Doesn't seem like you're still planning to do that at Wodgina. So what's changed and why? And that $1.6 billion number as it relates to 250,000 ton plants? Is that still a good approximation of what it would cost in Australia? Presumably, it's less than China. Just if he could just help us bridge that that'll be very helpful?
Kent Masters: Yes. So I mean, I guess our plans around the MARBL JV have evolved. But -- so the initial conversion is the Kemerton I/ II. And as we see it today, the second conversion facility and the second 50,000 would be in China. And that would be probably that first project that we were talking about in the Wave 3 projects.
Vincent Andrews: Okay. But presumably, that's going to come in less than the Australian CapEx cost that you'd envisioned. Is that correct?
Kent Masters: Yes. Absolutely. So it'll be quite a bit less than a Western Australia plan.
Vincent Andrews: Okay. And if I can also ask, what is the plan in terms of the Wodgina [ph] facility I believe is in care and maintenance mode right now? Do you intend to leave it like that? Or do you anticipate bringing it back online at some point this year?
Kent Masters: Well, I don't know about this year. So, we just have to see how we evolve as the Kemerton project comes on. And then we accelerate growth. I mean, Wodgina is on our plans for being a resource. It's a very good quality resource. So it's there. I don't know off the top -- and I don't want to commit to when we bring that resource on. But it would be as we start into these phase 3 projects, when we would need that-- need that resource.
Vincent Andrews: Thank you very much. I really appreciate it.
Operator: Thank you. Our next question comes from Kevin McCarthy with Vertical Research Partners. Your line is now open.
Unidentified Analyst: Hi, good morning. This is Cory on for Kevin. As it relates to the bromine business, at your 2019 Investor Day, you talked about expecting to resource discovery and expansion of offshore drilling. Obviously, things have changed. So how would you view the market changed? And can you talk a little bit more about your U.S. based bromine expansion?
Kent Masters: Yes. I think in terms of our view of the offshore oil market, I think it's muted slightly, things have changed a little bit. But we do see oil prices recovering, which we know with the lag time of six to nine months is going to be good for our business going forward. In terms of the U.S. expansion, it fits right along to the corporate strategy of accelerating lower capital intensity, higher return growth projects. Magnolia, for example, it's great jurisdiction for us. We've been there for decades. And we know those assets well. That really lends itself to investments that have a quicker return and a higher return. And those are the ones we'll leverage as we grow this business going forward.
Unidentified Analyst: Thank you. And if I'm may follow up, sort of pivoting here on divestitures. It sounds like you're close on performance catalysts. Do you have any expectations regarding aggregate proceeds and timing? And with lithium recovering and equity raises recently, would you consider separating the balance of your catalysts business at some point?
Kent Masters: Yes. So, I mean, FCS and PCS, we're on the same track that we were. It's gone slower, COVID slowed us down. But we're -- I'd say, we're back on track, but they're not done yet. And as we said in the prepared remarks that we'll kind of let you know when we get closer or those deals to get signed. On catalysts, I mean, we still think that we're kind of the best owners for that business. We've been in that business for some time. We add value. We've taken a hit over COVID-19 and the miles driven being down and refinery utilization, and all of those issues. But we still think we like the strategy of kind of becoming no more in crude to chemicals moving toward Asia as we move. And we still like the products we have and the innovation we have in that business. We think we're the best owners of that business for today. So we don't have immediate plans around divestiture of catalysts. They are core part of our businesses. Three businesses we have in the portfolio are all core for us.
Unidentified Analyst: Understood. Thank you very much for the color.
Operator: Thank you. Our next question comes from Jeff Zekauskas with JP Morgan. Your line is now open.
Jeff Zekauskas: Thanks very much. You're bringing on 50,000 tons in Kemerton, 30,000 of which is yours, you're bringing on 40,000 tons at La Negra. And you said that demand is going to be really strong for electric vehicles over a three-year period, much stronger than people thought before? So as the base case, how many tons do you expect to sell out of those two units in 2022? I know it takes time to ramp up. So of the 40,000 and the 30,000 that's yours, as a base case, how much will you sell in 2022?
Kent Masters: So, Eric, if you want to look at the detail on that, I would think as we bring those plants on and ramp them up, we'd expect to be selling kind of half of each in the first year. That's fair. Yes. If you look at -- we have an example, Jeff, obviously, we in growth mode, we've done this one other time before as part of Wave 1, Wodgina II. And that plant came up a little north of 50%. But it was a Brownfield facility with much of the existing infrastructure in place from the acquisition we've made prior to that. Kemerton -- is Greenfield, considering that 50% feels reasonable. And the same with La Negra as well, for 2022.
Jeff Zekauskas: Right? And for my follow-up, is there any volume or EBITDA benefit from either of these two projects in 2021? And I guess the rock for Kemerton has to come from Talison Greenbushes. Because the other -- the Wodgina mine is on -- is sleeping. Is that correct? Or is that not correct? And what's the effect on 2021?
Kent Masters: Yes. I don't think you're going to see much in 2021. I mean, we've got increased costs, because we're commissioning, bringing those on. And if we were to -- if we could accelerate and get a little bit of sales, it'd be offset by those costs. But I wouldn't be planning on benefit in 2021. And initial -- and initially is most likely will feel that -- the Kemerton from the initial phases with Talison product.
Jeff Zekauskas: Okay, great. Thank you so much.
Operator: Thank you. Our next question comes from PJ Juvekar with Citigroup. Your line is now open.
PJ Juvekar: Yes. Hi. Good morning. Currently in China, the carbonate prices are higher than hydroxide prices, because of comeback of the LSP batteries. Do you think that's a trend? Or it's an anomaly that may not last? And then secondly, just on pricing, you had given sort of 15% concessions on certain contracts in 2020. And the expectation that the time was in 2021, those contracts will go back to original pricing. Did that happen on those contracts?
Eric Norris: So on the first question, PJ, Good morning, it's Eric here. The carbon delta on carbonate and the inversion of carbonate being higher than historically -- historically hydroxide is a buck or two lower. We think that's a dislocation of a rapidly responding China market, which is largely carbonate and not a longtime trend. It's important to understand that a lot of the hydroxide market is supplied by low cost brine producers of which Albemarle is one, converting to hydroxide, which is what we do at Kings Mountain. And without that supply, there's not enough market, there's not enough volume for the marketplace. So the point is that the economics say that there has to be that incentive for those producers to go to hydroxide. So we expect that to revert and we are obviously very well-positioned in both product lines to participate. PJ your second question was what again, please?
PJ Juvekar: So you have contracts that were reset in 2020 lower, and they were expected to go back to the original price in 2021?
Eric Norris: Well what -- recall what we had -- what we've done. Our strategy has been to migrate these contracts to benefit from the recovering market price. What we have -- we have converted of several of them over and struck new ones based upon a market reference price, either and all or a part, it depends on the customer. And we are -- we'll do the remainder of this year going forward. So that's our strategy. Our strategy to take advantage of the inflection of price, not to go back to a fixed price in the past, necessarily, although there are some customers who are asking for that, right? So it's not a one-size-fits-all answer. But the aim is to benefit from a recovering market in prices, in terms of how we structure those contracts.
PJ Juvekar: So Eric, if I heard you, right, you saying that your contracts are going to be more sort of dependent on price or maybe more variable pricing as opposed to like a fixed annual price?
Kent Masters: That is correct. It will vary. Look, I can give you examples of some customers who want a fixed price, they want the stability. That today is a price is well above. We're not going to agree to that unless it's well above market. But that's one segment of the customer base. Another segment and a big chunk, want some variability to say that they're able to move with the marketplace relative to other -- their competitors or other sources of supply they buy. And as a result, those contracts will have that kind of market-based component to them, either collared or in part for their volume, or for a large part of their volume. The degree to which we give that flexibility also dictates how much of a commitment we make to them as well. The more spot-based a customer wants to be, the less likely we're going to commit to them long term, and use that as part of our justification for expansion. So there are some caveats there in our value proposition, but that's how we're approaching things. And all of this is going to allow us we believe, to really improve our overall mix on a price and profitability basis as the market price recovers.
PJ Juvekar: Great. Thank you for that.
Operator: Thank you. Our next question comes from Bob Koort with Goldman Sachs. Your line is now open.
Bob Koort: Thank you very much. I wanted to explore, a little bit more on the MARBL integration with how you plan your lithium expansion. So a couple questions there. What will be the transfer price from Talison to the Kermerton MARBL JVs. And why pursue the Chinese expansion in concert with MARBL if you could get 100% of it? And now you have the financial wherewithal with the -- accommodating equity markets to fund that kind of expansion, Why share that? Why not keep it all for your shareholders?
Scott Tozier: Yes. So well, I would say the short answer on that is that with in our original agreement that we would do two of the 50,000 tons, and then the next one we expect to do would be the one in China. And that's part of the JV. So we -- the JV was done cause one, to get the resource for the Wodgina mine, we have that. And also their expertise in mining to help us on that side, because we're more chemical processing expertise on our side, and they bring the expertise on the mining side. So that's kind of the logic behind overall. And that's part of the original deal that we did with them. So we're committed to doing another project, other conversion project with them.
Bob Koort: Okay. And maybe if I could get an answer on the transfer price from Talison. And then also, your new La Negra project is going to use a thermal evaporator. Can you talk about what that does to the cost structure out of La Negra III and IV versus the capacity that's already there in I and II from a cost curve standpoint? Thanks.
Kent Masters: Yes. So on the transfer price, I mean, it's a kind of established market price that we were following Australian tax rules around that. And so it's a market -- I would say it's a market price, arm's length market transaction around that. And then the thermal evaporator, I mean, it was a return project that's driven by financials. But probably just as much around sustainability. So it allows us to operate without water or much less water than we were using before. And that's an area where water is tight. And then the cost of that -- I think the returns were good. I don't recall exactly what they were. I don't know that they were extraordinary. But the benefit was also around from a sustainability perspective as well.
Bob Koort: Great. Thanks very much.
Operator: Thank you. Our next question comes from Mike Sison with Wells Fargo. Your line is open.
Mike Sison: Hey, guys, good morning. Just one quick question on your 2025 forecast. Do you in the sort of pundits believe the industry can sort of support that by then. And then how much capacity do you hope to have on online by 2025 to support that growth?
Kent Masters: So I think the -- I mean, I can't speak for the industry. So part of as we see acceleration in EV adoption that's kind of what has moved us in this current pivot toward accelerating our growth plans. And the goal was that we kind of maintain our share in there. Eric, maybe you want talk about the capacity in 2025. I don't have that number in my head.
Eric Norris: Well, I think a rule of thumb way to think about our capacity growth, and the plans that we put forth for Wave 3 and for Wave 4 to sustain our leadership and grow with the market. It's going to be hydroxide weighted the growth. We already comment on that earlier, in an earlier question. And it's going to require as you get on the middle part of the decade us to bringing at least 50,000 tons to market a year of hydroxide. And that is what that plan. If you look at the details would enable into the middle of a decade and beyond. So approximately speaking, you're talking about 150,000 tons of growth a year in the market price, or in that neighborhood, Mike and are bringing on 50,000. That's the kind of pace we're looking at.
Mike Sison: Great Thank you.
Operator: Thank you. This concludes our question and answer session. I would now like to turn the call back over to Kent Masters for closing remarks.
Kent Masters: Okay. Thank you, Joelle. In closing, Albemarle is well-positioned to capitalize on long term growth trends for all three of our core businesses. We have built the capabilities to accelerate low-capital intensity, higher-return growth. At the same time, we will continue to control what we can control. That means, first and foremost, focusing on the health and well being of our employees, customers and communities. It also means building operational discipline and sustainability into all aspects of our business including manufacturing, supply chain, capital project execution, and customer experience. We remain confident in our strategy and we will modify execution to position Albemarle for success. Thank you.
Operator: Ladies and gentlemen, this concludes today's conference call. Thank you for participating You may now disconnect. | [
{
"speaker": "Operator",
"text": "Ladies and gentlemen, thank you for standing by. And welcome to the Albemarle Corporation Q4 2020 Earnings Conference Call. At this time, all participants are in a listen-only mode. After the speaker presentation, there will be a question-and-answer session. [Operator Instructions]. Please be advised that today’s conference is being recorded. [Operator Instructions] I would now like to hand the conference to your speaker today, Meredith Bandy, VP of Investor Relations & Sustainability. Please go ahead, ma'am."
},
{
"speaker": "Meredith Bandy",
"text": "All right. Thank you, Joelle. And welcome to Albemarle’s fourth quarter 2020 earnings conference call. Our earnings were released after the closing the market yesterday and you will find the material posted to our website under the Investor Relations section at albemarle.com. Joining me on the call today are Kent Masters, Chief Executive Officer; and Scott Tozier, Chief Financial Officer. Raphael Crawford, President, Catalysts; Netha Johnson, President, Bromine and Eric Norris, President, Lithium, are also available for Q&A. As a reminder, some of the statements made during this conference call including our outlooks, expected company performance, expected impacted impacts of the COVID-19 pandemic and proposed expansion projects may constitute forward-looking statements within the meaning of federal securities laws. Please note the cautionary language about forward-looking statements in our press release and that same language applies to this call. Please also note that some of our comments today refer to financial measures that are not prepared in accordance with GAAP, a reconciliation of these measures to GAAP financial measures can be found in our earnings release and the appendix of our presentation, both of which are on our website. Now, I will turn the call over to Kent."
},
{
"speaker": "Kent Masters",
"text": "Thanks Meredith. And thank you all for joining us today. On today's call, I will highlight recent accomplishments and discuss our strategy to capitalize on the very attractive long-term growth trends we see for our businesses. Scott will give more detail on a result outlook and capital allocation. I'm pleased to say that Albemarle reported solid fourth quarter results including net sales of $879 million and adjusted EBITDA of $221 million, both of which were at or above the high end of our previous outlook. I'm also encouraged by the rebound we began to see in the second half of the year particularly for bromine and lithium. We expect to generate full-year 2021 net sales of between $3.2 billion and $3.3 billion and adjusted EBITDA of between $810 million and $860 million, both up from 2020 results. As I'm sure you're aware earlier this month we completed a $1.5 billion capital raise. The proceeds of this offering provide the financial flexibility to execute our long-term strategy including the acceleration of high return growth projects. Now, if we turn to slide five, we have a clear strategy to drive sustainable value for our shareholders. Albemarle has four primary strategic objectives. First, we will grow profitably. We have identified and planned a portfolio of low capital intensity high return projects. These projects lever our diverse world-class resources in both lithium and bromine. Over the past five years, we have built the internal team and capabilities to execute these projects on time and on budget. In addition, we have the long-term commercial relationship with customers that are required for these projects. We are working to ensure that we are aligning with their strategic requirements while achieving adequate returns for our shareholders. Of course, the majority of our growth will be lithium. But at the same time, we will be investing in our bromine projects. This will include highly efficient Brownfield projects with attractive returns and short paybacks. I'm sure, Netha will be happy to give you more detail when we get to Q&A. Second, we will maximize productivity. Over the past year, we have optimized earnings and cash flow generation across our business including our very successful, sustainable cost savings program. Operational discipline is essential for generating cash flow and supporting growth. And we will not take our eyes off the ball, even as we move into an accelerated growth phase. Third, we will invest with discipline, focusing our capital investments on our highest return opportunities, just as we have in the past, we will actively assess our portfolio for opportunities to unlock shareholder value. We will also continue to maintain our investment grade credit rating and support our dividend. Fourth, and finally, we will advance sustainability across our businesses, which is a core value for Albemarle. Our aim is to increase sustainability throughout the value chain from the resource to the end use of our products. Most recognizably, we develop lithium products that enable the reduction of greenhouse gas emissions through the adoption of battery electric vehicles. Our catalyst business contributes to sustainability by helping refiners produce cleaner transportation fuels. And our bromine products contribute to consumer safety by preventing fires and electronic equipment. With continued regulatory changes, advancements in technology and investments in infrastructure like charging stations, the current environment is ideal for a step-change in EV adoption. We are seeing this play out in the acceleration of global EV sales led by rebounding demand in China and new demand in Europe. Global EV sales increased 45% during 2020 and are expected to increase by over 70% in 2021. On the right hand side of the slide, you see demand projections for lithium over the next five to 10 years. Based on our internal estimates, we believe demand will reach more than 1.1 million tons by 2025, up from around 300,000 tons today. This is slightly higher than third party projections from industry analysts like Benchmark Minerals Roskill and the CRU Group. But as you can see, the consensus is that the industry expects to see significant growth in the coming years. As the industry leader in lithium, Albemarle is able to take these external estimates, internal forecast and discussions with our strategic customers and suppliers to generate a detailed demand forecast. On slide seven, you see other metrics we use to gauge the future of the lithium market. While Albemarle's demand outlook for lithium is above third party estimates. Our outlook is below some of the more ambitious targets from automotive OEMs. For example, Tesla's vision of three terawatt hours of battery production by 2030 would translate to roughly 2.3 million tons of lithium. That means that Tesla's demand alone would exceed estimates for the entire market. Additional regulatory impacts for example, if the U.S. decides to adopt more European like EV incentives would be incremental to our estimates. Total lithium demand is expected to grow by about 30% per year from 2020 to 2025, led by lithium consumption and electric vehicles, which is expected to grow by 47% per year. Two other trends support lithium demand, increased adoption of battery electric vehicles and larger battery size. Battery electric vehicles and larger battery size improve the consumer experience with longer driving ranges and innovation in batteries is also driving shorter charging times. It's important to note that this outlook does not assume a major shift in battery technologies over the next five years. Advanced battery technologies like solid state batteries could potentially increase lithium intensity later this decade. Since 2015, we've nearly tripled our nameplate conversion capacity to 85,000 tons per year. Later this year, we expect to complete two major projects, which we refer to as Wave 2. Wave 2 consists of La Negra III and IV project and Kemerton I and II projects, which will more than double our current capacity to 175,000 tons per year. Over the last five years, we engaged with our customers with long term volume commitment to execute this portfolio of projects. Now, with this new acceleration in demand, customers are asking us to repeat the model. Our next two waves of expansion could once again more than double our nameplate capacity. With lower capital intensity, we expect these projects to generate very attractive returns. The identified and planned Wave 3 projects would add 150,000 tons of annual capacity over the next three to five years. This third wave includes a conversion plan in China, which would be part of our MARBL joint venture, a smaller expansion at our silver peak asset in Nevada. Another plant in China on a new mega site, and Kemerton III and IV, a brownfield project in Australia. We also have identified opportunities for a fourth wave of projects. These could include further expansions in Australia, China and Southeast Asia, and the potential to restart the mine and expand our conversion facility at Kings Mountain in North Carolina. Wave 4 also includes options to support customers looking to localize supply, for example, by converting carbonate to hydroxide near the battery manufacturer. And before we continue, let me update you on our Wave 2 projects. So La Negra III and IV enables us to add lithium carbonate capacity at the very low end of the cost curve, the project remains on track for mechanical completion in mid 2021. Kemerton I and II, our new lithium hydroxide conversion plant in Western Australia is on track to reach mechanical completion late in 2021. Kemerton is core to our hydroxide capacity in line with expected strong long term market demand. Both of these projects will add significant commercial lithium sales beginning in 2022, following commissioning and customer qualification processes. As we move from Wave 2 to Wave 3 projects and beyond, we expect an estimated 40% reduction in capital intensity to support compelling economic returns. We can achieve these capital efficiencies and returns for three key reasons. First, we were able to leverage our experience in project execution by building standardized plants with economies of scale. For example, we expect new hydroxide plant would be a standard two trains or 50,000 tons per year, similar to what we are building at Kemerton today. Second, in many cases, we're moving from Greenfield to Brownfield economics, just as today we're moving from La Negra I and II to La Negra III and IV. Likewise, we'll move from Kemerton I and II to Kemerton III and IV and so on. As with Kemerton, the focus will be on building what we call mega sites, standardize large scale plants, able to support multiple trains for lithium conversion. Finally, we'll be buying or building additional facilities and low cost jurisdictions, as we did when we successively acquired and then expanded our Xinyu [ph] facility in China in 2016. Before I turn it over to Scott to review recent results, I'd like to acknowledge all the hard work by Albemarle team to continue to operate during the global pandemic, as well as their ability to achieve significant progress on our long term strategy. A year ago, when my predecessor laid out our 2020 strategic objectives, I don't think any of us can imagine how the year would play out. Despite all the challenges our team has delivered. We set ourselves up to grow profitably, keeping our major lithium capital projects on track for 2021 completion. We maximize productivity achieving $80 million of sustainable cost savings in 2020, 60%. above our initial targets. We demonstrated financial discipline, completing our 26th consecutive year of dividend increases and maintaining our investment grade credit rating throughout the pandemic related downturn. And finally, we improve the sustainability of our businesses by establishing baseline environmental data and improving our reporting and transparency. Now I'll now turn the call over to Scott for a detailed review of the 2020 financial results."
},
{
"speaker": "Scott Tozier",
"text": "Thanks, Kent and good morning everyone. Albemarle generated fourth quarter net sales of over $879 million, a decrease of about 11% compared to the prior year. But at the high end of our previous outlook. This reduction was primarily due to reduce prices and lithium has expected coming into the year and reduced volumes in catalysts offset by improvements in bromine. GAAP net income was $85 million, adjusted EPS of $1.17, excludes a pension mark-to-market loss due to lower discount rates. As Kent stated, adjusted EBITDA was $221 million, above the high end of our previous outlook. Turning to slide 13 for a look at adjusted EBITDA by business segment. Lithium's EBITDA declined by $17 million versus the prior year. Pricing was down about 20% in the quarter due to contract pricing adjustments agreed in late 2019, as well as product mix. Volumes were higher than expected due to a combination of improving demand and customers fulfilling their full year contract commitments. Cost savings help offset the impact of lower prices. Bromine's EBITDA was up about $7 million, the increase was due to higher volumes and higher pricing. Bromine is overall a good news story. The business has essentially rebounded to pre-pandemic levels. In Q4 they benefited from higher demand, customer restocking and some short term supply demand imbalances for both raw materials and finished goods. Catalysts EBITDA declined by $53 million, primarily due to lower volumes. This business continues to be the most challenged of the three due to ongoing travel restrictions, as well as reduced refinery capacity utilization and margins. Fluid Catalytic Cracking or FCC volume improved sequentially, but remained down compared to the prior year quarter. Hydroprocessing catalyst or HPC volumes were also down with a tough comparable relative to an unusually strong Q4 2019. Our corporate and other category EBITDA decreased by $8 million, due to a mix of slightly lower fine chemistry services results and slightly higher corporate costs. The FCS business is contract driven and can vary quarter to quarter. Full year results were very strong compared to history. Comparing the full year to fourth quarter, you can see it and get a sense of the rebound we started to see in the second half of 2020, particularly for lithium and bromine. We are pivoting capital allocation to prioritize high return growth projects to align with strategic customer demand and maintain our leadership positions. We remain committed to preserving the financial flexibility necessary to fund growth and to maintain our investment grade credit rating. We'll also continue to support our dividend. Although dividend growth may be lower than the historical average, while we build out the next wave of growth projects that will enable higher return opportunities. Finally, we will pursue a disciplined and thoughtful approach to investments, including M&A and joint ventures. As we said in the past, the most likely M&A you'd see us do would be bolt on acquisitions of lithium conversion assets, in cases where buying allows us to grow more quickly and generate better returns than building. We are finalizing the sale of our Fine Chemistry Services and performance catalysts solutions businesses and expect to update you in the coming months. Let's turn to slide 15 for look at our balance sheet. The primary use of proceeds from our equity offering is to accelerate profitable growth. The 90% or about 90% of the proceeds are for lithium growth, with most of the remainder for enhancements to our bromine business. The returns on these projects are highly attractive, and we expect to generate returns at least two times our weighted average cost of capital at mid cycle pricing. These are large, long dated projects with a bulk of incremental spending in 2022 through 2025. In the meantime, instead of holding the proceeds as cash we plan to delever, which will reduce interest expense and cash drag on the balance sheet. This will enable us to use cash and debt capacity to fund investments as they are approved. Our long term target net leverage ratio remains two to two and a half times adjusted EBITDA. Pro forma for the offering, we're below that range, but expect to increase our leverage as needed to accelerate growth and deliver returns to shareholders. Overall, we expect 2021 results to improve year-over-year. For the total company we expect net sales to be higher year-over-year as our businesses continue to recover from the events of 2020. Adjusted EBITDA of between $810 million and $860 million also suggests potential upside compared to 2020, due to higher net sales and ongoing cost savings. We expect CapEx to be slightly higher year-over-year as we begin to execute our accelerated growth projects. However, as they I mentioned earlier the bulk of that spending for these projects will be in 2022 to 2025. Net cash from operations is expected to be lower due to higher cash taxes and higher inventories, as we start up the two new lithium plants. Expectations for adjusted diluted EPS of $3.25 to $3.65 is lower than last year due to higher taxes and depreciation, as well as the increased share count. Due to the recent severe winter weather, we have temporarily shut down four of our U.S. plants; Our Bayport, Pasadena, Magnolia and Baton Rouge plants have been down since Monday. Once it is safe to do so, we will restart these facilities. And this situation is still evolving. At this point, we expect some impact to Q1 results and potentially Q2. It's possible the weather will have more of an impact than what is currently included in this outlook. And we'll update you if there are any material changes. Let's turn to slide 17. Lithium results are expected to be relatively flat compared to 2020. We expect slightly higher volumes, with the restart of North American production late last year, as well as modest efficiency improvements. As usual, we expect volumes to be back half weighted for lithium. At this point, we still anticipate slightly lower pricing depending on full year average realized pricing for carbonate and technical grade products. Our new contracts structures provide increased flexibility to increase price in response to improving market prices. Lithium costs will be slightly higher year-over-year related to the startup cost associated with La Negra and Kemerton partially offset by continued cost and efficiency improvements. And as Kent discussed, the long term growth story for lithium is intact. In catalysts, we expect 2021 results to be flat year-over-year, including higher PCS earnings. We expect the decline in North American refining catalysts volume. This is primarily a result of one customer who recently indicated that they would de-select album as catalysts due to our public support for electric vehicles. Longer term, we are continuing to position the catalysts business to grow in emerging markets and capitalize on our strengths as a global specialty chemicals producer in the crude to chemicals market and the renew renewable fuels market. Raphael, can give more color on the challenges and opportunities we see for our catalysts business during Q&A. In bromine, we expect full year 2021 results to improve modestly, with continued economic recovery and a return to sold out plants. Our ongoing savings initiatives should offset the impact of inflation. Looking ahead, we see steady demand increases for our flagship fire safety products driven by new technology trends, like 5G and electric vehicles. I'll turn it back to Kent to review our strategic objectives for 2021."
},
{
"speaker": "Kent Masters",
"text": "Thanks, Scott. Albemarle finished strong in 2020. And we are excited about the opportunities ahead of us in 2021. We will continue to execute our long term strategy. The successful completion of our Wave 2 projects and investment decisions on new expansion projects in lithium and bromine. We are also working with customers to reach commercial agreements for a majority of new capacity prior to investing. We will continue to maximize productivity with operational discipline across our businesses, including cost reduction, lean principles, continuous improvement and project execution excellence. We expect to achieve $75 million of productivity improvements in 2021. We will be disciplined stewards of capital investing in high return growth, maintaining our investment grade credit rating and supporting our dividend. Finally, we will continue to implement and improve sustainability across our company including setting near term goals to reduce greenhouse gas emissions at our existing operations and exploring science based target options for all three of our businesses. And with that, we'd like to open up the call for questions. So Joule, over to you."
},
{
"speaker": "Operator",
"text": "Thank you. [Operator Instructions] Our first question comes from David Begleiter with Deutsche Bank. Your line is now open."
},
{
"speaker": "David Begleiter",
"text": "Thank you. Good morning, Kent, on recycling in lithium, when do you expect it to become a bigger part of the market? And what will be Albemarle's role in lithium recycling going forward?"
},
{
"speaker": "Kent Masters",
"text": "So, let me -- I'll start with that, maybe Eric can give a little bit more details. So I mean, we've got activities around lithium, but we expect that to be a number of years out before it becomes a major business. So basically, there has to be enough lithium in the market to - for it to run its lifecycle in a vehicle and then come back for recycling. So -- and I think our roll in that. I mean, we'll have to look at those business options. But when you see lithium being recycled, there's a component of that that looks a lot like our conversion facility. So we would anticipate that we would play in that, but it's a number of years out before that comes to fruition. So Eric, anything you want to add there?"
},
{
"speaker": "Eric Norris",
"text": "Sure, Kent. David, I'd add that, we have a number of efforts already with existing customers, both in the U.S. and in Europe, who are very focused on investing in recycling capabilities. In some cases, in Europe, it's part of the EU battery directive. Those targets within the EU, for example, are still being set and being discussed. The industry is offering its views on technology as our way and when it will be ready. And as Kent pointed out, we're doing some novel process development and linking it into how we might run our conversion plants or adapt those plants and those designs for that capability. So it is early days. But Albemarle is really well-positioned with its customer base, and it's spread across the various cathode technologies and with our global footprint to really take advantage of that trend as it develops in the next decade."
},
{
"speaker": "David Begleiter",
"text": "Thank you. And just on your Wave 3 projects you listed on slide eight. When should we see, expect a formal announcement, and which projects will be moving forward? And how do you rank order these projects, right now, in your mind as likelihood of moving forward first?"
},
{
"speaker": "Kent Masters",
"text": "Yes. I think the order that we listed them, that's kind of our order. So we expect to see a China facility would be the first thing that we would move on. We're working on that, investigating it, doing planning around it now. But it's still at a point where it could be an acquisition. And then, an acquisition use in has some element of work to it before it really becomes an Albemarle facility, or a Greenfield plant. But we're working on that now. And we'd probably come to a FID on that late 2021, depending on whether it's an acquisition or a Greenfield."
},
{
"speaker": "David Begleiter",
"text": "Thank you very much."
},
{
"speaker": "Operator",
"text": "Thank you. Our next question comes from Ben Kallo with Baird. Your line is now open."
},
{
"speaker": "Ben Kallo",
"text": "Thanks for taking my question. Maybe I'm just taking a step back. Could you talk a bit about just visibility in your lithium sales as we move into next year? Like we see all these announcements from big auto OMS [ph] and then smaller start-ups. And can you talk about how your salespeople attack those companies and then your lead time to that? And then maybe meet -- weaving in next year going from I think the Streets are like $850 million this year to over $1 billion of EBITDA next year. Not to ask for guidance for 2022, but just can you give us some puts and takes for growth in 2022 with both volume and then how you think about pricing as well? Thank you."
},
{
"speaker": "Eric Norris",
"text": "Good morning, Ben. This is Eric Norris. First in terms of the visibility, we see near term, which I think was your first question. We have two approaches we take, right? One is exactly what Kent described in the call, which is a macro to micro approach of modeling demand. And that has led us with some of the announcements you've referenced to increase our demand outlook on a macro basis. That -- a big part of that is what happens on the ground with our salespeople. Our strategy has been and will continue to be to use contracts to secure long term volumes. That requires a discussion with a customer to commit anywhere from three to five years. And a discussion that follows that into the details of what they are looking at from a specific chemistry, location and quantity point of view. So I'd characterize our visibility is quite reasonable and good in that regard, giving us the certainty we need to expand and positioning us well in the market to grow with the additional resources we have. Maybe you could repeat your second question."
},
{
"speaker": "Ben Kallo",
"text": "My second question was just -- the Street is modeling about 20% growth, and it's mostly coming from lithium from 2021 to 2022. Can you talk about the puts and takes that we should think about without giving -- without having to give guidance, but the volume you're bringing on and then how we should think about that versus pricing that maybe rebounds as you move to new contracts?"
},
{
"speaker": "Scott Tozier",
"text": "Yes. Ben, this is Scott. I'll take that question. So as you look into 2022, the volumetric growth coming from lithium with the startup of La Negra III and IV and Kemerton I and II is clearly the highlight for that year. However, we do see continued recovery in refining catalysts as transportation fuels, and refinery utilization continues to improve. And potentially some additional growth in bromine, as some of those early growth projects come to fruition, and we're able to place that into the market. So, I think we're well-positioned going into 2022 to see very meaningful and high return growth in that year."
},
{
"speaker": "Ben Kallo",
"text": "Great. Thank you, guys."
},
{
"speaker": "Operator",
"text": "Thank you. Our next question comes from Chris Kapsch with Loop Capital Markets. Your line is open."
},
{
"speaker": "Chris Kapsch",
"text": "Yes. Good morning. Thanks for taking my questions. So, on the upward revisions here, 2025 lithium demand forecast, you pointed to, obviously, to EV penetration and the mix of EVs larger batteries as the drivers. I'm just wondering if you could provide color on the outlook from hydroxide versus carbonate standpoint. I'm just curious if the upward revision is tied mostly to higher energy density EVs, and therefore more skewed towards hydroxide?"
},
{
"speaker": "Kent Masters",
"text": "Morning, Chris. So relative to the demand question in the mix, it is weighted towards hydroxide. If you look at the market today, we see it being sort of a 30/70 split. And by the -- 30% hydroxide, that would bring that value. And if you look out to 2025. And there's going to be some error bars on this, of course. But it's about 60/40, 60% hydroxide. So the large part of the growth is in hydroxide high nickel chemistries. It's not to say there isn't growth in carbonate for more conventional technologies like LSP. But to enable the growth targets of the Western OEMs in particular, and the range they're looking for energy density is going to be hydroxide. And that's true even in 2021. The rate of growth we see for demand in 2021 is incrementally higher for hydroxide that it is for carbonate. And as you know, Albemarle is well-positioned no matter which way it goes. Because we have capacity coming on and we're doubling our capacity in both product lines. As we roll forward, look at Wave 3, the predominance of that is going to go towards hydroxide for the reasons I just referenced."
},
{
"speaker": "Chris Kapsch",
"text": "Got it. That's helpful. And the follow-up is regarding your comments about your contracts, which sort of are seemingly kind of sort of a perpetual renegotiation right now. But what you mentioned the ability to lift prices higher. I'm curious if there's also a floor in the renegotiated contracts and if it applies to both EV supply chain customers and industrial grade customers also. And then just any color on just as the tone of the conversations given that the world kind of has changed over the last three to six months. If they feels like the leverage has shifted back from them to the suppliers given maybe concerns about security of supply? Thanks."
},
{
"speaker": "Kent Masters",
"text": "Yes. So I'll start with that, and then maybe Eric gives some color. We're not sure. But I think for the industrial customers, I mean, the long term contracts are mostly in the EV market. So when we talk about our long term contracts, that's about the EV market less so on the industrial side. And I don't know, the leverage really has shifted, but it is changed the tone of the discussions. And it's -- we still sit with our long term prices above the spot market even with the moves that we've seen, but there's less pressure on those contracts. There's not that there's no pressure on those contracts, but there's -- I would say less pressure. If that trend continues, it will kind of move in the same direction. Eric, you want to top that off."
},
{
"speaker": "Eric Norris",
"text": "The only thing I would add Kent and Chris is that these contracts, you've characterized them, Kent, as if or Chris, as if they have been perpetually negotiated and that they may be one size fits all, that's the change. We did make an adjustment, a concession as the market pricing collapsed a year ago. And now, we're moving into restructuring these contracts based on customer needs. And there are going to be some that are going to look like spot. And that's going to be, as Kent pointed out, some of those contracts in the TG area and perhaps in the China market. There's others are going to be like the old variety, but the vast majority is going to be variable based pricing that reflects some market index, global index, not necessarily just China. And that's positioning us well as we go into an improving market from a price standpoint to benefit from a growth standpoint."
},
{
"speaker": "Chris Kapsch",
"text": "Very helpful. Thanks."
},
{
"speaker": "Operator",
"text": "Thank you. Our next question comes from Lawrence Alexander with Jefferies. Your line is open."
},
{
"speaker": "Laurence Alexander",
"text": "Good morning. So, I guess two questions. First, on the recycling comments earlier, is the message that you'll engage in significant recycling, when the returns are double your whack? Or is it that you are engaging in a significant amount of R&D, to try and position yourself for when that market develops? I mean, like, are you subsidizing the market to some development to some extent? And secondly, can you speak to the trends in conversion costs, as specs change at the automotive OEMs? Are the costs rising or falling over the next few years?"
},
{
"speaker": "Kent Masters",
"text": "Yes. So on recycling, I think, I would say it's really we're investing R&D process. But we're talking to customers about what a business model might look like. But it's really an early phase of that. And we're investing at this point, and trying to figure out what the business model would look like and what our role would be in that. But we're also investing in R&D to kind of get us there. So, I don't think -- we're, we're not sitting and waiting till we get the returns that we expect. And the kind of the biggest driver for that is there's not going to be no lithium that's coming through the lifecycle to feed recycling processes for another number of years. And I'm sorry, the second question?"
},
{
"speaker": "Laurence Alexander",
"text": "Just with respect, as auto OEM or as the battery specs are evolving, as the conversion costs rising or falling, is it becoming tougher to meet those specs?"
},
{
"speaker": "Kent Masters",
"text": "Yes. So, I mean, the specs are evolving. And but I don't know the processing costs are really going up. So we're driving hard on productivity to try and drive those costs down. There are in some cases, some steps that we've modified in order to meet some of the specs around crystallization. I don't think it's driving the cost up at this point. But it's probably offsetting some of our productivity gains. But as it gets more sophisticated, but we get better at making it. A lot of that's about process control. We are looking at one step in the process that we have to add in, which would add a little bit of cost, but I think we would at a minimum we'd offset that with our productivity."
},
{
"speaker": "Laurence Alexander",
"text": "Thank you."
},
{
"speaker": "Operator",
"text": "Thank you. Our next question comes from Mike Harrison with Seaport Global Securities. Your line is now open."
},
{
"speaker": "Mike Harrison",
"text": "Hi, good morning. Wanted to ask about the lithium business, your pricing and mix you said was down 20%. Typically, I think about pricing is flowing through pretty directly to the bottom line. And so that 20% decline would have been something like $80 million of an EBITDA headwind. Yet your EBITDA was only down $18 million. So how did you make up that fairly significant difference? It doesn't look like volume would have been big enough to make that up on its own."
},
{
"speaker": "Scott Tozier",
"text": "Yes. This is Scott. I would I would point to. There is volume growth in the quarter on a year-over-year basis. But also we're seeing the results of our productivity actions from a cost perspective. And so, that's been a big focus that we started in 2019 as we're trying to maximize the productivity, and not only have the world-class resources that give us low costs, but also have low cost operations. And we're seeing the benefits of that very clearly in the fourth quarter. And we'll see benefit of that in 2021 as well, both on the cost basis, but also we're seeing some volumetric growth just from the yield enhancements and improvements that the engineers are able to get out of our plants. So all pointing in the right direction for us."
},
{
"speaker": "Eric Norris",
"text": "And I would add to that. That mean those productivity improvements, that mean, they flow through, it's much more difficult to get them in flat volumes. As we get volume growth, those really start to show up. But there'll be new facilities, which will then kind of redo the playbook on productivity again. But I think as volume grows, those really show up more."
},
{
"speaker": "Mike Harrison",
"text": "Understood. Okay. And then over on the catalysts side, you mentioned the changing customer order patterns affecting maybe the cadence of the year. But I wanted to dig in a little bit on this customer that de-selected you guys, because of your support for electric vehicles. Do you see that as kind of a one-off happening with a specific customer? Or are there other customers where you see this coming into play going forward?"
},
{
"speaker": "Kent Masters",
"text": "Yes. So difficult to predict the future, but we kind of see it as kind of one customer took exception. And we're going to work pretty hard to gain their confidence and get that customer back. But they've kind of taken a different view at the moment."
},
{
"speaker": "Mike Harrison",
"text": "All right. Thanks very much."
},
{
"speaker": "Operator",
"text": "Thank you. Our next question comes from Arun Viswanathan with RBC Capital Markets. Your line is open."
},
{
"speaker": "Arun Viswanathan",
"text": "Great. Thanks for taking my question. Just curious on the pricing outlook, you commented that maybe, your overall pricing would be down a little bit year-on-year in 2021 versus 2020. And we have seen some initial improvement in pricing, I guess, in certain markets. So, maybe you can just give us your thoughts on how price and both carbon and hydroxide evolves through the year as you see it. And maybe if there's any regional differences between China and North America, that'd be helpful? Thanks."
},
{
"speaker": "Kent Masters",
"text": "So I'll make a comment and Eric can add some color. But I mean, I think we see the same numbers that you're seeing around spot prices. So they have moved China spot prices. So we sell little-to-no volume in China on a spot basis. So it's not directly applicable, but it is indicative of the market. But we've not really seen prices change outside of China for the contract prices we haven't really seen. But as I'd said earlier, it lessens the pressure on our discussions with customers. So it's not as much downward pressure, as we had seen, say, second quarter, third quarter of last year, because of spot prices have turned up. But we'll just have to see how it plays out during the year. At the moment, the spot prices are still below our contract prices. So it's not like a sea change. If it continues to move, that could give us some upside. But at the moment those prices are still below our contract prices."
},
{
"speaker": "Eric Norris",
"text": "And so I'd add to that. The prices in China that you're seeing are largely carbonate, and have largely inflected in the past two months. It's a bit early. It's an encouraging sign, but a bit early to extrapolate that to the world. And as Kent pointed out, our business is biased to more world, or ex China prices and in China prices. And most of our outlook is around carbonate and TG products, not around necessarily battery grade hydroxide, which is relatively flat in its outlook. So it's an encouraging sign. And the way we've got our contracts structured, should it continue broaden and deepen over time that trend, then we're in extremely good position to benefit from that going forward. And we'll just continue to watch it. I would say it's a matter of from where we are today. It's not a matter of if prices inflect -- inflect upwards, broadly, it's just a matter of when. And 2021 is a transition year. I think as we go forward in the future years is going to get pretty tight."
},
{
"speaker": "Arun Viswanathan",
"text": "Great. Thanks for that detail. And maybe you could also offer your thoughts on maybe a little bit longer term, you noted that it is going to get pretty tight. Would you expect pricing to kind of head back towards prior peaks that we saw in 2017 and 2018? And also maybe you can just comment on that as it relates to spodumene as well? Thanks."
},
{
"speaker": "Kent Masters",
"text": "Yes. So I would say I mean, we're predicting the future, right? And this industry is really only been through one down cycle, so we're coming off that. We don't anticipate that prices move back to the peaks that they were before, but we don't know that. So I think I'll leave it at that."
},
{
"speaker": "Eric Norris",
"text": "Yes. On spodumene, we are -- because of what's happened in China, what's really -- the reason we believe prices have spikes in China is a fundamental shortage now -- available carbonate inventory and available spodumene supply and inventory. So what's that meant is now prices have started to inflect upward for chemical grades spodumene, which should that trend continue, will provide more supply into that market to meet that need. What that all means from a future standpoint, as Kent said, the calculus too hard to say, given the maturity of this market, and we'll continue to watch."
},
{
"speaker": "Operator",
"text": "Thank you. Our next question comes from Vincent Andrews with Morgan Stanley. Your line is now open."
},
{
"speaker": "Vincent Andrews",
"text": "Thank you. Thank you for taking my question. I just wanted to bridge the Wave 3 on slide eight with sort of the plans from when you did the MARBL JV. And just looking back at that slide, you were going to build two stages of 50,000 tons of LCE at Wodgina, and it was going to be $1.6 billion split between the two parties. Doesn't seem like you're still planning to do that at Wodgina. So what's changed and why? And that $1.6 billion number as it relates to 250,000 ton plants? Is that still a good approximation of what it would cost in Australia? Presumably, it's less than China. Just if he could just help us bridge that that'll be very helpful?"
},
{
"speaker": "Kent Masters",
"text": "Yes. So I mean, I guess our plans around the MARBL JV have evolved. But -- so the initial conversion is the Kemerton I/ II. And as we see it today, the second conversion facility and the second 50,000 would be in China. And that would be probably that first project that we were talking about in the Wave 3 projects."
},
{
"speaker": "Vincent Andrews",
"text": "Okay. But presumably, that's going to come in less than the Australian CapEx cost that you'd envisioned. Is that correct?"
},
{
"speaker": "Kent Masters",
"text": "Yes. Absolutely. So it'll be quite a bit less than a Western Australia plan."
},
{
"speaker": "Vincent Andrews",
"text": "Okay. And if I can also ask, what is the plan in terms of the Wodgina [ph] facility I believe is in care and maintenance mode right now? Do you intend to leave it like that? Or do you anticipate bringing it back online at some point this year?"
},
{
"speaker": "Kent Masters",
"text": "Well, I don't know about this year. So, we just have to see how we evolve as the Kemerton project comes on. And then we accelerate growth. I mean, Wodgina is on our plans for being a resource. It's a very good quality resource. So it's there. I don't know off the top -- and I don't want to commit to when we bring that resource on. But it would be as we start into these phase 3 projects, when we would need that-- need that resource."
},
{
"speaker": "Vincent Andrews",
"text": "Thank you very much. I really appreciate it."
},
{
"speaker": "Operator",
"text": "Thank you. Our next question comes from Kevin McCarthy with Vertical Research Partners. Your line is now open."
},
{
"speaker": "Unidentified Analyst",
"text": "Hi, good morning. This is Cory on for Kevin. As it relates to the bromine business, at your 2019 Investor Day, you talked about expecting to resource discovery and expansion of offshore drilling. Obviously, things have changed. So how would you view the market changed? And can you talk a little bit more about your U.S. based bromine expansion?"
},
{
"speaker": "Kent Masters",
"text": "Yes. I think in terms of our view of the offshore oil market, I think it's muted slightly, things have changed a little bit. But we do see oil prices recovering, which we know with the lag time of six to nine months is going to be good for our business going forward. In terms of the U.S. expansion, it fits right along to the corporate strategy of accelerating lower capital intensity, higher return growth projects. Magnolia, for example, it's great jurisdiction for us. We've been there for decades. And we know those assets well. That really lends itself to investments that have a quicker return and a higher return. And those are the ones we'll leverage as we grow this business going forward."
},
{
"speaker": "Unidentified Analyst",
"text": "Thank you. And if I'm may follow up, sort of pivoting here on divestitures. It sounds like you're close on performance catalysts. Do you have any expectations regarding aggregate proceeds and timing? And with lithium recovering and equity raises recently, would you consider separating the balance of your catalysts business at some point?"
},
{
"speaker": "Kent Masters",
"text": "Yes. So, I mean, FCS and PCS, we're on the same track that we were. It's gone slower, COVID slowed us down. But we're -- I'd say, we're back on track, but they're not done yet. And as we said in the prepared remarks that we'll kind of let you know when we get closer or those deals to get signed. On catalysts, I mean, we still think that we're kind of the best owners for that business. We've been in that business for some time. We add value. We've taken a hit over COVID-19 and the miles driven being down and refinery utilization, and all of those issues. But we still think we like the strategy of kind of becoming no more in crude to chemicals moving toward Asia as we move. And we still like the products we have and the innovation we have in that business. We think we're the best owners of that business for today. So we don't have immediate plans around divestiture of catalysts. They are core part of our businesses. Three businesses we have in the portfolio are all core for us."
},
{
"speaker": "Unidentified Analyst",
"text": "Understood. Thank you very much for the color."
},
{
"speaker": "Operator",
"text": "Thank you. Our next question comes from Jeff Zekauskas with JP Morgan. Your line is now open."
},
{
"speaker": "Jeff Zekauskas",
"text": "Thanks very much. You're bringing on 50,000 tons in Kemerton, 30,000 of which is yours, you're bringing on 40,000 tons at La Negra. And you said that demand is going to be really strong for electric vehicles over a three-year period, much stronger than people thought before? So as the base case, how many tons do you expect to sell out of those two units in 2022? I know it takes time to ramp up. So of the 40,000 and the 30,000 that's yours, as a base case, how much will you sell in 2022?"
},
{
"speaker": "Kent Masters",
"text": "So, Eric, if you want to look at the detail on that, I would think as we bring those plants on and ramp them up, we'd expect to be selling kind of half of each in the first year. That's fair. Yes. If you look at -- we have an example, Jeff, obviously, we in growth mode, we've done this one other time before as part of Wave 1, Wodgina II. And that plant came up a little north of 50%. But it was a Brownfield facility with much of the existing infrastructure in place from the acquisition we've made prior to that. Kemerton -- is Greenfield, considering that 50% feels reasonable. And the same with La Negra as well, for 2022."
},
{
"speaker": "Jeff Zekauskas",
"text": "Right? And for my follow-up, is there any volume or EBITDA benefit from either of these two projects in 2021? And I guess the rock for Kemerton has to come from Talison Greenbushes. Because the other -- the Wodgina mine is on -- is sleeping. Is that correct? Or is that not correct? And what's the effect on 2021?"
},
{
"speaker": "Kent Masters",
"text": "Yes. I don't think you're going to see much in 2021. I mean, we've got increased costs, because we're commissioning, bringing those on. And if we were to -- if we could accelerate and get a little bit of sales, it'd be offset by those costs. But I wouldn't be planning on benefit in 2021. And initial -- and initially is most likely will feel that -- the Kemerton from the initial phases with Talison product."
},
{
"speaker": "Jeff Zekauskas",
"text": "Okay, great. Thank you so much."
},
{
"speaker": "Operator",
"text": "Thank you. Our next question comes from PJ Juvekar with Citigroup. Your line is now open."
},
{
"speaker": "PJ Juvekar",
"text": "Yes. Hi. Good morning. Currently in China, the carbonate prices are higher than hydroxide prices, because of comeback of the LSP batteries. Do you think that's a trend? Or it's an anomaly that may not last? And then secondly, just on pricing, you had given sort of 15% concessions on certain contracts in 2020. And the expectation that the time was in 2021, those contracts will go back to original pricing. Did that happen on those contracts?"
},
{
"speaker": "Eric Norris",
"text": "So on the first question, PJ, Good morning, it's Eric here. The carbon delta on carbonate and the inversion of carbonate being higher than historically -- historically hydroxide is a buck or two lower. We think that's a dislocation of a rapidly responding China market, which is largely carbonate and not a longtime trend. It's important to understand that a lot of the hydroxide market is supplied by low cost brine producers of which Albemarle is one, converting to hydroxide, which is what we do at Kings Mountain. And without that supply, there's not enough market, there's not enough volume for the marketplace. So the point is that the economics say that there has to be that incentive for those producers to go to hydroxide. So we expect that to revert and we are obviously very well-positioned in both product lines to participate. PJ your second question was what again, please?"
},
{
"speaker": "PJ Juvekar",
"text": "So you have contracts that were reset in 2020 lower, and they were expected to go back to the original price in 2021?"
},
{
"speaker": "Eric Norris",
"text": "Well what -- recall what we had -- what we've done. Our strategy has been to migrate these contracts to benefit from the recovering market price. What we have -- we have converted of several of them over and struck new ones based upon a market reference price, either and all or a part, it depends on the customer. And we are -- we'll do the remainder of this year going forward. So that's our strategy. Our strategy to take advantage of the inflection of price, not to go back to a fixed price in the past, necessarily, although there are some customers who are asking for that, right? So it's not a one-size-fits-all answer. But the aim is to benefit from a recovering market in prices, in terms of how we structure those contracts."
},
{
"speaker": "PJ Juvekar",
"text": "So Eric, if I heard you, right, you saying that your contracts are going to be more sort of dependent on price or maybe more variable pricing as opposed to like a fixed annual price?"
},
{
"speaker": "Kent Masters",
"text": "That is correct. It will vary. Look, I can give you examples of some customers who want a fixed price, they want the stability. That today is a price is well above. We're not going to agree to that unless it's well above market. But that's one segment of the customer base. Another segment and a big chunk, want some variability to say that they're able to move with the marketplace relative to other -- their competitors or other sources of supply they buy. And as a result, those contracts will have that kind of market-based component to them, either collared or in part for their volume, or for a large part of their volume. The degree to which we give that flexibility also dictates how much of a commitment we make to them as well. The more spot-based a customer wants to be, the less likely we're going to commit to them long term, and use that as part of our justification for expansion. So there are some caveats there in our value proposition, but that's how we're approaching things. And all of this is going to allow us we believe, to really improve our overall mix on a price and profitability basis as the market price recovers."
},
{
"speaker": "PJ Juvekar",
"text": "Great. Thank you for that."
},
{
"speaker": "Operator",
"text": "Thank you. Our next question comes from Bob Koort with Goldman Sachs. Your line is now open."
},
{
"speaker": "Bob Koort",
"text": "Thank you very much. I wanted to explore, a little bit more on the MARBL integration with how you plan your lithium expansion. So a couple questions there. What will be the transfer price from Talison to the Kermerton MARBL JVs. And why pursue the Chinese expansion in concert with MARBL if you could get 100% of it? And now you have the financial wherewithal with the -- accommodating equity markets to fund that kind of expansion, Why share that? Why not keep it all for your shareholders?"
},
{
"speaker": "Scott Tozier",
"text": "Yes. So well, I would say the short answer on that is that with in our original agreement that we would do two of the 50,000 tons, and then the next one we expect to do would be the one in China. And that's part of the JV. So we -- the JV was done cause one, to get the resource for the Wodgina mine, we have that. And also their expertise in mining to help us on that side, because we're more chemical processing expertise on our side, and they bring the expertise on the mining side. So that's kind of the logic behind overall. And that's part of the original deal that we did with them. So we're committed to doing another project, other conversion project with them."
},
{
"speaker": "Bob Koort",
"text": "Okay. And maybe if I could get an answer on the transfer price from Talison. And then also, your new La Negra project is going to use a thermal evaporator. Can you talk about what that does to the cost structure out of La Negra III and IV versus the capacity that's already there in I and II from a cost curve standpoint? Thanks."
},
{
"speaker": "Kent Masters",
"text": "Yes. So on the transfer price, I mean, it's a kind of established market price that we were following Australian tax rules around that. And so it's a market -- I would say it's a market price, arm's length market transaction around that. And then the thermal evaporator, I mean, it was a return project that's driven by financials. But probably just as much around sustainability. So it allows us to operate without water or much less water than we were using before. And that's an area where water is tight. And then the cost of that -- I think the returns were good. I don't recall exactly what they were. I don't know that they were extraordinary. But the benefit was also around from a sustainability perspective as well."
},
{
"speaker": "Bob Koort",
"text": "Great. Thanks very much."
},
{
"speaker": "Operator",
"text": "Thank you. Our next question comes from Mike Sison with Wells Fargo. Your line is open."
},
{
"speaker": "Mike Sison",
"text": "Hey, guys, good morning. Just one quick question on your 2025 forecast. Do you in the sort of pundits believe the industry can sort of support that by then. And then how much capacity do you hope to have on online by 2025 to support that growth?"
},
{
"speaker": "Kent Masters",
"text": "So I think the -- I mean, I can't speak for the industry. So part of as we see acceleration in EV adoption that's kind of what has moved us in this current pivot toward accelerating our growth plans. And the goal was that we kind of maintain our share in there. Eric, maybe you want talk about the capacity in 2025. I don't have that number in my head."
},
{
"speaker": "Eric Norris",
"text": "Well, I think a rule of thumb way to think about our capacity growth, and the plans that we put forth for Wave 3 and for Wave 4 to sustain our leadership and grow with the market. It's going to be hydroxide weighted the growth. We already comment on that earlier, in an earlier question. And it's going to require as you get on the middle part of the decade us to bringing at least 50,000 tons to market a year of hydroxide. And that is what that plan. If you look at the details would enable into the middle of a decade and beyond. So approximately speaking, you're talking about 150,000 tons of growth a year in the market price, or in that neighborhood, Mike and are bringing on 50,000. That's the kind of pace we're looking at."
},
{
"speaker": "Mike Sison",
"text": "Great Thank you."
},
{
"speaker": "Operator",
"text": "Thank you. This concludes our question and answer session. I would now like to turn the call back over to Kent Masters for closing remarks."
},
{
"speaker": "Kent Masters",
"text": "Okay. Thank you, Joelle. In closing, Albemarle is well-positioned to capitalize on long term growth trends for all three of our core businesses. We have built the capabilities to accelerate low-capital intensity, higher-return growth. At the same time, we will continue to control what we can control. That means, first and foremost, focusing on the health and well being of our employees, customers and communities. It also means building operational discipline and sustainability into all aspects of our business including manufacturing, supply chain, capital project execution, and customer experience. We remain confident in our strategy and we will modify execution to position Albemarle for success. Thank you."
},
{
"speaker": "Operator",
"text": "Ladies and gentlemen, this concludes today's conference call. Thank you for participating You may now disconnect."
}
] | Albemarle Corporation | 18,671 |
ALB | 3 | 2,020 | 2020-11-05 09:00:00 | Operator: Ladies and gentlemen, thank you for standing by. And welcome to the Q3 2020 Albemarle Corporation Earnings Conference Call. At this time, all participants are in a listen-only mode. After the speaker presentation, there will be a question-and-answer session. [Operator Instructions] Please be advised that today’s conference is being recorded. [Operator Instructions] I would now like to hand the conference to your presenter today, Ms. Meredith Bandy, Vice President of Investor Relations. Thank you. Please go ahead, ma'am.
Meredith Bandy: All right. Thanks, Mark and welcome to Albemarle’s third quarter 2020 earnings conference call. Our earnings were released after the close yesterday and you will find our press release, presentation and non-GAAP reconciliations posted to our website in the Investor Relations section at albemarle.com. Joining me on the call today are Kent Masters, Chief Executive Officer; and Scott Tozier, Chief Financial Officer. Raphael Crawford, President, Catalysts; Netha Johnson, President, Bromine Specialties; and Eric Norris, President, Lithium, are also available for Q&A. As a reminder, some of the statements made during this conference call including our outlooks, expected company performance, expected impacted impacts of the COVID-19 pandemic and proposed expansion projects may constitute forward-looking statements within the meaning of federal securities laws. Please note the cautionary language about forward-looking statements in our press release and that same language applies to this call. Please also note that some of our comments today refer to financial measures that are not prepared in accordance with U.S. GAAP. A reconciliation of these measures to GAAP financial measures can be found in our earnings release and the appendix of our presentation, both of which are on our website. Now, I will turn the call over to Kent.
Kent Masters: Thank you, Meredith, and good morning, everybody. On the call today, I will cover a high level overview of results and strategy and highlight additional actions we are taking to improve the sustainability of and to grow our business. Scott will then review third quarter financials, provide updates on our balance sheet and cost saving initiatives, and review our outlook. At Albemarle, our first priority is the safety and wellbeing of our employees, customers, and communities. Thanks to the courage and dedication of our employees, we've been able to safely operate our facilities throughout the pandemic to meet customer needs. Our cross-functional global response team continues to meet regularly to address -- to assess pandemic related risk and adapt protocols as necessary. Protocols, including restricted travel, shift adjustments, increased hygiene and social distancing remain in place at all locations. Our recent focus has shifted from managing the immediate crisis to building and flexibility to adjust for regional differences and changing conditions. Today, looking at our non-essential workers around the globe, most of North America remains on work-from-home status. Asia and Australia have returned to worksites. Most of Europe returned to worksites over the summer, but have now gone back to work-from-home, given rising COVID-19 cases and rates. And finally, in Chile, improving COVID-19 rates and falling cases have allowed us to trial a soft reopening approach at a worksite at reduced capacity. As we all know, the situation is challenging and continues to evolve. I'm grateful to our team for their continued vigilance and commitment to the working -- to working safely and productively. Turning to recent results. Yesterday, we released third quarter financials, including net income of $98 million or $0.92 per share and adjusted EBITDA of $216 million, down 15% from prior year. Our adjusted EBITDA results are past the high-end of our Q3 outlook by 14%, thanks to better than expected performance in Lithium and Bromine, and the exceptional cost-saving results across our businesses. We currently expect full year 2020 adjusted EBITDA of between $780 million and $810 million, lower year-over-year based on reduced global economic activity due to the global pandemic and reduced Lithium pricing as expected going into the year. Scott, we'll go into more detail on our outlook for the rest of this year and talk directionally about next year. In late 2019, we launched an initiative to achieve sustainable cost savings of over a $100 million per year by the end of 2021, with about half of that or $50 million to be achieved in 2020. Earlier this year with the onset of the pandemic related economic slowdown, we accelerated those initiatives, giving us line of sight to $50 million to $70 million savings in 2020. Implementation has been even more successful than we expected, and we are on track to deliver about $80 million in savings this year and to reach a run rate of more than $120 million by the end of 2021. We plan to turn this two-year project into an ongoing culture of operating discipline and continuous improvement with additional cost and efficiency targets. Our strategic approach to sustainability is another facet of this operational discipline and a key area of focus for Albemarle. Since we spoke last quarter, we have published our enhanced sustainability report, which expands on the four key quadrants of our sustainability framework and sets the baseline for our environmental performance and increased disclosures. Now, we are working to establish sustainability goals and targets and continue to make progress in each quadrant. This week, we also published our Global Labor Policy in alignment with International Labor Organization conventions and our human rights and global community relations and indigenous peoples policies, both consistent with UN guiding principles. These policies will be available on the sustainability section of our website. I'm proud to say that Albemarle generates more than 50% of our revenues from products that help reduce greenhouse gas emissions or promote greater resource efficiency, as our Lithium business grows and even larger proportion of our business will contribute to global sustainability. In summary, we are concentrating our efforts where they matter most, so we can continue to create sustainable value for our customers, investors, and stakeholders. Our growth projects at La Negra and Kemerton are key to increasing our battery grade lithium conversion capacity in line with long-term customer demand. La Negra III and IV is an expansion of our lithium carbonate capacity in Chile. The project is expected to reach mechanical completion in mid-2021, followed by a six-month commissioning and qualification process. La Negra III and IV allows us to add carbonate capacity at the very low end of the cost curve. Kemerton, our new lithium hydroxide conversion plant in Western Australia, is on track to reach mechanical completion by late 2021, with a six-month commissioning and qualification process to follow. Kemerton is core to growing our hydroxide capacity in line with expected strong long-term market demand. And with that update, I'll turn it over to Scott for more detail on our recent results.
Scott Tozier: Thank you, Kent. Good morning, everyone. Albemarle generated third quarter net sales of $747 million, a decrease of about 15% compared to the prior year and in line with our previous outlook. This reduction was driven primarily by reduced prices in Lithium as expected coming into the year and reduced volumes in Catalysts and Bromine related to pandemic related economic weakness. GAAP net income was $98 million or $0.92 per diluted share. The non-GAAP adjustments this quarter were primarily related to restructuring for cost savings and discrete tax items with adjusted earnings of a $1.09 per diluted share. Lower net income was primarily driven by lower net sales, partially offset by costs and efficiency improvements. Corporate and SG&A costs were lower versus the prior year due to these cost savings initiatives. As Kent stated, adjusted EBITDA was $216 million, a decrease of 15% from the prior year. The success of our short-term and sustainable savings initiatives, as well as timing of equity income from the Callison JV helped us improve margins and beat the midpoint of our Q3 EBITDA outlook by about 20%. Turning to slide eight for look at the EBITDA bridge by business segment. Adjusted EBITDA was down $38 million over the prior year, reflecting lower net sales and lower equity income partially offset by cost savings initiatives and efficiency improvements. Lithium's adjusted EBITDA declined by $31 million versus the prior year, excluding currency. Pricing was down about 17%, partially offset by cost savings. Lower pricing reflects previously agreed battery grade contract price concessions for 2020, as well as lower market pricing in technical grade products. Lithium EBITDA margin benefited from cost savings and the timing of Callison JV shipments to our partner Tianqi. Bromine's adjusted EBITDA was down about $10 million, excluding currency. The decline was primarily due to lower volumes as a result of the pandemic related economic downturn, partially offset by ongoing cost savings. Likewise, Catalyst adjusted EBITDA declined by $30 million, excluding currency, primarily due to lower volumes offset by cost savings and efficiency improvements. Fluid Catalytic Cracking, or FCC, volume improved sequentially, but remained down compared to the prior year due to lower transportation fuel consumption as a result of travel restrictions, Hydroprocessing Catalysts, or HPC, volumes were also down compared to the prior year due to normal lumpiness of shipments and softness related to lower oil prices and reduced fuel demand. Our corporate and other category adjusted EBITDA increased by $15 million, excluding currency, primarily due to improved Fine Chemistry Services results. We ended the quarter with liquidity of about $1.5 billion, including just over $700 million of cash, $610 million remaining under our revolver and $220 million on other available credit lines. Total debt was $3.5 billion, representing net debt to adjusted EBITDA of approximately 3.2 times. Our commercial papers supported by our revolver, which is not due until 2024. And so that leaves about $670 million of short-term debt to be restructured or repaid over the next year. We expect to repay the 2021 debt maturities out of cash on hand, assuming continued economic recovery and cash inflows from divestitures. However, we are also working with our banks on a delayed draw term loan to backstop those 2021 maturities. If the economic recovery or divestitures are delayed, we'd be able to refinance the short-term debt using this new delayed draw term loan. As Kent highlighted earlier, our 2020 sustainable cost savings initiative is on track to achieve cost reductions of about $80 million this year. That's 60% above our initial estimates. We expect to reach run rate savings of more than $120 million by the end of 2021, up 20% from the previous outlook. We continue to expect a short-term cash management actions, such as travel restrictions, limited use of external services and consultants and working capital management to save the company about $25 million to $40 million of cash per quarter this year. Next year, we expect some headwinds as some of these temporary cash savings reverse. Finally, we're narrowing our expected range of 2020 capital spending to $850 million to $900 million, based on timing of spend. Our two major capital projects, La Negra III and IV and Kemerton remain on track for completion in mid-2021 and late 2021, respectively. They will begin generating sales revenue in 2022, following a roughly six-month qualification period for each plant. Turning to our outlook. This quarter is a transition from quarterly to annual outlook. Our next quarter, we expect to return to our normal practice of giving annual outlooks. As we approach the end of the year, we currently expect to deliver full year 2020 net sales of around $3.1 billion at the midpoint of our range. Adjusted EBITDA of between $780 million and $810 million, and adjusted diluted earnings per share between $3.80 cents and $4.15. Lithium's Q4 adjusted EBITDA is expected to increase 10% to 20% compared to Q3, 2020, as battery grade customers continue to meet planned volume commitments. Bromine's Q4 EBITDA is expected to be similar to Q3. Stabilization in electronics and building and construction continue to help offset weakness in other energies markets, particularly deepwater drilling and automotive. Finally, Catalysts Q4 EBITDA is expected to be down between 20% and 30% sequentially, primarily due to HPC volumes and mix. FCC demand is expected to continue to recover, with increased travel and depletion of global gasoline inventories. But Q4 is expected to be particularly weak for HPC Catalysts, in part because of normal lumpiness, but also as refiners continue to defer HPC spending into 2021 and 2022. As we look beyond this year, visibility remains challenging. However, we are seeing signs of improvement or at least stabilization in our businesses. EV sales remain a key driver for the growth of our Lithium business. Global EV sales were up 90% in the month of September compared to the previous year. September represented a new monthly record of EV registrations led by European EV sales. The rest of the world continues to rebound from the pandemic related slowdown earlier this year, with year-to-date global EV sales up 15%. The fourth quarter is also typically a seasonally strong quarter for auto sales. And similarly, IHS market expects global EV production to increase by 20% to 30% in full year 2020 and by nearly 70% in 2021. Our Bromine business supplies a diverse set of end markets and is generally driven by a broader consumer sentiment and global GDP. Consumer sentiment continues to improve in most regions, albeit, still below pre-pandemic levels. Analysts now expect global and U.S. GDP to be down about 4% in 2020 before rebounding next year. Finally, in Catalysts, after the sharp drop-off in March, U.S. miles driven has rebounded, but remains well below normal levels. Similarly, refinery capacity utilization has improved from earlier this year, but remains well below typical levels. Refinery utilization rates in the mid 70% range are a challenge for an industry design to run efficiently at utilization rates of 85% or higher. Given recent shifts in demand and refining economics, we don't expect to see pre-pandemic levels until 2022 at the earliest. Forecast and leading indicators like these help gauge the outlook for our end use markets. However, a variety of factors, including supply chain lags, contract structure, inventory changes and regulatory impacts can cause our results to differ from the underlying market conditions. Now, let's turn to slide 13 for our current view of 2021. In Lithium, we expect full year 2021 volumes to be relatively flat, as our plants are effectively sold out, given current volume constraints. We expect to see volume growth in 2022 as when La Negra III and IV and Kemerton come online for your 2021. Lithium prices are expected to be down slightly due primarily to lower average realized pricing for carbonate and technical grade products. Discussions with long-term battery grade customers are underway. It's too early to say what changes will be made to those contracts for 2021. Lower average market pricing and higher inventories may pressure pricing. At the same time, many of our customers remain concerned about security of long-term high quality supply, which speaks to the strong demand growth seen for electric vehicles. In Bromine, we expect full year 2021 results to improve slightly, assuming continued economic recovery and ongoing cost savings. Our Bromine business was probably the least impacted of our businesses during 2020. And that's part of the reason we expect a fairly modest improvement in 2021. And in Catalysts, we expect 2021 results to continue to improve from the very low level seen in 2020, but to remain well below 2019 levels. Near-term, Catalysts results are challenging as reduced refinery capacity utilization and lower oil pricing continues to pressure our customers' margins. In the longer term, this business is well-positioned in growth regions like the Middle East and Asia, and poised to benefit as refineries shift production to chemicals.
Kent Masters: Thanks, Scott. Economic conditions are improving, but uncertainty remains, particularly if additional COVID-19 impacts lengthened the time to a full economic recovery. We have the playbook established and know how to manage through subsequent waves of COVID-19, as necessary. At the same time, we are confident in the long-term growth prospects of our core businesses and continue to focus on controlling what we can control. That means first and foremost, focusing on the health and wellbeing of our employees, customers and communities. It also means building operational discipline and sustainability into all aspects of our business, including manufacturing, supply chain, capital project execution and the customer experience. We remain confident in our strategy and we will modify execution that strategy to further position Albemarle for success.
Meredith Bandy: All right. Before we open the lines for Q&A, I'd just like to remind everyone to please limit questions to one question and one follow-up to make sure that we have enough time for as many questions as possible and feel free to get back in the queue for additional follow-ups if time allows. Thanks, Marcus. Please proceed with the Q&A.
Operator: Thank you. [Operator Instructions] Your first question comes from the line of Bob Koort with Goldman Sachs.
Tom Glinski: Good morning. This is Tom Glinski on for Bob. So, first question is, you're guiding flat volumes in 2021 for Lithium, even though the battery chemicals market should be growing nicely next year. I guess, this suggests that you're going to be losing market share first, are you okay with that? And then second, if other producers capture that incremental volume in 2021 and get through that challenging qualification process with the customers, do you expect to regain that market share in 2022 and beyond, or is there a risk -- your competitors maintain that? Thank you.
Kent Masters: Yeah. Tom. It's a function of our projects and when they're coming on and the capacity is coming on and who has that capacity to capture growth. So, there's not a lot we can do about that at this point. We're on our plan to bring that capacity on, but likely demand will pick up before we have that capacity, so we will lose a little share, but we expect that that'll move back to us as we get that capacity on as the market continues to grow out into the future.
Tom Glinski: Great. That makes sense. And then, I guess, higher level, looking at 2021, considering the moving pieces between price down in Lithium, volume flat, but capturing some incremental cost savings. Do you think you can grow segment EBITDA next year, or is EBITDA going to be flat to down? Thank you.
Kent Masters: Well, frankly, it's going to -- it'll depend on how the market develops over the year. Without having volume, we'll have some cost savings to offset inflation and those pieces, but we'll be close to -- we'll be around flat unless we get a material change in pricing.
Tom Glinski: Got it. That makes sense. Thank you.
Operator: Your next question comes from line of David Begleiter with Deutsche Bank.
David Fong: Hi. This is David Fong here for Dave. I guess, first, just on pricing, because it's something that's pricing have bought in and even some carbonate pricing started to recover. I guess, if you can just elaborate a little bit more on your pricing weakness on carbonate in 2021, and do you expect that to broaden during the year, would that be like a 2022 story?
Kent Masters: Yes. I'll make a comment and then let Eric give you a little bit more detail or his perspective. So, I mean, that's the magic question. It looks like when you look at the indices out there that it's at least bottomed, if not starting to pick up a little bit, but we'd probably need to see that a bit more to have more confidence. But we're anticipating that turns up during 2021. And the question is when during 2021? So, Eric, you want to add something?
Eric Norris: Yes. I can add. Specifically relative to carbonate, this is -- when we look at where the growth is coming in, in the coming year, we look at what's happened this year. It's more of a hydroxide growth story. Carbonate is therefore not enjoying as much of that. There is some growth in China. China is where we see more of these low prices and it's a more oversupplied market. Now, so, it is the magic question, as Kent refer to, we have on some reported indices seen it picking up, others see it flat. It's -- even from the price reporting groups, that -- report price around the world and in China specifically, it's murky and well below marginal cash costs. So, the price of carbon has gone well below what we thought it would have gone six months ago. It is trending up in one report. We'll have to see. Our view would be that given the supply dynamics I talked about and the growth being more driven on the hydroxide side that a clear movement above marginal cash costs for the spot prices of carbonate is more likely at 2022 event. I mean, not to say it couldn't happen in 2021, but that looks more favorable in 2022 hydroxide, however will be different we believe.
David Fong: Thanks. And then, on Catalysts, it looks like the recovery is a little bit slower than expected. So, since you're -- I mean, sales should be up slightly in 2021, I guess, what kind of improvement are we talking about? And then, just given that if we say the current pace of recovery in Catalysts, sales you expect that we can achieve the same level of EBITDA in 2022 as 2019 level?
Kent Masters: So, I'll comment and Raphael can also comment. But I think a lot of that -- it depends on demand and the view of -- when driving comes back, when travel comes back and it's really about fuel demand and refinery utilization for us. So, our view, we don't see us getting back to 2019 levels for 2020, until into 2022, probably very late 2022 would be back to that both from a fuel demand utilization and from our perspective as well.
Raphael Crawford: This is Raphael. I think, that's right, Kent. And when we look at the outlook, there's a few things that play in. One is the impact of the pandemic. And when do fuel volumes recovered to 2019 levels and that's a volume component, and the other is refining margins. So, there's a lot of pressure on refineries right now, or just total value of refined products from a margin perspective has gone down. And when that recovers, that's going to be dependent on volume, but also on utilization industry capacity. And so, we wouldn't see that returning $0.10 until sometime 2022 timeframe.
David Fong: Okay. Thank you.
Operator: Your next question comes from the line of Mike Harrison with Seaport Global Securities.
Mike Harrison: Hi, good morning. Coming back to this idea of that Lithium volumes are sold out for next year, if there is some additional demand pickup or if some of this over supply or inventory gets worked down, could that put you in a position to drive higher pricing? And can you maybe also comment on whether you have any flexibility to move more volume or to maybe accelerate some of your production, if you do see a demand picking up?
Kent Masters: Yeah. So, if the market gets tight and the supply is not there, I mean, prices should move up. When we -- we kind of expect to see that around hydroxide less about -- less with carbonate and it's difficult. I mean, we had delayed our projects a bit when the pandemic hit, because we just didn't know what things were going to look like. And as soon as we got some visibility, we kind of tried to pull those back as much as possible and we haven't lost much time on that. And we haven't really lost -- our capital estimates are still kind of in the same range as well. So -- but it's really not possible for us to pull it more forward than our current plans. We wouldn't be able to sell right now to impact when those projects are coming on stream. So, from our perspective, I don't think we're going to have extra capacity to what we are anticipating. We may be a little early with the projects are planned, but it's not going to be a dramatic.
Mike Harrison: I think everybody's kind of focused on what's happening here in the U.S. from a political standpoint, but can you maybe talk about Chile and whether some of the political news there could impact your relationship with the government or your rights in the Atacama?
Kent Masters: Right. So, while -- you know what's happening there, so they're going to redo their constitution. That's going to -- that's a pretty long process that they have in place to do that. And so far that's all been without too much turmoil. So, we don't -- we have to wait and see what that constitution looks like. We don't really expect it to impact our rights in the Atacama, but I mean, I guess that's something we'll have to wait and see. I don't think it would be -- I mean, it's not until our interest to start changing how they work with the international community. Chili's got a great reputation following the rule of law and having a strong economy in South America. It's kind of the example. So, I don't think they want to change that, but it's something we'll have to watch very closely as that plays out.
Mike Harrison: All right. Thanks very much.
Operator: Your next question comes from line of Vincent Andrews with Morgan Stanley.
Vincent Andrews: Thank you, and good morning, everyone. Just wondering, you talk about sort of 60% of your assets, you're going after what the new -- two new projects that are going to come on. What about the other 40%? Can you talk from a medium term perspective? What's it going to take for you to go after those assets, how much money it would require and CapEx spending? And at what point will you start talking about how you'll go after that and how you'll finance it?
Kent Masters: I'm not -- Vincent, I'm not sure I'm clear on the question. So, to go after the other 40% of the asset?
Vincent Andrews: Yeah. I guess, my question is, what -- when should we anticipate the other 40% coming online and how much will you have to spend to do it?
Kent Masters: From a resource standpoint you're talking?
Vincent Andrews: Correct.
Kent Masters: Yeah. Okay. So we have access to those resources. So, it's just about building conversion capacity. So, we've kind of started that process. So, La Negra and Kemerton is part of that. So we're building that out. We'll sell those plants out and then we'll layer in additional capacity to go after. I mean, that's our strategy and our plan longer term. We haven't necessarily laid out a CapEx program publicly over time. But that's the plan as we build capacity and then we sell it out and then we reinvest.
Vincent Andrews: Sorry. As a follow-up then, to the earlier question about market share, how do you think about the medium term in terms of not per se, having a suggested timeline for that other 40% of production versus how fast do you think the market's going to grow? Do you think you'll be able to bring that 40% on -- in conjunction with market growth, or is it possible that it'll lag?
Kent Masters: Well, we'd be layering in that capacity. So, what we're trying to do is kind of get it just right. So we add capacity as the market grows and bring that on as it's required. And it's a matter of -- how well we execute and how well we forecast the market, but we think we can. That's what we're trying to do.
Vincent Andrews: All right. Thank you very much. I appreciate it.
Operator: Your next question comes from line of John Roberts with UBS.
John Roberts: Thank you. Nice progress on the cost savings efforts. The -- that backstop indicates some uncertainty here in the divestment process for fine chemicals and catalyst additives. Are we expecting one buyer for both or two? And do you think both will be announced before year-end?
Scott Tozier: Hey, John. This is Scott. So, we're expecting that we'd have two different buyers for those two different businesses. Discussions continue favorably on both of those. A little bit too early to call exactly when would build to announce -- announced a deal on either one of them, but obviously we're pushing hard to do that. The backstop is also related to economic uncertainty. And so, we just got to -- I think we've just got to get through the winter period and the increasing COVID cases and whatever the government reactions to this are to fully understand kind of where we end up in 2021. And that's -- it's really just a safety valve for us, in case things go the wrong direction. And the banks have been very supportive of us in our story. So, really appreciate their contributions.
John Roberts: And then you mentioned in the third quarter, the benefit of a timing, Callison and shipments to Tianqi, was that a catch-up from 2Q? It doesn't sound like it's a pull forward from the fourth quarter, given the strong fourth quarter guidance.
Scott Tozier: Yeah. You've got it right, John. It was really a catch-up from the Q2 shutdown that they had. And just from an accounting perspective, when Tianqi takes more product, we ended up getting that equity income immediately. So, it helps our bottom line.
John Roberts: Great. Thank you.
Operator: Your next question comes from Arun with RBC Capital.
Arun Viswanathan: Great. Thanks for taking my question. Good morning. Yeah. Congrats on the results. Definitely nice to see the cost reductions playing out. I just wanted to ask about the contracting side on Lithium. You -- I think you had offered concessions to some of your customers this year in 2020, did you find the need to extend those concessions in the 2021? Could you just maybe comment on the contracting environment out there? Thanks.
Kent Masters: So we -- well, we're in the process of having those discussions with our customers. So I mean, you're right. We've made concessions late 2019 for the 2020 period. They were one year concessions. Market price is lower than it was at the time we made those concessions today. And so, we're having discussions about what -- those contracts will look like for 2021. At the moment it is too early to kind of give any -- too much guidance on exactly what that looks like, because we're having those discussions today.
Arun Viswanathan: Okay. I appreciate that. And then I guess on that note, I imagine that you maybe extending or rolling over maybe three-year contracts that you signed up in 2016 or 2017. Is that going on? When do you expect to do that? And I guess, would you expect to revert to the prior price umbrella on those contracts, or is there potential for those negotiations to result in pricing closer to market levels at this point?
Kent Masters: Eric, do you want to talk a little bit about the contracting strategy?
Eric Norris: Sure. So, to answer that first part of that question, Arun, we don't have any contracts -- any major better grade contracts with turnover next year. It's not to the following year in 2022 that we have one that does turnover. That being said, it might be worthwhile to discuss what we're trying to do, right? And with our contracts that just as a recollection of what we shared in the past, we're moving from what previously was a singular fixed price contract for all customers to a more segmented approach. And really putting that into -- I would put it simply into three buckets. One is, there'll be a group of customers that as we talk in the future with them, and we've actually had some new customers come in. So, we have some brand new LTS, one we've signed during the quarter, that is prospectively for the Kemerton volumes when they come online. So that first category our people that really want very little volatility in their price and our will -- and as a result, we are looking at or negotiating a fixed price with them. That's well above current prices and favorable investment economics for us. There's a second category that may want to have a little bit more volatility, but not quite so much. They don't want to have a nosebleed price when the market recovers. And we're insisting on a floor that we have -- we can earn a favorable reinvestment economics over that pricing cycle. That's that second category. And then there's a third, it'll be priced buyers. Now, our aim and the way this is shaping up is that we expect about once we have moved from this old contract structure to the new, and this price concession we gave this year is that bridging between the two contract structures, it's about 20% in that price bucket and about 80% in the first two buckets. And it's that 80% that driver capacity expansion. What they commit to us to -- these owners term contracts is the basis for our adding capacity over time. And any access is what we would then sell into the -- to the price market. So, we don't build for that price market, and we don't commit very long to that price market. That's the strategy. Where we are today, quite encouraging. We're starting to see with as a second six months of the year has come about. And you're looking now at 2021 as a very strong, we believe, demand curve associated with it. And we're starting to see that already in Europe. We're already 15% up year-to-date. With that -- with those positive signals coming through the channel, we're seeing more and more customers coming to us and wanting to talk with us about long-term contracts that have favorable reinvestment economics to us. Or transitioning their existing legacy contracts to that new structure I just described in a way that allows favorable reinvestment economics for us. And that is absolutely paramount, because I think a lot of the -- the rest of the industry that's still buying on price is not appreciating the fact that a current price is no one's going to expand and there isn't going to be sufficient lithium for them. And so having more and more customers, including automotive OEMs become aware of the need for reinvestment economics on behalf of the lithium supply industry is starting to turn the tide. 2021 will be -- because of the pandemic, it's going to be a bit of a transitional year. We're still working through that. That's why there's some uncertainty. And, of course, we talked about the weakness already in carbonate, but maybe that's helpful additional context to your question, Arun.
Arun Viswanathan: Very helpful. Thanks a lot, Eric.
Operator: Your next question comes from Laurence Alexander with Jefferies.
Laurence Alexander: Hi. Could you give a sense for your current thinking around inventory management? How much of an inventory build you need to do next year to prepare for the growth curve you expect in 2022 to 2023?
Kent Masters: Okay. So, I'm assuming you're talking about Lithium, that’s where we -- all the inventory questions come from -- one to qualify that. So, next year, I mean, we -- the inventory is probably in the channel. We don't think it really changed much from what we said in the last quarter. And we're saying demand has picked up and it feels better, but we don't have data to say that inventory is any less than it was last quarter. So that still has to be worked off. But given the demand profile we see in 2021, and our limited capacity, we got up -- we don't expect to build inventories there. We would expect actually to meet. We'll work those down. And then we're working off of what we would consider kind of standard inventory in the channel. So, we don't see it building at least from our perspective through 2021. We see us working inventories off.
Laurence Alexander: And then can you -- instead for Bromine, given the trends in the end markets, what negative factors do you see keeping the Bromine improvement next year at fairly modest?
Kent Masters: Netha, you want to make a few comments on that?
Netha Johnson: Sure. I think that the biggest impact for us is the overall macro economy. We tend to be driven by global GDP. So that's really the limiting factor for us is how fast this thing's going to come back. And this is going to come back in a stable, consistent way or is it going to be lumpy. And right now it's just a little bit unclear how that recovery is going to take place across the globe in 2021.
Laurence Alexander: Thank you.
Operator: Your next question comes the line of Joel Jackson with BMO Capital.
Robin Fiedler: Hi. This is Robin on for Joel. Can you provide some more order of magnitude around the guidance of the Catalysts EBITDA you expect next year? Is it reasonable to be about halfway between 2020 and 2022? Was it more likely to be above or below that level? If you can just kind of walk through some of the key building blocks to get there.
Scott Tozier: Hey, Robin. This is Scott. Let me make a quick comment and maybe Raphael can give some additional color. It's really going to depend on refinery utilization rates as well as transportation fuel demand. And given what we're seeing in projections right now, it's likely in the bottom half of that range that you just gave versus the top half. But maybe Raphael, you can add some more color as to what you're seeing.
Raphael Crawford: Hi, Robin. I think that Scott characterize it correctly. But over the next six months, I think we'll have a much clearer picture as to what that recovery will look like. As we see demand recovery, we see margin progress as refineries, we will have a better sense of that. But I wanted to at least give you a sense rather than -- while, it's going to be a challenging 2021, better than 2020. The business is still very focused on the right steps to return to growth in the future with a focus on chemicals, with a focus on refineries East of Suez, where demand continues to grow. So, while we have a challenge, we also have good strategies to establish us for long-term recovery and growth.
Robin Fiedler: That's helpful. Thank you. And just as a follow-up. I apologize, did I hear correctly early in the call that it was mentioned that Lithium EBITDA will be closer to flat for next year? I assume the cost savings or Lithium's portion of the cost savings is offsetting that -- slightly little pricing, is that right?
Scott Tozier: Yeah. Robin, this is Scott. I think, you had about right. It's really a little bit early to call exactly what the number is going to be. But Lithium EBITDA should be flat to maybe down a bit, just given the dynamics that we're seeing.
Robin Fiedler: Okay. Thank you.
Operator: Your next question comes from the line of P.J. Juvekar with Citigroup.
Prashant Juvekar: Yes. Hi. Good morning. So, it looks like you have some limited capacity growth and you might lose some share next year. Why couldn't you build inventories in 4Q here to sell -- so as to not to lose share? And then secondly, some of your capacity is still idle, like the Wodgina mine and what does it take for you to start that back up?
Eric Norris: Kent, would you like to take?
Kent Masters: Yeah. I'll start. So, first question about inventory. So, I mean, there's a limit on inventories on hydroxide, and we -- and they're a little more than normal in the channel and we've actually shutdown some facilities to manage that a little bit, because there's a life on hydroxide. So, you want to be careful about how you manage those inventories. So it -- and we'll work through those inventories the next year. So, we'll be able to probably -- we'll sell more than we'll be able to make. So, we are doing that to some degree, but we're limited by kind of the life of hydroxide. And that's where the extra demand comes from. The other question on Wodgina, so our limitation is on conversion capacity, right? So, Wodgina does not producing, but that's because we can't -- we don't have capacity to convert that. So, Kemerton brings us -- gets us going in that direction. And then we would just -- we have to manage between Wodgina and Callison about how that -- what resource we use there. So -- but we're limited more on conversion capacity. So we'd be needing to add additional conversion capacity to take full advantage of our resources.
Eric Norris: Yeah. Just to add Kent on -- this year – P.J., we are selling all the hydroxide that we can make. So, we're sold out this year. In fact -- and that's where -- we've made the concessions, we talked about on price and the leverage for that as we're getting the volumes this year that we planned the reason for the upward guidance for the fourth quarter. So, we're getting what we intended. And in fact, we'll be up year-over-year on volumes overall. I mean, we expect industry to be down. So, this will be in that regard, a solid year for Lithium. As you go into next year, Kent hit it, conversion capacity. In fact, our ratio of mining capacity to conversion capacity, mining potential to actual conversion backs is about quarter one. So, it's about more conversion assets. And we're being -- as we talked about in terms of managing our cash flow and managing our profitability, very disciplined about how we bring that conversion capacity to market. Next year will be a flat year, but we'll have significant capacity we bring on in 2022 and be in a position as we ramp those plants to recover any lost ground we have with our customers. And as I earlier said, we've also started to draw up new contracts with customers before that volume in that year.
Prashant Juvekar: Thank you for that color. It's interesting you're saying conversion capacity is the bottleneck, Kent, maybe related to that, can you talk about what's happening to conversion capacity in China? I know they -- at some point back in 2015, 2016, they were constrained that they overbuilt. Where do we stand on convergent capacity utilization in China? Can you just give us some update there? And could you -- and also, could you take some of your volumes into the Chinese third party conversion? Thanks.
Kent Masters: So, Eric, you want to …
Eric Norris: Yeah. Sure. So, in China, as you know these Chinese converters -- now, I assume you're talking not about our integrated competitors, such as [indiscernible] and kind of you're talking about other non-integrated producers, those do not own a resource. They're dependent upon economics, right? And they're net buyer of -- they have to buy their rock. Many of those minds have been curtailed. Alterra being the latest victim of low market prices and been able to operate. So, supply for rock has dried up and they'd been sustaining themselves to available inventory. That's one factor. Another factor is they themselves -- their current carbonate prices are breakeven at desk, and most are operating at a loss as we see the price in China -- spot prices in China below marginal cash costs. So, it's a pretty challenging economic picture for those producers. Market recovery, we expect that capacity to come back. And China's going to remain a very healthy market for Lithium into the future. So, I think there's going to be a place for those producers. In terms of our going in, as you know, we're looking in terms of growing our capacity. We've talked about buying versus building capacity. We still are evaluating that approach. And that means a viable expansion route for us. It's the way we got the capacity we have today, the basis for how we got our current Chinese conversion capacity. We are less inclined particularly for hydroxide, which is the growth part of the market, where there's a lot of process, know-how quality differentiators to teach at a toll producer, how to do that. And that's proprietary know-how that we would be concerned we'd lose, if we were to toll. So, our bias would be to acquire.
Prashant Juvekar: Great. Thank you, Your next question comes from the line of Mike Sison with Wells Fargo.
Mike Sison: Hey, good morning. Nice quarter. As I recall, you've got $40 million in carbonate coming on and -- I guess in 2022 and $50 million in hydroxide in 2022. How much of that is already sort of contracted out and how long do you think -- how long would you think you'll take to sell those out?
Kent Masters: So, your numbers are right. Although, they're not going to -- it's not going to turn on day one at those capacities, right? So, there's a ramp in our manufacturing processes to get us up to those full capacity. So, they won't come on all it, when you just turn a switch. Unfortunately, it doesn't work like that. And Eric, you want to talk about kind of the ramp of sales versus production.
Eric Norris: Yeah. So, we're -- I mentioned earlier, Mike, that we are on the -- particularly on the hydroxide side, which the tighter market, we are entertaining. Well, first of all, we already had long-term contracts, actually long-term contracts that had earmarks, if you will, against that capacity when it came on. And now we are having additional -- we signed one recently, as I said, during the quarter to increase that utilization of that plant. And we're in negotiation with still others. So, I don't think -- we're at liberty yet to share the details of exactly how much, but I would say significant portion of the Kemerton capacity is well shared from a sales standpoint. On the carbonate side, a little different. Most of the carbonate market is in -- is increasingly in China. As you know, the China market is a much shorter term contracting market. We have been very diligent to maintain relationships with our existing capacity out of a mega one and two, relationships and ongoing buying relationships, or sales to a number of leading Chinese producers with whom we are talking about growing our business. We are talking with him about committed volumes -- the nature of contracting that was different with those. So, it's going to be a little different with carbonate in terms of -- we'll be closer to bringing that to market before we have firm prices with -- for that volume. Though, remember that we're at the low in the cost curve. So, still very attractive business. Not withstanding the fact that it won't have some of the same long duration contracts that we see on the Kemerton inside.
Mike Sison: Right. Great. Thanks. And then a quick one on Catalysts, any thoughts on pricing for FCC heading into 2021?
Kent Masters: Raphael, you want to comment?
Raphael Crawford: Sure. Mike, this is Raphael. I think pricing in FCC has been challenged in 2020 for non-contract volumes. Non-specialty non-contract volumes have been under the most pressure in response to -- in decisions by refineries to look for perhaps less special -- less specialty catalysts in order to help their near term economic pain. Going into 2021, I think the trend would continue. I mean, I think, we'll continue to see pressure on non-contracted volumes, but where we create a differential value, namely in areas like high propylene yields, I think we'll continue to hold onto price and remain strong in that area.
Mike Sison: Great. Thank you.
Operator: Your next question comes from the line of Chris Kapsch with Loop Capital Markets.
Chris Kapsch: Yeah. Good morning. Thanks for taking my question. So sort of a follow-up on Eric's comprehensive comments about the shifting approach to the contracts and really, I guess, against the context of some of the anecdotal commentary about hydroxide versus carbonate. It seems like the oversupply is still a little more acute in carbonate versus hydroxide. So -- and then you obviously have this tension about some customers wanting near term pricing release and others maybe more focused on concerns about longer term supply. I'm wondering if those conversations reflect this bifurcation hydroxide versus carbonate. And if you could take another -- a little bit further, is it -- as this plays out, is it more likely in the context of those buckets that you described, Eric? More likely that the hydroxide guys are going to fall in this bucket where they want fixed prices, security of supply, and the carbonate customers are more likely to be willing to play some of the volatility.
Eric Norris: Sure. Any advanced comments Kent, before I dive in?
Kent Masters: No. Go ahead.
Eric Norris: Okay. So, I think the reflection about -- everything I've described and you asked Chris, is both -- there is a difference between carbonate and hydroxide. More of the carbonate market going forward will be in China. And to date, I don't see that same approach to security of supply in terms of contracting with us or with anybody for that volume. Rather I see that they -- that the market tends to be content to go for short duration on the bet that resources will continue to come online, converse best -- continue to come online and there'll be sufficient capacity. And there's also a bifurcation that based on who's buying, right? More of the purchasing decision is moving closer to the point of views. So it's moving to the battery producers and the automotive producers. And they given the investments they are making in the length of supply chain, whether it be carbonate or hydroxide tend to want longer the surety that they're going to have it, because of the size of investments they're making. Not everybody's doing that, but increasingly more are, and more becoming, I think, appropriately aware of the need to do that. So, it's also who we're contracting with and in these long-term contracts that plays a factor in that.
Chris Kapsch: Okay. Thanks for that. And then just as a follow-up. Could you -- I think the last quarter you characterize the inventories that you saw in the supply chain. Any update on that? And also just any changes to the timeline on the idling of your convert -- your hydroxide conversion facility in North America. Thanks.
Eric Norris: Yeah. So we have -- so first of all, I'll just reiterate what Kent said. Look, it is imperfect. The science of assessing how much inventory is in the channel. We can survey our customers and we do, and that gives us a basis for understanding that. We obviously don't know what our competition holds and they -- and some of held quite a bit. If we look at it things net-net, the overall months of inventory in the channel still about the same as it was three months ago, five months of execs, roughly speaking. Though, I think that shifted. There's probably more carbonate than hydroxide now. So, carbonate has built up a bit and hydroxide drawn down a bit. Again, we are probably wrong about that, but directionally correct. It doesn't feel that different. It feels a little bit better because I think that the pull-on hydroxide, but not too different. I'm sorry. Then you had a second part of your question, Chris?
Chris Kapsch: The timeline of your idling of your hydroxide conversion facility?
Eric Norris: Yeah. We have -- we are in the process of restarting the Kings Mountain hydroxide facility. Now, employees are returning that's sooner than we thought. And that's based upon the improvement we're seeing for demand next year and some of the earlier questions around, can you please try to get more volume next year. So, we're ramping that plant up. It's a small plant, so it has a very small impact to the overall volume growth, but we're starting that up. And Silver Peak, which is the feedstock plant that feeds that hydroxide plant with carbonate feedstock will restart on schedule beginning of the year 2021.
Operator: Your next question comes from the line of Colin Rusch with Oppenheimer.
Colin Rusch: Thanks so much, guys. Can you give us a sense of how mature the conversations are on the financing side? It sounds like things are going pretty well and there's some pretty meaningful opportunities to reduce your cost of capital going forward. But just curious how far down the road you are on then?
Kent Masters: Yeah. No, we're well advanced in those discussions. So, feel comfortable about where we're heading.
Colin Rusch: Excellent. And then the Lithium mark has been pretty well belabored [ph]. But I'm just curious if you're seeing any consolidation in terms of battery OEMs, given where we're seeing capacity efficient. It looks like there's going to be a handful of folks that really stride out here. And if there's any consolidation kind of below that with some of the cathode producers, as you look out over the next three to five years?
Kent Masters: Eric?
Eric Norris: Yeah. Sure. Thanks, Kent. So, on the battery OEMs, I don't be interested to see what you see, Colin, because we don't see that. In fact, I've seen the opposite. You've seen new players come into the market not very recently, but companies like [indiscernible] come into the market for Europe, and many other multi-nationals who have played around this space in the past, I think looking to come in to support the growth of the European market. So, I see more players coming into the market on the battery side, not less, and some of that's being supported and driven by the automotive OEMs. So, I think, want more op -- they want some negotiating leverage, right? They want more options, or they want more localized options for in the case of Europe. On the cathode side, it is constantly changing, right? This is the part of the market that has, as I said, is not necessarily directly involved in the person decision as much anymore, is being told what to make either by the automotive OEM or the battery makers. So, they're losing some of their power in the decision channel. And so I do expect some change consolidation. I can't point to any obvious ones now, but there's disruption. There's people gaining share and losing share. And so, I think, we'll continue to see evolution in that part of the channel. And also some backward integration, right? You have some battery makers now are building their own in-house cathode capabilities.
Colin Rusch: That's super helpful. I'd love to have that conversation offline. Thanks, guys.
Operator: At this time, we have no further questions. I will now turn the conference back over to Ms. Bandy.
Meredith Bandy: All right. Thank you all for your questions and your participation in today's conference call. As always, we appreciate your interest in Albemarle, and this concludes our earnings conference call.
Operator: This does conclude today's conference. You may now disconnect. | [
{
"speaker": "Operator",
"text": "Ladies and gentlemen, thank you for standing by. And welcome to the Q3 2020 Albemarle Corporation Earnings Conference Call. At this time, all participants are in a listen-only mode. After the speaker presentation, there will be a question-and-answer session. [Operator Instructions] Please be advised that today’s conference is being recorded. [Operator Instructions] I would now like to hand the conference to your presenter today, Ms. Meredith Bandy, Vice President of Investor Relations. Thank you. Please go ahead, ma'am."
},
{
"speaker": "Meredith Bandy",
"text": "All right. Thanks, Mark and welcome to Albemarle’s third quarter 2020 earnings conference call. Our earnings were released after the close yesterday and you will find our press release, presentation and non-GAAP reconciliations posted to our website in the Investor Relations section at albemarle.com. Joining me on the call today are Kent Masters, Chief Executive Officer; and Scott Tozier, Chief Financial Officer. Raphael Crawford, President, Catalysts; Netha Johnson, President, Bromine Specialties; and Eric Norris, President, Lithium, are also available for Q&A. As a reminder, some of the statements made during this conference call including our outlooks, expected company performance, expected impacted impacts of the COVID-19 pandemic and proposed expansion projects may constitute forward-looking statements within the meaning of federal securities laws. Please note the cautionary language about forward-looking statements in our press release and that same language applies to this call. Please also note that some of our comments today refer to financial measures that are not prepared in accordance with U.S. GAAP. A reconciliation of these measures to GAAP financial measures can be found in our earnings release and the appendix of our presentation, both of which are on our website. Now, I will turn the call over to Kent."
},
{
"speaker": "Kent Masters",
"text": "Thank you, Meredith, and good morning, everybody. On the call today, I will cover a high level overview of results and strategy and highlight additional actions we are taking to improve the sustainability of and to grow our business. Scott will then review third quarter financials, provide updates on our balance sheet and cost saving initiatives, and review our outlook. At Albemarle, our first priority is the safety and wellbeing of our employees, customers, and communities. Thanks to the courage and dedication of our employees, we've been able to safely operate our facilities throughout the pandemic to meet customer needs. Our cross-functional global response team continues to meet regularly to address -- to assess pandemic related risk and adapt protocols as necessary. Protocols, including restricted travel, shift adjustments, increased hygiene and social distancing remain in place at all locations. Our recent focus has shifted from managing the immediate crisis to building and flexibility to adjust for regional differences and changing conditions. Today, looking at our non-essential workers around the globe, most of North America remains on work-from-home status. Asia and Australia have returned to worksites. Most of Europe returned to worksites over the summer, but have now gone back to work-from-home, given rising COVID-19 cases and rates. And finally, in Chile, improving COVID-19 rates and falling cases have allowed us to trial a soft reopening approach at a worksite at reduced capacity. As we all know, the situation is challenging and continues to evolve. I'm grateful to our team for their continued vigilance and commitment to the working -- to working safely and productively. Turning to recent results. Yesterday, we released third quarter financials, including net income of $98 million or $0.92 per share and adjusted EBITDA of $216 million, down 15% from prior year. Our adjusted EBITDA results are past the high-end of our Q3 outlook by 14%, thanks to better than expected performance in Lithium and Bromine, and the exceptional cost-saving results across our businesses. We currently expect full year 2020 adjusted EBITDA of between $780 million and $810 million, lower year-over-year based on reduced global economic activity due to the global pandemic and reduced Lithium pricing as expected going into the year. Scott, we'll go into more detail on our outlook for the rest of this year and talk directionally about next year. In late 2019, we launched an initiative to achieve sustainable cost savings of over a $100 million per year by the end of 2021, with about half of that or $50 million to be achieved in 2020. Earlier this year with the onset of the pandemic related economic slowdown, we accelerated those initiatives, giving us line of sight to $50 million to $70 million savings in 2020. Implementation has been even more successful than we expected, and we are on track to deliver about $80 million in savings this year and to reach a run rate of more than $120 million by the end of 2021. We plan to turn this two-year project into an ongoing culture of operating discipline and continuous improvement with additional cost and efficiency targets. Our strategic approach to sustainability is another facet of this operational discipline and a key area of focus for Albemarle. Since we spoke last quarter, we have published our enhanced sustainability report, which expands on the four key quadrants of our sustainability framework and sets the baseline for our environmental performance and increased disclosures. Now, we are working to establish sustainability goals and targets and continue to make progress in each quadrant. This week, we also published our Global Labor Policy in alignment with International Labor Organization conventions and our human rights and global community relations and indigenous peoples policies, both consistent with UN guiding principles. These policies will be available on the sustainability section of our website. I'm proud to say that Albemarle generates more than 50% of our revenues from products that help reduce greenhouse gas emissions or promote greater resource efficiency, as our Lithium business grows and even larger proportion of our business will contribute to global sustainability. In summary, we are concentrating our efforts where they matter most, so we can continue to create sustainable value for our customers, investors, and stakeholders. Our growth projects at La Negra and Kemerton are key to increasing our battery grade lithium conversion capacity in line with long-term customer demand. La Negra III and IV is an expansion of our lithium carbonate capacity in Chile. The project is expected to reach mechanical completion in mid-2021, followed by a six-month commissioning and qualification process. La Negra III and IV allows us to add carbonate capacity at the very low end of the cost curve. Kemerton, our new lithium hydroxide conversion plant in Western Australia, is on track to reach mechanical completion by late 2021, with a six-month commissioning and qualification process to follow. Kemerton is core to growing our hydroxide capacity in line with expected strong long-term market demand. And with that update, I'll turn it over to Scott for more detail on our recent results."
},
{
"speaker": "Scott Tozier",
"text": "Thank you, Kent. Good morning, everyone. Albemarle generated third quarter net sales of $747 million, a decrease of about 15% compared to the prior year and in line with our previous outlook. This reduction was driven primarily by reduced prices in Lithium as expected coming into the year and reduced volumes in Catalysts and Bromine related to pandemic related economic weakness. GAAP net income was $98 million or $0.92 per diluted share. The non-GAAP adjustments this quarter were primarily related to restructuring for cost savings and discrete tax items with adjusted earnings of a $1.09 per diluted share. Lower net income was primarily driven by lower net sales, partially offset by costs and efficiency improvements. Corporate and SG&A costs were lower versus the prior year due to these cost savings initiatives. As Kent stated, adjusted EBITDA was $216 million, a decrease of 15% from the prior year. The success of our short-term and sustainable savings initiatives, as well as timing of equity income from the Callison JV helped us improve margins and beat the midpoint of our Q3 EBITDA outlook by about 20%. Turning to slide eight for look at the EBITDA bridge by business segment. Adjusted EBITDA was down $38 million over the prior year, reflecting lower net sales and lower equity income partially offset by cost savings initiatives and efficiency improvements. Lithium's adjusted EBITDA declined by $31 million versus the prior year, excluding currency. Pricing was down about 17%, partially offset by cost savings. Lower pricing reflects previously agreed battery grade contract price concessions for 2020, as well as lower market pricing in technical grade products. Lithium EBITDA margin benefited from cost savings and the timing of Callison JV shipments to our partner Tianqi. Bromine's adjusted EBITDA was down about $10 million, excluding currency. The decline was primarily due to lower volumes as a result of the pandemic related economic downturn, partially offset by ongoing cost savings. Likewise, Catalyst adjusted EBITDA declined by $30 million, excluding currency, primarily due to lower volumes offset by cost savings and efficiency improvements. Fluid Catalytic Cracking, or FCC, volume improved sequentially, but remained down compared to the prior year due to lower transportation fuel consumption as a result of travel restrictions, Hydroprocessing Catalysts, or HPC, volumes were also down compared to the prior year due to normal lumpiness of shipments and softness related to lower oil prices and reduced fuel demand. Our corporate and other category adjusted EBITDA increased by $15 million, excluding currency, primarily due to improved Fine Chemistry Services results. We ended the quarter with liquidity of about $1.5 billion, including just over $700 million of cash, $610 million remaining under our revolver and $220 million on other available credit lines. Total debt was $3.5 billion, representing net debt to adjusted EBITDA of approximately 3.2 times. Our commercial papers supported by our revolver, which is not due until 2024. And so that leaves about $670 million of short-term debt to be restructured or repaid over the next year. We expect to repay the 2021 debt maturities out of cash on hand, assuming continued economic recovery and cash inflows from divestitures. However, we are also working with our banks on a delayed draw term loan to backstop those 2021 maturities. If the economic recovery or divestitures are delayed, we'd be able to refinance the short-term debt using this new delayed draw term loan. As Kent highlighted earlier, our 2020 sustainable cost savings initiative is on track to achieve cost reductions of about $80 million this year. That's 60% above our initial estimates. We expect to reach run rate savings of more than $120 million by the end of 2021, up 20% from the previous outlook. We continue to expect a short-term cash management actions, such as travel restrictions, limited use of external services and consultants and working capital management to save the company about $25 million to $40 million of cash per quarter this year. Next year, we expect some headwinds as some of these temporary cash savings reverse. Finally, we're narrowing our expected range of 2020 capital spending to $850 million to $900 million, based on timing of spend. Our two major capital projects, La Negra III and IV and Kemerton remain on track for completion in mid-2021 and late 2021, respectively. They will begin generating sales revenue in 2022, following a roughly six-month qualification period for each plant. Turning to our outlook. This quarter is a transition from quarterly to annual outlook. Our next quarter, we expect to return to our normal practice of giving annual outlooks. As we approach the end of the year, we currently expect to deliver full year 2020 net sales of around $3.1 billion at the midpoint of our range. Adjusted EBITDA of between $780 million and $810 million, and adjusted diluted earnings per share between $3.80 cents and $4.15. Lithium's Q4 adjusted EBITDA is expected to increase 10% to 20% compared to Q3, 2020, as battery grade customers continue to meet planned volume commitments. Bromine's Q4 EBITDA is expected to be similar to Q3. Stabilization in electronics and building and construction continue to help offset weakness in other energies markets, particularly deepwater drilling and automotive. Finally, Catalysts Q4 EBITDA is expected to be down between 20% and 30% sequentially, primarily due to HPC volumes and mix. FCC demand is expected to continue to recover, with increased travel and depletion of global gasoline inventories. But Q4 is expected to be particularly weak for HPC Catalysts, in part because of normal lumpiness, but also as refiners continue to defer HPC spending into 2021 and 2022. As we look beyond this year, visibility remains challenging. However, we are seeing signs of improvement or at least stabilization in our businesses. EV sales remain a key driver for the growth of our Lithium business. Global EV sales were up 90% in the month of September compared to the previous year. September represented a new monthly record of EV registrations led by European EV sales. The rest of the world continues to rebound from the pandemic related slowdown earlier this year, with year-to-date global EV sales up 15%. The fourth quarter is also typically a seasonally strong quarter for auto sales. And similarly, IHS market expects global EV production to increase by 20% to 30% in full year 2020 and by nearly 70% in 2021. Our Bromine business supplies a diverse set of end markets and is generally driven by a broader consumer sentiment and global GDP. Consumer sentiment continues to improve in most regions, albeit, still below pre-pandemic levels. Analysts now expect global and U.S. GDP to be down about 4% in 2020 before rebounding next year. Finally, in Catalysts, after the sharp drop-off in March, U.S. miles driven has rebounded, but remains well below normal levels. Similarly, refinery capacity utilization has improved from earlier this year, but remains well below typical levels. Refinery utilization rates in the mid 70% range are a challenge for an industry design to run efficiently at utilization rates of 85% or higher. Given recent shifts in demand and refining economics, we don't expect to see pre-pandemic levels until 2022 at the earliest. Forecast and leading indicators like these help gauge the outlook for our end use markets. However, a variety of factors, including supply chain lags, contract structure, inventory changes and regulatory impacts can cause our results to differ from the underlying market conditions. Now, let's turn to slide 13 for our current view of 2021. In Lithium, we expect full year 2021 volumes to be relatively flat, as our plants are effectively sold out, given current volume constraints. We expect to see volume growth in 2022 as when La Negra III and IV and Kemerton come online for your 2021. Lithium prices are expected to be down slightly due primarily to lower average realized pricing for carbonate and technical grade products. Discussions with long-term battery grade customers are underway. It's too early to say what changes will be made to those contracts for 2021. Lower average market pricing and higher inventories may pressure pricing. At the same time, many of our customers remain concerned about security of long-term high quality supply, which speaks to the strong demand growth seen for electric vehicles. In Bromine, we expect full year 2021 results to improve slightly, assuming continued economic recovery and ongoing cost savings. Our Bromine business was probably the least impacted of our businesses during 2020. And that's part of the reason we expect a fairly modest improvement in 2021. And in Catalysts, we expect 2021 results to continue to improve from the very low level seen in 2020, but to remain well below 2019 levels. Near-term, Catalysts results are challenging as reduced refinery capacity utilization and lower oil pricing continues to pressure our customers' margins. In the longer term, this business is well-positioned in growth regions like the Middle East and Asia, and poised to benefit as refineries shift production to chemicals."
},
{
"speaker": "Kent Masters",
"text": "Thanks, Scott. Economic conditions are improving, but uncertainty remains, particularly if additional COVID-19 impacts lengthened the time to a full economic recovery. We have the playbook established and know how to manage through subsequent waves of COVID-19, as necessary. At the same time, we are confident in the long-term growth prospects of our core businesses and continue to focus on controlling what we can control. That means first and foremost, focusing on the health and wellbeing of our employees, customers and communities. It also means building operational discipline and sustainability into all aspects of our business, including manufacturing, supply chain, capital project execution and the customer experience. We remain confident in our strategy and we will modify execution that strategy to further position Albemarle for success."
},
{
"speaker": "Meredith Bandy",
"text": "All right. Before we open the lines for Q&A, I'd just like to remind everyone to please limit questions to one question and one follow-up to make sure that we have enough time for as many questions as possible and feel free to get back in the queue for additional follow-ups if time allows. Thanks, Marcus. Please proceed with the Q&A."
},
{
"speaker": "Operator",
"text": "Thank you. [Operator Instructions] Your first question comes from the line of Bob Koort with Goldman Sachs."
},
{
"speaker": "Tom Glinski",
"text": "Good morning. This is Tom Glinski on for Bob. So, first question is, you're guiding flat volumes in 2021 for Lithium, even though the battery chemicals market should be growing nicely next year. I guess, this suggests that you're going to be losing market share first, are you okay with that? And then second, if other producers capture that incremental volume in 2021 and get through that challenging qualification process with the customers, do you expect to regain that market share in 2022 and beyond, or is there a risk -- your competitors maintain that? Thank you."
},
{
"speaker": "Kent Masters",
"text": "Yeah. Tom. It's a function of our projects and when they're coming on and the capacity is coming on and who has that capacity to capture growth. So, there's not a lot we can do about that at this point. We're on our plan to bring that capacity on, but likely demand will pick up before we have that capacity, so we will lose a little share, but we expect that that'll move back to us as we get that capacity on as the market continues to grow out into the future."
},
{
"speaker": "Tom Glinski",
"text": "Great. That makes sense. And then, I guess, higher level, looking at 2021, considering the moving pieces between price down in Lithium, volume flat, but capturing some incremental cost savings. Do you think you can grow segment EBITDA next year, or is EBITDA going to be flat to down? Thank you."
},
{
"speaker": "Kent Masters",
"text": "Well, frankly, it's going to -- it'll depend on how the market develops over the year. Without having volume, we'll have some cost savings to offset inflation and those pieces, but we'll be close to -- we'll be around flat unless we get a material change in pricing."
},
{
"speaker": "Tom Glinski",
"text": "Got it. That makes sense. Thank you."
},
{
"speaker": "Operator",
"text": "Your next question comes from line of David Begleiter with Deutsche Bank."
},
{
"speaker": "David Fong",
"text": "Hi. This is David Fong here for Dave. I guess, first, just on pricing, because it's something that's pricing have bought in and even some carbonate pricing started to recover. I guess, if you can just elaborate a little bit more on your pricing weakness on carbonate in 2021, and do you expect that to broaden during the year, would that be like a 2022 story?"
},
{
"speaker": "Kent Masters",
"text": "Yes. I'll make a comment and then let Eric give you a little bit more detail or his perspective. So, I mean, that's the magic question. It looks like when you look at the indices out there that it's at least bottomed, if not starting to pick up a little bit, but we'd probably need to see that a bit more to have more confidence. But we're anticipating that turns up during 2021. And the question is when during 2021? So, Eric, you want to add something?"
},
{
"speaker": "Eric Norris",
"text": "Yes. I can add. Specifically relative to carbonate, this is -- when we look at where the growth is coming in, in the coming year, we look at what's happened this year. It's more of a hydroxide growth story. Carbonate is therefore not enjoying as much of that. There is some growth in China. China is where we see more of these low prices and it's a more oversupplied market. Now, so, it is the magic question, as Kent refer to, we have on some reported indices seen it picking up, others see it flat. It's -- even from the price reporting groups, that -- report price around the world and in China specifically, it's murky and well below marginal cash costs. So, the price of carbon has gone well below what we thought it would have gone six months ago. It is trending up in one report. We'll have to see. Our view would be that given the supply dynamics I talked about and the growth being more driven on the hydroxide side that a clear movement above marginal cash costs for the spot prices of carbonate is more likely at 2022 event. I mean, not to say it couldn't happen in 2021, but that looks more favorable in 2022 hydroxide, however will be different we believe."
},
{
"speaker": "David Fong",
"text": "Thanks. And then, on Catalysts, it looks like the recovery is a little bit slower than expected. So, since you're -- I mean, sales should be up slightly in 2021, I guess, what kind of improvement are we talking about? And then, just given that if we say the current pace of recovery in Catalysts, sales you expect that we can achieve the same level of EBITDA in 2022 as 2019 level?"
},
{
"speaker": "Kent Masters",
"text": "So, I'll comment and Raphael can also comment. But I think a lot of that -- it depends on demand and the view of -- when driving comes back, when travel comes back and it's really about fuel demand and refinery utilization for us. So, our view, we don't see us getting back to 2019 levels for 2020, until into 2022, probably very late 2022 would be back to that both from a fuel demand utilization and from our perspective as well."
},
{
"speaker": "Raphael Crawford",
"text": "This is Raphael. I think, that's right, Kent. And when we look at the outlook, there's a few things that play in. One is the impact of the pandemic. And when do fuel volumes recovered to 2019 levels and that's a volume component, and the other is refining margins. So, there's a lot of pressure on refineries right now, or just total value of refined products from a margin perspective has gone down. And when that recovers, that's going to be dependent on volume, but also on utilization industry capacity. And so, we wouldn't see that returning $0.10 until sometime 2022 timeframe."
},
{
"speaker": "David Fong",
"text": "Okay. Thank you."
},
{
"speaker": "Operator",
"text": "Your next question comes from the line of Mike Harrison with Seaport Global Securities."
},
{
"speaker": "Mike Harrison",
"text": "Hi, good morning. Coming back to this idea of that Lithium volumes are sold out for next year, if there is some additional demand pickup or if some of this over supply or inventory gets worked down, could that put you in a position to drive higher pricing? And can you maybe also comment on whether you have any flexibility to move more volume or to maybe accelerate some of your production, if you do see a demand picking up?"
},
{
"speaker": "Kent Masters",
"text": "Yeah. So, if the market gets tight and the supply is not there, I mean, prices should move up. When we -- we kind of expect to see that around hydroxide less about -- less with carbonate and it's difficult. I mean, we had delayed our projects a bit when the pandemic hit, because we just didn't know what things were going to look like. And as soon as we got some visibility, we kind of tried to pull those back as much as possible and we haven't lost much time on that. And we haven't really lost -- our capital estimates are still kind of in the same range as well. So -- but it's really not possible for us to pull it more forward than our current plans. We wouldn't be able to sell right now to impact when those projects are coming on stream. So, from our perspective, I don't think we're going to have extra capacity to what we are anticipating. We may be a little early with the projects are planned, but it's not going to be a dramatic."
},
{
"speaker": "Mike Harrison",
"text": "I think everybody's kind of focused on what's happening here in the U.S. from a political standpoint, but can you maybe talk about Chile and whether some of the political news there could impact your relationship with the government or your rights in the Atacama?"
},
{
"speaker": "Kent Masters",
"text": "Right. So, while -- you know what's happening there, so they're going to redo their constitution. That's going to -- that's a pretty long process that they have in place to do that. And so far that's all been without too much turmoil. So, we don't -- we have to wait and see what that constitution looks like. We don't really expect it to impact our rights in the Atacama, but I mean, I guess that's something we'll have to wait and see. I don't think it would be -- I mean, it's not until our interest to start changing how they work with the international community. Chili's got a great reputation following the rule of law and having a strong economy in South America. It's kind of the example. So, I don't think they want to change that, but it's something we'll have to watch very closely as that plays out."
},
{
"speaker": "Mike Harrison",
"text": "All right. Thanks very much."
},
{
"speaker": "Operator",
"text": "Your next question comes from line of Vincent Andrews with Morgan Stanley."
},
{
"speaker": "Vincent Andrews",
"text": "Thank you, and good morning, everyone. Just wondering, you talk about sort of 60% of your assets, you're going after what the new -- two new projects that are going to come on. What about the other 40%? Can you talk from a medium term perspective? What's it going to take for you to go after those assets, how much money it would require and CapEx spending? And at what point will you start talking about how you'll go after that and how you'll finance it?"
},
{
"speaker": "Kent Masters",
"text": "I'm not -- Vincent, I'm not sure I'm clear on the question. So, to go after the other 40% of the asset?"
},
{
"speaker": "Vincent Andrews",
"text": "Yeah. I guess, my question is, what -- when should we anticipate the other 40% coming online and how much will you have to spend to do it?"
},
{
"speaker": "Kent Masters",
"text": "From a resource standpoint you're talking?"
},
{
"speaker": "Vincent Andrews",
"text": "Correct."
},
{
"speaker": "Kent Masters",
"text": "Yeah. Okay. So we have access to those resources. So, it's just about building conversion capacity. So, we've kind of started that process. So, La Negra and Kemerton is part of that. So we're building that out. We'll sell those plants out and then we'll layer in additional capacity to go after. I mean, that's our strategy and our plan longer term. We haven't necessarily laid out a CapEx program publicly over time. But that's the plan as we build capacity and then we sell it out and then we reinvest."
},
{
"speaker": "Vincent Andrews",
"text": "Sorry. As a follow-up then, to the earlier question about market share, how do you think about the medium term in terms of not per se, having a suggested timeline for that other 40% of production versus how fast do you think the market's going to grow? Do you think you'll be able to bring that 40% on -- in conjunction with market growth, or is it possible that it'll lag?"
},
{
"speaker": "Kent Masters",
"text": "Well, we'd be layering in that capacity. So, what we're trying to do is kind of get it just right. So we add capacity as the market grows and bring that on as it's required. And it's a matter of -- how well we execute and how well we forecast the market, but we think we can. That's what we're trying to do."
},
{
"speaker": "Vincent Andrews",
"text": "All right. Thank you very much. I appreciate it."
},
{
"speaker": "Operator",
"text": "Your next question comes from line of John Roberts with UBS."
},
{
"speaker": "John Roberts",
"text": "Thank you. Nice progress on the cost savings efforts. The -- that backstop indicates some uncertainty here in the divestment process for fine chemicals and catalyst additives. Are we expecting one buyer for both or two? And do you think both will be announced before year-end?"
},
{
"speaker": "Scott Tozier",
"text": "Hey, John. This is Scott. So, we're expecting that we'd have two different buyers for those two different businesses. Discussions continue favorably on both of those. A little bit too early to call exactly when would build to announce -- announced a deal on either one of them, but obviously we're pushing hard to do that. The backstop is also related to economic uncertainty. And so, we just got to -- I think we've just got to get through the winter period and the increasing COVID cases and whatever the government reactions to this are to fully understand kind of where we end up in 2021. And that's -- it's really just a safety valve for us, in case things go the wrong direction. And the banks have been very supportive of us in our story. So, really appreciate their contributions."
},
{
"speaker": "John Roberts",
"text": "And then you mentioned in the third quarter, the benefit of a timing, Callison and shipments to Tianqi, was that a catch-up from 2Q? It doesn't sound like it's a pull forward from the fourth quarter, given the strong fourth quarter guidance."
},
{
"speaker": "Scott Tozier",
"text": "Yeah. You've got it right, John. It was really a catch-up from the Q2 shutdown that they had. And just from an accounting perspective, when Tianqi takes more product, we ended up getting that equity income immediately. So, it helps our bottom line."
},
{
"speaker": "John Roberts",
"text": "Great. Thank you."
},
{
"speaker": "Operator",
"text": "Your next question comes from Arun with RBC Capital."
},
{
"speaker": "Arun Viswanathan",
"text": "Great. Thanks for taking my question. Good morning. Yeah. Congrats on the results. Definitely nice to see the cost reductions playing out. I just wanted to ask about the contracting side on Lithium. You -- I think you had offered concessions to some of your customers this year in 2020, did you find the need to extend those concessions in the 2021? Could you just maybe comment on the contracting environment out there? Thanks."
},
{
"speaker": "Kent Masters",
"text": "So we -- well, we're in the process of having those discussions with our customers. So I mean, you're right. We've made concessions late 2019 for the 2020 period. They were one year concessions. Market price is lower than it was at the time we made those concessions today. And so, we're having discussions about what -- those contracts will look like for 2021. At the moment it is too early to kind of give any -- too much guidance on exactly what that looks like, because we're having those discussions today."
},
{
"speaker": "Arun Viswanathan",
"text": "Okay. I appreciate that. And then I guess on that note, I imagine that you maybe extending or rolling over maybe three-year contracts that you signed up in 2016 or 2017. Is that going on? When do you expect to do that? And I guess, would you expect to revert to the prior price umbrella on those contracts, or is there potential for those negotiations to result in pricing closer to market levels at this point?"
},
{
"speaker": "Kent Masters",
"text": "Eric, do you want to talk a little bit about the contracting strategy?"
},
{
"speaker": "Eric Norris",
"text": "Sure. So, to answer that first part of that question, Arun, we don't have any contracts -- any major better grade contracts with turnover next year. It's not to the following year in 2022 that we have one that does turnover. That being said, it might be worthwhile to discuss what we're trying to do, right? And with our contracts that just as a recollection of what we shared in the past, we're moving from what previously was a singular fixed price contract for all customers to a more segmented approach. And really putting that into -- I would put it simply into three buckets. One is, there'll be a group of customers that as we talk in the future with them, and we've actually had some new customers come in. So, we have some brand new LTS, one we've signed during the quarter, that is prospectively for the Kemerton volumes when they come online. So that first category our people that really want very little volatility in their price and our will -- and as a result, we are looking at or negotiating a fixed price with them. That's well above current prices and favorable investment economics for us. There's a second category that may want to have a little bit more volatility, but not quite so much. They don't want to have a nosebleed price when the market recovers. And we're insisting on a floor that we have -- we can earn a favorable reinvestment economics over that pricing cycle. That's that second category. And then there's a third, it'll be priced buyers. Now, our aim and the way this is shaping up is that we expect about once we have moved from this old contract structure to the new, and this price concession we gave this year is that bridging between the two contract structures, it's about 20% in that price bucket and about 80% in the first two buckets. And it's that 80% that driver capacity expansion. What they commit to us to -- these owners term contracts is the basis for our adding capacity over time. And any access is what we would then sell into the -- to the price market. So, we don't build for that price market, and we don't commit very long to that price market. That's the strategy. Where we are today, quite encouraging. We're starting to see with as a second six months of the year has come about. And you're looking now at 2021 as a very strong, we believe, demand curve associated with it. And we're starting to see that already in Europe. We're already 15% up year-to-date. With that -- with those positive signals coming through the channel, we're seeing more and more customers coming to us and wanting to talk with us about long-term contracts that have favorable reinvestment economics to us. Or transitioning their existing legacy contracts to that new structure I just described in a way that allows favorable reinvestment economics for us. And that is absolutely paramount, because I think a lot of the -- the rest of the industry that's still buying on price is not appreciating the fact that a current price is no one's going to expand and there isn't going to be sufficient lithium for them. And so having more and more customers, including automotive OEMs become aware of the need for reinvestment economics on behalf of the lithium supply industry is starting to turn the tide. 2021 will be -- because of the pandemic, it's going to be a bit of a transitional year. We're still working through that. That's why there's some uncertainty. And, of course, we talked about the weakness already in carbonate, but maybe that's helpful additional context to your question, Arun."
},
{
"speaker": "Arun Viswanathan",
"text": "Very helpful. Thanks a lot, Eric."
},
{
"speaker": "Operator",
"text": "Your next question comes from Laurence Alexander with Jefferies."
},
{
"speaker": "Laurence Alexander",
"text": "Hi. Could you give a sense for your current thinking around inventory management? How much of an inventory build you need to do next year to prepare for the growth curve you expect in 2022 to 2023?"
},
{
"speaker": "Kent Masters",
"text": "Okay. So, I'm assuming you're talking about Lithium, that’s where we -- all the inventory questions come from -- one to qualify that. So, next year, I mean, we -- the inventory is probably in the channel. We don't think it really changed much from what we said in the last quarter. And we're saying demand has picked up and it feels better, but we don't have data to say that inventory is any less than it was last quarter. So that still has to be worked off. But given the demand profile we see in 2021, and our limited capacity, we got up -- we don't expect to build inventories there. We would expect actually to meet. We'll work those down. And then we're working off of what we would consider kind of standard inventory in the channel. So, we don't see it building at least from our perspective through 2021. We see us working inventories off."
},
{
"speaker": "Laurence Alexander",
"text": "And then can you -- instead for Bromine, given the trends in the end markets, what negative factors do you see keeping the Bromine improvement next year at fairly modest?"
},
{
"speaker": "Kent Masters",
"text": "Netha, you want to make a few comments on that?"
},
{
"speaker": "Netha Johnson",
"text": "Sure. I think that the biggest impact for us is the overall macro economy. We tend to be driven by global GDP. So that's really the limiting factor for us is how fast this thing's going to come back. And this is going to come back in a stable, consistent way or is it going to be lumpy. And right now it's just a little bit unclear how that recovery is going to take place across the globe in 2021."
},
{
"speaker": "Laurence Alexander",
"text": "Thank you."
},
{
"speaker": "Operator",
"text": "Your next question comes the line of Joel Jackson with BMO Capital."
},
{
"speaker": "Robin Fiedler",
"text": "Hi. This is Robin on for Joel. Can you provide some more order of magnitude around the guidance of the Catalysts EBITDA you expect next year? Is it reasonable to be about halfway between 2020 and 2022? Was it more likely to be above or below that level? If you can just kind of walk through some of the key building blocks to get there."
},
{
"speaker": "Scott Tozier",
"text": "Hey, Robin. This is Scott. Let me make a quick comment and maybe Raphael can give some additional color. It's really going to depend on refinery utilization rates as well as transportation fuel demand. And given what we're seeing in projections right now, it's likely in the bottom half of that range that you just gave versus the top half. But maybe Raphael, you can add some more color as to what you're seeing."
},
{
"speaker": "Raphael Crawford",
"text": "Hi, Robin. I think that Scott characterize it correctly. But over the next six months, I think we'll have a much clearer picture as to what that recovery will look like. As we see demand recovery, we see margin progress as refineries, we will have a better sense of that. But I wanted to at least give you a sense rather than -- while, it's going to be a challenging 2021, better than 2020. The business is still very focused on the right steps to return to growth in the future with a focus on chemicals, with a focus on refineries East of Suez, where demand continues to grow. So, while we have a challenge, we also have good strategies to establish us for long-term recovery and growth."
},
{
"speaker": "Robin Fiedler",
"text": "That's helpful. Thank you. And just as a follow-up. I apologize, did I hear correctly early in the call that it was mentioned that Lithium EBITDA will be closer to flat for next year? I assume the cost savings or Lithium's portion of the cost savings is offsetting that -- slightly little pricing, is that right?"
},
{
"speaker": "Scott Tozier",
"text": "Yeah. Robin, this is Scott. I think, you had about right. It's really a little bit early to call exactly what the number is going to be. But Lithium EBITDA should be flat to maybe down a bit, just given the dynamics that we're seeing."
},
{
"speaker": "Robin Fiedler",
"text": "Okay. Thank you."
},
{
"speaker": "Operator",
"text": "Your next question comes from the line of P.J. Juvekar with Citigroup."
},
{
"speaker": "Prashant Juvekar",
"text": "Yes. Hi. Good morning. So, it looks like you have some limited capacity growth and you might lose some share next year. Why couldn't you build inventories in 4Q here to sell -- so as to not to lose share? And then secondly, some of your capacity is still idle, like the Wodgina mine and what does it take for you to start that back up?"
},
{
"speaker": "Eric Norris",
"text": "Kent, would you like to take?"
},
{
"speaker": "Kent Masters",
"text": "Yeah. I'll start. So, first question about inventory. So, I mean, there's a limit on inventories on hydroxide, and we -- and they're a little more than normal in the channel and we've actually shutdown some facilities to manage that a little bit, because there's a life on hydroxide. So, you want to be careful about how you manage those inventories. So it -- and we'll work through those inventories the next year. So, we'll be able to probably -- we'll sell more than we'll be able to make. So, we are doing that to some degree, but we're limited by kind of the life of hydroxide. And that's where the extra demand comes from. The other question on Wodgina, so our limitation is on conversion capacity, right? So, Wodgina does not producing, but that's because we can't -- we don't have capacity to convert that. So, Kemerton brings us -- gets us going in that direction. And then we would just -- we have to manage between Wodgina and Callison about how that -- what resource we use there. So -- but we're limited more on conversion capacity. So we'd be needing to add additional conversion capacity to take full advantage of our resources."
},
{
"speaker": "Eric Norris",
"text": "Yeah. Just to add Kent on -- this year – P.J., we are selling all the hydroxide that we can make. So, we're sold out this year. In fact -- and that's where -- we've made the concessions, we talked about on price and the leverage for that as we're getting the volumes this year that we planned the reason for the upward guidance for the fourth quarter. So, we're getting what we intended. And in fact, we'll be up year-over-year on volumes overall. I mean, we expect industry to be down. So, this will be in that regard, a solid year for Lithium. As you go into next year, Kent hit it, conversion capacity. In fact, our ratio of mining capacity to conversion capacity, mining potential to actual conversion backs is about quarter one. So, it's about more conversion assets. And we're being -- as we talked about in terms of managing our cash flow and managing our profitability, very disciplined about how we bring that conversion capacity to market. Next year will be a flat year, but we'll have significant capacity we bring on in 2022 and be in a position as we ramp those plants to recover any lost ground we have with our customers. And as I earlier said, we've also started to draw up new contracts with customers before that volume in that year."
},
{
"speaker": "Prashant Juvekar",
"text": "Thank you for that color. It's interesting you're saying conversion capacity is the bottleneck, Kent, maybe related to that, can you talk about what's happening to conversion capacity in China? I know they -- at some point back in 2015, 2016, they were constrained that they overbuilt. Where do we stand on convergent capacity utilization in China? Can you just give us some update there? And could you -- and also, could you take some of your volumes into the Chinese third party conversion? Thanks."
},
{
"speaker": "Kent Masters",
"text": "So, Eric, you want to …"
},
{
"speaker": "Eric Norris",
"text": "Yeah. Sure. So, in China, as you know these Chinese converters -- now, I assume you're talking not about our integrated competitors, such as [indiscernible] and kind of you're talking about other non-integrated producers, those do not own a resource. They're dependent upon economics, right? And they're net buyer of -- they have to buy their rock. Many of those minds have been curtailed. Alterra being the latest victim of low market prices and been able to operate. So, supply for rock has dried up and they'd been sustaining themselves to available inventory. That's one factor. Another factor is they themselves -- their current carbonate prices are breakeven at desk, and most are operating at a loss as we see the price in China -- spot prices in China below marginal cash costs. So, it's a pretty challenging economic picture for those producers. Market recovery, we expect that capacity to come back. And China's going to remain a very healthy market for Lithium into the future. So, I think there's going to be a place for those producers. In terms of our going in, as you know, we're looking in terms of growing our capacity. We've talked about buying versus building capacity. We still are evaluating that approach. And that means a viable expansion route for us. It's the way we got the capacity we have today, the basis for how we got our current Chinese conversion capacity. We are less inclined particularly for hydroxide, which is the growth part of the market, where there's a lot of process, know-how quality differentiators to teach at a toll producer, how to do that. And that's proprietary know-how that we would be concerned we'd lose, if we were to toll. So, our bias would be to acquire."
},
{
"speaker": "Prashant Juvekar",
"text": "Great. Thank you, Your next question comes from the line of Mike Sison with Wells Fargo."
},
{
"speaker": "Mike Sison",
"text": "Hey, good morning. Nice quarter. As I recall, you've got $40 million in carbonate coming on and -- I guess in 2022 and $50 million in hydroxide in 2022. How much of that is already sort of contracted out and how long do you think -- how long would you think you'll take to sell those out?"
},
{
"speaker": "Kent Masters",
"text": "So, your numbers are right. Although, they're not going to -- it's not going to turn on day one at those capacities, right? So, there's a ramp in our manufacturing processes to get us up to those full capacity. So, they won't come on all it, when you just turn a switch. Unfortunately, it doesn't work like that. And Eric, you want to talk about kind of the ramp of sales versus production."
},
{
"speaker": "Eric Norris",
"text": "Yeah. So, we're -- I mentioned earlier, Mike, that we are on the -- particularly on the hydroxide side, which the tighter market, we are entertaining. Well, first of all, we already had long-term contracts, actually long-term contracts that had earmarks, if you will, against that capacity when it came on. And now we are having additional -- we signed one recently, as I said, during the quarter to increase that utilization of that plant. And we're in negotiation with still others. So, I don't think -- we're at liberty yet to share the details of exactly how much, but I would say significant portion of the Kemerton capacity is well shared from a sales standpoint. On the carbonate side, a little different. Most of the carbonate market is in -- is increasingly in China. As you know, the China market is a much shorter term contracting market. We have been very diligent to maintain relationships with our existing capacity out of a mega one and two, relationships and ongoing buying relationships, or sales to a number of leading Chinese producers with whom we are talking about growing our business. We are talking with him about committed volumes -- the nature of contracting that was different with those. So, it's going to be a little different with carbonate in terms of -- we'll be closer to bringing that to market before we have firm prices with -- for that volume. Though, remember that we're at the low in the cost curve. So, still very attractive business. Not withstanding the fact that it won't have some of the same long duration contracts that we see on the Kemerton inside."
},
{
"speaker": "Mike Sison",
"text": "Right. Great. Thanks. And then a quick one on Catalysts, any thoughts on pricing for FCC heading into 2021?"
},
{
"speaker": "Kent Masters",
"text": "Raphael, you want to comment?"
},
{
"speaker": "Raphael Crawford",
"text": "Sure. Mike, this is Raphael. I think pricing in FCC has been challenged in 2020 for non-contract volumes. Non-specialty non-contract volumes have been under the most pressure in response to -- in decisions by refineries to look for perhaps less special -- less specialty catalysts in order to help their near term economic pain. Going into 2021, I think the trend would continue. I mean, I think, we'll continue to see pressure on non-contracted volumes, but where we create a differential value, namely in areas like high propylene yields, I think we'll continue to hold onto price and remain strong in that area."
},
{
"speaker": "Mike Sison",
"text": "Great. Thank you."
},
{
"speaker": "Operator",
"text": "Your next question comes from the line of Chris Kapsch with Loop Capital Markets."
},
{
"speaker": "Chris Kapsch",
"text": "Yeah. Good morning. Thanks for taking my question. So sort of a follow-up on Eric's comprehensive comments about the shifting approach to the contracts and really, I guess, against the context of some of the anecdotal commentary about hydroxide versus carbonate. It seems like the oversupply is still a little more acute in carbonate versus hydroxide. So -- and then you obviously have this tension about some customers wanting near term pricing release and others maybe more focused on concerns about longer term supply. I'm wondering if those conversations reflect this bifurcation hydroxide versus carbonate. And if you could take another -- a little bit further, is it -- as this plays out, is it more likely in the context of those buckets that you described, Eric? More likely that the hydroxide guys are going to fall in this bucket where they want fixed prices, security of supply, and the carbonate customers are more likely to be willing to play some of the volatility."
},
{
"speaker": "Eric Norris",
"text": "Sure. Any advanced comments Kent, before I dive in?"
},
{
"speaker": "Kent Masters",
"text": "No. Go ahead."
},
{
"speaker": "Eric Norris",
"text": "Okay. So, I think the reflection about -- everything I've described and you asked Chris, is both -- there is a difference between carbonate and hydroxide. More of the carbonate market going forward will be in China. And to date, I don't see that same approach to security of supply in terms of contracting with us or with anybody for that volume. Rather I see that they -- that the market tends to be content to go for short duration on the bet that resources will continue to come online, converse best -- continue to come online and there'll be sufficient capacity. And there's also a bifurcation that based on who's buying, right? More of the purchasing decision is moving closer to the point of views. So it's moving to the battery producers and the automotive producers. And they given the investments they are making in the length of supply chain, whether it be carbonate or hydroxide tend to want longer the surety that they're going to have it, because of the size of investments they're making. Not everybody's doing that, but increasingly more are, and more becoming, I think, appropriately aware of the need to do that. So, it's also who we're contracting with and in these long-term contracts that plays a factor in that."
},
{
"speaker": "Chris Kapsch",
"text": "Okay. Thanks for that. And then just as a follow-up. Could you -- I think the last quarter you characterize the inventories that you saw in the supply chain. Any update on that? And also just any changes to the timeline on the idling of your convert -- your hydroxide conversion facility in North America. Thanks."
},
{
"speaker": "Eric Norris",
"text": "Yeah. So we have -- so first of all, I'll just reiterate what Kent said. Look, it is imperfect. The science of assessing how much inventory is in the channel. We can survey our customers and we do, and that gives us a basis for understanding that. We obviously don't know what our competition holds and they -- and some of held quite a bit. If we look at it things net-net, the overall months of inventory in the channel still about the same as it was three months ago, five months of execs, roughly speaking. Though, I think that shifted. There's probably more carbonate than hydroxide now. So, carbonate has built up a bit and hydroxide drawn down a bit. Again, we are probably wrong about that, but directionally correct. It doesn't feel that different. It feels a little bit better because I think that the pull-on hydroxide, but not too different. I'm sorry. Then you had a second part of your question, Chris?"
},
{
"speaker": "Chris Kapsch",
"text": "The timeline of your idling of your hydroxide conversion facility?"
},
{
"speaker": "Eric Norris",
"text": "Yeah. We have -- we are in the process of restarting the Kings Mountain hydroxide facility. Now, employees are returning that's sooner than we thought. And that's based upon the improvement we're seeing for demand next year and some of the earlier questions around, can you please try to get more volume next year. So, we're ramping that plant up. It's a small plant, so it has a very small impact to the overall volume growth, but we're starting that up. And Silver Peak, which is the feedstock plant that feeds that hydroxide plant with carbonate feedstock will restart on schedule beginning of the year 2021."
},
{
"speaker": "Operator",
"text": "Your next question comes from the line of Colin Rusch with Oppenheimer."
},
{
"speaker": "Colin Rusch",
"text": "Thanks so much, guys. Can you give us a sense of how mature the conversations are on the financing side? It sounds like things are going pretty well and there's some pretty meaningful opportunities to reduce your cost of capital going forward. But just curious how far down the road you are on then?"
},
{
"speaker": "Kent Masters",
"text": "Yeah. No, we're well advanced in those discussions. So, feel comfortable about where we're heading."
},
{
"speaker": "Colin Rusch",
"text": "Excellent. And then the Lithium mark has been pretty well belabored [ph]. But I'm just curious if you're seeing any consolidation in terms of battery OEMs, given where we're seeing capacity efficient. It looks like there's going to be a handful of folks that really stride out here. And if there's any consolidation kind of below that with some of the cathode producers, as you look out over the next three to five years?"
},
{
"speaker": "Kent Masters",
"text": "Eric?"
},
{
"speaker": "Eric Norris",
"text": "Yeah. Sure. Thanks, Kent. So, on the battery OEMs, I don't be interested to see what you see, Colin, because we don't see that. In fact, I've seen the opposite. You've seen new players come into the market not very recently, but companies like [indiscernible] come into the market for Europe, and many other multi-nationals who have played around this space in the past, I think looking to come in to support the growth of the European market. So, I see more players coming into the market on the battery side, not less, and some of that's being supported and driven by the automotive OEMs. So, I think, want more op -- they want some negotiating leverage, right? They want more options, or they want more localized options for in the case of Europe. On the cathode side, it is constantly changing, right? This is the part of the market that has, as I said, is not necessarily directly involved in the person decision as much anymore, is being told what to make either by the automotive OEM or the battery makers. So, they're losing some of their power in the decision channel. And so I do expect some change consolidation. I can't point to any obvious ones now, but there's disruption. There's people gaining share and losing share. And so, I think, we'll continue to see evolution in that part of the channel. And also some backward integration, right? You have some battery makers now are building their own in-house cathode capabilities."
},
{
"speaker": "Colin Rusch",
"text": "That's super helpful. I'd love to have that conversation offline. Thanks, guys."
},
{
"speaker": "Operator",
"text": "At this time, we have no further questions. I will now turn the conference back over to Ms. Bandy."
},
{
"speaker": "Meredith Bandy",
"text": "All right. Thank you all for your questions and your participation in today's conference call. As always, we appreciate your interest in Albemarle, and this concludes our earnings conference call."
},
{
"speaker": "Operator",
"text": "This does conclude today's conference. You may now disconnect."
}
] | Albemarle Corporation | 18,671 |
ALB | 2 | 2,020 | 2020-08-06 09:00:00 | Operator: Ladies and gentlemen, thank you for standing by. And welcome to the Q2 2020 Albemarle Corporation Earnings Conference Call. At this time, all participants are in a listen-only mode. After the speaker presentation, there will be a question-and-answer session. [Operator Instructions] Please be advised that today’s conference is being recorded. [Operator Instructions] I would now like to hand the conference to your speaker today, Meredith Bandy, VP of Investor Relations and Suitability. Please go ahead, ma’am.
Meredith Bandy: Hi. Thank you, Joel, and thanks everyone. And welcome to Albemarle’s second quarter 2020 earnings conference call. Our earnings were released after the close yesterday and you will find our press release, presentation and non-GAAP reconciliations posted to our website under the Investor section at www.albemarle.com. Joining me on the call today are Kent Masters, Chief Executive Officer; and Scott Tozier, Chief Financial Officer. Raphael Crawford, President, Catalysts; Netha Johnson, President, Bromine Specialties; and Eric Norris, President, Lithium, are also available for Q&A. As a reminder, some of the statements made during this conference call including our outlooks, expected company performance, expected impacted impacts of the COVID-19 pandemic and proposed expansion parents -- plans may constitute forward-looking statements within the meaning of federal securities laws. Note that the cautionary language about forward-looking statements is contained in our press release and that same language applies to this call. Please also note that some of our comments today refer to financial measures that are not prepared in accordance with GAAP. A reconciliation of these measures to GAAP financial measures can be found in our earnings release and the appendix of our presentation, both of which are on our website. With that, I will turn it over to Kent.
Kent Masters: Thank you, Meredith, and good morning, everybody. On today’s call I will cover a high level overview of the current environment, give an update on our strategy and highlight some of the actions we are taking to improve the sustainability of our business. Scott will then review second quarter financials, provide updates on our balance sheet and cost saving initiatives, and review our outlook. I want to reaffirm that the safety and welfare of our people is our highest priority at Albemarle. Our core values are always define how we operate but even more so in the difficult situations we face today. During the pandemic, we have been able to continue to operate, because we care about the welfare of each other. We humbly acknowledge that this crisis is not about us but about everyone and we show integrity by doing the right thing. Thankfully the pandemic has not materially impacted our operations to-date. I deeply appreciate the courage and continued support of the frontline essential workers in our communities and our dedicated Albemarle employees, who continue to ensure safe operations at our facilities and offices worldwide. At this point in time, we have had relatively few diagnosed individuals out of more than 5,600 global employees, using our exposure protocol we have traced the contact path for any confirmed case among employees and have isolated colleagues as needed. We are staying in close contact with impacted employees to monitor their welfare. We are grateful that previously diagnosed employees have recovered or are recovering as expected. In areas where we are seeing unfavorable trends, such as Chile and parts of the U.S., we are extending work-from-home requirements for non-essential workers and working closely with our manufacturing sites to ensure safe operations can continue. At many of our locations non-essential employees have returned to work. We continue to be in close contact with site teams to support them and health -- in a healthy and safe return process. Our global cross functional COVID response team continues to meet weekly to mitigate the impact to our operations and manage the impacts to customer demand. Turning to recent results. Yesterday we released second quarter financials, including net income of $86 million or $0.80 per share and adjusted EBITDA of $185 million, down 29% from prior year. However, I am pleased to say that these results were at the high end of our previous outlook. Thanks to better than expected performance in Lithium and in Bromine. Our primary capital priorities continue to be paying dividends to shareholders, preserving our investment grade credit rating and maintaining our long-term growth profile. To that end, during the quarter we announced a dividend of $0.385 per share in line with the prior quarter and up 5% from last year. We continue to maintain adequate financial flexibility with liquidity of $1.5 billion and our previously announced cost saving initiatives are also on track. At a high level, Albemarle’s strategy has not materially changed. We will invest in and grow our Lithium business and we will fund Lithium growth with cash flows from our more mature businesses. Historically, we have actively managed our portfolio to generate shareholder value and will continue to do so. We will also maintain a disciplined approach to capital allocation. The difference is that the COVID-19 pandemic has pushed Lithium growth out by at least one year, while also impacting near-term cash flow from our other businesses. Our response is to broaden and accelerate our focus on operational discipline to continuously raise the bar on performance. And specifically, manufacturing excellence to drive best-in-class cost management and product quality with a relentless focus on safety, standard work, continuous improvement, and the application of gleam principles across our manufacturing operations. In business excellence to deliver exceptional value and service to our customers, and to capture profitable high value opportunities to tailor value propositions and optimize -- optimized business processes and resources, so customer facing, as well as back office. And capital project excellence to effectively manage capacity to demand through the use of standard reliable designs and discipline planning and process management. We know that being profitable and doing what’s right are not at odds with each other. We expect to do both well and our sustainability framework is our guide. In terms of our people and workplace, we continue to advance and promote inclusion and diversity across our organization. Last year, we added two highly experienced female Board members, currently 50% of our directors represent gender and racial diversity, which broadens the range of perspective, experiences and insights we can leverage to benefit our organization. Recent events of discrimination and violence against black citizens in our communities remind us that we need to work much harder to fight racism. As a result, we have introduced a multi-pronged strategy to refocus our inclusion and diversity efforts from the bottom up, as well as the top down. Current activities include the addition of a dedicated senior inclusion and diversity leader, unconscious bias training for leaders and incorporating inclusion and diversity into the onboarding process for all new employees. We are also focused on responsible natural resource management, water management is an important sustainability objective for Albemarle and to continue to grow it’s imperative that we manage water efficiently. One example of this is that our facility in Magnolia, Arkansas, one of the world’s largest Bromine and Bromine chemical sites, Magnolia uses as an artificial Marsh as a unique water treatment facility. We are actively collaborating and engaging with our communities. Our Lithium operations at the Salar de Atacama in Chile works closely with the local communities to promote environmental stewardship and foster the community’s long-term development. We share a percentage of our revenue with local indigenous communities and more than 35% of our employees in the region are indigenous. Finally, our sustainability business model helps create long-term value for all shareholders. For example, about 50% of our Catalyst revenues are from products that reduce SOx and NOx emissions to produce cleaner transportation fuels. In 2019, the use of our Catalysts prevented the release of about 10 million tons of sulfur into the environment. In the coming weeks we will publish an updated sustainability report to provide increase transparency and disclosure around these and other important topics as discussed at our Investor Day late last year. We are excited about the progress we have made on sustainability, but we also recognize that sustainability is by its nature a long term journey. In 2021 and beyond, our focus will shift from setting the baseline on sustainability performance to goal setting and continuous improvement. With that as a backdrop, I will turn it over to Scott for more detail on our recent results.
Scott Tozier: Thank you, Ken, and good morning, everyone. Albemarle generated second quarter net sales of $764 million, a decrease of about 14% compared to the prior year. This reduction was primarily driven by reduced prices in Lithium as expected coming into the year and reduced volumes in Catalysts and Bromine related to the COVID-19 pandemic. GAAP net income was %$86 million or $0.80 per diluted share. The non-GAAP adjustments this quarter were primarily related to restructuring costs with adjusted earnings of $0.86 per diluted share. Lower net income was primarily driven by lower net sales partially offset by over $30 million in cost and efficiency improvements, corporate and GS&A were lower versus the prior year due to these cost savings initiatives. As Ken stated, adjusted EBITDA was $185 million, a decrease of 29% from the prior year, but at the high end of the guidance we gave in May. If you look at slide eight for a look at the EBITDA bridge by business segment, adjusted EBITDA was down $77 million over the prior year reflecting lower net sales, higher freight costs and lower equity income, partially offset by the cost savings initiatives. Lithium adjusted EBITDA declined by $15 million versus the prior year, excluding currency, pricing was down about 14%, partially offset by cost savings initiatives, lower pricing reflects previously agreed battery grade contract price concessions, as well as lower market pricing. Adjusted EBITDA was also impacted by lower Callison equity income as our joint venture partner took lower volumes in the quarter. Bromine’s adjusted EBITDA was down $8 million excluding currency. The decline was primarily due to volume reductions related to demand softness, partially offset by cost savings and efficiency improvements. In Catalyst, adjusted EBITDA declined $44 million excluding currency. Volumes were down 22%, while pricing was down just 4%. Lower volumes primarily reflect FCC volume declines caused by reduced consumption of transportation fuel, high fuel inventories and continued travel restrictions. HPC volumes were down due to normal lumpiness in order patterns, as well as some softness related to lower oil prices and reduced fuel demand. Catalyst results were also impacted by a net $12 million correction of out of period errors related to inventory valuation and freight accruals. These errors occurred primarily in the first quarter of 2020 following the implementation of our ERP system. Our corporate and other category adjusted EBITDA increased $15 million due to improved fine chemistry services results and corporate cost reductions. As Kent mentioned, we ended the quarter with liquidity of about $1.5 billion, including $737 million of cash, $550 million remaining under our $1 billion revolver and $220 million on other available credit lines. Our short-term debt is comprised of commercial paper and the delayed draw term loan. We also have $441 million of senior notes due in late 2021. The investment grade market is open to us and we anticipate refinancing or rolling forward these debt maturities. The divestitures of FCS and PCS, which is a portion of our Catalyst business are ongoing, but progress continues to be slow due to COVID-19 pandemic related travel restrictions. The potential buyers remain interested and both transactions are potential liquidity events as we get back to normal. Turning to slide 10 for an update on our cost savings activities, as discussed last quarter, given the current economic environment, we are executing our downturn playbook to preserve cash. We continue to expect the short-term cash management actions to save the company about $25 million to $40 million per quarter. Examples of these short-term savings include things like, travel restrictions due to the COVID-19 pandemic, limited utilization of professional services and consultants, and actively managing our working capital. As previously disclosed, our two biggest capital projects, La Negra III and IV and Kemerton are being slow walked to preserve capital. We have the optionality to accelerate or stop these projects depending on market conditions. At this point, we continue to expect full year 2020 capital spending in the range of $850 million to $950 million, unchanged from our previous outlook and down 15% from our original outlook late last year. We are also temporarily reducing some production primarily in response to near-term demand weakness. In Catalysts we have idled one HPC production line and FCC production line that was idled in Q2 is now back up and running. In Lithium, we plan to idle portions of our Silver Peak and Kings Mountain production facilities in response to short-term supply demand imbalances and excess inventory builds in the battery-grade channel. We remain committed to the long-term operation of these facilities and currently plan to restart them in early 2021. And finally, our accelerated 2020 sustainable cost savings initiative is on track to achieve cost reductions of $50 million to $70 million this year until we reach run rate savings of at least $100 million by the end of 2021. These cost savings projects were already identified and underway when COVID-19 hit. For example, our Lithium team has identified $11 million of annual savings related to operational excellence and supply chain optimization. We are leveraging lean principles at our plants to optimize efficiency. Bromine and Catalyst both have projects aimed at reducing annual direct material costs by almost $7 million in total. We are examining all upcoming contracts for additional cost savings. Depending on market dynamics that may mean qualifying new suppliers and diversifying supply or consolidating spend with fewer suppliers in exchange for better pricing. And at Corporate, our global IT group is streamlining the number of software applications that they support to reduce costs and increase productivity resulting in a savings of about $4 million per year. Let’s turn to our outlook for the third quarter on page 11. Based on current order book and cost reduction actions, we expect Q3 2020 adjusted EBITDA in the range of $140 million to $190 million. Lithium’s Q3 2020 EBITDA is expected to be down about 10% to 20% sequentially. We continue to see the impact of contract price concessions agreed upon in late 2019, as well as lower market prices. Q3 results are also expected to be impacted by continued low OEM automotive production, higher inventory in the battery chain and reduced demand in the glass and ceramics markets. Bromine Q3 EBITDA is expected to be roughly flat sequentially, as we continue to see COVID-19 pandemic related impacts, which began in late Q2. Stabilization in some markets like construction offset continued weakness in other areas including flame retardants and drilling fluids. Finally, Catalyst Q3 EBITDA is expected to remain down about 50% to 60% from the prior year. FCC demand is expected to partially recover in the second half as travel resumes and global gasoline inventories continue to deplete. Conversely, the HPC business is expected to be negatively impacted in the second half as refiners to first spending and push turnarounds into 2021 and 2022. Looking beyond Q3 2020 continues to be challenging with limited visibility for most of our businesses. We are staying in close contact with customers and suppliers, and reviewing various economic forecast as we continue to navigate through this uncertain environment. Albemarle benefits from strong business positions across a wide range of end-user markets. About a quarter of our revenues are from transportation fuels, these revenues are largely tied to miles driven or fuel consumption. U.S. miles driven dropped off sharply in March with stay-at-home orders around the country and has rebounded since but remains well below our normal summer season. EIA forecast suggests that U.S. miles driven won’t return to 2019 levels until late next year. Electric vehicle sales are a key driver for our Energy Storage business. We look at a variety of auto production and sales forecasts including IHS markets forecast. IHS expects 2020 electric vehicle production of $3 million units, down significantly from now the pre-COVID forecast, but up about 20% from 2019. Expected 2021 EV production of 5.2 million units is also down from previous forecasts, but represents a significant rebound from current EV production levels. Of course, ultimately, what matters is consumer behavior and automotive sales, and to that end, we are also encouraged by recent green incentives we have seen around the world, which are supportive of EV demand. Many of our end-markets such as electronics, chemical synthesis and construction are driven by broader consumer sentiment and global GDP. Consumer sentiment is rebounding in all regions but remains below pre-COVID levels. In 2020 GDP forecasts have stabilized but represent a fairly significant year-over-year declines. These forecasts and leading indicators helped gauge the outlook for end-use markets, but a variety of factors including order lags, inventory changes and regulatory changes could cause our own results to differ from the underlying market conditions. And of course, secondary waves of infection could also cause setbacks in demand. Nevertheless, we are cautiously optimistic that many of our end-use markets are at least stabilizing if not starting to recover.
Kent Masters: Thanks, Scott. As we all know, economic conditions remain very challenging. Albemarle is an industry leader in all three of our core businesses. We believe in the long-term growth prospects of these businesses, but our immediate challenge is to manage through this crisis. In the meantime, we will focus on controlling what we can control. That means first and foremost, working hard to keep our people safe. It also means building operational discipline to improve cost and efficiency to deliver exceptional value and service and to optimize our capital spending. We remain confident in our strategy and we will modify execution of that strategy to further position Albemarle for success.
Meredith Bandy: All right. Before we open the lines for Q&A, I’d like to remind everyone to please limit questions to one question and one follow-up to ensure that as many participants as possible have a chance to ask a question and feel free to get back in the queue for additional follow-ups if time allows. And with that, Operator, please proceed with the Q&A.
Operator: Thank you. [Operator Instructions] Our first question comes from David Begleiter with Deutsche Bank. Your line is now open.
David Huang: Hi. This is David Huang here for Dave. I guess, first, you have just given the timing lag and probably some lower fixed cost absorption. Can Lithium EBITDA be up sequentially in Q4?
Scott Tozier: It’s really going to depend. This is Scott. It’s really going to depend on what the volume environment looks like in Q4. The team’s done a great job on cost reduction. I am not expecting any incremental sequential cost reduction going in the fourth quarter at this point in time unless demand starts to decline further. But at the end of the day, depending on fourth quarter growth is going to depend on what the volume looks like coming out of our customers.
David Huang: Okay. And then, I guess, if you have any early view on how your Lithium prices could trend in 2021?
Scott Tozier: Obviously, I think it’s trending 2021
Kent Masters: Yeah. So, yeah, this is Kent. Yeah. So that’s the magic question and it’s going to depend on volume right, as volume comes back and the market gets tighter. But we know there’s inventory and the supply chain it’s going to take a little bit of additional volume to work that off before price move. So that’s the inflection that we are looking forward. But it’s too early for us to call that.
David Huang: Okay. Thank you.
Operator: Thank you. Our next question comes from Joel Jackson with BMO Capital Markets. Your line is now open.
Robin Fiedler: Hi. This is Robin on for Joel. Thanks for taking my questions. If you describe the magnitude of the current LC inventory dynamic and if you could break it down both regionally and by end product versus feedstock if possible? Thank you.
Eric Norris: Hi, Robin. This is Eric Norris here. I will do this best I can, I don’t -- I can’t give you the granularity that you are asking. But we definitely saw during the second quarter inventories continue to build in the channel. This is because as we all know automotive services were shutdown for the second quarter. Our demand in the industrial sector has weakened and when those automotive producers reopened, we opened at lower rates. So that inventory rose to levels that are in excess of five months above normal levels for refined Lithium products. That’s largely almost entirely in the battery channel. I mean there may be some inventories in industrial but that’s being worked off, so it’s really the battery channel. And most of the battery industry today is in Asia, so regionally it’s going to be in Asia, although, some of that inventory is in suppliers hands as well, we talked about an action we are taking to reduce some of our inventory by idling facilities, but some of our competitors we believe may have excess inventories as well. So that would be -- it’s hard to say where that might be, that might be in the region of Asia, that might be at their production sites. But that that’s our view now and we are obviously watching very closely as we look towards a recovery to see that that peak can then begin to get drawn down as demand improves. The question is, of course, as Scott indicated, visibility to that demand improvement at this point.
Robin Fiedler: Great. Thanks for that. And just one quick follow-up, so can you just quantify the magnitude of the reduced production, is it about 2,000 tons or?
Eric Norris: Yeah. So the production were -- that we are talking about is for -- it’s going to be down for us, call it, the beginning of September through at this point the end of the year depending on market conditions. So approximately four months of production on a plant that annually, which really driven by our King’s Mountain facility, which produces hydroxide, what supplies that plant is Silver Peak, the carbonate that feeds it. So on an end hydroxide, that’s end product hydroxide basis annualize you are talking about 4,000 tons, 5,000 tons a year and so it can be down for four months of that at this point.
Robin Fiedler: Great. Thank you.
Operator: Thank you. Our next question comes from Mike Sison with Wells Fargo. Your line is now open.
Mike Sison: Hey. Good morning. Nice quarter. In terms of -- you used to have a nice slide talking about the potential demand for Lithium up to 2025 and I think the base case was 1 million tons. Can you sort of walk us through what you think that long-term potential is, has it changed materially or is about the same and how do you think that will work through over the next couple of years?
Kent Masters: So I will start with that and then Eric can fill in the details to the extent we can. So we have said and we still believe kind of a demand profile has been pushed out by about a year. So we -- and -- so we don’t think kind the long-term demand is affected, but the curve has changed probably steepened but it’s been pushed out a year during this. We continue to watch the forecast and how the EV penetration happens around the world to see if it changes that profile, but today we believe it’s the kind of the curve four years, five years out. The volume is the same. Curve is a little steeper to get there and starts about a year later.
Eric Norris: Yeah. There’s not much to add to that comment but if you do look at slide 12 you can see the steepness of that curve in the following way. We have said that the demand we thought would materialize in 2020 before the crisis, that growth has shifted a year, originally we thought that would be 4.1 million vehicles, if you want to put on a vehicle -- electric vehicle basis and so that did materialize. We are looking at IHS has currently forecasting something closer to 3 million vehicles. But if you look out for the next year, where we see the demand has shifted to, it’s 5.2 million vehicles is what HIS. That’s obviously higher than 4.1. So that’s the point at which this curve is getting steeper. We believe that the stimulus measures that have been added on top of already measures that are there on the OEM, the CO2 reductions, now you have consumer based incentives in Europe that have been added on top of those are part of what’s driving the steepness of that curve and allow us to stay on that projection we are going to detail modeling of it all the way after 2025 and it’s right around that 1 million be met tons that we talked about for the industry driven by electric vehicles.
Mike Sison: Got it. And then Eric as a quick follow-up, the price concessions, how does that get negotiated, if I recall that was sort of our fourth quarter event, right? So can you sort of walk through kind of the semantics of what will happened with those price concessions as you head into 2021?
Eric Norris: Yeah. You are right, Mike. It’s a bit early to say what’s going to happen. I can say this is, we are doing the same thing last year. We are looking at a falling set of market prices last year and we are in a -- we are trying to figure out how we are going to approach the year and that’s what led to the 2021 year concessions on these long-term agreements. If you sit here and look at 2021, the price in the market now is far lower than it was a year-ago. So that, I guess, would be the negative on this. The positive in that negotiation is what I just talked about is the steepness of that growth curve suspected or projected for next year, which there are other indications that are that is happening if you look at some of the Korean automotive public releases about what they see, not the Korean automotive, excuse me, the Korean battery producers, what they are projecting for their second half of the year, they are already starting to see and believe they are going to start to see that leading edge of that demand in terms of demand for that product. So that -- I can’t tell you how the negotiation is going to play out in terms of the exact way price will look in 2021, as Kent said earlier, that’s the big question. But I -- and those are the positives and negatives. Our LTAs have help, right, and we use them as part of the commercial negotiation use them as part of the commercial negotiation to find a good solution going forward that honors the spirit of inventory we have with them, right, with these customers. So we will be able to get more detail later in the year or earlier in the coming year.
Mike Sison: Great. Thank you.
Operator: Thank you. Our next question comes from Jim Sheehan with Truist Securities. Your line is open.
Jim Sheehan: Good morning. Thanks for taking my question. So could you talk about what downside and upside are from your segment guidance, so it looks like your full year EBITDA, sorry, your full company third quarter EBITDA guidance varies significantly from the segments. I am just trying to figure out either whether you have downsides and upsides baked in or is this coming from corporate and all other?
Scott Tozier: Yeah. Jim, this is Scott. So if you look at the segments, for Lithium we are expecting a range of being down sequentially by around 10% to 20%. So that kind of bounds what’s happened there. Most of that’s going to be volume related overall for Lithium. For Bromine, it’s relatively tight right now. They have got pretty good visibility into their order book at least through the end of August and so flat sequentially they could be down a little bit or up a little bit, but flat sequentially. And then Catalyst is expected to be down between 50% and 60% on a year-over-year basis, really on the back of hydro processing orders and the timing of those, as well as the recovery of FCC on the back of increased fuel demand globally and so that kind of balance the range. Corporate is pretty well bound in with the cost reductions that we have out there and the small business fine tuning services is doing well in the U.S., so.
Jim Sheehan: Thank you. And as it pertains to capital allocation, you have listed M&A in your slide on capital allocation. Maybe to talk about the pipeline what type of acquisitions you might be considering, what size and what region in the world or is that process really slowed down the same way that your asset sale process is?
Kent Masters: Yeah. So we continue to look for those opportunities, but there are going to be bolt-on, nothing dramatic. And -- but I would say, it’s probably fair to say that process has slowed down, but we continue to look for opportunities in the down market and that would probably most likely be around Lithium conversion assets that were available in the markets where we find that attractive.
Jim Sheehan: Thank you.
Operator: Thank you. And next question comes from Vincent Andrews with Morgan Stanley. Your line is now open.
Unidentified Analyst: Hi. Thank you for giving us time. This is Daniel Kutz [ph] on for Vincent. I just had a quick question in terms of the technical grade, how much is that like in the demand down this year versus battery grade demand and how fast do you expect technical to come back and kind of what are the sign posts that we should be watching to track that?
Eric Norris: Yeah. It’s a smaller market for us. I would say -- this is Eric speaking. I would say that the technical grade market, if you look at any industrial indicator for the recession, it’s going to be representative what that technical grade market is doing. I have seen some external statistics that say that the glass and ceramics industry is an example contracted by 25% in the second quarter. So that is -- that’s not obviously inconsistent with what’s happening economically around the world. So that’s the auto magnitude of what we are seeing. It’s a small part of our business, right? It’s less than 20% of our sales overall and it’s very mix, it’s not just glass and ceramics there are other segments that are doing better than the in the glass and ceramics sector. So we aren’t seeing any sign of recovery in that yet. As we -- or as we roll here into the third quarter and that’s what we expect in the fourth quarter again and that just comes on the head of what we talked about earlier, it’s very murky and hard to tell at this point, which is why we are cautious to give more detailed guidance on Q4.
Unidentified Analyst: Understood. Thank you. And then in terms of idling facilities, what is the cost of temporarily idling these and how quickly you can they both be taken down and brought back up. And I guess, just part of that, what is kind of the lowest that utilization rate that they can run at before it becomes unit cost derivatives.
Kent Masters: So I will take the cost of idling. It’s relatively small. So these are smaller plants with a relatively small workforce. So really in total less than $10 million is actually idle the plant itself. And Eric if you want to just talk about utilization and recovery?
Eric Norris: Yeah. We just told the workforce yesterday about this, right, and we expect to be fully idled or safely down by September the 1st. So that give you some idea of the down and then there will be comparable period to come up once we see the demand signals to come back up. It is -- I am sorry, second question, I guess, was utilization. This is a fairly small part of our mix, but it’s an important part of being able to supply 2021 we believe, provided recovery take through as we expected to. So it’s on utilization basis. It’s not a lot. But here is a point that I think is also implied in your question. It is not -- this is product that given the weakness in the market while our contracts are being upheld, any opportunities outside of those, any opportunities in China, any opportunities in industrial markets is limited, for all the reasons we have discussed, because of the contraction in the marketplace. So this is product that would have gone to inventory. So there’s not an EBITDA impact on our guidance associated with what of our guidance otherwise would have been associated with this. This is just a reduction in inventory and during this period of time of down, we will continue to make investments to prepare these assets to run full out when the recovery does occur, which we, again, hope will be and anticipate will be in 2021.
Unidentified Analyst: Very helpful. Thank you.
Operator: Thank you. Our next question comes from Arun Viswanathan with RBC Capital Markets. Your line is now open.
Arun Viswanathan: Great. Thanks. Good morning. I guess I just wanted to get your perspective on Lithium markets. I understand that your overall view is maybe even pushed out a year. But has there been any change in, I guess, how you are looking at supply demand, I mean, I appreciate that the automakers may not be coming back at full, but are they potentially coming back with greater focus on EVs and if so would that be a positive tailwind for you. So that’s my question on Lithium and then I have one more question on Catalysts, if you could maybe just characterize how you are thinking about that business on the surface, it looks like there could be some structural impairment that could last for quite a while. I guess is that a fair characterization. So, yeah, maybe you can just give your medium-term thoughts on both businesses? Thanks.
Kent Masters: So, again, I will comment on that and Eric can fill if I miss piece on the -- on Lithium. So as you said before, we really don’t think it’s changed the dynamic for the EV market long-term, so we kind of fundamentally believe in the EV market and the Lithium demand that’s going to go into that. So, the one thing that has happened, I guess, that is quite different is there incentives becoming -- becoming more incentives associated with electric vehicles and that’s primarily in Europe. That’s probably -- it’s going to drive that a little differently than it was before. So previously you didn’t have the depth, but the curve was a year earlier, the demand coming out now, you have got a depth that comes back a little stronger, primarily on those incentives and trying to figure out exactly what that curve looks like, we don’t know. And regardless of incentives and the demand that’s going to happen, I mean, consumers still have to buy cars and that’s the fundamental thing we don’t really know and I think the people forecasting that don’t know as well. So, Eric, anything on top of that.
Eric Norris: No. Nothing to add other than you just -- you all have to be conscious of the fact that just like the impacts that happened in the second quarter aren’t really hitting us until the third quarter. So to the recovery, just as I said, we have the Korean manufacturers out, saying, that they see a significant uptick in their sales. That’s probably and hopefully related to these -- what’s going on in Europe and there’s obviously a corresponding lag, particularly with excess channel inventories there for it to come back and hit us. So that’s why in the longer term, we are pretty optimistic, but in the next six months it’s very hard to say, very hard to say.
Kent Masters: Yeah. And then on your Catalysts question kind of the same approach. I will do a high level, Raphael, can fill in. But so oil prices are down and then the miles driven are pretty dramatic change and you could see on that slide, I think, it was slide 12, how dramatic that was miles driven and that’s changed that. We don’t really see it changing the fundamentals of that business long-term, but it is going to take some time for that to come back. Before people go back to work and commute and maybe they don’t commute as much as they did after this or maybe less miles driven, maybe more vacation by driving rather than flying, but then again, that’s air travel. So we think that’s been pushed out for some period of time, but peak oil probably it doesn’t change. We knew that was coming in some period of time, has that been pulled forward by a little bit, we don’t know that. Most of the forecast say maybe a year, maybe not. So I don’t think it fundamentally changes the business that we have, clean fuels continue to be important, our business is based on innovation around clean fuels, so we don’t think it fundamentally changes it or structurally changes it. But it might change the dynamics of where our markets are geographically and which of our customers do better or do worse during this.
Raphael Crawford: Yeah. This is Raphael, Arun. To add to that view, certainly, this is a time for our business to take action to mitigate the impact whether it would be, cost working capital, capital for the near-term, because it has -- COVID-19 has had an acute impact on our customers and suppliers to our customers. That being said, as Kent said, there is a bright future for refining Catalysts when positioned correctly and our strategy is really all around positioning our business to take advantage of trends in emerging markets where fuel consumption will continue to grow beyond global peak gasoline, as well as the emerging chemicals applications from refineries where we already have a position of strength and we need to advance that. So, with all of the challenges that COVID-19 brings, it is a great motivator for us as a company to stay on strategy and accelerate that strategy to be in more resilient spaces as we progress.
Arun Viswanathan: Thanks.
Operator: Thank you. Our next question comes from Mike Harrison with Seaport Global Securities. Your line is now open.
Mike Harrison: Hi. Good mornings. Raphael, maybe kind of continuing on the Catalyst discussion, can you talk about the FCC pricing outlook. I believe you saw a pricing in your Catalyst business overall decline by 4%, not sure if that’s pricing or mix, but are you seeing resilient FCC pricing and are you see any trading down as you look at your overall mix and Catalysts.
Raphael Crawford: Hey, Mike. Thanks for the question. So when we look at it, pricing does -- there has been some downward movement on price but not for the value-oriented products that are the bulk of our portfolio. So as you know in the FCC industry, you certainly have contracted business, you have business that’s not contract and then there are trials and trials are a period of time within a contract, when a competitor can bring a Catalyst into a refinery to test performance. Trial pricing is lower, so to the extent that within our mix we have trials and we are pursuing trials with new refineries or refineries we don’t have, yeah, that pricing is going to be lower than what we have typically seen. But for the business that’s our core business on performance products that pricing has been stable and I would even think, if I looked at prior quarter and looking ahead as we are negotiating for contracts where we are demonstrating value or increased value we are able to gain on price. So I would say, it’s sort of mix between trial pricing and contract pricing, and what we generate on value has the biggest impact on that.
Mike Harrison: All right. Thanks for that. And then on Lithium, I was wondering if you can give a little more color on where you are seeing the greatest concern in terms of inventories in the Lithium channel and in the battery channel. Is it with finished Catalyst material and the battery makers, is it hydroxide, is it carbonate, it’s probably mean maybe some more detail there?
Eric Norris: Hey, Mike. It’s Eric here. So look it’s, I would say, we have and you can sort of interpret this by the action we have taken with our plants, it’s both hydroxide and carbonate. And it’s with our customers, be the cathode customers or battery accounts and with -- we believe with suppliers in the channel. We understand that there are probably potentially even some excess inventories from a cathode standpoint. So I mean you have an industry that during the second quarter screeched to a halt, right? Nothing was happening for depended on plant it could have been a month more in terms of the OEM closures. So it’s in the battery channel and it’s at various points in the battery channel. And so I think it’s about the most color I can give you at this point in time. Spodumene is -- there continues to be excess spodumene in China. Some of that is below grade spodumene, meaning below 6%. Some of that it’s even the DSO variety, which is just raw rock, it’s not processed. And some of it by its purchasers just purchased the high prices for spodumene rock, so it’s an economic in the current situation. So there’s this spodumene -- excess spodumene there is well. That is a lot more opaque and hard to tell exactly how much however.
Mike Harrison: All right. Thanks very much.
Operator: Thank you. Our next question comes from Matthew DeYoe with Bank of America. Your line is now open.
Matthew DeYoe: Hi. I wanted to hit a little bit on the Catalyst trial pricing issue. I mean, why are your trial price is lower, are refineries just kind of trialing lower quality products, is the way to temporarily lower costs. Do you see risk of these get adopted because refineries don’t need better utilization rates right now that your higher FCCs would deliver?
Raphael Crawford: Hey, Matthew. This is Raphael. The -- some of it has to do with just the dynamic that every market is down and every Catalyst producer would like to look for new volume opportunities and the most accessible way to go and do that is to participate in trials. So I think the activity and the eagerness of the market around trials has increased and when in that competitive space, certainly, folks are -- and Albemarle included are willing to price lower than what we normally would, still at positive margin to participate in a trial to prove out value to a refinery over what they might already have with their current supplier. That being said, with trials, I mean, you get in the door to some extent that trial sets a benchmark for future pricing. But most refineries understand that pricing and Catalysts is very much tied to value and if you are generating value over time you are able to raise the price to what you are able to justify with your performance. Albemarle has been very good at doing that and where we participate in markets related to max chemicals, bottoms cracking, which is really our strength within FCC, we are able to demonstrate value and capture price over time.
Matthew DeYoe: Okay. And then if I would have just circle back on the excess spodumene comment, I know there was a fair amount that’s you mentioned below 6% and there is DSO. But how much excess spodumene out there that is above 6% and like a seasonable product. I think that was sized before at -- about three months to six months of excess inventory, is that still the case, is any of that have been worked down at all?
Eric Norris: I will have to go back to the kind of that again, the comment maybe for, it is incredibly opaque. And even to the point where sometimes inventory is counted twice depending on who you are talking to. So I really couldn’t tell you. I can tell you that 6% -- the 6% spodumene that has been produced for integrated producers like Albemarle, our partner, and obviously, competitors as well Tianqi, potentially for some of the other producers that are integrated like Kemerton. I doubt that they would be carrying a lot of excess inventories because we have been -- I am assuming that those competitors are doing the same thing that Albemarle is doing, which is we are trying as a leader in the industry trying to assist the challenge by reducing inventories and we -- and the outputs as you can see from our equity income is substantially reduced from Talison is the big part of that actually is Tianqi and the challenges they have had. So it’s -- that 6% which is very high quality rock that I think has been coming down. But as for the rest, the majority of which is below 6% or barely 6%, that’s probably were more of the excess is, because that’s a less economic product in today’s market with today’s prices.
Matthew DeYoe: Okay. I appreciate your -- the added detail. I know it’s definitely opaque. So thank you.
Operator: Thank you. Our next question comes from Bob Koort with Goldman Sachs. Your line is now open.
Bob Koort: Thank you. Good morning. A couple of Lithium questions, have you guys think about reconciling what seems to be some odd financial math when, I guess, in China we are seeing battery grade material under $6,000 you have got spodumene market prices under $400. And I think, Eric, you are talking about inventories might be bloated everywhere. So can your competitors in China make money? Is there the risk that they try to liquidate those inventories more aggressively in a weak period? Do you see a bifurcated market as China different than Japan and Korea? Can you just give us a little color there?
Eric Norris: Well, on -- hey Bob. It’s Eric here. On the first part of your question, I would say, that what you are seeing is, nothing has changed in the cost curves that we talked about. You can go back and look at the Investor Day, look at where we thought marginal cash costs are between $6 and $7 in that range. That hasn’t changed. There’s nothing that’s changed in that regard. And so, effectively at prices you are seeing in the China market now spot prices, the whole right hand side of the cost curve is underwater. They are not able to make money. They lose money selling product. So I can’t explain why that’s happening other than it’s a market that has gone through a compression that we talked about, because of the COVID crisis in second quarter and it’s started working its way out as we go into the second half of the year. And you have lower cost producers particularly in the carbonate side and remember China is largely a carbonate market, who have lower cost positions, brine -based rock -- brine based carbonate has a much lower cost position are able to sell well below the cash cost of those who are rock-based producers in the region. So I think that’s what’s happening. It sort of shows sort of the stress in the system. Will Chinese producers start to unload inventory? I think, potentially, in a desperation move, but I think at this point, most of that rock is sitting stationary until market values improve, at this point. You had a second part of your question, Bob, was about…
Bob Koort: Just wondering…
Eric Norris: …was there difference between China and elsewhere? Yeah. No. Yes. There’s a difference. Again, it’s largely a carbonate market, more of the high nickel chemistry today that hydroxide base has made outside of China, some of it’s -- maybe produced in China, but most of the demand for that is outside China. And of course, there are structural differences. There’s VAT difference between China and inside and outside of China as well. But again, I don’t know anything has changed other than the fact that we have had a demand crisis and that’s really put pressure on the system.
Bob Koort: And Eric you mentioned that your LTAs have largely held, I think, in the last couple of quarters, you have talked about you want to sell to your customers in the manner that they want to buy in terms of contract dynamics. But what’s your expectation for the desire for those LTAs, as you start to get to the exponential part of that demand curve, because it would seem the cathode folks are looking at this volatility and pricing and obviously resets on pricing, but then you have got some pretty dangerous implications for them if the industry curtails its expansion activity, where there may be a scarcity value sometime down the road. So I guess what I am asking is the game plan, do you think you will have a lot more LTAs at fixed prices two years and three years from now or a lot fewer because your customers are maybe moving away from that. Can you give me your sense of how this market develops from a very weak price period to a potentially very tight market in a few years?
Eric Norris: I don’t think the security of supply and notion of that has changed. But we do see our contracts starting to evolve from there. Do you want to comment, Kent?
Kent Masters: Yeah. And I would say, that security and how our customers look out a year or two and looking for guaranteed supply out in that timeframe is part of that dynamic. And we -- but we are seeing it as a portfolio with a percentage and they will be those long-term contracts, but with slightly different terms across the portfolio, some with guaranteed promises of supply a couple of years out and some without that and some more spot based and others more contracted with a formula that may indicate spot but not move with spot.
Eric Norris: Yeah. And what’s happening now is I think you have put your -- sort of put your finger on it Bob is that, short-termism is an interesting strategy. Now it will save you some money, because spot prices are really low. But as you have also point out, capacity is being withdrawn from the market. The economics to support expansion are not there today in the market for almost every producer except for the very lowest cost producers and there’s a scarcity at some point it starts to shift. We think the supply chain particularly those most invested in the supply chain, all the way to the top of it, the automotive producers are increasingly focused and will become increasingly focused on this issue, which is why, I think, there’s always a value for security supply. And to Kent’s point, we always want a portfolio. We are always going to want some of those price buyers, because that -- those -- that there is a value to that when the market goes up, right, in terms of what it means your EBITDA. We don’t want a majority of our business there but we will have some of it there.
Bob Koort: Great. Thanks for the insight.
Operator: Thank you. Our next question comes from Matthew Skowronski with UBS. Your line is now open.
Matthew Skowronski: Good morning. Thank you for taking my question. Can you give us an update on when we should expect to see sales from La Negra III and IV and if you have changed your view at all about the timing of the ramp of additional capacity given the demand disruption you have seen this year?
Kent Masters: Well, we had said last quarter, we have kind of slowed down the execution of those -- of our two big projects, La Negra III and IV and at Kemerton. And so that really hasn’t changed. We have slowed that down basically because we see demand being pushed out at gap and we did that to kind of preserve cash but it also matches what we see s supply-demand and obviously given the discussion you have seen today we are -- we have got our forecast and we have our view, but it’s a bit of a shot in the dark. But we see volume to your question from La Negra III and IV our capacity coming on late next year and then a qualification period after that.
Matthew Skowronski: Thank you.
Operator: Thank you. And our next question comes from Chris Kapsch with Loop Capital Markets. Your line is now open.
Chris Kapsch: Yeah. Good morning. Question is probably for Eric and slightly nuance follow-up to some of the stuff you have talked about. But just -- on the comments about excess inventory in the battery supply chain with hydroxide there’s a limited shelf life given its hydroscopic nature and no such issue with carbonates. So I am just wondering if your comments about inventories, if those -- if that dynamic is more pronounced for carbonate grades versus hydroxide grades. Maybe you got it just a little bit by suggesting that some of the excess inventories at cathode level, but just wondering given that a lot of these newly introduced EV models particularly in Europe are definitely deploying higher energy density cathodes that require hydroxide. I am wondering if there is a little bit of bifurcation in those dynamics?
Eric Norris: So you are right. Chris, this is Eric. There is sure shelf life for hydroxide, which is -- but it’s also a smaller market. So it’s a more -- if we look at our customer base, the number of customers that they use hydroxide to a large degree and would have high inventory levels. It’s a more manageable group of folks to work with. And it’s also the reason that the motivator for the idlings that we did and we announced to our employee yesterday in our release last night is driven first and foremost by the hydroxide. Carbonate is a bigger market and the shelf life considerations aren’t the same. So you do manage them differently, because it’s bigger, there’s a lot of carbonate inventory out there too, right? The more people produce it and more people buy it. So there’s a difference in the way in which we manage it, but the challenges are the same and that they are elevated for both.
Chris Kapsch: Okay. And my follow up is and you have got it just a little bit with -- in response to Bob’s question on your long-term agreements. But there’s obviously this acquisition where there is acute near-term oversupply probably amplified by the COVID pandemic. But then the increasing steepness of the EV adoption curve a couple few years out. So I am just wondering again probably looking at maybe the conversation around carbonate versus the conversations around long-term sourcing of hydroxide. Is there -- can you just provide any color on as some of those customers are looking for a little relief on the previously agreed to pricing floors. Is there still anxiousness about the ability to source a long-term basis hydroxide, is that -- and is that more noticeable with the conversation around hydroxide vis-à-vis carbonate? Thank you.
Eric Norris: I would say that that because the steepness in the growth curve that we -- that IHS is projecting and it’s a guided post for us provided it happens when it does, that’s also what our customers are seeing and it’s driven largely by -- a big chunk of it is driven by Europe and that is also a big hydroxide opportunity that, yes, there is improbably increased, I don’t know I think anxiety is the right word, but statement around from customers around, they are going to need more -- a lot more hydroxide in the coming year or so and they are banking on Albemarle to be able to bring Kemerton in particular online to meet that. Now, all of this is tampered about when, right? The steepness in that curve feels, right, based on what we are seeing, the timing of it is consumer spending driven. So we just keep a careful eye on that up and down the supply chain.
Chris Kapsch: Fair enough. Thanks guys.
Operator: Thank you. This concludes the question-and-answer session. I would now like to turn the call back over to Meredith Bandy for closing remarks.
Meredith Bandy: Hi. Thank you all for your questions and participation in today’s call. As always, we appreciate your interest in Albemarle and this concludes our call.
Operator: Ladies and gentlemen, this concludes today’s conference call. Thank you for participating. You may now disconnect. | [
{
"speaker": "Operator",
"text": "Ladies and gentlemen, thank you for standing by. And welcome to the Q2 2020 Albemarle Corporation Earnings Conference Call. At this time, all participants are in a listen-only mode. After the speaker presentation, there will be a question-and-answer session. [Operator Instructions] Please be advised that today’s conference is being recorded. [Operator Instructions] I would now like to hand the conference to your speaker today, Meredith Bandy, VP of Investor Relations and Suitability. Please go ahead, ma’am."
},
{
"speaker": "Meredith Bandy",
"text": "Hi. Thank you, Joel, and thanks everyone. And welcome to Albemarle’s second quarter 2020 earnings conference call. Our earnings were released after the close yesterday and you will find our press release, presentation and non-GAAP reconciliations posted to our website under the Investor section at www.albemarle.com. Joining me on the call today are Kent Masters, Chief Executive Officer; and Scott Tozier, Chief Financial Officer. Raphael Crawford, President, Catalysts; Netha Johnson, President, Bromine Specialties; and Eric Norris, President, Lithium, are also available for Q&A. As a reminder, some of the statements made during this conference call including our outlooks, expected company performance, expected impacted impacts of the COVID-19 pandemic and proposed expansion parents -- plans may constitute forward-looking statements within the meaning of federal securities laws. Note that the cautionary language about forward-looking statements is contained in our press release and that same language applies to this call. Please also note that some of our comments today refer to financial measures that are not prepared in accordance with GAAP. A reconciliation of these measures to GAAP financial measures can be found in our earnings release and the appendix of our presentation, both of which are on our website. With that, I will turn it over to Kent."
},
{
"speaker": "Kent Masters",
"text": "Thank you, Meredith, and good morning, everybody. On today’s call I will cover a high level overview of the current environment, give an update on our strategy and highlight some of the actions we are taking to improve the sustainability of our business. Scott will then review second quarter financials, provide updates on our balance sheet and cost saving initiatives, and review our outlook. I want to reaffirm that the safety and welfare of our people is our highest priority at Albemarle. Our core values are always define how we operate but even more so in the difficult situations we face today. During the pandemic, we have been able to continue to operate, because we care about the welfare of each other. We humbly acknowledge that this crisis is not about us but about everyone and we show integrity by doing the right thing. Thankfully the pandemic has not materially impacted our operations to-date. I deeply appreciate the courage and continued support of the frontline essential workers in our communities and our dedicated Albemarle employees, who continue to ensure safe operations at our facilities and offices worldwide. At this point in time, we have had relatively few diagnosed individuals out of more than 5,600 global employees, using our exposure protocol we have traced the contact path for any confirmed case among employees and have isolated colleagues as needed. We are staying in close contact with impacted employees to monitor their welfare. We are grateful that previously diagnosed employees have recovered or are recovering as expected. In areas where we are seeing unfavorable trends, such as Chile and parts of the U.S., we are extending work-from-home requirements for non-essential workers and working closely with our manufacturing sites to ensure safe operations can continue. At many of our locations non-essential employees have returned to work. We continue to be in close contact with site teams to support them and health -- in a healthy and safe return process. Our global cross functional COVID response team continues to meet weekly to mitigate the impact to our operations and manage the impacts to customer demand. Turning to recent results. Yesterday we released second quarter financials, including net income of $86 million or $0.80 per share and adjusted EBITDA of $185 million, down 29% from prior year. However, I am pleased to say that these results were at the high end of our previous outlook. Thanks to better than expected performance in Lithium and in Bromine. Our primary capital priorities continue to be paying dividends to shareholders, preserving our investment grade credit rating and maintaining our long-term growth profile. To that end, during the quarter we announced a dividend of $0.385 per share in line with the prior quarter and up 5% from last year. We continue to maintain adequate financial flexibility with liquidity of $1.5 billion and our previously announced cost saving initiatives are also on track. At a high level, Albemarle’s strategy has not materially changed. We will invest in and grow our Lithium business and we will fund Lithium growth with cash flows from our more mature businesses. Historically, we have actively managed our portfolio to generate shareholder value and will continue to do so. We will also maintain a disciplined approach to capital allocation. The difference is that the COVID-19 pandemic has pushed Lithium growth out by at least one year, while also impacting near-term cash flow from our other businesses. Our response is to broaden and accelerate our focus on operational discipline to continuously raise the bar on performance. And specifically, manufacturing excellence to drive best-in-class cost management and product quality with a relentless focus on safety, standard work, continuous improvement, and the application of gleam principles across our manufacturing operations. In business excellence to deliver exceptional value and service to our customers, and to capture profitable high value opportunities to tailor value propositions and optimize -- optimized business processes and resources, so customer facing, as well as back office. And capital project excellence to effectively manage capacity to demand through the use of standard reliable designs and discipline planning and process management. We know that being profitable and doing what’s right are not at odds with each other. We expect to do both well and our sustainability framework is our guide. In terms of our people and workplace, we continue to advance and promote inclusion and diversity across our organization. Last year, we added two highly experienced female Board members, currently 50% of our directors represent gender and racial diversity, which broadens the range of perspective, experiences and insights we can leverage to benefit our organization. Recent events of discrimination and violence against black citizens in our communities remind us that we need to work much harder to fight racism. As a result, we have introduced a multi-pronged strategy to refocus our inclusion and diversity efforts from the bottom up, as well as the top down. Current activities include the addition of a dedicated senior inclusion and diversity leader, unconscious bias training for leaders and incorporating inclusion and diversity into the onboarding process for all new employees. We are also focused on responsible natural resource management, water management is an important sustainability objective for Albemarle and to continue to grow it’s imperative that we manage water efficiently. One example of this is that our facility in Magnolia, Arkansas, one of the world’s largest Bromine and Bromine chemical sites, Magnolia uses as an artificial Marsh as a unique water treatment facility. We are actively collaborating and engaging with our communities. Our Lithium operations at the Salar de Atacama in Chile works closely with the local communities to promote environmental stewardship and foster the community’s long-term development. We share a percentage of our revenue with local indigenous communities and more than 35% of our employees in the region are indigenous. Finally, our sustainability business model helps create long-term value for all shareholders. For example, about 50% of our Catalyst revenues are from products that reduce SOx and NOx emissions to produce cleaner transportation fuels. In 2019, the use of our Catalysts prevented the release of about 10 million tons of sulfur into the environment. In the coming weeks we will publish an updated sustainability report to provide increase transparency and disclosure around these and other important topics as discussed at our Investor Day late last year. We are excited about the progress we have made on sustainability, but we also recognize that sustainability is by its nature a long term journey. In 2021 and beyond, our focus will shift from setting the baseline on sustainability performance to goal setting and continuous improvement. With that as a backdrop, I will turn it over to Scott for more detail on our recent results."
},
{
"speaker": "Scott Tozier",
"text": "Thank you, Ken, and good morning, everyone. Albemarle generated second quarter net sales of $764 million, a decrease of about 14% compared to the prior year. This reduction was primarily driven by reduced prices in Lithium as expected coming into the year and reduced volumes in Catalysts and Bromine related to the COVID-19 pandemic. GAAP net income was %$86 million or $0.80 per diluted share. The non-GAAP adjustments this quarter were primarily related to restructuring costs with adjusted earnings of $0.86 per diluted share. Lower net income was primarily driven by lower net sales partially offset by over $30 million in cost and efficiency improvements, corporate and GS&A were lower versus the prior year due to these cost savings initiatives. As Ken stated, adjusted EBITDA was $185 million, a decrease of 29% from the prior year, but at the high end of the guidance we gave in May. If you look at slide eight for a look at the EBITDA bridge by business segment, adjusted EBITDA was down $77 million over the prior year reflecting lower net sales, higher freight costs and lower equity income, partially offset by the cost savings initiatives. Lithium adjusted EBITDA declined by $15 million versus the prior year, excluding currency, pricing was down about 14%, partially offset by cost savings initiatives, lower pricing reflects previously agreed battery grade contract price concessions, as well as lower market pricing. Adjusted EBITDA was also impacted by lower Callison equity income as our joint venture partner took lower volumes in the quarter. Bromine’s adjusted EBITDA was down $8 million excluding currency. The decline was primarily due to volume reductions related to demand softness, partially offset by cost savings and efficiency improvements. In Catalyst, adjusted EBITDA declined $44 million excluding currency. Volumes were down 22%, while pricing was down just 4%. Lower volumes primarily reflect FCC volume declines caused by reduced consumption of transportation fuel, high fuel inventories and continued travel restrictions. HPC volumes were down due to normal lumpiness in order patterns, as well as some softness related to lower oil prices and reduced fuel demand. Catalyst results were also impacted by a net $12 million correction of out of period errors related to inventory valuation and freight accruals. These errors occurred primarily in the first quarter of 2020 following the implementation of our ERP system. Our corporate and other category adjusted EBITDA increased $15 million due to improved fine chemistry services results and corporate cost reductions. As Kent mentioned, we ended the quarter with liquidity of about $1.5 billion, including $737 million of cash, $550 million remaining under our $1 billion revolver and $220 million on other available credit lines. Our short-term debt is comprised of commercial paper and the delayed draw term loan. We also have $441 million of senior notes due in late 2021. The investment grade market is open to us and we anticipate refinancing or rolling forward these debt maturities. The divestitures of FCS and PCS, which is a portion of our Catalyst business are ongoing, but progress continues to be slow due to COVID-19 pandemic related travel restrictions. The potential buyers remain interested and both transactions are potential liquidity events as we get back to normal. Turning to slide 10 for an update on our cost savings activities, as discussed last quarter, given the current economic environment, we are executing our downturn playbook to preserve cash. We continue to expect the short-term cash management actions to save the company about $25 million to $40 million per quarter. Examples of these short-term savings include things like, travel restrictions due to the COVID-19 pandemic, limited utilization of professional services and consultants, and actively managing our working capital. As previously disclosed, our two biggest capital projects, La Negra III and IV and Kemerton are being slow walked to preserve capital. We have the optionality to accelerate or stop these projects depending on market conditions. At this point, we continue to expect full year 2020 capital spending in the range of $850 million to $950 million, unchanged from our previous outlook and down 15% from our original outlook late last year. We are also temporarily reducing some production primarily in response to near-term demand weakness. In Catalysts we have idled one HPC production line and FCC production line that was idled in Q2 is now back up and running. In Lithium, we plan to idle portions of our Silver Peak and Kings Mountain production facilities in response to short-term supply demand imbalances and excess inventory builds in the battery-grade channel. We remain committed to the long-term operation of these facilities and currently plan to restart them in early 2021. And finally, our accelerated 2020 sustainable cost savings initiative is on track to achieve cost reductions of $50 million to $70 million this year until we reach run rate savings of at least $100 million by the end of 2021. These cost savings projects were already identified and underway when COVID-19 hit. For example, our Lithium team has identified $11 million of annual savings related to operational excellence and supply chain optimization. We are leveraging lean principles at our plants to optimize efficiency. Bromine and Catalyst both have projects aimed at reducing annual direct material costs by almost $7 million in total. We are examining all upcoming contracts for additional cost savings. Depending on market dynamics that may mean qualifying new suppliers and diversifying supply or consolidating spend with fewer suppliers in exchange for better pricing. And at Corporate, our global IT group is streamlining the number of software applications that they support to reduce costs and increase productivity resulting in a savings of about $4 million per year. Let’s turn to our outlook for the third quarter on page 11. Based on current order book and cost reduction actions, we expect Q3 2020 adjusted EBITDA in the range of $140 million to $190 million. Lithium’s Q3 2020 EBITDA is expected to be down about 10% to 20% sequentially. We continue to see the impact of contract price concessions agreed upon in late 2019, as well as lower market prices. Q3 results are also expected to be impacted by continued low OEM automotive production, higher inventory in the battery chain and reduced demand in the glass and ceramics markets. Bromine Q3 EBITDA is expected to be roughly flat sequentially, as we continue to see COVID-19 pandemic related impacts, which began in late Q2. Stabilization in some markets like construction offset continued weakness in other areas including flame retardants and drilling fluids. Finally, Catalyst Q3 EBITDA is expected to remain down about 50% to 60% from the prior year. FCC demand is expected to partially recover in the second half as travel resumes and global gasoline inventories continue to deplete. Conversely, the HPC business is expected to be negatively impacted in the second half as refiners to first spending and push turnarounds into 2021 and 2022. Looking beyond Q3 2020 continues to be challenging with limited visibility for most of our businesses. We are staying in close contact with customers and suppliers, and reviewing various economic forecast as we continue to navigate through this uncertain environment. Albemarle benefits from strong business positions across a wide range of end-user markets. About a quarter of our revenues are from transportation fuels, these revenues are largely tied to miles driven or fuel consumption. U.S. miles driven dropped off sharply in March with stay-at-home orders around the country and has rebounded since but remains well below our normal summer season. EIA forecast suggests that U.S. miles driven won’t return to 2019 levels until late next year. Electric vehicle sales are a key driver for our Energy Storage business. We look at a variety of auto production and sales forecasts including IHS markets forecast. IHS expects 2020 electric vehicle production of $3 million units, down significantly from now the pre-COVID forecast, but up about 20% from 2019. Expected 2021 EV production of 5.2 million units is also down from previous forecasts, but represents a significant rebound from current EV production levels. Of course, ultimately, what matters is consumer behavior and automotive sales, and to that end, we are also encouraged by recent green incentives we have seen around the world, which are supportive of EV demand. Many of our end-markets such as electronics, chemical synthesis and construction are driven by broader consumer sentiment and global GDP. Consumer sentiment is rebounding in all regions but remains below pre-COVID levels. In 2020 GDP forecasts have stabilized but represent a fairly significant year-over-year declines. These forecasts and leading indicators helped gauge the outlook for end-use markets, but a variety of factors including order lags, inventory changes and regulatory changes could cause our own results to differ from the underlying market conditions. And of course, secondary waves of infection could also cause setbacks in demand. Nevertheless, we are cautiously optimistic that many of our end-use markets are at least stabilizing if not starting to recover."
},
{
"speaker": "Kent Masters",
"text": "Thanks, Scott. As we all know, economic conditions remain very challenging. Albemarle is an industry leader in all three of our core businesses. We believe in the long-term growth prospects of these businesses, but our immediate challenge is to manage through this crisis. In the meantime, we will focus on controlling what we can control. That means first and foremost, working hard to keep our people safe. It also means building operational discipline to improve cost and efficiency to deliver exceptional value and service and to optimize our capital spending. We remain confident in our strategy and we will modify execution of that strategy to further position Albemarle for success."
},
{
"speaker": "Meredith Bandy",
"text": "All right. Before we open the lines for Q&A, I’d like to remind everyone to please limit questions to one question and one follow-up to ensure that as many participants as possible have a chance to ask a question and feel free to get back in the queue for additional follow-ups if time allows. And with that, Operator, please proceed with the Q&A."
},
{
"speaker": "Operator",
"text": "Thank you. [Operator Instructions] Our first question comes from David Begleiter with Deutsche Bank. Your line is now open."
},
{
"speaker": "David Huang",
"text": "Hi. This is David Huang here for Dave. I guess, first, you have just given the timing lag and probably some lower fixed cost absorption. Can Lithium EBITDA be up sequentially in Q4?"
},
{
"speaker": "Scott Tozier",
"text": "It’s really going to depend. This is Scott. It’s really going to depend on what the volume environment looks like in Q4. The team’s done a great job on cost reduction. I am not expecting any incremental sequential cost reduction going in the fourth quarter at this point in time unless demand starts to decline further. But at the end of the day, depending on fourth quarter growth is going to depend on what the volume looks like coming out of our customers."
},
{
"speaker": "David Huang",
"text": "Okay. And then, I guess, if you have any early view on how your Lithium prices could trend in 2021?"
},
{
"speaker": "Scott Tozier",
"text": "Obviously, I think it’s trending 2021"
},
{
"speaker": "Kent Masters",
"text": "Yeah. So, yeah, this is Kent. Yeah. So that’s the magic question and it’s going to depend on volume right, as volume comes back and the market gets tighter. But we know there’s inventory and the supply chain it’s going to take a little bit of additional volume to work that off before price move. So that’s the inflection that we are looking forward. But it’s too early for us to call that."
},
{
"speaker": "David Huang",
"text": "Okay. Thank you."
},
{
"speaker": "Operator",
"text": "Thank you. Our next question comes from Joel Jackson with BMO Capital Markets. Your line is now open."
},
{
"speaker": "Robin Fiedler",
"text": "Hi. This is Robin on for Joel. Thanks for taking my questions. If you describe the magnitude of the current LC inventory dynamic and if you could break it down both regionally and by end product versus feedstock if possible? Thank you."
},
{
"speaker": "Eric Norris",
"text": "Hi, Robin. This is Eric Norris here. I will do this best I can, I don’t -- I can’t give you the granularity that you are asking. But we definitely saw during the second quarter inventories continue to build in the channel. This is because as we all know automotive services were shutdown for the second quarter. Our demand in the industrial sector has weakened and when those automotive producers reopened, we opened at lower rates. So that inventory rose to levels that are in excess of five months above normal levels for refined Lithium products. That’s largely almost entirely in the battery channel. I mean there may be some inventories in industrial but that’s being worked off, so it’s really the battery channel. And most of the battery industry today is in Asia, so regionally it’s going to be in Asia, although, some of that inventory is in suppliers hands as well, we talked about an action we are taking to reduce some of our inventory by idling facilities, but some of our competitors we believe may have excess inventories as well. So that would be -- it’s hard to say where that might be, that might be in the region of Asia, that might be at their production sites. But that that’s our view now and we are obviously watching very closely as we look towards a recovery to see that that peak can then begin to get drawn down as demand improves. The question is, of course, as Scott indicated, visibility to that demand improvement at this point."
},
{
"speaker": "Robin Fiedler",
"text": "Great. Thanks for that. And just one quick follow-up, so can you just quantify the magnitude of the reduced production, is it about 2,000 tons or?"
},
{
"speaker": "Eric Norris",
"text": "Yeah. So the production were -- that we are talking about is for -- it’s going to be down for us, call it, the beginning of September through at this point the end of the year depending on market conditions. So approximately four months of production on a plant that annually, which really driven by our King’s Mountain facility, which produces hydroxide, what supplies that plant is Silver Peak, the carbonate that feeds it. So on an end hydroxide, that’s end product hydroxide basis annualize you are talking about 4,000 tons, 5,000 tons a year and so it can be down for four months of that at this point."
},
{
"speaker": "Robin Fiedler",
"text": "Great. Thank you."
},
{
"speaker": "Operator",
"text": "Thank you. Our next question comes from Mike Sison with Wells Fargo. Your line is now open."
},
{
"speaker": "Mike Sison",
"text": "Hey. Good morning. Nice quarter. In terms of -- you used to have a nice slide talking about the potential demand for Lithium up to 2025 and I think the base case was 1 million tons. Can you sort of walk us through what you think that long-term potential is, has it changed materially or is about the same and how do you think that will work through over the next couple of years?"
},
{
"speaker": "Kent Masters",
"text": "So I will start with that and then Eric can fill in the details to the extent we can. So we have said and we still believe kind of a demand profile has been pushed out by about a year. So we -- and -- so we don’t think kind the long-term demand is affected, but the curve has changed probably steepened but it’s been pushed out a year during this. We continue to watch the forecast and how the EV penetration happens around the world to see if it changes that profile, but today we believe it’s the kind of the curve four years, five years out. The volume is the same. Curve is a little steeper to get there and starts about a year later."
},
{
"speaker": "Eric Norris",
"text": "Yeah. There’s not much to add to that comment but if you do look at slide 12 you can see the steepness of that curve in the following way. We have said that the demand we thought would materialize in 2020 before the crisis, that growth has shifted a year, originally we thought that would be 4.1 million vehicles, if you want to put on a vehicle -- electric vehicle basis and so that did materialize. We are looking at IHS has currently forecasting something closer to 3 million vehicles. But if you look out for the next year, where we see the demand has shifted to, it’s 5.2 million vehicles is what HIS. That’s obviously higher than 4.1. So that’s the point at which this curve is getting steeper. We believe that the stimulus measures that have been added on top of already measures that are there on the OEM, the CO2 reductions, now you have consumer based incentives in Europe that have been added on top of those are part of what’s driving the steepness of that curve and allow us to stay on that projection we are going to detail modeling of it all the way after 2025 and it’s right around that 1 million be met tons that we talked about for the industry driven by electric vehicles."
},
{
"speaker": "Mike Sison",
"text": "Got it. And then Eric as a quick follow-up, the price concessions, how does that get negotiated, if I recall that was sort of our fourth quarter event, right? So can you sort of walk through kind of the semantics of what will happened with those price concessions as you head into 2021?"
},
{
"speaker": "Eric Norris",
"text": "Yeah. You are right, Mike. It’s a bit early to say what’s going to happen. I can say this is, we are doing the same thing last year. We are looking at a falling set of market prices last year and we are in a -- we are trying to figure out how we are going to approach the year and that’s what led to the 2021 year concessions on these long-term agreements. If you sit here and look at 2021, the price in the market now is far lower than it was a year-ago. So that, I guess, would be the negative on this. The positive in that negotiation is what I just talked about is the steepness of that growth curve suspected or projected for next year, which there are other indications that are that is happening if you look at some of the Korean automotive public releases about what they see, not the Korean automotive, excuse me, the Korean battery producers, what they are projecting for their second half of the year, they are already starting to see and believe they are going to start to see that leading edge of that demand in terms of demand for that product. So that -- I can’t tell you how the negotiation is going to play out in terms of the exact way price will look in 2021, as Kent said earlier, that’s the big question. But I -- and those are the positives and negatives. Our LTAs have help, right, and we use them as part of the commercial negotiation use them as part of the commercial negotiation to find a good solution going forward that honors the spirit of inventory we have with them, right, with these customers. So we will be able to get more detail later in the year or earlier in the coming year."
},
{
"speaker": "Mike Sison",
"text": "Great. Thank you."
},
{
"speaker": "Operator",
"text": "Thank you. Our next question comes from Jim Sheehan with Truist Securities. Your line is open."
},
{
"speaker": "Jim Sheehan",
"text": "Good morning. Thanks for taking my question. So could you talk about what downside and upside are from your segment guidance, so it looks like your full year EBITDA, sorry, your full company third quarter EBITDA guidance varies significantly from the segments. I am just trying to figure out either whether you have downsides and upsides baked in or is this coming from corporate and all other?"
},
{
"speaker": "Scott Tozier",
"text": "Yeah. Jim, this is Scott. So if you look at the segments, for Lithium we are expecting a range of being down sequentially by around 10% to 20%. So that kind of bounds what’s happened there. Most of that’s going to be volume related overall for Lithium. For Bromine, it’s relatively tight right now. They have got pretty good visibility into their order book at least through the end of August and so flat sequentially they could be down a little bit or up a little bit, but flat sequentially. And then Catalyst is expected to be down between 50% and 60% on a year-over-year basis, really on the back of hydro processing orders and the timing of those, as well as the recovery of FCC on the back of increased fuel demand globally and so that kind of balance the range. Corporate is pretty well bound in with the cost reductions that we have out there and the small business fine tuning services is doing well in the U.S., so."
},
{
"speaker": "Jim Sheehan",
"text": "Thank you. And as it pertains to capital allocation, you have listed M&A in your slide on capital allocation. Maybe to talk about the pipeline what type of acquisitions you might be considering, what size and what region in the world or is that process really slowed down the same way that your asset sale process is?"
},
{
"speaker": "Kent Masters",
"text": "Yeah. So we continue to look for those opportunities, but there are going to be bolt-on, nothing dramatic. And -- but I would say, it’s probably fair to say that process has slowed down, but we continue to look for opportunities in the down market and that would probably most likely be around Lithium conversion assets that were available in the markets where we find that attractive."
},
{
"speaker": "Jim Sheehan",
"text": "Thank you."
},
{
"speaker": "Operator",
"text": "Thank you. And next question comes from Vincent Andrews with Morgan Stanley. Your line is now open."
},
{
"speaker": "Unidentified Analyst",
"text": "Hi. Thank you for giving us time. This is Daniel Kutz [ph] on for Vincent. I just had a quick question in terms of the technical grade, how much is that like in the demand down this year versus battery grade demand and how fast do you expect technical to come back and kind of what are the sign posts that we should be watching to track that?"
},
{
"speaker": "Eric Norris",
"text": "Yeah. It’s a smaller market for us. I would say -- this is Eric speaking. I would say that the technical grade market, if you look at any industrial indicator for the recession, it’s going to be representative what that technical grade market is doing. I have seen some external statistics that say that the glass and ceramics industry is an example contracted by 25% in the second quarter. So that is -- that’s not obviously inconsistent with what’s happening economically around the world. So that’s the auto magnitude of what we are seeing. It’s a small part of our business, right? It’s less than 20% of our sales overall and it’s very mix, it’s not just glass and ceramics there are other segments that are doing better than the in the glass and ceramics sector. So we aren’t seeing any sign of recovery in that yet. As we -- or as we roll here into the third quarter and that’s what we expect in the fourth quarter again and that just comes on the head of what we talked about earlier, it’s very murky and hard to tell at this point, which is why we are cautious to give more detailed guidance on Q4."
},
{
"speaker": "Unidentified Analyst",
"text": "Understood. Thank you. And then in terms of idling facilities, what is the cost of temporarily idling these and how quickly you can they both be taken down and brought back up. And I guess, just part of that, what is kind of the lowest that utilization rate that they can run at before it becomes unit cost derivatives."
},
{
"speaker": "Kent Masters",
"text": "So I will take the cost of idling. It’s relatively small. So these are smaller plants with a relatively small workforce. So really in total less than $10 million is actually idle the plant itself. And Eric if you want to just talk about utilization and recovery?"
},
{
"speaker": "Eric Norris",
"text": "Yeah. We just told the workforce yesterday about this, right, and we expect to be fully idled or safely down by September the 1st. So that give you some idea of the down and then there will be comparable period to come up once we see the demand signals to come back up. It is -- I am sorry, second question, I guess, was utilization. This is a fairly small part of our mix, but it’s an important part of being able to supply 2021 we believe, provided recovery take through as we expected to. So it’s on utilization basis. It’s not a lot. But here is a point that I think is also implied in your question. It is not -- this is product that given the weakness in the market while our contracts are being upheld, any opportunities outside of those, any opportunities in China, any opportunities in industrial markets is limited, for all the reasons we have discussed, because of the contraction in the marketplace. So this is product that would have gone to inventory. So there’s not an EBITDA impact on our guidance associated with what of our guidance otherwise would have been associated with this. This is just a reduction in inventory and during this period of time of down, we will continue to make investments to prepare these assets to run full out when the recovery does occur, which we, again, hope will be and anticipate will be in 2021."
},
{
"speaker": "Unidentified Analyst",
"text": "Very helpful. Thank you."
},
{
"speaker": "Operator",
"text": "Thank you. Our next question comes from Arun Viswanathan with RBC Capital Markets. Your line is now open."
},
{
"speaker": "Arun Viswanathan",
"text": "Great. Thanks. Good morning. I guess I just wanted to get your perspective on Lithium markets. I understand that your overall view is maybe even pushed out a year. But has there been any change in, I guess, how you are looking at supply demand, I mean, I appreciate that the automakers may not be coming back at full, but are they potentially coming back with greater focus on EVs and if so would that be a positive tailwind for you. So that’s my question on Lithium and then I have one more question on Catalysts, if you could maybe just characterize how you are thinking about that business on the surface, it looks like there could be some structural impairment that could last for quite a while. I guess is that a fair characterization. So, yeah, maybe you can just give your medium-term thoughts on both businesses? Thanks."
},
{
"speaker": "Kent Masters",
"text": "So, again, I will comment on that and Eric can fill if I miss piece on the -- on Lithium. So as you said before, we really don’t think it’s changed the dynamic for the EV market long-term, so we kind of fundamentally believe in the EV market and the Lithium demand that’s going to go into that. So, the one thing that has happened, I guess, that is quite different is there incentives becoming -- becoming more incentives associated with electric vehicles and that’s primarily in Europe. That’s probably -- it’s going to drive that a little differently than it was before. So previously you didn’t have the depth, but the curve was a year earlier, the demand coming out now, you have got a depth that comes back a little stronger, primarily on those incentives and trying to figure out exactly what that curve looks like, we don’t know. And regardless of incentives and the demand that’s going to happen, I mean, consumers still have to buy cars and that’s the fundamental thing we don’t really know and I think the people forecasting that don’t know as well. So, Eric, anything on top of that."
},
{
"speaker": "Eric Norris",
"text": "No. Nothing to add other than you just -- you all have to be conscious of the fact that just like the impacts that happened in the second quarter aren’t really hitting us until the third quarter. So to the recovery, just as I said, we have the Korean manufacturers out, saying, that they see a significant uptick in their sales. That’s probably and hopefully related to these -- what’s going on in Europe and there’s obviously a corresponding lag, particularly with excess channel inventories there for it to come back and hit us. So that’s why in the longer term, we are pretty optimistic, but in the next six months it’s very hard to say, very hard to say."
},
{
"speaker": "Kent Masters",
"text": "Yeah. And then on your Catalysts question kind of the same approach. I will do a high level, Raphael, can fill in. But so oil prices are down and then the miles driven are pretty dramatic change and you could see on that slide, I think, it was slide 12, how dramatic that was miles driven and that’s changed that. We don’t really see it changing the fundamentals of that business long-term, but it is going to take some time for that to come back. Before people go back to work and commute and maybe they don’t commute as much as they did after this or maybe less miles driven, maybe more vacation by driving rather than flying, but then again, that’s air travel. So we think that’s been pushed out for some period of time, but peak oil probably it doesn’t change. We knew that was coming in some period of time, has that been pulled forward by a little bit, we don’t know that. Most of the forecast say maybe a year, maybe not. So I don’t think it fundamentally changes the business that we have, clean fuels continue to be important, our business is based on innovation around clean fuels, so we don’t think it fundamentally changes it or structurally changes it. But it might change the dynamics of where our markets are geographically and which of our customers do better or do worse during this."
},
{
"speaker": "Raphael Crawford",
"text": "Yeah. This is Raphael, Arun. To add to that view, certainly, this is a time for our business to take action to mitigate the impact whether it would be, cost working capital, capital for the near-term, because it has -- COVID-19 has had an acute impact on our customers and suppliers to our customers. That being said, as Kent said, there is a bright future for refining Catalysts when positioned correctly and our strategy is really all around positioning our business to take advantage of trends in emerging markets where fuel consumption will continue to grow beyond global peak gasoline, as well as the emerging chemicals applications from refineries where we already have a position of strength and we need to advance that. So, with all of the challenges that COVID-19 brings, it is a great motivator for us as a company to stay on strategy and accelerate that strategy to be in more resilient spaces as we progress."
},
{
"speaker": "Arun Viswanathan",
"text": "Thanks."
},
{
"speaker": "Operator",
"text": "Thank you. Our next question comes from Mike Harrison with Seaport Global Securities. Your line is now open."
},
{
"speaker": "Mike Harrison",
"text": "Hi. Good mornings. Raphael, maybe kind of continuing on the Catalyst discussion, can you talk about the FCC pricing outlook. I believe you saw a pricing in your Catalyst business overall decline by 4%, not sure if that’s pricing or mix, but are you seeing resilient FCC pricing and are you see any trading down as you look at your overall mix and Catalysts."
},
{
"speaker": "Raphael Crawford",
"text": "Hey, Mike. Thanks for the question. So when we look at it, pricing does -- there has been some downward movement on price but not for the value-oriented products that are the bulk of our portfolio. So as you know in the FCC industry, you certainly have contracted business, you have business that’s not contract and then there are trials and trials are a period of time within a contract, when a competitor can bring a Catalyst into a refinery to test performance. Trial pricing is lower, so to the extent that within our mix we have trials and we are pursuing trials with new refineries or refineries we don’t have, yeah, that pricing is going to be lower than what we have typically seen. But for the business that’s our core business on performance products that pricing has been stable and I would even think, if I looked at prior quarter and looking ahead as we are negotiating for contracts where we are demonstrating value or increased value we are able to gain on price. So I would say, it’s sort of mix between trial pricing and contract pricing, and what we generate on value has the biggest impact on that."
},
{
"speaker": "Mike Harrison",
"text": "All right. Thanks for that. And then on Lithium, I was wondering if you can give a little more color on where you are seeing the greatest concern in terms of inventories in the Lithium channel and in the battery channel. Is it with finished Catalyst material and the battery makers, is it hydroxide, is it carbonate, it’s probably mean maybe some more detail there?"
},
{
"speaker": "Eric Norris",
"text": "Hey, Mike. It’s Eric here. So look it’s, I would say, we have and you can sort of interpret this by the action we have taken with our plants, it’s both hydroxide and carbonate. And it’s with our customers, be the cathode customers or battery accounts and with -- we believe with suppliers in the channel. We understand that there are probably potentially even some excess inventories from a cathode standpoint. So I mean you have an industry that during the second quarter screeched to a halt, right? Nothing was happening for depended on plant it could have been a month more in terms of the OEM closures. So it’s in the battery channel and it’s at various points in the battery channel. And so I think it’s about the most color I can give you at this point in time. Spodumene is -- there continues to be excess spodumene in China. Some of that is below grade spodumene, meaning below 6%. Some of that it’s even the DSO variety, which is just raw rock, it’s not processed. And some of it by its purchasers just purchased the high prices for spodumene rock, so it’s an economic in the current situation. So there’s this spodumene -- excess spodumene there is well. That is a lot more opaque and hard to tell exactly how much however."
},
{
"speaker": "Mike Harrison",
"text": "All right. Thanks very much."
},
{
"speaker": "Operator",
"text": "Thank you. Our next question comes from Matthew DeYoe with Bank of America. Your line is now open."
},
{
"speaker": "Matthew DeYoe",
"text": "Hi. I wanted to hit a little bit on the Catalyst trial pricing issue. I mean, why are your trial price is lower, are refineries just kind of trialing lower quality products, is the way to temporarily lower costs. Do you see risk of these get adopted because refineries don’t need better utilization rates right now that your higher FCCs would deliver?"
},
{
"speaker": "Raphael Crawford",
"text": "Hey, Matthew. This is Raphael. The -- some of it has to do with just the dynamic that every market is down and every Catalyst producer would like to look for new volume opportunities and the most accessible way to go and do that is to participate in trials. So I think the activity and the eagerness of the market around trials has increased and when in that competitive space, certainly, folks are -- and Albemarle included are willing to price lower than what we normally would, still at positive margin to participate in a trial to prove out value to a refinery over what they might already have with their current supplier. That being said, with trials, I mean, you get in the door to some extent that trial sets a benchmark for future pricing. But most refineries understand that pricing and Catalysts is very much tied to value and if you are generating value over time you are able to raise the price to what you are able to justify with your performance. Albemarle has been very good at doing that and where we participate in markets related to max chemicals, bottoms cracking, which is really our strength within FCC, we are able to demonstrate value and capture price over time."
},
{
"speaker": "Matthew DeYoe",
"text": "Okay. And then if I would have just circle back on the excess spodumene comment, I know there was a fair amount that’s you mentioned below 6% and there is DSO. But how much excess spodumene out there that is above 6% and like a seasonable product. I think that was sized before at -- about three months to six months of excess inventory, is that still the case, is any of that have been worked down at all?"
},
{
"speaker": "Eric Norris",
"text": "I will have to go back to the kind of that again, the comment maybe for, it is incredibly opaque. And even to the point where sometimes inventory is counted twice depending on who you are talking to. So I really couldn’t tell you. I can tell you that 6% -- the 6% spodumene that has been produced for integrated producers like Albemarle, our partner, and obviously, competitors as well Tianqi, potentially for some of the other producers that are integrated like Kemerton. I doubt that they would be carrying a lot of excess inventories because we have been -- I am assuming that those competitors are doing the same thing that Albemarle is doing, which is we are trying as a leader in the industry trying to assist the challenge by reducing inventories and we -- and the outputs as you can see from our equity income is substantially reduced from Talison is the big part of that actually is Tianqi and the challenges they have had. So it’s -- that 6% which is very high quality rock that I think has been coming down. But as for the rest, the majority of which is below 6% or barely 6%, that’s probably were more of the excess is, because that’s a less economic product in today’s market with today’s prices."
},
{
"speaker": "Matthew DeYoe",
"text": "Okay. I appreciate your -- the added detail. I know it’s definitely opaque. So thank you."
},
{
"speaker": "Operator",
"text": "Thank you. Our next question comes from Bob Koort with Goldman Sachs. Your line is now open."
},
{
"speaker": "Bob Koort",
"text": "Thank you. Good morning. A couple of Lithium questions, have you guys think about reconciling what seems to be some odd financial math when, I guess, in China we are seeing battery grade material under $6,000 you have got spodumene market prices under $400. And I think, Eric, you are talking about inventories might be bloated everywhere. So can your competitors in China make money? Is there the risk that they try to liquidate those inventories more aggressively in a weak period? Do you see a bifurcated market as China different than Japan and Korea? Can you just give us a little color there?"
},
{
"speaker": "Eric Norris",
"text": "Well, on -- hey Bob. It’s Eric here. On the first part of your question, I would say, that what you are seeing is, nothing has changed in the cost curves that we talked about. You can go back and look at the Investor Day, look at where we thought marginal cash costs are between $6 and $7 in that range. That hasn’t changed. There’s nothing that’s changed in that regard. And so, effectively at prices you are seeing in the China market now spot prices, the whole right hand side of the cost curve is underwater. They are not able to make money. They lose money selling product. So I can’t explain why that’s happening other than it’s a market that has gone through a compression that we talked about, because of the COVID crisis in second quarter and it’s started working its way out as we go into the second half of the year. And you have lower cost producers particularly in the carbonate side and remember China is largely a carbonate market, who have lower cost positions, brine -based rock -- brine based carbonate has a much lower cost position are able to sell well below the cash cost of those who are rock-based producers in the region. So I think that’s what’s happening. It sort of shows sort of the stress in the system. Will Chinese producers start to unload inventory? I think, potentially, in a desperation move, but I think at this point, most of that rock is sitting stationary until market values improve, at this point. You had a second part of your question, Bob, was about…"
},
{
"speaker": "Bob Koort",
"text": "Just wondering…"
},
{
"speaker": "Eric Norris",
"text": "…was there difference between China and elsewhere? Yeah. No. Yes. There’s a difference. Again, it’s largely a carbonate market, more of the high nickel chemistry today that hydroxide base has made outside of China, some of it’s -- maybe produced in China, but most of the demand for that is outside China. And of course, there are structural differences. There’s VAT difference between China and inside and outside of China as well. But again, I don’t know anything has changed other than the fact that we have had a demand crisis and that’s really put pressure on the system."
},
{
"speaker": "Bob Koort",
"text": "And Eric you mentioned that your LTAs have largely held, I think, in the last couple of quarters, you have talked about you want to sell to your customers in the manner that they want to buy in terms of contract dynamics. But what’s your expectation for the desire for those LTAs, as you start to get to the exponential part of that demand curve, because it would seem the cathode folks are looking at this volatility and pricing and obviously resets on pricing, but then you have got some pretty dangerous implications for them if the industry curtails its expansion activity, where there may be a scarcity value sometime down the road. So I guess what I am asking is the game plan, do you think you will have a lot more LTAs at fixed prices two years and three years from now or a lot fewer because your customers are maybe moving away from that. Can you give me your sense of how this market develops from a very weak price period to a potentially very tight market in a few years?"
},
{
"speaker": "Eric Norris",
"text": "I don’t think the security of supply and notion of that has changed. But we do see our contracts starting to evolve from there. Do you want to comment, Kent?"
},
{
"speaker": "Kent Masters",
"text": "Yeah. And I would say, that security and how our customers look out a year or two and looking for guaranteed supply out in that timeframe is part of that dynamic. And we -- but we are seeing it as a portfolio with a percentage and they will be those long-term contracts, but with slightly different terms across the portfolio, some with guaranteed promises of supply a couple of years out and some without that and some more spot based and others more contracted with a formula that may indicate spot but not move with spot."
},
{
"speaker": "Eric Norris",
"text": "Yeah. And what’s happening now is I think you have put your -- sort of put your finger on it Bob is that, short-termism is an interesting strategy. Now it will save you some money, because spot prices are really low. But as you have also point out, capacity is being withdrawn from the market. The economics to support expansion are not there today in the market for almost every producer except for the very lowest cost producers and there’s a scarcity at some point it starts to shift. We think the supply chain particularly those most invested in the supply chain, all the way to the top of it, the automotive producers are increasingly focused and will become increasingly focused on this issue, which is why, I think, there’s always a value for security supply. And to Kent’s point, we always want a portfolio. We are always going to want some of those price buyers, because that -- those -- that there is a value to that when the market goes up, right, in terms of what it means your EBITDA. We don’t want a majority of our business there but we will have some of it there."
},
{
"speaker": "Bob Koort",
"text": "Great. Thanks for the insight."
},
{
"speaker": "Operator",
"text": "Thank you. Our next question comes from Matthew Skowronski with UBS. Your line is now open."
},
{
"speaker": "Matthew Skowronski",
"text": "Good morning. Thank you for taking my question. Can you give us an update on when we should expect to see sales from La Negra III and IV and if you have changed your view at all about the timing of the ramp of additional capacity given the demand disruption you have seen this year?"
},
{
"speaker": "Kent Masters",
"text": "Well, we had said last quarter, we have kind of slowed down the execution of those -- of our two big projects, La Negra III and IV and at Kemerton. And so that really hasn’t changed. We have slowed that down basically because we see demand being pushed out at gap and we did that to kind of preserve cash but it also matches what we see s supply-demand and obviously given the discussion you have seen today we are -- we have got our forecast and we have our view, but it’s a bit of a shot in the dark. But we see volume to your question from La Negra III and IV our capacity coming on late next year and then a qualification period after that."
},
{
"speaker": "Matthew Skowronski",
"text": "Thank you."
},
{
"speaker": "Operator",
"text": "Thank you. And our next question comes from Chris Kapsch with Loop Capital Markets. Your line is now open."
},
{
"speaker": "Chris Kapsch",
"text": "Yeah. Good morning. Question is probably for Eric and slightly nuance follow-up to some of the stuff you have talked about. But just -- on the comments about excess inventory in the battery supply chain with hydroxide there’s a limited shelf life given its hydroscopic nature and no such issue with carbonates. So I am just wondering if your comments about inventories, if those -- if that dynamic is more pronounced for carbonate grades versus hydroxide grades. Maybe you got it just a little bit by suggesting that some of the excess inventories at cathode level, but just wondering given that a lot of these newly introduced EV models particularly in Europe are definitely deploying higher energy density cathodes that require hydroxide. I am wondering if there is a little bit of bifurcation in those dynamics?"
},
{
"speaker": "Eric Norris",
"text": "So you are right. Chris, this is Eric. There is sure shelf life for hydroxide, which is -- but it’s also a smaller market. So it’s a more -- if we look at our customer base, the number of customers that they use hydroxide to a large degree and would have high inventory levels. It’s a more manageable group of folks to work with. And it’s also the reason that the motivator for the idlings that we did and we announced to our employee yesterday in our release last night is driven first and foremost by the hydroxide. Carbonate is a bigger market and the shelf life considerations aren’t the same. So you do manage them differently, because it’s bigger, there’s a lot of carbonate inventory out there too, right? The more people produce it and more people buy it. So there’s a difference in the way in which we manage it, but the challenges are the same and that they are elevated for both."
},
{
"speaker": "Chris Kapsch",
"text": "Okay. And my follow up is and you have got it just a little bit with -- in response to Bob’s question on your long-term agreements. But there’s obviously this acquisition where there is acute near-term oversupply probably amplified by the COVID pandemic. But then the increasing steepness of the EV adoption curve a couple few years out. So I am just wondering again probably looking at maybe the conversation around carbonate versus the conversations around long-term sourcing of hydroxide. Is there -- can you just provide any color on as some of those customers are looking for a little relief on the previously agreed to pricing floors. Is there still anxiousness about the ability to source a long-term basis hydroxide, is that -- and is that more noticeable with the conversation around hydroxide vis-à-vis carbonate? Thank you."
},
{
"speaker": "Eric Norris",
"text": "I would say that that because the steepness in the growth curve that we -- that IHS is projecting and it’s a guided post for us provided it happens when it does, that’s also what our customers are seeing and it’s driven largely by -- a big chunk of it is driven by Europe and that is also a big hydroxide opportunity that, yes, there is improbably increased, I don’t know I think anxiety is the right word, but statement around from customers around, they are going to need more -- a lot more hydroxide in the coming year or so and they are banking on Albemarle to be able to bring Kemerton in particular online to meet that. Now, all of this is tampered about when, right? The steepness in that curve feels, right, based on what we are seeing, the timing of it is consumer spending driven. So we just keep a careful eye on that up and down the supply chain."
},
{
"speaker": "Chris Kapsch",
"text": "Fair enough. Thanks guys."
},
{
"speaker": "Operator",
"text": "Thank you. This concludes the question-and-answer session. I would now like to turn the call back over to Meredith Bandy for closing remarks."
},
{
"speaker": "Meredith Bandy",
"text": "Hi. Thank you all for your questions and participation in today’s call. As always, we appreciate your interest in Albemarle and this concludes our call."
},
{
"speaker": "Operator",
"text": "Ladies and gentlemen, this concludes today’s conference call. Thank you for participating. You may now disconnect."
}
] | Albemarle Corporation | 18,671 |
ALB | 1 | 2,020 | 2020-05-07 09:00:00 | Operator: Good day ladies and gentlemen, welcome to the First Quarter 2020 Albemarle Earnings Conference Call. At this time all participants are in a listen-only mode. Later we will conduct a question-and-answer session and instructions will follow at that time. [Operator Instructions]. As a reminder this conference is being recorded. I would now like to introduce your host for today's conference Ms. Meredith Bandy, Vice President of Investor Relations and Sustainability. Maám please go ahead.
Meredith Bandy: Alright, thank you and welcome to Albemarle's first quarter 2020 earnings conference call. Our earnings were released after the close of the market yesterday and you'll find the press release, earnings presentation, and non-GAAP reconciliations posted on our website under the Investors section www.albemarle.com. Joining me on the call today are Luke Kissam, former Chief Executive Officer; Kent Masters, current Chief Executive Officer; Scott Tozier, Chief Financial Officer. Raphael Crawford, President, Catalysts; Netha Johnson, President, Bromine Specialties; and Eric Norris, President, Lithium are also available for Q&A. As a reminder, some of the statements made during this conference call including our outlook, expected company performance, expected COVID-19 impacts, and proposed expansion projects may constitute forward-looking statements within the meaning of Federal Securities Laws. Please note the cautionary language about forward-looking statements contained in our press release, that same language applies to this call. Please also note that some of our comments today refer to financial measures that are not prepared in accordance with GAAP. A reconciliation of these measures to GAAP financial measures can be found on our earnings release and the appendix of our presentation, both of which are on our website. With that I will turn the call over to Luke.
Luke Kissam: Thanks Meredith and good morning everybody. I certainly hope that everybody is healthy and safe. I would like to take this opportunity to welcome Kent Masters as Albemarle's new CEO. Since Kent joined the Board in 2015 he has been one of my most trusted advisors and mentors. Kent has a proven track record in good times and in bad as a successful CEO of a publicly traded company and he thoroughly understands what is expected of a leader in that role. I am confident that Kent will continue with work with our Board and the entire Albemarle team to position the company from future success and deliver long-term value for our customers, our employees, shareholders, and other stakeholders. With that I'll turn it over to Kent.
Kent Masters: Thank you Luke. It's good to be here today. I'm excited for the opportunity and I look forward to meeting with members of the investment community virtually and eventually in person when it's safe for us to do so. As Luke mentioned I joined the Board in 2015 with the acquisition of Rockwood where I had been on the Board -- where I had been a Board Member there since 2007. Over the past five years I've worked closely with Luke and was actively involved with my Board colleagues in establishing the company's purpose and values which are core to our identity. What excites me about Albemarle is the innovation and leadership we bring to our markets and the prospects we have for future growth. We have earned an enviable position at our markets and with our strong strategy and values we will build on that legacy for years to come. On today's call I will cover a high level overview of the current environment, our actions in light of COVID-19, and our capital allocation priorities. Scott will review the first quarter financials, provide an update on cost savings, and review our outlook. First, I want to emphasize that the safety and welfare of our people is our highest priority. We are taking multiple actions to protect our employees, serve our customers, and help fight the spread of COVID-19. Thankfully to date our sites are operating without material impact related to the pandemic. I deeply appreciate the courage and continued support of the frontline essential workers and our communities and our dedicated Albemarle employees who continue to ensure safe operations at our facilities and offices worldwide. Yesterday we released first quarter results including net income of 107 million or a 1.01 per share. Adjusted EBITDA of 196 million was down 13% from prior year. We had previously communicated the outlook for first quarter EBITDA to be down about 25% from prior year. Ultimately we beat that outlook due to better sales in bromine and lithium and better than expected cost reductions. Of course there will be impacts to all of our businesses related to COVID-19. The timing, duration, and severity of those impacts will vary for each business. Given the degree of uncertainty we are withdrawing our full year 2020 outlook. We plan to reinstate long-term guidance as soon as it is practical to do so. In the meantime we are temporarily introducing quarterly guidance that Scott will walk you through in a few minutes. We have evaluated our capital allocation priorities in light of the current environment and are focusing on -- we're focusing our efforts on preserving cash and maintaining our dividend. That means taking preemptive measures to bolster our balance sheet and maintain financial flexibility. We are also stepping up and accelerating cost savings initiatives that were already underway and introducing short-term cash management plans. We will remain focused on controlling what is within our control and we'll continue to act in the best interest of our shareholders, employees, customers, and other stakeholders to ensure success in these uncertain times. Right now ensuring success means responding to COVID-19 in a way that protects our employees, customers, suppliers, and communities. Our Chinese operations were the first to be impacted by the virus. We have been able to take those early learning from our teams in China and apply them around the globe. In early March we created a global cross functional pandemic response team to recommend, develop, and implement strategies to respond to the pandemic. Albemarle's leadership team meets almost daily to review and take actions on recommendations from that team. In uncertain times communication is critical and we are in frequent dialogue with our employees around the world. To help our employees stay safe and healthy we have implemented protocols including restricting travel, implementing work from home for non-essential personnel, and adjusting shifts, increasing hygiene practices, and requiring social distancing for essential workers in our plants. To date we have had very few confirmed cases. However, availability of testing varies by region. A small number of employees have self quarantined due to prior travel, exposure to a COVID positive individual, or presenting mild flu, mild cold or flu like symptoms. We are thankful that the number of people directly impacted by COVID-19 has been trending down across the globe and we see this as evidence that the precautions we are taking are working. We are communicating frequently with our customers and suppliers to help us manage supply and demand issues as they arise. To date our plants have operated with minimal impacts other than in China where we operated at reduced rates for two weeks at the first -- during the first quarter. For the health and welfare of our business partners we have halted customer visits to our plant sites and have implemented plant entry protocols for safe and efficient deliveries. Logistics remain a concern across all of our businesses as trucking and shipping companies struggle with new demand patterns and border requirements. We are working through these challenges to keep our customers supplied. As the pandemic continues Albemarle is supporting our communities in the fight against COVID-19. We are providing mask and PPE to frontline health and relief workers and donations and grants to help fight hunger and improve access to online learning. We are collaborating with universities, local disaster relief funds, trade organizations, and other grand tours to extend the reach of our efforts. To date we have distributed more than $1 million to organizations around the globe. Some of our products are also used in the fight against COVID-19. For example our flame retardants are used in electrical medical equipment such as ventilators, our hydrobromic acid product is a catalyst in the manufacture of PET for protective clothing in hospitals. We produce a line of water treatment products and intermediates used in cleaning products and disinfectants, and at our plant in Germany we are producing hand sanitizer for the local community. While these products are not financially significant to our business, we are proud to do our part to protect against the spread of COVID-19. The extent of the economic impact of the global pandemic remains unclear but I am confident that the actions we are taking to adapt to current market conditions will position us to execute our strategy across the cycle. Now I'd like to set the groundwork for our capital allocation priorities. Our first priorities are to fund our dividend to maintain financial flexibility and that is unchanged in the current environment. 2020 is expected to be Albemarle's 26th consecutive year of dividend increases and we remain committed to shareholder returns. We are also committed to maintaining our investment grade credit rating. Execution of our other capital allocation priorities has shifted in this environment. First, all capital projects are being examined for opportunities to preserve cash and spending. Our two biggest capital projects Le Negra III and IV and Kemerton are being slow walked to preserve capital in the near-term. We are also reducing our sustaining capital spend with an eye to maintaining safety and critical main maintenance projects. Second, we are taking a disciplined and thoughtful approach to investments including M&A and joint ventures and will continue to act in the best interest of our shareholders. Lastly while our share repurchase authorization remains in place there are no buybacks planned in this environment. So with that as a backdrop I will turn it over to Scott for more details.
Scott Tozier: Thank you Kent. Albemarle generated first quarter net sales of $739 million, a decrease of about 11% compared to the prior year. This reduction was primarily driven by reduced volume in price in lithium as expected coming into the year and reduced volumes in Catalyst due in part to low transportation fuel demand caused by COVID-19. GAAP net income was $107 million or a $1.01 per diluted share. There were very minimal adjustments this quarter with adjusted earnings of $1 per diluted share. Corporate cost including SG&A, R&D, and interest and financing expenses were broadly in line with the prior year period. As Kent stated adjusted EBITDA was $196 million, a decrease of 13% from the prior year but above the previously communicated outlook. Turning to Slide 8 for a look at EBITDA by business segment. Adjusted EBITDA was down $30 million over the prior year. Solid performance in bromine and our FCS businesses and companywide cost savings partially offset top line decline for lithium and Catalyst. Lithium's adjusted EBITDA declined by $40 million versus the prior year excluding currency impacts. Pricing in volumes were down about 10% each offset by product and customer mix and cost savings initiatives. As you know in late 2019 we gave one year price concessions to many of our battery material customers. Also as expected customers reduced Q1 2020 shipments as they work through excess inventories from late 2019. In catalyst adjusted EBITDA declined $11 million excluding currency impacts. Both FCC and HPC volumes were down this quarter but for different reasons. The FCC decline was caused by reduced consumption of transportation fuel, stay at home orders, and travel restrictions mean refiners don’t have to run as hard to meet reduced demand. HPC volumes were impacted by logistics challenges as the world's cargo fleet and truck transportation adjusted to slowing global demand. Partially offsetting these challenges the Catalyst business benefited from lower raw materials, better product mix, and cost reduction efforts. Bromine's adjusted EBITDA was up $5 million excluding currency impacts. Improved average realized pricing, cost savings, and lower minority interest expense more than offset lower volume. The Q1 order book was strong but logistics challenges prevented us from filling all those orders during the quarter. Our corporate and other categories is driven primarily by our FCS business. FCS EBITDA was up nearly $16 million on higher volumes and product mix. While Q1 results were better than we had expected we are operating in uncertain times. As Kent discussed maintaining our strong financial position is a top priority and we remain committed to maintaining our investment grade rating. We had ample liquidity of about $1.7 billion as of quarter end consisting of $553 million of cash including $250 million drawn on our revolver plus $715 million remaining under our $1 billion revolver. $200 million available under our delayed draw term loan which we drew in April and $190 million on other available credit lines. Since quarter close we have issued additional commercial paper of that market return to more normal terms and tenders. In terms of debt maturity we are pretty well turned out. The only short-term debt is from commercial paper. Our revolver is not due until 2024 and we may choose to repay that sooner. Otherwise the nearest term maturities are $444 million due at the end of 2021. The investment market is open to us and I am confident we will be able to -- that or go forward. The divestitures of PTS, a portion of our Catalyst business and FCS are being slowed down due to the COVID-19 travel restrictions. The potential buyers remain interested in bulk transactions or potential liquidity events as we get back to normal. Turning to Slide 10 from more on our cost savings. We have had a strong history of generating operating cash including $359 million generated during the great recession in 2009. We expect to continue to generate significant operating cash thanks to industry leading positions in all of our businesses and through active cost management. As communicated during the fourth quarter earnings call, we are accelerating the 2020 sustainable cost savings initiatives. These were projects that were already identified and underway when COVID-19 hit. We now expect to achieve cost reductions of $50 million to $70 million this year and reach run rate savings of at least $100 million by the end of 2021. Basically we are bringing forward about $10 million to $20 million of cost savings in June of 2020. Based on our current order book and cost reduction actions we now expect Q2 2020 adjusted EBITDA in the range of $140 million to $190 million. Lithium's Q2 2020 EBITDA is expected to be down year-over-year but up slightly on a sequential basis. The Q2 order book continues to look solid albeit with some softness in technical grades. Specialties and technical grades make up about 40% of lithium revenues and have a pretty short supply chain. Lags are usually just a few months going into and coming out of recession [ph]. Specialties and technical grade products usually grow at or above GDP growth rates and are driven by consumer spending and industrial production. The energy storage market makes up about 60% of our lithium sales and has a relatively long supply chain with a one to two quarter lag on battery grade sales both in the downturn and in the recovery. Battery grade customers continue to forecast a stable order pattern in the second quarter as catalysts and battery manufacturers catch up on backlogs, backlog orders placed prior to COVID-19. We expect to see the impact of recent OEM automotive shutdowns flow through the supply chain in the second half. By year-end, OEM automotive restarts are expected to be supportive of battery and lithium demand. China OEM production has started back up and some European plants are scheduled to restart production in mid-May. Looking beyond Q2 for each of our businesses is difficult and nowhere is that more the case than with lithium. The electric vehicle market that is now the primary growth driver for lithium was not mature enough during the global financial crisis to provide much context for today. Nevertheless, we expect the EV growth curve to be delayed by at least one year. Bromine Q2 order patterns are starting to show the impact from COVID-19. They are off expectations by about 10% and down sequentially. We're seeing some indications that customers may push orders from late May or June into the third quarter. And net-net we expect first half EBITDA to be down year-over-year with Q2 EBITDA down about 20% from prior year. We do expect softness to continue into Q3 related to slowdowns in automotive, consumer electronics, appliances, and construction all as a result of impacts of COVID-19. Based on our position in the supply chain, we typically see a lag of at least one or two quarters and in some cases longer. Our bromine business has been profitable every year for 20 years. In the global financial crisis bromine's 2009 net sales were down 30% year-over-year, and EBITDA margins fell to 16%, compared to a more normal margin in the high 20% to low 30% range. Then the business rebounded very strongly in 2010 and 2011 back to and in some markets above prerecession levels, thanks to pent up demand. Compared to 2009, bromine today has a tighter supply demand balance going into the downturn. We've also seen some competitor specific supply disruptions, which somewhat muddied the water and may partially offset some of the demand softness. Bromine is also much more diversified as a business today. It tends to be relatively GDP driven with customers across multiple end user markets. Flame retardants make up about 50% of sales and are used in electronics, automotive, construction and in appliances. Oil-field represents up to 10% of sales, and other industrial uses include TET and agriculture. This diversity allows us to shift sales across markets into the best performing industries. Finally, as you know, our Catalyst business includes two primary product groups, FCC Catalyst and HPC Catalyst. Across the cycle, FCC and HPC are fairly similar in size, but the HPC business is much lumpier. Customers order HPCs only every two to five years when they perform turnarounds at refineries. Therefore, HPC demand is driven by customer turnaround schedules, whereas FCC demand is driven by transportation, fuel consumption, and miles driven. In a typical recession there's very minimal impact t FCCs. Oil pricing falls and miles driven goes up meaning more fuel demand and more Catalyst demand. HPCs on the other hand tend to see sharply lower demand when oil pricing contracts. Refineries run at lower rates and are able to push out turnarounds and conserve cash. In 2008 and 2009 and then 2014 and 2015, the oil price corrected by more than 50% in a matter of months. In both cases, FCC earnings were up slightly, but HPC earnings were down about 30% in 2009 and 50% in 2015. In the current economic environment, we do expect HPCs to be down, especially in the second half. But in this case, FCCs will also be down as widespread stay at home orders and travel restrictions lead to dramatically lower miles driven and transportation fuel consumptions. In Q2 we expect to see a full quarter impact of the travel restrictions that began in the first quarter. To date we've seen minimal changes to the FCC order book for Q2. But based on the experience of prior oil price reductions, we expect to see a shift of HPC orders out of second half and into 2021. The timing and extent of the downturn is unclear and a lot depends on how long travel restrictions are in place, how long the oil price remains low, and how much crude and refined product inventory is built up when restrictions are lifted. Given the current economic environment, we are executing our down-turn playbook for short-term cash management and have already activated many of these tactics. In terms of variable costs, restricted travel due to COVID-19 will continue, we're also strictly limiting professional services and consultants. On fixed cost we're reducing capital expenditures and limiting hiring over time and contractors. Senior executives and the Board have also agreed to a temporary 20% cut to base pay. We're also cutting sustaining and gross capital spending. We will continue to maintain our health, safety, and environmental standards. Beyond that, we're taking a critical look at all capital spending across our businesses. The most meaningful capital spend is at our lithium expansion projects Le Negra III and IV and Kemerton. We are slowing work on these projects to conserve cash and to reassess the demand requirement when the battery industry recovers. We have maintained optionality to defer additional capital or accelerate these projects depending on market conditions. Including cuts to sustaining a major project capital, we now expect our CAPEX to be in the range of $850 million to $950 million, a 15% reduction from the midpoint of previous guidance. Working capital averages about 25% of sales, so we'd expect to see some reduction here as revenue declines. We're also actively managing working capital to see further improvements, including seeking payment term extensions from vendors, accelerating collection of past receivables, and actively reducing inventories. We have begun shutdowns of some Catalyst's production and have plans in place to slow down our plants as needed, assuming demand declines as recent customer shutdowns work their way through supply chains. Also the short-term cash management actions detailed here are expected to save the company about $25 million to $40 million per quarter. That will be in addition to the CAPEX reductions and sustainable cost savings we just discussed. We're working hard to cut costs, but also minimize the impact for our employees. Unfortunately, depending on the length and severity of the downturn we may add additional production sites or take more drastic cost actions if necessary. These actions are difficult and not something that we undertake lightly, but they are meaningful to help position Albemarle to be stronger for longer. Now I will turn the call back over to Kent.
Kent Masters: Thanks, guys. Current economic conditions are challenging. Albemarle is an industry leader in all three of our core businesses. We believe in the long-term growth prospects in all of these businesses but our immediate challenge is to manage through this crisis. We will act on cost reduction measures quickly to preserve cash and maintain our financial flexibility. We will also be poised to respond to meet customer needs when the market returns. We remain confident in our strategy and we will modify execution of that strategy to further position Albemarle for success.
Meredith Bandy: Great, before we open the lines for Q&A, I would like to remind everyone to please limit questions to one question and one follow-up to ensure that as many participants have a chance to ask a question as possible. Feel free to get back in the queue for additional follow-up if time allows. Thank you. And Michelle, please proceed with the Q&A.
Operator: Thank you. [Operator Instructions]. Our first question comes from the line of Steve Byrne with Bank of America. Your line is open. Please go ahead.
Unidentified Analyst : Hi, this is Matthew on for Steve. I wanted to dig into the guidance a little bit more and see if you could kind of point out the drivers, which will result in either the low end or the high end of the guidance range. It seems like your direct segment commentary points to something like 150 million. How did you get to that 190 million number?
Scott Tozier: Hey, this is Scott. So I think a couple of key things around uncertainty. One is in each of our businesses we've got a pretty good visibility through the end of May beginning of June in terms of our order book and are executing to that. I think the uncertainty comes in each of the businesses as we go through the month of May, particularly with Catalyst in terms of how deep the slowdowns in the refineries will be or if they -- as the states start to come back on -- this refinery start back up. In bromine it's going to come down most likely to some logistics issues and questions around order books getting filled on time. And then Lithium, we do expect that the auto OEM shutdowns will be impacting us in the second half. Right now, the order books looked pretty good through June, but they are starting to soften. So there's some variability there as well. So those are the key drivers for us.
Unidentified Analyst : Okay, and I guess on prior calls you discussed the potential for overbuilding in battery cells as lithium demand appeared strong, despite what we saw was probably a slowdown in autos in 2Q and beyond, how did this end up playing out, where do you see downstream product inventories? And I guess finally Luke I want to wish you well. I always appreciate your candor and levity you brought to the conversations over the years.
Scott Tozier: Eric you want to take that question.
Eric Norris: Sure. So, Matt let me tell you what we know about battery cell manufacturers. We -- today we are seeing and have talked about excess inventories of lithium bearing products in the value chain that is being worked off as one of the reasons why our first quarter for us was weaker on volumes. We knew that, expected that coming into the quarter. In terms of battery cell manufacturer, it's actually the opposite of what you describe. The phenomenon we saw during the first quarter, particularly in Europe, was the battery manufacturers having a tough time keeping up with EV demand and production in the months of January and February. That's obviously started to change but it is one reason why the order books continue for the first and second quarter we believe to remain strong. But with these closures to see it tip down in the second half of the year, it's very hard for us to know what that means. And the second half the year is very cloudy. But those are the drivers and phenomenon we're seeing right now.
Unidentified Analyst : Thank you.
Operator: Thank you. And our next question comes from the line of Bob Koort with Goldman Sachs. Your line is open. Please go ahead.
Robert Koort: Thank you very much. I think Scott you might have mentioned that -- you thought maybe the demand curve on lithium was pushed out a year. So I guess I'm trying to ascertain is that an issue that is being episodic for these closures, is it the issue of a recessionary pressure dampening consumer spending, how do you come to that conclusion, what is sort of the calculus of a one year push out to the industry given that I guess a lot of the mandates don't go away and China seems to be cranking back up again?
Scott Tozier: Yeah, it's really based on current demand in 2020 and the recessionary impacts and some of the modeling that we've been doing. To be honest, we don't know exactly what that curve looks like. And Eric maybe you can provide a little bit more detail there. But right now, the expectations, even if you look at a source such as IHS would suggest that the growth curve is going to be pushed out by at least one year. So Eric, do you want to provide some more information.
Eric Norris: Yeah, I don't know if I can provide a lot of granularity. Bob, we know that automotive plants collectively are closing some -- openings are delayed here in the U.S. Tesla's opening is imminent, but has been delayed a few times. There's been openings in Germany so far, there hopefully will be more in May. And collectively, if you look at the duration of time that they've been down and look at the supply chain, this one and two quarter lag, we would expect that the third quarter is going to -- that the impact of that shutdown is going to impact to the market in the third quarter. It is much, much harder to ascertain what the consumer impact will be, consumer spending will look like. We do know that regulatory factors in Europe and in China play a role in the adoption. But we don't know what consumer purchasing will look like thereafter. So that's why, as Scott says, we we're only as good as looking at what other people say. And there are widely divergent views on what might happen. When we say we think it might be pushed out a year, that's sort of a consensus view, looking at all the data. And we're just going to have to, as time goes on, scrutinize that and get sharper at understanding with time. But right now, that's what we've got to work with.
Robert Koort: And if I could follow-up Scott, the covenant waiver efforts, are you going attempt to get a net debt measure in, what are the ramifications of seeking that covenant waiver, if you do end up violating that covenant?
Scott Tozier: Yeah Bob, so we're actively in the discussions with the banks even as we speak. So it's a little bit early to call exactly what the final outcome will be. But the banks have been very, very supportive of Albemarle, given our track record and the capability of our team to deliver. Clearly, a covenant breach is not a good thing and we're going to take all the action necessary to make sure we don't breach.
Robert Koort: Thank you.
Operator: Thank you. And our next question comes from the line of David Begleiter with Deutsche Bank. Your line is open. Please go ahead.
Unidentified Analyst : This is David Fong [ph] here for Dave. Just first for your Q1 lithium sales down 18% ex-FX. Can you talk about how much of the decline was pricing versus volume and probably your expectation for raising pricing for the rest of the year?
Scott Tozier: Yeah, this is Scott. So the first quarter lithium was down, as you say, both price and volume are down about 10% about equal. Really as expected on volume so we're expecting volume to be down coming into the year. Pricing in fact was a little bit better than we expected versus our expectations. So that was a positive surprise for us. As you go through the year, our current expectations are still that pricing is going to be down as expected.
Unidentified Analyst : And secondly, I guess for the RSO business, in your bromine segment, given producers are reducing their capital budgets and especially a very weak offshore drilling market what's your expectation or what type of impact do you expect that to have on your bromine business on the volume side in the medium term?
Scott Tozier: Netha do you want to take that.
Netha Johnson: Sure, good morning David, this is Netha. As you know our oil-field businesses, primarily with deep drilling fluids which is impact we see probably really into 2021, more so than 2020. It is about 9% of our business today. So in the medium term, we really see that impact coming to us next year rather than this year.
Unidentified Analyst : Thank you.
Operator: Thank you. And our next question comes from the line of Joel Jackson with BMO Capital Markets. Your line is open. Please go ahead.
Unidentified Analyst : Hi, this is Robin on for Joel. Thanks for taking my question. Your Greenbridge JV partner is out shopping a stake in the JV but LBB runs through increase leverage or issue equity or sell assets to buyout all or some of that space, and would you be concerned if that controlling stake ends up in another company's hand? Thanks.
Kent Masters: Okay, so we know that Talison is a good project for us and we're following that process closely and we'll see where it goes. We know that the Chinese government will probably have influence on where that asset ends up. But we're interested in it, we're following it, but we're also mindful of the current market environment. So there'll be more to come on that. But we're following it very closely.
Unidentified Analyst : And just one follow-up on that. Has there been any progress with Tianqi repaying the 100 million that they owe to the Talison JV?
Kent Masters: So there is a plan in place that we've agreed with them, or that Talison has agreed with them. And we expect that they'll meet that plan and we have actions that we've put in place to mitigate if for some reason they don't meet the plan.
Unidentified Analyst : Okay.
Operator: Alright and our next question comes from the line of Jim Sheehan with SunTrust. Your line is open. Please go ahead.
James Sheehan: Good morning. Thanks for taking my question. Could you give some more color on your plans to slow walk the lithium project spending, are you pushing out those projects by the same timeline as your expectations for electric vehicle demand or how are you thinking about that?
Kent Masters: So we're slowing the projects. It's a couple of things, but it's about cash management but it's also about where they are in their execution. So we're trying not to cross over a demobilization process. So that is something we could do if we needed to but that would be more difficult for us and would change the timeline. So they're being pushed out. What we both -- we think both of those projects stay reasonably close to their timeline and it will change depending on what we see in the market. So we have slowed those, we'll have the opportunity to slow down more or speed them up as we go, and as we learn more about what the environment looks like economically as a result of this crisis.
James Sheehan: Thank you. And on -- in China, where are -- you -- what are you seeing in terms of stimulus spending and other incentives to jump start the electric vehicle sales, are you expecting more of an impact on that in the second half?
Eric Norris: Yes, this is Eric, Jim. We would be looking at the same sort of announcements you have, which is announce an extension, a two year extension of the incentives for electric vehicles to consumers in China from where they were due to lapse or due to lapse this year, they've been extended. Our expectation, the data we're seeing is that China is improving, recovering from its portion of the pandemic. We hope that's sustained and the belief is by third parties, which we would subscribe to, that their demand will improve. And how much at this point though is again, just is too hard to call because we cannot speak to the strength of the consumer. We don’t understand what regulations are but in the end it's the consumer coming forward that'll make the difference.
James Sheehan: Thanks a lot.
Operator: Thank you. And our next question comes from the line of Kevin McCarthy with Vertical Research Partners. Your line is open. Please go ahead.
Kevin McCarthy: Yes, good morning. The EBITDA derives from your all other segment tripled versus the same period last year. Can you speak to what drove that increase and how sustainable or not you think it may be as 2020 progresses?
Scott Tozier: Hey Kevin, this is Scott. So, yeah, I think what we've seen in our business clearly a contract driven business and it all comes down to the timing of the shipments. And so throughout 2019, we saw sequential growth in that business quarter-to-quarter and our expectation coming into the year that we would see sequential declines in that business. So I'm starting with a higher first quarter decline into the back half. And that's basically the same expectation now. They did a little bit better on some earlier expected in Q1. Right now, Q3 are holding up and Q4 will be a little bit softer, but it really just comes down to the timing of their shipments and the contracts.
Kevin McCarthy: Very good and then to follow-up I wanted to ask about logistics. I think you cited it as an issue in the bromine business and also cited some challenges related to logistics as it relates to hydro processing catalysts. Can you expand on what those challenges are and are you seeing any alleviation here today as relates to the second quarter forecast?
Kent Masters: Yeah, so the challenges really come down to the disruption of demand throughout the logistics change. So, when China was down in the first quarter, all of a sudden a big chunk of the containers, the shipping fleet, trucking fleet were basically in the wrong spot to be able to support things in the rest of the world. And as they move through the crisis, you start to see border closures, restrictions in terms of when ports are going to be operating, all those types of things start to impact this as well. Things are at least marginally better now are things we're finding ways to manage through that. So, for example, we only have one product in our FCS business that we have the airship and we have the airship that we normally airship it into Denmark. That flight has been canceled. So that cargo flight has being canceled. We now have -- now going to Belgium and trucking that over to Denmark from there. So we're finding and managing our way through it. But, the challenges are still there. So, I mean, I think the waves of demand change is going to continue to be challenging so the global fleet out there and they're going to have to continue to adjust. Our logistics team are doing a great job working with our business guys to make sure our customers stay supplied. So I'm really happy for the work they are putting in.
Kevin McCarthy: Appreciate the color. And Luke all the best to you.
Luke Kissam: Hey, thanks Kevin.
Operator: Thank you. And our next question comes from the line of PJ Juvekar with Citi. Your line is open. Please go ahead.
Kendall Marthaler: Hey, good morning. This is Kendall Marthaler on for PJ. Just with the delayed impact of COVID from one agent to two agent, are there any thoughts on starting to reduce operating rates in the lithium segment now, to try and work through that supply outside of obviously the -- shutdown? And just could you give us an update on the inventory situation, I believe it was kind of thought that the lithium inventory should be worked through by year end to a early 2021, how do you see that progressing now?
Scott Tozier: Eric, you want to talk a little bit about our shutdown plans and your business and our current view on inventory and the supply chain.
Eric Norris: Yes, so we entered the year, as you know, with our capacity fully committed and under contract. 90% plus of our battery grade materials are under contract. And as we go through this year, we obviously have the uncertainty associated with what might happen in the second half. But our intent is to keep our plants running, to keep our customers supplied. We are seeing some indications that they -- from a few customers that they're going to want to reduce their forecast. Those will be commercial discussions we have with them. There are other opportunities we have to place that volume if we have to. But our intent is to and our hope is our customers want our contracts. So at the moment, we don't -- we're operating on a place to volume per plan mode. There is a playbook we have that in the event there is a worst case sort of recession coming there certainly is a playbook we have around what we need to do around how we run our plants. But we do not have any -- well beyond what we've already announced, have further intend to close any plants at this point in time until we see how the second half demand plays out. I think that was your first question. Second question was inventory correct, Kendall? So inventory has been drawn down to some extent with the customers we serve. We know that because they've reduced their volumes in the first half as expected. The challenge we have is not knowing what's happening elsewhere. Of course, China had a very weak first quarter itself because of the pandemic. Now, automotive plants in Europe and the U.S. are closing, which, as I said earlier could have a third quarter impact. And there's been numerous supply disruptions amongst our competitors, some of which is related to COVID-19, some of which frankly, has been related to their own liquidity challenges. So when you put all that together, it's very hard for me to comment on what inventory looks like and how much it has been drawn down across the channel, across the total industry. So I'll just have to sort of let you know as we go through. Maybe next quarter or two, we'll get better clarity on that. But right now, it's quite muddy.
Kendall Marthaler: Okay, thank you, very helpful.
Operator: Thank you. And our next question comes from the line of Matthew Skowronski with UBS. Your line is open. Please go ahead.
Matthew Skowronski: Good morning. Following up on Jim's question, you cut CAPEX for this year and obviously these are very, very challenging times to predict. But as of right now, what's your base case for CAPEX for 2021 and 2022 given your slowing down projects and then kind of alongside that, what is the minimum amount of CAPEX you would be willing to go down to if these trends continue?
Scott Tozier: Hey, this is Scott.
Kent Masters: Let me start, Scott and then you can look further out. So I mean we look at it in two different buckets. So we've got, well, sustaining capital, so capital on our plant but from a safety standpoint, from a maintenance perspective and then growth capital and the big projects. So we've cut back on the big projects to where we can without making a bigger move on those particular projects. I'm kind of more or less talking about La Negra and Kemerton at this point. So there's another leg that we can go down but from an execution standpoint, it makes that more difficult. And we don't really want to cross that but if things get difficult, we have that lever. Operationally we have -- for this year we've kind of narrowed it to the point where we can. There will be other know as we shut down, we'll be able to cut capital if we have to shut down lines. But we've kind of narrowed down to what we believe we have to do from a health and safety and from maintaining our assets perspective, plus a little bit of buffer. So we're not getting -- we're not to the bone but we're close on that for this year. And then as we look out, we would -- depending on what happens, we would go back to what the previous level of spin would be and increase a little bit in the sustaining part, some growth, but smaller growth projects with nice returns in the plants and then go back to the big projects what's necessary to execute those?
Matthew Skowronski: That's helpful. Thank you. And then with regards to FCC sales, can you just remind us how those are split geographically and if you're seeing any regions start to pick up besides presumably Asia? And then thank you for everything Luke over the past couple of years, best wishes for the future.
Luke Kissam: Hey, thanks a lot, Matt.
Raphael Crawford: Hey, Matt this is Raphael. Let me give you a little perspective on FCC. So geographically, the strengths for our business are in North America. Europe's a smaller market for FCC, but we're relatively strong in Europe. And our largest market is in Asia and India. So that's where we have our pockets of strength and from a product standpoint, we're very strong in bottoms cracking and in propylene in yield. So as you look at the impact of the pandemic and where we see recovery, for the first time last week global -- the inventory of gasoline in the United States went down from a record high of about 263 million barrels of gasoline inventory two weeks ago. So I think we started to see an inflection in North America. As you see states open up, it's going to start to improve from a bottoming out in North America. Asia has been recovering, so China has been recovering. There's still mandatory shutdowns and a lot of mandatory stay at home orders and reduced travel in a lot of Southeast Asia. So that has an impact on our business as well as in Europe. I would say that from a global perspective, I think we're near the bottom or at the bottom of the demand picture, and we should start to see a recovery from here on out. But there's a lot of uncertainty as to whether there is a second wave of outbreak of COVID, how fast it comes back. All that being said, I think we're positioned pretty well as an FCC business in the right markets with the right technologies for long-term success.
Matthew Skowronski: Thank you.
Operator: Thank you. And our next question comes from the line of Mike Sison with Wells Fargo. Your line is open. Please go ahead.
Mike Sison: Hey, good morning everyone. In 2019, there was an inventory build for lithium and I recall it somewhere in that 50,000 to 75,000 and then it tracked toward the end of the year. And you guys have tended to have a good feel for those levels. Do you think that eventually they will build back and then at the end of the day is the volume of lithium demand going to be down this year and by how much?
Eric Norris: Mike hi, good morning, it's Eric here. So with regard to inventory, I don't have that much to add versus the earlier question. We did have if you include all forms of lithium somewhere between refined lithium, maybe three to four months, if you add in spot, you mean maybe six months of inventory as we were exiting last year. As you know, and as Scott discussed in our results, our customers and we expected this drew down from our purchases that they'd otherwise have in the beginning of the year, their inventories. And it was particularly in Europe, a reasonably strong first quarter despite the onset of the pandemic outside of China. So there has been in a small -- our part of the world, some inventory reduction. But what I can't account for is what's happened elsewhere. China demand was not strong at all in the first quarter. It is the largest lithium market, however, producers to that market, many of our competitors weren't able to produce either. So the relative balance of the two and how that changed in a three month period, too hard to say, really too hard to say right now. So that's what I'd have to leave it at. Was there a second part to your question I missed?
Mike Sison: Yeah, just a quick follow up. If you think about the long-term, kind of the 2025 forecast for EV adoption, how does that change do you think with oil prices being low and kind of the impact on automakers and their ability to ramp up those cars? And then Luke I just want to wish you the best, I hope you have a lot of fishes to catch over the next couple of days?
Luke Kissam: Well don't forget you owe me that dinner and the wine over that bet you lost about the football games, but thanks Mike.
Mike Sison: I will get down on that.
Scott Tozier: So, on demand, I think it's like we said, we know that we're going to see a weaker second half, we don't know how weak Mike. So I really can't tell you how -- what is coming as demand is going to look like versus last year at this point in time. What I can tell you on EV specifically is that what we look at for EV adoption is not necessarily oil price. That's an older convention or rule of thumb that this does not seem relevant in a world where whole regions and countries are putting in regulations in place that are driving things towards electric vehicles. So that is -- that's what we look for and we see that sustained. We see that increasing in the case of China. There's a possibility those regulations are sustained or potentially increased under the Green Deal initiatives in Europe. We'll have to watch and see. But all that being said, as you said earlier, the reasons we think and we rely on third party research for this, that the EV curve has been shifted out perhaps by as much as a year or more is that consumer spending is going to be nicked significantly during this recession. We just don't know what that impact looks like. So we, like you are going to rely on experts who provide those forecasts and as we get more information, we'll provide more.
Operator: Thank you. And our next question comes from the line of Colin Rusch with Oppenheimer. Your line is open. Please go ahead.
Colin Rusch: Thanks so much, guys. Can you talk a little bit about the technology roadmaps or your cathode customers and whether those are accelerating or changing at all, we know you've got some targets out there, but are they taking this downtime to look at accelerating some of those roadmaps?
Kent Masters: I don't -- Colin, good morning. I don't think there's any material change to those roadmaps, so just at a high level what those are, is as chemistries moved to higher levels of nickel, NMC 62 or higher in the NMC chemistry area or NCA. And those are the preferred chemistries for energy density, therefore lower costs ultimately, and higher range for EV's. As all of these are electric vehicle manufacturers, particularly in Europe given the regulations I just referenced earlier that are driving this adoption roll out their plans, they're moving to those chemistries those are oriented towards hydroxide. There's some salt and pepper ingredients that are used on the anode side of things for proliferation and other things that are starting to develop as well, so some interesting technology developments. That's where we see the future. We're going to continue to see a core of chemistries used to support consumer electronics products, power tools, and lower range, lower value EV's which will be predominantly based in China. And those would be carbonate based chemistries, they can be lithium ion phosphate or NMC varietals that have lower levels of nickel and are therefore more economically produced with carbonate. And that's pretty much the story. It's been -- it hasn't changed a lot just given what's going on with the pandemic, most automotive and battery manufacturers are just dealing with the pandemic at the time being rather than accelerating their technology programs.
Colin Rusch: Alright, that's helpful. And then in terms of some of the health measures that you guys are implementing in your facilities, are there permanent changes to the cost structure on production and processing that you can speak to at this point?
Kent Masters: I wouldn't -- I mean what we've done from a health standpoint, I don't think we'll change our long-term cost structure. So that will move back. There are things that we're learning and that that will inform some decisions as we go forward. But so far, we've done that in response to the pandemic and to continue to operate in a difficult environment. We've done fairly well with that. But we'll go back to the way we were operating as soon as that's possible. But, some of the things that we have learnt will probably apply that may affect that but we are not in that spot today.
Colin Rusch: Great, thanks so much guys.
Operator: Thank you. And this does conclude today's Q&A session. I would now like to turn the conference back over to Ms. Meredith Bandy for any further remarks.
Meredith Bandy: Alright, thanks everyone for your questions and your participation in today's conference call. As always we do appreciate your interest in Albemarle and that concludes our first quarter conference call. Thank you.
Operator: Ladies and gentlemen thank you for participating in today's conference. This does conclude the program, and you may all disconnect. Everyone have a great day. | [
{
"speaker": "Operator",
"text": "Good day ladies and gentlemen, welcome to the First Quarter 2020 Albemarle Earnings Conference Call. At this time all participants are in a listen-only mode. Later we will conduct a question-and-answer session and instructions will follow at that time. [Operator Instructions]. As a reminder this conference is being recorded. I would now like to introduce your host for today's conference Ms. Meredith Bandy, Vice President of Investor Relations and Sustainability. Maám please go ahead."
},
{
"speaker": "Meredith Bandy",
"text": "Alright, thank you and welcome to Albemarle's first quarter 2020 earnings conference call. Our earnings were released after the close of the market yesterday and you'll find the press release, earnings presentation, and non-GAAP reconciliations posted on our website under the Investors section www.albemarle.com. Joining me on the call today are Luke Kissam, former Chief Executive Officer; Kent Masters, current Chief Executive Officer; Scott Tozier, Chief Financial Officer. Raphael Crawford, President, Catalysts; Netha Johnson, President, Bromine Specialties; and Eric Norris, President, Lithium are also available for Q&A. As a reminder, some of the statements made during this conference call including our outlook, expected company performance, expected COVID-19 impacts, and proposed expansion projects may constitute forward-looking statements within the meaning of Federal Securities Laws. Please note the cautionary language about forward-looking statements contained in our press release, that same language applies to this call. Please also note that some of our comments today refer to financial measures that are not prepared in accordance with GAAP. A reconciliation of these measures to GAAP financial measures can be found on our earnings release and the appendix of our presentation, both of which are on our website. With that I will turn the call over to Luke."
},
{
"speaker": "Luke Kissam",
"text": "Thanks Meredith and good morning everybody. I certainly hope that everybody is healthy and safe. I would like to take this opportunity to welcome Kent Masters as Albemarle's new CEO. Since Kent joined the Board in 2015 he has been one of my most trusted advisors and mentors. Kent has a proven track record in good times and in bad as a successful CEO of a publicly traded company and he thoroughly understands what is expected of a leader in that role. I am confident that Kent will continue with work with our Board and the entire Albemarle team to position the company from future success and deliver long-term value for our customers, our employees, shareholders, and other stakeholders. With that I'll turn it over to Kent."
},
{
"speaker": "Kent Masters",
"text": "Thank you Luke. It's good to be here today. I'm excited for the opportunity and I look forward to meeting with members of the investment community virtually and eventually in person when it's safe for us to do so. As Luke mentioned I joined the Board in 2015 with the acquisition of Rockwood where I had been on the Board -- where I had been a Board Member there since 2007. Over the past five years I've worked closely with Luke and was actively involved with my Board colleagues in establishing the company's purpose and values which are core to our identity. What excites me about Albemarle is the innovation and leadership we bring to our markets and the prospects we have for future growth. We have earned an enviable position at our markets and with our strong strategy and values we will build on that legacy for years to come. On today's call I will cover a high level overview of the current environment, our actions in light of COVID-19, and our capital allocation priorities. Scott will review the first quarter financials, provide an update on cost savings, and review our outlook. First, I want to emphasize that the safety and welfare of our people is our highest priority. We are taking multiple actions to protect our employees, serve our customers, and help fight the spread of COVID-19. Thankfully to date our sites are operating without material impact related to the pandemic. I deeply appreciate the courage and continued support of the frontline essential workers and our communities and our dedicated Albemarle employees who continue to ensure safe operations at our facilities and offices worldwide. Yesterday we released first quarter results including net income of 107 million or a 1.01 per share. Adjusted EBITDA of 196 million was down 13% from prior year. We had previously communicated the outlook for first quarter EBITDA to be down about 25% from prior year. Ultimately we beat that outlook due to better sales in bromine and lithium and better than expected cost reductions. Of course there will be impacts to all of our businesses related to COVID-19. The timing, duration, and severity of those impacts will vary for each business. Given the degree of uncertainty we are withdrawing our full year 2020 outlook. We plan to reinstate long-term guidance as soon as it is practical to do so. In the meantime we are temporarily introducing quarterly guidance that Scott will walk you through in a few minutes. We have evaluated our capital allocation priorities in light of the current environment and are focusing on -- we're focusing our efforts on preserving cash and maintaining our dividend. That means taking preemptive measures to bolster our balance sheet and maintain financial flexibility. We are also stepping up and accelerating cost savings initiatives that were already underway and introducing short-term cash management plans. We will remain focused on controlling what is within our control and we'll continue to act in the best interest of our shareholders, employees, customers, and other stakeholders to ensure success in these uncertain times. Right now ensuring success means responding to COVID-19 in a way that protects our employees, customers, suppliers, and communities. Our Chinese operations were the first to be impacted by the virus. We have been able to take those early learning from our teams in China and apply them around the globe. In early March we created a global cross functional pandemic response team to recommend, develop, and implement strategies to respond to the pandemic. Albemarle's leadership team meets almost daily to review and take actions on recommendations from that team. In uncertain times communication is critical and we are in frequent dialogue with our employees around the world. To help our employees stay safe and healthy we have implemented protocols including restricting travel, implementing work from home for non-essential personnel, and adjusting shifts, increasing hygiene practices, and requiring social distancing for essential workers in our plants. To date we have had very few confirmed cases. However, availability of testing varies by region. A small number of employees have self quarantined due to prior travel, exposure to a COVID positive individual, or presenting mild flu, mild cold or flu like symptoms. We are thankful that the number of people directly impacted by COVID-19 has been trending down across the globe and we see this as evidence that the precautions we are taking are working. We are communicating frequently with our customers and suppliers to help us manage supply and demand issues as they arise. To date our plants have operated with minimal impacts other than in China where we operated at reduced rates for two weeks at the first -- during the first quarter. For the health and welfare of our business partners we have halted customer visits to our plant sites and have implemented plant entry protocols for safe and efficient deliveries. Logistics remain a concern across all of our businesses as trucking and shipping companies struggle with new demand patterns and border requirements. We are working through these challenges to keep our customers supplied. As the pandemic continues Albemarle is supporting our communities in the fight against COVID-19. We are providing mask and PPE to frontline health and relief workers and donations and grants to help fight hunger and improve access to online learning. We are collaborating with universities, local disaster relief funds, trade organizations, and other grand tours to extend the reach of our efforts. To date we have distributed more than $1 million to organizations around the globe. Some of our products are also used in the fight against COVID-19. For example our flame retardants are used in electrical medical equipment such as ventilators, our hydrobromic acid product is a catalyst in the manufacture of PET for protective clothing in hospitals. We produce a line of water treatment products and intermediates used in cleaning products and disinfectants, and at our plant in Germany we are producing hand sanitizer for the local community. While these products are not financially significant to our business, we are proud to do our part to protect against the spread of COVID-19. The extent of the economic impact of the global pandemic remains unclear but I am confident that the actions we are taking to adapt to current market conditions will position us to execute our strategy across the cycle. Now I'd like to set the groundwork for our capital allocation priorities. Our first priorities are to fund our dividend to maintain financial flexibility and that is unchanged in the current environment. 2020 is expected to be Albemarle's 26th consecutive year of dividend increases and we remain committed to shareholder returns. We are also committed to maintaining our investment grade credit rating. Execution of our other capital allocation priorities has shifted in this environment. First, all capital projects are being examined for opportunities to preserve cash and spending. Our two biggest capital projects Le Negra III and IV and Kemerton are being slow walked to preserve capital in the near-term. We are also reducing our sustaining capital spend with an eye to maintaining safety and critical main maintenance projects. Second, we are taking a disciplined and thoughtful approach to investments including M&A and joint ventures and will continue to act in the best interest of our shareholders. Lastly while our share repurchase authorization remains in place there are no buybacks planned in this environment. So with that as a backdrop I will turn it over to Scott for more details."
},
{
"speaker": "Scott Tozier",
"text": "Thank you Kent. Albemarle generated first quarter net sales of $739 million, a decrease of about 11% compared to the prior year. This reduction was primarily driven by reduced volume in price in lithium as expected coming into the year and reduced volumes in Catalyst due in part to low transportation fuel demand caused by COVID-19. GAAP net income was $107 million or a $1.01 per diluted share. There were very minimal adjustments this quarter with adjusted earnings of $1 per diluted share. Corporate cost including SG&A, R&D, and interest and financing expenses were broadly in line with the prior year period. As Kent stated adjusted EBITDA was $196 million, a decrease of 13% from the prior year but above the previously communicated outlook. Turning to Slide 8 for a look at EBITDA by business segment. Adjusted EBITDA was down $30 million over the prior year. Solid performance in bromine and our FCS businesses and companywide cost savings partially offset top line decline for lithium and Catalyst. Lithium's adjusted EBITDA declined by $40 million versus the prior year excluding currency impacts. Pricing in volumes were down about 10% each offset by product and customer mix and cost savings initiatives. As you know in late 2019 we gave one year price concessions to many of our battery material customers. Also as expected customers reduced Q1 2020 shipments as they work through excess inventories from late 2019. In catalyst adjusted EBITDA declined $11 million excluding currency impacts. Both FCC and HPC volumes were down this quarter but for different reasons. The FCC decline was caused by reduced consumption of transportation fuel, stay at home orders, and travel restrictions mean refiners don’t have to run as hard to meet reduced demand. HPC volumes were impacted by logistics challenges as the world's cargo fleet and truck transportation adjusted to slowing global demand. Partially offsetting these challenges the Catalyst business benefited from lower raw materials, better product mix, and cost reduction efforts. Bromine's adjusted EBITDA was up $5 million excluding currency impacts. Improved average realized pricing, cost savings, and lower minority interest expense more than offset lower volume. The Q1 order book was strong but logistics challenges prevented us from filling all those orders during the quarter. Our corporate and other categories is driven primarily by our FCS business. FCS EBITDA was up nearly $16 million on higher volumes and product mix. While Q1 results were better than we had expected we are operating in uncertain times. As Kent discussed maintaining our strong financial position is a top priority and we remain committed to maintaining our investment grade rating. We had ample liquidity of about $1.7 billion as of quarter end consisting of $553 million of cash including $250 million drawn on our revolver plus $715 million remaining under our $1 billion revolver. $200 million available under our delayed draw term loan which we drew in April and $190 million on other available credit lines. Since quarter close we have issued additional commercial paper of that market return to more normal terms and tenders. In terms of debt maturity we are pretty well turned out. The only short-term debt is from commercial paper. Our revolver is not due until 2024 and we may choose to repay that sooner. Otherwise the nearest term maturities are $444 million due at the end of 2021. The investment market is open to us and I am confident we will be able to -- that or go forward. The divestitures of PTS, a portion of our Catalyst business and FCS are being slowed down due to the COVID-19 travel restrictions. The potential buyers remain interested in bulk transactions or potential liquidity events as we get back to normal. Turning to Slide 10 from more on our cost savings. We have had a strong history of generating operating cash including $359 million generated during the great recession in 2009. We expect to continue to generate significant operating cash thanks to industry leading positions in all of our businesses and through active cost management. As communicated during the fourth quarter earnings call, we are accelerating the 2020 sustainable cost savings initiatives. These were projects that were already identified and underway when COVID-19 hit. We now expect to achieve cost reductions of $50 million to $70 million this year and reach run rate savings of at least $100 million by the end of 2021. Basically we are bringing forward about $10 million to $20 million of cost savings in June of 2020. Based on our current order book and cost reduction actions we now expect Q2 2020 adjusted EBITDA in the range of $140 million to $190 million. Lithium's Q2 2020 EBITDA is expected to be down year-over-year but up slightly on a sequential basis. The Q2 order book continues to look solid albeit with some softness in technical grades. Specialties and technical grades make up about 40% of lithium revenues and have a pretty short supply chain. Lags are usually just a few months going into and coming out of recession [ph]. Specialties and technical grade products usually grow at or above GDP growth rates and are driven by consumer spending and industrial production. The energy storage market makes up about 60% of our lithium sales and has a relatively long supply chain with a one to two quarter lag on battery grade sales both in the downturn and in the recovery. Battery grade customers continue to forecast a stable order pattern in the second quarter as catalysts and battery manufacturers catch up on backlogs, backlog orders placed prior to COVID-19. We expect to see the impact of recent OEM automotive shutdowns flow through the supply chain in the second half. By year-end, OEM automotive restarts are expected to be supportive of battery and lithium demand. China OEM production has started back up and some European plants are scheduled to restart production in mid-May. Looking beyond Q2 for each of our businesses is difficult and nowhere is that more the case than with lithium. The electric vehicle market that is now the primary growth driver for lithium was not mature enough during the global financial crisis to provide much context for today. Nevertheless, we expect the EV growth curve to be delayed by at least one year. Bromine Q2 order patterns are starting to show the impact from COVID-19. They are off expectations by about 10% and down sequentially. We're seeing some indications that customers may push orders from late May or June into the third quarter. And net-net we expect first half EBITDA to be down year-over-year with Q2 EBITDA down about 20% from prior year. We do expect softness to continue into Q3 related to slowdowns in automotive, consumer electronics, appliances, and construction all as a result of impacts of COVID-19. Based on our position in the supply chain, we typically see a lag of at least one or two quarters and in some cases longer. Our bromine business has been profitable every year for 20 years. In the global financial crisis bromine's 2009 net sales were down 30% year-over-year, and EBITDA margins fell to 16%, compared to a more normal margin in the high 20% to low 30% range. Then the business rebounded very strongly in 2010 and 2011 back to and in some markets above prerecession levels, thanks to pent up demand. Compared to 2009, bromine today has a tighter supply demand balance going into the downturn. We've also seen some competitor specific supply disruptions, which somewhat muddied the water and may partially offset some of the demand softness. Bromine is also much more diversified as a business today. It tends to be relatively GDP driven with customers across multiple end user markets. Flame retardants make up about 50% of sales and are used in electronics, automotive, construction and in appliances. Oil-field represents up to 10% of sales, and other industrial uses include TET and agriculture. This diversity allows us to shift sales across markets into the best performing industries. Finally, as you know, our Catalyst business includes two primary product groups, FCC Catalyst and HPC Catalyst. Across the cycle, FCC and HPC are fairly similar in size, but the HPC business is much lumpier. Customers order HPCs only every two to five years when they perform turnarounds at refineries. Therefore, HPC demand is driven by customer turnaround schedules, whereas FCC demand is driven by transportation, fuel consumption, and miles driven. In a typical recession there's very minimal impact t FCCs. Oil pricing falls and miles driven goes up meaning more fuel demand and more Catalyst demand. HPCs on the other hand tend to see sharply lower demand when oil pricing contracts. Refineries run at lower rates and are able to push out turnarounds and conserve cash. In 2008 and 2009 and then 2014 and 2015, the oil price corrected by more than 50% in a matter of months. In both cases, FCC earnings were up slightly, but HPC earnings were down about 30% in 2009 and 50% in 2015. In the current economic environment, we do expect HPCs to be down, especially in the second half. But in this case, FCCs will also be down as widespread stay at home orders and travel restrictions lead to dramatically lower miles driven and transportation fuel consumptions. In Q2 we expect to see a full quarter impact of the travel restrictions that began in the first quarter. To date we've seen minimal changes to the FCC order book for Q2. But based on the experience of prior oil price reductions, we expect to see a shift of HPC orders out of second half and into 2021. The timing and extent of the downturn is unclear and a lot depends on how long travel restrictions are in place, how long the oil price remains low, and how much crude and refined product inventory is built up when restrictions are lifted. Given the current economic environment, we are executing our down-turn playbook for short-term cash management and have already activated many of these tactics. In terms of variable costs, restricted travel due to COVID-19 will continue, we're also strictly limiting professional services and consultants. On fixed cost we're reducing capital expenditures and limiting hiring over time and contractors. Senior executives and the Board have also agreed to a temporary 20% cut to base pay. We're also cutting sustaining and gross capital spending. We will continue to maintain our health, safety, and environmental standards. Beyond that, we're taking a critical look at all capital spending across our businesses. The most meaningful capital spend is at our lithium expansion projects Le Negra III and IV and Kemerton. We are slowing work on these projects to conserve cash and to reassess the demand requirement when the battery industry recovers. We have maintained optionality to defer additional capital or accelerate these projects depending on market conditions. Including cuts to sustaining a major project capital, we now expect our CAPEX to be in the range of $850 million to $950 million, a 15% reduction from the midpoint of previous guidance. Working capital averages about 25% of sales, so we'd expect to see some reduction here as revenue declines. We're also actively managing working capital to see further improvements, including seeking payment term extensions from vendors, accelerating collection of past receivables, and actively reducing inventories. We have begun shutdowns of some Catalyst's production and have plans in place to slow down our plants as needed, assuming demand declines as recent customer shutdowns work their way through supply chains. Also the short-term cash management actions detailed here are expected to save the company about $25 million to $40 million per quarter. That will be in addition to the CAPEX reductions and sustainable cost savings we just discussed. We're working hard to cut costs, but also minimize the impact for our employees. Unfortunately, depending on the length and severity of the downturn we may add additional production sites or take more drastic cost actions if necessary. These actions are difficult and not something that we undertake lightly, but they are meaningful to help position Albemarle to be stronger for longer. Now I will turn the call back over to Kent."
},
{
"speaker": "Kent Masters",
"text": "Thanks, guys. Current economic conditions are challenging. Albemarle is an industry leader in all three of our core businesses. We believe in the long-term growth prospects in all of these businesses but our immediate challenge is to manage through this crisis. We will act on cost reduction measures quickly to preserve cash and maintain our financial flexibility. We will also be poised to respond to meet customer needs when the market returns. We remain confident in our strategy and we will modify execution of that strategy to further position Albemarle for success."
},
{
"speaker": "Meredith Bandy",
"text": "Great, before we open the lines for Q&A, I would like to remind everyone to please limit questions to one question and one follow-up to ensure that as many participants have a chance to ask a question as possible. Feel free to get back in the queue for additional follow-up if time allows. Thank you. And Michelle, please proceed with the Q&A."
},
{
"speaker": "Operator",
"text": "Thank you. [Operator Instructions]. Our first question comes from the line of Steve Byrne with Bank of America. Your line is open. Please go ahead."
},
{
"speaker": "Unidentified Analyst",
"text": "Hi, this is Matthew on for Steve. I wanted to dig into the guidance a little bit more and see if you could kind of point out the drivers, which will result in either the low end or the high end of the guidance range. It seems like your direct segment commentary points to something like 150 million. How did you get to that 190 million number?"
},
{
"speaker": "Scott Tozier",
"text": "Hey, this is Scott. So I think a couple of key things around uncertainty. One is in each of our businesses we've got a pretty good visibility through the end of May beginning of June in terms of our order book and are executing to that. I think the uncertainty comes in each of the businesses as we go through the month of May, particularly with Catalyst in terms of how deep the slowdowns in the refineries will be or if they -- as the states start to come back on -- this refinery start back up. In bromine it's going to come down most likely to some logistics issues and questions around order books getting filled on time. And then Lithium, we do expect that the auto OEM shutdowns will be impacting us in the second half. Right now, the order books looked pretty good through June, but they are starting to soften. So there's some variability there as well. So those are the key drivers for us."
},
{
"speaker": "Unidentified Analyst",
"text": "Okay, and I guess on prior calls you discussed the potential for overbuilding in battery cells as lithium demand appeared strong, despite what we saw was probably a slowdown in autos in 2Q and beyond, how did this end up playing out, where do you see downstream product inventories? And I guess finally Luke I want to wish you well. I always appreciate your candor and levity you brought to the conversations over the years."
},
{
"speaker": "Scott Tozier",
"text": "Eric you want to take that question."
},
{
"speaker": "Eric Norris",
"text": "Sure. So, Matt let me tell you what we know about battery cell manufacturers. We -- today we are seeing and have talked about excess inventories of lithium bearing products in the value chain that is being worked off as one of the reasons why our first quarter for us was weaker on volumes. We knew that, expected that coming into the quarter. In terms of battery cell manufacturer, it's actually the opposite of what you describe. The phenomenon we saw during the first quarter, particularly in Europe, was the battery manufacturers having a tough time keeping up with EV demand and production in the months of January and February. That's obviously started to change but it is one reason why the order books continue for the first and second quarter we believe to remain strong. But with these closures to see it tip down in the second half of the year, it's very hard for us to know what that means. And the second half the year is very cloudy. But those are the drivers and phenomenon we're seeing right now."
},
{
"speaker": "Unidentified Analyst",
"text": "Thank you."
},
{
"speaker": "Operator",
"text": "Thank you. And our next question comes from the line of Bob Koort with Goldman Sachs. Your line is open. Please go ahead."
},
{
"speaker": "Robert Koort",
"text": "Thank you very much. I think Scott you might have mentioned that -- you thought maybe the demand curve on lithium was pushed out a year. So I guess I'm trying to ascertain is that an issue that is being episodic for these closures, is it the issue of a recessionary pressure dampening consumer spending, how do you come to that conclusion, what is sort of the calculus of a one year push out to the industry given that I guess a lot of the mandates don't go away and China seems to be cranking back up again?"
},
{
"speaker": "Scott Tozier",
"text": "Yeah, it's really based on current demand in 2020 and the recessionary impacts and some of the modeling that we've been doing. To be honest, we don't know exactly what that curve looks like. And Eric maybe you can provide a little bit more detail there. But right now, the expectations, even if you look at a source such as IHS would suggest that the growth curve is going to be pushed out by at least one year. So Eric, do you want to provide some more information."
},
{
"speaker": "Eric Norris",
"text": "Yeah, I don't know if I can provide a lot of granularity. Bob, we know that automotive plants collectively are closing some -- openings are delayed here in the U.S. Tesla's opening is imminent, but has been delayed a few times. There's been openings in Germany so far, there hopefully will be more in May. And collectively, if you look at the duration of time that they've been down and look at the supply chain, this one and two quarter lag, we would expect that the third quarter is going to -- that the impact of that shutdown is going to impact to the market in the third quarter. It is much, much harder to ascertain what the consumer impact will be, consumer spending will look like. We do know that regulatory factors in Europe and in China play a role in the adoption. But we don't know what consumer purchasing will look like thereafter. So that's why, as Scott says, we we're only as good as looking at what other people say. And there are widely divergent views on what might happen. When we say we think it might be pushed out a year, that's sort of a consensus view, looking at all the data. And we're just going to have to, as time goes on, scrutinize that and get sharper at understanding with time. But right now, that's what we've got to work with."
},
{
"speaker": "Robert Koort",
"text": "And if I could follow-up Scott, the covenant waiver efforts, are you going attempt to get a net debt measure in, what are the ramifications of seeking that covenant waiver, if you do end up violating that covenant?"
},
{
"speaker": "Scott Tozier",
"text": "Yeah Bob, so we're actively in the discussions with the banks even as we speak. So it's a little bit early to call exactly what the final outcome will be. But the banks have been very, very supportive of Albemarle, given our track record and the capability of our team to deliver. Clearly, a covenant breach is not a good thing and we're going to take all the action necessary to make sure we don't breach."
},
{
"speaker": "Robert Koort",
"text": "Thank you."
},
{
"speaker": "Operator",
"text": "Thank you. And our next question comes from the line of David Begleiter with Deutsche Bank. Your line is open. Please go ahead."
},
{
"speaker": "Unidentified Analyst",
"text": "This is David Fong [ph] here for Dave. Just first for your Q1 lithium sales down 18% ex-FX. Can you talk about how much of the decline was pricing versus volume and probably your expectation for raising pricing for the rest of the year?"
},
{
"speaker": "Scott Tozier",
"text": "Yeah, this is Scott. So the first quarter lithium was down, as you say, both price and volume are down about 10% about equal. Really as expected on volume so we're expecting volume to be down coming into the year. Pricing in fact was a little bit better than we expected versus our expectations. So that was a positive surprise for us. As you go through the year, our current expectations are still that pricing is going to be down as expected."
},
{
"speaker": "Unidentified Analyst",
"text": "And secondly, I guess for the RSO business, in your bromine segment, given producers are reducing their capital budgets and especially a very weak offshore drilling market what's your expectation or what type of impact do you expect that to have on your bromine business on the volume side in the medium term?"
},
{
"speaker": "Scott Tozier",
"text": "Netha do you want to take that."
},
{
"speaker": "Netha Johnson",
"text": "Sure, good morning David, this is Netha. As you know our oil-field businesses, primarily with deep drilling fluids which is impact we see probably really into 2021, more so than 2020. It is about 9% of our business today. So in the medium term, we really see that impact coming to us next year rather than this year."
},
{
"speaker": "Unidentified Analyst",
"text": "Thank you."
},
{
"speaker": "Operator",
"text": "Thank you. And our next question comes from the line of Joel Jackson with BMO Capital Markets. Your line is open. Please go ahead."
},
{
"speaker": "Unidentified Analyst",
"text": "Hi, this is Robin on for Joel. Thanks for taking my question. Your Greenbridge JV partner is out shopping a stake in the JV but LBB runs through increase leverage or issue equity or sell assets to buyout all or some of that space, and would you be concerned if that controlling stake ends up in another company's hand? Thanks."
},
{
"speaker": "Kent Masters",
"text": "Okay, so we know that Talison is a good project for us and we're following that process closely and we'll see where it goes. We know that the Chinese government will probably have influence on where that asset ends up. But we're interested in it, we're following it, but we're also mindful of the current market environment. So there'll be more to come on that. But we're following it very closely."
},
{
"speaker": "Unidentified Analyst",
"text": "And just one follow-up on that. Has there been any progress with Tianqi repaying the 100 million that they owe to the Talison JV?"
},
{
"speaker": "Kent Masters",
"text": "So there is a plan in place that we've agreed with them, or that Talison has agreed with them. And we expect that they'll meet that plan and we have actions that we've put in place to mitigate if for some reason they don't meet the plan."
},
{
"speaker": "Unidentified Analyst",
"text": "Okay."
},
{
"speaker": "Operator",
"text": "Alright and our next question comes from the line of Jim Sheehan with SunTrust. Your line is open. Please go ahead."
},
{
"speaker": "James Sheehan",
"text": "Good morning. Thanks for taking my question. Could you give some more color on your plans to slow walk the lithium project spending, are you pushing out those projects by the same timeline as your expectations for electric vehicle demand or how are you thinking about that?"
},
{
"speaker": "Kent Masters",
"text": "So we're slowing the projects. It's a couple of things, but it's about cash management but it's also about where they are in their execution. So we're trying not to cross over a demobilization process. So that is something we could do if we needed to but that would be more difficult for us and would change the timeline. So they're being pushed out. What we both -- we think both of those projects stay reasonably close to their timeline and it will change depending on what we see in the market. So we have slowed those, we'll have the opportunity to slow down more or speed them up as we go, and as we learn more about what the environment looks like economically as a result of this crisis."
},
{
"speaker": "James Sheehan",
"text": "Thank you. And on -- in China, where are -- you -- what are you seeing in terms of stimulus spending and other incentives to jump start the electric vehicle sales, are you expecting more of an impact on that in the second half?"
},
{
"speaker": "Eric Norris",
"text": "Yes, this is Eric, Jim. We would be looking at the same sort of announcements you have, which is announce an extension, a two year extension of the incentives for electric vehicles to consumers in China from where they were due to lapse or due to lapse this year, they've been extended. Our expectation, the data we're seeing is that China is improving, recovering from its portion of the pandemic. We hope that's sustained and the belief is by third parties, which we would subscribe to, that their demand will improve. And how much at this point though is again, just is too hard to call because we cannot speak to the strength of the consumer. We don’t understand what regulations are but in the end it's the consumer coming forward that'll make the difference."
},
{
"speaker": "James Sheehan",
"text": "Thanks a lot."
},
{
"speaker": "Operator",
"text": "Thank you. And our next question comes from the line of Kevin McCarthy with Vertical Research Partners. Your line is open. Please go ahead."
},
{
"speaker": "Kevin McCarthy",
"text": "Yes, good morning. The EBITDA derives from your all other segment tripled versus the same period last year. Can you speak to what drove that increase and how sustainable or not you think it may be as 2020 progresses?"
},
{
"speaker": "Scott Tozier",
"text": "Hey Kevin, this is Scott. So, yeah, I think what we've seen in our business clearly a contract driven business and it all comes down to the timing of the shipments. And so throughout 2019, we saw sequential growth in that business quarter-to-quarter and our expectation coming into the year that we would see sequential declines in that business. So I'm starting with a higher first quarter decline into the back half. And that's basically the same expectation now. They did a little bit better on some earlier expected in Q1. Right now, Q3 are holding up and Q4 will be a little bit softer, but it really just comes down to the timing of their shipments and the contracts."
},
{
"speaker": "Kevin McCarthy",
"text": "Very good and then to follow-up I wanted to ask about logistics. I think you cited it as an issue in the bromine business and also cited some challenges related to logistics as it relates to hydro processing catalysts. Can you expand on what those challenges are and are you seeing any alleviation here today as relates to the second quarter forecast?"
},
{
"speaker": "Kent Masters",
"text": "Yeah, so the challenges really come down to the disruption of demand throughout the logistics change. So, when China was down in the first quarter, all of a sudden a big chunk of the containers, the shipping fleet, trucking fleet were basically in the wrong spot to be able to support things in the rest of the world. And as they move through the crisis, you start to see border closures, restrictions in terms of when ports are going to be operating, all those types of things start to impact this as well. Things are at least marginally better now are things we're finding ways to manage through that. So, for example, we only have one product in our FCS business that we have the airship and we have the airship that we normally airship it into Denmark. That flight has been canceled. So that cargo flight has being canceled. We now have -- now going to Belgium and trucking that over to Denmark from there. So we're finding and managing our way through it. But, the challenges are still there. So, I mean, I think the waves of demand change is going to continue to be challenging so the global fleet out there and they're going to have to continue to adjust. Our logistics team are doing a great job working with our business guys to make sure our customers stay supplied. So I'm really happy for the work they are putting in."
},
{
"speaker": "Kevin McCarthy",
"text": "Appreciate the color. And Luke all the best to you."
},
{
"speaker": "Luke Kissam",
"text": "Hey, thanks Kevin."
},
{
"speaker": "Operator",
"text": "Thank you. And our next question comes from the line of PJ Juvekar with Citi. Your line is open. Please go ahead."
},
{
"speaker": "Kendall Marthaler",
"text": "Hey, good morning. This is Kendall Marthaler on for PJ. Just with the delayed impact of COVID from one agent to two agent, are there any thoughts on starting to reduce operating rates in the lithium segment now, to try and work through that supply outside of obviously the -- shutdown? And just could you give us an update on the inventory situation, I believe it was kind of thought that the lithium inventory should be worked through by year end to a early 2021, how do you see that progressing now?"
},
{
"speaker": "Scott Tozier",
"text": "Eric, you want to talk a little bit about our shutdown plans and your business and our current view on inventory and the supply chain."
},
{
"speaker": "Eric Norris",
"text": "Yes, so we entered the year, as you know, with our capacity fully committed and under contract. 90% plus of our battery grade materials are under contract. And as we go through this year, we obviously have the uncertainty associated with what might happen in the second half. But our intent is to keep our plants running, to keep our customers supplied. We are seeing some indications that they -- from a few customers that they're going to want to reduce their forecast. Those will be commercial discussions we have with them. There are other opportunities we have to place that volume if we have to. But our intent is to and our hope is our customers want our contracts. So at the moment, we don't -- we're operating on a place to volume per plan mode. There is a playbook we have that in the event there is a worst case sort of recession coming there certainly is a playbook we have around what we need to do around how we run our plants. But we do not have any -- well beyond what we've already announced, have further intend to close any plants at this point in time until we see how the second half demand plays out. I think that was your first question. Second question was inventory correct, Kendall? So inventory has been drawn down to some extent with the customers we serve. We know that because they've reduced their volumes in the first half as expected. The challenge we have is not knowing what's happening elsewhere. Of course, China had a very weak first quarter itself because of the pandemic. Now, automotive plants in Europe and the U.S. are closing, which, as I said earlier could have a third quarter impact. And there's been numerous supply disruptions amongst our competitors, some of which is related to COVID-19, some of which frankly, has been related to their own liquidity challenges. So when you put all that together, it's very hard for me to comment on what inventory looks like and how much it has been drawn down across the channel, across the total industry. So I'll just have to sort of let you know as we go through. Maybe next quarter or two, we'll get better clarity on that. But right now, it's quite muddy."
},
{
"speaker": "Kendall Marthaler",
"text": "Okay, thank you, very helpful."
},
{
"speaker": "Operator",
"text": "Thank you. And our next question comes from the line of Matthew Skowronski with UBS. Your line is open. Please go ahead."
},
{
"speaker": "Matthew Skowronski",
"text": "Good morning. Following up on Jim's question, you cut CAPEX for this year and obviously these are very, very challenging times to predict. But as of right now, what's your base case for CAPEX for 2021 and 2022 given your slowing down projects and then kind of alongside that, what is the minimum amount of CAPEX you would be willing to go down to if these trends continue?"
},
{
"speaker": "Scott Tozier",
"text": "Hey, this is Scott."
},
{
"speaker": "Kent Masters",
"text": "Let me start, Scott and then you can look further out. So I mean we look at it in two different buckets. So we've got, well, sustaining capital, so capital on our plant but from a safety standpoint, from a maintenance perspective and then growth capital and the big projects. So we've cut back on the big projects to where we can without making a bigger move on those particular projects. I'm kind of more or less talking about La Negra and Kemerton at this point. So there's another leg that we can go down but from an execution standpoint, it makes that more difficult. And we don't really want to cross that but if things get difficult, we have that lever. Operationally we have -- for this year we've kind of narrowed it to the point where we can. There will be other know as we shut down, we'll be able to cut capital if we have to shut down lines. But we've kind of narrowed down to what we believe we have to do from a health and safety and from maintaining our assets perspective, plus a little bit of buffer. So we're not getting -- we're not to the bone but we're close on that for this year. And then as we look out, we would -- depending on what happens, we would go back to what the previous level of spin would be and increase a little bit in the sustaining part, some growth, but smaller growth projects with nice returns in the plants and then go back to the big projects what's necessary to execute those?"
},
{
"speaker": "Matthew Skowronski",
"text": "That's helpful. Thank you. And then with regards to FCC sales, can you just remind us how those are split geographically and if you're seeing any regions start to pick up besides presumably Asia? And then thank you for everything Luke over the past couple of years, best wishes for the future."
},
{
"speaker": "Luke Kissam",
"text": "Hey, thanks a lot, Matt."
},
{
"speaker": "Raphael Crawford",
"text": "Hey, Matt this is Raphael. Let me give you a little perspective on FCC. So geographically, the strengths for our business are in North America. Europe's a smaller market for FCC, but we're relatively strong in Europe. And our largest market is in Asia and India. So that's where we have our pockets of strength and from a product standpoint, we're very strong in bottoms cracking and in propylene in yield. So as you look at the impact of the pandemic and where we see recovery, for the first time last week global -- the inventory of gasoline in the United States went down from a record high of about 263 million barrels of gasoline inventory two weeks ago. So I think we started to see an inflection in North America. As you see states open up, it's going to start to improve from a bottoming out in North America. Asia has been recovering, so China has been recovering. There's still mandatory shutdowns and a lot of mandatory stay at home orders and reduced travel in a lot of Southeast Asia. So that has an impact on our business as well as in Europe. I would say that from a global perspective, I think we're near the bottom or at the bottom of the demand picture, and we should start to see a recovery from here on out. But there's a lot of uncertainty as to whether there is a second wave of outbreak of COVID, how fast it comes back. All that being said, I think we're positioned pretty well as an FCC business in the right markets with the right technologies for long-term success."
},
{
"speaker": "Matthew Skowronski",
"text": "Thank you."
},
{
"speaker": "Operator",
"text": "Thank you. And our next question comes from the line of Mike Sison with Wells Fargo. Your line is open. Please go ahead."
},
{
"speaker": "Mike Sison",
"text": "Hey, good morning everyone. In 2019, there was an inventory build for lithium and I recall it somewhere in that 50,000 to 75,000 and then it tracked toward the end of the year. And you guys have tended to have a good feel for those levels. Do you think that eventually they will build back and then at the end of the day is the volume of lithium demand going to be down this year and by how much?"
},
{
"speaker": "Eric Norris",
"text": "Mike hi, good morning, it's Eric here. So with regard to inventory, I don't have that much to add versus the earlier question. We did have if you include all forms of lithium somewhere between refined lithium, maybe three to four months, if you add in spot, you mean maybe six months of inventory as we were exiting last year. As you know, and as Scott discussed in our results, our customers and we expected this drew down from our purchases that they'd otherwise have in the beginning of the year, their inventories. And it was particularly in Europe, a reasonably strong first quarter despite the onset of the pandemic outside of China. So there has been in a small -- our part of the world, some inventory reduction. But what I can't account for is what's happened elsewhere. China demand was not strong at all in the first quarter. It is the largest lithium market, however, producers to that market, many of our competitors weren't able to produce either. So the relative balance of the two and how that changed in a three month period, too hard to say, really too hard to say right now. So that's what I'd have to leave it at. Was there a second part to your question I missed?"
},
{
"speaker": "Mike Sison",
"text": "Yeah, just a quick follow up. If you think about the long-term, kind of the 2025 forecast for EV adoption, how does that change do you think with oil prices being low and kind of the impact on automakers and their ability to ramp up those cars? And then Luke I just want to wish you the best, I hope you have a lot of fishes to catch over the next couple of days?"
},
{
"speaker": "Luke Kissam",
"text": "Well don't forget you owe me that dinner and the wine over that bet you lost about the football games, but thanks Mike."
},
{
"speaker": "Mike Sison",
"text": "I will get down on that."
},
{
"speaker": "Scott Tozier",
"text": "So, on demand, I think it's like we said, we know that we're going to see a weaker second half, we don't know how weak Mike. So I really can't tell you how -- what is coming as demand is going to look like versus last year at this point in time. What I can tell you on EV specifically is that what we look at for EV adoption is not necessarily oil price. That's an older convention or rule of thumb that this does not seem relevant in a world where whole regions and countries are putting in regulations in place that are driving things towards electric vehicles. So that is -- that's what we look for and we see that sustained. We see that increasing in the case of China. There's a possibility those regulations are sustained or potentially increased under the Green Deal initiatives in Europe. We'll have to watch and see. But all that being said, as you said earlier, the reasons we think and we rely on third party research for this, that the EV curve has been shifted out perhaps by as much as a year or more is that consumer spending is going to be nicked significantly during this recession. We just don't know what that impact looks like. So we, like you are going to rely on experts who provide those forecasts and as we get more information, we'll provide more."
},
{
"speaker": "Operator",
"text": "Thank you. And our next question comes from the line of Colin Rusch with Oppenheimer. Your line is open. Please go ahead."
},
{
"speaker": "Colin Rusch",
"text": "Thanks so much, guys. Can you talk a little bit about the technology roadmaps or your cathode customers and whether those are accelerating or changing at all, we know you've got some targets out there, but are they taking this downtime to look at accelerating some of those roadmaps?"
},
{
"speaker": "Kent Masters",
"text": "I don't -- Colin, good morning. I don't think there's any material change to those roadmaps, so just at a high level what those are, is as chemistries moved to higher levels of nickel, NMC 62 or higher in the NMC chemistry area or NCA. And those are the preferred chemistries for energy density, therefore lower costs ultimately, and higher range for EV's. As all of these are electric vehicle manufacturers, particularly in Europe given the regulations I just referenced earlier that are driving this adoption roll out their plans, they're moving to those chemistries those are oriented towards hydroxide. There's some salt and pepper ingredients that are used on the anode side of things for proliferation and other things that are starting to develop as well, so some interesting technology developments. That's where we see the future. We're going to continue to see a core of chemistries used to support consumer electronics products, power tools, and lower range, lower value EV's which will be predominantly based in China. And those would be carbonate based chemistries, they can be lithium ion phosphate or NMC varietals that have lower levels of nickel and are therefore more economically produced with carbonate. And that's pretty much the story. It's been -- it hasn't changed a lot just given what's going on with the pandemic, most automotive and battery manufacturers are just dealing with the pandemic at the time being rather than accelerating their technology programs."
},
{
"speaker": "Colin Rusch",
"text": "Alright, that's helpful. And then in terms of some of the health measures that you guys are implementing in your facilities, are there permanent changes to the cost structure on production and processing that you can speak to at this point?"
},
{
"speaker": "Kent Masters",
"text": "I wouldn't -- I mean what we've done from a health standpoint, I don't think we'll change our long-term cost structure. So that will move back. There are things that we're learning and that that will inform some decisions as we go forward. But so far, we've done that in response to the pandemic and to continue to operate in a difficult environment. We've done fairly well with that. But we'll go back to the way we were operating as soon as that's possible. But, some of the things that we have learnt will probably apply that may affect that but we are not in that spot today."
},
{
"speaker": "Colin Rusch",
"text": "Great, thanks so much guys."
},
{
"speaker": "Operator",
"text": "Thank you. And this does conclude today's Q&A session. I would now like to turn the conference back over to Ms. Meredith Bandy for any further remarks."
},
{
"speaker": "Meredith Bandy",
"text": "Alright, thanks everyone for your questions and your participation in today's conference call. As always we do appreciate your interest in Albemarle and that concludes our first quarter conference call. Thank you."
},
{
"speaker": "Operator",
"text": "Ladies and gentlemen thank you for participating in today's conference. This does conclude the program, and you may all disconnect. Everyone have a great day."
}
] | Albemarle Corporation | 18,671 |
ALB | 4 | 2,021 | 2022-02-17 09:00:00 | Operator: Good day and welcome to the Fourth Quarter Albemarle Corporation Earnings Conference Call. At this time, all participants are in a listen-only mode. After the speakers’ presentation, there will be a question-and-answer session. [Operator Instructions] As a reminder, this call is being recorded. I would like to turn the call over to Meredith Bandy, Vice President of Investor Relations and Sustainability. You may begin.
Meredith Bandy: All right. Thanks, Michelle. Thank you all, and welcome to Albemarle’s fourth quarter 2021 earnings conference call. Our earnings were released after close of market yesterday, and you’ll find our press release and earnings presentation posted on our website under the Investors section at albemarle.com. Joining me on the call today are Kent Masters, Chief Executive Officer; and Scott Tozier, Chief Financial Officer. Our GBU Presidents, Raphael Crawford, Netha Johnson and Eric Norris are also available for Q&A. As a reminder, some of the statements made during this call, including outlook, guidance, expected company performance and timing of expansion projects may constitute forward-looking statements within the meaning of federal securities laws. Please note the cautionary language about forward-looking statements contained in our press release and earnings presentation. That same language applies to this call. Please also note that some of the comments made today refer to non-GAAP financial measures. A reconciliation to GAAP financial measures can be found in our earnings release and the appendix of our earnings presentation. Now I’ll turn the call over to Kent.
Kent Masters: Thanks, Meredith, and thank you all for joining us today. On today’s call, I will highlight our quarterly results, recap our 2021 successes and update you on our expansion plans. Scott will provide more details on our financial results, outlook and capital allocation priorities. And finally, I’ll walk you through our 2022 objectives. 2021 was a transformative year for Albemarle. Our strategic execution and ability to effectively manage the challenges of the global pandemic enabled us to capitalize on the strength of the lithium and bromine markets and generate results that exceeded expectations. For the year, excluding our Fine Chemistry Services business, which was sold in June of 2021, we increased net sales by 11% to $3.3 billion, which was in line with our previous guidance. Adjusted EBITDA grew 13% in 2021 to $871 million, surpassing the upper end of our guidance. Looking ahead, our outlook for 2022 has improved based primarily on favorable market conditions for lithium and bromine. We expect adjusted EBITDA to grow between 35% and 55% versus 2021, excluding Fine Chemistry Services. To continue driving this growth, we are focused on quickly bringing capacity online with accelerated investments. La Negra III and IV is currently in commercial qualification and we expect to start realizing first sales from this facility in the second quarter. In November, we achieved mechanical completion of the first train at Kemerton. The construction team is now dedicated to the second train, and we will be able to leverage our experience from Train 1 to improve efficiencies and timeliness of this project. And we recently signed a nonbinding letter agreement to explore the expansion of our MARBL joint venture with increased optionality and reduced risk. Now looking at Slide 5. We introduced this slide early last year to lay out our 2021 objectives designed to support the four pillars of our strategy, to grow profitably, to maximize productivity, to invest with discipline and to advance sustainability. I would like to thank our teams for their extraordinary efforts. Virtually all the goals we set last year were met or exceeded despite challenges related to severe weather, supply chain issues and the ongoing effects of the pandemic. The focus of our people around the world is what drove our strong year and underscores our ability to deliver on our commitments. These accomplishments have also set the stage for us to take advantage of the growth opportunities ahead. Just as important as driving growth is an ongoing dedication to strong ESG values. I’m very proud of what you see on Slide 6. Since I became CEO in 2020, one of my main priorities has been continued improvement in sustainability. I’m pleased to see that these efforts are increasingly being recognized externally, but it certainly isn’t a new initiative for Albemarle. Sustainability is not just doing the right thing but also doing it the right way. For example, the lithium market is expected to see significant demand growth in the coming years. As a leader in lithium production, we expect to be an example and help define the standards of sustainability in this market as it goes through this fundamental shift. Now turning to Slide 7 and more on the lithium market outlook. Based on our current market data, EV trends and regular interactions with our customers, we are revising our lithium demand outlook upwards once again. We now expect 2025 lithium demand of approximately 1.5 million tons, up more than 30% from our previous estimates. Beyond 2025, we anticipate continued growth with lithium demand of more than three million tons by 2030. EV sales growth is accelerating as consumers become more energy-conscious, governments incentivize clean energy, technology improves and EVs approach pricing parity with internal combustion vehicles. In 2021, global EV production nearly doubled to over six million vehicles from three million in 2020. By the end of the decade, EVs are expected to account for close to 40% of automotive sales. When you look at last year’s growth rate of nearly 50% and the auto industry’s ambitions for a rapid transition to EVs, it’s easy to see why demand expectations are so bullish. However, meeting this demand will be a challenge. Turning to our Wave II projects on Slide 8. La Negra III and IV, which will add conversion capacity for our Chilean brine resource in the Salar de Atacama is currently in the customer qualification process. We anticipate incremental volumes and revenue contribution from this project in the second quarter of this year. While there are significant changes taking place to the political landscape in Chile, we do not anticipate any material impacts to our business. We support the Chilean people’s right of self-determination and applaud the peaceful leadership transition in that country. Our team has already begun building relationships with the incoming administration. As I mentioned earlier, Kemerton I reached mechanical completion late last year and is currently in the commissioning phase. This puts us on track to begin first sales in the second half of this year. Kemerton II remains on track to reach mechanical completion by the end of this year. The OEMs and battery manufacturers have been investing heavily in growth, including commitments in North America and Europe, and the lithium industry must do the same. Turning to Slide 9. We provide an overview of how Albemarle is investing to support downstream growth. Since our Investor Day, we have accelerated and further defined our Wave III projects, including the announcement of three strategic investments in China. This wave of investments will provide Albemarle with approximately 200,000 tons of additional capacity. That’s up from 150,000 tons of capacity originally planned for Wave III. We’ve also continued to progress our growth options for Wave IV. Based on discussions with our customers, we are analyzing options to restart our Kings Mountain lithium mine and the potential to build conversion assets in North America and Europe. Our vertical integration, access to high quality, low cost resources, years of experience bringing conversion capacity online and strong balance sheet provide us with considerable advantages. I’m on Slide 10 now. In China, we expect to close the acquisition of the Qinzhou conversion facility in the first half of this year. This transaction is progressing well, and we continue to work through the appropriate regulatory reviews. The Qinzhou plant is currently being commissioned and we have begun tolling our spodumene to assist with that process. We continue to progress the two greenfield lithium conversion projects in Meishan and Zhangjiagang. We have started site clearing at Meishan and expect to break ground at Zhangjiagang later this year. We expect mechanical completion of both projects by the end of 2024. The restart of one of three processing lines at the Wodgina mine is going well, with first spodumene concentrate production now expected in the second quarter. At Greenbushes, Talison continues to ramp production from the CGP 2 facility to meet design throughput and recovery rates. In addition, the tailings project at Talison is on track. Before I turn the call over to Scott, I’d like to highlight our bromine growth projects on Slide 11. Our bromine business is investing in innovation and capital projects to take advantage of growth opportunities. We expect new products to make up more than 10% of annual bromine revenues by 2025, up from essentially a standing start. The first of these products to launch is SAYTEX ALERO, our next-generation polymeric flame retardant. We first discussed SAYTEX ALERO at our Investor Day last year, and I’m excited to say that we have achieved first commercial sales in January and expect to scale production throughout the year. We’ve also invested in the resource expansion at the Smackover formation in Arkansas, and we continue to grow our conversion and derivative capacity in both Arkansas and Jordan. With that as an overview, I’ll turn the call over to Scott to discuss recent results and our outlook.
Meredith Bandy: Scott?
Kent Masters: Scott, you might be on mute.
Scott Tozier: Hello? Can you hear me now?
Kent Masters: Yes. We hear you.
Scott Tozier: Okay. Sorry about that. I was on mute. Thanks, Kent, and good morning, everyone. I’ll begin on Slide 12. For the fourth quarter, we generated net sales of $894 million, which is an increase of $15 million compared to the prior year quarter. This was driven by higher sales from lithium and bromine, partially offset by the loss of revenue from our Fine Chemistry Services business, which was sold in June 2021. Excluding FCS, we grew by 11%. The fourth quarter net loss attributable to Albemarle was $4 million, reflecting an increased cost estimate to construct our Kemerton lithium hydroxide plant due to anticipated cost overruns from the impact of pandemic-related issues on the supply chain and labor. Fourth quarter adjusted diluted EPS of $1.01 was down 14% from the prior year. The primary adjustment to EPS is the $1.13 add-back of that Kemerton revision. Let’s turn to Slide 13 for more detail on adjusted EBITDA performance. Excluding FCS, fourth quarter adjusted EBITDA was up 12% from the prior year. Lithium results remained strong driven by higher volumes as well as higher pricing. Bromine results were roughly flat year-over-year, reflecting strong performance in late 2020 and repeating it in 2021. And Catalyst improved in the fourth quarter as refinery markets continue to rebound and the business saw benefits from one-time items. Our second half sales grew 13% from the first half of the year, following a relatively flat growth since mid-2020. This acceleration of growth is expected to continue into 2022. On Slide 14, you can see we are expecting both volume and pricing growth in all three of our business units in 2022. We expect net sales of between $4.2 billion to $4.5 billion and adjusted EBITDA in the range of $1.15 billion to $1.3 billion. This implies an adjusted EBITDA margin of between 27% and 29%. Adjusted diluted EPS and net cash from operations are also expected to improve year-over-year. We anticipate healthy growth in adjusted EBITDA in all four quarters this year, and we expect Q1 to be the strongest quarter for several reasons. All three GBUs are expected to benefit from lower-cost inventory sold at prices that have been raised in anticipation of inflation. In the first quarter, lithium also has the benefit of strong shipments from our Talison joint venture to our partner as well as a onetime spodumene sales material produced at Wodgina on initial start-up in 2019. And finally, going forward, higher spodumene transfer pricing increases are going to increase our cost of sales and only partially be offset by higher Talison joint venture income, which is included in our EBITDA after tax. And this creates a tax-impacted EBITDA margin drive. As Kent mentioned, CapEx is expected to increase to the $1.3 billion to $1.5 billion range this year as we accelerate lithium investments to meet increased customer demand. The key actions to meet or exceed this guidance include, first, successful execution of our lithium project start-ups; second, closing the acquisition in China; third, solid performance at our sold-out plants in lithium, bromine and FCC catalysts; fourth, continued strength in our end-use markets and favorable pricing environment; and lastly, solid procurements to combat inflation. Let’s turn to Slide 15 for more details by GBU. Lithium’s full year 2022 EBITDA is expected to be up 65% to 85%, a significant improvement from our previous outlook. We now expect volume growth to be up 20% to 30% for the year with the new capacity coming online as well as ongoing efficiency improvements. Average realized pricing is now expected to increase 40% to 45% compared to 2021 due to strong market pricing as well as the expiration of pricing concessions originally agreed to in late 2019. In some cases, as these concessions rolled off, pricing reverted to legacy contracts with significantly higher variable pricing. And as we’ve been saying, we’ve also taken the opportunity to work with our strategic customers to renegotiate contracts to more variable rate structures. Catalyst EBITDA is expected to be up 5% to 15%. This is below our previous outlook, primarily due to cost pressures related to high natural gas pricing in Europe and raw material inflation. Volumes are expected to grow across segments with overall refining markets improving. We continue to see volumes returning to pre-pandemic levels in late 2022 or 2023. FCC volumes are already there, but HPC volumes are lagging. Bromine EBITDA is expected to be up 5% to 10%, slightly above our previous outlook based on strong flame retardant demand supported by macro trends, such as digitalization and electrification. Volumes are expected to increase based on the expansions we began in 2021. And as discussed, higher pricing and ongoing cost and efficiency improvements are expected to offset higher freight and raw material costs. Now turning to Slide 16, I’ll provide some additional color on lithium volume growth. This slide shows the expected lithium production volume ramp from the new conversion facilities we expect to complete this year. We begin the year with a baseload production of 88,000 metric tons in 2021, which includes Silver Peak, Kings Mountain, Xinyu, Chengdu and La Negra I and II. And you can see that this is virtually a 50/50 split of carbonate and hydroxide. As our Wave II projects come online, output will begin to favor hydroxide. Generally speaking, we expect it to take about two years to ramp to full conversion capacity at a new plant, including approximately six months for commissioning and qualification. Therefore, we expect to reach our full 200,000 tons of conversion production by early 2025. Before I turn it back to Kent, I’d like to update you on our capital allocation priorities, and I’ll turn to Slide 17 to do that. Our capital allocation priorities remain the same. Our primary focus is to invest in profitable growth opportunities, particularly for lithium and bromine. Strategic portfolio management and maintaining financial flexibility are important levers to support this growth. For example, we have divested noncore businesses like FCS and reallocated funds to organic and inorganic growth opportunities, like the expected acquisition of the Qinzhou plant. The strategic review of Catalyst is progressing well and is on track for us to make an announcement of the outcome in the first half of this year. We’ll also continue to evaluate bolt-on acquisitions to accelerate growth or bolster our portfolio of top-tier assets. As always, future dividends and share repurchases are subject to Board approval. However, we expect to continue to support our dividend. Given the outsized growth opportunities we see in lithium, we don’t anticipate share repurchases in the foreseeable future. And with that, I’ll turn it back to Kent.
Kent Masters: Thanks, Scott. I’ll end our prepared remarks on Slide 18, outlining our 2022 objectives aligned with our long-term strategy. First, we will continue to grow profitably. This means completing our Wave II expansions and progressing Wave III expansions to grow lithium conversion capacity and volumes. We’ll also focus on safely and efficiency starting up those facilities. Next, we will continue to maximize productivity, and this is even more important in today’s environment with rising cost for raw materials. We will leverage our operational discipline to offset inflation through manufacturing excellence, implementing lean principles and embracing smart technology to improve HSE, cost, reliability and quality. Our procurement cost-saving initiatives and manufacturing excellence projects will be key to offsetting higher raw materials and freight cost as we work to achieve adjusted EBITDA margin of between 27% and 29%. We will invest with discipline. As Scott discussed, portfolio management and maintaining our investment-grade credit rating are both high priority for us and will continue to be a focus in 2022. Importantly, we plan to complete the catalyst strategic review later this year, which will maximize value and set that business up for success while enabling us to focus on growth. Finally, we will advance sustainability. That means driving progress toward our goals for greenhouse gas emissions and fresh water use and setting additional sustainability targets. We’ll also continue to work with our customers to improve the sustainability of the lithium supply chain by completing our mine site certifications, Scope 3 greenhouse gas assessments and analyzing product life cycles. So with that, I’d like to open the call for questions, and I’ll turn it back to Michelle.
Operator: [Operator Instructions] Our first question comes from David Deckelbaum with Cowen. Your line is open.
David Deckelbaum: Good morning guys. Thanks for taking my questions. I was curious if you could talk a little bit about the lithium pricing outlook. You raised your outlook to 40% to 45% increase in 2022. When you think about that, and you talked about renegotiating your fixed price contracts, how do we think about your exposure to spot market fluctuations now as we head into 2023? And I guess, in conjunction with that, would you expect that you would see further pricing increases into 2023 based on your outlook today?
Eric Norris: Good morning, David, this is Eric Norris. So our pricing outlook – let me start first with the composition, what we see in 2022. We have, as Scott and Kent indicated in the prepared remarks, moved our pricing structures to be more variable. About upwards of close to 50% of our existing battery-grade contracts have a variable component to an index with a price and a ceiling. Those indices are not what you would see in China. Those are indices based upon global publicly available indices, such as Benchmark Minerals, Fast Markets and the like. The remaining 10% of our business is spot in China, so that is going to be exposed to what you see. And the rest is largely, at this point, fixed. Although as Scott indicated, as we continue to approach customers and then they seek to add to their volumes through our expansions, we are in those discussions asking them and considering moving to more variable with them as well. So, we have bottom line increased our exposure to pricing upside, but I think you need to consider that the contracts that we – or excuse me, the indices we’re using largely are the global indices, not the China indices, where you see much higher price in the China market than you do globally. So in terms of the outlook going forward, I mean, I would say that we expect – it really comes down to what China pricing does. It is the lead, sort of the tip of the spear. Where that goes, the indices follow globally. Those global indices are about half, in some cases, of current China prices. So there’s probably room to go in those indices, but there’s – with prices where they are in China, one could only speculate what they would go. And could they go down? We don’t know. So there’s – there’ll always be some variability on that 10% of our business that’s in China.
David Deckelbaum: Appreciate that. Thanks for the color there. My follow-up is just on the capital raise, a $200 million increase this year to the budget. It sounds like that’s accelerating some of the conversion assets in China. Could you just give a little bit more color around that? And when do you expect to see some of the volumetric impact relative to your original outlook?
Kent Masters: Okay. So I’m not sure, volumetric impact – so you’re talking about our Wave III expansions when we see those volumes coming on? Is that...
David Deckelbaum: It sounds like that the timing has now accelerated around Wave III. So, I guess per your – if you were to look at it based on your original vision that you laid out at the Investor Day, how much time are you pulling forward with that additional $200 million around the conversion assets?
Kent Masters: Yes. So, we brought it forward because of the Meishan, Zhangjiagang – the acquisition Zhangjiagang. So that was not – we were hoping to do an acquisition. The hadn’t plan didn’t have that, nailed down at the – when we did the equity raise and the comments that we made then. So that brought it forward. And we’ve increased the capacity about 50,000 tons in that Wave. So the timeframe has been pulled a bit forward because we’ve confirmed that acquisition, and then we’ve increased that Wave by 50,000 tons. And as we said before, the two greenfields we think will be on by the end of 2024.
David Deckelbaum: Thank you all.
Operator: Our next question comes from Bob Koort with Goldman Sachs. Your line is open.
Bob Koort: Thank you. Good morning. Kent or Eric, I was wondering if you could talk about your strategy on contracting to customers in a growing and very tight market. Is there an approach to not contract all your volume to ensure your customers can get deliverability? Do you want to have as much as possible fixed volume obligations? How do you think about that?
Kent Masters: Yes. So I’ll just – at a high level, and Eric can give you a little more detail on it. But I think we’ve talked about it. We want to have a portfolio across the range of those projects. So, we’re not tying up all the volume on long-term fixed contracts. But we do want to have that element of it. It’s becoming a probably a bigger part. We’re probably fighting to make sure that we keep the portfolio the way we envision it.
Eric Norris: Yes. I don’t have much to add, Bob. You heard how I answered David’s question just before you on the mix. We’ve seen an influence that to have up to a half on some sort of variable price that has some floors and ceilings a bit of spot and then the rest fixed. And we still strive to have, as we grow the business and add capacity, an amount that we can play in the spot markets. And that gives us excess to flex with our contract customers as they grow as well. Strategy still remains to be a partner to our customers and to seek those partnerships for their long-term growth, and that’s becoming in this market a very important topic, that security of supply.
Bob Koort: Can I ask a follow-up? What was the reason? And what are the ramifications of changing your MARBL agreement?
Kent Masters: Yes. So we’re – I mean we’re in the middle of that. So, I don’t really want to front run the discussions that we’re having with our joint venture partner. But I mean it’s really about – it’s expanding it to giving us more reach and mitigating some of the risks that we see in the marketplace by sharing it with a partner.
Bob Koort: Got you. Thanks Kent.
Operator: Our next question comes from Jeff Zekauskas with JPMorgan. Your line is open.
Jeff Zekauskas: Thanks very much. When you look at your lithium carbonate, your LCE production from now to 2025. Does your cost per ton change very much and in what direction?
Eric Norris: Well, Jeff, as Kent described – this is Eric, good morning, first off. As Scott described, Wave III is hydroxide-based and spodumene-based in that regard. Those are – that’s a higher cost of production than carbonate production out of Chile. So generally speaking, because of the higher cost to produce hydroxide versus carbonate out of brine, the average cost goes up slightly. But that’s a function of resource and product mix. We continue to drive productivity throughout the portfolio to ensure that we’re operating at a low conversion cost to take advantage of the good resources we have.
Jeff Zekauskas: And I think Scott said that the first quarter would have the – of 2022 would have the highest EBITDA total of the year. Why is that given that lithium production would be much greater in the second half?
Kent Masters: So there are a couple of dynamics happening there. So first is, we’ve been aggressive around pricing given inflation coming through. And in the first quarter, we’re selling out of inventory where that inflation has not actually hit our cost base yet. So – and that’s true across all of our businesses. So that inflation catches up to us in the back half of the year, and we’ve already implemented pricing. So that there’s a lull on that. And then it’s really the same answer on lithium. That’s across all the businesses, but particularly in lithium, spodumene prices have gone up dramatically. In the first quarter, we’re selling out of inventories, which have 2021 costs. And in 2022, those cost increases come through the P&L. And that was the dynamic Scott was talking about, where our EBITDA becomes tax-affected because it’s minority interest from JV income. Because even though we’re protected from those spodumene prices going up, it shifts from being in our peer EBITDA minority interest, which gets added to EBITDA, but on an after-tax basis. So those are the – really the two drivers for why the first quarter is the highest EBITDA level.
Jeff Zekauskas: Great. Thank you so much.
Operator: Our next question comes from P.J. Juvekar with Citi. Your line is open.
P.J. Juvekar: Yes. Good morning. How quickly do you see the Wodgina ramp-up? And is that limited by available conversion capacity in Australia and China? And then talking about conversion capacity, your potential North American/European conversion capacities in Wave IV, what does it take to move it to Wave III?
Kent Masters: I’m going to take the second question first and then probably talk to Eric for the first. But – so what we define – I mean the Waves are really just – those are our definition of projects. So nothing else is going to change. It’s not going to move North America from IV to III, because III is defined, and we’re well into execution on those projects right now. And we’re still defining exactly what we will do in Wave IV. But we would – we look to accelerate those, but they’ll still remain in Wave IV.
Eric Norris: And P.J., on your first question about Wodgina, we are only with our joint venture partner ramping up the first train of Wodgina with 50,000 tons of 6% spodumene, a little over 30,000 tons on an LCE basis. We look at the China, the growth in conversion capacity and hydroxide from Wave III that Kent described as the output – or excuse me, the consumer for that material. As a side note, spodumene tends to come on pretty quickly. It’s a different kind of plan operation than a conversion – chemical conversion plant, which tends to ramp over two years. A spodumene plant can come up within six months.
Kent Masters: Plus those trains are already built.
Eric Norris: Plus the trains, yes, fair point. Plus trains are built and they’re just being restarted. So, we would expect by midyear and to see spodumene flowing from that and put it into the assets that we talked about in Wave III. And the balance, we’d consider looking at tolling for the balance. And then as we continue to progress Wave III and other expansion activities, we’d look down the road. We’ve made no decisions yet on the second and third train at Wodgina, but those would be for down the road, giving us plenty of dry powder, so to speak, to support our growth as we continue to build out conversion capacity.
P.J. Juvekar: Great. And you guided to lithium volume growth of 20% to 30%, which I would think is in line with where the industry is growing. But you have so much new capacity coming online in 2022, first half and second half. So, I would have thought that your volumes would grow faster than the industry. Any reason why it’s not growing faster than the industry?
Eric Norris: Well, certainly, we’d like to continue to maintain our position in the industry and growth of the industry. And you’re right, with this growth guidance, we were doing that. But underneath that are the practical realities of capacity limitation. So the guidance we’ve given, P.J., speaks to – we give you dates of when we think these plants will come online. We – and we first have that first qualification standpoint. We have a six-month period before it can be qualified, and then we have about a two-year ramp to ramp that. When you back calculate that math, that’s on our fixed base of 88,000 tons last year. That is the growth increment you get. So it happens to correspond to market growth, but it’s going as fast as we can on our capacity expansion.
P.J. Juvekar: Understood. Thank you.
Operator: Our next question comes from Christopher Parkinson with Mizuho. Your line is open.
Christopher Parkinson: Great. Thank you very much. Just two quick questions. Just the first would be for the Western OEMs, let’s say, all in on the EV front. Just what’s your assessment of their own perceptions just regarding some of the newer competitor supply additions and how that product will or potentially will not be accepted in the marketplace in the ultra, let’s say, near to intermediate term? Any color would be helpful. Thank you.
Eric Norris: Yes. Good morning, Chris. So by that, you’re referring to Western OEMs’ view of new lithium competitors coming into the market who are trying to bring capacity to market. Look, I mean, I think you’d have to ask their view on things. I will say this, security of supply is a very, very big concern in the market. I think that’s why in a pure spot market like China, you see prices that are in order of magnitude higher than they were a year ago. It’s folks trying to get supplied at any price. So that is true, certainly in China given those prices, but that same sentiment is true here in the U.S., particularly as Western OEMs or in Europe as well, underwrite big investments. So they are looking for lithium wherever they can get it. I think the offering that Albemarle brings and is part of our dialogue with them is we have the resources. We have the execution capability, and we’re reliable in bringing on supply. So, we’re an attractive partner for them in those dialogues, and we’re in the middle of all those discussions now as we bring on this new capacity and look into the future to bring on future capacity, particularly as Kent referenced, as we look to localize capacity in North America and Europe.
Christopher Parkinson: That’s helpful. And just a quick follow-up. Just what would just be your latest thought process? On the demand front, you already hit on a few things. But just in terms of battery technologies, energy density. Just any color on what you’ve seen in terms of new model launches and potentially advancing high-nickel cathode chemistries? That would be very helpful. Thank you.
Eric Norris: Yes. So on battery chemistry for electric vehicles, we still see over the five- and 10-year view – or sorry, I’ll put it another way, over the 2025 and 2030 view that we’ve characterized in our growth charts in the earnings deck. We still see nickel – high nickel being the key to higher range. And we further see innovations on the anode side in prelithiation and new technologies that will further allow more energy density and cost-effectiveness of those nickel chemistries with that parity to internal combustion engines and coming in within that 18- to 24-month period. That being said, it’s pretty clear and our projections would show that LFP for lower energy density for lower-range vehicles, lower-cost vehicles is going to remain a segment of this market, not only now, but through this 10-year period. And it’s a double-digit percentage over that period of time, a low double-digit percentage but a double-digit percentage of the market. But most of the growth will be hydroxide.
Christopher Parkinson: Thank you very much.
Operator: Our next question comes from Alex Yefremov with KeyBanc. Your line is open.
Alex Yefremov: Thank you. Good morning everyone. I think as I look at your pricing guidance for lithium segment, it was a very strong. If I even assume some level of cost inflation, that cost number to get to your EBITDA and EPS guidance ends up being very high based on my model, at least, maybe as high as 40% or more per ton. Is there anything else beyond the spodumene and Talison dynamics that you already described in terms of cost that we should keep in mind for 2022?
Kent Masters: So, I mean, I think you have to appreciate we’re bringing on new plants. And when we bring them on, they’re not loaded, right? So there’s a lot of – we’re doing multiple facilities doing that. So there’s high fixed costs associated that with lower volumes. But other than that, I mean, the pricing movements are pretty aggressive and pretty consistent. We’ve moved our portfolio quite a bit. We’ve been talking about that, and we’ve more or less done that. So, we’re more exposed to the market than we have been in the past. But I think you have to keep in mind that fixed cost piece about bringing on new facilities that are not loaded.
Alex Yefremov: Okay. Appreciate it. And then I wanted to follow-up on the pricing side. I guess, given approximately 50% of your volume have these indices, would any of these indices reset during the year? And could you end up above the 45% sort of upper bound of your lithium guidance – price guidance?
Eric Norris: It’s Eric. I can answer that. It’s – they are all based on indices that continue to move. The recent movement has been upward in the past three months. Again, sort of the tip of the spear being China prices, which are significantly higher. Where the market goes long-term, we don’t know. If there is a downward sort of correction in China prices, that will hit the China spot volumes we have. If however the spot – these indices for the large part of our business is variable fixed ceiling floor, those are well below those spot prices. It’s very hard to say. If the prices remain high, we could definitely be to the higher end of our range on price. And I think – I mean, I think part of your question was about are they fixed through the year. So they aren’t. Those – that move of the market can move during the year.
Alex Yefremov: Understand. Thanks a lot.
Operator: Our next question comes from Steve Richardson with Evercore. Your line is open.
Steve Richardson: Hi, good morning. I was wondering, again, just back on the capital piece. Scott, could you give us any more color just in terms of how much is cost inflation versus pull-forward? I appreciate that you kind of addressed this a little bit earlier, but it is something that continues to come up in our conversations and would be helpful. And then on the cost piece, just on the previous question, I appreciate that you’re dealing with a lot of fixed costs in terms of some of these new project starts. But could you maybe tease out, at least in terms of your unit cost, how much is process-related in terms of just general costs associated with the process versus what you’re seeing in terms of this mismatch between volumes and fixed cost versus variable?
Kent Masters: Yes. So let me take the first part of your question, Scott, and then I’ll kick over to Scott to talk about the margin piece and the conversion costs. So looking at the change in our capital forecast, it’s at least half acceleration. I mean there is – I mean we have had additional cost executing projects in Western Australia during the pandemic has been a challenge for us, and we’ve had additional costs as well as extending the projects on that. And we also see inflation impacting the projects that we’re kicking off now that we didn’t see a year ago. So it’s probably – how accurate we can be around that, but it’s probably half acceleration and half additional costs associated with inflation and pandemic cost. And Scott, I’ll kick to you for the margin question.
Scott Tozier: Hi, Steve, as you look at the lithium margins going into this year, the two factors are these plant start-ups and not being at full capacity. And that’s probably $100 million drag in the year, somewhere in that range. And then the impact of the spodumene prices going up and changing the dynamic between cost of sales, so increasing our cost of sales but also increasing our equity income on an after-tax basis, that’s probably north of $200 million. So those are the two biggest kind of movers as you look at the lithium margin.
Steve Richardson: Great. Thanks. I appreciate the additional clarity. And one follow-up, if I may, just for Eric, on the lithium outlook on the demand side. The $1.5 billion number is obviously huge relative to where the market had been, and I see the logic on the demand side. Can you address your view, like the industry’s ability to hit this from a supply perspective and at least how does this play out? Do we just end up seeing ever higher incentive price to bring marginal projects to bear? Or do we have a limiting factor here in terms of the supply side’s ability to hit that number? And certainly, the $3 million in 2030 is a huge number as well.
Eric Norris: Okay. I would say, Steve, that it’s going to take – it’s a hard run, right? It’s going to take everybody being ourselves and our competition being successful at hitting their milestones in order to provide that to meet that supply. So it’s an all-out effort to get there. So I don’t want to sugarcoat it. It’s – I think it’s the reason the industry is so tight is because there’s a view it takes a while and it’s – and it doesn’t go as it’s – always as expected. In terms of price, I don’t have a crystal ball. I don’t – I never would have predicted a $65 carbonate price. So I don’t know how to think about where that would go in the future. It does reflect that hard slog I just referred to, I think, that everybody’s got to step up and execute well in order to meet that demand.
Steve Richardson: Thank you very much.
Operator: Our next question comes from Joel Jackson with BMO Capital. Your line is open.
Joel Jackson: Hi, good morning everyone. Some years ago, you guys had talked about kind of a 40% EBITDA margin for lithium as kind of being what I think you make it over the course of the cycle. We’re now at 34%, 35% range over the last three years to much different pricing scenarios every year. And you talk about now fully loaded plants and how that may affect margin. You’re going to be, of course, ramping on plants indefinitely or for a long time. So should we be thinking about this as the right cost base going forward, this margin as the right kind of base going forward for lithium?
Kent Masters: I think what we’ve said in the past in the long term is we stand by that. So I think we’ve got one of the things you have to understand is as spodumene prices go up, that impacts our EBITDA margin because of the nature of the JV. So EBITDA effectively becomes tax-affected to some degree because of the product we purchased from Talison. And that will – and that won’t be different with MARBL going forward. So that has an impact on the pure EBITDA margin, but it still flows through the P&L once you get fully to the bottom line. So I think to kind of answer your question, we still stand by the guidance that we’ve provided in the long term. We still think it’s in that range.
Joel Jackson: The next question is, it’s great to have a 3 million-ton demand forecast for lithium for 2030. But let’s be honest, we’re never going to get there. There’s not supply out there. Even if there’s supply, we’re not going to get there in eight years for 3 million tons, right? You’ve got to have new resources, you got to have new technology, DLE whatever. You have to have lots of assets that aren’t producing now in lots of strange places, new feedstocks. So we’re never going to get to 3 million tons. Would you agree with that? And if that’s the case, what’s going to happen? So does that mean the EV acceleration has got to come down, OEMs have to change your plan? Or do I have it wrong?
Kent Masters: Eric said it before, that it’s a slog, but it’s doable. I think the industry has to be aggressive and has to execute well. And I think you’re seeing and some of that – that we’re getting through some of those growing pains. We think we’re probably as experienced as anyone at doing these large conversion facilities and bringing on new resources. But it’s a combination of resource and conversion capacity. It is a stretch, but – and it does require some new technology and operating in some places where historically, the lithium industry hasn’t done that, but it’s not impossible.
Joel Jackson: Thank you.
Operator: Our next question comes from Vincent Andrews with Morgan Stanley. Your line is open.
Vincent Andrews: Thank you and good morning everyone. Kent, just wondering if you could mark the, the Wave III total CapEx for us. I think you originally said it at $1.5 billion, and I think you mentioned half of the increase for 2022 was related to inflation. But it seems like maybe some of that was transitory if COVID indeed calms down. So how would you tell us to think about Wave III now versus the original $1.5 billion?
Kent Masters: Yes. Well, it’s – I mean it has stretched a little bit because we’ve accelerated and we’ve had inflation. So that inflation is – if it goes away in three years doesn’t matter because we’re building the projects in the next couple of years. So there is some impact on that. So it’s – we’ve accelerated because there’s additional capacity associated with that. So that is half of the difference and the other half is inflationary. So it’s – you got to add that on. And that – and even if it goes away, I mean, we’re not going to be necessarily in Western Australia, but there’s still going to be – and we see – our forecasting says inflation in the capital equipment that we’re buying in the next year and two.
Vincent Andrews: So if we thought of something like it was going to be like a $1.8 billion to $2 billion now instead of $1.5 billion, is that good for a ballpark number?
Kent Masters: Yes. I think I want to start estimating what the projects are going to turn out to be. But it’s up definitely from $1.5 billion. Part of that is the acceleration. So I’m kind of focused on the inflation part. But overall, that’s probably not a bad estimate.
Vincent Andrews: Okay. Thank you. And just on the Salar de Atacama technology projects, can you just talk to us about what milestones are left to hit on that so that you’d be confident that you’ll be able to execute it?
Kent Masters: Yes. So we’re just getting going into the real execution phase of that particular project, but I don’t know that – it’s not as complicated a project as a conversion facility. So I think we feel pretty good about executing on that. We are – we’ve lost a little bit of the float we had in the schedule, but that’s it. We’re still on plan and on the schedule that we had, but we have lost a little bit of the contingency from a time standpoint that we originally had built in.
Vincent Andrews: Okay, very good. Thank you. Appreciate the answers.
Operator: Our next question comes from Kevin McCarthy with Vertical Research. Your line is open.
Kevin McCarthy: Yes, good morning. A couple of questions on your catalyst business. First, I think you had announced some price increases in early January. Can you talk about the magnitude and the flow-through with regard to realization of those increases? And also related to catalysts, any update on your level of confidence with regard to the ongoing strategic review?
Kent Masters: Sorry, Raphael. Let me touch on the strategic review and then let you talk about pricing. So I mean we’re going through that process, and it’s going well. The timing we had said, we think we’ll have an answer by middle of the year. And I don’t really want to front-run it or comment too much on it beyond that. Raphael?
Raphael Crawford: Yes. Sure. Thanks, Kent. Kevin, as we – as you saw, we announced a price increase in January. That’s really to help offset the inflation that we’ve seen starting in the second half of 2021 into this year, particularly around natural gas. So that’s building momentum. So I think we’ll see north of $10 million worth of pricing in our forecast. Again, that’s really to offset what we’ve seen on raw materials. As you know, Kevin, we are – we produce performance products. So we create a lot of value for our customers. We think our pricing is justified. It’s mostly around FCC catalyst where we’re in a near sold-out position right now. All that being said, we’ve got a lot of confidence in what we shared as our long-term forecast for the business at Investor Day. We think some of the raw material headwinds will be covered with price over time, and we’ll be on track to deliver what we said.
Kevin McCarthy: Thank you for that. And then second, Kent, I think you mentioned in your prepared remarks you’ve begun to build some relationships with the incoming administration in Chile. Can you talk through what has changed in that country, I suppose politically, but also there’s an ongoing effort to rewrite the constitution. What in your mind will be fixed or remain the same? What are you watching in terms of potential changes? And how are you thinking about it in terms of capital allocation moving forward beyond La Negra III in country versus alternatives you may have in Australia, China, U.S. or other countries?
Kent Masters: Okay. So – yes, so there’s a lot going on in Chile. And new administration is not really in place. And we’re trying to build our relationships out in front of that with our local team there. But there have been discussions going on about rewriting the constitution and all of them. The mining royalties across multiple industries have been – those discussions have been happening for the last six months, if not a year. So there’s been a lot of discussion. So we’re trying to build relationships with the new government, stay close to it. We don’t anticipate a wholesale change in the direction that the government goes with respect to extractive industries, but we do think there’ll be changes. Most of that is going to be as you look forward as opposed to on existing, on existing businesses, particularly around lithium. So we don’t see a wholesale change in the way that lithium is – the existing business is done in Chile or our royalties that we pay. As an example, we think they’re very progressive, probably the highest in the world on lithium for sure and probably even in extractive industry. And we think that, that will hold and maybe become an example for some of the other resource-based industries in Chile. So we’re pretty optimistic about our position in Chile. From a capital allocation standpoint, I mean, we have – we’re spending money now there on the Salar Yield project. We’ve got the La Negra III and IV project is really done, and we’re in the process of ramping that up. So we won’t really need to make a capital allocation decision vis-à-vis Chile for a while. So we’ll have a much better view of what’s happening in Chile and what the new administration, the direction that they’re going and what the rules of the road are before we have to make a significant capital allocation decision there.
Kevin McCarthy: Perfect. Thank you very much.
Operator: Our final question comes from Chris Kapsch with Loop Capital Market. Your line is open.
Chris Kapsch: Good morning. Thank you. So slightly more nuanced follow-up on the pricing and then also the security of supply concept, something that Eric mentioned a couple of times. So obviously, it’s an increasingly important theme, I think. And this is really juxtaposed against these new demand scenarios that you put out this morning, the 1.5 million and the 3 million ton demand scenarios by 2025 and 2030. So at your Analyst Day in September, you talked about just how the industry’s demand – or sorry, cost curve will be steepening. And even your own portfolio, I would say it’s – you’re going to experience that. But as you ramp Wave III, even pulling forward the 50,000 metric tons, you’re talking about 200,000 metric tons. That’s only 20% of the increased industry demand from now to 2025, it looks like. So in terms of security of supply, we think these customers are just increasingly concerned about their ability to source lithium at reasonable prices. So my question really is, are they coming to a big and well-established and reliable integrated supplier like Albemarle and saying like, the pendulum swinging back towards this concept of being willing to pay higher fixed costs in order to ensure that supply. I know you’ve gone from sort of those floor pricing contracts to more of a variable structure. But I would think, given how acute this potential shortage is shaping up to be that they’d be more motivated to do that. And is that something you’re considering? Just wondering kind of – I was kind of asking a couple of other as in different ways. But it just seems like there’s – this is going to be a tough scenario, and the only answer is going to be for higher prices to induce more supply. Anyway, any more color around that would be appreciated. Thanks.
Kent Masters: Yes. So I’m going to take the first shot of that. And Eric, you can fill in if I miss some of the key points. But I guess the first thing is security of supply has always been a key part of our value proposition. And in our view, we – it didn’t get the attention that we thought it deserved in the past. We’ve always built on having multiple resources, different locations, diversification in our supply base and the security of supply. Albemarle has a portfolio that is unlike anyone else in the industry. And that’s from both a conversion, geopolitical resource, cost base, brine, rock everything. So that said, it is getting more attention. And I think the OEMs and the battery manufacturers, but probably the OEMs more than anything else, are paying more attention to that. They’re seeing that there may be a structural deficit or at least they want to make sure they align with the most reliable players. And we’re having conversations with different people. They’re just conversations about different pricing structures. In the industry, we’ve shifted our – the portfolio shift that we’ve done now is really something we started a couple of years ago, put it on hold when prices went so low because we didn’t want to renegotiate contracts at a trough. But we’ve been able to do that now, and that will probably continue to evolve. The structure that we have now is probably not the one that lasts for the balance of the industry. So I suspect there are changes in those structures to come and a lot of it will be based on security of supply and quality and the ability to bring on projects and deliver what you say you’re going to do.
Chris Kapsch: And I just have one follow-up. The – just on – I don’t know if, Eric, you want to add to that. But also just on your decision to sell spodumene, because I thought that you had explained in the past that, that would be for captive conversion to hydroxide, but now you’ve elected to, it sounds like, opportunistically, sell some of the spodumene into the market. Thanks.
Kent Masters: Yes. I wouldn’t read into that, that that’s a change in our strategy. It was opportunistic, and it was a product that we had sitting in inventory that had – was made several years ago and had just been sitting. And we took the opportunity to sell that into the market because there was just an opportunity, and we took advantage of it. It’s just opportunistic. You shouldn’t read into that, that we’ve changed our view on selling spodumene in the market.
Operator: That’s all the time we have scheduled for today’s call. I’d like to turn the call back over to Kent Masters for closing remarks.
Kent Masters: Okay. Thank you, Michelle, and thank you all for your participation on our call today. Our successes in 2021 have positioned us well to capitalize on the strength in the markets that we serve. And this coming year is about execution. I’m confident in our team’s ability to drive value for all of our stakeholders by accelerating the growth of our business in a sustainable way and to lead the industry by example. Thank you.
Operator: This concludes the program. You may now disconnect. Everyone, have a great day. | [
{
"speaker": "Operator",
"text": "Good day and welcome to the Fourth Quarter Albemarle Corporation Earnings Conference Call. At this time, all participants are in a listen-only mode. After the speakers’ presentation, there will be a question-and-answer session. [Operator Instructions] As a reminder, this call is being recorded. I would like to turn the call over to Meredith Bandy, Vice President of Investor Relations and Sustainability. You may begin."
},
{
"speaker": "Meredith Bandy",
"text": "All right. Thanks, Michelle. Thank you all, and welcome to Albemarle’s fourth quarter 2021 earnings conference call. Our earnings were released after close of market yesterday, and you’ll find our press release and earnings presentation posted on our website under the Investors section at albemarle.com. Joining me on the call today are Kent Masters, Chief Executive Officer; and Scott Tozier, Chief Financial Officer. Our GBU Presidents, Raphael Crawford, Netha Johnson and Eric Norris are also available for Q&A. As a reminder, some of the statements made during this call, including outlook, guidance, expected company performance and timing of expansion projects may constitute forward-looking statements within the meaning of federal securities laws. Please note the cautionary language about forward-looking statements contained in our press release and earnings presentation. That same language applies to this call. Please also note that some of the comments made today refer to non-GAAP financial measures. A reconciliation to GAAP financial measures can be found in our earnings release and the appendix of our earnings presentation. Now I’ll turn the call over to Kent."
},
{
"speaker": "Kent Masters",
"text": "Thanks, Meredith, and thank you all for joining us today. On today’s call, I will highlight our quarterly results, recap our 2021 successes and update you on our expansion plans. Scott will provide more details on our financial results, outlook and capital allocation priorities. And finally, I’ll walk you through our 2022 objectives. 2021 was a transformative year for Albemarle. Our strategic execution and ability to effectively manage the challenges of the global pandemic enabled us to capitalize on the strength of the lithium and bromine markets and generate results that exceeded expectations. For the year, excluding our Fine Chemistry Services business, which was sold in June of 2021, we increased net sales by 11% to $3.3 billion, which was in line with our previous guidance. Adjusted EBITDA grew 13% in 2021 to $871 million, surpassing the upper end of our guidance. Looking ahead, our outlook for 2022 has improved based primarily on favorable market conditions for lithium and bromine. We expect adjusted EBITDA to grow between 35% and 55% versus 2021, excluding Fine Chemistry Services. To continue driving this growth, we are focused on quickly bringing capacity online with accelerated investments. La Negra III and IV is currently in commercial qualification and we expect to start realizing first sales from this facility in the second quarter. In November, we achieved mechanical completion of the first train at Kemerton. The construction team is now dedicated to the second train, and we will be able to leverage our experience from Train 1 to improve efficiencies and timeliness of this project. And we recently signed a nonbinding letter agreement to explore the expansion of our MARBL joint venture with increased optionality and reduced risk. Now looking at Slide 5. We introduced this slide early last year to lay out our 2021 objectives designed to support the four pillars of our strategy, to grow profitably, to maximize productivity, to invest with discipline and to advance sustainability. I would like to thank our teams for their extraordinary efforts. Virtually all the goals we set last year were met or exceeded despite challenges related to severe weather, supply chain issues and the ongoing effects of the pandemic. The focus of our people around the world is what drove our strong year and underscores our ability to deliver on our commitments. These accomplishments have also set the stage for us to take advantage of the growth opportunities ahead. Just as important as driving growth is an ongoing dedication to strong ESG values. I’m very proud of what you see on Slide 6. Since I became CEO in 2020, one of my main priorities has been continued improvement in sustainability. I’m pleased to see that these efforts are increasingly being recognized externally, but it certainly isn’t a new initiative for Albemarle. Sustainability is not just doing the right thing but also doing it the right way. For example, the lithium market is expected to see significant demand growth in the coming years. As a leader in lithium production, we expect to be an example and help define the standards of sustainability in this market as it goes through this fundamental shift. Now turning to Slide 7 and more on the lithium market outlook. Based on our current market data, EV trends and regular interactions with our customers, we are revising our lithium demand outlook upwards once again. We now expect 2025 lithium demand of approximately 1.5 million tons, up more than 30% from our previous estimates. Beyond 2025, we anticipate continued growth with lithium demand of more than three million tons by 2030. EV sales growth is accelerating as consumers become more energy-conscious, governments incentivize clean energy, technology improves and EVs approach pricing parity with internal combustion vehicles. In 2021, global EV production nearly doubled to over six million vehicles from three million in 2020. By the end of the decade, EVs are expected to account for close to 40% of automotive sales. When you look at last year’s growth rate of nearly 50% and the auto industry’s ambitions for a rapid transition to EVs, it’s easy to see why demand expectations are so bullish. However, meeting this demand will be a challenge. Turning to our Wave II projects on Slide 8. La Negra III and IV, which will add conversion capacity for our Chilean brine resource in the Salar de Atacama is currently in the customer qualification process. We anticipate incremental volumes and revenue contribution from this project in the second quarter of this year. While there are significant changes taking place to the political landscape in Chile, we do not anticipate any material impacts to our business. We support the Chilean people’s right of self-determination and applaud the peaceful leadership transition in that country. Our team has already begun building relationships with the incoming administration. As I mentioned earlier, Kemerton I reached mechanical completion late last year and is currently in the commissioning phase. This puts us on track to begin first sales in the second half of this year. Kemerton II remains on track to reach mechanical completion by the end of this year. The OEMs and battery manufacturers have been investing heavily in growth, including commitments in North America and Europe, and the lithium industry must do the same. Turning to Slide 9. We provide an overview of how Albemarle is investing to support downstream growth. Since our Investor Day, we have accelerated and further defined our Wave III projects, including the announcement of three strategic investments in China. This wave of investments will provide Albemarle with approximately 200,000 tons of additional capacity. That’s up from 150,000 tons of capacity originally planned for Wave III. We’ve also continued to progress our growth options for Wave IV. Based on discussions with our customers, we are analyzing options to restart our Kings Mountain lithium mine and the potential to build conversion assets in North America and Europe. Our vertical integration, access to high quality, low cost resources, years of experience bringing conversion capacity online and strong balance sheet provide us with considerable advantages. I’m on Slide 10 now. In China, we expect to close the acquisition of the Qinzhou conversion facility in the first half of this year. This transaction is progressing well, and we continue to work through the appropriate regulatory reviews. The Qinzhou plant is currently being commissioned and we have begun tolling our spodumene to assist with that process. We continue to progress the two greenfield lithium conversion projects in Meishan and Zhangjiagang. We have started site clearing at Meishan and expect to break ground at Zhangjiagang later this year. We expect mechanical completion of both projects by the end of 2024. The restart of one of three processing lines at the Wodgina mine is going well, with first spodumene concentrate production now expected in the second quarter. At Greenbushes, Talison continues to ramp production from the CGP 2 facility to meet design throughput and recovery rates. In addition, the tailings project at Talison is on track. Before I turn the call over to Scott, I’d like to highlight our bromine growth projects on Slide 11. Our bromine business is investing in innovation and capital projects to take advantage of growth opportunities. We expect new products to make up more than 10% of annual bromine revenues by 2025, up from essentially a standing start. The first of these products to launch is SAYTEX ALERO, our next-generation polymeric flame retardant. We first discussed SAYTEX ALERO at our Investor Day last year, and I’m excited to say that we have achieved first commercial sales in January and expect to scale production throughout the year. We’ve also invested in the resource expansion at the Smackover formation in Arkansas, and we continue to grow our conversion and derivative capacity in both Arkansas and Jordan. With that as an overview, I’ll turn the call over to Scott to discuss recent results and our outlook."
},
{
"speaker": "Meredith Bandy",
"text": "Scott?"
},
{
"speaker": "Kent Masters",
"text": "Scott, you might be on mute."
},
{
"speaker": "Scott Tozier",
"text": "Hello? Can you hear me now?"
},
{
"speaker": "Kent Masters",
"text": "Yes. We hear you."
},
{
"speaker": "Scott Tozier",
"text": "Okay. Sorry about that. I was on mute. Thanks, Kent, and good morning, everyone. I’ll begin on Slide 12. For the fourth quarter, we generated net sales of $894 million, which is an increase of $15 million compared to the prior year quarter. This was driven by higher sales from lithium and bromine, partially offset by the loss of revenue from our Fine Chemistry Services business, which was sold in June 2021. Excluding FCS, we grew by 11%. The fourth quarter net loss attributable to Albemarle was $4 million, reflecting an increased cost estimate to construct our Kemerton lithium hydroxide plant due to anticipated cost overruns from the impact of pandemic-related issues on the supply chain and labor. Fourth quarter adjusted diluted EPS of $1.01 was down 14% from the prior year. The primary adjustment to EPS is the $1.13 add-back of that Kemerton revision. Let’s turn to Slide 13 for more detail on adjusted EBITDA performance. Excluding FCS, fourth quarter adjusted EBITDA was up 12% from the prior year. Lithium results remained strong driven by higher volumes as well as higher pricing. Bromine results were roughly flat year-over-year, reflecting strong performance in late 2020 and repeating it in 2021. And Catalyst improved in the fourth quarter as refinery markets continue to rebound and the business saw benefits from one-time items. Our second half sales grew 13% from the first half of the year, following a relatively flat growth since mid-2020. This acceleration of growth is expected to continue into 2022. On Slide 14, you can see we are expecting both volume and pricing growth in all three of our business units in 2022. We expect net sales of between $4.2 billion to $4.5 billion and adjusted EBITDA in the range of $1.15 billion to $1.3 billion. This implies an adjusted EBITDA margin of between 27% and 29%. Adjusted diluted EPS and net cash from operations are also expected to improve year-over-year. We anticipate healthy growth in adjusted EBITDA in all four quarters this year, and we expect Q1 to be the strongest quarter for several reasons. All three GBUs are expected to benefit from lower-cost inventory sold at prices that have been raised in anticipation of inflation. In the first quarter, lithium also has the benefit of strong shipments from our Talison joint venture to our partner as well as a onetime spodumene sales material produced at Wodgina on initial start-up in 2019. And finally, going forward, higher spodumene transfer pricing increases are going to increase our cost of sales and only partially be offset by higher Talison joint venture income, which is included in our EBITDA after tax. And this creates a tax-impacted EBITDA margin drive. As Kent mentioned, CapEx is expected to increase to the $1.3 billion to $1.5 billion range this year as we accelerate lithium investments to meet increased customer demand. The key actions to meet or exceed this guidance include, first, successful execution of our lithium project start-ups; second, closing the acquisition in China; third, solid performance at our sold-out plants in lithium, bromine and FCC catalysts; fourth, continued strength in our end-use markets and favorable pricing environment; and lastly, solid procurements to combat inflation. Let’s turn to Slide 15 for more details by GBU. Lithium’s full year 2022 EBITDA is expected to be up 65% to 85%, a significant improvement from our previous outlook. We now expect volume growth to be up 20% to 30% for the year with the new capacity coming online as well as ongoing efficiency improvements. Average realized pricing is now expected to increase 40% to 45% compared to 2021 due to strong market pricing as well as the expiration of pricing concessions originally agreed to in late 2019. In some cases, as these concessions rolled off, pricing reverted to legacy contracts with significantly higher variable pricing. And as we’ve been saying, we’ve also taken the opportunity to work with our strategic customers to renegotiate contracts to more variable rate structures. Catalyst EBITDA is expected to be up 5% to 15%. This is below our previous outlook, primarily due to cost pressures related to high natural gas pricing in Europe and raw material inflation. Volumes are expected to grow across segments with overall refining markets improving. We continue to see volumes returning to pre-pandemic levels in late 2022 or 2023. FCC volumes are already there, but HPC volumes are lagging. Bromine EBITDA is expected to be up 5% to 10%, slightly above our previous outlook based on strong flame retardant demand supported by macro trends, such as digitalization and electrification. Volumes are expected to increase based on the expansions we began in 2021. And as discussed, higher pricing and ongoing cost and efficiency improvements are expected to offset higher freight and raw material costs. Now turning to Slide 16, I’ll provide some additional color on lithium volume growth. This slide shows the expected lithium production volume ramp from the new conversion facilities we expect to complete this year. We begin the year with a baseload production of 88,000 metric tons in 2021, which includes Silver Peak, Kings Mountain, Xinyu, Chengdu and La Negra I and II. And you can see that this is virtually a 50/50 split of carbonate and hydroxide. As our Wave II projects come online, output will begin to favor hydroxide. Generally speaking, we expect it to take about two years to ramp to full conversion capacity at a new plant, including approximately six months for commissioning and qualification. Therefore, we expect to reach our full 200,000 tons of conversion production by early 2025. Before I turn it back to Kent, I’d like to update you on our capital allocation priorities, and I’ll turn to Slide 17 to do that. Our capital allocation priorities remain the same. Our primary focus is to invest in profitable growth opportunities, particularly for lithium and bromine. Strategic portfolio management and maintaining financial flexibility are important levers to support this growth. For example, we have divested noncore businesses like FCS and reallocated funds to organic and inorganic growth opportunities, like the expected acquisition of the Qinzhou plant. The strategic review of Catalyst is progressing well and is on track for us to make an announcement of the outcome in the first half of this year. We’ll also continue to evaluate bolt-on acquisitions to accelerate growth or bolster our portfolio of top-tier assets. As always, future dividends and share repurchases are subject to Board approval. However, we expect to continue to support our dividend. Given the outsized growth opportunities we see in lithium, we don’t anticipate share repurchases in the foreseeable future. And with that, I’ll turn it back to Kent."
},
{
"speaker": "Kent Masters",
"text": "Thanks, Scott. I’ll end our prepared remarks on Slide 18, outlining our 2022 objectives aligned with our long-term strategy. First, we will continue to grow profitably. This means completing our Wave II expansions and progressing Wave III expansions to grow lithium conversion capacity and volumes. We’ll also focus on safely and efficiency starting up those facilities. Next, we will continue to maximize productivity, and this is even more important in today’s environment with rising cost for raw materials. We will leverage our operational discipline to offset inflation through manufacturing excellence, implementing lean principles and embracing smart technology to improve HSE, cost, reliability and quality. Our procurement cost-saving initiatives and manufacturing excellence projects will be key to offsetting higher raw materials and freight cost as we work to achieve adjusted EBITDA margin of between 27% and 29%. We will invest with discipline. As Scott discussed, portfolio management and maintaining our investment-grade credit rating are both high priority for us and will continue to be a focus in 2022. Importantly, we plan to complete the catalyst strategic review later this year, which will maximize value and set that business up for success while enabling us to focus on growth. Finally, we will advance sustainability. That means driving progress toward our goals for greenhouse gas emissions and fresh water use and setting additional sustainability targets. We’ll also continue to work with our customers to improve the sustainability of the lithium supply chain by completing our mine site certifications, Scope 3 greenhouse gas assessments and analyzing product life cycles. So with that, I’d like to open the call for questions, and I’ll turn it back to Michelle."
},
{
"speaker": "Operator",
"text": "[Operator Instructions] Our first question comes from David Deckelbaum with Cowen. Your line is open."
},
{
"speaker": "David Deckelbaum",
"text": "Good morning guys. Thanks for taking my questions. I was curious if you could talk a little bit about the lithium pricing outlook. You raised your outlook to 40% to 45% increase in 2022. When you think about that, and you talked about renegotiating your fixed price contracts, how do we think about your exposure to spot market fluctuations now as we head into 2023? And I guess, in conjunction with that, would you expect that you would see further pricing increases into 2023 based on your outlook today?"
},
{
"speaker": "Eric Norris",
"text": "Good morning, David, this is Eric Norris. So our pricing outlook – let me start first with the composition, what we see in 2022. We have, as Scott and Kent indicated in the prepared remarks, moved our pricing structures to be more variable. About upwards of close to 50% of our existing battery-grade contracts have a variable component to an index with a price and a ceiling. Those indices are not what you would see in China. Those are indices based upon global publicly available indices, such as Benchmark Minerals, Fast Markets and the like. The remaining 10% of our business is spot in China, so that is going to be exposed to what you see. And the rest is largely, at this point, fixed. Although as Scott indicated, as we continue to approach customers and then they seek to add to their volumes through our expansions, we are in those discussions asking them and considering moving to more variable with them as well. So, we have bottom line increased our exposure to pricing upside, but I think you need to consider that the contracts that we – or excuse me, the indices we’re using largely are the global indices, not the China indices, where you see much higher price in the China market than you do globally. So in terms of the outlook going forward, I mean, I would say that we expect – it really comes down to what China pricing does. It is the lead, sort of the tip of the spear. Where that goes, the indices follow globally. Those global indices are about half, in some cases, of current China prices. So there’s probably room to go in those indices, but there’s – with prices where they are in China, one could only speculate what they would go. And could they go down? We don’t know. So there’s – there’ll always be some variability on that 10% of our business that’s in China."
},
{
"speaker": "David Deckelbaum",
"text": "Appreciate that. Thanks for the color there. My follow-up is just on the capital raise, a $200 million increase this year to the budget. It sounds like that’s accelerating some of the conversion assets in China. Could you just give a little bit more color around that? And when do you expect to see some of the volumetric impact relative to your original outlook?"
},
{
"speaker": "Kent Masters",
"text": "Okay. So I’m not sure, volumetric impact – so you’re talking about our Wave III expansions when we see those volumes coming on? Is that..."
},
{
"speaker": "David Deckelbaum",
"text": "It sounds like that the timing has now accelerated around Wave III. So, I guess per your – if you were to look at it based on your original vision that you laid out at the Investor Day, how much time are you pulling forward with that additional $200 million around the conversion assets?"
},
{
"speaker": "Kent Masters",
"text": "Yes. So, we brought it forward because of the Meishan, Zhangjiagang – the acquisition Zhangjiagang. So that was not – we were hoping to do an acquisition. The hadn’t plan didn’t have that, nailed down at the – when we did the equity raise and the comments that we made then. So that brought it forward. And we’ve increased the capacity about 50,000 tons in that Wave. So the timeframe has been pulled a bit forward because we’ve confirmed that acquisition, and then we’ve increased that Wave by 50,000 tons. And as we said before, the two greenfields we think will be on by the end of 2024."
},
{
"speaker": "David Deckelbaum",
"text": "Thank you all."
},
{
"speaker": "Operator",
"text": "Our next question comes from Bob Koort with Goldman Sachs. Your line is open."
},
{
"speaker": "Bob Koort",
"text": "Thank you. Good morning. Kent or Eric, I was wondering if you could talk about your strategy on contracting to customers in a growing and very tight market. Is there an approach to not contract all your volume to ensure your customers can get deliverability? Do you want to have as much as possible fixed volume obligations? How do you think about that?"
},
{
"speaker": "Kent Masters",
"text": "Yes. So I’ll just – at a high level, and Eric can give you a little more detail on it. But I think we’ve talked about it. We want to have a portfolio across the range of those projects. So, we’re not tying up all the volume on long-term fixed contracts. But we do want to have that element of it. It’s becoming a probably a bigger part. We’re probably fighting to make sure that we keep the portfolio the way we envision it."
},
{
"speaker": "Eric Norris",
"text": "Yes. I don’t have much to add, Bob. You heard how I answered David’s question just before you on the mix. We’ve seen an influence that to have up to a half on some sort of variable price that has some floors and ceilings a bit of spot and then the rest fixed. And we still strive to have, as we grow the business and add capacity, an amount that we can play in the spot markets. And that gives us excess to flex with our contract customers as they grow as well. Strategy still remains to be a partner to our customers and to seek those partnerships for their long-term growth, and that’s becoming in this market a very important topic, that security of supply."
},
{
"speaker": "Bob Koort",
"text": "Can I ask a follow-up? What was the reason? And what are the ramifications of changing your MARBL agreement?"
},
{
"speaker": "Kent Masters",
"text": "Yes. So we’re – I mean we’re in the middle of that. So, I don’t really want to front run the discussions that we’re having with our joint venture partner. But I mean it’s really about – it’s expanding it to giving us more reach and mitigating some of the risks that we see in the marketplace by sharing it with a partner."
},
{
"speaker": "Bob Koort",
"text": "Got you. Thanks Kent."
},
{
"speaker": "Operator",
"text": "Our next question comes from Jeff Zekauskas with JPMorgan. Your line is open."
},
{
"speaker": "Jeff Zekauskas",
"text": "Thanks very much. When you look at your lithium carbonate, your LCE production from now to 2025. Does your cost per ton change very much and in what direction?"
},
{
"speaker": "Eric Norris",
"text": "Well, Jeff, as Kent described – this is Eric, good morning, first off. As Scott described, Wave III is hydroxide-based and spodumene-based in that regard. Those are – that’s a higher cost of production than carbonate production out of Chile. So generally speaking, because of the higher cost to produce hydroxide versus carbonate out of brine, the average cost goes up slightly. But that’s a function of resource and product mix. We continue to drive productivity throughout the portfolio to ensure that we’re operating at a low conversion cost to take advantage of the good resources we have."
},
{
"speaker": "Jeff Zekauskas",
"text": "And I think Scott said that the first quarter would have the – of 2022 would have the highest EBITDA total of the year. Why is that given that lithium production would be much greater in the second half?"
},
{
"speaker": "Kent Masters",
"text": "So there are a couple of dynamics happening there. So first is, we’ve been aggressive around pricing given inflation coming through. And in the first quarter, we’re selling out of inventory where that inflation has not actually hit our cost base yet. So – and that’s true across all of our businesses. So that inflation catches up to us in the back half of the year, and we’ve already implemented pricing. So that there’s a lull on that. And then it’s really the same answer on lithium. That’s across all the businesses, but particularly in lithium, spodumene prices have gone up dramatically. In the first quarter, we’re selling out of inventories, which have 2021 costs. And in 2022, those cost increases come through the P&L. And that was the dynamic Scott was talking about, where our EBITDA becomes tax-affected because it’s minority interest from JV income. Because even though we’re protected from those spodumene prices going up, it shifts from being in our peer EBITDA minority interest, which gets added to EBITDA, but on an after-tax basis. So those are the – really the two drivers for why the first quarter is the highest EBITDA level."
},
{
"speaker": "Jeff Zekauskas",
"text": "Great. Thank you so much."
},
{
"speaker": "Operator",
"text": "Our next question comes from P.J. Juvekar with Citi. Your line is open."
},
{
"speaker": "P.J. Juvekar",
"text": "Yes. Good morning. How quickly do you see the Wodgina ramp-up? And is that limited by available conversion capacity in Australia and China? And then talking about conversion capacity, your potential North American/European conversion capacities in Wave IV, what does it take to move it to Wave III?"
},
{
"speaker": "Kent Masters",
"text": "I’m going to take the second question first and then probably talk to Eric for the first. But – so what we define – I mean the Waves are really just – those are our definition of projects. So nothing else is going to change. It’s not going to move North America from IV to III, because III is defined, and we’re well into execution on those projects right now. And we’re still defining exactly what we will do in Wave IV. But we would – we look to accelerate those, but they’ll still remain in Wave IV."
},
{
"speaker": "Eric Norris",
"text": "And P.J., on your first question about Wodgina, we are only with our joint venture partner ramping up the first train of Wodgina with 50,000 tons of 6% spodumene, a little over 30,000 tons on an LCE basis. We look at the China, the growth in conversion capacity and hydroxide from Wave III that Kent described as the output – or excuse me, the consumer for that material. As a side note, spodumene tends to come on pretty quickly. It’s a different kind of plan operation than a conversion – chemical conversion plant, which tends to ramp over two years. A spodumene plant can come up within six months."
},
{
"speaker": "Kent Masters",
"text": "Plus those trains are already built."
},
{
"speaker": "Eric Norris",
"text": "Plus the trains, yes, fair point. Plus trains are built and they’re just being restarted. So, we would expect by midyear and to see spodumene flowing from that and put it into the assets that we talked about in Wave III. And the balance, we’d consider looking at tolling for the balance. And then as we continue to progress Wave III and other expansion activities, we’d look down the road. We’ve made no decisions yet on the second and third train at Wodgina, but those would be for down the road, giving us plenty of dry powder, so to speak, to support our growth as we continue to build out conversion capacity."
},
{
"speaker": "P.J. Juvekar",
"text": "Great. And you guided to lithium volume growth of 20% to 30%, which I would think is in line with where the industry is growing. But you have so much new capacity coming online in 2022, first half and second half. So, I would have thought that your volumes would grow faster than the industry. Any reason why it’s not growing faster than the industry?"
},
{
"speaker": "Eric Norris",
"text": "Well, certainly, we’d like to continue to maintain our position in the industry and growth of the industry. And you’re right, with this growth guidance, we were doing that. But underneath that are the practical realities of capacity limitation. So the guidance we’ve given, P.J., speaks to – we give you dates of when we think these plants will come online. We – and we first have that first qualification standpoint. We have a six-month period before it can be qualified, and then we have about a two-year ramp to ramp that. When you back calculate that math, that’s on our fixed base of 88,000 tons last year. That is the growth increment you get. So it happens to correspond to market growth, but it’s going as fast as we can on our capacity expansion."
},
{
"speaker": "P.J. Juvekar",
"text": "Understood. Thank you."
},
{
"speaker": "Operator",
"text": "Our next question comes from Christopher Parkinson with Mizuho. Your line is open."
},
{
"speaker": "Christopher Parkinson",
"text": "Great. Thank you very much. Just two quick questions. Just the first would be for the Western OEMs, let’s say, all in on the EV front. Just what’s your assessment of their own perceptions just regarding some of the newer competitor supply additions and how that product will or potentially will not be accepted in the marketplace in the ultra, let’s say, near to intermediate term? Any color would be helpful. Thank you."
},
{
"speaker": "Eric Norris",
"text": "Yes. Good morning, Chris. So by that, you’re referring to Western OEMs’ view of new lithium competitors coming into the market who are trying to bring capacity to market. Look, I mean, I think you’d have to ask their view on things. I will say this, security of supply is a very, very big concern in the market. I think that’s why in a pure spot market like China, you see prices that are in order of magnitude higher than they were a year ago. It’s folks trying to get supplied at any price. So that is true, certainly in China given those prices, but that same sentiment is true here in the U.S., particularly as Western OEMs or in Europe as well, underwrite big investments. So they are looking for lithium wherever they can get it. I think the offering that Albemarle brings and is part of our dialogue with them is we have the resources. We have the execution capability, and we’re reliable in bringing on supply. So, we’re an attractive partner for them in those dialogues, and we’re in the middle of all those discussions now as we bring on this new capacity and look into the future to bring on future capacity, particularly as Kent referenced, as we look to localize capacity in North America and Europe."
},
{
"speaker": "Christopher Parkinson",
"text": "That’s helpful. And just a quick follow-up. Just what would just be your latest thought process? On the demand front, you already hit on a few things. But just in terms of battery technologies, energy density. Just any color on what you’ve seen in terms of new model launches and potentially advancing high-nickel cathode chemistries? That would be very helpful. Thank you."
},
{
"speaker": "Eric Norris",
"text": "Yes. So on battery chemistry for electric vehicles, we still see over the five- and 10-year view – or sorry, I’ll put it another way, over the 2025 and 2030 view that we’ve characterized in our growth charts in the earnings deck. We still see nickel – high nickel being the key to higher range. And we further see innovations on the anode side in prelithiation and new technologies that will further allow more energy density and cost-effectiveness of those nickel chemistries with that parity to internal combustion engines and coming in within that 18- to 24-month period. That being said, it’s pretty clear and our projections would show that LFP for lower energy density for lower-range vehicles, lower-cost vehicles is going to remain a segment of this market, not only now, but through this 10-year period. And it’s a double-digit percentage over that period of time, a low double-digit percentage but a double-digit percentage of the market. But most of the growth will be hydroxide."
},
{
"speaker": "Christopher Parkinson",
"text": "Thank you very much."
},
{
"speaker": "Operator",
"text": "Our next question comes from Alex Yefremov with KeyBanc. Your line is open."
},
{
"speaker": "Alex Yefremov",
"text": "Thank you. Good morning everyone. I think as I look at your pricing guidance for lithium segment, it was a very strong. If I even assume some level of cost inflation, that cost number to get to your EBITDA and EPS guidance ends up being very high based on my model, at least, maybe as high as 40% or more per ton. Is there anything else beyond the spodumene and Talison dynamics that you already described in terms of cost that we should keep in mind for 2022?"
},
{
"speaker": "Kent Masters",
"text": "So, I mean, I think you have to appreciate we’re bringing on new plants. And when we bring them on, they’re not loaded, right? So there’s a lot of – we’re doing multiple facilities doing that. So there’s high fixed costs associated that with lower volumes. But other than that, I mean, the pricing movements are pretty aggressive and pretty consistent. We’ve moved our portfolio quite a bit. We’ve been talking about that, and we’ve more or less done that. So, we’re more exposed to the market than we have been in the past. But I think you have to keep in mind that fixed cost piece about bringing on new facilities that are not loaded."
},
{
"speaker": "Alex Yefremov",
"text": "Okay. Appreciate it. And then I wanted to follow-up on the pricing side. I guess, given approximately 50% of your volume have these indices, would any of these indices reset during the year? And could you end up above the 45% sort of upper bound of your lithium guidance – price guidance?"
},
{
"speaker": "Eric Norris",
"text": "It’s Eric. I can answer that. It’s – they are all based on indices that continue to move. The recent movement has been upward in the past three months. Again, sort of the tip of the spear being China prices, which are significantly higher. Where the market goes long-term, we don’t know. If there is a downward sort of correction in China prices, that will hit the China spot volumes we have. If however the spot – these indices for the large part of our business is variable fixed ceiling floor, those are well below those spot prices. It’s very hard to say. If the prices remain high, we could definitely be to the higher end of our range on price. And I think – I mean, I think part of your question was about are they fixed through the year. So they aren’t. Those – that move of the market can move during the year."
},
{
"speaker": "Alex Yefremov",
"text": "Understand. Thanks a lot."
},
{
"speaker": "Operator",
"text": "Our next question comes from Steve Richardson with Evercore. Your line is open."
},
{
"speaker": "Steve Richardson",
"text": "Hi, good morning. I was wondering, again, just back on the capital piece. Scott, could you give us any more color just in terms of how much is cost inflation versus pull-forward? I appreciate that you kind of addressed this a little bit earlier, but it is something that continues to come up in our conversations and would be helpful. And then on the cost piece, just on the previous question, I appreciate that you’re dealing with a lot of fixed costs in terms of some of these new project starts. But could you maybe tease out, at least in terms of your unit cost, how much is process-related in terms of just general costs associated with the process versus what you’re seeing in terms of this mismatch between volumes and fixed cost versus variable?"
},
{
"speaker": "Kent Masters",
"text": "Yes. So let me take the first part of your question, Scott, and then I’ll kick over to Scott to talk about the margin piece and the conversion costs. So looking at the change in our capital forecast, it’s at least half acceleration. I mean there is – I mean we have had additional cost executing projects in Western Australia during the pandemic has been a challenge for us, and we’ve had additional costs as well as extending the projects on that. And we also see inflation impacting the projects that we’re kicking off now that we didn’t see a year ago. So it’s probably – how accurate we can be around that, but it’s probably half acceleration and half additional costs associated with inflation and pandemic cost. And Scott, I’ll kick to you for the margin question."
},
{
"speaker": "Scott Tozier",
"text": "Hi, Steve, as you look at the lithium margins going into this year, the two factors are these plant start-ups and not being at full capacity. And that’s probably $100 million drag in the year, somewhere in that range. And then the impact of the spodumene prices going up and changing the dynamic between cost of sales, so increasing our cost of sales but also increasing our equity income on an after-tax basis, that’s probably north of $200 million. So those are the two biggest kind of movers as you look at the lithium margin."
},
{
"speaker": "Steve Richardson",
"text": "Great. Thanks. I appreciate the additional clarity. And one follow-up, if I may, just for Eric, on the lithium outlook on the demand side. The $1.5 billion number is obviously huge relative to where the market had been, and I see the logic on the demand side. Can you address your view, like the industry’s ability to hit this from a supply perspective and at least how does this play out? Do we just end up seeing ever higher incentive price to bring marginal projects to bear? Or do we have a limiting factor here in terms of the supply side’s ability to hit that number? And certainly, the $3 million in 2030 is a huge number as well."
},
{
"speaker": "Eric Norris",
"text": "Okay. I would say, Steve, that it’s going to take – it’s a hard run, right? It’s going to take everybody being ourselves and our competition being successful at hitting their milestones in order to provide that to meet that supply. So it’s an all-out effort to get there. So I don’t want to sugarcoat it. It’s – I think it’s the reason the industry is so tight is because there’s a view it takes a while and it’s – and it doesn’t go as it’s – always as expected. In terms of price, I don’t have a crystal ball. I don’t – I never would have predicted a $65 carbonate price. So I don’t know how to think about where that would go in the future. It does reflect that hard slog I just referred to, I think, that everybody’s got to step up and execute well in order to meet that demand."
},
{
"speaker": "Steve Richardson",
"text": "Thank you very much."
},
{
"speaker": "Operator",
"text": "Our next question comes from Joel Jackson with BMO Capital. Your line is open."
},
{
"speaker": "Joel Jackson",
"text": "Hi, good morning everyone. Some years ago, you guys had talked about kind of a 40% EBITDA margin for lithium as kind of being what I think you make it over the course of the cycle. We’re now at 34%, 35% range over the last three years to much different pricing scenarios every year. And you talk about now fully loaded plants and how that may affect margin. You’re going to be, of course, ramping on plants indefinitely or for a long time. So should we be thinking about this as the right cost base going forward, this margin as the right kind of base going forward for lithium?"
},
{
"speaker": "Kent Masters",
"text": "I think what we’ve said in the past in the long term is we stand by that. So I think we’ve got one of the things you have to understand is as spodumene prices go up, that impacts our EBITDA margin because of the nature of the JV. So EBITDA effectively becomes tax-affected to some degree because of the product we purchased from Talison. And that will – and that won’t be different with MARBL going forward. So that has an impact on the pure EBITDA margin, but it still flows through the P&L once you get fully to the bottom line. So I think to kind of answer your question, we still stand by the guidance that we’ve provided in the long term. We still think it’s in that range."
},
{
"speaker": "Joel Jackson",
"text": "The next question is, it’s great to have a 3 million-ton demand forecast for lithium for 2030. But let’s be honest, we’re never going to get there. There’s not supply out there. Even if there’s supply, we’re not going to get there in eight years for 3 million tons, right? You’ve got to have new resources, you got to have new technology, DLE whatever. You have to have lots of assets that aren’t producing now in lots of strange places, new feedstocks. So we’re never going to get to 3 million tons. Would you agree with that? And if that’s the case, what’s going to happen? So does that mean the EV acceleration has got to come down, OEMs have to change your plan? Or do I have it wrong?"
},
{
"speaker": "Kent Masters",
"text": "Eric said it before, that it’s a slog, but it’s doable. I think the industry has to be aggressive and has to execute well. And I think you’re seeing and some of that – that we’re getting through some of those growing pains. We think we’re probably as experienced as anyone at doing these large conversion facilities and bringing on new resources. But it’s a combination of resource and conversion capacity. It is a stretch, but – and it does require some new technology and operating in some places where historically, the lithium industry hasn’t done that, but it’s not impossible."
},
{
"speaker": "Joel Jackson",
"text": "Thank you."
},
{
"speaker": "Operator",
"text": "Our next question comes from Vincent Andrews with Morgan Stanley. Your line is open."
},
{
"speaker": "Vincent Andrews",
"text": "Thank you and good morning everyone. Kent, just wondering if you could mark the, the Wave III total CapEx for us. I think you originally said it at $1.5 billion, and I think you mentioned half of the increase for 2022 was related to inflation. But it seems like maybe some of that was transitory if COVID indeed calms down. So how would you tell us to think about Wave III now versus the original $1.5 billion?"
},
{
"speaker": "Kent Masters",
"text": "Yes. Well, it’s – I mean it has stretched a little bit because we’ve accelerated and we’ve had inflation. So that inflation is – if it goes away in three years doesn’t matter because we’re building the projects in the next couple of years. So there is some impact on that. So it’s – we’ve accelerated because there’s additional capacity associated with that. So that is half of the difference and the other half is inflationary. So it’s – you got to add that on. And that – and even if it goes away, I mean, we’re not going to be necessarily in Western Australia, but there’s still going to be – and we see – our forecasting says inflation in the capital equipment that we’re buying in the next year and two."
},
{
"speaker": "Vincent Andrews",
"text": "So if we thought of something like it was going to be like a $1.8 billion to $2 billion now instead of $1.5 billion, is that good for a ballpark number?"
},
{
"speaker": "Kent Masters",
"text": "Yes. I think I want to start estimating what the projects are going to turn out to be. But it’s up definitely from $1.5 billion. Part of that is the acceleration. So I’m kind of focused on the inflation part. But overall, that’s probably not a bad estimate."
},
{
"speaker": "Vincent Andrews",
"text": "Okay. Thank you. And just on the Salar de Atacama technology projects, can you just talk to us about what milestones are left to hit on that so that you’d be confident that you’ll be able to execute it?"
},
{
"speaker": "Kent Masters",
"text": "Yes. So we’re just getting going into the real execution phase of that particular project, but I don’t know that – it’s not as complicated a project as a conversion facility. So I think we feel pretty good about executing on that. We are – we’ve lost a little bit of the float we had in the schedule, but that’s it. We’re still on plan and on the schedule that we had, but we have lost a little bit of the contingency from a time standpoint that we originally had built in."
},
{
"speaker": "Vincent Andrews",
"text": "Okay, very good. Thank you. Appreciate the answers."
},
{
"speaker": "Operator",
"text": "Our next question comes from Kevin McCarthy with Vertical Research. Your line is open."
},
{
"speaker": "Kevin McCarthy",
"text": "Yes, good morning. A couple of questions on your catalyst business. First, I think you had announced some price increases in early January. Can you talk about the magnitude and the flow-through with regard to realization of those increases? And also related to catalysts, any update on your level of confidence with regard to the ongoing strategic review?"
},
{
"speaker": "Kent Masters",
"text": "Sorry, Raphael. Let me touch on the strategic review and then let you talk about pricing. So I mean we’re going through that process, and it’s going well. The timing we had said, we think we’ll have an answer by middle of the year. And I don’t really want to front-run it or comment too much on it beyond that. Raphael?"
},
{
"speaker": "Raphael Crawford",
"text": "Yes. Sure. Thanks, Kent. Kevin, as we – as you saw, we announced a price increase in January. That’s really to help offset the inflation that we’ve seen starting in the second half of 2021 into this year, particularly around natural gas. So that’s building momentum. So I think we’ll see north of $10 million worth of pricing in our forecast. Again, that’s really to offset what we’ve seen on raw materials. As you know, Kevin, we are – we produce performance products. So we create a lot of value for our customers. We think our pricing is justified. It’s mostly around FCC catalyst where we’re in a near sold-out position right now. All that being said, we’ve got a lot of confidence in what we shared as our long-term forecast for the business at Investor Day. We think some of the raw material headwinds will be covered with price over time, and we’ll be on track to deliver what we said."
},
{
"speaker": "Kevin McCarthy",
"text": "Thank you for that. And then second, Kent, I think you mentioned in your prepared remarks you’ve begun to build some relationships with the incoming administration in Chile. Can you talk through what has changed in that country, I suppose politically, but also there’s an ongoing effort to rewrite the constitution. What in your mind will be fixed or remain the same? What are you watching in terms of potential changes? And how are you thinking about it in terms of capital allocation moving forward beyond La Negra III in country versus alternatives you may have in Australia, China, U.S. or other countries?"
},
{
"speaker": "Kent Masters",
"text": "Okay. So – yes, so there’s a lot going on in Chile. And new administration is not really in place. And we’re trying to build our relationships out in front of that with our local team there. But there have been discussions going on about rewriting the constitution and all of them. The mining royalties across multiple industries have been – those discussions have been happening for the last six months, if not a year. So there’s been a lot of discussion. So we’re trying to build relationships with the new government, stay close to it. We don’t anticipate a wholesale change in the direction that the government goes with respect to extractive industries, but we do think there’ll be changes. Most of that is going to be as you look forward as opposed to on existing, on existing businesses, particularly around lithium. So we don’t see a wholesale change in the way that lithium is – the existing business is done in Chile or our royalties that we pay. As an example, we think they’re very progressive, probably the highest in the world on lithium for sure and probably even in extractive industry. And we think that, that will hold and maybe become an example for some of the other resource-based industries in Chile. So we’re pretty optimistic about our position in Chile. From a capital allocation standpoint, I mean, we have – we’re spending money now there on the Salar Yield project. We’ve got the La Negra III and IV project is really done, and we’re in the process of ramping that up. So we won’t really need to make a capital allocation decision vis-à-vis Chile for a while. So we’ll have a much better view of what’s happening in Chile and what the new administration, the direction that they’re going and what the rules of the road are before we have to make a significant capital allocation decision there."
},
{
"speaker": "Kevin McCarthy",
"text": "Perfect. Thank you very much."
},
{
"speaker": "Operator",
"text": "Our final question comes from Chris Kapsch with Loop Capital Market. Your line is open."
},
{
"speaker": "Chris Kapsch",
"text": "Good morning. Thank you. So slightly more nuanced follow-up on the pricing and then also the security of supply concept, something that Eric mentioned a couple of times. So obviously, it’s an increasingly important theme, I think. And this is really juxtaposed against these new demand scenarios that you put out this morning, the 1.5 million and the 3 million ton demand scenarios by 2025 and 2030. So at your Analyst Day in September, you talked about just how the industry’s demand – or sorry, cost curve will be steepening. And even your own portfolio, I would say it’s – you’re going to experience that. But as you ramp Wave III, even pulling forward the 50,000 metric tons, you’re talking about 200,000 metric tons. That’s only 20% of the increased industry demand from now to 2025, it looks like. So in terms of security of supply, we think these customers are just increasingly concerned about their ability to source lithium at reasonable prices. So my question really is, are they coming to a big and well-established and reliable integrated supplier like Albemarle and saying like, the pendulum swinging back towards this concept of being willing to pay higher fixed costs in order to ensure that supply. I know you’ve gone from sort of those floor pricing contracts to more of a variable structure. But I would think, given how acute this potential shortage is shaping up to be that they’d be more motivated to do that. And is that something you’re considering? Just wondering kind of – I was kind of asking a couple of other as in different ways. But it just seems like there’s – this is going to be a tough scenario, and the only answer is going to be for higher prices to induce more supply. Anyway, any more color around that would be appreciated. Thanks."
},
{
"speaker": "Kent Masters",
"text": "Yes. So I’m going to take the first shot of that. And Eric, you can fill in if I miss some of the key points. But I guess the first thing is security of supply has always been a key part of our value proposition. And in our view, we – it didn’t get the attention that we thought it deserved in the past. We’ve always built on having multiple resources, different locations, diversification in our supply base and the security of supply. Albemarle has a portfolio that is unlike anyone else in the industry. And that’s from both a conversion, geopolitical resource, cost base, brine, rock everything. So that said, it is getting more attention. And I think the OEMs and the battery manufacturers, but probably the OEMs more than anything else, are paying more attention to that. They’re seeing that there may be a structural deficit or at least they want to make sure they align with the most reliable players. And we’re having conversations with different people. They’re just conversations about different pricing structures. In the industry, we’ve shifted our – the portfolio shift that we’ve done now is really something we started a couple of years ago, put it on hold when prices went so low because we didn’t want to renegotiate contracts at a trough. But we’ve been able to do that now, and that will probably continue to evolve. The structure that we have now is probably not the one that lasts for the balance of the industry. So I suspect there are changes in those structures to come and a lot of it will be based on security of supply and quality and the ability to bring on projects and deliver what you say you’re going to do."
},
{
"speaker": "Chris Kapsch",
"text": "And I just have one follow-up. The – just on – I don’t know if, Eric, you want to add to that. But also just on your decision to sell spodumene, because I thought that you had explained in the past that, that would be for captive conversion to hydroxide, but now you’ve elected to, it sounds like, opportunistically, sell some of the spodumene into the market. Thanks."
},
{
"speaker": "Kent Masters",
"text": "Yes. I wouldn’t read into that, that that’s a change in our strategy. It was opportunistic, and it was a product that we had sitting in inventory that had – was made several years ago and had just been sitting. And we took the opportunity to sell that into the market because there was just an opportunity, and we took advantage of it. It’s just opportunistic. You shouldn’t read into that, that we’ve changed our view on selling spodumene in the market."
},
{
"speaker": "Operator",
"text": "That’s all the time we have scheduled for today’s call. I’d like to turn the call back over to Kent Masters for closing remarks."
},
{
"speaker": "Kent Masters",
"text": "Okay. Thank you, Michelle, and thank you all for your participation on our call today. Our successes in 2021 have positioned us well to capitalize on the strength in the markets that we serve. And this coming year is about execution. I’m confident in our team’s ability to drive value for all of our stakeholders by accelerating the growth of our business in a sustainable way and to lead the industry by example. Thank you."
},
{
"speaker": "Operator",
"text": "This concludes the program. You may now disconnect. Everyone, have a great day."
}
] | Albemarle Corporation | 18,671 |
ALB | 3 | 2,021 | 2021-11-04 09:00:00 | Operator: Ladies and gentlemen, thank you for standing by and welcome to the Q3 2021 Albemarle Corporation earnings conference call. At this time, all participants are in a listen-only mode. After the speakers' presentation, there will be a question-and-answer session. [Operator Instructions] I would now like to hand the conference over to your speaker today, David Burke, Director of Investor Relations. Thank you. Please go ahead.
David Burke: Thank you, and welcome to Albemarle's Third Quarter 2021 Earnings Conference Call. Our earnings were released after close of market yesterday and you'll find our press release, earnings presentation, and non-GAAP reconciliations posted on our website under the Investors section at www. albemarle.com. Joining me on the call today are Kent Masters, our Chief Executive Officer, and Scott Tozier, our Chief Financial Officer. Raphael Crawford, President of Catalysts, Netha Johnson, President Bromine Specialties, and Eric Norris, President of Lithium, are also available for Q&A. As a reminder, some of the statements made during this call, including our outlet guidance, expected Company performance, and timing of expansion projects may constitute forward-looking statements within the meaning of federal securities law. Please note the cautionary language about forward-looking statements contained in our press release and earnings presentation. Same language applies to this call. Please also note that some of our comments today refer to non-GAAP financial measures, A reconciliation to GAAP financial measures can be found in our earnings release and the appendix of our earnings presentation, both of which are posted on our website. Now, I will turn the call over to Kent.
Kent Masters: Thanks David, and thank you all for joining us today. On today's call, I will highlight our quarterly results, provide an update on our goals for 2021 and discuss the progress of our ongoing expansion plans. Scott will provide more detail on our results, outlook, and guidance. We reported another solid quarter with net sales of $831 million and adjusted EBITDA of $218 million. Sales improved by 11% on a year-over-year basis, while adjusted EBITDA was relatively flat compared to the third quarter last year. Excluding SCS from our third quarter 2020 results our net sales were 19% higher, and EBITDA was up 14%. Scott will get into more detail on our financials in a few minutes, including favorable revisions to our guidance. As we stated in our earnings release this morning, we increased our guidance based on the third quarter results. During our recent investor day, we did a deep dive into our accelerated growth strategy and provided color on how we think about the near-term expansion of our Lithium business, as well as our disciplined investment approach. Since that event in early September, we are pleased to have announced several updates on those efforts. This includes signing an agreement to acquire Guangxi Tianyuan New Energy Materials or Tian Yon, which owns a recently built conversion plant near Qinzhou. We are totaling to ensure the plant operates as advertised and expect to close this transaction in the first quarter of next year. This puts us on track for first sales from this plant in the first half of next year. In addition to this plant, we have signed two recent agreements for investments in China to support 2 Greenfield projects. Each initially targeting 50,000 metric tons per year. These projects position us for initial added conversion capacity, up of up to 150,000 metric tons of lithium hydroxide on an annual basis to meet our customer's growing demands. In addition, our Marble joint venture announced the restart of the Wodgina lithium mine in Western Australia. On Slide 5, you will see the objectives we set for 2021. When we set these goals, we did so with the intent of challenging ourselves with plans that were aggressive, but achievable. As we approach the end of the year, I'm excited by the significant progress and proud of the effort our team has put into achieving these goals. As you see on the slide, we have accomplished the vast majority of what we set out to do. For example, we are successfully progressing high-return, fast-payback roaming projects at both Magnolia and JBC. These projects will increase our capacity and improve the efficiencies of our operations. We've also made significant progress on our lithium growth projects. Now let's turn to slide 6. First at La Negra 3 and 4, our team continues to execute the plan. I'm excited to announce that we recently completed a major milestone by achieving first lithium carbonate production in late October. Initial production volumes will be used to qualify the plant and the material with our customers to ensure we are meeting their requirements. This qualification process is proceeding on track with first sales expected in the first half of next year. In Western Australia, the ongoing labor shortages and pandemic related travel restrictions, have continued to significantly impact virtually all companies in that region and showed no signs of easing in the near-term. Despite these efforts and with herculean efforts, our team has managed to hold Kemerton 1 construction completion to year-end 2021. We now expect Kemerton 2 construction completion in the second half of 2022. While we are facing challenges at these projects, our strategy to consolidate resources and prioritize the first train continues to mitigate additional risks. On Slide 7, I'll highlight the progress we've made on our Wave 3 program since we last spoke to you at our Investor Day. At the end of September, we announced an agreement to acquire Tianyuan for $200 million, including a recently built conversion plant near the port of Qinzhou, designed to produce up to 25,000 metric tons of lithium per year, with the potential to expand to 50,000 metric tons per year. We expect this acquisition to follow a similar path as our acquisitions of Xinyu and Chengdu facilities back in 2016. Following the close of the transaction, which is expected in the first quarter of next year, we plan to make additional investments to bring Qinzhou plant to Albemarle standards and ramp to initial production of 25,000 metric tons. This acquisition enables us to accelerate conversion capacity growth and leverage our world-class resource space. Together with our partner, we agreed to restart operations at the Wodgina Lithium Mine in Western Australia. Initially, Wodgina will begin 1 of 3 processing lines, each of which can produce up to 250,000 metric tons of lithium spodumene concentrate. This resource will be critical as we ramp our conversion capacity in Western Australia with our Kemerton sites. We also signed agreements to invest in 2 Greenfield conversion sites in China at Zhangjiagang and Meishan. We plan to build identical conversion plants with initial target production of 50,000 metric tons of battery-grade lithium hydroxide at each site. These investments offer additional optionality for future growth and have expansion potential. Investing in China offers capital efficient, high return growth with proximity to our low cost Australian spodumene resources and many of our major cathode and battery customers. We continue to explore global expansion of our conversion capacity as the battery supply chain shifts west. Turning to Slide 8 for a review of our global project pipeline. As you can see, Albemarle is executing a robust pipeline of projects all around the world. For example, our Bromine business is pursuing incremental expansions in Jordan and the U.S.. These high return projects leverage our low-cost resources and technical know-how to support customers and growing and diverse markets, like electronics, telecom, and automotive. In Chile, the Salar Yield Improvement Project allows us to increase lithium production without increasing our brine pumping rates, utilizing a proprietary technology to improve efficiency and sustainability. In Australia, we continue to progress study work on additional Kemerton expansions to leverage greater scale and efficiency with repeatable designs. Finally, in the U.S., we are expanding our Silver Peak facility in the Nevada to double Lithium carbonate production. This is the first of several options to expand local U.S. production. In Kings Mountain, North Carolina, we continue to evaluate restarting our mine. And that our Bromine facility in Magnolia, Arkansas, we're evaluating the process technologies to leverage our [Indiscernible] to extract lithium. We'll continue to update you periodically on our pipeline. I hope this gives you a sense of the diversity and optionality Albemarle has as a global lithium producer. I'll now turn the call over to Scott for a look at the financials.
Scott Tozier: Thanks, Kent, and good morning, everyone. Let's begin on Slide 9. During the third quarter, we generated net sales of $831 million, an 11% increase from the same period last year. This improvement was driven by strong sales for our lithium and bromine segments. Adjusted EBITDA was essentially flat on a year-over-year basis, resulting from the sale of FCS and increased freight and raw material costs. The GAAP net loss of $393 million includes a $505 million after-tax charge related to the recently announced Huntsman arbitration decision. While we continue to assess our legal options. We have also initiated discussions with Huntsman regarding a potential resolution. Excluding this charge, adjusted EPS was a $1.05 for the quarter, down 4% from the prior year. Now, let's turn to Slide 10 for a look at adjusted EBITDA by business. Third quarter adjusted EBITDA of $218 million increased by 14% or $27 million compared to the prior year, excluding the sale of SCS. The higher adjusted EBITDA for Lithium and Bromine was partially offset by $13.5 million out-of-period adjustment regarding inventory valuation in our international locations impacting all three GBUs. Lithium's adjusted EBITDA increased by $25 million year-over-year, excluding foreign exchange. We were able to offset the limited impact of a 1-month strike in the Salar in Chile, thanks to higher tolling volumes and higher spodumene shipments from our Talison joint venture. Adjusted EBITDA for bromine increased by $5 million dollars compared to the prior year due to higher pricing, partially offset by increased freight and raw material costs. Volumes were flat, given the chlorine constraints in the quarter. In Catalysts, adjusted EBITDA declined $4 million from the previous year. This was due to lower sales and cost pressures, partially offset by higher-than-expected joint venture income, which included a favorable tax settlement in Brazil. Slide 11 highlights the Company's financial strength. That is key to our ability to execute our growth plans over the coming years. Our net debt to EBITDA at the end of the quarter was 1.7 times as below our targeted long-term range of 2 to 2.5 times. This provides us with capacity to fund growth while supporting modest dividend increases. We don't expect the recent arbitration decision to impact our current growth plans. But it could temporarily reduce our flexibility to take advantage of upside growth opportunities. Turning to Slide 12, I'll walk you through the updates to our guidance that Kent mentioned earlier. Higher full-year 2021 net sales and adjusted EBITDA guidance reflects our strong third quarter performance. Net cash from operations guidance is unchanged due to the timing of shipments to customers and increased raw materials and inventory costs. Capital expenditures were revised higher, related to the continuing tight labor markets and COVID related travel restrictions in Western Australia, as well as accelerated investments in growth. Turning to slide 13 for more detailed outlook on each of the GBUs, lithium's full-year 2021 adjusted EBITDA is now expected to grow in the mid-to-high teens year-over-year. That's up from our previous guidance due to higher volumes and pricing. The volume growth is driven primarily by tolling. And our full-year average realized pricing is now expected to be flat to slightly higher compared to 2020. As a reminder, most of our Battery-grade lithium sales are on long-term contracts with structured pricing mechanisms that are partially exposed to the market. We also benefit from stronger market pricing on shorter-term technical grade sales and on spot and tolling sales of battery-grade lithium. Full-year 2021 average margins are expected to remain below 35% due to higher cost related to the project startups and tolling partially offset by productivity improvements. Bromine 's full-year 2021 adjusted EBITDA growth is now expected to be in the low double-digits. That's also up from previous guidance due to the continued strength in demand and pricing for flame retardants. Our bromine volumes remain constrained due to sold-out conditions and a lack of inventory. The outlook for chlorine availability has improved since last quarter, but the market remains tight. And the impact of higher chlorine pricing is expected to be felt more in 2022 than in 2021 due to the timing of inventory changes and shipments. Year-to-date, higher bromine pricing has mostly offset higher raw material and freight costs. Catalyst full-year 2021 EBITDA is now expected to decline between 20% and 25%. That's also an improvement from our previous guidance, owing to the higher-than-expected joint venture income. The year-over-year decline in adjusted EBITDA is primarily due to the impact of the U.S. Gulf Coast winter storm in -- earlier in the year, product mix and the previously disclosed change in our customer's order patterns. Catalysts fourth-quarter margins will also be impacted by product mix, including a greater proportion of lower margin FCC and CFT [Indiscernible] orders. SCS demand continues to improve with increasing global fuel demand while HPC orders continue to be delayed. Overall, market conditions are improving, but volumes in Catalysts are not expected to return to pre -pandemic levels until late 2022 or 2023. In total, we expect EBITDA margins to be lower in the fourth quarter due to higher raw materials, energy, and freight costs across all three of our businesses. We are closely watching several key risk factors, including global supply chain disruptions, global impacts of the energy rationing in China and chip shortages. Supply chain and logistics challenges are the most immediate. Our teams are working day and night to navigate these port issues, the lack of drivers, and upstream supply disruptions to ensure our customers get their orders on time. We also continued to monitor the global situation with regard to chip shortages. We recognize that the auto industry has been struggling with those shortages. But to-date, we have not seen a direct impact on either our lithium or bromine orders. And with that, I'll hand it back to Kent.
Kent Masters: Thanks, Scott. I'll end our prepared remarks on Slide 14. As Scott mentioned, we are disappointed by the outcome of the Huntsman arbitration decision. But regardless of the ultimate outcome of that dispute, Albemarle will continue to focus on the execution of our growth strategy. As we highlighted during our Investor Day in September, we have a well thought out and focused operating model that we are implementing across our businesses. This model, the Albemarle way of excellence, provides us with a framework to execute our objectives effectively and efficiently, and will help us to remain on target as we pursue the significant growth opportunities ahead. And as we pursue these opportunities, we will be disciplined in our approach to capital allocation. Our primary capital priority is accelerating high return growth. This means that we will invest not just to get bigger, but to create tangible shareholder value and maintain financial flexibility to take advantage of future opportunities. Utilizing this approach with our low cost resources, we believe our annual adjusted EBITDA will triple by 2026. Finally, at the core of all of this is sustainability. As 1 of the world's largest lithium producers and innovators, we were able to work closely with our customers to create value and drive better sustainability outcomes for all stakeholders. With that, I'd like to open the call for questions. I'll hand over to the Operator.
Operator: Thank you, sir. And at this time, ladies and gentlemen, if you would like to ask a question during this time, [Operator Instructions]. Your first question comes from the line of John Roberts with UBS.
Matthew Konosky: Morning, this is Matt Gawronski (ph) on for John. In the past, you mentioned that Kemerton maybe able to ramp the 40% to 50% of capacity in a year following its commissioning and qualification process. Is this still the case for that first line that's supposed to be done with construction at the end of this year? Or is it going to take some additional time due to the constraints going on right now?
Kent Masters: So after that I think we got to get through mechanical completion then we've got the commissioning qualification. So -- and then I think what we've said is after that and that's about a 6-month process. Then after that, we think we would be able to ramp to maybe 50% in the first 12 months. That's probably a little aggressive, but that -- that's what we're targeting. And then, I think the labor and all those issues are primarily around construction. We've got operators in -- staffed and onboard, and they're helping with commissioning so, I mean, the labor market is going to be tied, and we'll -- we may fight to keep the ones we want, I'm not sure, but the real labor issue is around construction.
Matthew Konosky: Thank you. And then, Scott, you mentioned the HUN arbitration issue could impact your ability to opportunistically take hold of growth opportunities. Is that organic or just inorganic opportunities?
Scott Tozier: Yeah, I think it's really more -- truly 2. I think partly on the organic side, it's our ability to accelerate or further accelerate our projects. We'll be able to do some of it, but clearly, it's a big drag. And then the second is, any sort of larger type of inorganic would be -- would need some sort of more creative type of financing to do.
Operator: Your next question comes from the line of P.J. Juvekar with Citi.
P.J. Juvekar: Yes. Hi, good morning.
Kent Masters: Good morning.
P.J. Juvekar: So now that you expect lithium prices to be flat to up for this year and sort of down, are you -- must be expecting price gain in 4Q that are well into double-digits. Can you comment on that? And then, even as you look forward into next year, what percent of your contracts will be renewed next year? And do you have any early look into negotiations? Thank you.
Eric Norris: So P.J., good morning, it's Eric. I want to make sure I understand your first question. Your first question was, would they be double-digit in Q4, is that what you said?
P.J. Juvekar: Yes. As well into double-digits for Q4 for your pricing.
Eric Norris: The way to think about pricing is and the flat-to-down comment is that it's progressive throughout the year. Prices were at their lowest point late last year and early this year and have been gradually rising as we've gone through the year due to 2 factors, 1 is the exploration and the concession we gave against a fixed priced long-term agreement. And the second would be just the movement of spot prices for that portion of our business is exposed to that -- those markets, which I'm sure you're aware, know. Those price has gone up significantly and throughout the course of the year. So as the guidance we've given, that Scott gave at Investor Day for next year, was at least 15% to 20% year-on-year increase for 2022 versus 2021. And certainly, that's a progressive trend. So you could certainly see those kinds of increases starting to happen in Q4 versus a year ago.
P.J. Juvekar: Okay, great. And then on marble, you're restarting one of the 3 lines. Rock prices have skyrocketed, so why just 1 line? And then where would you concentrate that rock? Would that be at [Indiscernible]? Would that be in China? Can you just talk about that?
Kent Masters: Yeah. So the -- P.J., it's Kent, so I think we're going to get started on one and we'll ramp other facilities over time, but it's really our capacity to convert. So we're not really mining rock to sell spodumene into the market, we're mining rock to convert spodumene into finished products. And we'll do that at Kemerton. Initially -- I mean, I guess we haven't worked out exactly what the logistics are. So that product may go to China and other products go to Kemerton. So we just have to balance our sourcing of facilities, but that's the next tranche of our product in that part of the world.
Operator: Your next question comes from the line of Laurence Alexander with Jefferies.
Laurence Alexander: Good morning. First, on the bromine pricing, can you discuss how much of that you feel was transitory versus sustainable given the demand trends you're seeing? And can you give any sense of the magnitude of the chlorine headwind for this year, so that we have some better context for the larger-than-this-year headwind next year?
Raphael Crawford: I think, in terms of the pricing, we could probably figure most of that is transitory. It's based on the raw materials pricing that we pay and in the ability for us to absorb that and managed as we price forward. And in terms of the chlorine impact, it's more of a timing issue. We're going to get more chlorine next year, probably a different price than we're going to get this year. So you'll see that really impact us starting woefully in Q1 next year throughout the year.
Laurence Alexander: And then with Catalysts, the recovery next year, how much of your -- should that be lighting or coincident with production ramp-ups at the refineries?
Raphael Crawford: Hey, Lawrence, this is Raphael. The FCC business is very ratable to miles driven and that correlates to refining output. So I think FCC as is mentioned, sequentially continues to improve from a volume standpoint. So that one you would see first and there's usually a lag on hydroprocessing, which is 12 to 18-month lag. As conditions improve in refineries to get more capital availability and then reinvest in change outs for HPC. So that has more of the lag effect. But overall, at [Indiscernible] we see sequential improvement, we see refining conditions improving. We're very tied to that with our performance products, so we see that as a favorable outlook going forward.
Operator: Your next question comes from the line of Bob Koort with Goldman Sachs.
Mike Harris: Yeah, this is actually Mike Harris sitting in for Bob. If I could, might ask a question around the Lithium business, looking at the energy storage related sales, why is there a potential 1 to 2 quarter lag behind the EV production versus those sales actually, maybe leading?
Eric Norris: Yes, Mike, it's Eric here. It's simply a factor of the length of the supply chain. Lithium is consumed in the cathode material, which then is formulated into -- an electrode that's put into a battery. The battery is then assembled and then put into an ED car so that it's just the length of time that takes and the geographies involved. Most of the cathode -- nearly all the cathode production and a good amount of the battery production still is in Asia. And of course cars are produced various points around the world. So it's just the length of the supply chain. We are -- we see that lag, but recall we're well-positioned, we're able to supply anywhere in the world. So we look -- we are well-positioned to grow with the industry, but that lag is likely to remain there, given the length of the supply chain.
Mike Harris: Got it. Okay. That helps. And then also, just as a follow-up, when I think about lithium recycling, can you give me an idea of what kind of assumptions you guys have made around recycling and perhaps the potential impact on your business, if any at all?
Eric Norris: Recycling is a phenomenon that follows the end of life of batteries and further still want to have to factor in potential reuse of batteries. And given the 10-year life-cycle that is warranted on most batteries produced for automotive production. That's the kind of lag you're looking at. So batteries being produced today wouldn't even be considered for recycle until ten years from now. When we look at that, that means that we see recycling becoming important as the decade wears on. But still, by the middle of the decade being fairly small amount of lithium needed in the supply chain and maybe reaching a double-digit amount of a low double-digit amount of possible coming back into the stream by 2030.
Operator: Your next question comes from the line of David Begleiter with Deutsche Bank.
David Huang: Hi there. This is David Huang here for Dave. I guess, 1st, can you talk about your feedstock [Indiscernible] strategy for that 150K ton of lithium hydroxide capacity you're adding in China?
Raphael Crawford: I'm sorry. So that was the feed-stock strategy for the 150 new projects in China?
David Huang: Yes.
Raphael Crawford: So they'll be said with our [Indiscernible] coming out of Australia.
David Huang: Okay. And then secondly, are there any incremental headwinds or tailwinds to your 2022 guidance you provided, I mean, [Indiscernible], especially for a [Indiscernible] or do you still standby those guidance?
Raphael Crawford: Yes. We haven't updated our guidance since the Investor Day. So we're going through our annual operating plan process right now. In fact, next meeting is next week and we'll give you a more definitive guidance in our fourth quarter earnings call.
Operator: Your next question comes from the line of Joel Jackson with BMO Capital Markets.
Female_1: Hi, this is Bremer (ph) [Indiscernible] of Joel, thanks for taking my question. Just back on the pricing discussions in 2022, can you just give us a little bit more color on how the discussions with your lithium contract listeners are going? And then, are pricing mechanisms going to be similar in '22 to '21 or is there a move more to benchmark pricing?
Eric Norris: So the -- generally speaking, Bravey (ph), the discussions we're having with our customers are for price increase next year per -- and that aligns with the guidance I gave you in the remarks just a few moments ago. We have a book of contracts we've had under our basket, I should say, for some years now. Those are going back either to -- well, those are -- the fixed portion of those contracts are going back to the original long-term agreement, which is significantly higher in some cases than the average price that we're seeing for 2021. And then there is many of those contracts have a variable component and there is no one contract that looks exactly like the other, but that variable component can. We will also see increases. Some of those variable components are tied to indices. Others are just an annual increase nomination that's possible, a max increase nomination. And then finally, we have a good deal of technical-grade contracts where we'll see rising prices based upon an adjustment to what -- the rises we've seen this year, as we roll into next year. The last piece would be our China spot business. And that -- hard to say that we'd see a pretty big increase on that next year because prices are already extraordinarily high in China right now. But we'll continue to see possibly some upside on a year-over-year basis, particularly in the early part of the year, next year on that. So those are all the components that are driving our increase and types of discussions we're having with our customers which will give us nice leverage, upside leverage to the improving market conditions.
Female_1: Okay, that's certainly helpful. Thank you. And then I guess just like given the large upswing in LFP demand in recent tests of commentary, with that background, I just want to understand how you're thinking about investments into carbonate versus hydroxide. It seems your incremental investments are mostly focused on hydroxide currently.
Eric Norris: We see -- we monitor this very closely, we have a lot of analytics and customer dialogues up and down the supply chain from OEMs all way that back through the battery and cathode producers to assess those trends. What we believed and has been confirmed in our discussions with customers is while there is an uptake in LFP demand, there has also been an uptake in vehicle production outlook as well for electric vehicles. And where LFP is occupying a sweet spot is in the lower cost range, lower costs and lower driving range portion of the vehicle mix. For some automotive producers that will be a larger percentage of their mix than others. Bottom line, we see strong growth in both of those products, albeit we see still pretty -- the growth rate in hydroxide will be higher over the coming 5 years. And hence, we feel we're extremely well-positioned. We're bringing on 40,000 tons of carbonate capacity as we speak. And we have the hydroxide expansion strategy in addition to the Kemerton ramp that they can't earlier describe and feel we're well-positioned to meet both LFP demand and rising high - nickel demand for cathodes.
Operator: Your next question comes from the line of Jeff Zekauskas with J.P. Morgan.
Jeff Zekauskas: Thanks very much. You've described your lithium prices as perhaps being up 15% to 20% or more next year. Is the 15% to 20% representative, given market conditions, could it be up 30?
Scott Tozier: Well, I think it depends, as you might think, Jeff, on [Indiscernible] conditions. There's a portion of our business that is exposed to market -- pure market conditions. The majority of our business, even while there is on these long-term contracts, there's a variable component that the anchor around that is going to be around the fixed price, which is also going up because of the exploration of the concessions we gave. So at this point, it's probably too early to say what we think about price above 15% to 20%, because our guidance was at least 15% to 20%,
Eric Norris: Right.
Scott Tozier: So we'll have to provide you as the quarter wears on and the discussions continue that guidance as we get into the February call -- earnings call that we'll have in February.
Eric Norris: Okay. Then for my follow-up, when I look at quoted bromine prices in China, maybe since August, they're up 60%, something like that. Is that a representative price for what's going on in the market or it's not a representative price? Can you speak to bromine pricing in Asia and where it's been and where you see it going? What's driving it?
Netha Johnson: Yeah, Jeff, this is Netha. That's a reflection of a couple of things. First of all, demand is up, clearly across the market, and raw material pricing are up to produce brominated products that are being required. So what you're seeing is that's what's driving an enormous amount of price increase in the Chinese spot price.
Operator: Your next question comes from the line of Ben Kallo with Baird.
Ben Kallo: Thank you guys, and good morning. One of the things that we are thinking about is -- I love to hear your perspective with materials maybe being a bottleneck for EV production sales. If that's -- how you guys view that as a risk? Just overall -- meaning, is there enough lithium reserve, enough copper reserve, enough nickel? And then, how are customers, I guess, approaching you [Indiscernible] and your competitors for security in the supply chain. Does that -- does your scale and your diversity of your resources give you an advantage there over other people [Indiscernible] Will be more [Indiscernible] wrap up. Thank you.
Kent Masters: We talked a little bit about lithium, so copper, nickel, I don't know that we will want to weigh in on that, but we just talk -- I'll make a few comments, and then Eric can add some detail to it, but we 're investing heavily to keep up with that demand and maintain our share, which has been our strategy. And so we're investing along with our customers and security supply has always been a key part of the value proposition from Albemarle to their customers. And particularly around lithium. As you mentioned, the diversity of resources, the diversity of locations where we produce, and the -- we have carbonate and we have hydroxide today, and then we'll continue to evolve those chemistries as the market shift over time. So I think the network that we build is really a lot of that is focused around security of supply, and part of the key value proposition that we talk about constantly with our customers.
Eric Norris: Then I'll just add on the lithium side of material risks. There's enough material, there's enough lithium out there. The issue is the investment required to get there and the fact that it's going to be at a higher costs. The cross curve is upward sloping as you go to lower quality lithium resources that are out there. The discussions we're having with our customers are ones of deep desire for commitment and partnership. That's both the existing ones we've had, and as we bring on new capacity, new ones that we would look to target. And that's at various points in the value chain, but I would tell you that the most significant and urgent discussions around security are the closer you get to the automotive OEM. And so I think our track record of executing gives us that advantage for sure. And I think that's where the discussions land as us being sort of a base load partner for many of these automotive and battery firms. So I do think that's an advantage we have for sure.
Ben Kallo: Thank you, guys. It's about to get too ahead ourselves here, but are you at a point that you are allocating to customers? So you're picking your customers more than they are picking you or is it not like that? And thanks, guys.
Eric Norris: So I would say that's the merit of the partnership and why we have the discussions we do, because anyone -- any buy in who is not committed to us in a long-term way, so that could be a spot buyer on the battery side, that could be a tech grade buyer on the industrial side is -- does risk not getting the volume that they would like as we roll into 2022. So that's the basis for the partnership discussions that we're having is that desire for securities supply, given the points in time in that supply in the coming 5 years where things will be tightened, they are quite tight right now.
Operator: Your next question comes from the line of Vincent Andrews with Morgan Stanley.
Male_1: Hi. This is [Indiscernible] to you on for Vincent. Thank you for taking our question. Just back to the Huntsman arbitration, curious. What other alternatives are there in terms of discontinued process. I know you mentioned you've started to have discussions around settlement. So what other -- from a legal perspective, what other alternatives are there? And then how should we think about the timing of all of this?
Kent Masters: Well, I think it's -- it's a range. And we're not going to get into too much because there's an active process. So it is either through the arbitration process or from discussions that we've initiated that we would be able to -- that we could potentially reach agreement and resolve that matter. But it's a pretty -- those are the options and it's the time frame is pretty wide.
Male_1: Understood. And then as we think about Kemerton and your ability to fulfill those contracts particularly Kemerton 2 given the longer delay, will those be fulfilled through more tolling or how should we think about the volume and how that will be allocated in terms of -- as we think about next year, 2023, would that be less volume overall or just lower margin from tolling?
Kent Masters: Well, I think you'll see us -- you will fill that with tolling, and with this acquisition that we've done, and we expect to get that up to speed relatively quickly. I mean, there will be some -- we expect to do make rights to get it to our standard and the quality that we want. But we'll be aggressive around that. Those will be the two methods that we use to stay on our plan.
Operator: Your next question comes from the line of Kevin McCarthy with Vertical Research.
Cory Murphy: Hi, good morning. This is Cory Murphy on for Kevin. I wanted to follow on -- I think it was PJ's question earlier about Wodgina, you said you were starting up one line and it looks like it's going to start production maybe in the third quarter of 2022. Can you help me understand what the delays are or why the restart process seems to take maybe upwards of 6 to 10 months? And then given spodumene prices, why wouldn't you startup or try to start up all three lines? Are you able to sell the spodumene on the spot market or is it that there's contractual reasons not to?
Kent Masters: Well, it's -- on the selling spodumene, it's really strategic reasons, is that we want to convert it and sell the finished products to customers where we'd make commitments and we have long-term arrangements. So we might sell some spodumene here in there, but that's not our strategy. And then the starting up -- I mean, we might -- we're going to do -- start to first train then other. It's really neat to be in line with our conversion capacity. And then that timeline that you referenced where 6 or whatever the timeframe is to get it going, you've got labor issues in Western Australia, we face the same things there that we do at Kemerton to some degree, and really the lead time is on some of the big equipment that's necessary in mining, some of the yellow -- we call it -- they call it yellow equipment, that's necessary in operating these mines and the lead time on that.
Cory Murphy: Understood. That's very helpful. And then I just wanted to ask about tolling as well. It sounds like there's more tolling due to labor shortages or labor strikes in Chile. How would your volume trend without tolling? And when do you anticipate rolling off the tolling contracts related to the La Negra startup? I think you said you're bridging some capacity with that.
Eric Norris: Right. Well, I would say tolling is a strategy we use for bridging. That is correct. We do that. We expect to continue to toll next year for the purposes of La Negra, but also for the purposes of Kemerton. Look, I mean, I -- it's a bridging strategy, but the market is extremely strong right now. And because Kemerton has been delayed, there's spodumene that we can take advantage of. And as long as we have qualified tolling partner that is someone with -- we have a good relationship, we trust our quality. We have a business relationship where we can collaborate together, then we'll take advantage of that, both to bridge and take advantage of the strong market that's before us. So I think it's a variety of purposes. When it rolls off, it's hard for me to say, but we will have it as part of next year for sure.
Operator: Your next question comes from the line of Colin Rusch with Oppenheimer & Co.
Colin Rusch: Guys, thanks so much for all of these information. I'm curious about the order patterns from your customers. And this is a cross the you [Indiscernible]. If you're seeing any sort of double ordering that you can track or track all of the sell-through for those individual customers. Just it seems like that there may be some folks trying to build some inventory or really trying to give character or any other incremental demand that they could mean.
Eric Norris: Colin, Eric, from a Lithium perspective, I would say that there is -- we're very -- we touch all aspects of the supply chain. And so I don't see any double ordering. And furthermore, to buttress that remark, I would say that the discussions we have with our customers, we know they don't have any inventory. They are hand-to-mouth. So we know that because when -- with this crisis existing around the global supply chain, you can imagine we're not always able to precisely target the week or the day at which a shipment's going to arrive, and that causes pain for the customer. If it causes -- if it does for us, it does for them as well. So it's a very tight market still in lithium.
Netha Johnson: Hi, Colin, bromine. We're not seeing any double ordering court. Customers are not trying to build inventory at their sites in anticipation of supply chain disruptions. Supply chains are tight and things are difficult, but we've been able to manage it to a certain extent to where we can deliver within a window that they can live with. So we're not seeing those double orders or customers try to build-up inventory by ordering more than they need right at this time.
Raphael Crawford: Nor in Catalysts, either, Colin.
Colin Rusch: Okay. Thanks, guys. And then just on the lithium content per kilowatt hour, are you guys seeing any real trend lines on that? Certainly as some of these battery chemistries change. And folks are looking to figure out how to optimize some of the materials. Are you seeing lithium content increase, decrease, hold steady? And where would you peg that level right now?
Eric Norris: For the most part, I think as we sit here and look at the year 2021, we've seen any material change. Certainly we would expect it over a period of years as prelithiation enters the equation on the anode side. As further as our progress on solid-state or lithium metal anode technology progresses. That's definitely going to increase the content as it does, obviously the energy density, which is the whole point of those technology innovations. But as you sit here today, I think the technology trends are alive and well, but it's on a quarterly basis during 2021, and really I haven't seen significant change necessarily in that.
Operator: Your next question comes from the line of Arun Viswanathan with RBC Capital Markets.
Arun Viswanathan: Great, thanks for taking my question. I guess I had a question just on the contracting process here. What are you hearing from your customers as far as length? Are those contracts in lithium extending out now to 4 or 7 or 10 years? And then when you when you do those contracts, how do you kind of bridge the divide between this huge spot price of $28,000 plus per ton and something more reasonable and more in line with the increases from where you are on the contract side. I guess I'm just asking. Are you -- have you seen a material rise in the cost curve that would justify contracts going closer to spot? Thanks.
Eric Norris: I would say that there is -- the duration of requests from customers are increasing. I think we've characterized in the past, and on average it's about 3 years in our current mix. The new contracts under discussion, which would be slated to supply against the China expansions that Kent described, or future Kemerton expansions, or even down the road expansions we could have in the U.S. Those discussions are either 5-year plus or they don't even start until 2024, 2025. So we're having discussions with certain customers who are contracting for increments of time into the future, say '23 to '26, or '24 or '28. Those are the kinds of durations that people are thinking about and that's largely driven by the investments made on the automotive side. From a pricing standpoint, you can imagine because prices are rising, there's certainly a desire on behalf of those buyers to see what they can to not have to pay spot prices. But the reality is they either -- the discussion is either towards a much higher fixed price if they want some stability in their pricing term, or we're pricing against an established index so that it will rise with time. Now, remember the price you gave was a spodumene price when you said $2,800 a ton, the pricing in China is, on a U.S. basis is in the high 20s, close to 30 on a delivered basis. When you look at many of the indices around the world, most of these people are buying against a blend, and so the pricing around that is not quite as high, but it's still well into the high teens, if not the low 20s of what a lot of those pricing indices are. So we continue to have a discussion with customers and -- but those are some of the dynamics at play, which are leading us to long-term contracts with significantly higher price potential than what we're -- we've seen in the past.
Arun Viswanathan: Great, thanks for that. And then, I guess, just wanted to ask about the -- if there's any risk that you see on the political front in Chile -- yeah, it's a broad question -- I guess in the next month or two or so?
Kent Masters: There's a lot happening in Chile, so there's definitely political risk in Chile. They rewrite the constitution and things are changing. And we watch it closely and we operate there. So we -- and we're pretty close, we're close to the government. We see what's happened, but they are rewriting their constitution and there'll be changes in Chile. I think Chile wants to participate in lithium industry. They're looking to expand their participation. The contracts -- the agreements they have with us are very progressive, so they participate as prices go up. So that's an upside for them. So I believe they're going to -- they want to participate in that economically. But there's a lot happening in Chile at the moment, and we're watching it very closely.
Operator: Your next question comes from the line of Matthew DeYoe with Bank of America.
Matthew Deyoe: Thank you. So we touched a bit on tolling. I want to delve a little bit into it a little bit more because I know you said it's a bridging strategy and maybe we can be opportunistic. But you're sitting on a fair amount of latent capacity at Greenbushes. And the read seems to be that converters are struggling to find enough merchant supply of spodumene to actually continue to operate in some respect, so why not get more aggressive on the volume? I have to think: 1. Prices right now are really attractive but, 2. Almost somewhat concerning as it relates to the potential for over-investment and overheating in markets and things like that etc. I feel like if you -- with your volume, you might have an ability to kind of regulate this a little bit.
Kent Masters: Yeah. So I'll make a comment, and Eric can add some color on it. We don't -- we can't just turn a toller on because we -- they are going to our customers, we have to qualify them. So there is a process there. And not all of those tollers would qualify with our customers. So it's not -- we can't just turn them on. It's not quite that simple, even if we had the products. So now we're ramping and getting more spodumene going. It could give us optionality from a spodumene standpoint going forward, but we still have to make sure we choose the ones, and Eric talked about it, before they're people, they're tollers that we have relationships with that have been previously qualified or currently qualified with our customers. So you have to fit in all of those elements into it to really ramp it up. It would be a -- it's not a 6 months strategy. It's going to take a little longer to implement that.
Matthew Deyoe: Okay.
Kent Masters: [Indiscernible] anything?
Eric Norris: I think you handled that well. I mean, if -- don't think of these conversions [Indiscernible] doesn't -- there are people who are in the industry, but there's only several that we would consider as being partners or meeting our standards for serving our customers. So that's why there's a length involved that in the qualification process. So if there's opportunities, we'll take advantage of them, but we're very discriminating in how we approach that from a -- when it comes to serving our customers.
Kent Masters: Yeah. And key for us is, for me, that -- again, security of supply quality for the customer. The customers have to trust us. So if we're going to toll, we have to make sure that product meets our specs and our customer's standards as well.
Matthew Deyoe: Fair point. And we almost got there with Jeff's question. But if you look at Chinese bromine price, I know in the past it's been comments or maybe it's not correct on an absolute basis, but directionally it's consistent with what you're seeing. So given the move, should we think of this move as real and capturable in any capacity? And if so, is this a 2-year process, a 1-year process, a 3-year process? It would seem like there's a lot of room to offset higher chlorine costs as well. But I'm not sure if that's the case or not.
Netha Johnson: Yeah. This is Netha. Yes, those prices are real and they are really driven by demand. The demand is outstripping the supply. It takes almost 2 years to really bring on additional bromine supply in a meaningful way, so you'll continue to see that demand outstripped supply. It's similar to what we said in our Investor Day for the next planning period that we use, and we think that will continue. The question's by how much. We've announced processes and things we want to add, and I'm sure others have as well. But right now it's not complex. Demand is really exceeding supply and that's what's driving the Chinese bromine price up.
Operator: Your next question comes from the line of Christopher Parkinson with Mizuho.
Harris Fein: Hi. This is Harris Fein on for Chris. Thanks for taking my question. Turning back to Wodgina, so how should we be thinking about the cost that's associated with bringing that back into production and then understanding that Greenbushes is in a class of its own when it comes to cost per ton. How should we be thinking about the relative cost of spodumene that comes out of Wodgina?
Scott Tozier: This is this is Scott. I think, as you said Talison spodumene, world-class, right? Low costs in the world. Wodgina, we haven't operated yet, but we do believe it's going to be relatively close. Ultimately, it does have a lower concentration, so it won't meet it, but it will be relatively close.
Kent Masters: Maybe say, in the ballpark. And I think, Scott, the costs for this, Harris was asking about how to [Indiscernible] there. We've captured them in the guidance we provided, both capital and cash flow. It's largely joint venture capital costs to acquire this yellow equipment that we've talked about and ramp the JV.
Harris Fein: Got it. And then a lot of the Wave 3 announcements that you've made so far, actually all of them that have been disclosed, are really planned in China. So I'm curious what the strategic rationale was to focus so much on China. And I'm wondering whether it was a matter of lower capital costs or whether or not you see the Chinese market drifting more towards high nickel. And whether or not you expect most of those tons to stay domestic or make their way into other markets.
Kent Masters: Yes. So I mean, I think it's -- I mean Eric can get into detail, but kind of at the high level, I mean, it is -- I mean, we do see lower capital costs there. That's probably not the driver. The driver, that's where the market is today. And then that product can either serve Chinese market or be exported as well. And then as we anticipate seeing the battery supply chain shifting to the west, and then we will invest ahead of that. But for the near-term, we see that market in China today. And then we see that -- as we go forward, you hear us talking about North America and Europe to some degree, but we see that moving west. And then we will invest with it. Eric, you want to?
Eric Norris: You know, I mean, I think if you look at the percent of production of cathode on the world market, China is well over half of it today and that will increase between now and the middle of the decade. So China is the center of the world for all cathode technologies. Now, many of those are being developed. The supply chain is being developed prospectively to come into and match up to battery production ultimately in North America and Europe. And that's why we have a wave 4 plan that addresses that and we will speak to those opportunities to localize supply and it's an active program with us. But as we've said many times, wave 3 is largely Asia - centric, heavily China focus because that's where the market is. And we will build that repeatability of capital design and execution there that will serve us well as we continue to grow around the world. It's also where a large -- more of our resources are in Asia -- a bit Australia, but in the Asia region as opposed to the Western part of the world. So those are all the elements that play that strategy. And we look forward to growing with our customers as they expand into the West.
Operator: There are no further questions. I would now like to turn the call back over to Mr. Kent Masters for closing remarks.
Kent Masters: Okay. Thank you. And thank you all again for your participation on our call today. As we approach the end of the year, I'm extremely pleased with the progress and the focus our team has demonstrated. I look forward to updating you in February when we announced full-year results and provide more detail on 2022 objectives and outlook. This concludes our call and thank you for your interest in Albemarle.
Operator: Ladies and gentlemen, thank you for your participation in today's call. You may now disconnect at this time. | [
{
"speaker": "Operator",
"text": "Ladies and gentlemen, thank you for standing by and welcome to the Q3 2021 Albemarle Corporation earnings conference call. At this time, all participants are in a listen-only mode. After the speakers' presentation, there will be a question-and-answer session. [Operator Instructions] I would now like to hand the conference over to your speaker today, David Burke, Director of Investor Relations. Thank you. Please go ahead."
},
{
"speaker": "David Burke",
"text": "Thank you, and welcome to Albemarle's Third Quarter 2021 Earnings Conference Call. Our earnings were released after close of market yesterday and you'll find our press release, earnings presentation, and non-GAAP reconciliations posted on our website under the Investors section at www. albemarle.com. Joining me on the call today are Kent Masters, our Chief Executive Officer, and Scott Tozier, our Chief Financial Officer. Raphael Crawford, President of Catalysts, Netha Johnson, President Bromine Specialties, and Eric Norris, President of Lithium, are also available for Q&A. As a reminder, some of the statements made during this call, including our outlet guidance, expected Company performance, and timing of expansion projects may constitute forward-looking statements within the meaning of federal securities law. Please note the cautionary language about forward-looking statements contained in our press release and earnings presentation. Same language applies to this call. Please also note that some of our comments today refer to non-GAAP financial measures, A reconciliation to GAAP financial measures can be found in our earnings release and the appendix of our earnings presentation, both of which are posted on our website. Now, I will turn the call over to Kent."
},
{
"speaker": "Kent Masters",
"text": "Thanks David, and thank you all for joining us today. On today's call, I will highlight our quarterly results, provide an update on our goals for 2021 and discuss the progress of our ongoing expansion plans. Scott will provide more detail on our results, outlook, and guidance. We reported another solid quarter with net sales of $831 million and adjusted EBITDA of $218 million. Sales improved by 11% on a year-over-year basis, while adjusted EBITDA was relatively flat compared to the third quarter last year. Excluding SCS from our third quarter 2020 results our net sales were 19% higher, and EBITDA was up 14%. Scott will get into more detail on our financials in a few minutes, including favorable revisions to our guidance. As we stated in our earnings release this morning, we increased our guidance based on the third quarter results. During our recent investor day, we did a deep dive into our accelerated growth strategy and provided color on how we think about the near-term expansion of our Lithium business, as well as our disciplined investment approach. Since that event in early September, we are pleased to have announced several updates on those efforts. This includes signing an agreement to acquire Guangxi Tianyuan New Energy Materials or Tian Yon, which owns a recently built conversion plant near Qinzhou. We are totaling to ensure the plant operates as advertised and expect to close this transaction in the first quarter of next year. This puts us on track for first sales from this plant in the first half of next year. In addition to this plant, we have signed two recent agreements for investments in China to support 2 Greenfield projects. Each initially targeting 50,000 metric tons per year. These projects position us for initial added conversion capacity, up of up to 150,000 metric tons of lithium hydroxide on an annual basis to meet our customer's growing demands. In addition, our Marble joint venture announced the restart of the Wodgina lithium mine in Western Australia. On Slide 5, you will see the objectives we set for 2021. When we set these goals, we did so with the intent of challenging ourselves with plans that were aggressive, but achievable. As we approach the end of the year, I'm excited by the significant progress and proud of the effort our team has put into achieving these goals. As you see on the slide, we have accomplished the vast majority of what we set out to do. For example, we are successfully progressing high-return, fast-payback roaming projects at both Magnolia and JBC. These projects will increase our capacity and improve the efficiencies of our operations. We've also made significant progress on our lithium growth projects. Now let's turn to slide 6. First at La Negra 3 and 4, our team continues to execute the plan. I'm excited to announce that we recently completed a major milestone by achieving first lithium carbonate production in late October. Initial production volumes will be used to qualify the plant and the material with our customers to ensure we are meeting their requirements. This qualification process is proceeding on track with first sales expected in the first half of next year. In Western Australia, the ongoing labor shortages and pandemic related travel restrictions, have continued to significantly impact virtually all companies in that region and showed no signs of easing in the near-term. Despite these efforts and with herculean efforts, our team has managed to hold Kemerton 1 construction completion to year-end 2021. We now expect Kemerton 2 construction completion in the second half of 2022. While we are facing challenges at these projects, our strategy to consolidate resources and prioritize the first train continues to mitigate additional risks. On Slide 7, I'll highlight the progress we've made on our Wave 3 program since we last spoke to you at our Investor Day. At the end of September, we announced an agreement to acquire Tianyuan for $200 million, including a recently built conversion plant near the port of Qinzhou, designed to produce up to 25,000 metric tons of lithium per year, with the potential to expand to 50,000 metric tons per year. We expect this acquisition to follow a similar path as our acquisitions of Xinyu and Chengdu facilities back in 2016. Following the close of the transaction, which is expected in the first quarter of next year, we plan to make additional investments to bring Qinzhou plant to Albemarle standards and ramp to initial production of 25,000 metric tons. This acquisition enables us to accelerate conversion capacity growth and leverage our world-class resource space. Together with our partner, we agreed to restart operations at the Wodgina Lithium Mine in Western Australia. Initially, Wodgina will begin 1 of 3 processing lines, each of which can produce up to 250,000 metric tons of lithium spodumene concentrate. This resource will be critical as we ramp our conversion capacity in Western Australia with our Kemerton sites. We also signed agreements to invest in 2 Greenfield conversion sites in China at Zhangjiagang and Meishan. We plan to build identical conversion plants with initial target production of 50,000 metric tons of battery-grade lithium hydroxide at each site. These investments offer additional optionality for future growth and have expansion potential. Investing in China offers capital efficient, high return growth with proximity to our low cost Australian spodumene resources and many of our major cathode and battery customers. We continue to explore global expansion of our conversion capacity as the battery supply chain shifts west. Turning to Slide 8 for a review of our global project pipeline. As you can see, Albemarle is executing a robust pipeline of projects all around the world. For example, our Bromine business is pursuing incremental expansions in Jordan and the U.S.. These high return projects leverage our low-cost resources and technical know-how to support customers and growing and diverse markets, like electronics, telecom, and automotive. In Chile, the Salar Yield Improvement Project allows us to increase lithium production without increasing our brine pumping rates, utilizing a proprietary technology to improve efficiency and sustainability. In Australia, we continue to progress study work on additional Kemerton expansions to leverage greater scale and efficiency with repeatable designs. Finally, in the U.S., we are expanding our Silver Peak facility in the Nevada to double Lithium carbonate production. This is the first of several options to expand local U.S. production. In Kings Mountain, North Carolina, we continue to evaluate restarting our mine. And that our Bromine facility in Magnolia, Arkansas, we're evaluating the process technologies to leverage our [Indiscernible] to extract lithium. We'll continue to update you periodically on our pipeline. I hope this gives you a sense of the diversity and optionality Albemarle has as a global lithium producer. I'll now turn the call over to Scott for a look at the financials."
},
{
"speaker": "Scott Tozier",
"text": "Thanks, Kent, and good morning, everyone. Let's begin on Slide 9. During the third quarter, we generated net sales of $831 million, an 11% increase from the same period last year. This improvement was driven by strong sales for our lithium and bromine segments. Adjusted EBITDA was essentially flat on a year-over-year basis, resulting from the sale of FCS and increased freight and raw material costs. The GAAP net loss of $393 million includes a $505 million after-tax charge related to the recently announced Huntsman arbitration decision. While we continue to assess our legal options. We have also initiated discussions with Huntsman regarding a potential resolution. Excluding this charge, adjusted EPS was a $1.05 for the quarter, down 4% from the prior year. Now, let's turn to Slide 10 for a look at adjusted EBITDA by business. Third quarter adjusted EBITDA of $218 million increased by 14% or $27 million compared to the prior year, excluding the sale of SCS. The higher adjusted EBITDA for Lithium and Bromine was partially offset by $13.5 million out-of-period adjustment regarding inventory valuation in our international locations impacting all three GBUs. Lithium's adjusted EBITDA increased by $25 million year-over-year, excluding foreign exchange. We were able to offset the limited impact of a 1-month strike in the Salar in Chile, thanks to higher tolling volumes and higher spodumene shipments from our Talison joint venture. Adjusted EBITDA for bromine increased by $5 million dollars compared to the prior year due to higher pricing, partially offset by increased freight and raw material costs. Volumes were flat, given the chlorine constraints in the quarter. In Catalysts, adjusted EBITDA declined $4 million from the previous year. This was due to lower sales and cost pressures, partially offset by higher-than-expected joint venture income, which included a favorable tax settlement in Brazil. Slide 11 highlights the Company's financial strength. That is key to our ability to execute our growth plans over the coming years. Our net debt to EBITDA at the end of the quarter was 1.7 times as below our targeted long-term range of 2 to 2.5 times. This provides us with capacity to fund growth while supporting modest dividend increases. We don't expect the recent arbitration decision to impact our current growth plans. But it could temporarily reduce our flexibility to take advantage of upside growth opportunities. Turning to Slide 12, I'll walk you through the updates to our guidance that Kent mentioned earlier. Higher full-year 2021 net sales and adjusted EBITDA guidance reflects our strong third quarter performance. Net cash from operations guidance is unchanged due to the timing of shipments to customers and increased raw materials and inventory costs. Capital expenditures were revised higher, related to the continuing tight labor markets and COVID related travel restrictions in Western Australia, as well as accelerated investments in growth. Turning to slide 13 for more detailed outlook on each of the GBUs, lithium's full-year 2021 adjusted EBITDA is now expected to grow in the mid-to-high teens year-over-year. That's up from our previous guidance due to higher volumes and pricing. The volume growth is driven primarily by tolling. And our full-year average realized pricing is now expected to be flat to slightly higher compared to 2020. As a reminder, most of our Battery-grade lithium sales are on long-term contracts with structured pricing mechanisms that are partially exposed to the market. We also benefit from stronger market pricing on shorter-term technical grade sales and on spot and tolling sales of battery-grade lithium. Full-year 2021 average margins are expected to remain below 35% due to higher cost related to the project startups and tolling partially offset by productivity improvements. Bromine 's full-year 2021 adjusted EBITDA growth is now expected to be in the low double-digits. That's also up from previous guidance due to the continued strength in demand and pricing for flame retardants. Our bromine volumes remain constrained due to sold-out conditions and a lack of inventory. The outlook for chlorine availability has improved since last quarter, but the market remains tight. And the impact of higher chlorine pricing is expected to be felt more in 2022 than in 2021 due to the timing of inventory changes and shipments. Year-to-date, higher bromine pricing has mostly offset higher raw material and freight costs. Catalyst full-year 2021 EBITDA is now expected to decline between 20% and 25%. That's also an improvement from our previous guidance, owing to the higher-than-expected joint venture income. The year-over-year decline in adjusted EBITDA is primarily due to the impact of the U.S. Gulf Coast winter storm in -- earlier in the year, product mix and the previously disclosed change in our customer's order patterns. Catalysts fourth-quarter margins will also be impacted by product mix, including a greater proportion of lower margin FCC and CFT [Indiscernible] orders. SCS demand continues to improve with increasing global fuel demand while HPC orders continue to be delayed. Overall, market conditions are improving, but volumes in Catalysts are not expected to return to pre -pandemic levels until late 2022 or 2023. In total, we expect EBITDA margins to be lower in the fourth quarter due to higher raw materials, energy, and freight costs across all three of our businesses. We are closely watching several key risk factors, including global supply chain disruptions, global impacts of the energy rationing in China and chip shortages. Supply chain and logistics challenges are the most immediate. Our teams are working day and night to navigate these port issues, the lack of drivers, and upstream supply disruptions to ensure our customers get their orders on time. We also continued to monitor the global situation with regard to chip shortages. We recognize that the auto industry has been struggling with those shortages. But to-date, we have not seen a direct impact on either our lithium or bromine orders. And with that, I'll hand it back to Kent."
},
{
"speaker": "Kent Masters",
"text": "Thanks, Scott. I'll end our prepared remarks on Slide 14. As Scott mentioned, we are disappointed by the outcome of the Huntsman arbitration decision. But regardless of the ultimate outcome of that dispute, Albemarle will continue to focus on the execution of our growth strategy. As we highlighted during our Investor Day in September, we have a well thought out and focused operating model that we are implementing across our businesses. This model, the Albemarle way of excellence, provides us with a framework to execute our objectives effectively and efficiently, and will help us to remain on target as we pursue the significant growth opportunities ahead. And as we pursue these opportunities, we will be disciplined in our approach to capital allocation. Our primary capital priority is accelerating high return growth. This means that we will invest not just to get bigger, but to create tangible shareholder value and maintain financial flexibility to take advantage of future opportunities. Utilizing this approach with our low cost resources, we believe our annual adjusted EBITDA will triple by 2026. Finally, at the core of all of this is sustainability. As 1 of the world's largest lithium producers and innovators, we were able to work closely with our customers to create value and drive better sustainability outcomes for all stakeholders. With that, I'd like to open the call for questions. I'll hand over to the Operator."
},
{
"speaker": "Operator",
"text": "Thank you, sir. And at this time, ladies and gentlemen, if you would like to ask a question during this time, [Operator Instructions]. Your first question comes from the line of John Roberts with UBS."
},
{
"speaker": "Matthew Konosky",
"text": "Morning, this is Matt Gawronski (ph) on for John. In the past, you mentioned that Kemerton maybe able to ramp the 40% to 50% of capacity in a year following its commissioning and qualification process. Is this still the case for that first line that's supposed to be done with construction at the end of this year? Or is it going to take some additional time due to the constraints going on right now?"
},
{
"speaker": "Kent Masters",
"text": "So after that I think we got to get through mechanical completion then we've got the commissioning qualification. So -- and then I think what we've said is after that and that's about a 6-month process. Then after that, we think we would be able to ramp to maybe 50% in the first 12 months. That's probably a little aggressive, but that -- that's what we're targeting. And then, I think the labor and all those issues are primarily around construction. We've got operators in -- staffed and onboard, and they're helping with commissioning so, I mean, the labor market is going to be tied, and we'll -- we may fight to keep the ones we want, I'm not sure, but the real labor issue is around construction."
},
{
"speaker": "Matthew Konosky",
"text": "Thank you. And then, Scott, you mentioned the HUN arbitration issue could impact your ability to opportunistically take hold of growth opportunities. Is that organic or just inorganic opportunities?"
},
{
"speaker": "Scott Tozier",
"text": "Yeah, I think it's really more -- truly 2. I think partly on the organic side, it's our ability to accelerate or further accelerate our projects. We'll be able to do some of it, but clearly, it's a big drag. And then the second is, any sort of larger type of inorganic would be -- would need some sort of more creative type of financing to do."
},
{
"speaker": "Operator",
"text": "Your next question comes from the line of P.J. Juvekar with Citi."
},
{
"speaker": "P.J. Juvekar",
"text": "Yes. Hi, good morning."
},
{
"speaker": "Kent Masters",
"text": "Good morning."
},
{
"speaker": "P.J. Juvekar",
"text": "So now that you expect lithium prices to be flat to up for this year and sort of down, are you -- must be expecting price gain in 4Q that are well into double-digits. Can you comment on that? And then, even as you look forward into next year, what percent of your contracts will be renewed next year? And do you have any early look into negotiations? Thank you."
},
{
"speaker": "Eric Norris",
"text": "So P.J., good morning, it's Eric. I want to make sure I understand your first question. Your first question was, would they be double-digit in Q4, is that what you said?"
},
{
"speaker": "P.J. Juvekar",
"text": "Yes. As well into double-digits for Q4 for your pricing."
},
{
"speaker": "Eric Norris",
"text": "The way to think about pricing is and the flat-to-down comment is that it's progressive throughout the year. Prices were at their lowest point late last year and early this year and have been gradually rising as we've gone through the year due to 2 factors, 1 is the exploration and the concession we gave against a fixed priced long-term agreement. And the second would be just the movement of spot prices for that portion of our business is exposed to that -- those markets, which I'm sure you're aware, know. Those price has gone up significantly and throughout the course of the year. So as the guidance we've given, that Scott gave at Investor Day for next year, was at least 15% to 20% year-on-year increase for 2022 versus 2021. And certainly, that's a progressive trend. So you could certainly see those kinds of increases starting to happen in Q4 versus a year ago."
},
{
"speaker": "P.J. Juvekar",
"text": "Okay, great. And then on marble, you're restarting one of the 3 lines. Rock prices have skyrocketed, so why just 1 line? And then where would you concentrate that rock? Would that be at [Indiscernible]? Would that be in China? Can you just talk about that?"
},
{
"speaker": "Kent Masters",
"text": "Yeah. So the -- P.J., it's Kent, so I think we're going to get started on one and we'll ramp other facilities over time, but it's really our capacity to convert. So we're not really mining rock to sell spodumene into the market, we're mining rock to convert spodumene into finished products. And we'll do that at Kemerton. Initially -- I mean, I guess we haven't worked out exactly what the logistics are. So that product may go to China and other products go to Kemerton. So we just have to balance our sourcing of facilities, but that's the next tranche of our product in that part of the world."
},
{
"speaker": "Operator",
"text": "Your next question comes from the line of Laurence Alexander with Jefferies."
},
{
"speaker": "Laurence Alexander",
"text": "Good morning. First, on the bromine pricing, can you discuss how much of that you feel was transitory versus sustainable given the demand trends you're seeing? And can you give any sense of the magnitude of the chlorine headwind for this year, so that we have some better context for the larger-than-this-year headwind next year?"
},
{
"speaker": "Raphael Crawford",
"text": "I think, in terms of the pricing, we could probably figure most of that is transitory. It's based on the raw materials pricing that we pay and in the ability for us to absorb that and managed as we price forward. And in terms of the chlorine impact, it's more of a timing issue. We're going to get more chlorine next year, probably a different price than we're going to get this year. So you'll see that really impact us starting woefully in Q1 next year throughout the year."
},
{
"speaker": "Laurence Alexander",
"text": "And then with Catalysts, the recovery next year, how much of your -- should that be lighting or coincident with production ramp-ups at the refineries?"
},
{
"speaker": "Raphael Crawford",
"text": "Hey, Lawrence, this is Raphael. The FCC business is very ratable to miles driven and that correlates to refining output. So I think FCC as is mentioned, sequentially continues to improve from a volume standpoint. So that one you would see first and there's usually a lag on hydroprocessing, which is 12 to 18-month lag. As conditions improve in refineries to get more capital availability and then reinvest in change outs for HPC. So that has more of the lag effect. But overall, at [Indiscernible] we see sequential improvement, we see refining conditions improving. We're very tied to that with our performance products, so we see that as a favorable outlook going forward."
},
{
"speaker": "Operator",
"text": "Your next question comes from the line of Bob Koort with Goldman Sachs."
},
{
"speaker": "Mike Harris",
"text": "Yeah, this is actually Mike Harris sitting in for Bob. If I could, might ask a question around the Lithium business, looking at the energy storage related sales, why is there a potential 1 to 2 quarter lag behind the EV production versus those sales actually, maybe leading?"
},
{
"speaker": "Eric Norris",
"text": "Yes, Mike, it's Eric here. It's simply a factor of the length of the supply chain. Lithium is consumed in the cathode material, which then is formulated into -- an electrode that's put into a battery. The battery is then assembled and then put into an ED car so that it's just the length of time that takes and the geographies involved. Most of the cathode -- nearly all the cathode production and a good amount of the battery production still is in Asia. And of course cars are produced various points around the world. So it's just the length of the supply chain. We are -- we see that lag, but recall we're well-positioned, we're able to supply anywhere in the world. So we look -- we are well-positioned to grow with the industry, but that lag is likely to remain there, given the length of the supply chain."
},
{
"speaker": "Mike Harris",
"text": "Got it. Okay. That helps. And then also, just as a follow-up, when I think about lithium recycling, can you give me an idea of what kind of assumptions you guys have made around recycling and perhaps the potential impact on your business, if any at all?"
},
{
"speaker": "Eric Norris",
"text": "Recycling is a phenomenon that follows the end of life of batteries and further still want to have to factor in potential reuse of batteries. And given the 10-year life-cycle that is warranted on most batteries produced for automotive production. That's the kind of lag you're looking at. So batteries being produced today wouldn't even be considered for recycle until ten years from now. When we look at that, that means that we see recycling becoming important as the decade wears on. But still, by the middle of the decade being fairly small amount of lithium needed in the supply chain and maybe reaching a double-digit amount of a low double-digit amount of possible coming back into the stream by 2030."
},
{
"speaker": "Operator",
"text": "Your next question comes from the line of David Begleiter with Deutsche Bank."
},
{
"speaker": "David Huang",
"text": "Hi there. This is David Huang here for Dave. I guess, 1st, can you talk about your feedstock [Indiscernible] strategy for that 150K ton of lithium hydroxide capacity you're adding in China?"
},
{
"speaker": "Raphael Crawford",
"text": "I'm sorry. So that was the feed-stock strategy for the 150 new projects in China?"
},
{
"speaker": "David Huang",
"text": "Yes."
},
{
"speaker": "Raphael Crawford",
"text": "So they'll be said with our [Indiscernible] coming out of Australia."
},
{
"speaker": "David Huang",
"text": "Okay. And then secondly, are there any incremental headwinds or tailwinds to your 2022 guidance you provided, I mean, [Indiscernible], especially for a [Indiscernible] or do you still standby those guidance?"
},
{
"speaker": "Raphael Crawford",
"text": "Yes. We haven't updated our guidance since the Investor Day. So we're going through our annual operating plan process right now. In fact, next meeting is next week and we'll give you a more definitive guidance in our fourth quarter earnings call."
},
{
"speaker": "Operator",
"text": "Your next question comes from the line of Joel Jackson with BMO Capital Markets."
},
{
"speaker": "Female_1",
"text": "Hi, this is Bremer (ph) [Indiscernible] of Joel, thanks for taking my question. Just back on the pricing discussions in 2022, can you just give us a little bit more color on how the discussions with your lithium contract listeners are going? And then, are pricing mechanisms going to be similar in '22 to '21 or is there a move more to benchmark pricing?"
},
{
"speaker": "Eric Norris",
"text": "So the -- generally speaking, Bravey (ph), the discussions we're having with our customers are for price increase next year per -- and that aligns with the guidance I gave you in the remarks just a few moments ago. We have a book of contracts we've had under our basket, I should say, for some years now. Those are going back either to -- well, those are -- the fixed portion of those contracts are going back to the original long-term agreement, which is significantly higher in some cases than the average price that we're seeing for 2021. And then there is many of those contracts have a variable component and there is no one contract that looks exactly like the other, but that variable component can. We will also see increases. Some of those variable components are tied to indices. Others are just an annual increase nomination that's possible, a max increase nomination. And then finally, we have a good deal of technical-grade contracts where we'll see rising prices based upon an adjustment to what -- the rises we've seen this year, as we roll into next year. The last piece would be our China spot business. And that -- hard to say that we'd see a pretty big increase on that next year because prices are already extraordinarily high in China right now. But we'll continue to see possibly some upside on a year-over-year basis, particularly in the early part of the year, next year on that. So those are all the components that are driving our increase and types of discussions we're having with our customers which will give us nice leverage, upside leverage to the improving market conditions."
},
{
"speaker": "Female_1",
"text": "Okay, that's certainly helpful. Thank you. And then I guess just like given the large upswing in LFP demand in recent tests of commentary, with that background, I just want to understand how you're thinking about investments into carbonate versus hydroxide. It seems your incremental investments are mostly focused on hydroxide currently."
},
{
"speaker": "Eric Norris",
"text": "We see -- we monitor this very closely, we have a lot of analytics and customer dialogues up and down the supply chain from OEMs all way that back through the battery and cathode producers to assess those trends. What we believed and has been confirmed in our discussions with customers is while there is an uptake in LFP demand, there has also been an uptake in vehicle production outlook as well for electric vehicles. And where LFP is occupying a sweet spot is in the lower cost range, lower costs and lower driving range portion of the vehicle mix. For some automotive producers that will be a larger percentage of their mix than others. Bottom line, we see strong growth in both of those products, albeit we see still pretty -- the growth rate in hydroxide will be higher over the coming 5 years. And hence, we feel we're extremely well-positioned. We're bringing on 40,000 tons of carbonate capacity as we speak. And we have the hydroxide expansion strategy in addition to the Kemerton ramp that they can't earlier describe and feel we're well-positioned to meet both LFP demand and rising high - nickel demand for cathodes."
},
{
"speaker": "Operator",
"text": "Your next question comes from the line of Jeff Zekauskas with J.P. Morgan."
},
{
"speaker": "Jeff Zekauskas",
"text": "Thanks very much. You've described your lithium prices as perhaps being up 15% to 20% or more next year. Is the 15% to 20% representative, given market conditions, could it be up 30?"
},
{
"speaker": "Scott Tozier",
"text": "Well, I think it depends, as you might think, Jeff, on [Indiscernible] conditions. There's a portion of our business that is exposed to market -- pure market conditions. The majority of our business, even while there is on these long-term contracts, there's a variable component that the anchor around that is going to be around the fixed price, which is also going up because of the exploration of the concessions we gave. So at this point, it's probably too early to say what we think about price above 15% to 20%, because our guidance was at least 15% to 20%,"
},
{
"speaker": "Eric Norris",
"text": "Right."
},
{
"speaker": "Scott Tozier",
"text": "So we'll have to provide you as the quarter wears on and the discussions continue that guidance as we get into the February call -- earnings call that we'll have in February."
},
{
"speaker": "Eric Norris",
"text": "Okay. Then for my follow-up, when I look at quoted bromine prices in China, maybe since August, they're up 60%, something like that. Is that a representative price for what's going on in the market or it's not a representative price? Can you speak to bromine pricing in Asia and where it's been and where you see it going? What's driving it?"
},
{
"speaker": "Netha Johnson",
"text": "Yeah, Jeff, this is Netha. That's a reflection of a couple of things. First of all, demand is up, clearly across the market, and raw material pricing are up to produce brominated products that are being required. So what you're seeing is that's what's driving an enormous amount of price increase in the Chinese spot price."
},
{
"speaker": "Operator",
"text": "Your next question comes from the line of Ben Kallo with Baird."
},
{
"speaker": "Ben Kallo",
"text": "Thank you guys, and good morning. One of the things that we are thinking about is -- I love to hear your perspective with materials maybe being a bottleneck for EV production sales. If that's -- how you guys view that as a risk? Just overall -- meaning, is there enough lithium reserve, enough copper reserve, enough nickel? And then, how are customers, I guess, approaching you [Indiscernible] and your competitors for security in the supply chain. Does that -- does your scale and your diversity of your resources give you an advantage there over other people [Indiscernible] Will be more [Indiscernible] wrap up. Thank you."
},
{
"speaker": "Kent Masters",
"text": "We talked a little bit about lithium, so copper, nickel, I don't know that we will want to weigh in on that, but we just talk -- I'll make a few comments, and then Eric can add some detail to it, but we 're investing heavily to keep up with that demand and maintain our share, which has been our strategy. And so we're investing along with our customers and security supply has always been a key part of the value proposition from Albemarle to their customers. And particularly around lithium. As you mentioned, the diversity of resources, the diversity of locations where we produce, and the -- we have carbonate and we have hydroxide today, and then we'll continue to evolve those chemistries as the market shift over time. So I think the network that we build is really a lot of that is focused around security of supply, and part of the key value proposition that we talk about constantly with our customers."
},
{
"speaker": "Eric Norris",
"text": "Then I'll just add on the lithium side of material risks. There's enough material, there's enough lithium out there. The issue is the investment required to get there and the fact that it's going to be at a higher costs. The cross curve is upward sloping as you go to lower quality lithium resources that are out there. The discussions we're having with our customers are ones of deep desire for commitment and partnership. That's both the existing ones we've had, and as we bring on new capacity, new ones that we would look to target. And that's at various points in the value chain, but I would tell you that the most significant and urgent discussions around security are the closer you get to the automotive OEM. And so I think our track record of executing gives us that advantage for sure. And I think that's where the discussions land as us being sort of a base load partner for many of these automotive and battery firms. So I do think that's an advantage we have for sure."
},
{
"speaker": "Ben Kallo",
"text": "Thank you, guys. It's about to get too ahead ourselves here, but are you at a point that you are allocating to customers? So you're picking your customers more than they are picking you or is it not like that? And thanks, guys."
},
{
"speaker": "Eric Norris",
"text": "So I would say that's the merit of the partnership and why we have the discussions we do, because anyone -- any buy in who is not committed to us in a long-term way, so that could be a spot buyer on the battery side, that could be a tech grade buyer on the industrial side is -- does risk not getting the volume that they would like as we roll into 2022. So that's the basis for the partnership discussions that we're having is that desire for securities supply, given the points in time in that supply in the coming 5 years where things will be tightened, they are quite tight right now."
},
{
"speaker": "Operator",
"text": "Your next question comes from the line of Vincent Andrews with Morgan Stanley."
},
{
"speaker": "Male_1",
"text": "Hi. This is [Indiscernible] to you on for Vincent. Thank you for taking our question. Just back to the Huntsman arbitration, curious. What other alternatives are there in terms of discontinued process. I know you mentioned you've started to have discussions around settlement. So what other -- from a legal perspective, what other alternatives are there? And then how should we think about the timing of all of this?"
},
{
"speaker": "Kent Masters",
"text": "Well, I think it's -- it's a range. And we're not going to get into too much because there's an active process. So it is either through the arbitration process or from discussions that we've initiated that we would be able to -- that we could potentially reach agreement and resolve that matter. But it's a pretty -- those are the options and it's the time frame is pretty wide."
},
{
"speaker": "Male_1",
"text": "Understood. And then as we think about Kemerton and your ability to fulfill those contracts particularly Kemerton 2 given the longer delay, will those be fulfilled through more tolling or how should we think about the volume and how that will be allocated in terms of -- as we think about next year, 2023, would that be less volume overall or just lower margin from tolling?"
},
{
"speaker": "Kent Masters",
"text": "Well, I think you'll see us -- you will fill that with tolling, and with this acquisition that we've done, and we expect to get that up to speed relatively quickly. I mean, there will be some -- we expect to do make rights to get it to our standard and the quality that we want. But we'll be aggressive around that. Those will be the two methods that we use to stay on our plan."
},
{
"speaker": "Operator",
"text": "Your next question comes from the line of Kevin McCarthy with Vertical Research."
},
{
"speaker": "Cory Murphy",
"text": "Hi, good morning. This is Cory Murphy on for Kevin. I wanted to follow on -- I think it was PJ's question earlier about Wodgina, you said you were starting up one line and it looks like it's going to start production maybe in the third quarter of 2022. Can you help me understand what the delays are or why the restart process seems to take maybe upwards of 6 to 10 months? And then given spodumene prices, why wouldn't you startup or try to start up all three lines? Are you able to sell the spodumene on the spot market or is it that there's contractual reasons not to?"
},
{
"speaker": "Kent Masters",
"text": "Well, it's -- on the selling spodumene, it's really strategic reasons, is that we want to convert it and sell the finished products to customers where we'd make commitments and we have long-term arrangements. So we might sell some spodumene here in there, but that's not our strategy. And then the starting up -- I mean, we might -- we're going to do -- start to first train then other. It's really neat to be in line with our conversion capacity. And then that timeline that you referenced where 6 or whatever the timeframe is to get it going, you've got labor issues in Western Australia, we face the same things there that we do at Kemerton to some degree, and really the lead time is on some of the big equipment that's necessary in mining, some of the yellow -- we call it -- they call it yellow equipment, that's necessary in operating these mines and the lead time on that."
},
{
"speaker": "Cory Murphy",
"text": "Understood. That's very helpful. And then I just wanted to ask about tolling as well. It sounds like there's more tolling due to labor shortages or labor strikes in Chile. How would your volume trend without tolling? And when do you anticipate rolling off the tolling contracts related to the La Negra startup? I think you said you're bridging some capacity with that."
},
{
"speaker": "Eric Norris",
"text": "Right. Well, I would say tolling is a strategy we use for bridging. That is correct. We do that. We expect to continue to toll next year for the purposes of La Negra, but also for the purposes of Kemerton. Look, I mean, I -- it's a bridging strategy, but the market is extremely strong right now. And because Kemerton has been delayed, there's spodumene that we can take advantage of. And as long as we have qualified tolling partner that is someone with -- we have a good relationship, we trust our quality. We have a business relationship where we can collaborate together, then we'll take advantage of that, both to bridge and take advantage of the strong market that's before us. So I think it's a variety of purposes. When it rolls off, it's hard for me to say, but we will have it as part of next year for sure."
},
{
"speaker": "Operator",
"text": "Your next question comes from the line of Colin Rusch with Oppenheimer & Co."
},
{
"speaker": "Colin Rusch",
"text": "Guys, thanks so much for all of these information. I'm curious about the order patterns from your customers. And this is a cross the you [Indiscernible]. If you're seeing any sort of double ordering that you can track or track all of the sell-through for those individual customers. Just it seems like that there may be some folks trying to build some inventory or really trying to give character or any other incremental demand that they could mean."
},
{
"speaker": "Eric Norris",
"text": "Colin, Eric, from a Lithium perspective, I would say that there is -- we're very -- we touch all aspects of the supply chain. And so I don't see any double ordering. And furthermore, to buttress that remark, I would say that the discussions we have with our customers, we know they don't have any inventory. They are hand-to-mouth. So we know that because when -- with this crisis existing around the global supply chain, you can imagine we're not always able to precisely target the week or the day at which a shipment's going to arrive, and that causes pain for the customer. If it causes -- if it does for us, it does for them as well. So it's a very tight market still in lithium."
},
{
"speaker": "Netha Johnson",
"text": "Hi, Colin, bromine. We're not seeing any double ordering court. Customers are not trying to build inventory at their sites in anticipation of supply chain disruptions. Supply chains are tight and things are difficult, but we've been able to manage it to a certain extent to where we can deliver within a window that they can live with. So we're not seeing those double orders or customers try to build-up inventory by ordering more than they need right at this time."
},
{
"speaker": "Raphael Crawford",
"text": "Nor in Catalysts, either, Colin."
},
{
"speaker": "Colin Rusch",
"text": "Okay. Thanks, guys. And then just on the lithium content per kilowatt hour, are you guys seeing any real trend lines on that? Certainly as some of these battery chemistries change. And folks are looking to figure out how to optimize some of the materials. Are you seeing lithium content increase, decrease, hold steady? And where would you peg that level right now?"
},
{
"speaker": "Eric Norris",
"text": "For the most part, I think as we sit here and look at the year 2021, we've seen any material change. Certainly we would expect it over a period of years as prelithiation enters the equation on the anode side. As further as our progress on solid-state or lithium metal anode technology progresses. That's definitely going to increase the content as it does, obviously the energy density, which is the whole point of those technology innovations. But as you sit here today, I think the technology trends are alive and well, but it's on a quarterly basis during 2021, and really I haven't seen significant change necessarily in that."
},
{
"speaker": "Operator",
"text": "Your next question comes from the line of Arun Viswanathan with RBC Capital Markets."
},
{
"speaker": "Arun Viswanathan",
"text": "Great, thanks for taking my question. I guess I had a question just on the contracting process here. What are you hearing from your customers as far as length? Are those contracts in lithium extending out now to 4 or 7 or 10 years? And then when you when you do those contracts, how do you kind of bridge the divide between this huge spot price of $28,000 plus per ton and something more reasonable and more in line with the increases from where you are on the contract side. I guess I'm just asking. Are you -- have you seen a material rise in the cost curve that would justify contracts going closer to spot? Thanks."
},
{
"speaker": "Eric Norris",
"text": "I would say that there is -- the duration of requests from customers are increasing. I think we've characterized in the past, and on average it's about 3 years in our current mix. The new contracts under discussion, which would be slated to supply against the China expansions that Kent described, or future Kemerton expansions, or even down the road expansions we could have in the U.S. Those discussions are either 5-year plus or they don't even start until 2024, 2025. So we're having discussions with certain customers who are contracting for increments of time into the future, say '23 to '26, or '24 or '28. Those are the kinds of durations that people are thinking about and that's largely driven by the investments made on the automotive side. From a pricing standpoint, you can imagine because prices are rising, there's certainly a desire on behalf of those buyers to see what they can to not have to pay spot prices. But the reality is they either -- the discussion is either towards a much higher fixed price if they want some stability in their pricing term, or we're pricing against an established index so that it will rise with time. Now, remember the price you gave was a spodumene price when you said $2,800 a ton, the pricing in China is, on a U.S. basis is in the high 20s, close to 30 on a delivered basis. When you look at many of the indices around the world, most of these people are buying against a blend, and so the pricing around that is not quite as high, but it's still well into the high teens, if not the low 20s of what a lot of those pricing indices are. So we continue to have a discussion with customers and -- but those are some of the dynamics at play, which are leading us to long-term contracts with significantly higher price potential than what we're -- we've seen in the past."
},
{
"speaker": "Arun Viswanathan",
"text": "Great, thanks for that. And then, I guess, just wanted to ask about the -- if there's any risk that you see on the political front in Chile -- yeah, it's a broad question -- I guess in the next month or two or so?"
},
{
"speaker": "Kent Masters",
"text": "There's a lot happening in Chile, so there's definitely political risk in Chile. They rewrite the constitution and things are changing. And we watch it closely and we operate there. So we -- and we're pretty close, we're close to the government. We see what's happened, but they are rewriting their constitution and there'll be changes in Chile. I think Chile wants to participate in lithium industry. They're looking to expand their participation. The contracts -- the agreements they have with us are very progressive, so they participate as prices go up. So that's an upside for them. So I believe they're going to -- they want to participate in that economically. But there's a lot happening in Chile at the moment, and we're watching it very closely."
},
{
"speaker": "Operator",
"text": "Your next question comes from the line of Matthew DeYoe with Bank of America."
},
{
"speaker": "Matthew Deyoe",
"text": "Thank you. So we touched a bit on tolling. I want to delve a little bit into it a little bit more because I know you said it's a bridging strategy and maybe we can be opportunistic. But you're sitting on a fair amount of latent capacity at Greenbushes. And the read seems to be that converters are struggling to find enough merchant supply of spodumene to actually continue to operate in some respect, so why not get more aggressive on the volume? I have to think: 1. Prices right now are really attractive but, 2. Almost somewhat concerning as it relates to the potential for over-investment and overheating in markets and things like that etc. I feel like if you -- with your volume, you might have an ability to kind of regulate this a little bit."
},
{
"speaker": "Kent Masters",
"text": "Yeah. So I'll make a comment, and Eric can add some color on it. We don't -- we can't just turn a toller on because we -- they are going to our customers, we have to qualify them. So there is a process there. And not all of those tollers would qualify with our customers. So it's not -- we can't just turn them on. It's not quite that simple, even if we had the products. So now we're ramping and getting more spodumene going. It could give us optionality from a spodumene standpoint going forward, but we still have to make sure we choose the ones, and Eric talked about it, before they're people, they're tollers that we have relationships with that have been previously qualified or currently qualified with our customers. So you have to fit in all of those elements into it to really ramp it up. It would be a -- it's not a 6 months strategy. It's going to take a little longer to implement that."
},
{
"speaker": "Matthew Deyoe",
"text": "Okay."
},
{
"speaker": "Kent Masters",
"text": "[Indiscernible] anything?"
},
{
"speaker": "Eric Norris",
"text": "I think you handled that well. I mean, if -- don't think of these conversions [Indiscernible] doesn't -- there are people who are in the industry, but there's only several that we would consider as being partners or meeting our standards for serving our customers. So that's why there's a length involved that in the qualification process. So if there's opportunities, we'll take advantage of them, but we're very discriminating in how we approach that from a -- when it comes to serving our customers."
},
{
"speaker": "Kent Masters",
"text": "Yeah. And key for us is, for me, that -- again, security of supply quality for the customer. The customers have to trust us. So if we're going to toll, we have to make sure that product meets our specs and our customer's standards as well."
},
{
"speaker": "Matthew Deyoe",
"text": "Fair point. And we almost got there with Jeff's question. But if you look at Chinese bromine price, I know in the past it's been comments or maybe it's not correct on an absolute basis, but directionally it's consistent with what you're seeing. So given the move, should we think of this move as real and capturable in any capacity? And if so, is this a 2-year process, a 1-year process, a 3-year process? It would seem like there's a lot of room to offset higher chlorine costs as well. But I'm not sure if that's the case or not."
},
{
"speaker": "Netha Johnson",
"text": "Yeah. This is Netha. Yes, those prices are real and they are really driven by demand. The demand is outstripping the supply. It takes almost 2 years to really bring on additional bromine supply in a meaningful way, so you'll continue to see that demand outstripped supply. It's similar to what we said in our Investor Day for the next planning period that we use, and we think that will continue. The question's by how much. We've announced processes and things we want to add, and I'm sure others have as well. But right now it's not complex. Demand is really exceeding supply and that's what's driving the Chinese bromine price up."
},
{
"speaker": "Operator",
"text": "Your next question comes from the line of Christopher Parkinson with Mizuho."
},
{
"speaker": "Harris Fein",
"text": "Hi. This is Harris Fein on for Chris. Thanks for taking my question. Turning back to Wodgina, so how should we be thinking about the cost that's associated with bringing that back into production and then understanding that Greenbushes is in a class of its own when it comes to cost per ton. How should we be thinking about the relative cost of spodumene that comes out of Wodgina?"
},
{
"speaker": "Scott Tozier",
"text": "This is this is Scott. I think, as you said Talison spodumene, world-class, right? Low costs in the world. Wodgina, we haven't operated yet, but we do believe it's going to be relatively close. Ultimately, it does have a lower concentration, so it won't meet it, but it will be relatively close."
},
{
"speaker": "Kent Masters",
"text": "Maybe say, in the ballpark. And I think, Scott, the costs for this, Harris was asking about how to [Indiscernible] there. We've captured them in the guidance we provided, both capital and cash flow. It's largely joint venture capital costs to acquire this yellow equipment that we've talked about and ramp the JV."
},
{
"speaker": "Harris Fein",
"text": "Got it. And then a lot of the Wave 3 announcements that you've made so far, actually all of them that have been disclosed, are really planned in China. So I'm curious what the strategic rationale was to focus so much on China. And I'm wondering whether it was a matter of lower capital costs or whether or not you see the Chinese market drifting more towards high nickel. And whether or not you expect most of those tons to stay domestic or make their way into other markets."
},
{
"speaker": "Kent Masters",
"text": "Yes. So I mean, I think it's -- I mean Eric can get into detail, but kind of at the high level, I mean, it is -- I mean, we do see lower capital costs there. That's probably not the driver. The driver, that's where the market is today. And then that product can either serve Chinese market or be exported as well. And then as we anticipate seeing the battery supply chain shifting to the west, and then we will invest ahead of that. But for the near-term, we see that market in China today. And then we see that -- as we go forward, you hear us talking about North America and Europe to some degree, but we see that moving west. And then we will invest with it. Eric, you want to?"
},
{
"speaker": "Eric Norris",
"text": "You know, I mean, I think if you look at the percent of production of cathode on the world market, China is well over half of it today and that will increase between now and the middle of the decade. So China is the center of the world for all cathode technologies. Now, many of those are being developed. The supply chain is being developed prospectively to come into and match up to battery production ultimately in North America and Europe. And that's why we have a wave 4 plan that addresses that and we will speak to those opportunities to localize supply and it's an active program with us. But as we've said many times, wave 3 is largely Asia - centric, heavily China focus because that's where the market is. And we will build that repeatability of capital design and execution there that will serve us well as we continue to grow around the world. It's also where a large -- more of our resources are in Asia -- a bit Australia, but in the Asia region as opposed to the Western part of the world. So those are all the elements that play that strategy. And we look forward to growing with our customers as they expand into the West."
},
{
"speaker": "Operator",
"text": "There are no further questions. I would now like to turn the call back over to Mr. Kent Masters for closing remarks."
},
{
"speaker": "Kent Masters",
"text": "Okay. Thank you. And thank you all again for your participation on our call today. As we approach the end of the year, I'm extremely pleased with the progress and the focus our team has demonstrated. I look forward to updating you in February when we announced full-year results and provide more detail on 2022 objectives and outlook. This concludes our call and thank you for your interest in Albemarle."
},
{
"speaker": "Operator",
"text": "Ladies and gentlemen, thank you for your participation in today's call. You may now disconnect at this time."
}
] | Albemarle Corporation | 18,671 |
ALB | 2 | 2,021 | 2021-08-05 09:00:00 | Operator: Good morning, and welcome to the Q2 2021 Albemarle Corporation Earnings Conference Call. At this time, all participants are in a listen-only mode. Later, we will conduct a question-and-answer session and instructions will follow at that time. [Operator Instructions] As a reminder, this conference call is being recorded. I will now like to turn the conference over to your host, Meredith Bandy, Vice President of Sustainability and Investor Relations. Please go ahead.
Meredith Bandy: Thanks, operator, and welcome everyone to Albemarle's second quarter 2021 earnings conference call. Our earnings were released after the close of market yesterday, and you will find the press release, earnings presentation and non-GAAP reconciliations on our website under the Investor Relations section at albemarle.com. Joining me on the call today are Kent Masters, Chief Executive Officer; and Scott Tozier, Chief Financial Officer; Raphael Crawford, President, Catalysts; Netha Johnson, President, Bromine Specialties; and Eric Norris, President, Lithium are also available for Q&A. As a reminder, some of the statements made during this call including outlook guidance expected company performance and timing of expansion projects may constitute forward-looking statements within the meaning of Federal Securities laws. Please note the cautionary language about forward-looking statements contained in our press release and earnings presentation, that same language applies to this call. Also note that some of our comments today refer to non-GAAP financial measures. Reconciliation to GAAP financial measures can be found in our earnings release and the appendix of the presentation, both of which are posted on the website. And finally, as a reminder, Albemarle will be hosting our 2021 Investor Day, the morning of Friday, September 10th webcast live from our Charlotte offices. Registration for webcast is also available on the Investor Relations section of our website. And now I'll turn the call over to Kent.
Kent Masters: Good morning, and thank you all for joining us today. On today's call, I'll highlight quarterly results and our recent strategic achievements. I'll also introduce the new operating model we are implementing to support Albemarle's growth strategy. Scott will give you more detail on our results, outlook, and guidance. Our businesses continued to execute well, as global markets improved. Second quarter net sales were $774 million and adjusted EBITDA was $195 million, both of which marked a slight improvement compared to the second quarter of last year. Note that we closed the divestiture of FCS on June 1, so second quarter 2021 included only two months of FCS results. Excluding FCS, net sales increased 5% and adjusted EBITDA was up 13% compared to last year. In our financial release issued yesterday after the close, we revised our guidance for the year, in part to reflect higher lithium performance, but also supply chain disruptions for our Bromine business. We've also updated full year guidance to reflect the sale of FCS. Scott will walk you through those changes in more detail in just a few minutes. We continue to execute on our next wave of growth projects to capitalize on attractive long-term fundamentals in the markets we serve. We recently completed construction of La Negra III and IV, as planned and we are progressing through the commissioning stage. Finally, I want to briefly describe the operating model we are launching to drive greater value, improve performance, and deliver exceptional customer service and you see that on Slide 5. Our operating model, which we call the Albemarle Way of Excellence, or AWE, serves as a framework for how we execute, deliver, and ultimately accelerate our strategy. AWE is based on four pillars: sustainable approach, includes responsibly managing our natural resources and engaging with our stakeholders, high performance culture, includes focusing on safety leadership and fostering an agile, engaged corporate culture; competitive capabilities means we are ensuring we have the right talent, resources, and technologies; and finally, operational discipline is about embracing lean principles and operational excellence across the organization. The operating model helps us connect our strategy with day-to-day initiatives, prioritize projects, clarify resource allocation, ensure accountability, and drive efficient and profitable execution. We will discuss the operating model in more detail at our upcoming Investor Day on September 10th. Now turning to Slide 6. We've completed construction of La Negra III and IV in Chile and are in the commissioning stage. We expect commercial production from these two trains beginning in the first half of next year ramping to 40,000 tons of lithium carbonate per year by 2024. This brownfield project allows us to increase existing capacity and leverage our world-class brine resource in Chile, just one of the avenues of growth that we have as an established lithium producer with a global footprint. We also continue to progress our Kemerton conversion facility in Western Australia. To mitigate risk related to the tight labor market and COVID-related travel restrictions in Western Australia, we have modified our execution strategy to prioritize Kemerton I over Kemerton II. Kemerton I remains on track for construction completion by the end of the year. We now anticipate completion of Kemerton II by the end of the first quarter next year, a delay of about three months. These delays and higher labor rates have also increased capital cost. It's been a difficult situation and a labor market that was already tight, but we have been able to maintain the schedule for Kemerton I with only a three month delay for Kemerton II. We continue to expect commercial production for both Kemerton I and II during 2022. Importantly, we are making progress on our Wave 3 lithium projects and we will provide further details at Investor Day in September. Site selection is underway, and we are negotiating with the authorities to include investment agreements. We're also expediting investments in bromine to meet increasing demand. We completed the first well at Magnolia ahead of schedule and under budget. Unfortunately, we are unable to take advantage of that additional capacity in the second half due to shortages of chlorine and the supply chain. We also have two projects in Arkansas that are currently in the select phase. These projects are designed to increase production capacity of clear brine fluids and hydrobromic acid. A third project to increase the capacity of our brominated flame retardants is in the evaluate stage. I will now hand the call over to Scott, who will provide an overview of our financial results for the quarter.
Scott Tozier: Thanks, Kent, and good morning, everyone. I'll begin on Slide 7. We generated net sales of $774 million during the second quarter, which is a slight increase from the same period last year, driven by stronger sales from our Lithium and Bromine segment. Higher sales, as well as strong operating margins resulted in an adjusted EBITDA of $195 million, which was 5% higher year-over-year. GAAP net income of $425 million, includes an after-tax gain of $332 million related to the divestiture of our FCS business to W.R. Grace. Adjusted EPS, which excludes the gain on FCS was $0.89 for the quarter, up 4% from the prior year. Let's turn to Slide 8 for a look at adjusted EBITDA by business. Excluding FCS, second quarter adjusted EBITDA increased by 13% or $22 million compared to the prior year. Higher adjusted EBITDA for lithium and bromine was partially offset by higher corporate costs related to incentive compensation and foreign exchange movements. Lithium's adjusted EBITDA increased by $19 million excluding FX compared to last year, primarily driven by higher volumes as customers under long-term agreements continued to pull orders forward, and we shipped higher spodumene volumes from our Talison joint venture. Adjusted EBITDA for bromine increased by $16 million due to higher volumes and pricing. End market demand continues to be very strong. Following the winter storms experienced in Q1, we have very limited excess capacity or inventory to meet that additional demand. Catalysts' adjusted EBITDA declined just $1 million from the previous year. CFT volumes were down due to shipment timing. FCC continued to be impacted by a change in the order patterns from a large North American customer, although the FCC demand trend was generally higher. This was partially offset by excellent PCS results, which benefited from a favorable customer mix. Slide 9 highlights the company's financial strength. Since the beginning of the year, we have taken significant steps to strengthen our balance sheet. The strategic decision to divest our FCS business added cash proceeds to the balance sheet and reduced our leverage ratio to 1.5 times. That transaction further demonstrates our ability to drive value by prudently managing our asset portfolio. Our strong balance sheet and investment-grade credit rating gives us the financial flexibility we need to accelerate profitable growth and continue to provide a growing dividend. Turning to Slide 10, I'll walk you through the updates to our guidance that Kent mentioned earlier, and there are several key changes from our previous guidance. First, higher net sales guidance reflects higher lithium sales volumes and improving catalyst trends offset by our lower bromine outlook. Adjusted EBITDA guidance is the same, reflecting higher net sales, offset by higher corporate costs and foreign exchange expense. Guidance on adjusted diluted EPS and net cash from operations is improving from an expected reduction in interest expense and tax rate. The timing of working capital changes is also expected to benefit net cash from operations. And finally, we see capital expenditures trending toward the high end of our previous $850 million to $950 million range based on the tight labor markets in Western Australia, as Kent discussed. In the far right column, pro forma revised guidance ranges are adjusted for the sale of our FCS business on June 1st this year removing the guidance on FCS for the rest of the year. I'm turning to Slide 11 for a more detail on the GBUs outlook. Adjusted EBITDA for lithium is expected to increase by 10% to 15% over last year, an improvement from our previous outlook. Lithium volume growth is expected to be in the mid-teens on a percentage basis, mostly due to higher tolling volumes, as well as the restart of North American plants at the beginning of the year and improvements in plant productivity. Our pricing outlook is unchanged. We continue to expect average realized pricing to increase sequentially over the second half of the year, but to remain roughly flat compared to full year 2020. We also continue to expect margins to remain below 35%, owing to higher costs related to project start-ups and incremental tolling costs. Margin should improve, as the plants ramp up commercial sales volumes. Our outlook for Catalysts hasn't changed since the first quarter report with adjusted EBITDA anticipated to be lower by 30% to 40%. However, we are more optimistic, as fuel markets continued to improve globally. Lower year-over-year results are primarily related to the impact of the U.S. Gulf Coast, winter storm in the first quarter and the ongoing impact from the change in customer order patterns in North America. Finally for bromine, we now expect mid-single digit year-over-year growth in adjusted EBITDA, which is down from our previous outlook due to a force majeure declaration from our chlorine supplier in the U.S. Like many industrial companies, we are experiencing increased costs and supply disruptions for raw materials, but it is partially offset by price and productivity improvement. Results are expected to be lower in the second half, as production is constrained due to the chlorine shortage. We are accelerating our expansion plans in bromine. However, we have been unable to take advantage of this new capacity yet due to the chlorine disruption. Looking ahead to 2022, we expect sales and EBITDA increases for all three businesses, Lithium results are expected to improve on the higher volumes, as the new plants ramp up, Bromine results are expected to rebound from short-term supply chain disruptions and the winter storm impacts and Catalysts results are expected to rebound strongly from 2021 levels assuming continued improvements in global transportation fuel demand. And with that, I'll hand it back to Kent.
Kent Masters: Okay. Thanks, Scott. On Slide 12, we continue to execute on our strategic objectives for 2021. First, we are growing profitably. Construction is complete at La Negra, and we are commissioning this project with commercial volumes expected in the first half of next year. Both Kemerton trains are expected to contribute volumes in 2022 as well despite the restructuring of our execution plan at Kemerton. As previously discussed, we are making progress on our Wave 3 lithium projects and expediting investments in bromine to meet increasing demand. Second, we are increasing productivity. We are on track to achieve at least our targeted $75 million in productivity improvement this year. We expect to continue to build on these improvement, as we implement our operating model and build a culture of continuous improvement. Third, we are maintaining our disciplined approach to investments and continue to optimize shareholder value by actively managing our portfolio of assets, including the recently completed FCS divestiture. Finally, all of our efforts are being driven with sustainability in mind. In our annual sustainability report, published at the beginning of June, we disclosed initial sustainability targets, including plans to reduce greenhouse gas emissions and fresh water use. We are also working closely with customers, investors and ESG rating companies to make sure, they are up to speed in all of these developments, and have a full appreciation for our efforts. So with that, I'd like to open the call for questions.
Meredith Bandy: Operator, we're ready for questions now.
Operator: [Operator Instructions] First question comes from the line of P.J. Juvekar with Citi.
P.J. Juvekar: Good morning, Kent and Scott. Congrats on finishing La Negra III and IV. Now that's done, are you looking for new hydroxide conversion capacity either in China or elsewhere, and would you consider building a convergent plant in the U.S.?
Kent Masters: So good morning, PJ, and thanks for that. We are - so - we've completed construction, we're still commissioning, so still a little bit to go at La Negra. And then, as you see in the plans that we have, the Phase III is mostly about hydroxide capacity in the near term. So, Kemerton will be coming on in the next year. And then the next wave of investments at the moment are focused on China. And we are - we do look for acquisition of conversion capacity, but it's a bit of a challenge just to find the assets that we want and that are for sale. So, we kind of have a meeting of the mines there, but we're also in parallel are progressing our plans to do greenfield projects as well. And if we were able to find an acquisition, we continue to progress the greenfield plans that we have. So they would - they are not - if we did an acquisition, that doesn't mean we stop our greenfield plans and projects, but we would just do them in parallel.
P.J. Juvekar: Okay.
Kent Masters: And then the last part, and sorry last part about the U.S. So, I mean, we will look at the U.S., but it's not in the next year or so, right. So it's - there is time. I mean, our view is most of the cathode capacity that's being built and we will be producing for the next several years is going to be in China or at least Asia. And so, we have time before we have to see if we need capacity in North America or Europe.
P.J. Juvekar: Okay. And then, next question is, I want to go back to comments that you had made, Kent, I think on the last call about sort of market segmentation of customers that some customers will have a long-term contracts, some will have more market-related contract, especially customers like those who negotiated prices down in 2019. I was just wondering if either you or Eric could add some color on this sort of market segmentation of customers? Thank you.
Kent Masters: Sure. So yes, I don't know if we can add much more than we talked about previously, but we are - in the past we had kind of a long-term contract formula and it was - we were trying to use that strategy for all of our customers, and what we've learned is that not all customers want to buy that way. So we're trying to segment on how they want to buy, and actually we think it's good for us as well. So we are - we have longer-term contracts that look more like a fixed price. And ideally, we want those contracts to move with the market that just - slightly with the market, but it looks more like a long-term contract. And on the other extreme, we will have contracts that look more like spot. They are probably, it's not - probably not a one-year contract, but it’s probably more than that, but the - but it moves with the market or closely with the market, still may be dampened a bit, and then you'll have some in the middle where that shakes out from a portfolio standpoint until we settle all that with our customers. I can't tell you, but for lack of anything else, it's probably a third, a third, a third, it's kind of how we see it now.
Operator: Your next question comes from the line of John Roberts with UBS.
John Roberts: On the delay at Kemerton II, if you're having delays, is the entire industry having significant delays here? I mean, we've got the car companies accelerating their demand plans here, as the supply actually going to undershoot what the industry needs.
Kent Masters: Well, I can't speak to other projects, but I mean, if you're building in Western Australia, the availability of labor, the tightness is extreme. And Western Australia is kind of famous for labor market that gets difficult if you're doing large projects just because of the resource industry draws all of the resources. If their prices go up and their prices have gone up significantly for let's say iron ore, as an - is probably the biggest example, and they are drawing all the resources away, that’s always been an issue in Western Australia. But today we have COVID, so they locked down not only Australia, but state by state. So we can't move - not only can we not get resources from China or Thailand or even the U.K., we can't get resources from the east part of Australia. So, we're kind of stuck with what is in Western Australia. So - and I think that will affect anyone doing a big capital project in Western Australia or Australia. I'm not sure that it applies say in China, for example.
John Roberts: And then, when CATL announced its sodium ion battery, all the lithium stocks popped including Albemarle. Is sodium ion something that we need to pay more attention to?
Eric Norris: John, good morning. It's Eric. Sodium ion, as you may know isn't a new chemistry. The CATL's innovation is a matrix that may make it more, more effective. It is a chemistry that is lower energy density, heavier material. So it's an applicable product for the low, very low-end of EV ranges and maybe grid storage. I think one of the attractiveness components of it is that - it's - sodium is abundant, right. So it's - so it may alleviate, and – at that low end of the market of - given alternative, if lithium supplies become tight as they have been in the past year or so.
Operator: Your next question comes from the line of Bob Koort with Goldman Sachs.
Bob Koort: Good morning. Kent, I was wondering, you mentioned that La Negra is completed. It takes six months to commission. Is that a function of just the qualifying process, and can you inventory production while you're doing that, and then have a nice buffer of inventory to start selling from as soon as the qualification is complete or is it a function of making sure the process works properly?
Kent Masters: It's both. So, we are commissioning and qualifying in parallel. So we can kind of - we do early commissioning to get qualification samples, but the plant has not been operating at rate, so that it takes us time to get it operating at rate. So we - we're kind of at a long pole in the tent, so to speak, is the qualification process, but we're commissioning during that same time and we run them in parallel, so that we - to save time. So it's - I think the answer is both.
Bob Koort: And then - and on Wodgina, we've seen some pretty spectacular spot prices out there some north of $1,000. When do you turn that on and you imagine that would ever feed the Kemerton plants or will you feed Kemerton through Talison for the foreseeable future? Thank you.
Kent Masters: Yes. So yes, we'll see how that goes. I mean, our plans are to feed Kemerton from Talison. And then, as we either bring on other capacity or do an acquisition, we would use Wodgina for that. And our strategy about selling spodumene hasn't changed.
Operator: Your next question comes from the line of Edlain Rodriguez with Jefferies.
Edlain Rodriguez: Quick one on bromine. So you've talked about the chlorine issue you have in there, but when do you expect that to correct itself?
Kent Masters: So I'll start, Netha can add a little bit. So - and I think there is a broader issue in the chlorine space. But I mean, our suppliers had some equipment failures and we expect that to last, I mean, they're telling us a couple of months, right. So they've got a short-term fix. We hope, we'll get us back up to some higher rates and then the permanent fix is going to take kind of - I think - I think they told us two months to three months. Yes.
Edlain Rodriguez: Okay.
Netha Johnson: Yes. I mean, as we look at the - as we look at the broader chlorine market, we think there will be opportunities to get it back and balanced by Q4 that we're hopeful for that.
Edlain Rodriguez: Okay. Makes sense. Quick - another one. Like in terms of M&A, like you've done the FCS deal, so you - so you monetize that. But when you look at the rest of the portfolio like, is there anything else in there that you think might below - might be below somebody else. Can you talk about the rest of the portfolio, what you're seeing in there?
Kent Masters: Yes. So we - I mean we were looking at our PCS business, and we ran a process and we didn't get the pricing we wanted for. So it's performing well. And we pulled that, that is no longer for sale, and we're running as part of the portfolio, we're running as part of our catalysts business. So we've hold on to that. And then for the broader part of the portfolio, the three primary businesses bromine, lithium and catalysts, we see those as core businesses and that's kind of our fundamental portfolio. And now PCS is part of catalysts.
Operator: Your next question comes from the line of Joel Jackson with BMO Capital Markets.
Joel Jackson: Good morning, everyone. My first question, I follow-up on spodumene. Yes, we've seen pretty interesting surges in spodumene prices in the last, why shouldn't we say there is lag, contracts and stuff. But I think what - if we also - it seems like conversion margin, the proxy conversion margin will be extremely strong, so are those - as carbon hydroxide prices have been really strong. So do you see the spodumene price increases more of a lagging indicator or do you think that they're setting often to be another run up in spot prices sparked up, we can deal with the prices.
Kent Masters: Look, I'll make a broad comment, let Eric can try a little bit of a detail. It's hard for us to project, where the market is going. And we see prices about spodumene and carbonate and hydroxide prices being up. The only place you really have visibility of spot prices is in China for the carbonate and hydroxide. And so you see that, you see the same numbers that we do. Those have not fully translated into the contract prices, but we do see contract prices moving up. And spodumene, I mean, it has gone up, it come back down a little bit. I don't know that we're in, what you would call a super cycle or headed toward that. But I think - I do think prices will be higher than they have been in the last couple of years.
Eric Norris: Hi, Joel. What I would - this is - and I think your question reflects this. This is a China market phenomenon. The China market is very dependent for its growth on imported spodumene. So - and there is a shortfall of available supply to meet demand given the rapid growth post pandemic particularly in carbonate in China. So in that regard, maybe spodumene is a bit of a lead because it's the short supply. But I think what we expect to happen is more supply to come into China from other parts of the world. We've seen prices go up and stay up with demand. It's hard to say what's going to happen with spodumene prices. From a Albemarle perspective, the way we take advantage of that is we don't sell spodumene or yes, it's right. We don't sell chemical grade spodumene, as you say. We sell especially spodumene for the glass market, but for us it's tolling. So you've heard us talk about, looking at tolling opportunities and that's part of our improved guidance. And for that we're able to participate in that spot price market, which is as I've said earlier, very favorable.
Joel Jackson: Thank you for that. So my follow up would be just looking at out to 2022 for LCE volume increases. I think you talked about maybe gaining about 30,000 tons LCE volume for next year with the different expansions ramping on, Kemerton II is delayed a few months, maybe you've been pushing out a little more tolling now this year. Is it about 30,000 ton, still the right number to think about for next year?
Kent Masters: So Joel, I mean, I think it's, you have to break it down. First of all, I don't think we've said 30,000 tons. We've talked about ramp rates on plants. So the Kemerton plant with a start-up in the early part of next year, there was a three month delay to the second unit. We've talked about getting to full run rate capacity by the end of the second year in that facility. Similarly in carbonate, you'd see a phenomenon that is somewhat like that. I would say our run rate for carbonate by the end of '22, we will probably at the 30,000 run rate basis at the end of the year, as that ramps. It's a little bit different ramping brine versus spodumene because brine is obviously a harvested material, but - versus the fixed input, but that roughly should - between those two, we should be able to calculate sort of our guidance. The change would be a slight delay at Kemerton and in a year-on-year growth that we can achieve in tolling and that's going to be - it's harder for us to predict now because it's a function of what's available in the market for us to toll that.
Eric Norris: Yes. It's also a function of how fast we ramp up like so how well commissioning goes and then there is we - you'll commission, you'll be able to make products but at lower rates and that will ramp up over time. And it's how well we do in that ramp curve and it's hard to speculate on that.
Operator: Your next question comes from the line of Arun Viswanathan with RBC Capital Markets.
Arun Viswanathan: Thanks for taking my question. I guess, I just wanted to get your thoughts. We've had some different views, I guess, maybe just provide your color on spodumene, carbonate and hydroxide. Spodumene obviously there were some oversupply in years past, but it seems like most of that is slowly working itself out. Maybe you could just characterize supply demand in each of those areas? Thanks
Kent Masters: Okay. And again I'll start, Eric can fill in, where I miss things. But I think in the past, the industry is growing, right. So as the industry grows, you bring on capacity at a smaller percentage of the industry. So I don't think we're going to have those periods of oversupply, under supply as tight, as they were in the past with the extremes showing up in pricing. So that - I think that applies across for hard rock as well as kind of salt - conversion capacity for the salt. So I think as the industry gets bigger, each addition is a smaller percentage of the total industry and it has less of an impact. That said, where we are. I mean spodumene is pretty - spodumene is tight. And I think that the conversion capacity, as the growth rates that we see, which you've kind of seen as an indicator. In fact EV sales is forward looking growth curve for lithium, those are pretty tight. And you've got to make investments and you've got to be good at executing those projects and commissioning them and then, ramping them up to full capacity, which is we think we're good at that, but we're in the process of proving it.
Eric Norris: And I would just add, Arun that today as we sit here today, all three are extremely tight. If we had more carbonate that we could produce and sell, we could sell it readily, same with hydroxide. We don't have the disadvantage. We have the ability. We have idle capacity on the spodumene side. So we are not feedstock limited. That's a strength we have going forward. But what we are limited on is our ability to get conversion capacity in the ground quickly. So - and that's part of our plan for next year. As to the long term, my guess would be that our view would be, I should say that hydroxide will probably see their higher rate of growth going forward off a smaller base. Carbonate has done well in the near term based upon the LFP trend for lower end vehicles, particularly in China, and we see that starting to take root in some other regions as well for the low end. But the key to high EV penetration is higher energy density and the key to that is hydroxide and ultimately potentially solid state chemistries. So that's going to require a heavier burden on hydroxide. We see that being the tighter market from a long-term basis going forward.
Arun Viswanathan: And just wondering if there is any concern from elevated logistics cost for the next little while. Also maybe you can just address, if there is any concerns on the container shortage issue? Thanks.
Kent Masters: Well, I think, across all of our businesses, the supply chain is a challenge and a concern. So ocean-going freight probably the biggest, but well, chemicals supply chain in the U.S. is hitting us and particularly chlorine at the moment, but it's tight and a number of chemicals. But ocean-going freight is a big concern for us and something that we are working pretty hard to try and to manage. We spend a lot of time trying to streamline that supply chain digitizes, so we have much better visibility on it. So we're making progress on that, but it's still a concern.
Operator: Your next question comes from the line of Vincent Andrews with Morgan Stanley.
Vincent Andrews: If I just ask in bromine, it doesn't sound like either your sort of electronics sales or your auto sales that you're seeing any, any real volume issues from the shortage of microchip. So is that - that's just something that it's either being offset by other parts of the business or it's just not an issue either year-to-date or into the back half of the year?
Kent Masters: Yes. Vincent from where we sit in the supply chain, we're not seeing that at all in - from a demand side. Our demand in those areas have been steady.
Vincent Andrews: Okay. Great. And if I could just ask. You have the Analyst Day coming up, and you're also concurrently working on the Wave 3 projects and looking to move forward those. I mean should we be expecting a material update on those at the Analyst Day or are those two events unique?
Kent Masters: So material update, I'd say it depends on the definition. So we'll give you progress on where we are. But we're not, I mean - and - but we are still in the planning phase. We're not moving dirt on any of the projects, yet.
Vincent Andrews: Okay. So no FID - we shouldn't be expecting any FID decisions then?
Kent Masters: No. I mean we're progressing as we go, and we'll tell you the plans that we have. But we're - it's not at a - we'll not have a final investment decision by in a month.
Operator: Your next question comes from the line of David Begleiter with Deutsche Bank.
David Begleiter: Eric, couple of questions for you, just on lithium pricing in Q3. Is your guidance for that pricing to be up year-over-year in Q3?
Eric Norris: Yes. The second half - I mean, we were down 10%, so to recount a little history here to put in perspective. We're down 10% across the board in the first quarter, 4% in the second quarter, and we're staying flat for the year. So we will be up year-over-year. Another way to think about is our lowest price point over the past 24 months are including the rest of this year. So for 2020 and 2021, we expect to be the fourth quarter of last year. And ever since then, we sort of bottom there, we're seeing as spot prices move up for that small amount of our business is exposed to that such as better grade in China or tech rate. And as concessions to contracts given during the height of the pandemic roll off, we see those prices rising in the back - into the second half of this year. And given the tightness in the market, we expect into next year as well.
David Begleiter: Very good. And also, there has been some progress like DLE project near your operations in Southern Arkansas. Can you discuss the viability of a DLE project for you guys in Southern Arkansas going forward?
Eric Norris: Well, yes, so I'll say that for us, we continue to look at Magnolia brines, where we operate our bromine operation is being our spot, where we could process lithium and DLEs potential technology for that. DLE just - it's a bandied about term most often here in the U.S., who made the projects, what they're talking about is absorption, resins, and so it's a mechanical operation - for extracting brines, it's a mechanical operation as opposed to an evaporation effort such as we do in Chile. That you would only apply it, you have to apply, meaning you apply it to resources that are of lower quality or have higher impurities present, which is generally true with both oilfield brines, which is what we have in Magnolia or geothermal brines. So it's more capital intensive, but actually it also consumes a lot more water and energy given the price. So it has some drawbacks from it. We're studying what alternatives we could deploy to a resource like that, that could include absorption, that optimize those factors of cost and sustainability. Given where we are with our high quality resources, and then what we can do in the near term to drive our growth in next five years, we put that as a resource later in the decade that we would consider for that given its - given those technical challenge and given its cost profile.
Kent Masters: Yes. And I would just add. So we've - we didn't - it wasn't included in our Phase 3 and but it's something that we look at. We are looking at the technology. We have access to the brines, and we have the operation. We're already kind of pumping the brines around. So we'd be in a good position to leverage it if we think that if we get the technology right, and we believe the cost position is right. But it's something that comes probably in Phase 4, if we get that technology right.
Operator: Your next question comes from the line of Jeff Zekauskas with JPMorgan.
Jeff Zekauskas: Thanks very much. In your Talison operation and equity income in lithium, sometimes you are in the 30 million and sometimes you are in 15 million or 16 million. And what's the difference between the two, when we've had some 15s and 16s, are there any service to come?
Scott Tozier: Jeff, this is Scott. So the equity income in Talison is affected by two things, one is the volume that's being shipped both to ourselves as well as to Tianqi, our partner. And of course that has been either flat or rising over time. The bigger impact that you're seeing through the equity income is coming from the transfer price, which is affected by that - by the spodumene market price that's out there. So when that price is high, you're going to see a higher equity income, when it's lower, you will see a lower equity income. And generally that's going to track on about a six month lag to the market indicators that are out there. So as we talked about in the - some of the prior questions because the spodumene prices higher, are going higher right now, you should expect in the second half that, that equity income would also track to that.
Kent Masters: You should just keep in mind though that it's been our input cost for conversion goes up, when that price goes up. So we don't really - it doesn't matter so much to us because it's all - it washes through. But it's the difference between equity income and what shows up in the lithium P&L.
Jeff Zekauskas: Then for my follow up. I think over the past several years, if you had to describe the contractual terms of your long-term lithium contracts, I think, you would have said that they were above market. Given the changes in lithium market and its tightness or some toughness, is it now the case that your long-term contracts are more comparable to current prices?
Kent Masters: It depends on what you call current.
Jeff Zekauskas: Yes.
Kent Masters: Yes. I think it depends on what you're calling current prices. So if you're talking about spot prices in China, which is what everyone can see that's probably correct. But I think if you were to think about contract prices over time, contract prices outside of China that different suppliers have, it's probably in line or above those. I would say probably still above those.
Operator: Your next question comes from the line of Ben Kallo with Baird.
Ben Kallo: Good morning, guys. Thanks for taking my question. Just maybe two on the lithium front and then one on bromine. On lithium, you know, you get this question a lot, but just on recycling we saw redwood materials raise a large sum of money. I want to understand, how you see the players in the recycling as they work with your competitors - you - is number one. Number two, you know on the Tesla call, and then - and I think before that Mark was talking about the LFP and the increase there. Just want to understand and I think you talked a little bit about this, but how you make investments into carbonate versus hydroxide with that background looking like there is a large increase in demand for LFP. And then on bromine, just comfortable - how comfortable you are around the timing of the expansion. I think it's really chemical expanded already earlier. So just want to see how strong you think that market you know, for bringing on new capacity? Thank you very much, guys.
Eric Norris: Ben, this is Eric. On recycling, recycling is happening around the world and so the companies you're referring to are largely here in the U.S. There is a set of companies similarly in Europe. It's a regional business model because of the collection and nature of different regulations around the world. As a global player, we're engaged with all of these companies. We view them in almost every case as a partner, not a competitor and we bring process, not the technology and knowhow that's what we deploy in some of our existing virgin brine operations, it could be a partnership approach to helping to remove the lithium and/or take a byproduct that comes out of their operations, which is lithium rich. And so that's the way we work with them. You have to remember a lot of these companies got set up and this is - and then, Europe is a bit - is ahead on this largely go after the nickel and the cobalt, not lithium. Lithium is usually the byproduct of the recycling operation. That's where we fit in. And so as we look at trying to partner with our customers on and drive their success from a sustainability standpoint, we view this as an important part of the value mix we bring is helping them recycle to lithium and recycle it back to them for their continued growth. On the Tesla side, we view what Tesla's described as very - generally very consistent with our market outlook. It's going to continue to shift and I think expand meaning the size of those EV market, which by 2025 might be at one level, but by 2030, I think you're going to have a larger proportion of vehicles that are electrified. There's some news a lot about - some intentions around that here in the U.S. today. And for the lower end, LFP is the applicable technology. I mean, it gives you a lower range. We still believe though that for the mid and higher range vehicles, you're going to need - in order to get, you need higher energy density to get the range. And you can drive good cost, if you can get good technology and then, get the cost - the cost per kilowatt hour down, get the kilowatt hours up per unit weight. So that's the mix we see. And I - it's very consistent way Tesla is approaching the market as well. Turn it over to Netha for bromine.
Netha Johnson: Hello Ben. If you talk about the timing of our bromine expansions, I think we feel really good about the markets that we participate in and their projections over the next few years. And we're really just executing the company's strategy of building capabilities to accelerate lower capital intensity, higher return growth. And for us what we're doing it at is the Magnolia and that's a great place for us to do it because we have great jurisdiction. We've been there for over 50 years. We know the asset well, and we could produce every product that we make out of that facility. So that leads us to have high confidence in those projects and the timing of execution. And we feel really good about the plan there and their ability to deliver what we want out of those expansion projects.
Operator: Your next question comes from the line of Matthew DeYoe with Bank of America.
Matthew DeYoe: So as you ramp Talison to meet Kemerton demand, what do you expect your partner to do. I know they have their own kind of hydroxide plans, those have been pushed a bit. Do you expect Talison output to increase by the 50,000 metric tons, you're going to need or will be closer to 100,000 metric tons. And just how do you see that that, that timeline playing out can you move as fast as you think you'll need, if It's a joint discussion versus your singular desires, I guess.
Kent Masters: Yes. Well, it's definitely a joint discussion. It's a JV. And I think we'll optimize the supply. So the product that Talison our portion or half of that with Tianqi that - that's ours. But we have JV product at Wodgina. They have their own product in other parts of Australia. And we will swap product to kind of optimize economics. I think way you would think about it is Talison goes to feed our portion and then - and some other product feeds their portion at Kemerton. However, it physically, it probably won't work that way. We will swap product to optimize the economics.
Matthew DeYoe: All right. I guessing it more, what you expect Tianqi to do versus [indiscernible] portion about this?
Eric Norris: This is Eric jumping in. We can't predict what Tianqi is going to do. I mean, they have some public statements out there around their Kwinana facility, which is really very in terms of its potential over time similar in size to Kemerton at least our - at least our first investment in Kemerton. And the JV is owned by the two of us. So it produces a budget to what we need. So you really need to talk about what's on the ground there, CGP I and CGP II. We feel with CGP II being fully ramped, we will meet the needs of what we have invested in, and allow to ramp at Kemerton. And if they don't have the need on their side, they won't take their share right, is how it comes down to it. So that's how it works. We're always entitled to at least 50%. It could be of what's available. It could be more if they don't need to take more and vice versa on the other side.
Matthew DeYoe: Okay. If I could just follow up. So the new pricing approach, you talked about, I understand it's still in the works, but theoretically, I guess if you were to look over the last cycle maybe peaks in 2018 and trough more in 2020. Can you provide some context as to like how much your realized price would have been higher in 2018 had you chosen this path versus how much lower, you would have been in 2020, like how much higher with the peaks and how much lower with the troughs and I would imagine some sort of analysis has been done to kind of get a sense for, if this was a net winner or loser over time.
Kent Masters: Yes. So we've not - we've done analysis that we can share about what our price would have been under the new model. But you're right, it would have been higher, higher towards the peak and lower during the trough, so which is the point. We're trying to move a little bit more with the market, but not expose ourselves fully to the commodity price. But I don't have the numbers to share with you exactly what it would be. And the other part - the other part of that question, which we don't really know the answer to is how is the portfolio, what does it look like, how much of that spot type pricing, where we end up with versus that long-term contract pricing because during the last peak and bottom that we're pretty much we're all on the long-term contracts.
Eric Norris: I think it's also important that in the last peak and bottom, there were no automotive producers involved at all in the cycle. There are now, and there's a lot more demand now. And I'll a reference of Kent - a remark Kent made earlier that given the size and maturity of - we've only gone through one cycle before really since the dawn of the EV, and now we're moving through the next part of the cycle. It's going to look different and probably won't have the same volatility than before. We don't know. But I think the size of growth is such that it - and supply additions is such that it's going to change with time. So the pricing structure we're putting in place is going to continue to evolve. We have contracts to fit the structure. So we know it works. We have customers paying fixed prices. We have customers, who are only going to - we're only going to give them a year commitment, and they will take, they will - they want to ride the wave and at that point that wave is going up. So it's - how it settles out over time, we'll have to continue to dimension for you, but we're at the early stages.
Operator: Your next question comes from the line of Mike Sison with Wells Fargo.
Mike Sison: Nice quarter. Just curious what your thoughts on the lithium demand, whether percent or tons in '22 is expected to be for the industry?
Kent Masters: Yes. I - it's a question, Mike, that I may have to go back and look at our demand model. We do have a model we put out and it's - we - and it's still consistent with what we think today. And it was some months ago, earlier this year, we did that. We're seeing a much bigger demand here in '21 overall this year than last, because of the post-pandemic recovery. The overall market growth is 25% plus. So we're going to be at least in that order magnitude for '22 I'd say on a year-on-year basis.
Mike Sison: And then, I know, there is some timing in terms of getting the volume on for Wave 2, but when do you think roughly, you'll have all the capacity available to sell. Is it '23, '24, '25, just curious on the - when you'll be able to sell it all?
Kent Masters: When you say the capacity, you mean, La Negra and Kemerton?
Mike Sison: Yes.
Kent Masters: Okay. Because we're - I mean, our plan is, we're going to be building plants over time. It's going to be ramping up over time. But La Negra - between La Negra and Kemerton at full rates ramped up selling everything '24 for the full year.
Mike Sison: For the full year. Great. Thank you.
Operator: Your next question comes from the line of Chris Kapsch with Loop Capital Markets.
Chris Kapsch: Just slightly more nuance follow-up on this discussion around the increased volumes implied in your guidance and so it's nice most of that is coming from more volumes from via Greenbushes and that spodumene being converted downstream to via tollers. First, is that an accurate characterization. And then with that in mind, Eric, I appreciate you've stated in the past that you don't rely on toll conversion for battery grade chemicals, but only for technical grade lithium products. But in this case, it seems like the extra volumes are carbonate feeding into the LFP cathode market. So just wondering if that also is accurate, and if that's the case, I guess - should we be thinking of these carbonates grades via tollers as just or maybe just the LFP market being more of a technical grade market. And then finally just, it seems like this is part of the market, you will address once La Negra is ramped next year. But will then - will you then say that the current toll relationships that you're leaning into currently to opportunistically address these volumes?
Kent Masters: Well, a bunch of questions there, Chris. Let me go to the first one, which had to do with, help me here. I just stuck on the LFP, but you had something before that, what was that? What was your first question, Chris?
Chris Kapsch: Yes. So the --
Kent Masters: Ramp.
Chris Kapsch: The tolling volumes…
Kent Masters: Our volume, yes, yes, sorry. Senior moment there, I guess. The - if you look at our produced volumes, we're going to be fairly flat, first half to second half, maybe slightly better in the second half because we have little better production - we have some better production in Chile, in the fourth quarter, seasonally just by a tad. What's the real differences in our volume first and second half, and our volume growth year-over-year is on - the first half, second half is the tooling - increased tolling. Year-over-year is tolling, because we didn't had last year, as well as plants come back online and efficiencies in the plants, better operation in the plants year-over-year. So there's a bit of difference between first half, second half and year-over-year there. On what we're using that carbonate for when we toll it in China, it's going into the LFP market. I think what we - I don't know what we said a years ago, but what we said more recently is that the carbonate market, the tolling network is able to produce sufficient better grade quality to supply the LFP market for batteries in China. So that's where we are selling that material currently. And then, now, I'm going to ask you help again. The last question was --
Chris Kapsch: So since you're addressing that - via the tolling relationships currently, when you ramp La Negra next year, will you stayed those relationships or do you still intend to participate via tolling, obviously this has mixed implications given the higher feedstock costs and the fact that tollers need to make a margin. So curious if you've stayed those tolling relationships or maybe - would there be a bare hub like you've done in the past with tolling partners that you're comfortable with?
Kent Masters: It will be a bit of both. I mean our strategy for a lot of what we produce out of La Negra's growth, La Negra III and IV is to put it under a contract commitment in some form. That might be for price buyer only a year and for performance buyer might be a couple of years, but that's our strategy for that volume. Our strategy for the total volume is either to use it as a bridge to build the customer relationships when we have La Negra III and IV. So some of those customers we're currently selling toll volumes, where we will take advantage of selling La Negra III and IV to it as well. But in today's market, which is particularly tight, is also opportunistic to play in what is a pretty tight market and - and they were really playing on a - on a spot basis. So while we have higher cost to produce this whole volume, we're taking advantage of currently higher spot prices than contract.
Operator: And our final question comes from the line of Kevin McCarthy with Vertical Research.
Kevin McCarthy: Thank you for squeezing me in. Want to ask about your Catalysts business. If we look at margins in the first half of the year in broad strokes, they are running maybe half of historical levels, yet. In the prepared remarks, I think you indicated you anticipate strong rebound in the business. So I was wondering if you could flesh that out in terms of what you're seeing in your refinery catalyst order books. And when might we expect those margins to get back to historical levels might that be as soon as '22 or more likely '23 or later?
Raphael Crawford: Good morning, Kevin. This is Raphael. Just to respond, one, there has been a series of effects. I mean in the first half of the year, we certainly had an impact from the winter storm. We have residual impact from the pandemic, a lot of that pandemic impact was a down trade of high-performance catalyst to maybe more workhorse catalysts that has a effect on margins and as well as on our mix. Looking forward, I think we would see recovery. I mean, some of our best products what we're known, for example is our high performance hydroprocessing catalysts. As the markets recovering, as change out start to occur at a faster clip in 2022, we're going to start to see that come back. Again, we have great partnerships for great performance catalyst, those are the higher margin that will improve our mix. And I think it's that mix impact going into 2022 that you'll start to see that improvement in our margins. We already see it today, Kevin. We have customers that are, they down traded to lower performance catalysts, when they were under margin pressure. We just had a customer meeting this week with a large North American refiner, who is telling us that because they're starting to operate at higher rates, they're needing to run under more severe conditions, they need higher performance catalysts, those command higher margins for us. So we think it's a favorable trend. It will probably start to materialize in 2022, where you will start to see them.
Kevin McCarthy: Thank you for that. And then secondly, if I may for Eric. In a prior answer, I think you alluded to the news out today that the U.S. is now targeting 40% to 50% of new auto sales, as EVs by 2030, although I thought - I read that it might be non-mandatory. So just curious about your view on that. Is it incrementally accretive to your demand outlook in any way or are the U.S. automakers already tracking to similar levels or what do you think about the potential market impact of that announcement?
Kent Masters: Yes. So - this is Kent. That - it's early news. It's just out today. And I don't - from my understanding it was not mandatory. It's got something that it's trying to lead legislation to something maybe like that. It's - so I'd say it's early days. And then, I'm not - it - and it's probably in the ballpark of what the car companies are already thinking, maybe it's a little more aggressive. But it doesn't shift the model from our perspective, I don't think. I think our view would be that's neutral.
Operator: And now we will - I would like to turn the call over to Kent Masters for closing remarks.
Kent Masters: Thank you, Carol, and thank you all, again, for your participation on our call today. As you can see, we have a lot to be excited about at Albemarle, and we see extraordinary opportunities for growth. We are implementing a comprehensive operating model that will enable us to execute on our objectives effectively and efficiently. We look forward to discussing this in greater detail during our Investor Day on September 10, and we hope you will all be able to join us then. Thank you, and that concludes our call today.
Operator: Ladies and gentlemen, this concludes today's conference. Thank you for your participation, and have a wonderful day. You may now disconnect. | [
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"speaker": "Operator",
"text": "Good morning, and welcome to the Q2 2021 Albemarle Corporation Earnings Conference Call. At this time, all participants are in a listen-only mode. Later, we will conduct a question-and-answer session and instructions will follow at that time. [Operator Instructions] As a reminder, this conference call is being recorded. I will now like to turn the conference over to your host, Meredith Bandy, Vice President of Sustainability and Investor Relations. Please go ahead."
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"speaker": "Meredith Bandy",
"text": "Thanks, operator, and welcome everyone to Albemarle's second quarter 2021 earnings conference call. Our earnings were released after the close of market yesterday, and you will find the press release, earnings presentation and non-GAAP reconciliations on our website under the Investor Relations section at albemarle.com. Joining me on the call today are Kent Masters, Chief Executive Officer; and Scott Tozier, Chief Financial Officer; Raphael Crawford, President, Catalysts; Netha Johnson, President, Bromine Specialties; and Eric Norris, President, Lithium are also available for Q&A. As a reminder, some of the statements made during this call including outlook guidance expected company performance and timing of expansion projects may constitute forward-looking statements within the meaning of Federal Securities laws. Please note the cautionary language about forward-looking statements contained in our press release and earnings presentation, that same language applies to this call. Also note that some of our comments today refer to non-GAAP financial measures. Reconciliation to GAAP financial measures can be found in our earnings release and the appendix of the presentation, both of which are posted on the website. And finally, as a reminder, Albemarle will be hosting our 2021 Investor Day, the morning of Friday, September 10th webcast live from our Charlotte offices. Registration for webcast is also available on the Investor Relations section of our website. And now I'll turn the call over to Kent."
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"speaker": "Kent Masters",
"text": "Good morning, and thank you all for joining us today. On today's call, I'll highlight quarterly results and our recent strategic achievements. I'll also introduce the new operating model we are implementing to support Albemarle's growth strategy. Scott will give you more detail on our results, outlook, and guidance. Our businesses continued to execute well, as global markets improved. Second quarter net sales were $774 million and adjusted EBITDA was $195 million, both of which marked a slight improvement compared to the second quarter of last year. Note that we closed the divestiture of FCS on June 1, so second quarter 2021 included only two months of FCS results. Excluding FCS, net sales increased 5% and adjusted EBITDA was up 13% compared to last year. In our financial release issued yesterday after the close, we revised our guidance for the year, in part to reflect higher lithium performance, but also supply chain disruptions for our Bromine business. We've also updated full year guidance to reflect the sale of FCS. Scott will walk you through those changes in more detail in just a few minutes. We continue to execute on our next wave of growth projects to capitalize on attractive long-term fundamentals in the markets we serve. We recently completed construction of La Negra III and IV, as planned and we are progressing through the commissioning stage. Finally, I want to briefly describe the operating model we are launching to drive greater value, improve performance, and deliver exceptional customer service and you see that on Slide 5. Our operating model, which we call the Albemarle Way of Excellence, or AWE, serves as a framework for how we execute, deliver, and ultimately accelerate our strategy. AWE is based on four pillars: sustainable approach, includes responsibly managing our natural resources and engaging with our stakeholders, high performance culture, includes focusing on safety leadership and fostering an agile, engaged corporate culture; competitive capabilities means we are ensuring we have the right talent, resources, and technologies; and finally, operational discipline is about embracing lean principles and operational excellence across the organization. The operating model helps us connect our strategy with day-to-day initiatives, prioritize projects, clarify resource allocation, ensure accountability, and drive efficient and profitable execution. We will discuss the operating model in more detail at our upcoming Investor Day on September 10th. Now turning to Slide 6. We've completed construction of La Negra III and IV in Chile and are in the commissioning stage. We expect commercial production from these two trains beginning in the first half of next year ramping to 40,000 tons of lithium carbonate per year by 2024. This brownfield project allows us to increase existing capacity and leverage our world-class brine resource in Chile, just one of the avenues of growth that we have as an established lithium producer with a global footprint. We also continue to progress our Kemerton conversion facility in Western Australia. To mitigate risk related to the tight labor market and COVID-related travel restrictions in Western Australia, we have modified our execution strategy to prioritize Kemerton I over Kemerton II. Kemerton I remains on track for construction completion by the end of the year. We now anticipate completion of Kemerton II by the end of the first quarter next year, a delay of about three months. These delays and higher labor rates have also increased capital cost. It's been a difficult situation and a labor market that was already tight, but we have been able to maintain the schedule for Kemerton I with only a three month delay for Kemerton II. We continue to expect commercial production for both Kemerton I and II during 2022. Importantly, we are making progress on our Wave 3 lithium projects and we will provide further details at Investor Day in September. Site selection is underway, and we are negotiating with the authorities to include investment agreements. We're also expediting investments in bromine to meet increasing demand. We completed the first well at Magnolia ahead of schedule and under budget. Unfortunately, we are unable to take advantage of that additional capacity in the second half due to shortages of chlorine and the supply chain. We also have two projects in Arkansas that are currently in the select phase. These projects are designed to increase production capacity of clear brine fluids and hydrobromic acid. A third project to increase the capacity of our brominated flame retardants is in the evaluate stage. I will now hand the call over to Scott, who will provide an overview of our financial results for the quarter."
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{
"speaker": "Scott Tozier",
"text": "Thanks, Kent, and good morning, everyone. I'll begin on Slide 7. We generated net sales of $774 million during the second quarter, which is a slight increase from the same period last year, driven by stronger sales from our Lithium and Bromine segment. Higher sales, as well as strong operating margins resulted in an adjusted EBITDA of $195 million, which was 5% higher year-over-year. GAAP net income of $425 million, includes an after-tax gain of $332 million related to the divestiture of our FCS business to W.R. Grace. Adjusted EPS, which excludes the gain on FCS was $0.89 for the quarter, up 4% from the prior year. Let's turn to Slide 8 for a look at adjusted EBITDA by business. Excluding FCS, second quarter adjusted EBITDA increased by 13% or $22 million compared to the prior year. Higher adjusted EBITDA for lithium and bromine was partially offset by higher corporate costs related to incentive compensation and foreign exchange movements. Lithium's adjusted EBITDA increased by $19 million excluding FX compared to last year, primarily driven by higher volumes as customers under long-term agreements continued to pull orders forward, and we shipped higher spodumene volumes from our Talison joint venture. Adjusted EBITDA for bromine increased by $16 million due to higher volumes and pricing. End market demand continues to be very strong. Following the winter storms experienced in Q1, we have very limited excess capacity or inventory to meet that additional demand. Catalysts' adjusted EBITDA declined just $1 million from the previous year. CFT volumes were down due to shipment timing. FCC continued to be impacted by a change in the order patterns from a large North American customer, although the FCC demand trend was generally higher. This was partially offset by excellent PCS results, which benefited from a favorable customer mix. Slide 9 highlights the company's financial strength. Since the beginning of the year, we have taken significant steps to strengthen our balance sheet. The strategic decision to divest our FCS business added cash proceeds to the balance sheet and reduced our leverage ratio to 1.5 times. That transaction further demonstrates our ability to drive value by prudently managing our asset portfolio. Our strong balance sheet and investment-grade credit rating gives us the financial flexibility we need to accelerate profitable growth and continue to provide a growing dividend. Turning to Slide 10, I'll walk you through the updates to our guidance that Kent mentioned earlier, and there are several key changes from our previous guidance. First, higher net sales guidance reflects higher lithium sales volumes and improving catalyst trends offset by our lower bromine outlook. Adjusted EBITDA guidance is the same, reflecting higher net sales, offset by higher corporate costs and foreign exchange expense. Guidance on adjusted diluted EPS and net cash from operations is improving from an expected reduction in interest expense and tax rate. The timing of working capital changes is also expected to benefit net cash from operations. And finally, we see capital expenditures trending toward the high end of our previous $850 million to $950 million range based on the tight labor markets in Western Australia, as Kent discussed. In the far right column, pro forma revised guidance ranges are adjusted for the sale of our FCS business on June 1st this year removing the guidance on FCS for the rest of the year. I'm turning to Slide 11 for a more detail on the GBUs outlook. Adjusted EBITDA for lithium is expected to increase by 10% to 15% over last year, an improvement from our previous outlook. Lithium volume growth is expected to be in the mid-teens on a percentage basis, mostly due to higher tolling volumes, as well as the restart of North American plants at the beginning of the year and improvements in plant productivity. Our pricing outlook is unchanged. We continue to expect average realized pricing to increase sequentially over the second half of the year, but to remain roughly flat compared to full year 2020. We also continue to expect margins to remain below 35%, owing to higher costs related to project start-ups and incremental tolling costs. Margin should improve, as the plants ramp up commercial sales volumes. Our outlook for Catalysts hasn't changed since the first quarter report with adjusted EBITDA anticipated to be lower by 30% to 40%. However, we are more optimistic, as fuel markets continued to improve globally. Lower year-over-year results are primarily related to the impact of the U.S. Gulf Coast, winter storm in the first quarter and the ongoing impact from the change in customer order patterns in North America. Finally for bromine, we now expect mid-single digit year-over-year growth in adjusted EBITDA, which is down from our previous outlook due to a force majeure declaration from our chlorine supplier in the U.S. Like many industrial companies, we are experiencing increased costs and supply disruptions for raw materials, but it is partially offset by price and productivity improvement. Results are expected to be lower in the second half, as production is constrained due to the chlorine shortage. We are accelerating our expansion plans in bromine. However, we have been unable to take advantage of this new capacity yet due to the chlorine disruption. Looking ahead to 2022, we expect sales and EBITDA increases for all three businesses, Lithium results are expected to improve on the higher volumes, as the new plants ramp up, Bromine results are expected to rebound from short-term supply chain disruptions and the winter storm impacts and Catalysts results are expected to rebound strongly from 2021 levels assuming continued improvements in global transportation fuel demand. And with that, I'll hand it back to Kent."
},
{
"speaker": "Kent Masters",
"text": "Okay. Thanks, Scott. On Slide 12, we continue to execute on our strategic objectives for 2021. First, we are growing profitably. Construction is complete at La Negra, and we are commissioning this project with commercial volumes expected in the first half of next year. Both Kemerton trains are expected to contribute volumes in 2022 as well despite the restructuring of our execution plan at Kemerton. As previously discussed, we are making progress on our Wave 3 lithium projects and expediting investments in bromine to meet increasing demand. Second, we are increasing productivity. We are on track to achieve at least our targeted $75 million in productivity improvement this year. We expect to continue to build on these improvement, as we implement our operating model and build a culture of continuous improvement. Third, we are maintaining our disciplined approach to investments and continue to optimize shareholder value by actively managing our portfolio of assets, including the recently completed FCS divestiture. Finally, all of our efforts are being driven with sustainability in mind. In our annual sustainability report, published at the beginning of June, we disclosed initial sustainability targets, including plans to reduce greenhouse gas emissions and fresh water use. We are also working closely with customers, investors and ESG rating companies to make sure, they are up to speed in all of these developments, and have a full appreciation for our efforts. So with that, I'd like to open the call for questions."
},
{
"speaker": "Meredith Bandy",
"text": "Operator, we're ready for questions now."
},
{
"speaker": "Operator",
"text": "[Operator Instructions] First question comes from the line of P.J. Juvekar with Citi."
},
{
"speaker": "P.J. Juvekar",
"text": "Good morning, Kent and Scott. Congrats on finishing La Negra III and IV. Now that's done, are you looking for new hydroxide conversion capacity either in China or elsewhere, and would you consider building a convergent plant in the U.S.?"
},
{
"speaker": "Kent Masters",
"text": "So good morning, PJ, and thanks for that. We are - so - we've completed construction, we're still commissioning, so still a little bit to go at La Negra. And then, as you see in the plans that we have, the Phase III is mostly about hydroxide capacity in the near term. So, Kemerton will be coming on in the next year. And then the next wave of investments at the moment are focused on China. And we are - we do look for acquisition of conversion capacity, but it's a bit of a challenge just to find the assets that we want and that are for sale. So, we kind of have a meeting of the mines there, but we're also in parallel are progressing our plans to do greenfield projects as well. And if we were able to find an acquisition, we continue to progress the greenfield plans that we have. So they would - they are not - if we did an acquisition, that doesn't mean we stop our greenfield plans and projects, but we would just do them in parallel."
},
{
"speaker": "P.J. Juvekar",
"text": "Okay."
},
{
"speaker": "Kent Masters",
"text": "And then the last part, and sorry last part about the U.S. So, I mean, we will look at the U.S., but it's not in the next year or so, right. So it's - there is time. I mean, our view is most of the cathode capacity that's being built and we will be producing for the next several years is going to be in China or at least Asia. And so, we have time before we have to see if we need capacity in North America or Europe."
},
{
"speaker": "P.J. Juvekar",
"text": "Okay. And then, next question is, I want to go back to comments that you had made, Kent, I think on the last call about sort of market segmentation of customers that some customers will have a long-term contracts, some will have more market-related contract, especially customers like those who negotiated prices down in 2019. I was just wondering if either you or Eric could add some color on this sort of market segmentation of customers? Thank you."
},
{
"speaker": "Kent Masters",
"text": "Sure. So yes, I don't know if we can add much more than we talked about previously, but we are - in the past we had kind of a long-term contract formula and it was - we were trying to use that strategy for all of our customers, and what we've learned is that not all customers want to buy that way. So we're trying to segment on how they want to buy, and actually we think it's good for us as well. So we are - we have longer-term contracts that look more like a fixed price. And ideally, we want those contracts to move with the market that just - slightly with the market, but it looks more like a long-term contract. And on the other extreme, we will have contracts that look more like spot. They are probably, it's not - probably not a one-year contract, but it’s probably more than that, but the - but it moves with the market or closely with the market, still may be dampened a bit, and then you'll have some in the middle where that shakes out from a portfolio standpoint until we settle all that with our customers. I can't tell you, but for lack of anything else, it's probably a third, a third, a third, it's kind of how we see it now."
},
{
"speaker": "Operator",
"text": "Your next question comes from the line of John Roberts with UBS."
},
{
"speaker": "John Roberts",
"text": "On the delay at Kemerton II, if you're having delays, is the entire industry having significant delays here? I mean, we've got the car companies accelerating their demand plans here, as the supply actually going to undershoot what the industry needs."
},
{
"speaker": "Kent Masters",
"text": "Well, I can't speak to other projects, but I mean, if you're building in Western Australia, the availability of labor, the tightness is extreme. And Western Australia is kind of famous for labor market that gets difficult if you're doing large projects just because of the resource industry draws all of the resources. If their prices go up and their prices have gone up significantly for let's say iron ore, as an - is probably the biggest example, and they are drawing all the resources away, that’s always been an issue in Western Australia. But today we have COVID, so they locked down not only Australia, but state by state. So we can't move - not only can we not get resources from China or Thailand or even the U.K., we can't get resources from the east part of Australia. So, we're kind of stuck with what is in Western Australia. So - and I think that will affect anyone doing a big capital project in Western Australia or Australia. I'm not sure that it applies say in China, for example."
},
{
"speaker": "John Roberts",
"text": "And then, when CATL announced its sodium ion battery, all the lithium stocks popped including Albemarle. Is sodium ion something that we need to pay more attention to?"
},
{
"speaker": "Eric Norris",
"text": "John, good morning. It's Eric. Sodium ion, as you may know isn't a new chemistry. The CATL's innovation is a matrix that may make it more, more effective. It is a chemistry that is lower energy density, heavier material. So it's an applicable product for the low, very low-end of EV ranges and maybe grid storage. I think one of the attractiveness components of it is that - it's - sodium is abundant, right. So it's - so it may alleviate, and – at that low end of the market of - given alternative, if lithium supplies become tight as they have been in the past year or so."
},
{
"speaker": "Operator",
"text": "Your next question comes from the line of Bob Koort with Goldman Sachs."
},
{
"speaker": "Bob Koort",
"text": "Good morning. Kent, I was wondering, you mentioned that La Negra is completed. It takes six months to commission. Is that a function of just the qualifying process, and can you inventory production while you're doing that, and then have a nice buffer of inventory to start selling from as soon as the qualification is complete or is it a function of making sure the process works properly?"
},
{
"speaker": "Kent Masters",
"text": "It's both. So, we are commissioning and qualifying in parallel. So we can kind of - we do early commissioning to get qualification samples, but the plant has not been operating at rate, so that it takes us time to get it operating at rate. So we - we're kind of at a long pole in the tent, so to speak, is the qualification process, but we're commissioning during that same time and we run them in parallel, so that we - to save time. So it's - I think the answer is both."
},
{
"speaker": "Bob Koort",
"text": "And then - and on Wodgina, we've seen some pretty spectacular spot prices out there some north of $1,000. When do you turn that on and you imagine that would ever feed the Kemerton plants or will you feed Kemerton through Talison for the foreseeable future? Thank you."
},
{
"speaker": "Kent Masters",
"text": "Yes. So yes, we'll see how that goes. I mean, our plans are to feed Kemerton from Talison. And then, as we either bring on other capacity or do an acquisition, we would use Wodgina for that. And our strategy about selling spodumene hasn't changed."
},
{
"speaker": "Operator",
"text": "Your next question comes from the line of Edlain Rodriguez with Jefferies."
},
{
"speaker": "Edlain Rodriguez",
"text": "Quick one on bromine. So you've talked about the chlorine issue you have in there, but when do you expect that to correct itself?"
},
{
"speaker": "Kent Masters",
"text": "So I'll start, Netha can add a little bit. So - and I think there is a broader issue in the chlorine space. But I mean, our suppliers had some equipment failures and we expect that to last, I mean, they're telling us a couple of months, right. So they've got a short-term fix. We hope, we'll get us back up to some higher rates and then the permanent fix is going to take kind of - I think - I think they told us two months to three months. Yes."
},
{
"speaker": "Edlain Rodriguez",
"text": "Okay."
},
{
"speaker": "Netha Johnson",
"text": "Yes. I mean, as we look at the - as we look at the broader chlorine market, we think there will be opportunities to get it back and balanced by Q4 that we're hopeful for that."
},
{
"speaker": "Edlain Rodriguez",
"text": "Okay. Makes sense. Quick - another one. Like in terms of M&A, like you've done the FCS deal, so you - so you monetize that. But when you look at the rest of the portfolio like, is there anything else in there that you think might below - might be below somebody else. Can you talk about the rest of the portfolio, what you're seeing in there?"
},
{
"speaker": "Kent Masters",
"text": "Yes. So we - I mean we were looking at our PCS business, and we ran a process and we didn't get the pricing we wanted for. So it's performing well. And we pulled that, that is no longer for sale, and we're running as part of the portfolio, we're running as part of our catalysts business. So we've hold on to that. And then for the broader part of the portfolio, the three primary businesses bromine, lithium and catalysts, we see those as core businesses and that's kind of our fundamental portfolio. And now PCS is part of catalysts."
},
{
"speaker": "Operator",
"text": "Your next question comes from the line of Joel Jackson with BMO Capital Markets."
},
{
"speaker": "Joel Jackson",
"text": "Good morning, everyone. My first question, I follow-up on spodumene. Yes, we've seen pretty interesting surges in spodumene prices in the last, why shouldn't we say there is lag, contracts and stuff. But I think what - if we also - it seems like conversion margin, the proxy conversion margin will be extremely strong, so are those - as carbon hydroxide prices have been really strong. So do you see the spodumene price increases more of a lagging indicator or do you think that they're setting often to be another run up in spot prices sparked up, we can deal with the prices."
},
{
"speaker": "Kent Masters",
"text": "Look, I'll make a broad comment, let Eric can try a little bit of a detail. It's hard for us to project, where the market is going. And we see prices about spodumene and carbonate and hydroxide prices being up. The only place you really have visibility of spot prices is in China for the carbonate and hydroxide. And so you see that, you see the same numbers that we do. Those have not fully translated into the contract prices, but we do see contract prices moving up. And spodumene, I mean, it has gone up, it come back down a little bit. I don't know that we're in, what you would call a super cycle or headed toward that. But I think - I do think prices will be higher than they have been in the last couple of years."
},
{
"speaker": "Eric Norris",
"text": "Hi, Joel. What I would - this is - and I think your question reflects this. This is a China market phenomenon. The China market is very dependent for its growth on imported spodumene. So - and there is a shortfall of available supply to meet demand given the rapid growth post pandemic particularly in carbonate in China. So in that regard, maybe spodumene is a bit of a lead because it's the short supply. But I think what we expect to happen is more supply to come into China from other parts of the world. We've seen prices go up and stay up with demand. It's hard to say what's going to happen with spodumene prices. From a Albemarle perspective, the way we take advantage of that is we don't sell spodumene or yes, it's right. We don't sell chemical grade spodumene, as you say. We sell especially spodumene for the glass market, but for us it's tolling. So you've heard us talk about, looking at tolling opportunities and that's part of our improved guidance. And for that we're able to participate in that spot price market, which is as I've said earlier, very favorable."
},
{
"speaker": "Joel Jackson",
"text": "Thank you for that. So my follow up would be just looking at out to 2022 for LCE volume increases. I think you talked about maybe gaining about 30,000 tons LCE volume for next year with the different expansions ramping on, Kemerton II is delayed a few months, maybe you've been pushing out a little more tolling now this year. Is it about 30,000 ton, still the right number to think about for next year?"
},
{
"speaker": "Kent Masters",
"text": "So Joel, I mean, I think it's, you have to break it down. First of all, I don't think we've said 30,000 tons. We've talked about ramp rates on plants. So the Kemerton plant with a start-up in the early part of next year, there was a three month delay to the second unit. We've talked about getting to full run rate capacity by the end of the second year in that facility. Similarly in carbonate, you'd see a phenomenon that is somewhat like that. I would say our run rate for carbonate by the end of '22, we will probably at the 30,000 run rate basis at the end of the year, as that ramps. It's a little bit different ramping brine versus spodumene because brine is obviously a harvested material, but - versus the fixed input, but that roughly should - between those two, we should be able to calculate sort of our guidance. The change would be a slight delay at Kemerton and in a year-on-year growth that we can achieve in tolling and that's going to be - it's harder for us to predict now because it's a function of what's available in the market for us to toll that."
},
{
"speaker": "Eric Norris",
"text": "Yes. It's also a function of how fast we ramp up like so how well commissioning goes and then there is we - you'll commission, you'll be able to make products but at lower rates and that will ramp up over time. And it's how well we do in that ramp curve and it's hard to speculate on that."
},
{
"speaker": "Operator",
"text": "Your next question comes from the line of Arun Viswanathan with RBC Capital Markets."
},
{
"speaker": "Arun Viswanathan",
"text": "Thanks for taking my question. I guess, I just wanted to get your thoughts. We've had some different views, I guess, maybe just provide your color on spodumene, carbonate and hydroxide. Spodumene obviously there were some oversupply in years past, but it seems like most of that is slowly working itself out. Maybe you could just characterize supply demand in each of those areas? Thanks"
},
{
"speaker": "Kent Masters",
"text": "Okay. And again I'll start, Eric can fill in, where I miss things. But I think in the past, the industry is growing, right. So as the industry grows, you bring on capacity at a smaller percentage of the industry. So I don't think we're going to have those periods of oversupply, under supply as tight, as they were in the past with the extremes showing up in pricing. So that - I think that applies across for hard rock as well as kind of salt - conversion capacity for the salt. So I think as the industry gets bigger, each addition is a smaller percentage of the total industry and it has less of an impact. That said, where we are. I mean spodumene is pretty - spodumene is tight. And I think that the conversion capacity, as the growth rates that we see, which you've kind of seen as an indicator. In fact EV sales is forward looking growth curve for lithium, those are pretty tight. And you've got to make investments and you've got to be good at executing those projects and commissioning them and then, ramping them up to full capacity, which is we think we're good at that, but we're in the process of proving it."
},
{
"speaker": "Eric Norris",
"text": "And I would just add, Arun that today as we sit here today, all three are extremely tight. If we had more carbonate that we could produce and sell, we could sell it readily, same with hydroxide. We don't have the disadvantage. We have the ability. We have idle capacity on the spodumene side. So we are not feedstock limited. That's a strength we have going forward. But what we are limited on is our ability to get conversion capacity in the ground quickly. So - and that's part of our plan for next year. As to the long term, my guess would be that our view would be, I should say that hydroxide will probably see their higher rate of growth going forward off a smaller base. Carbonate has done well in the near term based upon the LFP trend for lower end vehicles, particularly in China, and we see that starting to take root in some other regions as well for the low end. But the key to high EV penetration is higher energy density and the key to that is hydroxide and ultimately potentially solid state chemistries. So that's going to require a heavier burden on hydroxide. We see that being the tighter market from a long-term basis going forward."
},
{
"speaker": "Arun Viswanathan",
"text": "And just wondering if there is any concern from elevated logistics cost for the next little while. Also maybe you can just address, if there is any concerns on the container shortage issue? Thanks."
},
{
"speaker": "Kent Masters",
"text": "Well, I think, across all of our businesses, the supply chain is a challenge and a concern. So ocean-going freight probably the biggest, but well, chemicals supply chain in the U.S. is hitting us and particularly chlorine at the moment, but it's tight and a number of chemicals. But ocean-going freight is a big concern for us and something that we are working pretty hard to try and to manage. We spend a lot of time trying to streamline that supply chain digitizes, so we have much better visibility on it. So we're making progress on that, but it's still a concern."
},
{
"speaker": "Operator",
"text": "Your next question comes from the line of Vincent Andrews with Morgan Stanley."
},
{
"speaker": "Vincent Andrews",
"text": "If I just ask in bromine, it doesn't sound like either your sort of electronics sales or your auto sales that you're seeing any, any real volume issues from the shortage of microchip. So is that - that's just something that it's either being offset by other parts of the business or it's just not an issue either year-to-date or into the back half of the year?"
},
{
"speaker": "Kent Masters",
"text": "Yes. Vincent from where we sit in the supply chain, we're not seeing that at all in - from a demand side. Our demand in those areas have been steady."
},
{
"speaker": "Vincent Andrews",
"text": "Okay. Great. And if I could just ask. You have the Analyst Day coming up, and you're also concurrently working on the Wave 3 projects and looking to move forward those. I mean should we be expecting a material update on those at the Analyst Day or are those two events unique?"
},
{
"speaker": "Kent Masters",
"text": "So material update, I'd say it depends on the definition. So we'll give you progress on where we are. But we're not, I mean - and - but we are still in the planning phase. We're not moving dirt on any of the projects, yet."
},
{
"speaker": "Vincent Andrews",
"text": "Okay. So no FID - we shouldn't be expecting any FID decisions then?"
},
{
"speaker": "Kent Masters",
"text": "No. I mean we're progressing as we go, and we'll tell you the plans that we have. But we're - it's not at a - we'll not have a final investment decision by in a month."
},
{
"speaker": "Operator",
"text": "Your next question comes from the line of David Begleiter with Deutsche Bank."
},
{
"speaker": "David Begleiter",
"text": "Eric, couple of questions for you, just on lithium pricing in Q3. Is your guidance for that pricing to be up year-over-year in Q3?"
},
{
"speaker": "Eric Norris",
"text": "Yes. The second half - I mean, we were down 10%, so to recount a little history here to put in perspective. We're down 10% across the board in the first quarter, 4% in the second quarter, and we're staying flat for the year. So we will be up year-over-year. Another way to think about is our lowest price point over the past 24 months are including the rest of this year. So for 2020 and 2021, we expect to be the fourth quarter of last year. And ever since then, we sort of bottom there, we're seeing as spot prices move up for that small amount of our business is exposed to that such as better grade in China or tech rate. And as concessions to contracts given during the height of the pandemic roll off, we see those prices rising in the back - into the second half of this year. And given the tightness in the market, we expect into next year as well."
},
{
"speaker": "David Begleiter",
"text": "Very good. And also, there has been some progress like DLE project near your operations in Southern Arkansas. Can you discuss the viability of a DLE project for you guys in Southern Arkansas going forward?"
},
{
"speaker": "Eric Norris",
"text": "Well, yes, so I'll say that for us, we continue to look at Magnolia brines, where we operate our bromine operation is being our spot, where we could process lithium and DLEs potential technology for that. DLE just - it's a bandied about term most often here in the U.S., who made the projects, what they're talking about is absorption, resins, and so it's a mechanical operation - for extracting brines, it's a mechanical operation as opposed to an evaporation effort such as we do in Chile. That you would only apply it, you have to apply, meaning you apply it to resources that are of lower quality or have higher impurities present, which is generally true with both oilfield brines, which is what we have in Magnolia or geothermal brines. So it's more capital intensive, but actually it also consumes a lot more water and energy given the price. So it has some drawbacks from it. We're studying what alternatives we could deploy to a resource like that, that could include absorption, that optimize those factors of cost and sustainability. Given where we are with our high quality resources, and then what we can do in the near term to drive our growth in next five years, we put that as a resource later in the decade that we would consider for that given its - given those technical challenge and given its cost profile."
},
{
"speaker": "Kent Masters",
"text": "Yes. And I would just add. So we've - we didn't - it wasn't included in our Phase 3 and but it's something that we look at. We are looking at the technology. We have access to the brines, and we have the operation. We're already kind of pumping the brines around. So we'd be in a good position to leverage it if we think that if we get the technology right, and we believe the cost position is right. But it's something that comes probably in Phase 4, if we get that technology right."
},
{
"speaker": "Operator",
"text": "Your next question comes from the line of Jeff Zekauskas with JPMorgan."
},
{
"speaker": "Jeff Zekauskas",
"text": "Thanks very much. In your Talison operation and equity income in lithium, sometimes you are in the 30 million and sometimes you are in 15 million or 16 million. And what's the difference between the two, when we've had some 15s and 16s, are there any service to come?"
},
{
"speaker": "Scott Tozier",
"text": "Jeff, this is Scott. So the equity income in Talison is affected by two things, one is the volume that's being shipped both to ourselves as well as to Tianqi, our partner. And of course that has been either flat or rising over time. The bigger impact that you're seeing through the equity income is coming from the transfer price, which is affected by that - by the spodumene market price that's out there. So when that price is high, you're going to see a higher equity income, when it's lower, you will see a lower equity income. And generally that's going to track on about a six month lag to the market indicators that are out there. So as we talked about in the - some of the prior questions because the spodumene prices higher, are going higher right now, you should expect in the second half that, that equity income would also track to that."
},
{
"speaker": "Kent Masters",
"text": "You should just keep in mind though that it's been our input cost for conversion goes up, when that price goes up. So we don't really - it doesn't matter so much to us because it's all - it washes through. But it's the difference between equity income and what shows up in the lithium P&L."
},
{
"speaker": "Jeff Zekauskas",
"text": "Then for my follow up. I think over the past several years, if you had to describe the contractual terms of your long-term lithium contracts, I think, you would have said that they were above market. Given the changes in lithium market and its tightness or some toughness, is it now the case that your long-term contracts are more comparable to current prices?"
},
{
"speaker": "Kent Masters",
"text": "It depends on what you call current."
},
{
"speaker": "Jeff Zekauskas",
"text": "Yes."
},
{
"speaker": "Kent Masters",
"text": "Yes. I think it depends on what you're calling current prices. So if you're talking about spot prices in China, which is what everyone can see that's probably correct. But I think if you were to think about contract prices over time, contract prices outside of China that different suppliers have, it's probably in line or above those. I would say probably still above those."
},
{
"speaker": "Operator",
"text": "Your next question comes from the line of Ben Kallo with Baird."
},
{
"speaker": "Ben Kallo",
"text": "Good morning, guys. Thanks for taking my question. Just maybe two on the lithium front and then one on bromine. On lithium, you know, you get this question a lot, but just on recycling we saw redwood materials raise a large sum of money. I want to understand, how you see the players in the recycling as they work with your competitors - you - is number one. Number two, you know on the Tesla call, and then - and I think before that Mark was talking about the LFP and the increase there. Just want to understand and I think you talked a little bit about this, but how you make investments into carbonate versus hydroxide with that background looking like there is a large increase in demand for LFP. And then on bromine, just comfortable - how comfortable you are around the timing of the expansion. I think it's really chemical expanded already earlier. So just want to see how strong you think that market you know, for bringing on new capacity? Thank you very much, guys."
},
{
"speaker": "Eric Norris",
"text": "Ben, this is Eric. On recycling, recycling is happening around the world and so the companies you're referring to are largely here in the U.S. There is a set of companies similarly in Europe. It's a regional business model because of the collection and nature of different regulations around the world. As a global player, we're engaged with all of these companies. We view them in almost every case as a partner, not a competitor and we bring process, not the technology and knowhow that's what we deploy in some of our existing virgin brine operations, it could be a partnership approach to helping to remove the lithium and/or take a byproduct that comes out of their operations, which is lithium rich. And so that's the way we work with them. You have to remember a lot of these companies got set up and this is - and then, Europe is a bit - is ahead on this largely go after the nickel and the cobalt, not lithium. Lithium is usually the byproduct of the recycling operation. That's where we fit in. And so as we look at trying to partner with our customers on and drive their success from a sustainability standpoint, we view this as an important part of the value mix we bring is helping them recycle to lithium and recycle it back to them for their continued growth. On the Tesla side, we view what Tesla's described as very - generally very consistent with our market outlook. It's going to continue to shift and I think expand meaning the size of those EV market, which by 2025 might be at one level, but by 2030, I think you're going to have a larger proportion of vehicles that are electrified. There's some news a lot about - some intentions around that here in the U.S. today. And for the lower end, LFP is the applicable technology. I mean, it gives you a lower range. We still believe though that for the mid and higher range vehicles, you're going to need - in order to get, you need higher energy density to get the range. And you can drive good cost, if you can get good technology and then, get the cost - the cost per kilowatt hour down, get the kilowatt hours up per unit weight. So that's the mix we see. And I - it's very consistent way Tesla is approaching the market as well. Turn it over to Netha for bromine."
},
{
"speaker": "Netha Johnson",
"text": "Hello Ben. If you talk about the timing of our bromine expansions, I think we feel really good about the markets that we participate in and their projections over the next few years. And we're really just executing the company's strategy of building capabilities to accelerate lower capital intensity, higher return growth. And for us what we're doing it at is the Magnolia and that's a great place for us to do it because we have great jurisdiction. We've been there for over 50 years. We know the asset well, and we could produce every product that we make out of that facility. So that leads us to have high confidence in those projects and the timing of execution. And we feel really good about the plan there and their ability to deliver what we want out of those expansion projects."
},
{
"speaker": "Operator",
"text": "Your next question comes from the line of Matthew DeYoe with Bank of America."
},
{
"speaker": "Matthew DeYoe",
"text": "So as you ramp Talison to meet Kemerton demand, what do you expect your partner to do. I know they have their own kind of hydroxide plans, those have been pushed a bit. Do you expect Talison output to increase by the 50,000 metric tons, you're going to need or will be closer to 100,000 metric tons. And just how do you see that that, that timeline playing out can you move as fast as you think you'll need, if It's a joint discussion versus your singular desires, I guess."
},
{
"speaker": "Kent Masters",
"text": "Yes. Well, it's definitely a joint discussion. It's a JV. And I think we'll optimize the supply. So the product that Talison our portion or half of that with Tianqi that - that's ours. But we have JV product at Wodgina. They have their own product in other parts of Australia. And we will swap product to kind of optimize economics. I think way you would think about it is Talison goes to feed our portion and then - and some other product feeds their portion at Kemerton. However, it physically, it probably won't work that way. We will swap product to optimize the economics."
},
{
"speaker": "Matthew DeYoe",
"text": "All right. I guessing it more, what you expect Tianqi to do versus [indiscernible] portion about this?"
},
{
"speaker": "Eric Norris",
"text": "This is Eric jumping in. We can't predict what Tianqi is going to do. I mean, they have some public statements out there around their Kwinana facility, which is really very in terms of its potential over time similar in size to Kemerton at least our - at least our first investment in Kemerton. And the JV is owned by the two of us. So it produces a budget to what we need. So you really need to talk about what's on the ground there, CGP I and CGP II. We feel with CGP II being fully ramped, we will meet the needs of what we have invested in, and allow to ramp at Kemerton. And if they don't have the need on their side, they won't take their share right, is how it comes down to it. So that's how it works. We're always entitled to at least 50%. It could be of what's available. It could be more if they don't need to take more and vice versa on the other side."
},
{
"speaker": "Matthew DeYoe",
"text": "Okay. If I could just follow up. So the new pricing approach, you talked about, I understand it's still in the works, but theoretically, I guess if you were to look over the last cycle maybe peaks in 2018 and trough more in 2020. Can you provide some context as to like how much your realized price would have been higher in 2018 had you chosen this path versus how much lower, you would have been in 2020, like how much higher with the peaks and how much lower with the troughs and I would imagine some sort of analysis has been done to kind of get a sense for, if this was a net winner or loser over time."
},
{
"speaker": "Kent Masters",
"text": "Yes. So we've not - we've done analysis that we can share about what our price would have been under the new model. But you're right, it would have been higher, higher towards the peak and lower during the trough, so which is the point. We're trying to move a little bit more with the market, but not expose ourselves fully to the commodity price. But I don't have the numbers to share with you exactly what it would be. And the other part - the other part of that question, which we don't really know the answer to is how is the portfolio, what does it look like, how much of that spot type pricing, where we end up with versus that long-term contract pricing because during the last peak and bottom that we're pretty much we're all on the long-term contracts."
},
{
"speaker": "Eric Norris",
"text": "I think it's also important that in the last peak and bottom, there were no automotive producers involved at all in the cycle. There are now, and there's a lot more demand now. And I'll a reference of Kent - a remark Kent made earlier that given the size and maturity of - we've only gone through one cycle before really since the dawn of the EV, and now we're moving through the next part of the cycle. It's going to look different and probably won't have the same volatility than before. We don't know. But I think the size of growth is such that it - and supply additions is such that it's going to change with time. So the pricing structure we're putting in place is going to continue to evolve. We have contracts to fit the structure. So we know it works. We have customers paying fixed prices. We have customers, who are only going to - we're only going to give them a year commitment, and they will take, they will - they want to ride the wave and at that point that wave is going up. So it's - how it settles out over time, we'll have to continue to dimension for you, but we're at the early stages."
},
{
"speaker": "Operator",
"text": "Your next question comes from the line of Mike Sison with Wells Fargo."
},
{
"speaker": "Mike Sison",
"text": "Nice quarter. Just curious what your thoughts on the lithium demand, whether percent or tons in '22 is expected to be for the industry?"
},
{
"speaker": "Kent Masters",
"text": "Yes. I - it's a question, Mike, that I may have to go back and look at our demand model. We do have a model we put out and it's - we - and it's still consistent with what we think today. And it was some months ago, earlier this year, we did that. We're seeing a much bigger demand here in '21 overall this year than last, because of the post-pandemic recovery. The overall market growth is 25% plus. So we're going to be at least in that order magnitude for '22 I'd say on a year-on-year basis."
},
{
"speaker": "Mike Sison",
"text": "And then, I know, there is some timing in terms of getting the volume on for Wave 2, but when do you think roughly, you'll have all the capacity available to sell. Is it '23, '24, '25, just curious on the - when you'll be able to sell it all?"
},
{
"speaker": "Kent Masters",
"text": "When you say the capacity, you mean, La Negra and Kemerton?"
},
{
"speaker": "Mike Sison",
"text": "Yes."
},
{
"speaker": "Kent Masters",
"text": "Okay. Because we're - I mean, our plan is, we're going to be building plants over time. It's going to be ramping up over time. But La Negra - between La Negra and Kemerton at full rates ramped up selling everything '24 for the full year."
},
{
"speaker": "Mike Sison",
"text": "For the full year. Great. Thank you."
},
{
"speaker": "Operator",
"text": "Your next question comes from the line of Chris Kapsch with Loop Capital Markets."
},
{
"speaker": "Chris Kapsch",
"text": "Just slightly more nuance follow-up on this discussion around the increased volumes implied in your guidance and so it's nice most of that is coming from more volumes from via Greenbushes and that spodumene being converted downstream to via tollers. First, is that an accurate characterization. And then with that in mind, Eric, I appreciate you've stated in the past that you don't rely on toll conversion for battery grade chemicals, but only for technical grade lithium products. But in this case, it seems like the extra volumes are carbonate feeding into the LFP cathode market. So just wondering if that also is accurate, and if that's the case, I guess - should we be thinking of these carbonates grades via tollers as just or maybe just the LFP market being more of a technical grade market. And then finally just, it seems like this is part of the market, you will address once La Negra is ramped next year. But will then - will you then say that the current toll relationships that you're leaning into currently to opportunistically address these volumes?"
},
{
"speaker": "Kent Masters",
"text": "Well, a bunch of questions there, Chris. Let me go to the first one, which had to do with, help me here. I just stuck on the LFP, but you had something before that, what was that? What was your first question, Chris?"
},
{
"speaker": "Chris Kapsch",
"text": "Yes. So the --"
},
{
"speaker": "Kent Masters",
"text": "Ramp."
},
{
"speaker": "Chris Kapsch",
"text": "The tolling volumes…"
},
{
"speaker": "Kent Masters",
"text": "Our volume, yes, yes, sorry. Senior moment there, I guess. The - if you look at our produced volumes, we're going to be fairly flat, first half to second half, maybe slightly better in the second half because we have little better production - we have some better production in Chile, in the fourth quarter, seasonally just by a tad. What's the real differences in our volume first and second half, and our volume growth year-over-year is on - the first half, second half is the tooling - increased tolling. Year-over-year is tolling, because we didn't had last year, as well as plants come back online and efficiencies in the plants, better operation in the plants year-over-year. So there's a bit of difference between first half, second half and year-over-year there. On what we're using that carbonate for when we toll it in China, it's going into the LFP market. I think what we - I don't know what we said a years ago, but what we said more recently is that the carbonate market, the tolling network is able to produce sufficient better grade quality to supply the LFP market for batteries in China. So that's where we are selling that material currently. And then, now, I'm going to ask you help again. The last question was --"
},
{
"speaker": "Chris Kapsch",
"text": "So since you're addressing that - via the tolling relationships currently, when you ramp La Negra next year, will you stayed those relationships or do you still intend to participate via tolling, obviously this has mixed implications given the higher feedstock costs and the fact that tollers need to make a margin. So curious if you've stayed those tolling relationships or maybe - would there be a bare hub like you've done in the past with tolling partners that you're comfortable with?"
},
{
"speaker": "Kent Masters",
"text": "It will be a bit of both. I mean our strategy for a lot of what we produce out of La Negra's growth, La Negra III and IV is to put it under a contract commitment in some form. That might be for price buyer only a year and for performance buyer might be a couple of years, but that's our strategy for that volume. Our strategy for the total volume is either to use it as a bridge to build the customer relationships when we have La Negra III and IV. So some of those customers we're currently selling toll volumes, where we will take advantage of selling La Negra III and IV to it as well. But in today's market, which is particularly tight, is also opportunistic to play in what is a pretty tight market and - and they were really playing on a - on a spot basis. So while we have higher cost to produce this whole volume, we're taking advantage of currently higher spot prices than contract."
},
{
"speaker": "Operator",
"text": "And our final question comes from the line of Kevin McCarthy with Vertical Research."
},
{
"speaker": "Kevin McCarthy",
"text": "Thank you for squeezing me in. Want to ask about your Catalysts business. If we look at margins in the first half of the year in broad strokes, they are running maybe half of historical levels, yet. In the prepared remarks, I think you indicated you anticipate strong rebound in the business. So I was wondering if you could flesh that out in terms of what you're seeing in your refinery catalyst order books. And when might we expect those margins to get back to historical levels might that be as soon as '22 or more likely '23 or later?"
},
{
"speaker": "Raphael Crawford",
"text": "Good morning, Kevin. This is Raphael. Just to respond, one, there has been a series of effects. I mean in the first half of the year, we certainly had an impact from the winter storm. We have residual impact from the pandemic, a lot of that pandemic impact was a down trade of high-performance catalyst to maybe more workhorse catalysts that has a effect on margins and as well as on our mix. Looking forward, I think we would see recovery. I mean, some of our best products what we're known, for example is our high performance hydroprocessing catalysts. As the markets recovering, as change out start to occur at a faster clip in 2022, we're going to start to see that come back. Again, we have great partnerships for great performance catalyst, those are the higher margin that will improve our mix. And I think it's that mix impact going into 2022 that you'll start to see that improvement in our margins. We already see it today, Kevin. We have customers that are, they down traded to lower performance catalysts, when they were under margin pressure. We just had a customer meeting this week with a large North American refiner, who is telling us that because they're starting to operate at higher rates, they're needing to run under more severe conditions, they need higher performance catalysts, those command higher margins for us. So we think it's a favorable trend. It will probably start to materialize in 2022, where you will start to see them."
},
{
"speaker": "Kevin McCarthy",
"text": "Thank you for that. And then secondly, if I may for Eric. In a prior answer, I think you alluded to the news out today that the U.S. is now targeting 40% to 50% of new auto sales, as EVs by 2030, although I thought - I read that it might be non-mandatory. So just curious about your view on that. Is it incrementally accretive to your demand outlook in any way or are the U.S. automakers already tracking to similar levels or what do you think about the potential market impact of that announcement?"
},
{
"speaker": "Kent Masters",
"text": "Yes. So - this is Kent. That - it's early news. It's just out today. And I don't - from my understanding it was not mandatory. It's got something that it's trying to lead legislation to something maybe like that. It's - so I'd say it's early days. And then, I'm not - it - and it's probably in the ballpark of what the car companies are already thinking, maybe it's a little more aggressive. But it doesn't shift the model from our perspective, I don't think. I think our view would be that's neutral."
},
{
"speaker": "Operator",
"text": "And now we will - I would like to turn the call over to Kent Masters for closing remarks."
},
{
"speaker": "Kent Masters",
"text": "Thank you, Carol, and thank you all, again, for your participation on our call today. As you can see, we have a lot to be excited about at Albemarle, and we see extraordinary opportunities for growth. We are implementing a comprehensive operating model that will enable us to execute on our objectives effectively and efficiently. We look forward to discussing this in greater detail during our Investor Day on September 10, and we hope you will all be able to join us then. Thank you, and that concludes our call today."
},
{
"speaker": "Operator",
"text": "Ladies and gentlemen, this concludes today's conference. Thank you for your participation, and have a wonderful day. You may now disconnect."
}
] | Albemarle Corporation | 18,671 |
ALB | 1 | 2,021 | 2021-05-06 09:00:00 | Operator: Ladies and gentlemen, thank you for standing by, and welcome to the First Quarter 2021 Albemarle Corporation Earnings Conference Call [Operator Instructions]. I would now like to hand the conference over to your speaker host, Meredith Bandy, Vice President of Investor Relations and Sustainability. Please go ahead.
Meredith Bandy: All right. Thank you, Olivia, and welcome to Albemarle's First Quarter Earnings Conference Call. Our earnings were released after the close of the market yesterday, and you'll find our press release, presentation and non-GAAP reconciliations posted to our Web site under the Investors section at albemarle.com. Joining me on the call today are Kent Masters, Chief Executive Officer; Scott Tozier, Chief Financial Officer; Raphael Crawford, President, Catalysts; Netha Johnson, President, Bromine Specialties; and Eric Norris, President, Lithium, are also available for Q&A. As a reminder, some of the statements made during this call, including our outlook, guidance, expected company performance and proposed divestitures and expansion projects, may constitute forward-looking statements within the meaning of federal securities laws. Please note the cautionary language about forward-looking statements contained in our press release and presentation that same language applies to this call. Please also note that some of our comments today refer to financial measures that are not prepared in accordance with GAAP. A reconciliation of these measures to GAAP financial measures can be found in our earnings release and the appendix of our presentation, both of which are posted to our Web site. And with that, I'll turn the call over to Kent.
Kent Masters: Okay. Thanks, Meredith. Good morning, and thanks to you all for joining us today. On today's call, I will highlight our recent accomplishments and discuss our strategy as it relates to accelerating growth and creating a more sustainable business. Scott will give us more detail on our results, outlook and capital allocation. This was another strong quarter for Albemarle with solid financial results. We generated net income of $96 million and adjusted EBITDA of $230 million, up 17% from last year. We benefited in part from several lithium customers that accelerated orders under long term agreements as well as favorable volume and customer mix in our bromine business. We continue to see strong market demand for lithium, especially from EVs. First quarter EV sales were up 135% versus last year, led by China. European and North American sales were also up significantly. All that said, remember that we are sold out in bromine and lithium. Therefore, we are maintaining our previously reported company guidance for the full year. Scott will provide additional detail on this in just a few minutes. We are advancing our growth plans with the progress being made at our Wave II lithium projects. These two projects, La Negra III, IV and Kemerton I, II, are expected to add volume beginning next year. As you are probably aware, during the first quarter, we successfully completed $1.5 billion equity offering and then subsequently reduced our debt. This enabled us to achieve two strategic goals. First, we are now well positioned to execute on our high return Wave III growth projects for lithium and bromine. And second, we have maintained our investment grade credit rating, which was recently upgraded to a BBB rating by S&P Global. I'm also proud to say that we have signed the UN Global Compact, joining the efforts of corporations and stakeholders worldwide to advance sustainability. On Slide 5, I want to update you on those two projects at La Negra and Kemerton, our two ongoing projects to increase lithium production from our world class resources. These conversion facilities are in the final stages of construction, and when complete, are expected to double our nameplate capacity to 175,000 metric tons per year. This added capacity will provide much needed volumes to support our customers' growth ambitions and will enhance our ability to drive further earnings expansion. Construction is on track for completion later this year. We are watching the Western Australia labor situation closely, but currently, we do not expect any impact to our schedule. Once complete, we move into final commissioning and customer qualification, which typically takes about six months. We expect to begin producing commercial volume from both projects in 2022. These two sites will complete our Wave II lithium projects and enable our team to focus on the execution of Wave III, which represents further 150,000 metric tons of conversion capacity. We expect to make investment decisions on the first projects from Wave III as early as the middle of this year. This includes a greenfield site in China and potentially the acquisition of a Chinese conversion plant. I would like to mention that the Chilean Nuclear Energy Commission, or CCEN, has confirmed that our resource and reserves report is in full compliance following the additional data we provided in January. We are committed to complying with our regulatory obligations around the world, and we are pleased to reach a satisfactory and collaborative resolution with CCEN. Finally, in bromine, we are accelerating our growth projects and expect to see the benefit of these projects beginning in 2022. I'll now turn the call over to Scott to review the first quarter results.
Scott Tozier: Thanks, Kent. I'll begin on Slide 6, and I'm happy to report on a strong start to the year. For the first quarter, we generated net sales of $829 million, a 12% increase from last year. This was driven by increased volumes across our three core businesses, as well as a favorable customer mix within our bromine unit. GAAP net income was $96 million. Adjusted EPS of $1.10 excludes the cost of early debt repayment that we incurred when we delevered in March following our equity raise. Our sales growth enabled us to generate adjusted EBITDA of $230 million, up 17% from last year, giving us an early start to meeting our guidance for the full year. Now turning to Slide 7 for a look at adjusted EBITDA by business. Adjusted EBITDA in total was up $34 million over last year, thanks to stronger lithium and bromine results and a foreign exchange tailwind. Lithium's adjusted EBITDA increased $30 million versus the prior year as some customers accelerated orders for battery grade carbonate and hydroxide into the first quarter. To meet this demand, we drew down lower cost inventories resulting in Q1 margin expansion. Average realized pricing was down 10% as expected due to lower carbonate and technical grade pricing. However, increased volumes more than offset the lower price. Market demand remains very strong but our plants are sold out, which limits our ability to increase volumes in 2021. Bromine's adjusted EBITDA grew by about $8 million compared to the first quarter of 2020, an increase of 9%. The strong quarter was due primarily to higher sales volumes across the product portfolio. Pricing was also higher, in large part related to a favorable customer mix. The US Gulf Coast winter storm reduced production and increased cost by about $6 million in the quarter. And just like lithium, we drew down inventory in Q1 and our bromine plants are sold out for the year, making it difficult to offset the production losses from the storm. We expect to see the impact from lost production in the Q2 and Q3 time frame. Catalysts adjusted EBITDA declined $23 million, primarily due to the US Gulf Coast winter storm, which impacted production in Bayport and Pasadena, Texas. These sites incurred increased electric and natural gas costs, production downtime and repair expenses that totaled $26 million. Our Q1 catalyst results from last year included $12 million of income that was later corrected as an out of period adjustment, which further complicates the year-over-year comparison for this quarter. Without this and the storm impact, our Catalyst EBITDA would have been up 31%. Our corporate and other category adjusted EBITDA increased by $4 million, primarily due to lower corporate costs. Slide 8 highlights the company's financial strength. With the proceeds from our $1.5 billion equity offering in February, we repaid debt. By deleveraging in the short term instead of holding the proceeds as cash, we were able to reduce interest expense and create the debt capacity that will allow us to accelerate our growth for the lithium and bromine businesses, funding investments as they are approved. You can see how we are executing on our commitment to grow our dividend and maintain our investment grade credit rating. We increased our dividend for the 27th consecutive year, which speaks to our ongoing success and a track record of shareholder returns, which we are proud to maintain. On Slide 9, we provide a look at our guidance for the year. I would like to note that our company guidance for the year includes a full year of Fine Chemistry Services results. In February, we entered into an agreement to sell the FCS business for proceeds of approximately $570 million. The transaction is expected to close in the second quarter of 2021. We've also given a breakout of second half guidance for FCS for modeling purposes. As we've discussed, our lithium and bromine businesses outperformed expectations for the quarter, primarily driven by accelerated customer orders and a favorable customer mix. We do not expect to see the same upside over the next three quarters, mostly because our lithium and bromine businesses are effectively sold out and we don't have excess inventory to meet increased demand. Timing of orders can shift from quarter-to-quarter but the outlook for full year volumes is mostly unchanged, except for modest increases in lithium. We continue to monitor the chip shortage at automotive manufacturers for impacts to lithium and bromine. And so far, we've not seen an impact. This may be due to our position in the supply chain. In May, IHS revised their forecast for 2021 EV production down 3% from prior forecasts related to microchip shortages and supply chain issues. EV production is still though expected to be up 70% year-over-year. We are maintaining our company guidance for the full year and continue to expect net sales to be in the $3.2 billion to $3.3 billion range, which is slightly higher than last year. The demand we saw during the first quarter and sold out volumes speak to the importance of investing in our lithium and bromine businesses to add to our future earnings potential. Our 2021 guidance for adjusted EBITDA remains between $810 million and $860 million. We continue to expect CapEx to be around $850 million to $950 million for the year as we complete our Wave II lithium projects and begin focusing our efforts on Wave III. Net cash from operations are also tracking on plan. As the year progresses, we expect higher inventories as we start to commission the two new lithium plants and higher cash taxes. Expectations for adjusted diluted EPS of $3.25 to $3.65 are on track, reflecting higher taxes, depreciation and increased share count and lower interest expense. While our total company guidance has not changed, the outlook for our lithium and catalyst businesses has, as shown on Slide 10. Our outlook for the lithium business has improved due to higher lithium volumes driven by plant productivity improvements, and we have added some tolling of lithium carbonate. We expect lithium prices to improve sequentially through the remainder of the year due to tightening market conditions. Overall, average realized pricing for the year will be flat compared to last year. We continue to expect higher costs in 2021 related to project startups, but this will be partially offset by efficiency improvements. In total, lithium EBITDA is now expected to be up high single digits on a percentage basis. The outlook for our catalyst business is lower than we had originally planned, offsetting the upside we expect from lithium. On a year-over-year basis, total catalyst results were projected to be down about 30% to 40%. This is primarily due to the impact of the US Gulf Coast winter storm and delays in customer FCC units. Our outlook for the bromine business has not changed. While we had a very strong first quarter, we do not expect the favorable customer mix to continue in future quarters and we will not be able to make up the lost production in the first quarter. In addition, raw material costs are moving higher. We continue to expect results to be modestly higher than last year due to continued economic recovery and improvements in certain end markets, including electronics and building and construction, along with ongoing cost savings and improved pricing. Finally, as to our quarterly progression for the full company, we expect Q2 to have modest growth in EBITDA and the second half to have a modest decline. We continue to expect that 2022 results will benefit from accelerated growth plans in bromine, recovery in catalysts and the initial lithium sales from La Negra III, IV and Kemerton I and II. And with that, I'll hand it back to Kent.
Kent Masters: Thanks, Scott. As I mentioned earlier, in April, we signed the UN Global Compact, a voluntary leadership platform for the development, implementation and disclosure of responsible business practices. In addition to supporting the UNGC principles, we are aligning our sustainability framework to the UN Sustainable Development Goals, the largest corporate sustainability initiative in the world. Over the past year, we've increased ESG disclosure, published updated sustainability policies and made public commitments to advance sustainability. Sustainability is, by its nature, a long term commitment. But I'm pleased to report that we are beginning to see the benefits of our efforts. For example, Albemarle was recently recognized and added to the S&P 500 ESG Index. You can expect more details on these and other sustainability related initiatives in our 2020 Annual Sustainability Report due to be issued in June. Now on Slide 12, I'd like to reiterate our corporate strategy. We have started 2021 with a strong quarter and continue to make progress on our four strategic pillars. We are completing our Wave II projects and plan for those to deliver commercial volumes and generate sales in 2022. We are making plans to execute on our Wave III lithium projects as well as expand our bromine resources to align with growing customer demand. And we are laser focused on operational discipline to drive maximum productivity across our businesses. We continue to expect around $75 million of productivity improvements this year and we will continuously work to improve efficiencies within our operations. With a revitalized balance sheet, we are well positioned to invest in high return growth, maintain our investment grade credit rating and support our dividend. Finally, sustainability remains a top priority and key component of our value proposition to our customers, and we are dedicated to exploring opportunities such as the UN Sustainable Development Goals to help us implement these efforts. With that, I'd like to open the call for questions, and we'll hand over to Olivia.
Operator: [Operator Instructions] And our first question coming from the line of David Deckelbaum with Cowen.
David Deckelbaum: I wanted to follow up on your questions around potentially looking at acquiring a Chinese hydroxide conversion facility. Can you just expand upon that a bit and just help us understand what sort of metrics are you using to weigh acquisition right now? We've seen a lot of your peers looking to expand conversion capacity in the Western Hemisphere. How should we think about the scale of this and what sort of things you'd be looking for before making an acquisition like that?
Kent Masters: So I'll make a few comments, and then Eric can give you some detail if I don't get there. But we've looked at China very much, we're very familiar with the operators there, and we've been kind of looking at these opportunities for some time. We've made acquisitions in the past so we feel pretty comfortable with this, with the assets that are on the ground and what we would need to do to move them to our standards. So we did that at Xinyu. We bought an asset and we've expanded, and we consider that to be very successful. So we like the model. We're comfortable. We've got people on the ground in China. So we're able to do good due diligence. We’d be able to staff a new facility with -- partially from people from our existing plants. So we feel very comfortable with the strategy. And then I think it seemed like part of your question was about people looking at different geographies. And we're looking at different geographies as well, but we still see growth in Asia as being a big part of the growth coming forward. And ultimately, we'll be moving in other locations around the world. But we still see growth in Asia, which is why we're looking at this as a strategy.
David Deckelbaum: And then just perhaps on my follow-up, you talked about just pricing this quarter, obviously, driven by increased volumes of greater mix of carbonate and industrial grade. As we think about growth coming online from Wave II, when do you think we should think -- as we think about pricing with contract rolling, at what point do we see battery grade making up a greater component of the overall mix? Is that really like a late 2023 dynamic just given sort of delays around qualification, or how should we think about that as you guys increase capacity into the market?
Kent Masters: So I think that means a big piece is already battery-grade material and both carbonate and hydroxide. But I'll let Eric get into the details, maybe around timing as they layer in.
Eric Norris: So the volume -- just to build on what Kent said, 60% of our business today is energy storage, and that's split between carbonate and hydroxide relatively evenly as we sit here today. With the expansions coming on, we have -- it will still be split because we have a large expansion in Kemerton on hydroxide and similarly one in La Negra on carbonate. So that's where our growth is. As we bring that capacity on, that's where the volume will go. So that 60% of sales will grow larger on a volume basis. Now in terms of pricing, that's an evolution that we're going through now in our contracts. We've had, as you may know, concessions we made to fixed price contracts we've done in the past. And while that's given us security of supply to run our plants and strong margins at the bottom of the cycle, we're now evolving those pricing mechanisms to give us more exposure to the market as it recovers. And that will benefit this volume as well, bring on volume under new terms that will allow us to benefit from a rising market.
Operator: Our next question coming from the line of Joe Jackson with BMO Capital Markets.
Unidentified Analyst: This is Robin on for Joel. You talked about being limited on lithium inventories to meet your own demand. How much offline conversion in spodumene capacity do you see reramping in the industry this year to meet total industry demand? And how quickly do you see industry inventories rebuilding, or maybe you can talk about overall tightness and what that could mean for pricing?
Eric Norris: I think the short answer to your question is while mines are restarting, there are still some that went into the bankruptcy phase in Australia that still haven't come back. It takes some time, particularly in Western Australia right now given the labor crisis and the rising iron ore prices, to mobilize both equipment and labor personnel to restart a plant. So what we foresee going forward, given the strong demand that's starting to develop -- has been under development in China and is now ramping around the world, that it's going to remain short in China. That spodumene is going to be a constraint. That is why you're seeing carbonate prices rise so quickly in China, where there is a high demand, in particular, for carbonate for some of the recovering industries in China post pandemic, but also because of the growth of LFP chemistry, specifically in China. And inventories are a bare minimum in the Chinese market and have come back to normal levels worldwide, which is why we were in a position during the first quarter to otherwise thought like as in prior quarters would not be a strong quarter, it was quite the opposite. We had to pull volumes forward into that to drive the growth that you saw. We're limited in what we can do, but we'll benefit greatly when we bring on that new capacity and be well positioned into 2022.
Unidentified Analyst: And just a quick follow up. So I assume the rationale to reinstate tolling is to meet that market tightness. So is that strategy temporary then? Maybe you can discuss the amount of volume from tolling and what the margin impact from that is? Because I think the previous long term target for lithium margins was closer to 40%. Obviously, things are trending sub 35 right now. Maybe you can just elaborate on those points.
Eric Norris: Tolling has always been a bridging strategy for us, and it's only ever done in carbonate because we feel that there's adequate carbonate capacity out there that can meet the standards for that product, and hydroxide is something we view as different and more proprietary. The bridging strategy, in this case, is to get us revamped in relationships with Chinese customers that we've supplied in the past, such that when we bring on La Negra III and IV next year, we have a ready customer base to take that on. So I would think of it as ad hoc or bridging. It's not a sustained strategy. It is something -- I can't get into the details of volumes per se. But it is to, as you point out, not as lucrative, not as high a margin of business for us because we're paying somebody to convert for us. So it moves us to the right on the cost curve, whereas we're normally on the left side, you're moving more towards the right, so that impacts margins. But it does provide incremental EBITDA, and it does set us up for a successful ramp next year.
Operator: And our next question coming from the line of David Begleiter with Deutsche Bank.
David Begleiter: First, in Lithium, what was the benefit of the acceleration of customer orders into Q1 on EBITDA?
Scott Tozier: David, I'm going to have -- let me just take a quick look. But I think it's meaningful in terms of the volume. So it's probably in the $30 million range, something like that.
Kent Masters: Another way of seeing that, David, is that you may have had -- I don't know your model, but you may have had to get to guidance. You may have had a much stronger second half than first half. And because of the robust demand, whatever we make, we're selling. There's not very little going to inventory. So the quarters are going to be a lot more even or similar this year than they were last year for the Lithium business.
David Begleiter: And Eric, just on La Negra and Kemerton following the commissioning qualification processes, how should we think about volume ramp up for these two new assets?
Eric Norris: So we've said those will ramp up over a period of time. So we first turn it on, nothing to getting us to expect to get to a full ramp of say, 18 months and some of that depends on demand and customers. So over that first year per line, probably 40% or 50% of capacity in the first 12 months, that's probably the best way to think about it and some of that will depend on demand but we think -- we expect demand to be there.
Operator: Our next question is coming from the line of Jeff Zekauskas with JPMorgan.
Jeff Zekauskas: When you bring on your new capacity in 2022, '23 in lithium, how might you compare the pricing structures that will be negotiated versus the current pricing structures that you have today? That is, how has the market changed and how has Albemarle changed in the way that you charge your customers, or contemplate charging your customers?
Kent Masters: So we've been talking about kind of the shift in our commercial strategy in lithium for some time. We kind of intentionally delayed the conversion from kind of a strict long term fixed price contract. So one that is more indicative of the market, that moves more with the market, and that we'd have different types of customers we contract slightly different ways. We delayed the conversion of that a little bit because the market was so far down. We didn't think it was the right time to negotiate at the bottom of the market, so we held off on that. So that strategy hasn't changed and the new volume doesn't change that. So I think we're moving into that dynamic as we go through the next 12 months, or the contracts we'll be negotiating will be on that new basis. So portfolio of customers with kind of customers who really want security of supply will be more of a fixed price, but it will still move with the markets and then contract with other people that look more like market prices, not spot prices contracted, but prices that move with the market. And that's what we've been talking about for the, I would say, almost the last year. And we did delay the implementation intentionally because we felt like we didn't want to negotiate at the bottom of the market.
Operator: Our next question coming from the line of Colin Rusch with Oppenheimer.
Unidentified Analyst: It's Joe on for Colin. Can you speak a little bit to how challenging hiring is at this point as you get ready to bring capacity on early next year?
Kent Masters: So I mean there were two locations. So Chile and Kemerton, so Western Australia, and a different dynamic because we've got a significant operation in Chile already. So it's not such a challenge in that location, abigger issue in Chile at the moment is COVID. But we're able to bring people on there and we've been bringing them on, training them with existing staff. And Australia is a little different because it's a true greenfield facility, but we've been hiring. We’re happy with the plan. We’ve been doing well. In the labor market, it's a little different dynamic in the construction market than it is in the chemical operating market. So we've been able to hire according to our plans and ramp up staff that would operate the facility according to our plan. So that hasn't impacted us. What's been more of a challenge is in the construction labor market and getting the staff that we need to complete construction. And we were actually trying to accelerate it but we're not able to do that, we're just kind of treading water with our original plan.
Unidentified Analyst: And then switching gears a little bit. Beyond pricing, can you speak to any other elements of your long term contracts that you're working to improve given what seems like a better negotiating position?
Kent Masters: Well, I mean I guess it's several elements, but it's really about the guaranteed supply, the profile of that supply. Pricing is a big part of that and liabilities. Eric, you have…
Eric Norris: I would say that the big -- the evolution of the dialog, where we feel we have a lot of value to offer now is on location of supply as well as the localization. And we've referenced in our expansion strategies down the road how we can play to that. And for many of our customers that's a down the road consideration because the vast majority of the business today is still Asia based. And then the other is sustainability. Sustainability has been key. As OEMs become more involved and have thought through their value proposition, which is based on lower CO2 and other sustainable factors, they want suppliers who are differentiated in that regard. And what we are doing, what Kent described in the call has real value. We talk in these calls very much about what it means to shareholders of being part of the S&P 500 ESG Index. For me, it's about driving a value proposition with our customers and getting paid for it. So that's become a big part of our proposition as well.
Operator: Our next question coming from the line of Vincent Andrews with Morgan Stanley.
Unidentified Analyst: This is Angel on for Vincent. Just curious on your Wave III, what are the key gating factors that you kind of see for both capacity and lithium and bromine before you actually announce FID?
Kent Masters: You said the key?
Unidentified Analyst: The key gating factors or what are the primary, I guess, checkpoints or things that you want to see before you actually make the FID decision?
Kent Masters: So I mean we're looking at projects, identifying them, designing in the plans for that. So I guess it's anything you would expect to see in a normal investment program. So we're making sure that we've got designs, the process chemistry that we like. We've aligned up -- we have the resources that's not an issue but a lot of it's about location, about permitting, workforce. I mean all the that you would see that we would line up. But we're relatively advanced at looking at that. And then obviously, when you get to that decision point, the returns are a big deal.
Unidentified Analyst: And then switching, I guess, to bromine a little bit. You talked about the favorable mix, customer, I guess, not repeating going forward. One, I guess, could you give us a little bit more color on that and why it won't repeat. And then as we think about kind of the second half or kind of 2Q and beyond, should we expect higher pricing in bromine to kind of offset both the shorter supply because of lost production and because of Uri and also the raw materials headwind that you mentioned?
Scott Tozier: I would start, and maybe Netha can add some additional color. But in the first quarter, the bromine market overall was relatively short. So it gave us some nice opportunities in the spot market to take advantage of that and get some upside. We're not expecting that kind of condition to continue through the rest of the year. But maybe, Netha, you have more specifics?
Netha Johnson: Just as Scott described, we had a chance to go sell some volume out of inventory to our noncontracted customers that increased demand based on market recovery, that's a unique opportunity and at very good pricing. We don't expect that to continue through the second half of the year. But just like other industrial businesses, as you look forward to the second part of your question, freight and raw materials are going up and they'll do the same for us and that will impact our business in Q2 and beyond for the rest of the year.
Operator: Our next question coming from the line of Matthew DeYoe with Bank of America.
Matthew DeYoe: Can we talk a little bit about the puts and takes on Lithium EBITDA as we move sequentially through the year? I kind of understand the transition from 1Q to 2Q. But it seems like you're guiding for price to improve sequentially as we move [here] but also costs are up. So perhaps like how much cost do you expect to incur with these new plant start ups and when would that roll off?
Scott Tozier: So in the second half, it’s up something in the range of $10 million to $15 million of incremental costs from those plants. It all depends on the timing of what those come in. But that's the kind of range that we're looking at ultimately. So as you look at the puts and takes, obviously, there's a limit in terms of our ability to supply additional volume. We're getting some out of tolling. Of course, that comes at a lower margin ultimately for us. So that's a bit of a drag from a margin perspective as well.
Matthew DeYoe: And then on catalysts, you made a comment that you don't expect to get back to pre COVID levels before late 2022, 2023. So can you just walk through your assumptions there? Is that just all miles driven or is there something else that's happening?
Scott Tozier: Ultimately, it's coming from our customers and what our customers are telling them. But maybe, Raphael, you can provide some additional color as to the specific parts of the market that are slower than others.
Raphael Crawford: So I think there's a few different pieces that come into play. I mean one of them is miles driven is a big driver of recovery in refining utilization. I think we're already starting to see an improvement in refining utilization, and you'll see that throughout the year and into next year, that's going to have -- will have a big effect on FCC usage at the refineries and our business, about 60% of our business is FCC, so we'll see that recovery. On the CFT or HPC business, that business is timed with turnarounds at refineries. A lot of that's been pushed out until 2022, and that's when we'll start to see an uptick in that business. The portfolio we have in our business is very much geared towards high performance. When refiners are running near capacity, that's really when the value of our products kicks in because we help them maximize on yield, maximize on the throughput through their assets. So as it recovers, we'll start to see that leverage effect in the return of our business.
Matthew DeYoe: And so just right now, you're seeing mix just mixing down across some of the catalyst because people don't need their utilization through the refiners…
Raphael Crawford: Yes, I think that's a fair statement. We see a mix impact and a volume impact, but we expect both of those to reverse as the world recovers.
Operator: Our next question coming from the line of Arun Viswanathan with RBC Capital Markets.
Arun Viswanathan: I'm just curious what you're seeing, I guess, in China. There's been obviously some robust recovery in lithium markets in there as well as in Europe. Do you expect that to kind of continue into next year? Is there an environment or scenario where you see prices kind of getting back to say the $12,000 to $14,000 per ton range? Maybe you can just comment on what your outlook for pricing is for hydroxide.
Kent Masters: It's hard to comment too much on price. I mean those are the -- that's the magic question. But the market is clearly moving in that direction. And you're seeing the demand growth, so the demand growth we expect to continue. I mean, what we're seeing is it's extraordinary, but it may not be 135%, but it's going to be 70%, 80% for the year around EV levels, and lithium is going to follow that. So demand growth is going to be there. And pricing has moved very quickly in China because that's mostly a spot market, so it would move quicker. That hasn't translated into the contract market fully yet. So it has started to, we think, and we see that moving in that direction over time. It's hard to predict what's going to happen out into the future, but we see prices moving up. And that what's happening in the spot market will translate into the contract prices and that will be a positive for Albemarle.
Arun Viswanathan: And just as a quick follow-up then. A couple of years ago, you were discussing contracts with term lengths of maybe seven, 10 years at times. Have you seen your customers kind of come back to you now with requests to kind of elongate their contracts or -- yes, maybe you can just comment on the customer environment from a contracting perspective.
Kent Masters: Let me start, Eric can add some detail to that. But I would say, I mean, our philosophy hasn't really changed. We've adjusted a bit on the kind of the nature. I would say we've evolved in our contracting structure, but it's really still the same philosophy. And I think our customers are kind of coming around to that way of thinking a bit. And I think it's changing because some of it's with OEMs now. Several years ago, we were talking to cathode makers, then battery makers and now it's OEMs and still talking across all three of those areas, but the OEMs are getting more involved, and they have a longer-term view. So I don't know about 10 year contracts, but three year, five year, maybe seven on the longest term. But those are the kind of -- that's the nature of the contracts that we're discussing. I don't know anyone's pushing us further than that.
Operator: Our next question coming from the line of Aleksey Yefremov with KeyBanc.
Unidentified Analyst: This is Paul on for Aleksey. Could you update us on any lithium recycling initiatives currently so far?
Eric Norris: Recycling is a key platform for us going forward from a growth standpoint, both because our customers who, as Kent just indicated, are increasingly OEMs value that as part of their partnership with us and because a good amount of the knowhow we have from processing lithium is going to be replicable in the streams that will come from a recycled process. We've got investments we've made and start ups are looking at making through some relationships we have. We've got technology initiatives underway with some business development activities underway to partner. We have one joint development agreement, which we’re currently doing with the customer. All these are all confidential at this stage, so I can't divulge names. But it's a pretty comprehensive effort and a critical one for our growth going forward. We view this as a future resource that we would like to play prominently in.
Operator: Our next question coming from the line of John Roberts from UBS.
Matt Skowronski: This is Matt Skowronski on for John. Going off of Jeff's question earlier, you mentioned that you're restructuring some of your lithium contracts. And I believe on the last call, you mentioned the majority of these contracts will eventually have some sort of variable based pricing tied to an index. When do you expect the majority of your contracts be based on this variable price mechanism and how frequently does a typical contract allow for price adjustments?
Eric Norris: You're right, our legacy contracts had, as Kent described in the past, a fixed price mechanism. And during the crisis of the past year plus we gave some relief on that, that relief clause expires during the course of this year. Some in the middle of this year, all by the end of the year. For our legacy contracts that's the time frame we'll be looking to move to the new structure that we'd earlier described and that will give us that upside to have price rise with the market more freely than it would have under the fixed price constructs. And it's the basis for any new contracts we've struck. We've struck several new contracts, both with battery and automotive OEM producers in the past three, six months and they are in that same construct. Now it's important to note, it's not one structure. We have some customers who actually value more consistency. And obviously, that's a higher price point from a fixed price standpoint, so we can get our returns over the cycle. And there are certain commitments we'll make to go along with them on volume. On the other hand, those who are more fixated on price we'll have a component of our mix there. We will be a little more -- just more discretion about how long we go on some of those contracts. And so there's going to be a mix there is kind of a mix that we see, but the underlying message is exposure to a rising market.
Operator: Our next question coming from the line of Ben Kallo with Baird.
Ben Kallo: Just on bromine, I know it's on the top of du jour, but the chip shortage that we see, everyone sees out there, can you talk about how your visibility is on that, or what you could gain if there is semiconductor new builds and if that [benefits] you? And then just on the lithium side, Scott, back when the worry was around not enough batteries being produced and from our EV coverage, I think that's a worry too. But what you guys see on that side as far as new capacity being built and how you guys are modeling that yourselves and the visibility on that?
Scott Tozier: So let me start with the second part first with the battery. I mean, we're focused on making sure we get the lithium that goes with the market. And we model that from the vehicle backwards to the battery and then to the cathodes, and there's a lot of plans and capacity being added. I don't know that we -- we're not going to put an opinion out there about capacity for batteries. We're very focused on making sure that we've got -- our part of the lithium market that we're building out -- what all of our growth plans are about. Those investments and executing on those investments, so we've got lithium to provide that market. So I don't think we should comment about the capacity in the battery market, but we see a lot of projects and a lot of capability in executing those projects. Maybe Netha could talk a little bit about the chip shortage and how that impacts bromine from a, I guess, that would be across all the electronics space.
Netha Johnson: Ben, we see the electronics market is really strong. But as Scott mentioned, we're not seeing the chip shortage impact us. A strong semiconductor chip electronics market is definitely good for us. But with us being sold out, we have very limited additional capacity to leverage that in the rest of the year. So we do have contracted volumes in those markets. Those volumes are being ordered as we expect. And so we don't really see that as an issue right now. Now things could always change but from where we sit in the supply chain, we're not seeing an impact right now with the chip shortage.
Kent Masters: And I think it's a little bit -- Ben, part of your question was just about an advantage we might see coming forward. I think that's really just going to be about demand of those electronics. So they need more chips, those underlying applications where we play, whether it's in automotive or just call it, the Internet of Things, so proliferation of chips and that's an advantage for us, but they have to be able to keep up with it for it to be an advantage for us.
Ben Kallo: And if I could sneak one more in. What about just the overall flexibility of the three businesses? And I know you guys have done a lot, but just overall, 80% of the questions are about lithium here. So how do you think about the portfolio altogether?
Kent Masters: So we've got three core businesses and it's a portfolio. So catalyst is struggling a little bit, their market is not as strong because the miles driven and the issues we saw from COVID there. Bromine held up very well during the pandemic. And then really, EVs and then part of that, the lithium market was accelerated through COVID because really the European response to the COVID was really about clean energy and electric vehicles. So I think the portfolio effect is working for us. I mean we'd love for all three businesses to be striking on all cylinders but that's part of the portfolio. We think they're key businesses. They all fit into the sustainability angle that we're pushing. There's a sustainability piece for all three of those businesses, and that's kind of what ties them all together, and we like that portfolio. And it's working because when one business is down, the other two are doing quite well and that will probably cycle.
Operator: Our next question coming from the line of Chris Kapsch with Loop Capital.
Chris Kapsch: So my question relates to lithium business in the industry and focused on your visibility more specifically. So the industry at this point is still pretty China centric and in the materials space, China has been notoriously sort of double ordered or build excess inventories during periods of rising commodity prices. And on the flip side, as this industry has witnessed the pain can be pretty acute when prices are coming in with destocking in the supply chain exacerbating the downward pricing pressures. Granted this lithium chemicals for the battery application are not as commodity oriented as say copper or iron ore or something. But I'm just wondering if you could comment on the ability right now for the industry to build back inventories or safety stocks, or buffer stocks? And maybe also speaking to your visibility, how is this changing along with the procurement strategies, which are migrating maybe away from cathode producers simply to cathode plus battery and in some cases, OEs? So just if you could speak to visibility on that, what the dynamic is currently and how you see that evolving.
Kent Masters: So I mean, I guess, a bit about China. I'm not sure we have a ton more visibility, but there's not -- I mean we're fighting to keep up with demand. I think the industry is doing the same. So I don't think they're building -- anybody's building inventory in the supply chain, and that probably goes from batteries, the cathodes to materials as well. I mean from our perspective, we're not building inventories. We actually sold down inventories to take advantage, or to satisfy demand in the first quarter. And I don't know, Eric, if you have any more visibility around that?
Eric Norris: No, I mean the industry is tight, up and down not just in China but around the world, and a consequence in some regards of just how bad it got last year from a value standpoint. There's a lot of capacity went out of the market, a lot of projects slowed down. So it's going to take a while to catch up and yet demand is accelerating. So we don't see a let up in the situation, which is one reason why we won't give a specific number. We see price rising going forward for the foreseeable future. China is still very important to the industry. If there's a delay anywhere in building out capacity downstream for batteries, it's outside of China. So Asia continues to be an important point going forward, which certainly in the near term suits where we're bringing on capacity. So we're very optimistic about being able to place that capacity we bring on next year.
Kent Masters: And I would just say one thing that's a little different than some of the other industries that kind of mining industries, iron ore, ferrous materials. I mean we are integrated into the resource and into the conversion as well. And that's not all China, the resources are really not in China, a lot of the conversion capacity and the customer demand today is in China. And we spent a lot of effort making sure we have a diverse resource base from a resource standpoint and also from a conversion specific. So we're not too heavy in China. It's why you see us building in Western Australia, and we're doing conversion capacity in Chile as well. So we focus on that diversification from a resource standpoint and a conversion basis as well. And in some cases, it's more expensive for us to do that but we think it's important.
Operator: And I'm not showing any further questions at this time. I would now like to turn the call back over to Mr. Kent Masters for closing remarks.
Kent Masters: Okay. Thank you, Olivia. And again, thank you all for joining us today. All the efforts and opportunities we discussed today require execution, and we have the capabilities, the resources and most importantly, the people to execute on our strategy. We expect to achieve accelerated growth with lower capital intensity, which should enable us to achieve higher returns. We will continue to work on our sustainability throughout the value chain, not only within Albemarle's operations but by continuing to support our customers. Thank you, and we look forward to speaking to you on our next call.
Operator: Ladies and gentlemen, that does conclude our conference for today. Thank you for your participation. You may now disconnect. | [
{
"speaker": "Operator",
"text": "Ladies and gentlemen, thank you for standing by, and welcome to the First Quarter 2021 Albemarle Corporation Earnings Conference Call [Operator Instructions]. I would now like to hand the conference over to your speaker host, Meredith Bandy, Vice President of Investor Relations and Sustainability. Please go ahead."
},
{
"speaker": "Meredith Bandy",
"text": "All right. Thank you, Olivia, and welcome to Albemarle's First Quarter Earnings Conference Call. Our earnings were released after the close of the market yesterday, and you'll find our press release, presentation and non-GAAP reconciliations posted to our Web site under the Investors section at albemarle.com. Joining me on the call today are Kent Masters, Chief Executive Officer; Scott Tozier, Chief Financial Officer; Raphael Crawford, President, Catalysts; Netha Johnson, President, Bromine Specialties; and Eric Norris, President, Lithium, are also available for Q&A. As a reminder, some of the statements made during this call, including our outlook, guidance, expected company performance and proposed divestitures and expansion projects, may constitute forward-looking statements within the meaning of federal securities laws. Please note the cautionary language about forward-looking statements contained in our press release and presentation that same language applies to this call. Please also note that some of our comments today refer to financial measures that are not prepared in accordance with GAAP. A reconciliation of these measures to GAAP financial measures can be found in our earnings release and the appendix of our presentation, both of which are posted to our Web site. And with that, I'll turn the call over to Kent."
},
{
"speaker": "Kent Masters",
"text": "Okay. Thanks, Meredith. Good morning, and thanks to you all for joining us today. On today's call, I will highlight our recent accomplishments and discuss our strategy as it relates to accelerating growth and creating a more sustainable business. Scott will give us more detail on our results, outlook and capital allocation. This was another strong quarter for Albemarle with solid financial results. We generated net income of $96 million and adjusted EBITDA of $230 million, up 17% from last year. We benefited in part from several lithium customers that accelerated orders under long term agreements as well as favorable volume and customer mix in our bromine business. We continue to see strong market demand for lithium, especially from EVs. First quarter EV sales were up 135% versus last year, led by China. European and North American sales were also up significantly. All that said, remember that we are sold out in bromine and lithium. Therefore, we are maintaining our previously reported company guidance for the full year. Scott will provide additional detail on this in just a few minutes. We are advancing our growth plans with the progress being made at our Wave II lithium projects. These two projects, La Negra III, IV and Kemerton I, II, are expected to add volume beginning next year. As you are probably aware, during the first quarter, we successfully completed $1.5 billion equity offering and then subsequently reduced our debt. This enabled us to achieve two strategic goals. First, we are now well positioned to execute on our high return Wave III growth projects for lithium and bromine. And second, we have maintained our investment grade credit rating, which was recently upgraded to a BBB rating by S&P Global. I'm also proud to say that we have signed the UN Global Compact, joining the efforts of corporations and stakeholders worldwide to advance sustainability. On Slide 5, I want to update you on those two projects at La Negra and Kemerton, our two ongoing projects to increase lithium production from our world class resources. These conversion facilities are in the final stages of construction, and when complete, are expected to double our nameplate capacity to 175,000 metric tons per year. This added capacity will provide much needed volumes to support our customers' growth ambitions and will enhance our ability to drive further earnings expansion. Construction is on track for completion later this year. We are watching the Western Australia labor situation closely, but currently, we do not expect any impact to our schedule. Once complete, we move into final commissioning and customer qualification, which typically takes about six months. We expect to begin producing commercial volume from both projects in 2022. These two sites will complete our Wave II lithium projects and enable our team to focus on the execution of Wave III, which represents further 150,000 metric tons of conversion capacity. We expect to make investment decisions on the first projects from Wave III as early as the middle of this year. This includes a greenfield site in China and potentially the acquisition of a Chinese conversion plant. I would like to mention that the Chilean Nuclear Energy Commission, or CCEN, has confirmed that our resource and reserves report is in full compliance following the additional data we provided in January. We are committed to complying with our regulatory obligations around the world, and we are pleased to reach a satisfactory and collaborative resolution with CCEN. Finally, in bromine, we are accelerating our growth projects and expect to see the benefit of these projects beginning in 2022. I'll now turn the call over to Scott to review the first quarter results."
},
{
"speaker": "Scott Tozier",
"text": "Thanks, Kent. I'll begin on Slide 6, and I'm happy to report on a strong start to the year. For the first quarter, we generated net sales of $829 million, a 12% increase from last year. This was driven by increased volumes across our three core businesses, as well as a favorable customer mix within our bromine unit. GAAP net income was $96 million. Adjusted EPS of $1.10 excludes the cost of early debt repayment that we incurred when we delevered in March following our equity raise. Our sales growth enabled us to generate adjusted EBITDA of $230 million, up 17% from last year, giving us an early start to meeting our guidance for the full year. Now turning to Slide 7 for a look at adjusted EBITDA by business. Adjusted EBITDA in total was up $34 million over last year, thanks to stronger lithium and bromine results and a foreign exchange tailwind. Lithium's adjusted EBITDA increased $30 million versus the prior year as some customers accelerated orders for battery grade carbonate and hydroxide into the first quarter. To meet this demand, we drew down lower cost inventories resulting in Q1 margin expansion. Average realized pricing was down 10% as expected due to lower carbonate and technical grade pricing. However, increased volumes more than offset the lower price. Market demand remains very strong but our plants are sold out, which limits our ability to increase volumes in 2021. Bromine's adjusted EBITDA grew by about $8 million compared to the first quarter of 2020, an increase of 9%. The strong quarter was due primarily to higher sales volumes across the product portfolio. Pricing was also higher, in large part related to a favorable customer mix. The US Gulf Coast winter storm reduced production and increased cost by about $6 million in the quarter. And just like lithium, we drew down inventory in Q1 and our bromine plants are sold out for the year, making it difficult to offset the production losses from the storm. We expect to see the impact from lost production in the Q2 and Q3 time frame. Catalysts adjusted EBITDA declined $23 million, primarily due to the US Gulf Coast winter storm, which impacted production in Bayport and Pasadena, Texas. These sites incurred increased electric and natural gas costs, production downtime and repair expenses that totaled $26 million. Our Q1 catalyst results from last year included $12 million of income that was later corrected as an out of period adjustment, which further complicates the year-over-year comparison for this quarter. Without this and the storm impact, our Catalyst EBITDA would have been up 31%. Our corporate and other category adjusted EBITDA increased by $4 million, primarily due to lower corporate costs. Slide 8 highlights the company's financial strength. With the proceeds from our $1.5 billion equity offering in February, we repaid debt. By deleveraging in the short term instead of holding the proceeds as cash, we were able to reduce interest expense and create the debt capacity that will allow us to accelerate our growth for the lithium and bromine businesses, funding investments as they are approved. You can see how we are executing on our commitment to grow our dividend and maintain our investment grade credit rating. We increased our dividend for the 27th consecutive year, which speaks to our ongoing success and a track record of shareholder returns, which we are proud to maintain. On Slide 9, we provide a look at our guidance for the year. I would like to note that our company guidance for the year includes a full year of Fine Chemistry Services results. In February, we entered into an agreement to sell the FCS business for proceeds of approximately $570 million. The transaction is expected to close in the second quarter of 2021. We've also given a breakout of second half guidance for FCS for modeling purposes. As we've discussed, our lithium and bromine businesses outperformed expectations for the quarter, primarily driven by accelerated customer orders and a favorable customer mix. We do not expect to see the same upside over the next three quarters, mostly because our lithium and bromine businesses are effectively sold out and we don't have excess inventory to meet increased demand. Timing of orders can shift from quarter-to-quarter but the outlook for full year volumes is mostly unchanged, except for modest increases in lithium. We continue to monitor the chip shortage at automotive manufacturers for impacts to lithium and bromine. And so far, we've not seen an impact. This may be due to our position in the supply chain. In May, IHS revised their forecast for 2021 EV production down 3% from prior forecasts related to microchip shortages and supply chain issues. EV production is still though expected to be up 70% year-over-year. We are maintaining our company guidance for the full year and continue to expect net sales to be in the $3.2 billion to $3.3 billion range, which is slightly higher than last year. The demand we saw during the first quarter and sold out volumes speak to the importance of investing in our lithium and bromine businesses to add to our future earnings potential. Our 2021 guidance for adjusted EBITDA remains between $810 million and $860 million. We continue to expect CapEx to be around $850 million to $950 million for the year as we complete our Wave II lithium projects and begin focusing our efforts on Wave III. Net cash from operations are also tracking on plan. As the year progresses, we expect higher inventories as we start to commission the two new lithium plants and higher cash taxes. Expectations for adjusted diluted EPS of $3.25 to $3.65 are on track, reflecting higher taxes, depreciation and increased share count and lower interest expense. While our total company guidance has not changed, the outlook for our lithium and catalyst businesses has, as shown on Slide 10. Our outlook for the lithium business has improved due to higher lithium volumes driven by plant productivity improvements, and we have added some tolling of lithium carbonate. We expect lithium prices to improve sequentially through the remainder of the year due to tightening market conditions. Overall, average realized pricing for the year will be flat compared to last year. We continue to expect higher costs in 2021 related to project startups, but this will be partially offset by efficiency improvements. In total, lithium EBITDA is now expected to be up high single digits on a percentage basis. The outlook for our catalyst business is lower than we had originally planned, offsetting the upside we expect from lithium. On a year-over-year basis, total catalyst results were projected to be down about 30% to 40%. This is primarily due to the impact of the US Gulf Coast winter storm and delays in customer FCC units. Our outlook for the bromine business has not changed. While we had a very strong first quarter, we do not expect the favorable customer mix to continue in future quarters and we will not be able to make up the lost production in the first quarter. In addition, raw material costs are moving higher. We continue to expect results to be modestly higher than last year due to continued economic recovery and improvements in certain end markets, including electronics and building and construction, along with ongoing cost savings and improved pricing. Finally, as to our quarterly progression for the full company, we expect Q2 to have modest growth in EBITDA and the second half to have a modest decline. We continue to expect that 2022 results will benefit from accelerated growth plans in bromine, recovery in catalysts and the initial lithium sales from La Negra III, IV and Kemerton I and II. And with that, I'll hand it back to Kent."
},
{
"speaker": "Kent Masters",
"text": "Thanks, Scott. As I mentioned earlier, in April, we signed the UN Global Compact, a voluntary leadership platform for the development, implementation and disclosure of responsible business practices. In addition to supporting the UNGC principles, we are aligning our sustainability framework to the UN Sustainable Development Goals, the largest corporate sustainability initiative in the world. Over the past year, we've increased ESG disclosure, published updated sustainability policies and made public commitments to advance sustainability. Sustainability is, by its nature, a long term commitment. But I'm pleased to report that we are beginning to see the benefits of our efforts. For example, Albemarle was recently recognized and added to the S&P 500 ESG Index. You can expect more details on these and other sustainability related initiatives in our 2020 Annual Sustainability Report due to be issued in June. Now on Slide 12, I'd like to reiterate our corporate strategy. We have started 2021 with a strong quarter and continue to make progress on our four strategic pillars. We are completing our Wave II projects and plan for those to deliver commercial volumes and generate sales in 2022. We are making plans to execute on our Wave III lithium projects as well as expand our bromine resources to align with growing customer demand. And we are laser focused on operational discipline to drive maximum productivity across our businesses. We continue to expect around $75 million of productivity improvements this year and we will continuously work to improve efficiencies within our operations. With a revitalized balance sheet, we are well positioned to invest in high return growth, maintain our investment grade credit rating and support our dividend. Finally, sustainability remains a top priority and key component of our value proposition to our customers, and we are dedicated to exploring opportunities such as the UN Sustainable Development Goals to help us implement these efforts. With that, I'd like to open the call for questions, and we'll hand over to Olivia."
},
{
"speaker": "Operator",
"text": "[Operator Instructions] And our first question coming from the line of David Deckelbaum with Cowen."
},
{
"speaker": "David Deckelbaum",
"text": "I wanted to follow up on your questions around potentially looking at acquiring a Chinese hydroxide conversion facility. Can you just expand upon that a bit and just help us understand what sort of metrics are you using to weigh acquisition right now? We've seen a lot of your peers looking to expand conversion capacity in the Western Hemisphere. How should we think about the scale of this and what sort of things you'd be looking for before making an acquisition like that?"
},
{
"speaker": "Kent Masters",
"text": "So I'll make a few comments, and then Eric can give you some detail if I don't get there. But we've looked at China very much, we're very familiar with the operators there, and we've been kind of looking at these opportunities for some time. We've made acquisitions in the past so we feel pretty comfortable with this, with the assets that are on the ground and what we would need to do to move them to our standards. So we did that at Xinyu. We bought an asset and we've expanded, and we consider that to be very successful. So we like the model. We're comfortable. We've got people on the ground in China. So we're able to do good due diligence. We’d be able to staff a new facility with -- partially from people from our existing plants. So we feel very comfortable with the strategy. And then I think it seemed like part of your question was about people looking at different geographies. And we're looking at different geographies as well, but we still see growth in Asia as being a big part of the growth coming forward. And ultimately, we'll be moving in other locations around the world. But we still see growth in Asia, which is why we're looking at this as a strategy."
},
{
"speaker": "David Deckelbaum",
"text": "And then just perhaps on my follow-up, you talked about just pricing this quarter, obviously, driven by increased volumes of greater mix of carbonate and industrial grade. As we think about growth coming online from Wave II, when do you think we should think -- as we think about pricing with contract rolling, at what point do we see battery grade making up a greater component of the overall mix? Is that really like a late 2023 dynamic just given sort of delays around qualification, or how should we think about that as you guys increase capacity into the market?"
},
{
"speaker": "Kent Masters",
"text": "So I think that means a big piece is already battery-grade material and both carbonate and hydroxide. But I'll let Eric get into the details, maybe around timing as they layer in."
},
{
"speaker": "Eric Norris",
"text": "So the volume -- just to build on what Kent said, 60% of our business today is energy storage, and that's split between carbonate and hydroxide relatively evenly as we sit here today. With the expansions coming on, we have -- it will still be split because we have a large expansion in Kemerton on hydroxide and similarly one in La Negra on carbonate. So that's where our growth is. As we bring that capacity on, that's where the volume will go. So that 60% of sales will grow larger on a volume basis. Now in terms of pricing, that's an evolution that we're going through now in our contracts. We've had, as you may know, concessions we made to fixed price contracts we've done in the past. And while that's given us security of supply to run our plants and strong margins at the bottom of the cycle, we're now evolving those pricing mechanisms to give us more exposure to the market as it recovers. And that will benefit this volume as well, bring on volume under new terms that will allow us to benefit from a rising market."
},
{
"speaker": "Operator",
"text": "Our next question coming from the line of Joe Jackson with BMO Capital Markets."
},
{
"speaker": "Unidentified Analyst",
"text": "This is Robin on for Joel. You talked about being limited on lithium inventories to meet your own demand. How much offline conversion in spodumene capacity do you see reramping in the industry this year to meet total industry demand? And how quickly do you see industry inventories rebuilding, or maybe you can talk about overall tightness and what that could mean for pricing?"
},
{
"speaker": "Eric Norris",
"text": "I think the short answer to your question is while mines are restarting, there are still some that went into the bankruptcy phase in Australia that still haven't come back. It takes some time, particularly in Western Australia right now given the labor crisis and the rising iron ore prices, to mobilize both equipment and labor personnel to restart a plant. So what we foresee going forward, given the strong demand that's starting to develop -- has been under development in China and is now ramping around the world, that it's going to remain short in China. That spodumene is going to be a constraint. That is why you're seeing carbonate prices rise so quickly in China, where there is a high demand, in particular, for carbonate for some of the recovering industries in China post pandemic, but also because of the growth of LFP chemistry, specifically in China. And inventories are a bare minimum in the Chinese market and have come back to normal levels worldwide, which is why we were in a position during the first quarter to otherwise thought like as in prior quarters would not be a strong quarter, it was quite the opposite. We had to pull volumes forward into that to drive the growth that you saw. We're limited in what we can do, but we'll benefit greatly when we bring on that new capacity and be well positioned into 2022."
},
{
"speaker": "Unidentified Analyst",
"text": "And just a quick follow up. So I assume the rationale to reinstate tolling is to meet that market tightness. So is that strategy temporary then? Maybe you can discuss the amount of volume from tolling and what the margin impact from that is? Because I think the previous long term target for lithium margins was closer to 40%. Obviously, things are trending sub 35 right now. Maybe you can just elaborate on those points."
},
{
"speaker": "Eric Norris",
"text": "Tolling has always been a bridging strategy for us, and it's only ever done in carbonate because we feel that there's adequate carbonate capacity out there that can meet the standards for that product, and hydroxide is something we view as different and more proprietary. The bridging strategy, in this case, is to get us revamped in relationships with Chinese customers that we've supplied in the past, such that when we bring on La Negra III and IV next year, we have a ready customer base to take that on. So I would think of it as ad hoc or bridging. It's not a sustained strategy. It is something -- I can't get into the details of volumes per se. But it is to, as you point out, not as lucrative, not as high a margin of business for us because we're paying somebody to convert for us. So it moves us to the right on the cost curve, whereas we're normally on the left side, you're moving more towards the right, so that impacts margins. But it does provide incremental EBITDA, and it does set us up for a successful ramp next year."
},
{
"speaker": "Operator",
"text": "And our next question coming from the line of David Begleiter with Deutsche Bank."
},
{
"speaker": "David Begleiter",
"text": "First, in Lithium, what was the benefit of the acceleration of customer orders into Q1 on EBITDA?"
},
{
"speaker": "Scott Tozier",
"text": "David, I'm going to have -- let me just take a quick look. But I think it's meaningful in terms of the volume. So it's probably in the $30 million range, something like that."
},
{
"speaker": "Kent Masters",
"text": "Another way of seeing that, David, is that you may have had -- I don't know your model, but you may have had to get to guidance. You may have had a much stronger second half than first half. And because of the robust demand, whatever we make, we're selling. There's not very little going to inventory. So the quarters are going to be a lot more even or similar this year than they were last year for the Lithium business."
},
{
"speaker": "David Begleiter",
"text": "And Eric, just on La Negra and Kemerton following the commissioning qualification processes, how should we think about volume ramp up for these two new assets?"
},
{
"speaker": "Eric Norris",
"text": "So we've said those will ramp up over a period of time. So we first turn it on, nothing to getting us to expect to get to a full ramp of say, 18 months and some of that depends on demand and customers. So over that first year per line, probably 40% or 50% of capacity in the first 12 months, that's probably the best way to think about it and some of that will depend on demand but we think -- we expect demand to be there."
},
{
"speaker": "Operator",
"text": "Our next question is coming from the line of Jeff Zekauskas with JPMorgan."
},
{
"speaker": "Jeff Zekauskas",
"text": "When you bring on your new capacity in 2022, '23 in lithium, how might you compare the pricing structures that will be negotiated versus the current pricing structures that you have today? That is, how has the market changed and how has Albemarle changed in the way that you charge your customers, or contemplate charging your customers?"
},
{
"speaker": "Kent Masters",
"text": "So we've been talking about kind of the shift in our commercial strategy in lithium for some time. We kind of intentionally delayed the conversion from kind of a strict long term fixed price contract. So one that is more indicative of the market, that moves more with the market, and that we'd have different types of customers we contract slightly different ways. We delayed the conversion of that a little bit because the market was so far down. We didn't think it was the right time to negotiate at the bottom of the market, so we held off on that. So that strategy hasn't changed and the new volume doesn't change that. So I think we're moving into that dynamic as we go through the next 12 months, or the contracts we'll be negotiating will be on that new basis. So portfolio of customers with kind of customers who really want security of supply will be more of a fixed price, but it will still move with the markets and then contract with other people that look more like market prices, not spot prices contracted, but prices that move with the market. And that's what we've been talking about for the, I would say, almost the last year. And we did delay the implementation intentionally because we felt like we didn't want to negotiate at the bottom of the market."
},
{
"speaker": "Operator",
"text": "Our next question coming from the line of Colin Rusch with Oppenheimer."
},
{
"speaker": "Unidentified Analyst",
"text": "It's Joe on for Colin. Can you speak a little bit to how challenging hiring is at this point as you get ready to bring capacity on early next year?"
},
{
"speaker": "Kent Masters",
"text": "So I mean there were two locations. So Chile and Kemerton, so Western Australia, and a different dynamic because we've got a significant operation in Chile already. So it's not such a challenge in that location, abigger issue in Chile at the moment is COVID. But we're able to bring people on there and we've been bringing them on, training them with existing staff. And Australia is a little different because it's a true greenfield facility, but we've been hiring. We’re happy with the plan. We’ve been doing well. In the labor market, it's a little different dynamic in the construction market than it is in the chemical operating market. So we've been able to hire according to our plans and ramp up staff that would operate the facility according to our plan. So that hasn't impacted us. What's been more of a challenge is in the construction labor market and getting the staff that we need to complete construction. And we were actually trying to accelerate it but we're not able to do that, we're just kind of treading water with our original plan."
},
{
"speaker": "Unidentified Analyst",
"text": "And then switching gears a little bit. Beyond pricing, can you speak to any other elements of your long term contracts that you're working to improve given what seems like a better negotiating position?"
},
{
"speaker": "Kent Masters",
"text": "Well, I mean I guess it's several elements, but it's really about the guaranteed supply, the profile of that supply. Pricing is a big part of that and liabilities. Eric, you have…"
},
{
"speaker": "Eric Norris",
"text": "I would say that the big -- the evolution of the dialog, where we feel we have a lot of value to offer now is on location of supply as well as the localization. And we've referenced in our expansion strategies down the road how we can play to that. And for many of our customers that's a down the road consideration because the vast majority of the business today is still Asia based. And then the other is sustainability. Sustainability has been key. As OEMs become more involved and have thought through their value proposition, which is based on lower CO2 and other sustainable factors, they want suppliers who are differentiated in that regard. And what we are doing, what Kent described in the call has real value. We talk in these calls very much about what it means to shareholders of being part of the S&P 500 ESG Index. For me, it's about driving a value proposition with our customers and getting paid for it. So that's become a big part of our proposition as well."
},
{
"speaker": "Operator",
"text": "Our next question coming from the line of Vincent Andrews with Morgan Stanley."
},
{
"speaker": "Unidentified Analyst",
"text": "This is Angel on for Vincent. Just curious on your Wave III, what are the key gating factors that you kind of see for both capacity and lithium and bromine before you actually announce FID?"
},
{
"speaker": "Kent Masters",
"text": "You said the key?"
},
{
"speaker": "Unidentified Analyst",
"text": "The key gating factors or what are the primary, I guess, checkpoints or things that you want to see before you actually make the FID decision?"
},
{
"speaker": "Kent Masters",
"text": "So I mean we're looking at projects, identifying them, designing in the plans for that. So I guess it's anything you would expect to see in a normal investment program. So we're making sure that we've got designs, the process chemistry that we like. We've aligned up -- we have the resources that's not an issue but a lot of it's about location, about permitting, workforce. I mean all the that you would see that we would line up. But we're relatively advanced at looking at that. And then obviously, when you get to that decision point, the returns are a big deal."
},
{
"speaker": "Unidentified Analyst",
"text": "And then switching, I guess, to bromine a little bit. You talked about the favorable mix, customer, I guess, not repeating going forward. One, I guess, could you give us a little bit more color on that and why it won't repeat. And then as we think about kind of the second half or kind of 2Q and beyond, should we expect higher pricing in bromine to kind of offset both the shorter supply because of lost production and because of Uri and also the raw materials headwind that you mentioned?"
},
{
"speaker": "Scott Tozier",
"text": "I would start, and maybe Netha can add some additional color. But in the first quarter, the bromine market overall was relatively short. So it gave us some nice opportunities in the spot market to take advantage of that and get some upside. We're not expecting that kind of condition to continue through the rest of the year. But maybe, Netha, you have more specifics?"
},
{
"speaker": "Netha Johnson",
"text": "Just as Scott described, we had a chance to go sell some volume out of inventory to our noncontracted customers that increased demand based on market recovery, that's a unique opportunity and at very good pricing. We don't expect that to continue through the second half of the year. But just like other industrial businesses, as you look forward to the second part of your question, freight and raw materials are going up and they'll do the same for us and that will impact our business in Q2 and beyond for the rest of the year."
},
{
"speaker": "Operator",
"text": "Our next question coming from the line of Matthew DeYoe with Bank of America."
},
{
"speaker": "Matthew DeYoe",
"text": "Can we talk a little bit about the puts and takes on Lithium EBITDA as we move sequentially through the year? I kind of understand the transition from 1Q to 2Q. But it seems like you're guiding for price to improve sequentially as we move [here] but also costs are up. So perhaps like how much cost do you expect to incur with these new plant start ups and when would that roll off?"
},
{
"speaker": "Scott Tozier",
"text": "So in the second half, it’s up something in the range of $10 million to $15 million of incremental costs from those plants. It all depends on the timing of what those come in. But that's the kind of range that we're looking at ultimately. So as you look at the puts and takes, obviously, there's a limit in terms of our ability to supply additional volume. We're getting some out of tolling. Of course, that comes at a lower margin ultimately for us. So that's a bit of a drag from a margin perspective as well."
},
{
"speaker": "Matthew DeYoe",
"text": "And then on catalysts, you made a comment that you don't expect to get back to pre COVID levels before late 2022, 2023. So can you just walk through your assumptions there? Is that just all miles driven or is there something else that's happening?"
},
{
"speaker": "Scott Tozier",
"text": "Ultimately, it's coming from our customers and what our customers are telling them. But maybe, Raphael, you can provide some additional color as to the specific parts of the market that are slower than others."
},
{
"speaker": "Raphael Crawford",
"text": "So I think there's a few different pieces that come into play. I mean one of them is miles driven is a big driver of recovery in refining utilization. I think we're already starting to see an improvement in refining utilization, and you'll see that throughout the year and into next year, that's going to have -- will have a big effect on FCC usage at the refineries and our business, about 60% of our business is FCC, so we'll see that recovery. On the CFT or HPC business, that business is timed with turnarounds at refineries. A lot of that's been pushed out until 2022, and that's when we'll start to see an uptick in that business. The portfolio we have in our business is very much geared towards high performance. When refiners are running near capacity, that's really when the value of our products kicks in because we help them maximize on yield, maximize on the throughput through their assets. So as it recovers, we'll start to see that leverage effect in the return of our business."
},
{
"speaker": "Matthew DeYoe",
"text": "And so just right now, you're seeing mix just mixing down across some of the catalyst because people don't need their utilization through the refiners…"
},
{
"speaker": "Raphael Crawford",
"text": "Yes, I think that's a fair statement. We see a mix impact and a volume impact, but we expect both of those to reverse as the world recovers."
},
{
"speaker": "Operator",
"text": "Our next question coming from the line of Arun Viswanathan with RBC Capital Markets."
},
{
"speaker": "Arun Viswanathan",
"text": "I'm just curious what you're seeing, I guess, in China. There's been obviously some robust recovery in lithium markets in there as well as in Europe. Do you expect that to kind of continue into next year? Is there an environment or scenario where you see prices kind of getting back to say the $12,000 to $14,000 per ton range? Maybe you can just comment on what your outlook for pricing is for hydroxide."
},
{
"speaker": "Kent Masters",
"text": "It's hard to comment too much on price. I mean those are the -- that's the magic question. But the market is clearly moving in that direction. And you're seeing the demand growth, so the demand growth we expect to continue. I mean, what we're seeing is it's extraordinary, but it may not be 135%, but it's going to be 70%, 80% for the year around EV levels, and lithium is going to follow that. So demand growth is going to be there. And pricing has moved very quickly in China because that's mostly a spot market, so it would move quicker. That hasn't translated into the contract market fully yet. So it has started to, we think, and we see that moving in that direction over time. It's hard to predict what's going to happen out into the future, but we see prices moving up. And that what's happening in the spot market will translate into the contract prices and that will be a positive for Albemarle."
},
{
"speaker": "Arun Viswanathan",
"text": "And just as a quick follow-up then. A couple of years ago, you were discussing contracts with term lengths of maybe seven, 10 years at times. Have you seen your customers kind of come back to you now with requests to kind of elongate their contracts or -- yes, maybe you can just comment on the customer environment from a contracting perspective."
},
{
"speaker": "Kent Masters",
"text": "Let me start, Eric can add some detail to that. But I would say, I mean, our philosophy hasn't really changed. We've adjusted a bit on the kind of the nature. I would say we've evolved in our contracting structure, but it's really still the same philosophy. And I think our customers are kind of coming around to that way of thinking a bit. And I think it's changing because some of it's with OEMs now. Several years ago, we were talking to cathode makers, then battery makers and now it's OEMs and still talking across all three of those areas, but the OEMs are getting more involved, and they have a longer-term view. So I don't know about 10 year contracts, but three year, five year, maybe seven on the longest term. But those are the kind of -- that's the nature of the contracts that we're discussing. I don't know anyone's pushing us further than that."
},
{
"speaker": "Operator",
"text": "Our next question coming from the line of Aleksey Yefremov with KeyBanc."
},
{
"speaker": "Unidentified Analyst",
"text": "This is Paul on for Aleksey. Could you update us on any lithium recycling initiatives currently so far?"
},
{
"speaker": "Eric Norris",
"text": "Recycling is a key platform for us going forward from a growth standpoint, both because our customers who, as Kent just indicated, are increasingly OEMs value that as part of their partnership with us and because a good amount of the knowhow we have from processing lithium is going to be replicable in the streams that will come from a recycled process. We've got investments we've made and start ups are looking at making through some relationships we have. We've got technology initiatives underway with some business development activities underway to partner. We have one joint development agreement, which we’re currently doing with the customer. All these are all confidential at this stage, so I can't divulge names. But it's a pretty comprehensive effort and a critical one for our growth going forward. We view this as a future resource that we would like to play prominently in."
},
{
"speaker": "Operator",
"text": "Our next question coming from the line of John Roberts from UBS."
},
{
"speaker": "Matt Skowronski",
"text": "This is Matt Skowronski on for John. Going off of Jeff's question earlier, you mentioned that you're restructuring some of your lithium contracts. And I believe on the last call, you mentioned the majority of these contracts will eventually have some sort of variable based pricing tied to an index. When do you expect the majority of your contracts be based on this variable price mechanism and how frequently does a typical contract allow for price adjustments?"
},
{
"speaker": "Eric Norris",
"text": "You're right, our legacy contracts had, as Kent described in the past, a fixed price mechanism. And during the crisis of the past year plus we gave some relief on that, that relief clause expires during the course of this year. Some in the middle of this year, all by the end of the year. For our legacy contracts that's the time frame we'll be looking to move to the new structure that we'd earlier described and that will give us that upside to have price rise with the market more freely than it would have under the fixed price constructs. And it's the basis for any new contracts we've struck. We've struck several new contracts, both with battery and automotive OEM producers in the past three, six months and they are in that same construct. Now it's important to note, it's not one structure. We have some customers who actually value more consistency. And obviously, that's a higher price point from a fixed price standpoint, so we can get our returns over the cycle. And there are certain commitments we'll make to go along with them on volume. On the other hand, those who are more fixated on price we'll have a component of our mix there. We will be a little more -- just more discretion about how long we go on some of those contracts. And so there's going to be a mix there is kind of a mix that we see, but the underlying message is exposure to a rising market."
},
{
"speaker": "Operator",
"text": "Our next question coming from the line of Ben Kallo with Baird."
},
{
"speaker": "Ben Kallo",
"text": "Just on bromine, I know it's on the top of du jour, but the chip shortage that we see, everyone sees out there, can you talk about how your visibility is on that, or what you could gain if there is semiconductor new builds and if that [benefits] you? And then just on the lithium side, Scott, back when the worry was around not enough batteries being produced and from our EV coverage, I think that's a worry too. But what you guys see on that side as far as new capacity being built and how you guys are modeling that yourselves and the visibility on that?"
},
{
"speaker": "Scott Tozier",
"text": "So let me start with the second part first with the battery. I mean, we're focused on making sure we get the lithium that goes with the market. And we model that from the vehicle backwards to the battery and then to the cathodes, and there's a lot of plans and capacity being added. I don't know that we -- we're not going to put an opinion out there about capacity for batteries. We're very focused on making sure that we've got -- our part of the lithium market that we're building out -- what all of our growth plans are about. Those investments and executing on those investments, so we've got lithium to provide that market. So I don't think we should comment about the capacity in the battery market, but we see a lot of projects and a lot of capability in executing those projects. Maybe Netha could talk a little bit about the chip shortage and how that impacts bromine from a, I guess, that would be across all the electronics space."
},
{
"speaker": "Netha Johnson",
"text": "Ben, we see the electronics market is really strong. But as Scott mentioned, we're not seeing the chip shortage impact us. A strong semiconductor chip electronics market is definitely good for us. But with us being sold out, we have very limited additional capacity to leverage that in the rest of the year. So we do have contracted volumes in those markets. Those volumes are being ordered as we expect. And so we don't really see that as an issue right now. Now things could always change but from where we sit in the supply chain, we're not seeing an impact right now with the chip shortage."
},
{
"speaker": "Kent Masters",
"text": "And I think it's a little bit -- Ben, part of your question was just about an advantage we might see coming forward. I think that's really just going to be about demand of those electronics. So they need more chips, those underlying applications where we play, whether it's in automotive or just call it, the Internet of Things, so proliferation of chips and that's an advantage for us, but they have to be able to keep up with it for it to be an advantage for us."
},
{
"speaker": "Ben Kallo",
"text": "And if I could sneak one more in. What about just the overall flexibility of the three businesses? And I know you guys have done a lot, but just overall, 80% of the questions are about lithium here. So how do you think about the portfolio altogether?"
},
{
"speaker": "Kent Masters",
"text": "So we've got three core businesses and it's a portfolio. So catalyst is struggling a little bit, their market is not as strong because the miles driven and the issues we saw from COVID there. Bromine held up very well during the pandemic. And then really, EVs and then part of that, the lithium market was accelerated through COVID because really the European response to the COVID was really about clean energy and electric vehicles. So I think the portfolio effect is working for us. I mean we'd love for all three businesses to be striking on all cylinders but that's part of the portfolio. We think they're key businesses. They all fit into the sustainability angle that we're pushing. There's a sustainability piece for all three of those businesses, and that's kind of what ties them all together, and we like that portfolio. And it's working because when one business is down, the other two are doing quite well and that will probably cycle."
},
{
"speaker": "Operator",
"text": "Our next question coming from the line of Chris Kapsch with Loop Capital."
},
{
"speaker": "Chris Kapsch",
"text": "So my question relates to lithium business in the industry and focused on your visibility more specifically. So the industry at this point is still pretty China centric and in the materials space, China has been notoriously sort of double ordered or build excess inventories during periods of rising commodity prices. And on the flip side, as this industry has witnessed the pain can be pretty acute when prices are coming in with destocking in the supply chain exacerbating the downward pricing pressures. Granted this lithium chemicals for the battery application are not as commodity oriented as say copper or iron ore or something. But I'm just wondering if you could comment on the ability right now for the industry to build back inventories or safety stocks, or buffer stocks? And maybe also speaking to your visibility, how is this changing along with the procurement strategies, which are migrating maybe away from cathode producers simply to cathode plus battery and in some cases, OEs? So just if you could speak to visibility on that, what the dynamic is currently and how you see that evolving."
},
{
"speaker": "Kent Masters",
"text": "So I mean, I guess, a bit about China. I'm not sure we have a ton more visibility, but there's not -- I mean we're fighting to keep up with demand. I think the industry is doing the same. So I don't think they're building -- anybody's building inventory in the supply chain, and that probably goes from batteries, the cathodes to materials as well. I mean from our perspective, we're not building inventories. We actually sold down inventories to take advantage, or to satisfy demand in the first quarter. And I don't know, Eric, if you have any more visibility around that?"
},
{
"speaker": "Eric Norris",
"text": "No, I mean the industry is tight, up and down not just in China but around the world, and a consequence in some regards of just how bad it got last year from a value standpoint. There's a lot of capacity went out of the market, a lot of projects slowed down. So it's going to take a while to catch up and yet demand is accelerating. So we don't see a let up in the situation, which is one reason why we won't give a specific number. We see price rising going forward for the foreseeable future. China is still very important to the industry. If there's a delay anywhere in building out capacity downstream for batteries, it's outside of China. So Asia continues to be an important point going forward, which certainly in the near term suits where we're bringing on capacity. So we're very optimistic about being able to place that capacity we bring on next year."
},
{
"speaker": "Kent Masters",
"text": "And I would just say one thing that's a little different than some of the other industries that kind of mining industries, iron ore, ferrous materials. I mean we are integrated into the resource and into the conversion as well. And that's not all China, the resources are really not in China, a lot of the conversion capacity and the customer demand today is in China. And we spent a lot of effort making sure we have a diverse resource base from a resource standpoint and also from a conversion specific. So we're not too heavy in China. It's why you see us building in Western Australia, and we're doing conversion capacity in Chile as well. So we focus on that diversification from a resource standpoint and a conversion basis as well. And in some cases, it's more expensive for us to do that but we think it's important."
},
{
"speaker": "Operator",
"text": "And I'm not showing any further questions at this time. I would now like to turn the call back over to Mr. Kent Masters for closing remarks."
},
{
"speaker": "Kent Masters",
"text": "Okay. Thank you, Olivia. And again, thank you all for joining us today. All the efforts and opportunities we discussed today require execution, and we have the capabilities, the resources and most importantly, the people to execute on our strategy. We expect to achieve accelerated growth with lower capital intensity, which should enable us to achieve higher returns. We will continue to work on our sustainability throughout the value chain, not only within Albemarle's operations but by continuing to support our customers. Thank you, and we look forward to speaking to you on our next call."
},
{
"speaker": "Operator",
"text": "Ladies and gentlemen, that does conclude our conference for today. Thank you for your participation. You may now disconnect."
}
] | Albemarle Corporation | 18,671 |
ALB | 4 | 2,022 | 2023-02-16 09:00:00 | Operator: Ladies and gentlemen, welcome to the Albemarle Corporation Q4 2022 Earnings Call. My name is Glenn, and I’ll be the moderator for today's call. [Operator Instructions] I will now hand you over to your host, Meredith Bandy, Vice President of Investor Relations and Sustainability. Meredith, please go ahead.
Meredith Bandy: All right. Thank you, Glenn, and welcome, everyone, to Albemarle's fourth quarter and full year 2022 earnings conference call. Our earnings were released after the close of market yesterday, and you will find the press release and earnings presentation posted to our website under the Investors section at albemarle.com. Joining me on the call today are Kent Masters, Chief Executive Officer and Scott Tozier, Chief Financial Officer, Raphael Crawford, President of Ketjen; Netha Johnson, President of Specialties; and Eric Norris, President of Energy Storage are also available for Q&A. I'll note that today's call will be limited to 30 minutes shorter than our usual quarterly updates since we just held an in-depth update about three weeks ago. The replay of that webcast is available on our website. As a reminder, some of the statements made during this call, including our outlook, guidance, expected company performance and timing of the expansion projects may constitute forward-looking statements. Please note the cautionary language about forward-looking statements contained in our press release and earnings presentation that same language applies to this call. I'll also note that some of our comments today refer to non-GAAP financial measures. A reconciliation to GAAP financial measures can be found in our earnings release and the appendix of our earnings presentation. With that, I'll turn the call over to Ken.
Kent Masters: Thanks, Meredith. Good morning, and thank you for joining us today. I'll start by highlighting that our fourth quarter results were exceptional with close to triple the net sales from the same period in 2021 and adjusted EBITDA up more than 400% year-over-year. And while rising lithium pricing contributed to these results, we also saw significant increased volume growth. Scott will go into the financial details for the quarter and the year. We are confident in our assessment of the market opportunity for our essential elements and equally confident of our ability to seize that opportunity. We anticipate net sales growth of 55% to 75% for 2023. Our strategy is not just to maintain but to build on our global leadership in both Energy Storage and Specialties, and we continue to invest in both capacity and innovation to make that happen. And now I'll turn it over to Scott for details.
Scott Tozier: Great. Thanks, Kent, and good morning, everyone. Let's start on slide 5 to quickly review the fourth quarter 2022 performance. Net sales for the fourth quarter closed at approximately $2.6 billion, up 193% from last year, driven primarily by our Lithium segment, but we saw increases in bromine as well. Net income attributable to Albemarle was $1.1 billion for the fourth quarter. Diluted EPS for the fourth quarter was $9.60, which was a record for Albemarle. In fact, it easily beat our previous full year EPS record of $6.34 back in 2018. Turning to slide 6. Fourth quarter adjusted EBITDA was over $1.2 billion, up almost 5.5 times year-over-year. This $1 billion increase was primarily driven by higher lithium prices and increased volumes. As you can see on the slide, this high quarterly results also contributed heavily to our full year increase in adjusted EBITDA of nearly 300%. Our Bromine segment was up slightly. And as expected, our Catalyst segment came in lower in the quarter as higher sales volumes and favorable pricing were offset by a plant shutdown due to the winter freeze in Texas in December. Full year 2023 guidance is unchanged from our strategic update in January. We continue to expect strong sequential sales growth in 2023. And remember, we have assumed flat year-end 2022 lithium pricing throughout 2023. We expect our adjusted EBITDA to be approximately 20% to 45% higher than 2022, with positive trends in all three businesses. Additionally, we expect net cash from operations to rise between 10% and 25% over 2022. And this means we expect to remain free cash flow positive this year even after increasing our growth investments. On slide 8, we expect to see net sales increase sequentially quarter-to-quarter, as our volumes ramp up. We project that our adjusted EBITDA will be evenly split between the first and second halves of the year. And as a result, we anticipate that margin rates will moderate as we progress through the year, and I'll come back to that in a moment. All three of our business segments are looking at healthy growth rates during the year reiterating what we detailed in our January event. Since our webcast in January, a lot of the questions we've gotten are around margins and capital expenditures. So I'll provide some additional color and time on those two items, and then Kent will provide a market update. So let's turn to slide 9. Energy Storage EBITDA margins were 65% in 2022. And then in 2023, a lower impact of spodumene inventory, and increased impact of our JVs is expected to normalize our 2023 margins to around 46% to 47%. Most of that roughly 20 percentage point decline is due to spodumene inventory lags. It takes about six months for spodumene to go from our mines through conversion to our customers. Last year, we saw dramatic increases in pricing for lithium and spodumene. And due to that time lag on spodumene inventory, we realized higher lithium pricing from our customers faster than higher spodumene costs. And as a result, we had unusually strong margins in 2022, particularly in the second half. The next item affecting margins is the accounting treatment of the MARBL joint venture. We expect to report 100% of net sales, but only our share of EBITDA, resulting in a lower reported margin on that portion of the business. As this joint venture continues to ramp up, this accounting impact will increase. We are in active discussions with our partner about restructuring the MARBL joint venture and expect to have news on this soon. Finally, our EBITDA margins are impacted by tax expense at our Talison joint venture. Talison income is included in our EBITDA on an after-tax basis. If you adjust Talison results to exclude this, margins would be about 8% to 10% higher in 2023. Let's turn to our capital expenditures outlook on slide 10. We are investing with three goals in mind. First, to add conversion capacity and remain vertically integrated; second, to invest in new product technology to support battery advances; and third, to build and maintain our world-class resource base. To meet these goals, we expect capital investment to increase from about $1.7 billion to $1.9 billion in 2023 to about $4 billion to $4.4 billion in 2027. About half the increase in capital expense relates to geographic diversification to support customer demand for regional lithium conversion and supply. In 2023, we're investing in our conversion capacity in Meishan in Qinzhou. And as the EV market develops in other parts of the world, we will continue to invest. For example, we are planning investments in North America and Europe, where we estimate capital intensity to be more than double. Second, by mid-decade, we expect to invest more in technology to produce advanced energy storage materials for next-generation batteries. And lastly, we expect to invest in additional resource development. Across our capital spending, about 5% is linked to sustainability, including improvements to new and existing facilities. These investments are expected to generate strong returns, allowing us to continue to invest to support our customers while generating significant free cash flow. With that, I'll turn it over to Kent for a brief market update and closing remarks.
Kent Masters: Okay. Thanks, Scott. As China reopens, we expect moderation in EV demand to be short-lived with medium and long-term demand remaining robust. We continue to expect EV sales in China to grow 40% year-over-year, an increase of nearly 3 million vehicles. As you can see in the chart on the right, sales in China are seasonally weak around the Lunar New Year. We believe the latest phasing out of subsidies will have limited impact on demand. EV subsidies have rolled off on schedule since 2013 with only brief declines in sales, continued municipal incentives and consumer preferences support a strong demand outlook for EVs. Our contract customers are not slowing down their ordering patterns and early indications are both that cathode inventory and battery inventory in China are decreasing, which is a good sign for lithium sales. We're listening to our customers, and we'll be watching the data, so we'll continue to adjust our expectation as the year progresses. Our biggest challenge is managing the tremendous growth opportunity that is in front of us. We are leveraging our durable competitive advantages like our world-class resources, our global asset portfolio and technical know-how to continue to grow. And we are being absolutely disciplined about how we build our leadership position, particularly when it comes to scaling lithium production and conversion. We intend to accelerate growth profitably and in ways that align with customer needs. We are confident that electrification will continue to be a primary pathway toward a clean energy future, but we also recognize that the future for Albemarle is built on more than electric vehicles and done more than just our production capacity. As we said in our strategic update, our strength in transforming resources into essential elements give us outstanding leadership opportunities in four key areas: mobility, energy, connectivity and health. We know that customer-focused innovations and sustainability are as essential to our future as our resource capacity as we work to fulfill our purpose of enabling a more resilient world. So, now we'll move to Q&A. And Glenn, you're going to moderate that.
Operator: Thank you. [Operator Instructions] Our first question comes from P.J. Juvekar from Citi P.J., your line is now open.
P.J. Juvekar: Yes. Hi, good morning everyone. Just a long-term question. As you get ready for Kings Mountain site to potentially restart in, let's say, four or five years, I know you're doing a lot of community outreach and engagement today. But can you lay out for us the milestones in terms of permitting process. And after the IRA, do you think the process has gotten any easier? Thank you.
Kent Masters: Okay. So, all right, interesting. So, I mean we are doing a lot of community outreach. It's not so much about the permitting process. It's just kind of how we're doing business when we go about a project like this. So, -- and we expect to continue to do that throughout the life of the mine as we do that and other mines and other sites as well. So, we're just -- we're changing a little bit how we do that, learning from some of the success that we've had in Lithium business, and we apply that to our other sites as well, whether we're mining there or not. But we'll continue to see that outreach. On the -- has the permitting process gotten easier since the IRA, I think there's a tension on it. We are hopeful that it may be a little bit easier and streamlined, but I can't -- we can't say that it's gotten that way yet. That's my view. And then some of the milestones in permitting, Eric, do you want to comment on that?
Eric Norris: I guess, P.J., good morning. I think that the first step would be permitting towards the latter as beginning to apply for permitting towards the latter half of this year. We've been in feasibility work on environmental side and sustainability side to prepare for that permit. And we have a permitting strategy that can get all the details on here, but I'd say leverage is the fact that it's a brownfield site. So, we're optimistic that even though there's -- as Kent said, there's tension and attention on the permitting process that this particular mine, given its brownfield history, we'll have hopefully a rapid review. So, we'll continue to monitor that closely and update you accordingly.
Kent Masters: Yes. But even though we're not -- we're filing for permits this year, we've been doing work on gathering data for that process for almost two years, I think, I'm not exactly sure how long, but for quite some time, the data that's necessary for those permits, the history around everything that you have to report on to get the permits. So, it's a process that takes a little time. And even though we haven't formally filed yet, we've been working on that for a couple of years.
P.J. Juvekar: Thank you. I'll pass it along.
Operator: Thank you, P.J. Your next question comes from David Begleiter from Deutsche Bank. David, your line is now open.
David Begleiter: Thank you. Good morning. Eric, just on lithium spot price in China, it's not a major focus of ours. We have seen continued softening over the last few weeks. What do you make of that?
Eric Norris: David, I would say it has a lot to do with what Kent described in his remarks. We've come off out of a period of time in 2022 of remarkable growth, that exceeded expectations in terms of EV production and was going at a pretty heady pace when the decision was taken to reopen the economy and then -- and of course, you know what happened thereafter. I mean the virus spread quite rapidly, and it did staff consumer demand at a time when seasonally, it was weak anyway because of the Lunar New Year. I think there's much been made about the subsidies as well rolling off, but those have been rolling off for several years. Some of them have been extended at the provincial level, and some of the more meaningful subsidies are at the state and local level anyway. So we don't think that, that's a big issue, and we've certainly seen that in prior years have initially a spike in demand immediately before the subsidy comes off, a drop in demand right after it comes off and then a rebound in demand. Our projection and our customers' view is that this year, particularly in the second half, we'll see that growth that's projected of close to 40%. In the meantime, people are buying under contracts, but not venturing into the spot market and bringing their -- in China, bringing their inventories down quite low, because we're in this post-holiday period with still some uncertainty in the very near term. We expect that to be short-lived though with the demand rebound later this year.
David Begleiter : Very helpful. And Scott, just on the full year guidance, thank you for the first half, second half split. Any further thoughts on the Q1 versus Q2 split in EBITDA?
Scott Tozier : Yes, I would expect that Q1 would be stronger than the second quarter. Again, it's really driven by that inventory lag that we're seeing ultimately as well as the strong prices in the fourth quarter that carry into the first quarter, ultimately. So, ultimately, I think the first quarter is a bit stronger than the second quarter.
David Begleiter : Excellent. Thank you very much.
Operator: Thank you, David. We have our next question comes from Jeff Zekauskas from JPMorgan. Jeff, your line is now open.
Jeff Zekauskas : Thanks very much. If lithium prices remain flat in 2023, is it the case that your equity income from Talison would remain at that 332 [ph] level all the way through 2023? And is Talison making as much spodumene as it can make or is there room for it to move up in 2023 and 2024?
Scott Tozier : Yes, I'll take the equity income question and maybe, Eric, you can take the production question. So we'd expect -- if lithium prices stay flat, we'd actually expect the equity income out of Talison to increase. If you remember, the transfer price out of Talison is on a, at least historically been on a six-month lag. It's now shifted to a three-month lag. And so that -- the increases that have happened last year will start to flow through in the first half of 2023. So I'd expect it to be higher. Eric, do you want to talk about production?
Eric Norris: Yes. And Jeff, with regard to production, you may know that CGP1, the first line has been running for years now is at max rates. CGP2 came on in the recent past and is ramping a ramp last year. There is possible -- possibility for that to run it slightly, I mean, the upside would be it can run at a slightly better rates. It's not -- there's some productivity in the bottlenecking activities to make that could result in that, although it is running close to capacity. And then there's additional from the tailings reprocess lithium that's being added. So it's higher year-on-year, and there's potential for be slightly higher if those productivity initiatives are successful.
Jeff Zekauskas : Okay. Great. And you spoke of your first half and second half lithium EBITDA as being comparable. Given that there's so much more production coming out of Chile. Why would that be the case? Shouldn't your volumes be stronger in the second half of 2023?
Scott Tozier: Yes. They'll definitely be stronger. It will be on the basis of the production out of Chile, but also the ramping up of lodging and the conversion there. And then the additional volume that Eric just talked about with Talison. Of course, prices are up, but we're assuming prices flat throughout the year based off of how we exited 2022. And then you have got to layer on the cost impacts that I talked about on the call. So you've got the spodumene inventory lag that corrects itself this year. You've got as Wodgina ramps up, you have a margin rate impact there that just due to the fact that we report a 100% of the revenue and only half of the EBITDA.
Jeff Zekauskas: Okay. Great. Thank you so much.
Operator: Thank you, Jeff. With our next question comes from Stephen Richardson from Evercore ISI. Stephen, your line is now open.
Stephen Richardson: Hi. Good morning. I was wondering if you could dig in a little bit on the European strategy. It seems clearly, in China, you've acquired and built conversion capacity. And in the US, it looks like things are really centered at Kings Mountain. Could you talk a little bit about Europe in terms of how you're thinking about how this evolves? I know it's early, but -- is this an area where we would see you bring material from either Chile or Western Australia? And then do you envision yourself partnering or doing more of a greenfield as it comes to supplying on the continent?
Kent Masters: So I'll start with that. Eric can fill in a little bit. So I think you're -- I mean, you answered part of the question. So -- we're moving from China. North America. We've got -- we have resource strategy and a program for North America, we're investing there and we'll be a similar program in Europe. We don't have the resource base in Europe that we have in North America. So we'd like it to be a combination of some local resource, which we don't have at the moment, and then bringing some -- bringing resource in, in some form. And that's most likely going to be from Chile and Western Australia, because it's where the big resource bases are at the moment. And we just got to work out the strategy of how we bring that in the most economically and the most sustainable way that we can, and that's going to be about the strategy with the assets that we put on the ground in Australia. Eric, can talk about partnering.
Eric Norris: Yes. So Stephen, it would be a greenfield site as there really are no brownfield sites for such capacity in Europe today. And we've gone through a site selection process and looked at numerous countries and haven't drawn that down close enough yet to make an announcement or to say anything publicly further about it. But that being said, it would be a plant that would be modeled very intentionally after what we've done here in North America or we want to do in North America, I should say -- around a plant that is able to process a variety of different feedstocks. I can't mention Chile. That would be a carbonate feed or spodumene or derivative of spodumene coming from Australia into Europe and also having the ability to have recycling. We very much view that kind of strategy being one that has an opportunity for a partner, whether that be an OEM or other producers in the battery supply chain in the region. And we don't have anything further we can say about that, but that's an effort that remains underway in terms of how we might partner to bring about that closed loop process in addition to the sort of the virgin lithium production we intend to put on the continent.
Stephen Richardson: Appreciate the color. Thanks. If I could just put in one follow-up, I appreciate the comments off the top in terms of the CapEx outlook. One of the questions that we fielded on this is it's clear that your – this CapEx outlook is a function of looking at the current environment or I think you used year-end 2022 environment for pricing going forward. So important to realize that you're not obligated to spend this $4.4 billion in 2017. I guess, the one point of clarification is, is that a peak for CapEx based on the Project Q that you're looking at, like this CapEx come down in 2028, 2029 based on that cadence of project spend? Thank you.
Kent Masters: Yeah. So yeah, I would say – I mean, you're right. We're not committed to it. So we will look, as things evolve and go, that's our best view. We put a five-year plan out there. That's our best view – the best view of what we'd be doing over five years. So – but any capital that we'll be investing in 2027 will be for 2031, 2032 market. And it's a pretty long way to be able to predict that from here. So it's – we don't want to go past that five-year forecast that we put out there. It could level off. I mean, it just depends on what the market looks like, and we'll know a lot more in five years' time than we do today. But any capital we're spending in 2027 is that's for 2032 or 2031, whatever the time frame is around that. And then it's important to note that, our CapEx program becomes more resource oriented. I mean, it will be – it's been conversion in the near-term, because we've had the resource. It will be more balanced between conversion and resource as we get out into that time frame.
Stephen Richardson: Thank you.
Operator: Thank you, Stephen. We have our next question comes from Christopher Parkinson from Mizuho. Christopher, your line is now open.
Christopher Parkinson: Great. Thank you so much. Can you just give a little bit more incremental information on how we should be thinking about the ramps at both Kemerton and Qinzhou, and whether or not there's any just very brief updated thought process on your additional capacity optionalities, especially in the United States through the balance of the decade? Thank you.
Kent Masters: Okay. So – and I guess, I mean, Qinzhou is operating, and it will ramp up. So there are make rights we have to do – we have to do there. So even we're operating today, we'll have to take it down to do those make rights to get additional volume, and there's a potential to expand at Qinzhou as well, but that's not a project that we're executing at the moment. So that's – we want to get up the speed and operating, but it's operating today, and we'll probably – it will ramp up over the next year, I think, to kind of the full capacity, acquisition capacity, which is around – we target at 25,000 tons. Kemerton is making product today, but we're not selling in the product because we need to get qualification from our customers. So we're – that's where we are. And then that will ramp over time – and we've – the strategy – originally, the strategy at Kemerton was to execute both train simultaneously. We've bifurcated that, because we struggled with labor during the pandemic and still, frankly, struggle with labor at Kemerton. So we're sequencing the commissioning and implementation. So Train 1 is operating and making product. Train 2 is not, and it's probably six months behind Train 1, I would say. And then that will ramp over time. We've always said, we ramp those projects, we planned those projects to ramp from start-up to full capacity over a two-year period. And I think that's probably the -- still the rule of thumb that we're following. And is there another part of the question?
Christopher Parkinson: Yeah. Just any updated thought process on your additional projects that you can assess specifically in the US over the next few years? Just any updated thoughts? That's all. Thank you.
Kent Masters: Yeah. So probably nothing new since the call a few weeks ago. So we're still looking at the site selection for a conversion facility to convert the Kings Mountain or Silver Peak, we've expanded and it's operating at that expansion rate, maybe a little bit more ramp-up to do at Silver Peak, but it's operating at that higher rate. And then the other would be Magnolia or -- and that is a little bit further out, but we're making progress there and planning that project, but we've not kicked it off from an FID standpoint yet.
Christopher Parkinson: Very helpful. Thank you so much.
Operator: Thank you, Christopher. And our last question comes from John Roberts from Credit Suisse. John, your line is now open.
John Roberts: Thank you. I think your guidance is based on the December 31st realized price, but I just want to clarify, the equity income within that guidance is based on price rising through the first quarter because of the lag and then for the remaining quarters of 2023, the equity income has a flat price after that lags recovered.
Scott Tozier: It's actually -- on the equity income, it actually goes up in the first half, through the first half. So -- and then we'll see volumetric increases out of that as well. So it actually increases through the year sequentially.
John Roberts: Okay. And then any update on the negotiations with Mineral Resources on the MARBL JV?
Kent Masters: So not a real update. Scott had said in his comments that we continue to talk with our partners and that we expect to be able to announce something soon, but nothing for today.
John Roberts: Okay. Thank you.
Operator: Thank you, John. Ladies and gentlemen, that's all the time we have for questions. I will now pass the floor back to Ken Master for closing remarks.
Kent Masters: Okay. Thank you. As you heard today and during our January webcast, we feel we have the right strategy, the operating model and the people to meet this opportunity and manage our business successfully to grow today and well into the future. So thank you for joining our call and your interest in Albemarle. Thank you.
Operator: Thank you. Ladies and gentlemen, this concludes today's call. Thank you for joining. You may now disconnect your lines. | [
{
"speaker": "Operator",
"text": "Ladies and gentlemen, welcome to the Albemarle Corporation Q4 2022 Earnings Call. My name is Glenn, and I’ll be the moderator for today's call. [Operator Instructions] I will now hand you over to your host, Meredith Bandy, Vice President of Investor Relations and Sustainability. Meredith, please go ahead."
},
{
"speaker": "Meredith Bandy",
"text": "All right. Thank you, Glenn, and welcome, everyone, to Albemarle's fourth quarter and full year 2022 earnings conference call. Our earnings were released after the close of market yesterday, and you will find the press release and earnings presentation posted to our website under the Investors section at albemarle.com. Joining me on the call today are Kent Masters, Chief Executive Officer and Scott Tozier, Chief Financial Officer, Raphael Crawford, President of Ketjen; Netha Johnson, President of Specialties; and Eric Norris, President of Energy Storage are also available for Q&A. I'll note that today's call will be limited to 30 minutes shorter than our usual quarterly updates since we just held an in-depth update about three weeks ago. The replay of that webcast is available on our website. As a reminder, some of the statements made during this call, including our outlook, guidance, expected company performance and timing of the expansion projects may constitute forward-looking statements. Please note the cautionary language about forward-looking statements contained in our press release and earnings presentation that same language applies to this call. I'll also note that some of our comments today refer to non-GAAP financial measures. A reconciliation to GAAP financial measures can be found in our earnings release and the appendix of our earnings presentation. With that, I'll turn the call over to Ken."
},
{
"speaker": "Kent Masters",
"text": "Thanks, Meredith. Good morning, and thank you for joining us today. I'll start by highlighting that our fourth quarter results were exceptional with close to triple the net sales from the same period in 2021 and adjusted EBITDA up more than 400% year-over-year. And while rising lithium pricing contributed to these results, we also saw significant increased volume growth. Scott will go into the financial details for the quarter and the year. We are confident in our assessment of the market opportunity for our essential elements and equally confident of our ability to seize that opportunity. We anticipate net sales growth of 55% to 75% for 2023. Our strategy is not just to maintain but to build on our global leadership in both Energy Storage and Specialties, and we continue to invest in both capacity and innovation to make that happen. And now I'll turn it over to Scott for details."
},
{
"speaker": "Scott Tozier",
"text": "Great. Thanks, Kent, and good morning, everyone. Let's start on slide 5 to quickly review the fourth quarter 2022 performance. Net sales for the fourth quarter closed at approximately $2.6 billion, up 193% from last year, driven primarily by our Lithium segment, but we saw increases in bromine as well. Net income attributable to Albemarle was $1.1 billion for the fourth quarter. Diluted EPS for the fourth quarter was $9.60, which was a record for Albemarle. In fact, it easily beat our previous full year EPS record of $6.34 back in 2018. Turning to slide 6. Fourth quarter adjusted EBITDA was over $1.2 billion, up almost 5.5 times year-over-year. This $1 billion increase was primarily driven by higher lithium prices and increased volumes. As you can see on the slide, this high quarterly results also contributed heavily to our full year increase in adjusted EBITDA of nearly 300%. Our Bromine segment was up slightly. And as expected, our Catalyst segment came in lower in the quarter as higher sales volumes and favorable pricing were offset by a plant shutdown due to the winter freeze in Texas in December. Full year 2023 guidance is unchanged from our strategic update in January. We continue to expect strong sequential sales growth in 2023. And remember, we have assumed flat year-end 2022 lithium pricing throughout 2023. We expect our adjusted EBITDA to be approximately 20% to 45% higher than 2022, with positive trends in all three businesses. Additionally, we expect net cash from operations to rise between 10% and 25% over 2022. And this means we expect to remain free cash flow positive this year even after increasing our growth investments. On slide 8, we expect to see net sales increase sequentially quarter-to-quarter, as our volumes ramp up. We project that our adjusted EBITDA will be evenly split between the first and second halves of the year. And as a result, we anticipate that margin rates will moderate as we progress through the year, and I'll come back to that in a moment. All three of our business segments are looking at healthy growth rates during the year reiterating what we detailed in our January event. Since our webcast in January, a lot of the questions we've gotten are around margins and capital expenditures. So I'll provide some additional color and time on those two items, and then Kent will provide a market update. So let's turn to slide 9. Energy Storage EBITDA margins were 65% in 2022. And then in 2023, a lower impact of spodumene inventory, and increased impact of our JVs is expected to normalize our 2023 margins to around 46% to 47%. Most of that roughly 20 percentage point decline is due to spodumene inventory lags. It takes about six months for spodumene to go from our mines through conversion to our customers. Last year, we saw dramatic increases in pricing for lithium and spodumene. And due to that time lag on spodumene inventory, we realized higher lithium pricing from our customers faster than higher spodumene costs. And as a result, we had unusually strong margins in 2022, particularly in the second half. The next item affecting margins is the accounting treatment of the MARBL joint venture. We expect to report 100% of net sales, but only our share of EBITDA, resulting in a lower reported margin on that portion of the business. As this joint venture continues to ramp up, this accounting impact will increase. We are in active discussions with our partner about restructuring the MARBL joint venture and expect to have news on this soon. Finally, our EBITDA margins are impacted by tax expense at our Talison joint venture. Talison income is included in our EBITDA on an after-tax basis. If you adjust Talison results to exclude this, margins would be about 8% to 10% higher in 2023. Let's turn to our capital expenditures outlook on slide 10. We are investing with three goals in mind. First, to add conversion capacity and remain vertically integrated; second, to invest in new product technology to support battery advances; and third, to build and maintain our world-class resource base. To meet these goals, we expect capital investment to increase from about $1.7 billion to $1.9 billion in 2023 to about $4 billion to $4.4 billion in 2027. About half the increase in capital expense relates to geographic diversification to support customer demand for regional lithium conversion and supply. In 2023, we're investing in our conversion capacity in Meishan in Qinzhou. And as the EV market develops in other parts of the world, we will continue to invest. For example, we are planning investments in North America and Europe, where we estimate capital intensity to be more than double. Second, by mid-decade, we expect to invest more in technology to produce advanced energy storage materials for next-generation batteries. And lastly, we expect to invest in additional resource development. Across our capital spending, about 5% is linked to sustainability, including improvements to new and existing facilities. These investments are expected to generate strong returns, allowing us to continue to invest to support our customers while generating significant free cash flow. With that, I'll turn it over to Kent for a brief market update and closing remarks."
},
{
"speaker": "Kent Masters",
"text": "Okay. Thanks, Scott. As China reopens, we expect moderation in EV demand to be short-lived with medium and long-term demand remaining robust. We continue to expect EV sales in China to grow 40% year-over-year, an increase of nearly 3 million vehicles. As you can see in the chart on the right, sales in China are seasonally weak around the Lunar New Year. We believe the latest phasing out of subsidies will have limited impact on demand. EV subsidies have rolled off on schedule since 2013 with only brief declines in sales, continued municipal incentives and consumer preferences support a strong demand outlook for EVs. Our contract customers are not slowing down their ordering patterns and early indications are both that cathode inventory and battery inventory in China are decreasing, which is a good sign for lithium sales. We're listening to our customers, and we'll be watching the data, so we'll continue to adjust our expectation as the year progresses. Our biggest challenge is managing the tremendous growth opportunity that is in front of us. We are leveraging our durable competitive advantages like our world-class resources, our global asset portfolio and technical know-how to continue to grow. And we are being absolutely disciplined about how we build our leadership position, particularly when it comes to scaling lithium production and conversion. We intend to accelerate growth profitably and in ways that align with customer needs. We are confident that electrification will continue to be a primary pathway toward a clean energy future, but we also recognize that the future for Albemarle is built on more than electric vehicles and done more than just our production capacity. As we said in our strategic update, our strength in transforming resources into essential elements give us outstanding leadership opportunities in four key areas: mobility, energy, connectivity and health. We know that customer-focused innovations and sustainability are as essential to our future as our resource capacity as we work to fulfill our purpose of enabling a more resilient world. So, now we'll move to Q&A. And Glenn, you're going to moderate that."
},
{
"speaker": "Operator",
"text": "Thank you. [Operator Instructions] Our first question comes from P.J. Juvekar from Citi P.J., your line is now open."
},
{
"speaker": "P.J. Juvekar",
"text": "Yes. Hi, good morning everyone. Just a long-term question. As you get ready for Kings Mountain site to potentially restart in, let's say, four or five years, I know you're doing a lot of community outreach and engagement today. But can you lay out for us the milestones in terms of permitting process. And after the IRA, do you think the process has gotten any easier? Thank you."
},
{
"speaker": "Kent Masters",
"text": "Okay. So, all right, interesting. So, I mean we are doing a lot of community outreach. It's not so much about the permitting process. It's just kind of how we're doing business when we go about a project like this. So, -- and we expect to continue to do that throughout the life of the mine as we do that and other mines and other sites as well. So, we're just -- we're changing a little bit how we do that, learning from some of the success that we've had in Lithium business, and we apply that to our other sites as well, whether we're mining there or not. But we'll continue to see that outreach. On the -- has the permitting process gotten easier since the IRA, I think there's a tension on it. We are hopeful that it may be a little bit easier and streamlined, but I can't -- we can't say that it's gotten that way yet. That's my view. And then some of the milestones in permitting, Eric, do you want to comment on that?"
},
{
"speaker": "Eric Norris",
"text": "I guess, P.J., good morning. I think that the first step would be permitting towards the latter as beginning to apply for permitting towards the latter half of this year. We've been in feasibility work on environmental side and sustainability side to prepare for that permit. And we have a permitting strategy that can get all the details on here, but I'd say leverage is the fact that it's a brownfield site. So, we're optimistic that even though there's -- as Kent said, there's tension and attention on the permitting process that this particular mine, given its brownfield history, we'll have hopefully a rapid review. So, we'll continue to monitor that closely and update you accordingly."
},
{
"speaker": "Kent Masters",
"text": "Yes. But even though we're not -- we're filing for permits this year, we've been doing work on gathering data for that process for almost two years, I think, I'm not exactly sure how long, but for quite some time, the data that's necessary for those permits, the history around everything that you have to report on to get the permits. So, it's a process that takes a little time. And even though we haven't formally filed yet, we've been working on that for a couple of years."
},
{
"speaker": "P.J. Juvekar",
"text": "Thank you. I'll pass it along."
},
{
"speaker": "Operator",
"text": "Thank you, P.J. Your next question comes from David Begleiter from Deutsche Bank. David, your line is now open."
},
{
"speaker": "David Begleiter",
"text": "Thank you. Good morning. Eric, just on lithium spot price in China, it's not a major focus of ours. We have seen continued softening over the last few weeks. What do you make of that?"
},
{
"speaker": "Eric Norris",
"text": "David, I would say it has a lot to do with what Kent described in his remarks. We've come off out of a period of time in 2022 of remarkable growth, that exceeded expectations in terms of EV production and was going at a pretty heady pace when the decision was taken to reopen the economy and then -- and of course, you know what happened thereafter. I mean the virus spread quite rapidly, and it did staff consumer demand at a time when seasonally, it was weak anyway because of the Lunar New Year. I think there's much been made about the subsidies as well rolling off, but those have been rolling off for several years. Some of them have been extended at the provincial level, and some of the more meaningful subsidies are at the state and local level anyway. So we don't think that, that's a big issue, and we've certainly seen that in prior years have initially a spike in demand immediately before the subsidy comes off, a drop in demand right after it comes off and then a rebound in demand. Our projection and our customers' view is that this year, particularly in the second half, we'll see that growth that's projected of close to 40%. In the meantime, people are buying under contracts, but not venturing into the spot market and bringing their -- in China, bringing their inventories down quite low, because we're in this post-holiday period with still some uncertainty in the very near term. We expect that to be short-lived though with the demand rebound later this year."
},
{
"speaker": "David Begleiter",
"text": "Very helpful. And Scott, just on the full year guidance, thank you for the first half, second half split. Any further thoughts on the Q1 versus Q2 split in EBITDA?"
},
{
"speaker": "Scott Tozier",
"text": "Yes, I would expect that Q1 would be stronger than the second quarter. Again, it's really driven by that inventory lag that we're seeing ultimately as well as the strong prices in the fourth quarter that carry into the first quarter, ultimately. So, ultimately, I think the first quarter is a bit stronger than the second quarter."
},
{
"speaker": "David Begleiter",
"text": "Excellent. Thank you very much."
},
{
"speaker": "Operator",
"text": "Thank you, David. We have our next question comes from Jeff Zekauskas from JPMorgan. Jeff, your line is now open."
},
{
"speaker": "Jeff Zekauskas",
"text": "Thanks very much. If lithium prices remain flat in 2023, is it the case that your equity income from Talison would remain at that 332 [ph] level all the way through 2023? And is Talison making as much spodumene as it can make or is there room for it to move up in 2023 and 2024?"
},
{
"speaker": "Scott Tozier",
"text": "Yes, I'll take the equity income question and maybe, Eric, you can take the production question. So we'd expect -- if lithium prices stay flat, we'd actually expect the equity income out of Talison to increase. If you remember, the transfer price out of Talison is on a, at least historically been on a six-month lag. It's now shifted to a three-month lag. And so that -- the increases that have happened last year will start to flow through in the first half of 2023. So I'd expect it to be higher. Eric, do you want to talk about production?"
},
{
"speaker": "Eric Norris",
"text": "Yes. And Jeff, with regard to production, you may know that CGP1, the first line has been running for years now is at max rates. CGP2 came on in the recent past and is ramping a ramp last year. There is possible -- possibility for that to run it slightly, I mean, the upside would be it can run at a slightly better rates. It's not -- there's some productivity in the bottlenecking activities to make that could result in that, although it is running close to capacity. And then there's additional from the tailings reprocess lithium that's being added. So it's higher year-on-year, and there's potential for be slightly higher if those productivity initiatives are successful."
},
{
"speaker": "Jeff Zekauskas",
"text": "Okay. Great. And you spoke of your first half and second half lithium EBITDA as being comparable. Given that there's so much more production coming out of Chile. Why would that be the case? Shouldn't your volumes be stronger in the second half of 2023?"
},
{
"speaker": "Scott Tozier",
"text": "Yes. They'll definitely be stronger. It will be on the basis of the production out of Chile, but also the ramping up of lodging and the conversion there. And then the additional volume that Eric just talked about with Talison. Of course, prices are up, but we're assuming prices flat throughout the year based off of how we exited 2022. And then you have got to layer on the cost impacts that I talked about on the call. So you've got the spodumene inventory lag that corrects itself this year. You've got as Wodgina ramps up, you have a margin rate impact there that just due to the fact that we report a 100% of the revenue and only half of the EBITDA."
},
{
"speaker": "Jeff Zekauskas",
"text": "Okay. Great. Thank you so much."
},
{
"speaker": "Operator",
"text": "Thank you, Jeff. With our next question comes from Stephen Richardson from Evercore ISI. Stephen, your line is now open."
},
{
"speaker": "Stephen Richardson",
"text": "Hi. Good morning. I was wondering if you could dig in a little bit on the European strategy. It seems clearly, in China, you've acquired and built conversion capacity. And in the US, it looks like things are really centered at Kings Mountain. Could you talk a little bit about Europe in terms of how you're thinking about how this evolves? I know it's early, but -- is this an area where we would see you bring material from either Chile or Western Australia? And then do you envision yourself partnering or doing more of a greenfield as it comes to supplying on the continent?"
},
{
"speaker": "Kent Masters",
"text": "So I'll start with that. Eric can fill in a little bit. So I think you're -- I mean, you answered part of the question. So -- we're moving from China. North America. We've got -- we have resource strategy and a program for North America, we're investing there and we'll be a similar program in Europe. We don't have the resource base in Europe that we have in North America. So we'd like it to be a combination of some local resource, which we don't have at the moment, and then bringing some -- bringing resource in, in some form. And that's most likely going to be from Chile and Western Australia, because it's where the big resource bases are at the moment. And we just got to work out the strategy of how we bring that in the most economically and the most sustainable way that we can, and that's going to be about the strategy with the assets that we put on the ground in Australia. Eric, can talk about partnering."
},
{
"speaker": "Eric Norris",
"text": "Yes. So Stephen, it would be a greenfield site as there really are no brownfield sites for such capacity in Europe today. And we've gone through a site selection process and looked at numerous countries and haven't drawn that down close enough yet to make an announcement or to say anything publicly further about it. But that being said, it would be a plant that would be modeled very intentionally after what we've done here in North America or we want to do in North America, I should say -- around a plant that is able to process a variety of different feedstocks. I can't mention Chile. That would be a carbonate feed or spodumene or derivative of spodumene coming from Australia into Europe and also having the ability to have recycling. We very much view that kind of strategy being one that has an opportunity for a partner, whether that be an OEM or other producers in the battery supply chain in the region. And we don't have anything further we can say about that, but that's an effort that remains underway in terms of how we might partner to bring about that closed loop process in addition to the sort of the virgin lithium production we intend to put on the continent."
},
{
"speaker": "Stephen Richardson",
"text": "Appreciate the color. Thanks. If I could just put in one follow-up, I appreciate the comments off the top in terms of the CapEx outlook. One of the questions that we fielded on this is it's clear that your – this CapEx outlook is a function of looking at the current environment or I think you used year-end 2022 environment for pricing going forward. So important to realize that you're not obligated to spend this $4.4 billion in 2017. I guess, the one point of clarification is, is that a peak for CapEx based on the Project Q that you're looking at, like this CapEx come down in 2028, 2029 based on that cadence of project spend? Thank you."
},
{
"speaker": "Kent Masters",
"text": "Yeah. So yeah, I would say – I mean, you're right. We're not committed to it. So we will look, as things evolve and go, that's our best view. We put a five-year plan out there. That's our best view – the best view of what we'd be doing over five years. So – but any capital that we'll be investing in 2027 will be for 2031, 2032 market. And it's a pretty long way to be able to predict that from here. So it's – we don't want to go past that five-year forecast that we put out there. It could level off. I mean, it just depends on what the market looks like, and we'll know a lot more in five years' time than we do today. But any capital we're spending in 2027 is that's for 2032 or 2031, whatever the time frame is around that. And then it's important to note that, our CapEx program becomes more resource oriented. I mean, it will be – it's been conversion in the near-term, because we've had the resource. It will be more balanced between conversion and resource as we get out into that time frame."
},
{
"speaker": "Stephen Richardson",
"text": "Thank you."
},
{
"speaker": "Operator",
"text": "Thank you, Stephen. We have our next question comes from Christopher Parkinson from Mizuho. Christopher, your line is now open."
},
{
"speaker": "Christopher Parkinson",
"text": "Great. Thank you so much. Can you just give a little bit more incremental information on how we should be thinking about the ramps at both Kemerton and Qinzhou, and whether or not there's any just very brief updated thought process on your additional capacity optionalities, especially in the United States through the balance of the decade? Thank you."
},
{
"speaker": "Kent Masters",
"text": "Okay. So – and I guess, I mean, Qinzhou is operating, and it will ramp up. So there are make rights we have to do – we have to do there. So even we're operating today, we'll have to take it down to do those make rights to get additional volume, and there's a potential to expand at Qinzhou as well, but that's not a project that we're executing at the moment. So that's – we want to get up the speed and operating, but it's operating today, and we'll probably – it will ramp up over the next year, I think, to kind of the full capacity, acquisition capacity, which is around – we target at 25,000 tons. Kemerton is making product today, but we're not selling in the product because we need to get qualification from our customers. So we're – that's where we are. And then that will ramp over time – and we've – the strategy – originally, the strategy at Kemerton was to execute both train simultaneously. We've bifurcated that, because we struggled with labor during the pandemic and still, frankly, struggle with labor at Kemerton. So we're sequencing the commissioning and implementation. So Train 1 is operating and making product. Train 2 is not, and it's probably six months behind Train 1, I would say. And then that will ramp over time. We've always said, we ramp those projects, we planned those projects to ramp from start-up to full capacity over a two-year period. And I think that's probably the -- still the rule of thumb that we're following. And is there another part of the question?"
},
{
"speaker": "Christopher Parkinson",
"text": "Yeah. Just any updated thought process on your additional projects that you can assess specifically in the US over the next few years? Just any updated thoughts? That's all. Thank you."
},
{
"speaker": "Kent Masters",
"text": "Yeah. So probably nothing new since the call a few weeks ago. So we're still looking at the site selection for a conversion facility to convert the Kings Mountain or Silver Peak, we've expanded and it's operating at that expansion rate, maybe a little bit more ramp-up to do at Silver Peak, but it's operating at that higher rate. And then the other would be Magnolia or -- and that is a little bit further out, but we're making progress there and planning that project, but we've not kicked it off from an FID standpoint yet."
},
{
"speaker": "Christopher Parkinson",
"text": "Very helpful. Thank you so much."
},
{
"speaker": "Operator",
"text": "Thank you, Christopher. And our last question comes from John Roberts from Credit Suisse. John, your line is now open."
},
{
"speaker": "John Roberts",
"text": "Thank you. I think your guidance is based on the December 31st realized price, but I just want to clarify, the equity income within that guidance is based on price rising through the first quarter because of the lag and then for the remaining quarters of 2023, the equity income has a flat price after that lags recovered."
},
{
"speaker": "Scott Tozier",
"text": "It's actually -- on the equity income, it actually goes up in the first half, through the first half. So -- and then we'll see volumetric increases out of that as well. So it actually increases through the year sequentially."
},
{
"speaker": "John Roberts",
"text": "Okay. And then any update on the negotiations with Mineral Resources on the MARBL JV?"
},
{
"speaker": "Kent Masters",
"text": "So not a real update. Scott had said in his comments that we continue to talk with our partners and that we expect to be able to announce something soon, but nothing for today."
},
{
"speaker": "John Roberts",
"text": "Okay. Thank you."
},
{
"speaker": "Operator",
"text": "Thank you, John. Ladies and gentlemen, that's all the time we have for questions. I will now pass the floor back to Ken Master for closing remarks."
},
{
"speaker": "Kent Masters",
"text": "Okay. Thank you. As you heard today and during our January webcast, we feel we have the right strategy, the operating model and the people to meet this opportunity and manage our business successfully to grow today and well into the future. So thank you for joining our call and your interest in Albemarle. Thank you."
},
{
"speaker": "Operator",
"text": "Thank you. Ladies and gentlemen, this concludes today's call. Thank you for joining. You may now disconnect your lines."
}
] | Albemarle Corporation | 18,671 |
ALB | 3 | 2,022 | 2022-11-03 09:00:00 | Operator: Hello, and welcome to the Q3 2022 Albemarle Corporation Earnings Conference Call. My name is Alex, and I'll be coordinating the call today. [Operator Instructions] I'll now hand over to your host, Meredith Bandy, Vice President of Investor Relations and Sustainability. Please go ahead.
Meredith Bandy: All right. Thank you, Alex, and welcome, everyone, to Albemarle's Third Quarter 2022 Earnings Conference Call. Our earnings were released after the close of market yesterday, and you'll find the press release and presentation posted to our website under the Investor Relations section at albemarle.com. Joining me on the call today are Kent Masters, Chief Executive Officer and Scott Tozier, Chief Financial Officer, Raphael Crawford, President of Catalyst, Netha Johnson, President of Bromine and Eric Norris, President of Lithium, are also available for Q&A. As a reminder, some of the statements made during this call, including our outlook, guidance, expected company performance and timing of expansion projects may constitute forward-looking statements within the meaning of federal securities laws. Please note the cautionary language about forward-looking statements contained in our press release and presentation, that same language applies to this call. Please also note that some of our comments today refer to non-GAAP financial measures. A reconciliation to GAAP financial measures can be found in our earnings release and the appendix of our earnings presentation. Lastly, I would like to highlight that in January, we plan to host a webcast to provide our full year 2023 guidance and new five-year targets for our restructured businesses. With that, I will turn the call over to Kent.
Kent Masters : Thanks. Meredith, and thank you all for joining us today. On today's call, I'll highlight our third quarter results and achievements. Scott will provide more detail on our financial results, outlook, balance sheet and capital allocation. I'll then close our prepared remarks with an update on our structure and our strategic growth projects. We had another excellent quarter as Albemarle continues to benefit from the demand for lithium-ion batteries driven by the energy transition. This, plus growth in bromine, drove a strong third quarter. We generated net sales of $2.1 billion or more than 2.5 times the prior year period. Third quarter adjusted EBITDA of $1.2 billion or approximately 5 times the prior year period, continued the trend of increase -- of EBITDA increasing significantly outpacing sales growth. We are tightening our previously raised 2022 outlook and reaffirming our expectation to be free cash flow positive for the year. Scott will review the key elements of our outlook in his remarks. In October, we completed the acquisition of the Qinzhou lithium conversion facility in China. This, along with the mechanical completion of the Kemerton II lithium conversion project in Australia has us on track to more than double our lithium conversion capacity this year. In response to the growth opportunities ahead of us, we announced during the quarter a new segment structure that is expected to take effect in January of 2023. We are realigning our core lithium and bromine businesses into Albemarle Energy Storage and Albemarle Specialties. Additionally, we completed the strategic review of the Catalysts business. After our work, we determined that the best course was to hold the business as a separate entity with a separate brand identity. Going forward, this business will be known as Ketjen. After the founder of the refining catalyst business, a call back to the business' proud history of innovation and sustainability. Now I'll turn the call over to Scott to walk through our financials.
Scott Tozier : Thanks, Kent, and good morning, everyone. I'll start on Slide five. Diluted EPS for the third quarter was $7.61 dollar compared to a loss of $3.36 dollar in the prior year period. As a reminder, last year was negatively impacted by a settlement of a legal matter. Adjusted diluted EPS for the third quarter was $7.50 dollar, 7 times the prior year EPS of just over $1.00 dollar. This overall performance was driven by strong net sales and margin improvement for the total company. Albemarle generated third quarter net sales of $2.1 billion, up 2.5 times year-over-year due to ongoing momentum in the Lithium and Bromine businesses. Adjusted EBITDA margins improved from 26% to 57% this year. Let's turn to Slide six for more details on adjusted EBITDA. Third quarter adjusted EBITDA was up $1.2 billion, nearly 450% increase year-over-year. This strong growth continued to be driven by higher lithium EBITDA that was nearly $1 billion higher than last year. In fact, lithium's Q3 EBITDA was more than double what we generated in all of last year. This record performance for the Lithium segment was driven by higher realized pricing, which was up nearly 300% and higher volumes that were up 20% versus the prior year quarter. Lithium adjusted EBITDA margins of 74% were more than double the previous year. Margins are expected to moderate in the Q4 and into next year for several reasons. First, a spodumene shipment from Talison originally expected in the fourth quarter occurred in Q3, resulting in a $100 million benefit in equity income. This benefit is not expected to reoccur. Second, margins benefited from the timing of spodumene shipments and the rapid rise we have experienced in spodumene and lithium prices. It takes up to six months for a ton of spodumene to navigate our supply chain from the mine to the customer. This has given us above-average margins in 2022, particularly in Q3 because we are selling at higher lithium market prices, but cost of sales is based on lower-priced spodumene held in inventory. Note, we would not expect this benefit to repeat in 2023 unless we see a similar rise in spodumene and lithium prices from current levels. And third, as the MARBL joint venture starts to generate revenue and earnings, we anticipate some margin rate reduction. This is because the MARBL joint venture is being reported under a distributor model. Under this structure, we report -- Albemarle reports 100% of the revenue but only our pro rata share of earnings. We would expect overall, a return to more normal Lithium margin levels in the mid-50% range in Q4. Bromine was also up compared to the prior year, primarily due to higher pricing, up 18% and volumes up 10%. However, we are beginning to see softness in some bromine markets, which I'll talk about in a few minutes. Catalysts EBITDA declined versus the year ago quarter as higher sales volumes and pricing continue to be more than offset by cost pressures, particularly for natural gas in Europe and raw materials. Moving to Slide seven. We are tightening our ranges from the increased 2022 outlook we provided last quarter. This reflects the continued strength in execution in our lithium business and more modest growth in bromine while our Catalysts performance is in line with our expectations. We have narrowed the ranges for the full year 2022 guidance as follows, net sales of $7.1 billion to $7.4 billion, more than doubling versus last year, adjusted EBITDA of $3.3 billion to $3.5 billion, reflecting a year-over-year improvement of nearly 300%, and adjusted diluted EPS of $19.75 dollar to $21.75 dollar, up about 5 times from 2021. We still expect to have positive free cash flow for the full year. And assuming flat market pricing, we expect to continue to generate positive free cash flow in 2023, even with continued growth investments. Security of supply remains the number one priority for our customers and we continue to partner and work closely with them to meet their growth requirements. Let's look at the next slide for more detail on our outlook by segment. Lithium continues its stellar performance. We maintain our expectation for the lithium segment's full year 2022 adjusted EBITDA to be up more than 500% year-over-year as strong market pricing flows through our index referenced variable price contracts. Pricing growth is expected to be 225% to 250% year-over-year resulting from our previously renegotiated contracts and increased market pricing. We also continue to expect year-over-year volume growth in the range of 20% to 30%. The current guidance range for the lithium segment reflects the potential upside for spot price improvements and the potential downside of volume shortfalls for the remainder of the year. For Bromine, we are slightly modifying our full year 2022 EBITDA expectations with year-over-year growth at the lower end of our recent outlook of 25% to 30%, but that's still above the outlook we had earlier in the year. The modification in our expectations reflects emerging softness in some end markets, such as consumer and industrial electronics and building and construction. The slowing in construction is a natural consequence of higher interest rates. Full year volume growth is also projected to be at the lower end of previous guidance for a 5% to 10% volume increase. For Catalysts, we expect full year EBITDA to be down between 45% and 65% year-over-year. We noted earlier that this market is being affected by significant cost pressures primarily related to natural gas in Europe affected by the Ukraine war, certain raw materials as well as freight and is partially offset by higher sales volumes and pricing. We are beginning to realize some price increases associated with natural gas surcharges and inflation adjustments, and those are expected to ramp up in Q4 and going into next year. Turning to Slide nine for an update on our lithium pricing and contracts. This slide reflects the expected split of our 2022 lithium revenues. Battery-grade revenues continue to make up approximately 85% of our Lithium contracts. Our revenue and contract mix are unchanged from last quarter. We remain committed to long-term contracts with our strategic customers, and most of our volumes are sold under two to five year contracts. The market index structure of our contracts allows us to capture the benefits of higher market pricing while also dampening volatility. It also means that neither Albemarle nor our customers are too far out of the market. From the beginning of the year to today, market indices are more than 100% higher on average, moving from about $35 dollar per kilogram to over $70 now. After holding at these levels for the last six months, indices recently ticked up again, thanks to healthy EV-related demand, particularly in China and North America. If price indices remain where they are, we would expect to realize healthy double-digit percentage price increases in 2023. Slide 10 shows the expected lithium sales volumes, including technical-grade spodumene and tolling sales. In 2022, as I said, we are looking at volume improvement of 20% to 30%, largely due to the expansion at La Negra, additional tolling, and some Qinzhou volumes. Volume growth in 2023 is expected to be north of 30% as La Negra, Kemerton and Qinzhou continue to ramp plus additional tolling volumes. Based on current project time lines, we see room for further upside in 2025 from additional conversion assets such as our greenfield plant in Meishan. Turning to Slide 11. Our strong net cash from operations and solid balance sheet support continued organic growth and our ability to pursue acquisitions that complement our growth strategy. Our balance sheet includes $1.4 billion of cash and available liquidity of over $3 billion. Since last quarter, net debt-to-adjusted EBITDA improved to approximately 0.9 times and should end the year between 0.6 times and 0.7 times. These levels give us excellent flexibility. During October, we upsized and extended our revolving credit facility to reflect our larger scale and position us well in case of market turbulence. Over 90% of our debt position is at a fixed rate, which safeguards us against the impacts of a rising interest rate environment. Knowing that the economy is on everyone's mind, let's turn to Slide 12 for more on the macro environment. We expect all three GBUs to grow in 2023 even in the turbulent market environment. But it's going to look different for each of our businesses. For example, in lithium and bromine, our vertical integration and access to low-cost resources helps control our cost structure. While approximately 45% of our costs come from raw materials and services, 20% of those relate to our own spodumene. We continue to expect strong demand for lithium driven by the secular shift to electric vehicles, including OEM investments and public policy support. We are watching to see how rising interest rates impact luxury vehicle sales in the short term, but we expect EVs to continue to grow and gain market share just as we saw in 2020 during the peak of the COVID pandemic. Of the three businesses, Bromine and our Lithium Specialties demand is likely the most leveraged to global economic trends in consumer and industrial spending, automotive and building and construction. At the same time, they benefit from having diverse end markets, meaning they can allocate production to higher growth or higher margin end markets as needed. Bromine and lithium specialties also tend to rebound quickly after a recession. Finally, Catalysts demand is closely linked to transportation fuel demand. In a typical recession, Catalysts is relatively resilient. Think about it this way. Oil prices generally drop in a recession and that drives higher fuel demand, which equals higher catalyst demand for refining. And typically, the Catalysts business would benefit from lower raw material costs in a recessionary environment. Before I turn the call back over to Kent, I wanted to briefly reiterate our capital allocation priorities to support our growth strategy as seen on Slide 13. Investing in high-return growth opportunities remains our top capital allocation priority. We remain committed to strategically growing our lithium and bromine capacity in a disciplined manner. For example, the Qinzhou acquisition we just closed allowed us to accelerate growth and meet our return hurdles. Maintaining financial flexibility and supporting our dividend are also key priorities. As we saw during the COVID pandemic, maintaining an investment-grade credit rating and a strong balance sheet are key to executing our growth strategy and weathering temporary economic downturns. Now I'll turn it back over to Kent.
Kent Masters : Thanks, Scott. Before we look at the growth projects, I wanted to update you on the separation of our Catalysts business and the reshaping of our core portfolio. We are realigning our core lithium and bromine businesses into energy storage and specialties and expect this to be effective in January of 2023. The restructuring is designed to allow for stronger focus and better execution on our multiple growth opportunities. Energy storage will focus on lithium ion battery evolution and the energy transition. And Albemarle specialties combines the existing bromine business with the Lithium Specialties business to focus on diverse growth opportunities in industries such as consumer and industrial electronics, healthcare, automotive and building and construction. Following the strategic review of the Catalysts business, we determined that the best course was to hold the business as a separate entity with a separate brand identity. This structure is intended to allow the Catalysts business to respond to unique customer needs and global market dynamics more effectively while also achieving its growth ambitions. The business will be named Ketjen, referencing the business' original founder, which draws on our entrepreneurial heritage, our Catalysts business. This business will continue to be managed by Raphael Crawford. Additionally, we have established an advisory board for Ketjen, with Netha Johnson acting as Chair. Its primary purpose is to provide thought leadership and strategic advice to Ketjen senior management. These changes reflect Albemarle's focus on growing our business, our people and our values by being agile and providing innovative solutions that anticipate customers' needs and meet the markets of tomorrow. So, looking at Slide 15. As one of the world's largest producers of lithium, we are well positioned to enable the global energy transition. We are focused on building the structure and capabilities to deliver significant conversion capacity around the world. We are investing in China, Australia and North and South America and anticipate production up to 500,000 tons per year on a nameplate conversion capacity by 2030. And we are off to a great start. When you look at where we were just a year ago at 85,000 tons compared to our expectation to end 2022 with 200,000 tons of capacity. Now a few recent highlights around that capacity. In Chile, the La Negra III and IV conversion plant has completed commercial qualification is now generating revenue and running as expected. We are looking at a variety of options to enhance our Chilean operations to accelerate sustainability and potentially expand production. For example, as discussed in our sustainability report, we are progressing options for renewable energy and desalinated water projects. Albemarle and our predecessor companies have operated in Chile for more than 40 years. Our current contract with CORFO runs through 2043. By continuing to advance sustainability, we can continue to be the partner of choice, sharing the benefits of lithium production with the community and earning the right to grow our operations in the future. In Australia, the Kemerton II conversion plant has successfully reached mechanical completion and has entered the commissioning phase of the project. Kemerton I continues in qualification, and we expect to produce qualification samples by year-end. We are also making progress with engineering on our Kemerton III and IV project as we started placing orders for long lead time equipment. In China, besides the acquisition of the Qinzhou lithium conversion plant, construction is progressing to plan at the 50,000 ton per year Meishan lithium hydroxide facility. Our ownership stakes at the Wodgina and Greenbushes lithium mines ensures we have access to low-cost spodumene to feed these conversion facilities. And finally, in the United States, the expansion to double production at Silver Peak is progressing ahead of schedule. At the Kings Mountain mine, studies continue to progress positively. We announced two weeks ago, we have received a $150 million grant from the U.S. Department of Energy to partially fund the construction of a lithium concentrator. We're proud to partner with the federal government on this project. To leverage our Kings Mountain lithium mine, we plan to build a multi-train conversion site in the Southeast U.S. This Megaflex site is designed to handle mineral resources from Kings Mountain and other Albemarle sites as well as recycling feedstock. We continue to expect the mine and the conversion site to be online later this decade, most likely in 2027. With our best-in-class know-how to design, build and commission both resource and conversion assets, Albemarle is well positioned to enable the localization of the battery supply chain in North America. The recently passed U.S. Inflation Reduction Act, or the IRA is designed to encourage domestic EV supply chain investment, among other objectives. The law includes manufacturing and consumer tax credits for sourcing critical minerals like lithium in the United States or in free trade agreement partner countries like Chile and Australia. The solid bar indicates 2022 expected lithium production in the United States and free trade agreement countries, both from Albemarle and other lithium producers. Compared to forecasted U.S. EV demand for lithium by 2030, there's a 400,000-ton gap between today's supply and the supply needed in 2030. The bar on the right indicate how Albemarle's planned expansions in the U.S., Australia and Chile can play a key role in increasing U.S. lithium supply and assisting our customers with increased demand for electric vehicles and localized supply. Now moving to our last slide, let me sum up the key points on our growth strategy. First, a strong outlook. For 2022, we're projecting revenue at double 2021, adjusted EBITDA at nearly 4 times 2021 and cash from operations at 4 times 2021. And we expect continued growth into 2023. Second, financial flexibility to fund profitable growth and maintain our credit rating while still supporting our dividend. Third, a strong operating model that should power us through the current macro-economic turbulence. Fourth, high-return growth projects are underway in both lithium and bromine. In total, Albemarle is well positioned to deliver growth and build long-term shareholder value. This concludes our prepared remarks. Now I'll ask Alex to open the call for questions. And we'll go from there.
Operator: [Operator Instructions] Our first question for today comes from P.J. Juvekar from Citi. P.J. Your line is now open.
PJ Juvekar : Yes. Good morning and Some good information here. Kent and Eric, you just built Kemerton I and II conversion plants in Australia, La Negra III and IV, the Qinzhou plant in China that you just bought. So, you have a good handle on the cost to build a conversion plant. What's your estimate to build a comparable conversion plant in U.S. versus Australia versus China? And do you think the costs are as much as 10 times higher in the U.S. than China to build a convergent plant?
Kent Masters : Good morning. P.J. So, no, not 10 times. I wouldn't -- I mean it's going to be more expensive to build in the U.S. than China. So we -- but we built in Australia now, and we're building in China. So, we've got a good handle on that. So, we think North America will be something like Australia and say for, and that might be twice China, but nothing like 10 times.
PJ Juvekar : Okay. And then we know that there is going to be huge demand for lithium hydroxide in the U.S. You have the IRA now and availability of funding and grants. Why wouldn't you go ahead and announce several sites than just rather than building just one mega site? And the reason I say that is that the time, as you know, takes to permit these facilities and build, why not get ahead of the curve if you want to meet that gap that you show on the chart between now and 2030?
Kent Masters : Yes. So, we're building pretty aggressively, and we need both elements. We need the resource and then we need the conversion assets. So, I mean, between balancing those, we're keeping less in balance and moving pretty much with the market. We may be half a step behind. I don't know that we wanted to 3 or 4 facilities in the U.S., I don't think we could feed those. I'm not sure that would make sense. We would do -- I mean, our plan is we'll do this large facility that we're looking at in the conversion site in the U.S. That's going to be a big facility and probably do another one at that scale, but we have to have the resource defeated.
Scott Tozier : Kent, I'd add too, we're progressing our direct lithium extraction work in Magnolia, Arkansas. And so, as that comes to maturity, you could expect a conversion facility in that area as well?
Kent Masters : Yes, it's a good point. And that's probably will be a little smaller facility just because of the resource from the direct lithium extraction. But that is a slightly different time frame than the conversion facility in the Southeast.
PJ Juvekar : Right. Just quickly, what was the size of the Megaflex facility? Thank you and I’ll pass it on.
Kent Masters : What was the question? What is the site? We have [indiscernible] southeast...
PJ Juvekar : Yes, the size -- no. No, the size. The size, yes.
Kent Masters : Okay. Sorry. So, the size of -- we're planning 100,000 for a conversion facility of 100,000 tons. It will come in phases. But the idea is roughly 25% would be from recycled materials, 75% from virgin material.
PJ Juvekar: Thank you.
Operator: Our next question comes from Matthew Deyoe from Bank of America.
Matthew Deyoe : Good morning every one. So, I wanted to, I guess, tap a little bit more on the equity income side of the equation. If I were to just look at what IGO reported as it relates to the equity income and the internal transfer pricing, can you help us kind of square how that kind of runs through your numbers, how that impacted the 3Q margins and maybe the puts and takes as we bridge to 4Q?
Scott Tozier : Yes. So, if you look at IGO's report, they show Talison's full equity -- full net income for the quarter. One thing to remember is for Albemarle, once we buy spodumene, we have to inventory that profit until we actually sell it to the end customer. And so that adjustment is kind of the reconciling item. And one way to kind of look at it is because of that six-month supply chain that I talked about in the prepared remarks, you actually go back to first quarter of this year, and that amount versus the amount in the third quarter is about what that inventory adjustment is.
Matthew Deyoe : Understood. And can I ask how you're thinking about future investment in China? I know you have Meishan and I remember when the Tianyuan acquisition was initially announced, there was talk about potentially debottlenecking that facility. But -- how do you balance the lower CapEx in market size with kind of what feels like growing geopolitical risk to the region?
Kent Masters : Yes. So that -- it's a good question. And what we are -- I mean you get lower capital, we referenced that kind of like half the capital to do that in China. The Qinzhou acquisition was good for us. So, we'll look at -- once we operate that for a while and get a good understanding, we'll look at expanding it. Probably, most likely, we'll expand that. And then we've got the Meishan project that we're doing there. And then we had a project that we were looking at Zhangjiagang, and that's another one that we think about, but we're -- as demand grows. So China is still the largest lithium market in the world, and their growth is quite significant. We've got demand growing in North America and Europe now. So, we're trying just to balance that, manage the opportunity and minimize the risk. So, I think that that's something that we look at all the time. Our plans -- our firm plans at the moment are -- we've done the Qinzhou acquisition, and we're building the Meishan project. And we're planning to do an expansion of the Qinzhou facility but we won't actually have to pull the trigger on that because we want to get a little bit of operating experience with that plant. And then change the design somewhat when we do the expansion. So, we look at it all the time and something that we just adjust to as to what's current.
Operator: Our next question comes from Aleksey Yefremov from KeyBanc Capital Markets. Aleksey your line is now open.
Aleksey Yefremov: Thank you and good morning every one. The lithium volume guidance for this year is 20% to 30% and you posted 20% year-over-year in third quarter, 18% in the second. So, is it fair to say if you're trending towards the lower end of this guidance for the full year at this point?
Scott Tozier : No, we should be probably in the middle of that guidance range. So, as we're ramping up volume at La Negra, you should see improvement to that growth rate in the fourth quarter. I don't know, Eric, if you have any more.
Eric Norris : Aleksey, I'd just add that, that has always been the case, is that because of the nature of the ramp of our plants, both La Negra, Kemerton, Qinzhou coming into the full, we've always been back half loaded. The challenge we had in the third quarter was on the production side, mostly in tolling in China due to brownouts -- rolling brownouts in the region and how that impacted operating rates of our tollers ability to toll convert. As we go into the cooler time of the year where we don't expect and have not seen those, obviously, now with the weather being warmer, we expect higher production rates on the tolling side plus the continued ramp up these plants as Scott referenced, that our owned plants. So, we'd expect to get into the middle of that guidance with a strong volume performance in the fourth quarter.
Aleksey Yefremov: Very helpful. Thanks. And just pretty fresh news. The Canadian government is forcing some divestments of lithium assets there. Are you potentially interested? And if not, do you have any thoughts on this development? Does it matter for lithium industry in general?
Kent Masters : Yes. I mean I don't know if we have specific thoughts on it, but we are always looking at lithium assets. We were kind of comb the planet for lithium assets. So, if they're interesting, we would be looking at them, but nothing to say on those particular assets today.
Operator: Our next question comes from Arun Viswanathan from RBC Capital Markets. Arun your line is now open.
Arun Viswanathan: Grate, thanks for taking my question. Congrats on the good results here. Just wanted to, I guess, maybe ask you guys to elaborate on some of the market movements you're seeing. You noted there's been some recent strong demand in EVs is moving prices higher. What's kind of the outlook as you look into the next couple of months? And could you also comment on potential elasticity impacts on EV demand, if there are any? What have you observed as far as demand trends kind of accelerating or decelerating on price increases?
Eric Norris : This is Eric. As you may know, EV sales through, I believe it's the end of September around the world are up 75%. And that's after a pretty soft part of the year -- early part of the year for China, in particular, because of the lockouts and because of supply chain challenges. The tone within the industry now on the automotive side is one of more concern about supply chain than it is about demand. And so, as the supply chain pressures ease, automotive vehicle stocks are very low. We expect to see continued strong growth through the balance of the year and well into next year as well. So, we remain bullish about those trends. Of course, the second part of your question, we continue to watch the economic impacts on purchasing behaviors. We note that in the COVID time and in other weak periods of economic weakness, EVs have been, by and large, more of a luxury item and have not seen reductions in volumes coupled with just the strong secular trend and government policies now that are reinforcing that. But we'll watch the effect of interest rates on that. A big part of the mid-to-low end of the market is actually in China. And with China is coming out of its COVID lockdowns and recovering, we're seeing strength in that sector. So, we'll continue to watch what the economy -- economic effects and higher interest rates around the world might have on demand, but we don't see any impact nor is history tell us we should expect one.
Arun Viswanathan: Okay. Great. And then just on the upstream resource side, we've been hearing reports that in some of the recently announced projects on the spodumene side may be difficult to move ahead just because of the increase in price and the capital that's required to develop those projects. Is that something that you're observing as well? And if so, what impact should that have, I guess, on spodumene and downstream hydroxide markets, if any?
Eric Norris : To clarify, you said increase in price was affecting projects. So, you're referring to the capital cost to build the facilities for such plant?
Arun Viswanathan: Yes, both. There is -- we've been hearing there's been some increase in spodumene costs, both the capital costs as well as the acquisition costs are prompting some recently announced projects to get delayed. I don't know if that's -- at least that's what we've been reading.
Eric Norris : Yes. I mean, I think certainly, the effects of inflation are having an impact on -- we see those in our own capital cost. They can have an impact on our inflation. And it's highlighted for us the importance of our scale and our global procurement strategy to drive down costs. For smaller companies, less experienced in executing capital. It could definitely have an impact. I don't know -- those are longer-term impacts than shorter term. So, we haven't seen that manifest itself yet in a change in market tone. And as we said earlier, the demand is so strong and the balance of supply and demand is such that at the moment, this would only aggravate the supply-demand issue and sustain strong prices at a market basis for lithium. So, we'll continue to watch it, but I think that's -- there might be some truth to what you're referring to that could have a long run impact.
Scott Tozier : Ultimately, it's another example of how lithium projects take time and effort and challenges to get through it. That's not an easy thing to go through.
Operator: Our next question comes from John Roberts of Credit Suisse. John your line is now open.
John Roberts: Thank you. Will the Megaflex plant be hydroxide or carbonate or both? And will the production trainer align campaign specific types of feedstock or -- and then switch back and forth? Or will it run a continuous blend of mixed feedstocks?
Kent Masters : Yes, you're way ahead of it, John. I think it is -- will be -- it will run. It will be a blend, right? We'll blend things that come through, but it's going to be designed around Kings Mountain. And then other resources that will feed that and then the recycling. So, it's going to be quite flexible and why we're calling it the Megaflex. So, there's -- there'll be flexibility around it. But I don't -- and it's not specific. We're not designing for a particular or typically. We try and -- we design in flexibility so we can operate on multiple resources.
Eric Norris : So that's where -- John, just to add. That's for some of the know-how and the process technology advantages that we have comes into play as we design that. But to go back to the first part of your question, the initial trains were targeting hydroxide at the moment. That's how it's -- we're looking at a 50,000-ton plant, and we're looking at what we've built in China, what we built in Australia. We're taking the learnings in the best and developing that into a plan for execution here. We'll watch the carbonate market development very carefully. With the recently passed IRA, it's very possible that more LFP capacity could come into the U.S. That being -- excuse me, cathode capacity. If that's the case, there could be a justification of future trains should be carbonate. We'll have to watch that carefully.
John Roberts: Okay. And then on the newly combined bromine and lithium specialty segment, it's going to be back integrated to resource and bromine. But I assume you're going to purchase lithium from the energy storage segment? How will that transfer pricing be handled?
Scott Tozier : Yes, John, we're still working through that. Likely, it will come through at cost, but we haven't sorted through all the details yet. So, we'll let us share that in our January meeting.
Operator: Our next question comes from Vincent Andrews of Morgan Stanley. Vincent your line is now open.
Vincent Andrews: Thank you, good morning every one. Are you still looking to potentially change your relationship with Mineral Resources or the JV terms? And could you also provide an update on the Wodgina restart? And do you think that as debottlenecking opportunities or potential to operate sort of above prior nameplate?
Kent Masters : Okay. So, first question about the JV. So, we continue to talk and look at opportunities to kind of optimize that between the two of us. So those are ongoing discussions. And if we get to something that's different, we'll finalize that. We'll tell the market as soon as that information is available. Wodgina is operating. It's up and operating and the -- there are debottlenecking opportunities and additional trains that are potential, but it is up and operating today on two trains, I believe. And then we have -- and we're talking about starting -- we're talking about a third train, but it's -- there are two trains today, and they are operating.
Vincent Andrews: What would be -- what's prohibiting you from going forward with the third train?
Kent Masters : Well, we need to -- we have designs of it, and we need to be able to have conversion capacity for that.
Operator: Our next question comes from Kevin McCarthy of Vertical Research Partners. Kevin your line is now open.
Kevin McCarthy: Yes, good morning. Now that you've had a few months to digest it, would you comment on what the economic impact of the IRA would be on Albemarle in terms of direct and indirect influences. And do you think it will influence how you allocate capital beyond the Megaflex project?
Kent Masters : So, has it been a couple of months? That's -- but it will -- I don't know that it directly impacts our economics, but it's changed the market a bit. I mean there's more requirement for local supply in the U.S. and then supply from countries with free trade agreements with the U.S. And actually, it works out, we're well positioned for that, and we had planned to have -- we were planning the Kings Mountain facility and conversion in the U.S., but that is accelerating that, I would say, trying to go as fast as we can. We did have plans already on the books before that happened, and this just kind of makes it more critical. So, I know -- now that you translate it specifically into our P&L, but it does drive demand toward North America and to localize supply to as much as possible, and I think it will accelerate EV demand in North America.
Scott Tozier : Yes. Beyond the effects, Kevin, of the incentives -- on the consumer incentives that are being put in place, there's a manufacturing tax credit that we will be able to benefit from. We're not exactly sure how it's going to work yet because the regulations haven't been put out. But it's a 10% of manufacturing cost for battery materials. So, for us, that's probably in the $10 million range on a full facility. And then the other aspect is the minimum income tax or what some people are calling the new AMT. Again, that wouldn't affect us immediately, but a minimum tax of 15% potentially could affect us in the future.
Eric Norris : And finally, Kevin, that's immediate topic you asked, I'll just add that it has an impact on purchasing behaviors. We're seeing a real not surprising interest for those who have U.S. based production to preferentially put a premium in their view on sourcing from free trade countries or from the U.S. itself. So, we'll be carefully sort of segmenting our customer base and looking at how we create the right value for ourselves and for our customers in terms of how we go to market and bring that and price that product in the marketplace.
Kevin McCarthy: So, that's really helpful. I appreciate the color and then as a follow-up, Scott, I think you mentioned in your prepared remarks that lithium prices on a realized basis could rise at a double-digit pace in 2023. Can you elaborate on that? What are you assuming in terms of market pricing vis-a-vis the uptick that you referenced in October? Maybe you could just kind of talk about where we're tracking in terms of low double digits or substantially higher than that and what you're baking in?
Scott Tozier : Yes. So, when I said that it's really based off of market indices that are where they are today, so there's really two big effects happening as we go into next year. One is just the annualization of what we experienced in 2022. And then the second is we continue -- Eric and his team continue to work on those fixed price contracts and convert those to the index reference variable contracts. So that's going to have a benefit for us as well. And while we haven't provided specific guidance, the kind of ranges we are talking about are kind of healthy double-digit price increases next year. So again, contributing to what we're expecting to be another strong year of growth from Lithium. And we're seeing it from all three of our businesses, to be honest, even in the face of potential slowdowns.
Operator: Our next question comes from Josh Spector from UBS. Josh your line is now open.
Josh Spector: Thanks, take my question. So just on the lithium contracts and some comments you made earlier. So your index references contracts used to be labeled a three to six-month lag. Now they're about three months. You talked about moving more fixed price over to those types of contracts. I guess the duration continues to get a bit shorter. I'm just wondering, should we expect that duration to approach less than three months, say, one month at some point in the future? Or is three months’ kind of the right range that you're finding customers want to two and four?
Eric Norris : Josh, I mean, I would think of it this way, first of all, to answer your question, three months is what we expect going forward as the lag. And that's a product of moving from a fixed contract with reopeners that are -- that had been up to six months to a full index where it's looking back three months on a rolling basis. So that is -- that's the standard of the term we're taking into the marketplace, and it's allowing us to benefit from rising prices while dampening the impact to the customer. So that's how we -- that's the strategy and how we plan to drive the portfolio going forward. And as Scott pointed out, we do expect some of the fix in that category of 20% that's on our contract slide to come down as we go into next year as well.
Josh Spector: Okay, thanks. And just on the DOE grant that you guys received. Is there a potential for you guys to receive more than one of those? I don't know if there's a limit per company or something else we could consider about additional support if you were to build additional facilities in the U.S.?
Kent Masters : Yes. So that was a particular program. So, we wouldn't expect to get anything additional out of that. There was a process we went through and applications. We got that particular grant. So, if there are other programs, we could do that. But under this existing program, that was it.
Operator: Our next question comes from David Begleiter from Deutsche Bank. David your line is now open.
David Begleiter : Thank you, good morning. Eric, just on Kemerton I and Kemerton II, what are you expecting for production output next year from these two units?
Eric Norris : Look, I think -- well, certainly, when we get into our January investor outlook for '23 and beyond, get into more details. But in the meantime, I apply the same rule of thumb we've applied all along, which is it takes up to two years to fully ramp to nameplate capacity. And you would expect that ramp to start with upon commissioning a six-month lag for qualification of the customer base. And in the first 12 months, getting to about half or slightly thereabouts of the capacity of any one of those plants. So -- we are -- just to put that into practical terms, we are now expect to sample for qualification Kemerton I this quarter, and we'd hope to early or during the first half of next year begin sampling for the second train and then you can apply those rules of thumbs I just outlined.
David Begleiter : Very helpful. And just on the recent spike in Chinese spot prices, how sustainable do you think this is over the next few months? And thoughts on the spot prices for next year?
Eric Norris : I don't -- it's very hard. I can only tell you, I think that the uptick of late has been a recovery in the market in China, in particular, from a demand perspective. And that has caused prices to -- they modulate -- moderated rather a bit in the middle part of the year and to come back up again. Where they go from here, David, hard to say. What we do know is as we look into next year, we still see a tight undersupplied market. So, the dynamics are going to be favorable for strong prices. What that means for a point estimate of Chinese spot prices is a tough one to come up with.
Operator: Our next question comes from David Deckelbaum from Cowen. David your line is now open.
David Deckelbaum: Good morning. Thanks, take my question. I wanted to just talk about IRA compliance. You highlighted, obviously, the fact that you have active production and conversion and free trade agreement countries. I just wanted to confirm whether it's your view that would you be selling qualifying materials from Kemerton or La Negra into the United States? Or would Kemerton be feeding U.S. customers? Or is that predominantly going to be feeding the Chinese market?
Eric Norris : So, actually answer is different by plant. If you start first with hydroxide and Kemerton, the intent for Kemerton, ever since it was built, long before IRA, long before recent geopolitical concerns was to supply a broad global market and to leverage the China assets we have for a China market. And as geopolitical circumstances have changed and things like the IRA have come along, as Kent said earlier, we're really moving towards a country-per-country or region-per-region-based strategy. So, China for China, Australia would feed Asia and Europe and North America in that regard. And that we believe that to be the efficient route to go. If you look at carbonate, carbonate is a little different. The majority of the carbonate market today is China. And we don't have carbonate assets currently within China. So, a large purchase, chunk of what we make, a large percentage of what we manufacture at Chile goes into China, as the RA develops -- as demand develops in the U.S. and Europe, and I have to say, develops because it's still very, very small. That could change that dynamic, driving the need for us to try to get more out of Chile or other carbonate sources as we go forward.
David Deckelbaum: I appreciate the color there. Perhaps my follow-up, there's a lot to ask here. But with the January update on your '23 outlook in the context of some of the U.S. expansion, the Megaflex site, Kings Mountain, you highlighted, I think before, Kent, that you'd aim to have these perhaps online in '27. Is that specific to just the Megaflex site? Or would that include Kings Mountain as well? And do you expect to have a capital program for those assets envisioned in 2023, perhaps even in January with this announcement and start beginning the permitting process next year?
Kent Masters : Yes. So, I mean we'll have capital. We'll definitely have capital in the '23 plan around those facilities. And the date, the '27 date is mine and conversion optimistically. It all depends on the permitting process and the schedule, but that's the thinking.
Operator: Our next question comes from Joel Jackson from BMO Capital Markets. Joel your line is now open.
Joel Jackson: Good morning. You obviously have some visibility now in the types of prices you're getting January, February into Q1 obviously. Can you give us a sense of it -- are February pricing coming in better than January, January price is coming better in December on a realized basis on average?
Scott Tozier : Well, I mean, Joel, I'd say where the indices are today, that you'd have to say that they're better than what they were a quarter ago. However, recognize that there's room for movement either up or down from that depending on how those indices move.
Joel Jackson: Okay. You made a comment earlier in the call, I think that if spot pricing stayed the same, that 2023 pricing would be up double digits. I think you said that. What would spot prices -- it's a very high-level question. Maybe you can just give us some color. What would spot price have to do across 2023 for your realized price in '23 to be about equal to '22? It seemed like a linear decline, just a hypothetical scenario. What would that imply in that scenario to get -- where would you need to get to flat pricing in '23 versus '22?
Scott Tozier : I got to think through the math there because there are a lot of different contracts with different caps on them that we've got an account. I don't know, Eric, have you got a gut feel for it or I have to get back to Joel.
Eric Norris : We may get back to you, Joel. But the factors are that, obviously, we've been moving all year long, this year, in 2022 in price. And that's been part of our growth. That's been part of our strategy. That's been part of what's driven some of the upsides to expectations along the way. We'll do a small amount of that to move to -- from fixed to variable next year, but the bulk of that is complete. But what happened during the year, if you just annual -- if you just take where we are now and annualize it in the next year, you've got a big increase. That, I think, is Scott's point. So, you'd have to see decreases that are pretty significant to draw that average down versus 2022. We'd have to do some modeling to see if we can give you better guidance than that.
Operator: Our next question comes from Christopher Parkinson from Mizuho. Christopher your line is now open.
Christopher Parkinson: Great, thank you so very much. Got two fairly simple one’s for you today. The first, just any quick update on your preliminary thoughts on a China EV subsidy in '23 and onwards?
Scott Tozier : I'm sorry I missed...
Eric Norris : Oh, right. Yes. Well, I don't know that our crystal ball is any better than anybody else's. I mean China has been easing its subsidies of late, and that has not dampened demand. Demand is up over -- sales are up over 100% year-on-year and then now accelerating in the back half of the year. I don't know that they need to accelerate but then they certainly have a lot of capacity in country that could serve that from a battery and cathode standpoint. Hard to say what industrial policy will be, sorry.
Christopher Parkinson: Your crystal ball is better than mine, for what it's worth. And then second question, just in the recent acquisitions in China, is that product already spec-ed in? Or what's the plan to have that spec-ed in with customers? Thank you.
Kent Masters : You mean qualified, you mean? Yes. So, we've been actually tolling through the facility. So, the acquisition took us a little longer to get some of the approvals than we anticipated. So, we sold our spodumene through it. So, we've qualified that product already.
Operator: Thank you. That's all the time we have for Q&A. So, I'll hand back to Kent Masters for any further remarks.
Kent Masters : Okay. Thank you, Alex, and thank you all again for your participation on our call today. Albemarle is a global market leader with a strong track record of financial and operational performance. We have a clear strategy to accelerate profitable growth, and we play an essential role in meeting the world's sustainability challenges. We are proud of what we have accomplished, and I am personally thankful for our outstanding employees as we reshape our business for even greater success going forward. Thank you.
Operator: Thank you for joining today's call. You may now disconnect. | [
{
"speaker": "Operator",
"text": "Hello, and welcome to the Q3 2022 Albemarle Corporation Earnings Conference Call. My name is Alex, and I'll be coordinating the call today. [Operator Instructions] I'll now hand over to your host, Meredith Bandy, Vice President of Investor Relations and Sustainability. Please go ahead."
},
{
"speaker": "Meredith Bandy",
"text": "All right. Thank you, Alex, and welcome, everyone, to Albemarle's Third Quarter 2022 Earnings Conference Call. Our earnings were released after the close of market yesterday, and you'll find the press release and presentation posted to our website under the Investor Relations section at albemarle.com. Joining me on the call today are Kent Masters, Chief Executive Officer and Scott Tozier, Chief Financial Officer, Raphael Crawford, President of Catalyst, Netha Johnson, President of Bromine and Eric Norris, President of Lithium, are also available for Q&A. As a reminder, some of the statements made during this call, including our outlook, guidance, expected company performance and timing of expansion projects may constitute forward-looking statements within the meaning of federal securities laws. Please note the cautionary language about forward-looking statements contained in our press release and presentation, that same language applies to this call. Please also note that some of our comments today refer to non-GAAP financial measures. A reconciliation to GAAP financial measures can be found in our earnings release and the appendix of our earnings presentation. Lastly, I would like to highlight that in January, we plan to host a webcast to provide our full year 2023 guidance and new five-year targets for our restructured businesses. With that, I will turn the call over to Kent."
},
{
"speaker": "Kent Masters",
"text": "Thanks. Meredith, and thank you all for joining us today. On today's call, I'll highlight our third quarter results and achievements. Scott will provide more detail on our financial results, outlook, balance sheet and capital allocation. I'll then close our prepared remarks with an update on our structure and our strategic growth projects. We had another excellent quarter as Albemarle continues to benefit from the demand for lithium-ion batteries driven by the energy transition. This, plus growth in bromine, drove a strong third quarter. We generated net sales of $2.1 billion or more than 2.5 times the prior year period. Third quarter adjusted EBITDA of $1.2 billion or approximately 5 times the prior year period, continued the trend of increase -- of EBITDA increasing significantly outpacing sales growth. We are tightening our previously raised 2022 outlook and reaffirming our expectation to be free cash flow positive for the year. Scott will review the key elements of our outlook in his remarks. In October, we completed the acquisition of the Qinzhou lithium conversion facility in China. This, along with the mechanical completion of the Kemerton II lithium conversion project in Australia has us on track to more than double our lithium conversion capacity this year. In response to the growth opportunities ahead of us, we announced during the quarter a new segment structure that is expected to take effect in January of 2023. We are realigning our core lithium and bromine businesses into Albemarle Energy Storage and Albemarle Specialties. Additionally, we completed the strategic review of the Catalysts business. After our work, we determined that the best course was to hold the business as a separate entity with a separate brand identity. Going forward, this business will be known as Ketjen. After the founder of the refining catalyst business, a call back to the business' proud history of innovation and sustainability. Now I'll turn the call over to Scott to walk through our financials."
},
{
"speaker": "Scott Tozier",
"text": "Thanks, Kent, and good morning, everyone. I'll start on Slide five. Diluted EPS for the third quarter was $7.61 dollar compared to a loss of $3.36 dollar in the prior year period. As a reminder, last year was negatively impacted by a settlement of a legal matter. Adjusted diluted EPS for the third quarter was $7.50 dollar, 7 times the prior year EPS of just over $1.00 dollar. This overall performance was driven by strong net sales and margin improvement for the total company. Albemarle generated third quarter net sales of $2.1 billion, up 2.5 times year-over-year due to ongoing momentum in the Lithium and Bromine businesses. Adjusted EBITDA margins improved from 26% to 57% this year. Let's turn to Slide six for more details on adjusted EBITDA. Third quarter adjusted EBITDA was up $1.2 billion, nearly 450% increase year-over-year. This strong growth continued to be driven by higher lithium EBITDA that was nearly $1 billion higher than last year. In fact, lithium's Q3 EBITDA was more than double what we generated in all of last year. This record performance for the Lithium segment was driven by higher realized pricing, which was up nearly 300% and higher volumes that were up 20% versus the prior year quarter. Lithium adjusted EBITDA margins of 74% were more than double the previous year. Margins are expected to moderate in the Q4 and into next year for several reasons. First, a spodumene shipment from Talison originally expected in the fourth quarter occurred in Q3, resulting in a $100 million benefit in equity income. This benefit is not expected to reoccur. Second, margins benefited from the timing of spodumene shipments and the rapid rise we have experienced in spodumene and lithium prices. It takes up to six months for a ton of spodumene to navigate our supply chain from the mine to the customer. This has given us above-average margins in 2022, particularly in Q3 because we are selling at higher lithium market prices, but cost of sales is based on lower-priced spodumene held in inventory. Note, we would not expect this benefit to repeat in 2023 unless we see a similar rise in spodumene and lithium prices from current levels. And third, as the MARBL joint venture starts to generate revenue and earnings, we anticipate some margin rate reduction. This is because the MARBL joint venture is being reported under a distributor model. Under this structure, we report -- Albemarle reports 100% of the revenue but only our pro rata share of earnings. We would expect overall, a return to more normal Lithium margin levels in the mid-50% range in Q4. Bromine was also up compared to the prior year, primarily due to higher pricing, up 18% and volumes up 10%. However, we are beginning to see softness in some bromine markets, which I'll talk about in a few minutes. Catalysts EBITDA declined versus the year ago quarter as higher sales volumes and pricing continue to be more than offset by cost pressures, particularly for natural gas in Europe and raw materials. Moving to Slide seven. We are tightening our ranges from the increased 2022 outlook we provided last quarter. This reflects the continued strength in execution in our lithium business and more modest growth in bromine while our Catalysts performance is in line with our expectations. We have narrowed the ranges for the full year 2022 guidance as follows, net sales of $7.1 billion to $7.4 billion, more than doubling versus last year, adjusted EBITDA of $3.3 billion to $3.5 billion, reflecting a year-over-year improvement of nearly 300%, and adjusted diluted EPS of $19.75 dollar to $21.75 dollar, up about 5 times from 2021. We still expect to have positive free cash flow for the full year. And assuming flat market pricing, we expect to continue to generate positive free cash flow in 2023, even with continued growth investments. Security of supply remains the number one priority for our customers and we continue to partner and work closely with them to meet their growth requirements. Let's look at the next slide for more detail on our outlook by segment. Lithium continues its stellar performance. We maintain our expectation for the lithium segment's full year 2022 adjusted EBITDA to be up more than 500% year-over-year as strong market pricing flows through our index referenced variable price contracts. Pricing growth is expected to be 225% to 250% year-over-year resulting from our previously renegotiated contracts and increased market pricing. We also continue to expect year-over-year volume growth in the range of 20% to 30%. The current guidance range for the lithium segment reflects the potential upside for spot price improvements and the potential downside of volume shortfalls for the remainder of the year. For Bromine, we are slightly modifying our full year 2022 EBITDA expectations with year-over-year growth at the lower end of our recent outlook of 25% to 30%, but that's still above the outlook we had earlier in the year. The modification in our expectations reflects emerging softness in some end markets, such as consumer and industrial electronics and building and construction. The slowing in construction is a natural consequence of higher interest rates. Full year volume growth is also projected to be at the lower end of previous guidance for a 5% to 10% volume increase. For Catalysts, we expect full year EBITDA to be down between 45% and 65% year-over-year. We noted earlier that this market is being affected by significant cost pressures primarily related to natural gas in Europe affected by the Ukraine war, certain raw materials as well as freight and is partially offset by higher sales volumes and pricing. We are beginning to realize some price increases associated with natural gas surcharges and inflation adjustments, and those are expected to ramp up in Q4 and going into next year. Turning to Slide nine for an update on our lithium pricing and contracts. This slide reflects the expected split of our 2022 lithium revenues. Battery-grade revenues continue to make up approximately 85% of our Lithium contracts. Our revenue and contract mix are unchanged from last quarter. We remain committed to long-term contracts with our strategic customers, and most of our volumes are sold under two to five year contracts. The market index structure of our contracts allows us to capture the benefits of higher market pricing while also dampening volatility. It also means that neither Albemarle nor our customers are too far out of the market. From the beginning of the year to today, market indices are more than 100% higher on average, moving from about $35 dollar per kilogram to over $70 now. After holding at these levels for the last six months, indices recently ticked up again, thanks to healthy EV-related demand, particularly in China and North America. If price indices remain where they are, we would expect to realize healthy double-digit percentage price increases in 2023. Slide 10 shows the expected lithium sales volumes, including technical-grade spodumene and tolling sales. In 2022, as I said, we are looking at volume improvement of 20% to 30%, largely due to the expansion at La Negra, additional tolling, and some Qinzhou volumes. Volume growth in 2023 is expected to be north of 30% as La Negra, Kemerton and Qinzhou continue to ramp plus additional tolling volumes. Based on current project time lines, we see room for further upside in 2025 from additional conversion assets such as our greenfield plant in Meishan. Turning to Slide 11. Our strong net cash from operations and solid balance sheet support continued organic growth and our ability to pursue acquisitions that complement our growth strategy. Our balance sheet includes $1.4 billion of cash and available liquidity of over $3 billion. Since last quarter, net debt-to-adjusted EBITDA improved to approximately 0.9 times and should end the year between 0.6 times and 0.7 times. These levels give us excellent flexibility. During October, we upsized and extended our revolving credit facility to reflect our larger scale and position us well in case of market turbulence. Over 90% of our debt position is at a fixed rate, which safeguards us against the impacts of a rising interest rate environment. Knowing that the economy is on everyone's mind, let's turn to Slide 12 for more on the macro environment. We expect all three GBUs to grow in 2023 even in the turbulent market environment. But it's going to look different for each of our businesses. For example, in lithium and bromine, our vertical integration and access to low-cost resources helps control our cost structure. While approximately 45% of our costs come from raw materials and services, 20% of those relate to our own spodumene. We continue to expect strong demand for lithium driven by the secular shift to electric vehicles, including OEM investments and public policy support. We are watching to see how rising interest rates impact luxury vehicle sales in the short term, but we expect EVs to continue to grow and gain market share just as we saw in 2020 during the peak of the COVID pandemic. Of the three businesses, Bromine and our Lithium Specialties demand is likely the most leveraged to global economic trends in consumer and industrial spending, automotive and building and construction. At the same time, they benefit from having diverse end markets, meaning they can allocate production to higher growth or higher margin end markets as needed. Bromine and lithium specialties also tend to rebound quickly after a recession. Finally, Catalysts demand is closely linked to transportation fuel demand. In a typical recession, Catalysts is relatively resilient. Think about it this way. Oil prices generally drop in a recession and that drives higher fuel demand, which equals higher catalyst demand for refining. And typically, the Catalysts business would benefit from lower raw material costs in a recessionary environment. Before I turn the call back over to Kent, I wanted to briefly reiterate our capital allocation priorities to support our growth strategy as seen on Slide 13. Investing in high-return growth opportunities remains our top capital allocation priority. We remain committed to strategically growing our lithium and bromine capacity in a disciplined manner. For example, the Qinzhou acquisition we just closed allowed us to accelerate growth and meet our return hurdles. Maintaining financial flexibility and supporting our dividend are also key priorities. As we saw during the COVID pandemic, maintaining an investment-grade credit rating and a strong balance sheet are key to executing our growth strategy and weathering temporary economic downturns. Now I'll turn it back over to Kent."
},
{
"speaker": "Kent Masters",
"text": "Thanks, Scott. Before we look at the growth projects, I wanted to update you on the separation of our Catalysts business and the reshaping of our core portfolio. We are realigning our core lithium and bromine businesses into energy storage and specialties and expect this to be effective in January of 2023. The restructuring is designed to allow for stronger focus and better execution on our multiple growth opportunities. Energy storage will focus on lithium ion battery evolution and the energy transition. And Albemarle specialties combines the existing bromine business with the Lithium Specialties business to focus on diverse growth opportunities in industries such as consumer and industrial electronics, healthcare, automotive and building and construction. Following the strategic review of the Catalysts business, we determined that the best course was to hold the business as a separate entity with a separate brand identity. This structure is intended to allow the Catalysts business to respond to unique customer needs and global market dynamics more effectively while also achieving its growth ambitions. The business will be named Ketjen, referencing the business' original founder, which draws on our entrepreneurial heritage, our Catalysts business. This business will continue to be managed by Raphael Crawford. Additionally, we have established an advisory board for Ketjen, with Netha Johnson acting as Chair. Its primary purpose is to provide thought leadership and strategic advice to Ketjen senior management. These changes reflect Albemarle's focus on growing our business, our people and our values by being agile and providing innovative solutions that anticipate customers' needs and meet the markets of tomorrow. So, looking at Slide 15. As one of the world's largest producers of lithium, we are well positioned to enable the global energy transition. We are focused on building the structure and capabilities to deliver significant conversion capacity around the world. We are investing in China, Australia and North and South America and anticipate production up to 500,000 tons per year on a nameplate conversion capacity by 2030. And we are off to a great start. When you look at where we were just a year ago at 85,000 tons compared to our expectation to end 2022 with 200,000 tons of capacity. Now a few recent highlights around that capacity. In Chile, the La Negra III and IV conversion plant has completed commercial qualification is now generating revenue and running as expected. We are looking at a variety of options to enhance our Chilean operations to accelerate sustainability and potentially expand production. For example, as discussed in our sustainability report, we are progressing options for renewable energy and desalinated water projects. Albemarle and our predecessor companies have operated in Chile for more than 40 years. Our current contract with CORFO runs through 2043. By continuing to advance sustainability, we can continue to be the partner of choice, sharing the benefits of lithium production with the community and earning the right to grow our operations in the future. In Australia, the Kemerton II conversion plant has successfully reached mechanical completion and has entered the commissioning phase of the project. Kemerton I continues in qualification, and we expect to produce qualification samples by year-end. We are also making progress with engineering on our Kemerton III and IV project as we started placing orders for long lead time equipment. In China, besides the acquisition of the Qinzhou lithium conversion plant, construction is progressing to plan at the 50,000 ton per year Meishan lithium hydroxide facility. Our ownership stakes at the Wodgina and Greenbushes lithium mines ensures we have access to low-cost spodumene to feed these conversion facilities. And finally, in the United States, the expansion to double production at Silver Peak is progressing ahead of schedule. At the Kings Mountain mine, studies continue to progress positively. We announced two weeks ago, we have received a $150 million grant from the U.S. Department of Energy to partially fund the construction of a lithium concentrator. We're proud to partner with the federal government on this project. To leverage our Kings Mountain lithium mine, we plan to build a multi-train conversion site in the Southeast U.S. This Megaflex site is designed to handle mineral resources from Kings Mountain and other Albemarle sites as well as recycling feedstock. We continue to expect the mine and the conversion site to be online later this decade, most likely in 2027. With our best-in-class know-how to design, build and commission both resource and conversion assets, Albemarle is well positioned to enable the localization of the battery supply chain in North America. The recently passed U.S. Inflation Reduction Act, or the IRA is designed to encourage domestic EV supply chain investment, among other objectives. The law includes manufacturing and consumer tax credits for sourcing critical minerals like lithium in the United States or in free trade agreement partner countries like Chile and Australia. The solid bar indicates 2022 expected lithium production in the United States and free trade agreement countries, both from Albemarle and other lithium producers. Compared to forecasted U.S. EV demand for lithium by 2030, there's a 400,000-ton gap between today's supply and the supply needed in 2030. The bar on the right indicate how Albemarle's planned expansions in the U.S., Australia and Chile can play a key role in increasing U.S. lithium supply and assisting our customers with increased demand for electric vehicles and localized supply. Now moving to our last slide, let me sum up the key points on our growth strategy. First, a strong outlook. For 2022, we're projecting revenue at double 2021, adjusted EBITDA at nearly 4 times 2021 and cash from operations at 4 times 2021. And we expect continued growth into 2023. Second, financial flexibility to fund profitable growth and maintain our credit rating while still supporting our dividend. Third, a strong operating model that should power us through the current macro-economic turbulence. Fourth, high-return growth projects are underway in both lithium and bromine. In total, Albemarle is well positioned to deliver growth and build long-term shareholder value. This concludes our prepared remarks. Now I'll ask Alex to open the call for questions. And we'll go from there."
},
{
"speaker": "Operator",
"text": "[Operator Instructions] Our first question for today comes from P.J. Juvekar from Citi. P.J. Your line is now open."
},
{
"speaker": "PJ Juvekar",
"text": "Yes. Good morning and Some good information here. Kent and Eric, you just built Kemerton I and II conversion plants in Australia, La Negra III and IV, the Qinzhou plant in China that you just bought. So, you have a good handle on the cost to build a conversion plant. What's your estimate to build a comparable conversion plant in U.S. versus Australia versus China? And do you think the costs are as much as 10 times higher in the U.S. than China to build a convergent plant?"
},
{
"speaker": "Kent Masters",
"text": "Good morning. P.J. So, no, not 10 times. I wouldn't -- I mean it's going to be more expensive to build in the U.S. than China. So we -- but we built in Australia now, and we're building in China. So, we've got a good handle on that. So, we think North America will be something like Australia and say for, and that might be twice China, but nothing like 10 times."
},
{
"speaker": "PJ Juvekar",
"text": "Okay. And then we know that there is going to be huge demand for lithium hydroxide in the U.S. You have the IRA now and availability of funding and grants. Why wouldn't you go ahead and announce several sites than just rather than building just one mega site? And the reason I say that is that the time, as you know, takes to permit these facilities and build, why not get ahead of the curve if you want to meet that gap that you show on the chart between now and 2030?"
},
{
"speaker": "Kent Masters",
"text": "Yes. So, we're building pretty aggressively, and we need both elements. We need the resource and then we need the conversion assets. So, I mean, between balancing those, we're keeping less in balance and moving pretty much with the market. We may be half a step behind. I don't know that we wanted to 3 or 4 facilities in the U.S., I don't think we could feed those. I'm not sure that would make sense. We would do -- I mean, our plan is we'll do this large facility that we're looking at in the conversion site in the U.S. That's going to be a big facility and probably do another one at that scale, but we have to have the resource defeated."
},
{
"speaker": "Scott Tozier",
"text": "Kent, I'd add too, we're progressing our direct lithium extraction work in Magnolia, Arkansas. And so, as that comes to maturity, you could expect a conversion facility in that area as well?"
},
{
"speaker": "Kent Masters",
"text": "Yes, it's a good point. And that's probably will be a little smaller facility just because of the resource from the direct lithium extraction. But that is a slightly different time frame than the conversion facility in the Southeast."
},
{
"speaker": "PJ Juvekar",
"text": "Right. Just quickly, what was the size of the Megaflex facility? Thank you and I’ll pass it on."
},
{
"speaker": "Kent Masters",
"text": "What was the question? What is the site? We have [indiscernible] southeast..."
},
{
"speaker": "PJ Juvekar",
"text": "Yes, the size -- no. No, the size. The size, yes."
},
{
"speaker": "Kent Masters",
"text": "Okay. Sorry. So, the size of -- we're planning 100,000 for a conversion facility of 100,000 tons. It will come in phases. But the idea is roughly 25% would be from recycled materials, 75% from virgin material."
},
{
"speaker": "PJ Juvekar",
"text": "Thank you."
},
{
"speaker": "Operator",
"text": "Our next question comes from Matthew Deyoe from Bank of America."
},
{
"speaker": "Matthew Deyoe",
"text": "Good morning every one. So, I wanted to, I guess, tap a little bit more on the equity income side of the equation. If I were to just look at what IGO reported as it relates to the equity income and the internal transfer pricing, can you help us kind of square how that kind of runs through your numbers, how that impacted the 3Q margins and maybe the puts and takes as we bridge to 4Q?"
},
{
"speaker": "Scott Tozier",
"text": "Yes. So, if you look at IGO's report, they show Talison's full equity -- full net income for the quarter. One thing to remember is for Albemarle, once we buy spodumene, we have to inventory that profit until we actually sell it to the end customer. And so that adjustment is kind of the reconciling item. And one way to kind of look at it is because of that six-month supply chain that I talked about in the prepared remarks, you actually go back to first quarter of this year, and that amount versus the amount in the third quarter is about what that inventory adjustment is."
},
{
"speaker": "Matthew Deyoe",
"text": "Understood. And can I ask how you're thinking about future investment in China? I know you have Meishan and I remember when the Tianyuan acquisition was initially announced, there was talk about potentially debottlenecking that facility. But -- how do you balance the lower CapEx in market size with kind of what feels like growing geopolitical risk to the region?"
},
{
"speaker": "Kent Masters",
"text": "Yes. So that -- it's a good question. And what we are -- I mean you get lower capital, we referenced that kind of like half the capital to do that in China. The Qinzhou acquisition was good for us. So, we'll look at -- once we operate that for a while and get a good understanding, we'll look at expanding it. Probably, most likely, we'll expand that. And then we've got the Meishan project that we're doing there. And then we had a project that we were looking at Zhangjiagang, and that's another one that we think about, but we're -- as demand grows. So China is still the largest lithium market in the world, and their growth is quite significant. We've got demand growing in North America and Europe now. So, we're trying just to balance that, manage the opportunity and minimize the risk. So, I think that that's something that we look at all the time. Our plans -- our firm plans at the moment are -- we've done the Qinzhou acquisition, and we're building the Meishan project. And we're planning to do an expansion of the Qinzhou facility but we won't actually have to pull the trigger on that because we want to get a little bit of operating experience with that plant. And then change the design somewhat when we do the expansion. So, we look at it all the time and something that we just adjust to as to what's current."
},
{
"speaker": "Operator",
"text": "Our next question comes from Aleksey Yefremov from KeyBanc Capital Markets. Aleksey your line is now open."
},
{
"speaker": "Aleksey Yefremov",
"text": "Thank you and good morning every one. The lithium volume guidance for this year is 20% to 30% and you posted 20% year-over-year in third quarter, 18% in the second. So, is it fair to say if you're trending towards the lower end of this guidance for the full year at this point?"
},
{
"speaker": "Scott Tozier",
"text": "No, we should be probably in the middle of that guidance range. So, as we're ramping up volume at La Negra, you should see improvement to that growth rate in the fourth quarter. I don't know, Eric, if you have any more."
},
{
"speaker": "Eric Norris",
"text": "Aleksey, I'd just add that, that has always been the case, is that because of the nature of the ramp of our plants, both La Negra, Kemerton, Qinzhou coming into the full, we've always been back half loaded. The challenge we had in the third quarter was on the production side, mostly in tolling in China due to brownouts -- rolling brownouts in the region and how that impacted operating rates of our tollers ability to toll convert. As we go into the cooler time of the year where we don't expect and have not seen those, obviously, now with the weather being warmer, we expect higher production rates on the tolling side plus the continued ramp up these plants as Scott referenced, that our owned plants. So, we'd expect to get into the middle of that guidance with a strong volume performance in the fourth quarter."
},
{
"speaker": "Aleksey Yefremov",
"text": "Very helpful. Thanks. And just pretty fresh news. The Canadian government is forcing some divestments of lithium assets there. Are you potentially interested? And if not, do you have any thoughts on this development? Does it matter for lithium industry in general?"
},
{
"speaker": "Kent Masters",
"text": "Yes. I mean I don't know if we have specific thoughts on it, but we are always looking at lithium assets. We were kind of comb the planet for lithium assets. So, if they're interesting, we would be looking at them, but nothing to say on those particular assets today."
},
{
"speaker": "Operator",
"text": "Our next question comes from Arun Viswanathan from RBC Capital Markets. Arun your line is now open."
},
{
"speaker": "Arun Viswanathan",
"text": "Grate, thanks for taking my question. Congrats on the good results here. Just wanted to, I guess, maybe ask you guys to elaborate on some of the market movements you're seeing. You noted there's been some recent strong demand in EVs is moving prices higher. What's kind of the outlook as you look into the next couple of months? And could you also comment on potential elasticity impacts on EV demand, if there are any? What have you observed as far as demand trends kind of accelerating or decelerating on price increases?"
},
{
"speaker": "Eric Norris",
"text": "This is Eric. As you may know, EV sales through, I believe it's the end of September around the world are up 75%. And that's after a pretty soft part of the year -- early part of the year for China, in particular, because of the lockouts and because of supply chain challenges. The tone within the industry now on the automotive side is one of more concern about supply chain than it is about demand. And so, as the supply chain pressures ease, automotive vehicle stocks are very low. We expect to see continued strong growth through the balance of the year and well into next year as well. So, we remain bullish about those trends. Of course, the second part of your question, we continue to watch the economic impacts on purchasing behaviors. We note that in the COVID time and in other weak periods of economic weakness, EVs have been, by and large, more of a luxury item and have not seen reductions in volumes coupled with just the strong secular trend and government policies now that are reinforcing that. But we'll watch the effect of interest rates on that. A big part of the mid-to-low end of the market is actually in China. And with China is coming out of its COVID lockdowns and recovering, we're seeing strength in that sector. So, we'll continue to watch what the economy -- economic effects and higher interest rates around the world might have on demand, but we don't see any impact nor is history tell us we should expect one."
},
{
"speaker": "Arun Viswanathan",
"text": "Okay. Great. And then just on the upstream resource side, we've been hearing reports that in some of the recently announced projects on the spodumene side may be difficult to move ahead just because of the increase in price and the capital that's required to develop those projects. Is that something that you're observing as well? And if so, what impact should that have, I guess, on spodumene and downstream hydroxide markets, if any?"
},
{
"speaker": "Eric Norris",
"text": "To clarify, you said increase in price was affecting projects. So, you're referring to the capital cost to build the facilities for such plant?"
},
{
"speaker": "Arun Viswanathan",
"text": "Yes, both. There is -- we've been hearing there's been some increase in spodumene costs, both the capital costs as well as the acquisition costs are prompting some recently announced projects to get delayed. I don't know if that's -- at least that's what we've been reading."
},
{
"speaker": "Eric Norris",
"text": "Yes. I mean, I think certainly, the effects of inflation are having an impact on -- we see those in our own capital cost. They can have an impact on our inflation. And it's highlighted for us the importance of our scale and our global procurement strategy to drive down costs. For smaller companies, less experienced in executing capital. It could definitely have an impact. I don't know -- those are longer-term impacts than shorter term. So, we haven't seen that manifest itself yet in a change in market tone. And as we said earlier, the demand is so strong and the balance of supply and demand is such that at the moment, this would only aggravate the supply-demand issue and sustain strong prices at a market basis for lithium. So, we'll continue to watch it, but I think that's -- there might be some truth to what you're referring to that could have a long run impact."
},
{
"speaker": "Scott Tozier",
"text": "Ultimately, it's another example of how lithium projects take time and effort and challenges to get through it. That's not an easy thing to go through."
},
{
"speaker": "Operator",
"text": "Our next question comes from John Roberts of Credit Suisse. John your line is now open."
},
{
"speaker": "John Roberts",
"text": "Thank you. Will the Megaflex plant be hydroxide or carbonate or both? And will the production trainer align campaign specific types of feedstock or -- and then switch back and forth? Or will it run a continuous blend of mixed feedstocks?"
},
{
"speaker": "Kent Masters",
"text": "Yes, you're way ahead of it, John. I think it is -- will be -- it will run. It will be a blend, right? We'll blend things that come through, but it's going to be designed around Kings Mountain. And then other resources that will feed that and then the recycling. So, it's going to be quite flexible and why we're calling it the Megaflex. So, there's -- there'll be flexibility around it. But I don't -- and it's not specific. We're not designing for a particular or typically. We try and -- we design in flexibility so we can operate on multiple resources."
},
{
"speaker": "Eric Norris",
"text": "So that's where -- John, just to add. That's for some of the know-how and the process technology advantages that we have comes into play as we design that. But to go back to the first part of your question, the initial trains were targeting hydroxide at the moment. That's how it's -- we're looking at a 50,000-ton plant, and we're looking at what we've built in China, what we built in Australia. We're taking the learnings in the best and developing that into a plan for execution here. We'll watch the carbonate market development very carefully. With the recently passed IRA, it's very possible that more LFP capacity could come into the U.S. That being -- excuse me, cathode capacity. If that's the case, there could be a justification of future trains should be carbonate. We'll have to watch that carefully."
},
{
"speaker": "John Roberts",
"text": "Okay. And then on the newly combined bromine and lithium specialty segment, it's going to be back integrated to resource and bromine. But I assume you're going to purchase lithium from the energy storage segment? How will that transfer pricing be handled?"
},
{
"speaker": "Scott Tozier",
"text": "Yes, John, we're still working through that. Likely, it will come through at cost, but we haven't sorted through all the details yet. So, we'll let us share that in our January meeting."
},
{
"speaker": "Operator",
"text": "Our next question comes from Vincent Andrews of Morgan Stanley. Vincent your line is now open."
},
{
"speaker": "Vincent Andrews",
"text": "Thank you, good morning every one. Are you still looking to potentially change your relationship with Mineral Resources or the JV terms? And could you also provide an update on the Wodgina restart? And do you think that as debottlenecking opportunities or potential to operate sort of above prior nameplate?"
},
{
"speaker": "Kent Masters",
"text": "Okay. So, first question about the JV. So, we continue to talk and look at opportunities to kind of optimize that between the two of us. So those are ongoing discussions. And if we get to something that's different, we'll finalize that. We'll tell the market as soon as that information is available. Wodgina is operating. It's up and operating and the -- there are debottlenecking opportunities and additional trains that are potential, but it is up and operating today on two trains, I believe. And then we have -- and we're talking about starting -- we're talking about a third train, but it's -- there are two trains today, and they are operating."
},
{
"speaker": "Vincent Andrews",
"text": "What would be -- what's prohibiting you from going forward with the third train?"
},
{
"speaker": "Kent Masters",
"text": "Well, we need to -- we have designs of it, and we need to be able to have conversion capacity for that."
},
{
"speaker": "Operator",
"text": "Our next question comes from Kevin McCarthy of Vertical Research Partners. Kevin your line is now open."
},
{
"speaker": "Kevin McCarthy",
"text": "Yes, good morning. Now that you've had a few months to digest it, would you comment on what the economic impact of the IRA would be on Albemarle in terms of direct and indirect influences. And do you think it will influence how you allocate capital beyond the Megaflex project?"
},
{
"speaker": "Kent Masters",
"text": "So, has it been a couple of months? That's -- but it will -- I don't know that it directly impacts our economics, but it's changed the market a bit. I mean there's more requirement for local supply in the U.S. and then supply from countries with free trade agreements with the U.S. And actually, it works out, we're well positioned for that, and we had planned to have -- we were planning the Kings Mountain facility and conversion in the U.S., but that is accelerating that, I would say, trying to go as fast as we can. We did have plans already on the books before that happened, and this just kind of makes it more critical. So, I know -- now that you translate it specifically into our P&L, but it does drive demand toward North America and to localize supply to as much as possible, and I think it will accelerate EV demand in North America."
},
{
"speaker": "Scott Tozier",
"text": "Yes. Beyond the effects, Kevin, of the incentives -- on the consumer incentives that are being put in place, there's a manufacturing tax credit that we will be able to benefit from. We're not exactly sure how it's going to work yet because the regulations haven't been put out. But it's a 10% of manufacturing cost for battery materials. So, for us, that's probably in the $10 million range on a full facility. And then the other aspect is the minimum income tax or what some people are calling the new AMT. Again, that wouldn't affect us immediately, but a minimum tax of 15% potentially could affect us in the future."
},
{
"speaker": "Eric Norris",
"text": "And finally, Kevin, that's immediate topic you asked, I'll just add that it has an impact on purchasing behaviors. We're seeing a real not surprising interest for those who have U.S. based production to preferentially put a premium in their view on sourcing from free trade countries or from the U.S. itself. So, we'll be carefully sort of segmenting our customer base and looking at how we create the right value for ourselves and for our customers in terms of how we go to market and bring that and price that product in the marketplace."
},
{
"speaker": "Kevin McCarthy",
"text": "So, that's really helpful. I appreciate the color and then as a follow-up, Scott, I think you mentioned in your prepared remarks that lithium prices on a realized basis could rise at a double-digit pace in 2023. Can you elaborate on that? What are you assuming in terms of market pricing vis-a-vis the uptick that you referenced in October? Maybe you could just kind of talk about where we're tracking in terms of low double digits or substantially higher than that and what you're baking in?"
},
{
"speaker": "Scott Tozier",
"text": "Yes. So, when I said that it's really based off of market indices that are where they are today, so there's really two big effects happening as we go into next year. One is just the annualization of what we experienced in 2022. And then the second is we continue -- Eric and his team continue to work on those fixed price contracts and convert those to the index reference variable contracts. So that's going to have a benefit for us as well. And while we haven't provided specific guidance, the kind of ranges we are talking about are kind of healthy double-digit price increases next year. So again, contributing to what we're expecting to be another strong year of growth from Lithium. And we're seeing it from all three of our businesses, to be honest, even in the face of potential slowdowns."
},
{
"speaker": "Operator",
"text": "Our next question comes from Josh Spector from UBS. Josh your line is now open."
},
{
"speaker": "Josh Spector",
"text": "Thanks, take my question. So just on the lithium contracts and some comments you made earlier. So your index references contracts used to be labeled a three to six-month lag. Now they're about three months. You talked about moving more fixed price over to those types of contracts. I guess the duration continues to get a bit shorter. I'm just wondering, should we expect that duration to approach less than three months, say, one month at some point in the future? Or is three months’ kind of the right range that you're finding customers want to two and four?"
},
{
"speaker": "Eric Norris",
"text": "Josh, I mean, I would think of it this way, first of all, to answer your question, three months is what we expect going forward as the lag. And that's a product of moving from a fixed contract with reopeners that are -- that had been up to six months to a full index where it's looking back three months on a rolling basis. So that is -- that's the standard of the term we're taking into the marketplace, and it's allowing us to benefit from rising prices while dampening the impact to the customer. So that's how we -- that's the strategy and how we plan to drive the portfolio going forward. And as Scott pointed out, we do expect some of the fix in that category of 20% that's on our contract slide to come down as we go into next year as well."
},
{
"speaker": "Josh Spector",
"text": "Okay, thanks. And just on the DOE grant that you guys received. Is there a potential for you guys to receive more than one of those? I don't know if there's a limit per company or something else we could consider about additional support if you were to build additional facilities in the U.S.?"
},
{
"speaker": "Kent Masters",
"text": "Yes. So that was a particular program. So, we wouldn't expect to get anything additional out of that. There was a process we went through and applications. We got that particular grant. So, if there are other programs, we could do that. But under this existing program, that was it."
},
{
"speaker": "Operator",
"text": "Our next question comes from David Begleiter from Deutsche Bank. David your line is now open."
},
{
"speaker": "David Begleiter",
"text": "Thank you, good morning. Eric, just on Kemerton I and Kemerton II, what are you expecting for production output next year from these two units?"
},
{
"speaker": "Eric Norris",
"text": "Look, I think -- well, certainly, when we get into our January investor outlook for '23 and beyond, get into more details. But in the meantime, I apply the same rule of thumb we've applied all along, which is it takes up to two years to fully ramp to nameplate capacity. And you would expect that ramp to start with upon commissioning a six-month lag for qualification of the customer base. And in the first 12 months, getting to about half or slightly thereabouts of the capacity of any one of those plants. So -- we are -- just to put that into practical terms, we are now expect to sample for qualification Kemerton I this quarter, and we'd hope to early or during the first half of next year begin sampling for the second train and then you can apply those rules of thumbs I just outlined."
},
{
"speaker": "David Begleiter",
"text": "Very helpful. And just on the recent spike in Chinese spot prices, how sustainable do you think this is over the next few months? And thoughts on the spot prices for next year?"
},
{
"speaker": "Eric Norris",
"text": "I don't -- it's very hard. I can only tell you, I think that the uptick of late has been a recovery in the market in China, in particular, from a demand perspective. And that has caused prices to -- they modulate -- moderated rather a bit in the middle part of the year and to come back up again. Where they go from here, David, hard to say. What we do know is as we look into next year, we still see a tight undersupplied market. So, the dynamics are going to be favorable for strong prices. What that means for a point estimate of Chinese spot prices is a tough one to come up with."
},
{
"speaker": "Operator",
"text": "Our next question comes from David Deckelbaum from Cowen. David your line is now open."
},
{
"speaker": "David Deckelbaum",
"text": "Good morning. Thanks, take my question. I wanted to just talk about IRA compliance. You highlighted, obviously, the fact that you have active production and conversion and free trade agreement countries. I just wanted to confirm whether it's your view that would you be selling qualifying materials from Kemerton or La Negra into the United States? Or would Kemerton be feeding U.S. customers? Or is that predominantly going to be feeding the Chinese market?"
},
{
"speaker": "Eric Norris",
"text": "So, actually answer is different by plant. If you start first with hydroxide and Kemerton, the intent for Kemerton, ever since it was built, long before IRA, long before recent geopolitical concerns was to supply a broad global market and to leverage the China assets we have for a China market. And as geopolitical circumstances have changed and things like the IRA have come along, as Kent said earlier, we're really moving towards a country-per-country or region-per-region-based strategy. So, China for China, Australia would feed Asia and Europe and North America in that regard. And that we believe that to be the efficient route to go. If you look at carbonate, carbonate is a little different. The majority of the carbonate market today is China. And we don't have carbonate assets currently within China. So, a large purchase, chunk of what we make, a large percentage of what we manufacture at Chile goes into China, as the RA develops -- as demand develops in the U.S. and Europe, and I have to say, develops because it's still very, very small. That could change that dynamic, driving the need for us to try to get more out of Chile or other carbonate sources as we go forward."
},
{
"speaker": "David Deckelbaum",
"text": "I appreciate the color there. Perhaps my follow-up, there's a lot to ask here. But with the January update on your '23 outlook in the context of some of the U.S. expansion, the Megaflex site, Kings Mountain, you highlighted, I think before, Kent, that you'd aim to have these perhaps online in '27. Is that specific to just the Megaflex site? Or would that include Kings Mountain as well? And do you expect to have a capital program for those assets envisioned in 2023, perhaps even in January with this announcement and start beginning the permitting process next year?"
},
{
"speaker": "Kent Masters",
"text": "Yes. So, I mean we'll have capital. We'll definitely have capital in the '23 plan around those facilities. And the date, the '27 date is mine and conversion optimistically. It all depends on the permitting process and the schedule, but that's the thinking."
},
{
"speaker": "Operator",
"text": "Our next question comes from Joel Jackson from BMO Capital Markets. Joel your line is now open."
},
{
"speaker": "Joel Jackson",
"text": "Good morning. You obviously have some visibility now in the types of prices you're getting January, February into Q1 obviously. Can you give us a sense of it -- are February pricing coming in better than January, January price is coming better in December on a realized basis on average?"
},
{
"speaker": "Scott Tozier",
"text": "Well, I mean, Joel, I'd say where the indices are today, that you'd have to say that they're better than what they were a quarter ago. However, recognize that there's room for movement either up or down from that depending on how those indices move."
},
{
"speaker": "Joel Jackson",
"text": "Okay. You made a comment earlier in the call, I think that if spot pricing stayed the same, that 2023 pricing would be up double digits. I think you said that. What would spot prices -- it's a very high-level question. Maybe you can just give us some color. What would spot price have to do across 2023 for your realized price in '23 to be about equal to '22? It seemed like a linear decline, just a hypothetical scenario. What would that imply in that scenario to get -- where would you need to get to flat pricing in '23 versus '22?"
},
{
"speaker": "Scott Tozier",
"text": "I got to think through the math there because there are a lot of different contracts with different caps on them that we've got an account. I don't know, Eric, have you got a gut feel for it or I have to get back to Joel."
},
{
"speaker": "Eric Norris",
"text": "We may get back to you, Joel. But the factors are that, obviously, we've been moving all year long, this year, in 2022 in price. And that's been part of our growth. That's been part of our strategy. That's been part of what's driven some of the upsides to expectations along the way. We'll do a small amount of that to move to -- from fixed to variable next year, but the bulk of that is complete. But what happened during the year, if you just annual -- if you just take where we are now and annualize it in the next year, you've got a big increase. That, I think, is Scott's point. So, you'd have to see decreases that are pretty significant to draw that average down versus 2022. We'd have to do some modeling to see if we can give you better guidance than that."
},
{
"speaker": "Operator",
"text": "Our next question comes from Christopher Parkinson from Mizuho. Christopher your line is now open."
},
{
"speaker": "Christopher Parkinson",
"text": "Great, thank you so very much. Got two fairly simple one’s for you today. The first, just any quick update on your preliminary thoughts on a China EV subsidy in '23 and onwards?"
},
{
"speaker": "Scott Tozier",
"text": "I'm sorry I missed..."
},
{
"speaker": "Eric Norris",
"text": "Oh, right. Yes. Well, I don't know that our crystal ball is any better than anybody else's. I mean China has been easing its subsidies of late, and that has not dampened demand. Demand is up over -- sales are up over 100% year-on-year and then now accelerating in the back half of the year. I don't know that they need to accelerate but then they certainly have a lot of capacity in country that could serve that from a battery and cathode standpoint. Hard to say what industrial policy will be, sorry."
},
{
"speaker": "Christopher Parkinson",
"text": "Your crystal ball is better than mine, for what it's worth. And then second question, just in the recent acquisitions in China, is that product already spec-ed in? Or what's the plan to have that spec-ed in with customers? Thank you."
},
{
"speaker": "Kent Masters",
"text": "You mean qualified, you mean? Yes. So, we've been actually tolling through the facility. So, the acquisition took us a little longer to get some of the approvals than we anticipated. So, we sold our spodumene through it. So, we've qualified that product already."
},
{
"speaker": "Operator",
"text": "Thank you. That's all the time we have for Q&A. So, I'll hand back to Kent Masters for any further remarks."
},
{
"speaker": "Kent Masters",
"text": "Okay. Thank you, Alex, and thank you all again for your participation on our call today. Albemarle is a global market leader with a strong track record of financial and operational performance. We have a clear strategy to accelerate profitable growth, and we play an essential role in meeting the world's sustainability challenges. We are proud of what we have accomplished, and I am personally thankful for our outstanding employees as we reshape our business for even greater success going forward. Thank you."
},
{
"speaker": "Operator",
"text": "Thank you for joining today's call. You may now disconnect."
}
] | Albemarle Corporation | 18,671 |
ALB | 2 | 2,022 | 2022-08-04 09:00:00 | Operator: Hello, everyone, and welcome to the Q2 2022 Albemarle Corporation Earnings Conference Call. My name is Nadia, and I'll be moderating your call today. [Operator Instructions] I’ll now hand it over to your host Meredith Bandy, Vice President of Investor Relations and Sustainability to begin. Meredith, please go ahead. .
Meredith Bandy: Thank you, Nadia. And welcome, everyone, to Albemarle's second quarter 2022 earnings conference call. Our earnings were released after the close of market yesterday, and you'll find the press release and earnings presentation posted to our website under the Investors section at albemarle.com. Joining me on the call today are Kent Masters, Chief Executive Officer; and Scott Tozier, Chief Financial Officer; Raphael Crawford, President of Catalyst; Netha Johnson, President of Bromine; and Eric Norris, President of Lithium are also available for Q&A.. As a reminder, some of the statements made during this call, including our outlook, guidance, expected company performance, and timing of the expansion projects may constitute forward-looking statements within the meaning of federal securities laws. Please note the cautionary language about forward-looking statements contained in our press release and earnings presentation. That same language applies to this call. Please also note that some of our comments today refer to non-GAAP financial measures. A reconciliation to GAAP financial measures can be found in our earnings release and the appendix of our earnings presentation. And now I'll turn the call over to Kent.
Kent Masters : Thanks Meredith. Thank you all for joining us today. On today’s call I’ll highlight our second quarter results and achievements. Scott will provide details on our financial results, outlook, balance sheet and capital allocation. I’ll then close our prepared remarks with an update on our operating model and strategic growth projects aimed at further strengthening our long-term financial performance and sustainable competitive advantages. Albemarle’s leadership position in Lithium and Bromine, coupled with our team’s ability to execute to the current inflationary environment led to another led to another quarter of strong results. In the second quarter, we generated net sales of $1.5 billion nearly double the prior year. Second quarter adjusted EBITDA of $610 million was over three times the prior year. Continuing the trend of EBITDA significantly outpacing sales growth. The supply demand balances remain tight in the markets we serve. Strong market prices and our continued success in contract renegotiation drove the tremendous strength we're experiencing in our lithium business. As a result, we are again raising our 2022 outlook and now expect to be free cash flow positive for the year. Scott will review the key elements of that outlook later on in the call. We are also successfully executing our growth strategy. Our Kemerton I lithium conversion plant in Western Australia achieved first product in July. I want to especially congratulate our teams in Western Australia for their hard work and dedication and achieving this goal. And lastly, we made a major announcement regarding plans to build an integrated lithium mega site in the United States. This will support our western expansion and the development of the battery material supply chain in North America. Now I'll turn the call over to Scott to walk through our financials.
Scott Tozier: Thanks, Kent. And good morning, everyone. I'll begin on slide 5. During the quarter, we generated net sales of approximately $1.5 billion, a year-over-year increase of 91%. This is due primarily to increased momentum in our pricing efforts as well as higher volumes driven by strong demand across our diverse end markets, especially for our lithium and bromine businesses. We saw volumes and pricing grow in all three of our businesses. For the second quarter, net income attributable to Albemarle was $407 million, compared to $425 million in the prior year. As a reminder, the year ago, quarterly results included a onetime benefit of $332 million related to the sale of Fine Chemistry Services. EPS for the second quarter was $3.46, a year-over-year improvement of 300%, excluding the onetime benefit of the FCS sale. This overall performance was driven by strong net sales and margin improvement, partially offset by the ongoing inflationary pressures we are feeling across all three businesses. Turning to slide 6, second quarter adjusted EBITDA was $610 million, up 214% year-over-year. The primary driver the strong growth was higher lithium EBITDA. Lithium was up nearly $400 million compared to the prior year, driven by momentum in our contracting efforts and overall higher market prices. That's an increase of 350%. In fact, lithium second quarter EBITDA was greater than the EBITDA it generated in the full year of 2021. Bromine was also favorable year-over-year up nearly 50%, reflecting higher pricing driven by tight market conditions and an uptick in volumes, partially offset by raw material and freight inflation. Catalysts was negative in the quarter as higher sales volumes and pricing were more than offset by cost pressures, particularly for natural gas in Europe and raw materials. And finally, we also experienced an overall FX headwind of $14 million for the total company. Moving to slide 7, we are further increase in our 2022 outlook from our last announcement in late May, primarily to reflect the expected continued strength in execution in our lithium business and further improvements in bromine. We now expect 2022 total company net sales to be in the range of $7.1 billion to $7.5 billion, up about 115% to 125% versus last year. Adjusted EBITDA is expected to be between $3.2 billion and $3.5 billion, reflecting a year-over-year improvement of up to 300%. This implies EBITDA margins are expected to improve significantly to a range of 45% to 47% for the total company. Together, this translates to updated 2022 adjusted EPS guidance in the range of $19.25 to $22.25. That is about five times more than 2021. Additionally, we're increasing our net cash from operations guidance to a range of $1.4 billion to $1.7 billion. Driven by our updated sales and margin expectations. We are maintaining guidance for capital expenditures of $1.3 billion to $1.5 billion as we drive our lithium investments forward to meet increased customer demand. Together, the midpoint of our guidance implies approximately $150 million in positive free cash flow for the full year. And further if you assume our realized pricing remains relatively flat next year, we expect to continue to generate positive free cash flow in 2023 even with continued growth investments. Security supply remains the number one priority for our customers, and we are continuing to partner and work closely with them. We are pushing hard to meet those accelerating customer growth requirements. Regarding the quarterly progression of sales and EBITDA, on our last call, we indicated that we expect results to be relatively evenly split among quarters. Given the underlying strength across our portfolio, and continued momentum in our contracting efforts, we now expect second half adjusted EBITDA to be roughly 120% higher relative to the first half. Turning to the next slide for more detail on our outlook by segment. Our lithium businesses full year 2022 EBITDA is expected to be up more than 500% year-over-year, up from the previous outlook for growth of approximately 300%. The improved outlook reflects renegotiations of pricing on legacy fixed price contracts, and continued strong market pricing flowing through our index referenced variable price contracts. We now expect our average realized selling price to be up more than 225% to 250% year-over-year. This is the result of our successful efforts to renegotiate legacy contracts and implement more index referenced variable price contracts, as well as a significant increase in index prices. From the beginning of the year to today, indices are up 60% to 130%. And note that our outlook assumes Albemarle’s expected Q3 realized selling price remains constant into the fourth quarter. There's no change to our lithium volume outlook for the year. We continue to expect year-over-year volume growth in the range of 20% to 30% as we bring on new conversion assets, plus some additional tolling. There's potential upside to our outlook if market prices remain near current levels, or with additional contract renegotiations or additional tolling volumes. And conversely, there's potential downside with material, the clients and market pricing or volume shortfalls. For bromine, we are also raising our full year 2022 EBITDA expectations with year-over-year improvement in the range of 25% to 30% compared to the prior outlook of 15% to 20%. This revised guidance reflects continued strong demand and pricing from end markets such as fire safety solutions, and oilfield services. Plus other macro trends such as digitalization and electrification. We expect higher volumes of 5% to 10% following our successful execution of growth projects last year. For catalysts, full year 2022 EBITDA is expected to be down 25% to 65% year-over-year. This is below our prior outlook due to significant cost pressures, primarily related to natural gas in Europe, certain raw materials, as well as freight, partially offset by higher sales volumes and pricing. The large outlook range for Catalysts reflects increased volatility, and a lack of visibility particularly related to the war in Ukraine. Given the extraordinary circumstances and the resulting changes in oil and gas markets, the business continues to aggressively see costs pass-through, particularly for higher natural gas costs. The strategic review of the catalysts’ business is ongoing, but it is taking longer than we anticipated. As soon as we have any news, we will provide an update. Turning to slide 9 for an update on our lithium pricing and contracts. This slide reflects the expected split of our 2022 lithium revenues. Battery grade revenues are now expected to make up approximately 85% compared to 70% to 80% in our prior guidance, due to successful contract negotiations, and higher market indices. Of the total battery grade revenues, 15% is expected to be from short term spot purchase orders. 65% is expected to be from index reference variable price contracts. Pricing on these contracts generally reset with a three month lag and a number of these contracts do have floors and ceilings in place. The remaining 20% comes from Legacy fixed contracts with price reopener normally every 6 or 12 months. And since we last updated the outlook in late May, we have successfully repriced a portion of these contracts to better reflect the current market price environment. This segmented approach to contracting gives more flexibility for our customers, while allowing Albemarle to preserve upside and ensure returns on our growth investments. Our operations and project teams are also delivering volumetric growth. Slide 10 shows the expected lithium sales volumes including technical grade spodumene and tolling sales. In 2022, we expect volumes to improve 20% to 30% year-over-year. This growth is largely driven by our expansions at La Negra and Kemerton, the acquisition of Qinzhou as well as some additional tolling volumes. Looking forward, we expect volumes to grow approximately 20% per year from 2022 to 2025, driven primarily by the ramp up of new conversion assets. We see room for further upside from additional conversion assets such as our Greenfield in Meishan or additional tolling volumes. Turning to slide 11, our strong net cash from operations and solid balance sheet give us ample financial flexibility to execute our growth strategy. Our balance sheet is in great shape with $931 million of cash and available liquidity of $2.6 billion. Current net debt to adjusted EBITDA is approximately 1.7x with rising EBITDA from higher pricing and volumes, we expect leverage to trend lower in the near term. This will -- this gives us plenty of capacity to accelerate our growth investments or value creating M&A. During the second quarter, we extended our debt maturity profile through a public offering of senior notes, proceeds total approximately $1.7 billion, a portion of which was used to redeem senior notes maturing in 2024. 92% of our debt position is at a fixed rate, which buffers us against the impacts of rising interest rate environment. Before I turn the call back over to Kent, I wanted to briefly review our capital allocation priorities and our ability to adapt to market changes while building durable capacities to support growth. Our capital allocation priorities are unchanged, we remain committed to strategically grow our lithium and bromine capacity in a disciplined manner. Capacity growth will also be supported in organically by continuously assessing our portfolio and pursuing bolt-on acquisitions at attractive returns to strengthen our top tier resource base. A perfect example of this strategy is the $200 million Zhangjiagang’s acquisition that is expected to close in the second half of the year. Maintaining financial flexibility and shareholder returns are also key capital allocation priorities. We remain committed to maintaining an investment grade rating and a strong balance sheet to provide significant optionality to fund future growth. Finally, we also plan to continue to support our dividend. We are laser focused on the durability of our business. The management team and the board regularly review our capital allocation priorities and have identified levers we can pull to quickly adapt to changing market conditions if needed. These include slowing non growth CaPex, reducing discretionary spending and hiring, shifting production volumes to highest demand markets, and accelerating partnering and tolling arrangements to support cash generation. Additionally, a downturn may allow us to take advantage of lower priced acquisitions, capitalizing on the strength of our balance sheet. In summary, we believe Albemarle’s ability to maintain a focus on growth through all market conditions is strong, thanks to our operating model that Kent is going to discuss next.
Kent Masters : Thanks, Scott. So let's turn to slide 13 to discuss our cost structure, and how we are managing inflation. Our vertical integration and access to low cost resources for lithium and bromine allow us to avoid the worst impacts of inflation and control our cost structure. For example, while approximately 45% of our costs come from raw materials and services, actually 20% of those costs relate to our own spodumene. The implementation of our operating model the Albemarle way of excellence, it’s also helping manage costs. In 2020, we identified our supply chain as a key area for improvement. At that time, we reorganized to form a global supply chain function and implemented a new Enhanced Procurement strategy that team's efforts are now paying dividends. Last year, our procurement team set a target to achieve $90 million in value creation by 2022 year end, we are on track to meet or exceed that target by about 40%. About half this from cost savings with lower year-over-year cost. And about half is from cost avoidance, where procurement efficiencies have allowed us to realize below market increases. An example of cost savings includes logistics efficiencies, minimizing material handling, maximizing equipment capacity and shortening haul routes. Cost avoidance includes using fewer suppliers and pooling buying for key raw materials and services to offset inflation. And other cases, we've shortened supply chains to improve resilience and reduce total cost. This success is driven by diverse teams, including supply chain, procurement and production scheduling. Thanks to everyone across the enterprise and around the globe, it took commitment from every individual to make this happen. Our operating model is also focused on building the structure, capabilities, discipline and design approach to enable faster capacity growth. As a leading lithium producer, Albemarle is investing in lithium production around the world, including China, Australia and the Americas. This year, we plan to deliver projects that more than double our annual capacity from 85,000 tons to 200,000 tons by year end. We are also progressing a portfolio of projects that can grow our conversion capacity to as much as 500,000 tons per year on a 100% bases. As you can see, the near term projects are largely in the Asia Pacific region. Longer term, we expect to transition to a more localized supply chain in North America and Europe. Turning to slide 15, our capacity additions in Australia and Asia significantly enhance our ability to leverage our low cost resource base. In terms of lithium conversion capacity, we've made progress on the regulatory approvals for the acquisition of the Qinzhou conversion facility. We continue to expect that acquisition to close in the second half of 2022. In the meantime, we continue to toll spodumene through this facility. As I mentioned earlier, Kemerton I has achieved first product. This important milestone signifies that the manufacturing processes and equipment can meet the project's design objectives. Our focus now is on qualifying our product with our customers. At our China Greenfield expansions, construction of a 50,000 ton per year lithium hydroxide conversion plant it Meishan is well underway. Importantly, with our ownership stakes at the Wodgina and Greenbushes lithium mines, we already have access to low cost spodumene to feed these conversion facilities. The restart of the Wodgina lithium mine by our JV partner Mineral Resources is going well. We continue to negotiate agreements to expand and restructure the MARBL joint venture and we'll update you when we have more information. We also have a 49% stake at Greenbushes. One of the best lithium resources in the world. The Talison joint venture is ramping up chemical-grade plant two or CGP2 and has approved construction of CGP3, which is broken ground. Our intention is to ramp up lithium resources in advance of conversion assets. In which case in the near term, we could be net long spodumene. If that's the case, we will elect to toll spodumene or sales spodumene into the market. If it's economical to do so, and if it allows us to bridge until new conversion assets ramp up. Albemarle is the leading global lithium producer with a significant US presence and access to some of the world's best resources. As such, we are well positioned to establish world class production of battery grade lithium that enables the localization of the battery supply chain in North America. This would offer important benefits to us based automotive OEMs seeking a de-risked local supply chain, more reliable logistics and a reduced carbon footprint. We plan to leverage our Kings Mountain lithium mine, a top tier resource and build a multi train conversion site in the southeast. This site would be capable of handling mineral resources from Kings Mountain, as well as recycled feedstock. This mega flex site would leverage Albemarle’s best-in-class know-how to design, build and commission both resource and conversion assets. This creates significant competitive advantages for Albemarle and its customers, while also addressing the need for localized lithium supply to support growing demand in North America. In closing on slide 17, we expect to achieve significant growth milestones this year, thanks to strong end market demand, as well as actions that we've taken to invest in profitable growth for lithium and bromine. Those investments are now paying off as we ramp up volumetric growth. To maintain our financial flexibility to fund growth through cash and our balance sheet, and to leverage our operating model to manage cost and execute our growth projects. So this concludes our prepared remarks. Now, I'll ask Nadia to open the question, open the call for questions.
Operator: [Operator Instructions] Our first question today comes from PJ Juvekar of Citi.
PJ Juvekar: Yes, good morning. Kent, your volume growth has been very impressive. Can you discuss your key steps you're taking at Kings Mountain in terms of building the mega site? What environmental permits do you need? Are you engaging with the community today? And the same question on Silver Peak? When you expand that what kind of production ramp up can you see?
Kent Masters : Right, so the two sides are slightly different scale. And so Kings Mountain is significant site, Silver Peak is smaller, but still the expansion is important. I mean, that is the only we're kind of lithium sourced in the US today. But at Kings Mountain, we're early in that process. We're still in pre-feasibility. So we've got to do permitting. But we have done a lot of work already. We've done all of the drilling necessary, well, we continue to do some of the drilling to make to understand the resource at Kings Mountain. But we still got to do permitting, we've engaged with the community. We've been doing community meetings for almost six months now maybe not quite six months early in the year that we started that process with public meetings, we've opened an office in the town so people can come in and ask questions. So we really engaged with the community early on. And we're working on the permitting processes that we have to go through but it's in pre- feasibility study. We feel confident we'll be able to get there at Kings Mountain, but there's a lot of work to do, including all the permitting.
PJ Juvekar: Great, and then you have a strong balance sheet. You have been free cash flow positive this year. You talked about M&A. Can you give us some idea of what you would potentially be looking at? Would you look at technologies like DLE? Or what geographies would you look at? Thank you.
Kent Masters : Yes, well, I think it's what we've really always talked about from an M&A standpoint. So we seeking virgin assets that we think are attractive so we would do that consider as a bolt-on technologies if we see technology to help us so direct lithium extraction, could be part of that. And then resources. So we continue. We're good on resources pretty close to the end of the decade. But we need to be planning now to build out our resource base past that. So I think those are the three primary categories.
Operator: Our next question comes from Christopher Parkinson of Mizuho.
Christopher Parkinson: Great, thank you so much for taking my question. Just turning to slide 18. The third and the fourth point, can you just give us a quick update on terms of some of the contracts negotiations on additional tolling, I mean, on the former, what percent are still up for renewal, that have essentially given you the momentum to raise guidance twice in the last quarter and a half or so. Just any color you could offer that would be very helpful. Thank you.
Eric Norris: Good morning, Chris. It's Eric here. So what we've been able to do, just to recap this year is we've been able to renegotiate contracts that have opportunities for reopener or with customers who are seeking additional line commitments in the out years. And in order to entertain those discussions we've opened up, have been able to ask for higher prices on legacy contracts. We don't have any contracts that are expiring anytime soon. Most of our book of businesses is committed, we're very tight in the next year or two as we anticipate bringing on new capacity from some of the projects I can't describe. But that doesn't mean we won't have opportunities, there might be still some contracts that shift, the big thing that's happened in the past year has been the movement to know having two thirds under our index reference variable price, whereas the foremost that was fixed. Now our movement is going to be very much driven by market prices and some potential changes on the margins, but few contracts, or potentially, if prices remain where they are some resets on some of the fixed prices, contracts.
Christopher Parkinson: Got it. And just a quick follow up just you've also seen OEMs make a very conscientious effort and yes been a little bit more decisive and attempting to lock-in incremental supply through, let's say, the middle in the balance of the decade. I mean, has that been fully reflected in your negotiations in terms of just what you're willing to commit to them? And as we progress over the next year or two, it seems like there's still a bit of a bottleneck in terms of the OEMs versus what's available in lithium in terms of better grade hydroxide. What else are you willing to do to help facilitate the growth plans? And how should we think about that, just from a broader market perspective you versus some of your peers. Thank you.
Kent Masters : We're working with our customers. And we're being very aggressive about adding capacity. So I think you see that in our investment plans, and they're coming through now. And we get better at that. So the period, when those come on, we're able, we believe we're able to execute better from a conversion. We're good on resource for a number of years. But we still need to add that. And we work with the customers to do kind of unique arrangements. We're having conversations with those but with our customers about those, but they have to work for us. And we're working towards some arrangement like that. So and they may or may not come to pass. I am not again say that because those are conversations and discussions that we're having. But we're in those discussions. And we're committed to build capacity to serve the customer base over the long term.
Scott Tozier: Yes, I think what's also unique, Chris, just to add is that we are speaking with OEMs, and battery companies on three different continents. Out in the out years, as you saw on the charts, we're looking towards Europe. So that's the further south, where we are established well now is in Asia. And where we've announced next we're headed is North America. And we've got the resource bases can't describe to be able to do that. So between that localization, which is very important to these OEMs and battery producers, the sustainability and principles in which we operate. And then some of the new technology areas we're focused in for next generation technology. The partnerships we strike are going to look -- are going to be at par with one of those dimensions. And we're not in a position where we need to raise capital. So we can look at and have been discussing with various producers, various OEMs, upfront and potentially forms of investment. But that's not a requirement for us. We don't need that capital. It would only be something we do as part of a broader deal to advance our strategic agenda and help our customers win in the market.
Operator: And our next question comes from David Begleiter of Deutsche Bank.
David Begleiter: Thank you. Good morning. Question for Eric. Eric, just on your slide 9, can you talk about the difference of pricing between the index reference contracts and the spot pricing in Q2. Another compare versus Q1.
Eric Norris: I'm sorry, David, just to make sure I understand your question. You're wondering how they compare now the prices versus back in Q2. Sorry to ask --
David Begleiter: The price difference between index referencing stock prices in Q2 versus a differential in Q1?
Eric Norris: Oh, okay. I'm sorry, we don't give enough detail and disclose that. But I will say that you know spot prices you would know by looking at indices are, they vary, but currently in the low 60s, and in China, they're actually some of the -- some contracts in outside of China are even higher now at $70. We are not there yet on our index pricing, which is one of the reasons our guidance and prices stay where they are, we could continue to have a rising mix, increase in our variable based contracts.
David Begleiter: Understood. And just on the southeast project, can you give now any cost or timing indications for their project?
Eric Norris: David, we have not given out any costs yet, since it's really prefeasibility. So timing wise, it's going to be later in the decade when that would come online, clearly, it needs to have a feedstock. With a mine, that's probably the long pole in the tent.
Operator: And the next question goes to Josh Specter of UBS.
James Cannon: Yes, hey, guys, this is James Cannon on for Josh. Just wondering why it seems like the sale dropped through the EBITDA this earnings upgrade is much higher than the last updates to the year. Can you give any color as to why that is? And similarly on SCF? Has anything in the underlying business change to improve that?
Scott Tozier: Yes, James, I think that the big difference is this upgrade has been purely driven by price. So you're seeing that drop through. And we're not seeing the same impact from spodumene which was a drag. So the spodumene price increases was a drag on our earnings in the last guidance. As you look at free cash flow, we continue to see improvements. They're driven by the growth in EBITDA and we're because of some of the tolling efforts that we're doing, we're actually absorbing some of the inventory that we didn't have before. So seeing a better working capital profile as a result.
Operator: And our next question goes to Colin Rusch of Oppenheimer.
Colin Rusch: Thanks so much. Can you just talk a little bit about the ramp up in Kemerton and any surprises you're seeing at this point, any concerns around labor or any equipment that you're concerned about here as we start moving forward.
Kent Masters : Yes, so I mean, look, where we've just -- we made first product last month, and we're just starting to ramp up. So I think the key thing for us, when we were able to make product and are comfortable with the quality, it means that our process chemistry is right and so there are no surprises really around the kind of core process chemistry around that. So that was a big milestone, that's kind of the first big hurdle that you want to clear. And then now it's just getting everything run at scale, and get purities up to the, to our specifications. So as you kind of run in a new plant, we continuously see that the spec on battery grade material is very high. And so it just takes a little bit of time to get to that and it takes volume to do that. So it's just about ramping up. We feel very good about the process chemistry and that we that the plant will be a good operating plant. It's just that we need a little bit of time to ramp it up and get to those purities we need and then we have to go through the qualification process with our customers. So that's on the doubt. That's on the first train second train is still on schedule that we've indicated in the past and the learnings we had on train one we've stumbled a bit on train one with issues and getting it there. We think, we -- as we saw those we've rectified that for train two. There are still labor issues in Western Australia but I think we're through the worst of that, because we're past most of the big construction elements of it. So now we're into commissioning on one and just finishing up construction on two. There's still labor issues in the operating facility to some degree, but that's kind of business as usual in Western Australia, I would say.
Colin Rusch: Thanks so much. And then on the North America, potential expansion, can you just talk about philosophically how you're thinking about contracting that out. Is that something where you would think about taking in prepayments to lock-in volumes of customers? How far down the road, are you in terms of the thought process and the discussions on off tech for that facility?
Kent Masters : Well, we're having discussions with people, but we're not, I would say, we're not very far down there. We're not locked anything in and we have some ideas around some unique models. And we're having conversations with people about that.
Operator: And our next question goes to Vincent Andrews of Morgan Stanley.
Vincent Andrews: Thank you and good morning, everyone. Kent, I think when you discuss the mega project, you indicated an ability to take recycled feedstock, I just was curious. One just for that mega project, how much of a contributor you thought that would be. And whether your customers are telling or indicating that obviously, maybe more in the out years, and anytime soon, they would like to have some percentage of recycled feedstock in the mix of lithium that they procure.
Kent Masters : Yes, so I mean it's a big part of the conversation. And it's about recycling, creating a recycle loop through the system. It is the years out, but we have to design it in. And so we think we can build the -- we'll build it in phases, but that ultimately will operate a recycled facility, the lower volumes at time, but we'll have time to ramp that up and really learn how to use that optimize that. And that would kind of be our facility that we would learn off as well. So it's part of we're trying to think ahead and design that and design that into a facility so we get scale with the other operating facilities and have the benefit of having an operating plant next door.
Operator: And the next question goes to Kevin McCarthy of Vertical Research Partners.
Cory Murphy: Hi, good morning. This Cory on for Kevin. Going back to slide 9 with the contract breakdown in lithium, I am curious versus last quarter, you have more index referenced variable price contracts, right? 65% versus 50%. And the fixed contract pieces down to 20% from 30% of your battery grade revenues. Do you have a number in mind for how low you can go on in terms of heading fix contracts? Are you trying to get to all index reference price contracts?
Kent Masters : Yes, so I think I mean, we've talked about this for a while. And we've always said we're not sure where this ends up, it is a little bit about how our customers want to contract and then the direction that we're trying to go. So what you're seeing in that is just how the math is evolving. So we've had -- we've upgraded, we've changed contract from those fixed. But remember, the fixed prices adjust over time, so they are not really fixed. And we're trying to shorten that period that we as they adjust. So I'm not -- I don't really want to call the mix. I mean, we had one time said we thought it might be a third, a third, a third between those categories. And it's turned out to be quite different. We do want to have some in the spot category that gives us flexibility. But I don't know, it's hard to say where it goes. We're not necessarily absolutely driving it to that variable price. But we kind of liked that model where it's index referenced and variable. And I think our customers are getting comfortable with it as well.
Scott Tozier: The other moving piece that as you look at that chart between different presentations is of course, where the market indices are. And so that can drive some mix shifts in those percentages, as you go forward.
Cory Murphy: Got it. And then I guess to stick with that slide similar question in terms of change quarter- over-quarter, last quarter you mentioned product offering, this quarter you mentioned the partnership offering and in the context of one of your competitors receiving a large upfront payment for future capacity. Have you approached anybody about similar upfront payments for future lithium capacity? Or maybe you could talk sort of the philosophical approach to how you want to contract future volumes. Thanks.
Kent Masters : Well, I think we've migrated our philosophy around pricing contract over time. And we talked about that quite a bit not that's coming to fruition. They are unique models we've been having. We've had discussions for years with people about prepayments and investments and things like that. We've not done that yet. It's not that we're opposed to it. That has to fit in our philosophy, and it has to work for us. And that -- and it's probably more relevant a few years ago, when we needed more cash for our investments and tool. It's less important for us today. But we're still open for those investments, but we consider them strategic as part of a relationship and not just because we need to cash.
Operator: And the next question goes to Alex Yefremov of KeyBanc Capital Markets.
Alex Yefremov: Thank you and good morning, everyone. As you resign these lithium contracts, what's your philosophy towards the floor and the ceiling in those contracts? Are you widening that range? Are you narrowing it? Is it kind of staying the same versus what you held in general last year?
Kent Masters : Yes, well, I would. I mean, it's a philosophy, but they are widening and going up. So there, it is definitely not narrowing so widening. And they're moving up. I guess that's our philosophy.
Alex Yefremov: I guess that I should assume that the floor is also moving up. Is it fair?
Kent Masters : Absolutely.
Alex Yefremov: And as a follow up question on Wodgina, is the restart contributing in any meaningful way to your second half results this year? Or is it mostly 2023? And thereafter story?
Kent Masters : So they'll probably be some volume coming through Wodgina in the second half, but it's not, I don't think it is material. So that'll start impacting in ‘23.
Operator: Our next question comes from Joel Jackson of BMO Capital Markets.
Joel Jackson: Hi, thanks, good morning. On slide 10, you gave your volume guidance, again per year. So you're going to something like 180,000 tons or something else I’ll see in ‘23? Could you maybe risk adjust that? How much of that incremental for next year is in the bag? How much maybe have to work for a bit harder and kind of get the ranges of how you get up to that number?
Kent Masters : So I think that I mean, if I understand your question from a volume standpoint, right, so there'll be -- it's ramping up at La Negra and Kemerton and some tolling volume. So it's -- we'll be producing tolling from Wodgina and ramping up at the facilities at Talison. And so it's pretty much within our control. So that's even put the risk however, you categorize each one of those, but it's probably we don't have to do anything extraordinary to get that. We have the plants that we built and now starting up, have to run and produce it volume. And then we just continue to ramp up La Negra, and we're going to have some toll volume and some of the Wodgina product before we're able to build conversion. So that that might be -- we've got -- the tolls we're using we use before. It's new product form. So there's a little bit of risk in that, but not -- it's not extraordinary.
Scott Tozier: Can I just add the other component is just the Qinzhou acquisition. So we start to close that. So it's progressing well. But again, there's potential risks but that just doesn't close.
Kent Masters : Yes, no, that's right. So that's probably the biggest -- that's probably the bigger risk in it.
Joel Jackson: Okay, then my second question would be the DoE seems to be throwing around a lot of money to battery metals to a lot of smaller companies these days, grants and loans, things like that. You could probably qualify for a bunch of this money. It's not a massive amount of money from where you guys sit, but it's probably a nice little kicker. Can you talk about that?
Kent Masters : Yes, I mean, look, it's money that's available strategically. It's in right, and we're working on that. So we're -- nothing that we can -- nothing we can announce today. But we're working on it.
Operator: The next question goes to Steve Richardson of Evercore.
Unidentified Analyst : Hello. Hi, this is Sean on for Steve. Just in terms of returning back to Wodgina and Kemerton production. Can you just please walk through how the volumes are fall into there then also in terms of Greenbushes, and how the COGS and the cost are monitoring throughout the year.
Kent Masters : So let's just I mean, Wodgina, I mean Wodgina, we are running Wodgina today, we're ramping up. But we will eventually told that we'll pull that volume until we get plants on that we can process through that. Kemerton is just it's a matter of ramping we've and we've kind of we've said historically, we bring a plant on we kind of our planning is we give it two years to run the full capacity, now we would hope to beat that. But that's kind of what we built in. That's how we build into our planning processes. And I know the other was about Talison. So that oh, that's the expansion, CGP2 is operating, and CGP3, which is the next one is we've broken ground on that. So we're ramping up. We're, CGP2, we're commissioning and ramping up, and we've just broken ground on CGP3, I think that's the right.
Scott Tozier: That's correct. CGP3 would come on and would be available on several years. And it would support some of the capacity expansions that are in one of our charts to talk about. Further China expansion comes in three, four. And then of course, as you already pointed out, Canada, the MARBL joint venture, some of those China plants, at least one would be a part of the joint venture potentially, and we would take that material.
Operator: And our next question, go to David Deckelbaum of Cowen.
David Deckelbaum: Thank you. Thanks for all for taking my questions today. Kent, I just wanted to follow up on the conversation around the mega, flex site. I believe the target was 100,000 tons per annum of conversion capacity. I just wanted to confirm whether you all felt that Kings Mountain and recycled feedstock would be enough to feed up to that capacity as a resource eventually worth it. It sounded like earlier, perhaps Eric was discussing perhaps another need for another asset to support that.
Kent Masters : Yes, so I'm thinking and again, it's prefeasibility. And it's still we're trying to make sure we understand exactly the resource at Kings Mountain. So we're doing more work on that. But we think that we could feed that mega, flex facility with Kings Mountain plus recite ultimately at steady state with recycled material that get to the scale that you're that you referenced 100,000 tons a year.
David Deckelbaum: Okay. And then I just want to follow up earlier on some of the conversations around upside volumes, it looks like in the current chart that you all, sort of are still assuming this 10,000 to 20,000 tons per annum of toll volumes, which is I guess, basically the levels that you're at in 2022. And how significant or how much available capacity is out there that you could theoretically toll into? Because I guess there's also the strategy of selling spodumene into the market, which seems like a pivot from sort of previous views that you all had, but just wondering volumetrically how much capacity upside do you think that there is in the market?
Kent Masters : So Eric can talk about the tolling, but just on spodumene, I mean, we're just being a little more flexible, that's a bridging strategy that we've not changed strategy long term about selling spodumene, we want to convert and sell to our end customers, the products that they use, the lithium salts. So if we have -- if we ramp up plants, you can't do all this perfectly right between conversion and mine. And we've decided to push the resources in advance to the mines because they have longer lead times typically. And we get them up and operating and if we've got resource available before we have conversion capacity will either toll it or we'll sell spodumene rather than let it and sale on the ground.
Eric Norris: Okay, so and to answer the question, there is no deviation from the strategy, no. Thank you.
Kent Masters : Yes. That's right.
Eric Norris: Yes, there's no deviation from the strategy, as to your question about the availability of tolling volume. There's still a healthy market of conversion capacity being built or operating in China without available spodumene to source against that. So it varies by year. And China's and a lot of these projects, it can be opaque. Sometimes you get the exact numbers. It's a big market, but it can be sometimes 60% to 70% utilized. So that implies that there's capacity out there in fact, we know this we are tolling now that's available or coming on, that we can take advantage of. But that is a bridging strategy to our own conversion assets and one would you prefer to do as opposed to selling spodumene directly into the market.
Operator: Our next question comes from Arun Viswanathan of RBC Capital Markets.
Arun Viswanathan: Great. Thanks for taking my question. Yes, so I guess I just wanted to ask more high level question. So you noted that obviously your contracts have your results or guidance has some upside if market prices stay where they are, but also some downside if we do receive from these present levels? So what would it take for the market to kind of go back to prior levels, obviously, $60 to $7 is a -- as a new normal? So is it really a new normal? Do we ever go back down into the lower 20s or 30s or 40s? Is there been any demand destruction or changes to the adoption curves that you've been observing, especially as the cost of lithium rises in the battery and the vehicle?
Kent Masters : Right, so that may, look, we're not going to call the long term price, because that we don't know that. And I think it will move up and down, it's not going to just go, not going to sit where it is forever, that's probably pretty confident in saying that, it will move around over time. But we see the market being tight on lithium for pretty long period of time, and then there might be periods like periods of oversupply, and that we see that several number of years out, but then that disappears pretty quickly. Soo we model that I'm sure all of you guys model that and everybody has their own opinion on it. But prices are going to move, they're going to move around. And we're not -- we can't call it. We do know that the cost to produce to get to the volume of the market needs goes up quite a bit from what we see the cost curve today, out over time, could it move into the 20s and 30s? At some point? It absolutely could. But we still -- we see the market being tight for a pretty long period of time. [Multiple Speakers]
Scott Tozier: You had another question that had to do with cost in the vehicle and technology. I mean, as you know, lithium is a small part of the cost of the battery. But it is seen as significant, as you pointed out escalation its costs over the past year. I think the other phenomenon that's important to note is the technology phenomenon around innovation and driving out. But longer range, energy density and penetration doesn't come from lower cost raw materials, it comes from innovation and energy density and more dense materials. So that's the movement towards higher nickel. That's the movement towards more elaborate chemistries on the anode side, and maybe potentially someday solid state. So those innovations are well and continue down that experience curve notwithstanding the price of lithium, which again, is a fairly small part of the cost of the battery.
Arun Viswanathan: Okay, that's helpful. And then maybe if I could just elaborate on that earlier, what you said the cost curve. Now, I guess, are you seeing most of the additions at the upper end of the cost curve outside of yourselves? And what would you kind of say is kind of a good range to think of as the cost curve, maybe the upper end? Should we just take kind of spodumene prices and use that and convert that into battery grade? Or how should we think about where the cost curve has moved to now?
Kent Masters : Well, I think, well, we're thinking -- we think about it as a longer term to get to the volumes the market needs over time. So new capacity coming on. And some of that is about the quality of the resource, where it is, the technology that you need, or even to develop in order to bring that to market. So we don't publish what our view of the cost curve. So we're not, I'm not going to talk about those particular numbers. But I think from our view, it's moved up over the last several years. And as the market requires more and more volume, it will continue to move up.
Operator: And the next question, go to Laurence Alexander of Jefferies.
Laurence Alexander: So good morning. How much could you flex the tolling side of the business? And I know the margins significantly different from your segment average. And secondly, with as you look at the opportunities around recycling, is there any incentive to shift your center of gravity downstream into more of the processing chemical or ways to integrate your knowledge of the chemistry with the downstream processing and capture more margin that way.
Scott Tozier: So, first of all, Lawrence on the tolling, I would say, we're evaluating that now there's, as per the earlier question, there's capacity in the marketplace. And we will have spodumene coming from MRL, the MARBL joint venture and our partner with MRL that we can put into the market. So it could flex upwards from the guidance that we have here that is possible. Our margins are slightly less, because you're paying several dollar a kilogram sort of see over what our normal costs would be. But obviously, at current pricing, that's fairly immaterial in the scheme of things. And then your second question, Lawrence was around recycling going downstream. I think we're looking at this now that we believe, if you look at what it takes to process black mass to various mineral components, and many of the unit operation, in fact we more than believe we know that many of the unit operations are very similar to what we do throughout our company and certainly in lithium. Many of the technologies are practiced in our existing operations to process mineral resources we do. And so other than just that last step processing to battery grade lithium, we're evaluating just how we partner, invest and develop that supply chain, which will be a regional effort from region to region, because it's very regionalized business recycling is. And so we're in that and well, as we develop that strategy further. We'll obviously share more details of that in future.
Operator: Thank you. That’s all the questions we have time for today. I will now hand back to Kent Masters for any closing remarks.
Kent Masters : Okay, thank you, Nadia. And thank you all for participation on our call today. The momentum we are experiencing in ‘22, combined with our pipeline of projects strongly positioned us to execute on profitable and sustainable growth for the longer term. I'm confident in our team's ability to drive value for all stakeholders by accelerating our growth in a sustainable way and to lead by example. Thank you for joining us.
Operator: Thank you. This concludes today's call. Thank you all for joining. You may now disconnect your lines. | [
{
"speaker": "Operator",
"text": "Hello, everyone, and welcome to the Q2 2022 Albemarle Corporation Earnings Conference Call. My name is Nadia, and I'll be moderating your call today. [Operator Instructions] I’ll now hand it over to your host Meredith Bandy, Vice President of Investor Relations and Sustainability to begin. Meredith, please go ahead. ."
},
{
"speaker": "Meredith Bandy",
"text": "Thank you, Nadia. And welcome, everyone, to Albemarle's second quarter 2022 earnings conference call. Our earnings were released after the close of market yesterday, and you'll find the press release and earnings presentation posted to our website under the Investors section at albemarle.com. Joining me on the call today are Kent Masters, Chief Executive Officer; and Scott Tozier, Chief Financial Officer; Raphael Crawford, President of Catalyst; Netha Johnson, President of Bromine; and Eric Norris, President of Lithium are also available for Q&A.. As a reminder, some of the statements made during this call, including our outlook, guidance, expected company performance, and timing of the expansion projects may constitute forward-looking statements within the meaning of federal securities laws. Please note the cautionary language about forward-looking statements contained in our press release and earnings presentation. That same language applies to this call. Please also note that some of our comments today refer to non-GAAP financial measures. A reconciliation to GAAP financial measures can be found in our earnings release and the appendix of our earnings presentation. And now I'll turn the call over to Kent."
},
{
"speaker": "Kent Masters",
"text": "Thanks Meredith. Thank you all for joining us today. On today’s call I’ll highlight our second quarter results and achievements. Scott will provide details on our financial results, outlook, balance sheet and capital allocation. I’ll then close our prepared remarks with an update on our operating model and strategic growth projects aimed at further strengthening our long-term financial performance and sustainable competitive advantages. Albemarle’s leadership position in Lithium and Bromine, coupled with our team’s ability to execute to the current inflationary environment led to another led to another quarter of strong results. In the second quarter, we generated net sales of $1.5 billion nearly double the prior year. Second quarter adjusted EBITDA of $610 million was over three times the prior year. Continuing the trend of EBITDA significantly outpacing sales growth. The supply demand balances remain tight in the markets we serve. Strong market prices and our continued success in contract renegotiation drove the tremendous strength we're experiencing in our lithium business. As a result, we are again raising our 2022 outlook and now expect to be free cash flow positive for the year. Scott will review the key elements of that outlook later on in the call. We are also successfully executing our growth strategy. Our Kemerton I lithium conversion plant in Western Australia achieved first product in July. I want to especially congratulate our teams in Western Australia for their hard work and dedication and achieving this goal. And lastly, we made a major announcement regarding plans to build an integrated lithium mega site in the United States. This will support our western expansion and the development of the battery material supply chain in North America. Now I'll turn the call over to Scott to walk through our financials."
},
{
"speaker": "Scott Tozier",
"text": "Thanks, Kent. And good morning, everyone. I'll begin on slide 5. During the quarter, we generated net sales of approximately $1.5 billion, a year-over-year increase of 91%. This is due primarily to increased momentum in our pricing efforts as well as higher volumes driven by strong demand across our diverse end markets, especially for our lithium and bromine businesses. We saw volumes and pricing grow in all three of our businesses. For the second quarter, net income attributable to Albemarle was $407 million, compared to $425 million in the prior year. As a reminder, the year ago, quarterly results included a onetime benefit of $332 million related to the sale of Fine Chemistry Services. EPS for the second quarter was $3.46, a year-over-year improvement of 300%, excluding the onetime benefit of the FCS sale. This overall performance was driven by strong net sales and margin improvement, partially offset by the ongoing inflationary pressures we are feeling across all three businesses. Turning to slide 6, second quarter adjusted EBITDA was $610 million, up 214% year-over-year. The primary driver the strong growth was higher lithium EBITDA. Lithium was up nearly $400 million compared to the prior year, driven by momentum in our contracting efforts and overall higher market prices. That's an increase of 350%. In fact, lithium second quarter EBITDA was greater than the EBITDA it generated in the full year of 2021. Bromine was also favorable year-over-year up nearly 50%, reflecting higher pricing driven by tight market conditions and an uptick in volumes, partially offset by raw material and freight inflation. Catalysts was negative in the quarter as higher sales volumes and pricing were more than offset by cost pressures, particularly for natural gas in Europe and raw materials. And finally, we also experienced an overall FX headwind of $14 million for the total company. Moving to slide 7, we are further increase in our 2022 outlook from our last announcement in late May, primarily to reflect the expected continued strength in execution in our lithium business and further improvements in bromine. We now expect 2022 total company net sales to be in the range of $7.1 billion to $7.5 billion, up about 115% to 125% versus last year. Adjusted EBITDA is expected to be between $3.2 billion and $3.5 billion, reflecting a year-over-year improvement of up to 300%. This implies EBITDA margins are expected to improve significantly to a range of 45% to 47% for the total company. Together, this translates to updated 2022 adjusted EPS guidance in the range of $19.25 to $22.25. That is about five times more than 2021. Additionally, we're increasing our net cash from operations guidance to a range of $1.4 billion to $1.7 billion. Driven by our updated sales and margin expectations. We are maintaining guidance for capital expenditures of $1.3 billion to $1.5 billion as we drive our lithium investments forward to meet increased customer demand. Together, the midpoint of our guidance implies approximately $150 million in positive free cash flow for the full year. And further if you assume our realized pricing remains relatively flat next year, we expect to continue to generate positive free cash flow in 2023 even with continued growth investments. Security supply remains the number one priority for our customers, and we are continuing to partner and work closely with them. We are pushing hard to meet those accelerating customer growth requirements. Regarding the quarterly progression of sales and EBITDA, on our last call, we indicated that we expect results to be relatively evenly split among quarters. Given the underlying strength across our portfolio, and continued momentum in our contracting efforts, we now expect second half adjusted EBITDA to be roughly 120% higher relative to the first half. Turning to the next slide for more detail on our outlook by segment. Our lithium businesses full year 2022 EBITDA is expected to be up more than 500% year-over-year, up from the previous outlook for growth of approximately 300%. The improved outlook reflects renegotiations of pricing on legacy fixed price contracts, and continued strong market pricing flowing through our index referenced variable price contracts. We now expect our average realized selling price to be up more than 225% to 250% year-over-year. This is the result of our successful efforts to renegotiate legacy contracts and implement more index referenced variable price contracts, as well as a significant increase in index prices. From the beginning of the year to today, indices are up 60% to 130%. And note that our outlook assumes Albemarle’s expected Q3 realized selling price remains constant into the fourth quarter. There's no change to our lithium volume outlook for the year. We continue to expect year-over-year volume growth in the range of 20% to 30% as we bring on new conversion assets, plus some additional tolling. There's potential upside to our outlook if market prices remain near current levels, or with additional contract renegotiations or additional tolling volumes. And conversely, there's potential downside with material, the clients and market pricing or volume shortfalls. For bromine, we are also raising our full year 2022 EBITDA expectations with year-over-year improvement in the range of 25% to 30% compared to the prior outlook of 15% to 20%. This revised guidance reflects continued strong demand and pricing from end markets such as fire safety solutions, and oilfield services. Plus other macro trends such as digitalization and electrification. We expect higher volumes of 5% to 10% following our successful execution of growth projects last year. For catalysts, full year 2022 EBITDA is expected to be down 25% to 65% year-over-year. This is below our prior outlook due to significant cost pressures, primarily related to natural gas in Europe, certain raw materials, as well as freight, partially offset by higher sales volumes and pricing. The large outlook range for Catalysts reflects increased volatility, and a lack of visibility particularly related to the war in Ukraine. Given the extraordinary circumstances and the resulting changes in oil and gas markets, the business continues to aggressively see costs pass-through, particularly for higher natural gas costs. The strategic review of the catalysts’ business is ongoing, but it is taking longer than we anticipated. As soon as we have any news, we will provide an update. Turning to slide 9 for an update on our lithium pricing and contracts. This slide reflects the expected split of our 2022 lithium revenues. Battery grade revenues are now expected to make up approximately 85% compared to 70% to 80% in our prior guidance, due to successful contract negotiations, and higher market indices. Of the total battery grade revenues, 15% is expected to be from short term spot purchase orders. 65% is expected to be from index reference variable price contracts. Pricing on these contracts generally reset with a three month lag and a number of these contracts do have floors and ceilings in place. The remaining 20% comes from Legacy fixed contracts with price reopener normally every 6 or 12 months. And since we last updated the outlook in late May, we have successfully repriced a portion of these contracts to better reflect the current market price environment. This segmented approach to contracting gives more flexibility for our customers, while allowing Albemarle to preserve upside and ensure returns on our growth investments. Our operations and project teams are also delivering volumetric growth. Slide 10 shows the expected lithium sales volumes including technical grade spodumene and tolling sales. In 2022, we expect volumes to improve 20% to 30% year-over-year. This growth is largely driven by our expansions at La Negra and Kemerton, the acquisition of Qinzhou as well as some additional tolling volumes. Looking forward, we expect volumes to grow approximately 20% per year from 2022 to 2025, driven primarily by the ramp up of new conversion assets. We see room for further upside from additional conversion assets such as our Greenfield in Meishan or additional tolling volumes. Turning to slide 11, our strong net cash from operations and solid balance sheet give us ample financial flexibility to execute our growth strategy. Our balance sheet is in great shape with $931 million of cash and available liquidity of $2.6 billion. Current net debt to adjusted EBITDA is approximately 1.7x with rising EBITDA from higher pricing and volumes, we expect leverage to trend lower in the near term. This will -- this gives us plenty of capacity to accelerate our growth investments or value creating M&A. During the second quarter, we extended our debt maturity profile through a public offering of senior notes, proceeds total approximately $1.7 billion, a portion of which was used to redeem senior notes maturing in 2024. 92% of our debt position is at a fixed rate, which buffers us against the impacts of rising interest rate environment. Before I turn the call back over to Kent, I wanted to briefly review our capital allocation priorities and our ability to adapt to market changes while building durable capacities to support growth. Our capital allocation priorities are unchanged, we remain committed to strategically grow our lithium and bromine capacity in a disciplined manner. Capacity growth will also be supported in organically by continuously assessing our portfolio and pursuing bolt-on acquisitions at attractive returns to strengthen our top tier resource base. A perfect example of this strategy is the $200 million Zhangjiagang’s acquisition that is expected to close in the second half of the year. Maintaining financial flexibility and shareholder returns are also key capital allocation priorities. We remain committed to maintaining an investment grade rating and a strong balance sheet to provide significant optionality to fund future growth. Finally, we also plan to continue to support our dividend. We are laser focused on the durability of our business. The management team and the board regularly review our capital allocation priorities and have identified levers we can pull to quickly adapt to changing market conditions if needed. These include slowing non growth CaPex, reducing discretionary spending and hiring, shifting production volumes to highest demand markets, and accelerating partnering and tolling arrangements to support cash generation. Additionally, a downturn may allow us to take advantage of lower priced acquisitions, capitalizing on the strength of our balance sheet. In summary, we believe Albemarle’s ability to maintain a focus on growth through all market conditions is strong, thanks to our operating model that Kent is going to discuss next."
},
{
"speaker": "Kent Masters",
"text": "Thanks, Scott. So let's turn to slide 13 to discuss our cost structure, and how we are managing inflation. Our vertical integration and access to low cost resources for lithium and bromine allow us to avoid the worst impacts of inflation and control our cost structure. For example, while approximately 45% of our costs come from raw materials and services, actually 20% of those costs relate to our own spodumene. The implementation of our operating model the Albemarle way of excellence, it’s also helping manage costs. In 2020, we identified our supply chain as a key area for improvement. At that time, we reorganized to form a global supply chain function and implemented a new Enhanced Procurement strategy that team's efforts are now paying dividends. Last year, our procurement team set a target to achieve $90 million in value creation by 2022 year end, we are on track to meet or exceed that target by about 40%. About half this from cost savings with lower year-over-year cost. And about half is from cost avoidance, where procurement efficiencies have allowed us to realize below market increases. An example of cost savings includes logistics efficiencies, minimizing material handling, maximizing equipment capacity and shortening haul routes. Cost avoidance includes using fewer suppliers and pooling buying for key raw materials and services to offset inflation. And other cases, we've shortened supply chains to improve resilience and reduce total cost. This success is driven by diverse teams, including supply chain, procurement and production scheduling. Thanks to everyone across the enterprise and around the globe, it took commitment from every individual to make this happen. Our operating model is also focused on building the structure, capabilities, discipline and design approach to enable faster capacity growth. As a leading lithium producer, Albemarle is investing in lithium production around the world, including China, Australia and the Americas. This year, we plan to deliver projects that more than double our annual capacity from 85,000 tons to 200,000 tons by year end. We are also progressing a portfolio of projects that can grow our conversion capacity to as much as 500,000 tons per year on a 100% bases. As you can see, the near term projects are largely in the Asia Pacific region. Longer term, we expect to transition to a more localized supply chain in North America and Europe. Turning to slide 15, our capacity additions in Australia and Asia significantly enhance our ability to leverage our low cost resource base. In terms of lithium conversion capacity, we've made progress on the regulatory approvals for the acquisition of the Qinzhou conversion facility. We continue to expect that acquisition to close in the second half of 2022. In the meantime, we continue to toll spodumene through this facility. As I mentioned earlier, Kemerton I has achieved first product. This important milestone signifies that the manufacturing processes and equipment can meet the project's design objectives. Our focus now is on qualifying our product with our customers. At our China Greenfield expansions, construction of a 50,000 ton per year lithium hydroxide conversion plant it Meishan is well underway. Importantly, with our ownership stakes at the Wodgina and Greenbushes lithium mines, we already have access to low cost spodumene to feed these conversion facilities. The restart of the Wodgina lithium mine by our JV partner Mineral Resources is going well. We continue to negotiate agreements to expand and restructure the MARBL joint venture and we'll update you when we have more information. We also have a 49% stake at Greenbushes. One of the best lithium resources in the world. The Talison joint venture is ramping up chemical-grade plant two or CGP2 and has approved construction of CGP3, which is broken ground. Our intention is to ramp up lithium resources in advance of conversion assets. In which case in the near term, we could be net long spodumene. If that's the case, we will elect to toll spodumene or sales spodumene into the market. If it's economical to do so, and if it allows us to bridge until new conversion assets ramp up. Albemarle is the leading global lithium producer with a significant US presence and access to some of the world's best resources. As such, we are well positioned to establish world class production of battery grade lithium that enables the localization of the battery supply chain in North America. This would offer important benefits to us based automotive OEMs seeking a de-risked local supply chain, more reliable logistics and a reduced carbon footprint. We plan to leverage our Kings Mountain lithium mine, a top tier resource and build a multi train conversion site in the southeast. This site would be capable of handling mineral resources from Kings Mountain, as well as recycled feedstock. This mega flex site would leverage Albemarle’s best-in-class know-how to design, build and commission both resource and conversion assets. This creates significant competitive advantages for Albemarle and its customers, while also addressing the need for localized lithium supply to support growing demand in North America. In closing on slide 17, we expect to achieve significant growth milestones this year, thanks to strong end market demand, as well as actions that we've taken to invest in profitable growth for lithium and bromine. Those investments are now paying off as we ramp up volumetric growth. To maintain our financial flexibility to fund growth through cash and our balance sheet, and to leverage our operating model to manage cost and execute our growth projects. So this concludes our prepared remarks. Now, I'll ask Nadia to open the question, open the call for questions."
},
{
"speaker": "Operator",
"text": "[Operator Instructions] Our first question today comes from PJ Juvekar of Citi."
},
{
"speaker": "PJ Juvekar",
"text": "Yes, good morning. Kent, your volume growth has been very impressive. Can you discuss your key steps you're taking at Kings Mountain in terms of building the mega site? What environmental permits do you need? Are you engaging with the community today? And the same question on Silver Peak? When you expand that what kind of production ramp up can you see?"
},
{
"speaker": "Kent Masters",
"text": "Right, so the two sides are slightly different scale. And so Kings Mountain is significant site, Silver Peak is smaller, but still the expansion is important. I mean, that is the only we're kind of lithium sourced in the US today. But at Kings Mountain, we're early in that process. We're still in pre-feasibility. So we've got to do permitting. But we have done a lot of work already. We've done all of the drilling necessary, well, we continue to do some of the drilling to make to understand the resource at Kings Mountain. But we still got to do permitting, we've engaged with the community. We've been doing community meetings for almost six months now maybe not quite six months early in the year that we started that process with public meetings, we've opened an office in the town so people can come in and ask questions. So we really engaged with the community early on. And we're working on the permitting processes that we have to go through but it's in pre- feasibility study. We feel confident we'll be able to get there at Kings Mountain, but there's a lot of work to do, including all the permitting."
},
{
"speaker": "PJ Juvekar",
"text": "Great, and then you have a strong balance sheet. You have been free cash flow positive this year. You talked about M&A. Can you give us some idea of what you would potentially be looking at? Would you look at technologies like DLE? Or what geographies would you look at? Thank you."
},
{
"speaker": "Kent Masters",
"text": "Yes, well, I think it's what we've really always talked about from an M&A standpoint. So we seeking virgin assets that we think are attractive so we would do that consider as a bolt-on technologies if we see technology to help us so direct lithium extraction, could be part of that. And then resources. So we continue. We're good on resources pretty close to the end of the decade. But we need to be planning now to build out our resource base past that. So I think those are the three primary categories."
},
{
"speaker": "Operator",
"text": "Our next question comes from Christopher Parkinson of Mizuho."
},
{
"speaker": "Christopher Parkinson",
"text": "Great, thank you so much for taking my question. Just turning to slide 18. The third and the fourth point, can you just give us a quick update on terms of some of the contracts negotiations on additional tolling, I mean, on the former, what percent are still up for renewal, that have essentially given you the momentum to raise guidance twice in the last quarter and a half or so. Just any color you could offer that would be very helpful. Thank you."
},
{
"speaker": "Eric Norris",
"text": "Good morning, Chris. It's Eric here. So what we've been able to do, just to recap this year is we've been able to renegotiate contracts that have opportunities for reopener or with customers who are seeking additional line commitments in the out years. And in order to entertain those discussions we've opened up, have been able to ask for higher prices on legacy contracts. We don't have any contracts that are expiring anytime soon. Most of our book of businesses is committed, we're very tight in the next year or two as we anticipate bringing on new capacity from some of the projects I can't describe. But that doesn't mean we won't have opportunities, there might be still some contracts that shift, the big thing that's happened in the past year has been the movement to know having two thirds under our index reference variable price, whereas the foremost that was fixed. Now our movement is going to be very much driven by market prices and some potential changes on the margins, but few contracts, or potentially, if prices remain where they are some resets on some of the fixed prices, contracts."
},
{
"speaker": "Christopher Parkinson",
"text": "Got it. And just a quick follow up just you've also seen OEMs make a very conscientious effort and yes been a little bit more decisive and attempting to lock-in incremental supply through, let's say, the middle in the balance of the decade. I mean, has that been fully reflected in your negotiations in terms of just what you're willing to commit to them? And as we progress over the next year or two, it seems like there's still a bit of a bottleneck in terms of the OEMs versus what's available in lithium in terms of better grade hydroxide. What else are you willing to do to help facilitate the growth plans? And how should we think about that, just from a broader market perspective you versus some of your peers. Thank you."
},
{
"speaker": "Kent Masters",
"text": "We're working with our customers. And we're being very aggressive about adding capacity. So I think you see that in our investment plans, and they're coming through now. And we get better at that. So the period, when those come on, we're able, we believe we're able to execute better from a conversion. We're good on resource for a number of years. But we still need to add that. And we work with the customers to do kind of unique arrangements. We're having conversations with those but with our customers about those, but they have to work for us. And we're working towards some arrangement like that. So and they may or may not come to pass. I am not again say that because those are conversations and discussions that we're having. But we're in those discussions. And we're committed to build capacity to serve the customer base over the long term."
},
{
"speaker": "Scott Tozier",
"text": "Yes, I think what's also unique, Chris, just to add is that we are speaking with OEMs, and battery companies on three different continents. Out in the out years, as you saw on the charts, we're looking towards Europe. So that's the further south, where we are established well now is in Asia. And where we've announced next we're headed is North America. And we've got the resource bases can't describe to be able to do that. So between that localization, which is very important to these OEMs and battery producers, the sustainability and principles in which we operate. And then some of the new technology areas we're focused in for next generation technology. The partnerships we strike are going to look -- are going to be at par with one of those dimensions. And we're not in a position where we need to raise capital. So we can look at and have been discussing with various producers, various OEMs, upfront and potentially forms of investment. But that's not a requirement for us. We don't need that capital. It would only be something we do as part of a broader deal to advance our strategic agenda and help our customers win in the market."
},
{
"speaker": "Operator",
"text": "And our next question comes from David Begleiter of Deutsche Bank."
},
{
"speaker": "David Begleiter",
"text": "Thank you. Good morning. Question for Eric. Eric, just on your slide 9, can you talk about the difference of pricing between the index reference contracts and the spot pricing in Q2. Another compare versus Q1."
},
{
"speaker": "Eric Norris",
"text": "I'm sorry, David, just to make sure I understand your question. You're wondering how they compare now the prices versus back in Q2. Sorry to ask --"
},
{
"speaker": "David Begleiter",
"text": "The price difference between index referencing stock prices in Q2 versus a differential in Q1?"
},
{
"speaker": "Eric Norris",
"text": "Oh, okay. I'm sorry, we don't give enough detail and disclose that. But I will say that you know spot prices you would know by looking at indices are, they vary, but currently in the low 60s, and in China, they're actually some of the -- some contracts in outside of China are even higher now at $70. We are not there yet on our index pricing, which is one of the reasons our guidance and prices stay where they are, we could continue to have a rising mix, increase in our variable based contracts."
},
{
"speaker": "David Begleiter",
"text": "Understood. And just on the southeast project, can you give now any cost or timing indications for their project?"
},
{
"speaker": "Eric Norris",
"text": "David, we have not given out any costs yet, since it's really prefeasibility. So timing wise, it's going to be later in the decade when that would come online, clearly, it needs to have a feedstock. With a mine, that's probably the long pole in the tent."
},
{
"speaker": "Operator",
"text": "And the next question goes to Josh Specter of UBS."
},
{
"speaker": "James Cannon",
"text": "Yes, hey, guys, this is James Cannon on for Josh. Just wondering why it seems like the sale dropped through the EBITDA this earnings upgrade is much higher than the last updates to the year. Can you give any color as to why that is? And similarly on SCF? Has anything in the underlying business change to improve that?"
},
{
"speaker": "Scott Tozier",
"text": "Yes, James, I think that the big difference is this upgrade has been purely driven by price. So you're seeing that drop through. And we're not seeing the same impact from spodumene which was a drag. So the spodumene price increases was a drag on our earnings in the last guidance. As you look at free cash flow, we continue to see improvements. They're driven by the growth in EBITDA and we're because of some of the tolling efforts that we're doing, we're actually absorbing some of the inventory that we didn't have before. So seeing a better working capital profile as a result."
},
{
"speaker": "Operator",
"text": "And our next question goes to Colin Rusch of Oppenheimer."
},
{
"speaker": "Colin Rusch",
"text": "Thanks so much. Can you just talk a little bit about the ramp up in Kemerton and any surprises you're seeing at this point, any concerns around labor or any equipment that you're concerned about here as we start moving forward."
},
{
"speaker": "Kent Masters",
"text": "Yes, so I mean, look, where we've just -- we made first product last month, and we're just starting to ramp up. So I think the key thing for us, when we were able to make product and are comfortable with the quality, it means that our process chemistry is right and so there are no surprises really around the kind of core process chemistry around that. So that was a big milestone, that's kind of the first big hurdle that you want to clear. And then now it's just getting everything run at scale, and get purities up to the, to our specifications. So as you kind of run in a new plant, we continuously see that the spec on battery grade material is very high. And so it just takes a little bit of time to get to that and it takes volume to do that. So it's just about ramping up. We feel very good about the process chemistry and that we that the plant will be a good operating plant. It's just that we need a little bit of time to ramp it up and get to those purities we need and then we have to go through the qualification process with our customers. So that's on the doubt. That's on the first train second train is still on schedule that we've indicated in the past and the learnings we had on train one we've stumbled a bit on train one with issues and getting it there. We think, we -- as we saw those we've rectified that for train two. There are still labor issues in Western Australia but I think we're through the worst of that, because we're past most of the big construction elements of it. So now we're into commissioning on one and just finishing up construction on two. There's still labor issues in the operating facility to some degree, but that's kind of business as usual in Western Australia, I would say."
},
{
"speaker": "Colin Rusch",
"text": "Thanks so much. And then on the North America, potential expansion, can you just talk about philosophically how you're thinking about contracting that out. Is that something where you would think about taking in prepayments to lock-in volumes of customers? How far down the road, are you in terms of the thought process and the discussions on off tech for that facility?"
},
{
"speaker": "Kent Masters",
"text": "Well, we're having discussions with people, but we're not, I would say, we're not very far down there. We're not locked anything in and we have some ideas around some unique models. And we're having conversations with people about that."
},
{
"speaker": "Operator",
"text": "And our next question goes to Vincent Andrews of Morgan Stanley."
},
{
"speaker": "Vincent Andrews",
"text": "Thank you and good morning, everyone. Kent, I think when you discuss the mega project, you indicated an ability to take recycled feedstock, I just was curious. One just for that mega project, how much of a contributor you thought that would be. And whether your customers are telling or indicating that obviously, maybe more in the out years, and anytime soon, they would like to have some percentage of recycled feedstock in the mix of lithium that they procure."
},
{
"speaker": "Kent Masters",
"text": "Yes, so I mean it's a big part of the conversation. And it's about recycling, creating a recycle loop through the system. It is the years out, but we have to design it in. And so we think we can build the -- we'll build it in phases, but that ultimately will operate a recycled facility, the lower volumes at time, but we'll have time to ramp that up and really learn how to use that optimize that. And that would kind of be our facility that we would learn off as well. So it's part of we're trying to think ahead and design that and design that into a facility so we get scale with the other operating facilities and have the benefit of having an operating plant next door."
},
{
"speaker": "Operator",
"text": "And the next question goes to Kevin McCarthy of Vertical Research Partners."
},
{
"speaker": "Cory Murphy",
"text": "Hi, good morning. This Cory on for Kevin. Going back to slide 9 with the contract breakdown in lithium, I am curious versus last quarter, you have more index referenced variable price contracts, right? 65% versus 50%. And the fixed contract pieces down to 20% from 30% of your battery grade revenues. Do you have a number in mind for how low you can go on in terms of heading fix contracts? Are you trying to get to all index reference price contracts?"
},
{
"speaker": "Kent Masters",
"text": "Yes, so I think I mean, we've talked about this for a while. And we've always said we're not sure where this ends up, it is a little bit about how our customers want to contract and then the direction that we're trying to go. So what you're seeing in that is just how the math is evolving. So we've had -- we've upgraded, we've changed contract from those fixed. But remember, the fixed prices adjust over time, so they are not really fixed. And we're trying to shorten that period that we as they adjust. So I'm not -- I don't really want to call the mix. I mean, we had one time said we thought it might be a third, a third, a third between those categories. And it's turned out to be quite different. We do want to have some in the spot category that gives us flexibility. But I don't know, it's hard to say where it goes. We're not necessarily absolutely driving it to that variable price. But we kind of liked that model where it's index referenced and variable. And I think our customers are getting comfortable with it as well."
},
{
"speaker": "Scott Tozier",
"text": "The other moving piece that as you look at that chart between different presentations is of course, where the market indices are. And so that can drive some mix shifts in those percentages, as you go forward."
},
{
"speaker": "Cory Murphy",
"text": "Got it. And then I guess to stick with that slide similar question in terms of change quarter- over-quarter, last quarter you mentioned product offering, this quarter you mentioned the partnership offering and in the context of one of your competitors receiving a large upfront payment for future capacity. Have you approached anybody about similar upfront payments for future lithium capacity? Or maybe you could talk sort of the philosophical approach to how you want to contract future volumes. Thanks."
},
{
"speaker": "Kent Masters",
"text": "Well, I think we've migrated our philosophy around pricing contract over time. And we talked about that quite a bit not that's coming to fruition. They are unique models we've been having. We've had discussions for years with people about prepayments and investments and things like that. We've not done that yet. It's not that we're opposed to it. That has to fit in our philosophy, and it has to work for us. And that -- and it's probably more relevant a few years ago, when we needed more cash for our investments and tool. It's less important for us today. But we're still open for those investments, but we consider them strategic as part of a relationship and not just because we need to cash."
},
{
"speaker": "Operator",
"text": "And the next question goes to Alex Yefremov of KeyBanc Capital Markets."
},
{
"speaker": "Alex Yefremov",
"text": "Thank you and good morning, everyone. As you resign these lithium contracts, what's your philosophy towards the floor and the ceiling in those contracts? Are you widening that range? Are you narrowing it? Is it kind of staying the same versus what you held in general last year?"
},
{
"speaker": "Kent Masters",
"text": "Yes, well, I would. I mean, it's a philosophy, but they are widening and going up. So there, it is definitely not narrowing so widening. And they're moving up. I guess that's our philosophy."
},
{
"speaker": "Alex Yefremov",
"text": "I guess that I should assume that the floor is also moving up. Is it fair?"
},
{
"speaker": "Kent Masters",
"text": "Absolutely."
},
{
"speaker": "Alex Yefremov",
"text": "And as a follow up question on Wodgina, is the restart contributing in any meaningful way to your second half results this year? Or is it mostly 2023? And thereafter story?"
},
{
"speaker": "Kent Masters",
"text": "So they'll probably be some volume coming through Wodgina in the second half, but it's not, I don't think it is material. So that'll start impacting in ‘23."
},
{
"speaker": "Operator",
"text": "Our next question comes from Joel Jackson of BMO Capital Markets."
},
{
"speaker": "Joel Jackson",
"text": "Hi, thanks, good morning. On slide 10, you gave your volume guidance, again per year. So you're going to something like 180,000 tons or something else I’ll see in ‘23? Could you maybe risk adjust that? How much of that incremental for next year is in the bag? How much maybe have to work for a bit harder and kind of get the ranges of how you get up to that number?"
},
{
"speaker": "Kent Masters",
"text": "So I think that I mean, if I understand your question from a volume standpoint, right, so there'll be -- it's ramping up at La Negra and Kemerton and some tolling volume. So it's -- we'll be producing tolling from Wodgina and ramping up at the facilities at Talison. And so it's pretty much within our control. So that's even put the risk however, you categorize each one of those, but it's probably we don't have to do anything extraordinary to get that. We have the plants that we built and now starting up, have to run and produce it volume. And then we just continue to ramp up La Negra, and we're going to have some toll volume and some of the Wodgina product before we're able to build conversion. So that that might be -- we've got -- the tolls we're using we use before. It's new product form. So there's a little bit of risk in that, but not -- it's not extraordinary."
},
{
"speaker": "Scott Tozier",
"text": "Can I just add the other component is just the Qinzhou acquisition. So we start to close that. So it's progressing well. But again, there's potential risks but that just doesn't close."
},
{
"speaker": "Kent Masters",
"text": "Yes, no, that's right. So that's probably the biggest -- that's probably the bigger risk in it."
},
{
"speaker": "Joel Jackson",
"text": "Okay, then my second question would be the DoE seems to be throwing around a lot of money to battery metals to a lot of smaller companies these days, grants and loans, things like that. You could probably qualify for a bunch of this money. It's not a massive amount of money from where you guys sit, but it's probably a nice little kicker. Can you talk about that?"
},
{
"speaker": "Kent Masters",
"text": "Yes, I mean, look, it's money that's available strategically. It's in right, and we're working on that. So we're -- nothing that we can -- nothing we can announce today. But we're working on it."
},
{
"speaker": "Operator",
"text": "The next question goes to Steve Richardson of Evercore."
},
{
"speaker": "Unidentified Analyst",
"text": "Hello. Hi, this is Sean on for Steve. Just in terms of returning back to Wodgina and Kemerton production. Can you just please walk through how the volumes are fall into there then also in terms of Greenbushes, and how the COGS and the cost are monitoring throughout the year."
},
{
"speaker": "Kent Masters",
"text": "So let's just I mean, Wodgina, I mean Wodgina, we are running Wodgina today, we're ramping up. But we will eventually told that we'll pull that volume until we get plants on that we can process through that. Kemerton is just it's a matter of ramping we've and we've kind of we've said historically, we bring a plant on we kind of our planning is we give it two years to run the full capacity, now we would hope to beat that. But that's kind of what we built in. That's how we build into our planning processes. And I know the other was about Talison. So that oh, that's the expansion, CGP2 is operating, and CGP3, which is the next one is we've broken ground on that. So we're ramping up. We're, CGP2, we're commissioning and ramping up, and we've just broken ground on CGP3, I think that's the right."
},
{
"speaker": "Scott Tozier",
"text": "That's correct. CGP3 would come on and would be available on several years. And it would support some of the capacity expansions that are in one of our charts to talk about. Further China expansion comes in three, four. And then of course, as you already pointed out, Canada, the MARBL joint venture, some of those China plants, at least one would be a part of the joint venture potentially, and we would take that material."
},
{
"speaker": "Operator",
"text": "And our next question, go to David Deckelbaum of Cowen."
},
{
"speaker": "David Deckelbaum",
"text": "Thank you. Thanks for all for taking my questions today. Kent, I just wanted to follow up on the conversation around the mega, flex site. I believe the target was 100,000 tons per annum of conversion capacity. I just wanted to confirm whether you all felt that Kings Mountain and recycled feedstock would be enough to feed up to that capacity as a resource eventually worth it. It sounded like earlier, perhaps Eric was discussing perhaps another need for another asset to support that."
},
{
"speaker": "Kent Masters",
"text": "Yes, so I'm thinking and again, it's prefeasibility. And it's still we're trying to make sure we understand exactly the resource at Kings Mountain. So we're doing more work on that. But we think that we could feed that mega, flex facility with Kings Mountain plus recite ultimately at steady state with recycled material that get to the scale that you're that you referenced 100,000 tons a year."
},
{
"speaker": "David Deckelbaum",
"text": "Okay. And then I just want to follow up earlier on some of the conversations around upside volumes, it looks like in the current chart that you all, sort of are still assuming this 10,000 to 20,000 tons per annum of toll volumes, which is I guess, basically the levels that you're at in 2022. And how significant or how much available capacity is out there that you could theoretically toll into? Because I guess there's also the strategy of selling spodumene into the market, which seems like a pivot from sort of previous views that you all had, but just wondering volumetrically how much capacity upside do you think that there is in the market?"
},
{
"speaker": "Kent Masters",
"text": "So Eric can talk about the tolling, but just on spodumene, I mean, we're just being a little more flexible, that's a bridging strategy that we've not changed strategy long term about selling spodumene, we want to convert and sell to our end customers, the products that they use, the lithium salts. So if we have -- if we ramp up plants, you can't do all this perfectly right between conversion and mine. And we've decided to push the resources in advance to the mines because they have longer lead times typically. And we get them up and operating and if we've got resource available before we have conversion capacity will either toll it or we'll sell spodumene rather than let it and sale on the ground."
},
{
"speaker": "Eric Norris",
"text": "Okay, so and to answer the question, there is no deviation from the strategy, no. Thank you."
},
{
"speaker": "Kent Masters",
"text": "Yes. That's right."
},
{
"speaker": "Eric Norris",
"text": "Yes, there's no deviation from the strategy, as to your question about the availability of tolling volume. There's still a healthy market of conversion capacity being built or operating in China without available spodumene to source against that. So it varies by year. And China's and a lot of these projects, it can be opaque. Sometimes you get the exact numbers. It's a big market, but it can be sometimes 60% to 70% utilized. So that implies that there's capacity out there in fact, we know this we are tolling now that's available or coming on, that we can take advantage of. But that is a bridging strategy to our own conversion assets and one would you prefer to do as opposed to selling spodumene directly into the market."
},
{
"speaker": "Operator",
"text": "Our next question comes from Arun Viswanathan of RBC Capital Markets."
},
{
"speaker": "Arun Viswanathan",
"text": "Great. Thanks for taking my question. Yes, so I guess I just wanted to ask more high level question. So you noted that obviously your contracts have your results or guidance has some upside if market prices stay where they are, but also some downside if we do receive from these present levels? So what would it take for the market to kind of go back to prior levels, obviously, $60 to $7 is a -- as a new normal? So is it really a new normal? Do we ever go back down into the lower 20s or 30s or 40s? Is there been any demand destruction or changes to the adoption curves that you've been observing, especially as the cost of lithium rises in the battery and the vehicle?"
},
{
"speaker": "Kent Masters",
"text": "Right, so that may, look, we're not going to call the long term price, because that we don't know that. And I think it will move up and down, it's not going to just go, not going to sit where it is forever, that's probably pretty confident in saying that, it will move around over time. But we see the market being tight on lithium for pretty long period of time, and then there might be periods like periods of oversupply, and that we see that several number of years out, but then that disappears pretty quickly. Soo we model that I'm sure all of you guys model that and everybody has their own opinion on it. But prices are going to move, they're going to move around. And we're not -- we can't call it. We do know that the cost to produce to get to the volume of the market needs goes up quite a bit from what we see the cost curve today, out over time, could it move into the 20s and 30s? At some point? It absolutely could. But we still -- we see the market being tight for a pretty long period of time. [Multiple Speakers]"
},
{
"speaker": "Scott Tozier",
"text": "You had another question that had to do with cost in the vehicle and technology. I mean, as you know, lithium is a small part of the cost of the battery. But it is seen as significant, as you pointed out escalation its costs over the past year. I think the other phenomenon that's important to note is the technology phenomenon around innovation and driving out. But longer range, energy density and penetration doesn't come from lower cost raw materials, it comes from innovation and energy density and more dense materials. So that's the movement towards higher nickel. That's the movement towards more elaborate chemistries on the anode side, and maybe potentially someday solid state. So those innovations are well and continue down that experience curve notwithstanding the price of lithium, which again, is a fairly small part of the cost of the battery."
},
{
"speaker": "Arun Viswanathan",
"text": "Okay, that's helpful. And then maybe if I could just elaborate on that earlier, what you said the cost curve. Now, I guess, are you seeing most of the additions at the upper end of the cost curve outside of yourselves? And what would you kind of say is kind of a good range to think of as the cost curve, maybe the upper end? Should we just take kind of spodumene prices and use that and convert that into battery grade? Or how should we think about where the cost curve has moved to now?"
},
{
"speaker": "Kent Masters",
"text": "Well, I think, well, we're thinking -- we think about it as a longer term to get to the volumes the market needs over time. So new capacity coming on. And some of that is about the quality of the resource, where it is, the technology that you need, or even to develop in order to bring that to market. So we don't publish what our view of the cost curve. So we're not, I'm not going to talk about those particular numbers. But I think from our view, it's moved up over the last several years. And as the market requires more and more volume, it will continue to move up."
},
{
"speaker": "Operator",
"text": "And the next question, go to Laurence Alexander of Jefferies."
},
{
"speaker": "Laurence Alexander",
"text": "So good morning. How much could you flex the tolling side of the business? And I know the margins significantly different from your segment average. And secondly, with as you look at the opportunities around recycling, is there any incentive to shift your center of gravity downstream into more of the processing chemical or ways to integrate your knowledge of the chemistry with the downstream processing and capture more margin that way."
},
{
"speaker": "Scott Tozier",
"text": "So, first of all, Lawrence on the tolling, I would say, we're evaluating that now there's, as per the earlier question, there's capacity in the marketplace. And we will have spodumene coming from MRL, the MARBL joint venture and our partner with MRL that we can put into the market. So it could flex upwards from the guidance that we have here that is possible. Our margins are slightly less, because you're paying several dollar a kilogram sort of see over what our normal costs would be. But obviously, at current pricing, that's fairly immaterial in the scheme of things. And then your second question, Lawrence was around recycling going downstream. I think we're looking at this now that we believe, if you look at what it takes to process black mass to various mineral components, and many of the unit operation, in fact we more than believe we know that many of the unit operations are very similar to what we do throughout our company and certainly in lithium. Many of the technologies are practiced in our existing operations to process mineral resources we do. And so other than just that last step processing to battery grade lithium, we're evaluating just how we partner, invest and develop that supply chain, which will be a regional effort from region to region, because it's very regionalized business recycling is. And so we're in that and well, as we develop that strategy further. We'll obviously share more details of that in future."
},
{
"speaker": "Operator",
"text": "Thank you. That’s all the questions we have time for today. I will now hand back to Kent Masters for any closing remarks."
},
{
"speaker": "Kent Masters",
"text": "Okay, thank you, Nadia. And thank you all for participation on our call today. The momentum we are experiencing in ‘22, combined with our pipeline of projects strongly positioned us to execute on profitable and sustainable growth for the longer term. I'm confident in our team's ability to drive value for all stakeholders by accelerating our growth in a sustainable way and to lead by example. Thank you for joining us."
},
{
"speaker": "Operator",
"text": "Thank you. This concludes today's call. Thank you all for joining. You may now disconnect your lines."
}
] | Albemarle Corporation | 18,671 |
ALB | 1 | 2,022 | 2022-05-05 10:20:00 | Operator: Hello, everyone, and thank you for joining the Q1 2022 Albemarle Corporation Earning Conference Call. My name is Terrence, and I'll be moderating your call today. Before I hand over to your host Meredith Bandy. [Operator Instructions]. I now have the pleasure of handing you over to Meredith Bandy, Vice President of Investor Relations and Sustainability. Please go ahead, Meredith.
Meredith Bandy: All right. Thank you, and welcome, everyone, to Albemarle's First Quarter 2022 Earnings Conference Call. Our earnings were released after the close of market yesterday, and you'll find the press release and earnings presentation posted on our website under the Investors section at albemarle.com. Joining me on the call today are Kent Masters, our Chief Executive Officer; Scott Tozier, Chief Financial Officer; Raphael Crawford, President, Catalyst; Netha Johnson, President, Bromine; and Eric Norris, President, Lithium. As a reminder, some of the statements made during this call, including our outlook, guidance, expected company performance and timing of the expansion projects may constitute forward-looking statements within the meaning of federal securities laws. Please note the cautionary language about forward-looking statements contained in our press release and earnings presentation, that same language applies to this call. Please also note that some of our comments today refer to non-GAAP financial measures. A reconciliation to GAAP financial measures can be found in our earnings release and the appendix of our earnings presentation. And now I’ll turn the call over to Kent.
Kent Masters: Thanks, Meredith, and thank you all for joining us today. On today's call, I will highlight our results and achievements during the recent quarter. Scott will provide more details on our financial results, outlook and balance sheet. I will then close our prepared remarks with an update on our growth projects and sustainability before opening the call for questions. Albemarle's leadership positions in lithium and bromine and our team's ability to execute have enabled us to generate increasingly strong results. In the first quarter, we generated net sales of $1.1 billion, up 44% compared to prior year. And that's excluding Fine Chemistry Services in the comparison, which we sold in June of last year. This fundamental strength allowed us to more than double our EBITDA year-over-year. The supply/demand balance remains tight in the markets we serve. This has enabled us to significantly increase our 2022 outlook based on continued pricing strength in our lithium and bromine businesses. Scott will dive into the key elements of that outlook later in today's presentation. In terms of operational highlights for the quarter, the restart of our Wodgina lithium mine in our MARBL joint venture is progressing well. First, spodumene concentrate from Train 1 is expected in May. We've agreed with our partners to accelerate the restart of Train 2 with the first spodumene concentrate from that train lie. Together, these two trains can feed conversion assets with annual capacity of around 70,000 tons of lithium hydroxide. Now I'll turn the call over to Scott to walk through our financials.
Scott Tozier: Thanks, Kent, and good morning, everyone. I'll begin on Slide 5. During the quarter, we generated net sales of $1.1 billion, a year-over-year increase of 36%, including the FCS business, which we sold in June last year. This is due primarily to increased pricing as well as higher volumes driven by strong demand from diverse end markets, especially for our lithium and bromine businesses. For the first quarter, net income attributable to Albemarle was $253 million, up $158 million from the prior year because of the strong net sales, partially offset by inflationary cost pressures. This includes the impact of natural gas prices in Europe on our catalyst business. Adjusted diluted EPS for the first quarter was $2.38. The primary adjustments to earnings were $0.07 add-back for a loss on property sales and a $0.19 add-back for tax-related items. On Slide 6, I'll walk you through our first quarter adjusted EBITDA. For the first quarter, our adjusted EBITDA was $432 million, up 107% year-over-year. The primary driver [Technical difficulty] pricing, driven by the move to index referenced variable price contracts and higher market pricing. Lithium also benefited from the sales of lower-cost inventories, including a one-time sale of spodumene stockpiled during the initial start-up of Wodgina. Bromine was also favorable year-over-year, reflecting higher pricing driven by tight market conditions and a slight uptick in volumes that was partially offset by raw material and freight inflation. Catalyst was down relative to the prior year, primarily driven by higher raw material costs and lower volumes. That was partially offset by pricing. And lastly, corporate expense and foreign exchange were mostly flat year-over-year. Moving to Slide 7. We have meaningfully increased our 2022 outlook primarily to reflect continued strength in our lithium business. I'll discuss our lithium outlook in greater detail in just a moment. For the total company, we now expect 2022 net sales to be in the range of $5.2 billion to $5.6 billion, up about 60% to 70% versus prior year. Adjusted EBITDA is expected to be between $1.7 billion and $2 billion, reflecting a year-over-year improvement of 120% at the midpoint of the range. This implies a total company EBITDA margin in the range of 33% to 36%. And together, this translates to updated 2022 adjusted diluted EPS guidance in the range of $9.25 to $12.25 compared to $4.04 in 2021. Additionally, we are maintaining our CapEx guidance range of $1.3 billion to $1.5 billion as we drive our lithium investments forward to meet increased customer demand. You may have noticed that we widened the range of our outlook to prudently reflect greater volatility in pricing for sales and inflation for cost of goods sold against the backdrop of a turbulent macro environment. And regarding the quarterly progression of sales and EBITDA, on our last call, we indicated that we expected Q1 to be our strongest quarter of the year, primarily due to higher pricing and sales of low-cost inventory. Given the continued strong pricing and rising volumes, we now expect our second half results to be about 55% of the total year. Turning to the next slide for more detail on our lithium outlook. Lithium's full year 2022 EBITDA is expected to be up 200% to 225% year-over-year, up from our previous outlook for growth of around 75%. We now expect our average realized selling price to be about double last year. This is the result of our efforts to move toward index referenced variable price contracts and a significant increase in index prices. We also have better line of sight to price in the full year. From the beginning of the year to today, indices are up between 85% and 125%. We're also assuming that our expected Q2 selling price remains at that level for the rest of the year. If current market prices remain at historically strong levels for the balance of the year, there would be upside to this guidance. There could also be additional upside if we transition additional existing contracts from fixed to variable pricing. However, if we see material declines from current market pricing or volume shortfalls, there would be downside to this guidance. There's no change to our lithium volume outlook for the year. We still expect year-over-year volume growth in the range of 20% to 30% as we bring on new conversion assets, particularly La Negra III and IV and Kemerton 1. For bromine, we are raising our full year 2022 EBITDA expectations with a year-over-year improvement of 15% to 20%. This revised guidance reflects higher pricing related to strong fire safety demand, supported by macro trends such as digitalization and electrification. We also expect higher volumes following our successful expansion last year in Jordan. For Catalysts, 2022 EBITDA is expected to be flat to down 65% year-over-year. This is below our prior outlook due to significant cost pressures primarily related to natural gas in Europe and certain raw materials and freight, partially offset by higher pricing. The large outlook range for Catalyst reflects increased volatility and lack of visibility, particularly related to the war in Ukraine. Given the extraordinary circumstances and the resulting changes in oil and gas markets, the business is aggressively seeking to pass through higher natural gas pricing to its customers. As previously discussed, we continue to expect a strategic review of the Catalyst business to be completed later this quarter. The review is intended to maximize value and position the business for success while enabling us to focus on growth. I will now turn to Slide 9 for a deeper dive on our lithium contracts and pricing. With the change in guidance, you can now see we have more exposure to changing market indices. Our segmented approach gives more flexibility to customers while still allowing Albemarle to preserve its upside and returns on our growth investments. This slide reflects the expected split of our 2022 revenues updated for current pricing. Battery-grade revenues are now expected to make up 70% to 80% of our 2022 revenues, of which 20% is expected to be from purchase orders on higher short-term pricing; about half are expected to be from contracts with variable pricing mechanisms, typically indexed reference with a 3- to 6-month lag; and the remaining 30% is from fixed price contracts. These fixed contracts also have price opener mechanisms to change prices over time. We continue to work with these customers to transition to contracts with variable index reference pricing. These negotiations are ongoing and progressing well. If we are successful, this could provide additional upside to our current outlook for the Lithium business. Following our last earnings call, we received a lot of questions regarding our expected lithium margins, so I wanted to provide some additional color on the moving pieces on Slide 10. We expect lithium margins to improve in 2022 driven by higher pricing, partially offset by the progressive commissions we pay in Chile under our CORFO contract. Another item to consider is the impact from higher fixed costs related to the startup and ramp of our new facilities such as the Wodgina mine and our La Negra and Kemerton conversion assets as well as the potential acquisition of the Chenzhou conversion plan. These plants are expected to more than double our lithium production. Over time, the impact of fixed costs on margins will diminish as production ramps and costs are absorbed. As a reminder, Albemarle calculates EBITDA by including joint venture equity income on an after-tax basis. This year, because of higher spodumene transfer pricing from our Greenbushes mine, this tax impact is much more meaningful than it has been in the past. This is simply a result of the line item where the tax hits our income statement. Albemarle remains fully integrated from resource to conversion. So effectively, we pay ourselves this higher spodumene pricing. On a completely pretax basis, lithium EBITDA margins are expected to be between 55% and 60% in 2022. Slide 11 highlights our expected volume ramp as our new lithium conversion facilities are completed. Last year, we converted 88,000 metric tons LCE including conversion at Silver Peak and Kings Mountain, Xinyu and Chengdu in China, and La Negra I and II in Chile. We are in the process of more than doubling conversion capacity with the expansions at La Negra and Kemerton, plus the acquisition of the Shinzo plant. We typically expect it to take about two years to ramp to full capacity at a new plan, including roughly six months for customer qualification. Tying all of this together, we expect to achieve [Technical Difficulty]. Total lithium volumes are expected to be higher than that, including technical-grade spodumene sales of about 10,000 tons per year, tolling volumes of anywhere between 0 and 20,000 tons per year, depending on market dynamics and [Technical Difficulty] the spodumene, plus any additional conversion capacity we buy or build during this period. Finally, let's turn to Slide 12 to look at our strong balance sheet and cash flow. Our 2022 revised operating cash flow guidance is $650 million at the midpoint. Relative to 2021, you can see incremental cash flow driven by the higher net income, adding back higher depreciation. This is partially offset by higher working capital related to higher sales volumes and pricing, plus higher cost of raw materials and inventories. As a reminder, working capital typically averages about 25% of net sales. Our balance sheet is in great shape with $463 million of cash and liquidity of almost $2 billion. Current net debt to adjusted EBITDA is approximately 1.9 times, with rising EBITDA from higher pricing and volumes, we expect leverage to remain at or below our target range of 2 to 2.5 times. Our balance sheet supports the CapEx for our lithium investments to meet growing customer demand. Following our equity offering early last year, we repaid debt with the intention of relevering as needed to fund capital projects. We are actively evaluating options to do just that. We are planning to be in the debt market this quarter if market conditions are favorable. We remain committed to maintaining our investment-grade credit rating, and the debt markets provide a favorable avenue of acquiring additional capital. With that, I'll turn it back to Kent for an update on our projects on Slide 13.
Kent Masters: Thanks, Scott. First, let's look at a few of our expansions in Asia Pacific. Albemarle was focused on expanding global lithium conversion capacity to leverage our low-cost resource base. The acquisition of the Qinzhou conversion facility is now expected to close in the second half of this year as we continue to work through regulatory approvals. We look forward to closing this transaction to bring an additional 25,000 tons of lithium to the market. The commissioning process at Kemerton 1 is progressing well. We have introduced spodumene into the process, and we expect to achieve first product by the end of the month. Kemerton II remains on track for mechanical completion later this year. At our China greenfield expansions, we have broken ground at Meishan to construct a 50,000 ton per year hydroxide conversion facility. There are also options to expand that facility. The second China greenfield project at Zhangjiaghang is currently in the engineering phase, and we are looking at options to produce either carbonate or hydroxide. Importantly with our ownership stakes at Wodgina and Greenbushes lithium mines, we already have access to low cost spodumene to feed these conversion facilities. As I mentioned previously, the restart of the Wodgina lithium mine by our JV partner Mineral Resources, is going well and we continue to negotiate agreements to expand and restructure the MARBL the joint venture. And we'll update the market when we have more information. We also have a 49% stake at Greenbushes, one of the highest quality lithium resources in the world. The Talison joint venture is ramping up CGP2 and has approved construction of CGP3 and that's expected to begin later this year. In addition, construction of the tailings retreatment plant was completed during the quarter and commissioning is progressing to plan. Our intention is to rent lithium resources in advance of conversion assets. In which case in the near term, we could be net long spodumene if so we may elect to toll or sell spodumene. The expansions in Australia and Asia are just a portion of the globally diverse lithium projects we have defined to meet growing customer demand. We remain focused on growing our global conversion capacity to leverage our world class resources in Australia, Chile and the United States. Our Wave 3 projects should provide Albemarle with approximately 200,000 tons of additional lithium conversion capacity, which is higher than the 150,000 tonnes that we originally planned. Additionally, we continued to progress our growth options for Wave 4, which is expected to bring an additional 75,000 to 125,000 tons of capacity. This includes continue evaluation of options to restart our Kings Mountain lithium mine and build conversion assets in North America and Europe. Our high degree of vertical integration, access to high quality, low cost resources. Years of experience bringing conversion capacity online and a strong balance sheet provide considerable advantages for the foreseeable future. Looking now at slide 15, as you can see, Albemarle is executing a robust pipeline of projects all around the world. Our bromine business is pursuing incremental expansions in Jordan in the United States. These high return projects leverage our low cost resources and technical knowhow to support customers in growing and diverse markets like electronics, telecom, and automotive. In Chile, the Salar Yield Improvement project is progressing and is expected to allow us to increase lithium production without increasing our Brian pumping rates, utilizing our proprietary technology to improve recovery, efficiency, and sustainability. We also have access to a lithium resource in Argentina, called Antofalla. We anticipate restarting exploration of Antofalla later this year after securing all necessary permits. In Australia, we continue to progress steady work on Kemerton expansions to leverage greater scale and efficiency with repeatable designs. Finally, in the United States, the expansion of our Silver Peak facility in Nevada is on track to double lithium carbonate production. This is the first of several options to expand U.S. production. In Kings Mountain North Carolina, we've begun a pre-feasibility study to evaluate restarting the mind and then our bromine facility in Magnolia Arkansas, we're evaluating process technologies to leverage our brines to extract lithium. This robust pipeline, coupled with our industry knowledge and strong balance sheet provides significant growth opportunities for Albemarle. Moving on to our sustainability initiatives on slide 16, creating sustainable shareholder value requires our company to continue to drive progress on our own ESG and sustainability efforts. And I'm proud of what we are achieving on that front. We will publish our 2021 corporate sustainability report on June 2. In that report, you will see strong progress and our work towards hitting our target reductions in greenhouse gas emissions and freshwater usage. Our initial Scope 3 emissions assessment and our first full lifecycle assessment for lithium products. You will also see further definition of our sustainability related targets including diversity and inclusion. In addition to publishing our new sustainability report, we will host a webcast on June 28. And I hope you will join to listen in. In that presentation we will discuss next steps, including full CDP disclosure with TCFD goals and disclosures and third party IRMA assessments at the Salar de Atacama. As you can see, we have accomplished a great deal and we are committed to continue that progress. So this concludes our prepared remarks. And now we will open the call for Q&A.
Operator: [Operator Instructions] Our first question comes from P.J. Juvekar from Citi. Please go ahead, P.J.
P.J. Juvekar : Yes, good morning. Good pricing initiatives. Given that your leverage is down substantially, it's a real advantage for you right now. Would you consider more M&A in lithium or getting into recycling? Or potentially going downstream? How would you view those options from a 60,000-foot view?
Kent Masters: So PJ, I think I mean, we've always we're looking at M&A on a regular basis, I don’t think really our view has changed. So we do want to be in recycling. And we feel like we have a plan. We're working toward being in the recycling business. We look at resources on a regular basis for acquisition, and we look at conversion assets as well. So our strategy has not changed. We may have a little more firepower now than we did in the past. But I think the strategy is [Technical Difficulty] the same areas and we're pretty focused on those areas.
P.J. Juvekar: Also in Argentina, in Antofalla what are the permits or hurdles that are remaining before you proceed? And similar for Kings Mountain, what could be some environmental concerns there, which has impacted other projects in the region? Thank you.
Kent Masters: Yes, so I'll just comment at a high level. I mean, it's all the permits that we need. I think we're closer and in Argentina, we are in Kings Mountain. But we're early in the process in North Carolina. But Eric can talk about more details there.
Eric Norris: These are classical studies, P.J., it’s Eric here, that you would do for any pre-feasibility work. There are - the Antofalla site is a greenfield site, and has not ever been mined before. So there are a host of different permits from environmental onwards that that would have to be achieved and those are underway and then we would progress from there. In the case of Kings Mountain, this is a brownfield site. And so much of the work has to be done. And similarly on testing -- groundwater testing, environmental, there's a lot of work we're doing also with the community. We’ve engaged them very early on and did so earlier this quarter to participate in that process. And so as Kent said, that's a little earlier on but it's also brownfield sites. So it'll have a slightly different trajectory than, say, a greenfield site like Antofalla.
P.J. Juvekar: Thank you.
Operator: Our next question comes from Jeff Zekauskas from JPMorgan. Please go ahead, Jeff.
Jeff Zekauskas : Thanks very much. You have a very clear idea of the capacity expansions you wish to execute over the next five years. What's the trajectory of capital expenditures from $1.3 billion to $1.5 billion level?
Kent Masters: Not sure -- you mean over past the next five years?
Jeff Zekauskas: Yes, exactly right. How do you expect your capital expenditures to change over that period?
Kent Masters: Yes, I think you're probably - we expect them to be in that range, right, over the over the next five-year period and going forward. I mean, it depends on what on opportunities. So resources, if we had additional resource that would change that profile. If we were able to acquire or identify additional resource, that could change that. But I think our baseline, which we've laid out in our Investor Day is kind of capital in that range over the next five-year period.
Jeff Zekauskas: Great. So lithium prices have really moved up. And are there limits to what cathode manufacturers or battery manufacturers can absorb? Or do you see any ceilings, or we'll just see what the market brings?
Kent Masters: Well, it's difficult to call what the market is going to do, so I think we have to see what the market is going to bring. And I think there are economic factors that come into play. But it - when you look at the overall cost of a vehicle, I mean, there's a lot of – there are a lot of components that go in there, lithium starts to become a little bit material, but it's still a small percentage of that overall cost. So I mean, like our view is that prices -- the market is moving, they have recently just come down a little bit, suspect that's because demand in China is off because of COVID-related issues. So it has softened recently. But we're trying to structure our contracts. We've talked about this for a while. So we move with the market. So we're not dislocated to the market in either up - either in an up market or a down market.
Jeff Zekauskas: Okay, great. Thank you so much.
Operator: Our next question comes from David Deckelbaum from Cowen. Please go ahead, David.
David Deckelbaum: Think about expansion and your growth projects in North America, you discussed accelerating some activity at Silver Peak, growing out the Kings Mountain facility and restarting the mine there and looking at, obviously, the Magnolia Brine operations. One, is there an interest? Or should we expect Albemarle to be filing any loan applications to look for some low-cost financing with any of these projects? And then my second part with that would be do you anticipate building out conversion facilities in and around the Kings Mountain, that would be sort of greater than your U.S. base resource on the upstream side?
Kent Masters: Okay. So there were a couple of questions in there. So I think first, I mean, loans, I think we'd be interested if we can get economically buyable loans better than we can do on our own. We're definitely interested in that to help us build out the battery supply chain in North America. And we would be looking to build conversion capacity locally, our customers want local conversion -- local resource and conversion capacity. And then I think your question would be outsized conversion, vis-à-vis the local resource that we have. So we'll have to work that out over time. But the way we see it, we've got to convert the local product, but probably have to supplement local product with product coming from outside the U.S. And then we want to make sure that we as we do this, we're considering recycling as well. So we want to have not only virgin lithium coming from the resources in the United States and outside the U.S., but capacity for recycling as well. And we see that as an integrated facility that does that.
David Deckelbaum: I appreciate the color on that. And then just my follow-up quickly. Maybe if you could just characterize the situation, you reiterated your outlook around volumes and obviously increased the outlook around pricing. Are you seeing any impacts, I guess, from some of the shipping woes that we hear getting into China or getting product into China? Are you anticipating that and then have you experienced little friction moving spodumene concentrate into your converters in China? And how do you see that situation kind of progressing throughout the year?
Kent Masters: Well, I mean, we see that in all of our businesses, right? So we're finding the supply chain, as you hear in the news, and with every other business. We're finding it, but we've been able to manage through it. Today, we can't say we don't have issues, but we've managed through it. But maybe Netha or Eric, you guys could comment a little bit on specifically, what you see in I guess really around China and Spodumene in and out. So relative to China and the lithium business. Just recall that we are an exporter, as well as an importer. So a lot of the hydroxide production that we make in China goes to that market and then a chunk goes outside and surrounding Asia countries as well. And vision, as you point out we're bringing spodumene from Australia and highly support those operations. We have not -- we've experienced some customer impacts. We haven't been able, due to logistics, to hit certain time lines. But we haven't had any material impact to our revenues or to our contracts with these customers, can it comes down to just a very active supply chain team that is constantly managing various ports across the East Coast -- the Eastern seaboard of China to find the right way in and out for those products. But, there are thousands of ships sitting of the coast of China, so it’s not a small task and so we’ll manage it on a day-to-day basis. The COVID crisis and how it's being managed there in China has definitely made this challenging, and we expect to continue to have that challenge and be very -- how we manage it, but no impact material variety so far.
Netha Johnson: And I think for us in bromine, China, we are a net importer, so for us getting material in is the same for Eric, an extreme challenge. But we're also getting on the back end seeing containers return from China to allow us to load up our facilities in America. And in the Middle East. That's probably the bigger issue. And that's part of the macro supply chain challenge and container movement around the world. We've got a great logistics team here Albemarle in supply chain with a brand-new leader, and we’re excited about what they’re doing to manage this difficulty. But again, no material impact, we’ve got a great team and they're managing that very well for us.
David Deckelbaum: Thanks Eric. And thanks Kent.
Operator: Our next question comes from Vincent Andrews from Morgan Stanley. Please go ahead, Vince.
Vincent Andrews: Thank you. Scott, I just was wondering if you could give us a bit more color on the working capital and how it works, just given so much of the increase in guidance was price related. So it’s just a question of receivables are going to spike for period of time as these prices flow through? Or is there anything going on the inventory side as well.
Kent Masters: Yes, Vince, I think you've nailed it. So as prices go up obviously the receivables go up, we’re generally averaging between 55 and 60 days as a total company, so you basically have two months of receivables and the impact of that. So that's a driver. The second one is on inventory rising and inflation. We’re seeing obviously our inventory costs go up as well even though the quantities are about the same, were actually a little bit lower, from what we saw last year. So those are the two drivers. We see a little bit of benefit in the payables to offset that inventory, but that's what's going on.
Vincent Andrews: Okay. And just as a follow-up. You mentioned that for some contracts that might be renegotiated midyear off of 6 to variable. Do you have a rough idea of what percentage of your mix that could be or that's at least in discussion?
Scott Tozier: Yes. So if you actually look at the chart that we put in the presentation that breaks down our revenue, those fix contract makeup about 30% of our battery grade revenue. And those are the ones that are in discussions right now. So we'll see. If we’re successful, there would be additional upside to the guidance. As we move this to variable pricing.
Vincent Andrews: But it’s all the 30% subset of it.
Kent Masters: Eric, do you want provide some addition detail there.
Eric Norris: Yes. I would -- just knowing the mix of business we have and so now I would say it is subset, we still have a double-digit percentage there, when go to zero. But it could come down from 30% if we prevail.
Vincent Andrews: Okay. Thanks and I appreciate the help.
Operator: Our next question comes from Joe Jackson, from BMO Capital Markets. Please go ahead.
Joe Jackson: Hi, good morning everyone. I wanted to ask question, and it's not just you, it's obviously the business and your peers, what you thought pricing would be in margins different look only three months ago, but into February into that quarter and Q1. And suddenly, the way your contracts are working with index pricing now, it's a lot higher pricing, it's a lot better margin, the story is really different. So I want to ask what really changed. And if things could change so quickly in three months, how can you be confident pricing your base case can stay flat for the rest of the year?
Kent Masters: Yes, so I mean, we've been talking about moving to these variable price contracts for over a year. And coming into the year, I mean, we're basically in the same position that we were at the beginning of the year. Most of the discussions that with most happened that changed our contract structure happened at the end of last year, toward the end of last year. What's changed is pricing. The indices have moved up, market has tightened. The market has gotten stronger from an EV demand standpoint and particularly in China. So that's really, I think, was the driver. Those were the first prices to move and other prices followed that. And it’s a tight market I mean the demand strong, and the supply is -- it's tight. It's a little bit an imbalance, and that's what's driven pricing. Well, it how it stays there. I mean, we have -- but there are lags on our contracts. So we feel like we understand the second quarter pricing, very good. And we don't see it dropping dramatically. That's why we were comfortable giving guidance holding what we see for the second quarter for the balance of the year. What it does going forward after that, it's difficult, it's difficult to call it the market is still tight, it's gotten a little soft, because the demand is off in China over COVID issues. Some of the EV plants were shut down, they're mostly backup now, but they are at lower rates. So demand is a little bit slower, which is caused a pause in the market and pricing has come off a little bit. It's hard to see how that comes down over time, I mean it can, but it's hard to see that happening very quickly.
Joe Jackson: Okay. If I follow up on that. So, if you are now more exposed to spot and not as much it's fixed so pricing moving around a lot more. How does that change how you manage the business? Because you can have a view right now, like you just said, but obviously that could change in a month or two. And that may change how you look at things, your risks, how you handle working capital, what level, how comfy you are with leverage, because it seems like your business now is going to be more variable with spot price of lithium, which have surged, and they're way more volatile than they were in the past. How does that change how you view the business month to month, quarter to quarter? How do you plan for it?
Kent Masters: Yes, so our contracts, I mean, they're not all spot. So these are contracts that we have. Some are shorter term in the variable category. Some are short term with that better index to the market, the longer term contracts, we have our index to the market, but tend to have collars on them with floors and ceilings. So that takes some of that variability out. So it's an evolution of our strategy around pricing. We are more indexed to the market today than we were a year ago. Definitely. And that was by design. And I think we know but we're confident in the volume growth and then pricing will -- it will move up and down. But we have a very good cost position with the resource base that we have in our cost position. We still think that we can invest capital to grow for this business and have confidence in them.
Operator: Our next question comes from Alex Yefremov from KeyBanc. Please go ahead, Alex.
Alex Yefremov : Thanks. Good morning, everyone. And congrats on renegotiating the contracts. Question on volumes. You're raising your Wodgina production goals for this year. And yet your overall volumes are about the same for this year. Could you kind of explain what's going on with your volume assumptions in lithium?
Scott Tozier: So the -- Good morning, Alex, and thanks for your words. The volumes that we have guided to our 20% 30% above last year's numbers about 88,000. That’s described to you in the chart on page 11. We had already contemplated in our guidance that some form of Wodgina 1 would be used to support that volume growth. Wodgina 2 coming on is to follow the strategy that Kent indicated of having an excess of resource capacity to conversion growth. And there's and we will look potentially there could be some possible upsides if that goes smoothly, it won't come until the second half of this year. There's some possibilities to toll or sell that as we indicated during our prepared remarks. So that would be certainly an access to the 20% 30% that was the range which is our internal production.
Alex Yefremov: Okay, understood. Thanks a lot. And the second question on pricing. I mean, you indicate three to six months lag effect for half of your battery grade revenues. So, if we take second quarter, for example, your expectation for second quarter pricing, and then we assume that these indices kind of stay flat where they are today. Does that imply that third quarter price and perhaps fourth quarter price go up sequentially? Would that be right logic given these lags?
Scott Tozier: Yes, given the lags, we only can see, as Kent said, clearly out three months because of the nature of these lags. But if market prices stay where they are, yes, there's upside. Very clear, there's upside. I think we said in our guidance that has to be a material decline in market prices. And what we've seen in the past couple of weeks in China's does not represent a material decline. So there has to be much more significant decline before that would have a downward impact on our guidance.
Alex Yefremov: Great, thanks a lot.
Operator: Our next question comes from Matthew DeYoe from Bank of America. Please go ahead, Matthew.
Matthew DeYoe: Good morning, everyone. So questions on MinRes MARBL joint venture? One, have they paid you for the 10% stake yet? Two, whom controls the decision to run Wodgina? And at what pace? Is that MinRes that you? Is that a joint decision? And then when you move to 50-50, is that going to establish after tax accounting for that business as well?
Kent Masters: So that I trying to take that. So that they not paid us for anything. And it's a concept, and we're negotiating that at the moment. So we're operating at a 60-40 structure that we had previously. So we're under discussions, and I would say negotiations around expanding that JV which and that expansion would move it to be 50-50 at Wodgina. But that's we've got to conclude all of that. And none of that will change until we conclude the discussions and get the final document. So the counting, Scott, I'll leave that to you.
Scott Tozier: Yes, so I mean, counting. Some of this depends on how those negotiate. So with a 50-50 joint venture, there's some complex accounting rules around control that we'll have to go through and evaluate that once those agreements are there. So there's two potential options there. One is that it is a consolidated joint venture on our books with minority similar to what we do with JBC, or with no control, and it'll just run through equity income, which would then create that tax impact that you asked about. So more to come on that, all depends on how the negotiations and the final contract comes out.
Matthew DeYoe: That's helpful. And then what do you -- what are the assumptions for second half 2022, spodumene internal transfers? If I were looking at sizing that impact, is it still 1770? Or have you moved that up?
Kent Masters: No, no, that's moved up. It's almost doubled from that. So I think it's Eric, do you have that.
Eric Norris : It will double.
Kent Masters: Will double. It's based on a formula with we've agreed to the JV has agreed to with the authorities in Australia for tax and royalty purposes. And then it's based upon a lagging basis of how spodumene prices in the market, several different indices have fared. So based on that, what you see spodumene prices rising with, certainly would be soft prices as well, that we talked about earlier, that average price is probably going on the order of double where it's been.
Matthew DeYoe: Yes, understood. Okay. Thank you.
Operator: Our next question comes from Christopher Parkinson from Mizuho. Please go ahead, Chris.
Unidentified Analyst : Hi, this is Harris fine on for Chris, thanks for taking my question. So your competitors have been discussing that there has been a noticeable step change in your customer’s willingness to enter into contracts and more of an acknowledgment that the world will be short lithium in the coming years. So I was wondering if you could give your perspective on that based on what you're seeing. And I know it's early but how what that implies for the setup for 2023 pricing, is it reasonable to expect that you would be able to maintain these levels?
Eric Norris: So, Harris this is Eric, I'll start and maybe others will add. So the market there is certainly a very big concern about security supply, with the rapid commitment -- with the significant commitment that automotive manufacturers are making towards EVs and the excitement that brings with it. There's a concern as well that that the whether the industry can spool up quickly enough to meet that demand. And in one regard, that might be why the spot price is so high, it's just a fundamental concern in that regard. And that's leading to long term partnership discussions, unfortunately, that falls squarely in a strategy we've had for years now, which is picking the right partners partnering with them long-term leveraging our world class resources, and our ability to execute well, to give them comfort that we're the right partner for them to ease that concern around security of supply. Price is -- as we've discussed at length in this call is a function of what happens with the market indices, for a large measure of our revenue currently 6% of our battery revenues are going to be impacted by that it is, and that's going to be what the market does. So there will be structures we take on with these sorts of partners. As Ken earlier said, we'll probably be index based and have some coloring on either side of them. And a long term commitment from these customers to buy in for us to supply where that price is, is going to be a function of the market. So hard to call that right now.
Unidentified Analyst : Got it. And piggybacking off that, in the past, you've been looking at sort of a 40% long-term EBITDA margin bogey for lithium and 1Q looks like a little bit of an anomaly. But given the current price setup that you're seeing, is there any meaningful change to your long-term, normalized margin outlook, it's a bit higher in 2022. And if you could also talk about helping us come up with a framework for quantifying how startup costs are going to play into that over the next few years, that would be really helpful?
Kent Masters: Yes, so I would say that our long-term view as we laid out last year in our investor day was in the mid-40s for the lithium business at mid-cycle pricing. So through the cycle. And I would say that our view really hasn't changed at this point in time, we'll continue to evaluate that. And just as we need to, as we better understand the long term pricing outlooks. Of course, as you mentioned, our plant startups do have an impact on that. It's bigger today, because we're doubling our capacity versus as you go forward in time, the next increment is going to be a smaller and smaller percentage, and eventually just be part of just part of our normal operating activities.
Operator: Our next question comes from Arun Viswanathan from RBC Capital Markets, please go ahead.
Arun Viswanathan : I mean, first off, I guess, just wanted to go back to the pricing discussion. So, we have had some majors announced, some new capacity announcements, I think, in thing and some, some others, as you know, and that would kind of potentially signal some confidence that we are in a new price regime. You've also taken up, your guidance for the full year. I'm just curious what you think, the new level of, say peak to trough pricing, and lithium is, as you move into '23. I mean, do you think you can build off of this space that you're at right now?
Kent Masters: So we're not going to call lithium pricing going forward. I mean, part of -- what we've done is we've structured our contract. So we move with the market, and we've given ourselves a little bit of stability, that's been part of our plan for some time. And it gives our customers visibility of what the price is relative to the market mean, they have the same visibility going forward as we do and as you do, so it's difficult for us to say where it goes in '23, we think the market is tight. When we look at the demand from EVs and demand on lithium, and what we see as capacity coming on the market is tight for years. So, for at least through our planning period, which I would call it five years. So we see it being pretty tight. Now there'll be periods where there's some oversupply, but the growth in the market, it catches up very quickly. So we think the market is tight, but we're not going to call lithium prices for '23.
Arun Viswanathan: Understood. And then I guess, we haven't really asked about bromine yet. So maybe I'll just ask quickly there. Maybe you can just provide a couple more details on your thoughts there. Do you expect continued price upward momentum there and what's the outlook, I guess from a demand standpoint?
Scott Tozier: Yes, Arun, in terms of pricing, I think we should see pretty stable pricing. We're pretty fortunate that the applications and digitalization, electrification continue to grow, and that those applications are growing slightly faster than supply can come onto the market. So similar to what we saw in our investor day, last fall, we expect this market to be fundamentally under supplied for the next five years or our planning period. So and we're adding capacity. So we expect the pricing to stay relatively strong for this foreseeable future.
Operator: Next question is from Ben Kallo from Baird, please go ahead.
Ben Kallo: Good morning, to all. Just two questions. First, hydroxide versus carbonate? And how do you decide on where to make the investment on the two, and then geopolitical risk, just as you invested in countries that there was a headline out yesterday about Mexico nationalizing their lithium resource, but as you look to Argentina making that investment in Chile, we get a lot of questions about that. So how do you think about that going forward? And thanks, guys.
Eric Norris: Ben, this is Eric, I can take the hydroxide and myself or Kent can address the geopolitical response. So first, on hydroxide versus carbonate. The prior question was about the trend towards long-term partnerships and security supply. We one of the benefits of the customer partnership approach is to leverage that their commitment to us in making commitment firmly to the product form that they wish it, there's also and this does relate to the geopolitical risk side of things, and that there's also a discussion around where they want it. And increasingly a concern and a desire to have localization of supply. So we leveraged the commitments we're trying to get in these contracts, always got some risk to narrow down those two issues, the product risk and the regional risk for the two, as an added comment we currently are seeing that maybe carbonate is or LSP, chemistries are about maybe 20% 25% of the market. That's our current view, we continue to monitor that carefully. Kent do you want to comment just on how we think about risk?
Kent Masters: Yes, I would say I mean, important for us, given the locations where [Technical Difficulty] we look at it kind of at a macro level, and by country, so and we look at it for particularly kind of we get deeper and deeper as we make a new investment. But we monitor that. So a lot happening in Chile, as you know, we talked about on these calls before Argentina, as we make investments there, we'll have to make sure that we're looking at those risks and monitoring that Australia less of an issue, China's another area that we have to focus on, and make sure we have our risk assessments but we monitor those, we try and combine it with active government relations on making sure that we're doing the right thing in the country. So we're seeing as a good actor, and that we're bringing value to them as well, that others can't necessarily bring. So that's a big part of how we feel that we mitigate the risk and some of those geographies.
Operator: Our next question is from Colin Rusch from Oppenheimer. Please go ahead, Colin.
Colin Rusch: Thanks so much guys. Can you talk a little bit about the potential for incremental customer deposits or customer funded CapEx? You guys are spending a ton of money to grow capacity, and then just worrying about some of the alternative strategies for finance?
Kent Masters: Yes, Colin I think it's a good question. I think, given the environment that we're in, and the concern around supply from our customers, we're exploring all sorts of options, partnership type of options, like Eric talked about pre payments, there's a variety of different things there. I think the key for us is to ensure that that those types of agreements are giving us incremental return, versus what we could do on our own. So clearly, our strong balance sheet, strong support from investors give us plenty of capacity to build and do it on our own. But if we can get incremental returns, we'll take a look at it.
Colin Rusch: Okay, and then just given the expertise that you guys have around cathode materials and formulation, I'm wondering about your willingness are interested in additional vertical integration. Obviously, you don't want to compete with your customers, but it seems like you guys have enough expertise that you could do some real work in that space?
Kent Masters: Is that a capital question or just a CapEx question?
Colin Rusch: Yes. CapEx, I wanted to hear vertical integration there.
Kent Masters: Yes. So I mean, look, we look at the different options, but we're from, we look at it from a material standpoint, our interest in batteries and cathodes is to make sure that we're producing and developing the right chemistry that go into our customer’s processes. So we're not looking to be in the cathode business, but we're looking to be an excellent supplier to those cathode makers and the OEMs that have a vested interest in the battery and the cathode technology.
Eric Norris : Yes, and I just expand Colin part of note, part of doing that as being able to understand that application very well, but not integrate forward into it. And as I would also say, though, that as we look at other advanced forms of lithium, we'll look at the -- again, question exactly how we want to play and still be material player, but what material are we supplying? And so we're looking at, as you look at solid state chemistries, there's a variety different ways we can play in that area. And we're doing a lot of work currently, with partners and customers in that area to determine the future.
Colin Rusch: That's it for all. Thanks, guys.
Operator: That's all the time we have for today's Q&A session. I'm now going to hand you back to Kent Master for any final remarks. Please go ahead.
Kent Masters: All right. Thank you, Terrence. And thank you all again for your participation on our call today. Our success in 2021 combined with the momentum we are experiencing in '22 strongly positions us for profitable growth. I'm confident in our team's ability to drive value for all of our stakeholders by accelerating our growth in a sustainable way and to lead by example. Thank you and thanks for joining us.
Operator: This conclude today’s call. Thank you for joining. You may now disconnect your lines. | [
{
"speaker": "Operator",
"text": "Hello, everyone, and thank you for joining the Q1 2022 Albemarle Corporation Earning Conference Call. My name is Terrence, and I'll be moderating your call today. Before I hand over to your host Meredith Bandy. [Operator Instructions]. I now have the pleasure of handing you over to Meredith Bandy, Vice President of Investor Relations and Sustainability. Please go ahead, Meredith."
},
{
"speaker": "Meredith Bandy",
"text": "All right. Thank you, and welcome, everyone, to Albemarle's First Quarter 2022 Earnings Conference Call. Our earnings were released after the close of market yesterday, and you'll find the press release and earnings presentation posted on our website under the Investors section at albemarle.com. Joining me on the call today are Kent Masters, our Chief Executive Officer; Scott Tozier, Chief Financial Officer; Raphael Crawford, President, Catalyst; Netha Johnson, President, Bromine; and Eric Norris, President, Lithium. As a reminder, some of the statements made during this call, including our outlook, guidance, expected company performance and timing of the expansion projects may constitute forward-looking statements within the meaning of federal securities laws. Please note the cautionary language about forward-looking statements contained in our press release and earnings presentation, that same language applies to this call. Please also note that some of our comments today refer to non-GAAP financial measures. A reconciliation to GAAP financial measures can be found in our earnings release and the appendix of our earnings presentation. And now I’ll turn the call over to Kent."
},
{
"speaker": "Kent Masters",
"text": "Thanks, Meredith, and thank you all for joining us today. On today's call, I will highlight our results and achievements during the recent quarter. Scott will provide more details on our financial results, outlook and balance sheet. I will then close our prepared remarks with an update on our growth projects and sustainability before opening the call for questions. Albemarle's leadership positions in lithium and bromine and our team's ability to execute have enabled us to generate increasingly strong results. In the first quarter, we generated net sales of $1.1 billion, up 44% compared to prior year. And that's excluding Fine Chemistry Services in the comparison, which we sold in June of last year. This fundamental strength allowed us to more than double our EBITDA year-over-year. The supply/demand balance remains tight in the markets we serve. This has enabled us to significantly increase our 2022 outlook based on continued pricing strength in our lithium and bromine businesses. Scott will dive into the key elements of that outlook later in today's presentation. In terms of operational highlights for the quarter, the restart of our Wodgina lithium mine in our MARBL joint venture is progressing well. First, spodumene concentrate from Train 1 is expected in May. We've agreed with our partners to accelerate the restart of Train 2 with the first spodumene concentrate from that train lie. Together, these two trains can feed conversion assets with annual capacity of around 70,000 tons of lithium hydroxide. Now I'll turn the call over to Scott to walk through our financials."
},
{
"speaker": "Scott Tozier",
"text": "Thanks, Kent, and good morning, everyone. I'll begin on Slide 5. During the quarter, we generated net sales of $1.1 billion, a year-over-year increase of 36%, including the FCS business, which we sold in June last year. This is due primarily to increased pricing as well as higher volumes driven by strong demand from diverse end markets, especially for our lithium and bromine businesses. For the first quarter, net income attributable to Albemarle was $253 million, up $158 million from the prior year because of the strong net sales, partially offset by inflationary cost pressures. This includes the impact of natural gas prices in Europe on our catalyst business. Adjusted diluted EPS for the first quarter was $2.38. The primary adjustments to earnings were $0.07 add-back for a loss on property sales and a $0.19 add-back for tax-related items. On Slide 6, I'll walk you through our first quarter adjusted EBITDA. For the first quarter, our adjusted EBITDA was $432 million, up 107% year-over-year. The primary driver [Technical difficulty] pricing, driven by the move to index referenced variable price contracts and higher market pricing. Lithium also benefited from the sales of lower-cost inventories, including a one-time sale of spodumene stockpiled during the initial start-up of Wodgina. Bromine was also favorable year-over-year, reflecting higher pricing driven by tight market conditions and a slight uptick in volumes that was partially offset by raw material and freight inflation. Catalyst was down relative to the prior year, primarily driven by higher raw material costs and lower volumes. That was partially offset by pricing. And lastly, corporate expense and foreign exchange were mostly flat year-over-year. Moving to Slide 7. We have meaningfully increased our 2022 outlook primarily to reflect continued strength in our lithium business. I'll discuss our lithium outlook in greater detail in just a moment. For the total company, we now expect 2022 net sales to be in the range of $5.2 billion to $5.6 billion, up about 60% to 70% versus prior year. Adjusted EBITDA is expected to be between $1.7 billion and $2 billion, reflecting a year-over-year improvement of 120% at the midpoint of the range. This implies a total company EBITDA margin in the range of 33% to 36%. And together, this translates to updated 2022 adjusted diluted EPS guidance in the range of $9.25 to $12.25 compared to $4.04 in 2021. Additionally, we are maintaining our CapEx guidance range of $1.3 billion to $1.5 billion as we drive our lithium investments forward to meet increased customer demand. You may have noticed that we widened the range of our outlook to prudently reflect greater volatility in pricing for sales and inflation for cost of goods sold against the backdrop of a turbulent macro environment. And regarding the quarterly progression of sales and EBITDA, on our last call, we indicated that we expected Q1 to be our strongest quarter of the year, primarily due to higher pricing and sales of low-cost inventory. Given the continued strong pricing and rising volumes, we now expect our second half results to be about 55% of the total year. Turning to the next slide for more detail on our lithium outlook. Lithium's full year 2022 EBITDA is expected to be up 200% to 225% year-over-year, up from our previous outlook for growth of around 75%. We now expect our average realized selling price to be about double last year. This is the result of our efforts to move toward index referenced variable price contracts and a significant increase in index prices. We also have better line of sight to price in the full year. From the beginning of the year to today, indices are up between 85% and 125%. We're also assuming that our expected Q2 selling price remains at that level for the rest of the year. If current market prices remain at historically strong levels for the balance of the year, there would be upside to this guidance. There could also be additional upside if we transition additional existing contracts from fixed to variable pricing. However, if we see material declines from current market pricing or volume shortfalls, there would be downside to this guidance. There's no change to our lithium volume outlook for the year. We still expect year-over-year volume growth in the range of 20% to 30% as we bring on new conversion assets, particularly La Negra III and IV and Kemerton 1. For bromine, we are raising our full year 2022 EBITDA expectations with a year-over-year improvement of 15% to 20%. This revised guidance reflects higher pricing related to strong fire safety demand, supported by macro trends such as digitalization and electrification. We also expect higher volumes following our successful expansion last year in Jordan. For Catalysts, 2022 EBITDA is expected to be flat to down 65% year-over-year. This is below our prior outlook due to significant cost pressures primarily related to natural gas in Europe and certain raw materials and freight, partially offset by higher pricing. The large outlook range for Catalyst reflects increased volatility and lack of visibility, particularly related to the war in Ukraine. Given the extraordinary circumstances and the resulting changes in oil and gas markets, the business is aggressively seeking to pass through higher natural gas pricing to its customers. As previously discussed, we continue to expect a strategic review of the Catalyst business to be completed later this quarter. The review is intended to maximize value and position the business for success while enabling us to focus on growth. I will now turn to Slide 9 for a deeper dive on our lithium contracts and pricing. With the change in guidance, you can now see we have more exposure to changing market indices. Our segmented approach gives more flexibility to customers while still allowing Albemarle to preserve its upside and returns on our growth investments. This slide reflects the expected split of our 2022 revenues updated for current pricing. Battery-grade revenues are now expected to make up 70% to 80% of our 2022 revenues, of which 20% is expected to be from purchase orders on higher short-term pricing; about half are expected to be from contracts with variable pricing mechanisms, typically indexed reference with a 3- to 6-month lag; and the remaining 30% is from fixed price contracts. These fixed contracts also have price opener mechanisms to change prices over time. We continue to work with these customers to transition to contracts with variable index reference pricing. These negotiations are ongoing and progressing well. If we are successful, this could provide additional upside to our current outlook for the Lithium business. Following our last earnings call, we received a lot of questions regarding our expected lithium margins, so I wanted to provide some additional color on the moving pieces on Slide 10. We expect lithium margins to improve in 2022 driven by higher pricing, partially offset by the progressive commissions we pay in Chile under our CORFO contract. Another item to consider is the impact from higher fixed costs related to the startup and ramp of our new facilities such as the Wodgina mine and our La Negra and Kemerton conversion assets as well as the potential acquisition of the Chenzhou conversion plan. These plants are expected to more than double our lithium production. Over time, the impact of fixed costs on margins will diminish as production ramps and costs are absorbed. As a reminder, Albemarle calculates EBITDA by including joint venture equity income on an after-tax basis. This year, because of higher spodumene transfer pricing from our Greenbushes mine, this tax impact is much more meaningful than it has been in the past. This is simply a result of the line item where the tax hits our income statement. Albemarle remains fully integrated from resource to conversion. So effectively, we pay ourselves this higher spodumene pricing. On a completely pretax basis, lithium EBITDA margins are expected to be between 55% and 60% in 2022. Slide 11 highlights our expected volume ramp as our new lithium conversion facilities are completed. Last year, we converted 88,000 metric tons LCE including conversion at Silver Peak and Kings Mountain, Xinyu and Chengdu in China, and La Negra I and II in Chile. We are in the process of more than doubling conversion capacity with the expansions at La Negra and Kemerton, plus the acquisition of the Shinzo plant. We typically expect it to take about two years to ramp to full capacity at a new plan, including roughly six months for customer qualification. Tying all of this together, we expect to achieve [Technical Difficulty]. Total lithium volumes are expected to be higher than that, including technical-grade spodumene sales of about 10,000 tons per year, tolling volumes of anywhere between 0 and 20,000 tons per year, depending on market dynamics and [Technical Difficulty] the spodumene, plus any additional conversion capacity we buy or build during this period. Finally, let's turn to Slide 12 to look at our strong balance sheet and cash flow. Our 2022 revised operating cash flow guidance is $650 million at the midpoint. Relative to 2021, you can see incremental cash flow driven by the higher net income, adding back higher depreciation. This is partially offset by higher working capital related to higher sales volumes and pricing, plus higher cost of raw materials and inventories. As a reminder, working capital typically averages about 25% of net sales. Our balance sheet is in great shape with $463 million of cash and liquidity of almost $2 billion. Current net debt to adjusted EBITDA is approximately 1.9 times, with rising EBITDA from higher pricing and volumes, we expect leverage to remain at or below our target range of 2 to 2.5 times. Our balance sheet supports the CapEx for our lithium investments to meet growing customer demand. Following our equity offering early last year, we repaid debt with the intention of relevering as needed to fund capital projects. We are actively evaluating options to do just that. We are planning to be in the debt market this quarter if market conditions are favorable. We remain committed to maintaining our investment-grade credit rating, and the debt markets provide a favorable avenue of acquiring additional capital. With that, I'll turn it back to Kent for an update on our projects on Slide 13."
},
{
"speaker": "Kent Masters",
"text": "Thanks, Scott. First, let's look at a few of our expansions in Asia Pacific. Albemarle was focused on expanding global lithium conversion capacity to leverage our low-cost resource base. The acquisition of the Qinzhou conversion facility is now expected to close in the second half of this year as we continue to work through regulatory approvals. We look forward to closing this transaction to bring an additional 25,000 tons of lithium to the market. The commissioning process at Kemerton 1 is progressing well. We have introduced spodumene into the process, and we expect to achieve first product by the end of the month. Kemerton II remains on track for mechanical completion later this year. At our China greenfield expansions, we have broken ground at Meishan to construct a 50,000 ton per year hydroxide conversion facility. There are also options to expand that facility. The second China greenfield project at Zhangjiaghang is currently in the engineering phase, and we are looking at options to produce either carbonate or hydroxide. Importantly with our ownership stakes at Wodgina and Greenbushes lithium mines, we already have access to low cost spodumene to feed these conversion facilities. As I mentioned previously, the restart of the Wodgina lithium mine by our JV partner Mineral Resources, is going well and we continue to negotiate agreements to expand and restructure the MARBL the joint venture. And we'll update the market when we have more information. We also have a 49% stake at Greenbushes, one of the highest quality lithium resources in the world. The Talison joint venture is ramping up CGP2 and has approved construction of CGP3 and that's expected to begin later this year. In addition, construction of the tailings retreatment plant was completed during the quarter and commissioning is progressing to plan. Our intention is to rent lithium resources in advance of conversion assets. In which case in the near term, we could be net long spodumene if so we may elect to toll or sell spodumene. The expansions in Australia and Asia are just a portion of the globally diverse lithium projects we have defined to meet growing customer demand. We remain focused on growing our global conversion capacity to leverage our world class resources in Australia, Chile and the United States. Our Wave 3 projects should provide Albemarle with approximately 200,000 tons of additional lithium conversion capacity, which is higher than the 150,000 tonnes that we originally planned. Additionally, we continued to progress our growth options for Wave 4, which is expected to bring an additional 75,000 to 125,000 tons of capacity. This includes continue evaluation of options to restart our Kings Mountain lithium mine and build conversion assets in North America and Europe. Our high degree of vertical integration, access to high quality, low cost resources. Years of experience bringing conversion capacity online and a strong balance sheet provide considerable advantages for the foreseeable future. Looking now at slide 15, as you can see, Albemarle is executing a robust pipeline of projects all around the world. Our bromine business is pursuing incremental expansions in Jordan in the United States. These high return projects leverage our low cost resources and technical knowhow to support customers in growing and diverse markets like electronics, telecom, and automotive. In Chile, the Salar Yield Improvement project is progressing and is expected to allow us to increase lithium production without increasing our Brian pumping rates, utilizing our proprietary technology to improve recovery, efficiency, and sustainability. We also have access to a lithium resource in Argentina, called Antofalla. We anticipate restarting exploration of Antofalla later this year after securing all necessary permits. In Australia, we continue to progress steady work on Kemerton expansions to leverage greater scale and efficiency with repeatable designs. Finally, in the United States, the expansion of our Silver Peak facility in Nevada is on track to double lithium carbonate production. This is the first of several options to expand U.S. production. In Kings Mountain North Carolina, we've begun a pre-feasibility study to evaluate restarting the mind and then our bromine facility in Magnolia Arkansas, we're evaluating process technologies to leverage our brines to extract lithium. This robust pipeline, coupled with our industry knowledge and strong balance sheet provides significant growth opportunities for Albemarle. Moving on to our sustainability initiatives on slide 16, creating sustainable shareholder value requires our company to continue to drive progress on our own ESG and sustainability efforts. And I'm proud of what we are achieving on that front. We will publish our 2021 corporate sustainability report on June 2. In that report, you will see strong progress and our work towards hitting our target reductions in greenhouse gas emissions and freshwater usage. Our initial Scope 3 emissions assessment and our first full lifecycle assessment for lithium products. You will also see further definition of our sustainability related targets including diversity and inclusion. In addition to publishing our new sustainability report, we will host a webcast on June 28. And I hope you will join to listen in. In that presentation we will discuss next steps, including full CDP disclosure with TCFD goals and disclosures and third party IRMA assessments at the Salar de Atacama. As you can see, we have accomplished a great deal and we are committed to continue that progress. So this concludes our prepared remarks. And now we will open the call for Q&A."
},
{
"speaker": "Operator",
"text": "[Operator Instructions] Our first question comes from P.J. Juvekar from Citi. Please go ahead, P.J."
},
{
"speaker": "P.J. Juvekar",
"text": "Yes, good morning. Good pricing initiatives. Given that your leverage is down substantially, it's a real advantage for you right now. Would you consider more M&A in lithium or getting into recycling? Or potentially going downstream? How would you view those options from a 60,000-foot view?"
},
{
"speaker": "Kent Masters",
"text": "So PJ, I think I mean, we've always we're looking at M&A on a regular basis, I don’t think really our view has changed. So we do want to be in recycling. And we feel like we have a plan. We're working toward being in the recycling business. We look at resources on a regular basis for acquisition, and we look at conversion assets as well. So our strategy has not changed. We may have a little more firepower now than we did in the past. But I think the strategy is [Technical Difficulty] the same areas and we're pretty focused on those areas."
},
{
"speaker": "P.J. Juvekar",
"text": "Also in Argentina, in Antofalla what are the permits or hurdles that are remaining before you proceed? And similar for Kings Mountain, what could be some environmental concerns there, which has impacted other projects in the region? Thank you."
},
{
"speaker": "Kent Masters",
"text": "Yes, so I'll just comment at a high level. I mean, it's all the permits that we need. I think we're closer and in Argentina, we are in Kings Mountain. But we're early in the process in North Carolina. But Eric can talk about more details there."
},
{
"speaker": "Eric Norris",
"text": "These are classical studies, P.J., it’s Eric here, that you would do for any pre-feasibility work. There are - the Antofalla site is a greenfield site, and has not ever been mined before. So there are a host of different permits from environmental onwards that that would have to be achieved and those are underway and then we would progress from there. In the case of Kings Mountain, this is a brownfield site. And so much of the work has to be done. And similarly on testing -- groundwater testing, environmental, there's a lot of work we're doing also with the community. We’ve engaged them very early on and did so earlier this quarter to participate in that process. And so as Kent said, that's a little earlier on but it's also brownfield sites. So it'll have a slightly different trajectory than, say, a greenfield site like Antofalla."
},
{
"speaker": "P.J. Juvekar",
"text": "Thank you."
},
{
"speaker": "Operator",
"text": "Our next question comes from Jeff Zekauskas from JPMorgan. Please go ahead, Jeff."
},
{
"speaker": "Jeff Zekauskas",
"text": "Thanks very much. You have a very clear idea of the capacity expansions you wish to execute over the next five years. What's the trajectory of capital expenditures from $1.3 billion to $1.5 billion level?"
},
{
"speaker": "Kent Masters",
"text": "Not sure -- you mean over past the next five years?"
},
{
"speaker": "Jeff Zekauskas",
"text": "Yes, exactly right. How do you expect your capital expenditures to change over that period?"
},
{
"speaker": "Kent Masters",
"text": "Yes, I think you're probably - we expect them to be in that range, right, over the over the next five-year period and going forward. I mean, it depends on what on opportunities. So resources, if we had additional resource that would change that profile. If we were able to acquire or identify additional resource, that could change that. But I think our baseline, which we've laid out in our Investor Day is kind of capital in that range over the next five-year period."
},
{
"speaker": "Jeff Zekauskas",
"text": "Great. So lithium prices have really moved up. And are there limits to what cathode manufacturers or battery manufacturers can absorb? Or do you see any ceilings, or we'll just see what the market brings?"
},
{
"speaker": "Kent Masters",
"text": "Well, it's difficult to call what the market is going to do, so I think we have to see what the market is going to bring. And I think there are economic factors that come into play. But it - when you look at the overall cost of a vehicle, I mean, there's a lot of – there are a lot of components that go in there, lithium starts to become a little bit material, but it's still a small percentage of that overall cost. So I mean, like our view is that prices -- the market is moving, they have recently just come down a little bit, suspect that's because demand in China is off because of COVID-related issues. So it has softened recently. But we're trying to structure our contracts. We've talked about this for a while. So we move with the market. So we're not dislocated to the market in either up - either in an up market or a down market."
},
{
"speaker": "Jeff Zekauskas",
"text": "Okay, great. Thank you so much."
},
{
"speaker": "Operator",
"text": "Our next question comes from David Deckelbaum from Cowen. Please go ahead, David."
},
{
"speaker": "David Deckelbaum",
"text": "Think about expansion and your growth projects in North America, you discussed accelerating some activity at Silver Peak, growing out the Kings Mountain facility and restarting the mine there and looking at, obviously, the Magnolia Brine operations. One, is there an interest? Or should we expect Albemarle to be filing any loan applications to look for some low-cost financing with any of these projects? And then my second part with that would be do you anticipate building out conversion facilities in and around the Kings Mountain, that would be sort of greater than your U.S. base resource on the upstream side?"
},
{
"speaker": "Kent Masters",
"text": "Okay. So there were a couple of questions in there. So I think first, I mean, loans, I think we'd be interested if we can get economically buyable loans better than we can do on our own. We're definitely interested in that to help us build out the battery supply chain in North America. And we would be looking to build conversion capacity locally, our customers want local conversion -- local resource and conversion capacity. And then I think your question would be outsized conversion, vis-à-vis the local resource that we have. So we'll have to work that out over time. But the way we see it, we've got to convert the local product, but probably have to supplement local product with product coming from outside the U.S. And then we want to make sure that we as we do this, we're considering recycling as well. So we want to have not only virgin lithium coming from the resources in the United States and outside the U.S., but capacity for recycling as well. And we see that as an integrated facility that does that."
},
{
"speaker": "David Deckelbaum",
"text": "I appreciate the color on that. And then just my follow-up quickly. Maybe if you could just characterize the situation, you reiterated your outlook around volumes and obviously increased the outlook around pricing. Are you seeing any impacts, I guess, from some of the shipping woes that we hear getting into China or getting product into China? Are you anticipating that and then have you experienced little friction moving spodumene concentrate into your converters in China? And how do you see that situation kind of progressing throughout the year?"
},
{
"speaker": "Kent Masters",
"text": "Well, I mean, we see that in all of our businesses, right? So we're finding the supply chain, as you hear in the news, and with every other business. We're finding it, but we've been able to manage through it. Today, we can't say we don't have issues, but we've managed through it. But maybe Netha or Eric, you guys could comment a little bit on specifically, what you see in I guess really around China and Spodumene in and out. So relative to China and the lithium business. Just recall that we are an exporter, as well as an importer. So a lot of the hydroxide production that we make in China goes to that market and then a chunk goes outside and surrounding Asia countries as well. And vision, as you point out we're bringing spodumene from Australia and highly support those operations. We have not -- we've experienced some customer impacts. We haven't been able, due to logistics, to hit certain time lines. But we haven't had any material impact to our revenues or to our contracts with these customers, can it comes down to just a very active supply chain team that is constantly managing various ports across the East Coast -- the Eastern seaboard of China to find the right way in and out for those products. But, there are thousands of ships sitting of the coast of China, so it’s not a small task and so we’ll manage it on a day-to-day basis. The COVID crisis and how it's being managed there in China has definitely made this challenging, and we expect to continue to have that challenge and be very -- how we manage it, but no impact material variety so far."
},
{
"speaker": "Netha Johnson",
"text": "And I think for us in bromine, China, we are a net importer, so for us getting material in is the same for Eric, an extreme challenge. But we're also getting on the back end seeing containers return from China to allow us to load up our facilities in America. And in the Middle East. That's probably the bigger issue. And that's part of the macro supply chain challenge and container movement around the world. We've got a great logistics team here Albemarle in supply chain with a brand-new leader, and we’re excited about what they’re doing to manage this difficulty. But again, no material impact, we’ve got a great team and they're managing that very well for us."
},
{
"speaker": "David Deckelbaum",
"text": "Thanks Eric. And thanks Kent."
},
{
"speaker": "Operator",
"text": "Our next question comes from Vincent Andrews from Morgan Stanley. Please go ahead, Vince."
},
{
"speaker": "Vincent Andrews",
"text": "Thank you. Scott, I just was wondering if you could give us a bit more color on the working capital and how it works, just given so much of the increase in guidance was price related. So it’s just a question of receivables are going to spike for period of time as these prices flow through? Or is there anything going on the inventory side as well."
},
{
"speaker": "Kent Masters",
"text": "Yes, Vince, I think you've nailed it. So as prices go up obviously the receivables go up, we’re generally averaging between 55 and 60 days as a total company, so you basically have two months of receivables and the impact of that. So that's a driver. The second one is on inventory rising and inflation. We’re seeing obviously our inventory costs go up as well even though the quantities are about the same, were actually a little bit lower, from what we saw last year. So those are the two drivers. We see a little bit of benefit in the payables to offset that inventory, but that's what's going on."
},
{
"speaker": "Vincent Andrews",
"text": "Okay. And just as a follow-up. You mentioned that for some contracts that might be renegotiated midyear off of 6 to variable. Do you have a rough idea of what percentage of your mix that could be or that's at least in discussion?"
},
{
"speaker": "Scott Tozier",
"text": "Yes. So if you actually look at the chart that we put in the presentation that breaks down our revenue, those fix contract makeup about 30% of our battery grade revenue. And those are the ones that are in discussions right now. So we'll see. If we’re successful, there would be additional upside to the guidance. As we move this to variable pricing."
},
{
"speaker": "Vincent Andrews",
"text": "But it’s all the 30% subset of it."
},
{
"speaker": "Kent Masters",
"text": "Eric, do you want provide some addition detail there."
},
{
"speaker": "Eric Norris",
"text": "Yes. I would -- just knowing the mix of business we have and so now I would say it is subset, we still have a double-digit percentage there, when go to zero. But it could come down from 30% if we prevail."
},
{
"speaker": "Vincent Andrews",
"text": "Okay. Thanks and I appreciate the help."
},
{
"speaker": "Operator",
"text": "Our next question comes from Joe Jackson, from BMO Capital Markets. Please go ahead."
},
{
"speaker": "Joe Jackson",
"text": "Hi, good morning everyone. I wanted to ask question, and it's not just you, it's obviously the business and your peers, what you thought pricing would be in margins different look only three months ago, but into February into that quarter and Q1. And suddenly, the way your contracts are working with index pricing now, it's a lot higher pricing, it's a lot better margin, the story is really different. So I want to ask what really changed. And if things could change so quickly in three months, how can you be confident pricing your base case can stay flat for the rest of the year?"
},
{
"speaker": "Kent Masters",
"text": "Yes, so I mean, we've been talking about moving to these variable price contracts for over a year. And coming into the year, I mean, we're basically in the same position that we were at the beginning of the year. Most of the discussions that with most happened that changed our contract structure happened at the end of last year, toward the end of last year. What's changed is pricing. The indices have moved up, market has tightened. The market has gotten stronger from an EV demand standpoint and particularly in China. So that's really, I think, was the driver. Those were the first prices to move and other prices followed that. And it’s a tight market I mean the demand strong, and the supply is -- it's tight. It's a little bit an imbalance, and that's what's driven pricing. Well, it how it stays there. I mean, we have -- but there are lags on our contracts. So we feel like we understand the second quarter pricing, very good. And we don't see it dropping dramatically. That's why we were comfortable giving guidance holding what we see for the second quarter for the balance of the year. What it does going forward after that, it's difficult, it's difficult to call it the market is still tight, it's gotten a little soft, because the demand is off in China over COVID issues. Some of the EV plants were shut down, they're mostly backup now, but they are at lower rates. So demand is a little bit slower, which is caused a pause in the market and pricing has come off a little bit. It's hard to see how that comes down over time, I mean it can, but it's hard to see that happening very quickly."
},
{
"speaker": "Joe Jackson",
"text": "Okay. If I follow up on that. So, if you are now more exposed to spot and not as much it's fixed so pricing moving around a lot more. How does that change how you manage the business? Because you can have a view right now, like you just said, but obviously that could change in a month or two. And that may change how you look at things, your risks, how you handle working capital, what level, how comfy you are with leverage, because it seems like your business now is going to be more variable with spot price of lithium, which have surged, and they're way more volatile than they were in the past. How does that change how you view the business month to month, quarter to quarter? How do you plan for it?"
},
{
"speaker": "Kent Masters",
"text": "Yes, so our contracts, I mean, they're not all spot. So these are contracts that we have. Some are shorter term in the variable category. Some are short term with that better index to the market, the longer term contracts, we have our index to the market, but tend to have collars on them with floors and ceilings. So that takes some of that variability out. So it's an evolution of our strategy around pricing. We are more indexed to the market today than we were a year ago. Definitely. And that was by design. And I think we know but we're confident in the volume growth and then pricing will -- it will move up and down. But we have a very good cost position with the resource base that we have in our cost position. We still think that we can invest capital to grow for this business and have confidence in them."
},
{
"speaker": "Operator",
"text": "Our next question comes from Alex Yefremov from KeyBanc. Please go ahead, Alex."
},
{
"speaker": "Alex Yefremov",
"text": "Thanks. Good morning, everyone. And congrats on renegotiating the contracts. Question on volumes. You're raising your Wodgina production goals for this year. And yet your overall volumes are about the same for this year. Could you kind of explain what's going on with your volume assumptions in lithium?"
},
{
"speaker": "Scott Tozier",
"text": "So the -- Good morning, Alex, and thanks for your words. The volumes that we have guided to our 20% 30% above last year's numbers about 88,000. That’s described to you in the chart on page 11. We had already contemplated in our guidance that some form of Wodgina 1 would be used to support that volume growth. Wodgina 2 coming on is to follow the strategy that Kent indicated of having an excess of resource capacity to conversion growth. And there's and we will look potentially there could be some possible upsides if that goes smoothly, it won't come until the second half of this year. There's some possibilities to toll or sell that as we indicated during our prepared remarks. So that would be certainly an access to the 20% 30% that was the range which is our internal production."
},
{
"speaker": "Alex Yefremov",
"text": "Okay, understood. Thanks a lot. And the second question on pricing. I mean, you indicate three to six months lag effect for half of your battery grade revenues. So, if we take second quarter, for example, your expectation for second quarter pricing, and then we assume that these indices kind of stay flat where they are today. Does that imply that third quarter price and perhaps fourth quarter price go up sequentially? Would that be right logic given these lags?"
},
{
"speaker": "Scott Tozier",
"text": "Yes, given the lags, we only can see, as Kent said, clearly out three months because of the nature of these lags. But if market prices stay where they are, yes, there's upside. Very clear, there's upside. I think we said in our guidance that has to be a material decline in market prices. And what we've seen in the past couple of weeks in China's does not represent a material decline. So there has to be much more significant decline before that would have a downward impact on our guidance."
},
{
"speaker": "Alex Yefremov",
"text": "Great, thanks a lot."
},
{
"speaker": "Operator",
"text": "Our next question comes from Matthew DeYoe from Bank of America. Please go ahead, Matthew."
},
{
"speaker": "Matthew DeYoe",
"text": "Good morning, everyone. So questions on MinRes MARBL joint venture? One, have they paid you for the 10% stake yet? Two, whom controls the decision to run Wodgina? And at what pace? Is that MinRes that you? Is that a joint decision? And then when you move to 50-50, is that going to establish after tax accounting for that business as well?"
},
{
"speaker": "Kent Masters",
"text": "So that I trying to take that. So that they not paid us for anything. And it's a concept, and we're negotiating that at the moment. So we're operating at a 60-40 structure that we had previously. So we're under discussions, and I would say negotiations around expanding that JV which and that expansion would move it to be 50-50 at Wodgina. But that's we've got to conclude all of that. And none of that will change until we conclude the discussions and get the final document. So the counting, Scott, I'll leave that to you."
},
{
"speaker": "Scott Tozier",
"text": "Yes, so I mean, counting. Some of this depends on how those negotiate. So with a 50-50 joint venture, there's some complex accounting rules around control that we'll have to go through and evaluate that once those agreements are there. So there's two potential options there. One is that it is a consolidated joint venture on our books with minority similar to what we do with JBC, or with no control, and it'll just run through equity income, which would then create that tax impact that you asked about. So more to come on that, all depends on how the negotiations and the final contract comes out."
},
{
"speaker": "Matthew DeYoe",
"text": "That's helpful. And then what do you -- what are the assumptions for second half 2022, spodumene internal transfers? If I were looking at sizing that impact, is it still 1770? Or have you moved that up?"
},
{
"speaker": "Kent Masters",
"text": "No, no, that's moved up. It's almost doubled from that. So I think it's Eric, do you have that."
},
{
"speaker": "Eric Norris",
"text": "It will double."
},
{
"speaker": "Kent Masters",
"text": "Will double. It's based on a formula with we've agreed to the JV has agreed to with the authorities in Australia for tax and royalty purposes. And then it's based upon a lagging basis of how spodumene prices in the market, several different indices have fared. So based on that, what you see spodumene prices rising with, certainly would be soft prices as well, that we talked about earlier, that average price is probably going on the order of double where it's been."
},
{
"speaker": "Matthew DeYoe",
"text": "Yes, understood. Okay. Thank you."
},
{
"speaker": "Operator",
"text": "Our next question comes from Christopher Parkinson from Mizuho. Please go ahead, Chris."
},
{
"speaker": "Unidentified Analyst",
"text": "Hi, this is Harris fine on for Chris, thanks for taking my question. So your competitors have been discussing that there has been a noticeable step change in your customer’s willingness to enter into contracts and more of an acknowledgment that the world will be short lithium in the coming years. So I was wondering if you could give your perspective on that based on what you're seeing. And I know it's early but how what that implies for the setup for 2023 pricing, is it reasonable to expect that you would be able to maintain these levels?"
},
{
"speaker": "Eric Norris",
"text": "So, Harris this is Eric, I'll start and maybe others will add. So the market there is certainly a very big concern about security supply, with the rapid commitment -- with the significant commitment that automotive manufacturers are making towards EVs and the excitement that brings with it. There's a concern as well that that the whether the industry can spool up quickly enough to meet that demand. And in one regard, that might be why the spot price is so high, it's just a fundamental concern in that regard. And that's leading to long term partnership discussions, unfortunately, that falls squarely in a strategy we've had for years now, which is picking the right partners partnering with them long-term leveraging our world class resources, and our ability to execute well, to give them comfort that we're the right partner for them to ease that concern around security of supply. Price is -- as we've discussed at length in this call is a function of what happens with the market indices, for a large measure of our revenue currently 6% of our battery revenues are going to be impacted by that it is, and that's going to be what the market does. So there will be structures we take on with these sorts of partners. As Ken earlier said, we'll probably be index based and have some coloring on either side of them. And a long term commitment from these customers to buy in for us to supply where that price is, is going to be a function of the market. So hard to call that right now."
},
{
"speaker": "Unidentified Analyst",
"text": "Got it. And piggybacking off that, in the past, you've been looking at sort of a 40% long-term EBITDA margin bogey for lithium and 1Q looks like a little bit of an anomaly. But given the current price setup that you're seeing, is there any meaningful change to your long-term, normalized margin outlook, it's a bit higher in 2022. And if you could also talk about helping us come up with a framework for quantifying how startup costs are going to play into that over the next few years, that would be really helpful?"
},
{
"speaker": "Kent Masters",
"text": "Yes, so I would say that our long-term view as we laid out last year in our investor day was in the mid-40s for the lithium business at mid-cycle pricing. So through the cycle. And I would say that our view really hasn't changed at this point in time, we'll continue to evaluate that. And just as we need to, as we better understand the long term pricing outlooks. Of course, as you mentioned, our plant startups do have an impact on that. It's bigger today, because we're doubling our capacity versus as you go forward in time, the next increment is going to be a smaller and smaller percentage, and eventually just be part of just part of our normal operating activities."
},
{
"speaker": "Operator",
"text": "Our next question comes from Arun Viswanathan from RBC Capital Markets, please go ahead."
},
{
"speaker": "Arun Viswanathan",
"text": "I mean, first off, I guess, just wanted to go back to the pricing discussion. So, we have had some majors announced, some new capacity announcements, I think, in thing and some, some others, as you know, and that would kind of potentially signal some confidence that we are in a new price regime. You've also taken up, your guidance for the full year. I'm just curious what you think, the new level of, say peak to trough pricing, and lithium is, as you move into '23. I mean, do you think you can build off of this space that you're at right now?"
},
{
"speaker": "Kent Masters",
"text": "So we're not going to call lithium pricing going forward. I mean, part of -- what we've done is we've structured our contract. So we move with the market, and we've given ourselves a little bit of stability, that's been part of our plan for some time. And it gives our customers visibility of what the price is relative to the market mean, they have the same visibility going forward as we do and as you do, so it's difficult for us to say where it goes in '23, we think the market is tight. When we look at the demand from EVs and demand on lithium, and what we see as capacity coming on the market is tight for years. So, for at least through our planning period, which I would call it five years. So we see it being pretty tight. Now there'll be periods where there's some oversupply, but the growth in the market, it catches up very quickly. So we think the market is tight, but we're not going to call lithium prices for '23."
},
{
"speaker": "Arun Viswanathan",
"text": "Understood. And then I guess, we haven't really asked about bromine yet. So maybe I'll just ask quickly there. Maybe you can just provide a couple more details on your thoughts there. Do you expect continued price upward momentum there and what's the outlook, I guess from a demand standpoint?"
},
{
"speaker": "Scott Tozier",
"text": "Yes, Arun, in terms of pricing, I think we should see pretty stable pricing. We're pretty fortunate that the applications and digitalization, electrification continue to grow, and that those applications are growing slightly faster than supply can come onto the market. So similar to what we saw in our investor day, last fall, we expect this market to be fundamentally under supplied for the next five years or our planning period. So and we're adding capacity. So we expect the pricing to stay relatively strong for this foreseeable future."
},
{
"speaker": "Operator",
"text": "Next question is from Ben Kallo from Baird, please go ahead."
},
{
"speaker": "Ben Kallo",
"text": "Good morning, to all. Just two questions. First, hydroxide versus carbonate? And how do you decide on where to make the investment on the two, and then geopolitical risk, just as you invested in countries that there was a headline out yesterday about Mexico nationalizing their lithium resource, but as you look to Argentina making that investment in Chile, we get a lot of questions about that. So how do you think about that going forward? And thanks, guys."
},
{
"speaker": "Eric Norris",
"text": "Ben, this is Eric, I can take the hydroxide and myself or Kent can address the geopolitical response. So first, on hydroxide versus carbonate. The prior question was about the trend towards long-term partnerships and security supply. We one of the benefits of the customer partnership approach is to leverage that their commitment to us in making commitment firmly to the product form that they wish it, there's also and this does relate to the geopolitical risk side of things, and that there's also a discussion around where they want it. And increasingly a concern and a desire to have localization of supply. So we leveraged the commitments we're trying to get in these contracts, always got some risk to narrow down those two issues, the product risk and the regional risk for the two, as an added comment we currently are seeing that maybe carbonate is or LSP, chemistries are about maybe 20% 25% of the market. That's our current view, we continue to monitor that carefully. Kent do you want to comment just on how we think about risk?"
},
{
"speaker": "Kent Masters",
"text": "Yes, I would say I mean, important for us, given the locations where [Technical Difficulty] we look at it kind of at a macro level, and by country, so and we look at it for particularly kind of we get deeper and deeper as we make a new investment. But we monitor that. So a lot happening in Chile, as you know, we talked about on these calls before Argentina, as we make investments there, we'll have to make sure that we're looking at those risks and monitoring that Australia less of an issue, China's another area that we have to focus on, and make sure we have our risk assessments but we monitor those, we try and combine it with active government relations on making sure that we're doing the right thing in the country. So we're seeing as a good actor, and that we're bringing value to them as well, that others can't necessarily bring. So that's a big part of how we feel that we mitigate the risk and some of those geographies."
},
{
"speaker": "Operator",
"text": "Our next question is from Colin Rusch from Oppenheimer. Please go ahead, Colin."
},
{
"speaker": "Colin Rusch",
"text": "Thanks so much guys. Can you talk a little bit about the potential for incremental customer deposits or customer funded CapEx? You guys are spending a ton of money to grow capacity, and then just worrying about some of the alternative strategies for finance?"
},
{
"speaker": "Kent Masters",
"text": "Yes, Colin I think it's a good question. I think, given the environment that we're in, and the concern around supply from our customers, we're exploring all sorts of options, partnership type of options, like Eric talked about pre payments, there's a variety of different things there. I think the key for us is to ensure that that those types of agreements are giving us incremental return, versus what we could do on our own. So clearly, our strong balance sheet, strong support from investors give us plenty of capacity to build and do it on our own. But if we can get incremental returns, we'll take a look at it."
},
{
"speaker": "Colin Rusch",
"text": "Okay, and then just given the expertise that you guys have around cathode materials and formulation, I'm wondering about your willingness are interested in additional vertical integration. Obviously, you don't want to compete with your customers, but it seems like you guys have enough expertise that you could do some real work in that space?"
},
{
"speaker": "Kent Masters",
"text": "Is that a capital question or just a CapEx question?"
},
{
"speaker": "Colin Rusch",
"text": "Yes. CapEx, I wanted to hear vertical integration there."
},
{
"speaker": "Kent Masters",
"text": "Yes. So I mean, look, we look at the different options, but we're from, we look at it from a material standpoint, our interest in batteries and cathodes is to make sure that we're producing and developing the right chemistry that go into our customer’s processes. So we're not looking to be in the cathode business, but we're looking to be an excellent supplier to those cathode makers and the OEMs that have a vested interest in the battery and the cathode technology."
},
{
"speaker": "Eric Norris",
"text": "Yes, and I just expand Colin part of note, part of doing that as being able to understand that application very well, but not integrate forward into it. And as I would also say, though, that as we look at other advanced forms of lithium, we'll look at the -- again, question exactly how we want to play and still be material player, but what material are we supplying? And so we're looking at, as you look at solid state chemistries, there's a variety different ways we can play in that area. And we're doing a lot of work currently, with partners and customers in that area to determine the future."
},
{
"speaker": "Colin Rusch",
"text": "That's it for all. Thanks, guys."
},
{
"speaker": "Operator",
"text": "That's all the time we have for today's Q&A session. I'm now going to hand you back to Kent Master for any final remarks. Please go ahead."
},
{
"speaker": "Kent Masters",
"text": "All right. Thank you, Terrence. And thank you all again for your participation on our call today. Our success in 2021 combined with the momentum we are experiencing in '22 strongly positions us for profitable growth. I'm confident in our team's ability to drive value for all of our stakeholders by accelerating our growth in a sustainable way and to lead by example. Thank you and thanks for joining us."
},
{
"speaker": "Operator",
"text": "This conclude today’s call. Thank you for joining. You may now disconnect your lines."
}
] | Albemarle Corporation | 18,671 |
ALB | 4 | 2,023 | 2024-02-15 09:00:00 | Operator: Hello and welcome to Albemarle Corporation’s Fourth Quarter 2023 Earnings Call. All lines have been placed on mute to prevent any background noise. After the speaker’s remarks, there will be a question-and-answer session. [Operator Instructions] I will now hand it over to Meredith Bandy, Vice President of Investor Relations and Sustainability.
Meredith Bandy: Thank you. And welcome everyone to Albemarle’s fourth quarter and full year 2023 earnings conference call. Our earnings were released after the close of market yesterday and you’ll find the press release and earnings presentation posted to our website under the Investor Section at albemarle.com. Joining me on the call today are Kent Masters, Chief Executive Officer; and Neal Sheorey, Chief Financial Officer. Netha Johnson, President of Specialties; and Eric Norris, President of Energy Storage are also available for Q&A. As a reminder, some of the statements made during this call, including our outlook considerations, guidance, expected company performance and timing of expansion projects, may constitute forward-looking statements. Please note the cautionary language about forward-looking statements contained in our press release and earnings presentation that also applies to this call. Please also note that some of our comments today refer to non-GAAP financial measures. Reconciliations can be found in our earnings materials. And now, I’ll turn the call over to Kent.
Kent Masters: Thank you, Meredith. Now, starting on slide four, our full year results show continued strong volumetric growth, with 2023 marking the highest net sales and second highest EPS in Albemarle’s history. This highlights the focus and ability of our global team to succeed in a macro environment that remains challenging. We ended the year with net sales of $9.6 billion, up 31% compared to 2022, of which 21% was related to volume growth. Energy Storage delivered 35% volumetric growth in 2023. For the full year of 2023, Albemarle’s adjusted EBITDA was $2.8 billion or $3.4 billion excluding a lower cost or market charge recorded in the fourth quarter. Excluding this non-cash charge, adjusted EBITDA was in line with our previous expectations. In January, we announced a series of proactive measures to re-phase our organic growth investments and optimize our cost structure. These disciplined actions should allow us to unlock more than $750 million of incremental cash, advance near-term growth and preserve future opportunities. Today, we will provide our initial thoughts on our full year 2024 earnings. To help investors model Albemarle in the current environment, we will introduce scenarios based on recently observed lithium market prices. Neal will provide more details on this in a few minutes. We remain as confident as ever in the future of Albemarle and ongoing demand for the essential elements we provide to support modern infrastructure, including mobility, energy, connectivity and health. The secular trends of clean energy, electrification and digitalization continue to drive growth. We are uniquely positioned to capitalize on the opportunities in our end markets, in particular lithium demand. Over the past year, we have further strengthened Albemarle’s position and are committed to navigating the near-term dynamics in a disciplined manner to both support and capitalize on these global trends. I’ll now hand it over to Neal to discuss our financial results.
Neal Sheorey: Thanks, Kent, and good morning, everyone. It’s a pleasure to join my first earnings call with Albemarle. I’ve hit the ground running, and in the coming weeks, I’ll be on the road meeting with our shareholders and analysts. I’m looking forward to reconnecting with many of you and building new relationships with those of you I haven’t yet met. Moving to slide five, I’ll start with a review of our fourth quarter and full year 2023 performance. In Q4, we reported net sales of $2.4 billion, down 10% compared to last year, as lower lithium market pricing was partially offset by increased volumes in Energy Storage and higher volumes in pricing in Ketjen. As Kent mentioned, we recorded two charges in Q4 that impacted results. The first was a lower of cost or market charge of $604 million and the second was a tax valuation allowance in China of $223 million. These charges were fundamentally related to the fact that in the second half of 2023, lithium market prices feel over a relatively short period of time. In the case of the LCM charge, market prices reached a level such that our cost of inventory, especially spodumene, which we purchased at a market price from our Talison JV, was above the market price of the final lithium salts, which resulted in us writing down the value of our inventory in accordance with GAAP. Similarly, in the case of the tax valuation allowance, the rapid decline in market prices led us to recognizing losses in China as we process the higher cost spodumene in inventory. In China, we are only allowed a five-year carry-forward period to utilize these losses. In accordance with GAAP, we recognize the valuation allowance against the losses. The company’s full year results excluding those charges met our previously announced expectations. Net sales of $9.6 billion were up 31%, primarily driven by volume growth. Adjusted diluted EPS, excluding both charges, was $22.25, roughly flat year-over-year. Looking at slide six, fourth quarter adjusted EBITDA was $289 million, excluding the lower of cost or market charge. This primarily reflects a decrease in Energy Storage adjusted EBITDA, driven by a lower lithium market pricing, which more than offset higher volumes. In Specialties, adjusted EBITDA declined $64 million, primarily due to lower sales volumes and pricing, reflecting ongoing demand weakness in key end markets. Ketjen adjusted EBITDA increased $34 million, as higher sales and higher pricing more than offset increased raw materials costs. Turning to slide seven, before I transition to forward-looking information, I want to take a moment to review our adjusted EBITDA definition and share an update that we plan to make. Effective with Q1 2024, we are updating our definition of adjusted EBITDA to include Albemarle’s share of the pre-tax earnings of our Talison joint venture. There are a few important reasons for this change. First, the updated definition better reflects our vertical integration with Talison’s Greenbushes mine, one of the world’s largest, highest grade and lowest cost lithium resources. Second, it smooths the impact of price variations in inventory timing that obscure the underlying profitability of our full-chain integration. And finally, this definition is consistent with the amendment to our revolving credit facility, which I’ll discuss later on the call. As a reference point, on this slide, we’ve given you both the Energy Storage and Albemarle full year 2023 adjusted EBITDA under the previous and updated adjusted EBITDA definition. We will report under the updated definition in 2024. Therefore, all of our comments and numbers regarding 2024 modeling considerations are based on this new definition. Turning to slide eight, to help investors model Albemarle’s earnings under different price scenarios, we have provided ranges of outcomes for our Energy Storage business based on three lithium market price scenarios that were observed in the back half of 2024. First, year-end 2023 market pricing of about $15 per kilogram of lithium carbonate equivalent or LCE. Second, Q4 2023 average market pricing, which was about $20 per kilogram of LCE. And third, second half 2023 average market pricing, which was about $25 per kilogram of LCE. Within each scenario, the ranges are based on our expectation to increase Energy Storage volumes by 10% to 20% in 2024 compared to 2023. All three scenarios assume flat market pricing flowing through Energy Storage’s current book of business. These scenarios demonstrate the resilience of our Energy Storage business. As you would expect, given our strong resource positions around the world, we can maintain solid margins even with lower year-over-year lithium pricing, which are further bolstered by our organic volumetric growth and the normalization of temporary inventory timing impacts. Moving to slide nine, here we provided modeling considerations for Specialties, Ketjen and Corporate. We expect Specialties 2024 net sales of $1.3 billion to $1.5 billion and adjusted EBITDA of $270 million to $330 million. Ketjen 2024 net sales are expected to be $1 billion to $1.2 billion with adjusted EBITDA of $130 million to $150 million. The Corporate outlook reflects our planned decrease in capital expenditures, which we expect to total $1.6 million to $1.8 billion in 2024, down from $2.1 billion in 2023. Corporate costs in 2024 are expected to be between $120 million and $150 million. Corporate costs in 2023 included interest income that is not expected to recur, and therefore, excluding this factor, Corporate costs are relatively flat year-over-year. Adding it all together on slide 10, we provided here the full roll-up of Albemarle under each of the Energy Storage price scenarios. Turning to slide 11, I’ll provide some further detail on the trends that underpin each segment’s outlook. In Energy Storage, approximately two-thirds of 2024 estimated volumes are expected to be sold on index-referenced, variable-priced contracts. The remaining approximately one-third of volume is expected to be sold on short-term purchase agreements. This is a modest change from our past mix and reflects our positioning in this lower price environment. We could potentially add additional long-term contracts, but we will only entertain that if the pricing and other terms reflect long-term industry fundamentals. Energy Storage volume is expected to be weighted toward the second half of 2024 as our own capacity expansions ramp and as we experience normal seasonality. Specialties results are also expected to be back-half-weighted. The Specialties outlook reflects continued softness and opaque demand conditions in consumer electronics and elastomers and markets, partially offset by strong demand in oilfield services, agriculture and pharmaceuticals. We continue to actively monitor the situation in the Middle East, and in particular the Red Sea, and are working with our partners to facilitate safe, efficient and cost-effective transport of our products to customers. To-date, operations continue largely as normal, though we are experiencing some shipping delays and tighter availability of processing materials. In Ketjen, we are optimistic about increased volumes driven by high refinery utilization, as well as higher pricing, primarily in clean-fuel technology products. Ketjen made good progress against its improvement plans in 2023 and we are expecting another year of improvement in both net sales and adjusted EBITDA. Moving to slide 12, we continue to deliver volumetric growth with line-of-sight to a growth CAGR of about 20% from 2022 to 2027. Our expected 2024 volume growth reflects projects that are at or near completion and which we have prioritized as we reduce capital spending in other areas. This includes commissioning and startup of the Meishan lithium conversion facility, completion of commissioning activities at the Kemerton lithium conversion facility and ongoing expansions at Silver Peak, La Negra and Qinzhou. Our long-term expected lithium sales volumes are mostly unchanged as we continue to utilize flexible tolling arrangements to bridge to full capacity at our conversion expansions, as well as pace supply to current market conditions. Turning to slide 13, this is an update to a slide we provided last quarter, which explains how Energy Storage margins are impacted by JV accounting and the inherent timing lag that occurs from the mine through our conversion processes. The inventory lag we saw beginning in the second half of 2023 is expected to be reduced for two reasons. First, the lower of cost or market charge recorded in Q4 2023 resets inventory costs closer to current market pricing. And second, the Talison JV partners recently agreed to change the spodumene pricing to M-1 or a one-month lag versus the prior use of a three-month lag. That said, these changes will not completely offset the inventory lag, particularly in a period where prices have significantly changed. And therefore, we expect our first half 2024 margins in Energy Storage to be impacted by the lag as we process higher cost spodumene inventory and by expected reduced sales from Talison to our JV partner. Importantly, when we look beyond these temporal impacts, we estimate that Energy Storage could exit the year at a margin of approximately 30%, assuming constant current market pricing and a return to normal shipments from the Talison JV. Turning to slide 14 and our financial position. As our rapid action in recent months has shown, we are committed to maintaining a solid investment-grade credit rating and enhancing our financial flexibility as we navigate the lower price environment. With our earnings release yesterday, we announced that we have completed an amendment to our revolving credit facility to ensure ongoing financial flexibility. The amendment uses the revised adjusted EBITDA definition consistent with the definition that we will use for financial reporting going forward. I’m happy to share that we had unanimous support from our bank syndicate for the amendment. This action, along with all the steps we are proactively taking as a company to modify our cost and capital spending, demonstrates our focus on maintaining financial flexibility, adapting with changing market conditions and exercising our investing discipline. With that, I’ll turn it back over to Kent to provide more details on our actions to preserve growth, reduce costs and optimize cash flow.
Kent Masters: Thanks, Neal. And now turning to slide 15. In markets as dynamic as ours, growth companies must be able to pivot and pace with disciplined decision-making and focused execution. This is especially true for Albemarle as a trusted leader in the markets we serve. At Albemarle, disciplined growth means carefully prioritizing CapEx timelines when pricing moves higher and re-phasing when the market shifts. As we look to 2024 and the current market dynamics, we’ve identified certain strategic investments and projects across the enterprise that do not need to grow as fast in the short-term. In short, the returns for new projects are not there at these prices, which we believe are well below reinvestment levels. As a result, we are reducing our CapEx in 2024 by $300 million to $500 million versus 2023 by refocusing our energy on the large, high return projects that are significantly progressed near completion or in startup. Additionally, we are aligning our OpEx to a slower pace of investment. We are taking action to reduce costs by nearly $100 million and we expect to realize more than $50 million of these savings in 2024. Our actions include reducing headcount and lowering spending on contracted services. We also continue to evaluate and execute the sale of non-core investments. For example, we recently monetized our Liontown holdings, given our decision to withdraw our non-binding offer. At the same time, we’re pursuing additional cash management actions, including optimizing our working capital. This includes initiatives focused on shortening the time from the mine to the customer in our supply chain. These measures together are expected to unlock more than $750 million of cash flow in the near term. This disciplined approach to managing the current market downturn reflects the actions that we must take to preserve our financial flexibility and re-pace our investments. The actions we are taking today will position Albemarle to emerge stronger to the benefit of our shareholders, partners, employees and the communities in which we operate. Moving to slide 16, the specific re-phasing decisions within our 2024 CapEx plan include continuing critical health, safety, environmental and site maintenance projects, commissioning the Meishan lithium conversion facility, which reached mechanical completion at the end of 2023, completing commissioning activities for trains 1 and 2 at the Kemerton lithium conversion facility and prioritizing construction on train 3 of the Kemerton Expansion Project, and prioritizing permitting activities at the Kings Mountain spodumene resource. We continue to have significant optionality for long-term organic growth. At the same time, if pricing remains below reinvestment economics, we will be disciplined and hold capital at or below current levels for the foreseeable future. Moving to slide 17, the Albemarle way of excellence remains the standard by which we operate and continues to serve us well in 2024. Here we provide more details on operational discipline, a key pillar of our operating model, especially given the current environment. In 2023, we realized productivity benefits of more than $300 million, well ahead of the initial target of $170 million and we’ve identified plans that target another $280 million in productivity benefits this year. In manufacturing, we continue to implement initiatives on overall equipment effectiveness, including improvements to recovery and utilization with expected benefits of $80 million. In procurement, we are targeting benefits of $150 million by pooling Corporate spend and continuing our strategic sourcing to recognize lower raw material pricing. And finally, after restructuring certain back office functions and with reprioritized projects, we expect to realize $50 million of productivity improvements. Slide 18 demonstrates the adjustments we’ve made to our capital allocation priorities as we navigate the dynamics of our key end markets. Our four capital allocation areas remain the same with shifts in how we prioritize. As Neal highlighted earlier, maintaining our financial flexibility in this environment is a central area of focus. We’ll continue to selectively invest in high return growth, but we’ll be patient and disciplined. We expect minimal M&A in this environment as we primarily focus on organically accelerating growth at attractive returns. As we have mentioned before, we’ll continue to actively assess our own portfolio to identify opportunities to create value. Moving to slide 19, while the pricing environment has softened for the moment, we should not lose sight of the fact that we continue to see significant long-term growth in demand for limited supply. This updated forecast is about 10% below our previous forecasts from early last year and it now reflects recent OEM announcements, more moderate battery size growth and inventory destocking. At the same time, global EV penetration is expected to grow significantly, resulting in anticipated 2.5 times lithium demand growth from 2024 to 2030. In 2024 alone, we expect demand growth of 28%. To put it another way, we expect that this industry needs more than 300,000 metric tons of new LCE capacity every year. In our view, incentivizing producers to meet this demand requires long-term pricing at or above investment economics and certainly above current market pricing. At today’s prices, the economics for new greenfield projects, particularly in the west are not supported. We expect near-term supply to be relatively balanced with demand and you see that adjustment starting to happen with recently announced production curtailments and project delays, including our own. As a leader, Albemarle remains well positioned to capitalize on the long-term growth trends we see in front of us, but we’ll be disciplined in how we capture our share of it. Slide 20 shows our durable competitive advantages and how Albemarle can win as we navigate near-term conditions. We are vertically integrated with a globally diversified portfolio of world-class, low-cost resources and industrial scale conversion assets. Albemarle has leading process chemistry that allows us to build and operate large-scale assets safely and efficiently. As a leader in the markets we serve, we are a partner of choice to strategic customers and stakeholders that seek to drive innovation and growth. For example, we recently signed a multiyear supply agreement with BMW, which takes effect in 2025. That agreement will also allow both companies the opportunity to partner on technology for safer and more energy-dense lithium-ion batteries. And last but certainly not least, we are committed to operating sustainably with industry-leading ESG performance and partnering with customers and suppliers to benefit the entire supply chain. As Albemarle adapts to the market dynamics, both present and future, we are confident in our ability to deliver on our strategy and drive value for shareholders. With that, we’d like to turn the call back over to the Operator to begin Q&A.
Operator: [Operator Instructions] Your first question comes from a line of Stephen Richardson from Evercore ISI. Your line is open.
Stephen Richardson: Hi. Good morning. I just wanted to get a clarification on slide 12, which is always very helpful in terms of sales volumes. Could you comment on what were your fourth quarter sales volumes and what do you expect Q1 to be?
Kent Masters: Neal, you want to take that?
Neal Sheorey: Sure. Hi, there. Good morning, Stephen. So if I heard your question right, you were looking for volume growth that we had in the fourth quarter, as well as volume growth that we expect in the first quarter. So we haven’t -- with regards to 2024, we haven’t given the specific volume growth numbers across the specific quarters in 2024. As we mentioned, we expect 10% to 20% growth in the year in 2024 and really the growth trajectory in the year will be dependent on how quickly we can ramp our existing assets that are in startup at the moment.
Stephen Richardson: Thanks. Maybe just a follow-up specifically on assets. The 10-K, which it looks like you just filed, suggests, just looking at those numbers, that the Atacama was flat year-over-year. Is -- could you just give us an update on the Salar expansion and what the status is in Chile right now in terms of incremental volumes?
Kent Masters: Yeah. So I can start. Eric can fill in a little bit. So at the Salar, we were operating at capacity. We’ve done expansions at La Negra. We need brine to feed that. So that expansion is complete. But we need the brine from the Salar to feed that and then we -- we’re in commissioning of the Salar Yield Project. That’s the project that will provide the additional brine. But once we do that, it has to work its way through the brine system, and then we can, that’ll end up feeding the La Negra project. And I think that’s probably, Eric, a six-month lag, roughly, from a Salar perspective?
Eric Norris: Yeah. I mean, for virgin brine that we pump, it’s -- I think the rule of thumb has been more like 18 months, but for the Salar Yield, it’s six months. We commissioned that in the middle of last year. That’s enabling, Steve, the growth that we will see in that 10% to 20% range. A big chunk of that is coming out from carbonate, from Chile, from the La Negra plant, enabled by Salar Yield.
Stephen Richardson: Perfect. Thanks very much.
Operator: Your next question comes from a line of Colin Rusch from Oppenheimer. Your line is open.
Colin Rusch: Thanks so much, guys. Can you talk a little bit about what you’re looking for as triggers for either Salar and -- or re-accelerating some of the CapEx investments for the rest of the year?
Kent Masters: Yeah. So, I mean, to be blunt, I think that’s going to be about the pricing levels that we see and the trends that we see. So, we see demand there. The volume growth in the industry is there and we start seeing some projects come out, operating projects, as well as projects on the books, like the ones that we described. So, for us to kind of re-accelerate, if you will, we’ll need to get a better view of what pricing is and the long-term view of that as well. So we think what the prices today are unsustainable. They’re below operating cash levels of some assets that are currently operating and they’re definitely below reinvestment levels, and as we said, particularly in the West, there’s not a particular price that kicks up necessarily a range of projects off. It’s all individual, depending on the resource, where it’s located, what the cost position is of that and the conversion asset, where that’s located. So, there’s not one number that we will look at, but we’ll look at it project-by-project, but it’s not going to -- if spot prices hit a number, that’s not going to necessarily turn us back into investment mode. We need to have a view that that’s a long-term number that we can rely on through the life of that asset.
Colin Rusch: Thanks so much. You’ve talked about inventory levels for the industry in the past and I wanted to get an updated view on what you think is a normalized inventory level for the channel to keep things healthy and moving and what you’re seeing right now in terms of inventories on hand through the channel?
Eric Norris: Hey, Colin. Hi. It’s Eric. We’ve spent a lot of time looking at inventory and there’s been a drawdown effect that’s been on and off throughout all of last year and into this year. At the top of the supply chain upstream, looking at lithium salts and even the next level cathode production, we feel that inventory is normalized. The drawdown we’re seeing now, harder to predict and understand because it’s less visible to us, is at the battery cell, battery module and EV level. There are a lot of reports out there that vary on that. It’s not a highly quantitative or a highly known number, but I -- we think there’s probably a couple months’ excess as we exited last year, that will be drawn down this year that’s going to affect apparent demand. So that’s why our demand forecast is a difference if you look at, I can’t remember which slide it is, the lithium supply side towards the back of the deck between lithium demand growth and EV growth, and that is that drawdown effect happening at the battery and EV level.
Colin Rusch: That’s super helpful. Thanks so much, guys.
Operator: Your next question comes from the line of Steve Byrne from Bank of America. Your line is open.
Steve Byrne: Yeah. Maybe just continuing on that discussion, where is it that you see the glut of inventory that is driving spot prices down? Is it spodumene inventories at converters that is really where the glut of material is?
Neal Sheorey: Hey, Steve. I’ll repeat what I said before. It is not upstream. We’re not seeing large inventory levels. We’re actually seeing projects, spodumene projects, go into care and maintenance. There’s several in Canada, or excuse me, in Australia, there’s one in Canada and some others that are questionable that we’re watching closely. And so it’s not there, it’s not at the conversion level. We track that as well, as well as the direct consumer for us, which is the cathode companies. We have very high visibility to that. That was at one point fairly high a year ago. That has since come down. The inventory that we’re seeing is further downstream, as I was saying earlier. It’s the battery and EV level of supply chain and that is affecting apparent demand to the lithium industry, albeit EVs are growing quite healthfully about 30% we see for the year going forward.
Steve Byrne: What would you say is driving the spot price of hydroxide to be meaningfully lower than carbonate in China and does it make sense for you to cut your operating rates to tighten that market up and drive an inflection?
Neal Sheorey: Well, look, I’ll answer the price question. Maybe Kent would like to comment on the broader supply question. On the price question, I think what you’re seeing in China is particular, let’s remember China’s almost three quarters, two-thirds to three quarters of lithium supply is consumed in China. It’s very much the market where things are set and the trend there has been strongly towards, in the past year, towards carbonate for LFP production. That trend is the opposite in other parts of the world that are developing like Europe and North America, although we are seeing LFP interest. So those two products are starting to balance out, looking to be closer to 50-50 in their mix, although we have to watch it. It will move with time as technology and scale economies develop. That is causing that near-term, if you will, putting things upside down because historically hydroxide has been higher than carbonate. In the near-term, we’re seeing that flip. We would expect that to revert over time as the industry grows. Do you want to comment on supply more broadly, Kent?
Kent Masters: I don’t -- I mean I don’t know if I have anything much to add to that. I think we supply hydroxide and carbonate. We tend to supply carbonate from Chile. So we are -- that capacity is growing, as we just talked about a little bit earlier. We will supply that into the LFP market. And then we are trying to be balanced between hydroxide and carbonate and catch those growing trends. It is a little bit more skewed toward carbonate at the moment and --but we think hydroxide catches up to that. Then your question about should we lower rates to bring that back into balance. So I don’t -- we are still ramping up and we still see growth in the market of 20% a year. We are 10% to 20% for us this year and the market is a little bit stronger than that. I think that demand catches up without us having to adjust operating rates. We are still trying to commission plants and catch up to that.
Steve Byrne: Thank you.
Operator: Your next question comes from a line of Josh Spector from UBS. Your line is open.
Josh Spector: Good morning. Good morning. So I had a couple of questions around your pricing scenarios. When you talk about $15 a kilogram on the Asian markets, what is implied in that scenario in terms of Albemarle realized pricing and really getting towards the impact of floors, if that is meaningful or not or if anything has changed in that regard?
Neal Sheorey: Yes. Josh, it is a bit of a complicated picture, because as you may know, there are varied price indices out there. There are some for China and some for outside China. Those inside tend to be 10% to 15% lower just because of the structural differences and some other aspects that drive that. But in any event, as you look at an average price across the two, we are going to be higher than the index generally for a couple of reasons, as -- particularly as prices go low. One is floors, so it’s -- our price is a little more sticky, even though it is linked to the index. And then the other is our mix. We tend to be more biased to outside China than in. That being said, where the price goes, that will be the trend that our ASP, our average selling price, follows.
Josh Spector: Your EBITDA ranges for 15% versus 20% versus 25%. It is the same change in EBITDA between each range. If there were floors in the high-teens, low 20s, wouldn’t the increment from 15% to 20% be a bigger step up than 20% to 25%? I guess, what would I be missing in that math?
Kent Masters: Josh, we might need to look at the math you are doing, because actually the transitions between those different scenarios are a little bit different and actually if you do some averaging math in those scenarios, you will see how we have a little bit different jump between the three different scenarios.
Josh Spector: Okay. I will follow up on that offline. Thanks.
Operator: Your next question comes from a line of Jeffrey Zekauskas from JPMorgan. Your line is open.
Jeffrey Zekauskas: Thanks very much. I have a question on your Specialties forecast. For next year, you -- at the midpoint, you assume EBITDA is about the same and revenues are about flat. And last year in the first quarter, I think, your Specialties EBITDA was something like $162 million and maybe you finished the year at something close to $30 million. How can you get to flat EBITDA as a base case?
Netha Johnson: Yeah. Hi, Jeff. This is Netha. I think if you look at the way we are projecting, the way pricing plays out throughout the year, you are right. The first quarter will be a little bit challenging on a year-over-year comparison standpoint. We still saw the numbers you saw, which was about a 60% growth in Q1 last year. The decline from that was really, really steep, driven by pricing. If you play that out on an annual basis for us, we think we can get back to where we were last year with maybe some upside or downside based on the ranges we provided with the pricing we expect to see going forward, and as Neal stated, that really is about a second half ramp in market volume and market pricing that we see coming and it’s really driven by how we look at the forward indicators with semiconductors, which for us is a good proxy for electronics already up 25% in the first quarter alone.
Jeffrey Zekauskas: Okay. And then for my follow-up, can you talk about what your either cash flow expectations are this year or free cash flow expectations for 2024?
Neal Sheorey: Yeah. Hi. I’m sorry, Jeff.
Jeffrey Zekauskas: Sure.
Neal Sheorey: Sorry. So this is Neal. Jeff, good morning. So, yes, we have obviously several things that are in motion right now with regards to our cash flow and I just want to put a finer point on what we’re working on with regards to operating cash flow. Obviously, we’ve already mentioned that we are working hard on aligning our own OpEx to the current pricing in the market. We’re also working on several operational things from a working capital perspective. You should expect in a deflationary environment that we should continue to release cash from working capital. And additionally, we’re looking for other levers that we can pull to further reduce inventory in our network. For example, investors are well aware that we have a long time between the mine and the customer in our natural supply chain. So we’re looking for ways that we can reduce that and harvest cash from there. And then, of course, from a free cash flow standpoint, we’re reducing CapEx, as Kent mentioned earlier. In addition to that, we also have what I call non-operational cash flow items that we’re working on. This is things such as looking at what we can do with our working capital balances and generating financing from that. Now, all of that said, I realize that, some people may want a rule of thumb of how to think about this. So if you think about things from a cash conversion standpoint, and obviously, it will depend on what your lithium scenario is, but a cash conversion, if you look over the last three years or four years, this company has averaged a conversion of about 50%, plus or minus 10%. So that’s one example that you can use to think about how to model operating cash flow.
Jeffrey Zekauskas: Great. Thank you very much.
Operator: Your next question comes from a line of Vincent Andrews from Morgan Stanley. Your line is open.
Vincent Andrews: Thank you very much and good morning. Maybe just following up on that, just looking at the balance sheet at the year end, your receivables are up year-over-year, your inventory is up year-over-year, your payables are about flat and that’s in a -- obviously, the lithium price ended the year much lower at the end of 2023 than it did at the end of 2022. So what’s the bridge on that that caused that working capital to build despite the lower prices?
Neal Sheorey: Yeah. Good morning, Vincent. So it’s a few things. I think one of the important ones with regard to inventory is, remember that we have several assets that are in startup. So there has been a natural build in inventory through 2023 and you will continue to see that to some extent in 2024 as we build that inventory and work through the commissioning and startup of these new facilities that we have around the world. Remember, too, that there’s a timing aspect to this as well and so you have the timing of shipment and how that flows through our working capital, and so when you look at an end of year punctual period, you won’t necessarily see the impact of the timing of those shipments and so when we take a snapshot at the end of the year, it might not accurately reflect sort of the lag that we have in our supply chain. But just to link your question, Vincent, also to what Jeff just asked, as you think about whatever your lithium price scenario is, and as you think about working capital cash release in 2024, depending on the scenario that you pick, if you use the scenarios we put in our deck, we’re looking at a sales decline of somewhere between $2 billion to $4 billion, depending on the scenario, and historically, we use a rule of thumb here at the company that working capital is around 25% of sales. So you should expect in 2024 that we can release cash to the tune of $500 million to $1 billion, depending, of course, on how those scenarios evolve in 2024.
Vincent Andrews: That’s very helpful. Thank you. And Kent, can I just ask you to refresh us on what return on invested capital you’re looking for when you put CapEx to work in the Energy Storage business and I don’t know if you want to define it differently by geography, but just sort of what those rough hurdle rates are and if they’ve evolved at all over the last few years, given the price movement.
Kent Masters: Yeah. So we -- I mean, we kind of have a benchmark that we use to where we say at trough pricing, we want to get our cost of capital and double that at kind of the mid-cycle pricing. So now those numbers have moved around on us, but that’s kind of our -- still our aim when we do projects is, when we look at it at what we believe is trough pricing, that that would generate a cost of capital and then kind of twice that at mid-cycle pricing -- average pricing.
Vincent Andrews: Thanks very much, guys.
Operator: Your next question comes from a line of David Begleiter from Deutsche Bank. Your line is open.
David Begleiter: Thank you. Good morning, and Neal, welcome aboard. Kent and Eric, Energy Storage EBITDA guidance, if you were to mark-to-market that guidance to current prices, assuming no change in prices for the rest of the year, how much lower would your EBITDA guidance be for Energy Storage?
Eric Norris: Yeah. Hi, David. Good morning. Look, I think we’ve provided the numbers here for people to interpolate as they would like to between these different lithium price scenarios and so you can do your interpolation based on what you think the market price is at the moment. The only caution that I would give you as you think about a lower price scenario, which I think is where your question is getting at is and you can see this in our scenarios, as you get to these levels, it’s not unreasonable to think you’re bumping into some of the floors that we have in our contracts and those are at varying price levels, but you will see that in the math of our scenario. So I wouldn’t necessarily take that interpolation one for one if you’re going down further than the scenarios we’ve given.
David Begleiter: Understood. And Eric, just on lepidolite production in China, how much do you think has been shut in? How much do you expect to be shut in? Why has there not been more shut-in up until now for lepidolite production in China?
Eric Norris: Well, thanks for the question, David. A couple of things I’d say. When we look at shut-in capacity or capacity that’s exited the market in general and a big chunk of it is lepidolite, but some of also non-integrated spodumene and some of it is spodumene itself that’s come offline or is about to come offline because it’s very high cost, it’s above current spodumene costs even or prices rather or the cost is above current spodumene prices. But that is about 200,000 tons in total that has come off. Lepidolite is probably close to maybe a third to a half of that, somewhere in that range. The non-integrated lepidolite production has come off. Some of the integrated lepidolite production that is of weaker grade is well below -- the price is well below the cash cost of that. It’s very hard for us to -- we know that, we know what the economics are, we can’t necessarily understand why some of it’s there. It’s still operating, because otherwise it should be -- our math tells us it should be coming offline. So we can’t quite understand what’s going on there, but there’s still quite a bit, there’s still some capacity in the market that’s, well, like I said, at current prices, cost is well above those prices.
David Begleiter: Thank you.
Operator: Your next question comes from a line of Joel Jackson from BMO Capital Markets. Your line is open.
Joel Jackson: Hi guys. I’m not sure it’s Joe Jackson. So I wanted to ask a question about some of your sales guns for Energy Storage. If I take your guide, it’s $15,000 a ton, 10% to 20% more volume than the 150,000 tons you did Energy Storage last year. That would imply sales just a bit below $3 billion, maybe $2.9 billion for Energy Storage for this year. We’re going to, I think, $3.3 billion or something like that. What is the $400 million or $500 million difference in sales? Is that an accounting thing, spodumene, can you explain it, please?
Neal Sheorey: Hi there, Joel. No. It is not an accounting thing. I am wondering what volumes you’re using, because the ranges that we set here in our scenarios are based on the range of volumes that we’ve put here on the slide, slide eight in our deck and so we’ve adjusted the ranges based on that. So there’s definitely no accounting noise in that revenue number. Additionally, I should say this, too. Maybe this explains it. Just remember that for Energy Storage in total, there are other products that are in Energy Storage that don’t necessarily move one for one with lithium market price. So maybe that’s another piece of what is in your math as well.
Joel Jackson: Yes. Okay. Fair enough. I just wanted to also ask you about the U.S. strategy. So as this industry was really looking at regional supply chains and you really were going to go after Kings Mountain and U.S. Mega-Flex, you put those plans on hold, but you’re still doing the permitting, of course, at Kings Mountain. As you know, it takes a while sometimes to get mine’s permit in the States. Is this -- how important is this U.S. strategy going to be? Is this something maybe that will have to be reassessed? Can the DoE or DoD with some of the different funding options help revive some of this? It seems like there’s a bit of a damper here on some of the objectives of political and the industry.
Eric Norris: Yeah. No. I think there’s a big impact on that. I’m building this, we say in the West, so called Europe and North America, but focus is and we were a bit more focused on North America, we have access to a great resource at Kings Mountain, but where prices are today, the economics aren’t there for those projects. So we continue to progress, as you said, the permitting, the kind of real long lead time items that are not real capital intensive, in anticipation of prices coming back to where we’d be able to do those investments or some support or another way that we maybe could do those. But they’ve been pushed out. I mean, our -- at Richburg, we haven’t, that’s not a canceled project, it’s been delayed. So we’re still doing some of the long lead time permitting there, but no construction and we stopped engineering work on it. And Kings Mountain, we’re progressing with the permitting because that’s long lead time. We hope to work out a solution, but it requires better pricing in order to execute on those projects. And those are prom -- and those are kind of the two of the best opportunities to start the supply chain. We need a lot more support, not just, we can’t do it ourselves, but that would be the first project we would bring to market in North America, and probably, as others as well, particularly around resources.
Operator: Your next question comes from a line of Mike Sison from Wells Fargo. Your line is open.
Mike Sison: Hey. Good morning. Could you just remind us, given your new CapEx plans, what your -- what capacity you’ll end with in 2024 and then could you give us an update on how you think that will unfold in 2025, 2026, 2027? So where do you think you’ll be in capacity to offer the market over the next several years?
Eric Norris: So depending on where we land -- Mike’s is Eric, depending on where we land in that range of 10% to 20%, you’re talking something that could be close to, it’s going to get close to 200,000 tons, 190,000 tons, 200,000 tons at the top end and that is being driven, just to be specific, by more production out of Chile, which we discussed earlier and that’s realizing some of the efficiencies of the Salar Yield Project and the bottlenecking capacity downstream for La Negra to drive that growth. It’s also being driven by increased spodumene production out of Australia and the ramp of Kemerton, Qinzhou as well, where Meishan is more of a 2025 item for the time being, but that plan is ramping nicely for that period of time. That then brings me to how you think about the future. Kemerton I and II will continue to ramp as you go into 2025. Meishan will start to ramp in 2025 and 2026. The interesting thing about our near-term volume picture is we’re going to be looking at that sort of 20% plus volume growth for some years to come, based upon the investments we have made already. The things that we have idled or paused from an investment standpoint that Kent earlier referenced were longer term, further out, sort of really second half of decade in terms of what they were going to deliver. So the impact of slowing those down, should prices stay low and we not return to investing those projects will be felt in the latter part of the decade, which is, I’ll also remind you, is a point in time where we see industry supply already getting tight relative to demand. So there’s some real challenges because we don’t see demand slowing down. We certainly see weakness in certain parts of the smallest market, which is North America, but on the whole we see a very strong growth and a challenging environment for supply to be able to meet it in the long term. But we have good growth, I would say, in the coming years for multiple several years ahead of us.
Kent Masters: And some of that is just the lead time and getting these investments on the books and then executing against it. It’s a number of years to get those out there. So the projects we’re pulling back on, as Eric said, impact the back half of the decade.
Mike Sison: Got it. And just a quick follow-up, and just because I figured you guys be better off knowing what the potential is for lithium prices. I know you don’t want to get into a specific forecast, but what do you think needs to happen to get pricing back to greenfield economics?
Kent Masters: Well, I mean, prices stay where they are. You’re going to see production come off and projects come off the books and that will eventually bring prices up and balance will happen. And then hoping we’re in a cycle where lower highs and higher lows starts to prevail, but -- and that was what we were anticipating in this cycle. This is still higher than the last low, so maybe it’s just not quite as mature as we had anticipated. But we need to get into lower highs and higher lows so that there is some consistency in the industry and people can see through to an investment case for new projects.
Eric Norris: It’s not an understatement to say, Mike, that if prices stay where they are, which is well below marginal cash costs, and as we said, we thought it would be less volatile, is that you’re going to see -- we believe, you’re going to see enough projects ultimately come off that that inflection point where we start to get structurally short on supply moves forward from the latter part of the decade into the middle part of the decade. So that only -- what that says is excessively low prices only aggravate excessively high prices potentially down the road. That’s the challenge. We, and certainly our customers, would love to see a much more moderated cycle and as the market does recover, we’ll look to try to find ways to reduce that volatility in our mix. But certainly we’d hope that for the industry more broadly as well.
Mike Sison: Got it. Thank you.
Operator: Your next question comes from a line of John Roberts from Mizuho. Your line is open.
John Roberts: Thank you. Does that lower end of the 2024 volume growth at 10% include a sequentially flat March quarter or sequentially down March quarter in volume?
Kent Masters: So sequentially from the fourth quarter, is that what your question, I guess, year-over-year…
John Roberts: Correct.
Kent Masters: Just to clarify the question.
John Roberts: We start the year out without any growth sequentially.
Kent Masters: Yeah. I mean, I think, there’s going to be a difference between production and sales. I think you -- if you look at what happens seasonally with EVs, it is -- each year is a rapid rise to December and then a drop seasonally in January. So from a production standpoint, we’ll be sequentially up. From a demand standpoint, seasonal demand plays a role for the whole industry, including us.
John Roberts: Okay. And then on slide 19 that has the industry EV growth and the lithium growth, so battery sizes are getting smaller here in the near-term, but it looks like it flips and the assumption here is that full EV start -- before the end of the decade, full electric start out growing hybrids again?
Kent Masters: Yeah. Well, and it’s hard to generalize that, John. I mean, I think, you have to go by region. So what I’d tell you is in China, there was a nice growth in plug-in hybrids last year. By our reckoning and our estimates, the estimates we had at the beginning of the year where we didn’t anticipate that, that plug-in hybrid growth came at the expense of internal combustion engines, not at the expense of battery electric vehicles in China, which is the largest market. It’s 6% of the market. In Europe in the past year, you’ve seen the opposite trend. Battery electric vehicles have been growing faster than plug-in hybrids. The U.S., which is the smallest market is in a pivot point now, which I don’t, we’ll have to see which direction it goes. There’s a lot of discussion about how certain automotive producers are struggling with demand and costs to play and so I think they’re looking at plug-in hybrids as an alternative, but it is on the margin it’s the smallest market. So I think it has the least effect on lithium demand. By and large, going back to your original question, battery size grows, may grow at varying rates year on year on year, but it grows over time as we go forward.
Operator: And our final question comes from a line of Kevin McCarthy from Vertical Research Partners. Your line is open.
Kevin McCarthy: Yes. Thank you and good morning. Would you comment on the expected quarterly cadence or phasing of your adjusted EBITDA and Energy Storage in your $15 per kilogram scenario? I thought I heard a comment in the prepared remarks that you would expect to be at a 30% margin by the end of the year. So perhaps you can kind of walk through that margin escalation expectation.
Neal Sheorey: Yeah. A couple of things to -- Kevin, good morning. This is Neal. Just a couple of things to think about as you think about the quarterly ramp. First of all, as we mentioned in our prepared remarks, in Energy Storage, we expect most of the volume growth or at least two-thirds of the volume growth to occur in the back half of the year as our plants ramp up. So remember that we are still ramping these facilities through the first half of the year and then you’ll start to see that volume kick in as we get into the back half of the year. That’s point number one. Point number two is that as we move through, particularly the first quarter, we are still working off some spodumene inventory that is higher priced. And so as we mentioned again in the prepared remarks, you should expect that that will weigh on our margins in the first quarter. That is just by nature of the inventory lag that everyone’s very familiar with as we process that spodumene. Why margins then start to improve as we go through the year and we exit the year at this sort of stronger 30% margin that I mentioned in the prepared remarks is because as things normalize and you have a spodumene cost running through our P&L that’s more indicative of the lithium salt prices, you start to see come through the margin strength of our Energy Storage business even in this lower priced environment, which you would expect when you’re sitting on some of the best resource in the world. And so I would -- my counsel here is to think about margins rising as you go through the year in one part because of volume, but also in another part as we work through this inventory lag and then get to the back half of the year.
Kevin McCarthy: That makes sense. Thank you for that. And as a follow-up, if I zoom out the lens and look at your segment margins during the last cyclical trough for lithium, they were around 34% or 35% under the old definition of adjusted EBITDA. And so my question would be if prices persist at the $15 per kilogram scenario, what do you think the new trough margins could be moving forward into let’s say 2025 plus? Is that mid-30% level still representative or indicative or do you think they would be materially higher or lower than that?
Neal Sheorey: I mean I’ll jump in here. I mean I think that it’s -- let me tell you the variables. The answer is it’s going to be fairly similar, we believe, because what are the factors? One, we are on -- again, once spodumene prices are indicative of lithium prices. They haven’t been most of all last year and into the early part of this year just because of the accounting we’ve talked about, the lag we’ve talked about within Talison. And once they are, you’re dealing with a margin. That’s one benefit that gets us back to where we were before. When you talk about the last cyclical trough, prices were even, well, they’re about where, they were lower than where they are now and we’re earning a 34% EBITDA margin. But the difference then is spodumene was a smaller percentage of our sales mix. It’s a much larger percentage now. It is a slightly higher cost than Chilean brine. That’s one thing to note at these prices. The other is that we didn’t have nearly as many plants in the commissioning stage and these are plants that take a couple years to ramp. They have a fixed cost associated with them. That’s a drag when you’re ramping those plants. The upside benefit of that is, without any further capital investment, we’re going to continue to grow for the next couple of years, as I said to Mike earlier. The downside is it’s a drag that brings your margins down. So that’s -- these are the factors that would lead us at these prices, which are, as I said, at this trough, above last -- the prior trough, amid sort of 30%s EBITDA margin.
Kevin McCarthy: Very helpful. Thanks a lot.
Operator: Thank you. That’s all the time we have for questions. I will now pass it back to Kent Masters for closing remarks.
Kent Masters: Thank you and thank you all for joining us today. Albemarle is a global leader in transforming essential resources into the critical ingredients for modern living, with people and planet in mind. Our strategy and path to capitalize on the opportunities of electrification over the coming years is clear and we will continue to operate with the discipline operating model to scale and innovate, deliver profitable growth and advance sustainability. We continue to work to be the partner of choice for our customers and the investment of choice for both the present and the future. Thank you for joining us.
Operator: This concludes today’s conference call. Thank you for your participation. You may now disconnect. | [
{
"speaker": "Operator",
"text": "Hello and welcome to Albemarle Corporation’s Fourth Quarter 2023 Earnings Call. All lines have been placed on mute to prevent any background noise. After the speaker’s remarks, there will be a question-and-answer session. [Operator Instructions] I will now hand it over to Meredith Bandy, Vice President of Investor Relations and Sustainability."
},
{
"speaker": "Meredith Bandy",
"text": "Thank you. And welcome everyone to Albemarle’s fourth quarter and full year 2023 earnings conference call. Our earnings were released after the close of market yesterday and you’ll find the press release and earnings presentation posted to our website under the Investor Section at albemarle.com. Joining me on the call today are Kent Masters, Chief Executive Officer; and Neal Sheorey, Chief Financial Officer. Netha Johnson, President of Specialties; and Eric Norris, President of Energy Storage are also available for Q&A. As a reminder, some of the statements made during this call, including our outlook considerations, guidance, expected company performance and timing of expansion projects, may constitute forward-looking statements. Please note the cautionary language about forward-looking statements contained in our press release and earnings presentation that also applies to this call. Please also note that some of our comments today refer to non-GAAP financial measures. Reconciliations can be found in our earnings materials. And now, I’ll turn the call over to Kent."
},
{
"speaker": "Kent Masters",
"text": "Thank you, Meredith. Now, starting on slide four, our full year results show continued strong volumetric growth, with 2023 marking the highest net sales and second highest EPS in Albemarle’s history. This highlights the focus and ability of our global team to succeed in a macro environment that remains challenging. We ended the year with net sales of $9.6 billion, up 31% compared to 2022, of which 21% was related to volume growth. Energy Storage delivered 35% volumetric growth in 2023. For the full year of 2023, Albemarle’s adjusted EBITDA was $2.8 billion or $3.4 billion excluding a lower cost or market charge recorded in the fourth quarter. Excluding this non-cash charge, adjusted EBITDA was in line with our previous expectations. In January, we announced a series of proactive measures to re-phase our organic growth investments and optimize our cost structure. These disciplined actions should allow us to unlock more than $750 million of incremental cash, advance near-term growth and preserve future opportunities. Today, we will provide our initial thoughts on our full year 2024 earnings. To help investors model Albemarle in the current environment, we will introduce scenarios based on recently observed lithium market prices. Neal will provide more details on this in a few minutes. We remain as confident as ever in the future of Albemarle and ongoing demand for the essential elements we provide to support modern infrastructure, including mobility, energy, connectivity and health. The secular trends of clean energy, electrification and digitalization continue to drive growth. We are uniquely positioned to capitalize on the opportunities in our end markets, in particular lithium demand. Over the past year, we have further strengthened Albemarle’s position and are committed to navigating the near-term dynamics in a disciplined manner to both support and capitalize on these global trends. I’ll now hand it over to Neal to discuss our financial results."
},
{
"speaker": "Neal Sheorey",
"text": "Thanks, Kent, and good morning, everyone. It’s a pleasure to join my first earnings call with Albemarle. I’ve hit the ground running, and in the coming weeks, I’ll be on the road meeting with our shareholders and analysts. I’m looking forward to reconnecting with many of you and building new relationships with those of you I haven’t yet met. Moving to slide five, I’ll start with a review of our fourth quarter and full year 2023 performance. In Q4, we reported net sales of $2.4 billion, down 10% compared to last year, as lower lithium market pricing was partially offset by increased volumes in Energy Storage and higher volumes in pricing in Ketjen. As Kent mentioned, we recorded two charges in Q4 that impacted results. The first was a lower of cost or market charge of $604 million and the second was a tax valuation allowance in China of $223 million. These charges were fundamentally related to the fact that in the second half of 2023, lithium market prices feel over a relatively short period of time. In the case of the LCM charge, market prices reached a level such that our cost of inventory, especially spodumene, which we purchased at a market price from our Talison JV, was above the market price of the final lithium salts, which resulted in us writing down the value of our inventory in accordance with GAAP. Similarly, in the case of the tax valuation allowance, the rapid decline in market prices led us to recognizing losses in China as we process the higher cost spodumene in inventory. In China, we are only allowed a five-year carry-forward period to utilize these losses. In accordance with GAAP, we recognize the valuation allowance against the losses. The company’s full year results excluding those charges met our previously announced expectations. Net sales of $9.6 billion were up 31%, primarily driven by volume growth. Adjusted diluted EPS, excluding both charges, was $22.25, roughly flat year-over-year. Looking at slide six, fourth quarter adjusted EBITDA was $289 million, excluding the lower of cost or market charge. This primarily reflects a decrease in Energy Storage adjusted EBITDA, driven by a lower lithium market pricing, which more than offset higher volumes. In Specialties, adjusted EBITDA declined $64 million, primarily due to lower sales volumes and pricing, reflecting ongoing demand weakness in key end markets. Ketjen adjusted EBITDA increased $34 million, as higher sales and higher pricing more than offset increased raw materials costs. Turning to slide seven, before I transition to forward-looking information, I want to take a moment to review our adjusted EBITDA definition and share an update that we plan to make. Effective with Q1 2024, we are updating our definition of adjusted EBITDA to include Albemarle’s share of the pre-tax earnings of our Talison joint venture. There are a few important reasons for this change. First, the updated definition better reflects our vertical integration with Talison’s Greenbushes mine, one of the world’s largest, highest grade and lowest cost lithium resources. Second, it smooths the impact of price variations in inventory timing that obscure the underlying profitability of our full-chain integration. And finally, this definition is consistent with the amendment to our revolving credit facility, which I’ll discuss later on the call. As a reference point, on this slide, we’ve given you both the Energy Storage and Albemarle full year 2023 adjusted EBITDA under the previous and updated adjusted EBITDA definition. We will report under the updated definition in 2024. Therefore, all of our comments and numbers regarding 2024 modeling considerations are based on this new definition. Turning to slide eight, to help investors model Albemarle’s earnings under different price scenarios, we have provided ranges of outcomes for our Energy Storage business based on three lithium market price scenarios that were observed in the back half of 2024. First, year-end 2023 market pricing of about $15 per kilogram of lithium carbonate equivalent or LCE. Second, Q4 2023 average market pricing, which was about $20 per kilogram of LCE. And third, second half 2023 average market pricing, which was about $25 per kilogram of LCE. Within each scenario, the ranges are based on our expectation to increase Energy Storage volumes by 10% to 20% in 2024 compared to 2023. All three scenarios assume flat market pricing flowing through Energy Storage’s current book of business. These scenarios demonstrate the resilience of our Energy Storage business. As you would expect, given our strong resource positions around the world, we can maintain solid margins even with lower year-over-year lithium pricing, which are further bolstered by our organic volumetric growth and the normalization of temporary inventory timing impacts. Moving to slide nine, here we provided modeling considerations for Specialties, Ketjen and Corporate. We expect Specialties 2024 net sales of $1.3 billion to $1.5 billion and adjusted EBITDA of $270 million to $330 million. Ketjen 2024 net sales are expected to be $1 billion to $1.2 billion with adjusted EBITDA of $130 million to $150 million. The Corporate outlook reflects our planned decrease in capital expenditures, which we expect to total $1.6 million to $1.8 billion in 2024, down from $2.1 billion in 2023. Corporate costs in 2024 are expected to be between $120 million and $150 million. Corporate costs in 2023 included interest income that is not expected to recur, and therefore, excluding this factor, Corporate costs are relatively flat year-over-year. Adding it all together on slide 10, we provided here the full roll-up of Albemarle under each of the Energy Storage price scenarios. Turning to slide 11, I’ll provide some further detail on the trends that underpin each segment’s outlook. In Energy Storage, approximately two-thirds of 2024 estimated volumes are expected to be sold on index-referenced, variable-priced contracts. The remaining approximately one-third of volume is expected to be sold on short-term purchase agreements. This is a modest change from our past mix and reflects our positioning in this lower price environment. We could potentially add additional long-term contracts, but we will only entertain that if the pricing and other terms reflect long-term industry fundamentals. Energy Storage volume is expected to be weighted toward the second half of 2024 as our own capacity expansions ramp and as we experience normal seasonality. Specialties results are also expected to be back-half-weighted. The Specialties outlook reflects continued softness and opaque demand conditions in consumer electronics and elastomers and markets, partially offset by strong demand in oilfield services, agriculture and pharmaceuticals. We continue to actively monitor the situation in the Middle East, and in particular the Red Sea, and are working with our partners to facilitate safe, efficient and cost-effective transport of our products to customers. To-date, operations continue largely as normal, though we are experiencing some shipping delays and tighter availability of processing materials. In Ketjen, we are optimistic about increased volumes driven by high refinery utilization, as well as higher pricing, primarily in clean-fuel technology products. Ketjen made good progress against its improvement plans in 2023 and we are expecting another year of improvement in both net sales and adjusted EBITDA. Moving to slide 12, we continue to deliver volumetric growth with line-of-sight to a growth CAGR of about 20% from 2022 to 2027. Our expected 2024 volume growth reflects projects that are at or near completion and which we have prioritized as we reduce capital spending in other areas. This includes commissioning and startup of the Meishan lithium conversion facility, completion of commissioning activities at the Kemerton lithium conversion facility and ongoing expansions at Silver Peak, La Negra and Qinzhou. Our long-term expected lithium sales volumes are mostly unchanged as we continue to utilize flexible tolling arrangements to bridge to full capacity at our conversion expansions, as well as pace supply to current market conditions. Turning to slide 13, this is an update to a slide we provided last quarter, which explains how Energy Storage margins are impacted by JV accounting and the inherent timing lag that occurs from the mine through our conversion processes. The inventory lag we saw beginning in the second half of 2023 is expected to be reduced for two reasons. First, the lower of cost or market charge recorded in Q4 2023 resets inventory costs closer to current market pricing. And second, the Talison JV partners recently agreed to change the spodumene pricing to M-1 or a one-month lag versus the prior use of a three-month lag. That said, these changes will not completely offset the inventory lag, particularly in a period where prices have significantly changed. And therefore, we expect our first half 2024 margins in Energy Storage to be impacted by the lag as we process higher cost spodumene inventory and by expected reduced sales from Talison to our JV partner. Importantly, when we look beyond these temporal impacts, we estimate that Energy Storage could exit the year at a margin of approximately 30%, assuming constant current market pricing and a return to normal shipments from the Talison JV. Turning to slide 14 and our financial position. As our rapid action in recent months has shown, we are committed to maintaining a solid investment-grade credit rating and enhancing our financial flexibility as we navigate the lower price environment. With our earnings release yesterday, we announced that we have completed an amendment to our revolving credit facility to ensure ongoing financial flexibility. The amendment uses the revised adjusted EBITDA definition consistent with the definition that we will use for financial reporting going forward. I’m happy to share that we had unanimous support from our bank syndicate for the amendment. This action, along with all the steps we are proactively taking as a company to modify our cost and capital spending, demonstrates our focus on maintaining financial flexibility, adapting with changing market conditions and exercising our investing discipline. With that, I’ll turn it back over to Kent to provide more details on our actions to preserve growth, reduce costs and optimize cash flow."
},
{
"speaker": "Kent Masters",
"text": "Thanks, Neal. And now turning to slide 15. In markets as dynamic as ours, growth companies must be able to pivot and pace with disciplined decision-making and focused execution. This is especially true for Albemarle as a trusted leader in the markets we serve. At Albemarle, disciplined growth means carefully prioritizing CapEx timelines when pricing moves higher and re-phasing when the market shifts. As we look to 2024 and the current market dynamics, we’ve identified certain strategic investments and projects across the enterprise that do not need to grow as fast in the short-term. In short, the returns for new projects are not there at these prices, which we believe are well below reinvestment levels. As a result, we are reducing our CapEx in 2024 by $300 million to $500 million versus 2023 by refocusing our energy on the large, high return projects that are significantly progressed near completion or in startup. Additionally, we are aligning our OpEx to a slower pace of investment. We are taking action to reduce costs by nearly $100 million and we expect to realize more than $50 million of these savings in 2024. Our actions include reducing headcount and lowering spending on contracted services. We also continue to evaluate and execute the sale of non-core investments. For example, we recently monetized our Liontown holdings, given our decision to withdraw our non-binding offer. At the same time, we’re pursuing additional cash management actions, including optimizing our working capital. This includes initiatives focused on shortening the time from the mine to the customer in our supply chain. These measures together are expected to unlock more than $750 million of cash flow in the near term. This disciplined approach to managing the current market downturn reflects the actions that we must take to preserve our financial flexibility and re-pace our investments. The actions we are taking today will position Albemarle to emerge stronger to the benefit of our shareholders, partners, employees and the communities in which we operate. Moving to slide 16, the specific re-phasing decisions within our 2024 CapEx plan include continuing critical health, safety, environmental and site maintenance projects, commissioning the Meishan lithium conversion facility, which reached mechanical completion at the end of 2023, completing commissioning activities for trains 1 and 2 at the Kemerton lithium conversion facility and prioritizing construction on train 3 of the Kemerton Expansion Project, and prioritizing permitting activities at the Kings Mountain spodumene resource. We continue to have significant optionality for long-term organic growth. At the same time, if pricing remains below reinvestment economics, we will be disciplined and hold capital at or below current levels for the foreseeable future. Moving to slide 17, the Albemarle way of excellence remains the standard by which we operate and continues to serve us well in 2024. Here we provide more details on operational discipline, a key pillar of our operating model, especially given the current environment. In 2023, we realized productivity benefits of more than $300 million, well ahead of the initial target of $170 million and we’ve identified plans that target another $280 million in productivity benefits this year. In manufacturing, we continue to implement initiatives on overall equipment effectiveness, including improvements to recovery and utilization with expected benefits of $80 million. In procurement, we are targeting benefits of $150 million by pooling Corporate spend and continuing our strategic sourcing to recognize lower raw material pricing. And finally, after restructuring certain back office functions and with reprioritized projects, we expect to realize $50 million of productivity improvements. Slide 18 demonstrates the adjustments we’ve made to our capital allocation priorities as we navigate the dynamics of our key end markets. Our four capital allocation areas remain the same with shifts in how we prioritize. As Neal highlighted earlier, maintaining our financial flexibility in this environment is a central area of focus. We’ll continue to selectively invest in high return growth, but we’ll be patient and disciplined. We expect minimal M&A in this environment as we primarily focus on organically accelerating growth at attractive returns. As we have mentioned before, we’ll continue to actively assess our own portfolio to identify opportunities to create value. Moving to slide 19, while the pricing environment has softened for the moment, we should not lose sight of the fact that we continue to see significant long-term growth in demand for limited supply. This updated forecast is about 10% below our previous forecasts from early last year and it now reflects recent OEM announcements, more moderate battery size growth and inventory destocking. At the same time, global EV penetration is expected to grow significantly, resulting in anticipated 2.5 times lithium demand growth from 2024 to 2030. In 2024 alone, we expect demand growth of 28%. To put it another way, we expect that this industry needs more than 300,000 metric tons of new LCE capacity every year. In our view, incentivizing producers to meet this demand requires long-term pricing at or above investment economics and certainly above current market pricing. At today’s prices, the economics for new greenfield projects, particularly in the west are not supported. We expect near-term supply to be relatively balanced with demand and you see that adjustment starting to happen with recently announced production curtailments and project delays, including our own. As a leader, Albemarle remains well positioned to capitalize on the long-term growth trends we see in front of us, but we’ll be disciplined in how we capture our share of it. Slide 20 shows our durable competitive advantages and how Albemarle can win as we navigate near-term conditions. We are vertically integrated with a globally diversified portfolio of world-class, low-cost resources and industrial scale conversion assets. Albemarle has leading process chemistry that allows us to build and operate large-scale assets safely and efficiently. As a leader in the markets we serve, we are a partner of choice to strategic customers and stakeholders that seek to drive innovation and growth. For example, we recently signed a multiyear supply agreement with BMW, which takes effect in 2025. That agreement will also allow both companies the opportunity to partner on technology for safer and more energy-dense lithium-ion batteries. And last but certainly not least, we are committed to operating sustainably with industry-leading ESG performance and partnering with customers and suppliers to benefit the entire supply chain. As Albemarle adapts to the market dynamics, both present and future, we are confident in our ability to deliver on our strategy and drive value for shareholders. With that, we’d like to turn the call back over to the Operator to begin Q&A."
},
{
"speaker": "Operator",
"text": "[Operator Instructions] Your first question comes from a line of Stephen Richardson from Evercore ISI. Your line is open."
},
{
"speaker": "Stephen Richardson",
"text": "Hi. Good morning. I just wanted to get a clarification on slide 12, which is always very helpful in terms of sales volumes. Could you comment on what were your fourth quarter sales volumes and what do you expect Q1 to be?"
},
{
"speaker": "Kent Masters",
"text": "Neal, you want to take that?"
},
{
"speaker": "Neal Sheorey",
"text": "Sure. Hi, there. Good morning, Stephen. So if I heard your question right, you were looking for volume growth that we had in the fourth quarter, as well as volume growth that we expect in the first quarter. So we haven’t -- with regards to 2024, we haven’t given the specific volume growth numbers across the specific quarters in 2024. As we mentioned, we expect 10% to 20% growth in the year in 2024 and really the growth trajectory in the year will be dependent on how quickly we can ramp our existing assets that are in startup at the moment."
},
{
"speaker": "Stephen Richardson",
"text": "Thanks. Maybe just a follow-up specifically on assets. The 10-K, which it looks like you just filed, suggests, just looking at those numbers, that the Atacama was flat year-over-year. Is -- could you just give us an update on the Salar expansion and what the status is in Chile right now in terms of incremental volumes?"
},
{
"speaker": "Kent Masters",
"text": "Yeah. So I can start. Eric can fill in a little bit. So at the Salar, we were operating at capacity. We’ve done expansions at La Negra. We need brine to feed that. So that expansion is complete. But we need the brine from the Salar to feed that and then we -- we’re in commissioning of the Salar Yield Project. That’s the project that will provide the additional brine. But once we do that, it has to work its way through the brine system, and then we can, that’ll end up feeding the La Negra project. And I think that’s probably, Eric, a six-month lag, roughly, from a Salar perspective?"
},
{
"speaker": "Eric Norris",
"text": "Yeah. I mean, for virgin brine that we pump, it’s -- I think the rule of thumb has been more like 18 months, but for the Salar Yield, it’s six months. We commissioned that in the middle of last year. That’s enabling, Steve, the growth that we will see in that 10% to 20% range. A big chunk of that is coming out from carbonate, from Chile, from the La Negra plant, enabled by Salar Yield."
},
{
"speaker": "Stephen Richardson",
"text": "Perfect. Thanks very much."
},
{
"speaker": "Operator",
"text": "Your next question comes from a line of Colin Rusch from Oppenheimer. Your line is open."
},
{
"speaker": "Colin Rusch",
"text": "Thanks so much, guys. Can you talk a little bit about what you’re looking for as triggers for either Salar and -- or re-accelerating some of the CapEx investments for the rest of the year?"
},
{
"speaker": "Kent Masters",
"text": "Yeah. So, I mean, to be blunt, I think that’s going to be about the pricing levels that we see and the trends that we see. So, we see demand there. The volume growth in the industry is there and we start seeing some projects come out, operating projects, as well as projects on the books, like the ones that we described. So, for us to kind of re-accelerate, if you will, we’ll need to get a better view of what pricing is and the long-term view of that as well. So we think what the prices today are unsustainable. They’re below operating cash levels of some assets that are currently operating and they’re definitely below reinvestment levels, and as we said, particularly in the West, there’s not a particular price that kicks up necessarily a range of projects off. It’s all individual, depending on the resource, where it’s located, what the cost position is of that and the conversion asset, where that’s located. So, there’s not one number that we will look at, but we’ll look at it project-by-project, but it’s not going to -- if spot prices hit a number, that’s not going to necessarily turn us back into investment mode. We need to have a view that that’s a long-term number that we can rely on through the life of that asset."
},
{
"speaker": "Colin Rusch",
"text": "Thanks so much. You’ve talked about inventory levels for the industry in the past and I wanted to get an updated view on what you think is a normalized inventory level for the channel to keep things healthy and moving and what you’re seeing right now in terms of inventories on hand through the channel?"
},
{
"speaker": "Eric Norris",
"text": "Hey, Colin. Hi. It’s Eric. We’ve spent a lot of time looking at inventory and there’s been a drawdown effect that’s been on and off throughout all of last year and into this year. At the top of the supply chain upstream, looking at lithium salts and even the next level cathode production, we feel that inventory is normalized. The drawdown we’re seeing now, harder to predict and understand because it’s less visible to us, is at the battery cell, battery module and EV level. There are a lot of reports out there that vary on that. It’s not a highly quantitative or a highly known number, but I -- we think there’s probably a couple months’ excess as we exited last year, that will be drawn down this year that’s going to affect apparent demand. So that’s why our demand forecast is a difference if you look at, I can’t remember which slide it is, the lithium supply side towards the back of the deck between lithium demand growth and EV growth, and that is that drawdown effect happening at the battery and EV level."
},
{
"speaker": "Colin Rusch",
"text": "That’s super helpful. Thanks so much, guys."
},
{
"speaker": "Operator",
"text": "Your next question comes from the line of Steve Byrne from Bank of America. Your line is open."
},
{
"speaker": "Steve Byrne",
"text": "Yeah. Maybe just continuing on that discussion, where is it that you see the glut of inventory that is driving spot prices down? Is it spodumene inventories at converters that is really where the glut of material is?"
},
{
"speaker": "Neal Sheorey",
"text": "Hey, Steve. I’ll repeat what I said before. It is not upstream. We’re not seeing large inventory levels. We’re actually seeing projects, spodumene projects, go into care and maintenance. There’s several in Canada, or excuse me, in Australia, there’s one in Canada and some others that are questionable that we’re watching closely. And so it’s not there, it’s not at the conversion level. We track that as well, as well as the direct consumer for us, which is the cathode companies. We have very high visibility to that. That was at one point fairly high a year ago. That has since come down. The inventory that we’re seeing is further downstream, as I was saying earlier. It’s the battery and EV level of supply chain and that is affecting apparent demand to the lithium industry, albeit EVs are growing quite healthfully about 30% we see for the year going forward."
},
{
"speaker": "Steve Byrne",
"text": "What would you say is driving the spot price of hydroxide to be meaningfully lower than carbonate in China and does it make sense for you to cut your operating rates to tighten that market up and drive an inflection?"
},
{
"speaker": "Neal Sheorey",
"text": "Well, look, I’ll answer the price question. Maybe Kent would like to comment on the broader supply question. On the price question, I think what you’re seeing in China is particular, let’s remember China’s almost three quarters, two-thirds to three quarters of lithium supply is consumed in China. It’s very much the market where things are set and the trend there has been strongly towards, in the past year, towards carbonate for LFP production. That trend is the opposite in other parts of the world that are developing like Europe and North America, although we are seeing LFP interest. So those two products are starting to balance out, looking to be closer to 50-50 in their mix, although we have to watch it. It will move with time as technology and scale economies develop. That is causing that near-term, if you will, putting things upside down because historically hydroxide has been higher than carbonate. In the near-term, we’re seeing that flip. We would expect that to revert over time as the industry grows. Do you want to comment on supply more broadly, Kent?"
},
{
"speaker": "Kent Masters",
"text": "I don’t -- I mean I don’t know if I have anything much to add to that. I think we supply hydroxide and carbonate. We tend to supply carbonate from Chile. So we are -- that capacity is growing, as we just talked about a little bit earlier. We will supply that into the LFP market. And then we are trying to be balanced between hydroxide and carbonate and catch those growing trends. It is a little bit more skewed toward carbonate at the moment and --but we think hydroxide catches up to that. Then your question about should we lower rates to bring that back into balance. So I don’t -- we are still ramping up and we still see growth in the market of 20% a year. We are 10% to 20% for us this year and the market is a little bit stronger than that. I think that demand catches up without us having to adjust operating rates. We are still trying to commission plants and catch up to that."
},
{
"speaker": "Steve Byrne",
"text": "Thank you."
},
{
"speaker": "Operator",
"text": "Your next question comes from a line of Josh Spector from UBS. Your line is open."
},
{
"speaker": "Josh Spector",
"text": "Good morning. Good morning. So I had a couple of questions around your pricing scenarios. When you talk about $15 a kilogram on the Asian markets, what is implied in that scenario in terms of Albemarle realized pricing and really getting towards the impact of floors, if that is meaningful or not or if anything has changed in that regard?"
},
{
"speaker": "Neal Sheorey",
"text": "Yes. Josh, it is a bit of a complicated picture, because as you may know, there are varied price indices out there. There are some for China and some for outside China. Those inside tend to be 10% to 15% lower just because of the structural differences and some other aspects that drive that. But in any event, as you look at an average price across the two, we are going to be higher than the index generally for a couple of reasons, as -- particularly as prices go low. One is floors, so it’s -- our price is a little more sticky, even though it is linked to the index. And then the other is our mix. We tend to be more biased to outside China than in. That being said, where the price goes, that will be the trend that our ASP, our average selling price, follows."
},
{
"speaker": "Josh Spector",
"text": "Your EBITDA ranges for 15% versus 20% versus 25%. It is the same change in EBITDA between each range. If there were floors in the high-teens, low 20s, wouldn’t the increment from 15% to 20% be a bigger step up than 20% to 25%? I guess, what would I be missing in that math?"
},
{
"speaker": "Kent Masters",
"text": "Josh, we might need to look at the math you are doing, because actually the transitions between those different scenarios are a little bit different and actually if you do some averaging math in those scenarios, you will see how we have a little bit different jump between the three different scenarios."
},
{
"speaker": "Josh Spector",
"text": "Okay. I will follow up on that offline. Thanks."
},
{
"speaker": "Operator",
"text": "Your next question comes from a line of Jeffrey Zekauskas from JPMorgan. Your line is open."
},
{
"speaker": "Jeffrey Zekauskas",
"text": "Thanks very much. I have a question on your Specialties forecast. For next year, you -- at the midpoint, you assume EBITDA is about the same and revenues are about flat. And last year in the first quarter, I think, your Specialties EBITDA was something like $162 million and maybe you finished the year at something close to $30 million. How can you get to flat EBITDA as a base case?"
},
{
"speaker": "Netha Johnson",
"text": "Yeah. Hi, Jeff. This is Netha. I think if you look at the way we are projecting, the way pricing plays out throughout the year, you are right. The first quarter will be a little bit challenging on a year-over-year comparison standpoint. We still saw the numbers you saw, which was about a 60% growth in Q1 last year. The decline from that was really, really steep, driven by pricing. If you play that out on an annual basis for us, we think we can get back to where we were last year with maybe some upside or downside based on the ranges we provided with the pricing we expect to see going forward, and as Neal stated, that really is about a second half ramp in market volume and market pricing that we see coming and it’s really driven by how we look at the forward indicators with semiconductors, which for us is a good proxy for electronics already up 25% in the first quarter alone."
},
{
"speaker": "Jeffrey Zekauskas",
"text": "Okay. And then for my follow-up, can you talk about what your either cash flow expectations are this year or free cash flow expectations for 2024?"
},
{
"speaker": "Neal Sheorey",
"text": "Yeah. Hi. I’m sorry, Jeff."
},
{
"speaker": "Jeffrey Zekauskas",
"text": "Sure."
},
{
"speaker": "Neal Sheorey",
"text": "Sorry. So this is Neal. Jeff, good morning. So, yes, we have obviously several things that are in motion right now with regards to our cash flow and I just want to put a finer point on what we’re working on with regards to operating cash flow. Obviously, we’ve already mentioned that we are working hard on aligning our own OpEx to the current pricing in the market. We’re also working on several operational things from a working capital perspective. You should expect in a deflationary environment that we should continue to release cash from working capital. And additionally, we’re looking for other levers that we can pull to further reduce inventory in our network. For example, investors are well aware that we have a long time between the mine and the customer in our natural supply chain. So we’re looking for ways that we can reduce that and harvest cash from there. And then, of course, from a free cash flow standpoint, we’re reducing CapEx, as Kent mentioned earlier. In addition to that, we also have what I call non-operational cash flow items that we’re working on. This is things such as looking at what we can do with our working capital balances and generating financing from that. Now, all of that said, I realize that, some people may want a rule of thumb of how to think about this. So if you think about things from a cash conversion standpoint, and obviously, it will depend on what your lithium scenario is, but a cash conversion, if you look over the last three years or four years, this company has averaged a conversion of about 50%, plus or minus 10%. So that’s one example that you can use to think about how to model operating cash flow."
},
{
"speaker": "Jeffrey Zekauskas",
"text": "Great. Thank you very much."
},
{
"speaker": "Operator",
"text": "Your next question comes from a line of Vincent Andrews from Morgan Stanley. Your line is open."
},
{
"speaker": "Vincent Andrews",
"text": "Thank you very much and good morning. Maybe just following up on that, just looking at the balance sheet at the year end, your receivables are up year-over-year, your inventory is up year-over-year, your payables are about flat and that’s in a -- obviously, the lithium price ended the year much lower at the end of 2023 than it did at the end of 2022. So what’s the bridge on that that caused that working capital to build despite the lower prices?"
},
{
"speaker": "Neal Sheorey",
"text": "Yeah. Good morning, Vincent. So it’s a few things. I think one of the important ones with regard to inventory is, remember that we have several assets that are in startup. So there has been a natural build in inventory through 2023 and you will continue to see that to some extent in 2024 as we build that inventory and work through the commissioning and startup of these new facilities that we have around the world. Remember, too, that there’s a timing aspect to this as well and so you have the timing of shipment and how that flows through our working capital, and so when you look at an end of year punctual period, you won’t necessarily see the impact of the timing of those shipments and so when we take a snapshot at the end of the year, it might not accurately reflect sort of the lag that we have in our supply chain. But just to link your question, Vincent, also to what Jeff just asked, as you think about whatever your lithium price scenario is, and as you think about working capital cash release in 2024, depending on the scenario that you pick, if you use the scenarios we put in our deck, we’re looking at a sales decline of somewhere between $2 billion to $4 billion, depending on the scenario, and historically, we use a rule of thumb here at the company that working capital is around 25% of sales. So you should expect in 2024 that we can release cash to the tune of $500 million to $1 billion, depending, of course, on how those scenarios evolve in 2024."
},
{
"speaker": "Vincent Andrews",
"text": "That’s very helpful. Thank you. And Kent, can I just ask you to refresh us on what return on invested capital you’re looking for when you put CapEx to work in the Energy Storage business and I don’t know if you want to define it differently by geography, but just sort of what those rough hurdle rates are and if they’ve evolved at all over the last few years, given the price movement."
},
{
"speaker": "Kent Masters",
"text": "Yeah. So we -- I mean, we kind of have a benchmark that we use to where we say at trough pricing, we want to get our cost of capital and double that at kind of the mid-cycle pricing. So now those numbers have moved around on us, but that’s kind of our -- still our aim when we do projects is, when we look at it at what we believe is trough pricing, that that would generate a cost of capital and then kind of twice that at mid-cycle pricing -- average pricing."
},
{
"speaker": "Vincent Andrews",
"text": "Thanks very much, guys."
},
{
"speaker": "Operator",
"text": "Your next question comes from a line of David Begleiter from Deutsche Bank. Your line is open."
},
{
"speaker": "David Begleiter",
"text": "Thank you. Good morning, and Neal, welcome aboard. Kent and Eric, Energy Storage EBITDA guidance, if you were to mark-to-market that guidance to current prices, assuming no change in prices for the rest of the year, how much lower would your EBITDA guidance be for Energy Storage?"
},
{
"speaker": "Eric Norris",
"text": "Yeah. Hi, David. Good morning. Look, I think we’ve provided the numbers here for people to interpolate as they would like to between these different lithium price scenarios and so you can do your interpolation based on what you think the market price is at the moment. The only caution that I would give you as you think about a lower price scenario, which I think is where your question is getting at is and you can see this in our scenarios, as you get to these levels, it’s not unreasonable to think you’re bumping into some of the floors that we have in our contracts and those are at varying price levels, but you will see that in the math of our scenario. So I wouldn’t necessarily take that interpolation one for one if you’re going down further than the scenarios we’ve given."
},
{
"speaker": "David Begleiter",
"text": "Understood. And Eric, just on lepidolite production in China, how much do you think has been shut in? How much do you expect to be shut in? Why has there not been more shut-in up until now for lepidolite production in China?"
},
{
"speaker": "Eric Norris",
"text": "Well, thanks for the question, David. A couple of things I’d say. When we look at shut-in capacity or capacity that’s exited the market in general and a big chunk of it is lepidolite, but some of also non-integrated spodumene and some of it is spodumene itself that’s come offline or is about to come offline because it’s very high cost, it’s above current spodumene costs even or prices rather or the cost is above current spodumene prices. But that is about 200,000 tons in total that has come off. Lepidolite is probably close to maybe a third to a half of that, somewhere in that range. The non-integrated lepidolite production has come off. Some of the integrated lepidolite production that is of weaker grade is well below -- the price is well below the cash cost of that. It’s very hard for us to -- we know that, we know what the economics are, we can’t necessarily understand why some of it’s there. It’s still operating, because otherwise it should be -- our math tells us it should be coming offline. So we can’t quite understand what’s going on there, but there’s still quite a bit, there’s still some capacity in the market that’s, well, like I said, at current prices, cost is well above those prices."
},
{
"speaker": "David Begleiter",
"text": "Thank you."
},
{
"speaker": "Operator",
"text": "Your next question comes from a line of Joel Jackson from BMO Capital Markets. Your line is open."
},
{
"speaker": "Joel Jackson",
"text": "Hi guys. I’m not sure it’s Joe Jackson. So I wanted to ask a question about some of your sales guns for Energy Storage. If I take your guide, it’s $15,000 a ton, 10% to 20% more volume than the 150,000 tons you did Energy Storage last year. That would imply sales just a bit below $3 billion, maybe $2.9 billion for Energy Storage for this year. We’re going to, I think, $3.3 billion or something like that. What is the $400 million or $500 million difference in sales? Is that an accounting thing, spodumene, can you explain it, please?"
},
{
"speaker": "Neal Sheorey",
"text": "Hi there, Joel. No. It is not an accounting thing. I am wondering what volumes you’re using, because the ranges that we set here in our scenarios are based on the range of volumes that we’ve put here on the slide, slide eight in our deck and so we’ve adjusted the ranges based on that. So there’s definitely no accounting noise in that revenue number. Additionally, I should say this, too. Maybe this explains it. Just remember that for Energy Storage in total, there are other products that are in Energy Storage that don’t necessarily move one for one with lithium market price. So maybe that’s another piece of what is in your math as well."
},
{
"speaker": "Joel Jackson",
"text": "Yes. Okay. Fair enough. I just wanted to also ask you about the U.S. strategy. So as this industry was really looking at regional supply chains and you really were going to go after Kings Mountain and U.S. Mega-Flex, you put those plans on hold, but you’re still doing the permitting, of course, at Kings Mountain. As you know, it takes a while sometimes to get mine’s permit in the States. Is this -- how important is this U.S. strategy going to be? Is this something maybe that will have to be reassessed? Can the DoE or DoD with some of the different funding options help revive some of this? It seems like there’s a bit of a damper here on some of the objectives of political and the industry."
},
{
"speaker": "Eric Norris",
"text": "Yeah. No. I think there’s a big impact on that. I’m building this, we say in the West, so called Europe and North America, but focus is and we were a bit more focused on North America, we have access to a great resource at Kings Mountain, but where prices are today, the economics aren’t there for those projects. So we continue to progress, as you said, the permitting, the kind of real long lead time items that are not real capital intensive, in anticipation of prices coming back to where we’d be able to do those investments or some support or another way that we maybe could do those. But they’ve been pushed out. I mean, our -- at Richburg, we haven’t, that’s not a canceled project, it’s been delayed. So we’re still doing some of the long lead time permitting there, but no construction and we stopped engineering work on it. And Kings Mountain, we’re progressing with the permitting because that’s long lead time. We hope to work out a solution, but it requires better pricing in order to execute on those projects. And those are prom -- and those are kind of the two of the best opportunities to start the supply chain. We need a lot more support, not just, we can’t do it ourselves, but that would be the first project we would bring to market in North America, and probably, as others as well, particularly around resources."
},
{
"speaker": "Operator",
"text": "Your next question comes from a line of Mike Sison from Wells Fargo. Your line is open."
},
{
"speaker": "Mike Sison",
"text": "Hey. Good morning. Could you just remind us, given your new CapEx plans, what your -- what capacity you’ll end with in 2024 and then could you give us an update on how you think that will unfold in 2025, 2026, 2027? So where do you think you’ll be in capacity to offer the market over the next several years?"
},
{
"speaker": "Eric Norris",
"text": "So depending on where we land -- Mike’s is Eric, depending on where we land in that range of 10% to 20%, you’re talking something that could be close to, it’s going to get close to 200,000 tons, 190,000 tons, 200,000 tons at the top end and that is being driven, just to be specific, by more production out of Chile, which we discussed earlier and that’s realizing some of the efficiencies of the Salar Yield Project and the bottlenecking capacity downstream for La Negra to drive that growth. It’s also being driven by increased spodumene production out of Australia and the ramp of Kemerton, Qinzhou as well, where Meishan is more of a 2025 item for the time being, but that plan is ramping nicely for that period of time. That then brings me to how you think about the future. Kemerton I and II will continue to ramp as you go into 2025. Meishan will start to ramp in 2025 and 2026. The interesting thing about our near-term volume picture is we’re going to be looking at that sort of 20% plus volume growth for some years to come, based upon the investments we have made already. The things that we have idled or paused from an investment standpoint that Kent earlier referenced were longer term, further out, sort of really second half of decade in terms of what they were going to deliver. So the impact of slowing those down, should prices stay low and we not return to investing those projects will be felt in the latter part of the decade, which is, I’ll also remind you, is a point in time where we see industry supply already getting tight relative to demand. So there’s some real challenges because we don’t see demand slowing down. We certainly see weakness in certain parts of the smallest market, which is North America, but on the whole we see a very strong growth and a challenging environment for supply to be able to meet it in the long term. But we have good growth, I would say, in the coming years for multiple several years ahead of us."
},
{
"speaker": "Kent Masters",
"text": "And some of that is just the lead time and getting these investments on the books and then executing against it. It’s a number of years to get those out there. So the projects we’re pulling back on, as Eric said, impact the back half of the decade."
},
{
"speaker": "Mike Sison",
"text": "Got it. And just a quick follow-up, and just because I figured you guys be better off knowing what the potential is for lithium prices. I know you don’t want to get into a specific forecast, but what do you think needs to happen to get pricing back to greenfield economics?"
},
{
"speaker": "Kent Masters",
"text": "Well, I mean, prices stay where they are. You’re going to see production come off and projects come off the books and that will eventually bring prices up and balance will happen. And then hoping we’re in a cycle where lower highs and higher lows starts to prevail, but -- and that was what we were anticipating in this cycle. This is still higher than the last low, so maybe it’s just not quite as mature as we had anticipated. But we need to get into lower highs and higher lows so that there is some consistency in the industry and people can see through to an investment case for new projects."
},
{
"speaker": "Eric Norris",
"text": "It’s not an understatement to say, Mike, that if prices stay where they are, which is well below marginal cash costs, and as we said, we thought it would be less volatile, is that you’re going to see -- we believe, you’re going to see enough projects ultimately come off that that inflection point where we start to get structurally short on supply moves forward from the latter part of the decade into the middle part of the decade. So that only -- what that says is excessively low prices only aggravate excessively high prices potentially down the road. That’s the challenge. We, and certainly our customers, would love to see a much more moderated cycle and as the market does recover, we’ll look to try to find ways to reduce that volatility in our mix. But certainly we’d hope that for the industry more broadly as well."
},
{
"speaker": "Mike Sison",
"text": "Got it. Thank you."
},
{
"speaker": "Operator",
"text": "Your next question comes from a line of John Roberts from Mizuho. Your line is open."
},
{
"speaker": "John Roberts",
"text": "Thank you. Does that lower end of the 2024 volume growth at 10% include a sequentially flat March quarter or sequentially down March quarter in volume?"
},
{
"speaker": "Kent Masters",
"text": "So sequentially from the fourth quarter, is that what your question, I guess, year-over-year…"
},
{
"speaker": "John Roberts",
"text": "Correct."
},
{
"speaker": "Kent Masters",
"text": "Just to clarify the question."
},
{
"speaker": "John Roberts",
"text": "We start the year out without any growth sequentially."
},
{
"speaker": "Kent Masters",
"text": "Yeah. I mean, I think, there’s going to be a difference between production and sales. I think you -- if you look at what happens seasonally with EVs, it is -- each year is a rapid rise to December and then a drop seasonally in January. So from a production standpoint, we’ll be sequentially up. From a demand standpoint, seasonal demand plays a role for the whole industry, including us."
},
{
"speaker": "John Roberts",
"text": "Okay. And then on slide 19 that has the industry EV growth and the lithium growth, so battery sizes are getting smaller here in the near-term, but it looks like it flips and the assumption here is that full EV start -- before the end of the decade, full electric start out growing hybrids again?"
},
{
"speaker": "Kent Masters",
"text": "Yeah. Well, and it’s hard to generalize that, John. I mean, I think, you have to go by region. So what I’d tell you is in China, there was a nice growth in plug-in hybrids last year. By our reckoning and our estimates, the estimates we had at the beginning of the year where we didn’t anticipate that, that plug-in hybrid growth came at the expense of internal combustion engines, not at the expense of battery electric vehicles in China, which is the largest market. It’s 6% of the market. In Europe in the past year, you’ve seen the opposite trend. Battery electric vehicles have been growing faster than plug-in hybrids. The U.S., which is the smallest market is in a pivot point now, which I don’t, we’ll have to see which direction it goes. There’s a lot of discussion about how certain automotive producers are struggling with demand and costs to play and so I think they’re looking at plug-in hybrids as an alternative, but it is on the margin it’s the smallest market. So I think it has the least effect on lithium demand. By and large, going back to your original question, battery size grows, may grow at varying rates year on year on year, but it grows over time as we go forward."
},
{
"speaker": "Operator",
"text": "And our final question comes from a line of Kevin McCarthy from Vertical Research Partners. Your line is open."
},
{
"speaker": "Kevin McCarthy",
"text": "Yes. Thank you and good morning. Would you comment on the expected quarterly cadence or phasing of your adjusted EBITDA and Energy Storage in your $15 per kilogram scenario? I thought I heard a comment in the prepared remarks that you would expect to be at a 30% margin by the end of the year. So perhaps you can kind of walk through that margin escalation expectation."
},
{
"speaker": "Neal Sheorey",
"text": "Yeah. A couple of things to -- Kevin, good morning. This is Neal. Just a couple of things to think about as you think about the quarterly ramp. First of all, as we mentioned in our prepared remarks, in Energy Storage, we expect most of the volume growth or at least two-thirds of the volume growth to occur in the back half of the year as our plants ramp up. So remember that we are still ramping these facilities through the first half of the year and then you’ll start to see that volume kick in as we get into the back half of the year. That’s point number one. Point number two is that as we move through, particularly the first quarter, we are still working off some spodumene inventory that is higher priced. And so as we mentioned again in the prepared remarks, you should expect that that will weigh on our margins in the first quarter. That is just by nature of the inventory lag that everyone’s very familiar with as we process that spodumene. Why margins then start to improve as we go through the year and we exit the year at this sort of stronger 30% margin that I mentioned in the prepared remarks is because as things normalize and you have a spodumene cost running through our P&L that’s more indicative of the lithium salt prices, you start to see come through the margin strength of our Energy Storage business even in this lower priced environment, which you would expect when you’re sitting on some of the best resource in the world. And so I would -- my counsel here is to think about margins rising as you go through the year in one part because of volume, but also in another part as we work through this inventory lag and then get to the back half of the year."
},
{
"speaker": "Kevin McCarthy",
"text": "That makes sense. Thank you for that. And as a follow-up, if I zoom out the lens and look at your segment margins during the last cyclical trough for lithium, they were around 34% or 35% under the old definition of adjusted EBITDA. And so my question would be if prices persist at the $15 per kilogram scenario, what do you think the new trough margins could be moving forward into let’s say 2025 plus? Is that mid-30% level still representative or indicative or do you think they would be materially higher or lower than that?"
},
{
"speaker": "Neal Sheorey",
"text": "I mean I’ll jump in here. I mean I think that it’s -- let me tell you the variables. The answer is it’s going to be fairly similar, we believe, because what are the factors? One, we are on -- again, once spodumene prices are indicative of lithium prices. They haven’t been most of all last year and into the early part of this year just because of the accounting we’ve talked about, the lag we’ve talked about within Talison. And once they are, you’re dealing with a margin. That’s one benefit that gets us back to where we were before. When you talk about the last cyclical trough, prices were even, well, they’re about where, they were lower than where they are now and we’re earning a 34% EBITDA margin. But the difference then is spodumene was a smaller percentage of our sales mix. It’s a much larger percentage now. It is a slightly higher cost than Chilean brine. That’s one thing to note at these prices. The other is that we didn’t have nearly as many plants in the commissioning stage and these are plants that take a couple years to ramp. They have a fixed cost associated with them. That’s a drag when you’re ramping those plants. The upside benefit of that is, without any further capital investment, we’re going to continue to grow for the next couple of years, as I said to Mike earlier. The downside is it’s a drag that brings your margins down. So that’s -- these are the factors that would lead us at these prices, which are, as I said, at this trough, above last -- the prior trough, amid sort of 30%s EBITDA margin."
},
{
"speaker": "Kevin McCarthy",
"text": "Very helpful. Thanks a lot."
},
{
"speaker": "Operator",
"text": "Thank you. That’s all the time we have for questions. I will now pass it back to Kent Masters for closing remarks."
},
{
"speaker": "Kent Masters",
"text": "Thank you and thank you all for joining us today. Albemarle is a global leader in transforming essential resources into the critical ingredients for modern living, with people and planet in mind. Our strategy and path to capitalize on the opportunities of electrification over the coming years is clear and we will continue to operate with the discipline operating model to scale and innovate, deliver profitable growth and advance sustainability. We continue to work to be the partner of choice for our customers and the investment of choice for both the present and the future. Thank you for joining us."
},
{
"speaker": "Operator",
"text": "This concludes today’s conference call. Thank you for your participation. You may now disconnect."
}
] | Albemarle Corporation | 18,671 |
ALB | 3 | 2,023 | 2023-11-02 11:53:00 | Operator: Ladies and gentlemen, thank you for standing by. My name is Sheryl and I will be your conference operator today. At this time, I would like to welcome everyone to Albemarle Corporation’s Q3 2023 Earnings Call. [Operator Instructions] Thank you. I will now hand it over to Meredith Bandy, Vice President of Investor Relations and Sustainability.
Meredith Bandy: Alright. Thank you, Sheryl and welcome to Albemarle’s third quarter conference call. Our earnings were released after the close of market yesterday and you will find the press release and earnings presentation posted to our website under the Investors section at albemarle.com. Joining me on the call today are Kent Masters, Chief Executive Officer; and Scott Tozier, Chief Financial Officer; Netha Johnson, President of Specialties; and Eric Norris, President of Energy Storage, are also available for Q&A. As a reminder, some of the statements made during this call, including our outlook, guidance, expected company performance, timing of expansion projects, and growth initiatives may constitute forward-looking statements. Please note the cautionary language about forward-looking statements contained in our press release and earnings presentation, which also applies to this call. Please also note that some of our comments today refer to non-GAAP financial measures. Reconciliations can be found in our earnings materials. And now, I will turn the call over to Kent.
Kent Masters: Thank you, Meredith. Before we begin, I am sure most of you have seen that this will be Scott’s last quarterly call as CFO. Scott is transitioning roles to become a strategic advisor, while Neal Sheorey will join the company as Executive Vice President and Chief Financial Officer on November 6. Scott has had a positive impact on the company since he joined in 2011. With his leadership, we have advanced Albemarle’s growth strategy and maintained our commitment to operating with people and planet in mind. In this new role, Scott will provide strategic advice into our long-range plans and will also be on hand to assist with Neal’s transition. I know you will join me in thanking Scott for his contributions to Albemarle over the past 13 years. Our third quarter results reflect strong operating performance and continued volumetric growth in a challenging macro environment. Our net sales were up 10% in the third quarter versus the same period last year. However, adjusted EBITDA was down due to softer lithium market pricing and timing impacts of spodumene inventory from our JV-owned assets. Based on current market prices, we have revised our 2023 outlook, which still contemplates an increase in net sales between 30% and 35% year-over-year. We remain bullish about Albemarle’s long-term growth, our role in enabling a more resilient world and our strategy to deliver enduring value. In the third quarter, we made significant progress advancing these efforts. During the quarter, we signed agreements with Caterpillar to collaborate on solutions to support the full circular battery value chain and sustainable mining operations. As part of the partnership, we will purchase an all-electric mining fleet for Kings Mountain and make our North American produced lithium available for use in Caterpillar battery production. We will also explore opportunities to collaborate with Caterpillar on R&D of battery cell technology and recycling techniques. With this collaboration, we and Caterpillar will be both customers and suppliers of each other with shared goals to pioneer the future of sustainable mining technology and operations. We also received a $90 million grant from the U.S. Department of Defense to help support the expansion of domestic mining and the production of lithium for the nation’s battery supply chain. The grant will be used to purchase fleet of mining equipment in support of the Kings Mountain restart. Earlier this month, we finalized simplified commercial arrangements related to our joint venture transaction with Mineral Resources. Under the revised agreements, Albemarle will take full ownership of the Kemerton lithium processing facility and 50% ownership of the Wodgina spodumene mine in Australia and retain full ownership of the Qinzhou and Meishan lithium processing facilities in China. I will now hand it over to Scott to walk through our financial results.
Scott Tozier: Thanks, Kent and hello everyone. On Slide 5, let’s review our third quarter performance. Net sales were $2.3 billion, up 10% compared to last year. This increase was driven by higher energy storage volumes, thanks to expansion of our mining and conversion assets. Net income attributable to Albemarle was approximately $303 million, down 66% compared to the prior year. Similarly, diluted EPS was $2.57, down 66%. Higher net sales were more than offset by higher cost of goods sold, primarily due to inventory timing and I will discuss these timing impacts more in a moment. Our year-to-date results reflect the strong performance and significant growth we have achieved this year despite recent softer lithium pricing. For the 9 months ended September 30, net sales are up 55% year-over-year and net income is up 42%. Looking at Slide 6, third quarter adjusted EBITDA was $453 million, a decrease of 62% year-over-year, driven primarily by softer lithium market pricing and timing impacts of spodumene inventory and energy storage. The Specialties business was also down due to continued lower volumes and pricing related to softness in certain end markets. For the first three quarters of 2023, adjusted EBITDA was more than $3 billion, up 38% against last year. Again, energy storage growth reflects the majority of that increase with both volumes and prices up year-over-year. On Slide 7, as Kent mentioned, we are lowering our total company outlook for 2023. As has been our practice, this outlook assumes recent lithium market price indices are constant for the remainder of the year. And as a result, we have decreased the range for net sales. Under this methodology, 2023 total company net sales would be in the range of $9.5 billion to $9.8 billion. This range represents an increase in net sales of 30% to 35% over the prior year, driven by the ramp of our energy storage volumes. Our adjusted EBITDA outlook is expected to be in the range of $3.2 billion to $3.4 billion. This implies full year EBITDA margins of 34% to 35%. Our full year 2023 adjusted EPS outlook has also been adjusted to a range of $21.50 to $23.50. We expect our net cash from operations to be in the range of $600 million to $800 million. The decrease in adjusted EBITDA and net cash from operations reflects current lithium market prices and lower expected sales volumes at our Talison joint venture. Our partner at Talison, elected not to take their full allocation in the second half of this year, and this has impacted our equity income for the period. Our CapEx guidance remains in line with previous forecasts at $1.9 billion to $2.1 billion, which as a reminder from last quarter, reflects 100% ownership of our conversion assets with the completed revised agreements with Mineral Resources. We expect to provide our full year 2024 outlook on our fourth quarter call in February. Turning to the next slide for more detail on our outlook by segment. Assuming recent lithium market prices remain constant through the rest of the year, we expect energy storage 2023 net sales in the range of $7 billion to $7.2 billion and adjusted EBITDA to be flat to slightly down on the year as timing impacts of higher priced spodumene more than offset higher net sales. We are projecting that full year average realized pricing increases will be in the range of 15% to 20% year-over-year and energy storage volume growth in the range of 30% to 35% year-over-year. We continue to expect Q4 to see stronger production volumes as a result of project ramps. In 2024, volume growth is anticipated to continue as as Kemerton, Qinzhou and La Negra ramp to meet the expected demand from continued strong EV production. In the Specialties, we now expect net sales to be approximately $1.5 billion, with adjusted EBITDA expected to be down 40% to 45% year-over-year for the full year. This is due to continued softness in consumer electronics and elastomers, partially offset by strength in demand in other specialties end markets, including pharmaceuticals and oilfield. We continue to monitor the situation in the Middle East and any impacts at our operations in Jordan. Currently, JBC is operating as usual without disruption to our supply chain. Macroeconomic and geopolitical uncertainties will impact market visibility in this business well into 2024. Ketjen’s 2023 full year adjusted EBITDA is now expected to be up 250% to 325% year-over-year due to higher pricing and volumes as well as productivity improvements. During the quarter, we saw higher volumes driven by high refinery utilization. We also saw benefits of higher contract pricing primarily for FCC products, which is expected to continue through 2023 and into 2024. We are encouraged to see inflation in Material and Energy costs moderating and expect this trend to continue through 2024. On Slide 9, we have an experienced team that knows how to operate in a variety of price environments. Maintaining our disciplined growth mindset we are taking a comprehensive review of actions that will support our near-term profitability and cash flow. As we’ve done in the past, we’re reviewing our project spend and sequencing of our projects to preserve cash. We’re also implementing cost and efficiency improvements across our business. For example, we’ve reduced non-critical travel and are reducing discretionary spending. Our Albemarle Way of Excellence is the standard by which we choose to operate. Slide 10 provides an update to the targets we’ve made in manufacturing and procurement. We’re on track to exceed our goal of $170 million in productivity benefits in 2023. In manufacturing, improvements to our overall equipment effectiveness to improve yield and utilization are expected to exceed $70 million in benefits. In procurement, we strategically sourced to capture lower raw material pricing. In 2024, we expect to increase these initiatives, targeting additional benefits across manufacturing, procurement and back office. Lowering operational costs in our business is critical to our success as we orient towards sustainable growth. As a reminder, most of our energy storage volumes are sold under long-term contracts with strategic customers. Our expected 2023 sales mix on Slide 11 remains unchanged from last quarter and reflects recent lithium market prices. We expect year-over-year energy storage volume growth to be in the range of 30% to 35% in 2023. This is driven by successful execution and ramping new capacity as well as additional tolling. With additional conversion assets coming online in 2024 and beyond, we still anticipate a 20% to 30% CAGR in Albemarle sales volumes between now and 2027. And we remain on track to nearly triple our volumes to more than 300,000 tons. Slide 13, is the updated bridge for our energy storage adjusted EBITDA margins. Full year 2023 margins are expected to normalize in the 40% range from the very high rates we saw in 2022. As always, Talison equity income is included in our adjusted EBITDA on an after-tax basis, that tax drag impacted EBITDA margins by about 7% to 10%. The other impacts on the chart are relatively small and our offsetting. Higher lithium pricing is offset by other items. This year, we had a 5% negative impact from MARBL JV accounting that goes away next year with the closure of the restructured MARBL JV. That leaves the largest impact to our margins at 20% spodumene inventory lag. We understand this inventory lag is complicated and can be difficult to forecast. So I want to spend a little bit more time on that. Through the Talison joint venture, Albemarle has access to one of the world’s best lithium resources. Greenbushes is a large, high-grade and, therefore, low-cost spodumene mine. We recognize our 49% share of Talison earnings in equity income and cash dividends. Our 50% share of Talison offtake also flows through inventories and cost of goods sold based on market pricing. The timing of inventories and sales can often drive short-term margin variations. Excluding these timing impacts, we expect energy storage adjusted EBITDA margins to be in the range of 30% to 40%, even at today’s prevailing market pricing for lithium and spodumene. Turning to Slide 15. In the Talison joint venture, we recognized profit associated with our partners’ offtake immediately. We recognized profit associated with our offtake when the product is converted and sold which typically takes about 6 months from when we first extract spodumene from the ground. Throughout 2022 in the first half of 2023, Talison pricing on partner shipments was higher than that realized on our own shipments. Timing differences between the recognition of our profit on our partner’s offtake and our offtake resulted in about $800 million of benefit to EBITDA during that period. As spodumene market prices decrease, we expect this effect to reverse as we recognized higher priced spodumene and cost of goods sold and lower prices in equity income. However, we expect this timing-related impact to be temporary, with no impact to adjusted EBITDA at steady market prices. Again, assuming today’s market prices are held constant, we expect energy storage adjusted EBITDA margins to average in the range of 30% to 40%. Turning to Slide 16. Albemarle’s capital allocation priorities remain unchanged. First, investing in high-return organic and inorganic growth, second, maintaining financial flexibility and our investment-grade credit rating; and lastly, funding our dividends. Planned expansions to deliver volumetric growth continue to progress across the company’s global portfolio. Although, as I mentioned before, in this softer market, we are taking a hard look at the level of our CapEx spending and the sequence of our projects. As it relates to inorganic opportunities, we announced a few weeks ago that we decided not to pursue a binding agreement to purchase Liontown and formally withdrew our non-binding offer. While we had productive engagement with Liontown and as we learn more, we decided that moving forward with the acquisition at this time was not in Albemarle’s best interest. This reflects our disciplined capital allocation and M&A approach. As we look forward, we continue to evaluate a broad range of M&A opportunities. However, in the current environment, the scale of those opportunities are not as big. And we have many options available across 3 areas: lithium resources, process technology for our core business and for new advanced materials and battery recycling. Turning to Slide 17. Our balance sheet flexibility is a competitive advantage that allows us to grow both organically and through acquisition as well as support shareholder returns. As of year-end 2023, we expect our leverage ratio to be 1.2x to 1.3x net debt-to-EBITDA. And with that, I’ll turn it back over to Kent for a market update and closing remarks.
Kent Masters: Thanks, Scott. On Slide 18, we highlight the continued growth in EV sales that reinforces our long-term growth opportunity. Year-to-date through September, EV sales remain on track for 40% year-on-year growth and show end market demand to be resilient. While the U.S. and Europe make up only about one-third of total EV production in ‘23 and ‘24, near term, we see potential challenges for EV growth in those regions related to economic softness and higher interest rates. We are monitoring any economic impacts to the seasonal acceleration in EV sales at the end of the year. Our long-term view of secular growth continues to be supported not only by the adoption of EVs, but transformations across mobility, energy, connectivity and health. Slide 19 provides a view of lithium inventories across the value chain. Both upstream and downstream producers have continued destocking with very low levels of lithium inventory at cathode producers. Cuts to higher-cost supply have continued as some lepidolite producers, and merchant converters have reduced production. Turning now to Slide 20. We remain on track to achieve strong net sales growth up 30% to 35% year-over-year. This reflects our continued growth investments and the strength of our portfolio that have enabled us to overcome the near-term pricing challenges. We are disciplined in both how we operate and how we allocate capital providing an edge across economic cycles. Albemarle is a global leader with world-class assets and a diversified product portfolio positioned to supply key growth sectors. We have a competitive advantage with vertically integrated assets and innovative advanced solutions designed to meet our customers’ needs. The actions we took this quarter, including our collaboration with Caterpillar, and the restructuring and simplification of the MARBL joint venture help us build on this advantage. The long-term growth trajectory of our end markets remain strong including continued growth in electric vehicles. Our strategy is clear to capitalize on this opportunity with a disciplined operating model to scale and innovate, accelerate profitable growth and advanced sustainability. With that, I’d like to turn the call back over to the operator to begin the Q&A portion.
Operator: [Operator Instructions] Your first question comes from the line of Patrick Cunningham with Citi. Patrick, your line is now open.
Patrick Cunningham: Hi, good morning. So one of your JV partners is not taking the full allocation at Greenbushes and do you still plan to take your full volume allocation? And do you see any risk of production cuts in the first quarter, perhaps its concentrated stockpile?
Kent Masters:
– :
Patrick Cunningham: That’s helpful. And then just given some of the recent price weakness headlines, dialing back EV targets, I’m just curious on more detail on how you’re thinking about growth investments and trajectory going forward. How has your thinking started to change on regions, project spending and sequencing of those projects?
Kent Masters: Yes. So we’re going through that at the moment. So we’re not prepared to really give guidance for next year’s capital plan, but we are taking a look at that. Everything we can do to cut capital, but without really impacting the long-term growth trajectory or the growth projects that we’ve developed out there. So there is some flexibility around sequencing and we will be able to put some projects out slightly without really changing the long-term profile for that. And that’s the work that we’re doing now, and we will be able to give guidance on that in the February call.
Patrick Cunningham: Alright, thank you.
Operator: Your next question comes from the line of Josh Spector with UBS. Josh, your line is open.
Josh Spector: Hi, thanks for taking my question. I guess, first, I wanted to ask on kind of lithium pricing and specifically the realized pricing for Albemarle. And just kind of thinking about a scenario where spot goes less than $20, so say, $18 per kilogram. What happens to the other 80% of your contracts? You’ve talked about floors, you’ve indicated that there above or at the high end of the cost curve. But what really does that mean? In that scenario, I guess, what does Albemarle realize in terms of pricing?
Eric Norris: Good morning, Josh, it’s Eric. As you know, we don’t give precise price guidance for our overall portfolio. But let me try to help and give you some perspective around this. First off, obviously, a spot price realized in China, will look different as you look at other market pricing around the world. There is – most of the supply or a lot of the supply comes from China, they are transactional and VAT considerations that would translate that to a higher price oftentimes outside of China. We have floors on our 80% of our index reference contracts. We have a variety of different floors. We don’t disclose that, but it’s designed to give us protection so that we can continue to operate well, continue to pursue growth capital in the near-term and to sustain the margins that Scott was talking about. And as we look forward, I mean, we are – I’d have to little bit perplexed as to why price is where it is. These are levels that for a great number of the higher-cost projects we would expect supply to come off, and in fact, have seen supply come off, should prevail. We’d expect to see potentially other resources or other projects be slowed down. From our perspective, though, we have a growth plan that’s double-digit growth next year. We feel comfortable with the protection of our contracts give us and importantly, the low-cost position we have going forward in our portfolio.
Josh Spector: Yes, thanks, Eric. And I guess I wanted to follow-up just on the margin comments that you made, Scott. So the range that you gave, I mean, it’s different than you go back a couple of years ago, you talked about 45% plus. And I believe at that time, you said you could maintain those margins in a lower price environment. I guess I don’t know if I’m remembering right or if anything has changed, but what accounts for the difference?
Scott Tozier: Yes. I think the difference, Josh, is that when we made those mid kind of 40% comments, we were thinking about a mid-cycle type of pricing. As we look at this 30% to 40% that I commented on today, that’s really at today’s prevailing prices. And again, it’s based on constant pricing as opposed to some of the volatility, which is going to distort our margins either higher as prices go up or lower as prices come down.
Josh Spector: Okay, thank you.
Operator: Your next question comes from the line of Joel Jackson with BMO Capital Markets. Joel, your line is open.
Joel Jackson: Good morning, Eric. So I think Eric, you just said you were perplexed how low prices have come down to maybe low 20s here, LCE – so you said you’re considering reinvestment economics. So maybe you could talk about why you think prices have gone down to where they are? Is it lepidolite? Is it African spodumene? Is it something else? What do you think? Everyone is still there?
Operator: We are here. [Operator Instructions]. Thank you.
Meredith Bandy: Hi, can you hear us on the line?
Operator: We can hear you.
Eric Norris: Shanelle, can you hear us?
Operator: Yes, we can hear you.
Eric Norris: Okay. Okay. Sorry, not sure what happened there. So Shanelle, I’ll – if it’s okay, and you can hear me, just confirming?
Operator: Yes, I can hear you.
Eric Norris: Okay. So I’ll continue to answer Joel’s question. Joel, so I apologize for the interruption...
Joel Jackson: Can we start from the beginning, Eric, if that’s okay? I didn’t hear it anyway.
Eric Norris: Yes. So what I was describing is that we do a lot of work to model supply and demand. And if you look last year, this year, next year, remove for a moment, what we know has happened this year, which has been an inventory correction in the supply chain, the industries by our reckoning is operating at us if you look at supply or demand over supply about a mid-90s capacity utilization rate. So that’s the part that’s perplexing. And in any other market, at those levels, you wouldn’t see pricing fall like it has. Now we have had an inventory correction this year. It’s largely run its course, at least at the cathode level in the largest market in the world, and that’s one of the slides we shared with you. Any inventory correction further in the supply chain, we would expect on balance to occur or be behind us or certainly be behind us in the balance of this year. And so as we look forward, we don’t see a rationale for why prices would fall to where they are because they are below reinvestment economics. As we’ve said many times, our concern would be towards the end of the decade that there needs to be a sufficient amount of capacity to serve the EV market. Here we are operating at a healthy – relatively healthy supply-demand utilization with prices where they are. So it’s very difficult to explain how that’s the case, Joel, but obviously, we’re well positioned with our cost position and our go-to-market strategy to weather that storm. It’s just – it’s going to be challenging for the industry at these levels. So that’s our greater concern is future availability and investment in supply to support the transition across the industry. So that’s probably the best we can tell you in terms of our view at the moment.
Joel Jackson: Okay, thank you for that. If I can follow-up, on them. I think it was Kent too said, a little few minutes ago, you’re going to look at maybe ratcheting back your growth plans, it look like slightly, so slow down a little bit sequencing, but not changing anything in your longer-term plan. So what if you’re not right about your lithium price view here and what if prices are lower and the returns aren’t as good as you think and you’re going to go full team ahead on a lot of this growth, but ends up not being needed? How do you balance the risk of overspending and driving negative free cash for a long time with making sure you are supplying enough volume for the market over time and maintaining your market share?
Kent Masters: Yes. So that’s the balance, right? I think what we’re saying is we look at our capital programs, and we’re going to cut back where we can. And – but it’s not changing our overall strategy around growth – and again, our cost position protects us with that. So it’s not really the returns on the projects given what we see, but it’s more about the capital that we’re investing while the market is down. So we’re just adjusting the timing on that, and then we will be cautious as we layer those back in over time to make sure that we’re right around pricing.
Joel Jackson: Thank you.
Operator: Our next question comes from the line of Michael with Wells Fargo Securities. Michael, your line is open.
Michael Sison: Hey, guys. Scott it’s been great working with you over the last decade or so. So for 2024, can you still do or do you still expect demand to support sort of that 200,000 KTs that you’re expecting to expand to? And if you do, I guess, at these pricing levels, you could do 30% to 40% EBITDA margin?
Eric Norris: Why don’t I comment on the demand first. I think it’s an important topic, and then I’ll turn it over to Scott. This is Eric speaking. A couple of facts just to get a flavor of our business today. All of our contracts are performing. We’re able to sell product into the spot markets for that 20%. There is a lot of negative sentiment broadly in sort of media around the marketplace. It happens to be around maybe certain manufacturers announcements. I think you can’t lose sight of the fact that the bigger markets, China, are the bigger producers in the EV space, are continuing to grow their output, and that’s driving healthy demand. It is true that this year demand from a production standpoint – the need for new production is probably underperformed the 40% growth. So the market for consumption it’s been closer to 35% growth year-on-year, where the EV market is growing at 40%, and that’s because of the inventory correction we see or have seen – but looking forward, that’s not a sustainable trend once inventory is running its course, there is a return to normalcy and/or potentially even a restocking that occurs. So we feel very good about what – we see what’s happening now is road bumps, but certainly not a determinant for the long-term growth we have. And as we look out to 2024, we will be bringing on capacity that will allow us to put against those contracts, as I said, are performing well, another double-digit year growth in 2024. As for margins, I’ll let Scott comment.
Scott Tozier: Yes. Thanks, Eric. So I think the way you should think about this is we’ve kind of illustrated on Slide 15 of our deck, we’re going to continue to see some level of the spodumene inventory lag affecting us in the first half of next year. And then by the second half, we will be in that kind of normalized 30% to 40% range that I talked about. So the full year is likely to be lower than that. However, we will get to normalized margins by the second half of the year, again, assuming if prices remain constant through that period. And we don’t see the price volatility that causes these ups and downs.
Michael Sison: And then I guess, if the industry is running in the mid-90s, and let’s just say demand does continue to grow next year. Stability in pricing hasn’t been the case, right, for the last year or so? I mean do you think there is potential for a quick rise again in pricing? Would that happen if prices – if folks restock?
Kent Masters: So look, this is – this industry – it’s still early in the industry, so it’s difficult to say. So we were anticipating some of the volatility coming out in this cycle, but that didn’t really happen. So it is difficult to say exactly how quick it responds, where it goes and where it comes back to. We anticipate over time the highs and lows in that volatility coming out. But the question is, what is that period of time?
Michael Sison: Got it. Thank you.
Operator: Our next question comes from the line of Jeff with JPMorgan. Jeff, your line is open.
Jeffrey Zekauskas: Thanks very much. Your cash flow through the first 9 months was $1.45 billion and you’re expecting cash flow for the year of $600 million to $800 million. Why is the cash flow in the fourth quarter, negative 6% or negative 8%? Is that one-time? Is it ongoing? And what do you make that?
Scott Tozier: Thanks, Jeff, for the question. So I think a couple of things are doing that. Of course, we’ve got lower EBITDA in the fourth quarter. As we look at our sales patterns, we’re back-end loaded in the quarter. So we have increased working capital as a result of that. And then we’ve got some one-time items, including the DOJ and SEC settlement that we did that flows through our operating cash flow. So those are the key drivers. And then right now, our CapEx is on track to be about the same as what it was in the third quarter. So those are kind of the moving pieces in our cash flow for the fourth quarter.
Jeffrey Zekauskas: Second, just what you said was that your EBITDA margin was being penalized by about 7 to 10 percentage points than your lithium business because of these timing differences. If you look at the EBITDA of energy storage, excluding equity income, in the quarter, it was about negative 15. And so if you take 10% of the energy storage revenues of $1.7 billion, that’s another $170 million. You netted out, that’s $150 million. So it looks like the EBITDA margin on your businesses, excluding Talison is about 8%. And – so what am I doing wrong in the math? What am I missing? And then why do the – so what are the returns on your business, excluding Talison and the changes in inventories?
Scott Tozier: Yes. So Jeff, this is important because our strategy is to be an integrated producer. That means we’re going to make money throughout the chain from the mine all the way through the chemical conversion into the salts business. Given where the prices are today and how they dropped, the JV is making the joint venture and we will just focus on Talison, but the same is happening at Wodgina. The JV is making a significant amount of our operating income. And as those high-cost spodumene inventories being processed in the quarter and the second half of this year, primarily in China, we are actually seeing losses as you commented on that conversion. But that’s really just being driven by the timing of that spodumene inventory being processed. If you were to normalize and again, in a flat rate and flat price environment, you would see normal margins in both the core business as well as the joint venture ultimately. And so again, I think as you look at the geography of our P&L, that’s the effect that we have been talking about with that inventory spodumene lag happening.
Operator: Your next question comes from the line of Aleksey Yefremov with KeyBanc Capital Markets. Your line is now open.
Aleksey Yefremov: Thanks and good morning everyone. On your fourth quarter guidance for lithium, if I look at your Slide 15 and sort of take the difference between your expected fourth quarter margin for the segment and expected normalized margin of 35%. I get about $300 million to $400 million EBITDA impact of this timing difference just in the fourth quarter. Does this sound about right to you as a dollar impact for this phenomenon?
Scott Tozier: Yes. That’s pretty close, Aleksey.
Aleksey Yefremov: Great. And another question is the – you mentioned the impact of lower equity income because your partner chose not to take their full allocation. Can you talk about the size of that impact in the fourth quarter? And also if you can talk about it directly, maybe you can speak about your equity income expectations in general in Q4.
Eric Norris: Aleksey, hey, it’s Eric Norris. It obviously because of that curve that you referenced on Slide 15, it would vary at any point in time. But in the fourth quarter itself, it’s over $100 million sort of in that $100 million to $200 million range.
Aleksey Yefremov: Thanks.
Operator: Your next question comes from the line of David with Deutsche Bank. David, your line is open.
David Begleiter: Thank you. You referenced some spodumene producers or lepidolite producers in China shutting down as well as maybe some non-integrated producers. When did you start see shutdowns to occur? And how much is being shutdown in your view?
Eric Norris: It’s Eric again. So, you may recall that we saw the same phenomenon in the – during the first quarter as well when prices took a similar dip and if you – and so there are a couple of factors going on. One, starting first with merchant spodumene producers, those are the producers we refer to as they are buying spodumene on the market, converting it in China. Their cost has – when you start to get certainly at current price levels, actually, probably when you get into the mid-20s and less, they start – their margins start to get upside down. In fact, the prior comment that Scott just answered around the negative margins that were pointed out in the quarter on a non-consolidated basis, for us are an illustration of what a non-integrated producer would be dealing with. So, they shutdown at those prices or they have to, unless they can get their hands on lower-cost spodumene. Spodumene has been coming down, hasn’t been coming down at the same rate. The big question, obviously, that pivot point of when they shutdown depends on when or what the spread is basically to spodumene, but that is currently negative. Lepidolite is a bit of a different story. It’s a much higher cost material to produce and has had – there has been froth with environmental and start-up challenges. So, there has been both a moderation of capacity for those reasons over the course of the year as well as a moderation of capacity for the same reason I just referenced. Un-integrated lepidolite producers who buy lithium in the market and convert it are seeing a similar margin loss at these prices. If you look at lepidolite producers from peak from where they started the beginning the year to now, it’s about a 40% reduction of which about 10% has come offline in the recent few months, some more came off in the earlier part of the year. So, those are the various factors that are driving closures within China at these prices. Obviously, price recovers, they could come back, of course.
David Begleiter: Got it. Eric, did you mention that ‘24 volumes in energy storage should be up around between a 20% to 30% range, that you were guiding to longer term?
Eric Norris: I don’t know that we have given a guidance fully on that yet. But I mean if you take the demand forecast that we gave you earlier in the year that were multiyear, you would see a similar growth rate projected for next year as we had this year. This year’s growth rate was clipped a little bit by – for lithium consumption. It was clipped a little bit by the inventory correction we saw during the year, but it’s well into the 30s for sure going into next year, we believe.
David Begleiter: Thank you.
Operator: Your next question comes from the line of David with TD Cowen. David, your line is open.
David Deckelbaum: Thanks for squeezing me in guys. I wanted to just ask maybe a non-lithium related question, I would say, I guess upwards of a year ago, you guys were looking strategically at that perhaps divesting the catch in business. We have seen a rebound in that business. And it seems like the outlook is fairly robust for the fourth quarter. Considering the balance with the energy storage side right now, is this potentially a strategic time of divesting that business or putting it under review or should we think of this as part of the going concern?
Kent Masters: So, I think we went through that process a year ago and couldn’t get the value for catching that we were thinking about. So, we rebranded it. we are treating it as a wholly owned subsidiary, and that’s kind of the go forward for the moment. I don’t know that we would think about it long-term as part of the overall strategy. But in the near-term, that’s part of the plan.
David Deckelbaum: Got it. And I guess just maybe a question for Eric. On the energy storage side, you talked about the Talison JV and partner electing not to take shipments in the fourth quarter. We have seen some other of your peers building inventory in the fourth quarter here. Do you anticipate doing that in any of your assets or advocating for incremental inventory stocking or slowing down at any of the other assets in Australia?
Eric Norris: The best way to answer that, and you are right, every supplier has a different situation and the situation for our partners at Talison that they have unique issues and challenges that are different perhaps than ours. When we look at our rate of capacity addition downstream for conversion, and that includes Qinzhou coming up and includes Kemerton I and II coming up in that part of the world, and continuing to run [Technical Difficulty] in our Qinzhou facilities at full capacity and then look at ramping Meishan later in the year next year. We see demand for more spodumene to obviously serve that growth. We haven’t given precise guidance on what that volume growth is for next year. We will do that in three months’ time. But as I have said, I think earlier, it’s a double-digit type growth we are expecting again, which has a demand on spodumene. Our mandate is to run efficiently in this environment, right, because cash preservation to support our growth is critical. So, we are not in a mode of trying to carry working capital that we aren’t going to put into – convert into cash in a reasonable timeframe. So, building inventories is less of a strategy than ramping production to match the conversion demand downstream. And again, we will give more guidance on all of that in a number of months.
David Deckelbaum: It sounds like you guys aren’t going to be coming back to the market with an update, like you did last January that we should wait until February with the fourth quarter earnings?
Kent Masters: Yes, the thinking at the moment is that we will do that in normal course to be the February earnings.
David Deckelbaum: Thank you all for the answers.
Operator: Your next question comes from the line of Kevin McCarthy of Vertical Research Partners. Kevin, your line is open,
Kevin McCarthy: Thank you and good morning. On Slide 11, you indicate that a $10 per kilogram change in market indices would equate to a change of $5 to $7 per kilogram in your realized pricing for this year. My question is, would that sort of rule of thumb apply to 2024 as well, or might it be different?
Scott Tozier: Yes. Kevin, so that should apply. And just as a reminder, that’s on a full year basis. So, it has to move by $10 over the full year and the full year impact of that kind of 5% to 7% range [Technical Difficulty] it’s a little bit confusing because that moves up and down like we did this year that makes it a little bit harder to track through that. But that ratio carries forward into 2024. Yes. So, the only – I would say we except from that is if you were to get into the contract or it’s correct. So, that number is kind of – when we put that out there, it was a higher number, wasn’t anywhere near the floors.
Kevin McCarthy: Thank you for that. And then coming back to Slide 15 and maybe the subject of the spodumene concentrate inventory flow-through, tempted to ask, Scott, how do you see the quarterly margin pattern progressing, or put differently, which do you think would be the trough margin quarter as you digest the expense of spodumene, might it be the first quarter of next year, the second quarter, or is it difficult to tell at this point?
Scott Tozier: Yes. I think as you look at that chart, you can kind of see where those lines start to converge and that the trough would be in this fourth quarter of 2023. Of course, as you look at that, you are going to have some impact in the first quarter. So, I think as you look at the next year from that impact that the trough in 2024 would be in the first quarter.
Kevin McCarthy: Okay. Thanks so much.
Operator: Your next question comes from the line of Vincent Andrews with Morgan Stanley. Vincent, your line is open.
Vincent Andrews: Thank you. Kent, can I ask you on the balance sheet philosophically? If we think back a couple of months with Liontown, you are going to debt finance that acquisition. And if I recall correctly in the slide deck, you had a range of outcomes on price, and I think the better case was about 15,000. So, how do you think about – or how do you think about using the balance sheet for M&A versus your growth CapEx plans, because I am just thinking about your comments from earlier that you might push things – change the sequencing or so forth. And I guess I am also wondering, are you less interested in debt financing, organic growth versus acquired growth? And as you think about the next couple of years, do you need to be free cash flow positive, or are you willing to let the leverage come up a little bit if that’s what happens?
Kent Masters: Yes. So, there is a lot in that question, and it depends on how things play out. I mean I guess the things – we want to make sure that we kind of set fundamentally, we want to be investment grade, and we kind of have a – we have a target or a kind of a ceiling that we kind of work to is about 2.5x around that. So, we want to be – and obviously, that’s under stress period, so we want to stay below that, and we will have to make adjustments to do that, right. So, we want to preserve our organic growth plan that we have because we have got resources for that. Our acquisitions have been focused on a couple of different areas. We will still look at M&A, but it’s not going to be at the same scale that we were frankly looking at six months ago.
Vincent Andrews: Okay. And then, Eric, if I could ask you on the Chinese converters or the non-integrated converters, kind of referenced this earlier that at current spodumene prices, some of them are backing off. At least on our calculations, spodumene prices could still go down quite substantially and most spodumene producers would still be quite profitable. So, is there a reason why that won’t happen that those spodumene producers won’t – just lower price to keep their customers operating so that they can make sales and generate cash, or is there something in that market dynamic that’s not obvious to me?
Eric Norris: Well, I mean I think in theory, you are right. I mean there is margin to give from a spodumene mine producer. But then on the other hand, there is market demand, what’s required. That’s the counter effect to price, obviously. And with the amount of capacity that will come off, while the room for spodumene prices to potentially come down at some point, there is now demand for salts in the market that is not being met, and that would turn things the other way around, right. So, it’s about the demand equation, which I think generally speaking, the market is to soft, not the trade, not the lithium market. But the broader global markets, stock markets are a little down on is that the demand is not as weak, we see it as weak as being portrayed and particularly in China. So, as that – and in China, as a reminder, is about 70% of the world’s consumption or production of EVs. So, I think it’s the demand factor that would be the mitigating factor on further spodumene prices. But to your point, I don’t know we know exactly where spodumene prices will go because we keep – it’s hard to predict relative to when there is a stimulus on demand that pulls them back up.
Vincent Andrews: Okay. Thanks very much. I appreciate it and congratulations, Scott, on retirement. I appreciate all your help over the years.
Scott Tozier: Thanks Vincent.
Operator: Your next question comes from Colin with Oppenheimer. Colin, your line is open.
Colin Rusch: Thanks so much guys. With the inventory hanging out at these lower levels, we are seeing some new balances in terms of a variety of supply chains. What’s your expectation around where that normalizes in terms of days of inventory? It seems like the industry is running awfully lean at this point. And then if you could also address what you are hearing from some of your longer term OEM customers around concerns on security supply as they adjust some of their EV production plans?
Eric Norris: So, Colin, it’s Eric. On your first question, I don’t know that we have a good answer for that. It’s because it’s perpetually operated, particularly if you look at Chinese cathode producers at levels which are less than a week, this is – contrast that with our supply chain and this inventory lag that is one of the most popular and understandably popular question being asked today, the reason we have that is it takes six months to go from mine to product on our side. And if there is any disruption in the supply chain, five days of supply at a cathode producer is not going to be enough. So, it doesn’t feel sustainable, but they have been able to operate that way throughout the year. So, there are some question marks we would have about what’s a sustainable and responsible way as a company to operate your supply chain for security purposes. And I just I got to believe that it’s got to be higher downstream at some point than it is, but I don’t think we know exactly what it could be. And then in terms of the global OEM sort of concern on security supply, there is no letup from OEMs on interest and long-term off-takes in securing supply. Yes, it is true. There are some OEMs who have announced some changes to their or expressed some concerns about their targets. But I think if you look at the larger players in the EV space, keeping in mind that, that isn’t necessarily the companies that are now announcing that they are pushing out their targets. Those larger producers are going to continue to increase their output whether they are here or in China or in Europe and they are continuing to demand security and supply because they realize they cannot fulfill the large investments they are making downstream in electric vehicles without lithium. So, I think that demand – that dynamic is still there with the OEMs.
Operator: Our final question comes from the line of Steven [ph] with Bank of America. Steven, your line is open.
Unidentified Analyst: I just wanted to ask you whether you would be looking at any new technologies to extract more lithium out of the brand deposits in Argentina, anything that you are – you think could bolster your production there at a more capital-efficient way in any of these technologies in development that you see could potentially lower the reinvestment economics?
Kent Masters: Yes. So, we – I mean look, we have a broad R&D program and extracting lithium and converting lithium to salt and other materials is the big part of that. From the program, it sounds like you are referencing would be around direct lithium extraction, which is a variety of technologies. It’s not just one particular thing, but a variety of technologies that tends to be unique for each brine. And we have a program around that, that’s – it’s kind of broad in nature, but it’s very focused on the resource we have in Magnolia and the Salar de Atacama. It would also apply in Argentina as well or to any brine resources. But what – at the moment, the work is particularly focused on the Salar de Atacama and the brine to Magnolia, Arkansas.
Unidentified Analyst: Very good. Thank you.
Operator: That was all the time we have for questions. I would like to turn the call back over to Kent.
Kent Masters: Okay. Thank you. Thank you all for joining us today, and I apologize for the technical difficulties. I think we have got the line on the speaker side muted for a period of time. I apologize for that. Albemarle leads the world in transforming essential resources into the critical ingredients for modern living with people and planted in mind. We are confident in the market opportunity and our disciplined strategy to achieve both short-term and long-term results. We continue to work to be the partner of choice for our customers and the investment of choice for both the present and the future. Thank you for joining us today.
Operator: Ladies and gentlemen, that concludes today’s conference call. Thank you for your participation. You may now disconnect. | [
{
"speaker": "Operator",
"text": "Ladies and gentlemen, thank you for standing by. My name is Sheryl and I will be your conference operator today. At this time, I would like to welcome everyone to Albemarle Corporation’s Q3 2023 Earnings Call. [Operator Instructions] Thank you. I will now hand it over to Meredith Bandy, Vice President of Investor Relations and Sustainability."
},
{
"speaker": "Meredith Bandy",
"text": "Alright. Thank you, Sheryl and welcome to Albemarle’s third quarter conference call. Our earnings were released after the close of market yesterday and you will find the press release and earnings presentation posted to our website under the Investors section at albemarle.com. Joining me on the call today are Kent Masters, Chief Executive Officer; and Scott Tozier, Chief Financial Officer; Netha Johnson, President of Specialties; and Eric Norris, President of Energy Storage, are also available for Q&A. As a reminder, some of the statements made during this call, including our outlook, guidance, expected company performance, timing of expansion projects, and growth initiatives may constitute forward-looking statements. Please note the cautionary language about forward-looking statements contained in our press release and earnings presentation, which also applies to this call. Please also note that some of our comments today refer to non-GAAP financial measures. Reconciliations can be found in our earnings materials. And now, I will turn the call over to Kent."
},
{
"speaker": "Kent Masters",
"text": "Thank you, Meredith. Before we begin, I am sure most of you have seen that this will be Scott’s last quarterly call as CFO. Scott is transitioning roles to become a strategic advisor, while Neal Sheorey will join the company as Executive Vice President and Chief Financial Officer on November 6. Scott has had a positive impact on the company since he joined in 2011. With his leadership, we have advanced Albemarle’s growth strategy and maintained our commitment to operating with people and planet in mind. In this new role, Scott will provide strategic advice into our long-range plans and will also be on hand to assist with Neal’s transition. I know you will join me in thanking Scott for his contributions to Albemarle over the past 13 years. Our third quarter results reflect strong operating performance and continued volumetric growth in a challenging macro environment. Our net sales were up 10% in the third quarter versus the same period last year. However, adjusted EBITDA was down due to softer lithium market pricing and timing impacts of spodumene inventory from our JV-owned assets. Based on current market prices, we have revised our 2023 outlook, which still contemplates an increase in net sales between 30% and 35% year-over-year. We remain bullish about Albemarle’s long-term growth, our role in enabling a more resilient world and our strategy to deliver enduring value. In the third quarter, we made significant progress advancing these efforts. During the quarter, we signed agreements with Caterpillar to collaborate on solutions to support the full circular battery value chain and sustainable mining operations. As part of the partnership, we will purchase an all-electric mining fleet for Kings Mountain and make our North American produced lithium available for use in Caterpillar battery production. We will also explore opportunities to collaborate with Caterpillar on R&D of battery cell technology and recycling techniques. With this collaboration, we and Caterpillar will be both customers and suppliers of each other with shared goals to pioneer the future of sustainable mining technology and operations. We also received a $90 million grant from the U.S. Department of Defense to help support the expansion of domestic mining and the production of lithium for the nation’s battery supply chain. The grant will be used to purchase fleet of mining equipment in support of the Kings Mountain restart. Earlier this month, we finalized simplified commercial arrangements related to our joint venture transaction with Mineral Resources. Under the revised agreements, Albemarle will take full ownership of the Kemerton lithium processing facility and 50% ownership of the Wodgina spodumene mine in Australia and retain full ownership of the Qinzhou and Meishan lithium processing facilities in China. I will now hand it over to Scott to walk through our financial results."
},
{
"speaker": "Scott Tozier",
"text": "Thanks, Kent and hello everyone. On Slide 5, let’s review our third quarter performance. Net sales were $2.3 billion, up 10% compared to last year. This increase was driven by higher energy storage volumes, thanks to expansion of our mining and conversion assets. Net income attributable to Albemarle was approximately $303 million, down 66% compared to the prior year. Similarly, diluted EPS was $2.57, down 66%. Higher net sales were more than offset by higher cost of goods sold, primarily due to inventory timing and I will discuss these timing impacts more in a moment. Our year-to-date results reflect the strong performance and significant growth we have achieved this year despite recent softer lithium pricing. For the 9 months ended September 30, net sales are up 55% year-over-year and net income is up 42%. Looking at Slide 6, third quarter adjusted EBITDA was $453 million, a decrease of 62% year-over-year, driven primarily by softer lithium market pricing and timing impacts of spodumene inventory and energy storage. The Specialties business was also down due to continued lower volumes and pricing related to softness in certain end markets. For the first three quarters of 2023, adjusted EBITDA was more than $3 billion, up 38% against last year. Again, energy storage growth reflects the majority of that increase with both volumes and prices up year-over-year. On Slide 7, as Kent mentioned, we are lowering our total company outlook for 2023. As has been our practice, this outlook assumes recent lithium market price indices are constant for the remainder of the year. And as a result, we have decreased the range for net sales. Under this methodology, 2023 total company net sales would be in the range of $9.5 billion to $9.8 billion. This range represents an increase in net sales of 30% to 35% over the prior year, driven by the ramp of our energy storage volumes. Our adjusted EBITDA outlook is expected to be in the range of $3.2 billion to $3.4 billion. This implies full year EBITDA margins of 34% to 35%. Our full year 2023 adjusted EPS outlook has also been adjusted to a range of $21.50 to $23.50. We expect our net cash from operations to be in the range of $600 million to $800 million. The decrease in adjusted EBITDA and net cash from operations reflects current lithium market prices and lower expected sales volumes at our Talison joint venture. Our partner at Talison, elected not to take their full allocation in the second half of this year, and this has impacted our equity income for the period. Our CapEx guidance remains in line with previous forecasts at $1.9 billion to $2.1 billion, which as a reminder from last quarter, reflects 100% ownership of our conversion assets with the completed revised agreements with Mineral Resources. We expect to provide our full year 2024 outlook on our fourth quarter call in February. Turning to the next slide for more detail on our outlook by segment. Assuming recent lithium market prices remain constant through the rest of the year, we expect energy storage 2023 net sales in the range of $7 billion to $7.2 billion and adjusted EBITDA to be flat to slightly down on the year as timing impacts of higher priced spodumene more than offset higher net sales. We are projecting that full year average realized pricing increases will be in the range of 15% to 20% year-over-year and energy storage volume growth in the range of 30% to 35% year-over-year. We continue to expect Q4 to see stronger production volumes as a result of project ramps. In 2024, volume growth is anticipated to continue as as Kemerton, Qinzhou and La Negra ramp to meet the expected demand from continued strong EV production. In the Specialties, we now expect net sales to be approximately $1.5 billion, with adjusted EBITDA expected to be down 40% to 45% year-over-year for the full year. This is due to continued softness in consumer electronics and elastomers, partially offset by strength in demand in other specialties end markets, including pharmaceuticals and oilfield. We continue to monitor the situation in the Middle East and any impacts at our operations in Jordan. Currently, JBC is operating as usual without disruption to our supply chain. Macroeconomic and geopolitical uncertainties will impact market visibility in this business well into 2024. Ketjen’s 2023 full year adjusted EBITDA is now expected to be up 250% to 325% year-over-year due to higher pricing and volumes as well as productivity improvements. During the quarter, we saw higher volumes driven by high refinery utilization. We also saw benefits of higher contract pricing primarily for FCC products, which is expected to continue through 2023 and into 2024. We are encouraged to see inflation in Material and Energy costs moderating and expect this trend to continue through 2024. On Slide 9, we have an experienced team that knows how to operate in a variety of price environments. Maintaining our disciplined growth mindset we are taking a comprehensive review of actions that will support our near-term profitability and cash flow. As we’ve done in the past, we’re reviewing our project spend and sequencing of our projects to preserve cash. We’re also implementing cost and efficiency improvements across our business. For example, we’ve reduced non-critical travel and are reducing discretionary spending. Our Albemarle Way of Excellence is the standard by which we choose to operate. Slide 10 provides an update to the targets we’ve made in manufacturing and procurement. We’re on track to exceed our goal of $170 million in productivity benefits in 2023. In manufacturing, improvements to our overall equipment effectiveness to improve yield and utilization are expected to exceed $70 million in benefits. In procurement, we strategically sourced to capture lower raw material pricing. In 2024, we expect to increase these initiatives, targeting additional benefits across manufacturing, procurement and back office. Lowering operational costs in our business is critical to our success as we orient towards sustainable growth. As a reminder, most of our energy storage volumes are sold under long-term contracts with strategic customers. Our expected 2023 sales mix on Slide 11 remains unchanged from last quarter and reflects recent lithium market prices. We expect year-over-year energy storage volume growth to be in the range of 30% to 35% in 2023. This is driven by successful execution and ramping new capacity as well as additional tolling. With additional conversion assets coming online in 2024 and beyond, we still anticipate a 20% to 30% CAGR in Albemarle sales volumes between now and 2027. And we remain on track to nearly triple our volumes to more than 300,000 tons. Slide 13, is the updated bridge for our energy storage adjusted EBITDA margins. Full year 2023 margins are expected to normalize in the 40% range from the very high rates we saw in 2022. As always, Talison equity income is included in our adjusted EBITDA on an after-tax basis, that tax drag impacted EBITDA margins by about 7% to 10%. The other impacts on the chart are relatively small and our offsetting. Higher lithium pricing is offset by other items. This year, we had a 5% negative impact from MARBL JV accounting that goes away next year with the closure of the restructured MARBL JV. That leaves the largest impact to our margins at 20% spodumene inventory lag. We understand this inventory lag is complicated and can be difficult to forecast. So I want to spend a little bit more time on that. Through the Talison joint venture, Albemarle has access to one of the world’s best lithium resources. Greenbushes is a large, high-grade and, therefore, low-cost spodumene mine. We recognize our 49% share of Talison earnings in equity income and cash dividends. Our 50% share of Talison offtake also flows through inventories and cost of goods sold based on market pricing. The timing of inventories and sales can often drive short-term margin variations. Excluding these timing impacts, we expect energy storage adjusted EBITDA margins to be in the range of 30% to 40%, even at today’s prevailing market pricing for lithium and spodumene. Turning to Slide 15. In the Talison joint venture, we recognized profit associated with our partners’ offtake immediately. We recognized profit associated with our offtake when the product is converted and sold which typically takes about 6 months from when we first extract spodumene from the ground. Throughout 2022 in the first half of 2023, Talison pricing on partner shipments was higher than that realized on our own shipments. Timing differences between the recognition of our profit on our partner’s offtake and our offtake resulted in about $800 million of benefit to EBITDA during that period. As spodumene market prices decrease, we expect this effect to reverse as we recognized higher priced spodumene and cost of goods sold and lower prices in equity income. However, we expect this timing-related impact to be temporary, with no impact to adjusted EBITDA at steady market prices. Again, assuming today’s market prices are held constant, we expect energy storage adjusted EBITDA margins to average in the range of 30% to 40%. Turning to Slide 16. Albemarle’s capital allocation priorities remain unchanged. First, investing in high-return organic and inorganic growth, second, maintaining financial flexibility and our investment-grade credit rating; and lastly, funding our dividends. Planned expansions to deliver volumetric growth continue to progress across the company’s global portfolio. Although, as I mentioned before, in this softer market, we are taking a hard look at the level of our CapEx spending and the sequence of our projects. As it relates to inorganic opportunities, we announced a few weeks ago that we decided not to pursue a binding agreement to purchase Liontown and formally withdrew our non-binding offer. While we had productive engagement with Liontown and as we learn more, we decided that moving forward with the acquisition at this time was not in Albemarle’s best interest. This reflects our disciplined capital allocation and M&A approach. As we look forward, we continue to evaluate a broad range of M&A opportunities. However, in the current environment, the scale of those opportunities are not as big. And we have many options available across 3 areas: lithium resources, process technology for our core business and for new advanced materials and battery recycling. Turning to Slide 17. Our balance sheet flexibility is a competitive advantage that allows us to grow both organically and through acquisition as well as support shareholder returns. As of year-end 2023, we expect our leverage ratio to be 1.2x to 1.3x net debt-to-EBITDA. And with that, I’ll turn it back over to Kent for a market update and closing remarks."
},
{
"speaker": "Kent Masters",
"text": "Thanks, Scott. On Slide 18, we highlight the continued growth in EV sales that reinforces our long-term growth opportunity. Year-to-date through September, EV sales remain on track for 40% year-on-year growth and show end market demand to be resilient. While the U.S. and Europe make up only about one-third of total EV production in ‘23 and ‘24, near term, we see potential challenges for EV growth in those regions related to economic softness and higher interest rates. We are monitoring any economic impacts to the seasonal acceleration in EV sales at the end of the year. Our long-term view of secular growth continues to be supported not only by the adoption of EVs, but transformations across mobility, energy, connectivity and health. Slide 19 provides a view of lithium inventories across the value chain. Both upstream and downstream producers have continued destocking with very low levels of lithium inventory at cathode producers. Cuts to higher-cost supply have continued as some lepidolite producers, and merchant converters have reduced production. Turning now to Slide 20. We remain on track to achieve strong net sales growth up 30% to 35% year-over-year. This reflects our continued growth investments and the strength of our portfolio that have enabled us to overcome the near-term pricing challenges. We are disciplined in both how we operate and how we allocate capital providing an edge across economic cycles. Albemarle is a global leader with world-class assets and a diversified product portfolio positioned to supply key growth sectors. We have a competitive advantage with vertically integrated assets and innovative advanced solutions designed to meet our customers’ needs. The actions we took this quarter, including our collaboration with Caterpillar, and the restructuring and simplification of the MARBL joint venture help us build on this advantage. The long-term growth trajectory of our end markets remain strong including continued growth in electric vehicles. Our strategy is clear to capitalize on this opportunity with a disciplined operating model to scale and innovate, accelerate profitable growth and advanced sustainability. With that, I’d like to turn the call back over to the operator to begin the Q&A portion."
},
{
"speaker": "Operator",
"text": "[Operator Instructions] Your first question comes from the line of Patrick Cunningham with Citi. Patrick, your line is now open."
},
{
"speaker": "Patrick Cunningham",
"text": "Hi, good morning. So one of your JV partners is not taking the full allocation at Greenbushes and do you still plan to take your full volume allocation? And do you see any risk of production cuts in the first quarter, perhaps its concentrated stockpile?"
},
{
"speaker": "Kent Masters",
"text": ""
},
{
"speaker": "–",
"text": ""
},
{
"speaker": "Patrick Cunningham",
"text": "That’s helpful. And then just given some of the recent price weakness headlines, dialing back EV targets, I’m just curious on more detail on how you’re thinking about growth investments and trajectory going forward. How has your thinking started to change on regions, project spending and sequencing of those projects?"
},
{
"speaker": "Kent Masters",
"text": "Yes. So we’re going through that at the moment. So we’re not prepared to really give guidance for next year’s capital plan, but we are taking a look at that. Everything we can do to cut capital, but without really impacting the long-term growth trajectory or the growth projects that we’ve developed out there. So there is some flexibility around sequencing and we will be able to put some projects out slightly without really changing the long-term profile for that. And that’s the work that we’re doing now, and we will be able to give guidance on that in the February call."
},
{
"speaker": "Patrick Cunningham",
"text": "Alright, thank you."
},
{
"speaker": "Operator",
"text": "Your next question comes from the line of Josh Spector with UBS. Josh, your line is open."
},
{
"speaker": "Josh Spector",
"text": "Hi, thanks for taking my question. I guess, first, I wanted to ask on kind of lithium pricing and specifically the realized pricing for Albemarle. And just kind of thinking about a scenario where spot goes less than $20, so say, $18 per kilogram. What happens to the other 80% of your contracts? You’ve talked about floors, you’ve indicated that there above or at the high end of the cost curve. But what really does that mean? In that scenario, I guess, what does Albemarle realize in terms of pricing?"
},
{
"speaker": "Eric Norris",
"text": "Good morning, Josh, it’s Eric. As you know, we don’t give precise price guidance for our overall portfolio. But let me try to help and give you some perspective around this. First off, obviously, a spot price realized in China, will look different as you look at other market pricing around the world. There is – most of the supply or a lot of the supply comes from China, they are transactional and VAT considerations that would translate that to a higher price oftentimes outside of China. We have floors on our 80% of our index reference contracts. We have a variety of different floors. We don’t disclose that, but it’s designed to give us protection so that we can continue to operate well, continue to pursue growth capital in the near-term and to sustain the margins that Scott was talking about. And as we look forward, I mean, we are – I’d have to little bit perplexed as to why price is where it is. These are levels that for a great number of the higher-cost projects we would expect supply to come off, and in fact, have seen supply come off, should prevail. We’d expect to see potentially other resources or other projects be slowed down. From our perspective, though, we have a growth plan that’s double-digit growth next year. We feel comfortable with the protection of our contracts give us and importantly, the low-cost position we have going forward in our portfolio."
},
{
"speaker": "Josh Spector",
"text": "Yes, thanks, Eric. And I guess I wanted to follow-up just on the margin comments that you made, Scott. So the range that you gave, I mean, it’s different than you go back a couple of years ago, you talked about 45% plus. And I believe at that time, you said you could maintain those margins in a lower price environment. I guess I don’t know if I’m remembering right or if anything has changed, but what accounts for the difference?"
},
{
"speaker": "Scott Tozier",
"text": "Yes. I think the difference, Josh, is that when we made those mid kind of 40% comments, we were thinking about a mid-cycle type of pricing. As we look at this 30% to 40% that I commented on today, that’s really at today’s prevailing prices. And again, it’s based on constant pricing as opposed to some of the volatility, which is going to distort our margins either higher as prices go up or lower as prices come down."
},
{
"speaker": "Josh Spector",
"text": "Okay, thank you."
},
{
"speaker": "Operator",
"text": "Your next question comes from the line of Joel Jackson with BMO Capital Markets. Joel, your line is open."
},
{
"speaker": "Joel Jackson",
"text": "Good morning, Eric. So I think Eric, you just said you were perplexed how low prices have come down to maybe low 20s here, LCE – so you said you’re considering reinvestment economics. So maybe you could talk about why you think prices have gone down to where they are? Is it lepidolite? Is it African spodumene? Is it something else? What do you think? Everyone is still there?"
},
{
"speaker": "Operator",
"text": "We are here. [Operator Instructions]. Thank you."
},
{
"speaker": "Meredith Bandy",
"text": "Hi, can you hear us on the line?"
},
{
"speaker": "Operator",
"text": "We can hear you."
},
{
"speaker": "Eric Norris",
"text": "Shanelle, can you hear us?"
},
{
"speaker": "Operator",
"text": "Yes, we can hear you."
},
{
"speaker": "Eric Norris",
"text": "Okay. Okay. Sorry, not sure what happened there. So Shanelle, I’ll – if it’s okay, and you can hear me, just confirming?"
},
{
"speaker": "Operator",
"text": "Yes, I can hear you."
},
{
"speaker": "Eric Norris",
"text": "Okay. So I’ll continue to answer Joel’s question. Joel, so I apologize for the interruption..."
},
{
"speaker": "Joel Jackson",
"text": "Can we start from the beginning, Eric, if that’s okay? I didn’t hear it anyway."
},
{
"speaker": "Eric Norris",
"text": "Yes. So what I was describing is that we do a lot of work to model supply and demand. And if you look last year, this year, next year, remove for a moment, what we know has happened this year, which has been an inventory correction in the supply chain, the industries by our reckoning is operating at us if you look at supply or demand over supply about a mid-90s capacity utilization rate. So that’s the part that’s perplexing. And in any other market, at those levels, you wouldn’t see pricing fall like it has. Now we have had an inventory correction this year. It’s largely run its course, at least at the cathode level in the largest market in the world, and that’s one of the slides we shared with you. Any inventory correction further in the supply chain, we would expect on balance to occur or be behind us or certainly be behind us in the balance of this year. And so as we look forward, we don’t see a rationale for why prices would fall to where they are because they are below reinvestment economics. As we’ve said many times, our concern would be towards the end of the decade that there needs to be a sufficient amount of capacity to serve the EV market. Here we are operating at a healthy – relatively healthy supply-demand utilization with prices where they are. So it’s very difficult to explain how that’s the case, Joel, but obviously, we’re well positioned with our cost position and our go-to-market strategy to weather that storm. It’s just – it’s going to be challenging for the industry at these levels. So that’s our greater concern is future availability and investment in supply to support the transition across the industry. So that’s probably the best we can tell you in terms of our view at the moment."
},
{
"speaker": "Joel Jackson",
"text": "Okay, thank you for that. If I can follow-up, on them. I think it was Kent too said, a little few minutes ago, you’re going to look at maybe ratcheting back your growth plans, it look like slightly, so slow down a little bit sequencing, but not changing anything in your longer-term plan. So what if you’re not right about your lithium price view here and what if prices are lower and the returns aren’t as good as you think and you’re going to go full team ahead on a lot of this growth, but ends up not being needed? How do you balance the risk of overspending and driving negative free cash for a long time with making sure you are supplying enough volume for the market over time and maintaining your market share?"
},
{
"speaker": "Kent Masters",
"text": "Yes. So that’s the balance, right? I think what we’re saying is we look at our capital programs, and we’re going to cut back where we can. And – but it’s not changing our overall strategy around growth – and again, our cost position protects us with that. So it’s not really the returns on the projects given what we see, but it’s more about the capital that we’re investing while the market is down. So we’re just adjusting the timing on that, and then we will be cautious as we layer those back in over time to make sure that we’re right around pricing."
},
{
"speaker": "Joel Jackson",
"text": "Thank you."
},
{
"speaker": "Operator",
"text": "Our next question comes from the line of Michael with Wells Fargo Securities. Michael, your line is open."
},
{
"speaker": "Michael Sison",
"text": "Hey, guys. Scott it’s been great working with you over the last decade or so. So for 2024, can you still do or do you still expect demand to support sort of that 200,000 KTs that you’re expecting to expand to? And if you do, I guess, at these pricing levels, you could do 30% to 40% EBITDA margin?"
},
{
"speaker": "Eric Norris",
"text": "Why don’t I comment on the demand first. I think it’s an important topic, and then I’ll turn it over to Scott. This is Eric speaking. A couple of facts just to get a flavor of our business today. All of our contracts are performing. We’re able to sell product into the spot markets for that 20%. There is a lot of negative sentiment broadly in sort of media around the marketplace. It happens to be around maybe certain manufacturers announcements. I think you can’t lose sight of the fact that the bigger markets, China, are the bigger producers in the EV space, are continuing to grow their output, and that’s driving healthy demand. It is true that this year demand from a production standpoint – the need for new production is probably underperformed the 40% growth. So the market for consumption it’s been closer to 35% growth year-on-year, where the EV market is growing at 40%, and that’s because of the inventory correction we see or have seen – but looking forward, that’s not a sustainable trend once inventory is running its course, there is a return to normalcy and/or potentially even a restocking that occurs. So we feel very good about what – we see what’s happening now is road bumps, but certainly not a determinant for the long-term growth we have. And as we look out to 2024, we will be bringing on capacity that will allow us to put against those contracts, as I said, are performing well, another double-digit year growth in 2024. As for margins, I’ll let Scott comment."
},
{
"speaker": "Scott Tozier",
"text": "Yes. Thanks, Eric. So I think the way you should think about this is we’ve kind of illustrated on Slide 15 of our deck, we’re going to continue to see some level of the spodumene inventory lag affecting us in the first half of next year. And then by the second half, we will be in that kind of normalized 30% to 40% range that I talked about. So the full year is likely to be lower than that. However, we will get to normalized margins by the second half of the year, again, assuming if prices remain constant through that period. And we don’t see the price volatility that causes these ups and downs."
},
{
"speaker": "Michael Sison",
"text": "And then I guess, if the industry is running in the mid-90s, and let’s just say demand does continue to grow next year. Stability in pricing hasn’t been the case, right, for the last year or so? I mean do you think there is potential for a quick rise again in pricing? Would that happen if prices – if folks restock?"
},
{
"speaker": "Kent Masters",
"text": "So look, this is – this industry – it’s still early in the industry, so it’s difficult to say. So we were anticipating some of the volatility coming out in this cycle, but that didn’t really happen. So it is difficult to say exactly how quick it responds, where it goes and where it comes back to. We anticipate over time the highs and lows in that volatility coming out. But the question is, what is that period of time?"
},
{
"speaker": "Michael Sison",
"text": "Got it. Thank you."
},
{
"speaker": "Operator",
"text": "Our next question comes from the line of Jeff with JPMorgan. Jeff, your line is open."
},
{
"speaker": "Jeffrey Zekauskas",
"text": "Thanks very much. Your cash flow through the first 9 months was $1.45 billion and you’re expecting cash flow for the year of $600 million to $800 million. Why is the cash flow in the fourth quarter, negative 6% or negative 8%? Is that one-time? Is it ongoing? And what do you make that?"
},
{
"speaker": "Scott Tozier",
"text": "Thanks, Jeff, for the question. So I think a couple of things are doing that. Of course, we’ve got lower EBITDA in the fourth quarter. As we look at our sales patterns, we’re back-end loaded in the quarter. So we have increased working capital as a result of that. And then we’ve got some one-time items, including the DOJ and SEC settlement that we did that flows through our operating cash flow. So those are the key drivers. And then right now, our CapEx is on track to be about the same as what it was in the third quarter. So those are kind of the moving pieces in our cash flow for the fourth quarter."
},
{
"speaker": "Jeffrey Zekauskas",
"text": "Second, just what you said was that your EBITDA margin was being penalized by about 7 to 10 percentage points than your lithium business because of these timing differences. If you look at the EBITDA of energy storage, excluding equity income, in the quarter, it was about negative 15. And so if you take 10% of the energy storage revenues of $1.7 billion, that’s another $170 million. You netted out, that’s $150 million. So it looks like the EBITDA margin on your businesses, excluding Talison is about 8%. And – so what am I doing wrong in the math? What am I missing? And then why do the – so what are the returns on your business, excluding Talison and the changes in inventories?"
},
{
"speaker": "Scott Tozier",
"text": "Yes. So Jeff, this is important because our strategy is to be an integrated producer. That means we’re going to make money throughout the chain from the mine all the way through the chemical conversion into the salts business. Given where the prices are today and how they dropped, the JV is making the joint venture and we will just focus on Talison, but the same is happening at Wodgina. The JV is making a significant amount of our operating income. And as those high-cost spodumene inventories being processed in the quarter and the second half of this year, primarily in China, we are actually seeing losses as you commented on that conversion. But that’s really just being driven by the timing of that spodumene inventory being processed. If you were to normalize and again, in a flat rate and flat price environment, you would see normal margins in both the core business as well as the joint venture ultimately. And so again, I think as you look at the geography of our P&L, that’s the effect that we have been talking about with that inventory spodumene lag happening."
},
{
"speaker": "Operator",
"text": "Your next question comes from the line of Aleksey Yefremov with KeyBanc Capital Markets. Your line is now open."
},
{
"speaker": "Aleksey Yefremov",
"text": "Thanks and good morning everyone. On your fourth quarter guidance for lithium, if I look at your Slide 15 and sort of take the difference between your expected fourth quarter margin for the segment and expected normalized margin of 35%. I get about $300 million to $400 million EBITDA impact of this timing difference just in the fourth quarter. Does this sound about right to you as a dollar impact for this phenomenon?"
},
{
"speaker": "Scott Tozier",
"text": "Yes. That’s pretty close, Aleksey."
},
{
"speaker": "Aleksey Yefremov",
"text": "Great. And another question is the – you mentioned the impact of lower equity income because your partner chose not to take their full allocation. Can you talk about the size of that impact in the fourth quarter? And also if you can talk about it directly, maybe you can speak about your equity income expectations in general in Q4."
},
{
"speaker": "Eric Norris",
"text": "Aleksey, hey, it’s Eric Norris. It obviously because of that curve that you referenced on Slide 15, it would vary at any point in time. But in the fourth quarter itself, it’s over $100 million sort of in that $100 million to $200 million range."
},
{
"speaker": "Aleksey Yefremov",
"text": "Thanks."
},
{
"speaker": "Operator",
"text": "Your next question comes from the line of David with Deutsche Bank. David, your line is open."
},
{
"speaker": "David Begleiter",
"text": "Thank you. You referenced some spodumene producers or lepidolite producers in China shutting down as well as maybe some non-integrated producers. When did you start see shutdowns to occur? And how much is being shutdown in your view?"
},
{
"speaker": "Eric Norris",
"text": "It’s Eric again. So, you may recall that we saw the same phenomenon in the – during the first quarter as well when prices took a similar dip and if you – and so there are a couple of factors going on. One, starting first with merchant spodumene producers, those are the producers we refer to as they are buying spodumene on the market, converting it in China. Their cost has – when you start to get certainly at current price levels, actually, probably when you get into the mid-20s and less, they start – their margins start to get upside down. In fact, the prior comment that Scott just answered around the negative margins that were pointed out in the quarter on a non-consolidated basis, for us are an illustration of what a non-integrated producer would be dealing with. So, they shutdown at those prices or they have to, unless they can get their hands on lower-cost spodumene. Spodumene has been coming down, hasn’t been coming down at the same rate. The big question, obviously, that pivot point of when they shutdown depends on when or what the spread is basically to spodumene, but that is currently negative. Lepidolite is a bit of a different story. It’s a much higher cost material to produce and has had – there has been froth with environmental and start-up challenges. So, there has been both a moderation of capacity for those reasons over the course of the year as well as a moderation of capacity for the same reason I just referenced. Un-integrated lepidolite producers who buy lithium in the market and convert it are seeing a similar margin loss at these prices. If you look at lepidolite producers from peak from where they started the beginning the year to now, it’s about a 40% reduction of which about 10% has come offline in the recent few months, some more came off in the earlier part of the year. So, those are the various factors that are driving closures within China at these prices. Obviously, price recovers, they could come back, of course."
},
{
"speaker": "David Begleiter",
"text": "Got it. Eric, did you mention that ‘24 volumes in energy storage should be up around between a 20% to 30% range, that you were guiding to longer term?"
},
{
"speaker": "Eric Norris",
"text": "I don’t know that we have given a guidance fully on that yet. But I mean if you take the demand forecast that we gave you earlier in the year that were multiyear, you would see a similar growth rate projected for next year as we had this year. This year’s growth rate was clipped a little bit by – for lithium consumption. It was clipped a little bit by the inventory correction we saw during the year, but it’s well into the 30s for sure going into next year, we believe."
},
{
"speaker": "David Begleiter",
"text": "Thank you."
},
{
"speaker": "Operator",
"text": "Your next question comes from the line of David with TD Cowen. David, your line is open."
},
{
"speaker": "David Deckelbaum",
"text": "Thanks for squeezing me in guys. I wanted to just ask maybe a non-lithium related question, I would say, I guess upwards of a year ago, you guys were looking strategically at that perhaps divesting the catch in business. We have seen a rebound in that business. And it seems like the outlook is fairly robust for the fourth quarter. Considering the balance with the energy storage side right now, is this potentially a strategic time of divesting that business or putting it under review or should we think of this as part of the going concern?"
},
{
"speaker": "Kent Masters",
"text": "So, I think we went through that process a year ago and couldn’t get the value for catching that we were thinking about. So, we rebranded it. we are treating it as a wholly owned subsidiary, and that’s kind of the go forward for the moment. I don’t know that we would think about it long-term as part of the overall strategy. But in the near-term, that’s part of the plan."
},
{
"speaker": "David Deckelbaum",
"text": "Got it. And I guess just maybe a question for Eric. On the energy storage side, you talked about the Talison JV and partner electing not to take shipments in the fourth quarter. We have seen some other of your peers building inventory in the fourth quarter here. Do you anticipate doing that in any of your assets or advocating for incremental inventory stocking or slowing down at any of the other assets in Australia?"
},
{
"speaker": "Eric Norris",
"text": "The best way to answer that, and you are right, every supplier has a different situation and the situation for our partners at Talison that they have unique issues and challenges that are different perhaps than ours. When we look at our rate of capacity addition downstream for conversion, and that includes Qinzhou coming up and includes Kemerton I and II coming up in that part of the world, and continuing to run [Technical Difficulty] in our Qinzhou facilities at full capacity and then look at ramping Meishan later in the year next year. We see demand for more spodumene to obviously serve that growth. We haven’t given precise guidance on what that volume growth is for next year. We will do that in three months’ time. But as I have said, I think earlier, it’s a double-digit type growth we are expecting again, which has a demand on spodumene. Our mandate is to run efficiently in this environment, right, because cash preservation to support our growth is critical. So, we are not in a mode of trying to carry working capital that we aren’t going to put into – convert into cash in a reasonable timeframe. So, building inventories is less of a strategy than ramping production to match the conversion demand downstream. And again, we will give more guidance on all of that in a number of months."
},
{
"speaker": "David Deckelbaum",
"text": "It sounds like you guys aren’t going to be coming back to the market with an update, like you did last January that we should wait until February with the fourth quarter earnings?"
},
{
"speaker": "Kent Masters",
"text": "Yes, the thinking at the moment is that we will do that in normal course to be the February earnings."
},
{
"speaker": "David Deckelbaum",
"text": "Thank you all for the answers."
},
{
"speaker": "Operator",
"text": "Your next question comes from the line of Kevin McCarthy of Vertical Research Partners. Kevin, your line is open,"
},
{
"speaker": "Kevin McCarthy",
"text": "Thank you and good morning. On Slide 11, you indicate that a $10 per kilogram change in market indices would equate to a change of $5 to $7 per kilogram in your realized pricing for this year. My question is, would that sort of rule of thumb apply to 2024 as well, or might it be different?"
},
{
"speaker": "Scott Tozier",
"text": "Yes. Kevin, so that should apply. And just as a reminder, that’s on a full year basis. So, it has to move by $10 over the full year and the full year impact of that kind of 5% to 7% range [Technical Difficulty] it’s a little bit confusing because that moves up and down like we did this year that makes it a little bit harder to track through that. But that ratio carries forward into 2024. Yes. So, the only – I would say we except from that is if you were to get into the contract or it’s correct. So, that number is kind of – when we put that out there, it was a higher number, wasn’t anywhere near the floors."
},
{
"speaker": "Kevin McCarthy",
"text": "Thank you for that. And then coming back to Slide 15 and maybe the subject of the spodumene concentrate inventory flow-through, tempted to ask, Scott, how do you see the quarterly margin pattern progressing, or put differently, which do you think would be the trough margin quarter as you digest the expense of spodumene, might it be the first quarter of next year, the second quarter, or is it difficult to tell at this point?"
},
{
"speaker": "Scott Tozier",
"text": "Yes. I think as you look at that chart, you can kind of see where those lines start to converge and that the trough would be in this fourth quarter of 2023. Of course, as you look at that, you are going to have some impact in the first quarter. So, I think as you look at the next year from that impact that the trough in 2024 would be in the first quarter."
},
{
"speaker": "Kevin McCarthy",
"text": "Okay. Thanks so much."
},
{
"speaker": "Operator",
"text": "Your next question comes from the line of Vincent Andrews with Morgan Stanley. Vincent, your line is open."
},
{
"speaker": "Vincent Andrews",
"text": "Thank you. Kent, can I ask you on the balance sheet philosophically? If we think back a couple of months with Liontown, you are going to debt finance that acquisition. And if I recall correctly in the slide deck, you had a range of outcomes on price, and I think the better case was about 15,000. So, how do you think about – or how do you think about using the balance sheet for M&A versus your growth CapEx plans, because I am just thinking about your comments from earlier that you might push things – change the sequencing or so forth. And I guess I am also wondering, are you less interested in debt financing, organic growth versus acquired growth? And as you think about the next couple of years, do you need to be free cash flow positive, or are you willing to let the leverage come up a little bit if that’s what happens?"
},
{
"speaker": "Kent Masters",
"text": "Yes. So, there is a lot in that question, and it depends on how things play out. I mean I guess the things – we want to make sure that we kind of set fundamentally, we want to be investment grade, and we kind of have a – we have a target or a kind of a ceiling that we kind of work to is about 2.5x around that. So, we want to be – and obviously, that’s under stress period, so we want to stay below that, and we will have to make adjustments to do that, right. So, we want to preserve our organic growth plan that we have because we have got resources for that. Our acquisitions have been focused on a couple of different areas. We will still look at M&A, but it’s not going to be at the same scale that we were frankly looking at six months ago."
},
{
"speaker": "Vincent Andrews",
"text": "Okay. And then, Eric, if I could ask you on the Chinese converters or the non-integrated converters, kind of referenced this earlier that at current spodumene prices, some of them are backing off. At least on our calculations, spodumene prices could still go down quite substantially and most spodumene producers would still be quite profitable. So, is there a reason why that won’t happen that those spodumene producers won’t – just lower price to keep their customers operating so that they can make sales and generate cash, or is there something in that market dynamic that’s not obvious to me?"
},
{
"speaker": "Eric Norris",
"text": "Well, I mean I think in theory, you are right. I mean there is margin to give from a spodumene mine producer. But then on the other hand, there is market demand, what’s required. That’s the counter effect to price, obviously. And with the amount of capacity that will come off, while the room for spodumene prices to potentially come down at some point, there is now demand for salts in the market that is not being met, and that would turn things the other way around, right. So, it’s about the demand equation, which I think generally speaking, the market is to soft, not the trade, not the lithium market. But the broader global markets, stock markets are a little down on is that the demand is not as weak, we see it as weak as being portrayed and particularly in China. So, as that – and in China, as a reminder, is about 70% of the world’s consumption or production of EVs. So, I think it’s the demand factor that would be the mitigating factor on further spodumene prices. But to your point, I don’t know we know exactly where spodumene prices will go because we keep – it’s hard to predict relative to when there is a stimulus on demand that pulls them back up."
},
{
"speaker": "Vincent Andrews",
"text": "Okay. Thanks very much. I appreciate it and congratulations, Scott, on retirement. I appreciate all your help over the years."
},
{
"speaker": "Scott Tozier",
"text": "Thanks Vincent."
},
{
"speaker": "Operator",
"text": "Your next question comes from Colin with Oppenheimer. Colin, your line is open."
},
{
"speaker": "Colin Rusch",
"text": "Thanks so much guys. With the inventory hanging out at these lower levels, we are seeing some new balances in terms of a variety of supply chains. What’s your expectation around where that normalizes in terms of days of inventory? It seems like the industry is running awfully lean at this point. And then if you could also address what you are hearing from some of your longer term OEM customers around concerns on security supply as they adjust some of their EV production plans?"
},
{
"speaker": "Eric Norris",
"text": "So, Colin, it’s Eric. On your first question, I don’t know that we have a good answer for that. It’s because it’s perpetually operated, particularly if you look at Chinese cathode producers at levels which are less than a week, this is – contrast that with our supply chain and this inventory lag that is one of the most popular and understandably popular question being asked today, the reason we have that is it takes six months to go from mine to product on our side. And if there is any disruption in the supply chain, five days of supply at a cathode producer is not going to be enough. So, it doesn’t feel sustainable, but they have been able to operate that way throughout the year. So, there are some question marks we would have about what’s a sustainable and responsible way as a company to operate your supply chain for security purposes. And I just I got to believe that it’s got to be higher downstream at some point than it is, but I don’t think we know exactly what it could be. And then in terms of the global OEM sort of concern on security supply, there is no letup from OEMs on interest and long-term off-takes in securing supply. Yes, it is true. There are some OEMs who have announced some changes to their or expressed some concerns about their targets. But I think if you look at the larger players in the EV space, keeping in mind that, that isn’t necessarily the companies that are now announcing that they are pushing out their targets. Those larger producers are going to continue to increase their output whether they are here or in China or in Europe and they are continuing to demand security and supply because they realize they cannot fulfill the large investments they are making downstream in electric vehicles without lithium. So, I think that demand – that dynamic is still there with the OEMs."
},
{
"speaker": "Operator",
"text": "Our final question comes from the line of Steven [ph] with Bank of America. Steven, your line is open."
},
{
"speaker": "Unidentified Analyst",
"text": "I just wanted to ask you whether you would be looking at any new technologies to extract more lithium out of the brand deposits in Argentina, anything that you are – you think could bolster your production there at a more capital-efficient way in any of these technologies in development that you see could potentially lower the reinvestment economics?"
},
{
"speaker": "Kent Masters",
"text": "Yes. So, we – I mean look, we have a broad R&D program and extracting lithium and converting lithium to salt and other materials is the big part of that. From the program, it sounds like you are referencing would be around direct lithium extraction, which is a variety of technologies. It’s not just one particular thing, but a variety of technologies that tends to be unique for each brine. And we have a program around that, that’s – it’s kind of broad in nature, but it’s very focused on the resource we have in Magnolia and the Salar de Atacama. It would also apply in Argentina as well or to any brine resources. But what – at the moment, the work is particularly focused on the Salar de Atacama and the brine to Magnolia, Arkansas."
},
{
"speaker": "Unidentified Analyst",
"text": "Very good. Thank you."
},
{
"speaker": "Operator",
"text": "That was all the time we have for questions. I would like to turn the call back over to Kent."
},
{
"speaker": "Kent Masters",
"text": "Okay. Thank you. Thank you all for joining us today, and I apologize for the technical difficulties. I think we have got the line on the speaker side muted for a period of time. I apologize for that. Albemarle leads the world in transforming essential resources into the critical ingredients for modern living with people and planted in mind. We are confident in the market opportunity and our disciplined strategy to achieve both short-term and long-term results. We continue to work to be the partner of choice for our customers and the investment of choice for both the present and the future. Thank you for joining us today."
},
{
"speaker": "Operator",
"text": "Ladies and gentlemen, that concludes today’s conference call. Thank you for your participation. You may now disconnect."
}
] | Albemarle Corporation | 18,671 |
ALB | 2 | 2,023 | 2023-08-03 10:30:00 | Operator: Hello, and welcome to Albemarle Corporation's Q2 2023 Earnings Call. [Operator Instructions]. I will now hand it over to Meredith Bandy, Vice President of Investor Relations and Sustainability.
Meredith Bandy: Thank you, Aisha, and welcome, everyone, to Albemarle's Second Quarter 2023 Earnings Conference Call. Our earnings released after the close of market yesterday, and you'll find the press release and earnings presentation posted to our website under the Investors section at albemarle.com. Joining me on the call today are Kent Masters, Chief Executive Officer; and Scott Tozier, Chief Financial Officer; Netha Johnson, President of Specialties; and Eric Norris, President of Energy Storage are also available for Q&A. As a reminder, some of the statements made during this call, including our outlook, guidance, expected company performance and timing of expansion projects, may constitute forward-looking statements. Please note the cautionary language about forward-looking statements contained in our press release and earnings presentation, which also applies to this call. Please also note that some of our comments today refer to non-GAAP financial measures. Reconciliations can be found in our earnings materials. Now I'll turn the call over to Kent.
Jerry Masters: Thank you, Meredith. Our second quarter results continued the positive trend from last quarter, with net sales up 60% and EBITDA up 69% versus the same period last year. We have increased our energy storage outlook for 2023 based on current market prices. Of course, the long-term shift to electric vehicles is well established and growing. Automakers are planning ahead to accommodate that future growth. For example, we signed a strategic agreement with Ford to supply over 100,000 metric tons of lithium hydroxide over a 5-year period, starting in 2026. One of the reasons our customers choose Albemarle is our commitment to sustainability. In June, our Salar de Atacama site became the first lithium resource in the world to complete an independent audit and have its audit report published by IRMA, the Initiative for Responsible Mining Assurance. We achieved an IRMA 50 level of performance and a third-party auditor verified that the Salar site met 70% of over 400 rigorous IRMA requirements, covering topics such as water management, human rights, greenhouse gas emissions, fair labor and terms of work. Also during the quarter, Albemarle's growth and impact on the energy transition were recognized by inclusion in the Fortune 500 rankings and in the TIME100 Most Influential Companies list. We continue to invest in future capacity to meet long-term demand. The Salar yield improvement project reached mechanical completion on schedule, and the Meishan project in China is ahead of schedule, with mechanical completion expected in early 2024. Last month, we announced agreements to simplify and amend our joint venture with Mineral Resources. I'll update you on these activities later in the presentation. And for now, I'll hand it over to Scott to walk you through our financial results.
Scott Tozier: Thanks, Kent, and hello, everyone. On Slide 5, let's review our second quarter performance. Net sales were $2.4 billion, up 60% compared to last year. This nearly $1 billion increase was driven by energy storage as a result of both higher market pricing and higher volumes, which were up almost 40%. Net income attributable to Albemarle was approximately $650 million, up 60% compared to the prior year. Diluted EPS was $$5.52, also up almost 60%, and adjusted diluted EPS of $7.33 was more than double last year. At the end of July, we reached agreements in principle with the Department of Justice on a matter that we initially disclosed in 2018 related to conduct in our catch-in business occurring prior to 2018. Our Q2 GAAP results include an approximately $219 million accrual to resolve this matter. Looking at Slide #6. Second quarter adjusted EBITDA was over $1 billion, an increase of nearly 70% year-over-year, driven primarily by higher pricing as well as higher volumes in Energy Storage. Our Specialties business was down year-over-year due to lower volumes and pricing related to weakness in certain end markets such as electronics and [Technical Difficulty], insurance claim receipts and lower energy costs. Let's look at the updated total company outlook on Slide 7. We are raising our 2023 guidance for net sales and adjusted EBITDA to reflect current lithium market prices. As has been our practice, this guidance assumes recent lithium market price indices are constant for the remainder of the year. And as a result, we have increased the lower end of the range for net sales. We now expect 2023 total company net sales to be in the range of $10.4 billion to $11.5 billion. We expect third quarter net sales to be relatively flat sequentially followed by an increase in fourth quarter net sales as we ramp energy storage volumes. We are increasing our adjusted EBITDA guidance to be in the range of $3.8 billion to $4.4 billion. This implies full year EBITDA margins in the range of 37% to 38%, also up from previous guidance. Our full year 2023 adjusted diluted EPS guidance is also increasing to a range of $25 to $29.50, reflecting a year-over-year improvement of about 25% at the midpoint. We expect our net cash from operations to be in the range of $1.2 billion to $1.8 billion. This is a decrease in outlook driven primarily by 2 factors. First, higher working capital related to the timing of our energy storage shipments. We now expect lithium sales volumes to be weighted towards the back half of the year, particularly in Q4, due to the timing of our growth projects and tolling volumes. This is expected to result in higher accounts receivable at year-end, which will convert to cash in early 2024. Second, this outlook assumes that the DOJ payment of approximately $219 million is made by year-end. Our CapEx guidance has increased to $1.9 billion to $2.1 billion. This increase reflects the revised agreements with Mineral Resources. Following these revisions, Albemarle will maintain 100% ownership of the Kemerton, Qinzhou and Meishan lithium processing plants. Apart from this change, capital spending is in line with previous forecasts. Turning to the next slide for more detail on our outlook by segment. We're increasing our full year 2023 energy storage net sales guidance to be in the range of $7.9 billion to $8.8 billion. Energy Storage volume growth is expected to be at the higher end of the previous range of 30% to 40% year-over-year thanks to increased tolling and successful project execution. We also project average realized pricing increases to be at the higher end of the previous range of 20% to 30% year-over-year, assuming recent lithium market prices continue through the rest of 2023. Adjusted EBITDA for Energy Storage is expected to increase in the range of $3.5 billion to $3.9 billion. This 15% to 30% increase is due to higher net sales, which we expect to more than offset the timing impacts of higher-priced spodumene inventories. In Specialties, we continue to see pressure in our end markets. Weakness in consumer and industrial electronics and elastomers is only partially offset by strong demand in other markets like pharmaceuticals, agriculture and oilfield services. Similar to other specialty chemicals companies, we are reducing our outlook for the full year 2023. Net sales are now expected in the range of $1.5 billion to $1.6 billion, and adjusted EBITDA is anticipated to be between $385 million and $440 million. Q2 is expected to be the weakest quarter of the year. We took advantage of the recent market slowdown to pull forward planned maintenance and reduce inventory to maximize efficiency and free cash flow in the second half of 2023. Ketjen's 2023 full year adjusted EBITDA is expected to be up 325% to 425% over the prior year. This increase in outlook is due primarily to insurance recoveries, which are not expected to recur, as well as ongoing recovery in refining prices and improved processing costs. As a reminder, most of our Energy Storage volumes are sold under long-term contracts with strategic customers. On Slide 9, we've updated our expected 2023 net sales mix to reflect recent lithium market prices. Due to the recent rebound in lithium pricing, our full year 2023 net sales mix is now expected to be 80% index referenced variable price contracts and 20% spot. There's been no other change to our contract philosophy or structure of these contracts. Our strategy to deliver long-term growth remains on track. Turning to Slide 10. We continue to expect year-over-year Energy Storage volume growth in the range of 30% to 40% in 2023. We anticipate coming in at the higher end of that range, primarily driven by the La Negra III/IV expansion, the acquisition of the Qinzhou conversion asset plus additional tolling. With additional conversion assets coming online in 2024, we still anticipate a 20% to 30% CAGR in Albemarle sales volumes between now and 2027. We remain on track to nearly triple sales volumes to more than 300,000 tonnes. Our revised Energy Storage outlook implies EBITDA margins of around 45% for 2023, up from the prior outlook based on higher market prices. As a reminder, year-over-year margins are expected to normalize from the very high level seen in late 2022 and early 2023, primarily related to spodumene inventory lags at our Talison joint venture. On average, it takes at least 6 months for spodumene to go from our mines through conversion to our customers. Last year, we saw dramatic increases in prices for lithium and spodumene. Due to the time lag on spodumene inventory, we realized higher lithium pricing faster than higher spodumene cost of goods sold. This year is the reverse. As prices decline, we are realizing lower lithium prices faster than lower spodumene costs, and we expect the majority of this impact is going to recur in the third quarter. The next item affecting margins is the accounting treatment of the MARBL joint venture. Under the amended agreements with Mineral Resources, we expect to continue to market and toll Wodgina product during 2023. As a result, we will recognize 100% of the net sales from MARBL but only our share of EBITDA. The result is about a 5% lower reported margin for 2023. Finally, our reported EBITDA margins are impacted by tax expense at Talison. Talison net income is included in our EBITDA on an after-tax basis. If you adjusted Talison results to exclude tax, margins would be about 6% [Technical Difficulty]. Turning to Slide 12, we will continue to invest with discipline, allocating our capital and cash flows to support our highest return growth opportunities. Our primary use of capital remains organic growth projects to leverage our low-cost resources in Australia and the Americas. Beyond organic growth, we also consider a broad range of M&A opportunities primarily across 3 areas: lithium resources, process technology for our core business and for new advanced materials, and battery recycling. As previously disclosed in March, Albemarle submitted an indicative proposal to acquire Liontown Resources, our preproduction spodumene resource in Australia. To date, the Liontown Board has not meaningfully engaged in progressing the transaction. Another example of our strategy is the acquisition of the Western Lithium subsidiary of Lithium Power International that we completed in July in a cash transaction of just over $20 million. This purchase provides Albemarle with prospective exploration tenements near our Greenbushes spodumene mine, regarded as one of the world's best hard rock lithium mine. And this week, we announced an investment in Patriot Battery Metals. This investment provides a 4.9% interest in a prospective spodumene deposit located in Northern Quebec. We intend to maintain our track record of a disciplined M&A process to accelerate higher return growth while preserving financial flexibility and maintaining our investment-grade credit rating. Our balance sheet flexibility is a competitive advantage that allows us to grow both organically and through acquisition as well as support our dividend. And with that, I'll turn it back over to Kent for a market update and closing remarks.
Jerry Masters: Thanks, Scott. One of the reasons we can report strong financial results is our disciplined operating model. We call it the Albemarle Way of Excellence. Our 4 operating pillars are high-performance culture, competitive capabilities, operational discipline and a sustainable approach. And these aren't just words, they are principles that guide our decision-making. Today, I'll highlight operational discipline, which includes business, manufacturing and capital project excellence. Through initiatives and operational discipline, we've targeted $250 million in productivity benefits over this year and the next, and we are on track to exceed that goal. Our goal in manufacturing excellence is to drive best-in-class discipline and operating efficiency, with a target of $150 million of savings over the next 2 years. Across our businesses, we realized value in our manufacturing operations through yield improvements and better utilization of raw materials and energy. Through Project AI, which we call Albemarle Intelligence, we're leveraging machine learning to optimize our manufacturing processes. Our global procurement team is strategically sourcing to pull purchasing and capture raw materials and logistics efficiency enhancements in real time. With continuous improvement, we are targeting $100 million of productivity benefits this year. Another execution principle under operational discipline is capital projects excellence. Our focus on capital project execution is paying off with 4 global projects progressing on time and on budget, including the Salar Yield Improvement Project, Meishan, Richburg, and Kings Mountain. As we continue to develop projects around the world, our objective is to build the structure, capabilities, discipline and design approach that enable faster capacity growth at lower capital intensity. Turning to Slide 14 for an update on more of our capital projects. In Chile, I'm pleased to report that our Salar Yield Improvement Project recently achieved mechanical completion on time and has transitioned into commissioning. In Australia, Kemerton I continues to produce battery-grade products subject to customer qualification. While there have been challenges, particularly in light of the very tight labor market in Western Australia, we are proud of our Australian team as they commission that plant and deliver products to our customers. We are applying what we've learned to the construction of Kemerton II and Kemerton III and IV projects have recently gated into execution. In China, Qinzhou is ramping up on budget and on schedule to nameplate capacity. And the construction of Meishan is progressing on budget and ahead of schedule, with mechanical completion now expected in early 2024. As mentioned earlier in the call, we have agreed to amend the terms of the transaction signed earlier this year with Mineral Resources. Under the amended agreements, we will acquire 100% ownership of Kemerton and retain 100% ownership of Meishan and Qinzhou lithium conversion assets. Other key aspects of the February 2023 agreement remain in effect, including a 50-50 ownership of the Wodgina mine and an April 2022 economic effective date. The transfer of 10% interest in Wodgina is exchanged for 25% interest in Kemerton. Upon closing, we expect to pay Mineral Resources $380 million to $400 million. About half is related to the purchase of the remaining 15% ownership stake in Kemerton and about half relates to economic effective date settlements and other transaction costs. This transaction is anticipated to close later this year after we received Australian regulatory approvals. On Slide 15. EV sales over the last quarter indicate 2023 global electric vehicle sales are on track for 40% growth. After a slower start to the year, EV sales have picked up with global sales up 41% and China up 45% year-over-year through June. China has regained growth momentum, with June representing the largest monthly EV sales since last December. In Europe, easing supply chain issues have lifted sales by about 20% year-to-date. Despite mixed macroeconomic conditions, the outlook for global full year EV demand remains resilient, driven by the introduction of new models, new incentives and the expansion of charging infrastructure. Since May, we have seen a rebound in lithium market pricing driven by downstream restocking and strong EV and battery production. Customers are returning to the spot market after destocking to unsustainably low levels of inventory against the backdrop of growing demand, with lithium inventories decreasing in the supply chain over the last few months. Global lithium supply demand remains relatively balanced, driven by increased EV demand as well as challenges in bringing on new projects. As we continue to expand our lithium capacity, our scale, global footprint, and vertical integration positions Albemarle to sustainably meet growing customer demand. While we're pleased that the lithium market remains strong, we continue to focus on managing the things that are within our control for long-term value creation. We're delivering growth in both sales and earnings. We anticipate 2023 sales to be up 40% to 55% over last year with healthy margins. While the EV market is clearly the star at the moment, we are a global leader in world-class long-term assets and a diversified product portfolio with broad opportunities in the mobility, energy, connectivity and health markets. Our focus on sustainability is not only aligned to our values, it also aligns with our customers' values and creates an advantage for us in the marketplace. Our strategy is clear, our markets are growing and our discipline in both how we operate and how we allocate capital gives us an edge across economic cycles. With that, I'd like to turn the call back over to the operator to begin the Q&A portion.
Operator: [Operator Instructions]. Your first question comes from the line of Josh Spector from UBS.
Christopher Perrella: It's Chris Perrella on for Josh. Could you work through the timing and the cost impact of the spodumene sales on the third quarter and fourth quarter?
Scott Tozier: Chris. This is Scott. So we expect the impact of the spodumene cost to be most acute in the third quarter. We'll see a headwind in the fourth quarter that's very similar to what we saw in the second quarter. So again, it will be mostly in the third quarter, and then it will start to abate in the fourth quarter.
Operator: Your next question comes from the line of Patrick Cunningham from Citi.
Patrick Cunningham: Can you elaborate a little bit on the strategic rationale for the investments in early-stage hard rock assets in Australia and Canada? Should we expect these regions to be the focus of resource M&A going forward? Or is there anything on the table maybe in South America or the U.S.?
Jerry Masters: Yes. I think -- I mean, we've been talking about pivoting toward resources from an M&A strategy for a while and then also going a little early stage so we get it on these opportunities earlier when they're not as expensive. Now there's more risk in that, and so -- but we're taking smaller stakes to getting our foot in the door, so to speak. And then it allows us to get information to analyze the opportunity as it develops, and then we will have an opportunity later whether we participate in a bigger way or not. And I don't -- it's not -- the opportunities are where the resource is, and we look at those. And if we try and -- we'll look at the jurisdictions where it's the most favorable for us to do business, so -- and really, that's wherever the resource is. But North America, Canada, Western Australia mining jurisdictions that we're very familiar with, we're used to it. Geopolitical, very stable. They're used to mining operations, so Canada a little bit more than North America, in the U.S. and North America. But those are favorable, but we'll look everywhere for where the resources are, including South America. Everywhere there's resources, we look, but we balance those geopolitical stability, are they used to mining, permitting, all of those issues when we make decisions.
Operator: Your next question comes from the line of Christopher Parkinson from company Mizuho.
Harris Fein: This is Harris Fein on for Chris. So now that you've basically bought MinRes out of your downstream assets, you have the Mega-Flex facility to be thinking about down the line. So how do you feel about your current resource footprint? And maybe it would be helpful if you could do a quick walk-through of how you're thinking about additions to the portfolio?
Jerry Masters: Yes. So look, we've -- few years -- a couple ago, we were talking about acquisition of conversion facilities. We did that at Qinzhou and we've been building those out organically. And we've been talking about pivoting toward resources as we feel like we -- starting to utilize our resource with the conversion facilities that we have. We need to identify additional resources toward the end of the decade, so we're pretty much good to about the end of the decade or so and we need additional resources beyond that. But the lead time given to identify, qualify and then bring a resource on, we need that kind of time. So we feel pretty balanced now. I mean look, the difference between now that we bought MinRes out, we've got full control of those assets. Operationally, it's simpler, it's better, but it wasn't a huge move between. We were probably a little short on conversion. Now we're a little long, but that gives us opportunities to -- if we find a resource, we can bring on quickly, we can process spodumene for our customers. We have some customers that have secured spodumene. We can process that and participate with them in that way. So I don't think it was a major shift and it's not a shift in our long-term strategy. We're still -- we're looking for those resources. We're good pretty much on resource and conversion with the current build program we have close to the end of the decade. But after that, we need more resources.
Operator: Your next question comes from the line of Colin Rusch from Oppenheimer.
Colin Rusch: I have a two part question. One, can you speak to how you're handling volumes that are going to fairly large OEMs in the U.S. and Europe that are a little bit slow in EV ramps? Where those volumes are ending up? And then the second question is around the viability of the pressure leaching process. How do you guys see that as a potential way to simplify supply chain logistics as you move into areas that have a little bit more intense environmental considerations from a compliance perspective?
Jerry Masters: Yes. Okay. Colin, can you just clarify the second comment? I'm not -- I didn't really pick up the technology you referenced.
Colin Rusch: The potential for pressure leaching processes rather than basically eliminating the asset from the process. Yes.
Jerry Masters: Do you want to take the OEM question?
Eric Norris: Sure. Colin, this is Eric. With regard to OEM volumes, I would -- just the first comment I would make is that the vast majority of OEM contracted volumes today are future based. They're for mid-decade onwards. More of the supply chain for their lithium needs is secured today through battery producers. We've seen, through the middle of the year, very strong demand, over 40% demand growth in registered EV sales through June. Early data from China on July looks promising as well, so we're not seeing any pressure. We've certainly seen headlines that certain EV models in the U.S. potentially may be slower, but I would caution you that that's a small part of the market. The rest of the market and the demand we're seeing is quite strong. As for the second question, I don't know if you want to address that, Kent.
Jerry Masters: Yes. I think, look, we have a lot of effort on R&D development, particularly around process chemistry and extraction around that. But I think the autoclave process is one of the ones we're investigating and I think the industry is looking at, but it's down the road. So we're focused on not only kind of near term, what we're operating today, because we think there are significant productivity gains that we get out of our existing facilities as we've developed more sophisticated processes around that in the years to come. So the new plants we're bringing up today, we see a big productivity opportunities going forward for the next, well, 10 years probably, and probably beyond that as we get better and better at the process chemistry. It's still early technology. It's been operated for quite some time, but at scale, it's still early technology. And then new technologies around that with different leaching agents and different techniques like pressure with an autoclave is something that we're looking at, but it's not something that's going to be in scale production in the next year or two.
Operator: Your next is from the line of David Deckelbaum from TD Cowen.
David Deckelbaum: I wanted to just ask, post the Mineral Resources restructuring and the MARBL JV you're obviously allocating more capital to conversion assets that you're building out in theory together in the future. That puts the burden more on CapEx this year, and presumably at some point next year. Does that in any way change how you're thinking about the trajectory of your growth investments as you manage the balance sheet over the next couple of years?
Jerry Masters: Yes. I don't -- I mean it doesn't -- I mean, look, it is -- we're spending a little more capital than we had originally anticipated. But it's not -- it doesn't change it dramatically, but we do have to watch balance sheet carefully and be disciplined as we invest. But we need to make sure that we're balanced as we go forward, but we don't give up opportunities. So you see us looking for those resources and investing in those and the opportunities that are public and the ones we've just closed. So it's a combination of getting resources that are near term to the market and then investing for the long term as well. And we're -- we're trying to be very disciplined about this. We watch our balance sheet. We're very serious about that. But we don't want to miss opportunities as they come up.
Scott Tozier: And David, I'd just add. I mean, this is a huge competitive advantage for Albemarle. Like if you look across the competitive set, the -- there just is not a big balance sheet out there at many of our competitors. That gives us -- that just gives us the flexibility to handle the ups and downs in the market, but then the opportunities that Kent talked about.
David Deckelbaum: It is, Scott. Maybe just a little bit more granular on tolling volumes. Can you give a sense of magnitude of tolling volumes expected in the back half of the year versus the beginning of the year? And was there a point, I suppose, in the first quarter where you might have been withholding tolled volumes just based on market conditions at the time?
Eric Norris: Yes. This is Eric speaking. So our tolling volumes overall for this year will be about twice what we did last year, and it is largely for 2 reasons. One, because it takes a while to qualify and find the right tollers and partners as we grow that volume, and that's -- so there's a lag in that. That pushes it into the second half of the year. As well as spodumene availability is also back-end loaded in the second year. And then finally, you referenced a market phenomenon. We were in a weak market in January, February where -- you're quite right, we were not aggressively going after incremental volumes because of the state of the market. As we sit here today, the market is quite strong. We've seen this growth I referenced in the earlier comment, around over 40% growth in EV sales. We see strong demand for product in all regions. And as it comes -- as it pertains to tolling in China, it will be back-end loaded both because the demand is there but also because we have the available supply and relationships in place.
Jerry Masters: Yes. And there's a balance here between -- I mean we're building large conversion assets and ramping those up. We're expanding mines and resources, bringing those on, some with different techniques around that. So tolling is a way that we can balance some of that, and we've been able to leverage that effectively.
Eric Norris: Yes. I might also add that to your earlier question that another individual asked around the -- some of the additional conversion capacity coming on the MinRes deal, that's now volume that we can self-produce as opposed to toll as well. And so while -- if you look at the next 18 months, we are probably still long resource versus conversion. Adding more conversion in near term means we can do less tolling and bring in self-produced. And that's really how we look at our tolling business. There's always some amount we do. It will vary as we bring on assets, and it allows us to continue to have a large and growing footprint in the market. It's a part of why we are going to be at the higher end of our 30% to 40% growth range in volume year-over-year. But then our strategy is to self-produce, and we certainly have the ability, probably more so than any other producers we talked about, to build that capacity both inside and outside of China to meet that demand growth.
Operator: Your next question comes from the line of Matthew DeYoe from Bank of America.
Matthew DeYoe: It seems like your inventory keeps building quarter-over-quarter here, and I assume maybe some of that's going to get fed into Kemerton. But it seems to imply like a pretty significant amount of tonnage is sitting on the books. What else is going on here? Or how should we think about the way that turns to cash if it does?
Scott Tozier: Yes, so it's a good question. So we continue to see our inventory balances grow. It's really being driven by 2 things: Volume, as we've been ramping capacity; Tolling, as we talked about, as Eric talked about. But the second thing to keep in mind is that spodumene prices are going up in that cycle, so that's an impact on our inventory balance. If you actually look at it on a days basis, so days of inventory, it's very consistent. So it's really just driven by the volumetric growth and those pricing impacts ultimately. So it's really not over -- we're not over-indexed on inventory. We're not under, kind of right in line with where we would expect to be.
Matthew DeYoe: Okay. And your partner at MARBL made some comments on the earnings call around questions for trade relationships between China and Australia, and where it makes sense to have conversion assets or not. I mean, do you think that they're wrong? And I guess does it make sense to look to secure hard rock in a country that maybe has better trade relationships with Australia over time as you think about the sustainability of feedstock to your China conversion network?
Jerry Masters: Yes, I'm not sure what -- exactly what Mineral Resources has said on their call, but we have different views of the geopolitical risk between Australia and China. They're an Australian company, we're a U.S. company, and we -- the lithium business is a significant business in China, and we've got significant footprint there and our customers all operate there for the most part. And then we've been very -- we've been public about our pivot to the West, so we plan to serve the Chinese market but also pivot and invest West so we can localize the supply chain in the West for both. And we'll continue to look for resource where we can find it. Australia is a -- I mean it's a stable economy. There's -- geopolitical risk is minimal, and it's a mining district. They understand mining. They understand tailings. It's just -- it's a good location to operate in from a mining standpoint, so we won't be shying away from that, from that standpoint. We'd love to diversify our resource base geographically more, but lithium is tight and where you find the good resource is where you end up going and then you end up having to manage the geopolitical aspects of that.
Eric Norris: And Kent, just to reiterate, just clarify that our resource base is in Australia, Western Australia. North America now with Kings Mountain, certainly Silver Peak. We have this investment now in Patriot and then South America, largely Chile, obviously. So our resources -- and those would be the areas that we continue to focus on as being the favorable jurisdiction with sort of low-cost first quartile cost position resources. So that's -- and what we do in China is conversion, and it's a great -- it's a large market for -- and demand in China is certainly a growing one as we move to the West.
Jerry Masters: Yes. And that's -- I think that is the most diverse resource network within the industry, and we would like to continue to build that.
Operator: Your next question comes from the line of Arun Viswanathan from RBC Capital Markets.
Arun Viswanathan: Great. Just had a question, I guess, on the guidance construct and the pricing. Obviously, when you move to more index-based contracts last year, definitely was a positive on the cash flow and balance sheet statement point of view. And Scott, you just kind of reiterated some of those benefits and competitive advantages. But obviously, we've also experienced quite a bit of volatility on the lithium price front. So I know it's not necessarily easy to forecast prices there, but that is a little bit more part of the Albemarle operating model now at this point, the lithium spot price environment. So I mean, is that an accurate statement? And how do you feel about providing guidance now with this volatility that we've experienced? So I guess, my concern would be prices again go back down to that $25,000 to $30,000 per ton level. Would you be required to kind of lower your guidance at that point? How do you just think about philosophically about the guidance construct at this point?
Jerry Masters: Right. So I mean, there's a couple of things in there. One, so we have pivoted to be more index based. I mean we still have typically long-term contract that they're referenced to a market index, so we're going to move with the market. And so with that move, we decided to do our guidance by not forecasting lithium prices, but by basically take the -- whatever the market is today and we forecast it for the balance of the year. And that's the methodology that we're going to use for the foreseeable future, the near term. Ultimately, our goal is that we get to where we can forecast lithium price, and we feel confident in that. We don't feel confident in that today, so it feels prudent to -- we tried to give you the tools to adjust based on your view of that market, and that's kind of how we do guide at the moment. Ultimately, we would like to be able to forecast and feel good about that, but that's not in the near term.
Scott Tozier: The other thing just to remember is given our low-cost resources, our low-cost operations, it allows us to earn throughout the cycle. So we're going to have reasonable margins throughout the cycle, no matter where that price goes. And so I think that gives us more confidence in being able to take this guidance approach as well.
Arun Viswanathan: Great. And just you made the investment in Patriot. There was obviously some other moves that you've approached on the M&A side. What else should we expect there? Continued partnerships? How do you feel about the integration level backwards into resource at this point? And are there any larger investments that you're still thinking about or contemplating?
Jerry Masters: I think if the question about integrating into the resource, I mean, that's fundamental to our strategy to be integrated from resource and conversion all the way to the customers. And we proved that we can guarantee the quality and the production because of the quality of the resource and then we actually do -- we do the conversion. So as requirements become more sophisticated and the lithium products become more sophisticated, we expect to be on the leading edge of that. So that's fundamental to our strategy. And I mean, from a resource standpoint, I mean as we said, we think we are pretty good until the end of the decade. But given the time it takes to develop resources, we need to be identifying and bringing and owning additional resources. We're working on that now. And you see us -- I mean, that's some of the activity that you see from us out there, and that -- we'll continue to do that.
Operator: Your next question is from the line of Kevin McCarthy from Vertical Research Partners.
Kevin McCarthy: A two part question on MARBL, if I may. Scott, would you comment on how margins might change as you execute on the second version of the restructuring of that joint venture? In other words, does the 5% drag that you referenced on Slide 11 go away completely or partially? And then in that same press release 2 weeks ago, you also indicated an acceleration of the Meishan project, and wondering why that's the case? Is it, for lack of a better term, related to an experience curve where you now have greater capability to bring on conversion capacity more quickly than was the case in the past?
Jerry Masters: You do the margin. I'll cover capital.
Scott Tozier: Yes, I'll take the MARBL question and the impact on margins. So as part of the restructuring of that joint venture, we've agreed for a period of time to continue to toll volumes out of the Wodgina mine on behalf of MinRes. And so for a period of time, I believe it goes through the middle of next year, we'll continue to have that margin headwind. Once that period is over, we'll end up improving our margin rate ultimately. We'll change the dollars because the EBITDA dollars will be the same, but the margin rate will certainly improve by that 5 percentage points.
Jerry Masters: And then on the Meishan being early, look, it's good old-fashioned project execution. We're getting better at it. It is also that there's a -- the capability in China is significant to execute these large projects. We don't have the labor issues there that we had in Australia, so there's a number of things. Part of it is our capability is getting significantly better. We're learning every time we do a project. Part of it is about just the capability in China. And then the biggest piece, 1 of the bigger pieces is that we have labor availability there that we didn't have in Australia.
Kevin McCarthy: I see. And as a brief follow-up, if I may. How is that experience at Meishan similar or different to what you would envision for Kemerton III/IV in terms of capital cost and speed of execution?
Jerry Masters: Well, I think -- I mean, well, not just III/IV, but let's say all the projects that we're working on, I think we're getting -- we're building a significant capability. It's materially different now than it was 3 or 4 years ago, and we think we can execute projects around the world on budget and on schedule. That said, those schedules and those budgets will be different depending on where you're executing. So Europe will be different than Western Australia, North America is different and China is different. So I wouldn't use Meishan capital numbers and apply those around the world. That's not how it works. We've executed a very good project. We're still executing. It's not complete yet, but we're getting there at Meishan. We think it's going to be a great project, and we're -- we feel like the capability we built is world class in this industry, in particular. But you can't take Meishan schedules and capital numbers and apply them in Western Australia or North America or Europe.
Operator: Your next question comes from the line of Mike Sison from Wells Fargo.
Michael Sison: Just curious on Energy Storage. When I think about 2024, which I understand is so far away, but if you think about volume growth next year, you should still be at 20%, 25%. If I keep -- how do I sort of calibrate where EBITDA could be from these levels? Meaning, does EBITDA just go up with volume growth next year? And then how do you sort of change or give us sort of a variable for pricing as we think about '24 for Energy Storage?
Scott Tozier: Yes, Mike, that's a little far out. It's certainly, given the way that we're giving guidance, it's going to be a volume story next year. Of course, pricing is going to be a question mark that we would have, and it's all based on the contract structures. We're not anticipating to have any big changes in the contract structures. So as that pricing moves, we'd expect to see that trailing kind of 3-month lag to what those indices are. I think scale becomes an important part of the story as well, so that will help on our fixed costs. So you'll see a little bit of improvement there. The operating margins will improve based on productivity. Kent talked about what we're seeing with our -- the Albemarle Way of Excellence and how that's translating into results, so we expect that to play a role in all of our businesses, ultimately. Eric, you have something...
Eric Norris: I'm just going to say, as it pertains to price, we -- as Kent said, we don't have the confidence to know exactly ourselves what price is going to do, but we do know this. We believe that the market will continue to be quite tight next year as well. There'll be significant demand growth in the market, and indeed, there will be more supply growth as well. But those two will be fairly matched, right? It will be a fairly tight market. So that much we foresee, how that plays out from a price standpoint, to be determined.
Michael Sison: Got it. And just a quick follow-up. As you add capacity through '27 or you scale up these projects. Your fixed cost, I think you sort of mentioned, did they go down as we get to the end of the decade?
Scott Tozier: Well, fixed cost on a unit basis will go down. Obviously, fixed costs will go up as you're adding plants on an absolute basis. But on a unit basis, meaning per ton, yes, they'll go down.
Operator: Your next question is from the line of Ben Isaacson from Scotiabank.
Benjamin Isaacson: Just in terms of the seasonality of EV sales, since we typically see a bit of weakness in Q1, some have suggested that that could lead to kind of seasonal pullbacks in the lithium price. I just wanted to get your thoughts on that? And then just as a follow-up, can you give some specifics on the Salar Yield Improvement? What is the volume lift? And what is the shape or the timing of that?
Eric Norris: So Ben, this is Eric. On seasonality, indeed, whether it's ICE vehicles or electric vehicles, there is a crescendo in the year, I guess the demand is stronger in the second half seasonally than in the first. However, I would be careful to say that we had weakness in the first part of the year. We had a weak January, particularly in China, the market did, but that's really China and the timing of the New Year. What happened with price and why we talked about price coming down and the inventory correction was inventory correction was not demand growth. Demand growth has remained strong and has strengthened as the year has gone on. U.S. up over 50%, China, up 45% through the middle part of the year. The only market that hasn't been as strong up in the 20s percent range is Europe, and I think that has a lot to do with some of the macro and other headwinds that we all know about in Europe. But as we look across the year, we still see a 40% growth in the marketplace. So there are certainly lots of macro headwinds we can talk about, but despite these, we still see that secular shift supported by incentives in China. Grid storage has also been a big growth in China recently as well and continued growth outside of China for EVs. So, yes. I guess I'd say on the demand front, be careful to assume that we had a weak first quarter. It was not bad when it ended. Pretty strong actually. The next question, I think to you was -- Ben, what was your second question? Please repeat it.
Benjamin Isaacson: Salar Yield.
Jerry Masters: Salar Yield. Yes. So we've reached mechanical completion and we now -- we're in the process of commissioning that, so that is an efficiency. So we are able to recover more lithium for every gallon of brine that we pump. But one that we have to -- it has to work its way through the Salar system, so there's an 18-month lead time before that -- those products start hitting the sales register, so to speak. So we still use the -- we still use the pond system to concentrate that, and I don't -- I'm not sure the uplift, what would you estimate that at when we get there?
Eric Norris: The uplift, well, look, I mean it's -- Salar Yield is going to allow us to get to nameplate capacity over the next couple of years at La Negra, which is 85,000 tonnes. And the -- once we start loading brine from the Salar Yield project in ponds, it's actually -- we're able to slightly more -- there is a shortcut, it's closer to 6 months. So within 6 months, so starting next year, we'll start to see the benefit of that uplift.
Operator: And our last question will be coming from the line of David Begleiter from Deutsche Bank.
David Begleiter: First, on the Energy Storage for your guidance increase. Can you just bridge us from the roughly $3 billion of prior guidance midpoint to now the $3.7 billion of current guidance?
Scott Tozier: Yes, David. It's really all price. I mean we got a little bit of extra volume, but it's all just driven by the price indices where they're sitting right now. Obviously, they've recovered off the lows that happened in April and have improved, and we've -- as we've mentioned on the -- in the prepared remarks, we've held them flat in our guidance as of the end of June.
David Begleiter: Interest in Arkansas lithium production potentially. What are your current thoughts as to accessing your assets down in that region?
Jerry Masters: Yes. So we -- I mean we have plans to exploit that. So we have access to the lithium in the Smackover and Magnolia. So basically, everything we pump for bromine today, we would kind of -- an easy answer is that we process that for lithium. It requires different technology, DLE based, absorption based which we have been working on. We have proprietary technology around that. We're doing -- we're building pilot plants at the moment, and we'll be able -- and we plan to execute projects around that, but we want to run pilot plant. It is a new technology, and we're going to make sure that we do it right, but we have access to the brines. We've got the infrastructure at Magnolia. We're well positioned to take advantage of that.
Operator: That's all the time we have for questions. I will now pass it back to Kent Masters for closing remarks.
Jerry Masters: Okay. Thank you, Aisha, and thank you all for joining us today. We are confident in market opportunity and our disciplined strategy to achieve both short-term and long-term results. We are a global leader in minerals that are critical to a mobile, connected, healthy and sustainable future. We continue to work to be the partner of choice for our customers and investment of choice for both the present and the future. Thank you for joining us.
Operator: This concludes today's conference call. Thank you for your participation. You may now disconnect. | [
{
"speaker": "Operator",
"text": "Hello, and welcome to Albemarle Corporation's Q2 2023 Earnings Call. [Operator Instructions]. I will now hand it over to Meredith Bandy, Vice President of Investor Relations and Sustainability."
},
{
"speaker": "Meredith Bandy",
"text": "Thank you, Aisha, and welcome, everyone, to Albemarle's Second Quarter 2023 Earnings Conference Call. Our earnings released after the close of market yesterday, and you'll find the press release and earnings presentation posted to our website under the Investors section at albemarle.com. Joining me on the call today are Kent Masters, Chief Executive Officer; and Scott Tozier, Chief Financial Officer; Netha Johnson, President of Specialties; and Eric Norris, President of Energy Storage are also available for Q&A. As a reminder, some of the statements made during this call, including our outlook, guidance, expected company performance and timing of expansion projects, may constitute forward-looking statements. Please note the cautionary language about forward-looking statements contained in our press release and earnings presentation, which also applies to this call. Please also note that some of our comments today refer to non-GAAP financial measures. Reconciliations can be found in our earnings materials. Now I'll turn the call over to Kent."
},
{
"speaker": "Jerry Masters",
"text": "Thank you, Meredith. Our second quarter results continued the positive trend from last quarter, with net sales up 60% and EBITDA up 69% versus the same period last year. We have increased our energy storage outlook for 2023 based on current market prices. Of course, the long-term shift to electric vehicles is well established and growing. Automakers are planning ahead to accommodate that future growth. For example, we signed a strategic agreement with Ford to supply over 100,000 metric tons of lithium hydroxide over a 5-year period, starting in 2026. One of the reasons our customers choose Albemarle is our commitment to sustainability. In June, our Salar de Atacama site became the first lithium resource in the world to complete an independent audit and have its audit report published by IRMA, the Initiative for Responsible Mining Assurance. We achieved an IRMA 50 level of performance and a third-party auditor verified that the Salar site met 70% of over 400 rigorous IRMA requirements, covering topics such as water management, human rights, greenhouse gas emissions, fair labor and terms of work. Also during the quarter, Albemarle's growth and impact on the energy transition were recognized by inclusion in the Fortune 500 rankings and in the TIME100 Most Influential Companies list. We continue to invest in future capacity to meet long-term demand. The Salar yield improvement project reached mechanical completion on schedule, and the Meishan project in China is ahead of schedule, with mechanical completion expected in early 2024. Last month, we announced agreements to simplify and amend our joint venture with Mineral Resources. I'll update you on these activities later in the presentation. And for now, I'll hand it over to Scott to walk you through our financial results."
},
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"speaker": "Scott Tozier",
"text": "Thanks, Kent, and hello, everyone. On Slide 5, let's review our second quarter performance. Net sales were $2.4 billion, up 60% compared to last year. This nearly $1 billion increase was driven by energy storage as a result of both higher market pricing and higher volumes, which were up almost 40%. Net income attributable to Albemarle was approximately $650 million, up 60% compared to the prior year. Diluted EPS was $$5.52, also up almost 60%, and adjusted diluted EPS of $7.33 was more than double last year. At the end of July, we reached agreements in principle with the Department of Justice on a matter that we initially disclosed in 2018 related to conduct in our catch-in business occurring prior to 2018. Our Q2 GAAP results include an approximately $219 million accrual to resolve this matter. Looking at Slide #6. Second quarter adjusted EBITDA was over $1 billion, an increase of nearly 70% year-over-year, driven primarily by higher pricing as well as higher volumes in Energy Storage. Our Specialties business was down year-over-year due to lower volumes and pricing related to weakness in certain end markets such as electronics and [Technical Difficulty], insurance claim receipts and lower energy costs. Let's look at the updated total company outlook on Slide 7. We are raising our 2023 guidance for net sales and adjusted EBITDA to reflect current lithium market prices. As has been our practice, this guidance assumes recent lithium market price indices are constant for the remainder of the year. And as a result, we have increased the lower end of the range for net sales. We now expect 2023 total company net sales to be in the range of $10.4 billion to $11.5 billion. We expect third quarter net sales to be relatively flat sequentially followed by an increase in fourth quarter net sales as we ramp energy storage volumes. We are increasing our adjusted EBITDA guidance to be in the range of $3.8 billion to $4.4 billion. This implies full year EBITDA margins in the range of 37% to 38%, also up from previous guidance. Our full year 2023 adjusted diluted EPS guidance is also increasing to a range of $25 to $29.50, reflecting a year-over-year improvement of about 25% at the midpoint. We expect our net cash from operations to be in the range of $1.2 billion to $1.8 billion. This is a decrease in outlook driven primarily by 2 factors. First, higher working capital related to the timing of our energy storage shipments. We now expect lithium sales volumes to be weighted towards the back half of the year, particularly in Q4, due to the timing of our growth projects and tolling volumes. This is expected to result in higher accounts receivable at year-end, which will convert to cash in early 2024. Second, this outlook assumes that the DOJ payment of approximately $219 million is made by year-end. Our CapEx guidance has increased to $1.9 billion to $2.1 billion. This increase reflects the revised agreements with Mineral Resources. Following these revisions, Albemarle will maintain 100% ownership of the Kemerton, Qinzhou and Meishan lithium processing plants. Apart from this change, capital spending is in line with previous forecasts. Turning to the next slide for more detail on our outlook by segment. We're increasing our full year 2023 energy storage net sales guidance to be in the range of $7.9 billion to $8.8 billion. Energy Storage volume growth is expected to be at the higher end of the previous range of 30% to 40% year-over-year thanks to increased tolling and successful project execution. We also project average realized pricing increases to be at the higher end of the previous range of 20% to 30% year-over-year, assuming recent lithium market prices continue through the rest of 2023. Adjusted EBITDA for Energy Storage is expected to increase in the range of $3.5 billion to $3.9 billion. This 15% to 30% increase is due to higher net sales, which we expect to more than offset the timing impacts of higher-priced spodumene inventories. In Specialties, we continue to see pressure in our end markets. Weakness in consumer and industrial electronics and elastomers is only partially offset by strong demand in other markets like pharmaceuticals, agriculture and oilfield services. Similar to other specialty chemicals companies, we are reducing our outlook for the full year 2023. Net sales are now expected in the range of $1.5 billion to $1.6 billion, and adjusted EBITDA is anticipated to be between $385 million and $440 million. Q2 is expected to be the weakest quarter of the year. We took advantage of the recent market slowdown to pull forward planned maintenance and reduce inventory to maximize efficiency and free cash flow in the second half of 2023. Ketjen's 2023 full year adjusted EBITDA is expected to be up 325% to 425% over the prior year. This increase in outlook is due primarily to insurance recoveries, which are not expected to recur, as well as ongoing recovery in refining prices and improved processing costs. As a reminder, most of our Energy Storage volumes are sold under long-term contracts with strategic customers. On Slide 9, we've updated our expected 2023 net sales mix to reflect recent lithium market prices. Due to the recent rebound in lithium pricing, our full year 2023 net sales mix is now expected to be 80% index referenced variable price contracts and 20% spot. There's been no other change to our contract philosophy or structure of these contracts. Our strategy to deliver long-term growth remains on track. Turning to Slide 10. We continue to expect year-over-year Energy Storage volume growth in the range of 30% to 40% in 2023. We anticipate coming in at the higher end of that range, primarily driven by the La Negra III/IV expansion, the acquisition of the Qinzhou conversion asset plus additional tolling. With additional conversion assets coming online in 2024, we still anticipate a 20% to 30% CAGR in Albemarle sales volumes between now and 2027. We remain on track to nearly triple sales volumes to more than 300,000 tonnes. Our revised Energy Storage outlook implies EBITDA margins of around 45% for 2023, up from the prior outlook based on higher market prices. As a reminder, year-over-year margins are expected to normalize from the very high level seen in late 2022 and early 2023, primarily related to spodumene inventory lags at our Talison joint venture. On average, it takes at least 6 months for spodumene to go from our mines through conversion to our customers. Last year, we saw dramatic increases in prices for lithium and spodumene. Due to the time lag on spodumene inventory, we realized higher lithium pricing faster than higher spodumene cost of goods sold. This year is the reverse. As prices decline, we are realizing lower lithium prices faster than lower spodumene costs, and we expect the majority of this impact is going to recur in the third quarter. The next item affecting margins is the accounting treatment of the MARBL joint venture. Under the amended agreements with Mineral Resources, we expect to continue to market and toll Wodgina product during 2023. As a result, we will recognize 100% of the net sales from MARBL but only our share of EBITDA. The result is about a 5% lower reported margin for 2023. Finally, our reported EBITDA margins are impacted by tax expense at Talison. Talison net income is included in our EBITDA on an after-tax basis. If you adjusted Talison results to exclude tax, margins would be about 6% [Technical Difficulty]. Turning to Slide 12, we will continue to invest with discipline, allocating our capital and cash flows to support our highest return growth opportunities. Our primary use of capital remains organic growth projects to leverage our low-cost resources in Australia and the Americas. Beyond organic growth, we also consider a broad range of M&A opportunities primarily across 3 areas: lithium resources, process technology for our core business and for new advanced materials, and battery recycling. As previously disclosed in March, Albemarle submitted an indicative proposal to acquire Liontown Resources, our preproduction spodumene resource in Australia. To date, the Liontown Board has not meaningfully engaged in progressing the transaction. Another example of our strategy is the acquisition of the Western Lithium subsidiary of Lithium Power International that we completed in July in a cash transaction of just over $20 million. This purchase provides Albemarle with prospective exploration tenements near our Greenbushes spodumene mine, regarded as one of the world's best hard rock lithium mine. And this week, we announced an investment in Patriot Battery Metals. This investment provides a 4.9% interest in a prospective spodumene deposit located in Northern Quebec. We intend to maintain our track record of a disciplined M&A process to accelerate higher return growth while preserving financial flexibility and maintaining our investment-grade credit rating. Our balance sheet flexibility is a competitive advantage that allows us to grow both organically and through acquisition as well as support our dividend. And with that, I'll turn it back over to Kent for a market update and closing remarks."
},
{
"speaker": "Jerry Masters",
"text": "Thanks, Scott. One of the reasons we can report strong financial results is our disciplined operating model. We call it the Albemarle Way of Excellence. Our 4 operating pillars are high-performance culture, competitive capabilities, operational discipline and a sustainable approach. And these aren't just words, they are principles that guide our decision-making. Today, I'll highlight operational discipline, which includes business, manufacturing and capital project excellence. Through initiatives and operational discipline, we've targeted $250 million in productivity benefits over this year and the next, and we are on track to exceed that goal. Our goal in manufacturing excellence is to drive best-in-class discipline and operating efficiency, with a target of $150 million of savings over the next 2 years. Across our businesses, we realized value in our manufacturing operations through yield improvements and better utilization of raw materials and energy. Through Project AI, which we call Albemarle Intelligence, we're leveraging machine learning to optimize our manufacturing processes. Our global procurement team is strategically sourcing to pull purchasing and capture raw materials and logistics efficiency enhancements in real time. With continuous improvement, we are targeting $100 million of productivity benefits this year. Another execution principle under operational discipline is capital projects excellence. Our focus on capital project execution is paying off with 4 global projects progressing on time and on budget, including the Salar Yield Improvement Project, Meishan, Richburg, and Kings Mountain. As we continue to develop projects around the world, our objective is to build the structure, capabilities, discipline and design approach that enable faster capacity growth at lower capital intensity. Turning to Slide 14 for an update on more of our capital projects. In Chile, I'm pleased to report that our Salar Yield Improvement Project recently achieved mechanical completion on time and has transitioned into commissioning. In Australia, Kemerton I continues to produce battery-grade products subject to customer qualification. While there have been challenges, particularly in light of the very tight labor market in Western Australia, we are proud of our Australian team as they commission that plant and deliver products to our customers. We are applying what we've learned to the construction of Kemerton II and Kemerton III and IV projects have recently gated into execution. In China, Qinzhou is ramping up on budget and on schedule to nameplate capacity. And the construction of Meishan is progressing on budget and ahead of schedule, with mechanical completion now expected in early 2024. As mentioned earlier in the call, we have agreed to amend the terms of the transaction signed earlier this year with Mineral Resources. Under the amended agreements, we will acquire 100% ownership of Kemerton and retain 100% ownership of Meishan and Qinzhou lithium conversion assets. Other key aspects of the February 2023 agreement remain in effect, including a 50-50 ownership of the Wodgina mine and an April 2022 economic effective date. The transfer of 10% interest in Wodgina is exchanged for 25% interest in Kemerton. Upon closing, we expect to pay Mineral Resources $380 million to $400 million. About half is related to the purchase of the remaining 15% ownership stake in Kemerton and about half relates to economic effective date settlements and other transaction costs. This transaction is anticipated to close later this year after we received Australian regulatory approvals. On Slide 15. EV sales over the last quarter indicate 2023 global electric vehicle sales are on track for 40% growth. After a slower start to the year, EV sales have picked up with global sales up 41% and China up 45% year-over-year through June. China has regained growth momentum, with June representing the largest monthly EV sales since last December. In Europe, easing supply chain issues have lifted sales by about 20% year-to-date. Despite mixed macroeconomic conditions, the outlook for global full year EV demand remains resilient, driven by the introduction of new models, new incentives and the expansion of charging infrastructure. Since May, we have seen a rebound in lithium market pricing driven by downstream restocking and strong EV and battery production. Customers are returning to the spot market after destocking to unsustainably low levels of inventory against the backdrop of growing demand, with lithium inventories decreasing in the supply chain over the last few months. Global lithium supply demand remains relatively balanced, driven by increased EV demand as well as challenges in bringing on new projects. As we continue to expand our lithium capacity, our scale, global footprint, and vertical integration positions Albemarle to sustainably meet growing customer demand. While we're pleased that the lithium market remains strong, we continue to focus on managing the things that are within our control for long-term value creation. We're delivering growth in both sales and earnings. We anticipate 2023 sales to be up 40% to 55% over last year with healthy margins. While the EV market is clearly the star at the moment, we are a global leader in world-class long-term assets and a diversified product portfolio with broad opportunities in the mobility, energy, connectivity and health markets. Our focus on sustainability is not only aligned to our values, it also aligns with our customers' values and creates an advantage for us in the marketplace. Our strategy is clear, our markets are growing and our discipline in both how we operate and how we allocate capital gives us an edge across economic cycles. With that, I'd like to turn the call back over to the operator to begin the Q&A portion."
},
{
"speaker": "Operator",
"text": "[Operator Instructions]. Your first question comes from the line of Josh Spector from UBS."
},
{
"speaker": "Christopher Perrella",
"text": "It's Chris Perrella on for Josh. Could you work through the timing and the cost impact of the spodumene sales on the third quarter and fourth quarter?"
},
{
"speaker": "Scott Tozier",
"text": "Chris. This is Scott. So we expect the impact of the spodumene cost to be most acute in the third quarter. We'll see a headwind in the fourth quarter that's very similar to what we saw in the second quarter. So again, it will be mostly in the third quarter, and then it will start to abate in the fourth quarter."
},
{
"speaker": "Operator",
"text": "Your next question comes from the line of Patrick Cunningham from Citi."
},
{
"speaker": "Patrick Cunningham",
"text": "Can you elaborate a little bit on the strategic rationale for the investments in early-stage hard rock assets in Australia and Canada? Should we expect these regions to be the focus of resource M&A going forward? Or is there anything on the table maybe in South America or the U.S.?"
},
{
"speaker": "Jerry Masters",
"text": "Yes. I think -- I mean, we've been talking about pivoting toward resources from an M&A strategy for a while and then also going a little early stage so we get it on these opportunities earlier when they're not as expensive. Now there's more risk in that, and so -- but we're taking smaller stakes to getting our foot in the door, so to speak. And then it allows us to get information to analyze the opportunity as it develops, and then we will have an opportunity later whether we participate in a bigger way or not. And I don't -- it's not -- the opportunities are where the resource is, and we look at those. And if we try and -- we'll look at the jurisdictions where it's the most favorable for us to do business, so -- and really, that's wherever the resource is. But North America, Canada, Western Australia mining jurisdictions that we're very familiar with, we're used to it. Geopolitical, very stable. They're used to mining operations, so Canada a little bit more than North America, in the U.S. and North America. But those are favorable, but we'll look everywhere for where the resources are, including South America. Everywhere there's resources, we look, but we balance those geopolitical stability, are they used to mining, permitting, all of those issues when we make decisions."
},
{
"speaker": "Operator",
"text": "Your next question comes from the line of Christopher Parkinson from company Mizuho."
},
{
"speaker": "Harris Fein",
"text": "This is Harris Fein on for Chris. So now that you've basically bought MinRes out of your downstream assets, you have the Mega-Flex facility to be thinking about down the line. So how do you feel about your current resource footprint? And maybe it would be helpful if you could do a quick walk-through of how you're thinking about additions to the portfolio?"
},
{
"speaker": "Jerry Masters",
"text": "Yes. So look, we've -- few years -- a couple ago, we were talking about acquisition of conversion facilities. We did that at Qinzhou and we've been building those out organically. And we've been talking about pivoting toward resources as we feel like we -- starting to utilize our resource with the conversion facilities that we have. We need to identify additional resources toward the end of the decade, so we're pretty much good to about the end of the decade or so and we need additional resources beyond that. But the lead time given to identify, qualify and then bring a resource on, we need that kind of time. So we feel pretty balanced now. I mean look, the difference between now that we bought MinRes out, we've got full control of those assets. Operationally, it's simpler, it's better, but it wasn't a huge move between. We were probably a little short on conversion. Now we're a little long, but that gives us opportunities to -- if we find a resource, we can bring on quickly, we can process spodumene for our customers. We have some customers that have secured spodumene. We can process that and participate with them in that way. So I don't think it was a major shift and it's not a shift in our long-term strategy. We're still -- we're looking for those resources. We're good pretty much on resource and conversion with the current build program we have close to the end of the decade. But after that, we need more resources."
},
{
"speaker": "Operator",
"text": "Your next question comes from the line of Colin Rusch from Oppenheimer."
},
{
"speaker": "Colin Rusch",
"text": "I have a two part question. One, can you speak to how you're handling volumes that are going to fairly large OEMs in the U.S. and Europe that are a little bit slow in EV ramps? Where those volumes are ending up? And then the second question is around the viability of the pressure leaching process. How do you guys see that as a potential way to simplify supply chain logistics as you move into areas that have a little bit more intense environmental considerations from a compliance perspective?"
},
{
"speaker": "Jerry Masters",
"text": "Yes. Okay. Colin, can you just clarify the second comment? I'm not -- I didn't really pick up the technology you referenced."
},
{
"speaker": "Colin Rusch",
"text": "The potential for pressure leaching processes rather than basically eliminating the asset from the process. Yes."
},
{
"speaker": "Jerry Masters",
"text": "Do you want to take the OEM question?"
},
{
"speaker": "Eric Norris",
"text": "Sure. Colin, this is Eric. With regard to OEM volumes, I would -- just the first comment I would make is that the vast majority of OEM contracted volumes today are future based. They're for mid-decade onwards. More of the supply chain for their lithium needs is secured today through battery producers. We've seen, through the middle of the year, very strong demand, over 40% demand growth in registered EV sales through June. Early data from China on July looks promising as well, so we're not seeing any pressure. We've certainly seen headlines that certain EV models in the U.S. potentially may be slower, but I would caution you that that's a small part of the market. The rest of the market and the demand we're seeing is quite strong. As for the second question, I don't know if you want to address that, Kent."
},
{
"speaker": "Jerry Masters",
"text": "Yes. I think, look, we have a lot of effort on R&D development, particularly around process chemistry and extraction around that. But I think the autoclave process is one of the ones we're investigating and I think the industry is looking at, but it's down the road. So we're focused on not only kind of near term, what we're operating today, because we think there are significant productivity gains that we get out of our existing facilities as we've developed more sophisticated processes around that in the years to come. So the new plants we're bringing up today, we see a big productivity opportunities going forward for the next, well, 10 years probably, and probably beyond that as we get better and better at the process chemistry. It's still early technology. It's been operated for quite some time, but at scale, it's still early technology. And then new technologies around that with different leaching agents and different techniques like pressure with an autoclave is something that we're looking at, but it's not something that's going to be in scale production in the next year or two."
},
{
"speaker": "Operator",
"text": "Your next is from the line of David Deckelbaum from TD Cowen."
},
{
"speaker": "David Deckelbaum",
"text": "I wanted to just ask, post the Mineral Resources restructuring and the MARBL JV you're obviously allocating more capital to conversion assets that you're building out in theory together in the future. That puts the burden more on CapEx this year, and presumably at some point next year. Does that in any way change how you're thinking about the trajectory of your growth investments as you manage the balance sheet over the next couple of years?"
},
{
"speaker": "Jerry Masters",
"text": "Yes. I don't -- I mean it doesn't -- I mean, look, it is -- we're spending a little more capital than we had originally anticipated. But it's not -- it doesn't change it dramatically, but we do have to watch balance sheet carefully and be disciplined as we invest. But we need to make sure that we're balanced as we go forward, but we don't give up opportunities. So you see us looking for those resources and investing in those and the opportunities that are public and the ones we've just closed. So it's a combination of getting resources that are near term to the market and then investing for the long term as well. And we're -- we're trying to be very disciplined about this. We watch our balance sheet. We're very serious about that. But we don't want to miss opportunities as they come up."
},
{
"speaker": "Scott Tozier",
"text": "And David, I'd just add. I mean, this is a huge competitive advantage for Albemarle. Like if you look across the competitive set, the -- there just is not a big balance sheet out there at many of our competitors. That gives us -- that just gives us the flexibility to handle the ups and downs in the market, but then the opportunities that Kent talked about."
},
{
"speaker": "David Deckelbaum",
"text": "It is, Scott. Maybe just a little bit more granular on tolling volumes. Can you give a sense of magnitude of tolling volumes expected in the back half of the year versus the beginning of the year? And was there a point, I suppose, in the first quarter where you might have been withholding tolled volumes just based on market conditions at the time?"
},
{
"speaker": "Eric Norris",
"text": "Yes. This is Eric speaking. So our tolling volumes overall for this year will be about twice what we did last year, and it is largely for 2 reasons. One, because it takes a while to qualify and find the right tollers and partners as we grow that volume, and that's -- so there's a lag in that. That pushes it into the second half of the year. As well as spodumene availability is also back-end loaded in the second year. And then finally, you referenced a market phenomenon. We were in a weak market in January, February where -- you're quite right, we were not aggressively going after incremental volumes because of the state of the market. As we sit here today, the market is quite strong. We've seen this growth I referenced in the earlier comment, around over 40% growth in EV sales. We see strong demand for product in all regions. And as it comes -- as it pertains to tolling in China, it will be back-end loaded both because the demand is there but also because we have the available supply and relationships in place."
},
{
"speaker": "Jerry Masters",
"text": "Yes. And there's a balance here between -- I mean we're building large conversion assets and ramping those up. We're expanding mines and resources, bringing those on, some with different techniques around that. So tolling is a way that we can balance some of that, and we've been able to leverage that effectively."
},
{
"speaker": "Eric Norris",
"text": "Yes. I might also add that to your earlier question that another individual asked around the -- some of the additional conversion capacity coming on the MinRes deal, that's now volume that we can self-produce as opposed to toll as well. And so while -- if you look at the next 18 months, we are probably still long resource versus conversion. Adding more conversion in near term means we can do less tolling and bring in self-produced. And that's really how we look at our tolling business. There's always some amount we do. It will vary as we bring on assets, and it allows us to continue to have a large and growing footprint in the market. It's a part of why we are going to be at the higher end of our 30% to 40% growth range in volume year-over-year. But then our strategy is to self-produce, and we certainly have the ability, probably more so than any other producers we talked about, to build that capacity both inside and outside of China to meet that demand growth."
},
{
"speaker": "Operator",
"text": "Your next question comes from the line of Matthew DeYoe from Bank of America."
},
{
"speaker": "Matthew DeYoe",
"text": "It seems like your inventory keeps building quarter-over-quarter here, and I assume maybe some of that's going to get fed into Kemerton. But it seems to imply like a pretty significant amount of tonnage is sitting on the books. What else is going on here? Or how should we think about the way that turns to cash if it does?"
},
{
"speaker": "Scott Tozier",
"text": "Yes, so it's a good question. So we continue to see our inventory balances grow. It's really being driven by 2 things: Volume, as we've been ramping capacity; Tolling, as we talked about, as Eric talked about. But the second thing to keep in mind is that spodumene prices are going up in that cycle, so that's an impact on our inventory balance. If you actually look at it on a days basis, so days of inventory, it's very consistent. So it's really just driven by the volumetric growth and those pricing impacts ultimately. So it's really not over -- we're not over-indexed on inventory. We're not under, kind of right in line with where we would expect to be."
},
{
"speaker": "Matthew DeYoe",
"text": "Okay. And your partner at MARBL made some comments on the earnings call around questions for trade relationships between China and Australia, and where it makes sense to have conversion assets or not. I mean, do you think that they're wrong? And I guess does it make sense to look to secure hard rock in a country that maybe has better trade relationships with Australia over time as you think about the sustainability of feedstock to your China conversion network?"
},
{
"speaker": "Jerry Masters",
"text": "Yes, I'm not sure what -- exactly what Mineral Resources has said on their call, but we have different views of the geopolitical risk between Australia and China. They're an Australian company, we're a U.S. company, and we -- the lithium business is a significant business in China, and we've got significant footprint there and our customers all operate there for the most part. And then we've been very -- we've been public about our pivot to the West, so we plan to serve the Chinese market but also pivot and invest West so we can localize the supply chain in the West for both. And we'll continue to look for resource where we can find it. Australia is a -- I mean it's a stable economy. There's -- geopolitical risk is minimal, and it's a mining district. They understand mining. They understand tailings. It's just -- it's a good location to operate in from a mining standpoint, so we won't be shying away from that, from that standpoint. We'd love to diversify our resource base geographically more, but lithium is tight and where you find the good resource is where you end up going and then you end up having to manage the geopolitical aspects of that."
},
{
"speaker": "Eric Norris",
"text": "And Kent, just to reiterate, just clarify that our resource base is in Australia, Western Australia. North America now with Kings Mountain, certainly Silver Peak. We have this investment now in Patriot and then South America, largely Chile, obviously. So our resources -- and those would be the areas that we continue to focus on as being the favorable jurisdiction with sort of low-cost first quartile cost position resources. So that's -- and what we do in China is conversion, and it's a great -- it's a large market for -- and demand in China is certainly a growing one as we move to the West."
},
{
"speaker": "Jerry Masters",
"text": "Yes. And that's -- I think that is the most diverse resource network within the industry, and we would like to continue to build that."
},
{
"speaker": "Operator",
"text": "Your next question comes from the line of Arun Viswanathan from RBC Capital Markets."
},
{
"speaker": "Arun Viswanathan",
"text": "Great. Just had a question, I guess, on the guidance construct and the pricing. Obviously, when you move to more index-based contracts last year, definitely was a positive on the cash flow and balance sheet statement point of view. And Scott, you just kind of reiterated some of those benefits and competitive advantages. But obviously, we've also experienced quite a bit of volatility on the lithium price front. So I know it's not necessarily easy to forecast prices there, but that is a little bit more part of the Albemarle operating model now at this point, the lithium spot price environment. So I mean, is that an accurate statement? And how do you feel about providing guidance now with this volatility that we've experienced? So I guess, my concern would be prices again go back down to that $25,000 to $30,000 per ton level. Would you be required to kind of lower your guidance at that point? How do you just think about philosophically about the guidance construct at this point?"
},
{
"speaker": "Jerry Masters",
"text": "Right. So I mean, there's a couple of things in there. One, so we have pivoted to be more index based. I mean we still have typically long-term contract that they're referenced to a market index, so we're going to move with the market. And so with that move, we decided to do our guidance by not forecasting lithium prices, but by basically take the -- whatever the market is today and we forecast it for the balance of the year. And that's the methodology that we're going to use for the foreseeable future, the near term. Ultimately, our goal is that we get to where we can forecast lithium price, and we feel confident in that. We don't feel confident in that today, so it feels prudent to -- we tried to give you the tools to adjust based on your view of that market, and that's kind of how we do guide at the moment. Ultimately, we would like to be able to forecast and feel good about that, but that's not in the near term."
},
{
"speaker": "Scott Tozier",
"text": "The other thing just to remember is given our low-cost resources, our low-cost operations, it allows us to earn throughout the cycle. So we're going to have reasonable margins throughout the cycle, no matter where that price goes. And so I think that gives us more confidence in being able to take this guidance approach as well."
},
{
"speaker": "Arun Viswanathan",
"text": "Great. And just you made the investment in Patriot. There was obviously some other moves that you've approached on the M&A side. What else should we expect there? Continued partnerships? How do you feel about the integration level backwards into resource at this point? And are there any larger investments that you're still thinking about or contemplating?"
},
{
"speaker": "Jerry Masters",
"text": "I think if the question about integrating into the resource, I mean, that's fundamental to our strategy to be integrated from resource and conversion all the way to the customers. And we proved that we can guarantee the quality and the production because of the quality of the resource and then we actually do -- we do the conversion. So as requirements become more sophisticated and the lithium products become more sophisticated, we expect to be on the leading edge of that. So that's fundamental to our strategy. And I mean, from a resource standpoint, I mean as we said, we think we are pretty good until the end of the decade. But given the time it takes to develop resources, we need to be identifying and bringing and owning additional resources. We're working on that now. And you see us -- I mean, that's some of the activity that you see from us out there, and that -- we'll continue to do that."
},
{
"speaker": "Operator",
"text": "Your next question is from the line of Kevin McCarthy from Vertical Research Partners."
},
{
"speaker": "Kevin McCarthy",
"text": "A two part question on MARBL, if I may. Scott, would you comment on how margins might change as you execute on the second version of the restructuring of that joint venture? In other words, does the 5% drag that you referenced on Slide 11 go away completely or partially? And then in that same press release 2 weeks ago, you also indicated an acceleration of the Meishan project, and wondering why that's the case? Is it, for lack of a better term, related to an experience curve where you now have greater capability to bring on conversion capacity more quickly than was the case in the past?"
},
{
"speaker": "Jerry Masters",
"text": "You do the margin. I'll cover capital."
},
{
"speaker": "Scott Tozier",
"text": "Yes, I'll take the MARBL question and the impact on margins. So as part of the restructuring of that joint venture, we've agreed for a period of time to continue to toll volumes out of the Wodgina mine on behalf of MinRes. And so for a period of time, I believe it goes through the middle of next year, we'll continue to have that margin headwind. Once that period is over, we'll end up improving our margin rate ultimately. We'll change the dollars because the EBITDA dollars will be the same, but the margin rate will certainly improve by that 5 percentage points."
},
{
"speaker": "Jerry Masters",
"text": "And then on the Meishan being early, look, it's good old-fashioned project execution. We're getting better at it. It is also that there's a -- the capability in China is significant to execute these large projects. We don't have the labor issues there that we had in Australia, so there's a number of things. Part of it is our capability is getting significantly better. We're learning every time we do a project. Part of it is about just the capability in China. And then the biggest piece, 1 of the bigger pieces is that we have labor availability there that we didn't have in Australia."
},
{
"speaker": "Kevin McCarthy",
"text": "I see. And as a brief follow-up, if I may. How is that experience at Meishan similar or different to what you would envision for Kemerton III/IV in terms of capital cost and speed of execution?"
},
{
"speaker": "Jerry Masters",
"text": "Well, I think -- I mean, well, not just III/IV, but let's say all the projects that we're working on, I think we're getting -- we're building a significant capability. It's materially different now than it was 3 or 4 years ago, and we think we can execute projects around the world on budget and on schedule. That said, those schedules and those budgets will be different depending on where you're executing. So Europe will be different than Western Australia, North America is different and China is different. So I wouldn't use Meishan capital numbers and apply those around the world. That's not how it works. We've executed a very good project. We're still executing. It's not complete yet, but we're getting there at Meishan. We think it's going to be a great project, and we're -- we feel like the capability we built is world class in this industry, in particular. But you can't take Meishan schedules and capital numbers and apply them in Western Australia or North America or Europe."
},
{
"speaker": "Operator",
"text": "Your next question comes from the line of Mike Sison from Wells Fargo."
},
{
"speaker": "Michael Sison",
"text": "Just curious on Energy Storage. When I think about 2024, which I understand is so far away, but if you think about volume growth next year, you should still be at 20%, 25%. If I keep -- how do I sort of calibrate where EBITDA could be from these levels? Meaning, does EBITDA just go up with volume growth next year? And then how do you sort of change or give us sort of a variable for pricing as we think about '24 for Energy Storage?"
},
{
"speaker": "Scott Tozier",
"text": "Yes, Mike, that's a little far out. It's certainly, given the way that we're giving guidance, it's going to be a volume story next year. Of course, pricing is going to be a question mark that we would have, and it's all based on the contract structures. We're not anticipating to have any big changes in the contract structures. So as that pricing moves, we'd expect to see that trailing kind of 3-month lag to what those indices are. I think scale becomes an important part of the story as well, so that will help on our fixed costs. So you'll see a little bit of improvement there. The operating margins will improve based on productivity. Kent talked about what we're seeing with our -- the Albemarle Way of Excellence and how that's translating into results, so we expect that to play a role in all of our businesses, ultimately. Eric, you have something..."
},
{
"speaker": "Eric Norris",
"text": "I'm just going to say, as it pertains to price, we -- as Kent said, we don't have the confidence to know exactly ourselves what price is going to do, but we do know this. We believe that the market will continue to be quite tight next year as well. There'll be significant demand growth in the market, and indeed, there will be more supply growth as well. But those two will be fairly matched, right? It will be a fairly tight market. So that much we foresee, how that plays out from a price standpoint, to be determined."
},
{
"speaker": "Michael Sison",
"text": "Got it. And just a quick follow-up. As you add capacity through '27 or you scale up these projects. Your fixed cost, I think you sort of mentioned, did they go down as we get to the end of the decade?"
},
{
"speaker": "Scott Tozier",
"text": "Well, fixed cost on a unit basis will go down. Obviously, fixed costs will go up as you're adding plants on an absolute basis. But on a unit basis, meaning per ton, yes, they'll go down."
},
{
"speaker": "Operator",
"text": "Your next question is from the line of Ben Isaacson from Scotiabank."
},
{
"speaker": "Benjamin Isaacson",
"text": "Just in terms of the seasonality of EV sales, since we typically see a bit of weakness in Q1, some have suggested that that could lead to kind of seasonal pullbacks in the lithium price. I just wanted to get your thoughts on that? And then just as a follow-up, can you give some specifics on the Salar Yield Improvement? What is the volume lift? And what is the shape or the timing of that?"
},
{
"speaker": "Eric Norris",
"text": "So Ben, this is Eric. On seasonality, indeed, whether it's ICE vehicles or electric vehicles, there is a crescendo in the year, I guess the demand is stronger in the second half seasonally than in the first. However, I would be careful to say that we had weakness in the first part of the year. We had a weak January, particularly in China, the market did, but that's really China and the timing of the New Year. What happened with price and why we talked about price coming down and the inventory correction was inventory correction was not demand growth. Demand growth has remained strong and has strengthened as the year has gone on. U.S. up over 50%, China, up 45% through the middle part of the year. The only market that hasn't been as strong up in the 20s percent range is Europe, and I think that has a lot to do with some of the macro and other headwinds that we all know about in Europe. But as we look across the year, we still see a 40% growth in the marketplace. So there are certainly lots of macro headwinds we can talk about, but despite these, we still see that secular shift supported by incentives in China. Grid storage has also been a big growth in China recently as well and continued growth outside of China for EVs. So, yes. I guess I'd say on the demand front, be careful to assume that we had a weak first quarter. It was not bad when it ended. Pretty strong actually. The next question, I think to you was -- Ben, what was your second question? Please repeat it."
},
{
"speaker": "Benjamin Isaacson",
"text": "Salar Yield."
},
{
"speaker": "Jerry Masters",
"text": "Salar Yield. Yes. So we've reached mechanical completion and we now -- we're in the process of commissioning that, so that is an efficiency. So we are able to recover more lithium for every gallon of brine that we pump. But one that we have to -- it has to work its way through the Salar system, so there's an 18-month lead time before that -- those products start hitting the sales register, so to speak. So we still use the -- we still use the pond system to concentrate that, and I don't -- I'm not sure the uplift, what would you estimate that at when we get there?"
},
{
"speaker": "Eric Norris",
"text": "The uplift, well, look, I mean it's -- Salar Yield is going to allow us to get to nameplate capacity over the next couple of years at La Negra, which is 85,000 tonnes. And the -- once we start loading brine from the Salar Yield project in ponds, it's actually -- we're able to slightly more -- there is a shortcut, it's closer to 6 months. So within 6 months, so starting next year, we'll start to see the benefit of that uplift."
},
{
"speaker": "Operator",
"text": "And our last question will be coming from the line of David Begleiter from Deutsche Bank."
},
{
"speaker": "David Begleiter",
"text": "First, on the Energy Storage for your guidance increase. Can you just bridge us from the roughly $3 billion of prior guidance midpoint to now the $3.7 billion of current guidance?"
},
{
"speaker": "Scott Tozier",
"text": "Yes, David. It's really all price. I mean we got a little bit of extra volume, but it's all just driven by the price indices where they're sitting right now. Obviously, they've recovered off the lows that happened in April and have improved, and we've -- as we've mentioned on the -- in the prepared remarks, we've held them flat in our guidance as of the end of June."
},
{
"speaker": "David Begleiter",
"text": "Interest in Arkansas lithium production potentially. What are your current thoughts as to accessing your assets down in that region?"
},
{
"speaker": "Jerry Masters",
"text": "Yes. So we -- I mean we have plans to exploit that. So we have access to the lithium in the Smackover and Magnolia. So basically, everything we pump for bromine today, we would kind of -- an easy answer is that we process that for lithium. It requires different technology, DLE based, absorption based which we have been working on. We have proprietary technology around that. We're doing -- we're building pilot plants at the moment, and we'll be able -- and we plan to execute projects around that, but we want to run pilot plant. It is a new technology, and we're going to make sure that we do it right, but we have access to the brines. We've got the infrastructure at Magnolia. We're well positioned to take advantage of that."
},
{
"speaker": "Operator",
"text": "That's all the time we have for questions. I will now pass it back to Kent Masters for closing remarks."
},
{
"speaker": "Jerry Masters",
"text": "Okay. Thank you, Aisha, and thank you all for joining us today. We are confident in market opportunity and our disciplined strategy to achieve both short-term and long-term results. We are a global leader in minerals that are critical to a mobile, connected, healthy and sustainable future. We continue to work to be the partner of choice for our customers and investment of choice for both the present and the future. Thank you for joining us."
},
{
"speaker": "Operator",
"text": "This concludes today's conference call. Thank you for your participation. You may now disconnect."
}
] | Albemarle Corporation | 18,671 |
ALB | 1 | 2,023 | 2023-05-04 13:35:00 | Operator: Hello, and welcome to Albemarle Corporation's Q1 2023 Earnings Call. [Operator Instructions] I will now hand it over to Meredith Bandy, Vice President of Investor Relations and Sustainability. Ms. Bandy, please proceed.
Meredith Bandy: All right. Thank you, Forum, and welcome, everyone, to Albemarle's First Quarter 2023 Earnings Conference Call. Our earnings were released after the close of market yesterday, and you'll find the press release and earnings presentation posted to our website under the Investors section at albemarle.com. Joining me on the call today are Kent Masters, Chief Executive Officer; and Scott Tozier, Chief Financial Officer. We also have Eric Norris, President of Energy Storage; Netha Johnson, President of Specialties; and Raphael Crawford, President of Ketjen available for Q&A. As a reminder, some of the questions -- some of the statements made during the call, including our outlook, guidance, company performance and timing of the expansion projects may constitute forward-looking statements. Please note the cautionary language about forward-looking statements contained in our press release and earnings presentation, which also applies to this call. Please also note that some of our comments today refer to non-GAAP financial measures. A reconciliation of which can be found in our earnings material. And I'll turn the call over to Kent.
Kent Masters: Thank you, Meredith. Our first quarter was excellent. With net sales more than doubling versus first quarter last year, and EBITDA up almost four times to $1.6 billion. This reflects the high market pricing for our Energy Storage business at the end of 2022. Our Specialties business also had a strong quarter, up sequentially from last quarter on higher pricing. Looking forward to the rest of this year, we are adjusting our expectations based on the current lithium market pricing, and Scott will go into that in more detail. We move the business forward in a number of ways during the quarter, including selecting the site for our U.S. Mega-Flex lithium processing facility in Richburg, South Carolina, which is a strategic move that is even more important given the U.S. Inflation Reduction Act. We also announced the restructure of our MARBL joint venture in Australia. And we announced the separate investment by mineral resources limited into two of Albemarle as conversion assets in China. We expect those two deals to receive regulatory approval and closed later this year. This week, we announced the final investment decision to build Kemerton trains III and IVin Australia, which will be 100% Albemarle owned. The fact that we are advancing the Kemerton trains and the U.S. Mega-Flex facility points to our confidence in the long term growth and opportunities of the lithium business and in particular, our Energy Storage segment. Lithium demand in the EV market continue to grow at extraordinary rates. And with that, I'll hand over to Scott.
Scott Tozier: Thanks, Ken. And hello, everyone. Let's review our first quarter performance on Slide five. Net sales for the first quarter were $2.6 billion up 129% compared to last year. This is a $1.5 billion increase and was driven by Energy Storage as a result of both higher market pricing flowing through our variable price contracts and higher volumes. Net income attributable to Albemarle was $1.2 billion, up almost 390% compared to the prior year. Diluted EPS was $10.51 also up almost 390% which is another record quarter for Albemarle. Looking at Slide six. First quarter adjusted EBITDA was almost $1.6 billion, an increase of approximately 270% year-over-year. This $1.1 billion increase was almost entirely driven by higher net sales in Energy Storage. Our Specialties business unit was up due to increased pricing and some lower freight costs, which are partially offset by lower volumes. Ketjen declined slightly due to volumes associated with a winter freeze in Texas earlier in the quarter. And importantly, we saw year-over-year price increases more than offsetting inflation in the quarter. On Slide seven, we are adjusting our 2023 guidance to reflect current lithium market pricing. On average, lithium indices are down about 50% to 60% since the start of the year, based on our established guidance methodology, we're taking lithium market price indices as of mid-April, and holding them flat for the balance of the year. To be clear, we are not predicting lithium market pricing, we're simply taking the current price, holding it flat and running it through our contract structure. This is the same way we provided guidance last year. As a result, we now expect 2023 total company net sales to be in the range of $9.8 billion to $11.5 billion. This is up 45% over the prior year at the midpoint. We expect to see sales for the second quarter to be in line with Q1 and then see a sequential increase in sales in both the third and fourth quarters as ramping Energy Storage volumes more than offset sequential price declines. Adjusted EBITDA is expected to be between $3.3 billion and $4 billion reflecting a year-over-year growth of 5% at the midpoint. This reflects a full year EBITDA margin in the range of 34% to 35% for the total company. Our full year 2023 adjusted diluted EPS guidance is now in the range of $20.75 to $25.75, reflecting a year-over-year improvement of 8% at the midpoint. We expect our net cash from operations to be in the range of $1.7 billion to $2.3 billion. And our CapEx guidance remains at 1.7 to $1.9 billion. So we still expect to maintain positive free cash flow for the year. Turning to the next slide for more detail on our outlook by segment. The 2023 Energy Storage volume outlook remains unchanged, up 30% to 40% year-over-year. We now project average realized pricing to be up 20% to 30% for the full year. And note that our realized prices are expected to be up year-over-year in the first half, including in Q2 and then down in the second half. We see volume growth in all quarters. This leaves potential upsides and downsides as the market price shifts during the year. Adjusted EBITA for energy storage is expected to be between $2.7 billion and $3.4 billion, essentially flat compared to 2022. Beginning in the second quarter, we expect to see pressure on EBITDA margins, largely related to the timing of higher priced spodumene inventories. And the increasing impact of the MARBL joint venture. And I'll cover that more on -- I have more on that shortly. For Specialties, we're maintain their guidance range for adjusted EBITDA to be up 5% to 10% compared to the previous year. We expect to see pressure in the second quarter as customers work through their current inventories. However, we expect the second half of the year to be stronger with a recovery of end market demand, particularly consumer electronics. Ketjen’s 2023 full year adjusted EBITDA is expected to be up 250% to 400% over the prior year. This increase in Outlook is due to higher volumes and better pricing. When we look at lithium market prices, we need to remember that most of our volumes are sold under long term contracts with strategic customers. We've updated our expected 2023 sales mix to reflect the recent market pricing. And there haven't been any changes to our contract structures in Q1. We expect our Energy Storage sales to be about 10% on spot, and 90% on index reference variable price contracts. These contracts are typically two to five years and in duration, and are designed to ensure security of supply for our customers as well as to make our sales more predictable. These strategic customers include partnerships across the value chain, including major cathode, battery, and automotive OEM customers. We are more weighted towards the market than we have been in the past. However, we will still have less volatility than a true spot business. Because of the index reference structure of these contracts. They typically have a three-month lag and have some of them have caps and floors. As Ken said, our confidence in the long term lithium market is reflected in our ongoing investments in resources and conversion capacity. As we look at Slide 10, you can see we continue to expect year-over-year volume growth in the range of 30% to 40% in 2023. As we bring on new conversion assets, specifically Kemerton and Qinzhou, plus some additional tolling volume. We still anticipate a 20% to 30% CAGR in Albemarle sales volumes between now and 2027, allowing us to maintain our leadership position and keep up with accelerated market demand. All told, we expect to nearly triple sales volumes to more than 300,000 tons by 2027. Long term, we continue to expect normalize Energy Storage margins in the mid to high 40% range, in line with the outlook that we gave in January. We now expect Energy Storage margins to be about 40% in 2023, primarily based on revised lithium market pricing and the impact of spodumene inventory lags. Most of the year-over-year decline in margins is related to that spodumene inventory lag on average, it takes about six months for spodumene to go from our minds through conversion to our customers. Last year we saw dramatic increases in pricing for lithium and spodumene and due to that time lag on spodumene inventory we’ve realized higher lithium pricing faster than higher spodumene cost of goods sold. As a result, we had unusually strong margins in 2022. This year is the reverse as prices decline, we're realizing lower lithium pricing faster than lower spodumene costs. The next item affecting margins as the accounting treatment of the MARBL joint venture. We expect to report 100% of net sales, but only our share of EBITDA resulting in a lower reported margin rate on that portion of the business. And finally, our reported EBITDA margins are impacted by tax expense at our Talison joint venture. Talison net income is included in our EBITDA on an after tax basis. If you had adjusted Talison’s results to exclude tax margins would be about six points higher in 2023. Turning to Slide 12, we will continue to invest with discipline, allocating our capital and free cash flows to support the highest return growth opportunities. Our primary use of capital remains organic growth projects to leverage our low cost resources in Australia and the Americas. And Kent will speak more about these projects in a moment. Beyond organic growth, we continue to evaluate a broad range of inorganic opportunities to expand capacity to meet our customers' future needs. Our primary targets are in three areas, lithium resources, extraction and processing technology, and battery recycling. We intend to maintain our track record of a disciplined M&A approach that improves returns preserves our financial flexibility with our investment grade credit rating. In line with that strategy, and as previously disclosed Albemarle submitted an indicative proposal to acquire Liontown Resources, a development stage spodumene resource in Australia. We believe this potential transaction would be consistent with our long term growth strategy and disciplined approach to capital allocation. To-date, the Liontown Board is not meaningfully engaged in progressing the transaction, we will provide updates if and when we have more information. Our balance sheet flexibility is a competitive advantage that allows us the opportunity to grow both organically and through acquisition as well as support our dividend. And with that, I'll turn it back to Kent for a market update and closing remarks.
Kent Masters: Thanks Scott. On Slide 13, the global outlook for full year EV sales remains robust. After slowness early in the first quarter due to China's reopening from COVID, global EV sales were up 26% year-over-year through March. Based on seasonal trends. China, EV sales are on track to achieve full year growth of 30%, an increase of more than two million vehicles over 2022. Outside of China, North America had a strong start to the year with 53% year-over-year EV sales growth. Demand has been boosted by government support the supply chain and increased model availability. In Europe, EV sales through March are up 7% versus prior year. A slower start due to supply bottlenecks and the phasing out of German plug in hybrid EV incentives. Lithium spot prices in China, particularly for carbonate have fallen primarily due to destocking of inventory in the battery supply chain. Outside of China, index prices for lithium hydroxide have remained relatively strong amid continued demand and less inventory pressure. Global lithium hydroxide prices are $15 to $20 per kilogram above Chinese carbonate spot prices, the largest spread on record. We have also started to see initial signs of tightening in the supply chain. Unlike Albemarle, non-integrated lithium converters purchased spodumene on the open market. Year-to-date spodumene pricing is down 30%, while lithium carbonate pricing is now more than 60%. As a result, some of the non-integrated producers are cutting production after their margins turn negative during the quarter. Following several months worth of destocking, customers have recently started to return to the spot market and as a result, Chinese carbonate pricing appears to have stabilized with spot prices up about 7% over the past week. We continue to expand our global lithium resource and conversion capacity based on our confidence in the long term outlook for lithium. On Slide 14, you can see our expanding presence in the U.S. as well as our plans for a lithium conversion and recycling facility in the European Union. We recently announced the site for our U.S. Mega-Flex processing facility in Richburg, South Carolina, strategically placed in the growing Southeast EV and battery ecosystem. We are also strengthening our resource production. In the U.S., our expansion at Silver Peak is ahead of schedule, and our studies for the Kings Mountain mines are moving forward as planned. Our project in Chile to improve the yield at our Salar de Atacama site is on schedule for mechanical completion this quarter. Recently, Chilean President Boric proposed a new national lithium policy. The government has repeatedly made it clear it would honor current concessions. Chile has always honored the rule of law, and we do not see the new policy as a threat to our current concession, which runs through 2043. In the future, the proposal, if enacted, may offer opportunities to expand our operations using new technology. We are proud of our more than 40 years of successful operations in Chile and value the good working relationships we have with the government and other leaders in the region. Elsewhere in the world, we are expanding both resources and conversion capacity. In Australia, the various trains of our Kemerton conversion facility are moving forward. For Kemerton 1, we are pleased to have reached the specified battery-grade product milestones and look forward to product qualification with our customers. Kemerton II is progressing through commissioning with first product expected in the third quarter of 2023. We have prioritized train I activity, and this had some impact on the schedule for train II. Kemerton III and IV now have final investment decisions and we are planning the constructions schedules. Note that we will have 100% ownership of trains III and IV. In China, Meishan construction is progressing on budget and on schedule with mechanical completion expected in 2024. Our resource expansion in this area of the world is progressing, both at Wodgina and Greenbushes. At Greenbushes, the tailings retreatment project completed last year is improving recoveries to increase spodumene production capacity. We have talked a lot over the past year about our durable competitive advantages, including our scale as one of the world's largest lithium producers, our geographic diversity, our world-class brine and spodumene resources and our vertical integration from resource to battery-grade lithium. The current lithium market conditions have tested these advantages and proven how durable they are and the difference they make for Albemarle. We are a company that looks to the horizon. Our sustainability commitment is an integral part of our long-term strategy and our customer value proposition, and we continuously measure our progress against sustainability goals. Our 2022 sustainability report will be issued on June 5, and we will hold a webcast on June 20 to discuss the key highlights from the report, including our initial reporting in alignment with the task force on climate-related disclosure recommendations, progress on environmental and DE&I targets and introducing new goals around Scope 3 and air quality. In summary, we had an exceptionally strong first quarter. While lithium prices have pulled back, our team continues to focus on the themes that are within our control. We're delivering volumetric growth and executing our projects. We are confident in our strategic delivery and the future of the EV market. Bringing all these factors together, we anticipate 2023 sales to be up 45% over last year. We remain a global leader with world-class long-term assets and a diversified product portfolio that highlights broader opportunities in the mobility, energy, connectivity and health markets. Innovation remains core to our business as we deliver advanced solutions tailored to our customers' needs. Our strategy is clear and disciplined. It enables us to accelerate profitability and to advance sustainability. And with that, I'd like to turn the call over to the operator to begin the Q&A portion.
Operator: [Operator Instructions] Our first question comes from the line of Colin Rusch with Oppenheimer. Colin, your line is now open.
Colin Rusch: Can you talk a little bit about what you're seeing in terms of order size in the spot market? And how that inventory is clearing at this point? Are you seeing any real meaningful change here in the last, call it, 3 or 4 weeks?
Eric Norris: Good morning, Colin, this is Eric. So you're talking about -- I didn't get your first part. You said order size and stock clearing, is that what you asked?
Colin Rusch: Yes, yes. Yes, this activity in the spot market just...
Eric Norris: Yes. Well, look, I mean -- yes, I think what really transpired and what Kent referred to in his prepared remarks, we saw a significant destocking happened in China, which affected the spot market. Our contract customers around the world continue to buy at their contracted volumes, as Ken pointed out. We've seen close to 30% growth in EV sales in the first quarter across the industry and over 50% in the U.S., a little weaker in Europe. Overall, the markets are performing largely as we thought it would of a strong year with what we think will be a tight supply as well. But specifically in the first quarter, with that destocking, we saw the spot market be practically nonexistent at times during the quarter. There's very little activity going on as these stocks were drawn down. Stocks were drawn down the levels at the cathode level and battery level in China lithium stocks to -- and in some cases, below a week, clearly not in the long run, a level that's sustainable for sustained operation. To your question, what we've seen in the past couple of weeks, we've seen spot buyers return. We've seen -- and we believe that's partially what's affecting the price that is popped -- is leveled and then started to rise within China. And we can -- and we see no change in what our projected sales for the year in EVs of about 30% growth anticipated in China, closer to 40% for the overall market. I think the spot orders, it would be premature for me to say how large they are, but they are beginning as these cathode producers now start to restock and prepare for a more stable operation for the balance of the year.
Colin Rusch: That's super helpful. And then in terms of the competitive landscape around -- just on the refining side, as we've seen some new entrants into the space, are you seeing any real meaningful evolution in terms of the technology piece of this? And how folks get to the quality spec across the landscape? And I'm asking that question in context of looking at some of the evolving chemistries that we're seeing that are preparing to go into production?
Kent Masters: Yes. I don't think we have visibility to that. So what we -- we've not seen -- I mean, the specs have not changed or whether people are getting qualified, taking longer to get qualified with some of this -- the newer facilities maybe that's some of the delays that we see, but we don't have visibility whether it's about qualification issues or just about production issues. I don't think we have visibility of that.
Eric Norris: No. In terms of the competitive landscape, I would tell you in terms of the expectations of customer of us, it is a moving ball. The expectations go up on quality, particularly in the higher energy -- higher energy density chemistries, which tend to be the nickel chemistries. We recently completed upgrades in some of our workhorse plants like Xinyu to drive even higher quality standards to remain a leader in that area and in that regard. So it is something that it is a barrier for any new entrant to be able to achieve and to get to for sure.
Colin Rusch: Thanks so much, guys.
Operator: Our next question comes from the line of David Begleiter with Deutsche Bank. David, your line is now open.
David Begleiter: This is David calling here for Dave. Just going back to the spodumene costs, can you talk about where the lower cost spots coming from in Q1 and probably how much was the benefit to margins in Q1? And also, is that higher cost of spodumene from the -- or is it from Greenbushes?
Scott Tozier: Yes. So the lower cost spodumene is really from the both Kemerton as well as Qinzhou just as -- sorry, Greenbushes. Just as a reminder, the reason it's lower cost is because of the timing lag and the rapid increase and then now decrease in spodumene prices. It's really not the operating cost of the minds itself that's causing this issue. In Q1, the benefit was probably in the kind of 15 to 20 percentage point type of range that we were seeing in Q1. And again, we'll see that reverse as we go through the rest of the year, and that will be a margin rate pressure on the business.
David Begleiter: Okay. And what was the final cost for Kemerton and I guess what will Kemerton III & IV cost?
Scott Tozier: So we haven't -- we haven't disclosed the total amount. So it's probably in the $1.5 billion to $1.7 billion range for Kemerton I and II. Kemerton III and IV will be in a similar type of range, partly because we've got an employment village that we're putting in place to help with the labor issues ultimately.
David Begleiter: Okay. Thank you.
Operator: Our next question comes from the line of David Deckelbaum with Cowen. David, your line is now open.
David Deckelbaum: Good morning, Ken, Eric and Scott. Thanks for taking my question today. I wanted to just ask about long-term planning, particularly for you, Scott, how you think about the move to be spending, I guess, about $4.2 billion in '27 versus $1.8 million this year? You point out obviously that your guidance always just illustrates pricing if you held conditions sort of flat today. You talked about this year spending within cash flow. I guess that these conditions obviously persist that you would be outspending cash flow if you followed that CapEx plan. How do we think about that planning cycle while you maintain sort of a long-term structurally bullish view on the market, You're expanding your conversion quite a bit to get to those CapEx numbers? I guess how do we think about that CapEx trajectory every year? And should we expect it to be governed by sort of the beginning of the year outlook for organic cash flows?
Kent Masters: Yes. So I think, as we've said, when we laid out our investment plans, but we look at the market and we'll adjust as we go through this. So what we put forward in January, those are our plans. And the market -- and our view of the market changes dramatically or significantly we'll adjust to that. So short-term cycles, if our view is right, we'll maintain and invest through those. But if our view of pricing changed longer term, then we would adjust our investment profile.
Scott Tozier: Yes. And I would just add, Kent, that given our volumetric growth at these kind of pricing levels, we'll continue to be generating significant cash flow to be able to fund that kind of CapEx growth. So the Albemarle story is not really about the price, it's about the volumetric growth. And the cash generation that's coming from this is significant. So...
David Deckelbaum: I appreciate that. Kent, in your prepared remarks, you talked about the minimal impact for now of the Chilean governmental moves, particularly given your contracts expiring in 2043. You also, I guess, highlighted looking at things like extraction technologies, processing technologies. I guess, did the move change any of your long-term strategy in the country and might have accelerated some of the investments? Or, I guess, exploration around direct lithium extraction and applications in Chile?
Kent Masters: Yes. So I guess we were surprised by the announcement that came out of Chile. We knew they were moving in that direction. A couple of things we learned in that. But our plans around DLA and our discussions with the government about using that in the Salar are consistent now and before. We're working to progress that as quickly as we can, and we'll do it in a number of places, but there's an opportunity to utilize that in the Salar as well. So I guess our view is -- I mean, we -- our concession goes through 2043, where the government has gone out of their way to assure us that, that's valid. But expansions and getting additional concessions will probably require us to use new technology and probably partner with the government as well around that. So we see that as an opportunity beyond our current concession.
David Deckelbaum: Appreciate the answers, guys.
Operator: Our next question comes from the line of Josh Spector with UBS. Josh, your line is now open.
Josh Spector: Hi, thanks for taking my question. I was wondering if you could talk about your thoughts around the EBITDA margin cadence in Energy Solutions through the year. I assume 2Q is probably going to see the biggest compression. But can you get back to that mid- to upper 40% range in fourth quarter? Or can you even get there with where spodumene prices are today once that does roll through?
Scott Tozier: Yes. So Josh, with where spodumene prices are and the projection that we've made using the mid-April prices, we'll be below that kind of mid-40% range in the second quarter all the way through the fourth quarter. So it's really, again, the pressures coming from that price being lower as well as that spodumene price drop or cost drop that is putting the pressure on the margins. If you were to stabilize that, I think you'd end up being more at the long-term expectations of that mid-40s to low 50% range. So really, this just as a reminder and repeat it again, this margin pressure is really just driven by the velocity and the change in the spodumene price flowing through our P&L.
Josh Spector: Okay. And just to make sure I'm clear, just in your pricing assumption, I mean, are you assuming that your contracts stepped down with the lag in the next couple of quarters along with that? Or are you assuming your current contract mix extends?
Scott Tozier: Yes. So what we do is we're taking our current contract mix as of today or let's just say, mid-April. We're applying the market indices that are referenced in those contracts, flowing that through and that generates what we think -- what the revenue will be. And so as you look at that on a sequential basis, we'll see price reductions each quarter. And as you look at it on a year-over-year basis, our first half of the year, we actually see price increases. In the second half of the year, we're seeing price decreases on a year-over-year basis. And again, that's just really just reflecting how those contracts are structured and the lags that are built into them. And a couple of the contracts have caps and floors that we'll have to take into account.
Josh Spector: Okay. Thanks, Scott.
Operator: Our next question comes from the line of Mike Sison with Wells Fargo. Mike, your line is now open.
Mike Sison: Hey, good morning, guys. Nice start to the year. In terms of inventory destocking, I understand there's been some in the industry, but your volumes were up in the first quarter. So are you not seeing destocking from customers? And is that a risk as you get into the second, third and fourth quarter?
Eric Norris: Hi, good morning, Mike. So this is Eric. The way I would qualify that as again that the destocking has happened specifically in one country, it's China. Now it happens to be the largest country in the market where almost all the spot volume activity is that's 10% of our mix, as we described on an annualized basis. All of our contracts are everywhere else around the world, including even some long-term contracts that are sourced into China are all operating according to the projected plan prior to beginning of the year prior to any destocking that happened in China, meaning the EV growth story is intact everywhere, all that's happening in China to destocking what's specifically there. And everywhere else, volume continues to flow. We're not seeing destocking as a widespread phenomenon just something in China and specific to the spot market.
Mike Sison: Got it. And then, so when you think about the volume growth as you head into the second half of the year, there -- it doesn't sound like there's a lot of risk to that on your end, right? Customers want that product and it's within your contract. So what is the risk for volume in your second half, if any?
Eric Norris: This is -- everything that's happened and that we've talked about on destocking has to do with a temporal effect in China. It has nothing to do with fundamentally demand that we've seen. It is true. The year started out a little weak in China on demand. Recovered rapidly by the end of March. So we saw a weak start in Europe, but that's a hangover effect, we believe, from what has been expiring incentives largely in Germany and the U.S. started off with a bang for the year. All of that is consistent with our look, our view at the beginning of the year, our view now that we're looking at a 40% year-on-year growth in demand, our customers need the supply. And frankly, we see the market as still being tight for the balance of the year. So this is a market that's healthy in that regard. Independent of what's going on with price now, the supply-demand fundamentals are very favorable.
Scott Tozier: Yes, Mike, I would just add to that, as you look at our projection, I mean, it's really an operational risk because we're ramping new plants, right? So it's really just our ability to ramp those plants, and we think we have it dialed in, but things can go wrong. So I think that's really the risk and also potential opportunity because if things go better, then we'll have more volume.
Mike Sison: Thank you.
Operator: Our next question comes from the line of Arun Viswanathan with RBC Capital Markets. Arun, your line is now open.
Arun Viswanathan: Hey, thanks for taking my question. Appreciating that it's a very volatile market that's constantly evolving. Could you just kind of review some of the drivers that you think are influential on price lithium spot prices? And maybe just give some perspective on the market? The declines that we saw were very swift and would indicate destocking and very high inventory levels, especially in China. I know that there's been some other factors like discounting on ICE vehicles over there, but maybe you can just provide your own perspective on what you're seeing?
Kent Masters: Yes. So it's difficult to say what's really happening in the spot market, kind of the fundamentals we rely on are the supply and demand balance. We spent a lot of time working on that, making sure that we understand that. We think we understand that and it kind of works where it's a tight market for a pretty long period of time. And the previous question, we're probably more concerned in this year about volume and being able to produce the volume as opposed to the demand that's there for the product. In the spot market, I mean, in China and the movement that we've seen, a lot of that is about destocking and that volume running down and shifting to different areas in the supply chain between the battery makers, the cathode makers and then the raw lithium salt providers like ourselves and converters that sit in the market as well. So it's moved around within that space. And then it's been -- there's been a lot of destocking in that. That's really driven the pricing. But it's in the spot market, as we've said before. It about 10% of our portfolio, has a big impact on the broader portfolio because we indexed our prices indexed to those with a lag, but it does have a bigger impact on our portfolio than just the 10% that we represent. Eric, do you have additional color?
Eric Norris: No. I mean I think the market is changing as well at the automotive level. I mean there's now more models, more vehicle producers, aggressive competition for share. So that's a dynamic that's going on within our customer base. But that's the industry rising up to meet the demand that's there for these vehicles. And it doesn't change the need for us to execute well in order to meet our customers' expectations. And as Kent said, the market for spot material is isolated largely to China. And so what you're seeing now is some dynamics playing out in China, which when you think about an inventory drawdown, it's temporal in nature with strong demand. We are going to pretty soon go to a point where many of -- much of the supply chain needs to start restocking in addition to just meeting its growth that move before it
Arun Viswanathan: Great. And then just as a quick follow-up, then you also noted that there potentially are some observations of a supply response in that some of the newer capacity that's potentially at higher cost levels may not come on or is being played. Could you just elaborate on that? What are you seeing there? Is that meant to also imply that maybe the mid-30s is the marginal cost of some of that new capacity, how should we think about that?
Kent Masters: Yes. I'm not sure we didn't -- we weren't talking about new capacity coming on that's been delayed. We were talking about converters in China that were shutting down because their math didn't work any longer between lithium prices and spodumene prices. So I'm not sure -- I'm not aware of anyone who's delayed a new project as a result of the current market pricing, although that could be the case, I'm not aware of that.
Eric Norris: No. I don't know that we have any intelligence that says a new project is delayed. There's still a fair amount of interest in bringing supply in order to meet the demand, which we believe will be necessary given the shortness in supply. But we know because we both compete, of course, in the China market against some of these converters who buy spodumene on the open market, but also toll with some of these individuals from the behavior that we have in that market, we've seen that market, we know very clearly that more tolling capacity is available because they cannot make money on existing spodumene conversion when they buy this spodumene themselves. So that's part of the evidence package we have that some capacity has been leaving the market at current prices.
Operator: Our next question comes from the line of Vincent Andrews with Morgan Stanley.
Vincent Andrews: Thank you. Good morning. Scott, I'm wondering if you can just help us on the inventory on your balance sheet. Just looking at the end of the year, it was a little south of $2.1 billion. And then at the end of the quarter, it's almost $3.2 billion. So what were the mechanics of that increase? I'm sure some of it is price, but how much of it is volume? And then I think you made an accounting change at 3Q in terms of how you deal with the unrealized profits from your JVs, and I think those now reduced inventory. So if you could just help us bridge the increase from 12/31 to 3/31 that would be great?
Scott Tozier: Yes, Vincent, I think -- so a significant amount of that increase is due to price. So as the price has moved up, obviously, there's an impact on our -- on the value. Also, we've got increase in volume as we're ramping both the expansion at Greenbushes as well as Wodgina. So you're going to see increases coming from that. And to your point, we did have an accounting change where we've changed how we're recognizing the profit in inventory that now is reflected in our inventory line as opposed to our investment line. That reduces the effect. So those are kind of the muting pieces.
Vincent Andrews: Okay. And then the other follow-up I had was just on your spodumene cost. It's very easy to understand what your -- what and how you're assuming lithium prices based on what you've said. But the spodumene cost that you're running through your guidance, are those the mid-April cost? Or do you have a sort of more of a projection on those that's baked into the guidance?
Scott Tozier: No. It's the same methodology is based on that mid-April -- that mid-April cost. So we don't take -- we're not taking a position on what that's going to do.
Operator: Our next question comes from the line of Christopher Parkinson with Mizuho. Christopher your line is now open.
Harris Fein: This is Harris Fein on for Chris. So there's been an effort over the past few years to increase the variable portion of your lithium tons All of your expansion plans are still going forward. It seems in tracking in line with expectations, and you're still generating a lot of cash. But I guess in light of what's going on in the market, can you speak to how comfortable you are with having this level of volatility in your results? Thanks.
Kent Masters: Yes. So there was quite an effort from us to move toward index-based pricing as pricing was moving, whereas historically, we've had more fixed price or at least agreed prices for a period of time. And it does create a little volatility in our results as the price moves, but it's a volatile market and this is a space, and it's probably going to move around like that for a period of time. So it could we, at some point, want to change that structure. But you never say never. It could be the case at some point. But given where the market is now, I think being indexed to the market, we like that. We think it's right for us and our customers. No one is really out of the market, either one, and that's kind of how we're going to operate now. It creates volatility in our results, and we just have to live with that in the near term.
Eric Norris: I also think that it's reflecting -- you can see in our performance that our low-cost resources and our low-cost operations benefits us. So we can handle this volatility better than many of our competitors, just given our cost position as well as our scale. So...
Harris Fein: And my second question is I would think that spodumene is the more commoditized product versus the downstream lithium salts. So I guess, why do you think that spodumene prices are holding in better more stable on a relative basis versus the downstream chemicals?
Kent Masters: Yes. Look, that's speculation, but there's just a longer lag in the way that works its way through our P&L and through the industry. So we kind of rely on what happens in the market where prices get set. It's not that material for us because we're integrated all the way from spodumene into lithium salt. So the real impact it's timing and the tax impact from the joint venture that hits us. That's kind of why you see that volatility. So it's -- but I think it lags just because of the timing of how long it takes to adjust those prices and how long it takes to move that material through the supply chain.
Eric Norris: Kent, I'd also add that fundamentally, this is an inventory drawdown in a period of time that won't last, we believe long, and we're seeing and we think it's fact transpired and it's behind us, and we see strong demand. I think the spodumene market is reacting to the strong demand and the need for the supply. So there is a time lag, but there's also just the supply/demand fundamentals are, again, very strong for growth going forward. So I think we can speculate, but some of that's at play as well in.
Kent Masters: There are no more questions?
Meredith Bandy: Everyone -- sorry, it seems that the operator dropped and we're getting our operator back. So everyone, if you just hold a moment. The next question is going to be from Joel Jackson at BMO. I don't know. It looks to me like your line is open, but we may have to wait for the operator.
Joel Jackson: Meredith, can you hear me?
Meredith Bandy: Yes, we can hear you. Go ahead, Joel. Thanks.
Joel Jackson: A couple of questions. So -- and maybe this is simple. I want to make sure that I understand. So when you talk about mid-April market pricing is what you're using for the rest of the year, are you talking about spot indice prices in the market? Or are you talking about so where we were mid-April? Or are you talking about the realized price that was going through your book in mid-April with your lags? And then what is that price level in mid-April that you are referring to?
Scott Tozier: Yes. So Joel, we're using the indices that are referenced in our contracts. So it's not just taking like the China spot or just 1 index where you're actually taking the actual indices that are referenced in our contracts as of mid-April, holding that flat and then calculating through the contract structures and the lags and caps and floors and all that kind of stuff to generate what that forecast is. And if you look at that as of mid-April to today, it's basically the same. So don't really move much in that time difference.
Joel Jackson: Great. But that is the unlagged mid-April market indices price?
Scott Tozier: That's correct. That's correct.
Eric Norris: Of course, there will be different in China versus outside China as well is a point yes. But it's -- as you know, they're very
Joel Jackson: It's a blank.
Eric Norris: Yes. That's correct.
Joel Jackson: Understood. Okay. Another question would be conversion margins have been negative for some months. And so like your actual business where you are buying spodumene, say, from Greenbushes -- excuse me, from Talison at the market price, that business of converting it is a negative margin business. I understand when you put the whole thing together, you're actually making money. But how do you think about that business that is negative? How does that change how you do things? And going forward, how do you think the mix of earnings mix of profitability should steady state out between conversion margins and spodumene production margins?
Kent Masters: We don't look at it that way. We're in the lithium business, and we're fundamental from the resource through to the salts that we sell to the customers, and we think of that as one business. And if the margin moves from one part of the business to the other, there are both ours, it's not that relevant to us.
Operator: The next question is coming from John Roberts with Credit Suisse. You may proceed.
John Roberts: Thank you. On your contracts that have caps and floors, do you expect to hit the floor on any contracts in 2023?
Kent Masters: I don't -- we've not disclosed that, right? We've not talked about specific contracts. I don't think we want to.
John Roberts: Okay. And then second question. I know it's small, but can you remind us of the main limitations of sodium-ion batteries and why the range won't improve over time for them?
Eric Norris: John, it's Eric. Its sodium-ion batteries are just less energy dense and heavier on weight for this comparable energy density. So while it may fulfill maybe a city, low-range vehicle, and that could help ease some of the ability of the industry to meet electric vehicle demand given the shortness of lithium we see in our forecast, it cannot replace it in whole in any significant way. However, it could be a viable technology in grid storage. So it just has inherent limitations given the energy density and weight to energy benefits.
Operator: Thank you, Mr. Roberts. The next question is from Chris Kapsch with Loop Capital. You may proceed.
Christopher Kapsch: A couple of follow-ups. One is on the pricing discussion. Just trying to get a little bit more granular because it sounds like you have good visibility on volumes. And then the variability is going to come from the pricing assumptions. But you alluded to the sort of the bifurcation in hydroxide and carbonate prices. Can you get more explicit in sharing with us like where the assumption baked into your guidance is on each of those chemistries? Is it that $15 to $20 delta that you're currently baking in your revised guidance?
Kent Masters: Yes. So I think what -- I mean we're looking at the market as it is today or middle of April, right? And we're using those spot markets to guide us for the balance of the year by the different chemistry. So carbonate would inform -- the carbonate business and hydroxide would inform the hydroxide business. So we're holding them flat as they were in middle of April from an indices standpoint. And again, the index that are for our different contracts we talked about the main.
Christopher Kapsch: Okay. And just to be clear, you have different indexes for both carbonate and hydroxide inside China and outside China?
Scott Tozier: That's right. Yes, we've got indices for the different products. You also have different countries, different regions, and some customers actually blend some of the indices. So it's a mix, right?
Christopher Kapsch: Makes sense. Got it. And then a follow-up just on the market intelligence about the nonintegrated converters shuttering in China. Just curious too, we had heard that. That's definitely the case with lepidolite. Just wondering if your commentary where you're talking about sort of more conventional SC6 feedstock users or for lepidolite or just across the board in terms of nonintegrated converters being uneconomic as where recent spot carbonate prices have been?
Eric Norris: Well, generally speaking, Chris, what we view lepidolite producers is tending to be more integrated producers from mineral resource of lepidolite all the way through conversion. Our comments on what we're seeing and who we'd be tolling with are obviously those who consume spodumene and who have to buy spodumene in the market to run their business. That's where our comments were focused on.
Christopher Kapsch: Got it. Thank you.
Operator: Our last question is from Ben Kallo with Baird. You may proceed.
Benjamin Kallo: Thank you very much for filling me in. If you could give us some help on marginal cost of the industry and you guys point about being integrated, not how you look at the margin in mining versus conversion. But how do we think about the marginal cost of the overall industry? And any way you can frame that for us? Because I think that's the biggest question when what everyone is looking at price is like how low can it go? And if you're the cost leader, then you set that price theoretically? And then I have a follow-up.
Kent Masters: Yes. So Eric can probably add details to this. But I would say, I mean we look at it and we think you should look at it our integrated producers are producers that are not integrated, and they probably set the marginal cost right, the ones that aren't integrated. So you spodumene price, you can see, for the most part, it's pretty transparent around that. And conversion on top of that to make a margin that -- those are the marginal producers when -- I guess it moves around depending on where spodumene sits, but you can see that and probably can determine that.
Eric Norris: Yes, I'd just add, Ben, that as when the spodumene when the battery-grade carbonate price -- spot price in China on the various indices across from the 30s into the 20s, you started to see that pain. We started to hear more producers who are having trouble operating. You start to see even more activity within China to try to find ways to sort that from falling further. You could tell -- we could tell from the market sentiment that, that was a point of pain from any of these producers. And it substantiates what we've said for some time that prices need to be at least in the 20s for this industry to operate if not higher.
Kent Masters: And then you see as new resources come on, right, and new technology comes to play, those could very well move out that cost curve as well as lower quality resources come to market with different technologies, that cost curve kind of it grows.
Benjamin Kallo: Thank you. And then just on -- I think we see this already to some extent, but a bifurcation, if that's the right word, of pricing that comes out of China versus elsewhere? And then if you wanted to go elsewhere to specifically in the U.S., I know there's not a lot of volume that comes out of the U.S. But in your discussions, how much of a difference is that pricing across different regions and where -- whether it's spodumene or carbonate or what have you the difference in pricing based on region?
Kent Masters: Yes. So yes, China is a big part of the market. And historically, it's kind of set that -- all of those -- that pricing historically. I think as the other regions grow and we start shipping volume into other regions, that's going to change. And it will start bifurcating and being different around the world. But I would say now, it's kind of one market. It's kind of -- it looks like it's wanting to separate a little bit, but I would call it one still.
Eric Norris: And it's particularly true then for carbonate, 70%, 80% of the world's carbonate is consumed in China. And so if China is destocking, that's going to have a disproportionate impact on carbonate in China.
Benjamin Kallo: And so the IRA the intent of the RA to move supply chain out of China has started impacting the market pricing yet?
Kent Masters: Yes, there's no real consumption around that at the moment. But it's the speculation around it has started. But there's not a lot of volume shift that's changed since that law came into effect
Operator: That is all the time we have for questions. I will now pass it back to Kent Masters for closing remarks.
Kent Masters: Okay. Thank you, and thank you all for joining us today. So it's clear we're a growth company that continues to provide added value to our markets. As a global leader in minerals that are critical to mobile, connected, healthy and sustainable future, we remain the partner of choice with customers and key stakeholders. Thank you
Operator: This concludes today's conference call. Thank you for your participation. You may now disconnect. | [
{
"speaker": "Operator",
"text": "Hello, and welcome to Albemarle Corporation's Q1 2023 Earnings Call. [Operator Instructions] I will now hand it over to Meredith Bandy, Vice President of Investor Relations and Sustainability. Ms. Bandy, please proceed."
},
{
"speaker": "Meredith Bandy",
"text": "All right. Thank you, Forum, and welcome, everyone, to Albemarle's First Quarter 2023 Earnings Conference Call. Our earnings were released after the close of market yesterday, and you'll find the press release and earnings presentation posted to our website under the Investors section at albemarle.com. Joining me on the call today are Kent Masters, Chief Executive Officer; and Scott Tozier, Chief Financial Officer. We also have Eric Norris, President of Energy Storage; Netha Johnson, President of Specialties; and Raphael Crawford, President of Ketjen available for Q&A. As a reminder, some of the questions -- some of the statements made during the call, including our outlook, guidance, company performance and timing of the expansion projects may constitute forward-looking statements. Please note the cautionary language about forward-looking statements contained in our press release and earnings presentation, which also applies to this call. Please also note that some of our comments today refer to non-GAAP financial measures. A reconciliation of which can be found in our earnings material. And I'll turn the call over to Kent."
},
{
"speaker": "Kent Masters",
"text": "Thank you, Meredith. Our first quarter was excellent. With net sales more than doubling versus first quarter last year, and EBITDA up almost four times to $1.6 billion. This reflects the high market pricing for our Energy Storage business at the end of 2022. Our Specialties business also had a strong quarter, up sequentially from last quarter on higher pricing. Looking forward to the rest of this year, we are adjusting our expectations based on the current lithium market pricing, and Scott will go into that in more detail. We move the business forward in a number of ways during the quarter, including selecting the site for our U.S. Mega-Flex lithium processing facility in Richburg, South Carolina, which is a strategic move that is even more important given the U.S. Inflation Reduction Act. We also announced the restructure of our MARBL joint venture in Australia. And we announced the separate investment by mineral resources limited into two of Albemarle as conversion assets in China. We expect those two deals to receive regulatory approval and closed later this year. This week, we announced the final investment decision to build Kemerton trains III and IVin Australia, which will be 100% Albemarle owned. The fact that we are advancing the Kemerton trains and the U.S. Mega-Flex facility points to our confidence in the long term growth and opportunities of the lithium business and in particular, our Energy Storage segment. Lithium demand in the EV market continue to grow at extraordinary rates. And with that, I'll hand over to Scott."
},
{
"speaker": "Scott Tozier",
"text": "Thanks, Ken. And hello, everyone. Let's review our first quarter performance on Slide five. Net sales for the first quarter were $2.6 billion up 129% compared to last year. This is a $1.5 billion increase and was driven by Energy Storage as a result of both higher market pricing flowing through our variable price contracts and higher volumes. Net income attributable to Albemarle was $1.2 billion, up almost 390% compared to the prior year. Diluted EPS was $10.51 also up almost 390% which is another record quarter for Albemarle. Looking at Slide six. First quarter adjusted EBITDA was almost $1.6 billion, an increase of approximately 270% year-over-year. This $1.1 billion increase was almost entirely driven by higher net sales in Energy Storage. Our Specialties business unit was up due to increased pricing and some lower freight costs, which are partially offset by lower volumes. Ketjen declined slightly due to volumes associated with a winter freeze in Texas earlier in the quarter. And importantly, we saw year-over-year price increases more than offsetting inflation in the quarter. On Slide seven, we are adjusting our 2023 guidance to reflect current lithium market pricing. On average, lithium indices are down about 50% to 60% since the start of the year, based on our established guidance methodology, we're taking lithium market price indices as of mid-April, and holding them flat for the balance of the year. To be clear, we are not predicting lithium market pricing, we're simply taking the current price, holding it flat and running it through our contract structure. This is the same way we provided guidance last year. As a result, we now expect 2023 total company net sales to be in the range of $9.8 billion to $11.5 billion. This is up 45% over the prior year at the midpoint. We expect to see sales for the second quarter to be in line with Q1 and then see a sequential increase in sales in both the third and fourth quarters as ramping Energy Storage volumes more than offset sequential price declines. Adjusted EBITDA is expected to be between $3.3 billion and $4 billion reflecting a year-over-year growth of 5% at the midpoint. This reflects a full year EBITDA margin in the range of 34% to 35% for the total company. Our full year 2023 adjusted diluted EPS guidance is now in the range of $20.75 to $25.75, reflecting a year-over-year improvement of 8% at the midpoint. We expect our net cash from operations to be in the range of $1.7 billion to $2.3 billion. And our CapEx guidance remains at 1.7 to $1.9 billion. So we still expect to maintain positive free cash flow for the year. Turning to the next slide for more detail on our outlook by segment. The 2023 Energy Storage volume outlook remains unchanged, up 30% to 40% year-over-year. We now project average realized pricing to be up 20% to 30% for the full year. And note that our realized prices are expected to be up year-over-year in the first half, including in Q2 and then down in the second half. We see volume growth in all quarters. This leaves potential upsides and downsides as the market price shifts during the year. Adjusted EBITA for energy storage is expected to be between $2.7 billion and $3.4 billion, essentially flat compared to 2022. Beginning in the second quarter, we expect to see pressure on EBITDA margins, largely related to the timing of higher priced spodumene inventories. And the increasing impact of the MARBL joint venture. And I'll cover that more on -- I have more on that shortly. For Specialties, we're maintain their guidance range for adjusted EBITDA to be up 5% to 10% compared to the previous year. We expect to see pressure in the second quarter as customers work through their current inventories. However, we expect the second half of the year to be stronger with a recovery of end market demand, particularly consumer electronics. Ketjen’s 2023 full year adjusted EBITDA is expected to be up 250% to 400% over the prior year. This increase in Outlook is due to higher volumes and better pricing. When we look at lithium market prices, we need to remember that most of our volumes are sold under long term contracts with strategic customers. We've updated our expected 2023 sales mix to reflect the recent market pricing. And there haven't been any changes to our contract structures in Q1. We expect our Energy Storage sales to be about 10% on spot, and 90% on index reference variable price contracts. These contracts are typically two to five years and in duration, and are designed to ensure security of supply for our customers as well as to make our sales more predictable. These strategic customers include partnerships across the value chain, including major cathode, battery, and automotive OEM customers. We are more weighted towards the market than we have been in the past. However, we will still have less volatility than a true spot business. Because of the index reference structure of these contracts. They typically have a three-month lag and have some of them have caps and floors. As Ken said, our confidence in the long term lithium market is reflected in our ongoing investments in resources and conversion capacity. As we look at Slide 10, you can see we continue to expect year-over-year volume growth in the range of 30% to 40% in 2023. As we bring on new conversion assets, specifically Kemerton and Qinzhou, plus some additional tolling volume. We still anticipate a 20% to 30% CAGR in Albemarle sales volumes between now and 2027, allowing us to maintain our leadership position and keep up with accelerated market demand. All told, we expect to nearly triple sales volumes to more than 300,000 tons by 2027. Long term, we continue to expect normalize Energy Storage margins in the mid to high 40% range, in line with the outlook that we gave in January. We now expect Energy Storage margins to be about 40% in 2023, primarily based on revised lithium market pricing and the impact of spodumene inventory lags. Most of the year-over-year decline in margins is related to that spodumene inventory lag on average, it takes about six months for spodumene to go from our minds through conversion to our customers. Last year we saw dramatic increases in pricing for lithium and spodumene and due to that time lag on spodumene inventory we’ve realized higher lithium pricing faster than higher spodumene cost of goods sold. As a result, we had unusually strong margins in 2022. This year is the reverse as prices decline, we're realizing lower lithium pricing faster than lower spodumene costs. The next item affecting margins as the accounting treatment of the MARBL joint venture. We expect to report 100% of net sales, but only our share of EBITDA resulting in a lower reported margin rate on that portion of the business. And finally, our reported EBITDA margins are impacted by tax expense at our Talison joint venture. Talison net income is included in our EBITDA on an after tax basis. If you had adjusted Talison’s results to exclude tax margins would be about six points higher in 2023. Turning to Slide 12, we will continue to invest with discipline, allocating our capital and free cash flows to support the highest return growth opportunities. Our primary use of capital remains organic growth projects to leverage our low cost resources in Australia and the Americas. And Kent will speak more about these projects in a moment. Beyond organic growth, we continue to evaluate a broad range of inorganic opportunities to expand capacity to meet our customers' future needs. Our primary targets are in three areas, lithium resources, extraction and processing technology, and battery recycling. We intend to maintain our track record of a disciplined M&A approach that improves returns preserves our financial flexibility with our investment grade credit rating. In line with that strategy, and as previously disclosed Albemarle submitted an indicative proposal to acquire Liontown Resources, a development stage spodumene resource in Australia. We believe this potential transaction would be consistent with our long term growth strategy and disciplined approach to capital allocation. To-date, the Liontown Board is not meaningfully engaged in progressing the transaction, we will provide updates if and when we have more information. Our balance sheet flexibility is a competitive advantage that allows us the opportunity to grow both organically and through acquisition as well as support our dividend. And with that, I'll turn it back to Kent for a market update and closing remarks."
},
{
"speaker": "Kent Masters",
"text": "Thanks Scott. On Slide 13, the global outlook for full year EV sales remains robust. After slowness early in the first quarter due to China's reopening from COVID, global EV sales were up 26% year-over-year through March. Based on seasonal trends. China, EV sales are on track to achieve full year growth of 30%, an increase of more than two million vehicles over 2022. Outside of China, North America had a strong start to the year with 53% year-over-year EV sales growth. Demand has been boosted by government support the supply chain and increased model availability. In Europe, EV sales through March are up 7% versus prior year. A slower start due to supply bottlenecks and the phasing out of German plug in hybrid EV incentives. Lithium spot prices in China, particularly for carbonate have fallen primarily due to destocking of inventory in the battery supply chain. Outside of China, index prices for lithium hydroxide have remained relatively strong amid continued demand and less inventory pressure. Global lithium hydroxide prices are $15 to $20 per kilogram above Chinese carbonate spot prices, the largest spread on record. We have also started to see initial signs of tightening in the supply chain. Unlike Albemarle, non-integrated lithium converters purchased spodumene on the open market. Year-to-date spodumene pricing is down 30%, while lithium carbonate pricing is now more than 60%. As a result, some of the non-integrated producers are cutting production after their margins turn negative during the quarter. Following several months worth of destocking, customers have recently started to return to the spot market and as a result, Chinese carbonate pricing appears to have stabilized with spot prices up about 7% over the past week. We continue to expand our global lithium resource and conversion capacity based on our confidence in the long term outlook for lithium. On Slide 14, you can see our expanding presence in the U.S. as well as our plans for a lithium conversion and recycling facility in the European Union. We recently announced the site for our U.S. Mega-Flex processing facility in Richburg, South Carolina, strategically placed in the growing Southeast EV and battery ecosystem. We are also strengthening our resource production. In the U.S., our expansion at Silver Peak is ahead of schedule, and our studies for the Kings Mountain mines are moving forward as planned. Our project in Chile to improve the yield at our Salar de Atacama site is on schedule for mechanical completion this quarter. Recently, Chilean President Boric proposed a new national lithium policy. The government has repeatedly made it clear it would honor current concessions. Chile has always honored the rule of law, and we do not see the new policy as a threat to our current concession, which runs through 2043. In the future, the proposal, if enacted, may offer opportunities to expand our operations using new technology. We are proud of our more than 40 years of successful operations in Chile and value the good working relationships we have with the government and other leaders in the region. Elsewhere in the world, we are expanding both resources and conversion capacity. In Australia, the various trains of our Kemerton conversion facility are moving forward. For Kemerton 1, we are pleased to have reached the specified battery-grade product milestones and look forward to product qualification with our customers. Kemerton II is progressing through commissioning with first product expected in the third quarter of 2023. We have prioritized train I activity, and this had some impact on the schedule for train II. Kemerton III and IV now have final investment decisions and we are planning the constructions schedules. Note that we will have 100% ownership of trains III and IV. In China, Meishan construction is progressing on budget and on schedule with mechanical completion expected in 2024. Our resource expansion in this area of the world is progressing, both at Wodgina and Greenbushes. At Greenbushes, the tailings retreatment project completed last year is improving recoveries to increase spodumene production capacity. We have talked a lot over the past year about our durable competitive advantages, including our scale as one of the world's largest lithium producers, our geographic diversity, our world-class brine and spodumene resources and our vertical integration from resource to battery-grade lithium. The current lithium market conditions have tested these advantages and proven how durable they are and the difference they make for Albemarle. We are a company that looks to the horizon. Our sustainability commitment is an integral part of our long-term strategy and our customer value proposition, and we continuously measure our progress against sustainability goals. Our 2022 sustainability report will be issued on June 5, and we will hold a webcast on June 20 to discuss the key highlights from the report, including our initial reporting in alignment with the task force on climate-related disclosure recommendations, progress on environmental and DE&I targets and introducing new goals around Scope 3 and air quality. In summary, we had an exceptionally strong first quarter. While lithium prices have pulled back, our team continues to focus on the themes that are within our control. We're delivering volumetric growth and executing our projects. We are confident in our strategic delivery and the future of the EV market. Bringing all these factors together, we anticipate 2023 sales to be up 45% over last year. We remain a global leader with world-class long-term assets and a diversified product portfolio that highlights broader opportunities in the mobility, energy, connectivity and health markets. Innovation remains core to our business as we deliver advanced solutions tailored to our customers' needs. Our strategy is clear and disciplined. It enables us to accelerate profitability and to advance sustainability. And with that, I'd like to turn the call over to the operator to begin the Q&A portion."
},
{
"speaker": "Operator",
"text": "[Operator Instructions] Our first question comes from the line of Colin Rusch with Oppenheimer. Colin, your line is now open."
},
{
"speaker": "Colin Rusch",
"text": "Can you talk a little bit about what you're seeing in terms of order size in the spot market? And how that inventory is clearing at this point? Are you seeing any real meaningful change here in the last, call it, 3 or 4 weeks?"
},
{
"speaker": "Eric Norris",
"text": "Good morning, Colin, this is Eric. So you're talking about -- I didn't get your first part. You said order size and stock clearing, is that what you asked?"
},
{
"speaker": "Colin Rusch",
"text": "Yes, yes. Yes, this activity in the spot market just..."
},
{
"speaker": "Eric Norris",
"text": "Yes. Well, look, I mean -- yes, I think what really transpired and what Kent referred to in his prepared remarks, we saw a significant destocking happened in China, which affected the spot market. Our contract customers around the world continue to buy at their contracted volumes, as Ken pointed out. We've seen close to 30% growth in EV sales in the first quarter across the industry and over 50% in the U.S., a little weaker in Europe. Overall, the markets are performing largely as we thought it would of a strong year with what we think will be a tight supply as well. But specifically in the first quarter, with that destocking, we saw the spot market be practically nonexistent at times during the quarter. There's very little activity going on as these stocks were drawn down. Stocks were drawn down the levels at the cathode level and battery level in China lithium stocks to -- and in some cases, below a week, clearly not in the long run, a level that's sustainable for sustained operation. To your question, what we've seen in the past couple of weeks, we've seen spot buyers return. We've seen -- and we believe that's partially what's affecting the price that is popped -- is leveled and then started to rise within China. And we can -- and we see no change in what our projected sales for the year in EVs of about 30% growth anticipated in China, closer to 40% for the overall market. I think the spot orders, it would be premature for me to say how large they are, but they are beginning as these cathode producers now start to restock and prepare for a more stable operation for the balance of the year."
},
{
"speaker": "Colin Rusch",
"text": "That's super helpful. And then in terms of the competitive landscape around -- just on the refining side, as we've seen some new entrants into the space, are you seeing any real meaningful evolution in terms of the technology piece of this? And how folks get to the quality spec across the landscape? And I'm asking that question in context of looking at some of the evolving chemistries that we're seeing that are preparing to go into production?"
},
{
"speaker": "Kent Masters",
"text": "Yes. I don't think we have visibility to that. So what we -- we've not seen -- I mean, the specs have not changed or whether people are getting qualified, taking longer to get qualified with some of this -- the newer facilities maybe that's some of the delays that we see, but we don't have visibility whether it's about qualification issues or just about production issues. I don't think we have visibility of that."
},
{
"speaker": "Eric Norris",
"text": "No. In terms of the competitive landscape, I would tell you in terms of the expectations of customer of us, it is a moving ball. The expectations go up on quality, particularly in the higher energy -- higher energy density chemistries, which tend to be the nickel chemistries. We recently completed upgrades in some of our workhorse plants like Xinyu to drive even higher quality standards to remain a leader in that area and in that regard. So it is something that it is a barrier for any new entrant to be able to achieve and to get to for sure."
},
{
"speaker": "Colin Rusch",
"text": "Thanks so much, guys."
},
{
"speaker": "Operator",
"text": "Our next question comes from the line of David Begleiter with Deutsche Bank. David, your line is now open."
},
{
"speaker": "David Begleiter",
"text": "This is David calling here for Dave. Just going back to the spodumene costs, can you talk about where the lower cost spots coming from in Q1 and probably how much was the benefit to margins in Q1? And also, is that higher cost of spodumene from the -- or is it from Greenbushes?"
},
{
"speaker": "Scott Tozier",
"text": "Yes. So the lower cost spodumene is really from the both Kemerton as well as Qinzhou just as -- sorry, Greenbushes. Just as a reminder, the reason it's lower cost is because of the timing lag and the rapid increase and then now decrease in spodumene prices. It's really not the operating cost of the minds itself that's causing this issue. In Q1, the benefit was probably in the kind of 15 to 20 percentage point type of range that we were seeing in Q1. And again, we'll see that reverse as we go through the rest of the year, and that will be a margin rate pressure on the business."
},
{
"speaker": "David Begleiter",
"text": "Okay. And what was the final cost for Kemerton and I guess what will Kemerton III & IV cost?"
},
{
"speaker": "Scott Tozier",
"text": "So we haven't -- we haven't disclosed the total amount. So it's probably in the $1.5 billion to $1.7 billion range for Kemerton I and II. Kemerton III and IV will be in a similar type of range, partly because we've got an employment village that we're putting in place to help with the labor issues ultimately."
},
{
"speaker": "David Begleiter",
"text": "Okay. Thank you."
},
{
"speaker": "Operator",
"text": "Our next question comes from the line of David Deckelbaum with Cowen. David, your line is now open."
},
{
"speaker": "David Deckelbaum",
"text": "Good morning, Ken, Eric and Scott. Thanks for taking my question today. I wanted to just ask about long-term planning, particularly for you, Scott, how you think about the move to be spending, I guess, about $4.2 billion in '27 versus $1.8 million this year? You point out obviously that your guidance always just illustrates pricing if you held conditions sort of flat today. You talked about this year spending within cash flow. I guess that these conditions obviously persist that you would be outspending cash flow if you followed that CapEx plan. How do we think about that planning cycle while you maintain sort of a long-term structurally bullish view on the market, You're expanding your conversion quite a bit to get to those CapEx numbers? I guess how do we think about that CapEx trajectory every year? And should we expect it to be governed by sort of the beginning of the year outlook for organic cash flows?"
},
{
"speaker": "Kent Masters",
"text": "Yes. So I think, as we've said, when we laid out our investment plans, but we look at the market and we'll adjust as we go through this. So what we put forward in January, those are our plans. And the market -- and our view of the market changes dramatically or significantly we'll adjust to that. So short-term cycles, if our view is right, we'll maintain and invest through those. But if our view of pricing changed longer term, then we would adjust our investment profile."
},
{
"speaker": "Scott Tozier",
"text": "Yes. And I would just add, Kent, that given our volumetric growth at these kind of pricing levels, we'll continue to be generating significant cash flow to be able to fund that kind of CapEx growth. So the Albemarle story is not really about the price, it's about the volumetric growth. And the cash generation that's coming from this is significant. So..."
},
{
"speaker": "David Deckelbaum",
"text": "I appreciate that. Kent, in your prepared remarks, you talked about the minimal impact for now of the Chilean governmental moves, particularly given your contracts expiring in 2043. You also, I guess, highlighted looking at things like extraction technologies, processing technologies. I guess, did the move change any of your long-term strategy in the country and might have accelerated some of the investments? Or, I guess, exploration around direct lithium extraction and applications in Chile?"
},
{
"speaker": "Kent Masters",
"text": "Yes. So I guess we were surprised by the announcement that came out of Chile. We knew they were moving in that direction. A couple of things we learned in that. But our plans around DLA and our discussions with the government about using that in the Salar are consistent now and before. We're working to progress that as quickly as we can, and we'll do it in a number of places, but there's an opportunity to utilize that in the Salar as well. So I guess our view is -- I mean, we -- our concession goes through 2043, where the government has gone out of their way to assure us that, that's valid. But expansions and getting additional concessions will probably require us to use new technology and probably partner with the government as well around that. So we see that as an opportunity beyond our current concession."
},
{
"speaker": "David Deckelbaum",
"text": "Appreciate the answers, guys."
},
{
"speaker": "Operator",
"text": "Our next question comes from the line of Josh Spector with UBS. Josh, your line is now open."
},
{
"speaker": "Josh Spector",
"text": "Hi, thanks for taking my question. I was wondering if you could talk about your thoughts around the EBITDA margin cadence in Energy Solutions through the year. I assume 2Q is probably going to see the biggest compression. But can you get back to that mid- to upper 40% range in fourth quarter? Or can you even get there with where spodumene prices are today once that does roll through?"
},
{
"speaker": "Scott Tozier",
"text": "Yes. So Josh, with where spodumene prices are and the projection that we've made using the mid-April prices, we'll be below that kind of mid-40% range in the second quarter all the way through the fourth quarter. So it's really, again, the pressures coming from that price being lower as well as that spodumene price drop or cost drop that is putting the pressure on the margins. If you were to stabilize that, I think you'd end up being more at the long-term expectations of that mid-40s to low 50% range. So really, this just as a reminder and repeat it again, this margin pressure is really just driven by the velocity and the change in the spodumene price flowing through our P&L."
},
{
"speaker": "Josh Spector",
"text": "Okay. And just to make sure I'm clear, just in your pricing assumption, I mean, are you assuming that your contracts stepped down with the lag in the next couple of quarters along with that? Or are you assuming your current contract mix extends?"
},
{
"speaker": "Scott Tozier",
"text": "Yes. So what we do is we're taking our current contract mix as of today or let's just say, mid-April. We're applying the market indices that are referenced in those contracts, flowing that through and that generates what we think -- what the revenue will be. And so as you look at that on a sequential basis, we'll see price reductions each quarter. And as you look at it on a year-over-year basis, our first half of the year, we actually see price increases. In the second half of the year, we're seeing price decreases on a year-over-year basis. And again, that's just really just reflecting how those contracts are structured and the lags that are built into them. And a couple of the contracts have caps and floors that we'll have to take into account."
},
{
"speaker": "Josh Spector",
"text": "Okay. Thanks, Scott."
},
{
"speaker": "Operator",
"text": "Our next question comes from the line of Mike Sison with Wells Fargo. Mike, your line is now open."
},
{
"speaker": "Mike Sison",
"text": "Hey, good morning, guys. Nice start to the year. In terms of inventory destocking, I understand there's been some in the industry, but your volumes were up in the first quarter. So are you not seeing destocking from customers? And is that a risk as you get into the second, third and fourth quarter?"
},
{
"speaker": "Eric Norris",
"text": "Hi, good morning, Mike. So this is Eric. The way I would qualify that as again that the destocking has happened specifically in one country, it's China. Now it happens to be the largest country in the market where almost all the spot volume activity is that's 10% of our mix, as we described on an annualized basis. All of our contracts are everywhere else around the world, including even some long-term contracts that are sourced into China are all operating according to the projected plan prior to beginning of the year prior to any destocking that happened in China, meaning the EV growth story is intact everywhere, all that's happening in China to destocking what's specifically there. And everywhere else, volume continues to flow. We're not seeing destocking as a widespread phenomenon just something in China and specific to the spot market."
},
{
"speaker": "Mike Sison",
"text": "Got it. And then, so when you think about the volume growth as you head into the second half of the year, there -- it doesn't sound like there's a lot of risk to that on your end, right? Customers want that product and it's within your contract. So what is the risk for volume in your second half, if any?"
},
{
"speaker": "Eric Norris",
"text": "This is -- everything that's happened and that we've talked about on destocking has to do with a temporal effect in China. It has nothing to do with fundamentally demand that we've seen. It is true. The year started out a little weak in China on demand. Recovered rapidly by the end of March. So we saw a weak start in Europe, but that's a hangover effect, we believe, from what has been expiring incentives largely in Germany and the U.S. started off with a bang for the year. All of that is consistent with our look, our view at the beginning of the year, our view now that we're looking at a 40% year-on-year growth in demand, our customers need the supply. And frankly, we see the market as still being tight for the balance of the year. So this is a market that's healthy in that regard. Independent of what's going on with price now, the supply-demand fundamentals are very favorable."
},
{
"speaker": "Scott Tozier",
"text": "Yes, Mike, I would just add to that, as you look at our projection, I mean, it's really an operational risk because we're ramping new plants, right? So it's really just our ability to ramp those plants, and we think we have it dialed in, but things can go wrong. So I think that's really the risk and also potential opportunity because if things go better, then we'll have more volume."
},
{
"speaker": "Mike Sison",
"text": "Thank you."
},
{
"speaker": "Operator",
"text": "Our next question comes from the line of Arun Viswanathan with RBC Capital Markets. Arun, your line is now open."
},
{
"speaker": "Arun Viswanathan",
"text": "Hey, thanks for taking my question. Appreciating that it's a very volatile market that's constantly evolving. Could you just kind of review some of the drivers that you think are influential on price lithium spot prices? And maybe just give some perspective on the market? The declines that we saw were very swift and would indicate destocking and very high inventory levels, especially in China. I know that there's been some other factors like discounting on ICE vehicles over there, but maybe you can just provide your own perspective on what you're seeing?"
},
{
"speaker": "Kent Masters",
"text": "Yes. So it's difficult to say what's really happening in the spot market, kind of the fundamentals we rely on are the supply and demand balance. We spent a lot of time working on that, making sure that we understand that. We think we understand that and it kind of works where it's a tight market for a pretty long period of time. And the previous question, we're probably more concerned in this year about volume and being able to produce the volume as opposed to the demand that's there for the product. In the spot market, I mean, in China and the movement that we've seen, a lot of that is about destocking and that volume running down and shifting to different areas in the supply chain between the battery makers, the cathode makers and then the raw lithium salt providers like ourselves and converters that sit in the market as well. So it's moved around within that space. And then it's been -- there's been a lot of destocking in that. That's really driven the pricing. But it's in the spot market, as we've said before. It about 10% of our portfolio, has a big impact on the broader portfolio because we indexed our prices indexed to those with a lag, but it does have a bigger impact on our portfolio than just the 10% that we represent. Eric, do you have additional color?"
},
{
"speaker": "Eric Norris",
"text": "No. I mean I think the market is changing as well at the automotive level. I mean there's now more models, more vehicle producers, aggressive competition for share. So that's a dynamic that's going on within our customer base. But that's the industry rising up to meet the demand that's there for these vehicles. And it doesn't change the need for us to execute well in order to meet our customers' expectations. And as Kent said, the market for spot material is isolated largely to China. And so what you're seeing now is some dynamics playing out in China, which when you think about an inventory drawdown, it's temporal in nature with strong demand. We are going to pretty soon go to a point where many of -- much of the supply chain needs to start restocking in addition to just meeting its growth that move before it"
},
{
"speaker": "Arun Viswanathan",
"text": "Great. And then just as a quick follow-up, then you also noted that there potentially are some observations of a supply response in that some of the newer capacity that's potentially at higher cost levels may not come on or is being played. Could you just elaborate on that? What are you seeing there? Is that meant to also imply that maybe the mid-30s is the marginal cost of some of that new capacity, how should we think about that?"
},
{
"speaker": "Kent Masters",
"text": "Yes. I'm not sure we didn't -- we weren't talking about new capacity coming on that's been delayed. We were talking about converters in China that were shutting down because their math didn't work any longer between lithium prices and spodumene prices. So I'm not sure -- I'm not aware of anyone who's delayed a new project as a result of the current market pricing, although that could be the case, I'm not aware of that."
},
{
"speaker": "Eric Norris",
"text": "No. I don't know that we have any intelligence that says a new project is delayed. There's still a fair amount of interest in bringing supply in order to meet the demand, which we believe will be necessary given the shortness in supply. But we know because we both compete, of course, in the China market against some of these converters who buy spodumene on the open market, but also toll with some of these individuals from the behavior that we have in that market, we've seen that market, we know very clearly that more tolling capacity is available because they cannot make money on existing spodumene conversion when they buy this spodumene themselves. So that's part of the evidence package we have that some capacity has been leaving the market at current prices."
},
{
"speaker": "Operator",
"text": "Our next question comes from the line of Vincent Andrews with Morgan Stanley."
},
{
"speaker": "Vincent Andrews",
"text": "Thank you. Good morning. Scott, I'm wondering if you can just help us on the inventory on your balance sheet. Just looking at the end of the year, it was a little south of $2.1 billion. And then at the end of the quarter, it's almost $3.2 billion. So what were the mechanics of that increase? I'm sure some of it is price, but how much of it is volume? And then I think you made an accounting change at 3Q in terms of how you deal with the unrealized profits from your JVs, and I think those now reduced inventory. So if you could just help us bridge the increase from 12/31 to 3/31 that would be great?"
},
{
"speaker": "Scott Tozier",
"text": "Yes, Vincent, I think -- so a significant amount of that increase is due to price. So as the price has moved up, obviously, there's an impact on our -- on the value. Also, we've got increase in volume as we're ramping both the expansion at Greenbushes as well as Wodgina. So you're going to see increases coming from that. And to your point, we did have an accounting change where we've changed how we're recognizing the profit in inventory that now is reflected in our inventory line as opposed to our investment line. That reduces the effect. So those are kind of the muting pieces."
},
{
"speaker": "Vincent Andrews",
"text": "Okay. And then the other follow-up I had was just on your spodumene cost. It's very easy to understand what your -- what and how you're assuming lithium prices based on what you've said. But the spodumene cost that you're running through your guidance, are those the mid-April cost? Or do you have a sort of more of a projection on those that's baked into the guidance?"
},
{
"speaker": "Scott Tozier",
"text": "No. It's the same methodology is based on that mid-April -- that mid-April cost. So we don't take -- we're not taking a position on what that's going to do."
},
{
"speaker": "Operator",
"text": "Our next question comes from the line of Christopher Parkinson with Mizuho. Christopher your line is now open."
},
{
"speaker": "Harris Fein",
"text": "This is Harris Fein on for Chris. So there's been an effort over the past few years to increase the variable portion of your lithium tons All of your expansion plans are still going forward. It seems in tracking in line with expectations, and you're still generating a lot of cash. But I guess in light of what's going on in the market, can you speak to how comfortable you are with having this level of volatility in your results? Thanks."
},
{
"speaker": "Kent Masters",
"text": "Yes. So there was quite an effort from us to move toward index-based pricing as pricing was moving, whereas historically, we've had more fixed price or at least agreed prices for a period of time. And it does create a little volatility in our results as the price moves, but it's a volatile market and this is a space, and it's probably going to move around like that for a period of time. So it could we, at some point, want to change that structure. But you never say never. It could be the case at some point. But given where the market is now, I think being indexed to the market, we like that. We think it's right for us and our customers. No one is really out of the market, either one, and that's kind of how we're going to operate now. It creates volatility in our results, and we just have to live with that in the near term."
},
{
"speaker": "Eric Norris",
"text": "I also think that it's reflecting -- you can see in our performance that our low-cost resources and our low-cost operations benefits us. So we can handle this volatility better than many of our competitors, just given our cost position as well as our scale. So..."
},
{
"speaker": "Harris Fein",
"text": "And my second question is I would think that spodumene is the more commoditized product versus the downstream lithium salts. So I guess, why do you think that spodumene prices are holding in better more stable on a relative basis versus the downstream chemicals?"
},
{
"speaker": "Kent Masters",
"text": "Yes. Look, that's speculation, but there's just a longer lag in the way that works its way through our P&L and through the industry. So we kind of rely on what happens in the market where prices get set. It's not that material for us because we're integrated all the way from spodumene into lithium salt. So the real impact it's timing and the tax impact from the joint venture that hits us. That's kind of why you see that volatility. So it's -- but I think it lags just because of the timing of how long it takes to adjust those prices and how long it takes to move that material through the supply chain."
},
{
"speaker": "Eric Norris",
"text": "Kent, I'd also add that fundamentally, this is an inventory drawdown in a period of time that won't last, we believe long, and we're seeing and we think it's fact transpired and it's behind us, and we see strong demand. I think the spodumene market is reacting to the strong demand and the need for the supply. So there is a time lag, but there's also just the supply/demand fundamentals are, again, very strong for growth going forward. So I think we can speculate, but some of that's at play as well in."
},
{
"speaker": "Kent Masters",
"text": "There are no more questions?"
},
{
"speaker": "Meredith Bandy",
"text": "Everyone -- sorry, it seems that the operator dropped and we're getting our operator back. So everyone, if you just hold a moment. The next question is going to be from Joel Jackson at BMO. I don't know. It looks to me like your line is open, but we may have to wait for the operator."
},
{
"speaker": "Joel Jackson",
"text": "Meredith, can you hear me?"
},
{
"speaker": "Meredith Bandy",
"text": "Yes, we can hear you. Go ahead, Joel. Thanks."
},
{
"speaker": "Joel Jackson",
"text": "A couple of questions. So -- and maybe this is simple. I want to make sure that I understand. So when you talk about mid-April market pricing is what you're using for the rest of the year, are you talking about spot indice prices in the market? Or are you talking about so where we were mid-April? Or are you talking about the realized price that was going through your book in mid-April with your lags? And then what is that price level in mid-April that you are referring to?"
},
{
"speaker": "Scott Tozier",
"text": "Yes. So Joel, we're using the indices that are referenced in our contracts. So it's not just taking like the China spot or just 1 index where you're actually taking the actual indices that are referenced in our contracts as of mid-April, holding that flat and then calculating through the contract structures and the lags and caps and floors and all that kind of stuff to generate what that forecast is. And if you look at that as of mid-April to today, it's basically the same. So don't really move much in that time difference."
},
{
"speaker": "Joel Jackson",
"text": "Great. But that is the unlagged mid-April market indices price?"
},
{
"speaker": "Scott Tozier",
"text": "That's correct. That's correct."
},
{
"speaker": "Eric Norris",
"text": "Of course, there will be different in China versus outside China as well is a point yes. But it's -- as you know, they're very"
},
{
"speaker": "Joel Jackson",
"text": "It's a blank."
},
{
"speaker": "Eric Norris",
"text": "Yes. That's correct."
},
{
"speaker": "Joel Jackson",
"text": "Understood. Okay. Another question would be conversion margins have been negative for some months. And so like your actual business where you are buying spodumene, say, from Greenbushes -- excuse me, from Talison at the market price, that business of converting it is a negative margin business. I understand when you put the whole thing together, you're actually making money. But how do you think about that business that is negative? How does that change how you do things? And going forward, how do you think the mix of earnings mix of profitability should steady state out between conversion margins and spodumene production margins?"
},
{
"speaker": "Kent Masters",
"text": "We don't look at it that way. We're in the lithium business, and we're fundamental from the resource through to the salts that we sell to the customers, and we think of that as one business. And if the margin moves from one part of the business to the other, there are both ours, it's not that relevant to us."
},
{
"speaker": "Operator",
"text": "The next question is coming from John Roberts with Credit Suisse. You may proceed."
},
{
"speaker": "John Roberts",
"text": "Thank you. On your contracts that have caps and floors, do you expect to hit the floor on any contracts in 2023?"
},
{
"speaker": "Kent Masters",
"text": "I don't -- we've not disclosed that, right? We've not talked about specific contracts. I don't think we want to."
},
{
"speaker": "John Roberts",
"text": "Okay. And then second question. I know it's small, but can you remind us of the main limitations of sodium-ion batteries and why the range won't improve over time for them?"
},
{
"speaker": "Eric Norris",
"text": "John, it's Eric. Its sodium-ion batteries are just less energy dense and heavier on weight for this comparable energy density. So while it may fulfill maybe a city, low-range vehicle, and that could help ease some of the ability of the industry to meet electric vehicle demand given the shortness of lithium we see in our forecast, it cannot replace it in whole in any significant way. However, it could be a viable technology in grid storage. So it just has inherent limitations given the energy density and weight to energy benefits."
},
{
"speaker": "Operator",
"text": "Thank you, Mr. Roberts. The next question is from Chris Kapsch with Loop Capital. You may proceed."
},
{
"speaker": "Christopher Kapsch",
"text": "A couple of follow-ups. One is on the pricing discussion. Just trying to get a little bit more granular because it sounds like you have good visibility on volumes. And then the variability is going to come from the pricing assumptions. But you alluded to the sort of the bifurcation in hydroxide and carbonate prices. Can you get more explicit in sharing with us like where the assumption baked into your guidance is on each of those chemistries? Is it that $15 to $20 delta that you're currently baking in your revised guidance?"
},
{
"speaker": "Kent Masters",
"text": "Yes. So I think what -- I mean we're looking at the market as it is today or middle of April, right? And we're using those spot markets to guide us for the balance of the year by the different chemistry. So carbonate would inform -- the carbonate business and hydroxide would inform the hydroxide business. So we're holding them flat as they were in middle of April from an indices standpoint. And again, the index that are for our different contracts we talked about the main."
},
{
"speaker": "Christopher Kapsch",
"text": "Okay. And just to be clear, you have different indexes for both carbonate and hydroxide inside China and outside China?"
},
{
"speaker": "Scott Tozier",
"text": "That's right. Yes, we've got indices for the different products. You also have different countries, different regions, and some customers actually blend some of the indices. So it's a mix, right?"
},
{
"speaker": "Christopher Kapsch",
"text": "Makes sense. Got it. And then a follow-up just on the market intelligence about the nonintegrated converters shuttering in China. Just curious too, we had heard that. That's definitely the case with lepidolite. Just wondering if your commentary where you're talking about sort of more conventional SC6 feedstock users or for lepidolite or just across the board in terms of nonintegrated converters being uneconomic as where recent spot carbonate prices have been?"
},
{
"speaker": "Eric Norris",
"text": "Well, generally speaking, Chris, what we view lepidolite producers is tending to be more integrated producers from mineral resource of lepidolite all the way through conversion. Our comments on what we're seeing and who we'd be tolling with are obviously those who consume spodumene and who have to buy spodumene in the market to run their business. That's where our comments were focused on."
},
{
"speaker": "Christopher Kapsch",
"text": "Got it. Thank you."
},
{
"speaker": "Operator",
"text": "Our last question is from Ben Kallo with Baird. You may proceed."
},
{
"speaker": "Benjamin Kallo",
"text": "Thank you very much for filling me in. If you could give us some help on marginal cost of the industry and you guys point about being integrated, not how you look at the margin in mining versus conversion. But how do we think about the marginal cost of the overall industry? And any way you can frame that for us? Because I think that's the biggest question when what everyone is looking at price is like how low can it go? And if you're the cost leader, then you set that price theoretically? And then I have a follow-up."
},
{
"speaker": "Kent Masters",
"text": "Yes. So Eric can probably add details to this. But I would say, I mean we look at it and we think you should look at it our integrated producers are producers that are not integrated, and they probably set the marginal cost right, the ones that aren't integrated. So you spodumene price, you can see, for the most part, it's pretty transparent around that. And conversion on top of that to make a margin that -- those are the marginal producers when -- I guess it moves around depending on where spodumene sits, but you can see that and probably can determine that."
},
{
"speaker": "Eric Norris",
"text": "Yes, I'd just add, Ben, that as when the spodumene when the battery-grade carbonate price -- spot price in China on the various indices across from the 30s into the 20s, you started to see that pain. We started to hear more producers who are having trouble operating. You start to see even more activity within China to try to find ways to sort that from falling further. You could tell -- we could tell from the market sentiment that, that was a point of pain from any of these producers. And it substantiates what we've said for some time that prices need to be at least in the 20s for this industry to operate if not higher."
},
{
"speaker": "Kent Masters",
"text": "And then you see as new resources come on, right, and new technology comes to play, those could very well move out that cost curve as well as lower quality resources come to market with different technologies, that cost curve kind of it grows."
},
{
"speaker": "Benjamin Kallo",
"text": "Thank you. And then just on -- I think we see this already to some extent, but a bifurcation, if that's the right word, of pricing that comes out of China versus elsewhere? And then if you wanted to go elsewhere to specifically in the U.S., I know there's not a lot of volume that comes out of the U.S. But in your discussions, how much of a difference is that pricing across different regions and where -- whether it's spodumene or carbonate or what have you the difference in pricing based on region?"
},
{
"speaker": "Kent Masters",
"text": "Yes. So yes, China is a big part of the market. And historically, it's kind of set that -- all of those -- that pricing historically. I think as the other regions grow and we start shipping volume into other regions, that's going to change. And it will start bifurcating and being different around the world. But I would say now, it's kind of one market. It's kind of -- it looks like it's wanting to separate a little bit, but I would call it one still."
},
{
"speaker": "Eric Norris",
"text": "And it's particularly true then for carbonate, 70%, 80% of the world's carbonate is consumed in China. And so if China is destocking, that's going to have a disproportionate impact on carbonate in China."
},
{
"speaker": "Benjamin Kallo",
"text": "And so the IRA the intent of the RA to move supply chain out of China has started impacting the market pricing yet?"
},
{
"speaker": "Kent Masters",
"text": "Yes, there's no real consumption around that at the moment. But it's the speculation around it has started. But there's not a lot of volume shift that's changed since that law came into effect"
},
{
"speaker": "Operator",
"text": "That is all the time we have for questions. I will now pass it back to Kent Masters for closing remarks."
},
{
"speaker": "Kent Masters",
"text": "Okay. Thank you, and thank you all for joining us today. So it's clear we're a growth company that continues to provide added value to our markets. As a global leader in minerals that are critical to mobile, connected, healthy and sustainable future, we remain the partner of choice with customers and key stakeholders. Thank you"
},
{
"speaker": "Operator",
"text": "This concludes today's conference call. Thank you for your participation. You may now disconnect."
}
] | Albemarle Corporation | 18,671 |
ALB | 4 | 2,024 | 2025-02-13 08:00:00 | Operator: Hello, and welcome to Albemarle Corporation's Q4 2024 earnings call. I will now hand it over to Meredith Bandy, Vice President of Investor Relations and Sustainability.
Meredith Bandy: Thank you, and welcome, everyone, to Albemarle's Fourth Quarter 2024 Earnings Conference Call. Our earnings were released after the market yesterday, and you'll find the press release and earnings presentation posted to our website under the Investors section at albemarle.com. Joining me on the call today are Kent Masters, Chief Executive Officer; and Neal Sheorey, Chief Financial Officer. Netha Johnson, Chief Operations Officer; and Eric Norris, Chief Commercial Officer, are also available for Q&A. As a reminder, some of the statements made during this call including our outlook, guidance, expected company performance and strategic initiatives may constitute forward-looking statements. Please note the cautionary language about forward-looking statements contained in our press release and earnings presentation, which also applies to this call. Please also note that some of our comments today refer to non-GAAP financial measures. Reconciliations can be found in our earnings materials. And now I'll turn the call over to Kent.
Jerry Masters: Thank you, Meredith. For the fourth quarter, we reported net sales of $1.2 billion and an adjusted EBITDA of $251 million with year-over-year EBITDA improvements in all of our business segments. Turning to the full year of 2024. We achieved an adjusted EBITDA of $1.1 billion in line with our outlook considerations due to significant productivity and cost improvements, higher volumes and strong contract performance. Our Energy Storage segment delivered a 26% year-over-year increase in sales volumes, surpassing our initial guidance of 10% to 20% growth, driven by successful project ramps and increased spodumene sales. We also generated $702 million in cash from operations with an operating cash conversion rate exceeding 60%, which is above our target of 50% and in line with our long-term objective. Albemarle continues to act decisively across four key areas: optimizing our conversion network, improving cost and efficiency, reducing capital expenditure and enhancing financial flexibility. We'll touch on each of these areas in more detail later in the call. As part of these initiatives, today, we're announcing new measures to further optimize our global conversion network, including placing the Chengdu lithium conversion facility into care and maintenance by midyear of 2025 and shifting capacity at our Qinzhou lithium conversion facility somewhat from hydroxide to carbonate. As we did last year, we are providing our outlook based on a range of lithium market prices, including a new $9 per kilogram scenario and updated $12 to $15 per kilogram and $20 per kilogram scenarios. Compared to 2024, we have improved our outlook across these ranges due to our ongoing efforts to enhance productivity and reduce cost. Additionally, we have further decreased our full year 2025 CapEx outlook by an additional $100 million, we now expect to spend in the range of $700 million to $800 million. Thanks to these and other measures, we now have line of sight to achieve breakeven free cash flow in 2025. Now I'll turn it over to Neal, who will provide more details on our full year and fourth quarter performance, outlook considerations and market conditions. Then I'll conclude our prepared remarks with updates on our long-term competitive position, strategic framework and execution.
Neal Sheorey: Thank you, Kent, and good morning, everyone. I will begin with a review of our fourth quarter and full year 2024 performance on Slide 5. In the fourth quarter, we reported net sales of $1.2 billion, which represented a year-over-year decline primarily due to lower lithium market pricing. Fourth quarter adjusted EBITDA was $251 million, an increase year-over-year driven by improvements across all 3 businesses as well as reduced corporate costs. Note that last year's adjusted EBITDA included a $604 million lower of cost or market pretax charge. Earnings per share for the fourth quarter were $0.29. Adjusted earnings per share reflected a loss of $1.09, excluding gains on asset sales, reduced restructuring charges and discrete tax items. For the full year 2024, net sales were $5.4 billion, marking a year-over-year decrease primarily related to lower lithium pricing, partially offset by robust growth in lithium volumes. Full year EBITDA reached $1.1 billion, in line with our outlook considerations. Slide 6 shows the drivers of our year-over-year EBITDA performance. Our Q4 adjusted EBITDA of $251 million surpassed last year's result due to higher volumes, productivity and lower COGS. The EBITDA volume benefit was driven by higher volumes in specialties and the conclusion of the MARBL JV marketing agreement at the end of 2023. The COGS improvement was split between lower spodumene costs and reduced lower of cost or market adjustments. These benefits were partially offset by lower pricing and pretax equity income, mainly from reduced lithium and spodumene market prices. As Kent mentioned, adjusted EBITDA improved year-over-year in all 3 business segments, and we also reported lower corporate overhead costs. Moving to Slide 7. We present our outlook considerations for 2025. As we did last year, we are providing ranges of outcomes for our energy storage business based on recently observed lithium market pricing, including year-end 2024 market pricing of about $9 per kilogram lithium carbonate equivalent, or LCE, the first half 2024 range of $12 to $15 per kilogram LCE and the fourth quarter 2023 average of about $20 per kilogram LCE. Within each scenario, we have provided ranges based on expected volume and mix. We anticipate that energy storage volumes will be slightly higher year-over-year. All three scenarios reflect the results of assumed flat market pricing across the year in conjunction with Energy Storage's current book of business. These scenarios illustrate the improved stability of our Energy Storage business. Given our extensive resource positions worldwide and our cost and productivity actions, we can sustain margins even with lower year-over-year lithium pricing. Additionally, we have maintained significant operating leverage with potential to benefit if pricing increases. For example, if market pricing were to average $12 per kilogram LCE, similar to last year, we would expect to see margin improvement rising from the mid-20% range that we delivered in 2024 to the mid-30% range. Moving to Slide 8. We present modeling considerations for Specialties, Ketjen and Corporate. Specialties 2025 net sales are projected to be $1.3 billion to $1.5 billion with adjusted EBITDA of $210 million to $280 million. Ketjen's 2025 net sales are projected to be $1 billion to $1.1 billion with adjusted EBITDA of $120 million to $150 million. The Corporate outlook shows a planned decrease in capital expenditures, which are now expected to total $700 million to $800 million in 2025, down from $1.7 billion in 2024. Corporate costs in 2025 are expected to range between $70 million and $100 million. We are seeing the benefits of our nonmanufacturing cost improvements and the changes in our operating structure. Corporate costs in 2025 are expected to decrease year-over-year, excluding favorable FX and interest income in the prior year. Adding it all together, slide 9 presents Albemarle's comprehensive company roll-up for each energy storage market price scenario. Recall that the full year 2024 included approximately $100 million of pretax equity income from onetime additional offtake by our JV partner at Talison. Notably, assuming a consistent average lithium market price of $12 per kilogram LCE in 2025, we expect cost and productivity improvements to more than compensate for the reduced equity earnings. Turning to Slide 10 for additional outlook commentary by segment. For Energy Storage, we anticipate volumes to be slightly higher year-over-year primarily due to the ongoing ramp of the Salar yield improvement project in Chile. In addition, we continue to ramp our conversion sites, including Meishan and Kemerton, which helps improve fixed cost absorption and result in reduced tolling volumes. Last year, we indicated that about 2/3 of our lithium salts volumes were sold on contracts, including both long-term agreements with floors and other contracts. For 2025, we've indicated that 50% of our lithium salts volumes are sold on long-term agreements with floors. This number now excludes other contracts to help simplify modeling. Our contracts continue to perform, and we have no significant contract renewals this year. We continue to have additional sales on contracts with volume commitments, giving us greater confidence in our volume expectations for this year. We foresee a modest volume-led recovery in Specialties year-over-year driven by strength in pharma, autos and oilfield applications. Finally, in Ketjen, we expect modest improvements in 2025 results related to product mix, cost and productivity improvements and continued execution of our turnaround plan. Please refer to our appendix slides in the deck for additional modeling considerations across the enterprise. Turning to our balance sheet and liquidity metrics on Slide 11. We concluded the fourth quarter with available liquidity of $2.8 billion predominantly comprising $1.2 billion in cash and cash equivalents and the full $1.5 billion available under our revolver. The measures we have implemented to enhance our cost structure and operational efficiency have also increased our financial flexibility. As a result of our proactive actions to reduce costs and optimize cash flow, we ended Q4 with a net debt to adjusted EBITDA ratio of 2.6x, favorable to previous expectations. For additional information on covenants, please refer to the appendix. We have a single upcoming maturity, which is our EUR 372 million Euro notes at 1.125% 8 percent due in November of this year. Given the favorable rate, there is no immediate urgency to refinance, and we continue to evaluate our options for managing this maturity. Slide 12 shows our focus on execution and converting our earnings into cash, evident in improved operating cash flow conversion due to operational discipline and cash management. For 2024, operating cash conversion was 62%, surpassing our target of 50% and aligning with our long-term target range. This was driven by increased Talison dividends from higher Greenbushes sales volumes and inventory and cash management improvements across operations. Looking to 2025, we expect our cash dividends from Talison in the year to remain below historical averages as Talison completes the CGP3 project at the Greenbushes mine. Nonetheless, we expect operating cash flow conversion to exceed 80% in 2025, above our long-term target range, due to ongoing working capital improvements and a $350 million customer prepayment. This prepayment relates to a recently signed contract for delivery of spodumene and lithium salts over the next 5 years at market index prices. As you see here, our efforts to enhance operating cash flow and cash flow conversion are paying off. This focus is evident in our free cash flow expectations this year. We now have line of sight to breakeven free cash flow through new capacity ramp-ups, inventory management, bidding events, cost and productivity measures and other cash conversion enhancements. Turning to Slide 13. I will provide some comments on the current conditions of the lithium market. We are in the process of updating our longer-term supply-demand forecast in light of recent policy and market developments. We expect to provide a more comprehensive update with our first quarter results. Lithium remains crucial to the energy transition and the long-term drivers of our business remain strong. The global energy transition is undoubtedly progressing. It is a matter of when, not if. In 2024, electric vehicle registrations increased by 25% year-over-year. Sales reached a new quarterly record in Q4 with December achieving all-time highs for both BEVs and PHEVs. Sales are influenced by customer preferences and the availability and cost of different models. As early as next year, we anticipate that consumers will find EV prices comparable to those of internal combustion engine vehicles. Global battery costs have fallen below the critical $100 per kilowatt hour pack average, which supports the relative EV affordability. Plus, EVs represent only a portion of the broader picture. Grid storage demand is also performing exceptionally well, increasing by nearly 50% year-over-year in 2024 driven by installations in the United States and China. Grid storage demand now constitutes nearly 20% of global lithium demand, up from less than 5% a few years ago. On the supply side, there have been several announced curtailments both upstream and downstream. Nonintegrated hard rock conversion remains unprofitable and larger integrated producers are facing pressure. Our estimates of pressure on the global cost curve are unchanged. We think that at least 25% of the global resource cost curve is either at or below breakeven. Slide 14 details 2024 global EV growth by region. China's demand was the key global driver by far, with demand increasing 37% year-over-year driven by balanced subsidies for battery EVs and plug-in hybrids. China now represents about 65% of the market demand. Europe had the weakest demand due to reduced subsidies and economic challenges, but potential price cuts and emissions targets may boost growth in 2025. North America grew 14% year-over-year with U.S. trends improving due to more model availability and affordability. Overall, these trends reinforce confidence in the industry's long-term growth potential but continue to highlight that the regional dynamics are important factors to consider as the industry expands. I'll now hand it back to Kent.
Jerry Masters: Thank you, Neal. Moving on to Slide 15. I will discuss the major initiatives we are implementing to reset our cost structure. These measures will enable us to sustain our leadership position and be competitive across the cycle. Moving to Slide 16. It is essential to place our recent initiatives within the context of the measures we have been implementing over several quarters as we navigate the current business environment. This year, we are optimizing our conversion network, including new actions at Chengdu and Qinzhou, improving cost and efficiency with significant progress toward our $300 million to $400 million target for cost and productivity improvements, reducing capital expenditures as we refine our 2025 execution plans and enhancing financial flexibility. Taken together, we now have greater confidence in our ability to achieve breakeven free cash flow as early as this year at current price levels. Our initiatives are comprehensive and designed to sustain our long-term competitive advantages in response to market conditions. As the dynamic environment persists, we are continually adding to our list of potential actions so that we can adapt as necessary. Turning to Slide 17 for additional details. The shifting market underscores the need for a globally diversified conversion network with product flexibility. As previously mentioned, we are optimizing production from both our carbonate and hydroxide assets. achieving record production at the La Negra lithium carbonate plant in Chile and the Meishan lithium hydroxide plant in China. As we have reviewed our conversion network for improvement opportunities, we have made the decision to place our Chengdu plant on care and maintenance due to market conditions and shifting product mix. Chengdu is a relatively small plant with a capacity to produce approximately 5,000 tons of lithium hydroxide annually. We will continue to service those customers through the ramp of newer, larger plants in Chile, China and Australia. This approach will enable us to provide high-quality secure supply to our customers while driving network efficiencies and better leveraging our scale. Moreover, we have identified a highly capital-efficient project at Qinzhou to shift conversion capacity partially from hydroxide to carbonate in response to strong market demand. In Australia, performance of our Kemerton lithium hydroxide facility continues to improve, and the site recently commenced its first battery-grade commercial sales. On the resources front, we are focused on preserving and maximizing the value of our advantaged low-cost resources. The Salar yield improvement project has exceeded a 50% operating rate milestone and is progressing towards nameplate capacity. We are leveraging our brine expertise, for example, in hydro geological mapping, to maximize recoveries at every stage of the resource. At Greenbushes, CGP3 is expected to produce its first ore in the fourth quarter of 2025, providing additional feedstock for increased lithium salts volumes in 2026. The Talison team, together with our JV partners, has undertaken technical studies to optimize Greenbushes' operation over the life of the mine. Please refer to Slide 18 for more details on cost and capital considerations. We've achieved over 50% of the $300 million to $400 million cost improvement announced the last quarter as we moved quickly to execute on our plans. Our goal is to reach a full run rate by year-end, possibly sooner. Additionally, we're reducing 2025 capital expenditures by $100 million to $700 million to $800 million, down more than 50% from 2024. This result stems from a more detailed review of our projects. Full year 2025 CapEx will focus on core assets with priorities on health, safety, environmental improvements and cost reductions. Moving to Slide 19. The actions being taken are intended to preserve Albemarle's competitive advantages and position the company for long-term value creation as outlined by the strategic framework on Slide 20. Our strategic framework continues to guide how we operate Albemarle as we lead the world in transforming essential resources into critical ingredients for modern living. Our vision is still the same. We want to lead with impact and be purpose-driven. The markets we serve are unchanged. Both of our core businesses have enormous secular growth opportunities across mobility, energy, connectivity and health, including the energy transition, electrification, population growth and shifting demographics. I want to feature on that next row of boxes, which highlights our strategic and competitive advantages. And they're highlighted in more detail on Slide 21. First, our industry-leading resources are unmatched with large-scale, high-grade and therefore low-cost assets. This core advantage is enhanced through our innovation and advanced process chemistry capabilities. We've used this for growth in the past and now are increasingly aiming these capabilities toward cost savings and incremental growth opportunities. Customer centricity is key. We stay focused on both the customer and end user, integrating from the resource to the final product. Close collaboration with customers lets us understand market trends and technology shifts, allowing us to adapt in our dynamic markets. We continue to get positive feedback that our customers seek to work with Albemarle for our capabilities, scale and reach. Lastly, our commitment to people and planet stewardship is fundamental. It underscores our value proposition by supporting our team and promoting sustainability across all our business lines and in the communities where we operate. There is no question that while our strategic framework has not changed, our execution has certainly adapted. We have implemented several key initiatives to enhance our operational efficiency and agility. Our commitment to innovation is evident in the strategic investments we have made in research and development. We are exploring cutting-edge technologies and sustainable practices to ensure that we remain at the forefront of the industry. This includes developing next-generation polymeric flame retardants and optimizing lithium conversion to meet shifting market demand. Innovation is also core to preserving our resource advantage with projects like the Salar yield improvement project in Chile and an innovative process upgrade in Jordan that we call NEBO, both of which allow us to increase production more sustainably without incremental brine pumping. We're also driving out cost and reducing capital intensity. For example, by leveraging advanced data analytics and digital tools, we are improving our ability to monitor and optimize production processes in real time. Throughout these changes, we remain dedicated to safety, sustainability and operational excellence, aiming to create long-term value for our stakeholders while fostering a more sustainable future. In summary, on Slide 23, Albemarle delivered solid 2024 performance while acting decisively to preserve long-term growth optionality and maintain the company's industry-leading position through the cycle. Our full year 2025 company outlook considerations build on the progress we've made to drive enterprise-wide cost improvements, strong energy storage project ramps and contract performance. We are focusing on taking broad-based proactive steps to control what we can control and ensure we are competitive across the cycle. Albemarle remains a global leader, and I am confident we are taking the right actions to maintain our competitive position and to capitalize on the long-term secular opportunities in our markets. I look forward to seeing some of you face-to-face at upcoming events listed here on Slide 24. And with that, I'd like to turn the call back over to the operator to begin the Q&A portion.
Operator: [Operator Instructions] Our first question is from Patrick Cunningham at Citi.
Patrick Cunningham: I guess my first question is on the contract mix. That remaining 50% piece not on long-term agreements, should we assume most of those follow spot mechanisms? And then was there any significant tranche of those long-term agreements that came up for renegotiation recently and had any respective reset in floors?
Jerry Masters: Yes. So your comment about the other 50% pretty much at index is -- that's a good assumption. And the shift that we've moved, I mean, we've reported previously that it was about 2/3 on contracts. So now we're reporting contracts only with floors. We had some long-term contracts that didn't have floors, and we pulled that out of that definition now. So that 50% has floors. I don't think we've had any we renegotiated in the near term recently or that have come up.
Patrick Cunningham: Understood. That's helpful. And if I'm reading the chart correctly, it seems like most of the CapEx reduction was CapEx previously devoted to the resource base. So where are you cutting back investments in resources? And given the current program, how quickly can you repossession and invest in additional brownfield to maybe support higher volume growth 2027 and beyond?
Jerry Masters: Yes. I'm not sure that's right. I mean, if you go back, I mean, the capital we pulled back a lot of it was conversion initially, and then we've gotten a little bit more focused, and we have pushed out on some resources and we're getting very focused on kind of the highest-quality, lowest-cost resources and we're not out pursuing as many resources as we were at one time. So I think the big piece, if you look at the capital that we've cut from our plans, a big piece of it was on conversion, at least initially. And then now we're getting a little bit more focused on operations, sustaining capital, and we have to cut back on resources as well. And I think, I mean, we've said a number of times that we can -- we think we can grow at 15% kind of a CAGR over a period from '22 to '27. And we start running out of the theme a little bit. So those growth rates come down after '27. And a lot of that -- most of that is about resource.
Operator: Our next question is from Rock Hoffman with Bank of America.
Rock Hoffman Blasko: Could your actions including cutting CapEx and placing Chengdu under care and maintenance influence the broader market? And how might your actions adjust further if pricing stays at the low end of the scenario analysis?
Jerry Masters: So I think you said do we think our actions at Chengdu will influence the market. So no, it's -- I don't think so. I mean, we're doing that because of market conditions and product mix. So we have an opportunity to shift some product from hydroxide to carbonate at Qinzhou. And Chengdu is one of our smallest facilities, which is why it's probably not that -- wouldn't influence the market that much. And then we make up that capacity because we're still ramping other larger assets at Xinyu, Qinzhou as a small investment and then Meishan and Kemerton as well.
Rock Hoffman Blasko: Got it. And would you be able to explain the wide range in the tax guide for 2025?
Neal Sheorey: This is Neal. Yes, so the wide range is really driven by the variety of scenarios that we have on the page or in the deck here. One of the reasons why we had kind of an odd tax rate in the fourth quarter and really in 2024 overall is that, as you've seen over the last few quarters, we've been reporting losses in a couple of jurisdictions where we took tax evaluation allowances. So therefore, we didn't get to recognize the tax credits in our tax expense line. Those two jurisdictions in particular are China and Australia, where we have some particulars that require us to take those tax valuation allowances. So why there's a wide variety on the tax ranges, it's really about where the lithium price is and that influence on our pretax income. Obviously, at the lower end of the range, what our guidance has said is go to a tax rate very similar to what we did in 2024. And if you're at the higher end of the range, you kind of come more to our run rate kind of statutory rate that we have based on our geographic mix.
Operator: Our next question is from Ben Isaacson from Scotiabank.
Apurva Kilambi: This is Apurva on for Ben. So you've discussed the line of sight to being free cash flow breakeven in 2025. So is that -- is achieving that really just the case of all the dominoes falling in place? Is there anything that could put this at risk beyond just pricing collapsing?
Jerry Masters: Well, I just -- we have to execute against our plan, right? So that is our plan to do that. We have to execute against that. And pricing would be one of those. But we have -- look, they're a pretty aggressive plans. You see the actions that we've taken. We think we've executed pretty well against it so far. So -- but we just need to execute to accomplish that.
Apurva Kilambi: Perfect. And then as a follow-up, at this stage, with all of the kind of revised plans that you've laid out, do you foresee any need for a capital raise in 2025? And if so, is there any sense of what magnitude or what form that could look like? I know last year, you folks did the preferred convertibles. Is that kind of no longer in the picture given all of these actions that you've planned?
Jerry Masters: Yes. So we're taking all these actions so we don't do that, right? So -- and we are -- again, that we have to execute against that but we see ourselves being free cash flow positive through the year, and we don't have plans to do an equity raise.
Operator: Our next question is from David Begleiter from Deutsche Bank.
David Begleiter: Kent, on your realized lithium prices in Q4, what was the difference in spread between your spot sales and your contract sales?
Jerry Masters: So we don't normally report on the exact pricing and particularly on our contract piece. So I'm going to decline to respond to that.
David Begleiter: Understood. I believe back in Q4, you were saying that roughly 10% to 12% of global lithium supply was shut down and curtailed due to lower prices. Is that still a good estimate? Or has it moved up since then?
Jerry Masters: Yes. So I think we were saying about 25%, we believe, is underwater. And we still think that's the case.
David Begleiter: But how much is actually curtailed or shut down?
Jerry Masters: Yes. So probably about -- it's about half of that 25%, I would say. And I think that both those numbers still hold.
Operator: Our next question is from Jeff Zekauskas from JPMorgan.
Jeffrey Zekauskas: On Slide 7, where you provide different scenarios, is the meaning of this slide that you're -- if there were no change in lithium prices today, the energy storage adjusted EBITDA would be between $0.6 billion and $0.7 billion? Or because of your contract prices, it's more complicated than that?
Neal Sheorey: Jeff, this is Neal. I think my answer is probably going to be towards the latter part of how you described it that, look, the prices that you see at the top of that slide are observed market prices, not our price -- what our realized prices are but market prices. The numbers below that then is if you take those market prices and move that through our book of business, you get these kinds of EBITDA ranges.
Jeffrey Zekauskas: Okay. Great. And then what you do on the right-hand column is you have some assumption, and you say we assume spodumene market pricing average is 10% of the LCE price. But aren't spodumene prices already below that? And you say you assume full Talison sales volumes. Are you currently receiving full Talison sales volumes? And what does that mean? What has to happen for you to receive full Talison sales volume?
Neal Sheorey: Yes, Jeff, let me take the second one. What we mean by full Talison sales volumes is that all the partners at Talison are taking their full allocation. That is the assumption that we've made. That hasn't always been the case if you go back over the years, but our assumption going forward is that's the case. As -- where I sit right now promptly is that is also the case right now. We're taking our full allocation in this environment. With regards to the spodumene average of 10% of LCE price, look, to your point, it has moved around over time, anywhere from -- in the 5% to 10% kind of range. So what we wanted to do was at least just put a mark in, in terms of how we've done these considerations, and we picked 10% because that was something that we sort of recently observed in 2024. But to your point, it can and it does shift around with the market dynamics.
Operator: Our next question is from John Roberts at Mizuho.
John Ezekiel Roberts: I believe IGO guided for essentially flat 2025 volume at Greenbushes. Can you confirm that? And then where is your growth, the 5% to 10% growth for 2025 coming from?
Eric Norris: John, it's Eric. That's correct. CGP2 was fully utilized, which was the last expansion at Talison in 2024. CGP2 does not come on until the very end of this year. So there is no growth capacity at Talison until that comes on. That's sort of the, as you know and appreciate the lumpy nature of bringing on capacity. Our 0% to 10% guidance on growth is all coming out of Chile, where the Salar yield project continues to ramp and drives debottlenecking effectively over the La Negra plant to march towards nameplate.
John Ezekiel Roberts: And then on Slide 18, you're targeting sustaining CapEx of 4% to 6%. Is the percent of sales the right way to think about targeting sustaining CapEx given the volatility that you get in pricing?
Jerry Masters: Yes. So we -- that's the right point. So we -- and we say that on a stabilized market, right? So -- and it's aspirational at the moment for us because we're not there, but we're also at what we think is the bottom of the market. So it's a good benchmark. We say a mid-cycle pricing is where we go to that. We're not at that level today. We still have some work to do around that. But we're getting focused on it and we wanted to have a benchmark out there that we can aim at.
Operator: Our next question is from Joel Jackson from BMO Capital Markets. .
Joel Jackson: I want to follow up a little bit on Ben's associate's prior question. So can you talk about what -- if you go to 2026, how much of the half of your sales here that are contracted floors? Do we expect the floors have to be negotiated? And how do you think about the balance sheet leverage if spot prices stick around where they are and we are renegotiating floors for 2026?
Jerry Masters: Yes. So look, we provided guidance for '25, not '26. But the way our contracts work is they don't -- and they don't usually end and then get renegotiated. They get adjusted over time as our customer wants something, we want something, they have adjusted. That's how they worked over time. And we expect that to happen. You see our portfolio of contracts has become a little bit more spot oriented in the recent past. That's because China is the biggest market. It's a spot market. It's growing. We've got new capacity coming on there with Meishan ramping. So that's really why that has shifted. Our contracts simply don't just come to an end. We negotiate terms somewhere along that and extend them out a year or two, and we've done that over time. And I suspect that's how it's going to play out going forward.
Joel Jackson: Okay. And then talking about 0.25% -- in your estimates 0.25% of lithium supply is underwater, maybe half of that's curtailed. We just -- it seems like CATL is bringing back lepidolite production in the last bunch of weeks. There's some maybe some rational behavior going on, although those mines are downstream with cathode and the battery. So I mean it seems like there are actors in this industry that are maybe manipulating price, maybe don't have the same objectives as Albemarle and other public companies. I mean, how do you act in this market? And is there any hope for material recovery if such behavior by such actors continue?
Jerry Masters: Okay. So I don't know if I can comment on all of that. I would say that we're pretty focused on making sure we can compete at the bottom of the cycle. And so when you see us taking actions and have targeted at that. So the capital that we pulled back on our growth to reduce capital as a result of that, driving cost out of the business, getting more focused on cost, not as much on growth and making sure that we can compete at that cycle and then pivot when the market comes back to take advantage of more growth and higher prices. So that's the approach that we're taking.
Operator: Our next question is from Vincent Andrews with Morgan Stanley.
Vincent Andrews: I wanted to follow up on the $350 million customer prepayment. And just a clarifying question to start off with, which would be, I assume that's included when you talk about the 80% conversion as well as being free cash flow neutral this year. I assume you're including the $350 million. And all else equal then, does that mean next year cash flow would be $350 million less?
Neal Sheorey: So Vincent, on the -- this is Neal. On the first part of your question, you are correct. So the $350 million is included in our cash conversion number of 80% for 2025. And with regards to looking over to 2026, let me just give you maybe two things to think about here. You are correct that, that $350 million won't recur again in 2026. But also remember that there are a lot of other things from a cash standpoint that will actually start to benefit us in 2026 and beyond. One of the key ones that I'll point out is that from a Talison JV perspective, right now they're obviously going through a large investment program. That program is going to be done at the end of this year. So we would expect, even in this low environment, as you would expect, Talison is a very competitive asset. So we would expect a return to dividend payouts from the JV as we get into 2026.
Vincent Andrews: And then just as a follow-up on your cash flow statement, for starters, thank you for the increased disclosure on working capital. But I have a reconciliation question. You have a new line item that says inventory net realizable value adjustment. And this year, it's a negative $500 million. Last year, it was a positive $604 million. So I'm just wondering, does that line reconcile somewhere else within cash flow from operations? Or what is that? Or any more detail you can provide would be helpful.
Neal Sheorey: Yes. So that line, Vincent, is predominantly going to be a reflection of the lower of cost or market adjustment that we took in fourth quarter of 2023. And so that's why you see those adjustments, and so that's the best -- the most of that line is related to that.
Operator: Our next question is from Aleksey Yefremov from KeyBanc.
Aleksey Yefremov: If you look at your CapEx, you're talking about maintenance level. Assuming market prices don't change, can you get to that maintenance level in 2026? And would you be willing to do so under these conditions?
Jerry Masters: Yes. So I'm not going to make a commitment for capital for '26. But those are -- our aspirations is that we want to get to like maintenance capital at that particular level. So we still have in our capital opportunity -- growth opportunities, say, growth or cost saving opportunities, smaller investments. So the Qinzhou investment that we talked about on the call is a good example of that, low single-digit millions of dollars. We were able to shift from hydroxide to carbonate about 10,000 tons a year. So that -- and that's great return project and pretty low capital. So we continue to look for those. Those tend to be more focused on cost savings now and maybe incremental growth, like what we're doing at Qinzhou. But the 4% to 6% at mid-cycle, that's an aspiration that we work to, and we continue to focus to try and drive to that. Whether we get there in '26 or not, we've not laid out plans in that detail for '26, so I can't answer that.
Aleksey Yefremov: And on CGP3, it's an important project for your cash flow this year and next year especially. Any comments on risk assessment for delays, cost overruns, that kind of thing? Like how is the project going from your point of view?
Jerry Masters: Yes. I think we're on schedule and around budget. I don't know exactly whether we're right on budget or not, but it's pretty close from a budget and a schedule perspective.
Operator: Our next question is from Kevin McCarthy at Vertical Research Partners.
Kevin McCarthy: Kent, you talked a little bit about the grid storage growth in your prepared remarks. Can you comment on your outlook for 2025 in that end market? And is your share in grid storage higher or lower or about the same as it is in your customers in the EV arena?
Jerry Masters: Yes. So the grid storage has been one that's been a positive surprise for us for a few years now as it's been growing. I think it was up almost 50% this year. And we anticipate that continuing to grow. And a couple of years ago, we probably would have thought lithium may not be the best solution for grid storage, but I think the way battery costs have come down and the popularity of LFP, it looks like grid storage is going to be lithium-based and LFP-based going forward. So it's a good opportunity. And it's on -- it's kind of, I think, everywhere. So the U.S. is starting to play out. You see that in Europe, and then China has been really strong around that. So it's a positive. It's a bright spot and it's offset a little bit of the little less growth that we saw in EVs and some of the shifts between plug-in hybrids and BEVs as well. So it's covered that and build in nicely.
Eric Norris: And Kevin, as for the market share, first of all, it's largely an LFP market. So if you look at our share in LFP on EVs, PHEVs, et cetera, can be similar to our share in grid storage. It's the same companies. It's deepened back into the supply chain that are providing the cathode and battery materials into that. So that's what determines our share of those relationships, not necessarily the end markets.
Kevin McCarthy: Understood. And then secondly, if I may, Kent, as the tariff regimes continue to evolve here. Are you managing the company any differently today than you were last year as it relates specifically to tariffs?
Jerry Masters: So are we managing the company differently? Look, we're paying very close attention to see what happened. It's evolving. I'm not sure, no one knows exactly what the final impact will be. But the direct impact on Albemarle is not going to be that significant. I mean, we're not -- we don't ship from China to the U.S., I mean, significantly. There is some, but it's not a big part of our business. It will impact our customers more than it will impact us directly. So the knock-on effect of us is some -- is what we're really paying attention to.
Operator: Our next question is from Laurence Alexander from Jefferies.
Laurence Alexander: So a couple of questions. First, on Energy Storage, how much of your capacity is under long-term contract compared to the EV market?
Jerry Masters: Laurence, I'm sorry, you said -- that was a fixed storage question?
Laurence Alexander: The Energy Storage side of your business, how much of that is under long-term contract? .
Jerry Masters: It's about 50%.
Eric Norris: Yes, it's the same, Laurence. Yes, the other 50% -- we talked about 50% being under floor-based contracts. The 50% that's not is the pricing mechanism of spot in the contracts. It's a mix of contracts that are shorter in duration and spot.
Jerry Masters: Okay. Sorry. Just to clarify there. So what we -- when we said the 50%, so those are long-term agreements, and we have floors on those agreements. There are some other longer-term agreements, we don't have floors. So we're now categorizing that in the same category as spot.
Laurence Alexander: Okay. Perfect. For the $350 million of cash inflows, just to be clear, if -- would the net effect be that the EBITDA related to that would show up in 2026 or '27 but then the cash conversion suffers? Or is there also an EBITDA -- is there also an impact on the EBITDA bridge?
Neal Sheorey: Yes. Laurence, I think you're circling on kind of the right mechanism here. So we have taken the prepayment upfront and already received it here in the first quarter. You'll see that with our first quarter results. And then we satisfy our obligation through product deliveries over actually the next 5 years. So -- and that's at prices that are indexed to market. So you are right. We will then recognize EBITDA in increments as we make those deliveries, but it is over the course of the next 5 years.
Operator: Our next question is from David Deckelbaum at TD Cowen.
David Deckelbaum: I was hoping to follow up just on the plans at Qinzhou to convert some of the capacity to carbonate versus hydroxide, mainly just being is this decision really just to capture the discrepancy in margin? Or do you have very differentiated views now over time on just the appetite for hydroxide? Are you seeing customer resistance for hydroxide volumes in the market and then you're seeing this pivot as a necessity to sell product at this point? And are there further plans? Should we expect further plans to pursue more conversion from hydroxide to carbonate?
Jerry Masters: Yes. So look, it is -- I mean, the hydroxide, there's a market hydroxide, it's growing. Carbonate is growing faster. So there's a stronger demand for carbonate. And this was kind of a unique opportunity for us because the plant was designed in this way. And we had -- there's a few things we have to execute against to take advantage of that. It's very small capital, as I said before. It's low single-digit millions in order to make that shift. It gives us more flexibility in the market. The market is stronger around carbonate now, so we can take advantage of that. Over time, we can shift this back either way. Once we make this investment, we'll be able to go -- we could go back to hydroxide if we wanted to or stay on carbonate. At the moment, it makes more sense to be on carbonate. It's about the market and the fact that this was designed in upfront, and we had to kind of finish some work in order to leverage the capability.
David Deckelbaum: If beyond sort of this year and the next you wanted to lean more heavily into carbonate, is there tolling capacity available in China that would enable you to do that? Or would that have to be a more significant investment on your part?
Jerry Masters: No, there's tolling capacity that's available and that -- we've taken advantage of that in the past, and it gives us flexibility in our supply chain. And then the growth you see from us in Chile as well at La Negra has allowed us to grow with that market, particularly around kind of on the back of the work at La Negra, but particularly Salar yield in the Salar.
Operator: Our next question is from Benjamin Kallo with Baird.
Ben Kallo: I wanted to follow up to an earlier question and maybe frame it just slightly different. There's capacity coming off-line, utilization going down and demand going up for EVs even at a slower rate than maybe we predicted a couple of years ago. At the same time, with all of that happening, which should indicate prices going up, prices have been coming down. So can you talk to anything to help us understand what that is and then anything that would change that? And then my follow-up question is, I do see a lot of reports around recycling in China. It seems like that's becoming a bigger industry there. I'm just wondering your thoughts around the impact of that on pricing as well.
Jerry Masters: Yes. So there are a lot of moving pieces in your question, but also in the market, right? So it is -- I mean, there's capacity that has come off, higher cost capacity. There is new capacity that has come on. There's excess conversion that sits in China as well. And then the recycling part. I mean, recycling has been growing over time. We actually -- with prices come down, we've seen recycling drop off a little bit in China because it's just not economic given where prices are for new material. All of that is going to work its way -- has to work its way through the system. It's a dynamic market. It's hard to say. But I would anticipate higher cost assets coming out, particularly. We've got -- we're still growing. This market is still growing 20% plus, right? So it's just not quite as high growth rates as we had anticipated, but it is still growing significantly. And China is the main driver of that, but North America and Europe are kind of coming from there. So there's going to be growth in this market for a long period of time. Capacity comes on in chunks and you get an imbalance, prices are going to be down. I don't know if I can explain it more than that. It's a very opaque market and particularly because a lot of it happens in China, but it is -- it relies basically on the supply/demand.
Operator: Our next question comes from Josh Spector with UBS.
Joshua Spector: I wanted to just ask on the prepayment that you got. Is there any requirement there to make further investments or some preemptive expectation around CapEx spending? Or was that just something you decided to do given your needs for cash and the customer focus on volumes?
Neal Sheorey: Yes. Josh. No, there's no further requirement on our side. We have everything we need to be able to satisfy that contract. And I would just say the last part of what you said, I'd say it a little bit differently. We have discussions with customers all the time. We've done these kind of prepayments actually in the past, and this was just a unique opportunity that came across our desk. And it was one that we went after. So I think it's just a sign of how we work with our partners in many different ways.
Joshua Spector: Understood. And I guess just to follow up on some prior questions, so specifically with the CATL restart, I've heard some mixed things around supply maybe being temporarily tighter versus their cost being more in line, I guess, closer to where the market prices have moved towards driving their restart. Do you guys have any view internally about why that's happening against the low price environment?
Jerry Masters: No. Look, I would say, I mean, look, we'd modeled more lepidolite coming in. So we weren't exactly targeting this particular asset, be the one that came back on. But we had lepidolite volume. China it's a strong market. It's growing. They're short of resource, not surprising. They're trying to get more domestic resource. So I think it's -- I think it's no more complicated than that.
Operator: Our last question comes from Andres Castanos from Berenberg.
Andres Castanos-Mollor: Of the 2025 lithium volumes, how much of it would be spodumene sales and how much would be lithium salts sales? Are there any significant tolling volumes left?
Jerry Masters: So I don't have that split, but it's mostly salt, right? There's -- the spodumene sales that we do are really more for transparency in the market, understanding that. We do sell some of that, other than we've shifted a little bit from a prepaid perspective. There's spodumene in that. There's not a lot of that in '25.
Eric Norris: Yes. It's under 10%, 15% of total LCEs this year roughly in that order of magnitude. It's basically the production coming out of Wodgina.
Operator: Thank you. That's all the time we have for questions. I will now pass it back to Kent Masters for closing remarks.
Jerry Masters: Okay. Thank you, operator. In conclusion, Albemarle's strong operational execution and strategic framework have positioned us to successfully navigate dynamic market conditions and maintain our long-term competitive edge. We are dedicated to delivering value for our stakeholders and driving sustainable growth. Thank you for joining us today, and we look forward to continuing on our journey together. Stay safe and take care.
Operator: This concludes today's conference call. Thank you for your participation. You may now disconnect. . | [
{
"speaker": "Operator",
"text": "Hello, and welcome to Albemarle Corporation's Q4 2024 earnings call. I will now hand it over to Meredith Bandy, Vice President of Investor Relations and Sustainability."
},
{
"speaker": "Meredith Bandy",
"text": "Thank you, and welcome, everyone, to Albemarle's Fourth Quarter 2024 Earnings Conference Call. Our earnings were released after the market yesterday, and you'll find the press release and earnings presentation posted to our website under the Investors section at albemarle.com. Joining me on the call today are Kent Masters, Chief Executive Officer; and Neal Sheorey, Chief Financial Officer. Netha Johnson, Chief Operations Officer; and Eric Norris, Chief Commercial Officer, are also available for Q&A. As a reminder, some of the statements made during this call including our outlook, guidance, expected company performance and strategic initiatives may constitute forward-looking statements. Please note the cautionary language about forward-looking statements contained in our press release and earnings presentation, which also applies to this call. Please also note that some of our comments today refer to non-GAAP financial measures. Reconciliations can be found in our earnings materials. And now I'll turn the call over to Kent."
},
{
"speaker": "Jerry Masters",
"text": "Thank you, Meredith. For the fourth quarter, we reported net sales of $1.2 billion and an adjusted EBITDA of $251 million with year-over-year EBITDA improvements in all of our business segments. Turning to the full year of 2024. We achieved an adjusted EBITDA of $1.1 billion in line with our outlook considerations due to significant productivity and cost improvements, higher volumes and strong contract performance. Our Energy Storage segment delivered a 26% year-over-year increase in sales volumes, surpassing our initial guidance of 10% to 20% growth, driven by successful project ramps and increased spodumene sales. We also generated $702 million in cash from operations with an operating cash conversion rate exceeding 60%, which is above our target of 50% and in line with our long-term objective. Albemarle continues to act decisively across four key areas: optimizing our conversion network, improving cost and efficiency, reducing capital expenditure and enhancing financial flexibility. We'll touch on each of these areas in more detail later in the call. As part of these initiatives, today, we're announcing new measures to further optimize our global conversion network, including placing the Chengdu lithium conversion facility into care and maintenance by midyear of 2025 and shifting capacity at our Qinzhou lithium conversion facility somewhat from hydroxide to carbonate. As we did last year, we are providing our outlook based on a range of lithium market prices, including a new $9 per kilogram scenario and updated $12 to $15 per kilogram and $20 per kilogram scenarios. Compared to 2024, we have improved our outlook across these ranges due to our ongoing efforts to enhance productivity and reduce cost. Additionally, we have further decreased our full year 2025 CapEx outlook by an additional $100 million, we now expect to spend in the range of $700 million to $800 million. Thanks to these and other measures, we now have line of sight to achieve breakeven free cash flow in 2025. Now I'll turn it over to Neal, who will provide more details on our full year and fourth quarter performance, outlook considerations and market conditions. Then I'll conclude our prepared remarks with updates on our long-term competitive position, strategic framework and execution."
},
{
"speaker": "Neal Sheorey",
"text": "Thank you, Kent, and good morning, everyone. I will begin with a review of our fourth quarter and full year 2024 performance on Slide 5. In the fourth quarter, we reported net sales of $1.2 billion, which represented a year-over-year decline primarily due to lower lithium market pricing. Fourth quarter adjusted EBITDA was $251 million, an increase year-over-year driven by improvements across all 3 businesses as well as reduced corporate costs. Note that last year's adjusted EBITDA included a $604 million lower of cost or market pretax charge. Earnings per share for the fourth quarter were $0.29. Adjusted earnings per share reflected a loss of $1.09, excluding gains on asset sales, reduced restructuring charges and discrete tax items. For the full year 2024, net sales were $5.4 billion, marking a year-over-year decrease primarily related to lower lithium pricing, partially offset by robust growth in lithium volumes. Full year EBITDA reached $1.1 billion, in line with our outlook considerations. Slide 6 shows the drivers of our year-over-year EBITDA performance. Our Q4 adjusted EBITDA of $251 million surpassed last year's result due to higher volumes, productivity and lower COGS. The EBITDA volume benefit was driven by higher volumes in specialties and the conclusion of the MARBL JV marketing agreement at the end of 2023. The COGS improvement was split between lower spodumene costs and reduced lower of cost or market adjustments. These benefits were partially offset by lower pricing and pretax equity income, mainly from reduced lithium and spodumene market prices. As Kent mentioned, adjusted EBITDA improved year-over-year in all 3 business segments, and we also reported lower corporate overhead costs. Moving to Slide 7. We present our outlook considerations for 2025. As we did last year, we are providing ranges of outcomes for our energy storage business based on recently observed lithium market pricing, including year-end 2024 market pricing of about $9 per kilogram lithium carbonate equivalent, or LCE, the first half 2024 range of $12 to $15 per kilogram LCE and the fourth quarter 2023 average of about $20 per kilogram LCE. Within each scenario, we have provided ranges based on expected volume and mix. We anticipate that energy storage volumes will be slightly higher year-over-year. All three scenarios reflect the results of assumed flat market pricing across the year in conjunction with Energy Storage's current book of business. These scenarios illustrate the improved stability of our Energy Storage business. Given our extensive resource positions worldwide and our cost and productivity actions, we can sustain margins even with lower year-over-year lithium pricing. Additionally, we have maintained significant operating leverage with potential to benefit if pricing increases. For example, if market pricing were to average $12 per kilogram LCE, similar to last year, we would expect to see margin improvement rising from the mid-20% range that we delivered in 2024 to the mid-30% range. Moving to Slide 8. We present modeling considerations for Specialties, Ketjen and Corporate. Specialties 2025 net sales are projected to be $1.3 billion to $1.5 billion with adjusted EBITDA of $210 million to $280 million. Ketjen's 2025 net sales are projected to be $1 billion to $1.1 billion with adjusted EBITDA of $120 million to $150 million. The Corporate outlook shows a planned decrease in capital expenditures, which are now expected to total $700 million to $800 million in 2025, down from $1.7 billion in 2024. Corporate costs in 2025 are expected to range between $70 million and $100 million. We are seeing the benefits of our nonmanufacturing cost improvements and the changes in our operating structure. Corporate costs in 2025 are expected to decrease year-over-year, excluding favorable FX and interest income in the prior year. Adding it all together, slide 9 presents Albemarle's comprehensive company roll-up for each energy storage market price scenario. Recall that the full year 2024 included approximately $100 million of pretax equity income from onetime additional offtake by our JV partner at Talison. Notably, assuming a consistent average lithium market price of $12 per kilogram LCE in 2025, we expect cost and productivity improvements to more than compensate for the reduced equity earnings. Turning to Slide 10 for additional outlook commentary by segment. For Energy Storage, we anticipate volumes to be slightly higher year-over-year primarily due to the ongoing ramp of the Salar yield improvement project in Chile. In addition, we continue to ramp our conversion sites, including Meishan and Kemerton, which helps improve fixed cost absorption and result in reduced tolling volumes. Last year, we indicated that about 2/3 of our lithium salts volumes were sold on contracts, including both long-term agreements with floors and other contracts. For 2025, we've indicated that 50% of our lithium salts volumes are sold on long-term agreements with floors. This number now excludes other contracts to help simplify modeling. Our contracts continue to perform, and we have no significant contract renewals this year. We continue to have additional sales on contracts with volume commitments, giving us greater confidence in our volume expectations for this year. We foresee a modest volume-led recovery in Specialties year-over-year driven by strength in pharma, autos and oilfield applications. Finally, in Ketjen, we expect modest improvements in 2025 results related to product mix, cost and productivity improvements and continued execution of our turnaround plan. Please refer to our appendix slides in the deck for additional modeling considerations across the enterprise. Turning to our balance sheet and liquidity metrics on Slide 11. We concluded the fourth quarter with available liquidity of $2.8 billion predominantly comprising $1.2 billion in cash and cash equivalents and the full $1.5 billion available under our revolver. The measures we have implemented to enhance our cost structure and operational efficiency have also increased our financial flexibility. As a result of our proactive actions to reduce costs and optimize cash flow, we ended Q4 with a net debt to adjusted EBITDA ratio of 2.6x, favorable to previous expectations. For additional information on covenants, please refer to the appendix. We have a single upcoming maturity, which is our EUR 372 million Euro notes at 1.125% 8 percent due in November of this year. Given the favorable rate, there is no immediate urgency to refinance, and we continue to evaluate our options for managing this maturity. Slide 12 shows our focus on execution and converting our earnings into cash, evident in improved operating cash flow conversion due to operational discipline and cash management. For 2024, operating cash conversion was 62%, surpassing our target of 50% and aligning with our long-term target range. This was driven by increased Talison dividends from higher Greenbushes sales volumes and inventory and cash management improvements across operations. Looking to 2025, we expect our cash dividends from Talison in the year to remain below historical averages as Talison completes the CGP3 project at the Greenbushes mine. Nonetheless, we expect operating cash flow conversion to exceed 80% in 2025, above our long-term target range, due to ongoing working capital improvements and a $350 million customer prepayment. This prepayment relates to a recently signed contract for delivery of spodumene and lithium salts over the next 5 years at market index prices. As you see here, our efforts to enhance operating cash flow and cash flow conversion are paying off. This focus is evident in our free cash flow expectations this year. We now have line of sight to breakeven free cash flow through new capacity ramp-ups, inventory management, bidding events, cost and productivity measures and other cash conversion enhancements. Turning to Slide 13. I will provide some comments on the current conditions of the lithium market. We are in the process of updating our longer-term supply-demand forecast in light of recent policy and market developments. We expect to provide a more comprehensive update with our first quarter results. Lithium remains crucial to the energy transition and the long-term drivers of our business remain strong. The global energy transition is undoubtedly progressing. It is a matter of when, not if. In 2024, electric vehicle registrations increased by 25% year-over-year. Sales reached a new quarterly record in Q4 with December achieving all-time highs for both BEVs and PHEVs. Sales are influenced by customer preferences and the availability and cost of different models. As early as next year, we anticipate that consumers will find EV prices comparable to those of internal combustion engine vehicles. Global battery costs have fallen below the critical $100 per kilowatt hour pack average, which supports the relative EV affordability. Plus, EVs represent only a portion of the broader picture. Grid storage demand is also performing exceptionally well, increasing by nearly 50% year-over-year in 2024 driven by installations in the United States and China. Grid storage demand now constitutes nearly 20% of global lithium demand, up from less than 5% a few years ago. On the supply side, there have been several announced curtailments both upstream and downstream. Nonintegrated hard rock conversion remains unprofitable and larger integrated producers are facing pressure. Our estimates of pressure on the global cost curve are unchanged. We think that at least 25% of the global resource cost curve is either at or below breakeven. Slide 14 details 2024 global EV growth by region. China's demand was the key global driver by far, with demand increasing 37% year-over-year driven by balanced subsidies for battery EVs and plug-in hybrids. China now represents about 65% of the market demand. Europe had the weakest demand due to reduced subsidies and economic challenges, but potential price cuts and emissions targets may boost growth in 2025. North America grew 14% year-over-year with U.S. trends improving due to more model availability and affordability. Overall, these trends reinforce confidence in the industry's long-term growth potential but continue to highlight that the regional dynamics are important factors to consider as the industry expands. I'll now hand it back to Kent."
},
{
"speaker": "Jerry Masters",
"text": "Thank you, Neal. Moving on to Slide 15. I will discuss the major initiatives we are implementing to reset our cost structure. These measures will enable us to sustain our leadership position and be competitive across the cycle. Moving to Slide 16. It is essential to place our recent initiatives within the context of the measures we have been implementing over several quarters as we navigate the current business environment. This year, we are optimizing our conversion network, including new actions at Chengdu and Qinzhou, improving cost and efficiency with significant progress toward our $300 million to $400 million target for cost and productivity improvements, reducing capital expenditures as we refine our 2025 execution plans and enhancing financial flexibility. Taken together, we now have greater confidence in our ability to achieve breakeven free cash flow as early as this year at current price levels. Our initiatives are comprehensive and designed to sustain our long-term competitive advantages in response to market conditions. As the dynamic environment persists, we are continually adding to our list of potential actions so that we can adapt as necessary. Turning to Slide 17 for additional details. The shifting market underscores the need for a globally diversified conversion network with product flexibility. As previously mentioned, we are optimizing production from both our carbonate and hydroxide assets. achieving record production at the La Negra lithium carbonate plant in Chile and the Meishan lithium hydroxide plant in China. As we have reviewed our conversion network for improvement opportunities, we have made the decision to place our Chengdu plant on care and maintenance due to market conditions and shifting product mix. Chengdu is a relatively small plant with a capacity to produce approximately 5,000 tons of lithium hydroxide annually. We will continue to service those customers through the ramp of newer, larger plants in Chile, China and Australia. This approach will enable us to provide high-quality secure supply to our customers while driving network efficiencies and better leveraging our scale. Moreover, we have identified a highly capital-efficient project at Qinzhou to shift conversion capacity partially from hydroxide to carbonate in response to strong market demand. In Australia, performance of our Kemerton lithium hydroxide facility continues to improve, and the site recently commenced its first battery-grade commercial sales. On the resources front, we are focused on preserving and maximizing the value of our advantaged low-cost resources. The Salar yield improvement project has exceeded a 50% operating rate milestone and is progressing towards nameplate capacity. We are leveraging our brine expertise, for example, in hydro geological mapping, to maximize recoveries at every stage of the resource. At Greenbushes, CGP3 is expected to produce its first ore in the fourth quarter of 2025, providing additional feedstock for increased lithium salts volumes in 2026. The Talison team, together with our JV partners, has undertaken technical studies to optimize Greenbushes' operation over the life of the mine. Please refer to Slide 18 for more details on cost and capital considerations. We've achieved over 50% of the $300 million to $400 million cost improvement announced the last quarter as we moved quickly to execute on our plans. Our goal is to reach a full run rate by year-end, possibly sooner. Additionally, we're reducing 2025 capital expenditures by $100 million to $700 million to $800 million, down more than 50% from 2024. This result stems from a more detailed review of our projects. Full year 2025 CapEx will focus on core assets with priorities on health, safety, environmental improvements and cost reductions. Moving to Slide 19. The actions being taken are intended to preserve Albemarle's competitive advantages and position the company for long-term value creation as outlined by the strategic framework on Slide 20. Our strategic framework continues to guide how we operate Albemarle as we lead the world in transforming essential resources into critical ingredients for modern living. Our vision is still the same. We want to lead with impact and be purpose-driven. The markets we serve are unchanged. Both of our core businesses have enormous secular growth opportunities across mobility, energy, connectivity and health, including the energy transition, electrification, population growth and shifting demographics. I want to feature on that next row of boxes, which highlights our strategic and competitive advantages. And they're highlighted in more detail on Slide 21. First, our industry-leading resources are unmatched with large-scale, high-grade and therefore low-cost assets. This core advantage is enhanced through our innovation and advanced process chemistry capabilities. We've used this for growth in the past and now are increasingly aiming these capabilities toward cost savings and incremental growth opportunities. Customer centricity is key. We stay focused on both the customer and end user, integrating from the resource to the final product. Close collaboration with customers lets us understand market trends and technology shifts, allowing us to adapt in our dynamic markets. We continue to get positive feedback that our customers seek to work with Albemarle for our capabilities, scale and reach. Lastly, our commitment to people and planet stewardship is fundamental. It underscores our value proposition by supporting our team and promoting sustainability across all our business lines and in the communities where we operate. There is no question that while our strategic framework has not changed, our execution has certainly adapted. We have implemented several key initiatives to enhance our operational efficiency and agility. Our commitment to innovation is evident in the strategic investments we have made in research and development. We are exploring cutting-edge technologies and sustainable practices to ensure that we remain at the forefront of the industry. This includes developing next-generation polymeric flame retardants and optimizing lithium conversion to meet shifting market demand. Innovation is also core to preserving our resource advantage with projects like the Salar yield improvement project in Chile and an innovative process upgrade in Jordan that we call NEBO, both of which allow us to increase production more sustainably without incremental brine pumping. We're also driving out cost and reducing capital intensity. For example, by leveraging advanced data analytics and digital tools, we are improving our ability to monitor and optimize production processes in real time. Throughout these changes, we remain dedicated to safety, sustainability and operational excellence, aiming to create long-term value for our stakeholders while fostering a more sustainable future. In summary, on Slide 23, Albemarle delivered solid 2024 performance while acting decisively to preserve long-term growth optionality and maintain the company's industry-leading position through the cycle. Our full year 2025 company outlook considerations build on the progress we've made to drive enterprise-wide cost improvements, strong energy storage project ramps and contract performance. We are focusing on taking broad-based proactive steps to control what we can control and ensure we are competitive across the cycle. Albemarle remains a global leader, and I am confident we are taking the right actions to maintain our competitive position and to capitalize on the long-term secular opportunities in our markets. I look forward to seeing some of you face-to-face at upcoming events listed here on Slide 24. And with that, I'd like to turn the call back over to the operator to begin the Q&A portion."
},
{
"speaker": "Operator",
"text": "[Operator Instructions] Our first question is from Patrick Cunningham at Citi."
},
{
"speaker": "Patrick Cunningham",
"text": "I guess my first question is on the contract mix. That remaining 50% piece not on long-term agreements, should we assume most of those follow spot mechanisms? And then was there any significant tranche of those long-term agreements that came up for renegotiation recently and had any respective reset in floors?"
},
{
"speaker": "Jerry Masters",
"text": "Yes. So your comment about the other 50% pretty much at index is -- that's a good assumption. And the shift that we've moved, I mean, we've reported previously that it was about 2/3 on contracts. So now we're reporting contracts only with floors. We had some long-term contracts that didn't have floors, and we pulled that out of that definition now. So that 50% has floors. I don't think we've had any we renegotiated in the near term recently or that have come up."
},
{
"speaker": "Patrick Cunningham",
"text": "Understood. That's helpful. And if I'm reading the chart correctly, it seems like most of the CapEx reduction was CapEx previously devoted to the resource base. So where are you cutting back investments in resources? And given the current program, how quickly can you repossession and invest in additional brownfield to maybe support higher volume growth 2027 and beyond?"
},
{
"speaker": "Jerry Masters",
"text": "Yes. I'm not sure that's right. I mean, if you go back, I mean, the capital we pulled back a lot of it was conversion initially, and then we've gotten a little bit more focused, and we have pushed out on some resources and we're getting very focused on kind of the highest-quality, lowest-cost resources and we're not out pursuing as many resources as we were at one time. So I think the big piece, if you look at the capital that we've cut from our plans, a big piece of it was on conversion, at least initially. And then now we're getting a little bit more focused on operations, sustaining capital, and we have to cut back on resources as well. And I think, I mean, we've said a number of times that we can -- we think we can grow at 15% kind of a CAGR over a period from '22 to '27. And we start running out of the theme a little bit. So those growth rates come down after '27. And a lot of that -- most of that is about resource."
},
{
"speaker": "Operator",
"text": "Our next question is from Rock Hoffman with Bank of America."
},
{
"speaker": "Rock Hoffman Blasko",
"text": "Could your actions including cutting CapEx and placing Chengdu under care and maintenance influence the broader market? And how might your actions adjust further if pricing stays at the low end of the scenario analysis?"
},
{
"speaker": "Jerry Masters",
"text": "So I think you said do we think our actions at Chengdu will influence the market. So no, it's -- I don't think so. I mean, we're doing that because of market conditions and product mix. So we have an opportunity to shift some product from hydroxide to carbonate at Qinzhou. And Chengdu is one of our smallest facilities, which is why it's probably not that -- wouldn't influence the market that much. And then we make up that capacity because we're still ramping other larger assets at Xinyu, Qinzhou as a small investment and then Meishan and Kemerton as well."
},
{
"speaker": "Rock Hoffman Blasko",
"text": "Got it. And would you be able to explain the wide range in the tax guide for 2025?"
},
{
"speaker": "Neal Sheorey",
"text": "This is Neal. Yes, so the wide range is really driven by the variety of scenarios that we have on the page or in the deck here. One of the reasons why we had kind of an odd tax rate in the fourth quarter and really in 2024 overall is that, as you've seen over the last few quarters, we've been reporting losses in a couple of jurisdictions where we took tax evaluation allowances. So therefore, we didn't get to recognize the tax credits in our tax expense line. Those two jurisdictions in particular are China and Australia, where we have some particulars that require us to take those tax valuation allowances. So why there's a wide variety on the tax ranges, it's really about where the lithium price is and that influence on our pretax income. Obviously, at the lower end of the range, what our guidance has said is go to a tax rate very similar to what we did in 2024. And if you're at the higher end of the range, you kind of come more to our run rate kind of statutory rate that we have based on our geographic mix."
},
{
"speaker": "Operator",
"text": "Our next question is from Ben Isaacson from Scotiabank."
},
{
"speaker": "Apurva Kilambi",
"text": "This is Apurva on for Ben. So you've discussed the line of sight to being free cash flow breakeven in 2025. So is that -- is achieving that really just the case of all the dominoes falling in place? Is there anything that could put this at risk beyond just pricing collapsing?"
},
{
"speaker": "Jerry Masters",
"text": "Well, I just -- we have to execute against our plan, right? So that is our plan to do that. We have to execute against that. And pricing would be one of those. But we have -- look, they're a pretty aggressive plans. You see the actions that we've taken. We think we've executed pretty well against it so far. So -- but we just need to execute to accomplish that."
},
{
"speaker": "Apurva Kilambi",
"text": "Perfect. And then as a follow-up, at this stage, with all of the kind of revised plans that you've laid out, do you foresee any need for a capital raise in 2025? And if so, is there any sense of what magnitude or what form that could look like? I know last year, you folks did the preferred convertibles. Is that kind of no longer in the picture given all of these actions that you've planned?"
},
{
"speaker": "Jerry Masters",
"text": "Yes. So we're taking all these actions so we don't do that, right? So -- and we are -- again, that we have to execute against that but we see ourselves being free cash flow positive through the year, and we don't have plans to do an equity raise."
},
{
"speaker": "Operator",
"text": "Our next question is from David Begleiter from Deutsche Bank."
},
{
"speaker": "David Begleiter",
"text": "Kent, on your realized lithium prices in Q4, what was the difference in spread between your spot sales and your contract sales?"
},
{
"speaker": "Jerry Masters",
"text": "So we don't normally report on the exact pricing and particularly on our contract piece. So I'm going to decline to respond to that."
},
{
"speaker": "David Begleiter",
"text": "Understood. I believe back in Q4, you were saying that roughly 10% to 12% of global lithium supply was shut down and curtailed due to lower prices. Is that still a good estimate? Or has it moved up since then?"
},
{
"speaker": "Jerry Masters",
"text": "Yes. So I think we were saying about 25%, we believe, is underwater. And we still think that's the case."
},
{
"speaker": "David Begleiter",
"text": "But how much is actually curtailed or shut down?"
},
{
"speaker": "Jerry Masters",
"text": "Yes. So probably about -- it's about half of that 25%, I would say. And I think that both those numbers still hold."
},
{
"speaker": "Operator",
"text": "Our next question is from Jeff Zekauskas from JPMorgan."
},
{
"speaker": "Jeffrey Zekauskas",
"text": "On Slide 7, where you provide different scenarios, is the meaning of this slide that you're -- if there were no change in lithium prices today, the energy storage adjusted EBITDA would be between $0.6 billion and $0.7 billion? Or because of your contract prices, it's more complicated than that?"
},
{
"speaker": "Neal Sheorey",
"text": "Jeff, this is Neal. I think my answer is probably going to be towards the latter part of how you described it that, look, the prices that you see at the top of that slide are observed market prices, not our price -- what our realized prices are but market prices. The numbers below that then is if you take those market prices and move that through our book of business, you get these kinds of EBITDA ranges."
},
{
"speaker": "Jeffrey Zekauskas",
"text": "Okay. Great. And then what you do on the right-hand column is you have some assumption, and you say we assume spodumene market pricing average is 10% of the LCE price. But aren't spodumene prices already below that? And you say you assume full Talison sales volumes. Are you currently receiving full Talison sales volumes? And what does that mean? What has to happen for you to receive full Talison sales volume?"
},
{
"speaker": "Neal Sheorey",
"text": "Yes, Jeff, let me take the second one. What we mean by full Talison sales volumes is that all the partners at Talison are taking their full allocation. That is the assumption that we've made. That hasn't always been the case if you go back over the years, but our assumption going forward is that's the case. As -- where I sit right now promptly is that is also the case right now. We're taking our full allocation in this environment. With regards to the spodumene average of 10% of LCE price, look, to your point, it has moved around over time, anywhere from -- in the 5% to 10% kind of range. So what we wanted to do was at least just put a mark in, in terms of how we've done these considerations, and we picked 10% because that was something that we sort of recently observed in 2024. But to your point, it can and it does shift around with the market dynamics."
},
{
"speaker": "Operator",
"text": "Our next question is from John Roberts at Mizuho."
},
{
"speaker": "John Ezekiel Roberts",
"text": "I believe IGO guided for essentially flat 2025 volume at Greenbushes. Can you confirm that? And then where is your growth, the 5% to 10% growth for 2025 coming from?"
},
{
"speaker": "Eric Norris",
"text": "John, it's Eric. That's correct. CGP2 was fully utilized, which was the last expansion at Talison in 2024. CGP2 does not come on until the very end of this year. So there is no growth capacity at Talison until that comes on. That's sort of the, as you know and appreciate the lumpy nature of bringing on capacity. Our 0% to 10% guidance on growth is all coming out of Chile, where the Salar yield project continues to ramp and drives debottlenecking effectively over the La Negra plant to march towards nameplate."
},
{
"speaker": "John Ezekiel Roberts",
"text": "And then on Slide 18, you're targeting sustaining CapEx of 4% to 6%. Is the percent of sales the right way to think about targeting sustaining CapEx given the volatility that you get in pricing?"
},
{
"speaker": "Jerry Masters",
"text": "Yes. So we -- that's the right point. So we -- and we say that on a stabilized market, right? So -- and it's aspirational at the moment for us because we're not there, but we're also at what we think is the bottom of the market. So it's a good benchmark. We say a mid-cycle pricing is where we go to that. We're not at that level today. We still have some work to do around that. But we're getting focused on it and we wanted to have a benchmark out there that we can aim at."
},
{
"speaker": "Operator",
"text": "Our next question is from Joel Jackson from BMO Capital Markets. ."
},
{
"speaker": "Joel Jackson",
"text": "I want to follow up a little bit on Ben's associate's prior question. So can you talk about what -- if you go to 2026, how much of the half of your sales here that are contracted floors? Do we expect the floors have to be negotiated? And how do you think about the balance sheet leverage if spot prices stick around where they are and we are renegotiating floors for 2026?"
},
{
"speaker": "Jerry Masters",
"text": "Yes. So look, we provided guidance for '25, not '26. But the way our contracts work is they don't -- and they don't usually end and then get renegotiated. They get adjusted over time as our customer wants something, we want something, they have adjusted. That's how they worked over time. And we expect that to happen. You see our portfolio of contracts has become a little bit more spot oriented in the recent past. That's because China is the biggest market. It's a spot market. It's growing. We've got new capacity coming on there with Meishan ramping. So that's really why that has shifted. Our contracts simply don't just come to an end. We negotiate terms somewhere along that and extend them out a year or two, and we've done that over time. And I suspect that's how it's going to play out going forward."
},
{
"speaker": "Joel Jackson",
"text": "Okay. And then talking about 0.25% -- in your estimates 0.25% of lithium supply is underwater, maybe half of that's curtailed. We just -- it seems like CATL is bringing back lepidolite production in the last bunch of weeks. There's some maybe some rational behavior going on, although those mines are downstream with cathode and the battery. So I mean it seems like there are actors in this industry that are maybe manipulating price, maybe don't have the same objectives as Albemarle and other public companies. I mean, how do you act in this market? And is there any hope for material recovery if such behavior by such actors continue?"
},
{
"speaker": "Jerry Masters",
"text": "Okay. So I don't know if I can comment on all of that. I would say that we're pretty focused on making sure we can compete at the bottom of the cycle. And so when you see us taking actions and have targeted at that. So the capital that we pulled back on our growth to reduce capital as a result of that, driving cost out of the business, getting more focused on cost, not as much on growth and making sure that we can compete at that cycle and then pivot when the market comes back to take advantage of more growth and higher prices. So that's the approach that we're taking."
},
{
"speaker": "Operator",
"text": "Our next question is from Vincent Andrews with Morgan Stanley."
},
{
"speaker": "Vincent Andrews",
"text": "I wanted to follow up on the $350 million customer prepayment. And just a clarifying question to start off with, which would be, I assume that's included when you talk about the 80% conversion as well as being free cash flow neutral this year. I assume you're including the $350 million. And all else equal then, does that mean next year cash flow would be $350 million less?"
},
{
"speaker": "Neal Sheorey",
"text": "So Vincent, on the -- this is Neal. On the first part of your question, you are correct. So the $350 million is included in our cash conversion number of 80% for 2025. And with regards to looking over to 2026, let me just give you maybe two things to think about here. You are correct that, that $350 million won't recur again in 2026. But also remember that there are a lot of other things from a cash standpoint that will actually start to benefit us in 2026 and beyond. One of the key ones that I'll point out is that from a Talison JV perspective, right now they're obviously going through a large investment program. That program is going to be done at the end of this year. So we would expect, even in this low environment, as you would expect, Talison is a very competitive asset. So we would expect a return to dividend payouts from the JV as we get into 2026."
},
{
"speaker": "Vincent Andrews",
"text": "And then just as a follow-up on your cash flow statement, for starters, thank you for the increased disclosure on working capital. But I have a reconciliation question. You have a new line item that says inventory net realizable value adjustment. And this year, it's a negative $500 million. Last year, it was a positive $604 million. So I'm just wondering, does that line reconcile somewhere else within cash flow from operations? Or what is that? Or any more detail you can provide would be helpful."
},
{
"speaker": "Neal Sheorey",
"text": "Yes. So that line, Vincent, is predominantly going to be a reflection of the lower of cost or market adjustment that we took in fourth quarter of 2023. And so that's why you see those adjustments, and so that's the best -- the most of that line is related to that."
},
{
"speaker": "Operator",
"text": "Our next question is from Aleksey Yefremov from KeyBanc."
},
{
"speaker": "Aleksey Yefremov",
"text": "If you look at your CapEx, you're talking about maintenance level. Assuming market prices don't change, can you get to that maintenance level in 2026? And would you be willing to do so under these conditions?"
},
{
"speaker": "Jerry Masters",
"text": "Yes. So I'm not going to make a commitment for capital for '26. But those are -- our aspirations is that we want to get to like maintenance capital at that particular level. So we still have in our capital opportunity -- growth opportunities, say, growth or cost saving opportunities, smaller investments. So the Qinzhou investment that we talked about on the call is a good example of that, low single-digit millions of dollars. We were able to shift from hydroxide to carbonate about 10,000 tons a year. So that -- and that's great return project and pretty low capital. So we continue to look for those. Those tend to be more focused on cost savings now and maybe incremental growth, like what we're doing at Qinzhou. But the 4% to 6% at mid-cycle, that's an aspiration that we work to, and we continue to focus to try and drive to that. Whether we get there in '26 or not, we've not laid out plans in that detail for '26, so I can't answer that."
},
{
"speaker": "Aleksey Yefremov",
"text": "And on CGP3, it's an important project for your cash flow this year and next year especially. Any comments on risk assessment for delays, cost overruns, that kind of thing? Like how is the project going from your point of view?"
},
{
"speaker": "Jerry Masters",
"text": "Yes. I think we're on schedule and around budget. I don't know exactly whether we're right on budget or not, but it's pretty close from a budget and a schedule perspective."
},
{
"speaker": "Operator",
"text": "Our next question is from Kevin McCarthy at Vertical Research Partners."
},
{
"speaker": "Kevin McCarthy",
"text": "Kent, you talked a little bit about the grid storage growth in your prepared remarks. Can you comment on your outlook for 2025 in that end market? And is your share in grid storage higher or lower or about the same as it is in your customers in the EV arena?"
},
{
"speaker": "Jerry Masters",
"text": "Yes. So the grid storage has been one that's been a positive surprise for us for a few years now as it's been growing. I think it was up almost 50% this year. And we anticipate that continuing to grow. And a couple of years ago, we probably would have thought lithium may not be the best solution for grid storage, but I think the way battery costs have come down and the popularity of LFP, it looks like grid storage is going to be lithium-based and LFP-based going forward. So it's a good opportunity. And it's on -- it's kind of, I think, everywhere. So the U.S. is starting to play out. You see that in Europe, and then China has been really strong around that. So it's a positive. It's a bright spot and it's offset a little bit of the little less growth that we saw in EVs and some of the shifts between plug-in hybrids and BEVs as well. So it's covered that and build in nicely."
},
{
"speaker": "Eric Norris",
"text": "And Kevin, as for the market share, first of all, it's largely an LFP market. So if you look at our share in LFP on EVs, PHEVs, et cetera, can be similar to our share in grid storage. It's the same companies. It's deepened back into the supply chain that are providing the cathode and battery materials into that. So that's what determines our share of those relationships, not necessarily the end markets."
},
{
"speaker": "Kevin McCarthy",
"text": "Understood. And then secondly, if I may, Kent, as the tariff regimes continue to evolve here. Are you managing the company any differently today than you were last year as it relates specifically to tariffs?"
},
{
"speaker": "Jerry Masters",
"text": "So are we managing the company differently? Look, we're paying very close attention to see what happened. It's evolving. I'm not sure, no one knows exactly what the final impact will be. But the direct impact on Albemarle is not going to be that significant. I mean, we're not -- we don't ship from China to the U.S., I mean, significantly. There is some, but it's not a big part of our business. It will impact our customers more than it will impact us directly. So the knock-on effect of us is some -- is what we're really paying attention to."
},
{
"speaker": "Operator",
"text": "Our next question is from Laurence Alexander from Jefferies."
},
{
"speaker": "Laurence Alexander",
"text": "So a couple of questions. First, on Energy Storage, how much of your capacity is under long-term contract compared to the EV market?"
},
{
"speaker": "Jerry Masters",
"text": "Laurence, I'm sorry, you said -- that was a fixed storage question?"
},
{
"speaker": "Laurence Alexander",
"text": "The Energy Storage side of your business, how much of that is under long-term contract? ."
},
{
"speaker": "Jerry Masters",
"text": "It's about 50%."
},
{
"speaker": "Eric Norris",
"text": "Yes, it's the same, Laurence. Yes, the other 50% -- we talked about 50% being under floor-based contracts. The 50% that's not is the pricing mechanism of spot in the contracts. It's a mix of contracts that are shorter in duration and spot."
},
{
"speaker": "Jerry Masters",
"text": "Okay. Sorry. Just to clarify there. So what we -- when we said the 50%, so those are long-term agreements, and we have floors on those agreements. There are some other longer-term agreements, we don't have floors. So we're now categorizing that in the same category as spot."
},
{
"speaker": "Laurence Alexander",
"text": "Okay. Perfect. For the $350 million of cash inflows, just to be clear, if -- would the net effect be that the EBITDA related to that would show up in 2026 or '27 but then the cash conversion suffers? Or is there also an EBITDA -- is there also an impact on the EBITDA bridge?"
},
{
"speaker": "Neal Sheorey",
"text": "Yes. Laurence, I think you're circling on kind of the right mechanism here. So we have taken the prepayment upfront and already received it here in the first quarter. You'll see that with our first quarter results. And then we satisfy our obligation through product deliveries over actually the next 5 years. So -- and that's at prices that are indexed to market. So you are right. We will then recognize EBITDA in increments as we make those deliveries, but it is over the course of the next 5 years."
},
{
"speaker": "Operator",
"text": "Our next question is from David Deckelbaum at TD Cowen."
},
{
"speaker": "David Deckelbaum",
"text": "I was hoping to follow up just on the plans at Qinzhou to convert some of the capacity to carbonate versus hydroxide, mainly just being is this decision really just to capture the discrepancy in margin? Or do you have very differentiated views now over time on just the appetite for hydroxide? Are you seeing customer resistance for hydroxide volumes in the market and then you're seeing this pivot as a necessity to sell product at this point? And are there further plans? Should we expect further plans to pursue more conversion from hydroxide to carbonate?"
},
{
"speaker": "Jerry Masters",
"text": "Yes. So look, it is -- I mean, the hydroxide, there's a market hydroxide, it's growing. Carbonate is growing faster. So there's a stronger demand for carbonate. And this was kind of a unique opportunity for us because the plant was designed in this way. And we had -- there's a few things we have to execute against to take advantage of that. It's very small capital, as I said before. It's low single-digit millions in order to make that shift. It gives us more flexibility in the market. The market is stronger around carbonate now, so we can take advantage of that. Over time, we can shift this back either way. Once we make this investment, we'll be able to go -- we could go back to hydroxide if we wanted to or stay on carbonate. At the moment, it makes more sense to be on carbonate. It's about the market and the fact that this was designed in upfront, and we had to kind of finish some work in order to leverage the capability."
},
{
"speaker": "David Deckelbaum",
"text": "If beyond sort of this year and the next you wanted to lean more heavily into carbonate, is there tolling capacity available in China that would enable you to do that? Or would that have to be a more significant investment on your part?"
},
{
"speaker": "Jerry Masters",
"text": "No, there's tolling capacity that's available and that -- we've taken advantage of that in the past, and it gives us flexibility in our supply chain. And then the growth you see from us in Chile as well at La Negra has allowed us to grow with that market, particularly around kind of on the back of the work at La Negra, but particularly Salar yield in the Salar."
},
{
"speaker": "Operator",
"text": "Our next question is from Benjamin Kallo with Baird."
},
{
"speaker": "Ben Kallo",
"text": "I wanted to follow up to an earlier question and maybe frame it just slightly different. There's capacity coming off-line, utilization going down and demand going up for EVs even at a slower rate than maybe we predicted a couple of years ago. At the same time, with all of that happening, which should indicate prices going up, prices have been coming down. So can you talk to anything to help us understand what that is and then anything that would change that? And then my follow-up question is, I do see a lot of reports around recycling in China. It seems like that's becoming a bigger industry there. I'm just wondering your thoughts around the impact of that on pricing as well."
},
{
"speaker": "Jerry Masters",
"text": "Yes. So there are a lot of moving pieces in your question, but also in the market, right? So it is -- I mean, there's capacity that has come off, higher cost capacity. There is new capacity that has come on. There's excess conversion that sits in China as well. And then the recycling part. I mean, recycling has been growing over time. We actually -- with prices come down, we've seen recycling drop off a little bit in China because it's just not economic given where prices are for new material. All of that is going to work its way -- has to work its way through the system. It's a dynamic market. It's hard to say. But I would anticipate higher cost assets coming out, particularly. We've got -- we're still growing. This market is still growing 20% plus, right? So it's just not quite as high growth rates as we had anticipated, but it is still growing significantly. And China is the main driver of that, but North America and Europe are kind of coming from there. So there's going to be growth in this market for a long period of time. Capacity comes on in chunks and you get an imbalance, prices are going to be down. I don't know if I can explain it more than that. It's a very opaque market and particularly because a lot of it happens in China, but it is -- it relies basically on the supply/demand."
},
{
"speaker": "Operator",
"text": "Our next question comes from Josh Spector with UBS."
},
{
"speaker": "Joshua Spector",
"text": "I wanted to just ask on the prepayment that you got. Is there any requirement there to make further investments or some preemptive expectation around CapEx spending? Or was that just something you decided to do given your needs for cash and the customer focus on volumes?"
},
{
"speaker": "Neal Sheorey",
"text": "Yes. Josh. No, there's no further requirement on our side. We have everything we need to be able to satisfy that contract. And I would just say the last part of what you said, I'd say it a little bit differently. We have discussions with customers all the time. We've done these kind of prepayments actually in the past, and this was just a unique opportunity that came across our desk. And it was one that we went after. So I think it's just a sign of how we work with our partners in many different ways."
},
{
"speaker": "Joshua Spector",
"text": "Understood. And I guess just to follow up on some prior questions, so specifically with the CATL restart, I've heard some mixed things around supply maybe being temporarily tighter versus their cost being more in line, I guess, closer to where the market prices have moved towards driving their restart. Do you guys have any view internally about why that's happening against the low price environment?"
},
{
"speaker": "Jerry Masters",
"text": "No. Look, I would say, I mean, look, we'd modeled more lepidolite coming in. So we weren't exactly targeting this particular asset, be the one that came back on. But we had lepidolite volume. China it's a strong market. It's growing. They're short of resource, not surprising. They're trying to get more domestic resource. So I think it's -- I think it's no more complicated than that."
},
{
"speaker": "Operator",
"text": "Our last question comes from Andres Castanos from Berenberg."
},
{
"speaker": "Andres Castanos-Mollor",
"text": "Of the 2025 lithium volumes, how much of it would be spodumene sales and how much would be lithium salts sales? Are there any significant tolling volumes left?"
},
{
"speaker": "Jerry Masters",
"text": "So I don't have that split, but it's mostly salt, right? There's -- the spodumene sales that we do are really more for transparency in the market, understanding that. We do sell some of that, other than we've shifted a little bit from a prepaid perspective. There's spodumene in that. There's not a lot of that in '25."
},
{
"speaker": "Eric Norris",
"text": "Yes. It's under 10%, 15% of total LCEs this year roughly in that order of magnitude. It's basically the production coming out of Wodgina."
},
{
"speaker": "Operator",
"text": "Thank you. That's all the time we have for questions. I will now pass it back to Kent Masters for closing remarks."
},
{
"speaker": "Jerry Masters",
"text": "Okay. Thank you, operator. In conclusion, Albemarle's strong operational execution and strategic framework have positioned us to successfully navigate dynamic market conditions and maintain our long-term competitive edge. We are dedicated to delivering value for our stakeholders and driving sustainable growth. Thank you for joining us today, and we look forward to continuing on our journey together. Stay safe and take care."
},
{
"speaker": "Operator",
"text": "This concludes today's conference call. Thank you for your participation. You may now disconnect. ."
}
] | Albemarle Corporation | 18,671 |
ALB | 3 | 2,024 | 2024-11-07 08:00:00 | Operator: Hello, and welcome to the Albemarle Corporation's Q3 2024 earnings call. We ask that you please hold all questions until the completion of the formal remarks, at which time you will be given instructions for the question and answer session. Also, as a reminder, this conference is being recorded today. I will now turn the call over to Meredith Bandy, Vice President of Investor Relations and Sustainability.
Meredith Bandy: Thank you, and welcome everyone to Albemarle's third quarter 2024 earnings conference call. Our earnings were released after the market yesterday, and you will find the press release and earnings presentation posted to our website under the investor section at Albemarle.com. Joining me on the call today are Kent Masters, Chief Executive Officer, and Neal Sheorey, Chief Financial Officer. Netha Johnson, Chief Operations Officer, and Eric Norris, Chief Commercial Officer, are also available for Q&A. As a reminder, some of the statements made during this call, including our outlook, guidance, expected company performance, and strategic initiatives, may constitute forward-looking statements. Please note the cautionary language about forward-looking statements contained in our press release and earnings presentation, which also applies to this call. Please also note that some of our comments today refer to non-GAAP financial measures. Reconciliations can be found in our earnings material. And now I will turn the call over to Kent.
Kent Masters: Thank you, Meredith. During the third quarter, Albemarle continued to demonstrate solid operational execution, delivering volumetric growth in energy storage and specialties, year-over-year EBITDA growth in specialties and kitchen, strong operating cash conversion of over 100%, and leverage metrics well below our covenant limits. We also continued to progress our cost improvement plans, further ramp our new facilities, and deliver higher volumes. As a result, we are maintaining our full-year 2024 corporate outlook considerations. In a few moments, Neal will give more detail on our third quarter performance, key results, and actions we are taking to preserve our financial flexibility. My focus today will be on addressing the outcomes that we are now driving as a result of the comprehensive cost and operating structure review we progressed over the past few months. In conjunction with this review, we are implementing a new operating structure, transitioning to a fully integrated functional model designed to deliver significant cost savings and maintain long-term competitiveness. We are targeting $300 to $400 million of further cost and productivity improvements by eliminating redundancies, reducing management layers, and optimizing manufacturing costs. These savings are due in part to the difficult but necessary decision to reduce our global workforce by an additional 6% to 7%. In total, we have eliminated nearly 1,000 roles, including all the actions announced this year. We also are now driving a year-over-year reduction in our full-year 2025 capital expenditures by at least $800 million or about 50%, with a disciplined focus on critical health, safety, environmental, and site maintenance and a phased approach to maintaining our world-class resource base. We are confident these actions are the right steps to adapt to market conditions while serving our customers and pursuing long-term value creation. I will have more to say about our cost-out and productivity plans later on the call. I will now hand it over to Neal to discuss our financial results during the quarter.
Neal Sheorey: Thanks, Kent, and good morning, everyone. Beginning on slide five, I will summarize our third quarter performance. We recorded net sales of $1.4 billion compared to $2.3 billion in the prior year quarter, a decline of 41% driven principally by lower pricing, particularly for lithium. During the quarter, we recorded a loss attributable to Albemarle of $1.1 billion and a diluted loss per share of $9.45. Adjusted diluted loss per share was $1.55. Our GAAP result included a pretax charge of $861 million related to capital project asset write-offs at Kemerton 3, and putting Cameron 2 into care and maintenance, of which about 10% is cash outflow in the second half of the year. This charge was below our initial estimate that we provided on the last earnings call of $900 million to $1.1 billion. Turning to Slide six, our third quarter adjusted EBITDA of $211 million was lower than the prior year period, also primarily due to lower lithium pricing. This was partially offset by lower cost of goods sold primarily related to reduced spodumene pricing. Other positives include higher volumes in energy storage related to delivery of our growth projects, and in specialties related to stronger end market demand. Our cost and efficiency initiatives also provided productivity which more than offset inflation. Looking at adjusted EBITDA by operating segment, we saw improved year-over-year profitability in specialties, due to productivity improvements and better end market demand. Catch in EBITDA also improved year-over-year as we continue to execute our turnaround plan during the quarter. Moving to slide seven, as Kent mentioned, we are maintaining our full-year 2024 outlook considerations thanks to the execution of cost and productivity improvements, continued strong volume growth, including higher sales volumes at Artalison JV, and contract performance in energy storage. As a reminder, these scenarios are based on historically observed lithium market pricing, and represent a blend of relevant market prices including both China and ex-China pricing, for lithium carbonate, and lithium hydroxide. Turning to slide eight for additional commentary on outlook, we expect corporate full-year 2024 net sales to be near the lower end of the $12 to $15 per kilogram scenario primarily due to weaker second-half pricing for lithium, offset by contract performance. Full-year 2024 adjusted EBITDA is expected to be in the middle of that same scenario range thanks to successful cost-cutting and productivity improvements. In energy storage, we now expect full-year volume growth to be more than 20% year-over-year, as we have continued to benefit from solid demand particularly in China, and ongoing ramps of our new facilities. Fourth-quarter volumes are expected to be down sequentially primarily due to timing of spodumene sales volumes, reduced tolling, and planned outages. Margins are expected to be slightly higher sequentially as the benefit of lower-priced spodumene in cost of goods sold offsets the impact of unabsorbed fixed costs as our new plants continue to ramp. At both specialties and kitchen, we continue to expect modest sequential improvements in the fourth quarter, thanks to better end market conditions and productivity benefits. Please refer to our appendix slides in the deck for additional modeling considerations across the enterprise. Moving to our balance sheet and liquidity metrics on slide nine, we ended the third quarter with available liquidity of $3.4 billion, including $1.7 billion of cash and cash equivalents and the full $1.5 billion available under our revolver. Actions we have taken to improve our cost structure and enhance operational efficiency have also provided enhanced financial flexibility. Thanks to our successful actions to reduce costs and optimize cash flow, we ended Q3 with net debt to adjusted EBITDA of 3.5 times, or two turns below the covenant limit in the quarter. To navigate market conditions, we took proactive measures in the quarter around our covenant waiver. The outcome of our action is shown on slide ten. In October, we proactively extended our covenant waiver through the third quarter of 2026 and reshaped it to ensure we have the financial flexibility needed as we execute our new operating structure and cost reduction actions. Moving forward, our goal remains to stay well within these limits through solid financial and operational execution, as we have shown throughout 2024. Slide eleven highlights our execution focus which is demonstrated by the continued improvement in our operating cash flow as a result of operational discipline and cash management actions. Our operating cash flow conversion defined as operating cash flow as a percent of adjusted EBITDA, was greater than 100% in the third quarter, primarily due to timing and management of working capital. We continue to expect full-year operating cash conversion to be approximately 50%, at the higher end of our historical range and above our expectations at the beginning of the year. This is driven by increased Talisin dividends with higher sales volumes at green bushes, and working capital improvements, including a significant focus on inventory and cash management across our operations. This means that we expect fourth-quarter cash conversion to be lower than recent quarters due in part to cash outflows associated with the workforce reductions we announced today as well as the timing of JV dividends. As a reminder, we account for our 49% interest in the Taliesin JV via the Equity method. Therefore, the impact to cash flows is in dividends received. As we have said before, we expect dividends to be lower than normal year, and into 2025 as Taliesin completes the CGP3 capital project at the Greenbushes mine. I'm pleased to see that our efforts to improve operating cash flow conversion are yielding results. We will continue driving toward free cash flow breakeven through our ongoing ramp of new capacity, inventory management, bidding events, cost out and productivity measures, and other cash conversion improvements. Turning to slide twelve, we will provide a few comments on current lithium market conditions, which have shown some positive signs. On the supply side, there have been several announced upstream and downstream curtailments. Non-integrated hard rock conversion is unprofitable, and larger integrated producers are under pressure. We estimate that at least 25% of the global resource cost curve is unprofitable or operating at a loss. On the demand side, grid storage demand continues to surprise to the upside, up 36% year-to-date led by installations in the US and China. Global electric vehicle registrations are up 23% year-to-date, led by China, and demand growth in the United States is also up double digits. Slide thirteen breaks down global EV demand growth by region. China represents 60% of the overall EV market with continued strong year-to-date demand growth of more than 30% in line to slightly ahead of initial expectations. In terms of demand mix, we have seen stronger growth in plug-in hybrid sales in China, as current subsidies are more balanced between battery EVs and plug-in hybrids. Chinese plug-in hybrids include range-extended vehicles with battery sizes somewhere between traditional battery EVs and plug-in hybrids. Meanwhile, the softest demand region globally is Europe, where EV sales growth is down slightly year-to-date due to reduced subsidies and weaker economic conditions. Potential price cuts and the drive toward EU emission targets represent rebound opportunities in 2025. North American sales are up 13% year-to-date, far stronger than suggested by recent headlines. US EV sales trends have strengthened in the back half of the year benefiting from increased model availability, and affordability. Looking further out on slide fourteen, longer term, we continue to expect lithium demand growth to expand by 2.5 times from 2024 to 2030. The global energy transition remains well underway, supported by consumer preferences, government policies, and technological advancements. From an affordability perspective, the global EV supply chain is on track to achieve the critical $100 per kilowatt hour tipping point, where EVs are at purchase price parity with ICE vehicles. The Chinese industry has likely surpassed that target with the rest of the world not far behind. Overall, these trends continue to reinforce our belief in the long-term growth potential of the industry. With that, I will now hand it back to Kent.
Kent Masters: Thanks, Neal. Turning to slide fifteen, I will cover the significant yet necessary actions we are taking to re-baseline our cost structure while allowing us to maintain our leadership position and preserve future growth. Let me start with our new operating structure on slide sixteen. Over the past several months, we have evaluated multiple models, balancing cost with an agile go-to-market approach. Following this review, we announced a new operating structure transitioning to a fully integrated functional model to deliver significant cost savings and maintain our long-term competitiveness. This slide shows our leadership team with several title and role changes to reflect our new structure. From a financial reporting perspective, we will continue to report across our three segments of energy storage, specialties, and kitchen. Our fully integrated organizational structure is designed to flex with the complexities of our markets and to strengthen our core capabilities in a cost-effective way to maintain our leadership position. Turning to slide seventeen, it's important to put our latest actions in context of the series of self-help steps we have been progressing for several months as we navigate the current business environment. Albemarle continues to act urgently across four key areas: optimizing our conversion network, improving cost and efficiency, reducing capital expenditures, and enhancing financial flexibility. Our actions are broad-based and designed to maintain our long-term competitive advantage in light of market conditions. And given the dynamic environment we continue to face, we are always adding to our list of potential actions so that we are ready to pivot as necessary. I'm confident in the team's ability to deliver these improvements based on our performance to date. We highlight that on slide eighteen. Here is a summary of our progress on the cost savings and cash flow initiatives introduced in January and July of this year, as well as the additional actions we are announcing today. All these programs are in execution, and the January and July actions are on track or ahead of plan, demonstrating our sharp focus on operational efficiency and proven ability to execute. Regarding the $300 million to $400 million of cost improvements we announced today, we expect to achieve a $40 million to $50 million run rate by the end of this year. Additionally, we plan to reduce our 2025 CapEx to between $800 million and $900 million, down about 50% versus 2024. How we got to these cost-out and CapEx targets was through rigorous analytics that involved a combination of robust peer benchmarking and bottoms-up project planning to estimate target savings. Over the quarter, we analyzed spend across three categories: non-manufacturing costs, specifically SG&A and R&D, manufacturing cost, and capital expenditures. Our levers to deliver the non-manufacturing and manufacturing cost and productivity savings are detailed on slide nineteen. Our total cost-out opportunity of $300 million to $400 million includes approximately $150 million in manufacturing opportunity split between cost reductions, like energy and maintenance efficiencies, and increased volume through plant ramps, yield improvements, and other areas. The $150 million to $250 million of non-manufacturing cost improvement follows a robust benchmarking review with the assistance of a third-party consultant. We evaluated and analyzed our non-manufacturing cost structure against like-sized peers in lithium and other related industries like specialty chemicals and mining. The biggest driver of these non-manufacturing savings is the change to our operating structure. The integrated model we made effective November first allows us to consolidate activities and reduce duplicative work, optimizing management layers, and increasing efficiency. Other key drivers include shifting more activities to established hubs and low-cost jurisdictions and leveraging technology to reduce manual work. We will continue to internally track our actions and progress through an established program management office, which will be laser-focused on these initiatives and leveraging our ability to execute. Slide twenty breaks down the third leg of our work, which is the reduction of our 2025 capital expenditures by more than $800 million versus 2024. Overall, we are targeting sustaining CapEx of 4% to 6% of net sales, in line with historical performance and specialty chemical averages. Though we have pulled down our spending, we will continue to invest in critical health, safety, environmental, and site maintenance projects. Through our disciplined capital allocation, we will maintain our industry-leading resource base at a phased manner. Additional growth capital will be limited to primarily high-return brownfield expansions and productivity improvements. Moving to slide twenty-one, the actions we are taking are designed to maintain Albemarle's significant competitive advantages and position us for long-term value creation, which is encapsulated by our strategic framework shown on slide twenty-three. Our strategy is unchanged but as always, we will adjust our execution to pivot and pace with the dynamic markets we serve. Our strategic framework continues to guide how we operate Albemarle as we lead the world in transforming essential resources into critical ingredients. The resources we provide play a critical role in areas where a compelling long-term growth profile. And we have competitive strengths that will allow us to navigate the environment highlighted in more detail on slide twenty-three. First, our world-class resources are arguably the best in the industry, with large-scale, high-grade, and therefore low-cost assets. In energy storage, we have access to some of the highest-grade resources in both Hard Rock in Australia and brine in Chile. Similarly, in specialties, we are the only producer with access to both tier-one bromine resources globally in Jordan and the United States. Second, our leading process chemistry know-how is key to achieving further productivity and cost improvements, safely and sustainably. At both the Salar and Magnolia, we have evaluated a wide range of direct lithium extraction options and are piloting solutions. Third, we have a pipeline of high-impact innovative in both bromine and lithium. Our research testing, and piloting facilities in North Carolina, Louisiana, and Germany allow us to participate in differentiated high-margin segments and support our customer-specific requirements. Fourth, Albemarle's leading industry position as a partner of choice is demonstrated through our partnerships with iconic pioneering companies. Both our businesses have high net promoter scores with significantly positive gaps relative to competitors, reflecting long-standing successful relationships with major customers. And we are increasingly recognized for the good work we do and the good that our work is doing. For example, we were recently named as one of the world's best companies by Time, demonstrating our commitment to creating a more resilient world and advancing the sustainability objectives of our customers. In summary, on slide twenty-four, Albemarle delivered another solid performance in the third quarter, including higher volumes in energy storage and specialties, and year-over-year improvements and adjusted EBITDA for specialties and kitchen. We've maintained our full-year 2024 outlook considerations thanks in part to enterprise-wide cost improvements, strong energy storage project ramps, and contract performance. We are focused on taking broad-based proactive steps to control what we can control and ensure we are competitive across the cycle. Albemarle remains a global leader with a world-class portfolio and vertical integration strength. I am confident we are taking the right actions to maintain our competitive position and to capitalize on the incredible long-term opportunity in our markets. I look forward to seeing some of you face-to-face at upcoming events listed here on slide twenty-five. And with that, I'd like to turn the call back over to the operator to begin the Q&A portion.
Operator: We will now move to our Q&A portion. If you would like to ask a question, please press star five to raise your hand. Our first question is from Aleksey Yefremov from KeyBanc. Aleksey, your line is open.
Kent Masters: Thanks. Good morning.
Neal Sheorey: Was lower fixed cost next year and some volume growth, can you keep your EBITDA at least flat if prices do not change? Or do you expect an increase or decline? So I okay. So that's a 2025 question as we go into a total and to be clear, we are not we are not gonna give an outlook for 2025 on this, but we can give you some kind of puts and takes off 2024. Neil, you wanna take that.
Neal Sheorey: Yeah. Sure. Good morning, Alexei. So, yeah, just a we're we're obviously working through our 2025 outlook right now, so it's a little premature for for us to talk about that. We'll talk about that on the next earnings call. But just to give you a couple of puts and takes here, so obviously, where pricing is today, that's something something that you can observe and and relative to the lower end of our guidance range today, we're probably 20% to 25% market pricing is below the average that we have achieved in in 2024. And so you can kinda build that if you if you assume today's prices kinda roll into next for in terms of a headwind for pricing. I'd also point you to all remember that in Q2, we had a bump up in our equity earnings from the Taliesin JV because we had an unusually high offtake by our partner at the JV and so we had about a $100 million uplift in the second quarter, and I do not expect that to repeat in 2025 as well. Now on the opposite side of that, is, as you mentioned, our fixed cost, we you should expect our fixed costs are gonna come down. We've, had the actions that we've announced today, the $300 to $400 million of cost and productivity action. We expect at the end of this year that we'll be at that 40% to 50% run rate. So that is savings that you can start to build into 2025 and, of course, we'll continue to build on those savings as we go through the through the year. And then, of course, we're also still ramping our our plants. Especially in the lithium business. And so you should you should expect that our fixed assets are are gonna continue to ramp as we go through 2025. So just a few puts and takes to think about things as you go through through 2025.
Kent Masters: And, Neil, I I need to follow-up on the on on the last point, you you cut your CapEx for 2025. How how is it affecting your your volumes next year? And and if you can provide any comments about volume growth right here in lithium.
Neal Sheorey: Yes. I do not I mean, the CapEx cuts were doing now won't impact volume our forecast for volume for next year. Those are it's adds further out and then us getting just tighter. On our CapEx program. So we're we're still we look at I think we previously talked about 20% growth through 2027. Some of the CapEx cuts we've done in taking some volume out, that's probably 15% CAGR through 2027. So that it's a little bit but it's longer term. It's not so much in 2025. Yeah. And, Alexei, maybe just to to pile on to that. The growth that I'm talking about for 2025 is is obviously driven by assets that are already built and and continuing to ramp. So, like, the Salar yield improvement project, Maishan in China, and will continue to ramp in 2025.
Operator: Our next question is from John Roberts with Mizuho. John, your line is open.
John Roberts: Thank you. On slide eight in that fourth quarter improved margin guidance for energy storage, what are you assuming for Talos and equity income in the fourth quarter? And what's the Talis and CapEx for 2024 and 2025?
Neal Sheorey: Yeah. So, John, this is Neil again. So when you think about equity income for next quarter, I think your assumption should be I mean, basically, spod pricing has been pretty flattish if you look at third quarter into into fourth quarter. So I think you should think about something kind of similar to what we've experienced in the in the third quarter, all things being equal. And then I think the second part of your question can you repeat that again? The budget for 2025 yet? And what what you think their 2024 CapEx comes in at? Yeah. So it it it is definitely premature for me to talk about the CapEx budget for 2025. For sure, there is capital that the JV continues to need to spend with regards to the CGP3 asset. That's an asset that will continue to be built. It will be finished up in 2025, and we expect it to be actually starting up as we get towards the end of 2025. But, John, we're literally working through the talisman budget with the JV and with the partners right now. So it's a little premature speak to that. We should have more to say okay. On the next earnings call. And what did you have to agree to or pay order to get the revised financial covenants?
John Roberts: Yeah.
Neal Sheorey: John, I won't I won't give you the exact number, but it was it was a very small amount. You should think about it being far less than a million dollars.
Operator: Our next question is from David Deckelbaum with Cowen. David, your line is open.
David Deckelbaum: Thanks for your time this morning. I was curious. You've received some questions on the impact of the CapEx cuts on your long-term growth profile. The reduction of that $800 to $900 million as you go through this strategic review, is that where we should think of approximately maintenance capital or as we get into 2026 and beyond, could we see numbers, you know, quite a bit below those levels?
Kent Masters: Yeah. So we're look, we're getting we're we're tightening down on maintenance capital, and we're targeting a range of 4% to 6% of revenue at some at a normalized level. So you'll see it's a little bit above that this year because we think pricing is below a normalized level. So we're a little above that, but we're also working working to tighten that up. And then you see growth capital in there for high return projects, productivity type projects, brownfield type expansions, which are high return and quick payback. So that's kinda how what we've got built into that that $800 to $900 million. And look, we'll continue to work on that. It depends on the opportunities that that we have, but we'll we'll continue to focus. But we're from a maintenance capital standpoint, we're trying to be in that range of 4% to 6% on a normalized basis. And we're we're a little ahead of that for this year. Or for next year. Sorry. Appreciate that.
David Deckelbaum: Yep.
Kent Masters: And then, you know, just continuing with just the theme of of cash. Preservation, what's what's the outlook for the next several quarters in terms of of cash conversion? Obviously, this quarter, there was some working capital management that really helped that conversion and and and helped kind of fortify the balance sheet. So I'm curious how you think about you know, the the next the next several quarters ahead of us here.
Kent Masters: Yeah. So Neil can give us some specifics on that. But but we're we're we're very focused on it. Some of our key metrics around that is is cash conversion. So up cash flow, everything around that, but a key management metric that that we're focused on is cash conversion. You saw a big number this quarter. We obviously can't we can't repeat that, so it it will come off that. We're we're above historic levels that oh, where we've operated historically, but we're focused on driving that conversion number up. Neil, do you wanna make any specific comment?
Neal Sheorey: Yeah. Just to just to add to that, Ken. So absolutely, I'll double down on what Kent said that we obviously have a very strong focus internally on cash generation, cash conversion, and driving to that free cash flow breakeven point in the future. And we're continuing every quarter to work on this. Several things that we're we've got in flight is obviously working capital management is is very much front and center. We have the cost and productivity that we are already doing, but obviously, today, we've announced even more that we're doing, and so we continue to drive on that. The the other piece that will be very important for our overall cash flow generation is how we think about the dividends coming off of the Taliesin joint venture. One of the reasons that we mentioned in the deck that our our cash conversion is going to be lower in the fourth quarter is that at the moment, we see those those dividends from the Talison joint venture in the fourth quarter coming down. They're right now, our assumption is they'll be zero. But obviously, as we get into 2025 and as we work through things with the JV, it will be very important to as we think through the dividends that that JV can can throw back to the partner.
Operator: Our next question is from Ben Isaacson with Scotia Capital. Ben, your line is open.
Ben Isaacson: Good morning. This is Apurva on for Ben. So my question for you is that so you've discussed your leverage covenant providing substantial offer. We thought kind of two x spread in Q3. Is there any color that you can provide on the shape of those limits as they evolve through to 2026? Moving specifically at Q2 and Q3 2025 where that lever the covenant limit rises to kind of 5.75 times. So any color there?
Neal Sheorey: Yeah. Perva. So, you know, essentially, the the shaping of that covenant waiver sort of follows recall that our covenant waiver is calculated on a trailing twelve month EBITDA. And so you can imagine that we've kind of shaped this based on how we look backwards at the the the shape of the EBITDA that we've generated so far in in 2024 as well. So that's really how we we've thought through how the trailing twelve months might look like as we go forward and then shape covenant waiver accordingly.
Ben Isaacson: Perfect. Thank you.
Operator: Our next question is from Steve Byrne with Bank of America. Steve, your line is open.
Steve Byrne: Hi. I'm Rob Hoffman on for Steven. In 3Q, realized pricing energy storage has seemingly come in at a lower premium relative to the lithium market price versus prior quarters. Was there any meaningful shift in the percent of contract price with one quarter lags and pricing floors? And what percent of the two-thirds contractors figure has pricing for us?
Kent Masters: Yeah. So I don't there's there's real no change in the contracts that that rolled off during the quarter. So that I'm not sure. So that that is a little different than the way that I think about it. But the contracts really, they they haven't changed. So it's the mix of where those customers are and where that volume gets taken is is how your average moves. Price.
Steve Byrne: And and we're I don't think we're gonna say anything more than we have said before about the contracts and the floors that we have. So we've got contract volume on about two-thirds of it. And some have floors and ceilings and and others don't. But not gonna but it hasn't changed.
Rob Hoffman: I could just ask. This is Eric that that that during during the quarter, we did see our highest volumes that we'll see any quarter. This to date and be hired in the fourth quarter as well. A lot of that was due to the timing of spot sales and spodumene sales. Which would buy us a mix and in a quarter and and has. So, I mean, I think I think you're noting something that is that is is on target that there's a mix effect there. That's not a reflection of contract that I would wash out on a full year basis and we can guidance. Makes sense. And then just a follow-up, given a look lower pricing being sustained, might you consider cutting operating rates to tighten the market rather than the aforementioned guided 15% year term catered growth and volume.
Kent Masters: So we we look at everything. It's probably it's less a little bit about tightening the market, but where it makes sense for us to what our customer demand is, what we see volumes growing to and the mix about where we produce most cost-effectively. So but but we we look we're looking at everything. Including operating rates at plants, but it it's really more about the mix of our customers, the demand growth, than it is about thinking about tightening the market.
Operator: Our next question is from Vincent Andrews with Morgan Stanley. Vincent, your line is open.
Vincent Andrews: Thank you, and and good morning. Neil, can I ask you on the $300 to $400 million, you know, 40% to 50% run rate by the end of this year? What then you know, gives you such a wide range for I guess, you're gonna finish all off by the end of year. But what would make it $300 and what would make it $400?
Kent Masters: I think that's I mean, it's just it's a range that we're giving and some of the things that we're working through around that. So it's not all completely detailed out. So and, that that dime there's a dynamic of around that. As we go. Some of it is around overhead, some of it's around operating cost, productivity improvements, and things that we're doing at plant. So there there's a range to give us a little bit of breathing room because we're the lower end would be fairly conservative, and the upper end would be a bit of a stretch. I don't think it's any more sophisticated than that.
Vincent Andrews: Fair enough. You can't if I could ask you, know, as we as we look ahead, we're obviously at the bottom of the cycle. Let's let's assume the cycle turns. Let's assume prices go back and I'll make up a number $25,000 a ton. You know, and you clean up your balance sheet issues. What what is Albemarle's strategy in gonna be? Is it just gonna be a reversion to what you were doing prior to last down cycle where you wanna get back into conversion and you wanna go out by resources? Or you're gonna do something different, or are there things you're not gonna do? You know, how are you how are you and how's the board thinking about, you know, sort of the where the company wants to be strategically going forward?
Kent Masters: Yeah. So we've said I actually said our prepared remarks that our strategy has not changed but the way we're executing against it has. So if we so when when we'll react to the market. So prices come back, to be honest, I think we're gonna be a little conservative to make sure that they are gonna stay there. Before we shift our our plans around that. So we'll be we'll be we wanna make sure if they move up, that they're gonna stay up and we're just not in another cycle. And I think right now, we're focused on making sure that we put the cost structure in place to compete through the bottom of the cycle and we'll be able to we're trying to create the flexibility to pivot up if the market returns, but we're gonna be a little conservative to make sure it really changed and we're just not in a cycle.
Operator: Our next question is with Kevin McCarthy from Vertical Research Partners. Kevin, your line is open.
Kevin McCarthy: Hi. This is Matt Hower on for Kevin McCarthy. During your cost structure review, what new processes did you learn from benchmarking lithium peers? And how do you plan to implement those at Albermaril? On slide nineteen, it looks like there's a gap between the current non-manufacturing costs.
Kent Masters: Yeah. Albemarle.
Matt Hower: And out of your meeting peer group? What did you identify as the source of that difference?
Kent Masters: So on the benchmarking, I'll take that. Sorry. We got a phone going off in the room. So I on the benchmark, I'm not sure we learn any new processes from benchmarking our peers, but it's more about a the cost the cost of overhead where people were operating and not it's less about lithium peers than it was just about broad corporate cost structure. With people that have a footprint that looks a bit like ours, very global, with heavy manufacturing those type of pieces. So I'm not sure we picked up any big process changes that we learned from our lithium peers. I I think it's just more about the the aspiration we took from a cost-saving standpoint based on what we saw other corporates doing. And maybe this is Neil. Just to just to add to a couple of things. Look, as an organization standpoint, we were obviously for for growth historically and now in this new environment, we're we're moving to more of a co cost-focused organization. Time and again, that that model that works is the functional model that we announced. And so I think one of the key things that we saw is that there are ways to achieve what you need to from a a strict functional model standpoint. So that's one of the the key things as we functionalize the company. There are naturally gonna be cost and simplification opportunities. And then the other thing I'll I'll point out too is that we have two up and running and and very well very well running back offices and those are areas that we can use much more efficiently especially in functionalized model as well. So those are just a couple of examples. You see them on on slide, I think it's nineteen as well. But those are really some of the core areas where we are finding cost-out opportunities.
Matt Hower: Thanks. And then could you comment on some of the recent supply curtailments that you've seen? There been any significant downward movement in lipidolite supply out of China or Africa? And given that, you know, you estimate 25% of the supply curve to be unprofitable, why do you think it's taken so long to see a a significant downward momentum in supply?
Eric Norris: Yes. Good morning. This is this is Eric. So speaking on lapelite, it was announced during the quarter and we've we've since been able to get corroboration although it's it isn't always clear in China, but that but the lopetalite one of the largest lopetalites suppliers had gone down into care and maintenance, taking some capacity offline, but there's still a pet light in the market. It's obviously, that's all in China. We've also seen continued growth in supply coming that's replacing that serving that growing China market coming out of Africa. We've seen a lot of the shutdowns have been some of the or modulations in some cases, has been out of the western Australian? Sites and some delays on some of the the the Brian projects that were more either Greenfield or significant brownfield expenses have been pushed out. I'm we could get in more detail, but that's a that's a quick summary. As to why more has not come out, it's it it is a little little puzzling. It is a fragmented market. It is a market with significant Chinese presence today. And it's it's a market where you have a lot of young companies whose sole reason for for existing is to to raise a lithium project. They may have cash on their balance sheets, and as long as they can continue to operate, they will do so. They don't have alternative. So I think it's the maturity, maybe one way putting up this market is such it's gonna take a little longer and that is reflected in our lower for longer view on pricing potentially, which is driving us our need to be competitive for the cost the cycle that that and then all these actions that we have talked about taking today.
Operator: Our next question is from Joel Jackson from BMO Capital Markets. Joel, your line is open.
Joel Jackson: Hi. Good morning, everyone. Just following up on that for my first question. Don't you think that more supply needs to come out of the market, like real supply? Not some projects three years from now, but real spodgy, I mean, real hard rock, real brine out of the market now. To get prices going, or what do you think needs to happen to get prices to recover? And it seems like it can't just be demand. It's gotta be supply at this point. Would you agree?
Kent Masters: Well, I think it's both. Right? So we we we do think more supply needs to come out, and then these and these prices persist as it will come out. It's a matter of how long it takes. And then and demand is still pretty strong. Right? It's over 20%. It's it's buck we've it it's been ticked up a little bit by some of the fixed storage volumes. That that in the last few quarters. A little stronger than we had anticipated, but it it is both. It's both demand and supply, and we we do we need more supply to come out, and we expect it to work at prices at these levels.
Joel Jackson: There have been a lot of stories in the media the last few months about Altima maybe looking at the massive sales whether it be your stake in Greenbushes or or Talosin, which I think you refuted publicly or had a retraction in the media, got a retraction made from that report in the media, but also maybe speculation you'd be considering selling your stake in Wajna you just generally talk about if you're looking at any asset sale.
Kent Masters: But we're always looking at from a port so Ketchum is an example of that that we talked about that and said that's a non-core asset that we look to sell. But Greenbush is something we are not when we're not we wouldn't speculate on rumors around that, but and we but we did clarify green bushes do not something we're thinking about selling.
Operator: Our next question is from Michael Sison from Wells Fargo. Michael, your line is now open.
Abigail: Hi there. This is Abigail on for Mike. Just wanted to ask about the status of Kings Mountain, if there's any update in terms of cost or plans or anything like that.
Kent Masters: So King's Mile is a project we continue to push and invest in. So we're we're going through the permitting process that and that process is on track. There there's a a number of permits that are necessary for that, and it's a pretty long time frame to secure all of those, but I would say we we continue to pursue that from a permitting standpoint. And it and the process is at this point, it's on track.
Abigail: Got it. Thanks.
Operator: Our next question is from Christopher Parkinson with Wolfe Research. Christopher, your line is now open.
Harris Fein: Hey. This is Harris Fine on for Chris. Thanks for taking my question. For my first one, it'd be helpful to hear some of your thoughts on the implications from the election how you're thinking about tariffs and EV subsidies, and and maybe how you're adapting strategy for that kind of environment. Thanks.
Kent Masters: Yeah. So it is well, it's a little early to to talk about what a Trump administration may do. We know what they've talked about. We'll have to see what they do. But this the energy transition is kind of a global phenomenon that that is happening. It's really driven first by China. Europe, probably the second largest market in that, and then North America. And I don't wanna speculate on what Trump administration might do. We'll have to wait see. I will say that we've we've worked across the aisle in, around the the US, and we have contacts there. We we know what they had talked about, but I think we just have to wait and see what they do, and then we'll we will adjust to that. But it is a global market. And this energy transition is happening. And we're pretty well positioned around the globe to take advantage of that. We we were a strategy had been to pivot to the west. We've kinda backed off that given that prices have been so low and economics are building that supply chain out in the west. We still hope to do that, but we have to wait and see what Trump administration wants to do.
Harris Fein: Got it. That that's helpful. And then for my second one, in slide seventeen, you mentioned, potential upside actions. Accelerating productivity and and reducing capital intensity even more. I guess maybe could you provide a little more detail to what's on the table right now? Anything you can share as to what that might entail? Thanks.
Kent Masters: So look, I think we're work we're working through this and we and as we said before, there we we've given a range because and we're we're being pretty aggressive around that and and it and it covers everything from overhead to R&D, part of that and our manufacturing base. So there's some opportunities to to take cost out of there. So I don't know that we wanna speculate on those. We need to do the work, and then we'll come back to it. Because I think first you'll see, hopefully, we'll be narrowing the range to the upside. As we go through and execute against this. And then if we have anything new to report, we'll do that in time, but I'm not I don't wanna get out in front of.
Operator: Our next question is from Joshua Spector with UBS. Joshua, your line is now open.
Chris Parela: Yes. It's Chris Parela on for Josh. Good morning, everyone. I wanted to follow-up on the contract outlook for lithium next year. I know it's two-thirds under contract, for this year, what are your expectations for the mix in 2025? And then I had a follow-up on use of cash in the fourth quarter.
Kent Masters: So I I guess as we go through this, so as the we're not our our mix won't change materially. Other than the fact that a lot of the growth will come on at spot volumes. It may and it may be under a contract, but it would be probably not with the same level of floors that we have in our current contract. So the growth kind of creates additional mix, if you will, so it's not really a change in those contracts, that the existing contracts per se, but new ones either that come on or we the volume that we sell is on a spot basis. It's more reflective of the spot market.
Chris Parela: Oh, thanks, Kent. And then I guess for Neil, the use of cash in the fourth quarter from an operational standpoint, quite large. Could you just bucket or size out and expand upon what the cash outflow or the use of cash is going to be from an operational standpoint in the fourth quarter?
Neal Sheorey: Yeah. Let me let me maybe give you a couple of things to to think about. So first of all, in the fourth quarter as I mentioned on a on a previous Q&A, we're right now not expecting a dividend from the Taliesin JV. If you go back and and look at what we did in the third quarter or what we got in the third quarter, you'd probably find that that that dividend was in the, let's call it, $70 million to $80 million kind of range in the third quarter. And so that's that's one piece that we won't we're not expecting on in the in the fourth quarter. The other piece is is as we mentioned in the prepared remarks, one of the one is that we there are two things behind our working capital performance in the third quarter. The first we said was working capital management working focused on on driving those to an efficient point by the end of the year. But we also talked about timing of working capital and what that was specifically is we had some items in a pay that moved from the third quarter into the fourth quarter. So we'll eventually have to obviously make those payments. And I I won't give you the exact number here but you can imagine that that's gonna be in the tens of millions of dollars. As we finish up those payments. And then the last one is these the payments related to the cost reduction actions that we announced today. If you go and look in our queue, I'm I I don't know if you've had time to look at that, but we've bread boxed that and it's kind of in that $40 million to $50 million kind of cash outflow range as well. So that that maybe gives you a few key buckets to think about from an operating cash flow perspective.
Operator: Our next question is Patrick Cunningham from Citi. Patrick, your line is now open.
Eric Zang: Hi. Good morning. This is Eric Zang on for Patrick. On the 2025 CapEx guide, can you walk us through the actions you guys taken to bring down CapEx and what is contemplated? And are there any assets under consideration that could potentially go into care and maintenance? Thank you.
Kent Masters: So okay. Midwoth Capital first. So and then know, you can help me on this a little bit. But we've looked up a across the organization and we've taken out there's some growth projects that we have taken out about of capital. We've tightened others up. And from a maintenance capital standpoint, we've gotten tighter on that, a little more rigorous, and I as always said before, what we've kept in, we've got maintenance capital, what we think is minimum that we need. And again, we're targeting that 4% to 6% of revenue for rain in the range for maintenance capital and we're a we're a little ahead of that for 2025 because we used that's on a normalized revenue basis and we think we're below a normalized level given lithium prices. And we've got projects around either oh, pretty short payback investment projects whether they're for cost improvement or additional product that would be a high return short payback type projects. We're still doing those and those larger growth projects, which is why we're we pulled back on our growth forecast out into the future because we're not doing some of those bigger projects that we had planned. And then the the second part of the question, I'm sorry.
Eric Zang: Oh, asset oh, sorry. Another question. So we.
Kent Masters: Yep. Yep. So we've done alright. Yep. I got it. So sorry. So we've we've done the train to at Kimberton and Cara then and depending on where prices go, we will look at other assets both from a resource and conversion standpoint across the portfolio. It's something that that we are that we will look at. We've not made decisions around that. And some of those are are require like say b decisions as well. So Woden is one where we're we're deciding about the number of trains that we operate at Wajina. It's something we have to agree with our joint venture partner.
Eric Zang: Okay. Thank you.
Operator: Thank you. That's all the time we have for questions. I will now pass it back to Kent Masters for closing remarks.
Kent Masters: Okay. Thank you, Jimmy. Albemarle continues to deliver solid operational results due to our execution across the company. With proactive steps underway to reduce cost and drive performance, we are well positioned to take advantage of the long-term growth opportunities across our end markets. Thank you for joining us today. And please stay safe.
Operator: This concludes today's conference call. Thank you for your participation. You may now disconnect. | [
{
"speaker": "Operator",
"text": "Hello, and welcome to the Albemarle Corporation's Q3 2024 earnings call. We ask that you please hold all questions until the completion of the formal remarks, at which time you will be given instructions for the question and answer session. Also, as a reminder, this conference is being recorded today. I will now turn the call over to Meredith Bandy, Vice President of Investor Relations and Sustainability."
},
{
"speaker": "Meredith Bandy",
"text": "Thank you, and welcome everyone to Albemarle's third quarter 2024 earnings conference call. Our earnings were released after the market yesterday, and you will find the press release and earnings presentation posted to our website under the investor section at Albemarle.com. Joining me on the call today are Kent Masters, Chief Executive Officer, and Neal Sheorey, Chief Financial Officer. Netha Johnson, Chief Operations Officer, and Eric Norris, Chief Commercial Officer, are also available for Q&A. As a reminder, some of the statements made during this call, including our outlook, guidance, expected company performance, and strategic initiatives, may constitute forward-looking statements. Please note the cautionary language about forward-looking statements contained in our press release and earnings presentation, which also applies to this call. Please also note that some of our comments today refer to non-GAAP financial measures. Reconciliations can be found in our earnings material. And now I will turn the call over to Kent."
},
{
"speaker": "Kent Masters",
"text": "Thank you, Meredith. During the third quarter, Albemarle continued to demonstrate solid operational execution, delivering volumetric growth in energy storage and specialties, year-over-year EBITDA growth in specialties and kitchen, strong operating cash conversion of over 100%, and leverage metrics well below our covenant limits. We also continued to progress our cost improvement plans, further ramp our new facilities, and deliver higher volumes. As a result, we are maintaining our full-year 2024 corporate outlook considerations. In a few moments, Neal will give more detail on our third quarter performance, key results, and actions we are taking to preserve our financial flexibility. My focus today will be on addressing the outcomes that we are now driving as a result of the comprehensive cost and operating structure review we progressed over the past few months. In conjunction with this review, we are implementing a new operating structure, transitioning to a fully integrated functional model designed to deliver significant cost savings and maintain long-term competitiveness. We are targeting $300 to $400 million of further cost and productivity improvements by eliminating redundancies, reducing management layers, and optimizing manufacturing costs. These savings are due in part to the difficult but necessary decision to reduce our global workforce by an additional 6% to 7%. In total, we have eliminated nearly 1,000 roles, including all the actions announced this year. We also are now driving a year-over-year reduction in our full-year 2025 capital expenditures by at least $800 million or about 50%, with a disciplined focus on critical health, safety, environmental, and site maintenance and a phased approach to maintaining our world-class resource base. We are confident these actions are the right steps to adapt to market conditions while serving our customers and pursuing long-term value creation. I will have more to say about our cost-out and productivity plans later on the call. I will now hand it over to Neal to discuss our financial results during the quarter."
},
{
"speaker": "Neal Sheorey",
"text": "Thanks, Kent, and good morning, everyone. Beginning on slide five, I will summarize our third quarter performance. We recorded net sales of $1.4 billion compared to $2.3 billion in the prior year quarter, a decline of 41% driven principally by lower pricing, particularly for lithium. During the quarter, we recorded a loss attributable to Albemarle of $1.1 billion and a diluted loss per share of $9.45. Adjusted diluted loss per share was $1.55. Our GAAP result included a pretax charge of $861 million related to capital project asset write-offs at Kemerton 3, and putting Cameron 2 into care and maintenance, of which about 10% is cash outflow in the second half of the year. This charge was below our initial estimate that we provided on the last earnings call of $900 million to $1.1 billion. Turning to Slide six, our third quarter adjusted EBITDA of $211 million was lower than the prior year period, also primarily due to lower lithium pricing. This was partially offset by lower cost of goods sold primarily related to reduced spodumene pricing. Other positives include higher volumes in energy storage related to delivery of our growth projects, and in specialties related to stronger end market demand. Our cost and efficiency initiatives also provided productivity which more than offset inflation. Looking at adjusted EBITDA by operating segment, we saw improved year-over-year profitability in specialties, due to productivity improvements and better end market demand. Catch in EBITDA also improved year-over-year as we continue to execute our turnaround plan during the quarter. Moving to slide seven, as Kent mentioned, we are maintaining our full-year 2024 outlook considerations thanks to the execution of cost and productivity improvements, continued strong volume growth, including higher sales volumes at Artalison JV, and contract performance in energy storage. As a reminder, these scenarios are based on historically observed lithium market pricing, and represent a blend of relevant market prices including both China and ex-China pricing, for lithium carbonate, and lithium hydroxide. Turning to slide eight for additional commentary on outlook, we expect corporate full-year 2024 net sales to be near the lower end of the $12 to $15 per kilogram scenario primarily due to weaker second-half pricing for lithium, offset by contract performance. Full-year 2024 adjusted EBITDA is expected to be in the middle of that same scenario range thanks to successful cost-cutting and productivity improvements. In energy storage, we now expect full-year volume growth to be more than 20% year-over-year, as we have continued to benefit from solid demand particularly in China, and ongoing ramps of our new facilities. Fourth-quarter volumes are expected to be down sequentially primarily due to timing of spodumene sales volumes, reduced tolling, and planned outages. Margins are expected to be slightly higher sequentially as the benefit of lower-priced spodumene in cost of goods sold offsets the impact of unabsorbed fixed costs as our new plants continue to ramp. At both specialties and kitchen, we continue to expect modest sequential improvements in the fourth quarter, thanks to better end market conditions and productivity benefits. Please refer to our appendix slides in the deck for additional modeling considerations across the enterprise. Moving to our balance sheet and liquidity metrics on slide nine, we ended the third quarter with available liquidity of $3.4 billion, including $1.7 billion of cash and cash equivalents and the full $1.5 billion available under our revolver. Actions we have taken to improve our cost structure and enhance operational efficiency have also provided enhanced financial flexibility. Thanks to our successful actions to reduce costs and optimize cash flow, we ended Q3 with net debt to adjusted EBITDA of 3.5 times, or two turns below the covenant limit in the quarter. To navigate market conditions, we took proactive measures in the quarter around our covenant waiver. The outcome of our action is shown on slide ten. In October, we proactively extended our covenant waiver through the third quarter of 2026 and reshaped it to ensure we have the financial flexibility needed as we execute our new operating structure and cost reduction actions. Moving forward, our goal remains to stay well within these limits through solid financial and operational execution, as we have shown throughout 2024. Slide eleven highlights our execution focus which is demonstrated by the continued improvement in our operating cash flow as a result of operational discipline and cash management actions. Our operating cash flow conversion defined as operating cash flow as a percent of adjusted EBITDA, was greater than 100% in the third quarter, primarily due to timing and management of working capital. We continue to expect full-year operating cash conversion to be approximately 50%, at the higher end of our historical range and above our expectations at the beginning of the year. This is driven by increased Talisin dividends with higher sales volumes at green bushes, and working capital improvements, including a significant focus on inventory and cash management across our operations. This means that we expect fourth-quarter cash conversion to be lower than recent quarters due in part to cash outflows associated with the workforce reductions we announced today as well as the timing of JV dividends. As a reminder, we account for our 49% interest in the Taliesin JV via the Equity method. Therefore, the impact to cash flows is in dividends received. As we have said before, we expect dividends to be lower than normal year, and into 2025 as Taliesin completes the CGP3 capital project at the Greenbushes mine. I'm pleased to see that our efforts to improve operating cash flow conversion are yielding results. We will continue driving toward free cash flow breakeven through our ongoing ramp of new capacity, inventory management, bidding events, cost out and productivity measures, and other cash conversion improvements. Turning to slide twelve, we will provide a few comments on current lithium market conditions, which have shown some positive signs. On the supply side, there have been several announced upstream and downstream curtailments. Non-integrated hard rock conversion is unprofitable, and larger integrated producers are under pressure. We estimate that at least 25% of the global resource cost curve is unprofitable or operating at a loss. On the demand side, grid storage demand continues to surprise to the upside, up 36% year-to-date led by installations in the US and China. Global electric vehicle registrations are up 23% year-to-date, led by China, and demand growth in the United States is also up double digits. Slide thirteen breaks down global EV demand growth by region. China represents 60% of the overall EV market with continued strong year-to-date demand growth of more than 30% in line to slightly ahead of initial expectations. In terms of demand mix, we have seen stronger growth in plug-in hybrid sales in China, as current subsidies are more balanced between battery EVs and plug-in hybrids. Chinese plug-in hybrids include range-extended vehicles with battery sizes somewhere between traditional battery EVs and plug-in hybrids. Meanwhile, the softest demand region globally is Europe, where EV sales growth is down slightly year-to-date due to reduced subsidies and weaker economic conditions. Potential price cuts and the drive toward EU emission targets represent rebound opportunities in 2025. North American sales are up 13% year-to-date, far stronger than suggested by recent headlines. US EV sales trends have strengthened in the back half of the year benefiting from increased model availability, and affordability. Looking further out on slide fourteen, longer term, we continue to expect lithium demand growth to expand by 2.5 times from 2024 to 2030. The global energy transition remains well underway, supported by consumer preferences, government policies, and technological advancements. From an affordability perspective, the global EV supply chain is on track to achieve the critical $100 per kilowatt hour tipping point, where EVs are at purchase price parity with ICE vehicles. The Chinese industry has likely surpassed that target with the rest of the world not far behind. Overall, these trends continue to reinforce our belief in the long-term growth potential of the industry. With that, I will now hand it back to Kent."
},
{
"speaker": "Kent Masters",
"text": "Thanks, Neal. Turning to slide fifteen, I will cover the significant yet necessary actions we are taking to re-baseline our cost structure while allowing us to maintain our leadership position and preserve future growth. Let me start with our new operating structure on slide sixteen. Over the past several months, we have evaluated multiple models, balancing cost with an agile go-to-market approach. Following this review, we announced a new operating structure transitioning to a fully integrated functional model to deliver significant cost savings and maintain our long-term competitiveness. This slide shows our leadership team with several title and role changes to reflect our new structure. From a financial reporting perspective, we will continue to report across our three segments of energy storage, specialties, and kitchen. Our fully integrated organizational structure is designed to flex with the complexities of our markets and to strengthen our core capabilities in a cost-effective way to maintain our leadership position. Turning to slide seventeen, it's important to put our latest actions in context of the series of self-help steps we have been progressing for several months as we navigate the current business environment. Albemarle continues to act urgently across four key areas: optimizing our conversion network, improving cost and efficiency, reducing capital expenditures, and enhancing financial flexibility. Our actions are broad-based and designed to maintain our long-term competitive advantage in light of market conditions. And given the dynamic environment we continue to face, we are always adding to our list of potential actions so that we are ready to pivot as necessary. I'm confident in the team's ability to deliver these improvements based on our performance to date. We highlight that on slide eighteen. Here is a summary of our progress on the cost savings and cash flow initiatives introduced in January and July of this year, as well as the additional actions we are announcing today. All these programs are in execution, and the January and July actions are on track or ahead of plan, demonstrating our sharp focus on operational efficiency and proven ability to execute. Regarding the $300 million to $400 million of cost improvements we announced today, we expect to achieve a $40 million to $50 million run rate by the end of this year. Additionally, we plan to reduce our 2025 CapEx to between $800 million and $900 million, down about 50% versus 2024. How we got to these cost-out and CapEx targets was through rigorous analytics that involved a combination of robust peer benchmarking and bottoms-up project planning to estimate target savings. Over the quarter, we analyzed spend across three categories: non-manufacturing costs, specifically SG&A and R&D, manufacturing cost, and capital expenditures. Our levers to deliver the non-manufacturing and manufacturing cost and productivity savings are detailed on slide nineteen. Our total cost-out opportunity of $300 million to $400 million includes approximately $150 million in manufacturing opportunity split between cost reductions, like energy and maintenance efficiencies, and increased volume through plant ramps, yield improvements, and other areas. The $150 million to $250 million of non-manufacturing cost improvement follows a robust benchmarking review with the assistance of a third-party consultant. We evaluated and analyzed our non-manufacturing cost structure against like-sized peers in lithium and other related industries like specialty chemicals and mining. The biggest driver of these non-manufacturing savings is the change to our operating structure. The integrated model we made effective November first allows us to consolidate activities and reduce duplicative work, optimizing management layers, and increasing efficiency. Other key drivers include shifting more activities to established hubs and low-cost jurisdictions and leveraging technology to reduce manual work. We will continue to internally track our actions and progress through an established program management office, which will be laser-focused on these initiatives and leveraging our ability to execute. Slide twenty breaks down the third leg of our work, which is the reduction of our 2025 capital expenditures by more than $800 million versus 2024. Overall, we are targeting sustaining CapEx of 4% to 6% of net sales, in line with historical performance and specialty chemical averages. Though we have pulled down our spending, we will continue to invest in critical health, safety, environmental, and site maintenance projects. Through our disciplined capital allocation, we will maintain our industry-leading resource base at a phased manner. Additional growth capital will be limited to primarily high-return brownfield expansions and productivity improvements. Moving to slide twenty-one, the actions we are taking are designed to maintain Albemarle's significant competitive advantages and position us for long-term value creation, which is encapsulated by our strategic framework shown on slide twenty-three. Our strategy is unchanged but as always, we will adjust our execution to pivot and pace with the dynamic markets we serve. Our strategic framework continues to guide how we operate Albemarle as we lead the world in transforming essential resources into critical ingredients. The resources we provide play a critical role in areas where a compelling long-term growth profile. And we have competitive strengths that will allow us to navigate the environment highlighted in more detail on slide twenty-three. First, our world-class resources are arguably the best in the industry, with large-scale, high-grade, and therefore low-cost assets. In energy storage, we have access to some of the highest-grade resources in both Hard Rock in Australia and brine in Chile. Similarly, in specialties, we are the only producer with access to both tier-one bromine resources globally in Jordan and the United States. Second, our leading process chemistry know-how is key to achieving further productivity and cost improvements, safely and sustainably. At both the Salar and Magnolia, we have evaluated a wide range of direct lithium extraction options and are piloting solutions. Third, we have a pipeline of high-impact innovative in both bromine and lithium. Our research testing, and piloting facilities in North Carolina, Louisiana, and Germany allow us to participate in differentiated high-margin segments and support our customer-specific requirements. Fourth, Albemarle's leading industry position as a partner of choice is demonstrated through our partnerships with iconic pioneering companies. Both our businesses have high net promoter scores with significantly positive gaps relative to competitors, reflecting long-standing successful relationships with major customers. And we are increasingly recognized for the good work we do and the good that our work is doing. For example, we were recently named as one of the world's best companies by Time, demonstrating our commitment to creating a more resilient world and advancing the sustainability objectives of our customers. In summary, on slide twenty-four, Albemarle delivered another solid performance in the third quarter, including higher volumes in energy storage and specialties, and year-over-year improvements and adjusted EBITDA for specialties and kitchen. We've maintained our full-year 2024 outlook considerations thanks in part to enterprise-wide cost improvements, strong energy storage project ramps, and contract performance. We are focused on taking broad-based proactive steps to control what we can control and ensure we are competitive across the cycle. Albemarle remains a global leader with a world-class portfolio and vertical integration strength. I am confident we are taking the right actions to maintain our competitive position and to capitalize on the incredible long-term opportunity in our markets. I look forward to seeing some of you face-to-face at upcoming events listed here on slide twenty-five. And with that, I'd like to turn the call back over to the operator to begin the Q&A portion."
},
{
"speaker": "Operator",
"text": "We will now move to our Q&A portion. If you would like to ask a question, please press star five to raise your hand. Our first question is from Aleksey Yefremov from KeyBanc. Aleksey, your line is open."
},
{
"speaker": "Kent Masters",
"text": "Thanks. Good morning."
},
{
"speaker": "Neal Sheorey",
"text": "Was lower fixed cost next year and some volume growth, can you keep your EBITDA at least flat if prices do not change? Or do you expect an increase or decline? So I okay. So that's a 2025 question as we go into a total and to be clear, we are not we are not gonna give an outlook for 2025 on this, but we can give you some kind of puts and takes off 2024. Neil, you wanna take that."
},
{
"speaker": "Neal Sheorey",
"text": "Yeah. Sure. Good morning, Alexei. So, yeah, just a we're we're obviously working through our 2025 outlook right now, so it's a little premature for for us to talk about that. We'll talk about that on the next earnings call. But just to give you a couple of puts and takes here, so obviously, where pricing is today, that's something something that you can observe and and relative to the lower end of our guidance range today, we're probably 20% to 25% market pricing is below the average that we have achieved in in 2024. And so you can kinda build that if you if you assume today's prices kinda roll into next for in terms of a headwind for pricing. I'd also point you to all remember that in Q2, we had a bump up in our equity earnings from the Taliesin JV because we had an unusually high offtake by our partner at the JV and so we had about a $100 million uplift in the second quarter, and I do not expect that to repeat in 2025 as well. Now on the opposite side of that, is, as you mentioned, our fixed cost, we you should expect our fixed costs are gonna come down. We've, had the actions that we've announced today, the $300 to $400 million of cost and productivity action. We expect at the end of this year that we'll be at that 40% to 50% run rate. So that is savings that you can start to build into 2025 and, of course, we'll continue to build on those savings as we go through the through the year. And then, of course, we're also still ramping our our plants. Especially in the lithium business. And so you should you should expect that our fixed assets are are gonna continue to ramp as we go through 2025. So just a few puts and takes to think about things as you go through through 2025."
},
{
"speaker": "Kent Masters",
"text": "And, Neil, I I need to follow-up on the on on the last point, you you cut your CapEx for 2025. How how is it affecting your your volumes next year? And and if you can provide any comments about volume growth right here in lithium."
},
{
"speaker": "Neal Sheorey",
"text": "Yes. I do not I mean, the CapEx cuts were doing now won't impact volume our forecast for volume for next year. Those are it's adds further out and then us getting just tighter. On our CapEx program. So we're we're still we look at I think we previously talked about 20% growth through 2027. Some of the CapEx cuts we've done in taking some volume out, that's probably 15% CAGR through 2027. So that it's a little bit but it's longer term. It's not so much in 2025. Yeah. And, Alexei, maybe just to to pile on to that. The growth that I'm talking about for 2025 is is obviously driven by assets that are already built and and continuing to ramp. So, like, the Salar yield improvement project, Maishan in China, and will continue to ramp in 2025."
},
{
"speaker": "Operator",
"text": "Our next question is from John Roberts with Mizuho. John, your line is open."
},
{
"speaker": "John Roberts",
"text": "Thank you. On slide eight in that fourth quarter improved margin guidance for energy storage, what are you assuming for Talos and equity income in the fourth quarter? And what's the Talis and CapEx for 2024 and 2025?"
},
{
"speaker": "Neal Sheorey",
"text": "Yeah. So, John, this is Neil again. So when you think about equity income for next quarter, I think your assumption should be I mean, basically, spod pricing has been pretty flattish if you look at third quarter into into fourth quarter. So I think you should think about something kind of similar to what we've experienced in the in the third quarter, all things being equal. And then I think the second part of your question can you repeat that again? The budget for 2025 yet? And what what you think their 2024 CapEx comes in at? Yeah. So it it it is definitely premature for me to talk about the CapEx budget for 2025. For sure, there is capital that the JV continues to need to spend with regards to the CGP3 asset. That's an asset that will continue to be built. It will be finished up in 2025, and we expect it to be actually starting up as we get towards the end of 2025. But, John, we're literally working through the talisman budget with the JV and with the partners right now. So it's a little premature speak to that. We should have more to say okay. On the next earnings call. And what did you have to agree to or pay order to get the revised financial covenants?"
},
{
"speaker": "John Roberts",
"text": "Yeah."
},
{
"speaker": "Neal Sheorey",
"text": "John, I won't I won't give you the exact number, but it was it was a very small amount. You should think about it being far less than a million dollars."
},
{
"speaker": "Operator",
"text": "Our next question is from David Deckelbaum with Cowen. David, your line is open."
},
{
"speaker": "David Deckelbaum",
"text": "Thanks for your time this morning. I was curious. You've received some questions on the impact of the CapEx cuts on your long-term growth profile. The reduction of that $800 to $900 million as you go through this strategic review, is that where we should think of approximately maintenance capital or as we get into 2026 and beyond, could we see numbers, you know, quite a bit below those levels?"
},
{
"speaker": "Kent Masters",
"text": "Yeah. So we're look, we're getting we're we're tightening down on maintenance capital, and we're targeting a range of 4% to 6% of revenue at some at a normalized level. So you'll see it's a little bit above that this year because we think pricing is below a normalized level. So we're a little above that, but we're also working working to tighten that up. And then you see growth capital in there for high return projects, productivity type projects, brownfield type expansions, which are high return and quick payback. So that's kinda how what we've got built into that that $800 to $900 million. And look, we'll continue to work on that. It depends on the opportunities that that we have, but we'll we'll continue to focus. But we're from a maintenance capital standpoint, we're trying to be in that range of 4% to 6% on a normalized basis. And we're we're a little ahead of that for this year. Or for next year. Sorry. Appreciate that."
},
{
"speaker": "David Deckelbaum",
"text": "Yep."
},
{
"speaker": "Kent Masters",
"text": "And then, you know, just continuing with just the theme of of cash. Preservation, what's what's the outlook for the next several quarters in terms of of cash conversion? Obviously, this quarter, there was some working capital management that really helped that conversion and and and helped kind of fortify the balance sheet. So I'm curious how you think about you know, the the next the next several quarters ahead of us here."
},
{
"speaker": "Kent Masters",
"text": "Yeah. So Neil can give us some specifics on that. But but we're we're we're very focused on it. Some of our key metrics around that is is cash conversion. So up cash flow, everything around that, but a key management metric that that we're focused on is cash conversion. You saw a big number this quarter. We obviously can't we can't repeat that, so it it will come off that. We're we're above historic levels that oh, where we've operated historically, but we're focused on driving that conversion number up. Neil, do you wanna make any specific comment?"
},
{
"speaker": "Neal Sheorey",
"text": "Yeah. Just to just to add to that, Ken. So absolutely, I'll double down on what Kent said that we obviously have a very strong focus internally on cash generation, cash conversion, and driving to that free cash flow breakeven point in the future. And we're continuing every quarter to work on this. Several things that we're we've got in flight is obviously working capital management is is very much front and center. We have the cost and productivity that we are already doing, but obviously, today, we've announced even more that we're doing, and so we continue to drive on that. The the other piece that will be very important for our overall cash flow generation is how we think about the dividends coming off of the Taliesin joint venture. One of the reasons that we mentioned in the deck that our our cash conversion is going to be lower in the fourth quarter is that at the moment, we see those those dividends from the Talison joint venture in the fourth quarter coming down. They're right now, our assumption is they'll be zero. But obviously, as we get into 2025 and as we work through things with the JV, it will be very important to as we think through the dividends that that JV can can throw back to the partner."
},
{
"speaker": "Operator",
"text": "Our next question is from Ben Isaacson with Scotia Capital. Ben, your line is open."
},
{
"speaker": "Ben Isaacson",
"text": "Good morning. This is Apurva on for Ben. So my question for you is that so you've discussed your leverage covenant providing substantial offer. We thought kind of two x spread in Q3. Is there any color that you can provide on the shape of those limits as they evolve through to 2026? Moving specifically at Q2 and Q3 2025 where that lever the covenant limit rises to kind of 5.75 times. So any color there?"
},
{
"speaker": "Neal Sheorey",
"text": "Yeah. Perva. So, you know, essentially, the the shaping of that covenant waiver sort of follows recall that our covenant waiver is calculated on a trailing twelve month EBITDA. And so you can imagine that we've kind of shaped this based on how we look backwards at the the the shape of the EBITDA that we've generated so far in in 2024 as well. So that's really how we we've thought through how the trailing twelve months might look like as we go forward and then shape covenant waiver accordingly."
},
{
"speaker": "Ben Isaacson",
"text": "Perfect. Thank you."
},
{
"speaker": "Operator",
"text": "Our next question is from Steve Byrne with Bank of America. Steve, your line is open."
},
{
"speaker": "Steve Byrne",
"text": "Hi. I'm Rob Hoffman on for Steven. In 3Q, realized pricing energy storage has seemingly come in at a lower premium relative to the lithium market price versus prior quarters. Was there any meaningful shift in the percent of contract price with one quarter lags and pricing floors? And what percent of the two-thirds contractors figure has pricing for us?"
},
{
"speaker": "Kent Masters",
"text": "Yeah. So I don't there's there's real no change in the contracts that that rolled off during the quarter. So that I'm not sure. So that that is a little different than the way that I think about it. But the contracts really, they they haven't changed. So it's the mix of where those customers are and where that volume gets taken is is how your average moves. Price."
},
{
"speaker": "Steve Byrne",
"text": "And and we're I don't think we're gonna say anything more than we have said before about the contracts and the floors that we have. So we've got contract volume on about two-thirds of it. And some have floors and ceilings and and others don't. But not gonna but it hasn't changed."
},
{
"speaker": "Rob Hoffman",
"text": "I could just ask. This is Eric that that that during during the quarter, we did see our highest volumes that we'll see any quarter. This to date and be hired in the fourth quarter as well. A lot of that was due to the timing of spot sales and spodumene sales. Which would buy us a mix and in a quarter and and has. So, I mean, I think I think you're noting something that is that is is on target that there's a mix effect there. That's not a reflection of contract that I would wash out on a full year basis and we can guidance. Makes sense. And then just a follow-up, given a look lower pricing being sustained, might you consider cutting operating rates to tighten the market rather than the aforementioned guided 15% year term catered growth and volume."
},
{
"speaker": "Kent Masters",
"text": "So we we look at everything. It's probably it's less a little bit about tightening the market, but where it makes sense for us to what our customer demand is, what we see volumes growing to and the mix about where we produce most cost-effectively. So but but we we look we're looking at everything. Including operating rates at plants, but it it's really more about the mix of our customers, the demand growth, than it is about thinking about tightening the market."
},
{
"speaker": "Operator",
"text": "Our next question is from Vincent Andrews with Morgan Stanley. Vincent, your line is open."
},
{
"speaker": "Vincent Andrews",
"text": "Thank you, and and good morning. Neil, can I ask you on the $300 to $400 million, you know, 40% to 50% run rate by the end of this year? What then you know, gives you such a wide range for I guess, you're gonna finish all off by the end of year. But what would make it $300 and what would make it $400?"
},
{
"speaker": "Kent Masters",
"text": "I think that's I mean, it's just it's a range that we're giving and some of the things that we're working through around that. So it's not all completely detailed out. So and, that that dime there's a dynamic of around that. As we go. Some of it is around overhead, some of it's around operating cost, productivity improvements, and things that we're doing at plant. So there there's a range to give us a little bit of breathing room because we're the lower end would be fairly conservative, and the upper end would be a bit of a stretch. I don't think it's any more sophisticated than that."
},
{
"speaker": "Vincent Andrews",
"text": "Fair enough. You can't if I could ask you, know, as we as we look ahead, we're obviously at the bottom of the cycle. Let's let's assume the cycle turns. Let's assume prices go back and I'll make up a number $25,000 a ton. You know, and you clean up your balance sheet issues. What what is Albemarle's strategy in gonna be? Is it just gonna be a reversion to what you were doing prior to last down cycle where you wanna get back into conversion and you wanna go out by resources? Or you're gonna do something different, or are there things you're not gonna do? You know, how are you how are you and how's the board thinking about, you know, sort of the where the company wants to be strategically going forward?"
},
{
"speaker": "Kent Masters",
"text": "Yeah. So we've said I actually said our prepared remarks that our strategy has not changed but the way we're executing against it has. So if we so when when we'll react to the market. So prices come back, to be honest, I think we're gonna be a little conservative to make sure that they are gonna stay there. Before we shift our our plans around that. So we'll be we'll be we wanna make sure if they move up, that they're gonna stay up and we're just not in another cycle. And I think right now, we're focused on making sure that we put the cost structure in place to compete through the bottom of the cycle and we'll be able to we're trying to create the flexibility to pivot up if the market returns, but we're gonna be a little conservative to make sure it really changed and we're just not in a cycle."
},
{
"speaker": "Operator",
"text": "Our next question is with Kevin McCarthy from Vertical Research Partners. Kevin, your line is open."
},
{
"speaker": "Kevin McCarthy",
"text": "Hi. This is Matt Hower on for Kevin McCarthy. During your cost structure review, what new processes did you learn from benchmarking lithium peers? And how do you plan to implement those at Albermaril? On slide nineteen, it looks like there's a gap between the current non-manufacturing costs."
},
{
"speaker": "Kent Masters",
"text": "Yeah. Albemarle."
},
{
"speaker": "Matt Hower",
"text": "And out of your meeting peer group? What did you identify as the source of that difference?"
},
{
"speaker": "Kent Masters",
"text": "So on the benchmarking, I'll take that. Sorry. We got a phone going off in the room. So I on the benchmark, I'm not sure we learn any new processes from benchmarking our peers, but it's more about a the cost the cost of overhead where people were operating and not it's less about lithium peers than it was just about broad corporate cost structure. With people that have a footprint that looks a bit like ours, very global, with heavy manufacturing those type of pieces. So I'm not sure we picked up any big process changes that we learned from our lithium peers. I I think it's just more about the the aspiration we took from a cost-saving standpoint based on what we saw other corporates doing. And maybe this is Neil. Just to just to add to a couple of things. Look, as an organization standpoint, we were obviously for for growth historically and now in this new environment, we're we're moving to more of a co cost-focused organization. Time and again, that that model that works is the functional model that we announced. And so I think one of the key things that we saw is that there are ways to achieve what you need to from a a strict functional model standpoint. So that's one of the the key things as we functionalize the company. There are naturally gonna be cost and simplification opportunities. And then the other thing I'll I'll point out too is that we have two up and running and and very well very well running back offices and those are areas that we can use much more efficiently especially in functionalized model as well. So those are just a couple of examples. You see them on on slide, I think it's nineteen as well. But those are really some of the core areas where we are finding cost-out opportunities."
},
{
"speaker": "Matt Hower",
"text": "Thanks. And then could you comment on some of the recent supply curtailments that you've seen? There been any significant downward movement in lipidolite supply out of China or Africa? And given that, you know, you estimate 25% of the supply curve to be unprofitable, why do you think it's taken so long to see a a significant downward momentum in supply?"
},
{
"speaker": "Eric Norris",
"text": "Yes. Good morning. This is this is Eric. So speaking on lapelite, it was announced during the quarter and we've we've since been able to get corroboration although it's it isn't always clear in China, but that but the lopetalite one of the largest lopetalites suppliers had gone down into care and maintenance, taking some capacity offline, but there's still a pet light in the market. It's obviously, that's all in China. We've also seen continued growth in supply coming that's replacing that serving that growing China market coming out of Africa. We've seen a lot of the shutdowns have been some of the or modulations in some cases, has been out of the western Australian? Sites and some delays on some of the the the Brian projects that were more either Greenfield or significant brownfield expenses have been pushed out. I'm we could get in more detail, but that's a that's a quick summary. As to why more has not come out, it's it it is a little little puzzling. It is a fragmented market. It is a market with significant Chinese presence today. And it's it's a market where you have a lot of young companies whose sole reason for for existing is to to raise a lithium project. They may have cash on their balance sheets, and as long as they can continue to operate, they will do so. They don't have alternative. So I think it's the maturity, maybe one way putting up this market is such it's gonna take a little longer and that is reflected in our lower for longer view on pricing potentially, which is driving us our need to be competitive for the cost the cycle that that and then all these actions that we have talked about taking today."
},
{
"speaker": "Operator",
"text": "Our next question is from Joel Jackson from BMO Capital Markets. Joel, your line is open."
},
{
"speaker": "Joel Jackson",
"text": "Hi. Good morning, everyone. Just following up on that for my first question. Don't you think that more supply needs to come out of the market, like real supply? Not some projects three years from now, but real spodgy, I mean, real hard rock, real brine out of the market now. To get prices going, or what do you think needs to happen to get prices to recover? And it seems like it can't just be demand. It's gotta be supply at this point. Would you agree?"
},
{
"speaker": "Kent Masters",
"text": "Well, I think it's both. Right? So we we we do think more supply needs to come out, and then these and these prices persist as it will come out. It's a matter of how long it takes. And then and demand is still pretty strong. Right? It's over 20%. It's it's buck we've it it's been ticked up a little bit by some of the fixed storage volumes. That that in the last few quarters. A little stronger than we had anticipated, but it it is both. It's both demand and supply, and we we do we need more supply to come out, and we expect it to work at prices at these levels."
},
{
"speaker": "Joel Jackson",
"text": "There have been a lot of stories in the media the last few months about Altima maybe looking at the massive sales whether it be your stake in Greenbushes or or Talosin, which I think you refuted publicly or had a retraction in the media, got a retraction made from that report in the media, but also maybe speculation you'd be considering selling your stake in Wajna you just generally talk about if you're looking at any asset sale."
},
{
"speaker": "Kent Masters",
"text": "But we're always looking at from a port so Ketchum is an example of that that we talked about that and said that's a non-core asset that we look to sell. But Greenbush is something we are not when we're not we wouldn't speculate on rumors around that, but and we but we did clarify green bushes do not something we're thinking about selling."
},
{
"speaker": "Operator",
"text": "Our next question is from Michael Sison from Wells Fargo. Michael, your line is now open."
},
{
"speaker": "Abigail",
"text": "Hi there. This is Abigail on for Mike. Just wanted to ask about the status of Kings Mountain, if there's any update in terms of cost or plans or anything like that."
},
{
"speaker": "Kent Masters",
"text": "So King's Mile is a project we continue to push and invest in. So we're we're going through the permitting process that and that process is on track. There there's a a number of permits that are necessary for that, and it's a pretty long time frame to secure all of those, but I would say we we continue to pursue that from a permitting standpoint. And it and the process is at this point, it's on track."
},
{
"speaker": "Abigail",
"text": "Got it. Thanks."
},
{
"speaker": "Operator",
"text": "Our next question is from Christopher Parkinson with Wolfe Research. Christopher, your line is now open."
},
{
"speaker": "Harris Fein",
"text": "Hey. This is Harris Fine on for Chris. Thanks for taking my question. For my first one, it'd be helpful to hear some of your thoughts on the implications from the election how you're thinking about tariffs and EV subsidies, and and maybe how you're adapting strategy for that kind of environment. Thanks."
},
{
"speaker": "Kent Masters",
"text": "Yeah. So it is well, it's a little early to to talk about what a Trump administration may do. We know what they've talked about. We'll have to see what they do. But this the energy transition is kind of a global phenomenon that that is happening. It's really driven first by China. Europe, probably the second largest market in that, and then North America. And I don't wanna speculate on what Trump administration might do. We'll have to wait see. I will say that we've we've worked across the aisle in, around the the US, and we have contacts there. We we know what they had talked about, but I think we just have to wait and see what they do, and then we'll we will adjust to that. But it is a global market. And this energy transition is happening. And we're pretty well positioned around the globe to take advantage of that. We we were a strategy had been to pivot to the west. We've kinda backed off that given that prices have been so low and economics are building that supply chain out in the west. We still hope to do that, but we have to wait and see what Trump administration wants to do."
},
{
"speaker": "Harris Fein",
"text": "Got it. That that's helpful. And then for my second one, in slide seventeen, you mentioned, potential upside actions. Accelerating productivity and and reducing capital intensity even more. I guess maybe could you provide a little more detail to what's on the table right now? Anything you can share as to what that might entail? Thanks."
},
{
"speaker": "Kent Masters",
"text": "So look, I think we're work we're working through this and we and as we said before, there we we've given a range because and we're we're being pretty aggressive around that and and it and it covers everything from overhead to R&D, part of that and our manufacturing base. So there's some opportunities to to take cost out of there. So I don't know that we wanna speculate on those. We need to do the work, and then we'll come back to it. Because I think first you'll see, hopefully, we'll be narrowing the range to the upside. As we go through and execute against this. And then if we have anything new to report, we'll do that in time, but I'm not I don't wanna get out in front of."
},
{
"speaker": "Operator",
"text": "Our next question is from Joshua Spector with UBS. Joshua, your line is now open."
},
{
"speaker": "Chris Parela",
"text": "Yes. It's Chris Parela on for Josh. Good morning, everyone. I wanted to follow-up on the contract outlook for lithium next year. I know it's two-thirds under contract, for this year, what are your expectations for the mix in 2025? And then I had a follow-up on use of cash in the fourth quarter."
},
{
"speaker": "Kent Masters",
"text": "So I I guess as we go through this, so as the we're not our our mix won't change materially. Other than the fact that a lot of the growth will come on at spot volumes. It may and it may be under a contract, but it would be probably not with the same level of floors that we have in our current contract. So the growth kind of creates additional mix, if you will, so it's not really a change in those contracts, that the existing contracts per se, but new ones either that come on or we the volume that we sell is on a spot basis. It's more reflective of the spot market."
},
{
"speaker": "Chris Parela",
"text": "Oh, thanks, Kent. And then I guess for Neil, the use of cash in the fourth quarter from an operational standpoint, quite large. Could you just bucket or size out and expand upon what the cash outflow or the use of cash is going to be from an operational standpoint in the fourth quarter?"
},
{
"speaker": "Neal Sheorey",
"text": "Yeah. Let me let me maybe give you a couple of things to to think about. So first of all, in the fourth quarter as I mentioned on a on a previous Q&A, we're right now not expecting a dividend from the Taliesin JV. If you go back and and look at what we did in the third quarter or what we got in the third quarter, you'd probably find that that that dividend was in the, let's call it, $70 million to $80 million kind of range in the third quarter. And so that's that's one piece that we won't we're not expecting on in the in the fourth quarter. The other piece is is as we mentioned in the prepared remarks, one of the one is that we there are two things behind our working capital performance in the third quarter. The first we said was working capital management working focused on on driving those to an efficient point by the end of the year. But we also talked about timing of working capital and what that was specifically is we had some items in a pay that moved from the third quarter into the fourth quarter. So we'll eventually have to obviously make those payments. And I I won't give you the exact number here but you can imagine that that's gonna be in the tens of millions of dollars. As we finish up those payments. And then the last one is these the payments related to the cost reduction actions that we announced today. If you go and look in our queue, I'm I I don't know if you've had time to look at that, but we've bread boxed that and it's kind of in that $40 million to $50 million kind of cash outflow range as well. So that that maybe gives you a few key buckets to think about from an operating cash flow perspective."
},
{
"speaker": "Operator",
"text": "Our next question is Patrick Cunningham from Citi. Patrick, your line is now open."
},
{
"speaker": "Eric Zang",
"text": "Hi. Good morning. This is Eric Zang on for Patrick. On the 2025 CapEx guide, can you walk us through the actions you guys taken to bring down CapEx and what is contemplated? And are there any assets under consideration that could potentially go into care and maintenance? Thank you."
},
{
"speaker": "Kent Masters",
"text": "So okay. Midwoth Capital first. So and then know, you can help me on this a little bit. But we've looked up a across the organization and we've taken out there's some growth projects that we have taken out about of capital. We've tightened others up. And from a maintenance capital standpoint, we've gotten tighter on that, a little more rigorous, and I as always said before, what we've kept in, we've got maintenance capital, what we think is minimum that we need. And again, we're targeting that 4% to 6% of revenue for rain in the range for maintenance capital and we're a we're a little ahead of that for 2025 because we used that's on a normalized revenue basis and we think we're below a normalized level given lithium prices. And we've got projects around either oh, pretty short payback investment projects whether they're for cost improvement or additional product that would be a high return short payback type projects. We're still doing those and those larger growth projects, which is why we're we pulled back on our growth forecast out into the future because we're not doing some of those bigger projects that we had planned. And then the the second part of the question, I'm sorry."
},
{
"speaker": "Eric Zang",
"text": "Oh, asset oh, sorry. Another question. So we."
},
{
"speaker": "Kent Masters",
"text": "Yep. Yep. So we've done alright. Yep. I got it. So sorry. So we've we've done the train to at Kimberton and Cara then and depending on where prices go, we will look at other assets both from a resource and conversion standpoint across the portfolio. It's something that that we are that we will look at. We've not made decisions around that. And some of those are are require like say b decisions as well. So Woden is one where we're we're deciding about the number of trains that we operate at Wajina. It's something we have to agree with our joint venture partner."
},
{
"speaker": "Eric Zang",
"text": "Okay. Thank you."
},
{
"speaker": "Operator",
"text": "Thank you. That's all the time we have for questions. I will now pass it back to Kent Masters for closing remarks."
},
{
"speaker": "Kent Masters",
"text": "Okay. Thank you, Jimmy. Albemarle continues to deliver solid operational results due to our execution across the company. With proactive steps underway to reduce cost and drive performance, we are well positioned to take advantage of the long-term growth opportunities across our end markets. Thank you for joining us today. And please stay safe."
},
{
"speaker": "Operator",
"text": "This concludes today's conference call. Thank you for your participation. You may now disconnect."
}
] | Albemarle Corporation | 18,671 |
ALB | 2 | 2,024 | 2024-08-01 08:00:00 | Operator: Hello and welcome to Albemarle Corporation's Q2 2024 Earnings Call. I will now hand it over to Meredith Bandy, Vice President of Investor Relations and Sustainability.
Meredith Bandy: Thank you and welcome everyone to Albemarle's second quarter 2024 earnings conference call. Our earnings were released after the market yesterday, and you'll find the press release and earnings presentation posted to our website under the Investor Section at albemarle.com. Also posted to our website is yesterday’s additional press release announcing our initiation of a comprehensive review of our cost and operating structure which we will also reference during our comments today. Joining me on the call today are Kent Masters, Chief Executive Officer; Neal Sheorey, Chief Financial Officer; Netha Johnson, President of Specialties; and Eric Norris, President of Energy Storage are also available for Q&A. As a reminder, some of the statements made during this call, including our outlook, guidance, expected company performance and strategic initiatives may constitute forward-looking statements. Please note the cautionary language about forward-looking statements contained in our press release and earnings presentation which also applies to this call. Please also note that some of our comments today refer to non-GAAP financial measures. Reconciliations can be found in our earnings materials. And now, I'll turn the call over to Kent.
Jerry Kent Masters, Jr.: Thank you Meredith. During the second quarter Albemarle continued to demonstrate strong operational execution. We recorded net sales of $1.4 billion and sequential increases in adjusted EBITDA and cash from operations, thanks in part to successful project delivery, productivity, and restructuring initiatives and working capital improvements. We continued to capture volumetric growth driven by our energy storage segment which was up 37% year-over-year, highlighting successful project ramps and spodumene sales in that segment. For example during the quarter we achieved first commercial sales from Meishan ahead of our original schedule by approximately six months. During the second quarter we also delivered more than $150 million in restructuring and productivity improvements consistent with our efforts to align our operations and cost structure with the current market environment. We are on track to exceed our full-year targets on this front by 50%. Looking to the rest of this year, our operational discipline allows us to maintain our full-year 2024 outlook considerations. Notably, we expect our $15 per kilogram lithium price scenario to apply even assuming that lower July market pricing persists. This is due to higher volumes, cost out and productivity progress, and contract performance. We have made great progress in strengthening our competitive position and enhancing our financial flexibility. However, industry headwinds that began last year have persisted longer than the sector anticipated, making it clear that we must proactively take additional steps. Building on the actions we announced this past January, we announced yesterday that we are taking a comprehensive review of our cost and operating structure with the goal of maintaining Albemarle’s competitive position and driving long-term value. As part of the initial review, we announced the difficult but necessary decision to immediately adjust our operating and capital spending plans at our Kemerton site in Australia. These actions showcase our deeper focus on cost and operating discipline. There's no question that the global energy transition is underway, however, the pace of the industry changes our dynamic and we must remain agile as well. Later on the call, I will spend some time diving deeper into the cost and asset actions that we continue to take in this environment to maintain our competitiveness. And I will also highlight the strategic advantages that remain proof points of Albemarle’s competitive and operational strengths. I'll now hand it over to Neal to talk about our financial results during the quarter.
Neal R. Sheorey: Thanks Kent and good morning everyone. Beginning on Slide 5, let's move to our second quarter performance. In Q2 2024, we recorded net sales of $1.4 billion, compared to $2.4 billion in the prior year quarter, a decline of 40% driven principally by lower pricing. During the quarter, we recorded a loss attributable to Albemarle of $188 million and a diluted loss per share of $1.96. This result included an after-tax charge of $215 million, primarily related to capital project asset write-offs for Kemerton 4. Adjusted diluted EPS was $0.4 per share. Moving to Slide 6, our second quarter adjusted EBITDA of $386 million was down substantially versus the year ago period, as favorable volume growth was more than offset by lower prices and reduced equity earnings due to soft fundamentals in the lithium value chain. Compared to the first quarter, second quarter adjusted EBITDA rose 33%, driven by higher sales volumes across all businesses and higher income from increased Talison JV sales volumes. As a reminder, on last quarter's earnings call, we said that we expected an approximately $100 million sequential lift to our EBITDA from higher than normal off-take by a partner at the Talison JV, and that's what we saw in the quarter. Turning to Slide 7. As we've done in prior quarters, we are providing full year 2024 outlook considerations based on historically observed lithium market pricing scenarios. The price scenario shown represent a blend of relevant market prices, including both China and ex China pricing for lithium carbonate and hydroxide. The numbers you see here on this slide have not changed since our last earnings call. What is new is what Kent mentioned at the top of the call. We now expect the $15 per kilogram price scenario to be applicable even assuming lower July market pricing persists for the balance of the year. We are able to maintain this scenario due to the success of our enterprise-wide cost improvements, continued strong volume growth, higher sales volumes at our Talison JV, and contract performance in energy storage. Moving to Slide 8. We continue to prioritize our financial flexibility and strong liquidity to navigate the dynamic market environment. We ended the second quarter with available liquidity of $3.5 billion, including $1.8 billion of cash and cash equivalents and $1.5 billion available under our revolver. Our net debt to adjusted EBITDA was 2.1 times which was well below the quarter's covenant maximum of 5 times. We continue to add new liquidity resources such as our AR factoring program, and from a long-term debt perspective, we are well positioned and have no significant maturities due until late 2025. Turning to Slide 9, which shows our improved operating cash flow performance and considerations. Our focus on cash generation and efficiency continues to drive important benefits. Our operating cash flow conversion in the second quarter was 94%, which was unusually high, primarily due to increased Talison dividends. We also continued to drive volume growth, cost and productivity improvements, and working capital efficiencies, all of which contributed to our cash conversion. As we look forward, we now expect our full year operating cash conversion to be approximately 50%, which is at the higher end of our historical range. I'll now hand it back to Kent.
Jerry Kent Masters, Jr.: Thanks, Neal. Turning to Slide 10, for more details about the actions we announced yesterday to streamline our operations, build on the cost out and productive actions we already have underway, and maintain Albemarle's competitive position across the cycle. Now on Slide 11, I'll first cover the fundamentals in our market. On the demand side, EV registrations are up more than 20% year-to-date through June, led by strong growth in China. However, the pace of growth in Europe and the U.S. has moderated substantially versus the industry's expectations. Across the value chain, we are seeing meaningful mix shifts. First, stronger growth in plug-in hybrid sales, which has translated to smaller batteries with less lithium per vehicle and second, we see a continuation in the trend towards more carbonate-based batteries. Both of these developments are still positive for overall long-term lithium demand, however, they highlight the shifting nature of this value chain as it develops and matures. These demand changes are occurring at the same time as we see dynamic conditions on the supply side. We have yet to see significant changes at the mine level as existing and new supplies continue to come to market. And on the conversion side, there is still oversupply predominantly in China. At current Chinese spot pricing, we believe and are hearing from the market that many nonintegrated producers are unprofitable with some operating at reduced rates or idling production. And we're hearing that even producers who are integrated into cathode or batteries are under pressure. Moreover, current pricing is well below the incentive pricing required for Western greenfield lithium projects. At the same time, geopolitical developments are also adding uncertainties to our business. This includes escalating trade tensions and ongoing armed conflicts. Challenging Western supply chain dynamics are also at play. Notably, the IRA's 30D consumer tax credit has yet to benefit upstream producers like Albemarle. And specific to our position, as written the Final U.S. Department of Energy Foreign Entity of Concern or FEOC rule will impact the eligibility of our Australian product, and we suspect that others could be impacted as well. While current dynamics add challenging uncertainties, there is no question that the energy transition remains well underway, and the long-term growth potential of our end markets is strong, as you can see on Slide 12. The global EV supply chain is on track to achieve the critical $100 per kilowatt hour tipping point where EVs are at cost parity with internal combustion engine vehicles. The Chinese industry has likely surpassed that target with the rest of the world not far behind. Taking all these changes into consideration, we continue to anticipate 2.5 times lithium demand growth from 2024 and to 2030. Additionally, we see battery size growing over time, driven by technology developments and EV adoption. These factors all translate to significantly higher long-term global lithium needs. Turning to Slide 13, in January, we announced a series of proactive actions to preserve growth, reduce cost, and optimize cash flow. Our teams have successfully executed on many of those actions, including ramping in-flight projects at Xinyu, Meishan and the Salar on or ahead of schedule, delivering cost out and productivity actions and we are now tracking to deliver 50% ahead of our initial targets, reducing 2024 estimated CAPEX by between $300 million and $400 million year-over-year, and enhancing our financial flexibility including improving cash generation and conversion. While these steps have served us well, the industry dynamics I just described require us to do more to ensure our competitiveness across the cycle. Building on the actions we announced in January, we announced yesterday that we were embarking on a comprehensive review of our cost and operating structure, pushing deeper into our playbook to further pivot and pace to maintain our leading position. We are focused on the four key areas you see on the slide: optimizing Albemarle's global conversion network to preserve our world-class resource advantages, improving our cost competitiveness and efficiency, continuing to reduce capital expenditures and future capital intensity, and enhancing Albemarle's financial flexibility. The middle section of this slide highlights that we've already taken the next set of actions across these four focus areas. And the bottom of the slide details additional opportunities that we'll closely evaluate as part of the process. The comprehensive review of our cost and operating structure has just begun, and we plan to provide additional details with our third quarter earnings. That said, we took the difficult but necessary decision to bring forward the first step in the review, which is to further optimize our Australian network as we show on Slide 14. As one of the first steps in this comprehensive review, we announced yesterday immediate adjustments to our Australian lithium hydroxide footprint. These changes follow our previously announced decision not to proceed with the construction of Kemerton Train 4. Specifically, we will idle production at Kemerton Train 2 and place the unit in care and maintenance. Additionally, we will stop construction activity on Train 3. Notably, we estimate that stopping construction on Train 3 will save at least $200 million to $300 million of capital spending over the next 18 months. These changes allow us to focus on optimizing and ramping Kemerton Train 1 to preserve optionality and diversity across both product type and geography. In the coming weeks, we'll be identifying other ways to optimize our global conversion network with a focus on the highest priority and highest return options. Our global portfolio of convergent assets and our extensive holding network provide the flexibility to maximize the value of our high-quality resources and to provide either carbonate or hydroxide to meet the needs of our customers as their demands and technologies evolve. Turning to Slide 15. As we deliver these initial savings and begin the next phase of our review, our operating model, the Albemarle Way of Excellence remains the standard by which we operate. By executing our operating model, we are building a culture of continuous improvement to identify best practices at every point in the cycle. We are on track to exceed our initial goals for restructuring and productivity savings through manufacturing, procurement, and back-office initiatives. Much of the better-than-expected performance to date is in manufacturing improvements. For example, optimized PON management at the Salar and overall equipment effectiveness improvements at La Negra have maximized production at one of our lowest-cost assets. These manufacturing benefits in Chile are in addition to the increased efficiency and volume we expect as the Salar yield improvement project continues to ramp. Moving to Slide 16 and our capital spending profile. As I mentioned earlier, we expect 2024 CAPEX to be $300 million to $400 million below 2023 levels. Moving forward, we are evaluating opportunities to further reduce our capital intensity and total capital spending. This will provide enhanced optionality, improve free cash flow, and put Albemarle in a stronger competitive position long term. Our capital spending profile is another element of our comprehensive review and we'll have more to say about our near-term spending plan on future calls. Moving to Slide 17. With all these near-term factors shifting and requiring us to take action, I think it's important to remember that Albemarle continues to have significant competitive strengths. And so I will end with a review of our framework and the core advantages we continue to prioritize as drivers of our long-term value creation. Slide 18 provides our strategic framework, which informs our planning and gives us confidence that we will achieve our growth ambition to lead the world in transforming essential resources into critical ingredients for modern living. This framework defines where we play, how we win, and how we deliver. Albemarle remains uniquely positioned to enable operational excellence during this dynamic period thanks to our competitive strengths, including our globally diverse portfolio of world-class resources, leading process chemistry, deep innovation, and technical know-how, customer-centric approach to the market, and responsible stewardship. Each of our competitive strength will help us right now and well into the future in ways that we summarize on Slide 19. First, our world-class resources are arguably the best in the industry with large-scale, high-grade and, therefore, low-cost assets. In energy storage, we have access to some of the high-grade resources in both hard rock and brine. In Australia with Greenbushes and Wodgina and one of the largest known hard rock assets in the U.S., Kings Mountain. And in Chile with our long-standing position in the Salar de Atacama. Similarly, in specialties, we are the only producer with access to both of the two best bromine resources globally. In Jordan, on the Southeast side of the Dead Sea, the source is the largest concentration of bromine in the world. And in the smack over formation in Arkansas, the only source of commercial bromine in the United States. In both of our core businesses, we maximize the value of our world-class resources by converting and flexibly derivatizing into higher value and use products in our conversion assets or in the case of energy storage, through our extensive tolling network. Second, our leading process chemistry know-how is key to achieving further productivity and cost improvements, safely and sustainably. For example, the Salar yield improvement project utilizes a proprietary technology to enable up to 20% higher yield. At Magnolia, we've leveraged advanced process controls to increase production while lowering costs and improving sustainability. And at both the Salar and Magnolia, we have evaluated a wide range of direct lithium extraction options and are piloting proprietary and third-party solutions in order to be prepared for technology shifts that could be important and more sustainable Salar yield options for this industry. Third, we have a pipeline of high-impact innovative solutions in both bromine and lithium. Our research, testing, and piloting facilities in North Carolina, Louisiana, and Langelsheim, Germany, allow us to participate in differentiated high-margin segments and support our customers' specific requirements. Fourth, Albemarle's leading industry position as a partner of choice is demonstrated through our growing number of partnerships with iconic pioneering companies. Both our businesses have high Net Promoter Scores with significantly positive gaps relative to competitors, reflecting long-standing successful relationships with major customers. And last but not least, our responsible stewardship, strong values and high-performance culture are increasingly recognized by leading organizations. For example, we recently earned an EcoVadis gold medal placing us in the top 5% of global companies and demonstrating our commitment to creating a more resilient world and advancing the sustainability objectives of our customers. In summary, on Slide 25, Albemarle delivered another strong quarterly performance in the second quarter, including sequential improvements in adjusted EBITDA and cash from operations. Despite lower market pricing, we've been able to maintain our full year 2024 outlook considerations, thanks in part to enterprise-wide cost improvements, strong energy storage project ramps, and contract performance. However, we understand these positive actions may not be sufficient given ongoing industry headwinds. Our entire organization is focused on delivering operational excellence while positioning the company to capitalize on the incredible long-term opportunities in our markets. That's why we are taking the proactive steps to control what we can control and ensure we are competitive across the cycle. Albemarle is a global leader with a world-class portfolio and vertical integration strength. We are uniquely positioned to win. I am confident we are taking the right actions to maintain our competitive position and ensure we execute with agility today and in the future. I look forward to seeing some of you face-to-face at upcoming events listed here on Slide 26. And with that, I'd like to turn the call back over to the operator to begin the Q&A portion.
Operator: [Operator Instructions]. Our first question comes from Aleksey Yefremov. Your line is now open. Please go ahead.
Unidentified Analyst: Thanks and good morning everyone. This is Ryan on for Aleksey. My first question would just be kind of around your EBITDA outlook for the year, right. So I understand that you are kind of maintaining the base case or the low case in the $15 per kilo scenario, even though prices currently are, let's say, $11 to $12 per kilogram. Is there the potential that EBITDA could improve if prices were to recover to that $15 per kilogram scenario here in the back half, I mean, you guys talked a lot about improved costs, so just wondering what you think about that?
Jerry Kent Masters, Jr.: So let's say you characterize what you've said. So even as we've moved that from $15 to, say, $12 to $15. And then we commented that even at July prices, those hold for the rest of the year, we'll make that forecast. And so if there's a chance it could be higher. If prices moved up or there are a number of reasons we're able to hold that forecast is around the volumes that we're selling contract terms, things like that. So it could move up if prices are stronger, it's not collared, so to speak. So if things work in our direction, it could be a number of different things. It could be higher than that. But that's the best visibility we have at the moment.
Unidentified Analyst: Okay, helpful. And then I know it's early, but just kind of initial expectations on volume growth for maybe 2025 and 2026, just after these actions that have just been taken at Kemerton now? Thanks.
Jerry Kent Masters, Jr.: Yes. So okay, you're right, it's early. But I think our volume and what we indicated in the beginning of the year, our volume growth shouldn't be significantly different than that. I mean we are changing some of our -- we're taking out conversion capacity, but we still have the resource that should align to that. So it's not significantly different than we had indicated at the last call.
Operator: Our next question comes from Steve Byrne. Steve, your line is now open. Please go ahead.
Stephen Byrne: Yeah, thank you. Kemerton has some more meaningful freight costs than some of your Chinese conversion. But roughly what is the cash margin for Kemerton 2 and where would you put it on the cost curve, what quartile?
Jerry Kent Masters, Jr.: Yes. So I guess we've never put any of our assets and given that type cost out there. So it is -- I guess it's a combination of -- so you're talking about 2. So 3 is really about some of the money that we're spending in growing that. And Kemerton 1 and 2 gives us a couple of things. So it's closer to the resource, but it gives us diversity just geographic diversity. So we would have Chile, we would have -- we have Australia, 1 and 2 help us with that, we have China. And then we still aspire to have conversion in the U.S. at some point if prices come back to that. So I'm not going to give you what our marginal cost is or our cash cost is at Kemerton, but that's some of the thinking that goes into the decisions we've made.
Stephen Byrne: Okay. It seems like there's more than just a cost cut. It's a supply cut. But with respect to the roughly $1 billion -- sure. Go ahead, Kent.
Jerry Kent Masters, Jr.: No, I was just going to say that it is on conversion. It is capacity cut on conversion. The resource is still available.
Stephen Byrne: Right. Understood. The $1 billion charge in 3Q, can you put that into buckets and how much of it is cash?
Neal R. Sheorey: Yes, hi Steve, good morning. This is Neal. So let me answer the second part of your question and maybe the two kind of go together. So roughly speaking, at this time, we've only had a very small group of people working on this. So we'll obviously refine this number quite a bit in the third quarter. But you should think about of that roughly $1 billion charge we announced today, somewhere at least 60% of that is noncash. And similarly, you can expect that kind of on that order represents what's already on our balance sheet that we're writing off. And then we'll give you a better assessment when we get to third quarter in terms of how much of the rest of that is actually cash. But I'd say at least 60% is noncash.
Operator: Our next question comes from Patrick Cunningham. Patrick, your line is now open. Please go ahead.
Patrick Cunningham: Hi, good morning. Thanks for taking my question. Maybe just trying to square the comments last time, cash conversion expectations expected to be well below historical averages versus strength in the outlook here. You had the $400 million to $600 million in headwinds. Was there any improvement in some of those items, whether it's deferral of discrete tax items or other things, some of the working capital ramp for projects, I'm just trying to understand cash drag for the remainder of the year?
Neal R. Sheorey: Yes. Yes. This is Neal, again. So yes, thanks for asking that question because we are -- as we said in our considerations in the prepared remarks, we're taking that range now up to a 50% conversion, which is towards the high end of our historical range now. And there's -- I'd say there's two things that I would point to that where we're doing better than expected. The first is from a dividend perspective from our equity companies, that was certainly better than we expected coming into the year. You heard in our prepared remarks and you know about the additional offtake that we saw at Talison. So that definitely boosted dividends in the second quarter and helped our cash conversion. And then the other part is, yes, on the working capital side, we are highly focused on it, and we have a lot of initiatives around this, and we're seeing some of those come through already in the first half of the year and are continuing to work on that in the back half of the year. So working capital was another nice tailwind to cash in terms of the release of cash from there.
Patrick Cunningham: Understood, very helpful. And then just generally on how we should think about 3Q sequentially for energy storage. Can you help us triangulate how much lower volumes will be sequentially based on some of this onetime benefit, where we should stand for pricing if we kind of hold the July averages here? And then is the remaining sensitivity in your numbers mostly around volume or is there something else?
Neal R. Sheorey: Yes. So I can maybe take the second part of that. We are obviously, from a volume perspective, we're obviously tracking towards the higher end of the 10% to 20% volume growth range that we gave you at the beginning of the year. And I think at this point for the visibility we have, we're probably going to keep tracking towards the high end of that range. So I wouldn't say our earnings corridor or our outlook considerations are really driven by volume per se. It's really around the pricing range that we've given you, that kind of $12 to $15 range today.
Jerry Kent Masters, Jr.: Yes. Just -- but the first part of the year was strong from a volume standpoint and that was fine [ph], the upper end of that range, 20%, Neal is saying it's going to be less year-on-year growth in the second half. But that's just because it's so strong in the first half, and we've had a mix of spodumene sales in there as well that's pulled some of that forward.
Operator: Our next question comes from Vincent Andrews. Vincent, your line is now open. Please go ahead.
Vincent Andrews: Thank you and good morning everyone. Last quarter, you had a slide on capital allocation priorities and it had a couple of things in it. I just would like to revisit. One was a commitment to investment-grade rating, the second was your ultimate long-term net debt to adjusted EBITDA target of less than 2.5 times, and then thirdly, the continuation to support and grow the dividend. How are you thinking about those three things as part of the comprehensive review?
Jerry Kent Masters, Jr.: Yes, I don't think our view has changed, right. So that will -- as we go through this, I mean, we'll reiterate that, but I suspect it will stay the same.
Vincent Andrews: And as a follow-up, could you speak a little bit about the factoring and how that process works for you and how we'll see it, I guess, in the working capital results?
Neal R. Sheorey: Yes. So Vincent, to your question, that's right. We put in place an AR factoring program. It's an initial program. We'll continue to evaluate that and add to it as we can as we go along. But essentially, that factoring program is currently untapped. We will use it when we need liquidity if and when we need liquidity. And so basically, at that point, that's when you'll see it, and we'll talk about it. But at this point, it's an untapped resource available to us.
Operator: Our next question comes from Chris Parkinson. Chris, your line is now open. Please go ahead.
Harris Fein: Hey, good morning. This is Harris Fein on for Chris. So we walked through that the $15 per kilo scenario still holds at $12. I guess how much of that is because of higher Talison shipments and cost improvements and I guess, like where would EBITDA be absent those items if we were just isolating the contract component and I am just kind of trying to get a sense of what that looks like if prices go down to, let's say, $10 per kilo through the back half of the year?
Jerry Kent Masters, Jr.: Yes. So we've said at July pricing, it basically holds the same, right. So $12 to $15 on the slide, but we've said in the remarks that, that July pricing it holds. If July pricing extends throughout the balance of the year, it still holds. So you can work out exactly what that number comes to. And there are a number of pieces that allow us to do that. So it's the volume mix, it is a little bit of additional volume from Talison, it's our contracts. It's a lot of things. It's the cost savings things that we're putting in place. So it's a number of things that go into making that statement true. So it's not one particular thing.
Neal R. Sheorey: Yes, maybe just to add on to that, just a reiteration that those outlook considerations we provided were always a view on the average pricing across the year. And so with the last couple of earnings releases, we've given you -- you obviously know the sales that we've had in energy storage, and we've given you the volumes that we've sold. So you can look at what our average realized price has been. It's been above $15 for the first half of the year. And so when you -- you can take your -- whatever lithium price you'd like to in the back half of the year and do the averaging. But that's why we say when you take July pricing and roll it forward, it falls within that range that we've given you. With regards to Talison, I think the best way to answer that is just to go back to what we've said before. We told you that in the second quarter, we expected about $100 million sequential lift related to the Talison offtake, the additional Talison offtake, and that's exactly what we saw. So maybe that gives you an idea of how to think about that part of your question.
Harris Fein: Got it, that's helpful. And then for my second question, in Slide 12 you show that the global average EV is on track for cross parity with ICE in the next year or two. It would be nice to hear your take maybe on what you make of some of the recent challenges that Western OEMs are having in making a profitable EV and also the fallout from European tariffs on Chinese EVs, kind of how that is playing into your demand outlook?
Jerry Kent Masters, Jr.: Okay. So -- I mean, the cost on -- the cost curve that you see, Neal said on Slide 12. I mean that's a curve that we've been -- that the industry has been looking at for some time. That $100 per kilowatt hour has been a benchmark or a tipping point we call it that people have been looking for, and we're below that in China today. Now some of that fair enough is on -- is because lithium prices are low, but the majority of it is just on the experience curve, the technology and the battery technology. So we think that maintains itself. And then the rest of the world will follow China and they've hit that hurdle. It's not there in the West yet, but we believe that it comes shortly. I'm not -- I don't think I want to comment on the OEMs' cost position. I think a lo1t of it goes into it, including batteries is a big part of it, but it's the rest of the vehicle as well. But we're not -- I'm not going to get into the comment on auto cost positions. But I think the battery technology is hitting those benchmarks we've been looking for, for a long time, and it's only going to get better.
Operator: Our next question comes from David Begleiter. David, your line is now open. Please go ahead.
David Begleiter: Thank you and good morning. Kent, what does the Kemerton capacity curtailments mean for Wodgina production, if anything?
Jerry Kent Masters, Jr.: I don't think it means anything for Wodgina production. So that there -- as we had said, so we're taking conversion capacity out and the resource piece we continue to operate from both the Greenbushes and a Wodgina standpoint. It's not really related to Kemerton.
David Begleiter: Very good. And just on what's happening in China, how much LiFePo production do you think is shut down and has that number changed at all in the last couple of months here?
Eric W. Norris: David, this is Eric, good morning. I would say in the last couple of months, it hasn't changed materially. There's some that's come off a bit. I'm going to guess tens of thousands of tons or less that is related to where we are in the cost, where price has gone. I think Kent in his remarks talked about the considerable pressure that anybody who is -- particularly anybody is not integrated in buying either spodumene or LiFePo [ph] is under. And in fact, most are operating at a loss, if they're not fully integrated inside of China. And so that's a factor. Another thing that happens this time of year is seasonal production of brine starts to ramp up in Western China. And so that's rising to sort of substitute that drop in LiFePo [ph]. I think overall, though, we're seeing rising inventories of lithium salt. So that is a concern to watch. And obviously, the price pressures I talked about, so I think -- we'll have to see how the industry responds. Obviously, there's a need for some caution in the market given where we see demand versus supply.
Operator: Our next question comes from Stephen Richardson. Stephen, your line is now open. Please go ahead.
Stephen Richardson: Hi, good morning. I was wondering Kent, appreciating that the review is ongoing, but I was wondering if you could talk a little bit more about your efforts on defining and lowering your sustaining capital. It seems like from the slide that you put forward on 16 that you're suggesting that sustaining capital is a little bit lower than it was previously and that there's a range here of minimum required capital that's sub-$1 billion. And I guess in an environment where current prices are sustained into 2025 do you envision corporate CAPEX below $1 billion next year, is that a feasible number?
Jerry Kent Masters, Jr.: Yes. So we are -- I mean look, we're going through this, we'll be cautious around that, right, to see what we can. As we are operating, we're not growing as fast. We're ramping some of these assets, but we have a view of sustaining capital, and we're challenging that. But we're going to push on that. We'll be rigorous about it. It might take risk, but we're going to be more aggressive around that than others. It's a big piece. Most -- a lot of these assets are still ramping and they're pretty new. So we've been conservative on our estimates around the sustaining capital. So we're going to dig into that and change our approach a little bit, but we see that as an opportunity.
Stephen Richardson: Okay, appreciate that. And maybe just a follow-up, if you did indeed kind of reduce a lot of your growth CAPEX and appreciate that you're outperforming growth on the ramping assets this year, would anybody be willing to hazard of guess as to if you -- on this plan what kind of remaining growth do you think you'd have in the program in 2025 just in terms of thinking about Salar and just the different projects that are out there that are still in flight in terms of growth, would that be still -- is it safe to assume you'd still be growing absolute volumes into 2025 just based on those ramps?
Jerry Kent Masters, Jr.: Yes. No, I think that's right. And I go back to the comments we've said earlier. So what we had said previously in the call or in the previous quarter's call, around the changes we did in January. We've got a couple of years of growth in the assets that we have on the ground and ramping. So we'll continue to do that at 2025 and into 2026, but then it starts to -- without further investment, we start to maximize on that. But we -- and Kemerton doesn't really change that. Again, the resource is there and the investments that we've made in there continue to ramp up. And -- but it's the conversion capacity. Actually changing Kemerton gives us a little more flexibility on product mix, but it limits us a little bit more, we're less diverse geographically around that. And that's the trade-off we're making.
Operator: Next question comes from Laurence Alexander. Laurence, your line is now open. Please go ahead.
Laurence Alexander: Good morning. Two questions. First can you just give a sense, not so much about kind of the next round of restructuring, but how you think about the longer-term objective. I mean if, for example, prices were to just stay at the current range, where would you expect energy storage margins to go over four, five, six years, however long it took for you to right size or how much do you think you can bring down the cost structure, so that's the first one, just how you think about the longer-term objectives for the business if market conditions do not improve? And secondly, can you just give a bit of a spotlight comments on sort of the state of play for DLE projects in Latin America, what do you need to see either in terms of partnerships or government support for anything to move forward in current conditions?
Jerry Kent Masters, Jr.: Okay. So the first one on the restructuring. So our goal is to put the company within the cost structure and the supply chain that we can compete at the pricing that we see today, and if it stays that way long term. So that's the hypothetical question you're asking, but that's what we're planning for. And we don't know when prices are going to rebound. We know they -- we think a lot of players are operating below cash cost. We think they have to come up. We just don't know when. So we're going to structure the company to operate and be competitive and profitable in that range. So what that margin -- what the margin looks like I'm not going to hazard a guess on that, but it is -- we're going to put ourselves in a position to be profitable and being able to compete where prices are today. Yes, so that's the first question. And the second one, DLE, and you said in South America, I'm going to talk about our view of DLE and our projects, not so much the industry. I mean I don't know -- I mean we are -- we're working on deal. We've got two projects, both going into pilot phase. We've done a lot of work around that for quite some time. One focused on the brines we have at the smackover formation at Magnolia and Arkansas in the United States where we process bromine. And we have that -- we can take that stream and process that. So we have a pilot that is in start-up at the moment around that. And then we'll do a similar pilot at the Salar de Atacama. One, I think we've said this in the remarks, one of the technologies is proprietary. The other is kind of commercial. So we're doing it in a couple of different ways. But I think the key to the -- I mean, DLE is the whole system, not just the extraction piece. There's a lot of focus on the absorption or a solvent extractor and whatever technology used to actually get the lithium molecule out. But the real art in it is the overall system and the integration in making it operate consistently day in, day out. You can do it in the lab, a lot of people can do it in a lab. You need to be able to do it in the field and do it all the time, and that's -- we're doing scale pilots that will prove that out. And so we'll see. So -- and what do we need from a government standpoint around that, I mean, for us, specifically, I don't think we're looking for government necessarily. I mean, funding would help that, but we are moving both of those projects forward. And its important technology for the industry and for us, for us to really leverage the lowest cost resource in the world in Salar de Atacama and get growth from that, we'll need DLE. So it is important. But I don't -- we're not we're not waiting on governments to help us fund it or do anything like that. We're moving forward.
Operator: Our next question comes from Kevin McCarthy. Kevin, your line is now open. Please go ahead.
Kevin McCarthy: Yes, thank you and good morning. Kent, in your prepared remarks, I think you commented that you're seeing an ongoing trend for carbonate-based batteries. Can you discuss why that's the case and whether that trend is intensifying or not and does it have any bearing on your decision to idle Kemerton 2?
Jerry Kent Masters, Jr.: Okay, so I'll go at a high level. If it gets deeper, Eric will jump in. But I mean, this is -- I mean, it is carbonate is usually the preferred chemistry for LFP technology, and there's been a shift toward LFP. And I would say that's the preferred technology in China. Because China is on such a growth rate and the West is slowing down a little bit. That's -- there's more of a shift of -- a little bit of a portfolio mix toward carbonate. Now the West is looking at carbonate or LFP as well. Therefore, our view from a year or two ago, we always expected a mix. It was a little more hydroxide heavy. Now it's probably carbonate heavy in that view. And then that product mix, I mentioned product mix earlier when I was talking about Kemerton, that does play into that. Kemerton is hydroxide, and we can toll that same resource for carbonate if we need to, and that gives us more flexibility. So it was a consideration in our decisions around 2 and 3.
Kevin McCarthy: Thank you for that. And then as a follow-up, what would you need to see specifically to make a decision to restart Kemerton 2 and how quickly might you be able to do that and is there a meaningful cost to restart?
Jerry Kent Masters, Jr.: Yes. So there's a cost to put it in care and maintenance, right and it would be a cost to come back, but I don't know that it's not dramatic. It would be ordinary course I think if we brought it back. There's a number of things we have to do. Part of the decision about focusing on Train 1 and not 2 is to really optimize that asset, get it to work. We've all -- we have struggled with workforce in Australia and we struggle to ramp the two of them together. So we're going to focus on one, ramp that up to make that really operate, really understand the technology and process. And we think we can bring it back faster and more efficiently to Train 2 when the conditions make that right. So we've got do a few things before we would do that, we would get the plant to operate, really understand the technology and the process chemistry that's unique to Kemerton. And then we can bring that to Train 2. It will be -- but we'll need the market to improve before we do that. And then there would be a time frame in order to bring it back. So it's not going to turn on a dime, but we'll plan for that. And it is not dramatic from a -- not big from a capital standpoint, but there would be cost to bring it back on, and we'd have to bring people back on to do that as well.
Operator: Our next question comes from Colin Rusch. Coli, your line is now open. Please go ahead.
Colin Rusch: Thanks so much guys. As you're working through enforcing these contracts, can you talk about some of the dynamics with the customers and any sort of compromises that you might be making to adjustments. Historically, you've kind of enforced some pricing and you reallocated volumes. Just want to get a sense of how those dynamics are playing out?
Eric W. Norris: Yes. Good morning Colin, it's Eric. As you point out, it's obvious with where market pricing is going. It is a discussion certainly around helping our customers remain competitive through this period of time, while at the same time, respecting the contracts we have and the thresholds that we have there in order to continue to invest on their behalf. I would tell you that all of these contracts are performing to date and it's our expectation that we'll continue to do so. And we'll keep working with our customers. There are things we can do in terms of source. Some of these contracts have a little bit of flexibility, and we can work around spodumene supply versus salt supply. We can look at sourcing points that are different that helps them with their supply chains while at the same time, respecting the core fundamentals of our contracts. So that's basically the nature of the discussions to date.
Colin Rusch: Thanks so much. And then just a little bit more on the technology side. As we see more silicon-based anodes, whether it's increased levels of doping or silicon, I know it's completely -- the challenge of lithiation is pretty substantial. Can you talk a little bit about how much leverage you're getting out of the R&D center and helping folks figure out process and approaches to the lithiation challenge?
Eric W. Norris: Well, this remains an area of focus for our growth. And when we talk about some of the advanced materials that are lithium-based looking at prelithiation materials that will support the adoption of silicon anodes or silicone doped anodes as you point out, for higher-capacity batteries that can lend themselves, obviously, to longer battery life or range. And furthermore, there is sort of the next journey -- step on that journey is moving towards a lithium metal anode as well, whether that's a solid state or even a liquid electrolyte used with lithium anodes. So these are areas of growth. These areas we see, frankly, having a faster adoption in technologies outside of electric vehicles, whether there's a smaller format battery and perhaps less risk involved in the customer base as a first step, on the one hand. On the other hand, if you speak to some of the more progressive vehicle producers, OEMs who are looking at future technologies, there's a lot of investment they're doing in this area as well. So it's part and parcel of the overall partnership we have with customers. I mean it's the reason that relative to the earlier question, maintaining a contract relationship and supporting us when prices are low, we support them throughout the cycle as well, is if we got to respect and have strong contracts -- contract relationships because they're more than just supply. They deal with things like technology as well that you're pointing out.
Operator: Our next question comes from David Deckelbaum. David, your line is now open. Please go ahead.
David Deckelbaum: Hi, thanks for the time today and for taking my questions. Maybe for Neal. I just wanted to understand, I think, the remarks with the Kemerton move, it saves $200 million to $300 million over the next 18 months or so. Can you talk about that in the context of where you expect next year's CAPEX to be And more just is $1 billion of sustaining CAPEX, is that a reasonable target for what you could get to next year or still have to take sort of a multiyear progression?
Neal R. Sheorey: Yes, I think I'm going to answer this probably very similar to the way that Kent did. So obviously, as we look at CAPEX into 2025 and 2026, this decision that we're sharing today around Kemerton will absolutely factor into lowering our CAPEX in those out years. And we've always talked about our focus on doing that in this environment. Just as Kent mentioned to an earlier question, we're working through that with our teams right now. And obviously, we understand that what the current environment looks like and that we need to spend a lot of hard time looking at our CAPEX spending and how we can -- where we can bring that down and how we can bring that down as quickly as possible without taking unnecessary risk. So I would just say like we're working on that equation now, and we'll have more to share, I think, in the next couple of quarters.
David Deckelbaum: I appreciate that. And then my follow-up is just -- on going forward now, with CGP 3 ramping at Greenbushes and volumes growing there. On the back end now with Kemerton having less capacity, is the commercial profile going forward just all going to be reliant on tolling or do you have flexibility to sell spodumen concentrate into the market? And will you be able to satisfy all of your customer contracts through tolling alone?
Jerry Kent Masters, Jr.: Well, it's not -- well, not just totally. So we've got a network of conversion assets today. And so Meishan is up and operating and ramping as we speak. And we've got first sales from Meishan in this quarter. And we -- as we said, ahead of schedule, we have multiple other facilities in China that we own and operate for conversion. So Kimberton is a portion of it, of our Hard Rock conversion assets. And it will be a blend. We will use some tolling to supplement our conversion assets, but we have significant conversion assets and the Kemerton 3 and 4 is just a portion of it. And again, we'll have 1 operating and 2 to bring on after that. So it's still a significant portfolio of conversion assets that we have, and then we don't want to forget about the carbonate that we bring from Chile as well. So it's a pretty good portfolio of conversion assets. And I would say this is a tweak, not like a big wholesale change in that network with the change to Kemerton.
Operator: Our last question comes from John Roberts. John, your line is now open. Please go ahead.
John Roberts: Thanks and who would have thought that [indiscernible] would be the good performing business here in the portfolio. I'll ask a question on the specialties business. Is some of the weakness in specialties temporary channel destocking or had those -- had your channels already destocked like many others have and the weakness you're seeing actually is reflective of the end market weakness?
Netha N. Johnson, Jr.: Yes, John, this is Netha. We are seeing some end market weakness. And rather than weakness, maybe not as quick as a recovery as we expected, particularly in electronics. We did have volume growth of 9%, but price declined. And if you look at the spot price, which is our only public spot price we have in the market in Q1, the Chinese bromine spot price was $3.11 per metric ton and in Q2 was $2.86 per metric ton, and that explains the pricing. But we are seeing green shoots and we are seeing that electronics recovery come, continuing strength in oil and gas, pharma and ag, and we expect to see that growth continue, maybe a little slower than what we thought, but throughout the rest of the year AND sequential growth in our financials as a result of that .
Operator: That's all the time we have for questions. I will now pass it back to Kent Masters for closing remarks.
Jerry Kent Masters, Jr.: Okay. Thank you, and thank you all for joining us today. We continue to adapt and move Albemarle forward to better position ourselves in the current market environment, enhance our company's profitable organic growth trajectory, and create long-term value for shareholders. I remain confident in the long-term secular growth opportunities in our end markets and that we are taking the right steps to position Albemarle for value creation. Thank you.
Operator: This concludes today's conference call. Thank you for your participation. You may now disconnect. | [
{
"speaker": "Operator",
"text": "Hello and welcome to Albemarle Corporation's Q2 2024 Earnings Call. I will now hand it over to Meredith Bandy, Vice President of Investor Relations and Sustainability."
},
{
"speaker": "Meredith Bandy",
"text": "Thank you and welcome everyone to Albemarle's second quarter 2024 earnings conference call. Our earnings were released after the market yesterday, and you'll find the press release and earnings presentation posted to our website under the Investor Section at albemarle.com. Also posted to our website is yesterday’s additional press release announcing our initiation of a comprehensive review of our cost and operating structure which we will also reference during our comments today. Joining me on the call today are Kent Masters, Chief Executive Officer; Neal Sheorey, Chief Financial Officer; Netha Johnson, President of Specialties; and Eric Norris, President of Energy Storage are also available for Q&A. As a reminder, some of the statements made during this call, including our outlook, guidance, expected company performance and strategic initiatives may constitute forward-looking statements. Please note the cautionary language about forward-looking statements contained in our press release and earnings presentation which also applies to this call. Please also note that some of our comments today refer to non-GAAP financial measures. Reconciliations can be found in our earnings materials. And now, I'll turn the call over to Kent."
},
{
"speaker": "Jerry Kent Masters, Jr.",
"text": "Thank you Meredith. During the second quarter Albemarle continued to demonstrate strong operational execution. We recorded net sales of $1.4 billion and sequential increases in adjusted EBITDA and cash from operations, thanks in part to successful project delivery, productivity, and restructuring initiatives and working capital improvements. We continued to capture volumetric growth driven by our energy storage segment which was up 37% year-over-year, highlighting successful project ramps and spodumene sales in that segment. For example during the quarter we achieved first commercial sales from Meishan ahead of our original schedule by approximately six months. During the second quarter we also delivered more than $150 million in restructuring and productivity improvements consistent with our efforts to align our operations and cost structure with the current market environment. We are on track to exceed our full-year targets on this front by 50%. Looking to the rest of this year, our operational discipline allows us to maintain our full-year 2024 outlook considerations. Notably, we expect our $15 per kilogram lithium price scenario to apply even assuming that lower July market pricing persists. This is due to higher volumes, cost out and productivity progress, and contract performance. We have made great progress in strengthening our competitive position and enhancing our financial flexibility. However, industry headwinds that began last year have persisted longer than the sector anticipated, making it clear that we must proactively take additional steps. Building on the actions we announced this past January, we announced yesterday that we are taking a comprehensive review of our cost and operating structure with the goal of maintaining Albemarle’s competitive position and driving long-term value. As part of the initial review, we announced the difficult but necessary decision to immediately adjust our operating and capital spending plans at our Kemerton site in Australia. These actions showcase our deeper focus on cost and operating discipline. There's no question that the global energy transition is underway, however, the pace of the industry changes our dynamic and we must remain agile as well. Later on the call, I will spend some time diving deeper into the cost and asset actions that we continue to take in this environment to maintain our competitiveness. And I will also highlight the strategic advantages that remain proof points of Albemarle’s competitive and operational strengths. I'll now hand it over to Neal to talk about our financial results during the quarter."
},
{
"speaker": "Neal R. Sheorey",
"text": "Thanks Kent and good morning everyone. Beginning on Slide 5, let's move to our second quarter performance. In Q2 2024, we recorded net sales of $1.4 billion, compared to $2.4 billion in the prior year quarter, a decline of 40% driven principally by lower pricing. During the quarter, we recorded a loss attributable to Albemarle of $188 million and a diluted loss per share of $1.96. This result included an after-tax charge of $215 million, primarily related to capital project asset write-offs for Kemerton 4. Adjusted diluted EPS was $0.4 per share. Moving to Slide 6, our second quarter adjusted EBITDA of $386 million was down substantially versus the year ago period, as favorable volume growth was more than offset by lower prices and reduced equity earnings due to soft fundamentals in the lithium value chain. Compared to the first quarter, second quarter adjusted EBITDA rose 33%, driven by higher sales volumes across all businesses and higher income from increased Talison JV sales volumes. As a reminder, on last quarter's earnings call, we said that we expected an approximately $100 million sequential lift to our EBITDA from higher than normal off-take by a partner at the Talison JV, and that's what we saw in the quarter. Turning to Slide 7. As we've done in prior quarters, we are providing full year 2024 outlook considerations based on historically observed lithium market pricing scenarios. The price scenario shown represent a blend of relevant market prices, including both China and ex China pricing for lithium carbonate and hydroxide. The numbers you see here on this slide have not changed since our last earnings call. What is new is what Kent mentioned at the top of the call. We now expect the $15 per kilogram price scenario to be applicable even assuming lower July market pricing persists for the balance of the year. We are able to maintain this scenario due to the success of our enterprise-wide cost improvements, continued strong volume growth, higher sales volumes at our Talison JV, and contract performance in energy storage. Moving to Slide 8. We continue to prioritize our financial flexibility and strong liquidity to navigate the dynamic market environment. We ended the second quarter with available liquidity of $3.5 billion, including $1.8 billion of cash and cash equivalents and $1.5 billion available under our revolver. Our net debt to adjusted EBITDA was 2.1 times which was well below the quarter's covenant maximum of 5 times. We continue to add new liquidity resources such as our AR factoring program, and from a long-term debt perspective, we are well positioned and have no significant maturities due until late 2025. Turning to Slide 9, which shows our improved operating cash flow performance and considerations. Our focus on cash generation and efficiency continues to drive important benefits. Our operating cash flow conversion in the second quarter was 94%, which was unusually high, primarily due to increased Talison dividends. We also continued to drive volume growth, cost and productivity improvements, and working capital efficiencies, all of which contributed to our cash conversion. As we look forward, we now expect our full year operating cash conversion to be approximately 50%, which is at the higher end of our historical range. I'll now hand it back to Kent."
},
{
"speaker": "Jerry Kent Masters, Jr.",
"text": "Thanks, Neal. Turning to Slide 10, for more details about the actions we announced yesterday to streamline our operations, build on the cost out and productive actions we already have underway, and maintain Albemarle's competitive position across the cycle. Now on Slide 11, I'll first cover the fundamentals in our market. On the demand side, EV registrations are up more than 20% year-to-date through June, led by strong growth in China. However, the pace of growth in Europe and the U.S. has moderated substantially versus the industry's expectations. Across the value chain, we are seeing meaningful mix shifts. First, stronger growth in plug-in hybrid sales, which has translated to smaller batteries with less lithium per vehicle and second, we see a continuation in the trend towards more carbonate-based batteries. Both of these developments are still positive for overall long-term lithium demand, however, they highlight the shifting nature of this value chain as it develops and matures. These demand changes are occurring at the same time as we see dynamic conditions on the supply side. We have yet to see significant changes at the mine level as existing and new supplies continue to come to market. And on the conversion side, there is still oversupply predominantly in China. At current Chinese spot pricing, we believe and are hearing from the market that many nonintegrated producers are unprofitable with some operating at reduced rates or idling production. And we're hearing that even producers who are integrated into cathode or batteries are under pressure. Moreover, current pricing is well below the incentive pricing required for Western greenfield lithium projects. At the same time, geopolitical developments are also adding uncertainties to our business. This includes escalating trade tensions and ongoing armed conflicts. Challenging Western supply chain dynamics are also at play. Notably, the IRA's 30D consumer tax credit has yet to benefit upstream producers like Albemarle. And specific to our position, as written the Final U.S. Department of Energy Foreign Entity of Concern or FEOC rule will impact the eligibility of our Australian product, and we suspect that others could be impacted as well. While current dynamics add challenging uncertainties, there is no question that the energy transition remains well underway, and the long-term growth potential of our end markets is strong, as you can see on Slide 12. The global EV supply chain is on track to achieve the critical $100 per kilowatt hour tipping point where EVs are at cost parity with internal combustion engine vehicles. The Chinese industry has likely surpassed that target with the rest of the world not far behind. Taking all these changes into consideration, we continue to anticipate 2.5 times lithium demand growth from 2024 and to 2030. Additionally, we see battery size growing over time, driven by technology developments and EV adoption. These factors all translate to significantly higher long-term global lithium needs. Turning to Slide 13, in January, we announced a series of proactive actions to preserve growth, reduce cost, and optimize cash flow. Our teams have successfully executed on many of those actions, including ramping in-flight projects at Xinyu, Meishan and the Salar on or ahead of schedule, delivering cost out and productivity actions and we are now tracking to deliver 50% ahead of our initial targets, reducing 2024 estimated CAPEX by between $300 million and $400 million year-over-year, and enhancing our financial flexibility including improving cash generation and conversion. While these steps have served us well, the industry dynamics I just described require us to do more to ensure our competitiveness across the cycle. Building on the actions we announced in January, we announced yesterday that we were embarking on a comprehensive review of our cost and operating structure, pushing deeper into our playbook to further pivot and pace to maintain our leading position. We are focused on the four key areas you see on the slide: optimizing Albemarle's global conversion network to preserve our world-class resource advantages, improving our cost competitiveness and efficiency, continuing to reduce capital expenditures and future capital intensity, and enhancing Albemarle's financial flexibility. The middle section of this slide highlights that we've already taken the next set of actions across these four focus areas. And the bottom of the slide details additional opportunities that we'll closely evaluate as part of the process. The comprehensive review of our cost and operating structure has just begun, and we plan to provide additional details with our third quarter earnings. That said, we took the difficult but necessary decision to bring forward the first step in the review, which is to further optimize our Australian network as we show on Slide 14. As one of the first steps in this comprehensive review, we announced yesterday immediate adjustments to our Australian lithium hydroxide footprint. These changes follow our previously announced decision not to proceed with the construction of Kemerton Train 4. Specifically, we will idle production at Kemerton Train 2 and place the unit in care and maintenance. Additionally, we will stop construction activity on Train 3. Notably, we estimate that stopping construction on Train 3 will save at least $200 million to $300 million of capital spending over the next 18 months. These changes allow us to focus on optimizing and ramping Kemerton Train 1 to preserve optionality and diversity across both product type and geography. In the coming weeks, we'll be identifying other ways to optimize our global conversion network with a focus on the highest priority and highest return options. Our global portfolio of convergent assets and our extensive holding network provide the flexibility to maximize the value of our high-quality resources and to provide either carbonate or hydroxide to meet the needs of our customers as their demands and technologies evolve. Turning to Slide 15. As we deliver these initial savings and begin the next phase of our review, our operating model, the Albemarle Way of Excellence remains the standard by which we operate. By executing our operating model, we are building a culture of continuous improvement to identify best practices at every point in the cycle. We are on track to exceed our initial goals for restructuring and productivity savings through manufacturing, procurement, and back-office initiatives. Much of the better-than-expected performance to date is in manufacturing improvements. For example, optimized PON management at the Salar and overall equipment effectiveness improvements at La Negra have maximized production at one of our lowest-cost assets. These manufacturing benefits in Chile are in addition to the increased efficiency and volume we expect as the Salar yield improvement project continues to ramp. Moving to Slide 16 and our capital spending profile. As I mentioned earlier, we expect 2024 CAPEX to be $300 million to $400 million below 2023 levels. Moving forward, we are evaluating opportunities to further reduce our capital intensity and total capital spending. This will provide enhanced optionality, improve free cash flow, and put Albemarle in a stronger competitive position long term. Our capital spending profile is another element of our comprehensive review and we'll have more to say about our near-term spending plan on future calls. Moving to Slide 17. With all these near-term factors shifting and requiring us to take action, I think it's important to remember that Albemarle continues to have significant competitive strengths. And so I will end with a review of our framework and the core advantages we continue to prioritize as drivers of our long-term value creation. Slide 18 provides our strategic framework, which informs our planning and gives us confidence that we will achieve our growth ambition to lead the world in transforming essential resources into critical ingredients for modern living. This framework defines where we play, how we win, and how we deliver. Albemarle remains uniquely positioned to enable operational excellence during this dynamic period thanks to our competitive strengths, including our globally diverse portfolio of world-class resources, leading process chemistry, deep innovation, and technical know-how, customer-centric approach to the market, and responsible stewardship. Each of our competitive strength will help us right now and well into the future in ways that we summarize on Slide 19. First, our world-class resources are arguably the best in the industry with large-scale, high-grade and, therefore, low-cost assets. In energy storage, we have access to some of the high-grade resources in both hard rock and brine. In Australia with Greenbushes and Wodgina and one of the largest known hard rock assets in the U.S., Kings Mountain. And in Chile with our long-standing position in the Salar de Atacama. Similarly, in specialties, we are the only producer with access to both of the two best bromine resources globally. In Jordan, on the Southeast side of the Dead Sea, the source is the largest concentration of bromine in the world. And in the smack over formation in Arkansas, the only source of commercial bromine in the United States. In both of our core businesses, we maximize the value of our world-class resources by converting and flexibly derivatizing into higher value and use products in our conversion assets or in the case of energy storage, through our extensive tolling network. Second, our leading process chemistry know-how is key to achieving further productivity and cost improvements, safely and sustainably. For example, the Salar yield improvement project utilizes a proprietary technology to enable up to 20% higher yield. At Magnolia, we've leveraged advanced process controls to increase production while lowering costs and improving sustainability. And at both the Salar and Magnolia, we have evaluated a wide range of direct lithium extraction options and are piloting proprietary and third-party solutions in order to be prepared for technology shifts that could be important and more sustainable Salar yield options for this industry. Third, we have a pipeline of high-impact innovative solutions in both bromine and lithium. Our research, testing, and piloting facilities in North Carolina, Louisiana, and Langelsheim, Germany, allow us to participate in differentiated high-margin segments and support our customers' specific requirements. Fourth, Albemarle's leading industry position as a partner of choice is demonstrated through our growing number of partnerships with iconic pioneering companies. Both our businesses have high Net Promoter Scores with significantly positive gaps relative to competitors, reflecting long-standing successful relationships with major customers. And last but not least, our responsible stewardship, strong values and high-performance culture are increasingly recognized by leading organizations. For example, we recently earned an EcoVadis gold medal placing us in the top 5% of global companies and demonstrating our commitment to creating a more resilient world and advancing the sustainability objectives of our customers. In summary, on Slide 25, Albemarle delivered another strong quarterly performance in the second quarter, including sequential improvements in adjusted EBITDA and cash from operations. Despite lower market pricing, we've been able to maintain our full year 2024 outlook considerations, thanks in part to enterprise-wide cost improvements, strong energy storage project ramps, and contract performance. However, we understand these positive actions may not be sufficient given ongoing industry headwinds. Our entire organization is focused on delivering operational excellence while positioning the company to capitalize on the incredible long-term opportunities in our markets. That's why we are taking the proactive steps to control what we can control and ensure we are competitive across the cycle. Albemarle is a global leader with a world-class portfolio and vertical integration strength. We are uniquely positioned to win. I am confident we are taking the right actions to maintain our competitive position and ensure we execute with agility today and in the future. I look forward to seeing some of you face-to-face at upcoming events listed here on Slide 26. And with that, I'd like to turn the call back over to the operator to begin the Q&A portion."
},
{
"speaker": "Operator",
"text": "[Operator Instructions]. Our first question comes from Aleksey Yefremov. Your line is now open. Please go ahead."
},
{
"speaker": "Unidentified Analyst",
"text": "Thanks and good morning everyone. This is Ryan on for Aleksey. My first question would just be kind of around your EBITDA outlook for the year, right. So I understand that you are kind of maintaining the base case or the low case in the $15 per kilo scenario, even though prices currently are, let's say, $11 to $12 per kilogram. Is there the potential that EBITDA could improve if prices were to recover to that $15 per kilogram scenario here in the back half, I mean, you guys talked a lot about improved costs, so just wondering what you think about that?"
},
{
"speaker": "Jerry Kent Masters, Jr.",
"text": "So let's say you characterize what you've said. So even as we've moved that from $15 to, say, $12 to $15. And then we commented that even at July prices, those hold for the rest of the year, we'll make that forecast. And so if there's a chance it could be higher. If prices moved up or there are a number of reasons we're able to hold that forecast is around the volumes that we're selling contract terms, things like that. So it could move up if prices are stronger, it's not collared, so to speak. So if things work in our direction, it could be a number of different things. It could be higher than that. But that's the best visibility we have at the moment."
},
{
"speaker": "Unidentified Analyst",
"text": "Okay, helpful. And then I know it's early, but just kind of initial expectations on volume growth for maybe 2025 and 2026, just after these actions that have just been taken at Kemerton now? Thanks."
},
{
"speaker": "Jerry Kent Masters, Jr.",
"text": "Yes. So okay, you're right, it's early. But I think our volume and what we indicated in the beginning of the year, our volume growth shouldn't be significantly different than that. I mean we are changing some of our -- we're taking out conversion capacity, but we still have the resource that should align to that. So it's not significantly different than we had indicated at the last call."
},
{
"speaker": "Operator",
"text": "Our next question comes from Steve Byrne. Steve, your line is now open. Please go ahead."
},
{
"speaker": "Stephen Byrne",
"text": "Yeah, thank you. Kemerton has some more meaningful freight costs than some of your Chinese conversion. But roughly what is the cash margin for Kemerton 2 and where would you put it on the cost curve, what quartile?"
},
{
"speaker": "Jerry Kent Masters, Jr.",
"text": "Yes. So I guess we've never put any of our assets and given that type cost out there. So it is -- I guess it's a combination of -- so you're talking about 2. So 3 is really about some of the money that we're spending in growing that. And Kemerton 1 and 2 gives us a couple of things. So it's closer to the resource, but it gives us diversity just geographic diversity. So we would have Chile, we would have -- we have Australia, 1 and 2 help us with that, we have China. And then we still aspire to have conversion in the U.S. at some point if prices come back to that. So I'm not going to give you what our marginal cost is or our cash cost is at Kemerton, but that's some of the thinking that goes into the decisions we've made."
},
{
"speaker": "Stephen Byrne",
"text": "Okay. It seems like there's more than just a cost cut. It's a supply cut. But with respect to the roughly $1 billion -- sure. Go ahead, Kent."
},
{
"speaker": "Jerry Kent Masters, Jr.",
"text": "No, I was just going to say that it is on conversion. It is capacity cut on conversion. The resource is still available."
},
{
"speaker": "Stephen Byrne",
"text": "Right. Understood. The $1 billion charge in 3Q, can you put that into buckets and how much of it is cash?"
},
{
"speaker": "Neal R. Sheorey",
"text": "Yes, hi Steve, good morning. This is Neal. So let me answer the second part of your question and maybe the two kind of go together. So roughly speaking, at this time, we've only had a very small group of people working on this. So we'll obviously refine this number quite a bit in the third quarter. But you should think about of that roughly $1 billion charge we announced today, somewhere at least 60% of that is noncash. And similarly, you can expect that kind of on that order represents what's already on our balance sheet that we're writing off. And then we'll give you a better assessment when we get to third quarter in terms of how much of the rest of that is actually cash. But I'd say at least 60% is noncash."
},
{
"speaker": "Operator",
"text": "Our next question comes from Patrick Cunningham. Patrick, your line is now open. Please go ahead."
},
{
"speaker": "Patrick Cunningham",
"text": "Hi, good morning. Thanks for taking my question. Maybe just trying to square the comments last time, cash conversion expectations expected to be well below historical averages versus strength in the outlook here. You had the $400 million to $600 million in headwinds. Was there any improvement in some of those items, whether it's deferral of discrete tax items or other things, some of the working capital ramp for projects, I'm just trying to understand cash drag for the remainder of the year?"
},
{
"speaker": "Neal R. Sheorey",
"text": "Yes. Yes. This is Neal, again. So yes, thanks for asking that question because we are -- as we said in our considerations in the prepared remarks, we're taking that range now up to a 50% conversion, which is towards the high end of our historical range now. And there's -- I'd say there's two things that I would point to that where we're doing better than expected. The first is from a dividend perspective from our equity companies, that was certainly better than we expected coming into the year. You heard in our prepared remarks and you know about the additional offtake that we saw at Talison. So that definitely boosted dividends in the second quarter and helped our cash conversion. And then the other part is, yes, on the working capital side, we are highly focused on it, and we have a lot of initiatives around this, and we're seeing some of those come through already in the first half of the year and are continuing to work on that in the back half of the year. So working capital was another nice tailwind to cash in terms of the release of cash from there."
},
{
"speaker": "Patrick Cunningham",
"text": "Understood, very helpful. And then just generally on how we should think about 3Q sequentially for energy storage. Can you help us triangulate how much lower volumes will be sequentially based on some of this onetime benefit, where we should stand for pricing if we kind of hold the July averages here? And then is the remaining sensitivity in your numbers mostly around volume or is there something else?"
},
{
"speaker": "Neal R. Sheorey",
"text": "Yes. So I can maybe take the second part of that. We are obviously, from a volume perspective, we're obviously tracking towards the higher end of the 10% to 20% volume growth range that we gave you at the beginning of the year. And I think at this point for the visibility we have, we're probably going to keep tracking towards the high end of that range. So I wouldn't say our earnings corridor or our outlook considerations are really driven by volume per se. It's really around the pricing range that we've given you, that kind of $12 to $15 range today."
},
{
"speaker": "Jerry Kent Masters, Jr.",
"text": "Yes. Just -- but the first part of the year was strong from a volume standpoint and that was fine [ph], the upper end of that range, 20%, Neal is saying it's going to be less year-on-year growth in the second half. But that's just because it's so strong in the first half, and we've had a mix of spodumene sales in there as well that's pulled some of that forward."
},
{
"speaker": "Operator",
"text": "Our next question comes from Vincent Andrews. Vincent, your line is now open. Please go ahead."
},
{
"speaker": "Vincent Andrews",
"text": "Thank you and good morning everyone. Last quarter, you had a slide on capital allocation priorities and it had a couple of things in it. I just would like to revisit. One was a commitment to investment-grade rating, the second was your ultimate long-term net debt to adjusted EBITDA target of less than 2.5 times, and then thirdly, the continuation to support and grow the dividend. How are you thinking about those three things as part of the comprehensive review?"
},
{
"speaker": "Jerry Kent Masters, Jr.",
"text": "Yes, I don't think our view has changed, right. So that will -- as we go through this, I mean, we'll reiterate that, but I suspect it will stay the same."
},
{
"speaker": "Vincent Andrews",
"text": "And as a follow-up, could you speak a little bit about the factoring and how that process works for you and how we'll see it, I guess, in the working capital results?"
},
{
"speaker": "Neal R. Sheorey",
"text": "Yes. So Vincent, to your question, that's right. We put in place an AR factoring program. It's an initial program. We'll continue to evaluate that and add to it as we can as we go along. But essentially, that factoring program is currently untapped. We will use it when we need liquidity if and when we need liquidity. And so basically, at that point, that's when you'll see it, and we'll talk about it. But at this point, it's an untapped resource available to us."
},
{
"speaker": "Operator",
"text": "Our next question comes from Chris Parkinson. Chris, your line is now open. Please go ahead."
},
{
"speaker": "Harris Fein",
"text": "Hey, good morning. This is Harris Fein on for Chris. So we walked through that the $15 per kilo scenario still holds at $12. I guess how much of that is because of higher Talison shipments and cost improvements and I guess, like where would EBITDA be absent those items if we were just isolating the contract component and I am just kind of trying to get a sense of what that looks like if prices go down to, let's say, $10 per kilo through the back half of the year?"
},
{
"speaker": "Jerry Kent Masters, Jr.",
"text": "Yes. So we've said at July pricing, it basically holds the same, right. So $12 to $15 on the slide, but we've said in the remarks that, that July pricing it holds. If July pricing extends throughout the balance of the year, it still holds. So you can work out exactly what that number comes to. And there are a number of pieces that allow us to do that. So it's the volume mix, it is a little bit of additional volume from Talison, it's our contracts. It's a lot of things. It's the cost savings things that we're putting in place. So it's a number of things that go into making that statement true. So it's not one particular thing."
},
{
"speaker": "Neal R. Sheorey",
"text": "Yes, maybe just to add on to that, just a reiteration that those outlook considerations we provided were always a view on the average pricing across the year. And so with the last couple of earnings releases, we've given you -- you obviously know the sales that we've had in energy storage, and we've given you the volumes that we've sold. So you can look at what our average realized price has been. It's been above $15 for the first half of the year. And so when you -- you can take your -- whatever lithium price you'd like to in the back half of the year and do the averaging. But that's why we say when you take July pricing and roll it forward, it falls within that range that we've given you. With regards to Talison, I think the best way to answer that is just to go back to what we've said before. We told you that in the second quarter, we expected about $100 million sequential lift related to the Talison offtake, the additional Talison offtake, and that's exactly what we saw. So maybe that gives you an idea of how to think about that part of your question."
},
{
"speaker": "Harris Fein",
"text": "Got it, that's helpful. And then for my second question, in Slide 12 you show that the global average EV is on track for cross parity with ICE in the next year or two. It would be nice to hear your take maybe on what you make of some of the recent challenges that Western OEMs are having in making a profitable EV and also the fallout from European tariffs on Chinese EVs, kind of how that is playing into your demand outlook?"
},
{
"speaker": "Jerry Kent Masters, Jr.",
"text": "Okay. So -- I mean, the cost on -- the cost curve that you see, Neal said on Slide 12. I mean that's a curve that we've been -- that the industry has been looking at for some time. That $100 per kilowatt hour has been a benchmark or a tipping point we call it that people have been looking for, and we're below that in China today. Now some of that fair enough is on -- is because lithium prices are low, but the majority of it is just on the experience curve, the technology and the battery technology. So we think that maintains itself. And then the rest of the world will follow China and they've hit that hurdle. It's not there in the West yet, but we believe that it comes shortly. I'm not -- I don't think I want to comment on the OEMs' cost position. I think a lo1t of it goes into it, including batteries is a big part of it, but it's the rest of the vehicle as well. But we're not -- I'm not going to get into the comment on auto cost positions. But I think the battery technology is hitting those benchmarks we've been looking for, for a long time, and it's only going to get better."
},
{
"speaker": "Operator",
"text": "Our next question comes from David Begleiter. David, your line is now open. Please go ahead."
},
{
"speaker": "David Begleiter",
"text": "Thank you and good morning. Kent, what does the Kemerton capacity curtailments mean for Wodgina production, if anything?"
},
{
"speaker": "Jerry Kent Masters, Jr.",
"text": "I don't think it means anything for Wodgina production. So that there -- as we had said, so we're taking conversion capacity out and the resource piece we continue to operate from both the Greenbushes and a Wodgina standpoint. It's not really related to Kemerton."
},
{
"speaker": "David Begleiter",
"text": "Very good. And just on what's happening in China, how much LiFePo production do you think is shut down and has that number changed at all in the last couple of months here?"
},
{
"speaker": "Eric W. Norris",
"text": "David, this is Eric, good morning. I would say in the last couple of months, it hasn't changed materially. There's some that's come off a bit. I'm going to guess tens of thousands of tons or less that is related to where we are in the cost, where price has gone. I think Kent in his remarks talked about the considerable pressure that anybody who is -- particularly anybody is not integrated in buying either spodumene or LiFePo [ph] is under. And in fact, most are operating at a loss, if they're not fully integrated inside of China. And so that's a factor. Another thing that happens this time of year is seasonal production of brine starts to ramp up in Western China. And so that's rising to sort of substitute that drop in LiFePo [ph]. I think overall, though, we're seeing rising inventories of lithium salt. So that is a concern to watch. And obviously, the price pressures I talked about, so I think -- we'll have to see how the industry responds. Obviously, there's a need for some caution in the market given where we see demand versus supply."
},
{
"speaker": "Operator",
"text": "Our next question comes from Stephen Richardson. Stephen, your line is now open. Please go ahead."
},
{
"speaker": "Stephen Richardson",
"text": "Hi, good morning. I was wondering Kent, appreciating that the review is ongoing, but I was wondering if you could talk a little bit more about your efforts on defining and lowering your sustaining capital. It seems like from the slide that you put forward on 16 that you're suggesting that sustaining capital is a little bit lower than it was previously and that there's a range here of minimum required capital that's sub-$1 billion. And I guess in an environment where current prices are sustained into 2025 do you envision corporate CAPEX below $1 billion next year, is that a feasible number?"
},
{
"speaker": "Jerry Kent Masters, Jr.",
"text": "Yes. So we are -- I mean look, we're going through this, we'll be cautious around that, right, to see what we can. As we are operating, we're not growing as fast. We're ramping some of these assets, but we have a view of sustaining capital, and we're challenging that. But we're going to push on that. We'll be rigorous about it. It might take risk, but we're going to be more aggressive around that than others. It's a big piece. Most -- a lot of these assets are still ramping and they're pretty new. So we've been conservative on our estimates around the sustaining capital. So we're going to dig into that and change our approach a little bit, but we see that as an opportunity."
},
{
"speaker": "Stephen Richardson",
"text": "Okay, appreciate that. And maybe just a follow-up, if you did indeed kind of reduce a lot of your growth CAPEX and appreciate that you're outperforming growth on the ramping assets this year, would anybody be willing to hazard of guess as to if you -- on this plan what kind of remaining growth do you think you'd have in the program in 2025 just in terms of thinking about Salar and just the different projects that are out there that are still in flight in terms of growth, would that be still -- is it safe to assume you'd still be growing absolute volumes into 2025 just based on those ramps?"
},
{
"speaker": "Jerry Kent Masters, Jr.",
"text": "Yes. No, I think that's right. And I go back to the comments we've said earlier. So what we had said previously in the call or in the previous quarter's call, around the changes we did in January. We've got a couple of years of growth in the assets that we have on the ground and ramping. So we'll continue to do that at 2025 and into 2026, but then it starts to -- without further investment, we start to maximize on that. But we -- and Kemerton doesn't really change that. Again, the resource is there and the investments that we've made in there continue to ramp up. And -- but it's the conversion capacity. Actually changing Kemerton gives us a little more flexibility on product mix, but it limits us a little bit more, we're less diverse geographically around that. And that's the trade-off we're making."
},
{
"speaker": "Operator",
"text": "Next question comes from Laurence Alexander. Laurence, your line is now open. Please go ahead."
},
{
"speaker": "Laurence Alexander",
"text": "Good morning. Two questions. First can you just give a sense, not so much about kind of the next round of restructuring, but how you think about the longer-term objective. I mean if, for example, prices were to just stay at the current range, where would you expect energy storage margins to go over four, five, six years, however long it took for you to right size or how much do you think you can bring down the cost structure, so that's the first one, just how you think about the longer-term objectives for the business if market conditions do not improve? And secondly, can you just give a bit of a spotlight comments on sort of the state of play for DLE projects in Latin America, what do you need to see either in terms of partnerships or government support for anything to move forward in current conditions?"
},
{
"speaker": "Jerry Kent Masters, Jr.",
"text": "Okay. So the first one on the restructuring. So our goal is to put the company within the cost structure and the supply chain that we can compete at the pricing that we see today, and if it stays that way long term. So that's the hypothetical question you're asking, but that's what we're planning for. And we don't know when prices are going to rebound. We know they -- we think a lot of players are operating below cash cost. We think they have to come up. We just don't know when. So we're going to structure the company to operate and be competitive and profitable in that range. So what that margin -- what the margin looks like I'm not going to hazard a guess on that, but it is -- we're going to put ourselves in a position to be profitable and being able to compete where prices are today. Yes, so that's the first question. And the second one, DLE, and you said in South America, I'm going to talk about our view of DLE and our projects, not so much the industry. I mean I don't know -- I mean we are -- we're working on deal. We've got two projects, both going into pilot phase. We've done a lot of work around that for quite some time. One focused on the brines we have at the smackover formation at Magnolia and Arkansas in the United States where we process bromine. And we have that -- we can take that stream and process that. So we have a pilot that is in start-up at the moment around that. And then we'll do a similar pilot at the Salar de Atacama. One, I think we've said this in the remarks, one of the technologies is proprietary. The other is kind of commercial. So we're doing it in a couple of different ways. But I think the key to the -- I mean, DLE is the whole system, not just the extraction piece. There's a lot of focus on the absorption or a solvent extractor and whatever technology used to actually get the lithium molecule out. But the real art in it is the overall system and the integration in making it operate consistently day in, day out. You can do it in the lab, a lot of people can do it in a lab. You need to be able to do it in the field and do it all the time, and that's -- we're doing scale pilots that will prove that out. And so we'll see. So -- and what do we need from a government standpoint around that, I mean, for us, specifically, I don't think we're looking for government necessarily. I mean, funding would help that, but we are moving both of those projects forward. And its important technology for the industry and for us, for us to really leverage the lowest cost resource in the world in Salar de Atacama and get growth from that, we'll need DLE. So it is important. But I don't -- we're not we're not waiting on governments to help us fund it or do anything like that. We're moving forward."
},
{
"speaker": "Operator",
"text": "Our next question comes from Kevin McCarthy. Kevin, your line is now open. Please go ahead."
},
{
"speaker": "Kevin McCarthy",
"text": "Yes, thank you and good morning. Kent, in your prepared remarks, I think you commented that you're seeing an ongoing trend for carbonate-based batteries. Can you discuss why that's the case and whether that trend is intensifying or not and does it have any bearing on your decision to idle Kemerton 2?"
},
{
"speaker": "Jerry Kent Masters, Jr.",
"text": "Okay, so I'll go at a high level. If it gets deeper, Eric will jump in. But I mean, this is -- I mean, it is carbonate is usually the preferred chemistry for LFP technology, and there's been a shift toward LFP. And I would say that's the preferred technology in China. Because China is on such a growth rate and the West is slowing down a little bit. That's -- there's more of a shift of -- a little bit of a portfolio mix toward carbonate. Now the West is looking at carbonate or LFP as well. Therefore, our view from a year or two ago, we always expected a mix. It was a little more hydroxide heavy. Now it's probably carbonate heavy in that view. And then that product mix, I mentioned product mix earlier when I was talking about Kemerton, that does play into that. Kemerton is hydroxide, and we can toll that same resource for carbonate if we need to, and that gives us more flexibility. So it was a consideration in our decisions around 2 and 3."
},
{
"speaker": "Kevin McCarthy",
"text": "Thank you for that. And then as a follow-up, what would you need to see specifically to make a decision to restart Kemerton 2 and how quickly might you be able to do that and is there a meaningful cost to restart?"
},
{
"speaker": "Jerry Kent Masters, Jr.",
"text": "Yes. So there's a cost to put it in care and maintenance, right and it would be a cost to come back, but I don't know that it's not dramatic. It would be ordinary course I think if we brought it back. There's a number of things we have to do. Part of the decision about focusing on Train 1 and not 2 is to really optimize that asset, get it to work. We've all -- we have struggled with workforce in Australia and we struggle to ramp the two of them together. So we're going to focus on one, ramp that up to make that really operate, really understand the technology and process. And we think we can bring it back faster and more efficiently to Train 2 when the conditions make that right. So we've got do a few things before we would do that, we would get the plant to operate, really understand the technology and the process chemistry that's unique to Kemerton. And then we can bring that to Train 2. It will be -- but we'll need the market to improve before we do that. And then there would be a time frame in order to bring it back. So it's not going to turn on a dime, but we'll plan for that. And it is not dramatic from a -- not big from a capital standpoint, but there would be cost to bring it back on, and we'd have to bring people back on to do that as well."
},
{
"speaker": "Operator",
"text": "Our next question comes from Colin Rusch. Coli, your line is now open. Please go ahead."
},
{
"speaker": "Colin Rusch",
"text": "Thanks so much guys. As you're working through enforcing these contracts, can you talk about some of the dynamics with the customers and any sort of compromises that you might be making to adjustments. Historically, you've kind of enforced some pricing and you reallocated volumes. Just want to get a sense of how those dynamics are playing out?"
},
{
"speaker": "Eric W. Norris",
"text": "Yes. Good morning Colin, it's Eric. As you point out, it's obvious with where market pricing is going. It is a discussion certainly around helping our customers remain competitive through this period of time, while at the same time, respecting the contracts we have and the thresholds that we have there in order to continue to invest on their behalf. I would tell you that all of these contracts are performing to date and it's our expectation that we'll continue to do so. And we'll keep working with our customers. There are things we can do in terms of source. Some of these contracts have a little bit of flexibility, and we can work around spodumene supply versus salt supply. We can look at sourcing points that are different that helps them with their supply chains while at the same time, respecting the core fundamentals of our contracts. So that's basically the nature of the discussions to date."
},
{
"speaker": "Colin Rusch",
"text": "Thanks so much. And then just a little bit more on the technology side. As we see more silicon-based anodes, whether it's increased levels of doping or silicon, I know it's completely -- the challenge of lithiation is pretty substantial. Can you talk a little bit about how much leverage you're getting out of the R&D center and helping folks figure out process and approaches to the lithiation challenge?"
},
{
"speaker": "Eric W. Norris",
"text": "Well, this remains an area of focus for our growth. And when we talk about some of the advanced materials that are lithium-based looking at prelithiation materials that will support the adoption of silicon anodes or silicone doped anodes as you point out, for higher-capacity batteries that can lend themselves, obviously, to longer battery life or range. And furthermore, there is sort of the next journey -- step on that journey is moving towards a lithium metal anode as well, whether that's a solid state or even a liquid electrolyte used with lithium anodes. So these are areas of growth. These areas we see, frankly, having a faster adoption in technologies outside of electric vehicles, whether there's a smaller format battery and perhaps less risk involved in the customer base as a first step, on the one hand. On the other hand, if you speak to some of the more progressive vehicle producers, OEMs who are looking at future technologies, there's a lot of investment they're doing in this area as well. So it's part and parcel of the overall partnership we have with customers. I mean it's the reason that relative to the earlier question, maintaining a contract relationship and supporting us when prices are low, we support them throughout the cycle as well, is if we got to respect and have strong contracts -- contract relationships because they're more than just supply. They deal with things like technology as well that you're pointing out."
},
{
"speaker": "Operator",
"text": "Our next question comes from David Deckelbaum. David, your line is now open. Please go ahead."
},
{
"speaker": "David Deckelbaum",
"text": "Hi, thanks for the time today and for taking my questions. Maybe for Neal. I just wanted to understand, I think, the remarks with the Kemerton move, it saves $200 million to $300 million over the next 18 months or so. Can you talk about that in the context of where you expect next year's CAPEX to be And more just is $1 billion of sustaining CAPEX, is that a reasonable target for what you could get to next year or still have to take sort of a multiyear progression?"
},
{
"speaker": "Neal R. Sheorey",
"text": "Yes, I think I'm going to answer this probably very similar to the way that Kent did. So obviously, as we look at CAPEX into 2025 and 2026, this decision that we're sharing today around Kemerton will absolutely factor into lowering our CAPEX in those out years. And we've always talked about our focus on doing that in this environment. Just as Kent mentioned to an earlier question, we're working through that with our teams right now. And obviously, we understand that what the current environment looks like and that we need to spend a lot of hard time looking at our CAPEX spending and how we can -- where we can bring that down and how we can bring that down as quickly as possible without taking unnecessary risk. So I would just say like we're working on that equation now, and we'll have more to share, I think, in the next couple of quarters."
},
{
"speaker": "David Deckelbaum",
"text": "I appreciate that. And then my follow-up is just -- on going forward now, with CGP 3 ramping at Greenbushes and volumes growing there. On the back end now with Kemerton having less capacity, is the commercial profile going forward just all going to be reliant on tolling or do you have flexibility to sell spodumen concentrate into the market? And will you be able to satisfy all of your customer contracts through tolling alone?"
},
{
"speaker": "Jerry Kent Masters, Jr.",
"text": "Well, it's not -- well, not just totally. So we've got a network of conversion assets today. And so Meishan is up and operating and ramping as we speak. And we've got first sales from Meishan in this quarter. And we -- as we said, ahead of schedule, we have multiple other facilities in China that we own and operate for conversion. So Kimberton is a portion of it, of our Hard Rock conversion assets. And it will be a blend. We will use some tolling to supplement our conversion assets, but we have significant conversion assets and the Kemerton 3 and 4 is just a portion of it. And again, we'll have 1 operating and 2 to bring on after that. So it's still a significant portfolio of conversion assets that we have, and then we don't want to forget about the carbonate that we bring from Chile as well. So it's a pretty good portfolio of conversion assets. And I would say this is a tweak, not like a big wholesale change in that network with the change to Kemerton."
},
{
"speaker": "Operator",
"text": "Our last question comes from John Roberts. John, your line is now open. Please go ahead."
},
{
"speaker": "John Roberts",
"text": "Thanks and who would have thought that [indiscernible] would be the good performing business here in the portfolio. I'll ask a question on the specialties business. Is some of the weakness in specialties temporary channel destocking or had those -- had your channels already destocked like many others have and the weakness you're seeing actually is reflective of the end market weakness?"
},
{
"speaker": "Netha N. Johnson, Jr.",
"text": "Yes, John, this is Netha. We are seeing some end market weakness. And rather than weakness, maybe not as quick as a recovery as we expected, particularly in electronics. We did have volume growth of 9%, but price declined. And if you look at the spot price, which is our only public spot price we have in the market in Q1, the Chinese bromine spot price was $3.11 per metric ton and in Q2 was $2.86 per metric ton, and that explains the pricing. But we are seeing green shoots and we are seeing that electronics recovery come, continuing strength in oil and gas, pharma and ag, and we expect to see that growth continue, maybe a little slower than what we thought, but throughout the rest of the year AND sequential growth in our financials as a result of that ."
},
{
"speaker": "Operator",
"text": "That's all the time we have for questions. I will now pass it back to Kent Masters for closing remarks."
},
{
"speaker": "Jerry Kent Masters, Jr.",
"text": "Okay. Thank you, and thank you all for joining us today. We continue to adapt and move Albemarle forward to better position ourselves in the current market environment, enhance our company's profitable organic growth trajectory, and create long-term value for shareholders. I remain confident in the long-term secular growth opportunities in our end markets and that we are taking the right steps to position Albemarle for value creation. Thank you."
},
{
"speaker": "Operator",
"text": "This concludes today's conference call. Thank you for your participation. You may now disconnect."
}
] | Albemarle Corporation | 18,671 |
ALB | 1 | 2,024 | 2024-05-02 14:30:00 | Operator: Hello and welcome to Albemarle Corporation's Q1 2024 Earnings Call. I will now hand it over to Meredith Bandy, Vice President of Investor Relations and Sustainability.
Meredith Bandy: Thank you. Welcome everyone to Albemarle's first quarter 2024 earnings conference call. Our earnings were released after the close of market yesterday, and you'll find the press release and earnings presentation posted to our website under the Investor Section at albemarle.com. Joining me on the call today are Kent Masters, Chief Executive Officer; and Neal Sheorey, Chief Financial Officer. Netha Johnson, President of Specialties; and Eric Norris, President of Energy Storage are also available for Q&A. As a reminder, some of the statements made during this call, including our outlook, guidance, expected company performance and timing of expansion projects, may constitute forward-looking statements. Please note the cautionary language about forward-looking statements contained in our press release and earnings presentation that same language applies to this call. Also note that some of our comments today refer to non-GAAP financial measures. Reconciliations can be found in our earnings materials. And now, I'll turn the call over to Kent.
Kent Masters: Thank you, Meredith. During the first quarter, our team demonstrated its ability to navigate dynamic market conditions with actions that position Albemarle for profitable growth and deliver on the operational steps that we have set out to achieve this year. We recorded net sales of $1.4 billion and adjusted EBITDA of $291 million. We saw continued volumetric growth, driven by Energy Storage segment highlighting the demand growth in the segment and our ability to capture it. We also ramp new conversion facilities, executed on our productivity plans and strengthened our competitive position and financial flexibility. During the quarter, we delivered more than $90 million in productivity and restructuring cost savings consistent with our efforts to align our costs with the current market environment. We are on track to deliver more than $280 million in productivity improvements in 2024, demonstrating our excellent execution. To drive lithium market transparency and discovery, we held several successful bidding events for spodumene concentrate and lithium carbonate in March and April. We are encouraged by the results and level of participation to date and plan to continue these efforts. We continue to advance our in-flight growth projects that are near completion or in start-up to deliver near-term volume growth and cash flow. In particular, we've reached important new milestones at Kemerton I and Meishan. Finally, the year so far has developed as we expected and we are reaffirming our full year 2024 outlook ranges that are based on observed lithium market price scenarios that we included for the first time last quarter. Our operational and strategic playbook positions us well to serve our customers today and for the future. With our focused execution and our continued confidence in the elements we provide, Albemarle is well-positioned to drive sustainable growth and create value. I'll now hand it over to Neal to talk about our financial results during the quarter.
Neal Sheorey: Thanks, Kent, and good morning, everyone. Beginning on Slide 5. Let's jump into our first quarter performance. In Q1 2024, we recorded net sales of $1.4 billion, compared to $2.6 billion for the prior year quarter, a year-over-year decline of 47%, driven principally by lower pricing, partially offset by volume growth. Adjusted EBITDA was $291 million significantly down from the same period last year, when pricing and margins across our Energy Storage and Specialties businesses were at peak levels. Diluted EPS was negative $0.08. Adjusted diluted EPS was $0.26, which excludes primarily restructuring charges and mark-to-market losses on public equity securities held or sold in the quarter. Our earnings decline was driven mostly by margin compression on lower pricing, especially within our Energy Storage segment. Additionally, we had some margin pressure due to timing of higher cost spodumene flowing through cost of goods sold and reduced equity earnings at the Talison joint venture. These factors were partially offset by volumetric growth, primarily lithium carbonate and hydroxide, and we also recorded spodumene sales at favorable pricing. Also, the Ketjen business recorded increased net sales and EBITDA driven primarily by higher volumes. Looking at Slide 6, we'll break down the company's first quarter adjusted EBITDA by driver. Compared to the prior year quarter, the decline in EBITDA was $1.4 billion related to lower lithium pricing in both Energy Storage and Specialties, $90 million in cost of goods sold due to timing of higher priced spodumene inventories built in prior periods and $270 million related to pretax equity income primarily from our Talison JV. Offsetting these declines were improvements of $251 million related to higher volumes as our Energy Storage projects continue to ramp as well as better Clean Fuel Technologies volumes at Ketjen, and $80 million of net improvements mainly due to restructuring and productivity benefits across multiple areas, including procurement, manufacturing and back office spend. This demonstrates our team's agility and focus on delivering higher volumes and productivity improvements in the current market environment. Turning to Slide 7. As we did last quarter, we are providing outlook ranges, based on historically observed lithium market pricing scenarios. We are reaffirming our outlook considerations published last quarter. There are two notable updates here related to our tax rate and share count expectations. We are updating our adjusted effective tax rate guidance to reflect the range of lithium price scenarios as well as our updated expectations for geographic income mix. At the $15 lithium price scenario we expect a modest tax expense benefit in our P&L. At higher pricing we expect a more typical tax rate in the mid to high 20% range. We have also accounted for the adjusted change in the diluted share count to reflect our $2.3 billion public mandatory convertible preferred stock offering. Moving to Slide 8, where we provide some operating cash flow considerations. We had previously highlighted that, our cash flow conversion would be constrained this year, and I want to provide some additional color on those drivers. As you see here, our cash flow conversion in 2024 is expected to be below historical averages for four reasons. First, Talison is progressing its chemical grade plant, or CGP3 expansion, resulting in lower dividends from the JV. Second, working capital release related to lower lithium pricing is expected to be mostly offset by increased working capital investments for our new plants at Kemerton, Meishan, Salar Yield and Qinzhou. Third, cash tax is expected to be similar to last year, primarily reflecting jurisdictional mix. For example, we will pay Australian cash taxes in mid-year, based on earnings estimates from the prior year period. Finally, we expect to have higher interest expenses year-over-year. Turning to Slide 9. I'll provide further details on trends in each segment's outlook. First, in Energy Storage, we continue to expect approximately two-thirds of our 2024 volumes to be sold on index referenced variable price contracts. The remaining one-third of the volume is still expected to be sold on short-term purchase agreements, including our recently announced bidding events, which Kent will discuss in a moment. Year-over-year energy storage volume growth is trending toward the high end of our expected 10% to 20% range, driven by timing of project ramps and spodumene sales. We continue to anticipate increased year-over-year volumes in the second half of the year due to the ramp of our expansions. All else being equal, we continue to expect improving margins through the year, as lower cost spodumene offsets new facility ramp costs. However, we expect some quarterly variance in EBITDA and margin due to the timing of Talison shipments. Specifically, in Q2, we expect a lift to our EBITDA margin of about 10 points from higher offtake by our partners at the Talison JV. Next, on Specialties. Our outlook reflects continued softness in Consumer Electronics, partially offset by solid demand in Oilfield Services, Agriculture and Pharmaceutical Applications. Furthermore, we are seeing higher costs for logistics as we manage through regional challenges, notably at our site in Jordan. We anticipate higher sales in the second half of the year, on the expectation of modest end market recovery and improved pricing in Bromine Specialties. Taking together, we now expect Specialties adjusted EBITDA to be toward the lower end of the outlook range. Finally, at Ketjen, we are seeing the building success of our turnaround program. We are optimistic about increased volumes driven by high refinery utilization. In Q1, we have seen end market strength primarily in clean fuel technology and expect higher volumes across each of the Ketjen businesses in 2024. Turning to Slide 10 and our financial position. As you know, during the quarter, we took action to maintain a solid investment grade credit rating and further enhance Albemarle's financial flexibility as we navigate this market down cycle. In March, we closed a $2.3 billion public preferred stock offering to fortify our competitive position and stay ahead of dynamic market conditions. Together, with the amended credit facility we discussed in February, these actions put Albemarle in a position to invest in and finish our last mile expansion projects, as well as capitalize on the secular growth trends we see in our core end markets of Mobility, Energy, Connectivity and Health. Following the offering, we repaid our outstanding commercial paper resulting in improved leverage. We ended the quarter with larger than normal cash balance and a primary of that cash will be to complete our in-flight capital project. Our balance sheet management highlights our focus on adopting to changing market condition and controlling the things in our control. Finally, turning to Slide 11 for a reminder of our capital allocation strategy. This is a slide you've seen before and we're touching on it briefly to acknowledge that our capital allocation priorities have not changed. We'll continue to selectively invest in high return growth, but we'll be patient and disciplined. Our near-term focus remains on operational execution and you can expect that our actions will be aligned with driving cost and productivity improvements, ramping our assets to full contribution and preserving our financial flexibility. While we believe current lithium prices are unsustainable for most of the industry in the long-term, we are managing to the current environment. To support our ability to reinvest and grow for the future, we are taking the prudent steps to right size our capital spending and cost structure, focusing on ramping our plants to full contribution and volume growth capture and taking steps to boost cash flow and enhance our financial flexibility. With that, I'll turn it back over to Kent to provide more details on the proactive actions Albemarle is taking in the current market to preserve long-term growth and value creation.
Kent Masters: Thanks, Neal. Moving to Slide 12. We continue to believe in the EV transition and the growth in lithium demand, as well as the opportunity it creates for Albemarle. Despite a downshift in demand growth in Europe and the United States, global EV sales were up 20% year-to-date, led by strong growth in China, which represents over 60% of the global EV market. We continue to anticipate 2.5x lithium demand growth from 2024 to 2030. Additionally, we see battery size growing over time, driven by technology developments and EV adoption. These factors all translate to significantly higher global lithium needs. To put all this in perspective, we expect that this industry needs more than 300,000 metric tons of new lithium capacity every year to satisfy this growth. This means, we need more than 100 new lithium projects across resources and conversion between now and 2030 to support this demand. Moving to Slide 13. Albemarle is actively contributing to the progress of price discovery and efficiency in the lithium market. We have conducted four successful bidding events for chemical grade spodumene and battery grade carbonate. These events inform the market of real time physical trading dynamics and promote greater transparency in the evolving lithium market. While the majority of our sales will continue to be on long-term agreements with our core strategic customers, bidding events give us another sales channel to expand our market access. We have partnered with Metals Hub, an industry-leading source-to-contract platform to host efficient and transparent bidding events. On the slide, you can see a few of the ways we've designed these events to promote transparency and efficiency while meeting customer needs, including zero cost to participate, sealed bids and better confidentiality as well as the winning price disclosed to all bidders following the events conclusion. Going forward, you should expect that we will have a regular cadence of these bidding events, including additional products for sale in various jurisdictions. The primary reason for holding these bidding events is to drive fair and transparent price discovery, something that is good for all market participants. Looking at Slide 14. The Albemarle Way of Excellence remains our operational standard and continues to serve us well. Within the operating model, our focus continues to be on efficiency and ensuring our costs reflect the current environment. As I mentioned earlier, we remain on track to exceed our 2024 target of $280 million in productivity benefits through manufacturing, procurement and back-office initiatives. Recently, we've added cash management to our tracker to enhance cash flow with particular emphasis on optimizing our cash conversion cycle. Looking beyond our cost actions, we also remain focused on the other elements of our model. This quarter, we plan to publish our sustainability report and host our Fourth Annual Sustainability Day featuring key highlights of our sustainable approach and updates on our environmental targets. Moving now to Slide 15. We've said that our focus this year is on getting our in-flight projects to completion and full production, allowing us to drive near-term volume growth and cash flow. We're making solid progress on multiple fronts. The Salar Yield improvement project in Chile is ramping well and has achieved over 50% operating rates. This project allows us to increase lithium production while reducing carbon and water intensity through the application of innovative proprietary technology. It also allows us to capture the full benefits of the capacity expansion at the La Negra conversion facility. In Australia, the first 2 trains, Kimberton I and II are in start-up, ramp and qualification phases. Kemerton I recently achieved a key milestone of 50% operating rates for battery-grade product, and that product is currently in qualification. The remaining capital spend for these facilities is modest and our focus is on continuing to ramp the facilities and get production qualified with customers. At train 3, we are progressing through construction in a prudent way. In China, the Qinzhou plant is ramping on schedule and is expected to achieve nameplate capacity by mid-year. Meishan marked its grand opening in April and is progressing through commissioning having achieved a 50% operating rate for battery-grade material. The remaining capital spend on Meishan is relatively small and related to the ongoing start-up activities. Looking at Slide 16. Our in-flight projects put us in a position to deliver volumetric growth of approximately 20% per year from 2022 to 2027. First quarter sales volumes were recorded at 40,000 tons LCE. We expect 2024 total volumes weighted toward the second half of the year due to demand seasonality and project ramp. We also have the flexibility to toll or sell excess spodumene to maximize economic returns depending on market conditions as we exercise that ability in the first quarter by selling some chemical grade spodumene. Moving on to Slide 17. It's important to highlight the unique advantages that Albemarle has today and how we see those advantages translating to significant margin expansion and earnings generation in the near term. It all starts with our high-quality, low-cost resource portfolio, including the Salar de Atacama, Greenbushes, Wodgina and Kings Mountain. Our global portfolio is arguably the best in the industry. Large-scale, high-grade assets are also low-cost assets and the advantages they provide are not insignificant, as you can see on the left-hand side of this slide. Access to world-class assets is, in turn, one key factor to help us maintain robust energy storage margins across the cycle. For example, at the $15 per kilogram lithium price scenario, we estimate energy storage margins would normalize above 30% after adjusting for the temporal impacts from lower partner offtake at Talison and lower fixed cost absorption at our new plants. And that's before the tailwind of price upside. We estimate that every $1 per kilogram of LCE price improvement would translate to more than 200 basis points of margin expansion. We are also diversified across resource types and finished products, vertically integrated and able to source product from free trade agreement jurisdictions such as Australia, Chile and the United States. Turning to Slide 18. Our comments today reflect the competitive strengths that position Albemarle for success. Beyond our world-class resource base, additional competitive advantages include our process chemistry knowledge and manufacturing expertise allow us to efficiently operate large-scale assets and drive down operating cost. Our targeted innovations, product reliability and reputation for quality make us a trusted partner of choice for our customers and our people and stewardship are a point of pride and competitive strength. We have a proven management team that has operated through cycles and continues to lead with a disciplined mindset. On Slide 19, these factors give Albemarle a strong value proposition and position us to win in the market. Our strategy and path to capitalize on the opportunities align with attractive trends in mobility, energy, connectivity and health is clear. We will continue to lead with discipline and to scale and innovate, accelerate profitable growth and advance sustainability to drive value for shareholders. I hope to see some of you face-to-face at these upcoming events listed here on Slide 20. And with that, I'd like to turn the call back over to the operator to begin the Q&A portion.
Operator: [Operator Instructions] Our first question is from Aleksey Yefremov at KeyBanc Capital.
Aleksey Yefremov: I just wanted to ask about your lithium volumes projection on Slide 16. If current prices don't change, can you get to these volumes and capacities, -- was that raising more equity or debt?
Kent Masters: Yes. So -- well, we forecast for the year looking out for the year, so 10% to 20%, and we've said we'd probably be at the upper end of that and those -- the volumes that we show are based on the capital program that the long-term volumes we show are based on the capital program that we have in place and the projects that we're executing currently and no need for additional capital for that.
Aleksey Yefremov: And just as a follow-up, I mean you gave us scenarios for your EBITDA based on pricing. And I was hoping to get a similar idea for your medium-term CapEx. If say prices stay where they are today, would you be able to sustain your current level of CapEx in 2025? Or does CapEx need to come down to balance your cash needs?
Kent Masters: Yes. So if prices stayed where they were today, you'd see us ramping CapEx down. It takes us a little bit of time. So it's not -- we have a run rate that we think is kind of a minimum CapEx level of about -- to maintain assets about $1 billion a year. We wouldn't get there in '25, but kind of a run rate in line with that toward the end of '25, we could if we felt prices were going to stay where they are today.
Operator: Our next question is from Arun Viswanathan of RBC Capital.
Arun Viswanathan: I just want to get your thoughts on maybe fundamentals that you're observing in the lithium markets. These days, it sounds like there was some disruption in some spodumene production. There was some, I think, curtailments in China related to disposal waste altogether that has taken some production off the market and may potentially stabilize the price environment. Could you maybe highlight some of those issues for us and maybe describe the inventory side as well, what you're observing in both the downstream cathode manufacturers and upstream lithium producers.
Netha Johnson: So let me start -- I'll start with that Eric can give you a little bit more detail on inventories. But I mean, you described the situation reasonably well. We've seen, as we expected, some production come offline, [indiscernible] in China and some higher cost spodumene resources. And we've seen price respond to that marginally, I would say, 15% or so change in price as a result of that. But that's what we thought the market would do. We don't really see it running dramatically up, and we still expect to see other resources coming off if prices stay where they are. So it's going to balance as the market kind of figures out exactly what price is doing and how production responds to that. So I think you'll see new projects that are planned coming off and struggling to get capital if we stay at prices like they are. So I think we're in a balancing mode at the moment. And we do expect to see additional resources come out. Eric, you want to talk about inventories?
Eric Norris: Sure. First of underneath that the other factor as important is demand. China stands as a market and start -- first of all, the majority of demand in the world, over 60% of the demand and start contrast to the U.S. or Europe with very strong growth you may have seen reported even in April growth that was quite significant for various automotive producers, BYD being up 49%. So there's very strong growth in China coming off of very low inventory levels. And that's obviously a favorable indicator for price in light of the pressure on producers at these price levels that Kent described. And the inventory more specifically, what we're seeing is inventory is pretty much at very low levels, ending in March, relatively speaking. So less than 2 weeks from a lithium producer standpoint, and about a week for downstream cathode company. That's in China. It's a little higher for battery producers -- or excuse me, for battery inventories. But again, at levels that are very low compared to the average we saw in 2023. So that, coupled with this demand signal we're getting from China, we see it as a positive signal for price going forward. And obviously, we'll have to -- we don't know for sure, but we'll watch that carefully. And should that happen, that will benefit our earnings going forward.
Arun Viswanathan: And I know there's going to be a lot of other questions about lithium. So maybe I'll ask one on specialties. Do you see any risk maybe to given we're geographically where some of your resources are in Jordan, I know there's been some activity there, obviously. So -- maybe you can just give us your thoughts on -- is that part of what's leading you to the lower end of guidance for specialties? Or what else would you cite, I guess?
Netha Johnson: Yes, I think it's a fair assumption. There's always risk in the Middle East. But in terms of our operational, we've seen limited operational impact year-to-date, but the logistics is where the challenge is and we are incurring additional costs to secure those logistics out of that part of the world. So that's what's impacting our business. But that's different than what it was last year. So yes, that's definitely a risk in the second half. As we move into that for specialties.
Operator: Our next question is from David Deckelbaum at TD Cowen.
David Deckelbaum: I wanted to just follow-up on the outlook if prices were to stay the same. You've obviously seen the impact of lower near-term production at Greenbushes. And then obviously, you have CGP3 which is still under construction and ramping. We've heard from Wodgina with the third train kind of being deferred a bit. Do you anticipate any more I guess, corrective actions or responses under some of the JV spodumen facilities that you're involved with, if prices were to remain where they are today?
Kent Masters: So the -- look, the resources that we operate, and we have made adjustments just to the market condition, but I don't think we make further ones. These are world-class resources and the lowest cost position. So we still operate and make money at the pricing level there. These were investments that were kind of happening in the near term when we had opportunities to adjust the execution profile as we have our own conversion assets as well, and our partners agreed to that. So we've made some adjustments. But Long term, we still expect to exploit these resources because they are some of the best in the world.
David Deckelbaum: I appreciate that. And I'm curious on the second question, just I think you've highlighted some EBITDA margin recovery in the second quarter with increased partner offtake at Talison and some variability there throughout the year. But as we think about your EBITDA margins in '24 versus '25, is there a ballpark range that you would estimate that commissioning new facilities has a sort of a drag on EBITDA margins this year versus next year? .
Neal Sheorey: Yes. David, this is Neal. Yes, absolutely. That's actually one of the reasons why we put that slide in the deck that showed that our range found that. I think that's Slide 17. So the way that we think about it, it's about a 500 basis point drag this year from the ramp-up of these new plants. Now you won't get all 500 basis points back in 2025 because obviously, we will still be working through the ramp of these facilities. But certainly, you can expect over the next couple of years as these facilities come up to full rate that you should start to see that margin expansion from those plants running full.
Operator: Our next question is from Steve Byrne, Bank of America.
Rob Hoffman: Rob Hoffman on for Steve Byrne. Out of the $280 million productivity benefits goal that you have set for 2024, given that you're already, I guess, above of $90 million in Q1, is this faster pace of Ketjen results and guidance.
Kent Masters: So I think we're using the $280 million and as we forecast that out. It's still early in the year. We're probably a little ahead of schedule, but not ready to call it and build into our forecast that will beat that. But we'll be -- we're optimistic. We're comfortable with the program and the target is a pretty big target for us across the organization, and we feel pretty good on a run rate that we can meet that or maybe beat it, but we've not built that into our forecast.
Neal Sheorey: Yes. And this is Neal. To the point of, can you see it in the financials, maybe just one example I'll give you is if you look at our SG&A line. So -- just remember that on the face of the income statement, our SG&A line includes about $35 million of onetime charges that was related to our restructuring activities that we announced in the first quarter. When you back that out and then look at our SG&A line versus the fourth quarter versus where we ended 2023, you will see about a $20 million to $25 million decline in our SG&A costs. So that gives you an idea that we are starting to see some traction on the productivity and restructuring savings that we already announced.
Rob Hoffman: That's helpful. And just a follow-up in terms of your longer-term volume growth chart here, -- why doesn't the potential tolling volume go down over time? Wouldn't you generate higher margins at your own conversion plants?
Eric Norris: Actually your question, just to make sure I'm clear on it. This is Eric speaking. Why would we see tolling volume go down over time?
Rob Hoffman: Why volume go down.
Eric Norris: Oh, I'm sorry. Yes, I think -- fair enough. You wouldn't -- it's all a factor of ramp of plants. Right, what it comes down to -- we have a plant in China Meishan that's ramping at a faster speed than the plant in Australia, and that has to do with operating experience. But if you look at this over a long-term basis, ultimately, we will -- our intention is to be fully integrated and to take all the available resources and convert them with company-built assets as opposed to tolling assets. Increasingly, those -- we would target those to be outside of the U.S., we have a considerable basis, as you know, today in China. But again, depending upon the speed with that, tolling always remains a flywheel, an option for us to go on the speed of branch to go to another alternative. But you're right, I mean, in time, that's why there's a plus/minus on that, it should come down. The [indiscernible] for the most part is a bridging strategy for us, sorry.
Operator: Our next question is from Andres Castanos at Berenberg.
Andres Castanos: I wanted to understand better why are you running spodumene auctions now? And to have a sense on what is the percentage of volume that goes in these options? Are in deals with dollars somewhat impacted by this.
Kent Masters: Yes. So I'm not sure that is the last part of the question. Let me start on the front and you catch that in the follow-up if I don't answer your question. So we're doing the auctions, both on spodumene and on salts, the health transparency in the marketplace, price discovery to really understand, make the market a little clearer, a little more transparent. We get good information for it. And then we've decided to include spodumene as part of that just more transparency in the market, more knowledge that we get around that. And it's an opportunity for us to participate in a different part of the value chain. So it's not a change in our strategy of being an integrated producer. We'll sell most of our products through these long-term agreements on a salt basis as we have historically. So that strategy didn't change, but it's just it's an adjustment to take -- to try and get more transparency in the marketplace and then to sell spodumene a different value, a different product at a different value in the marketplace. So if there are dislocations, we can take advantage of that.
Andres Castanos: Right. So I think it's a small percentage of the total volumes that essentially the deals with the tollers are still in place and they take the majority of the excess spodumene. My second question would be on the level of cost of inventory that you have at the moment for spodumene for the ones you take on board from Wodgina? Can you comment on that more or less where you sit versus the index?
Eric Norris: So I think the question was the cost of our spodumene inventory versus the index. So as we showed in our first quarter results, we are still working off a little bit of spodumene that went into inventory in prior periods, that is at a little bit higher cost than where it is today, and we documented how much of that was in our first quarter results in our EBITDA bridge. You can expect that there'll be a little bit more of that spodumene that we'll have to work off. But for the most part, you will start to see a spodumene costs rolling through our COGS that is consistent with what is in the market as we get towards the middle of the year and in the back half of the year. And that's built into the outlook scenarios that we've been publishing.
Operator: Our next question is from John Roberts at Mizuho Securities.
John Roberts: Last quarter, Slide 13 on Greenbush has discussed the lag and the lower cost of market issue. It projected a spodumene inventory cost for the March quarter of about $4,000 a ton. Does that play out the way you projected last quarter?
Neal Sheorey: John, so this is Neal. We would have to check your numbers. One of the big adjustments we made in the fourth quarter was that LCM, which really collapsed the gap that we previously had, that sort of 6-month lag that we had in the spodumene cost and how it rolls through cost of goods sold. Now even after taking the LCM, we did still -- prices did still come down as we started the first quarter. So we did still have a little bit of higher-priced spodumene that rolled through our P&L. But I think the numbers you're referring to maybe are before we took the LCM adjustment, and we collapsed a lot of that gap with that adjustment.
John Roberts: Yes. All right. And then have your thoughts on the role of catching in the portfolio changed at all since the last call?
Neal Sheorey: I would -- no, I would say. But look, we're -- we've said it's not a core business for us. So we would look to divest that at some point. But -- and we went through a process, which we talked quite a bit about didn't get the value wanted. So we're doing a turnaround. That program is going pretty well, but we would still anticipate doing a transaction on that business when the timing is right.
Operator: Our next question is from Christopher Parkinson at Wolfe Research.
Harris Fein: This is Harris Fein on for Chris. So I'm not sure if I'm reading too much into this. You left the EBITDA sensitivity is unchanged, but also volumes seem like they're trending towards the high end of the guide. Is it wrong to think that EBITDA will trend to the higher end of those ranges as well, all else equal?
Kent Masters: Yes. Actually, it's a fair assumption. Basically, the way that we constructed those EBITDA ranges reason their range is driven by that volume consideration that we have, the 10% to 20%. So I think all things being equal, that's a fair assumption to make.
Harris Fein: Then for my follow-up, there are a lot of moving pieces in the cash flow guide. I guess when I look at the reasoning for the lower conversion rate this year, it doesn't seem like those things are necessarily going away after this year, like you'll always be ramping projects. So how are you thinking about the operating cash conversion going forward?
Neal Sheorey: Well, actually, I have a little different viewpoint on that. I do think that our cash conversion should be improving in 2025 for a few reasons. Number one, as I mentioned or as we mentioned in the prepared remarks, our cash taxes are very similar this year to what we had last year, and that's primarily because of Australia, and we're paying taxes based on income from last year. If you assume that pricing is sort of flat for the rest of the year, I think you should assume that our cash taxes will be lower next year, all things being equal. The other part is that our facilities are so far, as you heard in Kent's remarks, ramping quite well. And so we would expect that those will start to contribute as we get into the back end of this year and into 2025. And as Kent mentioned, right now for where we are, the ramp that you see in our volume growth is just based on the projects that we are finishing up right now and are ramping right now. So we won't be ramping plants forever, that will most certainly come to an end and those plants will begin contributing and the back half of this year and into 2025. So I do anticipate our cash conversion to get better.
Eric Norris: Yes. And just a little finer point on Neal's point, I mean we are those -- the new plants that are ramping will be as we grow, our business grows, they become a smaller part of the portfolio. So we'll still be building new plant and ramping over time, but they become a smaller percentage of the portfolio. And then at the moment, we have a lot of plants ramping in that particular phase. I didn't necessarily plan it that way, but that's how it's worked out. We've got, I think, 4 plants actually ramping now at the same time. And that's not the plan. Going forward, it won't be that many. And if they were, it would be a smaller part of the portfolio just because we've grown.
Operator: Our next question is from Kevin McCarthy at Vertical Research Partners.
Matt Hettwer: This is Matt Hettwer on for Kevin McCarthy. Regarding the spodumene and carbonate auctions that you just touched on, what does the customer feedback been like? And how has the auction participation rates trended?
Eric Norris: Matt, this is Eric. We've got very good participation. We're very early in our process. And so we're very -- with a qualification process to make sure we're -- we're inviting people to these auctions that meet certain standards, but that's growing over time. The participation rate we received and the corresponding conversion of those invited versus those who put in a bid has been strong. The interest has been, therefore, good and the outcome has been well received what we think about the market, particularly from a price reporting agency, we found that these through the normal surveying process, the results of these bids have found their way into the price reporting agencies. Of course, they determine how they use that in their next calculations, but it's our anticipation that they're lending there as well. And then as we turn to the -- to our sort of contracted customer base, they appreciate that what we're doing is better understanding in what is a pretty immature market how -- what the drivers are, as Kent was referring to different types of prices, whether that's inside the country, outside of country or an IRA compliant, non-RA compliant product or a spodumene versus a better grade carbonate. It's giving us better intelligence to better segment, understand what's happening in the market and a lot of the same for our customers in the contract side ultimately because that would be reflected in the indices they referenced.
Matt Hettwer: And then as a follow-up, I believe in the prepared remarks, you mentioned expanding the auctions to other geographies and products. What other geographies are you looking at? And in the future, might you include hydroxide in the auctions?
Eric Norris: Yes. So I touched on a little bit when I talked about IRA compliant. But just as reference, almost -- actually, all 4 auctions that we've done today have all been inside of China with available inventory on the ground there. We'll be looking for product outside of China shipped on a CIF basis, for example. We'll be looking at that certainly for our Australia product. We'll be looking at it for [indiscernible] compliance ship to the U.S. and across our product range, including hydroxide.
Operator: Our next question is from Ben Isaacson at Scotia Capital, Inc.
Apurva Kilambi: This is Apurva on for Ben. So we're heading into what has historically been a peak buying season in China just off of the earlier comments on demand, are you starting to see this restocking materialize?
Eric Norris: Yes, this is Eric. As I pointed out, we've seen inventories at a fairly low level, ending in March, and I do think a part of the demand is to restock in anticipation of the midyear and into later year seasonality of EVs. It's one reason why it's very hard to look at Q1 sales of EVs and correlate that to real on-the-ground demand because the EVs that are being sold in the first quarter this year were lithium for that was sold late last year -- middle of the late of last year. And we are seeing -- I think it's a part of the demand that I referred to earlier, it's not only fundamental demand for what our increased EV sales that are coming in that -- we see in April and we expect in May and June, but also it's a result of some restocking because some of the levels of which inventory gone to, it just weren't sustainable for these operations to run without taking considerable risk of not being able to meet demand.
Apurva Kilambi: Great. And as my follow-up, looking back with your 10-K, you actually published an updated technical report on Greenbushes. With that report, we saw something of a step down in both grades and recoveries and concurrently, costs have moved upwards. Given those technical effects, where do you see the next phase of resource growth coming from for Greenbushes.
Eric Norris: Well, that's you're correct. You're referencing a report that we published on our SEC guidelines, which are have a different standard. It's not uncommon in mining for different standards around the world and different standards are more strict and how they should be exercised and that produced some of the results you're describing. This is still even in that report on a relative basis the best spodumene resource reported in the world. And our aims are to continue, as we've described to -- we are now executing with our joint venture partners at CGP3 expansion. There is the possibility long term, although we have not announced this formally or committed to it for further expansion of CGP4 and continued operation of that operation at its current grid reported for quite some years, decades to come. So our intention is to maximize that resource given its low cost potential.
Operator: Our next question is from Michael Sison at Wells Fargo Securities.
Michael Sison: Good start to the year. You have a slide on sort of minimum capital and I think the line looks like billion. So if hiking kind of stays here, is that where CapEx will go in '25. And what would that mean to your capacity potential in longer term if that has to be the case.
Neal Sheorey: Yes. So I think we've commented on that earlier. So we can -- we would look at the billion that's kind of maintenance capital for us around to maintain our assets and continue to operate there. And we could -- if we -- if prices stay where they are, we could get to that kind of on a run rate by the end of '25, so '26 number, so to speak. '25 would be a little bit higher, but we get to the run rate by '25. That would impact our long-term growth if we went to that level. So the current planning that we have, the projects we're executing at the moment, get us kind of a 20% growth rate through '27 or so. And if we were to cut back to those levels, we'd impact that materially beyond that.
Michael Sison: And as a follow-up, your EBITDA margins for any storage, they're pretty good. And I know you think we need -- you need higher pricing for the industry. So I mean, what price do you think lithium needs to be at to support the growth that is expected for the end of the decade, and maybe any thoughts on where you think others around the world who are -- where their margins are because yours are again, from a -- are pretty good, not as good as it used to be, but I think there's still a pretty good margin.
Eric Norris: Right. So I'm not going to comment on other people's margins. But if we stay where we are, we can operate at about -- at a 30%-ish type margin rate once we get the noise out of the P&L, that kind of the transition from the big prices and some of the spodumene costs. So on a run rate we could get to around 30% and still grow our business for us. I think that's the good margins that you're talking about. We've had stronger margins than that, and they would be stronger if prices move up. The issue with price is really about returns on new investment projects more than it is about our existing business, P&L and the margins that we can deliver. So prices need to move up in order to develop new projects to get the growth the industry needs to support the EV transition. I'm not going to comment on because it's different by every project and every geography as to what price you need and you need to believe that for 10 or 15 years in order to get a return on the project when you go through FID. So I can't say a number and if I had one, I probably wouldn't say it, but they are different by geography, by region, by technology, what the resource looks like. So it's quite different. There's no way to pick one particular number.
Operator: Our next question is from Joshua Spector of UBS.
Chris Perrella: It's Chris Perrella on for Josh. I just wanted to follow up on Neal, the 2Q Energy Storage EBITDA margin that you guided to, given the puts and takes, you have the higher cost spodumene inventory, which is maybe a $50 million drag in the second quarter, but you also have the one-off from Talison. So how does that bridge together to get to your 2Q margin? And then does it step down with the absence of the Talison one-off in the second half of the year?
Neal Sheorey: Yes. So I think if I -- let's talk about the second quarter first. So basically, the way to think about this, I think your numbers are probably all in the right kind of range. If you do the math based on the first quarter and what we said in the prepared remarks that we expect about a 10-point bump in energy storages, EBITDA margin in the second quarter. You probably will get into the range of about $100 million bump to EBITDA Q2 versus Q1. And that's really just driven primarily by the expectation that all partners are taking their allotment off of Talison plus we have that additional 200,000 tons that is getting offtake in the second quarter as well. And so that's basically what serves as the basis for the 10 percentage point bump. In terms of then going forward, it is sort of a onetime bump up. And then what you should expect in the third and the fourth quarter is that we'll come back down to again, pretty healthy margins. It won't be as healthy as the second quarter. But you can expect that we will, as our plants continue to ramp up and we continue to absorb fixed cost, that will continue to get some margin expansion versus the first quarter, for sure, in the third and the fourth quarters as we exit the year.
Chris Perrella: That's perfect. And then a quick follow-up. Sequentially into the second quarter, do you expect volumes to be up? I'm just trying to bridge the seasonality to get to the 190 [indiscernible] for the full year?
Neal Sheorey: Yes. So we will have volume -- at least sequentially, what you're asking about is, yes, we will have some higher volumes as we get into Q2 versus Q1. Remember that the peak for energy storage demand is usually in the third quarter. So we're building to that peak. So it won't be the highest quarter of the year. But yes, I would expect that you'll see a little bit higher volume in Q2 versus Q1.
Operator: Our next question is from Colin Rusch at Oppenheimer.
Colin Rusch: Given the dynamics around geopolitical positioning on manufacturing for batteries and some of the evolution of the tariffs that we're seeing on the solar side and other areas. Can you talk a little bit about the importance of refining and your thought process around that importance in North America as you enter into the balance of this year and next year?
Netha Johnson: Yes. So okay, interesting question. So the politics is playing into the market significantly, and we've got the integrated strategy. So we've got a good resource position, and it's spread around the world, so we have nice diversity around that. And we've built conversion. So we have conversion in Chile, in the U.S., lower scale at the moment. And Australia and China. So we're spread around the world, and we've got nice diversity around that and it allows us to kind of plan for some of these aspects. So our goal would be to have larger scale conversion in North America to satisfy the North American market and we are -- but we've paused on that a little bit, just on some of the issues that you've described, price being a big one, how geopolitics plays into it. And we're going to use that pause to figure out exactly what we do around that.
Colin Rusch: Okay. Great. And then in terms of some of the evolving cathode chemistries, obviously, we're seeing some activity around Delta LFP, and I'm assuming that the precursor materials are evolving a little bit. Can you talk a little bit about some of the specific adjustments that you're making around some of the refining processes to meet those cathode needs in a more tangible way as you go through the balance of this year and into next year?
Neal Sheorey: Yes. I'll start on that. Eric can fill in the gaps. I think -- I mean the biggest thing for us at the moment is with the primary products around hydroxide and carbonate is balancing that. So as LFP has become more prevalent. It's got stronger demand on carbonate and we've been a stronger -- a larger percentage of our portfolio is carbonate historically. We've been building out hydroxide and then balancing those 2 is understanding where those chemistries go. And then long term, it's going to be about solid state and then how you shift from so much -- be more about carbonated hydroxide to about lithium metal. But that's a longer-term scenario. The carbonate hydroxide is playing out in the assets we're building now.
Eric Norris: Yes. So Colin, just a little shed more color around that. I would say that we still see a market that is for hydroxide, high nickel is favored outside of China versus in with carbonate and supporting LFP being a very big part of the China market. The innovations that have been coming out of -- largely out of China and LFP chemistries for higher energy density and efficiencies as well as the cost profile of that cathode are obviously very increasingly now interesting to the West. And so we expect that. Certainly, our Chile position is in a position of power in which we can supply into that opportunity. We'll watch that carefully. As Kent talks about -- had talked about earlier about pausing the investment here in the U.S. or North America to figure out in this uncertain market direction and develop our own strategy there. One of those -- one of the components of that has to be on the assessment of LFP in the U.S., and that will be will be part of that equation as well.
Operator: Our final question is from Patrick Cunningham at Citi.
Patrick Cunningham: In the past, you've talked about the marginal cost of production being $20 [indiscernible] and maybe new projects pushing that curve up over time. Do you still believe that to be the case given we've seen relatively tepid supply response at current prices?
Kent Masters: Yes, it changes -- it changes over time with volumes in the industry. But most new projects come on are going to be higher on the cost curve and moving that up. So we still think that within a $1 or $2, the accuracy of that. But I think we still believe that fundamentally is about the target of marginal cost today.
Patrick Cunningham: Got it. And then just a quick follow-up. Did price floors play a meaningful impact with price levels in the low teens for a good part of the quarter?
Eric Norris: I'm sorry, your question was -- the price floor impact on our realized price for the quarter? Or was that the question?
Patrick Cunningham: Yes, yes. Was there meaningful impact.
Eric Norris: Let's put it this way. We don't disclose a lot of our price floors, and they tend to range because often based on age of contracts. At current prices, some of those floors, some are being tested, floors have held. And so we certainly are seeing the floors come into play for some of our business.
Operator: Thank you. That's all the time we have for questions. I will now pass it back to Kent Masters for closing remarks.
Kent Masters: Okay. Thank you, and thank you all for joining us today. We continue to innovate, adapt and lead the world in transforming essential resources into the critical ingredients for modern living with people and planet in mind. We are focused on continuing to be the partner of choice for our customers and investment of choice for both the present and the future. Thank you for joining us.
Operator: This concludes today's conference call. Thank you for your participation. You may now disconnect. | [
{
"speaker": "Operator",
"text": "Hello and welcome to Albemarle Corporation's Q1 2024 Earnings Call. I will now hand it over to Meredith Bandy, Vice President of Investor Relations and Sustainability."
},
{
"speaker": "Meredith Bandy",
"text": "Thank you. Welcome everyone to Albemarle's first quarter 2024 earnings conference call. Our earnings were released after the close of market yesterday, and you'll find the press release and earnings presentation posted to our website under the Investor Section at albemarle.com. Joining me on the call today are Kent Masters, Chief Executive Officer; and Neal Sheorey, Chief Financial Officer. Netha Johnson, President of Specialties; and Eric Norris, President of Energy Storage are also available for Q&A. As a reminder, some of the statements made during this call, including our outlook, guidance, expected company performance and timing of expansion projects, may constitute forward-looking statements. Please note the cautionary language about forward-looking statements contained in our press release and earnings presentation that same language applies to this call. Also note that some of our comments today refer to non-GAAP financial measures. Reconciliations can be found in our earnings materials. And now, I'll turn the call over to Kent."
},
{
"speaker": "Kent Masters",
"text": "Thank you, Meredith. During the first quarter, our team demonstrated its ability to navigate dynamic market conditions with actions that position Albemarle for profitable growth and deliver on the operational steps that we have set out to achieve this year. We recorded net sales of $1.4 billion and adjusted EBITDA of $291 million. We saw continued volumetric growth, driven by Energy Storage segment highlighting the demand growth in the segment and our ability to capture it. We also ramp new conversion facilities, executed on our productivity plans and strengthened our competitive position and financial flexibility. During the quarter, we delivered more than $90 million in productivity and restructuring cost savings consistent with our efforts to align our costs with the current market environment. We are on track to deliver more than $280 million in productivity improvements in 2024, demonstrating our excellent execution. To drive lithium market transparency and discovery, we held several successful bidding events for spodumene concentrate and lithium carbonate in March and April. We are encouraged by the results and level of participation to date and plan to continue these efforts. We continue to advance our in-flight growth projects that are near completion or in start-up to deliver near-term volume growth and cash flow. In particular, we've reached important new milestones at Kemerton I and Meishan. Finally, the year so far has developed as we expected and we are reaffirming our full year 2024 outlook ranges that are based on observed lithium market price scenarios that we included for the first time last quarter. Our operational and strategic playbook positions us well to serve our customers today and for the future. With our focused execution and our continued confidence in the elements we provide, Albemarle is well-positioned to drive sustainable growth and create value. I'll now hand it over to Neal to talk about our financial results during the quarter."
},
{
"speaker": "Neal Sheorey",
"text": "Thanks, Kent, and good morning, everyone. Beginning on Slide 5. Let's jump into our first quarter performance. In Q1 2024, we recorded net sales of $1.4 billion, compared to $2.6 billion for the prior year quarter, a year-over-year decline of 47%, driven principally by lower pricing, partially offset by volume growth. Adjusted EBITDA was $291 million significantly down from the same period last year, when pricing and margins across our Energy Storage and Specialties businesses were at peak levels. Diluted EPS was negative $0.08. Adjusted diluted EPS was $0.26, which excludes primarily restructuring charges and mark-to-market losses on public equity securities held or sold in the quarter. Our earnings decline was driven mostly by margin compression on lower pricing, especially within our Energy Storage segment. Additionally, we had some margin pressure due to timing of higher cost spodumene flowing through cost of goods sold and reduced equity earnings at the Talison joint venture. These factors were partially offset by volumetric growth, primarily lithium carbonate and hydroxide, and we also recorded spodumene sales at favorable pricing. Also, the Ketjen business recorded increased net sales and EBITDA driven primarily by higher volumes. Looking at Slide 6, we'll break down the company's first quarter adjusted EBITDA by driver. Compared to the prior year quarter, the decline in EBITDA was $1.4 billion related to lower lithium pricing in both Energy Storage and Specialties, $90 million in cost of goods sold due to timing of higher priced spodumene inventories built in prior periods and $270 million related to pretax equity income primarily from our Talison JV. Offsetting these declines were improvements of $251 million related to higher volumes as our Energy Storage projects continue to ramp as well as better Clean Fuel Technologies volumes at Ketjen, and $80 million of net improvements mainly due to restructuring and productivity benefits across multiple areas, including procurement, manufacturing and back office spend. This demonstrates our team's agility and focus on delivering higher volumes and productivity improvements in the current market environment. Turning to Slide 7. As we did last quarter, we are providing outlook ranges, based on historically observed lithium market pricing scenarios. We are reaffirming our outlook considerations published last quarter. There are two notable updates here related to our tax rate and share count expectations. We are updating our adjusted effective tax rate guidance to reflect the range of lithium price scenarios as well as our updated expectations for geographic income mix. At the $15 lithium price scenario we expect a modest tax expense benefit in our P&L. At higher pricing we expect a more typical tax rate in the mid to high 20% range. We have also accounted for the adjusted change in the diluted share count to reflect our $2.3 billion public mandatory convertible preferred stock offering. Moving to Slide 8, where we provide some operating cash flow considerations. We had previously highlighted that, our cash flow conversion would be constrained this year, and I want to provide some additional color on those drivers. As you see here, our cash flow conversion in 2024 is expected to be below historical averages for four reasons. First, Talison is progressing its chemical grade plant, or CGP3 expansion, resulting in lower dividends from the JV. Second, working capital release related to lower lithium pricing is expected to be mostly offset by increased working capital investments for our new plants at Kemerton, Meishan, Salar Yield and Qinzhou. Third, cash tax is expected to be similar to last year, primarily reflecting jurisdictional mix. For example, we will pay Australian cash taxes in mid-year, based on earnings estimates from the prior year period. Finally, we expect to have higher interest expenses year-over-year. Turning to Slide 9. I'll provide further details on trends in each segment's outlook. First, in Energy Storage, we continue to expect approximately two-thirds of our 2024 volumes to be sold on index referenced variable price contracts. The remaining one-third of the volume is still expected to be sold on short-term purchase agreements, including our recently announced bidding events, which Kent will discuss in a moment. Year-over-year energy storage volume growth is trending toward the high end of our expected 10% to 20% range, driven by timing of project ramps and spodumene sales. We continue to anticipate increased year-over-year volumes in the second half of the year due to the ramp of our expansions. All else being equal, we continue to expect improving margins through the year, as lower cost spodumene offsets new facility ramp costs. However, we expect some quarterly variance in EBITDA and margin due to the timing of Talison shipments. Specifically, in Q2, we expect a lift to our EBITDA margin of about 10 points from higher offtake by our partners at the Talison JV. Next, on Specialties. Our outlook reflects continued softness in Consumer Electronics, partially offset by solid demand in Oilfield Services, Agriculture and Pharmaceutical Applications. Furthermore, we are seeing higher costs for logistics as we manage through regional challenges, notably at our site in Jordan. We anticipate higher sales in the second half of the year, on the expectation of modest end market recovery and improved pricing in Bromine Specialties. Taking together, we now expect Specialties adjusted EBITDA to be toward the lower end of the outlook range. Finally, at Ketjen, we are seeing the building success of our turnaround program. We are optimistic about increased volumes driven by high refinery utilization. In Q1, we have seen end market strength primarily in clean fuel technology and expect higher volumes across each of the Ketjen businesses in 2024. Turning to Slide 10 and our financial position. As you know, during the quarter, we took action to maintain a solid investment grade credit rating and further enhance Albemarle's financial flexibility as we navigate this market down cycle. In March, we closed a $2.3 billion public preferred stock offering to fortify our competitive position and stay ahead of dynamic market conditions. Together, with the amended credit facility we discussed in February, these actions put Albemarle in a position to invest in and finish our last mile expansion projects, as well as capitalize on the secular growth trends we see in our core end markets of Mobility, Energy, Connectivity and Health. Following the offering, we repaid our outstanding commercial paper resulting in improved leverage. We ended the quarter with larger than normal cash balance and a primary of that cash will be to complete our in-flight capital project. Our balance sheet management highlights our focus on adopting to changing market condition and controlling the things in our control. Finally, turning to Slide 11 for a reminder of our capital allocation strategy. This is a slide you've seen before and we're touching on it briefly to acknowledge that our capital allocation priorities have not changed. We'll continue to selectively invest in high return growth, but we'll be patient and disciplined. Our near-term focus remains on operational execution and you can expect that our actions will be aligned with driving cost and productivity improvements, ramping our assets to full contribution and preserving our financial flexibility. While we believe current lithium prices are unsustainable for most of the industry in the long-term, we are managing to the current environment. To support our ability to reinvest and grow for the future, we are taking the prudent steps to right size our capital spending and cost structure, focusing on ramping our plants to full contribution and volume growth capture and taking steps to boost cash flow and enhance our financial flexibility. With that, I'll turn it back over to Kent to provide more details on the proactive actions Albemarle is taking in the current market to preserve long-term growth and value creation."
},
{
"speaker": "Kent Masters",
"text": "Thanks, Neal. Moving to Slide 12. We continue to believe in the EV transition and the growth in lithium demand, as well as the opportunity it creates for Albemarle. Despite a downshift in demand growth in Europe and the United States, global EV sales were up 20% year-to-date, led by strong growth in China, which represents over 60% of the global EV market. We continue to anticipate 2.5x lithium demand growth from 2024 to 2030. Additionally, we see battery size growing over time, driven by technology developments and EV adoption. These factors all translate to significantly higher global lithium needs. To put all this in perspective, we expect that this industry needs more than 300,000 metric tons of new lithium capacity every year to satisfy this growth. This means, we need more than 100 new lithium projects across resources and conversion between now and 2030 to support this demand. Moving to Slide 13. Albemarle is actively contributing to the progress of price discovery and efficiency in the lithium market. We have conducted four successful bidding events for chemical grade spodumene and battery grade carbonate. These events inform the market of real time physical trading dynamics and promote greater transparency in the evolving lithium market. While the majority of our sales will continue to be on long-term agreements with our core strategic customers, bidding events give us another sales channel to expand our market access. We have partnered with Metals Hub, an industry-leading source-to-contract platform to host efficient and transparent bidding events. On the slide, you can see a few of the ways we've designed these events to promote transparency and efficiency while meeting customer needs, including zero cost to participate, sealed bids and better confidentiality as well as the winning price disclosed to all bidders following the events conclusion. Going forward, you should expect that we will have a regular cadence of these bidding events, including additional products for sale in various jurisdictions. The primary reason for holding these bidding events is to drive fair and transparent price discovery, something that is good for all market participants. Looking at Slide 14. The Albemarle Way of Excellence remains our operational standard and continues to serve us well. Within the operating model, our focus continues to be on efficiency and ensuring our costs reflect the current environment. As I mentioned earlier, we remain on track to exceed our 2024 target of $280 million in productivity benefits through manufacturing, procurement and back-office initiatives. Recently, we've added cash management to our tracker to enhance cash flow with particular emphasis on optimizing our cash conversion cycle. Looking beyond our cost actions, we also remain focused on the other elements of our model. This quarter, we plan to publish our sustainability report and host our Fourth Annual Sustainability Day featuring key highlights of our sustainable approach and updates on our environmental targets. Moving now to Slide 15. We've said that our focus this year is on getting our in-flight projects to completion and full production, allowing us to drive near-term volume growth and cash flow. We're making solid progress on multiple fronts. The Salar Yield improvement project in Chile is ramping well and has achieved over 50% operating rates. This project allows us to increase lithium production while reducing carbon and water intensity through the application of innovative proprietary technology. It also allows us to capture the full benefits of the capacity expansion at the La Negra conversion facility. In Australia, the first 2 trains, Kimberton I and II are in start-up, ramp and qualification phases. Kemerton I recently achieved a key milestone of 50% operating rates for battery-grade product, and that product is currently in qualification. The remaining capital spend for these facilities is modest and our focus is on continuing to ramp the facilities and get production qualified with customers. At train 3, we are progressing through construction in a prudent way. In China, the Qinzhou plant is ramping on schedule and is expected to achieve nameplate capacity by mid-year. Meishan marked its grand opening in April and is progressing through commissioning having achieved a 50% operating rate for battery-grade material. The remaining capital spend on Meishan is relatively small and related to the ongoing start-up activities. Looking at Slide 16. Our in-flight projects put us in a position to deliver volumetric growth of approximately 20% per year from 2022 to 2027. First quarter sales volumes were recorded at 40,000 tons LCE. We expect 2024 total volumes weighted toward the second half of the year due to demand seasonality and project ramp. We also have the flexibility to toll or sell excess spodumene to maximize economic returns depending on market conditions as we exercise that ability in the first quarter by selling some chemical grade spodumene. Moving on to Slide 17. It's important to highlight the unique advantages that Albemarle has today and how we see those advantages translating to significant margin expansion and earnings generation in the near term. It all starts with our high-quality, low-cost resource portfolio, including the Salar de Atacama, Greenbushes, Wodgina and Kings Mountain. Our global portfolio is arguably the best in the industry. Large-scale, high-grade assets are also low-cost assets and the advantages they provide are not insignificant, as you can see on the left-hand side of this slide. Access to world-class assets is, in turn, one key factor to help us maintain robust energy storage margins across the cycle. For example, at the $15 per kilogram lithium price scenario, we estimate energy storage margins would normalize above 30% after adjusting for the temporal impacts from lower partner offtake at Talison and lower fixed cost absorption at our new plants. And that's before the tailwind of price upside. We estimate that every $1 per kilogram of LCE price improvement would translate to more than 200 basis points of margin expansion. We are also diversified across resource types and finished products, vertically integrated and able to source product from free trade agreement jurisdictions such as Australia, Chile and the United States. Turning to Slide 18. Our comments today reflect the competitive strengths that position Albemarle for success. Beyond our world-class resource base, additional competitive advantages include our process chemistry knowledge and manufacturing expertise allow us to efficiently operate large-scale assets and drive down operating cost. Our targeted innovations, product reliability and reputation for quality make us a trusted partner of choice for our customers and our people and stewardship are a point of pride and competitive strength. We have a proven management team that has operated through cycles and continues to lead with a disciplined mindset. On Slide 19, these factors give Albemarle a strong value proposition and position us to win in the market. Our strategy and path to capitalize on the opportunities align with attractive trends in mobility, energy, connectivity and health is clear. We will continue to lead with discipline and to scale and innovate, accelerate profitable growth and advance sustainability to drive value for shareholders. I hope to see some of you face-to-face at these upcoming events listed here on Slide 20. And with that, I'd like to turn the call back over to the operator to begin the Q&A portion."
},
{
"speaker": "Operator",
"text": "[Operator Instructions] Our first question is from Aleksey Yefremov at KeyBanc Capital."
},
{
"speaker": "Aleksey Yefremov",
"text": "I just wanted to ask about your lithium volumes projection on Slide 16. If current prices don't change, can you get to these volumes and capacities, -- was that raising more equity or debt?"
},
{
"speaker": "Kent Masters",
"text": "Yes. So -- well, we forecast for the year looking out for the year, so 10% to 20%, and we've said we'd probably be at the upper end of that and those -- the volumes that we show are based on the capital program that the long-term volumes we show are based on the capital program that we have in place and the projects that we're executing currently and no need for additional capital for that."
},
{
"speaker": "Aleksey Yefremov",
"text": "And just as a follow-up, I mean you gave us scenarios for your EBITDA based on pricing. And I was hoping to get a similar idea for your medium-term CapEx. If say prices stay where they are today, would you be able to sustain your current level of CapEx in 2025? Or does CapEx need to come down to balance your cash needs?"
},
{
"speaker": "Kent Masters",
"text": "Yes. So if prices stayed where they were today, you'd see us ramping CapEx down. It takes us a little bit of time. So it's not -- we have a run rate that we think is kind of a minimum CapEx level of about -- to maintain assets about $1 billion a year. We wouldn't get there in '25, but kind of a run rate in line with that toward the end of '25, we could if we felt prices were going to stay where they are today."
},
{
"speaker": "Operator",
"text": "Our next question is from Arun Viswanathan of RBC Capital."
},
{
"speaker": "Arun Viswanathan",
"text": "I just want to get your thoughts on maybe fundamentals that you're observing in the lithium markets. These days, it sounds like there was some disruption in some spodumene production. There was some, I think, curtailments in China related to disposal waste altogether that has taken some production off the market and may potentially stabilize the price environment. Could you maybe highlight some of those issues for us and maybe describe the inventory side as well, what you're observing in both the downstream cathode manufacturers and upstream lithium producers."
},
{
"speaker": "Netha Johnson",
"text": "So let me start -- I'll start with that Eric can give you a little bit more detail on inventories. But I mean, you described the situation reasonably well. We've seen, as we expected, some production come offline, [indiscernible] in China and some higher cost spodumene resources. And we've seen price respond to that marginally, I would say, 15% or so change in price as a result of that. But that's what we thought the market would do. We don't really see it running dramatically up, and we still expect to see other resources coming off if prices stay where they are. So it's going to balance as the market kind of figures out exactly what price is doing and how production responds to that. So I think you'll see new projects that are planned coming off and struggling to get capital if we stay at prices like they are. So I think we're in a balancing mode at the moment. And we do expect to see additional resources come out. Eric, you want to talk about inventories?"
},
{
"speaker": "Eric Norris",
"text": "Sure. First of underneath that the other factor as important is demand. China stands as a market and start -- first of all, the majority of demand in the world, over 60% of the demand and start contrast to the U.S. or Europe with very strong growth you may have seen reported even in April growth that was quite significant for various automotive producers, BYD being up 49%. So there's very strong growth in China coming off of very low inventory levels. And that's obviously a favorable indicator for price in light of the pressure on producers at these price levels that Kent described. And the inventory more specifically, what we're seeing is inventory is pretty much at very low levels, ending in March, relatively speaking. So less than 2 weeks from a lithium producer standpoint, and about a week for downstream cathode company. That's in China. It's a little higher for battery producers -- or excuse me, for battery inventories. But again, at levels that are very low compared to the average we saw in 2023. So that, coupled with this demand signal we're getting from China, we see it as a positive signal for price going forward. And obviously, we'll have to -- we don't know for sure, but we'll watch that carefully. And should that happen, that will benefit our earnings going forward."
},
{
"speaker": "Arun Viswanathan",
"text": "And I know there's going to be a lot of other questions about lithium. So maybe I'll ask one on specialties. Do you see any risk maybe to given we're geographically where some of your resources are in Jordan, I know there's been some activity there, obviously. So -- maybe you can just give us your thoughts on -- is that part of what's leading you to the lower end of guidance for specialties? Or what else would you cite, I guess?"
},
{
"speaker": "Netha Johnson",
"text": "Yes, I think it's a fair assumption. There's always risk in the Middle East. But in terms of our operational, we've seen limited operational impact year-to-date, but the logistics is where the challenge is and we are incurring additional costs to secure those logistics out of that part of the world. So that's what's impacting our business. But that's different than what it was last year. So yes, that's definitely a risk in the second half. As we move into that for specialties."
},
{
"speaker": "Operator",
"text": "Our next question is from David Deckelbaum at TD Cowen."
},
{
"speaker": "David Deckelbaum",
"text": "I wanted to just follow-up on the outlook if prices were to stay the same. You've obviously seen the impact of lower near-term production at Greenbushes. And then obviously, you have CGP3 which is still under construction and ramping. We've heard from Wodgina with the third train kind of being deferred a bit. Do you anticipate any more I guess, corrective actions or responses under some of the JV spodumen facilities that you're involved with, if prices were to remain where they are today?"
},
{
"speaker": "Kent Masters",
"text": "So the -- look, the resources that we operate, and we have made adjustments just to the market condition, but I don't think we make further ones. These are world-class resources and the lowest cost position. So we still operate and make money at the pricing level there. These were investments that were kind of happening in the near term when we had opportunities to adjust the execution profile as we have our own conversion assets as well, and our partners agreed to that. So we've made some adjustments. But Long term, we still expect to exploit these resources because they are some of the best in the world."
},
{
"speaker": "David Deckelbaum",
"text": "I appreciate that. And I'm curious on the second question, just I think you've highlighted some EBITDA margin recovery in the second quarter with increased partner offtake at Talison and some variability there throughout the year. But as we think about your EBITDA margins in '24 versus '25, is there a ballpark range that you would estimate that commissioning new facilities has a sort of a drag on EBITDA margins this year versus next year? ."
},
{
"speaker": "Neal Sheorey",
"text": "Yes. David, this is Neal. Yes, absolutely. That's actually one of the reasons why we put that slide in the deck that showed that our range found that. I think that's Slide 17. So the way that we think about it, it's about a 500 basis point drag this year from the ramp-up of these new plants. Now you won't get all 500 basis points back in 2025 because obviously, we will still be working through the ramp of these facilities. But certainly, you can expect over the next couple of years as these facilities come up to full rate that you should start to see that margin expansion from those plants running full."
},
{
"speaker": "Operator",
"text": "Our next question is from Steve Byrne, Bank of America."
},
{
"speaker": "Rob Hoffman",
"text": "Rob Hoffman on for Steve Byrne. Out of the $280 million productivity benefits goal that you have set for 2024, given that you're already, I guess, above of $90 million in Q1, is this faster pace of Ketjen results and guidance."
},
{
"speaker": "Kent Masters",
"text": "So I think we're using the $280 million and as we forecast that out. It's still early in the year. We're probably a little ahead of schedule, but not ready to call it and build into our forecast that will beat that. But we'll be -- we're optimistic. We're comfortable with the program and the target is a pretty big target for us across the organization, and we feel pretty good on a run rate that we can meet that or maybe beat it, but we've not built that into our forecast."
},
{
"speaker": "Neal Sheorey",
"text": "Yes. And this is Neal. To the point of, can you see it in the financials, maybe just one example I'll give you is if you look at our SG&A line. So -- just remember that on the face of the income statement, our SG&A line includes about $35 million of onetime charges that was related to our restructuring activities that we announced in the first quarter. When you back that out and then look at our SG&A line versus the fourth quarter versus where we ended 2023, you will see about a $20 million to $25 million decline in our SG&A costs. So that gives you an idea that we are starting to see some traction on the productivity and restructuring savings that we already announced."
},
{
"speaker": "Rob Hoffman",
"text": "That's helpful. And just a follow-up in terms of your longer-term volume growth chart here, -- why doesn't the potential tolling volume go down over time? Wouldn't you generate higher margins at your own conversion plants?"
},
{
"speaker": "Eric Norris",
"text": "Actually your question, just to make sure I'm clear on it. This is Eric speaking. Why would we see tolling volume go down over time?"
},
{
"speaker": "Rob Hoffman",
"text": "Why volume go down."
},
{
"speaker": "Eric Norris",
"text": "Oh, I'm sorry. Yes, I think -- fair enough. You wouldn't -- it's all a factor of ramp of plants. Right, what it comes down to -- we have a plant in China Meishan that's ramping at a faster speed than the plant in Australia, and that has to do with operating experience. But if you look at this over a long-term basis, ultimately, we will -- our intention is to be fully integrated and to take all the available resources and convert them with company-built assets as opposed to tolling assets. Increasingly, those -- we would target those to be outside of the U.S., we have a considerable basis, as you know, today in China. But again, depending upon the speed with that, tolling always remains a flywheel, an option for us to go on the speed of branch to go to another alternative. But you're right, I mean, in time, that's why there's a plus/minus on that, it should come down. The [indiscernible] for the most part is a bridging strategy for us, sorry."
},
{
"speaker": "Operator",
"text": "Our next question is from Andres Castanos at Berenberg."
},
{
"speaker": "Andres Castanos",
"text": "I wanted to understand better why are you running spodumene auctions now? And to have a sense on what is the percentage of volume that goes in these options? Are in deals with dollars somewhat impacted by this."
},
{
"speaker": "Kent Masters",
"text": "Yes. So I'm not sure that is the last part of the question. Let me start on the front and you catch that in the follow-up if I don't answer your question. So we're doing the auctions, both on spodumene and on salts, the health transparency in the marketplace, price discovery to really understand, make the market a little clearer, a little more transparent. We get good information for it. And then we've decided to include spodumene as part of that just more transparency in the market, more knowledge that we get around that. And it's an opportunity for us to participate in a different part of the value chain. So it's not a change in our strategy of being an integrated producer. We'll sell most of our products through these long-term agreements on a salt basis as we have historically. So that strategy didn't change, but it's just it's an adjustment to take -- to try and get more transparency in the marketplace and then to sell spodumene a different value, a different product at a different value in the marketplace. So if there are dislocations, we can take advantage of that."
},
{
"speaker": "Andres Castanos",
"text": "Right. So I think it's a small percentage of the total volumes that essentially the deals with the tollers are still in place and they take the majority of the excess spodumene. My second question would be on the level of cost of inventory that you have at the moment for spodumene for the ones you take on board from Wodgina? Can you comment on that more or less where you sit versus the index?"
},
{
"speaker": "Eric Norris",
"text": "So I think the question was the cost of our spodumene inventory versus the index. So as we showed in our first quarter results, we are still working off a little bit of spodumene that went into inventory in prior periods, that is at a little bit higher cost than where it is today, and we documented how much of that was in our first quarter results in our EBITDA bridge. You can expect that there'll be a little bit more of that spodumene that we'll have to work off. But for the most part, you will start to see a spodumene costs rolling through our COGS that is consistent with what is in the market as we get towards the middle of the year and in the back half of the year. And that's built into the outlook scenarios that we've been publishing."
},
{
"speaker": "Operator",
"text": "Our next question is from John Roberts at Mizuho Securities."
},
{
"speaker": "John Roberts",
"text": "Last quarter, Slide 13 on Greenbush has discussed the lag and the lower cost of market issue. It projected a spodumene inventory cost for the March quarter of about $4,000 a ton. Does that play out the way you projected last quarter?"
},
{
"speaker": "Neal Sheorey",
"text": "John, so this is Neal. We would have to check your numbers. One of the big adjustments we made in the fourth quarter was that LCM, which really collapsed the gap that we previously had, that sort of 6-month lag that we had in the spodumene cost and how it rolls through cost of goods sold. Now even after taking the LCM, we did still -- prices did still come down as we started the first quarter. So we did still have a little bit of higher-priced spodumene that rolled through our P&L. But I think the numbers you're referring to maybe are before we took the LCM adjustment, and we collapsed a lot of that gap with that adjustment."
},
{
"speaker": "John Roberts",
"text": "Yes. All right. And then have your thoughts on the role of catching in the portfolio changed at all since the last call?"
},
{
"speaker": "Neal Sheorey",
"text": "I would -- no, I would say. But look, we're -- we've said it's not a core business for us. So we would look to divest that at some point. But -- and we went through a process, which we talked quite a bit about didn't get the value wanted. So we're doing a turnaround. That program is going pretty well, but we would still anticipate doing a transaction on that business when the timing is right."
},
{
"speaker": "Operator",
"text": "Our next question is from Christopher Parkinson at Wolfe Research."
},
{
"speaker": "Harris Fein",
"text": "This is Harris Fein on for Chris. So I'm not sure if I'm reading too much into this. You left the EBITDA sensitivity is unchanged, but also volumes seem like they're trending towards the high end of the guide. Is it wrong to think that EBITDA will trend to the higher end of those ranges as well, all else equal?"
},
{
"speaker": "Kent Masters",
"text": "Yes. Actually, it's a fair assumption. Basically, the way that we constructed those EBITDA ranges reason their range is driven by that volume consideration that we have, the 10% to 20%. So I think all things being equal, that's a fair assumption to make."
},
{
"speaker": "Harris Fein",
"text": "Then for my follow-up, there are a lot of moving pieces in the cash flow guide. I guess when I look at the reasoning for the lower conversion rate this year, it doesn't seem like those things are necessarily going away after this year, like you'll always be ramping projects. So how are you thinking about the operating cash conversion going forward?"
},
{
"speaker": "Neal Sheorey",
"text": "Well, actually, I have a little different viewpoint on that. I do think that our cash conversion should be improving in 2025 for a few reasons. Number one, as I mentioned or as we mentioned in the prepared remarks, our cash taxes are very similar this year to what we had last year, and that's primarily because of Australia, and we're paying taxes based on income from last year. If you assume that pricing is sort of flat for the rest of the year, I think you should assume that our cash taxes will be lower next year, all things being equal. The other part is that our facilities are so far, as you heard in Kent's remarks, ramping quite well. And so we would expect that those will start to contribute as we get into the back end of this year and into 2025. And as Kent mentioned, right now for where we are, the ramp that you see in our volume growth is just based on the projects that we are finishing up right now and are ramping right now. So we won't be ramping plants forever, that will most certainly come to an end and those plants will begin contributing and the back half of this year and into 2025. So I do anticipate our cash conversion to get better."
},
{
"speaker": "Eric Norris",
"text": "Yes. And just a little finer point on Neal's point, I mean we are those -- the new plants that are ramping will be as we grow, our business grows, they become a smaller part of the portfolio. So we'll still be building new plant and ramping over time, but they become a smaller percentage of the portfolio. And then at the moment, we have a lot of plants ramping in that particular phase. I didn't necessarily plan it that way, but that's how it's worked out. We've got, I think, 4 plants actually ramping now at the same time. And that's not the plan. Going forward, it won't be that many. And if they were, it would be a smaller part of the portfolio just because we've grown."
},
{
"speaker": "Operator",
"text": "Our next question is from Kevin McCarthy at Vertical Research Partners."
},
{
"speaker": "Matt Hettwer",
"text": "This is Matt Hettwer on for Kevin McCarthy. Regarding the spodumene and carbonate auctions that you just touched on, what does the customer feedback been like? And how has the auction participation rates trended?"
},
{
"speaker": "Eric Norris",
"text": "Matt, this is Eric. We've got very good participation. We're very early in our process. And so we're very -- with a qualification process to make sure we're -- we're inviting people to these auctions that meet certain standards, but that's growing over time. The participation rate we received and the corresponding conversion of those invited versus those who put in a bid has been strong. The interest has been, therefore, good and the outcome has been well received what we think about the market, particularly from a price reporting agency, we found that these through the normal surveying process, the results of these bids have found their way into the price reporting agencies. Of course, they determine how they use that in their next calculations, but it's our anticipation that they're lending there as well. And then as we turn to the -- to our sort of contracted customer base, they appreciate that what we're doing is better understanding in what is a pretty immature market how -- what the drivers are, as Kent was referring to different types of prices, whether that's inside the country, outside of country or an IRA compliant, non-RA compliant product or a spodumene versus a better grade carbonate. It's giving us better intelligence to better segment, understand what's happening in the market and a lot of the same for our customers in the contract side ultimately because that would be reflected in the indices they referenced."
},
{
"speaker": "Matt Hettwer",
"text": "And then as a follow-up, I believe in the prepared remarks, you mentioned expanding the auctions to other geographies and products. What other geographies are you looking at? And in the future, might you include hydroxide in the auctions?"
},
{
"speaker": "Eric Norris",
"text": "Yes. So I touched on a little bit when I talked about IRA compliant. But just as reference, almost -- actually, all 4 auctions that we've done today have all been inside of China with available inventory on the ground there. We'll be looking for product outside of China shipped on a CIF basis, for example. We'll be looking at that certainly for our Australia product. We'll be looking at it for [indiscernible] compliance ship to the U.S. and across our product range, including hydroxide."
},
{
"speaker": "Operator",
"text": "Our next question is from Ben Isaacson at Scotia Capital, Inc."
},
{
"speaker": "Apurva Kilambi",
"text": "This is Apurva on for Ben. So we're heading into what has historically been a peak buying season in China just off of the earlier comments on demand, are you starting to see this restocking materialize?"
},
{
"speaker": "Eric Norris",
"text": "Yes, this is Eric. As I pointed out, we've seen inventories at a fairly low level, ending in March, and I do think a part of the demand is to restock in anticipation of the midyear and into later year seasonality of EVs. It's one reason why it's very hard to look at Q1 sales of EVs and correlate that to real on-the-ground demand because the EVs that are being sold in the first quarter this year were lithium for that was sold late last year -- middle of the late of last year. And we are seeing -- I think it's a part of the demand that I referred to earlier, it's not only fundamental demand for what our increased EV sales that are coming in that -- we see in April and we expect in May and June, but also it's a result of some restocking because some of the levels of which inventory gone to, it just weren't sustainable for these operations to run without taking considerable risk of not being able to meet demand."
},
{
"speaker": "Apurva Kilambi",
"text": "Great. And as my follow-up, looking back with your 10-K, you actually published an updated technical report on Greenbushes. With that report, we saw something of a step down in both grades and recoveries and concurrently, costs have moved upwards. Given those technical effects, where do you see the next phase of resource growth coming from for Greenbushes."
},
{
"speaker": "Eric Norris",
"text": "Well, that's you're correct. You're referencing a report that we published on our SEC guidelines, which are have a different standard. It's not uncommon in mining for different standards around the world and different standards are more strict and how they should be exercised and that produced some of the results you're describing. This is still even in that report on a relative basis the best spodumene resource reported in the world. And our aims are to continue, as we've described to -- we are now executing with our joint venture partners at CGP3 expansion. There is the possibility long term, although we have not announced this formally or committed to it for further expansion of CGP4 and continued operation of that operation at its current grid reported for quite some years, decades to come. So our intention is to maximize that resource given its low cost potential."
},
{
"speaker": "Operator",
"text": "Our next question is from Michael Sison at Wells Fargo Securities."
},
{
"speaker": "Michael Sison",
"text": "Good start to the year. You have a slide on sort of minimum capital and I think the line looks like billion. So if hiking kind of stays here, is that where CapEx will go in '25. And what would that mean to your capacity potential in longer term if that has to be the case."
},
{
"speaker": "Neal Sheorey",
"text": "Yes. So I think we've commented on that earlier. So we can -- we would look at the billion that's kind of maintenance capital for us around to maintain our assets and continue to operate there. And we could -- if we -- if prices stay where they are, we could get to that kind of on a run rate by the end of '25, so '26 number, so to speak. '25 would be a little bit higher, but we get to the run rate by '25. That would impact our long-term growth if we went to that level. So the current planning that we have, the projects we're executing at the moment, get us kind of a 20% growth rate through '27 or so. And if we were to cut back to those levels, we'd impact that materially beyond that."
},
{
"speaker": "Michael Sison",
"text": "And as a follow-up, your EBITDA margins for any storage, they're pretty good. And I know you think we need -- you need higher pricing for the industry. So I mean, what price do you think lithium needs to be at to support the growth that is expected for the end of the decade, and maybe any thoughts on where you think others around the world who are -- where their margins are because yours are again, from a -- are pretty good, not as good as it used to be, but I think there's still a pretty good margin."
},
{
"speaker": "Eric Norris",
"text": "Right. So I'm not going to comment on other people's margins. But if we stay where we are, we can operate at about -- at a 30%-ish type margin rate once we get the noise out of the P&L, that kind of the transition from the big prices and some of the spodumene costs. So on a run rate we could get to around 30% and still grow our business for us. I think that's the good margins that you're talking about. We've had stronger margins than that, and they would be stronger if prices move up. The issue with price is really about returns on new investment projects more than it is about our existing business, P&L and the margins that we can deliver. So prices need to move up in order to develop new projects to get the growth the industry needs to support the EV transition. I'm not going to comment on because it's different by every project and every geography as to what price you need and you need to believe that for 10 or 15 years in order to get a return on the project when you go through FID. So I can't say a number and if I had one, I probably wouldn't say it, but they are different by geography, by region, by technology, what the resource looks like. So it's quite different. There's no way to pick one particular number."
},
{
"speaker": "Operator",
"text": "Our next question is from Joshua Spector of UBS."
},
{
"speaker": "Chris Perrella",
"text": "It's Chris Perrella on for Josh. I just wanted to follow up on Neal, the 2Q Energy Storage EBITDA margin that you guided to, given the puts and takes, you have the higher cost spodumene inventory, which is maybe a $50 million drag in the second quarter, but you also have the one-off from Talison. So how does that bridge together to get to your 2Q margin? And then does it step down with the absence of the Talison one-off in the second half of the year?"
},
{
"speaker": "Neal Sheorey",
"text": "Yes. So I think if I -- let's talk about the second quarter first. So basically, the way to think about this, I think your numbers are probably all in the right kind of range. If you do the math based on the first quarter and what we said in the prepared remarks that we expect about a 10-point bump in energy storages, EBITDA margin in the second quarter. You probably will get into the range of about $100 million bump to EBITDA Q2 versus Q1. And that's really just driven primarily by the expectation that all partners are taking their allotment off of Talison plus we have that additional 200,000 tons that is getting offtake in the second quarter as well. And so that's basically what serves as the basis for the 10 percentage point bump. In terms of then going forward, it is sort of a onetime bump up. And then what you should expect in the third and the fourth quarter is that we'll come back down to again, pretty healthy margins. It won't be as healthy as the second quarter. But you can expect that we will, as our plants continue to ramp up and we continue to absorb fixed cost, that will continue to get some margin expansion versus the first quarter, for sure, in the third and the fourth quarters as we exit the year."
},
{
"speaker": "Chris Perrella",
"text": "That's perfect. And then a quick follow-up. Sequentially into the second quarter, do you expect volumes to be up? I'm just trying to bridge the seasonality to get to the 190 [indiscernible] for the full year?"
},
{
"speaker": "Neal Sheorey",
"text": "Yes. So we will have volume -- at least sequentially, what you're asking about is, yes, we will have some higher volumes as we get into Q2 versus Q1. Remember that the peak for energy storage demand is usually in the third quarter. So we're building to that peak. So it won't be the highest quarter of the year. But yes, I would expect that you'll see a little bit higher volume in Q2 versus Q1."
},
{
"speaker": "Operator",
"text": "Our next question is from Colin Rusch at Oppenheimer."
},
{
"speaker": "Colin Rusch",
"text": "Given the dynamics around geopolitical positioning on manufacturing for batteries and some of the evolution of the tariffs that we're seeing on the solar side and other areas. Can you talk a little bit about the importance of refining and your thought process around that importance in North America as you enter into the balance of this year and next year?"
},
{
"speaker": "Netha Johnson",
"text": "Yes. So okay, interesting question. So the politics is playing into the market significantly, and we've got the integrated strategy. So we've got a good resource position, and it's spread around the world, so we have nice diversity around that. And we've built conversion. So we have conversion in Chile, in the U.S., lower scale at the moment. And Australia and China. So we're spread around the world, and we've got nice diversity around that and it allows us to kind of plan for some of these aspects. So our goal would be to have larger scale conversion in North America to satisfy the North American market and we are -- but we've paused on that a little bit, just on some of the issues that you've described, price being a big one, how geopolitics plays into it. And we're going to use that pause to figure out exactly what we do around that."
},
{
"speaker": "Colin Rusch",
"text": "Okay. Great. And then in terms of some of the evolving cathode chemistries, obviously, we're seeing some activity around Delta LFP, and I'm assuming that the precursor materials are evolving a little bit. Can you talk a little bit about some of the specific adjustments that you're making around some of the refining processes to meet those cathode needs in a more tangible way as you go through the balance of this year and into next year?"
},
{
"speaker": "Neal Sheorey",
"text": "Yes. I'll start on that. Eric can fill in the gaps. I think -- I mean the biggest thing for us at the moment is with the primary products around hydroxide and carbonate is balancing that. So as LFP has become more prevalent. It's got stronger demand on carbonate and we've been a stronger -- a larger percentage of our portfolio is carbonate historically. We've been building out hydroxide and then balancing those 2 is understanding where those chemistries go. And then long term, it's going to be about solid state and then how you shift from so much -- be more about carbonated hydroxide to about lithium metal. But that's a longer-term scenario. The carbonate hydroxide is playing out in the assets we're building now."
},
{
"speaker": "Eric Norris",
"text": "Yes. So Colin, just a little shed more color around that. I would say that we still see a market that is for hydroxide, high nickel is favored outside of China versus in with carbonate and supporting LFP being a very big part of the China market. The innovations that have been coming out of -- largely out of China and LFP chemistries for higher energy density and efficiencies as well as the cost profile of that cathode are obviously very increasingly now interesting to the West. And so we expect that. Certainly, our Chile position is in a position of power in which we can supply into that opportunity. We'll watch that carefully. As Kent talks about -- had talked about earlier about pausing the investment here in the U.S. or North America to figure out in this uncertain market direction and develop our own strategy there. One of those -- one of the components of that has to be on the assessment of LFP in the U.S., and that will be will be part of that equation as well."
},
{
"speaker": "Operator",
"text": "Our final question is from Patrick Cunningham at Citi."
},
{
"speaker": "Patrick Cunningham",
"text": "In the past, you've talked about the marginal cost of production being $20 [indiscernible] and maybe new projects pushing that curve up over time. Do you still believe that to be the case given we've seen relatively tepid supply response at current prices?"
},
{
"speaker": "Kent Masters",
"text": "Yes, it changes -- it changes over time with volumes in the industry. But most new projects come on are going to be higher on the cost curve and moving that up. So we still think that within a $1 or $2, the accuracy of that. But I think we still believe that fundamentally is about the target of marginal cost today."
},
{
"speaker": "Patrick Cunningham",
"text": "Got it. And then just a quick follow-up. Did price floors play a meaningful impact with price levels in the low teens for a good part of the quarter?"
},
{
"speaker": "Eric Norris",
"text": "I'm sorry, your question was -- the price floor impact on our realized price for the quarter? Or was that the question?"
},
{
"speaker": "Patrick Cunningham",
"text": "Yes, yes. Was there meaningful impact."
},
{
"speaker": "Eric Norris",
"text": "Let's put it this way. We don't disclose a lot of our price floors, and they tend to range because often based on age of contracts. At current prices, some of those floors, some are being tested, floors have held. And so we certainly are seeing the floors come into play for some of our business."
},
{
"speaker": "Operator",
"text": "Thank you. That's all the time we have for questions. I will now pass it back to Kent Masters for closing remarks."
},
{
"speaker": "Kent Masters",
"text": "Okay. Thank you, and thank you all for joining us today. We continue to innovate, adapt and lead the world in transforming essential resources into the critical ingredients for modern living with people and planet in mind. We are focused on continuing to be the partner of choice for our customers and investment of choice for both the present and the future. Thank you for joining us."
},
{
"speaker": "Operator",
"text": "This concludes today's conference call. Thank you for your participation. You may now disconnect."
}
] | Albemarle Corporation | 18,671 |
ALB | 1 | 2,025 | 2025-05-01 08:00:00 | Operator: Hello, and welcome to Albemarle Corporation's Q1 2025 Earnings Call. I will now hand it over to Meredith Bandy, Vice President of Investor Relations and Sustainability.
Meredith Bandy: Thank you, and welcome, everyone, to Albemarle's First Quarter 2025 Earnings conference call. Our earnings were released after market closed yesterday, and you'll find the press release and earnings presentation posted to our website under the Investors section at albemarle.com. Joining me on the call today are Kent Masters, Chief Executive and Neal Sheorey, Chief Financial Officer Netha Johnson, Chief Operations Officer and Eric Norris, Chief Commercial Officer are also available for Q&A. As a reminder, some of the statements made during this call, including our outlook, guidance, expected company performance and strategic initiatives may constitute forward-looking statements. Please note the cautionary language about forward-looking statements contained in our press release and earnings presentation that also applies to our call. Please also note that some of our comments today refer to non-GAAP financial measures. Reconciliations can be found in the earnings materials. And now, I'll turn the call over to Kent.
Kent Masters: Thank you, Meredith. For the first quarter, we reported net sales of $1.1 billion including increased specialties volumes and record lithium production from our integrated lithium conversion network. Adjusted EBITDA was $267 million reflecting strong year-over-year improvements in specialties and kitchen. We generated $545 million in cash from operations, achieving an operating cash conversion rate exceeding 200%. We are maintaining our 2025 outlook considerations based on recently observed lithium market prices. These considerations include the anticipated direct impact of tariffs announced to date. Note that the direct impact of tariffs is expected to be minimal as Albermarle benefits from global diversification and current exemptions, particularly for critical minerals such as lithium salts and spodumene. Neal will provide more details on this later in the call. Regardless of shifts in the external market environment, Albemarle remains focused on controllable factors to ensure competitiveness through the cycle. To that end, we continue to act decisively across four key areas, optimizing our conversion network, improving cost and productivity, reducing capital expenditure and enhancing financial flexibility. For example, through April, we achieved approximately 90% run rate to get to the midpoint of our $350 million cost and productivity improvement target. And our team has identified opportunities to reach the high end of the $300 million to $400 million range. This includes incremental volume improvements as we ramp our new facilities and cost savings from placing our Chengdu site on care and maintenance. This quarter, we are also providing updated forecasts for global lithium market demand and supply. We anticipate global lithium demand growth in the 15% to 40% range in 2025, depending on tariff impacts, policy changes and macroeconomic trends. Longer term, we expect the lithium demand outlook to remain robust, more than doubling from 2024 to 2030, driven by the energy transition and global demand for electric vehicles and grid storage. Incentivizing supply growth requires long term lithium pricing well above current spot prices. Now, I'll turn it over to Neal, who will provide more details on our financial performance and outlook considerations. I will conclude our prepared remarks with further details on our lithium market forecast before opening the call for Q&A.
Neal Sheorey: Thank you, Kent, and good morning, everyone. I will begin with a review of our first quarter financial performance on slide 5. We reported first quarter net sales of $1.1 billion which were lower year-over-year, mainly due to lower lithium market pricing. The pricing decline was partially offset by higher volumes in specialties. Energy storage volume was flat year-over-year as we optimized our own lithium conversion network and reduced the need for tolling volumes. First quarter adjusted EBITDA was $267 million down 8% year-over-year, as lower input costs and ongoing cost and productivity improvements partially mitigated the impact of lower lithium pricing and reduced JV pretax equity earnings. Our focus on cost is showing through in the improved quality of our business, evidenced by our adjusted EBITDA margin improving by approximately 400 basis points year-over-year. Earnings per share was breakeven in the first quarter. Adjusted diluted earnings per share was a loss of $0.18 after preferred dividends and excluding discrete tax items and other nonrecurring factors. Slide 6 highlights the drivers of our year-over-year EBITDA performance. As I mentioned, Specialties drove the volume benefit, while energy storage volume remained stable due to ramping conversion plants balanced by lower tolling volumes. Q1 adjusted EBITDA was down slightly due to lower lithium pricing and pretax equity income, partly offset by reduced COGS from lower cost spodumene. Our SG&A costs were down more than 20% year-over-year due to our restructuring and cost savings initiatives. Adjusted EBITDA increased by 30% in Specialties and 76% in Ketjen year-over-year. Corporate EBITDA declined due to a foreign exchange loss compared to last year's gain. Turning to slide 7 for an update on the recently announced tariffs. The focus of our comments today will be on the direct impact of the tariffs that have been announced or amended as of this earnings release. We estimate the direct impact of the tariffs in 2025 to be relatively modest at approximately $30 million to $40 million on an unmitigated basis. This impact is mostly attributed to Specialties and Ketjen. Notably, the direct impact on our energy storage business is expected to be effectively zero as most of our lithium production is sold within Asia. Additionally, we benefit from current exemptions for critical minerals, such as lithium salts and spodumene. Our teams are actively working on mitigations to these impacts, and we expect the mitigated impact could be significantly lower. In some jurisdictions, we have inventories that help to mitigate near term impacts in other cases, tariffs present opportunities to increase sales in countries with lower tariffs. For instance, we may be able to capitalize on our US manufacturing footprint to sell more bromine products from Magnolia into US end markets. While the full economic impact of the recently announced tariffs and other global trade actions is unclear, we benefit from our global footprint and the current exemptions for critical minerals. As a result, we're able to maintain our full year 2025 outlook considerations even with the anticipated direct impact of tariffs announced to date. Moving to slide 8. As usual, we are providing outlook scenarios based on recently observed lithium market pricing. And on this slide, we have presented Albemarle's comprehensive company roll up for each lithium market price scenario. As I just mentioned, these outlook considerations have not changed since we unveiled them last quarter. As a reminder, we have provided modeling for three price scenarios, including: year end 2024 market pricing of about $9 per kilogram lithium carbonate equivalent, or LCE the first half 2024 range of $12 to $15 per kilogram LCE and the fourth quarter 2023 average of about $20 per kilogram LCE. All three scenarios reflect the results of assumed flat market pricing across the year in conjunction with Energy Storage's current book of business, with ranges based on expected volume and mix. Turning to slide 9 for additional outlook commentary by segment. First, in Energy Storage. As a reminder, for 2025, approximately 50% of our lithium salts volumes are sold on long term agreements with floors. Our contracts continue to perform in line with our forecast, and we have no significant contracts up for renewal this year. With these long term agreements, plus other sales on contracts with volume commitments and market based pricing, we continue to expect volumes to be slightly higher year-over-year. This is primarily due to the ongoing ramp of the Salar yield improvement project in Chile, plus production ramps at our conversion sites, which helps improve fixed cost absorption and results in reduced tolling volumes. We realized a strong first quarter Energy Storage EBITDA margin of 36%, thanks to lower input costs and a greater proportion of lithium salts sold under long term agreements. Second quarter margin is expected to be lower due to a lower proportion of lithium salts sold under long term agreements. Net net, we continue to expect the full year and the first half 2025 Energy Storage EBITDA margin to average in the mid-20% range, assuming our $9 per LCE price scenario. In Specialties, we continue to expect modest volume growth year-over-year. We also expect to see revenue and pricing improvements mid-year, partially due to steady demand and temporary industry supply disruptions. Q2 EBITDA is expected to be lower primarily due to product mix. Finally, at Ketjen, we expect modest improvements in 2025 related to product mix, continued execution of our turnaround plan. While revenue is expected to improve sequentially, Q2 EBITDA is expected to be lower due to product mix. Please refer to our appendix slides in the deck for additional modeling considerations across the enterprise. Advancing to slide 10. We continue to progress broad initiatives designed to maintain our long term competitive advantages through market cycles. Given the ongoing dynamic environment, we are consistently augmenting our playbook of potential measures to ensure timely adaptation as required. In terms of optimizing our lithium conversion network, we achieved record quarterly production at five sites across our company operated conversion network, La Negra, Kemerton, Xinyu, Qinzhou and Meishan. Meanwhile, since our announcement last quarter, we've shifted operations at our Chengdu facility, which is ramping down and preparing to go into care and maintenance. These actions allow for lower cost to serve, better fixed cost absorption and reduced tolling volumes. Second, improving costs and productivity. We have moved rapidly on our $300 million to $400 million cost and productivity target and have already reached an approximately 90% run rate against the midpoint of the savings range. And additionally, we have identified opportunities to reach the high end of the range and are already developing execution plans to drive those benefits. These opportunities include further reductions to non-headcount spending, supply chain efficiencies, and further volume improvements at key manufacturing sites. Third, we remain on track to reduce capital expenditures by more than 50% year-over-year. And finally, we remain focused on enhancing our financial flexibility and driving cash flow generation and cash conversion even in this uncertain market environment evidenced by our more than 200% operating cash conversion in the first quarter driven by the receipt of the customer prepayment. In summary, we remain focused on our deep and broad playbook of actions in our control, and we continue to execute successfully across our planned operational and financial priorities. Turning to our balance sheet and liquidity metrics on slide 11. We ended the first quarter with available liquidity of $3.1 billion largely made up of $1.5 billion in cash and cash equivalents and the full $1.5 billion available under our revolver. The measures we've implemented to control costs, capital spending and cash conversion have also enhanced our financial flexibility. As a result of our proactive efforts to reduce costs and optimize cash flow, we ended Q1 with a net debt to adjusted EBITDA ratio of 2.4 times. Slide 12 highlights our commitment to effective execution and converting earnings into cash. This is demonstrated by improved operating cash flow conversion resulting from operational discipline and efficient cash management. In the first quarter, operating cash conversion exceeded 200%, a large part of which was driven by the customer prepayment received in January. However, even when excluding this prepayment, first quarter operating cash conversion was 73%, above our long range target, thanks to the timing of Talison dividends, enhancements in inventory and other cash management actions across our enterprise. And just as important, we delivered slightly positive free cash flow without the customer prepayment. As we said last quarter, we anticipate that our 2025 cash dividends from the Talison JV will be below historical average as Talison completes its CGP3 capital project at the Greenbushes mine. Nevertheless, we expect operating cash flow conversion to surpass 80% in 2025, exceeding our long term target range, driven by ongoing working capital improvements and the $350 million customer prepayment. Combining that with our capital spending range of $700 million to $800 million, we maintain our expectation of breakeven free cash flow for the full year of 2025. I'll now turn it back to Kent.
Kent Masters: Thanks, Neal. Now I'll cover our long term lithium supply demand outlook. Lithium is vital for the energy transition, and our long term business drivers are robust. Beginning on slide 14, 2025 EV demand growth is off to a strong start led by China, with EV sales up 41% year-to-date, driven by subsidies for battery EVs and plug in hybrids. China now represents approximately 60% of the overall market demand. Europe also had a strong start to the year with sales up 19% in January and February, thanks to a step change in regulatory emission targets. Finally, North America grew 17% year-over-year with US trends improving due to greater model availability and affordability. Overall, these trends reinforce confidence in the industry's long term growth potential and continue to highlight that the regional dynamics are important factors to consider as the industry expands. Turning to slide 15, we expect lithium demand to more than double from 2024 to 2030, driven primarily by stationary storage and electric vehicle demand. Near term, we expect 2025 demand growth in the range of 15% to 40%, a wider than usual range reflecting uncertainties around tariffs and other trade actions and their impact on the macroeconomic environment. We feel confident in the ability to reach the low end of the range given year-to-date performance, revised EU emission targets and even modest growth in China. The high end of the 2025 outlook range assumes strong grid installations, particularly in China and South Asia, plus Europe and China EV sales growth continuing closer to the year-to-date trend. For what we know today, we see the most likely outcome being a growth rate in between these two extremes in the mid 20% range or similar to the growth rate in 2024. These figures include the anticipated impact of tariffs announced to date under current macroeconomic conditions. However, they do not include the impact of a global economic recession. We expect lithium supply to remain relatively balanced over the forecast period given recently announced and ongoing project curtailments and delays. Incentivizing supply growth to meet long term demand requires prices well above current levels. The global energy transition is undoubtedly progressing. It is a matter of how fast, not if. Globally, electric vehicle market penetration or share of vehicle production is expected to exceed internal combustion engines by the end of the decade. In China, EV production is expected to overtake ICE production by as early as this year. European EV penetration is driven by the EU's CO2 emissions targets and is expected to reach 65% by 2030, assuming the current policies remain in effect. The US EV market is earlier in its development with a range of outcomes primarily reflecting uncertain policy impacts. On the supply side, there have been several announced curtailments both upstream and downstream. Non-integrated hard rock conversion remains unprofitable and large integrated producers are facing pressure. As prices have declined, we now believe that about 40% of global capacity is currently either at or below breakeven, of which only about one-third has come offline. In a growing market, all of that supply and more is required to meet long run demand. In fact, we estimate lithium supply must double by 2030 to keep pace with demand. As a result, we continue to expect that prices well above current levels are required to support the necessary investment. In summary, on slide 18, Albemarle delivered solid first quarter performance while continuing to act decisively to preserve long-term growth optionality and maintain the company's industry leading position through the cycle. We are maintaining our full year 2025 company outlook considerations, building on the progress we've made to drive enterprise wide cost improvements and strong energy storage project ramps. We are progressing broad based comprehensive actions to manage controllable factors and generate value across the cycle. I am confident we are taking the necessary steps to maintain our competitive position and to capitalize on the long term secular opportunities in our markets. With that, I'll turn the call back over to the operator to begin the Q&A portion.
Operator: [Operator Instructions] Our first question comes from Rock Hoffman with Bank of America. Your line is open.
Rock Hoffman: We're already one third done with, the year. Could you speak a little more to, the different scenarios which may get the demand to lower the higher end of that, guided 15% to 40%, within the vendor in 2025?
Kent Masters: Yeah. So I guess okay. So that's right. We're about a third in, but it's a pretty uncertain environment at the moment. So and that reflects the range that we put out there, why it is as wide as it is. And we said in our comments, we thought for lack of another number, I mean, the middle of the range is kind of what we think is reasonable at the moment. I mean, that's the two extremes are kind of the downside and the upside. So either everything going the wrong way or everything going in the right direction. So our best view at the moment, it's in the mid 20% range. That's our view. We're off to a good start, so it was stronger than that. And we know that some of that was pulled from last year a little bit. So our best guess is in the mid-twenties.
Rock Hoffman: And just as a follow-up, could you speak a little more to the progress in your productivity initiatives? And given you're already 90% of the way through the midpoint, in other words, roughly $315 million run rate, Is there upside to that $400 million high end either in 2025 or thereafter?
Kent Masters: Yeah. So we're kind of fighting to get to the top end of that range, but that's a this is a kind of a one off program. We look at productivity and those type benefits as something that we constantly do. But we think we can get to the top end of the range. We've gotten to kind of 90% of it at the moment to the at least the midpoint. And we think we'll get to the top end of that range, but then we'll keep working on that. So productivity is kind of a constant thing. It is not something that's going to end when this program is over, and we'll continue to look for opportunities around that.
Operator: Our next question comes from John Roberts with Mizuho Securities. Your line is now open.
John Roberts: Back to the range on lithium demand forecast, do you have an opinion on how hard or easy it would be for US and European EV makers to copy some of the recent Chinese breakthroughs in cell pack design? How easy or how hard?
Kent Masters: I think look. We're still early in the technology curve around lithium ion batteries and other batteries in the similar space. Right? So we are still early, either on the ones that are the more mature, like the high nickel and LFP. I think we're still early in that cycle. So you're going to still see advancements. You're going to see them from global players regardless of what geography they're in. So I think there's still a lot to play out around energy storage and whether it's lithium ion or sodium, for example. We're still early in that technology curve. So there there's a lot of room for improvement and from a variety of different players.
Operator: Our next question comes from Colin Rusch with Oppenheimer. Your line is now open.
Colin Rusch: Thanks so much, guys. This one's for Neal. I mean, if you look at the industry now that we've seen some deeper rationalization, how are you thinking about cross cycle cash management and return on investment if we think about a three to five year time period around those stock?
Neal Sheorey: So, look, from a cash management standpoint or maybe, more importantly, I think where I go to first is thinking about the cash conversion, of this company. Obviously, for the work that we are doing around our cost savings, ramping our assets, and so on, if I look over the next three years, we've set a range of, 60% to 70% kind of cash conversion as our benchmark, and that's what's turned up as we've done benchmarking with similar companies. And so that's something that we want to strive for, not just performing that way in a single year, but really being able to do that in a more consistent way. And I think as we line out our assets and, you know, get through our cost savings and work on the productivity initiatives that Kent mentioned, I think that we can get there, and we can do that in an in a ratable way. We've also said from a- this kind of ties into the cash management piece from a leverage standpoint. Obviously, we want to be lower than where we are today. We've always said that less than two and a half times across the cycle is our target. We're not there today, so we're going to keep working on that. And you've seen the things that we've done to enhance our financial flexibility and make sure that we have, we're moving in the right direction on that front. So, look, I don't think there's a big change in our long term targets, but I hope what you hear from our comments today and the performance that we've had over the last several quarters is that we are very focused every day on ensuring that we're driving to those targets or better, kind of using this benchmarking mindset, to guide our actions.
Colin Rusch: And then just on the lithium contracting strategy, I appreciate the comments that you don't have any major contracts rolling off this year. As you see the landscape evolving a little bit and we start to see autonomous vehicles start to drive more EV adoption. Is there another cycle where you guys will have a little bit more leverage around contract negotiations and pricing as folks really start to attack the autonomous vehicle market here by the end of the second?
Kent Masters: I think from just from our contracting strategy, I think, ultimately, it doesn't change. It evolves. And I think our customers, they want to have long term security of supply, the contracting element is part of that. Different markets have different preferences from a contracting or not contracting standpoint. So the Chinese market is, for the most part, spot. But a lot of the OEMs and players within the industry, particularly in the West, like to have a contract. They like that security of supply. They know that they've got that supply lined up for them. So I think we'll continue to do that. Up around where it's autonomous or not in that market, I'm not sure that changes our contracting strategy. I think, it will evolve over time depending on the way the industry evolves, but I still see us having a mix. And we always talk about the portfolio we have. So we have a certain amount of our portfolio in spot. We like having a certain part of that. We like having a piece in contracts. We see that it allows us to play in various parts of the market and mitigate risk in certain contractual strategies. So you'll always see us with that portfolio. It will probably shift a little bit over time depending on the market.
Operator: Our next question comes from Patrick Cunningham with Citi. Your line is open.
Unidentified Analyst: Good morning. This is Rachel on for Patrick. Very helpful view on the lithium demand. I guess, how much of the strong demand year-to-date would you attribute to tariff prebuying? And any concerns on gas at risk for ESS given the tariffs?
Kent Masters: I'm not sure if much of it was tariff prebuying so much as it is was about- we do know that our customers have told us they shifted volume from the end of last year into this year more about regulatory issues in Europe than anything else. And it was a strong start to the year. I'm not sure we can define exactly what that it was, so we didn't have as weak of a period around Lunar New Year as we normally do. So it was a little stronger on that. I don't think it was tariff related, but with regulatory in Europe and to be honest, I'm sure why it was stronger than it was in China, but it was.
Unidentified Analyst: On the supply side, you've mentioned supply curtailments, but we've continued to see that supply response mainly from China. So do you think there are particular regions where you expect to see supply removed or any large project cancellations?
Kent Masters: I think well, and it's going to be nonintegrated hardrock conversion. Right? So either the hardrock resource or that conversion is- they're in the difficult part on the cost curve. So that's probably where we see that, and we see it more in Western players than we would in Chinese players.
Operator: Our next question comes from Aleksey Yefremov with KeyBanc.
Aleksey Yefremov: Just to stay with the lithium market. You're forecasting demand to grow 200 to 600 kilotons this year. How much do you think the upstream capacity would be added this year as well?
Kent Masters: So I think so you're basically saying supply demand. Right? So given the market growth, we see how much comes on. So there's room to absorb that, but there is still some capacity that will come on. I don't know exactly. I mean, our view of supply demand essentially stays more or less the same throughout the year unless a significant amount comes off.
Aleksey Yefremov: And then about your feedstock costs, we saw that cost of mining fell at Wodgina. I don't know if you really saw the benefit of that this quarter or expect to see later this year. But could you also broadly talk about your outlook for mining costs at both Wodgina and Greenbushes and maybe La Negra as your volumes ramp in Chile?
Kent Masters: Yeah. So, like, I guess you'd have to go through each of those. I mean, we're driving Greenbushes there is pretty mature. We've got a lot of initiatives around that where we're getting more focused on the mining, so we are able to drive cost from that. CGP-3 will be the next big step there, and that program comes on later in the year. So you'll get a little bit more scale, which will help us on a cost standpoint. Well, I'd do know we're working through a probably a difficult part of the mine at the moment to remove material and get to the best ore there. So it's higher at the moment, but we expect to get the better cost position there. And LA Negra is one of the lowest - from the Florida Atacama, the one of the lowest sources, lowest cost sources resource in the world. So we continue to drive, productivity and operations there. The Salar Yield project is ramping up. We had record production at La Negra in this particular quarter, so that's all going well, which should drive the cost down slightly. Those are incremental improvements, but they move to drive the cost down as we leverage the fixed cost over more volume.
Operator: Our next question comes from Chris Perrella with UBS.
Chris Perrella: I wanted to follow-up on the margins within Energy Storage. And how much lower, I guess, are contract sales in 2Q? And how do the volumes ramp over the course of the year to sort of come out to your mid-20% margin target for the full year?
Neal Sheorey: This is Neal. Maybe I can give you a little bit of color here. So, you know, the first thing, to highlight about the first quarter is, historically, just in general from a seasonality perspective, the first quarter is usually a slower volume quarter for energy storage. And I think you can see that in our deck. We provided our production in energy storage. It was around 40 kT in the quarter, and that's less than 25% for the year. And so what you should expect is that there will be our higher volume months tend to be in the second and the third quarter. And, usually, with those higher quarter months, what that means is that there's more volume that is going to be sold off of our long term agreement. So those are going to be at prices a little bit more like current market prices or current spot prices. So that's why we say from an energy storage perspective, it's more of a mix as the volume ramps up over the next couple of quarters. And that's why we see the margin kicking lower in the second quarter versus the first quarter.
Chris Perrella: All right. And just a follow-up question. With the cutback in CapEx and the ramping or the remixing of your production or optimizing of your conversion network, where do you guys see maintenance CapEx on a go-forward basis when everything settles out over the course of this year?
Kent Masters: When you're asking the question, I was thinking about a longer term answer rather than this year. So I think it's going to be a little longer term, but look. We're trying to get about a 6% of revenue from a capital standpoint, and we kind of say that at a mid-cycle price. We just say at $15, we would aspire to get to 6%, and we're a bit above that now. Prices are a little lower than that. That includes some small capital projects that give us productivity, incremental benefit, cost out type programs in that. So that's kind of where we're driving. And if we get to that point, then we'll reassess and see if we can do something different like that. But we're above that at the moment, but that's where we're headed.
Neal Sheorey: And Chris, this is Neal. Maybe just to give you a little bit of color. We actually provided a chart. We didn't provide it this quarter because nothing has changed about it. But if you look at our last quarter earnings deck, we provided a chart with a little bit of that breakdown of our capital spending. As you can imagine, because of the reductions we've made, there's very little capital that we're spending on incremental growth right now. Most of it is going into regulatory, maintenance capital, those kinds of things. And it wouldn't surprise me if you go back and look at that chart. You'll probably come to a number in the, call it, $400 million or $500 million kind of range that's in that sustaining bucket.
Operator: Our next question comes from Joel Jackson with BMO.
Joel Jackson: First question, there's been some reports over the last week or so that one chemical conversion plant or chemical plant in China broke a long-term contract, broke floor pricing. know that you did nothing gets reset this year. I think some need reset next year in your own book. Are you starting to see some discussions with your customers asking questions as the lithium price keeps sort of eroding slowly here?
Kent Masters: I'm not exact sure of the question, Joel, what you're getting at. So let me start-
Joel Jackson: You came back that a chemical plant in China broke its long term contracts and broke its floors. Are you seeing any discussions from customers on asking if they can break their floors too?
Kent Masters: I would say no. Not any different than we have for the last three years. We all talk about this. Our contracts evolve over time, and we've adjusted them. So we did have contracts in the last cycle that, the floors did not hold, and we've adjusted the nature of the contract and who we contract with. So that’s why you see us go more to the spot market in China. But our contracts are holding, and, that doesn't mean that we don't renegotiate them over time. If our customer wants something, we want something. If we can find a middle ground, we adjust. We've done that over time, and I how it goes, how this market works over time. But I think our contracts are holding and doing what we expect them to do.
Joel Jackson: And then it's kind of a two part, my second question, but would you first agree that what's caught the market off guard the last couple years is not demand. Demand's been fine. It's been just supply. And then following up on that in a prior question that was asked on this call, you have a very granular demand outlook. The supply outlook or comments you gave seem like more high level. Do you not worry that the supply there, it's hard to see it coming. And, you know, even with great demand growth, it's going to lead to a tough market, because there is so much supply out there. It's hard to see.
Kent Masters: It is difficult to understand the supply side. I think the demand side as well, but there's more external people looking at it, and people report on that. So it's, I think, a little easier to get your head around it. Supply is a little different. It's stickier. Things that we are pretty sure are losing cash or still operating. Difficult to understand that, how long people can hold on to that. So there will be pluses and minuses that we don't necessarily see coming on the supply side, but I think what gives us some comfort is that long term, that marginal cost that is required to get the volumes that are necessary to meet demand means prices have to be higher or those investments won't happen. So I think that's the best way I can answer that question.
Operator: Our next question comes from Vincent Andrews with Morgan Stanley.
Vincent Andrews: Neal, could I ask you, the $350 million of deferred revenue that came in, it's obviously cash on your balance sheet now, but it's also a deferred liability on your balance sheet. So I'm wondering, do the credit rating agencies, when they look at your metrics, do they give you complete credit for the $350 million in the net debt to EBITDA calculation, or do they haircut it by some amount because, ultimately, you have to deliver on that revenue and their costs associated with doing such?
Neal Sheorey: Without getting into maybe the specifics of our discussion with the rating agencies, yes, they do give us credit for that prepayment, and it has to do with the way in which we've structured that prepayment. But I think more importantly, the discussion with the rating agency hasn't just been about the prepayment. It's been about really the collective series of actions that the company has done to ensure that we have the financial flexibility and keep working our leverage down and get it under control. So I think, outside of the prepayment even, they've been very happy with the focus that we've had as a team on ensuring we've got the right metrics going forward.
Vincent Andrews: And just as a follow-up, on cash flow from financing this year, last year, had about $350 million of outflows, most of which was the common and the preferred dividend. But I think there was about $50 million or $60 million of other items in there. Would you anticipate a similar amount of that this year to $50 million, or would it be less than that or a little bit more? Any thoughts there?
Neal Sheorey: I'm trying to remember, sort of where we sit right now, on all those miscellaneous items. That's probably a good assumption for now, Vincent. I can always have the IR team get back to you, but I don't expect a lot of noise in that, in that part of the cash flow statement outside of the dividend payments that we have.
Operator: Our next question comes from David Deckelbaum with TD Cowen. Your line is open.
David Deckelbaum: Neal, maybe for you, I just wanted to clarify. As you think about maybe the $9 a kilo scenario, if that persists in the ‘26, given all of the cost cuts that you guys have exceeded on so far, you guys guided on the EBITDA margin for the second quarter and obviously highlighted the strength in the first quarter. How do you sort of think of the normalized EBITDA margin for the Energy Storage business exiting this year in sort of a $9 a kilo world?
Neal Sheorey: So, look, I think there are a couple of things. The Energy Storage business obviously is generating healthier margins, and we talked about this in the prepared remarks that the quality of the of the business and of the company has improved because of the cost savings. As you roll over into next year, I think there are a couple of things that are at flat pricing, there's couple of things that are working in our favor here. You know, obviously, as we get into 2026, number one is our assets will be further ramped. That's the Salar Yield Improvement Project. That's Meishan, Kemerton, etc. So that should help with our fixed cost absorption and, obviously, incrementally improve the energy storage margin. I think another piece of this also is that, you will have more production coming out of, Greenbushes with the CGP-3 investment then coming online. So that's obviously not only a benefit for that JV, but that also means that we can push more of that Greenbushes spot through our own operation and even maybe, leverage some of our tolling network as well to increase our volumes in the market too. So, look, I think net net, not counting on price, I think that we still have some tailwinds that can be beneficial to the energy storage business, even going into 2026. And by the way, I forgot to mention, then you have a full year also of the cost savings. So not only do we- this year, obviously, we are ramping into the cost savings, and we're continuing to deliver that. We hope to be at a pretty high run rate by the end of this year. Then next year, you obviously get the full benefit of that, through the entire company, but, of course, the Energy Storage business benefits from that as well.
David Deckelbaum: As my follow-up, just maybe for Ken, just a higher level question. In the outlook, you talked about that industry is obviously operating below incentive price levels now. How do you think about if pricing were to move to incentive levels, what is sort of the incentive price for Albemarle to begin spending growth CapEx again? And I guess, given some of the recent focus on the balance sheet and obviously on margin and cost savings, how long would you need to see a price response back to incentive levels before looking to get out of maybe maintenance level and start investing for long-term growth versus perhaps shoring up the balance sheet?
Kent Masters: Yeah. So I mean, look. Our priorities now is we are shoring up the balance sheet, making sure we're in the right position there. Look, the incentive price for different projects are all going to be different. And depends on where they are, what it is, whether it's resource from a resource perspective or conversion, they're all at different prices. And it's. whether it bounces back and the prices bifurcate by market would be another indicator of that. So those would be some of the things we would need to see, and we get a little price room, we're not going to jump toward kind of big investments. We're going to be a little bit cautious here. And as you say, shore up the balance sheet is our priority at the moment is to make sure that we can manage this business through the cycle. So we do think there are going to be cycles both up and down, and we have to make sure we're in the right position for that and balance that with the growth because we want to make the investments in the right place. And we do have access to resources, world class resources that we can invest behind, that's probably where you see us go first.
Operator: Our next question comes from Arun Viswanathan with RBC. Your line is open.
Arun Viswanathan: Congrats on the Q1 performance. First off, you mentioned the potential for grid storage to drive maybe some slightly better than expected volumes or maybe in the upper end of that range. Could you just discuss maybe some more of your efforts there and or maybe even within the industry? Have you seen any further commercialization there? And what's Albemarle's participation there?
Kent Masters: Yeah. So I mean, the fixed storage or grid storage, we tend to call it fixed storage, but it's the same thing. It has, over the last few years, been about renewables and then balancing that with storage. So there were regulations in China that if you did renewables, you're required to put storage with that renewable at the same location. That regulation has changed, but you're still required to do fixed storage, but it can be done centrally. So that's a little bit of a shift in the regulation, but it's the incentives are still there, and that's a growing space now. It's becoming a little bit more about grid stability around AI data centers and things like that. So same application, interestingly enough, we're selling it to the same customers. We sell to the same location, and but they're selling into different segments. And, a few years ago, we had trouble understanding where the volume was going into, right, whether it was fixed storage or mobility or EVs, and we've spent some time trying to understand that a little better. We have a better handle on it than we did. But even today, we sell to the same customers, and that goes into the EV market or to the fixed storage market based on their book of business. So it's opportunistic, and it's been a good space for us. Frankly, a couple of years ago, we didn't think it was a place for lithium to play, that it would be a minor spot. Fixed storage now is getting close to 20% of the demand for lithium. And last year, it grew more than EVs marginally, but still it was growing there. So it's going to be an important component of our portfolio over time.
Arun Viswanathan: I guess, last year, we did see some curtailments over the summer. You noted that several other competitors in the lithium space may be in uneconomic territory. So do you expect some similar curtailments this year as you move into the summer? And similarly, do you expect curtailments based on environmental regulations? Or maybe you can just comment a little bit about supply given you've already commented on demand.
Kent Masters: I don't have a way of saying what everybody in the industry is going to do. We know that there's pressure because of the cost position and where prices are. There'll be pressure on people, and how long they hold out and operate at breakeven or less is hard to say. We have seen some assets, the highest ones we know have come out of the market, and we don't see them coming back in the near term. And, there'll be pressure for others to come out of the market, but I can't say when and if they do it. It's impossible to call. And then environmental pressure, around lepidolite in China, assuming that's what you're talking about, we have don't have great insight into that.
Operator: Our next question comes from Laurence Alexander with Jefferies.
Unidentified Analyst: This is Dan Rizwan for Laurence. How does your strategy shift if governments subsidize supply and keep prices at the lower end of the range?
Kent Masters: Yeah. I guess our strategy is make sure that we are at a cost position and competitive at the bottom of the cycle wherever that is. And what gives us confidence we can do that is the quality of the resources that we have. That allows us to participate at the very bottom of the cycle. And I don't think it can stay there forever. So there will be opportunity, but the strategy really is the same. It's to leverage the quality of the resources we have and to make sure that we are very cost efficient.
Operator: Our next question comes from Pete Osterland with Truist.
Pete Osterland: First, just wanted to ask a clarification on the mix impact driving the energy storage margin guidance. You're expecting 50% of volumes on LTAs for the year. What percentage are you expecting to be sold under LTAs in the second quarter?
Kent Masters: We don't give that level of specificity by the quarters. Like I said, I think I will lean back on my answer earlier on the call, which is in the first quarter, we had lower volumes and a little bit more of our mix was on those LTAs. As you think about the second quarter, think about, as a percentage wise, there will be less volume on the LTAs and more as we ramp our volumes, more will be on those other contracts that we have that are more tied to current market prices or current spot. And so that's the mix point that we're trying to make here is that as we ramp those volumes, there will naturally be more volumes on those kinds of contracts, and that will lead to the margin being a little bit lower in Q2 versus Q1.
Pete Osterland: I also wanted to ask about recent news that there's going be some new derivatives contracts for battery materials, including lithium being launched in June. What impact do you think that this could have on your lithium contract? I mean, you get any sense from customers that whether it's duration or pricing terms of how your contract mix would evolve if there's additional pricing transparency in the market?
Kent Masters: Yeah. I would say it won't have much of an impact initially, and it could over time if they take hold and there's more volume in the space, but there are other financial instruments out there now that you can hedge, but they're not significant, from a volume standpoint. So it doesn't impact us on a material basis. And I think that would be the same way at least in the near term. If they take hold, and we anticipate they will over time and they become a larger piece that our customers could hedge and we could hedge and do things a different way, but that volume is not available today.
Operator: Our final question comes from Andres Castanos with Berenberg.
Andres Castanos: My question will be on bromine, please. Have you noticed any changes in the situation of bromine and bromine derivatives from the USA to China? Has this impacted bromine pricing in general or at least in maybe some decoupling in the two regions?
Kent Masters: I don't know that we've seen a change. They do move in that direction. They have over time. I don't know that we've seen a significant change in derivatives from bromine moving to China.
Eric Norris: No. We haven't seen any change in that. Tariffs have played a role and a potential role, but there's been some exemptions as well that have allowed. So there hasn't been any real material change in the flow. And maybe the biggest short term change is just a response to maybe a shortage supply in the industry that moved prices over the last month from $3 a kilogram to a high of $5.14 a kilogram, but that's since come back down to between a range of $3 and $3.29. So that's moved through the system already.
Operator: Thank you. That's all the time we have for questions. I will now pass it back to Kent Masters for closing remarks.
Kent Masters: Thank you, operator. And to wrap up, Albemarle's strong operational execution and strategic framework positioned us to effectively navigate market conditions and maintain our long term competitive advantages, including our world class resources, process chemistry expertise, and our customer centric market approach. We are dedicated to delivering value for our stakeholders and driving sustainable growth. Thank you for joining us today, and we look forward to seeing you face to face at the upcoming events you see on the next slide listed on slide 20. Stay safe, and thank you.
Operator: This concludes today's conference call. Thank you for your participation. You may now disconnect. | [
{
"speaker": "Operator",
"text": "Hello, and welcome to Albemarle Corporation's Q1 2025 Earnings Call. I will now hand it over to Meredith Bandy, Vice President of Investor Relations and Sustainability."
},
{
"speaker": "Meredith Bandy",
"text": "Thank you, and welcome, everyone, to Albemarle's First Quarter 2025 Earnings conference call. Our earnings were released after market closed yesterday, and you'll find the press release and earnings presentation posted to our website under the Investors section at albemarle.com. Joining me on the call today are Kent Masters, Chief Executive and Neal Sheorey, Chief Financial Officer Netha Johnson, Chief Operations Officer and Eric Norris, Chief Commercial Officer are also available for Q&A. As a reminder, some of the statements made during this call, including our outlook, guidance, expected company performance and strategic initiatives may constitute forward-looking statements. Please note the cautionary language about forward-looking statements contained in our press release and earnings presentation that also applies to our call. Please also note that some of our comments today refer to non-GAAP financial measures. Reconciliations can be found in the earnings materials. And now, I'll turn the call over to Kent."
},
{
"speaker": "Kent Masters",
"text": "Thank you, Meredith. For the first quarter, we reported net sales of $1.1 billion including increased specialties volumes and record lithium production from our integrated lithium conversion network. Adjusted EBITDA was $267 million reflecting strong year-over-year improvements in specialties and kitchen. We generated $545 million in cash from operations, achieving an operating cash conversion rate exceeding 200%. We are maintaining our 2025 outlook considerations based on recently observed lithium market prices. These considerations include the anticipated direct impact of tariffs announced to date. Note that the direct impact of tariffs is expected to be minimal as Albermarle benefits from global diversification and current exemptions, particularly for critical minerals such as lithium salts and spodumene. Neal will provide more details on this later in the call. Regardless of shifts in the external market environment, Albemarle remains focused on controllable factors to ensure competitiveness through the cycle. To that end, we continue to act decisively across four key areas, optimizing our conversion network, improving cost and productivity, reducing capital expenditure and enhancing financial flexibility. For example, through April, we achieved approximately 90% run rate to get to the midpoint of our $350 million cost and productivity improvement target. And our team has identified opportunities to reach the high end of the $300 million to $400 million range. This includes incremental volume improvements as we ramp our new facilities and cost savings from placing our Chengdu site on care and maintenance. This quarter, we are also providing updated forecasts for global lithium market demand and supply. We anticipate global lithium demand growth in the 15% to 40% range in 2025, depending on tariff impacts, policy changes and macroeconomic trends. Longer term, we expect the lithium demand outlook to remain robust, more than doubling from 2024 to 2030, driven by the energy transition and global demand for electric vehicles and grid storage. Incentivizing supply growth requires long term lithium pricing well above current spot prices. Now, I'll turn it over to Neal, who will provide more details on our financial performance and outlook considerations. I will conclude our prepared remarks with further details on our lithium market forecast before opening the call for Q&A."
},
{
"speaker": "Neal Sheorey",
"text": "Thank you, Kent, and good morning, everyone. I will begin with a review of our first quarter financial performance on slide 5. We reported first quarter net sales of $1.1 billion which were lower year-over-year, mainly due to lower lithium market pricing. The pricing decline was partially offset by higher volumes in specialties. Energy storage volume was flat year-over-year as we optimized our own lithium conversion network and reduced the need for tolling volumes. First quarter adjusted EBITDA was $267 million down 8% year-over-year, as lower input costs and ongoing cost and productivity improvements partially mitigated the impact of lower lithium pricing and reduced JV pretax equity earnings. Our focus on cost is showing through in the improved quality of our business, evidenced by our adjusted EBITDA margin improving by approximately 400 basis points year-over-year. Earnings per share was breakeven in the first quarter. Adjusted diluted earnings per share was a loss of $0.18 after preferred dividends and excluding discrete tax items and other nonrecurring factors. Slide 6 highlights the drivers of our year-over-year EBITDA performance. As I mentioned, Specialties drove the volume benefit, while energy storage volume remained stable due to ramping conversion plants balanced by lower tolling volumes. Q1 adjusted EBITDA was down slightly due to lower lithium pricing and pretax equity income, partly offset by reduced COGS from lower cost spodumene. Our SG&A costs were down more than 20% year-over-year due to our restructuring and cost savings initiatives. Adjusted EBITDA increased by 30% in Specialties and 76% in Ketjen year-over-year. Corporate EBITDA declined due to a foreign exchange loss compared to last year's gain. Turning to slide 7 for an update on the recently announced tariffs. The focus of our comments today will be on the direct impact of the tariffs that have been announced or amended as of this earnings release. We estimate the direct impact of the tariffs in 2025 to be relatively modest at approximately $30 million to $40 million on an unmitigated basis. This impact is mostly attributed to Specialties and Ketjen. Notably, the direct impact on our energy storage business is expected to be effectively zero as most of our lithium production is sold within Asia. Additionally, we benefit from current exemptions for critical minerals, such as lithium salts and spodumene. Our teams are actively working on mitigations to these impacts, and we expect the mitigated impact could be significantly lower. In some jurisdictions, we have inventories that help to mitigate near term impacts in other cases, tariffs present opportunities to increase sales in countries with lower tariffs. For instance, we may be able to capitalize on our US manufacturing footprint to sell more bromine products from Magnolia into US end markets. While the full economic impact of the recently announced tariffs and other global trade actions is unclear, we benefit from our global footprint and the current exemptions for critical minerals. As a result, we're able to maintain our full year 2025 outlook considerations even with the anticipated direct impact of tariffs announced to date. Moving to slide 8. As usual, we are providing outlook scenarios based on recently observed lithium market pricing. And on this slide, we have presented Albemarle's comprehensive company roll up for each lithium market price scenario. As I just mentioned, these outlook considerations have not changed since we unveiled them last quarter. As a reminder, we have provided modeling for three price scenarios, including: year end 2024 market pricing of about $9 per kilogram lithium carbonate equivalent, or LCE the first half 2024 range of $12 to $15 per kilogram LCE and the fourth quarter 2023 average of about $20 per kilogram LCE. All three scenarios reflect the results of assumed flat market pricing across the year in conjunction with Energy Storage's current book of business, with ranges based on expected volume and mix. Turning to slide 9 for additional outlook commentary by segment. First, in Energy Storage. As a reminder, for 2025, approximately 50% of our lithium salts volumes are sold on long term agreements with floors. Our contracts continue to perform in line with our forecast, and we have no significant contracts up for renewal this year. With these long term agreements, plus other sales on contracts with volume commitments and market based pricing, we continue to expect volumes to be slightly higher year-over-year. This is primarily due to the ongoing ramp of the Salar yield improvement project in Chile, plus production ramps at our conversion sites, which helps improve fixed cost absorption and results in reduced tolling volumes. We realized a strong first quarter Energy Storage EBITDA margin of 36%, thanks to lower input costs and a greater proportion of lithium salts sold under long term agreements. Second quarter margin is expected to be lower due to a lower proportion of lithium salts sold under long term agreements. Net net, we continue to expect the full year and the first half 2025 Energy Storage EBITDA margin to average in the mid-20% range, assuming our $9 per LCE price scenario. In Specialties, we continue to expect modest volume growth year-over-year. We also expect to see revenue and pricing improvements mid-year, partially due to steady demand and temporary industry supply disruptions. Q2 EBITDA is expected to be lower primarily due to product mix. Finally, at Ketjen, we expect modest improvements in 2025 related to product mix, continued execution of our turnaround plan. While revenue is expected to improve sequentially, Q2 EBITDA is expected to be lower due to product mix. Please refer to our appendix slides in the deck for additional modeling considerations across the enterprise. Advancing to slide 10. We continue to progress broad initiatives designed to maintain our long term competitive advantages through market cycles. Given the ongoing dynamic environment, we are consistently augmenting our playbook of potential measures to ensure timely adaptation as required. In terms of optimizing our lithium conversion network, we achieved record quarterly production at five sites across our company operated conversion network, La Negra, Kemerton, Xinyu, Qinzhou and Meishan. Meanwhile, since our announcement last quarter, we've shifted operations at our Chengdu facility, which is ramping down and preparing to go into care and maintenance. These actions allow for lower cost to serve, better fixed cost absorption and reduced tolling volumes. Second, improving costs and productivity. We have moved rapidly on our $300 million to $400 million cost and productivity target and have already reached an approximately 90% run rate against the midpoint of the savings range. And additionally, we have identified opportunities to reach the high end of the range and are already developing execution plans to drive those benefits. These opportunities include further reductions to non-headcount spending, supply chain efficiencies, and further volume improvements at key manufacturing sites. Third, we remain on track to reduce capital expenditures by more than 50% year-over-year. And finally, we remain focused on enhancing our financial flexibility and driving cash flow generation and cash conversion even in this uncertain market environment evidenced by our more than 200% operating cash conversion in the first quarter driven by the receipt of the customer prepayment. In summary, we remain focused on our deep and broad playbook of actions in our control, and we continue to execute successfully across our planned operational and financial priorities. Turning to our balance sheet and liquidity metrics on slide 11. We ended the first quarter with available liquidity of $3.1 billion largely made up of $1.5 billion in cash and cash equivalents and the full $1.5 billion available under our revolver. The measures we've implemented to control costs, capital spending and cash conversion have also enhanced our financial flexibility. As a result of our proactive efforts to reduce costs and optimize cash flow, we ended Q1 with a net debt to adjusted EBITDA ratio of 2.4 times. Slide 12 highlights our commitment to effective execution and converting earnings into cash. This is demonstrated by improved operating cash flow conversion resulting from operational discipline and efficient cash management. In the first quarter, operating cash conversion exceeded 200%, a large part of which was driven by the customer prepayment received in January. However, even when excluding this prepayment, first quarter operating cash conversion was 73%, above our long range target, thanks to the timing of Talison dividends, enhancements in inventory and other cash management actions across our enterprise. And just as important, we delivered slightly positive free cash flow without the customer prepayment. As we said last quarter, we anticipate that our 2025 cash dividends from the Talison JV will be below historical average as Talison completes its CGP3 capital project at the Greenbushes mine. Nevertheless, we expect operating cash flow conversion to surpass 80% in 2025, exceeding our long term target range, driven by ongoing working capital improvements and the $350 million customer prepayment. Combining that with our capital spending range of $700 million to $800 million, we maintain our expectation of breakeven free cash flow for the full year of 2025. I'll now turn it back to Kent."
},
{
"speaker": "Kent Masters",
"text": "Thanks, Neal. Now I'll cover our long term lithium supply demand outlook. Lithium is vital for the energy transition, and our long term business drivers are robust. Beginning on slide 14, 2025 EV demand growth is off to a strong start led by China, with EV sales up 41% year-to-date, driven by subsidies for battery EVs and plug in hybrids. China now represents approximately 60% of the overall market demand. Europe also had a strong start to the year with sales up 19% in January and February, thanks to a step change in regulatory emission targets. Finally, North America grew 17% year-over-year with US trends improving due to greater model availability and affordability. Overall, these trends reinforce confidence in the industry's long term growth potential and continue to highlight that the regional dynamics are important factors to consider as the industry expands. Turning to slide 15, we expect lithium demand to more than double from 2024 to 2030, driven primarily by stationary storage and electric vehicle demand. Near term, we expect 2025 demand growth in the range of 15% to 40%, a wider than usual range reflecting uncertainties around tariffs and other trade actions and their impact on the macroeconomic environment. We feel confident in the ability to reach the low end of the range given year-to-date performance, revised EU emission targets and even modest growth in China. The high end of the 2025 outlook range assumes strong grid installations, particularly in China and South Asia, plus Europe and China EV sales growth continuing closer to the year-to-date trend. For what we know today, we see the most likely outcome being a growth rate in between these two extremes in the mid 20% range or similar to the growth rate in 2024. These figures include the anticipated impact of tariffs announced to date under current macroeconomic conditions. However, they do not include the impact of a global economic recession. We expect lithium supply to remain relatively balanced over the forecast period given recently announced and ongoing project curtailments and delays. Incentivizing supply growth to meet long term demand requires prices well above current levels. The global energy transition is undoubtedly progressing. It is a matter of how fast, not if. Globally, electric vehicle market penetration or share of vehicle production is expected to exceed internal combustion engines by the end of the decade. In China, EV production is expected to overtake ICE production by as early as this year. European EV penetration is driven by the EU's CO2 emissions targets and is expected to reach 65% by 2030, assuming the current policies remain in effect. The US EV market is earlier in its development with a range of outcomes primarily reflecting uncertain policy impacts. On the supply side, there have been several announced curtailments both upstream and downstream. Non-integrated hard rock conversion remains unprofitable and large integrated producers are facing pressure. As prices have declined, we now believe that about 40% of global capacity is currently either at or below breakeven, of which only about one-third has come offline. In a growing market, all of that supply and more is required to meet long run demand. In fact, we estimate lithium supply must double by 2030 to keep pace with demand. As a result, we continue to expect that prices well above current levels are required to support the necessary investment. In summary, on slide 18, Albemarle delivered solid first quarter performance while continuing to act decisively to preserve long-term growth optionality and maintain the company's industry leading position through the cycle. We are maintaining our full year 2025 company outlook considerations, building on the progress we've made to drive enterprise wide cost improvements and strong energy storage project ramps. We are progressing broad based comprehensive actions to manage controllable factors and generate value across the cycle. I am confident we are taking the necessary steps to maintain our competitive position and to capitalize on the long term secular opportunities in our markets. With that, I'll turn the call back over to the operator to begin the Q&A portion."
},
{
"speaker": "Operator",
"text": "[Operator Instructions] Our first question comes from Rock Hoffman with Bank of America. Your line is open."
},
{
"speaker": "Rock Hoffman",
"text": "We're already one third done with, the year. Could you speak a little more to, the different scenarios which may get the demand to lower the higher end of that, guided 15% to 40%, within the vendor in 2025?"
},
{
"speaker": "Kent Masters",
"text": "Yeah. So I guess okay. So that's right. We're about a third in, but it's a pretty uncertain environment at the moment. So and that reflects the range that we put out there, why it is as wide as it is. And we said in our comments, we thought for lack of another number, I mean, the middle of the range is kind of what we think is reasonable at the moment. I mean, that's the two extremes are kind of the downside and the upside. So either everything going the wrong way or everything going in the right direction. So our best view at the moment, it's in the mid 20% range. That's our view. We're off to a good start, so it was stronger than that. And we know that some of that was pulled from last year a little bit. So our best guess is in the mid-twenties."
},
{
"speaker": "Rock Hoffman",
"text": "And just as a follow-up, could you speak a little more to the progress in your productivity initiatives? And given you're already 90% of the way through the midpoint, in other words, roughly $315 million run rate, Is there upside to that $400 million high end either in 2025 or thereafter?"
},
{
"speaker": "Kent Masters",
"text": "Yeah. So we're kind of fighting to get to the top end of that range, but that's a this is a kind of a one off program. We look at productivity and those type benefits as something that we constantly do. But we think we can get to the top end of the range. We've gotten to kind of 90% of it at the moment to the at least the midpoint. And we think we'll get to the top end of that range, but then we'll keep working on that. So productivity is kind of a constant thing. It is not something that's going to end when this program is over, and we'll continue to look for opportunities around that."
},
{
"speaker": "Operator",
"text": "Our next question comes from John Roberts with Mizuho Securities. Your line is now open."
},
{
"speaker": "John Roberts",
"text": "Back to the range on lithium demand forecast, do you have an opinion on how hard or easy it would be for US and European EV makers to copy some of the recent Chinese breakthroughs in cell pack design? How easy or how hard?"
},
{
"speaker": "Kent Masters",
"text": "I think look. We're still early in the technology curve around lithium ion batteries and other batteries in the similar space. Right? So we are still early, either on the ones that are the more mature, like the high nickel and LFP. I think we're still early in that cycle. So you're going to still see advancements. You're going to see them from global players regardless of what geography they're in. So I think there's still a lot to play out around energy storage and whether it's lithium ion or sodium, for example. We're still early in that technology curve. So there there's a lot of room for improvement and from a variety of different players."
},
{
"speaker": "Operator",
"text": "Our next question comes from Colin Rusch with Oppenheimer. Your line is now open."
},
{
"speaker": "Colin Rusch",
"text": "Thanks so much, guys. This one's for Neal. I mean, if you look at the industry now that we've seen some deeper rationalization, how are you thinking about cross cycle cash management and return on investment if we think about a three to five year time period around those stock?"
},
{
"speaker": "Neal Sheorey",
"text": "So, look, from a cash management standpoint or maybe, more importantly, I think where I go to first is thinking about the cash conversion, of this company. Obviously, for the work that we are doing around our cost savings, ramping our assets, and so on, if I look over the next three years, we've set a range of, 60% to 70% kind of cash conversion as our benchmark, and that's what's turned up as we've done benchmarking with similar companies. And so that's something that we want to strive for, not just performing that way in a single year, but really being able to do that in a more consistent way. And I think as we line out our assets and, you know, get through our cost savings and work on the productivity initiatives that Kent mentioned, I think that we can get there, and we can do that in an in a ratable way. We've also said from a- this kind of ties into the cash management piece from a leverage standpoint. Obviously, we want to be lower than where we are today. We've always said that less than two and a half times across the cycle is our target. We're not there today, so we're going to keep working on that. And you've seen the things that we've done to enhance our financial flexibility and make sure that we have, we're moving in the right direction on that front. So, look, I don't think there's a big change in our long term targets, but I hope what you hear from our comments today and the performance that we've had over the last several quarters is that we are very focused every day on ensuring that we're driving to those targets or better, kind of using this benchmarking mindset, to guide our actions."
},
{
"speaker": "Colin Rusch",
"text": "And then just on the lithium contracting strategy, I appreciate the comments that you don't have any major contracts rolling off this year. As you see the landscape evolving a little bit and we start to see autonomous vehicles start to drive more EV adoption. Is there another cycle where you guys will have a little bit more leverage around contract negotiations and pricing as folks really start to attack the autonomous vehicle market here by the end of the second?"
},
{
"speaker": "Kent Masters",
"text": "I think from just from our contracting strategy, I think, ultimately, it doesn't change. It evolves. And I think our customers, they want to have long term security of supply, the contracting element is part of that. Different markets have different preferences from a contracting or not contracting standpoint. So the Chinese market is, for the most part, spot. But a lot of the OEMs and players within the industry, particularly in the West, like to have a contract. They like that security of supply. They know that they've got that supply lined up for them. So I think we'll continue to do that. Up around where it's autonomous or not in that market, I'm not sure that changes our contracting strategy. I think, it will evolve over time depending on the way the industry evolves, but I still see us having a mix. And we always talk about the portfolio we have. So we have a certain amount of our portfolio in spot. We like having a certain part of that. We like having a piece in contracts. We see that it allows us to play in various parts of the market and mitigate risk in certain contractual strategies. So you'll always see us with that portfolio. It will probably shift a little bit over time depending on the market."
},
{
"speaker": "Operator",
"text": "Our next question comes from Patrick Cunningham with Citi. Your line is open."
},
{
"speaker": "Unidentified Analyst",
"text": "Good morning. This is Rachel on for Patrick. Very helpful view on the lithium demand. I guess, how much of the strong demand year-to-date would you attribute to tariff prebuying? And any concerns on gas at risk for ESS given the tariffs?"
},
{
"speaker": "Kent Masters",
"text": "I'm not sure if much of it was tariff prebuying so much as it is was about- we do know that our customers have told us they shifted volume from the end of last year into this year more about regulatory issues in Europe than anything else. And it was a strong start to the year. I'm not sure we can define exactly what that it was, so we didn't have as weak of a period around Lunar New Year as we normally do. So it was a little stronger on that. I don't think it was tariff related, but with regulatory in Europe and to be honest, I'm sure why it was stronger than it was in China, but it was."
},
{
"speaker": "Unidentified Analyst",
"text": "On the supply side, you've mentioned supply curtailments, but we've continued to see that supply response mainly from China. So do you think there are particular regions where you expect to see supply removed or any large project cancellations?"
},
{
"speaker": "Kent Masters",
"text": "I think well, and it's going to be nonintegrated hardrock conversion. Right? So either the hardrock resource or that conversion is- they're in the difficult part on the cost curve. So that's probably where we see that, and we see it more in Western players than we would in Chinese players."
},
{
"speaker": "Operator",
"text": "Our next question comes from Aleksey Yefremov with KeyBanc."
},
{
"speaker": "Aleksey Yefremov",
"text": "Just to stay with the lithium market. You're forecasting demand to grow 200 to 600 kilotons this year. How much do you think the upstream capacity would be added this year as well?"
},
{
"speaker": "Kent Masters",
"text": "So I think so you're basically saying supply demand. Right? So given the market growth, we see how much comes on. So there's room to absorb that, but there is still some capacity that will come on. I don't know exactly. I mean, our view of supply demand essentially stays more or less the same throughout the year unless a significant amount comes off."
},
{
"speaker": "Aleksey Yefremov",
"text": "And then about your feedstock costs, we saw that cost of mining fell at Wodgina. I don't know if you really saw the benefit of that this quarter or expect to see later this year. But could you also broadly talk about your outlook for mining costs at both Wodgina and Greenbushes and maybe La Negra as your volumes ramp in Chile?"
},
{
"speaker": "Kent Masters",
"text": "Yeah. So, like, I guess you'd have to go through each of those. I mean, we're driving Greenbushes there is pretty mature. We've got a lot of initiatives around that where we're getting more focused on the mining, so we are able to drive cost from that. CGP-3 will be the next big step there, and that program comes on later in the year. So you'll get a little bit more scale, which will help us on a cost standpoint. Well, I'd do know we're working through a probably a difficult part of the mine at the moment to remove material and get to the best ore there. So it's higher at the moment, but we expect to get the better cost position there. And LA Negra is one of the lowest - from the Florida Atacama, the one of the lowest sources, lowest cost sources resource in the world. So we continue to drive, productivity and operations there. The Salar Yield project is ramping up. We had record production at La Negra in this particular quarter, so that's all going well, which should drive the cost down slightly. Those are incremental improvements, but they move to drive the cost down as we leverage the fixed cost over more volume."
},
{
"speaker": "Operator",
"text": "Our next question comes from Chris Perrella with UBS."
},
{
"speaker": "Chris Perrella",
"text": "I wanted to follow-up on the margins within Energy Storage. And how much lower, I guess, are contract sales in 2Q? And how do the volumes ramp over the course of the year to sort of come out to your mid-20% margin target for the full year?"
},
{
"speaker": "Neal Sheorey",
"text": "This is Neal. Maybe I can give you a little bit of color here. So, you know, the first thing, to highlight about the first quarter is, historically, just in general from a seasonality perspective, the first quarter is usually a slower volume quarter for energy storage. And I think you can see that in our deck. We provided our production in energy storage. It was around 40 kT in the quarter, and that's less than 25% for the year. And so what you should expect is that there will be our higher volume months tend to be in the second and the third quarter. And, usually, with those higher quarter months, what that means is that there's more volume that is going to be sold off of our long term agreement. So those are going to be at prices a little bit more like current market prices or current spot prices. So that's why we say from an energy storage perspective, it's more of a mix as the volume ramps up over the next couple of quarters. And that's why we see the margin kicking lower in the second quarter versus the first quarter."
},
{
"speaker": "Chris Perrella",
"text": "All right. And just a follow-up question. With the cutback in CapEx and the ramping or the remixing of your production or optimizing of your conversion network, where do you guys see maintenance CapEx on a go-forward basis when everything settles out over the course of this year?"
},
{
"speaker": "Kent Masters",
"text": "When you're asking the question, I was thinking about a longer term answer rather than this year. So I think it's going to be a little longer term, but look. We're trying to get about a 6% of revenue from a capital standpoint, and we kind of say that at a mid-cycle price. We just say at $15, we would aspire to get to 6%, and we're a bit above that now. Prices are a little lower than that. That includes some small capital projects that give us productivity, incremental benefit, cost out type programs in that. So that's kind of where we're driving. And if we get to that point, then we'll reassess and see if we can do something different like that. But we're above that at the moment, but that's where we're headed."
},
{
"speaker": "Neal Sheorey",
"text": "And Chris, this is Neal. Maybe just to give you a little bit of color. We actually provided a chart. We didn't provide it this quarter because nothing has changed about it. But if you look at our last quarter earnings deck, we provided a chart with a little bit of that breakdown of our capital spending. As you can imagine, because of the reductions we've made, there's very little capital that we're spending on incremental growth right now. Most of it is going into regulatory, maintenance capital, those kinds of things. And it wouldn't surprise me if you go back and look at that chart. You'll probably come to a number in the, call it, $400 million or $500 million kind of range that's in that sustaining bucket."
},
{
"speaker": "Operator",
"text": "Our next question comes from Joel Jackson with BMO."
},
{
"speaker": "Joel Jackson",
"text": "First question, there's been some reports over the last week or so that one chemical conversion plant or chemical plant in China broke a long-term contract, broke floor pricing. know that you did nothing gets reset this year. I think some need reset next year in your own book. Are you starting to see some discussions with your customers asking questions as the lithium price keeps sort of eroding slowly here?"
},
{
"speaker": "Kent Masters",
"text": "I'm not exact sure of the question, Joel, what you're getting at. So let me start-"
},
{
"speaker": "Joel Jackson",
"text": "You came back that a chemical plant in China broke its long term contracts and broke its floors. Are you seeing any discussions from customers on asking if they can break their floors too?"
},
{
"speaker": "Kent Masters",
"text": "I would say no. Not any different than we have for the last three years. We all talk about this. Our contracts evolve over time, and we've adjusted them. So we did have contracts in the last cycle that, the floors did not hold, and we've adjusted the nature of the contract and who we contract with. So that’s why you see us go more to the spot market in China. But our contracts are holding, and, that doesn't mean that we don't renegotiate them over time. If our customer wants something, we want something. If we can find a middle ground, we adjust. We've done that over time, and I how it goes, how this market works over time. But I think our contracts are holding and doing what we expect them to do."
},
{
"speaker": "Joel Jackson",
"text": "And then it's kind of a two part, my second question, but would you first agree that what's caught the market off guard the last couple years is not demand. Demand's been fine. It's been just supply. And then following up on that in a prior question that was asked on this call, you have a very granular demand outlook. The supply outlook or comments you gave seem like more high level. Do you not worry that the supply there, it's hard to see it coming. And, you know, even with great demand growth, it's going to lead to a tough market, because there is so much supply out there. It's hard to see."
},
{
"speaker": "Kent Masters",
"text": "It is difficult to understand the supply side. I think the demand side as well, but there's more external people looking at it, and people report on that. So it's, I think, a little easier to get your head around it. Supply is a little different. It's stickier. Things that we are pretty sure are losing cash or still operating. Difficult to understand that, how long people can hold on to that. So there will be pluses and minuses that we don't necessarily see coming on the supply side, but I think what gives us some comfort is that long term, that marginal cost that is required to get the volumes that are necessary to meet demand means prices have to be higher or those investments won't happen. So I think that's the best way I can answer that question."
},
{
"speaker": "Operator",
"text": "Our next question comes from Vincent Andrews with Morgan Stanley."
},
{
"speaker": "Vincent Andrews",
"text": "Neal, could I ask you, the $350 million of deferred revenue that came in, it's obviously cash on your balance sheet now, but it's also a deferred liability on your balance sheet. So I'm wondering, do the credit rating agencies, when they look at your metrics, do they give you complete credit for the $350 million in the net debt to EBITDA calculation, or do they haircut it by some amount because, ultimately, you have to deliver on that revenue and their costs associated with doing such?"
},
{
"speaker": "Neal Sheorey",
"text": "Without getting into maybe the specifics of our discussion with the rating agencies, yes, they do give us credit for that prepayment, and it has to do with the way in which we've structured that prepayment. But I think more importantly, the discussion with the rating agency hasn't just been about the prepayment. It's been about really the collective series of actions that the company has done to ensure that we have the financial flexibility and keep working our leverage down and get it under control. So I think, outside of the prepayment even, they've been very happy with the focus that we've had as a team on ensuring we've got the right metrics going forward."
},
{
"speaker": "Vincent Andrews",
"text": "And just as a follow-up, on cash flow from financing this year, last year, had about $350 million of outflows, most of which was the common and the preferred dividend. But I think there was about $50 million or $60 million of other items in there. Would you anticipate a similar amount of that this year to $50 million, or would it be less than that or a little bit more? Any thoughts there?"
},
{
"speaker": "Neal Sheorey",
"text": "I'm trying to remember, sort of where we sit right now, on all those miscellaneous items. That's probably a good assumption for now, Vincent. I can always have the IR team get back to you, but I don't expect a lot of noise in that, in that part of the cash flow statement outside of the dividend payments that we have."
},
{
"speaker": "Operator",
"text": "Our next question comes from David Deckelbaum with TD Cowen. Your line is open."
},
{
"speaker": "David Deckelbaum",
"text": "Neal, maybe for you, I just wanted to clarify. As you think about maybe the $9 a kilo scenario, if that persists in the ‘26, given all of the cost cuts that you guys have exceeded on so far, you guys guided on the EBITDA margin for the second quarter and obviously highlighted the strength in the first quarter. How do you sort of think of the normalized EBITDA margin for the Energy Storage business exiting this year in sort of a $9 a kilo world?"
},
{
"speaker": "Neal Sheorey",
"text": "So, look, I think there are a couple of things. The Energy Storage business obviously is generating healthier margins, and we talked about this in the prepared remarks that the quality of the of the business and of the company has improved because of the cost savings. As you roll over into next year, I think there are a couple of things that are at flat pricing, there's couple of things that are working in our favor here. You know, obviously, as we get into 2026, number one is our assets will be further ramped. That's the Salar Yield Improvement Project. That's Meishan, Kemerton, etc. So that should help with our fixed cost absorption and, obviously, incrementally improve the energy storage margin. I think another piece of this also is that, you will have more production coming out of, Greenbushes with the CGP-3 investment then coming online. So that's obviously not only a benefit for that JV, but that also means that we can push more of that Greenbushes spot through our own operation and even maybe, leverage some of our tolling network as well to increase our volumes in the market too. So, look, I think net net, not counting on price, I think that we still have some tailwinds that can be beneficial to the energy storage business, even going into 2026. And by the way, I forgot to mention, then you have a full year also of the cost savings. So not only do we- this year, obviously, we are ramping into the cost savings, and we're continuing to deliver that. We hope to be at a pretty high run rate by the end of this year. Then next year, you obviously get the full benefit of that, through the entire company, but, of course, the Energy Storage business benefits from that as well."
},
{
"speaker": "David Deckelbaum",
"text": "As my follow-up, just maybe for Ken, just a higher level question. In the outlook, you talked about that industry is obviously operating below incentive price levels now. How do you think about if pricing were to move to incentive levels, what is sort of the incentive price for Albemarle to begin spending growth CapEx again? And I guess, given some of the recent focus on the balance sheet and obviously on margin and cost savings, how long would you need to see a price response back to incentive levels before looking to get out of maybe maintenance level and start investing for long-term growth versus perhaps shoring up the balance sheet?"
},
{
"speaker": "Kent Masters",
"text": "Yeah. So I mean, look. Our priorities now is we are shoring up the balance sheet, making sure we're in the right position there. Look, the incentive price for different projects are all going to be different. And depends on where they are, what it is, whether it's resource from a resource perspective or conversion, they're all at different prices. And it's. whether it bounces back and the prices bifurcate by market would be another indicator of that. So those would be some of the things we would need to see, and we get a little price room, we're not going to jump toward kind of big investments. We're going to be a little bit cautious here. And as you say, shore up the balance sheet is our priority at the moment is to make sure that we can manage this business through the cycle. So we do think there are going to be cycles both up and down, and we have to make sure we're in the right position for that and balance that with the growth because we want to make the investments in the right place. And we do have access to resources, world class resources that we can invest behind, that's probably where you see us go first."
},
{
"speaker": "Operator",
"text": "Our next question comes from Arun Viswanathan with RBC. Your line is open."
},
{
"speaker": "Arun Viswanathan",
"text": "Congrats on the Q1 performance. First off, you mentioned the potential for grid storage to drive maybe some slightly better than expected volumes or maybe in the upper end of that range. Could you just discuss maybe some more of your efforts there and or maybe even within the industry? Have you seen any further commercialization there? And what's Albemarle's participation there?"
},
{
"speaker": "Kent Masters",
"text": "Yeah. So I mean, the fixed storage or grid storage, we tend to call it fixed storage, but it's the same thing. It has, over the last few years, been about renewables and then balancing that with storage. So there were regulations in China that if you did renewables, you're required to put storage with that renewable at the same location. That regulation has changed, but you're still required to do fixed storage, but it can be done centrally. So that's a little bit of a shift in the regulation, but it's the incentives are still there, and that's a growing space now. It's becoming a little bit more about grid stability around AI data centers and things like that. So same application, interestingly enough, we're selling it to the same customers. We sell to the same location, and but they're selling into different segments. And, a few years ago, we had trouble understanding where the volume was going into, right, whether it was fixed storage or mobility or EVs, and we've spent some time trying to understand that a little better. We have a better handle on it than we did. But even today, we sell to the same customers, and that goes into the EV market or to the fixed storage market based on their book of business. So it's opportunistic, and it's been a good space for us. Frankly, a couple of years ago, we didn't think it was a place for lithium to play, that it would be a minor spot. Fixed storage now is getting close to 20% of the demand for lithium. And last year, it grew more than EVs marginally, but still it was growing there. So it's going to be an important component of our portfolio over time."
},
{
"speaker": "Arun Viswanathan",
"text": "I guess, last year, we did see some curtailments over the summer. You noted that several other competitors in the lithium space may be in uneconomic territory. So do you expect some similar curtailments this year as you move into the summer? And similarly, do you expect curtailments based on environmental regulations? Or maybe you can just comment a little bit about supply given you've already commented on demand."
},
{
"speaker": "Kent Masters",
"text": "I don't have a way of saying what everybody in the industry is going to do. We know that there's pressure because of the cost position and where prices are. There'll be pressure on people, and how long they hold out and operate at breakeven or less is hard to say. We have seen some assets, the highest ones we know have come out of the market, and we don't see them coming back in the near term. And, there'll be pressure for others to come out of the market, but I can't say when and if they do it. It's impossible to call. And then environmental pressure, around lepidolite in China, assuming that's what you're talking about, we have don't have great insight into that."
},
{
"speaker": "Operator",
"text": "Our next question comes from Laurence Alexander with Jefferies."
},
{
"speaker": "Unidentified Analyst",
"text": "This is Dan Rizwan for Laurence. How does your strategy shift if governments subsidize supply and keep prices at the lower end of the range?"
},
{
"speaker": "Kent Masters",
"text": "Yeah. I guess our strategy is make sure that we are at a cost position and competitive at the bottom of the cycle wherever that is. And what gives us confidence we can do that is the quality of the resources that we have. That allows us to participate at the very bottom of the cycle. And I don't think it can stay there forever. So there will be opportunity, but the strategy really is the same. It's to leverage the quality of the resources we have and to make sure that we are very cost efficient."
},
{
"speaker": "Operator",
"text": "Our next question comes from Pete Osterland with Truist."
},
{
"speaker": "Pete Osterland",
"text": "First, just wanted to ask a clarification on the mix impact driving the energy storage margin guidance. You're expecting 50% of volumes on LTAs for the year. What percentage are you expecting to be sold under LTAs in the second quarter?"
},
{
"speaker": "Kent Masters",
"text": "We don't give that level of specificity by the quarters. Like I said, I think I will lean back on my answer earlier on the call, which is in the first quarter, we had lower volumes and a little bit more of our mix was on those LTAs. As you think about the second quarter, think about, as a percentage wise, there will be less volume on the LTAs and more as we ramp our volumes, more will be on those other contracts that we have that are more tied to current market prices or current spot. And so that's the mix point that we're trying to make here is that as we ramp those volumes, there will naturally be more volumes on those kinds of contracts, and that will lead to the margin being a little bit lower in Q2 versus Q1."
},
{
"speaker": "Pete Osterland",
"text": "I also wanted to ask about recent news that there's going be some new derivatives contracts for battery materials, including lithium being launched in June. What impact do you think that this could have on your lithium contract? I mean, you get any sense from customers that whether it's duration or pricing terms of how your contract mix would evolve if there's additional pricing transparency in the market?"
},
{
"speaker": "Kent Masters",
"text": "Yeah. I would say it won't have much of an impact initially, and it could over time if they take hold and there's more volume in the space, but there are other financial instruments out there now that you can hedge, but they're not significant, from a volume standpoint. So it doesn't impact us on a material basis. And I think that would be the same way at least in the near term. If they take hold, and we anticipate they will over time and they become a larger piece that our customers could hedge and we could hedge and do things a different way, but that volume is not available today."
},
{
"speaker": "Operator",
"text": "Our final question comes from Andres Castanos with Berenberg."
},
{
"speaker": "Andres Castanos",
"text": "My question will be on bromine, please. Have you noticed any changes in the situation of bromine and bromine derivatives from the USA to China? Has this impacted bromine pricing in general or at least in maybe some decoupling in the two regions?"
},
{
"speaker": "Kent Masters",
"text": "I don't know that we've seen a change. They do move in that direction. They have over time. I don't know that we've seen a significant change in derivatives from bromine moving to China."
},
{
"speaker": "Eric Norris",
"text": "No. We haven't seen any change in that. Tariffs have played a role and a potential role, but there's been some exemptions as well that have allowed. So there hasn't been any real material change in the flow. And maybe the biggest short term change is just a response to maybe a shortage supply in the industry that moved prices over the last month from $3 a kilogram to a high of $5.14 a kilogram, but that's since come back down to between a range of $3 and $3.29. So that's moved through the system already."
},
{
"speaker": "Operator",
"text": "Thank you. That's all the time we have for questions. I will now pass it back to Kent Masters for closing remarks."
},
{
"speaker": "Kent Masters",
"text": "Thank you, operator. And to wrap up, Albemarle's strong operational execution and strategic framework positioned us to effectively navigate market conditions and maintain our long term competitive advantages, including our world class resources, process chemistry expertise, and our customer centric market approach. We are dedicated to delivering value for our stakeholders and driving sustainable growth. Thank you for joining us today, and we look forward to seeing you face to face at the upcoming events you see on the next slide listed on slide 20. Stay safe, and thank you."
},
{
"speaker": "Operator",
"text": "This concludes today's conference call. Thank you for your participation. You may now disconnect."
}
] | Albemarle Corporation | 18,671 |
ALGN | 4 | 2,020 | 2021-02-04 16:30:00 | Operator: Greetings and welcome to the Align 4Q and Fiscal Year Earnings 2020 Call. [Operator Instructions] It is now my pleasure to introduce your host, Shirley Stacy. Thank you, Shirley. You may begin.
Shirley Stacy: Good afternoon and thank you for joining us. I'm Shirley Stacy, Vice President of Corporate Communications and Investor Relations. Joining me for today's call is Joe Hogan, President and CEO and John Morici, CFO. We issued fourth quarter and full year 2020 financial results today via GlobeNewswire, which is available on our website at investor.aligntech.com. Today's conference call is being audio webcast and will be archived on our website for approximately one month. A telephone replay will be available today by approximately 5:30 P.M. Eastern Time through 5:30 p.m. Eastern Time on February 17. To access the telephone replay, domestic callers should dial 877-660-6853 with conference number 13714292 followed by pound. International callers should dial 201-612-7415 with the same conference number. As a reminder, the information provided and discussed today will include forward-looking statements, including statements about Align's future events and product outlook. These forward-looking statements are only predictions and involve risks and uncertainties that are described in more detail in our most recent periodic reports filed with the Securities and Exchange Commission available on our website and at sec.gov. Actual results may vary significantly and Align expressly assumes no obligation to update any forward-looking statement. We have posted historical financial statements, including the corresponding reconciliations, including our GAAP to non-GAAP reconciliation if applicable, and our fourth quarter and full year 2020 conference call slides are on our website under Quarterly Results. Please refer to these files for more detailed information. And with that, I like turn the call over to Align Technology's President and CEO, Joe Hogan. Joe?
Joe Hogan: Thanks, Shirley. Good afternoon and thanks for joining us. On our call today, I'll provide some highlights from the fourth quarter and full year, then briefly discuss the performance of our two operating segments Clear Aligners and Systems and Services. John will provide more detail on our financial results and share additional color on business trends. Following that, I'll come back and summarize a few key points and open the call to questions. Our fourth quarter was a strong finish to the year with record revenues and volumes from both Invisalign aligners and iTero scanners, as well as increased gross margins, operating margins, EPS and cash flow. Our fourth quarter performance is driven by strong year-over-year growth across customer channels and regions and continued momentum sequentially. During the quarter, we achieved a major milestone in EMEA with the shipment to our 2 millionth Invisalign patient that will be amplified with the EMEA-wide campaign that will launch next month. This milestone from reflects strong acceleration in Invisalign adoption and growth. For Q4, total revenues were $834.5 million, up 13.7% sequentially and up 28.4% year-over-year. Q4 '20 Clear Aligner revenues of $700.7 million were up 12.9% sequentially and increased 28.9% year-over-year. In Q4, we shipped a record 568,000 Invisalign cases, an increase of 14.5% sequentially and 37.3% year-over-year. Q4 reflects increased Invisalign adoption from both adults and teenagers, which were up 36.7% and 38.7% year-over-year respectively. Our Teen and Mom-focused consumer campaign generated 77% year-over-year increase in unique visitors to our website and 76% increase in leads generation. In addition, Invisalign social media influencers like Charli D' Amelio, Marsai Martin, Christina Milian, Tisha Campbell-Martin, Rachel Zoe, Tiffany Ma, and Tahj Mowry continued to deliver exciting new content and increased engagement for the Invisalign brand with consumers and among their millions of followers. Our digital platform continues to gain traction as doctors uses of iTero scanners increase. Our Consumer and Patient app was rolled out to more than 50 markets, resulting in more than a 2.5 times increase in apps download and monthly active users in 2020 versus a year ago. Our patient feature usage continues to increase, for example, Invisalign Virtual appointment was used 68,000 times. Our insurance verification feature was used 26,000 times and more than 30,000 patients enrolled in Invisalign Virtual Care in 2020. Our new consumer website was rolled out to more than 40 markets around the world and is driving increased effectiveness in lead generation. We also launched an improved new doctor recruitment website in the U.S. and Canada to support our digital conversion journey. This will be expanded to other markets in the next few months. From a product perspective, growth was strong across Invisalign portfolio, especially for non-comprehensive cases including Invisalign Go and Invisalign Moderate. There are also more doctors engaging with us through the Align Digital and Practice Transformation or ADAPT program, as more practices are moving towards digital practice optimization. As you'll recall, ADAPT was piloted over two years ago and is being commercialized as a standalone service providing the relevant workforce, clinical and marketing support to enable doctors to digitally transform their practices. In Q4, we shipped a record 77,000 Invisalign doctors worldwide of which a record 7,300 were first time customers. We also trained over 6,400 new docs in Q4, including over 3,900 international doctors. Q4 '20 System and Services revenues of $133.8 million were up 18% sequentially driven by momentum in the Americas and EMEA, and up 26% year-over-year, reflecting strong growth in EMEA and Asia Pacific. Our results reflect continued strong uptake of the iTero Element 5D, the only intraoral scanner with caries detection which is scaling rapidly across each region and represented approximately a third of iTero volumes in Q4. Innovation remains a cornerstone of our business. Today, we announced the availability of the iTero Element Plus Series, which expands our portfolio of iTero Element Scanners in Imaging Systems to include new solutions that serve a broader range of the dental marketplace. The new iTero Element Plus Series of scanners in Imaging Systems builds on the success of the award winning iTero Element family and offers all of the existing orthodontic and restorative digital capabilities doctors have come to rely on, plus faster processing time and advanced visualization capabilities for seamless scanning experience in a new sleek ergonomically designed package. We announced the launch of our next-gen ClinCheck Pro 6.0 proprietary treatment planning software with in-face visualization and our Invisalign G8 improved predictability in our last earnings call we announced. Their availability is being expanded across all regions. Further, we launched several enhancements to our treatment planning, including improved Final teeth position and Auto segmentation. We also added several new features to our Virtual Care tool. For the full year 2020, total net revenues were a record $2.5 billion, up 2.7% year-over-year. Clear Aligner revenues of $2.1 billion were up 3.7% reflecting a record $1.6 million Invisalign shipments and growth of 7.9%. During the year, 30.3% of total Invisalign cases or nearly 500,000 teens or younger started Invisalign treatment. This is up 11.5% from 2019. System and Services revenues were down slightly compared to 2019. 2020 was a year unlike any other that we've experienced. The COVID-19 pandemic and its impact have been life-changing, marked by loss and separation, recovery and renewal, record highs and lows, and significant milestones and accomplishments. Even in a time of huge disruption, we all had to adapt, evaluate priorities and develop new ways of doing things both personally and professionally. Through it all, Align's priority has been the health and well-being of our employees and their families and our doctor, customers and their staff. And that remains a constant. Despite the swift onset of the pandemic and the uncertainty through 2020, we didn't hold our plans or change our strategy for continued growth. We completed the acquisition of exocad, accelerated our investments in marketing to create Invisalign brand awareness and drive consumer demand for our doctors' offices. Accelerated new technology to market with virtual tools that enable our doctors to stay connected with their patients, provided PPE to those in need and supported doctors and their teams with online education and digital forums that went beyond products to help them navigate the uncertainties of the pandemic. As a result of our continued strategic focus and investments, we exited the year stronger than we started and 2021 is off to a great start. Now, let's turn to the specifics around our fourth quarter starting with the Americas. With the Americas region, Q4 Invisalign case volume was up 12.7% sequentially and up 34.1% year-over-year, reflecting increased utilization of Invisalign treatment for both orthodontic and GP channels. Our continued investments in digital marketing and sales programs and focus on market segmentation are helping drive strong growth of Invisalign Clear Aligners and iTero products. During the quarter, we continued offering sales initiatives to our doctor partners to help drive adoption of Invisalign and iTero products. The Bracket BuyBack Switch program, which we launched in North America in Q2 '20 continues to drive conversion from wires and brackets to Invisalign clear aligners. During Q4, this program resulting -- has resulted in about 10,000 new cases similar to Q3. We believe this is also causing a halo effect with patients switching from wires and brackets to Invisalign clear aligners with increased awareness of the benefits of Invisalign treatment and how it is less disruptive to their lives with the outcome of a beautiful smile through an Invisalign trained doctor. The Teen Awesomeness Centers programs direct patients to Invisalign doctors who are experts at treating teens and are seen as the go-to docs for treatment. We continue to see growth with Invisalign First for treatment in younger kids driving increased comprehensive treatments within North America Ortho channel. Latin American volume was also up year-over-year, led by strong growth in Brazil and Mexico. We believe the market for orthodontic treatment is huge in Latin America as we continue to grow our presence across the region. We saw increased utilization in the GP channel with Invisalign Go and the continued adoption of Moderate. The GP Accelerator program designed exclusively for general practitioner dentist provides an all-encompassing support plan based on practice needs that is centered around maximizing iTero integration, clinical support needs, and implementing new marketing strategies. We also see increased utilization with GP dentists that have enrolled in the iPro program as well as with doctors that have installed the iTero scanner. DSO utilization also increased and continues to be a strong growth driver led by Heartland and Smile Docs. For the full year, Americas Invisalign volume was up 3.6% For our International business, Q4 Invisalign case volume was up sequentially 6.7% [ph], led by a strong growth in EMEA as doctors returned from summer holiday season, offset somewhat by seasonally slower period in China. On a year-over-year basis, International shipments were up 41.1%, reflecting increases throughout both EMEA and APAC. For the full year, International Invisalign volume was up 13.3%. For EMEA, Q4 volumes were up sequentially 47.9% and 48.3% on a year-over-year basis across all markets, with strong performance across both Ortho and GP channels. Within the GP channel specifically, we saw acceleration in both utilization and shipments with Invisalign Go. We also saw acceleration in both core and expansion markets, with growth in our core markets, led by Iberia, UK and France, along with continued growth in our expansion markets, led by Central and Eastern Europe and the Benelux. We introduced the Ortho Recovery 360 Program in EMEA last quarter to support our orthodontists as they started reopening their businesses. As of Q4, 3,200 orthodontists have enrolled in the program. During the quarter, we launched the Recovery II Program with a refreshed website featuring all digital tools, growth programs and education events for EMEA doctors to support their relief efforts during COVID-19. We also held our Digital Innovation Forum at the beginning of December where approximately 900 doctors, both Ortho and GP, attended the two-day forum event with keynotes on the digitization of dental practices. We also continued our Digital Excellence Series of webinars launched by the iTero team. Throughout the quarter, the following digital innovations were also launched across EMEA, Invisalign G8, ClinCheck Pro 6.0 and Invisalign Go Plus, to help drive Invisalign clear aligner utilization. To support our GP doctors, we launched our GP Recovery 360 program last quarter, with over 2,700 GPs enrolled so far. We continued to offer online and on-demand education events, which reached over 15,000 GPs cumulatively. For the full year, EMEA Invisalign volume was up 12.6%. For APAC, Q4 volumes were down sequentially 14.7%. Notwithstanding typical Q4 seasonality in China, following a strong Q3, we had strong growth in Japan and ANZ and Southeast Asia. On a year-over-year basis, APAC was up 30% compared to the prior year, reflecting continued strong growth across the region. We were pleased to see growth in the Adult segment with non-comprehensive cases with the Invisalign Moderate product in the GP channel. In the Teen segment, we also saw an increase in utilization amongst Invisalign doctors and we saw continued acceleration from Japan and ANZ. For the full year, APAC Invisalign volume was up 14.3.%. Last year, we launched a new and improved digital learning environment for our doctors offering a comprehensive learning platform with role-specific content for orthos, GPs and their teams. The improved functionality enables more online learning opportunities with spotlight features for what's trending now, recommended learning path based on doctors' experiences, and expanded categories including digital treatment planning, comprehensive dentistry, and team education. For the year, over 127,000 doctors have accessed recorded lectures, completed self-paced learning modules, and watched how-to videos, with new certified doctors viewing more than 1.4 million pages of content. Among the ortho channel, over 47,000 unique users have engaged with the digital learning site with an additional 80,000 unique users from the GP channel. As we've mentioned, we are seeing good adoption of the ADAPT program, which is an expert and independent fee-based business consulting service offered by Align to optimize clinics' operational workflow and processes to enhance patient experience and customer and staff satisfaction, which will in turn translate into higher growth and greater efficiencies for orthodontic practices. As a result, the ADAPT service participating practices in Q4 improved profitability significantly after implementation. Our consumer marketing is focused on capitalizing on the massive market opportunity to transform 500 million smiles, educating consumers about the Invisalign system and driving that demand to our Invisalign doctor offices. In Q4, we saw strong digital engagement globally with more than 77% increase in unique visitors, 108% increase in doc locator searches and 76% increase in leads created, driven by our global adult and mom-focused campaigns and teen-focused influencer content. Our US Mom/Teen multi-touch multimillion dollar campaign with influencer-led YouTube videos, a mom-focused TV spot, a custom Twitch activation, and mega teen sensation Charli D'Amelio continued to perform very well and garnered 2.7 billion impressions in Q4. The statistics I shared previously speak to the successful reach of this marketing campaign is having to not only drive demand with consumers, but also in educating them on the benefits of Invisalign treatment through a doctor's office. In Q4, we also launched media tests in the EMEA region in the UK, Germany and France and in the APAC region in Australia and Japan. These have worked very well and resulted in a more than six-times increase in leads in EMEA and a 3-times increase in leads in APAC. Several key metrics that show increased activity and engagement with the Invisalign brand are included in our Q4 quarterly presentation slides available on our website. Align is always looking for new opportunities to reach consumers and be relevant to potential patients wherever they work, live, and play, which is why we announced that the Invisalign brand is the Official Clear Aligner Sponsor of the National Football League, the NFL, and 11 NFL teams, including the Tampa Bay Buccaneers and the Kansas City Chiefs. The NFL league partnership, designed to expand our reach with consumers, generated over 150 million impressions in 2020, helping to drive awareness of Invisalign clear aligner treatment at a national level, while the team agreements are designed to help us engage within key markets and connect consumers with doctors in those markets. For our Systems and Services business, Q4 revenues were up 18% sequentially due to higher shipments and services revenues. We continued to see momentum with the iTero Element 5D Imaging System, gaining traction in all regions with significant Element Flex sales in EMEA. On a year-over-year basis, Systems and Services revenues were up 26% due to higher shipments and services. For the year, our Systems and Services total revenues were down 2.8% year-over-year. Cumulatively, over 31.4 million orthodontic scans and 6.7 million restorative scans have been performed with iTero scanners. For Q4, total Invisalign cases submitted with a digital scanner in the Americas increased to 84% from 79.5% in Q4 last year. International scans increased to 73.7%, up from 64.7% in the same quarter last year. We're pleased to see that within the Americas 94.8% of cases submitted by North American orthodontists were submitted digitally. We're also proud to share that iTero Element intraoral scanners are the winners of the 2020 Dentaltown Townie Choice Award for Digital Impressioning category. Also, during the quarter, the National Association of Dental Laboratories judging panel selected the iTero Element 5D as the winner of the 2020 Journal of Dental Technology WOW! Award. The award represents the recognition of our commitment to enhancing patient engagement and communications that support efficient laboratory production. For exocad, during the quarter we launched two of the largest software releases in history, DentalCAD and exoplan. DentalCAD3.0 Galway includes over 90 new features and over 80 enhanced functionalities with significant improvements to reduce design time, such as Instant Anatomic Morphing. exoplan 3.0 Galway includes over 40 new features and over 60 enhanced functionalities that support planning of edentulous cases, including the design of surgical guides. During the quarter, exocad also added two new large implant manufacturers as OEMs for exoplan in Brazil. With that, I'll now turn it over to John.
John Morici: Thanks, Joe. Now for our Q4 financial results. Total revenues for the fourth quarter were $834.5 million, up 13.7% from the prior quarter and up 28.4% from the corresponding quarter a year ago. For Clear Aligners, Q4 revenues of $700.7 million were up 12.9% sequentially and up 28.9% year-over-year reflecting Invisalign volume growth in all regions, partially offset by lower ASPs. Clear Aligner revenues growth was favorably impacted by foreign exchange of approximately $5 million or approximately 0.8 points sequentially and on a year-over-year basis by approximately $10.3 million or approximately 1.9 points. Q4 Invisalign ASPs were down sequentially $15 primarily due to increased revenue deferrals related to a higher mix of new cases versus additional aligners, partially offset by favorable foreign exchange, and lower promotional discounts. As we mentioned last quarter, we did not implement a price increase in 2020 given our continued commitment to helping our customers in their recovery efforts during the pandemic. On a year-over-year basis, Q4 Invisalign ASPs decreased approximately $75 primarily due to our decision not to raise prices last summer, increased revenue deferrals for new cases versus additional aligners, and higher promotional discounts, partially offset by favorable foreign exchange. As a result, clear aligner deferred revenue on the balance sheet increased $83 million sequentially and $195 million year-over-year and will be recognized as the additional aligners are shipped. Total Q4 Clear Aligner shipments of 568,000 cases were up 14.5% sequentially and up 37.3% year-over-year. Our System and Services revenues for the fourth quarter was $133.8 million, up 18% sequentially due to an increase in scanner sales and increased services revenues from our larger installed base and higher ASPs. Year-over-year System and Services revenue was up 26% due to higher scanner sales, services revenue, and the inclusion of exocad's CAD/CAM services, partially offset by lower scanner ASPs. Imaging Systems and CAD/CAM Services deferred revenue was up 30% sequentially and up 69% year-over-year primarily due to the increase in scanner sales and the deferral of service revenues, which will be recognized ratably over the service period. Moving on to gross margin. Fourth quarter overall gross margin was 73.2%, up 0.4 points sequentially and up 0.5 points year-over-year. On a non-GAAP basis, excluding stock-based compensation expense and amortization of intangibles related to exocad, overall gross margin was 73.6% for the fourth quarter, up 0.3 points sequentially and up 0.7 points year-over-year. Clear Aligner gross margin for the fourth quarter was 74.9%, up 0.1 point sequentially due to lower additional aligner volume, partially offset by higher warranty, other manufacturing costs and lower ASPs. Clear Aligner gross margin was up 0.7 points year-over-year primarily due to favorable product mix from increased iTero scanner absorption as a result of increased manufacturing volumes partially offset by lower ASPs, higher warranty costs and other manufacturing costs. Systems and Services gross margin for the fourth quarter was 64.2%, up 2.2 points sequentially primarily due to higher ASPs and increased manufacturing efficiencies from higher productions volumes. Systems and Services gross margin was down 0.7 points year-over-year due to lower ASPs, higher freight and other manufacturing costs partially offset by higher services revenue. Q4 operating expenses were $397.3 million, up sequentially 11.3% and up 23.8% year-over-year. The sequential increase in operating expenses is due to increased marketing and media spend and spending commensurate with business growth. Year-over-year, operating expenses increased by $76.5 million, reflecting our continued investment in sales and marketing, R&D activities, and manufacturing operations. On a non-GAAP basis, operating expenses were $372.3 million, up sequentially 12.1% and up 23.4% year-over-year due to the reasons as described earlier. Our fourth quarter operating income of $213.2 million resulted in an operating margin of 25.5%, up 1.4 points sequentially and up 2.3 points year-over-year. The sequential and year-over-year increases in operating income and the operating margin are primarily attributed to higher gross margin and operating leverage. On a non-GAAP basis, which excludes stock-based compensation, amortization of intangibles related to exocad, and acquisition-related costs, operating margin for the fourth quarter was 28.9%, up 0.9 points sequentially, and up 2.5 points year-over-year. Interest and other income and expense, net for the fourth quarter, was a benefit of $1.4 million, primarily driven by favorable foreign exchange. With regards to the fourth quarter tax provision, our GAAP tax rate was 25.9% which includes tax benefits of approximately $11 million related to adjustments in prior years' unrecognized tax positions. The fourth quarter tax rate on a non-GAAP basis was 14.5% compared to 16.6% in prior quarter and 20.9% in the same quarter a year ago. The fourth quarter non-GAAP tax rate was lower than the third quarter's rate primarily due to the reason previously stated. Fourth quarter net income per diluted share was $2.00, up $0.24 sequentially and up $0.47 compared to the prior year. On a non-GAAP basis, net income per diluted share was $2.61 for the fourth quarter, up $0.37 sequentially and up $0.85 year-over-year. Moving on to the balance sheet. As of December 31, 2020, cash and cash equivalents were $960.8 million, an increase of approximately $345.3 million from the prior quarter, which is primarily due to higher cash flow from operations. Of our $960.8 million of cash and cash equivalents, $548.3 million was held in the U.S. and $412.5 million was held by our International entities. Q4 accounts receivable balance was $657.7 million, up approximately 5% sequentially. Our overall days sales outstanding was 71 days, down approximately 6 days sequentially and down approximately 5 days as compared to Q4 last year due to strong cash collections. Cash flow from operations for the fourth quarter was $381.4 million. Capital expenditures for the fourth quarter were $53.2 million, primarily related to our continued investment in increasing aligner capacity and facilities. Free cash flow, defined as cash flow from operations less capital expenditures, amounted to $328.3 million. Under our May 2018 Repurchase Program, we have $100 million still available for repurchase of our common stock. Before we move to the outlook, I would like to make a few comments on the full year 2020 results. In 2020, we shipped a record 1.6 million Invisalign cases, up 7.9% year-over-year. This reflects 13.3% volume growth from our International doctors and 3.6% volume growth from our Americas doctors. System and Services volumes were down 12% compared to 2019, reflecting the impact of COVID-19 pandemic on equipment sales. Total revenue was a record $2.5 billion, up 2.7% year-over-year, with Clear Aligner revenues a record $2.1 billion, up 3.7% year-over-year. 2020 Systems and Services revenues were $370.5 million, including exocad revenues from April 1, 2020 forward compared to $381 million in 2019. Full year 2020 operating income of $387.2 million, down 28.6% versus 2019 and operating margin at 15.7% versus 22.5% in 2019. 2019 operating income included a litigation benefit of $51 million and Invisalign Store closures of $23 million for a net benefit on operating margin of 1.1%. With regards to a full year tax provision, our GAAP tax rate was negative 368.6%, which includes a one-time tax benefit of approximately $1.5 billion, net of current year amortization, associated with the recognition of a deferred tax asset related to an intra-entity sale of certain intellectual property rights resulting from our corporate structure reorganization completed in the first quarter of 2020. Excluding the tax benefit related to our corporate structure reorganization and the related tax effects of stock-based compensation and other non-GAAP adjustments, the full year tax rate on a non-GAAP basis was 17.6% compared to 22% for 2019. 2020 diluted EPS was $22.41. On a non-GAAP basis, 2020 diluted EPS was $5.25. Free cash flow was $507.3 million for 2020, down $90.3 million versus 2019. Now, let me turn to our outlook. Overall, we are very pleased with our Q4 performance and the strong momentum in our business, which has continued through January for both Clear Aligners and Systems and Services. As we discussed at our Investor day in November, we are committed to making significant investments to drive growth and we are seeing good return on these investments across all regions and customer channels. These strong returns give us confidence to continue investing in sales, marketing, innovation and manufacturing capacity to accelerate adoption in a huge, underpenetrated market. These investments coupled with typically higher seasonal operating expenses as a percentage of revenue are expected to result in a sequentially lower operating margin percent in Q1 as we have historically seen. While the global environment surrounding the pandemic remains uncertain, we will continue to focus on what we can control and we are confident in our ability to continue to execute. Our responsibility is to continue driving innovation and delivering on the needs of our customer doctors and their patients. Over the past 24 years, Align has invested billions in technology, innovation, consumer marketing and demand creation to connect millions of consumers with our doctor customers. We will continue to invest in this business to drive demand and to drive adoption of the Align Digital Platform, including manufacturing and operational expansion. We will always be responsible. Just like we've done in the past, we make investments to drive growth and maximize ROI. We remain committed to our long-term target model of 20% to 30% revenue growth for Clear Aligners and Systems and Services, and operating margin of 25% to 30%. With that, I'll turn it back over to Joe for final comments. Joe?
Joe Hogan: Thanks, John. The choices we made in 2020, to protect employees, support customers, and press forward on our strategy for growth, were possible because of the strength of our balance sheet and the confidence we have in our business model. Our actions reflect our conviction in the enormous opportunity we have to transform smiles and change lives. With 15 million orthodontic cases starts annually and more than 500 million consumers who can benefit from a better smile, the market for digital orthodontics and restorative dentistry is massive and has been unleashed by the need for digital. In a macro sense, COVID-19 has accentuated the benefits and pervasiveness of the digital economy. From an Align standpoint, practices across every region are embracing digital treatment in new ways and more purposefully than ever before. Invisalign providers are using our virtual tools to minimize in-office appointments and deliver doctor-directed, personalized treatment that meets the needs of the moment and that will reshape the future of treatment. Digital acceleration is not just around Invisalign treatment. It includes digital workflows around iTero scanners and general dentistry. Doctors tell us that the iTero scanner is central to their practice and their practice workflows, and it is key to driving digital treatment. We've always known this, iTero and now exocad are core components of the Align Digital Platform, our integrated suite of unique, proprietary technologies and services delivered as a seamless, end-to-end solution for patients and consumers, orthodontists and GP dentists, and lab partners. And particularly, we now have all the building blocks to create digital workflows, leveraging the combined power of Invisalign treatment, iTero scanners, and exocad software to become more relevant to the GP market, which is critical to accessing the 500 million consumer opportunity. Align is a growth business with huge opportunities, but the environment remains uncertain due to COVID-19. Our plan is still to counter uncertainty by staying focused on our long-term strategy, living our values, supporting our employees and customers, and keeping in mind the demand drivers we've identified over the past year, the re-direction of disposable income for many consumers, channel focus that allows us to reach and support a wider range of customers within each channel. And most importantly, the digital mindset that's taking hold with more and more of our customers and that we are supporting through innovative products and programs that can help support their digital transformation. We are not ignoring the reality of COVID-19 and how long it may be part of our lives, but we're also not going to stop driving the business forward for the good of customers and their patients, our employees, and our stakeholders. In closing, I want to leave you with a few thoughts as we begin the new year. While there is considerable amount of turmoil in the world, our focus is on what we can control as a company. We have strong momentum. We'll stay focused on our strategic priorities, international expansion, patient demand and conversion, orthodontist utilization, and GP dentist treatment. In summary, we are very pleased with the fourth quarter and full year results of 2020, during a remarkable year with events beyond our control as a result of COVID-19. It is during times such as this when having a solid strategy combined with focused execution can lead to outcomes that support growth, not only for Align's business but also practice growth for Align's customers which also leads to more and more Invisalign smiles. With that, turn it over to the operator and we'll take calls.
Operator: [Operator Instructions] Thank you. Our first question comes from Ravi Misra with Berenberg Capital Markets. Please proceed with your question.
Ravi Misra: Hi. Thanks for the question. Hi. How are you?
Joe Hogan: Good.
Ravi Misra: Happy New Year. So I just wanted to maybe start on -- I'll let the others maybe talk about the quarterly trends, but one of the things that kind of stood out to me was you're driving extremely strong volume growth amidst what's kind of a stable to slightly declining pricing environment. Just curious, first, when do you think you'll be able to go back to the kind of prior model where you're able to take pricing? Is that still in the cards? And then secondly, I think the teen market is an area that we've kind of always been looking at as the next leg of growth, the kind of huge market that's out there. And you're talking about some of the conversion and the lead generations. Can you help us understand kind of the conversion rates around the leads that you generate in terms of timing and how long this takes to get the ROI that is put into the advertisements that you're putting out there?
Joe Hogan: Ravi, first of all, I guess, your first question is on average selling prices. We try to communicate this as strongly as we can is to keep your eyes on gross margin, because we have huge mix, whether it's international mix or it's product mix, you see a lot of progress in iGo and products like Moderate and Invisalign First in those products. The carry actually lower average selling prices, but higher margins, and so you can often mix up on those things. So I'd say as we keep emphasizing is don't be overly concerned about ASPs or focused on ASPs. Like John said, we didn't increase ASPs this year because we're interested in supporting our customers and making sure that this is difficult -- a really difficult transition for many practices right now and instituting a price increase just wouldn't have been responsible in that sense. But at the same time, we drove incredible productivity across the business and we're able to show those kind of gross margins. So I hope you and the rest of the analysts community out there can actually see that. We've been talking about this for a few years, but actually taking place. On the teen side and the conversions from an advertising standpoint, I mean, we come out just from a lot of different ways and a lot of different areas. And we -- if we are going to start teen season, you really have to start in February in the United States and you have to really work through a lot of different aspects of social media. You advertise differently for moms and you do teens and different things like that. So I can't give you a correlation coefficient in the sense of here we invest and how much we get back, but we understand as well as a business, we've been doing it for years. We understand the timing of it. And more and more we become more specific on the social advertising pieces and how to implement that properly. And John, do you have anything you want to add?
John Morici: No. As you said, I mean, it's -- there's others that are in the equation. You have to reach the teen, as Joe described, and we talked about social influencers and so on. You have to reach the parents and we try that. And then also have the right formula with the doctors. So getting those three to think about going into treatment is really the key.
Ravi Misra: Okay. Then maybe one last one if I can ask one more, just on the reopening and vaccination progress and kind of volumes. How are you guys kind of thinking about the consumer spending environment as the options that the patient is going to have start increasing. I mean is that going to require more investment here in the near term or do you think kind of where we're at a baseline where you've kind of gotten the ramp where things are starting to really click here with the advertising that you're doing as is? Thank you.
John Morici: Yes, Ravi, it's a good question. I mean, look, we're always looking to maximize our return on investment. We talk about that to grow in this vastly underpenetrated market. In some countries like in the U.S., it's just a matter of refining how we spend. We talked about the influencers, talked about NFL and other things. And in other countries, we've really started spending some of that consumer advertising and we see a great response and we see a strong return. And those are areas that, as we see that response, we see it turn into volume, those are areas that will continue. So we're always looking at return on investment and we'll find ways to be able to grow our volume that way.
Joe Hogan: Thanks, Ravi.
Operator: Thank you. Our next question comes from Jon Block with Stifel. Please proceed with your question.
Jon Block: Hey, Joe. Good afternoon. Joe, you mentioned 2021 is off to a great start. From 2015 to 2019, so I'm sort of isolating pre-COVID management guidance for 1Q cases, the guidance for 1Q cases were up pretty consistently, just low single-digits off of what you did in the fourth quarter. And I guess where I'm going with this is at a high level, what's the expectation for case growth sequentially? And I'm just trying to level set as the back part of 2020 likely benefited from some pent-up demand. So just how we should think about the trend line, if you would, into the early part of 2021?
Joe Hogan: Jon, I'll let John have the specifics. I would just tell you that January was a really strong orders quarter, so that momentum really continues.
John Morici: And look, Jon, I think as we've said it, we're controlling what we can control, making investments that help drive this business. We look at -- as Joe said, we felt really good about how we exited Q4. We saw that in January as well, and we don't want to guide. We basically haven't because there is things that are outside of our control. And we'll leave that as it is. What we're trying to give you is kind of the latest information without projecting forward.
Jon Block: Okay, fair enough. And I'll ask a quick two-part for the second one. EMEA was just gangbusters, I mean, it was up 48% of a 32% comp, shout out to Markus, but anything to call out there? I mean, the number was huge. And then the second part is teen up almost 40%, Joe. What do you think the underlying ortho market was growing? Where I'm going with this is just your conviction of sort of maybe a type of inflection point, if you would, with teen's share of share. Thanks, guys.
Joe Hogan: Jon, I appreciate you bringing up EMEA, I mean, that was just an amazing performance when you see that. I've been doing business in Europe since I was 30 years and you see growth like that by countries, it's amazing. And I think that, to me, that was really a story on the fourth quarter too was the breadth of that growth. It wasn't just North America. It wasn't just Asia. It was deep across segments, across GPs, across orthos. So Jon, I'm not ready to talk about an inflection point. All I can say is when you think about, we had 77,000 doctors that ordered that I talked about in my script. And then 7,200 to 7,300 more doctors, that's 10% more doctors, that's a record for us too. So we see Invisalign, this digital treatment really catching on in a big way and it's meaningful. Look, we're gearing up for it. We're obviously advertising to drive that demand and will stay focused on just executing, Jon, right now.
Jon Block: Thanks, guys.
Shirley Stacy: Thanks, Jon. Next question?
Operator: Thank you. Our next question comes from Steve Beuchaw with Wolfe Research. Please proceed with your question.
Steve Beuchaw: Hi. Thanks for the time here, guys. I wanted to try to understand a little bit better the relationship between some of the things that you flagged, John, in your prepared remarks as it relates to deferrals and ASP. I certainly agree with the view that gross margins are really the critical metric, but I'm sure we're going to get a lot of questions about ASP tonight and over the next couple of days. So I wonder if you could help us understand a little bit more deeply, one, why we'd be seeing more deferred revenue here both on aligners and scanners? And what's the relationship to ASP and do we see that reverse?
John Morici: Yes, Steve, the basic way to think about this as we look at our revenue, we've got revenue on a new case that we ship out. And there is a certain amount that you recognize on that shipment based on our rev rec. And then there is a certain amount for future aligners or future modifications that are needed. That will be deferred revenue. And then you also get into your revenue so that those deferrals that you've made for maybe previous quarters or even previous year that as they -- that doctor needs to use that additional lines, you're going to get revenue for that. When you have a mix like we have, where there is much more, there is this demand for future volume for new cases, you get a mix where we just have a lot more as a percentage of new cases and that's what impacts ASPs. When we look at that from a margin standpoint, it's margin accretive. We're getting as new cases. Many of the cases that we get back from a deferred revenue standpoint where there's refinements we just don't make as much margin on that. You get the deferred revenue, but you don't get as much of the margin. So there is those dynamics that we have. We saw just when you have a significant volume increase like we saw in our third and fourth quarter.
Steve Beuchaw: Okay. Thank you, John. And then I wanted to follow-up about the GP channel. GP has been just gangbusters here lately. I wonder if I could try to understand that a little bit more deeply. One is do you think it continues to grow at the sort of clip relative to the ortho channel? Maybe two, do you think exocad has been a driver of incremental growth in that channel at this point? And then lastly, should we think about the shift to DSOs being a variable one way or another. And I apologize for my kids screaming in the background.
Joe Hogan: That's the life we live now, Steve. We understand. It happens on and off like every call. From a GP channel standpoint, I mean, three years ago when we first started segmenting in Europe and now we are doing in the States and we do it all over the world. And then we introduced products like iGo that were specific to it. And just a salesforce that can communicate with GPs because it's a different conversation than with orthos. Yes, I can't tell you where it's going, but when we talk about that 500 million patients like I did in my script, that's where they are, and that's where you touch them. I mean, it's a different. It's not a big teen market. It's a lot of adults. But it has to have a workflow that's specific to a GP. And that's why we drive their products, that's why iTero is so important from a front-end standpoint. Your question on exocad is, we think that's going to be a big GP driver for us. It is a big legitimate piece for us, but I don't think it's adding to volume right now. We're just rolling out these new products. We're just starting to integrate that kind of software code into iTero and into our programs and that's certainly will drive increased penetration in the future.
Steve Beuchaw: Got it. Thank you so much for all the perspective here.
John Morici: Yes. Thanks, Steve.
Shirley Stacy: Next question?
Operator: Thank you. Our next question comes from Jeff Johnson with Robert W. Baird & Co. Please proceed with your question.
Jeff Johnson: Thank you. Good evening, guys. Hey, Joe. I wanted to start with -- I know it's tough and maybe there is not even a way to do it, but any way to think about especially over the last two quarters, how much of this patient volume has been backlog versus the zoom effect versus true kind of accelerating penetration of clear aligners versus brackets and wires. Just is there any way to bucket or any metrics you're looking at that tells you this is truly kind of that secular uptick we've all been waiting for versus backlog and some of the zoom effect?
Joe Hogan: I think as we get further and further from the second quarter obviously the backlog question becomes less and less as part of the noise of the structure, right. I feel a lot of analysts, Jeff, they wonder, hey, we had a great third quarter obviously and it was, well, how much of that was really the second quarter that's rolled into the third. We really don't know what that was. We don't. And our doctors don't know it either as we talk to them. The fourth obviously had less of that. And we really felt good about our orders in January too. So I think we're really moving away from that question here soon. The number of docs like I just quoted with over 7,000 new docs ordering from us, 77,000 in total shows you the breadth of what's going on. And what's really struck me in this entire thing too, Jeff, is really this is not just United States, this is all over the world. It's Latin America, it's APAC. It's tremendous growth in Japan and ANZ and traditional markets, in China, in Europe. So there is breadth to this and then the segments we talked about, both GPs and orthos. So look, there have been backlog in the third quarter. There has to be some backlog in the fourth quarter or whatever. But we don't think that's the overriding story here.
Jeff Johnson: Yes, that's fair. And then one other kind of maybe more a conceptual question. Just as I think about -- I think about it through your Advantages program, but are you seeing doctors that are the high volume guys, the Platinum guys moving up to Diamond and Double Diamond? Is it the lower Bronze or Gold guys moving up to Platinum? Does it matter to you which it is? But more importantly conceptually, is it getting those low volume guys to really go all in here or the high volume guys to convert completely to Invisalign? And I'm sure you're going to tell me it's a mix of both of that, but just kind of what you're seeing would be helpful there on your own customer base.
Joe Hogan: Yes. You helped me answer that question, Jeff, it is a mix. But it is really broad. I mean, we see in the Bronze accounts and Golds and all the way to Diamond and Diamond Plus. And we see growth in all those segments. And I think it's kind of logical, right. The people that know how to do digital are going to expand on it, because digital really allows them to function in this COVID environment in a way that allows them fewer customer touches and they can actually carry on their practices in a normal way. Other doctors actually see the advantages of that. They have patients asking for them. And they start to move toward a digital kind of a platform. And overall, again, it's a breadth discussion. It's not just one area, it's not just one country, it's not one segment of the Advantage program. We just weren't seeing adoption across the board. And John, anything to add on that?
John Morici: I'd echo this, the breadth. I mean, you have new doctors, like Joe said, 7,000 new doctors that come in with and want to do cases that come into our ecosystem and start cases. You see doctors who have done just a few cases really start to accelerate and then at the top of the pyramid, you have people that are doing a lot of cases and they do even more cases. So that's part of when we talk about the breadth of this growth and what makes it excited. And it's like Joe said, not just a U.S. phenomena, it's pretty much everywhere.
Joe Hogan: And Jeff, I think the last thing you said is do you care which I thought was kind of interesting is like we really don't care. We just want to serve the doctors who want to work with us. We see this market -- we talk about how large this market is and how under-penetrated it is. And we just want to see wherever that growth is, that's great. It's on the low end, that's terrific. It's on the high end, that's terrific. We set this company up to be able to service either side to work well with them.
Jeff Johnson: Thank you. I appreciate the comments.
Joe Hogan: Thanks, Jeff.
Operator: Thank you. Our next question comes from Elizabeth Anderson with Evercore. Please proceed with your question.
Elizabeth Anderson: Hi, guys. Thanks so much for the question. Hey, Joe. I always thought -- obviously the -- one of the many nice parts of the quarter was the scanner and CAD/CAM revenue. Can you talk a little bit about what you sort of see as market growth there? Like where are you taking share? Is it in the GP, more on the ortho channel? Is it orthodontists adding their third scanner? Is it people finally saying, yes, I'll go digital? Obviously, the total number of cases submitted digitally was very high. Any other color you could provide there would be really helpful.
Joe Hogan: Elizabeth, you could work for us, okay. You kind of described exactly how that demand is, it's coming from all these different places. And a lot of it when you say where you're taking share, a lot of is just analog share. There is so much in dentistry is still just completely analog. They're still doing impression and different pieces. And so it's the growth has been tremendous in that sense. Your question about orthodontists that start to move up into a significant part of their practice being Invisalign, you'll see -- you see a scanner at every chair. And they use these things are constantly. It's part of what they do. What we see on the GP segment is the communication tool ends up being the scanner in the front of the scanner. Because you know in the past, they'd hold up a mirror and say, can you see that, that second molar back there and you'd say, yes, but you really couldn't, right. Now, you throw it on a screen. It's live, you can see exactly what's going on. It becomes an incredible patient-communication tool in a sense of where is your dentist and what needs to be done and helps to convince patients of what the doctor wants to do and the validity of that kind of treatment. So this is where dentistry is going. And when you look at iTero, it is arguably the highest performing scanner in the world, the speed of it, the exactness of it, color rendering, and also with NIRI technology to be able to see caries or cavities is a real benefit, even to orthodontists who want to make sure that before you start the treatment that dentition is in good enough shape to able to except that kind of movement. So that's just -- this is the time for digitization inside of dentistry and iTero plays a big role in that and it front-ends our digital platform.
John Morici: Especially in a COVID environment, given the fact that you don't want to have as much time for impressions and so on and you want to be able to have something that's fast and really be part of that digital workflow, this iTero lends itself well.
Joe Hogan: Yes.
Elizabeth Anderson: Okay, that's super helpful. And Joe, sort of like to just follow up more a housekeeping question. One, obviously you announced the new products today and I imagine that that's something you'll be talking about in sort of the virtual Chicago Midwinter and what you would have discussed a lot of it IDS. Is there anything we should keep in mind in terms of the ramp of sort of new products or impacts from IDS moving to the back half of the year? And then on the other side, obviously we saw your announcement about the move to Arizona. Sounds exciting. I just didn't know if that had any impact in terms of something we should model in on taxes or anything else just to touch on that as well.
John Morici: Yes, I think I can answer the tax piece of it. No, really not a tax impact. It really came down to when we look at the campus that we have in San Jose and the expansion that we have from a technology center, we become space constraint. And so we want to keep that technology center, that innovation center in San Jose and expand that out and add more to help with that innovation. And then moving to here in Tempe for kind of that head office just made sense to us.
Elizabeth Anderson: Okay, thanks.
Joe Hogan: Yes, it is upon the new product pieces. Keep in mind we talked about we spend $500 million a year on advertising and also new product development, you'll see a lot of new products. We don't pace ourselves on those introductions based on IDS. And that's why we obviously announced the new iTero scanner. We talked about the new 6.0 software that we have. A lot of changes to FiPos, it's our final positioning aspect to dentition. We had the Plus product from iGo, the in-face visualization. This is a digital business that requires constant iterations in products. And obviously Midwinter and those things are great places to highlight it. But our innovation, we looked at it agile, not waterfall anymore. In the sense, waterfall used to be invent during the year, release one period of the year. More and more, you'll see us just monthly just rolling out new products as we adapt to a more kind of an agile philosophy of development than a waterfall type of -- if that's what you're asking, Elizabeth.
Elizabeth Anderson: Makes total sense. Thank you so much.
Joe Hogan: Yes. You're welcome.
Operator: Thank you. Our next question comes from Richard Newitter with SVB Leerink. Please proceed with your question.
Richard Newitter: Hi, thank you for taking the questions. Just maybe to start off the Switch program, which has fairly been extremely successful for you. I'm curious to know how much more runway there is associated program, and maybe if you could just comment on kind of how you're at least thinking about that from your internal modeling?
Joe Hogan: Yes, look, I think it has a huge amount of breadth to it. I mean, it's not just U.S. We started this in Japan actually years ago and introduced in the United States. And you think about -- it's just a great winner, detaching those wires and brackets from people's teeth using Invisalign, understanding, like we said, in our script, is how much more simple it is and better for people and comfortable for people to go with our product line. So we think it's -- we have a lot of room to grow and we're going to keep supporting it.
John Morici: Yes. And Rich, it's John. I mean, we are always looking at those types of promotions for an ROI. And in these cases, many cases looking at it from an incremental standpoint, nothing could be more incremental than it was glued onto someone's teeth and now they come off and they go to Invisalign. So we like those dynamics there. It sends a great message. And those people who had wires and brackets on their teeth can talk about their experience with Invisalign. So there is a lot of positives to it, as Joe said, it started in Japan. And we've seen great success in the U.S. and we look to other places as well.
Richard Newitter: Got it. Helpful. And Joe, you said a few times how encouraging the trends have been in January. I'm just curious, understanding it's only one month, but how well is the growth, if the trend that you're seeing now were to whole kind of for a good portion of the year, where in your long-term kind of long-range plan of 20% to 30% do you think you'd be falling towards the mid to upper end? I'm just trying to get a sense for kind of what do you think in there?
Joe Hogan: Nice try, Richard. Look, we're very committed to our long-term growth model 20% to 30%. That's really all I can say right now. Rich, we're in a really uncertain environment. We're happy about January. It is why we're not giving guidance. It's -- we're all living with volatility right now and we'll just continue to execute and keep our heads down, but we're committed to that 20% to 30% growth model that we've been talking about for several years.
Richard Newitter: Okay, thanks. Thank you.
Shirley Stacy: Next question?
Operator: Thank you. Our next question comes from John Kreger with William Blair. Please proceed with your question.
John Kreger: Hey, Joe. Just sticking with that answer, you were obviously above that in terms of volumes in the fourth quarter. How do you feel about your ability to deliver on that if the order flow were sustained? In terms of fabrication and fulfillment, how are those metrics holding up at this point?
Joe Hogan: Our supply chains, we try to keep ahead in that sense. So, I feel we have adequate plans and capacity right now to be able to handle the surge in demand.
John Kreger: Great. Okay. And then, John, I think you've talked about in the past a reasonable assumption is kind of a flattish ASP, and realized there's a lot of puts and takes. But is that still a reasonable kind of planning thing for us? Or are you guys thinking less on the pricing front, and, therefore, maybe more of a downward trend over the coming year?
John Morici: It's tough because it really becomes kind of the end result, because if you have more primary cases as I spoke compared to secondaries, you can get some of these impacts in ASPs. I think, in general, there is not a significant change that we would expect in some of the mix or some of that some of that pricing. So that being said, you wouldn't expect too much fluctuations in ASPs. But like I said, it depends on that demand that comes forward from our doctors.
John Kreger: Got it, okay. And then one more, Joe, sorry, in a typical year, we'd assume kind of teens would be big in Q3 and adults would be bigger in Q4. Is that same sort of seasonal pattern likely do you think in '21 given what we know now, or would you expect kind of teen order flow to be more kind of spread evenly throughout the year.
Joe Hogan: Hey, John, we don't know. But I'd say it became muted this year. Obviously, we saw as much stronger fourth quarter United States in teens than we saw -- that you normally see from a seasonal standpoint, it got continued. So I think all of us are expecting summer and fall months as COVID to start to retreat a little bit, that might take us back to the patterns that we had before. But I don't think it's going to be binary. I really don't, I think this could have changed the pattern. We're just going to have to -- we're going to have to just ride the curve here and see how it goes. But we'll continue to advertise through this to execute on a place that we talked about in our scripts and we've really feel confident we can continue to drive significant teen demand.
John Kreger: Great, thank you.
Joe Hogan: Thanks, John.
Shirley Stacy: Operator, we'll take one or two more questions please.
Operator: Okay. Our next question comes from Jason Bednar with Piper Sandler. Please proceed with your question.
Jason Bednar: Hey, good afternoon, everyone. Thanks for taking my questions here. Congrats on another really strong quarter. I appreciate all the details you discussed. Maybe building off some of the real-time commentary you shared at the end of your prepared remarks there, Joe, just curious if you can expand on what you're seeing in January for maybe a utilization perspective, maybe in the context of where we were October through December, any notable call-outs in January from a good geographic perspective or teens or adults?
Joe Hogan: I think the call-out, Jason, really is just the breadth of it really. There wasn't any geography in particular that dominated or it was just in segment to GP and ortho continued to be strong. So when you exit a year and you're at our new year, you're obviously glued to that month to see, especially in a business like this, what the momentum is and we just see a continuation of the strong momentum that we had in the fourth quarter. That's -- John, anything to add on that.
John Morici: I think the breadth of it is my note on this that we have across geographies between GP and orthos. And what we described is a lot of doctors that are higher-up in the tier, they're continuing to do a lot of volume, and then a lot of new doctors that come in that come in with cases in hand. And we can get them to start the Invisalign system into our digital ecosystem. So, that continued from Q4 into Q1.
Jason Bednar: Okay. That's helpful, guys. And then just focusing on China here just for a quick moment. There wasn't a great deal of discussion probably less in this call than maybe any other call in recent memory on China in particular. But impression, the seasonality that happens here in the fourth quarter, but maybe just wondering if you can expand on what you're seeing with your business and the Clear Aligner market in China specifically and maybe compare that against some of your other APAC markets.
Joe Hogan: Yes, we felt good about our growth in China 26% for the quarter overall. China, we see shutdowns periodically, issues in Shanghai or different places and Chinese are pretty draconian, I'd use the move is when they COVID, they move pretty quickly. The public hospitals have been throttled to certain extent unlike the procedures. But we feel good about the quarter and we feel, honestly, our investments in China, we really feel good about those. The manufacturing piece helps legitimizes us our IT systems from a data protection standpoint have to be geared towards China. We're in good shape with that. We're assembling iTero there now. We feel great about our training centers, great about our treatment planning capabilities. So overall, we remain bullish on China and we think that China will start to, with the rest of the world, will start to recover in the second half of next year too and we expect to be a big part of that.
Jason Bednar: Got it. Very helpful. Thanks, guys.
Shirley Stacy: Operator, we'll take one more question, please. I know we went over.
Operator: Okay. Our last question comes from Nathan Rich with Goldman Sachs. Please proceed with your question.
Nathan Rich: Hey, Joe. Good afternoon. Thanks for squeezing me in. Obviously, results over the past couple of quarters have been really strong. I guess, when we look out to 2021, it's tough to know what happens with COVID, but hopefully we'll start to get back to normal life later this year or 2022. I think as we look at where consensus is modeled I think on a high-teens revenue growth. It seems like you still feel comfortable with the 20% to 30% target. So do you feel like we should be expecting that type of growth in line with the long-term range off of this new higher level of volumes that you're starting to see in the back half of this year.
Joe Hogan: Nathan, that's -- we try to emphasize as much as we can, we feel very confident about those 20% to 30% ranges of growth. And continue to target 25, 30% operating profit to in order to do that. So you'll see us in investor rates that John talked about we're putting in place to drive that demand. So we make -- we remain committed to that model growth.
John Morici: And it starts with the vastly under-penetrated market and the investment opportunities we talk about. We tried to give you a kind of the breadth of all the different levers that we have to pull to be able to drive that return. And we continue to make that. It changes over time in terms of how we invest and where and so on, but that, that belief is still there. And when we make those forward investments, we're invested into that under-penetrated market that we think we can grow 22% in and do it at a 25%-plus op margin rate.
Joe Hogan: Yes.
Nathan Rich: Great. Well, congratulations on the strong quarter.
Joe Hogan: Thanks a lot, Nathan. I appreciate it
Shirley Stacy: Thanks, Nate. Well, thank you everyone for joining us today. This concludes our earnings call. If you have any follow-up questions, please contact our Investor Relations department. And we look forward to following up with you at upcoming conferences and virtual events. Have a great day.
Operator: This concludes today's conference. You may disconnect your lines at this time. Thank you for your participation. Have a wonderful evening. | [
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"speaker": "Operator",
"text": "Greetings and welcome to the Align 4Q and Fiscal Year Earnings 2020 Call. [Operator Instructions] It is now my pleasure to introduce your host, Shirley Stacy. Thank you, Shirley. You may begin."
},
{
"speaker": "Shirley Stacy",
"text": "Good afternoon and thank you for joining us. I'm Shirley Stacy, Vice President of Corporate Communications and Investor Relations. Joining me for today's call is Joe Hogan, President and CEO and John Morici, CFO. We issued fourth quarter and full year 2020 financial results today via GlobeNewswire, which is available on our website at investor.aligntech.com. Today's conference call is being audio webcast and will be archived on our website for approximately one month. A telephone replay will be available today by approximately 5:30 P.M. Eastern Time through 5:30 p.m. Eastern Time on February 17. To access the telephone replay, domestic callers should dial 877-660-6853 with conference number 13714292 followed by pound. International callers should dial 201-612-7415 with the same conference number. As a reminder, the information provided and discussed today will include forward-looking statements, including statements about Align's future events and product outlook. These forward-looking statements are only predictions and involve risks and uncertainties that are described in more detail in our most recent periodic reports filed with the Securities and Exchange Commission available on our website and at sec.gov. Actual results may vary significantly and Align expressly assumes no obligation to update any forward-looking statement. We have posted historical financial statements, including the corresponding reconciliations, including our GAAP to non-GAAP reconciliation if applicable, and our fourth quarter and full year 2020 conference call slides are on our website under Quarterly Results. Please refer to these files for more detailed information. And with that, I like turn the call over to Align Technology's President and CEO, Joe Hogan. Joe?"
},
{
"speaker": "Joe Hogan",
"text": "Thanks, Shirley. Good afternoon and thanks for joining us. On our call today, I'll provide some highlights from the fourth quarter and full year, then briefly discuss the performance of our two operating segments Clear Aligners and Systems and Services. John will provide more detail on our financial results and share additional color on business trends. Following that, I'll come back and summarize a few key points and open the call to questions. Our fourth quarter was a strong finish to the year with record revenues and volumes from both Invisalign aligners and iTero scanners, as well as increased gross margins, operating margins, EPS and cash flow. Our fourth quarter performance is driven by strong year-over-year growth across customer channels and regions and continued momentum sequentially. During the quarter, we achieved a major milestone in EMEA with the shipment to our 2 millionth Invisalign patient that will be amplified with the EMEA-wide campaign that will launch next month. This milestone from reflects strong acceleration in Invisalign adoption and growth. For Q4, total revenues were $834.5 million, up 13.7% sequentially and up 28.4% year-over-year. Q4 '20 Clear Aligner revenues of $700.7 million were up 12.9% sequentially and increased 28.9% year-over-year. In Q4, we shipped a record 568,000 Invisalign cases, an increase of 14.5% sequentially and 37.3% year-over-year. Q4 reflects increased Invisalign adoption from both adults and teenagers, which were up 36.7% and 38.7% year-over-year respectively. Our Teen and Mom-focused consumer campaign generated 77% year-over-year increase in unique visitors to our website and 76% increase in leads generation. In addition, Invisalign social media influencers like Charli D' Amelio, Marsai Martin, Christina Milian, Tisha Campbell-Martin, Rachel Zoe, Tiffany Ma, and Tahj Mowry continued to deliver exciting new content and increased engagement for the Invisalign brand with consumers and among their millions of followers. Our digital platform continues to gain traction as doctors uses of iTero scanners increase. Our Consumer and Patient app was rolled out to more than 50 markets, resulting in more than a 2.5 times increase in apps download and monthly active users in 2020 versus a year ago. Our patient feature usage continues to increase, for example, Invisalign Virtual appointment was used 68,000 times. Our insurance verification feature was used 26,000 times and more than 30,000 patients enrolled in Invisalign Virtual Care in 2020. Our new consumer website was rolled out to more than 40 markets around the world and is driving increased effectiveness in lead generation. We also launched an improved new doctor recruitment website in the U.S. and Canada to support our digital conversion journey. This will be expanded to other markets in the next few months. From a product perspective, growth was strong across Invisalign portfolio, especially for non-comprehensive cases including Invisalign Go and Invisalign Moderate. There are also more doctors engaging with us through the Align Digital and Practice Transformation or ADAPT program, as more practices are moving towards digital practice optimization. As you'll recall, ADAPT was piloted over two years ago and is being commercialized as a standalone service providing the relevant workforce, clinical and marketing support to enable doctors to digitally transform their practices. In Q4, we shipped a record 77,000 Invisalign doctors worldwide of which a record 7,300 were first time customers. We also trained over 6,400 new docs in Q4, including over 3,900 international doctors. Q4 '20 System and Services revenues of $133.8 million were up 18% sequentially driven by momentum in the Americas and EMEA, and up 26% year-over-year, reflecting strong growth in EMEA and Asia Pacific. Our results reflect continued strong uptake of the iTero Element 5D, the only intraoral scanner with caries detection which is scaling rapidly across each region and represented approximately a third of iTero volumes in Q4. Innovation remains a cornerstone of our business. Today, we announced the availability of the iTero Element Plus Series, which expands our portfolio of iTero Element Scanners in Imaging Systems to include new solutions that serve a broader range of the dental marketplace. The new iTero Element Plus Series of scanners in Imaging Systems builds on the success of the award winning iTero Element family and offers all of the existing orthodontic and restorative digital capabilities doctors have come to rely on, plus faster processing time and advanced visualization capabilities for seamless scanning experience in a new sleek ergonomically designed package. We announced the launch of our next-gen ClinCheck Pro 6.0 proprietary treatment planning software with in-face visualization and our Invisalign G8 improved predictability in our last earnings call we announced. Their availability is being expanded across all regions. Further, we launched several enhancements to our treatment planning, including improved Final teeth position and Auto segmentation. We also added several new features to our Virtual Care tool. For the full year 2020, total net revenues were a record $2.5 billion, up 2.7% year-over-year. Clear Aligner revenues of $2.1 billion were up 3.7% reflecting a record $1.6 million Invisalign shipments and growth of 7.9%. During the year, 30.3% of total Invisalign cases or nearly 500,000 teens or younger started Invisalign treatment. This is up 11.5% from 2019. System and Services revenues were down slightly compared to 2019. 2020 was a year unlike any other that we've experienced. The COVID-19 pandemic and its impact have been life-changing, marked by loss and separation, recovery and renewal, record highs and lows, and significant milestones and accomplishments. Even in a time of huge disruption, we all had to adapt, evaluate priorities and develop new ways of doing things both personally and professionally. Through it all, Align's priority has been the health and well-being of our employees and their families and our doctor, customers and their staff. And that remains a constant. Despite the swift onset of the pandemic and the uncertainty through 2020, we didn't hold our plans or change our strategy for continued growth. We completed the acquisition of exocad, accelerated our investments in marketing to create Invisalign brand awareness and drive consumer demand for our doctors' offices. Accelerated new technology to market with virtual tools that enable our doctors to stay connected with their patients, provided PPE to those in need and supported doctors and their teams with online education and digital forums that went beyond products to help them navigate the uncertainties of the pandemic. As a result of our continued strategic focus and investments, we exited the year stronger than we started and 2021 is off to a great start. Now, let's turn to the specifics around our fourth quarter starting with the Americas. With the Americas region, Q4 Invisalign case volume was up 12.7% sequentially and up 34.1% year-over-year, reflecting increased utilization of Invisalign treatment for both orthodontic and GP channels. Our continued investments in digital marketing and sales programs and focus on market segmentation are helping drive strong growth of Invisalign Clear Aligners and iTero products. During the quarter, we continued offering sales initiatives to our doctor partners to help drive adoption of Invisalign and iTero products. The Bracket BuyBack Switch program, which we launched in North America in Q2 '20 continues to drive conversion from wires and brackets to Invisalign clear aligners. During Q4, this program resulting -- has resulted in about 10,000 new cases similar to Q3. We believe this is also causing a halo effect with patients switching from wires and brackets to Invisalign clear aligners with increased awareness of the benefits of Invisalign treatment and how it is less disruptive to their lives with the outcome of a beautiful smile through an Invisalign trained doctor. The Teen Awesomeness Centers programs direct patients to Invisalign doctors who are experts at treating teens and are seen as the go-to docs for treatment. We continue to see growth with Invisalign First for treatment in younger kids driving increased comprehensive treatments within North America Ortho channel. Latin American volume was also up year-over-year, led by strong growth in Brazil and Mexico. We believe the market for orthodontic treatment is huge in Latin America as we continue to grow our presence across the region. We saw increased utilization in the GP channel with Invisalign Go and the continued adoption of Moderate. The GP Accelerator program designed exclusively for general practitioner dentist provides an all-encompassing support plan based on practice needs that is centered around maximizing iTero integration, clinical support needs, and implementing new marketing strategies. We also see increased utilization with GP dentists that have enrolled in the iPro program as well as with doctors that have installed the iTero scanner. DSO utilization also increased and continues to be a strong growth driver led by Heartland and Smile Docs. For the full year, Americas Invisalign volume was up 3.6% For our International business, Q4 Invisalign case volume was up sequentially 6.7% [ph], led by a strong growth in EMEA as doctors returned from summer holiday season, offset somewhat by seasonally slower period in China. On a year-over-year basis, International shipments were up 41.1%, reflecting increases throughout both EMEA and APAC. For the full year, International Invisalign volume was up 13.3%. For EMEA, Q4 volumes were up sequentially 47.9% and 48.3% on a year-over-year basis across all markets, with strong performance across both Ortho and GP channels. Within the GP channel specifically, we saw acceleration in both utilization and shipments with Invisalign Go. We also saw acceleration in both core and expansion markets, with growth in our core markets, led by Iberia, UK and France, along with continued growth in our expansion markets, led by Central and Eastern Europe and the Benelux. We introduced the Ortho Recovery 360 Program in EMEA last quarter to support our orthodontists as they started reopening their businesses. As of Q4, 3,200 orthodontists have enrolled in the program. During the quarter, we launched the Recovery II Program with a refreshed website featuring all digital tools, growth programs and education events for EMEA doctors to support their relief efforts during COVID-19. We also held our Digital Innovation Forum at the beginning of December where approximately 900 doctors, both Ortho and GP, attended the two-day forum event with keynotes on the digitization of dental practices. We also continued our Digital Excellence Series of webinars launched by the iTero team. Throughout the quarter, the following digital innovations were also launched across EMEA, Invisalign G8, ClinCheck Pro 6.0 and Invisalign Go Plus, to help drive Invisalign clear aligner utilization. To support our GP doctors, we launched our GP Recovery 360 program last quarter, with over 2,700 GPs enrolled so far. We continued to offer online and on-demand education events, which reached over 15,000 GPs cumulatively. For the full year, EMEA Invisalign volume was up 12.6%. For APAC, Q4 volumes were down sequentially 14.7%. Notwithstanding typical Q4 seasonality in China, following a strong Q3, we had strong growth in Japan and ANZ and Southeast Asia. On a year-over-year basis, APAC was up 30% compared to the prior year, reflecting continued strong growth across the region. We were pleased to see growth in the Adult segment with non-comprehensive cases with the Invisalign Moderate product in the GP channel. In the Teen segment, we also saw an increase in utilization amongst Invisalign doctors and we saw continued acceleration from Japan and ANZ. For the full year, APAC Invisalign volume was up 14.3.%. Last year, we launched a new and improved digital learning environment for our doctors offering a comprehensive learning platform with role-specific content for orthos, GPs and their teams. The improved functionality enables more online learning opportunities with spotlight features for what's trending now, recommended learning path based on doctors' experiences, and expanded categories including digital treatment planning, comprehensive dentistry, and team education. For the year, over 127,000 doctors have accessed recorded lectures, completed self-paced learning modules, and watched how-to videos, with new certified doctors viewing more than 1.4 million pages of content. Among the ortho channel, over 47,000 unique users have engaged with the digital learning site with an additional 80,000 unique users from the GP channel. As we've mentioned, we are seeing good adoption of the ADAPT program, which is an expert and independent fee-based business consulting service offered by Align to optimize clinics' operational workflow and processes to enhance patient experience and customer and staff satisfaction, which will in turn translate into higher growth and greater efficiencies for orthodontic practices. As a result, the ADAPT service participating practices in Q4 improved profitability significantly after implementation. Our consumer marketing is focused on capitalizing on the massive market opportunity to transform 500 million smiles, educating consumers about the Invisalign system and driving that demand to our Invisalign doctor offices. In Q4, we saw strong digital engagement globally with more than 77% increase in unique visitors, 108% increase in doc locator searches and 76% increase in leads created, driven by our global adult and mom-focused campaigns and teen-focused influencer content. Our US Mom/Teen multi-touch multimillion dollar campaign with influencer-led YouTube videos, a mom-focused TV spot, a custom Twitch activation, and mega teen sensation Charli D'Amelio continued to perform very well and garnered 2.7 billion impressions in Q4. The statistics I shared previously speak to the successful reach of this marketing campaign is having to not only drive demand with consumers, but also in educating them on the benefits of Invisalign treatment through a doctor's office. In Q4, we also launched media tests in the EMEA region in the UK, Germany and France and in the APAC region in Australia and Japan. These have worked very well and resulted in a more than six-times increase in leads in EMEA and a 3-times increase in leads in APAC. Several key metrics that show increased activity and engagement with the Invisalign brand are included in our Q4 quarterly presentation slides available on our website. Align is always looking for new opportunities to reach consumers and be relevant to potential patients wherever they work, live, and play, which is why we announced that the Invisalign brand is the Official Clear Aligner Sponsor of the National Football League, the NFL, and 11 NFL teams, including the Tampa Bay Buccaneers and the Kansas City Chiefs. The NFL league partnership, designed to expand our reach with consumers, generated over 150 million impressions in 2020, helping to drive awareness of Invisalign clear aligner treatment at a national level, while the team agreements are designed to help us engage within key markets and connect consumers with doctors in those markets. For our Systems and Services business, Q4 revenues were up 18% sequentially due to higher shipments and services revenues. We continued to see momentum with the iTero Element 5D Imaging System, gaining traction in all regions with significant Element Flex sales in EMEA. On a year-over-year basis, Systems and Services revenues were up 26% due to higher shipments and services. For the year, our Systems and Services total revenues were down 2.8% year-over-year. Cumulatively, over 31.4 million orthodontic scans and 6.7 million restorative scans have been performed with iTero scanners. For Q4, total Invisalign cases submitted with a digital scanner in the Americas increased to 84% from 79.5% in Q4 last year. International scans increased to 73.7%, up from 64.7% in the same quarter last year. We're pleased to see that within the Americas 94.8% of cases submitted by North American orthodontists were submitted digitally. We're also proud to share that iTero Element intraoral scanners are the winners of the 2020 Dentaltown Townie Choice Award for Digital Impressioning category. Also, during the quarter, the National Association of Dental Laboratories judging panel selected the iTero Element 5D as the winner of the 2020 Journal of Dental Technology WOW! Award. The award represents the recognition of our commitment to enhancing patient engagement and communications that support efficient laboratory production. For exocad, during the quarter we launched two of the largest software releases in history, DentalCAD and exoplan. DentalCAD3.0 Galway includes over 90 new features and over 80 enhanced functionalities with significant improvements to reduce design time, such as Instant Anatomic Morphing. exoplan 3.0 Galway includes over 40 new features and over 60 enhanced functionalities that support planning of edentulous cases, including the design of surgical guides. During the quarter, exocad also added two new large implant manufacturers as OEMs for exoplan in Brazil. With that, I'll now turn it over to John."
},
{
"speaker": "John Morici",
"text": "Thanks, Joe. Now for our Q4 financial results. Total revenues for the fourth quarter were $834.5 million, up 13.7% from the prior quarter and up 28.4% from the corresponding quarter a year ago. For Clear Aligners, Q4 revenues of $700.7 million were up 12.9% sequentially and up 28.9% year-over-year reflecting Invisalign volume growth in all regions, partially offset by lower ASPs. Clear Aligner revenues growth was favorably impacted by foreign exchange of approximately $5 million or approximately 0.8 points sequentially and on a year-over-year basis by approximately $10.3 million or approximately 1.9 points. Q4 Invisalign ASPs were down sequentially $15 primarily due to increased revenue deferrals related to a higher mix of new cases versus additional aligners, partially offset by favorable foreign exchange, and lower promotional discounts. As we mentioned last quarter, we did not implement a price increase in 2020 given our continued commitment to helping our customers in their recovery efforts during the pandemic. On a year-over-year basis, Q4 Invisalign ASPs decreased approximately $75 primarily due to our decision not to raise prices last summer, increased revenue deferrals for new cases versus additional aligners, and higher promotional discounts, partially offset by favorable foreign exchange. As a result, clear aligner deferred revenue on the balance sheet increased $83 million sequentially and $195 million year-over-year and will be recognized as the additional aligners are shipped. Total Q4 Clear Aligner shipments of 568,000 cases were up 14.5% sequentially and up 37.3% year-over-year. Our System and Services revenues for the fourth quarter was $133.8 million, up 18% sequentially due to an increase in scanner sales and increased services revenues from our larger installed base and higher ASPs. Year-over-year System and Services revenue was up 26% due to higher scanner sales, services revenue, and the inclusion of exocad's CAD/CAM services, partially offset by lower scanner ASPs. Imaging Systems and CAD/CAM Services deferred revenue was up 30% sequentially and up 69% year-over-year primarily due to the increase in scanner sales and the deferral of service revenues, which will be recognized ratably over the service period. Moving on to gross margin. Fourth quarter overall gross margin was 73.2%, up 0.4 points sequentially and up 0.5 points year-over-year. On a non-GAAP basis, excluding stock-based compensation expense and amortization of intangibles related to exocad, overall gross margin was 73.6% for the fourth quarter, up 0.3 points sequentially and up 0.7 points year-over-year. Clear Aligner gross margin for the fourth quarter was 74.9%, up 0.1 point sequentially due to lower additional aligner volume, partially offset by higher warranty, other manufacturing costs and lower ASPs. Clear Aligner gross margin was up 0.7 points year-over-year primarily due to favorable product mix from increased iTero scanner absorption as a result of increased manufacturing volumes partially offset by lower ASPs, higher warranty costs and other manufacturing costs. Systems and Services gross margin for the fourth quarter was 64.2%, up 2.2 points sequentially primarily due to higher ASPs and increased manufacturing efficiencies from higher productions volumes. Systems and Services gross margin was down 0.7 points year-over-year due to lower ASPs, higher freight and other manufacturing costs partially offset by higher services revenue. Q4 operating expenses were $397.3 million, up sequentially 11.3% and up 23.8% year-over-year. The sequential increase in operating expenses is due to increased marketing and media spend and spending commensurate with business growth. Year-over-year, operating expenses increased by $76.5 million, reflecting our continued investment in sales and marketing, R&D activities, and manufacturing operations. On a non-GAAP basis, operating expenses were $372.3 million, up sequentially 12.1% and up 23.4% year-over-year due to the reasons as described earlier. Our fourth quarter operating income of $213.2 million resulted in an operating margin of 25.5%, up 1.4 points sequentially and up 2.3 points year-over-year. The sequential and year-over-year increases in operating income and the operating margin are primarily attributed to higher gross margin and operating leverage. On a non-GAAP basis, which excludes stock-based compensation, amortization of intangibles related to exocad, and acquisition-related costs, operating margin for the fourth quarter was 28.9%, up 0.9 points sequentially, and up 2.5 points year-over-year. Interest and other income and expense, net for the fourth quarter, was a benefit of $1.4 million, primarily driven by favorable foreign exchange. With regards to the fourth quarter tax provision, our GAAP tax rate was 25.9% which includes tax benefits of approximately $11 million related to adjustments in prior years' unrecognized tax positions. The fourth quarter tax rate on a non-GAAP basis was 14.5% compared to 16.6% in prior quarter and 20.9% in the same quarter a year ago. The fourth quarter non-GAAP tax rate was lower than the third quarter's rate primarily due to the reason previously stated. Fourth quarter net income per diluted share was $2.00, up $0.24 sequentially and up $0.47 compared to the prior year. On a non-GAAP basis, net income per diluted share was $2.61 for the fourth quarter, up $0.37 sequentially and up $0.85 year-over-year. Moving on to the balance sheet. As of December 31, 2020, cash and cash equivalents were $960.8 million, an increase of approximately $345.3 million from the prior quarter, which is primarily due to higher cash flow from operations. Of our $960.8 million of cash and cash equivalents, $548.3 million was held in the U.S. and $412.5 million was held by our International entities. Q4 accounts receivable balance was $657.7 million, up approximately 5% sequentially. Our overall days sales outstanding was 71 days, down approximately 6 days sequentially and down approximately 5 days as compared to Q4 last year due to strong cash collections. Cash flow from operations for the fourth quarter was $381.4 million. Capital expenditures for the fourth quarter were $53.2 million, primarily related to our continued investment in increasing aligner capacity and facilities. Free cash flow, defined as cash flow from operations less capital expenditures, amounted to $328.3 million. Under our May 2018 Repurchase Program, we have $100 million still available for repurchase of our common stock. Before we move to the outlook, I would like to make a few comments on the full year 2020 results. In 2020, we shipped a record 1.6 million Invisalign cases, up 7.9% year-over-year. This reflects 13.3% volume growth from our International doctors and 3.6% volume growth from our Americas doctors. System and Services volumes were down 12% compared to 2019, reflecting the impact of COVID-19 pandemic on equipment sales. Total revenue was a record $2.5 billion, up 2.7% year-over-year, with Clear Aligner revenues a record $2.1 billion, up 3.7% year-over-year. 2020 Systems and Services revenues were $370.5 million, including exocad revenues from April 1, 2020 forward compared to $381 million in 2019. Full year 2020 operating income of $387.2 million, down 28.6% versus 2019 and operating margin at 15.7% versus 22.5% in 2019. 2019 operating income included a litigation benefit of $51 million and Invisalign Store closures of $23 million for a net benefit on operating margin of 1.1%. With regards to a full year tax provision, our GAAP tax rate was negative 368.6%, which includes a one-time tax benefit of approximately $1.5 billion, net of current year amortization, associated with the recognition of a deferred tax asset related to an intra-entity sale of certain intellectual property rights resulting from our corporate structure reorganization completed in the first quarter of 2020. Excluding the tax benefit related to our corporate structure reorganization and the related tax effects of stock-based compensation and other non-GAAP adjustments, the full year tax rate on a non-GAAP basis was 17.6% compared to 22% for 2019. 2020 diluted EPS was $22.41. On a non-GAAP basis, 2020 diluted EPS was $5.25. Free cash flow was $507.3 million for 2020, down $90.3 million versus 2019. Now, let me turn to our outlook. Overall, we are very pleased with our Q4 performance and the strong momentum in our business, which has continued through January for both Clear Aligners and Systems and Services. As we discussed at our Investor day in November, we are committed to making significant investments to drive growth and we are seeing good return on these investments across all regions and customer channels. These strong returns give us confidence to continue investing in sales, marketing, innovation and manufacturing capacity to accelerate adoption in a huge, underpenetrated market. These investments coupled with typically higher seasonal operating expenses as a percentage of revenue are expected to result in a sequentially lower operating margin percent in Q1 as we have historically seen. While the global environment surrounding the pandemic remains uncertain, we will continue to focus on what we can control and we are confident in our ability to continue to execute. Our responsibility is to continue driving innovation and delivering on the needs of our customer doctors and their patients. Over the past 24 years, Align has invested billions in technology, innovation, consumer marketing and demand creation to connect millions of consumers with our doctor customers. We will continue to invest in this business to drive demand and to drive adoption of the Align Digital Platform, including manufacturing and operational expansion. We will always be responsible. Just like we've done in the past, we make investments to drive growth and maximize ROI. We remain committed to our long-term target model of 20% to 30% revenue growth for Clear Aligners and Systems and Services, and operating margin of 25% to 30%. With that, I'll turn it back over to Joe for final comments. Joe?"
},
{
"speaker": "Joe Hogan",
"text": "Thanks, John. The choices we made in 2020, to protect employees, support customers, and press forward on our strategy for growth, were possible because of the strength of our balance sheet and the confidence we have in our business model. Our actions reflect our conviction in the enormous opportunity we have to transform smiles and change lives. With 15 million orthodontic cases starts annually and more than 500 million consumers who can benefit from a better smile, the market for digital orthodontics and restorative dentistry is massive and has been unleashed by the need for digital. In a macro sense, COVID-19 has accentuated the benefits and pervasiveness of the digital economy. From an Align standpoint, practices across every region are embracing digital treatment in new ways and more purposefully than ever before. Invisalign providers are using our virtual tools to minimize in-office appointments and deliver doctor-directed, personalized treatment that meets the needs of the moment and that will reshape the future of treatment. Digital acceleration is not just around Invisalign treatment. It includes digital workflows around iTero scanners and general dentistry. Doctors tell us that the iTero scanner is central to their practice and their practice workflows, and it is key to driving digital treatment. We've always known this, iTero and now exocad are core components of the Align Digital Platform, our integrated suite of unique, proprietary technologies and services delivered as a seamless, end-to-end solution for patients and consumers, orthodontists and GP dentists, and lab partners. And particularly, we now have all the building blocks to create digital workflows, leveraging the combined power of Invisalign treatment, iTero scanners, and exocad software to become more relevant to the GP market, which is critical to accessing the 500 million consumer opportunity. Align is a growth business with huge opportunities, but the environment remains uncertain due to COVID-19. Our plan is still to counter uncertainty by staying focused on our long-term strategy, living our values, supporting our employees and customers, and keeping in mind the demand drivers we've identified over the past year, the re-direction of disposable income for many consumers, channel focus that allows us to reach and support a wider range of customers within each channel. And most importantly, the digital mindset that's taking hold with more and more of our customers and that we are supporting through innovative products and programs that can help support their digital transformation. We are not ignoring the reality of COVID-19 and how long it may be part of our lives, but we're also not going to stop driving the business forward for the good of customers and their patients, our employees, and our stakeholders. In closing, I want to leave you with a few thoughts as we begin the new year. While there is considerable amount of turmoil in the world, our focus is on what we can control as a company. We have strong momentum. We'll stay focused on our strategic priorities, international expansion, patient demand and conversion, orthodontist utilization, and GP dentist treatment. In summary, we are very pleased with the fourth quarter and full year results of 2020, during a remarkable year with events beyond our control as a result of COVID-19. It is during times such as this when having a solid strategy combined with focused execution can lead to outcomes that support growth, not only for Align's business but also practice growth for Align's customers which also leads to more and more Invisalign smiles. With that, turn it over to the operator and we'll take calls."
},
{
"speaker": "Operator",
"text": "[Operator Instructions] Thank you. Our first question comes from Ravi Misra with Berenberg Capital Markets. Please proceed with your question."
},
{
"speaker": "Ravi Misra",
"text": "Hi. Thanks for the question. Hi. How are you?"
},
{
"speaker": "Joe Hogan",
"text": "Good."
},
{
"speaker": "Ravi Misra",
"text": "Happy New Year. So I just wanted to maybe start on -- I'll let the others maybe talk about the quarterly trends, but one of the things that kind of stood out to me was you're driving extremely strong volume growth amidst what's kind of a stable to slightly declining pricing environment. Just curious, first, when do you think you'll be able to go back to the kind of prior model where you're able to take pricing? Is that still in the cards? And then secondly, I think the teen market is an area that we've kind of always been looking at as the next leg of growth, the kind of huge market that's out there. And you're talking about some of the conversion and the lead generations. Can you help us understand kind of the conversion rates around the leads that you generate in terms of timing and how long this takes to get the ROI that is put into the advertisements that you're putting out there?"
},
{
"speaker": "Joe Hogan",
"text": "Ravi, first of all, I guess, your first question is on average selling prices. We try to communicate this as strongly as we can is to keep your eyes on gross margin, because we have huge mix, whether it's international mix or it's product mix, you see a lot of progress in iGo and products like Moderate and Invisalign First in those products. The carry actually lower average selling prices, but higher margins, and so you can often mix up on those things. So I'd say as we keep emphasizing is don't be overly concerned about ASPs or focused on ASPs. Like John said, we didn't increase ASPs this year because we're interested in supporting our customers and making sure that this is difficult -- a really difficult transition for many practices right now and instituting a price increase just wouldn't have been responsible in that sense. But at the same time, we drove incredible productivity across the business and we're able to show those kind of gross margins. So I hope you and the rest of the analysts community out there can actually see that. We've been talking about this for a few years, but actually taking place. On the teen side and the conversions from an advertising standpoint, I mean, we come out just from a lot of different ways and a lot of different areas. And we -- if we are going to start teen season, you really have to start in February in the United States and you have to really work through a lot of different aspects of social media. You advertise differently for moms and you do teens and different things like that. So I can't give you a correlation coefficient in the sense of here we invest and how much we get back, but we understand as well as a business, we've been doing it for years. We understand the timing of it. And more and more we become more specific on the social advertising pieces and how to implement that properly. And John, do you have anything you want to add?"
},
{
"speaker": "John Morici",
"text": "No. As you said, I mean, it's -- there's others that are in the equation. You have to reach the teen, as Joe described, and we talked about social influencers and so on. You have to reach the parents and we try that. And then also have the right formula with the doctors. So getting those three to think about going into treatment is really the key."
},
{
"speaker": "Ravi Misra",
"text": "Okay. Then maybe one last one if I can ask one more, just on the reopening and vaccination progress and kind of volumes. How are you guys kind of thinking about the consumer spending environment as the options that the patient is going to have start increasing. I mean is that going to require more investment here in the near term or do you think kind of where we're at a baseline where you've kind of gotten the ramp where things are starting to really click here with the advertising that you're doing as is? Thank you."
},
{
"speaker": "John Morici",
"text": "Yes, Ravi, it's a good question. I mean, look, we're always looking to maximize our return on investment. We talk about that to grow in this vastly underpenetrated market. In some countries like in the U.S., it's just a matter of refining how we spend. We talked about the influencers, talked about NFL and other things. And in other countries, we've really started spending some of that consumer advertising and we see a great response and we see a strong return. And those are areas that, as we see that response, we see it turn into volume, those are areas that will continue. So we're always looking at return on investment and we'll find ways to be able to grow our volume that way."
},
{
"speaker": "Joe Hogan",
"text": "Thanks, Ravi."
},
{
"speaker": "Operator",
"text": "Thank you. Our next question comes from Jon Block with Stifel. Please proceed with your question."
},
{
"speaker": "Jon Block",
"text": "Hey, Joe. Good afternoon. Joe, you mentioned 2021 is off to a great start. From 2015 to 2019, so I'm sort of isolating pre-COVID management guidance for 1Q cases, the guidance for 1Q cases were up pretty consistently, just low single-digits off of what you did in the fourth quarter. And I guess where I'm going with this is at a high level, what's the expectation for case growth sequentially? And I'm just trying to level set as the back part of 2020 likely benefited from some pent-up demand. So just how we should think about the trend line, if you would, into the early part of 2021?"
},
{
"speaker": "Joe Hogan",
"text": "Jon, I'll let John have the specifics. I would just tell you that January was a really strong orders quarter, so that momentum really continues."
},
{
"speaker": "John Morici",
"text": "And look, Jon, I think as we've said it, we're controlling what we can control, making investments that help drive this business. We look at -- as Joe said, we felt really good about how we exited Q4. We saw that in January as well, and we don't want to guide. We basically haven't because there is things that are outside of our control. And we'll leave that as it is. What we're trying to give you is kind of the latest information without projecting forward."
},
{
"speaker": "Jon Block",
"text": "Okay, fair enough. And I'll ask a quick two-part for the second one. EMEA was just gangbusters, I mean, it was up 48% of a 32% comp, shout out to Markus, but anything to call out there? I mean, the number was huge. And then the second part is teen up almost 40%, Joe. What do you think the underlying ortho market was growing? Where I'm going with this is just your conviction of sort of maybe a type of inflection point, if you would, with teen's share of share. Thanks, guys."
},
{
"speaker": "Joe Hogan",
"text": "Jon, I appreciate you bringing up EMEA, I mean, that was just an amazing performance when you see that. I've been doing business in Europe since I was 30 years and you see growth like that by countries, it's amazing. And I think that, to me, that was really a story on the fourth quarter too was the breadth of that growth. It wasn't just North America. It wasn't just Asia. It was deep across segments, across GPs, across orthos. So Jon, I'm not ready to talk about an inflection point. All I can say is when you think about, we had 77,000 doctors that ordered that I talked about in my script. And then 7,200 to 7,300 more doctors, that's 10% more doctors, that's a record for us too. So we see Invisalign, this digital treatment really catching on in a big way and it's meaningful. Look, we're gearing up for it. We're obviously advertising to drive that demand and will stay focused on just executing, Jon, right now."
},
{
"speaker": "Jon Block",
"text": "Thanks, guys."
},
{
"speaker": "Shirley Stacy",
"text": "Thanks, Jon. Next question?"
},
{
"speaker": "Operator",
"text": "Thank you. Our next question comes from Steve Beuchaw with Wolfe Research. Please proceed with your question."
},
{
"speaker": "Steve Beuchaw",
"text": "Hi. Thanks for the time here, guys. I wanted to try to understand a little bit better the relationship between some of the things that you flagged, John, in your prepared remarks as it relates to deferrals and ASP. I certainly agree with the view that gross margins are really the critical metric, but I'm sure we're going to get a lot of questions about ASP tonight and over the next couple of days. So I wonder if you could help us understand a little bit more deeply, one, why we'd be seeing more deferred revenue here both on aligners and scanners? And what's the relationship to ASP and do we see that reverse?"
},
{
"speaker": "John Morici",
"text": "Yes, Steve, the basic way to think about this as we look at our revenue, we've got revenue on a new case that we ship out. And there is a certain amount that you recognize on that shipment based on our rev rec. And then there is a certain amount for future aligners or future modifications that are needed. That will be deferred revenue. And then you also get into your revenue so that those deferrals that you've made for maybe previous quarters or even previous year that as they -- that doctor needs to use that additional lines, you're going to get revenue for that. When you have a mix like we have, where there is much more, there is this demand for future volume for new cases, you get a mix where we just have a lot more as a percentage of new cases and that's what impacts ASPs. When we look at that from a margin standpoint, it's margin accretive. We're getting as new cases. Many of the cases that we get back from a deferred revenue standpoint where there's refinements we just don't make as much margin on that. You get the deferred revenue, but you don't get as much of the margin. So there is those dynamics that we have. We saw just when you have a significant volume increase like we saw in our third and fourth quarter."
},
{
"speaker": "Steve Beuchaw",
"text": "Okay. Thank you, John. And then I wanted to follow-up about the GP channel. GP has been just gangbusters here lately. I wonder if I could try to understand that a little bit more deeply. One is do you think it continues to grow at the sort of clip relative to the ortho channel? Maybe two, do you think exocad has been a driver of incremental growth in that channel at this point? And then lastly, should we think about the shift to DSOs being a variable one way or another. And I apologize for my kids screaming in the background."
},
{
"speaker": "Joe Hogan",
"text": "That's the life we live now, Steve. We understand. It happens on and off like every call. From a GP channel standpoint, I mean, three years ago when we first started segmenting in Europe and now we are doing in the States and we do it all over the world. And then we introduced products like iGo that were specific to it. And just a salesforce that can communicate with GPs because it's a different conversation than with orthos. Yes, I can't tell you where it's going, but when we talk about that 500 million patients like I did in my script, that's where they are, and that's where you touch them. I mean, it's a different. It's not a big teen market. It's a lot of adults. But it has to have a workflow that's specific to a GP. And that's why we drive their products, that's why iTero is so important from a front-end standpoint. Your question on exocad is, we think that's going to be a big GP driver for us. It is a big legitimate piece for us, but I don't think it's adding to volume right now. We're just rolling out these new products. We're just starting to integrate that kind of software code into iTero and into our programs and that's certainly will drive increased penetration in the future."
},
{
"speaker": "Steve Beuchaw",
"text": "Got it. Thank you so much for all the perspective here."
},
{
"speaker": "John Morici",
"text": "Yes. Thanks, Steve."
},
{
"speaker": "Shirley Stacy",
"text": "Next question?"
},
{
"speaker": "Operator",
"text": "Thank you. Our next question comes from Jeff Johnson with Robert W. Baird & Co. Please proceed with your question."
},
{
"speaker": "Jeff Johnson",
"text": "Thank you. Good evening, guys. Hey, Joe. I wanted to start with -- I know it's tough and maybe there is not even a way to do it, but any way to think about especially over the last two quarters, how much of this patient volume has been backlog versus the zoom effect versus true kind of accelerating penetration of clear aligners versus brackets and wires. Just is there any way to bucket or any metrics you're looking at that tells you this is truly kind of that secular uptick we've all been waiting for versus backlog and some of the zoom effect?"
},
{
"speaker": "Joe Hogan",
"text": "I think as we get further and further from the second quarter obviously the backlog question becomes less and less as part of the noise of the structure, right. I feel a lot of analysts, Jeff, they wonder, hey, we had a great third quarter obviously and it was, well, how much of that was really the second quarter that's rolled into the third. We really don't know what that was. We don't. And our doctors don't know it either as we talk to them. The fourth obviously had less of that. And we really felt good about our orders in January too. So I think we're really moving away from that question here soon. The number of docs like I just quoted with over 7,000 new docs ordering from us, 77,000 in total shows you the breadth of what's going on. And what's really struck me in this entire thing too, Jeff, is really this is not just United States, this is all over the world. It's Latin America, it's APAC. It's tremendous growth in Japan and ANZ and traditional markets, in China, in Europe. So there is breadth to this and then the segments we talked about, both GPs and orthos. So look, there have been backlog in the third quarter. There has to be some backlog in the fourth quarter or whatever. But we don't think that's the overriding story here."
},
{
"speaker": "Jeff Johnson",
"text": "Yes, that's fair. And then one other kind of maybe more a conceptual question. Just as I think about -- I think about it through your Advantages program, but are you seeing doctors that are the high volume guys, the Platinum guys moving up to Diamond and Double Diamond? Is it the lower Bronze or Gold guys moving up to Platinum? Does it matter to you which it is? But more importantly conceptually, is it getting those low volume guys to really go all in here or the high volume guys to convert completely to Invisalign? And I'm sure you're going to tell me it's a mix of both of that, but just kind of what you're seeing would be helpful there on your own customer base."
},
{
"speaker": "Joe Hogan",
"text": "Yes. You helped me answer that question, Jeff, it is a mix. But it is really broad. I mean, we see in the Bronze accounts and Golds and all the way to Diamond and Diamond Plus. And we see growth in all those segments. And I think it's kind of logical, right. The people that know how to do digital are going to expand on it, because digital really allows them to function in this COVID environment in a way that allows them fewer customer touches and they can actually carry on their practices in a normal way. Other doctors actually see the advantages of that. They have patients asking for them. And they start to move toward a digital kind of a platform. And overall, again, it's a breadth discussion. It's not just one area, it's not just one country, it's not one segment of the Advantage program. We just weren't seeing adoption across the board. And John, anything to add on that?"
},
{
"speaker": "John Morici",
"text": "I'd echo this, the breadth. I mean, you have new doctors, like Joe said, 7,000 new doctors that come in with and want to do cases that come into our ecosystem and start cases. You see doctors who have done just a few cases really start to accelerate and then at the top of the pyramid, you have people that are doing a lot of cases and they do even more cases. So that's part of when we talk about the breadth of this growth and what makes it excited. And it's like Joe said, not just a U.S. phenomena, it's pretty much everywhere."
},
{
"speaker": "Joe Hogan",
"text": "And Jeff, I think the last thing you said is do you care which I thought was kind of interesting is like we really don't care. We just want to serve the doctors who want to work with us. We see this market -- we talk about how large this market is and how under-penetrated it is. And we just want to see wherever that growth is, that's great. It's on the low end, that's terrific. It's on the high end, that's terrific. We set this company up to be able to service either side to work well with them."
},
{
"speaker": "Jeff Johnson",
"text": "Thank you. I appreciate the comments."
},
{
"speaker": "Joe Hogan",
"text": "Thanks, Jeff."
},
{
"speaker": "Operator",
"text": "Thank you. Our next question comes from Elizabeth Anderson with Evercore. Please proceed with your question."
},
{
"speaker": "Elizabeth Anderson",
"text": "Hi, guys. Thanks so much for the question. Hey, Joe. I always thought -- obviously the -- one of the many nice parts of the quarter was the scanner and CAD/CAM revenue. Can you talk a little bit about what you sort of see as market growth there? Like where are you taking share? Is it in the GP, more on the ortho channel? Is it orthodontists adding their third scanner? Is it people finally saying, yes, I'll go digital? Obviously, the total number of cases submitted digitally was very high. Any other color you could provide there would be really helpful."
},
{
"speaker": "Joe Hogan",
"text": "Elizabeth, you could work for us, okay. You kind of described exactly how that demand is, it's coming from all these different places. And a lot of it when you say where you're taking share, a lot of is just analog share. There is so much in dentistry is still just completely analog. They're still doing impression and different pieces. And so it's the growth has been tremendous in that sense. Your question about orthodontists that start to move up into a significant part of their practice being Invisalign, you'll see -- you see a scanner at every chair. And they use these things are constantly. It's part of what they do. What we see on the GP segment is the communication tool ends up being the scanner in the front of the scanner. Because you know in the past, they'd hold up a mirror and say, can you see that, that second molar back there and you'd say, yes, but you really couldn't, right. Now, you throw it on a screen. It's live, you can see exactly what's going on. It becomes an incredible patient-communication tool in a sense of where is your dentist and what needs to be done and helps to convince patients of what the doctor wants to do and the validity of that kind of treatment. So this is where dentistry is going. And when you look at iTero, it is arguably the highest performing scanner in the world, the speed of it, the exactness of it, color rendering, and also with NIRI technology to be able to see caries or cavities is a real benefit, even to orthodontists who want to make sure that before you start the treatment that dentition is in good enough shape to able to except that kind of movement. So that's just -- this is the time for digitization inside of dentistry and iTero plays a big role in that and it front-ends our digital platform."
},
{
"speaker": "John Morici",
"text": "Especially in a COVID environment, given the fact that you don't want to have as much time for impressions and so on and you want to be able to have something that's fast and really be part of that digital workflow, this iTero lends itself well."
},
{
"speaker": "Joe Hogan",
"text": "Yes."
},
{
"speaker": "Elizabeth Anderson",
"text": "Okay, that's super helpful. And Joe, sort of like to just follow up more a housekeeping question. One, obviously you announced the new products today and I imagine that that's something you'll be talking about in sort of the virtual Chicago Midwinter and what you would have discussed a lot of it IDS. Is there anything we should keep in mind in terms of the ramp of sort of new products or impacts from IDS moving to the back half of the year? And then on the other side, obviously we saw your announcement about the move to Arizona. Sounds exciting. I just didn't know if that had any impact in terms of something we should model in on taxes or anything else just to touch on that as well."
},
{
"speaker": "John Morici",
"text": "Yes, I think I can answer the tax piece of it. No, really not a tax impact. It really came down to when we look at the campus that we have in San Jose and the expansion that we have from a technology center, we become space constraint. And so we want to keep that technology center, that innovation center in San Jose and expand that out and add more to help with that innovation. And then moving to here in Tempe for kind of that head office just made sense to us."
},
{
"speaker": "Elizabeth Anderson",
"text": "Okay, thanks."
},
{
"speaker": "Joe Hogan",
"text": "Yes, it is upon the new product pieces. Keep in mind we talked about we spend $500 million a year on advertising and also new product development, you'll see a lot of new products. We don't pace ourselves on those introductions based on IDS. And that's why we obviously announced the new iTero scanner. We talked about the new 6.0 software that we have. A lot of changes to FiPos, it's our final positioning aspect to dentition. We had the Plus product from iGo, the in-face visualization. This is a digital business that requires constant iterations in products. And obviously Midwinter and those things are great places to highlight it. But our innovation, we looked at it agile, not waterfall anymore. In the sense, waterfall used to be invent during the year, release one period of the year. More and more, you'll see us just monthly just rolling out new products as we adapt to a more kind of an agile philosophy of development than a waterfall type of -- if that's what you're asking, Elizabeth."
},
{
"speaker": "Elizabeth Anderson",
"text": "Makes total sense. Thank you so much."
},
{
"speaker": "Joe Hogan",
"text": "Yes. You're welcome."
},
{
"speaker": "Operator",
"text": "Thank you. Our next question comes from Richard Newitter with SVB Leerink. Please proceed with your question."
},
{
"speaker": "Richard Newitter",
"text": "Hi, thank you for taking the questions. Just maybe to start off the Switch program, which has fairly been extremely successful for you. I'm curious to know how much more runway there is associated program, and maybe if you could just comment on kind of how you're at least thinking about that from your internal modeling?"
},
{
"speaker": "Joe Hogan",
"text": "Yes, look, I think it has a huge amount of breadth to it. I mean, it's not just U.S. We started this in Japan actually years ago and introduced in the United States. And you think about -- it's just a great winner, detaching those wires and brackets from people's teeth using Invisalign, understanding, like we said, in our script, is how much more simple it is and better for people and comfortable for people to go with our product line. So we think it's -- we have a lot of room to grow and we're going to keep supporting it."
},
{
"speaker": "John Morici",
"text": "Yes. And Rich, it's John. I mean, we are always looking at those types of promotions for an ROI. And in these cases, many cases looking at it from an incremental standpoint, nothing could be more incremental than it was glued onto someone's teeth and now they come off and they go to Invisalign. So we like those dynamics there. It sends a great message. And those people who had wires and brackets on their teeth can talk about their experience with Invisalign. So there is a lot of positives to it, as Joe said, it started in Japan. And we've seen great success in the U.S. and we look to other places as well."
},
{
"speaker": "Richard Newitter",
"text": "Got it. Helpful. And Joe, you said a few times how encouraging the trends have been in January. I'm just curious, understanding it's only one month, but how well is the growth, if the trend that you're seeing now were to whole kind of for a good portion of the year, where in your long-term kind of long-range plan of 20% to 30% do you think you'd be falling towards the mid to upper end? I'm just trying to get a sense for kind of what do you think in there?"
},
{
"speaker": "Joe Hogan",
"text": "Nice try, Richard. Look, we're very committed to our long-term growth model 20% to 30%. That's really all I can say right now. Rich, we're in a really uncertain environment. We're happy about January. It is why we're not giving guidance. It's -- we're all living with volatility right now and we'll just continue to execute and keep our heads down, but we're committed to that 20% to 30% growth model that we've been talking about for several years."
},
{
"speaker": "Richard Newitter",
"text": "Okay, thanks. Thank you."
},
{
"speaker": "Shirley Stacy",
"text": "Next question?"
},
{
"speaker": "Operator",
"text": "Thank you. Our next question comes from John Kreger with William Blair. Please proceed with your question."
},
{
"speaker": "John Kreger",
"text": "Hey, Joe. Just sticking with that answer, you were obviously above that in terms of volumes in the fourth quarter. How do you feel about your ability to deliver on that if the order flow were sustained? In terms of fabrication and fulfillment, how are those metrics holding up at this point?"
},
{
"speaker": "Joe Hogan",
"text": "Our supply chains, we try to keep ahead in that sense. So, I feel we have adequate plans and capacity right now to be able to handle the surge in demand."
},
{
"speaker": "John Kreger",
"text": "Great. Okay. And then, John, I think you've talked about in the past a reasonable assumption is kind of a flattish ASP, and realized there's a lot of puts and takes. But is that still a reasonable kind of planning thing for us? Or are you guys thinking less on the pricing front, and, therefore, maybe more of a downward trend over the coming year?"
},
{
"speaker": "John Morici",
"text": "It's tough because it really becomes kind of the end result, because if you have more primary cases as I spoke compared to secondaries, you can get some of these impacts in ASPs. I think, in general, there is not a significant change that we would expect in some of the mix or some of that some of that pricing. So that being said, you wouldn't expect too much fluctuations in ASPs. But like I said, it depends on that demand that comes forward from our doctors."
},
{
"speaker": "John Kreger",
"text": "Got it, okay. And then one more, Joe, sorry, in a typical year, we'd assume kind of teens would be big in Q3 and adults would be bigger in Q4. Is that same sort of seasonal pattern likely do you think in '21 given what we know now, or would you expect kind of teen order flow to be more kind of spread evenly throughout the year."
},
{
"speaker": "Joe Hogan",
"text": "Hey, John, we don't know. But I'd say it became muted this year. Obviously, we saw as much stronger fourth quarter United States in teens than we saw -- that you normally see from a seasonal standpoint, it got continued. So I think all of us are expecting summer and fall months as COVID to start to retreat a little bit, that might take us back to the patterns that we had before. But I don't think it's going to be binary. I really don't, I think this could have changed the pattern. We're just going to have to -- we're going to have to just ride the curve here and see how it goes. But we'll continue to advertise through this to execute on a place that we talked about in our scripts and we've really feel confident we can continue to drive significant teen demand."
},
{
"speaker": "John Kreger",
"text": "Great, thank you."
},
{
"speaker": "Joe Hogan",
"text": "Thanks, John."
},
{
"speaker": "Shirley Stacy",
"text": "Operator, we'll take one or two more questions please."
},
{
"speaker": "Operator",
"text": "Okay. Our next question comes from Jason Bednar with Piper Sandler. Please proceed with your question."
},
{
"speaker": "Jason Bednar",
"text": "Hey, good afternoon, everyone. Thanks for taking my questions here. Congrats on another really strong quarter. I appreciate all the details you discussed. Maybe building off some of the real-time commentary you shared at the end of your prepared remarks there, Joe, just curious if you can expand on what you're seeing in January for maybe a utilization perspective, maybe in the context of where we were October through December, any notable call-outs in January from a good geographic perspective or teens or adults?"
},
{
"speaker": "Joe Hogan",
"text": "I think the call-out, Jason, really is just the breadth of it really. There wasn't any geography in particular that dominated or it was just in segment to GP and ortho continued to be strong. So when you exit a year and you're at our new year, you're obviously glued to that month to see, especially in a business like this, what the momentum is and we just see a continuation of the strong momentum that we had in the fourth quarter. That's -- John, anything to add on that."
},
{
"speaker": "John Morici",
"text": "I think the breadth of it is my note on this that we have across geographies between GP and orthos. And what we described is a lot of doctors that are higher-up in the tier, they're continuing to do a lot of volume, and then a lot of new doctors that come in that come in with cases in hand. And we can get them to start the Invisalign system into our digital ecosystem. So, that continued from Q4 into Q1."
},
{
"speaker": "Jason Bednar",
"text": "Okay. That's helpful, guys. And then just focusing on China here just for a quick moment. There wasn't a great deal of discussion probably less in this call than maybe any other call in recent memory on China in particular. But impression, the seasonality that happens here in the fourth quarter, but maybe just wondering if you can expand on what you're seeing with your business and the Clear Aligner market in China specifically and maybe compare that against some of your other APAC markets."
},
{
"speaker": "Joe Hogan",
"text": "Yes, we felt good about our growth in China 26% for the quarter overall. China, we see shutdowns periodically, issues in Shanghai or different places and Chinese are pretty draconian, I'd use the move is when they COVID, they move pretty quickly. The public hospitals have been throttled to certain extent unlike the procedures. But we feel good about the quarter and we feel, honestly, our investments in China, we really feel good about those. The manufacturing piece helps legitimizes us our IT systems from a data protection standpoint have to be geared towards China. We're in good shape with that. We're assembling iTero there now. We feel great about our training centers, great about our treatment planning capabilities. So overall, we remain bullish on China and we think that China will start to, with the rest of the world, will start to recover in the second half of next year too and we expect to be a big part of that."
},
{
"speaker": "Jason Bednar",
"text": "Got it. Very helpful. Thanks, guys."
},
{
"speaker": "Shirley Stacy",
"text": "Operator, we'll take one more question, please. I know we went over."
},
{
"speaker": "Operator",
"text": "Okay. Our last question comes from Nathan Rich with Goldman Sachs. Please proceed with your question."
},
{
"speaker": "Nathan Rich",
"text": "Hey, Joe. Good afternoon. Thanks for squeezing me in. Obviously, results over the past couple of quarters have been really strong. I guess, when we look out to 2021, it's tough to know what happens with COVID, but hopefully we'll start to get back to normal life later this year or 2022. I think as we look at where consensus is modeled I think on a high-teens revenue growth. It seems like you still feel comfortable with the 20% to 30% target. So do you feel like we should be expecting that type of growth in line with the long-term range off of this new higher level of volumes that you're starting to see in the back half of this year."
},
{
"speaker": "Joe Hogan",
"text": "Nathan, that's -- we try to emphasize as much as we can, we feel very confident about those 20% to 30% ranges of growth. And continue to target 25, 30% operating profit to in order to do that. So you'll see us in investor rates that John talked about we're putting in place to drive that demand. So we make -- we remain committed to that model growth."
},
{
"speaker": "John Morici",
"text": "And it starts with the vastly under-penetrated market and the investment opportunities we talk about. We tried to give you a kind of the breadth of all the different levers that we have to pull to be able to drive that return. And we continue to make that. It changes over time in terms of how we invest and where and so on, but that, that belief is still there. And when we make those forward investments, we're invested into that under-penetrated market that we think we can grow 22% in and do it at a 25%-plus op margin rate."
},
{
"speaker": "Joe Hogan",
"text": "Yes."
},
{
"speaker": "Nathan Rich",
"text": "Great. Well, congratulations on the strong quarter."
},
{
"speaker": "Joe Hogan",
"text": "Thanks a lot, Nathan. I appreciate it"
},
{
"speaker": "Shirley Stacy",
"text": "Thanks, Nate. Well, thank you everyone for joining us today. This concludes our earnings call. If you have any follow-up questions, please contact our Investor Relations department. And we look forward to following up with you at upcoming conferences and virtual events. Have a great day."
},
{
"speaker": "Operator",
"text": "This concludes today's conference. You may disconnect your lines at this time. Thank you for your participation. Have a wonderful evening."
}
] | Align Technology, Inc. | 24,568 |
ALGN | 3 | 2,020 | 2020-10-22 16:30:00 | Operator: Greetings, and welcome to Align Technology’s Third Quarter 2020 Earnings Call. At this time, all participants are in a listen-only mode. A question-and-answer session will follow the formal presentation. [Operator Instructions] As a reminder, this conference is being recorded. It is now my pleasure to introduce your host, Shirley Stacy, Vice President, Corporate and Investor Communications. Thank you. You may begin.
Shirley Stacy: Thank you. Thank you for joining us everyone. Joining me on today’s call is Joe Hogan, President and CEO; and John Morici, CFO. We issued third quarter 2020 financial results today via GlobeNewswire, which is available on our website at investor.aligntech.com. Today's conference call is being audio webcast and will be archived on our website for approximately one month. A telephone replay will be available today by approximately 5:30 PM Eastern Time through 5:30 PM Eastern Time on November 4. To access the telephone replay, domestic callers should dial 877-660-6853, with conference number 13710706, followed by pound. International callers should dial 201-612-7415, with the same conference number. As a reminder, the information provided and discussed today will include forward-looking statements, including statements about Align's future events and product outlook. These forward-looking statements are only predictions and involve risks and uncertainties that are described in more detail in our most recent periodic reports filed with the Securities and Exchange Commission available on our website and at sec.gov. Actual results may vary significantly, and Align expressly assumes no obligation to update any forward-looking statement. We have posted historical financial statements, including the corresponding reconciliations, including our GAAP and non-GAAP reconciliation, if applicable. And our third quarter 2020 conference call slides are on our website under Quarterly Results. Please refer to these files for more detailed information. With that, I’ll turn the call over to Align Technology's President and CEO, Joe Hogan. Joe?
Joe Hogan: Thanks, Shirley. Good afternoon, and thanks for joining us. I'm pleased to report stronger than expected results with record third quarter revenues up 21% year-over-year, reflecting strong momentum across all regions and customer channels for both Invisalign clear aligners and iTero scanners and services. During the quarter, we continued to support doctor recovery efforts with products, programs and virtual tools and training that helped more docs transition their practices to digital technologies and drove record utilization across the Invisalign portfolio. Capping off a record quarter is an achievement of our 9th million Invisalign patient milestone. We also saw a strong response to our new teen and mom-focused consumer campaign with a 118% year-over-year increase in total leads, garnered 3.3 billion impressions, an uptick in consumer engagement from new social media influencers like Charli D’Amelio and Marsai Martin, a 26% increase year-over-year in teenagers using Invisalign clear aligners. Our overall revenue momentum has continued into October and we are encouraged by positive feedback from Invisalign practices regarding the benefits of digital orthodontics starting with an iTero scanner for Invisalign treatment, especially in this COVID environment. For Q3, total revenues were $733 million, up 108% sequentially and up 21% year-over-year, reflecting a sharp rebound in sales for both Invisalign clear aligners and iTero imaging systems as practices around the world reopened and got back to work treating existing and new patients. Q3 revenues for clear aligners were $621 million, up 20% year-over-year, and imaging systems and CAD/CAM Services were $113.4 million, up 24.5% year-over-year. Q3 Invisalign shipments were a record of 496,000 cases, up 28.7% versus prior year and up 124% versus prior quarter, reflecting strong recovery across all regions. During the quarter, we saw increased demand for new cases as restrictions eased and doctors ramped up their practices. This is in contrast to Q2, where doctors’ primary focus was to maintain continuity of patient care for their existing patients through additional aligner shipments and replacement aligners. John mentioned this in his comments last quarter and we'll touch on it again today. For the quarter, we shipped Invisalign cases to a record 70,000 doctors, of which 5,800 were first-time customers, reflecting increased doctor activity as practices have reopened. We have also trained approximately 6,500 new doctors in Q3, including 3,200 international doctors, reflecting increased doctor engagement through our online virtual education courses, summits and forums. Across the business, we believe there are several factors contributing to our strong performance, starting with pent-up demand. Many of our doctors indicate that they are making good progress in working the backlog of patients from office shutdowns. Pent-up disposable income remains a key factor as consumers focus on feel good investments, while many other quality of life options are low. In our new normal, there are far fewer trips abroad, fewer flights, less money spent on gas, dry cleaning, et cetera. More people can afford to allocate that spending to Invisalign treatment, especially when they're working remotely and critiquing themselves on camera so much of the time. That's the Zoom effect that we've heard about across multiple sectors. As we look at our customer channels, we feel the strategy to dedicate sales representatives by specialty alignment is bearing fruit, particularly in the GP Dental segment. Sales reps were able to partner with a wider range of providers within their designated specialty during the downturn and assess mindset and specific needs during the recovery and tailor plans to thrive beyond COVID. A digital mindset has been key and we believe this is the largest influence in the ortho market, and the one we've been laying the foundation for over the last several years. For many doctors, there are still down from normal years in terms of overall production and weekly patient flow. But they have prioritized Invisalign clear aligners as their preferred modality, expanded to the first age group and leverage programs that help to make the transition from analog to digital treatment. We see this both in teen and adult treatment growing with the same provider, increased use of iTero scanners, our Virtual Care, our high overlap of bracket buyback switch. As part of our recovery programs, we offer doctors two programs, either switch their braces in patients into Invisalign treatment by buying their wires and brackets or just buy back their existing inventory. We took out the equivalent of 10,000 cases. Providers actively reduced their analog footprints by proactively switching their patients to sustainable digital care with Invisalign. And for GPs, who already demonstrated a momentum with digital, an active choice was made to position Invisalign as a priority. Scanning every patient with iTero is generating more opportunity from recall patients, even if overall practice capacity is still down. Because doctors in both channels are trying to anticipate what may come in terms of additional waves and office shutdowns, they are hyper-focused on ensuring that they have the best plan for continuity of care and business continuity, which is digital. To support them in this digital journey, we've rolled out My Invisalign app and Virtual Care to 40-plus countries. These tools have been received very positively by our doctors and are quickly becoming part of their practice workflow. Our commitment to continuous innovation is key. We've recently announced our treatment planning evolution and global availability of our next generation ClinCheck Pro 6.0 proprietary treatment planning software. ClinCheck Pro 6.0 moves Invisalign digital treatment planning to the cloud, making its robust treatment planning tools and features available to doctors anytime, anywhere on any laptop, personal computer, tablet or phone. The release includes a new ClinCheck In-Face Visualization tool and enhanced doctor-facing digital clinical tool that combines a photo of the patient's face with their 3D Invisalign treatment plan, creating a personalized view of how their new smile will look. In addition, we also announced today Invisalign G8 predictability improvement with SmartForce Aligner Activation for both orthodontists and general dentists starting in Q1 2021. Invisalign G8 with SmartForce Aligner Activation is our newest biomechanical innovation and the latest in our long history of Invisalign predictability improvements. We continue to focus on building partnerships with doctors. Our data shows that providers who had or quickly developed momentum around digital orthodontics leaned into our comprehensive platform and a variety of our programs and resources to accelerate a digital shift. It's a compelling story of how engagement may be the first step that transformation is achieved through the breadth of product and services only Align can provide. Transformation and support programs like ADAPT, virtual tools, development of Teen Awesomeness Centers, GP Accelerator, Teen Conversion, Aligner Intensive Fellowship, iPro and doctor-led coaching programs that support GP growth. Building on the teen market in Q3, 163,000 teens and pre-teens started treatment with Invisalign clear aligners, representing 33% of total cases shipped, reflecting growth predominantly from North American orthos and EMEA regions. In parts of the market, we saw an initial rush for teen treatments earlier in the quarter with a slight change in demand profile compared to what we normally see in a typical season, which may be the result of a different type of back-to-school season as most kids return to school late or through virtual learning. Invisalign First continues to accelerate among young patients as well. In terms of products performance, we saw strong growth across the portfolio and non-comprehensive outpaced comprehensive even with the record adult shipments for the quarter. Growth with the Invisalign Go product also increased among GPs, driven by North America and EMEA, and there was an increase in our express package shipments with North America contributing to the majority of that growth. Overall, both non-comprehensive and comprehensive shipments were up, with continued increased adoption of our Moderate product among the ortho and GP channels. Now let's turn to the specifics around our third quarter results, starting with the Americas. For the Americas region, Q3 Invisalign case volume was up 166% sequentially and 25% year-over-year, reflecting an increase in shipments due in large part to the digital programs and tools implemented during the pandemic to help our doctors as well as our continued investments in targeted marketing and sales efforts. The Q3 utilization was up for North American ortho and GPs both quarter-over-quarter and year-over-year. We saw continued utilization increases during the quarter, especially among our orthodontic customers in the teen segment, the strongest teen quarter in the last six quarters. As we mentioned previously in Q2, we started the Bracket Buy Back program to enable doctors to switch their braces patients into Invisalign treatment by buying back their wires and brackets inventory. We also saw stronger growth in the adult segment. We believe that some of the increase in adult shipments is reflective of how circumstances have changed today, with adults in our target demographic having more disposable directed – more disposable income directed at getting their smiles fixed. In Latin America, volume was also up year-over-year, led by strong growth in Mexico and Brazil. When you consider the timing of the pandemic and the shutdowns occurring later in Q2 for LATAM, we were encouraged by the growth this quarter. We also saw increased utilization in the GP channel with Invisalign Go and the adoption of Moderate. DSO utilization also increased and continues to be a strong growth driven by Heartland and also Aspen. For our international business, Q3 Invisalign case volume was up a sequential 88%, led by a significant increase in EMEA. On a year-over-year basis, international shipments were up 34%, reflecting increases through both EMEA and APAC. For EMEA, Q3 volumes were up sequentially 104% and up 38% on a year-over-year basis, across all markets, with strong performances from the ortho channel as well as the GP channel, as many doctors kept their offices open during their typical summer holiday season. Both core and expansion markets accelerated with growth in our core markets led by Iberia, the UKI, Germany and growth in our expansion markets led by Central and Eastern Europe and the Benelux. We introduced the Ortho Recovery 360 program in EMEA last quarter to support our orthodontists as they started reopening their businesses. As of Q3, over 4,000 orthodontists have enrolled in the program with over 13,000 touch points with sales team members, providing a dedicated support in July and August alone. As a result, we continue to see an increase in net promoter score or NPS with qualitative feedback from doctors showing that they appreciate Align for the support during this difficult time. We also rolled out Your Brilliance Enhanced marketing campaign in select EMEA markets that highlights the skills of our orthodontists and illustrates how partnering with Align and using Invisalign clear aligners and iTero systems and services can help further enhance the brilliance of these specialists. To support our GP doctors, we also launched our GP Recovery 360 program during the quarter with over 2,900 GPs enrolled so far. At the beginning of the quarter, we also launched the Invisalign Go Plus system in the UK in Benelux and had 2,500 GPs attend the event. During the quarter, we continue to offer virtual and hybrid education events for our doctors with online and on demand education events, which reached over 2,000 GPs cumulatively. For APAC, in Q3, volumes were up sequentially 74% reflecting continued improvement within the region. On a year-over-year basis, APAC was up 30% compared to the prior year. During the quarter, we were pleased to see a record number of unique doctors submitting cases and positive growth in the adult segment with growth in GP channels and non-comprehensive cases with Moderate product. In the teen segment, shipments were at an all-time high as doctors’ offices continue to recover. We also saw acceleration from Japan and ANZ. During the quarter, we celebrated the grand opening of our China manufacturing facility in Ziyang. The event was attended by key partners and doctors in China. The state-of-the-art facility replaces our original temporary facility, further establishing our commitment and capacity to manufacture Invisalign aligners and iTero imaging systems in China. Align was also one of the sponsors of APAC Med Virtual Forum 2020, which attracted over 1,000 attendees from the MedTech industry. The forum consisted of panel discussions and live video chat sessions at the Align virtual booth as we continue to establish Align as a global medical company that aims to transform smiles and change lives in the APAC region. Last week, we also hosted the Align APAC Virtual Symposium, a fully digital event that showcased digital treatment technologies and featured practitioners from across the Asia-Pacific region with over 800 participants. Our consumer marketing is focused on building the clear aligner category and driving demand for Invisalign treatment through a doctors’ office. In Q3, we saw strong digital engagement globally with more than 78% increase in unique visitors as well as on leads created, driven by our new campaign, revamped social media strategy and our new invisalign.com website that was rolled out to 15 plus countries. Several key metrics show increased activity engagement with the Invisalign brand and are included in our Q3 quarterly presentation slides available on our website. We're pleased with the strong engagement and activity we've seen on our consumer platforms over the last few months, and believe it speaks to the strength of the brand and consumer interest in treatment, even during the challenges of the last few months. As you’ll recall from last quarter, we launched our Mom multi-touch campaign, with incremental support to drive reach, awareness, and foot traffic to practices during the key teen season. We also launched a new multimillion dollar TV campaign designed to reach Mom and Teens across a broad range of networks nationwide including cable and connected TV networks. Align is always looking for new opportunities to reach consumers and be relevant to potential patients wherever they work, live and play. During the quarter we announced that the Invisalign brand is the official clear aligner sponsor of the NFL Football League, so 11 NFL teams working with great sports brands like the NFL is another way to connect with consumers by leveraging the power of the NFL brand and its existing brand platforms. The NFL league partnership will help build awareness of Invisalign clear aligner treatment at a national level, while the team agreement will help us engage within key markets and connect consumers with doctors in those markets. During the quarter, we also extended our innovation to drive engagement with new Invisalign Stickables, designed to personalize Invisalign clear aligners, especially for younger patients. The innovative sticker accessories, designed exclusively for use with SmartTrack material, are available in a variety of designs, colors, shapes and themes, and reflect patients desire to show their personal flair during Invisalign treatment. For our Systems and Services business, Q3 revenues were up 110% sequentially due to higher shipments and services revenues. We continued to see momentum with the Element 5D Imaging System, gaining traction in North America and APAC region. On a year-over-year basis, Systems and Services revenues were up 24.5% due to higher shipments and service. Cumulatively, over 27.4 million orthodontic scans and 6 million restorative scans have been performed with iTero scanners. For Q3, total Invisalign cases submitted with a digital scanner in the Americas increased to 83% from 79% in Q3 last year. International scans increased to 72% up from 63% in the same quarter last year. We’re pleased to see that within the Americas, 95% of cases submitted by North American orthodontists were submitted digitally. Our Q3 Systems and Services revenue also includes exocad CAD/CAM products and services. exocad’s expertise in restorative dentistry, implantology, guided surgery, and smile design extends our digital dental solutions and broadens Align’s digital platform toward a fully-integrated interdisciplinary end-to-end workflows, and we are excited about our continued integration progress and product plans. In September, exocad celebrated its 10th anniversary in conjunction with exocad Insights 2020 an annual event for manufacturers and users of dental CAD/CAM technologies entitled "A Decade of Digital Innovation." The event attracted over 300 dental technicians, dentists and over 40 partner companies, as well as 1,600 users of digital technologies in laboratories and practices from 55 countries. With that, I'll turn the call over to John.
John Morici: Thanks Joe, now for our Q3 financial results. Total revenues for the third quarter were $734.1 million, up 108.4% from the prior quarter and up 20.9% from the corresponding quarter a year-ago. For clear aligners, Q3 revenues of $620.8 million were up 108.1% sequentially and up 20.2% year-over-year due to Invisalign volume growth in all regions, driven by North America, EMEA, APAC and LATAM, partially offset by lower ASPs. Historically we have raised prices by approximately $50 per case in the third quarter. Given our continued commitment to helping our customers in their recovery efforts, we did not implement a price increase this year. Q3 Invisalign ASPs were down sequentially $75 primarily due to higher mix of new cases versus additional aligner shipments as Joe mentioned earlier. Recall Q2 ASPs benefited from more additional aligner shipments as doctors were focused on maintaining treatment progress for existing Invisalign patients. This trend reversed itself after practices reopened in Q3 and demand for new cases ramped up significantly. As a result, our deferred revenue balances increased $93 million from Q2, of which, the majority of this increase is related to clear aligner, and will be recognized with future additional aligner shipments. On a year-over-year basis, Q3 Invisalign ASPs decreased approximately $80 primarily reflecting higher promotional discounts and increased deferrals related to additional aligners. In addition, we provided doctors with incentives designed to specifically aid them in the recovery during the pandemic. Q3 total Invisalign shipments of 496.1 million cases were up 123.6% sequentially and up 28.7% year-over-year. Our System and Services revenues for the third quarter was $113.4 million up 110.1% sequentially due to an increase in scanner sales and increased services revenues from higher installed base. Year-over-year System and Services revenue was up 24.5% due to higher scanner sales, services revenue, and the inclusion of exocad’s CAD/CAM services, partially offset by lower scanner ASPs. Imaging Systems and CAD/CAM Services deferred revenue also increased 28%, primarily due to the increase in scanner sales and the deferral of service revenues, which we recognized ratably over the service period. Moving on to gross margin, third quarter overall gross margin was 72.7%, up 9.1 points sequentially and up 0.7 points year-over-year. On a non-GAAP basis, excluding stock based compensation expense and amortization of intangibles related to exocad, overall gross margin was 73.3% for the third quarter, up 8.9 points sequentially and up 1 point year-over-year. Clear aligner gross margin for the third quarter was 74.7%, up 10.2 points sequentially due to increased volumes driving favorable manufacturing absorption of fixed costs coupled with lower freight costs from increased domestic shipments, partially offset by lower ASPs. Clear aligner gross margin was up 1.2 points year-over-year due to increased manufacturing volumes driving favorable absorption and lower doctor training, partially offset by lower ASPs. Systems and Services gross margin for the third quarter was 62%, up 2.8 points sequentially primarily due to favorable product mix shift to higher margin scanners, higher services revenue, partially offset by freight and training costs. Systems and Services gross margin was down 2.1 points year-over-year due to lower ASPs and higher freight and training costs offset by higher services revenue and product mix shift. Q3 operating expenses were $357 million, up sequentially 20.1% and up 15% year-over-year. The sequential increase in operating expenses is due to increased compensation, marketing and media spend, and favorable foreign exchange. Year-over-year operating expenses increased by $46.6 million, reflecting our continued investment in sales and marketing and R&D activities, additionally prior year included a benefit of $6.8 million from the early termination of our discontinued Invisalign store leases. On a non-GAAP basis operating expenses were $332.1 million, up sequentially 25% and up 12.8% year-over-year due to the reasons as described above. Our third quarter operating income of $177.1 million resulted in an operating margin of 24.1%, up 44.8 points sequentially and up 3.2 points year-over-year. The sequential increases in operating income and operating margin are primarily attributed to higher gross margin and operating leverage. On a year-over-year basis, the increases in operating income and operating margin reflects higher gross margin and operating leverage partially offset by our continued investment in R&D, geographic expansion and go-to-market activities. On a non-GAAP basis, which excludes stock based compensation, acquisition-related costs and amortization of intangibles related to exocad, operating margin for the third quarter was 28%, up 39 points sequentially and up 4.2 points year-over-year. Interest and other income expense net for the third quarter was a gain of $7.5 million, primarily driven by favorable foreign exchange. With regards to the third quarter tax provision, our GAAP tax rate was 24.5% which includes tax benefits of approximately $8 million related to the release of certain previously unrecognized tax benefits as a result of the closure of an income tax audit. Third quarter tax rate on a non-GAAP basis was 16.6% compared to 27.8% in the prior quarter and 18.8% in the same quarter a year ago. The third quarter non-GAAP tax rate was lower than the second quarter’s rate primarily due to reduction in tax benefits resulting from considerable profits recorded in Q3 as opposed to losses incurred in Q2. Third quarter net income per diluted share was $1.76, up $2.28 sequentially and up $0.48 compared to the prior year. On a non-GAAP basis, net income per diluted share was $2.25 for the third quarter, up $2.60 sequentially and up $0.77 year-over-year. Moving on to the balance sheet, as of September 30, 2020, cash and cash equivalents were $615.5 million, an increase of approximately $211 million from the prior quarter, which is primarily due to higher cash flow from operations. Of our $615.5 million of cash and cash equivalents, $298.8 million was held in the U.S. and $316.7 million was held by our international entities. Q3 accounts receivable balance was $626 million, up approximately 32.3% sequentially. Our overall days sales outstanding was 76.5 days, down 44 days sequentially and down two days as compared to Q3 last year due to strong cash collections as doctor’s offices reopened from Q2 shutdowns. Cash flow from operations for the third quarter was $211 million. Capital expenditures for the third quarter were $21.3 million, primarily related to our continued investment in increasing aligner capacity and facilities. Free cash flow, defined as cash flow from operations less capital expenditures amounted to $189.8 million. Under our May 2018 repurchase program, we have $100 million still available for repurchase of our common stock. Now let me turn to our outlook. Overall, we’re pleased with our Q3 performance and the strong momentum in our business. We made investment decisions that helped drive and capture demand across all regions and all customer channels. We see good return on our investments and strong revenue growth, which has continued into October. We are confident in the huge market opportunity, our industry leadership, and our ability to execute. At the same time, there continues to be uncertainty around the pandemic and global environment, therefore we aren’t providing specific guidance. With that, I will turn it back over to Joe for final comments. Joe?
Joe Hogan: In summary, we are certainly pleased with our progress in the third quarter. We have taken a very thoughtful approach to recovery and we have persevered in large part by living the values that are important to us as an organization; agility, customer and accountability. In a time of great uncertainty, when swift actions have been required, we have responded like no other company in our industry. Most importantly, we have followed our guiding principles and supported our employees and customers, protecting employee jobs and salaries and working to support the needs of our teams globally, and supporting our customers with PPE, extended payment terms, postponed subscription fees for iTero, and numerous programs to help them through this crisis. We also applied our manufacturing experience and resources to making testing swabs for hospitals and PPE for our own teams and also customers. Instead of going quiet or holding on planned spend, we accelerated our investments in marketing to drive consumer demand to our doctors’ offices and stay top of mind with consumers. We accelerated new digital technology to market so that we could provide virtual tools to our doctors that enabled them to stay connected with their patient and keep their treatment moving forward. We supported doctors and their teams with online education and digital forums that went beyond product and clinical education to help navigate PPE shortages and recovery planning; and we continued to grow the business, not just protecting jobs but adding headcount, continuing our investments in R&D and product innovation as you saw in our Invisalign G8 announcement today and developing our plans for manufacturing expansion. Our actions are a result of the conviction that we have in our business model, supported by the strength of our balance sheet, to drive results that exhibit our accountability to our employees, customers and shareholders. Even in a time that required us to change and adapt, we maintained our long-term focus. I feel this is what good companies do and its proof that being a good company and delivering the type of results we’ve seen this quarter can go hand-in-hand. We have remained a growth business, driving programs in anticipation of recovery, but we acknowledge that there still remains uncertainty due to COVID-19. Our plan is to counter future uncertainty by staying focused on our long-term strategy, living our values, supporting our employees and customers, and keeping the demand drivers we’ve identified over the last few months in mind. The re-direction of disposable income for many consumers; channel focus that allows us to reach and support a wider range of customers within each channel and most importantly, the digital mindset that is really taking hold with more and more of our customers and that we are supporting through innovative products and programs that can help support their digital transformation. We are not ignoring the reality of COVID-19 and how long it may be part of our lives, but we’re also not going to stop driving the business forward for the good of customers, their patients, our employees, and stakeholders. With that, I want to thank you again for joining our call. I look forward to updating you on our progress as the year continues to unfold. On November 20 to 21, Align will be hosting the Invisalign Ortho Summit, Virtual Edition, with the theme Digital is the Answer. This Invisalign Summit is the ultimate learning experience for orthodontic practices. From digital practice transformation to great patient experiences, there’s never been a more exciting time to learn about digital orthodontics. Align will also host a virtual Investor Day on November 23, where I also look forward to sharing our views on the incredible market opportunity that we have combined with the unmatched power of Align’s digital platform, technology innovation, global reach, and brand equity. Now with that, I’ll turn it over to the operator for questions. Operator?
Operator: Thank you. Ladies and gentlemen, at this time, we will be conducting a question-and-answer session. [Operator Instructions] Our first question comes from the line of Nathan Rich with Goldman Sachs. Please proceed with your question.
Nathan Rich: Thanks, and good afternoon. Joe and John, obviously, great to see the volumes come back so nicely. It sounds like the momentum continued in October. Could you maybe just kind of help us understand kind of the cadence of growth that you saw over the quarter? And any comments on how October has fared so far, maybe relative to the type of case growth that you saw in 3Q?
Joe Hogan: Yes, yes, Nathan, thanks for the question. Look, we just built through the quarter. Every month we saw actually continue to enhance momentum. And the short answer to your question is, we’ve seen that build in October also.
Nathan Rich: That’s great. And Joe, obviously, you kind of talked through in detail about what has kind of driven the stronger utilization that you’ve seen and the value of digital treatment. When you kind of take a step back and kind of think longer-term, how has that kind of changed your outlook or influence your kind of multi-year outlook for kind of what you could see from this business over the next several years going forward?
Joe Hogan: Nathan, you’ve known John and me and Shirley long enough. I mean, we’re incredibly enthusiastic about this business and bullish about this business. And you can see we’re even more so as obviously we deliver the kind of results we have in 3Q. I think you always have to keep in mind two things here. One is, we’re in a very volatile environment. We understand that and we’ve done some things. We feel that’s really helped our doctors through this and made the company stronger coming out at the other end. But always remember, we’re completely underpenetrated in this marketplace, right? We’re still less than 10% penetrated from an orthodontic procedure standpoint, let alone those 300 million patients we talk about there that should receive orthodontic treatment that aren’t receiving orthodontic treatment. So we remain incredibly bullish with a digital format to be able to go after those patients and be able to continue to drive the growth of this business.
Shirley Stacy: Thanks, Rich. Next question…
Nathan Rich: Okay. Thanks.
Joe Hogan: Yes.
Shirley Stacy: Next question, please.
Operator: Our next question comes from the line of Erin Wright with Credit Suisse. Please proceed with your question.
Erin Wright: Great, thanks. So, can you speak to some of the contributions from the recovery efforts in switching brackets and wires patients? Or are you continuing to see those contributions and efforts into the fourth quarter? And do you think that will drive the Board’s longer-term shift here? Do you have any indication based on the responses? I guess you’ve seen from practitioners how sticky that is? Thanks.
Joe Hogan: Well, it’s – overall – hey, it’s Joe. I mean, overall, it’s pretty sticky when we buy their wires and brackets inventory back. And then we introduced in the programs like ADAPT and different things that really allow them to begin a digital transformation within their practices. So I feel that part is very sticky. I can’t sit here and naively say that everyone who starts to move digital in this crisis is going to stay digital. But I can tell you that we have the tools, being able to drive consumer demand and consumer awareness and all those things, helps us to maintain that stickiness. And I think over time, we’ll just have to see how sticky it is as we come out of this COVID crisis.
Erin Wright: Okay, great. And then on ASPs in the quarter, I guess, is that the run rate we should be thinking about? I know you didn’t take the price hikes, but any other mix dynamics as we think about the next quarter and beyond?
John Morici: Hey, Erin, this is John. Yes, the mix that we saw – we talked about some of the dynamics of all those new cases coming in and we saw that. We also talked about not having a price increase given the conditions that we’re in. We’ll evaluate going forward as to any changes we might make in pricing and so on. But I think from a run rate standpoint, this is a good starting point for going forward.
Erin Wright: Okay, great. Thanks.
Operator: Our next question comes from the line of Steve Beuchaw with Wolfe Research. Please proceed with your question.
Joe Hogan: Hi, Steve.
Steve Beuchaw: Hi, good afternoon, and thanks for the time here. I wonder if you could expound a little bit on some of the numbers that you’ve given here at this quarter, and I believe you did in the prior quarter as well around not just the training numbers, but some of the data that you gave on people who are not just getting trained, but who are new to Invisalign. I’m sorry, I don’t know, maybe some do. But what were those numbers a year ago? And do you have visibility into what those training numbers look like out into 4Q or even beyond?
John Morici: Yes, Steve, this is John. I think when you look at being able to train like we can now doing much more virtual being able to have that remote training as well as where you can in person gives us a lot of flexibility going forward to be able to expand out our training. So there’s a lot of new capabilities, a lot of new tools that we’ve introduced this quarter to be able to help our customers and train new customers as well as our sales team be able to reach those. So it’s a key part as you know to our growth and we’re going to continue to find ways to be able to connect with new doctors to be able to get them to understand the benefits of Invisalign and ultimately have them use it more and more to grow.
Steve Beuchaw: Okay. Thanks, John. And then, Joe, one for you. So I’ll let you carry the burden of being the CEO of the first big dental company here in the U.S. to report. Just give a little bit of perspective on how you imagine policy evolves. As you talk to folks around the CDC, AAO, the ADA, any of their counterpart organizations in Europe, do you see any sign that there might be a move toward practice closures? Or are we really past that now that we’ve got PPE in place? I ask because I think they’re just a lot of folks who are looking at the growth, not just at Align, but at some other companies and it’s really attractive growth, but people are just worried about the possibility that we see lockdowns again. So any perspective you could offer there would be really helpful? Thank you.
Joe Hogan: Yes, Steve. Steve, I’d tell you, talking to obviously doctors all around the world or whatever. I don’t see that there’s any imminent, a lot of closures in the industry. I mean, there’s frustration with the closures and obviously a lot of disagreement in the sense of when they’re told to close. Fortunately, what we’ve seen with the COVID coming back here in the fall, we haven’t seen the institution of going back and closing these doctors’ offices, which help. I can tell you, Steve, since I’ve been here five years, there’s always a certain segment of the dental industry that is looking to sell or looking to change and get out, but not close down. So I honestly think that there’s still optimism out there. I’ve seen the doctors do a great job in a sense of being able to protect their employees, make sure that they protect their patients and do the things that are needed. I know by reading your material and other materials that we’ve all picked up that most of the doctors are running at 70%, 75% kind of a capacity, but they’re finding a way to make it work. So I’m not looking at any imminent demise in the business in the sense of close downs or anything like that. And I think the offices are getting better and better being able to drive volume through their offices. And again, you know that this is a digital format that we feel that sets a foundation for them to have a much better patient flow through or a much fewer touches in this COVID world, which we hope hopefully will carry over as we move out of this next year.
Steve Beuchaw: Really appreciate that. Thanks for all the time here.
Joe Hogan: Thanks, Steve.
Operator: Our next question comes from the line of Jon Block with Stifel. Please proceed with your question.
Jon Block: Great. Thanks, guys.
Joe Hogan: Hi, Jon.
Jon Block: Hey, Joe, actually, first one for you. Sort of qualitatively, can you give us a beat or a signal on teen share of chair? And do you see a broadening out within your ortho customer base? I think that’s the key sort of the broadening out. In other words, are you seeing the one from orthos that we’re always, I don’t know, call it less than 5% Invisalign shared chair. Are they stepping up to the plate because of clear aligner workflow advantages? And if so, how do you sort of ensure that you capitalize on that longer term?
Joe Hogan: Yes. Well, I think it’s a couple things, Jon. Obviously, COVID has been an added incentive to move people out of analog into digital because of fewer touches and being able to maintain continuity of treatment, even if things are shutdown. So there’s no question, we saw our share of chair increased in that sense. I think also when you see new products like Invisalign First and those things we’ve introduced in the last few years, that’s – as you know well, that’s extended our reach from a HDM point within that specific demographic. That’s helped us also. And I think there’s a combination here of further and further realization of how digital processes and orthodontics really can help, can help be more efficient, but also realization from consumers that it is an offering here that is better than wires and brackets, and more efficient, certainly in this COVID kind of environment. So how do we – how are we certain that we maintain that? Jon, when you look at programs like ADAPT and things, those – that switch over – let’s back up for a second. Jon, five years ago, we were fighting for clinical, I’d say relevancy in this industry. That’s not a question anymore. All the docs – most of the docs out there understand very clearly we can do 80%, 90% of the cases out there. It becomes a business formula. Can we really make money with a digital kind of a system? And those are the programs that we’ve been putting together with doctors with outside experts that can really train doctors as to how digital can work, how can expand their practices and how actually can be more profitable in a digital process. And I’m confident with what we’re building up in that area, we’ll be able to extend that going forward.
Jon Block: Got it. Fair enough. I’ll shift over to GP side for the other question. The utilization over four, I think I’ve been waiting 10 or so years for that and I get it. Some of it’s probably pent-up demand. You talked to that a little bit on the call, but what about the other components? Is it some scanner digitizing the front end, the bifurcating of the sales force? I mean, essentially Joe, have you given the tools that you needed to the GP to finally sort of step function that utilization rate higher that was always sort of stuck right around that mid threes for a number of years? Thanks guys.
Joe Hogan: Yes. Jon, I feel the answer to your question is yes, we have. I mean everything from iTero and really the inside of iTero and the software programs at all in conjunction with iGo that make it much simpler for doctors that haven’t been associated with digital orthodontics before. Our segmented sales force, for sure. I mean, we’ve piloted this in Europe first and somewhat in APAC. So we knew what to expect. We were just fortunate enough to launch it ahead of this issue, ahead of the COVID issue, and they have the salespeople ready to have that touch with customers to make it work. What I’m excited about this, Jon, we have so much more that we can do to make that work also. And I think with a confidence that GPs are having in this kind of a system, it’s a light touch system, it’s a high revenue kind of a product and it’s gaining more attention in that channel. So, yes, I’m really – we’re all thrilled here to see the utilization rates, but it is on the back of those kinds of innovations in distribution and also product that we think we’ve been able to drive it.
Jon Block: Okay. And if I can just quickly slip in one more, just for a clarification, I think it was all the way back to Nathan’s first question, just to be clear when you say momentum building, I mean, do we take that your October year-over-year growth rate was north of your worldwide 3Q growth rate that you posted? Thanks, guys.
John Morici: Jon, you’re right. We see momentum building and that continues – it continues that growth from a revenue and a volume standpoint into October.
Shirley Stacy: Thanks, Jon. Next question, please.
Joe Hogan: Thanks, Jon.
Operator: Our next question comes from the line of Elizabeth Anderson with Evercore. Please proceed with your question.
Joe Hogan: Hi, Elizabeth.
Elizabeth Anderson: Hi, guys. Thanks so much for the question. As we think about the outlook for 4Q and as we come out of COVID more broadly, are there any – I know you guys obviously didn’t cut costs, kept the sales force, because you maybe foresaw some of this growth coming back. Is there anything in terms of investments of the ramp back that we should be considering?
Joe Hogan: Well, I think there’s just continuity of investments is the way I’d answer your question. They’re not new investments. We’ll continue to invest in the consumer side, pretty dramatically. You’ll see that we’re doing that all around the world. It’s not just in the United States or Canada. We’re also – you’ll see investments in Europe and also Asia to a degree that we haven’t made before. We have a series of new products that we’re investing in. We kept that momentum in the third quarter and where we hired engineers to keep that moving. And then these specific programs for doctors like ADAPT that we’re talking about, and AIF and different things, they’re really an important part of this because you have to make sure that these workflow changes, and the way ClinCheck works, like ClinCheck Pro and whatever, they have to be introduced to docs and we got to have the high touch kind of a system to give them the confidence in those programs. So it’s a long answer to your question, but I’d say we maintain and enhance what we have been doing is what you’ll see in the fourth quarter and as we go into the first quarter too.
John Morici: The added piece, Elizabeth, from an investment standpoint is investing in operations to stay ahead of the volume. And making those investments we did so in Q3, we’ll continue to make those investments in Q4.
Elizabeth Anderson: Okay. But it doesn’t sound like there’s anything totally different that this sort of – because we could consider catch up or something on that front. Okay. I guess – yes.
Joe Hogan: You go ahead, Elizabeth.
Elizabeth Anderson: No, I was just wondering, you talked about some of your continued spend on social channels in terms of marketing and that seemed also a continuation plus obviously the buyback program in the quarter. Is there anything else that you guys see changing in terms of your marketing spend going forward? Would you say it’s sort of like a continuation of the types of programs that you were doing in the third quarter?
Joe Hogan: Well, I think, obviously, Raj and our marketing team are very innovative and it’s not that we’ll just keep with the same themes. We obviously we run – we run trials, we do different things, we’ll change them up or whatever based on what we’re experiencing in the marketplace. So our investments will continue to be very aggressive. We’ll continue to be innovative in the sense of how we do these things, but we certainly won’t let off the gas in the sense of the focus that we’ve had over the last few quarters.
Shirley Stacy: Thanks, Elizabeth. Next question, please.
Operator: Our next question comes from the line of Steve Valiquette with Barclays. Please proceed with your question.
Jonathan Young: Hi, this is Jonathan Young on for Steve.
Shirley Stacy: Hi, Steve. Hi, there.
Jonathan Young: Hey, it’s Jonathan. Hi. So you just from relation to the backlog, you were talking about on the pent-up demand, I guess from your perspective, how much backlog do you think is kind of still out there with the docs before it normalizes out as we kind of move forward?
Joe Hogan: Steve, you asked a big question. I mean, from a backlog standpoint, we really don’t know. When you talk from an empirical standpoint, when you talk to many of our docs, they’ll say they cleared out their backlog in July and August. But this is a global business it’s hard to talk about all over the world where it stands, but – when things came out of lockdown and when they didn’t. So we struggled to be able to quantify a number for you in that sense.
Jonathan Young: Okay. And just going back to the comment about the utilization of docs being at about 70%, 75% capacity, I guess, from – that’s from the capacity standpoint, but from your customer base, are they all largely open at this point or is there still 10%, 20% that still remains close due to random shutdowns globally or locally in certain areas? Thanks.
Joe Hogan: No, they’re largely open.
Jonathan Young: Great. Thank you.
Joe Hogan: Yes. You're welcome Jon.
Operator: Our next question comes from the line of John Kreger with William Blair. Please proceed with your question.
John Kreger: Hey guys.
Joe Hogan: Hey John.
John Kreger: Hey. Can you just talk a little bit more about again the uncertainties that prompted you to not guide to Q4 after a very, very good third quarter? And one thing I was thinking about given the rebound in cases in Europe are you seeing any signs of maybe just patient traffic slowing down even if practices aren't closing per se?
Joe Hogan: Yes, jump in.
John Morici: Yes. I think, when you think about what we've seen in terms of the momentum we see we tried to lay that out, obviously there are still unknowns in the world. I would say COVID in the global economy and so on. But for the things that we can control and what we tried to lay out around the R&D investments, in manufacturing, and marketing and sales we feel really good about our momentum and what we can drive in the future. We just have unknowns that are outside of our control and so that's the reason from a guidance standpoint that we didn't give specific guidance. But we wanted to highlight that we've – because our continued momentum as we went through the quarter both for revenue and volume, and that continued past the quarter end.
John Kreger: Great. Thank you. Joe, a question for you about sort of the strategy to get the attention more of GPs. Can you just talk about how exocad is going and what else your – what other levers you're pulling to sort of become more of that sort of daily thought process for the typical general dentist?
Joe Hogan: Yes, John that’s a good question. Look, I feel great about exocad and obviously when I talked about in the highlights that we just went over is, I mean its digital dentistry on the GP side. You have to go around the world and understand how exocad is, exocad is very embedded in Europe also in various parts of the far-east and in some parts of the United States, but the key is just a digital workflow and it's between iTero France is, it's in a obviously a GPs office and that CAD/CAM piece is either extended in office or primarily it goes to labs. I think it's given us the initial boost that we wanted to in the sense of our relevancy in the GPs office in the sense of an iTero scanner can do these kinds of restorative scans and this kind of restorative workflow. What's really exciting is, when you look at how you can integrate what exocad does in a seamless workflow way with iTero and also Invisalign, it just gives us a lot of degrees of freedom to really change that kind of restorative dentistry. I'm really excited about the progress even in the short amount of time.
John Kreger: Great. Thank you.
Shirley Stacy: Thanks, John.
Operator: Our next question comes from the line of Brandon Couillard with Jefferies. Please proceed with your question.
Brandon Couillard: Hi, thanks. Good afternoon. John, I think you said leads were up something like 120% year-over-year. How do we think about the relevancy of that metric as a leading indicator of revenue growth, it's not a metric I can recall you really discussing before?
John Morici: Well, that's a good question. I mean, we do – I don't know how we've communicated that before, but it certainly is a term we use internally here at Align all the time. A lead is just what you would guess it is Brandon and it's a strong lead in the sense of a customer wanting to turn into a patient. And we have several ways of touching that customer they can come through our Invisalign app. They could be contacted by a concierge service. Concierge service can take the information and move it onto a doctor's office, but it's a lead and it's a great leading indicator of the interest of patients out there. And it's, again, one of the major attributes of Align of what we bring to the marketplace is to be able to excite consumers and move them into our doctor partner groups.
Brandon Couillard: Okay. And then John, any chance you could specifically speak to China growth in the third quarter? And then secondly the financial impact of opening the new permanent manufacturing facility as opposed to the temporary site you have been operating be in terms of revenue growth or profitability or expenses you think you can share there?
John Morici: In China, we saw a good sequential growth, continues to grow. I mean, obviously they were the first ones kind of in the pandemic to starting Q1 we saw some growth in Q2 and significantly more growth in Q3. The manufacturing like you said, is gone live it's now greenfield facility where everything's up and running. We're adding more capacity there to meet our demands. But it was a very smooth transition. We learned a lot from having that temporary facility and learning kind of the manufacturing, the scale up that we needed and that transitioned very well into the new facility.
Brandon Couillard: Great. Thank you.
Operator: Our next question comes from the line of Jeff Johnson with Baird. Please proceed with your question.
Jeff Johnson: Thank you. Good evening guys.
Joe Hogan: Hey Jeff.
Jeff Johnson: Hello. Joe, wanted to the start with you again, it's the same thing, Jon Block's trying to feel out here, but was there anything different in your North American ortho customer mix? Did the Diamond and Double Diamond guys come back much faster than the lower-end guys, anything at all like that? And I guess what I'm trying to get at and same thing, like I said, John is sustainability of that 24% North American ortho utilization number, a fantastic number, is that our evidence, is that our proof point there of this move from analog to digital, as you keep talking about it, is that the number to focus in on there and then obviously the GP number as well?
John Morici: Yes, I think, Jeff if your real question is about utilization being the key metric, I mean, it certainly is, but who has led that, our Diamond and Diamond Plus docs are already having a big digital aspect of what they were doing. We're able to function extremely well in this environment. Remember our virtual care tool that we bought out really six months before we wanted to do it, it wasn't the best tool in the world, but we've made it better over time. Really gave them that digital interface with their patient base that allowed them to be able to track their patients without having come back to the office that was for a certain period of time. So but to say that it was only those practices would be wrong. We saw no matter what tier they were in our advantage program, we saw them reaching for training, wanting to work from a digital standpoint. The orthodontist recognized the advantages of digital during this whole sequence and again, that's why the program and the things that we've had in place, the investments we made or whatever, they were very timely to help to support that interest.
Jeff Johnson: Yes. Understood. And then maybe just a follow-up for John. So John, you seem to imply that maybe ASP is here at this level are good way to think about the next few quarters. Does that mean some of the incentives kind of sustain here? Do you leave them in place? And I just want to understand the accounting. Does the bracket buybacks, does that go against ASPs in any way or is that a cost buried somewhere else in the P&L? Thanks.
John Morici: No, that is a cost against as a promotion, so it goes against revenue for the bracket buyback in. And we'll evaluate as we do on a normal basis with promotions, what promotions are working, what's driving that right level of utilization and engagement, whether a new doctor to a doctor that does a lot of volume. We did mention that we didn't increase price and that was something that's just a reflection of what's happening in the marketplace. And look we are very pleased with, when you look at Invisalign ASPs that it's 74.7%. We haven't seen that in several quarters. So, we're very aware of the dynamics around promotions and what that drives, but ultimately its driving profitability and we saw great gross margin growth.
Jeff Johnson: Yes. Understood. Thanks.
Joe Hogan: Thanks, Jeff.
Operator: Our next question comes from the line of Glen Santangelo with Guggenheim. Please proceed with your question.
Joe Hogan: Hey, Glen.
Shirley Stacy: Hey Glen, you there? We maybe not hearing your line clearly.
Glen Santangelo: Hello. Can you hear me now?
Joe Hogan: Yes, we can.
Glen Santangelo: Hey Joe, how are you? Thanks so much. Joe. I just want to take a step back. I mean a lot of the questions were already asked, but I wanted one of the follow-up to response you said to the earlier question. What's your sense going on with your organic growth rate of this business? I mean, are you seeing that the organic growth rate of just the ortho business in general accelerate through the pandemic, and then as you think about sort of the penetration of clear aligners versus total cases, you sort of cited that you still think we're less than 10% penetrated. Could you maybe talk about the penetration in North America and international, maybe how you see those sort of penetration rates evolving over the next couple of years?
Joe Hogan: Well, I mean, obviously we measure ourselves from a penetration rate standpoint overall and we split the market up obviously in teens and adults, ortho versus the general segment with GPs. But if I'm answering your question right, Glen, I mean we have increasing penetration in the utilization we call on different parts of the marketplace. The digital platforms and things that we've put in place are really enhancement to doctors to get on these digital platforms and use the tools and things that we have. So Glen, I think again as I mentioned in the other question on like this is – remember we're still underpenetrated, it really as digital orthodontics has such a long runway, but it is a different workflow for doctors and it's a different expectation from a patient base, understanding you really can use in digital platform in order to move teeth as efficiently or better than wires and brackets and so. It's so important that we have a strong digital platform that unites the workflow between us and doctors, and doctors and patients that you have a breadth of product, everything from Invisalign First, all the way to express and comprehensive products, and retainers and things in between. Sales forces are incredibly important for that penetration, the sense of how you talked – how you touch docs and how you move things forward. So I would say Glen, to answer your question here, there's no magic on this penetration piece. It's a lot of work. It's a lot of work and a lot of friction you have to overcome, there's no escaping it, but it's inevitable. Digital is better than analog in a COVID environment or not in a COVID environment. That's our position and that's what we'll continue to drive.
Glen Santangelo: And Joe, it seems like you may be expanded your sort of technology lead again with sort of this latest development on the G8 side. Could you maybe just give us a quick update on the competitive landscape? Are you seeing anything else in the market that is starting to get any traction or is it still kind of really just an execution issue for you?
Joe Hogan: This is all about execution with us. It's a – from – I have nothing from an update from a competitive standpoint, really to report. Remember our competition is about expanding the marketplace that is what it's all about. This is not a scrum of a bunch of people making plastic aligners. This is a scrum about what can you do to reduce the friction of getting dentists and orthodontists to move forward in a digital process. It's the growth of this marketplace that is really the material difference here. It's not individual competition in the trenches that we're focused on or concerned about how do we expand the marketplace Glen.
Glen Santangelo: Okay. Thanks for the comments.
Joe Hogan: Yes. Thank you.
Operator: Our next question comes from the line of Richard Newitter with SVB Leerink. Please proceed with your question.
Richard Newitter: Hi, thanks for taking the question.
Joe Hogan: Hi, Rich.
Richard Newitter: Hi, how are you doing, Joe.
Joe Hogan: Good.
Richard Newitter: Wanted to just start-off, just thinking back over the 20 year journey that you had or longer than that now, you're not specifically, but just in aligners and what you've seen in your tenure and what you know before, can you – there'll probably be an inflection point moments and I'm just curious where and how kind of this COVID opportunity, which is clearly on some level creating an inflection point on some level, where that stacks up? And a year or two years from now, do you think we're going to be saying this was probably the one of the defining periods for you guys to capitalize on converting the gene segment and getting that accelerated kind of digital boost that you needed to really kind of move this market conversion opportunity in a step function fashion. I'm just trying to put it in perspective, are we kind of at the demarcation here, where this is kind of defining period for the company?
Joe Hogan: Well, you know Richard this is always really – it's hard to always call it, you're asking about the tipping point. And John has a great saying you never know the tipping point until it tips, right. So, but I would tell you that, obviously in the current environment that we have right now, where infection is a concern, digital becomes predominant in that sense of doctors looking at it. But I think another good signal that you can say that this can become more permanent, what's really unusual here is take a look at iTero growing 25%, right. You see capital of goods in a situation like this are going to lag, because doctors aren't going to make that kind of a capital outlay when their businesses are under pressure. And what we saw in this case is iTero grew phenomenally and then what we know, and you see that 93% of the cases in the United States right now for ortho is coming through digitally, when you get an iTero scanner into an office whether it's a GP or ortho they become really committed on the digital piece of want to learn. So I think that kind of demand for iTero scanner, what I call a hurricane right now from a doctor’s cash flow standpoint really shows that they're interested in the sense of this digital transformation and want to stick with it.
Richard Newitter: That's helpful. And maybe just want to follow up on the competitive comments and questions from the prior. I'm just curious, your ability to train virtually and remotely and your customer base and the advantage you have there. Are your competitors able to kind of get into the channel even as effectively as they might have otherwise been or you basically kind of converting on your own right now, I'm just curious if there's just an inherent structural advantage that you have there during this period and if competitor sales reps are allowed to say engage as actively as you are?
Joe Hogan: Yes. Forgive me if I don't answer your question properly, but what I can drive from that is the importance of a sales force versus competition, and then the importance of training. And there's no company in the world that can provide digital training, whether it's virtual or if it's allowed in the future, which it will be obviously face-to-face across a number of platforms that Align can provide. ADAPT is another kind of training, ADAPT is Align Digital and Practice Transformation program that kind of experts that we put in place that understand doctors office workflow and economics, and how we can work through them. Our sales force is, since I've been in this business five years now and I've run sales forces in businesses pretty much my entire adult life. I have never seen such a high touch sales force in my life. The importance of touch with a sales team with those doctors is incredibly important because of how different digital is from a workflow standpoint, a clinical standpoint than what an analog procedure is. So there's no way around that. And then the last part is, maybe we're taking advantage of our competitors or something. And I don't say there in any arrogance or whatever, the competitions, I actually welcome it to a certain extent because it helps to legitimize a digital space. Our job broadly is how do we go and get dentists and orthodontists to move from analog to digital, not so much what the next competitor's product is out there and we're fighting for that extra ounce of share, that's not where we are right now. This is about an expensive marketplace.
Richard Newitter: Thank you.
Joe Hogan: Yes. Thank you.
Operator: Our next question comes from the line of Ravi Misra with Berenberg Capital Markets. Please proceed with your question.
Ravi Misra: Hi team. How's it going? Hope everyone's well.
Shirley Stacy: Hi, Ravi.
Joe Hogan: Thank you so much.
Ravi Misra: To take a pivot to G8 for a second, and remembering correctly prior versions of the systems have been seen as the step function advancements that have opened the door to more cases and more comfort with doing the system. With G8, just curious in terms of number one, how do you see it kind of increasing the addressable market for the number of cases you can treat? I mean, is this opening up doors that couldn't be done before by the sort of average dentist. And number two, do we have any sort of IP protection around this. I mean, looking at the press release, it seems like a pretty powerful set of innovations in the way you're staging it or this kind of a function or development on top of existing technologies in that sense from an IP perspective?
Joe Hogan: Yes. Hey Ravi, good question. First of all, when you think of how we got the G8 is, we've done 9 million patients, right. And probably deep bite cases are 30% of those cases and G8’s around deep bite. And when you do deep bite, there's a lot of extrusion in deep bite, now I don’t want to get to clinically into this thing but extrusion means you're pulling the tooth down or pushing a tooth up. And those are the most difficult movements that we make. They're the hardest movements to do. When we talk about IP, it has to be with the specific kind of attachment, it's where you place that attachment. It's that interface of that attachment with the aligner and how the aligner – actually that's what we call it the activated part of this thing. And I'd say do we have IP around that? Sure, we do. Do we have IP around doing a deep bite case? No, but our products are specifically geared to be able to do that. And so we use a lot of AI and machine learning to mine that database to figure out where these deep bite cases weren't finishing as fast as they could be at times. And the new G8 supposed to make this better it's been tried in different areas. And in the end, what it does it gives doctors more confidence to be able to get into those cases and though they can finish them the way they want to finish them and that's the purpose of the product.
Ravi Misra: Great. And then maybe if I can build on that.
Shirley Stacy: Thanks, Ravi.
Joe Hogan: Yes, go ahead.
Ravi Misra: Sure. So one more. So pre-pandemic, you guys were on a kind of case growth basis somewhere in the 30’s, high 20’s range. I appreciate that it's very difficult to look past what's going on in the world right now, but say we do kind of normalize at some point in the future post-pandemic. With these innovations and the sales force touch points that you mentioned, is that 20% to 30% case growth, given where we are on the adoption curve still a kind of reasonable proxy for where this market can go. Thanks.
John Morici: Hey Ravi, this is John. Good question. When we think about the investments that we make in the – as we've described, the vastly underpenetrated market that we're in, we look at our investments to say, look, we can grow revenue in the 20% to 30% and that's how we think of things. And that's what we think that we can control the investments that we're making to be able to grow in this market to that. We didn't guide to that because there's unknowns outside of what we can control and we've kept it at that. But certainly when we look at investments in this market and the opportunities that we have, we look at those investments with the long-term growth model from a revenue standpoint of 20% to 30%.
Joe Hogan: Thanks, Ravi.
Operator: Our next question comes from the line of Michael Ryskin with Bank of America. Please proceed with your question.
Michael Ryskin: Hey, guys. Thanks for fitting me in. Yes, it's late, so I'll just keep it to one. Obviously, seeing the really strong utilization numbers in the Americas for the orthos and GPs. But obviously that's only half of the equation, because you also got the number of docs actually receiving those. So I was just wondering if you could provide any additional color on the split between ortho and GP, which really drove the volume in the quarter in the Americas. What I'm getting at is, with the rebound you commented on and some of that pent-up demand was there one part of your customer base that really accelerated better than the others or was it pretty broad based?
John Morici: Yes. I can take that, Michael. This is John. Really when we look at the utilization and the growth that we saw was very broad, it was across GP and ortho. It was across multiple-tiers. We just saw a good adoption of our technology as these practices opened. Patients ask for it by name, doctors used our product. There were many doctors that were higher up on the tiers accelerated their cases. And then even new doctors or doctors that are at lower tiers were able to increase the utilization. So, we're very happy with the results that we saw from newer doctors to more experienced doctors and felt really good about how they were in that recovery mode. As we said, it's tough to understand and break out the piece of how much is pent-up demand versus run rate. But as we went through the quarter, as we said, we got stronger and stronger. So we feel good about the situation that we left Q3 with.
Michael Ryskin: Great. Thanks.
Shirley Stacy: Thanks, Michael. We've got time for one more question, operator.
Operator: Our next question comes from the line of Jason Bednar with Piper Sandler. Please proceed with your question.
Shirley Stacy: Hey, Jason.
Jason Bednar: Great. Thanks for squeezing me in here. Hi, there. Congrats on a nice quarter, everyone. Have a clarification question just real quick and then another I'll ask upfront here. Just that enhanced momentum building comment that you made for October, Joe, can you just confirm that holds for all major reporting channels you have with GPs and orthodontists? And then, I know it's early days for iGo Plus, but curious if you could just talk about initial feedback on the system in the first markets you entered in Europe, any learnings you can draw on the early days of that launch before you look to take that system and do additional markets? Thanks.
Joe Hogan: Yes, Jason. First of all, I can confirm that it's across all channels, all markets. There's nothing really like in sight, it's not with that momentum that we – on iPro Plus, iPro Plus is about just enhancing the ability of doctors that are on iPro to be able to do more enhanced cases. And the feedback is great. We started in Europe, because that's where iPro really started from in a big way. And those are the first doctors that really asked for that. And then as and we've rolled that out in general. And it's really on the back of like the ClinCheck 6.0, the cloud-type-based product that we've done. That's one of the great things about digital platforms because you can expand them to be able to fit specifically in different markets at different times. And that's what iPro Plus really represents. So, I hope that helps, Jason.
Jason Bednar: Yes. Thanks, Joe.
Joe Hogan: Yes. Take care.
Operator: There are no other questions in the queue. I'd like to hand it back to management.
Shirley Stacy: Thanks, everyone. We appreciate your time today. If you have any follow-up questions, please contact Investor Relations and we look forward to speaking to you at our Investor Day, November 23rd. Have a great night.
Operator: Ladies and gentlemen, this does conclude today’s teleconference. Thank you for your participation. You may disconnect your lines at this time and have a wonderful day. | [
{
"speaker": "Operator",
"text": "Greetings, and welcome to Align Technology’s Third Quarter 2020 Earnings Call. At this time, all participants are in a listen-only mode. A question-and-answer session will follow the formal presentation. [Operator Instructions] As a reminder, this conference is being recorded. It is now my pleasure to introduce your host, Shirley Stacy, Vice President, Corporate and Investor Communications. Thank you. You may begin."
},
{
"speaker": "Shirley Stacy",
"text": "Thank you. Thank you for joining us everyone. Joining me on today’s call is Joe Hogan, President and CEO; and John Morici, CFO. We issued third quarter 2020 financial results today via GlobeNewswire, which is available on our website at investor.aligntech.com. Today's conference call is being audio webcast and will be archived on our website for approximately one month. A telephone replay will be available today by approximately 5:30 PM Eastern Time through 5:30 PM Eastern Time on November 4. To access the telephone replay, domestic callers should dial 877-660-6853, with conference number 13710706, followed by pound. International callers should dial 201-612-7415, with the same conference number. As a reminder, the information provided and discussed today will include forward-looking statements, including statements about Align's future events and product outlook. These forward-looking statements are only predictions and involve risks and uncertainties that are described in more detail in our most recent periodic reports filed with the Securities and Exchange Commission available on our website and at sec.gov. Actual results may vary significantly, and Align expressly assumes no obligation to update any forward-looking statement. We have posted historical financial statements, including the corresponding reconciliations, including our GAAP and non-GAAP reconciliation, if applicable. And our third quarter 2020 conference call slides are on our website under Quarterly Results. Please refer to these files for more detailed information. With that, I’ll turn the call over to Align Technology's President and CEO, Joe Hogan. Joe?"
},
{
"speaker": "Joe Hogan",
"text": "Thanks, Shirley. Good afternoon, and thanks for joining us. I'm pleased to report stronger than expected results with record third quarter revenues up 21% year-over-year, reflecting strong momentum across all regions and customer channels for both Invisalign clear aligners and iTero scanners and services. During the quarter, we continued to support doctor recovery efforts with products, programs and virtual tools and training that helped more docs transition their practices to digital technologies and drove record utilization across the Invisalign portfolio. Capping off a record quarter is an achievement of our 9th million Invisalign patient milestone. We also saw a strong response to our new teen and mom-focused consumer campaign with a 118% year-over-year increase in total leads, garnered 3.3 billion impressions, an uptick in consumer engagement from new social media influencers like Charli D’Amelio and Marsai Martin, a 26% increase year-over-year in teenagers using Invisalign clear aligners. Our overall revenue momentum has continued into October and we are encouraged by positive feedback from Invisalign practices regarding the benefits of digital orthodontics starting with an iTero scanner for Invisalign treatment, especially in this COVID environment. For Q3, total revenues were $733 million, up 108% sequentially and up 21% year-over-year, reflecting a sharp rebound in sales for both Invisalign clear aligners and iTero imaging systems as practices around the world reopened and got back to work treating existing and new patients. Q3 revenues for clear aligners were $621 million, up 20% year-over-year, and imaging systems and CAD/CAM Services were $113.4 million, up 24.5% year-over-year. Q3 Invisalign shipments were a record of 496,000 cases, up 28.7% versus prior year and up 124% versus prior quarter, reflecting strong recovery across all regions. During the quarter, we saw increased demand for new cases as restrictions eased and doctors ramped up their practices. This is in contrast to Q2, where doctors’ primary focus was to maintain continuity of patient care for their existing patients through additional aligner shipments and replacement aligners. John mentioned this in his comments last quarter and we'll touch on it again today. For the quarter, we shipped Invisalign cases to a record 70,000 doctors, of which 5,800 were first-time customers, reflecting increased doctor activity as practices have reopened. We have also trained approximately 6,500 new doctors in Q3, including 3,200 international doctors, reflecting increased doctor engagement through our online virtual education courses, summits and forums. Across the business, we believe there are several factors contributing to our strong performance, starting with pent-up demand. Many of our doctors indicate that they are making good progress in working the backlog of patients from office shutdowns. Pent-up disposable income remains a key factor as consumers focus on feel good investments, while many other quality of life options are low. In our new normal, there are far fewer trips abroad, fewer flights, less money spent on gas, dry cleaning, et cetera. More people can afford to allocate that spending to Invisalign treatment, especially when they're working remotely and critiquing themselves on camera so much of the time. That's the Zoom effect that we've heard about across multiple sectors. As we look at our customer channels, we feel the strategy to dedicate sales representatives by specialty alignment is bearing fruit, particularly in the GP Dental segment. Sales reps were able to partner with a wider range of providers within their designated specialty during the downturn and assess mindset and specific needs during the recovery and tailor plans to thrive beyond COVID. A digital mindset has been key and we believe this is the largest influence in the ortho market, and the one we've been laying the foundation for over the last several years. For many doctors, there are still down from normal years in terms of overall production and weekly patient flow. But they have prioritized Invisalign clear aligners as their preferred modality, expanded to the first age group and leverage programs that help to make the transition from analog to digital treatment. We see this both in teen and adult treatment growing with the same provider, increased use of iTero scanners, our Virtual Care, our high overlap of bracket buyback switch. As part of our recovery programs, we offer doctors two programs, either switch their braces in patients into Invisalign treatment by buying their wires and brackets or just buy back their existing inventory. We took out the equivalent of 10,000 cases. Providers actively reduced their analog footprints by proactively switching their patients to sustainable digital care with Invisalign. And for GPs, who already demonstrated a momentum with digital, an active choice was made to position Invisalign as a priority. Scanning every patient with iTero is generating more opportunity from recall patients, even if overall practice capacity is still down. Because doctors in both channels are trying to anticipate what may come in terms of additional waves and office shutdowns, they are hyper-focused on ensuring that they have the best plan for continuity of care and business continuity, which is digital. To support them in this digital journey, we've rolled out My Invisalign app and Virtual Care to 40-plus countries. These tools have been received very positively by our doctors and are quickly becoming part of their practice workflow. Our commitment to continuous innovation is key. We've recently announced our treatment planning evolution and global availability of our next generation ClinCheck Pro 6.0 proprietary treatment planning software. ClinCheck Pro 6.0 moves Invisalign digital treatment planning to the cloud, making its robust treatment planning tools and features available to doctors anytime, anywhere on any laptop, personal computer, tablet or phone. The release includes a new ClinCheck In-Face Visualization tool and enhanced doctor-facing digital clinical tool that combines a photo of the patient's face with their 3D Invisalign treatment plan, creating a personalized view of how their new smile will look. In addition, we also announced today Invisalign G8 predictability improvement with SmartForce Aligner Activation for both orthodontists and general dentists starting in Q1 2021. Invisalign G8 with SmartForce Aligner Activation is our newest biomechanical innovation and the latest in our long history of Invisalign predictability improvements. We continue to focus on building partnerships with doctors. Our data shows that providers who had or quickly developed momentum around digital orthodontics leaned into our comprehensive platform and a variety of our programs and resources to accelerate a digital shift. It's a compelling story of how engagement may be the first step that transformation is achieved through the breadth of product and services only Align can provide. Transformation and support programs like ADAPT, virtual tools, development of Teen Awesomeness Centers, GP Accelerator, Teen Conversion, Aligner Intensive Fellowship, iPro and doctor-led coaching programs that support GP growth. Building on the teen market in Q3, 163,000 teens and pre-teens started treatment with Invisalign clear aligners, representing 33% of total cases shipped, reflecting growth predominantly from North American orthos and EMEA regions. In parts of the market, we saw an initial rush for teen treatments earlier in the quarter with a slight change in demand profile compared to what we normally see in a typical season, which may be the result of a different type of back-to-school season as most kids return to school late or through virtual learning. Invisalign First continues to accelerate among young patients as well. In terms of products performance, we saw strong growth across the portfolio and non-comprehensive outpaced comprehensive even with the record adult shipments for the quarter. Growth with the Invisalign Go product also increased among GPs, driven by North America and EMEA, and there was an increase in our express package shipments with North America contributing to the majority of that growth. Overall, both non-comprehensive and comprehensive shipments were up, with continued increased adoption of our Moderate product among the ortho and GP channels. Now let's turn to the specifics around our third quarter results, starting with the Americas. For the Americas region, Q3 Invisalign case volume was up 166% sequentially and 25% year-over-year, reflecting an increase in shipments due in large part to the digital programs and tools implemented during the pandemic to help our doctors as well as our continued investments in targeted marketing and sales efforts. The Q3 utilization was up for North American ortho and GPs both quarter-over-quarter and year-over-year. We saw continued utilization increases during the quarter, especially among our orthodontic customers in the teen segment, the strongest teen quarter in the last six quarters. As we mentioned previously in Q2, we started the Bracket Buy Back program to enable doctors to switch their braces patients into Invisalign treatment by buying back their wires and brackets inventory. We also saw stronger growth in the adult segment. We believe that some of the increase in adult shipments is reflective of how circumstances have changed today, with adults in our target demographic having more disposable directed – more disposable income directed at getting their smiles fixed. In Latin America, volume was also up year-over-year, led by strong growth in Mexico and Brazil. When you consider the timing of the pandemic and the shutdowns occurring later in Q2 for LATAM, we were encouraged by the growth this quarter. We also saw increased utilization in the GP channel with Invisalign Go and the adoption of Moderate. DSO utilization also increased and continues to be a strong growth driven by Heartland and also Aspen. For our international business, Q3 Invisalign case volume was up a sequential 88%, led by a significant increase in EMEA. On a year-over-year basis, international shipments were up 34%, reflecting increases through both EMEA and APAC. For EMEA, Q3 volumes were up sequentially 104% and up 38% on a year-over-year basis, across all markets, with strong performances from the ortho channel as well as the GP channel, as many doctors kept their offices open during their typical summer holiday season. Both core and expansion markets accelerated with growth in our core markets led by Iberia, the UKI, Germany and growth in our expansion markets led by Central and Eastern Europe and the Benelux. We introduced the Ortho Recovery 360 program in EMEA last quarter to support our orthodontists as they started reopening their businesses. As of Q3, over 4,000 orthodontists have enrolled in the program with over 13,000 touch points with sales team members, providing a dedicated support in July and August alone. As a result, we continue to see an increase in net promoter score or NPS with qualitative feedback from doctors showing that they appreciate Align for the support during this difficult time. We also rolled out Your Brilliance Enhanced marketing campaign in select EMEA markets that highlights the skills of our orthodontists and illustrates how partnering with Align and using Invisalign clear aligners and iTero systems and services can help further enhance the brilliance of these specialists. To support our GP doctors, we also launched our GP Recovery 360 program during the quarter with over 2,900 GPs enrolled so far. At the beginning of the quarter, we also launched the Invisalign Go Plus system in the UK in Benelux and had 2,500 GPs attend the event. During the quarter, we continue to offer virtual and hybrid education events for our doctors with online and on demand education events, which reached over 2,000 GPs cumulatively. For APAC, in Q3, volumes were up sequentially 74% reflecting continued improvement within the region. On a year-over-year basis, APAC was up 30% compared to the prior year. During the quarter, we were pleased to see a record number of unique doctors submitting cases and positive growth in the adult segment with growth in GP channels and non-comprehensive cases with Moderate product. In the teen segment, shipments were at an all-time high as doctors’ offices continue to recover. We also saw acceleration from Japan and ANZ. During the quarter, we celebrated the grand opening of our China manufacturing facility in Ziyang. The event was attended by key partners and doctors in China. The state-of-the-art facility replaces our original temporary facility, further establishing our commitment and capacity to manufacture Invisalign aligners and iTero imaging systems in China. Align was also one of the sponsors of APAC Med Virtual Forum 2020, which attracted over 1,000 attendees from the MedTech industry. The forum consisted of panel discussions and live video chat sessions at the Align virtual booth as we continue to establish Align as a global medical company that aims to transform smiles and change lives in the APAC region. Last week, we also hosted the Align APAC Virtual Symposium, a fully digital event that showcased digital treatment technologies and featured practitioners from across the Asia-Pacific region with over 800 participants. Our consumer marketing is focused on building the clear aligner category and driving demand for Invisalign treatment through a doctors’ office. In Q3, we saw strong digital engagement globally with more than 78% increase in unique visitors as well as on leads created, driven by our new campaign, revamped social media strategy and our new invisalign.com website that was rolled out to 15 plus countries. Several key metrics show increased activity engagement with the Invisalign brand and are included in our Q3 quarterly presentation slides available on our website. We're pleased with the strong engagement and activity we've seen on our consumer platforms over the last few months, and believe it speaks to the strength of the brand and consumer interest in treatment, even during the challenges of the last few months. As you’ll recall from last quarter, we launched our Mom multi-touch campaign, with incremental support to drive reach, awareness, and foot traffic to practices during the key teen season. We also launched a new multimillion dollar TV campaign designed to reach Mom and Teens across a broad range of networks nationwide including cable and connected TV networks. Align is always looking for new opportunities to reach consumers and be relevant to potential patients wherever they work, live and play. During the quarter we announced that the Invisalign brand is the official clear aligner sponsor of the NFL Football League, so 11 NFL teams working with great sports brands like the NFL is another way to connect with consumers by leveraging the power of the NFL brand and its existing brand platforms. The NFL league partnership will help build awareness of Invisalign clear aligner treatment at a national level, while the team agreement will help us engage within key markets and connect consumers with doctors in those markets. During the quarter, we also extended our innovation to drive engagement with new Invisalign Stickables, designed to personalize Invisalign clear aligners, especially for younger patients. The innovative sticker accessories, designed exclusively for use with SmartTrack material, are available in a variety of designs, colors, shapes and themes, and reflect patients desire to show their personal flair during Invisalign treatment. For our Systems and Services business, Q3 revenues were up 110% sequentially due to higher shipments and services revenues. We continued to see momentum with the Element 5D Imaging System, gaining traction in North America and APAC region. On a year-over-year basis, Systems and Services revenues were up 24.5% due to higher shipments and service. Cumulatively, over 27.4 million orthodontic scans and 6 million restorative scans have been performed with iTero scanners. For Q3, total Invisalign cases submitted with a digital scanner in the Americas increased to 83% from 79% in Q3 last year. International scans increased to 72% up from 63% in the same quarter last year. We’re pleased to see that within the Americas, 95% of cases submitted by North American orthodontists were submitted digitally. Our Q3 Systems and Services revenue also includes exocad CAD/CAM products and services. exocad’s expertise in restorative dentistry, implantology, guided surgery, and smile design extends our digital dental solutions and broadens Align’s digital platform toward a fully-integrated interdisciplinary end-to-end workflows, and we are excited about our continued integration progress and product plans. In September, exocad celebrated its 10th anniversary in conjunction with exocad Insights 2020 an annual event for manufacturers and users of dental CAD/CAM technologies entitled \"A Decade of Digital Innovation.\" The event attracted over 300 dental technicians, dentists and over 40 partner companies, as well as 1,600 users of digital technologies in laboratories and practices from 55 countries. With that, I'll turn the call over to John."
},
{
"speaker": "John Morici",
"text": "Thanks Joe, now for our Q3 financial results. Total revenues for the third quarter were $734.1 million, up 108.4% from the prior quarter and up 20.9% from the corresponding quarter a year-ago. For clear aligners, Q3 revenues of $620.8 million were up 108.1% sequentially and up 20.2% year-over-year due to Invisalign volume growth in all regions, driven by North America, EMEA, APAC and LATAM, partially offset by lower ASPs. Historically we have raised prices by approximately $50 per case in the third quarter. Given our continued commitment to helping our customers in their recovery efforts, we did not implement a price increase this year. Q3 Invisalign ASPs were down sequentially $75 primarily due to higher mix of new cases versus additional aligner shipments as Joe mentioned earlier. Recall Q2 ASPs benefited from more additional aligner shipments as doctors were focused on maintaining treatment progress for existing Invisalign patients. This trend reversed itself after practices reopened in Q3 and demand for new cases ramped up significantly. As a result, our deferred revenue balances increased $93 million from Q2, of which, the majority of this increase is related to clear aligner, and will be recognized with future additional aligner shipments. On a year-over-year basis, Q3 Invisalign ASPs decreased approximately $80 primarily reflecting higher promotional discounts and increased deferrals related to additional aligners. In addition, we provided doctors with incentives designed to specifically aid them in the recovery during the pandemic. Q3 total Invisalign shipments of 496.1 million cases were up 123.6% sequentially and up 28.7% year-over-year. Our System and Services revenues for the third quarter was $113.4 million up 110.1% sequentially due to an increase in scanner sales and increased services revenues from higher installed base. Year-over-year System and Services revenue was up 24.5% due to higher scanner sales, services revenue, and the inclusion of exocad’s CAD/CAM services, partially offset by lower scanner ASPs. Imaging Systems and CAD/CAM Services deferred revenue also increased 28%, primarily due to the increase in scanner sales and the deferral of service revenues, which we recognized ratably over the service period. Moving on to gross margin, third quarter overall gross margin was 72.7%, up 9.1 points sequentially and up 0.7 points year-over-year. On a non-GAAP basis, excluding stock based compensation expense and amortization of intangibles related to exocad, overall gross margin was 73.3% for the third quarter, up 8.9 points sequentially and up 1 point year-over-year. Clear aligner gross margin for the third quarter was 74.7%, up 10.2 points sequentially due to increased volumes driving favorable manufacturing absorption of fixed costs coupled with lower freight costs from increased domestic shipments, partially offset by lower ASPs. Clear aligner gross margin was up 1.2 points year-over-year due to increased manufacturing volumes driving favorable absorption and lower doctor training, partially offset by lower ASPs. Systems and Services gross margin for the third quarter was 62%, up 2.8 points sequentially primarily due to favorable product mix shift to higher margin scanners, higher services revenue, partially offset by freight and training costs. Systems and Services gross margin was down 2.1 points year-over-year due to lower ASPs and higher freight and training costs offset by higher services revenue and product mix shift. Q3 operating expenses were $357 million, up sequentially 20.1% and up 15% year-over-year. The sequential increase in operating expenses is due to increased compensation, marketing and media spend, and favorable foreign exchange. Year-over-year operating expenses increased by $46.6 million, reflecting our continued investment in sales and marketing and R&D activities, additionally prior year included a benefit of $6.8 million from the early termination of our discontinued Invisalign store leases. On a non-GAAP basis operating expenses were $332.1 million, up sequentially 25% and up 12.8% year-over-year due to the reasons as described above. Our third quarter operating income of $177.1 million resulted in an operating margin of 24.1%, up 44.8 points sequentially and up 3.2 points year-over-year. The sequential increases in operating income and operating margin are primarily attributed to higher gross margin and operating leverage. On a year-over-year basis, the increases in operating income and operating margin reflects higher gross margin and operating leverage partially offset by our continued investment in R&D, geographic expansion and go-to-market activities. On a non-GAAP basis, which excludes stock based compensation, acquisition-related costs and amortization of intangibles related to exocad, operating margin for the third quarter was 28%, up 39 points sequentially and up 4.2 points year-over-year. Interest and other income expense net for the third quarter was a gain of $7.5 million, primarily driven by favorable foreign exchange. With regards to the third quarter tax provision, our GAAP tax rate was 24.5% which includes tax benefits of approximately $8 million related to the release of certain previously unrecognized tax benefits as a result of the closure of an income tax audit. Third quarter tax rate on a non-GAAP basis was 16.6% compared to 27.8% in the prior quarter and 18.8% in the same quarter a year ago. The third quarter non-GAAP tax rate was lower than the second quarter’s rate primarily due to reduction in tax benefits resulting from considerable profits recorded in Q3 as opposed to losses incurred in Q2. Third quarter net income per diluted share was $1.76, up $2.28 sequentially and up $0.48 compared to the prior year. On a non-GAAP basis, net income per diluted share was $2.25 for the third quarter, up $2.60 sequentially and up $0.77 year-over-year. Moving on to the balance sheet, as of September 30, 2020, cash and cash equivalents were $615.5 million, an increase of approximately $211 million from the prior quarter, which is primarily due to higher cash flow from operations. Of our $615.5 million of cash and cash equivalents, $298.8 million was held in the U.S. and $316.7 million was held by our international entities. Q3 accounts receivable balance was $626 million, up approximately 32.3% sequentially. Our overall days sales outstanding was 76.5 days, down 44 days sequentially and down two days as compared to Q3 last year due to strong cash collections as doctor’s offices reopened from Q2 shutdowns. Cash flow from operations for the third quarter was $211 million. Capital expenditures for the third quarter were $21.3 million, primarily related to our continued investment in increasing aligner capacity and facilities. Free cash flow, defined as cash flow from operations less capital expenditures amounted to $189.8 million. Under our May 2018 repurchase program, we have $100 million still available for repurchase of our common stock. Now let me turn to our outlook. Overall, we’re pleased with our Q3 performance and the strong momentum in our business. We made investment decisions that helped drive and capture demand across all regions and all customer channels. We see good return on our investments and strong revenue growth, which has continued into October. We are confident in the huge market opportunity, our industry leadership, and our ability to execute. At the same time, there continues to be uncertainty around the pandemic and global environment, therefore we aren’t providing specific guidance. With that, I will turn it back over to Joe for final comments. Joe?"
},
{
"speaker": "Joe Hogan",
"text": "In summary, we are certainly pleased with our progress in the third quarter. We have taken a very thoughtful approach to recovery and we have persevered in large part by living the values that are important to us as an organization; agility, customer and accountability. In a time of great uncertainty, when swift actions have been required, we have responded like no other company in our industry. Most importantly, we have followed our guiding principles and supported our employees and customers, protecting employee jobs and salaries and working to support the needs of our teams globally, and supporting our customers with PPE, extended payment terms, postponed subscription fees for iTero, and numerous programs to help them through this crisis. We also applied our manufacturing experience and resources to making testing swabs for hospitals and PPE for our own teams and also customers. Instead of going quiet or holding on planned spend, we accelerated our investments in marketing to drive consumer demand to our doctors’ offices and stay top of mind with consumers. We accelerated new digital technology to market so that we could provide virtual tools to our doctors that enabled them to stay connected with their patient and keep their treatment moving forward. We supported doctors and their teams with online education and digital forums that went beyond product and clinical education to help navigate PPE shortages and recovery planning; and we continued to grow the business, not just protecting jobs but adding headcount, continuing our investments in R&D and product innovation as you saw in our Invisalign G8 announcement today and developing our plans for manufacturing expansion. Our actions are a result of the conviction that we have in our business model, supported by the strength of our balance sheet, to drive results that exhibit our accountability to our employees, customers and shareholders. Even in a time that required us to change and adapt, we maintained our long-term focus. I feel this is what good companies do and its proof that being a good company and delivering the type of results we’ve seen this quarter can go hand-in-hand. We have remained a growth business, driving programs in anticipation of recovery, but we acknowledge that there still remains uncertainty due to COVID-19. Our plan is to counter future uncertainty by staying focused on our long-term strategy, living our values, supporting our employees and customers, and keeping the demand drivers we’ve identified over the last few months in mind. The re-direction of disposable income for many consumers; channel focus that allows us to reach and support a wider range of customers within each channel and most importantly, the digital mindset that is really taking hold with more and more of our customers and that we are supporting through innovative products and programs that can help support their digital transformation. We are not ignoring the reality of COVID-19 and how long it may be part of our lives, but we’re also not going to stop driving the business forward for the good of customers, their patients, our employees, and stakeholders. With that, I want to thank you again for joining our call. I look forward to updating you on our progress as the year continues to unfold. On November 20 to 21, Align will be hosting the Invisalign Ortho Summit, Virtual Edition, with the theme Digital is the Answer. This Invisalign Summit is the ultimate learning experience for orthodontic practices. From digital practice transformation to great patient experiences, there’s never been a more exciting time to learn about digital orthodontics. Align will also host a virtual Investor Day on November 23, where I also look forward to sharing our views on the incredible market opportunity that we have combined with the unmatched power of Align’s digital platform, technology innovation, global reach, and brand equity. Now with that, I’ll turn it over to the operator for questions. Operator?"
},
{
"speaker": "Operator",
"text": "Thank you. Ladies and gentlemen, at this time, we will be conducting a question-and-answer session. [Operator Instructions] Our first question comes from the line of Nathan Rich with Goldman Sachs. Please proceed with your question."
},
{
"speaker": "Nathan Rich",
"text": "Thanks, and good afternoon. Joe and John, obviously, great to see the volumes come back so nicely. It sounds like the momentum continued in October. Could you maybe just kind of help us understand kind of the cadence of growth that you saw over the quarter? And any comments on how October has fared so far, maybe relative to the type of case growth that you saw in 3Q?"
},
{
"speaker": "Joe Hogan",
"text": "Yes, yes, Nathan, thanks for the question. Look, we just built through the quarter. Every month we saw actually continue to enhance momentum. And the short answer to your question is, we’ve seen that build in October also."
},
{
"speaker": "Nathan Rich",
"text": "That’s great. And Joe, obviously, you kind of talked through in detail about what has kind of driven the stronger utilization that you’ve seen and the value of digital treatment. When you kind of take a step back and kind of think longer-term, how has that kind of changed your outlook or influence your kind of multi-year outlook for kind of what you could see from this business over the next several years going forward?"
},
{
"speaker": "Joe Hogan",
"text": "Nathan, you’ve known John and me and Shirley long enough. I mean, we’re incredibly enthusiastic about this business and bullish about this business. And you can see we’re even more so as obviously we deliver the kind of results we have in 3Q. I think you always have to keep in mind two things here. One is, we’re in a very volatile environment. We understand that and we’ve done some things. We feel that’s really helped our doctors through this and made the company stronger coming out at the other end. But always remember, we’re completely underpenetrated in this marketplace, right? We’re still less than 10% penetrated from an orthodontic procedure standpoint, let alone those 300 million patients we talk about there that should receive orthodontic treatment that aren’t receiving orthodontic treatment. So we remain incredibly bullish with a digital format to be able to go after those patients and be able to continue to drive the growth of this business."
},
{
"speaker": "Shirley Stacy",
"text": "Thanks, Rich. Next question…"
},
{
"speaker": "Nathan Rich",
"text": "Okay. Thanks."
},
{
"speaker": "Joe Hogan",
"text": "Yes."
},
{
"speaker": "Shirley Stacy",
"text": "Next question, please."
},
{
"speaker": "Operator",
"text": "Our next question comes from the line of Erin Wright with Credit Suisse. Please proceed with your question."
},
{
"speaker": "Erin Wright",
"text": "Great, thanks. So, can you speak to some of the contributions from the recovery efforts in switching brackets and wires patients? Or are you continuing to see those contributions and efforts into the fourth quarter? And do you think that will drive the Board’s longer-term shift here? Do you have any indication based on the responses? I guess you’ve seen from practitioners how sticky that is? Thanks."
},
{
"speaker": "Joe Hogan",
"text": "Well, it’s – overall – hey, it’s Joe. I mean, overall, it’s pretty sticky when we buy their wires and brackets inventory back. And then we introduced in the programs like ADAPT and different things that really allow them to begin a digital transformation within their practices. So I feel that part is very sticky. I can’t sit here and naively say that everyone who starts to move digital in this crisis is going to stay digital. But I can tell you that we have the tools, being able to drive consumer demand and consumer awareness and all those things, helps us to maintain that stickiness. And I think over time, we’ll just have to see how sticky it is as we come out of this COVID crisis."
},
{
"speaker": "Erin Wright",
"text": "Okay, great. And then on ASPs in the quarter, I guess, is that the run rate we should be thinking about? I know you didn’t take the price hikes, but any other mix dynamics as we think about the next quarter and beyond?"
},
{
"speaker": "John Morici",
"text": "Hey, Erin, this is John. Yes, the mix that we saw – we talked about some of the dynamics of all those new cases coming in and we saw that. We also talked about not having a price increase given the conditions that we’re in. We’ll evaluate going forward as to any changes we might make in pricing and so on. But I think from a run rate standpoint, this is a good starting point for going forward."
},
{
"speaker": "Erin Wright",
"text": "Okay, great. Thanks."
},
{
"speaker": "Operator",
"text": "Our next question comes from the line of Steve Beuchaw with Wolfe Research. Please proceed with your question."
},
{
"speaker": "Joe Hogan",
"text": "Hi, Steve."
},
{
"speaker": "Steve Beuchaw",
"text": "Hi, good afternoon, and thanks for the time here. I wonder if you could expound a little bit on some of the numbers that you’ve given here at this quarter, and I believe you did in the prior quarter as well around not just the training numbers, but some of the data that you gave on people who are not just getting trained, but who are new to Invisalign. I’m sorry, I don’t know, maybe some do. But what were those numbers a year ago? And do you have visibility into what those training numbers look like out into 4Q or even beyond?"
},
{
"speaker": "John Morici",
"text": "Yes, Steve, this is John. I think when you look at being able to train like we can now doing much more virtual being able to have that remote training as well as where you can in person gives us a lot of flexibility going forward to be able to expand out our training. So there’s a lot of new capabilities, a lot of new tools that we’ve introduced this quarter to be able to help our customers and train new customers as well as our sales team be able to reach those. So it’s a key part as you know to our growth and we’re going to continue to find ways to be able to connect with new doctors to be able to get them to understand the benefits of Invisalign and ultimately have them use it more and more to grow."
},
{
"speaker": "Steve Beuchaw",
"text": "Okay. Thanks, John. And then, Joe, one for you. So I’ll let you carry the burden of being the CEO of the first big dental company here in the U.S. to report. Just give a little bit of perspective on how you imagine policy evolves. As you talk to folks around the CDC, AAO, the ADA, any of their counterpart organizations in Europe, do you see any sign that there might be a move toward practice closures? Or are we really past that now that we’ve got PPE in place? I ask because I think they’re just a lot of folks who are looking at the growth, not just at Align, but at some other companies and it’s really attractive growth, but people are just worried about the possibility that we see lockdowns again. So any perspective you could offer there would be really helpful? Thank you."
},
{
"speaker": "Joe Hogan",
"text": "Yes, Steve. Steve, I’d tell you, talking to obviously doctors all around the world or whatever. I don’t see that there’s any imminent, a lot of closures in the industry. I mean, there’s frustration with the closures and obviously a lot of disagreement in the sense of when they’re told to close. Fortunately, what we’ve seen with the COVID coming back here in the fall, we haven’t seen the institution of going back and closing these doctors’ offices, which help. I can tell you, Steve, since I’ve been here five years, there’s always a certain segment of the dental industry that is looking to sell or looking to change and get out, but not close down. So I honestly think that there’s still optimism out there. I’ve seen the doctors do a great job in a sense of being able to protect their employees, make sure that they protect their patients and do the things that are needed. I know by reading your material and other materials that we’ve all picked up that most of the doctors are running at 70%, 75% kind of a capacity, but they’re finding a way to make it work. So I’m not looking at any imminent demise in the business in the sense of close downs or anything like that. And I think the offices are getting better and better being able to drive volume through their offices. And again, you know that this is a digital format that we feel that sets a foundation for them to have a much better patient flow through or a much fewer touches in this COVID world, which we hope hopefully will carry over as we move out of this next year."
},
{
"speaker": "Steve Beuchaw",
"text": "Really appreciate that. Thanks for all the time here."
},
{
"speaker": "Joe Hogan",
"text": "Thanks, Steve."
},
{
"speaker": "Operator",
"text": "Our next question comes from the line of Jon Block with Stifel. Please proceed with your question."
},
{
"speaker": "Jon Block",
"text": "Great. Thanks, guys."
},
{
"speaker": "Joe Hogan",
"text": "Hi, Jon."
},
{
"speaker": "Jon Block",
"text": "Hey, Joe, actually, first one for you. Sort of qualitatively, can you give us a beat or a signal on teen share of chair? And do you see a broadening out within your ortho customer base? I think that’s the key sort of the broadening out. In other words, are you seeing the one from orthos that we’re always, I don’t know, call it less than 5% Invisalign shared chair. Are they stepping up to the plate because of clear aligner workflow advantages? And if so, how do you sort of ensure that you capitalize on that longer term?"
},
{
"speaker": "Joe Hogan",
"text": "Yes. Well, I think it’s a couple things, Jon. Obviously, COVID has been an added incentive to move people out of analog into digital because of fewer touches and being able to maintain continuity of treatment, even if things are shutdown. So there’s no question, we saw our share of chair increased in that sense. I think also when you see new products like Invisalign First and those things we’ve introduced in the last few years, that’s – as you know well, that’s extended our reach from a HDM point within that specific demographic. That’s helped us also. And I think there’s a combination here of further and further realization of how digital processes and orthodontics really can help, can help be more efficient, but also realization from consumers that it is an offering here that is better than wires and brackets, and more efficient, certainly in this COVID kind of environment. So how do we – how are we certain that we maintain that? Jon, when you look at programs like ADAPT and things, those – that switch over – let’s back up for a second. Jon, five years ago, we were fighting for clinical, I’d say relevancy in this industry. That’s not a question anymore. All the docs – most of the docs out there understand very clearly we can do 80%, 90% of the cases out there. It becomes a business formula. Can we really make money with a digital kind of a system? And those are the programs that we’ve been putting together with doctors with outside experts that can really train doctors as to how digital can work, how can expand their practices and how actually can be more profitable in a digital process. And I’m confident with what we’re building up in that area, we’ll be able to extend that going forward."
},
{
"speaker": "Jon Block",
"text": "Got it. Fair enough. I’ll shift over to GP side for the other question. The utilization over four, I think I’ve been waiting 10 or so years for that and I get it. Some of it’s probably pent-up demand. You talked to that a little bit on the call, but what about the other components? Is it some scanner digitizing the front end, the bifurcating of the sales force? I mean, essentially Joe, have you given the tools that you needed to the GP to finally sort of step function that utilization rate higher that was always sort of stuck right around that mid threes for a number of years? Thanks guys."
},
{
"speaker": "Joe Hogan",
"text": "Yes. Jon, I feel the answer to your question is yes, we have. I mean everything from iTero and really the inside of iTero and the software programs at all in conjunction with iGo that make it much simpler for doctors that haven’t been associated with digital orthodontics before. Our segmented sales force, for sure. I mean, we’ve piloted this in Europe first and somewhat in APAC. So we knew what to expect. We were just fortunate enough to launch it ahead of this issue, ahead of the COVID issue, and they have the salespeople ready to have that touch with customers to make it work. What I’m excited about this, Jon, we have so much more that we can do to make that work also. And I think with a confidence that GPs are having in this kind of a system, it’s a light touch system, it’s a high revenue kind of a product and it’s gaining more attention in that channel. So, yes, I’m really – we’re all thrilled here to see the utilization rates, but it is on the back of those kinds of innovations in distribution and also product that we think we’ve been able to drive it."
},
{
"speaker": "Jon Block",
"text": "Okay. And if I can just quickly slip in one more, just for a clarification, I think it was all the way back to Nathan’s first question, just to be clear when you say momentum building, I mean, do we take that your October year-over-year growth rate was north of your worldwide 3Q growth rate that you posted? Thanks, guys."
},
{
"speaker": "John Morici",
"text": "Jon, you’re right. We see momentum building and that continues – it continues that growth from a revenue and a volume standpoint into October."
},
{
"speaker": "Shirley Stacy",
"text": "Thanks, Jon. Next question, please."
},
{
"speaker": "Joe Hogan",
"text": "Thanks, Jon."
},
{
"speaker": "Operator",
"text": "Our next question comes from the line of Elizabeth Anderson with Evercore. Please proceed with your question."
},
{
"speaker": "Joe Hogan",
"text": "Hi, Elizabeth."
},
{
"speaker": "Elizabeth Anderson",
"text": "Hi, guys. Thanks so much for the question. As we think about the outlook for 4Q and as we come out of COVID more broadly, are there any – I know you guys obviously didn’t cut costs, kept the sales force, because you maybe foresaw some of this growth coming back. Is there anything in terms of investments of the ramp back that we should be considering?"
},
{
"speaker": "Joe Hogan",
"text": "Well, I think there’s just continuity of investments is the way I’d answer your question. They’re not new investments. We’ll continue to invest in the consumer side, pretty dramatically. You’ll see that we’re doing that all around the world. It’s not just in the United States or Canada. We’re also – you’ll see investments in Europe and also Asia to a degree that we haven’t made before. We have a series of new products that we’re investing in. We kept that momentum in the third quarter and where we hired engineers to keep that moving. And then these specific programs for doctors like ADAPT that we’re talking about, and AIF and different things, they’re really an important part of this because you have to make sure that these workflow changes, and the way ClinCheck works, like ClinCheck Pro and whatever, they have to be introduced to docs and we got to have the high touch kind of a system to give them the confidence in those programs. So it’s a long answer to your question, but I’d say we maintain and enhance what we have been doing is what you’ll see in the fourth quarter and as we go into the first quarter too."
},
{
"speaker": "John Morici",
"text": "The added piece, Elizabeth, from an investment standpoint is investing in operations to stay ahead of the volume. And making those investments we did so in Q3, we’ll continue to make those investments in Q4."
},
{
"speaker": "Elizabeth Anderson",
"text": "Okay. But it doesn’t sound like there’s anything totally different that this sort of – because we could consider catch up or something on that front. Okay. I guess – yes."
},
{
"speaker": "Joe Hogan",
"text": "You go ahead, Elizabeth."
},
{
"speaker": "Elizabeth Anderson",
"text": "No, I was just wondering, you talked about some of your continued spend on social channels in terms of marketing and that seemed also a continuation plus obviously the buyback program in the quarter. Is there anything else that you guys see changing in terms of your marketing spend going forward? Would you say it’s sort of like a continuation of the types of programs that you were doing in the third quarter?"
},
{
"speaker": "Joe Hogan",
"text": "Well, I think, obviously, Raj and our marketing team are very innovative and it’s not that we’ll just keep with the same themes. We obviously we run – we run trials, we do different things, we’ll change them up or whatever based on what we’re experiencing in the marketplace. So our investments will continue to be very aggressive. We’ll continue to be innovative in the sense of how we do these things, but we certainly won’t let off the gas in the sense of the focus that we’ve had over the last few quarters."
},
{
"speaker": "Shirley Stacy",
"text": "Thanks, Elizabeth. Next question, please."
},
{
"speaker": "Operator",
"text": "Our next question comes from the line of Steve Valiquette with Barclays. Please proceed with your question."
},
{
"speaker": "Jonathan Young",
"text": "Hi, this is Jonathan Young on for Steve."
},
{
"speaker": "Shirley Stacy",
"text": "Hi, Steve. Hi, there."
},
{
"speaker": "Jonathan Young",
"text": "Hey, it’s Jonathan. Hi. So you just from relation to the backlog, you were talking about on the pent-up demand, I guess from your perspective, how much backlog do you think is kind of still out there with the docs before it normalizes out as we kind of move forward?"
},
{
"speaker": "Joe Hogan",
"text": "Steve, you asked a big question. I mean, from a backlog standpoint, we really don’t know. When you talk from an empirical standpoint, when you talk to many of our docs, they’ll say they cleared out their backlog in July and August. But this is a global business it’s hard to talk about all over the world where it stands, but – when things came out of lockdown and when they didn’t. So we struggled to be able to quantify a number for you in that sense."
},
{
"speaker": "Jonathan Young",
"text": "Okay. And just going back to the comment about the utilization of docs being at about 70%, 75% capacity, I guess, from – that’s from the capacity standpoint, but from your customer base, are they all largely open at this point or is there still 10%, 20% that still remains close due to random shutdowns globally or locally in certain areas? Thanks."
},
{
"speaker": "Joe Hogan",
"text": "No, they’re largely open."
},
{
"speaker": "Jonathan Young",
"text": "Great. Thank you."
},
{
"speaker": "Joe Hogan",
"text": "Yes. You're welcome Jon."
},
{
"speaker": "Operator",
"text": "Our next question comes from the line of John Kreger with William Blair. Please proceed with your question."
},
{
"speaker": "John Kreger",
"text": "Hey guys."
},
{
"speaker": "Joe Hogan",
"text": "Hey John."
},
{
"speaker": "John Kreger",
"text": "Hey. Can you just talk a little bit more about again the uncertainties that prompted you to not guide to Q4 after a very, very good third quarter? And one thing I was thinking about given the rebound in cases in Europe are you seeing any signs of maybe just patient traffic slowing down even if practices aren't closing per se?"
},
{
"speaker": "Joe Hogan",
"text": "Yes, jump in."
},
{
"speaker": "John Morici",
"text": "Yes. I think, when you think about what we've seen in terms of the momentum we see we tried to lay that out, obviously there are still unknowns in the world. I would say COVID in the global economy and so on. But for the things that we can control and what we tried to lay out around the R&D investments, in manufacturing, and marketing and sales we feel really good about our momentum and what we can drive in the future. We just have unknowns that are outside of our control and so that's the reason from a guidance standpoint that we didn't give specific guidance. But we wanted to highlight that we've – because our continued momentum as we went through the quarter both for revenue and volume, and that continued past the quarter end."
},
{
"speaker": "John Kreger",
"text": "Great. Thank you. Joe, a question for you about sort of the strategy to get the attention more of GPs. Can you just talk about how exocad is going and what else your – what other levers you're pulling to sort of become more of that sort of daily thought process for the typical general dentist?"
},
{
"speaker": "Joe Hogan",
"text": "Yes, John that’s a good question. Look, I feel great about exocad and obviously when I talked about in the highlights that we just went over is, I mean its digital dentistry on the GP side. You have to go around the world and understand how exocad is, exocad is very embedded in Europe also in various parts of the far-east and in some parts of the United States, but the key is just a digital workflow and it's between iTero France is, it's in a obviously a GPs office and that CAD/CAM piece is either extended in office or primarily it goes to labs. I think it's given us the initial boost that we wanted to in the sense of our relevancy in the GPs office in the sense of an iTero scanner can do these kinds of restorative scans and this kind of restorative workflow. What's really exciting is, when you look at how you can integrate what exocad does in a seamless workflow way with iTero and also Invisalign, it just gives us a lot of degrees of freedom to really change that kind of restorative dentistry. I'm really excited about the progress even in the short amount of time."
},
{
"speaker": "John Kreger",
"text": "Great. Thank you."
},
{
"speaker": "Shirley Stacy",
"text": "Thanks, John."
},
{
"speaker": "Operator",
"text": "Our next question comes from the line of Brandon Couillard with Jefferies. Please proceed with your question."
},
{
"speaker": "Brandon Couillard",
"text": "Hi, thanks. Good afternoon. John, I think you said leads were up something like 120% year-over-year. How do we think about the relevancy of that metric as a leading indicator of revenue growth, it's not a metric I can recall you really discussing before?"
},
{
"speaker": "John Morici",
"text": "Well, that's a good question. I mean, we do – I don't know how we've communicated that before, but it certainly is a term we use internally here at Align all the time. A lead is just what you would guess it is Brandon and it's a strong lead in the sense of a customer wanting to turn into a patient. And we have several ways of touching that customer they can come through our Invisalign app. They could be contacted by a concierge service. Concierge service can take the information and move it onto a doctor's office, but it's a lead and it's a great leading indicator of the interest of patients out there. And it's, again, one of the major attributes of Align of what we bring to the marketplace is to be able to excite consumers and move them into our doctor partner groups."
},
{
"speaker": "Brandon Couillard",
"text": "Okay. And then John, any chance you could specifically speak to China growth in the third quarter? And then secondly the financial impact of opening the new permanent manufacturing facility as opposed to the temporary site you have been operating be in terms of revenue growth or profitability or expenses you think you can share there?"
},
{
"speaker": "John Morici",
"text": "In China, we saw a good sequential growth, continues to grow. I mean, obviously they were the first ones kind of in the pandemic to starting Q1 we saw some growth in Q2 and significantly more growth in Q3. The manufacturing like you said, is gone live it's now greenfield facility where everything's up and running. We're adding more capacity there to meet our demands. But it was a very smooth transition. We learned a lot from having that temporary facility and learning kind of the manufacturing, the scale up that we needed and that transitioned very well into the new facility."
},
{
"speaker": "Brandon Couillard",
"text": "Great. Thank you."
},
{
"speaker": "Operator",
"text": "Our next question comes from the line of Jeff Johnson with Baird. Please proceed with your question."
},
{
"speaker": "Jeff Johnson",
"text": "Thank you. Good evening guys."
},
{
"speaker": "Joe Hogan",
"text": "Hey Jeff."
},
{
"speaker": "Jeff Johnson",
"text": "Hello. Joe, wanted to the start with you again, it's the same thing, Jon Block's trying to feel out here, but was there anything different in your North American ortho customer mix? Did the Diamond and Double Diamond guys come back much faster than the lower-end guys, anything at all like that? And I guess what I'm trying to get at and same thing, like I said, John is sustainability of that 24% North American ortho utilization number, a fantastic number, is that our evidence, is that our proof point there of this move from analog to digital, as you keep talking about it, is that the number to focus in on there and then obviously the GP number as well?"
},
{
"speaker": "John Morici",
"text": "Yes, I think, Jeff if your real question is about utilization being the key metric, I mean, it certainly is, but who has led that, our Diamond and Diamond Plus docs are already having a big digital aspect of what they were doing. We're able to function extremely well in this environment. Remember our virtual care tool that we bought out really six months before we wanted to do it, it wasn't the best tool in the world, but we've made it better over time. Really gave them that digital interface with their patient base that allowed them to be able to track their patients without having come back to the office that was for a certain period of time. So but to say that it was only those practices would be wrong. We saw no matter what tier they were in our advantage program, we saw them reaching for training, wanting to work from a digital standpoint. The orthodontist recognized the advantages of digital during this whole sequence and again, that's why the program and the things that we've had in place, the investments we made or whatever, they were very timely to help to support that interest."
},
{
"speaker": "Jeff Johnson",
"text": "Yes. Understood. And then maybe just a follow-up for John. So John, you seem to imply that maybe ASP is here at this level are good way to think about the next few quarters. Does that mean some of the incentives kind of sustain here? Do you leave them in place? And I just want to understand the accounting. Does the bracket buybacks, does that go against ASPs in any way or is that a cost buried somewhere else in the P&L? Thanks."
},
{
"speaker": "John Morici",
"text": "No, that is a cost against as a promotion, so it goes against revenue for the bracket buyback in. And we'll evaluate as we do on a normal basis with promotions, what promotions are working, what's driving that right level of utilization and engagement, whether a new doctor to a doctor that does a lot of volume. We did mention that we didn't increase price and that was something that's just a reflection of what's happening in the marketplace. And look we are very pleased with, when you look at Invisalign ASPs that it's 74.7%. We haven't seen that in several quarters. So, we're very aware of the dynamics around promotions and what that drives, but ultimately its driving profitability and we saw great gross margin growth."
},
{
"speaker": "Jeff Johnson",
"text": "Yes. Understood. Thanks."
},
{
"speaker": "Joe Hogan",
"text": "Thanks, Jeff."
},
{
"speaker": "Operator",
"text": "Our next question comes from the line of Glen Santangelo with Guggenheim. Please proceed with your question."
},
{
"speaker": "Joe Hogan",
"text": "Hey, Glen."
},
{
"speaker": "Shirley Stacy",
"text": "Hey Glen, you there? We maybe not hearing your line clearly."
},
{
"speaker": "Glen Santangelo",
"text": "Hello. Can you hear me now?"
},
{
"speaker": "Joe Hogan",
"text": "Yes, we can."
},
{
"speaker": "Glen Santangelo",
"text": "Hey Joe, how are you? Thanks so much. Joe. I just want to take a step back. I mean a lot of the questions were already asked, but I wanted one of the follow-up to response you said to the earlier question. What's your sense going on with your organic growth rate of this business? I mean, are you seeing that the organic growth rate of just the ortho business in general accelerate through the pandemic, and then as you think about sort of the penetration of clear aligners versus total cases, you sort of cited that you still think we're less than 10% penetrated. Could you maybe talk about the penetration in North America and international, maybe how you see those sort of penetration rates evolving over the next couple of years?"
},
{
"speaker": "Joe Hogan",
"text": "Well, I mean, obviously we measure ourselves from a penetration rate standpoint overall and we split the market up obviously in teens and adults, ortho versus the general segment with GPs. But if I'm answering your question right, Glen, I mean we have increasing penetration in the utilization we call on different parts of the marketplace. The digital platforms and things that we've put in place are really enhancement to doctors to get on these digital platforms and use the tools and things that we have. So Glen, I think again as I mentioned in the other question on like this is – remember we're still underpenetrated, it really as digital orthodontics has such a long runway, but it is a different workflow for doctors and it's a different expectation from a patient base, understanding you really can use in digital platform in order to move teeth as efficiently or better than wires and brackets and so. It's so important that we have a strong digital platform that unites the workflow between us and doctors, and doctors and patients that you have a breadth of product, everything from Invisalign First, all the way to express and comprehensive products, and retainers and things in between. Sales forces are incredibly important for that penetration, the sense of how you talked – how you touch docs and how you move things forward. So I would say Glen, to answer your question here, there's no magic on this penetration piece. It's a lot of work. It's a lot of work and a lot of friction you have to overcome, there's no escaping it, but it's inevitable. Digital is better than analog in a COVID environment or not in a COVID environment. That's our position and that's what we'll continue to drive."
},
{
"speaker": "Glen Santangelo",
"text": "And Joe, it seems like you may be expanded your sort of technology lead again with sort of this latest development on the G8 side. Could you maybe just give us a quick update on the competitive landscape? Are you seeing anything else in the market that is starting to get any traction or is it still kind of really just an execution issue for you?"
},
{
"speaker": "Joe Hogan",
"text": "This is all about execution with us. It's a – from – I have nothing from an update from a competitive standpoint, really to report. Remember our competition is about expanding the marketplace that is what it's all about. This is not a scrum of a bunch of people making plastic aligners. This is a scrum about what can you do to reduce the friction of getting dentists and orthodontists to move forward in a digital process. It's the growth of this marketplace that is really the material difference here. It's not individual competition in the trenches that we're focused on or concerned about how do we expand the marketplace Glen."
},
{
"speaker": "Glen Santangelo",
"text": "Okay. Thanks for the comments."
},
{
"speaker": "Joe Hogan",
"text": "Yes. Thank you."
},
{
"speaker": "Operator",
"text": "Our next question comes from the line of Richard Newitter with SVB Leerink. Please proceed with your question."
},
{
"speaker": "Richard Newitter",
"text": "Hi, thanks for taking the question."
},
{
"speaker": "Joe Hogan",
"text": "Hi, Rich."
},
{
"speaker": "Richard Newitter",
"text": "Hi, how are you doing, Joe."
},
{
"speaker": "Joe Hogan",
"text": "Good."
},
{
"speaker": "Richard Newitter",
"text": "Wanted to just start-off, just thinking back over the 20 year journey that you had or longer than that now, you're not specifically, but just in aligners and what you've seen in your tenure and what you know before, can you – there'll probably be an inflection point moments and I'm just curious where and how kind of this COVID opportunity, which is clearly on some level creating an inflection point on some level, where that stacks up? And a year or two years from now, do you think we're going to be saying this was probably the one of the defining periods for you guys to capitalize on converting the gene segment and getting that accelerated kind of digital boost that you needed to really kind of move this market conversion opportunity in a step function fashion. I'm just trying to put it in perspective, are we kind of at the demarcation here, where this is kind of defining period for the company?"
},
{
"speaker": "Joe Hogan",
"text": "Well, you know Richard this is always really – it's hard to always call it, you're asking about the tipping point. And John has a great saying you never know the tipping point until it tips, right. So, but I would tell you that, obviously in the current environment that we have right now, where infection is a concern, digital becomes predominant in that sense of doctors looking at it. But I think another good signal that you can say that this can become more permanent, what's really unusual here is take a look at iTero growing 25%, right. You see capital of goods in a situation like this are going to lag, because doctors aren't going to make that kind of a capital outlay when their businesses are under pressure. And what we saw in this case is iTero grew phenomenally and then what we know, and you see that 93% of the cases in the United States right now for ortho is coming through digitally, when you get an iTero scanner into an office whether it's a GP or ortho they become really committed on the digital piece of want to learn. So I think that kind of demand for iTero scanner, what I call a hurricane right now from a doctor’s cash flow standpoint really shows that they're interested in the sense of this digital transformation and want to stick with it."
},
{
"speaker": "Richard Newitter",
"text": "That's helpful. And maybe just want to follow up on the competitive comments and questions from the prior. I'm just curious, your ability to train virtually and remotely and your customer base and the advantage you have there. Are your competitors able to kind of get into the channel even as effectively as they might have otherwise been or you basically kind of converting on your own right now, I'm just curious if there's just an inherent structural advantage that you have there during this period and if competitor sales reps are allowed to say engage as actively as you are?"
},
{
"speaker": "Joe Hogan",
"text": "Yes. Forgive me if I don't answer your question properly, but what I can drive from that is the importance of a sales force versus competition, and then the importance of training. And there's no company in the world that can provide digital training, whether it's virtual or if it's allowed in the future, which it will be obviously face-to-face across a number of platforms that Align can provide. ADAPT is another kind of training, ADAPT is Align Digital and Practice Transformation program that kind of experts that we put in place that understand doctors office workflow and economics, and how we can work through them. Our sales force is, since I've been in this business five years now and I've run sales forces in businesses pretty much my entire adult life. I have never seen such a high touch sales force in my life. The importance of touch with a sales team with those doctors is incredibly important because of how different digital is from a workflow standpoint, a clinical standpoint than what an analog procedure is. So there's no way around that. And then the last part is, maybe we're taking advantage of our competitors or something. And I don't say there in any arrogance or whatever, the competitions, I actually welcome it to a certain extent because it helps to legitimize a digital space. Our job broadly is how do we go and get dentists and orthodontists to move from analog to digital, not so much what the next competitor's product is out there and we're fighting for that extra ounce of share, that's not where we are right now. This is about an expensive marketplace."
},
{
"speaker": "Richard Newitter",
"text": "Thank you."
},
{
"speaker": "Joe Hogan",
"text": "Yes. Thank you."
},
{
"speaker": "Operator",
"text": "Our next question comes from the line of Ravi Misra with Berenberg Capital Markets. Please proceed with your question."
},
{
"speaker": "Ravi Misra",
"text": "Hi team. How's it going? Hope everyone's well."
},
{
"speaker": "Shirley Stacy",
"text": "Hi, Ravi."
},
{
"speaker": "Joe Hogan",
"text": "Thank you so much."
},
{
"speaker": "Ravi Misra",
"text": "To take a pivot to G8 for a second, and remembering correctly prior versions of the systems have been seen as the step function advancements that have opened the door to more cases and more comfort with doing the system. With G8, just curious in terms of number one, how do you see it kind of increasing the addressable market for the number of cases you can treat? I mean, is this opening up doors that couldn't be done before by the sort of average dentist. And number two, do we have any sort of IP protection around this. I mean, looking at the press release, it seems like a pretty powerful set of innovations in the way you're staging it or this kind of a function or development on top of existing technologies in that sense from an IP perspective?"
},
{
"speaker": "Joe Hogan",
"text": "Yes. Hey Ravi, good question. First of all, when you think of how we got the G8 is, we've done 9 million patients, right. And probably deep bite cases are 30% of those cases and G8’s around deep bite. And when you do deep bite, there's a lot of extrusion in deep bite, now I don’t want to get to clinically into this thing but extrusion means you're pulling the tooth down or pushing a tooth up. And those are the most difficult movements that we make. They're the hardest movements to do. When we talk about IP, it has to be with the specific kind of attachment, it's where you place that attachment. It's that interface of that attachment with the aligner and how the aligner – actually that's what we call it the activated part of this thing. And I'd say do we have IP around that? Sure, we do. Do we have IP around doing a deep bite case? No, but our products are specifically geared to be able to do that. And so we use a lot of AI and machine learning to mine that database to figure out where these deep bite cases weren't finishing as fast as they could be at times. And the new G8 supposed to make this better it's been tried in different areas. And in the end, what it does it gives doctors more confidence to be able to get into those cases and though they can finish them the way they want to finish them and that's the purpose of the product."
},
{
"speaker": "Ravi Misra",
"text": "Great. And then maybe if I can build on that."
},
{
"speaker": "Shirley Stacy",
"text": "Thanks, Ravi."
},
{
"speaker": "Joe Hogan",
"text": "Yes, go ahead."
},
{
"speaker": "Ravi Misra",
"text": "Sure. So one more. So pre-pandemic, you guys were on a kind of case growth basis somewhere in the 30’s, high 20’s range. I appreciate that it's very difficult to look past what's going on in the world right now, but say we do kind of normalize at some point in the future post-pandemic. With these innovations and the sales force touch points that you mentioned, is that 20% to 30% case growth, given where we are on the adoption curve still a kind of reasonable proxy for where this market can go. Thanks."
},
{
"speaker": "John Morici",
"text": "Hey Ravi, this is John. Good question. When we think about the investments that we make in the – as we've described, the vastly underpenetrated market that we're in, we look at our investments to say, look, we can grow revenue in the 20% to 30% and that's how we think of things. And that's what we think that we can control the investments that we're making to be able to grow in this market to that. We didn't guide to that because there's unknowns outside of what we can control and we've kept it at that. But certainly when we look at investments in this market and the opportunities that we have, we look at those investments with the long-term growth model from a revenue standpoint of 20% to 30%."
},
{
"speaker": "Joe Hogan",
"text": "Thanks, Ravi."
},
{
"speaker": "Operator",
"text": "Our next question comes from the line of Michael Ryskin with Bank of America. Please proceed with your question."
},
{
"speaker": "Michael Ryskin",
"text": "Hey, guys. Thanks for fitting me in. Yes, it's late, so I'll just keep it to one. Obviously, seeing the really strong utilization numbers in the Americas for the orthos and GPs. But obviously that's only half of the equation, because you also got the number of docs actually receiving those. So I was just wondering if you could provide any additional color on the split between ortho and GP, which really drove the volume in the quarter in the Americas. What I'm getting at is, with the rebound you commented on and some of that pent-up demand was there one part of your customer base that really accelerated better than the others or was it pretty broad based?"
},
{
"speaker": "John Morici",
"text": "Yes. I can take that, Michael. This is John. Really when we look at the utilization and the growth that we saw was very broad, it was across GP and ortho. It was across multiple-tiers. We just saw a good adoption of our technology as these practices opened. Patients ask for it by name, doctors used our product. There were many doctors that were higher up on the tiers accelerated their cases. And then even new doctors or doctors that are at lower tiers were able to increase the utilization. So, we're very happy with the results that we saw from newer doctors to more experienced doctors and felt really good about how they were in that recovery mode. As we said, it's tough to understand and break out the piece of how much is pent-up demand versus run rate. But as we went through the quarter, as we said, we got stronger and stronger. So we feel good about the situation that we left Q3 with."
},
{
"speaker": "Michael Ryskin",
"text": "Great. Thanks."
},
{
"speaker": "Shirley Stacy",
"text": "Thanks, Michael. We've got time for one more question, operator."
},
{
"speaker": "Operator",
"text": "Our next question comes from the line of Jason Bednar with Piper Sandler. Please proceed with your question."
},
{
"speaker": "Shirley Stacy",
"text": "Hey, Jason."
},
{
"speaker": "Jason Bednar",
"text": "Great. Thanks for squeezing me in here. Hi, there. Congrats on a nice quarter, everyone. Have a clarification question just real quick and then another I'll ask upfront here. Just that enhanced momentum building comment that you made for October, Joe, can you just confirm that holds for all major reporting channels you have with GPs and orthodontists? And then, I know it's early days for iGo Plus, but curious if you could just talk about initial feedback on the system in the first markets you entered in Europe, any learnings you can draw on the early days of that launch before you look to take that system and do additional markets? Thanks."
},
{
"speaker": "Joe Hogan",
"text": "Yes, Jason. First of all, I can confirm that it's across all channels, all markets. There's nothing really like in sight, it's not with that momentum that we – on iPro Plus, iPro Plus is about just enhancing the ability of doctors that are on iPro to be able to do more enhanced cases. And the feedback is great. We started in Europe, because that's where iPro really started from in a big way. And those are the first doctors that really asked for that. And then as and we've rolled that out in general. And it's really on the back of like the ClinCheck 6.0, the cloud-type-based product that we've done. That's one of the great things about digital platforms because you can expand them to be able to fit specifically in different markets at different times. And that's what iPro Plus really represents. So, I hope that helps, Jason."
},
{
"speaker": "Jason Bednar",
"text": "Yes. Thanks, Joe."
},
{
"speaker": "Joe Hogan",
"text": "Yes. Take care."
},
{
"speaker": "Operator",
"text": "There are no other questions in the queue. I'd like to hand it back to management."
},
{
"speaker": "Shirley Stacy",
"text": "Thanks, everyone. We appreciate your time today. If you have any follow-up questions, please contact Investor Relations and we look forward to speaking to you at our Investor Day, November 23rd. Have a great night."
},
{
"speaker": "Operator",
"text": "Ladies and gentlemen, this does conclude today’s teleconference. Thank you for your participation. You may disconnect your lines at this time and have a wonderful day."
}
] | Align Technology, Inc. | 24,568 |
ALGN | 2 | 2,020 | 2020-07-22 16:30:00 | Operator: Greetings and welcome to the Align Technology Second Quarter Earnings Call. At this time all participants are in a listen-only mode. A brief question-and-answer session will follow the formal presentation. [Operator Instructions]. As a reminder this conference is being recorded. It is now my pleasure to introduce your host Shirley Stacy, Vice President of Corporate Investor Communication. Thank you may begin.
Shirley Stacy: Thank you everyone and thank you for joining us. Joining me today is Joe Hogan, President, and CEO; and John Morici, CFO. We issued second quarter 2020 financial results today via GlobeNewswire, which is available on our website at investor.aligntech.com. On April 1st, 2020 we completed the acquisition of privately held exocad Global Holdings GMBH exocad. To reflect this addition acquisition of exocad into our operations as of Q2 2020, we have renamed the Scanner and Services segment to Imaging System and CAD/CAM Services or Systems and Services. Today's conference call is being audio webcast and will be archived on our website for approximately one month. A Telephone replay will be available today by approximately 5:30 P.M. Eastern Time through 5:30 P.M. Eastern Time on August 5th. To access the telephone replay, domestic callers should dial 877-660-6853 with conference number 13705887 followed by pound. International callers should dial 201-612-7415 with the same conference number. As a reminder, the information provided and discussed today will include forward-looking statements, including statements about Align's future events and product outlook. These forward-looking statements are only predictions and involve risks and uncertainties that are described in more detail in our most recent periodic reports filed with the Securities and Exchange Commission available on our website and at sec.gov. Actual results may vary significantly, and Align expressly assumes no obligation to update any forward-looking statement. We have posted historical financials including the corresponding reconciliations, including our GAAP to non-GAAP reconciliation as applicable. And our second quarter 2020 conference call slides are on our website under Quarterly Results. Please refer to these files for more detailed information. With that, I'd like to the call over to Align Technology's President and CEO, Joe Hogan. Joe?
Joe Hogan: Thanks Shirley. Good afternoon and thanks for joining us. I am pleased to report Q2 results and continued progress across all regions and customer channels that reflect our COVID-19 recovery efforts, and those of our customers. Practices across every region have reopened and are seeing patients and many of those practices are embracing digital treatment in new ways and more purposely than ever before. In particular Invisalign providers are using the virtual tools we expedited over the last few months to minimize in office appointments and deliver doctor-directed personalized treatment that meets the needs of the moment, trusted, safe, convenient, and reflecting the digital option. The initiatives we have prioritized globally over the last few months, including support for doctors to ensure treatment and business continuity a shift to online education, and training, ramping availability of virtual tools to keep doctors and patients connected throughout the treatment, and continued investment in consumer marketing, and concierge program, and personal protective equipment or PPE are helping doctors navigate this evolving environment and come back stronger as their practices have reopened. We have received consistently positive reactions and feedbacks from doctors in support of our efforts over the last few months. While it's too early to know for sure how extensive and sustainable the digital transition will be. Interest in digital solutions is building even among doctors who were not early adopters or advocates prior to the pandemic. The positive feedback and momentum is not just around Invisalign treatment. It includes digital workflow around iTero scanners and general dentistry. Doctors are telling us that iTero is central to their practice and to their practice workflows and its key to driving digital treatment. With that let me turn to results. For Q2, total revenues were $352 million down, 36% sequentially and down 41% year-over-year reflecting significantly lower sales in Invisalign clear aligners and iTero scanners due to a full quarter’s effects of COVID-19 pandemic on practice closures. Revenues from clear aligners were $298 million and Imaging System and CAD/CAM services were $54 million. On a year-over-year basis while clear aligner shipments were 222,000 cases down 41% year-over-year, we are pleased with the continued progresses we seen from our recovery efforts throughout the quarter. For the quarter, we shipped Invisalign cases to approximately 48,000 doctors, of which 3,000 were first time customers, reflecting lower doctor activity due to practice closures primarily in Americas GP channel. We also trained approximately 3500 new doctors in Q2 including 2350 international doctors. While our inability to hold in person courses due to COVID-19 result in fewer trained doctors in the second quarter, we continue with a significantly larger number of Invisalign doctors through online virtual education courses, summits, and forums. For the teen market in Q2 71,000 teens and preteens started treatment with Invisalign clear aligners, representing 32% of total cases shipped, reflecting growth from APAC across comprehensive products. By the end of the quarter we started to see recovery in the Ortho channel with increases in Invisalign comprehensive treatments in the teens and preteens segment across most regions with positive growth predominantly in the APAC in the teen segment. Invisalign first continues to accelerate among young patients as well and reflects greater resiliency as parents continue to prioritize orthodontic treatment for their kids. Overall, both non comprehensive and comprehensive shipments were down, but with increased adoption of our moderate product among the Ortho channel. Last week, we held our Teen Forum-Virtual Edition, taking what was a popular teen-intensive program for orthodontists launched last year and recreating it as a virtual experience. 6:29 In order to facilitate broader attendance among our customer doctors, we scheduled two teen virtual events. The first took place on July 17th and the second will be held this Friday. The program is designed to help doctors understand the highly visual online and on-demand world of today’s teens and provides the know how tools and confidence to differentiate and grow their Invisalign teen practices. Approximately 800 customers have registered for this full day session that combines live and on demand sessions, clinical practice investor presentations, panel discussions, and invaluable insights from experts with successful teen practices. Now let's turn to the specifics around our second quarter results starting with the Americas. For the Americas region Q2 Invisalign case volume was down 53% sequentially and down 52% year-over-year reflecting significantly fewer Invisalign case shipments due to the impact of COVID-19. For Q2 reported utilization was down for NA Orthos and GP both quarter-over-quarter and year-over-year, however utilization increased in June especially among certain orthodontists doing more Invisalign treatments with teen shipments recovering faster in North America, in late May, and through June. As part of our recovery programs we enabled doctors to switch their patients into Invisalign treatment by buying their wires and brackets. This program was well received and as a result doctors converted approximately 2500 wires and brackets cases to Invisalign clear aligner patients. In the GP segment the timing of officer openings and case prioritization are slow to recovery in this key segment as compared to the orthodontic segment, but the GP segment is catching up. In terms of timing of the recovery in the Americas, the US continues to lead followed by Canada and LatAm corresponding to the timing of the pandemic related shutdown and reopenings in each region. For international business Q2 Invisalign case volumes were down 17.2% sequentially reflecting a significant decrease in EMEA again due to the impact of COVID-19, partially offset by growth from APAC which was ahead in the recovery curve in China, Taiwan, Hong Kong, and South Korea. On a year-over-year basis international shipments were down 27.1% reflecting a decline in EMEA partially offset by slight growth in APAC. For EMEA Q2 volumes were down sequentially 44% and down 46% on a year-over-year basis across all markets with more softness in the GP channel compared to. ortho We continue to see momentum within Invisalign first for Invisalign treatment in young patients. Overall we saw slower deceleration in teen shipment growth than adults driven by Germany and France. The expansion market had less decline and only accounted for five points decline in EMEA. We also rolled out a recovery 360 program in EMEA with over 3700 Orthodonists enrolled resulting in a stronger partnership perception by our customers including an increase in our Net Promoter Score or NPS. Using a combination of our adapt consultants which I'll be describing more later and territory managers, we held practices with the workflow and scheduling, increased our doctors engagement with their patients through the use of education, and communication tools, and provided business by ability, access sustainability materials to the doctors. In May over 1400 attendees from three regions, 75 countries participated in our virtual Invisalign scientific forum in EMEA. At the end of June we held a virtual GP growth Summit with over 1300 doctors from over 42 countries who signed up to gain insights on business, dentistry, health, and chain management. During the summit we launched our GP recovery program and we received great feedback on the tools and approach we provide to support business recovery. During the quarter we also offered over 150 online and on-demand education events which reached over 20,000 GPs cumulatively. In July we launched the Invisalign Gold Plus system in UK, in Nordic, and Benelux which offers a wider treatment options, enables dentist to treat more patients with confidence, and can be easily integrated into a wide range of restorative treatments in their practice. For APAC Q2 volumes were up sequentially 41% reflecting improving trends as practices reopened and got back the business, as well as COVID-19 recovery measures we implemented in China. On a year-over-year basis APAC was up 3.4% compared to the prior year and was the only region up year-on-year. As mentioned earlier we saw positive growth in APAC in teen shipments led by China reflecting a strong uptick recovery programs. In the GP segment we saw growth in the non comprehensive cases with Invisalign Gold and the launch of [indiscernible] in China continuing to further demonstrate doctor confidence in treating young patients with Invisalign. Throughout the region Japan, Taiwan, and South Korea successfully managed recovery efforts and performed better than expected. During the quarter, we reached a major milestone with our 1 million Invisalign patient in APAC, an athlete in modern day and fencing who is being treated by Dr. Yogart in Tokyo, Japan. Earlier this month we held the Invisalign Teen forum in China in a virtual from broadcast of four venues in Beijing, Shunde, Wuhan to approximately 8000 participants. The forum focused on the innovations and applications of digital technology in clear aligners as well as theories in clinical practices for teen patients. The forum brought together outstanding orthodontists from leading dental colleges from approximately 30 academic institutions. We believe that our global clinical education programs are the best in the industry and we’ve been even more valuable to doctors throughout the pandemic. We launched a new improved digital learning environment for our doctors this year offering a comprehensive learning platform with role specific content for orthos, GPs, and their teams. They improved functionality enables more online learning opportunities with Spotlight features for what's trending now recommending learning paths based on doctors experiences in extended categories including digital treatment planning, comprehensive dentistry, and team education. To date over 85,000 doctors have access to recorded lectures and completed self pace learning models and watched how to videos and over 3 million sessions. Among the ortho channel over 30,000 unique users have engaged with the digital learning side with an additional 50,000 unique users from the GP channel. We are encouraged by the digital training utilization rates among our doctors which has helped them continue their Invisalign treatment learning journey during the pandemic. Feedback from the participants describes the courses as engaging, providing broader reach to online events, and a strong desire that Align continue to provide these virtually. They also acknowledged Align’s agility, and providing relevant tools and content to help them during the lockdown. We see this as an ongoing opportunity to enhance doctor learning to direct feedback and continuous improvement. Building on the benefit of clinical education and training today we announced a global launch of the Align digital and practice transformation or ADAPT service. This is our first customized consulting services in support offering for doctors and was developed based on years of learnings from practices that saw strong growth, and practice transformation when changing their practice to digital. Initially available to Invisalign and iTero doctors in select segments of the EMEA market and then in the US, the global program is now generally available in EMEA and APAC regions that will be available in the US in the second half of this year. The ADAPT program is an expert in independent fee based business consulting services offered by Align to optimize clinics, operational workflow, and processes to enhance patient experience, and customer, and staff satisfaction which will turn translate into higher growth and greater efficiencies for orthodontic practices That goal of ADAPT program is to support digital practice transformation for doctors and their staff. ADAPT is designed for orthodontists as approximately 200 total cases start per year who are seeking to build their future business. Driven by a team of independent business consultants, analysts, and program support specialists, ADAPT offers a customized on-site consulting service to each participating practice. The program combines a review of business operations and practice workflow data with Align's expertise and digital workflow optimization, practice support, business transformation, marketing, and clinical education support. The pilot version of the program has been successfully developed across EMEA, the United States, Asia Pacific region over the last 12 months. As a result of the ADAPT service participating practices improved profitability of 15% within six months of implementation and increased practice revenue up to 20%. Our consumer marketing is focused on building the clear liner category and driving demand for Invisalign treatment through a doctor's office. In Q2 we saw strong digital engagement globally with more than 70% increase in unique visitors as well on leads. Other key metrics showed increased activity engagement with Invisalign brand and are included in our Q2 quarterly presentation slides available on our website. We're pleased with our strong engagement and activity we have seen on our customer platforms over the last few months. I do believe it speaks to the strength of the brand, a consumer interest in treatment even doing a challenges the last few months. In Q3 we're coming into what is typically the strongest part of the teen season with teens and younger kids are home from the summer break and likely to start treatment before heading back to school. And while back-to-school looks very different this year in many countries including United States, this is still a time and practice is orthodontic practices are focusing on younger patients. Teens are the biggest, the most critical part of orthodontic practices and our huge influences and drivers of practice growth. That matters now more than ever as we partner with practices in this recovery. One of the most important ways we partner with customers is by creating demand for Invisalign treatment and to drive teens and parents to the practices for great outcomes and great treatment experiences. We have just launched a new Teen and month-focused consumer campaign designed to do this just that by reaching teens and moms where they are most engaged on digital platform, social channels and later this year national cable TV channels where they sped the most time like Instagram, Twitch for Teens, Instagram, Facebook and people.com for moms. We're going to leverage influences that teens and kids follow interest like Charlie D’Melio. We recently established a new partnership with Charlie, who is a really dynamic kid and accomplished dancer who has a combined following of over 90 million fans on TikTok and Instagram, she's about to become a new Invisalign patient and ambassador for our brand. She'll be sharing her treatment journey in a way that is relevant to teens across social platforms. And our new campaign will get the heart of what, it get to the heart of what Invisalign is and what it isn’t, using straightforward language that teens respond to. Our goal is to tell teens why parents and Invisalign is more of advanced and or more comfortable than traditional braces emphasizing that this is not your parent’s braces. We also want to ensure that they know that doctors are front and center in the Invisalign treatment because it's time to be very candid about the benefits of digital orthodontics and Invisalign treatment specifically. For our assistance and services business which now includes exocad Q2 revenues were down 22% sequentially. We are pleased to see the momentum with Element 5D Imaging Systems in North America and APAC along with sales of iTero element one scanner modeling China and significant sales of the flex scanners modeling EMEA. On a year-over-year basis, system and services revenues were down 48% were slightly offset by the inclusion of exocad CAD/CAM services. Cumulative the over 24 million orthodontic scans are 5.5 million restorative scans have been performed with iTero scanners. For Q2 total Invisalign cases in mid of the digital scanner in the Americas increased to 86% from 77% in Q2 last year. International scans increased to 72%, up from 61% in the same quarter last year. We're pleased to see that within the Americas 96% of cases submitted by North American orthodontists were submitted digitally. We also recently announced that the iTero Element 5D Imaging System was awarded best new technology solution for dentistry in the 2020 Medtech awards. The annual program honors outstanding health and medical technology products and companies. We also received an award for dentistry IQ naming the iTero, Element 5D Imaging System as number 10 of 14 products and services to help dentist rebound from COVID-19. With that I turn the call over to John.
John Morici: Thanks John, now for our Q2 financial results. Total revenue for the second quarter was $352.3 million, down 36.1% from the prior quarter and down 41.3% from the corresponding quarter a year ago. For clear aligners, Q2 revenues of $298.3 million was down 38.1% sequentially and down 39.9% year-over-year due to volume decreases across most regions. Driven by North America and EMEA and LATAM partially offset by APAC. Clear aligner revenue growth was impacted unfavorably from foreign exchange of approximately $6 million or approximately one point year-over-year. Q2 Invisalign ASPs were flat sequentially at $1,255 primarily due to promotional discounts and unfavorable foreign exchange mostly offset by increased revenue from countries with higher list prices and increased other case and revenue revenues. On a year over year basis Q2 Invisalign ASPs increased approximately $25 primarily reflecting price increases in all regions and additional line of revenue, partially offset by promotional discounts and unfavorable foreign exchange. One example of our crisis recovery program that we have implemented in Q2 was a switch program that enable doctors to switch wires and bracket patients into Invisalign clear aligners. Total Q2 Invisalign shipments of 221.9 thousand cases were down 38.3% sequentially and down 41.2% year-over-year. Our system and services revenues for the second quarter was $54 million down 22.2% sequentially and down 48.1% year-over-year due to volume decreases across most regions except APAC. Promotional discounts and a decrease in service revenue partially offset by exocad revenue. Moving on to gross margin. Second quarter overall gross margin was 63.7% down 7.9% sequentially and down 8.3 points year-over-year. On a non-GAAP basis, excluding stock-based compensation expense and amortization of intangibles related to exocad, overall gross margin was 64.4% for the second quarter down 7.4 points sequentially and down 7.8 points year-over-year. Q2 gross margin reflects Align’s decision to maintain our head count and salaries across our operations in anticipation of a volume pick up as the COVID-19 pandemic subsides. This decision also enabled us to manufacture nasal tests swabs for hospitals and PPE for use by our own employees as well as our doctors as they reopen their practices. We also postponed iTero subscription fees for one month in the US and parts of APAC. On a year-over-year basis Q2 gross margin includes approximately 0.7% impact from unfavorable foreign-exchange. Clear aligner gross margin for the second quarter was 64.5%, down 8.5 points sequentially and down 9.2 points year-over-year due to lower volumes driving higher cost per case and increased freight costs from higher international shipment mix. On a year over year basis, the decreased in the clear aligner gross margin was partially offset by an increase in Invisalign ASPs and continued in efficiency improvements. Systems and services gross margin for the second quarter was 59.2%, down 2.6 points sequentially and 4.4 points year-over-year due to lower ASPs and lower volumes with higher cost per unit and amortization of intangible assets related to the exocad acquisition partially offset by lower service support part. Q2 operating expenses were $297.3 million, down sequentially 8.4% and up 60.2% year-over-year. The sequential decrease in operating expenses reflects lower travel spend, decreased compensation related to commissions and lower marketing and media spend, partially offset by higher exocad acquisition cost. Year-over-year, operating expenses increased by $41.5 million, this is mainly caused by the $51 million favorable litigation settlement received in Q2, 2019 offset by cost controls measures in Q2 of 2020. On a non-GAAP basis, operating expenses were $265.6 million down sequentially 11.9% and down 7% year-over-year due to the reasons as described above, offset by exocad cost. Our second quarter operating loss was $73 million, down 204.4% sequentially and down 141.4% year-over-year. Our second quarter operating margin was negative 20.7% down 33.4 points sequentially and down 50.1 points year-over-year. The sequential decrease in operating income and operating margin are primarily attributed to lower revenues and gross margin as a result of lower volume from COVID-19 impacts. Operating margin was unfavorably impacted by approximately 0.9 points year-over-year from foreign exchange. On a year-over-year basis the decrease in operating income and operating margin primarily reflects lower gross profit on lower volumes from the impact of COVID-19 in addition to the prior-year quarter included the $51 million favorable litigation settlement. On a non-GAAP basis which excludes stock -based compensation, acquisition-related costs and amortization of intangibles related to exocad, operating margin for the second quarter was minus 11%, down 28.1 point sequentially and down 35.6 points year-over-year. Interest and other income and expense net for the quarter was an expense of $0.5 million including a $1 million hedge loss related to the exocad acquisition excluding the hedge loss interest in other income and expense net was 0.5 million income on a non-GAAP basis. With regards to the second quarter tax provision, our GAAP tax rate was 44. 8% which includes a tax benefit related to the impact of changes in the jurisdictional mix of forecasted income to GAAP profits recorded last quarter. The second quarter tax rate on a non-GAAP basis was 27.8% compared to 33.2% in prior quarter and 25.3% in the same quarter a year ago. The second quarter non-GAAP tax rate was lower than the first quarter’s rate primarily due to changes in jurisdictional mix of forecasted full year results. Second quarter net loss per diluted share was negative $0.52 down $19.73 sequentially and down $2.35 compared to prior year. On a non-GAAP basis, net loss per diluted share was negative $0.35 for the second quarter down $1.08 sequentially and down $1.84 year-over-year. Moving on to the balance sheet. As of June 30th, 2020 cash and cash equivalents were $404.4 million, a decrease of approximately $386.3 million from the prior quarter, which is primarily due to the acquisition of exocad partially offset by a free cash flow improvement. Of our $404.4 million of cash and cash equivalents, $160.2 million was held in the US and $244.2 million was held by our international entities. Q2 accounts receivable balance was $473.3 million down approximately 11.2% sequentially. Our overall days sales outstanding, DSO’s was 121 days, up 34 days sequentially and up 44 days as compared to Q2 last year due to doctor office closures that resulted in slower accounts receivable collections. We expect DSOs to remain relatively high has doctor’s offices return resume normal business activity. Cash flow from operations for the second quarter was $59.9 million. Capital expenditures for the second quarter were $34.4 million, primarily related to our continued investment in increasing aligner capacity and facilities. Free cash flow defined as cash flow from operations less capital expenditures amounted to $25.5 million. Under our May 2018 repurchase program, we have $100 million still available for repurchase of our common stock. Now let me turn to our outlook. Since the last time that we talked, the orthodontic and dental market had continued to evolve in response to government regulations and safety guidance from local, regional and national health officials. We believe that all of our markets have bottomed out and are recovering, albeit at different rates and different times corresponding with regional outbreaks and recoveries from COVID-19 preventative measures as we're now seeing improvements in consumer and doctor activity. Nevertheless, we're mindful that the demand environment remains uncertain. There may be additional waves of infection and governments around the world may strategically choose to shut down cities, states and countries again forcing people to shelter in place and practices to close again therefore we're not providing any forward-looking guidance. While our management team understands the markets remain fluid, we continue to focus on taking care of our employees, customers and shareholders for our employees we are committed to protecting our employees, and do not intend to implement furloughs or salary reduction. For our customers we will continue to be supportive of our customers who are impacted by COVID 19 and are committed to helping slow the spread of virus by providing PPE to doctors. We continue to release products, tools, and promotions to help our doctors recover from the crisis. For our shareholders, we will continue to invest in our strategic initiatives to grow in a vastly underpenetrated market and position our company to capture growth as the market returns to normal. This includes continued investment in Align’s end to end digital workflow as well as increased investment in the Invisalign brand and consumer demand creation as you heard Joe described earlier. We will continue to add resources in markets that give us a good return. I’m very proud of what Align is accomplished while maintaining our financial discipline during this pandemic. We finished Q2 with $404.4 million in cash and cash equivalents, closed the purchase of exocad for $430 million and still delivered free cash flow of $25.5 million despite having the lowest volume Align has had in a very long time. Our cash flow reflects the strength of our business model, the strength of our balance sheet, and our strong operational focus. I’m also pleased to share that we have established a new line of credit of $300 million with a consortium of banks led by Citibank. This new land replaces our line of credit with Wells Fargo. As a market leader in clear aligners and digital dentistry we are well positioned to continue investing strategically for the future. With that I'll turn it back to Joe for final comments Joe.
Joe Hogan: Thanks John. In summary we're pleased with our progress last quarter and by the customer responses to the actions we’ve been taking to support their practices and patients. We have developed a careful recovery approach that accounts for the safety of our employees, our customers, and their teams, and their patients, and are committed to helping doctors navigate this evolving environment, and be successful. One of the biggest lessons we have learned over the last few months is about the critical importance of digital technology. Align has always been a proponent of digital treatment to think about all these things that digital platforms and virtual tools have enabled during the crisis. The people in the businesses, and the customers who stayed connected, the way we’re able to adapt to working from home, the rise of tele consults, the AI that modeled the virus patterns, and informed health experts, and so much more. Consider also the companies that have thrived, most of the companies that are digital with their core, Amazon, Apples, Zoom and Netflix just to name a few. The advantage of digital are much more magnified to practitioners and consumers. This became even clear in our industry when practices were shut down for months. Over and over we heard I‘ve been able to help my Invisalign patients progress in progress, but I had to just try to keep my patients in a holding pattern with wires and brackets. Treating orthodontic cases has amplified the clear benefits of digital technology in clear aligners. This is a method self serving. This pandemic has emphasized the benefits of digital technology across many facets of our lives and businesses. Our acquisition of exocad adds additional digital workflows that play in the GP space and lab space. We're all excited about the exocad team and what our investment brings to this new world of the digital dentistry. Align’s digital platform has made it possible for thousands of doctors and patients to continue Invisalign treatments throughout the global disruption. Thanks to the digital orthodontics of Invisalign aligners, iTero digital, records, and simulations, digital treatment planning, and virtual monitoring, and care. At Align we have always believed that digital orthodontics is the best option for teens and adults. As you can see from a peak at our current teen campaign, we’re going to feature this going forward. What’s clear to us is that the momentum we’re seeing in the business and in the dental and ortho practices reflects more than just one thing or one new products or tool or one program or action. It reflects continued improvement and continued execution of our core strategy across our business in every region. We’re going to continue to stay the course while remaining vigilant and agile. We feel good about the progress that we have made and as we continue along the recovery phase of COVID 19 crisis in many regions we are focused on what we can control and impact. We are in a unique position to continue investing to a huge underpenetrated market, to extend our lead, and accelerated growth. With that I want to thank you again for joining our call. I look forward to updating on our progress as the year unfolds. Now I’ll turn the call over to the operator for questions. Operator?
Operator: [Operator Instructions]. Our first question comes from the line of Nathan Rich with Goldman Sachs. Please proceed with your question.
Nathan Rich: Thanks. Good afternoon. Thanks for the question. Joe you highlighted the improvement that you saw in June. I understand sort of the rational for now providing guidance for 3Q kind of given kind of the situation, but can you maybe help us better understand kind of where the business kind of you and so just we have better sense of what the jumping out point is as we think about the back half of the year?
Joe Hogan: Yeah I mean we saw dramatic improvement between April and June. Obviously we were kind of in the jaws of COVID 19 with all the shutdowns in April. May was little better and then we’ve seen strong momentum as we’ve moved into June. So I think you can look at that as a significant improvement in our business overall.
Nathan Rich: Okay great and then you highlighted the 3000 customers that were new to Invisalign this quarter. Can you maybe just talk about how that compares to maybe what you see in a typical quarter and kind of what you’re doing was going to ensure that those doctors become kind of longer term customers of Invisalign?
Joe Hogan: Yeah I mean that’s. I mean when you think about COVID 19 and what the business has really faced in that. 3000 customers thus for us was terrific in that way. You don't actually look for new customers coming in on that. You’re looking for utilization rates on your current base. I mean we felt and I felt really great about the 3000. Obviously that got stronger as the quarter went on.
Operator: Thank you. Our next question comes from the line of Elizabeth Anderson with Evercore. Please proceed with your question.
Elizabeth Anderson: Hi. Can you talk about. Do you think Asia is a good path to think about in terms of the recovery or do you see sort of significant differences in that geography that should prevent this from extrapolating?
Joe Hogan: Yeah I think Asia is so diverse in itself. It’s hard just to extrapolate Asia Elizabeth. .I mean obviously China was kind of first out of this thing, but China has had bumpy road also with the recent issues in Shanghai and different areas, so every one of these regions has its own unique footprint in its own unique model in a sense of how they’ve dealt with the virus, but obviously it in our transcript, but we’ve seen significant improvement in really every region around the world.
Elizabeth Anderson: Okay and I think you commented also in terms of your cost structure, in terms of not furloughing in place. Is there any other major changes to the cost structure in the third quarter maybe just in the back of the year generally that we should think about as we’re updating our models?
John Morici: Hi Elizabeth this is John. We continue to believe in our model. It’s a vastly underpenetrated market. We're going to make strategic investments to better grow in that market. Whether it’s R&D, sales, and marketing we’re going to continue to make those investments where we see a return.
Operator: Thank you. Our next question comes from the line of Steve Beuchaw with Wolfe Research. Please proceed with your question.
Steve Beuchaw: Hi good afternoon. Thanks for the time here. I wonder first Joe, could you give us any more color on the breadth of uptake of some of the new digital tools that you referred to and the extent to which practices are making these changes and converting over to something of a virtual experience. I mean is this. Is this 2% of your customer base? Is it a lot bigger than that? Any color is really very helpful there?
Joe Hogan: Steve when we talk about digital platform, you really start with iTero on the front end and even in a downturn like we saw with COVID in the capital equipment business. iTero showed up well and particularly with 5D in different areas, but that’s the front end of this whole piece that we talk about on digital platform, then you move through our obviously our treatment planning, and all, but what we added had when you think about the whole breadth of a global digital platform we added virtual care, that knew about and we came out so that. Doctors could talk to our patients remotely and be able to track treatment and actually we had several doctors actually close treatments cases remotely with our virtual treatment capability. And that really extended the effectiveness of the doctor's, and the effectiveness of the digital treatment in that sense too. There is a lot of imaging that we do now in our treatment planning and all too, so it’s not just tracking patients, it's also having images and different things that you can share with the patient is a sense of where they should be around treatment in those types of areas. So it's a broad kind of a digital platform we're talking about. I mean we had tens of thousands of people on our virtual care platform as we rolled that thing out in a matter of 30 days and all around the world. And we’ll continue to update that platform with AI. We’ll make it much more predictive so that doctors don't have to look at every patient. We have a strong roadmap in that sense too Steve so it’s just, it’s the breadth of the digital platform, and how it covers everything from starting with the consumer, turning them into a patient from iTero all the way to the back end up being able to monitor, and treat those patients.
Steve Beuchaw: Just one more from me. What I'm trying to get to here is some perspective on what the underlying trend is and I appreciate that you don't want to talk about the exit rate leaving 2Q and you're not going to give guidance for 3Q, but what if I said let's imagine a scenario where we don't have another wave of lockdowns where practices are operating, and what is admittedly a challenging environment, but we don't have any sort of government level, or professional society level. You’ve got to stop doing cases or stop engaging in practices. If that's the operating environment we’re in I mean can you grow in 3Q or the back half of the year? Can you speak at all to what the business would look like in that situation if we don't get more lockdowns? Thank you.
Joe Hogan: Steve I’d say we're incredibly optimistic in this scenario that you painted where we don't see another COVID shutdown on a major market that lasts a long period of time. Based on the recoveries that we’ve seen in the latter half of May and then the strong recovery in June, we feel really good about the future of this business in the third and fourth quarter and beyond. John anything to add?
John Morici: That covers it.
Steve Beuchaw: Okay thanks a lot.
Operator: Thank you. Our next question comes from the line of Jon Block with Stifel. Please proceed with your question.
Jon Block: Hey guys. Good afternoon hey. Joe I hope you can hear me okay. A similar line of questioning, just sort of emendated with e mails about sorts of trends so let me try to frame it this way. I think with slide 8 you guys have increase in North America utilization for June. I think first part of the question is I just want to be clear. That was for both orthos and GPs up the slide. It was hard to tease that out and if that’s the case Joe was that pure. In other words I’m getting questions on practices reopened in May and obviously there is a lot of backlog, so you’re saying North America grew in June, but was it pure or? Was it a benefit of backlog and maybe you could comment if that growth continued into July would be very helpful for North America?
John Morici: Hey John this is John. Some of that is, some of its backlog, and some of it is additional growth that they would have, so the utilization has improved as those doctors have come back to work and they’re seeing patients, and that’s true in North America and that’s true in all countries where we see those doctors’ offices opening up, so it's hard to tell how much is backlog versus how much is more run rate going forward, but we’re a combination of both.
Jon Block: And the second part of the questions is Joe I’ve got you. That increase or the year over year growth in North America does that continue to the month of July?
Joe Hogan: That momentum continued to be strong John.
Jon Block: Okay fantastic and the second part of the question, go from very near term next month to sort of 18 months out, 24 months out. John just as we think about the model longer term I think there Street has you guys from a 2021 perspective. Revenue is higher in 2021 to 2019. Let put away 2020 for a whole host of reasons, but let's look at 2010 versus 2019. Structurally if revs are higher by ex %, should the margin structure also be higher. I look back to 2019, you had someone timers and legal et cetera. You reset the base, but if that were the case I'm just trying to figure out do you think the margin profile would also follow when we look at the earnings power? Thanks guys.
Joe Hogan: Yeah, thanks John. So as we look at investing our believing in our long-term model, a long term growth model and that has up margin at the 25+% so that's how we look to keep investing. As you get some benefit through the expansion and other things you might get some leverage as you go but we believe in that long-term model and that's how we look forward on our investments.
Jon Block: Okay. Thanks guys a follow up, I appreciate it.
Joe Hogan: Thanks Jon.
Operator: Thank you our next question comes from the line of Ravi Misra with Berenberg Capital Markets. Please proceed with your question.
Ravi Misra: Hi thanks for taking the question, I hope everyone is well. So it is just first I wanted to ask you gave us some sort of inclination about what the COVID impact was in Q1, anything that you can provide color-wise on that for Q2?
Joe Hogan: Yeah I think Ravi was [indiscernible] you know obviously April was tough as you came out of March into April, you know we saw some stabilization in May and then good progress in June overall so it just a complete kind of beginning and end of the quarter overall and like we just mentioned by John is that’s what continued into July also.
Ravi Misra: Okay I guess and I guess it's going to be hard to get a dollar figure out of you guys. How about just on a ADAPT I'm curious about the business model here when you're talking about kind of increase in utilization, can you help us think about how you plan on monetizing that is there some sort of profit-sharing or revenue-sharing that comes to the increased caseload and when does that kind of start to kind of flow through the P&L should we expect this as a 2021 event or when is this a small program that shouldn't really ever material impact to revenue. Thanks.
John Morici: Ravi this is John, so you talk about that ADAPT program that we spoke about?
Ravi Misra: Yeah.
Joe Hogan: Look, we believe the digital transformation and this is the way we see that in testing that we have done to be able to help practices be more efficient moving from analog to digital, we believe in the platform and believe in that process and these are initiatives that will take to help the fact. It will be a service for a fee and those doctors, those practices will see the benefit we have seen it time after time on those practices that they have seen improvement in their efficiency and profitability and we want to be at a provide that service.
Ravi Misra: What kind of a upfront payment?
Joe Hogan: Well I think you know the way we have built that will be probably different by region but it is not an easy transition for practitioners to go from analog to digital and we have known that’s been one of the fictional point for customers wanting to obviously go digital from a dentistry standpoint, orthodontic standpoint so we have learned a lot and we're using those learnings for customers to reach out and really want to make a commitment for digital transformation and we know we can help, we filed last year in every region and we rolled it out full force now.
Operator: Thank you. Our next question comes from the line of Steven Valiquette with Barclays. Please proceed with your question.
Steven Valiquette: You guys mentioned the, that braces buyback program which had some success with 2500 patients which is I guess I was curious whether that program as something started turn into substantially larger numbers in the remainder of 2020 or that can maybe a smaller part of the overall picture, also did you do that just in North America or you planning to do that in most regions thanks?
Joe Hogan: We have been doing that program in different countries in Asia for a while so I mean how to implement it. We thought of the good time in North America obviously because some doctors being trapped with the large and brackets patients and their inability to be able to help them so, we'll continue that, we’ll continue through this quarter if we, whether we continue or not, it was really based on what consumer needs are and what doctors need are but will make that decision when time comes, we just trying to help in the moment and in the sense of doctors being able to control the practices and I help the patients.
Steven Valiquette: Okay, finally my pre-teen daughter was wondering if you can say hi to Charlie D’Melio for when you get a chance.
Joe Hogan: Got it, got it surely better than what I will be important for us okay.
Operator: Thank you our next question comes from the line of Matt O'Brien with Piper Sandler. Please proceed with your question.
Matt O'Brien: Good afternoon, thanks for taking that question. Just for a starters, just as we think about the recovery here in Q2, I look at the adult number on a worldwide basis as it was down 45, teen was down 32 per my math, but obviously in the US or North America that number was much lower so with the higher unemployment rates with more people kind of staying at home, how does the adult market in the US recovered during the back half of the year?
Joe Hogan: You know I think it's honestly hard to call them and obviously which are playing out our teams here, and this is a seasonal time for teens and we know we'll get a strong signal here in the third quarter. But we're a lot optimistic about adults, I think there is a lot of just talking to different people in marketplace and you noticed to this seems to be a lot of people with time on their hand, wanting to do elective procedures that they didn't have time to do before, we’re picking this stuff all around the country. So unlike 2008 where a lot of things folded up because people are worried about their personal wealth, people are sheltering in place, socially distancing and especially our demographic that we work through right now, seem to have more time on their hands to be able to pursue these kinds of things so we're also be optimistic on the adult segment going forward third and fourth quarter also.
Matt O'Brien: Okay. Thanks and then a follow-up question. Joe just to your point about all this enthusiasm that you are seeing going forward in holding SG&A higher, gross margins and taking a hit right now because you are keeping folks in place, you got all this optimism. The doctoring number was down a little bit but obviously that’s COVID related, so can you just illuminate a little bit more where all this enthusiasm and optimism comes from as we start thinking beyond this year, we are touch points on the dockside in terms of virtual in person way higher, I guess what everybody's trying to get their hands on because of COVID, do you think this could accelerate the adoption of clear aligners versus traditional practices and wires given all the benefits of less office visits et cetera?
Joe Hogan: Matthew you asked the million-dollar question right or the billion dollar question all right. We think, obviously our story has always been, we’re way underpenetrating this marketplace based on what consumers want, based on what our technology can do from a clinical standpoint. The consumer experience that's going on, I think we all think that COVID is really shine the light on this of much less invasive treatment, much easier in this sense location standpoint, much better workflow for doctors to keep track of their patient. So, we think if anything this is a time if this could happen, we're not telling you that this is a tipping point in entire thing but we certainly see this isn't hurting our story and it certainly being supported out there not just in United States but broadly around the world.
Matt O'Brien: Got it, thank you.
Operator: Thank you our next question comes from the line of John Kreger with William Blair. Please proceed with your question.
Joe Hogan: Hey John.
John Kreger: I just following up on Matt's question just if you could give us your sense of how you view the attitude of the consumer right now, they have the sort of forced deferral as practices shut down but now the practices are reopen, what is your sense about the willingness of the consumers sort of step up and make this purchase, does it fell like business is normal or still very much in a wait-and-see mode?
Joe Hogan: Well it feels like you know to it a teen season, we talked about this before John, we call this elective procedures but Teens have a certain clinical window that they fit into and it's always a timeframe with parents and we're very optimistic that that kind of Team focus and growth will continue in the third quarter, in China too, in United States and different places. But also this is a different, John this is different than 2008 from what we feel is consumers seem to have more optimism in the sense of economy you see it in the stock market right now we're see it there and they have more time on their hands with many people not working from offices. And so we're optimistic again that there is money out there and there is a willingness of patient to pursue this electric treatments and I think you also have to look at the static market from a surgical standpoint and see what’s going on there too. It seems it support that kind of an idea also. So it’s, this is different than what we have seen in past recessions for sure, I am not a registered economist, neither is John, we're good at visualizing in this business and that's where we can only just a reiterate to you the signals we are seeing in the marketplace. But right now as this comes back, we know that all dental offices are not completely up to speed but that is not necessary based on demand, that’s based on the way that they have to actually face this patients through their practices and make sure that they keep their staff safe and they keep patients safe too.
John Kreger: Great. Thank you and then one last one, you mentioned being still very much committed innovation, can you give us an update there, how is an mandibular advancement being adopted and any update on palate expansion?
Joe Hogan: Yeah it’s hard to take a second quarter on MA and give you a trend because it was a pretty hard hit overall, obviously bringing shock on my numbers. You know I would say overall mandibular advancement continues to go well, we pair with our team first product, Invisalign first product line which is doing extremely well also and so yeah what you really find around the world, John as you find some doctors just glued to amend that advancement, they would love it, they use it every day, other ones are trying it out, that they have had it on some patients and watching through it. On the first product line, they got to combine that together and so we see significant increase in what I call a clinical penetration because we can do those kinds of cases that we could really have done, you know every two years ago at all. So I would say, the way to look at that is our Teen first product, Invisalign first being the most uptake and a fastest uptake with mandibular advancement right behind it.
John Kreger: Great and any update on palate expansion?
Joe Hogan: We have all the protocols we know how to do it, we're trying to find manufacturing capabilities that can scale with what we have been in middle out there, that sounds trivial but in a business like this where you have credible amount of volume you have to put through, we still have some work to do in that skillet more.
John Kreger: Great thank you.
Joe Hogan: Thanks John.
Operator: Thank you our next question comes from the line of Jeff Johnson with Robert W. Baird. Please proceed with your question.
Joe Hogan: Hi Jeff.
Jeff Johnson: So what the qualifying questions here if I could, when I saw that like John Black's question on the North American number, it depends on how you read the sentences in your slide deck, was North America up year-over-year in June and then if I take your April, May, June comments and May a little bit better than June a significant better. It seems like June on the kind of global revenue basis had to be down only 10% to 20% or so I don't know if you’ve talked to that at all but when I look at street down 20% in 3Q, it seems like you sitting pretty comfortable with the street kind of the $486 million revenue number where that right now, so just any help you can give us again we want to make sure we get kind of that 3Q at least ballpark accurate?
Joe Hogan: Yeah just a top year over year, not just total not from a June standpoint. Not just quarter-over-quarter but June year-over-year, so this is a pretty strong signal.
Jeff Johnson: Is that year-over-year in June?
Joe Hogan: Yes.
Jeff Johnson: Okay, and the [indiscernible] down 20% in the third quarter from a global revenue perspective, it sounds like your June kind of globally was probably down less than that 20% if I cannot see April, May, June comments. So just kind of your comfort at that $486 million number where the 3Q I know that you're not guiding but I would assume you don’t have too many concerns on that number?
John Morici: We'll give you an A for trying. That’s a good one Jeff.
Joe Hogan: That’s was good one John. No, we are not guiding but trying to give you as much information on people doing surveys and other work as well you can up trying a little around it but just I want to give out for the things we talked about, don't want to give on future guidance. Jeff you're not being Q here, it’s hard to read signal, two noise right now and that's okay.
Jeff Johnson: Totally understood, last question. Just on the virtual tools as some doctors come back we are talking to on the therapy and hey I have had patients that I haven't seen in three months are so progressing wow, there may be going to go to a Q3 month instead of every two months follow-up schedule with their clear aligner patients in that. I mean it seems like to me we're getting here if I’m down on even some of these really messed up teen cases o three hours, four hours for tools may be take that lower time, just talk of the efficiency and throughput advantage of that’s going to have braces even that's going to be the real driver even more sale than others digital and what have you it's just the efficiency improvements are getting so good here in clear aligners.
Joe Hogan: Yeah, I would say when we say all that digital, it’s just that what allows them to drive the efficiency you're talking about, just so when you have this kind of digital tools, allow you to monitor patients to communicate with patients one on one or you know any kind of AI they can tell patient if they're off-track or on track and we know that interaction also encourages patients with the most important variable Invisalign treatment is compliance, making sure that they have their aligners intact and if doctors are watching and we are keeping up, in that sense it helps also. And so what doctors find out overtime is that they can -- they will have to see these patients like every three weeks, like they do with wires and brackets, they don’t have to -- the obviously the PPE and everything else associated with their staff and all working through these patients. And, if the patient doesn't have to come in from a clear aligner standpoint, you either give them all their aligners upfront or you give them more aligners that allow them to continue to treatment, without having an actual doctor’s visit. So, it’s just tools, they are kind of tools that we use now and from a business standpoint that we have, but it is applied from a clinical standpoint to keep track of patients and to allow doctors to be more productive for sure.
Jeff Johnson: Understood, thanks.
Joe Hogan: Yeah, thanks Jeff.
Operator: Thank you. Our final question comes from the line of Richard Newitter with SVB Leerink. Please proceed with your question.
Richard Newitter: Hi thanks for taking the question. I was just curious, the Switch program that you guys launched this quarter, has it been more effective in teens or adults and then I have a follow-up.
John Morici: Yeah, Rich, this is John. It is a program as Joe said that we had in Japan and other places as well, it is something that our doctors and many of their patients who were stuck in treatment and teeth were moving wanted to make a switch to this. It is not necessarily a teen versus adult, it's just patients who want to progress with treatment and did not want the uncertainty of the current environment that they are in or future environment and went to their doctors and their doctors wanted to be able to switch them over and we made it so that they could do so.
Joe Hogan: I think Richard, what you are hearing from both of us is, in this case we're not quite sure exactly how many teens and adults were on Switch program, it is a good question, but you got to guess statistically the orthodontic market in the United States is 80% teens and 20% adults. So you can guess the majority of Switches were probably teens, but that is – let me get that data back to you.
Richard Newitter: And the bigger question there that I'm trying to get at with some of the things that you're talking about in a post COVID world and all of the benefits that now kind of pile on to aligners versus wires and brackets. I was trying to ask the question through the Switch program to see if it would -- to test [indiscernible] but it would seem that teen doing the conversion with adult - the conversation with adults and being able to get teens and the parents over the finish line, you have an added level of sell now. Is that what you're actually seeing in the marketplace and is it fair to say that maybe COVID has - has resulted in the much anticipated inflection point for teens, is that fair.
Joe Hogan: Well it's fair that it helped. I cannot tell you that the inflection point is here, but we certainly see a lot of uptake and interest and a digital workflow and our digital methodology in light of COVID-19, our experience has been when doctors can really convert most of their practice and that's why ADAPT, once you get over 50%, 60% digital, your practices change significantly and the consumers like it better, doctors tend to like it better, what we talked about you have higher margin and also a dramatic increase like 20% increase from a revenue standpoint. So, yeah, this is certainly - a COVID is certainly been a push for this. We are cautious, we don't want to talk about a crisis that’s just terrible for people, actually enhancing our business, but the fact is it does promote a workflow and a capability that's much more convenient at this point in time given the COVID threat.
Richard Newitter: Thank you.
Operator: Thank you. Our next question comes from the line of Michael Ryskin with Bank of America. Please proceed with your question.
Michael Ryskin: Hi there, thanks for taking the question guys. I have a couple of quick ones. In your prepared remarks Joe and John, you obviously talked about third quarter, how that's typically the strongest part of the teen season, typically you see the nice little bolus, in the summer as everyone kind of stays home. I'm just curious with the strength that you saw in 2Q, do you think there could have been any sort of pull forward in teens in the quarter, just looking at for the last couple of months everyone’s been home anyway. So any expectations of maybe a little bit of a lull in 3Q or should we expect further pickup from current levels.
Joe Hogan: I think Michael when you ask a question like that and you need to think of our business and how broad it is and global it is today. There's a lot of mitigating factors, right, so we cannot tell you if there is a backlog of patients that have come in sooner or whatever. We just know it’s teen season in United States and its Canada and I mean, I'm sorry in China, Canada also and we're June was indicative of a good increase in the sense of teens looking for treatment and we think that will continue.
Michael Ryskin: Great, thanks, and then another quick one. I realize you don't want to talk about the exit run rate or anything like that, but I think a lot of the assumptions is go forward are that there are no further lockdowns, there are no further sort of quarantine measures implemented, but I just want to ask in the recent weeks [indiscernible] in the Sunbelt, Texas, California, Florida, have you seen any fluctuation in volumes, any early indications there. I guess I am kind of asking of on the one hand you have a full recovery of the economy, on the other half you have full locking out, what if we were somewhat in the middle, are you seeing any indications there?
John Morici: Mike, I think you look at – every area is different, we are seeing a different pace of recovery for the various regions and locations and practices, some practices they are open but then somebody within the practice develops COVID and it shuts down so it varies across. We're doing everything we can to make sure that those doctors have their PPE, they have promotion, they have things in place to be able to help drive volume, but it's very dependent on those specific areas not just in the U.S. but we're seeing this across the other regions as well.
Joe Hogan: Mike, right, it is back to Joe again too, I just want you to know we have great enthusiasm for teen and no matter where it is around the world but we can't tell you if there is a surge of teen patients based on a lot of teens not being in school, we cannot tell you if it's a backlog or whatever, but we can tell you we're enthusiastic about the season and that June was a good indication that it's heading in the right direction.
Michael Ryskin: Great, thanks. Can I ask a quick clarification, okay just this has come up a dozen times in the past five minutes. Your response to Jeff's question on June, do you mean absolute case volume was up in North America in June or utilization is up in June.
Joe Hogan: Utilization.
Michael Ryskin: Okay, thank you so much, thanks.
Operator: Thank you. Our final question comes from the line of Brandon Couillard with Jefferies. Please proceed with your question.
Brandon Couillard: Joe or John, just a question on China, if you could speak to growth specifically in 2Q I know it is still down year over year, were there any other reasons kind of outside the three that you listed, Japan, South Korea, and Taiwan that were ahead of kind of your internal expectations?
Joe Hogan: No I cannot say that there was really, I mean we didn't talk a lot specifically about that but Japan, Taiwan, and Korea were exceptions because there were hardly a blip in a sense of what we saw and how they were affected with COVID but really every other country in APAC and most countries around the world we say except for the expansion markets in Asia and obviously COVID was a big impact on them.
Brandon Couillard: Okay.
Joe Hogan: And then balance of the question John, I think so.
Brandon Couillard: John, any chance you could share with us the exocad contribution in the second quarter or to results or should we just wait for the [Q4] for that.
John Morici: Yeah, I think we talked about been in the scanner and services segment that we have and I think you can wait for the Q on that but it's - we acquired and it is part of our business and we will put more details into the Q.
Shirley Stacy: I think that's the last question. So thank you everyone for joining us today. This concludes our conference call. If you have any follow-up questions, please follow up with Investor Relations. Have a great day. | [
{
"speaker": "Operator",
"text": "Greetings and welcome to the Align Technology Second Quarter Earnings Call. At this time all participants are in a listen-only mode. A brief question-and-answer session will follow the formal presentation. [Operator Instructions]. As a reminder this conference is being recorded. It is now my pleasure to introduce your host Shirley Stacy, Vice President of Corporate Investor Communication. Thank you may begin."
},
{
"speaker": "Shirley Stacy",
"text": "Thank you everyone and thank you for joining us. Joining me today is Joe Hogan, President, and CEO; and John Morici, CFO. We issued second quarter 2020 financial results today via GlobeNewswire, which is available on our website at investor.aligntech.com. On April 1st, 2020 we completed the acquisition of privately held exocad Global Holdings GMBH exocad. To reflect this addition acquisition of exocad into our operations as of Q2 2020, we have renamed the Scanner and Services segment to Imaging System and CAD/CAM Services or Systems and Services. Today's conference call is being audio webcast and will be archived on our website for approximately one month. A Telephone replay will be available today by approximately 5:30 P.M. Eastern Time through 5:30 P.M. Eastern Time on August 5th. To access the telephone replay, domestic callers should dial 877-660-6853 with conference number 13705887 followed by pound. International callers should dial 201-612-7415 with the same conference number. As a reminder, the information provided and discussed today will include forward-looking statements, including statements about Align's future events and product outlook. These forward-looking statements are only predictions and involve risks and uncertainties that are described in more detail in our most recent periodic reports filed with the Securities and Exchange Commission available on our website and at sec.gov. Actual results may vary significantly, and Align expressly assumes no obligation to update any forward-looking statement. We have posted historical financials including the corresponding reconciliations, including our GAAP to non-GAAP reconciliation as applicable. And our second quarter 2020 conference call slides are on our website under Quarterly Results. Please refer to these files for more detailed information. With that, I'd like to the call over to Align Technology's President and CEO, Joe Hogan. Joe?"
},
{
"speaker": "Joe Hogan",
"text": "Thanks Shirley. Good afternoon and thanks for joining us. I am pleased to report Q2 results and continued progress across all regions and customer channels that reflect our COVID-19 recovery efforts, and those of our customers. Practices across every region have reopened and are seeing patients and many of those practices are embracing digital treatment in new ways and more purposely than ever before. In particular Invisalign providers are using the virtual tools we expedited over the last few months to minimize in office appointments and deliver doctor-directed personalized treatment that meets the needs of the moment, trusted, safe, convenient, and reflecting the digital option. The initiatives we have prioritized globally over the last few months, including support for doctors to ensure treatment and business continuity a shift to online education, and training, ramping availability of virtual tools to keep doctors and patients connected throughout the treatment, and continued investment in consumer marketing, and concierge program, and personal protective equipment or PPE are helping doctors navigate this evolving environment and come back stronger as their practices have reopened. We have received consistently positive reactions and feedbacks from doctors in support of our efforts over the last few months. While it's too early to know for sure how extensive and sustainable the digital transition will be. Interest in digital solutions is building even among doctors who were not early adopters or advocates prior to the pandemic. The positive feedback and momentum is not just around Invisalign treatment. It includes digital workflow around iTero scanners and general dentistry. Doctors are telling us that iTero is central to their practice and to their practice workflows and its key to driving digital treatment. With that let me turn to results. For Q2, total revenues were $352 million down, 36% sequentially and down 41% year-over-year reflecting significantly lower sales in Invisalign clear aligners and iTero scanners due to a full quarter’s effects of COVID-19 pandemic on practice closures. Revenues from clear aligners were $298 million and Imaging System and CAD/CAM services were $54 million. On a year-over-year basis while clear aligner shipments were 222,000 cases down 41% year-over-year, we are pleased with the continued progresses we seen from our recovery efforts throughout the quarter. For the quarter, we shipped Invisalign cases to approximately 48,000 doctors, of which 3,000 were first time customers, reflecting lower doctor activity due to practice closures primarily in Americas GP channel. We also trained approximately 3500 new doctors in Q2 including 2350 international doctors. While our inability to hold in person courses due to COVID-19 result in fewer trained doctors in the second quarter, we continue with a significantly larger number of Invisalign doctors through online virtual education courses, summits, and forums. For the teen market in Q2 71,000 teens and preteens started treatment with Invisalign clear aligners, representing 32% of total cases shipped, reflecting growth from APAC across comprehensive products. By the end of the quarter we started to see recovery in the Ortho channel with increases in Invisalign comprehensive treatments in the teens and preteens segment across most regions with positive growth predominantly in the APAC in the teen segment. Invisalign first continues to accelerate among young patients as well and reflects greater resiliency as parents continue to prioritize orthodontic treatment for their kids. Overall, both non comprehensive and comprehensive shipments were down, but with increased adoption of our moderate product among the Ortho channel. Last week, we held our Teen Forum-Virtual Edition, taking what was a popular teen-intensive program for orthodontists launched last year and recreating it as a virtual experience. 6:29 In order to facilitate broader attendance among our customer doctors, we scheduled two teen virtual events. The first took place on July 17th and the second will be held this Friday. The program is designed to help doctors understand the highly visual online and on-demand world of today’s teens and provides the know how tools and confidence to differentiate and grow their Invisalign teen practices. Approximately 800 customers have registered for this full day session that combines live and on demand sessions, clinical practice investor presentations, panel discussions, and invaluable insights from experts with successful teen practices. Now let's turn to the specifics around our second quarter results starting with the Americas. For the Americas region Q2 Invisalign case volume was down 53% sequentially and down 52% year-over-year reflecting significantly fewer Invisalign case shipments due to the impact of COVID-19. For Q2 reported utilization was down for NA Orthos and GP both quarter-over-quarter and year-over-year, however utilization increased in June especially among certain orthodontists doing more Invisalign treatments with teen shipments recovering faster in North America, in late May, and through June. As part of our recovery programs we enabled doctors to switch their patients into Invisalign treatment by buying their wires and brackets. This program was well received and as a result doctors converted approximately 2500 wires and brackets cases to Invisalign clear aligner patients. In the GP segment the timing of officer openings and case prioritization are slow to recovery in this key segment as compared to the orthodontic segment, but the GP segment is catching up. In terms of timing of the recovery in the Americas, the US continues to lead followed by Canada and LatAm corresponding to the timing of the pandemic related shutdown and reopenings in each region. For international business Q2 Invisalign case volumes were down 17.2% sequentially reflecting a significant decrease in EMEA again due to the impact of COVID-19, partially offset by growth from APAC which was ahead in the recovery curve in China, Taiwan, Hong Kong, and South Korea. On a year-over-year basis international shipments were down 27.1% reflecting a decline in EMEA partially offset by slight growth in APAC. For EMEA Q2 volumes were down sequentially 44% and down 46% on a year-over-year basis across all markets with more softness in the GP channel compared to. ortho We continue to see momentum within Invisalign first for Invisalign treatment in young patients. Overall we saw slower deceleration in teen shipment growth than adults driven by Germany and France. The expansion market had less decline and only accounted for five points decline in EMEA. We also rolled out a recovery 360 program in EMEA with over 3700 Orthodonists enrolled resulting in a stronger partnership perception by our customers including an increase in our Net Promoter Score or NPS. Using a combination of our adapt consultants which I'll be describing more later and territory managers, we held practices with the workflow and scheduling, increased our doctors engagement with their patients through the use of education, and communication tools, and provided business by ability, access sustainability materials to the doctors. In May over 1400 attendees from three regions, 75 countries participated in our virtual Invisalign scientific forum in EMEA. At the end of June we held a virtual GP growth Summit with over 1300 doctors from over 42 countries who signed up to gain insights on business, dentistry, health, and chain management. During the summit we launched our GP recovery program and we received great feedback on the tools and approach we provide to support business recovery. During the quarter we also offered over 150 online and on-demand education events which reached over 20,000 GPs cumulatively. In July we launched the Invisalign Gold Plus system in UK, in Nordic, and Benelux which offers a wider treatment options, enables dentist to treat more patients with confidence, and can be easily integrated into a wide range of restorative treatments in their practice. For APAC Q2 volumes were up sequentially 41% reflecting improving trends as practices reopened and got back the business, as well as COVID-19 recovery measures we implemented in China. On a year-over-year basis APAC was up 3.4% compared to the prior year and was the only region up year-on-year. As mentioned earlier we saw positive growth in APAC in teen shipments led by China reflecting a strong uptick recovery programs. In the GP segment we saw growth in the non comprehensive cases with Invisalign Gold and the launch of [indiscernible] in China continuing to further demonstrate doctor confidence in treating young patients with Invisalign. Throughout the region Japan, Taiwan, and South Korea successfully managed recovery efforts and performed better than expected. During the quarter, we reached a major milestone with our 1 million Invisalign patient in APAC, an athlete in modern day and fencing who is being treated by Dr. Yogart in Tokyo, Japan. Earlier this month we held the Invisalign Teen forum in China in a virtual from broadcast of four venues in Beijing, Shunde, Wuhan to approximately 8000 participants. The forum focused on the innovations and applications of digital technology in clear aligners as well as theories in clinical practices for teen patients. The forum brought together outstanding orthodontists from leading dental colleges from approximately 30 academic institutions. We believe that our global clinical education programs are the best in the industry and we’ve been even more valuable to doctors throughout the pandemic. We launched a new improved digital learning environment for our doctors this year offering a comprehensive learning platform with role specific content for orthos, GPs, and their teams. They improved functionality enables more online learning opportunities with Spotlight features for what's trending now recommending learning paths based on doctors experiences in extended categories including digital treatment planning, comprehensive dentistry, and team education. To date over 85,000 doctors have access to recorded lectures and completed self pace learning models and watched how to videos and over 3 million sessions. Among the ortho channel over 30,000 unique users have engaged with the digital learning side with an additional 50,000 unique users from the GP channel. We are encouraged by the digital training utilization rates among our doctors which has helped them continue their Invisalign treatment learning journey during the pandemic. Feedback from the participants describes the courses as engaging, providing broader reach to online events, and a strong desire that Align continue to provide these virtually. They also acknowledged Align’s agility, and providing relevant tools and content to help them during the lockdown. We see this as an ongoing opportunity to enhance doctor learning to direct feedback and continuous improvement. Building on the benefit of clinical education and training today we announced a global launch of the Align digital and practice transformation or ADAPT service. This is our first customized consulting services in support offering for doctors and was developed based on years of learnings from practices that saw strong growth, and practice transformation when changing their practice to digital. Initially available to Invisalign and iTero doctors in select segments of the EMEA market and then in the US, the global program is now generally available in EMEA and APAC regions that will be available in the US in the second half of this year. The ADAPT program is an expert in independent fee based business consulting services offered by Align to optimize clinics, operational workflow, and processes to enhance patient experience, and customer, and staff satisfaction which will turn translate into higher growth and greater efficiencies for orthodontic practices That goal of ADAPT program is to support digital practice transformation for doctors and their staff. ADAPT is designed for orthodontists as approximately 200 total cases start per year who are seeking to build their future business. Driven by a team of independent business consultants, analysts, and program support specialists, ADAPT offers a customized on-site consulting service to each participating practice. The program combines a review of business operations and practice workflow data with Align's expertise and digital workflow optimization, practice support, business transformation, marketing, and clinical education support. The pilot version of the program has been successfully developed across EMEA, the United States, Asia Pacific region over the last 12 months. As a result of the ADAPT service participating practices improved profitability of 15% within six months of implementation and increased practice revenue up to 20%. Our consumer marketing is focused on building the clear liner category and driving demand for Invisalign treatment through a doctor's office. In Q2 we saw strong digital engagement globally with more than 70% increase in unique visitors as well on leads. Other key metrics showed increased activity engagement with Invisalign brand and are included in our Q2 quarterly presentation slides available on our website. We're pleased with our strong engagement and activity we have seen on our customer platforms over the last few months. I do believe it speaks to the strength of the brand, a consumer interest in treatment even doing a challenges the last few months. In Q3 we're coming into what is typically the strongest part of the teen season with teens and younger kids are home from the summer break and likely to start treatment before heading back to school. And while back-to-school looks very different this year in many countries including United States, this is still a time and practice is orthodontic practices are focusing on younger patients. Teens are the biggest, the most critical part of orthodontic practices and our huge influences and drivers of practice growth. That matters now more than ever as we partner with practices in this recovery. One of the most important ways we partner with customers is by creating demand for Invisalign treatment and to drive teens and parents to the practices for great outcomes and great treatment experiences. We have just launched a new Teen and month-focused consumer campaign designed to do this just that by reaching teens and moms where they are most engaged on digital platform, social channels and later this year national cable TV channels where they sped the most time like Instagram, Twitch for Teens, Instagram, Facebook and people.com for moms. We're going to leverage influences that teens and kids follow interest like Charlie D’Melio. We recently established a new partnership with Charlie, who is a really dynamic kid and accomplished dancer who has a combined following of over 90 million fans on TikTok and Instagram, she's about to become a new Invisalign patient and ambassador for our brand. She'll be sharing her treatment journey in a way that is relevant to teens across social platforms. And our new campaign will get the heart of what, it get to the heart of what Invisalign is and what it isn’t, using straightforward language that teens respond to. Our goal is to tell teens why parents and Invisalign is more of advanced and or more comfortable than traditional braces emphasizing that this is not your parent’s braces. We also want to ensure that they know that doctors are front and center in the Invisalign treatment because it's time to be very candid about the benefits of digital orthodontics and Invisalign treatment specifically. For our assistance and services business which now includes exocad Q2 revenues were down 22% sequentially. We are pleased to see the momentum with Element 5D Imaging Systems in North America and APAC along with sales of iTero element one scanner modeling China and significant sales of the flex scanners modeling EMEA. On a year-over-year basis, system and services revenues were down 48% were slightly offset by the inclusion of exocad CAD/CAM services. Cumulative the over 24 million orthodontic scans are 5.5 million restorative scans have been performed with iTero scanners. For Q2 total Invisalign cases in mid of the digital scanner in the Americas increased to 86% from 77% in Q2 last year. International scans increased to 72%, up from 61% in the same quarter last year. We're pleased to see that within the Americas 96% of cases submitted by North American orthodontists were submitted digitally. We also recently announced that the iTero Element 5D Imaging System was awarded best new technology solution for dentistry in the 2020 Medtech awards. The annual program honors outstanding health and medical technology products and companies. We also received an award for dentistry IQ naming the iTero, Element 5D Imaging System as number 10 of 14 products and services to help dentist rebound from COVID-19. With that I turn the call over to John."
},
{
"speaker": "John Morici",
"text": "Thanks John, now for our Q2 financial results. Total revenue for the second quarter was $352.3 million, down 36.1% from the prior quarter and down 41.3% from the corresponding quarter a year ago. For clear aligners, Q2 revenues of $298.3 million was down 38.1% sequentially and down 39.9% year-over-year due to volume decreases across most regions. Driven by North America and EMEA and LATAM partially offset by APAC. Clear aligner revenue growth was impacted unfavorably from foreign exchange of approximately $6 million or approximately one point year-over-year. Q2 Invisalign ASPs were flat sequentially at $1,255 primarily due to promotional discounts and unfavorable foreign exchange mostly offset by increased revenue from countries with higher list prices and increased other case and revenue revenues. On a year over year basis Q2 Invisalign ASPs increased approximately $25 primarily reflecting price increases in all regions and additional line of revenue, partially offset by promotional discounts and unfavorable foreign exchange. One example of our crisis recovery program that we have implemented in Q2 was a switch program that enable doctors to switch wires and bracket patients into Invisalign clear aligners. Total Q2 Invisalign shipments of 221.9 thousand cases were down 38.3% sequentially and down 41.2% year-over-year. Our system and services revenues for the second quarter was $54 million down 22.2% sequentially and down 48.1% year-over-year due to volume decreases across most regions except APAC. Promotional discounts and a decrease in service revenue partially offset by exocad revenue. Moving on to gross margin. Second quarter overall gross margin was 63.7% down 7.9% sequentially and down 8.3 points year-over-year. On a non-GAAP basis, excluding stock-based compensation expense and amortization of intangibles related to exocad, overall gross margin was 64.4% for the second quarter down 7.4 points sequentially and down 7.8 points year-over-year. Q2 gross margin reflects Align’s decision to maintain our head count and salaries across our operations in anticipation of a volume pick up as the COVID-19 pandemic subsides. This decision also enabled us to manufacture nasal tests swabs for hospitals and PPE for use by our own employees as well as our doctors as they reopen their practices. We also postponed iTero subscription fees for one month in the US and parts of APAC. On a year-over-year basis Q2 gross margin includes approximately 0.7% impact from unfavorable foreign-exchange. Clear aligner gross margin for the second quarter was 64.5%, down 8.5 points sequentially and down 9.2 points year-over-year due to lower volumes driving higher cost per case and increased freight costs from higher international shipment mix. On a year over year basis, the decreased in the clear aligner gross margin was partially offset by an increase in Invisalign ASPs and continued in efficiency improvements. Systems and services gross margin for the second quarter was 59.2%, down 2.6 points sequentially and 4.4 points year-over-year due to lower ASPs and lower volumes with higher cost per unit and amortization of intangible assets related to the exocad acquisition partially offset by lower service support part. Q2 operating expenses were $297.3 million, down sequentially 8.4% and up 60.2% year-over-year. The sequential decrease in operating expenses reflects lower travel spend, decreased compensation related to commissions and lower marketing and media spend, partially offset by higher exocad acquisition cost. Year-over-year, operating expenses increased by $41.5 million, this is mainly caused by the $51 million favorable litigation settlement received in Q2, 2019 offset by cost controls measures in Q2 of 2020. On a non-GAAP basis, operating expenses were $265.6 million down sequentially 11.9% and down 7% year-over-year due to the reasons as described above, offset by exocad cost. Our second quarter operating loss was $73 million, down 204.4% sequentially and down 141.4% year-over-year. Our second quarter operating margin was negative 20.7% down 33.4 points sequentially and down 50.1 points year-over-year. The sequential decrease in operating income and operating margin are primarily attributed to lower revenues and gross margin as a result of lower volume from COVID-19 impacts. Operating margin was unfavorably impacted by approximately 0.9 points year-over-year from foreign exchange. On a year-over-year basis the decrease in operating income and operating margin primarily reflects lower gross profit on lower volumes from the impact of COVID-19 in addition to the prior-year quarter included the $51 million favorable litigation settlement. On a non-GAAP basis which excludes stock -based compensation, acquisition-related costs and amortization of intangibles related to exocad, operating margin for the second quarter was minus 11%, down 28.1 point sequentially and down 35.6 points year-over-year. Interest and other income and expense net for the quarter was an expense of $0.5 million including a $1 million hedge loss related to the exocad acquisition excluding the hedge loss interest in other income and expense net was 0.5 million income on a non-GAAP basis. With regards to the second quarter tax provision, our GAAP tax rate was 44. 8% which includes a tax benefit related to the impact of changes in the jurisdictional mix of forecasted income to GAAP profits recorded last quarter. The second quarter tax rate on a non-GAAP basis was 27.8% compared to 33.2% in prior quarter and 25.3% in the same quarter a year ago. The second quarter non-GAAP tax rate was lower than the first quarter’s rate primarily due to changes in jurisdictional mix of forecasted full year results. Second quarter net loss per diluted share was negative $0.52 down $19.73 sequentially and down $2.35 compared to prior year. On a non-GAAP basis, net loss per diluted share was negative $0.35 for the second quarter down $1.08 sequentially and down $1.84 year-over-year. Moving on to the balance sheet. As of June 30th, 2020 cash and cash equivalents were $404.4 million, a decrease of approximately $386.3 million from the prior quarter, which is primarily due to the acquisition of exocad partially offset by a free cash flow improvement. Of our $404.4 million of cash and cash equivalents, $160.2 million was held in the US and $244.2 million was held by our international entities. Q2 accounts receivable balance was $473.3 million down approximately 11.2% sequentially. Our overall days sales outstanding, DSO’s was 121 days, up 34 days sequentially and up 44 days as compared to Q2 last year due to doctor office closures that resulted in slower accounts receivable collections. We expect DSOs to remain relatively high has doctor’s offices return resume normal business activity. Cash flow from operations for the second quarter was $59.9 million. Capital expenditures for the second quarter were $34.4 million, primarily related to our continued investment in increasing aligner capacity and facilities. Free cash flow defined as cash flow from operations less capital expenditures amounted to $25.5 million. Under our May 2018 repurchase program, we have $100 million still available for repurchase of our common stock. Now let me turn to our outlook. Since the last time that we talked, the orthodontic and dental market had continued to evolve in response to government regulations and safety guidance from local, regional and national health officials. We believe that all of our markets have bottomed out and are recovering, albeit at different rates and different times corresponding with regional outbreaks and recoveries from COVID-19 preventative measures as we're now seeing improvements in consumer and doctor activity. Nevertheless, we're mindful that the demand environment remains uncertain. There may be additional waves of infection and governments around the world may strategically choose to shut down cities, states and countries again forcing people to shelter in place and practices to close again therefore we're not providing any forward-looking guidance. While our management team understands the markets remain fluid, we continue to focus on taking care of our employees, customers and shareholders for our employees we are committed to protecting our employees, and do not intend to implement furloughs or salary reduction. For our customers we will continue to be supportive of our customers who are impacted by COVID 19 and are committed to helping slow the spread of virus by providing PPE to doctors. We continue to release products, tools, and promotions to help our doctors recover from the crisis. For our shareholders, we will continue to invest in our strategic initiatives to grow in a vastly underpenetrated market and position our company to capture growth as the market returns to normal. This includes continued investment in Align’s end to end digital workflow as well as increased investment in the Invisalign brand and consumer demand creation as you heard Joe described earlier. We will continue to add resources in markets that give us a good return. I’m very proud of what Align is accomplished while maintaining our financial discipline during this pandemic. We finished Q2 with $404.4 million in cash and cash equivalents, closed the purchase of exocad for $430 million and still delivered free cash flow of $25.5 million despite having the lowest volume Align has had in a very long time. Our cash flow reflects the strength of our business model, the strength of our balance sheet, and our strong operational focus. I’m also pleased to share that we have established a new line of credit of $300 million with a consortium of banks led by Citibank. This new land replaces our line of credit with Wells Fargo. As a market leader in clear aligners and digital dentistry we are well positioned to continue investing strategically for the future. With that I'll turn it back to Joe for final comments Joe."
},
{
"speaker": "Joe Hogan",
"text": "Thanks John. In summary we're pleased with our progress last quarter and by the customer responses to the actions we’ve been taking to support their practices and patients. We have developed a careful recovery approach that accounts for the safety of our employees, our customers, and their teams, and their patients, and are committed to helping doctors navigate this evolving environment, and be successful. One of the biggest lessons we have learned over the last few months is about the critical importance of digital technology. Align has always been a proponent of digital treatment to think about all these things that digital platforms and virtual tools have enabled during the crisis. The people in the businesses, and the customers who stayed connected, the way we’re able to adapt to working from home, the rise of tele consults, the AI that modeled the virus patterns, and informed health experts, and so much more. Consider also the companies that have thrived, most of the companies that are digital with their core, Amazon, Apples, Zoom and Netflix just to name a few. The advantage of digital are much more magnified to practitioners and consumers. This became even clear in our industry when practices were shut down for months. Over and over we heard I‘ve been able to help my Invisalign patients progress in progress, but I had to just try to keep my patients in a holding pattern with wires and brackets. Treating orthodontic cases has amplified the clear benefits of digital technology in clear aligners. This is a method self serving. This pandemic has emphasized the benefits of digital technology across many facets of our lives and businesses. Our acquisition of exocad adds additional digital workflows that play in the GP space and lab space. We're all excited about the exocad team and what our investment brings to this new world of the digital dentistry. Align’s digital platform has made it possible for thousands of doctors and patients to continue Invisalign treatments throughout the global disruption. Thanks to the digital orthodontics of Invisalign aligners, iTero digital, records, and simulations, digital treatment planning, and virtual monitoring, and care. At Align we have always believed that digital orthodontics is the best option for teens and adults. As you can see from a peak at our current teen campaign, we’re going to feature this going forward. What’s clear to us is that the momentum we’re seeing in the business and in the dental and ortho practices reflects more than just one thing or one new products or tool or one program or action. It reflects continued improvement and continued execution of our core strategy across our business in every region. We’re going to continue to stay the course while remaining vigilant and agile. We feel good about the progress that we have made and as we continue along the recovery phase of COVID 19 crisis in many regions we are focused on what we can control and impact. We are in a unique position to continue investing to a huge underpenetrated market, to extend our lead, and accelerated growth. With that I want to thank you again for joining our call. I look forward to updating on our progress as the year unfolds. Now I’ll turn the call over to the operator for questions. Operator?"
},
{
"speaker": "Operator",
"text": "[Operator Instructions]. Our first question comes from the line of Nathan Rich with Goldman Sachs. Please proceed with your question."
},
{
"speaker": "Nathan Rich",
"text": "Thanks. Good afternoon. Thanks for the question. Joe you highlighted the improvement that you saw in June. I understand sort of the rational for now providing guidance for 3Q kind of given kind of the situation, but can you maybe help us better understand kind of where the business kind of you and so just we have better sense of what the jumping out point is as we think about the back half of the year?"
},
{
"speaker": "Joe Hogan",
"text": "Yeah I mean we saw dramatic improvement between April and June. Obviously we were kind of in the jaws of COVID 19 with all the shutdowns in April. May was little better and then we’ve seen strong momentum as we’ve moved into June. So I think you can look at that as a significant improvement in our business overall."
},
{
"speaker": "Nathan Rich",
"text": "Okay great and then you highlighted the 3000 customers that were new to Invisalign this quarter. Can you maybe just talk about how that compares to maybe what you see in a typical quarter and kind of what you’re doing was going to ensure that those doctors become kind of longer term customers of Invisalign?"
},
{
"speaker": "Joe Hogan",
"text": "Yeah I mean that’s. I mean when you think about COVID 19 and what the business has really faced in that. 3000 customers thus for us was terrific in that way. You don't actually look for new customers coming in on that. You’re looking for utilization rates on your current base. I mean we felt and I felt really great about the 3000. Obviously that got stronger as the quarter went on."
},
{
"speaker": "Operator",
"text": "Thank you. Our next question comes from the line of Elizabeth Anderson with Evercore. Please proceed with your question."
},
{
"speaker": "Elizabeth Anderson",
"text": "Hi. Can you talk about. Do you think Asia is a good path to think about in terms of the recovery or do you see sort of significant differences in that geography that should prevent this from extrapolating?"
},
{
"speaker": "Joe Hogan",
"text": "Yeah I think Asia is so diverse in itself. It’s hard just to extrapolate Asia Elizabeth. .I mean obviously China was kind of first out of this thing, but China has had bumpy road also with the recent issues in Shanghai and different areas, so every one of these regions has its own unique footprint in its own unique model in a sense of how they’ve dealt with the virus, but obviously it in our transcript, but we’ve seen significant improvement in really every region around the world."
},
{
"speaker": "Elizabeth Anderson",
"text": "Okay and I think you commented also in terms of your cost structure, in terms of not furloughing in place. Is there any other major changes to the cost structure in the third quarter maybe just in the back of the year generally that we should think about as we’re updating our models?"
},
{
"speaker": "John Morici",
"text": "Hi Elizabeth this is John. We continue to believe in our model. It’s a vastly underpenetrated market. We're going to make strategic investments to better grow in that market. Whether it’s R&D, sales, and marketing we’re going to continue to make those investments where we see a return."
},
{
"speaker": "Operator",
"text": "Thank you. Our next question comes from the line of Steve Beuchaw with Wolfe Research. Please proceed with your question."
},
{
"speaker": "Steve Beuchaw",
"text": "Hi good afternoon. Thanks for the time here. I wonder first Joe, could you give us any more color on the breadth of uptake of some of the new digital tools that you referred to and the extent to which practices are making these changes and converting over to something of a virtual experience. I mean is this. Is this 2% of your customer base? Is it a lot bigger than that? Any color is really very helpful there?"
},
{
"speaker": "Joe Hogan",
"text": "Steve when we talk about digital platform, you really start with iTero on the front end and even in a downturn like we saw with COVID in the capital equipment business. iTero showed up well and particularly with 5D in different areas, but that’s the front end of this whole piece that we talk about on digital platform, then you move through our obviously our treatment planning, and all, but what we added had when you think about the whole breadth of a global digital platform we added virtual care, that knew about and we came out so that. Doctors could talk to our patients remotely and be able to track treatment and actually we had several doctors actually close treatments cases remotely with our virtual treatment capability. And that really extended the effectiveness of the doctor's, and the effectiveness of the digital treatment in that sense too. There is a lot of imaging that we do now in our treatment planning and all too, so it’s not just tracking patients, it's also having images and different things that you can share with the patient is a sense of where they should be around treatment in those types of areas. So it's a broad kind of a digital platform we're talking about. I mean we had tens of thousands of people on our virtual care platform as we rolled that thing out in a matter of 30 days and all around the world. And we’ll continue to update that platform with AI. We’ll make it much more predictive so that doctors don't have to look at every patient. We have a strong roadmap in that sense too Steve so it’s just, it’s the breadth of the digital platform, and how it covers everything from starting with the consumer, turning them into a patient from iTero all the way to the back end up being able to monitor, and treat those patients."
},
{
"speaker": "Steve Beuchaw",
"text": "Just one more from me. What I'm trying to get to here is some perspective on what the underlying trend is and I appreciate that you don't want to talk about the exit rate leaving 2Q and you're not going to give guidance for 3Q, but what if I said let's imagine a scenario where we don't have another wave of lockdowns where practices are operating, and what is admittedly a challenging environment, but we don't have any sort of government level, or professional society level. You’ve got to stop doing cases or stop engaging in practices. If that's the operating environment we’re in I mean can you grow in 3Q or the back half of the year? Can you speak at all to what the business would look like in that situation if we don't get more lockdowns? Thank you."
},
{
"speaker": "Joe Hogan",
"text": "Steve I’d say we're incredibly optimistic in this scenario that you painted where we don't see another COVID shutdown on a major market that lasts a long period of time. Based on the recoveries that we’ve seen in the latter half of May and then the strong recovery in June, we feel really good about the future of this business in the third and fourth quarter and beyond. John anything to add?"
},
{
"speaker": "John Morici",
"text": "That covers it."
},
{
"speaker": "Steve Beuchaw",
"text": "Okay thanks a lot."
},
{
"speaker": "Operator",
"text": "Thank you. Our next question comes from the line of Jon Block with Stifel. Please proceed with your question."
},
{
"speaker": "Jon Block",
"text": "Hey guys. Good afternoon hey. Joe I hope you can hear me okay. A similar line of questioning, just sort of emendated with e mails about sorts of trends so let me try to frame it this way. I think with slide 8 you guys have increase in North America utilization for June. I think first part of the question is I just want to be clear. That was for both orthos and GPs up the slide. It was hard to tease that out and if that’s the case Joe was that pure. In other words I’m getting questions on practices reopened in May and obviously there is a lot of backlog, so you’re saying North America grew in June, but was it pure or? Was it a benefit of backlog and maybe you could comment if that growth continued into July would be very helpful for North America?"
},
{
"speaker": "John Morici",
"text": "Hey John this is John. Some of that is, some of its backlog, and some of it is additional growth that they would have, so the utilization has improved as those doctors have come back to work and they’re seeing patients, and that’s true in North America and that’s true in all countries where we see those doctors’ offices opening up, so it's hard to tell how much is backlog versus how much is more run rate going forward, but we’re a combination of both."
},
{
"speaker": "Jon Block",
"text": "And the second part of the questions is Joe I’ve got you. That increase or the year over year growth in North America does that continue to the month of July?"
},
{
"speaker": "Joe Hogan",
"text": "That momentum continued to be strong John."
},
{
"speaker": "Jon Block",
"text": "Okay fantastic and the second part of the question, go from very near term next month to sort of 18 months out, 24 months out. John just as we think about the model longer term I think there Street has you guys from a 2021 perspective. Revenue is higher in 2021 to 2019. Let put away 2020 for a whole host of reasons, but let's look at 2010 versus 2019. Structurally if revs are higher by ex %, should the margin structure also be higher. I look back to 2019, you had someone timers and legal et cetera. You reset the base, but if that were the case I'm just trying to figure out do you think the margin profile would also follow when we look at the earnings power? Thanks guys."
},
{
"speaker": "Joe Hogan",
"text": "Yeah, thanks John. So as we look at investing our believing in our long-term model, a long term growth model and that has up margin at the 25+% so that's how we look to keep investing. As you get some benefit through the expansion and other things you might get some leverage as you go but we believe in that long-term model and that's how we look forward on our investments."
},
{
"speaker": "Jon Block",
"text": "Okay. Thanks guys a follow up, I appreciate it."
},
{
"speaker": "Joe Hogan",
"text": "Thanks Jon."
},
{
"speaker": "Operator",
"text": "Thank you our next question comes from the line of Ravi Misra with Berenberg Capital Markets. Please proceed with your question."
},
{
"speaker": "Ravi Misra",
"text": "Hi thanks for taking the question, I hope everyone is well. So it is just first I wanted to ask you gave us some sort of inclination about what the COVID impact was in Q1, anything that you can provide color-wise on that for Q2?"
},
{
"speaker": "Joe Hogan",
"text": "Yeah I think Ravi was [indiscernible] you know obviously April was tough as you came out of March into April, you know we saw some stabilization in May and then good progress in June overall so it just a complete kind of beginning and end of the quarter overall and like we just mentioned by John is that’s what continued into July also."
},
{
"speaker": "Ravi Misra",
"text": "Okay I guess and I guess it's going to be hard to get a dollar figure out of you guys. How about just on a ADAPT I'm curious about the business model here when you're talking about kind of increase in utilization, can you help us think about how you plan on monetizing that is there some sort of profit-sharing or revenue-sharing that comes to the increased caseload and when does that kind of start to kind of flow through the P&L should we expect this as a 2021 event or when is this a small program that shouldn't really ever material impact to revenue. Thanks."
},
{
"speaker": "John Morici",
"text": "Ravi this is John, so you talk about that ADAPT program that we spoke about?"
},
{
"speaker": "Ravi Misra",
"text": "Yeah."
},
{
"speaker": "Joe Hogan",
"text": "Look, we believe the digital transformation and this is the way we see that in testing that we have done to be able to help practices be more efficient moving from analog to digital, we believe in the platform and believe in that process and these are initiatives that will take to help the fact. It will be a service for a fee and those doctors, those practices will see the benefit we have seen it time after time on those practices that they have seen improvement in their efficiency and profitability and we want to be at a provide that service."
},
{
"speaker": "Ravi Misra",
"text": "What kind of a upfront payment?"
},
{
"speaker": "Joe Hogan",
"text": "Well I think you know the way we have built that will be probably different by region but it is not an easy transition for practitioners to go from analog to digital and we have known that’s been one of the fictional point for customers wanting to obviously go digital from a dentistry standpoint, orthodontic standpoint so we have learned a lot and we're using those learnings for customers to reach out and really want to make a commitment for digital transformation and we know we can help, we filed last year in every region and we rolled it out full force now."
},
{
"speaker": "Operator",
"text": "Thank you. Our next question comes from the line of Steven Valiquette with Barclays. Please proceed with your question."
},
{
"speaker": "Steven Valiquette",
"text": "You guys mentioned the, that braces buyback program which had some success with 2500 patients which is I guess I was curious whether that program as something started turn into substantially larger numbers in the remainder of 2020 or that can maybe a smaller part of the overall picture, also did you do that just in North America or you planning to do that in most regions thanks?"
},
{
"speaker": "Joe Hogan",
"text": "We have been doing that program in different countries in Asia for a while so I mean how to implement it. We thought of the good time in North America obviously because some doctors being trapped with the large and brackets patients and their inability to be able to help them so, we'll continue that, we’ll continue through this quarter if we, whether we continue or not, it was really based on what consumer needs are and what doctors need are but will make that decision when time comes, we just trying to help in the moment and in the sense of doctors being able to control the practices and I help the patients."
},
{
"speaker": "Steven Valiquette",
"text": "Okay, finally my pre-teen daughter was wondering if you can say hi to Charlie D’Melio for when you get a chance."
},
{
"speaker": "Joe Hogan",
"text": "Got it, got it surely better than what I will be important for us okay."
},
{
"speaker": "Operator",
"text": "Thank you our next question comes from the line of Matt O'Brien with Piper Sandler. Please proceed with your question."
},
{
"speaker": "Matt O'Brien",
"text": "Good afternoon, thanks for taking that question. Just for a starters, just as we think about the recovery here in Q2, I look at the adult number on a worldwide basis as it was down 45, teen was down 32 per my math, but obviously in the US or North America that number was much lower so with the higher unemployment rates with more people kind of staying at home, how does the adult market in the US recovered during the back half of the year?"
},
{
"speaker": "Joe Hogan",
"text": "You know I think it's honestly hard to call them and obviously which are playing out our teams here, and this is a seasonal time for teens and we know we'll get a strong signal here in the third quarter. But we're a lot optimistic about adults, I think there is a lot of just talking to different people in marketplace and you noticed to this seems to be a lot of people with time on their hand, wanting to do elective procedures that they didn't have time to do before, we’re picking this stuff all around the country. So unlike 2008 where a lot of things folded up because people are worried about their personal wealth, people are sheltering in place, socially distancing and especially our demographic that we work through right now, seem to have more time on their hands to be able to pursue these kinds of things so we're also be optimistic on the adult segment going forward third and fourth quarter also."
},
{
"speaker": "Matt O'Brien",
"text": "Okay. Thanks and then a follow-up question. Joe just to your point about all this enthusiasm that you are seeing going forward in holding SG&A higher, gross margins and taking a hit right now because you are keeping folks in place, you got all this optimism. The doctoring number was down a little bit but obviously that’s COVID related, so can you just illuminate a little bit more where all this enthusiasm and optimism comes from as we start thinking beyond this year, we are touch points on the dockside in terms of virtual in person way higher, I guess what everybody's trying to get their hands on because of COVID, do you think this could accelerate the adoption of clear aligners versus traditional practices and wires given all the benefits of less office visits et cetera?"
},
{
"speaker": "Joe Hogan",
"text": "Matthew you asked the million-dollar question right or the billion dollar question all right. We think, obviously our story has always been, we’re way underpenetrating this marketplace based on what consumers want, based on what our technology can do from a clinical standpoint. The consumer experience that's going on, I think we all think that COVID is really shine the light on this of much less invasive treatment, much easier in this sense location standpoint, much better workflow for doctors to keep track of their patient. So, we think if anything this is a time if this could happen, we're not telling you that this is a tipping point in entire thing but we certainly see this isn't hurting our story and it certainly being supported out there not just in United States but broadly around the world."
},
{
"speaker": "Matt O'Brien",
"text": "Got it, thank you."
},
{
"speaker": "Operator",
"text": "Thank you our next question comes from the line of John Kreger with William Blair. Please proceed with your question."
},
{
"speaker": "Joe Hogan",
"text": "Hey John."
},
{
"speaker": "John Kreger",
"text": "I just following up on Matt's question just if you could give us your sense of how you view the attitude of the consumer right now, they have the sort of forced deferral as practices shut down but now the practices are reopen, what is your sense about the willingness of the consumers sort of step up and make this purchase, does it fell like business is normal or still very much in a wait-and-see mode?"
},
{
"speaker": "Joe Hogan",
"text": "Well it feels like you know to it a teen season, we talked about this before John, we call this elective procedures but Teens have a certain clinical window that they fit into and it's always a timeframe with parents and we're very optimistic that that kind of Team focus and growth will continue in the third quarter, in China too, in United States and different places. But also this is a different, John this is different than 2008 from what we feel is consumers seem to have more optimism in the sense of economy you see it in the stock market right now we're see it there and they have more time on their hands with many people not working from offices. And so we're optimistic again that there is money out there and there is a willingness of patient to pursue this electric treatments and I think you also have to look at the static market from a surgical standpoint and see what’s going on there too. It seems it support that kind of an idea also. So it’s, this is different than what we have seen in past recessions for sure, I am not a registered economist, neither is John, we're good at visualizing in this business and that's where we can only just a reiterate to you the signals we are seeing in the marketplace. But right now as this comes back, we know that all dental offices are not completely up to speed but that is not necessary based on demand, that’s based on the way that they have to actually face this patients through their practices and make sure that they keep their staff safe and they keep patients safe too."
},
{
"speaker": "John Kreger",
"text": "Great. Thank you and then one last one, you mentioned being still very much committed innovation, can you give us an update there, how is an mandibular advancement being adopted and any update on palate expansion?"
},
{
"speaker": "Joe Hogan",
"text": "Yeah it’s hard to take a second quarter on MA and give you a trend because it was a pretty hard hit overall, obviously bringing shock on my numbers. You know I would say overall mandibular advancement continues to go well, we pair with our team first product, Invisalign first product line which is doing extremely well also and so yeah what you really find around the world, John as you find some doctors just glued to amend that advancement, they would love it, they use it every day, other ones are trying it out, that they have had it on some patients and watching through it. On the first product line, they got to combine that together and so we see significant increase in what I call a clinical penetration because we can do those kinds of cases that we could really have done, you know every two years ago at all. So I would say, the way to look at that is our Teen first product, Invisalign first being the most uptake and a fastest uptake with mandibular advancement right behind it."
},
{
"speaker": "John Kreger",
"text": "Great and any update on palate expansion?"
},
{
"speaker": "Joe Hogan",
"text": "We have all the protocols we know how to do it, we're trying to find manufacturing capabilities that can scale with what we have been in middle out there, that sounds trivial but in a business like this where you have credible amount of volume you have to put through, we still have some work to do in that skillet more."
},
{
"speaker": "John Kreger",
"text": "Great thank you."
},
{
"speaker": "Joe Hogan",
"text": "Thanks John."
},
{
"speaker": "Operator",
"text": "Thank you our next question comes from the line of Jeff Johnson with Robert W. Baird. Please proceed with your question."
},
{
"speaker": "Joe Hogan",
"text": "Hi Jeff."
},
{
"speaker": "Jeff Johnson",
"text": "So what the qualifying questions here if I could, when I saw that like John Black's question on the North American number, it depends on how you read the sentences in your slide deck, was North America up year-over-year in June and then if I take your April, May, June comments and May a little bit better than June a significant better. It seems like June on the kind of global revenue basis had to be down only 10% to 20% or so I don't know if you’ve talked to that at all but when I look at street down 20% in 3Q, it seems like you sitting pretty comfortable with the street kind of the $486 million revenue number where that right now, so just any help you can give us again we want to make sure we get kind of that 3Q at least ballpark accurate?"
},
{
"speaker": "Joe Hogan",
"text": "Yeah just a top year over year, not just total not from a June standpoint. Not just quarter-over-quarter but June year-over-year, so this is a pretty strong signal."
},
{
"speaker": "Jeff Johnson",
"text": "Is that year-over-year in June?"
},
{
"speaker": "Joe Hogan",
"text": "Yes."
},
{
"speaker": "Jeff Johnson",
"text": "Okay, and the [indiscernible] down 20% in the third quarter from a global revenue perspective, it sounds like your June kind of globally was probably down less than that 20% if I cannot see April, May, June comments. So just kind of your comfort at that $486 million number where the 3Q I know that you're not guiding but I would assume you don’t have too many concerns on that number?"
},
{
"speaker": "John Morici",
"text": "We'll give you an A for trying. That’s a good one Jeff."
},
{
"speaker": "Joe Hogan",
"text": "That’s was good one John. No, we are not guiding but trying to give you as much information on people doing surveys and other work as well you can up trying a little around it but just I want to give out for the things we talked about, don't want to give on future guidance. Jeff you're not being Q here, it’s hard to read signal, two noise right now and that's okay."
},
{
"speaker": "Jeff Johnson",
"text": "Totally understood, last question. Just on the virtual tools as some doctors come back we are talking to on the therapy and hey I have had patients that I haven't seen in three months are so progressing wow, there may be going to go to a Q3 month instead of every two months follow-up schedule with their clear aligner patients in that. I mean it seems like to me we're getting here if I’m down on even some of these really messed up teen cases o three hours, four hours for tools may be take that lower time, just talk of the efficiency and throughput advantage of that’s going to have braces even that's going to be the real driver even more sale than others digital and what have you it's just the efficiency improvements are getting so good here in clear aligners."
},
{
"speaker": "Joe Hogan",
"text": "Yeah, I would say when we say all that digital, it’s just that what allows them to drive the efficiency you're talking about, just so when you have this kind of digital tools, allow you to monitor patients to communicate with patients one on one or you know any kind of AI they can tell patient if they're off-track or on track and we know that interaction also encourages patients with the most important variable Invisalign treatment is compliance, making sure that they have their aligners intact and if doctors are watching and we are keeping up, in that sense it helps also. And so what doctors find out overtime is that they can -- they will have to see these patients like every three weeks, like they do with wires and brackets, they don’t have to -- the obviously the PPE and everything else associated with their staff and all working through these patients. And, if the patient doesn't have to come in from a clear aligner standpoint, you either give them all their aligners upfront or you give them more aligners that allow them to continue to treatment, without having an actual doctor’s visit. So, it’s just tools, they are kind of tools that we use now and from a business standpoint that we have, but it is applied from a clinical standpoint to keep track of patients and to allow doctors to be more productive for sure."
},
{
"speaker": "Jeff Johnson",
"text": "Understood, thanks."
},
{
"speaker": "Joe Hogan",
"text": "Yeah, thanks Jeff."
},
{
"speaker": "Operator",
"text": "Thank you. Our final question comes from the line of Richard Newitter with SVB Leerink. Please proceed with your question."
},
{
"speaker": "Richard Newitter",
"text": "Hi thanks for taking the question. I was just curious, the Switch program that you guys launched this quarter, has it been more effective in teens or adults and then I have a follow-up."
},
{
"speaker": "John Morici",
"text": "Yeah, Rich, this is John. It is a program as Joe said that we had in Japan and other places as well, it is something that our doctors and many of their patients who were stuck in treatment and teeth were moving wanted to make a switch to this. It is not necessarily a teen versus adult, it's just patients who want to progress with treatment and did not want the uncertainty of the current environment that they are in or future environment and went to their doctors and their doctors wanted to be able to switch them over and we made it so that they could do so."
},
{
"speaker": "Joe Hogan",
"text": "I think Richard, what you are hearing from both of us is, in this case we're not quite sure exactly how many teens and adults were on Switch program, it is a good question, but you got to guess statistically the orthodontic market in the United States is 80% teens and 20% adults. So you can guess the majority of Switches were probably teens, but that is – let me get that data back to you."
},
{
"speaker": "Richard Newitter",
"text": "And the bigger question there that I'm trying to get at with some of the things that you're talking about in a post COVID world and all of the benefits that now kind of pile on to aligners versus wires and brackets. I was trying to ask the question through the Switch program to see if it would -- to test [indiscernible] but it would seem that teen doing the conversion with adult - the conversation with adults and being able to get teens and the parents over the finish line, you have an added level of sell now. Is that what you're actually seeing in the marketplace and is it fair to say that maybe COVID has - has resulted in the much anticipated inflection point for teens, is that fair."
},
{
"speaker": "Joe Hogan",
"text": "Well it's fair that it helped. I cannot tell you that the inflection point is here, but we certainly see a lot of uptake and interest and a digital workflow and our digital methodology in light of COVID-19, our experience has been when doctors can really convert most of their practice and that's why ADAPT, once you get over 50%, 60% digital, your practices change significantly and the consumers like it better, doctors tend to like it better, what we talked about you have higher margin and also a dramatic increase like 20% increase from a revenue standpoint. So, yeah, this is certainly - a COVID is certainly been a push for this. We are cautious, we don't want to talk about a crisis that’s just terrible for people, actually enhancing our business, but the fact is it does promote a workflow and a capability that's much more convenient at this point in time given the COVID threat."
},
{
"speaker": "Richard Newitter",
"text": "Thank you."
},
{
"speaker": "Operator",
"text": "Thank you. Our next question comes from the line of Michael Ryskin with Bank of America. Please proceed with your question."
},
{
"speaker": "Michael Ryskin",
"text": "Hi there, thanks for taking the question guys. I have a couple of quick ones. In your prepared remarks Joe and John, you obviously talked about third quarter, how that's typically the strongest part of the teen season, typically you see the nice little bolus, in the summer as everyone kind of stays home. I'm just curious with the strength that you saw in 2Q, do you think there could have been any sort of pull forward in teens in the quarter, just looking at for the last couple of months everyone’s been home anyway. So any expectations of maybe a little bit of a lull in 3Q or should we expect further pickup from current levels."
},
{
"speaker": "Joe Hogan",
"text": "I think Michael when you ask a question like that and you need to think of our business and how broad it is and global it is today. There's a lot of mitigating factors, right, so we cannot tell you if there is a backlog of patients that have come in sooner or whatever. We just know it’s teen season in United States and its Canada and I mean, I'm sorry in China, Canada also and we're June was indicative of a good increase in the sense of teens looking for treatment and we think that will continue."
},
{
"speaker": "Michael Ryskin",
"text": "Great, thanks, and then another quick one. I realize you don't want to talk about the exit run rate or anything like that, but I think a lot of the assumptions is go forward are that there are no further lockdowns, there are no further sort of quarantine measures implemented, but I just want to ask in the recent weeks [indiscernible] in the Sunbelt, Texas, California, Florida, have you seen any fluctuation in volumes, any early indications there. I guess I am kind of asking of on the one hand you have a full recovery of the economy, on the other half you have full locking out, what if we were somewhat in the middle, are you seeing any indications there?"
},
{
"speaker": "John Morici",
"text": "Mike, I think you look at – every area is different, we are seeing a different pace of recovery for the various regions and locations and practices, some practices they are open but then somebody within the practice develops COVID and it shuts down so it varies across. We're doing everything we can to make sure that those doctors have their PPE, they have promotion, they have things in place to be able to help drive volume, but it's very dependent on those specific areas not just in the U.S. but we're seeing this across the other regions as well."
},
{
"speaker": "Joe Hogan",
"text": "Mike, right, it is back to Joe again too, I just want you to know we have great enthusiasm for teen and no matter where it is around the world but we can't tell you if there is a surge of teen patients based on a lot of teens not being in school, we cannot tell you if it's a backlog or whatever, but we can tell you we're enthusiastic about the season and that June was a good indication that it's heading in the right direction."
},
{
"speaker": "Michael Ryskin",
"text": "Great, thanks. Can I ask a quick clarification, okay just this has come up a dozen times in the past five minutes. Your response to Jeff's question on June, do you mean absolute case volume was up in North America in June or utilization is up in June."
},
{
"speaker": "Joe Hogan",
"text": "Utilization."
},
{
"speaker": "Michael Ryskin",
"text": "Okay, thank you so much, thanks."
},
{
"speaker": "Operator",
"text": "Thank you. Our final question comes from the line of Brandon Couillard with Jefferies. Please proceed with your question."
},
{
"speaker": "Brandon Couillard",
"text": "Joe or John, just a question on China, if you could speak to growth specifically in 2Q I know it is still down year over year, were there any other reasons kind of outside the three that you listed, Japan, South Korea, and Taiwan that were ahead of kind of your internal expectations?"
},
{
"speaker": "Joe Hogan",
"text": "No I cannot say that there was really, I mean we didn't talk a lot specifically about that but Japan, Taiwan, and Korea were exceptions because there were hardly a blip in a sense of what we saw and how they were affected with COVID but really every other country in APAC and most countries around the world we say except for the expansion markets in Asia and obviously COVID was a big impact on them."
},
{
"speaker": "Brandon Couillard",
"text": "Okay."
},
{
"speaker": "Joe Hogan",
"text": "And then balance of the question John, I think so."
},
{
"speaker": "Brandon Couillard",
"text": "John, any chance you could share with us the exocad contribution in the second quarter or to results or should we just wait for the [Q4] for that."
},
{
"speaker": "John Morici",
"text": "Yeah, I think we talked about been in the scanner and services segment that we have and I think you can wait for the Q on that but it's - we acquired and it is part of our business and we will put more details into the Q."
},
{
"speaker": "Shirley Stacy",
"text": "I think that's the last question. So thank you everyone for joining us today. This concludes our conference call. If you have any follow-up questions, please follow up with Investor Relations. Have a great day."
}
] | Align Technology, Inc. | 24,568 |
ALGN | 1 | 2,020 | 2020-04-29 16:30:00 | Operator: Greetings and welcome to the Align Technology First Quarter Earnings Call. At this time, all participants are in a listen-only mode. A brief question-and-answer session will follow the formal presentation. [Operator Instructions] As a reminder, this conference is being recorded. It is now my pleasure to introduce your host Shirley Stacy, VP of Corporate and Investor Communications. Thank you. You may begin.
Shirley Stacy: Thank you. Good afternoon everyone. Thank you for joining us. Joining me today is Joe Hogan, President and CEO; and John Morici, CFO. We issued first quarter 2020 financial results today via GlobeNewswire, which is available on our website at investor.aligntech.com. Today's conference call is being audio webcast and will be archived on our website for approximately one month. Telephone replay will be available today by approximately 5:30 P.M. Eastern Time through 5:30 P.M. Eastern Time on May 13th. To access the telephone replay, domestic callers should dial 877-660-6853 with conference number 13701221 followed by pound. International callers should dial 201-612-7415 with the same conference number. As a reminder, the information that the presenters discuss today will include forward-looking statements, including statements about Align's future events and product outlook. These forward-looking statements are only predictions and involve risks and uncertainties that are set forth in more detail in our most recent periodic reports filed with the Securities and Exchange Commission available on our website and at sec.gov. Actual results vary significantly, and Align expressly assumes no obligation to update any forward-looking statement. We have posted historical financial statements, including the corresponding reconciliations, if applicable, and our first quarter 2020 conference and earnings release and conference call slides on our website under Quarterly Results. Please refer to these files for more detailed information. With that, I'll turn the call over to Align Technology's President and CEO, Joe Hogan. Joe?
Joe Hogan: Thanks Shirley. Good afternoon and thanks for joining us. I hope that you and your families are well. Given the significant disruption to our business caused by the extraordinary measures taken by governments, public and private institutions, and businesses around the world to fight the spread of COVID-19, most of the performance metrics I would normally discuss are less meaningful. Therefore, on our call today, in addition to the highlights from our Q1 results, I'll discuss the trends that we're seeing through early March prior to the escalation in the COVID-19 cases that resulted in shutdowns across Europe and North America, and compounded the initial impact from similar shutdowns in China beginning in January. I'll also talk about our view of recovery and strategy to help our doctor-customers navigate this challenging environment and ensure our business continuity. John will provide more detail on our financial performance and comment on the current trends across our business globally, including the momentum we're beginning to see in China. Following that, I'll come back and summarize a few key points and open up the call to questions. With that, let me start with a few comments on our first quarter results through early March. At that time, China was progressing in line with our original guidance for Q1, which include approximately 20,000 to 25,000 fewer cases and $30 million to $35 million less revenues for Invisalign and iTero products, and other regions were performing ahead of our Q1 outlook. However, the situation quickly changed in mid-March as most governments in EMEA and North America closed down non-essential businesses initiated stay-at-home orders. As a result, the vast majority of Invisalign practices shut down and stopped seeing patients, and our business fell off sharply. We believe the incremental impact of COVID-19 on our Q1 results was approximately 50,000 fewer cases and approximately $85 million less revenues for Invisalign and iTero products. At the same time, while EMEA, North America and other parts of APAC fell off in mid-March, we began to see improvements in China as the country started to open up again. While it's still early in the recovery process and the situation is different in every city and for every practice, we're working closely with our doctors to support their current needs and ensure they have a game plan to resume operations in a very different environment for the foreseeable future. More on that in a few minutes. Now let's go through our first quarter results. For Q1, total revenues were $551 million, down 15.2% sequentially and unchanged year-over-year, reflecting significantly lower-than-expected sales of Invisalign clear aligners and iTero scanners due to the COVID-19 pandemic. Revenues from clear aligners were $481.6 million, and iTero scanners and services were $69.4 million. Clear aligner shipments were 359.4 thousand cases. Notwithstanding the impact of COVID-19, shipment volumes were up 2.9% year-over-year, reflecting solid growth from non-comprehensive products driven by Invisalign Go systems across all regions, as well as Invisalign Moderate. This was offset by a lower mix of comprehensive products primarily due to the shortfall in China. For the quarter, we shipped Invisalign cases to approximately 61,000 doctors, of which 4,100 were first time customers. We also trained over 4,600 new doctors in Q1, including 2,600 international doctors. Overall for the teen market in Q1, 104,000 teens and preteens started treatment with Invisalign clear aligners, representing 29% of total cases shipped, reflecting growth from EMEA and the Americas regions and across comprehensive products. During the quarter, we reached another major milestone with our 2 millionth Invisalign teenage patient, treatment of orthos. A student and athlete, we started treatment recently with Dr. Tom Hartzog, a U.S. based orthodontist in Kentucky. Dr. Hartzog has been a terrific practicing orthodontic for about 30 years and credits Invisalign with revitalizing his practice at a time when a lot of doctors think about slowing down. He says his approach is to lead with Invisalign, and he's got a new digital mindset now, and we're excited he's going to share more about that at our upcoming Invisalign Team Forum Virtual Edition, this July. The teen segment represents the largest portion of existing orthodontic case starts each year. And as we head into the summer season, the busiest time in orthos practice, we are working to help doctors capture as much of the teen season as possible under the circumstances. Now let's turn to specifics around our first quarter results, starting with the Americas region. For the Americas region, through early March, solid sequential growth was driven primarily by North American GP dentists and DSOs, along with continued strength in Latin American doctors. On a reported basis, Q1 Invisalign case volume was down 5.5% sequentially and up 5.2% year-over-year, reflecting significantly less-than-expected Invisalign case shipments in March due to the impact of COVID-19. Year-over-year growth for Q1 reflects growth from both orthodontists and GP dentist channels, which were up 5.6% and 4.6%, respectively. Latin America volume was up 83% year-over-year led by strong growth from Brazil. For our international business, through early March, with the exception of China, the EMEA and APAC regions were performing well. On a reported basis, Q1 Invisalign case volume was down 22.3%, sequentially, reflecting significant decrease in APAC, primarily China, due to the impact from COVID-19, partially offset by growth in EMEA. On a year-over-year basis, international shipments are flat, reflecting growth from EMEA, offset by a decline in APAC. For EMEA, Q1 volumes were down sequentially and up 11.1% on a year-over-year basis driven by growth in Spain, the U.K. and Germany, along with our expansion markets led by Central Eastern Europe and Benelux, including the teen segment. For APAC, Q1 was down sequentially as expected, reflecting a significant reduction in volume in China due to COVID-19. On a year-over-year basis, APAC was down 18.2% compared to the prior year, reflecting a longer duration of COVID-19 measures implemented in China, and was the only region down year-over-year. Japan, Taiwan, Korea and India saw continued year-over-year growth in Q1. And as noted earlier, we began to see signs of improvement in China in early March as the government began to relax some, or all of the restrictions and business began the road to recovery. Our consumer marketing is focused on building the clear aligner category and driving demand for Invisalign treatment through a doctor's office. In Q1, we saw strong digital engagement globally, including 7.1 million unique visitors to our websites and 274,000 leads, both metrics growing by more than 40%. Consumer engagement growth for Invisalign was enabled by the launch of our new consumer campaign, Invis, strong media spend and a robust omni-channel presence. Our Invisalign concierge team is nurturing consumer leads and virtually until doctor's office is open, which is key to realizing and converting consumer interest into cases. Further, our modeling indicates that consumer marketing drove incremental growth in Q1 and reinforces our strategy to invest in brand building and maintain high visibility with consumers through the COVID-19 crisis. Other key metrics showing increased activity and engagement with the Invisalign brand and are included in our Q1 quarterly slides. For iTero scanner and services business, Q1 revenues were down sequentially as expected, following a seasonally strong Q4 and consistent with trends in the capital equipment market. Q1 also reflects the impact of COVID-19 across all regions in especially North America, Australia, China, Japan and other APAC countries. On a year-over-year basis, iTero scanner revenues were down 13.1%, due to lower sales in North America and APAC region primarily due to COVID-19 despite increased revenues in EMEA and Latin America, reflecting the addition of Zimmer Biomet distribution agreement, the introduction of our iTero 5D going direct to Mexico and additional LATAM distributor markets. The total year-over-year decrease in scanner revenue was slightly offset by increased services revenue from a larger iTero installed base. Cumulatively, over 23 million orthodontic scans, 5.2 million restorative scans have been performed with iTero scanners. For Q1, total Invisalign cases submitted with a digital scanner in the Americas increased to 80.5% from 76.1% in Q1 last year. International scans increased 68.7%, up from 59.3% in the same quarter last year. We're pleased to see that within the Americas, 93.6% of cases submitted by North American orthodontists were submitted digitally. I'm also pleased to share that we received FDA 510(k) clearance for iTero Element 5D Imaging System. The iTero Element 5D Imaging System seamlessly combines three scanning technologies, 3D data, intraoral color photos and NIRI images. NIRI is near-infrared imaging technology, which allows you to see carries in different aspects from a dentition standpoint. It's an integrated scan, and we're excited to bring the advancement in inter oral scan technology to the United States market to help doctors provide better oral care for their patients. At this time, we're mindful of the current environment and the impact that COVID-19 pandemic is having across the world and are focused on customer education and training regarding this new technology while so many dental practices in the U.S. are operating on a limited schedule. We remain confident that the iTero business will continue to help drive our overall long-term growth and help increase adoption of the digital platform with Invisalign treatment. To that end, during the quarter, we announced the acquisition of exocad, a global CAD/CAM software leader, and completed the transaction on April 1st. John will talk more about the acquisition in a moment, but let me say just that the rise in consumer awareness around dentistry extends beyond the benefits of straight teeth and orthodontics. There are significant opportunities for all kinds of treatments, from simple cosmetic fixes to ortho-restorative that can help us accelerate growth of our digital solutions for ortho-restorative cases and really drive growth and adoption of the Invisalign iTero digital platform. I'm very excited about the addition of exocad's proven restorative experience, expertise, and functionality to our platform, and I want to welcome exocad Founders, Till Steinbrecher and Maik Gerth and the entire exocad team to Align. Let me now turn to some of the initiatives we've taken to support our doctors and their patients. We recognize the enormous hardship that COVID-19 has caused Invisalign practices around the world. We're working in every region to support doctors and find ways to minimize disruptions to their businesses and to strengthen the experiences their patients have with Invisalign treatment. We have learned a lot from our doctor partners and teams in the Asia-Pacific region, and we've been navigating the impact of COVID-19 for months. We're applying their experiences and insights across all regions. Many of our customers are sharing creative ideas and suggestions as we all work to manage the situation together. One of the first things we did was address clinical education, an integral part of doctor engagement. Across all three of our regions, we moved most of our education programs to online digital platforms, continuing to provide hundreds of valuable Invisalign and iTero training and education resources, many peer-to-peer for doctors and their teams in a virtual setting. We also identified opportunities to collaborate with Invisalign practices to manage ongoing cases and explore new ways for doctors to conduct consultations. Early on, many doctors began using video calls, text, and patients submitted photos through a variety of platforms to help monitor patient progress, reduce in-office appointments, and ensure continuity of patient care during treatment. It quickly became clear that doctors needed a better way to connect and monitor patients. So, we accelerated the launch of new tools that were still in pilot mode. The Invisalign virtual appointment tool enables doctors to easily set up HIPAA-compliant video appointments to monitor existing patients and to have an initial conversation with patients interested in learning more about Invisalign clear aligner treatment for the doctor. The Invisalign virtual care program can also use video appointments and enables doctors to monitor treatment progress and stay connected with patients through a virtual platform. Patients use the intuitive My Invisalign app to stay engaged in the treatment and convey progress photos to their doctor who review these photos on their Invisalign doctor's site, communicates any needed instruction, and ensures treatment is on track. These tools are available through our Invisalign Doctor Site, IDS, in the My Invisalign app and work as part of the end-to-end digital platform for Invisalign treatment. While both tools are still in early stages of rollout, our goal is to provide doctors with a way to maintain care until patients are again able to visit the doctor's office. Feedback to-date has been relatively positive, and we believe that doctors will continue using these tools to improve patient experience and increase efficiencies well after COVID-19 restrictions have been listed. We're also supporting doctors through financial and operating challenges and are providing additional resources, including industry experts to help navigate this ongoing crisis. This includes webcast, e-blast and micro sites on IDS again, the Invisalign Doctor Site, with advice on extending aligner wear and holding patients at specific treatment stages; options for redirecting aligner shipments and helping address customer cash flow concerns caused by the pandemic. We're creating programs with partners like LendingPoint that are part of recovery playbooks to help doctors with speed to cash that is expected to launch in May -- on May 1. Before I turn the call over to John, I'd like to spend a few minutes talking about the strength and resiliency of Align and our business model and our view of the path to recovery. There's no question that we are in uncharted territory. And while supporting our doctors in their current situation is still critical right now, planning for recovery is just as important. Overcoming challenges is not new to Align and our employees. Our response to COVID-19, decisions and investments we are making, now to anticipate customer needs and adapt in a dynamic environment are based in part on the lessons learned throughout our history and will further our competitive advantage and position us to capitalize on the market as it returns. We serve a huge under-penetrated market, and our share of more than 300 million people who want a better smile is less than 3%. Teens are an important segment, and our share is a small fraction of the market. And yet, we know that teens remain the heart and soul of orthodontic practices and will drive their recovery. There's no single blueprint for us to follow in this recovery. Our underlying business is healthy. We have an excellent balance sheet with no debt. And over the last 5 years, we've grown a business that has generated 25% compounded revenue growth and consistently delivered 72% gross margins, 22% operating margins and generated cash flow from operations in excess of 22% of revenues each year. We also have operational resiliency in terms of global manufacturing that has taken us years to develop and is simply unmatched, and is a key reason why we're able to continue operations in the crisis and expect to ramp up quickly in recovery. The core components being supply chain, digital treatment planning, treat aligner fabrication, AFAB, supply chain. During normal business, we carry enough buffer stock in our warehouse to handle 2 disruptions to the supply chain. So if a batch go sideways, we can handle that twice. After COVID-19 broke in China, we anticipated that we needed to mobilize existing suppliers and add 3 to 6 months of additional inventory so that we could weather the potential storm. For many of our suppliers, we have alternative redundant suppliers in case of shutdown in one geography impacts a supplier. Treat, the investments we have made over the years in having Treat in multiple locations, allows us some flexibility in business continuity to respond to customer needs. Before COVID-19, we had evaluated potential for doing treatment planning from home or remote locations and the implications to hardware needs, data security and productivity. When COVID-19 hit China, we ramped up our ability to do that and started transitioning our CAD designers to do treatment planning at home and have been successful in that sense. We are confident we could have maintained 80% of our normal output, but volumes fell off before we could prove that point. China hit first, so we load balanced with our other Treat locations. So as this went from east to west, we didn't have significant issues in our treatment operations. This is our model, and we'll continue to strengthen it going forward. Aligner fabrication, we have aligner fabrication operations in Huang, China and Juarez, Mexico and plans for a third facility in Europe that we're looking to accelerate into 2021. Our facilities have excess capacity built in. And while we never have 100% redundancy, we do have the ability to shift production volumes based on that excess capacity. Worst case scenario, if one of these facilities goes down, then customers wait a little longer for their aligners, but production will continue, and we believe we can recover swiftly. In short, when we have an issue in one part of the world, we have designed our operations to enable us to load balance across facilities. We've had to do this, because of our growth and huge growth spurts that made it necessary to remain flexible. Additionally, the steps we've implemented during COVID crisis like work-from-home for CAD designers gives us even more flexibility, and we'll leverage that going forward as we evaluate facilities requirements and potential cost savings. Beyond our business strength and operational resiliency, we are at the forefront of digital dentistry. And this pandemic has exposed the weakness of analog approaches and strengthens and benefits the digital technology in every aspect of our life. There's been a lot of concern over the years about digital driving us apart and keeping people from interacting. People focused on their screens in social media rather than with each other, interacting with businesses online rather than in person, et cetera. I think what we're seeing through this terrible situation is that digital actually unites us. It keeps us connected, gives us flexibility and options. Without digital technology during this crisis, how would kids go to school? How would any of us be productive working from home? How would universities and public health experts, model the curve without data mining and AI? I am proud and thankful of our digital platform is able to Invisalign patients moving forward in treatment, while physical practices are closed, that it can connect doctors and patients to monitor issues and track treatment, that because of digital, we can get a replacement aligner for some new retainers to a kid sheltering in place. And together with doctors, we're going to leverage that power of digital for dentistry and orthodontics more than ever. Doctors are not going back to before. We all know that digital dentistry is the future, and that is a part of why Align is weathering this pandemic and why I believe we are well positioned for success going into recovery. With that, I'll now turn it over to John.
John Morici: Thanks, Joe. Now for our Q1 financial results. Total revenue for the first quarter was $551 million, down 15.2% from the prior quarter and up 0.4% from the corresponding quarter a year ago. For clear aligners, Q1 revenues of $481.6 million, was down 11.4% sequentially across all regions driven by Asia Pacific. Year-over-year clear aligner revenues growth of 2.6% reflects growth from EMEA and the Americas, offset by APAC. Clear aligner revenue growth was unfavorably impacted by approximately $6 million or approximately 1 point year-over-year from foreign exchange. Q1 Invisalign ASPs were up sequentially by approximately $15 to $1,255, primarily due to lower net deferrals due to a decrease in primary case shipments across all regions. On a year-over-year basis, Q1 Invisalign ASPs increased approximately $10, primarily reflecting price increases in all regions and increased additional aligner revenues, partially offset by promotional discounts and unfavorable foreign exchange. Total Q1 Invisalign shipments of 359,400 cases were down 13.1% sequentially and up 2.9% year-over-year. Our scanner and services revenue for the first quarter was $69.4 million, down 34.7% sequentially due to volume decreases in all regions. Year-over-year revenues were down 13.1%, primarily due to volume decreases in North America, partially offset by increases in EMEA and LatAm, and increases in service revenue off an increased installed base. Moving on to gross margin, first quarter overall gross margin was 71.6%, down one point sequentially and down 1.6 points year-over-year. On a non-GAAP basis, excluding stock-based compensation expense, overall gross margin was 71.8% for the first quarter, down one point sequentially and down 1.6 points year-over-year. Clear aligner gross margin for the first quarter was 73%, down 1.1 points sequentially and down 1.9 points year-over-year, primarily due to lower volumes and higher cost per case, partially offset by an increase in Invisalign ASPs. Scanner gross margin for the first quarter was 61.8%, down 3.1 points sequentially and 1.8 points year-over-year due to increased manufacturing variances, lower ASPs and partially offset by higher service revenue. Q1 operating expenses were $324.4 million, up sequentially 1.1% and up 3.2% year-over-year. The sequential increase in operating expenses reflects higher legal and outside services. Year-over-year, the increase reflects our continued investment in sales and R&D activities, including increased compensation from additional headcount and consumer marketing spend, partially offset by the $29.8 million charge related to the Invisalign store closure costs recorded in Q1 of 2019. Our first quarter operating income was $69.9 million, down 53.7% sequentially and down 20.3% year-over-year. Our first quarter operating margin was 12.7%, down 10.6 points sequentially and down 3.3 points year-over-year. The sequential decrease in operating income and operating margin are primarily attributed to lower volume, revenue, and gross margin as a result of the COVID-19 impact. Operating margin was impacted by approximately 0.8 points year-over-year from foreign exchange. On a year-over-year basis, the decrease in operating margin and operating margin primarily reflects lower gross profit and higher operating expenses related to go-to-market activities, partially offset by the $29.8 million charge related to the Invisalign store closure in Q1 2019. On a non-GAAP basis, which excludes stock-based compensation, acquisition-related costs and impairment, and other costs related to Invisalign store closures in the prior year, operating margin for the first quarter was 17. 1%, down 9.3 points sequentially and down 8.1 points year-over-year. Interest and other income expense net for the first quarter was an expense of $16.9 million, including a $9.2 million hedge loss related to the anticipated exocad acquisition. Excluding the hedge loss, interest and other income expense net was $7.4 million expense on a non-GAAP basis. With regards to the first quarter tax provision, our tax rate was negative 2,745%, which includes a onetime tax benefit of approximately $1.5 billion associated with the recognition of a deferred tax asset related to the intra entity sale of certain intellectual property rights, resulting from our corporate structure reorganization completed during the quarter. This deferred tax benefit will be amortized starting in 2020 and continue into subsequent quarters and years. The period over which the tax benefit will be recognized depends on the profitability of our Swiss headquarters and is still under assessment and review with the Swiss tax authorities. Excluding the tax benefit related to our corporate structure reorganization and the related tax effects on stock-based compensation and other non-GAAP adjustments, the first quarter tax rate on a non-GAAP basis was 33.2% compared to 29 -- 20.9% in prior quarter and 22.8% in the same quarter a year ago. The non-GAAP tax rate was higher-than-forecasted due to lower-than-expected profits in regions outside the U.S. First quarter diluted earnings per share was $19.21, up $17.68 sequentially and up $18.32 compared to the prior year. On a non-GAAP basis diluted earnings per share was $0.73 for the first quarter, down $1.03 sequentially and down $0.52 year-over-year. Moving on to the balance sheet, as of March 31, 2020, cash, cash equivalents and marketable securities were $790.7 million, a decrease of approximately $77.9 million from the prior quarter, which is primarily due to the annual bonus payout and the purchase of an additional San Jose, California facility combined with slower AR collections. Of our $790.7 million of cash and cash equivalents, $119.2 million was held in the U.S. and $671.5 million was held by our international entities. Q1 accounts receivable balance was $533 million, down approximately 3.1% sequentially. Our overall days sales outstanding, DSOs, was 87 days, up 11 days sequentially and up 9 days as compared to Q1 last year. We expect DSOs to increase in Q2 as a result of anticipated lower collections. Cash flow from operations for the first quarter was $9.8 million. Capital expenditures for the first quarter were $46.1 million, primarily related to our continued investment in increasing aligner capacity and facilities. Free cash flow, defined as cash flow from operations less capital expenditures, amounted to negative $36.3 million. Under our May 2018 repurchase program, we still have $100 million available for repurchase of our common stock. On April 1, 2020, we completed the acquisition of privately held exocad global whole needs, GMBH, a global leader in the dental CAD/CAM software market for a purchase price of approximately $430 million in cash. The acquisition of exocad broadens our digital platform reached by adding technology that addresses restorative needs in an end-to-end digital platform workflow to facilitate ortho restorative and comprehensive dentistry and also brings exocad's expertise in restorative dentistry, implantology, guided surgery and smile design of the Align Technology portfolio. We expected to complement and extend our Invisalign and iTero digital solutions paving the way for new seamless cross-disciplinary dentistry in the lab and at chairside. exocad also broadened our platform reach in the digital dentistry with close to 200 partners and more than 35,000 licenses installed worldwide. Now, let me turn to our outlook. As Joe described earlier, through early March, our business was performing well, and we believe we would exceed our Q1 guidance. However, things quickly changed in the latter part of March as the majority of Invisalign practices in our core markets in EMEA and the Americas regions closed their offices and stop seeing patients, which caused Invisalign case receipts to drop rapidly and continue into April. At this time, due to the fluid market condition caused by the COVID-19 pandemic, we are not providing guidance for Q2, and we are withdrawing our prior commentary regarding our full year 2020. What I can offer is the following directional commentary. For China, which was the first major country impacted by COVID-19 and was shut down almost overnight at the end of January, as reflected in our Q1 guidance provided on the January earnings call. It has shown continued improvement beginning in early March. Our case receipts or orders in China are currently running at 80-plus percent of mid-January's level, but with fair amount of variability week-to-week in between various provinces and cities. Keep in mind that there is about a three to four week lag between case receipts and orders to case shipments. China provinces are not uniform in their recovery, but all continue to improve. Guangdong, Shanghai and Ziyang are now at or above pre-pandemic levels. Beijing and Hubei's slower recovery is consistent with later reopening and/or heavier restrictions. Early indications of patient flow is also positive, but it's too early to determine, if it is pent-up demand due to the lockdown. We also heard today that China is lifting travel restrictions within China, which should facilitate business. APAC, excluding China, is still very fluid as Japan shut down later than the rest of APAC and other countries like Taiwan and Korea are also improving, but our trailing China For the Americas, its unclear how volume will evolve due to staggered lockdown and subsequent staggered re-openings by state. We would expect the situation in the U.S. to be similar to what we've seen in China with recovery starting in the states in the middle of the country working its way out to the coast, on a city-by-city basis. In LATAM, it is still fluid as it is shut down later than the rest of the Americas. The EMEA market is beginning to open up, and Germany is making good strides. We are monitoring each market to see how each is responding to the various government isolation regulations and is still fluid and a lot of variability week-to-week. For iTero, as a result of COVID-19, we did see some deferral purchase decisions at the end of the quarter, and I would expect that to continue. We finished Q1 with $791 million in cash and cash equivalents. Since then, we have closed our purchase of exocad for $431 million on April 1st. Align's priorities during the pandemic are to take care of our employees, customers and shareholders. With these priorities in mind, we are taking actions to ensure the business is well positioned to weather the pandemic. In order to maintain our financial health, we are taking the following actions; holding our current headcount level steady to support the initiatives Joe discussed while making sure we are prepared for the market recovery; controlling discretionary spending such as travel and meeting-related expenses; slowing some of our capital expenditures; and working with many vendors who have allowed us to increase payment terms, while providing extended payment terms to many of our customers. As always, we are balancing future investments to drive growth in a vastly underpenetrated market versus making the appropriate cost reductions and cash actions that have less impact to the business. With that, I'll turn it over to Joe for final comments. Joe?
Joe Hogan: Thanks John and thanks again for joining us today. Before I close, I want to take a minute to talk about some of Align's actions to support relief efforts in the communities in which we live and work. One of the things that makes Align a great place to work is the concern our employees have for the world around us and their commitment to helping others. The passion is core to our purpose of transforming smiles and changing lives. And in this time of need, how we support our employees and customers and serve our communities is more important than ever. Early on in the outbreak, we donated RMB1 million to the Chinese Red Cross to support relief efforts and what were then some of the hardest hit areas. More recently, we committed $1 million to the Align Foundation, Align's donor advised fund through Fidelity Charitable. And our teams have been working together to source and supply additional personal protection equipment, or PPE, and medical supply donations for frontline health care workers in the communities we serve. Here's some slides to give you more details on this. Finally, thanks to the ingenuity and diligence of our manufacturing engineering team, we're able to leverage our 3D printing technology and manufacturing expertise to produce face shields and medical swabs for COVID-19 testing kits. Through our network of connections with hospitals across the globe, we are donating them to hospitals with the most critical needs. As our existing 3D printing equipment is highly customized for aligner fabrication and can't be reconfigured, we acquired some new separate 3D printers to specifically help with relief efforts. I'm extremely proud of what our employees are doing individually to make a difference in what Align is doing as a business overall. In summary, we're all operating in a tough environment. And even as we start to see signs of recovery in some geographies, we don't know when we'll get back to normal or even near-normal operations. As always, we're committed to the safety and well-being of our employees, doctor partners, their staff and patients. That remains our top priority in the weeks and months ahead. That and working with our stakeholders and communities to get through this together. With that said, I want to make it clear that we are not resting on our laurels waiting for the business in better days. Align Technology believes in playing offense and investing for our future. And that includes, first and foremost, protecting the jobs of our employees and keeping them ready to pivot for a fast recovery. That means no furloughs, no reduced salaries, staying focused on our long-term strategy. Employees remain our most strategic asset. Closing the exocad acquisition in early April to help expand our digital platform for the ortho restorative treatment. We are very excited about this opportunity. Adding resources to support international expansion. For example, approximately 100 new sales reps in China, improving virtual treatment options, and releasing new products and digital tools to meet our customers' needs like Invisalign virtual appointment and Invisalign virtual care to help doctors and patients connect while practices are closed and beyond. Key to expanding our digital platform in a post-COVID-19 environment, investing in marketing in media to reach of consumers while they're at home during the pandemic and keep our brand top of mind, something that other companies have stopped to conserve cash. Extending our working capital to help our customers manage their cash flow and expenses. We are very aware of the near-term volume challenges of consumer sheltering in place, closed ortho and dental offices and possible delays in new treatment as consumers go back to work and evaluate their priorities. But we're still focused on investing in a vastly under-penetrated market and believe that Align is uniquely positioned for recovery and continued growth coming out of the pandemic. COVID-19 will continue to have significant implications to the world and to our industry. Our digital platform has made it possible for thousands of doctors and patients to continue Invisalign treatments throughout this global disruption, thanks to the digital orthodontics and Invisalign aligners, digital treatment planning and virtual monitoring and care. I think coming out of this, more doctors than ever will have experience the benefit of digital treatment and digital tools for their practices and many we have seen firsthand the limitations and frustrations of the traditional analog approach to patient treatment like wires and brackets. With that said, I want to thank you again for joining the call. I look forward to updating you on our progress as the year unfolds. Now I'll turn the call over to our operator for questions.
Operator: [Operator Instructions] Our first question comes from the line of Nathan Rich with Goldman Sachs. Please proceed with your question.
Nathan Rich: Good afternoon. Thanks for the question and hope you and Align team are all doing well. Appreciate all the color you gave on the call. I guess, Joe, maybe starting with China, serving potentially as a guide for how the U.S. and EMEA might recover. Was there anything that you would call out in terms of either the types of cases or the channels that started to come back first, I guess, in China? And as we think about, if China does serve as a guide for the U.S., does that sort of mean that we're looking at sort of like 3 to 4 months for kind of those case receipts to get back to that 80% level that you referenced in your remark.
Joe Hogan: You know first of all you know China is China, right. China has a very rigid lockdown procedures they were into this first; I don’t think you can really take up that from China in this vector work at United States from a Western geography in general. We also see as John indicated in his written script, is that this is coming up in China by city. And we see Beijing and Wuhan area and all Hubei Province being behind in that sense. So I think as you look at the United States, too, New York and California will come up differently than the middle part of the nation is what we're seeing right now, too. So you talked about some segmentation in the sense of how it's come back in China, too, remember, it's primarily a comprehensive product base that we have in China. And it's pretty much stay. I mean we're selling some moderate there and some different things. But it's primarily coming back as a comprehensive piece. So again, I don't think that's a vector that we'll use when you look at other areas, too. So I mean there's no question, Nathan, the other countries will come back. I'm just very reluctant to take a vector from China and really relate that to the Western economies in different countries because it's all being handled differently around the world.
Nathan Rich: Okay. Joe, I appreciate that. I guess just a quick follow-up. I mean when you think about these practices kind of opening back up, and you made some comments about how you're supporting customers, are there any changes that you're thinking about from like a marketing or levers that you've kind of used in the past, maybe gearing those up as you think about helping volumes start to kind of get back to more normalized levels?
Joe Hogan: And we honestly feel that, particularly in the orthodontic community, there'll be a much harder leaning toward a digital kind of environment because with the chance of re-infection rates with COVID-19 and concerns about future shutdowns or slowdowns, as we mentioned in our scripts, you just have a lot of variability and flexibility that you can use in a digital format that you can't use in an analog format. So we'll be going to our customers with programs that really help them through to figure out, how to convert more and more of their volume to a digital environment. Not that, we haven't done that before, but we'll be very specific about it. And as we move into teen season, teen season in second quarter, you'll see us really focused on teens because we know Orthos will be focused on teens, too. And that's a different demographic. It segments differently in a sense of our product lines like first and math. And we'll also be ready with PPE equipment and other things. They'll prepare doctors for the concerns that they're going to have of protecting their patients and also their employees, too. Did I miss anything, John, or anything you'd add?
Shirley Stacy: Thanks, Nathan. Next question, please.
Operator: Thank you. Our next question comes from the line of Brandon Couillard with Jefferies. Please proceed with your question.
Brandon Couillard: Hi. Thanks. Good afternoon.
Joe Hogan: Hey, Brandon.
Brandon Couillard: Joe and John, can you sort of just talk about the flexibility you have in your cost structure, how much of OpEx is discretionary or variable? It sounds like you're focused on kind of holding Align in terms of headcount and marketing. But how should we think about the leverage you have to kind of control costs during this period right now?
John Morici: Hey, Brandon, this is John. Yes, as we said, there are levers that we could pull. Just as we accelerate growth, there's levers we pull. And when we look at our existing OpEx, as we look to spend some of our marketing dollars, where we spend it, how we spend it, there's levers around that spend. As with the travel restrictions and less conferences and so on there's a lot of other operating expenditures that can be pushed out and not spent currently. So we're focused in on and still investing for the future to be able to work with our doctors, as Joe has mentioned, on a lot of new technologies and making sure that we keep the employees and the focus that we have on our structure that we have, but we'll modulate as we needed -- as we need to going forward, if it's needed.
Brandon Couillard: Okay. Thanks. And then a follow-up for Joe. As you think about sort of the leverage you have to drive demand, would you expect to be somewhat more aggressive in terms of ASPs? And are you planning to adjust your Advantage program levels or hurdles to give that as a bit of a break given they've had their offices closed? Thanks.
Joe Hogan: Brandon, we've already extended up from an Advantage tier standpoint with our customers, when they went into that. So, I don't know, how much of an effect that will have on an ASP standpoint, because we basically be holding them to where they are. But overall, it's not price. It's our strategy here as we come up out of here. It's how do we support our customers in a digital environment. We're trying to explain how do we -- how do we really support them from a PPE standpoint and an export standpoint. We talked about loans, different things from a cash flow standpoint. We know many of them are going to be challenged in that way. And we have been offering some payables relief and deferral going forward. So it's a broad aspect of needs, we think, our customers will have. Advantage is one part of that, but it's what we can bring to these customers holistically to help their practice and help them grow.
Brandon Couillard: Okay. Thanks.
Joe Hogan: Yes.
Operator: Thank you. Our next question comes from the line of Jon Block with Stifel. Please proceed with your question.
Jon Block: Great, thanks guys.
Joe Hogan: Hey Joe.
Jon Block: Joe, you mentioned protecting employees, no furloughs or salary cuts. I'm just curious about the competition. And has anything changed in the marketplace around the competitive landscape? We've heard some chatter about sort of, call it, cut back in the orthodontic divisions -- of some of the other players, but maybe you can elaborate on what you're hearing or seeing out there.
Joe Hogan: Hey Jon, I won't be specific, but I mean, most of our competitors have had layoffs or cutbacks in some way. We've been just been blessed with a really strong balance sheet going in. This allows us to have the flexibility and do it as we do. We're a growth business. You know that Jon well. We're set up for 20% to 30% kind of growth, and we have to position ourselves for that. In that sense, making sure that our production capacity is ready, that our employee base is ready, too. Our sales teams are really critical in that sense, too and it's wonderful. We can see some of the investments like Invisalign Virtual Assistance and things that we're working with customers right now, that we can launch those products and continue to drive those products going forward with a full force engineering team also. So, from a competitive standpoint, I mean, we're seeing varying degrees of cutbacks and moves in that sense. But we're not focused on that, Jon, really. We're just focused on what we think we should do, what's important in our portfolio, and how we can help our doctors out.
Jon Block: Okay. Helpful. The second one is a little bit long. But just some Swift. I know you kicked off a pilot recently. I think it's an important sort of initiative long-term to better get after the lower acuity market. I'm just curious, Joe, you kicked it off when there was a lot going on, so did you get enough of a signal during that time to share some takeaways from the Swift initiative? And then could we see you lean on that a little bit more in coming months? Because it is a little bit more price-sensitive for the consumer. It has a monthly. And in this environment of job uncertainty might really resonate. So curious your thoughts there. Thanks guys.
Joe Hogan: Yes, Jon, when we launched Swift, timing couldn't be worse in that sense because COVID hit pretty far after that, but we got a pretty strong signal in that, that we think we understand at least part of the demand equation. We're going to look at rolling that out in a broader sense going forward in the United States and maybe in different parts of the world. But I think when you talked about the price point on ASP and different things, and obviously, we broach that with the doctors who are part of the Swift program. But Jon, you know this; I want to make sure our colleagues understand. This is -- our margins on this product line are accretive to our gross margin area and how we're going into it. So, it's really important in how we position that going forward. But again, those 300 million patients out there, we know there's some price sensitivity and then there's some clinical aspects from a simplicity standpoint that we're going out with that product line. And we think it will respond real well in a broader sense as we begin to roll that out.
Jon Block: Okay. Perfect. Thanks guys.
Joe Hogan: Thanks Jon.
Operator: Thank you. Our next question comes from the line of Steve Beuchaw with Wolfe Research. Please proceed with your question.
Joe Hogan: Hi Steve.
Steve Beuchaw: Hey there. Thanks for the time here. I also wanted to ask in a way about Swift, but with a very different angle. As we think about the operating environment prospectively for some amount of time, people are going to be concerned about safety. And so I wonder to what extent, and you definitely alluded to this in your prepared remarks, can you flex some of the technology that you have with Swift and some of the things you have in development to decrease the amount of face-to-face contact? Again, I know you alluded to this, but I wonder if you could take it a few steps further, give us more context, a little bit more insight into your plans. How do you think about making Invisalign treatment achievable with a minimum of in-person interaction for those who might be concerned about that even in an environment where PPE is more widely used?
Joe Hogan: Steve, that's top of mind as we do things today, too. So actually, even before COVID, when we designed Swift, Swift was designed for basically 2 to 3-doctor direct contact and that's it. And that was part of making the equation for doctors a profitable equation, too. Then you roll in our remote monitoring capability we just rolled out, which gives doctors a tool to be able to do that, and we'll be able to enhance that tool going forward. There's limited amount of attachments in IPR on things like Swift, too. And it's not that our clinical protocols are going to, in some way, decrease in the sense of what the clinical capability are and what we can do. We're also cognizant in the sense of time and mouth. And we'll adjust that. We might tie those things differently to help doctors, too. But there's a lot of different things that we're contemplating. We talked about at the conference last year about direct printed attachments and those kinds of things that in the future and not-too-distant future, will allow a lot less contact and a lot of speed from a productivity standpoint with doctors and patients be able to do those things. So it's the right line of questioning, Steve. So remote monitoring, a digital platform that allows us to anticipate exactly when you'll be seeing a patient and what will need to be done in that sense, not duplicating treatments at the office that don't need to be done and keeping up with patients in a sense remotely and only calling them in when something goes away or a doctor has a concern in some way. So we feel our digital platform and things we have in the pipeline, Steve, we're really well positioned to address that.
Steve Beuchaw: Okay. Good. Good to hear. The second question I wanted to ask actually relates to the practice in the U.S. So it's been -- well, for some of us months, but for -- in practices, certainly many weeks. How do you think about the most likely, as you talk to the orthodontic and dental societies, the most likely path forward for practice reopening in the U.S.? And I know it's a complicated question because there will be a lot of regional variation in staging, but to what extent -- to any extent you can, can you give us your sense for how you guys are thinking about that and your planning specific to the U.S.?
Joe Hogan: Yes, Steve, I think it's going to be -- it's certainly not going to be uniform in the sense of how we go about that, whether it's in the states or anywhere around the world, there are going to be certain government restrictions. I think there's going to be certain -- when I say restrictions, too, it's going to be equipment that's available from a PPE standpoint, what patients are going to be prepared to do? We see some -- if you look at treatment planning alternatives or when patients enter an office right now, they're not even coming into the office. At the time, they stay in their car until they're summoned in some way to make sure that there's less interaction and proper social distancing within the office itself. So I can't really tell you yet. The only thing is I think there's going to be a lot more caution about, obviously, transmission of the disease. That's going to include how you stage patients, how often you see these patients. And I think from a dental versus orthodontic standpoint, they are obviously going to be different protocols because of the different procedures that take place there. Steve, there's an interesting article in the New York Times yesterday that really did an X/Y kind of a graph on different types of professions that interface with customers and which ones are most time from an intimacy standpoint and could transmit a virus. And dentistry came up almost on the top of that whole thing. So I mean that's going to be watched closely, and I think we have to make sure we work with our customers -- I mean doctors and to help them through this, too.
Steve Beuchaw: Thanks for all the -- for the perspective there.
Joe Hogan: Yes. Thanks, Steve.
Shirley Stacy: Thank you, Steve.
Operator: Thank you. Our next question comes from the line of Elizabeth Anderson with Evercore ISI. Please proceed with your question.
Elizabeth Anderson: Hi, guys. Thanks for taking the question.
Joe Hogan: Hi, Elizabeth.
Elizabeth Anderson: Hope everyone is doing okay. I want to ask a question on the sort of digital access of what you guys can do in the near-term. I know you said that, you were sort of unveiling the app as sort of like a beta test, and you were rapidly rolling that forward and allowing more access and training and things to that. Can you speak to any more of the details in terms of sort of like the uptake or how the training is going or the case use of that for like ongoing patients?
Shirley Stacy: Elizabeth, just to make clear, you're talking about Virtual -- appointment of Virtual Care, right?
Elizabeth Anderson: Yes. Yes.
Joe Hogan: Elizabeth, you're talking about just training of doctors online rather than face-to-face?
Elizabeth Anderson: Oh, no. Sorry. I meant on the Virtual Care side.
Joe Hogan: Okay. And so your question is on the workflow of that. Is that --
Elizabeth Anderson: Yes. As you said -- you said they were going slow and sort of like how have you seen uptake of that so far? Is it -- I assume that there's some sort of training that has happened beforehand or how have you been able to roll that out considering that -- data testing right before you this all happen.
Joe Hogan: I get it, Elizabeth. Look, first of all, we've been -- we didn't just roll -- we just rolled this out. We've been working on it for over a year. And so we actually rush this to the market. And as we rush into the market, we were cautious in a sense of how many doctors we -- you had in the program. And we started here in the United States, and now we're gradually moving it to broader to more doctors in the U.S. and across the world, too. We had to train the doctors to do this, but the great thing it is on our IDS platform. And it has a great user interface that the team put together. So from the feedback that, I've gotten from the teams and the doctors, too, that user interface has been pretty simple in how they've been able to put that piece together. And remember, the whole idea there is just that how do you stay -- and these kind of lockdown periods or future workflows where patients don't want to come into the office all the time to see a doctor, how in the world can you track treatment and how can you communicate? And it's gone really well. And we will have actually more doctors who want it that we can give it to right now. We just want to make sure we don't burden them, and we just roll it out piece-by-piece to make sure that it's robust enough to handle more and more doctors over time.
Elizabeth Anderson: Okay. Perfect. And so just on -- you did a virtual visit with some of that in the first quarter -- over next set of patients?
Joe Hogan: Yes. More than 2,000 doctors, we have more than 2,000 doctors trained right now -- trained and beginning to use Virtual Care. And obviously, we have tens of thousands of doctors out there that we'll want to roll this out, too, and we think they'll have an interest in it.
Elizabeth Anderson: Okay. Perfect. That's helpful. Thank you.
Joe Hogan: And we've had over -- just I'm getting some other data here, too. We have over 3,500 appointments right now that have been done through Virtual Care. Elizabeth, if we think about this, too, it just makes sense, right? I mean in everybody's kind of -- in today's COVID environment, it obviously makes sense to try to eliminate patients trying to have this person-to-person contact. But I mean going forward, too, in a digital kind of environment, having these kind of tools just make sense from a productivity standpoint for both doctors and patients, too. So we'll continue to invest pretty heavily in this to get better and better at it. This is our initial launch, but you'll see more and more iterations to help to enhance this
Operator: Thank you. Our next question comes from the line of Jeff Johnson with Baird. Please proceed with your question.
Joe Hogan: Hi Jeff.
Jeff Johnson: Thank you, guys. Hey Joe, how are you? Good afternoon. Just two questions, I guess. One, we've seen some news in the last couple of days from one of your DTC competitors on some patents they were able to get and some better business bureau recommendations on some advertising. I would love your view not so much on what that means for them, but does that have any implications for you either on the Swift product where some of that is kind of a monthly fee? I don't think any of that would trip any of the stuff in their new patent, but also if they have to rein in a little bit of their advertising. I would assume that's a good thing for you, but would just like to get your view.
Joe Hogan: Jeff, overall, that's not a model that competes with us. We go directly to doctors in everything we do, work through a doctor base. And so from what we know of the -- I haven't looked at the patent or whatever. I just read most of the information that's out there. That has to do with Invisalign. And we have to do with just scanning a patient in a store and transferring a file that the -- never really reaches a doctor in any way except from a teledentistry standpoint. So, we don't see it being an issue for us at all.
Jeff Johnson: Sorry, I was on mute. Thank you. And then just my follow-up question. Obviously, we're all going to be watching PPE. We're all going to be watching patients' willingness to go into these offices. What are you hearing from the doctor side? From an orthodontist standpoint, the office is maybe a little cleaner, less aerosolization, if that's even a word, of fluids and what have you. So, are your orthodontists, especially kind of chomping at the bit to get back? I'm sure they are financially. But do they feel safe? Do they feel like this will be an environment they can bring their staff back into it can bring patients into things like that? Thanks.
Joe Hogan: From an orthodontist standpoint, Jeff, you're right to segment those two because, obviously, dentistry is a lot different than orthodontist and whatever. The orthodontists that we look to, I would say that they're not concerned, but they're cautious in the sense of what they have to do, the precautions they have to make with the patients and also with their employees internally. They are anxious to get back. But I mean there's a good degree of caution to make sure that they come back in the right way, in a thoughtful way, too. And again, I think this could vary by state also in the sense of how it's applied and what kind of regulations are put in place. But I know there's -- they're really interested to come back. And the ones that really went into this was a significant amount of Invisalign feel good that they've been able to stay in contact with their patients and be able to send passive aligners with different things that's helped in any kind of course correction or holding patients to where they are. So, on the dentistry side, I mean, that's obviously going to be different. But when you think about it, an Invisalign is one of the least invasive procedures that you're going to see in dentistry. And we'll certainly be emphasizing that and trying to work with doctors to help them through. And we talked about iGo and the growth of iGo, and that's a great -- when you think about you think when we talk about a digital platform, that's a terrific product for GPs in the sense of being able to leverage that and then send a more difficult cases of the orthodontist side. We'll be working with GPs to really help through that transition.
Jeff Johnson: Understood. Thank you.
Joe Hogan: All right, Jeff. Thank you.
Operator: Thank you. Our next question comes from the line of John Kreger with William Blair. Please proceed with your question.
John Kreger: Hi thanks very much. Joe, could you remind us what's the lag time between order receipt from a customer -- from when -- to the point where you can actually ship the aligners?
Joe Hogan: So we call it CCA, and CCA would be in order. And I'd say, John can correct me on this; I'd say it's four days to five days.
John Morici: But from an order to an after shipment, it could be three to four weeks because it's the back and forth. He's describing kind of initial to the actual shipment. It could be three to four weeks depending on how much back and forth. As you know, John, getting that treatment plan just exactly the way the doctor has and wants it takes a number of iterations. And then the actual manufacture and shipment can do. So on the outset, it could be 4 weeks in total.
John Kreger: Okay. Great. So from a fabrication standpoint, for a region like the U.S. that got locked down in mid-March that backlog probably would have -- would be reasonable to assume that kind of carried through to mid-April.
John Morici: Well, there's still going to be back and forth that goes on. So I mean you have patients that have not been able to make it into the office to look at the final plan for doctors to meet other things that go on. So it's going to vary by this until the doctor actually approve the treatment plan and then it gets manufactured. So remember, our business is a made-to-order business. I mean there's no inventory. And as things change in the environment, when there -- people can't come to the office to seek treatment or to make sure that they're going to prove that treatment plan, things shut down right away. And it takes some time to see that ramp back up.
John Kreger: Great. That's helpful. And then anything you can give us in terms of contribution from exocad since that'll be in there for the full second quarter?
John Morici: Yes. Nothing on that John that we're giving on any forward guidance other than what we've had in our prepared remarks.
Shirley Stacy: Thanks John, next question please.
Operator: Thank you. Our next question comes from the line of Kevin Caliendo with UBS. Please proceed with your question.
Kevin Caliendo: Thank you. First question, you're talking about a digital and analog world. But if I think about Align a year from now, and hopefully, we're through this, competitively, not just with other manufacturers, but against wires and brackets. I mean, is there a marketing pitch here that the orthodontist can go and say, hey, instead of using wires and brackets or you can even pitch to the orthodontist, that there might be a greater demand to use clear aligners versus wires and brackets simply because you're able to keep patients out of the -- keep them out of the orthodontist office or the dentist office more frequently? Is that something that you've contemplated that could necessarily be a positive for market share for you?
Joe Hogan: Kevin, prior to the COVID-19, we have a program called ADAPT where doctors -- orthodontists come to us and say, look, you want to go primarily 80%, 90% Invisalign. How do we do that, right? And so how do you do that, you're going to crank up your volume in a significant way. And to do that, you just needed to drive more productivity. And so we were pushing that piece is you don't have to see patients as often, right? You might have patients come back every 3 or 4 weeks to adjust wires and brackets. Likely, they're going to come back doing their episode with a wire that comes out, and it's an emergency procedure, about 20% of an orthos time that doesn't have wires and brackets or emergency cases. We talk to doctors about how you can really control your schedule much better in a digital environment and how patients don't have to come back so often. We talk about 7 weeks, 8 weeks seeing patients. Now that becomes even more magnified when you think about profitability of infection and concern about COVID-19. It's not just a productivity play. It's a way of being able to treat patients in a way that's safer for your staff and safer for those patients, too. So we'll certainly be emphasizing that. And -- but it goes -- it just goes along with a digital platform. It is -- it's much more productive. And doctors will need less time per patient. And I mean, we know that well from the millions of patients that we've done.
Kevin Caliendo: One quick follow-up. The DSO spiked. I know you made some comments earlier about offering payment terms and loans and the like. Does that explain the bump-up the nine day you said expect DSOs to continue to move higher? So what was the impact of, I guess, would be improved payment terms for the doctors on your DSOs?
John Morici: Yes. It varies by doctors and so on. But as they have working capital concerns, we're in a fortunate position to be able to help out. So we work with them to kind of manage their cash flow in terms of paying us. And then the DSO impact is obviously impacted by lower revenue as well, which causes that to increase. So -- but we're working closely with our customers, and making sure that they can help weather the storm, stay close with them. And as they start to ramp up, we want to be their partners with them, and cash is an important part of that.
Kevin Caliendo: Great. Thanks. Stay safe everybody.
John Morici: Thanks, Kevin, you too.
Shirley Stacy: Operator, we'll take one more question, please.
Operator: Thank you. Our final question comes from the line of Richard Newitter with SVB Leerink. Please proceed with your question.
Jaime Morgan: Hi, guys. This is Jaime on for Rich, this afternoon. Thanks for taking my questions. Just a housekeeping one. You guys had said in the beginning of your prepared remarks, incremental impact from COVID-19 was about 50 fewer cases and, I think, $85 million less revenue. So I just wanted to make sure that, that is something -- like the way that we should be thinking about that is incremental to what you had originally contemplated in your 1Q guidance of, I think, about 20,000 to 25,000 case impact in a $30 million to $35 million revenue impact?
John Morici: That's correct, Jaime. You would think of that as incremental to how we guided.
Jaime Morgan: Got it. So the fair way to think about that in total would be about $115 million to $120 million of impact to revenue from the coronavirus in the first quarter?
John Morici: That's correct.
Jaime Morgan: Got it. Okay. And just last one for me. Any sort of update on where you guys stand with launching the Palate Expander product?
Joe Hogan: Hi, Jaime. I'll take that. We're still -- we have the design. We're still working that piece. We have to find an effective way to manufacture it. So I don't have a date that I can give you, but I can tell you that it's high on our priority list.
Jaime Morgan: Thank you.
Joe Hogan: Thank you, Jamie.
Operator: Thank you. We have reached the end of our question-and-answer session. I'd like to turn the call back over to Ms. Stacy Shirley for any closing remarks.
Shirley Stacy: Well, thank you, everyone, for joining us. We look forward to speaking with you at upcoming virtual financial conferences in the future. If you have any questions, please contact Investor Relations, and hope you have a great day. Take care.
Operator: Thank you. This concludes today's teleconference. You may disconnect your lines at this time. Thank you for your participation. Have a wonderful day. | [
{
"speaker": "Operator",
"text": "Greetings and welcome to the Align Technology First Quarter Earnings Call. At this time, all participants are in a listen-only mode. A brief question-and-answer session will follow the formal presentation. [Operator Instructions] As a reminder, this conference is being recorded. It is now my pleasure to introduce your host Shirley Stacy, VP of Corporate and Investor Communications. Thank you. You may begin."
},
{
"speaker": "Shirley Stacy",
"text": "Thank you. Good afternoon everyone. Thank you for joining us. Joining me today is Joe Hogan, President and CEO; and John Morici, CFO. We issued first quarter 2020 financial results today via GlobeNewswire, which is available on our website at investor.aligntech.com. Today's conference call is being audio webcast and will be archived on our website for approximately one month. Telephone replay will be available today by approximately 5:30 P.M. Eastern Time through 5:30 P.M. Eastern Time on May 13th. To access the telephone replay, domestic callers should dial 877-660-6853 with conference number 13701221 followed by pound. International callers should dial 201-612-7415 with the same conference number. As a reminder, the information that the presenters discuss today will include forward-looking statements, including statements about Align's future events and product outlook. These forward-looking statements are only predictions and involve risks and uncertainties that are set forth in more detail in our most recent periodic reports filed with the Securities and Exchange Commission available on our website and at sec.gov. Actual results vary significantly, and Align expressly assumes no obligation to update any forward-looking statement. We have posted historical financial statements, including the corresponding reconciliations, if applicable, and our first quarter 2020 conference and earnings release and conference call slides on our website under Quarterly Results. Please refer to these files for more detailed information. With that, I'll turn the call over to Align Technology's President and CEO, Joe Hogan. Joe?"
},
{
"speaker": "Joe Hogan",
"text": "Thanks Shirley. Good afternoon and thanks for joining us. I hope that you and your families are well. Given the significant disruption to our business caused by the extraordinary measures taken by governments, public and private institutions, and businesses around the world to fight the spread of COVID-19, most of the performance metrics I would normally discuss are less meaningful. Therefore, on our call today, in addition to the highlights from our Q1 results, I'll discuss the trends that we're seeing through early March prior to the escalation in the COVID-19 cases that resulted in shutdowns across Europe and North America, and compounded the initial impact from similar shutdowns in China beginning in January. I'll also talk about our view of recovery and strategy to help our doctor-customers navigate this challenging environment and ensure our business continuity. John will provide more detail on our financial performance and comment on the current trends across our business globally, including the momentum we're beginning to see in China. Following that, I'll come back and summarize a few key points and open up the call to questions. With that, let me start with a few comments on our first quarter results through early March. At that time, China was progressing in line with our original guidance for Q1, which include approximately 20,000 to 25,000 fewer cases and $30 million to $35 million less revenues for Invisalign and iTero products, and other regions were performing ahead of our Q1 outlook. However, the situation quickly changed in mid-March as most governments in EMEA and North America closed down non-essential businesses initiated stay-at-home orders. As a result, the vast majority of Invisalign practices shut down and stopped seeing patients, and our business fell off sharply. We believe the incremental impact of COVID-19 on our Q1 results was approximately 50,000 fewer cases and approximately $85 million less revenues for Invisalign and iTero products. At the same time, while EMEA, North America and other parts of APAC fell off in mid-March, we began to see improvements in China as the country started to open up again. While it's still early in the recovery process and the situation is different in every city and for every practice, we're working closely with our doctors to support their current needs and ensure they have a game plan to resume operations in a very different environment for the foreseeable future. More on that in a few minutes. Now let's go through our first quarter results. For Q1, total revenues were $551 million, down 15.2% sequentially and unchanged year-over-year, reflecting significantly lower-than-expected sales of Invisalign clear aligners and iTero scanners due to the COVID-19 pandemic. Revenues from clear aligners were $481.6 million, and iTero scanners and services were $69.4 million. Clear aligner shipments were 359.4 thousand cases. Notwithstanding the impact of COVID-19, shipment volumes were up 2.9% year-over-year, reflecting solid growth from non-comprehensive products driven by Invisalign Go systems across all regions, as well as Invisalign Moderate. This was offset by a lower mix of comprehensive products primarily due to the shortfall in China. For the quarter, we shipped Invisalign cases to approximately 61,000 doctors, of which 4,100 were first time customers. We also trained over 4,600 new doctors in Q1, including 2,600 international doctors. Overall for the teen market in Q1, 104,000 teens and preteens started treatment with Invisalign clear aligners, representing 29% of total cases shipped, reflecting growth from EMEA and the Americas regions and across comprehensive products. During the quarter, we reached another major milestone with our 2 millionth Invisalign teenage patient, treatment of orthos. A student and athlete, we started treatment recently with Dr. Tom Hartzog, a U.S. based orthodontist in Kentucky. Dr. Hartzog has been a terrific practicing orthodontic for about 30 years and credits Invisalign with revitalizing his practice at a time when a lot of doctors think about slowing down. He says his approach is to lead with Invisalign, and he's got a new digital mindset now, and we're excited he's going to share more about that at our upcoming Invisalign Team Forum Virtual Edition, this July. The teen segment represents the largest portion of existing orthodontic case starts each year. And as we head into the summer season, the busiest time in orthos practice, we are working to help doctors capture as much of the teen season as possible under the circumstances. Now let's turn to specifics around our first quarter results, starting with the Americas region. For the Americas region, through early March, solid sequential growth was driven primarily by North American GP dentists and DSOs, along with continued strength in Latin American doctors. On a reported basis, Q1 Invisalign case volume was down 5.5% sequentially and up 5.2% year-over-year, reflecting significantly less-than-expected Invisalign case shipments in March due to the impact of COVID-19. Year-over-year growth for Q1 reflects growth from both orthodontists and GP dentist channels, which were up 5.6% and 4.6%, respectively. Latin America volume was up 83% year-over-year led by strong growth from Brazil. For our international business, through early March, with the exception of China, the EMEA and APAC regions were performing well. On a reported basis, Q1 Invisalign case volume was down 22.3%, sequentially, reflecting significant decrease in APAC, primarily China, due to the impact from COVID-19, partially offset by growth in EMEA. On a year-over-year basis, international shipments are flat, reflecting growth from EMEA, offset by a decline in APAC. For EMEA, Q1 volumes were down sequentially and up 11.1% on a year-over-year basis driven by growth in Spain, the U.K. and Germany, along with our expansion markets led by Central Eastern Europe and Benelux, including the teen segment. For APAC, Q1 was down sequentially as expected, reflecting a significant reduction in volume in China due to COVID-19. On a year-over-year basis, APAC was down 18.2% compared to the prior year, reflecting a longer duration of COVID-19 measures implemented in China, and was the only region down year-over-year. Japan, Taiwan, Korea and India saw continued year-over-year growth in Q1. And as noted earlier, we began to see signs of improvement in China in early March as the government began to relax some, or all of the restrictions and business began the road to recovery. Our consumer marketing is focused on building the clear aligner category and driving demand for Invisalign treatment through a doctor's office. In Q1, we saw strong digital engagement globally, including 7.1 million unique visitors to our websites and 274,000 leads, both metrics growing by more than 40%. Consumer engagement growth for Invisalign was enabled by the launch of our new consumer campaign, Invis, strong media spend and a robust omni-channel presence. Our Invisalign concierge team is nurturing consumer leads and virtually until doctor's office is open, which is key to realizing and converting consumer interest into cases. Further, our modeling indicates that consumer marketing drove incremental growth in Q1 and reinforces our strategy to invest in brand building and maintain high visibility with consumers through the COVID-19 crisis. Other key metrics showing increased activity and engagement with the Invisalign brand and are included in our Q1 quarterly slides. For iTero scanner and services business, Q1 revenues were down sequentially as expected, following a seasonally strong Q4 and consistent with trends in the capital equipment market. Q1 also reflects the impact of COVID-19 across all regions in especially North America, Australia, China, Japan and other APAC countries. On a year-over-year basis, iTero scanner revenues were down 13.1%, due to lower sales in North America and APAC region primarily due to COVID-19 despite increased revenues in EMEA and Latin America, reflecting the addition of Zimmer Biomet distribution agreement, the introduction of our iTero 5D going direct to Mexico and additional LATAM distributor markets. The total year-over-year decrease in scanner revenue was slightly offset by increased services revenue from a larger iTero installed base. Cumulatively, over 23 million orthodontic scans, 5.2 million restorative scans have been performed with iTero scanners. For Q1, total Invisalign cases submitted with a digital scanner in the Americas increased to 80.5% from 76.1% in Q1 last year. International scans increased 68.7%, up from 59.3% in the same quarter last year. We're pleased to see that within the Americas, 93.6% of cases submitted by North American orthodontists were submitted digitally. I'm also pleased to share that we received FDA 510(k) clearance for iTero Element 5D Imaging System. The iTero Element 5D Imaging System seamlessly combines three scanning technologies, 3D data, intraoral color photos and NIRI images. NIRI is near-infrared imaging technology, which allows you to see carries in different aspects from a dentition standpoint. It's an integrated scan, and we're excited to bring the advancement in inter oral scan technology to the United States market to help doctors provide better oral care for their patients. At this time, we're mindful of the current environment and the impact that COVID-19 pandemic is having across the world and are focused on customer education and training regarding this new technology while so many dental practices in the U.S. are operating on a limited schedule. We remain confident that the iTero business will continue to help drive our overall long-term growth and help increase adoption of the digital platform with Invisalign treatment. To that end, during the quarter, we announced the acquisition of exocad, a global CAD/CAM software leader, and completed the transaction on April 1st. John will talk more about the acquisition in a moment, but let me say just that the rise in consumer awareness around dentistry extends beyond the benefits of straight teeth and orthodontics. There are significant opportunities for all kinds of treatments, from simple cosmetic fixes to ortho-restorative that can help us accelerate growth of our digital solutions for ortho-restorative cases and really drive growth and adoption of the Invisalign iTero digital platform. I'm very excited about the addition of exocad's proven restorative experience, expertise, and functionality to our platform, and I want to welcome exocad Founders, Till Steinbrecher and Maik Gerth and the entire exocad team to Align. Let me now turn to some of the initiatives we've taken to support our doctors and their patients. We recognize the enormous hardship that COVID-19 has caused Invisalign practices around the world. We're working in every region to support doctors and find ways to minimize disruptions to their businesses and to strengthen the experiences their patients have with Invisalign treatment. We have learned a lot from our doctor partners and teams in the Asia-Pacific region, and we've been navigating the impact of COVID-19 for months. We're applying their experiences and insights across all regions. Many of our customers are sharing creative ideas and suggestions as we all work to manage the situation together. One of the first things we did was address clinical education, an integral part of doctor engagement. Across all three of our regions, we moved most of our education programs to online digital platforms, continuing to provide hundreds of valuable Invisalign and iTero training and education resources, many peer-to-peer for doctors and their teams in a virtual setting. We also identified opportunities to collaborate with Invisalign practices to manage ongoing cases and explore new ways for doctors to conduct consultations. Early on, many doctors began using video calls, text, and patients submitted photos through a variety of platforms to help monitor patient progress, reduce in-office appointments, and ensure continuity of patient care during treatment. It quickly became clear that doctors needed a better way to connect and monitor patients. So, we accelerated the launch of new tools that were still in pilot mode. The Invisalign virtual appointment tool enables doctors to easily set up HIPAA-compliant video appointments to monitor existing patients and to have an initial conversation with patients interested in learning more about Invisalign clear aligner treatment for the doctor. The Invisalign virtual care program can also use video appointments and enables doctors to monitor treatment progress and stay connected with patients through a virtual platform. Patients use the intuitive My Invisalign app to stay engaged in the treatment and convey progress photos to their doctor who review these photos on their Invisalign doctor's site, communicates any needed instruction, and ensures treatment is on track. These tools are available through our Invisalign Doctor Site, IDS, in the My Invisalign app and work as part of the end-to-end digital platform for Invisalign treatment. While both tools are still in early stages of rollout, our goal is to provide doctors with a way to maintain care until patients are again able to visit the doctor's office. Feedback to-date has been relatively positive, and we believe that doctors will continue using these tools to improve patient experience and increase efficiencies well after COVID-19 restrictions have been listed. We're also supporting doctors through financial and operating challenges and are providing additional resources, including industry experts to help navigate this ongoing crisis. This includes webcast, e-blast and micro sites on IDS again, the Invisalign Doctor Site, with advice on extending aligner wear and holding patients at specific treatment stages; options for redirecting aligner shipments and helping address customer cash flow concerns caused by the pandemic. We're creating programs with partners like LendingPoint that are part of recovery playbooks to help doctors with speed to cash that is expected to launch in May -- on May 1. Before I turn the call over to John, I'd like to spend a few minutes talking about the strength and resiliency of Align and our business model and our view of the path to recovery. There's no question that we are in uncharted territory. And while supporting our doctors in their current situation is still critical right now, planning for recovery is just as important. Overcoming challenges is not new to Align and our employees. Our response to COVID-19, decisions and investments we are making, now to anticipate customer needs and adapt in a dynamic environment are based in part on the lessons learned throughout our history and will further our competitive advantage and position us to capitalize on the market as it returns. We serve a huge under-penetrated market, and our share of more than 300 million people who want a better smile is less than 3%. Teens are an important segment, and our share is a small fraction of the market. And yet, we know that teens remain the heart and soul of orthodontic practices and will drive their recovery. There's no single blueprint for us to follow in this recovery. Our underlying business is healthy. We have an excellent balance sheet with no debt. And over the last 5 years, we've grown a business that has generated 25% compounded revenue growth and consistently delivered 72% gross margins, 22% operating margins and generated cash flow from operations in excess of 22% of revenues each year. We also have operational resiliency in terms of global manufacturing that has taken us years to develop and is simply unmatched, and is a key reason why we're able to continue operations in the crisis and expect to ramp up quickly in recovery. The core components being supply chain, digital treatment planning, treat aligner fabrication, AFAB, supply chain. During normal business, we carry enough buffer stock in our warehouse to handle 2 disruptions to the supply chain. So if a batch go sideways, we can handle that twice. After COVID-19 broke in China, we anticipated that we needed to mobilize existing suppliers and add 3 to 6 months of additional inventory so that we could weather the potential storm. For many of our suppliers, we have alternative redundant suppliers in case of shutdown in one geography impacts a supplier. Treat, the investments we have made over the years in having Treat in multiple locations, allows us some flexibility in business continuity to respond to customer needs. Before COVID-19, we had evaluated potential for doing treatment planning from home or remote locations and the implications to hardware needs, data security and productivity. When COVID-19 hit China, we ramped up our ability to do that and started transitioning our CAD designers to do treatment planning at home and have been successful in that sense. We are confident we could have maintained 80% of our normal output, but volumes fell off before we could prove that point. China hit first, so we load balanced with our other Treat locations. So as this went from east to west, we didn't have significant issues in our treatment operations. This is our model, and we'll continue to strengthen it going forward. Aligner fabrication, we have aligner fabrication operations in Huang, China and Juarez, Mexico and plans for a third facility in Europe that we're looking to accelerate into 2021. Our facilities have excess capacity built in. And while we never have 100% redundancy, we do have the ability to shift production volumes based on that excess capacity. Worst case scenario, if one of these facilities goes down, then customers wait a little longer for their aligners, but production will continue, and we believe we can recover swiftly. In short, when we have an issue in one part of the world, we have designed our operations to enable us to load balance across facilities. We've had to do this, because of our growth and huge growth spurts that made it necessary to remain flexible. Additionally, the steps we've implemented during COVID crisis like work-from-home for CAD designers gives us even more flexibility, and we'll leverage that going forward as we evaluate facilities requirements and potential cost savings. Beyond our business strength and operational resiliency, we are at the forefront of digital dentistry. And this pandemic has exposed the weakness of analog approaches and strengthens and benefits the digital technology in every aspect of our life. There's been a lot of concern over the years about digital driving us apart and keeping people from interacting. People focused on their screens in social media rather than with each other, interacting with businesses online rather than in person, et cetera. I think what we're seeing through this terrible situation is that digital actually unites us. It keeps us connected, gives us flexibility and options. Without digital technology during this crisis, how would kids go to school? How would any of us be productive working from home? How would universities and public health experts, model the curve without data mining and AI? I am proud and thankful of our digital platform is able to Invisalign patients moving forward in treatment, while physical practices are closed, that it can connect doctors and patients to monitor issues and track treatment, that because of digital, we can get a replacement aligner for some new retainers to a kid sheltering in place. And together with doctors, we're going to leverage that power of digital for dentistry and orthodontics more than ever. Doctors are not going back to before. We all know that digital dentistry is the future, and that is a part of why Align is weathering this pandemic and why I believe we are well positioned for success going into recovery. With that, I'll now turn it over to John."
},
{
"speaker": "John Morici",
"text": "Thanks, Joe. Now for our Q1 financial results. Total revenue for the first quarter was $551 million, down 15.2% from the prior quarter and up 0.4% from the corresponding quarter a year ago. For clear aligners, Q1 revenues of $481.6 million, was down 11.4% sequentially across all regions driven by Asia Pacific. Year-over-year clear aligner revenues growth of 2.6% reflects growth from EMEA and the Americas, offset by APAC. Clear aligner revenue growth was unfavorably impacted by approximately $6 million or approximately 1 point year-over-year from foreign exchange. Q1 Invisalign ASPs were up sequentially by approximately $15 to $1,255, primarily due to lower net deferrals due to a decrease in primary case shipments across all regions. On a year-over-year basis, Q1 Invisalign ASPs increased approximately $10, primarily reflecting price increases in all regions and increased additional aligner revenues, partially offset by promotional discounts and unfavorable foreign exchange. Total Q1 Invisalign shipments of 359,400 cases were down 13.1% sequentially and up 2.9% year-over-year. Our scanner and services revenue for the first quarter was $69.4 million, down 34.7% sequentially due to volume decreases in all regions. Year-over-year revenues were down 13.1%, primarily due to volume decreases in North America, partially offset by increases in EMEA and LatAm, and increases in service revenue off an increased installed base. Moving on to gross margin, first quarter overall gross margin was 71.6%, down one point sequentially and down 1.6 points year-over-year. On a non-GAAP basis, excluding stock-based compensation expense, overall gross margin was 71.8% for the first quarter, down one point sequentially and down 1.6 points year-over-year. Clear aligner gross margin for the first quarter was 73%, down 1.1 points sequentially and down 1.9 points year-over-year, primarily due to lower volumes and higher cost per case, partially offset by an increase in Invisalign ASPs. Scanner gross margin for the first quarter was 61.8%, down 3.1 points sequentially and 1.8 points year-over-year due to increased manufacturing variances, lower ASPs and partially offset by higher service revenue. Q1 operating expenses were $324.4 million, up sequentially 1.1% and up 3.2% year-over-year. The sequential increase in operating expenses reflects higher legal and outside services. Year-over-year, the increase reflects our continued investment in sales and R&D activities, including increased compensation from additional headcount and consumer marketing spend, partially offset by the $29.8 million charge related to the Invisalign store closure costs recorded in Q1 of 2019. Our first quarter operating income was $69.9 million, down 53.7% sequentially and down 20.3% year-over-year. Our first quarter operating margin was 12.7%, down 10.6 points sequentially and down 3.3 points year-over-year. The sequential decrease in operating income and operating margin are primarily attributed to lower volume, revenue, and gross margin as a result of the COVID-19 impact. Operating margin was impacted by approximately 0.8 points year-over-year from foreign exchange. On a year-over-year basis, the decrease in operating margin and operating margin primarily reflects lower gross profit and higher operating expenses related to go-to-market activities, partially offset by the $29.8 million charge related to the Invisalign store closure in Q1 2019. On a non-GAAP basis, which excludes stock-based compensation, acquisition-related costs and impairment, and other costs related to Invisalign store closures in the prior year, operating margin for the first quarter was 17. 1%, down 9.3 points sequentially and down 8.1 points year-over-year. Interest and other income expense net for the first quarter was an expense of $16.9 million, including a $9.2 million hedge loss related to the anticipated exocad acquisition. Excluding the hedge loss, interest and other income expense net was $7.4 million expense on a non-GAAP basis. With regards to the first quarter tax provision, our tax rate was negative 2,745%, which includes a onetime tax benefit of approximately $1.5 billion associated with the recognition of a deferred tax asset related to the intra entity sale of certain intellectual property rights, resulting from our corporate structure reorganization completed during the quarter. This deferred tax benefit will be amortized starting in 2020 and continue into subsequent quarters and years. The period over which the tax benefit will be recognized depends on the profitability of our Swiss headquarters and is still under assessment and review with the Swiss tax authorities. Excluding the tax benefit related to our corporate structure reorganization and the related tax effects on stock-based compensation and other non-GAAP adjustments, the first quarter tax rate on a non-GAAP basis was 33.2% compared to 29 -- 20.9% in prior quarter and 22.8% in the same quarter a year ago. The non-GAAP tax rate was higher-than-forecasted due to lower-than-expected profits in regions outside the U.S. First quarter diluted earnings per share was $19.21, up $17.68 sequentially and up $18.32 compared to the prior year. On a non-GAAP basis diluted earnings per share was $0.73 for the first quarter, down $1.03 sequentially and down $0.52 year-over-year. Moving on to the balance sheet, as of March 31, 2020, cash, cash equivalents and marketable securities were $790.7 million, a decrease of approximately $77.9 million from the prior quarter, which is primarily due to the annual bonus payout and the purchase of an additional San Jose, California facility combined with slower AR collections. Of our $790.7 million of cash and cash equivalents, $119.2 million was held in the U.S. and $671.5 million was held by our international entities. Q1 accounts receivable balance was $533 million, down approximately 3.1% sequentially. Our overall days sales outstanding, DSOs, was 87 days, up 11 days sequentially and up 9 days as compared to Q1 last year. We expect DSOs to increase in Q2 as a result of anticipated lower collections. Cash flow from operations for the first quarter was $9.8 million. Capital expenditures for the first quarter were $46.1 million, primarily related to our continued investment in increasing aligner capacity and facilities. Free cash flow, defined as cash flow from operations less capital expenditures, amounted to negative $36.3 million. Under our May 2018 repurchase program, we still have $100 million available for repurchase of our common stock. On April 1, 2020, we completed the acquisition of privately held exocad global whole needs, GMBH, a global leader in the dental CAD/CAM software market for a purchase price of approximately $430 million in cash. The acquisition of exocad broadens our digital platform reached by adding technology that addresses restorative needs in an end-to-end digital platform workflow to facilitate ortho restorative and comprehensive dentistry and also brings exocad's expertise in restorative dentistry, implantology, guided surgery and smile design of the Align Technology portfolio. We expected to complement and extend our Invisalign and iTero digital solutions paving the way for new seamless cross-disciplinary dentistry in the lab and at chairside. exocad also broadened our platform reach in the digital dentistry with close to 200 partners and more than 35,000 licenses installed worldwide. Now, let me turn to our outlook. As Joe described earlier, through early March, our business was performing well, and we believe we would exceed our Q1 guidance. However, things quickly changed in the latter part of March as the majority of Invisalign practices in our core markets in EMEA and the Americas regions closed their offices and stop seeing patients, which caused Invisalign case receipts to drop rapidly and continue into April. At this time, due to the fluid market condition caused by the COVID-19 pandemic, we are not providing guidance for Q2, and we are withdrawing our prior commentary regarding our full year 2020. What I can offer is the following directional commentary. For China, which was the first major country impacted by COVID-19 and was shut down almost overnight at the end of January, as reflected in our Q1 guidance provided on the January earnings call. It has shown continued improvement beginning in early March. Our case receipts or orders in China are currently running at 80-plus percent of mid-January's level, but with fair amount of variability week-to-week in between various provinces and cities. Keep in mind that there is about a three to four week lag between case receipts and orders to case shipments. China provinces are not uniform in their recovery, but all continue to improve. Guangdong, Shanghai and Ziyang are now at or above pre-pandemic levels. Beijing and Hubei's slower recovery is consistent with later reopening and/or heavier restrictions. Early indications of patient flow is also positive, but it's too early to determine, if it is pent-up demand due to the lockdown. We also heard today that China is lifting travel restrictions within China, which should facilitate business. APAC, excluding China, is still very fluid as Japan shut down later than the rest of APAC and other countries like Taiwan and Korea are also improving, but our trailing China For the Americas, its unclear how volume will evolve due to staggered lockdown and subsequent staggered re-openings by state. We would expect the situation in the U.S. to be similar to what we've seen in China with recovery starting in the states in the middle of the country working its way out to the coast, on a city-by-city basis. In LATAM, it is still fluid as it is shut down later than the rest of the Americas. The EMEA market is beginning to open up, and Germany is making good strides. We are monitoring each market to see how each is responding to the various government isolation regulations and is still fluid and a lot of variability week-to-week. For iTero, as a result of COVID-19, we did see some deferral purchase decisions at the end of the quarter, and I would expect that to continue. We finished Q1 with $791 million in cash and cash equivalents. Since then, we have closed our purchase of exocad for $431 million on April 1st. Align's priorities during the pandemic are to take care of our employees, customers and shareholders. With these priorities in mind, we are taking actions to ensure the business is well positioned to weather the pandemic. In order to maintain our financial health, we are taking the following actions; holding our current headcount level steady to support the initiatives Joe discussed while making sure we are prepared for the market recovery; controlling discretionary spending such as travel and meeting-related expenses; slowing some of our capital expenditures; and working with many vendors who have allowed us to increase payment terms, while providing extended payment terms to many of our customers. As always, we are balancing future investments to drive growth in a vastly underpenetrated market versus making the appropriate cost reductions and cash actions that have less impact to the business. With that, I'll turn it over to Joe for final comments. Joe?"
},
{
"speaker": "Joe Hogan",
"text": "Thanks John and thanks again for joining us today. Before I close, I want to take a minute to talk about some of Align's actions to support relief efforts in the communities in which we live and work. One of the things that makes Align a great place to work is the concern our employees have for the world around us and their commitment to helping others. The passion is core to our purpose of transforming smiles and changing lives. And in this time of need, how we support our employees and customers and serve our communities is more important than ever. Early on in the outbreak, we donated RMB1 million to the Chinese Red Cross to support relief efforts and what were then some of the hardest hit areas. More recently, we committed $1 million to the Align Foundation, Align's donor advised fund through Fidelity Charitable. And our teams have been working together to source and supply additional personal protection equipment, or PPE, and medical supply donations for frontline health care workers in the communities we serve. Here's some slides to give you more details on this. Finally, thanks to the ingenuity and diligence of our manufacturing engineering team, we're able to leverage our 3D printing technology and manufacturing expertise to produce face shields and medical swabs for COVID-19 testing kits. Through our network of connections with hospitals across the globe, we are donating them to hospitals with the most critical needs. As our existing 3D printing equipment is highly customized for aligner fabrication and can't be reconfigured, we acquired some new separate 3D printers to specifically help with relief efforts. I'm extremely proud of what our employees are doing individually to make a difference in what Align is doing as a business overall. In summary, we're all operating in a tough environment. And even as we start to see signs of recovery in some geographies, we don't know when we'll get back to normal or even near-normal operations. As always, we're committed to the safety and well-being of our employees, doctor partners, their staff and patients. That remains our top priority in the weeks and months ahead. That and working with our stakeholders and communities to get through this together. With that said, I want to make it clear that we are not resting on our laurels waiting for the business in better days. Align Technology believes in playing offense and investing for our future. And that includes, first and foremost, protecting the jobs of our employees and keeping them ready to pivot for a fast recovery. That means no furloughs, no reduced salaries, staying focused on our long-term strategy. Employees remain our most strategic asset. Closing the exocad acquisition in early April to help expand our digital platform for the ortho restorative treatment. We are very excited about this opportunity. Adding resources to support international expansion. For example, approximately 100 new sales reps in China, improving virtual treatment options, and releasing new products and digital tools to meet our customers' needs like Invisalign virtual appointment and Invisalign virtual care to help doctors and patients connect while practices are closed and beyond. Key to expanding our digital platform in a post-COVID-19 environment, investing in marketing in media to reach of consumers while they're at home during the pandemic and keep our brand top of mind, something that other companies have stopped to conserve cash. Extending our working capital to help our customers manage their cash flow and expenses. We are very aware of the near-term volume challenges of consumer sheltering in place, closed ortho and dental offices and possible delays in new treatment as consumers go back to work and evaluate their priorities. But we're still focused on investing in a vastly under-penetrated market and believe that Align is uniquely positioned for recovery and continued growth coming out of the pandemic. COVID-19 will continue to have significant implications to the world and to our industry. Our digital platform has made it possible for thousands of doctors and patients to continue Invisalign treatments throughout this global disruption, thanks to the digital orthodontics and Invisalign aligners, digital treatment planning and virtual monitoring and care. I think coming out of this, more doctors than ever will have experience the benefit of digital treatment and digital tools for their practices and many we have seen firsthand the limitations and frustrations of the traditional analog approach to patient treatment like wires and brackets. With that said, I want to thank you again for joining the call. I look forward to updating you on our progress as the year unfolds. Now I'll turn the call over to our operator for questions."
},
{
"speaker": "Operator",
"text": "[Operator Instructions] Our first question comes from the line of Nathan Rich with Goldman Sachs. Please proceed with your question."
},
{
"speaker": "Nathan Rich",
"text": "Good afternoon. Thanks for the question and hope you and Align team are all doing well. Appreciate all the color you gave on the call. I guess, Joe, maybe starting with China, serving potentially as a guide for how the U.S. and EMEA might recover. Was there anything that you would call out in terms of either the types of cases or the channels that started to come back first, I guess, in China? And as we think about, if China does serve as a guide for the U.S., does that sort of mean that we're looking at sort of like 3 to 4 months for kind of those case receipts to get back to that 80% level that you referenced in your remark."
},
{
"speaker": "Joe Hogan",
"text": "You know first of all you know China is China, right. China has a very rigid lockdown procedures they were into this first; I don’t think you can really take up that from China in this vector work at United States from a Western geography in general. We also see as John indicated in his written script, is that this is coming up in China by city. And we see Beijing and Wuhan area and all Hubei Province being behind in that sense. So I think as you look at the United States, too, New York and California will come up differently than the middle part of the nation is what we're seeing right now, too. So you talked about some segmentation in the sense of how it's come back in China, too, remember, it's primarily a comprehensive product base that we have in China. And it's pretty much stay. I mean we're selling some moderate there and some different things. But it's primarily coming back as a comprehensive piece. So again, I don't think that's a vector that we'll use when you look at other areas, too. So I mean there's no question, Nathan, the other countries will come back. I'm just very reluctant to take a vector from China and really relate that to the Western economies in different countries because it's all being handled differently around the world."
},
{
"speaker": "Nathan Rich",
"text": "Okay. Joe, I appreciate that. I guess just a quick follow-up. I mean when you think about these practices kind of opening back up, and you made some comments about how you're supporting customers, are there any changes that you're thinking about from like a marketing or levers that you've kind of used in the past, maybe gearing those up as you think about helping volumes start to kind of get back to more normalized levels?"
},
{
"speaker": "Joe Hogan",
"text": "And we honestly feel that, particularly in the orthodontic community, there'll be a much harder leaning toward a digital kind of environment because with the chance of re-infection rates with COVID-19 and concerns about future shutdowns or slowdowns, as we mentioned in our scripts, you just have a lot of variability and flexibility that you can use in a digital format that you can't use in an analog format. So we'll be going to our customers with programs that really help them through to figure out, how to convert more and more of their volume to a digital environment. Not that, we haven't done that before, but we'll be very specific about it. And as we move into teen season, teen season in second quarter, you'll see us really focused on teens because we know Orthos will be focused on teens, too. And that's a different demographic. It segments differently in a sense of our product lines like first and math. And we'll also be ready with PPE equipment and other things. They'll prepare doctors for the concerns that they're going to have of protecting their patients and also their employees, too. Did I miss anything, John, or anything you'd add?"
},
{
"speaker": "Shirley Stacy",
"text": "Thanks, Nathan. Next question, please."
},
{
"speaker": "Operator",
"text": "Thank you. Our next question comes from the line of Brandon Couillard with Jefferies. Please proceed with your question."
},
{
"speaker": "Brandon Couillard",
"text": "Hi. Thanks. Good afternoon."
},
{
"speaker": "Joe Hogan",
"text": "Hey, Brandon."
},
{
"speaker": "Brandon Couillard",
"text": "Joe and John, can you sort of just talk about the flexibility you have in your cost structure, how much of OpEx is discretionary or variable? It sounds like you're focused on kind of holding Align in terms of headcount and marketing. But how should we think about the leverage you have to kind of control costs during this period right now?"
},
{
"speaker": "John Morici",
"text": "Hey, Brandon, this is John. Yes, as we said, there are levers that we could pull. Just as we accelerate growth, there's levers we pull. And when we look at our existing OpEx, as we look to spend some of our marketing dollars, where we spend it, how we spend it, there's levers around that spend. As with the travel restrictions and less conferences and so on there's a lot of other operating expenditures that can be pushed out and not spent currently. So we're focused in on and still investing for the future to be able to work with our doctors, as Joe has mentioned, on a lot of new technologies and making sure that we keep the employees and the focus that we have on our structure that we have, but we'll modulate as we needed -- as we need to going forward, if it's needed."
},
{
"speaker": "Brandon Couillard",
"text": "Okay. Thanks. And then a follow-up for Joe. As you think about sort of the leverage you have to drive demand, would you expect to be somewhat more aggressive in terms of ASPs? And are you planning to adjust your Advantage program levels or hurdles to give that as a bit of a break given they've had their offices closed? Thanks."
},
{
"speaker": "Joe Hogan",
"text": "Brandon, we've already extended up from an Advantage tier standpoint with our customers, when they went into that. So, I don't know, how much of an effect that will have on an ASP standpoint, because we basically be holding them to where they are. But overall, it's not price. It's our strategy here as we come up out of here. It's how do we support our customers in a digital environment. We're trying to explain how do we -- how do we really support them from a PPE standpoint and an export standpoint. We talked about loans, different things from a cash flow standpoint. We know many of them are going to be challenged in that way. And we have been offering some payables relief and deferral going forward. So it's a broad aspect of needs, we think, our customers will have. Advantage is one part of that, but it's what we can bring to these customers holistically to help their practice and help them grow."
},
{
"speaker": "Brandon Couillard",
"text": "Okay. Thanks."
},
{
"speaker": "Joe Hogan",
"text": "Yes."
},
{
"speaker": "Operator",
"text": "Thank you. Our next question comes from the line of Jon Block with Stifel. Please proceed with your question."
},
{
"speaker": "Jon Block",
"text": "Great, thanks guys."
},
{
"speaker": "Joe Hogan",
"text": "Hey Joe."
},
{
"speaker": "Jon Block",
"text": "Joe, you mentioned protecting employees, no furloughs or salary cuts. I'm just curious about the competition. And has anything changed in the marketplace around the competitive landscape? We've heard some chatter about sort of, call it, cut back in the orthodontic divisions -- of some of the other players, but maybe you can elaborate on what you're hearing or seeing out there."
},
{
"speaker": "Joe Hogan",
"text": "Hey Jon, I won't be specific, but I mean, most of our competitors have had layoffs or cutbacks in some way. We've been just been blessed with a really strong balance sheet going in. This allows us to have the flexibility and do it as we do. We're a growth business. You know that Jon well. We're set up for 20% to 30% kind of growth, and we have to position ourselves for that. In that sense, making sure that our production capacity is ready, that our employee base is ready, too. Our sales teams are really critical in that sense, too and it's wonderful. We can see some of the investments like Invisalign Virtual Assistance and things that we're working with customers right now, that we can launch those products and continue to drive those products going forward with a full force engineering team also. So, from a competitive standpoint, I mean, we're seeing varying degrees of cutbacks and moves in that sense. But we're not focused on that, Jon, really. We're just focused on what we think we should do, what's important in our portfolio, and how we can help our doctors out."
},
{
"speaker": "Jon Block",
"text": "Okay. Helpful. The second one is a little bit long. But just some Swift. I know you kicked off a pilot recently. I think it's an important sort of initiative long-term to better get after the lower acuity market. I'm just curious, Joe, you kicked it off when there was a lot going on, so did you get enough of a signal during that time to share some takeaways from the Swift initiative? And then could we see you lean on that a little bit more in coming months? Because it is a little bit more price-sensitive for the consumer. It has a monthly. And in this environment of job uncertainty might really resonate. So curious your thoughts there. Thanks guys."
},
{
"speaker": "Joe Hogan",
"text": "Yes, Jon, when we launched Swift, timing couldn't be worse in that sense because COVID hit pretty far after that, but we got a pretty strong signal in that, that we think we understand at least part of the demand equation. We're going to look at rolling that out in a broader sense going forward in the United States and maybe in different parts of the world. But I think when you talked about the price point on ASP and different things, and obviously, we broach that with the doctors who are part of the Swift program. But Jon, you know this; I want to make sure our colleagues understand. This is -- our margins on this product line are accretive to our gross margin area and how we're going into it. So, it's really important in how we position that going forward. But again, those 300 million patients out there, we know there's some price sensitivity and then there's some clinical aspects from a simplicity standpoint that we're going out with that product line. And we think it will respond real well in a broader sense as we begin to roll that out."
},
{
"speaker": "Jon Block",
"text": "Okay. Perfect. Thanks guys."
},
{
"speaker": "Joe Hogan",
"text": "Thanks Jon."
},
{
"speaker": "Operator",
"text": "Thank you. Our next question comes from the line of Steve Beuchaw with Wolfe Research. Please proceed with your question."
},
{
"speaker": "Joe Hogan",
"text": "Hi Steve."
},
{
"speaker": "Steve Beuchaw",
"text": "Hey there. Thanks for the time here. I also wanted to ask in a way about Swift, but with a very different angle. As we think about the operating environment prospectively for some amount of time, people are going to be concerned about safety. And so I wonder to what extent, and you definitely alluded to this in your prepared remarks, can you flex some of the technology that you have with Swift and some of the things you have in development to decrease the amount of face-to-face contact? Again, I know you alluded to this, but I wonder if you could take it a few steps further, give us more context, a little bit more insight into your plans. How do you think about making Invisalign treatment achievable with a minimum of in-person interaction for those who might be concerned about that even in an environment where PPE is more widely used?"
},
{
"speaker": "Joe Hogan",
"text": "Steve, that's top of mind as we do things today, too. So actually, even before COVID, when we designed Swift, Swift was designed for basically 2 to 3-doctor direct contact and that's it. And that was part of making the equation for doctors a profitable equation, too. Then you roll in our remote monitoring capability we just rolled out, which gives doctors a tool to be able to do that, and we'll be able to enhance that tool going forward. There's limited amount of attachments in IPR on things like Swift, too. And it's not that our clinical protocols are going to, in some way, decrease in the sense of what the clinical capability are and what we can do. We're also cognizant in the sense of time and mouth. And we'll adjust that. We might tie those things differently to help doctors, too. But there's a lot of different things that we're contemplating. We talked about at the conference last year about direct printed attachments and those kinds of things that in the future and not-too-distant future, will allow a lot less contact and a lot of speed from a productivity standpoint with doctors and patients be able to do those things. So it's the right line of questioning, Steve. So remote monitoring, a digital platform that allows us to anticipate exactly when you'll be seeing a patient and what will need to be done in that sense, not duplicating treatments at the office that don't need to be done and keeping up with patients in a sense remotely and only calling them in when something goes away or a doctor has a concern in some way. So we feel our digital platform and things we have in the pipeline, Steve, we're really well positioned to address that."
},
{
"speaker": "Steve Beuchaw",
"text": "Okay. Good. Good to hear. The second question I wanted to ask actually relates to the practice in the U.S. So it's been -- well, for some of us months, but for -- in practices, certainly many weeks. How do you think about the most likely, as you talk to the orthodontic and dental societies, the most likely path forward for practice reopening in the U.S.? And I know it's a complicated question because there will be a lot of regional variation in staging, but to what extent -- to any extent you can, can you give us your sense for how you guys are thinking about that and your planning specific to the U.S.?"
},
{
"speaker": "Joe Hogan",
"text": "Yes, Steve, I think it's going to be -- it's certainly not going to be uniform in the sense of how we go about that, whether it's in the states or anywhere around the world, there are going to be certain government restrictions. I think there's going to be certain -- when I say restrictions, too, it's going to be equipment that's available from a PPE standpoint, what patients are going to be prepared to do? We see some -- if you look at treatment planning alternatives or when patients enter an office right now, they're not even coming into the office. At the time, they stay in their car until they're summoned in some way to make sure that there's less interaction and proper social distancing within the office itself. So I can't really tell you yet. The only thing is I think there's going to be a lot more caution about, obviously, transmission of the disease. That's going to include how you stage patients, how often you see these patients. And I think from a dental versus orthodontic standpoint, they are obviously going to be different protocols because of the different procedures that take place there. Steve, there's an interesting article in the New York Times yesterday that really did an X/Y kind of a graph on different types of professions that interface with customers and which ones are most time from an intimacy standpoint and could transmit a virus. And dentistry came up almost on the top of that whole thing. So I mean that's going to be watched closely, and I think we have to make sure we work with our customers -- I mean doctors and to help them through this, too."
},
{
"speaker": "Steve Beuchaw",
"text": "Thanks for all the -- for the perspective there."
},
{
"speaker": "Joe Hogan",
"text": "Yes. Thanks, Steve."
},
{
"speaker": "Shirley Stacy",
"text": "Thank you, Steve."
},
{
"speaker": "Operator",
"text": "Thank you. Our next question comes from the line of Elizabeth Anderson with Evercore ISI. Please proceed with your question."
},
{
"speaker": "Elizabeth Anderson",
"text": "Hi, guys. Thanks for taking the question."
},
{
"speaker": "Joe Hogan",
"text": "Hi, Elizabeth."
},
{
"speaker": "Elizabeth Anderson",
"text": "Hope everyone is doing okay. I want to ask a question on the sort of digital access of what you guys can do in the near-term. I know you said that, you were sort of unveiling the app as sort of like a beta test, and you were rapidly rolling that forward and allowing more access and training and things to that. Can you speak to any more of the details in terms of sort of like the uptake or how the training is going or the case use of that for like ongoing patients?"
},
{
"speaker": "Shirley Stacy",
"text": "Elizabeth, just to make clear, you're talking about Virtual -- appointment of Virtual Care, right?"
},
{
"speaker": "Elizabeth Anderson",
"text": "Yes. Yes."
},
{
"speaker": "Joe Hogan",
"text": "Elizabeth, you're talking about just training of doctors online rather than face-to-face?"
},
{
"speaker": "Elizabeth Anderson",
"text": "Oh, no. Sorry. I meant on the Virtual Care side."
},
{
"speaker": "Joe Hogan",
"text": "Okay. And so your question is on the workflow of that. Is that --"
},
{
"speaker": "Elizabeth Anderson",
"text": "Yes. As you said -- you said they were going slow and sort of like how have you seen uptake of that so far? Is it -- I assume that there's some sort of training that has happened beforehand or how have you been able to roll that out considering that -- data testing right before you this all happen."
},
{
"speaker": "Joe Hogan",
"text": "I get it, Elizabeth. Look, first of all, we've been -- we didn't just roll -- we just rolled this out. We've been working on it for over a year. And so we actually rush this to the market. And as we rush into the market, we were cautious in a sense of how many doctors we -- you had in the program. And we started here in the United States, and now we're gradually moving it to broader to more doctors in the U.S. and across the world, too. We had to train the doctors to do this, but the great thing it is on our IDS platform. And it has a great user interface that the team put together. So from the feedback that, I've gotten from the teams and the doctors, too, that user interface has been pretty simple in how they've been able to put that piece together. And remember, the whole idea there is just that how do you stay -- and these kind of lockdown periods or future workflows where patients don't want to come into the office all the time to see a doctor, how in the world can you track treatment and how can you communicate? And it's gone really well. And we will have actually more doctors who want it that we can give it to right now. We just want to make sure we don't burden them, and we just roll it out piece-by-piece to make sure that it's robust enough to handle more and more doctors over time."
},
{
"speaker": "Elizabeth Anderson",
"text": "Okay. Perfect. And so just on -- you did a virtual visit with some of that in the first quarter -- over next set of patients?"
},
{
"speaker": "Joe Hogan",
"text": "Yes. More than 2,000 doctors, we have more than 2,000 doctors trained right now -- trained and beginning to use Virtual Care. And obviously, we have tens of thousands of doctors out there that we'll want to roll this out, too, and we think they'll have an interest in it."
},
{
"speaker": "Elizabeth Anderson",
"text": "Okay. Perfect. That's helpful. Thank you."
},
{
"speaker": "Joe Hogan",
"text": "And we've had over -- just I'm getting some other data here, too. We have over 3,500 appointments right now that have been done through Virtual Care. Elizabeth, if we think about this, too, it just makes sense, right? I mean in everybody's kind of -- in today's COVID environment, it obviously makes sense to try to eliminate patients trying to have this person-to-person contact. But I mean going forward, too, in a digital kind of environment, having these kind of tools just make sense from a productivity standpoint for both doctors and patients, too. So we'll continue to invest pretty heavily in this to get better and better at it. This is our initial launch, but you'll see more and more iterations to help to enhance this"
},
{
"speaker": "Operator",
"text": "Thank you. Our next question comes from the line of Jeff Johnson with Baird. Please proceed with your question."
},
{
"speaker": "Joe Hogan",
"text": "Hi Jeff."
},
{
"speaker": "Jeff Johnson",
"text": "Thank you, guys. Hey Joe, how are you? Good afternoon. Just two questions, I guess. One, we've seen some news in the last couple of days from one of your DTC competitors on some patents they were able to get and some better business bureau recommendations on some advertising. I would love your view not so much on what that means for them, but does that have any implications for you either on the Swift product where some of that is kind of a monthly fee? I don't think any of that would trip any of the stuff in their new patent, but also if they have to rein in a little bit of their advertising. I would assume that's a good thing for you, but would just like to get your view."
},
{
"speaker": "Joe Hogan",
"text": "Jeff, overall, that's not a model that competes with us. We go directly to doctors in everything we do, work through a doctor base. And so from what we know of the -- I haven't looked at the patent or whatever. I just read most of the information that's out there. That has to do with Invisalign. And we have to do with just scanning a patient in a store and transferring a file that the -- never really reaches a doctor in any way except from a teledentistry standpoint. So, we don't see it being an issue for us at all."
},
{
"speaker": "Jeff Johnson",
"text": "Sorry, I was on mute. Thank you. And then just my follow-up question. Obviously, we're all going to be watching PPE. We're all going to be watching patients' willingness to go into these offices. What are you hearing from the doctor side? From an orthodontist standpoint, the office is maybe a little cleaner, less aerosolization, if that's even a word, of fluids and what have you. So, are your orthodontists, especially kind of chomping at the bit to get back? I'm sure they are financially. But do they feel safe? Do they feel like this will be an environment they can bring their staff back into it can bring patients into things like that? Thanks."
},
{
"speaker": "Joe Hogan",
"text": "From an orthodontist standpoint, Jeff, you're right to segment those two because, obviously, dentistry is a lot different than orthodontist and whatever. The orthodontists that we look to, I would say that they're not concerned, but they're cautious in the sense of what they have to do, the precautions they have to make with the patients and also with their employees internally. They are anxious to get back. But I mean there's a good degree of caution to make sure that they come back in the right way, in a thoughtful way, too. And again, I think this could vary by state also in the sense of how it's applied and what kind of regulations are put in place. But I know there's -- they're really interested to come back. And the ones that really went into this was a significant amount of Invisalign feel good that they've been able to stay in contact with their patients and be able to send passive aligners with different things that's helped in any kind of course correction or holding patients to where they are. So, on the dentistry side, I mean, that's obviously going to be different. But when you think about it, an Invisalign is one of the least invasive procedures that you're going to see in dentistry. And we'll certainly be emphasizing that and trying to work with doctors to help them through. And we talked about iGo and the growth of iGo, and that's a great -- when you think about you think when we talk about a digital platform, that's a terrific product for GPs in the sense of being able to leverage that and then send a more difficult cases of the orthodontist side. We'll be working with GPs to really help through that transition."
},
{
"speaker": "Jeff Johnson",
"text": "Understood. Thank you."
},
{
"speaker": "Joe Hogan",
"text": "All right, Jeff. Thank you."
},
{
"speaker": "Operator",
"text": "Thank you. Our next question comes from the line of John Kreger with William Blair. Please proceed with your question."
},
{
"speaker": "John Kreger",
"text": "Hi thanks very much. Joe, could you remind us what's the lag time between order receipt from a customer -- from when -- to the point where you can actually ship the aligners?"
},
{
"speaker": "Joe Hogan",
"text": "So we call it CCA, and CCA would be in order. And I'd say, John can correct me on this; I'd say it's four days to five days."
},
{
"speaker": "John Morici",
"text": "But from an order to an after shipment, it could be three to four weeks because it's the back and forth. He's describing kind of initial to the actual shipment. It could be three to four weeks depending on how much back and forth. As you know, John, getting that treatment plan just exactly the way the doctor has and wants it takes a number of iterations. And then the actual manufacture and shipment can do. So on the outset, it could be 4 weeks in total."
},
{
"speaker": "John Kreger",
"text": "Okay. Great. So from a fabrication standpoint, for a region like the U.S. that got locked down in mid-March that backlog probably would have -- would be reasonable to assume that kind of carried through to mid-April."
},
{
"speaker": "John Morici",
"text": "Well, there's still going to be back and forth that goes on. So I mean you have patients that have not been able to make it into the office to look at the final plan for doctors to meet other things that go on. So it's going to vary by this until the doctor actually approve the treatment plan and then it gets manufactured. So remember, our business is a made-to-order business. I mean there's no inventory. And as things change in the environment, when there -- people can't come to the office to seek treatment or to make sure that they're going to prove that treatment plan, things shut down right away. And it takes some time to see that ramp back up."
},
{
"speaker": "John Kreger",
"text": "Great. That's helpful. And then anything you can give us in terms of contribution from exocad since that'll be in there for the full second quarter?"
},
{
"speaker": "John Morici",
"text": "Yes. Nothing on that John that we're giving on any forward guidance other than what we've had in our prepared remarks."
},
{
"speaker": "Shirley Stacy",
"text": "Thanks John, next question please."
},
{
"speaker": "Operator",
"text": "Thank you. Our next question comes from the line of Kevin Caliendo with UBS. Please proceed with your question."
},
{
"speaker": "Kevin Caliendo",
"text": "Thank you. First question, you're talking about a digital and analog world. But if I think about Align a year from now, and hopefully, we're through this, competitively, not just with other manufacturers, but against wires and brackets. I mean, is there a marketing pitch here that the orthodontist can go and say, hey, instead of using wires and brackets or you can even pitch to the orthodontist, that there might be a greater demand to use clear aligners versus wires and brackets simply because you're able to keep patients out of the -- keep them out of the orthodontist office or the dentist office more frequently? Is that something that you've contemplated that could necessarily be a positive for market share for you?"
},
{
"speaker": "Joe Hogan",
"text": "Kevin, prior to the COVID-19, we have a program called ADAPT where doctors -- orthodontists come to us and say, look, you want to go primarily 80%, 90% Invisalign. How do we do that, right? And so how do you do that, you're going to crank up your volume in a significant way. And to do that, you just needed to drive more productivity. And so we were pushing that piece is you don't have to see patients as often, right? You might have patients come back every 3 or 4 weeks to adjust wires and brackets. Likely, they're going to come back doing their episode with a wire that comes out, and it's an emergency procedure, about 20% of an orthos time that doesn't have wires and brackets or emergency cases. We talk to doctors about how you can really control your schedule much better in a digital environment and how patients don't have to come back so often. We talk about 7 weeks, 8 weeks seeing patients. Now that becomes even more magnified when you think about profitability of infection and concern about COVID-19. It's not just a productivity play. It's a way of being able to treat patients in a way that's safer for your staff and safer for those patients, too. So we'll certainly be emphasizing that. And -- but it goes -- it just goes along with a digital platform. It is -- it's much more productive. And doctors will need less time per patient. And I mean, we know that well from the millions of patients that we've done."
},
{
"speaker": "Kevin Caliendo",
"text": "One quick follow-up. The DSO spiked. I know you made some comments earlier about offering payment terms and loans and the like. Does that explain the bump-up the nine day you said expect DSOs to continue to move higher? So what was the impact of, I guess, would be improved payment terms for the doctors on your DSOs?"
},
{
"speaker": "John Morici",
"text": "Yes. It varies by doctors and so on. But as they have working capital concerns, we're in a fortunate position to be able to help out. So we work with them to kind of manage their cash flow in terms of paying us. And then the DSO impact is obviously impacted by lower revenue as well, which causes that to increase. So -- but we're working closely with our customers, and making sure that they can help weather the storm, stay close with them. And as they start to ramp up, we want to be their partners with them, and cash is an important part of that."
},
{
"speaker": "Kevin Caliendo",
"text": "Great. Thanks. Stay safe everybody."
},
{
"speaker": "John Morici",
"text": "Thanks, Kevin, you too."
},
{
"speaker": "Shirley Stacy",
"text": "Operator, we'll take one more question, please."
},
{
"speaker": "Operator",
"text": "Thank you. Our final question comes from the line of Richard Newitter with SVB Leerink. Please proceed with your question."
},
{
"speaker": "Jaime Morgan",
"text": "Hi, guys. This is Jaime on for Rich, this afternoon. Thanks for taking my questions. Just a housekeeping one. You guys had said in the beginning of your prepared remarks, incremental impact from COVID-19 was about 50 fewer cases and, I think, $85 million less revenue. So I just wanted to make sure that, that is something -- like the way that we should be thinking about that is incremental to what you had originally contemplated in your 1Q guidance of, I think, about 20,000 to 25,000 case impact in a $30 million to $35 million revenue impact?"
},
{
"speaker": "John Morici",
"text": "That's correct, Jaime. You would think of that as incremental to how we guided."
},
{
"speaker": "Jaime Morgan",
"text": "Got it. So the fair way to think about that in total would be about $115 million to $120 million of impact to revenue from the coronavirus in the first quarter?"
},
{
"speaker": "John Morici",
"text": "That's correct."
},
{
"speaker": "Jaime Morgan",
"text": "Got it. Okay. And just last one for me. Any sort of update on where you guys stand with launching the Palate Expander product?"
},
{
"speaker": "Joe Hogan",
"text": "Hi, Jaime. I'll take that. We're still -- we have the design. We're still working that piece. We have to find an effective way to manufacture it. So I don't have a date that I can give you, but I can tell you that it's high on our priority list."
},
{
"speaker": "Jaime Morgan",
"text": "Thank you."
},
{
"speaker": "Joe Hogan",
"text": "Thank you, Jamie."
},
{
"speaker": "Operator",
"text": "Thank you. We have reached the end of our question-and-answer session. I'd like to turn the call back over to Ms. Stacy Shirley for any closing remarks."
},
{
"speaker": "Shirley Stacy",
"text": "Well, thank you, everyone, for joining us. We look forward to speaking with you at upcoming virtual financial conferences in the future. If you have any questions, please contact Investor Relations, and hope you have a great day. Take care."
},
{
"speaker": "Operator",
"text": "Thank you. This concludes today's teleconference. You may disconnect your lines at this time. Thank you for your participation. Have a wonderful day."
}
] | Align Technology, Inc. | 24,568 |
ALGN | 4 | 2,021 | 2022-02-02 16:30:00 | Operator: Greetings. Welcome to the Align Q4 '21 Earnings Call. [Operator Instructions] Please note this conference is being recorded. I will now turn the conference over to your host, Shirley Stacy, with Align Technology. You may begin.
Shirley Stacy: Thank you. Good afternoon, and thank you for joining us. I'm Shirley Stacy, Vice President of Corporate Communications and Investor Relations. Joining me for today's call is Joe Hogan, President and CEO; and John Morici, CFO. We issued fourth quarter and full year 2021 financial results today via Globe Newswire, which is available on our website at investor.aligntech.com. Today's conference call is being audio webcast and will be archived on our website for approximately 1 month. The telephone replay will be available today by approximately 5:30 p.m. Eastern Time through 5:30 p.m. Eastern Time on February 16. To access the telephone replay, domestic callers should dial (877) 660-6853 with conference number 13725950 followed by #. International callers should dial (201) 612-7415 with the same conference number. As a reminder, the information provided and discussed today will include forward-looking statements, including statements about Align's future events and product outlook. These forward-looking statements are only predictions and involve risks and uncertainties that are described in more detail in our most recent periodic reports filed with the Securities and Exchange Commission available on our website and at sec.gov. Actual results may vary significantly, and Align expressly assumes no obligation to update any forward-looking statements. We've posted historical financial statements, including the corresponding reconciliations including our GAAP to non-GAAP reconciliation, if applicable, and our fourth quarter and full year 2021 conference call slides on our website under quarterly results. Please refer to these files for more detailed information. With that, I'll turn the call over to Align Technology's President and CEO, Joe Hogan. Joe?
Joe Hogan: Thanks, Shirley. Good afternoon, and thanks for joining us. On our call today, I'll provide some highlights from the fourth quarter, then briefly discuss the performance of our 2 operating segments, Services Systems and Clear Aligners. John will provide more detail on our financial results and discuss our outlook. Following that, I'll come back and summarize a few key points and open the call to questions. Overall, I'm very pleased to report fourth quarter results and another record year -- full year for Align. Net revenues of $4 billion and operating margin of 24.7% were both at the high end of our guidance for fiscal 2021. For Systems and Services, full year revenues increased 90.4% over the prior year to a record $705.5 million. For Clear Aligners, full year revenues increased 54.5% over the prior year to a record $3.2 billion. During 2021, we achieved several major installed base milestones, including our 12 millionth Invisalign patient, 68,000 iTero scanners sold and 47,000 Exocad software license install. Together, these elements are the foundation of the Align Digital platform. Proprietary combination of software, systems and services designed to provide a seamless experience and workflow that integrates and connects all users, doctors, labs, patients and consumers. For Q4, revenues reflect continued strong growth and momentum from iTero scanner services revenues, particularly in North America, offset by lower-than-expected Invisalign Clear Aligner revenues. Through most of the fourth quarter, our Clear Aligner volumes were trending in line with our Q4 seasonality. However, the environment quickly changed in December with the rise of COVID-19 Omicron variant. We believe our Q4 Clear Aligners volumes were impacted by an increase in COVID-19 Omicron cases that cause customer lab shortages from a staff standpoint, practice closures or reduced hours and less patient traffic in December and that continued into Q1. This compounded an already slower seasonal period for many practices in which offices took time off in between the holidays. We estimate that our Q4 was negatively impacted by roughly 3 points of year-over-year revenue growth as a result of these factors. While there are some similarities to what we experienced 2 years ago when COVID-19 first appeared, especially in China, which currently has a 0 tolerance COVID policy, the environment today is total -- today is different. There aren't broad government-mandated shutdowns, stay-at-home orders or extended quarantines, but there is more consumer caution, self-imposed quarantines, higher inflation, less economic stimulus and supply chain shortages, which makes it more difficult to predict when recovery may occur. Nonetheless, Invisalign doctor submitters and case submissions are improving. We're working closely with our customers to support their needs and protect the health and safety of our employees. For Q4, Systems and Services revenues were up 61.3% year-over-year and up 21% sequentially, with strong revenue growth across all regions. Q4 results reflect the continued adoption of the iTero Element 5D Plus imaging system, which we launched last year and that features innovative technology like Near Infrared technology with aid in detection and monitoring of interproximal caries lesions or cavities above the gingiva without harmful radiation. The iTero Element 5D Plus imaging system represents 75% of iTero volumes in Q4. In addition, over 50% of iTero scanner sales in Q4 were sold to first-time scanner buyers who are just beginning their Align Digital Platform journey. We also continue to see growth in our iTero scanner installed base with strong service revenues, which historically have been a leading indicator of increased digital adoption among doctors. For Q4, Clear Aligners revenues were up 16.3% year-over-year with strong revenue growth across all regions and across the portfolio, including comprehensive and noncomprehensive products as well as Invisalign First, Invisalign Moderate and Invisalign Go products. Our fourth quarter revenues also include non-case revenue for clinical training and education, doctor prescribed retainer products and other dental consumables. During the quarter, we saw good performance from our retainer business overall, delivering strong revenue growth, along with increased enthusiasm for the doctor subscription program pilot in North America. As we mentioned last quarter, our share of the retention market is significantly underpenetrated even more so than our share of the orthodontic case starts. We have been developing a robust retainer strategy, including a separate marketing team, focused solely on driving adoption and increasing market share in the U.S. Our objective is to build brand awareness for Vivera retainers and drive engagement with doctors through clinical education and sales initiatives, while connecting consumers to doctors through demand creation programs and our concierge service. We've also recently implemented social media campaigns featuring the benefit of Vivera from the makers of Invisalign Clear Aligners. We believe that incremental investments will increase value for Invisalign practices and contribute to growth consistent with our long-term financial model target. Q4 non-case revenues also include accessories and consumables such as Aligner cases, clamshells, cleaning crystals, Invisalign Whitening Pen and other oral health products that are available on our e-commerce channel, including the Invisalign accessory store, walmart.com and amazon.com. We view these ancillary products as a natural brand extension, enabling patient and doctor behavior with the power in the Invisalign brand. Our full year results reflect continued adoption and demand for both the Invisalign system and iTero systems and services and exocad CAD/CAM software as more doctors transform their practices to digital and more consumers need to transform their smiles through doctor-directed Invisalign treatment. Now let's turn to the specifics around our fourth quarter results, starting with the Americas. For the Americas region, full year 2021 Invisalign case volumes were up 57.6%. For Q4, Invisalign case volumes were up 11.5% year-over-year, reflecting growth across the region, especially in LatAm. On a sequential basis, American shipments were down 7.9%, primarily reflecting the impact of Omicron previously described as well as a seasonally slower teen season from Q3 to Q4. We also saw higher GP and adult case volume and continued momentum from our doctor subscription plan pilot. In Q4, we pledged a $1 million donation to the American Association of Orthodontists Foundation, the charitable arm of the American Association of Orthodontists in support of the science of orthodontics. We're also investing in educational grants, programs to provide universities with greater access to all line products for education and training purposes. Through these programs, our partnership with the aligner intensive fellowship and the other in-person educational programs, we are investing in the orthodontic profession through the people who care for and treat patients directly. For Systems and Services, Q4 was a strong quarter for Americas, driven by continued adoption of iTero 5D Plus imaging system across customer channels, including our DSO partners. Services revenues continue to grow nicely, reflecting the growth of the iTero scanner installed base in North America. For the full year, international Invisalign case volume was up 51.6%. For our international business, Q4 Invisalign case volumes were up 10.7% year-over-year on tough comps compared to 2020. On a sequential basis, international shipments were up 1.7%. Notwithstanding the impact of Omicron in December, we still saw strong growth in EMEA, offset somewhat by a seasonally slower period primarily in China. For the full year, EMEA Invisalign volume was up 69.5%. For EMEA, Q4 Invisalign case volumes were up 14.9% year-over-year, with broad-based growth across all markets, led by Italy and Iberia, along with continued growth in our expansion markets in Turkey, Russia, CIS and Benelux. For Q4, year-over-year Invisalign case volume in EMEA was driven by increased submissions primarily from the orthodontist channel. On a sequential basis, despite the impact of Omicron, EMEA Invisalign case volume was up 13.6%, primarily as a result of strong ortho channel performance especially in the teen market. During Q4, we began commercial operations in Africa, with our initial focus on North Africa and then plan to enter Sub-Sahara Africa and South Africa this year further broadening our expansion markets in EMEA. It's exciting opportunity for Align in this untapped and expanding totally addressable market. We're also making great progress on building our Europe and manufacturing facility in Wroclaw, Poland, which will be our third global aligner manufacturing operation. The Europe manufacturing facility is on track to go live during the first half of 2022, further increasing our ability to efficiently provide the Invisalign system to our valued doctor customers within the European region. For Q4, we saw strong scanner shipments during the quarter as more doctors in the EMEA region continue to digitize their practices. Through a full year APAC, Invisalign case volume was up 27.1%. For Q4, APAC Invisalign case volumes led by Japan, Korea and India were up 3.4% year-over-year on tough comps despite continued COVID resurgences and lockdown sporadically impacting various APAC countries, including China. We also saw strength in the GP dentist channel with increased Invisalign submitters and in the teen market with increased submissions from the orthodontic channel. On a sequential basis, APAC was down 15.4% notwithstanding the impact of Omicron in December and Q4 seasonality in China. We had strong growth in Thailand, Southeast Asia, Taiwan. Overall, it was encouraging to see record numbers of shipments to those markets in APAC and that were not as impacted by the most severe lockdowns. In Q4, Systems and Services in APAC saw the highest percentage of iTero scanners sold to new doctors. Today, we announced new Invisalign Systems innovations for the Align Digital platform, a proprietary combination of software, systems and services, designed to provide a seamless experience and workflow that integrates and connects all users, doctors, labs, patients and consumers. These new innovations include ClinCheck live update for 3D controls; the Invisalign Practice App; Invisalign Personalized Plan, or IPP; and the Invisalign Smile Architect. We believe they will revolutionize digital treatment planning for orthodontics and restorative dentistry by providing doctors with greater flexibility, consistency of treatment preferences and real-time treatment planning access and modification capabilities. Each of these innovations is designed to enhance Invisalign treatment planning quality, efficiency and scale and contribute to better doctor patient engagement and treatment outcomes. ClinCheck live update for 3D controls enables real-time ClinCheck treatment plan modifications that improve practice productivity significantly while also improving quality of treatment plans. Invisalign practice app provides mobile integration with the Invisalign Doctor Site or IDS. It enables doctors to manage their practices at their fingertips. Invisalign's Personal Plan, or IPP, automatically applies the doctor's specific treatment preferences for comprehensive cases, enhancing efficiency and step changing treatment planning consistency. Invisalign Smile Architect software is designed for GP dentists to create and visualize orthodontic restorative treatment plans for their patients using iTero digital scans and wide smile photos on the Invisalign Go platform. The technical design assessment go-to-market is scheduled for Q4 '22. We know that every Invisalign trained doctor has distinct preferences. Every patient is unique and every treatment plan can vary depending on a variety of factors such as the type of malocclusion, patient age and desired outcome. Because of that, doctors spend time planning and reviewing and modifying their ClinCheck plans and it multiplies with practice growth. IPP and ClinCheck live update for 3D controls are game-changing innovations that represent a step change in digital treatment planning to help doctors achieve more personalized ClinCheck treatment plans. By using 3D controls, doctors can see greater efficiency with changes reflected in real time. Invisalign Smile Architect combines basically driven in ortho restorative treatment planning within the power of ClinCheck software, providing flexibility across treatment planning to address a variety of patient needs, whether it may be orthodontic, restorative or ortho restorative combined. It allows doctors to share their vision with patients and use digital technology and tools to achieve the best quality clinical outcomes for their patients. It's through the convergence of advancements in digital technology, Align's unique capabilities and know-how, and data from millions of Invisalign patients that we’re able to bring these new Invisalign innovations to our customers this year. The journey to deliver a ClinCheck live update in Invisalign Personal Plan has taken thousands of combined person years of development, testing and learning. It is only possible through the experience data and insights we have gained from over 12 million Invisalign cases. Across our innovations, we're also using a combination of AI and automation to reimagine what the treatment planning experience looks like for our doctors, doctor customers and augmenting their expertise and experience to help them create and personalize and modify Invisalign treatment plans more efficiently and more consistently than ever before. What used to take several days can now be accomplished in just a few minutes, and it's a huge productivity win for doctors and their patients. Our consumer marketing is focused on educating consumers about the Invisalign system and driving that demand to Invisalign doctors offices, ultimately capitalizing on the massive market opportunity to transform 500 million smiles. Consumer interest in the Invisalign brand remains high, and we are continuing to invest in building the brand in key markets and customer segments. This includes investments in social media as an effective channel to increase awareness and interest for Invisalign treatment. We're continuing to work closely with our media partners to reach consumers with the right creative and compelling campaigns, optimize our buys and test new approaches. In Q4, we continued to build on our successful "Invis is" multi-media campaign across the Americas, EMEA and APAC and drove awareness and interest in Invisalign treatment with adult, teen and parent consumer segments. Globally, we delivered record impression volume with over 8 billion impressions, representing 84% year-over-year growth and 21.7 million unique visitors to our website, a 127% increase year-over-year. In the U.S., we amplified our campaigns across the top social media platforms such as TikTok, Snapchat, Instagram and YouTube to increase awareness with teens about Invisalign treatment. Our campaigns continue to feature some of the largest teen influencers from our Invisalign Smile Squad, such as Collins, Devon Key, Charli D'Amelio and Michael Lay, each of whom share their personal experiences with Invisalign treatment and why they chose to transform their smiles with Invisalign aligners. Our consumer marketing programs also include connecting with teams within gaming, specifically on Twitch, with a customized integration that was awarded the gold medal in the Annual Internationalist Awards for innovation in digital marketing solutions. To continue growing our young adult business across the Americas, EMEA and APAC, we built upon our successful "Invis Is a Powerful Thing” campaign, which highlights the power of Invisalign treatment transformation for every young adult self confidence. Our integrated media plans across YouTube, Snapchat, Instagram, Facebook and TikTok connected with young adults in the media channels, they consume the most. In Brazil, we continue to amplify our "Invis Is a Powerful Thing" powerful thing campaign, featuring mega influencer, Taís Araujo, driving a 400% year-over-year increase in web traffic. In the EMEA region, we successfully expanded into new markets such as Italy in the Netherlands. To complement our integrated media plan with Google and YouTube, we also leverage newer media channels such as TikTok and Snapchat to drive engagement with consumers resulting in more than 170% year-over-year increase in unique visitors. We continue to expand our investment in consumer advertising across the APAC region, resulting in a 192% year-over-year increase in unique visitors and a 235% year-over-year increase in impressions. We continue to strengthen our investments in Australia leveraging leading influencers featured in premium placements in TikTok and also YouTube. In Japan, we continue to see strong response from consumers as evidenced by 117% year-over-year increase in unique visitors. Lastly, we expanded our advertising investments in India and Taiwan, which generated a strong consumer response. We saw 1,200% and 628% increase in impressions and a 470% and 116% increase in unique visitors to our website in India and Taiwan, respectively. Adoption of our consumer and patient app, My Invisalign continued to increase with 1.4 million downloads to date. Usage of our 4 digital tools continues to increase. For example, in addition to My Invisalign just mentioned, the Invisalign virtual appointment tool was used over 14,000x and our insurance verification feature was used 20,000x in Q4. Further, globally, we received more than 45,000 patient photos in our virtual care feature globally, which continues to provide us with rich data to leverage our AI capabilities and improve our services for doctors and patients. Our Systems and Services business, Q4 revenues grew 61.3% year-over-year, reflecting strong scanner shipments and services up 21% sequentially. This is the sixth consecutive quarter of sequential revenue growth for our Systems and Services business. And I as mentioned earlier, over 50% of scanner sales in Q4 were the first time iTero scanner buyers. We're pleased to see doctors continue to go digital and invest in the Align digital platform. The iTero Element 5D Plus imaging system continued to gain traction across all regions with the most recent launch in China during Q4. The series expands the portfolio of iTero Element scanners and imaging systems to include new solutions that more broadly serve the needs of doctors and patients in the dental market. A strong indicator of digital acceleration within the dental offices is a number of intraoral digital scans used for Invisalign case submissions. Total worldwide inter-oral digital scan submitted to start an Invisalign case in Q4 increased to 85.4% from 79.3% in Q4 last year. International inter-oral digital scans for Invisalign case submissions increased 80.8%, up from 73.7% in the same quarter last year. For the Americas, 89.1% of Invisalign cases were submitted using an inter-oral digital scan compared to 84% in the same quarter last year. Cumulatively, over 50 million orthodontic scans and 10.3 million restorative scans have been performed with iTero scanners. With continued growth of the iTero scanner at 68,000 scanners sold worldwide as of Q4, approximately 30% is services revenue, which includes reoccurring revenue subscriptions, CAT scan software and ancillary products. And we continue to make improvements in our scanner and imaging systems, making iTero systems and service as an integral part of orthodontic and GP dentist workflow. For example, we streamlined the Invisalign case submission process with the iTero Element 5D imaging systems Auto Upload functionality. Turning to exocad. For Q4 Systems and Services, revenues also include exocad CAD/CAM products and services. exocad's expertise in restorative dentistry, implantology, guided surgery and smile design extends our digital dental solutions and broadens Align's digital platform towards a fully integrated interdisciplinary end-to-end workflows. Cumulatively, as Q4 exocad now has over 47,000 software license worldwide. During the quarter, exocad announced the release of ChairsideCAD 3.0 Galway. It's a next generation of easy-to-use CAD software for single-visit dentistry. With this new release, exocad offers dentist design tools for a vast range of indications with a wide choice of integrated devices. Also during the quarter, exocad announced the availability of ChairsideCAD 3.0 Galway software in the U.S. and Canada, where the software is now available in North America, EU and other selected markets. Exocad’s ChairsideCAD is groundbreaking open architecture CAD software for single-visit dentistry. It received the 2021 Cellerant best-of-class technology award from Cellerant Consulting Group during the quarter as well. This is the third consecutive year that ChairsideCAD has been recognized for this award. With that, I'll now turn this over to John.
John Morici: Thanks, Joe. Now for our Q4 financial results. Total revenues for the fourth quarter were $1.31 billion, up 1.5% from the prior quarter and up 23.6% from the corresponding quarter a year ago. For Clear Aligners, Q4 revenues of $815.3 million were down 2.7% sequentially due to lower Invisalign volumes, partially offset by slightly higher ASPs and up 16.3% year-over-year, reflecting Invisalign volume growth across all geographies and higher ASPs. In Q4, we shipped 631,100 Invisalign cases, a decrease of 3.7% sequentially, an increase of 11.1% year-over-year. In addition, we shipped to 83,500 Invisalign doctors worldwide, of which over 6,400 were to first-time customers. Q4 comprehensive volume increased 13.1% year-over-year and decreased 4.5% sequentially. And Q4 noncomprehensive volume increased 6.6% year-over-year and decreased 1.7% sequentially. Q4 adult patients increased 10.4% year-over-year and increased 0.1% sequentially. In Q4, teens or younger patients increased 13% year-over-year and decreased 11.8% sequentially. Clear Aligner revenues were unfavorably impacted by foreign exchange of approximately $11.4 million or approximately 1.4 points sequentially. On a year-over-year basis, Clear Aligner revenues were unfavorably impacted by foreign exchange of approximately $1.5 million or approximately 0.2 points. For Q4, Invisalign comprehensive ASPs increased sequentially and year-over-year. On a sequential basis, Invisalign comprehensive ASPs reflect higher additional liners, partially offset by unfavorable foreign exchange and higher discounts. On a year-over-year basis, comprehensive ASPs reflect higher additional aligners, partially offset by higher discounts. Q4 Invisalign noncomprehensive ASPs decreased sequentially and increased year-over-year. On a sequential basis, Invisalign noncomprehensive ASPs were unfavorably impacted by foreign exchange, partially offset by higher additional aligners. On a year-over-year basis, Invisalign noncomprehensive ASPs reflect higher additional liners and product mix, partially offset by higher discounts. Clear Aligner deferred revenues on the balance sheet increased $68.5 million or 6.9% sequentially and $332.9 million or 45.8% year-over-year and will be recognized as the additional aligners are shipped. Our Systems and Services revenues for the fourth quarter were a record $215.8 million, up 21% sequentially and up 61.3% year-over-year. This marks the sixth consecutive quarter of sequential revenue growth. The increase sequentially can be attributed to increased scanner shipments and increased service revenues from our larger installed base. The increase year-over-year can be attributed to increased scanner shipments, increased service revenues from our larger installed base as well as higher ASPs from the favorable mix shift towards higher-priced iTero 5D scanners and imaging systems. Our Systems and Services deferred revenue on the balance sheet was up $42.6 million or 22.8% sequentially and up $116.2 million or 102.6% year-over-year, primarily due to the increase in scanner sales and the deferred -- and the deferral of services revenues, which will be recognized ratably over the service period. Moving on to gross margin. Fourth quarter overall gross margin was 72.2%, down 2.1 points sequentially and down 0.9 points year-over-year. On a non-GAAP basis, excluding stock-based compensation expense and amortization of intangibles related to acquisitions, overall, gross margin was 72.6% for the fourth quarter, down 2.1 points sequentially and down 0.9 points year-over-year. Overall gross margin was unfavorably impacted by approximately 0.1 points on a year-over-year basis and by approximately 0.4% sequentially due to foreign exchange. Clear Aligner gross margin for the fourth quarter was 74.2%, down 2 points sequentially due to higher freight costs and additional aligners, along with lower primary shipments, partially offset by higher ASPs. Clear Aligner gross margin was down 0.6 points year-over-year due to higher additional aligners and higher freight costs, partially offset by higher ASPs and improved manufacturing absorption due to higher volumes. Systems and Services gross margin for the fourth quarter was 64.7%, down 0.9 points sequentially, primarily due to higher freight costs and increased component costs, partially offset by higher ASP from 5D Plus mix and higher service revenues. Systems and Services gross margin was up 0.4 points year-over-year due to higher ASP from higher mix of iTero 5D Plus and higher service revenues, partially offset by higher freight costs and increased component costs. We are actively engaged in activities to mitigate supply disruptions by expanding supplier communications, modifying our purchase order coverage and increasing inventory levels for key components. Q4 operating expenses were $523.7 million, up sequentially 6% and up 31.8% year-over-year. On a sequential basis, operating expenses were up by $29.7 million. Year-over-year operating expenses increased by $126.4 million, reflecting increased headcount and our continued investment in marketing, sales, in R&D activities and other investments commensurate with business growth. On a non-GAAP basis, excluding stock-based compensation and amortization of acquired intangibles related to certain acquisitions, operating expenses were $494.4 million, up sequentially 6.1% and up 32.8% year-over-year due to the reasons described earlier. Our fourth quarter operating income of $220.9 million resulted in an operating margin of 21.4%, down 4.3 points sequentially and down 4.1 points year-over-year. The sequential and year-over-year decreases in operating margin are primarily attributed to lower gross margin, investments in our go-to-market teams and technology as well as unfavorable impact from foreign exchange. On a non-GAAP basis, which excludes stock-based compensation and amortization of intangibles related to certain acquisitions, operating margin for the fourth quarter was 24.7%, down 4.1 points sequentially and down 4.3 points year-over-year. Interest and other income and expense net for the fourth quarter was a loss of $0.9 million, down sequentially by $1.7 million and down year-over-year by $2.2 million. The GAAP tax rate for the fourth quarter was 13.2% compared to 30.9% in the third quarter and 25.9% in the fourth quarter of the prior year. Our non-GAAP effective tax rate was 11.5% in the fourth quarter compared to 22.2% in the third quarter and 14.5% in the fourth quarter of the prior fourth quarter. The fourth quarter GAAP and non-GAAP effective tax rates reflected an out-of-period adjustment, which reduced our tax rate by 7.3% and 6.3%, respectively. Fourth quarter net income per diluted share was $2.40, up sequentially $0.12 and up $0.40 compared to the prior year. On a non-GAAP basis, net income per diluted share was $2.83 for the fourth quarter, down $0.04 sequentially and up $0.22 year-over-year. For the full year, net income per diluted share was $9.69, down $12.72 year-over-year due to the onetime tax benefit in 2020 of approximately $1.5 billion associated with our corporate structure reorganization completed during the first quarter of 2020. On a non-GAAP basis, net income per diluted share was $11.22 for the full year, up $5.97 year-over-year. Moving on to the balance sheet. As of December 31, 2021, cash, cash equivalents and short-term and long-term marketable securities were $1.3 billion, up sequentially $58.8 million and up $335.8 million year-over-year. Of our $1.3 billion balance, $582.9 million was held in the U.S. and $713.8 million was held by our international entities. Q4 accounts receivable balance was $897.2 million, up approximately 4.9% sequentially. Our overall days sales outstanding was 78 days, up approximately 3 days sequentially and up approximately 7 days as compared to Q4 last year. Cash flow from operations for the fourth quarter was $272.8 million. Capital expenditures for the fourth quarter were $109.1 million, primarily related to our continued investment in increasing aligner manufacturing capability -- capacity and facilities. Free cash flow, defined as cash flow from operations less capital expenditures, amounted to $163.8 million. In November 2021, we purchased $100 million of our common stock through an accelerated share repurchase, which was approximately 0.2 million shares at an average price of $666.53 per share. We have approximately $725 million remaining available for repurchase under our May 13, 2021, $1 billion repurchase program. Before I move to our outlook, I would like to make a few comments on our full year 2021 results. In 2021, we shipped a record 2.5 million Invisalign cases, up 54.8% year-over-year. This reflects 51.6% volume growth from our international doctors and 57.6% volume growth from our Americas doctors. Total revenues were a record $4 billion, up 59.9% year-over-year with Clear Aligner revenues a record $3.2 billion, up 54.5% year-over-year. 2021 Systems and Services revenue were a record $705.5 million compared to $370.5 million in 2020, up 90.4% year-over-year. Full year 2021 GAAP operating income of $976.4 million was up 152.2% versus 2020, and operating margin at 24.7% versus 15.7% in 2020. On a non-GAAP basis, 2021 operating margin was 27.9% versus 20.3% in 2020. 2021 interest income and other income and expense net of $36 million included the SmileDirectClub arbitration award gain of $43.4 million. Excluding the SmileDirectClub arbitration award gain, interest and other income and expense was $7.4 million expense on a non-GAAP basis. With regards to full year tax provision, our GAAP tax rate was 23.7%. The full year tax rate on a non-GAAP basis was 18.5% compared to 17.6% for 2020. 2021 diluted EPS was $9.69. On a non-GAAP basis, 2021 diluted EPS was $11.22. Free cash flow was $771.4 million for 2021, up $264.2 million versus 2020. Overall, we are pleased with our Q4 results and another record year for Align. We delivered strong growth and profitability, in line with our guidance despite disruptions late in the quarter from Omicron and others factors. Our Q4 revenue year-over-year growth was within our long-term model despite disruptions impacting roughly 3 points of growth. We continue to see strong momentum and demand for our Systems and Services throughout Q4, with the majority of scanners being sold to first-time buyers. We believe this is a good leading indicator of future Invisalign growth as our customers continue to invest in digital technology even during COVID. Let me turn to our outlook. We would normally expect sequentially higher Invisalign revenues and lower Systems and Services revenue, consistent with the typical Q1 seasonality. However, due to the continued impact of Omicron into Q1, we now expect our total Q1 revenue to be slightly down sequentially. We remain confident in our strategy, our huge underpenetrated market opportunity, our industry leadership and our ability to execute. These factors have guided our approach throughout the pandemic, where we continue to invest in new technology, commercial expansion and manufacturing capabilities to drive our growth. We plan to continue these investments in Q1 and therefore, expect our Q1 operating margin to be less than 20%. In addition, during Q1 2020 -- 2022, we expect to repurchase up to $75 million of our common stock through either a combination of open market repurchases or an accelerated stock repurchase agreement. Turning to full year 2022. Despite Omicron headwinds, we expect 2022 revenue growth to be in line with our long-term model range of 20% to 30%. Our 2022 guidance assumes no significant new COVID surges after the current wave. No meaningful practice disruptions nor material supply chain issues throughout the year. On a GAAP basis, we anticipate our 2022 operating margin to be around 24%. On a non-GAAP basis, we expect 2022 operating margin to be approximately 3 points higher than our GAAP operating margin after excluding stock-based compensation and intangible amortization from certain acquisitions. For 2022, we expect our investments in capital expenditures to exceed $350 million. Capital expenditures primarily relate to building in construction and improvements as well as additional manufacturing capacity to support our international expansion. This includes our planned investment in a Clear Aligner manufacturing facility in Wroclaw, Poland, which is expected to begin serving doctors in 2022 as part of our strategy to bring operational facilities closer to customers. With that, I'll turn it back over to Joe for final comments. Joe?
Joe Hogan: Thanks, John. Overall, despite the disruption from the Omicron in December, we delivered a record year with strong revenue growth and operating margin, in line with our guidance for the full year on top of a record Q4 and 2020 a year ago. As you look back, I wanted to take a moment to recognize our accomplishments and thank our employees and our customers for another remarkable year. In the face of ongoing challenges related to COVID-19 and economic uncertainty, we remain steadfast in our commitment to our employees, customers and the focused execution of our strategic initiatives, and our customers remain confident in our ability to support them. Operating in this environment has not been easy, but after 2 years of navigating uncharted waters, the Align team is more agile and resilient than ever. In 2021, we met our goals and achieved numerous milestones. Globally, we delivered across each of our strategic priorities, which are highlighted in our Q4 '21 webcast slides. Our performance over the last year reaffirms the incredible size of our target market, and demonstrates that our strategy and investment in recent years are validated by the trust and faith our customers place in us. In 2022, we must continue to extend our leadership in digital orthodontics and restorative dentistry through relentless execution of our strategic initiatives, focusing on expanding our commercial, manufacturing, R&D, clinical, treatment planning and manufacturing operations, and building our quality and regulatory muscle globally in existing and emerging markets, reaching millions of consumers who want to transform their smiles using the most advanced Clear Aligner system in the world through the right investments in advertising, PR, digital, social media and influencer marketing to drive demand and conversion through Invisalign trained doctors. Invisalign ortho adoption and teen utilization of Invisalign treatment and training and educating GP dentists on how the iTero Element family of inter-oral scanners and imaging systems can propel today's dental practice into the future by enhancing patient experience and elevating clinical precision, and on the benefits of digital dentistry with the Invisalign system trusted by more than 12 million people worldwide to transform smiles. We remain mindful of the ongoing uncertainty surrounding COVID-19 and the challenges that go with it. While there is still uncertainty, it has become increasingly clear over the last year with the first spread of the Delta variant, now Omicron, that COVID-19 may never fully go away and may be a virus that persist in one variant form or another for the foreseeable future. And like other viruses, new or different vaccines will be needed and new therapies will be developed to minimize the impact and treat COVID-19 more effectively in our most vulnerable populations. The reality of living with COVID is one of the government's businesses and communities all over the world are beginning to acknowledge and move towards, and at Align, we will do the same. In closing, I'm going to share some thoughts that I expressed to our employees recently. What we learn in life, both in business and our personal lines, is that we're not fully in control of our environment and destiny. This is a fact of life that we face every day, but not being in control does not mean that we can't make good choices regardless of the situation or challenges we all face. We must look forward focused on the opportunities. Align has numerous growth drivers in a vastly underpenetrated market. And while we continue to see some lasting impact and continued uncertainty due to COVID-19, we remain confident in both the enormous opportunity to lead the evolution of digital orthodontics and comprehensive dentistry. We never forget that digital orthodontics presents the fastest growing and largest market in the world of medical devices. We have the greatest Clear Aligner system, scanners, GP lab software in the world and the broadest and deepest digital dental platform. We have the most recognized consumer brand in the largest direct sales force in the dental space with over 4,000 salespeople supporting over 212,000 doctors and labs and their staff, who have incredible skills and dedication to their patients. We have an amazing team of employees committed to our purpose. It's a unique opportunity unlike anything I've ever seen in my career. They both continue to grow Align and be part of the positively changing millions of lives by transforming their smiles. Thank you for your time today. We look forward to speaking to you again as the year progresses. Now I'll turn the call over to the operator. Operator?
Operator: [Operator Instructions] Our first question comes from the line of Nathan Rich with Goldman Sachs.
Nathan Rich : Joe, thanks for all the details on the outlook. You called out the 300 basis point headwind from COVID in the quarter, with the impact, I think, concentrated in December. So maybe a bit higher as we think about what the headwind was exiting the year. Could you maybe talk about how the impact in January as compared to what you experienced in December? And can you maybe elaborate on what you've seen in recent weeks? I'm just looking for a sense of maybe where January is trending and kind of what you're assuming for the balance of the quarter to get you to the guidance that you gave for 1Q?
Joe Hogan: Nathan, look, we saw what we talked about in December, we had a rapid decrease through COVID. But what we've seen as we've gone into January is just a progressive improvement. And we feel good about that. We feel it's moving in the right way. And it's in direct correlation. We track it around the country with what's going on with Omicron in certain states and certain regions. And remember, this is in just the United States. We've seen this all over the world. We see it in APAC, and we see it in Europe too when we track it.
Nathan Rich : Okay. And maybe just building on that at a high level, Joe, do you feel like the slowdown, I guess, is primarily a supply issue, just given the practice closures and lockdowns and staffing issues that you cited versus a demand issue? Because I think in your prepared remarks, you also mentioned some impacts from inflation and less stimulus. So I was just curious to kind of get your thoughts there.
Joe Hogan: No, we don't see this as a demand issue. I mean, we look at the market as we always have. That's why we reasserted our 20%, 30% growth rate for this year. So this is not a demand equation issue or you call it a supply, but I'd call it demand from a patient standpoint. We just see it's patients and doctors in the sense of cancellations, availability and all those things that COVID has impacted around. So we remain very confident. That's why you see us to continue to make investments, the things we announced today. We feel really good about the business. We just have to get through this first quarter and what we talked about, and we'll move on. We feel really good about it.
Operator: And our next question comes from the line of Matt Miksic with Credit Suisse.
Matt Miksic: Just maybe a follow-up on that -- the question on planning assumptions around your Q1 comments and 2022 guidance. Maybe, Joe, if you could just give a sense as to how -- you mentioned improvements in early January. Is this kind of sluggish recovery wrapping up by the end of the quarter? Is Q2 the inflection to help you get to that 20%, 30% growth that you mentioned? And then just if I could also on a similar topic. Just the idea that somehow there is -- you've -- I think many of the folks on the call heard this idea that somehow there was outsized growth due to the pandemic, and we're sort of digesting that somehow now, which I know it's sort of one of the ways that folks look at Align and aligners and so on. If you could maybe just talk about your confidence that, once we get through the staffing that the demand that's in front of you of the growth drivers that you're laying in on top of your core markets, that we're not looking to digest some sort of outsized growth during the pandemic here in '22, but we're getting back to a growth market that's still highly underpenetrated? Sorry for the lengthy 2-part question, but I would appreciate it.
Joe Hogan: We understand the basis of your question, Matt. That's not a problem in that sense. Look, as I mentioned before, we're really confident in demand equation in the sense of Clear Aligners and Invisalign. What we're experiencing right now is obviously somewhat of a slowdown in our order demand pattern based on what we see through the virus that's going on around the world. As soon as that clears and we see it clearing around the world, and as I mentioned, we see January improving over December, we're very confident in demand models that we've expressed for this business over the last several years.
Operator: And our next question comes from the line of Elizabeth Anderson with Evercore ISI.
Elizabeth Anderson: I guess on the first side, I think you obviously talked about some of the increased investments that you're making on marketing and also in sales capacity, et cetera. How do we think about the conversion efforts of those initiatives versus sort of prior -- and sort of where do you sort of see that hitting in terms of as we're thinking about the pacing of the year?
Joe Hogan: Yes. I mean the pacing of the year, I mean we continue to invest, as we mentioned, John mentioned, I mentioned too in marketing. Where we invest? We understand the returns that we get, no matter what the country is or what kind of media we use in order to go after consumers. So we've been very consistent in the sense of that investment. And we move money around based on where we see the most opportunity. John, anything to add?
John Morici : And we -- as we mentioned, we added some sales resources in Q4 to get ahead of sales territories and changes and so on. We saw that show up in Q4, but it really gives us the opportunity then to be able to grow as we get into this year. So it's continued investments to drive the biggest return and that's what we're continuing to do.
Elizabeth Anderson: Okay. So it sounds like maybe no change in sort of the pacing that we've been seeing before. Maybe as a follow-up, I know you obviously highlighted that the total growth of the company would be in your 20% to 30% range. Do you also see that the case growth on a year-over-year basis would be above 20% as you look out at this point?
John Morici : We'd expect them to be similar. When we talk about 20% to 30%, we're talking about revenue for the entire company, but they would be similar from an outlook standpoint.
Operator: And our next question comes from the line of Jon Block with Stifel.
Jon Block: Maybe just the first one. The outmargin compression year-over-year, the 24.7-ish gap that is to the 24%. Maybe you could talk to that, John, I was just going to say it's a gross margin thing with scanners likely to grow much faster than case vol. But to Elizabeth's question, it seems like you expect both to be within the guardrails of 20% to 30%. So is it more a function of you guys just sort of, call it, running a little bit harder on the OpEx line to drive that case volume and why we would see that year-over-year OM compression. Again, I'm just sort of referring gap-to-gap for apples-to-apples?
John Morici : I think, Jon, it's continued investments like we have with the story to continue to invest that we have and being able to be able to grow into this market. So I think when we look at it overall, we're kind of pegging the GAAP rate to be at 24% for 2022, and we'll evaluate and update as we go forward. But it's continuing to invest. We've got, as you know, our Poland facility going live in 2022. And we have some of those moving parts that will impact our gross margin slightly as a result of that, but -- and that translates to op margin. But those are the initiatives that we have, but nothing out of the ordinary that we've done in the past.
Jon Block: Okay. Heads up this next one is going to be long, probably 2 parts. But maybe can you just get people comfortable with the fact that if you look at your 2Q, 3Q, 4Q '21 case files and the implied guidance for 1Q, to get to 20% to 30% case volumes for the year, you're going to have to rip sequentially in 2Q, 3Q, 4Q of '22. Maybe if you could talk to that? And then the other sort of third question, if you would admittedly is I'm confused on the 3 points. So if 4Q was impacted by 3 points of growth, why don't you we capture, I don't know, 2 or 3 points of that in 1Q '22? Where are those cases going if they're not showing up in the next possible quarter?
John Morici : I think I'll maybe start with the last part of your question, Jon. When you think of what's happened in the world with Omicron and the effects of that, it's affecting parts of the world at different paces. You see it even within the U.S. Northeast maybe gets hit with it first. It starts to open up later. After that, maybe other parts of the country get impacted. So it's not like it just happens and you immediately get it back. It comes down to when people are able to go to work, in this case, at doctors' offices to be able to provide care and then it comes down to when patients feel comfortable to be able to go back in. And so it's not an immediate effect in how we look at it. So think of -- and what we've learned from kind of COVID 1.0, the first time we saw this, we know that there's an impact, and then there's a recovery period -- and that's our best view of that recovery period.
Joe Hogan: John, on your your other part about you have the rest of the year, we understand that. I mean we've modeled it out. Remember, our comparisons are a little better in second half than they were first half when you look at what we did in 2021 in the first half of the year. So look, we wouldn't make that prediction if we didn't think it was feasible based on what we've seen and what we've modeled.
Operator: Our next question comes from the line of Jeff Johnson with Robert W. Baird.
Jeff Johnson: Just a couple of questions here for me. I guess one, John, in 2021, you guys were talking about being within your LRP, but at the upper end of that, do you want to put any quality buyers on kind of the LRP for 2022. It feels like kind of low end, given where 1Q is starting. But one, do you want to put any qualifiers around where within that LRP you'd expect to be? And two, just to go back to the last 2 questions again. I feel like I'm talking to my 10-year-old kid here, so apologies, but I'm going to give you one more chance. Do you feel like case shipments can still grow within that LRP this year too, not just revenue because you've got some of the new products you're selling, plus you've got faster iTero growth than that, but case shipments also can be within that 20% to 30% LRP. I just want to make sure I'm hearing that correctly.
John Morici : I can answer both of those, Jeff, in terms of the 20% to 30%. We're not going to call kind of high low on that. We're kind of reaffirming our 20% to 30%, similar to what we talked about at Investor Day despite some of the things that we've talked about here with Omicron in some of those cases and so on. But when we look at Invisalign case volume, we would expect to be in and above that range. So nothing out of the ordinary from what we expect. We don't see -- our ASPs were very similar to what they were in the prior quarter, provided that there's not FX or other things that we're not projecting now. And if there's no change there, we would expect to be in that range as well.
Jeff Johnson: Fair enough. And then, Joe, maybe kind of just update us on kind of the competitive landscape. We've seen a couple of DSO contracts get announced here from others in the last few months and maybe some talk over in China about some growing competition or slowing end markets in that. But where do you see your end markets across the globe from a competitive standpoint? Would just love to hear your update there?
Joe Hogan: Jeff, I think from a competitive standpoint, nothing's really changed. As we look out there, you can see the tech we just announced this week, we move on in the sense of our capabilities, what we can do. My position has always been that competition isn't really affecting us from a price standpoint. I think you see that in what we're doing. But they do serve to help to broaden the market and increase the market and make -- increase the awareness. So we feel we are -- in this kind of competitive environment, we're doing well, and we lead in this sense and there's nothing as we go into 2022 that I won't reflect on it's changed competitively than what I've seen over the last 3 years.
Operator: And our next question comes from the line of John Kreger with William Blair.
John Kreger: John, two quick ones for you. I think you said that the receivable DSOs were up about 7 days year-over-year. Can you just expand on that? Was that -- were you providing some extra inducements to practices or anything to be concerned about there?
John Morici : Nothing to be concerned. We're in a fortunate cash position as a company to be able to generate a lot of CFOA and free cash flow. And in working with doctors to be able to give them more flexibility, sometimes we'll extend payments. But we've actually seen historically low amount of past dues as we've gone through this time period in 2021. So we feel very comfortable with that. It's just working with doctors to kind of meet their cash flow needs, but nothing out of the ordinary.
John Kreger: Okay. Great. And then one other one to clarify. I think you said that you expect the EBIT margin to be under 20% in the first quarter. Was that GAAP or non-GAAP?
John Morici : That's GAAP.
Operator: Our next question comes from the line of Jason Bednar with Piper Sandler.
Jason Bednar: Joe, just real quick, and I asked whether you can confirm you said January improved over December. I thought I heard you say that earlier in the call? Or is it just that the January trend line showed improvement as the month unfolded? Sorry for just clarifying that something nuanced like that here.
John Morici : Yes. I think to clarify, Jason, the month end showed improvement versus December. It was -- it's how COVID spreads across, whether it's one country or parts of countries and so on and how it affects the staff and how it affects the patients in. But as we exited, we're in a better trend line than we started the month with.
Jason Bednar: Okay. Understood. And then maybe as a follow-up to an earlier question, really for Joe or John. I know you often talk about the internal investments you keep making in the business, you talked about running a similar growth algorithm here in '22 as you have in the past. But we also have 2 different case examples here of the market with pre-COVID, a lot of those resources were helping funding faster growth in your team business. And then the last 18 months during the pandemic, adult demand has really taken off and growing faster than teens. So I guess my question here is, as you went through your year-end planning and you're obviously resourcing this business in another significant way here in '22, how do you approach it for this year? Is it from a sales force add marketing plan and whatnot? Is it -- are you really with respect to how you're thinking about the adult and teen mix that you're expecting for this year?
Joe Hogan: I mean we're -- it's Joe, Jason. I mean there's no big change in the sense of what we think the critical drivers are that we have to invest in to drive growth. Where we invest and how we invest is really important. When you look at technology, when you look at consumer pieces, however, parts of those demand inflations you want to go to. But remember, there are certain ratios that we always hold to in this business, its that what we invest in. And we hold ourselves accountable for those ratios and that performance from a profitability standpoint. But I can't overstate the importance of having a strong sales force. We talked about additional sales people that we are putting in place. Our consumer brand means a lot in the sense of our growth. And that's becoming more and more sophisticated in the sense of where we spend those dollars and how we spend those dollars. But leading in technology, you have to have technology in this business, and that's why we're excited to really announce what we did today. We've been working on these programs for 3 years or more. And these are game breakers in the sense of how you interface with a doctor and how a doctor interface with patients.
John Morici : And I would just add to that, Jason. We're investing with that return on investment in mind. That's how we look at our long-term growth model. And when we make investments, we have that in mind. In some countries, you're going deeper, you're adding more salespeople to get closer to doctors and really talk to drive that utilization. In other areas where you don't have a direct sales force, you're just adding and just trying to get the breadth in there. And then we've been talking about a lot of the marketing activities and other things that we do to drive that awareness in some of those markets and coupled with the research and development investments. Some of it operations, again, to get closer to our customers like in Poland. So it's a multitude of investments, but we look at it with how do we generate the best return and there's multiple different ways that we do it across these functions.
Shirley Stacy: Thanks, Jason. Operator, we'll take one more call, please?
Operator: Sure. The last question we have is from the line of Brandon Couillard with Jefferies.
Brandon Couillard: John, you've talked about freight costs for a few quarters now. Any chance you're planning a less price increase this year to help offset some of that? It's been a few years since you've taken less pricing?
John Morici : Yes, it's a good question. We are seeing freight -- it looks like many companies have. We have a lot of plans in place to drive productivity. The operating team is very aware of our cost inputs and where we can drive productivity, getting closer to our customers, like we talk in Poland. Once we get there, that will be a freight savings. And once we're operational there, and that will help. But we haven't really finalized any plans on a price increase. We'll evaluate as we go through. And the first people that we talked to would be our customers. But you're right, we understand the price is important, but we're also very sensitive to our customers and what they've had to go through as we've been on this COVID journey. So nothing in the works now.
Brandon Couillard: Okay. And then Joe, on Ontario, I appreciate the detail as far as more than 50% of placements being new buyers. I would actually expect that to be normally the case. So what's the relevancy of that metric? Is that up a lot compared to historical levels? And what percent of those placements are being used for Invisalign case submissions?
Joe Hogan: Over the years, Brandon, we've obviously seen that correlation, and we've communicated it to you in a sense if you sell more iTero scanners, you sell more Invisalign. And that's obviously, the front end of our digital system and it works for us really well. We just had to side the 50% because, one, you saw we had a very strong fourth quarter for iTero. And we always have strong fourth quarters. So this was exceptional in that sense. And it was a good signal from the practices that we're dealing with that this had to do with the day-to-day flow that you see from an Invisalign patient standpoint, it had nothing to do with their enthusiasm in the sense of embracing the digital environment that we're talking about. And so to see the number of sales that we had really in the last couple of weeks of the quarter, it was just a good signal for us. And we wanted to share that with you is that this market is embracing digital even when it's under pressure, and we're performing really well in that area. As far as 50%, whatever and how, I don't know exactly what the historical percentages are in that way. But we're -- obviously, what we're excited about is once those scanners are in place, it gives us a good foundation to sell Invisalign.
Operator: And we have reached the end of our question and session. I now turn the call back over to Shirley Stacy for closing remarks.
Shirley Stacy: Thank you. Thanks, everyone, for joining us today. We look forward to speaking to you at upcoming financial conferences and industry meetings. If you have any questions or follow-up, please contact our Investor Relations team. Have a great day.
Operator: Thank you. This concludes today's conference, and you may disconnect your lines at this time. Thank you for your participation. | [
{
"speaker": "Operator",
"text": "Greetings. Welcome to the Align Q4 '21 Earnings Call. [Operator Instructions] Please note this conference is being recorded. I will now turn the conference over to your host, Shirley Stacy, with Align Technology. You may begin."
},
{
"speaker": "Shirley Stacy",
"text": "Thank you. Good afternoon, and thank you for joining us. I'm Shirley Stacy, Vice President of Corporate Communications and Investor Relations. Joining me for today's call is Joe Hogan, President and CEO; and John Morici, CFO. We issued fourth quarter and full year 2021 financial results today via Globe Newswire, which is available on our website at investor.aligntech.com. Today's conference call is being audio webcast and will be archived on our website for approximately 1 month. The telephone replay will be available today by approximately 5:30 p.m. Eastern Time through 5:30 p.m. Eastern Time on February 16. To access the telephone replay, domestic callers should dial (877) 660-6853 with conference number 13725950 followed by #. International callers should dial (201) 612-7415 with the same conference number. As a reminder, the information provided and discussed today will include forward-looking statements, including statements about Align's future events and product outlook. These forward-looking statements are only predictions and involve risks and uncertainties that are described in more detail in our most recent periodic reports filed with the Securities and Exchange Commission available on our website and at sec.gov. Actual results may vary significantly, and Align expressly assumes no obligation to update any forward-looking statements. We've posted historical financial statements, including the corresponding reconciliations including our GAAP to non-GAAP reconciliation, if applicable, and our fourth quarter and full year 2021 conference call slides on our website under quarterly results. Please refer to these files for more detailed information. With that, I'll turn the call over to Align Technology's President and CEO, Joe Hogan. Joe?"
},
{
"speaker": "Joe Hogan",
"text": "Thanks, Shirley. Good afternoon, and thanks for joining us. On our call today, I'll provide some highlights from the fourth quarter, then briefly discuss the performance of our 2 operating segments, Services Systems and Clear Aligners. John will provide more detail on our financial results and discuss our outlook. Following that, I'll come back and summarize a few key points and open the call to questions. Overall, I'm very pleased to report fourth quarter results and another record year -- full year for Align. Net revenues of $4 billion and operating margin of 24.7% were both at the high end of our guidance for fiscal 2021. For Systems and Services, full year revenues increased 90.4% over the prior year to a record $705.5 million. For Clear Aligners, full year revenues increased 54.5% over the prior year to a record $3.2 billion. During 2021, we achieved several major installed base milestones, including our 12 millionth Invisalign patient, 68,000 iTero scanners sold and 47,000 Exocad software license install. Together, these elements are the foundation of the Align Digital platform. Proprietary combination of software, systems and services designed to provide a seamless experience and workflow that integrates and connects all users, doctors, labs, patients and consumers. For Q4, revenues reflect continued strong growth and momentum from iTero scanner services revenues, particularly in North America, offset by lower-than-expected Invisalign Clear Aligner revenues. Through most of the fourth quarter, our Clear Aligner volumes were trending in line with our Q4 seasonality. However, the environment quickly changed in December with the rise of COVID-19 Omicron variant. We believe our Q4 Clear Aligners volumes were impacted by an increase in COVID-19 Omicron cases that cause customer lab shortages from a staff standpoint, practice closures or reduced hours and less patient traffic in December and that continued into Q1. This compounded an already slower seasonal period for many practices in which offices took time off in between the holidays. We estimate that our Q4 was negatively impacted by roughly 3 points of year-over-year revenue growth as a result of these factors. While there are some similarities to what we experienced 2 years ago when COVID-19 first appeared, especially in China, which currently has a 0 tolerance COVID policy, the environment today is total -- today is different. There aren't broad government-mandated shutdowns, stay-at-home orders or extended quarantines, but there is more consumer caution, self-imposed quarantines, higher inflation, less economic stimulus and supply chain shortages, which makes it more difficult to predict when recovery may occur. Nonetheless, Invisalign doctor submitters and case submissions are improving. We're working closely with our customers to support their needs and protect the health and safety of our employees. For Q4, Systems and Services revenues were up 61.3% year-over-year and up 21% sequentially, with strong revenue growth across all regions. Q4 results reflect the continued adoption of the iTero Element 5D Plus imaging system, which we launched last year and that features innovative technology like Near Infrared technology with aid in detection and monitoring of interproximal caries lesions or cavities above the gingiva without harmful radiation. The iTero Element 5D Plus imaging system represents 75% of iTero volumes in Q4. In addition, over 50% of iTero scanner sales in Q4 were sold to first-time scanner buyers who are just beginning their Align Digital Platform journey. We also continue to see growth in our iTero scanner installed base with strong service revenues, which historically have been a leading indicator of increased digital adoption among doctors. For Q4, Clear Aligners revenues were up 16.3% year-over-year with strong revenue growth across all regions and across the portfolio, including comprehensive and noncomprehensive products as well as Invisalign First, Invisalign Moderate and Invisalign Go products. Our fourth quarter revenues also include non-case revenue for clinical training and education, doctor prescribed retainer products and other dental consumables. During the quarter, we saw good performance from our retainer business overall, delivering strong revenue growth, along with increased enthusiasm for the doctor subscription program pilot in North America. As we mentioned last quarter, our share of the retention market is significantly underpenetrated even more so than our share of the orthodontic case starts. We have been developing a robust retainer strategy, including a separate marketing team, focused solely on driving adoption and increasing market share in the U.S. Our objective is to build brand awareness for Vivera retainers and drive engagement with doctors through clinical education and sales initiatives, while connecting consumers to doctors through demand creation programs and our concierge service. We've also recently implemented social media campaigns featuring the benefit of Vivera from the makers of Invisalign Clear Aligners. We believe that incremental investments will increase value for Invisalign practices and contribute to growth consistent with our long-term financial model target. Q4 non-case revenues also include accessories and consumables such as Aligner cases, clamshells, cleaning crystals, Invisalign Whitening Pen and other oral health products that are available on our e-commerce channel, including the Invisalign accessory store, walmart.com and amazon.com. We view these ancillary products as a natural brand extension, enabling patient and doctor behavior with the power in the Invisalign brand. Our full year results reflect continued adoption and demand for both the Invisalign system and iTero systems and services and exocad CAD/CAM software as more doctors transform their practices to digital and more consumers need to transform their smiles through doctor-directed Invisalign treatment. Now let's turn to the specifics around our fourth quarter results, starting with the Americas. For the Americas region, full year 2021 Invisalign case volumes were up 57.6%. For Q4, Invisalign case volumes were up 11.5% year-over-year, reflecting growth across the region, especially in LatAm. On a sequential basis, American shipments were down 7.9%, primarily reflecting the impact of Omicron previously described as well as a seasonally slower teen season from Q3 to Q4. We also saw higher GP and adult case volume and continued momentum from our doctor subscription plan pilot. In Q4, we pledged a $1 million donation to the American Association of Orthodontists Foundation, the charitable arm of the American Association of Orthodontists in support of the science of orthodontics. We're also investing in educational grants, programs to provide universities with greater access to all line products for education and training purposes. Through these programs, our partnership with the aligner intensive fellowship and the other in-person educational programs, we are investing in the orthodontic profession through the people who care for and treat patients directly. For Systems and Services, Q4 was a strong quarter for Americas, driven by continued adoption of iTero 5D Plus imaging system across customer channels, including our DSO partners. Services revenues continue to grow nicely, reflecting the growth of the iTero scanner installed base in North America. For the full year, international Invisalign case volume was up 51.6%. For our international business, Q4 Invisalign case volumes were up 10.7% year-over-year on tough comps compared to 2020. On a sequential basis, international shipments were up 1.7%. Notwithstanding the impact of Omicron in December, we still saw strong growth in EMEA, offset somewhat by a seasonally slower period primarily in China. For the full year, EMEA Invisalign volume was up 69.5%. For EMEA, Q4 Invisalign case volumes were up 14.9% year-over-year, with broad-based growth across all markets, led by Italy and Iberia, along with continued growth in our expansion markets in Turkey, Russia, CIS and Benelux. For Q4, year-over-year Invisalign case volume in EMEA was driven by increased submissions primarily from the orthodontist channel. On a sequential basis, despite the impact of Omicron, EMEA Invisalign case volume was up 13.6%, primarily as a result of strong ortho channel performance especially in the teen market. During Q4, we began commercial operations in Africa, with our initial focus on North Africa and then plan to enter Sub-Sahara Africa and South Africa this year further broadening our expansion markets in EMEA. It's exciting opportunity for Align in this untapped and expanding totally addressable market. We're also making great progress on building our Europe and manufacturing facility in Wroclaw, Poland, which will be our third global aligner manufacturing operation. The Europe manufacturing facility is on track to go live during the first half of 2022, further increasing our ability to efficiently provide the Invisalign system to our valued doctor customers within the European region. For Q4, we saw strong scanner shipments during the quarter as more doctors in the EMEA region continue to digitize their practices. Through a full year APAC, Invisalign case volume was up 27.1%. For Q4, APAC Invisalign case volumes led by Japan, Korea and India were up 3.4% year-over-year on tough comps despite continued COVID resurgences and lockdown sporadically impacting various APAC countries, including China. We also saw strength in the GP dentist channel with increased Invisalign submitters and in the teen market with increased submissions from the orthodontic channel. On a sequential basis, APAC was down 15.4% notwithstanding the impact of Omicron in December and Q4 seasonality in China. We had strong growth in Thailand, Southeast Asia, Taiwan. Overall, it was encouraging to see record numbers of shipments to those markets in APAC and that were not as impacted by the most severe lockdowns. In Q4, Systems and Services in APAC saw the highest percentage of iTero scanners sold to new doctors. Today, we announced new Invisalign Systems innovations for the Align Digital platform, a proprietary combination of software, systems and services, designed to provide a seamless experience and workflow that integrates and connects all users, doctors, labs, patients and consumers. These new innovations include ClinCheck live update for 3D controls; the Invisalign Practice App; Invisalign Personalized Plan, or IPP; and the Invisalign Smile Architect. We believe they will revolutionize digital treatment planning for orthodontics and restorative dentistry by providing doctors with greater flexibility, consistency of treatment preferences and real-time treatment planning access and modification capabilities. Each of these innovations is designed to enhance Invisalign treatment planning quality, efficiency and scale and contribute to better doctor patient engagement and treatment outcomes. ClinCheck live update for 3D controls enables real-time ClinCheck treatment plan modifications that improve practice productivity significantly while also improving quality of treatment plans. Invisalign practice app provides mobile integration with the Invisalign Doctor Site or IDS. It enables doctors to manage their practices at their fingertips. Invisalign's Personal Plan, or IPP, automatically applies the doctor's specific treatment preferences for comprehensive cases, enhancing efficiency and step changing treatment planning consistency. Invisalign Smile Architect software is designed for GP dentists to create and visualize orthodontic restorative treatment plans for their patients using iTero digital scans and wide smile photos on the Invisalign Go platform. The technical design assessment go-to-market is scheduled for Q4 '22. We know that every Invisalign trained doctor has distinct preferences. Every patient is unique and every treatment plan can vary depending on a variety of factors such as the type of malocclusion, patient age and desired outcome. Because of that, doctors spend time planning and reviewing and modifying their ClinCheck plans and it multiplies with practice growth. IPP and ClinCheck live update for 3D controls are game-changing innovations that represent a step change in digital treatment planning to help doctors achieve more personalized ClinCheck treatment plans. By using 3D controls, doctors can see greater efficiency with changes reflected in real time. Invisalign Smile Architect combines basically driven in ortho restorative treatment planning within the power of ClinCheck software, providing flexibility across treatment planning to address a variety of patient needs, whether it may be orthodontic, restorative or ortho restorative combined. It allows doctors to share their vision with patients and use digital technology and tools to achieve the best quality clinical outcomes for their patients. It's through the convergence of advancements in digital technology, Align's unique capabilities and know-how, and data from millions of Invisalign patients that we’re able to bring these new Invisalign innovations to our customers this year. The journey to deliver a ClinCheck live update in Invisalign Personal Plan has taken thousands of combined person years of development, testing and learning. It is only possible through the experience data and insights we have gained from over 12 million Invisalign cases. Across our innovations, we're also using a combination of AI and automation to reimagine what the treatment planning experience looks like for our doctors, doctor customers and augmenting their expertise and experience to help them create and personalize and modify Invisalign treatment plans more efficiently and more consistently than ever before. What used to take several days can now be accomplished in just a few minutes, and it's a huge productivity win for doctors and their patients. Our consumer marketing is focused on educating consumers about the Invisalign system and driving that demand to Invisalign doctors offices, ultimately capitalizing on the massive market opportunity to transform 500 million smiles. Consumer interest in the Invisalign brand remains high, and we are continuing to invest in building the brand in key markets and customer segments. This includes investments in social media as an effective channel to increase awareness and interest for Invisalign treatment. We're continuing to work closely with our media partners to reach consumers with the right creative and compelling campaigns, optimize our buys and test new approaches. In Q4, we continued to build on our successful \"Invis is\" multi-media campaign across the Americas, EMEA and APAC and drove awareness and interest in Invisalign treatment with adult, teen and parent consumer segments. Globally, we delivered record impression volume with over 8 billion impressions, representing 84% year-over-year growth and 21.7 million unique visitors to our website, a 127% increase year-over-year. In the U.S., we amplified our campaigns across the top social media platforms such as TikTok, Snapchat, Instagram and YouTube to increase awareness with teens about Invisalign treatment. Our campaigns continue to feature some of the largest teen influencers from our Invisalign Smile Squad, such as Collins, Devon Key, Charli D'Amelio and Michael Lay, each of whom share their personal experiences with Invisalign treatment and why they chose to transform their smiles with Invisalign aligners. Our consumer marketing programs also include connecting with teams within gaming, specifically on Twitch, with a customized integration that was awarded the gold medal in the Annual Internationalist Awards for innovation in digital marketing solutions. To continue growing our young adult business across the Americas, EMEA and APAC, we built upon our successful \"Invis Is a Powerful Thing” campaign, which highlights the power of Invisalign treatment transformation for every young adult self confidence. Our integrated media plans across YouTube, Snapchat, Instagram, Facebook and TikTok connected with young adults in the media channels, they consume the most. In Brazil, we continue to amplify our \"Invis Is a Powerful Thing\" powerful thing campaign, featuring mega influencer, Taís Araujo, driving a 400% year-over-year increase in web traffic. In the EMEA region, we successfully expanded into new markets such as Italy in the Netherlands. To complement our integrated media plan with Google and YouTube, we also leverage newer media channels such as TikTok and Snapchat to drive engagement with consumers resulting in more than 170% year-over-year increase in unique visitors. We continue to expand our investment in consumer advertising across the APAC region, resulting in a 192% year-over-year increase in unique visitors and a 235% year-over-year increase in impressions. We continue to strengthen our investments in Australia leveraging leading influencers featured in premium placements in TikTok and also YouTube. In Japan, we continue to see strong response from consumers as evidenced by 117% year-over-year increase in unique visitors. Lastly, we expanded our advertising investments in India and Taiwan, which generated a strong consumer response. We saw 1,200% and 628% increase in impressions and a 470% and 116% increase in unique visitors to our website in India and Taiwan, respectively. Adoption of our consumer and patient app, My Invisalign continued to increase with 1.4 million downloads to date. Usage of our 4 digital tools continues to increase. For example, in addition to My Invisalign just mentioned, the Invisalign virtual appointment tool was used over 14,000x and our insurance verification feature was used 20,000x in Q4. Further, globally, we received more than 45,000 patient photos in our virtual care feature globally, which continues to provide us with rich data to leverage our AI capabilities and improve our services for doctors and patients. Our Systems and Services business, Q4 revenues grew 61.3% year-over-year, reflecting strong scanner shipments and services up 21% sequentially. This is the sixth consecutive quarter of sequential revenue growth for our Systems and Services business. And I as mentioned earlier, over 50% of scanner sales in Q4 were the first time iTero scanner buyers. We're pleased to see doctors continue to go digital and invest in the Align digital platform. The iTero Element 5D Plus imaging system continued to gain traction across all regions with the most recent launch in China during Q4. The series expands the portfolio of iTero Element scanners and imaging systems to include new solutions that more broadly serve the needs of doctors and patients in the dental market. A strong indicator of digital acceleration within the dental offices is a number of intraoral digital scans used for Invisalign case submissions. Total worldwide inter-oral digital scan submitted to start an Invisalign case in Q4 increased to 85.4% from 79.3% in Q4 last year. International inter-oral digital scans for Invisalign case submissions increased 80.8%, up from 73.7% in the same quarter last year. For the Americas, 89.1% of Invisalign cases were submitted using an inter-oral digital scan compared to 84% in the same quarter last year. Cumulatively, over 50 million orthodontic scans and 10.3 million restorative scans have been performed with iTero scanners. With continued growth of the iTero scanner at 68,000 scanners sold worldwide as of Q4, approximately 30% is services revenue, which includes reoccurring revenue subscriptions, CAT scan software and ancillary products. And we continue to make improvements in our scanner and imaging systems, making iTero systems and service as an integral part of orthodontic and GP dentist workflow. For example, we streamlined the Invisalign case submission process with the iTero Element 5D imaging systems Auto Upload functionality. Turning to exocad. For Q4 Systems and Services, revenues also include exocad CAD/CAM products and services. exocad's expertise in restorative dentistry, implantology, guided surgery and smile design extends our digital dental solutions and broadens Align's digital platform towards a fully integrated interdisciplinary end-to-end workflows. Cumulatively, as Q4 exocad now has over 47,000 software license worldwide. During the quarter, exocad announced the release of ChairsideCAD 3.0 Galway. It's a next generation of easy-to-use CAD software for single-visit dentistry. With this new release, exocad offers dentist design tools for a vast range of indications with a wide choice of integrated devices. Also during the quarter, exocad announced the availability of ChairsideCAD 3.0 Galway software in the U.S. and Canada, where the software is now available in North America, EU and other selected markets. Exocad’s ChairsideCAD is groundbreaking open architecture CAD software for single-visit dentistry. It received the 2021 Cellerant best-of-class technology award from Cellerant Consulting Group during the quarter as well. This is the third consecutive year that ChairsideCAD has been recognized for this award. With that, I'll now turn this over to John."
},
{
"speaker": "John Morici",
"text": "Thanks, Joe. Now for our Q4 financial results. Total revenues for the fourth quarter were $1.31 billion, up 1.5% from the prior quarter and up 23.6% from the corresponding quarter a year ago. For Clear Aligners, Q4 revenues of $815.3 million were down 2.7% sequentially due to lower Invisalign volumes, partially offset by slightly higher ASPs and up 16.3% year-over-year, reflecting Invisalign volume growth across all geographies and higher ASPs. In Q4, we shipped 631,100 Invisalign cases, a decrease of 3.7% sequentially, an increase of 11.1% year-over-year. In addition, we shipped to 83,500 Invisalign doctors worldwide, of which over 6,400 were to first-time customers. Q4 comprehensive volume increased 13.1% year-over-year and decreased 4.5% sequentially. And Q4 noncomprehensive volume increased 6.6% year-over-year and decreased 1.7% sequentially. Q4 adult patients increased 10.4% year-over-year and increased 0.1% sequentially. In Q4, teens or younger patients increased 13% year-over-year and decreased 11.8% sequentially. Clear Aligner revenues were unfavorably impacted by foreign exchange of approximately $11.4 million or approximately 1.4 points sequentially. On a year-over-year basis, Clear Aligner revenues were unfavorably impacted by foreign exchange of approximately $1.5 million or approximately 0.2 points. For Q4, Invisalign comprehensive ASPs increased sequentially and year-over-year. On a sequential basis, Invisalign comprehensive ASPs reflect higher additional liners, partially offset by unfavorable foreign exchange and higher discounts. On a year-over-year basis, comprehensive ASPs reflect higher additional aligners, partially offset by higher discounts. Q4 Invisalign noncomprehensive ASPs decreased sequentially and increased year-over-year. On a sequential basis, Invisalign noncomprehensive ASPs were unfavorably impacted by foreign exchange, partially offset by higher additional aligners. On a year-over-year basis, Invisalign noncomprehensive ASPs reflect higher additional liners and product mix, partially offset by higher discounts. Clear Aligner deferred revenues on the balance sheet increased $68.5 million or 6.9% sequentially and $332.9 million or 45.8% year-over-year and will be recognized as the additional aligners are shipped. Our Systems and Services revenues for the fourth quarter were a record $215.8 million, up 21% sequentially and up 61.3% year-over-year. This marks the sixth consecutive quarter of sequential revenue growth. The increase sequentially can be attributed to increased scanner shipments and increased service revenues from our larger installed base. The increase year-over-year can be attributed to increased scanner shipments, increased service revenues from our larger installed base as well as higher ASPs from the favorable mix shift towards higher-priced iTero 5D scanners and imaging systems. Our Systems and Services deferred revenue on the balance sheet was up $42.6 million or 22.8% sequentially and up $116.2 million or 102.6% year-over-year, primarily due to the increase in scanner sales and the deferred -- and the deferral of services revenues, which will be recognized ratably over the service period. Moving on to gross margin. Fourth quarter overall gross margin was 72.2%, down 2.1 points sequentially and down 0.9 points year-over-year. On a non-GAAP basis, excluding stock-based compensation expense and amortization of intangibles related to acquisitions, overall, gross margin was 72.6% for the fourth quarter, down 2.1 points sequentially and down 0.9 points year-over-year. Overall gross margin was unfavorably impacted by approximately 0.1 points on a year-over-year basis and by approximately 0.4% sequentially due to foreign exchange. Clear Aligner gross margin for the fourth quarter was 74.2%, down 2 points sequentially due to higher freight costs and additional aligners, along with lower primary shipments, partially offset by higher ASPs. Clear Aligner gross margin was down 0.6 points year-over-year due to higher additional aligners and higher freight costs, partially offset by higher ASPs and improved manufacturing absorption due to higher volumes. Systems and Services gross margin for the fourth quarter was 64.7%, down 0.9 points sequentially, primarily due to higher freight costs and increased component costs, partially offset by higher ASP from 5D Plus mix and higher service revenues. Systems and Services gross margin was up 0.4 points year-over-year due to higher ASP from higher mix of iTero 5D Plus and higher service revenues, partially offset by higher freight costs and increased component costs. We are actively engaged in activities to mitigate supply disruptions by expanding supplier communications, modifying our purchase order coverage and increasing inventory levels for key components. Q4 operating expenses were $523.7 million, up sequentially 6% and up 31.8% year-over-year. On a sequential basis, operating expenses were up by $29.7 million. Year-over-year operating expenses increased by $126.4 million, reflecting increased headcount and our continued investment in marketing, sales, in R&D activities and other investments commensurate with business growth. On a non-GAAP basis, excluding stock-based compensation and amortization of acquired intangibles related to certain acquisitions, operating expenses were $494.4 million, up sequentially 6.1% and up 32.8% year-over-year due to the reasons described earlier. Our fourth quarter operating income of $220.9 million resulted in an operating margin of 21.4%, down 4.3 points sequentially and down 4.1 points year-over-year. The sequential and year-over-year decreases in operating margin are primarily attributed to lower gross margin, investments in our go-to-market teams and technology as well as unfavorable impact from foreign exchange. On a non-GAAP basis, which excludes stock-based compensation and amortization of intangibles related to certain acquisitions, operating margin for the fourth quarter was 24.7%, down 4.1 points sequentially and down 4.3 points year-over-year. Interest and other income and expense net for the fourth quarter was a loss of $0.9 million, down sequentially by $1.7 million and down year-over-year by $2.2 million. The GAAP tax rate for the fourth quarter was 13.2% compared to 30.9% in the third quarter and 25.9% in the fourth quarter of the prior year. Our non-GAAP effective tax rate was 11.5% in the fourth quarter compared to 22.2% in the third quarter and 14.5% in the fourth quarter of the prior fourth quarter. The fourth quarter GAAP and non-GAAP effective tax rates reflected an out-of-period adjustment, which reduced our tax rate by 7.3% and 6.3%, respectively. Fourth quarter net income per diluted share was $2.40, up sequentially $0.12 and up $0.40 compared to the prior year. On a non-GAAP basis, net income per diluted share was $2.83 for the fourth quarter, down $0.04 sequentially and up $0.22 year-over-year. For the full year, net income per diluted share was $9.69, down $12.72 year-over-year due to the onetime tax benefit in 2020 of approximately $1.5 billion associated with our corporate structure reorganization completed during the first quarter of 2020. On a non-GAAP basis, net income per diluted share was $11.22 for the full year, up $5.97 year-over-year. Moving on to the balance sheet. As of December 31, 2021, cash, cash equivalents and short-term and long-term marketable securities were $1.3 billion, up sequentially $58.8 million and up $335.8 million year-over-year. Of our $1.3 billion balance, $582.9 million was held in the U.S. and $713.8 million was held by our international entities. Q4 accounts receivable balance was $897.2 million, up approximately 4.9% sequentially. Our overall days sales outstanding was 78 days, up approximately 3 days sequentially and up approximately 7 days as compared to Q4 last year. Cash flow from operations for the fourth quarter was $272.8 million. Capital expenditures for the fourth quarter were $109.1 million, primarily related to our continued investment in increasing aligner manufacturing capability -- capacity and facilities. Free cash flow, defined as cash flow from operations less capital expenditures, amounted to $163.8 million. In November 2021, we purchased $100 million of our common stock through an accelerated share repurchase, which was approximately 0.2 million shares at an average price of $666.53 per share. We have approximately $725 million remaining available for repurchase under our May 13, 2021, $1 billion repurchase program. Before I move to our outlook, I would like to make a few comments on our full year 2021 results. In 2021, we shipped a record 2.5 million Invisalign cases, up 54.8% year-over-year. This reflects 51.6% volume growth from our international doctors and 57.6% volume growth from our Americas doctors. Total revenues were a record $4 billion, up 59.9% year-over-year with Clear Aligner revenues a record $3.2 billion, up 54.5% year-over-year. 2021 Systems and Services revenue were a record $705.5 million compared to $370.5 million in 2020, up 90.4% year-over-year. Full year 2021 GAAP operating income of $976.4 million was up 152.2% versus 2020, and operating margin at 24.7% versus 15.7% in 2020. On a non-GAAP basis, 2021 operating margin was 27.9% versus 20.3% in 2020. 2021 interest income and other income and expense net of $36 million included the SmileDirectClub arbitration award gain of $43.4 million. Excluding the SmileDirectClub arbitration award gain, interest and other income and expense was $7.4 million expense on a non-GAAP basis. With regards to full year tax provision, our GAAP tax rate was 23.7%. The full year tax rate on a non-GAAP basis was 18.5% compared to 17.6% for 2020. 2021 diluted EPS was $9.69. On a non-GAAP basis, 2021 diluted EPS was $11.22. Free cash flow was $771.4 million for 2021, up $264.2 million versus 2020. Overall, we are pleased with our Q4 results and another record year for Align. We delivered strong growth and profitability, in line with our guidance despite disruptions late in the quarter from Omicron and others factors. Our Q4 revenue year-over-year growth was within our long-term model despite disruptions impacting roughly 3 points of growth. We continue to see strong momentum and demand for our Systems and Services throughout Q4, with the majority of scanners being sold to first-time buyers. We believe this is a good leading indicator of future Invisalign growth as our customers continue to invest in digital technology even during COVID. Let me turn to our outlook. We would normally expect sequentially higher Invisalign revenues and lower Systems and Services revenue, consistent with the typical Q1 seasonality. However, due to the continued impact of Omicron into Q1, we now expect our total Q1 revenue to be slightly down sequentially. We remain confident in our strategy, our huge underpenetrated market opportunity, our industry leadership and our ability to execute. These factors have guided our approach throughout the pandemic, where we continue to invest in new technology, commercial expansion and manufacturing capabilities to drive our growth. We plan to continue these investments in Q1 and therefore, expect our Q1 operating margin to be less than 20%. In addition, during Q1 2020 -- 2022, we expect to repurchase up to $75 million of our common stock through either a combination of open market repurchases or an accelerated stock repurchase agreement. Turning to full year 2022. Despite Omicron headwinds, we expect 2022 revenue growth to be in line with our long-term model range of 20% to 30%. Our 2022 guidance assumes no significant new COVID surges after the current wave. No meaningful practice disruptions nor material supply chain issues throughout the year. On a GAAP basis, we anticipate our 2022 operating margin to be around 24%. On a non-GAAP basis, we expect 2022 operating margin to be approximately 3 points higher than our GAAP operating margin after excluding stock-based compensation and intangible amortization from certain acquisitions. For 2022, we expect our investments in capital expenditures to exceed $350 million. Capital expenditures primarily relate to building in construction and improvements as well as additional manufacturing capacity to support our international expansion. This includes our planned investment in a Clear Aligner manufacturing facility in Wroclaw, Poland, which is expected to begin serving doctors in 2022 as part of our strategy to bring operational facilities closer to customers. With that, I'll turn it back over to Joe for final comments. Joe?"
},
{
"speaker": "Joe Hogan",
"text": "Thanks, John. Overall, despite the disruption from the Omicron in December, we delivered a record year with strong revenue growth and operating margin, in line with our guidance for the full year on top of a record Q4 and 2020 a year ago. As you look back, I wanted to take a moment to recognize our accomplishments and thank our employees and our customers for another remarkable year. In the face of ongoing challenges related to COVID-19 and economic uncertainty, we remain steadfast in our commitment to our employees, customers and the focused execution of our strategic initiatives, and our customers remain confident in our ability to support them. Operating in this environment has not been easy, but after 2 years of navigating uncharted waters, the Align team is more agile and resilient than ever. In 2021, we met our goals and achieved numerous milestones. Globally, we delivered across each of our strategic priorities, which are highlighted in our Q4 '21 webcast slides. Our performance over the last year reaffirms the incredible size of our target market, and demonstrates that our strategy and investment in recent years are validated by the trust and faith our customers place in us. In 2022, we must continue to extend our leadership in digital orthodontics and restorative dentistry through relentless execution of our strategic initiatives, focusing on expanding our commercial, manufacturing, R&D, clinical, treatment planning and manufacturing operations, and building our quality and regulatory muscle globally in existing and emerging markets, reaching millions of consumers who want to transform their smiles using the most advanced Clear Aligner system in the world through the right investments in advertising, PR, digital, social media and influencer marketing to drive demand and conversion through Invisalign trained doctors. Invisalign ortho adoption and teen utilization of Invisalign treatment and training and educating GP dentists on how the iTero Element family of inter-oral scanners and imaging systems can propel today's dental practice into the future by enhancing patient experience and elevating clinical precision, and on the benefits of digital dentistry with the Invisalign system trusted by more than 12 million people worldwide to transform smiles. We remain mindful of the ongoing uncertainty surrounding COVID-19 and the challenges that go with it. While there is still uncertainty, it has become increasingly clear over the last year with the first spread of the Delta variant, now Omicron, that COVID-19 may never fully go away and may be a virus that persist in one variant form or another for the foreseeable future. And like other viruses, new or different vaccines will be needed and new therapies will be developed to minimize the impact and treat COVID-19 more effectively in our most vulnerable populations. The reality of living with COVID is one of the government's businesses and communities all over the world are beginning to acknowledge and move towards, and at Align, we will do the same. In closing, I'm going to share some thoughts that I expressed to our employees recently. What we learn in life, both in business and our personal lines, is that we're not fully in control of our environment and destiny. This is a fact of life that we face every day, but not being in control does not mean that we can't make good choices regardless of the situation or challenges we all face. We must look forward focused on the opportunities. Align has numerous growth drivers in a vastly underpenetrated market. And while we continue to see some lasting impact and continued uncertainty due to COVID-19, we remain confident in both the enormous opportunity to lead the evolution of digital orthodontics and comprehensive dentistry. We never forget that digital orthodontics presents the fastest growing and largest market in the world of medical devices. We have the greatest Clear Aligner system, scanners, GP lab software in the world and the broadest and deepest digital dental platform. We have the most recognized consumer brand in the largest direct sales force in the dental space with over 4,000 salespeople supporting over 212,000 doctors and labs and their staff, who have incredible skills and dedication to their patients. We have an amazing team of employees committed to our purpose. It's a unique opportunity unlike anything I've ever seen in my career. They both continue to grow Align and be part of the positively changing millions of lives by transforming their smiles. Thank you for your time today. We look forward to speaking to you again as the year progresses. Now I'll turn the call over to the operator. Operator?"
},
{
"speaker": "Operator",
"text": "[Operator Instructions] Our first question comes from the line of Nathan Rich with Goldman Sachs."
},
{
"speaker": "Nathan Rich",
"text": "Joe, thanks for all the details on the outlook. You called out the 300 basis point headwind from COVID in the quarter, with the impact, I think, concentrated in December. So maybe a bit higher as we think about what the headwind was exiting the year. Could you maybe talk about how the impact in January as compared to what you experienced in December? And can you maybe elaborate on what you've seen in recent weeks? I'm just looking for a sense of maybe where January is trending and kind of what you're assuming for the balance of the quarter to get you to the guidance that you gave for 1Q?"
},
{
"speaker": "Joe Hogan",
"text": "Nathan, look, we saw what we talked about in December, we had a rapid decrease through COVID. But what we've seen as we've gone into January is just a progressive improvement. And we feel good about that. We feel it's moving in the right way. And it's in direct correlation. We track it around the country with what's going on with Omicron in certain states and certain regions. And remember, this is in just the United States. We've seen this all over the world. We see it in APAC, and we see it in Europe too when we track it."
},
{
"speaker": "Nathan Rich",
"text": "Okay. And maybe just building on that at a high level, Joe, do you feel like the slowdown, I guess, is primarily a supply issue, just given the practice closures and lockdowns and staffing issues that you cited versus a demand issue? Because I think in your prepared remarks, you also mentioned some impacts from inflation and less stimulus. So I was just curious to kind of get your thoughts there."
},
{
"speaker": "Joe Hogan",
"text": "No, we don't see this as a demand issue. I mean, we look at the market as we always have. That's why we reasserted our 20%, 30% growth rate for this year. So this is not a demand equation issue or you call it a supply, but I'd call it demand from a patient standpoint. We just see it's patients and doctors in the sense of cancellations, availability and all those things that COVID has impacted around. So we remain very confident. That's why you see us to continue to make investments, the things we announced today. We feel really good about the business. We just have to get through this first quarter and what we talked about, and we'll move on. We feel really good about it."
},
{
"speaker": "Operator",
"text": "And our next question comes from the line of Matt Miksic with Credit Suisse."
},
{
"speaker": "Matt Miksic",
"text": "Just maybe a follow-up on that -- the question on planning assumptions around your Q1 comments and 2022 guidance. Maybe, Joe, if you could just give a sense as to how -- you mentioned improvements in early January. Is this kind of sluggish recovery wrapping up by the end of the quarter? Is Q2 the inflection to help you get to that 20%, 30% growth that you mentioned? And then just if I could also on a similar topic. Just the idea that somehow there is -- you've -- I think many of the folks on the call heard this idea that somehow there was outsized growth due to the pandemic, and we're sort of digesting that somehow now, which I know it's sort of one of the ways that folks look at Align and aligners and so on. If you could maybe just talk about your confidence that, once we get through the staffing that the demand that's in front of you of the growth drivers that you're laying in on top of your core markets, that we're not looking to digest some sort of outsized growth during the pandemic here in '22, but we're getting back to a growth market that's still highly underpenetrated? Sorry for the lengthy 2-part question, but I would appreciate it."
},
{
"speaker": "Joe Hogan",
"text": "We understand the basis of your question, Matt. That's not a problem in that sense. Look, as I mentioned before, we're really confident in demand equation in the sense of Clear Aligners and Invisalign. What we're experiencing right now is obviously somewhat of a slowdown in our order demand pattern based on what we see through the virus that's going on around the world. As soon as that clears and we see it clearing around the world, and as I mentioned, we see January improving over December, we're very confident in demand models that we've expressed for this business over the last several years."
},
{
"speaker": "Operator",
"text": "And our next question comes from the line of Elizabeth Anderson with Evercore ISI."
},
{
"speaker": "Elizabeth Anderson",
"text": "I guess on the first side, I think you obviously talked about some of the increased investments that you're making on marketing and also in sales capacity, et cetera. How do we think about the conversion efforts of those initiatives versus sort of prior -- and sort of where do you sort of see that hitting in terms of as we're thinking about the pacing of the year?"
},
{
"speaker": "Joe Hogan",
"text": "Yes. I mean the pacing of the year, I mean we continue to invest, as we mentioned, John mentioned, I mentioned too in marketing. Where we invest? We understand the returns that we get, no matter what the country is or what kind of media we use in order to go after consumers. So we've been very consistent in the sense of that investment. And we move money around based on where we see the most opportunity. John, anything to add?"
},
{
"speaker": "John Morici",
"text": "And we -- as we mentioned, we added some sales resources in Q4 to get ahead of sales territories and changes and so on. We saw that show up in Q4, but it really gives us the opportunity then to be able to grow as we get into this year. So it's continued investments to drive the biggest return and that's what we're continuing to do."
},
{
"speaker": "Elizabeth Anderson",
"text": "Okay. So it sounds like maybe no change in sort of the pacing that we've been seeing before. Maybe as a follow-up, I know you obviously highlighted that the total growth of the company would be in your 20% to 30% range. Do you also see that the case growth on a year-over-year basis would be above 20% as you look out at this point?"
},
{
"speaker": "John Morici",
"text": "We'd expect them to be similar. When we talk about 20% to 30%, we're talking about revenue for the entire company, but they would be similar from an outlook standpoint."
},
{
"speaker": "Operator",
"text": "And our next question comes from the line of Jon Block with Stifel."
},
{
"speaker": "Jon Block",
"text": "Maybe just the first one. The outmargin compression year-over-year, the 24.7-ish gap that is to the 24%. Maybe you could talk to that, John, I was just going to say it's a gross margin thing with scanners likely to grow much faster than case vol. But to Elizabeth's question, it seems like you expect both to be within the guardrails of 20% to 30%. So is it more a function of you guys just sort of, call it, running a little bit harder on the OpEx line to drive that case volume and why we would see that year-over-year OM compression. Again, I'm just sort of referring gap-to-gap for apples-to-apples?"
},
{
"speaker": "John Morici",
"text": "I think, Jon, it's continued investments like we have with the story to continue to invest that we have and being able to be able to grow into this market. So I think when we look at it overall, we're kind of pegging the GAAP rate to be at 24% for 2022, and we'll evaluate and update as we go forward. But it's continuing to invest. We've got, as you know, our Poland facility going live in 2022. And we have some of those moving parts that will impact our gross margin slightly as a result of that, but -- and that translates to op margin. But those are the initiatives that we have, but nothing out of the ordinary that we've done in the past."
},
{
"speaker": "Jon Block",
"text": "Okay. Heads up this next one is going to be long, probably 2 parts. But maybe can you just get people comfortable with the fact that if you look at your 2Q, 3Q, 4Q '21 case files and the implied guidance for 1Q, to get to 20% to 30% case volumes for the year, you're going to have to rip sequentially in 2Q, 3Q, 4Q of '22. Maybe if you could talk to that? And then the other sort of third question, if you would admittedly is I'm confused on the 3 points. So if 4Q was impacted by 3 points of growth, why don't you we capture, I don't know, 2 or 3 points of that in 1Q '22? Where are those cases going if they're not showing up in the next possible quarter?"
},
{
"speaker": "John Morici",
"text": "I think I'll maybe start with the last part of your question, Jon. When you think of what's happened in the world with Omicron and the effects of that, it's affecting parts of the world at different paces. You see it even within the U.S. Northeast maybe gets hit with it first. It starts to open up later. After that, maybe other parts of the country get impacted. So it's not like it just happens and you immediately get it back. It comes down to when people are able to go to work, in this case, at doctors' offices to be able to provide care and then it comes down to when patients feel comfortable to be able to go back in. And so it's not an immediate effect in how we look at it. So think of -- and what we've learned from kind of COVID 1.0, the first time we saw this, we know that there's an impact, and then there's a recovery period -- and that's our best view of that recovery period."
},
{
"speaker": "Joe Hogan",
"text": "John, on your your other part about you have the rest of the year, we understand that. I mean we've modeled it out. Remember, our comparisons are a little better in second half than they were first half when you look at what we did in 2021 in the first half of the year. So look, we wouldn't make that prediction if we didn't think it was feasible based on what we've seen and what we've modeled."
},
{
"speaker": "Operator",
"text": "Our next question comes from the line of Jeff Johnson with Robert W. Baird."
},
{
"speaker": "Jeff Johnson",
"text": "Just a couple of questions here for me. I guess one, John, in 2021, you guys were talking about being within your LRP, but at the upper end of that, do you want to put any quality buyers on kind of the LRP for 2022. It feels like kind of low end, given where 1Q is starting. But one, do you want to put any qualifiers around where within that LRP you'd expect to be? And two, just to go back to the last 2 questions again. I feel like I'm talking to my 10-year-old kid here, so apologies, but I'm going to give you one more chance. Do you feel like case shipments can still grow within that LRP this year too, not just revenue because you've got some of the new products you're selling, plus you've got faster iTero growth than that, but case shipments also can be within that 20% to 30% LRP. I just want to make sure I'm hearing that correctly."
},
{
"speaker": "John Morici",
"text": "I can answer both of those, Jeff, in terms of the 20% to 30%. We're not going to call kind of high low on that. We're kind of reaffirming our 20% to 30%, similar to what we talked about at Investor Day despite some of the things that we've talked about here with Omicron in some of those cases and so on. But when we look at Invisalign case volume, we would expect to be in and above that range. So nothing out of the ordinary from what we expect. We don't see -- our ASPs were very similar to what they were in the prior quarter, provided that there's not FX or other things that we're not projecting now. And if there's no change there, we would expect to be in that range as well."
},
{
"speaker": "Jeff Johnson",
"text": "Fair enough. And then, Joe, maybe kind of just update us on kind of the competitive landscape. We've seen a couple of DSO contracts get announced here from others in the last few months and maybe some talk over in China about some growing competition or slowing end markets in that. But where do you see your end markets across the globe from a competitive standpoint? Would just love to hear your update there?"
},
{
"speaker": "Joe Hogan",
"text": "Jeff, I think from a competitive standpoint, nothing's really changed. As we look out there, you can see the tech we just announced this week, we move on in the sense of our capabilities, what we can do. My position has always been that competition isn't really affecting us from a price standpoint. I think you see that in what we're doing. But they do serve to help to broaden the market and increase the market and make -- increase the awareness. So we feel we are -- in this kind of competitive environment, we're doing well, and we lead in this sense and there's nothing as we go into 2022 that I won't reflect on it's changed competitively than what I've seen over the last 3 years."
},
{
"speaker": "Operator",
"text": "And our next question comes from the line of John Kreger with William Blair."
},
{
"speaker": "John Kreger",
"text": "John, two quick ones for you. I think you said that the receivable DSOs were up about 7 days year-over-year. Can you just expand on that? Was that -- were you providing some extra inducements to practices or anything to be concerned about there?"
},
{
"speaker": "John Morici",
"text": "Nothing to be concerned. We're in a fortunate cash position as a company to be able to generate a lot of CFOA and free cash flow. And in working with doctors to be able to give them more flexibility, sometimes we'll extend payments. But we've actually seen historically low amount of past dues as we've gone through this time period in 2021. So we feel very comfortable with that. It's just working with doctors to kind of meet their cash flow needs, but nothing out of the ordinary."
},
{
"speaker": "John Kreger",
"text": "Okay. Great. And then one other one to clarify. I think you said that you expect the EBIT margin to be under 20% in the first quarter. Was that GAAP or non-GAAP?"
},
{
"speaker": "John Morici",
"text": "That's GAAP."
},
{
"speaker": "Operator",
"text": "Our next question comes from the line of Jason Bednar with Piper Sandler."
},
{
"speaker": "Jason Bednar",
"text": "Joe, just real quick, and I asked whether you can confirm you said January improved over December. I thought I heard you say that earlier in the call? Or is it just that the January trend line showed improvement as the month unfolded? Sorry for just clarifying that something nuanced like that here."
},
{
"speaker": "John Morici",
"text": "Yes. I think to clarify, Jason, the month end showed improvement versus December. It was -- it's how COVID spreads across, whether it's one country or parts of countries and so on and how it affects the staff and how it affects the patients in. But as we exited, we're in a better trend line than we started the month with."
},
{
"speaker": "Jason Bednar",
"text": "Okay. Understood. And then maybe as a follow-up to an earlier question, really for Joe or John. I know you often talk about the internal investments you keep making in the business, you talked about running a similar growth algorithm here in '22 as you have in the past. But we also have 2 different case examples here of the market with pre-COVID, a lot of those resources were helping funding faster growth in your team business. And then the last 18 months during the pandemic, adult demand has really taken off and growing faster than teens. So I guess my question here is, as you went through your year-end planning and you're obviously resourcing this business in another significant way here in '22, how do you approach it for this year? Is it from a sales force add marketing plan and whatnot? Is it -- are you really with respect to how you're thinking about the adult and teen mix that you're expecting for this year?"
},
{
"speaker": "Joe Hogan",
"text": "I mean we're -- it's Joe, Jason. I mean there's no big change in the sense of what we think the critical drivers are that we have to invest in to drive growth. Where we invest and how we invest is really important. When you look at technology, when you look at consumer pieces, however, parts of those demand inflations you want to go to. But remember, there are certain ratios that we always hold to in this business, its that what we invest in. And we hold ourselves accountable for those ratios and that performance from a profitability standpoint. But I can't overstate the importance of having a strong sales force. We talked about additional sales people that we are putting in place. Our consumer brand means a lot in the sense of our growth. And that's becoming more and more sophisticated in the sense of where we spend those dollars and how we spend those dollars. But leading in technology, you have to have technology in this business, and that's why we're excited to really announce what we did today. We've been working on these programs for 3 years or more. And these are game breakers in the sense of how you interface with a doctor and how a doctor interface with patients."
},
{
"speaker": "John Morici",
"text": "And I would just add to that, Jason. We're investing with that return on investment in mind. That's how we look at our long-term growth model. And when we make investments, we have that in mind. In some countries, you're going deeper, you're adding more salespeople to get closer to doctors and really talk to drive that utilization. In other areas where you don't have a direct sales force, you're just adding and just trying to get the breadth in there. And then we've been talking about a lot of the marketing activities and other things that we do to drive that awareness in some of those markets and coupled with the research and development investments. Some of it operations, again, to get closer to our customers like in Poland. So it's a multitude of investments, but we look at it with how do we generate the best return and there's multiple different ways that we do it across these functions."
},
{
"speaker": "Shirley Stacy",
"text": "Thanks, Jason. Operator, we'll take one more call, please?"
},
{
"speaker": "Operator",
"text": "Sure. The last question we have is from the line of Brandon Couillard with Jefferies."
},
{
"speaker": "Brandon Couillard",
"text": "John, you've talked about freight costs for a few quarters now. Any chance you're planning a less price increase this year to help offset some of that? It's been a few years since you've taken less pricing?"
},
{
"speaker": "John Morici",
"text": "Yes, it's a good question. We are seeing freight -- it looks like many companies have. We have a lot of plans in place to drive productivity. The operating team is very aware of our cost inputs and where we can drive productivity, getting closer to our customers, like we talk in Poland. Once we get there, that will be a freight savings. And once we're operational there, and that will help. But we haven't really finalized any plans on a price increase. We'll evaluate as we go through. And the first people that we talked to would be our customers. But you're right, we understand the price is important, but we're also very sensitive to our customers and what they've had to go through as we've been on this COVID journey. So nothing in the works now."
},
{
"speaker": "Brandon Couillard",
"text": "Okay. And then Joe, on Ontario, I appreciate the detail as far as more than 50% of placements being new buyers. I would actually expect that to be normally the case. So what's the relevancy of that metric? Is that up a lot compared to historical levels? And what percent of those placements are being used for Invisalign case submissions?"
},
{
"speaker": "Joe Hogan",
"text": "Over the years, Brandon, we've obviously seen that correlation, and we've communicated it to you in a sense if you sell more iTero scanners, you sell more Invisalign. And that's obviously, the front end of our digital system and it works for us really well. We just had to side the 50% because, one, you saw we had a very strong fourth quarter for iTero. And we always have strong fourth quarters. So this was exceptional in that sense. And it was a good signal from the practices that we're dealing with that this had to do with the day-to-day flow that you see from an Invisalign patient standpoint, it had nothing to do with their enthusiasm in the sense of embracing the digital environment that we're talking about. And so to see the number of sales that we had really in the last couple of weeks of the quarter, it was just a good signal for us. And we wanted to share that with you is that this market is embracing digital even when it's under pressure, and we're performing really well in that area. As far as 50%, whatever and how, I don't know exactly what the historical percentages are in that way. But we're -- obviously, what we're excited about is once those scanners are in place, it gives us a good foundation to sell Invisalign."
},
{
"speaker": "Operator",
"text": "And we have reached the end of our question and session. I now turn the call back over to Shirley Stacy for closing remarks."
},
{
"speaker": "Shirley Stacy",
"text": "Thank you. Thanks, everyone, for joining us today. We look forward to speaking to you at upcoming financial conferences and industry meetings. If you have any questions or follow-up, please contact our Investor Relations team. Have a great day."
},
{
"speaker": "Operator",
"text": "Thank you. This concludes today's conference, and you may disconnect your lines at this time. Thank you for your participation."
}
] | Align Technology, Inc. | 24,568 |
ALGN | 3 | 2,021 | 2021-10-27 16:30:00 | Operator: Greetings and welcome to Align Technology's Third Quarter 2021 Earnings Conference Call. At this time, all participants are on a listen-only mode. A question-and-answer session will follow the formal presentation. [Operator instructions]. As a reminder, this conference is being recorded. I would now like to turn the conference over to your host, Shirley Stacy, Vice President of Corporate Communications. Thank you, you may begin.
Shirley Stacy: Good afternoon, and thank you for joining us. Joining me today for our conference call is Joseph Hogan, President and CEO, and John Morici, CFO. We issued third quarter 2021 financial results today via GlobeNewswire, which is available on our website at investor. aligntech.com Today's conference call is being audio webcast and will be archived on our website for approximately 1 month. A telephone replay will be available today by approximately 5:30 PM Eastern Time through 5:30 PM Eastern Time on November 10th. To access the telephone replay, domestic callers should dial 877-660-6853 with conference number 13723267 followed by [Indiscernible]. International caller should dial 201-612-7415 with the same conference number. As a reminder the information provided and discussed today will include forward-looking statements, including statements that aligns future events and product outlook. These forward-looking statements are only predictions and Involve risks and uncertainties described in more detail in our most recent periodic reports filed with the Securities and Exchange Commission available on our website [email protected]. Actual results may vary significantly and align expressly assumes no obligation to update any forward-looking statements. We have posted historical financial statements, including the corresponding reconciliations on our -- on our GAAP -- of our GAAP and non-GAAP reconciliation if applicable. And our third quarter 2021 conference call slides are on our website under Quarterly Results. Please refer to these files for more detailed information. With that, I'd like to turn the call over to Align Technology's President and CEO, Joe Hogan. Joe.
Joseph Hogan: Thanks, Shirley. Good afternoon and thanks for joining us. On our call today, I'll provide some highlights in the third quarter, then briefly discuss the performance of our 2 operating segments, system services, and Clear Aligners. John will provide more detail on our financial results and discuss our outlook. Following that, I'll come back and summarize a few key points and open the call to questions. I am pleased to report strong third quarter results with revenue growth of 38.4% year-over-year on top of a record third quarter last year, driven by the strength across all regions, customer channels, and products. For Q3 we shipped to a record 85,500 doctors in the quarter and reached 11.6 million Invisalign patients cumulatively. On a sequential basis, Q3 results reflect continued adoption of iTero scanners and increased utilization of Invisalign Clear Aligners in the Americas and APAC regions, as well as the growth in teen segment, especially in the North America orthodontics channel. Our third quarter revenues reflect a growing confidence of doctors and patients with Invisalign treatment, iTero scanners and Exocad software, as more doctors discover the benefits of digital treatment and transform their practices with the Align Digital Platform. For Q3, Systems and Services revenues were up 57.3% year-over-year, with strong revenue growth across all regions, and up 5% sequentially, primarily in North America. Q3 results reflect the continued adoption of iTero Element 5D Plus Series, our next-generation scanners and imaging system, which launched earlier this year and feature innovative technology like Near Infrared technology we call NIRI, which aid in detection and monitoring of interproximal caries lesions or cavities above the gingiva without harmful radiation. For Q3, Clear Aligner revenues were up 34.9% year-over-year, with strong revenue growth across all regions and across the portfolio, including comprehensive and non-comprehensive products, as well as Invisalign moderate and Invisalign Go. On a sequential basis, Q3 Clear Aligners revenues were down very slightly from record Q2 reflecting more pronounced summer seasonality than last year, especially in EMEA, were practices and patients appear to have taken extended holidays and where offices were impacted due to resurgence of COVID-19 cases and restrictions especially in some markets in Asia-Pacific. And the team segment Q3 '21 Invisalign Clear Aligner volumes for teens were strong, up 13.8% sequentially, and 26.6% year-over-year to a record 206,000 teens, representing approximately 1/3 of total cases shipped, with strong shipment growth from North American orthodontists and a record quarter for teen and APAC. Our third quarter revenues also include non-case revenue for clinical training and education, and doctor prescribed retainer products. Retention is a critical part of creating and maintaining a beautiful new smile. Retainers prevent teeth from gradually shifting back to their initial positions after treatment ends. Studies show that without retention, even perfectly aligned teeth can gradually revert to their pre -treatment state. And that dentition continues to change as patients age, often requiring limited treatment, also known as touch-up treatment, if not properly retained. Our retention products are designed to maintain teeth that have been aligned by Invisalign Aligners, braces, or other aligners. These retainer products can accommodate lingual bars, wires, also known as a permanent retainer, missing teeth that require an artificial tooth, and bite ramps, also known as turbos or blocks. While our retainer business continues to deliver solid revenue growth, our share of retention market is significantly under-penetrated. Even more so than in our share of the orthodontic case starts. We've been developing a robust retainer strategy, including a separate marketing team focused solely on driving adoption, and increasing market share in the United States. Our objective is to build brand awareness for Vivera retainers, and driving engagement with doctors through clinical education and sales initiatives, while connecting consumers to doctors through demand creation programs and our concierge service. We've also recently implemented social media campaigns featuring the benefits of Vivera from the makers of Invisalign Clear Aligners. We believe that incremental investments will provide increased value for Invisalign practices, and drive growth consistent with our long-term financial model target. In addition, we successfully rolled out a limited pilot program to participate in Invisalign Providers in the United States and Canada, that offers a monthly targeted subscription program to address the unmet patient demand for retention or touch-up cases. Our goal is to encourage experienced high-volume Invisalign practices, who regularly treat patients with our comprehensive products to offer premium retention or entry-level products for the long-term health of their patients, and to grow their businesses. Practices in this pilot program can purchase a monthly subscription at a fixed price, based on their monthly needs for retention or limited treatment. The program allows doctors the flexibility to order both touch-up or retention Aligners with their tier subscription. The program is designed for a segment of experienced Invisalign doctors, who are now regularly using our retainers or low stage Aligners. The positive feedback from our doctors have been encouraging. For instance, the doctors at [Indiscernible] told us the program is very straightforward and easy to understand, and they've been hoping Align would do something like this. Doctor Jonathan Nicozisis at Princeton Orthodontics called the program a home run. We went on to -- he went to predict it should replace the idea that doctors invest in 3D printing and the additional complications and expenses it requires. Including the need for a full-time employee and additional overhead costs, particularly because he believes h is treatment outcomes are always better with Align. Q3 non-case revenues also included accessories and consumables such as aligner cases called Clam Shells, cleaning crystals, and other oral health products that are available on our e-commerce channels in the U.S. only, including the Invisalign accessories store, Walmart, and Amazon. In Q3, we announced an exclusive supply distribution agreement with Ultradent Products, Incorporated, a leading developer and manufacturer of high-tech dental materials, devices and instruments worldwide. The Invisalign Professional whitening program powered OpEx essence is optimized for Invisalign aligners and Vivera Retainers and is available only through Invisalign trained doctors. Also in Q3, we launched the Invisalign whitening pen through an e-commerce channels in the U.S. only. The whitening Pen is over-the-counter retail product for consumers seeking quick tooth whitening at a lower price and is not intended to be used with aligners. The whitening Pen complements the other accessory products that Align already marks to consumers through its existing e-commerce channels and is a key addition to our consumable product portfolio. Now let's turn to the specifics around our third quarter results, starting with the Americas. With Americas, Q3 results reflected strong performance, including record revenues for Latin America, as well as summer seasonality for adult case starts in North America that primarily impacted GP practices, strong ortho performance, especially in the teen market that included increased utilization from the orthodontic channel. Invisalign Case volume was up 0.7% sequentially, and up 36.4% year-over-year, reflecting growth across the region especially in Latin. DSO utilization continued to be a strong growth driver as well, led by Heartland and Smile Docs. For our international business, Q3 Invisalign case volume was up 27% year-over-year on top of record growth in the same quarter last year. On a sequential basis, international shipments were down sequentially 4.3%, primarily as a result of greater seasonality in COVID related shutdowns in APAC markets. For EMEA, Q3 Invisalign case volumes were up 49.6% year-over-year, with broad-based growth across all markets led by the U.K. and Iberia, along with continued growth in our expansion markets in Central and Eastern Europe and the Benelux. For Q3 year-over-year Invisalign volume in EMEA was driven by increased submitters from both orthodontics and GPEs and increase utilization primarily from orthos. On a sequential basis, EMEA was down sequentially 60.5% following a record Q2, primarily as a result of the extended seasonality we had anticipated, primarily from summer holidays and vacations across the region. For APAC, Q3 volumes were up 4.2% compared to a record Q3 last year in APAC. On a year-over-year basis, growth was uneven. The market as APAC, the first region to emerge from the depths of the COVID lockdown in 2020. Additionally, we saw COVID resurgences and lockdowns sporadically impact various APAC countries in Q3. On a sequential basis, Q3 Invisalign volumes were up 21.2%, reflecting growth across the region led by a record quarter in China, especially from teen cases, as well as strong growth in Japan, and A&G. In Q3 growth from both channels was strong with ortho growth driven by increased Invisalign utilization and cheapy growth, channel growth driven by increased Invisalign submitters. APAC teen shipments reached an all-time high in Q3, at the recent 10th China Finance Summit Awards, Align was recognized as the 2021 most innovative enterprise for its advancements and outstanding contributions in the field of Digital orthodontics. This award builds on our prior recognition of Align's leadership in the digital orthodontics industry and its efforts to promote the modernization of orthodontics. Our consumer marketing focuses on educating consumers about the Invisalign system, to drive demand to Invisalign doctors offices, ultimately capitalizing on the massive market opportunity to transform 500 million smiles. In Q3, we expanded a next-generation of the Invis Is media campaign across EMEA, APAC, and Brazil to increase awareness with adult, mom, and teen consumers. Globally, we delivered 6.45 billion impressions, growing 42% year-over-year, resulting in a 70% year-over-year increase in unique visitors to our websites. In the U.S., we connected with teens on Snapchat, YouTube, and Twitch, with our Invis is Not Your Parents Braces campaigns. These campaigns continue to feature some of the largest teen influencers from our Invisalign SmileSquad, like Charlie D'Amelio, Marci Martin, Michael Leon Collins, and Devin Key. These influencers share their personal experience with Invisalign treatment, including why they chose Invisalign treatment to shape their smiles. As part of our focus on teens, with our Invisalign teens makers program, we hold a recognition event hosted by Marcel Martin with teens across the country to celebrate and recognize 100 teens across the country who drove positive change within their communities. To continue growing for our young adult businesses, we expanded the Invis is a powerful thing campaign, which highlights how powerful the smile transformation with Invisalign treatment can be for their self confidence. In U.S we expanded our Invisalign smile squad to include young adult influencers such as Cody Rigsby, Lana Candor, and Emily Hampshire, who help to deliver over 405 million impressions. Additionally, our influencer partnerships with TikTok creators helped increase traffic to our sites, with a 127% increase in click-through rates. In Brazil, we launched the Invis is a Powerful Thing campaign, and teamed up with mega influencer [Indiscernible] to increase website traffic by 30%. In the EMEA region, we expanded into new media channels such as TikTok and Snapchat across the UK, Germany, and France to drive engagement. These efforts led to more than a 153% increase in unique visitors. We also started consumer advertising in Russia, which resulted in more of a 1000 increase in unique visitors to our website. In Q3, we continue to expand our consumer advertising across the APAC region, experienced a 132% increase in unique visitors to our websites. And Australia, we expanded our media mix to include partners such as TikTok and Snapchat. Which resulted in 250% -- 250% growth year-over-year in unique visitors to our website. In Japan, we continue to see a strong response from consumers to our [Indiscernible] campaign, resulting in more than an 800% increase year-over-year in unique visitors to our website. Adoption of our consumer in patient app, my Invisalign continued to increase in Q3 with 1.2 million downloads to date. Usage of our 4 digital tools also continued to increase. For example, our Invisalign virtual appointment tool was used over 15,000 times and our insurance verification feature was used 14,000 times in Q3. Furthermore, we received more than 1.5 million patient photos in our Virtual Care feature today globally, which continues to provide us with rich data to leverage our AI capabilities and improve our services for doctors that is used to enhance their patients care. For our systems and services business, Q3 revenues grew 57.3% year-over-year, reflecting strong scanner shipments and services, and was up 5% sequentially. This is the fifth consecutive quarter of sequential revenue growth for our systems and services business. The iTero Element 5D Plus Imaging system continued gaining traction across all regions, with the most recent launch in Japan in Q3. The iTero Element 5D Plus Imaging System will be available in China in Q4 of this year. Additionally, The iTero Element Plus Series was launched in Korea in Q3. The series expands the portfolio of iTero Element Scanners and Imaging Systems to include new solutions that serve the needs of a broader range of doctors and patients in the dental market. Moreover, I'm proud to say that in a recent clinical study, the iTero Element 5D Intraoral Scanner was found to be more sensitive than bitewing radiology. in detecting early enamel lesions, providing further evidence of the benefits of iTero 5D Scanner in detection and monitoring of interproximal caries lesions or cavities above the gingiva, without exposing patients to harmful ionizing radiation. This is great news for our iTero business, as a study further supports the diagnostic ability of Near-Infrared imaging technology offered by the iTero 5D Scanner for early proximal caries detection. The findings also underscore the valuable role that NIRI technology can have in dental health assessment and early detection of cavities, which is important to the overall oral healthcare treatment options. And a comfortable, safe experience for a broad population of patients. A strong indicator of the digital acceleration with dental offices is a number of intraoral digital scans used for Invisalign case submissions. Total worldwide intraoral digital scans used to start an Invisalign case in Q3 increased 84.2% from 78.3% in Q3 last year. International intraoral digital scanners for Invisalign case submissions increased 79.3% up from 72.1% in the same last year. For the America's, 88% of cases were submitted using an intraoral digital scan compared to 83.2% a year ago. Cumulatively, over 44.9 million orthodontics scans and 9.3 million restorative scans have been performed with iTero scanners. Our Q3 systems and services revenues also includes Exocad, CAD CAM products and services. Exocad expertise -- expertise in restorative dentistry, implantology, guidance surgery and smile design, extends our digital -- our digital dental solutions and broadens Align digital platform towards fully integrated into disciplinary and workflows, we remained excited about our continued integration progress and product plans with Exocad. During the quarter, Exocad launched, chair-side CAD 3.0 Galloway. The next-generation of Exocad, easy-to-use CAD software for single-visit dentistry. The software has improved automation for fast crown design enables users to integrate open hardware and material s of choice. Exocad, chair-side CAD received 2021 seller best-of-class technology award for the third consecutive year. Also during the quarter, Exocad has its largest ever presence at IDS, International Dental Show, where they showcased their seamless digital workflows, and the simplicity of the use of Exocad Galway software release. Exocad was the only Company at IDS to showcase live patient treatment with a smile creator experience station, featuring iTero scans, instant smile makeovers, and production of clip on smiles. With that, I will now turn it over to John.
John Morici: Thanks, Joe. Now for our Q3 financial results. Total revenues for the third quarter were $1.016 billion, up 0.5% from the prior quarter and up 38.4% from the corresponding quarter a year-ago. For Clear Aligners, Q3 revenues $837.6 million were down 0.4% sequentially, and up 34.9% year-over-year, reflecting Invisalign volume growth across all geographies. In Q3, we shipped 655,100 Invisalign cases, a decrease of 1.6% sequentially with an increase of 32.1% year-over-year. In addition, we shipped to a record 85,500 Invisalign doctors worldwide, of which approximately 7200 were first-time customers. Q3 Clear Aligner revenues reflect strong growth across the Invisalign portfolio, led by comprehensive products. Q3 comprehensive volume increased 1.3% sequentially, and 30.3% year-over-year. And Q3 non-comprehensive volume decreased 8.1% sequentially, and increased 36.8% year-over-year. Q3 adult patients decreased 7.3% sequentially, and increased 34.7% year-over-year. In Q3, teens or younger patients increased 13.8% sequentially and 26.6% year-over-year. Clear Aligner revenues were unfavorably impacted by foreign exchange of approximately $1.5 million or approximately 0.2 points sequentially. On a year-over-year basis. Clear Aligner revenues were favorably impacted by foreign exchange of approximately $16.1 million or approximately 2.6 points. For Q3 Invisalign comprehensive ASPs increased sequentially and year-over-year. On a sequential basis, Invisalign comprehensive ASPs reflect higher additional aligners. On a year-over-year basis, comprehensive ASPs reflect favorable foreign exchange, partially offset by the increase in net revenue deferrals for new Invisalign cases versus additional Aligner shipments. Q3 Invisalign non-comprehensive ASPs increased sequentially and year-over-year. On a sequential basis, Invisalign non-comprehensive ASPs reflect higher additional Aligners, partially offset by higher discounts. On a year-over-year basis, Invisalign non-comprehensive ASPs were favorably impacted by foreign exchange, higher additional Aligners, and lower discounts. Clear Aligner deferred revenues on the balance sheet increased $84 million or 9.3% sequentially, and $347.3 million or 53.9% year-over-year, and will be recognized as the additional Aligners are shipped. Our Systems and Services revenues for the third quarter were a record $178.3 million, up 5% sequentially, and up 57.3% year-over-year. This marks the fifth quarter in a row of sequential revenue increase. The increase sequentially can be attributed to increased scanner shipments, and increased services revenues from our larger installed base. The increase year-over-year can be attributed to increased scanner shipments, increased service revenues from our larger installed base, as well as higher ASPs from a favorable mix shift towards higher price iTero 5D scanners and imaging systems. Our systems and services deferred revenue on the balance sheet was up $27.2 million or 17% sequentially, and up $100.1 million or a 115.2% year-over-year, primarily due to the increase in scanner sales and deferral of services revenue, which we recognized ratably over the service period. Moving on to gross margin. Third quarter overall gross margin was 74.3% down 0.7 points sequentially, and up 1.6 points year-over-year. On a non-GAAP basis, excluding stock-based compensation and amortization of intangibles related to our 2020 Exocad acquisition, overall gross margin was 74.7% for the third quarter, down 0.7 points sequentially, and up 1.4 points year-over-year. Overall, gross margin was favorably impacted by approximately 0.5 points on a year-over-year basis, due to foreign exchange and relatively unchanged sequentially. Clear Aligner gross margin for the third quarter was 76.2%, down 0.7 points sequentially due to higher manufacturing costs, and higher additional Aligners, partially offset by higher ASPs and lower freight. Clear Aligner gross margin was up 1.5 points year-over-year due to improved manufacturing efficiencies from higher production volume, partially offset by higher ASPs. Systems and services gross margin for the third quarter was 65.6% down 0.3 sequentially, primarily due to lower ASPs and higher manufacturing variances, partially offset by higher service revenue. Systems and services gross margin was up 3.6 points year-over-year due to higher ASPs from product mix shift to iTero 5D and 5D Plus series and service revenues, partially offset by higher freight costs. Q3 operating expenses were $494 million up sequentially, 0.9% and up 38.4% year-over-year. On a sequential basis, operating expenses were up slightly by $4.4 million. Year-over-year, operating expenses increased by $137 million, reflecting increased headcount in our continued investment in marketing, sales, and R$D activities. and invents -- investments commensurate with business growth. On a non-GAAP basis, excluding stock-based compensation, and amortization of intangibles and acquisition costs related to our 2020 Exocad acquisition, operating expenses were $466.1 million up sequentially 1% and up 40.3% year-over-year due to the reasons described earlier. Our third quarter operating income of $261.1 million resulted in an operating margin of 25.7%, down 0.9 points from the prior quarter, and up 1.6 points year-over-year. The sequential decrease in operating margin was attributable primarily to lower gross margin. The year-over-year increase in operating margin was primarily attributed to higher gross margin and operating leverage, as well as the favorable impact from foreign exchange by approximately 0.7 points, partially offset by continued investment as mentioned earlier. On a non-GAAP basis, which excludes stock-based compensation and amortization of intangibles and acquisition-related costs, the operating margin for the third quarter was 28.8%, down 0.9 points sequentially, and up 0.8 points year-over-year. Interest and other income and expense, net for the third quarter was a gain of $0.8 million up sequentially by 0.9 million and down year-over-year by $6.6 million. On a year-over-year basis, interest and other income and expense decreased primarily due to net foreign exchange losses in the 3 months ended September 30th, 2021, as compared to net foreign exchange gains in the same period in 2020, which was partially offset by an unrealized gain and an investment held in a private Company recognized in the three months ended September 30th 2021. The GAAP effective tax rate for the third quarter was 30.9%, compared to 25.7% in the second quarter, and 24.5% in the third quarter of the prior year. On an non-GAAP -- our non-GAAP effective tax rate was 22.2% in the third quarter, compared to 19.5% in the second quarter, and 16.6% in the third quarter of the prior year. The third quarter GAAP and non-GAAP effective tax rates were higher than the second quarter, primarily due to our foreign income being taxed at different rates and tax true-ups. Our GAAP and non-GAAP third quarter effective tax rates were higher than the third quarter of the prior year, primarily due to lower tax benefits from foreign income tax at lower rates and a tax benefit recognized last year resulting from an income tax audit settlement. Third quarter net income per diluted share was $2.28, down sequentially $0.23 and up $0.52 compared to the prior year. On a non-GAAP basis, net income per diluted share was $2.87 for the third quarter, down $0.17 sequentially and up $0.62 year-over-year. Moving onto the balance sheet. As of September 30th, 2021, cash and cash equivalents were $1.2 billion, up sequentially $151.5 million, and up $622.3 million year-over-year. Of our 1.2 billion of cash and cash equivalents, $607.5 million was held in the U.S., and $630.3 million was held by our international entities. Q3 accounts receivable balance was $855 million, up approximately 5.8% sequentially, our overall days sales outstanding was 75 days, up approximately three days sequentially, and down approximately two days as compared to Q3 last year. Cash flow from operations for the third quarter was $355 million. Capital expenditures for the third quarter were $124.3 million. As we continue to invest in increased in the liner capacity and facilities. Free cash flow defined as cash flow from operations, less capital expenditures amounted to $230.7 million. We also have $300 million available under our untapped revolving line of credit. Under our $1 billion repurchase program announced in May of 2021, we have $825 million remaining available for repurchase of our common stock. Now let me turn to our outlook and the factors that inform our view for the remainder of the year. We're very pleased with our Q3 results and strong year-over-year growth, which reflects continued customer adoption of the iTero scanners and increased Invisalign utilization across customer channels, including teens, adults, and young patients. Over the last 18 months, our investment decisions have helped drive and capture demand across all regions and customer channels. We continued spending in many areas, and have seen good return on our investments and strong revenue growth. Consumer interest in improving smiles is high, and doctor acceptance into Align Digital Platform is helping drive growth across all regions and market segments. As anticipated in our Q3 outlook, we experienced more pronounced summer seasonality, more noticeably in September and continued into October as practices took more extended vacations, and patient traffic low was sporadically interrupted by regional COVID resurgence, restrictions, and other lockdowns. We anticipate these COVID challenges and the general macroeconomic uncertainties to continue into Q4. Taking this all into account, as we look at the remainder of 2021, we expect revenues for the year to be in the range of $3.9 billion to $3.95 billion, at the high end of our original guidance range. We also expect our outlook in revenue growth for the second half of 2021 to be in the high end of our long-term operating model of 20% to 30%. On a GAAP basis, we anticipate our 2021 operating margin to be around 25%. On a non-GAAP basis, we expect 2021 operating margin to be approximately 3 points higher than our GAAP operating margin, after excluding stock-based compensation and intangible amortization from our 2020 Exocad acquisition. We remain confident in the huge market opportunities for our business, our industry leadership, and our ability to execute. We will continue to invest in sales, marketing, innovation, and manufacturing capacity to drive our growth and accelerate adoption in a huge under-penetrated market. In addition, during Q4 2021, we expect to repurchase up to $100 million of our common stock through either a combination of open market repurchases or an accelerated stock repurchase agreement. For 2021 we expect our investments in capital expenditures to be above $400 million. Capital expenditures primarily relate to building construction improvements, as well as additional manufacturing capacity to support our international expansion. This includes our planned investment in our new work -- our new facility in Wroclaw, Poland, the first in the EMEA region. With that, I'll turn it back over to Joe for final comments. Joe.
Joseph Hogan: Thanks, John. Summary, Q3 was a strong quarter and we're pleased with our performance across the business. Align is uniquely positioned. We have a clinical capability and product portfolio supported by doctor and patient workflows only accessible through the proprietary Align Digital Platform, to address the broadest range of orthodontic cases with the Invisalign system through a network of trained Invisalign doctors who had the expertise to reach more than the 500 million potential global patients. As we develop our annual plan for 2022 over the next few months, it's important that we continue to expand our commercial manufacturing, R&D clinical treatment planning and manufacturing operations, and continue to leverage our global quality and regulatory muscles in existing and emerging markets. Which millions of consumers who want to transform their smile with the most advanced Clear Aligner systems in the world. Through advertising, PR, digital, social media, and influencer marketing to drive demand and conversion through Invisalign trained doctors. Increased ortho adoption and team utilization of Invisalign treatment, and train and educate GP Dentist on how the iTero Element family of inter-oral scanners in imaging systems propel today's dental practice into the future by enhancing patient experience and elevating clinical precision, and in the benefits of digital dentistry with the Invisalign system, trusted by more than 11 million people worldwide to improve their smiles. Remained focused on strategic execution, accountability, agility, customer service excellence, and continuing to make investments to grow our business. This is a multi-variable equation that we continue to talk about, and that in combination where we remain uniquely able to offer. As we continue to stay the course with our strategic initiatives, we also continue to navigate the COVID-19 environment and the challenges and uncertainty that go with it. Throughout the pandemic, our top priority has been consistent. The health and safety of our employees and their families, doctors and their staff. And that has not changed. The situation with COVID remains very fluid, and with the rise of the Delta variant, many cities, states, and countries have issued or planned to issue new guidance, including mass requirements, regular testing, capacity limits, and vaccination mandates. Operating in this evolving environment is challenging for everyone, and we're staying as close as we can to the situation. The shift from traditional analog wires and brackets to a fully end-to-end digital platform is not easy and cannot be done without very complex and industry-leading technology, and talented passionate people. But the digital transformation in orthodontics is inevitable. Our technology is prevalent, touching every aspect of what we do from manufacturing excellence, where we currently produce over 750,000 unique Aligners a day, to expanding our geographic footprint to over a 100 markets, to building a network of over 210,000 trained Invisalign doctors, and providing a technology to our doctors and a complete digital system, the Align Digital Platform. As the inventor of the leading Clear Aligner system, we've been investing in this therapy for over 24 years to get it to where it is today, and yet the majority of the market opportunity remains largely untapped. with over 500 million potential cases starts globally. Align is in a rare position to address this market with the Align Digital Platform, powered by two decades of research and development, manufacturing excellence clinical data based on more than 11 million patients, with AI machine learning and digital tools to help our doctors efficiently communicate with our patients, show and explain any issues and visualize potential treatment options. And together with doctors, we're going to unleash the power of digital for dentistry in orthodontics more than ever. Thank you for your time today. I look forward to speaking with you on Friday at our Investor Day where we'll share more details on the Align Digital Platform and our vision and strategy to make Clear Aligner treatment available to everyone through doctors. Now I will turn the call over to our operator for your questions. Operator?
Operator: Thank you. At this time, we'll be conducting a question-and-answer session. [Operator instructions]. We ask that you please limit to 1 question and 1 follow-up. [Operator instructions]. For participants using speaker equipment, it may be necessary to pick up your handset before pressing the star keys. One moment please while we pull for questions. Our first question comes from Nathan Rich with Goldman Sachs. Please proceed with your question.
Nathan Rich: Hi, good afternoon. Hey, Joe. Joe and John, you highlighted the seasonal softness in September and that extended into October. I wonder if you could maybe just provide a little bit more detail on what you've seen in October so far, maybe how that compared to September. And then as we've seen the latest COVID case spikes subside in recent weeks, have you seen -- the patient traffic flow that you mentioned, has that started to pick up as COVID cases have ticked down?
John Morici: Yes. Hi, Nate. This is John. As we said, the extended seasonality continued into September and October. And then some of the COVID uncertainty still remains. And some places more back to normal than others, and -- but that uncertainty remains. Taking all that together, our forecast reflects that. So the total year -- the remaining for total year reflects everything that we've seen to this date.
Nathan Rich: Okay. That's fair, I guess. Joe, maybe a follow-up. I mean, you've continued to have confidence in that 20% to 30% long-term range. Maybe we'll hear more on Friday at the Analyst Day. But do you have an initial view on growth for next year, and do you feel like once this period of more pronounced seasonality is behind you, we get back to a more normalized trajectory for the business as we head into next year. Thanks for the questions.
Joseph Hogan: Well, Nathan we are growing at a pretty good pace right now. So it's actually above our long-term growth model, which is 20% to 30%. And as we move into 2022, we'll retain that 20% revenue growth target, and we're happy to discuss it more in detail on Friday.
Shirley Stacy: Thanks, Nathan. Next question, please.
Operator: Our next question is from John Block with Stifle. please proceed with your question.
Jonathan Block: Thanks, guys. Good afternoon. John, I just might follow in Nathan's path, but let me take a different approach. The new rev range that you gave for this year, you clearly brought it up a little bit, it seems to imply a bit over a billion dollars for the fourth quarter. If I assume the scanner up sequentially from the 178, and 55 million - ish give or take in non-case revenue. And it looks like case volume is expected to be flat to maybe even down low-to-mid-single-digits sequentially. So a couple of things there, is that the right way to think about things specific to case volumes? And if so, I know you touched on this a little bit, but why sort of the different trend line versus prior to COVID, if you would, where that was more up mid-single-digit plus?
John Morici: Yeah, Jon. I think when you look at prior years with COVID not in the mix, things were maybe more seasonal. And you could see some of the standard patterns from let's say a Q3 to Q4, given COVID and given some of the uncertainties that you have. And certain economies and how they are responding and opening up, Things don't always apply to mainly what's happened in the past. So that guidance that we gave is a reflection of what we've seen.
Jonathan Block: Okay. Got it. And Joe, just a follow-up, we keep on hearing about the iOS changed from Apple on privacy and you guys have such a broad reach in terms of marketing. But I am curious if you're seeing any impact? Is it impacting leads? Yes or no, and if so, could that actually continue into 2022? We'd love your feedback there. Thanks.
Joseph Hogan: John, it's a good question we've seen an impact on it. The thing is a lot of other media you can -- you can pivot to in order to find those patients. So have we seen it and have we had to do a certain amount of pivot to do that? Yes. But you know as far as our marketing efforts, I wouldn't discount them in any way in this sense of that change being material in some sense in the near future.
Jonathan Block: Fair enough. See you on Friday.
Joseph Hogan: [Indiscernible]
Operator: Our next question comes from John Kreger with William Blair. Please proceed with your question.
John Kreger: Hey, guys. Thanks. I'm curious now that you've exited another typical teen season what penetration do you think Invisalign has of total teens starts at this point?
Joseph Hogan: Well, I mean globally -- hey John, it's Joe. Globally, it's less than 5%. When you look at -- we'll show on Friday exactly what we think that is. In United States, I think our current number is the mid-teens. Yes. John, I think that too. We have so far to go, right. This is a superior treatment, like I said in our script, we can do 90% of the orthodontic cases that are out there. It's just us continuing to work really closely with the orthodontist, and advertise to consumers to explain the benefits of digital orthodontics and move this forward. But like I said, this is inevitable. Digital is better. We know it's better. We've made it better. It's more comprehensive than it was before, it's faster, less invasive. I could go on all day. And that's what drives this Company, that's our purpose. We know we'll hit it. It's just -- there's just a lot of work to get from here to there.
John Kreger: Thanks.That was Joe, that was my follow-up. As you talk to your power users or maybe people that are just getting started. You've made the product better. You made the software better. What do you think is the key point of friction at this point to get that adoption rate up where I think most of us on this call assume it can get to longer-term?
Joseph Hogan: But John, I think it's the classic early adopter syndrome. The doctors who use our product almost exclusively 100% can't imagine not using our product line. But they're early adopters in the classical sense. There's 2 things; 1, there's the clinical confidence people, people that are out there that we have to convince. It's much easier that it is today than it was five years ago. Given products like first giving products like [Indiscernible] those kind of things that extend it. And then the predictability of our products. Secondly, it's the business equation inside the orthodontic practices that they're convinced they can actually keep up the margins and the growth capability they have for their practices, we understand that. And that's why we have programs like adapt that we put together, John, that orthodontist who want to engage with us we can show them how to really operate in a digital environment and actually exceed from a margin standpoint, and growth standpoint.
John Kreger: Sounds good. Thank you.
Joseph Hogan: Yes. Thanks, John.
Operator: The next question comes from Jason Bednar with Piper Sandler. Please proceed with your question.
Jason Bednar: Thanks for taking the questions and congrats on the record quarter here.
Joseph Hogan: Thanks Jason.
Jason Bednar: A couple of questions from our side. One big picture. First for you, Joe. One of the key drivers of growth, the past year has been really the adult category outpacing that of teens. It really seemed like heading into this quarter could be the proof-point quarter and whether that growth would flip back to teen, but adult was again stronger than teens here. It seems like some good staying power. So I guess Joe, how do you think about these -- how these 2 segments play out from Here, both obviously have a ton of growth potential, but as the business for Align shifted to where we should be thinking about adult growth, outpacing that of teens. As we look forward to the coming quarters and years?
Joseph Hogan: Yes. Jason, it's a good question, but I think it's -- and you'll hear a lot about it this Friday, is the demand equation on this business is incredible, right. The 500 million patients we've talked about, they'll primarily be serviced at the general dentistry area, and then the over 20 million, that's on the -- in the orthodontics side. That mean -- that's -- you look at that. It's a wide open marketplace. Adults have done well, teens will do well. I just think you have to have them both go up. And remember their dealer from different basis in the sense of, traditionally, 75% of our cases have been adults and 25% teens, so there is a large number on the adult side, but the growth potential is amazing. And we'll just going to go after both ends of that equation as aggressively as we can.
Jason Bednar: Got it. Okay, that's helpful. I look forward to more on Friday then. And then maybe some more of a real-time look and also following up on Nate's question there to start out, but asking also a different way. Maybe wonder if you could talk about how utilization trends have gone here month-to-month on a regional basis, September, October, and then maybe based on the treatment plans and missions, other measures of your funnel. What does the utilization look like as we shift from October and November? Thanks.
John Morici: Yes, Jason, this is John. We've seen some improvements in utilization and it's a reflection of kind of coming out of that seasonality piece of what we've talked about and kind of navigating through COVID. But we've been happy with the utilization that we've seen as of late.
Jason Bednar: All right. Thanks so much.
Joseph Hogan: Thanks, Jason.
Operator: Our next question comes from Elizabeth Anderson with Evercore. Please proceed with your question.
Joseph Hogan: Hi, Elizabeth.
Elizabeth Anderson: Hi, guys. Thanks so much for the question. I had a question on the gross margin line. I think you guys talked about how you're seeing maybe slightly higher manufacturing costs in Clear Aligners and then lower freight and higher freight in iTero that has other -- the higher freight costs there. So I was just wondering, as we think about some of the global supply chain issues that we've been reading about and hearing about from other companies, if you could just elaborate a little bit on what you're seeing in both of those areas. Thanks.
John Morici: Hi, Elizabeth. This is John. I can take that. I think when you look at our overall gross margin, broadly impacted as we've talked about. Additional liners, as we now have ramped up and we've seen those cases from the last several quarters as doctors make refinements and get patiently in to make refinements to the care. We see an improvement there in ASPs, but there's some offset in gross margin. But broadly, when we look at some of the inflationary [Indiscernible] and so on, we have long term contracts, we have got a supply chain where we're driving a lot of productivity and efficiencies through. So, we feel we're pretty well balanced as we see some of these inflationary headwinds, not that it's not a challenge out there for everybody, but we feel that between the contracts we have and the efficiencies we can drive, we balance it.
Elizabeth Anderson: That's really helpful and maybe I saw that in your outlook, you're obviously talking about around a $100 million in share repurchases in the fourth quarter. But your cash balance is moving up nicely and I was wondering if you could comment on what you see sort of how preferred level of cash balance and if there's any potential for acceleration on the share repurchase line or, things that we should consider in thinking that should be a little bit higher than where it's been traditionally.
John Morici: Yeah, I think when you look at -- I'm balanced, Elizabet, we're very pleased with the cash generation, almost 900 million of CFOA, 3 quarters of the year. It's phenomenal cash. A lot going back into the business to grow our business, make investments in some of the operating expenditures to grow our business, continue to make investments in capacity and adding capacity, getting closer to our customers. And then as we've said with our cash, we'll give back to shareholders through repurchase. So we're very happy with how things have progressed. We don't have a magical number in terms of how much cash we should have, but all things in balance. We feel like we're executing to our strategy.
Elizabeth Anderson: Perfect, thanks.
Operator: Our next question comes from Jeff Johnson with Baird, please proceed with your question.
Jeffrey Johnson: Thanks. Good afternoon, guys. Joe, I wanted to start maybe on system and services, or maybe John this is for you, but where are at, as what portion of that revenue is the recurring services' side as opposed to system sales? And in 4Q, we're still hearing about a decent amount of PPP money floating around. Obviously, you've got the incremental launch coming in China and that of 5D. Should we think of 4Q being a better system quarter sequentially again, just with seasonality there?
John Morici: Yeah, Jeff, this is John. We've been very pleased with our sequential improvements that we've seen in the systems and services -- in scanner services business. When we look at five quarters in a row of kind of really helping us lead the recovery out of COVID. And a lot of investments that doctors are making -- our doctors are making in the Digital Platform, there's an excellent reflection of that, we have a lot of new doctors that started Invisalign this quarter with us and many of them start with getting an iTero and being able to utilize that within their practice. So we feel very good about the scanner and services business. About a third of that business is services. So that's the reoccurring. And as we improve and have more of an installed base, that just grows that business. So you got a very big and growing installed base coupled with great products that are really driving that adoption. And especially among newer doctors coming in, they're coming in with that scanner to really incorporate that digital technology into their practice.
Jeffrey Johnson: Yeah. Understood. And then Joe, maybe bigger picture question just on the return in the chair and what docs are seeing for Clear Aligner and this a line of specialty relative to braces. But we've talked more and more docs just even over the last maybe few months who seem to be really spacing those follow-up visits in Invisalign out to 3 or even 4 months. It's cutting the chair time even in half relative to pre - COVID levels and well below braces. Are you seeing the same thing? I know virtual is helping that a little bit. I think some docs even doing it without virtual, just given their confidence and outcomes. But how much is that driving the argument in that secular push into Clear Aligner, especially with staffing issues that maybe you guys are hearing about at some of the offices, things like that?
Joseph Hogan: Yeah, Jeff, that's one of the key ingredients, is the productivity of a doctor's time and the productivity of the real estate within that office. And in digital kind of situation, you can remote monitor like you do on Virtual Care, some other products that are out there and doctors are taking advantage of that. But also there's a lot of confidence doctors have too if their patients are using the Aligners they will bring them back every so often and take a look to that. That's a big part of it. Secondly, Jeff, is it -- you can actually work with less labor content, and less doctor content and people in the office. And also size of the office too. You see a whole lot of orthodontists understanding that, and really embracing it. There's a whole referral aspect to Invisalign, is once a patient has an experience with Invisalign, they are often ready to refer another patient to that doctor much more so than wires and brackets. And they said they benefit from that because they see an increase in their sales too. And we see that constantly and adapt and we focus on that, and can actually predict it to a certain extent of time. So I hope I'm answering your question, Jeff, but that is the whole idea of Digital. And then we keep talking about our Align Digital capability, and being able to service a doctor through iTero, being -- having Virtual Care on both ends, and having the kind of capability and horsepower that we can provide with our algorithms in the extent of our clinical capability, is just -- it gives us a huge amount of breadth and capability at orthodontist.
Jeffrey Johnson: Sure. I understood. Thanks, guys.
Joseph Hogan: Thanks [Indiscernible]
Operator: Our next question comes from Brandon Couillard with Jeffrey's, please proceed with your question.
Brandon Couillard: Thanks.Good afternoon. I actually want to switch gears, you talked quite a bit about the non-case business and the retainer business. Can you help us understand why your share has historically lagged there? Maybe a sense of what your capture rate is today in terms of the cases that also have a follow-on retainer. And how would you frame the revenue opportunity from these newer initiatives?
Joseph Hogan: Brian, it's a good -- it's why we highlighted it and it's obviously why we've put money into this thing and our focus on it over the last years. There's certain things in this business that we all know, but there's so many things to do and focus on it. Sometimes something it's so obvious like that, lacks the attention that you want to give to it. And we've been talking about this over time. So, beginning of this year, put a team together to really go after those things. It's hard to say the reason why. It's just we haven't been as focused on retention as we need to be. And many orthodontists, they make their own retainers. They do it because we just haven't been competitive in the sense of how we can deliver, how fast we can deliver, how easy we make it for them. But I guarantee you if you go out Brandon and you query even orthodontist that seldom use our retainers, they'll tell you we make the best retainers in the world. And we should when we make a 750,000 unique parts a day, right? We know what we're doing. The fits are exquisite. When you have an iTero scanner, it'd be able to do that. And we've set this thing up as a play for doctors that they can feel confident that we'll get these retailers to them in a quick amount of time. They're going to be terrific retainers, something they are proud to really get to their patients. And we've had great feedback on this so far. So I can't apologize for the past or give you the whole history why we haven't done it, but I feel really good about the progress we've made so far.
Brandon Couillard: Fine. And then just a question on scanner business. I mean, pretty remarkable strength for a while now. Can you just help us understand where the sources of this momentum, and is the NIRI study the type of data set that can move the needle with GP that?yield loss? can talk about clinical studies, especially within?Joel's? beginners, but just trying to get a sense of how significant you'll be able to go in and have this data there might be for a GP that doesn't use digital impressioning today, or might be on the fence.
Joseph Hogan: Yeah. I think NIRI really helps. I really do. It's one of those -- you know in electronics we all know there's killer apps, right? Killer applications. When you can see?carriers?, cavities, right? We use the clinical term, but when you can see cavities without ionizing radiation and Brand of what's amazing when you see this to what happens is the enamel almost becomes invisible, it's almost translucent. You can see through the enamel right to where the carriers is. And there's certain amount of training that has to be done in order to do it and -- look, I grew up in ionizing radiation business. I know what it is and CT and x-ray and it's that radiation component is better today than it used to be, but it's still exist and patients are still concerned with it over time and to be able to do this in a sense, in a safe way, and as a quick way like we do it. You know what it is to put bitewings in a chair. I mean, it's terrible in a dentist chair, right. Bite down, turn your head sideways. I could go through it all day. And this is a quick scan, one minute scan. minute and a half scan. It pops up on the screen. You can have a conversation with a patient, say there it is, what he deals with. So yes, I think it's a killer application. We'll convince all GPs to buy iTero, no. But then you have to look at Exocad, that critical workflow between labs and GPs really sets us up nicely for restorative pieces. Soon to announce [Indiscernible] architect, which really allows doctors to use restored of Orthodontics as a standard of care, we'll talk about that more Friday. Look, I'm biased. I've been in the -- I'd say the medical imaging equipment business for 15 years of my life count, and iTero, this is the best scanner in the marketplace. And we're just out to show it and to prove it.
Brandon Couillard: Thank you.
Joseph Hogan: Thank you.
Operator: Our next question is from Chris Cooley with Stephens, please proceed with your question.
Chris Cooley: Good afternoon and thanks for taking the questions. Congratulations on the record quarter.
Joseph Hogan: Thanks, Chris.
Chris Cooley: Just from me as we all start looking forward to upcoming event here this Friday, and Saturday maybe a bigger picture question. As we think about the business you've made significant investments in technology, not only pioneering the category, but expanding its indications for use. You subsequently invested in chair-side, really facilitating the diagnostic aspect. And as the businesses now kind of inflecting here, two straight quarters of a billion dollars plus, do we think about the next stage of investment really kind of going back to a prior question being tools that enable or enhance the productivity of the clinician or patient flow. more to marketing at the consumer and clinical level? I'm just thinking about how the business now pivots for that next stage of continued growth at this greater scale. And I have just one quick follow-up after that, if I may.
Joseph Hogan: Chris, it's really good question, because obviously as we're going through our AOP for next year and putting those things together. But when you say pivot.I wouldn't use the word pivot. I'd say that we extend to what we're doing. And then we place bets accordingly and where we think we'll get the best return. We -- I got to continue advertising. We have a superior system. We have a wonderful brand. We have to leverage that piece. But specifically, and this goes to last questions we had too, doctor productivity is a big deal. And when you look at our Align Digital Platform, inherently that's what it's about. It's how do you make doctors more productive to make sure that we don't go back and forth with 8 clean checks, or how do we make sure that from our standpoint that we can respond quickly to customer issues. And we're investing heavily in all those things and making good progress. It's expensive, the lot of things that you have to do when you really grounded in software and making those changes. We have really great talent here that knows how to do that. We've been actually working the productivity of clean checking those things for 3 to 4 years. And it's just starting to bring technology to the marketplace. So you're right. We're not pivoting toward that. We've been investing in it, but you'll see the combination of that more and more as we enter next year in the second half of next year too. John, anything to add?
John Morici: No. I think that's the investments that we continue to make. It's about productivity. It's about growing in this Digital orthodontics, and our doctors expected and our tools will provide that.
Chris Cooley: That's great. And if I could just squeeze in a quick follow-on, just want to make sure, doesn't look out of proportion, but I just want to make sure we didn't miss something there on the deferred piece in the quarter, I think was approximately 84 million. Anything just COVID-related that we should be mindful of there is that just normal course of business when we look at the deferred revenue component for the 3Q. Thanks so much for wrapping the quarter.
John Morici: Thanks, Chris.
Joseph Hogan: Thanks, Chris.
John Morici: It's completely normal course of business, nothing COVID related within there, just deferred revenue that we'll recognize in future periods.
Chris Cooley: Thanks.
Joseph Hogan: Thanks, Chris.
Operator: Our next question comes from Michael Ryskin with Bank of America. Please proceed with your question.
Michael Ryskin : All right. Thanks for taking the question, guys. Couple of quick ones from me, but I'll try to tie them together into one. On the scanners and service revenue, I've noted that your digitally submitted cases continues to grind higher, pretty close to hitting 90%, maybe in a year or 2. I am just wondering as you continue to play iTero into the field, How often are you surplacing a second or third unit, versus getting a new one out there, versus a competitor placement where you're displacing someone else potentially. And then as a follow-on to that, sort of building off of I think Elizabeth question earlier on the supply chain. Any specific to semis that we should be thinking about, this is the question that's come up a lot some of other names, and want to make sure we tie that off as far as it relates to scanners. Thanks.
Joseph Hogan: Hey, Mike. From a scanner standpoint is -- obviously we have a great scanner, and I think your question asked more about saturation, more than anything. Our feeling is you got 2 million dentists out there and orthodontist. And each of them actually, if you're going to run a digital practice, you need more than one scanner, you need a scanner per chair. You think, let's just say the average doctor has three chairs and there's 2 million doctors out there, we're just touching this thing. We got a 50 thousand unit installed base. And obviously this is a growth equation. It's not one where we're looking to playing out in some time, and obviously it's a portfolio insurance over time, because the technology moves fast too. So, it creates some of its own demand through our solar system. John, I'm done.
John Morici: And from a supply standpoint, obviously, we're mindful of concerns and things that go on from a global supply chain. But we feel comfortable that between the inventory we have and some of the things that we've been able to do that we can manage to, in a supply chain concerns that are out there.
Michael Ryskin : All right. Thanks a lot.
Operator: Our next question is from Devin Misra with Birenberg, please proceed with your question.
Doug: Hey Devin, Doug here for Ravi from Berenberg. Thanks for taking my question. I want to revisit the marketing side. I think you guys have been ramping up marketing spending and there was a long list of things with very large percentage increases noted earlier. Where are you seeing a higher ROI in regards to marketing? Are there any specific regions? And then also just going back to a question on growth of teens versus adults, if we look at the marketing spend on things that you noted, it seems like a focus is on the teen side, which is indicative that that's where you see more growth and stronger returns. So any color around that and then I have a quick follow-up.
Joseph Hogan: First of all, from a marketing spend standpoint, we really do understand by region our return on investment and what we get. I'm not going to share that over the phone but we're very aware of that and what it is. We also -- when you asked about the teen advertisements, there's a seasonality for teams around the world too. So you'll see like in the quarter we just came out of and the second quarter we were going into, that's teen season. It's big in China, big in the States. And so you'll see a larger part of our advertising budget go towards that in order to capture that demand. This is part of how we go-to-market. We have a great brand. That brand needs to be enhanced with patients and we want those patients go into doctors asking for Invisalign. We have some very good capability here from a marketing standpoint to exercise that. John?
John Morici: And what we've learned over time is, we're -- it's not one size fits all across all the markets. You're trying to maximize return on investment and in certain markets you are doing things that are different than others. Maybe more established markets, you try something different. Maybe other markets that we have where we can advertise. we try different things. But I think the key is we understand what levers to pull. We've learned a lot over the last several years. We're very excited about these opportunities. And as Joe said, we have the best brand -- best global brand out there, and we want to be able to reach those potential patients in the way that they are living their lives. That's the philosophy that we have, and we talked a lot about that front-end at top of the funnel metrics, and we're very excited about what we're seeing as we've gone due to the last several quarters.
Doug: Okay, great. And then kind of following up on that direct-to-consumer focus question early on, there was launch of that team -- of teeth whitening solution and hopefully they would go to their Align shops that be litigation with the SCE. it's a focus point there. As we envision where the direct-to-consumer side of Align business goes, how does that teeth whitening solution, and -- how does that fit in? I'm trying to see -- it seems like there's a big push to a dredge consumer with the -- with that side coming up. So any color on that would be helpful.
Joseph Hogan: Well, if your question implies a direct-to-consumer kind of a mode, that's not us, it's not what we do. It's not what -- but you know, we obviously have an e-commerce site. We have a great brand called Invisalign. Patients ask us all the time for whitening, cleansers, chewys, things associated with it. And what is exercising that capability? It's one with the whitening standpoint, we probably should have been more aggressive on before. But again, it's one of those things that we decided to focus on recently. And we're getting great feedback from the doctors in doing that. It only makes sense. It's classic brand extension, and we're going to leverage that and use Align brand as well as we can.
Doug: Great, thanks.
Joseph Hogan: Thank you.
Operator: We have reached the end of the question-and-answer session. At this time, I'd like to turn the call over to Shirley Stacy for closing comments.
Shirley Stacy: Thank you, Operator. And thank you everyone for joining us today. This concludes our conference call. We look forward to speaking to you again on Friday at the Align 2021 Investor Day, in conjunction with our GP Growth Summit here in Las Vegas. If you have any future questions, please contact Investor Relations. And thank you for your time and have a great day.
Operator: This concludes today's conference. You may disconnect your lines at this time, and we thank you for your participation. | [
{
"speaker": "Operator",
"text": "Greetings and welcome to Align Technology's Third Quarter 2021 Earnings Conference Call. At this time, all participants are on a listen-only mode. A question-and-answer session will follow the formal presentation. [Operator instructions]. As a reminder, this conference is being recorded. I would now like to turn the conference over to your host, Shirley Stacy, Vice President of Corporate Communications. Thank you, you may begin."
},
{
"speaker": "Shirley Stacy",
"text": "Good afternoon, and thank you for joining us. Joining me today for our conference call is Joseph Hogan, President and CEO, and John Morici, CFO. We issued third quarter 2021 financial results today via GlobeNewswire, which is available on our website at investor. aligntech.com Today's conference call is being audio webcast and will be archived on our website for approximately 1 month. A telephone replay will be available today by approximately 5:30 PM Eastern Time through 5:30 PM Eastern Time on November 10th. To access the telephone replay, domestic callers should dial 877-660-6853 with conference number 13723267 followed by [Indiscernible]. International caller should dial 201-612-7415 with the same conference number. As a reminder the information provided and discussed today will include forward-looking statements, including statements that aligns future events and product outlook. These forward-looking statements are only predictions and Involve risks and uncertainties described in more detail in our most recent periodic reports filed with the Securities and Exchange Commission available on our website [email protected]. Actual results may vary significantly and align expressly assumes no obligation to update any forward-looking statements. We have posted historical financial statements, including the corresponding reconciliations on our -- on our GAAP -- of our GAAP and non-GAAP reconciliation if applicable. And our third quarter 2021 conference call slides are on our website under Quarterly Results. Please refer to these files for more detailed information. With that, I'd like to turn the call over to Align Technology's President and CEO, Joe Hogan. Joe."
},
{
"speaker": "Joseph Hogan",
"text": "Thanks, Shirley. Good afternoon and thanks for joining us. On our call today, I'll provide some highlights in the third quarter, then briefly discuss the performance of our 2 operating segments, system services, and Clear Aligners. John will provide more detail on our financial results and discuss our outlook. Following that, I'll come back and summarize a few key points and open the call to questions. I am pleased to report strong third quarter results with revenue growth of 38.4% year-over-year on top of a record third quarter last year, driven by the strength across all regions, customer channels, and products. For Q3 we shipped to a record 85,500 doctors in the quarter and reached 11.6 million Invisalign patients cumulatively. On a sequential basis, Q3 results reflect continued adoption of iTero scanners and increased utilization of Invisalign Clear Aligners in the Americas and APAC regions, as well as the growth in teen segment, especially in the North America orthodontics channel. Our third quarter revenues reflect a growing confidence of doctors and patients with Invisalign treatment, iTero scanners and Exocad software, as more doctors discover the benefits of digital treatment and transform their practices with the Align Digital Platform. For Q3, Systems and Services revenues were up 57.3% year-over-year, with strong revenue growth across all regions, and up 5% sequentially, primarily in North America. Q3 results reflect the continued adoption of iTero Element 5D Plus Series, our next-generation scanners and imaging system, which launched earlier this year and feature innovative technology like Near Infrared technology we call NIRI, which aid in detection and monitoring of interproximal caries lesions or cavities above the gingiva without harmful radiation. For Q3, Clear Aligner revenues were up 34.9% year-over-year, with strong revenue growth across all regions and across the portfolio, including comprehensive and non-comprehensive products, as well as Invisalign moderate and Invisalign Go. On a sequential basis, Q3 Clear Aligners revenues were down very slightly from record Q2 reflecting more pronounced summer seasonality than last year, especially in EMEA, were practices and patients appear to have taken extended holidays and where offices were impacted due to resurgence of COVID-19 cases and restrictions especially in some markets in Asia-Pacific. And the team segment Q3 '21 Invisalign Clear Aligner volumes for teens were strong, up 13.8% sequentially, and 26.6% year-over-year to a record 206,000 teens, representing approximately 1/3 of total cases shipped, with strong shipment growth from North American orthodontists and a record quarter for teen and APAC. Our third quarter revenues also include non-case revenue for clinical training and education, and doctor prescribed retainer products. Retention is a critical part of creating and maintaining a beautiful new smile. Retainers prevent teeth from gradually shifting back to their initial positions after treatment ends. Studies show that without retention, even perfectly aligned teeth can gradually revert to their pre -treatment state. And that dentition continues to change as patients age, often requiring limited treatment, also known as touch-up treatment, if not properly retained. Our retention products are designed to maintain teeth that have been aligned by Invisalign Aligners, braces, or other aligners. These retainer products can accommodate lingual bars, wires, also known as a permanent retainer, missing teeth that require an artificial tooth, and bite ramps, also known as turbos or blocks. While our retainer business continues to deliver solid revenue growth, our share of retention market is significantly under-penetrated. Even more so than in our share of the orthodontic case starts. We've been developing a robust retainer strategy, including a separate marketing team focused solely on driving adoption, and increasing market share in the United States. Our objective is to build brand awareness for Vivera retainers, and driving engagement with doctors through clinical education and sales initiatives, while connecting consumers to doctors through demand creation programs and our concierge service. We've also recently implemented social media campaigns featuring the benefits of Vivera from the makers of Invisalign Clear Aligners. We believe that incremental investments will provide increased value for Invisalign practices, and drive growth consistent with our long-term financial model target. In addition, we successfully rolled out a limited pilot program to participate in Invisalign Providers in the United States and Canada, that offers a monthly targeted subscription program to address the unmet patient demand for retention or touch-up cases. Our goal is to encourage experienced high-volume Invisalign practices, who regularly treat patients with our comprehensive products to offer premium retention or entry-level products for the long-term health of their patients, and to grow their businesses. Practices in this pilot program can purchase a monthly subscription at a fixed price, based on their monthly needs for retention or limited treatment. The program allows doctors the flexibility to order both touch-up or retention Aligners with their tier subscription. The program is designed for a segment of experienced Invisalign doctors, who are now regularly using our retainers or low stage Aligners. The positive feedback from our doctors have been encouraging. For instance, the doctors at [Indiscernible] told us the program is very straightforward and easy to understand, and they've been hoping Align would do something like this. Doctor Jonathan Nicozisis at Princeton Orthodontics called the program a home run. We went on to -- he went to predict it should replace the idea that doctors invest in 3D printing and the additional complications and expenses it requires. Including the need for a full-time employee and additional overhead costs, particularly because he believes h is treatment outcomes are always better with Align. Q3 non-case revenues also included accessories and consumables such as aligner cases called Clam Shells, cleaning crystals, and other oral health products that are available on our e-commerce channels in the U.S. only, including the Invisalign accessories store, Walmart, and Amazon. In Q3, we announced an exclusive supply distribution agreement with Ultradent Products, Incorporated, a leading developer and manufacturer of high-tech dental materials, devices and instruments worldwide. The Invisalign Professional whitening program powered OpEx essence is optimized for Invisalign aligners and Vivera Retainers and is available only through Invisalign trained doctors. Also in Q3, we launched the Invisalign whitening pen through an e-commerce channels in the U.S. only. The whitening Pen is over-the-counter retail product for consumers seeking quick tooth whitening at a lower price and is not intended to be used with aligners. The whitening Pen complements the other accessory products that Align already marks to consumers through its existing e-commerce channels and is a key addition to our consumable product portfolio. Now let's turn to the specifics around our third quarter results, starting with the Americas. With Americas, Q3 results reflected strong performance, including record revenues for Latin America, as well as summer seasonality for adult case starts in North America that primarily impacted GP practices, strong ortho performance, especially in the teen market that included increased utilization from the orthodontic channel. Invisalign Case volume was up 0.7% sequentially, and up 36.4% year-over-year, reflecting growth across the region especially in Latin. DSO utilization continued to be a strong growth driver as well, led by Heartland and Smile Docs. For our international business, Q3 Invisalign case volume was up 27% year-over-year on top of record growth in the same quarter last year. On a sequential basis, international shipments were down sequentially 4.3%, primarily as a result of greater seasonality in COVID related shutdowns in APAC markets. For EMEA, Q3 Invisalign case volumes were up 49.6% year-over-year, with broad-based growth across all markets led by the U.K. and Iberia, along with continued growth in our expansion markets in Central and Eastern Europe and the Benelux. For Q3 year-over-year Invisalign volume in EMEA was driven by increased submitters from both orthodontics and GPEs and increase utilization primarily from orthos. On a sequential basis, EMEA was down sequentially 60.5% following a record Q2, primarily as a result of the extended seasonality we had anticipated, primarily from summer holidays and vacations across the region. For APAC, Q3 volumes were up 4.2% compared to a record Q3 last year in APAC. On a year-over-year basis, growth was uneven. The market as APAC, the first region to emerge from the depths of the COVID lockdown in 2020. Additionally, we saw COVID resurgences and lockdowns sporadically impact various APAC countries in Q3. On a sequential basis, Q3 Invisalign volumes were up 21.2%, reflecting growth across the region led by a record quarter in China, especially from teen cases, as well as strong growth in Japan, and A&G. In Q3 growth from both channels was strong with ortho growth driven by increased Invisalign utilization and cheapy growth, channel growth driven by increased Invisalign submitters. APAC teen shipments reached an all-time high in Q3, at the recent 10th China Finance Summit Awards, Align was recognized as the 2021 most innovative enterprise for its advancements and outstanding contributions in the field of Digital orthodontics. This award builds on our prior recognition of Align's leadership in the digital orthodontics industry and its efforts to promote the modernization of orthodontics. Our consumer marketing focuses on educating consumers about the Invisalign system, to drive demand to Invisalign doctors offices, ultimately capitalizing on the massive market opportunity to transform 500 million smiles. In Q3, we expanded a next-generation of the Invis Is media campaign across EMEA, APAC, and Brazil to increase awareness with adult, mom, and teen consumers. Globally, we delivered 6.45 billion impressions, growing 42% year-over-year, resulting in a 70% year-over-year increase in unique visitors to our websites. In the U.S., we connected with teens on Snapchat, YouTube, and Twitch, with our Invis is Not Your Parents Braces campaigns. These campaigns continue to feature some of the largest teen influencers from our Invisalign SmileSquad, like Charlie D'Amelio, Marci Martin, Michael Leon Collins, and Devin Key. These influencers share their personal experience with Invisalign treatment, including why they chose Invisalign treatment to shape their smiles. As part of our focus on teens, with our Invisalign teens makers program, we hold a recognition event hosted by Marcel Martin with teens across the country to celebrate and recognize 100 teens across the country who drove positive change within their communities. To continue growing for our young adult businesses, we expanded the Invis is a powerful thing campaign, which highlights how powerful the smile transformation with Invisalign treatment can be for their self confidence. In U.S we expanded our Invisalign smile squad to include young adult influencers such as Cody Rigsby, Lana Candor, and Emily Hampshire, who help to deliver over 405 million impressions. Additionally, our influencer partnerships with TikTok creators helped increase traffic to our sites, with a 127% increase in click-through rates. In Brazil, we launched the Invis is a Powerful Thing campaign, and teamed up with mega influencer [Indiscernible] to increase website traffic by 30%. In the EMEA region, we expanded into new media channels such as TikTok and Snapchat across the UK, Germany, and France to drive engagement. These efforts led to more than a 153% increase in unique visitors. We also started consumer advertising in Russia, which resulted in more of a 1000 increase in unique visitors to our website. In Q3, we continue to expand our consumer advertising across the APAC region, experienced a 132% increase in unique visitors to our websites. And Australia, we expanded our media mix to include partners such as TikTok and Snapchat. Which resulted in 250% -- 250% growth year-over-year in unique visitors to our website. In Japan, we continue to see a strong response from consumers to our [Indiscernible] campaign, resulting in more than an 800% increase year-over-year in unique visitors to our website. Adoption of our consumer in patient app, my Invisalign continued to increase in Q3 with 1.2 million downloads to date. Usage of our 4 digital tools also continued to increase. For example, our Invisalign virtual appointment tool was used over 15,000 times and our insurance verification feature was used 14,000 times in Q3. Furthermore, we received more than 1.5 million patient photos in our Virtual Care feature today globally, which continues to provide us with rich data to leverage our AI capabilities and improve our services for doctors that is used to enhance their patients care. For our systems and services business, Q3 revenues grew 57.3% year-over-year, reflecting strong scanner shipments and services, and was up 5% sequentially. This is the fifth consecutive quarter of sequential revenue growth for our systems and services business. The iTero Element 5D Plus Imaging system continued gaining traction across all regions, with the most recent launch in Japan in Q3. The iTero Element 5D Plus Imaging System will be available in China in Q4 of this year. Additionally, The iTero Element Plus Series was launched in Korea in Q3. The series expands the portfolio of iTero Element Scanners and Imaging Systems to include new solutions that serve the needs of a broader range of doctors and patients in the dental market. Moreover, I'm proud to say that in a recent clinical study, the iTero Element 5D Intraoral Scanner was found to be more sensitive than bitewing radiology. in detecting early enamel lesions, providing further evidence of the benefits of iTero 5D Scanner in detection and monitoring of interproximal caries lesions or cavities above the gingiva, without exposing patients to harmful ionizing radiation. This is great news for our iTero business, as a study further supports the diagnostic ability of Near-Infrared imaging technology offered by the iTero 5D Scanner for early proximal caries detection. The findings also underscore the valuable role that NIRI technology can have in dental health assessment and early detection of cavities, which is important to the overall oral healthcare treatment options. And a comfortable, safe experience for a broad population of patients. A strong indicator of the digital acceleration with dental offices is a number of intraoral digital scans used for Invisalign case submissions. Total worldwide intraoral digital scans used to start an Invisalign case in Q3 increased 84.2% from 78.3% in Q3 last year. International intraoral digital scanners for Invisalign case submissions increased 79.3% up from 72.1% in the same last year. For the America's, 88% of cases were submitted using an intraoral digital scan compared to 83.2% a year ago. Cumulatively, over 44.9 million orthodontics scans and 9.3 million restorative scans have been performed with iTero scanners. Our Q3 systems and services revenues also includes Exocad, CAD CAM products and services. Exocad expertise -- expertise in restorative dentistry, implantology, guidance surgery and smile design, extends our digital -- our digital dental solutions and broadens Align digital platform towards fully integrated into disciplinary and workflows, we remained excited about our continued integration progress and product plans with Exocad. During the quarter, Exocad launched, chair-side CAD 3.0 Galloway. The next-generation of Exocad, easy-to-use CAD software for single-visit dentistry. The software has improved automation for fast crown design enables users to integrate open hardware and material s of choice. Exocad, chair-side CAD received 2021 seller best-of-class technology award for the third consecutive year. Also during the quarter, Exocad has its largest ever presence at IDS, International Dental Show, where they showcased their seamless digital workflows, and the simplicity of the use of Exocad Galway software release. Exocad was the only Company at IDS to showcase live patient treatment with a smile creator experience station, featuring iTero scans, instant smile makeovers, and production of clip on smiles. With that, I will now turn it over to John."
},
{
"speaker": "John Morici",
"text": "Thanks, Joe. Now for our Q3 financial results. Total revenues for the third quarter were $1.016 billion, up 0.5% from the prior quarter and up 38.4% from the corresponding quarter a year-ago. For Clear Aligners, Q3 revenues $837.6 million were down 0.4% sequentially, and up 34.9% year-over-year, reflecting Invisalign volume growth across all geographies. In Q3, we shipped 655,100 Invisalign cases, a decrease of 1.6% sequentially with an increase of 32.1% year-over-year. In addition, we shipped to a record 85,500 Invisalign doctors worldwide, of which approximately 7200 were first-time customers. Q3 Clear Aligner revenues reflect strong growth across the Invisalign portfolio, led by comprehensive products. Q3 comprehensive volume increased 1.3% sequentially, and 30.3% year-over-year. And Q3 non-comprehensive volume decreased 8.1% sequentially, and increased 36.8% year-over-year. Q3 adult patients decreased 7.3% sequentially, and increased 34.7% year-over-year. In Q3, teens or younger patients increased 13.8% sequentially and 26.6% year-over-year. Clear Aligner revenues were unfavorably impacted by foreign exchange of approximately $1.5 million or approximately 0.2 points sequentially. On a year-over-year basis. Clear Aligner revenues were favorably impacted by foreign exchange of approximately $16.1 million or approximately 2.6 points. For Q3 Invisalign comprehensive ASPs increased sequentially and year-over-year. On a sequential basis, Invisalign comprehensive ASPs reflect higher additional aligners. On a year-over-year basis, comprehensive ASPs reflect favorable foreign exchange, partially offset by the increase in net revenue deferrals for new Invisalign cases versus additional Aligner shipments. Q3 Invisalign non-comprehensive ASPs increased sequentially and year-over-year. On a sequential basis, Invisalign non-comprehensive ASPs reflect higher additional Aligners, partially offset by higher discounts. On a year-over-year basis, Invisalign non-comprehensive ASPs were favorably impacted by foreign exchange, higher additional Aligners, and lower discounts. Clear Aligner deferred revenues on the balance sheet increased $84 million or 9.3% sequentially, and $347.3 million or 53.9% year-over-year, and will be recognized as the additional Aligners are shipped. Our Systems and Services revenues for the third quarter were a record $178.3 million, up 5% sequentially, and up 57.3% year-over-year. This marks the fifth quarter in a row of sequential revenue increase. The increase sequentially can be attributed to increased scanner shipments, and increased services revenues from our larger installed base. The increase year-over-year can be attributed to increased scanner shipments, increased service revenues from our larger installed base, as well as higher ASPs from a favorable mix shift towards higher price iTero 5D scanners and imaging systems. Our systems and services deferred revenue on the balance sheet was up $27.2 million or 17% sequentially, and up $100.1 million or a 115.2% year-over-year, primarily due to the increase in scanner sales and deferral of services revenue, which we recognized ratably over the service period. Moving on to gross margin. Third quarter overall gross margin was 74.3% down 0.7 points sequentially, and up 1.6 points year-over-year. On a non-GAAP basis, excluding stock-based compensation and amortization of intangibles related to our 2020 Exocad acquisition, overall gross margin was 74.7% for the third quarter, down 0.7 points sequentially, and up 1.4 points year-over-year. Overall, gross margin was favorably impacted by approximately 0.5 points on a year-over-year basis, due to foreign exchange and relatively unchanged sequentially. Clear Aligner gross margin for the third quarter was 76.2%, down 0.7 points sequentially due to higher manufacturing costs, and higher additional Aligners, partially offset by higher ASPs and lower freight. Clear Aligner gross margin was up 1.5 points year-over-year due to improved manufacturing efficiencies from higher production volume, partially offset by higher ASPs. Systems and services gross margin for the third quarter was 65.6% down 0.3 sequentially, primarily due to lower ASPs and higher manufacturing variances, partially offset by higher service revenue. Systems and services gross margin was up 3.6 points year-over-year due to higher ASPs from product mix shift to iTero 5D and 5D Plus series and service revenues, partially offset by higher freight costs. Q3 operating expenses were $494 million up sequentially, 0.9% and up 38.4% year-over-year. On a sequential basis, operating expenses were up slightly by $4.4 million. Year-over-year, operating expenses increased by $137 million, reflecting increased headcount in our continued investment in marketing, sales, and R$D activities. and invents -- investments commensurate with business growth. On a non-GAAP basis, excluding stock-based compensation, and amortization of intangibles and acquisition costs related to our 2020 Exocad acquisition, operating expenses were $466.1 million up sequentially 1% and up 40.3% year-over-year due to the reasons described earlier. Our third quarter operating income of $261.1 million resulted in an operating margin of 25.7%, down 0.9 points from the prior quarter, and up 1.6 points year-over-year. The sequential decrease in operating margin was attributable primarily to lower gross margin. The year-over-year increase in operating margin was primarily attributed to higher gross margin and operating leverage, as well as the favorable impact from foreign exchange by approximately 0.7 points, partially offset by continued investment as mentioned earlier. On a non-GAAP basis, which excludes stock-based compensation and amortization of intangibles and acquisition-related costs, the operating margin for the third quarter was 28.8%, down 0.9 points sequentially, and up 0.8 points year-over-year. Interest and other income and expense, net for the third quarter was a gain of $0.8 million up sequentially by 0.9 million and down year-over-year by $6.6 million. On a year-over-year basis, interest and other income and expense decreased primarily due to net foreign exchange losses in the 3 months ended September 30th, 2021, as compared to net foreign exchange gains in the same period in 2020, which was partially offset by an unrealized gain and an investment held in a private Company recognized in the three months ended September 30th 2021. The GAAP effective tax rate for the third quarter was 30.9%, compared to 25.7% in the second quarter, and 24.5% in the third quarter of the prior year. On an non-GAAP -- our non-GAAP effective tax rate was 22.2% in the third quarter, compared to 19.5% in the second quarter, and 16.6% in the third quarter of the prior year. The third quarter GAAP and non-GAAP effective tax rates were higher than the second quarter, primarily due to our foreign income being taxed at different rates and tax true-ups. Our GAAP and non-GAAP third quarter effective tax rates were higher than the third quarter of the prior year, primarily due to lower tax benefits from foreign income tax at lower rates and a tax benefit recognized last year resulting from an income tax audit settlement. Third quarter net income per diluted share was $2.28, down sequentially $0.23 and up $0.52 compared to the prior year. On a non-GAAP basis, net income per diluted share was $2.87 for the third quarter, down $0.17 sequentially and up $0.62 year-over-year. Moving onto the balance sheet. As of September 30th, 2021, cash and cash equivalents were $1.2 billion, up sequentially $151.5 million, and up $622.3 million year-over-year. Of our 1.2 billion of cash and cash equivalents, $607.5 million was held in the U.S., and $630.3 million was held by our international entities. Q3 accounts receivable balance was $855 million, up approximately 5.8% sequentially, our overall days sales outstanding was 75 days, up approximately three days sequentially, and down approximately two days as compared to Q3 last year. Cash flow from operations for the third quarter was $355 million. Capital expenditures for the third quarter were $124.3 million. As we continue to invest in increased in the liner capacity and facilities. Free cash flow defined as cash flow from operations, less capital expenditures amounted to $230.7 million. We also have $300 million available under our untapped revolving line of credit. Under our $1 billion repurchase program announced in May of 2021, we have $825 million remaining available for repurchase of our common stock. Now let me turn to our outlook and the factors that inform our view for the remainder of the year. We're very pleased with our Q3 results and strong year-over-year growth, which reflects continued customer adoption of the iTero scanners and increased Invisalign utilization across customer channels, including teens, adults, and young patients. Over the last 18 months, our investment decisions have helped drive and capture demand across all regions and customer channels. We continued spending in many areas, and have seen good return on our investments and strong revenue growth. Consumer interest in improving smiles is high, and doctor acceptance into Align Digital Platform is helping drive growth across all regions and market segments. As anticipated in our Q3 outlook, we experienced more pronounced summer seasonality, more noticeably in September and continued into October as practices took more extended vacations, and patient traffic low was sporadically interrupted by regional COVID resurgence, restrictions, and other lockdowns. We anticipate these COVID challenges and the general macroeconomic uncertainties to continue into Q4. Taking this all into account, as we look at the remainder of 2021, we expect revenues for the year to be in the range of $3.9 billion to $3.95 billion, at the high end of our original guidance range. We also expect our outlook in revenue growth for the second half of 2021 to be in the high end of our long-term operating model of 20% to 30%. On a GAAP basis, we anticipate our 2021 operating margin to be around 25%. On a non-GAAP basis, we expect 2021 operating margin to be approximately 3 points higher than our GAAP operating margin, after excluding stock-based compensation and intangible amortization from our 2020 Exocad acquisition. We remain confident in the huge market opportunities for our business, our industry leadership, and our ability to execute. We will continue to invest in sales, marketing, innovation, and manufacturing capacity to drive our growth and accelerate adoption in a huge under-penetrated market. In addition, during Q4 2021, we expect to repurchase up to $100 million of our common stock through either a combination of open market repurchases or an accelerated stock repurchase agreement. For 2021 we expect our investments in capital expenditures to be above $400 million. Capital expenditures primarily relate to building construction improvements, as well as additional manufacturing capacity to support our international expansion. This includes our planned investment in our new work -- our new facility in Wroclaw, Poland, the first in the EMEA region. With that, I'll turn it back over to Joe for final comments. Joe."
},
{
"speaker": "Joseph Hogan",
"text": "Thanks, John. Summary, Q3 was a strong quarter and we're pleased with our performance across the business. Align is uniquely positioned. We have a clinical capability and product portfolio supported by doctor and patient workflows only accessible through the proprietary Align Digital Platform, to address the broadest range of orthodontic cases with the Invisalign system through a network of trained Invisalign doctors who had the expertise to reach more than the 500 million potential global patients. As we develop our annual plan for 2022 over the next few months, it's important that we continue to expand our commercial manufacturing, R&D clinical treatment planning and manufacturing operations, and continue to leverage our global quality and regulatory muscles in existing and emerging markets. Which millions of consumers who want to transform their smile with the most advanced Clear Aligner systems in the world. Through advertising, PR, digital, social media, and influencer marketing to drive demand and conversion through Invisalign trained doctors. Increased ortho adoption and team utilization of Invisalign treatment, and train and educate GP Dentist on how the iTero Element family of inter-oral scanners in imaging systems propel today's dental practice into the future by enhancing patient experience and elevating clinical precision, and in the benefits of digital dentistry with the Invisalign system, trusted by more than 11 million people worldwide to improve their smiles. Remained focused on strategic execution, accountability, agility, customer service excellence, and continuing to make investments to grow our business. This is a multi-variable equation that we continue to talk about, and that in combination where we remain uniquely able to offer. As we continue to stay the course with our strategic initiatives, we also continue to navigate the COVID-19 environment and the challenges and uncertainty that go with it. Throughout the pandemic, our top priority has been consistent. The health and safety of our employees and their families, doctors and their staff. And that has not changed. The situation with COVID remains very fluid, and with the rise of the Delta variant, many cities, states, and countries have issued or planned to issue new guidance, including mass requirements, regular testing, capacity limits, and vaccination mandates. Operating in this evolving environment is challenging for everyone, and we're staying as close as we can to the situation. The shift from traditional analog wires and brackets to a fully end-to-end digital platform is not easy and cannot be done without very complex and industry-leading technology, and talented passionate people. But the digital transformation in orthodontics is inevitable. Our technology is prevalent, touching every aspect of what we do from manufacturing excellence, where we currently produce over 750,000 unique Aligners a day, to expanding our geographic footprint to over a 100 markets, to building a network of over 210,000 trained Invisalign doctors, and providing a technology to our doctors and a complete digital system, the Align Digital Platform. As the inventor of the leading Clear Aligner system, we've been investing in this therapy for over 24 years to get it to where it is today, and yet the majority of the market opportunity remains largely untapped. with over 500 million potential cases starts globally. Align is in a rare position to address this market with the Align Digital Platform, powered by two decades of research and development, manufacturing excellence clinical data based on more than 11 million patients, with AI machine learning and digital tools to help our doctors efficiently communicate with our patients, show and explain any issues and visualize potential treatment options. And together with doctors, we're going to unleash the power of digital for dentistry in orthodontics more than ever. Thank you for your time today. I look forward to speaking with you on Friday at our Investor Day where we'll share more details on the Align Digital Platform and our vision and strategy to make Clear Aligner treatment available to everyone through doctors. Now I will turn the call over to our operator for your questions. Operator?"
},
{
"speaker": "Operator",
"text": "Thank you. At this time, we'll be conducting a question-and-answer session. [Operator instructions]. We ask that you please limit to 1 question and 1 follow-up. [Operator instructions]. For participants using speaker equipment, it may be necessary to pick up your handset before pressing the star keys. One moment please while we pull for questions. Our first question comes from Nathan Rich with Goldman Sachs. Please proceed with your question."
},
{
"speaker": "Nathan Rich",
"text": "Hi, good afternoon. Hey, Joe. Joe and John, you highlighted the seasonal softness in September and that extended into October. I wonder if you could maybe just provide a little bit more detail on what you've seen in October so far, maybe how that compared to September. And then as we've seen the latest COVID case spikes subside in recent weeks, have you seen -- the patient traffic flow that you mentioned, has that started to pick up as COVID cases have ticked down?"
},
{
"speaker": "John Morici",
"text": "Yes. Hi, Nate. This is John. As we said, the extended seasonality continued into September and October. And then some of the COVID uncertainty still remains. And some places more back to normal than others, and -- but that uncertainty remains. Taking all that together, our forecast reflects that. So the total year -- the remaining for total year reflects everything that we've seen to this date."
},
{
"speaker": "Nathan Rich",
"text": "Okay. That's fair, I guess. Joe, maybe a follow-up. I mean, you've continued to have confidence in that 20% to 30% long-term range. Maybe we'll hear more on Friday at the Analyst Day. But do you have an initial view on growth for next year, and do you feel like once this period of more pronounced seasonality is behind you, we get back to a more normalized trajectory for the business as we head into next year. Thanks for the questions."
},
{
"speaker": "Joseph Hogan",
"text": "Well, Nathan we are growing at a pretty good pace right now. So it's actually above our long-term growth model, which is 20% to 30%. And as we move into 2022, we'll retain that 20% revenue growth target, and we're happy to discuss it more in detail on Friday."
},
{
"speaker": "Shirley Stacy",
"text": "Thanks, Nathan. Next question, please."
},
{
"speaker": "Operator",
"text": "Our next question is from John Block with Stifle. please proceed with your question."
},
{
"speaker": "Jonathan Block",
"text": "Thanks, guys. Good afternoon. John, I just might follow in Nathan's path, but let me take a different approach. The new rev range that you gave for this year, you clearly brought it up a little bit, it seems to imply a bit over a billion dollars for the fourth quarter. If I assume the scanner up sequentially from the 178, and 55 million - ish give or take in non-case revenue. And it looks like case volume is expected to be flat to maybe even down low-to-mid-single-digits sequentially. So a couple of things there, is that the right way to think about things specific to case volumes? And if so, I know you touched on this a little bit, but why sort of the different trend line versus prior to COVID, if you would, where that was more up mid-single-digit plus?"
},
{
"speaker": "John Morici",
"text": "Yeah, Jon. I think when you look at prior years with COVID not in the mix, things were maybe more seasonal. And you could see some of the standard patterns from let's say a Q3 to Q4, given COVID and given some of the uncertainties that you have. And certain economies and how they are responding and opening up, Things don't always apply to mainly what's happened in the past. So that guidance that we gave is a reflection of what we've seen."
},
{
"speaker": "Jonathan Block",
"text": "Okay. Got it. And Joe, just a follow-up, we keep on hearing about the iOS changed from Apple on privacy and you guys have such a broad reach in terms of marketing. But I am curious if you're seeing any impact? Is it impacting leads? Yes or no, and if so, could that actually continue into 2022? We'd love your feedback there. Thanks."
},
{
"speaker": "Joseph Hogan",
"text": "John, it's a good question we've seen an impact on it. The thing is a lot of other media you can -- you can pivot to in order to find those patients. So have we seen it and have we had to do a certain amount of pivot to do that? Yes. But you know as far as our marketing efforts, I wouldn't discount them in any way in this sense of that change being material in some sense in the near future."
},
{
"speaker": "Jonathan Block",
"text": "Fair enough. See you on Friday."
},
{
"speaker": "Joseph Hogan",
"text": "[Indiscernible]"
},
{
"speaker": "Operator",
"text": "Our next question comes from John Kreger with William Blair. Please proceed with your question."
},
{
"speaker": "John Kreger",
"text": "Hey, guys. Thanks. I'm curious now that you've exited another typical teen season what penetration do you think Invisalign has of total teens starts at this point?"
},
{
"speaker": "Joseph Hogan",
"text": "Well, I mean globally -- hey John, it's Joe. Globally, it's less than 5%. When you look at -- we'll show on Friday exactly what we think that is. In United States, I think our current number is the mid-teens. Yes. John, I think that too. We have so far to go, right. This is a superior treatment, like I said in our script, we can do 90% of the orthodontic cases that are out there. It's just us continuing to work really closely with the orthodontist, and advertise to consumers to explain the benefits of digital orthodontics and move this forward. But like I said, this is inevitable. Digital is better. We know it's better. We've made it better. It's more comprehensive than it was before, it's faster, less invasive. I could go on all day. And that's what drives this Company, that's our purpose. We know we'll hit it. It's just -- there's just a lot of work to get from here to there."
},
{
"speaker": "John Kreger",
"text": "Thanks.That was Joe, that was my follow-up. As you talk to your power users or maybe people that are just getting started. You've made the product better. You made the software better. What do you think is the key point of friction at this point to get that adoption rate up where I think most of us on this call assume it can get to longer-term?"
},
{
"speaker": "Joseph Hogan",
"text": "But John, I think it's the classic early adopter syndrome. The doctors who use our product almost exclusively 100% can't imagine not using our product line. But they're early adopters in the classical sense. There's 2 things; 1, there's the clinical confidence people, people that are out there that we have to convince. It's much easier that it is today than it was five years ago. Given products like first giving products like [Indiscernible] those kind of things that extend it. And then the predictability of our products. Secondly, it's the business equation inside the orthodontic practices that they're convinced they can actually keep up the margins and the growth capability they have for their practices, we understand that. And that's why we have programs like adapt that we put together, John, that orthodontist who want to engage with us we can show them how to really operate in a digital environment and actually exceed from a margin standpoint, and growth standpoint."
},
{
"speaker": "John Kreger",
"text": "Sounds good. Thank you."
},
{
"speaker": "Joseph Hogan",
"text": "Yes. Thanks, John."
},
{
"speaker": "Operator",
"text": "The next question comes from Jason Bednar with Piper Sandler. Please proceed with your question."
},
{
"speaker": "Jason Bednar",
"text": "Thanks for taking the questions and congrats on the record quarter here."
},
{
"speaker": "Joseph Hogan",
"text": "Thanks Jason."
},
{
"speaker": "Jason Bednar",
"text": "A couple of questions from our side. One big picture. First for you, Joe. One of the key drivers of growth, the past year has been really the adult category outpacing that of teens. It really seemed like heading into this quarter could be the proof-point quarter and whether that growth would flip back to teen, but adult was again stronger than teens here. It seems like some good staying power. So I guess Joe, how do you think about these -- how these 2 segments play out from Here, both obviously have a ton of growth potential, but as the business for Align shifted to where we should be thinking about adult growth, outpacing that of teens. As we look forward to the coming quarters and years?"
},
{
"speaker": "Joseph Hogan",
"text": "Yes. Jason, it's a good question, but I think it's -- and you'll hear a lot about it this Friday, is the demand equation on this business is incredible, right. The 500 million patients we've talked about, they'll primarily be serviced at the general dentistry area, and then the over 20 million, that's on the -- in the orthodontics side. That mean -- that's -- you look at that. It's a wide open marketplace. Adults have done well, teens will do well. I just think you have to have them both go up. And remember their dealer from different basis in the sense of, traditionally, 75% of our cases have been adults and 25% teens, so there is a large number on the adult side, but the growth potential is amazing. And we'll just going to go after both ends of that equation as aggressively as we can."
},
{
"speaker": "Jason Bednar",
"text": "Got it. Okay, that's helpful. I look forward to more on Friday then. And then maybe some more of a real-time look and also following up on Nate's question there to start out, but asking also a different way. Maybe wonder if you could talk about how utilization trends have gone here month-to-month on a regional basis, September, October, and then maybe based on the treatment plans and missions, other measures of your funnel. What does the utilization look like as we shift from October and November? Thanks."
},
{
"speaker": "John Morici",
"text": "Yes, Jason, this is John. We've seen some improvements in utilization and it's a reflection of kind of coming out of that seasonality piece of what we've talked about and kind of navigating through COVID. But we've been happy with the utilization that we've seen as of late."
},
{
"speaker": "Jason Bednar",
"text": "All right. Thanks so much."
},
{
"speaker": "Joseph Hogan",
"text": "Thanks, Jason."
},
{
"speaker": "Operator",
"text": "Our next question comes from Elizabeth Anderson with Evercore. Please proceed with your question."
},
{
"speaker": "Joseph Hogan",
"text": "Hi, Elizabeth."
},
{
"speaker": "Elizabeth Anderson",
"text": "Hi, guys. Thanks so much for the question. I had a question on the gross margin line. I think you guys talked about how you're seeing maybe slightly higher manufacturing costs in Clear Aligners and then lower freight and higher freight in iTero that has other -- the higher freight costs there. So I was just wondering, as we think about some of the global supply chain issues that we've been reading about and hearing about from other companies, if you could just elaborate a little bit on what you're seeing in both of those areas. Thanks."
},
{
"speaker": "John Morici",
"text": "Hi, Elizabeth. This is John. I can take that. I think when you look at our overall gross margin, broadly impacted as we've talked about. Additional liners, as we now have ramped up and we've seen those cases from the last several quarters as doctors make refinements and get patiently in to make refinements to the care. We see an improvement there in ASPs, but there's some offset in gross margin. But broadly, when we look at some of the inflationary [Indiscernible] and so on, we have long term contracts, we have got a supply chain where we're driving a lot of productivity and efficiencies through. So, we feel we're pretty well balanced as we see some of these inflationary headwinds, not that it's not a challenge out there for everybody, but we feel that between the contracts we have and the efficiencies we can drive, we balance it."
},
{
"speaker": "Elizabeth Anderson",
"text": "That's really helpful and maybe I saw that in your outlook, you're obviously talking about around a $100 million in share repurchases in the fourth quarter. But your cash balance is moving up nicely and I was wondering if you could comment on what you see sort of how preferred level of cash balance and if there's any potential for acceleration on the share repurchase line or, things that we should consider in thinking that should be a little bit higher than where it's been traditionally."
},
{
"speaker": "John Morici",
"text": "Yeah, I think when you look at -- I'm balanced, Elizabet, we're very pleased with the cash generation, almost 900 million of CFOA, 3 quarters of the year. It's phenomenal cash. A lot going back into the business to grow our business, make investments in some of the operating expenditures to grow our business, continue to make investments in capacity and adding capacity, getting closer to our customers. And then as we've said with our cash, we'll give back to shareholders through repurchase. So we're very happy with how things have progressed. We don't have a magical number in terms of how much cash we should have, but all things in balance. We feel like we're executing to our strategy."
},
{
"speaker": "Elizabeth Anderson",
"text": "Perfect, thanks."
},
{
"speaker": "Operator",
"text": "Our next question comes from Jeff Johnson with Baird, please proceed with your question."
},
{
"speaker": "Jeffrey Johnson",
"text": "Thanks. Good afternoon, guys. Joe, I wanted to start maybe on system and services, or maybe John this is for you, but where are at, as what portion of that revenue is the recurring services' side as opposed to system sales? And in 4Q, we're still hearing about a decent amount of PPP money floating around. Obviously, you've got the incremental launch coming in China and that of 5D. Should we think of 4Q being a better system quarter sequentially again, just with seasonality there?"
},
{
"speaker": "John Morici",
"text": "Yeah, Jeff, this is John. We've been very pleased with our sequential improvements that we've seen in the systems and services -- in scanner services business. When we look at five quarters in a row of kind of really helping us lead the recovery out of COVID. And a lot of investments that doctors are making -- our doctors are making in the Digital Platform, there's an excellent reflection of that, we have a lot of new doctors that started Invisalign this quarter with us and many of them start with getting an iTero and being able to utilize that within their practice. So we feel very good about the scanner and services business. About a third of that business is services. So that's the reoccurring. And as we improve and have more of an installed base, that just grows that business. So you got a very big and growing installed base coupled with great products that are really driving that adoption. And especially among newer doctors coming in, they're coming in with that scanner to really incorporate that digital technology into their practice."
},
{
"speaker": "Jeffrey Johnson",
"text": "Yeah. Understood. And then Joe, maybe bigger picture question just on the return in the chair and what docs are seeing for Clear Aligner and this a line of specialty relative to braces. But we've talked more and more docs just even over the last maybe few months who seem to be really spacing those follow-up visits in Invisalign out to 3 or even 4 months. It's cutting the chair time even in half relative to pre - COVID levels and well below braces. Are you seeing the same thing? I know virtual is helping that a little bit. I think some docs even doing it without virtual, just given their confidence and outcomes. But how much is that driving the argument in that secular push into Clear Aligner, especially with staffing issues that maybe you guys are hearing about at some of the offices, things like that?"
},
{
"speaker": "Joseph Hogan",
"text": "Yeah, Jeff, that's one of the key ingredients, is the productivity of a doctor's time and the productivity of the real estate within that office. And in digital kind of situation, you can remote monitor like you do on Virtual Care, some other products that are out there and doctors are taking advantage of that. But also there's a lot of confidence doctors have too if their patients are using the Aligners they will bring them back every so often and take a look to that. That's a big part of it. Secondly, Jeff, is it -- you can actually work with less labor content, and less doctor content and people in the office. And also size of the office too. You see a whole lot of orthodontists understanding that, and really embracing it. There's a whole referral aspect to Invisalign, is once a patient has an experience with Invisalign, they are often ready to refer another patient to that doctor much more so than wires and brackets. And they said they benefit from that because they see an increase in their sales too. And we see that constantly and adapt and we focus on that, and can actually predict it to a certain extent of time. So I hope I'm answering your question, Jeff, but that is the whole idea of Digital. And then we keep talking about our Align Digital capability, and being able to service a doctor through iTero, being -- having Virtual Care on both ends, and having the kind of capability and horsepower that we can provide with our algorithms in the extent of our clinical capability, is just -- it gives us a huge amount of breadth and capability at orthodontist."
},
{
"speaker": "Jeffrey Johnson",
"text": "Sure. I understood. Thanks, guys."
},
{
"speaker": "Joseph Hogan",
"text": "Thanks [Indiscernible]"
},
{
"speaker": "Operator",
"text": "Our next question comes from Brandon Couillard with Jeffrey's, please proceed with your question."
},
{
"speaker": "Brandon Couillard",
"text": "Thanks.Good afternoon. I actually want to switch gears, you talked quite a bit about the non-case business and the retainer business. Can you help us understand why your share has historically lagged there? Maybe a sense of what your capture rate is today in terms of the cases that also have a follow-on retainer. And how would you frame the revenue opportunity from these newer initiatives?"
},
{
"speaker": "Joseph Hogan",
"text": "Brian, it's a good -- it's why we highlighted it and it's obviously why we've put money into this thing and our focus on it over the last years. There's certain things in this business that we all know, but there's so many things to do and focus on it. Sometimes something it's so obvious like that, lacks the attention that you want to give to it. And we've been talking about this over time. So, beginning of this year, put a team together to really go after those things. It's hard to say the reason why. It's just we haven't been as focused on retention as we need to be. And many orthodontists, they make their own retainers. They do it because we just haven't been competitive in the sense of how we can deliver, how fast we can deliver, how easy we make it for them. But I guarantee you if you go out Brandon and you query even orthodontist that seldom use our retainers, they'll tell you we make the best retainers in the world. And we should when we make a 750,000 unique parts a day, right? We know what we're doing. The fits are exquisite. When you have an iTero scanner, it'd be able to do that. And we've set this thing up as a play for doctors that they can feel confident that we'll get these retailers to them in a quick amount of time. They're going to be terrific retainers, something they are proud to really get to their patients. And we've had great feedback on this so far. So I can't apologize for the past or give you the whole history why we haven't done it, but I feel really good about the progress we've made so far."
},
{
"speaker": "Brandon Couillard",
"text": "Fine. And then just a question on scanner business. I mean, pretty remarkable strength for a while now. Can you just help us understand where the sources of this momentum, and is the NIRI study the type of data set that can move the needle with GP that?yield loss? can talk about clinical studies, especially within?Joel's? beginners, but just trying to get a sense of how significant you'll be able to go in and have this data there might be for a GP that doesn't use digital impressioning today, or might be on the fence."
},
{
"speaker": "Joseph Hogan",
"text": "Yeah. I think NIRI really helps. I really do. It's one of those -- you know in electronics we all know there's killer apps, right? Killer applications. When you can see?carriers?, cavities, right? We use the clinical term, but when you can see cavities without ionizing radiation and Brand of what's amazing when you see this to what happens is the enamel almost becomes invisible, it's almost translucent. You can see through the enamel right to where the carriers is. And there's certain amount of training that has to be done in order to do it and -- look, I grew up in ionizing radiation business. I know what it is and CT and x-ray and it's that radiation component is better today than it used to be, but it's still exist and patients are still concerned with it over time and to be able to do this in a sense, in a safe way, and as a quick way like we do it. You know what it is to put bitewings in a chair. I mean, it's terrible in a dentist chair, right. Bite down, turn your head sideways. I could go through it all day. And this is a quick scan, one minute scan. minute and a half scan. It pops up on the screen. You can have a conversation with a patient, say there it is, what he deals with. So yes, I think it's a killer application. We'll convince all GPs to buy iTero, no. But then you have to look at Exocad, that critical workflow between labs and GPs really sets us up nicely for restorative pieces. Soon to announce [Indiscernible] architect, which really allows doctors to use restored of Orthodontics as a standard of care, we'll talk about that more Friday. Look, I'm biased. I've been in the -- I'd say the medical imaging equipment business for 15 years of my life count, and iTero, this is the best scanner in the marketplace. And we're just out to show it and to prove it."
},
{
"speaker": "Brandon Couillard",
"text": "Thank you."
},
{
"speaker": "Joseph Hogan",
"text": "Thank you."
},
{
"speaker": "Operator",
"text": "Our next question is from Chris Cooley with Stephens, please proceed with your question."
},
{
"speaker": "Chris Cooley",
"text": "Good afternoon and thanks for taking the questions. Congratulations on the record quarter."
},
{
"speaker": "Joseph Hogan",
"text": "Thanks, Chris."
},
{
"speaker": "Chris Cooley",
"text": "Just from me as we all start looking forward to upcoming event here this Friday, and Saturday maybe a bigger picture question. As we think about the business you've made significant investments in technology, not only pioneering the category, but expanding its indications for use. You subsequently invested in chair-side, really facilitating the diagnostic aspect. And as the businesses now kind of inflecting here, two straight quarters of a billion dollars plus, do we think about the next stage of investment really kind of going back to a prior question being tools that enable or enhance the productivity of the clinician or patient flow. more to marketing at the consumer and clinical level? I'm just thinking about how the business now pivots for that next stage of continued growth at this greater scale. And I have just one quick follow-up after that, if I may."
},
{
"speaker": "Joseph Hogan",
"text": "Chris, it's really good question, because obviously as we're going through our AOP for next year and putting those things together. But when you say pivot.I wouldn't use the word pivot. I'd say that we extend to what we're doing. And then we place bets accordingly and where we think we'll get the best return. We -- I got to continue advertising. We have a superior system. We have a wonderful brand. We have to leverage that piece. But specifically, and this goes to last questions we had too, doctor productivity is a big deal. And when you look at our Align Digital Platform, inherently that's what it's about. It's how do you make doctors more productive to make sure that we don't go back and forth with 8 clean checks, or how do we make sure that from our standpoint that we can respond quickly to customer issues. And we're investing heavily in all those things and making good progress. It's expensive, the lot of things that you have to do when you really grounded in software and making those changes. We have really great talent here that knows how to do that. We've been actually working the productivity of clean checking those things for 3 to 4 years. And it's just starting to bring technology to the marketplace. So you're right. We're not pivoting toward that. We've been investing in it, but you'll see the combination of that more and more as we enter next year in the second half of next year too. John, anything to add?"
},
{
"speaker": "John Morici",
"text": "No. I think that's the investments that we continue to make. It's about productivity. It's about growing in this Digital orthodontics, and our doctors expected and our tools will provide that."
},
{
"speaker": "Chris Cooley",
"text": "That's great. And if I could just squeeze in a quick follow-on, just want to make sure, doesn't look out of proportion, but I just want to make sure we didn't miss something there on the deferred piece in the quarter, I think was approximately 84 million. Anything just COVID-related that we should be mindful of there is that just normal course of business when we look at the deferred revenue component for the 3Q. Thanks so much for wrapping the quarter."
},
{
"speaker": "John Morici",
"text": "Thanks, Chris."
},
{
"speaker": "Joseph Hogan",
"text": "Thanks, Chris."
},
{
"speaker": "John Morici",
"text": "It's completely normal course of business, nothing COVID related within there, just deferred revenue that we'll recognize in future periods."
},
{
"speaker": "Chris Cooley",
"text": "Thanks."
},
{
"speaker": "Joseph Hogan",
"text": "Thanks, Chris."
},
{
"speaker": "Operator",
"text": "Our next question comes from Michael Ryskin with Bank of America. Please proceed with your question."
},
{
"speaker": "Michael Ryskin",
"text": "All right. Thanks for taking the question, guys. Couple of quick ones from me, but I'll try to tie them together into one. On the scanners and service revenue, I've noted that your digitally submitted cases continues to grind higher, pretty close to hitting 90%, maybe in a year or 2. I am just wondering as you continue to play iTero into the field, How often are you surplacing a second or third unit, versus getting a new one out there, versus a competitor placement where you're displacing someone else potentially. And then as a follow-on to that, sort of building off of I think Elizabeth question earlier on the supply chain. Any specific to semis that we should be thinking about, this is the question that's come up a lot some of other names, and want to make sure we tie that off as far as it relates to scanners. Thanks."
},
{
"speaker": "Joseph Hogan",
"text": "Hey, Mike. From a scanner standpoint is -- obviously we have a great scanner, and I think your question asked more about saturation, more than anything. Our feeling is you got 2 million dentists out there and orthodontist. And each of them actually, if you're going to run a digital practice, you need more than one scanner, you need a scanner per chair. You think, let's just say the average doctor has three chairs and there's 2 million doctors out there, we're just touching this thing. We got a 50 thousand unit installed base. And obviously this is a growth equation. It's not one where we're looking to playing out in some time, and obviously it's a portfolio insurance over time, because the technology moves fast too. So, it creates some of its own demand through our solar system. John, I'm done."
},
{
"speaker": "John Morici",
"text": "And from a supply standpoint, obviously, we're mindful of concerns and things that go on from a global supply chain. But we feel comfortable that between the inventory we have and some of the things that we've been able to do that we can manage to, in a supply chain concerns that are out there."
},
{
"speaker": "Michael Ryskin",
"text": "All right. Thanks a lot."
},
{
"speaker": "Operator",
"text": "Our next question is from Devin Misra with Birenberg, please proceed with your question."
},
{
"speaker": "Doug",
"text": "Hey Devin, Doug here for Ravi from Berenberg. Thanks for taking my question. I want to revisit the marketing side. I think you guys have been ramping up marketing spending and there was a long list of things with very large percentage increases noted earlier. Where are you seeing a higher ROI in regards to marketing? Are there any specific regions? And then also just going back to a question on growth of teens versus adults, if we look at the marketing spend on things that you noted, it seems like a focus is on the teen side, which is indicative that that's where you see more growth and stronger returns. So any color around that and then I have a quick follow-up."
},
{
"speaker": "Joseph Hogan",
"text": "First of all, from a marketing spend standpoint, we really do understand by region our return on investment and what we get. I'm not going to share that over the phone but we're very aware of that and what it is. We also -- when you asked about the teen advertisements, there's a seasonality for teams around the world too. So you'll see like in the quarter we just came out of and the second quarter we were going into, that's teen season. It's big in China, big in the States. And so you'll see a larger part of our advertising budget go towards that in order to capture that demand. This is part of how we go-to-market. We have a great brand. That brand needs to be enhanced with patients and we want those patients go into doctors asking for Invisalign. We have some very good capability here from a marketing standpoint to exercise that. John?"
},
{
"speaker": "John Morici",
"text": "And what we've learned over time is, we're -- it's not one size fits all across all the markets. You're trying to maximize return on investment and in certain markets you are doing things that are different than others. Maybe more established markets, you try something different. Maybe other markets that we have where we can advertise. we try different things. But I think the key is we understand what levers to pull. We've learned a lot over the last several years. We're very excited about these opportunities. And as Joe said, we have the best brand -- best global brand out there, and we want to be able to reach those potential patients in the way that they are living their lives. That's the philosophy that we have, and we talked a lot about that front-end at top of the funnel metrics, and we're very excited about what we're seeing as we've gone due to the last several quarters."
},
{
"speaker": "Doug",
"text": "Okay, great. And then kind of following up on that direct-to-consumer focus question early on, there was launch of that team -- of teeth whitening solution and hopefully they would go to their Align shops that be litigation with the SCE. it's a focus point there. As we envision where the direct-to-consumer side of Align business goes, how does that teeth whitening solution, and -- how does that fit in? I'm trying to see -- it seems like there's a big push to a dredge consumer with the -- with that side coming up. So any color on that would be helpful."
},
{
"speaker": "Joseph Hogan",
"text": "Well, if your question implies a direct-to-consumer kind of a mode, that's not us, it's not what we do. It's not what -- but you know, we obviously have an e-commerce site. We have a great brand called Invisalign. Patients ask us all the time for whitening, cleansers, chewys, things associated with it. And what is exercising that capability? It's one with the whitening standpoint, we probably should have been more aggressive on before. But again, it's one of those things that we decided to focus on recently. And we're getting great feedback from the doctors in doing that. It only makes sense. It's classic brand extension, and we're going to leverage that and use Align brand as well as we can."
},
{
"speaker": "Doug",
"text": "Great, thanks."
},
{
"speaker": "Joseph Hogan",
"text": "Thank you."
},
{
"speaker": "Operator",
"text": "We have reached the end of the question-and-answer session. At this time, I'd like to turn the call over to Shirley Stacy for closing comments."
},
{
"speaker": "Shirley Stacy",
"text": "Thank you, Operator. And thank you everyone for joining us today. This concludes our conference call. We look forward to speaking to you again on Friday at the Align 2021 Investor Day, in conjunction with our GP Growth Summit here in Las Vegas. If you have any future questions, please contact Investor Relations. And thank you for your time and have a great day."
},
{
"speaker": "Operator",
"text": "This concludes today's conference. You may disconnect your lines at this time, and we thank you for your participation."
}
] | Align Technology, Inc. | 24,568 |
ALGN | 2 | 2,021 | 2021-07-29 18:30:00 | Operator: Greetings, and welcome to the Align Technology, Inc. Conference Call. At this time, all participants are in a listen-only mode. A question-and-answer session will follow the formal presentation. [Operator Instructions]. As a reminder, this conference is being recorded. I would now like to turn the conference over to your host, Shirley Stacy, VP, Corporate Communications and Investor Relations.
Shirley Stacy: Good afternoon and thank you for joining us. I'm Shirley Stacy, Vice President of Corporate Communications and Investor Relations. Joining me for today's call is Joe Hogan, President and CEO; and John Morici, CFO. We issued second quarter 2021 financial results today via Globe Newswire, which is available on our Web site at investor.aligntech.com. Today's conference call is being audio webcast and will be archived on our Web site for approximately one month. A telephone replay will be available by approximately 5.30 PM Eastern Time through 5.30 PM Eastern Time on August 11. To access the telephone replay, domestic callers should dial 877-660-6853 with conference number 13720779 followed by pound. International callers should dial 201-612-7415 with the same conference number. As a reminder, the information provided and discussed today will include forward-looking statements including statements about Align's future events and product outlook. These forward-looking statements are only predictions and involve risks and uncertainties that are described in more detail in our most recent periodic reports filed with the Securities and Exchange Commission, available on our Web site and at sec.gov. Actual results may vary significantly, and Align expressly assumes no obligation to update any forward-looking statements. We have posted historical financial statements, including the corresponding reconciliations, including our GAAP to non-GAAP reconciliation, if applicable, and our second quarter 2021 conference call slides on our Web site under Quarterly Results. Please refer to these files for more detailed information. With that, I'd like to turn the call over to Align Technology's President and CEO, Joe Hogan. Joe?
Joseph Hogan: Thanks, Shirley. Good afternoon and thanks for joining us. On our call today, I'll provide some highlights from the second quarter, then briefly discuss the performance of our two operating segments, Systems and Services and Clear Aligners. John will provide more detail on our financial results and discuss our outlook. Following that, I'll come back and summarize a few key points and open the call to questions. I'm pleased to report our first $1 billion revenue quarter with record volumes reflecting continued momentum from both Clear Aligners and Systems and Services. For Q2, Systems and Services revenues reflect strong growth across all regions and the strategic value of the iTero business with continued adoption of the iTero Element 5D Plus Series of next-generation scanners and imaging systems which launched in February. Increasingly, doctors are seeing the strategic impact and value of iTero scanners in their practices. In addition to its role in Invisalign case submissions, it is a true workhorse and digital enabler in every type of practice and across every type of orthodontic and restorative workflow. Q2 sequential Clear Aligner volumes were primarily driven by strength in both adult and teen market segments and across customer channels and regions, especially from the Americas and EMEA regions, reflecting the expanding opportunity for Invisalign treatment among adults globally, as well as the underlying orthodontic market as we continue to build awareness of the Invisalign brand and drive utilization among teens and younger patients. For Q2 '21, Invisalign Clear Aligner volumes for teens were up 9.5% sequentially and 156% year-over-year to 181,000 teens, representing one-third of total cases shipped, with strong growth from North America and EMEA orthodontists. During the quarter, we hosted several team-focused, peer-to-peer events designed to build clinical competence in teen treatment and highlight the teen digital treatment journey with Invisalign treatment. The recent APAC Virtual Symposium featured leading providers focusing on clinical excellence with teen treatment, and North America hosted the Invisalign Teen forum; Virtual Edition for Invisalign doctors bringing together clinical speakers, digital industry experts and teen patient panelists to share their insights. In May, Align focused on the Align Digital Platform at the 2021 AAO annual session, featuring a dynamic virtual line-up of Invisalign doctors describing how they have grown their practices through adoption of digital technology. Our Q2 results also reflect the positive impact of our investments in consumer marketing, generating billions of impressions and 33% year-over-year increase in leads for Invisalign doctors. During the quarter, we launched the next phase of our Mom/Teen multi-touch campaign, as well as the new “Invis is a Powerful Thing” campaign designed to engage teens and young adults. We also deepened our partnership with influencers like Charli D'Amelio with the first limited-edition aligner case as part of our new e-Commerce initiative featuring custom cases, cleaning and oral care products, as well as accessories like Invisalign Stickables, all of which are available on Invisalign.com. These and other consumer initiatives are important in supporting doctors’ practices especially through the busy summer teen season and beyond. They also build on our investments in digital technology and innovation that are the foundation of the Align Digital Platform, including integrated digital workflows and virtual tools designed to improve clinical confidence, treatment efficiency, and patient outcomes. A year ago, we released Invisalign Virtual Appointment and Invisalign Virtual Care tools within our My Invisalign app, in response to the global pandemic to enable Invisalign doctors to provide continuity of care for their patients. Today, Invisalign Virtual Care is available globally in 60 markets and the My Invisalign app has been downloaded 1 million times with Invisalign patients worldwide. It was recently recognized as the “Best Virtual Care Platform” by the MedTech Breakthrough Awards program and as “Digital Innovation of the Year” by Healthcare Asia Medtech Awards. As part of Invisalign Virtual Care, patients use My Invisalign app to stay engaged with their treatment and convey progress photos to their doctor, fostering two-way communication with their doctor throughout their Invisalign treatment journey. Now let's turn to the specifics around our second quarter results, starting with the Americas. For the Americas region, Q2 was another strong quarter with Invisalign case volumes up 11% sequentially and 261% year-over-year, reflecting growth across the region especially in the United States and Canada, from both comprehensive and non-comprehensive products, and increased Invisalign utilization from orthodontic and GP channels. DSO utilization continues to be a strong growth driver as well, led by Heartland and Smile Docs. For our international business, Q2 Invisalign case volume was up sequentially 12.7% on a year-over-year basis. International shipments were up 149%. For EMEA, Q2 volumes were up sequentially 17% and 265% year-over-year with broad-based growth across all markets, led by Iberia, UK, and Italy along with continued growth in our expansion markets. In Q2, growth from both channels was strong, with orthodontic channel growth reflecting increased Invisalign utilization, and GP channel growth driven by increased Invisalign submitters. For Q2, EMEA growth also reflects adoption of the Invisalign First product, designed to treat a broad range of teeth straightening issues in growing children, from simple to complex, including crowding, spacing, and narrow dental arches. Aiding in treatment engagement for those younger patients, Invisalign Stickables are innovative accessories designed exclusively for use with the patented SmartTrack material in Invisalign clear systems. Available in an array of designs, colors, shapes, and themes, Invisalign Stickables are a fun way for patients to show their personal style during Invisalign treatment. During the quarter, we also hosted a successful virtual edition of GP Growth Summit attended by over 1,200 doctors from the EMEA region. For APAC, Q2 volumes were up sequentially 4.8% and 50% on a year year-over-year basis, reflecting growth across the region, led by Japan, China and ANZ, despite new and extended COVID restrictions in several APAC markets. APAC performance reflects strength in GP Channel with increased Invisalign submitters, especially in Japan which continues to deliver strong growth. During the quarter, we hosted our China Forum, attended by over 1,500 doctors from private clinics, our APAC Virtual Symposium, attended by 1,400 doctors as well as the China Public Hospital Forum in June. Our consumer marketing is focused on educating consumers about the Invisalign system and driving that demand to Invisalign doctors’ offices, ultimately capitalizing on the massive market opportunity to transform 500 million smiles. We have provided many of our key metrics that show increased activity and engagement with the Invisalign brand in our Q2 quarterly presentation slides available on aligntech.com. In Q2, we launched the next generation of “Invis Is” multi-touch campaign driving reach and awareness with adult, mom and teen consumers yielding more than 200% growth in visitors globally to our Web sites and more than 82% increase in searches for an Invisalign trained doctor. Leading with the Invis is Not Your Parents Braces campaign, we connected with teens, utilizing digital media such as YouTube, Twitch, and social media. We also continued with our Invisalign ChangeMakers program that celebrated and recognized teens driving change in their communities which was covered by multiple media outlets such as Elite Daily, Refinery29, Yahoo! Unwind, Hollywood Life, SheKnows, J-14, Yahoo Finance, Parents.com, Glamour and NewBeauty and generated more than 600 million impressions. In the EMEA region, our new marketing campaign to drive engagement, “Invis is a powerful thing,” went live in the UK, Germany, and France during the quarter resulting in more than 170% year-over-year increase in unique visitors and 136% year-over-year increase in doctor locater searches. We will continue to roll out the campaign to additional markets in the region during the third quarter. We continued to expand our consumer advertising in the APAC region in Australia, Japan, and China and saw more than an 800% increase in consumer engagement and a 55% year-over-year increase in leads. Lastly, we continue to build strong relationships with global search and social media giants like Google, Snapchat, and TikTok in order to further leverage our best-in-class consumer demand programs more effective globally. These partners recognize the power of the Invisalign brand and are helping us amplify and gain efficiencies from our investments. For our Systems and Services business, Q2 revenues were up 20% sequentially and up 214% year-over-year reflecting strong scanner shipments and services. This represents the fourth consecutive quarter of sequential revenue growth. The iTero Element 5D Plus Imaging System continues to gain traction across all regions with strong adoption with new customers in the APAC and EMEA regions and with existing customers in the Americas region. In APAC, the iTero Element 2 intraoral scanner did well during the quarter, helping to transform digital workflows and chairside consults for doctors. During the quarter, we announced a new iTero Workflow 2.0 software and previewed auto-upload functionality in the iTero Element 5D Imaging System. The iTero Workflow 2.0 software advanced features, including faster scanning, improved visualization, and enhanced patient communication tools, were rolled out regionally in all markets where the iTero Element Plus imaging systems were sold. The iTero Element 5D imaging system auto-upload feature will eliminate steps and streamline Invisalign case submissions with intraoral color scan images that can be used in place of traditional intraoral photos. The auto-upload functionality is scheduled for release during the third quarter of 2021. There is great symmetry between Systems and Services business with Clear Aligner business reflected in the positive correlation between the deployment of scanners and the increased utilization of Invisalign Clear Aligners. In terms of digital scans used for Invisalign case submissions, total digital scans in Q2 increased to 82.2% from 78.5% in Q2 last year. International scans increased to 76.2%, up from 72% in the same quarter last year. For the Americas, 86.6% of cases were submitted digitally compared to 86% a year ago. Cumulatively, over 40.1 million orthodontic scans and 8.4 million restorative scans have been performed with iTero scanners. I’m also pleased to share that Align received regulatory approval for the iTero 5D Plus series in Japan on July 1, with a formal launch event planned for August. Turning to exocad. During the quarter, exocad launched the Creator Center, the new exocad one-stop-shop for online and in-person educational events with a database consisting of 35 educational webinars showcasing the highlights and add-on features of exocad’s software solutions, DentalCAD Galway 3.0 and exoplan 3.0 Galway. More than 2,500 users and distributors have been trained on the new software releases worldwide. exocad also expanded their market coverage with a new global OEM partner, Ivoclar Vivadent, or we call IV, one of the largest manufacturers in the dental industry. This strategic collaboration will give exocad access to thousands of new IV users worldwide and will also provide exocad users with access to production processes with removable prosthetics in the future. Earlier this month, exocad has released PartialCAD 3.0 Galway, its module for removable partial denture frameworks, which has new and advanced features for the design of high quality partial dentures. This new release enhances digital CAD/CAM possibilities for exocad users and dental technicians by providing simpler design solutions for complex cases. PartialCAD 3.0 Galway provides both experts and new users with smooth, improved integration with DentalCAD, exocad’s leading software for dental laboratories. Bringing the iTero and exocad businesses together makes us more viable within the GP segment and more relevant in day-to-day comprehensive dentistry for our customers. The combination of Invisalign Clear Aligners and iTero scanners have long provided a seamless workflow for orthodontic treatment. The integration of exocad’s expertise in restorative dentistry and implantology, guided surgery and smile design takes the Align technology portfolio beyond our established footprint in orthodontics to ortho-restorative and restorative treatment, and paves the way for new, cross-disciplinary workflows that span from visualization and treatment planning to lab production to chairside. exocad also broadens Align’s platform reach in digital dentistry with over 200 partners and more than 40,000 licenses installed worldwide. With that, I’ll now turn the call over to John.
John Morici: Thanks, Joe. Let me begin by reminding everyone that for Align and many companies, Q2 2020 was significantly impacted by COVID-19 business disruptions, and comparisons of our results for Q2 2021 should be considered accordingly. Now for our Q2 financial results. Total revenues for the second quarter were $1 billion, up 13% from the prior quarter and up 186.9% from the corresponding quarter a year ago. For Clear Aligners, Q2 revenues of $841 million were up 11.6% sequentially and up 181.9% year-over-year reflecting Invisalign volume growth in most geographies. In Q2, we shipped a record 665.6 thousand Invisalign cases, an increase of 11.7% sequentially and 200% year-over-year. In addition, we shipped a record 83.5 thousand Invisalign doctors worldwide, of which approximately 7.2 thousand were first-time customers. Q2 Clear Aligner revenues reflect strong growth across the Invisalign portfolio for both Comprehensive and non-Comprehensive products. Q2 Comprehensive volume increased 11.4% sequentially and 181.9% year-over-year. And Q2 non-Comprehensive volume increased 12.3% sequentially driven by strength in Invisalign Moderate and Invisalign Go and up 251.7% year-over-year. Q2 adult patients increased 12.6% sequentially and 220.4% year-over-year. In Q2, teens or younger patients increased 9.5% sequentially and 156.3% year-over-year. Clear Aligner revenues were unfavorably impacted by foreign exchange of approximately $3.4 million or approximately 0.5 points sequentially. On a year-over-year basis, Clear Aligner revenues were favorably impacted by foreign exchange of approximately $36.7 million or approximately 12.3 points. For Q2, Invisalign Comprehensive ASPs decreased sequentially and year-over-year. On a sequential basis, Invisalign Comprehensive ASPs reflect higher discounts, credits, and foreign exchange, partially offset by regional mix. On a year-over-year basis, Comprehensive ASPs reflect the increase in net revenue deferrals for new Invisalign cases versus additional aligner shipments partially offset by foreign exchange. Recall Q2 2020 ASPs increased as a result of more additional aligner shipments as doctors were focused on maintaining treatment progress for existing Invisalign patients. This trend reversed itself after practices reopened in Q3 and demand for new cases ramped up significantly. Q2 Invisalign non-Comprehensive ASPs increased sequentially and were flat year-over-year. On a sequential basis, Invisalign non-Comprehensive ASPs reflect lower discounts partially offset by foreign exchange. On a year-over-year basis, Invisalign non-Comprehensive ASPs were favorably impacted by foreign exchange offset by higher mix of new Invisalign cases versus additional aligner shipments. Clear aligner deferred revenues on the balance sheet increased $101 million sequentially and $337 million year-over-year and will be recognized as the additional aligners are shipped. Our System and Services revenues for the second quarter were a record $169.8 million, up 20% sequentially and up 214.7% year-over-year. The increase sequentially and year-over-year can be attributed to increased scanner shipments, higher ASP and increased services revenues from our larger installed base. Our Systems and Services deferred revenue on the balance sheet was up 22% sequentially and up 135% year-over-year, primarily due to the increase in scanner sales and the deferral of service revenues, which will be recognized ratably over the service period. Moving on to gross margin. Second quarter gross margin was 75%, down 0.6 points sequentially and up 11.4 points year-over-year. On a non-GAAP basis, excluding stock-based compensation and amortization of intangibles related to our exocad acquisition, overall gross margin was 75.4% for the second quarter, down 0.7 points sequentially and up 11 points year-over-year. Overall gross margin was favorably impacted by approximately 1.1 points on a year-over-year basis due to foreign exchange and relatively unchanged sequentially. Clear Aligner gross margin for the second quarter was 76.9%, down 0.7 points sequentially due to higher freight costs and slightly lower ASPs. Clear Aligner gross margin was 12.4 points year-over-year due to increased manufacturing efficiencies from higher production volumes, partially offset by lower ASPs. Systems and Services gross margin for the second quarter was a record 65.9%, up 0.5 points sequentially primarily due to higher ASPs, partially offset by manufacturing variances and higher freight costs. Systems and Services gross margin was up 6.6 points year-over-year due to higher ASPs and services revenues, in addition to improved manufacturing efficiencies from higher production volumes, partially offset by higher freight costs. Q2 operating expenses were $489.6 million, up sequentially 8.4% and up 64.7% year-over-year. The sequential increase in operating expenses is due to increased consumer marketing spend, increased compensation related to additional headcount and higher commissions, and other general and administrative costs. Year-over-year, operating expenses increased by $192.3 million, reflecting our continued investment in marketing and sales and R&D activities and investments commensurate with business growth. On a non-GAAP basis, which excludes stock-based compensation and amortization of intangibles related to our exocad acquisition, operating expenses were $461.2 million, up sequentially 8.6% and up 73.6% year-over-year due to the reasons described above. Our second quarter operating income of $268.9 million resulted in an operating margin of 26.6%, up 1.4 points versus prior quarter and up 47.3 points year-over-year. The sequential increase in operating margin was attributable primarily to operational leverage. The year-over-year increase in operating margin was primarily attributable to higher gross margin and operating leverage as well as the favorable impact from foreign exchange by approximate 1.8 points. On a non-GAAP basis, which excludes stock-based compensation and amortization of intangibles, operating margin for the second quarter was 29.8%, up 1.2 points sequentially, and up 40.8 points year-over-year. Interest and other income and expense, net for the second quarter was a loss of 0.1 million, down sequentially by $36.3 million primarily due to the SDC arbitration award gain recorded in the first quarter. With regards to the second quarter tax provision, our GAAP tax rate was 25.7%, which was higher than the prior quarter rate of 23.4% primarily due to lower excess tax benefits from stock-based compensation. Our GAAP tax rate was lower than the same quarter last year, which was 44.8%, primarily due to foreign income taxed at lower rates. The second quarter tax rate on a non-GAAP basis was 19.5% compared to 20.2% in the prior quarter and 27.8% in the prior year. The second quarter non-GAAP tax rate was lower than the prior quarter and the second quarter of the prior year rates due to foreign income taxed at lower rates. Second quarter net income per diluted share was $2.51, flat sequentially and up $3.03 compared to the prior year. On a non-GAAP basis, net income per diluted share was $3.04 for the second quarter, up $0.55 sequentially and up $3.39 year-over-year. Moving on to the balance sheet. As of June 30, 2021, cash and cash equivalents were $1.1 billion, flat sequentially. Of our $1.1 billion of cash and cash equivalents, $551 million was held in the U.S. and $535.3 million was held by our international entities. Q2 accounts receivable balance was $808.1 million, up approximately 12.4% sequentially. Our overall days sales outstanding was 72 days, flat sequentially and down approximately 49.1 days as compared to Q2 last year. Cash flow from operations for the second quarter was $317.5 million. Capital expenditures for the second quarter were $124.2 million, primarily related to our continued investment in increasing aligner capacity and facilities. Free cash flow, defined as cash flow from operations less capital expenditures, amounted to $193.3 million. We also have $300 million available under our revolving line of credit. Under our $1 Billion repurchase program announced in May 2021, we have $900 million remaining available for repurchase of our common stock. Now let me turn to our outlook and the factors that inform our view for the remainder of the year. Overall, we are very pleased with our second quarter results and our continued strong performance across regions, customer channels and products. While there continues to be uncertainty around the pandemic and increasing restrictions related to COVID-19 in certain geographies, we are continuing to invest in our strategic growth initiatives, including sales, marketing, innovation and manufacturing capacity, to drive demand and conversion globally and are confident in our competitive position and ability to execute. At the same time, we are also anticipating more pronounced summer seasonality across all regions than we have experienced in recent years, as doctors, their staff and patients take long overdue vacations. Notwithstanding seasonality, given our strong performance and continued confidence in the huge market opportunity, our industry leadership and our ability to execute, we are increasing our 2021 revenue guidance provided in April on the Q1 '21 earnings call to a range of $3.85 billion to $3.95 billion. Additionally, we now expect our second half year-over-year revenue growth rate to be above the midpoint of our long-term operating model target of 20% to 30%. On a GAAP basis, we now anticipate our 2021 operation margin to be better than our prior guidance, in the range of 24% to 25%. On a non-GAAP basis, we expect the 2021 operating margin to be approximately 3 points higher than our GAAP operating margin, after excluding stock-based compensation and intangible amortization. In addition, during Q3 '21, we expect to repurchase up to $75 million of our common stock through either a combination of open market repurchases or an accelerated stock repurchase agreement. For 2021, we expect our investments in capital expenditures to be approximately $500 million. Capital expenditures primarily relate to building construction and improvements as well as additional manufacturing capacity to support our international expansion. This includes our planned investment in a new manufacturing facility in Poland, our first one in the EMEA region. With that, I’ll turn it back over to Joe for final comments. Joe?
Joseph Hogan: Thanks, John. Q2 was a terrific quarter and we’re very pleased with the improvements we’re seeing in recovery in doctor’s practices. We truly value their increasing adoption of digital treatment approaches, their confidence in the unique Align Digital Platform that spans from iTero to the world’s most sophisticated treatment planning, the world’s largest 3D printing business on the globe to a patient app with over 1 million consumers along with the world’s most recognized orthodontic brand has driven strong performance across the business. Our performance over the last year confirms the incredible size of our target market and demonstrates that our strategy and investments in recent years have helped further solidify our competitive position. We have numerous growth drivers in a vastly underpenetrated market. And while we continue to see some lasting impact and continued uncertainty due to COVID, we remain confident in both the enormous opportunity we have to lead the evolution of digital orthodontics and comprehensive dentistry with our doctor customers, and in our ability to execute our strategy to increase adoption of Invisalign treatment globally. We’re also confident in and excited about the benefits of digital treatment that more and more doctors are experiencing by transforming their practices with Invisalign digital orthodontics and iTero scanners for chairside treatment planning and visualization. In fact, Invisalign treatment requires on an average 30% fewer doctor visits than fixed appliances, creating efficiency gains for the doctors and a better patient experience. And 85% of orthodontists surveyed agree that adopting the Align Digital Platform has made a huge difference in their practices. It provides ways to improve their efficiency and productivity. I look forward to updating you at the GP Summit and Investor Day in October in Las Vegas and sharing more examples of how Align is helping doctors transform their practices and their approach to treatment. Now I’ll turn the call over to the operator for questions. Operator?
Operator: Thank you. At this time, we'll be conducting a question-and-answer session. [Operator Instructions]. Our first question comes from Nathan Rich with Goldman Sachs. Please state your question.
Nathan Rich: Hi. Good afternoon. Thanks for the questions. Joe, I wanted to start with the increased guidance and the expectations around the back half of the year being at the high end of the long-term range. I guess several of the factors that you highlighted on the call, the growth in new customers, the strong iTero placements, those have all historically been good leading indicators of growth in Invisalign. It also sounds like you're seeing better uptake from the DSO channels. That's obviously an opportunity that you guys have been going after for a long time. But I guess at this point, does that change how you're thinking about what the right target is for top line growth kind of next year, within the long-term range that you have?
Joseph Hogan: Hi, Nathan. Look, I think you said it really well what we're seeing right now, what we're experiencing overall, and we are calling strong growth for the second half of this year. But, look, our revenue guidance for the long term for the business is 20% to 30%. And we continue to work within those boundaries. So we're not prepared to change that at the moment. John, any thoughts on --?
John Morici: No, that's exactly -- we feel good about what we're seeing in the marketplace and our guide reflects that.
Nathan Rich: I appreciate that. And then, John, maybe a follow up for you. Can you maybe go into a little bit more detail around your comments on the more pronounced summer seasonality, just how that impacts your expectations for the sequential growth we're likely to see in 3Q and 4Q of this year, maybe versus what you would expect in a normal year?
John Morici: Well, as we know, there's a summer period where people take vacations, holidays and so on in EMEA and other places, and we expect and I think what we see in our own lives is you take longer weekends or maybe more pronounced vacations, people doing things in advance of shutdowns or lockdowns that might happen. And I think we're just being reflective of that. But really looking at all the variables that we normally see and talking to what we expect for the second half, which is to the upper side of our midpoint on a year-over-year basis.
Nathan Rich: Got it. Thanks for the questions.
Joseph Hogan: Thanks, Nathan.
Operator: Our next question comes from Jon Block with Stifel. Please go ahead.
Joseph Hogan: Hi, Jon.
Jonathan Block: Hi, Joe. Good afternoon, guys. I think, Joe, I'll start with you with the first one. I think it was 5.3 North American GPU utilization number was huge and I think we all waited for a while to get that to get to 4. Now it's towards the 5. Just talk to us on what that is? I'm assuming what? It's more scanners. Is it also just increased utilization with even those that have had the scanner for some time? Would love some color and maybe just more importantly, is that 5 handle on the North American GPU utilization, do you view that as sustainable going forward? And then I've got a follow up.
Joseph Hogan: Jon, I consider everything we do has more than a single variable to it and that's the platform that we work with that you know as well as anybody. But I'd say yes. Scanners serve that very well. Our increased advertising helps to drive that too. It brings more patients to the GPs. And thirdly, new product like [indiscernible] and different derivatives of that product line that are very efficient for GPs to use. And it gives them a huge amount of confidence in our product line when they use it, Jon. So it's a combination of our brand, it's a combination of our digital platform with iTero. It's a combination of product piece. And then we don't talk about it a lot, but we split our sales force years ago. And we have a specific focused sales force on GPs. And GPs speak a different language, Jon. It's different than orthodontists altogether, and that team has been incredibly effective being able to work with doctors, how they can integrate Invisalign into the workflow. And from a restorative standpoint, how you use this proactively. So I'm confident that's a great market for us. We know that 500 million patients we talk about globally sits broadly in that segment, but you need a different kind of a product approach, a different sales approach, and a strong platform geared to those guys to keep that going. And we feel good about that.
Jonathan Block: Okay. And actually you brought up an interesting point. I think the sales force is I believe bifurcating international more recently in North America. So I guess we're starting to see that come through. Second question, John, just let me try to be as detailed as possible. So you've got solid 2Q '21 sales upside that you just reported. Then you raised the back part of the year from roughly 25% year-over-year revenue midpoint growth to closer to 27%. Yet you call out some more pronounced summer seasonality, and those seem at odds with one another. So can you just reconcile those two data points? In other words, you're alluding to more seasonality, yet you just took up the forecast in the back part of the year even in the face of that. So any color would be great.
John Morici: I think it really reflects just the timing between quarters and not kind of as you said looking at the second half in a way, not knowing how vacations and holidays and lockdowns potential might play out but by looking at it in totality and kind of looking at from a second half standpoint.
Jonathan Block: Thanks, guys.
Joseph Hogan: Thanks, Jon.
Operator: Our next question comes from Jason Bednar with Piper Sandler. Please state your question.
Jason Bednar: Hi, everyone. Good afternoon. Congrats on the strong quarter here. Joe, I want to follow up on Nathan’s question there going back to the first one. Maybe if you can unpack a bit further what you're seeing here as we look ahead in the next couple quarters, especially now that we've lapped the easiest of your comps, your guide here with suggest momentum strong across the business. But the key question I keep getting from investors is really how that adult consumer in the second half of the year and then into '22, how they're going to respond? So the question I guess for you is just how you're seeing the adult consumer respond in your various geographies as economies have opened back up and as we start staring down some tougher paths on the adult side? Then I've got a follow up.
Joseph Hogan: Well, I think, Jason, in what we see with adults, and we see this really all over the globe, is we obviously had a big uptake from an adult standpoint, but you can see our team numbers up pretty substantially too at the same time. So there's a good balance. The previous question that Jon asked too with GPs, it comes into broadly an adult segment and that segment also. And my explanation in the sense of why we've been effective in that segment, we think we can continue to be helps to contribute to that. Now when we talk about third quarter and seasonality that Jon's talking about whatever, a lot of that is around adult patients and vacations and different things too and it affects different parts of the organization, and how we go to market. But in general, we just feel good about the direction of the business, the signal and words that we're getting from our doctors and what they're explaining they're seeing out there. And that's all incorporated into what we've been forecasting for you. And the one thing to never forget about too, Jason, is the size of this marketplace. We talk about 500 million patients and I know you hear from a lot of other companies in different industries about oversize, SIMs and whatever. This is true. If anything should have shown, like I mentioned in my closing comments, that this market is as big as we talk about being is what you've seen from this business over the last year in the adult segment of that part too, which is a big part of that 500 million patients that we talk about.
Jason Bednar: That's helpful, Joe. And then just looking at least relative to our model in the quarter, it looks like -- most of the outperformance or disproportion amount came from the Americas. I'm sure that's U.S., but also maybe Brazil. And you made some pretty strong comments in the past on what Brazil could do for your business in a pretty short window of time. So just wondering if you could update us here on where you're at with expansion in Brazil, maybe how much that market in particular is contributing to sequential case growth?
Joseph Hogan: Yes, no statistics for it. Brazil continues to be strong. I think you know it's a big aesthetic market, one of the biggest aesthetic markets in the world. It parallels Iberia in a lot of ways as we -- how we have to go in there and move. We're primarily in the orthodontic segment there and not in the GP segment right now on how we have done it. It's a different market that way because ortho play in a much more broader sense in that country than we do here. But we have a very experienced team there. We funded it well. I feel good about our position from a product standpoint and iTero scanners. And it's a big market for us. And don't just think about Brazil too. Latin America in general, it's been a big expanding market for us. So Brazil leads because of the size, population and essentially talked about. But overall, our LATAM market is extremely strong and we're well positioned there. John, any thoughts on that?
John Morici: I think you covered it.
Jason Bednar: All right. Thanks, guys.
Joseph Hogan: All right, Jason. Thanks.
Operator: Our next question comes from Erin Wright with Credit Suisse. Please go ahead.
Erin Wright: Great. Sticking with that international topic, can you speak to the growth in the quarter in Asia Pac and what you're seeing across that market? Are you still seeing some COVID related lingering headwinds there? And can you speak to some of the competitive landscape dynamics as well? And then also your efforts in terms of expanding the consumer advertising effort across that geography as well? Thanks.
John Morici: Hi, Erin. This is John. I can address the start of that. Look, APAC is an important region for us, a huge market opportunity. We've invested, as we've talked about, with manufacturing and treatment planning and other places. We recently have added some additional advertising in APAC, and we see great results where there's a lot of interest, a lot of awareness that it drives, people come to our Web site and look for doctors and so on. And we think that translates very well. We're very happy with the quarter for Q2. You do have pockets of areas where there's COVID, more of a COVID impact; Southeast Asia, parts of China, other areas that we're always mindful of. But when we look at the investments we're making, the return that we're getting from those investments, we feel really good about APAC.
Erin Wright: Okay. And then how should we be thinking about the quarterly progression of the gross margin from here and the run rate going forward? Is there anything to call out in terms of mix or ASPs? Are some of those seasonal dynamics you were talking about that we should be thinking about as we think about the third and the fourth quarter gross margin trends? Thanks.
Joseph Hogan: Nothing of major note, Erin. We've seen that -- as we drive utilization, have more coming through our factories, it’s very productive for us. We're very mindful of the tradeoffs that affect our margin, and you're seeing that come through. So as we look at some of the investments that we're making and how we're going to market products that we have, how we view things, there's nothing that should be too different than what we've seen from a gross margin standpoint.
Erin Wright: Okay, great. Thank you.
Joseph Hogan: Thanks, Erin.
Operator: Our next question comes from Jeff Johnson with Robert W. Baird & Co. Please go ahead.
Joseph Hogan: Hi, Jeff.
Jeffrey Johnson: Good afternoon. Hi, Joe. How are you? A couple of questions here I guess. One, on the seasonality, again, I hate to keep harping on that. But typically by this point, late July, you guys now know July numbers, you probably know pretty much what's lined up for August given cases that are in treatment planning phase right now. So are the seasonality comments driven by something you're seeing so far in the numbers? Is it something that you're just expecting could come in late in the quarter? Is it focused on the adult side, just kind of any more color there would be helpful as well?
Joseph Hogan: Jeff, it's based on our experience with the season. I think you know. You've been following our business long enough. Third quarter is a real transition quarter from a vacation standpoint, teams coming in here. European vacations, which are really big. And our comments are just reflecting what we're hearing from our customer base, our doctor base not just in the United States, but all over the world. And we're just trying to share that with you. But at the same time, the guide that we've taken up, you have to remember we're at the upper end of our growth model for the second half. And when you think about it, we have two real strong quarters last year, Jeff, third and fourth quarters. So it's just a lot of confidence in what we see and what we feel.
Jeffrey Johnson: Yes, understood. And then on ASPs, John, maybe for you. It sounds like some of the rebaiting or some of the promotional activity, I guess I should say, maybe has stepped down just a little bit. Obviously, you're running some bigger trading programs in that late last year and the early part of this year. Is that an opportunity then for ASPs to float a little bit higher into the back half of next year, or do other promotions pop up and just think about ASPs kind of straight lining from here? Thanks.
John Morici: Yes, I would say the latter. Look, there's always promotions that we're running to drive that right utilization, and you try to find that right mix. And what we talk about and I think everybody gets is, it has to translate to gross margin, and we feel good about the gross margin that it's ultimately driving and our op margins that it brings to our bottom line. So there will be some tradeoffs, but I don't expect too much of a change in ASP. And the way we've looked at it, and just because some grow faster than others, look at it from a Comprehensive standpoint versus a non-Comprehensive standpoint to be relatively stable.
Jeffrey Johnson: Yes, understood. Thanks, guys.
Joseph Hogan: Thanks, Jeff.
Operator: Our next question comes from John Kreger with William Blair. Please go ahead.
Joseph Hogan: Hi, John.
John Kreger: Hi, guys. Thanks so much. Maybe just one more follow up. I would assume the seasonality comment is mainly sort of one about adults. But curious if you've got any thoughts on how the teen season might differ this year? Is it shaping up to be sort of a normal year as we assume schools are open again, or maybe more spread evenly across the second half?
John Morici: I think you look at it, John, just from the standpoint that there are unknowns around COVID and vacations and other things. COVID is one of them. Some places we hear some of the countries and regions, school is going to open up earlier; some are saying that it's later. So we're just trying to be mindful that there's going to be changes that happen to this and try to give as much information about that as possible.
John Kreger: Great. Thanks, John. And then maybe one follow up on ASP. It seemed like the year-over-year trend was different in Comprehensive versus non-Comprehensive. Can you just explain that again? Why would the Comprehensive change have been greater than a non-Comprehensive? And when you think about that metric longer term, do you assume the trajectory is similar across those two buckets or not?
John Morici: Yes, the biggest change from last year to this year is really around the additional treatment that doctors were provided. So remember, last year, they didn't have as many new patients coming in, but they were still keeping existing patients along in treatment. It doesn't count as a new case. It really just counts as additional revenue. And therefore ASPs are higher as a result of that. Conversely, as now they've focused more on primary cases and new patients coming in, we see that shift -- we saw that shift. It really started in the third quarter of last year. It's kind of progressed relatively steady from third quarter on. And that's kind of how we think of it. There's not a -- it's not a promotional change or there's nothing of that nature. It's just really more just on how we're recognizing revenue between a primary shipment and then an additional treatment that a doctor provides.
John Kreger: Okay, makes sense. Thank you.
Joseph Hogan: Thanks, John.
Operator: Our next question comes from Elizabeth Anderson with Evercore. Please go ahead.
Elizabeth Anderson: Hi, guys. Thanks so much for the question. So my question is in terms of the second quarter, could you talk about how you saw volumes progressing maybe in the U.S. across the three months?
John Morici: I think when we look at -- hi, Elizabeth. It’s John. We saw strength across our business. We're not going to get into kind of month-by-month, but I think what we saw and you saw in the print for second quarter, very strong across geographies, products and so on. And what we're seeing is a reflection of that with our guidance.
Elizabeth Anderson: Okay, that makes sense. And then turning to the cash flow, I appreciate the CapEx increase this year is largely a function of the new facility in Poland. Is that something that should continue on at that kind of pace going forward, or do you see kind of all of that wrapped up in this year's expense? And then we should go back to sort of more normalized levels afterwards.
John Morici: Yes, I think what you'll see with kind of the convergence of what we have now, we have a lot of capacity that we're adding to meet the demand in the markets that we have. And we have that unique event with Poland kind of going on from a land, purchase, building and equipment that goes in. So this year will be a little bit heavy from that standpoint. And then going forward, it should just be more of the expansion and growth that way, but not as much as this year with the building as well.
Joseph Hogan: Elizabeth, this is Joe. And thinking about -- we’re talking about 200% growth rates, right. And we're talking about growth rates on the upper end of what our revenue models have been given to you guys. So it requires actually that kind of investment. And it's a good question. But like John said, we’ll hit it hard this year, build some more capacity and this will lay in over time.
Elizabeth Anderson: Yes, that certainly makes sense, especially as you have to build it ahead of the growth. Thank you.
Operator: Our next question comes from Liza Garcia with Wolfe Research. Please go ahead.
Liza Garcia: Hi, guys. Can you hear me all right?
Shirley Stacy: Yes, we hear you fine.
Joseph Hogan: Yes. Hi, Liza.
Liza Garcia: So I guess just digging into kind of how you're thinking about the exocad expansion with the [indiscernible] and kind of how you see the opportunity building there. You've mentioned a couple of things. And also should we view this kind of as like a first move for exocad and going forward strategy into more CAD/CAM?
Joseph Hogan: Yes, Liza, that's a good question. When you think about -- we talk about the GP segment, we talk about ortho-restorative and I think most people, if you study this, you know the exocad is one of the few companies out there that actually offers a digital type of restorative platform for dentists all around the world. Our vision for our business, as we become a big part of restorative and saving enamel and moving teeth, before you actually do implants, you need to do different things. And that's what -- like that's we think is the revolution of orthodontics, because that wasn't a tool that was really used before. And so exocad and iTero plug in really well behind that. Never forget that our strategy is always about selling more Invisalign. That's what exocad is about. That's what iTero is about too. But they also have to have credibility as units in those segments. And that's when we talk about what we're doing with exocad and iTero, we're expanding our technology but always with a thought of how we can be more effective in ortho-restorative. John actually runs the business. I’ll let him talk about it.
John Morici: No, I think you summarized it well. This is a -- it's been just over a year. We're very pleased with how the business stands, as it stands alone, and then the technical and commercial integration that's been going on. And we see more and more synergies and feel good about the digital platform that this helps us move forward. So more to come on this. But after a year, we're very pleased.
Liza Garcia: Great. Awesome. And then I was just wondering if you're hearing any indications from your customers about staffing as a potential issue, that's kind of limiting their availability anywhere? It doesn't -- obviously, the report doesn't certainly seem that way. But channel checks have kind of indicated some more limited staffing.
Joseph Hogan: Yes. Liza, it’s Joe again. I wouldn't call it a hindrance right now. They have to pay more to find these people. There is concern out there in the sense of how much people have to pay to bring them in. But we haven't had that as an excuse of doctor saying, I can't do more cases because I can't find staff. It's just harder to spend more time doing.
John Morici: The one thing that you do hear and it's just the reality when we talk about some of that seasonality, people take vacations or doctors on vacation as well as staff and patients. So they might fall into that bucket as well to limit some of that staff at their offices.
Liza Garcia: Great. Thanks so much.
Operator: Our next question comes from Richard Newitter with SVB Leerink. Please go ahead.
Jamie Morgan: Hi, guys. It's Jamie on for Rich. A quick question for me on teens. Obviously, our checks, specifically within the ortho channel have been very bullish over the last couple of months. And now with it representing greater than a third of total case shifts, is it fair to say now that teen adoption is finally hitting that inflection point in the U.S.? And if not, kind of what are some of the things that you think still need to happen to really start to take on this sort of viewpoint?
Joseph Hogan: It’s Joe. Look, this is not a tipping point as you referred to it. It's been a ground war actually. And that ground war is basically started with product liability. And obviously, with Invisalign First and mandibular advancement and some of our other innovations that we've had, we've really opened up that segment and made it available to us too. Now the work is primarily with orthodontists to make them confident that they can service these teens, not just clinically but from a business standpoint also. That's why our programs like ADAPT and different things we put into place. And remember the war here is not against other clear aligner companies, it's about braces and fixed appliances. And that's what we really have to break through and get done. And honestly, orthodontists just have to be comfortable, not clinically but also from a business standpoint. And I feel like we're making progress in educating teens and educating mom, but on the other end, educating orthodontists to how they can properly do this clinically and also be efficient in their practices in doing it, and that's the ground war part. I feel we're well positioned. And obviously our numbers say we're making progress, but we're not declaring victory here at all.
Jamie Morgan: Got it. And then just one follow up back to kind of some of the more pronounced summer seasonality. If I look back kind of through 2017 through 2019, it seems like you guys have seen anywhere from flat to maybe mid-single digit sequential improvement. Consensus is currently standing at something that would imply a decline. So is there any reason to be thinking that it shouldn't at least fall within the bounds of zero, a flat, mid-single digit improvement versus what consensus is currently implying, which would be a decline, just trying to get better calibration there.
John Morici: Yes, Jamie, this is John. Look, we're trying to give you color to the second half because it's implied in our total year, and you can kind of defer or kind of infer what that means from third quarter and fourth quarter, but just trying to give you as much color without giving quarterly guidance is all that has been.
Jamie Morgan: Okay. Thanks.
Joseph Hogan: Thanks, Jamie.
Operator: Our next question comes from Michael Ryskin with Bank of America. Please go ahead.
Michael Ryskin: Hi, guys. How are you doing? Congrats on the quarter of the guide raise. I want to ask first on the -- I guess for John on the operating margin, especially on the non-GAAP side, had another really good quarter there. You bumped the guide a little bit, but you're still sort of -- your outlook for the second half still implies a pretty decent step down in operating margin. So I'm just wondering what's going on there? Is there any incremental spend that you're budgeting? And just in general, sort of expand on that? Can you talk a little bit about consumer marketing spend? How are those costs trending? How's the return on that going?
John Morici: Yes, good question. Look, we're very pleased with our margins that we've seen through the first half, as you noted, very strong performance, a good reflection of a lot of the investments that we made, and we continue to make to help grow our business. And we look at the second half as continuing these investments to expand from a sales and marketing standpoint. There's some operating costs that we have to be able to grow our business, like we have. It reflects those investments and we're trying to continue to position ourselves so that we would continue momentum and be able to start next year with that momentum. So it's really more of a reflection of that. And obviously, as we go through the second half, we'll update on what that means for margin.
Michael Ryskin: Okay. And then on the gross margin line, again, just on the -- you got the manufacturing facility in China. You're talking about the plant in Poland up in 2022. Could you give us an update or reminder of sort of how we should think about progression there in terms of shifting some of the manufacturing there, and how they should work its way through the gross margin lines? And when do to those plants reach more or less full capacity and sort of you work through the ramp up there?
John Morici: Yes, you're right. When we go live, there is -- until you get that capacity up, and we're really -- we know how to do that manufacturing, we've learned as we've gone through some of the China facility ramp up, that will get applied to how we ramp up in Poland. We'll move doctors over kind of country by country and ramp things up. That will happen in the first half next year. But very mindful of what it means from a margin standpoint and do everything we can to minimize that inefficiency that you have when you first start up, and be able to get those facilities up and running at near 100% capacity.
Joseph Hogan: Yes. And one of the things that John knows better than me on this one, Michael, is when we ramped up China, remember we started with a rental temporary facility that was not even close to scale, and it just pounded our cost. But we just wanted to get in place, get the workflow done. We built a building next to the where that area was, then transitioned into it. So that was a pretty big bump that we took there. We're not anticipating, John, the same.
John Morici: Right. And that would happen, Michael, when we kind of quietly went live in Q2 of last year with that new Greenfield facility. And it's all about running that factory with a high utilization. They have an efficient labor and productivity there that we know how to drive. But there is some ramp up period, but we'll look to that in kind of the first half, and then see improvement as we go into the second half.
Michael Ryskin: Okay. Fantastic. Thanks.
Joseph Hogan: Thanks, Michael.
Operator: Our next question comes from Ravi Misra with Berenberg Capital Markets. Please go ahead.
Ravi Misra: Hi, team. How are you doing? Can you hear me?
Joseph Hogan: Hi, Ravi.
Shirley Stacy: Hi, Ravi.
Ravi Misra: Hi. So I guess I have two questions. One is more on the R&D side and one on China. So just on the R&D, one of your competitors announced a new polymer. And I think one of the things that's actually turned up in our checks with orthos at least is that SmartTrack gives you an edge. Just curious on your view and whether that's kind of starting to have any sort of impact, or is it too early? And then how you plan to maybe position yourself to kind of keep ahead of the peers? And then secondly, just around China, I guess it’s another kind of competition question with I guess your largest facility, a relatively small competitor going public? How are you kind of viewing that market now with kind of another I guess well funded competitor out there in terms of the ability to grow the market or kind of go after potential segment of that market, whether it's the more luxury focus patient or how are you kind of segmenting the population there? Thanks.
Joseph Hogan: On your first question on a new polymer, we do multi-layer material. So it's various polymers that you put together and we were balancing the equation between elasticity and overall rigidity or retention [h] strength. And it's like our other competitors are starting to figure that piece out and see pieces of it. We have strong patents around SmartTrack and obviously improving over time is a real important part about not just having the right materials, but having the right kind of system in place. And that's the treatment planning part that we talked about, 25 years of understanding how to really activate those aligners and make that plastic actually work through those algorithms. And we don't use a displacement methodology, which is basically built on aligner that kind of leads things. It actually engages with these things in a different way. So I expect more companies to come out and work different polymers or whatever. We have a huge amount of experience of that, but don't forget about the entire system, the algorithms, how it works together and how it works the attachments, the exactness of the attachments, where you put those attachments, how they're shaped, so a lot going on there. We feel good about our position, and we'll continue to innovate in that space across all those spectrums. But there's nothing in the competitive marketplace that we are concerned with that would change the trajectory of where we're investing right now. From a China competitive standpoint, obviously Angel Align IPO, we watched that closely and get some clarity to everybody in that marketplace as they IPO’ed and what's going on. And I think you see they're strong in Tier 3 cities, they're strong with public hospitals in different areas. But look, I feel good about our position in China. Our manufacturing is strong. Our training centers there are strong. Our treatment planning is strong. It's close to accounts. We had good growth in the quarter overall, good sequential growth, good year-on-year growth. You might want to [indiscernible], John.
John Morici: Yes, just to add in China, we've been competing in China with various companies since we've been there. So it is nothing new really with the IPO. It's really more of a reflection of this under penetrated market in China. China is a huge opportunity for the clear aligner business. And so we feel very good about our positioning there. Primarily cases are done with wires and brackets. And so this is less about share shifting amongst clear aligner and more about growth in the category.
Ravi Misra: Thanks.
Shirley Stacy: Thanks, Ravi. Well, listen, thank you everyone for joining us today. We really appreciate your time. Look forward to speaking to you at upcoming financial conferences and industry meetings, including the International Dental Show in Cologne, Germany, September 22 through 25, where we'll be showcasing Align, exocad innovations and a hybrid and multimedia exhibition space through physical and virtual experiences. We'll also be hosting an investor meeting in conjunction with our GP Summit in October in Las Vegas in Nevada. We'll have that October 29 and 30. So look for more information. And if you have any additional questions, please follow up with our Investor Relations Department. Thanks and have a great day.
Operator: This concludes today's conference. You may disconnect your lines at this time. Thank you for your participation. | [
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"speaker": "Operator",
"text": "Greetings, and welcome to the Align Technology, Inc. Conference Call. At this time, all participants are in a listen-only mode. A question-and-answer session will follow the formal presentation. [Operator Instructions]. As a reminder, this conference is being recorded. I would now like to turn the conference over to your host, Shirley Stacy, VP, Corporate Communications and Investor Relations."
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{
"speaker": "Shirley Stacy",
"text": "Good afternoon and thank you for joining us. I'm Shirley Stacy, Vice President of Corporate Communications and Investor Relations. Joining me for today's call is Joe Hogan, President and CEO; and John Morici, CFO. We issued second quarter 2021 financial results today via Globe Newswire, which is available on our Web site at investor.aligntech.com. Today's conference call is being audio webcast and will be archived on our Web site for approximately one month. A telephone replay will be available by approximately 5.30 PM Eastern Time through 5.30 PM Eastern Time on August 11. To access the telephone replay, domestic callers should dial 877-660-6853 with conference number 13720779 followed by pound. International callers should dial 201-612-7415 with the same conference number. As a reminder, the information provided and discussed today will include forward-looking statements including statements about Align's future events and product outlook. These forward-looking statements are only predictions and involve risks and uncertainties that are described in more detail in our most recent periodic reports filed with the Securities and Exchange Commission, available on our Web site and at sec.gov. Actual results may vary significantly, and Align expressly assumes no obligation to update any forward-looking statements. We have posted historical financial statements, including the corresponding reconciliations, including our GAAP to non-GAAP reconciliation, if applicable, and our second quarter 2021 conference call slides on our Web site under Quarterly Results. Please refer to these files for more detailed information. With that, I'd like to turn the call over to Align Technology's President and CEO, Joe Hogan. Joe?"
},
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"speaker": "Joseph Hogan",
"text": "Thanks, Shirley. Good afternoon and thanks for joining us. On our call today, I'll provide some highlights from the second quarter, then briefly discuss the performance of our two operating segments, Systems and Services and Clear Aligners. John will provide more detail on our financial results and discuss our outlook. Following that, I'll come back and summarize a few key points and open the call to questions. I'm pleased to report our first $1 billion revenue quarter with record volumes reflecting continued momentum from both Clear Aligners and Systems and Services. For Q2, Systems and Services revenues reflect strong growth across all regions and the strategic value of the iTero business with continued adoption of the iTero Element 5D Plus Series of next-generation scanners and imaging systems which launched in February. Increasingly, doctors are seeing the strategic impact and value of iTero scanners in their practices. In addition to its role in Invisalign case submissions, it is a true workhorse and digital enabler in every type of practice and across every type of orthodontic and restorative workflow. Q2 sequential Clear Aligner volumes were primarily driven by strength in both adult and teen market segments and across customer channels and regions, especially from the Americas and EMEA regions, reflecting the expanding opportunity for Invisalign treatment among adults globally, as well as the underlying orthodontic market as we continue to build awareness of the Invisalign brand and drive utilization among teens and younger patients. For Q2 '21, Invisalign Clear Aligner volumes for teens were up 9.5% sequentially and 156% year-over-year to 181,000 teens, representing one-third of total cases shipped, with strong growth from North America and EMEA orthodontists. During the quarter, we hosted several team-focused, peer-to-peer events designed to build clinical competence in teen treatment and highlight the teen digital treatment journey with Invisalign treatment. The recent APAC Virtual Symposium featured leading providers focusing on clinical excellence with teen treatment, and North America hosted the Invisalign Teen forum; Virtual Edition for Invisalign doctors bringing together clinical speakers, digital industry experts and teen patient panelists to share their insights. In May, Align focused on the Align Digital Platform at the 2021 AAO annual session, featuring a dynamic virtual line-up of Invisalign doctors describing how they have grown their practices through adoption of digital technology. Our Q2 results also reflect the positive impact of our investments in consumer marketing, generating billions of impressions and 33% year-over-year increase in leads for Invisalign doctors. During the quarter, we launched the next phase of our Mom/Teen multi-touch campaign, as well as the new “Invis is a Powerful Thing” campaign designed to engage teens and young adults. We also deepened our partnership with influencers like Charli D'Amelio with the first limited-edition aligner case as part of our new e-Commerce initiative featuring custom cases, cleaning and oral care products, as well as accessories like Invisalign Stickables, all of which are available on Invisalign.com. These and other consumer initiatives are important in supporting doctors’ practices especially through the busy summer teen season and beyond. They also build on our investments in digital technology and innovation that are the foundation of the Align Digital Platform, including integrated digital workflows and virtual tools designed to improve clinical confidence, treatment efficiency, and patient outcomes. A year ago, we released Invisalign Virtual Appointment and Invisalign Virtual Care tools within our My Invisalign app, in response to the global pandemic to enable Invisalign doctors to provide continuity of care for their patients. Today, Invisalign Virtual Care is available globally in 60 markets and the My Invisalign app has been downloaded 1 million times with Invisalign patients worldwide. It was recently recognized as the “Best Virtual Care Platform” by the MedTech Breakthrough Awards program and as “Digital Innovation of the Year” by Healthcare Asia Medtech Awards. As part of Invisalign Virtual Care, patients use My Invisalign app to stay engaged with their treatment and convey progress photos to their doctor, fostering two-way communication with their doctor throughout their Invisalign treatment journey. Now let's turn to the specifics around our second quarter results, starting with the Americas. For the Americas region, Q2 was another strong quarter with Invisalign case volumes up 11% sequentially and 261% year-over-year, reflecting growth across the region especially in the United States and Canada, from both comprehensive and non-comprehensive products, and increased Invisalign utilization from orthodontic and GP channels. DSO utilization continues to be a strong growth driver as well, led by Heartland and Smile Docs. For our international business, Q2 Invisalign case volume was up sequentially 12.7% on a year-over-year basis. International shipments were up 149%. For EMEA, Q2 volumes were up sequentially 17% and 265% year-over-year with broad-based growth across all markets, led by Iberia, UK, and Italy along with continued growth in our expansion markets. In Q2, growth from both channels was strong, with orthodontic channel growth reflecting increased Invisalign utilization, and GP channel growth driven by increased Invisalign submitters. For Q2, EMEA growth also reflects adoption of the Invisalign First product, designed to treat a broad range of teeth straightening issues in growing children, from simple to complex, including crowding, spacing, and narrow dental arches. Aiding in treatment engagement for those younger patients, Invisalign Stickables are innovative accessories designed exclusively for use with the patented SmartTrack material in Invisalign clear systems. Available in an array of designs, colors, shapes, and themes, Invisalign Stickables are a fun way for patients to show their personal style during Invisalign treatment. During the quarter, we also hosted a successful virtual edition of GP Growth Summit attended by over 1,200 doctors from the EMEA region. For APAC, Q2 volumes were up sequentially 4.8% and 50% on a year year-over-year basis, reflecting growth across the region, led by Japan, China and ANZ, despite new and extended COVID restrictions in several APAC markets. APAC performance reflects strength in GP Channel with increased Invisalign submitters, especially in Japan which continues to deliver strong growth. During the quarter, we hosted our China Forum, attended by over 1,500 doctors from private clinics, our APAC Virtual Symposium, attended by 1,400 doctors as well as the China Public Hospital Forum in June. Our consumer marketing is focused on educating consumers about the Invisalign system and driving that demand to Invisalign doctors’ offices, ultimately capitalizing on the massive market opportunity to transform 500 million smiles. We have provided many of our key metrics that show increased activity and engagement with the Invisalign brand in our Q2 quarterly presentation slides available on aligntech.com. In Q2, we launched the next generation of “Invis Is” multi-touch campaign driving reach and awareness with adult, mom and teen consumers yielding more than 200% growth in visitors globally to our Web sites and more than 82% increase in searches for an Invisalign trained doctor. Leading with the Invis is Not Your Parents Braces campaign, we connected with teens, utilizing digital media such as YouTube, Twitch, and social media. We also continued with our Invisalign ChangeMakers program that celebrated and recognized teens driving change in their communities which was covered by multiple media outlets such as Elite Daily, Refinery29, Yahoo! Unwind, Hollywood Life, SheKnows, J-14, Yahoo Finance, Parents.com, Glamour and NewBeauty and generated more than 600 million impressions. In the EMEA region, our new marketing campaign to drive engagement, “Invis is a powerful thing,” went live in the UK, Germany, and France during the quarter resulting in more than 170% year-over-year increase in unique visitors and 136% year-over-year increase in doctor locater searches. We will continue to roll out the campaign to additional markets in the region during the third quarter. We continued to expand our consumer advertising in the APAC region in Australia, Japan, and China and saw more than an 800% increase in consumer engagement and a 55% year-over-year increase in leads. Lastly, we continue to build strong relationships with global search and social media giants like Google, Snapchat, and TikTok in order to further leverage our best-in-class consumer demand programs more effective globally. These partners recognize the power of the Invisalign brand and are helping us amplify and gain efficiencies from our investments. For our Systems and Services business, Q2 revenues were up 20% sequentially and up 214% year-over-year reflecting strong scanner shipments and services. This represents the fourth consecutive quarter of sequential revenue growth. The iTero Element 5D Plus Imaging System continues to gain traction across all regions with strong adoption with new customers in the APAC and EMEA regions and with existing customers in the Americas region. In APAC, the iTero Element 2 intraoral scanner did well during the quarter, helping to transform digital workflows and chairside consults for doctors. During the quarter, we announced a new iTero Workflow 2.0 software and previewed auto-upload functionality in the iTero Element 5D Imaging System. The iTero Workflow 2.0 software advanced features, including faster scanning, improved visualization, and enhanced patient communication tools, were rolled out regionally in all markets where the iTero Element Plus imaging systems were sold. The iTero Element 5D imaging system auto-upload feature will eliminate steps and streamline Invisalign case submissions with intraoral color scan images that can be used in place of traditional intraoral photos. The auto-upload functionality is scheduled for release during the third quarter of 2021. There is great symmetry between Systems and Services business with Clear Aligner business reflected in the positive correlation between the deployment of scanners and the increased utilization of Invisalign Clear Aligners. In terms of digital scans used for Invisalign case submissions, total digital scans in Q2 increased to 82.2% from 78.5% in Q2 last year. International scans increased to 76.2%, up from 72% in the same quarter last year. For the Americas, 86.6% of cases were submitted digitally compared to 86% a year ago. Cumulatively, over 40.1 million orthodontic scans and 8.4 million restorative scans have been performed with iTero scanners. I’m also pleased to share that Align received regulatory approval for the iTero 5D Plus series in Japan on July 1, with a formal launch event planned for August. Turning to exocad. During the quarter, exocad launched the Creator Center, the new exocad one-stop-shop for online and in-person educational events with a database consisting of 35 educational webinars showcasing the highlights and add-on features of exocad’s software solutions, DentalCAD Galway 3.0 and exoplan 3.0 Galway. More than 2,500 users and distributors have been trained on the new software releases worldwide. exocad also expanded their market coverage with a new global OEM partner, Ivoclar Vivadent, or we call IV, one of the largest manufacturers in the dental industry. This strategic collaboration will give exocad access to thousands of new IV users worldwide and will also provide exocad users with access to production processes with removable prosthetics in the future. Earlier this month, exocad has released PartialCAD 3.0 Galway, its module for removable partial denture frameworks, which has new and advanced features for the design of high quality partial dentures. This new release enhances digital CAD/CAM possibilities for exocad users and dental technicians by providing simpler design solutions for complex cases. PartialCAD 3.0 Galway provides both experts and new users with smooth, improved integration with DentalCAD, exocad’s leading software for dental laboratories. Bringing the iTero and exocad businesses together makes us more viable within the GP segment and more relevant in day-to-day comprehensive dentistry for our customers. The combination of Invisalign Clear Aligners and iTero scanners have long provided a seamless workflow for orthodontic treatment. The integration of exocad’s expertise in restorative dentistry and implantology, guided surgery and smile design takes the Align technology portfolio beyond our established footprint in orthodontics to ortho-restorative and restorative treatment, and paves the way for new, cross-disciplinary workflows that span from visualization and treatment planning to lab production to chairside. exocad also broadens Align’s platform reach in digital dentistry with over 200 partners and more than 40,000 licenses installed worldwide. With that, I’ll now turn the call over to John."
},
{
"speaker": "John Morici",
"text": "Thanks, Joe. Let me begin by reminding everyone that for Align and many companies, Q2 2020 was significantly impacted by COVID-19 business disruptions, and comparisons of our results for Q2 2021 should be considered accordingly. Now for our Q2 financial results. Total revenues for the second quarter were $1 billion, up 13% from the prior quarter and up 186.9% from the corresponding quarter a year ago. For Clear Aligners, Q2 revenues of $841 million were up 11.6% sequentially and up 181.9% year-over-year reflecting Invisalign volume growth in most geographies. In Q2, we shipped a record 665.6 thousand Invisalign cases, an increase of 11.7% sequentially and 200% year-over-year. In addition, we shipped a record 83.5 thousand Invisalign doctors worldwide, of which approximately 7.2 thousand were first-time customers. Q2 Clear Aligner revenues reflect strong growth across the Invisalign portfolio for both Comprehensive and non-Comprehensive products. Q2 Comprehensive volume increased 11.4% sequentially and 181.9% year-over-year. And Q2 non-Comprehensive volume increased 12.3% sequentially driven by strength in Invisalign Moderate and Invisalign Go and up 251.7% year-over-year. Q2 adult patients increased 12.6% sequentially and 220.4% year-over-year. In Q2, teens or younger patients increased 9.5% sequentially and 156.3% year-over-year. Clear Aligner revenues were unfavorably impacted by foreign exchange of approximately $3.4 million or approximately 0.5 points sequentially. On a year-over-year basis, Clear Aligner revenues were favorably impacted by foreign exchange of approximately $36.7 million or approximately 12.3 points. For Q2, Invisalign Comprehensive ASPs decreased sequentially and year-over-year. On a sequential basis, Invisalign Comprehensive ASPs reflect higher discounts, credits, and foreign exchange, partially offset by regional mix. On a year-over-year basis, Comprehensive ASPs reflect the increase in net revenue deferrals for new Invisalign cases versus additional aligner shipments partially offset by foreign exchange. Recall Q2 2020 ASPs increased as a result of more additional aligner shipments as doctors were focused on maintaining treatment progress for existing Invisalign patients. This trend reversed itself after practices reopened in Q3 and demand for new cases ramped up significantly. Q2 Invisalign non-Comprehensive ASPs increased sequentially and were flat year-over-year. On a sequential basis, Invisalign non-Comprehensive ASPs reflect lower discounts partially offset by foreign exchange. On a year-over-year basis, Invisalign non-Comprehensive ASPs were favorably impacted by foreign exchange offset by higher mix of new Invisalign cases versus additional aligner shipments. Clear aligner deferred revenues on the balance sheet increased $101 million sequentially and $337 million year-over-year and will be recognized as the additional aligners are shipped. Our System and Services revenues for the second quarter were a record $169.8 million, up 20% sequentially and up 214.7% year-over-year. The increase sequentially and year-over-year can be attributed to increased scanner shipments, higher ASP and increased services revenues from our larger installed base. Our Systems and Services deferred revenue on the balance sheet was up 22% sequentially and up 135% year-over-year, primarily due to the increase in scanner sales and the deferral of service revenues, which will be recognized ratably over the service period. Moving on to gross margin. Second quarter gross margin was 75%, down 0.6 points sequentially and up 11.4 points year-over-year. On a non-GAAP basis, excluding stock-based compensation and amortization of intangibles related to our exocad acquisition, overall gross margin was 75.4% for the second quarter, down 0.7 points sequentially and up 11 points year-over-year. Overall gross margin was favorably impacted by approximately 1.1 points on a year-over-year basis due to foreign exchange and relatively unchanged sequentially. Clear Aligner gross margin for the second quarter was 76.9%, down 0.7 points sequentially due to higher freight costs and slightly lower ASPs. Clear Aligner gross margin was 12.4 points year-over-year due to increased manufacturing efficiencies from higher production volumes, partially offset by lower ASPs. Systems and Services gross margin for the second quarter was a record 65.9%, up 0.5 points sequentially primarily due to higher ASPs, partially offset by manufacturing variances and higher freight costs. Systems and Services gross margin was up 6.6 points year-over-year due to higher ASPs and services revenues, in addition to improved manufacturing efficiencies from higher production volumes, partially offset by higher freight costs. Q2 operating expenses were $489.6 million, up sequentially 8.4% and up 64.7% year-over-year. The sequential increase in operating expenses is due to increased consumer marketing spend, increased compensation related to additional headcount and higher commissions, and other general and administrative costs. Year-over-year, operating expenses increased by $192.3 million, reflecting our continued investment in marketing and sales and R&D activities and investments commensurate with business growth. On a non-GAAP basis, which excludes stock-based compensation and amortization of intangibles related to our exocad acquisition, operating expenses were $461.2 million, up sequentially 8.6% and up 73.6% year-over-year due to the reasons described above. Our second quarter operating income of $268.9 million resulted in an operating margin of 26.6%, up 1.4 points versus prior quarter and up 47.3 points year-over-year. The sequential increase in operating margin was attributable primarily to operational leverage. The year-over-year increase in operating margin was primarily attributable to higher gross margin and operating leverage as well as the favorable impact from foreign exchange by approximate 1.8 points. On a non-GAAP basis, which excludes stock-based compensation and amortization of intangibles, operating margin for the second quarter was 29.8%, up 1.2 points sequentially, and up 40.8 points year-over-year. Interest and other income and expense, net for the second quarter was a loss of 0.1 million, down sequentially by $36.3 million primarily due to the SDC arbitration award gain recorded in the first quarter. With regards to the second quarter tax provision, our GAAP tax rate was 25.7%, which was higher than the prior quarter rate of 23.4% primarily due to lower excess tax benefits from stock-based compensation. Our GAAP tax rate was lower than the same quarter last year, which was 44.8%, primarily due to foreign income taxed at lower rates. The second quarter tax rate on a non-GAAP basis was 19.5% compared to 20.2% in the prior quarter and 27.8% in the prior year. The second quarter non-GAAP tax rate was lower than the prior quarter and the second quarter of the prior year rates due to foreign income taxed at lower rates. Second quarter net income per diluted share was $2.51, flat sequentially and up $3.03 compared to the prior year. On a non-GAAP basis, net income per diluted share was $3.04 for the second quarter, up $0.55 sequentially and up $3.39 year-over-year. Moving on to the balance sheet. As of June 30, 2021, cash and cash equivalents were $1.1 billion, flat sequentially. Of our $1.1 billion of cash and cash equivalents, $551 million was held in the U.S. and $535.3 million was held by our international entities. Q2 accounts receivable balance was $808.1 million, up approximately 12.4% sequentially. Our overall days sales outstanding was 72 days, flat sequentially and down approximately 49.1 days as compared to Q2 last year. Cash flow from operations for the second quarter was $317.5 million. Capital expenditures for the second quarter were $124.2 million, primarily related to our continued investment in increasing aligner capacity and facilities. Free cash flow, defined as cash flow from operations less capital expenditures, amounted to $193.3 million. We also have $300 million available under our revolving line of credit. Under our $1 Billion repurchase program announced in May 2021, we have $900 million remaining available for repurchase of our common stock. Now let me turn to our outlook and the factors that inform our view for the remainder of the year. Overall, we are very pleased with our second quarter results and our continued strong performance across regions, customer channels and products. While there continues to be uncertainty around the pandemic and increasing restrictions related to COVID-19 in certain geographies, we are continuing to invest in our strategic growth initiatives, including sales, marketing, innovation and manufacturing capacity, to drive demand and conversion globally and are confident in our competitive position and ability to execute. At the same time, we are also anticipating more pronounced summer seasonality across all regions than we have experienced in recent years, as doctors, their staff and patients take long overdue vacations. Notwithstanding seasonality, given our strong performance and continued confidence in the huge market opportunity, our industry leadership and our ability to execute, we are increasing our 2021 revenue guidance provided in April on the Q1 '21 earnings call to a range of $3.85 billion to $3.95 billion. Additionally, we now expect our second half year-over-year revenue growth rate to be above the midpoint of our long-term operating model target of 20% to 30%. On a GAAP basis, we now anticipate our 2021 operation margin to be better than our prior guidance, in the range of 24% to 25%. On a non-GAAP basis, we expect the 2021 operating margin to be approximately 3 points higher than our GAAP operating margin, after excluding stock-based compensation and intangible amortization. In addition, during Q3 '21, we expect to repurchase up to $75 million of our common stock through either a combination of open market repurchases or an accelerated stock repurchase agreement. For 2021, we expect our investments in capital expenditures to be approximately $500 million. Capital expenditures primarily relate to building construction and improvements as well as additional manufacturing capacity to support our international expansion. This includes our planned investment in a new manufacturing facility in Poland, our first one in the EMEA region. With that, I’ll turn it back over to Joe for final comments. Joe?"
},
{
"speaker": "Joseph Hogan",
"text": "Thanks, John. Q2 was a terrific quarter and we’re very pleased with the improvements we’re seeing in recovery in doctor’s practices. We truly value their increasing adoption of digital treatment approaches, their confidence in the unique Align Digital Platform that spans from iTero to the world’s most sophisticated treatment planning, the world’s largest 3D printing business on the globe to a patient app with over 1 million consumers along with the world’s most recognized orthodontic brand has driven strong performance across the business. Our performance over the last year confirms the incredible size of our target market and demonstrates that our strategy and investments in recent years have helped further solidify our competitive position. We have numerous growth drivers in a vastly underpenetrated market. And while we continue to see some lasting impact and continued uncertainty due to COVID, we remain confident in both the enormous opportunity we have to lead the evolution of digital orthodontics and comprehensive dentistry with our doctor customers, and in our ability to execute our strategy to increase adoption of Invisalign treatment globally. We’re also confident in and excited about the benefits of digital treatment that more and more doctors are experiencing by transforming their practices with Invisalign digital orthodontics and iTero scanners for chairside treatment planning and visualization. In fact, Invisalign treatment requires on an average 30% fewer doctor visits than fixed appliances, creating efficiency gains for the doctors and a better patient experience. And 85% of orthodontists surveyed agree that adopting the Align Digital Platform has made a huge difference in their practices. It provides ways to improve their efficiency and productivity. I look forward to updating you at the GP Summit and Investor Day in October in Las Vegas and sharing more examples of how Align is helping doctors transform their practices and their approach to treatment. Now I’ll turn the call over to the operator for questions. Operator?"
},
{
"speaker": "Operator",
"text": "Thank you. At this time, we'll be conducting a question-and-answer session. [Operator Instructions]. Our first question comes from Nathan Rich with Goldman Sachs. Please state your question."
},
{
"speaker": "Nathan Rich",
"text": "Hi. Good afternoon. Thanks for the questions. Joe, I wanted to start with the increased guidance and the expectations around the back half of the year being at the high end of the long-term range. I guess several of the factors that you highlighted on the call, the growth in new customers, the strong iTero placements, those have all historically been good leading indicators of growth in Invisalign. It also sounds like you're seeing better uptake from the DSO channels. That's obviously an opportunity that you guys have been going after for a long time. But I guess at this point, does that change how you're thinking about what the right target is for top line growth kind of next year, within the long-term range that you have?"
},
{
"speaker": "Joseph Hogan",
"text": "Hi, Nathan. Look, I think you said it really well what we're seeing right now, what we're experiencing overall, and we are calling strong growth for the second half of this year. But, look, our revenue guidance for the long term for the business is 20% to 30%. And we continue to work within those boundaries. So we're not prepared to change that at the moment. John, any thoughts on --?"
},
{
"speaker": "John Morici",
"text": "No, that's exactly -- we feel good about what we're seeing in the marketplace and our guide reflects that."
},
{
"speaker": "Nathan Rich",
"text": "I appreciate that. And then, John, maybe a follow up for you. Can you maybe go into a little bit more detail around your comments on the more pronounced summer seasonality, just how that impacts your expectations for the sequential growth we're likely to see in 3Q and 4Q of this year, maybe versus what you would expect in a normal year?"
},
{
"speaker": "John Morici",
"text": "Well, as we know, there's a summer period where people take vacations, holidays and so on in EMEA and other places, and we expect and I think what we see in our own lives is you take longer weekends or maybe more pronounced vacations, people doing things in advance of shutdowns or lockdowns that might happen. And I think we're just being reflective of that. But really looking at all the variables that we normally see and talking to what we expect for the second half, which is to the upper side of our midpoint on a year-over-year basis."
},
{
"speaker": "Nathan Rich",
"text": "Got it. Thanks for the questions."
},
{
"speaker": "Joseph Hogan",
"text": "Thanks, Nathan."
},
{
"speaker": "Operator",
"text": "Our next question comes from Jon Block with Stifel. Please go ahead."
},
{
"speaker": "Joseph Hogan",
"text": "Hi, Jon."
},
{
"speaker": "Jonathan Block",
"text": "Hi, Joe. Good afternoon, guys. I think, Joe, I'll start with you with the first one. I think it was 5.3 North American GPU utilization number was huge and I think we all waited for a while to get that to get to 4. Now it's towards the 5. Just talk to us on what that is? I'm assuming what? It's more scanners. Is it also just increased utilization with even those that have had the scanner for some time? Would love some color and maybe just more importantly, is that 5 handle on the North American GPU utilization, do you view that as sustainable going forward? And then I've got a follow up."
},
{
"speaker": "Joseph Hogan",
"text": "Jon, I consider everything we do has more than a single variable to it and that's the platform that we work with that you know as well as anybody. But I'd say yes. Scanners serve that very well. Our increased advertising helps to drive that too. It brings more patients to the GPs. And thirdly, new product like [indiscernible] and different derivatives of that product line that are very efficient for GPs to use. And it gives them a huge amount of confidence in our product line when they use it, Jon. So it's a combination of our brand, it's a combination of our digital platform with iTero. It's a combination of product piece. And then we don't talk about it a lot, but we split our sales force years ago. And we have a specific focused sales force on GPs. And GPs speak a different language, Jon. It's different than orthodontists altogether, and that team has been incredibly effective being able to work with doctors, how they can integrate Invisalign into the workflow. And from a restorative standpoint, how you use this proactively. So I'm confident that's a great market for us. We know that 500 million patients we talk about globally sits broadly in that segment, but you need a different kind of a product approach, a different sales approach, and a strong platform geared to those guys to keep that going. And we feel good about that."
},
{
"speaker": "Jonathan Block",
"text": "Okay. And actually you brought up an interesting point. I think the sales force is I believe bifurcating international more recently in North America. So I guess we're starting to see that come through. Second question, John, just let me try to be as detailed as possible. So you've got solid 2Q '21 sales upside that you just reported. Then you raised the back part of the year from roughly 25% year-over-year revenue midpoint growth to closer to 27%. Yet you call out some more pronounced summer seasonality, and those seem at odds with one another. So can you just reconcile those two data points? In other words, you're alluding to more seasonality, yet you just took up the forecast in the back part of the year even in the face of that. So any color would be great."
},
{
"speaker": "John Morici",
"text": "I think it really reflects just the timing between quarters and not kind of as you said looking at the second half in a way, not knowing how vacations and holidays and lockdowns potential might play out but by looking at it in totality and kind of looking at from a second half standpoint."
},
{
"speaker": "Jonathan Block",
"text": "Thanks, guys."
},
{
"speaker": "Joseph Hogan",
"text": "Thanks, Jon."
},
{
"speaker": "Operator",
"text": "Our next question comes from Jason Bednar with Piper Sandler. Please state your question."
},
{
"speaker": "Jason Bednar",
"text": "Hi, everyone. Good afternoon. Congrats on the strong quarter here. Joe, I want to follow up on Nathan’s question there going back to the first one. Maybe if you can unpack a bit further what you're seeing here as we look ahead in the next couple quarters, especially now that we've lapped the easiest of your comps, your guide here with suggest momentum strong across the business. But the key question I keep getting from investors is really how that adult consumer in the second half of the year and then into '22, how they're going to respond? So the question I guess for you is just how you're seeing the adult consumer respond in your various geographies as economies have opened back up and as we start staring down some tougher paths on the adult side? Then I've got a follow up."
},
{
"speaker": "Joseph Hogan",
"text": "Well, I think, Jason, in what we see with adults, and we see this really all over the globe, is we obviously had a big uptake from an adult standpoint, but you can see our team numbers up pretty substantially too at the same time. So there's a good balance. The previous question that Jon asked too with GPs, it comes into broadly an adult segment and that segment also. And my explanation in the sense of why we've been effective in that segment, we think we can continue to be helps to contribute to that. Now when we talk about third quarter and seasonality that Jon's talking about whatever, a lot of that is around adult patients and vacations and different things too and it affects different parts of the organization, and how we go to market. But in general, we just feel good about the direction of the business, the signal and words that we're getting from our doctors and what they're explaining they're seeing out there. And that's all incorporated into what we've been forecasting for you. And the one thing to never forget about too, Jason, is the size of this marketplace. We talk about 500 million patients and I know you hear from a lot of other companies in different industries about oversize, SIMs and whatever. This is true. If anything should have shown, like I mentioned in my closing comments, that this market is as big as we talk about being is what you've seen from this business over the last year in the adult segment of that part too, which is a big part of that 500 million patients that we talk about."
},
{
"speaker": "Jason Bednar",
"text": "That's helpful, Joe. And then just looking at least relative to our model in the quarter, it looks like -- most of the outperformance or disproportion amount came from the Americas. I'm sure that's U.S., but also maybe Brazil. And you made some pretty strong comments in the past on what Brazil could do for your business in a pretty short window of time. So just wondering if you could update us here on where you're at with expansion in Brazil, maybe how much that market in particular is contributing to sequential case growth?"
},
{
"speaker": "Joseph Hogan",
"text": "Yes, no statistics for it. Brazil continues to be strong. I think you know it's a big aesthetic market, one of the biggest aesthetic markets in the world. It parallels Iberia in a lot of ways as we -- how we have to go in there and move. We're primarily in the orthodontic segment there and not in the GP segment right now on how we have done it. It's a different market that way because ortho play in a much more broader sense in that country than we do here. But we have a very experienced team there. We funded it well. I feel good about our position from a product standpoint and iTero scanners. And it's a big market for us. And don't just think about Brazil too. Latin America in general, it's been a big expanding market for us. So Brazil leads because of the size, population and essentially talked about. But overall, our LATAM market is extremely strong and we're well positioned there. John, any thoughts on that?"
},
{
"speaker": "John Morici",
"text": "I think you covered it."
},
{
"speaker": "Jason Bednar",
"text": "All right. Thanks, guys."
},
{
"speaker": "Joseph Hogan",
"text": "All right, Jason. Thanks."
},
{
"speaker": "Operator",
"text": "Our next question comes from Erin Wright with Credit Suisse. Please go ahead."
},
{
"speaker": "Erin Wright",
"text": "Great. Sticking with that international topic, can you speak to the growth in the quarter in Asia Pac and what you're seeing across that market? Are you still seeing some COVID related lingering headwinds there? And can you speak to some of the competitive landscape dynamics as well? And then also your efforts in terms of expanding the consumer advertising effort across that geography as well? Thanks."
},
{
"speaker": "John Morici",
"text": "Hi, Erin. This is John. I can address the start of that. Look, APAC is an important region for us, a huge market opportunity. We've invested, as we've talked about, with manufacturing and treatment planning and other places. We recently have added some additional advertising in APAC, and we see great results where there's a lot of interest, a lot of awareness that it drives, people come to our Web site and look for doctors and so on. And we think that translates very well. We're very happy with the quarter for Q2. You do have pockets of areas where there's COVID, more of a COVID impact; Southeast Asia, parts of China, other areas that we're always mindful of. But when we look at the investments we're making, the return that we're getting from those investments, we feel really good about APAC."
},
{
"speaker": "Erin Wright",
"text": "Okay. And then how should we be thinking about the quarterly progression of the gross margin from here and the run rate going forward? Is there anything to call out in terms of mix or ASPs? Are some of those seasonal dynamics you were talking about that we should be thinking about as we think about the third and the fourth quarter gross margin trends? Thanks."
},
{
"speaker": "Joseph Hogan",
"text": "Nothing of major note, Erin. We've seen that -- as we drive utilization, have more coming through our factories, it’s very productive for us. We're very mindful of the tradeoffs that affect our margin, and you're seeing that come through. So as we look at some of the investments that we're making and how we're going to market products that we have, how we view things, there's nothing that should be too different than what we've seen from a gross margin standpoint."
},
{
"speaker": "Erin Wright",
"text": "Okay, great. Thank you."
},
{
"speaker": "Joseph Hogan",
"text": "Thanks, Erin."
},
{
"speaker": "Operator",
"text": "Our next question comes from Jeff Johnson with Robert W. Baird & Co. Please go ahead."
},
{
"speaker": "Joseph Hogan",
"text": "Hi, Jeff."
},
{
"speaker": "Jeffrey Johnson",
"text": "Good afternoon. Hi, Joe. How are you? A couple of questions here I guess. One, on the seasonality, again, I hate to keep harping on that. But typically by this point, late July, you guys now know July numbers, you probably know pretty much what's lined up for August given cases that are in treatment planning phase right now. So are the seasonality comments driven by something you're seeing so far in the numbers? Is it something that you're just expecting could come in late in the quarter? Is it focused on the adult side, just kind of any more color there would be helpful as well?"
},
{
"speaker": "Joseph Hogan",
"text": "Jeff, it's based on our experience with the season. I think you know. You've been following our business long enough. Third quarter is a real transition quarter from a vacation standpoint, teams coming in here. European vacations, which are really big. And our comments are just reflecting what we're hearing from our customer base, our doctor base not just in the United States, but all over the world. And we're just trying to share that with you. But at the same time, the guide that we've taken up, you have to remember we're at the upper end of our growth model for the second half. And when you think about it, we have two real strong quarters last year, Jeff, third and fourth quarters. So it's just a lot of confidence in what we see and what we feel."
},
{
"speaker": "Jeffrey Johnson",
"text": "Yes, understood. And then on ASPs, John, maybe for you. It sounds like some of the rebaiting or some of the promotional activity, I guess I should say, maybe has stepped down just a little bit. Obviously, you're running some bigger trading programs in that late last year and the early part of this year. Is that an opportunity then for ASPs to float a little bit higher into the back half of next year, or do other promotions pop up and just think about ASPs kind of straight lining from here? Thanks."
},
{
"speaker": "John Morici",
"text": "Yes, I would say the latter. Look, there's always promotions that we're running to drive that right utilization, and you try to find that right mix. And what we talk about and I think everybody gets is, it has to translate to gross margin, and we feel good about the gross margin that it's ultimately driving and our op margins that it brings to our bottom line. So there will be some tradeoffs, but I don't expect too much of a change in ASP. And the way we've looked at it, and just because some grow faster than others, look at it from a Comprehensive standpoint versus a non-Comprehensive standpoint to be relatively stable."
},
{
"speaker": "Jeffrey Johnson",
"text": "Yes, understood. Thanks, guys."
},
{
"speaker": "Joseph Hogan",
"text": "Thanks, Jeff."
},
{
"speaker": "Operator",
"text": "Our next question comes from John Kreger with William Blair. Please go ahead."
},
{
"speaker": "Joseph Hogan",
"text": "Hi, John."
},
{
"speaker": "John Kreger",
"text": "Hi, guys. Thanks so much. Maybe just one more follow up. I would assume the seasonality comment is mainly sort of one about adults. But curious if you've got any thoughts on how the teen season might differ this year? Is it shaping up to be sort of a normal year as we assume schools are open again, or maybe more spread evenly across the second half?"
},
{
"speaker": "John Morici",
"text": "I think you look at it, John, just from the standpoint that there are unknowns around COVID and vacations and other things. COVID is one of them. Some places we hear some of the countries and regions, school is going to open up earlier; some are saying that it's later. So we're just trying to be mindful that there's going to be changes that happen to this and try to give as much information about that as possible."
},
{
"speaker": "John Kreger",
"text": "Great. Thanks, John. And then maybe one follow up on ASP. It seemed like the year-over-year trend was different in Comprehensive versus non-Comprehensive. Can you just explain that again? Why would the Comprehensive change have been greater than a non-Comprehensive? And when you think about that metric longer term, do you assume the trajectory is similar across those two buckets or not?"
},
{
"speaker": "John Morici",
"text": "Yes, the biggest change from last year to this year is really around the additional treatment that doctors were provided. So remember, last year, they didn't have as many new patients coming in, but they were still keeping existing patients along in treatment. It doesn't count as a new case. It really just counts as additional revenue. And therefore ASPs are higher as a result of that. Conversely, as now they've focused more on primary cases and new patients coming in, we see that shift -- we saw that shift. It really started in the third quarter of last year. It's kind of progressed relatively steady from third quarter on. And that's kind of how we think of it. There's not a -- it's not a promotional change or there's nothing of that nature. It's just really more just on how we're recognizing revenue between a primary shipment and then an additional treatment that a doctor provides."
},
{
"speaker": "John Kreger",
"text": "Okay, makes sense. Thank you."
},
{
"speaker": "Joseph Hogan",
"text": "Thanks, John."
},
{
"speaker": "Operator",
"text": "Our next question comes from Elizabeth Anderson with Evercore. Please go ahead."
},
{
"speaker": "Elizabeth Anderson",
"text": "Hi, guys. Thanks so much for the question. So my question is in terms of the second quarter, could you talk about how you saw volumes progressing maybe in the U.S. across the three months?"
},
{
"speaker": "John Morici",
"text": "I think when we look at -- hi, Elizabeth. It’s John. We saw strength across our business. We're not going to get into kind of month-by-month, but I think what we saw and you saw in the print for second quarter, very strong across geographies, products and so on. And what we're seeing is a reflection of that with our guidance."
},
{
"speaker": "Elizabeth Anderson",
"text": "Okay, that makes sense. And then turning to the cash flow, I appreciate the CapEx increase this year is largely a function of the new facility in Poland. Is that something that should continue on at that kind of pace going forward, or do you see kind of all of that wrapped up in this year's expense? And then we should go back to sort of more normalized levels afterwards."
},
{
"speaker": "John Morici",
"text": "Yes, I think what you'll see with kind of the convergence of what we have now, we have a lot of capacity that we're adding to meet the demand in the markets that we have. And we have that unique event with Poland kind of going on from a land, purchase, building and equipment that goes in. So this year will be a little bit heavy from that standpoint. And then going forward, it should just be more of the expansion and growth that way, but not as much as this year with the building as well."
},
{
"speaker": "Joseph Hogan",
"text": "Elizabeth, this is Joe. And thinking about -- we’re talking about 200% growth rates, right. And we're talking about growth rates on the upper end of what our revenue models have been given to you guys. So it requires actually that kind of investment. And it's a good question. But like John said, we’ll hit it hard this year, build some more capacity and this will lay in over time."
},
{
"speaker": "Elizabeth Anderson",
"text": "Yes, that certainly makes sense, especially as you have to build it ahead of the growth. Thank you."
},
{
"speaker": "Operator",
"text": "Our next question comes from Liza Garcia with Wolfe Research. Please go ahead."
},
{
"speaker": "Liza Garcia",
"text": "Hi, guys. Can you hear me all right?"
},
{
"speaker": "Shirley Stacy",
"text": "Yes, we hear you fine."
},
{
"speaker": "Joseph Hogan",
"text": "Yes. Hi, Liza."
},
{
"speaker": "Liza Garcia",
"text": "So I guess just digging into kind of how you're thinking about the exocad expansion with the [indiscernible] and kind of how you see the opportunity building there. You've mentioned a couple of things. And also should we view this kind of as like a first move for exocad and going forward strategy into more CAD/CAM?"
},
{
"speaker": "Joseph Hogan",
"text": "Yes, Liza, that's a good question. When you think about -- we talk about the GP segment, we talk about ortho-restorative and I think most people, if you study this, you know the exocad is one of the few companies out there that actually offers a digital type of restorative platform for dentists all around the world. Our vision for our business, as we become a big part of restorative and saving enamel and moving teeth, before you actually do implants, you need to do different things. And that's what -- like that's we think is the revolution of orthodontics, because that wasn't a tool that was really used before. And so exocad and iTero plug in really well behind that. Never forget that our strategy is always about selling more Invisalign. That's what exocad is about. That's what iTero is about too. But they also have to have credibility as units in those segments. And that's when we talk about what we're doing with exocad and iTero, we're expanding our technology but always with a thought of how we can be more effective in ortho-restorative. John actually runs the business. I’ll let him talk about it."
},
{
"speaker": "John Morici",
"text": "No, I think you summarized it well. This is a -- it's been just over a year. We're very pleased with how the business stands, as it stands alone, and then the technical and commercial integration that's been going on. And we see more and more synergies and feel good about the digital platform that this helps us move forward. So more to come on this. But after a year, we're very pleased."
},
{
"speaker": "Liza Garcia",
"text": "Great. Awesome. And then I was just wondering if you're hearing any indications from your customers about staffing as a potential issue, that's kind of limiting their availability anywhere? It doesn't -- obviously, the report doesn't certainly seem that way. But channel checks have kind of indicated some more limited staffing."
},
{
"speaker": "Joseph Hogan",
"text": "Yes. Liza, it’s Joe again. I wouldn't call it a hindrance right now. They have to pay more to find these people. There is concern out there in the sense of how much people have to pay to bring them in. But we haven't had that as an excuse of doctor saying, I can't do more cases because I can't find staff. It's just harder to spend more time doing."
},
{
"speaker": "John Morici",
"text": "The one thing that you do hear and it's just the reality when we talk about some of that seasonality, people take vacations or doctors on vacation as well as staff and patients. So they might fall into that bucket as well to limit some of that staff at their offices."
},
{
"speaker": "Liza Garcia",
"text": "Great. Thanks so much."
},
{
"speaker": "Operator",
"text": "Our next question comes from Richard Newitter with SVB Leerink. Please go ahead."
},
{
"speaker": "Jamie Morgan",
"text": "Hi, guys. It's Jamie on for Rich. A quick question for me on teens. Obviously, our checks, specifically within the ortho channel have been very bullish over the last couple of months. And now with it representing greater than a third of total case shifts, is it fair to say now that teen adoption is finally hitting that inflection point in the U.S.? And if not, kind of what are some of the things that you think still need to happen to really start to take on this sort of viewpoint?"
},
{
"speaker": "Joseph Hogan",
"text": "It’s Joe. Look, this is not a tipping point as you referred to it. It's been a ground war actually. And that ground war is basically started with product liability. And obviously, with Invisalign First and mandibular advancement and some of our other innovations that we've had, we've really opened up that segment and made it available to us too. Now the work is primarily with orthodontists to make them confident that they can service these teens, not just clinically but from a business standpoint also. That's why our programs like ADAPT and different things we put into place. And remember the war here is not against other clear aligner companies, it's about braces and fixed appliances. And that's what we really have to break through and get done. And honestly, orthodontists just have to be comfortable, not clinically but also from a business standpoint. And I feel like we're making progress in educating teens and educating mom, but on the other end, educating orthodontists to how they can properly do this clinically and also be efficient in their practices in doing it, and that's the ground war part. I feel we're well positioned. And obviously our numbers say we're making progress, but we're not declaring victory here at all."
},
{
"speaker": "Jamie Morgan",
"text": "Got it. And then just one follow up back to kind of some of the more pronounced summer seasonality. If I look back kind of through 2017 through 2019, it seems like you guys have seen anywhere from flat to maybe mid-single digit sequential improvement. Consensus is currently standing at something that would imply a decline. So is there any reason to be thinking that it shouldn't at least fall within the bounds of zero, a flat, mid-single digit improvement versus what consensus is currently implying, which would be a decline, just trying to get better calibration there."
},
{
"speaker": "John Morici",
"text": "Yes, Jamie, this is John. Look, we're trying to give you color to the second half because it's implied in our total year, and you can kind of defer or kind of infer what that means from third quarter and fourth quarter, but just trying to give you as much color without giving quarterly guidance is all that has been."
},
{
"speaker": "Jamie Morgan",
"text": "Okay. Thanks."
},
{
"speaker": "Joseph Hogan",
"text": "Thanks, Jamie."
},
{
"speaker": "Operator",
"text": "Our next question comes from Michael Ryskin with Bank of America. Please go ahead."
},
{
"speaker": "Michael Ryskin",
"text": "Hi, guys. How are you doing? Congrats on the quarter of the guide raise. I want to ask first on the -- I guess for John on the operating margin, especially on the non-GAAP side, had another really good quarter there. You bumped the guide a little bit, but you're still sort of -- your outlook for the second half still implies a pretty decent step down in operating margin. So I'm just wondering what's going on there? Is there any incremental spend that you're budgeting? And just in general, sort of expand on that? Can you talk a little bit about consumer marketing spend? How are those costs trending? How's the return on that going?"
},
{
"speaker": "John Morici",
"text": "Yes, good question. Look, we're very pleased with our margins that we've seen through the first half, as you noted, very strong performance, a good reflection of a lot of the investments that we made, and we continue to make to help grow our business. And we look at the second half as continuing these investments to expand from a sales and marketing standpoint. There's some operating costs that we have to be able to grow our business, like we have. It reflects those investments and we're trying to continue to position ourselves so that we would continue momentum and be able to start next year with that momentum. So it's really more of a reflection of that. And obviously, as we go through the second half, we'll update on what that means for margin."
},
{
"speaker": "Michael Ryskin",
"text": "Okay. And then on the gross margin line, again, just on the -- you got the manufacturing facility in China. You're talking about the plant in Poland up in 2022. Could you give us an update or reminder of sort of how we should think about progression there in terms of shifting some of the manufacturing there, and how they should work its way through the gross margin lines? And when do to those plants reach more or less full capacity and sort of you work through the ramp up there?"
},
{
"speaker": "John Morici",
"text": "Yes, you're right. When we go live, there is -- until you get that capacity up, and we're really -- we know how to do that manufacturing, we've learned as we've gone through some of the China facility ramp up, that will get applied to how we ramp up in Poland. We'll move doctors over kind of country by country and ramp things up. That will happen in the first half next year. But very mindful of what it means from a margin standpoint and do everything we can to minimize that inefficiency that you have when you first start up, and be able to get those facilities up and running at near 100% capacity."
},
{
"speaker": "Joseph Hogan",
"text": "Yes. And one of the things that John knows better than me on this one, Michael, is when we ramped up China, remember we started with a rental temporary facility that was not even close to scale, and it just pounded our cost. But we just wanted to get in place, get the workflow done. We built a building next to the where that area was, then transitioned into it. So that was a pretty big bump that we took there. We're not anticipating, John, the same."
},
{
"speaker": "John Morici",
"text": "Right. And that would happen, Michael, when we kind of quietly went live in Q2 of last year with that new Greenfield facility. And it's all about running that factory with a high utilization. They have an efficient labor and productivity there that we know how to drive. But there is some ramp up period, but we'll look to that in kind of the first half, and then see improvement as we go into the second half."
},
{
"speaker": "Michael Ryskin",
"text": "Okay. Fantastic. Thanks."
},
{
"speaker": "Joseph Hogan",
"text": "Thanks, Michael."
},
{
"speaker": "Operator",
"text": "Our next question comes from Ravi Misra with Berenberg Capital Markets. Please go ahead."
},
{
"speaker": "Ravi Misra",
"text": "Hi, team. How are you doing? Can you hear me?"
},
{
"speaker": "Joseph Hogan",
"text": "Hi, Ravi."
},
{
"speaker": "Shirley Stacy",
"text": "Hi, Ravi."
},
{
"speaker": "Ravi Misra",
"text": "Hi. So I guess I have two questions. One is more on the R&D side and one on China. So just on the R&D, one of your competitors announced a new polymer. And I think one of the things that's actually turned up in our checks with orthos at least is that SmartTrack gives you an edge. Just curious on your view and whether that's kind of starting to have any sort of impact, or is it too early? And then how you plan to maybe position yourself to kind of keep ahead of the peers? And then secondly, just around China, I guess it’s another kind of competition question with I guess your largest facility, a relatively small competitor going public? How are you kind of viewing that market now with kind of another I guess well funded competitor out there in terms of the ability to grow the market or kind of go after potential segment of that market, whether it's the more luxury focus patient or how are you kind of segmenting the population there? Thanks."
},
{
"speaker": "Joseph Hogan",
"text": "On your first question on a new polymer, we do multi-layer material. So it's various polymers that you put together and we were balancing the equation between elasticity and overall rigidity or retention [h] strength. And it's like our other competitors are starting to figure that piece out and see pieces of it. We have strong patents around SmartTrack and obviously improving over time is a real important part about not just having the right materials, but having the right kind of system in place. And that's the treatment planning part that we talked about, 25 years of understanding how to really activate those aligners and make that plastic actually work through those algorithms. And we don't use a displacement methodology, which is basically built on aligner that kind of leads things. It actually engages with these things in a different way. So I expect more companies to come out and work different polymers or whatever. We have a huge amount of experience of that, but don't forget about the entire system, the algorithms, how it works together and how it works the attachments, the exactness of the attachments, where you put those attachments, how they're shaped, so a lot going on there. We feel good about our position, and we'll continue to innovate in that space across all those spectrums. But there's nothing in the competitive marketplace that we are concerned with that would change the trajectory of where we're investing right now. From a China competitive standpoint, obviously Angel Align IPO, we watched that closely and get some clarity to everybody in that marketplace as they IPO’ed and what's going on. And I think you see they're strong in Tier 3 cities, they're strong with public hospitals in different areas. But look, I feel good about our position in China. Our manufacturing is strong. Our training centers there are strong. Our treatment planning is strong. It's close to accounts. We had good growth in the quarter overall, good sequential growth, good year-on-year growth. You might want to [indiscernible], John."
},
{
"speaker": "John Morici",
"text": "Yes, just to add in China, we've been competing in China with various companies since we've been there. So it is nothing new really with the IPO. It's really more of a reflection of this under penetrated market in China. China is a huge opportunity for the clear aligner business. And so we feel very good about our positioning there. Primarily cases are done with wires and brackets. And so this is less about share shifting amongst clear aligner and more about growth in the category."
},
{
"speaker": "Ravi Misra",
"text": "Thanks."
},
{
"speaker": "Shirley Stacy",
"text": "Thanks, Ravi. Well, listen, thank you everyone for joining us today. We really appreciate your time. Look forward to speaking to you at upcoming financial conferences and industry meetings, including the International Dental Show in Cologne, Germany, September 22 through 25, where we'll be showcasing Align, exocad innovations and a hybrid and multimedia exhibition space through physical and virtual experiences. We'll also be hosting an investor meeting in conjunction with our GP Summit in October in Las Vegas in Nevada. We'll have that October 29 and 30. So look for more information. And if you have any additional questions, please follow up with our Investor Relations Department. Thanks and have a great day."
},
{
"speaker": "Operator",
"text": "This concludes today's conference. You may disconnect your lines at this time. Thank you for your participation."
}
] | Align Technology, Inc. | 24,568 |
ALGN | 1 | 2,021 | 2021-04-28 16:30:00 | Operator: Greetings, and welcome to the Align Q1 '21 Earnings Call. [Operator Instructions]. As a reminder, this conference is being recorded. I would now like to turn the conference over to your host, Shirley Stacy, Vice President, Corporate Communications and Investor Relations. Please go ahead.
Shirley Stacy: Good afternoon, and thank you for joining us. I'm Shirley Stacy, Vice President of Corporate Communications and Investor Relations. Joining me for today's call is Joe Hogan, President and CEO; and John Morici, CFO. We issued first quarter 2021 financial results today via Globe Newswire, which is available on our website at investor.aligntech.com. Today's conference call is being audio webcast and will be archived on our website for approximately 1 month. A telephone replay will be available today by approximately 5:30 p.m. Eastern Time through 5:30 p.m. Eastern Time on May 12. To access the telephone replay, domestic callers should dial 877-660-6853 with conference number 13718065 followed by pound. International callers should dial 201-612-7415 with the same conference number. As a reminder, the information provided and discussed today will include forward-looking statements including statements about Align's future events and product outlook. These forward-looking statements are only predictions and involve risks and uncertainties that are described in more detail in our most recent periodic reports filed with the Securities and Exchange Commission, available on our website and at sec.gov. Actual results may vary significantly, and Align expressly assumes no obligation to update any forward-looking statements. We have posted historical financial statements, including the corresponding reconciliations, including our GAAP to non-GAAP reconciliation, if applicable, and our first quarter 2021 conference call slides on our website under Quarterly Results. Please refer to these files for more detailed information. Please note, as of Q1 '21, we are no longer including number of doctors trained, Clear Aligner shipment volume by region and total worldwide average selling price. We will continue to share information management uses to evaluate the business and metrics to help investors and analysts assess our financial performance. With that, I'll turn the call over to Align Technology's President and CEO, Joe Hogan. Joe?
Joseph Hogan: Thanks, Shirley. Good afternoon, and thanks for joining us. On our call today, I'll provide some highlights from the first quarter, then briefly discuss the performance of our 2 operating segments, Clear Aligners and Systems and Services. John will provide more detail on our financial results and discuss our outlook for the full year. Following that, I'll come back and summarize a few key points and open the call to questions. I'm pleased to report another strong quarter with record revenues and volumes reflecting strong growth for both Invisalign Clear Aligners and iTero Systems and Services across products and customer channels worldwide. Q1 sequential Invisalign Clear Aligner growth was driven by strength in both adult and teen market segments across products, customer channels, especially in North America and the EMEA region. The year is off to a great start, and Q1 reflects increasing momentum and the benefit from continued investments in our strategic initiatives focusing on: expanding our operations globally in existing and emerging international markets; increasing ortho adoption and utilization of Invisalign treatment, especially with teens; training and education GP dentists; an increasing conversion to Clear Aligners; and building Invisalign brand preference with millions of consumers through advertising, PR, digital, social media and influencer marketing to drive demand and conversion through Invisalign-trained doctors. For Q1, total revenues were $894.8 million, up 7.2% sequentially and 62.4% year-over-year. Q1 System and Services were $141.5 million, up 5.8% sequentially and up 104% year-over-year. Q1 '21 Clear Aligner revenues of $753.3 million were up 7.5% sequentially and increased of 56.4% year-over-year. In Q1, we shipped a record 595,800 Invisalign cases, an increase of 4.9% sequentially and 65.8% year-over-year. In addition, we shipped to a record 78,600 Invisalign doctors worldwide, of which approximately 6,600 were first-time customers. During the quarter, we reached a significant milestone with our 10 millionth Invisalign patient, Gabriela Silva, who recently began our treatment with Dr. Eunice Blind, an Invisalign-trained orthodontist in São Paulo, Brazil, one of our fastest-growing country markets. It's remarkable to think about the pace of growth and adoption that we are experiencing worldwide, especially when considering it took 10 years to achieve our 1 millionth Invisalign patient milestone and now we're adding 1 million new Invisalign patients in less than 6 months. We're grateful to our doctor partners and their patients and to our 20,000 employees around the world who have helped us reach this milestone. In recognition of our 10 millionth Invisalign milestone, we have donated $10 million to the Align Foundation donor-advised fund, are kicking off a campaign called 10 Million Smiles, 10 Million Thanks centered around the transformative power of Invisalign treatment through the eyes of Invisalign patients. From a product perspective, Q1 clear aligner revenues reflect strong growth across the Invisalign portfolio for both comprehensive and noncomprehensive products. Q1 comp volume increased 4.9% sequentially and 62.3% year-over-year, and Q1 non-comp or noncomprehensive volume increased 5.0% sequentially and 74.4% year-over-year. Invisalign Clear Aligners address a wide range of case complexity and can treat approximately 90% of case starts for adults and teens and phase 1 treatment for kids as young as 6 years old. Q1 adult patients increased 5.8% sequentially and 68.5% year-over-year. Q1 teens or younger patients increased 2.7% sequentially, 58.9% year-over-year. Teenage cases made up nearly 75% of the 15 million ortho starts each year and despite our rapid growth and adoption, Invisalign treatment is still only single digits worldwide, so we continue to see significant runway here. Our strong Q1 results also reflect our multimillion-dollar consumer marketing investment across key media channels with broad reach to drive consumers to Invisalign doctor practices. Our teen and mom-focused consumer campaign generated 138% year-over-year increase in unique visitors to our website and 35% increase in leads generated. In addition, Invisalign social media influencers like Charli D'Amelio, Avani Gregg, and Tan France and many other content creators/influencers enabled a delivery of 4.2 billion impressions in Q1 '21, delivering exciting new content and increased engagement for the Invisalign brand among their millions of followers. The consumer insights and data we receive from our programs suggest adults are also continuing to invest more in themselves for their overall health and well-being and have more disposable income to do so. They are seeking Invisalign clear aligner treatment from our Invisalign doctors and sharing their positive experiences with their friends, family and social networks, becoming influencers themselves. Now let's turn to the specifics around our first quarter results, starting with the Americas. For the Americas region, Q1 was another strong quarter with Invisalign case volume up 8.4% sequentially and 53.8% year-over-year reflecting increased Invisalign submitters and utilization growth for both orthodontic and GP channels. Q1 results also reflect continued investment in digital marketing, sales programs, our channel focus around GPs, orthos and DSOs and other initiatives to help drive utilization. In the GP channel, Invisalign Moderate and Invisalign Go continue to gain traction. This was especially true for GP dentists that enrolled in the iPro program as well as doctors that have installed iTero scanners. The GP Accelerator program, designed exclusively for GPs, provides an all-encompassing support plan based on practice needs that is centered around maximizing iTero integration, clinical support needs and implementing new marketing strategies. DSO utilization also increased and continues to be a strong growth driver and outpaced non-DSO practices. Today, we announced that we have extended our relationship with DECA Dental Group and have signed a new multiyear agreement for the Invisalign System through early 2025. In addition, DECA Dental Group is extending utilization of iTero Element 5D imaging system across its affiliate practices in the United States. This provides DECA Dental doctors and clinical support team members with access to Align's customized clinical education for the Invisalign system and the iTero Element 5D imaging system to support practices in adopting new workflows for restorative dentistry and for digital orthodontics. In the ortho channel, the Teen Awesomeness Centers program direct patients to Invisalign doctors who are experts are treating teens and are seen as the go-to doctors in their markets, helping to drive increased comprehensive treatments within the North American ortho channel. Tomorrow, registration opens for the 2021 Teen Forum: Virtual Edition to be held on June 10 and 11, which combines 2 days of all new dynamic sessions focused on the Invisalign teen patient journey. Sessions will focus on building clinical confidence, efficient workflows, teen and parent conversion and the overall digital treatment experience that teens expect. The timing of the forum is designed as a strong lead to the busy teen season, and attendees will have the option, at the post forum mentoring by Invisalign teen experts, to help orthos and their staff apply the tools from the teen forum to their practices and get additional support through their busy summer. For our international business, Q1 Invisalign case volume was up sequentially 0.9%. On a year-over-year basis, international shipments were up 83.2%. In EMEA, Q1 volumes were sequentially 3.7%, up 74.9% year-over-year, with strong broad-based growth across all markets, led by the U.K., France and Italy, along with continued growth in our expansion markets, led by Turkey, Russia, CIS and Benelux. We also saw strong performance from both ortho and GP channels, with momentum in the GP channels with adults reflected in strong utilization in shipments from Invisalign Go. EMEA growth programs are customized by market and customers' type to encourage Invisalign utilization, such as Professional 360 Ortho and Advance 360 Ortho programs with over 2,000 orthodontist enrolled. We also had GP Move 360, a program design to be able to help move doctors along their developmental journey, with an increase in GP cohorts of over 117% compared to a prior year. We're also continuing to offer online and on-demand education events, which have reached over 15,000 GPs cumulatively. In the region, we hosted several successful summits and forums for Invisalign doctors this quarter in all-virtual formats: the U.K. GP Forum and Ortho Summit, French Ortho Summit and the iTero Element Plus launch media event. In addition, we just held the Italian and DACH or German Ortho Summits last week. International expansion remains one of our key strategic pillars. Last week, we announced plans to open a new manufacturing facility in Poland, which will be our first Aligner plant in the EMEA region and our third plant worldwide joining Juarez, Mexico and Ziyang, China. The new facility is expected to be supplying customers in the EMEA region in early 2022, helping address the large and relatively untapped market of more than 5 million annual orthodontic case starts and more than 150 million EMEA customers who could benefit from treatment. The investment is part of our strategy to bring operational facilities closer to our customers and reflects our commitment to Invisalign-trained doctors and their patients in the EMEA region and extends our local operations in the region. The state-of-the-art EMEA plant in Wroclaw is expected to have more than 2,500 jobs by the end of 2025, making it the company's largest investment in EMEA to date and the largest 3D printing operation in the region. For APAC, Q1 volumes were down sequentially 3.9% as expected, reflecting seasonality. On a year-over-year basis, APAC was up 101.3% compared to the prior year, reflecting continued strong growth across the region, led by China, Japan and ANZ. Invisalign volume growth drivers were young adults, with young kids ramping faster than any other age group. In the teen segment, Invisalign volumes accelerated during the quarter and were driven by increased Invisalign utilization and case submissions from Invisalign doctors. We also continue to see good adoption of the Invisalign Moderate product for noncomprehensive treatment in the GP channel. During the quarter, we continued to offer online and on-demand education events which reached over 14,000 GPs cumulatively. Invisalign volumes in China were flat sequentially and up over 200% year-over-year. In Q1, China volumes gained momentum throughout the quarter. The Align clinical education site is the go-to digital hub for Invisalign doctors and team education and training. The digital learning environment was relaunched in February 2020 for Invisalign doctors, offering a comprehensive learning platform with role-specific content for orthos, GPs and their teams. The site enables more online learning opportunities with spotlight features for what's trending now, recommended learning paths based on doctors' experiences and expanded categories, including digital treatment planning, comprehensive dentistry and team education. During the quarter, over 102,000 unique users, having accessed the records lecture, completed self-paced learning modules and watched how-to videos, viewing more than 3 million pages of learning content. On the Ortho channel, over 38,000 unique users have engaged with a digital learning site and additional 63,000 unique users from the GP channel. We also continue to see good adoption of the ADAPT program, which is an expert and independent fee-based business consulting service offered by Align to optimize clinics' operational workflow and processes to enhance patient experience, customer and staff satisfaction. As a result of the ADAPT service, practices experience higher growth and greater efficiencies for orthodontic practices as well as improved profitability after implementation. To date, we've seen a 50% increase in Invisalign cases among doctors' cohorts within 6 months of participation in the ADAPT program. In addition, while still early in the program, we're also seeing a strong correlation or halo effect on teen utilization among ADAPT doctor cohorts. On consumer marketing, this focuses on educating consumers about the Invisalign system and driving that demand to our Invisalign doctor offices, ultimately capitalizing on the massive market opportunity to transform 500 million smiles. In Q1, we continue to see strong digital engagement globally with more than 138% increase in unique visitors, 95% increase in doctor locator searches and 35% increase in leads created on a year-over-year basis, driven by our global adult and mom-focused campaigns and teen-focused influencer content. Our U.S. Mom/Teen multitouch, multimillion-dollar campaign with influencer-led YouTube videos, a mom-focused TV spot, a custom Twitch activation and mega teen sensations such as Charli D'Amelio and Avani Gregg continued to perform well and garnered 4.2 billion impressions in Q1. The statistics I shared previously speak to the continued success this marketing campaign is having to not only drive demand with consumers but also educate them on the benefits of Invisalign treatment through a doctor's office. The Align Digital Platform continues to gain traction globally. Our consumer and patient app, My Invisalign, is now available in 58 markets, resulting in a more than 4x increase in app downloads and 3x increase in patients actively using our app in Q1 '21 versus the same period a year ago. Our consumer and patient feature usage continues to increase. For example, Invisalign Virtual Appointment Tool was used 86,000 times and our insurance verification feature was used 27,000 times in Q1. Further, we received more than 575,000 patient photos in our Virtual Care feature to date globally, providing us rich data to leverage our AI capabilities to improve our services for doctors and patients. Lastly, our new consumer website has been rolled out to more than 50 markets and continues to drive increased effectiveness in lead creation. In the EMEA region, we built on the tremendous success we saw with the consumer marketing pilot in Q4 in the U.K. and expanded our media investments across the U.K., Germany and France to drive engagements, resulting in more than 335% increase in unique visitors and a 95% increase in leads. We also expanded our consumer advertising in the APAC region in Australia, Japan and China, and saw more than a 2,000% increase in consumer engagement and a 298% increase in leads. Several key metrics that show increased activity engagement with Invisalign brand are included in our Q1 quarterly presentation slides available on our website. Our NFL partnership continues to do well, generating over 23.5 million impressions during the quarter. It continues to be another major integral channel to reach adults considering clear aligner treatment through an Invisalign-trained doctor. During the quarter, we expanded our sports partnership marketing strategy with the Invisalign brand named the official smile partner of the Golden State Warriors. As part of the agreement with the 6x NBA Champion Golden State Warriors, the Invisalign brand also is the official smile partner of the Santa Cruz Warriors, the Golden State's G League affiliate, and the Golden Guardians, its e-sport affiliate. The sponsorship includes an omnichannel activation across TV, digital media, social, a jersey partnership with the Golden Guardians and the Santa Cruz Warriors. Finally, on the consumer marketing front, we also launched our first ever social purpose initiative in Q1 called Invisalign ChangeMakers, an award program we developed in partnership with the National 4-H Council. This is to celebrate and highlight teens in making an impact in their communities. We were blown away by the number of recommendations and stories we received about teens, from redistributing excess food to combat hunger in their communities, to donating weighted blankets to those in the autism spectrum. Overall, it's been heartwarming to learn about each of these amazing teenagers who bring a unique approach to positively impacting their communities and following their passions to create change. In total, we received nearly 800 ChangeMakers applications. On June 28, we will announce 100 winners, each of whom will receive $5,000 to help them continue their goodwill efforts. We'll also celebrate these young forces of change with a virtual ceremony currently slated for mid-July. We are continuing to invest in creating consumer demand for Invisalign Aligners in markets around the world. Our global campaigns include a multichannel media strategy using digital video, social media, influencer marketing and TV. For our Systems and Services business, Q1 revenues were up 5.8% sequentially, reflecting slightly lower scanner volume following a record fourth quarter. This is primarily due to the seasonality of capital equipment sales at year-end and higher services revenue. On a year-over-year basis, Systems and Services revenues were up 104%, reflecting strong scanner shipments and services. The iTero Element 5D Imaging System continues to gain traction across all regions. Element 5D is the first integrated dental imaging system that simultaneously records 3D intra-oral optical impressions, 2D color images and Near Infrared Images or NIRI technology. Full arch scans can be completed in as little as 60 seconds, and NIRI technology scans the structure of the tooth in real-time without harmful radiation, acting as digital aid for detection of interproximal caries, or cavities, above the gingiva line. In APAC, the Element Flex is doing well with its wand-only configuration that provides needed mobility so doctors can see patients anywhere they choose and also or perform full arch scans in even the smallest office. During the quarter, we announced availability of the iTero Element Plus series, which expands the iTero portfolio to serve a broad range of the dental market. The new Element Plus series offers faster processing time, advanced visualization capabilities for a seamless scanning experience in a new sleek ergonomically-designed package. It's also engineered with the latest computing power, a dedicated AI chip and new AI-based features as well as an easy upgrade path for future innovation. In terms of digital scans used for Invisalign case submissions in Q1, total digital scans increased to 80.9% from 75.8% in Q1 last year. International scans increased to 75.1%, up from 68.7% in the same quarter last year. For the Americas, 85.5% of the cases submitted digitally compared to 80.5% a year ago. Cumulatively, over 35.4 million orthodontic scans and 7.5 million restorative scans have been performed with iTero scanners. Turning to exocad. A year ago in April, we welcomed exocad into the Align family. I want to thank the entire team for their continued progress on integration and road map development. Together, we are working to extend exocad's position as a key technology provider for the dental CAD/CAM industry and to drive continuous innovation with the open and integrated approach that is the foundation of exocad. During Q1, the new release of exocad's DentalCAD3.0 Galway was successfully rolled out globally with very positive customer feedback. A record number of over 70,000 verified prosthetic components were created in DentalCAD Galway, one of the largest prosthetic libraries in the industry. exocad also reached a new milestone for the exoplan database, which now supports nearly 10,000 implants from over 90 manufacturers. The new release also includes a unique and highly innovative DentalCAD feature, Instant Anatomic Morphing, that reduces design time by up to 30% compared to previous version. It also includes new AI technology for exocad's Smile Creator, which enables time-saving automatic detection of facial features. In addition, the new MyiTero Connector was launched directly to exocad labs. The MyiTero Connector creates an easy and integrated way to receive intra-oral scan cases from thousands of iTero doctors worldwide. New cases are downloaded automatically and will show up directly in the DentalDB case list. exocad also co-hosted a joint dentistry event in the U.K. to showcase full workflow with ChairsideCAD titled Digital Dentistry Hands On. The virtual roadshow aimed at general dentists showcases a full digital workflow for the clinical environment with ChairsideCAD, exocad's complete open architecture CAD software platform for single-visit dentistry. Hosted by Dr. Gulshan Murgai, the participants of the roadshow series learn how to use the software for single-visit restorations and implant planning in the dental practice along the entire digital dentistry workflow. These are just a few milestones, and we're excited about the opportunities ahead to shape the dental industry with technology and expertise that benefits all customers, labs, partners and users. We look forward to sharing more about ongoing exocad developments. With that, I'll now turn it over to John.
John Morici: Thanks, Joe. Now for our Q1 financial results. Total revenues for the first quarter were $894.8 million, up 7.2% from the prior quarter and up 62.4% from the corresponding quarter a year ago. For Clear Aligners, Q1 revenues of $753.3 million were up 7.5% sequentially and up 56.4% year-over-year, reflecting Invisalign volume growth in most geographies. Clear Aligner revenue growth was favorably impacted by foreign exchange of approximately $14.4 million or approximately 2.1 points sequentially and on a year-over-year basis, by approximately $22.3 million or approximately 4.6 points. For Q1, Invisalign Comprehensive and Non-Comprehensive ASPs were both up sequentially. On a year-over-year basis, Q1 Invisalign Comprehensive and Non-Comprehensive ASP decreased. Overall, on a sequential and year-over-year basis, ASPs were favorably impacted by foreign exchange. On a year-over-year basis, ASPs were impacted by higher net revenue deferrals in all regions and higher promotional discounts. Clear aligner deferred revenue on the balance sheet increased $79 million sequentially and $256 million year-over-year and will be recognized as the additional aligners are shipped. Total Q1 clear aligner shipments of 595,800 cases were up 4.9% sequentially and up 65.8% year-over-year. Our Systems and Services revenues for the first quarter was a record $141.5 million, up 5.8% sequentially due to product mix and increased services revenues from our larger installed base and exocad's CAD/CAM services. Year-over-year, Systems and Services revenues was up 104% due to higher scanner shipments and services and the inclusion of exocad's CAD/CAM services from the April 2020 acquisition and increased services from our larger installed base. Our Systems and Services deferred revenue was up 17% sequentially and up 102% year-over-year, primarily due to the increase in scanner sales and the deferral of service revenues, which will be recognized ratably over the service period. Moving on to gross margin. First quarter overall gross margin was 75.7%, up 2.5 points sequentially and up 4.1 points year-over-year. On a non-GAAP basis, excluding stock-based compensation and amortization of intangibles related to our exocad acquisition, overall gross margin was 76.1% for the first quarter and up 2.5 points sequentially and up 4.2 points year-over-year. Overall gross margin was favorably impacted by approximately 0.5 points sequentially and 0.7 points on a year-over-year basis due to foreign exchange. Clear Aligner gross margin for the first quarter was 77.6%, up 2.7 points sequentially due to increased manufacturing efficiencies from higher production volumes, higher ASPs and lower freight, partially offset by higher additional aligner volume. Clear Aligner gross margin was up 4.6 points year-over-year due to increased manufacturing efficiencies from higher production volumes and lower freight, partially offset by lower ASPs. Systems and Services gross margin for the first quarter was a record 65.4%, up 1.2 points sequentially, primarily due to manufacturing efficiencies from higher production volumes and higher ASPs, partially offset by increased freight. Systems and Services gross margin was up 3.6 points year-over-year due to manufacturing efficiencies from increased volume, higher ASPs and services revenues. Q1 operating expenses were $451.7 million, up sequentially 13.7% and up 39.2% year-over-year. The sequential increase in operating expenses is due to increased compensation, primarily from additional headcount and incentive compensation, consumer marketing spend and other general and administrative costs. Year-over-year, operating expenses increased by $127.2 million, reflecting our continued investment in sales and R&D activities and investments commensurate with business growth. On a non-GAAP basis, which excludes stock-based compensation, amortization of intangibles related to our exocad acquisition and acquisition costs related to our exocad acquisition, operating expenses were $424.8 million, up sequentially 14.1% and up 40.9% year-over-year. Our first quarter operating income of $225.4 million resulted in an operating margin of 25.2%, down 0.3 points sequentially and up 12.5 points year-over-year. The sequential decrease in operating margin is attributed to operational investments. The year-over-year increase in operating margin are primarily attributed to higher gross margin and operating leverage. On a non-GAAP basis, which excludes stock-based compensation and amortization of intangibles, the acquisition costs related to our exocad acquisition, operating margin for the first quarter was 28.6%, down 0.4 points sequentially and up 11.5 points year-over-year. Our operating margin was favorably impacted by approximately 0.8 points sequentially and 1.5 points on a year-over-year basis due to foreign exchange. Interest and other income and expense, net, for the first quarter was a gain of $36.2 million, primarily driven by the SDC arbitration award gain. Excluding the SDC arbitration award gain, interest and other income and expense, net, was a $7.2 million expense on a non-GAAP basis. With regards to the first quarter tax provision, our GAAP tax rate was 23.4%, which includes tax expense of approximately $11 million related to U.S. taxes on the SDC arbitration award received and approximately $14 million of excess tax benefits related to stock-based compensation. Our GAAP tax rate this quarter was lower than the prior quarter rate of 25.9%, primarily due to the higher excess tax benefits from stock-based compensation, partially offset by foreign income taxes at different rates. Our GAAP tax rate was higher than the same quarter last year, which was negative 2,745%, primarily due to a onetime tax benefit of approximately $1.5 billion associated with our corporate structure reorganization completed during the first quarter of 2020. The first quarter tax rate on a non-GAAP basis was 20.2% compared to 14.5% in prior quarter and 33.2% in the prior year. The first quarter non-GAAP tax rate was higher than the prior quarter rate, primarily due to lower tax benefits from foreign income tax at different rates. In comparison to prior year, the non-GAAP tax rate for the first quarter was lower primarily due to higher tax benefits from foreign income tax at different rates. First quarter net income per diluted share was $2.51, up $0.51 sequentially and down $16.70 compared to prior year. On a non-GAAP basis, net income per diluted share was $2.49 for the first quarter, down $0.12 sequentially and up $1.76 year-over-year. Moving on to the balance sheet. As of March 31, 2021, cash and cash equivalents were $1.1 billion, an increase of approximately $170.9 million from the prior quarter, which is primarily due to cash flow from operations. Of our $1.1 billion of cash and cash equivalents, $684.4 million was held in the U.S. and $447.3 million was held by our international entities. Q1 accounts receivable balance was $719 million, up approximately 9.3% sequentially. Our overall days sales outstanding was 72 days, up approximately 1 day sequentially and down approximately 15 days as compared to Q1 last year. Cash flow from operations for the first quarter was $227.2 million. Capital expenditures for the first quarter were $43.4 million, primarily related to our continued investment in increasing aligner capacity and facilities. Free cash flow, defined as cash flow from operations less capital expenditures, amounted to $183.8 million. We also have $300 million available under our revolving line of credit. Under our May 2018 repurchase program, we have $100 million remaining available for repurchase of our common stock. Now let me turn to our outlook. Overall, we are very pleased with our first quarter results and our continued strong momentum across regions and customer channels. It has been over a year since the pandemic began, and I want to briefly recap the actions we took to support our employees by protecting employee jobs and salaries and by supporting our customers with PPE, extended payment terms, training and many other areas of assistance. Instead of going quiet, we accelerated our investments in marketing to drive consumer demand to our doctors' offices and stay top of mind with consumers. We accelerated our digital technology investments so that we could provide virtual tools to our doctors, enabling them to stay connected with their patients and keep their treatment moving forward. We continued to grow the business, increased our investments in R&D and product innovation and developing our plans for manufacturing expansion in EMEA. We did all these things for our customers, partners, employees and shareholders because we believe in the industry and the size of the market opportunity. Our results are the outcome of our conviction in our business model, focus and ability to execute. While there continues to be uncertainty around the pandemic and global environment, the strength in our business reflects the purposeful decisions we made through the pandemic and fuels our confidence in continuing to invest into growth to drive demand and conversion globally. Q2 is off to a great start and momentum has continued through April. Consumer demand trends and patient traffic across the dental industry are favorable and continue to improve. Given these factors and the positive trends we continue to see across the business, we believe it is important to share our current outlook and provide guidance for the full year. Note that the outlook we are providing does not reflect any potential significant disruption or additional costs related to any supply constraints. With that, let's turn to our full year 2021 outlook and the factors that inform our view. We have growing confidence in our digital platform and how it is driving growth across all regions and market segments. We expect 2021 revenues of $3.7 billion to $3.9 billion, up 50% to 58% year-over-year. Consistent with past years, we expect second half revenue to make up more than half of the full year revenue, and our second half revenue to grow year-over-year around the midpoint of our long-term operating model target of 20% to 30%. As discussed during our last earnings call, we are increasing our investments in sales, marketing, innovation and manufacturing capacity to continue to drive our growth programs and accelerate adoption in a vastly underpenetrated market. On a GAAP basis, we anticipate 2021 and operating margin to be between 23.5% and 24.5%. On a non-GAAP basis, we expect 2021 operating margin to be approximately 3 points higher than our GAAP operating margin after excluding stock-based compensation and intangible amortization. In addition, during Q2 '21, we expect to repurchase $100 million of our common stock through either open market repurchases or an accelerated stock repurchase agreement we intend to enter into on or prior to May 3, 2021. The repurchase is intended to complete the $600 million stock repurchase authorization announced on May 23, 2018. For 2021, we expect our investments in capital expenditures to exceed $300 million. Capital expenditures primarily relate to building construction and improvements as well as additional manufacturing capacity to support our international expansion. This includes our planned investment in a new manufacturing facility in Wroclaw, Poland, our first one in the EMEA region. We intend to fund these needs with cash generated from operations. With that, I'll turn it back over to Joe for final comments. Joe?
Joseph Hogan: Thanks, John. In summary, we're very pleased with the first quarter results of 2021. Our strong growth and continued momentum reflect our strategic initiatives and investments, including support for doctors to ensure treatment and business continuity, ramping availability of virtual tools to keep doctors and patients connected throughout treatment and increased consumer marketing and concierge programs. The benefits of digital treatment and digital tools and the limitations of outdated old analog approaches continue to drive adoption of Invisalign Clear Aligners and iTero scanners and services. Over the past year, more doctors have experienced Align's digital platform, which made it possible for thousands of Invisalign practices and patients to continue treatments throughout global disruption, thanks to Invisalign aligners, digital treatment planning, virtual monitoring and care as well as iTero scanners. But the shift from traditional analog wires and brackets to a fully end-to-end digital platform is not easy, cannot be done without very complex technology. And this technology is prevalent, touching every aspect of what we do from manufacturing excellence where we currently manufacture over 700,000 unique aligners per day, to expanding our geographic footprint to over 100 markets, to building a network of over 200,000 trained Invisalign doctors and providing the technology to our doctors in a complete digital system, the Aligned digital platform. As the market leader in the clear aligner space, we have been building this industry over 24 years to get to where it is today and yet the majority of the market opportunity remains largely untapped. With over 500 million potential case starts globally, Align is in a rare position to address this market with the Align Digital Platform, powered by 2 decades of clinical data based on more than 10.2 million patients with AI machine learning and digital tools to help our doctors efficiently communicate with their patients, show and explain any issues and visualize potential treatment outcomes. And together with doctors, we're going to leverage the power of digital dentistry and orthodontics more than ever. We remain focused on our strategic execution, agility, customer service excellence and continuing to make investments to grow our business to drive utilization of the Invisalign system, ultimately returning value to our shareholders. This is the multi-variable equation that we talk about and there's no other company in the market today that has all these capabilities combined. Finally, throughout the pandemic, our priority has been the health and safety of our employees and their families and our doctor customers and their staff, and that has not changed. We remain dedicated to their well-being, and I want to reiterate our commitment to all Invisalign practices and our employees around the world, especially those in areas recently affected by a surge in COVID-19: India, Brazil, France, Poland, Ukraine, Mexico, Thailand and Japan. We are continuing to monitor the situations and are providing support and resources to those impacted employees. Thanks for your time today. I look forward to updating you on our progress as the year unfolds. Now I'll turn the call back over to the operator.
Operator: [Operator Instructions]. The first question is from Nathan Rich from Goldman Sachs.
Nathan Rich: Maybe starting with the guidance for the year and your expectations over the balance of the year. I appreciate the detail that you gave. I guess, should we think about the revenue cadence as being similar to a normal year? And Joe, I mean, it certainly seems like the shift in market share that you've been highlighting has accelerated during the pandemic. I guess I'd be curious to know if you have any way of kind of quantifying the magnitude of this shift as we think about the ability of -- you just kind of sustain this momentum going forward and the gains that obviously Clear Aligners has had during the pandemic.
Joseph Hogan: All right. Nathan, we're obviously optimistic. I mean, given the guidance we had today and the strong first quarter results, we really feel good about where we are. The great thing about this growth is it's been broad and deep, okay? It is across every region. We see it whether it's in APAC, or whether it's EMEA, whether it's in the Americas overall. And then across the GP spectrum, across the ortho spectrum, too, it's been terrific. And it's also up and down. That's why we're giving you comprehensive, noncomprehensive now, all different kinds of cases. So we just feel great about the demand patterns, the depth and breadth of this rebound and that's why we have some clarity now. We decided to give guidance, and we're excited about this year and going forward. John, any thoughts on it?
John Morici: And to add to your question, Nathan, the seasonality and things that we've seen in the past will continue. We would expect those to continue as we go through this year. So it's hard to compare year-over-year, especially in the first half. But going forward, it makes sense to look at it quarter-over-quarter.
Nathan Rich: Great. And if I could just ask a quick follow-up on the -- it seems like it's going to -- there's going to be more discussion around comprehensive versus noncomprehensive instead of the regional breakout going forward. So I was wondering if you could just level set us on the current mix of business between comprehensive and non-comprehensive cases. And how you're thinking about the growth of those two categories going forward?
John Morici: Yes. When you look at it, Nathan, it's about 75% comprehensive, 25% noncomprehensive. It can vary by quarter based on teen season and so on, but that's roughly the split there. And we're investing in both areas to be able to grow, whether it's on the ortho side or the GP side for those categories.
Joseph Hogan: And Nate, I think you know the margin on those products also. So there's not -- this is not like a margin split. I mean, you still have higher margins on the less than comprehensive product line, too. So it's a good mix.
Operator: The next question is from Jason Bednar from Piper Sandler.
Jason Bednar: Congrats on a really nice quarter here. I actually want to start on guidance as well. If I focus in the second half of the year, maybe when comps tend to normalize a bit and use the midpoint of that 20% to 30% long-term guide you've got out there. Are you able to talk about how this comes together from a regional or channel perspective? Is it safe to assume that teens international still grows above that mid-20s level? And then is it right to think about imaging and CAD/CAM growing at that mid-20s level as well?
John Morici: Jason, this is John. We would look at Invisalign and our System and Services to grow at that midpoint in the second half, so around that 25% year-over-year across the business. And we're making investments and continued investments, as we've talked about, to really establish and continue our growth.
Jason Bednar: Okay. And John, just sorry, anything from a regional or channel perspective, international or teens or just how that all comes together?
John Morici: I think we're not forecasting by each of the regions and so on from that. I think you can -- from our business, we're trying to grow teens. It's a great indicator for the penetration on the ortho side, and we'll continue to grow that, but not giving specifics by region.
Jason Bednar: Okay. Understood. And then just one other follow-up. I mean, the Clear Aligner gross margin was extremely strong this quarter. The Clear Aligner revenue, that grew $50 million sequentially with COGS that fell by $10 million. John, I know you stepped through some of the factors just incorporated there. But is this a sustainable level that we should be thinking about for Clear Aligner gross margin going forward, kind of in this upper 70s level? Or maybe were there some other factors that helped push that gross margin higher here just in the first quarter?
John Morici: Well, we did see some FX benefit, as we called out, but it's a reflection of investing in this business, adding capacity, adding in places where we see the growth, and this was leveraging some of that -- those investments. So it's a reflection of the work that we have, the productivity that we can drive across the business, utilizing some of the facilities that we have and then benefit a bit from FX on a quarter-over-quarter basis.
Operator: The next question is from Elizabeth Anderson from Evercore.
Elizabeth Anderson: Congrats on a nice quarter. Can you talk about any changes in your DSO strategy? I know you obviously, highlighted the DECA renewal in the quarter, but I just didn't know if there -- as we come out of COVID, anything to think about there in terms of how you're working with that group of customers?
Joseph Hogan: No, Elizabeth, actually, we do, we can. We bring the entire Align digital platform together with iTero, the different -- some DSOs want to approach this thing from a comprehensive standpoint, some want noncomprehensive. So we just basically gear our digital platform and our product line based on what a DSO wants to do and what they want to accomplish, and not just in the U.S. but really all over the world.
Elizabeth Anderson: Got it. That's helpful. And then in terms of the new facility in Poland, should we think about the potential impact on the gross margin line to be similar to when you open the Ziyang facility? Or is there a different way that you -- that this one is different?
John Morici: I think when we look at that, we'll leverage to ramp up that facility as fast as possible as a lot of volume can come through from EMEA. So I wouldn't look at that as a model for that. Remember what we did in China was a temporary facility to move to a greenfield, and this is a greenfield new facility to start with.
Operator: The next question is from Jon Block from Stifel.
Jonathan Block: Joe, nice quarter. Two relatively quick ones. I guess to start, Joe, you called out EMEA and North America as the primary case volume, call it, upside drivers, not APAC. And just maybe if you could talk to APAC a little bit more. It was sort of first in COVID, and I think everyone was thinking first in, first out, but it seems like EMEA has been stronger. I mean, it was on a 2-year stack basis despite all the headline stuff that we hear in EMEA. Any details on APAC? Obviously, you've got a pretty big competitor in China. Any more granularity there would be very helpful. And then I've got a little bit of a tighter follow-up.
Joseph Hogan: Jon, first of all, I mean, EMEA was amazing in that way, but I wouldn't let it eclipse APAC, right? We feel really good about APAC across the board. China, obviously, being a big area, the sequential growth of China. When you look at fourth quarter versus first quarter, it's right in that 7%, 7.5% range like the entire business is. And then obviously, APAC is extremely diverse, but from Japan, ANZ, those key areas that we have in APAC, it's really strong growth. So I really feel great about APAC. It's just there's somewhat of an eclipse right now because EMEA was extremely strong. But you shouldn't let yourself think in any way that, that means APAC was weak in some way. We feel good about APAC as we go into the first quarter and the whole year.
Jonathan Block: Okay. Yes, I guess, good problem to have. Second one is sort of a derivative of Nathan's question. But the biggest question I get from investors is this pull-forward of demand, right? In other words, is the 1Q '21 volume, call it, success, is that at the expense of future quarters? And it seems like your guidance suggests you're not too worried about that, Joe. But can you give us more detail here? Like why aren't you worried about any pull-forward? What are you hearing from sales reps? What are docs saying about sustaining the momentum throughout the year?
Joseph Hogan: Yes, John. John, first of all, it's the breadth of this growth, right? It's not like it's a singular region like we just talked about with EMEA and APAC and how strong the Americas is. We're seeing great uptake in the GP side. We see terrific growth there, the orthodontic side. You see our team numbers are good and respectable. We're moving in the teen season. So what we feel good about is just the breadth and depth of this business. It's not just leaning on 1 or 2 legs from a strategy standpoint, it really is well positioned going forward. We hear the same thing about demand pull-forward or whatever. We -- doctors aren't talking like that. Remember, the questions back in the third quarter, fourth quarter was backlog, right? How much of this was backlog that wasn't consummated in second quarter, early third quarter. And we got way past that. Obviously, we got into the fourth quarter, whatever. So I think we're just seeing a realization in the adult and the teen market of what digital orthodontics can do. And our company is very well positioned to take advantage of that when you look throughout the world. John, anything to add?
John Morici: Okay.
Operator: The next question is from Kevin Caliendo from UBS.
Kevin Caliendo: I want to talk a little bit about how to think about seasonality with regards to teens. You typically -- you gear up the summer, it's a big teen season historically. Has there -- do you expect that again next year as sort of back-to-school might be a little more normal? And what -- how should we think about you gearing up for another incremental teen season? What might be different? Any expectations around incremental share for teens? I'd just love to hear the strategy.
Joseph Hogan: Well, I think we have a strategy really based on every region because the teen season is different by region from a calendar standpoint. And doctors apply our technology in different ways with teens. But let's just take U.S. and Canada for a second. Obviously, in the second quarter, beginning of third quarter, those are the really strong areas where you'll see our advertising program really kick in, in a big way. We talked about the Teen Awesomeness Centers that we put in place. That's with making sure that we have doctors that are really well-equipped to handle teens, and we direct the leads to that teams with confidence that they can be serviced properly. Overseas, we understand what those timing are for the teens also, and we put those programs together, too. Honestly, Kevin, we have a great portfolio, right? And we can go across teens in a lot of different ways, all the way from 6 year olds, to really older teens when you get to 16 to 19 years old, and the tooth movements associated with those two. So it's just having those doctors ready. It's having the communications with the teens and the moms to make sure they're aware of a digital orthodontic option, and they really ask for that as they go into the doctors. And that's a strategy we apply just in different ways and different seasons around the world, but it specifically applies to teens.
Kevin Caliendo: That's helpful. And one -- just one follow-up on margins. The gross margin number was mentioned. You covered that already. Should we think about any of that flowing down to the operating margin? Or any sort of target for operating margins over the next couple of years? You've historically always looked to spend to grow, and it's always -- you've always been rewarded for it. There's no reason to change. But just thinking sort of where you are now, maybe if you do have a little bit of an uptick in the gross margin that you can let more of it flow through to the operating side. How do you think about that?
John Morici: I think when you look at it -- Kevin, this is John. I mean, we're looking to balance our growth opportunities with our margin. And in certain countries, you might be at different parts of that equation. But on balance, we're pleased with the gross margin. We've talked a lot about the investments, the productivity and other things that we see, and that continues. And it gives us a lot of flexibility to be able to invest. But in a vastly underpenetrated market that we're in, making these investments to grow volume make a lot of sense to us. But we're always mindful of that balance between volume and margin.
Operator: The next question is from Ravi Misra from Berenberg Capital Markets.
Ravi Misra: So just want to press a little bit more on kind of just some of the marketing opportunities that you're highlighting. And just curious, you have the ski team now, you're talking about the Golden State Warriors. I'm sure Draymond Green is not very happy about that. But just can you help us understand, like, what do you go after when you look at the marketing opportunity? Like in terms of the return that you're searching for the particular brands that you're aligning with? And then I have a follow-up after that.
Joseph Hogan: We do a lot of work on this, just figuring out what channels, what kind of return we get by channel, how much you put in social media, sports team, how much do you put in television. But overall, John and I expect a certain return, and we know what those returns are by region. We invest a dollar here, we know what we get back. I don't necessarily want to convey exactly what those returns are but we make sure they're positive. And you've seen us increase our advertising pretty dramatically outside the United States. The response for that has been really good. And obviously, we use a lot of what we learned here in North America to apply that around the world. So Invisalign is an incredibly well-known brand, not just in North America, but all around the world. And being to leverage that and having that as kind of a common name around the world, it's very helpful for us in the sense of driving volumes, giving doctors confidence and patients confidence, too. So we really feel good about our investments. And obviously, we balance that well with increased salespeople, with technology investments, all the things you have to do when you run a business like this, but it is something that obviously gains a lot of attention and a lot of analysis from us.
Ravi Misra: Great. And then maybe just one on -- on the press release, something caught my eye around your kind of Ortho Summit Case Shoot-out where the highest vote was around kind of a Class II/Class III Invisalign case presentation. Historically, that's been something -- I think maybe -- that unless you're a bleeding edge KOL or doctor that you weren't doing. The fact that, that's kind of winning the kind of peer award now, does that suggest that you're getting deeper into these more complicated cases? And just more specifically, do you feel that you have an edge versus your competitors in the space that allow you to do this? Or is this kind of a class effect that you think has to do with comfort and ease of use of the technology as a whole?
Joseph Hogan: Yes, Ravi, it's a good question. Look, remember, we have -- we've done, what, we said 10.2 million cases. And through those 10.2 million cases, we've learned a lot, and we learn more every day. And we run AI and machine learning across those cases. And that's how we just launched GA, as we understood and defined cases. We have some issues with posterior open bite and different clinical kind of issues that would bore you to death, but we understand based on millions of cases that we have done, which is the best way to move those teeth to ensure that they end up in the right positions with the right smile at -- obviously, you want to do this as quickly as you possibly can because patients don't want to be in treatment over 5 years. So I feel we have an incredible advantage. You look at SmartTrack, you look at how we initiate that with over 4 million lines of codes that we have in ClinCheck. You look at the accuracy of iTero in the sense of transferring information through over to our manufacturing facility in order to make this. It's so -- and I feel very confident about a 24-year first-mover advantage on what we've done. Now obviously, there's competitors out there and competitors are coming up. But a lot of them have to crawl through the friction that we did in order to learn this. And a lot of the IP that we've put down that makes us unique in the sense of how we position ourselves in the marketplace. So back to what you started with, when you do these shoot-outs and all, it's really great to sit in the audience and look at the before and after photos. I mean it's amazing. When I first joined this business, I just said, I -- hard to believe that you can do this. What's happening today is it's becoming more common. I mean you go all around the world. It was -- it's not 1 or 2 doctors doing this. There's hundreds, if not thousands, that are doing incredible kinds of cases. And so -- which I think that more and more, it just lends credibility to this product line. It can do what we say now 90% of all the cases that are out there. That's not just because it's plastic, right? It is the whole system from how we 3D print, what plastic we use, the algorithms we use, how we constantly tweak it by the information that we have, driving a brand like this, having the kind of training. We talked about 200,000 doctors that we've trained who've gone through these things. This takes time to do, it takes expertise. And doctors need that confidence in understanding. And we feel we can give it to them better than anyone.
John Morici: And that technology is brought about by investments, and we'll invest over $250 million this year alone in R&D to improve our systems and Invisalign for our customers. And that's an advantage. It's an advantage, like Joe said, over a period of time, but we're continuing to invest to make things better and better for our customers.
Operator: The next question is from Richard Newitter from SVB Leerink.
Jaime Morgan: This is Jaime on for Rich. Just one question for me. Appreciating that you guys are obviously focused on driving higher ortho teen utilization, overall GP adoption at the same time. I'm just curious, in your view, which of the 2 is likely to be the bigger make-or-break driver of growth over the near to intermediate term?
Joseph Hogan: You know, it just sounds like a terrible answer to you, but they're both. Really, we talk about 500 million patients out there that could use Invisalign treatment. We know that of the 15 million orthodontic cases, roughly 75% to 80% are teens -- I mean all those -- they're both huge opportunities. And there's not a difference from a technology standpoint or how you apply that technology to either of those that would make one easier to do or more beneficial than another. So honestly, both of those are great reservoirs of growth for us.
Jaime Morgan: Got it. Okay. And then just...
Joseph Hogan: Go ahead, Jaime.
Jaime Morgan: One last one for me, just on the DSO. Kind of the business model and strategy that you guys have for entrenching iTero systems in DSOs across all practices, kind of how do you approach that? And when you do see DSOs where the large majority of their practices have adopt the iTero scanner, what's the sort of pickup that you guys see in terms of utilization?
Joseph Hogan: Well, where you use iTero scanners, you train the doctors properly, you have the right products in a GP channel like iGo and different products like that. We get terrific uptake. I mean, you can't measure it the way you do share a chair at the orthodontic office. But we get -- our DSO business is significant now. It's meaningful that way. And it's one where that digital platform strategy, as you kind of outlined in your question, is what we employ. But again, we employ it in different ways, depending on how a DSO really wants to engage with us.
Operator: Next question is from Jeff Johnson from Baird.
Jeffrey Johnson: John, I want to go back. You mentioned the $250 million in R&D. And I think the number we've discussed over the last, I don't know, probably somewhere in the last 6 or 9 months or so, it's like $500 million total of what you guys spend, not only on R&D, but channel support, advertising, social media, all that stuff. And on our mind, that's one of your bigger barriers to entry, even probably more so than some of the IP and what have you. But it sounds like with some of the stuff, you're taking up EMEA, you're taking up APAC advertising, more and more sports teams and things like that. Is that $500 million number a dated number at this point? Is that barrier to entry and that spend even going well above that number in the near to intermediate term?
John Morici: You will see that. That's a good question, Jeff. We talked about that at our last Investor Day, about the $500 million combined kind of the marketing go-to-market plus the R&D. And what you'll see is as in success. And we've talked about a lot, as you know, where we see returns, where we see volume, where we see profitability, we're going to continue to make those investments. So as we go through this year, that number will most likely go up as we find success in these investments and find that right return.
Jeffrey Johnson: Yes. Fair enough. And Joe, I'd be interested. I mean, we saw COVID case counts and restrictions even in the 1Q in some of the markets you called out in EMEA as being so strong, U.K., France. I'm sure some others, you called out other areas. Obviously. India that we're all watching closely, but a lot of other markets as well that are still dealing with COVID case counts and heightened risks there. Does that even matter to case shipments to Invisalign at this point? I guess what I'm trying to figure out is, is that stuff holding back some volumes that could come through next year? Are we all just with COVID fatigue still comfortable going in and getting Clear Aligner cases even in those markets? So is COVID a risk factor, I guess, that you've had to build in some caution in the guidance for in some of those markets? Or are cases just as strong in those markets as they are in markets where maybe COVID is a little more under control?
Joseph Hogan: Yes. Jeff, it's a good question. It's just what we've seen. There's one definitive. If offices are shut down and patients aren't allowed to go to offices, we saw that. That happened in the second quarter, it happened all around the world. And then the term lockdown is used very loosely all around the world, what's a lockdown and what isn't. The situations like in India right now are a disaster, obviously, and people are very cautious. But the rest of the way around the world, what we see is it looks like communities and people have been able to manage this, okay? Is there any kind of a backlog of patients not going into dental offices because of that? I think in certain countries around the world, there is, but we can't really quantify that right now. And again, the breadth and depth of our demand pattern gives us confidence that we think we can predict around it.
Operator: The next question is from Erin Wright from Crédit Suisse.
Erin Wright: Great. Can you speak a little bit about what you're doing differently in terms of promotions or other initiatives around iTero that's really resonating with customers maybe differently now? And where is the traction mostly tied to, on the ortho or GP channel? And do you anticipate any lumpiness quarter-to-quarter across that business?
Joseph Hogan: Yes. Well, iTero's been great for us, right? You have a good services business there. We announced the Plus series iTero, which is -- Erin, it's a breakthrough. I mean, it sounds like it's a derivative as far as incremental but it is really a strong platform. We talk about the artificial intelligence we've been able to embed in that machine. We see doctors, both on the GP side and the orthodontic side, really excited about it. This is not a promotional discussion in a sense of when you ask your question about how to promote it. There's nothing tricky there. What we do is we have a broad number of products. You have the NIRI product plus, which is the very high end of the product line. Then you have a flex system, which I mentioned in my opening, which is basically a wand itself and it's used with the -- a normal kind of a computer that's adapted to that. And it helps to get flexibility in the sense of what a customer wants to use or a doctor wants to use on both ends. So I feel it's like how we take this to market, the different products that we have and the different way that we segment that is -- and then, obviously, if you want to do Invisalign, this is the front end, the key end of our digital platform and that's very attractive to both GPs and orthos that really want to do Invisalign. They know that iTero is critical for that.
Operator: The next question is from Brandon Couillard from Jefferies.
Brandon Couillard: John, maybe just a two part question around guidance. The operating margin outlook would suggest your margins kind of moderate a bit over the balance of the year from 1Q levels. Can you sort of elaborate on your expectations for gross margins for the balance of the year? And then what should we -- how should we think about the trend of ASPs over the next few quarters? I'd just leave it there.
John Morici: Yes. Brandon, when we look at -- we're pleased with our gross margin and margins that we had in the first quarter. A lot of things came together on that. When we look at the investments and the growth opportunities we have, we're not giving specific guidance around our gross margin. What you can see as it translates to op margins, it's a reflection of the growth opportunities we have, the investment opportunities that we have to be able to invest and grow in this business. And we can update as we go forward based on what we see. Your other part of the question regarding kind of ASPs and so on. When you look at -- we have a breakout, and we show that on a regular basis between comprehensive and noncomprehensive. We don't expect any major fluctuation across our ASPs. The only thing that comes up, and we saw it in this quarter a bit was with currency changes. But in terms of the promotions and how we go about the business and how we're trying to drive growth, there's nothing out of the ordinary that would impact ASPs.
Operator: The next question is from John Kreger from William Blair.
John Kreger: I just wanted to follow-up on Jeff's question a bit. So if you move beyond office closures, as you look at certain regions of the world becoming hot spots and then that fading, does that impact demand levels that you're seeing?
Joseph Hogan: It's not a great answer for us, John, it's yes and no, okay? Depending on the severity and where it is, I can say yes. For the most part, we say no. And that's after the second quarter when, again, the definitive piece, if you shut offices down and you won't let patients in there, we're going to have an issue. But actually, after the second quarter, early third quarter, we've been dealing with lockdowns that are basically lockdowns of time frame, lockdowns of where people can travel, but not specific lockdowns of doctor offices. If the market stays away from that, we feel we're pretty good.
Shirley Stacy: Thanks, John. Operator, we'll take one more question.
Operator: The next question is from Michael Ryskin of Bank of America.
Michael Ryskin: I'll just ask a quick one. Sort of want to expand a little bit on the ASP question that was just asked. I'm just wondering, you cited a little bit in your prepared remarks in terms of promotional things like that, discounts. Are you referring specifically to the Advantage program? And if you could talk about how some of the orthos and GPs are falling in with those tiers. Have you seen any movement over the last couple of quarters where people are falling more into the platinum and the diamond grouping there? Kind of also backing into sort of the numbers on utilization between ortho, I've seen some really nice numbers the last couple of quarters. Is that indicative of that, a higher portion of orthos and GPs falling at those higher tiers and therefore, walking in those -- the higher promotional discounts?
John Morici: Yes. Certainly, that is an impact. When you have -- as doctors grow through the tiers, they become more proficient. They had taken on more cases, whether they're on the ortho side or the GP side, we see them work their way through tiers. They do more cases, then we get that volume benefit. And then they'll see those discounts there. We've had those programs in place. Those programs really help drive utilization and really talk to the utilization growth that you noted there. So those are programs that we've had. They're there to drive utilization, and it's something that we've used in our business and expect to continue to use.
Operator: This concludes the question-and-answer session. I'd like to turn the call back over to Shirley Stacy for closing remarks.
Shirley Stacy: Well, thank you, everyone, for joining us today. We appreciate your time. We look forward to seeing you or speaking with you at upcoming financial conferences and industry meetings and events. If you have any follow-up questions, please contact our Investor Relations department. Have a great day.
Operator: This concludes today's conference. You may disconnect your lines at this time. Thank you for your participation. | [
{
"speaker": "Operator",
"text": "Greetings, and welcome to the Align Q1 '21 Earnings Call. [Operator Instructions]. As a reminder, this conference is being recorded. I would now like to turn the conference over to your host, Shirley Stacy, Vice President, Corporate Communications and Investor Relations. Please go ahead."
},
{
"speaker": "Shirley Stacy",
"text": "Good afternoon, and thank you for joining us. I'm Shirley Stacy, Vice President of Corporate Communications and Investor Relations. Joining me for today's call is Joe Hogan, President and CEO; and John Morici, CFO. We issued first quarter 2021 financial results today via Globe Newswire, which is available on our website at investor.aligntech.com. Today's conference call is being audio webcast and will be archived on our website for approximately 1 month. A telephone replay will be available today by approximately 5:30 p.m. Eastern Time through 5:30 p.m. Eastern Time on May 12. To access the telephone replay, domestic callers should dial 877-660-6853 with conference number 13718065 followed by pound. International callers should dial 201-612-7415 with the same conference number. As a reminder, the information provided and discussed today will include forward-looking statements including statements about Align's future events and product outlook. These forward-looking statements are only predictions and involve risks and uncertainties that are described in more detail in our most recent periodic reports filed with the Securities and Exchange Commission, available on our website and at sec.gov. Actual results may vary significantly, and Align expressly assumes no obligation to update any forward-looking statements. We have posted historical financial statements, including the corresponding reconciliations, including our GAAP to non-GAAP reconciliation, if applicable, and our first quarter 2021 conference call slides on our website under Quarterly Results. Please refer to these files for more detailed information. Please note, as of Q1 '21, we are no longer including number of doctors trained, Clear Aligner shipment volume by region and total worldwide average selling price. We will continue to share information management uses to evaluate the business and metrics to help investors and analysts assess our financial performance. With that, I'll turn the call over to Align Technology's President and CEO, Joe Hogan. Joe?"
},
{
"speaker": "Joseph Hogan",
"text": "Thanks, Shirley. Good afternoon, and thanks for joining us. On our call today, I'll provide some highlights from the first quarter, then briefly discuss the performance of our 2 operating segments, Clear Aligners and Systems and Services. John will provide more detail on our financial results and discuss our outlook for the full year. Following that, I'll come back and summarize a few key points and open the call to questions. I'm pleased to report another strong quarter with record revenues and volumes reflecting strong growth for both Invisalign Clear Aligners and iTero Systems and Services across products and customer channels worldwide. Q1 sequential Invisalign Clear Aligner growth was driven by strength in both adult and teen market segments across products, customer channels, especially in North America and the EMEA region. The year is off to a great start, and Q1 reflects increasing momentum and the benefit from continued investments in our strategic initiatives focusing on: expanding our operations globally in existing and emerging international markets; increasing ortho adoption and utilization of Invisalign treatment, especially with teens; training and education GP dentists; an increasing conversion to Clear Aligners; and building Invisalign brand preference with millions of consumers through advertising, PR, digital, social media and influencer marketing to drive demand and conversion through Invisalign-trained doctors. For Q1, total revenues were $894.8 million, up 7.2% sequentially and 62.4% year-over-year. Q1 System and Services were $141.5 million, up 5.8% sequentially and up 104% year-over-year. Q1 '21 Clear Aligner revenues of $753.3 million were up 7.5% sequentially and increased of 56.4% year-over-year. In Q1, we shipped a record 595,800 Invisalign cases, an increase of 4.9% sequentially and 65.8% year-over-year. In addition, we shipped to a record 78,600 Invisalign doctors worldwide, of which approximately 6,600 were first-time customers. During the quarter, we reached a significant milestone with our 10 millionth Invisalign patient, Gabriela Silva, who recently began our treatment with Dr. Eunice Blind, an Invisalign-trained orthodontist in São Paulo, Brazil, one of our fastest-growing country markets. It's remarkable to think about the pace of growth and adoption that we are experiencing worldwide, especially when considering it took 10 years to achieve our 1 millionth Invisalign patient milestone and now we're adding 1 million new Invisalign patients in less than 6 months. We're grateful to our doctor partners and their patients and to our 20,000 employees around the world who have helped us reach this milestone. In recognition of our 10 millionth Invisalign milestone, we have donated $10 million to the Align Foundation donor-advised fund, are kicking off a campaign called 10 Million Smiles, 10 Million Thanks centered around the transformative power of Invisalign treatment through the eyes of Invisalign patients. From a product perspective, Q1 clear aligner revenues reflect strong growth across the Invisalign portfolio for both comprehensive and noncomprehensive products. Q1 comp volume increased 4.9% sequentially and 62.3% year-over-year, and Q1 non-comp or noncomprehensive volume increased 5.0% sequentially and 74.4% year-over-year. Invisalign Clear Aligners address a wide range of case complexity and can treat approximately 90% of case starts for adults and teens and phase 1 treatment for kids as young as 6 years old. Q1 adult patients increased 5.8% sequentially and 68.5% year-over-year. Q1 teens or younger patients increased 2.7% sequentially, 58.9% year-over-year. Teenage cases made up nearly 75% of the 15 million ortho starts each year and despite our rapid growth and adoption, Invisalign treatment is still only single digits worldwide, so we continue to see significant runway here. Our strong Q1 results also reflect our multimillion-dollar consumer marketing investment across key media channels with broad reach to drive consumers to Invisalign doctor practices. Our teen and mom-focused consumer campaign generated 138% year-over-year increase in unique visitors to our website and 35% increase in leads generated. In addition, Invisalign social media influencers like Charli D'Amelio, Avani Gregg, and Tan France and many other content creators/influencers enabled a delivery of 4.2 billion impressions in Q1 '21, delivering exciting new content and increased engagement for the Invisalign brand among their millions of followers. The consumer insights and data we receive from our programs suggest adults are also continuing to invest more in themselves for their overall health and well-being and have more disposable income to do so. They are seeking Invisalign clear aligner treatment from our Invisalign doctors and sharing their positive experiences with their friends, family and social networks, becoming influencers themselves. Now let's turn to the specifics around our first quarter results, starting with the Americas. For the Americas region, Q1 was another strong quarter with Invisalign case volume up 8.4% sequentially and 53.8% year-over-year reflecting increased Invisalign submitters and utilization growth for both orthodontic and GP channels. Q1 results also reflect continued investment in digital marketing, sales programs, our channel focus around GPs, orthos and DSOs and other initiatives to help drive utilization. In the GP channel, Invisalign Moderate and Invisalign Go continue to gain traction. This was especially true for GP dentists that enrolled in the iPro program as well as doctors that have installed iTero scanners. The GP Accelerator program, designed exclusively for GPs, provides an all-encompassing support plan based on practice needs that is centered around maximizing iTero integration, clinical support needs and implementing new marketing strategies. DSO utilization also increased and continues to be a strong growth driver and outpaced non-DSO practices. Today, we announced that we have extended our relationship with DECA Dental Group and have signed a new multiyear agreement for the Invisalign System through early 2025. In addition, DECA Dental Group is extending utilization of iTero Element 5D imaging system across its affiliate practices in the United States. This provides DECA Dental doctors and clinical support team members with access to Align's customized clinical education for the Invisalign system and the iTero Element 5D imaging system to support practices in adopting new workflows for restorative dentistry and for digital orthodontics. In the ortho channel, the Teen Awesomeness Centers program direct patients to Invisalign doctors who are experts are treating teens and are seen as the go-to doctors in their markets, helping to drive increased comprehensive treatments within the North American ortho channel. Tomorrow, registration opens for the 2021 Teen Forum: Virtual Edition to be held on June 10 and 11, which combines 2 days of all new dynamic sessions focused on the Invisalign teen patient journey. Sessions will focus on building clinical confidence, efficient workflows, teen and parent conversion and the overall digital treatment experience that teens expect. The timing of the forum is designed as a strong lead to the busy teen season, and attendees will have the option, at the post forum mentoring by Invisalign teen experts, to help orthos and their staff apply the tools from the teen forum to their practices and get additional support through their busy summer. For our international business, Q1 Invisalign case volume was up sequentially 0.9%. On a year-over-year basis, international shipments were up 83.2%. In EMEA, Q1 volumes were sequentially 3.7%, up 74.9% year-over-year, with strong broad-based growth across all markets, led by the U.K., France and Italy, along with continued growth in our expansion markets, led by Turkey, Russia, CIS and Benelux. We also saw strong performance from both ortho and GP channels, with momentum in the GP channels with adults reflected in strong utilization in shipments from Invisalign Go. EMEA growth programs are customized by market and customers' type to encourage Invisalign utilization, such as Professional 360 Ortho and Advance 360 Ortho programs with over 2,000 orthodontist enrolled. We also had GP Move 360, a program design to be able to help move doctors along their developmental journey, with an increase in GP cohorts of over 117% compared to a prior year. We're also continuing to offer online and on-demand education events, which have reached over 15,000 GPs cumulatively. In the region, we hosted several successful summits and forums for Invisalign doctors this quarter in all-virtual formats: the U.K. GP Forum and Ortho Summit, French Ortho Summit and the iTero Element Plus launch media event. In addition, we just held the Italian and DACH or German Ortho Summits last week. International expansion remains one of our key strategic pillars. Last week, we announced plans to open a new manufacturing facility in Poland, which will be our first Aligner plant in the EMEA region and our third plant worldwide joining Juarez, Mexico and Ziyang, China. The new facility is expected to be supplying customers in the EMEA region in early 2022, helping address the large and relatively untapped market of more than 5 million annual orthodontic case starts and more than 150 million EMEA customers who could benefit from treatment. The investment is part of our strategy to bring operational facilities closer to our customers and reflects our commitment to Invisalign-trained doctors and their patients in the EMEA region and extends our local operations in the region. The state-of-the-art EMEA plant in Wroclaw is expected to have more than 2,500 jobs by the end of 2025, making it the company's largest investment in EMEA to date and the largest 3D printing operation in the region. For APAC, Q1 volumes were down sequentially 3.9% as expected, reflecting seasonality. On a year-over-year basis, APAC was up 101.3% compared to the prior year, reflecting continued strong growth across the region, led by China, Japan and ANZ. Invisalign volume growth drivers were young adults, with young kids ramping faster than any other age group. In the teen segment, Invisalign volumes accelerated during the quarter and were driven by increased Invisalign utilization and case submissions from Invisalign doctors. We also continue to see good adoption of the Invisalign Moderate product for noncomprehensive treatment in the GP channel. During the quarter, we continued to offer online and on-demand education events which reached over 14,000 GPs cumulatively. Invisalign volumes in China were flat sequentially and up over 200% year-over-year. In Q1, China volumes gained momentum throughout the quarter. The Align clinical education site is the go-to digital hub for Invisalign doctors and team education and training. The digital learning environment was relaunched in February 2020 for Invisalign doctors, offering a comprehensive learning platform with role-specific content for orthos, GPs and their teams. The site enables more online learning opportunities with spotlight features for what's trending now, recommended learning paths based on doctors' experiences and expanded categories, including digital treatment planning, comprehensive dentistry and team education. During the quarter, over 102,000 unique users, having accessed the records lecture, completed self-paced learning modules and watched how-to videos, viewing more than 3 million pages of learning content. On the Ortho channel, over 38,000 unique users have engaged with a digital learning site and additional 63,000 unique users from the GP channel. We also continue to see good adoption of the ADAPT program, which is an expert and independent fee-based business consulting service offered by Align to optimize clinics' operational workflow and processes to enhance patient experience, customer and staff satisfaction. As a result of the ADAPT service, practices experience higher growth and greater efficiencies for orthodontic practices as well as improved profitability after implementation. To date, we've seen a 50% increase in Invisalign cases among doctors' cohorts within 6 months of participation in the ADAPT program. In addition, while still early in the program, we're also seeing a strong correlation or halo effect on teen utilization among ADAPT doctor cohorts. On consumer marketing, this focuses on educating consumers about the Invisalign system and driving that demand to our Invisalign doctor offices, ultimately capitalizing on the massive market opportunity to transform 500 million smiles. In Q1, we continue to see strong digital engagement globally with more than 138% increase in unique visitors, 95% increase in doctor locator searches and 35% increase in leads created on a year-over-year basis, driven by our global adult and mom-focused campaigns and teen-focused influencer content. Our U.S. Mom/Teen multitouch, multimillion-dollar campaign with influencer-led YouTube videos, a mom-focused TV spot, a custom Twitch activation and mega teen sensations such as Charli D'Amelio and Avani Gregg continued to perform well and garnered 4.2 billion impressions in Q1. The statistics I shared previously speak to the continued success this marketing campaign is having to not only drive demand with consumers but also educate them on the benefits of Invisalign treatment through a doctor's office. The Align Digital Platform continues to gain traction globally. Our consumer and patient app, My Invisalign, is now available in 58 markets, resulting in a more than 4x increase in app downloads and 3x increase in patients actively using our app in Q1 '21 versus the same period a year ago. Our consumer and patient feature usage continues to increase. For example, Invisalign Virtual Appointment Tool was used 86,000 times and our insurance verification feature was used 27,000 times in Q1. Further, we received more than 575,000 patient photos in our Virtual Care feature to date globally, providing us rich data to leverage our AI capabilities to improve our services for doctors and patients. Lastly, our new consumer website has been rolled out to more than 50 markets and continues to drive increased effectiveness in lead creation. In the EMEA region, we built on the tremendous success we saw with the consumer marketing pilot in Q4 in the U.K. and expanded our media investments across the U.K., Germany and France to drive engagements, resulting in more than 335% increase in unique visitors and a 95% increase in leads. We also expanded our consumer advertising in the APAC region in Australia, Japan and China, and saw more than a 2,000% increase in consumer engagement and a 298% increase in leads. Several key metrics that show increased activity engagement with Invisalign brand are included in our Q1 quarterly presentation slides available on our website. Our NFL partnership continues to do well, generating over 23.5 million impressions during the quarter. It continues to be another major integral channel to reach adults considering clear aligner treatment through an Invisalign-trained doctor. During the quarter, we expanded our sports partnership marketing strategy with the Invisalign brand named the official smile partner of the Golden State Warriors. As part of the agreement with the 6x NBA Champion Golden State Warriors, the Invisalign brand also is the official smile partner of the Santa Cruz Warriors, the Golden State's G League affiliate, and the Golden Guardians, its e-sport affiliate. The sponsorship includes an omnichannel activation across TV, digital media, social, a jersey partnership with the Golden Guardians and the Santa Cruz Warriors. Finally, on the consumer marketing front, we also launched our first ever social purpose initiative in Q1 called Invisalign ChangeMakers, an award program we developed in partnership with the National 4-H Council. This is to celebrate and highlight teens in making an impact in their communities. We were blown away by the number of recommendations and stories we received about teens, from redistributing excess food to combat hunger in their communities, to donating weighted blankets to those in the autism spectrum. Overall, it's been heartwarming to learn about each of these amazing teenagers who bring a unique approach to positively impacting their communities and following their passions to create change. In total, we received nearly 800 ChangeMakers applications. On June 28, we will announce 100 winners, each of whom will receive $5,000 to help them continue their goodwill efforts. We'll also celebrate these young forces of change with a virtual ceremony currently slated for mid-July. We are continuing to invest in creating consumer demand for Invisalign Aligners in markets around the world. Our global campaigns include a multichannel media strategy using digital video, social media, influencer marketing and TV. For our Systems and Services business, Q1 revenues were up 5.8% sequentially, reflecting slightly lower scanner volume following a record fourth quarter. This is primarily due to the seasonality of capital equipment sales at year-end and higher services revenue. On a year-over-year basis, Systems and Services revenues were up 104%, reflecting strong scanner shipments and services. The iTero Element 5D Imaging System continues to gain traction across all regions. Element 5D is the first integrated dental imaging system that simultaneously records 3D intra-oral optical impressions, 2D color images and Near Infrared Images or NIRI technology. Full arch scans can be completed in as little as 60 seconds, and NIRI technology scans the structure of the tooth in real-time without harmful radiation, acting as digital aid for detection of interproximal caries, or cavities, above the gingiva line. In APAC, the Element Flex is doing well with its wand-only configuration that provides needed mobility so doctors can see patients anywhere they choose and also or perform full arch scans in even the smallest office. During the quarter, we announced availability of the iTero Element Plus series, which expands the iTero portfolio to serve a broad range of the dental market. The new Element Plus series offers faster processing time, advanced visualization capabilities for a seamless scanning experience in a new sleek ergonomically-designed package. It's also engineered with the latest computing power, a dedicated AI chip and new AI-based features as well as an easy upgrade path for future innovation. In terms of digital scans used for Invisalign case submissions in Q1, total digital scans increased to 80.9% from 75.8% in Q1 last year. International scans increased to 75.1%, up from 68.7% in the same quarter last year. For the Americas, 85.5% of the cases submitted digitally compared to 80.5% a year ago. Cumulatively, over 35.4 million orthodontic scans and 7.5 million restorative scans have been performed with iTero scanners. Turning to exocad. A year ago in April, we welcomed exocad into the Align family. I want to thank the entire team for their continued progress on integration and road map development. Together, we are working to extend exocad's position as a key technology provider for the dental CAD/CAM industry and to drive continuous innovation with the open and integrated approach that is the foundation of exocad. During Q1, the new release of exocad's DentalCAD3.0 Galway was successfully rolled out globally with very positive customer feedback. A record number of over 70,000 verified prosthetic components were created in DentalCAD Galway, one of the largest prosthetic libraries in the industry. exocad also reached a new milestone for the exoplan database, which now supports nearly 10,000 implants from over 90 manufacturers. The new release also includes a unique and highly innovative DentalCAD feature, Instant Anatomic Morphing, that reduces design time by up to 30% compared to previous version. It also includes new AI technology for exocad's Smile Creator, which enables time-saving automatic detection of facial features. In addition, the new MyiTero Connector was launched directly to exocad labs. The MyiTero Connector creates an easy and integrated way to receive intra-oral scan cases from thousands of iTero doctors worldwide. New cases are downloaded automatically and will show up directly in the DentalDB case list. exocad also co-hosted a joint dentistry event in the U.K. to showcase full workflow with ChairsideCAD titled Digital Dentistry Hands On. The virtual roadshow aimed at general dentists showcases a full digital workflow for the clinical environment with ChairsideCAD, exocad's complete open architecture CAD software platform for single-visit dentistry. Hosted by Dr. Gulshan Murgai, the participants of the roadshow series learn how to use the software for single-visit restorations and implant planning in the dental practice along the entire digital dentistry workflow. These are just a few milestones, and we're excited about the opportunities ahead to shape the dental industry with technology and expertise that benefits all customers, labs, partners and users. We look forward to sharing more about ongoing exocad developments. With that, I'll now turn it over to John."
},
{
"speaker": "John Morici",
"text": "Thanks, Joe. Now for our Q1 financial results. Total revenues for the first quarter were $894.8 million, up 7.2% from the prior quarter and up 62.4% from the corresponding quarter a year ago. For Clear Aligners, Q1 revenues of $753.3 million were up 7.5% sequentially and up 56.4% year-over-year, reflecting Invisalign volume growth in most geographies. Clear Aligner revenue growth was favorably impacted by foreign exchange of approximately $14.4 million or approximately 2.1 points sequentially and on a year-over-year basis, by approximately $22.3 million or approximately 4.6 points. For Q1, Invisalign Comprehensive and Non-Comprehensive ASPs were both up sequentially. On a year-over-year basis, Q1 Invisalign Comprehensive and Non-Comprehensive ASP decreased. Overall, on a sequential and year-over-year basis, ASPs were favorably impacted by foreign exchange. On a year-over-year basis, ASPs were impacted by higher net revenue deferrals in all regions and higher promotional discounts. Clear aligner deferred revenue on the balance sheet increased $79 million sequentially and $256 million year-over-year and will be recognized as the additional aligners are shipped. Total Q1 clear aligner shipments of 595,800 cases were up 4.9% sequentially and up 65.8% year-over-year. Our Systems and Services revenues for the first quarter was a record $141.5 million, up 5.8% sequentially due to product mix and increased services revenues from our larger installed base and exocad's CAD/CAM services. Year-over-year, Systems and Services revenues was up 104% due to higher scanner shipments and services and the inclusion of exocad's CAD/CAM services from the April 2020 acquisition and increased services from our larger installed base. Our Systems and Services deferred revenue was up 17% sequentially and up 102% year-over-year, primarily due to the increase in scanner sales and the deferral of service revenues, which will be recognized ratably over the service period. Moving on to gross margin. First quarter overall gross margin was 75.7%, up 2.5 points sequentially and up 4.1 points year-over-year. On a non-GAAP basis, excluding stock-based compensation and amortization of intangibles related to our exocad acquisition, overall gross margin was 76.1% for the first quarter and up 2.5 points sequentially and up 4.2 points year-over-year. Overall gross margin was favorably impacted by approximately 0.5 points sequentially and 0.7 points on a year-over-year basis due to foreign exchange. Clear Aligner gross margin for the first quarter was 77.6%, up 2.7 points sequentially due to increased manufacturing efficiencies from higher production volumes, higher ASPs and lower freight, partially offset by higher additional aligner volume. Clear Aligner gross margin was up 4.6 points year-over-year due to increased manufacturing efficiencies from higher production volumes and lower freight, partially offset by lower ASPs. Systems and Services gross margin for the first quarter was a record 65.4%, up 1.2 points sequentially, primarily due to manufacturing efficiencies from higher production volumes and higher ASPs, partially offset by increased freight. Systems and Services gross margin was up 3.6 points year-over-year due to manufacturing efficiencies from increased volume, higher ASPs and services revenues. Q1 operating expenses were $451.7 million, up sequentially 13.7% and up 39.2% year-over-year. The sequential increase in operating expenses is due to increased compensation, primarily from additional headcount and incentive compensation, consumer marketing spend and other general and administrative costs. Year-over-year, operating expenses increased by $127.2 million, reflecting our continued investment in sales and R&D activities and investments commensurate with business growth. On a non-GAAP basis, which excludes stock-based compensation, amortization of intangibles related to our exocad acquisition and acquisition costs related to our exocad acquisition, operating expenses were $424.8 million, up sequentially 14.1% and up 40.9% year-over-year. Our first quarter operating income of $225.4 million resulted in an operating margin of 25.2%, down 0.3 points sequentially and up 12.5 points year-over-year. The sequential decrease in operating margin is attributed to operational investments. The year-over-year increase in operating margin are primarily attributed to higher gross margin and operating leverage. On a non-GAAP basis, which excludes stock-based compensation and amortization of intangibles, the acquisition costs related to our exocad acquisition, operating margin for the first quarter was 28.6%, down 0.4 points sequentially and up 11.5 points year-over-year. Our operating margin was favorably impacted by approximately 0.8 points sequentially and 1.5 points on a year-over-year basis due to foreign exchange. Interest and other income and expense, net, for the first quarter was a gain of $36.2 million, primarily driven by the SDC arbitration award gain. Excluding the SDC arbitration award gain, interest and other income and expense, net, was a $7.2 million expense on a non-GAAP basis. With regards to the first quarter tax provision, our GAAP tax rate was 23.4%, which includes tax expense of approximately $11 million related to U.S. taxes on the SDC arbitration award received and approximately $14 million of excess tax benefits related to stock-based compensation. Our GAAP tax rate this quarter was lower than the prior quarter rate of 25.9%, primarily due to the higher excess tax benefits from stock-based compensation, partially offset by foreign income taxes at different rates. Our GAAP tax rate was higher than the same quarter last year, which was negative 2,745%, primarily due to a onetime tax benefit of approximately $1.5 billion associated with our corporate structure reorganization completed during the first quarter of 2020. The first quarter tax rate on a non-GAAP basis was 20.2% compared to 14.5% in prior quarter and 33.2% in the prior year. The first quarter non-GAAP tax rate was higher than the prior quarter rate, primarily due to lower tax benefits from foreign income tax at different rates. In comparison to prior year, the non-GAAP tax rate for the first quarter was lower primarily due to higher tax benefits from foreign income tax at different rates. First quarter net income per diluted share was $2.51, up $0.51 sequentially and down $16.70 compared to prior year. On a non-GAAP basis, net income per diluted share was $2.49 for the first quarter, down $0.12 sequentially and up $1.76 year-over-year. Moving on to the balance sheet. As of March 31, 2021, cash and cash equivalents were $1.1 billion, an increase of approximately $170.9 million from the prior quarter, which is primarily due to cash flow from operations. Of our $1.1 billion of cash and cash equivalents, $684.4 million was held in the U.S. and $447.3 million was held by our international entities. Q1 accounts receivable balance was $719 million, up approximately 9.3% sequentially. Our overall days sales outstanding was 72 days, up approximately 1 day sequentially and down approximately 15 days as compared to Q1 last year. Cash flow from operations for the first quarter was $227.2 million. Capital expenditures for the first quarter were $43.4 million, primarily related to our continued investment in increasing aligner capacity and facilities. Free cash flow, defined as cash flow from operations less capital expenditures, amounted to $183.8 million. We also have $300 million available under our revolving line of credit. Under our May 2018 repurchase program, we have $100 million remaining available for repurchase of our common stock. Now let me turn to our outlook. Overall, we are very pleased with our first quarter results and our continued strong momentum across regions and customer channels. It has been over a year since the pandemic began, and I want to briefly recap the actions we took to support our employees by protecting employee jobs and salaries and by supporting our customers with PPE, extended payment terms, training and many other areas of assistance. Instead of going quiet, we accelerated our investments in marketing to drive consumer demand to our doctors' offices and stay top of mind with consumers. We accelerated our digital technology investments so that we could provide virtual tools to our doctors, enabling them to stay connected with their patients and keep their treatment moving forward. We continued to grow the business, increased our investments in R&D and product innovation and developing our plans for manufacturing expansion in EMEA. We did all these things for our customers, partners, employees and shareholders because we believe in the industry and the size of the market opportunity. Our results are the outcome of our conviction in our business model, focus and ability to execute. While there continues to be uncertainty around the pandemic and global environment, the strength in our business reflects the purposeful decisions we made through the pandemic and fuels our confidence in continuing to invest into growth to drive demand and conversion globally. Q2 is off to a great start and momentum has continued through April. Consumer demand trends and patient traffic across the dental industry are favorable and continue to improve. Given these factors and the positive trends we continue to see across the business, we believe it is important to share our current outlook and provide guidance for the full year. Note that the outlook we are providing does not reflect any potential significant disruption or additional costs related to any supply constraints. With that, let's turn to our full year 2021 outlook and the factors that inform our view. We have growing confidence in our digital platform and how it is driving growth across all regions and market segments. We expect 2021 revenues of $3.7 billion to $3.9 billion, up 50% to 58% year-over-year. Consistent with past years, we expect second half revenue to make up more than half of the full year revenue, and our second half revenue to grow year-over-year around the midpoint of our long-term operating model target of 20% to 30%. As discussed during our last earnings call, we are increasing our investments in sales, marketing, innovation and manufacturing capacity to continue to drive our growth programs and accelerate adoption in a vastly underpenetrated market. On a GAAP basis, we anticipate 2021 and operating margin to be between 23.5% and 24.5%. On a non-GAAP basis, we expect 2021 operating margin to be approximately 3 points higher than our GAAP operating margin after excluding stock-based compensation and intangible amortization. In addition, during Q2 '21, we expect to repurchase $100 million of our common stock through either open market repurchases or an accelerated stock repurchase agreement we intend to enter into on or prior to May 3, 2021. The repurchase is intended to complete the $600 million stock repurchase authorization announced on May 23, 2018. For 2021, we expect our investments in capital expenditures to exceed $300 million. Capital expenditures primarily relate to building construction and improvements as well as additional manufacturing capacity to support our international expansion. This includes our planned investment in a new manufacturing facility in Wroclaw, Poland, our first one in the EMEA region. We intend to fund these needs with cash generated from operations. With that, I'll turn it back over to Joe for final comments. Joe?"
},
{
"speaker": "Joseph Hogan",
"text": "Thanks, John. In summary, we're very pleased with the first quarter results of 2021. Our strong growth and continued momentum reflect our strategic initiatives and investments, including support for doctors to ensure treatment and business continuity, ramping availability of virtual tools to keep doctors and patients connected throughout treatment and increased consumer marketing and concierge programs. The benefits of digital treatment and digital tools and the limitations of outdated old analog approaches continue to drive adoption of Invisalign Clear Aligners and iTero scanners and services. Over the past year, more doctors have experienced Align's digital platform, which made it possible for thousands of Invisalign practices and patients to continue treatments throughout global disruption, thanks to Invisalign aligners, digital treatment planning, virtual monitoring and care as well as iTero scanners. But the shift from traditional analog wires and brackets to a fully end-to-end digital platform is not easy, cannot be done without very complex technology. And this technology is prevalent, touching every aspect of what we do from manufacturing excellence where we currently manufacture over 700,000 unique aligners per day, to expanding our geographic footprint to over 100 markets, to building a network of over 200,000 trained Invisalign doctors and providing the technology to our doctors in a complete digital system, the Aligned digital platform. As the market leader in the clear aligner space, we have been building this industry over 24 years to get to where it is today and yet the majority of the market opportunity remains largely untapped. With over 500 million potential case starts globally, Align is in a rare position to address this market with the Align Digital Platform, powered by 2 decades of clinical data based on more than 10.2 million patients with AI machine learning and digital tools to help our doctors efficiently communicate with their patients, show and explain any issues and visualize potential treatment outcomes. And together with doctors, we're going to leverage the power of digital dentistry and orthodontics more than ever. We remain focused on our strategic execution, agility, customer service excellence and continuing to make investments to grow our business to drive utilization of the Invisalign system, ultimately returning value to our shareholders. This is the multi-variable equation that we talk about and there's no other company in the market today that has all these capabilities combined. Finally, throughout the pandemic, our priority has been the health and safety of our employees and their families and our doctor customers and their staff, and that has not changed. We remain dedicated to their well-being, and I want to reiterate our commitment to all Invisalign practices and our employees around the world, especially those in areas recently affected by a surge in COVID-19: India, Brazil, France, Poland, Ukraine, Mexico, Thailand and Japan. We are continuing to monitor the situations and are providing support and resources to those impacted employees. Thanks for your time today. I look forward to updating you on our progress as the year unfolds. Now I'll turn the call back over to the operator."
},
{
"speaker": "Operator",
"text": "[Operator Instructions]. The first question is from Nathan Rich from Goldman Sachs."
},
{
"speaker": "Nathan Rich",
"text": "Maybe starting with the guidance for the year and your expectations over the balance of the year. I appreciate the detail that you gave. I guess, should we think about the revenue cadence as being similar to a normal year? And Joe, I mean, it certainly seems like the shift in market share that you've been highlighting has accelerated during the pandemic. I guess I'd be curious to know if you have any way of kind of quantifying the magnitude of this shift as we think about the ability of -- you just kind of sustain this momentum going forward and the gains that obviously Clear Aligners has had during the pandemic."
},
{
"speaker": "Joseph Hogan",
"text": "All right. Nathan, we're obviously optimistic. I mean, given the guidance we had today and the strong first quarter results, we really feel good about where we are. The great thing about this growth is it's been broad and deep, okay? It is across every region. We see it whether it's in APAC, or whether it's EMEA, whether it's in the Americas overall. And then across the GP spectrum, across the ortho spectrum, too, it's been terrific. And it's also up and down. That's why we're giving you comprehensive, noncomprehensive now, all different kinds of cases. So we just feel great about the demand patterns, the depth and breadth of this rebound and that's why we have some clarity now. We decided to give guidance, and we're excited about this year and going forward. John, any thoughts on it?"
},
{
"speaker": "John Morici",
"text": "And to add to your question, Nathan, the seasonality and things that we've seen in the past will continue. We would expect those to continue as we go through this year. So it's hard to compare year-over-year, especially in the first half. But going forward, it makes sense to look at it quarter-over-quarter."
},
{
"speaker": "Nathan Rich",
"text": "Great. And if I could just ask a quick follow-up on the -- it seems like it's going to -- there's going to be more discussion around comprehensive versus noncomprehensive instead of the regional breakout going forward. So I was wondering if you could just level set us on the current mix of business between comprehensive and non-comprehensive cases. And how you're thinking about the growth of those two categories going forward?"
},
{
"speaker": "John Morici",
"text": "Yes. When you look at it, Nathan, it's about 75% comprehensive, 25% noncomprehensive. It can vary by quarter based on teen season and so on, but that's roughly the split there. And we're investing in both areas to be able to grow, whether it's on the ortho side or the GP side for those categories."
},
{
"speaker": "Joseph Hogan",
"text": "And Nate, I think you know the margin on those products also. So there's not -- this is not like a margin split. I mean, you still have higher margins on the less than comprehensive product line, too. So it's a good mix."
},
{
"speaker": "Operator",
"text": "The next question is from Jason Bednar from Piper Sandler."
},
{
"speaker": "Jason Bednar",
"text": "Congrats on a really nice quarter here. I actually want to start on guidance as well. If I focus in the second half of the year, maybe when comps tend to normalize a bit and use the midpoint of that 20% to 30% long-term guide you've got out there. Are you able to talk about how this comes together from a regional or channel perspective? Is it safe to assume that teens international still grows above that mid-20s level? And then is it right to think about imaging and CAD/CAM growing at that mid-20s level as well?"
},
{
"speaker": "John Morici",
"text": "Jason, this is John. We would look at Invisalign and our System and Services to grow at that midpoint in the second half, so around that 25% year-over-year across the business. And we're making investments and continued investments, as we've talked about, to really establish and continue our growth."
},
{
"speaker": "Jason Bednar",
"text": "Okay. And John, just sorry, anything from a regional or channel perspective, international or teens or just how that all comes together?"
},
{
"speaker": "John Morici",
"text": "I think we're not forecasting by each of the regions and so on from that. I think you can -- from our business, we're trying to grow teens. It's a great indicator for the penetration on the ortho side, and we'll continue to grow that, but not giving specifics by region."
},
{
"speaker": "Jason Bednar",
"text": "Okay. Understood. And then just one other follow-up. I mean, the Clear Aligner gross margin was extremely strong this quarter. The Clear Aligner revenue, that grew $50 million sequentially with COGS that fell by $10 million. John, I know you stepped through some of the factors just incorporated there. But is this a sustainable level that we should be thinking about for Clear Aligner gross margin going forward, kind of in this upper 70s level? Or maybe were there some other factors that helped push that gross margin higher here just in the first quarter?"
},
{
"speaker": "John Morici",
"text": "Well, we did see some FX benefit, as we called out, but it's a reflection of investing in this business, adding capacity, adding in places where we see the growth, and this was leveraging some of that -- those investments. So it's a reflection of the work that we have, the productivity that we can drive across the business, utilizing some of the facilities that we have and then benefit a bit from FX on a quarter-over-quarter basis."
},
{
"speaker": "Operator",
"text": "The next question is from Elizabeth Anderson from Evercore."
},
{
"speaker": "Elizabeth Anderson",
"text": "Congrats on a nice quarter. Can you talk about any changes in your DSO strategy? I know you obviously, highlighted the DECA renewal in the quarter, but I just didn't know if there -- as we come out of COVID, anything to think about there in terms of how you're working with that group of customers?"
},
{
"speaker": "Joseph Hogan",
"text": "No, Elizabeth, actually, we do, we can. We bring the entire Align digital platform together with iTero, the different -- some DSOs want to approach this thing from a comprehensive standpoint, some want noncomprehensive. So we just basically gear our digital platform and our product line based on what a DSO wants to do and what they want to accomplish, and not just in the U.S. but really all over the world."
},
{
"speaker": "Elizabeth Anderson",
"text": "Got it. That's helpful. And then in terms of the new facility in Poland, should we think about the potential impact on the gross margin line to be similar to when you open the Ziyang facility? Or is there a different way that you -- that this one is different?"
},
{
"speaker": "John Morici",
"text": "I think when we look at that, we'll leverage to ramp up that facility as fast as possible as a lot of volume can come through from EMEA. So I wouldn't look at that as a model for that. Remember what we did in China was a temporary facility to move to a greenfield, and this is a greenfield new facility to start with."
},
{
"speaker": "Operator",
"text": "The next question is from Jon Block from Stifel."
},
{
"speaker": "Jonathan Block",
"text": "Joe, nice quarter. Two relatively quick ones. I guess to start, Joe, you called out EMEA and North America as the primary case volume, call it, upside drivers, not APAC. And just maybe if you could talk to APAC a little bit more. It was sort of first in COVID, and I think everyone was thinking first in, first out, but it seems like EMEA has been stronger. I mean, it was on a 2-year stack basis despite all the headline stuff that we hear in EMEA. Any details on APAC? Obviously, you've got a pretty big competitor in China. Any more granularity there would be very helpful. And then I've got a little bit of a tighter follow-up."
},
{
"speaker": "Joseph Hogan",
"text": "Jon, first of all, I mean, EMEA was amazing in that way, but I wouldn't let it eclipse APAC, right? We feel really good about APAC across the board. China, obviously, being a big area, the sequential growth of China. When you look at fourth quarter versus first quarter, it's right in that 7%, 7.5% range like the entire business is. And then obviously, APAC is extremely diverse, but from Japan, ANZ, those key areas that we have in APAC, it's really strong growth. So I really feel great about APAC. It's just there's somewhat of an eclipse right now because EMEA was extremely strong. But you shouldn't let yourself think in any way that, that means APAC was weak in some way. We feel good about APAC as we go into the first quarter and the whole year."
},
{
"speaker": "Jonathan Block",
"text": "Okay. Yes, I guess, good problem to have. Second one is sort of a derivative of Nathan's question. But the biggest question I get from investors is this pull-forward of demand, right? In other words, is the 1Q '21 volume, call it, success, is that at the expense of future quarters? And it seems like your guidance suggests you're not too worried about that, Joe. But can you give us more detail here? Like why aren't you worried about any pull-forward? What are you hearing from sales reps? What are docs saying about sustaining the momentum throughout the year?"
},
{
"speaker": "Joseph Hogan",
"text": "Yes, John. John, first of all, it's the breadth of this growth, right? It's not like it's a singular region like we just talked about with EMEA and APAC and how strong the Americas is. We're seeing great uptake in the GP side. We see terrific growth there, the orthodontic side. You see our team numbers are good and respectable. We're moving in the teen season. So what we feel good about is just the breadth and depth of this business. It's not just leaning on 1 or 2 legs from a strategy standpoint, it really is well positioned going forward. We hear the same thing about demand pull-forward or whatever. We -- doctors aren't talking like that. Remember, the questions back in the third quarter, fourth quarter was backlog, right? How much of this was backlog that wasn't consummated in second quarter, early third quarter. And we got way past that. Obviously, we got into the fourth quarter, whatever. So I think we're just seeing a realization in the adult and the teen market of what digital orthodontics can do. And our company is very well positioned to take advantage of that when you look throughout the world. John, anything to add?"
},
{
"speaker": "John Morici",
"text": "Okay."
},
{
"speaker": "Operator",
"text": "The next question is from Kevin Caliendo from UBS."
},
{
"speaker": "Kevin Caliendo",
"text": "I want to talk a little bit about how to think about seasonality with regards to teens. You typically -- you gear up the summer, it's a big teen season historically. Has there -- do you expect that again next year as sort of back-to-school might be a little more normal? And what -- how should we think about you gearing up for another incremental teen season? What might be different? Any expectations around incremental share for teens? I'd just love to hear the strategy."
},
{
"speaker": "Joseph Hogan",
"text": "Well, I think we have a strategy really based on every region because the teen season is different by region from a calendar standpoint. And doctors apply our technology in different ways with teens. But let's just take U.S. and Canada for a second. Obviously, in the second quarter, beginning of third quarter, those are the really strong areas where you'll see our advertising program really kick in, in a big way. We talked about the Teen Awesomeness Centers that we put in place. That's with making sure that we have doctors that are really well-equipped to handle teens, and we direct the leads to that teams with confidence that they can be serviced properly. Overseas, we understand what those timing are for the teens also, and we put those programs together, too. Honestly, Kevin, we have a great portfolio, right? And we can go across teens in a lot of different ways, all the way from 6 year olds, to really older teens when you get to 16 to 19 years old, and the tooth movements associated with those two. So it's just having those doctors ready. It's having the communications with the teens and the moms to make sure they're aware of a digital orthodontic option, and they really ask for that as they go into the doctors. And that's a strategy we apply just in different ways and different seasons around the world, but it specifically applies to teens."
},
{
"speaker": "Kevin Caliendo",
"text": "That's helpful. And one -- just one follow-up on margins. The gross margin number was mentioned. You covered that already. Should we think about any of that flowing down to the operating margin? Or any sort of target for operating margins over the next couple of years? You've historically always looked to spend to grow, and it's always -- you've always been rewarded for it. There's no reason to change. But just thinking sort of where you are now, maybe if you do have a little bit of an uptick in the gross margin that you can let more of it flow through to the operating side. How do you think about that?"
},
{
"speaker": "John Morici",
"text": "I think when you look at it -- Kevin, this is John. I mean, we're looking to balance our growth opportunities with our margin. And in certain countries, you might be at different parts of that equation. But on balance, we're pleased with the gross margin. We've talked a lot about the investments, the productivity and other things that we see, and that continues. And it gives us a lot of flexibility to be able to invest. But in a vastly underpenetrated market that we're in, making these investments to grow volume make a lot of sense to us. But we're always mindful of that balance between volume and margin."
},
{
"speaker": "Operator",
"text": "The next question is from Ravi Misra from Berenberg Capital Markets."
},
{
"speaker": "Ravi Misra",
"text": "So just want to press a little bit more on kind of just some of the marketing opportunities that you're highlighting. And just curious, you have the ski team now, you're talking about the Golden State Warriors. I'm sure Draymond Green is not very happy about that. But just can you help us understand, like, what do you go after when you look at the marketing opportunity? Like in terms of the return that you're searching for the particular brands that you're aligning with? And then I have a follow-up after that."
},
{
"speaker": "Joseph Hogan",
"text": "We do a lot of work on this, just figuring out what channels, what kind of return we get by channel, how much you put in social media, sports team, how much do you put in television. But overall, John and I expect a certain return, and we know what those returns are by region. We invest a dollar here, we know what we get back. I don't necessarily want to convey exactly what those returns are but we make sure they're positive. And you've seen us increase our advertising pretty dramatically outside the United States. The response for that has been really good. And obviously, we use a lot of what we learned here in North America to apply that around the world. So Invisalign is an incredibly well-known brand, not just in North America, but all around the world. And being to leverage that and having that as kind of a common name around the world, it's very helpful for us in the sense of driving volumes, giving doctors confidence and patients confidence, too. So we really feel good about our investments. And obviously, we balance that well with increased salespeople, with technology investments, all the things you have to do when you run a business like this, but it is something that obviously gains a lot of attention and a lot of analysis from us."
},
{
"speaker": "Ravi Misra",
"text": "Great. And then maybe just one on -- on the press release, something caught my eye around your kind of Ortho Summit Case Shoot-out where the highest vote was around kind of a Class II/Class III Invisalign case presentation. Historically, that's been something -- I think maybe -- that unless you're a bleeding edge KOL or doctor that you weren't doing. The fact that, that's kind of winning the kind of peer award now, does that suggest that you're getting deeper into these more complicated cases? And just more specifically, do you feel that you have an edge versus your competitors in the space that allow you to do this? Or is this kind of a class effect that you think has to do with comfort and ease of use of the technology as a whole?"
},
{
"speaker": "Joseph Hogan",
"text": "Yes, Ravi, it's a good question. Look, remember, we have -- we've done, what, we said 10.2 million cases. And through those 10.2 million cases, we've learned a lot, and we learn more every day. And we run AI and machine learning across those cases. And that's how we just launched GA, as we understood and defined cases. We have some issues with posterior open bite and different clinical kind of issues that would bore you to death, but we understand based on millions of cases that we have done, which is the best way to move those teeth to ensure that they end up in the right positions with the right smile at -- obviously, you want to do this as quickly as you possibly can because patients don't want to be in treatment over 5 years. So I feel we have an incredible advantage. You look at SmartTrack, you look at how we initiate that with over 4 million lines of codes that we have in ClinCheck. You look at the accuracy of iTero in the sense of transferring information through over to our manufacturing facility in order to make this. It's so -- and I feel very confident about a 24-year first-mover advantage on what we've done. Now obviously, there's competitors out there and competitors are coming up. But a lot of them have to crawl through the friction that we did in order to learn this. And a lot of the IP that we've put down that makes us unique in the sense of how we position ourselves in the marketplace. So back to what you started with, when you do these shoot-outs and all, it's really great to sit in the audience and look at the before and after photos. I mean it's amazing. When I first joined this business, I just said, I -- hard to believe that you can do this. What's happening today is it's becoming more common. I mean you go all around the world. It was -- it's not 1 or 2 doctors doing this. There's hundreds, if not thousands, that are doing incredible kinds of cases. And so -- which I think that more and more, it just lends credibility to this product line. It can do what we say now 90% of all the cases that are out there. That's not just because it's plastic, right? It is the whole system from how we 3D print, what plastic we use, the algorithms we use, how we constantly tweak it by the information that we have, driving a brand like this, having the kind of training. We talked about 200,000 doctors that we've trained who've gone through these things. This takes time to do, it takes expertise. And doctors need that confidence in understanding. And we feel we can give it to them better than anyone."
},
{
"speaker": "John Morici",
"text": "And that technology is brought about by investments, and we'll invest over $250 million this year alone in R&D to improve our systems and Invisalign for our customers. And that's an advantage. It's an advantage, like Joe said, over a period of time, but we're continuing to invest to make things better and better for our customers."
},
{
"speaker": "Operator",
"text": "The next question is from Richard Newitter from SVB Leerink."
},
{
"speaker": "Jaime Morgan",
"text": "This is Jaime on for Rich. Just one question for me. Appreciating that you guys are obviously focused on driving higher ortho teen utilization, overall GP adoption at the same time. I'm just curious, in your view, which of the 2 is likely to be the bigger make-or-break driver of growth over the near to intermediate term?"
},
{
"speaker": "Joseph Hogan",
"text": "You know, it just sounds like a terrible answer to you, but they're both. Really, we talk about 500 million patients out there that could use Invisalign treatment. We know that of the 15 million orthodontic cases, roughly 75% to 80% are teens -- I mean all those -- they're both huge opportunities. And there's not a difference from a technology standpoint or how you apply that technology to either of those that would make one easier to do or more beneficial than another. So honestly, both of those are great reservoirs of growth for us."
},
{
"speaker": "Jaime Morgan",
"text": "Got it. Okay. And then just..."
},
{
"speaker": "Joseph Hogan",
"text": "Go ahead, Jaime."
},
{
"speaker": "Jaime Morgan",
"text": "One last one for me, just on the DSO. Kind of the business model and strategy that you guys have for entrenching iTero systems in DSOs across all practices, kind of how do you approach that? And when you do see DSOs where the large majority of their practices have adopt the iTero scanner, what's the sort of pickup that you guys see in terms of utilization?"
},
{
"speaker": "Joseph Hogan",
"text": "Well, where you use iTero scanners, you train the doctors properly, you have the right products in a GP channel like iGo and different products like that. We get terrific uptake. I mean, you can't measure it the way you do share a chair at the orthodontic office. But we get -- our DSO business is significant now. It's meaningful that way. And it's one where that digital platform strategy, as you kind of outlined in your question, is what we employ. But again, we employ it in different ways, depending on how a DSO really wants to engage with us."
},
{
"speaker": "Operator",
"text": "Next question is from Jeff Johnson from Baird."
},
{
"speaker": "Jeffrey Johnson",
"text": "John, I want to go back. You mentioned the $250 million in R&D. And I think the number we've discussed over the last, I don't know, probably somewhere in the last 6 or 9 months or so, it's like $500 million total of what you guys spend, not only on R&D, but channel support, advertising, social media, all that stuff. And on our mind, that's one of your bigger barriers to entry, even probably more so than some of the IP and what have you. But it sounds like with some of the stuff, you're taking up EMEA, you're taking up APAC advertising, more and more sports teams and things like that. Is that $500 million number a dated number at this point? Is that barrier to entry and that spend even going well above that number in the near to intermediate term?"
},
{
"speaker": "John Morici",
"text": "You will see that. That's a good question, Jeff. We talked about that at our last Investor Day, about the $500 million combined kind of the marketing go-to-market plus the R&D. And what you'll see is as in success. And we've talked about a lot, as you know, where we see returns, where we see volume, where we see profitability, we're going to continue to make those investments. So as we go through this year, that number will most likely go up as we find success in these investments and find that right return."
},
{
"speaker": "Jeffrey Johnson",
"text": "Yes. Fair enough. And Joe, I'd be interested. I mean, we saw COVID case counts and restrictions even in the 1Q in some of the markets you called out in EMEA as being so strong, U.K., France. I'm sure some others, you called out other areas. Obviously. India that we're all watching closely, but a lot of other markets as well that are still dealing with COVID case counts and heightened risks there. Does that even matter to case shipments to Invisalign at this point? I guess what I'm trying to figure out is, is that stuff holding back some volumes that could come through next year? Are we all just with COVID fatigue still comfortable going in and getting Clear Aligner cases even in those markets? So is COVID a risk factor, I guess, that you've had to build in some caution in the guidance for in some of those markets? Or are cases just as strong in those markets as they are in markets where maybe COVID is a little more under control?"
},
{
"speaker": "Joseph Hogan",
"text": "Yes. Jeff, it's a good question. It's just what we've seen. There's one definitive. If offices are shut down and patients aren't allowed to go to offices, we saw that. That happened in the second quarter, it happened all around the world. And then the term lockdown is used very loosely all around the world, what's a lockdown and what isn't. The situations like in India right now are a disaster, obviously, and people are very cautious. But the rest of the way around the world, what we see is it looks like communities and people have been able to manage this, okay? Is there any kind of a backlog of patients not going into dental offices because of that? I think in certain countries around the world, there is, but we can't really quantify that right now. And again, the breadth and depth of our demand pattern gives us confidence that we think we can predict around it."
},
{
"speaker": "Operator",
"text": "The next question is from Erin Wright from Crédit Suisse."
},
{
"speaker": "Erin Wright",
"text": "Great. Can you speak a little bit about what you're doing differently in terms of promotions or other initiatives around iTero that's really resonating with customers maybe differently now? And where is the traction mostly tied to, on the ortho or GP channel? And do you anticipate any lumpiness quarter-to-quarter across that business?"
},
{
"speaker": "Joseph Hogan",
"text": "Yes. Well, iTero's been great for us, right? You have a good services business there. We announced the Plus series iTero, which is -- Erin, it's a breakthrough. I mean, it sounds like it's a derivative as far as incremental but it is really a strong platform. We talk about the artificial intelligence we've been able to embed in that machine. We see doctors, both on the GP side and the orthodontic side, really excited about it. This is not a promotional discussion in a sense of when you ask your question about how to promote it. There's nothing tricky there. What we do is we have a broad number of products. You have the NIRI product plus, which is the very high end of the product line. Then you have a flex system, which I mentioned in my opening, which is basically a wand itself and it's used with the -- a normal kind of a computer that's adapted to that. And it helps to get flexibility in the sense of what a customer wants to use or a doctor wants to use on both ends. So I feel it's like how we take this to market, the different products that we have and the different way that we segment that is -- and then, obviously, if you want to do Invisalign, this is the front end, the key end of our digital platform and that's very attractive to both GPs and orthos that really want to do Invisalign. They know that iTero is critical for that."
},
{
"speaker": "Operator",
"text": "The next question is from Brandon Couillard from Jefferies."
},
{
"speaker": "Brandon Couillard",
"text": "John, maybe just a two part question around guidance. The operating margin outlook would suggest your margins kind of moderate a bit over the balance of the year from 1Q levels. Can you sort of elaborate on your expectations for gross margins for the balance of the year? And then what should we -- how should we think about the trend of ASPs over the next few quarters? I'd just leave it there."
},
{
"speaker": "John Morici",
"text": "Yes. Brandon, when we look at -- we're pleased with our gross margin and margins that we had in the first quarter. A lot of things came together on that. When we look at the investments and the growth opportunities we have, we're not giving specific guidance around our gross margin. What you can see as it translates to op margins, it's a reflection of the growth opportunities we have, the investment opportunities that we have to be able to invest and grow in this business. And we can update as we go forward based on what we see. Your other part of the question regarding kind of ASPs and so on. When you look at -- we have a breakout, and we show that on a regular basis between comprehensive and noncomprehensive. We don't expect any major fluctuation across our ASPs. The only thing that comes up, and we saw it in this quarter a bit was with currency changes. But in terms of the promotions and how we go about the business and how we're trying to drive growth, there's nothing out of the ordinary that would impact ASPs."
},
{
"speaker": "Operator",
"text": "The next question is from John Kreger from William Blair."
},
{
"speaker": "John Kreger",
"text": "I just wanted to follow-up on Jeff's question a bit. So if you move beyond office closures, as you look at certain regions of the world becoming hot spots and then that fading, does that impact demand levels that you're seeing?"
},
{
"speaker": "Joseph Hogan",
"text": "It's not a great answer for us, John, it's yes and no, okay? Depending on the severity and where it is, I can say yes. For the most part, we say no. And that's after the second quarter when, again, the definitive piece, if you shut offices down and you won't let patients in there, we're going to have an issue. But actually, after the second quarter, early third quarter, we've been dealing with lockdowns that are basically lockdowns of time frame, lockdowns of where people can travel, but not specific lockdowns of doctor offices. If the market stays away from that, we feel we're pretty good."
},
{
"speaker": "Shirley Stacy",
"text": "Thanks, John. Operator, we'll take one more question."
},
{
"speaker": "Operator",
"text": "The next question is from Michael Ryskin of Bank of America."
},
{
"speaker": "Michael Ryskin",
"text": "I'll just ask a quick one. Sort of want to expand a little bit on the ASP question that was just asked. I'm just wondering, you cited a little bit in your prepared remarks in terms of promotional things like that, discounts. Are you referring specifically to the Advantage program? And if you could talk about how some of the orthos and GPs are falling in with those tiers. Have you seen any movement over the last couple of quarters where people are falling more into the platinum and the diamond grouping there? Kind of also backing into sort of the numbers on utilization between ortho, I've seen some really nice numbers the last couple of quarters. Is that indicative of that, a higher portion of orthos and GPs falling at those higher tiers and therefore, walking in those -- the higher promotional discounts?"
},
{
"speaker": "John Morici",
"text": "Yes. Certainly, that is an impact. When you have -- as doctors grow through the tiers, they become more proficient. They had taken on more cases, whether they're on the ortho side or the GP side, we see them work their way through tiers. They do more cases, then we get that volume benefit. And then they'll see those discounts there. We've had those programs in place. Those programs really help drive utilization and really talk to the utilization growth that you noted there. So those are programs that we've had. They're there to drive utilization, and it's something that we've used in our business and expect to continue to use."
},
{
"speaker": "Operator",
"text": "This concludes the question-and-answer session. I'd like to turn the call back over to Shirley Stacy for closing remarks."
},
{
"speaker": "Shirley Stacy",
"text": "Well, thank you, everyone, for joining us today. We appreciate your time. We look forward to seeing you or speaking with you at upcoming financial conferences and industry meetings and events. If you have any follow-up questions, please contact our Investor Relations department. Have a great day."
},
{
"speaker": "Operator",
"text": "This concludes today's conference. You may disconnect your lines at this time. Thank you for your participation."
}
] | Align Technology, Inc. | 24,568 |
ALGN | 4 | 2,022 | 2023-02-01 16:30:00 | Operator: Greetings, welcome to the Align Fourth Quarter and 2022 Earnings Call. [Operator Instructions]. Please note, this conference is being recorded. I will now turn the conference over to your host, Shirley Stacy, with Align Technology. You may begin.
Shirley Stacy: Thank you. Good afternoon. Thank you for joining us. I'm Shirley Stacy, Vice President of Corporate Communications and Investor Relations. Joining me for today's call is Joe Hogan, President and CEO; and John Morici, CFO. We issued fourth quarter and full year 2022 financial results today via Business Wire, which is available on our website at investor.aligntech.com. Today's conference call is being audio webcast and will be archived on our website for approximately 1 month. A telephone replay will be available by approximately 5:30 p.m. Eastern time through 5:30 p.m. Eastern time on February 15. To access the telephone replay, domestic callers should dial 866-813-9403 with access code 328900. International callers should dial 929-458-6194 using the same access code. As a reminder, the information provided and discussed today will include forward-looking statements, including statements about Align's future events and product outlook. These forward-looking statements are only predictions and involve risks and uncertainties that are described in more detail in our most recent periodic reports filed with the Securities and Exchange Commission available on our website and at sec.gov. Actual results may vary significantly, and Align expressly assumes no obligation to update any forward-looking statements. We have posted historical financial statements, including the corresponding reconciliations, including our GAAP to non-GAAP reconciliation if applicable. And our fourth quarter and full year 2022 conference call slides on our website under Align quarterly results. Please refer to these files for more detailed information. With that, I'd like to turn the call over to Align Technology's President and CEO, Joe Hogan. Joe?
Joseph Hogan: Thanks, Shirley. Good afternoon, and thanks for joining us. On our call today, I'll provide an overview of our fourth quarter results and discuss a few highlights from our 2 operating segments, Systems and Services and Clear Aligners. John will provide more detail on our Q4 financial performance and comment on our views for 2023. Following that, I'll come back and summarize a few key points and open the call to questions. You'll note that we have shortened our formal remarks in order to leave more time for Q&A. Overall, I'm pleased to report fourth quarter results that reflect a more stable environment for doctors and their patients than the recent quarters, especially in the Americas and EMEA regions, as well as parts of APAC. For Q4, trends in consumer interest for orthodontic treatment, patient traffic in doctors' practices and iTero scanner demos improved. However, the unfavorable effect of foreign exchange on our fourth quarter and full year 2022 results reduced our revenues and margins significantly. Despite the large impact of unfavorable foreign exchange, Q4 revenues of $901.5 million, increased sequentially from Q3, reflecting growth in Systems and Services as well as a slight increase in Clear Aligner shipments. This is the first quarter in a year that our total revenues and Clear Aligner volumes increased sequentially. As we move through 2023 and hopeful that we'll see continued stability in an improving operating environment, but remind everyone that the macroeconomic situation remains fragile. Regardless, we are confident in our large untapped market opportunity for digital orthodontics and restorative dentistry. We anticipate 2023 will be an exciting year for new innovation at Align, and we'll begin to commercialize one of the largest new product and technology cycles in our 25-year history. The Q4 Systems and Services revenue of $169.9 million were up 7.8% sequentially and down 21.3% year-over-year. On a constant currency basis, Q4 Systems and Services revenues were impacted by unfavorable foreign exchange of approximately $2.7 million or 1.5% sequentially and approximately $11.2 million or 6.2% year-over-year. For Q4, Systems and Services revenues increased sequentially, driven by growth in the Americas and EMEA regions, reflecting continued sales of intraoral scanners, especially the iTero 5D. Q4 sequential growth also reflects continued growth of our scanner rental programs as well as initial deployment of a certified preowned, what we call CPO scanner leasing rental program with desktop metal, that I'll describe in more detail shortly. We continue to develop new capital equipment opportunities to meet the digital transformation needs of our customers, and DSO partners, which is a natural progression for our equipment business with a large and growing base of scanners sold. As our scanner portfolio expands and we introduce new products, we increased the opportunities for customers to upgrade to make trade-ins to provide refurbished scanners for emerging markets. We expect to continue rolling out programs such as leasing and rental offerings that help customers in the current macroeconomic environment by leveraging our balance sheet and selling the way our customers want to buy. On a year-over-year basis, Q4 services revenues increased primarily due to increased subscription revenue, resulting in a larger number of field scanners. We also had higher non-case systems revenues related to our scanner leasing rental programs previously mentioned. To help accelerate the adoption of digital orthodontics and restorative dentistry, in Q4, we announced a strategic collaboration with Desktop Metal to supply iTero Element Flex scanners to Desktop Labs, one of the largest lab networks in the U.S. serving general dentists. The iTero Element Flex is now the preferred restorative scanner for desktop labs and will connect dentists directly to a suite of offerings from desktop labs that simplifies the digital design and manufacture restorations with both traditional and digital technologies. Our collaboration with Desktop Metal reflects our commitment to a relationship we expect will evolve and expand to being advanced restorative workflows to market. We see significant opportunities to enable dentists to use scan data directly order restorative services or printed ready digital files from Desktop Labs that can be used for 3D printing in their offices. In addition to iTero scanners, we're also excited about extending the benefits of the Align Digital Platform, including the Invisalign System and Exocad software to Desktop Labs' customers as well. For Q4, total Clear Aligner revenues of $731.7 million were down slightly, 0.2% sequentially and down 10.3% year-over-year. On a constant currency basis, for Q4 Clear Aligner revenues were impacted by unfavorable foreign exchange of $13.4 million or 1.8% sequentially and $56.4 million or 7.2% year-over-year. Q4 total Clear Aligner volumes of $583,000 was up slightly sequentially, reflecting growth in the Americas and EMEA regions, offset by lower APAC volumes primarily in China. For the Americas, Q4 Clear Aligner volumes were down slightly sequentially, reflecting lower ortho cases, especially teen starts as compared to the typical higher teen season in Q3. Offset primarily by an increase in adult patients from the GP dentist channel. For Q4, Clear Aligner volume from DSO customers continue to outpace non-DSO customers. For EMEA, Q4 Clear Aligner volume increased sequentially in all markets and across products, especially recently launched Invisalign Moderate, iGO Plus and iGO Express, which enabled GP dentists to treat a broader range of cases, mild-to-moderate types of malocclusions and can easily be integrated in a wide range of restorative treatments in a dental practice. EMEA had a strong sequential growth in the teen market segment with continued demand for Invisalign Teen case packs, which are available in France and Iberia as well as Invisalign's first treatment for kids as young as 6 years old. APAC, Q4 Clear Aligner volumes were lower sequentially due primarily to China, which continues to be impacted by COVID. In Q4, ongoing COVID restrictions and lockdowns in China persisted throughout the quarter. Outside of China, APAC volumes increased sequentially led by Japan, Taiwan, India and Southeast Asia markets. On a year-over-year basis, Q4 Clear Aligner case volumes reflected increased shipments led by Korea, India, Japan, Taiwan and Vietnam. While the easing of COVID restrictions in China and the more recent downward trend in COVID infection rates are encouraging, many uncertainties remain, including the lingering impacts from COVID across the population and the time and effort needed to restore consumer confidence. For the other non-case revenues, which include retention products such as our Vivera Retainers, clinical training and education, accessories, e-commerce, and a new subscription programs such as our DSP, fourth quarter revenues were down slightly sequentially and up double digits year-over-year. For retention and e-commerce products, Q4 revenues were relatively unchanged from Q3. We are pleased with our subscription-based programs like DSP, which increased sequentially and year-over-year and expect to continue expanding DSP offerings in other regions. For Q4, the total number of new Invisalign trained doctors decreased sequentially due primarily to fourth quarter being a seasonally slower period for clinical education with holidays, et cetera, as well as fewer trainings in China and Brazil. This was offset by somewhat significantly higher numbers of new Invisalign doctors trained in EMEA. Teen orthodontic treatment is the largest segment of the orthodontic market worldwide and represents our largest opportunity for Clear Aligner sales to orthos. We continue to focus on gaining share from traditional metal braces through team specific sales and marketing programs and product features, including Invisalign First for kids, as young as 6, which was up sequentially across all markets. For Q4, total Clear Aligner teen cases were down sequentially due primarily to the impact of COVID in China as well as seasonally fewer team starts in North America as compared to Q3. According to the December gauge report, which tracks approximately 1,000 orthos in the United States and Canada, new patient exams for teens slowed in Q4, while new patient exams for adults improved slightly. A smaller pool of potential teen patients may put pressure on traditional orthos and cause them to go between clear aligners and wires and brackets, especially those practices that have failed to understand the significant benefits of adopting more efficient digital workflows, believing metal braces are more profitable. In EMEA, Q4 was a record quarter for teen case starts. On a year-over-year basis, Q4 teen case starts were relatively unchanged. For Q4, Invisalign First increased year-over-year and was strong across all regions. Invisalign First Clear Aligner treatment is designed for predictive results and a positive experience while addressing the unique needs of growing children from as young as 6 to treat Phase I. For the full year, Invisalign Clear aligner shipments for teens and young kids was approximately 733,000 cases, our teen case mix overall was a record 31% of Invisalign cases shipped for the year. Finally, in Q4, the total number of doctors shipped was 82, 900 doctors, a slight decrease due primarily to the impact of COVID in China and off our Q3 '22 high point, which included a major DSO onboarding in North America. For the full year 2023, we also shipped to the highest cumulative number of Invisalign trained doctors over 124,000 doctors, reinforcing our commitment to doctor-directed care for Clear Aligner treatment to achieve the safest and best possible clinical treatment outcomes for patients. With that, I'll now turn the call over to John.
John Morici: Thanks, Joe. Before I go through the details of our Q4 results, I want to comment on 2 items in our fourth quarter financial results. Restructuring and other charges, during Q4 2022, we incurred a total of $14.3 million of restructuring and other charges, of which $2.9 million was included in the cost of net revenues and $11.5 million included in operating expenses. Restructuring and other charges included $8.7 million of severance-related costs and $5.6 million of certain lease terminations and asset impairments, primarily related to rightsizing operations in Russia in light of business needs. Second, non-GAAP tax rate. In Q4 2022, we changed to a long-term projected tax rate for our non-GAAP provision for income taxes. Our previous methodology for calculating our non-GAAP effective tax rates included certain nonrecurring and period-specific items. That produced fluctuating effective tax rates that management does not believe are reflective of the company's long-term effective tax rate. We have recast non-GAAP results for our provision for income taxes. Effective tax rate, net income and diluted net income per share for each reporting period in 2022 to reflect this change. We did not make any changes to the results reported for 2021 as reflecting the change in our methodology for the computation of the non-GAAP effective tax rate was immaterial to our 2021 results. Refer to the section in our Q4 press release titled Recast financial measures for prior periods in 2022 for a tax rate change under unaudited GAAP to non-GAAP reconciliation for further information. Now for our Q4 financial results. Total revenues for the fourth quarter were $901.5 million, up 1.3% from the prior quarter and down 12.6% from the corresponding quarter a year ago. On a constant currency basis, Q4 2022 revenues were impacted by unfavorable foreign exchange of approximately $16 million or approximately 1.7% sequentially and approximately $67.6 million year-over-year or approximately 7%. For Clear Aligners, Q4 revenues of $731.7 million were flat sequentially, primarily from lower ASPs, mostly offset by higher volumes. On a year-over-year basis, Q4 Clear Aligner revenues were down 10.3% and primarily due to lower volumes and lower ASPs, partially offset by higher non-case revenues. For Q4, Invisalign ASPs for comprehensive treatment were flat sequentially and decreased year-over-year. On a sequential basis, ASPs reflect the unfavorable impact from foreign exchange, partially offset by higher additional aligners and product mix shift. On a year-over-year basis, the decline in comprehensive ASPs reflect the significant impact of unfavorable foreign exchange, product mix shift and higher discounts partially offset by higher additional aligners and per order processing fees. For Q4, Invisalign ASPs for noncomprehensive treatment decreased sequentially and year-over-year. On a sequential basis, the decline in ASPs reflect product mix shift, unfavorable impact from foreign exchange and higher discounts, partially offset by higher additional aligners. On a year-over-year basis, the decline in ASPs reflect the significant impact of unfavorable foreign exchange, product mix shift and higher discounts, partially offset by higher additional aligners and per order processing fees. As we mentioned last quarter, as our revenues from subscriptions, retainers and other ancillary products continue to grow and expand globally, some of the historical metrics that focus only on case shipments do not account for our overall growth. In our earnings release and financial slides, you will see that we've added our total Clear Aligner revenue per case shipment, which is more indicative of our overall growth strategy. Clear Aligner's deferred revenues on the balance sheet increased $56.4 million or 4.8% sequentially and $171.9 million or up 16.2% year-over-year and will be recognized as the additional aligners are shipped. Q4 2022 Systems and Services revenues of $169.9 million were up 7.8% sequentially, primarily due to higher scanner volume, services and exocad revenues, partially offset by lower ASPs and were down 21.3% year-over-year primarily due to lower scanner volume and ASPs, partially offset by higher services revenue from our larger installed base of scanners and increased nonsystem revenues related to our certified preowned and leasing and rental programs. Q4 2022 Systems and Services revenue were unfavorably impacted by foreign exchange of approximately $2.7 million or approximately 1.5% sequentially. On a year-over-year basis, System and Services revenue were unfavorably impacted by foreign exchange of approximately $11.2 million or approximately 6.2%. The Systems and Services deferred revenues on the balance sheet was up $9 million or 3.4% sequentially and up $42.9 million or 18.7% year-over-year, primarily due to the increase in scanner sales and the deferral of service revenues included with the scanner purchase, which will be recognized ratably over the service period. Moving on to gross margin. Fourth quarter overall gross margin was 68.5%, down 1 point sequentially and down 3.7 points year-over-year. Overall, gross margin was unfavorably impacted by foreign exchange on our revenues by approximately 0.6 points sequentially and 2.2 points on a year-over-year basis. Clear Aligner gross margin for the fourth quarter was 70.8%, down 0.1 point sequentially due to lower ASPs and higher warranty and restructuring costs, partially offset by improved manufacturing absorption and lower training costs. Clear Aligner gross margin for the fourth quarter was down 3.4 points year-over-year, primarily due to lower ASPs, increased manufacturing spend as we continue to ramp up operations at our new manufacturing facility in Poland and a higher mix of additional aligner volume. Systems and Services gross margin for the fourth quarter was 58.8%, down 4.6 points sequentially due to lower ASPs and higher inventory costs and manufacturing inefficiencies, partially offset by higher services revenues and lower freight costs. Systems and Services gross margin for the fourth quarter was down 5.9 points year-over-year for the reasons stated previously. Q4 operating expenses were $505 million, up sequentially 6.2% and down 3.6% year-over-year. On a sequential basis, operating expenses were up $29.5 million, mainly due to restructuring and other charges and our continued investment in sales and R&D activities, along with higher consulting expenses. Year-over-year, operating expenses decreased by $18.6 million primarily due to controlled spend on advertising and marketing as part of our efforts to proactively manage costs as well as lower incentive compensation, partially offset by restructuring and other charges. On a non-GAAP basis, excluding stock-based compensation, restructuring and other charges and amortization of acquired intangibles related to certain acquisitions, operating expenses were up were $459.7 million, up 3.7% sequentially and down 7% year-over-year. Our fourth quarter operating income of $112.7 million resulted in an operating margin of 12.5%, down 3.6 points sequentially and down 8.9 points year-over-year. Operating margin was unfavorably impacted by 0.9 points sequentially, primarily due to foreign exchange and lower gross margin. The year-over-year decrease in operating margin is primarily attributed to lower gross margin, investments in our go-to-market teams and technology as well as unfavorable impact from foreign exchange by approximately 4.2 points. On a non-GAAP basis, which excludes stock-based compensation, restructuring and other charges and amortization of intangibles related to certain acquisitions. Operating margin for the fourth quarter was 18.3%, down 1.9 points sequentially and down 6.4 points year-over-year. Interest and other income expense net for the fourth quarter was income of $2.7 million compared to a loss of $21 million in the third quarter and a loss of $0.9 million in Q4 of 2021, primarily due to net foreign exchange gains from the strengthening of certain foreign currencies against the U.S. dollar. The GAAP effective tax rate in the fourth quarter was 63.8% compared to 40.7% in the third quarter and 13.2% in the fourth quarter of the prior year. The fourth quarter GAAP effective tax rate was higher than the third quarter effective tax rate primarily due to decreased earnings in low tax jurisdictions as -- and an increase in the amount of U.S. minimum tax on foreign earnings. Our non-GAAP effective tax rate was 20% in the fourth quarter and reflects the change in our methodology that was discussed earlier. Our non-GAAP effective tax rate was 11.5% in the fourth quarter of the prior year in 2021, which does not reflect the change in our methodology. Fourth quarter net income per diluted share was $0.54, down sequentially $0.39 and down $1.86 compared to the prior year. Our earnings per share was unfavorably impacted by $0.04 on a sequential basis and $0.22 on a year-over-year basis due to foreign exchange. On a non-GAAP basis, net income per diluted share was $1.73 for the fourth quarter, up $0.10 sequentially and down $1.10 year-over-year. Note that the prior year 2021 non-GAAP net income per diluted share or prior year 2021 EPS does not reflect the Q4 2022 change in our methodology for the computation of the non-GAAP effective tax rate. Moving on to the balance sheet. As of December 31, 2022, cash and cash equivalents and short-term and long-term marketable securities were $1 billion, down sequentially $99.5 million and down $255.1 million year-over-year. Of our $1 billion balance $387.9 million was held in the U.S. and $653.7 million was held by our international entities. In October 2022, we purchased approximately 848,000 shares of our common stock at an average price of $188.62 per share through a $200 million accelerated share repurchase under our May 2021, $1 billion stock repurchase program. We have $250 million remaining available for repurchase under this program, and we plan to repurchase this remaining amount starting in Q1 2023 through either -- either or a combination of open market repurchases or an accelerated stock repurchase agreement, completing the repurchases in Q2 of 2023. Q4 accounts receivable balance was $859.7 million, flat sequentially. Our overall days sales outstanding was 85 days, down 1 day sequentially and up approximately 7 days as compared to Q4 last year. Cash flow from operations for the fourth quarter was $144.7 million, Capital expenditures for the fourth quarter were $53.2 million, primarily related to our continued investment to increase aligner manufacturing capacity and facilities. Free cash flow, defined as cash flow from operations less capital expenditures, amounted to $91.5 million. We exited fiscal 2022 with a strong balance sheet, including $1 billion in cash and investments, a healthy cash flow position and no long-term debt. As we announced with our earnings, Align's Board of Directors has authorized a new $1 billion stock repurchase program to succeed the current $1 billion program. This new $1 billion program reflects the strength of our balance sheet and our cash flow generation as well as management and our board's continued confidence in our ability to capitalize on large market opportunities in our target markets and trajectory for growth while concurrently returning capital to our shareholders. Now turning to our outlook. As Joe mentioned earlier, we are pleased with our Q4 results and what appears to be a more stable environment in North America and EMEA. We are cautiously optimistic for continued stability and improving trends as we move through the year. However, the macroeconomic environment remains fragile. And given continued global challenges in the and uncertainty, we are not providing full year revenue guidance. We would like to see improvements in the operating environment and consumer demand signals, including stability in China before revisiting our approach. At the same time, we are confident in our large, untapped market opportunity for digital orthodontics and restorative dentistry and our ability to make progress towards our strategic initiatives. We intend to focus on the things we can control and influence, which includes strategic investments in sales, marketing, technology and innovation. For full year 2023, assuming no additional material disruptions or circumstances beyond our control, we anticipate our 2023 non-GAAP operating margin to be slightly above 20%. With this backdrop for Q1 2023, we anticipate Clear Aligner volumes to be down sequentially, primarily due to weakness in China from COVID, partially offset by some stability from our Americas and EMEA regions. We anticipate Clear Aligner ASPs to be up from Q4 2022, primarily due to higher pricing and non-favorable and favorable foreign exchange rates. We anticipate iTero scanner and services revenue to be down sequentially as the business follows a more typical capital equipment cycle. Taken in total, we expect Q1 2023 revenues to be about flat to Q4 of 2022. We expect our Q1 2023 non-GAAP operating margin to be consistent with our Q4 2022 non-GAAP operating margin as we continue to make investments in R&D and other go-to-market activities. For 2023, we expect our investments in capital expenditures to exceed $200 million. Capital expenditures primarily relate to building construction and improvements as well as additional manufacturing capacity to support our international expansion. With that, I'll turn it back over to Joe for final comments. Joe?
Joseph Hogan: Thanks, John. In closing, we're pleased with our fourth quarter results and the improved trends in sequential growth we saw in the Americas and EMEA regions and parts of APAC that reflect a more stable environment for doctors and their patients. While still very early and many uncertainties remain, we're hopeful that we'll see continued stability across the business and regions, especially in China. As we continue to work through these challenges, we're confident in our ability to focus on our customers and deliver key technology and innovation that furthers our leadership position in digital orthodontics and restorative dentistry. We are balancing investments to deliver shareholder value through transformative digital orthodontic solutions unique to Align. Align is a purpose-driven business, and we are committed to helping doctors transform smiles and change lives of millions of people around the world. Over the last year, we have flooded our customer base with a lot of new technology that represents one of the largest new product cycles in our history. But there is still a great deal of room for innovation. In the next 1 to 3 years, you should expect to see new platforms from us that will continue to revolutionize doctors' practices and patients' expectations for doctor-led treatment. And scanning, making it simpler and faster. In software, saving both doctors and patients more time with improved clinical outcomes. In direct 3D printing, an evolution in both product and material science. These 3 platforms will give doctors tools only dreamt of before with a singular focus to make the Invisalign system the standard of orthodontic and restorative care, and we couldn't be more excited about it. Thank you for your time today. We look forward to updating you on our next earnings call. Now I'll turn the call back over to the operator for questions. Operator?
Operator: [Operator Instructions]. The first call is from Jason Bednar with Piper Sandler.
Jason Bednar: Joe and John, congrats on seeing the stability return to the business. Maybe I'll start with that point. If you could talk about maybe what's changed versus, say, 3 to 6 months ago, the adult part of the market still sounds maybe a little sluggish, but you also saw that sequential improvement. Teens are holding in. Could you maybe speak to the visibility you have today versus where you sat last summer or in the fall? What has led to the greater confidence in demand forecasting?
Joseph Hogan: Jason, it's Joe. First of all, I think we have a more stable macroeconomic environment. Mean obviously, 2022 was pretty unprecedented when you think about China situation, Ukraine situation in Europe, the rapid increase federal reserve rates that really put the economy in a lot of ways. So I mean we're working from a better platform in that sense. And I think, obviously, Powell's comments today and 0.25 increase in all. I mean it shows a little bit of confidence on the Fed's partners and what they're seeing and what they're directing to. So I'd just say, Jason, from a broad standpoint, we feel really good about our portfolio. We feel good about the technology we talk about and all those things. We're just looking for a stable platform from an economic standpoint to operate from.
Jason Bednar: Okay. No, that's helpful. It definitely sounds more macro related than anything else. But that's helpful. And then maybe, Joe, I wanted to pick up on one point you mentioned regarding the bracket and wire piece. It sure seems like maybe a profit motivated decision for docs, maybe shortsighted, but still profit motivated as they focus on the cost of brackets and wires versus that Clear Aligner lab fee. Maybe what do you think it's going to take to reverse that trend back to Clear Aligners picking up meaningful share I guess, especially with teens, do market volumes need to come back in a bigger way to convince doctors to free up more chair time with Clear Aligners? Or is there something you can do on your end to really stimulate that shift back towards Invisalign?
Joseph Hogan: Jason, that's a great question. First of all, I mean, doctors are doing what they think are in their best financial interest and from a patient standpoint, too. A stronger economic environment will help in that sense, because they'll have a higher patient traffic and the trade-off won't be as severe in that sense because of the patient throughput. But where we help us in technology and that's why we emphasize the technology developments and the investments that we're making that are really significant as we launch in this year. And like I talked about with just software alone to pick one in the sense of being able to move patients through faster being able to have doctors really do cases a lot faster before with our products like IPP in different areas. So those technology advancements are really important. And then how we put those together in business models like our digital subscription programs really help doctors get over that line, too. So I feel we have a good format to be able to address that going forward. But again, I'll emphasize, we need a market that we can stand on in the sense and predict.
Shirley Stacy: Appreciate it. Next question, please.
Operator: Absolutely. The next question comes from Jeff Johnson with Baird.
Jeffrey Johnson: Joe, I just want to ask a couple of questions here. I guess, one, just on the Clear Aligner volume guidance for 1Q. It sounds like it's because China, incrementally weaker stability in Americas and the EMEA, you kind of had that in the press release. You got some hedging words in there about primarily due to weakness in China and some stability in the Americas and EMEA. I mean, should we be thinking at this point that your Americas and the EMEA are kind of a baseline here? And I know, obviously, macro can change from here, but assuming that macro change away, are we kind of at a baseline level now in absolute volumes for Americas and the EMEA? And do you think China, could it be a recovery play throughout this year? Are you seeing any early signs of some pickup in some of those big dental hospitals or the new adult standard product there or anything?
Joseph Hogan: Jeff, first of all, on the front end with the Western economies is we just see stability. That's what we talked about. That's what we see versus before we saw the market falling away from us. So right now, we see it being stable. And feel better about that point. On China, I mean, uncertainty in China is incredible when you think about billion people being sick there right now or have been sick over the last couple of weeks. And Jeff, I refuse to give a forecast over a number of quarters now because a lot of it has to do with the uncertainty that we see in China and specifically, which our second biggest market in the world. So I don't want to try to forecast China right now. I can tell you now it's a blur for us and very difficult, but just we feel good about where we stand with EMEA and the States from a stability standpoint. We try to reflect as much in our words, what we see for the first quarter for you, too.
Jeffrey Johnson: Understood. And I'm sure there's going to be a lot more questions here on the short-term things. I don't want to look or ask you about the Desktop Metal deal, though. On that, right now, is it all for kind of milling using iTero to connect to the lab there for milling and/or 3D printing of just restorations. Are you guys doing any early work with them on 3D printing of Clear Aligners? And just kind of again kind of update us maybe with your most recent thoughts on when we might start seeing 3D printing of the aligners in the office and kind of your competitive advantages you think you can -- as Align carve out in that kind of setting?
Joseph Hogan: Yes, Jeff, that's a good question. The Desktop Metals is primarily we think about a restorative play, how labs play a huge role and restore a dentistry with general dentists. I mean, they're really strong partners in that sense. What Desktop Metal represents is you see a lot of 3D printing going on. There's some really great resin development around restorative types of things, dentures, different areas the Desktop Metal leads in and our iTero scanner can really help with that, too. Also, we have a vision of ortho restorative where you use our orthodontic procedures in order to reduce the amount of tooth loss mass that often comes with restorative procedures, too, that we'll work together with Desktop about. The idea of printing aligners and standard types of STL kind of processes from a 3D standpoint. I don't see that. And honestly, Jeff, I'm not one to think that doctors should turn their offices into production facilities. 3D printing is hard. The materials are difficult. There's a lot of doctors actually trying it, but I feel like doctors are much better being physicians and doctors in that sense than trying to run a manufacturing operation.
Jeffrey Johnson: Even in that first case to try to seal the deal and really lock that patient in as a pain customer?
Joseph Hogan: Jeff, I just think there are some things that kind of make sense from a productivity standpoint and some things that don't. Maybe the technology changes to the point, Jeff, will have a different conversation. But as it stands today, I really don't believe that.
Operator: Our next question comes from Elizabeth Anderson with Evercore.
Elizabeth Anderson: I was wondering if you could talk about, one, how you sort of think about the OpEx spend in terms of particularly sales and marketing in this environment? Do you sort of -- obviously, with the uncertain demand profile, are there things that you're doing incrementally in fourth quarter and the first quarter that sort of switch that spend around?
John Morici: Yes, I think what we always look at, Elizabeth, this is John. We're always looking at trying to find the right return on investment. So as you see some of the markets stabilize and start to come back that we see, that's where we'll continue to make investments. And as we see volumes come back, we'll invest even more. Like we talked about some of the stability in Americas and EMEA. So we'll also look at trying to find the right return on investment. And as those markets stabilize and come back, you'll see us continue to invest in there. And as we said, last year, we kind of had to pair some of that back based on the conditions. And ideally, we could be in a better situation where we can make additional investments this year.
Elizabeth Anderson: That makes sense. And maybe I was wondering if you could talk a little bit more about the GP demand profile, because it was interesting how that was sort of holding up on a relative basis. I heard what you said, obviously, about the teen commentary. Is it something about that market or maybe the lower price point per case or anything like that, that would sort of be impacting that? I'd be just curious to get more color on that.
Joseph Hogan: Elizabeth, it's Joe. Could you restate that question? I didn't quite get the entire question.
Elizabeth Anderson: I think in your prepared remarks, you talked about the GP dentist sort of strength versus the ortho on a relative basis in the quarter. So I was wondering if you could talk more about sort of the underlying color about why that -- why you sort of think that is at this point?
Joseph Hogan: Yes, that's a good question. When you think about it, we have -- we're an elective procedure, right? And so someone is going to go to an orthodontist on a procedure like this to have teeth straighten. With the GP dentist, there is patient traffic there constantly with cleaning and restorations and different things. And so just it's an area right now where -- since it's not just elective procedures there, we feel GPs are just seeing more patients than an ortho would when you compare period to period.
Operator: The following question comes from Jon Block with Stifel.
Jonathan Block: Maybe for the first one, John or Joe, can you just talk about the 5.5% price increase for 2023? The 1Q guidance is lower cases, lower scanner and services but revs flat. So clearly, ASP benefits. And I think you realized the 5.5%, the doc stays on comprehensive or goes to 3 x 3. But how do we think about what flows to realized ASP, John, is that sort of a, I don't know, a plus 2% or 3% from the 4Q '22 levels when we think about 1Q '23 and into the balance of '23?
John Morici: That's a good way to look at it, John, because you're going to have some cases that kind of carry over where they kind of order them and they get shipped a little bit later. And then you're right, you're going to have some mix shift between the 3x3, which is kind of the same price and then the full comprehensive. So 2% to 3% in that first quarter is about in that range. Okay. Go ahead, Jon.
Jonathan Block: I'm sorry, I know it was to clarify. That was just 2% to 3% sequential, John, correct from the 4Q to 1Q?
John Morici: Yes, that's correct. Okay.
Jonathan Block: Okay. And sorry, the second question, just on the op margin, I think you said 18% non-GAAP for 1Q greater than 20% for the year. I'll just sort of load up a modeling question here. Do we think about a sequential improvement for each of the quarters throughout 2023? And then -- that might be for John. And Joe for you. Just talk to us on how you're comfortable on that OM guide, when you still have a lot of moving parts with the economy, you've got what's going on in China? I think you framed it as a fragile environment. How do you get comfortable with that OM guide there's enough wiggle room, I suppose, in the OpEx where you feel you could titrate spend accordingly?
John Morici: Yes, I'll take the modeling question, John. Yes, you would expect that just like we have in maybe prior years and so on, as you start to get that volume leverage, you'll start to see some of that margin improvement as you go throughout the year. So kind of starts at that lower point and you would model it to see some improvement as you go through the year. And like we said, total year slightly above the 20%.
Joseph Hogan: And John, on the OM guide and the confidence is related to what we see right now and what we think is some macro trends that are much more stable than what we've experienced before. So from that, we understand our costs, and we know what we have give and take. And John and I watch it closely and we obviously manage it as a percentage of the total revenues are 2. So revenues have to adjust. We have to adjust to. But again, I think we know what the levers are in this business. And within the context of stability, we feel we can manage to the numbers that we've given.
Operator: Our next question comes from Nathan Rich with Goldman Sachs.
Nathan Rich: Joe, I just wanted to kind of follow up on your comments about starting to commercialize. Obviously, product and technology cycle that you seem very excited about in that sort of ortho and restorative vision. I guess could you maybe just kind of help crystallize that for us in terms of how that kind of come to market in 2023 and the kind of type of investment that the company needs to make to kind of go after that opportunity?
Joseph Hogan: Nathan, overall, obviously, we do spend a significant amount on R&D in the business. And the foundation of that is the history of Align because basically we realize we're a revolutionized digital orthodontics overall. But what we see is it's not just invention for inventions sake, we're always after, how can we do these cases faster, how do we do them more predictably, how do we make it simpler for doctors, a better treatment for patients overall and experience? And just to give you one statistic, right? So versus wires and brackets, which you talked about in the script. On an average, we do patient cases 5 months fast and 35% fewer visits to a doctor. And you do that from technology, right? You do that through remote monitoring, you do that through the consistency of your algorithms and moving teeth and knowing when those seats are going to land as long as patients were. And so the technology I talked about in those 3 areas, first of all, whether it's scanning, we get better on scanning every year. AI is a real important part of that because through AI, you can anticipate a lot of things move these scans through a lot faster. Inventions last year like IPP, Invisalign Personal Plan, those kinds of technologies really reduce the traffic and communications between a doctor and us in the sense of setting up treatment plans. And lastly, 3D printed devices, as I mentioned, has always been the holy grail because we're the biggest 3D printer in the world, but we don't really 3D print devices, we print molds, which you vacuum form over top of it. When you vacuum-form over top of a mold, you can't control wall thickness as you can in 3D printing. And all think this is really critical to move teeth. So all these inventions take a lot of time and money overall, but we just see a huge opportunity for us to be able to increase clinical efficacy, efficiency for doctors and patient experience, and that's why we're so excited about it.
Nathan Rich: Okay. Great. And then just a quick clarification. On the adult side, cases were up 7% sequentially and it sounds like you saw a modest improvement in North America. I think that was the case in APAC as well. I guess I didn't hear reference to adult as you're talking about EMEA. I guess, was the -- kind of adult dynamic kind of more in -- when thinking about the Western economy is more in North America. Just curious if you also saw the same thing play out in EMEA as well?
Joseph Hogan: If I get the question right, Nathan, I mean, EMEA was great, both adults and teens. We felt good about it. They came -- you always go around, I call it, the dark side of the moon in Europe in the third quarter, right? But when they came out from the third quarter, we had a good fourth quarter from that. And so we felt good on both the adult side and the teen side in Europe.
Operator: Our next question comes from Kevin Caliendo with UBS.
Kevin Caliendo: I always struggle with this number that you really haven't grown the number of docs and it's been a while. And I understand that when demand is down, you don't ship to docs every quarter. But even the ones that are registered Invisalign users haven't really grown. And I guess my question is, is there an issue with that? Like why hasn't that number really expanded over the last 4 to 5 quarters? And do you need it as part of your growth algorithm to keep expanding the number of doctors? Is it just a change in culture in the world right now? Or is it competitive pressures? Or is it just harder to find docs, who are willing to do this? Because the penetration of Clear Aligners would suggest there's a lot of doctors out there that could be doing this.
Joseph Hogan: I mean, doctors both on the orthodontic side and on the GP side. I mean, obviously, you're right about that. And obviously, we expand a lot globally, too. So everything you said is true. I'll just give you one word on your questions on China. China is China is like -- it's down. We ship the thousands of doctors in China, we can't ship to right now. And that's the answer to your question since why it's gone down. There's no systemic overall issue in the sense of us being penetrated to the point that we can't buy more doctors, it's just we can't escape the downdraft of China right now.
John Morici: And your equation is right. It's new doctors, doctors ship to as well as utilization. That is -- those are 2 key metrics that help us grow our business.
Kevin Caliendo: Can I ask a quick follow-up? You talk about the need to see consumer demand signals improving. And how far ahead can you actually see that? Meaning -- is it -- is there something in ordering and planning? Like can you see 3 months ahead or 6 months ahead in terms of you're starting to see demand increase? Or is it really real time, like we've made -- we're starting to see an inflection point? I guess it gets to the point of like what do you need to see in terms of consumer demand? How far forward can you look before you can really feel comfortable that there's been an inflection plan?
Joseph Hogan: Kevin, when we look at things, we're a real-time business, obviously, when you have 3D freebies like we do what we make. And there's no leading indicator that would say it hasn't or squared of overnight, 90%. But what we watch closely are the consumer confidence indices in the States and Europe where we can get good wins. Now they're more confirming than they are predictive in what we're seeing but they reflect the, I think, best from a demand standpoint of what we can expect in the consumer confidence indices that we see both in Europe and the States have flattened out or turned slightly positive in the last month or so.
Shirley Stacy: Next question please.
Operator: Absolutely. Our next one comes from Brandon Vazquez with William Blair.
Brandon Vazquez: I wanted to ask one to kind of go back to a couple of us, who are trying to get at. You guided to a full year op margin above 20%, and you're a little bit below that now, of course, probably transient. The question being, do you need sequential improvements in sales to then drive the sequential improvements in op margins through the year? Like how should we be thinking about that? Or are you prepared to kind of deliver that 20% even if let's say, were just stable through the rest of the year rather than improving?
John Morici: Yes, it's a good question. I mean we would expect as we start to see demand as it stabilized as things change in the world and give us a better operating environment, we would expect to see some sequential improvement in revenue as you go through the year. And that would help us get some of the leverage that we need from an op margin standpoint.
Shirley Stacy: Next question please.
Operator: Absolutely. The next question comes from Erin Wright with Morgan Stanley.
Erin Wright: Great. Just a follow-up to that last question, just to clarify, I understand you're not giving the full year guidance from a volume perspective. But if you do continue to see the environment is what you're saying sustained where it is today or get slightly better? You are in a position to grow volume year-over-year in 2023. And then just a separate question on subscription offerings, particularly in retainers. And I'm curious how that's resonating with customers today as another revenue driver for the practice. And when do you think that, that will be material in terms of contribution?
John Morici: I can start on the volume. I mean we would expect -- we're watching a lot of the signals closely. We tried to give more color around Q1 and the rest of the year will play out as things as things in the world change to the situation. So we'll watch volume closely. But like I said, we would expect some sequential improvement as you go forward through the year. But -- we're not getting into the specifics of what it is for total.
Joseph Hogan: It's Joe, on the DSP program, originally, that was targeted primarily at retainers or orthodontists because a lot of orthodontists are making their own retainers in the back room and picking up for wires and brackets. And so we signed up, we also obviously do the touch-up cases with that too is 10 aligners less. That's worked out well. And we -- I think what you're referring to in the end is that's a subscription program to the doctor but we also have a subscription program we offer from the doctor through the patients, and we're implementing that now. There's a lot of enthusiasm from our doctors about that because it becomes a reoccurring revenue stream for them that they haven't many of them haven't tapped into before. And so we feel good about that. And we'll be working closely with our doctors to implement that more fully this year.
Shirley Stacy: Next question, please.
Operator: Absolutely. The next question comes from Michael Ryskin with Bank of America.
Michael Ryskin: Also on a couple of just real quick, some are very fast. First, on China. I think you mentioned that you used the word on more, which is kind of understandable. But any updated thoughts on BPP or any [indiscernible] Can you tell what's going on there while the COVID situation is ongoing? Or is it just kind of a box. And then I also wanted to ask on the tax rate, the non-GAAP tax rate, you called out 20% in 4Q, should we sort of assume that the tax rate go forward?
John Morici: So Michael, this is John. On tax rate for the non-GAAP tax rate assumed 20% going forward.
Joseph Hogan: On China, BPP, I mean, obviously, that program over there, we talked about it several times, it's in Tier 3, Tier 4 cities. It's really not in the middle of our portfolio. It was picked up by some Chinese competitors. We're primarily private over there. We will sell the public hospitals. The program is not exclusive in that sense, too. So may we feel like we can manage in China right now around this fine.
Shirley Stacy: Well, thank you, everyone. We appreciate your time today. This concludes our conference call. We look forward to speaking to you at upcoming financial conferences and industry meetings, including Chicago Midwinter, IDS and AAO. If you have any follow-up questions, please contact our Investor Relations line. Have a great day.
Operator: This concludes today's conference. Thank you for your participation. You may now disconnect your lines. | [
{
"speaker": "Operator",
"text": "Greetings, welcome to the Align Fourth Quarter and 2022 Earnings Call. [Operator Instructions]. Please note, this conference is being recorded. I will now turn the conference over to your host, Shirley Stacy, with Align Technology. You may begin."
},
{
"speaker": "Shirley Stacy",
"text": "Thank you. Good afternoon. Thank you for joining us. I'm Shirley Stacy, Vice President of Corporate Communications and Investor Relations. Joining me for today's call is Joe Hogan, President and CEO; and John Morici, CFO. We issued fourth quarter and full year 2022 financial results today via Business Wire, which is available on our website at investor.aligntech.com. Today's conference call is being audio webcast and will be archived on our website for approximately 1 month. A telephone replay will be available by approximately 5:30 p.m. Eastern time through 5:30 p.m. Eastern time on February 15. To access the telephone replay, domestic callers should dial 866-813-9403 with access code 328900. International callers should dial 929-458-6194 using the same access code. As a reminder, the information provided and discussed today will include forward-looking statements, including statements about Align's future events and product outlook. These forward-looking statements are only predictions and involve risks and uncertainties that are described in more detail in our most recent periodic reports filed with the Securities and Exchange Commission available on our website and at sec.gov. Actual results may vary significantly, and Align expressly assumes no obligation to update any forward-looking statements. We have posted historical financial statements, including the corresponding reconciliations, including our GAAP to non-GAAP reconciliation if applicable. And our fourth quarter and full year 2022 conference call slides on our website under Align quarterly results. Please refer to these files for more detailed information. With that, I'd like to turn the call over to Align Technology's President and CEO, Joe Hogan. Joe?"
},
{
"speaker": "Joseph Hogan",
"text": "Thanks, Shirley. Good afternoon, and thanks for joining us. On our call today, I'll provide an overview of our fourth quarter results and discuss a few highlights from our 2 operating segments, Systems and Services and Clear Aligners. John will provide more detail on our Q4 financial performance and comment on our views for 2023. Following that, I'll come back and summarize a few key points and open the call to questions. You'll note that we have shortened our formal remarks in order to leave more time for Q&A. Overall, I'm pleased to report fourth quarter results that reflect a more stable environment for doctors and their patients than the recent quarters, especially in the Americas and EMEA regions, as well as parts of APAC. For Q4, trends in consumer interest for orthodontic treatment, patient traffic in doctors' practices and iTero scanner demos improved. However, the unfavorable effect of foreign exchange on our fourth quarter and full year 2022 results reduced our revenues and margins significantly. Despite the large impact of unfavorable foreign exchange, Q4 revenues of $901.5 million, increased sequentially from Q3, reflecting growth in Systems and Services as well as a slight increase in Clear Aligner shipments. This is the first quarter in a year that our total revenues and Clear Aligner volumes increased sequentially. As we move through 2023 and hopeful that we'll see continued stability in an improving operating environment, but remind everyone that the macroeconomic situation remains fragile. Regardless, we are confident in our large untapped market opportunity for digital orthodontics and restorative dentistry. We anticipate 2023 will be an exciting year for new innovation at Align, and we'll begin to commercialize one of the largest new product and technology cycles in our 25-year history. The Q4 Systems and Services revenue of $169.9 million were up 7.8% sequentially and down 21.3% year-over-year. On a constant currency basis, Q4 Systems and Services revenues were impacted by unfavorable foreign exchange of approximately $2.7 million or 1.5% sequentially and approximately $11.2 million or 6.2% year-over-year. For Q4, Systems and Services revenues increased sequentially, driven by growth in the Americas and EMEA regions, reflecting continued sales of intraoral scanners, especially the iTero 5D. Q4 sequential growth also reflects continued growth of our scanner rental programs as well as initial deployment of a certified preowned, what we call CPO scanner leasing rental program with desktop metal, that I'll describe in more detail shortly. We continue to develop new capital equipment opportunities to meet the digital transformation needs of our customers, and DSO partners, which is a natural progression for our equipment business with a large and growing base of scanners sold. As our scanner portfolio expands and we introduce new products, we increased the opportunities for customers to upgrade to make trade-ins to provide refurbished scanners for emerging markets. We expect to continue rolling out programs such as leasing and rental offerings that help customers in the current macroeconomic environment by leveraging our balance sheet and selling the way our customers want to buy. On a year-over-year basis, Q4 services revenues increased primarily due to increased subscription revenue, resulting in a larger number of field scanners. We also had higher non-case systems revenues related to our scanner leasing rental programs previously mentioned. To help accelerate the adoption of digital orthodontics and restorative dentistry, in Q4, we announced a strategic collaboration with Desktop Metal to supply iTero Element Flex scanners to Desktop Labs, one of the largest lab networks in the U.S. serving general dentists. The iTero Element Flex is now the preferred restorative scanner for desktop labs and will connect dentists directly to a suite of offerings from desktop labs that simplifies the digital design and manufacture restorations with both traditional and digital technologies. Our collaboration with Desktop Metal reflects our commitment to a relationship we expect will evolve and expand to being advanced restorative workflows to market. We see significant opportunities to enable dentists to use scan data directly order restorative services or printed ready digital files from Desktop Labs that can be used for 3D printing in their offices. In addition to iTero scanners, we're also excited about extending the benefits of the Align Digital Platform, including the Invisalign System and Exocad software to Desktop Labs' customers as well. For Q4, total Clear Aligner revenues of $731.7 million were down slightly, 0.2% sequentially and down 10.3% year-over-year. On a constant currency basis, for Q4 Clear Aligner revenues were impacted by unfavorable foreign exchange of $13.4 million or 1.8% sequentially and $56.4 million or 7.2% year-over-year. Q4 total Clear Aligner volumes of $583,000 was up slightly sequentially, reflecting growth in the Americas and EMEA regions, offset by lower APAC volumes primarily in China. For the Americas, Q4 Clear Aligner volumes were down slightly sequentially, reflecting lower ortho cases, especially teen starts as compared to the typical higher teen season in Q3. Offset primarily by an increase in adult patients from the GP dentist channel. For Q4, Clear Aligner volume from DSO customers continue to outpace non-DSO customers. For EMEA, Q4 Clear Aligner volume increased sequentially in all markets and across products, especially recently launched Invisalign Moderate, iGO Plus and iGO Express, which enabled GP dentists to treat a broader range of cases, mild-to-moderate types of malocclusions and can easily be integrated in a wide range of restorative treatments in a dental practice. EMEA had a strong sequential growth in the teen market segment with continued demand for Invisalign Teen case packs, which are available in France and Iberia as well as Invisalign's first treatment for kids as young as 6 years old. APAC, Q4 Clear Aligner volumes were lower sequentially due primarily to China, which continues to be impacted by COVID. In Q4, ongoing COVID restrictions and lockdowns in China persisted throughout the quarter. Outside of China, APAC volumes increased sequentially led by Japan, Taiwan, India and Southeast Asia markets. On a year-over-year basis, Q4 Clear Aligner case volumes reflected increased shipments led by Korea, India, Japan, Taiwan and Vietnam. While the easing of COVID restrictions in China and the more recent downward trend in COVID infection rates are encouraging, many uncertainties remain, including the lingering impacts from COVID across the population and the time and effort needed to restore consumer confidence. For the other non-case revenues, which include retention products such as our Vivera Retainers, clinical training and education, accessories, e-commerce, and a new subscription programs such as our DSP, fourth quarter revenues were down slightly sequentially and up double digits year-over-year. For retention and e-commerce products, Q4 revenues were relatively unchanged from Q3. We are pleased with our subscription-based programs like DSP, which increased sequentially and year-over-year and expect to continue expanding DSP offerings in other regions. For Q4, the total number of new Invisalign trained doctors decreased sequentially due primarily to fourth quarter being a seasonally slower period for clinical education with holidays, et cetera, as well as fewer trainings in China and Brazil. This was offset by somewhat significantly higher numbers of new Invisalign doctors trained in EMEA. Teen orthodontic treatment is the largest segment of the orthodontic market worldwide and represents our largest opportunity for Clear Aligner sales to orthos. We continue to focus on gaining share from traditional metal braces through team specific sales and marketing programs and product features, including Invisalign First for kids, as young as 6, which was up sequentially across all markets. For Q4, total Clear Aligner teen cases were down sequentially due primarily to the impact of COVID in China as well as seasonally fewer team starts in North America as compared to Q3. According to the December gauge report, which tracks approximately 1,000 orthos in the United States and Canada, new patient exams for teens slowed in Q4, while new patient exams for adults improved slightly. A smaller pool of potential teen patients may put pressure on traditional orthos and cause them to go between clear aligners and wires and brackets, especially those practices that have failed to understand the significant benefits of adopting more efficient digital workflows, believing metal braces are more profitable. In EMEA, Q4 was a record quarter for teen case starts. On a year-over-year basis, Q4 teen case starts were relatively unchanged. For Q4, Invisalign First increased year-over-year and was strong across all regions. Invisalign First Clear Aligner treatment is designed for predictive results and a positive experience while addressing the unique needs of growing children from as young as 6 to treat Phase I. For the full year, Invisalign Clear aligner shipments for teens and young kids was approximately 733,000 cases, our teen case mix overall was a record 31% of Invisalign cases shipped for the year. Finally, in Q4, the total number of doctors shipped was 82, 900 doctors, a slight decrease due primarily to the impact of COVID in China and off our Q3 '22 high point, which included a major DSO onboarding in North America. For the full year 2023, we also shipped to the highest cumulative number of Invisalign trained doctors over 124,000 doctors, reinforcing our commitment to doctor-directed care for Clear Aligner treatment to achieve the safest and best possible clinical treatment outcomes for patients. With that, I'll now turn the call over to John."
},
{
"speaker": "John Morici",
"text": "Thanks, Joe. Before I go through the details of our Q4 results, I want to comment on 2 items in our fourth quarter financial results. Restructuring and other charges, during Q4 2022, we incurred a total of $14.3 million of restructuring and other charges, of which $2.9 million was included in the cost of net revenues and $11.5 million included in operating expenses. Restructuring and other charges included $8.7 million of severance-related costs and $5.6 million of certain lease terminations and asset impairments, primarily related to rightsizing operations in Russia in light of business needs. Second, non-GAAP tax rate. In Q4 2022, we changed to a long-term projected tax rate for our non-GAAP provision for income taxes. Our previous methodology for calculating our non-GAAP effective tax rates included certain nonrecurring and period-specific items. That produced fluctuating effective tax rates that management does not believe are reflective of the company's long-term effective tax rate. We have recast non-GAAP results for our provision for income taxes. Effective tax rate, net income and diluted net income per share for each reporting period in 2022 to reflect this change. We did not make any changes to the results reported for 2021 as reflecting the change in our methodology for the computation of the non-GAAP effective tax rate was immaterial to our 2021 results. Refer to the section in our Q4 press release titled Recast financial measures for prior periods in 2022 for a tax rate change under unaudited GAAP to non-GAAP reconciliation for further information. Now for our Q4 financial results. Total revenues for the fourth quarter were $901.5 million, up 1.3% from the prior quarter and down 12.6% from the corresponding quarter a year ago. On a constant currency basis, Q4 2022 revenues were impacted by unfavorable foreign exchange of approximately $16 million or approximately 1.7% sequentially and approximately $67.6 million year-over-year or approximately 7%. For Clear Aligners, Q4 revenues of $731.7 million were flat sequentially, primarily from lower ASPs, mostly offset by higher volumes. On a year-over-year basis, Q4 Clear Aligner revenues were down 10.3% and primarily due to lower volumes and lower ASPs, partially offset by higher non-case revenues. For Q4, Invisalign ASPs for comprehensive treatment were flat sequentially and decreased year-over-year. On a sequential basis, ASPs reflect the unfavorable impact from foreign exchange, partially offset by higher additional aligners and product mix shift. On a year-over-year basis, the decline in comprehensive ASPs reflect the significant impact of unfavorable foreign exchange, product mix shift and higher discounts partially offset by higher additional aligners and per order processing fees. For Q4, Invisalign ASPs for noncomprehensive treatment decreased sequentially and year-over-year. On a sequential basis, the decline in ASPs reflect product mix shift, unfavorable impact from foreign exchange and higher discounts, partially offset by higher additional aligners. On a year-over-year basis, the decline in ASPs reflect the significant impact of unfavorable foreign exchange, product mix shift and higher discounts, partially offset by higher additional aligners and per order processing fees. As we mentioned last quarter, as our revenues from subscriptions, retainers and other ancillary products continue to grow and expand globally, some of the historical metrics that focus only on case shipments do not account for our overall growth. In our earnings release and financial slides, you will see that we've added our total Clear Aligner revenue per case shipment, which is more indicative of our overall growth strategy. Clear Aligner's deferred revenues on the balance sheet increased $56.4 million or 4.8% sequentially and $171.9 million or up 16.2% year-over-year and will be recognized as the additional aligners are shipped. Q4 2022 Systems and Services revenues of $169.9 million were up 7.8% sequentially, primarily due to higher scanner volume, services and exocad revenues, partially offset by lower ASPs and were down 21.3% year-over-year primarily due to lower scanner volume and ASPs, partially offset by higher services revenue from our larger installed base of scanners and increased nonsystem revenues related to our certified preowned and leasing and rental programs. Q4 2022 Systems and Services revenue were unfavorably impacted by foreign exchange of approximately $2.7 million or approximately 1.5% sequentially. On a year-over-year basis, System and Services revenue were unfavorably impacted by foreign exchange of approximately $11.2 million or approximately 6.2%. The Systems and Services deferred revenues on the balance sheet was up $9 million or 3.4% sequentially and up $42.9 million or 18.7% year-over-year, primarily due to the increase in scanner sales and the deferral of service revenues included with the scanner purchase, which will be recognized ratably over the service period. Moving on to gross margin. Fourth quarter overall gross margin was 68.5%, down 1 point sequentially and down 3.7 points year-over-year. Overall, gross margin was unfavorably impacted by foreign exchange on our revenues by approximately 0.6 points sequentially and 2.2 points on a year-over-year basis. Clear Aligner gross margin for the fourth quarter was 70.8%, down 0.1 point sequentially due to lower ASPs and higher warranty and restructuring costs, partially offset by improved manufacturing absorption and lower training costs. Clear Aligner gross margin for the fourth quarter was down 3.4 points year-over-year, primarily due to lower ASPs, increased manufacturing spend as we continue to ramp up operations at our new manufacturing facility in Poland and a higher mix of additional aligner volume. Systems and Services gross margin for the fourth quarter was 58.8%, down 4.6 points sequentially due to lower ASPs and higher inventory costs and manufacturing inefficiencies, partially offset by higher services revenues and lower freight costs. Systems and Services gross margin for the fourth quarter was down 5.9 points year-over-year for the reasons stated previously. Q4 operating expenses were $505 million, up sequentially 6.2% and down 3.6% year-over-year. On a sequential basis, operating expenses were up $29.5 million, mainly due to restructuring and other charges and our continued investment in sales and R&D activities, along with higher consulting expenses. Year-over-year, operating expenses decreased by $18.6 million primarily due to controlled spend on advertising and marketing as part of our efforts to proactively manage costs as well as lower incentive compensation, partially offset by restructuring and other charges. On a non-GAAP basis, excluding stock-based compensation, restructuring and other charges and amortization of acquired intangibles related to certain acquisitions, operating expenses were up were $459.7 million, up 3.7% sequentially and down 7% year-over-year. Our fourth quarter operating income of $112.7 million resulted in an operating margin of 12.5%, down 3.6 points sequentially and down 8.9 points year-over-year. Operating margin was unfavorably impacted by 0.9 points sequentially, primarily due to foreign exchange and lower gross margin. The year-over-year decrease in operating margin is primarily attributed to lower gross margin, investments in our go-to-market teams and technology as well as unfavorable impact from foreign exchange by approximately 4.2 points. On a non-GAAP basis, which excludes stock-based compensation, restructuring and other charges and amortization of intangibles related to certain acquisitions. Operating margin for the fourth quarter was 18.3%, down 1.9 points sequentially and down 6.4 points year-over-year. Interest and other income expense net for the fourth quarter was income of $2.7 million compared to a loss of $21 million in the third quarter and a loss of $0.9 million in Q4 of 2021, primarily due to net foreign exchange gains from the strengthening of certain foreign currencies against the U.S. dollar. The GAAP effective tax rate in the fourth quarter was 63.8% compared to 40.7% in the third quarter and 13.2% in the fourth quarter of the prior year. The fourth quarter GAAP effective tax rate was higher than the third quarter effective tax rate primarily due to decreased earnings in low tax jurisdictions as -- and an increase in the amount of U.S. minimum tax on foreign earnings. Our non-GAAP effective tax rate was 20% in the fourth quarter and reflects the change in our methodology that was discussed earlier. Our non-GAAP effective tax rate was 11.5% in the fourth quarter of the prior year in 2021, which does not reflect the change in our methodology. Fourth quarter net income per diluted share was $0.54, down sequentially $0.39 and down $1.86 compared to the prior year. Our earnings per share was unfavorably impacted by $0.04 on a sequential basis and $0.22 on a year-over-year basis due to foreign exchange. On a non-GAAP basis, net income per diluted share was $1.73 for the fourth quarter, up $0.10 sequentially and down $1.10 year-over-year. Note that the prior year 2021 non-GAAP net income per diluted share or prior year 2021 EPS does not reflect the Q4 2022 change in our methodology for the computation of the non-GAAP effective tax rate. Moving on to the balance sheet. As of December 31, 2022, cash and cash equivalents and short-term and long-term marketable securities were $1 billion, down sequentially $99.5 million and down $255.1 million year-over-year. Of our $1 billion balance $387.9 million was held in the U.S. and $653.7 million was held by our international entities. In October 2022, we purchased approximately 848,000 shares of our common stock at an average price of $188.62 per share through a $200 million accelerated share repurchase under our May 2021, $1 billion stock repurchase program. We have $250 million remaining available for repurchase under this program, and we plan to repurchase this remaining amount starting in Q1 2023 through either -- either or a combination of open market repurchases or an accelerated stock repurchase agreement, completing the repurchases in Q2 of 2023. Q4 accounts receivable balance was $859.7 million, flat sequentially. Our overall days sales outstanding was 85 days, down 1 day sequentially and up approximately 7 days as compared to Q4 last year. Cash flow from operations for the fourth quarter was $144.7 million, Capital expenditures for the fourth quarter were $53.2 million, primarily related to our continued investment to increase aligner manufacturing capacity and facilities. Free cash flow, defined as cash flow from operations less capital expenditures, amounted to $91.5 million. We exited fiscal 2022 with a strong balance sheet, including $1 billion in cash and investments, a healthy cash flow position and no long-term debt. As we announced with our earnings, Align's Board of Directors has authorized a new $1 billion stock repurchase program to succeed the current $1 billion program. This new $1 billion program reflects the strength of our balance sheet and our cash flow generation as well as management and our board's continued confidence in our ability to capitalize on large market opportunities in our target markets and trajectory for growth while concurrently returning capital to our shareholders. Now turning to our outlook. As Joe mentioned earlier, we are pleased with our Q4 results and what appears to be a more stable environment in North America and EMEA. We are cautiously optimistic for continued stability and improving trends as we move through the year. However, the macroeconomic environment remains fragile. And given continued global challenges in the and uncertainty, we are not providing full year revenue guidance. We would like to see improvements in the operating environment and consumer demand signals, including stability in China before revisiting our approach. At the same time, we are confident in our large, untapped market opportunity for digital orthodontics and restorative dentistry and our ability to make progress towards our strategic initiatives. We intend to focus on the things we can control and influence, which includes strategic investments in sales, marketing, technology and innovation. For full year 2023, assuming no additional material disruptions or circumstances beyond our control, we anticipate our 2023 non-GAAP operating margin to be slightly above 20%. With this backdrop for Q1 2023, we anticipate Clear Aligner volumes to be down sequentially, primarily due to weakness in China from COVID, partially offset by some stability from our Americas and EMEA regions. We anticipate Clear Aligner ASPs to be up from Q4 2022, primarily due to higher pricing and non-favorable and favorable foreign exchange rates. We anticipate iTero scanner and services revenue to be down sequentially as the business follows a more typical capital equipment cycle. Taken in total, we expect Q1 2023 revenues to be about flat to Q4 of 2022. We expect our Q1 2023 non-GAAP operating margin to be consistent with our Q4 2022 non-GAAP operating margin as we continue to make investments in R&D and other go-to-market activities. For 2023, we expect our investments in capital expenditures to exceed $200 million. Capital expenditures primarily relate to building construction and improvements as well as additional manufacturing capacity to support our international expansion. With that, I'll turn it back over to Joe for final comments. Joe?"
},
{
"speaker": "Joseph Hogan",
"text": "Thanks, John. In closing, we're pleased with our fourth quarter results and the improved trends in sequential growth we saw in the Americas and EMEA regions and parts of APAC that reflect a more stable environment for doctors and their patients. While still very early and many uncertainties remain, we're hopeful that we'll see continued stability across the business and regions, especially in China. As we continue to work through these challenges, we're confident in our ability to focus on our customers and deliver key technology and innovation that furthers our leadership position in digital orthodontics and restorative dentistry. We are balancing investments to deliver shareholder value through transformative digital orthodontic solutions unique to Align. Align is a purpose-driven business, and we are committed to helping doctors transform smiles and change lives of millions of people around the world. Over the last year, we have flooded our customer base with a lot of new technology that represents one of the largest new product cycles in our history. But there is still a great deal of room for innovation. In the next 1 to 3 years, you should expect to see new platforms from us that will continue to revolutionize doctors' practices and patients' expectations for doctor-led treatment. And scanning, making it simpler and faster. In software, saving both doctors and patients more time with improved clinical outcomes. In direct 3D printing, an evolution in both product and material science. These 3 platforms will give doctors tools only dreamt of before with a singular focus to make the Invisalign system the standard of orthodontic and restorative care, and we couldn't be more excited about it. Thank you for your time today. We look forward to updating you on our next earnings call. Now I'll turn the call back over to the operator for questions. Operator?"
},
{
"speaker": "Operator",
"text": "[Operator Instructions]. The first call is from Jason Bednar with Piper Sandler."
},
{
"speaker": "Jason Bednar",
"text": "Joe and John, congrats on seeing the stability return to the business. Maybe I'll start with that point. If you could talk about maybe what's changed versus, say, 3 to 6 months ago, the adult part of the market still sounds maybe a little sluggish, but you also saw that sequential improvement. Teens are holding in. Could you maybe speak to the visibility you have today versus where you sat last summer or in the fall? What has led to the greater confidence in demand forecasting?"
},
{
"speaker": "Joseph Hogan",
"text": "Jason, it's Joe. First of all, I think we have a more stable macroeconomic environment. Mean obviously, 2022 was pretty unprecedented when you think about China situation, Ukraine situation in Europe, the rapid increase federal reserve rates that really put the economy in a lot of ways. So I mean we're working from a better platform in that sense. And I think, obviously, Powell's comments today and 0.25 increase in all. I mean it shows a little bit of confidence on the Fed's partners and what they're seeing and what they're directing to. So I'd just say, Jason, from a broad standpoint, we feel really good about our portfolio. We feel good about the technology we talk about and all those things. We're just looking for a stable platform from an economic standpoint to operate from."
},
{
"speaker": "Jason Bednar",
"text": "Okay. No, that's helpful. It definitely sounds more macro related than anything else. But that's helpful. And then maybe, Joe, I wanted to pick up on one point you mentioned regarding the bracket and wire piece. It sure seems like maybe a profit motivated decision for docs, maybe shortsighted, but still profit motivated as they focus on the cost of brackets and wires versus that Clear Aligner lab fee. Maybe what do you think it's going to take to reverse that trend back to Clear Aligners picking up meaningful share I guess, especially with teens, do market volumes need to come back in a bigger way to convince doctors to free up more chair time with Clear Aligners? Or is there something you can do on your end to really stimulate that shift back towards Invisalign?"
},
{
"speaker": "Joseph Hogan",
"text": "Jason, that's a great question. First of all, I mean, doctors are doing what they think are in their best financial interest and from a patient standpoint, too. A stronger economic environment will help in that sense, because they'll have a higher patient traffic and the trade-off won't be as severe in that sense because of the patient throughput. But where we help us in technology and that's why we emphasize the technology developments and the investments that we're making that are really significant as we launch in this year. And like I talked about with just software alone to pick one in the sense of being able to move patients through faster being able to have doctors really do cases a lot faster before with our products like IPP in different areas. So those technology advancements are really important. And then how we put those together in business models like our digital subscription programs really help doctors get over that line, too. So I feel we have a good format to be able to address that going forward. But again, I'll emphasize, we need a market that we can stand on in the sense and predict."
},
{
"speaker": "Shirley Stacy",
"text": "Appreciate it. Next question, please."
},
{
"speaker": "Operator",
"text": "Absolutely. The next question comes from Jeff Johnson with Baird."
},
{
"speaker": "Jeffrey Johnson",
"text": "Joe, I just want to ask a couple of questions here. I guess, one, just on the Clear Aligner volume guidance for 1Q. It sounds like it's because China, incrementally weaker stability in Americas and the EMEA, you kind of had that in the press release. You got some hedging words in there about primarily due to weakness in China and some stability in the Americas and EMEA. I mean, should we be thinking at this point that your Americas and the EMEA are kind of a baseline here? And I know, obviously, macro can change from here, but assuming that macro change away, are we kind of at a baseline level now in absolute volumes for Americas and the EMEA? And do you think China, could it be a recovery play throughout this year? Are you seeing any early signs of some pickup in some of those big dental hospitals or the new adult standard product there or anything?"
},
{
"speaker": "Joseph Hogan",
"text": "Jeff, first of all, on the front end with the Western economies is we just see stability. That's what we talked about. That's what we see versus before we saw the market falling away from us. So right now, we see it being stable. And feel better about that point. On China, I mean, uncertainty in China is incredible when you think about billion people being sick there right now or have been sick over the last couple of weeks. And Jeff, I refuse to give a forecast over a number of quarters now because a lot of it has to do with the uncertainty that we see in China and specifically, which our second biggest market in the world. So I don't want to try to forecast China right now. I can tell you now it's a blur for us and very difficult, but just we feel good about where we stand with EMEA and the States from a stability standpoint. We try to reflect as much in our words, what we see for the first quarter for you, too."
},
{
"speaker": "Jeffrey Johnson",
"text": "Understood. And I'm sure there's going to be a lot more questions here on the short-term things. I don't want to look or ask you about the Desktop Metal deal, though. On that, right now, is it all for kind of milling using iTero to connect to the lab there for milling and/or 3D printing of just restorations. Are you guys doing any early work with them on 3D printing of Clear Aligners? And just kind of again kind of update us maybe with your most recent thoughts on when we might start seeing 3D printing of the aligners in the office and kind of your competitive advantages you think you can -- as Align carve out in that kind of setting?"
},
{
"speaker": "Joseph Hogan",
"text": "Yes, Jeff, that's a good question. The Desktop Metals is primarily we think about a restorative play, how labs play a huge role and restore a dentistry with general dentists. I mean, they're really strong partners in that sense. What Desktop Metal represents is you see a lot of 3D printing going on. There's some really great resin development around restorative types of things, dentures, different areas the Desktop Metal leads in and our iTero scanner can really help with that, too. Also, we have a vision of ortho restorative where you use our orthodontic procedures in order to reduce the amount of tooth loss mass that often comes with restorative procedures, too, that we'll work together with Desktop about. The idea of printing aligners and standard types of STL kind of processes from a 3D standpoint. I don't see that. And honestly, Jeff, I'm not one to think that doctors should turn their offices into production facilities. 3D printing is hard. The materials are difficult. There's a lot of doctors actually trying it, but I feel like doctors are much better being physicians and doctors in that sense than trying to run a manufacturing operation."
},
{
"speaker": "Jeffrey Johnson",
"text": "Even in that first case to try to seal the deal and really lock that patient in as a pain customer?"
},
{
"speaker": "Joseph Hogan",
"text": "Jeff, I just think there are some things that kind of make sense from a productivity standpoint and some things that don't. Maybe the technology changes to the point, Jeff, will have a different conversation. But as it stands today, I really don't believe that."
},
{
"speaker": "Operator",
"text": "Our next question comes from Elizabeth Anderson with Evercore."
},
{
"speaker": "Elizabeth Anderson",
"text": "I was wondering if you could talk about, one, how you sort of think about the OpEx spend in terms of particularly sales and marketing in this environment? Do you sort of -- obviously, with the uncertain demand profile, are there things that you're doing incrementally in fourth quarter and the first quarter that sort of switch that spend around?"
},
{
"speaker": "John Morici",
"text": "Yes, I think what we always look at, Elizabeth, this is John. We're always looking at trying to find the right return on investment. So as you see some of the markets stabilize and start to come back that we see, that's where we'll continue to make investments. And as we see volumes come back, we'll invest even more. Like we talked about some of the stability in Americas and EMEA. So we'll also look at trying to find the right return on investment. And as those markets stabilize and come back, you'll see us continue to invest in there. And as we said, last year, we kind of had to pair some of that back based on the conditions. And ideally, we could be in a better situation where we can make additional investments this year."
},
{
"speaker": "Elizabeth Anderson",
"text": "That makes sense. And maybe I was wondering if you could talk a little bit more about the GP demand profile, because it was interesting how that was sort of holding up on a relative basis. I heard what you said, obviously, about the teen commentary. Is it something about that market or maybe the lower price point per case or anything like that, that would sort of be impacting that? I'd be just curious to get more color on that."
},
{
"speaker": "Joseph Hogan",
"text": "Elizabeth, it's Joe. Could you restate that question? I didn't quite get the entire question."
},
{
"speaker": "Elizabeth Anderson",
"text": "I think in your prepared remarks, you talked about the GP dentist sort of strength versus the ortho on a relative basis in the quarter. So I was wondering if you could talk more about sort of the underlying color about why that -- why you sort of think that is at this point?"
},
{
"speaker": "Joseph Hogan",
"text": "Yes, that's a good question. When you think about it, we have -- we're an elective procedure, right? And so someone is going to go to an orthodontist on a procedure like this to have teeth straighten. With the GP dentist, there is patient traffic there constantly with cleaning and restorations and different things. And so just it's an area right now where -- since it's not just elective procedures there, we feel GPs are just seeing more patients than an ortho would when you compare period to period."
},
{
"speaker": "Operator",
"text": "The following question comes from Jon Block with Stifel."
},
{
"speaker": "Jonathan Block",
"text": "Maybe for the first one, John or Joe, can you just talk about the 5.5% price increase for 2023? The 1Q guidance is lower cases, lower scanner and services but revs flat. So clearly, ASP benefits. And I think you realized the 5.5%, the doc stays on comprehensive or goes to 3 x 3. But how do we think about what flows to realized ASP, John, is that sort of a, I don't know, a plus 2% or 3% from the 4Q '22 levels when we think about 1Q '23 and into the balance of '23?"
},
{
"speaker": "John Morici",
"text": "That's a good way to look at it, John, because you're going to have some cases that kind of carry over where they kind of order them and they get shipped a little bit later. And then you're right, you're going to have some mix shift between the 3x3, which is kind of the same price and then the full comprehensive. So 2% to 3% in that first quarter is about in that range. Okay. Go ahead, Jon."
},
{
"speaker": "Jonathan Block",
"text": "I'm sorry, I know it was to clarify. That was just 2% to 3% sequential, John, correct from the 4Q to 1Q?"
},
{
"speaker": "John Morici",
"text": "Yes, that's correct. Okay."
},
{
"speaker": "Jonathan Block",
"text": "Okay. And sorry, the second question, just on the op margin, I think you said 18% non-GAAP for 1Q greater than 20% for the year. I'll just sort of load up a modeling question here. Do we think about a sequential improvement for each of the quarters throughout 2023? And then -- that might be for John. And Joe for you. Just talk to us on how you're comfortable on that OM guide, when you still have a lot of moving parts with the economy, you've got what's going on in China? I think you framed it as a fragile environment. How do you get comfortable with that OM guide there's enough wiggle room, I suppose, in the OpEx where you feel you could titrate spend accordingly?"
},
{
"speaker": "John Morici",
"text": "Yes, I'll take the modeling question, John. Yes, you would expect that just like we have in maybe prior years and so on, as you start to get that volume leverage, you'll start to see some of that margin improvement as you go throughout the year. So kind of starts at that lower point and you would model it to see some improvement as you go through the year. And like we said, total year slightly above the 20%."
},
{
"speaker": "Joseph Hogan",
"text": "And John, on the OM guide and the confidence is related to what we see right now and what we think is some macro trends that are much more stable than what we've experienced before. So from that, we understand our costs, and we know what we have give and take. And John and I watch it closely and we obviously manage it as a percentage of the total revenues are 2. So revenues have to adjust. We have to adjust to. But again, I think we know what the levers are in this business. And within the context of stability, we feel we can manage to the numbers that we've given."
},
{
"speaker": "Operator",
"text": "Our next question comes from Nathan Rich with Goldman Sachs."
},
{
"speaker": "Nathan Rich",
"text": "Joe, I just wanted to kind of follow up on your comments about starting to commercialize. Obviously, product and technology cycle that you seem very excited about in that sort of ortho and restorative vision. I guess could you maybe just kind of help crystallize that for us in terms of how that kind of come to market in 2023 and the kind of type of investment that the company needs to make to kind of go after that opportunity?"
},
{
"speaker": "Joseph Hogan",
"text": "Nathan, overall, obviously, we do spend a significant amount on R&D in the business. And the foundation of that is the history of Align because basically we realize we're a revolutionized digital orthodontics overall. But what we see is it's not just invention for inventions sake, we're always after, how can we do these cases faster, how do we do them more predictably, how do we make it simpler for doctors, a better treatment for patients overall and experience? And just to give you one statistic, right? So versus wires and brackets, which you talked about in the script. On an average, we do patient cases 5 months fast and 35% fewer visits to a doctor. And you do that from technology, right? You do that through remote monitoring, you do that through the consistency of your algorithms and moving teeth and knowing when those seats are going to land as long as patients were. And so the technology I talked about in those 3 areas, first of all, whether it's scanning, we get better on scanning every year. AI is a real important part of that because through AI, you can anticipate a lot of things move these scans through a lot faster. Inventions last year like IPP, Invisalign Personal Plan, those kinds of technologies really reduce the traffic and communications between a doctor and us in the sense of setting up treatment plans. And lastly, 3D printed devices, as I mentioned, has always been the holy grail because we're the biggest 3D printer in the world, but we don't really 3D print devices, we print molds, which you vacuum form over top of it. When you vacuum-form over top of a mold, you can't control wall thickness as you can in 3D printing. And all think this is really critical to move teeth. So all these inventions take a lot of time and money overall, but we just see a huge opportunity for us to be able to increase clinical efficacy, efficiency for doctors and patient experience, and that's why we're so excited about it."
},
{
"speaker": "Nathan Rich",
"text": "Okay. Great. And then just a quick clarification. On the adult side, cases were up 7% sequentially and it sounds like you saw a modest improvement in North America. I think that was the case in APAC as well. I guess I didn't hear reference to adult as you're talking about EMEA. I guess, was the -- kind of adult dynamic kind of more in -- when thinking about the Western economy is more in North America. Just curious if you also saw the same thing play out in EMEA as well?"
},
{
"speaker": "Joseph Hogan",
"text": "If I get the question right, Nathan, I mean, EMEA was great, both adults and teens. We felt good about it. They came -- you always go around, I call it, the dark side of the moon in Europe in the third quarter, right? But when they came out from the third quarter, we had a good fourth quarter from that. And so we felt good on both the adult side and the teen side in Europe."
},
{
"speaker": "Operator",
"text": "Our next question comes from Kevin Caliendo with UBS."
},
{
"speaker": "Kevin Caliendo",
"text": "I always struggle with this number that you really haven't grown the number of docs and it's been a while. And I understand that when demand is down, you don't ship to docs every quarter. But even the ones that are registered Invisalign users haven't really grown. And I guess my question is, is there an issue with that? Like why hasn't that number really expanded over the last 4 to 5 quarters? And do you need it as part of your growth algorithm to keep expanding the number of doctors? Is it just a change in culture in the world right now? Or is it competitive pressures? Or is it just harder to find docs, who are willing to do this? Because the penetration of Clear Aligners would suggest there's a lot of doctors out there that could be doing this."
},
{
"speaker": "Joseph Hogan",
"text": "I mean, doctors both on the orthodontic side and on the GP side. I mean, obviously, you're right about that. And obviously, we expand a lot globally, too. So everything you said is true. I'll just give you one word on your questions on China. China is China is like -- it's down. We ship the thousands of doctors in China, we can't ship to right now. And that's the answer to your question since why it's gone down. There's no systemic overall issue in the sense of us being penetrated to the point that we can't buy more doctors, it's just we can't escape the downdraft of China right now."
},
{
"speaker": "John Morici",
"text": "And your equation is right. It's new doctors, doctors ship to as well as utilization. That is -- those are 2 key metrics that help us grow our business."
},
{
"speaker": "Kevin Caliendo",
"text": "Can I ask a quick follow-up? You talk about the need to see consumer demand signals improving. And how far ahead can you actually see that? Meaning -- is it -- is there something in ordering and planning? Like can you see 3 months ahead or 6 months ahead in terms of you're starting to see demand increase? Or is it really real time, like we've made -- we're starting to see an inflection point? I guess it gets to the point of like what do you need to see in terms of consumer demand? How far forward can you look before you can really feel comfortable that there's been an inflection plan?"
},
{
"speaker": "Joseph Hogan",
"text": "Kevin, when we look at things, we're a real-time business, obviously, when you have 3D freebies like we do what we make. And there's no leading indicator that would say it hasn't or squared of overnight, 90%. But what we watch closely are the consumer confidence indices in the States and Europe where we can get good wins. Now they're more confirming than they are predictive in what we're seeing but they reflect the, I think, best from a demand standpoint of what we can expect in the consumer confidence indices that we see both in Europe and the States have flattened out or turned slightly positive in the last month or so."
},
{
"speaker": "Shirley Stacy",
"text": "Next question please."
},
{
"speaker": "Operator",
"text": "Absolutely. Our next one comes from Brandon Vazquez with William Blair."
},
{
"speaker": "Brandon Vazquez",
"text": "I wanted to ask one to kind of go back to a couple of us, who are trying to get at. You guided to a full year op margin above 20%, and you're a little bit below that now, of course, probably transient. The question being, do you need sequential improvements in sales to then drive the sequential improvements in op margins through the year? Like how should we be thinking about that? Or are you prepared to kind of deliver that 20% even if let's say, were just stable through the rest of the year rather than improving?"
},
{
"speaker": "John Morici",
"text": "Yes, it's a good question. I mean we would expect as we start to see demand as it stabilized as things change in the world and give us a better operating environment, we would expect to see some sequential improvement in revenue as you go through the year. And that would help us get some of the leverage that we need from an op margin standpoint."
},
{
"speaker": "Shirley Stacy",
"text": "Next question please."
},
{
"speaker": "Operator",
"text": "Absolutely. The next question comes from Erin Wright with Morgan Stanley."
},
{
"speaker": "Erin Wright",
"text": "Great. Just a follow-up to that last question, just to clarify, I understand you're not giving the full year guidance from a volume perspective. But if you do continue to see the environment is what you're saying sustained where it is today or get slightly better? You are in a position to grow volume year-over-year in 2023. And then just a separate question on subscription offerings, particularly in retainers. And I'm curious how that's resonating with customers today as another revenue driver for the practice. And when do you think that, that will be material in terms of contribution?"
},
{
"speaker": "John Morici",
"text": "I can start on the volume. I mean we would expect -- we're watching a lot of the signals closely. We tried to give more color around Q1 and the rest of the year will play out as things as things in the world change to the situation. So we'll watch volume closely. But like I said, we would expect some sequential improvement as you go forward through the year. But -- we're not getting into the specifics of what it is for total."
},
{
"speaker": "Joseph Hogan",
"text": "It's Joe, on the DSP program, originally, that was targeted primarily at retainers or orthodontists because a lot of orthodontists are making their own retainers in the back room and picking up for wires and brackets. And so we signed up, we also obviously do the touch-up cases with that too is 10 aligners less. That's worked out well. And we -- I think what you're referring to in the end is that's a subscription program to the doctor but we also have a subscription program we offer from the doctor through the patients, and we're implementing that now. There's a lot of enthusiasm from our doctors about that because it becomes a reoccurring revenue stream for them that they haven't many of them haven't tapped into before. And so we feel good about that. And we'll be working closely with our doctors to implement that more fully this year."
},
{
"speaker": "Shirley Stacy",
"text": "Next question, please."
},
{
"speaker": "Operator",
"text": "Absolutely. The next question comes from Michael Ryskin with Bank of America."
},
{
"speaker": "Michael Ryskin",
"text": "Also on a couple of just real quick, some are very fast. First, on China. I think you mentioned that you used the word on more, which is kind of understandable. But any updated thoughts on BPP or any [indiscernible] Can you tell what's going on there while the COVID situation is ongoing? Or is it just kind of a box. And then I also wanted to ask on the tax rate, the non-GAAP tax rate, you called out 20% in 4Q, should we sort of assume that the tax rate go forward?"
},
{
"speaker": "John Morici",
"text": "So Michael, this is John. On tax rate for the non-GAAP tax rate assumed 20% going forward."
},
{
"speaker": "Joseph Hogan",
"text": "On China, BPP, I mean, obviously, that program over there, we talked about it several times, it's in Tier 3, Tier 4 cities. It's really not in the middle of our portfolio. It was picked up by some Chinese competitors. We're primarily private over there. We will sell the public hospitals. The program is not exclusive in that sense, too. So may we feel like we can manage in China right now around this fine."
},
{
"speaker": "Shirley Stacy",
"text": "Well, thank you, everyone. We appreciate your time today. This concludes our conference call. We look forward to speaking to you at upcoming financial conferences and industry meetings, including Chicago Midwinter, IDS and AAO. If you have any follow-up questions, please contact our Investor Relations line. Have a great day."
},
{
"speaker": "Operator",
"text": "This concludes today's conference. Thank you for your participation. You may now disconnect your lines."
}
] | Align Technology, Inc. | 24,568 |
ALGN | 3 | 2,022 | 2022-10-26 16:30:00 | Operator: Greetings. Welcome to the Align Q3 2022 Earnings Call. At this time, all participants are in a listen-only mode. A question and answer session will follow the formal presentation. Please note this conference will be recorded. I would now like to turn the conference over to our host, Shirley Stacy, with Align Technology. You may begin.
Shirley Stacy: Good afternoon, and thank you for joining us. I'm Shirley Stacy, Vice President of Corporate Communications and Investor Relations. Joining me for today's call is Joe Hogan, President and CEO; and John Morici, CFO. We issued third quarter 2022 financial results today via Business Wire, which is available on our website at investor.aligntech.com. Today's conference call is being audio webcast and will be archived on our website for approximately 1 month. A telephone replay will be available today by approximately 5:30 p.m. Eastern time through 5:30 p.m. Eastern time on November 9. To access the telephone replay, domestic callers should dial (866) 813-9403 with access code 119351. International callers should dial (929)458-6194 using the same access code. As a reminder, the information provided and discussed today will include forward-looking statements, including statements about Align's future events and product outlook. These forward-looking statements are only predictions and involve risks and uncertainties and that are described in more detail in our most recent periodic reports filed with the Securities and Exchange Commission available on our website and at sec.gov. Actual results may vary significantly, and Align expressly assumes no obligation to update any forward-looking statements. We have posted historical financial statements, including the corresponding reconciliations, including our GAAP to non-GAAP reconciliations, if applicable, and our third quarter 2022 conference call slides on our website under quarterly results. Please refer to these files for more detailed information. And with that, I'd like to turn the call over to Align Technology's President and CEO, Joe Hogan. Joe?
Joe Hogan: Thanks, Shirley. Good afternoon, and thanks for joining us. On our call today, I'll provide an overview of our Q3 results and discuss the performance of our two operating segments, System and Services and Clear Aligners. John will provide more detail on our financial performance and our view for the remainder of the year. Following that, I'll come back, summarize a few key points and open the call to questions. Our third quarter results reflect the continued macroeconomic uncertainty and weaker consumer confidence as well as significant impact from unfavorable foreign exchange rates across currencies that affect our operations. On a constant currency basis, total Q3 revenues were reduced by $25 million or 2.7% sequentially and $57.4 million or 6.1% year-over-year, one of the largest quarterly foreign exchange impacts in our history. We remain confident in the execution of our strategic growth drivers despite the continuing economic headwinds. In Q3, we reached our 14 millionth Invisalign patient milestone during the quarter, which includes nearly 4 million teenagers and kids as young as six years old, who have been treated with Invisalign clear aligners. In Q3, teen case starts of 200,000 were up 13% sequentially and just off slightly compared to Q3 '21 a year ago when a record 206,000 teenagers started Invisalign treatment. We're also excited to be launching significantly new products and technologies that further enhance the Align Digital platform. Leading the digital transformation are the practice of dentistry, during the quarter we also began to commercialize ClinCheck live update software, Invisalign Practice App, Invisalign Personal Plan, Invisalign Smile Architect, the Invisalign Outcome Simulator Pro with in-face visualization, Cone Beam Computed Tomography integration with ClinCheck software Invisalign, virtual AI software and iTero-exocad Connector. These technology advancements represent an important expansion of our digital platform that we believe will help our doctor customers increase treatment efficiency and deliver superior clinical outcomes and patient experiences, positioning us to drive growth when the market inevitably rebounds. We'll be showcasing these innovations next month at the Invisalign Ortho Summit Las Vegas, the premier education and networking experience for Invisalign practices with the most peer-to-peer presentations of any Invisalign education event. Through Q3, Systems and Services, interest in our iTero scanners was good with increased product demos across the regions. Doctors are increasingly recognizing the substantial benefits of intraoral scanning and end-to-end digital workflows with the iTero scanner and imaging systems. At the same time, increasing inflation, rising interest rates and less patient traffic and dental practices are lengthening sales cycles and conversion time. For Q3, System and Services revenues of $157.5 million were down sequentially year-over-year. On a constant currency basis, unfavorable foreign exchange reduced Q3 '22 systems and services revenues by approximately $4.1 million or 2.5% sequentially and approximately $9.9 million or 5.9% year-over-year. For Q3, scanner services year-over-year revenue growth was strong across all regions, particularly due to increased subscription revenue driven by growth of the installed base of iTero scanners. Year-over-year growth also reflects increased sales of iTero warrants lease and continued growth of our scanner leasing rental programs. We continue to work closely with our doctor customers to support their practice growth and digital transformation goals. This includes understanding different ways to enable them to navigate to more uncertain economic environment. Over the past year, we've had good success rolling out new leasing programs in Latin America and certified pre-owned or CPO, as we call it, options in India and North America. We're also looking at new opportunities on the capital equipment side for our DSO partners. This is a natural progression in an equipment business with a large and growing installed base. As we introduce new products, there are more opportunities for customers to upgrade to make trade-ins and to provide refurbished scanners for emerging markets, too. We expect to continue to roll out programs that are especially helpful for customers in the current macroeconomic environment. It's selling the way doctors and customers want to do business and leveraging our balance sheet. We're still early. We're pleased with the contribution of margin accretion we're seeing. For our Clear Aligner segment, macroeconomic uncertainty and waiting consumer confidence continues to impact the dental market overall, making for a challenging operating environment across the board. For Q3, third-party reports indicate there are fewer new patient visits, less traffic flow and lower orthodontic case starts overall. Our Clear Aligner volumes further reflect the underlying orthodontic market trends and a shift away from adults toward teens in Q3. Q3 Clear Aligner revenues were down 8.2% sequentially and down 12.5% year-over-year compared to Q3 '21 year-over-year revenue growth rates of plus 35%. On a constant currency basis, Q3 '22 Clear Aligner revenues were reduced by unfavorable foreign exchange of approximately $21 million or approximately 2.8% sequentially and approximately $47.4 million or approximately 6.1% year-over-year. For the quarter, Q3 Aligner volumes reflect a sequential increase in Invisalign shipments from Asia-Pacific and Latin America as well as North America Invisalign teen cases offset by lower volume in EMEA and North America, primarily Invisalign adult cases. For Q3, Invisalign First for kids as young as 6 grew year-over-year and was strong across all regions. On a trailing 12-month basis, as of Q3, Invisalign Clear Aligner shipments for teens and young kids using Invisalign First up year-over-year to over 734,000 cases. For Q3, the total number of new Invisalign trained doctors increased sequentially 8.5% driven by North America and Asia-Pacific. In terms of Invisalign submitters, the total number of doctors shipped to for Q3 increased sequentially to 84,400 doctors, the second highest number this year, driven by Asia-Pacific and the Americas. From a channel perspective, ortho submitters were slightly year-over-year up especially from doctors submitting teen cases, offsetting -- offset by a few GP dentists year-over-year, especially in EMEA. For other non-case revenues, which include retention products such as Vivera retainers, clinical training and education, accessories, e-commerce and our new subscription programs such as our DSP, Q3 revenues were up both sequentially and year-over-year. This reflects strong growth in retainers sequentially and year-over-year growth across all regions, driven by more submitters. In U.S., revenues for our doctor subscription program increased sequentially and year-over-year. I'm very pleased to see continued momentum in non-case revenues driven by subscription-based programs that we expect to continue to expanding across the business. Now let's turn to the specifics around the third quarter results, starting with the Americas. The Q3 Invisalign case volumes for Americas was down sequentially single-digit percentages and primarily due to lower Invisalign bulk shipments. The environment remains challenging and feedback from our customers indicates consumer financing and patient no shows affecting their practices in Q3, especially with adult patients. Q3 Invisalign volume also reflects increased case submissions from orthodontic channel and sequential growth in the teen segment. For Q3, teen patients were most resilient, reflecting continued momentum in younger patients with Invisalign First as well as the new Invisalign Teen Case Pack. During Q3, Invisalign Teen Case Packs grew both sequentially and year-over-year. As a reminder, Invisalign Teen Case Pack, a new subscription program that enables orthodontists to buy Clear Aligners and packs in advance. They also include exclusive practice development benefits with the Invisalign brand and require an incremental volume commitment from doctors. Teen case packs are currently available in the U.S., Canada and France, and we expect to be expanded more in EMEA region. Turning to our international business for Q3, Invisalign Clear Aligner volume was down very slightly sequentially, 1.4%, with strong sequential growth for APAC, offset by lower volume in EMEA. For EMEA, Q3 operating environment was challenging. Inflation in the Eurozone is more than 10% and global macroeconomic factors weighed on consumer sentiment and purchasing decisions, especially for adult patients, which compounded the impact of Q3 summer seasonality. Similar to the Americas, doctors in EMEA also reported increased appointment cancellations and the impact of less patients financing their purchases. EMEA teen patients also resilient in Q3 increased sequentially in Iberia as well as France, where we introduced Teen case packs during the quarter. In APAC, Q3 sequential growth was led by China, Japan and ANZ despite ongoing COVID restrictions and lockdowns in parts of China and Japan. On a year-over-year basis, Invisalign case volumes reflected increased shipments across almost all markets, led by Taiwan, Thailand, India and Korea, driven by increased submitters. In Q3, APAC sequential growth also reflects strong demand from our expanded Invisalign Clear Aligner product portfolio in China. Recall in late April, Q2, we introduced two new products that better serve the expanding market in China. Invisalign Adult and Invisalign Standard Clear Aligners leverage our proven technology while broadening our appeal to more consumer segments. Q3 was the first full quarter offering these new products that provide doctors and patients in China with broader clinical and affordable options for moderate-to-complex adult cases. Finally, I'm pleased to share that the Invisalign system was recently awarded the Gold Design Award for 2022, making it the first orthodontic appliance to win the prestigious award in Japan. In the judge's assessment of the Invisalign system, they emphasized that the opportunity for teeth straightening is high in Japan and cited the barrier to adoption by Japanese consumers is resistance to metal braces and praised the Invisalign system as an orthodontic solution that can improve the quality of life during treatment. We certainly recognize the importance of the Japanese market for digital orthodontics and is one of the reasons we opened our first office in Tokyo nearly 15 years ago and established treatment planning operations in Yokohama a few years ago. Turning to new innovations. We continue to deliver our technology road map. As I mentioned earlier, during the quarter, we began to commercialize several new products and services that we previously announced would come to market in the second half of 2022. These technology advancements illustrate our commitment to continuous innovation in digital orthodontics, and we remain excited about the transformational projects that we're working on as we continue to drive the evolution of our industry. No other dental company has the experience, including over 14 million patients treated to date to lead the transformation of the practice of dentistry. Our consumer marketing focus on educating consumers about the Invisalign system and driving that demand to Invisalign doctor's offices ultimately capitalize on the massive market opportunity to transform 500 million smiles globally. In Q3, we built on our successful Invis Is media campaign and continued our launch of the Invis Is trauma free targeted at teens and Invis Is when everything clicks targeted at adults. Our teen campaign, Invis is trauma free highlights the benefits of Invisalign while humorously juxtaposing them with the significant trade-offs involved with using braces. Our Invis Is when everything clicks campaign showcases Invisalign treatment transforming smiles and the resulting confidence it gifts young adults. During Q3, we had over 4.3 billion impressions delivered in 14 million business to our website, a 1.6% year-over-year increase as a result of rightsizing our media investments. We're also rightsizing our consumer media investments across all core EMEA markets, impacting the impressions and unique visits. In U.S., we continued our influencer and creator-centric campaigns, partnering with leading smile squad creators like Olympic Gold Medalist, Suni Lee, Michael Lee, Josh Richards and Marsai Martin. Each of these creators share their personal experience of Invisalign treatment and why they chose to transform their smile with Invisalign aligners. Most recently, Suni Lee shared her positive experience with Invisalign in major media programming include Good Morning America, people.com, resulting in over 93 million impressions. We continue to invest in consumer advertising across APAC region, resulting in a 72% year-over-year increase in impressions and 29% year-over-year increase in unique visitors. Our ongoing campaigns were omnipresent across the top social media platforms such as TikTok, Snapchat, Instagram, and YouTube to increase the awareness of the Invisalign brand with young adults and teens. In Q3, we launched a global plot on the Roblox platform within the popular game, Livetopia, creating a fun experience for players to learn about the benefits of Invisalign treatment. To date, we had over 5.9 million impressions delivered in over 2.6 million unique visitors on the game experience. Adoption of My Invisalign Consumer and Patient app continues to increase with 2.2 million downloads to date. Usage of our key digital tools also continued to increase. Live update was used by 41,000 doctors or more than 395,000 cases, reduced time spent in modifying treatment by 18% and Invisalign Practice app has downloaded 314,000 times to date. Further, we received more than 110,000 patient photos in our virtual care capability to date, providing rich global data to leverage our AI capabilities and improve our services for doctors and patients. The investments that we make to drive patient demand and conversion to support our doctor customers is unparalleled in our industry, leveraging the global recognition of the Invisalign system. No other dental company equals our brand strength today. For more details on our consumer marketing programs, please see our Q3 '22 earnings and conference slides. Turning to exocad. Overall, I'm very pleased with our progress with the exocad business and its leadership and restorative dentistry. In addition to the iTero-exocad Connector, I mentioned previously, during the quarter, we also introduced iTero NIRI, NIRI is near infrared technology intraoral camera images and are now automatically imported into dental CAD when designing restorations, enabling technicians to visualize the internal and external tooth structure and optimize the process of margin line tracing. The new xSnap module is a model attachment for a printable 3D articulated system, featuring a spherical head, which allows a precisely executed movement. And Ivoclar's Ivotion Denture System, a complete workflow for digital production of high-quality removable dentures is now available on exocad. Together, the iTero and exocad product portfolios help accelerate the digital transformation of dental practices by facilitating the way doctors and labs collaborate to deliver better care for their patients. As part of the Align Digital platform, the integration of iTero's digital scanning and exocad's complete software solution delivers seamless end-to-end digital workflows from diagnosis to treatment, planning and then fabrication. Customers are already utilizing the automated workflows, unlocking efficiencies and productivities, which are more important than ever in the current economic climate. With the recent integration of iTero NIRI and intraoral camera images unique to iTero Element 5D imaging systems and exocad Rijeka software release, Align is redefining restorative visualization and treatment planning for the doctors and labs. We are committed to continuing innovating in the dental industry to drive efficiency and clinical excellence for the benefit of our customers and their patients. With that, I'll now turn it over to John.
John Morici: Thanks, Joe. Now for our Q3 financial results. Total revenues for the third quarter were $890.3 million, down 8.2% from the prior quarter and down 12.4% from the corresponding quarter a year ago. On a constant currency basis, Q3 2022 unfavorable foreign exchange reduced Q3 revenues by approximately $25.1 million sequentially and approximately $57.4 million year-over-year. For Clear Aligners, Q3 revenues up $732.8 million were down 8.2% sequentially primarily due to lower volumes, unfavorable foreign exchange, higher promotions and discounts and product mix shift, partially offset by higher additional aligners. On a year-over-year basis, Q3 Clear Aligner revenue were down 12.5%, primarily reflecting the aforementioned items, offset somewhat by per order processing fees and higher non-case revenues. On a constant currency basis, Q3 '22 unfavorable foreign exchange reduced Q3 Clear Aligner revenues by approximately $21 million or approximately 2.8% sequentially and approximately $47.4 million or approximately 6.1% year-over-year. For Q3, Invisalign ASPs for both comprehensive and noncomprehensive treatment decreased sequentially and year-over-year. On a sequential basis, the decline in ASPs reflect unfavorable impact from foreign exchange that Joe described earlier as well as higher discounts and product mix shift, partially offset by higher additional aligners. On a year-over-year basis, the decline in ASPs reflect the significant impact of unfavorable foreign exchange, product mix shift and higher discounts, partially offset by the higher additional aligners and per order processing fees. As our revenues from subscription, retainers and other ancillary products continue to grow and expand globally, some of the historical metrics that focus only on case shipments do not account for our overall growth. In our earnings release and financial slides, you will see that we have added our total Clear Aligner revenue per case shipment which is more indicative of our overall growth strategy. Clear Aligner deferred revenues on the balance sheet increased $37 million or 3.3% sequentially and $184 million or up 18.6% year-over-year and will be recognized as the additional aligners are shipped. During the three months ended September 30, 2022, we recognized $137.2 million that was included in the Clear Aligner deferred revenue balance at December 31, 2021. The Q3 Systems and Services revenue of $157.5 million were down 8% sequentially, primarily due to lower scanner volume, partially offset by higher services revenues from our larger installed base and were down 11.7% year-over-year, primarily due to lower scanner volume and lower ASP, partially offset by higher services revenue from our larger installed base. Q3 '22, Systems and Services revenue were unfavorably impacted by foreign exchange of approximately $4.1 million or approximately 2.5% sequentially. On a year-over-year basis, System and Services revenues were unfavorably impacted by foreign exchange of approximately $9.9 million or approximately 5.9%. Systems and Services deferred revenues on the balance sheet was up $4.1 million or 1.6% sequentially and up $76.5 million or 40.9% year-over-year, primarily due to the increase in scanner sales and the deferral of service revenues included with the scanner purchase, which will be recognized ratably over the service period. During the 3 months ended September 30, 2022, we recognized $13.3 million that was included in the Systems and Services deferred revenues balance as of December 31, 2021. Moving on to gross margin. Third quarter overall gross margin was 69.5% down 1.4 points sequentially and down 4.8 points year-over-year. Overall gross margin was unfavorably impacted by approximately 0.8 points sequentially and 1.8 points on a year-over-year basis due to the impact of foreign exchange on our revenues. Clear Aligner gross margin for the third quarter was 70.9% down 2.4 points sequentially due to lower ASPs and increased manufacturing spend as we continue to ramp up operations at our new manufacturing facility in Poland. Clear Aligner gross margin for the third quarter was down 5.3 points year-over-year due to increased manufacturing spend for the reasons stated previously, higher freight and a higher mix of additional aligner volume and lower ASPs. Systems and Services gross margin for the third quarter was 63.3%, up 3.6 points sequentially due to improved manufacturing absorption and lower freight costs. Systems and Services gross margin for the third quarter was down 2.3 points year-over-year due to higher inventory costs and manufacturing inefficiencies coupled with lower ASPs, partially offset by higher service revenues. Q3 operating expenses were $475.5 million, down sequentially 4.8% and down 3.7% year-over-year. On a sequential basis, operating expenses were down $23.9 million, mainly due to controlled spend on advertising and marketing as part of our efforts to proactively manage costs. Year-over-year, operating expenses decreased by $18.5 million for the same reasons as sequential as well as lower incentive compensation. On a non-GAAP basis, excluding stock-based compensation and amortization of acquired intangibles related to certain acquisitions, Operating expenses were $443.4 million, down sequentially 4.8% and down 4.9% year-over-year. Our third quarter operating income of $143.7 million resulted in an operating margin of 16.1%, down 3.3 points sequentially and down 9.6 points year-over-year. Operating margin was unfavorably impacted by approximately 1.6 points sequentially due to foreign exchange and lower gross margin. The year-over-year decrease in operating margin is primarily attributed to lower gross margin, investments in our go-to-market teams and technology as well as unfavorable impact from foreign exchange by approximately 3.5 points. On a non-GAAP basis, which excludes stock-based compensation and amortization of intangibles related to certain acquisition, the operating margin for the third quarter was 20.2%, down 3 points sequentially and down 8.6 points year-over-year. Interest and other income and expense net for the third quarter was a loss of $21 million compared to a loss of $14.6 million in Q2 and an income of $0.8 million in Q3 of '21, primarily due to larger net foreign exchange losses from the weakening of certain foreign currencies against the U.S. dollar. The GAAP effective tax rate for the third quarter was 40.7% and compared to 35% in the second quarter and 30.9% in the third quarter of the prior year. The third quarter GAAP effective tax rate was higher than the second quarter effective tax rate, primarily due to the decrease in profits and changes in jurisdictional mix of income, resulting in lower tax benefits from foreign income tax at different rates and higher than in the U.S. On a non-GAAP -- our non-GAAP effective tax rate was 33.1% in the third quarter compared to 25.6% in the second quarter and 22.2% in the third quarter of the prior year. Third quarter net income per diluted share was $0.93, down sequentially $0.51 and down $1.35 compared to the prior year. Our EPS was unfavorably impacted by $0.30 on a sequential basis and $0.48 on a year-over-year basis due to foreign exchange. On a non-GAAP basis, net income per diluted share was $1.36 for the third quarter, down $0.64 sequentially and down $1.51 year-over-year. Moving on to the balance sheet. As of September 30, 2022, cash, cash equivalents and short-term and long-term marketable securities were $1.1 billion, up sequentially $163.8 million and down $96.8 million year-over-year. Of the $1.1 billion balance, $471 million was held in the U.S. and $670 million was held by our international entities. Q3 accounts receivable balance was $859.6 million, down approximately 7.8% sequentially. Our overall days sales outstanding was 86 days, flat sequentially and up approximately 11 days as compared to Q3 last year. Cash flow from operations for the third quarter was $266.5 million. Capital expenditures for the third quarter were $75.3 million, primarily related to our continued investments to increase Aligne’r manufacturing capacity and facilities. Free cash flow, defined as cash flow from operations less capital expenditures amounted to $191.1 million. We are well capitalized to continue to invest for growth while managing through these challenging market conditions, exiting the quarter with over $1 billion in cash on the balance sheet and 0 debt. Now turning to full year 2022 and the factors that influence our views on our business outlook. Underlying market dynamics as well as the reactions to macroeconomic headwinds by central banks, governments and consumers remain uncertain. We will continue to focus on those matters that have been central to our historically successful business strategies by managing those things within our control. This includes maintaining fiscal controls and focused delivery on our business model so that we are positioned for success once the difficult operating environment ultimately abates. We remain confident in the huge underpenetrated market for the digital orthodontics and restorative dentistry, our technology and industry leadership and our ability to execute and make progress toward our long-term model of 20% to 30% revenue growth. We expect to be below our fiscal 2022 GAAP operating margin target of 20%, which includes the impact from the current unfavorable foreign exchange of approximately 2 points to 3 points that was not factored into our operating margin guidance for the fiscal year 2022 when we gave an update on the Q1 '22 earnings call in April. For 2022, we expect our investments in capital expenditures to exceed $300 million. Capital expenditures primarily relate to building construction and improvements as well as additional manufacturing capacity to support our international expansion. This includes our investment in the aligner fabrication facility in Wroclaw, Poland, which began servicing doctors in the second quarter of 2022. In addition, during Q4 2022, we expect to repurchase up to $200 million of our common stock through either or a combination of open market repurchases or an accelerated stock repurchase agreement. With that, I'll turn it back over to Joe for final comments. Joe?
Joe Hogan: Thanks, John. As we continue to navigate a macroeconomic uncertainty, weaker consumer confidence and the lingering impacts of COVID-19 shutdowns primarily in China and Japan, we remain focused on our strategic initiatives as well as the incredible market opportunity for digital dentistry and our products. We believe our unwavering drive to transform smiles and change lives for millions of people around the world is on one other clear aligner company can match and positions us to better address this market opportunity. Regardless of the operating environment, we are committed to balancing investments to drive growth and long-term strategic priorities that will transform the practice of dentistry and strengthen our business. These are uncertain times. Every business is being impacted by macroeconomic environmental uncertainty. In addition, as a multinational company based in the United States with roughly half of our sales outside the country, the negative impact from unfavorable foreign exchange has been like anything I've ever seen in my career. We will continue to invest in digital solutions and demand creation to help doctors and their patients. We are committed to doctor-directed care and transforming the industry together while working through these global macro economic challenges. Thank you for your time today. We look forward to updating you on our next earnings call. Now I'll turn the call over to the operator for questions. Operator?
Operator: [Operator Instructions] Our first question comes from Jason Bednar with Piper Sandler.
Jason Bednar: Joe, from what we've seen and heard in the market, I think it goes without saying that monthly demand has just been quite choppy here in the U.S. I think July and September were pretty darn soft, August, maybe not as weak, but still not great. I guess, did you see a similar level of uneven demand when we look outside the U.S. and I guess is there anything you'd call out geographically or in any of your channels that was maybe less bad than what you were prepared for three months ago?
Joe Hogan: Jason, we started with not high expectations to begin with, all right? But I would say the U.S. market panned out the way we thought overall, maybe a little more strength in Latin America, a little momentum despite the elections and some economics there. Europe just wasn't quite as strong as what we thought. And as we tried to explain in my notes that I really feel it's just -- it's the uncertainty that circulates Europe right now and Ukraine situation doesn't help either. From an Asia standpoint, we're affected by COVID again. We saw it in China, even though we had growth in China, which was respectable and in Japan also, but we saw the market impact in those two areas, too. I felt great about it's a smaller part of the business, but Korea, Taiwan, Thailand and other businesses that were up significantly, but our major three were still affected, primarily the three is Australia and China and Japan with some COVID issues. So it's a way of saying, I think in general, we anticipated where we are, we were hoping for the best year. But what really grabs me to, Jason, maybe I'm giving you too much for your call is that the teen demand, we felt good about overall across the globe in the United States, too. The teen packs did well overall. And obviously, we'll roll that out in other parts of the world, too. The adult -- the impact on the adult cases is what was -- to me, is astounding in the sense, and you see that flow through the orthodontic community, the GP community too. And that's not just in the United States, we see that all over the world. .
Jason Bednar: Maybe Joe or John, just on the margin topic, you are backing away from that 20% margin floor commentary that you had given previously. Fully understanding part of this is FX related. But maybe can you talk about how much of it's tied to the decremental impact from lower volumes. And then you fully understand this is a tough macro environment to forecast. But a lot of investors right now are really trying to get comfortable with how defensible margins and profitability are as we look out to 2023, which I hope it's not, but it could very well be another tough year for the business just given the global macro environment we're in. So just -- are you willing to provide any guardrails around what we can consider for 2023 margins? Or maybe talk about how much flexibility you have in the P&L to offset pressures from lower volumes?
Joe Hogan: Jason, it's a fair question. First of all, I'll turn it over to John, but I'm going to give that 20% operating margin piece. I had no idea. You'd see international currency swings. And way we've seen it. I've been in these jobs for a long time and you don't expect 25% decreases year-over-year in currency. And so obviously, we had to back up on that piece. I feel good about the way we manage our cost I feel good about where we're investing and where we continue to rightsize. John will give you more specifics.
John Morici: So on a constant currency basis, we expect to be at that 20% or above. It's just like Joe said, it's pretty dramatic to see the FX changes that we have. As noted in the comments, we said it going to affect the year by 2 to 3 points. So there's no -- there's a commitment to that margin, and we're investing based on volume that we see and other priorities that we have on R&D and go-to-market activities and so on. But it's just that FX piece that we're calling out. But on a constant currency basis, we feel that that number of 20% still holds from earlier.
Operator: Our next question comes from Brandon Velasquez with William Blair.
Brandon Velasquez: I wanted to go -- I'd like to go back for a second kind of to the monthly progression just to -- I think what might be helpful to kind of understand underlying market dynamics and maybe you can tease it out a little bit in Americas versus international. Just -- what were you seeing through the quarter where you -- did you exit the quarter and go into Q4? Were things stabilizing? Were they getting better? Were they getting worse? Any kind of color you can give us around what the situation is like as we go forward from Q3?
Joe Hogan: Again, like on the last call, Brendon, I think it played out the way our expectations, I think were formatted. We talked about teens in the third quarter. And obviously, that's teen season. That played out well from what we anticipated. And as we mentioned before, we think teens are somewhat shielded -- not completely, but shielded from the economic environment because of the time window for treatment and parents that want to help their teens through that whole process. The adult segment was the -- we saw the most volatility in for sure, both in the United States, Europe and in Asia. It's hard for me to tell you that we're -- there's any kind of change from month-to-month or quarter-to-quarter. It was pretty consistent from what we've seen. John, would you add anything else? .
Brandon Velasquez: I mean that's how we saw it. Okay. And then internationally, you guys sound pretty excited about kind of the new product launches within China, specifically offering that new maybe lower-tier product. Can you just talk a little bit about what you're seeing there? How strong has the recovery been in China? How much of that recovery has come from really opening up the product portfolio there? And how should that kind of continue going forward?
Joe Hogan: That's a good question. I mean, China is a very important market for us. As we talked about on other calls, those Tier 3 and Tier 4 cities have been an important target for us. We've known for about two years, we have a hole in our portfolio in those areas, particularly with -- we have comprehensive on top, and then we have a moderate product between it. So we announced Invisalign standard, Invisalign adult. And what this does is it just helps us segment the market. These are not -- they can't handle -- these products can have handle cases like Invisalign First Scan or mandibular advancement or some of the sophisticated cases we have out there. We don't offer CBCT 5-minute ClinCheck and those kind of things around those products, too. So we tailor those products for more moderate kinds of cases in those specific areas where public hospitals have been strong. And we really good results from the standpoint of what we saw in the uptake that we saw over this last quarter, and we'll continue with that strategy. We feel good about it.
John Morici: And it's about market expansion there. We're selling to more doctors than we've sold to in the past with these products. So we're really trying to capture more of that market, as Joe said, into Tier 3, Tier 4 cities, and we saw good uptake from that. And it's something that we know to go to the market and be able to reach these potential customers. These are the types of products that we need. .
Joe Hogan: Yes. So Brandon, I think honestly, I feel really good about our positioning there. China did perform well from a volume standpoint, and we'll continue to update on our progress. .
Operator: Our next question comes from John Block with Stifel.
John Block: Maybe just first first for me. The 3Q '22 ASP of 1150 versus 1220, so I'm calcing down 6% Q-over-Q. Some of that's FX, but I think if I look at your comments, it seems like half of that 6% headwind is FX. And John, I know you said mix, but I'm counting that teen was about 35% of your 3Q '22 cases versus 30% of your 2Q '22 cases and teen is a high acuity comprehensive ASP. I would think DSP is also helping pull out some of the lower ASP cases as DSP ramps quarter in, quarter out. So can you just help me with the ASP movement, what else was it outside of FX? And if it was mix, why mix based on my teen commentary?
John Morici: Yes, I think you've hit the major pieces, John. When you look at it majority was FX. We saw the dollar strengthening, that obviously hits our numbers. And then you look at the other parts, we do have a higher proportion of teen in the third quarter, and that's a help. We also have things that we've done like we answered on the previous call about mix in China and expansion out, and there's offsets to that. But it's primarily FX and then you have some mix. But from a discounting standpoint, or other things, there was really no overall change to how we've done stuff. It's primarily the FX piece and the mix.
Joe Hogan: John, one other thing to add to that, too, on the DSP program, we look at that as incremental, not as replacing other business that we've had in the past. So like we feel good that's an expansion play for us. And I think you see that in the numbers, too.
John Block: So maybe just quickly on that last point, Joe. Question on B would be, you don't really think any cases are being pulled out of the case volume number into DSP that's actually having an incremental negative impact to '22? Do you think those are just truly largely incremental. That was 1B, just to be clear.
Joe Hogan: Yes, I think you learn a business, John, never be binary, either or. I'd say the majority of those cases, if you look at it, we're picking up from an ortho standpoint, a lot of retention we never had before. We see orthos doing touch-up cases and all that might have been done in-house at times. So I'm not saying that there's absolutely nothing that would transpose from one to another, but I'd say primarily, we're looking at that as a growth opportunity for us.
John Block: And then the last question, and it's just where I struggle the most. I think sort of who cares, but my view on teen versus how you guys have positioned it with all due respect. And I get the teen 2Q to 3Q had a good sequential growth rate, but the 1Q to 3Q because 2Q was weak, was actually below trend on a four-year average throwing out 2020. And Joe, just -- if we can go down that road a little bit more, teen case volumes were still down 3% year-over-year. This whole story is about taking maybe 200 bps of share every year in this market. What do you think overall teen case volume was globally if you guys were down 3%? And maybe just really the questions about market share gains and if you still feel like you've got the momentum there or if that has slowed as of late and what can reaccelerate it?
Joe Hogan: Yes, John, again, that's a good question. I think when you talk about first quarter to second quarter, the rhythm that we had there, remember, the normal rhythms we've seen in this business, the seasonality, we call it. We have not seen that since really 2019. And so we had muted signals on teens through 2020, '21. Just -- it wasn't the same. What I liked about -- what I saw in the third quarter was we saw teens come back in the sense of in a pattern of what you'd expect in teen season, Q3, Q4. It's too early for me to dig out the data and tell you how much share we're gaining against wires and brackets. John, we don't talk about a lot or products like -- and we highlighted it here today, when you look at the Invisalign First product line, we're really getting tremendous results out there on young patients, 6 to 9 years old, the Phase I, Phase II treatments, where often the Phase II can be a lot less extensive than what the Phase I was with wires and brackets. So our different expansion devices. So we see a big uptake in that product line from a teen standpoint. We see that as penetration too. We've seen consistent growth from a share standpoint in those teen cases in Americas globally. So -- we just introduced curved wings mandibular advancement too that's having a really good start in the market, too, to address some cases that mandibular advancement couldn't get in the past. So John, both with technology, with our advertising campaigns, the teen packs and whatever, I continue to feel good about our movement. We'll have more as we analyze the trends, the share trends and stuff that we'll be able to share with you, but I do like our position in the marketplace in teens.
Operator: Our next question comes from Brandon Couillard with Jefferies.
Brandon Couillard: Just a question on just OpEx and how you're managing headcount, whether you pulled back in any parts of the business globally? And maybe just talk about the levers that might be at your disposal if the environment continues to deteriorate and maybe if there are some areas that would be ring-fenced as far as potential cuts.
Joe Hogan: Ben, it's Joe. Look, first of all, what I protect with my life here are our direct salespeople and also our technology and our engineering team and what we focus on. And so we've made sure that we continue to reinforce those. There's just other parts of our business, too, that we rightsized. I mean, obviously, this business is used to growing 20%, 30%. And so we kind of came into the year with that mindset. We quickly realized it wasn't. And so we've taken actions in order to do that. But you see that throughout the business. Don't forget, we also have really strong productivity programs and manufacturing and all, that really help us during these times. Emory and his team do a terrific job, they help to drive that. John will give you another insight in a sense of how we're managing OpEx across the business.
John Morici: We have good insight into our P&Ls across the world. So we're looking at country by country in certain regions and so on. And like Joe said, from an overall focus, we want to make sure that we're going to market and protecting the sales, make sure our R&D technology is putting out the best products and the best technology going forward. . So we protect that. And then we look at what expenses make sense in the short and long term in various regions, various campaigns that we have to make sure that we're getting the return that's appropriate given the market conditions. So we're constantly iterating and changing things. it's no different on the other side of things. When a year ago, we were looking at the growth opportunities. We're looking at it the same type of way kind of on a country-by-country, market-by-market basis is just the other way as it is now. So we feel like we have a good understanding of our return on investment and a good understanding of the levers that we need to pull or not pull given these conditions.
Brandon Couillard: And then John, just one follow-up. Can you help me just kind of understand what's going on with the inventory line and why that continues to grow year-over-year and sequentially. Is there something tied to the new European fab facility that may be driving that? And what we should expect on that line in the next few quarters?
John Morici: Yes. I think we're kind of getting to -- we kind of get to a point where some of that is due to just the fact that you have a third manufacturing site, and you're going to have raw materials related to that and other in-process inventory and so on there. So you're going to have some of that. Some of it is also on the iTero side where you're manufacturing and you're doing some things where you're securing supply. I mean there's been a lot of talk and we feel good about our supply to be able to components and so on. We've purchased several components just to make sure that we had adequate supply for our forecast and so on. But nothing out of the ordinary other than some expansion that we have with new manufacturing and then making sure that we secured our supply lines, and that's what we've seen in our numbers. .
Operator: Our next question comes from Jeff Johnson with Baird. Your line is open.
Jeff Johnson: So Joe, I want to pin you down a little bit on a couple of things, if I could here that questions that have been asked. And on the teen packs especially, I mean, look, we know there were so many adult cases last year with the assume a factor, whatever we want to call it and stimulus spending and all that. But the teen number is obviously the important number. I think we're all trying to focus on here. The down 3%, I think is what you said year-over-year, up sequentially. That's down 3% year-over-year on teen cases globally. I mean, how do you feel like that compares to the overall ortho market? Were you better or worse than other teen cases done with brackets and wires when you throw in other clear aligners from the competitors, things like that? Just how are you competing in that teen market right now?
Joe Hogan: Jeff, it's a fair question. I'd first take it to Europe. I mean Europe was down substantially for us, too. So I don't think we've got a clear signal out of there because of the economics and in general. I mean we did fairly well in -- from a European standpoint. But third quarter in Europe is never a particularly strong quarter. We're going to pull a signal out of -- you look at the United States, you go to Gaidge Data. And you'll see that inside Gaidge Data aligners were down but Invisalign was actually above what the generic aligners are reported in Gaidge data, which says we continue to do well with our teen portfolio and what we do. . You see wires and brackets cases actually expanded. But what that is, is you see if they're doing more -- fewer adults -- and you know how orthos have held on to teens for a long time, you get a mix phenomenon there where it looks like they're doing more wires and brackets, but they're not. They're just doing fewer adults, and they mix down in that sense. So -- and then move over to Asia, I've always felt good about Asia is different by country. But the COVID overlay in Japan in particular, but also China. I thought the teen case volume was still reasonable. But it's still hard to pull a signal out of a lot of noise with the COVID shutdowns in all of those countries. So again, just like in John's question, Jeff, is I do feel great about our portfolio. I feel good about how we're positioning the product. I think the teen packs are a way to sell the way doctors want to commit in this area, I think we'll continue to get strong there. The future of those teen cases, there's no question it's digital. It's just how we approach it, the products we launch and convincing doctors more and more that teens will use these and showing them the results that we're seeing all over the world.
Jeff Johnson: Yes. Fair enough. All right. And then I'm going to jam two questions together, kind of ala John Black here, I'll call it, 2A and 2B and other separate questions. But any update on volume-based procurement in China, how we should think about that? And then I didn't see a breakout for Americas versus international doctors shipped to. You provided that in the past. Any way we could get that number this time?
John Morici: Well, on the doctor shipped to, what we've done is consolidate them together to a total. And what we saw, if you looked at international versus domestic, they're both up. And the numbers that we had. This is actually our second highest ever from a shipped to standpoint. But we decided to consolidate those together without giving too much more details on that. But they're both up.
Jeff Johnson: Sequentially, John, just to be clear?
John Morici: Yes. Yes.
Jeff Johnson: John, both up sequentially. Sorry, Joe. .
John Morici: Yes, yes, correct. .
Joe Hogan: Yes, on sequential. On the volume-based purchasing in China, we have our eyes all over, Jeff, as you can guess. It represents anywhere between 15% and 18% of our business there. The way they're setting this up, pretty much in what we would call not our main areas in where we do business in China. I think we've positioned ourselves for this. strategically, I feel we can make the right move here. Look, I have friends and other medical device businesses. I was in the medical devices for a while. We know what this did to stents and hip transplants and different things. I feel like the way they set this up, one is 70% of it will be BBP in those areas, 30% will still be up to the doctors in the sense of what they want to use and how they want to use it. So what's key here is that we exercise our portfolio and the capacity that we have over there to just have a strategic positioning in that. So I don't expect any major differences as we move into 2023. We'll just have to wait to see how that goes. And as we move into 2024, 2025, how the government -- which way the government moves.
Operator: Our next question comes from Elizabeth Anderson with Evercore ISI.
Elizabeth Anderson: I guess my first question is just on equipment line. I noticed you sort of talking more about leased equipment in the quarter. Can you sort of talk about how that's been growing and sort of what contribution that made to the equipment revenues in the quarter?
John Morici: Yes, I can start with that. It's obviously a strategy that we have. We've got great equipment, great products, and we want to be able to get those to our customers in a way that they want to buy. Sometimes those doctors of ours don't necessarily want to purchase it outright. They want to try other things. And so we've tested in certain markets, just alternatives, kind of the rental model and so on. And we see good uptake. We see them these doctors now wanting to get a scanner to be able to digitize their practice. So it's really at early stage right now, Elizabeth, but it is something that when we think about how we want to go to market, we want to offer alternatives such as leasing or expanding rental or other parts of our business are going to see the certified preowned where you have upgrades and other things that happen as we have a larger and larger installed base, we're going to get some of that equipment back. We want to be able to have a mechanism to be able to use that equipment, use it in other places, and give our customers alternatives, both in terms of the equipment that they can purchase from us and then how they purchase and use that equipment from a financing or maybe leasing or rental options. And we think that they'll end up using our equipment more and more. And then we know that helps from a digital standpoint when they use their equipment and then they'll end up using more Invisalign. So it all kind of works from an ecosystem standpoint.
Elizabeth Anderson: And then just in terms of on the P&L, like one of the things that, obviously, saw the change in SG&A spend in the quarter and how you pulled back on spending there. What about on the R&D line? Do you sort of see an opportunity to pull back on R&D as well going forward? Or is that something you're sort of keener to defend going forward? .
Joe Hogan: Elizabeth, it's Joe. We want to defend R&D. Very important part of the business. You can see the programs are rolling out. The programs we're rolling out, we didn't do them this year, right? Some of these are 3-year old programs that we've been working on. And so I don't want to stop the momentum on those. I mean obviously, we'll take any steps here to preserve the cash flow and integrity of this business that we have to do. But our front lines are our sales organization and technology. And before we go anywhere near those, we want to make sure we do everything we can, the right size of business in other areas.
Elizabeth Anderson: And then just in terms of my 2B question, in terms of like what you're seeing through the month of October so far, if we're sort of thinking about how the cadence of 4Q is shaping up, which is to expect like the cases to be sort of flat sequentially at this point based on what you're seeing? Or like how do we think about sort of where we are now?
Joe Hogan: Kind of anticipating that question is, we're not seeing any major change, I'd say, from the momentum that we saw in the second quarter. .
Elizabeth Anderson: You mean the third quarter?
Joe Hogan: I'm sorry, third quarter. That's right, a little bit...
Operator: Our next question comes from Erin Wright with MS. Your line is now open.
Erin Wright: So how should we think about underlying ASPs going forward, excluding the FX dynamics from here just given some of the mix dynamics you noted. And FX is FX, and that's understandable. But if we do continue to see what we're seeing in terms of the macro environment, what do we think about in terms of trough margins from here? And do you see an opportunity for a sort of recovery near term? Or any sort of margin expansion? Anything you can give us on that front would be helpful.
John Morici: Yes. Obviously, Erin, this is John. Obviously, gross margin, op margins is a primary concern for us. We want to make sure that we're managing things appropriately. From an ASP standpoint, take FX out of this and really FX out of our margin because it's hard to so much coming through from a P&L standpoint. But we're always looking at productivity to be able to help drive the business. And as we scale up Poland is a great example, we'll become more productive there, and that will help our margin. It's kind of in our margins right now as an impact, but it will get better over time through utilization. . We look at the technology that we have in the business and what it means from an ASP standpoint. And our customers understand that. There's always going to be geographical mix shifts that happen. Certain parts of the world are at different times throughout the year. But I don't expect a dramatic shift in our overall ASPs. Take FX out of it from an overall ASP standpoint and then we're really focused on what can we do to look at savings that help us from a gross margin standpoint and see that. And then also on an op margin standpoint for all the OpEx things that we previously talked about.
Erin Wright: And then just going back to Elizabeth's question on the quarterly cadence. Just in the teen market, in particular, what are you seeing in terms of typical seasonality there? And did you see some of that momentum continuing here into the fourth quarter in that particular segment? Or how should we be thinking about the quarter-to-quarter cadence given -- relative to what you typically see from a seasonal standpoint. .
Joe Hogan: The teen market predominantly, if we look at the third quarter. Obviously, a bleed some into the fourth quarter, whatever, but I wouldn't take anything we're seeing right now and projected into the future to change what the normal fourth quarter sequence could be. So like I said previously on the question as far as when you look at third quarter moving in the fourth quarter, we're not seeing any meaningful change one way or another.
Operator: Our next question comes from Nathan Rich from Goldman Sachs. Your line is now open.
Nathan Rich: If I could go back to margins for a minute. You mentioned not changing the target for this year on a constant currency basis. I guess -- if I could maybe ask the question this way, if we don't see further changes to FX or the kind of overall demand environment, do you think the 16% margin that you saw this quarter on a GAAP basis is indicative of what we should assume going forward, again, kind of -- assuming no kind of changes in the underlying environment? .
John Morici: I wouldn't take that. I think when we're talking about for the full year, we're kind of looking at kind of that on a constant currency basis, that 20%. And I think you have impacts with Poland startup and some other things in the quarter that are impacting that. But when we look at the 20% and what we were calling earlier in the year, we were thinking about that less about the quarters, but on a -- more on a total year basis on a constant currency basis.
Nathan Rich: Okay. And the FX headwind for the year on margins is that 2% to 3%?
John Morici: That's the way to look at it, Nate. It's -- we're kind of looking at -- as best as we can call it now, we're kind of using the latest FX rates that you have now. It's up to predict what's going to happen in the next 2 months. But if you took kind of currently and kind of what we've done throughout the year and then use the current FX rates, we think that's a 2- to 3-point impact. And without that FX rates, we -- our GAAP numbers would have been at the 20%, like we called.
Nathan Rich: If I could just ask a quick follow-up. Joe, I think you had noted less willingness of consumers to finance treatments in both the U.S. and Europe. How big is that as a percent of case volumes in terms of what's typically financed? And how much in particular kind of might have this weight on demand? And I guess, bigger picture, are there ways kind of in this environment that you kind of see as kind of maybe being best able to stimulate demand just in terms of how you might either help customers or doctors in this environment?
Joe Hogan: Yes, Nathan, I think what we gave you is basically data that we receive from the marketplace. It's what we're hearing from orthodontists and dentists in general in treatment. We don't have any quantification to say so many patients were seeking funding, they didn't get it or there's so many losses in that sense. That's pretty much listed as the reasons why patients have refused treatment or thinking about treatment in the financial considerations of it. John, would you?
John Morici: No, I think you're always going to have a mix of -- some patients, they'll pay for it all upfront. Some will finance either through the doctor or some outside group. And I think you're constantly going to have that. We do think as much as we can with our doctors to give them some of the financial flexibility, so that as they maybe have additional terms where they pay us, the doctors, they can maybe apply some of that to their patients, and they can help their patients as well, manage some of the cash flow. So we're aware of it. We do as much as we can. It's just kind of out there. And like Joe said, we don't have a quantification of it, but in tougher economic times, we know that patients will be looking for different alternatives.
Joe Hogan: And the other part of your question, Nick, about how do we help accounts. We watch payments. We try to help in that sense at times. We try to drive direct Invisalign docs to do a lot of Invisalign. And obviously, our advertising is extremely important to them. So we have our whole lead program to help them drive those things. We just want to be as close to our customers as possible because they're feeling what we feel. And we have strong relationships with many of them, and they're part of the family here. And we work it country by country, doctor by doctor, region by region to see how we can help. .
Shirley Stacy: Operator, we'll take one more question, please.
Operator: Our final question comes from Kevin Caliendo with UBS.
Kevin Caliendo: So may have found a little bit on the comment around October, saying that the momentum continued. If we think about that, that was sort of down 12%, right, year-over-year. I think what we're all looking for is we saw cases flat Q1 to Q2. And then we saw a step down in Q3 despite a stronger teen season. So I think what we're all trying to figure out here is adjusting for the third quarter strength, seasonality in teen, when do you actually expect to see stabilization globally in cases, meaning either sequentially or year-over-year flatness? Like when do you actually expect that, that could happen?
Joe Hogan: Kevin, it's Joe. Look, I think we can sit here and tell you, I think we're in pretty volatile economic times. I can't tell you what the dollar is going to be in 3 months. I don't know what's going to happen in Europe. I don't know how bad COVID hits China. I don't know what it does in Japan. So I know exactly what you're asking for and every investor is asking for. And we'd give you that data if we thought we had it, but we are in such a volatile time right now. We're just working this thing from month to month. As I mentioned, as we go into the fourth quarter, obviously, there's a rhythm between teens and adults from the third quarter to the fourth quarter. What I mentioned from a continuation standpoint is we haven't seen much of a change between the third and the fourth right now as we move into it. That's about as well as I can tell you of what we're seeing and what we're experiencing, trying to forecast what's going to happen toward the end of the quarter, next quarter, I can't do that. I don't think anybody here can.
Kevin Caliendo: And if I can just ask a follow-up. There's been a lot of talk about spending and margins in 20% and everything else. And historically, in the past, you guys always just invested to grow. Is it now given the uncertainty of everything that you're just going to manage through a margin or try to manage to the 20% margin ex FX? Or -- I mean, is that the strategy? Or is it still to try to get back to the -- what you would need to do normally to hit certain growth targets that you've had?
Joe Hogan: It's a growth business, Kevin. If we had good economic times here, I can tell you, we'd be having a much different conversation. So the challenge with this business is how are we responsible on cost and obviously, a challenged demand environment [indiscernible] this company very strong because when this market comes back, you just go back in history and take a look, it comes back and it comes back hard. And we've got to make sure that we're in a good position to be able to field that when it does occur. So you'll see us be, what I call, fiscally responsible, but we'll continue to make sure that we invest and make as many changes as we can around different areas of OpEx, but to protect those key areas where our customer interface and the development of our technology. And actually, the operations capacity we need in this business when this thing does bring back. And that's not just in manufacturing aligners. That's in being able to service customers across the board. So you'll see us balance that well as we should do from a leadership standpoint.
Shirley Stacy: Well, thank you, everyone, for joining us today. We appreciate your time and look forward to speaking with you at upcoming financial conferences and industry meetings, including the Ortho Summit in Las Vegas next month. If you have any further questions or follow-up, please contact our Investor Relations team. Have a great day .
Operator: That concludes the conference call. Thank you for your participation. You may now disconnect your lines. | [
{
"speaker": "Operator",
"text": "Greetings. Welcome to the Align Q3 2022 Earnings Call. At this time, all participants are in a listen-only mode. A question and answer session will follow the formal presentation. Please note this conference will be recorded. I would now like to turn the conference over to our host, Shirley Stacy, with Align Technology. You may begin."
},
{
"speaker": "Shirley Stacy",
"text": "Good afternoon, and thank you for joining us. I'm Shirley Stacy, Vice President of Corporate Communications and Investor Relations. Joining me for today's call is Joe Hogan, President and CEO; and John Morici, CFO. We issued third quarter 2022 financial results today via Business Wire, which is available on our website at investor.aligntech.com. Today's conference call is being audio webcast and will be archived on our website for approximately 1 month. A telephone replay will be available today by approximately 5:30 p.m. Eastern time through 5:30 p.m. Eastern time on November 9. To access the telephone replay, domestic callers should dial (866) 813-9403 with access code 119351. International callers should dial (929)458-6194 using the same access code. As a reminder, the information provided and discussed today will include forward-looking statements, including statements about Align's future events and product outlook. These forward-looking statements are only predictions and involve risks and uncertainties and that are described in more detail in our most recent periodic reports filed with the Securities and Exchange Commission available on our website and at sec.gov. Actual results may vary significantly, and Align expressly assumes no obligation to update any forward-looking statements. We have posted historical financial statements, including the corresponding reconciliations, including our GAAP to non-GAAP reconciliations, if applicable, and our third quarter 2022 conference call slides on our website under quarterly results. Please refer to these files for more detailed information. And with that, I'd like to turn the call over to Align Technology's President and CEO, Joe Hogan. Joe?"
},
{
"speaker": "Joe Hogan",
"text": "Thanks, Shirley. Good afternoon, and thanks for joining us. On our call today, I'll provide an overview of our Q3 results and discuss the performance of our two operating segments, System and Services and Clear Aligners. John will provide more detail on our financial performance and our view for the remainder of the year. Following that, I'll come back, summarize a few key points and open the call to questions. Our third quarter results reflect the continued macroeconomic uncertainty and weaker consumer confidence as well as significant impact from unfavorable foreign exchange rates across currencies that affect our operations. On a constant currency basis, total Q3 revenues were reduced by $25 million or 2.7% sequentially and $57.4 million or 6.1% year-over-year, one of the largest quarterly foreign exchange impacts in our history. We remain confident in the execution of our strategic growth drivers despite the continuing economic headwinds. In Q3, we reached our 14 millionth Invisalign patient milestone during the quarter, which includes nearly 4 million teenagers and kids as young as six years old, who have been treated with Invisalign clear aligners. In Q3, teen case starts of 200,000 were up 13% sequentially and just off slightly compared to Q3 '21 a year ago when a record 206,000 teenagers started Invisalign treatment. We're also excited to be launching significantly new products and technologies that further enhance the Align Digital platform. Leading the digital transformation are the practice of dentistry, during the quarter we also began to commercialize ClinCheck live update software, Invisalign Practice App, Invisalign Personal Plan, Invisalign Smile Architect, the Invisalign Outcome Simulator Pro with in-face visualization, Cone Beam Computed Tomography integration with ClinCheck software Invisalign, virtual AI software and iTero-exocad Connector. These technology advancements represent an important expansion of our digital platform that we believe will help our doctor customers increase treatment efficiency and deliver superior clinical outcomes and patient experiences, positioning us to drive growth when the market inevitably rebounds. We'll be showcasing these innovations next month at the Invisalign Ortho Summit Las Vegas, the premier education and networking experience for Invisalign practices with the most peer-to-peer presentations of any Invisalign education event. Through Q3, Systems and Services, interest in our iTero scanners was good with increased product demos across the regions. Doctors are increasingly recognizing the substantial benefits of intraoral scanning and end-to-end digital workflows with the iTero scanner and imaging systems. At the same time, increasing inflation, rising interest rates and less patient traffic and dental practices are lengthening sales cycles and conversion time. For Q3, System and Services revenues of $157.5 million were down sequentially year-over-year. On a constant currency basis, unfavorable foreign exchange reduced Q3 '22 systems and services revenues by approximately $4.1 million or 2.5% sequentially and approximately $9.9 million or 5.9% year-over-year. For Q3, scanner services year-over-year revenue growth was strong across all regions, particularly due to increased subscription revenue driven by growth of the installed base of iTero scanners. Year-over-year growth also reflects increased sales of iTero warrants lease and continued growth of our scanner leasing rental programs. We continue to work closely with our doctor customers to support their practice growth and digital transformation goals. This includes understanding different ways to enable them to navigate to more uncertain economic environment. Over the past year, we've had good success rolling out new leasing programs in Latin America and certified pre-owned or CPO, as we call it, options in India and North America. We're also looking at new opportunities on the capital equipment side for our DSO partners. This is a natural progression in an equipment business with a large and growing installed base. As we introduce new products, there are more opportunities for customers to upgrade to make trade-ins and to provide refurbished scanners for emerging markets, too. We expect to continue to roll out programs that are especially helpful for customers in the current macroeconomic environment. It's selling the way doctors and customers want to do business and leveraging our balance sheet. We're still early. We're pleased with the contribution of margin accretion we're seeing. For our Clear Aligner segment, macroeconomic uncertainty and waiting consumer confidence continues to impact the dental market overall, making for a challenging operating environment across the board. For Q3, third-party reports indicate there are fewer new patient visits, less traffic flow and lower orthodontic case starts overall. Our Clear Aligner volumes further reflect the underlying orthodontic market trends and a shift away from adults toward teens in Q3. Q3 Clear Aligner revenues were down 8.2% sequentially and down 12.5% year-over-year compared to Q3 '21 year-over-year revenue growth rates of plus 35%. On a constant currency basis, Q3 '22 Clear Aligner revenues were reduced by unfavorable foreign exchange of approximately $21 million or approximately 2.8% sequentially and approximately $47.4 million or approximately 6.1% year-over-year. For the quarter, Q3 Aligner volumes reflect a sequential increase in Invisalign shipments from Asia-Pacific and Latin America as well as North America Invisalign teen cases offset by lower volume in EMEA and North America, primarily Invisalign adult cases. For Q3, Invisalign First for kids as young as 6 grew year-over-year and was strong across all regions. On a trailing 12-month basis, as of Q3, Invisalign Clear Aligner shipments for teens and young kids using Invisalign First up year-over-year to over 734,000 cases. For Q3, the total number of new Invisalign trained doctors increased sequentially 8.5% driven by North America and Asia-Pacific. In terms of Invisalign submitters, the total number of doctors shipped to for Q3 increased sequentially to 84,400 doctors, the second highest number this year, driven by Asia-Pacific and the Americas. From a channel perspective, ortho submitters were slightly year-over-year up especially from doctors submitting teen cases, offsetting -- offset by a few GP dentists year-over-year, especially in EMEA. For other non-case revenues, which include retention products such as Vivera retainers, clinical training and education, accessories, e-commerce and our new subscription programs such as our DSP, Q3 revenues were up both sequentially and year-over-year. This reflects strong growth in retainers sequentially and year-over-year growth across all regions, driven by more submitters. In U.S., revenues for our doctor subscription program increased sequentially and year-over-year. I'm very pleased to see continued momentum in non-case revenues driven by subscription-based programs that we expect to continue to expanding across the business. Now let's turn to the specifics around the third quarter results, starting with the Americas. The Q3 Invisalign case volumes for Americas was down sequentially single-digit percentages and primarily due to lower Invisalign bulk shipments. The environment remains challenging and feedback from our customers indicates consumer financing and patient no shows affecting their practices in Q3, especially with adult patients. Q3 Invisalign volume also reflects increased case submissions from orthodontic channel and sequential growth in the teen segment. For Q3, teen patients were most resilient, reflecting continued momentum in younger patients with Invisalign First as well as the new Invisalign Teen Case Pack. During Q3, Invisalign Teen Case Packs grew both sequentially and year-over-year. As a reminder, Invisalign Teen Case Pack, a new subscription program that enables orthodontists to buy Clear Aligners and packs in advance. They also include exclusive practice development benefits with the Invisalign brand and require an incremental volume commitment from doctors. Teen case packs are currently available in the U.S., Canada and France, and we expect to be expanded more in EMEA region. Turning to our international business for Q3, Invisalign Clear Aligner volume was down very slightly sequentially, 1.4%, with strong sequential growth for APAC, offset by lower volume in EMEA. For EMEA, Q3 operating environment was challenging. Inflation in the Eurozone is more than 10% and global macroeconomic factors weighed on consumer sentiment and purchasing decisions, especially for adult patients, which compounded the impact of Q3 summer seasonality. Similar to the Americas, doctors in EMEA also reported increased appointment cancellations and the impact of less patients financing their purchases. EMEA teen patients also resilient in Q3 increased sequentially in Iberia as well as France, where we introduced Teen case packs during the quarter. In APAC, Q3 sequential growth was led by China, Japan and ANZ despite ongoing COVID restrictions and lockdowns in parts of China and Japan. On a year-over-year basis, Invisalign case volumes reflected increased shipments across almost all markets, led by Taiwan, Thailand, India and Korea, driven by increased submitters. In Q3, APAC sequential growth also reflects strong demand from our expanded Invisalign Clear Aligner product portfolio in China. Recall in late April, Q2, we introduced two new products that better serve the expanding market in China. Invisalign Adult and Invisalign Standard Clear Aligners leverage our proven technology while broadening our appeal to more consumer segments. Q3 was the first full quarter offering these new products that provide doctors and patients in China with broader clinical and affordable options for moderate-to-complex adult cases. Finally, I'm pleased to share that the Invisalign system was recently awarded the Gold Design Award for 2022, making it the first orthodontic appliance to win the prestigious award in Japan. In the judge's assessment of the Invisalign system, they emphasized that the opportunity for teeth straightening is high in Japan and cited the barrier to adoption by Japanese consumers is resistance to metal braces and praised the Invisalign system as an orthodontic solution that can improve the quality of life during treatment. We certainly recognize the importance of the Japanese market for digital orthodontics and is one of the reasons we opened our first office in Tokyo nearly 15 years ago and established treatment planning operations in Yokohama a few years ago. Turning to new innovations. We continue to deliver our technology road map. As I mentioned earlier, during the quarter, we began to commercialize several new products and services that we previously announced would come to market in the second half of 2022. These technology advancements illustrate our commitment to continuous innovation in digital orthodontics, and we remain excited about the transformational projects that we're working on as we continue to drive the evolution of our industry. No other dental company has the experience, including over 14 million patients treated to date to lead the transformation of the practice of dentistry. Our consumer marketing focus on educating consumers about the Invisalign system and driving that demand to Invisalign doctor's offices ultimately capitalize on the massive market opportunity to transform 500 million smiles globally. In Q3, we built on our successful Invis Is media campaign and continued our launch of the Invis Is trauma free targeted at teens and Invis Is when everything clicks targeted at adults. Our teen campaign, Invis is trauma free highlights the benefits of Invisalign while humorously juxtaposing them with the significant trade-offs involved with using braces. Our Invis Is when everything clicks campaign showcases Invisalign treatment transforming smiles and the resulting confidence it gifts young adults. During Q3, we had over 4.3 billion impressions delivered in 14 million business to our website, a 1.6% year-over-year increase as a result of rightsizing our media investments. We're also rightsizing our consumer media investments across all core EMEA markets, impacting the impressions and unique visits. In U.S., we continued our influencer and creator-centric campaigns, partnering with leading smile squad creators like Olympic Gold Medalist, Suni Lee, Michael Lee, Josh Richards and Marsai Martin. Each of these creators share their personal experience of Invisalign treatment and why they chose to transform their smile with Invisalign aligners. Most recently, Suni Lee shared her positive experience with Invisalign in major media programming include Good Morning America, people.com, resulting in over 93 million impressions. We continue to invest in consumer advertising across APAC region, resulting in a 72% year-over-year increase in impressions and 29% year-over-year increase in unique visitors. Our ongoing campaigns were omnipresent across the top social media platforms such as TikTok, Snapchat, Instagram, and YouTube to increase the awareness of the Invisalign brand with young adults and teens. In Q3, we launched a global plot on the Roblox platform within the popular game, Livetopia, creating a fun experience for players to learn about the benefits of Invisalign treatment. To date, we had over 5.9 million impressions delivered in over 2.6 million unique visitors on the game experience. Adoption of My Invisalign Consumer and Patient app continues to increase with 2.2 million downloads to date. Usage of our key digital tools also continued to increase. Live update was used by 41,000 doctors or more than 395,000 cases, reduced time spent in modifying treatment by 18% and Invisalign Practice app has downloaded 314,000 times to date. Further, we received more than 110,000 patient photos in our virtual care capability to date, providing rich global data to leverage our AI capabilities and improve our services for doctors and patients. The investments that we make to drive patient demand and conversion to support our doctor customers is unparalleled in our industry, leveraging the global recognition of the Invisalign system. No other dental company equals our brand strength today. For more details on our consumer marketing programs, please see our Q3 '22 earnings and conference slides. Turning to exocad. Overall, I'm very pleased with our progress with the exocad business and its leadership and restorative dentistry. In addition to the iTero-exocad Connector, I mentioned previously, during the quarter, we also introduced iTero NIRI, NIRI is near infrared technology intraoral camera images and are now automatically imported into dental CAD when designing restorations, enabling technicians to visualize the internal and external tooth structure and optimize the process of margin line tracing. The new xSnap module is a model attachment for a printable 3D articulated system, featuring a spherical head, which allows a precisely executed movement. And Ivoclar's Ivotion Denture System, a complete workflow for digital production of high-quality removable dentures is now available on exocad. Together, the iTero and exocad product portfolios help accelerate the digital transformation of dental practices by facilitating the way doctors and labs collaborate to deliver better care for their patients. As part of the Align Digital platform, the integration of iTero's digital scanning and exocad's complete software solution delivers seamless end-to-end digital workflows from diagnosis to treatment, planning and then fabrication. Customers are already utilizing the automated workflows, unlocking efficiencies and productivities, which are more important than ever in the current economic climate. With the recent integration of iTero NIRI and intraoral camera images unique to iTero Element 5D imaging systems and exocad Rijeka software release, Align is redefining restorative visualization and treatment planning for the doctors and labs. We are committed to continuing innovating in the dental industry to drive efficiency and clinical excellence for the benefit of our customers and their patients. With that, I'll now turn it over to John."
},
{
"speaker": "John Morici",
"text": "Thanks, Joe. Now for our Q3 financial results. Total revenues for the third quarter were $890.3 million, down 8.2% from the prior quarter and down 12.4% from the corresponding quarter a year ago. On a constant currency basis, Q3 2022 unfavorable foreign exchange reduced Q3 revenues by approximately $25.1 million sequentially and approximately $57.4 million year-over-year. For Clear Aligners, Q3 revenues up $732.8 million were down 8.2% sequentially primarily due to lower volumes, unfavorable foreign exchange, higher promotions and discounts and product mix shift, partially offset by higher additional aligners. On a year-over-year basis, Q3 Clear Aligner revenue were down 12.5%, primarily reflecting the aforementioned items, offset somewhat by per order processing fees and higher non-case revenues. On a constant currency basis, Q3 '22 unfavorable foreign exchange reduced Q3 Clear Aligner revenues by approximately $21 million or approximately 2.8% sequentially and approximately $47.4 million or approximately 6.1% year-over-year. For Q3, Invisalign ASPs for both comprehensive and noncomprehensive treatment decreased sequentially and year-over-year. On a sequential basis, the decline in ASPs reflect unfavorable impact from foreign exchange that Joe described earlier as well as higher discounts and product mix shift, partially offset by higher additional aligners. On a year-over-year basis, the decline in ASPs reflect the significant impact of unfavorable foreign exchange, product mix shift and higher discounts, partially offset by the higher additional aligners and per order processing fees. As our revenues from subscription, retainers and other ancillary products continue to grow and expand globally, some of the historical metrics that focus only on case shipments do not account for our overall growth. In our earnings release and financial slides, you will see that we have added our total Clear Aligner revenue per case shipment which is more indicative of our overall growth strategy. Clear Aligner deferred revenues on the balance sheet increased $37 million or 3.3% sequentially and $184 million or up 18.6% year-over-year and will be recognized as the additional aligners are shipped. During the three months ended September 30, 2022, we recognized $137.2 million that was included in the Clear Aligner deferred revenue balance at December 31, 2021. The Q3 Systems and Services revenue of $157.5 million were down 8% sequentially, primarily due to lower scanner volume, partially offset by higher services revenues from our larger installed base and were down 11.7% year-over-year, primarily due to lower scanner volume and lower ASP, partially offset by higher services revenue from our larger installed base. Q3 '22, Systems and Services revenue were unfavorably impacted by foreign exchange of approximately $4.1 million or approximately 2.5% sequentially. On a year-over-year basis, System and Services revenues were unfavorably impacted by foreign exchange of approximately $9.9 million or approximately 5.9%. Systems and Services deferred revenues on the balance sheet was up $4.1 million or 1.6% sequentially and up $76.5 million or 40.9% year-over-year, primarily due to the increase in scanner sales and the deferral of service revenues included with the scanner purchase, which will be recognized ratably over the service period. During the 3 months ended September 30, 2022, we recognized $13.3 million that was included in the Systems and Services deferred revenues balance as of December 31, 2021. Moving on to gross margin. Third quarter overall gross margin was 69.5% down 1.4 points sequentially and down 4.8 points year-over-year. Overall gross margin was unfavorably impacted by approximately 0.8 points sequentially and 1.8 points on a year-over-year basis due to the impact of foreign exchange on our revenues. Clear Aligner gross margin for the third quarter was 70.9% down 2.4 points sequentially due to lower ASPs and increased manufacturing spend as we continue to ramp up operations at our new manufacturing facility in Poland. Clear Aligner gross margin for the third quarter was down 5.3 points year-over-year due to increased manufacturing spend for the reasons stated previously, higher freight and a higher mix of additional aligner volume and lower ASPs. Systems and Services gross margin for the third quarter was 63.3%, up 3.6 points sequentially due to improved manufacturing absorption and lower freight costs. Systems and Services gross margin for the third quarter was down 2.3 points year-over-year due to higher inventory costs and manufacturing inefficiencies coupled with lower ASPs, partially offset by higher service revenues. Q3 operating expenses were $475.5 million, down sequentially 4.8% and down 3.7% year-over-year. On a sequential basis, operating expenses were down $23.9 million, mainly due to controlled spend on advertising and marketing as part of our efforts to proactively manage costs. Year-over-year, operating expenses decreased by $18.5 million for the same reasons as sequential as well as lower incentive compensation. On a non-GAAP basis, excluding stock-based compensation and amortization of acquired intangibles related to certain acquisitions, Operating expenses were $443.4 million, down sequentially 4.8% and down 4.9% year-over-year. Our third quarter operating income of $143.7 million resulted in an operating margin of 16.1%, down 3.3 points sequentially and down 9.6 points year-over-year. Operating margin was unfavorably impacted by approximately 1.6 points sequentially due to foreign exchange and lower gross margin. The year-over-year decrease in operating margin is primarily attributed to lower gross margin, investments in our go-to-market teams and technology as well as unfavorable impact from foreign exchange by approximately 3.5 points. On a non-GAAP basis, which excludes stock-based compensation and amortization of intangibles related to certain acquisition, the operating margin for the third quarter was 20.2%, down 3 points sequentially and down 8.6 points year-over-year. Interest and other income and expense net for the third quarter was a loss of $21 million compared to a loss of $14.6 million in Q2 and an income of $0.8 million in Q3 of '21, primarily due to larger net foreign exchange losses from the weakening of certain foreign currencies against the U.S. dollar. The GAAP effective tax rate for the third quarter was 40.7% and compared to 35% in the second quarter and 30.9% in the third quarter of the prior year. The third quarter GAAP effective tax rate was higher than the second quarter effective tax rate, primarily due to the decrease in profits and changes in jurisdictional mix of income, resulting in lower tax benefits from foreign income tax at different rates and higher than in the U.S. On a non-GAAP -- our non-GAAP effective tax rate was 33.1% in the third quarter compared to 25.6% in the second quarter and 22.2% in the third quarter of the prior year. Third quarter net income per diluted share was $0.93, down sequentially $0.51 and down $1.35 compared to the prior year. Our EPS was unfavorably impacted by $0.30 on a sequential basis and $0.48 on a year-over-year basis due to foreign exchange. On a non-GAAP basis, net income per diluted share was $1.36 for the third quarter, down $0.64 sequentially and down $1.51 year-over-year. Moving on to the balance sheet. As of September 30, 2022, cash, cash equivalents and short-term and long-term marketable securities were $1.1 billion, up sequentially $163.8 million and down $96.8 million year-over-year. Of the $1.1 billion balance, $471 million was held in the U.S. and $670 million was held by our international entities. Q3 accounts receivable balance was $859.6 million, down approximately 7.8% sequentially. Our overall days sales outstanding was 86 days, flat sequentially and up approximately 11 days as compared to Q3 last year. Cash flow from operations for the third quarter was $266.5 million. Capital expenditures for the third quarter were $75.3 million, primarily related to our continued investments to increase Aligne’r manufacturing capacity and facilities. Free cash flow, defined as cash flow from operations less capital expenditures amounted to $191.1 million. We are well capitalized to continue to invest for growth while managing through these challenging market conditions, exiting the quarter with over $1 billion in cash on the balance sheet and 0 debt. Now turning to full year 2022 and the factors that influence our views on our business outlook. Underlying market dynamics as well as the reactions to macroeconomic headwinds by central banks, governments and consumers remain uncertain. We will continue to focus on those matters that have been central to our historically successful business strategies by managing those things within our control. This includes maintaining fiscal controls and focused delivery on our business model so that we are positioned for success once the difficult operating environment ultimately abates. We remain confident in the huge underpenetrated market for the digital orthodontics and restorative dentistry, our technology and industry leadership and our ability to execute and make progress toward our long-term model of 20% to 30% revenue growth. We expect to be below our fiscal 2022 GAAP operating margin target of 20%, which includes the impact from the current unfavorable foreign exchange of approximately 2 points to 3 points that was not factored into our operating margin guidance for the fiscal year 2022 when we gave an update on the Q1 '22 earnings call in April. For 2022, we expect our investments in capital expenditures to exceed $300 million. Capital expenditures primarily relate to building construction and improvements as well as additional manufacturing capacity to support our international expansion. This includes our investment in the aligner fabrication facility in Wroclaw, Poland, which began servicing doctors in the second quarter of 2022. In addition, during Q4 2022, we expect to repurchase up to $200 million of our common stock through either or a combination of open market repurchases or an accelerated stock repurchase agreement. With that, I'll turn it back over to Joe for final comments. Joe?"
},
{
"speaker": "Joe Hogan",
"text": "Thanks, John. As we continue to navigate a macroeconomic uncertainty, weaker consumer confidence and the lingering impacts of COVID-19 shutdowns primarily in China and Japan, we remain focused on our strategic initiatives as well as the incredible market opportunity for digital dentistry and our products. We believe our unwavering drive to transform smiles and change lives for millions of people around the world is on one other clear aligner company can match and positions us to better address this market opportunity. Regardless of the operating environment, we are committed to balancing investments to drive growth and long-term strategic priorities that will transform the practice of dentistry and strengthen our business. These are uncertain times. Every business is being impacted by macroeconomic environmental uncertainty. In addition, as a multinational company based in the United States with roughly half of our sales outside the country, the negative impact from unfavorable foreign exchange has been like anything I've ever seen in my career. We will continue to invest in digital solutions and demand creation to help doctors and their patients. We are committed to doctor-directed care and transforming the industry together while working through these global macro economic challenges. Thank you for your time today. We look forward to updating you on our next earnings call. Now I'll turn the call over to the operator for questions. Operator?"
},
{
"speaker": "Operator",
"text": "[Operator Instructions] Our first question comes from Jason Bednar with Piper Sandler."
},
{
"speaker": "Jason Bednar",
"text": "Joe, from what we've seen and heard in the market, I think it goes without saying that monthly demand has just been quite choppy here in the U.S. I think July and September were pretty darn soft, August, maybe not as weak, but still not great. I guess, did you see a similar level of uneven demand when we look outside the U.S. and I guess is there anything you'd call out geographically or in any of your channels that was maybe less bad than what you were prepared for three months ago?"
},
{
"speaker": "Joe Hogan",
"text": "Jason, we started with not high expectations to begin with, all right? But I would say the U.S. market panned out the way we thought overall, maybe a little more strength in Latin America, a little momentum despite the elections and some economics there. Europe just wasn't quite as strong as what we thought. And as we tried to explain in my notes that I really feel it's just -- it's the uncertainty that circulates Europe right now and Ukraine situation doesn't help either. From an Asia standpoint, we're affected by COVID again. We saw it in China, even though we had growth in China, which was respectable and in Japan also, but we saw the market impact in those two areas, too. I felt great about it's a smaller part of the business, but Korea, Taiwan, Thailand and other businesses that were up significantly, but our major three were still affected, primarily the three is Australia and China and Japan with some COVID issues. So it's a way of saying, I think in general, we anticipated where we are, we were hoping for the best year. But what really grabs me to, Jason, maybe I'm giving you too much for your call is that the teen demand, we felt good about overall across the globe in the United States, too. The teen packs did well overall. And obviously, we'll roll that out in other parts of the world, too. The adult -- the impact on the adult cases is what was -- to me, is astounding in the sense, and you see that flow through the orthodontic community, the GP community too. And that's not just in the United States, we see that all over the world. ."
},
{
"speaker": "Jason Bednar",
"text": "Maybe Joe or John, just on the margin topic, you are backing away from that 20% margin floor commentary that you had given previously. Fully understanding part of this is FX related. But maybe can you talk about how much of it's tied to the decremental impact from lower volumes. And then you fully understand this is a tough macro environment to forecast. But a lot of investors right now are really trying to get comfortable with how defensible margins and profitability are as we look out to 2023, which I hope it's not, but it could very well be another tough year for the business just given the global macro environment we're in. So just -- are you willing to provide any guardrails around what we can consider for 2023 margins? Or maybe talk about how much flexibility you have in the P&L to offset pressures from lower volumes?"
},
{
"speaker": "Joe Hogan",
"text": "Jason, it's a fair question. First of all, I'll turn it over to John, but I'm going to give that 20% operating margin piece. I had no idea. You'd see international currency swings. And way we've seen it. I've been in these jobs for a long time and you don't expect 25% decreases year-over-year in currency. And so obviously, we had to back up on that piece. I feel good about the way we manage our cost I feel good about where we're investing and where we continue to rightsize. John will give you more specifics."
},
{
"speaker": "John Morici",
"text": "So on a constant currency basis, we expect to be at that 20% or above. It's just like Joe said, it's pretty dramatic to see the FX changes that we have. As noted in the comments, we said it going to affect the year by 2 to 3 points. So there's no -- there's a commitment to that margin, and we're investing based on volume that we see and other priorities that we have on R&D and go-to-market activities and so on. But it's just that FX piece that we're calling out. But on a constant currency basis, we feel that that number of 20% still holds from earlier."
},
{
"speaker": "Operator",
"text": "Our next question comes from Brandon Velasquez with William Blair."
},
{
"speaker": "Brandon Velasquez",
"text": "I wanted to go -- I'd like to go back for a second kind of to the monthly progression just to -- I think what might be helpful to kind of understand underlying market dynamics and maybe you can tease it out a little bit in Americas versus international. Just -- what were you seeing through the quarter where you -- did you exit the quarter and go into Q4? Were things stabilizing? Were they getting better? Were they getting worse? Any kind of color you can give us around what the situation is like as we go forward from Q3?"
},
{
"speaker": "Joe Hogan",
"text": "Again, like on the last call, Brendon, I think it played out the way our expectations, I think were formatted. We talked about teens in the third quarter. And obviously, that's teen season. That played out well from what we anticipated. And as we mentioned before, we think teens are somewhat shielded -- not completely, but shielded from the economic environment because of the time window for treatment and parents that want to help their teens through that whole process. The adult segment was the -- we saw the most volatility in for sure, both in the United States, Europe and in Asia. It's hard for me to tell you that we're -- there's any kind of change from month-to-month or quarter-to-quarter. It was pretty consistent from what we've seen. John, would you add anything else? ."
},
{
"speaker": "Brandon Velasquez",
"text": "I mean that's how we saw it. Okay. And then internationally, you guys sound pretty excited about kind of the new product launches within China, specifically offering that new maybe lower-tier product. Can you just talk a little bit about what you're seeing there? How strong has the recovery been in China? How much of that recovery has come from really opening up the product portfolio there? And how should that kind of continue going forward?"
},
{
"speaker": "Joe Hogan",
"text": "That's a good question. I mean, China is a very important market for us. As we talked about on other calls, those Tier 3 and Tier 4 cities have been an important target for us. We've known for about two years, we have a hole in our portfolio in those areas, particularly with -- we have comprehensive on top, and then we have a moderate product between it. So we announced Invisalign standard, Invisalign adult. And what this does is it just helps us segment the market. These are not -- they can't handle -- these products can have handle cases like Invisalign First Scan or mandibular advancement or some of the sophisticated cases we have out there. We don't offer CBCT 5-minute ClinCheck and those kind of things around those products, too. So we tailor those products for more moderate kinds of cases in those specific areas where public hospitals have been strong. And we really good results from the standpoint of what we saw in the uptake that we saw over this last quarter, and we'll continue with that strategy. We feel good about it."
},
{
"speaker": "John Morici",
"text": "And it's about market expansion there. We're selling to more doctors than we've sold to in the past with these products. So we're really trying to capture more of that market, as Joe said, into Tier 3, Tier 4 cities, and we saw good uptake from that. And it's something that we know to go to the market and be able to reach these potential customers. These are the types of products that we need. ."
},
{
"speaker": "Joe Hogan",
"text": "Yes. So Brandon, I think honestly, I feel really good about our positioning there. China did perform well from a volume standpoint, and we'll continue to update on our progress. ."
},
{
"speaker": "Operator",
"text": "Our next question comes from John Block with Stifel."
},
{
"speaker": "John Block",
"text": "Maybe just first first for me. The 3Q '22 ASP of 1150 versus 1220, so I'm calcing down 6% Q-over-Q. Some of that's FX, but I think if I look at your comments, it seems like half of that 6% headwind is FX. And John, I know you said mix, but I'm counting that teen was about 35% of your 3Q '22 cases versus 30% of your 2Q '22 cases and teen is a high acuity comprehensive ASP. I would think DSP is also helping pull out some of the lower ASP cases as DSP ramps quarter in, quarter out. So can you just help me with the ASP movement, what else was it outside of FX? And if it was mix, why mix based on my teen commentary?"
},
{
"speaker": "John Morici",
"text": "Yes, I think you've hit the major pieces, John. When you look at it majority was FX. We saw the dollar strengthening, that obviously hits our numbers. And then you look at the other parts, we do have a higher proportion of teen in the third quarter, and that's a help. We also have things that we've done like we answered on the previous call about mix in China and expansion out, and there's offsets to that. But it's primarily FX and then you have some mix. But from a discounting standpoint, or other things, there was really no overall change to how we've done stuff. It's primarily the FX piece and the mix."
},
{
"speaker": "Joe Hogan",
"text": "John, one other thing to add to that, too, on the DSP program, we look at that as incremental, not as replacing other business that we've had in the past. So like we feel good that's an expansion play for us. And I think you see that in the numbers, too."
},
{
"speaker": "John Block",
"text": "So maybe just quickly on that last point, Joe. Question on B would be, you don't really think any cases are being pulled out of the case volume number into DSP that's actually having an incremental negative impact to '22? Do you think those are just truly largely incremental. That was 1B, just to be clear."
},
{
"speaker": "Joe Hogan",
"text": "Yes, I think you learn a business, John, never be binary, either or. I'd say the majority of those cases, if you look at it, we're picking up from an ortho standpoint, a lot of retention we never had before. We see orthos doing touch-up cases and all that might have been done in-house at times. So I'm not saying that there's absolutely nothing that would transpose from one to another, but I'd say primarily, we're looking at that as a growth opportunity for us."
},
{
"speaker": "John Block",
"text": "And then the last question, and it's just where I struggle the most. I think sort of who cares, but my view on teen versus how you guys have positioned it with all due respect. And I get the teen 2Q to 3Q had a good sequential growth rate, but the 1Q to 3Q because 2Q was weak, was actually below trend on a four-year average throwing out 2020. And Joe, just -- if we can go down that road a little bit more, teen case volumes were still down 3% year-over-year. This whole story is about taking maybe 200 bps of share every year in this market. What do you think overall teen case volume was globally if you guys were down 3%? And maybe just really the questions about market share gains and if you still feel like you've got the momentum there or if that has slowed as of late and what can reaccelerate it?"
},
{
"speaker": "Joe Hogan",
"text": "Yes, John, again, that's a good question. I think when you talk about first quarter to second quarter, the rhythm that we had there, remember, the normal rhythms we've seen in this business, the seasonality, we call it. We have not seen that since really 2019. And so we had muted signals on teens through 2020, '21. Just -- it wasn't the same. What I liked about -- what I saw in the third quarter was we saw teens come back in the sense of in a pattern of what you'd expect in teen season, Q3, Q4. It's too early for me to dig out the data and tell you how much share we're gaining against wires and brackets. John, we don't talk about a lot or products like -- and we highlighted it here today, when you look at the Invisalign First product line, we're really getting tremendous results out there on young patients, 6 to 9 years old, the Phase I, Phase II treatments, where often the Phase II can be a lot less extensive than what the Phase I was with wires and brackets. So our different expansion devices. So we see a big uptake in that product line from a teen standpoint. We see that as penetration too. We've seen consistent growth from a share standpoint in those teen cases in Americas globally. So -- we just introduced curved wings mandibular advancement too that's having a really good start in the market, too, to address some cases that mandibular advancement couldn't get in the past. So John, both with technology, with our advertising campaigns, the teen packs and whatever, I continue to feel good about our movement. We'll have more as we analyze the trends, the share trends and stuff that we'll be able to share with you, but I do like our position in the marketplace in teens."
},
{
"speaker": "Operator",
"text": "Our next question comes from Brandon Couillard with Jefferies."
},
{
"speaker": "Brandon Couillard",
"text": "Just a question on just OpEx and how you're managing headcount, whether you pulled back in any parts of the business globally? And maybe just talk about the levers that might be at your disposal if the environment continues to deteriorate and maybe if there are some areas that would be ring-fenced as far as potential cuts."
},
{
"speaker": "Joe Hogan",
"text": "Ben, it's Joe. Look, first of all, what I protect with my life here are our direct salespeople and also our technology and our engineering team and what we focus on. And so we've made sure that we continue to reinforce those. There's just other parts of our business, too, that we rightsized. I mean, obviously, this business is used to growing 20%, 30%. And so we kind of came into the year with that mindset. We quickly realized it wasn't. And so we've taken actions in order to do that. But you see that throughout the business. Don't forget, we also have really strong productivity programs and manufacturing and all, that really help us during these times. Emory and his team do a terrific job, they help to drive that. John will give you another insight in a sense of how we're managing OpEx across the business."
},
{
"speaker": "John Morici",
"text": "We have good insight into our P&Ls across the world. So we're looking at country by country in certain regions and so on. And like Joe said, from an overall focus, we want to make sure that we're going to market and protecting the sales, make sure our R&D technology is putting out the best products and the best technology going forward. . So we protect that. And then we look at what expenses make sense in the short and long term in various regions, various campaigns that we have to make sure that we're getting the return that's appropriate given the market conditions. So we're constantly iterating and changing things. it's no different on the other side of things. When a year ago, we were looking at the growth opportunities. We're looking at it the same type of way kind of on a country-by-country, market-by-market basis is just the other way as it is now. So we feel like we have a good understanding of our return on investment and a good understanding of the levers that we need to pull or not pull given these conditions."
},
{
"speaker": "Brandon Couillard",
"text": "And then John, just one follow-up. Can you help me just kind of understand what's going on with the inventory line and why that continues to grow year-over-year and sequentially. Is there something tied to the new European fab facility that may be driving that? And what we should expect on that line in the next few quarters?"
},
{
"speaker": "John Morici",
"text": "Yes. I think we're kind of getting to -- we kind of get to a point where some of that is due to just the fact that you have a third manufacturing site, and you're going to have raw materials related to that and other in-process inventory and so on there. So you're going to have some of that. Some of it is also on the iTero side where you're manufacturing and you're doing some things where you're securing supply. I mean there's been a lot of talk and we feel good about our supply to be able to components and so on. We've purchased several components just to make sure that we had adequate supply for our forecast and so on. But nothing out of the ordinary other than some expansion that we have with new manufacturing and then making sure that we secured our supply lines, and that's what we've seen in our numbers. ."
},
{
"speaker": "Operator",
"text": "Our next question comes from Jeff Johnson with Baird. Your line is open."
},
{
"speaker": "Jeff Johnson",
"text": "So Joe, I want to pin you down a little bit on a couple of things, if I could here that questions that have been asked. And on the teen packs especially, I mean, look, we know there were so many adult cases last year with the assume a factor, whatever we want to call it and stimulus spending and all that. But the teen number is obviously the important number. I think we're all trying to focus on here. The down 3%, I think is what you said year-over-year, up sequentially. That's down 3% year-over-year on teen cases globally. I mean, how do you feel like that compares to the overall ortho market? Were you better or worse than other teen cases done with brackets and wires when you throw in other clear aligners from the competitors, things like that? Just how are you competing in that teen market right now?"
},
{
"speaker": "Joe Hogan",
"text": "Jeff, it's a fair question. I'd first take it to Europe. I mean Europe was down substantially for us, too. So I don't think we've got a clear signal out of there because of the economics and in general. I mean we did fairly well in -- from a European standpoint. But third quarter in Europe is never a particularly strong quarter. We're going to pull a signal out of -- you look at the United States, you go to Gaidge Data. And you'll see that inside Gaidge Data aligners were down but Invisalign was actually above what the generic aligners are reported in Gaidge data, which says we continue to do well with our teen portfolio and what we do. . You see wires and brackets cases actually expanded. But what that is, is you see if they're doing more -- fewer adults -- and you know how orthos have held on to teens for a long time, you get a mix phenomenon there where it looks like they're doing more wires and brackets, but they're not. They're just doing fewer adults, and they mix down in that sense. So -- and then move over to Asia, I've always felt good about Asia is different by country. But the COVID overlay in Japan in particular, but also China. I thought the teen case volume was still reasonable. But it's still hard to pull a signal out of a lot of noise with the COVID shutdowns in all of those countries. So again, just like in John's question, Jeff, is I do feel great about our portfolio. I feel good about how we're positioning the product. I think the teen packs are a way to sell the way doctors want to commit in this area, I think we'll continue to get strong there. The future of those teen cases, there's no question it's digital. It's just how we approach it, the products we launch and convincing doctors more and more that teens will use these and showing them the results that we're seeing all over the world."
},
{
"speaker": "Jeff Johnson",
"text": "Yes. Fair enough. All right. And then I'm going to jam two questions together, kind of ala John Black here, I'll call it, 2A and 2B and other separate questions. But any update on volume-based procurement in China, how we should think about that? And then I didn't see a breakout for Americas versus international doctors shipped to. You provided that in the past. Any way we could get that number this time?"
},
{
"speaker": "John Morici",
"text": "Well, on the doctor shipped to, what we've done is consolidate them together to a total. And what we saw, if you looked at international versus domestic, they're both up. And the numbers that we had. This is actually our second highest ever from a shipped to standpoint. But we decided to consolidate those together without giving too much more details on that. But they're both up."
},
{
"speaker": "Jeff Johnson",
"text": "Sequentially, John, just to be clear?"
},
{
"speaker": "John Morici",
"text": "Yes. Yes."
},
{
"speaker": "Jeff Johnson",
"text": "John, both up sequentially. Sorry, Joe. ."
},
{
"speaker": "John Morici",
"text": "Yes, yes, correct. ."
},
{
"speaker": "Joe Hogan",
"text": "Yes, on sequential. On the volume-based purchasing in China, we have our eyes all over, Jeff, as you can guess. It represents anywhere between 15% and 18% of our business there. The way they're setting this up, pretty much in what we would call not our main areas in where we do business in China. I think we've positioned ourselves for this. strategically, I feel we can make the right move here. Look, I have friends and other medical device businesses. I was in the medical devices for a while. We know what this did to stents and hip transplants and different things. I feel like the way they set this up, one is 70% of it will be BBP in those areas, 30% will still be up to the doctors in the sense of what they want to use and how they want to use it. So what's key here is that we exercise our portfolio and the capacity that we have over there to just have a strategic positioning in that. So I don't expect any major differences as we move into 2023. We'll just have to wait to see how that goes. And as we move into 2024, 2025, how the government -- which way the government moves."
},
{
"speaker": "Operator",
"text": "Our next question comes from Elizabeth Anderson with Evercore ISI."
},
{
"speaker": "Elizabeth Anderson",
"text": "I guess my first question is just on equipment line. I noticed you sort of talking more about leased equipment in the quarter. Can you sort of talk about how that's been growing and sort of what contribution that made to the equipment revenues in the quarter?"
},
{
"speaker": "John Morici",
"text": "Yes, I can start with that. It's obviously a strategy that we have. We've got great equipment, great products, and we want to be able to get those to our customers in a way that they want to buy. Sometimes those doctors of ours don't necessarily want to purchase it outright. They want to try other things. And so we've tested in certain markets, just alternatives, kind of the rental model and so on. And we see good uptake. We see them these doctors now wanting to get a scanner to be able to digitize their practice. So it's really at early stage right now, Elizabeth, but it is something that when we think about how we want to go to market, we want to offer alternatives such as leasing or expanding rental or other parts of our business are going to see the certified preowned where you have upgrades and other things that happen as we have a larger and larger installed base, we're going to get some of that equipment back. We want to be able to have a mechanism to be able to use that equipment, use it in other places, and give our customers alternatives, both in terms of the equipment that they can purchase from us and then how they purchase and use that equipment from a financing or maybe leasing or rental options. And we think that they'll end up using our equipment more and more. And then we know that helps from a digital standpoint when they use their equipment and then they'll end up using more Invisalign. So it all kind of works from an ecosystem standpoint."
},
{
"speaker": "Elizabeth Anderson",
"text": "And then just in terms of on the P&L, like one of the things that, obviously, saw the change in SG&A spend in the quarter and how you pulled back on spending there. What about on the R&D line? Do you sort of see an opportunity to pull back on R&D as well going forward? Or is that something you're sort of keener to defend going forward? ."
},
{
"speaker": "Joe Hogan",
"text": "Elizabeth, it's Joe. We want to defend R&D. Very important part of the business. You can see the programs are rolling out. The programs we're rolling out, we didn't do them this year, right? Some of these are 3-year old programs that we've been working on. And so I don't want to stop the momentum on those. I mean obviously, we'll take any steps here to preserve the cash flow and integrity of this business that we have to do. But our front lines are our sales organization and technology. And before we go anywhere near those, we want to make sure we do everything we can, the right size of business in other areas."
},
{
"speaker": "Elizabeth Anderson",
"text": "And then just in terms of my 2B question, in terms of like what you're seeing through the month of October so far, if we're sort of thinking about how the cadence of 4Q is shaping up, which is to expect like the cases to be sort of flat sequentially at this point based on what you're seeing? Or like how do we think about sort of where we are now?"
},
{
"speaker": "Joe Hogan",
"text": "Kind of anticipating that question is, we're not seeing any major change, I'd say, from the momentum that we saw in the second quarter. ."
},
{
"speaker": "Elizabeth Anderson",
"text": "You mean the third quarter?"
},
{
"speaker": "Joe Hogan",
"text": "I'm sorry, third quarter. That's right, a little bit..."
},
{
"speaker": "Operator",
"text": "Our next question comes from Erin Wright with MS. Your line is now open."
},
{
"speaker": "Erin Wright",
"text": "So how should we think about underlying ASPs going forward, excluding the FX dynamics from here just given some of the mix dynamics you noted. And FX is FX, and that's understandable. But if we do continue to see what we're seeing in terms of the macro environment, what do we think about in terms of trough margins from here? And do you see an opportunity for a sort of recovery near term? Or any sort of margin expansion? Anything you can give us on that front would be helpful."
},
{
"speaker": "John Morici",
"text": "Yes. Obviously, Erin, this is John. Obviously, gross margin, op margins is a primary concern for us. We want to make sure that we're managing things appropriately. From an ASP standpoint, take FX out of this and really FX out of our margin because it's hard to so much coming through from a P&L standpoint. But we're always looking at productivity to be able to help drive the business. And as we scale up Poland is a great example, we'll become more productive there, and that will help our margin. It's kind of in our margins right now as an impact, but it will get better over time through utilization. . We look at the technology that we have in the business and what it means from an ASP standpoint. And our customers understand that. There's always going to be geographical mix shifts that happen. Certain parts of the world are at different times throughout the year. But I don't expect a dramatic shift in our overall ASPs. Take FX out of it from an overall ASP standpoint and then we're really focused on what can we do to look at savings that help us from a gross margin standpoint and see that. And then also on an op margin standpoint for all the OpEx things that we previously talked about."
},
{
"speaker": "Erin Wright",
"text": "And then just going back to Elizabeth's question on the quarterly cadence. Just in the teen market, in particular, what are you seeing in terms of typical seasonality there? And did you see some of that momentum continuing here into the fourth quarter in that particular segment? Or how should we be thinking about the quarter-to-quarter cadence given -- relative to what you typically see from a seasonal standpoint. ."
},
{
"speaker": "Joe Hogan",
"text": "The teen market predominantly, if we look at the third quarter. Obviously, a bleed some into the fourth quarter, whatever, but I wouldn't take anything we're seeing right now and projected into the future to change what the normal fourth quarter sequence could be. So like I said previously on the question as far as when you look at third quarter moving in the fourth quarter, we're not seeing any meaningful change one way or another."
},
{
"speaker": "Operator",
"text": "Our next question comes from Nathan Rich from Goldman Sachs. Your line is now open."
},
{
"speaker": "Nathan Rich",
"text": "If I could go back to margins for a minute. You mentioned not changing the target for this year on a constant currency basis. I guess -- if I could maybe ask the question this way, if we don't see further changes to FX or the kind of overall demand environment, do you think the 16% margin that you saw this quarter on a GAAP basis is indicative of what we should assume going forward, again, kind of -- assuming no kind of changes in the underlying environment? ."
},
{
"speaker": "John Morici",
"text": "I wouldn't take that. I think when we're talking about for the full year, we're kind of looking at kind of that on a constant currency basis, that 20%. And I think you have impacts with Poland startup and some other things in the quarter that are impacting that. But when we look at the 20% and what we were calling earlier in the year, we were thinking about that less about the quarters, but on a -- more on a total year basis on a constant currency basis."
},
{
"speaker": "Nathan Rich",
"text": "Okay. And the FX headwind for the year on margins is that 2% to 3%?"
},
{
"speaker": "John Morici",
"text": "That's the way to look at it, Nate. It's -- we're kind of looking at -- as best as we can call it now, we're kind of using the latest FX rates that you have now. It's up to predict what's going to happen in the next 2 months. But if you took kind of currently and kind of what we've done throughout the year and then use the current FX rates, we think that's a 2- to 3-point impact. And without that FX rates, we -- our GAAP numbers would have been at the 20%, like we called."
},
{
"speaker": "Nathan Rich",
"text": "If I could just ask a quick follow-up. Joe, I think you had noted less willingness of consumers to finance treatments in both the U.S. and Europe. How big is that as a percent of case volumes in terms of what's typically financed? And how much in particular kind of might have this weight on demand? And I guess, bigger picture, are there ways kind of in this environment that you kind of see as kind of maybe being best able to stimulate demand just in terms of how you might either help customers or doctors in this environment?"
},
{
"speaker": "Joe Hogan",
"text": "Yes, Nathan, I think what we gave you is basically data that we receive from the marketplace. It's what we're hearing from orthodontists and dentists in general in treatment. We don't have any quantification to say so many patients were seeking funding, they didn't get it or there's so many losses in that sense. That's pretty much listed as the reasons why patients have refused treatment or thinking about treatment in the financial considerations of it. John, would you?"
},
{
"speaker": "John Morici",
"text": "No, I think you're always going to have a mix of -- some patients, they'll pay for it all upfront. Some will finance either through the doctor or some outside group. And I think you're constantly going to have that. We do think as much as we can with our doctors to give them some of the financial flexibility, so that as they maybe have additional terms where they pay us, the doctors, they can maybe apply some of that to their patients, and they can help their patients as well, manage some of the cash flow. So we're aware of it. We do as much as we can. It's just kind of out there. And like Joe said, we don't have a quantification of it, but in tougher economic times, we know that patients will be looking for different alternatives."
},
{
"speaker": "Joe Hogan",
"text": "And the other part of your question, Nick, about how do we help accounts. We watch payments. We try to help in that sense at times. We try to drive direct Invisalign docs to do a lot of Invisalign. And obviously, our advertising is extremely important to them. So we have our whole lead program to help them drive those things. We just want to be as close to our customers as possible because they're feeling what we feel. And we have strong relationships with many of them, and they're part of the family here. And we work it country by country, doctor by doctor, region by region to see how we can help. ."
},
{
"speaker": "Shirley Stacy",
"text": "Operator, we'll take one more question, please."
},
{
"speaker": "Operator",
"text": "Our final question comes from Kevin Caliendo with UBS."
},
{
"speaker": "Kevin Caliendo",
"text": "So may have found a little bit on the comment around October, saying that the momentum continued. If we think about that, that was sort of down 12%, right, year-over-year. I think what we're all looking for is we saw cases flat Q1 to Q2. And then we saw a step down in Q3 despite a stronger teen season. So I think what we're all trying to figure out here is adjusting for the third quarter strength, seasonality in teen, when do you actually expect to see stabilization globally in cases, meaning either sequentially or year-over-year flatness? Like when do you actually expect that, that could happen?"
},
{
"speaker": "Joe Hogan",
"text": "Kevin, it's Joe. Look, I think we can sit here and tell you, I think we're in pretty volatile economic times. I can't tell you what the dollar is going to be in 3 months. I don't know what's going to happen in Europe. I don't know how bad COVID hits China. I don't know what it does in Japan. So I know exactly what you're asking for and every investor is asking for. And we'd give you that data if we thought we had it, but we are in such a volatile time right now. We're just working this thing from month to month. As I mentioned, as we go into the fourth quarter, obviously, there's a rhythm between teens and adults from the third quarter to the fourth quarter. What I mentioned from a continuation standpoint is we haven't seen much of a change between the third and the fourth right now as we move into it. That's about as well as I can tell you of what we're seeing and what we're experiencing, trying to forecast what's going to happen toward the end of the quarter, next quarter, I can't do that. I don't think anybody here can."
},
{
"speaker": "Kevin Caliendo",
"text": "And if I can just ask a follow-up. There's been a lot of talk about spending and margins in 20% and everything else. And historically, in the past, you guys always just invested to grow. Is it now given the uncertainty of everything that you're just going to manage through a margin or try to manage to the 20% margin ex FX? Or -- I mean, is that the strategy? Or is it still to try to get back to the -- what you would need to do normally to hit certain growth targets that you've had?"
},
{
"speaker": "Joe Hogan",
"text": "It's a growth business, Kevin. If we had good economic times here, I can tell you, we'd be having a much different conversation. So the challenge with this business is how are we responsible on cost and obviously, a challenged demand environment [indiscernible] this company very strong because when this market comes back, you just go back in history and take a look, it comes back and it comes back hard. And we've got to make sure that we're in a good position to be able to field that when it does occur. So you'll see us be, what I call, fiscally responsible, but we'll continue to make sure that we invest and make as many changes as we can around different areas of OpEx, but to protect those key areas where our customer interface and the development of our technology. And actually, the operations capacity we need in this business when this thing does bring back. And that's not just in manufacturing aligners. That's in being able to service customers across the board. So you'll see us balance that well as we should do from a leadership standpoint."
},
{
"speaker": "Shirley Stacy",
"text": "Well, thank you, everyone, for joining us today. We appreciate your time and look forward to speaking with you at upcoming financial conferences and industry meetings, including the Ortho Summit in Las Vegas next month. If you have any further questions or follow-up, please contact our Investor Relations team. Have a great day ."
},
{
"speaker": "Operator",
"text": "That concludes the conference call. Thank you for your participation. You may now disconnect your lines."
}
] | Align Technology, Inc. | 24,568 |
ALGN | 2 | 2,022 | 2022-07-27 16:30:00 | Operator: Greetings. Welcome to the Align Q2 2022 earnings call. At this time, all participants are in a listen-only mode. A question-and-answer session will follow the formal presentation. Please note this conference will be recorded. I will now turn the conference over to your host, Shirley Stacy with Align Technology. You may begin
Shirley Stacy: Good afternoon, and thank you for joining us. I'm Shirley Stacy, Vice President of Corporate Communications and Investor Relations. Joining me for today’s call is Joe Hogan, President and CEO; and John Morici, CFO. We issued second quarter 2022 financial results today via Business Wire, which is available on our website at investor.aligntech.com. Today’s conference call is being audio webcast and will be archived on our website for approximately one month. A telephone replay will be available today by approximately 5:30 PM Eastern Time through 5:30 PM Eastern Time on August 10. To access the telephone replay, domestic callers should dial 866-813-9403 with access code 137829. International callers should dial 929-458-6194 using the same access code. As a reminder, the information provided and discussed today will include forward-looking statements, including statements about Align’s future events and product outlook. These forward-looking statements are only predictions and involve risks and uncertainties that are described in more detail in our most recent periodic reports filed with the Securities and Exchange Commission available on our website and at sec.gov. Actual results may vary significantly and Align expressly assumes no obligation to update any forward-looking statement. We have posted historical financial statements, including the corresponding reconciliations, including our GAAP to non-GAAP reconciliation, if applicable, and our second quarter 2022 conference call slides on our website under quarterly results. Please refer to these files for more detailed information. And with that, I'd like to turn the call over to Align Technology's President and CEO, Joe Hogan. Joe?
Joe Hogan: Thanks, Shirley. Good afternoon, and thanks for joining us. On our call today, I'll provide an overview of our Q2 results and discuss the performance of our two operating segments, Systems and Services and Clear Aligners. John will provide more detail on our financial performance and our view for the remainder of the year. Following that, I'll come back and summarize a few key points and open the call to questions. I'm pleased to report solid second quarter results with top line revenues relatively unchanged from Q1, and operating margin of approximately 20%, despite unfavorable foreign exchange. The underlying market for orthodontics continues to be impacted by macroeconomic environment factors and lingering effects of COVID-19 variants in certain markets. Notwithstanding, these headwinds, we've remained focused on achieving our strategic initiatives, including opening new offices in the Middle East and Africa and our new manufacturing facility in Poland, launching new solutions to better support the way our customers want to do business, such as a doctor subscription program, and teen case packs, and announcing new products and innovation to help our doctors and their patients. These new innovations are revolutionizing the digital treatment planning and helping to drive the evolution of digital orthodontics and comprehensive dentistry. Align is well-positioned to withstand the current market conditions to lead the digital revolution in orthodontics and dentistry as the environment and growth trends improve. For System and Services, Q2 revenues were up 4.7% sequentially and up slightly year-over-year compared to Q2 2021 year-over-year growth of 215%. Q2 Services and Systems revenues increased sequentially driven by scanner volume growth in the Americas and APAC, partially offset by lower volume in EMEA, and unfavorable impact of foreign exchange. The iTero Element 5D imaging system continues to represent the majority of our scanner volume as doctors recognize the benefits of going digital. In APAC, the iTero entry-level Flex scanner offering was up sequentially in Q2, reflecting increased adoption. I'm also pleased with sequentially increasing services revenues in Q2, reflecting growth from the installed base. Services revenues represent approximately 40% of our Systems and Services business. For our Clear Aligner segment, Q2 revenues were down slightly sequentially and down 5.1% year-over-year compared to our Q2 2021 record year-over-year revenue growth of 182%. For the quarter, Q2 Clear Aligner volumes reflect sequential growth across the Americas and parts of EMEA, partially offset by China and UK Q2 Invisalign case starts for teens and younger patients was 177.3000 up slightly sequentially and down 2.1% year-over-year compared last year when our Teen case shipment growth rate was an all-time high. For Q2, Invisalign First for kids as young as six years old, grew year-over-year and was strong across all regions. During Q2, we introduced Invisalign Teen Packs in the US and Canada and France. Teen Packs, our new subscription program, which enables orthodontists to buy clear aligners and packs in advance, similar to the way they buy wires and brackets today. Our Teen Case Pack simplified the ordering process and make the billing more predictable for doctors. Teen Case Packs also include exclusive practice development benefits with the Invisalign brand and requires an incremental volume commitment from doctors. To date, enrollment has been encouraging with early adoptions highest among doctors who have not historically used Invisalign aligners to treat their teen patients. For other non-case revenues, which include retention products such as Vivera Retainers, clinical training and education, accessories, e-commerce and our new subscription programs such as our DSP revenues, were up both sequentially and year-over-year. For retainers, Q2 shipments had strong momentum with sequential and year-over-year growth across all regions driven by both submitters and utilization. Momentum in our doctor subscription program continued and Q2 revenues increased over 60% sequentially. Now let's turn to the specifics around our second quarter results, starting with the Americas. For the Americas region, Q2 Invisalign case volumes were up sequentially, reflecting increased submissions from the orthodontic channel and increased utilization from the GP channel. From a product standpoint, Q2 sequential Invisalign case growth reflects increases in both comprehensive and non-comprehensive products, including Invisalign First and Invisalign Moderate. Q2 also benefited from increased utilization in the DSO channel. Our international Clear Aligners, Q2 Invisalign case volumes were down 1.7% sequentially, primarily as a result of the headwinds described previously. For EMEA, Q2 Invisalign case volumes were down slightly primarily reflecting a slight increase in Iberia and Italy, offset primarily by slightly lower sequential volumes in the UK and France. For Q2, expansion market shipments declined sequentially. Q2 Invisalign teen patients increased sequentially driven by an increase in the number of doctors submitting teen cases. Turning to APAC. Invisalign case volumes were down slightly, reflecting a full quarter effect of continued lockdowns in China. For Q2, Taiwan, Hong Kong, Japan and India performed well during the quarter. On a year-over-year basis, Invisalign case shipments growth was strong in Japan, India, Taiwan, Thailand and Korea. The APAC teen case volume increased year-over-year, primarily driven by increased doctor submitters. Turning to new innovations. The Align Digital Platform is an integrated suite of proprietary technologies and services delivered as a seamless end-to-end solution to customers that connects all users, doctors, labs patients and consumers to transform smiles, and change lives. Our technology advancements help our doctor customers deliver superior clinical outcomes, treatment efficiency and also superior patient experience. In Q2, we introduced Invisalign Outcome Simulator Pro and Cone Beam being Computed Tomography systems, integration for ClinCheck software, building on several new innovations announced last quarter that we'll begin rolling out across the regions in August. Invisalign Outcome Simulator Pro, the next-generation patient communication tool that empowers doctors to help patients visualize their potential new smile after Invisalign treatment. Use in-phase visualization in 3D dentition view, all done chairside in minutes. Cone Beam Computed Tomography systems, or what we call CBCT, integration for ClinCheck software is designed to deliver a complete view of a patient's roots, crown and jawbone. CBCT integration for ClinCheck software enables doctors to confidently deliver a more informed Invisalign clear liner treatment plan or a wide range of cases. The user-friendly interface makes easy for doctors to see their patients root, crown and jawbone and one automatically digitally fused 3D model. This allows doctors to tailor their treatment plan based on their experience and their patients' needs. CBCT integration for ClinCheck software gives doctors the control and confidence to expand treatment planning to a broad range of mal inclusions, including surgical, restorative, expansion, extraction as well as teen cases with impacted or unterrupted team. While it's still early in the commercialization of these new products, initial feedback from doctors is encouraging. We are excited to begin scaling them across our customer base in the second half of 2022. Also, during the quarter, we awarded 11 new research grants, totaling $275,000 to universities around the world. Through our annual research awards program, we help advance orthodontic and dental research, furthering our commitment to the future of digital orthodontics and restorative dentistry. Our consumer marketing is focused on educating consumers about the Invisalign system, and driving that demand to Invisalign doctors offices, ultimately capitalizing on the massive market opportunity to transform 500 million smiles. For Q2, we had over 16.2 million visits to our websites, a 15% year-over-year increase, and delivered over 6.3 billion impressions. Both metrics were lower versus Q1 as we chose to rightsize our size and media spend in Q2, given the macroeconomic environment. During the quarter, we built on our successful “Invis Is” multimedia campaign and launched in the US the next evolution with two new campaigns, “Invis Is” trauma-free, targeted at teens, and Invis Is when everything clicks, targeted at adults. Our Invis Is trauma-free campaign highlights the benefits of Invisalign treatment, while numerously juxtaposing teams with the significant hassles involved with using braces. Our Invis Is when everything clicks campaign showcases Invisalign treatment, transforming smiles and the resulting confidence it gives the young adults. Both campaigns will be rolled out to markets around the world in Q3. About some of our consumer patient app My Invisalign continued to increase with 1.8 million downloads to date. Uses of our four digital tools continues to increase, for example, Invisalign virtual appointment tool was used over 12,000 times, and our insurance verification feature was used 36,000 times in Q2. Further, we received more than 91,000 patient photos in our virtual care feature globally, which continues to provide us with rich data to leverage our artificial intelligence capabilities and improve our services for doctors and patients. Additional consumer demand metrics are included in our Q2 earnings slides posted on our website. We are pleased with our Q2 Systems and Services revenues, which were up 5% sequentially and up 1% year-over-year. Q2 sequential growth primarily reflects higher scanner volumes in the Americas and APAC, and increased subscriptions. Year-over-year results primarily reflect increased scanner revenues in the Americas, offset by lower volume in APAC and EMEA. Growth of our iTero scanner installed base is driving an increase in services revenue. On a year-over-year basis, Systems and Services growth reflects increased service revenues from our largest scanner installed base, higher subscription revenues and increased sales of scanner once leased. The number of intraoral digital scans used for Invisalign case submissions in Q2 reflect continued adoption of our digital scanners and our larger installed base. Total worldwide intraoral digital scan submitted to start an Invisalign case in Q2 increased 88.4% from 82.2% in Q2 of last year. International intraoral digital scans for Invisalign case submissions increased 84.4%, up from 76.2% in Q2 of last year. For the Americas, 91.4% of Invisalign cases were submitted using an intraoral digital scan compared to 87% in Q2 last year. Cumulatively, over 60.4 million orthodontic scans and over 12.6 million restorative scans have been performed with iTero scanners. Our Q2 exocad CAD/CAM products and services, which include restorative dentistry, implantology, guided surgery and smile design offerings are included in our Systems and Services revenue. Exocad products and services are helping extend our digital dental solutions and broaden the Align Digital Platform towards fully integrated interdisciplinary end-to-end workflows. During the quarter, exocad released dental CAD 3.1 Rijeka in the new powerful lab software, which saves design time and offers more intuitive workflows along the designs earning from CAD to CAM. In addition, the release -- the exocad release launched the new, myexocad portal, introducing mandatory end-user software use registration that for the first time, allows exocad to collect information about who and how customers are using the software. This expands the opportunities for future product improvements. Also during the quarter, we signed a new long-term contract with exocad’s largest customer, Arming Gearbox, further strengthening our relationship. Finally, we continue to execute our strategy of geographic expansion. In June, our European manufacturing facility in Wroclaw, Poland began manufacturing clear aligners for the EMEA region. Locally, for the first time, we also continued our operational expansion in Poland with our latest treatment planning facility. Our expanded operation in Poland supports Invisalign doctors in local languages, increases our flexibility and timeliness and supporting our doctor customers across the region, and we expect will positively influence the quality and time of preparation of ClinCheck treatment plans and provide our doctor customers with benefits of digital orthodontics with the Invisalign system. We are uniquely positioned with manufacturing and treatment planning in all three regions, and no other clear aligner manufacturer has our global footprint and capabilities. With that, I'll now turn the call over to John.
John Morici: Thanks, Joe. Now for our Q2 financial results. Total revenues for the second quarter were $969.6 million, down 0.4% from the prior quarter and down 4.1% from the corresponding quarter a year ago. This is compared to Q2 2021 revenues of $1 billion, which had a year-over-year growth rate of 186.9%. For clear aligners, Q2 revenues of $798.4 million were down 1.4% sequentially, due primarily to product mix and unfavorable foreign exchange, partially offset by higher non-case revenues, and down 5.1% year-over-year, primarily reflecting lower volumes, unfavorable impact from foreign exchange and product mix shift, partially offset by higher additional aligners per order processing fees and higher non-case revenues. Q2 2022 Clear Aligner revenues were unfavorably impacted by foreign exchange of approximately $12.3 million, or approximately 1.5% sequentially, and approximately $32.9 million, or approximately 4% year-over-year. For Q2, Invisalign comprehensive ASPs decreased sequentially and increased year-over-year. On a sequential basis, the decline in comprehensive ASPs reflect higher discounts and unfavorable impact from foreign exchange, partially offset by higher additional aligners. On a year-over-year basis, higher comprehensive ASPs reflect the impact of higher additional aligners and per order processing fees, partially offset by the impact of unfavorable foreign exchange and higher discounts. Q2 Invisalign non-comprehensive ASPs increased sequentially and year-over-year. On a sequential basis, Invisalign non-comprehensive ASPs were favorably impacted by lower discounts, partially offset by product mix and unfavorable foreign exchange. On a year-over-year basis, higher Invisalign non-comprehensive ASPs reflect lower discounts, per order processing fees and higher additional aligners, partially offset by the impact of unfavorable foreign exchange and product mix shift. Clear Aligner of deferred revenues on the balance sheet increased $25.4 million, or 2.3% sequentially and $231 million, or up 2.5% year-over-year, and will be recognized as the additional aligners are shipped. Q2 2022 Systems and Services revenue of $171.2 million were up 4.7% sequentially, primarily due to higher scanner volume and ASP, and were up slightly by 0.8% year-over-year, primarily from higher services revenues from our larger installed base, partially offset by lower scanner volume and lower ASP. Systems and Services revenue were unfavorably impacted by foreign exchange of approximately $2.9 million, or approximately 1.7% sequentially. On a year-over-year basis, Systems and Services revenue were unfavorably impacted by foreign exchange of approximately $7 million, or approximately 3.9%. Systems and Services deferred revenues on the balance sheet was $13.3 million, or 5.4% sequentially, and up $99.6 million, or 62.3% year-over-year primarily due to the increase in scanner sales and the deferral of service revenues included with the scanner purchase, which will be recognized ratably over the service period. Moving on to gross margin. Second quarter overall gross margin was 70.9%, down two points sequentially and down 4.1 points year-over-year. Overall, gross margin was unfavorably impacted by approximately 0.5 points sequentially and 1.1 points on a year-over-year basis due to foreign exchange. Clear Aligner gross margin for the second quarter was 73.3%, down 1.5 points sequentially due to lower ASPs and higher freight costs. Clear Aligner gross margin was down 3.6 points year-over-year due to a higher mix of additional aligner volume, higher freight and manufacturing spend, partially offset by higher ASPs. Systems and Services gross margin for the second quarter was 59.8%, down 3.6 points sequentially due to higher manufacturing variances and freight costs, partially offset by higher ASPs. Systems and Services gross margin was down 6.1 points year-over-year due to lower ASPs and higher manufacturing variances, partially offset by higher service mix. Q2 operating expenses were $499.4 million, down sequentially 2.3%, and up 2% year-over-year. On a sequential basis, operating expenses were down by $11.9 million mainly due to lower incentive compensation and controlled spend on advertising and marketing as part of our efforts to proactively manage costs. Year-over-year, operating expenses increased by $9.7 million, reflecting our continued investment in marketing, sales and R&D activities and investments commensurate with business growth. On a non-GAAP basis, excluding stock-based compensation, amortization of acquired intangibles related to certain acquisitions and acquisition costs, operating expenses were $466 million down sequentially 3% and up 1% year-over-year. Our second quarter operating income of $188.2 million resulted in an operating margin of 19.4% and down 0.9 points sequentially and down 7.2 points year-over-year. Operating margin was unfavorably impacted by approximately 1.1 points sequentially due to foreign exchange. The year-over-year decrease in operating margin is primarily attributable to lower gross margin, investments in our go-to-market teams and technology as well as unfavorable impact from foreign exchange by approximately 2.4 points. On a non-GAAP basis, which excludes stock-based compensation, of intangibles related to certain acquisitions and acquisition costs, operating margin for the second quarter was 23.3%, down 0.7 points sequentially and down 6.5 points year-over-year. Interest and other income expense net for the second quarter was a loss of $14.6 million, down sequentially by $4 million and down year-over-year by $14.5 million, primarily due to larger net foreign exchange losses from the weakening of certain foreign currencies against the US dollar. The GAAP effective tax rate in the second quarter was 35% compared to 28.4% in the first quarter and 25.7% in the second quarter of the prior year. Our non-GAAP effective tax rate was 25.6% in the second quarter compared to 24.2% in the first quarter and 19.5% in the second quarter of the prior year. The second quarter GAAP effective tax rate was higher than the first quarter effective tax rate primarily due to foreign income tax at different rates and lower excess tax benefits from stock-based compensation. Second quarter net income per diluted share was $1.44, down sequentially $0.26 and down $1.07 compared to the prior year. Our EPS was unfavorably impacted by $0.26 on a sequential basis and $0.42 on a year-over-year basis due to foreign exchange. On a non-GAAP basis, net income per share was $2 for the second quarter, down $0.13 sequentially and down $1.04 year-over-year. Moving on to the balance sheet. As of June 30, 2022, cash, cash equivalents and short- and long-term marketable securities were $977.2 million, down sequentially $143.4 million and down $109.2 million year-over-year. Of our $977.2 million balance, $251.4 million was held in the US and $725.8 million was held by our international entities. Q2 accounts receivable balance was $931.9 million, down approximately 2% sequentially. Our overall days sales outstanding was 85 days, down approximately two days sequentially and up approximately 13 days as compared to Q2 last year. Cash flow from operations for the second quarter was $127 million. Capital expenditures for the second quarter were $76 million, primarily related to our continued investments to increase aligner manufacturing capacity and facilities. Free cash flow, defined as cash flow from operations less capital expenditures amounted to $51 million. In Q2, we purchased $200 million of our common stock through an accelerated stock repurchase program, receiving approximately 757,000 shares at an average price of $264.37 per share. We are over halfway through our May 2021 $1 billion repurchase program, and have approximately $450 million remaining available for purchase. Now turning to full year 2022 and the factors that influence our views on our business outlook. Overall, our Q2 results were solid, and we feel good about the execution across the business, especially in an increasingly challenging global economic environment. Delivering revenues and volumes relatively unchanged from Q1 and down only slightly year-over-year despite unfavorable impacts from foreign exchange speak to the strength of our underlying products and services and the size of our market opportunity. We remain confident in the huge underpenetrated market for digital orthodontics and restorative dentistry, our technology and our industry leadership and our ability to execute and make progress towards our long-term model of 20% to 30% revenue growth. We also remain committed to our goal for fiscal 2022 to deliver GAAP operating margins above 20%, while making strategic investments in sales, marketing, R&D and operations, notwithstanding the impact from unfavorable foreign exchange, which was not factored into our operating margin guidance for the full year. Capital expenditures primarily relate to building construction and improvements as well as a digital manufacturing capacity to support our international expansion. For 2022, we expect our investment in capital expenditures to exceed $300 million. This includes our investment in our aligner fabrication facility in Wroclaw, Poland. In times like these, our strong fundamental Business differentiates align, and we are grateful to have a profitable underlying business model that generates strong cash flow as well as a healthy balance sheet that provides flexibility to invest in our growth while supporting our employees, customers and shareholders. As we move into the second half of the year, we will continue to manage our investments to account for headwinds and uncertainty while focusing on successfully delivering on our strategic growth drivers. With that, I'll turn it back over to Joe for final comments. Joe?
Joe Hogan: Thanks, John. Closing Q2 in the first half of 2022 has proved to be tougher than we expected. As we continue to navigate macroeconomic uncertainty and weaker consumer confidence and impacts related to COVID-19 variance, we cannot lose sight of the strong fundamentals of our business and the enormous market opportunity for digital orthodontics and restorative dentistry. The decisions we make this year will have lasting strategic implications for the future of our industry and the competitive landscape. We are holding true to our business strategy, and making good progress in a very difficult operating environment. We remain committed to balancing investments to drive growth and long-term strategic priorities with near-term headwinds while acting with a sense of urgency to ensure that we're ready to capitalize and extend our global innovation leadership as growth resumes. Thanks for your time today. We look forward to updating you on our next earnings call. With that, I'll turn it over to the operator. Operator?
Operator: Thank you. At this time, we will conducting a question-and-answer session. [Operator Instructions] The first question is from Nathan Rich with Goldman Sachs. Please proceed.
Nathan Rich: Thank you, good afternoon. Hey, Joe and John. I guess, I wanted to start high level. Joe, you kind of highlighted the consistent case in revenue trends in the second quarter relative to the first. But within the context of a challenging macro environment, I guess, how does that influence your thinking on the trajectory of the business? And have you seen an impact on patient traffic to dental practices or treatment acceptance rates that's kind of driving that commentary?
Joe Hogan: Nate, it's a -- if you look at this from a domestic standpoint, you can pull out some signal, but I think you have to when you're asking a demand question like that, you have to look at this globally. And I think like John and I were just clear in our introduction that basically, if you took Asia, COVID-19 impacted us pretty tremendously in Asia. Japan for a little bit in the first part of the quarter in China almost throughout the quarter. So it was really a COVID discussion there, and it's hard to pull a demand signal out. In the United States, I mean, if you look at the data that we do, you'll see from a general practitioner standpoint or whatever, some stability in patient vision to what's going on. Our concern here is, obviously, this is a product where like a cap or a crown or cleaning or something that needs to be done, it's somewhat discretionary. And we see that from an adult standpoint, more variability in adult selection than in teens. Teens have been pretty stable in that way if we talked about before. Moving over to Europe. We're working off 300% growth rates in Europe last year, okay, which you have to internalize that. It's a pretty big comparison year-on-year. And there weren't standard vacations being taken in Europe to the beginning of the end of the second quarter and the third quarter. So overall, I'd say, as you look around the globe, I fee like -- I felt good, as we mentioned in the script, about Q1 versus Q2 and pretty much the same kind of demand pattern. But right now, I can't really give you a trajectory in the third quarter and the fourth quarter, because of the macro environment, concerns again in China from another COVID shutdown and those types of things. I hope that makes sense, Nate.
Nathan Rich: Yes, definitely. And maybe just a quick follow-up. – were you, I guess, able to size kind of the headwind from the lockdowns in China? And with that -- in that market specifically, have you started to see those volumes recover as we're starting to see those lockdowns ease?
Joe Hogan: For sure. I mean it's direct correlation there as soon as they let Shanghai open again, we saw it reflected in our order rates there. And look, we continue to feel good about China in a stable market. It's just the dramatic way that China continues to address COVID cases by major cities. This just creates a huge amount of uncertainty as when the next lockdown will be.
Nathan Rich: Thank you.
Joe Hogan: Thank you.
Operator: Thank you, Mr. Rich. The next question is from the line of Elizabeth Anderson with Evercore. Please proceed.
Elizabeth Anderson: Hi, guys.
Joe Hogan: Hi, Elizabeth.
Elizabeth Anderson: Thanks so much for the question. One thing I was wondering if you could comment about -- I know in the sort of fourth quarter of last year, and into the first quarter, you did increase the sales hiring, sequentially and year-over-year. Could you sort of talk through sort of the impact of those salespeople? Where are they in the ramp process? And how do you -- should we think about their potential for contributing in the back half of the year? Thanks.
Joe Hogan: That's a good question, Elizabeth. Obviously, our sales force -- being a direct sales force is really important to us in that way. And so the way we do this, obviously, as you indicated, we hire a lot of salespeople upfront. We have sales training programs too that help to initiate them as they come into the corporation. But I would tell you, depending on where you are around the globe, there is a six-month and nine-month burn-in period, before you really feel that they're up to speed. They understand the Invisalign system, the digital platform and those types of things. So I would say in some simpler kinds of situations geographically, it could be six months. But in general, it's nine months or so before we have confidence that they're going to be really good on their feet as they talk to our doctors.
Elizabeth Anderson: Got it. That's helpful. And then one thing that depressed me in the quarter a little bit was about the teen number. I know that sometimes this quarter, it's been off because of COVID in terms of seasonality, and it's not necessarily always the strongest quarter for teen. But how are you thinking about that versus the economic sensitivity of adult cases and sort of how -- do you expect that to sort of trend in the sort of near-term?
Joe Hogan: Yes. Keep in mind, we see a lot more concern from an adult standpoint, when you look year-over-year in the sense of our order growth in adults, I mean it's been affected Elizabeth, and there's a lot of data that we produce that will show you that. On the teen side, it's hard to pull a lot of the second quarter because it really starts in the third quarter. But I felt overall good about it, but again, not surprised because we've always felt that teens have a certain window of time from a treatment standpoint. And so it's not necessarily an emotional purchase in a way, it's usually planned for and anticipated. And -- and what we saw between the second quarter and beginning of the third quarter, it really bears that out.
Elizabeth Anderson: Got it. Okay. Thank you very much.
Joe Hogan: You’re welcome.
Operator: Thank you, Ms. Anderson. Our next question is from the line of Jon Block with Stifel. Please proceed.
Jon Block: Great. Thanks, guys. Good afternoon. I'll follow up on teen, maybe just to go there. I think worldwide teen was down year-over-year. And I believe, Joe, you mentioned that teen and APAC was up year-over-year, which sort of implies that North American teen was down maybe a decent amount. So anything to call out there? Why do we see that maybe specific to North America? And then more importantly, you did have some positive commentary around teen case packs, you talked about enrollment. So maybe just talk to us on how long it might take for the teen case pack program in North America to give that segment a shot in the arm and then your plans to roll that out internationally? I've got a follow-up.
Joe Hogan: Jon, on the teen side, remember, we kind of lost -- or we had a muted signal on the team side. It needs to be very clear from quarter-to-quarter before COVID. If you remember last year, it was much more muted. This year, we're hoping to see a less muted cycle. And I think we're starting to feel that, Jon. So it's -- I don't think you can look too much between what we're doing between the first quarter and second quarter and pull a clear teen signal out of there. The other thing on teen too is there's always competitive concern with other clear aligner whatever. But basically, this is a wires and brackets competition with us. It's always been and continues to be that way. And in new products that we're launching these teen packs, we feel good about them. They've been -- as I mentioned in my script too, they've been received well. And it's been with the lower-end orthodontics from our standpoint that haven't done a lot of teen cases in the past. And that's a segment that we were fishing for to give them more confidence to be able to move in with teens. So we're not declaring victory, but we feel we have a good product that's timed well. And we're not seeing the cycles in the teen marketplace as we're seeing in the adult marketplace. And obviously, Jon, as we get through the third quarter, we'll have a much better understanding of how we turn out that way. But I didn't pull anything out between the first and the second quarter that concerned me.
Jon Block: Got it. Helpful. Thank you. And then for my second one, let me try to maybe jam two in one, and hopefully not make a mess of it. So just for us on the 3Q versus 2Q overall case volumes, China is reopened. China is a decent chunk of business for you guys. So if China snaps back, you talked about Shanghai, then maybe talk to us on why we wouldn't see you guys resume some sequential growth 3Q versus 2Q? I know there's many other markets. And then maybe just to stick with China. I just love your thoughts on what's going on over there, maybe in terms of market share, your main competitor had some quasi numbers out recently. It looked like they were down mid-single digits in cases 1H 2022 year-over-year, which quite honestly, I actually thought that was a good number considering the environment. So I would love your thoughts on just China and your ability to hold share on what's going on from a market share perspective? Thanks guys.
Joe Hogan: Yeah. I'll start with the China and move backwards, Jon. And I'll get John involved here, too. But from the China side, obviously, we saw what you published there, whatever, but I looked at Angel numbers, and it basically same thing we experienced. I mean, we experienced a shutdown of Shanghai, slowdowns in some other regions, and there was nothing in those numbers that really surprised me. As I look at China, our ability to compete there. I feel great about it. And again, our investments we've made there in treatment planning and manufacturing. We've only added to that. The efficiency of those organizations have done well. Our product is great for that marketplace, and some of the most difficult cases that we encounter exist there, too. So I feel good about our ability to compete in that market against Angel or anyone else who's there. We just need a stable marketplace that we can operate in, and it hasn't been stable for -- goodness knows, it's been, what, almost two years. And I mean I just read this morning, the Wuhan's looking at the close down. So I mean, Jon, there's a lot of variability there, a concern with COVID and shutdowns, particularly in the second half of this year in China, but I continue to be concerned about that can disrupt the marketplace. But if that stays clear, we're going to have China in the second half that we can operate from. To answer your question, I feel good about our competitive position there, our ability to compete against with anyone.
John Morici: And we should see some of the sequential history that we normally see in our business. It goes to what Joe said that, there's just some unforeseen variables that are still there. If there is a shutdown in China, that will impact our numbers. If there's no shutdown, we should see sequential improvement. And then you have some of the other macro economics that we've talked about in terms of potential recession or other things that people are concerned about, that affects their decisions on whether they go into treatment. But we're watching closer to see how sequentially things are behaving and making investments appropriate based on what we see.
Joe Hogan: And Jon, sorry, just staying back to your second question...
Jon Block: Sorry. if I can just jump in...
Joe Hogan: Go ahead, Jon.
Jon Block: Sorry, Joe. I was just going to say, John and Joe, maybe to follow up on that lasts comment just for clarity purposes because I think it's an important one. Are you guys saying sort of as you sit here today, who the heck knows what's going on with Wuhan, I don't know, something worse incrementally with the economy. But as we sit here today in late July, you're expecting the resumption of sequential growth off the 2Q number, this evening?
Joe Hogan: Well, I'd say, Jon, expecting anything in this market might be a sign of a low IQ. When you look at what's going on in China, I'm not going to sit here and tell you I expect a stable market in the second half based on their COVID policies. So I hope -- from the United States standpoint, there's a lot going on trying to explain to the teen market overall outside of China, I feel is the most stable market we have, and the one that we're ready to compete with, and we're moving into seasonality, what really makes a difference. We have -- we're positioned well with products. But as you know, Jon, as well as anybody, that's always been a wires and brackets marketplace. We've been taking share 1.5 points, two points a year. We're hoping some moves we make can make that better, but we'll know a lot more when the third quarter is over in the sense.
Jon Block: Okay. Very helpful. Thanks, guys.
Joe Hogan: Thanks, Jon.
Operator: Thank you, Mr. Block. Our next question comes from the line of Jeff Johnson with Baird. Please proceed.
Jeff Johnson: Thank you. Good afternoon, guys. Joe – hey, Joe, so I just wanted to talk maybe on the doctor shift to that number this quarter. It's trended down each of the last couple of quarters. This quarter in the Americas, it did trend back up just a touch. What are your views on what that means? Is that a -- market stabilized a little bit? Is that maybe the competitive positioning is stabilizing a little bit? Just how do you view that number in the Americas? And is there room left in the Americas for that number over the next couple of years to keep moving higher? Are you kind of at a point where you've saturated kind of the Americas market with a number of doctors who are going to be performing in these cases?
Joe Hogan: Just to answer your last part of your question first, Jeff. No, we have a lot of room to grow in the Americas, too. In United States, Canada, but also you have to throw in Latin America and Brazil in that. There's a lot of growth, John and I have ported over these numbers a lot. You know what happens, if you backed these numbers up before really the big surge in orders that we had before, we can draw a line through these things. It doesn't upset us. You have to split orthos and GPs very clearly. Remember, you have some GPs that do like three cases a year. As things kind of slow down, they'll be out of the circulation for a while and then they order another and whatever. And these numbers will go up 81, 1,000, 2,000, we'll see them go up and down. But don't look at this in any way as that we're saturated in this marketplace, both from an orthodontic standpoint and a GP standpoint. Jeff, the other thing too, I think, that people forget from an orthodontic standpoint is that our orthodontists who do teens. These are orthodontists that are really committed to Invisalign for the most part, and they do a lot of teens. But we still have a significant amount of orthodontists at do Invisalign almost exclusively for adults. And so you'll see that whole piece from a utilization standpoint as we increase our team penetration, you should see the utilization rates there improve.
Jeff Johnson: Yeah, that's helpful. And then maybe kind of a follow-up on all that a two-parter, just the international number again, kind of, did tick down a little bit that number of factors shipped to internationally. One, I would assume you think there's a lot more room even there to saturate that market over the next few years, that would seem to make sense to me anyway. But is there any way to look at what that number did in China? And was there sequential decline largely driven by the shutdowns in China, or ex-China, would that number have been up? And then I was a little surprised to hear cases down, I think you said in UK year-over-year. Is that just a tough comp, or what's going on in the UK? I think we are all aware of China pressures in early, Japan pressures or early quarter Japan pressures, but UK caught me off guard a little bit there? Thanks.
Joe Hogan: I'll answer the UK piece first. The UK was outstanding for us last year. Remember, Europe grew 300% for us last year, Jeff, right? The UK led that. So I'm sure that UK number is higher than what that aggregate number is. And so what you're seeing is adult retrenchment in the UK from an order standpoint, but not an indication of a utilization issue that I'd say, across the doctor base that we have in the UK. John, I don't know… : And just on the China piece or the APAC piece for international. So that was certainly an impact in terms of the lockdowns, and doctors just not being able to transact and therefore, don't have ship to. So the international side of the doctor ship was certainly impacted by COVID. We won't break it out by the sub-regions. But that was an impact that look, as those offices open up, as those lockdowns are minimized, we would expect that to increase from a ship to stand.
Jeff Johnson: Thanks guys.
Joe Hogan: Yeah. Thanks Jeff.
Operator: Thank you, Mr. Johnson. Our next question is from the line of Justin Lin [ph] with William Blair. Please proceed.
Unidentified Analyst: Hi, good afternoon. Can you just touch on your sales and marketing spending strategy a little bit in the short-term and longer term? I guess, when can you decide to flip the switch?
Joe Hogan: You mean flip the switches as far as up or down?
Unidentified Analyst: Yeah, yeah.
Joe Hogan: Yeah. I mean, obviously, obviously, we saw our adults dramatically decreased, and so the return on investment in some specific geographies. John, as I take a look at it, and we don't eliminate it, but we reduce it in accordance with what we think the demand pattern is. And we spread it around into other countries that we feel we can get a higher return on. And we just basically sizing our advertising to what we think the demand patterns are around the business in different areas. And so I wouldn't look at this as any way that we'll continue to advertise aggressively and promote our brand and to drive value in our change to bring customers to our doctor base, but we can be responsible to we can advertise at the rate that we did last year when we were growing at over 100% in a lot of these regions, we have to modify it somewhat in order to address that demand pattern.
John Morici: And we adjust into the market. So keep the overall brand awareness, keep that averages. Remember, still sudden spending even as we right-size things, hundreds of millions of dollars in marketing and media to be able to go to market, drive that awareness. But then in certain markets, if there's COVID or if there's economic concerns and so on, we're adjusting things to make sure that we right-size and continue to make sure that we make the right trade-off between how we're investing in go-to-market, and continue to reinvest in the rest of the business like R&D and operations.
Unidentified Analyst: Got it. That's very helpful. And I guess just pivoting to a more sort of higher-level question. Any update on commercial operations in sort of your emerging markets like Brazil, India, Africa, what would you say current penetration levels are over there? And I guess, realistically, how much revenue can you capture from those regions in the next, let's say, five to 10 years?
A – Joe Hogan: And the region that you mentioned were really underpenetrated, huge opportunity. I mean we've seen great progress in Brazil. We're seeing good progress in India. Reported in -- I mean, it's -- when we talk about those 500 million patients, they're out there. And the way to get them is we do -- we put salespeople in place. We put the right kind of capability on the ground. This is a direct sales force that you have to have in order to sell our product line. But to answer your specific question, the penetration rates aren't even close. And that's -- again, you can see that in our script, that's how we remain so confident that in a stable environment, we'll continue to perform really well.
John Morici: And we're built as a company to really expand into those markets. We've got that global footprint for manufacturing now in all three geographies. We've got treatment planning. We've got that go-to-market sales force -- direct sales force with great products. So we're built in all those markets. We like the dynamics of these markets where you have a growing middle class, big population. You've got people who want to straighten their teeth, and we've got a great way for them to get to that. So all the markets you described as well as many others, those are where we think of some of the investments because it's a great return on those investments.
Unidentified Analyst: Got it. Thank you very much.
Joe Hogan: Thank you.
Operator: Thank you, Mr. [indiscernible]. Our next question is from the line of Jason Bednar with Piper Sandler. Please proceed.
Joe Hogan: Hi, Jason.
Jason Bednar: Hey, good afternoon. Yes. So Joe, I'll go big picture here in the US market, and maybe go back to clarifying point on Jon Block's question earlier. On one hand, demand in the category broadly just did seem to show some signs of moderation in the second half of last year relation to a bit of a leading indicator in other parts of high end then on the help of the average consumer. I mean this needs are going to be coming into some easier absolute comparisons as we head into the back half of this year, which I don't know, maybe helps reverse this downtrend in Invisalign case growth. But I guess we're also in the early days of what still could be some more pain coming for the consumer. So I guess what dominates in your opinion? Do the easier comps dominate, or does it more challenge on consumer dominate? And again, just thinking about the domestic market you're and ignoring again some of that China and predictability that's out there.
Joe Hogan: Yes. I'll let John take a shot at this, too. But I would say, I mean, obviously, you talk about easier comps. I mean when you're comping against 300% growth, like we just talked about, it's one of the tougher comps on a large number I've had in my business career. And so obviously, when you get some light on that line, it helps somewhat. But consumer confidence. I'd say, outside of the COVID, the way I'd look at the business again is COVID affected Asia in a big way. We had some COVID staffing issues or whatever, but predominantly in the West, it's consumer confidence that we look at. And so those consumer confidence numbers start to equalize to start to get better. Some of the ones we look in Europe are all-time lows. I feel that means a lot. It means that means more to meet in those comparisons years from here. We report more confidence in consumers in a trend where in that kind of environment, we think we see the adult cases resume at a pace that we'd be equal to our long-term growth rate.
John Morici: Yes. It's consumer confidence overall, and in certain cases…
Jason Bednar: I guess, just real quick, I guess I would -- yeah, I guess I was just focusing more on the US market. And I totally understand Europe and China and APAC and all the different dynamics there. But just in within the US market, I mean, the comps do get easier, absolute comps -- they did tick down starting in the second half of last year. So just I'd be where I'd be focusing the question here, sorry to interrupt.
Joe Hogan: Yeah. No, Jason, that's okay. I look at the United States too is -- I just give you consumer confidence more than anything. Not just saying that there's no big variant issue or something that happens with COVID. We're all kind of have PTSD in that sense and what we experienced over the last two years. But yeah, I like the comparison year-over-year. That's going to be helpful. But those consumer confidence numbers, whether I'm talking about Europe or I'm talking about the States, those are the ones that we stay alluded to that we think are a really good indicator in the sense of our market, and that adult market that we appeal to, both in the GP segment and the adult market in the orthodontic segment, too.
John Morici: And the piece that I would add to the US is just that as we get into teen season now as we go from Q2 to Q3. Teens will be important to see. We've got great products. We've got great go-to-market opportunities to be able to grow in those markets and get more market share. When we think of teens everywhere in the world, it's single digit and even in the US. So we look at growth opportunities that will be teens, maybe a little bit less of more resistant to maybe some of that consumer concerns that they have. Consumer concerns certainly show up on the adult side, but we think teams can help offset that just a bit because it's less discretionary.
Jason Bednar: Okay. That's helpful. And maybe just a quick follow-up here. A lot of questions out there right now from investors on the decremental margin impact for the business with volumes and revenue doing what it's doing here. You added a lot of head count. It's significantly expanded branding and advertising efforts during the pandemic really helped to widen the competitive moat, so really impressive. It sounds like some of that marketing though has been recalibrated here. Are there further resets that -- with the OpEx structure that might be necessary in this environment? And I guess, what's the trigger for you to decide that a further rightsizing is necessary?
Joe Hogan: I mean rightsizing, when I hear words like that, it means that we've gone to the layoffs, so we haven't laid anything off. Remember, we -- any one off in that sense. We normally hire to a 20% to 30% growth rate. And so -- and we -- our OpEx spend is in that range, too. So, obviously, we didn't -- we couldn't hire in that range, and so if you call that a cutback, it's a cutback from our normal OpEx. What we do is we normally balance OpEx to revenue at about a 50% range, and there's a lot of variables in that line from an OpEx standpoint that we can go about. Remember, our most important areas that we want to make sure we take care of is our commercial team, our engineering effort and also our marketing. We know those are really key. And we focus on those, and we balance the business well. John, anything you want to add?
John Morici: It's a balance, both short and long-term. So as we balance out our plans, we look to the growth opportunities we have, we want to make sure we continue to invest in those growth opportunities. But then obviously, we have to be mindful of the current conditions that we're in, and we'll adjust as needed to still maximize the return on investments that we're making.
Jason Bednar: All right. Thanks so much.
John Morici: Thanks Jason.
Operator: Thank you, Mr. Bednar. Our next question is from the line of Erin Wright with Morgan Stanley. Please proceed.
Erin Wright: Great. Thanks. And I wanted to ask another Americas teen question here. But just given the seasonality and given this is an area where you should have some better visibility. I just want to clarify, does this -- does this mean you're going to see a meaningful sequential pickup in the coming quarter, or why would that not happen for you? And just given that should be an area more under your control here. Thanks.
Joe Hogan: Yes. Our normal growth pattern between the second quarter and the third quarter is flat to down 1 percentage point or so. John can confirm that. So the second quarter to third quarter is a big teen season, but there's other parts of our portfolio that kind of balance out with that. It's not traditionally a jump from second to third quarter. But again, we're focused on teens because we feel teens have a lot less elasticity than what adults have right now based on the consumer confidence level. So I just -- but I'd just caution you here. Remember, this is a wires and brackets play. It's something that's systemic that we have worked on for years. We have many new products like Invisalign First, I mean give advancement and several new teen products that help us with this. The new teen packs help also. We think we're well positioned, but we have to get into the quarter and be able to assess how well that market is actually holding up. John, anything...
John Morici: But specifically in the US, US teen, we should see sequential improvement as we get into teen season, going from Q2 to Q3, notwithstanding any occurrences that happened from an economic standpoint, but the expectation is given our products, given the opportunity, given the utilization that we have, we should be able to see growth. Notwithstanding, anything else that gets in our way.
Erin Wright: Okay. Thanks. And then ASPs for the balance of the year, how should we be thinking about that and the FX impact?
John Morici: Erin, FX, obviously, Q1 to Q2 was a big impact in FX. We see it in the numbers from revenue all the way down to our EPS. I would think of it's tough to forecast where FX is going to go. Certainly, dollar has strengthened. I think you kind of take the numbers that they're at now and kind of play that forward for the rest of the year is how we look at that. I think from an overall ASP standpoint, there's always going to be puts and takes. So we're not doing anything different from a discounting standpoint, how we're going to market and so on. You might have some mix effects that come through. But I take the FX rates kind of as they are now, project those forward and then ASP should be too much different than what you see now notwithstanding any FX.
Erin Wright: Okay. Thank you.
Operator: Thank you, Ms. Wright. The next question is from the line of Brandon Couillard with Jefferies. Please proceed.
Brandon Couillard: Thanks, John, a quick follow-up on that FX question. I appreciate all the details in the deck. It is very, very helpful. Just curious, what is the estimated impact of currency on the operating margin for the year now in the ballpark?
John Morici: Well, ballpark, I would look at that is about 1 point, maybe just over 1 point of impact. We saw that 1.1 point impact from Q1 to Q2 in op margin. I would kind of look at the full year and about the same.
Brandon Couillard: Thanks. And then Joe, on the scanner business, any color between the North American segment and international in terms of growth rate, how would you sort of characterize the capital spending environment in those two regions, specifically?
Joe Hogan: Yes. I'll start with -- I mean, obviously, we had trouble selling scanners in China because China shut down. And China is one of our bigger markets is between China and Japan and Asia. So I didn't look at that so much as and overall market problem, I looked at that as more of a COVID problem. And so hopeful of, as I mentioned before, if that COVID stays clear, that will write itself. United States, just a good job by the team, strong demand there. 5G plus tends to be the really strong scanner out there. On the restorative side, dentists liking the NERI, the near-infrared technology for carries detection and orthodontists continue like the exactness of how our workflows at all from an overall iTero standpoint. So I feel good about the Americas and what the performance was in that piece. And as I mentioned in my script is 40% with a large installed base now, 40% is services, too, which is really helpful in that business overall. And look, I feel good about, again, our scanners in Europe compared to get some pretty big numbers again last year. So I wouldn't be blinded by the year-over-year number in that sense. But Europe has the added pressure right now from a Ukraine standpoint. It's just -- it wears on the consumer sentiment piece. I think it makes docs a little more reluctant in -- but there's -- I feel good about our position in Europe from a scanner standpoint. And as the market hopefully starts to stabilize here, we'll see that business that we had return loans.
Brandon Couillard: Okay. Thanks.
Operator: Thank you. Our next question is from the line of Kevin Caliendo with UBS. Please proceed.
Kevin Caliendo: Hi, thanks for getting me in. So just want to think about how -- or what it would take for you guys to feel comfortable with providing guidance again, or feeling comfortable that you can hit your longer term targets rather than making progress towards it. Do we need to see consumer confidence go back above 99% or something like that, or I mean, at the beginning of the year, you caveated and said, listen, if there's no more COVID outbreaks, we'd still be able to do this. What do you need to see before you can come to us and say, hey, we're back on track or we think we can do this? So we feel comfortable. We're going to be able to grow at ex-rate going forward, even be able to provide guidance for like a quarter going forward, even if it's not for the full year. What needs to happen, in your mind?
Joe Hogan: I'll turn it over to John. But first of all is, remember, we don't carry inventory in this business outside of scanners. So it's a real-time business. We don't have any inventory to reflect from or any -- very little business from a week-to-week standpoint. So I'll move it over to John, but keep that in mind that we, kind of, feel these trends early on both ends. As the economy picks up, we'll probably feel it first. And as it turns down, we feel it by just the nature of the business first.
John Morici: It really comes down to, Kevin, more just having more predictability on a macro basis, understanding you mentioned COVID and thinking that we're through it, then you have China lockdowns or some of the consumer sentiment and things that come up that are outside of our control, we feel very good about being able to control what we can control, making the right investments as we go to market or adding investments in R&D to better our products and so on, and drive that return. And, therefore, like I said, we can manage that 20%, that’s something that we can manage as we go through the quarter. It really comes out to having more predictability on a macro basis. And once we get confidence in that, and we work our way to that understanding, look, the economies are going to do what they're going to do. They're going to go up or down. But if I have more predictability on the direction that they're going and how they're going to go, then we can give a good forecast.
Kevin Caliendo: All right. Appreciate that. Thank you.
Operator: Thank you, Mr. Caliendo. Our next question is from the line of Michael Ryskin with Bank of America. Please proceed.
Michael Ryskin: Great. Thanks for taking the question guys. I have kind of a follow-up to one of the earlier ones, and some that Kevin just asked sort of on the moving pieces going forward. I mean we spent a lot of time talking about China lockdowns and the impact that had, and there was some discussion on consumer confidence as well. But it was sort of brought up in the sense of, well, what happens when things improve. I hate to be the pessimist here, but can we talk about the other side of things as inflation is one thing and consumer sentiment and consumer confidence is another thing. But recessionary impact, if unemployment goes higher, if job losses start to accelerate, there is a scenario where things are -- should get worse for the next couple of quarters before they get better. So can you talk through sort of how you view the likelihood of that happening, the impact you think it will have on the business? And also sort of what's your response going to be what's the game plan? You talked a little bit about controlling costs in the quarter already. What would be the other levers you would pull if things for the consumer in the Americas and in Europe get materially worse over the next three to six to nine months?
Joe Hogan: It's Joe. Look, I think you've seen that -- I feel we've been responsible in the sense of adjusting the business to a lower demand signal than the business is used to having. I think you saw us respond the same way when COVID hit in March of in 2020, and how we ran the business. If it gets worse, and it could get worse is the way -- I mean from the standpoint of whatever happens from an economic standpoint. I'd just say that, look, John and I come from businesses where we've been through these cycles. We know how to operate in a down cycle. We run a business that way. This is a growth business, and we'll treat it as a growth business, but we're responsible from a standpoint of making sure that we adjust this business to whatever economic conditions that we see out there.
John Morici: And as a result, we've been able to make these adjustments. We're fortunate as a company to have the cash position, the balance sheet that we have and all these other. And in the end, you know the story, we have a huge opportunity to be able to grow. You just have this in our way. And like Joe said, and what many others say is it could get worse. We have to be able to be able to balance those short-term worse to with our long-term goal of being able to make Invisalign the standard of care. And that's what we're balancing right now, and that could play out -- that will play out in the next -- whatever, a year to 18 months, things will evolve. We hope that the economies improve. We hope that that a lot of this has just got a short term and things get better. And when things do get better, we're well positioned to be able to grow into this market, but we just have to be based on the realities of what's happening in short term.
Michael Ryskin: Great. And a quick follow-up, if I can. On 1Q, you kind of gave some comments on pacing through the quarter, and gave some comments on April as it relates to March. Kind of get the sense that things probably slowed down at the end of 2Q or bit in June, both between FX and China lockdowns being worse. Any sense you can give on sort of the progression through the course of 2Q? And just any early signs you've seen from July, again, realize that walk-down in China and FX is playing a big role. But maybe if you could just focus on America's trends through the quarter, and July. That will be helpful.
John Morici: Yes. No, it's a good question. So if you think like an overall picture, you hit some of the FX and so on, you look -- everybody can look at FX rates and see the changes and so on, you can project based on those. When you talk about a COVID lockdown or talk specifically in China, there was an impact for us. And we've seen that in the first quarter, we saw it in the second quarter, but it's -- happens in China. It happens in every place that we see where there's a lockdown, we have a reduction in volume. Where that lockdown goes away, the volume starts to come back. So I would say when you think of China, as you go from lockdown to not lockdown, that's favorable for us. We start to see some of the volume come back. And I think when you look at -- I think part of your question is around the US, I think what do you see for the US is it's -- maybe things stabilizing a little bit more. You're not seeing -- maybe it's pretty similar to what we exited Q2 into Q3. And I think when you look at the team benefit that ideally comes through with some of the products and programs that we have in teen in the US and other places, but focus on the US, we think that's helpful for us as we go from Q2 to Q3.
Michael Ryskin: Okay. Thanks.
Operator: Thank you, Mr. Ryskin. We have reached the end of our question-and-answer session. I will now turn the call back over to Shirley Stacy for closing remarks.
Shirley Stacy: Thank you, operator, and thank you, everyone, for joining us today. We look forward to speaking to you at upcoming financial conferences and industry meetings. And if you have any follow-up questions, please contact our Investor Relations team. Have a great day.
Operator: Thank you. This concludes today's conference, and you may now disconnect your lines at this time. Thank you for your participation. | [
{
"speaker": "Operator",
"text": "Greetings. Welcome to the Align Q2 2022 earnings call. At this time, all participants are in a listen-only mode. A question-and-answer session will follow the formal presentation. Please note this conference will be recorded. I will now turn the conference over to your host, Shirley Stacy with Align Technology. You may begin"
},
{
"speaker": "Shirley Stacy",
"text": "Good afternoon, and thank you for joining us. I'm Shirley Stacy, Vice President of Corporate Communications and Investor Relations. Joining me for today’s call is Joe Hogan, President and CEO; and John Morici, CFO. We issued second quarter 2022 financial results today via Business Wire, which is available on our website at investor.aligntech.com. Today’s conference call is being audio webcast and will be archived on our website for approximately one month. A telephone replay will be available today by approximately 5:30 PM Eastern Time through 5:30 PM Eastern Time on August 10. To access the telephone replay, domestic callers should dial 866-813-9403 with access code 137829. International callers should dial 929-458-6194 using the same access code. As a reminder, the information provided and discussed today will include forward-looking statements, including statements about Align’s future events and product outlook. These forward-looking statements are only predictions and involve risks and uncertainties that are described in more detail in our most recent periodic reports filed with the Securities and Exchange Commission available on our website and at sec.gov. Actual results may vary significantly and Align expressly assumes no obligation to update any forward-looking statement. We have posted historical financial statements, including the corresponding reconciliations, including our GAAP to non-GAAP reconciliation, if applicable, and our second quarter 2022 conference call slides on our website under quarterly results. Please refer to these files for more detailed information. And with that, I'd like to turn the call over to Align Technology's President and CEO, Joe Hogan. Joe?"
},
{
"speaker": "Joe Hogan",
"text": "Thanks, Shirley. Good afternoon, and thanks for joining us. On our call today, I'll provide an overview of our Q2 results and discuss the performance of our two operating segments, Systems and Services and Clear Aligners. John will provide more detail on our financial performance and our view for the remainder of the year. Following that, I'll come back and summarize a few key points and open the call to questions. I'm pleased to report solid second quarter results with top line revenues relatively unchanged from Q1, and operating margin of approximately 20%, despite unfavorable foreign exchange. The underlying market for orthodontics continues to be impacted by macroeconomic environment factors and lingering effects of COVID-19 variants in certain markets. Notwithstanding, these headwinds, we've remained focused on achieving our strategic initiatives, including opening new offices in the Middle East and Africa and our new manufacturing facility in Poland, launching new solutions to better support the way our customers want to do business, such as a doctor subscription program, and teen case packs, and announcing new products and innovation to help our doctors and their patients. These new innovations are revolutionizing the digital treatment planning and helping to drive the evolution of digital orthodontics and comprehensive dentistry. Align is well-positioned to withstand the current market conditions to lead the digital revolution in orthodontics and dentistry as the environment and growth trends improve. For System and Services, Q2 revenues were up 4.7% sequentially and up slightly year-over-year compared to Q2 2021 year-over-year growth of 215%. Q2 Services and Systems revenues increased sequentially driven by scanner volume growth in the Americas and APAC, partially offset by lower volume in EMEA, and unfavorable impact of foreign exchange. The iTero Element 5D imaging system continues to represent the majority of our scanner volume as doctors recognize the benefits of going digital. In APAC, the iTero entry-level Flex scanner offering was up sequentially in Q2, reflecting increased adoption. I'm also pleased with sequentially increasing services revenues in Q2, reflecting growth from the installed base. Services revenues represent approximately 40% of our Systems and Services business. For our Clear Aligner segment, Q2 revenues were down slightly sequentially and down 5.1% year-over-year compared to our Q2 2021 record year-over-year revenue growth of 182%. For the quarter, Q2 Clear Aligner volumes reflect sequential growth across the Americas and parts of EMEA, partially offset by China and UK Q2 Invisalign case starts for teens and younger patients was 177.3000 up slightly sequentially and down 2.1% year-over-year compared last year when our Teen case shipment growth rate was an all-time high. For Q2, Invisalign First for kids as young as six years old, grew year-over-year and was strong across all regions. During Q2, we introduced Invisalign Teen Packs in the US and Canada and France. Teen Packs, our new subscription program, which enables orthodontists to buy clear aligners and packs in advance, similar to the way they buy wires and brackets today. Our Teen Case Pack simplified the ordering process and make the billing more predictable for doctors. Teen Case Packs also include exclusive practice development benefits with the Invisalign brand and requires an incremental volume commitment from doctors. To date, enrollment has been encouraging with early adoptions highest among doctors who have not historically used Invisalign aligners to treat their teen patients. For other non-case revenues, which include retention products such as Vivera Retainers, clinical training and education, accessories, e-commerce and our new subscription programs such as our DSP revenues, were up both sequentially and year-over-year. For retainers, Q2 shipments had strong momentum with sequential and year-over-year growth across all regions driven by both submitters and utilization. Momentum in our doctor subscription program continued and Q2 revenues increased over 60% sequentially. Now let's turn to the specifics around our second quarter results, starting with the Americas. For the Americas region, Q2 Invisalign case volumes were up sequentially, reflecting increased submissions from the orthodontic channel and increased utilization from the GP channel. From a product standpoint, Q2 sequential Invisalign case growth reflects increases in both comprehensive and non-comprehensive products, including Invisalign First and Invisalign Moderate. Q2 also benefited from increased utilization in the DSO channel. Our international Clear Aligners, Q2 Invisalign case volumes were down 1.7% sequentially, primarily as a result of the headwinds described previously. For EMEA, Q2 Invisalign case volumes were down slightly primarily reflecting a slight increase in Iberia and Italy, offset primarily by slightly lower sequential volumes in the UK and France. For Q2, expansion market shipments declined sequentially. Q2 Invisalign teen patients increased sequentially driven by an increase in the number of doctors submitting teen cases. Turning to APAC. Invisalign case volumes were down slightly, reflecting a full quarter effect of continued lockdowns in China. For Q2, Taiwan, Hong Kong, Japan and India performed well during the quarter. On a year-over-year basis, Invisalign case shipments growth was strong in Japan, India, Taiwan, Thailand and Korea. The APAC teen case volume increased year-over-year, primarily driven by increased doctor submitters. Turning to new innovations. The Align Digital Platform is an integrated suite of proprietary technologies and services delivered as a seamless end-to-end solution to customers that connects all users, doctors, labs patients and consumers to transform smiles, and change lives. Our technology advancements help our doctor customers deliver superior clinical outcomes, treatment efficiency and also superior patient experience. In Q2, we introduced Invisalign Outcome Simulator Pro and Cone Beam being Computed Tomography systems, integration for ClinCheck software, building on several new innovations announced last quarter that we'll begin rolling out across the regions in August. Invisalign Outcome Simulator Pro, the next-generation patient communication tool that empowers doctors to help patients visualize their potential new smile after Invisalign treatment. Use in-phase visualization in 3D dentition view, all done chairside in minutes. Cone Beam Computed Tomography systems, or what we call CBCT, integration for ClinCheck software is designed to deliver a complete view of a patient's roots, crown and jawbone. CBCT integration for ClinCheck software enables doctors to confidently deliver a more informed Invisalign clear liner treatment plan or a wide range of cases. The user-friendly interface makes easy for doctors to see their patients root, crown and jawbone and one automatically digitally fused 3D model. This allows doctors to tailor their treatment plan based on their experience and their patients' needs. CBCT integration for ClinCheck software gives doctors the control and confidence to expand treatment planning to a broad range of mal inclusions, including surgical, restorative, expansion, extraction as well as teen cases with impacted or unterrupted team. While it's still early in the commercialization of these new products, initial feedback from doctors is encouraging. We are excited to begin scaling them across our customer base in the second half of 2022. Also, during the quarter, we awarded 11 new research grants, totaling $275,000 to universities around the world. Through our annual research awards program, we help advance orthodontic and dental research, furthering our commitment to the future of digital orthodontics and restorative dentistry. Our consumer marketing is focused on educating consumers about the Invisalign system, and driving that demand to Invisalign doctors offices, ultimately capitalizing on the massive market opportunity to transform 500 million smiles. For Q2, we had over 16.2 million visits to our websites, a 15% year-over-year increase, and delivered over 6.3 billion impressions. Both metrics were lower versus Q1 as we chose to rightsize our size and media spend in Q2, given the macroeconomic environment. During the quarter, we built on our successful “Invis Is” multimedia campaign and launched in the US the next evolution with two new campaigns, “Invis Is” trauma-free, targeted at teens, and Invis Is when everything clicks, targeted at adults. Our Invis Is trauma-free campaign highlights the benefits of Invisalign treatment, while numerously juxtaposing teams with the significant hassles involved with using braces. Our Invis Is when everything clicks campaign showcases Invisalign treatment, transforming smiles and the resulting confidence it gives the young adults. Both campaigns will be rolled out to markets around the world in Q3. About some of our consumer patient app My Invisalign continued to increase with 1.8 million downloads to date. Uses of our four digital tools continues to increase, for example, Invisalign virtual appointment tool was used over 12,000 times, and our insurance verification feature was used 36,000 times in Q2. Further, we received more than 91,000 patient photos in our virtual care feature globally, which continues to provide us with rich data to leverage our artificial intelligence capabilities and improve our services for doctors and patients. Additional consumer demand metrics are included in our Q2 earnings slides posted on our website. We are pleased with our Q2 Systems and Services revenues, which were up 5% sequentially and up 1% year-over-year. Q2 sequential growth primarily reflects higher scanner volumes in the Americas and APAC, and increased subscriptions. Year-over-year results primarily reflect increased scanner revenues in the Americas, offset by lower volume in APAC and EMEA. Growth of our iTero scanner installed base is driving an increase in services revenue. On a year-over-year basis, Systems and Services growth reflects increased service revenues from our largest scanner installed base, higher subscription revenues and increased sales of scanner once leased. The number of intraoral digital scans used for Invisalign case submissions in Q2 reflect continued adoption of our digital scanners and our larger installed base. Total worldwide intraoral digital scan submitted to start an Invisalign case in Q2 increased 88.4% from 82.2% in Q2 of last year. International intraoral digital scans for Invisalign case submissions increased 84.4%, up from 76.2% in Q2 of last year. For the Americas, 91.4% of Invisalign cases were submitted using an intraoral digital scan compared to 87% in Q2 last year. Cumulatively, over 60.4 million orthodontic scans and over 12.6 million restorative scans have been performed with iTero scanners. Our Q2 exocad CAD/CAM products and services, which include restorative dentistry, implantology, guided surgery and smile design offerings are included in our Systems and Services revenue. Exocad products and services are helping extend our digital dental solutions and broaden the Align Digital Platform towards fully integrated interdisciplinary end-to-end workflows. During the quarter, exocad released dental CAD 3.1 Rijeka in the new powerful lab software, which saves design time and offers more intuitive workflows along the designs earning from CAD to CAM. In addition, the release -- the exocad release launched the new, myexocad portal, introducing mandatory end-user software use registration that for the first time, allows exocad to collect information about who and how customers are using the software. This expands the opportunities for future product improvements. Also during the quarter, we signed a new long-term contract with exocad’s largest customer, Arming Gearbox, further strengthening our relationship. Finally, we continue to execute our strategy of geographic expansion. In June, our European manufacturing facility in Wroclaw, Poland began manufacturing clear aligners for the EMEA region. Locally, for the first time, we also continued our operational expansion in Poland with our latest treatment planning facility. Our expanded operation in Poland supports Invisalign doctors in local languages, increases our flexibility and timeliness and supporting our doctor customers across the region, and we expect will positively influence the quality and time of preparation of ClinCheck treatment plans and provide our doctor customers with benefits of digital orthodontics with the Invisalign system. We are uniquely positioned with manufacturing and treatment planning in all three regions, and no other clear aligner manufacturer has our global footprint and capabilities. With that, I'll now turn the call over to John."
},
{
"speaker": "John Morici",
"text": "Thanks, Joe. Now for our Q2 financial results. Total revenues for the second quarter were $969.6 million, down 0.4% from the prior quarter and down 4.1% from the corresponding quarter a year ago. This is compared to Q2 2021 revenues of $1 billion, which had a year-over-year growth rate of 186.9%. For clear aligners, Q2 revenues of $798.4 million were down 1.4% sequentially, due primarily to product mix and unfavorable foreign exchange, partially offset by higher non-case revenues, and down 5.1% year-over-year, primarily reflecting lower volumes, unfavorable impact from foreign exchange and product mix shift, partially offset by higher additional aligners per order processing fees and higher non-case revenues. Q2 2022 Clear Aligner revenues were unfavorably impacted by foreign exchange of approximately $12.3 million, or approximately 1.5% sequentially, and approximately $32.9 million, or approximately 4% year-over-year. For Q2, Invisalign comprehensive ASPs decreased sequentially and increased year-over-year. On a sequential basis, the decline in comprehensive ASPs reflect higher discounts and unfavorable impact from foreign exchange, partially offset by higher additional aligners. On a year-over-year basis, higher comprehensive ASPs reflect the impact of higher additional aligners and per order processing fees, partially offset by the impact of unfavorable foreign exchange and higher discounts. Q2 Invisalign non-comprehensive ASPs increased sequentially and year-over-year. On a sequential basis, Invisalign non-comprehensive ASPs were favorably impacted by lower discounts, partially offset by product mix and unfavorable foreign exchange. On a year-over-year basis, higher Invisalign non-comprehensive ASPs reflect lower discounts, per order processing fees and higher additional aligners, partially offset by the impact of unfavorable foreign exchange and product mix shift. Clear Aligner of deferred revenues on the balance sheet increased $25.4 million, or 2.3% sequentially and $231 million, or up 2.5% year-over-year, and will be recognized as the additional aligners are shipped. Q2 2022 Systems and Services revenue of $171.2 million were up 4.7% sequentially, primarily due to higher scanner volume and ASP, and were up slightly by 0.8% year-over-year, primarily from higher services revenues from our larger installed base, partially offset by lower scanner volume and lower ASP. Systems and Services revenue were unfavorably impacted by foreign exchange of approximately $2.9 million, or approximately 1.7% sequentially. On a year-over-year basis, Systems and Services revenue were unfavorably impacted by foreign exchange of approximately $7 million, or approximately 3.9%. Systems and Services deferred revenues on the balance sheet was $13.3 million, or 5.4% sequentially, and up $99.6 million, or 62.3% year-over-year primarily due to the increase in scanner sales and the deferral of service revenues included with the scanner purchase, which will be recognized ratably over the service period. Moving on to gross margin. Second quarter overall gross margin was 70.9%, down two points sequentially and down 4.1 points year-over-year. Overall, gross margin was unfavorably impacted by approximately 0.5 points sequentially and 1.1 points on a year-over-year basis due to foreign exchange. Clear Aligner gross margin for the second quarter was 73.3%, down 1.5 points sequentially due to lower ASPs and higher freight costs. Clear Aligner gross margin was down 3.6 points year-over-year due to a higher mix of additional aligner volume, higher freight and manufacturing spend, partially offset by higher ASPs. Systems and Services gross margin for the second quarter was 59.8%, down 3.6 points sequentially due to higher manufacturing variances and freight costs, partially offset by higher ASPs. Systems and Services gross margin was down 6.1 points year-over-year due to lower ASPs and higher manufacturing variances, partially offset by higher service mix. Q2 operating expenses were $499.4 million, down sequentially 2.3%, and up 2% year-over-year. On a sequential basis, operating expenses were down by $11.9 million mainly due to lower incentive compensation and controlled spend on advertising and marketing as part of our efforts to proactively manage costs. Year-over-year, operating expenses increased by $9.7 million, reflecting our continued investment in marketing, sales and R&D activities and investments commensurate with business growth. On a non-GAAP basis, excluding stock-based compensation, amortization of acquired intangibles related to certain acquisitions and acquisition costs, operating expenses were $466 million down sequentially 3% and up 1% year-over-year. Our second quarter operating income of $188.2 million resulted in an operating margin of 19.4% and down 0.9 points sequentially and down 7.2 points year-over-year. Operating margin was unfavorably impacted by approximately 1.1 points sequentially due to foreign exchange. The year-over-year decrease in operating margin is primarily attributable to lower gross margin, investments in our go-to-market teams and technology as well as unfavorable impact from foreign exchange by approximately 2.4 points. On a non-GAAP basis, which excludes stock-based compensation, of intangibles related to certain acquisitions and acquisition costs, operating margin for the second quarter was 23.3%, down 0.7 points sequentially and down 6.5 points year-over-year. Interest and other income expense net for the second quarter was a loss of $14.6 million, down sequentially by $4 million and down year-over-year by $14.5 million, primarily due to larger net foreign exchange losses from the weakening of certain foreign currencies against the US dollar. The GAAP effective tax rate in the second quarter was 35% compared to 28.4% in the first quarter and 25.7% in the second quarter of the prior year. Our non-GAAP effective tax rate was 25.6% in the second quarter compared to 24.2% in the first quarter and 19.5% in the second quarter of the prior year. The second quarter GAAP effective tax rate was higher than the first quarter effective tax rate primarily due to foreign income tax at different rates and lower excess tax benefits from stock-based compensation. Second quarter net income per diluted share was $1.44, down sequentially $0.26 and down $1.07 compared to the prior year. Our EPS was unfavorably impacted by $0.26 on a sequential basis and $0.42 on a year-over-year basis due to foreign exchange. On a non-GAAP basis, net income per share was $2 for the second quarter, down $0.13 sequentially and down $1.04 year-over-year. Moving on to the balance sheet. As of June 30, 2022, cash, cash equivalents and short- and long-term marketable securities were $977.2 million, down sequentially $143.4 million and down $109.2 million year-over-year. Of our $977.2 million balance, $251.4 million was held in the US and $725.8 million was held by our international entities. Q2 accounts receivable balance was $931.9 million, down approximately 2% sequentially. Our overall days sales outstanding was 85 days, down approximately two days sequentially and up approximately 13 days as compared to Q2 last year. Cash flow from operations for the second quarter was $127 million. Capital expenditures for the second quarter were $76 million, primarily related to our continued investments to increase aligner manufacturing capacity and facilities. Free cash flow, defined as cash flow from operations less capital expenditures amounted to $51 million. In Q2, we purchased $200 million of our common stock through an accelerated stock repurchase program, receiving approximately 757,000 shares at an average price of $264.37 per share. We are over halfway through our May 2021 $1 billion repurchase program, and have approximately $450 million remaining available for purchase. Now turning to full year 2022 and the factors that influence our views on our business outlook. Overall, our Q2 results were solid, and we feel good about the execution across the business, especially in an increasingly challenging global economic environment. Delivering revenues and volumes relatively unchanged from Q1 and down only slightly year-over-year despite unfavorable impacts from foreign exchange speak to the strength of our underlying products and services and the size of our market opportunity. We remain confident in the huge underpenetrated market for digital orthodontics and restorative dentistry, our technology and our industry leadership and our ability to execute and make progress towards our long-term model of 20% to 30% revenue growth. We also remain committed to our goal for fiscal 2022 to deliver GAAP operating margins above 20%, while making strategic investments in sales, marketing, R&D and operations, notwithstanding the impact from unfavorable foreign exchange, which was not factored into our operating margin guidance for the full year. Capital expenditures primarily relate to building construction and improvements as well as a digital manufacturing capacity to support our international expansion. For 2022, we expect our investment in capital expenditures to exceed $300 million. This includes our investment in our aligner fabrication facility in Wroclaw, Poland. In times like these, our strong fundamental Business differentiates align, and we are grateful to have a profitable underlying business model that generates strong cash flow as well as a healthy balance sheet that provides flexibility to invest in our growth while supporting our employees, customers and shareholders. As we move into the second half of the year, we will continue to manage our investments to account for headwinds and uncertainty while focusing on successfully delivering on our strategic growth drivers. With that, I'll turn it back over to Joe for final comments. Joe?"
},
{
"speaker": "Joe Hogan",
"text": "Thanks, John. Closing Q2 in the first half of 2022 has proved to be tougher than we expected. As we continue to navigate macroeconomic uncertainty and weaker consumer confidence and impacts related to COVID-19 variance, we cannot lose sight of the strong fundamentals of our business and the enormous market opportunity for digital orthodontics and restorative dentistry. The decisions we make this year will have lasting strategic implications for the future of our industry and the competitive landscape. We are holding true to our business strategy, and making good progress in a very difficult operating environment. We remain committed to balancing investments to drive growth and long-term strategic priorities with near-term headwinds while acting with a sense of urgency to ensure that we're ready to capitalize and extend our global innovation leadership as growth resumes. Thanks for your time today. We look forward to updating you on our next earnings call. With that, I'll turn it over to the operator. Operator?"
},
{
"speaker": "Operator",
"text": "Thank you. At this time, we will conducting a question-and-answer session. [Operator Instructions] The first question is from Nathan Rich with Goldman Sachs. Please proceed."
},
{
"speaker": "Nathan Rich",
"text": "Thank you, good afternoon. Hey, Joe and John. I guess, I wanted to start high level. Joe, you kind of highlighted the consistent case in revenue trends in the second quarter relative to the first. But within the context of a challenging macro environment, I guess, how does that influence your thinking on the trajectory of the business? And have you seen an impact on patient traffic to dental practices or treatment acceptance rates that's kind of driving that commentary?"
},
{
"speaker": "Joe Hogan",
"text": "Nate, it's a -- if you look at this from a domestic standpoint, you can pull out some signal, but I think you have to when you're asking a demand question like that, you have to look at this globally. And I think like John and I were just clear in our introduction that basically, if you took Asia, COVID-19 impacted us pretty tremendously in Asia. Japan for a little bit in the first part of the quarter in China almost throughout the quarter. So it was really a COVID discussion there, and it's hard to pull a demand signal out. In the United States, I mean, if you look at the data that we do, you'll see from a general practitioner standpoint or whatever, some stability in patient vision to what's going on. Our concern here is, obviously, this is a product where like a cap or a crown or cleaning or something that needs to be done, it's somewhat discretionary. And we see that from an adult standpoint, more variability in adult selection than in teens. Teens have been pretty stable in that way if we talked about before. Moving over to Europe. We're working off 300% growth rates in Europe last year, okay, which you have to internalize that. It's a pretty big comparison year-on-year. And there weren't standard vacations being taken in Europe to the beginning of the end of the second quarter and the third quarter. So overall, I'd say, as you look around the globe, I fee like -- I felt good, as we mentioned in the script, about Q1 versus Q2 and pretty much the same kind of demand pattern. But right now, I can't really give you a trajectory in the third quarter and the fourth quarter, because of the macro environment, concerns again in China from another COVID shutdown and those types of things. I hope that makes sense, Nate."
},
{
"speaker": "Nathan Rich",
"text": "Yes, definitely. And maybe just a quick follow-up. – were you, I guess, able to size kind of the headwind from the lockdowns in China? And with that -- in that market specifically, have you started to see those volumes recover as we're starting to see those lockdowns ease?"
},
{
"speaker": "Joe Hogan",
"text": "For sure. I mean it's direct correlation there as soon as they let Shanghai open again, we saw it reflected in our order rates there. And look, we continue to feel good about China in a stable market. It's just the dramatic way that China continues to address COVID cases by major cities. This just creates a huge amount of uncertainty as when the next lockdown will be."
},
{
"speaker": "Nathan Rich",
"text": "Thank you."
},
{
"speaker": "Joe Hogan",
"text": "Thank you."
},
{
"speaker": "Operator",
"text": "Thank you, Mr. Rich. The next question is from the line of Elizabeth Anderson with Evercore. Please proceed."
},
{
"speaker": "Elizabeth Anderson",
"text": "Hi, guys."
},
{
"speaker": "Joe Hogan",
"text": "Hi, Elizabeth."
},
{
"speaker": "Elizabeth Anderson",
"text": "Thanks so much for the question. One thing I was wondering if you could comment about -- I know in the sort of fourth quarter of last year, and into the first quarter, you did increase the sales hiring, sequentially and year-over-year. Could you sort of talk through sort of the impact of those salespeople? Where are they in the ramp process? And how do you -- should we think about their potential for contributing in the back half of the year? Thanks."
},
{
"speaker": "Joe Hogan",
"text": "That's a good question, Elizabeth. Obviously, our sales force -- being a direct sales force is really important to us in that way. And so the way we do this, obviously, as you indicated, we hire a lot of salespeople upfront. We have sales training programs too that help to initiate them as they come into the corporation. But I would tell you, depending on where you are around the globe, there is a six-month and nine-month burn-in period, before you really feel that they're up to speed. They understand the Invisalign system, the digital platform and those types of things. So I would say in some simpler kinds of situations geographically, it could be six months. But in general, it's nine months or so before we have confidence that they're going to be really good on their feet as they talk to our doctors."
},
{
"speaker": "Elizabeth Anderson",
"text": "Got it. That's helpful. And then one thing that depressed me in the quarter a little bit was about the teen number. I know that sometimes this quarter, it's been off because of COVID in terms of seasonality, and it's not necessarily always the strongest quarter for teen. But how are you thinking about that versus the economic sensitivity of adult cases and sort of how -- do you expect that to sort of trend in the sort of near-term?"
},
{
"speaker": "Joe Hogan",
"text": "Yes. Keep in mind, we see a lot more concern from an adult standpoint, when you look year-over-year in the sense of our order growth in adults, I mean it's been affected Elizabeth, and there's a lot of data that we produce that will show you that. On the teen side, it's hard to pull a lot of the second quarter because it really starts in the third quarter. But I felt overall good about it, but again, not surprised because we've always felt that teens have a certain window of time from a treatment standpoint. And so it's not necessarily an emotional purchase in a way, it's usually planned for and anticipated. And -- and what we saw between the second quarter and beginning of the third quarter, it really bears that out."
},
{
"speaker": "Elizabeth Anderson",
"text": "Got it. Okay. Thank you very much."
},
{
"speaker": "Joe Hogan",
"text": "You’re welcome."
},
{
"speaker": "Operator",
"text": "Thank you, Ms. Anderson. Our next question is from the line of Jon Block with Stifel. Please proceed."
},
{
"speaker": "Jon Block",
"text": "Great. Thanks, guys. Good afternoon. I'll follow up on teen, maybe just to go there. I think worldwide teen was down year-over-year. And I believe, Joe, you mentioned that teen and APAC was up year-over-year, which sort of implies that North American teen was down maybe a decent amount. So anything to call out there? Why do we see that maybe specific to North America? And then more importantly, you did have some positive commentary around teen case packs, you talked about enrollment. So maybe just talk to us on how long it might take for the teen case pack program in North America to give that segment a shot in the arm and then your plans to roll that out internationally? I've got a follow-up."
},
{
"speaker": "Joe Hogan",
"text": "Jon, on the teen side, remember, we kind of lost -- or we had a muted signal on the team side. It needs to be very clear from quarter-to-quarter before COVID. If you remember last year, it was much more muted. This year, we're hoping to see a less muted cycle. And I think we're starting to feel that, Jon. So it's -- I don't think you can look too much between what we're doing between the first quarter and second quarter and pull a clear teen signal out of there. The other thing on teen too is there's always competitive concern with other clear aligner whatever. But basically, this is a wires and brackets competition with us. It's always been and continues to be that way. And in new products that we're launching these teen packs, we feel good about them. They've been -- as I mentioned in my script too, they've been received well. And it's been with the lower-end orthodontics from our standpoint that haven't done a lot of teen cases in the past. And that's a segment that we were fishing for to give them more confidence to be able to move in with teens. So we're not declaring victory, but we feel we have a good product that's timed well. And we're not seeing the cycles in the teen marketplace as we're seeing in the adult marketplace. And obviously, Jon, as we get through the third quarter, we'll have a much better understanding of how we turn out that way. But I didn't pull anything out between the first and the second quarter that concerned me."
},
{
"speaker": "Jon Block",
"text": "Got it. Helpful. Thank you. And then for my second one, let me try to maybe jam two in one, and hopefully not make a mess of it. So just for us on the 3Q versus 2Q overall case volumes, China is reopened. China is a decent chunk of business for you guys. So if China snaps back, you talked about Shanghai, then maybe talk to us on why we wouldn't see you guys resume some sequential growth 3Q versus 2Q? I know there's many other markets. And then maybe just to stick with China. I just love your thoughts on what's going on over there, maybe in terms of market share, your main competitor had some quasi numbers out recently. It looked like they were down mid-single digits in cases 1H 2022 year-over-year, which quite honestly, I actually thought that was a good number considering the environment. So I would love your thoughts on just China and your ability to hold share on what's going on from a market share perspective? Thanks guys."
},
{
"speaker": "Joe Hogan",
"text": "Yeah. I'll start with the China and move backwards, Jon. And I'll get John involved here, too. But from the China side, obviously, we saw what you published there, whatever, but I looked at Angel numbers, and it basically same thing we experienced. I mean, we experienced a shutdown of Shanghai, slowdowns in some other regions, and there was nothing in those numbers that really surprised me. As I look at China, our ability to compete there. I feel great about it. And again, our investments we've made there in treatment planning and manufacturing. We've only added to that. The efficiency of those organizations have done well. Our product is great for that marketplace, and some of the most difficult cases that we encounter exist there, too. So I feel good about our ability to compete in that market against Angel or anyone else who's there. We just need a stable marketplace that we can operate in, and it hasn't been stable for -- goodness knows, it's been, what, almost two years. And I mean I just read this morning, the Wuhan's looking at the close down. So I mean, Jon, there's a lot of variability there, a concern with COVID and shutdowns, particularly in the second half of this year in China, but I continue to be concerned about that can disrupt the marketplace. But if that stays clear, we're going to have China in the second half that we can operate from. To answer your question, I feel good about our competitive position there, our ability to compete against with anyone."
},
{
"speaker": "John Morici",
"text": "And we should see some of the sequential history that we normally see in our business. It goes to what Joe said that, there's just some unforeseen variables that are still there. If there is a shutdown in China, that will impact our numbers. If there's no shutdown, we should see sequential improvement. And then you have some of the other macro economics that we've talked about in terms of potential recession or other things that people are concerned about, that affects their decisions on whether they go into treatment. But we're watching closer to see how sequentially things are behaving and making investments appropriate based on what we see."
},
{
"speaker": "Joe Hogan",
"text": "And Jon, sorry, just staying back to your second question..."
},
{
"speaker": "Jon Block",
"text": "Sorry. if I can just jump in..."
},
{
"speaker": "Joe Hogan",
"text": "Go ahead, Jon."
},
{
"speaker": "Jon Block",
"text": "Sorry, Joe. I was just going to say, John and Joe, maybe to follow up on that lasts comment just for clarity purposes because I think it's an important one. Are you guys saying sort of as you sit here today, who the heck knows what's going on with Wuhan, I don't know, something worse incrementally with the economy. But as we sit here today in late July, you're expecting the resumption of sequential growth off the 2Q number, this evening?"
},
{
"speaker": "Joe Hogan",
"text": "Well, I'd say, Jon, expecting anything in this market might be a sign of a low IQ. When you look at what's going on in China, I'm not going to sit here and tell you I expect a stable market in the second half based on their COVID policies. So I hope -- from the United States standpoint, there's a lot going on trying to explain to the teen market overall outside of China, I feel is the most stable market we have, and the one that we're ready to compete with, and we're moving into seasonality, what really makes a difference. We have -- we're positioned well with products. But as you know, Jon, as well as anybody, that's always been a wires and brackets marketplace. We've been taking share 1.5 points, two points a year. We're hoping some moves we make can make that better, but we'll know a lot more when the third quarter is over in the sense."
},
{
"speaker": "Jon Block",
"text": "Okay. Very helpful. Thanks, guys."
},
{
"speaker": "Joe Hogan",
"text": "Thanks, Jon."
},
{
"speaker": "Operator",
"text": "Thank you, Mr. Block. Our next question comes from the line of Jeff Johnson with Baird. Please proceed."
},
{
"speaker": "Jeff Johnson",
"text": "Thank you. Good afternoon, guys. Joe – hey, Joe, so I just wanted to talk maybe on the doctor shift to that number this quarter. It's trended down each of the last couple of quarters. This quarter in the Americas, it did trend back up just a touch. What are your views on what that means? Is that a -- market stabilized a little bit? Is that maybe the competitive positioning is stabilizing a little bit? Just how do you view that number in the Americas? And is there room left in the Americas for that number over the next couple of years to keep moving higher? Are you kind of at a point where you've saturated kind of the Americas market with a number of doctors who are going to be performing in these cases?"
},
{
"speaker": "Joe Hogan",
"text": "Just to answer your last part of your question first, Jeff. No, we have a lot of room to grow in the Americas, too. In United States, Canada, but also you have to throw in Latin America and Brazil in that. There's a lot of growth, John and I have ported over these numbers a lot. You know what happens, if you backed these numbers up before really the big surge in orders that we had before, we can draw a line through these things. It doesn't upset us. You have to split orthos and GPs very clearly. Remember, you have some GPs that do like three cases a year. As things kind of slow down, they'll be out of the circulation for a while and then they order another and whatever. And these numbers will go up 81, 1,000, 2,000, we'll see them go up and down. But don't look at this in any way as that we're saturated in this marketplace, both from an orthodontic standpoint and a GP standpoint. Jeff, the other thing too, I think, that people forget from an orthodontic standpoint is that our orthodontists who do teens. These are orthodontists that are really committed to Invisalign for the most part, and they do a lot of teens. But we still have a significant amount of orthodontists at do Invisalign almost exclusively for adults. And so you'll see that whole piece from a utilization standpoint as we increase our team penetration, you should see the utilization rates there improve."
},
{
"speaker": "Jeff Johnson",
"text": "Yeah, that's helpful. And then maybe kind of a follow-up on all that a two-parter, just the international number again, kind of, did tick down a little bit that number of factors shipped to internationally. One, I would assume you think there's a lot more room even there to saturate that market over the next few years, that would seem to make sense to me anyway. But is there any way to look at what that number did in China? And was there sequential decline largely driven by the shutdowns in China, or ex-China, would that number have been up? And then I was a little surprised to hear cases down, I think you said in UK year-over-year. Is that just a tough comp, or what's going on in the UK? I think we are all aware of China pressures in early, Japan pressures or early quarter Japan pressures, but UK caught me off guard a little bit there? Thanks."
},
{
"speaker": "Joe Hogan",
"text": "I'll answer the UK piece first. The UK was outstanding for us last year. Remember, Europe grew 300% for us last year, Jeff, right? The UK led that. So I'm sure that UK number is higher than what that aggregate number is. And so what you're seeing is adult retrenchment in the UK from an order standpoint, but not an indication of a utilization issue that I'd say, across the doctor base that we have in the UK. John, I don't know… : And just on the China piece or the APAC piece for international. So that was certainly an impact in terms of the lockdowns, and doctors just not being able to transact and therefore, don't have ship to. So the international side of the doctor ship was certainly impacted by COVID. We won't break it out by the sub-regions. But that was an impact that look, as those offices open up, as those lockdowns are minimized, we would expect that to increase from a ship to stand."
},
{
"speaker": "Jeff Johnson",
"text": "Thanks guys."
},
{
"speaker": "Joe Hogan",
"text": "Yeah. Thanks Jeff."
},
{
"speaker": "Operator",
"text": "Thank you, Mr. Johnson. Our next question is from the line of Justin Lin [ph] with William Blair. Please proceed."
},
{
"speaker": "Unidentified Analyst",
"text": "Hi, good afternoon. Can you just touch on your sales and marketing spending strategy a little bit in the short-term and longer term? I guess, when can you decide to flip the switch?"
},
{
"speaker": "Joe Hogan",
"text": "You mean flip the switches as far as up or down?"
},
{
"speaker": "Unidentified Analyst",
"text": "Yeah, yeah."
},
{
"speaker": "Joe Hogan",
"text": "Yeah. I mean, obviously, obviously, we saw our adults dramatically decreased, and so the return on investment in some specific geographies. John, as I take a look at it, and we don't eliminate it, but we reduce it in accordance with what we think the demand pattern is. And we spread it around into other countries that we feel we can get a higher return on. And we just basically sizing our advertising to what we think the demand patterns are around the business in different areas. And so I wouldn't look at this as any way that we'll continue to advertise aggressively and promote our brand and to drive value in our change to bring customers to our doctor base, but we can be responsible to we can advertise at the rate that we did last year when we were growing at over 100% in a lot of these regions, we have to modify it somewhat in order to address that demand pattern."
},
{
"speaker": "John Morici",
"text": "And we adjust into the market. So keep the overall brand awareness, keep that averages. Remember, still sudden spending even as we right-size things, hundreds of millions of dollars in marketing and media to be able to go to market, drive that awareness. But then in certain markets, if there's COVID or if there's economic concerns and so on, we're adjusting things to make sure that we right-size and continue to make sure that we make the right trade-off between how we're investing in go-to-market, and continue to reinvest in the rest of the business like R&D and operations."
},
{
"speaker": "Unidentified Analyst",
"text": "Got it. That's very helpful. And I guess just pivoting to a more sort of higher-level question. Any update on commercial operations in sort of your emerging markets like Brazil, India, Africa, what would you say current penetration levels are over there? And I guess, realistically, how much revenue can you capture from those regions in the next, let's say, five to 10 years?"
},
{
"speaker": "A – Joe Hogan",
"text": "And the region that you mentioned were really underpenetrated, huge opportunity. I mean we've seen great progress in Brazil. We're seeing good progress in India. Reported in -- I mean, it's -- when we talk about those 500 million patients, they're out there. And the way to get them is we do -- we put salespeople in place. We put the right kind of capability on the ground. This is a direct sales force that you have to have in order to sell our product line. But to answer your specific question, the penetration rates aren't even close. And that's -- again, you can see that in our script, that's how we remain so confident that in a stable environment, we'll continue to perform really well."
},
{
"speaker": "John Morici",
"text": "And we're built as a company to really expand into those markets. We've got that global footprint for manufacturing now in all three geographies. We've got treatment planning. We've got that go-to-market sales force -- direct sales force with great products. So we're built in all those markets. We like the dynamics of these markets where you have a growing middle class, big population. You've got people who want to straighten their teeth, and we've got a great way for them to get to that. So all the markets you described as well as many others, those are where we think of some of the investments because it's a great return on those investments."
},
{
"speaker": "Unidentified Analyst",
"text": "Got it. Thank you very much."
},
{
"speaker": "Joe Hogan",
"text": "Thank you."
},
{
"speaker": "Operator",
"text": "Thank you, Mr. [indiscernible]. Our next question is from the line of Jason Bednar with Piper Sandler. Please proceed."
},
{
"speaker": "Joe Hogan",
"text": "Hi, Jason."
},
{
"speaker": "Jason Bednar",
"text": "Hey, good afternoon. Yes. So Joe, I'll go big picture here in the US market, and maybe go back to clarifying point on Jon Block's question earlier. On one hand, demand in the category broadly just did seem to show some signs of moderation in the second half of last year relation to a bit of a leading indicator in other parts of high end then on the help of the average consumer. I mean this needs are going to be coming into some easier absolute comparisons as we head into the back half of this year, which I don't know, maybe helps reverse this downtrend in Invisalign case growth. But I guess we're also in the early days of what still could be some more pain coming for the consumer. So I guess what dominates in your opinion? Do the easier comps dominate, or does it more challenge on consumer dominate? And again, just thinking about the domestic market you're and ignoring again some of that China and predictability that's out there."
},
{
"speaker": "Joe Hogan",
"text": "Yes. I'll let John take a shot at this, too. But I would say, I mean, obviously, you talk about easier comps. I mean when you're comping against 300% growth, like we just talked about, it's one of the tougher comps on a large number I've had in my business career. And so obviously, when you get some light on that line, it helps somewhat. But consumer confidence. I'd say, outside of the COVID, the way I'd look at the business again is COVID affected Asia in a big way. We had some COVID staffing issues or whatever, but predominantly in the West, it's consumer confidence that we look at. And so those consumer confidence numbers start to equalize to start to get better. Some of the ones we look in Europe are all-time lows. I feel that means a lot. It means that means more to meet in those comparisons years from here. We report more confidence in consumers in a trend where in that kind of environment, we think we see the adult cases resume at a pace that we'd be equal to our long-term growth rate."
},
{
"speaker": "John Morici",
"text": "Yes. It's consumer confidence overall, and in certain cases…"
},
{
"speaker": "Jason Bednar",
"text": "I guess, just real quick, I guess I would -- yeah, I guess I was just focusing more on the US market. And I totally understand Europe and China and APAC and all the different dynamics there. But just in within the US market, I mean, the comps do get easier, absolute comps -- they did tick down starting in the second half of last year. So just I'd be where I'd be focusing the question here, sorry to interrupt."
},
{
"speaker": "Joe Hogan",
"text": "Yeah. No, Jason, that's okay. I look at the United States too is -- I just give you consumer confidence more than anything. Not just saying that there's no big variant issue or something that happens with COVID. We're all kind of have PTSD in that sense and what we experienced over the last two years. But yeah, I like the comparison year-over-year. That's going to be helpful. But those consumer confidence numbers, whether I'm talking about Europe or I'm talking about the States, those are the ones that we stay alluded to that we think are a really good indicator in the sense of our market, and that adult market that we appeal to, both in the GP segment and the adult market in the orthodontic segment, too."
},
{
"speaker": "John Morici",
"text": "And the piece that I would add to the US is just that as we get into teen season now as we go from Q2 to Q3. Teens will be important to see. We've got great products. We've got great go-to-market opportunities to be able to grow in those markets and get more market share. When we think of teens everywhere in the world, it's single digit and even in the US. So we look at growth opportunities that will be teens, maybe a little bit less of more resistant to maybe some of that consumer concerns that they have. Consumer concerns certainly show up on the adult side, but we think teams can help offset that just a bit because it's less discretionary."
},
{
"speaker": "Jason Bednar",
"text": "Okay. That's helpful. And maybe just a quick follow-up here. A lot of questions out there right now from investors on the decremental margin impact for the business with volumes and revenue doing what it's doing here. You added a lot of head count. It's significantly expanded branding and advertising efforts during the pandemic really helped to widen the competitive moat, so really impressive. It sounds like some of that marketing though has been recalibrated here. Are there further resets that -- with the OpEx structure that might be necessary in this environment? And I guess, what's the trigger for you to decide that a further rightsizing is necessary?"
},
{
"speaker": "Joe Hogan",
"text": "I mean rightsizing, when I hear words like that, it means that we've gone to the layoffs, so we haven't laid anything off. Remember, we -- any one off in that sense. We normally hire to a 20% to 30% growth rate. And so -- and we -- our OpEx spend is in that range, too. So, obviously, we didn't -- we couldn't hire in that range, and so if you call that a cutback, it's a cutback from our normal OpEx. What we do is we normally balance OpEx to revenue at about a 50% range, and there's a lot of variables in that line from an OpEx standpoint that we can go about. Remember, our most important areas that we want to make sure we take care of is our commercial team, our engineering effort and also our marketing. We know those are really key. And we focus on those, and we balance the business well. John, anything you want to add?"
},
{
"speaker": "John Morici",
"text": "It's a balance, both short and long-term. So as we balance out our plans, we look to the growth opportunities we have, we want to make sure we continue to invest in those growth opportunities. But then obviously, we have to be mindful of the current conditions that we're in, and we'll adjust as needed to still maximize the return on investments that we're making."
},
{
"speaker": "Jason Bednar",
"text": "All right. Thanks so much."
},
{
"speaker": "John Morici",
"text": "Thanks Jason."
},
{
"speaker": "Operator",
"text": "Thank you, Mr. Bednar. Our next question is from the line of Erin Wright with Morgan Stanley. Please proceed."
},
{
"speaker": "Erin Wright",
"text": "Great. Thanks. And I wanted to ask another Americas teen question here. But just given the seasonality and given this is an area where you should have some better visibility. I just want to clarify, does this -- does this mean you're going to see a meaningful sequential pickup in the coming quarter, or why would that not happen for you? And just given that should be an area more under your control here. Thanks."
},
{
"speaker": "Joe Hogan",
"text": "Yes. Our normal growth pattern between the second quarter and the third quarter is flat to down 1 percentage point or so. John can confirm that. So the second quarter to third quarter is a big teen season, but there's other parts of our portfolio that kind of balance out with that. It's not traditionally a jump from second to third quarter. But again, we're focused on teens because we feel teens have a lot less elasticity than what adults have right now based on the consumer confidence level. So I just -- but I'd just caution you here. Remember, this is a wires and brackets play. It's something that's systemic that we have worked on for years. We have many new products like Invisalign First, I mean give advancement and several new teen products that help us with this. The new teen packs help also. We think we're well positioned, but we have to get into the quarter and be able to assess how well that market is actually holding up. John, anything..."
},
{
"speaker": "John Morici",
"text": "But specifically in the US, US teen, we should see sequential improvement as we get into teen season, going from Q2 to Q3, notwithstanding any occurrences that happened from an economic standpoint, but the expectation is given our products, given the opportunity, given the utilization that we have, we should be able to see growth. Notwithstanding, anything else that gets in our way."
},
{
"speaker": "Erin Wright",
"text": "Okay. Thanks. And then ASPs for the balance of the year, how should we be thinking about that and the FX impact?"
},
{
"speaker": "John Morici",
"text": "Erin, FX, obviously, Q1 to Q2 was a big impact in FX. We see it in the numbers from revenue all the way down to our EPS. I would think of it's tough to forecast where FX is going to go. Certainly, dollar has strengthened. I think you kind of take the numbers that they're at now and kind of play that forward for the rest of the year is how we look at that. I think from an overall ASP standpoint, there's always going to be puts and takes. So we're not doing anything different from a discounting standpoint, how we're going to market and so on. You might have some mix effects that come through. But I take the FX rates kind of as they are now, project those forward and then ASP should be too much different than what you see now notwithstanding any FX."
},
{
"speaker": "Erin Wright",
"text": "Okay. Thank you."
},
{
"speaker": "Operator",
"text": "Thank you, Ms. Wright. The next question is from the line of Brandon Couillard with Jefferies. Please proceed."
},
{
"speaker": "Brandon Couillard",
"text": "Thanks, John, a quick follow-up on that FX question. I appreciate all the details in the deck. It is very, very helpful. Just curious, what is the estimated impact of currency on the operating margin for the year now in the ballpark?"
},
{
"speaker": "John Morici",
"text": "Well, ballpark, I would look at that is about 1 point, maybe just over 1 point of impact. We saw that 1.1 point impact from Q1 to Q2 in op margin. I would kind of look at the full year and about the same."
},
{
"speaker": "Brandon Couillard",
"text": "Thanks. And then Joe, on the scanner business, any color between the North American segment and international in terms of growth rate, how would you sort of characterize the capital spending environment in those two regions, specifically?"
},
{
"speaker": "Joe Hogan",
"text": "Yes. I'll start with -- I mean, obviously, we had trouble selling scanners in China because China shut down. And China is one of our bigger markets is between China and Japan and Asia. So I didn't look at that so much as and overall market problem, I looked at that as more of a COVID problem. And so hopeful of, as I mentioned before, if that COVID stays clear, that will write itself. United States, just a good job by the team, strong demand there. 5G plus tends to be the really strong scanner out there. On the restorative side, dentists liking the NERI, the near-infrared technology for carries detection and orthodontists continue like the exactness of how our workflows at all from an overall iTero standpoint. So I feel good about the Americas and what the performance was in that piece. And as I mentioned in my script is 40% with a large installed base now, 40% is services, too, which is really helpful in that business overall. And look, I feel good about, again, our scanners in Europe compared to get some pretty big numbers again last year. So I wouldn't be blinded by the year-over-year number in that sense. But Europe has the added pressure right now from a Ukraine standpoint. It's just -- it wears on the consumer sentiment piece. I think it makes docs a little more reluctant in -- but there's -- I feel good about our position in Europe from a scanner standpoint. And as the market hopefully starts to stabilize here, we'll see that business that we had return loans."
},
{
"speaker": "Brandon Couillard",
"text": "Okay. Thanks."
},
{
"speaker": "Operator",
"text": "Thank you. Our next question is from the line of Kevin Caliendo with UBS. Please proceed."
},
{
"speaker": "Kevin Caliendo",
"text": "Hi, thanks for getting me in. So just want to think about how -- or what it would take for you guys to feel comfortable with providing guidance again, or feeling comfortable that you can hit your longer term targets rather than making progress towards it. Do we need to see consumer confidence go back above 99% or something like that, or I mean, at the beginning of the year, you caveated and said, listen, if there's no more COVID outbreaks, we'd still be able to do this. What do you need to see before you can come to us and say, hey, we're back on track or we think we can do this? So we feel comfortable. We're going to be able to grow at ex-rate going forward, even be able to provide guidance for like a quarter going forward, even if it's not for the full year. What needs to happen, in your mind?"
},
{
"speaker": "Joe Hogan",
"text": "I'll turn it over to John. But first of all is, remember, we don't carry inventory in this business outside of scanners. So it's a real-time business. We don't have any inventory to reflect from or any -- very little business from a week-to-week standpoint. So I'll move it over to John, but keep that in mind that we, kind of, feel these trends early on both ends. As the economy picks up, we'll probably feel it first. And as it turns down, we feel it by just the nature of the business first."
},
{
"speaker": "John Morici",
"text": "It really comes down to, Kevin, more just having more predictability on a macro basis, understanding you mentioned COVID and thinking that we're through it, then you have China lockdowns or some of the consumer sentiment and things that come up that are outside of our control, we feel very good about being able to control what we can control, making the right investments as we go to market or adding investments in R&D to better our products and so on, and drive that return. And, therefore, like I said, we can manage that 20%, that’s something that we can manage as we go through the quarter. It really comes out to having more predictability on a macro basis. And once we get confidence in that, and we work our way to that understanding, look, the economies are going to do what they're going to do. They're going to go up or down. But if I have more predictability on the direction that they're going and how they're going to go, then we can give a good forecast."
},
{
"speaker": "Kevin Caliendo",
"text": "All right. Appreciate that. Thank you."
},
{
"speaker": "Operator",
"text": "Thank you, Mr. Caliendo. Our next question is from the line of Michael Ryskin with Bank of America. Please proceed."
},
{
"speaker": "Michael Ryskin",
"text": "Great. Thanks for taking the question guys. I have kind of a follow-up to one of the earlier ones, and some that Kevin just asked sort of on the moving pieces going forward. I mean we spent a lot of time talking about China lockdowns and the impact that had, and there was some discussion on consumer confidence as well. But it was sort of brought up in the sense of, well, what happens when things improve. I hate to be the pessimist here, but can we talk about the other side of things as inflation is one thing and consumer sentiment and consumer confidence is another thing. But recessionary impact, if unemployment goes higher, if job losses start to accelerate, there is a scenario where things are -- should get worse for the next couple of quarters before they get better. So can you talk through sort of how you view the likelihood of that happening, the impact you think it will have on the business? And also sort of what's your response going to be what's the game plan? You talked a little bit about controlling costs in the quarter already. What would be the other levers you would pull if things for the consumer in the Americas and in Europe get materially worse over the next three to six to nine months?"
},
{
"speaker": "Joe Hogan",
"text": "It's Joe. Look, I think you've seen that -- I feel we've been responsible in the sense of adjusting the business to a lower demand signal than the business is used to having. I think you saw us respond the same way when COVID hit in March of in 2020, and how we ran the business. If it gets worse, and it could get worse is the way -- I mean from the standpoint of whatever happens from an economic standpoint. I'd just say that, look, John and I come from businesses where we've been through these cycles. We know how to operate in a down cycle. We run a business that way. This is a growth business, and we'll treat it as a growth business, but we're responsible from a standpoint of making sure that we adjust this business to whatever economic conditions that we see out there."
},
{
"speaker": "John Morici",
"text": "And as a result, we've been able to make these adjustments. We're fortunate as a company to have the cash position, the balance sheet that we have and all these other. And in the end, you know the story, we have a huge opportunity to be able to grow. You just have this in our way. And like Joe said, and what many others say is it could get worse. We have to be able to be able to balance those short-term worse to with our long-term goal of being able to make Invisalign the standard of care. And that's what we're balancing right now, and that could play out -- that will play out in the next -- whatever, a year to 18 months, things will evolve. We hope that the economies improve. We hope that that a lot of this has just got a short term and things get better. And when things do get better, we're well positioned to be able to grow into this market, but we just have to be based on the realities of what's happening in short term."
},
{
"speaker": "Michael Ryskin",
"text": "Great. And a quick follow-up, if I can. On 1Q, you kind of gave some comments on pacing through the quarter, and gave some comments on April as it relates to March. Kind of get the sense that things probably slowed down at the end of 2Q or bit in June, both between FX and China lockdowns being worse. Any sense you can give on sort of the progression through the course of 2Q? And just any early signs you've seen from July, again, realize that walk-down in China and FX is playing a big role. But maybe if you could just focus on America's trends through the quarter, and July. That will be helpful."
},
{
"speaker": "John Morici",
"text": "Yes. No, it's a good question. So if you think like an overall picture, you hit some of the FX and so on, you look -- everybody can look at FX rates and see the changes and so on, you can project based on those. When you talk about a COVID lockdown or talk specifically in China, there was an impact for us. And we've seen that in the first quarter, we saw it in the second quarter, but it's -- happens in China. It happens in every place that we see where there's a lockdown, we have a reduction in volume. Where that lockdown goes away, the volume starts to come back. So I would say when you think of China, as you go from lockdown to not lockdown, that's favorable for us. We start to see some of the volume come back. And I think when you look at -- I think part of your question is around the US, I think what do you see for the US is it's -- maybe things stabilizing a little bit more. You're not seeing -- maybe it's pretty similar to what we exited Q2 into Q3. And I think when you look at the team benefit that ideally comes through with some of the products and programs that we have in teen in the US and other places, but focus on the US, we think that's helpful for us as we go from Q2 to Q3."
},
{
"speaker": "Michael Ryskin",
"text": "Okay. Thanks."
},
{
"speaker": "Operator",
"text": "Thank you, Mr. Ryskin. We have reached the end of our question-and-answer session. I will now turn the call back over to Shirley Stacy for closing remarks."
},
{
"speaker": "Shirley Stacy",
"text": "Thank you, operator, and thank you, everyone, for joining us today. We look forward to speaking to you at upcoming financial conferences and industry meetings. And if you have any follow-up questions, please contact our Investor Relations team. Have a great day."
},
{
"speaker": "Operator",
"text": "Thank you. This concludes today's conference, and you may now disconnect your lines at this time. Thank you for your participation."
}
] | Align Technology, Inc. | 24,568 |
ALGN | 1 | 2,022 | 2022-04-27 16:30:00 | Operator: Greetings. Welcome to the Align Q1 2022 Earnings Call. At this time, all participants are in a listen-only mode. A question-and-answer session will follow the formal presentation. Please note this conference is being recorded. I will now turn the conference over to your host, Shirley Stacy with Align Technology. You may begin
Shirley Stacy: Thank you. Good afternoon. Thank you for joining us. I’m Shirley Stacy, Vice President of Corporate Communications and Investor Relations. Joining me for today’s call is Joe Hogan, President and CEO, and John Morici, CFO. We issued first quarter 2022 financial results today via GlobeNewswire, which is available on our website at investor.aligntech.com. Today’s conference call is being audio webcast and will be archived on our website for approximately one month. A telephone replay will be available today by approximately 5:30 PM, Eastern Time, through 5:30 PM, Eastern Time, on May 11th. To access the telephone replay domestic callers should dial 866-813-9403 with access code 335004. International callers should dial 929-458-6194 using the same access code. As a reminder, the information provided and discussed today will include forward-looking statements including statements about Align’s future events and product outlook. These forward-looking statements are only predictions and involve risks and uncertainties that are described in more detail in our Form -- in our most recent periodic reports filed with the Securities and Exchange Commission available on our website and at sec.gov. Actual results may vary significantly and Align expressly assumes no obligation to update any forward-looking statement. We have posted historical financial statements including the corresponding reconciliations including our GAAP to non-GAAP reconciliation, if applicable, and our first quarter 2022 conference call slides on our website under Quarterly Results. Please refer to these files for more detailed information. With that, I’ll turn the call over to Align Technology’s President and CEO, Joe Hogan. Joe?
Joe Hogan: Thanks Shirley. Good afternoon and thanks for joining us. On our call today, I'll provide an overview of our Q1 results and discuss the performance of our two operating segments; Systems and Services and Clear Aligners. John will provide more detail on our financial performance and our view for the remainder of the year. Following that, I'll come back and summarize a few key points and open the call to questions. Overall, the first quarter proved to be a tougher-than-expected operating environment globally and we believe our results primarily reflect three key factors; the continued impact of COVID-19 waves in every region and especially in China, with its restrictions and lockdowns under their Zero COVID policy; a weaker economic environment and waning consumer confidence driven by increasing inflationary pressures and supply chain disruptions; and the military conflict in the Ukraine and fallout across Europe. In addition, with approximately half our business occurring outside the United States, unfavorable foreign exchange rates negatively impacting our revenues, margins, and EPS. Notwithstanding these headwinds, Q1 2022 total revenues of $973.2 million were up 8.8% year-over-year compared to Q1 2021 revenues of $894 million with a growth rate of 62% year-over-year. Our Q1 2022 operating income was $198 million and operating margin was 20.4%. In Q1, Systems and Services revenues were up 15.6% year-over-year, but down 24% sequentially coming off our sixth consecutive quarter of sequential growth and record scanner and services revenue. Sequential results primarily reflect lower volumes from our aforementioned headwinds and from seasonality as Q4 is historically a stronger capital equipment sales quarter. For Q1, Clear Aligner revenues were up 7.5% year-over-year, reflecting revenue growth across regions and products and were down slightly sequentially from Q4 at minus 0.7%. In the teen segment, 175,000 teen started treatment with Invisalign Aligners, up 6% year-over-year. Invisalign First for kids as young as six years old grew sequentially year-over-year and was strong across all regions. Q1 non-case revenues would include doctor-prescribed retention products, clinical training and education and other dental consumables performed well and grew both year-over-year and sequentially. Our Doctor Subscription Plan, or DSP, pilot was launched last year in the United States and Canada, and it continues to ramp nicely, driving strong revenue growth. DSP is a monthly subscription program, designed for a segment of experienced Invisalign doctors, who are not regularly using our retainers or low-stage aligners. We're very excited about the feedback and uptake we're seeing, and we'll expand the program into other markets this year Here are just a few things from doctors who are saying about DSP. Dr. De Ferris in Santa Barbara, California, 'we have shifted our retention model and workflow. We really like the material, the fit and the precision of the product and having everything in Align systems versus printing in-house and having to maintain it ourselves.' Dr. Sandra Tai, in Vancouver, Canada, 'This program fits my business model very well. I'm able to pass savings to patients.' Now let's turn to the specifics around the first quarter results, starting with the Americas. For Q1, Invisalign case volumes were down 1.5% year-over-year. On a sequential basis, Americas case volumes were down 4.3%, primarily reflecting the impact from COVID-19 waves. First experience in North America beginning in Q4 2021 and continue into Q1 and later in Latin America, causing consumers customer staffing shortages and practice closures as well as decreased patient traffic and increased deployment cancellations. The latest data from the gauge practice analysis tool that collect and consolidates data from about 700 ortho practices, covering more than 1,000 orthodontists across 1,600 locations in the United States and Canada, showed weakening underlying patient demand trends in the first quarter for both adult and teens and across wires and brackets and Clear Aligner products. New patient visits were down 7.6% year-over-year ortho starts were down 7.2% year-over-year. In the DSO channel, in Q1 2022, DSO practices grew faster than non-DSO practices with utilization led by Heartland and Smile Doctors. Earlier this month, we announced a new DSO partnership with Dental Corp, Canada's largest and fastest-growing network of dental practices. Dental Corp plans to extend its offering of Invisalign brand, Clear Aligner treatment to Canadians nationwide through its ortho acceleration program. This strategic collaboration also provides dental course network of doctors across nearly 460 practices with access to enhanced benefits, dedicated learning opportunities, and treatment planning support for the Invisalign system. Also this month, we launched a new Invisalign Teen subscription program in the United States and Canada to help unlock the massive opportunity from teen orthodontics, which makes up approximately 75% of the 5 million annual case starts in North America. The teen subscription program enables orthodontists to buy Clear Aligners in case packs in advance, much like the way they buy wires and brackets today, offering simple and more predictable billing for doctors. It also includes exclusive practice development benefits with the Invisalign brand and requires an incremental volume commitment from doctors. The timing of the new teen program coincides with the beginning of the summer teen season, and we're excited to continue partnering with doctors to grow their practice with Invisalign treatment with less than 10% share of teen case starts, the teen subscription program has the potential to help accelerate Invisalign adoption in the largest segment of the orthodontic market teams. For our international business, Q1 Invisalign case volumes were up 3% year-over-year. On a sequential basis, international case volumes were down 6.1%, primarily reflecting the headwinds described earlier, especially the impact of COVID-19 restrictions and lockdowns in China in the fallout across Europe from the military conflict in Ukraine. For EMEA, Q1 Invisalign case with core growth in our core markets led by Italy and Germany and doc, along with the growth expansion markets led by Turkey and EMEA. The Q1 year-over-year Invisalign case volume in EMEA was driven by increased emissions, primarily from the orthodontist channel, especially in the teen market. During the quarter, we launched our first ever directed teen campaign in EMEA focused on educating teens about the benefits in Invisalign treatment over traditional wires and brackets, increasing consumer demand as part of our wider teen growth plan, combined with our parent of teen campaign and to help give teens critical influence in the parent decision by driving peer word of mouth. More recently, we launched the Invisalign Go Express system, the latest addition to the Invisalign Go portfolio for general dentists. First launched in EMEA in 2016 as a 20-stage aligner treatment offering, the Invisalign Go portfolio system is designed for general dentists to treat mild to moderate malocclusions, to integrate tooth alignment into restorative and comprehensive dental care. Additionally, building of our European manufacturing facility in Wroclaw, Polar remains on track to go live this quarter, increasing our flexibility and timeliness in supporting our value doctor customers across the EMEA region. Turning to APAC for Q1. APAC Invisalign case volumes were up 4.7% year-over-year. With strengthened the GP dentist channel, primarily through increased Invisalign submissions with the Invisalign Go product and in the teen market with increased submissions from the orthodontic channel. On a sequential basis, APAC was down 2.6%, reflecting a larger impact from surges in new COVID-19 cases that led to significant lockdowns in China. Alternatively, despite headwinds, Japan and Taiwan performed well. We had strong growth in emerging markets like Korea and India and Thailand on a year-over-year basis. Earlier this month, we expanded the Invisalign Clear Aligner product portfolio with new offerings that better serve the expanding market in China. The two new products Invisalign Adult and Invisalign Standard Clear Aligners are designed for more specific types of malocclusion cases and private doctors and their patients with a more clinical and affordable options for moderate to complex cases. Invisalign Adult and Invisalign Standard Clear Aligners built on our proven technology for a wider range and scope in malocclusion. During the quarter we announced new Invisalign innovations for the Align Digital platform. Proprietary combination of software, systems and services designed to provide a seamless experience and workflow that integrates and connects all users, doctors, labs, patients and consumers. These new Invisalign innovations include ClinCheck Live update, the Invisalign Practice App, Invisalign Personalized Plan or IPP, Invisalign Smile Architect and the cone beam computed tomography, CDCT integration feature for ClinCheck digital treatment planning software. These innovations will revolutionize digital treatment planning for orthodontics and restorative dentistry by providing doctors with greater flexibility and real-time treatment plan access and modification capabilities. Each of these innovations are designed to enhance Invisalign treatment planning quality, efficiency, and scale and contribute to a better doctor-patient experience. More recently, we introduced a new enhancement for the Invisalign system with mandibular advancement feature. The Invisalign system with mandibular advancement is the only clinically proven Clear Aligner product in the world today that address a Class II correction with simultaneous alignment. Using feedback from customers, we've enhanced the original design with new enhanced precision wins that provide increased durability and comfort as well as great overlap to help ensure that the Aligners remain seated and properly engaged to more effectively address Class II malocclusions in growing preteen and teen patients. Our consumer marketing focus on educating consumers about the Invisalign system and driving that demand to Invisalign doctors' offices ultimately capitalizing on the massive market opportunity to transform 500 million smiles. In Q1, we built on a successful Invis Is Multimedia campaign across the Americas, EMEA and APAC driving awareness and interest in Invisalign treatment with adult, teen, and parent consumer segments. Globally, we delivered strong impression volume with over 23.7 million visits to our websites, 11 with a -- 113% [ph] year-over-year increase and over 7.8 billion impressions delivered, representing a 32% year-over-year increase. In the US, we continue to amplify our campaigns across the top social platforms such as TikTok, Snapchat, Instagram, and YouTube to increased awareness of Invisalign brand with young adults and teens. Our campaigns featured collaborations with some of the largest influencers in social media, including Charli D'Amelio, Lana Condor, Devon Key, Michael Le, and Josh Richards. Each of these creators shared their personal experience with Invisalign treatment and why they chose to transform their smiles with Invisalign Aligners. To continue growing our young adult business across the Americas, EMEA, and APAC, we hold upon our successful Invis Is a Powerful Thing campaign, which highlights how powerful the smile transformation with Invisalign treatment can be for even young adults' self-confidence. We leverage top influers like Leana Green and Lana Condor and integrated media campaigns. Further, we are expanding our collaboration with influencers globally and are excited to welcome Olympic Gold Medalist, Suni Lee and creators Josh Richards, [indiscernible], and Scarlett Estevez who have chosen to shape their smiles with Invisalign treatment. In the EMEA region, we accelerated our media investments across digital media platforms, including YouTube, TikTok, Meta, and Snapchat and expanded our Invisalign Smile squad roster with new influencers. Additionally, we launched a pilot in the UK to reach teams with special campaigns to create awareness of the unique benefits of Invisalign treatment. Our consumer campaigns delivered more 8.8 million unique visitors to our website, representing 170% increase year-over-year with over 2.5 billion media impressions. We continue to expand our investment in consumer advertising across the APAC region, excluding -- including China, resulting in a 278% increase year-over-year in unique visitors and a 265% year-over-year increase in impressions. We continue to strengthen our investments in Australia by expanding our reach via social media platforms such as TikTok, Meta, and YouTube. In Japan, we built upon our successful consumer campaigns by expanding into Twitter and continue to see strong response from consumers as evidenced by a 373% increase in unique visitors to our site. For our Systems and Services business, Q1 revenues were up 15.6% year-over-year, reflecting strong scanner shipments and services and down 24.2% sequentially, primarily reflecting lower volumes from the previous mentioned headwinds and capital equipment seasonality. During the past quarter, we saw continued adoption of the iTero Element 5D imaging system we launched last year that features innovative technology like near infrared technology that we call NIRI, which age into detection and monitoring of Interproximal Caries Lesions or cavities without -- above the gingiva without harmful radiation. A strong indicator of the digital adoption within dental offices is a number of intraoral scans used for Invisalign case submissions. Total worldwide in oral digital scan submitted to start an Invisalign case in Q1 increased to 87.1% from 80.9% in Q1 last year. International intraoral digital scans for Invisalign case submissions increased to 83%, up from 75% in Q1 last year. For the Americas, 91% of Invisalign cases were submitted using an intraoral digital scan compared to 85.5% in Q1 of last year. Cumulatively, over 54.9 million orthodontic scans and over 11.4 million restorative scans have been formed with iTero scanners. During the quarter, the iTero Element 5D Plus won the best new imaging or CAD/CAM product from DrBicuspid.com and Cuspies award. The award reflects our commitment to develop innovative solutions that help doctors transform lives by improving patients' journey to a healthy, beautiful smile. We are pleased to share that the iTero Element scanner received in ortho town, 2021 Townie Choice Awards, which seeks to recognize the top gear recommended products and services and dentistry. We're proud that the iTero Element 5D Plus imaging system provides dental practices with Alvadis [ph] and imaging technology, cutting-edge enhanced chair-side visualizations and applications that can drive practice growth in treatment acceptance. Continued growth in the iTero scanner installed base is driving increased services revenues as well as exocad CAD/CAM software solutions that integrate workflows to the dental labs and dental practices. Our Q1 exocad CAD/CAM products and services, which include restorative dentistry, implantology, guided surgery and smile design offerings are included in scanner and services revenues and are helping extend our digital dental solutions and broaden Aligned digital platform towards fully integrated interdisciplinary and workflows. As we continue to lead the evolution of digital orthodontics and restorative dentistry, our goal is to make orthodontics a pillar of dentistry. April 2 marked our second anniversary since welcoming exocad into the Align family. And together, we're working to ensure that every dental technician in every dentist planning restorative treatment in centers of benefits of digital orthodontics first. We're continuing to focus on integration and road map development to strengthen the Align Digital platform by addressing restorative needs to facilitate both ortho restorative and comprehensive dentistry. Two years after exocad joined Align, we are more excited than ever about the opportunities ahead to shape the dental industry and with technology and expertise that complement the many benefits of the Align Digital platform and bringing all key stakeholders together, doctor, customers, labs, partners and users as we continue transforming smiles and changing lives. During the quarter, exocad participated in the 2022 Dental South China show in Guangzhou, China, showcasing its newest software release, Dental CAD 3.0 Galway plus other open software solutions like Innovative Smile Design program called Smile Creator. The show allowed the exocad team to deepen their relationships with the dental community to discover new trends emerging in the growing dental market in China. Attendees have both the experienced in firsthand how exocad's wizard guided workflows and easy online communication programs streamline the treatment journey from consultation to final restoration. Finally, this quarter, exocad is opening its new headquarters in Seoul, South Korea, which provides a robust high-tech infrastructure to a key region of our business. exocad has been working with a growing number of Korean manufacturers for many years, and this location help facilitate strategic relationships in the region. With that, I'll now turn over the call to John.
John Morici: Thanks Joe. Now, for our Q1 financial results. Total revenues for the first quarter were $973.2 million, down 5.6% from the prior quarter and up 8.8% from the corresponding quarter a year ago. For Clear Aligners, Q1 revenues of $809.7 million were down 0.7% sequentially due to lower Invisalign case volumes, partially offset by higher ASPs, reflecting higher ASPs and up 7.5% year-over-year reflecting higher ASPs in non-case revenues. In Q1, Invisalign case volume were down 5.1% sequentially and up 0.5% year-over-year. In addition, we shipped Clear Aligners to 82,400 Invisalign doctors worldwide, of which over 5,000 were first-time customers. Q1 comprehensive volume increased 2. 4% year-over-year and decreased 5% sequentially. Q1 non-comprehensive volume decreased 4% year-over-year and decreased 5.4% sequentially. Q1 adult patients decreased 1.6% year-over-year and decreased 5.7% sequentially. In Q1, teens or younger patients increased 6% year-over-year and decreased 3.6% sequentially. Clear Aligner revenues were unfavorably impacted by foreign exchange of approximately $6.5 million or approximately 0.8 points sequentially. On a year-over-year basis, Clear Aligner revenues were unfavorably impacted by foreign exchange of approximately $24 million or approximately 3.2 points. For Q1, Invisalign comprehensive ASPs increased sequentially and year-over-year. On a sequential basis, Invisalign comprehensive ASPs reflect per order processing fees charged on most Clear Aligner shipments, lower discounts, and higher additional lines, partially offset by unfavorable foreign exchange. On a year-over-year basis, comprehensive ASPs reflect higher additional aligners and per order processing fees, partially offset by unfavorable foreign exchange. Q1 Invisalign non-comprehensive ASPs increased sequentially and year-over-year. On a sequential basis, Invisalign non-comprehensive ASPs were favorably impacted by per order processing fees and lower discounts, partially offset by unfavorable foreign exchange. On a year-over-year basis, Invisalign non-comprehensive ASPs reflect per order processing fees, higher additional aligners, partially offset by foreign exchange. Clear Aligner deferred revenues on the balance sheet increased $53 million or 5% sequentially and $307.1 million or 38.1% year-over-year and will be recognized as the additional lenders are shipped. Our Systems and Services revenue for the first quarter were $163.5 million, down 24.2% sequentially and up 15.6% year-over-year. The decrease sequentially can be attributed to lower scanner volume following a strong Q4 and consistent with seasonality in the capital equipment business, coupled with the headwinds described earlier. The increase year-over-year can be attributed to increased services revenue from our larger installed base as well as slightly higher scanner volume. Our Systems and Services deferred revenues on the balance sheet was up $16.5 million or 7.2% sequentially and up $114.9 million or 87.6% year-over-year, primarily due to the increase in scanner sales and the deferral of service revenue included with our -- with the scanner purchase, which will be recognized ratably over the service period. Moving on to gross margin. First quarter overall gross margin was 72.9%, up 0.7 points sequentially and down 2.8 points year-over-year. On a non-GAAP basis, excluding stock-based compensation expense and amortization of intangibles related to acquisitions, overall gross margin was 73.3% for the first quarter, up 0.7 points sequentially and down 2.8 points year-over-year. Overall gross margin was unfavorably impacted by approximately 0.8 points on a year-over-year basis and by approximately 0.2 points sequentially due to foreign exchange. Clear Aligner gross margin for the first quarter was 74.8%, up 0.6 point sequentially due to higher ASPs, partially offset by higher mix of additional aligner volume and higher freight costs. Clear Aligner gross margin was down 2.8 points year-over-year due to higher mix of additional aligner volume and higher freight costs, partially offset by higher ASPs. Systems and Services gross margin for the first quarter was 63.4%, down 1.3 points sequentially due to lower volume and lower ASPs, partially offset by lower freight costs. Systems and Services gross margin was down 2 points year-over-year due to higher manufacturing inefficiencies, partially offset by higher mix of service revenues and increased ASPs. Q1 operating expenses were $511.3 million, down sequentially 2.4% and up 13.2% year-over-year. On a sequential basis, operating expenses were down $12.4 million. Year-over-year, operating expenses increased by $59.6 million, reflecting increased headcount and our continued investment in marketing sales and R&D activities and investments commensurate with business growth. On a non-GAAP basis, excluding stock-based compensation, amortization of acquired intangibles related to certain acquisitions and acquisition costs. Operating expenses were $480.2 million, down sequentially 2.9% and up 13.1% year-over-year due to the reasons described above. Our first quarter operating income of $198.1 million resulted in an operating margin of 20.4%, down 1.1 points sequentially and down 4.8 points year-over-year. The year-over-year decrease in operating margin is primarily attributed to lower gross margin, investments in our go-to-market teams and technology as well as unfavorable impact from foreign exchange. On a non-GAAP basis, which excludes stock-based compensation, amortization of intangibles related to certain acquisitions and acquisition costs, operating margin for the first quarter was 24%, down 0.7 points sequentially and down 4.6 points year-over-year. Interest and other income and expense net for the first quarter was a loss of $10.6 million, down sequentially by $9. 7 million and down year-over-year by $46.8 million. Q1 of 2021 included the SEC arbitration award gain of $43.4 million. The GAAP effective tax rate for the first quarter was 28.4% compared to 13.2% in the fourth quarter and 23.4% in the first quarter of the prior year. Our non-GAAP effective tax rate was 24.2% in the first quarter compared to 11.5% in the fourth quarter and 20.2% in the first quarter of the prior year. The first quarter GAAP and non-GAAP effective tax rates were higher than fourth quarter effective tax rates, primarily due to tax benefits related to expiration of statutes of limitations for timely asserting claims and an out-of-period adjustment recorded last quarter. First quarter net income per diluted share was $1.70, down sequentially $0.70 and down $0.81 compared to the prior year. Our EPS was unfavorably impacted by $0.13 on a sequential basis and $0.28 on a year-over-year basis due to foreign exchange. On a non-GAAP basis, net income per diluted share was $2.13 for the first quarter, down $0.70 sequentially and down $0.36 year-over-year. Moving on to the balance sheet. As of March 31st, 2022, cash, cash equivalents, and short-term and long-term marketable securities were $1.1 billion, down sequentially $176.1 million and down $11.1 million year-over-year. Of our $1.1 billion balance, $453 million was held in the US and $667.6 million was held by our international entities. Q1 accounts receivable balance was $950.9 million, up approximately 6% sequentially. Our overall days sales outstanding was 87 days, up approximately nine days sequentially and up approximately 15 days as compared to Q1 last year. Cash flow from operations for the first quarter was $30.5 million. Capital expenditures for the first quarter were $87.3 million, primarily related to our continued investment to increase aligner manufacturing capacity and facilities. Free cash flow, defined as cash flow from operations, less capital expenditures, amounted to negative $56.8 million. In February, we repurchased $75 million of our common stock through open market repurchases of approximately 143,600 shares at an average price of $522.61 per share. We have approximately $650 million remaining available for repurchase under our May 13th, 2021, $1 billion repurchase program. As described during our Q4 2021 earnings call, we provided our fiscal year 2022 outlook with revenue growth in line with our long-term revenue range of 20% to 30%. This revenue growth assumed no significant new COVID surges after current wave, no meaningful practice disruption nor material supply chain issues throughout the year. At that time, we were seeing some recovery as Omicron headwinds began to ease and COVID restrictions were relaxing. However, later in the quarter, unfavorable impacts on our business occurred driven by China lockdowns, weaker consumer confidence, inflationary pressures and the Russia-Ukraine conflict. For April, we have not seen momentum return as the headwinds previously mentioned persist. Now turning to full year 2022. We remain confident in the huge underpenetrated market, our technology and industry leadership and our ability to execute and make progress toward our long-term model of 20% to 30% revenue growth. At the same time, the headwinds we're experiencing, which include increased COVID waves and significant China lockdowns, weaker consumer confidence, inflation pressures the Russia-Ukraine conflict have increased uncertainty across all markets. We also anticipate capital equipment sales will be increasingly constrained throughout the year as practices adjust to these headwinds. Given less visibility and an increasing unpredictable operating environment, we are not providing revenue guidance for the year. However, assuming no additional material disruptions or circumstances beyond our control, our goal for fiscal 2022 is to deliver GAAP operating margin above 20%, while making strategic investments in sales, marketing, R&D and operations In addition, during Q2 2022, we expect to repurchase up to $200 million of our common stock through either a combination of open market repurchases or an accelerated stock repurchase agreement. For 2022, we expect our investments in capital expenditures to exceed $300 million. Capital expenditures primarily relate to building construction and improvements as well as a digital manufacturing capacity to support our international expansion. This includes our investment in an aligner fabrication facility in Wroclaw, Poland, which is expected to begin serving doctors in the second quarter of 2022 as part of our strategy to bring operational facilities closer to customers. As we continue growing, we intend to expand our investments in research and development, manufacturing, treatment planning, sales and marketing operations to meet the actual and anticipated local and regional demands. With that, I'll turn it back over to Joe for final comments. Joe?
Joe Hogan: Thanks, John.
Operator: Excuse me. Joe Hogan, are you there?
Shirley Stacy: Yes, operator.
Joe Hogan: Thanks, John. I'll run by this again. Okay. That was my fault. Over our first quarter results reflect a more challenging environment than expected. We know that COVID lockdowns, weaker consumer confidence, inflationary pressures and the Russia-Ukraine conflict have created headwinds, but we remain excited and committed to realizing the enormous opportunity in front of us to lead the evolution of digital orthodontics and comprehensive dentistry. With less than 10% share of the 21 million starts each year with over 500 million people globally who can benefit from a healthy beautiful smile, our market is as large as ever. No other company is as well positioned as us to take advantage of that potential as the environment improves and growth trends return. We will continue to focus on the execution of our strategic growth drivers, while managing investments in the near-term to account for the headwinds and uncertainty, and we will remain confident in our long-term revenue growth model of 20% to 30%. Before we open the call to questions, I want to address the military conflict in the Ukraine and our operations in Russia. It's a human tragedy for all people involved and our thoughts go out to everyone impacted and especially to those with personal connections who are undoubtedly concerned with their families and loved ones. Our primary concern remains the safety and security of our employees and their families, our doctors, their staff and patients. We have nothing to do with this conflict. As a global medical device provider of doctor-prescribed products, continuity of care is critical to the doctors and their patients in orthodontic treatment. We discontinued commercial activities in Russia that are not essential to providing continuity of care to patients. Our focus on only our values and ethical responsibility of patients in treatment. In the process, we are also adhering to the international sanctions that have been imposed. Our IT infrastructure, including covet intellectual property is hosted outside of Russia. Prior to the conflict, we have begun expanding our R&D teams in Downstate, Germany; Madrid, Spain; Toronto, Canada; and Austin, Texas. And we're prudently working with the team on the ground in Russia on work pieces. A number of our Russian employees have already transitioned and are in various stages of transitioning their families to Armenia, where we've set up an R&D center in urban to support those who choose to relocate. At the same time, it's humbling to see the tremendous outpouring of kindness and support throughout the company as our employees respond to the humanitarian needs of the crisis. Our Polish team members has set up donation centers at our facilities where employees are contributing food, clothing, supplies, and human care. Many are also taking Ukrainian refugees into their homes. And we're proud of the tremendous initiative by our colleagues and are grateful for their actions. In addition to our employees' efforts, Align is donating $300,000 to support humanitarian relief efforts through organizations providing shelter food, medicines and vital supplies. We can only hope that the conflict in Ukraine will end soon, that the ongoing impact of the pandemic will lessen for good, and that economic factors facing many customers and consumers will abate. But these things are beyond our control, so we will continue to prioritize the health and safety of employees, customers, and patients and will stay focused on strategic initiatives. In closing, April 3rd marked the 25th anniversary of the founding of Align Technology. And shortly thereafter, the long of the Invisalign system. Over the past 25 years, we've transformed the orthodontic industry with a passion for innovation as we've evolved from leading the evolution from digital appliances to digital platform. We've created an incredible company unlike any other. Invisalign's unique mass customization business operating in real time with no inventory or distribution at the front end of our market. Consequence of fluctuations in the macroeconomic environment are felt faster at Align than I've ever experienced anywhere in my career. And we monitored these trends to make adjustments in our business when needed. Our success is a result of a vision and purpose and results. Thanks to our employees and our doctor customers around the world, who took a chance on a Silicon Valley start-up and risked everything. Today, Align is the largest 3D printing operation in the world, producing 1 million customized aligners each day based on the learnings gained from nearly 13 million Invisalign patients and 60 million iTero digital scans Our global team of over 25,000 employees support more than 250,000 doctors and labs in more than 150 countries. There are more than 500 million people in the world that can benefit from orthodontic procedures. It's huge. And you can only address opportunities of that size with digital orthodontics. It could never happen using old analog methods. As we have digitized that capability, it has opened up a market broadly for orthodontic treatment to the masses. It's hard to believe that after 25 years, we're still in the early phases of transforming the orthodontic market. We look forward to sharing more milestones over the next 25 years as we continue to lead the digital evolution of orthodontics and dentistry, deliver great treatment outcomes and treatment experiences to doctors and patients around the world. Thank you for your time today. I'll now turn it over to the operator for questions. Operator?
Operator: Thank you. At this time we will be conducting a question-and-answer session. [Operator Instructions] The first question is from the line of Jason Bednar with Piper Sandler. You may proceed.
Joe Hogan: Hi, Jason.
Jason Bednar: Hey, good afternoon, everyone. Hey, there. Thanks for taking the questions. So Joe, I guess just to start with you. I mean, you and John called out the consumer confidence items and the inflationary pressures impacting the business. The wind shifting pretty abruptly on you. I guess, are there tools you have at your disposal to manage through these pressures, or is this a matter of just keeping your head down, waiting for the macro environment to settle down, I guess, really just trying to get a sense of how we should be moderating expectations from what's typical sequential growth we would see in the business?
Joe Hogan: Yes, Jason, good question. I'd say being a global business, we talked about having 50% of our revenues outside. It just gives us good scope in the sense to take advantage where opportunities are. And so I feel really good about the company in that sense. And we've made great development over the last three years from an international standpoint. We also have a great portfolio. We have iTero scanners. We talked about some reluctance in the sense that we saw at the end of the first quarter as some doctors to really commit to it. But I mean that demand is still out there. When you look at iTero scanners are so underpenetrated still when you look at digital dentistry and what the future really brings. And so pushing that and pushing it in the right places and also you see the expansion of our Invisalign technology and what we're doing in different areas, too. So I feel like we have a lot of levers that we can pull, but we are constrained by these headwinds that we've seen. And obviously, we'll respect those and make the kind of adjustments needed to make sure this business stays on track with. Look, I love our portfolio. I love our position. I see a great future. We'll manage our way through this, Jason.
Jason Bednar: Okay. That’s helpful. And then maybe shifting over to the – the margin side, you're not stepping off the gas with spending. I wouldn't expect it to given the opportunity that you're talking about here today and you've talked about for quite some time. But I guess are you still comfortable with that long-term model of 25% plus operating margins? I know we've seen that for some select periods for the business. But is that the right margin level to think about for the business when you're driving towards that 20% topline growth? Just -- can you truly balance that, or do you have to sacrifice one for the other, again, thinking longer term here?
Joe Hogan: I think, Jason, honestly, I think we've managed that well over the years. I mean you can see how well we did last year in the sense of that operating profit has been squarely on top of that piece. And I think we've managed it within that bandwidth very well, and that's -- this current situation is not going to change that.
Jason Bednar: All right. Thanks guys.
Joe Hogan: Thank you, Jason.
Operator: Thank you. The next question is from the line of Jeff Johnson with Baird. You may proceed.
Joe Hogan: Hi Jeff.
Jeff Johnson: Thank you. Hey guys, how are you? So, Joe, let me just pick up on that last point. I mean, you said you've managed OpEx well over the years in that. I guess, let me just be direct on it. I mean, if end markets are cyclically slowing that's kind of out of your control, do you put the gas pedal down to the accelerator? Do you say there's not a whole lot that that's going to accomplish? So I kind of protect margins here in the short run. Just what's your OpEx outlook kind of in the near term -- near to intermediate term, I guess, given some of this macro uncertainty?
Joe Hogan: Jeff, it's more the latter of your question. It's just you take off the accelerator. And we know -- John and I know where to adjust it won't hurt the business. We continue to invest in innovation in different areas, too. But there are several areas of short-term investments that aren't going to help us in this current crisis that will obviously lean into and make sure that we preserve margins as much as we can. : But with those investments, yes, it will be -- when we talked about the 20-plus percent on a GAAP basis, that's the trade-off that we'll have. We'll invest where we can see a return. And based on the volume that we expect, but deliver 20-plus percent op margin.
Jeff Johnson: Yes, got it. Thanks John. And then a follow-up question, I guess, just on the gauge data, you talked about down 7% case starts ortho year-to-date. I'm hearing that through April, not just through March. But I don't get the whole gauge data set, but what I've seen is that the adult data is worse than the teen data, which would make sense to me. Everybody sitting at home, all the adults sitting home last year with the Zoom effect going on at this point in stimulus checks, sitting in pockets and all that. So, that all makes sense. But just what's the tenor in North America or in those markets that aren't impacted by China and Russia, Ukraine in that? What's the tenor of the teen business? And is the core that part of the business still doing better than you've just got real tough comps because all those adults were coming in last year as they were sitting at home and had nothing better to do than get Clear Aligners?
Joe Hogan: Hey Jeff, it's Joe. Look, the teen market, you're good to focus on that. I mean that's -- we look at that as a fairly secure market. Obviously, it can move up and down, but it won't have the volatility and you've seen in the adult market and you're comparing a against last year is a good way to look at it, given the Zoom effect and things we talked about before. So -- and Jeff, that's why you see us launching these teen products right now and getting ready from a summer time standpoint. We want to take advantage of that demand as much as we possibly can, especially in times like this. We know the adult market is going to be pressured. I'm talking about the US right now, but this sets leave China now because China is a unique position in the sense of a lockdown that they're going through. But we're -- you're going to see us take the same tact in Europe also. And you saw our teen volume in Europe was actually pretty good in the first quarter.
Jeff Johnson: What about that teen volume in the US, Joe?
Joe Hogan: We expect that teen volume to be good. Summer seasonality is there. And it's funny. There's a window for to really have their teeth treated. And we've known that here for years, and that's why we prepared for teen season. And this year, honestly, Jeff, I feel better about our positioning for teens in the United States and also in Europe. I have many time since I've been here with these teen packs that we just talked about and how we'll go about it, I think we're well positioned to make further penetration in the teen market versus wires and brackets.
Jeff Johnson: Yes, got it. Thanks, guys.
Joe Hogan: Thank you.
Operator: Thank you. Your next question is from the line of Jonathan Block with Stifel. You may proceed.
Joe Hogan: Hey, Jon.
Jonathan Block: Hey, guys. Thanks. Hey, guys. Good segue. I'll start with the teen case packs. We picked up on that program right after April. Quite honestly, unfortunately, I'm old enough to remember your teens pack programs internationally from like a decade ago. And if I remember this correctly, Joe, it is just hard to collect, if you would, if someone did below their threshold and hopefully, I'm making some sense. So maybe just talk to us -- here you are going after it, you're going after for teens, not overall, you're launching it. What's going to be different this go round when someone commits to a 50-case pack or a 100-case pack, let's go with 100, they do 88 and you've got to go out there and say, 'Hey, look, it's a user or lose it, we got to collect for you and then also just keep the tenor of the relationship or the goodwill of the relationship intact because now argue even have more options to go somewhere else versus what they were staring down a decade ago. So maybe if you could talk to that and just the timing behind kicking off the program, that will be a great place to start.
Joe Hogan: Jon, you're like an Align history, and that's a good question, right? Because I can tell you, I doesn't hear where that happened in Europe, but it's legendary here. But if you go back in time, I think our business in Europe was less than $10 million back then. Okay, now it’s over $1 billion. And I think the whole world is much more coined with Clear Aligners than when it was back then, we were really pioneers at that point in time. If you look at our DSP program, it's basically the same thing. They make commitments to how many aligners are going to buy over a certain period of time. We haven't had any issues in DSP with having customers regress or not making those benchmarks. So we feel pretty good about where we are. I mean will we run into a few situations, I think we will. I think they'll be outliers, and we'll deal with them in time.
Jonathan Block: Okay. Fair enough. And I just might go back to sort of where Jason started a little bit. There's going to be a lot of questions on 2022 and pulling the top line guidance. So let me just throw out a couple of things, and we could sort of work through it. If I look back the past five to six years, the first quarter was about 22% of total revenue. And if you run that exercise for this year, you get about 11% or 12% year-over-year revenue growth and you've got an incremental FX headwind. So should we throw a dart at 10%? And what's wrong with that thought process in getting to, call it, low double-digit 10%, 12% top line growth for 2022? Thanks, guys.
John Morici: I think -- Jon, this is John. As we talked about that last earnings, there's a lot of changes that have happened in the marketplace and in the world. And as a result of that, we pulled the top line guidance until we get further clarity as how things are going to shake out. What we have committed to is being able to grow in a profitable way in a way that you would expect us to be responsible being at 20-plus percent, but we pulled that guidance because of the uncertainty.
Joe Hogan: Jon, just to add to John's comments, too, is that as we look at April versus March, we haven't seen any momentum from an April standpoint too. And we start from that standpoint also.
Jonathan Block: Okay. That’s helpful color. Thanks, guys.
Operator: Thank you. The next question is from the line of Erin Wright with Morgan Stanley. You may proceed.
Erin Wright: Great. Thanks.
Joe Hogan: Hi Erin.
Erin Wright: In the Americas -- hi, good to hear from you. So, in the Americas, can you parse out a little bit about what you're seeing in terms of macro headwinds compared to maybe some of the lingering COVID impact? And does it seem like some -- I mean it doesn't seem like some of these cases are coming back from maybe Omicron delays. But what are in terms of the dynamics there? Just trying to kind of parse out. Last quarter, you did break out kind of a COVID impact, but could you do that this quarter?
Joe Hogan: It's hard to be very discrete in the sense of what that impact is, Erin. But I'd say we -- obviously faced staffing shortages and things at different doctors in the first part of the first quarter that affected us. I'd say that drifted through to basically late February, early March. After that, you can -- if you watch the consumer confidence statistics in the United States, they've gone down pretty dramatically. And we started getting a lot of reports from our doctors is patients thought saying no, but patients not as quick to say, yes, that they wanted treatment. And we hear that both in the GP segment in the orthodontic segment. So, you can call out what you want to, okay? But do we see some reticence in the marketplace to move forward with treatment and again, it's not binary. It's not everybody is saying, no, like in the heart of a deep recession or something we saw back in 2007 or 2008. It's just more cautiousness from people about their personal finances.
Erin Wright: Okay, great. Thanks. And then on ASPs for the balance of the year, I guess, how should we be thinking about that and the levers, I guess, you can pull on that front? Thanks.
John Morici: Hey Erin, this is John. From an overall ASP standpoint, we don't have any anything unusual from a promotion standpoint or anything else that would affect us. Obviously, notwithstanding FX, we've seen unfavorable FX as we've gone through this year so far. But notwithstanding FX, we wouldn't expect anything dramatically different from an ASP standpoint.
Erin Wright: Okay, great. Thank you.
Joe Hogan: Thanks Erin.
Operator: Thank you. The next question is from the line of Kevin Caliendo with UBS. You may proceed.
Kevin Caliendo: Hi, thanks for taking my call.
Joe Hogan: Hey Kevin.
Kevin Caliendo: Hi. So, I guess the question I have is, the first one is really why have the doc adds -- doc starts been so sluggish? Is it demand driven? Is it competitive positioning? Is it -- I would just love to hear sort of why in the US, especially the sort of doc ads have been flattish for the last couple of quarters? If there's anything, if it's macro or micro or competitive?
Joe Hogan: Well, I think I read your question, I think you're asking if it's competitive because I mean we're pretty clear on what we've been seeing around the globe in the United States from a macro standpoint, Kevin. So, I just -- look, from a competition standpoint, we don't see any major issue with competition in the sense of being a factor in this demand cycle that we're talking about.
Kevin Caliendo: And when we try to think about the impacts here that are driving all of this, how much do you -- have you guys been able to ascertain how much of this is economic-driven? You're talking about decisions taking longer and people being more hesitant and volumes being down, how much of that is economic versus COVID versus other -- like have you been able to just parse out what's really driving it as a percentage? Is it mostly simply listen, we're in an inflationary environment. People don't have as much to spend, consumers aren't spending as much broadly versus just an overall demand for your products and/or COVID, like those three things, if you were to group them?
Joe Hogan: Kevin, our announcement and the way we communicate to the marketplace, we talk about this huge market, right? We're totally underpenetrated in the orthodontic segment, less than 10% of 21 million case starts a year. Talking about what we see through the 500 million patients. So there's not a lack of demand out there and the lack of opportunity. There's not a competitive issue that we think is affecting our growth or our earnings. And so obviously, COVID is part of this thing. Part of it we see in Europe was the Ukraine conflict that's going on today. And I think significant amount of it is too is what we're seeing in the marketplace, too, from a consumer standpoint. I can't put any weighted averages on these things to give you an example. And I think -- if I compare to when we last talked to you at the first couple of days of February, the way things have changed, those variables in that equation, I think, have changed pretty dramatically. So it's really hard to say going forward what that might be.
Kevin Caliendo: Are there any goals that you have -- one last one for me. Are there any goals that you have for this year in terms of quantifiable goals in terms of whether it be doc ads or utilization uptick or -- I mean, I know those are the things you were focused on when you talked about increasing your spend. Like what are you targeting at this point? Is there anything that we can sort of put a stick in the ground and say, 'okay, here's something that the company is hoping to achieve in 2022 in terms of a quantifiable number.
Joe Hogan: Kevin, this is a growth company. And it never leaves our thought process. So what are we trying to do? We're trying to run the way we always do. We're running at these plays in a much more difficult market with more headwinds. That's all. And so we'll move these place around. We'll look at them by country. We'll see what makes the most sense. We still keep a good strong focus on how we can grow and where we can grow and we'll find those ways.
Kevin Caliendo: Appreciate it. Thanks, guys.
Joe Hogan: Thanks, Kevin.
Operator: Thank you. The next question is from the line of Michael Ryskin of Bank of America. You may proceed.
Michael Ryskin: Great. Thanks for taking the questions, guys. I got two, a few I want to touch on. Can you hear me?
Joe Hogan: Yes.
Michael Ryskin: Okay. Great. Thanks. One is just sort of talking through some of the dynamics we're talking to. You talked for the quarter. I think we can all kind of see that a lot of it or a lot of it is macro driven, a lot of it's global driven and each of these events that we're following, whether it's the China lockdowns or the conflict in Europe or even things like FX are going to be more temporary than others. I know your long-term outlook is still there for the 20% to 30% volume growth and revenue growth. But what about sort of catch-up spend on these things? Is there an expectation somewhere and you kind of touched on this when you talked about your spend and your expectations on investment this year? As we go through the next couple of months, next couple of quarters as some of these things start to fade, are you expecting another bolus of catch-up as these cases come back like we saw in 2020 and 2021? Anything you can sort of comment on that? And then I've got a follow-up.
Joe Hogan: I think a bolus, you talked about -- I mean, that was interesting is what we saw after the last downturn, it was first like COVID. I mean I look at that, Mike, overall, is it just shows you the demand out there for our kind of procedures. So it's there. And so John and I are in setting here are predicting another bolus or a wave or whatever, but I think it just shows you the demand that exists in this business and it can be pent up at times. We'll just have to see how the headwinds that we see filter through the marketplace and how it affects consumers and doctors.
Michael Ryskin: Okay. I appreciate that. And then the follow-up, you touched on this in an answer earlier when you sort of referenced the 2007, 2008 downturn. Obviously, hopefully, we're not going to something quite like that in the coming year, too. But there's still a lot of talk about recession and sort of what the impact of prolong inflation is going to be on the consumer. Could you talk us through your plans if things do continue to deteriorate on that front, we're not there yet, but six months from now, a year from now, things are still heading in that direction sort of what are your internal plans for adjusting both on operations growth in that kind of environment? Because if you look back at 2007, 2008, 2009, there was a protracted period of essentially flat growth. So could you compare--
Joe Hogan: Yes, it's Joe again. I just -- we have a really strong balance sheet to start with. It's great to have a strong balance sheet and really no net debt from a company standpoint. So, look, it's -- I'm not an economist, but I'm not predicting a meltdown of our financial system, like we saw in 2007, 2008 depending on what Federal Reserve does or whatever, we're probably going to see an adjustment as they try to attack inflation. So, look, we -- this business is incredibly healthy. It generates a lot of cash. It's extremely international now. And we have a lot of levers to pull and a lot of things to do to keep this business going. So -- but if something dire did happen, I feel we got a balance sheet to be able to cover it, too, and we'll manage the business responsibly that way. So, I'd just tell you don't give up on us, okay? We love this business. We love the position that it's in. We're confident about the future. We're just going to see how these headwinds hit and how they subside, and we'll be ready on either end of that to be able to position this company to do well.
John Morici: And I might add, just we are a different business than we were back in 2007, 2008. We didn't have iTero. We have iTero, much more of a global products, much further along in the teen market, more consumer awareness, all the things that we've done over this time period now being 25 years, we've evolved over time and created a business where we're very mindful of what is happening from a demand standpoint, and we can do a lot of things from a leverage standpoint in order to drive that right amount of profitability.
Michael Ryskin: Thank you.
Joe Hogan: Thanks Mike.
Operator: Thank you. The next question is from the line of Nathan Rich with Goldman Sachs. you may proceed.
Nathan Rich: Hi, thanks for the questions. I wanted to follow-up on your commentary on April and not seeing momentum return. I was just wondering if there's any parameters you could put around that relative to maybe what you've seen in the first quarter? I guess like would that sort of mean volumes more flattish, anything that you could do to kind of help us think about how the business kind of exited the first quarter and where the current run rate is would be helpful?
Joe Hogan: Yes. Nate, I'll give you a quick rundown, and John can give you specifics to is. Look, we -- this is flattish to use your term. When you look at between March and April is more flattish than anything. But just remember, we have -- China is still our second biggest country in the world. It's locked down. Shanghai -- Beijing is going into lockdown. That's not the first lockdown we've seen in China. Remember, there are several provinces that were locked down before that, too. So, that part of our business has really been impacted in a big way, and that's part of that flattishness that we're talking about, too. So we're seeing impact in every region of the world in different ways. And on the APAC side, particularly with China, it's dramatic.
John Morici: I don't have much -- anything to add to it. I just -- a lot has changed as we've seen over the last couple of months, and we're responding to that change.
Nathan Rich: Makes sense. And I guess, I'd be curious just to get your thoughts on sort of the consumer environment. I know it's been touched on in other questions. But Invisalign treatment is a higher ticket purchase, and we've kind of always thought of it as catering to a more affluent consumer. I guess, is there anything that you've seen kind of between higher-end consumer versus lower-end consumer? And they're going back to, I think, the way you framed it, kind of the reticence to start treatment, any difference that you've seen among maybe the different segments of the population that could be considering treatment? .
Joe Hogan: I commented that back to the other question was asked about teens, right? The teen aspect in the orthodontic segment is pretty resilient, and that is a certain demographic that it's always existed in the sense of the parents that they can afford that kind of treatment of young children. The adult segment, it's all over the place depending on -- sometimes, it's just teeth straightening. Some of times, it's a broad worth correction on what's going on. We don't have any data in that adult segment to say that a certain FIFA score certain match, certain amount would be fewer people taking treatment or whatever. I don't have that data. I don't know if John has seen it either. But you'd have to guess that the more your finances are impacted, you're actually going to sign up for a $3,500 to $7,000 treatment depending on what you want or how you're in a contract for it. So it's logical that certain demographics would be less willing at this point in time.
Shirley Stacy: Thanks. Operator, we'll take one more question, please.
Operator: Absolutely. The next question is from the line of Elizabeth Anderson with Evercore ISI. You may proceed.
Elizabeth Anderson: Hi, guys. Thanks so much for the question.
Joe Hogan: Hi, Elizabeth.
Elizabeth Anderson: So maybe one question on the iTero scanner growth. Obviously, we saw a deceleration quarter-over-quarter, but still year-over-year growth there. When you sort of talk about how providers are looking at demand, and I realize that not all of that is like pure like iTero sales. How do we think about sort of what's driving the purchases in the first quarter? Obviously, there is some seasonality. But if you like, overall visits, maybe ex-Clear Aligners are not has maybe haven't been quite as impacted. Are we seeing sort of a reticence to spend? Is it sort of interest rates going up and people worried about sort of equipment financing? Could you walk us through some of the puts and takes of the demand drivers there?
Joe Hogan: Elizabeth, it's Joe. I'd start with the still market is broadly unpenetrated from a scanner standpoint. GP side, the ortho side, an ortho that does a lot of Invisalign, they can have four, five, six scanners overall. So look, with the GE Healthcare for years, ABB, I understand the capital equipment cycle. There is a true cycle in capital equipment. When people get concerned, they'll delay those kinds of purchases. And I think, obviously, you have -- when I talk about 250,000 doctors that we service today, some of them are going to be worried about what their cash flow is going to look like. They're going to be reticent in the sense of saying they want to sign up for a scanner that can cost anywhere between $15,000 to $35,000 right now and what we sell. So, I can't tell you by country or by region or whatever, but we didn't see things shut off. We just saw things as the quarter got through, they just didn't have as strong as demand for iTero than we anticipated. So, we'll have to -- obviously, we get into this way it goes. But there's going to be some more scrutiny, I think, around capital investment, if doctors are seeing less traffic through their practices.
John Morici: Yes. It's just the delays that they put to not close and necessarily within the quarter. It's not going away, but it's just a delay. And we have to work to try to get them to say.
Elizabeth Anderson: And you're not having any like supply chain issues on that side in terms of like being able to manufacture the equipment?
Joe Hogan: We didn't have any in the first quarter. We won't have any in the second quarter either.
Elizabeth Anderson: Okay. And one more quick follow-up. In terms of the gross margin impact of the new Poland facility, can you remind us about the cadence of the gross margin pressure when you open a new facility as it scale? So, I'm just trying to be able to parse that out versus maybe some of the deleveraging impact of some of the volume shifts versus that.
John Morici: Yes, Elizabeth. What we'll see is we'll go live in the second quarter here and that does have a gross margin impact. It really comes down to trying to get as much utilization through the plant as possible converting -- moving those countries and doctors through the plant. And then once that utilization increases, then you start to see some of that productivity. So, it hits about a quarter, maybe a little bit more than a quarter and then it subsides and then it gets more on a regular operating basis.
Elizabeth Anderson: Got it. Thank you very much.
Shirley Stacy: Thanks, Elizabeth. Well, thank you, everyone, for joining us today. This concludes our conference call. We look forward to speaking to you at upcoming conferences and industry meetings. And if you have any questions, please contact Investor Relations, and have a great day.
Operator: This concludes today's conference. You may now disconnect your line at this time. Thank you for your participation. | [
{
"speaker": "Operator",
"text": "Greetings. Welcome to the Align Q1 2022 Earnings Call. At this time, all participants are in a listen-only mode. A question-and-answer session will follow the formal presentation. Please note this conference is being recorded. I will now turn the conference over to your host, Shirley Stacy with Align Technology. You may begin"
},
{
"speaker": "Shirley Stacy",
"text": "Thank you. Good afternoon. Thank you for joining us. I’m Shirley Stacy, Vice President of Corporate Communications and Investor Relations. Joining me for today’s call is Joe Hogan, President and CEO, and John Morici, CFO. We issued first quarter 2022 financial results today via GlobeNewswire, which is available on our website at investor.aligntech.com. Today’s conference call is being audio webcast and will be archived on our website for approximately one month. A telephone replay will be available today by approximately 5:30 PM, Eastern Time, through 5:30 PM, Eastern Time, on May 11th. To access the telephone replay domestic callers should dial 866-813-9403 with access code 335004. International callers should dial 929-458-6194 using the same access code. As a reminder, the information provided and discussed today will include forward-looking statements including statements about Align’s future events and product outlook. These forward-looking statements are only predictions and involve risks and uncertainties that are described in more detail in our Form -- in our most recent periodic reports filed with the Securities and Exchange Commission available on our website and at sec.gov. Actual results may vary significantly and Align expressly assumes no obligation to update any forward-looking statement. We have posted historical financial statements including the corresponding reconciliations including our GAAP to non-GAAP reconciliation, if applicable, and our first quarter 2022 conference call slides on our website under Quarterly Results. Please refer to these files for more detailed information. With that, I’ll turn the call over to Align Technology’s President and CEO, Joe Hogan. Joe?"
},
{
"speaker": "Joe Hogan",
"text": "Thanks Shirley. Good afternoon and thanks for joining us. On our call today, I'll provide an overview of our Q1 results and discuss the performance of our two operating segments; Systems and Services and Clear Aligners. John will provide more detail on our financial performance and our view for the remainder of the year. Following that, I'll come back and summarize a few key points and open the call to questions. Overall, the first quarter proved to be a tougher-than-expected operating environment globally and we believe our results primarily reflect three key factors; the continued impact of COVID-19 waves in every region and especially in China, with its restrictions and lockdowns under their Zero COVID policy; a weaker economic environment and waning consumer confidence driven by increasing inflationary pressures and supply chain disruptions; and the military conflict in the Ukraine and fallout across Europe. In addition, with approximately half our business occurring outside the United States, unfavorable foreign exchange rates negatively impacting our revenues, margins, and EPS. Notwithstanding these headwinds, Q1 2022 total revenues of $973.2 million were up 8.8% year-over-year compared to Q1 2021 revenues of $894 million with a growth rate of 62% year-over-year. Our Q1 2022 operating income was $198 million and operating margin was 20.4%. In Q1, Systems and Services revenues were up 15.6% year-over-year, but down 24% sequentially coming off our sixth consecutive quarter of sequential growth and record scanner and services revenue. Sequential results primarily reflect lower volumes from our aforementioned headwinds and from seasonality as Q4 is historically a stronger capital equipment sales quarter. For Q1, Clear Aligner revenues were up 7.5% year-over-year, reflecting revenue growth across regions and products and were down slightly sequentially from Q4 at minus 0.7%. In the teen segment, 175,000 teen started treatment with Invisalign Aligners, up 6% year-over-year. Invisalign First for kids as young as six years old grew sequentially year-over-year and was strong across all regions. Q1 non-case revenues would include doctor-prescribed retention products, clinical training and education and other dental consumables performed well and grew both year-over-year and sequentially. Our Doctor Subscription Plan, or DSP, pilot was launched last year in the United States and Canada, and it continues to ramp nicely, driving strong revenue growth. DSP is a monthly subscription program, designed for a segment of experienced Invisalign doctors, who are not regularly using our retainers or low-stage aligners. We're very excited about the feedback and uptake we're seeing, and we'll expand the program into other markets this year Here are just a few things from doctors who are saying about DSP. Dr. De Ferris in Santa Barbara, California, 'we have shifted our retention model and workflow. We really like the material, the fit and the precision of the product and having everything in Align systems versus printing in-house and having to maintain it ourselves.' Dr. Sandra Tai, in Vancouver, Canada, 'This program fits my business model very well. I'm able to pass savings to patients.' Now let's turn to the specifics around the first quarter results, starting with the Americas. For Q1, Invisalign case volumes were down 1.5% year-over-year. On a sequential basis, Americas case volumes were down 4.3%, primarily reflecting the impact from COVID-19 waves. First experience in North America beginning in Q4 2021 and continue into Q1 and later in Latin America, causing consumers customer staffing shortages and practice closures as well as decreased patient traffic and increased deployment cancellations. The latest data from the gauge practice analysis tool that collect and consolidates data from about 700 ortho practices, covering more than 1,000 orthodontists across 1,600 locations in the United States and Canada, showed weakening underlying patient demand trends in the first quarter for both adult and teens and across wires and brackets and Clear Aligner products. New patient visits were down 7.6% year-over-year ortho starts were down 7.2% year-over-year. In the DSO channel, in Q1 2022, DSO practices grew faster than non-DSO practices with utilization led by Heartland and Smile Doctors. Earlier this month, we announced a new DSO partnership with Dental Corp, Canada's largest and fastest-growing network of dental practices. Dental Corp plans to extend its offering of Invisalign brand, Clear Aligner treatment to Canadians nationwide through its ortho acceleration program. This strategic collaboration also provides dental course network of doctors across nearly 460 practices with access to enhanced benefits, dedicated learning opportunities, and treatment planning support for the Invisalign system. Also this month, we launched a new Invisalign Teen subscription program in the United States and Canada to help unlock the massive opportunity from teen orthodontics, which makes up approximately 75% of the 5 million annual case starts in North America. The teen subscription program enables orthodontists to buy Clear Aligners in case packs in advance, much like the way they buy wires and brackets today, offering simple and more predictable billing for doctors. It also includes exclusive practice development benefits with the Invisalign brand and requires an incremental volume commitment from doctors. The timing of the new teen program coincides with the beginning of the summer teen season, and we're excited to continue partnering with doctors to grow their practice with Invisalign treatment with less than 10% share of teen case starts, the teen subscription program has the potential to help accelerate Invisalign adoption in the largest segment of the orthodontic market teams. For our international business, Q1 Invisalign case volumes were up 3% year-over-year. On a sequential basis, international case volumes were down 6.1%, primarily reflecting the headwinds described earlier, especially the impact of COVID-19 restrictions and lockdowns in China in the fallout across Europe from the military conflict in Ukraine. For EMEA, Q1 Invisalign case with core growth in our core markets led by Italy and Germany and doc, along with the growth expansion markets led by Turkey and EMEA. The Q1 year-over-year Invisalign case volume in EMEA was driven by increased emissions, primarily from the orthodontist channel, especially in the teen market. During the quarter, we launched our first ever directed teen campaign in EMEA focused on educating teens about the benefits in Invisalign treatment over traditional wires and brackets, increasing consumer demand as part of our wider teen growth plan, combined with our parent of teen campaign and to help give teens critical influence in the parent decision by driving peer word of mouth. More recently, we launched the Invisalign Go Express system, the latest addition to the Invisalign Go portfolio for general dentists. First launched in EMEA in 2016 as a 20-stage aligner treatment offering, the Invisalign Go portfolio system is designed for general dentists to treat mild to moderate malocclusions, to integrate tooth alignment into restorative and comprehensive dental care. Additionally, building of our European manufacturing facility in Wroclaw, Polar remains on track to go live this quarter, increasing our flexibility and timeliness in supporting our value doctor customers across the EMEA region. Turning to APAC for Q1. APAC Invisalign case volumes were up 4.7% year-over-year. With strengthened the GP dentist channel, primarily through increased Invisalign submissions with the Invisalign Go product and in the teen market with increased submissions from the orthodontic channel. On a sequential basis, APAC was down 2.6%, reflecting a larger impact from surges in new COVID-19 cases that led to significant lockdowns in China. Alternatively, despite headwinds, Japan and Taiwan performed well. We had strong growth in emerging markets like Korea and India and Thailand on a year-over-year basis. Earlier this month, we expanded the Invisalign Clear Aligner product portfolio with new offerings that better serve the expanding market in China. The two new products Invisalign Adult and Invisalign Standard Clear Aligners are designed for more specific types of malocclusion cases and private doctors and their patients with a more clinical and affordable options for moderate to complex cases. Invisalign Adult and Invisalign Standard Clear Aligners built on our proven technology for a wider range and scope in malocclusion. During the quarter we announced new Invisalign innovations for the Align Digital platform. Proprietary combination of software, systems and services designed to provide a seamless experience and workflow that integrates and connects all users, doctors, labs, patients and consumers. These new Invisalign innovations include ClinCheck Live update, the Invisalign Practice App, Invisalign Personalized Plan or IPP, Invisalign Smile Architect and the cone beam computed tomography, CDCT integration feature for ClinCheck digital treatment planning software. These innovations will revolutionize digital treatment planning for orthodontics and restorative dentistry by providing doctors with greater flexibility and real-time treatment plan access and modification capabilities. Each of these innovations are designed to enhance Invisalign treatment planning quality, efficiency, and scale and contribute to a better doctor-patient experience. More recently, we introduced a new enhancement for the Invisalign system with mandibular advancement feature. The Invisalign system with mandibular advancement is the only clinically proven Clear Aligner product in the world today that address a Class II correction with simultaneous alignment. Using feedback from customers, we've enhanced the original design with new enhanced precision wins that provide increased durability and comfort as well as great overlap to help ensure that the Aligners remain seated and properly engaged to more effectively address Class II malocclusions in growing preteen and teen patients. Our consumer marketing focus on educating consumers about the Invisalign system and driving that demand to Invisalign doctors' offices ultimately capitalizing on the massive market opportunity to transform 500 million smiles. In Q1, we built on a successful Invis Is Multimedia campaign across the Americas, EMEA and APAC driving awareness and interest in Invisalign treatment with adult, teen, and parent consumer segments. Globally, we delivered strong impression volume with over 23.7 million visits to our websites, 11 with a -- 113% [ph] year-over-year increase and over 7.8 billion impressions delivered, representing a 32% year-over-year increase. In the US, we continue to amplify our campaigns across the top social platforms such as TikTok, Snapchat, Instagram, and YouTube to increased awareness of Invisalign brand with young adults and teens. Our campaigns featured collaborations with some of the largest influencers in social media, including Charli D'Amelio, Lana Condor, Devon Key, Michael Le, and Josh Richards. Each of these creators shared their personal experience with Invisalign treatment and why they chose to transform their smiles with Invisalign Aligners. To continue growing our young adult business across the Americas, EMEA, and APAC, we hold upon our successful Invis Is a Powerful Thing campaign, which highlights how powerful the smile transformation with Invisalign treatment can be for even young adults' self-confidence. We leverage top influers like Leana Green and Lana Condor and integrated media campaigns. Further, we are expanding our collaboration with influencers globally and are excited to welcome Olympic Gold Medalist, Suni Lee and creators Josh Richards, [indiscernible], and Scarlett Estevez who have chosen to shape their smiles with Invisalign treatment. In the EMEA region, we accelerated our media investments across digital media platforms, including YouTube, TikTok, Meta, and Snapchat and expanded our Invisalign Smile squad roster with new influencers. Additionally, we launched a pilot in the UK to reach teams with special campaigns to create awareness of the unique benefits of Invisalign treatment. Our consumer campaigns delivered more 8.8 million unique visitors to our website, representing 170% increase year-over-year with over 2.5 billion media impressions. We continue to expand our investment in consumer advertising across the APAC region, excluding -- including China, resulting in a 278% increase year-over-year in unique visitors and a 265% year-over-year increase in impressions. We continue to strengthen our investments in Australia by expanding our reach via social media platforms such as TikTok, Meta, and YouTube. In Japan, we built upon our successful consumer campaigns by expanding into Twitter and continue to see strong response from consumers as evidenced by a 373% increase in unique visitors to our site. For our Systems and Services business, Q1 revenues were up 15.6% year-over-year, reflecting strong scanner shipments and services and down 24.2% sequentially, primarily reflecting lower volumes from the previous mentioned headwinds and capital equipment seasonality. During the past quarter, we saw continued adoption of the iTero Element 5D imaging system we launched last year that features innovative technology like near infrared technology that we call NIRI, which age into detection and monitoring of Interproximal Caries Lesions or cavities without -- above the gingiva without harmful radiation. A strong indicator of the digital adoption within dental offices is a number of intraoral scans used for Invisalign case submissions. Total worldwide in oral digital scan submitted to start an Invisalign case in Q1 increased to 87.1% from 80.9% in Q1 last year. International intraoral digital scans for Invisalign case submissions increased to 83%, up from 75% in Q1 last year. For the Americas, 91% of Invisalign cases were submitted using an intraoral digital scan compared to 85.5% in Q1 of last year. Cumulatively, over 54.9 million orthodontic scans and over 11.4 million restorative scans have been formed with iTero scanners. During the quarter, the iTero Element 5D Plus won the best new imaging or CAD/CAM product from DrBicuspid.com and Cuspies award. The award reflects our commitment to develop innovative solutions that help doctors transform lives by improving patients' journey to a healthy, beautiful smile. We are pleased to share that the iTero Element scanner received in ortho town, 2021 Townie Choice Awards, which seeks to recognize the top gear recommended products and services and dentistry. We're proud that the iTero Element 5D Plus imaging system provides dental practices with Alvadis [ph] and imaging technology, cutting-edge enhanced chair-side visualizations and applications that can drive practice growth in treatment acceptance. Continued growth in the iTero scanner installed base is driving increased services revenues as well as exocad CAD/CAM software solutions that integrate workflows to the dental labs and dental practices. Our Q1 exocad CAD/CAM products and services, which include restorative dentistry, implantology, guided surgery and smile design offerings are included in scanner and services revenues and are helping extend our digital dental solutions and broaden Aligned digital platform towards fully integrated interdisciplinary and workflows. As we continue to lead the evolution of digital orthodontics and restorative dentistry, our goal is to make orthodontics a pillar of dentistry. April 2 marked our second anniversary since welcoming exocad into the Align family. And together, we're working to ensure that every dental technician in every dentist planning restorative treatment in centers of benefits of digital orthodontics first. We're continuing to focus on integration and road map development to strengthen the Align Digital platform by addressing restorative needs to facilitate both ortho restorative and comprehensive dentistry. Two years after exocad joined Align, we are more excited than ever about the opportunities ahead to shape the dental industry and with technology and expertise that complement the many benefits of the Align Digital platform and bringing all key stakeholders together, doctor, customers, labs, partners and users as we continue transforming smiles and changing lives. During the quarter, exocad participated in the 2022 Dental South China show in Guangzhou, China, showcasing its newest software release, Dental CAD 3.0 Galway plus other open software solutions like Innovative Smile Design program called Smile Creator. The show allowed the exocad team to deepen their relationships with the dental community to discover new trends emerging in the growing dental market in China. Attendees have both the experienced in firsthand how exocad's wizard guided workflows and easy online communication programs streamline the treatment journey from consultation to final restoration. Finally, this quarter, exocad is opening its new headquarters in Seoul, South Korea, which provides a robust high-tech infrastructure to a key region of our business. exocad has been working with a growing number of Korean manufacturers for many years, and this location help facilitate strategic relationships in the region. With that, I'll now turn over the call to John."
},
{
"speaker": "John Morici",
"text": "Thanks Joe. Now, for our Q1 financial results. Total revenues for the first quarter were $973.2 million, down 5.6% from the prior quarter and up 8.8% from the corresponding quarter a year ago. For Clear Aligners, Q1 revenues of $809.7 million were down 0.7% sequentially due to lower Invisalign case volumes, partially offset by higher ASPs, reflecting higher ASPs and up 7.5% year-over-year reflecting higher ASPs in non-case revenues. In Q1, Invisalign case volume were down 5.1% sequentially and up 0.5% year-over-year. In addition, we shipped Clear Aligners to 82,400 Invisalign doctors worldwide, of which over 5,000 were first-time customers. Q1 comprehensive volume increased 2. 4% year-over-year and decreased 5% sequentially. Q1 non-comprehensive volume decreased 4% year-over-year and decreased 5.4% sequentially. Q1 adult patients decreased 1.6% year-over-year and decreased 5.7% sequentially. In Q1, teens or younger patients increased 6% year-over-year and decreased 3.6% sequentially. Clear Aligner revenues were unfavorably impacted by foreign exchange of approximately $6.5 million or approximately 0.8 points sequentially. On a year-over-year basis, Clear Aligner revenues were unfavorably impacted by foreign exchange of approximately $24 million or approximately 3.2 points. For Q1, Invisalign comprehensive ASPs increased sequentially and year-over-year. On a sequential basis, Invisalign comprehensive ASPs reflect per order processing fees charged on most Clear Aligner shipments, lower discounts, and higher additional lines, partially offset by unfavorable foreign exchange. On a year-over-year basis, comprehensive ASPs reflect higher additional aligners and per order processing fees, partially offset by unfavorable foreign exchange. Q1 Invisalign non-comprehensive ASPs increased sequentially and year-over-year. On a sequential basis, Invisalign non-comprehensive ASPs were favorably impacted by per order processing fees and lower discounts, partially offset by unfavorable foreign exchange. On a year-over-year basis, Invisalign non-comprehensive ASPs reflect per order processing fees, higher additional aligners, partially offset by foreign exchange. Clear Aligner deferred revenues on the balance sheet increased $53 million or 5% sequentially and $307.1 million or 38.1% year-over-year and will be recognized as the additional lenders are shipped. Our Systems and Services revenue for the first quarter were $163.5 million, down 24.2% sequentially and up 15.6% year-over-year. The decrease sequentially can be attributed to lower scanner volume following a strong Q4 and consistent with seasonality in the capital equipment business, coupled with the headwinds described earlier. The increase year-over-year can be attributed to increased services revenue from our larger installed base as well as slightly higher scanner volume. Our Systems and Services deferred revenues on the balance sheet was up $16.5 million or 7.2% sequentially and up $114.9 million or 87.6% year-over-year, primarily due to the increase in scanner sales and the deferral of service revenue included with our -- with the scanner purchase, which will be recognized ratably over the service period. Moving on to gross margin. First quarter overall gross margin was 72.9%, up 0.7 points sequentially and down 2.8 points year-over-year. On a non-GAAP basis, excluding stock-based compensation expense and amortization of intangibles related to acquisitions, overall gross margin was 73.3% for the first quarter, up 0.7 points sequentially and down 2.8 points year-over-year. Overall gross margin was unfavorably impacted by approximately 0.8 points on a year-over-year basis and by approximately 0.2 points sequentially due to foreign exchange. Clear Aligner gross margin for the first quarter was 74.8%, up 0.6 point sequentially due to higher ASPs, partially offset by higher mix of additional aligner volume and higher freight costs. Clear Aligner gross margin was down 2.8 points year-over-year due to higher mix of additional aligner volume and higher freight costs, partially offset by higher ASPs. Systems and Services gross margin for the first quarter was 63.4%, down 1.3 points sequentially due to lower volume and lower ASPs, partially offset by lower freight costs. Systems and Services gross margin was down 2 points year-over-year due to higher manufacturing inefficiencies, partially offset by higher mix of service revenues and increased ASPs. Q1 operating expenses were $511.3 million, down sequentially 2.4% and up 13.2% year-over-year. On a sequential basis, operating expenses were down $12.4 million. Year-over-year, operating expenses increased by $59.6 million, reflecting increased headcount and our continued investment in marketing sales and R&D activities and investments commensurate with business growth. On a non-GAAP basis, excluding stock-based compensation, amortization of acquired intangibles related to certain acquisitions and acquisition costs. Operating expenses were $480.2 million, down sequentially 2.9% and up 13.1% year-over-year due to the reasons described above. Our first quarter operating income of $198.1 million resulted in an operating margin of 20.4%, down 1.1 points sequentially and down 4.8 points year-over-year. The year-over-year decrease in operating margin is primarily attributed to lower gross margin, investments in our go-to-market teams and technology as well as unfavorable impact from foreign exchange. On a non-GAAP basis, which excludes stock-based compensation, amortization of intangibles related to certain acquisitions and acquisition costs, operating margin for the first quarter was 24%, down 0.7 points sequentially and down 4.6 points year-over-year. Interest and other income and expense net for the first quarter was a loss of $10.6 million, down sequentially by $9. 7 million and down year-over-year by $46.8 million. Q1 of 2021 included the SEC arbitration award gain of $43.4 million. The GAAP effective tax rate for the first quarter was 28.4% compared to 13.2% in the fourth quarter and 23.4% in the first quarter of the prior year. Our non-GAAP effective tax rate was 24.2% in the first quarter compared to 11.5% in the fourth quarter and 20.2% in the first quarter of the prior year. The first quarter GAAP and non-GAAP effective tax rates were higher than fourth quarter effective tax rates, primarily due to tax benefits related to expiration of statutes of limitations for timely asserting claims and an out-of-period adjustment recorded last quarter. First quarter net income per diluted share was $1.70, down sequentially $0.70 and down $0.81 compared to the prior year. Our EPS was unfavorably impacted by $0.13 on a sequential basis and $0.28 on a year-over-year basis due to foreign exchange. On a non-GAAP basis, net income per diluted share was $2.13 for the first quarter, down $0.70 sequentially and down $0.36 year-over-year. Moving on to the balance sheet. As of March 31st, 2022, cash, cash equivalents, and short-term and long-term marketable securities were $1.1 billion, down sequentially $176.1 million and down $11.1 million year-over-year. Of our $1.1 billion balance, $453 million was held in the US and $667.6 million was held by our international entities. Q1 accounts receivable balance was $950.9 million, up approximately 6% sequentially. Our overall days sales outstanding was 87 days, up approximately nine days sequentially and up approximately 15 days as compared to Q1 last year. Cash flow from operations for the first quarter was $30.5 million. Capital expenditures for the first quarter were $87.3 million, primarily related to our continued investment to increase aligner manufacturing capacity and facilities. Free cash flow, defined as cash flow from operations, less capital expenditures, amounted to negative $56.8 million. In February, we repurchased $75 million of our common stock through open market repurchases of approximately 143,600 shares at an average price of $522.61 per share. We have approximately $650 million remaining available for repurchase under our May 13th, 2021, $1 billion repurchase program. As described during our Q4 2021 earnings call, we provided our fiscal year 2022 outlook with revenue growth in line with our long-term revenue range of 20% to 30%. This revenue growth assumed no significant new COVID surges after current wave, no meaningful practice disruption nor material supply chain issues throughout the year. At that time, we were seeing some recovery as Omicron headwinds began to ease and COVID restrictions were relaxing. However, later in the quarter, unfavorable impacts on our business occurred driven by China lockdowns, weaker consumer confidence, inflationary pressures and the Russia-Ukraine conflict. For April, we have not seen momentum return as the headwinds previously mentioned persist. Now turning to full year 2022. We remain confident in the huge underpenetrated market, our technology and industry leadership and our ability to execute and make progress toward our long-term model of 20% to 30% revenue growth. At the same time, the headwinds we're experiencing, which include increased COVID waves and significant China lockdowns, weaker consumer confidence, inflation pressures the Russia-Ukraine conflict have increased uncertainty across all markets. We also anticipate capital equipment sales will be increasingly constrained throughout the year as practices adjust to these headwinds. Given less visibility and an increasing unpredictable operating environment, we are not providing revenue guidance for the year. However, assuming no additional material disruptions or circumstances beyond our control, our goal for fiscal 2022 is to deliver GAAP operating margin above 20%, while making strategic investments in sales, marketing, R&D and operations In addition, during Q2 2022, we expect to repurchase up to $200 million of our common stock through either a combination of open market repurchases or an accelerated stock repurchase agreement. For 2022, we expect our investments in capital expenditures to exceed $300 million. Capital expenditures primarily relate to building construction and improvements as well as a digital manufacturing capacity to support our international expansion. This includes our investment in an aligner fabrication facility in Wroclaw, Poland, which is expected to begin serving doctors in the second quarter of 2022 as part of our strategy to bring operational facilities closer to customers. As we continue growing, we intend to expand our investments in research and development, manufacturing, treatment planning, sales and marketing operations to meet the actual and anticipated local and regional demands. With that, I'll turn it back over to Joe for final comments. Joe?"
},
{
"speaker": "Joe Hogan",
"text": "Thanks, John."
},
{
"speaker": "Operator",
"text": "Excuse me. Joe Hogan, are you there?"
},
{
"speaker": "Shirley Stacy",
"text": "Yes, operator."
},
{
"speaker": "Joe Hogan",
"text": "Thanks, John. I'll run by this again. Okay. That was my fault. Over our first quarter results reflect a more challenging environment than expected. We know that COVID lockdowns, weaker consumer confidence, inflationary pressures and the Russia-Ukraine conflict have created headwinds, but we remain excited and committed to realizing the enormous opportunity in front of us to lead the evolution of digital orthodontics and comprehensive dentistry. With less than 10% share of the 21 million starts each year with over 500 million people globally who can benefit from a healthy beautiful smile, our market is as large as ever. No other company is as well positioned as us to take advantage of that potential as the environment improves and growth trends return. We will continue to focus on the execution of our strategic growth drivers, while managing investments in the near-term to account for the headwinds and uncertainty, and we will remain confident in our long-term revenue growth model of 20% to 30%. Before we open the call to questions, I want to address the military conflict in the Ukraine and our operations in Russia. It's a human tragedy for all people involved and our thoughts go out to everyone impacted and especially to those with personal connections who are undoubtedly concerned with their families and loved ones. Our primary concern remains the safety and security of our employees and their families, our doctors, their staff and patients. We have nothing to do with this conflict. As a global medical device provider of doctor-prescribed products, continuity of care is critical to the doctors and their patients in orthodontic treatment. We discontinued commercial activities in Russia that are not essential to providing continuity of care to patients. Our focus on only our values and ethical responsibility of patients in treatment. In the process, we are also adhering to the international sanctions that have been imposed. Our IT infrastructure, including covet intellectual property is hosted outside of Russia. Prior to the conflict, we have begun expanding our R&D teams in Downstate, Germany; Madrid, Spain; Toronto, Canada; and Austin, Texas. And we're prudently working with the team on the ground in Russia on work pieces. A number of our Russian employees have already transitioned and are in various stages of transitioning their families to Armenia, where we've set up an R&D center in urban to support those who choose to relocate. At the same time, it's humbling to see the tremendous outpouring of kindness and support throughout the company as our employees respond to the humanitarian needs of the crisis. Our Polish team members has set up donation centers at our facilities where employees are contributing food, clothing, supplies, and human care. Many are also taking Ukrainian refugees into their homes. And we're proud of the tremendous initiative by our colleagues and are grateful for their actions. In addition to our employees' efforts, Align is donating $300,000 to support humanitarian relief efforts through organizations providing shelter food, medicines and vital supplies. We can only hope that the conflict in Ukraine will end soon, that the ongoing impact of the pandemic will lessen for good, and that economic factors facing many customers and consumers will abate. But these things are beyond our control, so we will continue to prioritize the health and safety of employees, customers, and patients and will stay focused on strategic initiatives. In closing, April 3rd marked the 25th anniversary of the founding of Align Technology. And shortly thereafter, the long of the Invisalign system. Over the past 25 years, we've transformed the orthodontic industry with a passion for innovation as we've evolved from leading the evolution from digital appliances to digital platform. We've created an incredible company unlike any other. Invisalign's unique mass customization business operating in real time with no inventory or distribution at the front end of our market. Consequence of fluctuations in the macroeconomic environment are felt faster at Align than I've ever experienced anywhere in my career. And we monitored these trends to make adjustments in our business when needed. Our success is a result of a vision and purpose and results. Thanks to our employees and our doctor customers around the world, who took a chance on a Silicon Valley start-up and risked everything. Today, Align is the largest 3D printing operation in the world, producing 1 million customized aligners each day based on the learnings gained from nearly 13 million Invisalign patients and 60 million iTero digital scans Our global team of over 25,000 employees support more than 250,000 doctors and labs in more than 150 countries. There are more than 500 million people in the world that can benefit from orthodontic procedures. It's huge. And you can only address opportunities of that size with digital orthodontics. It could never happen using old analog methods. As we have digitized that capability, it has opened up a market broadly for orthodontic treatment to the masses. It's hard to believe that after 25 years, we're still in the early phases of transforming the orthodontic market. We look forward to sharing more milestones over the next 25 years as we continue to lead the digital evolution of orthodontics and dentistry, deliver great treatment outcomes and treatment experiences to doctors and patients around the world. Thank you for your time today. I'll now turn it over to the operator for questions. Operator?"
},
{
"speaker": "Operator",
"text": "Thank you. At this time we will be conducting a question-and-answer session. [Operator Instructions] The first question is from the line of Jason Bednar with Piper Sandler. You may proceed."
},
{
"speaker": "Joe Hogan",
"text": "Hi, Jason."
},
{
"speaker": "Jason Bednar",
"text": "Hey, good afternoon, everyone. Hey, there. Thanks for taking the questions. So Joe, I guess just to start with you. I mean, you and John called out the consumer confidence items and the inflationary pressures impacting the business. The wind shifting pretty abruptly on you. I guess, are there tools you have at your disposal to manage through these pressures, or is this a matter of just keeping your head down, waiting for the macro environment to settle down, I guess, really just trying to get a sense of how we should be moderating expectations from what's typical sequential growth we would see in the business?"
},
{
"speaker": "Joe Hogan",
"text": "Yes, Jason, good question. I'd say being a global business, we talked about having 50% of our revenues outside. It just gives us good scope in the sense to take advantage where opportunities are. And so I feel really good about the company in that sense. And we've made great development over the last three years from an international standpoint. We also have a great portfolio. We have iTero scanners. We talked about some reluctance in the sense that we saw at the end of the first quarter as some doctors to really commit to it. But I mean that demand is still out there. When you look at iTero scanners are so underpenetrated still when you look at digital dentistry and what the future really brings. And so pushing that and pushing it in the right places and also you see the expansion of our Invisalign technology and what we're doing in different areas, too. So I feel like we have a lot of levers that we can pull, but we are constrained by these headwinds that we've seen. And obviously, we'll respect those and make the kind of adjustments needed to make sure this business stays on track with. Look, I love our portfolio. I love our position. I see a great future. We'll manage our way through this, Jason."
},
{
"speaker": "Jason Bednar",
"text": "Okay. That’s helpful. And then maybe shifting over to the – the margin side, you're not stepping off the gas with spending. I wouldn't expect it to given the opportunity that you're talking about here today and you've talked about for quite some time. But I guess are you still comfortable with that long-term model of 25% plus operating margins? I know we've seen that for some select periods for the business. But is that the right margin level to think about for the business when you're driving towards that 20% topline growth? Just -- can you truly balance that, or do you have to sacrifice one for the other, again, thinking longer term here?"
},
{
"speaker": "Joe Hogan",
"text": "I think, Jason, honestly, I think we've managed that well over the years. I mean you can see how well we did last year in the sense of that operating profit has been squarely on top of that piece. And I think we've managed it within that bandwidth very well, and that's -- this current situation is not going to change that."
},
{
"speaker": "Jason Bednar",
"text": "All right. Thanks guys."
},
{
"speaker": "Joe Hogan",
"text": "Thank you, Jason."
},
{
"speaker": "Operator",
"text": "Thank you. The next question is from the line of Jeff Johnson with Baird. You may proceed."
},
{
"speaker": "Joe Hogan",
"text": "Hi Jeff."
},
{
"speaker": "Jeff Johnson",
"text": "Thank you. Hey guys, how are you? So, Joe, let me just pick up on that last point. I mean, you said you've managed OpEx well over the years in that. I guess, let me just be direct on it. I mean, if end markets are cyclically slowing that's kind of out of your control, do you put the gas pedal down to the accelerator? Do you say there's not a whole lot that that's going to accomplish? So I kind of protect margins here in the short run. Just what's your OpEx outlook kind of in the near term -- near to intermediate term, I guess, given some of this macro uncertainty?"
},
{
"speaker": "Joe Hogan",
"text": "Jeff, it's more the latter of your question. It's just you take off the accelerator. And we know -- John and I know where to adjust it won't hurt the business. We continue to invest in innovation in different areas, too. But there are several areas of short-term investments that aren't going to help us in this current crisis that will obviously lean into and make sure that we preserve margins as much as we can. : But with those investments, yes, it will be -- when we talked about the 20-plus percent on a GAAP basis, that's the trade-off that we'll have. We'll invest where we can see a return. And based on the volume that we expect, but deliver 20-plus percent op margin."
},
{
"speaker": "Jeff Johnson",
"text": "Yes, got it. Thanks John. And then a follow-up question, I guess, just on the gauge data, you talked about down 7% case starts ortho year-to-date. I'm hearing that through April, not just through March. But I don't get the whole gauge data set, but what I've seen is that the adult data is worse than the teen data, which would make sense to me. Everybody sitting at home, all the adults sitting home last year with the Zoom effect going on at this point in stimulus checks, sitting in pockets and all that. So, that all makes sense. But just what's the tenor in North America or in those markets that aren't impacted by China and Russia, Ukraine in that? What's the tenor of the teen business? And is the core that part of the business still doing better than you've just got real tough comps because all those adults were coming in last year as they were sitting at home and had nothing better to do than get Clear Aligners?"
},
{
"speaker": "Joe Hogan",
"text": "Hey Jeff, it's Joe. Look, the teen market, you're good to focus on that. I mean that's -- we look at that as a fairly secure market. Obviously, it can move up and down, but it won't have the volatility and you've seen in the adult market and you're comparing a against last year is a good way to look at it, given the Zoom effect and things we talked about before. So -- and Jeff, that's why you see us launching these teen products right now and getting ready from a summer time standpoint. We want to take advantage of that demand as much as we possibly can, especially in times like this. We know the adult market is going to be pressured. I'm talking about the US right now, but this sets leave China now because China is a unique position in the sense of a lockdown that they're going through. But we're -- you're going to see us take the same tact in Europe also. And you saw our teen volume in Europe was actually pretty good in the first quarter."
},
{
"speaker": "Jeff Johnson",
"text": "What about that teen volume in the US, Joe?"
},
{
"speaker": "Joe Hogan",
"text": "We expect that teen volume to be good. Summer seasonality is there. And it's funny. There's a window for to really have their teeth treated. And we've known that here for years, and that's why we prepared for teen season. And this year, honestly, Jeff, I feel better about our positioning for teens in the United States and also in Europe. I have many time since I've been here with these teen packs that we just talked about and how we'll go about it, I think we're well positioned to make further penetration in the teen market versus wires and brackets."
},
{
"speaker": "Jeff Johnson",
"text": "Yes, got it. Thanks, guys."
},
{
"speaker": "Joe Hogan",
"text": "Thank you."
},
{
"speaker": "Operator",
"text": "Thank you. Your next question is from the line of Jonathan Block with Stifel. You may proceed."
},
{
"speaker": "Joe Hogan",
"text": "Hey, Jon."
},
{
"speaker": "Jonathan Block",
"text": "Hey, guys. Thanks. Hey, guys. Good segue. I'll start with the teen case packs. We picked up on that program right after April. Quite honestly, unfortunately, I'm old enough to remember your teens pack programs internationally from like a decade ago. And if I remember this correctly, Joe, it is just hard to collect, if you would, if someone did below their threshold and hopefully, I'm making some sense. So maybe just talk to us -- here you are going after it, you're going after for teens, not overall, you're launching it. What's going to be different this go round when someone commits to a 50-case pack or a 100-case pack, let's go with 100, they do 88 and you've got to go out there and say, 'Hey, look, it's a user or lose it, we got to collect for you and then also just keep the tenor of the relationship or the goodwill of the relationship intact because now argue even have more options to go somewhere else versus what they were staring down a decade ago. So maybe if you could talk to that and just the timing behind kicking off the program, that will be a great place to start."
},
{
"speaker": "Joe Hogan",
"text": "Jon, you're like an Align history, and that's a good question, right? Because I can tell you, I doesn't hear where that happened in Europe, but it's legendary here. But if you go back in time, I think our business in Europe was less than $10 million back then. Okay, now it’s over $1 billion. And I think the whole world is much more coined with Clear Aligners than when it was back then, we were really pioneers at that point in time. If you look at our DSP program, it's basically the same thing. They make commitments to how many aligners are going to buy over a certain period of time. We haven't had any issues in DSP with having customers regress or not making those benchmarks. So we feel pretty good about where we are. I mean will we run into a few situations, I think we will. I think they'll be outliers, and we'll deal with them in time."
},
{
"speaker": "Jonathan Block",
"text": "Okay. Fair enough. And I just might go back to sort of where Jason started a little bit. There's going to be a lot of questions on 2022 and pulling the top line guidance. So let me just throw out a couple of things, and we could sort of work through it. If I look back the past five to six years, the first quarter was about 22% of total revenue. And if you run that exercise for this year, you get about 11% or 12% year-over-year revenue growth and you've got an incremental FX headwind. So should we throw a dart at 10%? And what's wrong with that thought process in getting to, call it, low double-digit 10%, 12% top line growth for 2022? Thanks, guys."
},
{
"speaker": "John Morici",
"text": "I think -- Jon, this is John. As we talked about that last earnings, there's a lot of changes that have happened in the marketplace and in the world. And as a result of that, we pulled the top line guidance until we get further clarity as how things are going to shake out. What we have committed to is being able to grow in a profitable way in a way that you would expect us to be responsible being at 20-plus percent, but we pulled that guidance because of the uncertainty."
},
{
"speaker": "Joe Hogan",
"text": "Jon, just to add to John's comments, too, is that as we look at April versus March, we haven't seen any momentum from an April standpoint too. And we start from that standpoint also."
},
{
"speaker": "Jonathan Block",
"text": "Okay. That’s helpful color. Thanks, guys."
},
{
"speaker": "Operator",
"text": "Thank you. The next question is from the line of Erin Wright with Morgan Stanley. You may proceed."
},
{
"speaker": "Erin Wright",
"text": "Great. Thanks."
},
{
"speaker": "Joe Hogan",
"text": "Hi Erin."
},
{
"speaker": "Erin Wright",
"text": "In the Americas -- hi, good to hear from you. So, in the Americas, can you parse out a little bit about what you're seeing in terms of macro headwinds compared to maybe some of the lingering COVID impact? And does it seem like some -- I mean it doesn't seem like some of these cases are coming back from maybe Omicron delays. But what are in terms of the dynamics there? Just trying to kind of parse out. Last quarter, you did break out kind of a COVID impact, but could you do that this quarter?"
},
{
"speaker": "Joe Hogan",
"text": "It's hard to be very discrete in the sense of what that impact is, Erin. But I'd say we -- obviously faced staffing shortages and things at different doctors in the first part of the first quarter that affected us. I'd say that drifted through to basically late February, early March. After that, you can -- if you watch the consumer confidence statistics in the United States, they've gone down pretty dramatically. And we started getting a lot of reports from our doctors is patients thought saying no, but patients not as quick to say, yes, that they wanted treatment. And we hear that both in the GP segment in the orthodontic segment. So, you can call out what you want to, okay? But do we see some reticence in the marketplace to move forward with treatment and again, it's not binary. It's not everybody is saying, no, like in the heart of a deep recession or something we saw back in 2007 or 2008. It's just more cautiousness from people about their personal finances."
},
{
"speaker": "Erin Wright",
"text": "Okay, great. Thanks. And then on ASPs for the balance of the year, I guess, how should we be thinking about that and the levers, I guess, you can pull on that front? Thanks."
},
{
"speaker": "John Morici",
"text": "Hey Erin, this is John. From an overall ASP standpoint, we don't have any anything unusual from a promotion standpoint or anything else that would affect us. Obviously, notwithstanding FX, we've seen unfavorable FX as we've gone through this year so far. But notwithstanding FX, we wouldn't expect anything dramatically different from an ASP standpoint."
},
{
"speaker": "Erin Wright",
"text": "Okay, great. Thank you."
},
{
"speaker": "Joe Hogan",
"text": "Thanks Erin."
},
{
"speaker": "Operator",
"text": "Thank you. The next question is from the line of Kevin Caliendo with UBS. You may proceed."
},
{
"speaker": "Kevin Caliendo",
"text": "Hi, thanks for taking my call."
},
{
"speaker": "Joe Hogan",
"text": "Hey Kevin."
},
{
"speaker": "Kevin Caliendo",
"text": "Hi. So, I guess the question I have is, the first one is really why have the doc adds -- doc starts been so sluggish? Is it demand driven? Is it competitive positioning? Is it -- I would just love to hear sort of why in the US, especially the sort of doc ads have been flattish for the last couple of quarters? If there's anything, if it's macro or micro or competitive?"
},
{
"speaker": "Joe Hogan",
"text": "Well, I think I read your question, I think you're asking if it's competitive because I mean we're pretty clear on what we've been seeing around the globe in the United States from a macro standpoint, Kevin. So, I just -- look, from a competition standpoint, we don't see any major issue with competition in the sense of being a factor in this demand cycle that we're talking about."
},
{
"speaker": "Kevin Caliendo",
"text": "And when we try to think about the impacts here that are driving all of this, how much do you -- have you guys been able to ascertain how much of this is economic-driven? You're talking about decisions taking longer and people being more hesitant and volumes being down, how much of that is economic versus COVID versus other -- like have you been able to just parse out what's really driving it as a percentage? Is it mostly simply listen, we're in an inflationary environment. People don't have as much to spend, consumers aren't spending as much broadly versus just an overall demand for your products and/or COVID, like those three things, if you were to group them?"
},
{
"speaker": "Joe Hogan",
"text": "Kevin, our announcement and the way we communicate to the marketplace, we talk about this huge market, right? We're totally underpenetrated in the orthodontic segment, less than 10% of 21 million case starts a year. Talking about what we see through the 500 million patients. So there's not a lack of demand out there and the lack of opportunity. There's not a competitive issue that we think is affecting our growth or our earnings. And so obviously, COVID is part of this thing. Part of it we see in Europe was the Ukraine conflict that's going on today. And I think significant amount of it is too is what we're seeing in the marketplace, too, from a consumer standpoint. I can't put any weighted averages on these things to give you an example. And I think -- if I compare to when we last talked to you at the first couple of days of February, the way things have changed, those variables in that equation, I think, have changed pretty dramatically. So it's really hard to say going forward what that might be."
},
{
"speaker": "Kevin Caliendo",
"text": "Are there any goals that you have -- one last one for me. Are there any goals that you have for this year in terms of quantifiable goals in terms of whether it be doc ads or utilization uptick or -- I mean, I know those are the things you were focused on when you talked about increasing your spend. Like what are you targeting at this point? Is there anything that we can sort of put a stick in the ground and say, 'okay, here's something that the company is hoping to achieve in 2022 in terms of a quantifiable number."
},
{
"speaker": "Joe Hogan",
"text": "Kevin, this is a growth company. And it never leaves our thought process. So what are we trying to do? We're trying to run the way we always do. We're running at these plays in a much more difficult market with more headwinds. That's all. And so we'll move these place around. We'll look at them by country. We'll see what makes the most sense. We still keep a good strong focus on how we can grow and where we can grow and we'll find those ways."
},
{
"speaker": "Kevin Caliendo",
"text": "Appreciate it. Thanks, guys."
},
{
"speaker": "Joe Hogan",
"text": "Thanks, Kevin."
},
{
"speaker": "Operator",
"text": "Thank you. The next question is from the line of Michael Ryskin of Bank of America. You may proceed."
},
{
"speaker": "Michael Ryskin",
"text": "Great. Thanks for taking the questions, guys. I got two, a few I want to touch on. Can you hear me?"
},
{
"speaker": "Joe Hogan",
"text": "Yes."
},
{
"speaker": "Michael Ryskin",
"text": "Okay. Great. Thanks. One is just sort of talking through some of the dynamics we're talking to. You talked for the quarter. I think we can all kind of see that a lot of it or a lot of it is macro driven, a lot of it's global driven and each of these events that we're following, whether it's the China lockdowns or the conflict in Europe or even things like FX are going to be more temporary than others. I know your long-term outlook is still there for the 20% to 30% volume growth and revenue growth. But what about sort of catch-up spend on these things? Is there an expectation somewhere and you kind of touched on this when you talked about your spend and your expectations on investment this year? As we go through the next couple of months, next couple of quarters as some of these things start to fade, are you expecting another bolus of catch-up as these cases come back like we saw in 2020 and 2021? Anything you can sort of comment on that? And then I've got a follow-up."
},
{
"speaker": "Joe Hogan",
"text": "I think a bolus, you talked about -- I mean, that was interesting is what we saw after the last downturn, it was first like COVID. I mean I look at that, Mike, overall, is it just shows you the demand out there for our kind of procedures. So it's there. And so John and I are in setting here are predicting another bolus or a wave or whatever, but I think it just shows you the demand that exists in this business and it can be pent up at times. We'll just have to see how the headwinds that we see filter through the marketplace and how it affects consumers and doctors."
},
{
"speaker": "Michael Ryskin",
"text": "Okay. I appreciate that. And then the follow-up, you touched on this in an answer earlier when you sort of referenced the 2007, 2008 downturn. Obviously, hopefully, we're not going to something quite like that in the coming year, too. But there's still a lot of talk about recession and sort of what the impact of prolong inflation is going to be on the consumer. Could you talk us through your plans if things do continue to deteriorate on that front, we're not there yet, but six months from now, a year from now, things are still heading in that direction sort of what are your internal plans for adjusting both on operations growth in that kind of environment? Because if you look back at 2007, 2008, 2009, there was a protracted period of essentially flat growth. So could you compare--"
},
{
"speaker": "Joe Hogan",
"text": "Yes, it's Joe again. I just -- we have a really strong balance sheet to start with. It's great to have a strong balance sheet and really no net debt from a company standpoint. So, look, it's -- I'm not an economist, but I'm not predicting a meltdown of our financial system, like we saw in 2007, 2008 depending on what Federal Reserve does or whatever, we're probably going to see an adjustment as they try to attack inflation. So, look, we -- this business is incredibly healthy. It generates a lot of cash. It's extremely international now. And we have a lot of levers to pull and a lot of things to do to keep this business going. So -- but if something dire did happen, I feel we got a balance sheet to be able to cover it, too, and we'll manage the business responsibly that way. So, I'd just tell you don't give up on us, okay? We love this business. We love the position that it's in. We're confident about the future. We're just going to see how these headwinds hit and how they subside, and we'll be ready on either end of that to be able to position this company to do well."
},
{
"speaker": "John Morici",
"text": "And I might add, just we are a different business than we were back in 2007, 2008. We didn't have iTero. We have iTero, much more of a global products, much further along in the teen market, more consumer awareness, all the things that we've done over this time period now being 25 years, we've evolved over time and created a business where we're very mindful of what is happening from a demand standpoint, and we can do a lot of things from a leverage standpoint in order to drive that right amount of profitability."
},
{
"speaker": "Michael Ryskin",
"text": "Thank you."
},
{
"speaker": "Joe Hogan",
"text": "Thanks Mike."
},
{
"speaker": "Operator",
"text": "Thank you. The next question is from the line of Nathan Rich with Goldman Sachs. you may proceed."
},
{
"speaker": "Nathan Rich",
"text": "Hi, thanks for the questions. I wanted to follow-up on your commentary on April and not seeing momentum return. I was just wondering if there's any parameters you could put around that relative to maybe what you've seen in the first quarter? I guess like would that sort of mean volumes more flattish, anything that you could do to kind of help us think about how the business kind of exited the first quarter and where the current run rate is would be helpful?"
},
{
"speaker": "Joe Hogan",
"text": "Yes. Nate, I'll give you a quick rundown, and John can give you specifics to is. Look, we -- this is flattish to use your term. When you look at between March and April is more flattish than anything. But just remember, we have -- China is still our second biggest country in the world. It's locked down. Shanghai -- Beijing is going into lockdown. That's not the first lockdown we've seen in China. Remember, there are several provinces that were locked down before that, too. So, that part of our business has really been impacted in a big way, and that's part of that flattishness that we're talking about, too. So we're seeing impact in every region of the world in different ways. And on the APAC side, particularly with China, it's dramatic."
},
{
"speaker": "John Morici",
"text": "I don't have much -- anything to add to it. I just -- a lot has changed as we've seen over the last couple of months, and we're responding to that change."
},
{
"speaker": "Nathan Rich",
"text": "Makes sense. And I guess, I'd be curious just to get your thoughts on sort of the consumer environment. I know it's been touched on in other questions. But Invisalign treatment is a higher ticket purchase, and we've kind of always thought of it as catering to a more affluent consumer. I guess, is there anything that you've seen kind of between higher-end consumer versus lower-end consumer? And they're going back to, I think, the way you framed it, kind of the reticence to start treatment, any difference that you've seen among maybe the different segments of the population that could be considering treatment? ."
},
{
"speaker": "Joe Hogan",
"text": "I commented that back to the other question was asked about teens, right? The teen aspect in the orthodontic segment is pretty resilient, and that is a certain demographic that it's always existed in the sense of the parents that they can afford that kind of treatment of young children. The adult segment, it's all over the place depending on -- sometimes, it's just teeth straightening. Some of times, it's a broad worth correction on what's going on. We don't have any data in that adult segment to say that a certain FIFA score certain match, certain amount would be fewer people taking treatment or whatever. I don't have that data. I don't know if John has seen it either. But you'd have to guess that the more your finances are impacted, you're actually going to sign up for a $3,500 to $7,000 treatment depending on what you want or how you're in a contract for it. So it's logical that certain demographics would be less willing at this point in time."
},
{
"speaker": "Shirley Stacy",
"text": "Thanks. Operator, we'll take one more question, please."
},
{
"speaker": "Operator",
"text": "Absolutely. The next question is from the line of Elizabeth Anderson with Evercore ISI. You may proceed."
},
{
"speaker": "Elizabeth Anderson",
"text": "Hi, guys. Thanks so much for the question."
},
{
"speaker": "Joe Hogan",
"text": "Hi, Elizabeth."
},
{
"speaker": "Elizabeth Anderson",
"text": "So maybe one question on the iTero scanner growth. Obviously, we saw a deceleration quarter-over-quarter, but still year-over-year growth there. When you sort of talk about how providers are looking at demand, and I realize that not all of that is like pure like iTero sales. How do we think about sort of what's driving the purchases in the first quarter? Obviously, there is some seasonality. But if you like, overall visits, maybe ex-Clear Aligners are not has maybe haven't been quite as impacted. Are we seeing sort of a reticence to spend? Is it sort of interest rates going up and people worried about sort of equipment financing? Could you walk us through some of the puts and takes of the demand drivers there?"
},
{
"speaker": "Joe Hogan",
"text": "Elizabeth, it's Joe. I'd start with the still market is broadly unpenetrated from a scanner standpoint. GP side, the ortho side, an ortho that does a lot of Invisalign, they can have four, five, six scanners overall. So look, with the GE Healthcare for years, ABB, I understand the capital equipment cycle. There is a true cycle in capital equipment. When people get concerned, they'll delay those kinds of purchases. And I think, obviously, you have -- when I talk about 250,000 doctors that we service today, some of them are going to be worried about what their cash flow is going to look like. They're going to be reticent in the sense of saying they want to sign up for a scanner that can cost anywhere between $15,000 to $35,000 right now and what we sell. So, I can't tell you by country or by region or whatever, but we didn't see things shut off. We just saw things as the quarter got through, they just didn't have as strong as demand for iTero than we anticipated. So, we'll have to -- obviously, we get into this way it goes. But there's going to be some more scrutiny, I think, around capital investment, if doctors are seeing less traffic through their practices."
},
{
"speaker": "John Morici",
"text": "Yes. It's just the delays that they put to not close and necessarily within the quarter. It's not going away, but it's just a delay. And we have to work to try to get them to say."
},
{
"speaker": "Elizabeth Anderson",
"text": "And you're not having any like supply chain issues on that side in terms of like being able to manufacture the equipment?"
},
{
"speaker": "Joe Hogan",
"text": "We didn't have any in the first quarter. We won't have any in the second quarter either."
},
{
"speaker": "Elizabeth Anderson",
"text": "Okay. And one more quick follow-up. In terms of the gross margin impact of the new Poland facility, can you remind us about the cadence of the gross margin pressure when you open a new facility as it scale? So, I'm just trying to be able to parse that out versus maybe some of the deleveraging impact of some of the volume shifts versus that."
},
{
"speaker": "John Morici",
"text": "Yes, Elizabeth. What we'll see is we'll go live in the second quarter here and that does have a gross margin impact. It really comes down to trying to get as much utilization through the plant as possible converting -- moving those countries and doctors through the plant. And then once that utilization increases, then you start to see some of that productivity. So, it hits about a quarter, maybe a little bit more than a quarter and then it subsides and then it gets more on a regular operating basis."
},
{
"speaker": "Elizabeth Anderson",
"text": "Got it. Thank you very much."
},
{
"speaker": "Shirley Stacy",
"text": "Thanks, Elizabeth. Well, thank you, everyone, for joining us today. This concludes our conference call. We look forward to speaking to you at upcoming conferences and industry meetings. And if you have any questions, please contact Investor Relations, and have a great day."
},
{
"speaker": "Operator",
"text": "This concludes today's conference. You may now disconnect your line at this time. Thank you for your participation."
}
] | Align Technology, Inc. | 24,568 |
ALGN | 4 | 2,023 | 2024-01-31 16:30:00 | Shirley Stacy: Good afternoon, and thank you for joining us. I'm Shirley Stacy, Vice President of Corporate Communications and Investor Relations. Joining me for today's call is Joe Hogan, President and CEO; and John Morici, CFO. We issued fourth quarter and full year 2023 financial results today via Business Wire, which is available on our website at investor.aligntech.com. Today's conference call is being audio webcast and will be archived on our website for approximately 1 month. As a reminder, the information provided and discussed today will include forward-looking statements, including statements about Align's future events and product outlook. These forward-looking statements are only predictions and involve risks and uncertainties that are described in more detail in our most recent periodic reports filed with the Securities and Exchange Commission available on our website and at sec.gov. Actual results may vary significantly, and Align expressly assumes no obligation to update any forward-looking statements. We have posted historical financial statements, including the corresponding reconciliations, including our GAAP to non-GAAP reconciliation, if applicable, and our fourth quarter and full year 2023 conference call slides on our website under quarterly results. Please refer to these files for more detailed information. With that, I'll turn the call over to Align Technology President and CEO, Joe Hogan. Joe?
Joseph Hogan: Thanks, Shirley. Good afternoon, and thanks for joining us. On our call today, I'll provide an overview of our fourth quarter and full results and discuss a few highlights from our 2 operating segments, Systems, Services and Clear Aligners. John will provide more detail on our Q4 financial performance and comment on our views for 2024. Following that, I'll come back and summarize a few key points and open the call to questions. I'm pleased to report fourth quarter results with better-than-expected revenues and earnings. As of the end of Q4, we achieved several major milestones, including 17 million Invisalign patients treated, including 4.7 million teens, plus 4 million Vivera Retainer cases and over 100,000 iTero scanners sold. And for the full year -- fiscal year 2023, total revenues exceeded our prior outlook, and we delivered fiscal 2023 non-GAAP operating margin above 21%. For Q4, total revenues were up 6.1% year-over-year, reflecting increased Systems and Services revenues. Strength in Clear Aligner volumes for teens and international doctors as well as continued growth from Invisalign touch-up cases, under our Invisalign Doctor Subscription Program, or DSP. Our Q4 Systems and Services revenues were up year-over-year, primarily due to increased services, CAD/CAM and nonsystems revenues, including scanner leasing and rental programs and certified preowned scanner sales. Q4 total Clear Aligner shipments were slightly lower year-over-year. On a year-over-year basis, Clear Aligner volumes were down for the Americas and EMEA regions and were up for the APAC region. For Q4, Clear Aligner shipments include approximately 20,000 Invisalign DSP touch-up cases, primarily in North America, an increase of more than 60% year-over-year from Q4 '22. DSP continues to be well received by our customers and is currently available in the U.S. and Canada, Iberia and Nordics and most recently, the U.K. We're excited that DSP is proving helpful to doctors and their patients as we continue to expand the program. For fiscal 2023, total Invisalign DSP touch-up cases shipped were 73,000, up 85% year-over-year. For non-case revenues, Q4 was up 13.3% year-over-year, primarily due to continued growth from Vivera Retainers along with Invisalign DSP retainer revenues. On a sequential basis, Q4 total revenues were down slightly, 0.4%, primarily reflecting anticipated seasonally lower teens case starts, especially in the U.S. ortho channel and unfavorable foreign exchange offset somewhat by increased revenues from System and Services as well as an increase in Clear Aligner volume for adults and noncomprehensive cases and stronger volumes from Canada and the EMEA region. Q4 total Aligner shipments were slightly lower sequentially. On a sequential basis, Clear Aligner volumes were down for the Americas and APAC regions and were up sequentially for the EMEA region. The December gauge practice analysis tool that collects and consolidates data from approximately 1,000 orthodontic practices across the U.S. and Canada reported year-over-year decline for new patients, total exams and total starts, particularly among teens and kids. It also shows a year-over-year decline for wires and brackets and total Clear Aligner starts with Invisalign case starts better than the Clear Aligner brand. And the teen segment for Q4, a 197,000 teens and younger patients started treatment with Invisalign Clear Aligner Systems, up 6% year-over-year and were a record number of teen cases shipped compared to prior fourth quarters. Q4 teens starts were down sequentially, consistent with historical seasonality, primarily in China as well as seasonally fewer teen starts in North America compared to Q3. For fiscal 2023, total Invisalign Clear Aligner shipments for teens and younger patients reached a total of 809,000 cases, up 8% compared to the prior year and made up 34% of total Clear Aligner shipments. During Q4, we announced that the U.S. Food and Drug Administration cleared the Invisalign Palatal Expander System, we call it IPE, Invisalign Palatal Expander for commercial availability in the United States. The FDA 510(k) clearance is for broad patient applicability, including growing children, teens and adults. Full early intervention treatments such as Phase I or early interceptive treatment, makes up about 20% of the orthodontic case starts each year and is growing. Together with Invisalign First Aligners, IPEs provide doctors with a solution set to treat the most common skeletal, dental malocclusions in growing children. The addition of mandibular advancement features to Invisalign aligners also provides doctors with more options for treating skeletal, dental joint balances and bite correction and for their growing patients during their teenage years. Essentially, we now have an Invisalign digital treatment solution for every phase of treatment. IPE is currently available on a limited basis in Canada and the United States, and we recently received regulatory clearance in Australia and New Zealand where we anticipate commercialization in Q2. We expect IPE to be available in other markets pending future applicable regulatory approvals. We're also launching ClinCheck smile video, the next generation of In-Face digitalization with AI-assisted video that is expected to be available to all doctors who use the Invisalign Practice App and ClinCheck treatment planning software. This new tool is designed to help improve patients' understanding and of the confidence in Invisalign treatment and is based on iTero Intraoral Scanner and doctors ClinCheck plan for Invisalign treatment. ClinCheck smile video simulates the doctor's ClinCheck treatment plan with a short video of a patient's face, and they talk and smile, which helps patients visualize their potential new smile and can lead to a higher patient treatment acceptance. We expect to roll out ClinCheck smile video in Q1 '24 in North America and EMEA, followed by APAC later in the year. Before I turn the call over to John for our fourth quarter financial review, I want to share one more exciting news. Today, we introduced the latest innovation in the iTero family of inter-oral scanners. The iTero Lumina inter-oral scanner designed to meet the needs of doctors and their patients by offering smaller wand with unparalleled data capture capabilities for effortlessly scanning by clinical members. The iTero Lumina Inter-oral scanner is a breakthrough technology. With 3x wider field of capture and a 50% smaller wand that delivers faster scanning, higher accuracy and superior visualization for greater practice efficiency. iTero Lumina quickly, easily and accurately captures more data while delivering exceptionally scanned quality and photorealistic images that eliminate the need for inter-oral photos altogether. Doctors can now scan at twice the speed with a wide field of capture, multi-angled scanning and large capture distance, meaning they can capture more dentition in greater detail throughout the scanning process. To date, Align has filed over 30 patent applications covering technology related to the iTero Lumina inter-oral scanner. I believe iTero Lumina has the potential to set a new standard of care for dental practices by simplifying the scanning of complex oral regions while offering superior chairside visualization and more comfortable experience for patients, especially kids. Initial doctor feedback has been very positive, noting that iTero Lumina scanner is much faster, clear, less invasive for their patients and the imaging and visualization translates to better communications and patient experience. The iTero Lumina inter-oral scanner is available now with orthodontic workflows and will be available in the second half of 2024 restorative workflows, although we expect that GP practices can benefit now from the new scanning technology. A global broadcast to unveil iTero Lumina and provide attendees with insights and detailed information from our iTero team and early customer users is planned for February 15. Registration will open on February 1 and the link has been provided in our financial slides as well as in today's press release. With that, I'll turn the call over to John.
John Morici: Thanks, Joe. Now for our Q4 financial results. Total revenues for the fourth quarter were $956.7 million, down 0.4% from the prior quarter and up 6.1% from the corresponding quarter a year ago. On a constant currency basis, Q4 '23 revenues were impacted by unfavorable foreign exchange of approximately $12.8 million or approximately 1.3% sequentially and were favorably impacted by approximately $13.8 million year-over-year or approximately 1.5%. For Clear Aligners, Q4 revenues of $781.9 million were down 1.6% sequentially, primarily from lower volumes. On a year-over-year basis, Q4 Clear Aligner revenues were up 6.9% and primarily due to higher ASPs and non-case revenues slightly offset by lower volumes. For Q4, Invisalign ASPs for comprehensive treatment were up sequentially and up year-over-year. On a sequential basis, ASPs reflect higher additional aligners, partially offset by the unfavorable impact from foreign exchange, higher sales credits and higher discounts. On a year-over-year basis, the increase in comprehensive ASPs reflect higher additional aligners, price increases and favorable impact from foreign exchange partially offset by higher discounts in product mix to lower ASP products. For Q4, ASPs for noncomprehensive treatment were down sequentially and up year-over-year. On a sequential basis, the decline in ASPs reflect the unfavorable impact from foreign exchange, a product mix shift to lower ASP products and higher net revenue deferrals, partially offset by price increases and lower discounts. On a year-over-year basis, the increase in ASPs reflect price increases, the impact from favorable foreign exchange and higher additional aligners, partially offset by a product mix shift to lower ASP products and higher discounts. Last quarter, we announced about a 5% global price increase for some Invisalign products across most markets effective January 1, 2024. Invisalign Comprehensive Three and Three product is available in North America and certain markets in EMEA and APAC, most recently launching in China, Korea, Hong Kong and Taiwan. We are pleased with the continued adoption of the Invisalign Comprehensive Three and Three product and anticipate it will continue to increase, providing doctors the flexibility they want and allowing us to recognize more revenue upfront with deferred revenue being recognized over a shorter period compared to our traditional Invisalign comprehensive product. Q4 '23 Clear Aligner revenues were impacted by unfavorable foreign exchange of approximately $10.7 million or approximately 1.4% sequentially. On a year-over-year basis, Clear Aligner revenues were favorably impacted by foreign exchange of approximately $12 million or approximately 1.6%. Clear Aligner deferred revenues on the balance sheet increased $14.9 million or 1.2% sequentially and $74.6 million or up 6.1% year-over-year and will be recognized as the additional aligners are shipped. Q4 '23 Systems and Services revenues of $174.8 million were up 5.8% sequentially primarily due to higher ASPs and an increase in CAD/CAM and services revenue, partially offset by lower volumes and were up 2.9% year-over-year, primarily due to higher services revenues from our larger base of scanners sold and increased nonsystem revenues related to our CPO and leasing rental programs mostly offset by lower ASPs and scanner volume. CAD/CAM and services revenues for Q4 represent approximately 50% of our Systems and Services business. Q4 '23 Systems and Services revenues were unfavorably impacted by foreign exchange of approximately $2.1 million or approximately 1.2% sequential. On a year-over-year basis, Systems and Services revenue were favorably impacted by foreign exchange of approximately $1.9 million or approximately 1.1%. Systems and Services deferred revenues on the balance sheet were down $4.3 million or 1.6% sequentially and down $13.1 million or 4.8% year-over-year, primarily due to the recognition of services revenue which is recognized ratably over the service period. As our scanner portfolio expands and we introduce new products, we increased the opportunities for customers to upgrade, make trade-ins and purchase certified preowned scanners in certain markets. Developing new capital equipment opportunities to meet the digital transformation needs of our customers and DSO partners is a natural progression for our equipment business with a large and growing base of scanners sold. Moving on to gross margin. Fourth quarter overall gross margin was 70%, up 0.9 points sequentially and up 1.5 points year-over-year. Q4 non-GAAP gross margin was 70.5% up 0.9 points sequentially and up 1.2 points year-over-year. Overall, gross margin was unfavorably impacted by foreign exchange by approximately 0.4 points sequentially and favorably impacted by approximately 0.4 points on a year-over-year basis. Clear Aligner gross margin for the fourth quarter was 71.1% up 0.4 points sequentially primarily due to lower manufacturing spend, partially offset by higher freight costs. Clear Aligner gross margin for the fourth quarter was up 0.3 points year-over-year, primarily due to higher ASPs and favorable foreign exchange, partially offset by higher manufacturing spend and freight costs. Systems and Services gross margin for the fourth quarter was 64.8%, up 3.8 points sequentially due to higher ASPs, partially offset by higher service and freight costs. Systems and Services gross margin for the fourth quarter was up 6 points year-over-year due to improved manufacturing efficiencies and favorable foreign exchange, partially offset by lower ASPs. Before I go into the details, I want to note that during Q4 '23, we incurred a total of $14 million of restructuring and other charges, primarily related to post-employment benefits. Q4 operating expenses were $498 million, roughly flat sequentially and down 1.4 points year-over-year. On a sequential basis, operating expenses were up slightly due -- primarily due to restructuring and other charges, offset by lower employee compensation. Year-over-year operating expenses decreased by $7.1 million primarily due to controlled spend on advertising and marketing as part of our efforts to proactively manage costs, partially offset by employee-related costs and slightly higher restructuring charges. On a non-GAAP basis, excluding stock-based compensation, restructuring and other charges and amortization of acquired intangibles related to certain acquisitions, operating expenses were $446.7 million, down 2.5% sequentially and down 2.8% year-over-year. Our fourth quarter operating income of $171.5 million resulted in an operating margin of 17.9%, up 0.6 points sequentially and up 5.4 points year-over-year. Operating margin was unfavorably impacted by approximately 0.6 points sequentially primarily due to foreign exchange. The year-over-year increase in operating margin is primarily attributed to operating leverage and proactively managing our costs as well as favorable impact from foreign exchange by approximately 0.6 points. On a non-GAAP basis, which excludes stock-based compensation, restructuring and other charges, the amortization of intangibles related to certain acquisition, operating margin for the fourth quarter was 23.8%, up 2 points sequentially and up 5.5 points year-over-year. Interest and other income and expense net for the fourth quarter was an income of $1.3 million compared to a loss of $4.2 million in the third quarter and income of $2.7 million in Q4 2022, primarily driven by favorable foreign exchange. The GAAP effective tax rate for the fourth quarter was 28.3%, higher than the third quarter effective tax rate of 25.1% and lower than the fourth quarter effective tax rate of 63.8% in the prior year. The fourth quarter GAAP effective tax rate was higher than the third quarter effective tax rate primarily due to onetime benefit related to tax guidance issued in Q3, partially offset by lower U.S. taxes on foreign earnings in Q4. As a reminder, in Q4 2022, we changed our methodology for the computation of our non-GAAP effective tax rate to a long-term projected tax rate and have given effect to the new methodology from January 1, 2022. Our non-GAAP effective tax rate for the fourth quarter was 20%, reflecting the change in our methodology. Fourth quarter net income per share was $1.64, up sequentially $0.06 and up $1.10 compared to the prior year. Our EPS was unfavorably impacted by $0.07 on a sequential basis and favorably impacted by $0.08 on a year-over-year basis due to foreign exchange. On a non-GAAP basis, net income per diluted share was $2.42 for the fourth quarter up $0.28 sequentially and up $0.69 year-over-year. Moving on to the balance sheet. As of December 31, 2023, cash, cash equivalents and short and long term marketable securities were $980.8 million, down sequentially $321.2 million and down $60.8 million year-over-year. Of our $980.8 million balance, $196.1 million was held in the U.S. and $784.7 million was held by our international entities. In October 2023, we purchased approximately 1 million shares of our common stock at an average price of $190.56 per share through a $250 million Accelerated Share Repurchase. And in November and December 2023, we purchased approximately 466,000 shares of our common stock at an average price of $214.81 per share through a $100 million open market purchase, both under Align's current $1 billion stock repurchase program. We have $650 million remaining available for repurchase of our common stock under this stock repurchase program. Q4 accounts receivable balance was $903.4 million, slightly down sequentially. Our overall days sales outstanding was 85 days, flat sequentially and year-over-year. Cash flow from operations for the fourth quarter was $46.9 million. Capital expenditures for the fourth quarter were $33.4 million, primarily related to our continued investments to increase aligner manufacturing capacity in facilities. Free cash flow, defined as cash flow from operations less capital expenditures, amounted to $13.5 million. Now turning to our outlook. Assuming no circumstances occur beyond our control, we provide the following framework for Q1 and fiscal 2024. For Q1 2024, we expect our worldwide revenues to be in the range of $960 million to $980 million, up slightly from Q4 of 2023. We expect Clear Aligner volume and ASPs to be up slightly sequentially. We expect Systems and Services revenue to be down slightly sequentially, although less than the historical seasonal decline, given the launch of the iTero Lumina for ortho workflows in Q1 2024. We expect our Q1 2024 GAAP operating margin and non-GAAP operating margin to be slightly above Q1 2023 GAAP operating margin and non-GAAP operating margin, respectively. For full year, we expect fiscal 2024 total revenues to be up mid-single digits over 2023. We expect fiscal 2024 Clear Aligner and Systems and Services revenues to grow year-over-year in the same approximate range as our 2024 total revenues. We expect fiscal 2024 Clear Aligner ASPs to be up slightly year-over-year primarily due to price increases and favorable foreign exchange, partially offset by a higher mix of noncomprehensive products, which have lower ASPs. We expect fiscal 2024 GAAP operating margin and non-GAAP operating margin to be slightly above the 2023 GAAP operating margin and non-GAAP operating margin, respectively. We expect our investments in capital expenditures for the fiscal 2024 to be approximately $100 million. Capital expenditures are expected to primarily relate to building construction and improvements as well as manufacturing capacity in support of our continued expansion. In summary, I am pleased with our fourth quarter and fiscal 2023 results, and I am especially proud of our continued focused execution of our product road map and innovation pipeline. We are committed to delivering on our strategic growth drivers of international expansion, patient demand, orthodontist utilization and GP dentist treatment to extend our leadership in digital orthodontics and dentistry. I believe that the next wave of innovation that we are introducing into the market will further differentiate Align and allow us to continue to increase our share of the large untapped market opportunity of 22 million annual orthodontic case starts as well as an additional 600 million consumers who could benefit from a healthy, beautiful smile using Invisalign Clear Aligners. With that, I'll turn it back to Joe for final comments. Joe?
Joseph Hogan: Thanks, John. In closing, while I'm pleased with our better-than-expected fourth quarter results and start to the year, I'm even more excited about Align innovation in 2024 and our next wave of growth drivers. When I spoke to you about a year ago, I discussed the innovations that we are planning to bring to market that we continue to revolutionize the orthodontic and dental industry and scanning software and direct 3D printing. We are delivering on that promise. With the introduction of iTero Lumina powered by Multi-Direct Capture technology, we are pushing the boundaries of what inter-oral scanners can do. iTero Lumina is a combination of years of research and development to offer visualization capabilities that support doctors, clinical decisions while also enhancing their patients' comfort and overall treatment experiences. Building on more than 20 years of expertise in revolutionizing imaging technologies, the iTero Lumina scanner elevates the standard in digital scanning to achieve exceptional clinical outcomes and increased practice efficiency. The iTero scanner is at the forefront of digital dentistry. With the closing of our acquisition of Cubicure, a pioneer of direct 3D printing solutions for polymer additive manufacturing, we will enable the next generation of 3D printed products, helping to create more unique configurations for aligners that are more sustainable and also efficient solutions. We also expect it to extend and scale our printing materials and manufacturing capabilities for our 3D printed product portfolio, which now includes the Invisalign Palate Expander System. And with the introduction of IPE, we have expanded the clinical applicability of the Invisalign system to nearly 100% of the orthodontic case starts. The ability to direct 3D print, IPE will eventually lead to other direct printed products with the goal of direct 3D printed Invisalign Clear Aligners, which we hope to achieve in the next couple of years. As a company, Align has multifaceted competitive advantage, technology innovation, where we invest up to $300 million in R&D per year to bring in some of the most disruptive products in digital dentistry and orthodontics to the market in a highly regulated industry. A direct sales force that consists of 5,000 highly trained specialists, a doctor-centered model because we understand the importance of doctor-directed care, a $1 billion brand trusted by over 17 million patients worldwide and global scale and manufacturing to deliver millions of customized Clear Aligner parts every day. We are extremely pleased with our latest innovations and commercialization of products to better serve our doctors, customers and their patients. Our belief in the future business overall is unwavering. Before we turn the call over to the operator, I want to address an important matter regarding DTC or direct to consumer Clear Aligners in our industry. Align has always believed that a doctor-centered model for orthodontic treatment is the safest for patients, and we're always looking for new and better ways to support doctors as they work to create better smiles for their patients. Recent news regarding the bankruptcy of a DTC clear aligner company has led many consumers to reach out to Invisalign providers to address their unmet needs, including helping those DTC patients with incomplete treatments. To support these former DTC patients who are seeking help from Invisalign providers and practices, in Q4 we introduced a program in the U.S. and select other markets, offering up to a 50% off Invisalign case submission in Vivera Retention to help offset any additional cost to finish their treatment. We want to help everyone achieve a healthy beautiful smile and strongly recommend that individuals who are impacted by this matter seek the advice of a licensed orthodontist or dentist. Our concierge team is always available to answer questions and help connect consumers with Invisalign practices. With that, I'll thank you for your time today. We look forward to updating you on our next earnings call. Now I'll turn the call over to the operator for questions. Operator?
Operator: [Operator Instructions]. Our first question comes from Elizabeth Anderson with Evercore ISI.
Elizabeth Anderson: Congrats on the quarter. I was wondering if you could walk us through the components of the mid-single-digit guide. I got -- for 2024. I understand what you said that like Systems and Services and Clear Aligners would be in the same range. I guess I'm just sort of thinking about like how to think about that. It seems like maybe it's like low single-digit ASP improvement and then sort of low to mid-single-digit case growth. Is that the right way to think about it? Like what else can you -- is there anything else you can sort of clarify on that? And sort of how do you expect at least currently, the sort of pacing of the year to progress.
John Morici: Yes. Elizabeth, this is John. You haven't framed the right way. We're looking at the segments up mid-single digits and then ASPs because of the price increase. We have some offset due to some of the lower-stage products that we have, including the DSP touch-ups and so on, that you would expect then a little bit lower of ASP impact year-over-year.
Elizabeth Anderson: Got it. That makes sense. And then separately, how has the volume in sort of market in China been progressing across the fourth quarter and maybe into the first quarter so far as you can comment.
Joseph Hogan: Elizabeth, it's Joe. We felt good about China last year. But remember, we had year-over-year comparisons that were really favorable because of the COVID shuts down over there last year. But overall, as we exited the year, we felt good about our performance there, and we feel good about as we move into 2024 about our competitive position there in -- a China market that I think is a little more predictable because it's not the overhead that we've seen with COVID over the last, really, several years.
Elizabeth Anderson: Got it. And sorry, maybe one last one for me. Can you just remind us the sort of 1Q dip in the operating margins and then how it sort of steps up across the year. I understand the guidance you gave for the first quarter of the year, but just why that first quarter has a sort of different perspective than the rest of the year?
John Morici: Yes. So we wanted to give to prior year because in that prior year, when you start the year, you have certain expenses that you incur right at the beginning, payroll, taxes and other things that you incur initially some of the investments that you make that you then get leverage on as you go through the year. So it's similar to how we position things from last year in 2023.
Operator: Our next question comes from Jeff Johnson with Baird.
Jeffrey Johnson: Can you hear me out there?
Shirley Stacy: Yes. We hear you fine.
Jeffrey Johnson: John, maybe I want to -- I'll follow up on Elizabeth's margin question there beyond just the 1Q. Let's say, you hit your guidance this year on operating margin is up nominally from 2023 level. It'd be 3 years in a row kind of in that low to mid-21% range. I think pre-COVID you were up in the 25% range or so. What's it going to take to get those margins moving back towards those pre-COVID. You've taken price increases 2 years in a row. It feels like your R&D should be coming down a little bit. Obviously, with Cubicure and that, I know you're continuing to invest aggressively, but IPE is out, Lumina now out, things like that. So just help us understand when could we start to see a path back towards getting those margins maybe up a few points from where they've settled in the last few years?
John Morici: Yes, Jeff, this is John. Really, when you start to get some of that volume leverage, we're positioned as having our manufacturing and the organization that we have that's really set to drive more growth. And once we get some of that volume leverage, we should see that benefit showing up in our numbers. And it's really what we saw as we went through the quarters last year where you see some of that volume benefit. You get that benefit as well when you go through the year, but really looking to try to drive as much volume as we can and you'll start to see some of that leverage that shows up in our numbers.
Jeffrey Johnson: All right. Fair enough. And then, Joe, I think we've talked for many years now how iTero is carved out such a commanding, strong competitive position. You've sold a ton of iTeros over the last 5, 6 years or so. They're all probably getting, I don't know, close to their end of their useful life or so. Lumina for the first time feels like that kind of product with a better form factor, especially things like that, that could really cause some of these docs to say, I got to get rid of this big iTero and go back down to this much smaller one, and things like that, just things that would actually matter to the docs, and I'm sure the technology does this, too, I don't want to just put it on the size. But just thinking there, is this the kind of product that can finally kick off that multiyear upgrade strategy or path in iTero that we've kind of been waiting to see?
Joseph Hogan: Jeff, the easy answer and the quick answer is yes. I mean it's just a brand-new platform. Now we set up -- I mentioned in my script about we have 100,000 units out there that we've sold so far. About 1/3 of those are 5D pluses, which are upgradable by just wand switch out. This is the way we've designed Lumina. And so that part's easy. Also, we've been really aggressively upgrading our installed base between E1 and E2 out there too to better position it for this kind of a move. So as we develop Lumina, we had exactly in mind what you just questioned, and we think we're in a good position to do that.
Jeffrey Johnson: And if you switch out that wand from the 5 to the Lumina, there is a fee there, right? It's not like, hey, you bought this knowing that you could always upgrade at no charge to Lumina?
Joseph Hogan: There's no charity here at Align. There will be a charge.
Jeffrey Johnson: I like to hear that. God bless capitalism.
Operator: Our next question comes from Jon Block with Stifel.
Jonathan Block: So Joe, maybe this one's for you. Video 1Q '24 IPE some markets today, but more in the common IPE should have longer term with team, docs might take a little bit of a wait-and-see approach. You talked about the new scanner. In your opinion, like is innovation are we seeing that in the '24 guide? Or is that more of like a ramp in the '25? And maybe even to take that a step further, John, for you, is there a way to sort of quantify out of that mid-single-digit revenue growth, what can you attribute to these new products coming on board in '24? I'm just trying to think about the impact of '24, is this more the ramp or the slope in the '25 for the innovation hitting?
Joseph Hogan: Jon, I like the way you set that up. It's a ramp, it really is. But we feel good that we can play offense with these product lines. Now we still have to scale IPE. We have a great team that knows how to scale, and we'll get through that. Obviously, Lumina is a completely different set of outside of the computer itself. The wand itself is we feel good about the scale part of that as we sell through the marketplace. But overall, I think the way you described it is a ramp of this new technology really beginning in 2024 is a good foundation for that kind of thought process.
Jonathan Block: And any way to quantify what's in there from the current guide or no? Is that just too difficult to tease out?
Joseph Hogan: It really is just too...
Jonathan Block: Okay. Okay. So second one is maybe a multipart. But just first on the CapEx, $100 million. I mean I was really surprised on how low that number was for this year. It's $400 million in '21, $300 million in '22 million, and I was maybe even more surprised when I think about the direct fabrication initiatives. So I know the slides say hoping to print Invisalign Clear Aligner "next couple of years". Do we still think retainers 2H '24, 1H '25? When do we feel like you proved it out, so to say? And do we start to see gross margin benefits from this as early as next year, turning accretive in 2025. And then admittedly just a jump to another question. For the guidance, can you just help us what's embedded in there? And I bring that up because we've seen this big move in U.S. consumer confidence. Europe still seems very choppy. So when we tie back to your guidance for the year, what are you extrapolating out, if you would, for the current macro?
John Morici: I'll start with that, Jon, in terms of the current guidance. Look, we're looking at the environment that we're all in. It's not a great economy, most places, but it is more stable, and we're building off of that. And then as Joe said, we're doing things to play offense. New products that we have with Lumina and IPE and so on, which we think, can help us grow in this environment.
Joseph Hogan: Jon, your question about the ramp up, the margin piece or part of that, what's that mean in 2025 or whatever. Look, we feel confident, and as you know from our discussions and our analyst presentation last year is 3D printing is foundationally, it can be less expensive as we scale. And so I mean, we'll start to see that come through as we scale that. But we need time to scale this. No one's ever had this polymer before that has a scale. No one's ever used the Cubicure system to the degree that we need to use it. Now we did this with 3D systems years ago because we basically scaled those systems through our team and team knows how to do that. I just can't tell you specifically within those in the next 1 to 3 years, with this being the first year, exactly when that really hits that hyperbolic side.
John Morici: And just to close on the CapEx, those prior years, that was -- a lot of that was -- it was equipment. Of course, we are always adding capacity, but a lot of that was very much unique for buildings, adding buildings for our locations, manufacturing and so on. And when we add some of the capacity that we're adding for our manufacturing, it will go in existing buildings. So we don't have to add another building in most cases for this. So that's why the CapEx is where it is.
Operator: Our next question comes from Brandon Vazquez with William Blair.
Brandon Vazquez: On the guidance, maybe one other way I wanted to ask you and see if I could tease out a little bit of color on what's assumed here. If I kind of go back to some old sequentials in the teen side, assuming that's a little less susceptible to macro headwinds, you can probably kind of get to a low single-digit volume growth, I think, for the entire Clear Aligner business already, but probably not even including some DSP. So is that -- am I thinking about this correctly that really out of adults on a year-over-year basis for full year '24, you're really assuming kind of flattish, maybe even down depending on how teens and some of the DSP cases are doing?
John Morici: I would characterize it, Brandon, this is John, that both teen and adult are positive on a year-over-year basis, expect maybe adults to grow faster as we've seen compared to -- teens grow faster than adults as we've seen in the past, but I would expect both of them to be up and show our numbers that way.
Brandon Vazquez: Okay. And then can you just reiterate maybe both for IPE and for Lumina exciting. It seems like they're going to ramp over the coming quarters. Are there any like key quarters and catalysts that we should think about that might take that up. You're talking about a ramp, but we get to the next level on the ramp on any of those when they go from maybe a limited launch to full market relief, anything like that?
Joseph Hogan: Brandon, Joe again. On the Lumina side, remember, our restorative scanner for GPs comes out in the third quarter. But as like John indicated, we indicated, we feel we can sell that into the market now with the capabilities it has, but that will ramp in -- that will probably be more hinged to the regulatory approvals we have to get around the world. Right now, as I mentioned, we only have the United States and Canada and ANZ. Secondly, on IPE, it's the same thing is we're regulatory constrained. We still have to go through Europe. And as I mentioned, IPE will come out in the second quarter in Australia and also. And as we gave that, obviously, we'll be scaling IPE too and understanding the dynamics around that. So it's more of a ramp, as I mentioned a few calls ago than anything.
Operator: Our next question comes from Jason Bednar with Piper Sandler.
Jason Bednar: I'm going to pile on here on the guidance, just to focus there first. You mentioned noncomprehensive mix as being an offsetting factor to ASPs. I know you've got that DSP factor. I had thought maybe originally you were signaling adults growing better than teens, but doesn't seem like that's the case just given your comments there to Brandon. But I guess, regardless on adults, are you seeing this market getting its footing back, it sounds like it, but if you are, what's giving you the confidence? Or what are you seeing that kind of the day-to-day or month-to-month that's showing adults are coming back into the office for treatment. And then sorry to load a few in here, but should we expect this faster noncomprehensive mix also to have gross margin benefits for the year as well? I think it typically does, but I don't think we've gotten kind of a gross margin cadence outlook for '24.
Joseph Hogan: Jason, I'll take the first part of your question and hand the rest off to John, is we feel we're on a more stable, I'd call it, economic platform than last year. And so the adult and teen question that you had is we expect that to carry through in 2024, as we indicated with our guidance, too. So when I look back, everybody has a clear vision backwards than forward, we look back to last year, a pretty unstable platform that we experienced for the year and the third quarter was a tough one in that sense. But I think we all see it right now, we have more confidence that at least we're dealing with stability from an economic standpoint in most parts of the world from what we see.
John Morici: And on the noncomprehensive and gross margin questions and related to that. Look, as we have the mix that shifts through and you might have an ASP lower on some of the non-comp DSP and others that fall into that. Those are our highest gross margin products from a rate standpoint. So they're helpful for us as a business. It's really what that customer wants for him or her to run their practice and that's how we balance things out. But overall, we expect that we would see benefits in gross margin just like we're talking about op margin year-over-year benefits, we should see a benefit as well in gross margin.
Jason Bednar: All right. That's helpful. And then for the follow-up here, I'll ask on teens. It does look like you're back to gaining share against brackets and wires. It looks like the kind of the second consecutive quarter of that. I'm curious if you could talk maybe bigger picture, what's changed to what you think has changed over the last 3 to 6 months versus maybe the 12-plus months that preceded that. But do you think the share gains you're seeing versus brackets and wires, does that have to do with changes you made to that Teen Guarantee program middle part of last year? Or are there other items at the practice level or associated with your go-to-market activities that are driving that shift?
Joseph Hogan: You can always say that at Align, there's no single variable equations. And this is another one. The Teen Guarantee, we think is some of it, obviously, our portfolio and how we put that together, our DSP programs, the uniqueness of Invisalign First. All those things really help. And from an adult standpoint, with the firmer economic platform I talked about, I just think there's more confidence out there that we're starting to see lead through.
Operator: Our next question comes from Michael Ryskin with Bank of America.
Michael Ryskin: I want to start with DSP kind of where you left off really successful, obviously, and you had great growth year-over-year for the whole year. But it's kind of moved in sort of like a step function. If I just look at the numbers, 6,000, 7,000, 9,000 and then you're kind of like an 11,000, 12,000 range. Now you're in the 18,000, 19,000, 20,000 range. Is there another step function coming next year? Is there -- could you dig into a little bit into what's driving that? And just sort of where do you see that going over the next couple of years?
John Morici: Michael, this is John. I would say as we look to expand this out, it's been successful, every place that we've done, we've seen, as you said, North America starts with this. So you see some doctors start and then we have more and more doctors that sign up for the program. And then as the doctors sign up for the program, then they end up doing more and more volume with us. We've taken that same approach to other countries, and now we've introduced this in EMEA and other places. And the same thing happens. More and more doctors sign up for it. They start to see the benefits of it, and then they utilize it more. So it's really just a matter of now scaling this to other parts of the world because we find that this is really a nice way to supplement how a doctor wants to run their practice.
Michael Ryskin: Okay. And then maybe a follow-up on a few questions that were asked on Cubicure and Direct 3D printing earlier. Really exciting technology that you unveiled late last year, and definitely see the opportunity. But could you help walk us through the road map a little bit sort of like what should we be looking for as sort of goal post 6 months out, a year out, 2 years out, just to sort of track progress and see how it -- see how it's progressing?
Joseph Hogan: Michael, it's Joe again. I think the best way to describe it to you, it's -- like I said in my script, it's a 1- to 3-year journey. And obviously, we'll -- we know how to make these aligners now. We understand how to do it. It's just a scalability of resin in the Cubicure process and that takes time. And we'll obviously report on it quarter by quarter. So you really understand where we're going and what the hurdles are and what the opportunities are.
Michael Ryskin: Okay. Maybe if I could just tweak that a little bit. Is there -- just help us understand, is there anything in terms of -- when you talk about scalability of the resin and the polymer, if you're looking at comprehensive, noncomprehensive, you talked about retainers and being able to put those. Is there anything in terms of your portfolio that makes some products more amenable or would be amenable earlier than others? Or is this just going to be all or nothing?
Joseph Hogan: I mean obviously, the scale, you look at retainers first because units of one. And that's why you'd end up with comprehensive full cases in some way. And that's basically how we'll ramp.
Operator: Our next question comes from Nathan Rich with Goldman Sachs.
Nathan Rich: I wanted to ask on the Systems and Services revenue guidance for 2024. This looks low to me just given -- I think growth in '23 was basically flat, up slightly. With the Lumina launch, we thought it would maybe be up more than it was in 2023. So I don't know if you could just maybe elaborate on what you're expecting for that segment?
John Morici: Nate, this is John. We're looking at, like we said, this year, you're kind of in that mid-single digits. We do have Lumina, which helps, but there's also unknowns about the macro economy. We were very pleased with what we saw in the fourth quarter with doctors buying and actually doing better than what we had really guided to. So we're pleased with the performance of Q4, but we just want to make sure that as we ramp up Lumina that we're properly positioned there, and we'll update as we go along.
Nathan Rich: Okay. Great. And then just going back to the margin cadence, I guess are there any either upfront or onetime costs associated with either the launches of Lumina or IPE that impact the margin in the early part of the year just as we think about cadence and sort of what the right baseline is.
John Morici: There is some of that in Q1. We're ramping that up. So it's not a big, huge splash where there's a lot of expenses and kind of hits all in 1 quarter. But there is some ramp up, but that's factored into our guidance. So when we say that we expect the year-over-year in the first quarter to be slightly up, it's factored in -- those expenses are factored in.
Operator: Our next question comes from Ann Wright with Morgan Stanley. You may proceed.
Unidentified Analyst: You mentioned at the end of the call, some of the DTC customers that you are tailoring some of the offerings to. I guess, was this material at all in the quarter? Maybe it's not large enough at this point, but any sort of contributions in 2024 as we think about picking up some of that business? And then also, DSO relationships, has there been any changes there in terms of the relationships on that front? How would you characterize those at this point? Are you seeing any greater traction there? Do some of these new products really move the needle on some of those relationships or conversations you're having?
Joseph Hogan: Ann, on the DTC customers, we've always argued that, that wasn't our marketplace in the sense of the price point and all. But I mean, obviously, these patients will pursue treatment. Now probably more so for doctors than DTC. And we're just doing what we can in order to support those customers going forward. But again, as I was clear in my script, we're a doctor-focused client company, and we'll keep it that way. But we do see this as being a certain opportunity. It's just hard for us to quantify right now. On the DSO relationships, I'd say this has gotten stronger all around the globe. Two to call out would be Heartland and [indiscernible] being more new ortho side and Heartland being more on the GP side. But we have really good relationships and we leverage our portfolio well with them to help them grow and we grow with them. So I feel good about our position with DSOs, and we have good strong relationships out there with them.
Operator: Our next question comes from Brandon Couillard with Jefferies.
Brandon Couillard: Joe, given the positive macro shift we've seen in the last few months with consumer confidence coming back, any chance you can comment on what you've seen in case starts in January an inflection? And then with respect to the '24 growth outlook. Any chance you could break that out between Americas and International.
Joseph Hogan: Yes. I can't -- I really wouldn't break it out between Americas and International because we felt good about the geographies in general as you went across the world for especially latter half of the fourth quarter of last year. As we go into this year, as I talk about, we're looking at, I think, a stable economic platform. Some of the data that you cited would support that overall. And we feel good about our new products. We think we can play offense. And that's what we're focused on right now.
Brandon Couillard: Okay. And then one housekeeping one for you, John. The fourth quarter operating cash flow was pretty weak. Can you just unpack any of the moving parts that might have been onetime in the quarter. It looks like there was a spike in prepaid expenses on the balance sheet. But anything you would call out?
John Morici: Things that related to like tax payments and things. It's just some timing as things go through the year. But we feel great. I mean, it's a great model. It generates a lot of cash. It gives us a lot of flexibility, and we were able to use that cash, that $350 million buyback that we did last quarter.
Operator: And we have reached the end of our question-and-answer session. I will now turn the call back over to Shirley Stacy for closing remarks.
Shirley Stacy: Thank you, everyone. We appreciate you joining us today. We look forward to speaking with you at upcoming financial conferences and at industry meetings such as Chicago Midwinter. If you have any questions or follow-up, please contact our Investor Relations. Thanks, and have a great day.
Operator: Thank you. This concludes today's conference, and you may disconnect your lines at this time. Thank you for your participation. | [
{
"speaker": "Shirley Stacy",
"text": "Good afternoon, and thank you for joining us. I'm Shirley Stacy, Vice President of Corporate Communications and Investor Relations. Joining me for today's call is Joe Hogan, President and CEO; and John Morici, CFO. We issued fourth quarter and full year 2023 financial results today via Business Wire, which is available on our website at investor.aligntech.com. Today's conference call is being audio webcast and will be archived on our website for approximately 1 month. As a reminder, the information provided and discussed today will include forward-looking statements, including statements about Align's future events and product outlook. These forward-looking statements are only predictions and involve risks and uncertainties that are described in more detail in our most recent periodic reports filed with the Securities and Exchange Commission available on our website and at sec.gov. Actual results may vary significantly, and Align expressly assumes no obligation to update any forward-looking statements. We have posted historical financial statements, including the corresponding reconciliations, including our GAAP to non-GAAP reconciliation, if applicable, and our fourth quarter and full year 2023 conference call slides on our website under quarterly results. Please refer to these files for more detailed information. With that, I'll turn the call over to Align Technology President and CEO, Joe Hogan. Joe?"
},
{
"speaker": "Joseph Hogan",
"text": "Thanks, Shirley. Good afternoon, and thanks for joining us. On our call today, I'll provide an overview of our fourth quarter and full results and discuss a few highlights from our 2 operating segments, Systems, Services and Clear Aligners. John will provide more detail on our Q4 financial performance and comment on our views for 2024. Following that, I'll come back and summarize a few key points and open the call to questions. I'm pleased to report fourth quarter results with better-than-expected revenues and earnings. As of the end of Q4, we achieved several major milestones, including 17 million Invisalign patients treated, including 4.7 million teens, plus 4 million Vivera Retainer cases and over 100,000 iTero scanners sold. And for the full year -- fiscal year 2023, total revenues exceeded our prior outlook, and we delivered fiscal 2023 non-GAAP operating margin above 21%. For Q4, total revenues were up 6.1% year-over-year, reflecting increased Systems and Services revenues. Strength in Clear Aligner volumes for teens and international doctors as well as continued growth from Invisalign touch-up cases, under our Invisalign Doctor Subscription Program, or DSP. Our Q4 Systems and Services revenues were up year-over-year, primarily due to increased services, CAD/CAM and nonsystems revenues, including scanner leasing and rental programs and certified preowned scanner sales. Q4 total Clear Aligner shipments were slightly lower year-over-year. On a year-over-year basis, Clear Aligner volumes were down for the Americas and EMEA regions and were up for the APAC region. For Q4, Clear Aligner shipments include approximately 20,000 Invisalign DSP touch-up cases, primarily in North America, an increase of more than 60% year-over-year from Q4 '22. DSP continues to be well received by our customers and is currently available in the U.S. and Canada, Iberia and Nordics and most recently, the U.K. We're excited that DSP is proving helpful to doctors and their patients as we continue to expand the program. For fiscal 2023, total Invisalign DSP touch-up cases shipped were 73,000, up 85% year-over-year. For non-case revenues, Q4 was up 13.3% year-over-year, primarily due to continued growth from Vivera Retainers along with Invisalign DSP retainer revenues. On a sequential basis, Q4 total revenues were down slightly, 0.4%, primarily reflecting anticipated seasonally lower teens case starts, especially in the U.S. ortho channel and unfavorable foreign exchange offset somewhat by increased revenues from System and Services as well as an increase in Clear Aligner volume for adults and noncomprehensive cases and stronger volumes from Canada and the EMEA region. Q4 total Aligner shipments were slightly lower sequentially. On a sequential basis, Clear Aligner volumes were down for the Americas and APAC regions and were up sequentially for the EMEA region. The December gauge practice analysis tool that collects and consolidates data from approximately 1,000 orthodontic practices across the U.S. and Canada reported year-over-year decline for new patients, total exams and total starts, particularly among teens and kids. It also shows a year-over-year decline for wires and brackets and total Clear Aligner starts with Invisalign case starts better than the Clear Aligner brand. And the teen segment for Q4, a 197,000 teens and younger patients started treatment with Invisalign Clear Aligner Systems, up 6% year-over-year and were a record number of teen cases shipped compared to prior fourth quarters. Q4 teens starts were down sequentially, consistent with historical seasonality, primarily in China as well as seasonally fewer teen starts in North America compared to Q3. For fiscal 2023, total Invisalign Clear Aligner shipments for teens and younger patients reached a total of 809,000 cases, up 8% compared to the prior year and made up 34% of total Clear Aligner shipments. During Q4, we announced that the U.S. Food and Drug Administration cleared the Invisalign Palatal Expander System, we call it IPE, Invisalign Palatal Expander for commercial availability in the United States. The FDA 510(k) clearance is for broad patient applicability, including growing children, teens and adults. Full early intervention treatments such as Phase I or early interceptive treatment, makes up about 20% of the orthodontic case starts each year and is growing. Together with Invisalign First Aligners, IPEs provide doctors with a solution set to treat the most common skeletal, dental malocclusions in growing children. The addition of mandibular advancement features to Invisalign aligners also provides doctors with more options for treating skeletal, dental joint balances and bite correction and for their growing patients during their teenage years. Essentially, we now have an Invisalign digital treatment solution for every phase of treatment. IPE is currently available on a limited basis in Canada and the United States, and we recently received regulatory clearance in Australia and New Zealand where we anticipate commercialization in Q2. We expect IPE to be available in other markets pending future applicable regulatory approvals. We're also launching ClinCheck smile video, the next generation of In-Face digitalization with AI-assisted video that is expected to be available to all doctors who use the Invisalign Practice App and ClinCheck treatment planning software. This new tool is designed to help improve patients' understanding and of the confidence in Invisalign treatment and is based on iTero Intraoral Scanner and doctors ClinCheck plan for Invisalign treatment. ClinCheck smile video simulates the doctor's ClinCheck treatment plan with a short video of a patient's face, and they talk and smile, which helps patients visualize their potential new smile and can lead to a higher patient treatment acceptance. We expect to roll out ClinCheck smile video in Q1 '24 in North America and EMEA, followed by APAC later in the year. Before I turn the call over to John for our fourth quarter financial review, I want to share one more exciting news. Today, we introduced the latest innovation in the iTero family of inter-oral scanners. The iTero Lumina inter-oral scanner designed to meet the needs of doctors and their patients by offering smaller wand with unparalleled data capture capabilities for effortlessly scanning by clinical members. The iTero Lumina Inter-oral scanner is a breakthrough technology. With 3x wider field of capture and a 50% smaller wand that delivers faster scanning, higher accuracy and superior visualization for greater practice efficiency. iTero Lumina quickly, easily and accurately captures more data while delivering exceptionally scanned quality and photorealistic images that eliminate the need for inter-oral photos altogether. Doctors can now scan at twice the speed with a wide field of capture, multi-angled scanning and large capture distance, meaning they can capture more dentition in greater detail throughout the scanning process. To date, Align has filed over 30 patent applications covering technology related to the iTero Lumina inter-oral scanner. I believe iTero Lumina has the potential to set a new standard of care for dental practices by simplifying the scanning of complex oral regions while offering superior chairside visualization and more comfortable experience for patients, especially kids. Initial doctor feedback has been very positive, noting that iTero Lumina scanner is much faster, clear, less invasive for their patients and the imaging and visualization translates to better communications and patient experience. The iTero Lumina inter-oral scanner is available now with orthodontic workflows and will be available in the second half of 2024 restorative workflows, although we expect that GP practices can benefit now from the new scanning technology. A global broadcast to unveil iTero Lumina and provide attendees with insights and detailed information from our iTero team and early customer users is planned for February 15. Registration will open on February 1 and the link has been provided in our financial slides as well as in today's press release. With that, I'll turn the call over to John."
},
{
"speaker": "John Morici",
"text": "Thanks, Joe. Now for our Q4 financial results. Total revenues for the fourth quarter were $956.7 million, down 0.4% from the prior quarter and up 6.1% from the corresponding quarter a year ago. On a constant currency basis, Q4 '23 revenues were impacted by unfavorable foreign exchange of approximately $12.8 million or approximately 1.3% sequentially and were favorably impacted by approximately $13.8 million year-over-year or approximately 1.5%. For Clear Aligners, Q4 revenues of $781.9 million were down 1.6% sequentially, primarily from lower volumes. On a year-over-year basis, Q4 Clear Aligner revenues were up 6.9% and primarily due to higher ASPs and non-case revenues slightly offset by lower volumes. For Q4, Invisalign ASPs for comprehensive treatment were up sequentially and up year-over-year. On a sequential basis, ASPs reflect higher additional aligners, partially offset by the unfavorable impact from foreign exchange, higher sales credits and higher discounts. On a year-over-year basis, the increase in comprehensive ASPs reflect higher additional aligners, price increases and favorable impact from foreign exchange partially offset by higher discounts in product mix to lower ASP products. For Q4, ASPs for noncomprehensive treatment were down sequentially and up year-over-year. On a sequential basis, the decline in ASPs reflect the unfavorable impact from foreign exchange, a product mix shift to lower ASP products and higher net revenue deferrals, partially offset by price increases and lower discounts. On a year-over-year basis, the increase in ASPs reflect price increases, the impact from favorable foreign exchange and higher additional aligners, partially offset by a product mix shift to lower ASP products and higher discounts. Last quarter, we announced about a 5% global price increase for some Invisalign products across most markets effective January 1, 2024. Invisalign Comprehensive Three and Three product is available in North America and certain markets in EMEA and APAC, most recently launching in China, Korea, Hong Kong and Taiwan. We are pleased with the continued adoption of the Invisalign Comprehensive Three and Three product and anticipate it will continue to increase, providing doctors the flexibility they want and allowing us to recognize more revenue upfront with deferred revenue being recognized over a shorter period compared to our traditional Invisalign comprehensive product. Q4 '23 Clear Aligner revenues were impacted by unfavorable foreign exchange of approximately $10.7 million or approximately 1.4% sequentially. On a year-over-year basis, Clear Aligner revenues were favorably impacted by foreign exchange of approximately $12 million or approximately 1.6%. Clear Aligner deferred revenues on the balance sheet increased $14.9 million or 1.2% sequentially and $74.6 million or up 6.1% year-over-year and will be recognized as the additional aligners are shipped. Q4 '23 Systems and Services revenues of $174.8 million were up 5.8% sequentially primarily due to higher ASPs and an increase in CAD/CAM and services revenue, partially offset by lower volumes and were up 2.9% year-over-year, primarily due to higher services revenues from our larger base of scanners sold and increased nonsystem revenues related to our CPO and leasing rental programs mostly offset by lower ASPs and scanner volume. CAD/CAM and services revenues for Q4 represent approximately 50% of our Systems and Services business. Q4 '23 Systems and Services revenues were unfavorably impacted by foreign exchange of approximately $2.1 million or approximately 1.2% sequential. On a year-over-year basis, Systems and Services revenue were favorably impacted by foreign exchange of approximately $1.9 million or approximately 1.1%. Systems and Services deferred revenues on the balance sheet were down $4.3 million or 1.6% sequentially and down $13.1 million or 4.8% year-over-year, primarily due to the recognition of services revenue which is recognized ratably over the service period. As our scanner portfolio expands and we introduce new products, we increased the opportunities for customers to upgrade, make trade-ins and purchase certified preowned scanners in certain markets. Developing new capital equipment opportunities to meet the digital transformation needs of our customers and DSO partners is a natural progression for our equipment business with a large and growing base of scanners sold. Moving on to gross margin. Fourth quarter overall gross margin was 70%, up 0.9 points sequentially and up 1.5 points year-over-year. Q4 non-GAAP gross margin was 70.5% up 0.9 points sequentially and up 1.2 points year-over-year. Overall, gross margin was unfavorably impacted by foreign exchange by approximately 0.4 points sequentially and favorably impacted by approximately 0.4 points on a year-over-year basis. Clear Aligner gross margin for the fourth quarter was 71.1% up 0.4 points sequentially primarily due to lower manufacturing spend, partially offset by higher freight costs. Clear Aligner gross margin for the fourth quarter was up 0.3 points year-over-year, primarily due to higher ASPs and favorable foreign exchange, partially offset by higher manufacturing spend and freight costs. Systems and Services gross margin for the fourth quarter was 64.8%, up 3.8 points sequentially due to higher ASPs, partially offset by higher service and freight costs. Systems and Services gross margin for the fourth quarter was up 6 points year-over-year due to improved manufacturing efficiencies and favorable foreign exchange, partially offset by lower ASPs. Before I go into the details, I want to note that during Q4 '23, we incurred a total of $14 million of restructuring and other charges, primarily related to post-employment benefits. Q4 operating expenses were $498 million, roughly flat sequentially and down 1.4 points year-over-year. On a sequential basis, operating expenses were up slightly due -- primarily due to restructuring and other charges, offset by lower employee compensation. Year-over-year operating expenses decreased by $7.1 million primarily due to controlled spend on advertising and marketing as part of our efforts to proactively manage costs, partially offset by employee-related costs and slightly higher restructuring charges. On a non-GAAP basis, excluding stock-based compensation, restructuring and other charges and amortization of acquired intangibles related to certain acquisitions, operating expenses were $446.7 million, down 2.5% sequentially and down 2.8% year-over-year. Our fourth quarter operating income of $171.5 million resulted in an operating margin of 17.9%, up 0.6 points sequentially and up 5.4 points year-over-year. Operating margin was unfavorably impacted by approximately 0.6 points sequentially primarily due to foreign exchange. The year-over-year increase in operating margin is primarily attributed to operating leverage and proactively managing our costs as well as favorable impact from foreign exchange by approximately 0.6 points. On a non-GAAP basis, which excludes stock-based compensation, restructuring and other charges, the amortization of intangibles related to certain acquisition, operating margin for the fourth quarter was 23.8%, up 2 points sequentially and up 5.5 points year-over-year. Interest and other income and expense net for the fourth quarter was an income of $1.3 million compared to a loss of $4.2 million in the third quarter and income of $2.7 million in Q4 2022, primarily driven by favorable foreign exchange. The GAAP effective tax rate for the fourth quarter was 28.3%, higher than the third quarter effective tax rate of 25.1% and lower than the fourth quarter effective tax rate of 63.8% in the prior year. The fourth quarter GAAP effective tax rate was higher than the third quarter effective tax rate primarily due to onetime benefit related to tax guidance issued in Q3, partially offset by lower U.S. taxes on foreign earnings in Q4. As a reminder, in Q4 2022, we changed our methodology for the computation of our non-GAAP effective tax rate to a long-term projected tax rate and have given effect to the new methodology from January 1, 2022. Our non-GAAP effective tax rate for the fourth quarter was 20%, reflecting the change in our methodology. Fourth quarter net income per share was $1.64, up sequentially $0.06 and up $1.10 compared to the prior year. Our EPS was unfavorably impacted by $0.07 on a sequential basis and favorably impacted by $0.08 on a year-over-year basis due to foreign exchange. On a non-GAAP basis, net income per diluted share was $2.42 for the fourth quarter up $0.28 sequentially and up $0.69 year-over-year. Moving on to the balance sheet. As of December 31, 2023, cash, cash equivalents and short and long term marketable securities were $980.8 million, down sequentially $321.2 million and down $60.8 million year-over-year. Of our $980.8 million balance, $196.1 million was held in the U.S. and $784.7 million was held by our international entities. In October 2023, we purchased approximately 1 million shares of our common stock at an average price of $190.56 per share through a $250 million Accelerated Share Repurchase. And in November and December 2023, we purchased approximately 466,000 shares of our common stock at an average price of $214.81 per share through a $100 million open market purchase, both under Align's current $1 billion stock repurchase program. We have $650 million remaining available for repurchase of our common stock under this stock repurchase program. Q4 accounts receivable balance was $903.4 million, slightly down sequentially. Our overall days sales outstanding was 85 days, flat sequentially and year-over-year. Cash flow from operations for the fourth quarter was $46.9 million. Capital expenditures for the fourth quarter were $33.4 million, primarily related to our continued investments to increase aligner manufacturing capacity in facilities. Free cash flow, defined as cash flow from operations less capital expenditures, amounted to $13.5 million. Now turning to our outlook. Assuming no circumstances occur beyond our control, we provide the following framework for Q1 and fiscal 2024. For Q1 2024, we expect our worldwide revenues to be in the range of $960 million to $980 million, up slightly from Q4 of 2023. We expect Clear Aligner volume and ASPs to be up slightly sequentially. We expect Systems and Services revenue to be down slightly sequentially, although less than the historical seasonal decline, given the launch of the iTero Lumina for ortho workflows in Q1 2024. We expect our Q1 2024 GAAP operating margin and non-GAAP operating margin to be slightly above Q1 2023 GAAP operating margin and non-GAAP operating margin, respectively. For full year, we expect fiscal 2024 total revenues to be up mid-single digits over 2023. We expect fiscal 2024 Clear Aligner and Systems and Services revenues to grow year-over-year in the same approximate range as our 2024 total revenues. We expect fiscal 2024 Clear Aligner ASPs to be up slightly year-over-year primarily due to price increases and favorable foreign exchange, partially offset by a higher mix of noncomprehensive products, which have lower ASPs. We expect fiscal 2024 GAAP operating margin and non-GAAP operating margin to be slightly above the 2023 GAAP operating margin and non-GAAP operating margin, respectively. We expect our investments in capital expenditures for the fiscal 2024 to be approximately $100 million. Capital expenditures are expected to primarily relate to building construction and improvements as well as manufacturing capacity in support of our continued expansion. In summary, I am pleased with our fourth quarter and fiscal 2023 results, and I am especially proud of our continued focused execution of our product road map and innovation pipeline. We are committed to delivering on our strategic growth drivers of international expansion, patient demand, orthodontist utilization and GP dentist treatment to extend our leadership in digital orthodontics and dentistry. I believe that the next wave of innovation that we are introducing into the market will further differentiate Align and allow us to continue to increase our share of the large untapped market opportunity of 22 million annual orthodontic case starts as well as an additional 600 million consumers who could benefit from a healthy, beautiful smile using Invisalign Clear Aligners. With that, I'll turn it back to Joe for final comments. Joe?"
},
{
"speaker": "Joseph Hogan",
"text": "Thanks, John. In closing, while I'm pleased with our better-than-expected fourth quarter results and start to the year, I'm even more excited about Align innovation in 2024 and our next wave of growth drivers. When I spoke to you about a year ago, I discussed the innovations that we are planning to bring to market that we continue to revolutionize the orthodontic and dental industry and scanning software and direct 3D printing. We are delivering on that promise. With the introduction of iTero Lumina powered by Multi-Direct Capture technology, we are pushing the boundaries of what inter-oral scanners can do. iTero Lumina is a combination of years of research and development to offer visualization capabilities that support doctors, clinical decisions while also enhancing their patients' comfort and overall treatment experiences. Building on more than 20 years of expertise in revolutionizing imaging technologies, the iTero Lumina scanner elevates the standard in digital scanning to achieve exceptional clinical outcomes and increased practice efficiency. The iTero scanner is at the forefront of digital dentistry. With the closing of our acquisition of Cubicure, a pioneer of direct 3D printing solutions for polymer additive manufacturing, we will enable the next generation of 3D printed products, helping to create more unique configurations for aligners that are more sustainable and also efficient solutions. We also expect it to extend and scale our printing materials and manufacturing capabilities for our 3D printed product portfolio, which now includes the Invisalign Palate Expander System. And with the introduction of IPE, we have expanded the clinical applicability of the Invisalign system to nearly 100% of the orthodontic case starts. The ability to direct 3D print, IPE will eventually lead to other direct printed products with the goal of direct 3D printed Invisalign Clear Aligners, which we hope to achieve in the next couple of years. As a company, Align has multifaceted competitive advantage, technology innovation, where we invest up to $300 million in R&D per year to bring in some of the most disruptive products in digital dentistry and orthodontics to the market in a highly regulated industry. A direct sales force that consists of 5,000 highly trained specialists, a doctor-centered model because we understand the importance of doctor-directed care, a $1 billion brand trusted by over 17 million patients worldwide and global scale and manufacturing to deliver millions of customized Clear Aligner parts every day. We are extremely pleased with our latest innovations and commercialization of products to better serve our doctors, customers and their patients. Our belief in the future business overall is unwavering. Before we turn the call over to the operator, I want to address an important matter regarding DTC or direct to consumer Clear Aligners in our industry. Align has always believed that a doctor-centered model for orthodontic treatment is the safest for patients, and we're always looking for new and better ways to support doctors as they work to create better smiles for their patients. Recent news regarding the bankruptcy of a DTC clear aligner company has led many consumers to reach out to Invisalign providers to address their unmet needs, including helping those DTC patients with incomplete treatments. To support these former DTC patients who are seeking help from Invisalign providers and practices, in Q4 we introduced a program in the U.S. and select other markets, offering up to a 50% off Invisalign case submission in Vivera Retention to help offset any additional cost to finish their treatment. We want to help everyone achieve a healthy beautiful smile and strongly recommend that individuals who are impacted by this matter seek the advice of a licensed orthodontist or dentist. Our concierge team is always available to answer questions and help connect consumers with Invisalign practices. With that, I'll thank you for your time today. We look forward to updating you on our next earnings call. Now I'll turn the call over to the operator for questions. Operator?"
},
{
"speaker": "Operator",
"text": "[Operator Instructions]. Our first question comes from Elizabeth Anderson with Evercore ISI."
},
{
"speaker": "Elizabeth Anderson",
"text": "Congrats on the quarter. I was wondering if you could walk us through the components of the mid-single-digit guide. I got -- for 2024. I understand what you said that like Systems and Services and Clear Aligners would be in the same range. I guess I'm just sort of thinking about like how to think about that. It seems like maybe it's like low single-digit ASP improvement and then sort of low to mid-single-digit case growth. Is that the right way to think about it? Like what else can you -- is there anything else you can sort of clarify on that? And sort of how do you expect at least currently, the sort of pacing of the year to progress."
},
{
"speaker": "John Morici",
"text": "Yes. Elizabeth, this is John. You haven't framed the right way. We're looking at the segments up mid-single digits and then ASPs because of the price increase. We have some offset due to some of the lower-stage products that we have, including the DSP touch-ups and so on, that you would expect then a little bit lower of ASP impact year-over-year."
},
{
"speaker": "Elizabeth Anderson",
"text": "Got it. That makes sense. And then separately, how has the volume in sort of market in China been progressing across the fourth quarter and maybe into the first quarter so far as you can comment."
},
{
"speaker": "Joseph Hogan",
"text": "Elizabeth, it's Joe. We felt good about China last year. But remember, we had year-over-year comparisons that were really favorable because of the COVID shuts down over there last year. But overall, as we exited the year, we felt good about our performance there, and we feel good about as we move into 2024 about our competitive position there in -- a China market that I think is a little more predictable because it's not the overhead that we've seen with COVID over the last, really, several years."
},
{
"speaker": "Elizabeth Anderson",
"text": "Got it. And sorry, maybe one last one for me. Can you just remind us the sort of 1Q dip in the operating margins and then how it sort of steps up across the year. I understand the guidance you gave for the first quarter of the year, but just why that first quarter has a sort of different perspective than the rest of the year?"
},
{
"speaker": "John Morici",
"text": "Yes. So we wanted to give to prior year because in that prior year, when you start the year, you have certain expenses that you incur right at the beginning, payroll, taxes and other things that you incur initially some of the investments that you make that you then get leverage on as you go through the year. So it's similar to how we position things from last year in 2023."
},
{
"speaker": "Operator",
"text": "Our next question comes from Jeff Johnson with Baird."
},
{
"speaker": "Jeffrey Johnson",
"text": "Can you hear me out there?"
},
{
"speaker": "Shirley Stacy",
"text": "Yes. We hear you fine."
},
{
"speaker": "Jeffrey Johnson",
"text": "John, maybe I want to -- I'll follow up on Elizabeth's margin question there beyond just the 1Q. Let's say, you hit your guidance this year on operating margin is up nominally from 2023 level. It'd be 3 years in a row kind of in that low to mid-21% range. I think pre-COVID you were up in the 25% range or so. What's it going to take to get those margins moving back towards those pre-COVID. You've taken price increases 2 years in a row. It feels like your R&D should be coming down a little bit. Obviously, with Cubicure and that, I know you're continuing to invest aggressively, but IPE is out, Lumina now out, things like that. So just help us understand when could we start to see a path back towards getting those margins maybe up a few points from where they've settled in the last few years?"
},
{
"speaker": "John Morici",
"text": "Yes, Jeff, this is John. Really, when you start to get some of that volume leverage, we're positioned as having our manufacturing and the organization that we have that's really set to drive more growth. And once we get some of that volume leverage, we should see that benefit showing up in our numbers. And it's really what we saw as we went through the quarters last year where you see some of that volume benefit. You get that benefit as well when you go through the year, but really looking to try to drive as much volume as we can and you'll start to see some of that leverage that shows up in our numbers."
},
{
"speaker": "Jeffrey Johnson",
"text": "All right. Fair enough. And then, Joe, I think we've talked for many years now how iTero is carved out such a commanding, strong competitive position. You've sold a ton of iTeros over the last 5, 6 years or so. They're all probably getting, I don't know, close to their end of their useful life or so. Lumina for the first time feels like that kind of product with a better form factor, especially things like that, that could really cause some of these docs to say, I got to get rid of this big iTero and go back down to this much smaller one, and things like that, just things that would actually matter to the docs, and I'm sure the technology does this, too, I don't want to just put it on the size. But just thinking there, is this the kind of product that can finally kick off that multiyear upgrade strategy or path in iTero that we've kind of been waiting to see?"
},
{
"speaker": "Joseph Hogan",
"text": "Jeff, the easy answer and the quick answer is yes. I mean it's just a brand-new platform. Now we set up -- I mentioned in my script about we have 100,000 units out there that we've sold so far. About 1/3 of those are 5D pluses, which are upgradable by just wand switch out. This is the way we've designed Lumina. And so that part's easy. Also, we've been really aggressively upgrading our installed base between E1 and E2 out there too to better position it for this kind of a move. So as we develop Lumina, we had exactly in mind what you just questioned, and we think we're in a good position to do that."
},
{
"speaker": "Jeffrey Johnson",
"text": "And if you switch out that wand from the 5 to the Lumina, there is a fee there, right? It's not like, hey, you bought this knowing that you could always upgrade at no charge to Lumina?"
},
{
"speaker": "Joseph Hogan",
"text": "There's no charity here at Align. There will be a charge."
},
{
"speaker": "Jeffrey Johnson",
"text": "I like to hear that. God bless capitalism."
},
{
"speaker": "Operator",
"text": "Our next question comes from Jon Block with Stifel."
},
{
"speaker": "Jonathan Block",
"text": "So Joe, maybe this one's for you. Video 1Q '24 IPE some markets today, but more in the common IPE should have longer term with team, docs might take a little bit of a wait-and-see approach. You talked about the new scanner. In your opinion, like is innovation are we seeing that in the '24 guide? Or is that more of like a ramp in the '25? And maybe even to take that a step further, John, for you, is there a way to sort of quantify out of that mid-single-digit revenue growth, what can you attribute to these new products coming on board in '24? I'm just trying to think about the impact of '24, is this more the ramp or the slope in the '25 for the innovation hitting?"
},
{
"speaker": "Joseph Hogan",
"text": "Jon, I like the way you set that up. It's a ramp, it really is. But we feel good that we can play offense with these product lines. Now we still have to scale IPE. We have a great team that knows how to scale, and we'll get through that. Obviously, Lumina is a completely different set of outside of the computer itself. The wand itself is we feel good about the scale part of that as we sell through the marketplace. But overall, I think the way you described it is a ramp of this new technology really beginning in 2024 is a good foundation for that kind of thought process."
},
{
"speaker": "Jonathan Block",
"text": "And any way to quantify what's in there from the current guide or no? Is that just too difficult to tease out?"
},
{
"speaker": "Joseph Hogan",
"text": "It really is just too..."
},
{
"speaker": "Jonathan Block",
"text": "Okay. Okay. So second one is maybe a multipart. But just first on the CapEx, $100 million. I mean I was really surprised on how low that number was for this year. It's $400 million in '21, $300 million in '22 million, and I was maybe even more surprised when I think about the direct fabrication initiatives. So I know the slides say hoping to print Invisalign Clear Aligner \"next couple of years\". Do we still think retainers 2H '24, 1H '25? When do we feel like you proved it out, so to say? And do we start to see gross margin benefits from this as early as next year, turning accretive in 2025. And then admittedly just a jump to another question. For the guidance, can you just help us what's embedded in there? And I bring that up because we've seen this big move in U.S. consumer confidence. Europe still seems very choppy. So when we tie back to your guidance for the year, what are you extrapolating out, if you would, for the current macro?"
},
{
"speaker": "John Morici",
"text": "I'll start with that, Jon, in terms of the current guidance. Look, we're looking at the environment that we're all in. It's not a great economy, most places, but it is more stable, and we're building off of that. And then as Joe said, we're doing things to play offense. New products that we have with Lumina and IPE and so on, which we think, can help us grow in this environment."
},
{
"speaker": "Joseph Hogan",
"text": "Jon, your question about the ramp up, the margin piece or part of that, what's that mean in 2025 or whatever. Look, we feel confident, and as you know from our discussions and our analyst presentation last year is 3D printing is foundationally, it can be less expensive as we scale. And so I mean, we'll start to see that come through as we scale that. But we need time to scale this. No one's ever had this polymer before that has a scale. No one's ever used the Cubicure system to the degree that we need to use it. Now we did this with 3D systems years ago because we basically scaled those systems through our team and team knows how to do that. I just can't tell you specifically within those in the next 1 to 3 years, with this being the first year, exactly when that really hits that hyperbolic side."
},
{
"speaker": "John Morici",
"text": "And just to close on the CapEx, those prior years, that was -- a lot of that was -- it was equipment. Of course, we are always adding capacity, but a lot of that was very much unique for buildings, adding buildings for our locations, manufacturing and so on. And when we add some of the capacity that we're adding for our manufacturing, it will go in existing buildings. So we don't have to add another building in most cases for this. So that's why the CapEx is where it is."
},
{
"speaker": "Operator",
"text": "Our next question comes from Brandon Vazquez with William Blair."
},
{
"speaker": "Brandon Vazquez",
"text": "On the guidance, maybe one other way I wanted to ask you and see if I could tease out a little bit of color on what's assumed here. If I kind of go back to some old sequentials in the teen side, assuming that's a little less susceptible to macro headwinds, you can probably kind of get to a low single-digit volume growth, I think, for the entire Clear Aligner business already, but probably not even including some DSP. So is that -- am I thinking about this correctly that really out of adults on a year-over-year basis for full year '24, you're really assuming kind of flattish, maybe even down depending on how teens and some of the DSP cases are doing?"
},
{
"speaker": "John Morici",
"text": "I would characterize it, Brandon, this is John, that both teen and adult are positive on a year-over-year basis, expect maybe adults to grow faster as we've seen compared to -- teens grow faster than adults as we've seen in the past, but I would expect both of them to be up and show our numbers that way."
},
{
"speaker": "Brandon Vazquez",
"text": "Okay. And then can you just reiterate maybe both for IPE and for Lumina exciting. It seems like they're going to ramp over the coming quarters. Are there any like key quarters and catalysts that we should think about that might take that up. You're talking about a ramp, but we get to the next level on the ramp on any of those when they go from maybe a limited launch to full market relief, anything like that?"
},
{
"speaker": "Joseph Hogan",
"text": "Brandon, Joe again. On the Lumina side, remember, our restorative scanner for GPs comes out in the third quarter. But as like John indicated, we indicated, we feel we can sell that into the market now with the capabilities it has, but that will ramp in -- that will probably be more hinged to the regulatory approvals we have to get around the world. Right now, as I mentioned, we only have the United States and Canada and ANZ. Secondly, on IPE, it's the same thing is we're regulatory constrained. We still have to go through Europe. And as I mentioned, IPE will come out in the second quarter in Australia and also. And as we gave that, obviously, we'll be scaling IPE too and understanding the dynamics around that. So it's more of a ramp, as I mentioned a few calls ago than anything."
},
{
"speaker": "Operator",
"text": "Our next question comes from Jason Bednar with Piper Sandler."
},
{
"speaker": "Jason Bednar",
"text": "I'm going to pile on here on the guidance, just to focus there first. You mentioned noncomprehensive mix as being an offsetting factor to ASPs. I know you've got that DSP factor. I had thought maybe originally you were signaling adults growing better than teens, but doesn't seem like that's the case just given your comments there to Brandon. But I guess, regardless on adults, are you seeing this market getting its footing back, it sounds like it, but if you are, what's giving you the confidence? Or what are you seeing that kind of the day-to-day or month-to-month that's showing adults are coming back into the office for treatment. And then sorry to load a few in here, but should we expect this faster noncomprehensive mix also to have gross margin benefits for the year as well? I think it typically does, but I don't think we've gotten kind of a gross margin cadence outlook for '24."
},
{
"speaker": "Joseph Hogan",
"text": "Jason, I'll take the first part of your question and hand the rest off to John, is we feel we're on a more stable, I'd call it, economic platform than last year. And so the adult and teen question that you had is we expect that to carry through in 2024, as we indicated with our guidance, too. So when I look back, everybody has a clear vision backwards than forward, we look back to last year, a pretty unstable platform that we experienced for the year and the third quarter was a tough one in that sense. But I think we all see it right now, we have more confidence that at least we're dealing with stability from an economic standpoint in most parts of the world from what we see."
},
{
"speaker": "John Morici",
"text": "And on the noncomprehensive and gross margin questions and related to that. Look, as we have the mix that shifts through and you might have an ASP lower on some of the non-comp DSP and others that fall into that. Those are our highest gross margin products from a rate standpoint. So they're helpful for us as a business. It's really what that customer wants for him or her to run their practice and that's how we balance things out. But overall, we expect that we would see benefits in gross margin just like we're talking about op margin year-over-year benefits, we should see a benefit as well in gross margin."
},
{
"speaker": "Jason Bednar",
"text": "All right. That's helpful. And then for the follow-up here, I'll ask on teens. It does look like you're back to gaining share against brackets and wires. It looks like the kind of the second consecutive quarter of that. I'm curious if you could talk maybe bigger picture, what's changed to what you think has changed over the last 3 to 6 months versus maybe the 12-plus months that preceded that. But do you think the share gains you're seeing versus brackets and wires, does that have to do with changes you made to that Teen Guarantee program middle part of last year? Or are there other items at the practice level or associated with your go-to-market activities that are driving that shift?"
},
{
"speaker": "Joseph Hogan",
"text": "You can always say that at Align, there's no single variable equations. And this is another one. The Teen Guarantee, we think is some of it, obviously, our portfolio and how we put that together, our DSP programs, the uniqueness of Invisalign First. All those things really help. And from an adult standpoint, with the firmer economic platform I talked about, I just think there's more confidence out there that we're starting to see lead through."
},
{
"speaker": "Operator",
"text": "Our next question comes from Michael Ryskin with Bank of America."
},
{
"speaker": "Michael Ryskin",
"text": "I want to start with DSP kind of where you left off really successful, obviously, and you had great growth year-over-year for the whole year. But it's kind of moved in sort of like a step function. If I just look at the numbers, 6,000, 7,000, 9,000 and then you're kind of like an 11,000, 12,000 range. Now you're in the 18,000, 19,000, 20,000 range. Is there another step function coming next year? Is there -- could you dig into a little bit into what's driving that? And just sort of where do you see that going over the next couple of years?"
},
{
"speaker": "John Morici",
"text": "Michael, this is John. I would say as we look to expand this out, it's been successful, every place that we've done, we've seen, as you said, North America starts with this. So you see some doctors start and then we have more and more doctors that sign up for the program. And then as the doctors sign up for the program, then they end up doing more and more volume with us. We've taken that same approach to other countries, and now we've introduced this in EMEA and other places. And the same thing happens. More and more doctors sign up for it. They start to see the benefits of it, and then they utilize it more. So it's really just a matter of now scaling this to other parts of the world because we find that this is really a nice way to supplement how a doctor wants to run their practice."
},
{
"speaker": "Michael Ryskin",
"text": "Okay. And then maybe a follow-up on a few questions that were asked on Cubicure and Direct 3D printing earlier. Really exciting technology that you unveiled late last year, and definitely see the opportunity. But could you help walk us through the road map a little bit sort of like what should we be looking for as sort of goal post 6 months out, a year out, 2 years out, just to sort of track progress and see how it -- see how it's progressing?"
},
{
"speaker": "Joseph Hogan",
"text": "Michael, it's Joe again. I think the best way to describe it to you, it's -- like I said in my script, it's a 1- to 3-year journey. And obviously, we'll -- we know how to make these aligners now. We understand how to do it. It's just a scalability of resin in the Cubicure process and that takes time. And we'll obviously report on it quarter by quarter. So you really understand where we're going and what the hurdles are and what the opportunities are."
},
{
"speaker": "Michael Ryskin",
"text": "Okay. Maybe if I could just tweak that a little bit. Is there -- just help us understand, is there anything in terms of -- when you talk about scalability of the resin and the polymer, if you're looking at comprehensive, noncomprehensive, you talked about retainers and being able to put those. Is there anything in terms of your portfolio that makes some products more amenable or would be amenable earlier than others? Or is this just going to be all or nothing?"
},
{
"speaker": "Joseph Hogan",
"text": "I mean obviously, the scale, you look at retainers first because units of one. And that's why you'd end up with comprehensive full cases in some way. And that's basically how we'll ramp."
},
{
"speaker": "Operator",
"text": "Our next question comes from Nathan Rich with Goldman Sachs."
},
{
"speaker": "Nathan Rich",
"text": "I wanted to ask on the Systems and Services revenue guidance for 2024. This looks low to me just given -- I think growth in '23 was basically flat, up slightly. With the Lumina launch, we thought it would maybe be up more than it was in 2023. So I don't know if you could just maybe elaborate on what you're expecting for that segment?"
},
{
"speaker": "John Morici",
"text": "Nate, this is John. We're looking at, like we said, this year, you're kind of in that mid-single digits. We do have Lumina, which helps, but there's also unknowns about the macro economy. We were very pleased with what we saw in the fourth quarter with doctors buying and actually doing better than what we had really guided to. So we're pleased with the performance of Q4, but we just want to make sure that as we ramp up Lumina that we're properly positioned there, and we'll update as we go along."
},
{
"speaker": "Nathan Rich",
"text": "Okay. Great. And then just going back to the margin cadence, I guess are there any either upfront or onetime costs associated with either the launches of Lumina or IPE that impact the margin in the early part of the year just as we think about cadence and sort of what the right baseline is."
},
{
"speaker": "John Morici",
"text": "There is some of that in Q1. We're ramping that up. So it's not a big, huge splash where there's a lot of expenses and kind of hits all in 1 quarter. But there is some ramp up, but that's factored into our guidance. So when we say that we expect the year-over-year in the first quarter to be slightly up, it's factored in -- those expenses are factored in."
},
{
"speaker": "Operator",
"text": "Our next question comes from Ann Wright with Morgan Stanley. You may proceed."
},
{
"speaker": "Unidentified Analyst",
"text": "You mentioned at the end of the call, some of the DTC customers that you are tailoring some of the offerings to. I guess, was this material at all in the quarter? Maybe it's not large enough at this point, but any sort of contributions in 2024 as we think about picking up some of that business? And then also, DSO relationships, has there been any changes there in terms of the relationships on that front? How would you characterize those at this point? Are you seeing any greater traction there? Do some of these new products really move the needle on some of those relationships or conversations you're having?"
},
{
"speaker": "Joseph Hogan",
"text": "Ann, on the DTC customers, we've always argued that, that wasn't our marketplace in the sense of the price point and all. But I mean, obviously, these patients will pursue treatment. Now probably more so for doctors than DTC. And we're just doing what we can in order to support those customers going forward. But again, as I was clear in my script, we're a doctor-focused client company, and we'll keep it that way. But we do see this as being a certain opportunity. It's just hard for us to quantify right now. On the DSO relationships, I'd say this has gotten stronger all around the globe. Two to call out would be Heartland and [indiscernible] being more new ortho side and Heartland being more on the GP side. But we have really good relationships and we leverage our portfolio well with them to help them grow and we grow with them. So I feel good about our position with DSOs, and we have good strong relationships out there with them."
},
{
"speaker": "Operator",
"text": "Our next question comes from Brandon Couillard with Jefferies."
},
{
"speaker": "Brandon Couillard",
"text": "Joe, given the positive macro shift we've seen in the last few months with consumer confidence coming back, any chance you can comment on what you've seen in case starts in January an inflection? And then with respect to the '24 growth outlook. Any chance you could break that out between Americas and International."
},
{
"speaker": "Joseph Hogan",
"text": "Yes. I can't -- I really wouldn't break it out between Americas and International because we felt good about the geographies in general as you went across the world for especially latter half of the fourth quarter of last year. As we go into this year, as I talk about, we're looking at, I think, a stable economic platform. Some of the data that you cited would support that overall. And we feel good about our new products. We think we can play offense. And that's what we're focused on right now."
},
{
"speaker": "Brandon Couillard",
"text": "Okay. And then one housekeeping one for you, John. The fourth quarter operating cash flow was pretty weak. Can you just unpack any of the moving parts that might have been onetime in the quarter. It looks like there was a spike in prepaid expenses on the balance sheet. But anything you would call out?"
},
{
"speaker": "John Morici",
"text": "Things that related to like tax payments and things. It's just some timing as things go through the year. But we feel great. I mean, it's a great model. It generates a lot of cash. It gives us a lot of flexibility, and we were able to use that cash, that $350 million buyback that we did last quarter."
},
{
"speaker": "Operator",
"text": "And we have reached the end of our question-and-answer session. I will now turn the call back over to Shirley Stacy for closing remarks."
},
{
"speaker": "Shirley Stacy",
"text": "Thank you, everyone. We appreciate you joining us today. We look forward to speaking with you at upcoming financial conferences and at industry meetings such as Chicago Midwinter. If you have any questions or follow-up, please contact our Investor Relations. Thanks, and have a great day."
},
{
"speaker": "Operator",
"text": "Thank you. This concludes today's conference, and you may disconnect your lines at this time. Thank you for your participation."
}
] | Align Technology, Inc. | 24,568 |
ALGN | 3 | 2,023 | 2023-10-25 16:30:00 | Operator: Welcome to Align Technology, Third Quarter 2023 Earnings Call. [Operator Instructions] Please note that this conference call is being recorded. I would now like to turn the conference over to your host, Shirley Stacy, with Align Technologies. You may begin.
Shirley Stacy: Thank you. Good afternoon and thank you for joining us. I'm Shirley Stacy, Vice President of Corporate Communications and Investor Relations. Joining me for today's call is Joe Hogan, president and CEO, and John Morici, CFO. We issued third quarter 2023 financial results today via Businesswire, which is available on our website at investor.aligntech.com. Today's conference call is being audio webcast and will be archived on our website for approximately one month. As a reminder, the information provided and discussed today will include forward-looking statements, including statements about Align's future events, products and outlook. These forward-looking statements are only predictions and involve risks and uncertainties that are described in more detail in our most recent periodic reports filed with the Securities and Exchange Commission, available on our website and at sec.gov. Actual results may vary significantly and Align expressly assumes no obligation to update any forward-looking statement. We have posted historical financial statements, including the corresponding reconciliations, including our gap to non-GAAP reconciliation if applicable, and our third quarter 2023 conference call slides on our website under Quarterly Results. Please refer to these files for more detail. Note as of Q3, DSP touch-up cases and associated revenues have been reclassified to the non-comprehensive clear Aligner segment and are now reflected in our reported clear Aligner case volumes, revenues and business metrics. Prior to this quarter, they were not reported in the non-case category. Unless otherwise stated all metrics include DSP touch up cases in reported clear Aligner volumes. With that, I'll turn the call over to Align technologies President and CEO Joe Hogan. Joe?
Joseph Hogan: Thanks, Shirley. Good afternoon and thanks for joining us. On our call today I'll provide an overview of our third quarter results and discuss a few highlights from our two operating segments, Systems and Services and Clear Liners. Jon will provide more detail on our Q3 financial performance and comment on our views for the remainder of the year. Following that, we'll come back and summarize a few key points and we'll take questions. Our third quarter results reflect lower than expected demand in a more difficult macro environment than we experienced in the first half of 2023. Dental practices and industry research firms have reported deteriorating trends, including decreased patient visits and increased patient cancellations, along with fewer orthodontic case starts overall, especially among adult patients. The September Gauge report, which reflect more than 1200 North American Orthopactices shows deceleration for orthodontic treatment, and new orthodontic patient appointments were down 8.7% year over year, and ortho case starts were down 6.9% year over year, the biggest decrease in over a year. Despite these headwinds, total Q3 worldwide revenues of 960 million were up 7.8% year over year, with growth across all regions. For Q3, we had record clear liner shipments to teenage and younger patients, which increased 10% sequentially, and 8.4% year over year, driven by continued strength from iInvisalign First. Q3 year over year revenue growth also reflects improvement in APAC, offset by more pronounced summer seasonality in EMEA and North America. Our Q3 systems and services revenues were up 4.9% year over year despite continued challenges for capital equipment, primarily due to higher iTero scanner volumes in the Americas and APAC regions, reflecting certified preowned or what we call CPO sales, scanner, leasing and rental programs, as well as increased services revenue. Q3 systems and services revenues were down sequentially, primarily due to a weaker capital equipment cycle, as well as lower non-systems revenues. This was partially offset by higher scanner volumes in the Americas, reflecting an increased mix of iTero 5D plus scanners, including more trade in trade ups for DSO customer in Q3. Q3 non-case revenues were up 13.5% year over year, primarily due to continued growth from Vivera retainers and increased adoption of Invisalign Doctor Subscription Program, or DSP, our monthly subscription based clear liner program, which includes retainers, low stage touchup and clear liner treatment. For Q3, we shipped over 19,000 DSP touchup cases, primarily in North America, an increase of more than 70% year over year from Q3 '22. DSP continues to be well received by our customers and is currently available in the US, Canada, Iberia and the Nordics. We are excited about the DSP is proving helpful to doctors and their patients. We're continuing to expand the program in EMEA and with certain DSO partners in Q4. For Q3, total clear aligner volumes were down 3.3% sequentially and up 2.3% year over year, primarily reflecting weaker than expected demand for orthodontic treatment, especially for adult patients. As I said earlier, despite soft consumer trends, our teen and younger patient business was strong across all regions, up both sequentially and year over year, primarily due to continued adoption of invisalign first for kids as young as six years old. In terms of invisalign submitters, the total number of doctors shipped for Q3 increased sequentially to approximately 85.2 thousand doctors, the highest number in two years, driven by the Americas and APAC regions. From a channel perspective, orthodontist submitters were up year over year, especially from doctors submitting teenage cases, offset by fewer GP dentists year over year, particularly in the Americas. On a geographic basis, Q3 clear aligner volumes reflect a sequential increase in invisalign shipments from the APAC and Latin American regions, as well as North American Invisalign teenage cases, this is offset by lower volume and more pronounced softness from summer seasonality in EMEA and North America, primarily invisalign adult cases. For the America's invisalign case volume, Q3 '23 was down sequentially, primarily due to lower invisalign adult shipments in the GP channel and slightly down year over year. Q3 '23 clear aligner volumes reflect increased submitters in the Ortho channel, with an increase in teen and younger case starts driven by momentum from invisalign first. This is reflected in the September Gauge data, which shows an invisalign orthostart performed better than wires and brackets and other clear liners. In North America, adoption of invisalign comprehensive three and three product drove sequential volume growth in Q3 '23. Invisalign DSP touchup cases in North America also drove growth sequentially year over year. For a EMEA [ph] Q3 Three clear liner volumes were down sequentially, primarily from the impact of Q3 summer seasonality when doctors offices are closed for summer vacations and more consumers are traveling. This was partially offset by sequential growth in Italy, Benelux, Turkey and the Middle East. Year over year clear liner volumes were up reflecting continued adoption of invisalign moderate, the comprehensive three and three product, as well as an increase in Teen Case starts, driven primarily by Invisalign first and our new Invisalign Teen Case packs. For APAC Q3'23 Clear Aligner volumes were up sequentially and up year over year reflecting improving trends in China as well as other key markets like India, Taiwan, Korea, Japan and Thailand. Q3 APAC results also reflected increased invisalign submitters and higher utilization, especially for teen patients driven by growth from invisalign first in the Orthodontic channel during our typically strong teen season in China. Q3 APAC results also reflect growth in a GP channel with increased invisalign submitters and higher utilization sequentially and year over year. During Q3, we continue the rollout of Invisalign comprehensive three and three product in APAC most recently launched in China. Invisalign comprehensive three and three is also available in Hong Kong, Korea, Taiwan and India. We are pleased with the adoption of the three and three product in APAC, where the majority of cases treated are comprehensive, allowing our doctor customers more flexibility within the invisalign product portfolio. During the quarter, we also shipped to a record number of doctors in APAC, increasing both sequentially and year over year. Invisalign is the most trusted brand in the orthodontic industry globally, and it's important that we continue to create demand for invisalign clear aligners, especially given the macroeconomic pressures on doctors and their patients. In Q3- three, we delivered 11.1 billion impressions and had 27.7 million visits to our websites globally. To increase awareness and educate young adults, parents and teens about the benefits of the invisalign brand, we continue to invest and create campaigns in top media platforms such as TikTok, Instagram, YouTube, Snapchat, WeChat and Dillion across markets. The underlying market opportunity for clear liner of treatment, especially for teens and kids, remains huge and significantly underpenetrated. We know invisalign clear liner of treatment is faster and more effective than Braces [ph] yet the vast majority of orthodontic cases are still treated using brackets and wires. Differentiation is key to increasing invisalign share of the orthodontic case starts, especially among teens and their parents. We are continuing to differentiate through novel campaigns such as our new Invis is Drama Free campaign ., which uses humor to juxtapose the significant benefits of invisalign treatment over metal braces. Similarly, to differentiate invisalign treatment for adults, we launched new campaigns globally using powerful patient stories that share how important a smile is and how invisalign treatment increases self confidence that transforms lives. Reaching young adults as well as teens and their parents also requires the right engagement through invisalign influencers and creator centric campaigns, which delivered 5.8 billion impressions in the Americas in Q3. Creators such as Michael Simoneau, Jalen Hall, NFL player Darren Warren and also Leilani Green showed their results and why they chose to transform their smiles with invisalign aligners. In the EMEA [ph] region, we partnered with Influencers to reach consumers across social media platforms including TikTok and Meta, and launched our Global Consumer Campaign for teens and parents of teens, highlighting the benefits of invisalign treatment versus braces. In Germany, we continue to see positive engagement with our patient testimonial campaigns launched in the previous quarter. Our consumer campaigns delivered more than 1.4 billion media impressions and 6.9 million visitors to our website. We continue to invest in consumer advertising across the APAC region, resulting in more than 3.9 billion impressions and 11.9 million visitors to our websites in the quarter. We expanded our reach in Japan and India via Meta and YouTube, and partnered with key Influencers to reach consumers across social media. We saw increased brand interest from consumers, as evidenced by an over 800% increase in unique visitors to our website in India and 135% increase in Japan. Finally, digital tools such as My Invisalign Consumer and Patient app continue to increase with 3.4 million downloads to date and over 367,000 monthly active users, representing a 19% year over year growth. With that, I'll now turn the call over to John.
John Morici: Thanks Joe. Now for our Q3 '23 financial results. Total revenues for the third quarter were $960.2 million, down 4.2% from the prior quarter and up 7.8% from the corresponding quarter a year ago. On a constant currency basis, Q3 revenues were impacted by unfavorable foreign exchange of approximately $2.7 million, or approximately 0.3% sequentially and favorably impacted by approximately $4.2 million year over year, or approximately 0.4%. For clear aligners, Q3 revenues of $794.9 million were down 4.5% sequentially, primarily from lower volumes and lower ASPs. On a year over year basis, Q3 clear aligner revenues were up 8.5%, primarily due to higher ASPs, higher volumes and higher non case revenues. For Q3 invisalign ASPs for comprehensive treatment were down sequentially and up year over year. On a sequential basis, ASPs reflect larger discounts, product shift, mix shift to lower priced products and unfavorable foreign exchange, partially offset by higher additional aligners. On a year over year basis, the increase in comprehensive ASPs reflect higher additional aligners and price increases, partially offset by larger discounts and unfavorable product mix shift. For Q3 invisalign ASPs for non-comprehensive treatment were down sequentially and up year over year. On a sequential basis the decrease in ASPs reflects larger discounts, higher sales credits, and unfavorable product mix, partially offset by higher additional liners and favorable foreign exchange. On a year over year basis, the increase in non-comprehensive ASPs reflects price increases, higher additional aligners and favorable foreign exchange, partially offset by product mix shift. In Q1 '23 we launched the invisalign comprehensive Three and Three product. The Three and Three configuration offers our doctor customers invisalign comprehensive treatment with three additional liners included within three years of the treatment end date, instead of unlimited additional liners within five years of the treatment end date. At the 2022 Invisalign comprehensive product price, Invisalign comprehensive Three and Three product is available in North America and in certain markets in EMEA and APAC, most recently launching in China, Korea, Hong Kong and Taiwan. We are pleased with the continued adoption of the Invisalign comprehensive Three and Three product and anticipate it will continue to increase, providing doctors the flexibility they want and allowing us to recognize more revenue upfront with deferred revenue being recognized over a shorter period of time compared to our traditional Invisalign comprehensive product. As we begin to ship more additional aligners for comprehensive Three and Three products, we expect to see an ASB benefit. As revenues from subscriptions, retainers and other ancillary products continue to grow globally some of the historical metrics that only focus on case shipments are expected to account for a lesser percentage of our overall growth. In our earnings release and financial slides, you will see that we have added our total clear aligner revenue per case shipment, which we believe to be a more indicative measure of our overall growth strategy. Q3 '23 clear aligner revenues were impacted by unfavorable foreign exchange of approximately $2 million, or approximately 0.3% sequentially. On a year over year basis clear aligner revenues were favorably impacted by foreign exchange of approximately $3.8 million, or approximately 0.5%. Clear aligner deferred revenues on the balance sheet increased $14.1 million, or up 1.1% sequentially and up $116 million or up 9.9% year over year, and will be recognized as the additional liners are shipped. Q3 '23 systems and service revenues of $165.3 million were down 2.5% sequentially, mostly due to unfavorable ASPs and lower revenues from our certified preowned program, partially offset by higher scanner volume and higher services revenues. On a year over year basis, Q3 '23 systems and services revenue were up 4.9% due to higher scanner volume, higher services revenue from our larger base of scanners sold, and higher revenues from our certified preowned and leasing rental programs, partially offset by unfavorable ASPs. Q3 '23 systems and services revenues were impacted by unfavorable foreign exchange of approximately $0.7 million, or approximately 0.4% sequentially. On a year over year basis system and services revenues were favorably impacted by foreign exchange of approximately $0.4 million, or approximately 0.3%. Systems and services deferred revenues on the balance sheet was down $4.4 million, or 1.6% sequentially, primarily due to the decrease in the deferral of service revenues included with scanner purchases and essentially flat or up slightly to 0.1 million or 0.1% year over year. Services deferred revenues will be recognized ratably over the service period. As our scanner portfolio expands and we introduce new products, we increase the opportunities for customers to upgrade, make trade ins and purchase certified pre owned scanners in certain markets. Developing new capital equipment opportunities to meet the digital transformation needs of our customers and DSO partners is a natural progression for our equipment business with a large and growing base of scanners sold. Moving on to gross margin, third quarter overall gross margin was 69.1%, down 2.1 points sequentially and down 0.5 points year over year. Overall gross margin was unfavorably impacted by foreign exchange by approximately 0.1 point on a sequential basis, and favorably impacted by foreign exchange by approximately 0.1 point on a year over year basis. Clear aligner gross margin for the third quarter was 70.7%, down 1.7 points sequentially, primarily from higher manufacturing spend and a higher mix of additional aligner volume and lower ASPs. Clear aligner gross margin for the third quarter was roughly flat year over year, primarily due to increased manufacturing spend as we continue to ramp up operations at our new manufacturing facility in Poland, partially offset by higher ASPs. Systems and services gross margin for the third quarter was 61%, down 4.1 points sequentially, primarily from lower ASPs, partially offset by favorable manufacturing variances, lower service and freight costs, and higher services revenues. Systems and services gross margin for the third quarter was down 2.3 points year over year, primarily from lower ASPs, partially offset by favorable manufacturing variances, lower service and freight costs, favorable foreign exchange, and higher service revenues. Q3 '23 operating expenses were $496.7 million, down sequentially 8.3% and up 4.5% year over year. On a sequential basis, operating expenses were down $44.9 million, primarily from lower consumer marketing spend and lower incentive compensation. Year over year, operating expenses increased by $21.2 million, primarily due to higher incentive compensation in our continued investments in sales and R&D activities, partially offset by controlled spending on advertising and marketing, as part of our efforts to proactively manage costs. On a non-GAAP basis, excluding stock based compensation and amortization of acquired intangibles related to certain acquisitions, operating expenses were $458.2 million, down 9.3% sequentially and up 3.3% year over year. Our third quarter operating income of $166.3 million resulted in an operating margin of 17.3%, up 0.1 points sequentially and up 1.2 points year over year. Operating margin was unfavorably impacted by approximately 0.3 points sequentially, primarily due to foreign exchange. The year over year increase in operating margin is primarily attributable to operating leverage, partially offset by investments in our go to market teams and technology, as well as unfavorable impact from foreign exchange by approximately 0.1 point. On a non-GAAP basis, which excludes stock based compensation and amortization of intangibles related to certain acquisitions, operating margin for the third quarter was 21.8%, up 0.5 points sequentially and up 1.6 points year over year. Interest and other income expense net for the third quarter was a loss of $4.2 million, compared to a loss of $0.3 million in the second quarter and a loss of $21 million in the third quarter a year ago, primarily due to foreign exchange. The GAAP effective tax rate for the third quarter was 25.1% lower than the second quarter effective tax rate of 34.8%, and lower than the third quarter effective tax rate of 40.7% of the prior year. The third quarter GAAP effective tax rate was lower than the second quarter effective tax rate, primarily due to the application of newly issued tax guidance and lower US taxes on foreign earnings in Q3. As a reminder, in Q4 '22, we changed our methodology for the computation of our non-GAAP effective tax rate to a long term projected tax rate and have given effect to the new methodology from January 1, 2022, and recast previously reported quarterly periods in 2022 2022. Our non-GAAP effective tax rate in the third quarter was 20%, reflecting the change in our methodology. Third quarter net income per diluted share was $1.58, up sequentially $0.12 [ph] and up $0.65 compared to the prior year. Our EPS was unfavorably impacted by $0.08 on a sequential basis and unfavorably impacted by $0.05 on a year over year basis due to foreign exchange. On a non GAAP basis, net income per diluted share was $2.14 for the third quarter, down $0.08 sequentially and up $0.51 year over year. Note that the prior year 2022 non-GAAP net income and prior year 2022 non-GAAP EPS reflects the Q4 '22 change in our methodology for the computation of our non-GAAP effective tax rate. Moving on to the balance sheet. As of September 30, 2023, cash equivalents and short and long term marketable securities were $1,301.9 billion [ph] up sequentially, $268.1 million, and up $160.9 million year over year. Of our $1.3 billion dollar balance, 381 million was held in the US and $920.6 million was held by our international entities. Q3 accounts receivable balance was $904.2 million down sequentially, our overall day sales outstanding was 84 days, up approximately three days sequentially and down approximately two days as compared to Q3 last year. Cash flow from our operations for the third quarter was $287.2 million. Capital expenditures for the third quarter were $21.6 million, primarily related to our continued investments to increase aligner manufacturing capacity and facilities. Free cash flow, defined as cash flow from operations, less capital expenditures amounted to $265.6 million. Now, turning to our fourth quarter outlook. For Q4 '23, assuming no circumstances occur that are beyond our control, we anticipate our worldwide revenue to be in the range of $920 to $940 million down sequentially from Q3 of '23. We expect both clear aligner and systems and services revenues to be down sequentially, reflecting a more challenging macro environment for doctors and patients with fewer orthodontic case starts overall unfavorable foreign exchange given the strengthening of the US dollar against key currencies and longer sales cycles for capital equipment purchases. For our clear aligner business, we expect clear aligner teen volume to be seasonally lower in Q4 of '23, and we don't anticipate improvement in adult volumes. For Q4 '23, we also expect clear aligner ASPs to be down sequentially, primarily due to the strengthening US dollar. For our systems and services business, we anticipate increasing headwinds for macro uncertainty and potential supply issues related to the war in the Middle East. We expect our Q4 '23 GAAP operating margin to be down sequentially from Q3 of '23 due to restructuring primarily related to severance as we adjust headcount for this environment. We anticipate our non-GAAP operating margin to be up sequentially from Q3 of '23. During Q1 '23, we announced that our Board of Directors authorized a new $1 billion stock repurchase program to succeed the 2021 $1 billion program. Currently, $1 billion remains available for repurchase under the 2023 stock repurchase program. During Q4 '23, we expect to repurchase up to $250 million of our common stock through either or a combination of open market repurchases or an accelerated stock repurchase agreement. For full year 2023, assuming no circumstances occur that are beyond our control, we anticipate our 2023 worldwide revenue to be in the range of $3.83 billion to $3.85 billion. We also expect our full year 2023 GAAP operating margin to be roughly one point lower than 2022 and our 2023 non-GAAP operating margin to be slightly above 21%. For 2023, we expect investments in capital expenditures to be approximately $200 million. Capital expenditures are expected to primarily relate to building construction and improvements as well as manufacturing capacity in support of our continued international expansion. With that, I'll turn it back over to Joe for final comments. Joe.
Joseph Hogan: Thanks, John. While our third quarter results and fourth quarter outlook reflect weaker consumer sentiment and increased headwinds including foreign exchange, Align is in a unique position to continue driving the digital revolution in the dental industry to help doctors transform and grow their practices with invisalign clear aligners, Itero Scanners and Align digital platform. We are very excited about the recent innovations developed to further revolutionize digital treatment planning for Orthodontics and also restore to dentistry by providing doctors with greater flexibility, real time treatment plan modification capabilities, and digital solutions to help improve practice productivity and patient experience, which are even more important to our customers in the current environment. This includes clincheck live update for 3D controls invisalign practice App, invisalign personal plan or IPP, Invisalign Smile Architect, Itero exocad [ph] connector Invisalign Outcome Simulator pro and invisalign virtual Care AI software. These digital tools are continuing to gain adoption and help doctors gain efficiencies. In Q3 Clincheck Live Update was used by 41,000 doctors on more than 560,000 cases, reducing time spent and modifying treatment by 21%. Invisalign Practice app is now actively used by about 87,000 doctors, with over 5.2 million photos uploaded during the quarter via the Practice app. In addition, we will launch Invisalign Pallet expander or IPE system in Canada this quarter. IP is our first direct printed orthodontic device that provides a safe, comfortable, and clinically effective alternative to metal paddled, expanders and boosts our market opportunity in the teen market by addressing a portion of cases we couldn't otherwise treat without IPE. In summary, we're committed to balancing our investments in near and long term growth drivers while delivering improved operating margin as we navigate one of the most challenging operating environments in recent history with increasing macroeconomic pressure on doctors and their patients, we have an enormous opportunity to continue driving adoption of digital orthodontics and restorative dentistry and a responsibility to optimize our investments for the current environment. Before turning the call over for questions, I'd like to address the war in the Middle East and our Itero scanner business. The situation continues to evolve and is very fluid. We are monitoring developments closely. Our singular focus at this stage is on the safety and security of our employees and their families and our doctors and their staff and patients. Align offices and scanner manufacturing facility in Israel are currently open and operating. While we hope the situation will improve, we're preparing mitigation plans to ensure business continuity and we'll update our customers and other stakeholders as needed. Now I'll turn the call back over to the operator for questions.
Operator: Certainly. [Operator Instructions] And our first question comes from the line of Jason Bednar from Piper Sandler. Your question, please.
Joseph Hogan: Hi, Jason.
Operator: Jason, you might have your phone on mute.
Shirley Stacy: Operator, you want to go to the next question?
Operator: Certainly.
Shirley Stacy: And we'll come back.
Operator: Certainly. One moment. And our next question comes in line Brandon Vazquez from William Blair. Your question, please.
Brandon Vazquez: Hey, everyone, thanks for taking the question. On the first one, maybe can we just start a little bit? It sounds like macro, and given the data that you guys were talking about is probably getting a little worse into the end of the year. Maybe just talk about how that kind of trended through the quarter, how we're trending now. I think what a lot of us are trying to get our head around is what's the direction of macro in the dental space going into the end of the year and into 2024, especially as you look at kind of the consumer and then CapEx on scanners. So how are you guys seeing that from your end right now?
Joseph Hogan: When you look at the fourth quarter and the way we have done our forecast overall, we felt great about teens in the third quarter and what we reported to, but adults were really highly affected. And when you run through the fourth quarter, it's primarily an adult season for us. And China is a big teen season in the third quarter, too. When you look at the gauge data for September and what we see in October so far, and even some of the consumer profiles around how they're feeling about their finances and all, we've basically just projected what we've seen in September forward to the fourth quarter.
Brandon Vazquez: Okay. And then maybe as a follow up on the teen side, it sounds like the Ortho channel, based off the market data you have, is that teens are declining year over year. But you guys, or at least sequentially, you guys are up both, it looks like. So are you guys taking share within the teen market? It's a little bit of a funny dynamic because I think earlier this year, as the Ortho channel got a little weaker, they were going to wires and brackets. But it seems like now you're taking share. How durable is that and what are you guys kind of seeing that's driving that in the underlying market? Thanks.
Joseph Hogan: We were happy to see that change and the gauge data that showed wires and brackets going down and competitive aligners going down and us going up. But you can't draw a line through one dot. We feel good again about the technology and all that. We're presenting the Efficiencies and all we're offering to Orthodontists, and we think that's a good stimulant in that sense. But right now, we're going to have to take this thing quarter to quarter.
Operator: Thank you. One moment for our next question. And Jason Bednar from Piper Sandler. Your line is open.
Joseph Hogan: Hi, Jason.
Operator: Jason, we're still not hearing you. Shall I move on? Yes, please. Certainly. One moment for our next question. And our next question comes from the line of Jeff Johnson from Baird. Your question, please.
Operator: Mr. Johnson, your line is open. One moment - certainly as we go to our next question. Our next question comes from the line of Jon Block from Stifel. Your question, please.
Jon Block: Hey, guys, can you hear me okay?
Joseph Hogan: Hey, John. Just fine.
Jon Block: All right, so far so good. Maybe a couple of questions. I'll start right now, you just seem highly tethered to the consumer. But in '24, you've got some incrementals, right? You just launched IP in Canada. You've got remote monitoring. We think maybe you have a new scanner. So just like your thoughts on the ability for the company to manufacture more of your own growth in 2024, and any commitment to grow revenues year over year in '24. And where I'm going with that is even the revised guidance you'll grow year over year in 2H '23. But if I annualize your 4Q number and just sort of run rate that you arguably land down year over year with call it a more dynamic set of innovation. So not asking for a number, but clearly things are moving around. And how do we think about what that means again, to manufacture your own growth in '24 and any commitment to have positive revenue growth in '24?
Joseph Hogan: Hey, John, it's a good question that's one of the things we talk about obviously here is with what we presented at the Investors conference and the new technology that we're offering, those are areas that we can really expand what we call our penetration in the marketplace and control a certain amount of our destiny. I think you know as well as know we can't fight a market from a down standpoint in the sense of that that won't affect us in some way. I would throw DSP into that whole question also because you see the continued growth in DSP and I'd say a business model change. And so those kinds of things, I feel like we can drive more demand in the marketplace as we get into 2024. I just can't preclude what that consumer sentiment is going to look like at that point in time, but it certainly gives us also the efficiency gains that we show through the software that I just talked about in my script, too, with different orthodontists that seem to be taking hold and you pick up in your surveys also, John. So we do feel good about that. It's just the uncertainty of this marketplace and it obviously surprised us coming out of the third quarter. We're going to have to get through this quarter, and as we go into 2024, we can be more specific about what we think, what that opportunity is.
Jon Block: Okay, that was very helpful. And then maybe just this might build on Brandon's question earlier, but when you guys guide, you've got almost half the quarter in the bag. So clearly things changed, notably in the last seven weeks of the third quarter. I know you guys called out Gage's September data. Joe, you referenced the October what was the 3Q deviation? I mean seems like it was largely North America. And EMEA, did APAC perform as expected, if you could answer that. And then I guess where I'm struggling is I think we all know it's not a robust consumer out there and that narrative around soft landing or not, if that holds true, but it doesn't seem like things changed all that dramatically in the last seven weeks. And so anything you can give Joe to elaborate, because clearly the exit rate in the quarter was very different than the way things started. Thank you.
Joseph Hogan: Yeah. John, you know, third quarter is I call, our most non linear quarter, and it's the most difficult to predict. And it's because it know three major components to it. One is obviously the seasonality of our European business because of the vacation base or whatever, and the way that comes back is not always consistent. And in this case, it did not come back in the way that we had hoped it would. Secondly is you count on a big China teen market. And we did well in China, I feel, from a growth standpoint, but it wasn't to a point that it could offset a slower rebound overall from a European standpoint. And the last thing is, in the United States, that lack of adult cases I mean, we did well on teen that lack of adult cases when we went into September was really felt. And so it's those three key variables that I think, is how we came out of this differently than what we anticipated as we went in.
Jon Block: Thanks, guys.
Joseph Hogan: Thanks, John.
Operator: Thank you. One moment for our next question. And our next question comes from the line of Elizabeth Anderson from Evercore ISI your question, please.
Elizabeth Anderson: Hi, guys. Thanks so much for the question. My question is so if we think about obviously we're talking about consumer weakness and sort of the cyclicalness of the business. If we think about sort of the headcount reduction and the SG&A spend can you help us parse out a little bit more about the cuts and how to think about how to sort of preserve margin as sort of we're seeing weaker demand and then how you need to invest again on the upcycle in order to continue to push penetration in what's obviously a very largely underpenetrated market over a longer period.
John Morici: Hey, Elizabeth, this is John. So as we go through our planning process, like we do every year, we're prioritizing investments that we can continue to invest to be able to help grow the business. So we look at some R&D and some of the investments we make. We have a lot of new products coming to market, as we've talked about at Investor Day. We want to preserve that flow of products. We want to make sure we're properly reaching our customers so we prioritize some of the sales and go to market activities that we have around that. But we're looking at all parts of the business to say, okay, what can we adjust? What can we make adjustments to still deliver on our priorities that we have as a business to help try to grow with the means that we've seen, but then also deliver the profitability and being able to see this margin accretion. We've seen that all year as we've gone through. And essentially what we're calling for in the fourth quarter is the continuation of that margin accretion. And that's just through a combination of just looking at those investments and making sure that we properly invest for the future.
Elizabeth Anderson: Got it. And maybe as a follow up, obviously I have hope for the safety of all of your employees in Israel. Can you talk about sort of the capacity of that organization if sort of things stay as they are? Is that something where you're sort of drawing down inventory elsewhere, not able to produce, if any, more details you could provide on that obviously unfortunate situation.
John Morici: Back to know we're producing over there right now. I don't give you this. It's a reasonable amount of capacity. I've had other businesses in Israel at times like this, too. Not this bad. But in those situations, I feel like where it is now, we can manage it. As we talked about in the script, if the things get worse, the war over there. We can't guarantee what we have. But we have a terrific team there, very dedicated team. They're working both sides of the angle right now. We're bringing in materials. We're converting those materials, we're shipping those out. So the business is operating fine right now, but we have to just wait in the upcoming weeks and see what develops on their homeland.
Elizabeth Anderson: Got it. Thank you very much.
Operator: Yeah, thank you. One moment for our next question. And our next question comes from the line of Aaron Wright from Morgan Stanley. Your question, please.
Aaron Wright: Great, thanks. I'm curious if you could break down a little bit the key components of the teen case volume trend you saw in the quarter by geography, specifically in the Americas region, and what's driving that. And I think you mentioned, like, invisalign first and how we should be thinking about visibility across that patient cohort just given you have some more inherent control over maybe that segment in this sort of environment. And then second part of my question is just more of a clarification, I guess, in terms of the fourth quarter guidance. Does it specifically assume that there's a further deterioration in the macro or just a continuation of what you saw in this September experience? And I just want to understand the buffers I guess you have in that expectation at this point. Thanks.
Joseph Hogan: As far as the teenage patients, again, we're really pleased with the growth that we saw in teens, and it's a very important teen season. I think the teens perform extremely well. We saw strength across every geography. We saw in Europe. We saw in North America. We also saw it in China. I think our portfolio helps us a lot invisalign first. We led with that. Remember, those are patients that are anywhere between six and ten years old. We really have terrific results in those areas, but also with permanent dentition. We saw some good growth, too. So overall, I feel like it's a strong indication in the sense that we're hitting the dot, in the sense of where we want to with those specific consumers, and through the advertising programs that I talked about and also through our digital platform and then the specific products, like invisalign first and then IPE that rolls into Canada. And then more broadly as we move into 2024.
John Morici: And just on the fourth quarter, Aaron really taking what we see in September continues into October, and we assume that things don't get better than what we saw in September. So it's a tough macro environment. There's less orthodontic case starts, lower patient traffic. And so we factor in all those based on what we saw, and that's what our projection is for. Q four.
Aaron Wright: Okay. Thank you.
Operator: Thank you. One moment for our next question. And our next question comes from the line of Jeff Johnson from Baird. Your question, please. Jeff, I don't know if you're on a speaker phone, but if you could lift the handset if that were the case. Still not hearing anything from Mr. Johnson. One moment for our next question .And our next question comes from Jason Bednar from Piper Sandler. Your question, please. Still not hearing Jason?
Shirley Stacy: That's strange. We certainly will follow up with both Jeff and Jason. Operator, do you mind just going to the next question, please?
Operator: Certainly. One moment for our next question. Our next question comes from the line of Nathan Rich from Goldman Sachs. Your question please.
Nathan Rich: Great, thank you. Can you hear me okay?
Joseph Hogan: Yes.
Nathan Rich: Okay, great. Joe, you mentioned the focus on delivering improved operating margins and you guided to non GAAP margins being up sequentially in the fourth quarter despite the reduction in the revenue guidance. I guess as we think about the business going forward, should we think about that four Q margin as a good base level for the business even in an uncertain demand environment? And are there additional actions you can take on the cost side to give yourself some additional cushion for margins going forward?
Joseph Hogan: You've been watching us long enough to know that each of our quarters have a certain personality in the sense of the kind of operating profit we deliver. You can see in the fourth quarter that we feel good about where we stand right now and the levers that we can pull in order to deliver the operating margin that John talked about. So – I think you know, more than anything, I want the investors to understand that while we have this uncertain environment, from a demand standpoint, we're going to be responsible on cost. We'll invest in technology and we'll focus in those areas, but we're always looking closely in the sense of where we can rationalize, also where we can prioritize in different areas that will help in that operating profit area. John, anything you want to add on that's?
John Morici: So we'll see the benefit that we've seen all year to be able to see that operating margin improvement. But as Joe said, we're prioritizing our investments. We look at this time as we finalize our plan for next year. But we have got a lot of technology coming and we want to make sure that we're properly invested there as well as being able to deliver like we can on an margin basis.
Nathan Rich: Okay, great. And if I could just ask a follow up on the 4Q guidance for clear liner volumes. I think you had said that you don't expect improvement in adult and had talked about, I guess, modeling what you saw in September through the fourth quarter. I guess how should we think about adult cases relative to the 381,000? I guess when we take that together, given how it sounds like September shaped up, should we expect a decline off of that 381 level in the fourth quarter for the adult cases specifically?
Joseph Hogan: I think when you look at things, Nathan, like we said, teen showed up well in the third quarter. We're pleased with that. Seasonally comes down in the fourth quarter. And based on what we saw in September and so far in October, I think you would expect to see adults down as well.
Nathan Rich: Great. Thank you for the color.
Operator: Thank you. One moment for our next question. And our next question comes from the line of Brandon Couillard from Jeffries. Your question, please.
Brandon Couillard: Hey, thanks. Good afternoon. Just a clarification, Joe or John on the adult trends and the weakness, is that predominantly in the US or is it about to extend outside the US as well? If you have any chance, you're willing to take a stab at some of the factors behind that and whether or not student loan repayments may be contributing to some of the [indiscernible] and sentiment in that customer base.
Joseph Hogan: Remember, third quarter is a big teen quarter, but adults are obviously a large component of that. We saw that adult phenomenon in North America, but we saw it across each geography.
Brandon Couillard: Okay, then just to follow up, John, on the fourth quarter, margins operating margins up with revs down sequentially, is that all coming from OpEx, or would you expect gross margins to bounce up sequentially as well?
John Morici: When we talked about down sequentially on Op margin, that was on a GAAP basis. We have some of the restructuring and other things that include we expect sequential improvement on a non-GAAP basis from Q3 to Q4. And we didn't give specific gross margin guidance, but we're working to try to make sure that we work on our gross margin as well. But right now we've kind of given the guidance down to our margin.
Brandon Couillard: Thank you.
Operator: Thank you. One moment for our next question. And our next question comes from the line of Mike Ryskin from Bank of America. Your question, please.
Mike Ryskin: Great. Thanks for taking the question, guys. I got a couple real quick here. First, hopefully you can hear me. First I want to ask on the right, sizing or some of the layoffs you discussed. I'm thinking back to 2020, sort of like peak COVID when everyone was panicking and some of your competitors or other players in the dental space announced some layoffs and you held fast and powered through it. And then the argument was that you saw it as being transient and you wanted to invest in growth and sort of be ready for the rebound. Just contrasting that with a decision to implement some cuts here. Does that mean anything in terms of your thoughts on the duration of the macro slowdown? Why, if this is just macro related and as you said, September slowed pretty suddenly, if there is a rebound, why not continue to invest given the balance sheet is strong, the free cash flows are strong, just sort of compare and contrast and lay out your thinking on that.
Joseph Hogan: First of all, when you go back to 2020 that you referenced, and we did power through that personally, what I looked at that is I looked at that as not an economic issue. That was obviously a pandemic kind of an issue and I think I anticipated it have a clear beginning and a clear end. And so in that sense, I think it's easier to make that decision, whether that's right or wrong, with that kind of a thought process in mind. In this case, we're seeing unprecedented change from an economic standpoint. We're seeing consumer sentiment down. I mean, I'll have to go through all the economic data. You probably know this better than me, so there's a lot of uncertainty there. But I don't want to be misinterpreted that we're going to disadvantage this company in a rebound. No way. We're going to make sure that we're responsible in the sense of the resources and the restructuring that John talked about, too. We're going to make sure that we're well positioned in the key areas, too, that if we have a rebound, we'll be able to respond with the right kind of capacity and the right kind of product. So I feel like we're balancing that well right now.
Mike Ryskin: Okay. All right. I appreciate that. And then second point, sort of piggybacking on I think it was Block's question earlier. Not going to ask you for the specifics on '24, but just thinking about this year. The price you took earlier this year certainly contributed to your revenue growth as we think forward to next year and your ability to take price again or potentially have to give price, given how much the macro has changed and how the demand dynamics have changed, how do you feel about pricing and products? Any opportunity to take that up again next year? Or on the flip side, are you potentially getting some pressure there where you might have to give a little bit?
Joseph Hogan: Mike, I appreciate the question, but as far as price goes, we wouldn't make an announcement until our doctors really know in that sense, and we're still working through 2024.
Mike Ryskin: Okay. All right, thanks.
Operator: Thank you. This does conclude the question and answer session of today's program. I'd like to hand the program back to Shirley Stacy for any further remarks.
Shirley Stacy: Thank you, operator, and thank you for joining the call today. We look forward to speaking to you at upcoming financial conferences and industry meetings. If you have any questions, please follow up with Investor Relations Team and Jeff and Jason we certainly will get back to you after the call and speak on one and one Thanks everyone, have a great day.
Operator: Thank you. Ladies and gentlemen for your participation in today’s conference. This does conclude the program. You may now disconnect. Good day.+ | [
{
"speaker": "Operator",
"text": "Welcome to Align Technology, Third Quarter 2023 Earnings Call. [Operator Instructions] Please note that this conference call is being recorded. I would now like to turn the conference over to your host, Shirley Stacy, with Align Technologies. You may begin."
},
{
"speaker": "Shirley Stacy",
"text": "Thank you. Good afternoon and thank you for joining us. I'm Shirley Stacy, Vice President of Corporate Communications and Investor Relations. Joining me for today's call is Joe Hogan, president and CEO, and John Morici, CFO. We issued third quarter 2023 financial results today via Businesswire, which is available on our website at investor.aligntech.com. Today's conference call is being audio webcast and will be archived on our website for approximately one month. As a reminder, the information provided and discussed today will include forward-looking statements, including statements about Align's future events, products and outlook. These forward-looking statements are only predictions and involve risks and uncertainties that are described in more detail in our most recent periodic reports filed with the Securities and Exchange Commission, available on our website and at sec.gov. Actual results may vary significantly and Align expressly assumes no obligation to update any forward-looking statement. We have posted historical financial statements, including the corresponding reconciliations, including our gap to non-GAAP reconciliation if applicable, and our third quarter 2023 conference call slides on our website under Quarterly Results. Please refer to these files for more detail. Note as of Q3, DSP touch-up cases and associated revenues have been reclassified to the non-comprehensive clear Aligner segment and are now reflected in our reported clear Aligner case volumes, revenues and business metrics. Prior to this quarter, they were not reported in the non-case category. Unless otherwise stated all metrics include DSP touch up cases in reported clear Aligner volumes. With that, I'll turn the call over to Align technologies President and CEO Joe Hogan. Joe?"
},
{
"speaker": "Joseph Hogan",
"text": "Thanks, Shirley. Good afternoon and thanks for joining us. On our call today I'll provide an overview of our third quarter results and discuss a few highlights from our two operating segments, Systems and Services and Clear Liners. Jon will provide more detail on our Q3 financial performance and comment on our views for the remainder of the year. Following that, we'll come back and summarize a few key points and we'll take questions. Our third quarter results reflect lower than expected demand in a more difficult macro environment than we experienced in the first half of 2023. Dental practices and industry research firms have reported deteriorating trends, including decreased patient visits and increased patient cancellations, along with fewer orthodontic case starts overall, especially among adult patients. The September Gauge report, which reflect more than 1200 North American Orthopactices shows deceleration for orthodontic treatment, and new orthodontic patient appointments were down 8.7% year over year, and ortho case starts were down 6.9% year over year, the biggest decrease in over a year. Despite these headwinds, total Q3 worldwide revenues of 960 million were up 7.8% year over year, with growth across all regions. For Q3, we had record clear liner shipments to teenage and younger patients, which increased 10% sequentially, and 8.4% year over year, driven by continued strength from iInvisalign First. Q3 year over year revenue growth also reflects improvement in APAC, offset by more pronounced summer seasonality in EMEA and North America. Our Q3 systems and services revenues were up 4.9% year over year despite continued challenges for capital equipment, primarily due to higher iTero scanner volumes in the Americas and APAC regions, reflecting certified preowned or what we call CPO sales, scanner, leasing and rental programs, as well as increased services revenue. Q3 systems and services revenues were down sequentially, primarily due to a weaker capital equipment cycle, as well as lower non-systems revenues. This was partially offset by higher scanner volumes in the Americas, reflecting an increased mix of iTero 5D plus scanners, including more trade in trade ups for DSO customer in Q3. Q3 non-case revenues were up 13.5% year over year, primarily due to continued growth from Vivera retainers and increased adoption of Invisalign Doctor Subscription Program, or DSP, our monthly subscription based clear liner program, which includes retainers, low stage touchup and clear liner treatment. For Q3, we shipped over 19,000 DSP touchup cases, primarily in North America, an increase of more than 70% year over year from Q3 '22. DSP continues to be well received by our customers and is currently available in the US, Canada, Iberia and the Nordics. We are excited about the DSP is proving helpful to doctors and their patients. We're continuing to expand the program in EMEA and with certain DSO partners in Q4. For Q3, total clear aligner volumes were down 3.3% sequentially and up 2.3% year over year, primarily reflecting weaker than expected demand for orthodontic treatment, especially for adult patients. As I said earlier, despite soft consumer trends, our teen and younger patient business was strong across all regions, up both sequentially and year over year, primarily due to continued adoption of invisalign first for kids as young as six years old. In terms of invisalign submitters, the total number of doctors shipped for Q3 increased sequentially to approximately 85.2 thousand doctors, the highest number in two years, driven by the Americas and APAC regions. From a channel perspective, orthodontist submitters were up year over year, especially from doctors submitting teenage cases, offset by fewer GP dentists year over year, particularly in the Americas. On a geographic basis, Q3 clear aligner volumes reflect a sequential increase in invisalign shipments from the APAC and Latin American regions, as well as North American Invisalign teenage cases, this is offset by lower volume and more pronounced softness from summer seasonality in EMEA and North America, primarily invisalign adult cases. For the America's invisalign case volume, Q3 '23 was down sequentially, primarily due to lower invisalign adult shipments in the GP channel and slightly down year over year. Q3 '23 clear aligner volumes reflect increased submitters in the Ortho channel, with an increase in teen and younger case starts driven by momentum from invisalign first. This is reflected in the September Gauge data, which shows an invisalign orthostart performed better than wires and brackets and other clear liners. In North America, adoption of invisalign comprehensive three and three product drove sequential volume growth in Q3 '23. Invisalign DSP touchup cases in North America also drove growth sequentially year over year. For a EMEA [ph] Q3 Three clear liner volumes were down sequentially, primarily from the impact of Q3 summer seasonality when doctors offices are closed for summer vacations and more consumers are traveling. This was partially offset by sequential growth in Italy, Benelux, Turkey and the Middle East. Year over year clear liner volumes were up reflecting continued adoption of invisalign moderate, the comprehensive three and three product, as well as an increase in Teen Case starts, driven primarily by Invisalign first and our new Invisalign Teen Case packs. For APAC Q3'23 Clear Aligner volumes were up sequentially and up year over year reflecting improving trends in China as well as other key markets like India, Taiwan, Korea, Japan and Thailand. Q3 APAC results also reflected increased invisalign submitters and higher utilization, especially for teen patients driven by growth from invisalign first in the Orthodontic channel during our typically strong teen season in China. Q3 APAC results also reflect growth in a GP channel with increased invisalign submitters and higher utilization sequentially and year over year. During Q3, we continue the rollout of Invisalign comprehensive three and three product in APAC most recently launched in China. Invisalign comprehensive three and three is also available in Hong Kong, Korea, Taiwan and India. We are pleased with the adoption of the three and three product in APAC, where the majority of cases treated are comprehensive, allowing our doctor customers more flexibility within the invisalign product portfolio. During the quarter, we also shipped to a record number of doctors in APAC, increasing both sequentially and year over year. Invisalign is the most trusted brand in the orthodontic industry globally, and it's important that we continue to create demand for invisalign clear aligners, especially given the macroeconomic pressures on doctors and their patients. In Q3- three, we delivered 11.1 billion impressions and had 27.7 million visits to our websites globally. To increase awareness and educate young adults, parents and teens about the benefits of the invisalign brand, we continue to invest and create campaigns in top media platforms such as TikTok, Instagram, YouTube, Snapchat, WeChat and Dillion across markets. The underlying market opportunity for clear liner of treatment, especially for teens and kids, remains huge and significantly underpenetrated. We know invisalign clear liner of treatment is faster and more effective than Braces [ph] yet the vast majority of orthodontic cases are still treated using brackets and wires. Differentiation is key to increasing invisalign share of the orthodontic case starts, especially among teens and their parents. We are continuing to differentiate through novel campaigns such as our new Invis is Drama Free campaign ., which uses humor to juxtapose the significant benefits of invisalign treatment over metal braces. Similarly, to differentiate invisalign treatment for adults, we launched new campaigns globally using powerful patient stories that share how important a smile is and how invisalign treatment increases self confidence that transforms lives. Reaching young adults as well as teens and their parents also requires the right engagement through invisalign influencers and creator centric campaigns, which delivered 5.8 billion impressions in the Americas in Q3. Creators such as Michael Simoneau, Jalen Hall, NFL player Darren Warren and also Leilani Green showed their results and why they chose to transform their smiles with invisalign aligners. In the EMEA [ph] region, we partnered with Influencers to reach consumers across social media platforms including TikTok and Meta, and launched our Global Consumer Campaign for teens and parents of teens, highlighting the benefits of invisalign treatment versus braces. In Germany, we continue to see positive engagement with our patient testimonial campaigns launched in the previous quarter. Our consumer campaigns delivered more than 1.4 billion media impressions and 6.9 million visitors to our website. We continue to invest in consumer advertising across the APAC region, resulting in more than 3.9 billion impressions and 11.9 million visitors to our websites in the quarter. We expanded our reach in Japan and India via Meta and YouTube, and partnered with key Influencers to reach consumers across social media. We saw increased brand interest from consumers, as evidenced by an over 800% increase in unique visitors to our website in India and 135% increase in Japan. Finally, digital tools such as My Invisalign Consumer and Patient app continue to increase with 3.4 million downloads to date and over 367,000 monthly active users, representing a 19% year over year growth. With that, I'll now turn the call over to John."
},
{
"speaker": "John Morici",
"text": "Thanks Joe. Now for our Q3 '23 financial results. Total revenues for the third quarter were $960.2 million, down 4.2% from the prior quarter and up 7.8% from the corresponding quarter a year ago. On a constant currency basis, Q3 revenues were impacted by unfavorable foreign exchange of approximately $2.7 million, or approximately 0.3% sequentially and favorably impacted by approximately $4.2 million year over year, or approximately 0.4%. For clear aligners, Q3 revenues of $794.9 million were down 4.5% sequentially, primarily from lower volumes and lower ASPs. On a year over year basis, Q3 clear aligner revenues were up 8.5%, primarily due to higher ASPs, higher volumes and higher non case revenues. For Q3 invisalign ASPs for comprehensive treatment were down sequentially and up year over year. On a sequential basis, ASPs reflect larger discounts, product shift, mix shift to lower priced products and unfavorable foreign exchange, partially offset by higher additional aligners. On a year over year basis, the increase in comprehensive ASPs reflect higher additional aligners and price increases, partially offset by larger discounts and unfavorable product mix shift. For Q3 invisalign ASPs for non-comprehensive treatment were down sequentially and up year over year. On a sequential basis the decrease in ASPs reflects larger discounts, higher sales credits, and unfavorable product mix, partially offset by higher additional liners and favorable foreign exchange. On a year over year basis, the increase in non-comprehensive ASPs reflects price increases, higher additional aligners and favorable foreign exchange, partially offset by product mix shift. In Q1 '23 we launched the invisalign comprehensive Three and Three product. The Three and Three configuration offers our doctor customers invisalign comprehensive treatment with three additional liners included within three years of the treatment end date, instead of unlimited additional liners within five years of the treatment end date. At the 2022 Invisalign comprehensive product price, Invisalign comprehensive Three and Three product is available in North America and in certain markets in EMEA and APAC, most recently launching in China, Korea, Hong Kong and Taiwan. We are pleased with the continued adoption of the Invisalign comprehensive Three and Three product and anticipate it will continue to increase, providing doctors the flexibility they want and allowing us to recognize more revenue upfront with deferred revenue being recognized over a shorter period of time compared to our traditional Invisalign comprehensive product. As we begin to ship more additional aligners for comprehensive Three and Three products, we expect to see an ASB benefit. As revenues from subscriptions, retainers and other ancillary products continue to grow globally some of the historical metrics that only focus on case shipments are expected to account for a lesser percentage of our overall growth. In our earnings release and financial slides, you will see that we have added our total clear aligner revenue per case shipment, which we believe to be a more indicative measure of our overall growth strategy. Q3 '23 clear aligner revenues were impacted by unfavorable foreign exchange of approximately $2 million, or approximately 0.3% sequentially. On a year over year basis clear aligner revenues were favorably impacted by foreign exchange of approximately $3.8 million, or approximately 0.5%. Clear aligner deferred revenues on the balance sheet increased $14.1 million, or up 1.1% sequentially and up $116 million or up 9.9% year over year, and will be recognized as the additional liners are shipped. Q3 '23 systems and service revenues of $165.3 million were down 2.5% sequentially, mostly due to unfavorable ASPs and lower revenues from our certified preowned program, partially offset by higher scanner volume and higher services revenues. On a year over year basis, Q3 '23 systems and services revenue were up 4.9% due to higher scanner volume, higher services revenue from our larger base of scanners sold, and higher revenues from our certified preowned and leasing rental programs, partially offset by unfavorable ASPs. Q3 '23 systems and services revenues were impacted by unfavorable foreign exchange of approximately $0.7 million, or approximately 0.4% sequentially. On a year over year basis system and services revenues were favorably impacted by foreign exchange of approximately $0.4 million, or approximately 0.3%. Systems and services deferred revenues on the balance sheet was down $4.4 million, or 1.6% sequentially, primarily due to the decrease in the deferral of service revenues included with scanner purchases and essentially flat or up slightly to 0.1 million or 0.1% year over year. Services deferred revenues will be recognized ratably over the service period. As our scanner portfolio expands and we introduce new products, we increase the opportunities for customers to upgrade, make trade ins and purchase certified pre owned scanners in certain markets. Developing new capital equipment opportunities to meet the digital transformation needs of our customers and DSO partners is a natural progression for our equipment business with a large and growing base of scanners sold. Moving on to gross margin, third quarter overall gross margin was 69.1%, down 2.1 points sequentially and down 0.5 points year over year. Overall gross margin was unfavorably impacted by foreign exchange by approximately 0.1 point on a sequential basis, and favorably impacted by foreign exchange by approximately 0.1 point on a year over year basis. Clear aligner gross margin for the third quarter was 70.7%, down 1.7 points sequentially, primarily from higher manufacturing spend and a higher mix of additional aligner volume and lower ASPs. Clear aligner gross margin for the third quarter was roughly flat year over year, primarily due to increased manufacturing spend as we continue to ramp up operations at our new manufacturing facility in Poland, partially offset by higher ASPs. Systems and services gross margin for the third quarter was 61%, down 4.1 points sequentially, primarily from lower ASPs, partially offset by favorable manufacturing variances, lower service and freight costs, and higher services revenues. Systems and services gross margin for the third quarter was down 2.3 points year over year, primarily from lower ASPs, partially offset by favorable manufacturing variances, lower service and freight costs, favorable foreign exchange, and higher service revenues. Q3 '23 operating expenses were $496.7 million, down sequentially 8.3% and up 4.5% year over year. On a sequential basis, operating expenses were down $44.9 million, primarily from lower consumer marketing spend and lower incentive compensation. Year over year, operating expenses increased by $21.2 million, primarily due to higher incentive compensation in our continued investments in sales and R&D activities, partially offset by controlled spending on advertising and marketing, as part of our efforts to proactively manage costs. On a non-GAAP basis, excluding stock based compensation and amortization of acquired intangibles related to certain acquisitions, operating expenses were $458.2 million, down 9.3% sequentially and up 3.3% year over year. Our third quarter operating income of $166.3 million resulted in an operating margin of 17.3%, up 0.1 points sequentially and up 1.2 points year over year. Operating margin was unfavorably impacted by approximately 0.3 points sequentially, primarily due to foreign exchange. The year over year increase in operating margin is primarily attributable to operating leverage, partially offset by investments in our go to market teams and technology, as well as unfavorable impact from foreign exchange by approximately 0.1 point. On a non-GAAP basis, which excludes stock based compensation and amortization of intangibles related to certain acquisitions, operating margin for the third quarter was 21.8%, up 0.5 points sequentially and up 1.6 points year over year. Interest and other income expense net for the third quarter was a loss of $4.2 million, compared to a loss of $0.3 million in the second quarter and a loss of $21 million in the third quarter a year ago, primarily due to foreign exchange. The GAAP effective tax rate for the third quarter was 25.1% lower than the second quarter effective tax rate of 34.8%, and lower than the third quarter effective tax rate of 40.7% of the prior year. The third quarter GAAP effective tax rate was lower than the second quarter effective tax rate, primarily due to the application of newly issued tax guidance and lower US taxes on foreign earnings in Q3. As a reminder, in Q4 '22, we changed our methodology for the computation of our non-GAAP effective tax rate to a long term projected tax rate and have given effect to the new methodology from January 1, 2022, and recast previously reported quarterly periods in 2022 2022. Our non-GAAP effective tax rate in the third quarter was 20%, reflecting the change in our methodology. Third quarter net income per diluted share was $1.58, up sequentially $0.12 [ph] and up $0.65 compared to the prior year. Our EPS was unfavorably impacted by $0.08 on a sequential basis and unfavorably impacted by $0.05 on a year over year basis due to foreign exchange. On a non GAAP basis, net income per diluted share was $2.14 for the third quarter, down $0.08 sequentially and up $0.51 year over year. Note that the prior year 2022 non-GAAP net income and prior year 2022 non-GAAP EPS reflects the Q4 '22 change in our methodology for the computation of our non-GAAP effective tax rate. Moving on to the balance sheet. As of September 30, 2023, cash equivalents and short and long term marketable securities were $1,301.9 billion [ph] up sequentially, $268.1 million, and up $160.9 million year over year. Of our $1.3 billion dollar balance, 381 million was held in the US and $920.6 million was held by our international entities. Q3 accounts receivable balance was $904.2 million down sequentially, our overall day sales outstanding was 84 days, up approximately three days sequentially and down approximately two days as compared to Q3 last year. Cash flow from our operations for the third quarter was $287.2 million. Capital expenditures for the third quarter were $21.6 million, primarily related to our continued investments to increase aligner manufacturing capacity and facilities. Free cash flow, defined as cash flow from operations, less capital expenditures amounted to $265.6 million. Now, turning to our fourth quarter outlook. For Q4 '23, assuming no circumstances occur that are beyond our control, we anticipate our worldwide revenue to be in the range of $920 to $940 million down sequentially from Q3 of '23. We expect both clear aligner and systems and services revenues to be down sequentially, reflecting a more challenging macro environment for doctors and patients with fewer orthodontic case starts overall unfavorable foreign exchange given the strengthening of the US dollar against key currencies and longer sales cycles for capital equipment purchases. For our clear aligner business, we expect clear aligner teen volume to be seasonally lower in Q4 of '23, and we don't anticipate improvement in adult volumes. For Q4 '23, we also expect clear aligner ASPs to be down sequentially, primarily due to the strengthening US dollar. For our systems and services business, we anticipate increasing headwinds for macro uncertainty and potential supply issues related to the war in the Middle East. We expect our Q4 '23 GAAP operating margin to be down sequentially from Q3 of '23 due to restructuring primarily related to severance as we adjust headcount for this environment. We anticipate our non-GAAP operating margin to be up sequentially from Q3 of '23. During Q1 '23, we announced that our Board of Directors authorized a new $1 billion stock repurchase program to succeed the 2021 $1 billion program. Currently, $1 billion remains available for repurchase under the 2023 stock repurchase program. During Q4 '23, we expect to repurchase up to $250 million of our common stock through either or a combination of open market repurchases or an accelerated stock repurchase agreement. For full year 2023, assuming no circumstances occur that are beyond our control, we anticipate our 2023 worldwide revenue to be in the range of $3.83 billion to $3.85 billion. We also expect our full year 2023 GAAP operating margin to be roughly one point lower than 2022 and our 2023 non-GAAP operating margin to be slightly above 21%. For 2023, we expect investments in capital expenditures to be approximately $200 million. Capital expenditures are expected to primarily relate to building construction and improvements as well as manufacturing capacity in support of our continued international expansion. With that, I'll turn it back over to Joe for final comments. Joe."
},
{
"speaker": "Joseph Hogan",
"text": "Thanks, John. While our third quarter results and fourth quarter outlook reflect weaker consumer sentiment and increased headwinds including foreign exchange, Align is in a unique position to continue driving the digital revolution in the dental industry to help doctors transform and grow their practices with invisalign clear aligners, Itero Scanners and Align digital platform. We are very excited about the recent innovations developed to further revolutionize digital treatment planning for Orthodontics and also restore to dentistry by providing doctors with greater flexibility, real time treatment plan modification capabilities, and digital solutions to help improve practice productivity and patient experience, which are even more important to our customers in the current environment. This includes clincheck live update for 3D controls invisalign practice App, invisalign personal plan or IPP, Invisalign Smile Architect, Itero exocad [ph] connector Invisalign Outcome Simulator pro and invisalign virtual Care AI software. These digital tools are continuing to gain adoption and help doctors gain efficiencies. In Q3 Clincheck Live Update was used by 41,000 doctors on more than 560,000 cases, reducing time spent and modifying treatment by 21%. Invisalign Practice app is now actively used by about 87,000 doctors, with over 5.2 million photos uploaded during the quarter via the Practice app. In addition, we will launch Invisalign Pallet expander or IPE system in Canada this quarter. IP is our first direct printed orthodontic device that provides a safe, comfortable, and clinically effective alternative to metal paddled, expanders and boosts our market opportunity in the teen market by addressing a portion of cases we couldn't otherwise treat without IPE. In summary, we're committed to balancing our investments in near and long term growth drivers while delivering improved operating margin as we navigate one of the most challenging operating environments in recent history with increasing macroeconomic pressure on doctors and their patients, we have an enormous opportunity to continue driving adoption of digital orthodontics and restorative dentistry and a responsibility to optimize our investments for the current environment. Before turning the call over for questions, I'd like to address the war in the Middle East and our Itero scanner business. The situation continues to evolve and is very fluid. We are monitoring developments closely. Our singular focus at this stage is on the safety and security of our employees and their families and our doctors and their staff and patients. Align offices and scanner manufacturing facility in Israel are currently open and operating. While we hope the situation will improve, we're preparing mitigation plans to ensure business continuity and we'll update our customers and other stakeholders as needed. Now I'll turn the call back over to the operator for questions."
},
{
"speaker": "Operator",
"text": "Certainly. [Operator Instructions] And our first question comes from the line of Jason Bednar from Piper Sandler. Your question, please."
},
{
"speaker": "Joseph Hogan",
"text": "Hi, Jason."
},
{
"speaker": "Operator",
"text": "Jason, you might have your phone on mute."
},
{
"speaker": "Shirley Stacy",
"text": "Operator, you want to go to the next question?"
},
{
"speaker": "Operator",
"text": "Certainly."
},
{
"speaker": "Shirley Stacy",
"text": "And we'll come back."
},
{
"speaker": "Operator",
"text": "Certainly. One moment. And our next question comes in line Brandon Vazquez from William Blair. Your question, please."
},
{
"speaker": "Brandon Vazquez",
"text": "Hey, everyone, thanks for taking the question. On the first one, maybe can we just start a little bit? It sounds like macro, and given the data that you guys were talking about is probably getting a little worse into the end of the year. Maybe just talk about how that kind of trended through the quarter, how we're trending now. I think what a lot of us are trying to get our head around is what's the direction of macro in the dental space going into the end of the year and into 2024, especially as you look at kind of the consumer and then CapEx on scanners. So how are you guys seeing that from your end right now?"
},
{
"speaker": "Joseph Hogan",
"text": "When you look at the fourth quarter and the way we have done our forecast overall, we felt great about teens in the third quarter and what we reported to, but adults were really highly affected. And when you run through the fourth quarter, it's primarily an adult season for us. And China is a big teen season in the third quarter, too. When you look at the gauge data for September and what we see in October so far, and even some of the consumer profiles around how they're feeling about their finances and all, we've basically just projected what we've seen in September forward to the fourth quarter."
},
{
"speaker": "Brandon Vazquez",
"text": "Okay. And then maybe as a follow up on the teen side, it sounds like the Ortho channel, based off the market data you have, is that teens are declining year over year. But you guys, or at least sequentially, you guys are up both, it looks like. So are you guys taking share within the teen market? It's a little bit of a funny dynamic because I think earlier this year, as the Ortho channel got a little weaker, they were going to wires and brackets. But it seems like now you're taking share. How durable is that and what are you guys kind of seeing that's driving that in the underlying market? Thanks."
},
{
"speaker": "Joseph Hogan",
"text": "We were happy to see that change and the gauge data that showed wires and brackets going down and competitive aligners going down and us going up. But you can't draw a line through one dot. We feel good again about the technology and all that. We're presenting the Efficiencies and all we're offering to Orthodontists, and we think that's a good stimulant in that sense. But right now, we're going to have to take this thing quarter to quarter."
},
{
"speaker": "Operator",
"text": "Thank you. One moment for our next question. And Jason Bednar from Piper Sandler. Your line is open."
},
{
"speaker": "Joseph Hogan",
"text": "Hi, Jason."
},
{
"speaker": "Operator",
"text": "Jason, we're still not hearing you. Shall I move on? Yes, please. Certainly. One moment for our next question. And our next question comes from the line of Jeff Johnson from Baird. Your question, please."
},
{
"speaker": "Operator",
"text": "Mr. Johnson, your line is open. One moment - certainly as we go to our next question. Our next question comes from the line of Jon Block from Stifel. Your question, please."
},
{
"speaker": "Jon Block",
"text": "Hey, guys, can you hear me okay?"
},
{
"speaker": "Joseph Hogan",
"text": "Hey, John. Just fine."
},
{
"speaker": "Jon Block",
"text": "All right, so far so good. Maybe a couple of questions. I'll start right now, you just seem highly tethered to the consumer. But in '24, you've got some incrementals, right? You just launched IP in Canada. You've got remote monitoring. We think maybe you have a new scanner. So just like your thoughts on the ability for the company to manufacture more of your own growth in 2024, and any commitment to grow revenues year over year in '24. And where I'm going with that is even the revised guidance you'll grow year over year in 2H '23. But if I annualize your 4Q number and just sort of run rate that you arguably land down year over year with call it a more dynamic set of innovation. So not asking for a number, but clearly things are moving around. And how do we think about what that means again, to manufacture your own growth in '24 and any commitment to have positive revenue growth in '24?"
},
{
"speaker": "Joseph Hogan",
"text": "Hey, John, it's a good question that's one of the things we talk about obviously here is with what we presented at the Investors conference and the new technology that we're offering, those are areas that we can really expand what we call our penetration in the marketplace and control a certain amount of our destiny. I think you know as well as know we can't fight a market from a down standpoint in the sense of that that won't affect us in some way. I would throw DSP into that whole question also because you see the continued growth in DSP and I'd say a business model change. And so those kinds of things, I feel like we can drive more demand in the marketplace as we get into 2024. I just can't preclude what that consumer sentiment is going to look like at that point in time, but it certainly gives us also the efficiency gains that we show through the software that I just talked about in my script, too, with different orthodontists that seem to be taking hold and you pick up in your surveys also, John. So we do feel good about that. It's just the uncertainty of this marketplace and it obviously surprised us coming out of the third quarter. We're going to have to get through this quarter, and as we go into 2024, we can be more specific about what we think, what that opportunity is."
},
{
"speaker": "Jon Block",
"text": "Okay, that was very helpful. And then maybe just this might build on Brandon's question earlier, but when you guys guide, you've got almost half the quarter in the bag. So clearly things changed, notably in the last seven weeks of the third quarter. I know you guys called out Gage's September data. Joe, you referenced the October what was the 3Q deviation? I mean seems like it was largely North America. And EMEA, did APAC perform as expected, if you could answer that. And then I guess where I'm struggling is I think we all know it's not a robust consumer out there and that narrative around soft landing or not, if that holds true, but it doesn't seem like things changed all that dramatically in the last seven weeks. And so anything you can give Joe to elaborate, because clearly the exit rate in the quarter was very different than the way things started. Thank you."
},
{
"speaker": "Joseph Hogan",
"text": "Yeah. John, you know, third quarter is I call, our most non linear quarter, and it's the most difficult to predict. And it's because it know three major components to it. One is obviously the seasonality of our European business because of the vacation base or whatever, and the way that comes back is not always consistent. And in this case, it did not come back in the way that we had hoped it would. Secondly is you count on a big China teen market. And we did well in China, I feel, from a growth standpoint, but it wasn't to a point that it could offset a slower rebound overall from a European standpoint. And the last thing is, in the United States, that lack of adult cases I mean, we did well on teen that lack of adult cases when we went into September was really felt. And so it's those three key variables that I think, is how we came out of this differently than what we anticipated as we went in."
},
{
"speaker": "Jon Block",
"text": "Thanks, guys."
},
{
"speaker": "Joseph Hogan",
"text": "Thanks, John."
},
{
"speaker": "Operator",
"text": "Thank you. One moment for our next question. And our next question comes from the line of Elizabeth Anderson from Evercore ISI your question, please."
},
{
"speaker": "Elizabeth Anderson",
"text": "Hi, guys. Thanks so much for the question. My question is so if we think about obviously we're talking about consumer weakness and sort of the cyclicalness of the business. If we think about sort of the headcount reduction and the SG&A spend can you help us parse out a little bit more about the cuts and how to think about how to sort of preserve margin as sort of we're seeing weaker demand and then how you need to invest again on the upcycle in order to continue to push penetration in what's obviously a very largely underpenetrated market over a longer period."
},
{
"speaker": "John Morici",
"text": "Hey, Elizabeth, this is John. So as we go through our planning process, like we do every year, we're prioritizing investments that we can continue to invest to be able to help grow the business. So we look at some R&D and some of the investments we make. We have a lot of new products coming to market, as we've talked about at Investor Day. We want to preserve that flow of products. We want to make sure we're properly reaching our customers so we prioritize some of the sales and go to market activities that we have around that. But we're looking at all parts of the business to say, okay, what can we adjust? What can we make adjustments to still deliver on our priorities that we have as a business to help try to grow with the means that we've seen, but then also deliver the profitability and being able to see this margin accretion. We've seen that all year as we've gone through. And essentially what we're calling for in the fourth quarter is the continuation of that margin accretion. And that's just through a combination of just looking at those investments and making sure that we properly invest for the future."
},
{
"speaker": "Elizabeth Anderson",
"text": "Got it. And maybe as a follow up, obviously I have hope for the safety of all of your employees in Israel. Can you talk about sort of the capacity of that organization if sort of things stay as they are? Is that something where you're sort of drawing down inventory elsewhere, not able to produce, if any, more details you could provide on that obviously unfortunate situation."
},
{
"speaker": "John Morici",
"text": "Back to know we're producing over there right now. I don't give you this. It's a reasonable amount of capacity. I've had other businesses in Israel at times like this, too. Not this bad. But in those situations, I feel like where it is now, we can manage it. As we talked about in the script, if the things get worse, the war over there. We can't guarantee what we have. But we have a terrific team there, very dedicated team. They're working both sides of the angle right now. We're bringing in materials. We're converting those materials, we're shipping those out. So the business is operating fine right now, but we have to just wait in the upcoming weeks and see what develops on their homeland."
},
{
"speaker": "Elizabeth Anderson",
"text": "Got it. Thank you very much."
},
{
"speaker": "Operator",
"text": "Yeah, thank you. One moment for our next question. And our next question comes from the line of Aaron Wright from Morgan Stanley. Your question, please."
},
{
"speaker": "Aaron Wright",
"text": "Great, thanks. I'm curious if you could break down a little bit the key components of the teen case volume trend you saw in the quarter by geography, specifically in the Americas region, and what's driving that. And I think you mentioned, like, invisalign first and how we should be thinking about visibility across that patient cohort just given you have some more inherent control over maybe that segment in this sort of environment. And then second part of my question is just more of a clarification, I guess, in terms of the fourth quarter guidance. Does it specifically assume that there's a further deterioration in the macro or just a continuation of what you saw in this September experience? And I just want to understand the buffers I guess you have in that expectation at this point. Thanks."
},
{
"speaker": "Joseph Hogan",
"text": "As far as the teenage patients, again, we're really pleased with the growth that we saw in teens, and it's a very important teen season. I think the teens perform extremely well. We saw strength across every geography. We saw in Europe. We saw in North America. We also saw it in China. I think our portfolio helps us a lot invisalign first. We led with that. Remember, those are patients that are anywhere between six and ten years old. We really have terrific results in those areas, but also with permanent dentition. We saw some good growth, too. So overall, I feel like it's a strong indication in the sense that we're hitting the dot, in the sense of where we want to with those specific consumers, and through the advertising programs that I talked about and also through our digital platform and then the specific products, like invisalign first and then IPE that rolls into Canada. And then more broadly as we move into 2024."
},
{
"speaker": "John Morici",
"text": "And just on the fourth quarter, Aaron really taking what we see in September continues into October, and we assume that things don't get better than what we saw in September. So it's a tough macro environment. There's less orthodontic case starts, lower patient traffic. And so we factor in all those based on what we saw, and that's what our projection is for. Q four."
},
{
"speaker": "Aaron Wright",
"text": "Okay. Thank you."
},
{
"speaker": "Operator",
"text": "Thank you. One moment for our next question. And our next question comes from the line of Jeff Johnson from Baird. Your question, please. Jeff, I don't know if you're on a speaker phone, but if you could lift the handset if that were the case. Still not hearing anything from Mr. Johnson. One moment for our next question .And our next question comes from Jason Bednar from Piper Sandler. Your question, please. Still not hearing Jason?"
},
{
"speaker": "Shirley Stacy",
"text": "That's strange. We certainly will follow up with both Jeff and Jason. Operator, do you mind just going to the next question, please?"
},
{
"speaker": "Operator",
"text": "Certainly. One moment for our next question. Our next question comes from the line of Nathan Rich from Goldman Sachs. Your question please."
},
{
"speaker": "Nathan Rich",
"text": "Great, thank you. Can you hear me okay?"
},
{
"speaker": "Joseph Hogan",
"text": "Yes."
},
{
"speaker": "Nathan Rich",
"text": "Okay, great. Joe, you mentioned the focus on delivering improved operating margins and you guided to non GAAP margins being up sequentially in the fourth quarter despite the reduction in the revenue guidance. I guess as we think about the business going forward, should we think about that four Q margin as a good base level for the business even in an uncertain demand environment? And are there additional actions you can take on the cost side to give yourself some additional cushion for margins going forward?"
},
{
"speaker": "Joseph Hogan",
"text": "You've been watching us long enough to know that each of our quarters have a certain personality in the sense of the kind of operating profit we deliver. You can see in the fourth quarter that we feel good about where we stand right now and the levers that we can pull in order to deliver the operating margin that John talked about. So – I think you know, more than anything, I want the investors to understand that while we have this uncertain environment, from a demand standpoint, we're going to be responsible on cost. We'll invest in technology and we'll focus in those areas, but we're always looking closely in the sense of where we can rationalize, also where we can prioritize in different areas that will help in that operating profit area. John, anything you want to add on that's?"
},
{
"speaker": "John Morici",
"text": "So we'll see the benefit that we've seen all year to be able to see that operating margin improvement. But as Joe said, we're prioritizing our investments. We look at this time as we finalize our plan for next year. But we have got a lot of technology coming and we want to make sure that we're properly invested there as well as being able to deliver like we can on an margin basis."
},
{
"speaker": "Nathan Rich",
"text": "Okay, great. And if I could just ask a follow up on the 4Q guidance for clear liner volumes. I think you had said that you don't expect improvement in adult and had talked about, I guess, modeling what you saw in September through the fourth quarter. I guess how should we think about adult cases relative to the 381,000? I guess when we take that together, given how it sounds like September shaped up, should we expect a decline off of that 381 level in the fourth quarter for the adult cases specifically?"
},
{
"speaker": "Joseph Hogan",
"text": "I think when you look at things, Nathan, like we said, teen showed up well in the third quarter. We're pleased with that. Seasonally comes down in the fourth quarter. And based on what we saw in September and so far in October, I think you would expect to see adults down as well."
},
{
"speaker": "Nathan Rich",
"text": "Great. Thank you for the color."
},
{
"speaker": "Operator",
"text": "Thank you. One moment for our next question. And our next question comes from the line of Brandon Couillard from Jeffries. Your question, please."
},
{
"speaker": "Brandon Couillard",
"text": "Hey, thanks. Good afternoon. Just a clarification, Joe or John on the adult trends and the weakness, is that predominantly in the US or is it about to extend outside the US as well? If you have any chance, you're willing to take a stab at some of the factors behind that and whether or not student loan repayments may be contributing to some of the [indiscernible] and sentiment in that customer base."
},
{
"speaker": "Joseph Hogan",
"text": "Remember, third quarter is a big teen quarter, but adults are obviously a large component of that. We saw that adult phenomenon in North America, but we saw it across each geography."
},
{
"speaker": "Brandon Couillard",
"text": "Okay, then just to follow up, John, on the fourth quarter, margins operating margins up with revs down sequentially, is that all coming from OpEx, or would you expect gross margins to bounce up sequentially as well?"
},
{
"speaker": "John Morici",
"text": "When we talked about down sequentially on Op margin, that was on a GAAP basis. We have some of the restructuring and other things that include we expect sequential improvement on a non-GAAP basis from Q3 to Q4. And we didn't give specific gross margin guidance, but we're working to try to make sure that we work on our gross margin as well. But right now we've kind of given the guidance down to our margin."
},
{
"speaker": "Brandon Couillard",
"text": "Thank you."
},
{
"speaker": "Operator",
"text": "Thank you. One moment for our next question. And our next question comes from the line of Mike Ryskin from Bank of America. Your question, please."
},
{
"speaker": "Mike Ryskin",
"text": "Great. Thanks for taking the question, guys. I got a couple real quick here. First, hopefully you can hear me. First I want to ask on the right, sizing or some of the layoffs you discussed. I'm thinking back to 2020, sort of like peak COVID when everyone was panicking and some of your competitors or other players in the dental space announced some layoffs and you held fast and powered through it. And then the argument was that you saw it as being transient and you wanted to invest in growth and sort of be ready for the rebound. Just contrasting that with a decision to implement some cuts here. Does that mean anything in terms of your thoughts on the duration of the macro slowdown? Why, if this is just macro related and as you said, September slowed pretty suddenly, if there is a rebound, why not continue to invest given the balance sheet is strong, the free cash flows are strong, just sort of compare and contrast and lay out your thinking on that."
},
{
"speaker": "Joseph Hogan",
"text": "First of all, when you go back to 2020 that you referenced, and we did power through that personally, what I looked at that is I looked at that as not an economic issue. That was obviously a pandemic kind of an issue and I think I anticipated it have a clear beginning and a clear end. And so in that sense, I think it's easier to make that decision, whether that's right or wrong, with that kind of a thought process in mind. In this case, we're seeing unprecedented change from an economic standpoint. We're seeing consumer sentiment down. I mean, I'll have to go through all the economic data. You probably know this better than me, so there's a lot of uncertainty there. But I don't want to be misinterpreted that we're going to disadvantage this company in a rebound. No way. We're going to make sure that we're responsible in the sense of the resources and the restructuring that John talked about, too. We're going to make sure that we're well positioned in the key areas, too, that if we have a rebound, we'll be able to respond with the right kind of capacity and the right kind of product. So I feel like we're balancing that well right now."
},
{
"speaker": "Mike Ryskin",
"text": "Okay. All right. I appreciate that. And then second point, sort of piggybacking on I think it was Block's question earlier. Not going to ask you for the specifics on '24, but just thinking about this year. The price you took earlier this year certainly contributed to your revenue growth as we think forward to next year and your ability to take price again or potentially have to give price, given how much the macro has changed and how the demand dynamics have changed, how do you feel about pricing and products? Any opportunity to take that up again next year? Or on the flip side, are you potentially getting some pressure there where you might have to give a little bit?"
},
{
"speaker": "Joseph Hogan",
"text": "Mike, I appreciate the question, but as far as price goes, we wouldn't make an announcement until our doctors really know in that sense, and we're still working through 2024."
},
{
"speaker": "Mike Ryskin",
"text": "Okay. All right, thanks."
},
{
"speaker": "Operator",
"text": "Thank you. This does conclude the question and answer session of today's program. I'd like to hand the program back to Shirley Stacy for any further remarks."
},
{
"speaker": "Shirley Stacy",
"text": "Thank you, operator, and thank you for joining the call today. We look forward to speaking to you at upcoming financial conferences and industry meetings. If you have any questions, please follow up with Investor Relations Team and Jeff and Jason we certainly will get back to you after the call and speak on one and one Thanks everyone, have a great day."
},
{
"speaker": "Operator",
"text": "Thank you. Ladies and gentlemen for your participation in today’s conference. This does conclude the program. You may now disconnect. Good day.+"
}
] | Align Technology, Inc. | 24,568 |
ALGN | 2 | 2,023 | 2023-07-26 16:30:00 | Operator: Greetings, welcome to the Align Second Quarter 2023 Earnings Call. At this time, all participants are in a listen-only mode. A question-and-answer session will follow the formal presentation. Please note this conference is being recorded. I will now turn the conference over to your host, Shirley Stacy, with Align Technology. You may begin.
Shirley Stacy: Thank you. Good afternoon, and thank you for joining us. I'm Shirley Stacy, Vice President of Corporate Communications and Investor Relations. Joining me for today's call is Joe Hogan, President and CEO; and John Morici, CFO. We issued second quarter 2023 financial results today via Business Wire, which is available on our website at investor.aligntech.com. Today's conference call is being audio webcast and will be archived on our website for approximately one month. A telephone replay will be available today by approximately 5:30 p.m. Eastern Time through 5:30 p.m. Eastern Time on August 9th. To access the telephone replay domestic callers should dial (929)-458-6194 with access code 342791. International callers should dial 44-204-525-0658 using the same access code. As a reminder, the information provided and discussed today will include forward-looking statements, including statements about Align's future events, products and outlook. These forward-looking statements are only predictions and involve risks and uncertainties that are described in more detail in our most recent periodic reports filed with the Securities and Exchange Commission available on our website and at sec.gov. Actual results may vary significantly, and Align expressly assumes no obligation to update any forward-looking statements. We've posted historical financial statements, including the corresponding reconciliations, including our GAAP to non-GAAP reconciliation, if applicable, and our second quarter 2023 conference call slides on our website under quarterly results. Please refer to these files for more detailed information. With that, I'd like to turn the call over to Align Technology's President and CEO, Joe Hogan. Joe?
Joseph Hogan: Thanks, Shirley. Good afternoon, and thanks for joining us. On our call today, I'll provide an overview of our second quarter results and discuss a few highlights from our two operating segments, system services and clear aligners. John will provide more detail on our Q2 financial performance and comment on our views for the third quarter and 2023 overall. Following that, I'll come back and summarize a few key points, and we'll open the call to questions. Overall, I'm pleased to report another better-than-expected quarter with Q2 revenues and operating margins that exceeded our guidance. Q2 results reflect improving trends across regions, strength in teen and younger patient volumes, driven by momentum in both submitters and utilization as well as continued growth from Invisalign First. In the Teen segment, which represents the largest portion of the 21 million annual orthodontic case starts, 195,000 teens and kids started treatment with Invisalign clear aligners during the second quarter. An increase of 7% sequentially and 10% year-over-year, reflecting the highest annual growth rate in the teen segment since 2021. For Systems & Services, second quarter revenues of $169.5 million were up 10.5% sequentially and down very slightly 1% year-over-year. For Q2, sequential increases in systems and services revenues, reflects increased scanner volumes across the regions and higher services and non-system revenues, reflecting increased sales of certified pre-owned or what we call CPO scanners and higher subscription revenues. On a year-over-year basis, Q2 services revenues increased primarily due to higher subscription revenues from a large number of iTero scanners in the field. We also had higher non-system scanner revenues related to our certified pre-owned again CPOs and our scanner leasing and rental programs. For Q2, total clear aligner revenues of $832.7 million up 5.4% sequentially and 4.3% year-over-year. Q2 sequential revenue growth rate is consistent with our historical three year average and reflects growth across all regions. Q2 non-case revenues at $80 million were up 6.2% sequentially and 18% year-over-year, reflecting continued growth from Vivera retainers and Invisalign Doctor Subscription Program, or DSP, our monthly subscription-based clear aligner program. And Commerce sales for aligner-related consumables, like aligner cases and whitening and cleaning products. DSP has been successful in addressing an important and growing opportunity for experienced Invisalign doctors. It is our first subscription-based clear aligner program that enables doctors to reach new patients and provide them with a better overall experience. DSP enables doctors flexibilities to treat simple touch-up cases or offer their patients a superior, flexible, and convenient retention solution. We introduced DSP in the United States and Canada in 2021. We expanded it to Spain and the Nordic countries in Q2 2023, and we'll launch DSP in France and the United Kingdom in the second half of this year. We have also extended DSP to DSO partners who recognize the value of our Invisalign subscription aligner put model. Over the past two years, our DSP subscription program has continued to ramp and in Q2 drove strong volume growth in touch-up cases typically five to 10 stage cases of aligners. For Q2 '23, we shipped over 18,000 DSP touch-up cases in North America, up from 15,500 in Q1 '23 and more than double the case volume in Q2 '22 last year. Given its continued success and contribution to our growth this year, DSP touch-up cases are included in my overall commentary for clear aligners. Otherwise, specified in my remarks, our case volumes and metrics do not include DSP and touch up cases. For Q2, total clear aligner volumes were up 5% sequentially and up 1% year-over-year. Q2 clear aligner volumes, including DSP touch-up cases, were up 5.4% sequentially and up 2.4% year-over-year. For the Americas, Q2 clear aligner volumes reflect sequential growth across the region from both ortho and GP dentist channels, an increase in teen case starts driven by momentum from Invisalign First and increased adult patients from the GP dentist channel. In North America, adoption of the Invisalign Comprehensive three and three product drove sequential volume growth. For Q2, North American ortho utilization was up sequentially and down a fraction year-over-year, including DSP touch-up cases. Q2 North American ortho utilization was up both sequentially and year-over-year as noted in our Q2 '23 earnings slides. For EMEA, Q2 clear aligner volumes were up sequentially and year-over-year, reflecting growth across the region and continued adoption of Invisalign Moderate, Invisalign Comprehensive three and three products as well as an increase in teen case starts, which grew sequentially and year-over-year driven by Invisalign First and our new Invisalign Teen case packs. On a sequential basis, clear aligner growth was led by Iberia, Italy, DACH, and Turkey. For APAC, Q2 clear aligner volumes were up sequentially and up year-over-year, reflecting improving trends in China as well as other key markets like Japan, Taiwan, Korea and India. Q2 APAC results also reflect increased Invisalign submitters and higher utilization, especially for teen patients, driven by growth from Invisalign First in the orthodontic channel, which is especially important as we enter the China team season in Q3. Q2 APAC results also reflect growth in the GP channel with increased Invisalign submitters and higher utilization sequentially and year-over-year. During Q2, we continued to roll out the Invisalign Comprehensive three and three product in APAC, where it is now available in Hong Kong, Korea, Taiwan, and India. We plan to launch Invisalign three and three in China in Q3. We are also pleased with the additional adoption of three and three product in APAC, where the majority of cases treated are comprehensive, allowing our doctor customers more flexibility within the Invisalign product portfolio. In June, we hosted 2023 Invisalign APAC Summit in Singapore and brought together nearly a 1,000 orthodontists and general practitioners, dentists and clinic staff from 18 countries across the Asia Pacific region. The Summit showcased Invisalign and iTero products, the Align Digital platform and the recent and upcoming innovations, while also highlighting our doctors' experience with digital transformation, and how it improves the patient treatment journey. Attendees joined expert sessions focused on enhancing treatment planning efficiency, optimizing digital workflows, addressing the unique needs of teens and younger patients in exploring the essential aspect shaping today's digitally driven orthodontic practices. Teen orthodontic treatment is the largest segment of the orthodontic market worldwide and represents our largest opportunity for clear aligner sales to Orthos. We continue to focus on gaining share from traditional metal braces through teen-specific sales and marketing programs and product features unique to the Invisalign system. For Q2, total clear aligner cases for teenagers were up 7% sequentially and 9.7% year-over-year, reflecting improving trends across the regions. On a sequential basis, growth was driven by increased submitters in the APAC and EMEA regions on a year-over-year basis. TNK starts were in the APAC region, driven by increased submitters and in the EMEA region, driven by increased submitters and utilization, both in the orthodontic channel. Last year, we introduced the Teen Case Packs in the United States and Canada, and in Q1, Q2, we launched them in France, Scandinavia and Iberia. For the quarter, Teen Case Packs increased sequentially and year-over-year, driven by strength in EMEA. Invisalign First also was up sequentially and year-over-year across all regions and continues to drive adoption of Invisalign treatment among young patients. Invisalign First aligners are designed for Phase 1 treatment, typically in growing children six to 10 years old, making up about 20% of orthodontic case starts. For the dental service organizations, or DSO customers, Q2 clear aligner volumes increased sequentially primarily from the Americas region. Overall, clear aligner growth rate from DSO doctors continues to outpace non-DSO doctors and our DST touch-up cases are ramping nicely up as DSO doctors understand the value of the subscription program brings regarding pricing and flexibility for their patients. Invisalign is one of the most trusted brands in the orthodontic industry globally among both doctors and patients. On the consumer marketing front, we delivered $10.3 billion impressions and had 30.9 million visits to our website in Q2 '23. To increase awareness and educate young adults, parents teams about the benefits of Invisalign brand, we continue to invest in top media platforms such as TikTok, YouTube, Snapchat, Instagram across all markets as well as key social media influencers and brand ambassadors. In the Americas, we focused on reaching young adults as well as teens and their parents through our influencer and creator-centric campaigns partnering with leading smile squad creators, including Marshall Martin, Rally Shaw, and Jeremy Lin. Each of these creators shared their personal experiences with Invisalign treatment and why they chose to transform their smile with Invisalign aligners. Additionally, in the United States, we work closely with athletes over time, a high school sports social media platform that showcases the benefits of Invisalign treatment. Brand interest remained strong throughout the quarter with 9.2 million consumers visiting our websites in the Americas region, representing 17% growth year-on-year. In EMEA region, we partnered with new influencers to reach consumers across social media platforms, including TikTok and Meta. In Germany, we launched new testimonial campaigns highlighting the stories of 70 young adults and teens who share why they chose Invisalign treatment and how it impacted their lives. Our consumer campaigns delivered more than 1.7 billion media impressions and 9.7 million visitors to our website. We continue to invest in consumer advertising across the APAC region, resulting in more than 12 million visitors to our websites and over $4.8 billion impression. We expanded our region in Japan and India via TikTok, Meta and YouTube. We partner with key influencers like [indiscernible]. We saw increased brand interest in consumers as evidenced by 270% year-over-year increase in unique visitors to our website in India and a 46% year-over-year increase in Japan. Adoption of My Invisalign consumer and patient apps continued to increase with 3.1 million downloads to date and over 350,000 monthly active users, a 28% year-over-year growth. Uses of other digital tools also continue to increase. ClinCheck live update was used by 40,000 doctors on more than 580,000 cases, reducing time spent and modifying treatment by 20%. Invisalign practice app is increasing in adoption with 88,000 doctors who are actively using this app and 5.1 million photos were uploaded in Q2 via the Invisalign practice set. With that, I'll turn the call over to John.
John Morici: Thanks, Joe. Now for our Q2 financial results. Total revenues for the second quarter were $1.002 billion up 6.3% from the prior quarter and up 3.4% from the corresponding quarter a year ago. On a constant currency basis, Q2 '23 revenues were impacted by favorable foreign exchange of approximately $1.3 million or approximately 0.1% sequentially. And unfavorably impacted by approximately $19.4 million year-over-year or approximately 1.9%. Clear aligners Q2 revenues of $832.7 million were up 5.4% sequentially, primarily from higher volumes, higher non-case revenues and higher ASPs. On a year-over-year basis, Q2 clear aligner revenues were up 4.3%, primarily due to higher ASPs, higher non-case revenues and higher volumes. For Q2, Invisalign ASPs for comprehensive treatment were down sequentially and up year-over-year. On a sequential basis, ASPs reflect larger discounts and product mix shift to lower-priced products partially offset by price increases. On a year-over-year basis, the increase in comprehensive ASPs reflect price increases and higher additional aligners, partially offset by product mix shift, larger discounts and unfavorable foreign exchange. For Q2, Invisalign ASPs for non-comprehensive treatment were up sequentially and year-over-year. On a sequential basis, the increase in ASPs reflect lower discounts, higher additional aligners, price increases, and favorable foreign exchange. On a year-over-year basis, the increase in non-comprehensive ASPs reflect price increases and higher additional Aligners, partially offset by product mix shift, larger discounts and unfavorable foreign exchange. In Q1 '23, we launched Invisalign Comprehensive three and three products in most markets, and we have continued to expand into more markets, as previously mentioned. The three and three configuration offers our doctor customers, our Invisalign comprehensive treatment with three additional aligners included within three years of the treatment end date, instead of unlimited additional aligners with five years of the treatment end date at the 2022 Invisalign comprehensive product price. Over time, we have come to learn that on average, Invisalign doctors complete a comprehensive Invisalign treatment with two or fewer additional aligners. We are pleased with the continued adoption of the Invisalign Comprehensive three and three product and anticipate that it will continue to grow, providing doctors the flexibility they desire and allowing us to recognize more revenue upfront with deferred revenue being recognized over a shorter period of time, compared to our traditional Invisalign comprehensive product. As revenues from subscriptions, retainers, and ancillary products continue to grow globally, some of the historical metrics that only focus on case shipments are expected to account for a lesser percentage of our overall growth. In our earnings release and financial slides, you will see that we have added our total clear aligner revenue per case shipment, which we believe to be more indicative measure of our overall growth strategy. Q2 '23 clear aligner revenues impacted from favorable foreign exchange of approximately $1.2 million or approximately 0.1% sequentially. On a year-over-year basis, clear aligner revenues were unfavorably impacted by foreign exchange of approximately $16.3 million or approximately 1.9%. Clear aligner deferred revenues on the balance sheet increased $13 million or up 1% sequentially and $138.6 million or up 12.2% year-over-year and will be recognized as the additional aligners are shipped. Q2 '23 systems and services revenue of $169.5 million were up 10.5% sequentially, mostly due to higher scanner volume, higher revenues from our certified preowned program and higher services revenue from our larger base of scanners sold, partially offset by unfavorable ASPs. On a year-over-year basis, Q2 '23 systems and services revenue were down 1%, primarily due to lower scanner volume and unfavorable ASPs, partially offset by higher services revenues from our larger base of scanners sold and higher revenues from our CPO and leasing rental programs. Q2 '23 systems and services revenue were impacted from favorable foreign exchange of approximately $0.1 million or approximately 0.1% sequentially. On a year-over-year basis, systems and services revenue were unfavorably impacted by foreign exchange of approximately $3.1 million or approximately 1.8%. Systems and Services deferred revenues on the balance sheet was down $2.3 million or 0.8% sequentially, primarily due to the decrease in the deferral of service revenues included with our scanner purchase and up $8.6 million or 3.3% year-over-year, primarily due to the increase in scanner sales, and the deferral of service revenues included with our scanner purchase, which will be recognized ratably over the service period. As our scanner portfolio expands, and we introduced new products, we increased the opportunities for customers to upgrade, make trade-ins, and provide refurbished scanners for certain markets. As such, our model is changing. We expect to continue growing our programs and as offering our CPO units for purchase and selling the way the customer -- our customers desire. Developing new capital equipment opportunities to meet the digital transformation needs of our customers and DSO partners, is a natural progression for our equipment business with a large and growing base of scanner sold. Moving on to gross margin. Second quarter overall gross margin was 71.2%, up 1.2 points sequentially and up 0.3 points year-over-year. Overall gross margin was unfavorably impacted by foreign exchange of approximately 0.5 points on a year-over-year basis. Clear aligner gross margin for the second quarter was 72.4%, up 0.7 points sequentially, primarily due to the lower mix of additional aligners, favorable manufacturing variances and higher ASPs. Clear aligner gross margin for the second quarter was down 0.9 points year-over-year, primarily due to increased manufacturing spend as we continue to ramp up operations at our new manufacturing facility in Poland and a higher mix of additional aligner volume, partially offset by higher ASPs and lower freight. Systems and Services gross margin for the second quarter was 65.1%, up 3.5 points sequentially, primarily from lower service and freight costs, partially offset by lower ASPs. Systems and Services gross margin for the second quarter was up 5.3 points year-over-year, primarily from lower service and freight costs and higher services revenue, partially offset by lower ASPs. Q2 operating expenses were $541.7 million, up sequentially 2.8% and up 8.5% year-over-year. On a sequential basis, operating expenses were up $14.5 million, primarily from higher consumer marketing spend and higher incentive compensation. Year-over-year, operating expenses increased by $42.3 million, primarily due to higher incentive compensation and our continued investments in sales and R&D activities, partially offset by controlled spending on advertising and marketing as part of our efforts to proactively manage costs. On a non-GAAP basis, excluding stock-based compensation, and amortization of acquired intangibles related to certain acquisitions, partially offset by restructuring and other charges, operating expenses were $505 million up 2.9% sequentially and up 8.4% year-over-year. Our second quarter operating income of $171.9 million resulted in an operating margin of 17.2% up 3 points sequentially and down 2.2 points year-over-year. The sequential increase in operating margin is primarily attributed to higher gross margin, as well as favorable impact from foreign exchange of 0.1 points. The year-over-year decrease in operating margin is primarily attributed to investments in our go-to-market teams and technology, as well as unfavorable impact from foreign exchange by approximately 1.1 points. On a non-GAAP basis, which excludes stock-based compensation, amortization of intangibles related to certain acquisitions, offset by restructuring other charges, operating margin for the second quarter was 21.3%, and up 2.8 points sequentially and down 2 points year-over-year. Interest and other income and expense net for the second quarter was a loss of $0.3 million compared to an income of $1.1 million in the first quarter and a loss of $14.6 million in the second quarter a year ago, primarily due to foreign exchange. The GAAP effective tax rate for the second quarter was 34.8%, consistent with the first quarter effective tax rate of 34.8% and 35% in the second quarter of the prior year. As a reminder, in Q4 2022, we changed our methodology for the computation of our non-GAAP effective tax rate to a long-term projected tax rate and have given effect to the new methodology from January 1, 2022, and recast previously reported quarterly results in 2022. Our non-GAAP effective tax rate in the second quarter was 20%, reflecting the change in our methodology. Second quarter net income per diluted share was $1.46, up sequentially $0.32 and up $0.02 compared to the prior year. Our EPS was unfavorably impacted by $0.02 on a sequential basis and unfavorably impacted by $0.15 on a year-over-year basis due to foreign exchange. On a non-GAAP basis, net income per diluted share was $2.22 for the second quarter, up $0.40 sequentially and up $0.07 year-over-year. Note that the prior year 2022 non-GAAP net income per diluted share in our prior year 2022 non-GAAP reflects the Q4 2022 change in our methodology for the computation of our non-GAAP effective tax rate. Moving on to the balance sheet. As of June 30, 2023, cash, cash equivalents and short-term, and long-term marketable securities were $133.8 billion up sequentially $112.4 million and up $56.6 million year-over-year. Of our $133.8 billion balance $314.3 million was held in the U.S. and $719.5 million was held by our international entities. In Q2, we completed a $75 million equity investment in Heartland Dental a multi-disciplinary DSO with GP and ortho practices across the U.S. During Q1 2023, we announced that our Board of Directors authorized a new $1 billion stock repurchase program to succeed the 2021 $1 billion program. Currently, $1 billion remains available for repurchase under the 2023 $1 billion stock repurchase program. Q2 accounts receivable balance was $908.4 million, up sequentially. Our overall days sales outstanding was 81 days, down approximately two days sequentially and down approximately four days as compared to Q2 last year. Cash flow from operations for the second quarter was $251.9 million. Capital expenditures for the second quarter were $58.5 million, primarily related to our continued investments to increase aligner manufacturing capacity in facilities. Free cash flow, defined as cash flow from operations less capital expenditures amounted to $193.3 million. Now turning to our outlook. As Joe mentioned earlier, we are pleased with our Q2 results. While the macroeconomic environment still remains uncertain, we have seen improvements in the operating environment and the consumer demand signals that influence our outlook. For Q3 2023, we anticipate our worldwide revenue to be in the range of $990 million to $1.01 billion, up approximately 12% year-over-year at the midpoint. We expect our Q3 2023 GAAP and non-GAAP operating margin to be slightly up from Q2 2023 as we continue to strategically prioritize our investments in R&D and go-to-market activities to drive growth. For full-year 2023, assuming no circumstances occur that are beyond our control, we anticipate our 2023 worldwide revenue to be in the range of $3.97 billion to $3.99 billion, up approximately 7% year-over-year at the midpoint. We also expect our full-year 2023 GAAP operating margin to be slightly above 17% and our 2023 non-GAAP operating margin to be slightly above 21%, a 1 point improvement from the guidance we provided in April of 2023. For 2023, we expect investments in capital expenditures to be approximately $200 million. Capital expenditures are expected to primarily relate to building construction improvements as well as manufacturing capacity in support of our continued international expansion. With that, I'll turn it back over to Joe for final comments. Joe?
Joseph Hogan: At our continued growth despite the economic slowdown in uncertain environment. Q2 results demonstrate our resilience and adaptability. While we cannot predict future economic conditions, we're confident in our ability to focus and execute on our strategic growth initiatives. As a leader in digital transformation, we offer a powerful suite of innovative digital tools that make up the aligned digital platform, which provides a seamless end-to-end digital experience for doctors and their patients. Innovations launched over the last year include ClinCheck live update for 3D controls. This enables doctors to generate modified Invisalign patient treatment plans in real time, reducing modifications that used to take weeks to as little as two minutes. Improving practice productivity while also improving the quality of treatment plans. Invisalign Personal Plan, or IPP streamlines the treatment planning process and helps doctors achieve their desired treatment plans more consistently and efficiently. Invisalign Smile Architect allows general dentists to integrate clear aligner therapy into their comprehensive treatment plans by combining tooth alignment and restorative planning in a single platform. Invisalign Virtual Care, equips doctor with a next generation remote monitoring solution that has new artificial intelligence assisted capabilities to streamline their workflows. Cowen being computed tomography or CVCT, enables doctors to visualize the patient's roots as part of the digital treatment planning process. Invisalign Outcome Simulator Pro, expand Align's existing Invisalign outcome simulator technology and adds the benefit of the company's ClinCheck in-face visualization tool that combines a photo of a patient's face, with their 3D treatment simulation, creating a truly personalized view of how their new smile will look. Itero-exocad Connector integrates iTero intraoral camera and NIRI images with exocad DentalCAD 3.1 software, and allows dental professionals to visualize the internal and external structure of teeth. In addition to these and other incredible innovations in the coming years, we'll continue to build a digital platform and add new capabilities to improve clinical outcomes and elevate the patient experience to drive continued practice growth and positive patient experiences. Thank you for your time today. We look forward to speaking to you at our upcoming Investor Day on September 6, where we'll share with you our views about the incredible market opportunity we have and how Align is uniquely positioned to continue to lead the transformation of the digital orthodontic industry. Now I'll turn the call over to the operator for questions. Operator?
Operator: Thank you. At this time, we'll be conducting a question-and-answer session. [Operator Instructions]. Our first question comes from the line of Jeff Johnson with Baird. Please go ahead.
Jeffrey Johnson: Thank you. Good afternoon guys. Hey Joe, congrats on a nice bounce back quarter here. I wanted to start really on the teen market. Obviously, that's where we all focus long-term on the business. But that 9.7% year-over-year growth, when I look back last year, it was your first quarter in a long time of negative year-over-year growth in teens. So you had a bit of an easy comp there, although, obviously, '21 was a fantastic year. So I guess I'm trying to figure out in this economy, when I think about comps from '21 that were so tough, when I think about competition that's out there, where do you think that 9%, 10% teen growth is relative to where you expect to be normalized? Are we still expecting a nice improvement of this over the next few years back to kind of mid, upper teens, something like that? I just would like to get your views on that.
Joseph Hogan: Jeff, I mean you know how important that teen market is to us, like I talked about in the script of the 21 million case starts and the majority of those 75%, 80% being teen. So I look at that sequential growth in teens is being really positive. Now we did have a good number to compare against, like you said. But when I highlighted in our -- the Invisalign First product line and how well that product is doing overall, and it continues to grow phenomenally throughout the world in all three regions that we have. Our teen packs different business models or plans that we put together, really helps with that piece, too. So Jeff, when you look at our coming technology improvements and products and those kinds of things, they're targeted really well with the teen market also. So the numbers that you mentioned about potential growth and penetration in that marketplace, in line with our investments and where we think we'll go in the marketplace. But let's be honest, it's been -- that's a struggle to get orthodontists to really move on teens. But our top docs are almost exclusively Invisalign across the board. Our job is to bring this new technology out, but also infuse it well within doctors, so they're comfortable with the work practices and comfortable with the clinical outcomes. And I feel we've made really good progress in that area.
Jeffrey Johnson: That's helpful. Thank you. And then just would like an update maybe on China. Obviously, third quarter tends to be a big teen season there, but we're also seeing some mixed macro feedback on China as a whole kind of from an overall economic standpoint. So just what's kind of current tenor of business in China? And just remind us how bad were things in third quarter last year in China, we just kind of lose track of the COVID shutdowns and all that, but should third quarter be an easy comp in China? Or were things opening back up there before we got to the beginning of this year where they shut back down again. Thanks.
Joseph Hogan: Yes. China, obviously, from an economic standpoint, Jeff, it's -- we watch that closely as everybody does, too, but we have to take it as it is right now. And we had a good quarter. We had a good start in the first quarter, too. And so we're seeing good sequential momentum, an improvement in that sense in the business overall. Obviously, when you look at the third quarter, I mean, we all know you watch our stock closely. We know the third quarter is a huge teen market in China, as I mentioned in the script, too. And we're really good on that, but we feel very confident in the sense of our positioning there and where China stands right now. I can't comment on future economic activity there with any more accuracy than you can. But what we've experienced in the second quarter and what we see going into the third, we feel good about it.
Jeffrey Johnson: Thank you.
Joseph Hogan: Thank you, Jeff.
Operator: Thank you. Our next question comes from the line of Jon Block with Stifel. Please go ahead.
Joseph Hogan: Hi, Jon.
Jonathan Block: Good afternoon. Hi, Joe. I'll start on innovation. And Joe, going into '23, you called out this year is one of the biggest for Align in terms of innovation when we think about the company's history. At the end of the prepared remarks, that was really helpful. You laid out a handful of innovations. Where are you with the next wave? And when I say the next wave, any details that you can give with paddle expansion in terms of timing in the U.S., maybe if you can elaborate a little bit on the limited rollout in Canada to date. And is there anything else that we should expect more near term, i.e., maybe next three to 12 months before some of those longer-term aspirations come into play on direct printing? And then I'll ask my follow-up.
Joseph Hogan: Jon, obviously, the Invisalign Palate Expander has come a long way. You probably get -- that we've had some four ways into Canada recently and good feedback on our product line. When we look at the investor conference coming up, we'll obviously give you a much more detailed discussion in the sense of where that product stands, and how we'll commercialize it. But overall, what I'd tell you, John, we know how to make it. We have a process that makes it. Remember, with our business though, just making it doesn't mean anything, you've got to scale this thing to million. And so that's what our focus is right now is how we scale, how we roll this out. There's obviously a lot of regulatory qualifications we have to meet in each area because it's a new device, too, but I feel good about that. And Jon, when you look our development, you know this well, you can almost draw a line between the production of product and then the software that we talked about with the software piece. Obviously, IPE represents both of those, right? It's new software and new kind of treatment planning, but it's actually a 3D-printed device that we haven't launched before. So just think about in the scale-up mode, but when we see you on September 6, we'll have many more details for you.
Jonathan Block: Okay. That's helpful. And then maybe as my second question, sort of one of those famous two partners. John, to start with you, can you elaborate on the ASP for comprehensive Q-over-Q? I believe you said it was down Q-over-Q, little confused because I think you would have had the full quarter the price increase on the 3x3 and the comprehensive. So if I've got that right, maybe if you can tease out why it would have been down Q-over-Q. And then, Joe, the upside for the cases, I'm packing it around 10,000 relative to the implied guide that you gave back for 2Q. I've got the U.S. cases essentially in line with our estimate. International seems to have really been the driver of the upside. And maybe to build on Jeff's question, can you just give some more details where the outperformance was? Was it China? Was it EMEA? Where do you see maybe the better-than-expected results specific to those international regions? Thanks guys.
John Morici: Yes. Just first on the ASP, Jon. Yes, the comprehensive were down slightly, just a reflection of some of the product mix that we had as well as some of the discounts that we have partially offset by price decrease. So nothing out of the ordinary there, we actually saw an increase on a sequential basis for non-comp. But the comprehensive was just more mix.
Joseph Hogan: Jon, back to me is -- yes, you're right. I mean, when you look at from a regional standpoint, EMEA and APAC stood out. Really across the board in EMEA, I mean like I mentioned in my script, had Iberia did well. U.K. did well. The Nordic side, we just introduced DSP and different things. We're excited about those areas, too. So -- and then the teen growth there overall across those geographies was good. So I mean, it's just -- I think just good strong performance. And then when you think about the EMEA economy, too, Jon, I mean last year there was a lot of uncertainty with the Ukraine situation that hasn't gotten any better, but Europeans and the European countries, I think have solidified their economies around that. And just we're seeing some improvement from a consumer sentiment standpoint, too. So that's reflected in our numbers also. On APAC, obviously, China was good year-on-year. Japan actually was very strong for us, too, along with Korea, in different parts of Asia, as I mentioned. So it's still broadly really good improvements in both of those regions by country and also specifically in that teen segment that I mentioned. So we're seeing good improvement Jon, from a sequential standpoint.
Shirley Stacy: Next question please.
Operator: Our next question comes from the line of Nathan Rich with Goldman Sachs. Please go ahead.
Nathan Rich: Great, good afternoon. Thanks for the questions. Hey Joe, hey John. I guess, could you maybe just talk about how adult cases performed relative to your expectations, improved slightly, but I think still down a little bit year-over-year. And how are you thinking about the biggest swing factors that could impact revenue in the back half. Does the guidance kind of just reflect a continuation of the environment that you saw in 2Q? And is there any kind of part of the business that you're watching specifically, either teen versus adult or certain markets that you feel are especially big swing factors in the back half?
John Morici: Yes, I'll take that one, Nate. This is John. When you look at the commentary that we gave, we saw improving trends as we went into the second quarter. We see that in the results. And our guidance reflects that. It shows up in Q3, and it also gives us the confidence to talk to a guide for the total year. So that's how we've kind of factored things in and looking at the normal metrics in indices that help us with that. As far as adult versus teen, as we said, teen season now. We saw good results in Q2, and we expect that to continue in Q3. As we've said, China is a big market, U.S. big market in Q3, and we expect that to continue. And adults important for us, too. We have a lot of capabilities to be able to go to those general dentists and try to work where those adults might be wanting to come into treatment and be able to help provide for them as well as our orthodontists. So we feel good about the efforts that we have to try to improve both teen and adult as we go through this year.
Nathan Rich: Okay, great. And then just a clarification on the touch-up cases. So -- it sounds like that's pressuring the North America ortho utilization metric. But if you back that out, or kind of include touch up, it would have been up year-over-year. I'd just be curious to get your sense of what portion of those 18,000 touch-up cases would have been cases kind of in your view in the past prior to DSP just so we get a sense of what that shift might look like?
John Morici: Yes. So those touch-up cases, as we talked to those 18,000, those would have been -- those are the touch-up cases that would have been the lower-stage products that we had 5 stage, maybe 7 up to 10, but in that range, 5 to 10, but probably more on the low side of that in terms of the stages. And we see this great adoption with the DSP program, as we mentioned in the prepared remarks, it doubled from last year. We wanted to give some commentary about how big this is becoming and show them in our kind of our discussion about the year-over-year, and the sequential and so on. And at Investor Day in September, I'll give a lot more detail about kind of where it came from, how it's become more and more important and what it means going forward because we're going to include these cases going forward. But in the end, we see in all cases where we see -- we've seen the DSP program, it drives incremental volume for us. Those doctors continue to do those comprehensive cases that we see, but those doctors are also doing these low stage touch-up cases as well as retention. And we think that's a good thing for our doctors.
Nathan Rich: Great, thank you.
John Morici: Thanks, Nate.
Operator: Thank you. Our next question comes from the line of Brandon Vazquez with William Blair. Please go ahead.
Joseph Hogan: Hi, Brandon.
Brandon Vazquez: Hello, thanks for taking the question. I just wanted to follow-up first on the DSP program. If we're doing our math correctly, it seems like most, if not all of the year-over-year increase in case volumes is actually coming from the DSP program. So one, is that correct? And two, maybe if it is, can you talk about where do you think the mix goes eventually to DSP? And is DSP at this point accretive to your case volumes? Or are you seeing accounts kind of switch what they would have been doing as kind of normal base volumes into DSP?
John Morici: We're actually seeing DSP as accretive. So we're not seeing -- we're seeing -- fundamentally, we're seeing doctors who were either making them themselves or going to lab or other ways of making the Aligners actually switching over and continuing to give us those comprehensive cases, but then they're also now giving us the DSP cases. Remember, most of DSPs, the majority of DSP is retention, and it's the retention that we're providing. But then a subset of that is these touch-up cases and like I said, about 18,000 or so. And what we've also commented to it would have -- it would have helped us by about 1.5 points on an overall basis. So we reported our volumes up about 0.9%. And they would have been up 1.5 points on that to 2.4%. So it's accretive no matter how we look at it, and it's certainly accretive from a standpoint of the margin that it generates. It's generating some of the highest margin from our product portfolio that we have because the cost to serve is very straightforward for us. There's no additional liners or anything else. So we recognize all the revenue as soon as we ship without additional aligners related to that.
Brandon Vazquez: Okay. And then one other second on......
Joseph Hogan: Other clarification on your question was whether you put DSP or not, we were up year-over-year in our numbers.
Brandon Vazquez: Got it.
Joseph Hogan: So sequentially not sure -- go ahead.
Brandon Vazquez: Got it. That's helpful. The next question is just on teens. I think, Joe, you had said a little earlier, a little frank about there's hurdles within the teen market and kind of pushing that share into existing accounts to get a little deeper -- can you guys just talk about what are kind of the top hurdles right now? Why has it been a little bit tougher to get the incremental share in the teen market? And what are you guys kind of focused on in the next six to 12 months to push that share forward? Thanks.
Joseph Hogan: Hey Brandon, in general, when you look at orthodontic workflows, if they're not completely digitized in the sense of what they do and you're kind of in a down cycle right now with orthodontists and their challenge. They feel like on a wire bracket side, they can just make more money with wires and brackets versus Invisalign because the raw material costs are 3.5x. Now if you're fully digitized your workflows and everything else, obviously, you make more money with Invisalign. But I think in these kind of challenging economic times, it's just more difficult to move the orthodontic community over to the clear aligner piece because they're just used to the workflow of what we have with versus wires and brackets. I can say Invisalign First seems to be an exception to that. In the sense of how Phase I kind of patients are treated. That's not a constant when you look at what's going on in the orthodontic industry. But we see a lot more interest in Phase I with Invisalign First than we thought before. I think that's going to help to be a span breaker for us in this whole thing. In the future, there's no doubt to us in the sense that clear aligners of the future, no white spot lesions, obviously six months faster than a normal kind of a treatment, much easier for patients. We know all those things. When you ask what the biggest issues are, they're not basically clinical anymore. It's about workflow, workflow and confidence in orthodontic practice.
Operator: Thank you. Our next question comes from the line of Elizabeth Anderson with Evercore ISI. Please go ahead.
Elizabeth Anderson: Hi guys. Congrats on the quarter and thanks so much for the question. One, this -- don't take this as a complete because I'm very happy that we have full-year guide. What I was -- wanted to ask was like what -- did you guys see sort of in the end markets or in your -- the visibility of your results to the macro picture that made sort of this time the right time to kind of move on from what we've had in the quarterly guide, the last couple of quarters into this sort of longer guidance.
Joseph Hogan: Yes, I'll give you the high-level view, and I'll turn it over to John, Elizabeth for the ground thing. But I mean, obviously, we had a good second quarter, and we feel we can see through to the third quarter whatever. At that point, too, like we said, with the qualifiers is continued economic situation that we see now, we feel confident just based on what we understand from a cyclical standpoint to be able to call the fourth quarter. And so look, we're still in very difficult economic times and uncertain times. But with the second quarter out of the way and with what we talked about improvement, particularly in a sequential sense, we just felt like I mean we're going to give it to you, you're going to make it up. So we might give the best guess we have. But John can give you more.
John Morici: Yes look, I can't add much more to that. We've got now a couple good quarters behind us. We've seen stability kind of turning to improving trends. It's a good position to be in. We continue to see that into the third quarter. As Joe said, it's not great, but it's better than it has been from an overall economic standpoint. And so based on the order trends and kind of how things are looking, we felt comfortable about Q3 and translate that to total year as well.
Elizabeth Anderson: Got it. And just as a follow-up, are you guys taking any different approach to sort of like, sales either so from like a personnel perspective or a focus versus earlier in the year? I know sometimes you guys have sort of been ramping reps. And then that had sort of flatlined. So I just wanted to understand sort of like how you're thinking about that as we go into the balance of the year and sort of set up for 2024?
Joseph Hogan: Elizabeth, I'd say our sales practices are consistent and dynamic in the same way, consistent in the sense of the number of salespeople we have, how we train those salespeople, how they go to market. We obviously offer different products in different areas. We split up orthodontics salespeople and general dentistry salespeople specifically because it's just a different kind of a call. So there's no I'd say, big change in the sense of how we go to market. And obviously, our iTero sales force works really closely with the Invisalign sales force and overlaps in some areas. But I might be missing your question, but there's no, I'd say, material changes going on from a sales as salespeople, a number of salespeople standpoint and specifically the way we approach the market.
Elizabeth Anderson: Okay, thank you guys.
Operator: Thank you. Our next question comes from the line of Michael Ryskin with Bank of America. Please go ahead.
Michael Ryskin: Thanks for taking the questions. I got a couple of quick ones. One is well, actually kind of related. One is just related to the results, 1Q to 2Q and sort of your outlook for 3Q -- just sort of a yes or no question. Is it safe to say that you're kind of back to the usual seasonality you've seen historically, it's been a little volatile for the last couple of years, but it seems like we're setting the back in that routine. Is it safe to say that, that should be our base case approach going forward?
John Morici: Well, I think what we see is in terms of our Q2 to Q3 guide, that is more of a typical seasonality flat to slightly up from Q2 to Q3. So that's -- that is that how that goes going forward. I think given the commentary that we've given just the overall macro uncertainty, we're not ready to say that. We're completely back to normal seasonality. But what we see in the short term here in the guidance that we gave that reflects that.
Michael Ryskin: Okay. And then the second one would be on the Analyst Day. I mean, a couple of pieces there. One is, could you just what goes into the thought process that now is the right time to have the Analyst Day. As you say markets are still pretty uncertain. There's still some volatility, visibility is not fully back. So kind of what goes into that decision? And then related to that, the long-term guide, is that something you're going to be addressing just as we start thinking about modeling 2024 and going forward from there?
Joseph Hogan: We usually do this about every two years, Michael. It is a really sophisticated algorithm we use to figure that out, but it's about every two years. And we think it's just about time for that, too, from the standpoint of just to reinitiate the investor base in the sense of where we're investing, how we see the marketplace. And just a good summary of a lot of the questions that have been asked.
Michael Ryskin: Got it.
Shirley Stacy: Yes, sorry. Is there one more question?
Operator: Our next question comes from the line of Jason Bednar with Piper Sandler. Please go ahead.
Joseph Hogan: Hi, Jason.
Jason Bednar: Thanks. Good afternoon. Thanks for taking my questions guys. I wanted to touch on a few things that stood out to us in the quarter. Maybe first, just the combination of a sequential increase in doctors you ship to plus higher utilization across all channels that you serve again, always good to see that combination come together. I know you don't provide the granularity anymore on doctor shipped across the U.S. or international markets. But -- just I guess, directionally, are you able to specify whether the increase in doctors is exclusive to China coming back online and expansion in APAC? Or did you see an increase in users in your North American channels and EMEA channels as well?
John Morici: Yes, Jason, you're right. We don't give that level of detail, but we saw more doctors that we ship to in APAC related to China, as you said, and we saw it in other regions as well. So we are pleased with the number of doctors that we're shipping to. It's a reflection of our products. And what they want to do and then as well, being able to be up on a utilization basis is a good metric as well.
Jason Bednar: Okay. I guess maybe just to follow-up there, John, real quick. Can you confirm whether or not you saw that increase in North America in Orthos or GPs or both?
John Morici: Yes, we saw improvement for North America as well.
Jason Bednar: Okay, all right. Great. And then I know we got some good details on some of your APAC markets, including China. But I guess wondering if you can talk about just monthly cadence of U.S. trends throughout the quarter and maybe even here in July. Some of the work we've done shows that there's maybe a bit more mix trends in April and June, May was pretty strong. I guess just wondering how that drives what you were seeing in your case shipment trends throughout the quarter? And then same question for EMEA, if you could elaborate just on how the quarter unfolded in that region? Thank you.
John Morici: Yes. We're really not giving -- like -- I don't really want to get into the month-by-month activity. I think the results kind of show where they were, Jason, and then it also kind of reflects what we've been able to give from a guidance standpoint as well. But without getting into months by country and region and so on, it gets a little difficult to give that level of detail. But I think the results that we have for Q2 and what we've talked about how the sequential improvement and what we were able to see on a quarter-over-quarter basis and what it means for the guidance kind of speak to that.
Jason Bednar: Okay, fair enough. Thanks.
John Morici: Thanks, Jason.
Operator: Our next question comes from the line of Brandon Couillard with Jefferies. Please go ahead.
Brandon Couillard: Hey thanks guys.
Joseph Hogan: Hi, Brandon.
Brandon Couillard: You mentioned scanner ASPs as a bad guy in terms of segment gross margin sequentially and year-over-year. Joe, could you just talk about the competitive environment and whether you're seeing pricing pressure intensifying, just your macro view there would be helpful. Thanks.
Joseph Hogan: Yes, I wouldn't call it, a bad guy. I think what we tried to communicate was, we have a mix in there that's from a price standpoint. We feel good about our upper-end product line and the prices we're able to get for a 5D Plus and 5D Flex and it's a premier scanner in the marketplace. As you mentioned before and as you know, I mean, there's a certain sensitivity in the marketplace about these kind of capital expenditures in a dental office when a lot of the economics are challenged right now in the orthodontic and in dental side. So we see that. But despite that, you could see we turned really good numbers around. Our CPOs help us to fight on the lower end. CPOs are the certified preowned that allow us to go down market if we have to. And obviously, when you look at the marketplace, it's pretty -- if you have the -- what we would call the confocal imaging scanners, like that we lead with. And then there's products like Metadata whatever they try to take the low end and whatever. But we feel -- I feel good about our capability, our value proposition, and I think our numbers reflect that this quarter and in the past too. So I'm not saying there's not a competitive environment. I just feel we have a superior product line, and then we have a good value stream that we offer from a standpoint of the integration with Invisalign through iTero and then [indiscernible].
Brandon Couillard: Great. And John, you mentioned freight costs coming down year-over-year as a positive tailwind to gross margins. I think first time in a while. I think that's been the case. Do you expect that to be sustainable over the next several quarters? And any color on how we should about gross margins in the second half of the year relative to 2Q base?
John Morici: I think it's a reflection of just it's freight, but maybe some of the material costs and others that as we manage things, manage our business and we see less inflationary pressure from kind of the raw material/freight and other inputs. And we're always driving productivity. We're always trying to be improve our productivity. We saw that in some of our gross margin improvements, both for clear aligner and the scanner and services. And we'll work to continue to manage it. But seeing some of those pricing pressures, the input pricing pressure come down that continues.
Brandon Couillard: Very good. Thank you.
Operator: Thank you. And we have reached the end of our question-and-answer session. I will now hand the call back over to Shirley Stacy for closing remarks.
Shirley Stacy: Thank you, everyone, and thank you again for joining us. We look forward to speaking to you at any financial conferences and industry meetings. And as Joe mentioned, Align is hosting its 2023 Investor Day, September 6 in Las Vegas. For more information, please visit our Investor Relations page on aligntech.com. Or if you have any questions, please contact Investor Relations. Thanks, and have a great day.
Operator: Thank you. This concludes today's conference, and you may now disconnect your lines at this time. Thank you for your participation. | [
{
"speaker": "Operator",
"text": "Greetings, welcome to the Align Second Quarter 2023 Earnings Call. At this time, all participants are in a listen-only mode. A question-and-answer session will follow the formal presentation. Please note this conference is being recorded. I will now turn the conference over to your host, Shirley Stacy, with Align Technology. You may begin."
},
{
"speaker": "Shirley Stacy",
"text": "Thank you. Good afternoon, and thank you for joining us. I'm Shirley Stacy, Vice President of Corporate Communications and Investor Relations. Joining me for today's call is Joe Hogan, President and CEO; and John Morici, CFO. We issued second quarter 2023 financial results today via Business Wire, which is available on our website at investor.aligntech.com. Today's conference call is being audio webcast and will be archived on our website for approximately one month. A telephone replay will be available today by approximately 5:30 p.m. Eastern Time through 5:30 p.m. Eastern Time on August 9th. To access the telephone replay domestic callers should dial (929)-458-6194 with access code 342791. International callers should dial 44-204-525-0658 using the same access code. As a reminder, the information provided and discussed today will include forward-looking statements, including statements about Align's future events, products and outlook. These forward-looking statements are only predictions and involve risks and uncertainties that are described in more detail in our most recent periodic reports filed with the Securities and Exchange Commission available on our website and at sec.gov. Actual results may vary significantly, and Align expressly assumes no obligation to update any forward-looking statements. We've posted historical financial statements, including the corresponding reconciliations, including our GAAP to non-GAAP reconciliation, if applicable, and our second quarter 2023 conference call slides on our website under quarterly results. Please refer to these files for more detailed information. With that, I'd like to turn the call over to Align Technology's President and CEO, Joe Hogan. Joe?"
},
{
"speaker": "Joseph Hogan",
"text": "Thanks, Shirley. Good afternoon, and thanks for joining us. On our call today, I'll provide an overview of our second quarter results and discuss a few highlights from our two operating segments, system services and clear aligners. John will provide more detail on our Q2 financial performance and comment on our views for the third quarter and 2023 overall. Following that, I'll come back and summarize a few key points, and we'll open the call to questions. Overall, I'm pleased to report another better-than-expected quarter with Q2 revenues and operating margins that exceeded our guidance. Q2 results reflect improving trends across regions, strength in teen and younger patient volumes, driven by momentum in both submitters and utilization as well as continued growth from Invisalign First. In the Teen segment, which represents the largest portion of the 21 million annual orthodontic case starts, 195,000 teens and kids started treatment with Invisalign clear aligners during the second quarter. An increase of 7% sequentially and 10% year-over-year, reflecting the highest annual growth rate in the teen segment since 2021. For Systems & Services, second quarter revenues of $169.5 million were up 10.5% sequentially and down very slightly 1% year-over-year. For Q2, sequential increases in systems and services revenues, reflects increased scanner volumes across the regions and higher services and non-system revenues, reflecting increased sales of certified pre-owned or what we call CPO scanners and higher subscription revenues. On a year-over-year basis, Q2 services revenues increased primarily due to higher subscription revenues from a large number of iTero scanners in the field. We also had higher non-system scanner revenues related to our certified pre-owned again CPOs and our scanner leasing and rental programs. For Q2, total clear aligner revenues of $832.7 million up 5.4% sequentially and 4.3% year-over-year. Q2 sequential revenue growth rate is consistent with our historical three year average and reflects growth across all regions. Q2 non-case revenues at $80 million were up 6.2% sequentially and 18% year-over-year, reflecting continued growth from Vivera retainers and Invisalign Doctor Subscription Program, or DSP, our monthly subscription-based clear aligner program. And Commerce sales for aligner-related consumables, like aligner cases and whitening and cleaning products. DSP has been successful in addressing an important and growing opportunity for experienced Invisalign doctors. It is our first subscription-based clear aligner program that enables doctors to reach new patients and provide them with a better overall experience. DSP enables doctors flexibilities to treat simple touch-up cases or offer their patients a superior, flexible, and convenient retention solution. We introduced DSP in the United States and Canada in 2021. We expanded it to Spain and the Nordic countries in Q2 2023, and we'll launch DSP in France and the United Kingdom in the second half of this year. We have also extended DSP to DSO partners who recognize the value of our Invisalign subscription aligner put model. Over the past two years, our DSP subscription program has continued to ramp and in Q2 drove strong volume growth in touch-up cases typically five to 10 stage cases of aligners. For Q2 '23, we shipped over 18,000 DSP touch-up cases in North America, up from 15,500 in Q1 '23 and more than double the case volume in Q2 '22 last year. Given its continued success and contribution to our growth this year, DSP touch-up cases are included in my overall commentary for clear aligners. Otherwise, specified in my remarks, our case volumes and metrics do not include DSP and touch up cases. For Q2, total clear aligner volumes were up 5% sequentially and up 1% year-over-year. Q2 clear aligner volumes, including DSP touch-up cases, were up 5.4% sequentially and up 2.4% year-over-year. For the Americas, Q2 clear aligner volumes reflect sequential growth across the region from both ortho and GP dentist channels, an increase in teen case starts driven by momentum from Invisalign First and increased adult patients from the GP dentist channel. In North America, adoption of the Invisalign Comprehensive three and three product drove sequential volume growth. For Q2, North American ortho utilization was up sequentially and down a fraction year-over-year, including DSP touch-up cases. Q2 North American ortho utilization was up both sequentially and year-over-year as noted in our Q2 '23 earnings slides. For EMEA, Q2 clear aligner volumes were up sequentially and year-over-year, reflecting growth across the region and continued adoption of Invisalign Moderate, Invisalign Comprehensive three and three products as well as an increase in teen case starts, which grew sequentially and year-over-year driven by Invisalign First and our new Invisalign Teen case packs. On a sequential basis, clear aligner growth was led by Iberia, Italy, DACH, and Turkey. For APAC, Q2 clear aligner volumes were up sequentially and up year-over-year, reflecting improving trends in China as well as other key markets like Japan, Taiwan, Korea and India. Q2 APAC results also reflect increased Invisalign submitters and higher utilization, especially for teen patients, driven by growth from Invisalign First in the orthodontic channel, which is especially important as we enter the China team season in Q3. Q2 APAC results also reflect growth in the GP channel with increased Invisalign submitters and higher utilization sequentially and year-over-year. During Q2, we continued to roll out the Invisalign Comprehensive three and three product in APAC, where it is now available in Hong Kong, Korea, Taiwan, and India. We plan to launch Invisalign three and three in China in Q3. We are also pleased with the additional adoption of three and three product in APAC, where the majority of cases treated are comprehensive, allowing our doctor customers more flexibility within the Invisalign product portfolio. In June, we hosted 2023 Invisalign APAC Summit in Singapore and brought together nearly a 1,000 orthodontists and general practitioners, dentists and clinic staff from 18 countries across the Asia Pacific region. The Summit showcased Invisalign and iTero products, the Align Digital platform and the recent and upcoming innovations, while also highlighting our doctors' experience with digital transformation, and how it improves the patient treatment journey. Attendees joined expert sessions focused on enhancing treatment planning efficiency, optimizing digital workflows, addressing the unique needs of teens and younger patients in exploring the essential aspect shaping today's digitally driven orthodontic practices. Teen orthodontic treatment is the largest segment of the orthodontic market worldwide and represents our largest opportunity for clear aligner sales to Orthos. We continue to focus on gaining share from traditional metal braces through teen-specific sales and marketing programs and product features unique to the Invisalign system. For Q2, total clear aligner cases for teenagers were up 7% sequentially and 9.7% year-over-year, reflecting improving trends across the regions. On a sequential basis, growth was driven by increased submitters in the APAC and EMEA regions on a year-over-year basis. TNK starts were in the APAC region, driven by increased submitters and in the EMEA region, driven by increased submitters and utilization, both in the orthodontic channel. Last year, we introduced the Teen Case Packs in the United States and Canada, and in Q1, Q2, we launched them in France, Scandinavia and Iberia. For the quarter, Teen Case Packs increased sequentially and year-over-year, driven by strength in EMEA. Invisalign First also was up sequentially and year-over-year across all regions and continues to drive adoption of Invisalign treatment among young patients. Invisalign First aligners are designed for Phase 1 treatment, typically in growing children six to 10 years old, making up about 20% of orthodontic case starts. For the dental service organizations, or DSO customers, Q2 clear aligner volumes increased sequentially primarily from the Americas region. Overall, clear aligner growth rate from DSO doctors continues to outpace non-DSO doctors and our DST touch-up cases are ramping nicely up as DSO doctors understand the value of the subscription program brings regarding pricing and flexibility for their patients. Invisalign is one of the most trusted brands in the orthodontic industry globally among both doctors and patients. On the consumer marketing front, we delivered $10.3 billion impressions and had 30.9 million visits to our website in Q2 '23. To increase awareness and educate young adults, parents teams about the benefits of Invisalign brand, we continue to invest in top media platforms such as TikTok, YouTube, Snapchat, Instagram across all markets as well as key social media influencers and brand ambassadors. In the Americas, we focused on reaching young adults as well as teens and their parents through our influencer and creator-centric campaigns partnering with leading smile squad creators, including Marshall Martin, Rally Shaw, and Jeremy Lin. Each of these creators shared their personal experiences with Invisalign treatment and why they chose to transform their smile with Invisalign aligners. Additionally, in the United States, we work closely with athletes over time, a high school sports social media platform that showcases the benefits of Invisalign treatment. Brand interest remained strong throughout the quarter with 9.2 million consumers visiting our websites in the Americas region, representing 17% growth year-on-year. In EMEA region, we partnered with new influencers to reach consumers across social media platforms, including TikTok and Meta. In Germany, we launched new testimonial campaigns highlighting the stories of 70 young adults and teens who share why they chose Invisalign treatment and how it impacted their lives. Our consumer campaigns delivered more than 1.7 billion media impressions and 9.7 million visitors to our website. We continue to invest in consumer advertising across the APAC region, resulting in more than 12 million visitors to our websites and over $4.8 billion impression. We expanded our region in Japan and India via TikTok, Meta and YouTube. We partner with key influencers like [indiscernible]. We saw increased brand interest in consumers as evidenced by 270% year-over-year increase in unique visitors to our website in India and a 46% year-over-year increase in Japan. Adoption of My Invisalign consumer and patient apps continued to increase with 3.1 million downloads to date and over 350,000 monthly active users, a 28% year-over-year growth. Uses of other digital tools also continue to increase. ClinCheck live update was used by 40,000 doctors on more than 580,000 cases, reducing time spent and modifying treatment by 20%. Invisalign practice app is increasing in adoption with 88,000 doctors who are actively using this app and 5.1 million photos were uploaded in Q2 via the Invisalign practice set. With that, I'll turn the call over to John."
},
{
"speaker": "John Morici",
"text": "Thanks, Joe. Now for our Q2 financial results. Total revenues for the second quarter were $1.002 billion up 6.3% from the prior quarter and up 3.4% from the corresponding quarter a year ago. On a constant currency basis, Q2 '23 revenues were impacted by favorable foreign exchange of approximately $1.3 million or approximately 0.1% sequentially. And unfavorably impacted by approximately $19.4 million year-over-year or approximately 1.9%. Clear aligners Q2 revenues of $832.7 million were up 5.4% sequentially, primarily from higher volumes, higher non-case revenues and higher ASPs. On a year-over-year basis, Q2 clear aligner revenues were up 4.3%, primarily due to higher ASPs, higher non-case revenues and higher volumes. For Q2, Invisalign ASPs for comprehensive treatment were down sequentially and up year-over-year. On a sequential basis, ASPs reflect larger discounts and product mix shift to lower-priced products partially offset by price increases. On a year-over-year basis, the increase in comprehensive ASPs reflect price increases and higher additional aligners, partially offset by product mix shift, larger discounts and unfavorable foreign exchange. For Q2, Invisalign ASPs for non-comprehensive treatment were up sequentially and year-over-year. On a sequential basis, the increase in ASPs reflect lower discounts, higher additional aligners, price increases, and favorable foreign exchange. On a year-over-year basis, the increase in non-comprehensive ASPs reflect price increases and higher additional Aligners, partially offset by product mix shift, larger discounts and unfavorable foreign exchange. In Q1 '23, we launched Invisalign Comprehensive three and three products in most markets, and we have continued to expand into more markets, as previously mentioned. The three and three configuration offers our doctor customers, our Invisalign comprehensive treatment with three additional aligners included within three years of the treatment end date, instead of unlimited additional aligners with five years of the treatment end date at the 2022 Invisalign comprehensive product price. Over time, we have come to learn that on average, Invisalign doctors complete a comprehensive Invisalign treatment with two or fewer additional aligners. We are pleased with the continued adoption of the Invisalign Comprehensive three and three product and anticipate that it will continue to grow, providing doctors the flexibility they desire and allowing us to recognize more revenue upfront with deferred revenue being recognized over a shorter period of time, compared to our traditional Invisalign comprehensive product. As revenues from subscriptions, retainers, and ancillary products continue to grow globally, some of the historical metrics that only focus on case shipments are expected to account for a lesser percentage of our overall growth. In our earnings release and financial slides, you will see that we have added our total clear aligner revenue per case shipment, which we believe to be more indicative measure of our overall growth strategy. Q2 '23 clear aligner revenues impacted from favorable foreign exchange of approximately $1.2 million or approximately 0.1% sequentially. On a year-over-year basis, clear aligner revenues were unfavorably impacted by foreign exchange of approximately $16.3 million or approximately 1.9%. Clear aligner deferred revenues on the balance sheet increased $13 million or up 1% sequentially and $138.6 million or up 12.2% year-over-year and will be recognized as the additional aligners are shipped. Q2 '23 systems and services revenue of $169.5 million were up 10.5% sequentially, mostly due to higher scanner volume, higher revenues from our certified preowned program and higher services revenue from our larger base of scanners sold, partially offset by unfavorable ASPs. On a year-over-year basis, Q2 '23 systems and services revenue were down 1%, primarily due to lower scanner volume and unfavorable ASPs, partially offset by higher services revenues from our larger base of scanners sold and higher revenues from our CPO and leasing rental programs. Q2 '23 systems and services revenue were impacted from favorable foreign exchange of approximately $0.1 million or approximately 0.1% sequentially. On a year-over-year basis, systems and services revenue were unfavorably impacted by foreign exchange of approximately $3.1 million or approximately 1.8%. Systems and Services deferred revenues on the balance sheet was down $2.3 million or 0.8% sequentially, primarily due to the decrease in the deferral of service revenues included with our scanner purchase and up $8.6 million or 3.3% year-over-year, primarily due to the increase in scanner sales, and the deferral of service revenues included with our scanner purchase, which will be recognized ratably over the service period. As our scanner portfolio expands, and we introduced new products, we increased the opportunities for customers to upgrade, make trade-ins, and provide refurbished scanners for certain markets. As such, our model is changing. We expect to continue growing our programs and as offering our CPO units for purchase and selling the way the customer -- our customers desire. Developing new capital equipment opportunities to meet the digital transformation needs of our customers and DSO partners, is a natural progression for our equipment business with a large and growing base of scanner sold. Moving on to gross margin. Second quarter overall gross margin was 71.2%, up 1.2 points sequentially and up 0.3 points year-over-year. Overall gross margin was unfavorably impacted by foreign exchange of approximately 0.5 points on a year-over-year basis. Clear aligner gross margin for the second quarter was 72.4%, up 0.7 points sequentially, primarily due to the lower mix of additional aligners, favorable manufacturing variances and higher ASPs. Clear aligner gross margin for the second quarter was down 0.9 points year-over-year, primarily due to increased manufacturing spend as we continue to ramp up operations at our new manufacturing facility in Poland and a higher mix of additional aligner volume, partially offset by higher ASPs and lower freight. Systems and Services gross margin for the second quarter was 65.1%, up 3.5 points sequentially, primarily from lower service and freight costs, partially offset by lower ASPs. Systems and Services gross margin for the second quarter was up 5.3 points year-over-year, primarily from lower service and freight costs and higher services revenue, partially offset by lower ASPs. Q2 operating expenses were $541.7 million, up sequentially 2.8% and up 8.5% year-over-year. On a sequential basis, operating expenses were up $14.5 million, primarily from higher consumer marketing spend and higher incentive compensation. Year-over-year, operating expenses increased by $42.3 million, primarily due to higher incentive compensation and our continued investments in sales and R&D activities, partially offset by controlled spending on advertising and marketing as part of our efforts to proactively manage costs. On a non-GAAP basis, excluding stock-based compensation, and amortization of acquired intangibles related to certain acquisitions, partially offset by restructuring and other charges, operating expenses were $505 million up 2.9% sequentially and up 8.4% year-over-year. Our second quarter operating income of $171.9 million resulted in an operating margin of 17.2% up 3 points sequentially and down 2.2 points year-over-year. The sequential increase in operating margin is primarily attributed to higher gross margin, as well as favorable impact from foreign exchange of 0.1 points. The year-over-year decrease in operating margin is primarily attributed to investments in our go-to-market teams and technology, as well as unfavorable impact from foreign exchange by approximately 1.1 points. On a non-GAAP basis, which excludes stock-based compensation, amortization of intangibles related to certain acquisitions, offset by restructuring other charges, operating margin for the second quarter was 21.3%, and up 2.8 points sequentially and down 2 points year-over-year. Interest and other income and expense net for the second quarter was a loss of $0.3 million compared to an income of $1.1 million in the first quarter and a loss of $14.6 million in the second quarter a year ago, primarily due to foreign exchange. The GAAP effective tax rate for the second quarter was 34.8%, consistent with the first quarter effective tax rate of 34.8% and 35% in the second quarter of the prior year. As a reminder, in Q4 2022, we changed our methodology for the computation of our non-GAAP effective tax rate to a long-term projected tax rate and have given effect to the new methodology from January 1, 2022, and recast previously reported quarterly results in 2022. Our non-GAAP effective tax rate in the second quarter was 20%, reflecting the change in our methodology. Second quarter net income per diluted share was $1.46, up sequentially $0.32 and up $0.02 compared to the prior year. Our EPS was unfavorably impacted by $0.02 on a sequential basis and unfavorably impacted by $0.15 on a year-over-year basis due to foreign exchange. On a non-GAAP basis, net income per diluted share was $2.22 for the second quarter, up $0.40 sequentially and up $0.07 year-over-year. Note that the prior year 2022 non-GAAP net income per diluted share in our prior year 2022 non-GAAP reflects the Q4 2022 change in our methodology for the computation of our non-GAAP effective tax rate. Moving on to the balance sheet. As of June 30, 2023, cash, cash equivalents and short-term, and long-term marketable securities were $133.8 billion up sequentially $112.4 million and up $56.6 million year-over-year. Of our $133.8 billion balance $314.3 million was held in the U.S. and $719.5 million was held by our international entities. In Q2, we completed a $75 million equity investment in Heartland Dental a multi-disciplinary DSO with GP and ortho practices across the U.S. During Q1 2023, we announced that our Board of Directors authorized a new $1 billion stock repurchase program to succeed the 2021 $1 billion program. Currently, $1 billion remains available for repurchase under the 2023 $1 billion stock repurchase program. Q2 accounts receivable balance was $908.4 million, up sequentially. Our overall days sales outstanding was 81 days, down approximately two days sequentially and down approximately four days as compared to Q2 last year. Cash flow from operations for the second quarter was $251.9 million. Capital expenditures for the second quarter were $58.5 million, primarily related to our continued investments to increase aligner manufacturing capacity in facilities. Free cash flow, defined as cash flow from operations less capital expenditures amounted to $193.3 million. Now turning to our outlook. As Joe mentioned earlier, we are pleased with our Q2 results. While the macroeconomic environment still remains uncertain, we have seen improvements in the operating environment and the consumer demand signals that influence our outlook. For Q3 2023, we anticipate our worldwide revenue to be in the range of $990 million to $1.01 billion, up approximately 12% year-over-year at the midpoint. We expect our Q3 2023 GAAP and non-GAAP operating margin to be slightly up from Q2 2023 as we continue to strategically prioritize our investments in R&D and go-to-market activities to drive growth. For full-year 2023, assuming no circumstances occur that are beyond our control, we anticipate our 2023 worldwide revenue to be in the range of $3.97 billion to $3.99 billion, up approximately 7% year-over-year at the midpoint. We also expect our full-year 2023 GAAP operating margin to be slightly above 17% and our 2023 non-GAAP operating margin to be slightly above 21%, a 1 point improvement from the guidance we provided in April of 2023. For 2023, we expect investments in capital expenditures to be approximately $200 million. Capital expenditures are expected to primarily relate to building construction improvements as well as manufacturing capacity in support of our continued international expansion. With that, I'll turn it back over to Joe for final comments. Joe?"
},
{
"speaker": "Joseph Hogan",
"text": "At our continued growth despite the economic slowdown in uncertain environment. Q2 results demonstrate our resilience and adaptability. While we cannot predict future economic conditions, we're confident in our ability to focus and execute on our strategic growth initiatives. As a leader in digital transformation, we offer a powerful suite of innovative digital tools that make up the aligned digital platform, which provides a seamless end-to-end digital experience for doctors and their patients. Innovations launched over the last year include ClinCheck live update for 3D controls. This enables doctors to generate modified Invisalign patient treatment plans in real time, reducing modifications that used to take weeks to as little as two minutes. Improving practice productivity while also improving the quality of treatment plans. Invisalign Personal Plan, or IPP streamlines the treatment planning process and helps doctors achieve their desired treatment plans more consistently and efficiently. Invisalign Smile Architect allows general dentists to integrate clear aligner therapy into their comprehensive treatment plans by combining tooth alignment and restorative planning in a single platform. Invisalign Virtual Care, equips doctor with a next generation remote monitoring solution that has new artificial intelligence assisted capabilities to streamline their workflows. Cowen being computed tomography or CVCT, enables doctors to visualize the patient's roots as part of the digital treatment planning process. Invisalign Outcome Simulator Pro, expand Align's existing Invisalign outcome simulator technology and adds the benefit of the company's ClinCheck in-face visualization tool that combines a photo of a patient's face, with their 3D treatment simulation, creating a truly personalized view of how their new smile will look. Itero-exocad Connector integrates iTero intraoral camera and NIRI images with exocad DentalCAD 3.1 software, and allows dental professionals to visualize the internal and external structure of teeth. In addition to these and other incredible innovations in the coming years, we'll continue to build a digital platform and add new capabilities to improve clinical outcomes and elevate the patient experience to drive continued practice growth and positive patient experiences. Thank you for your time today. We look forward to speaking to you at our upcoming Investor Day on September 6, where we'll share with you our views about the incredible market opportunity we have and how Align is uniquely positioned to continue to lead the transformation of the digital orthodontic industry. Now I'll turn the call over to the operator for questions. Operator?"
},
{
"speaker": "Operator",
"text": "Thank you. At this time, we'll be conducting a question-and-answer session. [Operator Instructions]. Our first question comes from the line of Jeff Johnson with Baird. Please go ahead."
},
{
"speaker": "Jeffrey Johnson",
"text": "Thank you. Good afternoon guys. Hey Joe, congrats on a nice bounce back quarter here. I wanted to start really on the teen market. Obviously, that's where we all focus long-term on the business. But that 9.7% year-over-year growth, when I look back last year, it was your first quarter in a long time of negative year-over-year growth in teens. So you had a bit of an easy comp there, although, obviously, '21 was a fantastic year. So I guess I'm trying to figure out in this economy, when I think about comps from '21 that were so tough, when I think about competition that's out there, where do you think that 9%, 10% teen growth is relative to where you expect to be normalized? Are we still expecting a nice improvement of this over the next few years back to kind of mid, upper teens, something like that? I just would like to get your views on that."
},
{
"speaker": "Joseph Hogan",
"text": "Jeff, I mean you know how important that teen market is to us, like I talked about in the script of the 21 million case starts and the majority of those 75%, 80% being teen. So I look at that sequential growth in teens is being really positive. Now we did have a good number to compare against, like you said. But when I highlighted in our -- the Invisalign First product line and how well that product is doing overall, and it continues to grow phenomenally throughout the world in all three regions that we have. Our teen packs different business models or plans that we put together, really helps with that piece, too. So Jeff, when you look at our coming technology improvements and products and those kinds of things, they're targeted really well with the teen market also. So the numbers that you mentioned about potential growth and penetration in that marketplace, in line with our investments and where we think we'll go in the marketplace. But let's be honest, it's been -- that's a struggle to get orthodontists to really move on teens. But our top docs are almost exclusively Invisalign across the board. Our job is to bring this new technology out, but also infuse it well within doctors, so they're comfortable with the work practices and comfortable with the clinical outcomes. And I feel we've made really good progress in that area."
},
{
"speaker": "Jeffrey Johnson",
"text": "That's helpful. Thank you. And then just would like an update maybe on China. Obviously, third quarter tends to be a big teen season there, but we're also seeing some mixed macro feedback on China as a whole kind of from an overall economic standpoint. So just what's kind of current tenor of business in China? And just remind us how bad were things in third quarter last year in China, we just kind of lose track of the COVID shutdowns and all that, but should third quarter be an easy comp in China? Or were things opening back up there before we got to the beginning of this year where they shut back down again. Thanks."
},
{
"speaker": "Joseph Hogan",
"text": "Yes. China, obviously, from an economic standpoint, Jeff, it's -- we watch that closely as everybody does, too, but we have to take it as it is right now. And we had a good quarter. We had a good start in the first quarter, too. And so we're seeing good sequential momentum, an improvement in that sense in the business overall. Obviously, when you look at the third quarter, I mean, we all know you watch our stock closely. We know the third quarter is a huge teen market in China, as I mentioned in the script, too. And we're really good on that, but we feel very confident in the sense of our positioning there and where China stands right now. I can't comment on future economic activity there with any more accuracy than you can. But what we've experienced in the second quarter and what we see going into the third, we feel good about it."
},
{
"speaker": "Jeffrey Johnson",
"text": "Thank you."
},
{
"speaker": "Joseph Hogan",
"text": "Thank you, Jeff."
},
{
"speaker": "Operator",
"text": "Thank you. Our next question comes from the line of Jon Block with Stifel. Please go ahead."
},
{
"speaker": "Joseph Hogan",
"text": "Hi, Jon."
},
{
"speaker": "Jonathan Block",
"text": "Good afternoon. Hi, Joe. I'll start on innovation. And Joe, going into '23, you called out this year is one of the biggest for Align in terms of innovation when we think about the company's history. At the end of the prepared remarks, that was really helpful. You laid out a handful of innovations. Where are you with the next wave? And when I say the next wave, any details that you can give with paddle expansion in terms of timing in the U.S., maybe if you can elaborate a little bit on the limited rollout in Canada to date. And is there anything else that we should expect more near term, i.e., maybe next three to 12 months before some of those longer-term aspirations come into play on direct printing? And then I'll ask my follow-up."
},
{
"speaker": "Joseph Hogan",
"text": "Jon, obviously, the Invisalign Palate Expander has come a long way. You probably get -- that we've had some four ways into Canada recently and good feedback on our product line. When we look at the investor conference coming up, we'll obviously give you a much more detailed discussion in the sense of where that product stands, and how we'll commercialize it. But overall, what I'd tell you, John, we know how to make it. We have a process that makes it. Remember, with our business though, just making it doesn't mean anything, you've got to scale this thing to million. And so that's what our focus is right now is how we scale, how we roll this out. There's obviously a lot of regulatory qualifications we have to meet in each area because it's a new device, too, but I feel good about that. And Jon, when you look our development, you know this well, you can almost draw a line between the production of product and then the software that we talked about with the software piece. Obviously, IPE represents both of those, right? It's new software and new kind of treatment planning, but it's actually a 3D-printed device that we haven't launched before. So just think about in the scale-up mode, but when we see you on September 6, we'll have many more details for you."
},
{
"speaker": "Jonathan Block",
"text": "Okay. That's helpful. And then maybe as my second question, sort of one of those famous two partners. John, to start with you, can you elaborate on the ASP for comprehensive Q-over-Q? I believe you said it was down Q-over-Q, little confused because I think you would have had the full quarter the price increase on the 3x3 and the comprehensive. So if I've got that right, maybe if you can tease out why it would have been down Q-over-Q. And then, Joe, the upside for the cases, I'm packing it around 10,000 relative to the implied guide that you gave back for 2Q. I've got the U.S. cases essentially in line with our estimate. International seems to have really been the driver of the upside. And maybe to build on Jeff's question, can you just give some more details where the outperformance was? Was it China? Was it EMEA? Where do you see maybe the better-than-expected results specific to those international regions? Thanks guys."
},
{
"speaker": "John Morici",
"text": "Yes. Just first on the ASP, Jon. Yes, the comprehensive were down slightly, just a reflection of some of the product mix that we had as well as some of the discounts that we have partially offset by price decrease. So nothing out of the ordinary there, we actually saw an increase on a sequential basis for non-comp. But the comprehensive was just more mix."
},
{
"speaker": "Joseph Hogan",
"text": "Jon, back to me is -- yes, you're right. I mean, when you look at from a regional standpoint, EMEA and APAC stood out. Really across the board in EMEA, I mean like I mentioned in my script, had Iberia did well. U.K. did well. The Nordic side, we just introduced DSP and different things. We're excited about those areas, too. So -- and then the teen growth there overall across those geographies was good. So I mean, it's just -- I think just good strong performance. And then when you think about the EMEA economy, too, Jon, I mean last year there was a lot of uncertainty with the Ukraine situation that hasn't gotten any better, but Europeans and the European countries, I think have solidified their economies around that. And just we're seeing some improvement from a consumer sentiment standpoint, too. So that's reflected in our numbers also. On APAC, obviously, China was good year-on-year. Japan actually was very strong for us, too, along with Korea, in different parts of Asia, as I mentioned. So it's still broadly really good improvements in both of those regions by country and also specifically in that teen segment that I mentioned. So we're seeing good improvement Jon, from a sequential standpoint."
},
{
"speaker": "Shirley Stacy",
"text": "Next question please."
},
{
"speaker": "Operator",
"text": "Our next question comes from the line of Nathan Rich with Goldman Sachs. Please go ahead."
},
{
"speaker": "Nathan Rich",
"text": "Great, good afternoon. Thanks for the questions. Hey Joe, hey John. I guess, could you maybe just talk about how adult cases performed relative to your expectations, improved slightly, but I think still down a little bit year-over-year. And how are you thinking about the biggest swing factors that could impact revenue in the back half. Does the guidance kind of just reflect a continuation of the environment that you saw in 2Q? And is there any kind of part of the business that you're watching specifically, either teen versus adult or certain markets that you feel are especially big swing factors in the back half?"
},
{
"speaker": "John Morici",
"text": "Yes, I'll take that one, Nate. This is John. When you look at the commentary that we gave, we saw improving trends as we went into the second quarter. We see that in the results. And our guidance reflects that. It shows up in Q3, and it also gives us the confidence to talk to a guide for the total year. So that's how we've kind of factored things in and looking at the normal metrics in indices that help us with that. As far as adult versus teen, as we said, teen season now. We saw good results in Q2, and we expect that to continue in Q3. As we've said, China is a big market, U.S. big market in Q3, and we expect that to continue. And adults important for us, too. We have a lot of capabilities to be able to go to those general dentists and try to work where those adults might be wanting to come into treatment and be able to help provide for them as well as our orthodontists. So we feel good about the efforts that we have to try to improve both teen and adult as we go through this year."
},
{
"speaker": "Nathan Rich",
"text": "Okay, great. And then just a clarification on the touch-up cases. So -- it sounds like that's pressuring the North America ortho utilization metric. But if you back that out, or kind of include touch up, it would have been up year-over-year. I'd just be curious to get your sense of what portion of those 18,000 touch-up cases would have been cases kind of in your view in the past prior to DSP just so we get a sense of what that shift might look like?"
},
{
"speaker": "John Morici",
"text": "Yes. So those touch-up cases, as we talked to those 18,000, those would have been -- those are the touch-up cases that would have been the lower-stage products that we had 5 stage, maybe 7 up to 10, but in that range, 5 to 10, but probably more on the low side of that in terms of the stages. And we see this great adoption with the DSP program, as we mentioned in the prepared remarks, it doubled from last year. We wanted to give some commentary about how big this is becoming and show them in our kind of our discussion about the year-over-year, and the sequential and so on. And at Investor Day in September, I'll give a lot more detail about kind of where it came from, how it's become more and more important and what it means going forward because we're going to include these cases going forward. But in the end, we see in all cases where we see -- we've seen the DSP program, it drives incremental volume for us. Those doctors continue to do those comprehensive cases that we see, but those doctors are also doing these low stage touch-up cases as well as retention. And we think that's a good thing for our doctors."
},
{
"speaker": "Nathan Rich",
"text": "Great, thank you."
},
{
"speaker": "John Morici",
"text": "Thanks, Nate."
},
{
"speaker": "Operator",
"text": "Thank you. Our next question comes from the line of Brandon Vazquez with William Blair. Please go ahead."
},
{
"speaker": "Joseph Hogan",
"text": "Hi, Brandon."
},
{
"speaker": "Brandon Vazquez",
"text": "Hello, thanks for taking the question. I just wanted to follow-up first on the DSP program. If we're doing our math correctly, it seems like most, if not all of the year-over-year increase in case volumes is actually coming from the DSP program. So one, is that correct? And two, maybe if it is, can you talk about where do you think the mix goes eventually to DSP? And is DSP at this point accretive to your case volumes? Or are you seeing accounts kind of switch what they would have been doing as kind of normal base volumes into DSP?"
},
{
"speaker": "John Morici",
"text": "We're actually seeing DSP as accretive. So we're not seeing -- we're seeing -- fundamentally, we're seeing doctors who were either making them themselves or going to lab or other ways of making the Aligners actually switching over and continuing to give us those comprehensive cases, but then they're also now giving us the DSP cases. Remember, most of DSPs, the majority of DSP is retention, and it's the retention that we're providing. But then a subset of that is these touch-up cases and like I said, about 18,000 or so. And what we've also commented to it would have -- it would have helped us by about 1.5 points on an overall basis. So we reported our volumes up about 0.9%. And they would have been up 1.5 points on that to 2.4%. So it's accretive no matter how we look at it, and it's certainly accretive from a standpoint of the margin that it generates. It's generating some of the highest margin from our product portfolio that we have because the cost to serve is very straightforward for us. There's no additional liners or anything else. So we recognize all the revenue as soon as we ship without additional aligners related to that."
},
{
"speaker": "Brandon Vazquez",
"text": "Okay. And then one other second on......"
},
{
"speaker": "Joseph Hogan",
"text": "Other clarification on your question was whether you put DSP or not, we were up year-over-year in our numbers."
},
{
"speaker": "Brandon Vazquez",
"text": "Got it."
},
{
"speaker": "Joseph Hogan",
"text": "So sequentially not sure -- go ahead."
},
{
"speaker": "Brandon Vazquez",
"text": "Got it. That's helpful. The next question is just on teens. I think, Joe, you had said a little earlier, a little frank about there's hurdles within the teen market and kind of pushing that share into existing accounts to get a little deeper -- can you guys just talk about what are kind of the top hurdles right now? Why has it been a little bit tougher to get the incremental share in the teen market? And what are you guys kind of focused on in the next six to 12 months to push that share forward? Thanks."
},
{
"speaker": "Joseph Hogan",
"text": "Hey Brandon, in general, when you look at orthodontic workflows, if they're not completely digitized in the sense of what they do and you're kind of in a down cycle right now with orthodontists and their challenge. They feel like on a wire bracket side, they can just make more money with wires and brackets versus Invisalign because the raw material costs are 3.5x. Now if you're fully digitized your workflows and everything else, obviously, you make more money with Invisalign. But I think in these kind of challenging economic times, it's just more difficult to move the orthodontic community over to the clear aligner piece because they're just used to the workflow of what we have with versus wires and brackets. I can say Invisalign First seems to be an exception to that. In the sense of how Phase I kind of patients are treated. That's not a constant when you look at what's going on in the orthodontic industry. But we see a lot more interest in Phase I with Invisalign First than we thought before. I think that's going to help to be a span breaker for us in this whole thing. In the future, there's no doubt to us in the sense that clear aligners of the future, no white spot lesions, obviously six months faster than a normal kind of a treatment, much easier for patients. We know all those things. When you ask what the biggest issues are, they're not basically clinical anymore. It's about workflow, workflow and confidence in orthodontic practice."
},
{
"speaker": "Operator",
"text": "Thank you. Our next question comes from the line of Elizabeth Anderson with Evercore ISI. Please go ahead."
},
{
"speaker": "Elizabeth Anderson",
"text": "Hi guys. Congrats on the quarter and thanks so much for the question. One, this -- don't take this as a complete because I'm very happy that we have full-year guide. What I was -- wanted to ask was like what -- did you guys see sort of in the end markets or in your -- the visibility of your results to the macro picture that made sort of this time the right time to kind of move on from what we've had in the quarterly guide, the last couple of quarters into this sort of longer guidance."
},
{
"speaker": "Joseph Hogan",
"text": "Yes, I'll give you the high-level view, and I'll turn it over to John, Elizabeth for the ground thing. But I mean, obviously, we had a good second quarter, and we feel we can see through to the third quarter whatever. At that point, too, like we said, with the qualifiers is continued economic situation that we see now, we feel confident just based on what we understand from a cyclical standpoint to be able to call the fourth quarter. And so look, we're still in very difficult economic times and uncertain times. But with the second quarter out of the way and with what we talked about improvement, particularly in a sequential sense, we just felt like I mean we're going to give it to you, you're going to make it up. So we might give the best guess we have. But John can give you more."
},
{
"speaker": "John Morici",
"text": "Yes look, I can't add much more to that. We've got now a couple good quarters behind us. We've seen stability kind of turning to improving trends. It's a good position to be in. We continue to see that into the third quarter. As Joe said, it's not great, but it's better than it has been from an overall economic standpoint. And so based on the order trends and kind of how things are looking, we felt comfortable about Q3 and translate that to total year as well."
},
{
"speaker": "Elizabeth Anderson",
"text": "Got it. And just as a follow-up, are you guys taking any different approach to sort of like, sales either so from like a personnel perspective or a focus versus earlier in the year? I know sometimes you guys have sort of been ramping reps. And then that had sort of flatlined. So I just wanted to understand sort of like how you're thinking about that as we go into the balance of the year and sort of set up for 2024?"
},
{
"speaker": "Joseph Hogan",
"text": "Elizabeth, I'd say our sales practices are consistent and dynamic in the same way, consistent in the sense of the number of salespeople we have, how we train those salespeople, how they go to market. We obviously offer different products in different areas. We split up orthodontics salespeople and general dentistry salespeople specifically because it's just a different kind of a call. So there's no I'd say, big change in the sense of how we go to market. And obviously, our iTero sales force works really closely with the Invisalign sales force and overlaps in some areas. But I might be missing your question, but there's no, I'd say, material changes going on from a sales as salespeople, a number of salespeople standpoint and specifically the way we approach the market."
},
{
"speaker": "Elizabeth Anderson",
"text": "Okay, thank you guys."
},
{
"speaker": "Operator",
"text": "Thank you. Our next question comes from the line of Michael Ryskin with Bank of America. Please go ahead."
},
{
"speaker": "Michael Ryskin",
"text": "Thanks for taking the questions. I got a couple of quick ones. One is well, actually kind of related. One is just related to the results, 1Q to 2Q and sort of your outlook for 3Q -- just sort of a yes or no question. Is it safe to say that you're kind of back to the usual seasonality you've seen historically, it's been a little volatile for the last couple of years, but it seems like we're setting the back in that routine. Is it safe to say that, that should be our base case approach going forward?"
},
{
"speaker": "John Morici",
"text": "Well, I think what we see is in terms of our Q2 to Q3 guide, that is more of a typical seasonality flat to slightly up from Q2 to Q3. So that's -- that is that how that goes going forward. I think given the commentary that we've given just the overall macro uncertainty, we're not ready to say that. We're completely back to normal seasonality. But what we see in the short term here in the guidance that we gave that reflects that."
},
{
"speaker": "Michael Ryskin",
"text": "Okay. And then the second one would be on the Analyst Day. I mean, a couple of pieces there. One is, could you just what goes into the thought process that now is the right time to have the Analyst Day. As you say markets are still pretty uncertain. There's still some volatility, visibility is not fully back. So kind of what goes into that decision? And then related to that, the long-term guide, is that something you're going to be addressing just as we start thinking about modeling 2024 and going forward from there?"
},
{
"speaker": "Joseph Hogan",
"text": "We usually do this about every two years, Michael. It is a really sophisticated algorithm we use to figure that out, but it's about every two years. And we think it's just about time for that, too, from the standpoint of just to reinitiate the investor base in the sense of where we're investing, how we see the marketplace. And just a good summary of a lot of the questions that have been asked."
},
{
"speaker": "Michael Ryskin",
"text": "Got it."
},
{
"speaker": "Shirley Stacy",
"text": "Yes, sorry. Is there one more question?"
},
{
"speaker": "Operator",
"text": "Our next question comes from the line of Jason Bednar with Piper Sandler. Please go ahead."
},
{
"speaker": "Joseph Hogan",
"text": "Hi, Jason."
},
{
"speaker": "Jason Bednar",
"text": "Thanks. Good afternoon. Thanks for taking my questions guys. I wanted to touch on a few things that stood out to us in the quarter. Maybe first, just the combination of a sequential increase in doctors you ship to plus higher utilization across all channels that you serve again, always good to see that combination come together. I know you don't provide the granularity anymore on doctor shipped across the U.S. or international markets. But -- just I guess, directionally, are you able to specify whether the increase in doctors is exclusive to China coming back online and expansion in APAC? Or did you see an increase in users in your North American channels and EMEA channels as well?"
},
{
"speaker": "John Morici",
"text": "Yes, Jason, you're right. We don't give that level of detail, but we saw more doctors that we ship to in APAC related to China, as you said, and we saw it in other regions as well. So we are pleased with the number of doctors that we're shipping to. It's a reflection of our products. And what they want to do and then as well, being able to be up on a utilization basis is a good metric as well."
},
{
"speaker": "Jason Bednar",
"text": "Okay. I guess maybe just to follow-up there, John, real quick. Can you confirm whether or not you saw that increase in North America in Orthos or GPs or both?"
},
{
"speaker": "John Morici",
"text": "Yes, we saw improvement for North America as well."
},
{
"speaker": "Jason Bednar",
"text": "Okay, all right. Great. And then I know we got some good details on some of your APAC markets, including China. But I guess wondering if you can talk about just monthly cadence of U.S. trends throughout the quarter and maybe even here in July. Some of the work we've done shows that there's maybe a bit more mix trends in April and June, May was pretty strong. I guess just wondering how that drives what you were seeing in your case shipment trends throughout the quarter? And then same question for EMEA, if you could elaborate just on how the quarter unfolded in that region? Thank you."
},
{
"speaker": "John Morici",
"text": "Yes. We're really not giving -- like -- I don't really want to get into the month-by-month activity. I think the results kind of show where they were, Jason, and then it also kind of reflects what we've been able to give from a guidance standpoint as well. But without getting into months by country and region and so on, it gets a little difficult to give that level of detail. But I think the results that we have for Q2 and what we've talked about how the sequential improvement and what we were able to see on a quarter-over-quarter basis and what it means for the guidance kind of speak to that."
},
{
"speaker": "Jason Bednar",
"text": "Okay, fair enough. Thanks."
},
{
"speaker": "John Morici",
"text": "Thanks, Jason."
},
{
"speaker": "Operator",
"text": "Our next question comes from the line of Brandon Couillard with Jefferies. Please go ahead."
},
{
"speaker": "Brandon Couillard",
"text": "Hey thanks guys."
},
{
"speaker": "Joseph Hogan",
"text": "Hi, Brandon."
},
{
"speaker": "Brandon Couillard",
"text": "You mentioned scanner ASPs as a bad guy in terms of segment gross margin sequentially and year-over-year. Joe, could you just talk about the competitive environment and whether you're seeing pricing pressure intensifying, just your macro view there would be helpful. Thanks."
},
{
"speaker": "Joseph Hogan",
"text": "Yes, I wouldn't call it, a bad guy. I think what we tried to communicate was, we have a mix in there that's from a price standpoint. We feel good about our upper-end product line and the prices we're able to get for a 5D Plus and 5D Flex and it's a premier scanner in the marketplace. As you mentioned before and as you know, I mean, there's a certain sensitivity in the marketplace about these kind of capital expenditures in a dental office when a lot of the economics are challenged right now in the orthodontic and in dental side. So we see that. But despite that, you could see we turned really good numbers around. Our CPOs help us to fight on the lower end. CPOs are the certified preowned that allow us to go down market if we have to. And obviously, when you look at the marketplace, it's pretty -- if you have the -- what we would call the confocal imaging scanners, like that we lead with. And then there's products like Metadata whatever they try to take the low end and whatever. But we feel -- I feel good about our capability, our value proposition, and I think our numbers reflect that this quarter and in the past too. So I'm not saying there's not a competitive environment. I just feel we have a superior product line, and then we have a good value stream that we offer from a standpoint of the integration with Invisalign through iTero and then [indiscernible]."
},
{
"speaker": "Brandon Couillard",
"text": "Great. And John, you mentioned freight costs coming down year-over-year as a positive tailwind to gross margins. I think first time in a while. I think that's been the case. Do you expect that to be sustainable over the next several quarters? And any color on how we should about gross margins in the second half of the year relative to 2Q base?"
},
{
"speaker": "John Morici",
"text": "I think it's a reflection of just it's freight, but maybe some of the material costs and others that as we manage things, manage our business and we see less inflationary pressure from kind of the raw material/freight and other inputs. And we're always driving productivity. We're always trying to be improve our productivity. We saw that in some of our gross margin improvements, both for clear aligner and the scanner and services. And we'll work to continue to manage it. But seeing some of those pricing pressures, the input pricing pressure come down that continues."
},
{
"speaker": "Brandon Couillard",
"text": "Very good. Thank you."
},
{
"speaker": "Operator",
"text": "Thank you. And we have reached the end of our question-and-answer session. I will now hand the call back over to Shirley Stacy for closing remarks."
},
{
"speaker": "Shirley Stacy",
"text": "Thank you, everyone, and thank you again for joining us. We look forward to speaking to you at any financial conferences and industry meetings. And as Joe mentioned, Align is hosting its 2023 Investor Day, September 6 in Las Vegas. For more information, please visit our Investor Relations page on aligntech.com. Or if you have any questions, please contact Investor Relations. Thanks, and have a great day."
},
{
"speaker": "Operator",
"text": "Thank you. This concludes today's conference, and you may now disconnect your lines at this time. Thank you for your participation."
}
] | Align Technology, Inc. | 24,568 |
ALGN | 1 | 2,023 | 2023-04-26 08:00:00 | Operator: Greetings, welcome to the Align First Quarter 2023 Earnings Call. At this time, all participants are in a listen-only mode. A question-and-answer session will follow the formal presentation. Please note, this conference is being recorded. I'll now turn the conference over to your host, Shirley Stacy, with Align Technology. You may begin.
Shirley Stacy: Good afternoon and thank you for joining us. I'm Shirley Stacy, Vice President of Corporate Communications and Investor Relations. Joining me for today's call is Joe Hogan, President and CEO; and John Morici, CFO. We issued first quarter 2023 financial results today via Business Wire, which is available on our website at investor.aligntech.com. Today's conference call is being audio webcast and will be archived on our website for approximately one month. A telephone replay will be available by approximately 5:30 p.m. Eastern time through 5:30 p.m. Eastern time on May 10. To access the telephone replay, domestic callers should dial 833-470-1428 with access code 635629. International callers should dial 44-204-525-0658 using the same access code. As a reminder, the information provided and discussed today will include forward-looking statements, including statements about Align's future events and product outlook. These forward-looking statements are only predictions and involve risks and uncertainties that are described in more detail in our most recent periodic reports filed with the Securities and Exchange Commission available on our website and at sec.gov. Actual results may vary significantly, and Align expressly assumes no obligation to update any forward-looking statements. We have posted historical financial statements, including the corresponding reconciliations, including our GAAP to non-GAAP reconciliation if applicable. And our first quarter 2023 conference call slides on our website under Align quarterly results. Please refer to these files for more detailed information. With that, I'd like to turn the call over to Align Technology's President and CEO, Joe Hogan. Joe?
Joe Hogan: Thanks, Shirley. Good afternoon, and thanks for joining us. On our call today, I'll provide an overview of our first quarter results and discuss a few highlights from our two operating segments, Systems and Services and Clear Aligners. John will provide more detail on our Q1 financial performance and comment on our views for the second quarter in 2023. Following that, I'll come back and summarize a few key points and open the call to questions. Overall, I'm please report better than expected first quarter revenues and earnings. The sequential increase in first quarter revenues of 943 million reflects stability across all regions for Clear Aligner business and favorable average selling price for the Clear Aligner and Systems and Services segments. Q1 sequential growth reflects an increase in non-case revenues, which also increased year-over-year driven by continued growth from our Invisalign Doctor subscription program the Vivera Retainers. And the team segment, which represents the largest portion of the 21 million annual orthodontic case starts 182,000 teens and kids started treatment with Invisalign Clear Aligners during the first quarter, increasing both sequentially and year-over-year, which is encouraging as we head into the important summer season for teens and kids. Overall, remain confident in our large underpenetrated market opportunity globally. And our ability to deliver digital products and technology that are helping doctors transform smiles and change lives for millions of people. Processes and services in Q1 revenues of 153.3 million were down 9.7% sequentially, and 6.2% year-over-year. As expected Q1 systems and services revenues decreased sequentially consistent with seasonal capital equipment cycles compared to Q4. For Q1 system and services revenues were sequentially lower primarily in the Americas and APAC regions, offset somewhat by an increase in EMEA. For non-system scanner revenues Q1 was up sequentially in year-over-year, reflecting increased scanner rentals, upgrades and certified pre-owned or CPO leasing programs to one CPO sales and food initial shipments of leasing units to desktop metal, who's supplying iTero element flex scanners to desktop labs. One of the largest lab networks in the United States serving general dentists. On a year-over-year basis Q1 services revenues increased primarily due to higher subscription revenues resulting from the large number of iTero scanners in the field. We also had higher non-systems revenues related to our scanner leasing and rental programs previously mentioned. The Q1 total Clear Aligner of revenues of 789.8 million was up sequentially and down year-over-year. Q1 sequential revenue growth reflects increases across the regions driven by price increases favorable foreign exchange and more additional liners. Q1 non-case revenues were up sequentially and year-over-year, reflecting continued growth from DSP, Vivera Retainers in commerce sales, which include everything from a liner cases to whitening and cleaning products. DSP has been very successful and enabling doctors to purchase aligners on a subscription basis, giving them flexibility to treat simple touch up cases, or offer their patients a superior flexible and convenient retention solution. We introduce DSP in North America during the pandemic, and are continuing to expand DSP offerings in the main region. The contribution of DSP to non-case revenues is important to understand, especially the impact overall Clear Aligner volumes. While we don't report the number of DSP, Clear Aligners shipped, and we don't include them in our total Clear Aligner volumes, if we were to calculate an equivalent case shipment for touch up patients, using our DSP aligners, we estimate those cases would increase approximately 25% sequentially. Q1 call total Clear Aligner volumes of 575.4,000 were down slightly sequentially reflecting stability across regions, and improvements in consumer confidence, as well as the easing of COVID restrictions recently in China. For the Americas Q1 Clear Aligner volumes were up slightly sequentially reflecting higher orthodontic cases, especially teen case starts with growth in both Invisalign Teen case packs and Invisalign First treatment for kids as young as six, offset primarily by a decrease in adult patients from the GP dental channel. Based on the most recent gauge practice analysis tool that collects and consolidates data from approximately 700 ortho practices in North America, overall, new patient flow and adult exams were lower this period while teens outpaced adults. During this period, wires and brackets cases continue to grow ahead of Clear Aligners, although at a slower rate than in recent quarters. And Invisalign cases outpaced other Clear Aligner brands. The gauge report also included a few data points regarding no shows which are exam schedule, which we believe may provide insight into consumer sentiment and macro conditions. Regarding no shows, over the last 12 months, there's been a large increase in the number of patient no shows. However, that rate appears to be stabilized. Conversely, over the last 12 months, future exams scheduled were negative year-over-year, but the rate has steadily improved in the most recent months covered by the report, which we believe may be a good gauge for consumer optimism. For EMEA, Q1 Clear Aligner volumes include strong adoption of Invisalign moderate across the region in both the adult and team segments. Invisalign Moderate Package's a 20-stage treatment option designed for patients whose treatment goals fall between the existing Invisalign Light and Invisalign comprehensive packages. For APAC, Q1 Clear Aligner volumes reflect improvement in China and continued growth in markets like Japan, Korea and India with positive year-over-year growth, including teams. Teen orthodontic treatment is the largest segment of the orthodontic market worldwide and represents our largest opportunity for Clear Aligner sales to orthos. We continue to focus on gaining share from traditional metal prices through teen specific sales and marketing programs and product features, including Invisalign First for kids as young as six, which is up sequentially across all markets. For Q1, total Clear Aligner cases for teenagers were up sequentially and year-over-year, reflecting improving trends across the regions. On a sequential basis, growth was driven by increased submitters in the APAC and Americas region. On a year-over-year basis, teen case starts were up in EMEA region by reflecting increased utilization and the recent introduction of Invisalign moderate across the region, which outpaced the year-over-year growth rate of Invisalign First, which also continues to perform very well across markets. Invisalign First was also up sequentially and year-over-year across all regions. Invisalign First is designed to treat a broad range of -- issues in growing children from simple to complex. And because Invisalign First is removable, it's easier for kids to brush and flows. There's also no discomfort from rubbing braces or poking fires for metal braces. These benefits, along with positive compliance experience, may also contribute to continued momentum for Invisalign First. In fact, the majority of surveyed Invisalign orthodontists agreed that their young patients are highly compliant with Invisalign First treatment. Understanding that younger kids are highly compliant and Invisalign First provides an opportunity to sort of overall practice growth. The Q1 Clear Aligner volume from dental service organizations, or DSO customers continue to outpace non-DSO customers. Q1 Clear Aligner volume from DSO customers increased sequentially, reflecting growth in the Americas region. DSOs make up approximately 20% of the dental market and represent one of the most important channels for digital orthodontics and restorative dentistry. Through their network of doctors and systematic approach to clinical education and practice management, DSOs are uniquely positioned to drive adoption of new technologies and tools that increase practice efficiency and profitability and deliver a better patient experience. We have well-established relationships with many DSOs, especially in the United States, with DSOs such as Smile Docs and Heartland Dental. And we are continuously exploring collaboration with others that drive adoption of digital dentistry. Each DSO has a different strategy and business model. And our focus is working with them and encouraging DSOs align with our vision, strategy and business model goals. One of the most digitally minded DSOs is Heartland Dental. And today, we announced a $75 million equity investment in Heartland. Heartland is a multidisciplinary DSO with GDP and ortho practices across the U.S. Their growth strategy includes Heartland's de novo dental practices, which feature modern technology, are located in areas with strong community need for dentistry, where Heartland provides practices with opportunities for mentorship, leadership training and continuing education. In the last three years, Heartland opened 188 state-of-the-art de novo practices across the United States and are planning to continue investing through more de novo openings. We have a shared sense of purpose with Heartland. Their mission is to help doctors and their teams deliver the highest quality digital dental care to the communities they serve. The ban creation remains an important strategic growth driver, and we continue to invest in consumer marketing programs that create awareness of the Invisalign system and that drive demand to Invisalign practices. In Q1 '23, we delivered 7.8 billion impressions and had 22.1 million visits to our websites and continue to invest in top media platforms such as TikTok, Snapchat, Instagram and YouTube across markets. For more details on our programs and key Q1 performance metrics, please see our presentation slides on our website. We're also developing digital tools and apps for consumers, patients and for doctors. The Q1 adoption of the My Invisalign consumer and patient app continue to increase with 3.1 million plus downloads to date and over 350,000 monthly active users, representing 28% year-over-year growth. Usage of our other digital tools includes ClinCheck, Live Update, which is used by 38,000 doctors to reduce time, spent modifying treatment plans of up to 13% and Invisalign practice app with 58,000 doctors actively using this feature and uploading more than 5.1 million photos to date. Finally, in addition to our focus on consumer marketing and digital tools, we're committed to driving excellent treatment and align innovation through industry and align hosted clinical education events. Our team has just participated in the annual AAO conference, which took place in Chicago, where we engaged with a broad range of orthodontists. In March, we participated in IDS in Cologne, Germany, one of the largest dental shows in the world focused on digital dentistry and the technologies shaping the industry. Earlier in the quarter, we hosted the second align's symposium on the digital practice, a smaller align event from the most engaged in experience Invisalign orthodontists in the world. It was an amazing opportunity to come together with long-term global partners and thought leaders in orthodontics to see how we are driving the digital transformation of dentistry together. By our participation in each of these events and opportunities, we continue to reinforce the importance of peer-to-peer clinical education and our investments in the orthodontic specialty. We are grateful for all of our customers, GP, orthodontists, corporate practices but we know that the orthodontic specialty leads the way in adoption of digital orthodontics. We are excited about the future we see them in the orthodontic profession. Align abruptly supports the orthodontic profession through education, grants and continued innovation. Our educational pathway was created to support recent graduates, and we career doctors at critical career transition points. As a result of schooling and early career initiatives, graduates will be educated on digital dentistry and digital orthodontics, connected with and supported by colleagues more experienced ortho experts in the Align team and engaged with Align Digital Platform. Align supports doctors throughout all stages of their career, from educating facilities at dental schools and orthodontic programs to education for residents. Early to mid-career providers and more seasoned professionals looking to expand their clinical capabilities and practices. Align is expanding its global footprint of education centers to provide a forum for hands-on learning and continued development in key cities across our regions. We are also focused on continuing to innovate in digital dentistry, scaling capacity to manage the millions of digital requests, patient scans and orders flowing through our systems, while also using technologies like AI and machine learning to increase efficiencies, speed treatment planning and quickly deliver products so patients can begin to pass to transforming their smiles. In the next one to two or three years, Align believes our newest technologies and innovations will revolutionize our existing offerings in the ways in which doctors and their patients experience orthodontic treatment. Together with our customers, we are developing the future of digital dentistry and digital orthodontics not just the technology that drive treatment, but the models reshaping how we interact with customers and deliver treatment experiences for their patients. We look forward to sharing more with you in the coming months. With that, I'll now turn it over to John.
John Morici: Thanks, Joe. Now for our Q1 financial results. Total revenues for the first quarter were $943.1 million, up 4.6% from the prior quarter and down 3.1% from the corresponding quarter a year ago. On a constant currency basis, Q1 '23 revenues were impacted by favorable foreign exchange of approximately $25.8 million or approximately 2.8% sequentially and unfavorably impacted by approximately $34.9 million year-over-year or approximately 3.6%. For Clear Aligners, Q1 revenues of $789.8 million were up 7.9% sequentially primarily from higher ASPs and higher non-case revenues, partially offset by lower volumes. On a year-over-year basis, Q1 Clear Aligner revenues were down 2.5%, primarily due to lower volumes, lower ASPs, including unfavorable foreign exchange, partially offset by higher non-case revenues. For Q1, Invisalign ASPs for comprehensive treatment were up sequentially and decreased slightly year-over-year. On a sequential basis, ASPs reflect price increases, favorable foreign exchange and higher additional liners, partially offset by product mix and larger discounts. On a year-over-year basis, the ASPs for our comprehensive treatment were almost flat, primarily due to product mix shift, unfavorable foreign exchange and higher discounts, mostly offset by price increases and higher additional aligners. For Q1, Invisalign ASPs for non-comprehensive treatment were up sequentially and year-over-year. On a sequential basis, the increase in ASPs reflect price increases, favorable foreign exchange and higher additional aligners, partially offset by higher discounts. On a year-over-year basis, the increase in ASPs reflects price increases and higher additional aligners, partially offset by product mix shift, unfavorable foreign exchange and higher discounts. During the quarter, we launched Invisalign Comprehensive three and three product in most markets. The three and three configuration offers our doctor customers our Invisalign comprehensive treatment with three additional aligners included within three years of treatment end date. Instead of unlimited additional aligners within five years of the treatment end date. At the 2022 Invisalign comprehensive product price, over time, we have come to learn that on average, Invisalign doctors complete a comprehensive Invisalign treatment with less than two additional aligners. We are pleased with the initial adoption of the Invisalign comprehensive -- and anticipate that its impact will be more meaningful, providing doctors the flexibility they desire and allowing us to recognize more revenue upfront with deferred revenue being recognized over a shorter period of time compared to our traditional Invisalign comprehensive product. As revenues from subscription retainers and other ancillary products continue to grow globally, some of the historical metrics that only focus on case shipments are expected to account for a lesser percentage of our overall growth. In our earnings release and financial slides, you will see that we have added our total Clear Aligner revenue per case shipment, which we believe to be more indicative measure of our overall growth strategy. Clear Aligner deferred revenues on the balance sheet increased $32 million or up 2.6% sequentially and $150.9 million or up 13.6% year-over-year and will be recognized as the additional aligners per shipping. Q1 23 systems and services revenue of $153.3 million were down 9.7% sequentially primarily due to the seasonally lower scanner volume, partially offset by higher services revenues from our larger base of scanners sold, higher revenues from our CPO and leasing rental programs and favorable ASPs, down 6.2% year-over-year primarily for the reasons just stated. Q1 '23 systems and services revenue was impacted from favorable foreign exchange of approximately $4 million or approximately 2.7% sequentially. On a year-over-year basis, System and Services revenues were unfavorably impacted by foreign exchange of approximately $5.8 million or approximately 3.6%. Systems and Services deferred revenues on the balance sheet was down $2.2 million or 0.8% sequentially, primarily due to the decrease in scanners sales and deferral of service revenues included with the scanner purchase and up $24.2 million or 9.8% year-over-year, primarily due to the increase in scanner sales and the deferral of service revenues included with the scanner purchase, which will be recognized ratably over the service period. As our scanner portfolio expands and we introduce new products, we increased the opportunities for customers to upgrade, make trade-ins and provide refurbished scanners for certain markets. As such, our model is changing. We expect to continue to roll out programs such as our certified pre-owned leasing and rental offerings -- by possibly leveraging our balance sheet and selling the way our customers desire. Developing new capital equipment opportunities to meet the digital transformation needs of our customers and DSO partners is a natural progression for our equipment business with a large and growing scanner sold. Moving on to gross margin, first quarter overall gross margin of 70%, up 1.5 points sequentially and down 2.9 points year-over-year. Overall gross margin was favorably impacted by foreign exchange by approximately 0.8 points sequentially and unfavorably impacted by approximately 1.1 points on a year-over-year basis. Clear Aligner gross margin for the first quarter was 71.7%, up 0.9 points sequentially due to higher ASPs, partially offset by higher manufacturing absorption. Clear Aligner gross margin for the first quarter was down 3.1 points year-over-year, primarily to lower ASPs, increased manufacturing spend as we continue to ramp up operations at our new manufacturing facility in Poland and a higher mix of additional aligner volume. Systems and Services gross margin for the first quarter was 61.6%, up 2.8 points sequentially primarily from increased manufacturing efficiencies. Systems and Services gross margin for the first quarter was down 1.8 points year-over-year due to lower volumes, partially offset by higher services revenues and ASPs. Q1 operating expenses were $527.1 million, up sequentially 4.4% and up 3.1% year-over-year. On a sequential basis, operating expenses were up $22.1 million, primarily from higher incentive compensation and consumer marketing spend partially offset by restructuring and other charges not recurring in Q1. Year-over-year, operating expenses increased by $15.9 million, primarily due to higher incentive compensation and our continued investments in sales and R&D activities, partially offset by controlled spending on advertising and marketing as part of our efforts to proactively manage costs. On a non-GAAP basis, excluding stock-based compensation and amortization of acquired intangibles related to certain acquisitions, partially offset by restructuring and other charges, operating expenses were $490.5 million, up 6.7% sequentially and up 2.1% year-over-year. Our first quarter operating income of $133.5 million resulted in an operating margin of 14.2%, up 1.7 points sequentially and down 6.2 points year-over-year. Operating margin was favorably impacted by approximately 1.5 points sequentially, primarily due to foreign exchange and higher gross margins. The year-over-year decrease in operating margin is primarily attributed to lower gross margin. Investments in go-to-market teams and technology as well as unfavorable impact from foreign exchange by approximately two points. On a non-GAAP basis, which excludes stock-based compensation, amortization of intangibles related to certain acquisitions, offset by restructuring and other charges. Operating margin for the first quarter was 18.5%, up 0.2 points sequentially and down 5.5 points year-over-year. Interest and other income and expense net for the first quarter was an income of $1.1 million compared to an income of $2.7 million in the fourth quarter and a loss of $10.6 million in the first quarter a year ago, primarily due to net foreign exchange gains from the strengthening of certain foreign currencies against the U.S. dollar. The GAAP effective tax rate in the first quarter was 34.8% compared to 63.8% in the fourth quarter and 28.4% in the first quarter of the prior year. The first quarter GAAP effective tax rate was lower than the fourth quarter effective tax rate, primarily due to increased earnings in low tax jurisdictions in Q1 2023 and an audit settlement in Q4 2022. As a reminder, in Q4 2022, we changed our methodology for the computation of our non-GAAP effective tax rate to a long-term projected tax rate and have given effect to the new methodology from January 1, 2022, and recast previously reported quarterly periods in 2022. Our non-GAAP effective tax rate for the first quarter was 20%, reflecting the change in our methodology. First quarter net income per diluted share was $1.14, up sequentially $0.60 and down $0.56 compared to the prior year. Our EPS was favorably impacted by $0.14 on a sequential basis and unfavorably impacted by $0.21 on a year-over-year basis due to foreign exchange. On a non-GAAP basis, net income per diluted share was $1.82 for the first quarter, up $0.09 sequentially and down $0.43 year-over-year. Note, the prior year 2022 non-GAAP net income for diluted share in our prior year 2022 non-GAAP EPS reflects the Q4 2022 change in our methodology for the computation of the non-GAAP effective tax rate. Moving on to the balance sheet. As of March 31, 2023, cash, cash equivalents and short-term and long-term marketable securities was $921.4 million, down sequentially $120.2 million and down $199.2 million year-over-year. Of the $921.4 million balance, $310.5 million was held in the U.S. and $610.9 million was held by our international entities. During Q1 2023, we purchased approximately 942,000 shares of our common stock at an average price of $307.74 per share for a total purchase price of $290 million, completing a $200 million accelerated share repurchase from Q4 2022, a $250 million ASR from Q1 2023 and in our May 2021, $1 billion stock repurchase program. During Q1 2023, we announced that our Board of Directors authorized a new $1 billion stock repurchase program to succeed the 2021 $1 billion program. Currently, $1 billion remains available for repurchase under the 2023 $1 billion stock repurchase program. Q1 accounts receivable balance was $884 million, up sequentially. Our overall days sales outstanding was $83, down approximately two days sequentially and down approximately four days as compared to Q1 last year. Cash flow from operations for the first quarter was $199.9 million. Capital expenditures for the first quarter were $64.1 million, primarily related to our continued investments to increase aligner manufacturing capacity and facilities. Free cash flow, defined as cash flow from operations less capital expenditures, amounted to $135.8 million. Now turning to our outlook, as Joe mentioned earlier, we are pleased with our Q1 results and what continues to be a more stable environment across all regions. We remain cautiously optimistic for continued stability, as we move through the year. However, the macroeconomic environment remains uncertain. And given continued domestic and global challenges and unpredictability, we are not providing full year revenue guidance. We would like to see consistent improvements in the operating environment and consumer demand signals before revisiting our approach. We remain focused on making investments to drive growth and penetration into a huge untapped market opportunity, including our strategic investments in sales, marketing, technology and innovation. We are confident in our ability to address the massive opportunity for digital orthodontics and restorative dentistry, with our execution centered on our strategic initiatives. With this as a backdrop for Q2 2023, we anticipate Clear Aligner volume and ASPs to be up sequentially. We also anticipate Systems and Services revenue to be up sequentially. For Q2 2023, we anticipate revenues to be in the range of $980 million to $1 billion. We expect our Q2 2023 non-GAAP gross margins to be flat to slightly up from Q1 '23, and our Q2 2023 non-GAAP operating margin to be up by approximately one point sequentially as we continue to strategically prioritize our investments in go-to-market activities and R&D to drive growth. For full year 2023, assuming no circumstances beyond our control, we reiterate our 2023 non-GAAP operating margin to be slightly above 20%. For 2023, we expect our investments in capital expenditures to exceed $200 million. Capital expenditures primarily relate to building construction and improvements as well as additional manufacturing capacity to support our international expansion. Finally, as it relates to the $75 million equity investment in Heartland Dental that Joe discussed, our investment is less than 5% of the Company and the line has no oversight or involvement in management of Heartland Dental or its affiliates. With that, I'll turn it back over to Joe for final comments. Joe?
Joe Hogan: Thanks, John. In closing, we're pleased with our first quarter results that reflected an environment of continued stability for our doctor customers. However, degrees of uncertainty remain from market to market. We're confident in our durable competitive advantage as we continue to transform the orthodontic industry, bringing digital dentistry and clear line of treatment to more doctors and the patients they serve, driven by our strategic initiatives of international expansion, orthodontist utilization, general dentist treatment and patient demand and conversion. We will continue to focus on the next phase of new platform innovations in scanning, software and direct 3D printing while prioritizing the needs of our customers for the ultimate benefit of their patients. We are a purpose-driven organization with a tireless commitment to transform more smiles and change more lives. We're the only digital orthodontic company in the world today with the scale and reach to address the 500 million potential people that could benefit from teeth straightening within the line system. Thank you for your time today. We look forward to updating you on our next earnings call. Now, I'll turn the call over to the operator for questions.
Operator: Thank you. At this time, we'll be conducting a question-and-answer session. [Operator Instructions] Our first question today comes from Jason Bednar from Piper Sandler.
Jason Bednar: I wanted to start first maybe with the 2Q outlook. You're pointing to a sequential uplift in cases in the quarter. I think that's consistent with what we typically see in a normal year from first quarter to second quarter. I think it's normally a 5% to 10% uplift. So maybe a good sign if we're continuing to move back towards normal, I'm not sure if you're willing to touch a typical pattern there, Joe or John, just to comment on the second quarter. But regardless, can you elaborate maybe on the rhythm of activity you're seeing in the U.S. or international markets that contributing to the visibility today and calling for those improved case volumes in the second quarter?
Joe Hogan: Jason, it's Joe. First of all, I'd just describe what we have is stability right now. I mean you talk about the quarter-over-quarter seasonality of the business. We haven't really seen that for a long period of time. Obviously, that's embedded in our forecast right now. But I'd characterize again, what we're seeing right now is stability, which I feel is good in the sense that we've had such instability over the number of years. And from quarter-to-quarter, we're seeing some consistency in that sense. And I think -- in this economic environment right now with the uncertainty in different aspects going on out there, I think the stability piece and that's what we're leaning on as we move into Q2, is the right theme and the right kind of focus.
Jason Bednar: Okay. All right. Understood. Maybe to follow up and press a little bit more on maybe on the utilization side. Could you talk about maybe the puts and takes around some of the utilization metrics you're putting up here in the quarter and as we think forward in the future. It seems like that ortho channel is seeing some good uplift. The first sequential improvement we've seen in over a year. international utilization did tick lower, but I'm wondering if there's a dynamic plan out there where some of your China doctors are coming back online and starting to do cases, but not yet fully back up to normal. So maybe just curious if you could unpack what you're seeing with utilization in those two channels, the North American ortho channel, your international customer base.
Joe Hogan: Utilization statistic is, Jason, obviously, important to us. Remember, it often gets somewhat muddled in the sense of DSO aggregation and different things in different areas that we've had a report in an investment community at times. Your point on China is a good one. China was somewhat dark for us during the COVID piece, and we do see that coming back. The orthodontic piece is a good signal to. So overall, I feel good about those -- the utilization numbers. I felt obviously good about the gauge data. I hate to see the wires and brackets moving up, but you could see we outperformed on the Clear Aligner segment on that piece, too. So, we're seeing good doctor engagement and that's on both the GP side and the ortho side. I think the overall piece here is you have to look at a continued challenge from an adult standpoint, when you look at our numbers across the globe. And I think that's more reflective of the consumer index and confidence things that we've talked about in the past. And the teens in that certain window of treatment are more certain for this in treatment than some of the adults in those cases. And that addresses your question, Jason.
Operator: Our next question comes from Elizabeth Anderson from Evercore ISI. Your line is open.
Elizabeth Anderson: So, my first question would be, I know you said China is coming back. Are you seeing that continue to sort of improve as we think about the second quarter? I mean, obviously, you're lapping some of these shutdowns last year, but I'd be curious about how that was improving. And then just to, I think you called out some broader utilization and improvements to help drive the margins higher in the second quarter and the guidance that you just gave, but could you go into a little bit more detail about what specifically is helping to push those up?
John Morici: I think, Elizabeth, I'll take the kind of the margin piece. This is John. We'll see improvements as we produce more product, sell more product. We talked about that being sequentially up from a volume standpoint and utilize our facilities, whether it's clear liner or on the Systems and Services side. So that's definitely a help. And in particular, with some of the improvements that we're seeing with higher utilization in Poland, as that plant continues to ramp up, will -- we see improvements in gross margin that way.
Joe Hogan: Elizabeth on China, I could -- it was kind of a difficult quarter in a sense of how it started. But we saw good unfolding as the quarter went forward. I'd say when I hear people say China returning, China is coming out of a COVID crisis. I think we see, obviously, across different industries. China improving in that sense, but I'd say no way is China back in the sense of we envision China four years ago or so before we went into this mess. Right now, I'd say what we've seen in China the last few months is just stability, I'd say, some stability and a more clear signal out of China than we've seen in the past, but nothing that we're ready to forecast through individual growth standpoint.
Operator: Our next question comes from Jon Block from Stifel. Your line is open.
Jon Block: Maybe somewhat of a similar line of the question, but I just want to stick to maybe the March quarter. So let's say, most of the 1Q '20 revenue be is specific to ASP related, if you would. So I'm curious how Invisalign cases trended throughout the March quarter. And if there's anything to call out within the different regions and how that played out, call it, from a Jan to March -- because when you do start some of the implied math based on, John, your commentary where 1Q ASP was going to land, it seems like case falls were maybe on your number prior, not ahead. So again, just any color around case falls throughout the quarter and by region would be helpful.
John Morici: John, this is John. So I would say in specific, as we said in China, we saw improvement in China. I mean it went from January with a lot of the COVID cases and February was better than January and March was better than February. We saw that. And then as Joe described, we've seen stability in a lot of the other markets where there's puts and takes, but overall, more stability throughout the quarter. And that's what kind of got us to our overall volume numbers.
Jon Block: Okay. So then I'll ask my follow-up and I'll ask my second question. I think on the initial guide, China was supposed to be down Q-over-Q, was China still down Q-over-Q, 4Q to 1Q based on your commentary? Or was that up and you gave it back a little bit somewhere else. That would just be the follow-up to the first question. The second question is just burning one on 2Q a little bit. When you say ASP up 2Q versus 1Q, is there a dart throw of maybe low single digits or 1% to 2%. I'm guessing you get the stub on the price increase. You get the full quarter in 2Q that you didn't get in 1Q. And maybe FX, as we sit here today is more favorable for the June quarter versus March.
John Morici: Yes. Thanks, Jon. Yes, on China, we didn't specifically guide for China in Q1, and it played out as we described there, but that's what we saw in China, which adds to what Joe was talking about just that stability that we saw there that we haven't seen in three years or so. On ASPs, you're right. We expect it to be slightly up over Q1. It's getting that full quarter of price change and so on the price increase we have and kind of taking the FX where it's at right now so slightly up compared to what we saw in Q1.
Operator: Our next question comes from Jeff Johnson from Baird. Your line is open.
Jeff Johnson: Following up on John's question, I think he was trying to get up the same thing. But look, I mean, revenue in 1Q came in clearly ahead of what you guys were talking about. 2Q is at least being guided above the street, which I say encouraging. You're talking about stability throughout the quarter. So I guess I'm trying to understand why isn't that translating to slightly better margins? I think your margin number in the 1Q was spot on with us. It was above the street right on what we were thinking, but your full year guidance is staying the same. And it sounds like you feel a little better about the end markets. You're definitely translating that to better revenue. I would just think even with fixed cost leverage, maybe we would have seen a little bit better margin in the 1Q and a little bit more optimistic outlook for the year.
John Morici: I think, John, when you look at -- or sorry, Jeff, when you think of the total year, there's still uncertainty in the second half. So we tried to give a good view of where we think Q2 will be based on that guidance, but they're still uncertainty in the second half. And that's why we've stayed away from that revenue guide for the total year and kept our op margin that we talked about, the non-GAAP at or slightly above kind of out there just for that uncertainty still in the second half.
Jeff Johnson: Okay. And then maybe a follow-up. I just want to make sure on DSP. I think I know the answer to this. I don't want to expose my -- pay if it is that. But I know there's commercial product in there. I know obviously, there's -- there do any cases get captured within DSP? Obviously, as DSP is growing nicely, the 575,000 cases you did this quarter, the 598,000 cases you did last year in the first quarter. If we subtracted out DSP or if that didn't exist, would those case volumes be different at all, is the down 3%, 4% year-over-year being impacted at all by more things moving to DSP? Just want to understand the impact that has as we look at these reported global case volumes.
John Morici: No, you're right, Jeff. I mean, so as DSP grows, there are some non-comprehensive typically cases that get caught in there. Those would be minor adjustments, minor movement cases that those doctors would want instead of going into a non-comprehensive case, in ordering that, they're using DSP. And so therefore, DSP kind of includes it. It's great revenue for us. It's additional revenue. That's why when you think of that other revenue piece of it. It's growing faster as DSP grows, and it's really fulfilling the way the doctors want to be sold to. But some of that case volume gets trapped within DSP.
Shirley Stacy: But Jeff, just to make sure we're talking kind of apples-to-apples, you asked if you stripped out those cases from our reported case volumes, they're not counted in the case volume is the point, and that was the comments that John made on the script about the implied impact of DSP revenue growth because those aren't counted in case shipments.
Jeff Johnson: Right. And as they're growing, then I'm assuming the 4% year-over-year case volume contraction you reported this year in the first quarter looks a little worse than it actually would have been if DSP wasn't out there. And that's what I'm trying to get at. Is there any way to quantify that? Would cases, if not for DSP, been closer to flat year-over-year? Or is there just any way to kind of guide us round about what that impact of DSP growing nicely year-over-year, but then that's capturing -- DSP is capturing more cases this quarter -- this year in the first would have then did last year in the first quarter.
John Morici: Yes. We haven't broken that out, Jeff, within DSP. But you're right. The year-over-year case volume change would not have been down by as much. It would have been more -- it would have been adjusted because DSP is growing, and there's more cases that kind of get trapped within there. But as Shirley said, we don't report those DSP cases. They're not there. They just show up in our other revenue.
Operator: Our next question comes from Brandon Vazquez from William Blair. Your line is open.
Brandon Vazquez: I think first, I just wanted to focus kind of on the adult side. The cases were down quarter-over-quarter. Those are the cases a little more exposed to the macro side. But you are also guiding to sequential improvements in volumes going forward. So just kind of curious if you can talk about that dynamic. Is team quarter-over-quarter growth enough to kind of offset that? Are you expecting adults to also improve -- just kind of any dynamics around that would be helpful?
Joe Hogan: It's Joe. Look, I think when you look at adults, I look at that as really tied to the consumer confidence indices, particularly in the western world that we can track. And look, I'm not -- we're not smart enough to project where that's going. It looks like that's stable right now, too, when you look at the way those lines are trending in the United States and different parts of the Western world. On the teen side, our second quarter is a big teen season. In the western world, third quarter is big teens for China. And so that's why we talked about it in my script is that we came out of the first quarter with really positive signs on teens. As we go into the quarter, we have some momentum in that sense. And so we stay focused on adults and we'll execute well around adults. But in teen season two, we keep a very sharp focus there because we think that demand equation is much more consistent.
Brandon Vazquez: Okay. And then maybe I'll take us a step away from kind of the near-term stuff and just talk a higher-level strategy on the DSOs. It looks like you guys are having good progress there. Can you talk about -- are there any kind of like fundamental differences of going to that market? Any commercial strategy differences? Are there potential margin benefits because you're kind of dealing with one large organization that sells to bigger accounts, anything you can call out there for us?
Joe Hogan: Yes, it's a good question. The DSOs, you're right, there's something we call OpEx, some cost aspects you don't have to have as high as the number of salespeople calling on that account, you organize resources differently to make sure you support a team like Heartland, the way they need to be supported. What's really great is a very synergistic effect, too, in the sense of how they execute on their clinicals throughout their organization from an efficiency standpoint, how to teach our doctors to use our product to enhance what their capability is in the digital dentistry side. And so -- and then obviously, we help to teach through their teachers in the sense of how we train the doctors and all. So what we really like about with Heartland, and we have a good relationship with other DSOs with Heartland is a really good focus from a digital standpoint and good execution around how they want to move that to the marketplace to their doctors. It's very professional, and that's why we've seen growth in that channel and -- we see that with Smile docs also on the orthodontic side, there are strong orthodontic DSO. And we're really, really happy to partner with them because we have the same vision and the same focus on expanding the marketplace for digital orthotics.
Operator: Our next question comes from Nathan Rich from Goldman Sachs. Your line is open.
Nathan Rich: Maybe going back to China, if I could. Joe, is there any way to characterize kind of where case shipments were March relative to maybe where the business was prior to the lockdowns? And can you maybe just talk generally how you feel about the consumer there and they're kind of coming out of these lockdowns willingness to spend on dental treatment.
Joe Hogan: Well, I think we're coming out of a complete blackness, okay, when you get it. So Nave's really hard to pull a signal out of all that noise, except for we had a reasonable quarter, and you can see we're predicting that in the second quarter for China. That's kind of as far as I want to go. When you think about China itself, from a consumer standpoint, you have to look at the private institution. You have to look at the public hospitals. And again, that data isn't clear enough for us in the sense of what the sustainability is on that piece. So we're just being cautious. I don't think China is going to revert back into a COVID kind of a shutdown. I think we all know that. But that economy is somewhat questionable right now in the sense of how fast it will rebound and what direction it rebounds in We're just being cautious in the sense of how we're going to forecast
Nathan Rich: Okay. Sounds good. And then, John, maybe a follow-up for you. Could you maybe just help us get a sense of where the 3x3 case penetration was in 1Q and it sounds like you're expecting a pretty meaningful step up in 2Q. I don't know if you can kind of put any numbers around that in terms of what that will do in terms of the revenue recognition that you'll get kind of incrementally relative to the first quarter as that penetration increases?
John Morici: Well, I think first off, the three and three, it's a great product that our customers want and they're utilizing and so we're happy to see in the markets that we've released good adoption started in January for us, and we saw it progressively increase as we went through -- in through the quarter. So every month got better. And it really gives doctors more options in terms of how they want to purchase our product. As I said in my remarks, many of our doctors -- most of our doctors don't do more than two refinements. So this is a product that's perfect for them, allows them to treat patients the way they can. And then from a revenue recognition standpoint, it -- because we don't have -- we have pretty much a defined number of aligners only up to three refinement. And it's over a three-year period. So we're able to recognize revenue over a shorter period of time and the adoption of this as well as other factors are in the overall Q2 guide.
Operator: Our next question comes from Michael Ryskin from Bank of America. Your line is open.
Michael Ryskin: I want to follow up on an earlier question regarding what you saw in adult versus teens, recognize your point on adults being a little bit more consumer exposed and maybe some of that is a little bit more macro driven. But just wondering, anything you can comment to in terms of how that progressed through the quarter? Or any difference you're seeing U.S. versus Europe versus EMEA, just given anything on progression there? I think with that? Just to sort of that back to your comments on stability, it would be really helpful to bridge that.
Joe Hogan: Michael, it's Joe. I mean if anything has been consistent, we have seen the pressure on adults during this whole downturn. Now we can see pressure on teens, too, but not to the same extent. These things vary by country in Europe. There's no Europe, you have to look at by country or whatever in the United States. But in general, we see very similar trends from an adult and team standpoint, with more teen demand, not saying positive team demand, but stronger teen demand than we've seen with adults. So what we feel good about is that we're seeing decent stability in those numbers. And adult creep up a little bit. We saw our DSOs in the United States execute really well around adults, which shows you that if you have the right kind of focus, you can still have a good patient yield on the adult side, if you're working that piece. But in general, I think until we see significant economic improvement, I don't know if that adult -- teen kind of ratio in the sense that we're seeing is going to change dramatically. I think we have to see a good upturn in consumer confidence before we see that reflected in the adult volume. Doesn't mean that confidence doesn't affect teens, but it doesn't affect it to the same degree.
Michael Ryskin: Okay. All right. That's helpful. And then on the ASP front, again, I know you guys just talked about the price hike for a while and you discussed some of the factors that led to the ASPs in 1Q and sort of out for 2Q. I'm just wondering, we've always sort of debated price elasticity or demand elasticity as it relates to price. I know there's a lot of going on that earlier this year. Just wondering if now that you've got a full quarter under your belt any additional learnings on price sensitivity in the market, ability to take more price through another price hikes. So what are your thoughts on that a couple of months in.
Joe Hogan: I think price elasticity is a good question in this marketplace. Michael, I think we've always known it's been there. I mean we see -- our competitors don't necessarily compete at all on technology, they compete on price. And then we know that it's had a certain amount of success in a certain part of the marketplace, and that will always be there. But when you look at our price increase here, and I think you're associating our price increase with price elasticity and our volume is our 3x3, which we didn't increase. And obviously, there's a limitation on additional aligners. It was really well received by the marketplace and very from a GP standpoint and ortho standpoint too. And our increase on our comprehensive was seen as fair and also the other parts, I would say -- but everybody loves a price increase, and we see our NPS score. But if I've been here long enough to have enough data points to tell you that, I think this price increase -- our pricing approach was received better by the marketplace than any other one that I've instituted since I've been here. And so, I feel good about it because I think it matched our customer expectations with what we need from a business standpoint. And so I don't think that that elasticity was negative at all in the sense with the price increases here. And most of our competitors, they are truly competitors followed in that sense with price increases, too.
Operator: Our next question comes from Erin Wright from Morgan Stanley. Your line is open.
Erin Wright: I'll ask my question both upfront here, but first on Heartland and the investment there. And how does the relationship change now with the investment? And would this constrain any future relationships with DSO partners. Did you contemplate any sort of conflict of interest that could arise there? And then second question would be on the scanner business and how we should be thinking about the quarterly progression of the segment and stability across the business? And how we're just thinking about just equipment demand trends in general overall with iTero?
Joe Hogan: Erin, it's Joe. I'll take them. On the DSO side, I don't see a conflict of all. We have DSOs that really want to address digital dentistry through digital orthodontics and we're excited about our -- obviously, our digital footprint and what we can offer from a platform standpoint. And so Heartland is helping the lead on the GP side in that sense, and I mentioned the Smile docs on the ortho side is there, too. So again, I don't expect this to be an issue within any of our accounts because we will engage with them and to help them on a demand equation if they want to be as aggressive and inconsistent and this implementation is what Heartland has been and which our docs have been, too. So -- and I don't see a conflict of interest at all. When I hear that term, my hair goes up in the year. I don't see anything that's conflicting at all. I think this is completely in line with what we believe in. We want to drive digital orthodontics as fast as we possibly can. And those DSOs and frankly, not just DSOs, just we have several doctors that have multiple practices that we engage with to try to expand those practices with them because we know they've committed to digital orthodontics and can drive those things forward. So I'd look at this as a positive statement that we're ready to engage and invest with our partners that share our vision. And then secondly, on the scanner business, I think you look at what happened between fourth quarter and first quarter. I think you have to take that in context. Fourth quarter is always a big capital equipment cycle. And first quarter is lower. This wasn't much different when you look at the numbers. When you look at our overall services business through that business because we have such a broad installed base that held up very well. So as I look at the scanner marketplace and where we stand today, I believe we have the largest installed base out there. We monetize that well from a services standpoint, we work with those accounts. When you look at our NPS scores of customers that use iTero, significantly higher customer satisfaction than ones that don't and try to use PVS impressions or something else, too. So when I look at our technology versus technology from competitors, I feel we lead, and we'll continue to lead in the marketplace. So our iTero scanner is critical for us going forward. It's a key part of our digital platform. Don't look at the fourth quarter and first quarter as any kind of a signal to say that we're losing momentum in that business. We always see that difference between fourth quarter and first quarter. John, you add anything? You...
John Morici: That's good. I mean, it's very consistent.
Operator: Our final question today comes from Kevin Caliendo from UBS. Your line is open.
Kevin Caliendo: I just want to go back to Heartland. Can you tell me how much volume you did with Heartland in '22? Is this going to potentially impact that going forward? Like is there any guarantees or any buy-ins or do you maybe more contribute to their growth as they continue to grow? And I guess the follow-up to there is, how are you accounting for this? It says less than 5% ownership. I'm assuming that means whatever runs through the P&L would be a noncontrolling interest, right? And -- or is it somehow above the line? And is this impacting margins in any way, shape or form?
Joe Hogan: Kevin, I'll take the first one. John is our expert in accounting here. I'll let them take the next one. So on Heartland, look, we don't give individual numbers like this, but you can guess Heartland is the biggest DSO in the world, and they're very effective DSO in that sense. And this is a meaningful investment, and we're seeing meaningful growth with those guys. And I think we're trying to model something, I think, of us a model. It's a good relationship and has a good trajectory from a growth standpoint. John accounting?
John Morici: Yes. In terms of the investment, less than 5%, it doesn't show up in our op margin or anything of that nature. And it's an investment that we made, and it stays on our books that way. But there's nothing that would show up in our op margin or anything else related to that investment.
Joe Hogan: Kevin, also just -- as John talking and thinking of my comment to you is your comment might have inferred something like a quid pro quo or something like that. There's nothing like that. There's no piece of that. We have a joint vision in the sense of how we can move digital orthodontics through the general dentistry, and we share that, and we're helping to invest in that so we can drive it forward. But there's no give and take in that sense. Appreciate your questions.
Kevin Caliendo: Hopefully, it's a good financial investment. You make money as well as advanced digital dentistry. If I can ask...
Joe Hogan: Follow up. Yes.
Kevin Caliendo: U.S. case growth, do you expect U.S. cases to grow year-over-year beginning in 2Q? Is that part of the assumption or how we should think about that? Can you get down to that kind of granularity, U.S. or Americas?
John Morici: Yes. We're not at the -- we're just not giving that case growth numbers, we just kind of wanted to talk sequentially, but you would expect, as we've kind of said from Q1 to Q2, we would expect overall volumes to increase sequentially as you get into teens and others, it's going to vary by region. But if you're talking specifically the U.S., you start to get into more of a teen season basis, and that's the expectation for our overall numbers.
Shirley Stacy: Yes. Thanks, everyone. We appreciate your time today, and thank you for joining us. We look forward to speaking to you at upcoming financial conferences and meetings. If you have any follow-up questions, please contact Investor Relations. Have a great day.
Operator: Thank you. This concludes today's conference, and you may now disconnect your lines at this time. Thank you for your participation. | [
{
"speaker": "Operator",
"text": "Greetings, welcome to the Align First Quarter 2023 Earnings Call. At this time, all participants are in a listen-only mode. A question-and-answer session will follow the formal presentation. Please note, this conference is being recorded. I'll now turn the conference over to your host, Shirley Stacy, with Align Technology. You may begin."
},
{
"speaker": "Shirley Stacy",
"text": "Good afternoon and thank you for joining us. I'm Shirley Stacy, Vice President of Corporate Communications and Investor Relations. Joining me for today's call is Joe Hogan, President and CEO; and John Morici, CFO. We issued first quarter 2023 financial results today via Business Wire, which is available on our website at investor.aligntech.com. Today's conference call is being audio webcast and will be archived on our website for approximately one month. A telephone replay will be available by approximately 5:30 p.m. Eastern time through 5:30 p.m. Eastern time on May 10. To access the telephone replay, domestic callers should dial 833-470-1428 with access code 635629. International callers should dial 44-204-525-0658 using the same access code. As a reminder, the information provided and discussed today will include forward-looking statements, including statements about Align's future events and product outlook. These forward-looking statements are only predictions and involve risks and uncertainties that are described in more detail in our most recent periodic reports filed with the Securities and Exchange Commission available on our website and at sec.gov. Actual results may vary significantly, and Align expressly assumes no obligation to update any forward-looking statements. We have posted historical financial statements, including the corresponding reconciliations, including our GAAP to non-GAAP reconciliation if applicable. And our first quarter 2023 conference call slides on our website under Align quarterly results. Please refer to these files for more detailed information. With that, I'd like to turn the call over to Align Technology's President and CEO, Joe Hogan. Joe?"
},
{
"speaker": "Joe Hogan",
"text": "Thanks, Shirley. Good afternoon, and thanks for joining us. On our call today, I'll provide an overview of our first quarter results and discuss a few highlights from our two operating segments, Systems and Services and Clear Aligners. John will provide more detail on our Q1 financial performance and comment on our views for the second quarter in 2023. Following that, I'll come back and summarize a few key points and open the call to questions. Overall, I'm please report better than expected first quarter revenues and earnings. The sequential increase in first quarter revenues of 943 million reflects stability across all regions for Clear Aligner business and favorable average selling price for the Clear Aligner and Systems and Services segments. Q1 sequential growth reflects an increase in non-case revenues, which also increased year-over-year driven by continued growth from our Invisalign Doctor subscription program the Vivera Retainers. And the team segment, which represents the largest portion of the 21 million annual orthodontic case starts 182,000 teens and kids started treatment with Invisalign Clear Aligners during the first quarter, increasing both sequentially and year-over-year, which is encouraging as we head into the important summer season for teens and kids. Overall, remain confident in our large underpenetrated market opportunity globally. And our ability to deliver digital products and technology that are helping doctors transform smiles and change lives for millions of people. Processes and services in Q1 revenues of 153.3 million were down 9.7% sequentially, and 6.2% year-over-year. As expected Q1 systems and services revenues decreased sequentially consistent with seasonal capital equipment cycles compared to Q4. For Q1 system and services revenues were sequentially lower primarily in the Americas and APAC regions, offset somewhat by an increase in EMEA. For non-system scanner revenues Q1 was up sequentially in year-over-year, reflecting increased scanner rentals, upgrades and certified pre-owned or CPO leasing programs to one CPO sales and food initial shipments of leasing units to desktop metal, who's supplying iTero element flex scanners to desktop labs. One of the largest lab networks in the United States serving general dentists. On a year-over-year basis Q1 services revenues increased primarily due to higher subscription revenues resulting from the large number of iTero scanners in the field. We also had higher non-systems revenues related to our scanner leasing and rental programs previously mentioned. The Q1 total Clear Aligner of revenues of 789.8 million was up sequentially and down year-over-year. Q1 sequential revenue growth reflects increases across the regions driven by price increases favorable foreign exchange and more additional liners. Q1 non-case revenues were up sequentially and year-over-year, reflecting continued growth from DSP, Vivera Retainers in commerce sales, which include everything from a liner cases to whitening and cleaning products. DSP has been very successful and enabling doctors to purchase aligners on a subscription basis, giving them flexibility to treat simple touch up cases, or offer their patients a superior flexible and convenient retention solution. We introduce DSP in North America during the pandemic, and are continuing to expand DSP offerings in the main region. The contribution of DSP to non-case revenues is important to understand, especially the impact overall Clear Aligner volumes. While we don't report the number of DSP, Clear Aligners shipped, and we don't include them in our total Clear Aligner volumes, if we were to calculate an equivalent case shipment for touch up patients, using our DSP aligners, we estimate those cases would increase approximately 25% sequentially. Q1 call total Clear Aligner volumes of 575.4,000 were down slightly sequentially reflecting stability across regions, and improvements in consumer confidence, as well as the easing of COVID restrictions recently in China. For the Americas Q1 Clear Aligner volumes were up slightly sequentially reflecting higher orthodontic cases, especially teen case starts with growth in both Invisalign Teen case packs and Invisalign First treatment for kids as young as six, offset primarily by a decrease in adult patients from the GP dental channel. Based on the most recent gauge practice analysis tool that collects and consolidates data from approximately 700 ortho practices in North America, overall, new patient flow and adult exams were lower this period while teens outpaced adults. During this period, wires and brackets cases continue to grow ahead of Clear Aligners, although at a slower rate than in recent quarters. And Invisalign cases outpaced other Clear Aligner brands. The gauge report also included a few data points regarding no shows which are exam schedule, which we believe may provide insight into consumer sentiment and macro conditions. Regarding no shows, over the last 12 months, there's been a large increase in the number of patient no shows. However, that rate appears to be stabilized. Conversely, over the last 12 months, future exams scheduled were negative year-over-year, but the rate has steadily improved in the most recent months covered by the report, which we believe may be a good gauge for consumer optimism. For EMEA, Q1 Clear Aligner volumes include strong adoption of Invisalign moderate across the region in both the adult and team segments. Invisalign Moderate Package's a 20-stage treatment option designed for patients whose treatment goals fall between the existing Invisalign Light and Invisalign comprehensive packages. For APAC, Q1 Clear Aligner volumes reflect improvement in China and continued growth in markets like Japan, Korea and India with positive year-over-year growth, including teams. Teen orthodontic treatment is the largest segment of the orthodontic market worldwide and represents our largest opportunity for Clear Aligner sales to orthos. We continue to focus on gaining share from traditional metal prices through teen specific sales and marketing programs and product features, including Invisalign First for kids as young as six, which is up sequentially across all markets. For Q1, total Clear Aligner cases for teenagers were up sequentially and year-over-year, reflecting improving trends across the regions. On a sequential basis, growth was driven by increased submitters in the APAC and Americas region. On a year-over-year basis, teen case starts were up in EMEA region by reflecting increased utilization and the recent introduction of Invisalign moderate across the region, which outpaced the year-over-year growth rate of Invisalign First, which also continues to perform very well across markets. Invisalign First was also up sequentially and year-over-year across all regions. Invisalign First is designed to treat a broad range of -- issues in growing children from simple to complex. And because Invisalign First is removable, it's easier for kids to brush and flows. There's also no discomfort from rubbing braces or poking fires for metal braces. These benefits, along with positive compliance experience, may also contribute to continued momentum for Invisalign First. In fact, the majority of surveyed Invisalign orthodontists agreed that their young patients are highly compliant with Invisalign First treatment. Understanding that younger kids are highly compliant and Invisalign First provides an opportunity to sort of overall practice growth. The Q1 Clear Aligner volume from dental service organizations, or DSO customers continue to outpace non-DSO customers. Q1 Clear Aligner volume from DSO customers increased sequentially, reflecting growth in the Americas region. DSOs make up approximately 20% of the dental market and represent one of the most important channels for digital orthodontics and restorative dentistry. Through their network of doctors and systematic approach to clinical education and practice management, DSOs are uniquely positioned to drive adoption of new technologies and tools that increase practice efficiency and profitability and deliver a better patient experience. We have well-established relationships with many DSOs, especially in the United States, with DSOs such as Smile Docs and Heartland Dental. And we are continuously exploring collaboration with others that drive adoption of digital dentistry. Each DSO has a different strategy and business model. And our focus is working with them and encouraging DSOs align with our vision, strategy and business model goals. One of the most digitally minded DSOs is Heartland Dental. And today, we announced a $75 million equity investment in Heartland. Heartland is a multidisciplinary DSO with GDP and ortho practices across the U.S. Their growth strategy includes Heartland's de novo dental practices, which feature modern technology, are located in areas with strong community need for dentistry, where Heartland provides practices with opportunities for mentorship, leadership training and continuing education. In the last three years, Heartland opened 188 state-of-the-art de novo practices across the United States and are planning to continue investing through more de novo openings. We have a shared sense of purpose with Heartland. Their mission is to help doctors and their teams deliver the highest quality digital dental care to the communities they serve. The ban creation remains an important strategic growth driver, and we continue to invest in consumer marketing programs that create awareness of the Invisalign system and that drive demand to Invisalign practices. In Q1 '23, we delivered 7.8 billion impressions and had 22.1 million visits to our websites and continue to invest in top media platforms such as TikTok, Snapchat, Instagram and YouTube across markets. For more details on our programs and key Q1 performance metrics, please see our presentation slides on our website. We're also developing digital tools and apps for consumers, patients and for doctors. The Q1 adoption of the My Invisalign consumer and patient app continue to increase with 3.1 million plus downloads to date and over 350,000 monthly active users, representing 28% year-over-year growth. Usage of our other digital tools includes ClinCheck, Live Update, which is used by 38,000 doctors to reduce time, spent modifying treatment plans of up to 13% and Invisalign practice app with 58,000 doctors actively using this feature and uploading more than 5.1 million photos to date. Finally, in addition to our focus on consumer marketing and digital tools, we're committed to driving excellent treatment and align innovation through industry and align hosted clinical education events. Our team has just participated in the annual AAO conference, which took place in Chicago, where we engaged with a broad range of orthodontists. In March, we participated in IDS in Cologne, Germany, one of the largest dental shows in the world focused on digital dentistry and the technologies shaping the industry. Earlier in the quarter, we hosted the second align's symposium on the digital practice, a smaller align event from the most engaged in experience Invisalign orthodontists in the world. It was an amazing opportunity to come together with long-term global partners and thought leaders in orthodontics to see how we are driving the digital transformation of dentistry together. By our participation in each of these events and opportunities, we continue to reinforce the importance of peer-to-peer clinical education and our investments in the orthodontic specialty. We are grateful for all of our customers, GP, orthodontists, corporate practices but we know that the orthodontic specialty leads the way in adoption of digital orthodontics. We are excited about the future we see them in the orthodontic profession. Align abruptly supports the orthodontic profession through education, grants and continued innovation. Our educational pathway was created to support recent graduates, and we career doctors at critical career transition points. As a result of schooling and early career initiatives, graduates will be educated on digital dentistry and digital orthodontics, connected with and supported by colleagues more experienced ortho experts in the Align team and engaged with Align Digital Platform. Align supports doctors throughout all stages of their career, from educating facilities at dental schools and orthodontic programs to education for residents. Early to mid-career providers and more seasoned professionals looking to expand their clinical capabilities and practices. Align is expanding its global footprint of education centers to provide a forum for hands-on learning and continued development in key cities across our regions. We are also focused on continuing to innovate in digital dentistry, scaling capacity to manage the millions of digital requests, patient scans and orders flowing through our systems, while also using technologies like AI and machine learning to increase efficiencies, speed treatment planning and quickly deliver products so patients can begin to pass to transforming their smiles. In the next one to two or three years, Align believes our newest technologies and innovations will revolutionize our existing offerings in the ways in which doctors and their patients experience orthodontic treatment. Together with our customers, we are developing the future of digital dentistry and digital orthodontics not just the technology that drive treatment, but the models reshaping how we interact with customers and deliver treatment experiences for their patients. We look forward to sharing more with you in the coming months. With that, I'll now turn it over to John."
},
{
"speaker": "John Morici",
"text": "Thanks, Joe. Now for our Q1 financial results. Total revenues for the first quarter were $943.1 million, up 4.6% from the prior quarter and down 3.1% from the corresponding quarter a year ago. On a constant currency basis, Q1 '23 revenues were impacted by favorable foreign exchange of approximately $25.8 million or approximately 2.8% sequentially and unfavorably impacted by approximately $34.9 million year-over-year or approximately 3.6%. For Clear Aligners, Q1 revenues of $789.8 million were up 7.9% sequentially primarily from higher ASPs and higher non-case revenues, partially offset by lower volumes. On a year-over-year basis, Q1 Clear Aligner revenues were down 2.5%, primarily due to lower volumes, lower ASPs, including unfavorable foreign exchange, partially offset by higher non-case revenues. For Q1, Invisalign ASPs for comprehensive treatment were up sequentially and decreased slightly year-over-year. On a sequential basis, ASPs reflect price increases, favorable foreign exchange and higher additional liners, partially offset by product mix and larger discounts. On a year-over-year basis, the ASPs for our comprehensive treatment were almost flat, primarily due to product mix shift, unfavorable foreign exchange and higher discounts, mostly offset by price increases and higher additional aligners. For Q1, Invisalign ASPs for non-comprehensive treatment were up sequentially and year-over-year. On a sequential basis, the increase in ASPs reflect price increases, favorable foreign exchange and higher additional aligners, partially offset by higher discounts. On a year-over-year basis, the increase in ASPs reflects price increases and higher additional aligners, partially offset by product mix shift, unfavorable foreign exchange and higher discounts. During the quarter, we launched Invisalign Comprehensive three and three product in most markets. The three and three configuration offers our doctor customers our Invisalign comprehensive treatment with three additional aligners included within three years of treatment end date. Instead of unlimited additional aligners within five years of the treatment end date. At the 2022 Invisalign comprehensive product price, over time, we have come to learn that on average, Invisalign doctors complete a comprehensive Invisalign treatment with less than two additional aligners. We are pleased with the initial adoption of the Invisalign comprehensive -- and anticipate that its impact will be more meaningful, providing doctors the flexibility they desire and allowing us to recognize more revenue upfront with deferred revenue being recognized over a shorter period of time compared to our traditional Invisalign comprehensive product. As revenues from subscription retainers and other ancillary products continue to grow globally, some of the historical metrics that only focus on case shipments are expected to account for a lesser percentage of our overall growth. In our earnings release and financial slides, you will see that we have added our total Clear Aligner revenue per case shipment, which we believe to be more indicative measure of our overall growth strategy. Clear Aligner deferred revenues on the balance sheet increased $32 million or up 2.6% sequentially and $150.9 million or up 13.6% year-over-year and will be recognized as the additional aligners per shipping. Q1 23 systems and services revenue of $153.3 million were down 9.7% sequentially primarily due to the seasonally lower scanner volume, partially offset by higher services revenues from our larger base of scanners sold, higher revenues from our CPO and leasing rental programs and favorable ASPs, down 6.2% year-over-year primarily for the reasons just stated. Q1 '23 systems and services revenue was impacted from favorable foreign exchange of approximately $4 million or approximately 2.7% sequentially. On a year-over-year basis, System and Services revenues were unfavorably impacted by foreign exchange of approximately $5.8 million or approximately 3.6%. Systems and Services deferred revenues on the balance sheet was down $2.2 million or 0.8% sequentially, primarily due to the decrease in scanners sales and deferral of service revenues included with the scanner purchase and up $24.2 million or 9.8% year-over-year, primarily due to the increase in scanner sales and the deferral of service revenues included with the scanner purchase, which will be recognized ratably over the service period. As our scanner portfolio expands and we introduce new products, we increased the opportunities for customers to upgrade, make trade-ins and provide refurbished scanners for certain markets. As such, our model is changing. We expect to continue to roll out programs such as our certified pre-owned leasing and rental offerings -- by possibly leveraging our balance sheet and selling the way our customers desire. Developing new capital equipment opportunities to meet the digital transformation needs of our customers and DSO partners is a natural progression for our equipment business with a large and growing scanner sold. Moving on to gross margin, first quarter overall gross margin of 70%, up 1.5 points sequentially and down 2.9 points year-over-year. Overall gross margin was favorably impacted by foreign exchange by approximately 0.8 points sequentially and unfavorably impacted by approximately 1.1 points on a year-over-year basis. Clear Aligner gross margin for the first quarter was 71.7%, up 0.9 points sequentially due to higher ASPs, partially offset by higher manufacturing absorption. Clear Aligner gross margin for the first quarter was down 3.1 points year-over-year, primarily to lower ASPs, increased manufacturing spend as we continue to ramp up operations at our new manufacturing facility in Poland and a higher mix of additional aligner volume. Systems and Services gross margin for the first quarter was 61.6%, up 2.8 points sequentially primarily from increased manufacturing efficiencies. Systems and Services gross margin for the first quarter was down 1.8 points year-over-year due to lower volumes, partially offset by higher services revenues and ASPs. Q1 operating expenses were $527.1 million, up sequentially 4.4% and up 3.1% year-over-year. On a sequential basis, operating expenses were up $22.1 million, primarily from higher incentive compensation and consumer marketing spend partially offset by restructuring and other charges not recurring in Q1. Year-over-year, operating expenses increased by $15.9 million, primarily due to higher incentive compensation and our continued investments in sales and R&D activities, partially offset by controlled spending on advertising and marketing as part of our efforts to proactively manage costs. On a non-GAAP basis, excluding stock-based compensation and amortization of acquired intangibles related to certain acquisitions, partially offset by restructuring and other charges, operating expenses were $490.5 million, up 6.7% sequentially and up 2.1% year-over-year. Our first quarter operating income of $133.5 million resulted in an operating margin of 14.2%, up 1.7 points sequentially and down 6.2 points year-over-year. Operating margin was favorably impacted by approximately 1.5 points sequentially, primarily due to foreign exchange and higher gross margins. The year-over-year decrease in operating margin is primarily attributed to lower gross margin. Investments in go-to-market teams and technology as well as unfavorable impact from foreign exchange by approximately two points. On a non-GAAP basis, which excludes stock-based compensation, amortization of intangibles related to certain acquisitions, offset by restructuring and other charges. Operating margin for the first quarter was 18.5%, up 0.2 points sequentially and down 5.5 points year-over-year. Interest and other income and expense net for the first quarter was an income of $1.1 million compared to an income of $2.7 million in the fourth quarter and a loss of $10.6 million in the first quarter a year ago, primarily due to net foreign exchange gains from the strengthening of certain foreign currencies against the U.S. dollar. The GAAP effective tax rate in the first quarter was 34.8% compared to 63.8% in the fourth quarter and 28.4% in the first quarter of the prior year. The first quarter GAAP effective tax rate was lower than the fourth quarter effective tax rate, primarily due to increased earnings in low tax jurisdictions in Q1 2023 and an audit settlement in Q4 2022. As a reminder, in Q4 2022, we changed our methodology for the computation of our non-GAAP effective tax rate to a long-term projected tax rate and have given effect to the new methodology from January 1, 2022, and recast previously reported quarterly periods in 2022. Our non-GAAP effective tax rate for the first quarter was 20%, reflecting the change in our methodology. First quarter net income per diluted share was $1.14, up sequentially $0.60 and down $0.56 compared to the prior year. Our EPS was favorably impacted by $0.14 on a sequential basis and unfavorably impacted by $0.21 on a year-over-year basis due to foreign exchange. On a non-GAAP basis, net income per diluted share was $1.82 for the first quarter, up $0.09 sequentially and down $0.43 year-over-year. Note, the prior year 2022 non-GAAP net income for diluted share in our prior year 2022 non-GAAP EPS reflects the Q4 2022 change in our methodology for the computation of the non-GAAP effective tax rate. Moving on to the balance sheet. As of March 31, 2023, cash, cash equivalents and short-term and long-term marketable securities was $921.4 million, down sequentially $120.2 million and down $199.2 million year-over-year. Of the $921.4 million balance, $310.5 million was held in the U.S. and $610.9 million was held by our international entities. During Q1 2023, we purchased approximately 942,000 shares of our common stock at an average price of $307.74 per share for a total purchase price of $290 million, completing a $200 million accelerated share repurchase from Q4 2022, a $250 million ASR from Q1 2023 and in our May 2021, $1 billion stock repurchase program. During Q1 2023, we announced that our Board of Directors authorized a new $1 billion stock repurchase program to succeed the 2021 $1 billion program. Currently, $1 billion remains available for repurchase under the 2023 $1 billion stock repurchase program. Q1 accounts receivable balance was $884 million, up sequentially. Our overall days sales outstanding was $83, down approximately two days sequentially and down approximately four days as compared to Q1 last year. Cash flow from operations for the first quarter was $199.9 million. Capital expenditures for the first quarter were $64.1 million, primarily related to our continued investments to increase aligner manufacturing capacity and facilities. Free cash flow, defined as cash flow from operations less capital expenditures, amounted to $135.8 million. Now turning to our outlook, as Joe mentioned earlier, we are pleased with our Q1 results and what continues to be a more stable environment across all regions. We remain cautiously optimistic for continued stability, as we move through the year. However, the macroeconomic environment remains uncertain. And given continued domestic and global challenges and unpredictability, we are not providing full year revenue guidance. We would like to see consistent improvements in the operating environment and consumer demand signals before revisiting our approach. We remain focused on making investments to drive growth and penetration into a huge untapped market opportunity, including our strategic investments in sales, marketing, technology and innovation. We are confident in our ability to address the massive opportunity for digital orthodontics and restorative dentistry, with our execution centered on our strategic initiatives. With this as a backdrop for Q2 2023, we anticipate Clear Aligner volume and ASPs to be up sequentially. We also anticipate Systems and Services revenue to be up sequentially. For Q2 2023, we anticipate revenues to be in the range of $980 million to $1 billion. We expect our Q2 2023 non-GAAP gross margins to be flat to slightly up from Q1 '23, and our Q2 2023 non-GAAP operating margin to be up by approximately one point sequentially as we continue to strategically prioritize our investments in go-to-market activities and R&D to drive growth. For full year 2023, assuming no circumstances beyond our control, we reiterate our 2023 non-GAAP operating margin to be slightly above 20%. For 2023, we expect our investments in capital expenditures to exceed $200 million. Capital expenditures primarily relate to building construction and improvements as well as additional manufacturing capacity to support our international expansion. Finally, as it relates to the $75 million equity investment in Heartland Dental that Joe discussed, our investment is less than 5% of the Company and the line has no oversight or involvement in management of Heartland Dental or its affiliates. With that, I'll turn it back over to Joe for final comments. Joe?"
},
{
"speaker": "Joe Hogan",
"text": "Thanks, John. In closing, we're pleased with our first quarter results that reflected an environment of continued stability for our doctor customers. However, degrees of uncertainty remain from market to market. We're confident in our durable competitive advantage as we continue to transform the orthodontic industry, bringing digital dentistry and clear line of treatment to more doctors and the patients they serve, driven by our strategic initiatives of international expansion, orthodontist utilization, general dentist treatment and patient demand and conversion. We will continue to focus on the next phase of new platform innovations in scanning, software and direct 3D printing while prioritizing the needs of our customers for the ultimate benefit of their patients. We are a purpose-driven organization with a tireless commitment to transform more smiles and change more lives. We're the only digital orthodontic company in the world today with the scale and reach to address the 500 million potential people that could benefit from teeth straightening within the line system. Thank you for your time today. We look forward to updating you on our next earnings call. Now, I'll turn the call over to the operator for questions."
},
{
"speaker": "Operator",
"text": "Thank you. At this time, we'll be conducting a question-and-answer session. [Operator Instructions] Our first question today comes from Jason Bednar from Piper Sandler."
},
{
"speaker": "Jason Bednar",
"text": "I wanted to start first maybe with the 2Q outlook. You're pointing to a sequential uplift in cases in the quarter. I think that's consistent with what we typically see in a normal year from first quarter to second quarter. I think it's normally a 5% to 10% uplift. So maybe a good sign if we're continuing to move back towards normal, I'm not sure if you're willing to touch a typical pattern there, Joe or John, just to comment on the second quarter. But regardless, can you elaborate maybe on the rhythm of activity you're seeing in the U.S. or international markets that contributing to the visibility today and calling for those improved case volumes in the second quarter?"
},
{
"speaker": "Joe Hogan",
"text": "Jason, it's Joe. First of all, I'd just describe what we have is stability right now. I mean you talk about the quarter-over-quarter seasonality of the business. We haven't really seen that for a long period of time. Obviously, that's embedded in our forecast right now. But I'd characterize again, what we're seeing right now is stability, which I feel is good in the sense that we've had such instability over the number of years. And from quarter-to-quarter, we're seeing some consistency in that sense. And I think -- in this economic environment right now with the uncertainty in different aspects going on out there, I think the stability piece and that's what we're leaning on as we move into Q2, is the right theme and the right kind of focus."
},
{
"speaker": "Jason Bednar",
"text": "Okay. All right. Understood. Maybe to follow up and press a little bit more on maybe on the utilization side. Could you talk about maybe the puts and takes around some of the utilization metrics you're putting up here in the quarter and as we think forward in the future. It seems like that ortho channel is seeing some good uplift. The first sequential improvement we've seen in over a year. international utilization did tick lower, but I'm wondering if there's a dynamic plan out there where some of your China doctors are coming back online and starting to do cases, but not yet fully back up to normal. So maybe just curious if you could unpack what you're seeing with utilization in those two channels, the North American ortho channel, your international customer base."
},
{
"speaker": "Joe Hogan",
"text": "Utilization statistic is, Jason, obviously, important to us. Remember, it often gets somewhat muddled in the sense of DSO aggregation and different things in different areas that we've had a report in an investment community at times. Your point on China is a good one. China was somewhat dark for us during the COVID piece, and we do see that coming back. The orthodontic piece is a good signal to. So overall, I feel good about those -- the utilization numbers. I felt obviously good about the gauge data. I hate to see the wires and brackets moving up, but you could see we outperformed on the Clear Aligner segment on that piece, too. So, we're seeing good doctor engagement and that's on both the GP side and the ortho side. I think the overall piece here is you have to look at a continued challenge from an adult standpoint, when you look at our numbers across the globe. And I think that's more reflective of the consumer index and confidence things that we've talked about in the past. And the teens in that certain window of treatment are more certain for this in treatment than some of the adults in those cases. And that addresses your question, Jason."
},
{
"speaker": "Operator",
"text": "Our next question comes from Elizabeth Anderson from Evercore ISI. Your line is open."
},
{
"speaker": "Elizabeth Anderson",
"text": "So, my first question would be, I know you said China is coming back. Are you seeing that continue to sort of improve as we think about the second quarter? I mean, obviously, you're lapping some of these shutdowns last year, but I'd be curious about how that was improving. And then just to, I think you called out some broader utilization and improvements to help drive the margins higher in the second quarter and the guidance that you just gave, but could you go into a little bit more detail about what specifically is helping to push those up?"
},
{
"speaker": "John Morici",
"text": "I think, Elizabeth, I'll take the kind of the margin piece. This is John. We'll see improvements as we produce more product, sell more product. We talked about that being sequentially up from a volume standpoint and utilize our facilities, whether it's clear liner or on the Systems and Services side. So that's definitely a help. And in particular, with some of the improvements that we're seeing with higher utilization in Poland, as that plant continues to ramp up, will -- we see improvements in gross margin that way."
},
{
"speaker": "Joe Hogan",
"text": "Elizabeth on China, I could -- it was kind of a difficult quarter in a sense of how it started. But we saw good unfolding as the quarter went forward. I'd say when I hear people say China returning, China is coming out of a COVID crisis. I think we see, obviously, across different industries. China improving in that sense, but I'd say no way is China back in the sense of we envision China four years ago or so before we went into this mess. Right now, I'd say what we've seen in China the last few months is just stability, I'd say, some stability and a more clear signal out of China than we've seen in the past, but nothing that we're ready to forecast through individual growth standpoint."
},
{
"speaker": "Operator",
"text": "Our next question comes from Jon Block from Stifel. Your line is open."
},
{
"speaker": "Jon Block",
"text": "Maybe somewhat of a similar line of the question, but I just want to stick to maybe the March quarter. So let's say, most of the 1Q '20 revenue be is specific to ASP related, if you would. So I'm curious how Invisalign cases trended throughout the March quarter. And if there's anything to call out within the different regions and how that played out, call it, from a Jan to March -- because when you do start some of the implied math based on, John, your commentary where 1Q ASP was going to land, it seems like case falls were maybe on your number prior, not ahead. So again, just any color around case falls throughout the quarter and by region would be helpful."
},
{
"speaker": "John Morici",
"text": "John, this is John. So I would say in specific, as we said in China, we saw improvement in China. I mean it went from January with a lot of the COVID cases and February was better than January and March was better than February. We saw that. And then as Joe described, we've seen stability in a lot of the other markets where there's puts and takes, but overall, more stability throughout the quarter. And that's what kind of got us to our overall volume numbers."
},
{
"speaker": "Jon Block",
"text": "Okay. So then I'll ask my follow-up and I'll ask my second question. I think on the initial guide, China was supposed to be down Q-over-Q, was China still down Q-over-Q, 4Q to 1Q based on your commentary? Or was that up and you gave it back a little bit somewhere else. That would just be the follow-up to the first question. The second question is just burning one on 2Q a little bit. When you say ASP up 2Q versus 1Q, is there a dart throw of maybe low single digits or 1% to 2%. I'm guessing you get the stub on the price increase. You get the full quarter in 2Q that you didn't get in 1Q. And maybe FX, as we sit here today is more favorable for the June quarter versus March."
},
{
"speaker": "John Morici",
"text": "Yes. Thanks, Jon. Yes, on China, we didn't specifically guide for China in Q1, and it played out as we described there, but that's what we saw in China, which adds to what Joe was talking about just that stability that we saw there that we haven't seen in three years or so. On ASPs, you're right. We expect it to be slightly up over Q1. It's getting that full quarter of price change and so on the price increase we have and kind of taking the FX where it's at right now so slightly up compared to what we saw in Q1."
},
{
"speaker": "Operator",
"text": "Our next question comes from Jeff Johnson from Baird. Your line is open."
},
{
"speaker": "Jeff Johnson",
"text": "Following up on John's question, I think he was trying to get up the same thing. But look, I mean, revenue in 1Q came in clearly ahead of what you guys were talking about. 2Q is at least being guided above the street, which I say encouraging. You're talking about stability throughout the quarter. So I guess I'm trying to understand why isn't that translating to slightly better margins? I think your margin number in the 1Q was spot on with us. It was above the street right on what we were thinking, but your full year guidance is staying the same. And it sounds like you feel a little better about the end markets. You're definitely translating that to better revenue. I would just think even with fixed cost leverage, maybe we would have seen a little bit better margin in the 1Q and a little bit more optimistic outlook for the year."
},
{
"speaker": "John Morici",
"text": "I think, John, when you look at -- or sorry, Jeff, when you think of the total year, there's still uncertainty in the second half. So we tried to give a good view of where we think Q2 will be based on that guidance, but they're still uncertainty in the second half. And that's why we've stayed away from that revenue guide for the total year and kept our op margin that we talked about, the non-GAAP at or slightly above kind of out there just for that uncertainty still in the second half."
},
{
"speaker": "Jeff Johnson",
"text": "Okay. And then maybe a follow-up. I just want to make sure on DSP. I think I know the answer to this. I don't want to expose my -- pay if it is that. But I know there's commercial product in there. I know obviously, there's -- there do any cases get captured within DSP? Obviously, as DSP is growing nicely, the 575,000 cases you did this quarter, the 598,000 cases you did last year in the first quarter. If we subtracted out DSP or if that didn't exist, would those case volumes be different at all, is the down 3%, 4% year-over-year being impacted at all by more things moving to DSP? Just want to understand the impact that has as we look at these reported global case volumes."
},
{
"speaker": "John Morici",
"text": "No, you're right, Jeff. I mean, so as DSP grows, there are some non-comprehensive typically cases that get caught in there. Those would be minor adjustments, minor movement cases that those doctors would want instead of going into a non-comprehensive case, in ordering that, they're using DSP. And so therefore, DSP kind of includes it. It's great revenue for us. It's additional revenue. That's why when you think of that other revenue piece of it. It's growing faster as DSP grows, and it's really fulfilling the way the doctors want to be sold to. But some of that case volume gets trapped within DSP."
},
{
"speaker": "Shirley Stacy",
"text": "But Jeff, just to make sure we're talking kind of apples-to-apples, you asked if you stripped out those cases from our reported case volumes, they're not counted in the case volume is the point, and that was the comments that John made on the script about the implied impact of DSP revenue growth because those aren't counted in case shipments."
},
{
"speaker": "Jeff Johnson",
"text": "Right. And as they're growing, then I'm assuming the 4% year-over-year case volume contraction you reported this year in the first quarter looks a little worse than it actually would have been if DSP wasn't out there. And that's what I'm trying to get at. Is there any way to quantify that? Would cases, if not for DSP, been closer to flat year-over-year? Or is there just any way to kind of guide us round about what that impact of DSP growing nicely year-over-year, but then that's capturing -- DSP is capturing more cases this quarter -- this year in the first would have then did last year in the first quarter."
},
{
"speaker": "John Morici",
"text": "Yes. We haven't broken that out, Jeff, within DSP. But you're right. The year-over-year case volume change would not have been down by as much. It would have been more -- it would have been adjusted because DSP is growing, and there's more cases that kind of get trapped within there. But as Shirley said, we don't report those DSP cases. They're not there. They just show up in our other revenue."
},
{
"speaker": "Operator",
"text": "Our next question comes from Brandon Vazquez from William Blair. Your line is open."
},
{
"speaker": "Brandon Vazquez",
"text": "I think first, I just wanted to focus kind of on the adult side. The cases were down quarter-over-quarter. Those are the cases a little more exposed to the macro side. But you are also guiding to sequential improvements in volumes going forward. So just kind of curious if you can talk about that dynamic. Is team quarter-over-quarter growth enough to kind of offset that? Are you expecting adults to also improve -- just kind of any dynamics around that would be helpful?"
},
{
"speaker": "Joe Hogan",
"text": "It's Joe. Look, I think when you look at adults, I look at that as really tied to the consumer confidence indices, particularly in the western world that we can track. And look, I'm not -- we're not smart enough to project where that's going. It looks like that's stable right now, too, when you look at the way those lines are trending in the United States and different parts of the Western world. On the teen side, our second quarter is a big teen season. In the western world, third quarter is big teens for China. And so that's why we talked about it in my script is that we came out of the first quarter with really positive signs on teens. As we go into the quarter, we have some momentum in that sense. And so we stay focused on adults and we'll execute well around adults. But in teen season two, we keep a very sharp focus there because we think that demand equation is much more consistent."
},
{
"speaker": "Brandon Vazquez",
"text": "Okay. And then maybe I'll take us a step away from kind of the near-term stuff and just talk a higher-level strategy on the DSOs. It looks like you guys are having good progress there. Can you talk about -- are there any kind of like fundamental differences of going to that market? Any commercial strategy differences? Are there potential margin benefits because you're kind of dealing with one large organization that sells to bigger accounts, anything you can call out there for us?"
},
{
"speaker": "Joe Hogan",
"text": "Yes, it's a good question. The DSOs, you're right, there's something we call OpEx, some cost aspects you don't have to have as high as the number of salespeople calling on that account, you organize resources differently to make sure you support a team like Heartland, the way they need to be supported. What's really great is a very synergistic effect, too, in the sense of how they execute on their clinicals throughout their organization from an efficiency standpoint, how to teach our doctors to use our product to enhance what their capability is in the digital dentistry side. And so -- and then obviously, we help to teach through their teachers in the sense of how we train the doctors and all. So what we really like about with Heartland, and we have a good relationship with other DSOs with Heartland is a really good focus from a digital standpoint and good execution around how they want to move that to the marketplace to their doctors. It's very professional, and that's why we've seen growth in that channel and -- we see that with Smile docs also on the orthodontic side, there are strong orthodontic DSO. And we're really, really happy to partner with them because we have the same vision and the same focus on expanding the marketplace for digital orthotics."
},
{
"speaker": "Operator",
"text": "Our next question comes from Nathan Rich from Goldman Sachs. Your line is open."
},
{
"speaker": "Nathan Rich",
"text": "Maybe going back to China, if I could. Joe, is there any way to characterize kind of where case shipments were March relative to maybe where the business was prior to the lockdowns? And can you maybe just talk generally how you feel about the consumer there and they're kind of coming out of these lockdowns willingness to spend on dental treatment."
},
{
"speaker": "Joe Hogan",
"text": "Well, I think we're coming out of a complete blackness, okay, when you get it. So Nave's really hard to pull a signal out of all that noise, except for we had a reasonable quarter, and you can see we're predicting that in the second quarter for China. That's kind of as far as I want to go. When you think about China itself, from a consumer standpoint, you have to look at the private institution. You have to look at the public hospitals. And again, that data isn't clear enough for us in the sense of what the sustainability is on that piece. So we're just being cautious. I don't think China is going to revert back into a COVID kind of a shutdown. I think we all know that. But that economy is somewhat questionable right now in the sense of how fast it will rebound and what direction it rebounds in We're just being cautious in the sense of how we're going to forecast"
},
{
"speaker": "Nathan Rich",
"text": "Okay. Sounds good. And then, John, maybe a follow-up for you. Could you maybe just help us get a sense of where the 3x3 case penetration was in 1Q and it sounds like you're expecting a pretty meaningful step up in 2Q. I don't know if you can kind of put any numbers around that in terms of what that will do in terms of the revenue recognition that you'll get kind of incrementally relative to the first quarter as that penetration increases?"
},
{
"speaker": "John Morici",
"text": "Well, I think first off, the three and three, it's a great product that our customers want and they're utilizing and so we're happy to see in the markets that we've released good adoption started in January for us, and we saw it progressively increase as we went through -- in through the quarter. So every month got better. And it really gives doctors more options in terms of how they want to purchase our product. As I said in my remarks, many of our doctors -- most of our doctors don't do more than two refinements. So this is a product that's perfect for them, allows them to treat patients the way they can. And then from a revenue recognition standpoint, it -- because we don't have -- we have pretty much a defined number of aligners only up to three refinement. And it's over a three-year period. So we're able to recognize revenue over a shorter period of time and the adoption of this as well as other factors are in the overall Q2 guide."
},
{
"speaker": "Operator",
"text": "Our next question comes from Michael Ryskin from Bank of America. Your line is open."
},
{
"speaker": "Michael Ryskin",
"text": "I want to follow up on an earlier question regarding what you saw in adult versus teens, recognize your point on adults being a little bit more consumer exposed and maybe some of that is a little bit more macro driven. But just wondering, anything you can comment to in terms of how that progressed through the quarter? Or any difference you're seeing U.S. versus Europe versus EMEA, just given anything on progression there? I think with that? Just to sort of that back to your comments on stability, it would be really helpful to bridge that."
},
{
"speaker": "Joe Hogan",
"text": "Michael, it's Joe. I mean if anything has been consistent, we have seen the pressure on adults during this whole downturn. Now we can see pressure on teens, too, but not to the same extent. These things vary by country in Europe. There's no Europe, you have to look at by country or whatever in the United States. But in general, we see very similar trends from an adult and team standpoint, with more teen demand, not saying positive team demand, but stronger teen demand than we've seen with adults. So what we feel good about is that we're seeing decent stability in those numbers. And adult creep up a little bit. We saw our DSOs in the United States execute really well around adults, which shows you that if you have the right kind of focus, you can still have a good patient yield on the adult side, if you're working that piece. But in general, I think until we see significant economic improvement, I don't know if that adult -- teen kind of ratio in the sense that we're seeing is going to change dramatically. I think we have to see a good upturn in consumer confidence before we see that reflected in the adult volume. Doesn't mean that confidence doesn't affect teens, but it doesn't affect it to the same degree."
},
{
"speaker": "Michael Ryskin",
"text": "Okay. All right. That's helpful. And then on the ASP front, again, I know you guys just talked about the price hike for a while and you discussed some of the factors that led to the ASPs in 1Q and sort of out for 2Q. I'm just wondering, we've always sort of debated price elasticity or demand elasticity as it relates to price. I know there's a lot of going on that earlier this year. Just wondering if now that you've got a full quarter under your belt any additional learnings on price sensitivity in the market, ability to take more price through another price hikes. So what are your thoughts on that a couple of months in."
},
{
"speaker": "Joe Hogan",
"text": "I think price elasticity is a good question in this marketplace. Michael, I think we've always known it's been there. I mean we see -- our competitors don't necessarily compete at all on technology, they compete on price. And then we know that it's had a certain amount of success in a certain part of the marketplace, and that will always be there. But when you look at our price increase here, and I think you're associating our price increase with price elasticity and our volume is our 3x3, which we didn't increase. And obviously, there's a limitation on additional aligners. It was really well received by the marketplace and very from a GP standpoint and ortho standpoint too. And our increase on our comprehensive was seen as fair and also the other parts, I would say -- but everybody loves a price increase, and we see our NPS score. But if I've been here long enough to have enough data points to tell you that, I think this price increase -- our pricing approach was received better by the marketplace than any other one that I've instituted since I've been here. And so, I feel good about it because I think it matched our customer expectations with what we need from a business standpoint. And so I don't think that that elasticity was negative at all in the sense with the price increases here. And most of our competitors, they are truly competitors followed in that sense with price increases, too."
},
{
"speaker": "Operator",
"text": "Our next question comes from Erin Wright from Morgan Stanley. Your line is open."
},
{
"speaker": "Erin Wright",
"text": "I'll ask my question both upfront here, but first on Heartland and the investment there. And how does the relationship change now with the investment? And would this constrain any future relationships with DSO partners. Did you contemplate any sort of conflict of interest that could arise there? And then second question would be on the scanner business and how we should be thinking about the quarterly progression of the segment and stability across the business? And how we're just thinking about just equipment demand trends in general overall with iTero?"
},
{
"speaker": "Joe Hogan",
"text": "Erin, it's Joe. I'll take them. On the DSO side, I don't see a conflict of all. We have DSOs that really want to address digital dentistry through digital orthodontics and we're excited about our -- obviously, our digital footprint and what we can offer from a platform standpoint. And so Heartland is helping the lead on the GP side in that sense, and I mentioned the Smile docs on the ortho side is there, too. So again, I don't expect this to be an issue within any of our accounts because we will engage with them and to help them on a demand equation if they want to be as aggressive and inconsistent and this implementation is what Heartland has been and which our docs have been, too. So -- and I don't see a conflict of interest at all. When I hear that term, my hair goes up in the year. I don't see anything that's conflicting at all. I think this is completely in line with what we believe in. We want to drive digital orthodontics as fast as we possibly can. And those DSOs and frankly, not just DSOs, just we have several doctors that have multiple practices that we engage with to try to expand those practices with them because we know they've committed to digital orthodontics and can drive those things forward. So I'd look at this as a positive statement that we're ready to engage and invest with our partners that share our vision. And then secondly, on the scanner business, I think you look at what happened between fourth quarter and first quarter. I think you have to take that in context. Fourth quarter is always a big capital equipment cycle. And first quarter is lower. This wasn't much different when you look at the numbers. When you look at our overall services business through that business because we have such a broad installed base that held up very well. So as I look at the scanner marketplace and where we stand today, I believe we have the largest installed base out there. We monetize that well from a services standpoint, we work with those accounts. When you look at our NPS scores of customers that use iTero, significantly higher customer satisfaction than ones that don't and try to use PVS impressions or something else, too. So when I look at our technology versus technology from competitors, I feel we lead, and we'll continue to lead in the marketplace. So our iTero scanner is critical for us going forward. It's a key part of our digital platform. Don't look at the fourth quarter and first quarter as any kind of a signal to say that we're losing momentum in that business. We always see that difference between fourth quarter and first quarter. John, you add anything? You..."
},
{
"speaker": "John Morici",
"text": "That's good. I mean, it's very consistent."
},
{
"speaker": "Operator",
"text": "Our final question today comes from Kevin Caliendo from UBS. Your line is open."
},
{
"speaker": "Kevin Caliendo",
"text": "I just want to go back to Heartland. Can you tell me how much volume you did with Heartland in '22? Is this going to potentially impact that going forward? Like is there any guarantees or any buy-ins or do you maybe more contribute to their growth as they continue to grow? And I guess the follow-up to there is, how are you accounting for this? It says less than 5% ownership. I'm assuming that means whatever runs through the P&L would be a noncontrolling interest, right? And -- or is it somehow above the line? And is this impacting margins in any way, shape or form?"
},
{
"speaker": "Joe Hogan",
"text": "Kevin, I'll take the first one. John is our expert in accounting here. I'll let them take the next one. So on Heartland, look, we don't give individual numbers like this, but you can guess Heartland is the biggest DSO in the world, and they're very effective DSO in that sense. And this is a meaningful investment, and we're seeing meaningful growth with those guys. And I think we're trying to model something, I think, of us a model. It's a good relationship and has a good trajectory from a growth standpoint. John accounting?"
},
{
"speaker": "John Morici",
"text": "Yes. In terms of the investment, less than 5%, it doesn't show up in our op margin or anything of that nature. And it's an investment that we made, and it stays on our books that way. But there's nothing that would show up in our op margin or anything else related to that investment."
},
{
"speaker": "Joe Hogan",
"text": "Kevin, also just -- as John talking and thinking of my comment to you is your comment might have inferred something like a quid pro quo or something like that. There's nothing like that. There's no piece of that. We have a joint vision in the sense of how we can move digital orthodontics through the general dentistry, and we share that, and we're helping to invest in that so we can drive it forward. But there's no give and take in that sense. Appreciate your questions."
},
{
"speaker": "Kevin Caliendo",
"text": "Hopefully, it's a good financial investment. You make money as well as advanced digital dentistry. If I can ask..."
},
{
"speaker": "Joe Hogan",
"text": "Follow up. Yes."
},
{
"speaker": "Kevin Caliendo",
"text": "U.S. case growth, do you expect U.S. cases to grow year-over-year beginning in 2Q? Is that part of the assumption or how we should think about that? Can you get down to that kind of granularity, U.S. or Americas?"
},
{
"speaker": "John Morici",
"text": "Yes. We're not at the -- we're just not giving that case growth numbers, we just kind of wanted to talk sequentially, but you would expect, as we've kind of said from Q1 to Q2, we would expect overall volumes to increase sequentially as you get into teens and others, it's going to vary by region. But if you're talking specifically the U.S., you start to get into more of a teen season basis, and that's the expectation for our overall numbers."
},
{
"speaker": "Shirley Stacy",
"text": "Yes. Thanks, everyone. We appreciate your time today, and thank you for joining us. We look forward to speaking to you at upcoming financial conferences and meetings. If you have any follow-up questions, please contact Investor Relations. Have a great day."
},
{
"speaker": "Operator",
"text": "Thank you. This concludes today's conference, and you may now disconnect your lines at this time. Thank you for your participation."
}
] | Align Technology, Inc. | 24,568 |
ALGN | 4 | 2,024 | 2025-02-05 16:30:00 | Operator: Greetings. Welcome to the Align Fourth Quarter and Full Year 2024 Earnings Call. At this time, all participants are in a listen-only mode. A question-and-answer session will follow the formal presentation. Please note, this conference is being recorded. I will now turn the conference over to your host, Shirley Stacy with Align Technology. You may begin.
Shirley Stacy: Good afternoon, and thank you for joining us. I'm Shirley Stacy, Vice President of Corporate Communications and Investor Relations. Joining me for today's call is Joe Hogan, President and CEO, and John Morici, CFO. We issued fourth quarter and full year 2024 financial results today via Business Wire, which is available on our website at investor.aligntech.com. Today's conference call is being audio webcast and will be archived on our website for approximately one month. As a reminder, the information provided and discussed today will include forward-looking statements, including statements about Align's future events and product outlook. These forward-looking statements are only predictions and involve risks and uncertainties that are described in more detail in our most recent periodic reports filed with the Securities and Exchange Commission available on our website and at sec.gov. Actual results may vary significantly, and Align expressly assumes no obligation to update any forward-looking statement. We've posted historical financial statements with corresponding reconciliations, including our GAAP to non-GAAP reconciliation, if applicable, and our fourth quarter and full year 2024 conference call slides on our website under Quarterly Results. Please refer to these files for more detailed information. With that, I'll turn the call over to Align Technology's President and CEO, Joe Hogan. Joe?
Joe Hogan: Thanks, Shirley. Good afternoon, and thanks for joining us today. On our call today, I'll provide an overview of our fourth quarter and full year results and discuss a few highlights from our two operating segments, System Services and Clear Aligners. John will provide more detail on our financial performance and comment on views for 2025. Following that, I'll come back and summarize a few key points and open the call to questions. I'm pleased to report that Q4 total revenues, Clear Aligner volumes, Systems and Services revenues were in line with our Q4 outlook, and both GAAP and non-GAAP operating margins were better than our Q4 outlook. Q4 Clear Aligner ASPs were lower than our Q4 outlook due primarily to the impact of unfavorable foreign exchange from the strengthening the US dollar against major currencies from late October through December, as John will explain in his remarks. On a year-over-year basis, fourth quarter revenues of $995 million increased 4%, reflecting 14.9% growth from Systems and Services revenues and 1.6% growth from Clear Aligner revenues. On a year-over-year basis, Clear Aligner volumes grew 6.1%, driven by increased shipments across all regions with strength in EMEA, APAC and LatAm regions and stability in North America. From a channel perspective, Clear Aligner volumes in the ortho and GP channels were up a year-over-year basis with a number of submitters and utilization amongst the highest in the past few years. On a sequential basis, fourth quarter revenue growth of 1.8% reflects continued momentum from sales of iTero Lumina scanners and increased Invisalign Clear Aligner volumes in the EMEA region, especially from teens and growing patients as well as growth from the LatAm regions. Across the orthodontists and GP dentists offset by clear aligner seasonality in in APAC, mostly China, which had a strong teen quarter in Q3. For the Americas, Q4 Clear Aligner volumes reflect a seasonally soft orthodontic channel, offset somewhat by strength in the GP channel in the adult segment. For the full year 2024, total revenues of $4 billion and Clear Aligner volumes of 2.5 million cases were both up 3.5% year-over-year. We delivered fiscal 2024 non-GAAP operating margin of 21.8%, above fiscal 2023 and in line with our 2024 outlook. As of Q4 2024, we achieved several cumulative milestones, including 272,000 active Invisalign trained practitioners, 19.5 million Invisalign patients, including over 5.6 billion teens and kids and over 2 billion clear aligners manufactured worldwide. For clear aligners in Q4, year-over-year volume growth in the Americas reflects strength in Latin America as well as improving trends in North America, especially for GP dentists. In the EMEA region, Q4 year-over-year Clear Aligner volume growth reflects increased volumes from core Europe as well as strong growth from EMEA, Eastern Europe, Middle East and Africa markets. From a channel perspective, EMEA Clear Aligner growth reflects strength in both ortho and GP as well as teens, kids and adult patients. In APAC region, Q4 year-over-year Clear Aligner volume growth was driven by China and Japan, as well as strong growth from our emerging APAC countries led by India, Thailand and Korea. For Q4, APAC growth also reflects increased utilization and submitters in both doctor channels and growth in both patient segments. Q4, we had 85,700 doctors submitters worldwide, a record total in the fourth quarter, primarily reflecting a sequential increase in clear aligner volume for adults and non-comprehensive cases. In the adult clear aligner segment, we're pleased to see both year-over-year and sequential growth across all regions. In the teen and growing kids segments, approximately 216,000 teens and kids started treatment with Invisalign Clear Aligners during the fourth quarter, a decrease of 8.6% sequentially off a record Q3 teen season and an increase of 9.8% year-over-year, reflecting growth across regions, especially from Invisalign First in the APAC and EMEA regions. For Q4, number of doctors submitting cases starts for teens and kids was up 6.2% year-over-year, led by continued strength from doctors treating young kids or growing patients. For fiscal 2024, Total Invisalign Clear Aligner shipments for teens and kids reached a record total of 868,000 Invisalign cases and shipped up to -- a year up to 7.7% compared to the prior year and comprising approximately 35% of the 2.5 million total Clear Aligner case shipments for the year. Teen-specific consumer marketing and sales programs, along with the continued momentum for Invisalign First for kids as young as six and Invisalign Palatal Expander systems help drive adoption globally. During the quarter, we continued to commercialize the Invisalign Palatal Expander with steady momentum for doctor's submitters and shipments. In its first full year of availability in North America, Invisalign Palatal Expander adoption was followed by similar trajectory in Invisalign First, which launched 2017. But Invisalign First did not require regional or country-specific regulatory approvals like Invisalign Palatal Expander is required. In Q4, we received the CE mark under the medical device regulation to market the Invisalign Palatal Expander system in most of Europe and also completed registration with the Medicines and Healthcare Products Regulatory Agency for the United Kingdom and overseas territory. Both approvals are for broad patient applicability, including growing children, teens and adults with surgery or other techniques. These approvals mark a significant milestone in our efforts to enhance clinical outcomes and efficiency in orthodontics and enable us to commercialize the Invisalign Palatal Expander across most of the major EMEA region in 2025. We are continuing to make progress in establishing the clinical efficacy and improved patient experience of Invisalign Palatal Expander, which recently made to cover of the Journal of Clinical Orthodontics, or JCO, and an article published by Dr. Jonathan Nicozisis. There have been multiple peer review studies published on the effectiveness of the Invisalign Palatal Expander as well as mandibular advancement. We also are receiving positive parental feedback, as reflected in the article, 7 Reasons Parents Love the Invisalign Palatal Expander System. Overall, the Invisalign Palatal Expander system is gaining traction among orthodontists and patients due to its innovative design and user-friendly feature. As more clinical data becomes available and practitioners gain experience with the device and parents become informed, we believe adoption will continue to grow. Q4 non-case revenues were up year-over-year, primarily due to continued growth in retainers and our Doctor Subscription Program, or DSP, including non-Invisalign patients at getting retainers. Non-case revenues, including our Vivera Retainers, retention aligners ordered to our Doctor Subscription Program, clinical training, education, accessories and e-commerce. DSP also includes Invisalign touch-up cases, which includes up to 14 stages and is currently available in North America and certain countries in Europe and was most recently launched in Brazil. For Q4, total Invisalign DSP touch-up cases were up nearly 37% year-over-year to more than 27,000 cases. For fiscal 2024, total DSP touch-up cases shipped were over 100,000, up 37% compared to 2023. 224 Clear Aligner volume from DSO customers increased sequentially and year-over-year, reflecting growth across all regions. The DSO business continues to outpace our retail doctors globally. And in the U.S., it's driven by our largest DSO partners, Smile Doctors and Heartland Dental, and also had strong growth in iTero scanner sales as DSO invested in their members' practices end-to-end digital workflows. In December, we completed $30 million equity investment in Smile Doctors, the largest orthodontic focused DSO in the U.S. with more than 450 locations in 32 states. Smile Doctors has a rich history of developing and growing affiliated practices by providing tools and technology that allow their orthodontists to focus entirely on patient care, and we are continuously exploring collaboration with DSOs that share our vision of furthering the adoption of digital dentistry. Each DSO has a different strategy and business model. We're focused on working and with encouraging the DSOs aligned with our vision strategy and business model goals. Those DSOs that recognize the benefits of digital workflows enabled by our portfolio of products and services that make up the Align digital platform, including increased practice efficiency and profitability, as well as delivering a better patient experience for shorter cycle times and proximity to their customers. Turning to Systems and Services. Q4 was another strong quarter, with year-over-year revenue growth of 14.9%. On a sequential basis, Q4 Systems and Services revenues were up 5.2%. In Q1 2024, we launched the iTero Lumina with orthodontic workflows as a new stand-alone scanner, or as a wand upgrade from our iTero Element 5D Plus scanner. Overall, we continue to be very pleased with the ongoing adoption of iTero Lumina scanner, and we're looking forward to building on its success with the launch of the iTero Lumina scanner with restorative capabilities. During the fourth quarter, we began a limited market release of our restorative software on the iTero Lumina scanner, and doctor feedback has been outstanding. Our iTero Lumina innovation represents continuous advancement in our mission to deliver unparalleled value to customers and dental professionals worldwide. Doctors can continue to purchase the current version of iTero Lumina scanner today, knowing that it will automatically update to the new version free of charge once it becomes available at the end of March. With that, I'll now turn the call over to John.
John Morici: Thanks Joe. Now, for our Q4 financial results. Total revenues for the fourth quarter were $995.2 million, up 1.8% from the prior quarter and up 4% from the corresponding quarter a year ago. This reflects an increase in clear aligner volumes up 1.9% sequentially and 6.1% year-over-year and revenue growth from Systems and Services of 5.2% sequentially and 14.9% year-over-year. On a constant currency basis, Q4 2024 revenues were favorably impacted by approximately $0.8 million or approximately 0.1% sequentially and were unfavorably impacted by approximately $0.9 million year-over-year or approximately 0.1%. For Clear Aligners, Q4 2024 revenues of $794.3 million were up 0.9% sequentially, primarily from higher volumes, geographic mix shift to higher-priced countries, and lower net revenue deferrals, partially offset by product mix shift to lower-priced products and higher discounts. Q4 Clear Aligner revenues were favorably impacted by approximately $0.7 million or approximately 0.1% from foreign exchange sequentially. Q4 2024 Clear Aligner per case shipment of $1,265 was lower by $10 on a sequential basis, primarily due to product mix shift and higher discounts, partially offset by favorable geography mix and lower net deferrals. Even though FX had a minor impact on our reported quarter-over-quarter results, our Q4 guidance did not forecast any substantial change from the October spot rate foreign exchange rates. However, the U.S. dollar unexpectedly strengthened in November and December. If foreign exchange rates in October had remained constant for November and December, then Clear Aligner ASPs would have increased approximately $10 quarter-over-quarter, or the equivalent of $14 million. On a year-over-year basis, Q4 Clear Aligner revenues were up 1.6%, primarily from higher volumes, lower net deferrals, price increases, and higher non-case revenues, partially offset by lower ASPs, reflecting the impact from unfavorable foreign exchange of $0.7 million or approximately 0.1% product mix shift to lower-priced products and geographic mix. Q4 2024 Clear Aligner per case shipment of $1,265 was down $55 on a year-over-year basis due to the impact of U.K. VAT of $13, product and geographic mix, and higher discounts, partially offset by lower net revenue deferrals and price increases. During Q4, we reached a favorable outcome with the U.K. tax authorities regarding cumulative assessments of approximately $100 million for unpaid VAT related to certain Clear Aligner sales made during the period of October 2019 through October 2023. In Q4, we received a full refund of this $100 million from U.K. tax authorities. This settlement also relieved us of any potential assessments for sales through mid-October 2023. As a result, we have approximately $7 million of VAT paid for periods up to December 2023 that are still in dispute. We expect a ruling by the UK courts in the first half of 2024 for this remaining VAT amount. This ruling will also give clarity whether a 20% VAT is required to be applied to all Clear Aligner sales in the UK going forward. We believe that Clear Aligner should continue to be exempt from that. Clear Aligner deferred revenues on the balance sheet as of December 31, 2024, decreased $51.3 million or 4.1% sequentially and decreased $92.1 million or 7% year-over-year and will be recognized as the additional aligners are shipped under each sales contract. Q4 2024, Systems and Services revenues of $200.9 million were up 5.2% sequentially, primarily due to higher scanner volumes, higher non-systems revenue, driven by iTero Lumina upgrades, partially offset by lower scanner ASPs. Q4 2024, Systems and Services revenue were up 14.9% year-over-year, primarily due to higher scanner volumes, higher ASP and increased non-systems revenues, mostly related to upgrades and leasing rental programs. Q4 2024, Systems and Services revenue impact by foreign exchange was approximately $0.1 million, flat sequentially. On a year-over-year basis, Systems and Services revenues were unfavorably impacted by foreign exchange of approximately $0.2 million or approximately 0.1%. Systems and Services deferred revenue on the balance sheet was down $4.1 million or 1.8% sequentially, and down $40.3 million, or 15.5% year-over-year, primarily due to the recognition of service revenues, which are recognized ratably over the service period. The decline in deferred revenues, both sequentially and year-over-year, primarily reflects the shorter duration of service contracts applicable to initial scanner purchases. Moving on to gross margin. Fourth quarter overall gross margin was 70%, up 0.3 points sequentially and flat year-over-year. Overall, total gross margin was not significantly impacted by foreign exchange sequentially or on a year-over-year basis. Clear Aligner gross margin for the fourth quarter was 70.2%, down 0.1 points sequentially due primarily to lower ASPs and restructuring costs, partially offset by lower manufacturing costs. Clear Aligner gross margin for the fourth quarter was down one point year-over-year, primarily due to lower ASP and restructuring costs, partially offset by lower additional aligners. Overall, Clear Aligner gross margin was not significantly impacted by foreign exchange sequentially or on a year-over-year basis. Systems and Services gross margin for the fourth quarter was 69.4%, up 1.9 points sequentially due to lower manufacturing and freight costs, partially offset by lower scanner ASPs. Systems and Services gross margin for the fourth quarter was up 4.7 points year-over-year due to manufacturing efficiencies and lower freight costs and service cost and higher scanner ASPs. Overall, Systems and Services gross margin was not impacted by foreign exchange sequentially or on a year-over-year basis. Q4 operating expenses were $552.8 million, up 6.4% sequentially and up 11% year-over-year. On a sequential basis, operating expenses were $33.3 million higher due primarily to restructuring costs. Year-over-year operating expenses increased by $54.8 million, primarily due to restructuring, advertising and marketing expenses. Q4 restructuring charges related to severance for impacted employees were higher than anticipated. On a non-GAAP basis, operating expenses were $474.7 million, up 0.4% sequentially and up 6.3% year-over-year. Our fourth quarter operating income of $144.1 million resulted in an operating margin of 14.5%, down 2.1 points sequentially and down 3.4 points year-over-year. Operating margin was favorably impacted by foreign exchange of approximately 0.1 points sequentially and unfavorably impacted by 0.2 points year-over-year. The effective restructuring on GAAP operating margin was approximately 3.7 points. Q4 non-GAAP operating margin was 23.2%, up 1.1 points sequentially and down 0.6 points year-over-year. Interest and other income and expense net for the fourth quarter was an expense of $3.4 million compared to income of $3.6 million in Q3 2024, primarily due to unfavorable foreign exchange movements of $15.3 million, partially offset by higher interest income and gain on investments. On a year-over-year basis, Q4 2024 interest and other income and expense was unfavorable compared to income of $1.3 million in Q4 2023, primarily due to unfavorable foreign exchange movements, partially offset by higher interest income and gain on investments. The GAAP effective tax rate in the fourth quarter was 26.3% compared to 30.1% in the third quarter and 28.3% in the fourth the fourth quarter of prior year. The quarter GAAP effective tax rate was lower than the third quarter effective tax rate primarily due to the release of uncertain tax position reserves, partially offset by onetime deferred tax adjustments in certain foreign jurisdictions. The fourth quarter GAAP effective tax rate was lower than the fourth quarter effective tax rate of the prior year, primarily due to the release of certain tax position reserves, partially offset by one-time deferred tax adjustments in certain foreign jurisdictions. On a non-GAAP -- our non-GAAP effective tax rate in the fourth quarter was 20%, which reflects our long-term projected tax rate. Fourth quarter net income per diluted share was $1.39, down $0.16 sequentially and $0.25 compared to the prior year. Our Q4 2024 EPS was unfavorably impacted by a stronger US dollar, which amounted to approximately $0.14 per diluted share to net foreign exchange losses related to the revaluation of certain balance sheet accounts. On a non-GAAP basis, Q4 2024 net income per diluted share was $2.44 for the fourth quarter, up $0.9 sequentially and up $0.02 year-over-year. Moving on to the balance sheet. As of December 31, 2024, cash and cash equivalents were $1,043.9 million, up sequentially $2 million and down $106.4 million year-over-year. Of our $1,043.9 billion balance, $188.7 million was held in the US and $855.2 million was held by our international entities. During Q4 2024, we initiated a plan to repurchase $275 million of our common stock through open market repurchases. As of December 31, 2024, we had purchased approximately 0.9 million shares at an average price of $222.94 per share for an aggregate of approximately $202.9 million. The remaining $72.1 million of the $275 million was completed in January of 2025. As of January 30, 2025, $225 million remains available for repurchases of our common stock under our stock repurchase program approved in January of 2023. As Joe mentioned earlier, during the quarter, we completed a $30 million equity investment in Smile Doctors, the largest ortho-focused dental support organization in the US. Q4 accounts receivable balance was $995.7 million, down sequentially. Our overall days sales outstanding was 90 days, down approximately three days sequentially and up approximately five days as compared to Q4 last year. Cash flow from operations for the fourth quarter was $286.1 million. Capital expenditures for the fourth quarter were $23 million, primarily related to investments in our manufacturing capacity and facilities. Free cash flow, defined as cash flow from operations less capital expenditures, amounted to $263 million. Before I turn to our Q1 and fiscal 2025 outlook, I'd like to provide the following context around pricing and potential new tariffs. On March 1, 2025, we will raise the list price of clear aligners by about 3% on average in the Americas and EMEA regions. At the same time, we will remove the $10 to $15 per order processing fee for all new clear aligner orders, all new clear aligner refinement orders from past cases and non-DSP Vivera cases. We expect the net effect from these two actions on ASPs to be zero for 2025. We currently manufacture clear aligners in Mexico and ship them to the US primarily for our US customers, with the remainder eventually shipping to other international locations. The US-Mexico tariff situation remains very fluid, and we are unable to predict whether new tariffs will go into effect in the future. We are monitoring events closely. Our Clear Aligner COGS include material, labor, overhead and freight costs. We expect an incremental tariff if implemented, to be applied to transfer prices from Mexico shipments to the US. These transfer prices would not include treatment planning costs, freight and other overhead and similar costs. Align's global operations have evolved significantly over the past several years, and we have greater flexibility to support our global business. However, assuming a new 25% tariff on shipments the US from Mexico, we believe it still would be more economically viable to ship clear aligners from the US -- to the US for Mexico due to a variety of factors, including the incremental additional freight costs incurred, where we shipped from our Polish facility. Regarding China, we currently manufacture our products in China for the benefit of our customers China. With that as a backdrop, assuming no circumstances occur beyond our control, including foreign exchange and new tariffs, for Q1 2025 and fiscal 2025, we provide the following outlook. We expect Q1 worldwide revenues to be in the range of $965 million to $985 million, down sequentially from Q4, primarily due to the impact from foreign exchange rates at current spot rates and lower capital equipment sales, reflecting historical Q1 seasonality. We expect Q1 Clear Aligner volume to be up slightly sequentially and expect Q1 Clear Aligner ASPs to be down sequentially, primarily due to unfavorable foreign exchange at current spot rates as well as continued product mix shift to non-comprehensive Clear Aligners. In addition to seasonality, we expect Q1 Systems and Services revenue to be down sequentially due to the timing of commercial availability of our iTero Lumina scanner with restorative software, which is expected at the end of March. We expect our Q1 2025 GAAP operating margin to be below Q1 2024 GAAP operating margin by approximately 2 points, primarily due to unfavorable foreign exchange at current spot rates. We expect our Q1 2025 non-GAAP operating margin to be below Q1 2024 non-GAAP operating margin by approximately 1 point, primarily due to unfavorable foreign exchange at current spot rates. For fiscal 2025, we expect 2025 year-over-year revenue growth to be in the low single-digits, which reflects approximately 2 points of unfavorable foreign exchange at current spot rates. We expect 2025 Clear Aligner volume growth to be up approximately mid-single-digits year-over-year compared to up 3.5% year-over-year in 2025. We expect 2025 Clear Aligner ASPs to be down year-over-year due to unfavorable foreign exchange at current spot rates and continued product mix shift to noncompetitive, non-comprehensive Clear Aligners. We expect 2025 Systems and Services year-over-year revenues to grow faster than Clear Aligner revenues. We expect 2025 GAAP operating margin to be approximately 2 points above 2024 GAAP operating margin, and we expect 2025 non-GAAP operating margin to be approximately 22.5%, which both reflect the impact of unfavorable foreign exchange at current spot rates, partially offset by the benefits from restructuring actions we took in Q4 to improve profitability and give us margin accretion in 2025, even as we scale our next-generation direct 3D printing fabrication manufacturing. We expect our investments in capital expenditures for fiscal 2025 to be between $100 million and $150 million. Capital expenditures primarily relate to building construction and improvements, as well as manufacturing capacity in support of our continued expansion. Overall, I am pleased with our fourth quarter and fiscal 2024 results, particularly the year-over-year Clear Aligner volume growth, the record number of submitters, the continued momentum from our Systems and Services business, and our operating margin improvement. After repurchasing $353 million of our Align common stock during 2024, we continued -- we concluded the year with no debt and approximately $1.044 billion in cash and cash equivalents. Our goal, as always, is to deliver value to our shareholders. Now, I'll turn the call -- now I'll turn it back over to Joe for final comments. Joe?
Joe Hogan: Thanks John. In closing, 2024 was a year of solid progress across the business. Record full year total worldwide revenues of $4 billion, record full year total worldwide System and Services revenue of $769 million, record teen shipments and growth in both teens and adult markets, record 130,400 doctors shipped to, 19.5 million total patients treated, with 5.6 million teens in kids. We ended the year with over $1 billion in cash and equivalents after repurchasing 1.5 million shares for $353 million. In another year where the dental industry is down and we continue to grow, I feel good about where we ended the year, and I'm excited to kick off 2025 with a team focused on building the innovations introduced in 2024 that drive efficiency and growth for practices and that are committed in delivering the best customer and patient experiences in the industry. I want to highlight just a few of the Align innovations that we introduced in 2024 that we believe will continue to drive adoption and utilization. In January 2024, we unveiled a breakthrough technology, the iTero Lumina intraoral scanner with 3x wider field of capture and a 50% smaller wand that delivers faster scanning, higher accuracy and superior visualization for greater practice efficiency and with orthodontic workflows. We look forward to introducing at the end of Q1 2025, the iTero Lumina intraoral scanner with software capabilities to enable efficient restorative and ortho restorative workloads to help general practitioner dentists deliver exceptional restorative outcomes. The iTero scanner is the front end of Align digital platform, designed to give doctors the capability to run simulations and communicate with patients, so the patients can see their smiles and the time that it would take them to get that outcome. It's also a big part of our growth algorithm, and we've had good accretive margin on the iTero Lumina scanner product since its launch. We also started rolling out ClinCheck in minutes, delivering treatment plans based on doctors building personalized treatment preferences for almost touchless digital workflows, which we'll expand to more doctors this year, bringing an unprecedented level of speed and customization to digital treatment planning. Changing the paradigm for how doctors can treat growing patients is one of our biggest opportunities. As we continue to deliver innovations that help doctors achieve more of a treatment at younger ages, potentially decreasing the amount of orthodontic treatment that younger and teen patients need overall. As we continue to commercialize the Invisalign Palatal Expander system, Align's first direct 3D-printed device that provides doctors with a solution set to treat the most common skeletal and dental malocclusions in growing children, we anticipate introducing the next in a series of direct 3D-printed devices with a pilot for Invisalign First direct printed retainers in the first half of 2025. We have also Invisalign mandibular advancement with the occlusal blocks now in limited market release, giving doctors and patients a better option for Class II correction in younger patients while simultaneously strengthening their team. We're also excited about the future of digital orthodontics focused on growth opportunities as a company while driving margin improvement and our unique ability to leverage aggregated and anonymized data from approximately 19.5 million Invisalign cases to continue to gain more knowledge about the science of orthodontics to move the industry forward. And while we're now in our 28th year, in the same way, we're just at the beginning. It's that motivating and exciting for the whole Align team. With that, I thank you for your time today. I look forward to updating you on our continued progress over the coming quarters. Now I'll turn the call back to the operator for your questions. Operator?
Operator: At this time, we will be conducting a question-and-answer session. [Operator Instructions] And our first question will come from the line of Michael Cherny from Leerink Partners. Your line is open.
Michael Cherny: Good afternoon, and thank you for a ton of detail already. Maybe if I could just dive in a bit to the guidance, especially on the Clear Aligner side. Is there any way to give a little bit more of a breakdown as you think about the dynamics on volume versus price? Hear you loud and clear on the ASP impact from FX. But curious how to the growth dynamics on aligners as a whole, especially coming off of the mix of, obviously, easier comps in 2024 versus what's still an uncertain macro environment? Thank you.
John Morici: Yeah. Michael, this is John. When we talk about the -- kind of give picture for the total year, we're looking at volume for Clear Aligners at up mid-single digits, and that's how we look at that. It varies like it does across different regions and different times of the year and so on. But we've looked at it that way, and that's the perspective that we have for year. We were pleased with how we exited in 2024 with the volumes that we had, and that's the overall guidance that we have for the year.
Michael Cherny: And just along those lines and the volumes, mid-single digits, obviously, a really solid number. How do you think about the competitive dynamics in the market now? And are there opportunities either in terms of other competitors exiting? Or how do you think about the components of what drives that in terms of market dynamics, competitive dynamics, share gains, anything more to break down that obviously strong number would be great as well. Thank you so much.
Joe Hogan: Yeah. And Michael, it's Joe. I think on the competitive dynamics, I don't see a big change in the dynamics when you look at 2024 and 2025. Overall, we feel our new innovation all continues to put us ahead. Obviously, the Minute ClinCheck really drives our super users to a level of productivity they haven't had before. So I feel really good about our competitive ability all around the world, including China, including some specific areas about it. So as we move into 2025, I really feel that we're gaining momentum in that sense.
Operator: Thank you. One moment for next question. Our next question will come from the line of Elizabeth Anderson from Evercore ISI. Your line is open.
Elizabeth Anderson: Hi, guys. Congrats on the quarter, and thanks so much for the question. I was wondering, if you could talk about two things. Maybe as regards to the Lumina and the scanner business more broadly, it looked like you were -- you obviously have the launch coming up in the first quarter. So if you could talk a little bit on your expectations for that, maybe given what you've learned on the ortho side for Lumina? And then two, you talked about sort of the impact, obviously, of more leases and things like that versus perhaps capital equipment sales. Can you talk about, sort of, help us understand maybe on a unit basis, how you're thinking about the growth in that business? I think that would be one thing that would be helpful. And then maybe if you could also help us understand a little bit better that maybe some of the growth dynamics, particularly in North America, DSO versus non-DSO customers? Thank you.
Joe Hogan: Elizabeth, it's Joe. I'll take the first part of your question. When you look at what we learned in the orthodontic release of Lumina was a product was everything we hoped it would be. I talked about the wider field of view, the speed. I didn't talk a lot the optics. So image quality is fantastic on the product line. The lightness of the one and all that was really important for the technicians that that use wand day in and day out because in the past, we had a lot of complaints in the sense of the heaviness and kind of bulkiness of the wands that are in the marketplace right now, particularly on the confocal imaging side. So as we move that into more of the restorative marketplace, remember, we had a good take-up of GPs using that product line last year, too. This will complete the -- the whole system for GPs because they can do the restorative work they had on it and not just the orthodontic side. So we're excited about it. We're looking forward to it. Obviously, we'll talk about it coming up at the IDS, and we look forward to launching it in March and then bringing you through the second quarter.
John Morici: And as Joe said, kind of to your second part of the question, Elizabeth, look, this rounds out our portfolio. We've got a complete portfolio from the most advanced scanner and the latest with Lumina to all other types of products that we have, all the way down to certified pre-owned. And so that portfolio is rounded up, but we also, as you mentioned, the leasing and other rental, we offer a lot of options for our customers. Some customers want to buy, and they want that legacy equipment, that's great, and they'll buy that new equipment, do trade-ins or just add another scanner and so on. But some also don't want to put that capital up, especially in this environment. So we offer them a lot of different opportunities to lease that equipment to use external financing that gets them at a good rate for external financing to purchase, or some just want to rent it. And so we feel like we can offer that customer any which way that they want to be able to utilize our equipment. And as we continue to release new products, keep we surf pre-owned in and so on. We're just expanding our base, which is helpful for our overall business.
Shirley Stacy: Thanks, Elizabeth. Next question,
Operator: Thank you. One moment for our next question. Next question will come from the line of Glen Santangelo from Jefferies. Your line is open.
Glen Santangelo: Hi. Thanks for taking my question. Hey, Joe, I also want to follow up on this volume issue because it seems like in the fourth quarter and into 2025, you're forecasting some pretty decent volumes. And I'm kind of curious, could you put that in the context of where you think the overall ortho industry is now? Do you feel like you're kind of getting some share back because in 2024, in 2023, the theme was macro uncertainty, but you're not really talking about that anymore? And I'm just kind of curious if you think maybe the industries get a little bit better? Or is some of these DTC offerings that may be faded into the background, like what's enabling you to improve your volume, you think? And then I just had a follow-up for John.
Joe Hogan: Yes, Glen, it's a good question. I think we've been talking about stability for a while now, too. And again, I think we stand on that platform also. Each one of these regions are different from what we've seen. We felt good about Europe in the fourth quarter. We saw some momentum there, felt reasonable about APAC in a sense, I mentioned China and Japan. And increases in Thailand and different in China and different -- I mean, in different parts of the APAC region. When you come to the United States, the orthodontic marketplace, Glen, has really been flat for the last three years. Now, I think we made progress, good progress with the new products that we've had. But we've been challenged in that segment. And I wouldn't call it so much competition as I would -- it's been a wires and brackets kind of regression in that marketplace because of when doctors are seeing less patient throughput, they're looking to save margin, and it's difficult to really appeal to them with clear aligners when they're not at capacity in that sense. But on the counter of that, Glen, we've seen really good progress in GPs and good growth in GPs, not just in the US but all over the world, and that's really helped us. And so remember, we changed our channel strategy years ago to make sure that we went to the GP channel with the GP sales force and ortho, with ortho sales force, too. And I think that's really helped us to give us insight into the industry and position our products properly for both those areas. So I hope that helps to answer your question. I think our new technology, too, gives us a lot of confidence. Specifically in the orthodontic channel since offering differentiation, those early patients that we talked about. We feel we have the three products I mentioned in my script, we feel we have something that's special in the orthodontic community in a sense of that younger patient piece, and you'll see us push that really hard as we move into 2025.
Glen Santangelo: That's awesome. And John, maybe if I could just follow up with you on this ASP issue, right? I mean, obviously, everyone is focused on the fact that ASPs will be down. And you highlighted FX and you highlighted mix shift. I was wondering if you could just unpack that a little bit to tell us -- and I'm sorry if I missed this, exactly how much FX is playing a role here on that ASP number in 2025?
John Morici: Yes. Yes. That's a good question, Glen. Overall, when we look at 2025 in terms of how we've guided, we have about 2 points of FX headwind on a year-over-year basis. It's just the strengthening of the dollar. We saw that as it came out October and it continues to be strong November, December, January. We're basically forecasting what we see now on a spot rate standpoint and expecting it to be strong, and that impact is about 2 points unfavorable on a year-over-year basis.
Glen Santangelo: Okay. Thank you very much.
Operator: One moment for our next question. Our next question will come from the line of Jon Block from Stifel. Your line is open.
Jon Block: Thanks, guys. Hey, Joe. First one, the 1Q 2025 revenue guidance is down around 2% at the midpoint. The full year revenue guidance is up low-single digits. And I think some of that is the 1Q comp, I believe also the scanner timing, if you would, due to the Resto launch. But I think it's an important question, Joe. Can you talk about other reasons why the rest of the year, you're arguably up, call it like low to mid-single digits versus the down 2% and 1Q 2025, again it's a guide? And then I think what people are going to be worried about is, is there an embedded assumption that things pick up in the guide? Or is it just sort of the moving parts again of the comp, the Resto launch, et cetera? And I'll sort of pause there and then I'll ask my follow-up.
Joe Hogan: John, I'd say we obviously introducing the restorative scanner in March, we don't get the full benefit of that in the first quarter, and you're accurate in the sense of reflecting that in your comments overall. I would say we're not talking about a build as we go through the year. I think you have to look at exchange on a whole thing, and John can explain that in a sense of how we've baked that in overall. But obviously, you have a full year of IPE coming in this year. We have the regulatory approvals for that going into Europe and different parts of Asia, too, and we think we'll hit mainstream in that end too. And may deal with advancement with a plus of blocks too is another one that we think is going to be a specific grower for us also. So I mean, that's how I'd pretty much tackle that is that we have new technology rolling in. You have the iTero restorative coming in also. And John, what would you add?
John Morici: Yes. And we're not expecting, Jon, any overall improvement in the macro economy. If it happens, great, that will be good for the entire business. But we're not expecting an overall improvement there. We did see as we came out of Q4, I mean, just the 6% growth in volume in Q4, that's the highest growth that we've seen in three years on a year-over-year basis. So that's good to see. We want to continue to see that that momentum. And like Joe said, we're doing everything we can with new products, new innovations, new ways to go to market to be able to continue that.
Jon Block: Yes. No, beat on balance, got it ahead on balance for 1Q, I get that. And then just second question is, I think, Joe, this one is for you. But for a couple of quarters now, at least two, maybe more, we've heard you detail, call it, the faster growth from the DSOs. And so a couple of questions here. Joe, what is are the DSOs, call it, as a part of your North American business, if you could just give us a rough number? But more importantly, the plays that you run with the DSOs -- and we've heard of some those, the marketing support -- pardon -- this is my language, not your -- they might be more sophisticated with your help. Are those transferable to the fragmented GP market? And if so, how long does that take to go ahead and manifest on your part? Because clearly, if you could extrapolate that faster growth to the individual practices, that would be -- certainly, I'm positive and something to get excited about. So, maybe your comments on, again, the percent of their weighting of your bids? And more importantly, can you see yourself running the same plays with the individual practices?
Joe Hogan: Hey Jon, it's a great question. Really, first of all, I look at -- I talk about it internally, too. I look at DSOs as a force multiplier. They can actually take our technology, what we learned in a sense of a sense of efficiency, what we learned from brand, from a demographic zone brand you can apply to. And they just have an ability to be able to disseminate that within their teams. Much better than doing that individually door-to-door like we do with our normal sales force, which is kind of obvious. But that doesn't preclude us from what we're taking to the DSOs in the sense of what we know and what they incorporate. Our salespeople are -- many of them have been with us many years, they understand that also. They just have to find the right orthodontists and the right general dentists to really want to implement those procedures in their marketplace. That's why I -- talking about the sales kickoff the other day down in Dallas. And it said that we have the longest or the hardest last mile of any company I've ever worked with because you are calling on these individual family-driven practices. And not that they're stupid or anything, they are very smart. But they're very -- not necessarily business minded always. They're clinically minded, and it takes a while to gain their confidence and move it forward. DSOs help to accelerate that, Jon, is the best way I can explain that. Jon, you've got--
Jon Block: Thanks for the color guys.
Joe Hogan: Jon, thank you.
Operator: Our next question comes from the line of David Saxon from Needham. Your line is open.
David Saxon: Great. Good afternoon Jon and John. Thanks for taking my questions. Yes, I had a couple of follow-ups on the guide for Clear Aligner. So, mid-single-digit volume growth for Clear Aligners. Joe, based on your answer to a previous question, it sounds like U.S. volume growth should probably be slower than international, but I just wanted to confirm that's how you're thinking about it? And then on the ASP side, to down year-on-year for the full year, first quarter ASPs look be to down high single-digits year-on-year based off of the first quarter ASP guidance. But you have this price increase starting in second quarter. So, just I'd love to hear how we should think about pricing in quarters two through four on a year-over-year basis?
Joe Hogan: Hey David, I'll take the first part of your question, which, yes, our forecast for next year does imply a slower U.S. than the rest of the world. And that's -- to me, that's -- we're just projecting what we saw in 2024 into 2025. But we don't have any data right now that would make us change that in some way from a consumer confidence. And to see or any kind of change in the last several quarters, I would say that it would be different going. As far as ASPs go...
John Morici : Look, ASPs, they're heavily impacted with our business, over 50% of it outside the U.S. They're impacted by a stronger dollar. And I just tried to make it very clear in terms of our guidance based on what those spot rates are as of now and saying this is how it's going to play out in the future. Obviously, it changes. And -- but at least give you a reference point to jump off of. So when you look at Q1, you'd see that ASPs will be down. It's a reflection of the foreign exchange, and that's the primary driver of that. It will change as it goes through each of the quarters. I mean, by the end of the year, it kind of catches up, and that strength of the dollar that we saw in November and December won't have as much a year-over-year impact. But in Q1, it has that impact.
David Saxon: Okay. All right. That's helpful. And then maybe sticking with you, John. So operating margin down year-on-year in the first quarter, but guiding to expansion for the full year. So I'd love to just hear kind of the puts and takes that drive that ramp? And maybe it would be great if you could talk about quarterly cadence. Thanks so much.
John Morici : Yes. When you think of the op margin that we'll have, we did actions last year to be able to get our op margin in a place from a cost standpoint to be able to provide that margin accretion. The first quarter is one where, as you start to ramp up, usually first quarter op margin is and at a rate standpoint, the lowest or one of the lowest for the quarters as you -- it builds as you go through year. It's based on volume. As we have more volume coming through our facilities, we generate additional productivity, and that shows up. We have new products, as Joe described, with the Lumina Restorative, different products where we're expanding out and so on that help us drive additional margin as we go through. So we've got the levers that we can pull and adjust as we go through the year to be able to generate that margin accretion on a year-over-year basis. And that is margin accretion that we talked about at 22.5%, that's despite unfavorable FX on a year-over-year basis. So you can tell some of that margin accretion that that we're talking about. But it's -- it's all about driving productivity through volume you have and being smart about the other investments that you're making.
David Saxon: Great. Thanks so much.
John Morici : Thanks, David.
Operator: One moment for next question. Our next question will come from the line of Jeff Johnson from Baird. Your line is open.
Joe Hogan : Hi, Jeff.
Jeff Johnson: Hi, thanks. Hi, Joe, how are you? Good afternoon, guys. So look, we're all going around kind of this 1Q, trying to understand it relative to the rest of the year. The one thing I haven't heard and maybe I just missed it, but you guys are talking about a 200 basis point headwind for the year from currency. I think that is pretty much flow through to ASP as to ASP as well, about a two-point headwind for the year well on the Clear Aligner side. But I haven't heard you quantify Q1. My math and my currency math is terrible, but my math would put currency at almost a 3, 3.5 point headwind in 1Q to both ASPs and global revenue. Am I close on that? Is it bigger in 1Q?
John Morici : Yes. That's the right way to phrase it, Jeff. It is bigger just based on what the dollar was doing last year compared to this year. So there is a bigger currency effect in Q1 than on average for the year.
Jeff Johnson: Ballpark, am I close on that 3, 3.5?
John Morici : Yes. You're close on that.
Jeff Johnson: Okay. And then just my other question is really kind of the same kind of FX question, but on the gross margin side -- sorry, on the company margin side, on the operating margin side. You're guiding to 70 basis points of year-over-year improvement at the op margin line on a non-GAAP basis. How much is currency weighing on, I don't care if it's gross margin or operating margin, however you want to provide the answer. But how much is currency weighing there? And then how much of the incremental direct fab investments potentially weighing this year on gross or overall margin? It seems like this could have been a year if currency neutral and you didn't have the direct fab incremental investments that we really would have started to see a recapture back towards those pre-COVID numbers. So just trying to understand all those moving pieces? Thank you.
John Morici: Yeah. Jeff, when you talk about the FX impact on op margins, its over one point, you're right, it's two points at revenue on a year-over-year basis, falls to just over one point on an op margin basis. So a large part of that falls through. So, you're right, calling 70 basis point improvement year-over-year. That's despite having one point of op margin pressure from an FX standpoint. And then, of course, all the other things that we're doing to invest in. So and there's some offsets to that in terms of scaling up our growth platforms and so on. But that's all in the number that we have at the 22.5%. So if FX was going the other way, you would see even more margin accretion, and we'll see how that foreign exchange plays out as we go through the rest of the year.
Jeff Johnson: Understood. Thank you guys.
Joe Hogan: Thanks Jeff.
Operator: One moment for next question. Our next question will come from the line of Brandon Vazquez from William Blair. Your line is open.
Brandon Vazquez: Hi, everyone. Thanks. Hey guys, thanks for taking the question. Joe, maybe for you on the IPE side, I think we're a little bit over year after the launch of that product now. Curious if you could comment on maybe two things. One, what's the adoption curve looking like relative to your expectations now that we're about a year in? And then two, is this a product that could maybe be a catalyst within the teen market to let you get that next incremental leg of adoption given that that's kind of the third year end market that you guys are underpenetrated in?
Joe Hogan: Yeah. Brad, first of all, I mean, the adoption curve has been good, as I mentioned in my script, it follows Invisalign First. Invisalign First is what we call a dental expansion product. It's kind of moving your teeth, but it's not moving bone in that sense. In this case with IP, we're moving bone. And so that's why the regulatory things and all that I mentioned that we have to go through each region in order to move that through. I feel really good about it. It's such a breakthrough product and a different product. It takes doctors a while in a number of cases to become comfortable with it. We have a wonderful feedback from patients in the sense of the comfort of the product line. And many of the patients or parents have gone through the Hi-Res [ph] device and the wrench and those kind of things. And that makes parents a little more susceptible to wanting Invisalign Palatal Expander too. So I feel good about it. We've had some things too on the release. We didn't have full visualization from a scanning standpoint when we first started. There were some attachment pieces that we had to improve in the sense of how you attach. And then there's also some just wearability aspects about how long you wear this. But we've come over those and we're making good progress in it. So I'm very optimistic about it. And it's great to see it really go from a regional standpoint to a global standpoint now. But we have a great one, two punch in that marketplace with Invisalign First. And that's also worth mentioning, too, we're seeing many doctors, as they do the upper palate expansion, they use Invisalign First on the bottom in order to expand the teeth to be -- to make sure that they're in line with the sense of the bite as they're setting in their upper arch, too. So it's good to see a synergistic effect on those two products. I hope I answered your question, but that's the momentum that we're talking about.
Brandon Vazquez: Yeah. Maybe as a quick follow-up on a separate note. International has been more durable for you guys in the Americas these days. Is that simply a result of just being earlier in the adoption curve and so things are doing a little bit better there? Or is macro and international just doing a little bit better than the Americas? Just trying to understand how durable international outperforming should be as we go into 2025 even if macro and Americas stays relatively muted? Thanks.
Joe Hogan: It's hard to be discrete on that answer. Overall, Brandon, I would say there are certain areas where, obviously, it's the initial penetration of our product line in certain area, but I certainly wouldn't say that about Latin America. We've been now for many years and we see continued growth in that sense. Middle East, Africa in those areas too, some of the places of Africa are new, and they'll hit a certain inflection point. But overall, I feel like we face better economies in those regions. They didn't necessarily, I think, overextend their economies, the way we saw in the Western world and which has affected a large part of Western Europe and also in the United States. And specifically in Asia, outside of China, the other countries in Asia just came back out of COVID in a better position than we were before. But some of those countries are penetration. Some of those countries are just expansion too. So I think overall, it's just a good mix there, Brandon. And I like that. It's good to have. And then as you roll out these new technologies, remember it offers you new opportunities in those countries, too. So that expansion piece can continue.
Shirley Stacy: Thanks, Brandon. Operator, we want to try and get through the covering analysts that are still on the line. So -- and if I can ask folks to limit to one question so we can get through everyone's questions, please.
Operator: Thank you. One moment for our next question. Our next question will come from the line of Jason Bednar from Piper Sandler. Your line is open.
Jason Bednar: Hey, good afternoon. Thanks for taking the question. I'll try be an quick here. I really want to ask on just maybe thematically reducing frictions -- I'm sorry, trailing to pack kind of a combo in here, but this is -- is there a way to reduce frictions within the teen channel and really address what has been maybe a bit of a challenge or sluggish ortho environment? Anything that you can do from a marketing initiative to really create better demand pull effect? And then also on the friction side, maybe help with the business rationale, removing that $10 to $15 process, and you see you all neutralizing it with price increases. Is that -- have you had pushback on the processing fees? Has this caused friction with doctors that you're trying to remove? Thank you.
Joe Hogan: Yeah, Jason, that's a good question. First of all, the friction in teen channel is -- a lot of it has to do with the economics in the orthodontists office today. We talked about the orthodontic offices in the United States haven't really -- in North America haven't seen really any substantial growth in the last three years. And so again, there are individual practices, and I think they're trying to maximize their bottom line as much as they can. And so I think they've been very cautious from a business standpoint. The friction you talked about with our processing fees and all, those are real. We have a pushback, not as much in Asia. We had a lot of pushback in Europe and in the US on that. And we decided to roll that back with that aggregate price increase. And we have a good response from our doctors in order to do that. And that is a friction piece. And it was -- to me, it was an annoyance to the sales team to have to kind of fight through that when they had to talk to doctors in either joining what we were doing or having been with us for a while and explaining those things. So I think that's very helpful. John, I'm sure you have some ideas to it.
John Morici: I mean, in the end, we want to focus on driving this driving this business, category, driving our products too and less about some of the other minor things like this with processing fees and so on. So this is a good opportunity to kind of put this together, get it in the right place and talk about the future of the business versus some of the other past expenses like this.
Shirley Stacy: Yes. Thanks.
Jason Bednar: Thank you.
Operator: One moment for our next question. Our next question will come from the line of Steven Valiquette from Mizuho. Your line is open.
Steven Valiquette: Thanks everyone. Thanks for taking the question. So obviously, there's a lot of puts and takes related to the evolving tariff situation. But one area I was just hoping to get your thoughts on is given that there's a large competitor Chinese base as some investors are watching closely as that competitor tries to establish a larger market share in the US market, really, with this new political backdrop for the next four years under the new administration, I'm wondering whether some practitioners in the US may be a little more hesitant to want to buy into the ecosystem of really any competitors that are headquartered or based outside the US, just given the heightened risk of trade wars, et cetera. So perhaps I could play into your hands favorably, at least in the US market, which I think it's still your biggest market. So just a high level, just curious to get your thoughts on that potential dynamic? Thanks.
Joe Hogan: Hi, Steven, it is, just to confirm, US is still our biggest market in the world in that sense. Remember, I just talked about the orthodontic market not really growing for the last three years, too. So we have had competition. Obviously, we know that your comments really refer to Angel Aligner or maybe some other Chinese suppliers coming in. I think overall, you first win with customer service and you win with technology, you win with relationships, and that's what our sales force is really talking about. We felt that the Chinese have come in on unsustainable prices. When you look at -- we kind of know the prices you have to charge in order to have a decent return. And we think that always takes care of itself one way or another, and we've seen that with other competitors in the marketplace also. So I don't – I can't really speak for 10,000 orthos or GPs that are around the United States and how they feel about international politics or anything they do. But our job is to make sure that we keep our heads down. We deliver the best technology, best productivity, the best brand, all those things to make sure we win in the marketplace, and we'll let that other piece decide for itself.
Steven Valiquette: Okay. Got it. Thanks.
Operator: One moment for our next question. Our next question comes from the line of Kevin Caliendo from UBS. Your line is open.
Q – Unidentified Analyst: Thanks for the question. This is Dylan on from – Dylan Kim on for Kevin. Thanks for the question. A quick question on direct fabrication. You guys previously have talked to potentially commercializing products this year, I believe, starting with the retainer product. So any update there on commercialization of products? And maybe detail on the P&L too into both revenue and investment into costs, into the manufacturing capabilities that you can call out?
Joe Hogan: First of all, I'd say our IPE device is 3D printed, but it's not the Cubicure process and it's not the resin that we'll used in the Cubicure process. So as I mentioned in my script, we will begin to -- just with limited release, an Invisalign First retainer. Invisalign First retainer is a very complicated. It has to have a high modulus. It has to have a huge amount of variability in the sense of how you structure that depending on where that person's arch is at that point in time. And it's the perfect fit for us as we try to ramp up and we ramp up our new our new Cubicure process with resin too. So again, like I mentioned, you'll see just the beginning of that in the first half of this year. And in the second half of this year, we should begin to get ourselves more ready for general release in third and fourth quarters of that product line. That's the beginning. After that, we'll move into what we call mandibular advancement. But any kind of aligners that have auxiliary types of things that you would have to have printed on those or difficult cases where wall thicknesses need to be different in some ways. So, we're really excited about the efficiency of that particular technology, but also the design and incredible design capability and design freedom orthodontists will have in order to do that. So, that's about as well as I can do for you now.
Shirley Stacy: Thanks. Next question please.
Operator: Our next question from the line of Michael Ryskin from Bank of America. Your line is open.
Michael Ryskin: Hey, thanks for squeezing me in guys. Just one quick one for me, hopefully. John, I appreciate the commentary you had on tariffs to Mexico and realize there's still a lot of moving pieces, but I just want to make sure I understood that. Just a comment on transfer prices. I mean, I hear you on overhead and freight cost, treatment planning not being included. How should we think of it as a percent of your COGS? I think if you just go through the P&L with something like $375 COGS per case roughly? Is the transfer -- like how much would be impacted? Is it 50% to 75% of that? And just walk us through the transfer price math, just so we can--?
John Morici: No, it's a good question, Mike. And you're right. I tried to give a perspective of, look, you start with COGS and then there's some hard COGS that have nothing to do with what we're doing in Mexico freight and treatment planning and other things, specifically the value add and the work that's being done there than that transfer price. I guess to put it in perspective in terms of -- there's been a lot of people thinking about what this could be, just based on your question and so on. But like on an average month, that tariff, if it's that 25%, might impact us $4 million to $5 million of cost or that might be the cost perspective of this. So, that gives you an idea of like how this kind of fits into this. This is something, as I said in my prepared remarks -- look, if at that amount of tariffs, 25%, if that ever was implemented, it's not a big enough cost on tariff for us to switch some of the manufacturing and move from perhaps manufacturing in Mexico to Poland. But we'll evaluate that as we go forward. But I just want to kind of size that for you. We'll evaluate as we go forward, we'll understand more as these days come about. We hope there's not anything, but we have a perspective in terms of what it means from a cost standpoint, and we will make decisions based on that. And that will impact us what we do in the short and long-term.
Michael Ryskin: Thank you. Thanks.
Shirley Stacy: Operator, we'll take one last question.
Operator: And our last question will come from the line of Erin Wright from Morgan Stanley. Your line is open.
Erin Wright: Great. Thanks for squeezing me in. Just a follow-up on that last one. Just to clarify, so there's no buffer kind of embedded in your guidance as it stands today from a tariff perspective? And just on China, just the environment there, not necessarily from a tariff perspective, but just more so from demand trends? And even China from a competitive standpoint, I guess, expectations for the balance of the year, if you could touch on those? Thanks.
John Morici: That's great, Erin. I'll take the first one on tariffs. So we're not in our forecast and what we've given for guidance at that margin of 22.5%. There's no additional new tariffs that we've contemplated in that number. So, we'll see how things come about. But in the framework, if there is a tariff, and it should be 25% from Mexico to the U.S., it's $4 million to $5 million depending on volume per month from an expense standpoint. And then on China, I don't know if you want to give -- Joe, any other perspective on the kind of the market there?
Joe Hogan: I'd say the China market, we were pleased with the third quarter. The fourth quarter, obviously, is always less in China what the third quarter was. There was nothing in that that quarter made me think that anything was different in China and since its trajected the business, from what we've seen. So overall, I'd call China stable right now.
Erin Wright: Okay. Thank you.
John Morici: Thank you.
Joe Hogan : You’re welcome.
Operator: And I will now turn the call over back to Shirley Stacy for any closing remarks.
Shirley Stacy: Well, thank you, everyone, for joining our call today. We appreciate it. If you have any follow-up questions, please reach out to Investor Relations. We look forward to seeing you at our next industry events, including the Chicago Midwinter Dental Show coming up here later in February. I hope everyone has a great day.
Operator: This concludes today's conference. You may now disconnect your lines at this time. Thank you for your participation. Everyone, have a great day. | [
{
"speaker": "Operator",
"text": "Greetings. Welcome to the Align Fourth Quarter and Full Year 2024 Earnings Call. At this time, all participants are in a listen-only mode. A question-and-answer session will follow the formal presentation. Please note, this conference is being recorded. I will now turn the conference over to your host, Shirley Stacy with Align Technology. You may begin."
},
{
"speaker": "Shirley Stacy",
"text": "Good afternoon, and thank you for joining us. I'm Shirley Stacy, Vice President of Corporate Communications and Investor Relations. Joining me for today's call is Joe Hogan, President and CEO, and John Morici, CFO. We issued fourth quarter and full year 2024 financial results today via Business Wire, which is available on our website at investor.aligntech.com. Today's conference call is being audio webcast and will be archived on our website for approximately one month. As a reminder, the information provided and discussed today will include forward-looking statements, including statements about Align's future events and product outlook. These forward-looking statements are only predictions and involve risks and uncertainties that are described in more detail in our most recent periodic reports filed with the Securities and Exchange Commission available on our website and at sec.gov. Actual results may vary significantly, and Align expressly assumes no obligation to update any forward-looking statement. We've posted historical financial statements with corresponding reconciliations, including our GAAP to non-GAAP reconciliation, if applicable, and our fourth quarter and full year 2024 conference call slides on our website under Quarterly Results. Please refer to these files for more detailed information. With that, I'll turn the call over to Align Technology's President and CEO, Joe Hogan. Joe?"
},
{
"speaker": "Joe Hogan",
"text": "Thanks, Shirley. Good afternoon, and thanks for joining us today. On our call today, I'll provide an overview of our fourth quarter and full year results and discuss a few highlights from our two operating segments, System Services and Clear Aligners. John will provide more detail on our financial performance and comment on views for 2025. Following that, I'll come back and summarize a few key points and open the call to questions. I'm pleased to report that Q4 total revenues, Clear Aligner volumes, Systems and Services revenues were in line with our Q4 outlook, and both GAAP and non-GAAP operating margins were better than our Q4 outlook. Q4 Clear Aligner ASPs were lower than our Q4 outlook due primarily to the impact of unfavorable foreign exchange from the strengthening the US dollar against major currencies from late October through December, as John will explain in his remarks. On a year-over-year basis, fourth quarter revenues of $995 million increased 4%, reflecting 14.9% growth from Systems and Services revenues and 1.6% growth from Clear Aligner revenues. On a year-over-year basis, Clear Aligner volumes grew 6.1%, driven by increased shipments across all regions with strength in EMEA, APAC and LatAm regions and stability in North America. From a channel perspective, Clear Aligner volumes in the ortho and GP channels were up a year-over-year basis with a number of submitters and utilization amongst the highest in the past few years. On a sequential basis, fourth quarter revenue growth of 1.8% reflects continued momentum from sales of iTero Lumina scanners and increased Invisalign Clear Aligner volumes in the EMEA region, especially from teens and growing patients as well as growth from the LatAm regions. Across the orthodontists and GP dentists offset by clear aligner seasonality in in APAC, mostly China, which had a strong teen quarter in Q3. For the Americas, Q4 Clear Aligner volumes reflect a seasonally soft orthodontic channel, offset somewhat by strength in the GP channel in the adult segment. For the full year 2024, total revenues of $4 billion and Clear Aligner volumes of 2.5 million cases were both up 3.5% year-over-year. We delivered fiscal 2024 non-GAAP operating margin of 21.8%, above fiscal 2023 and in line with our 2024 outlook. As of Q4 2024, we achieved several cumulative milestones, including 272,000 active Invisalign trained practitioners, 19.5 million Invisalign patients, including over 5.6 billion teens and kids and over 2 billion clear aligners manufactured worldwide. For clear aligners in Q4, year-over-year volume growth in the Americas reflects strength in Latin America as well as improving trends in North America, especially for GP dentists. In the EMEA region, Q4 year-over-year Clear Aligner volume growth reflects increased volumes from core Europe as well as strong growth from EMEA, Eastern Europe, Middle East and Africa markets. From a channel perspective, EMEA Clear Aligner growth reflects strength in both ortho and GP as well as teens, kids and adult patients. In APAC region, Q4 year-over-year Clear Aligner volume growth was driven by China and Japan, as well as strong growth from our emerging APAC countries led by India, Thailand and Korea. For Q4, APAC growth also reflects increased utilization and submitters in both doctor channels and growth in both patient segments. Q4, we had 85,700 doctors submitters worldwide, a record total in the fourth quarter, primarily reflecting a sequential increase in clear aligner volume for adults and non-comprehensive cases. In the adult clear aligner segment, we're pleased to see both year-over-year and sequential growth across all regions. In the teen and growing kids segments, approximately 216,000 teens and kids started treatment with Invisalign Clear Aligners during the fourth quarter, a decrease of 8.6% sequentially off a record Q3 teen season and an increase of 9.8% year-over-year, reflecting growth across regions, especially from Invisalign First in the APAC and EMEA regions. For Q4, number of doctors submitting cases starts for teens and kids was up 6.2% year-over-year, led by continued strength from doctors treating young kids or growing patients. For fiscal 2024, Total Invisalign Clear Aligner shipments for teens and kids reached a record total of 868,000 Invisalign cases and shipped up to -- a year up to 7.7% compared to the prior year and comprising approximately 35% of the 2.5 million total Clear Aligner case shipments for the year. Teen-specific consumer marketing and sales programs, along with the continued momentum for Invisalign First for kids as young as six and Invisalign Palatal Expander systems help drive adoption globally. During the quarter, we continued to commercialize the Invisalign Palatal Expander with steady momentum for doctor's submitters and shipments. In its first full year of availability in North America, Invisalign Palatal Expander adoption was followed by similar trajectory in Invisalign First, which launched 2017. But Invisalign First did not require regional or country-specific regulatory approvals like Invisalign Palatal Expander is required. In Q4, we received the CE mark under the medical device regulation to market the Invisalign Palatal Expander system in most of Europe and also completed registration with the Medicines and Healthcare Products Regulatory Agency for the United Kingdom and overseas territory. Both approvals are for broad patient applicability, including growing children, teens and adults with surgery or other techniques. These approvals mark a significant milestone in our efforts to enhance clinical outcomes and efficiency in orthodontics and enable us to commercialize the Invisalign Palatal Expander across most of the major EMEA region in 2025. We are continuing to make progress in establishing the clinical efficacy and improved patient experience of Invisalign Palatal Expander, which recently made to cover of the Journal of Clinical Orthodontics, or JCO, and an article published by Dr. Jonathan Nicozisis. There have been multiple peer review studies published on the effectiveness of the Invisalign Palatal Expander as well as mandibular advancement. We also are receiving positive parental feedback, as reflected in the article, 7 Reasons Parents Love the Invisalign Palatal Expander System. Overall, the Invisalign Palatal Expander system is gaining traction among orthodontists and patients due to its innovative design and user-friendly feature. As more clinical data becomes available and practitioners gain experience with the device and parents become informed, we believe adoption will continue to grow. Q4 non-case revenues were up year-over-year, primarily due to continued growth in retainers and our Doctor Subscription Program, or DSP, including non-Invisalign patients at getting retainers. Non-case revenues, including our Vivera Retainers, retention aligners ordered to our Doctor Subscription Program, clinical training, education, accessories and e-commerce. DSP also includes Invisalign touch-up cases, which includes up to 14 stages and is currently available in North America and certain countries in Europe and was most recently launched in Brazil. For Q4, total Invisalign DSP touch-up cases were up nearly 37% year-over-year to more than 27,000 cases. For fiscal 2024, total DSP touch-up cases shipped were over 100,000, up 37% compared to 2023. 224 Clear Aligner volume from DSO customers increased sequentially and year-over-year, reflecting growth across all regions. The DSO business continues to outpace our retail doctors globally. And in the U.S., it's driven by our largest DSO partners, Smile Doctors and Heartland Dental, and also had strong growth in iTero scanner sales as DSO invested in their members' practices end-to-end digital workflows. In December, we completed $30 million equity investment in Smile Doctors, the largest orthodontic focused DSO in the U.S. with more than 450 locations in 32 states. Smile Doctors has a rich history of developing and growing affiliated practices by providing tools and technology that allow their orthodontists to focus entirely on patient care, and we are continuously exploring collaboration with DSOs that share our vision of furthering the adoption of digital dentistry. Each DSO has a different strategy and business model. We're focused on working and with encouraging the DSOs aligned with our vision strategy and business model goals. Those DSOs that recognize the benefits of digital workflows enabled by our portfolio of products and services that make up the Align digital platform, including increased practice efficiency and profitability, as well as delivering a better patient experience for shorter cycle times and proximity to their customers. Turning to Systems and Services. Q4 was another strong quarter, with year-over-year revenue growth of 14.9%. On a sequential basis, Q4 Systems and Services revenues were up 5.2%. In Q1 2024, we launched the iTero Lumina with orthodontic workflows as a new stand-alone scanner, or as a wand upgrade from our iTero Element 5D Plus scanner. Overall, we continue to be very pleased with the ongoing adoption of iTero Lumina scanner, and we're looking forward to building on its success with the launch of the iTero Lumina scanner with restorative capabilities. During the fourth quarter, we began a limited market release of our restorative software on the iTero Lumina scanner, and doctor feedback has been outstanding. Our iTero Lumina innovation represents continuous advancement in our mission to deliver unparalleled value to customers and dental professionals worldwide. Doctors can continue to purchase the current version of iTero Lumina scanner today, knowing that it will automatically update to the new version free of charge once it becomes available at the end of March. With that, I'll now turn the call over to John."
},
{
"speaker": "John Morici",
"text": "Thanks Joe. Now, for our Q4 financial results. Total revenues for the fourth quarter were $995.2 million, up 1.8% from the prior quarter and up 4% from the corresponding quarter a year ago. This reflects an increase in clear aligner volumes up 1.9% sequentially and 6.1% year-over-year and revenue growth from Systems and Services of 5.2% sequentially and 14.9% year-over-year. On a constant currency basis, Q4 2024 revenues were favorably impacted by approximately $0.8 million or approximately 0.1% sequentially and were unfavorably impacted by approximately $0.9 million year-over-year or approximately 0.1%. For Clear Aligners, Q4 2024 revenues of $794.3 million were up 0.9% sequentially, primarily from higher volumes, geographic mix shift to higher-priced countries, and lower net revenue deferrals, partially offset by product mix shift to lower-priced products and higher discounts. Q4 Clear Aligner revenues were favorably impacted by approximately $0.7 million or approximately 0.1% from foreign exchange sequentially. Q4 2024 Clear Aligner per case shipment of $1,265 was lower by $10 on a sequential basis, primarily due to product mix shift and higher discounts, partially offset by favorable geography mix and lower net deferrals. Even though FX had a minor impact on our reported quarter-over-quarter results, our Q4 guidance did not forecast any substantial change from the October spot rate foreign exchange rates. However, the U.S. dollar unexpectedly strengthened in November and December. If foreign exchange rates in October had remained constant for November and December, then Clear Aligner ASPs would have increased approximately $10 quarter-over-quarter, or the equivalent of $14 million. On a year-over-year basis, Q4 Clear Aligner revenues were up 1.6%, primarily from higher volumes, lower net deferrals, price increases, and higher non-case revenues, partially offset by lower ASPs, reflecting the impact from unfavorable foreign exchange of $0.7 million or approximately 0.1% product mix shift to lower-priced products and geographic mix. Q4 2024 Clear Aligner per case shipment of $1,265 was down $55 on a year-over-year basis due to the impact of U.K. VAT of $13, product and geographic mix, and higher discounts, partially offset by lower net revenue deferrals and price increases. During Q4, we reached a favorable outcome with the U.K. tax authorities regarding cumulative assessments of approximately $100 million for unpaid VAT related to certain Clear Aligner sales made during the period of October 2019 through October 2023. In Q4, we received a full refund of this $100 million from U.K. tax authorities. This settlement also relieved us of any potential assessments for sales through mid-October 2023. As a result, we have approximately $7 million of VAT paid for periods up to December 2023 that are still in dispute. We expect a ruling by the UK courts in the first half of 2024 for this remaining VAT amount. This ruling will also give clarity whether a 20% VAT is required to be applied to all Clear Aligner sales in the UK going forward. We believe that Clear Aligner should continue to be exempt from that. Clear Aligner deferred revenues on the balance sheet as of December 31, 2024, decreased $51.3 million or 4.1% sequentially and decreased $92.1 million or 7% year-over-year and will be recognized as the additional aligners are shipped under each sales contract. Q4 2024, Systems and Services revenues of $200.9 million were up 5.2% sequentially, primarily due to higher scanner volumes, higher non-systems revenue, driven by iTero Lumina upgrades, partially offset by lower scanner ASPs. Q4 2024, Systems and Services revenue were up 14.9% year-over-year, primarily due to higher scanner volumes, higher ASP and increased non-systems revenues, mostly related to upgrades and leasing rental programs. Q4 2024, Systems and Services revenue impact by foreign exchange was approximately $0.1 million, flat sequentially. On a year-over-year basis, Systems and Services revenues were unfavorably impacted by foreign exchange of approximately $0.2 million or approximately 0.1%. Systems and Services deferred revenue on the balance sheet was down $4.1 million or 1.8% sequentially, and down $40.3 million, or 15.5% year-over-year, primarily due to the recognition of service revenues, which are recognized ratably over the service period. The decline in deferred revenues, both sequentially and year-over-year, primarily reflects the shorter duration of service contracts applicable to initial scanner purchases. Moving on to gross margin. Fourth quarter overall gross margin was 70%, up 0.3 points sequentially and flat year-over-year. Overall, total gross margin was not significantly impacted by foreign exchange sequentially or on a year-over-year basis. Clear Aligner gross margin for the fourth quarter was 70.2%, down 0.1 points sequentially due primarily to lower ASPs and restructuring costs, partially offset by lower manufacturing costs. Clear Aligner gross margin for the fourth quarter was down one point year-over-year, primarily due to lower ASP and restructuring costs, partially offset by lower additional aligners. Overall, Clear Aligner gross margin was not significantly impacted by foreign exchange sequentially or on a year-over-year basis. Systems and Services gross margin for the fourth quarter was 69.4%, up 1.9 points sequentially due to lower manufacturing and freight costs, partially offset by lower scanner ASPs. Systems and Services gross margin for the fourth quarter was up 4.7 points year-over-year due to manufacturing efficiencies and lower freight costs and service cost and higher scanner ASPs. Overall, Systems and Services gross margin was not impacted by foreign exchange sequentially or on a year-over-year basis. Q4 operating expenses were $552.8 million, up 6.4% sequentially and up 11% year-over-year. On a sequential basis, operating expenses were $33.3 million higher due primarily to restructuring costs. Year-over-year operating expenses increased by $54.8 million, primarily due to restructuring, advertising and marketing expenses. Q4 restructuring charges related to severance for impacted employees were higher than anticipated. On a non-GAAP basis, operating expenses were $474.7 million, up 0.4% sequentially and up 6.3% year-over-year. Our fourth quarter operating income of $144.1 million resulted in an operating margin of 14.5%, down 2.1 points sequentially and down 3.4 points year-over-year. Operating margin was favorably impacted by foreign exchange of approximately 0.1 points sequentially and unfavorably impacted by 0.2 points year-over-year. The effective restructuring on GAAP operating margin was approximately 3.7 points. Q4 non-GAAP operating margin was 23.2%, up 1.1 points sequentially and down 0.6 points year-over-year. Interest and other income and expense net for the fourth quarter was an expense of $3.4 million compared to income of $3.6 million in Q3 2024, primarily due to unfavorable foreign exchange movements of $15.3 million, partially offset by higher interest income and gain on investments. On a year-over-year basis, Q4 2024 interest and other income and expense was unfavorable compared to income of $1.3 million in Q4 2023, primarily due to unfavorable foreign exchange movements, partially offset by higher interest income and gain on investments. The GAAP effective tax rate in the fourth quarter was 26.3% compared to 30.1% in the third quarter and 28.3% in the fourth the fourth quarter of prior year. The quarter GAAP effective tax rate was lower than the third quarter effective tax rate primarily due to the release of uncertain tax position reserves, partially offset by onetime deferred tax adjustments in certain foreign jurisdictions. The fourth quarter GAAP effective tax rate was lower than the fourth quarter effective tax rate of the prior year, primarily due to the release of certain tax position reserves, partially offset by one-time deferred tax adjustments in certain foreign jurisdictions. On a non-GAAP -- our non-GAAP effective tax rate in the fourth quarter was 20%, which reflects our long-term projected tax rate. Fourth quarter net income per diluted share was $1.39, down $0.16 sequentially and $0.25 compared to the prior year. Our Q4 2024 EPS was unfavorably impacted by a stronger US dollar, which amounted to approximately $0.14 per diluted share to net foreign exchange losses related to the revaluation of certain balance sheet accounts. On a non-GAAP basis, Q4 2024 net income per diluted share was $2.44 for the fourth quarter, up $0.9 sequentially and up $0.02 year-over-year. Moving on to the balance sheet. As of December 31, 2024, cash and cash equivalents were $1,043.9 million, up sequentially $2 million and down $106.4 million year-over-year. Of our $1,043.9 billion balance, $188.7 million was held in the US and $855.2 million was held by our international entities. During Q4 2024, we initiated a plan to repurchase $275 million of our common stock through open market repurchases. As of December 31, 2024, we had purchased approximately 0.9 million shares at an average price of $222.94 per share for an aggregate of approximately $202.9 million. The remaining $72.1 million of the $275 million was completed in January of 2025. As of January 30, 2025, $225 million remains available for repurchases of our common stock under our stock repurchase program approved in January of 2023. As Joe mentioned earlier, during the quarter, we completed a $30 million equity investment in Smile Doctors, the largest ortho-focused dental support organization in the US. Q4 accounts receivable balance was $995.7 million, down sequentially. Our overall days sales outstanding was 90 days, down approximately three days sequentially and up approximately five days as compared to Q4 last year. Cash flow from operations for the fourth quarter was $286.1 million. Capital expenditures for the fourth quarter were $23 million, primarily related to investments in our manufacturing capacity and facilities. Free cash flow, defined as cash flow from operations less capital expenditures, amounted to $263 million. Before I turn to our Q1 and fiscal 2025 outlook, I'd like to provide the following context around pricing and potential new tariffs. On March 1, 2025, we will raise the list price of clear aligners by about 3% on average in the Americas and EMEA regions. At the same time, we will remove the $10 to $15 per order processing fee for all new clear aligner orders, all new clear aligner refinement orders from past cases and non-DSP Vivera cases. We expect the net effect from these two actions on ASPs to be zero for 2025. We currently manufacture clear aligners in Mexico and ship them to the US primarily for our US customers, with the remainder eventually shipping to other international locations. The US-Mexico tariff situation remains very fluid, and we are unable to predict whether new tariffs will go into effect in the future. We are monitoring events closely. Our Clear Aligner COGS include material, labor, overhead and freight costs. We expect an incremental tariff if implemented, to be applied to transfer prices from Mexico shipments to the US. These transfer prices would not include treatment planning costs, freight and other overhead and similar costs. Align's global operations have evolved significantly over the past several years, and we have greater flexibility to support our global business. However, assuming a new 25% tariff on shipments the US from Mexico, we believe it still would be more economically viable to ship clear aligners from the US -- to the US for Mexico due to a variety of factors, including the incremental additional freight costs incurred, where we shipped from our Polish facility. Regarding China, we currently manufacture our products in China for the benefit of our customers China. With that as a backdrop, assuming no circumstances occur beyond our control, including foreign exchange and new tariffs, for Q1 2025 and fiscal 2025, we provide the following outlook. We expect Q1 worldwide revenues to be in the range of $965 million to $985 million, down sequentially from Q4, primarily due to the impact from foreign exchange rates at current spot rates and lower capital equipment sales, reflecting historical Q1 seasonality. We expect Q1 Clear Aligner volume to be up slightly sequentially and expect Q1 Clear Aligner ASPs to be down sequentially, primarily due to unfavorable foreign exchange at current spot rates as well as continued product mix shift to non-comprehensive Clear Aligners. In addition to seasonality, we expect Q1 Systems and Services revenue to be down sequentially due to the timing of commercial availability of our iTero Lumina scanner with restorative software, which is expected at the end of March. We expect our Q1 2025 GAAP operating margin to be below Q1 2024 GAAP operating margin by approximately 2 points, primarily due to unfavorable foreign exchange at current spot rates. We expect our Q1 2025 non-GAAP operating margin to be below Q1 2024 non-GAAP operating margin by approximately 1 point, primarily due to unfavorable foreign exchange at current spot rates. For fiscal 2025, we expect 2025 year-over-year revenue growth to be in the low single-digits, which reflects approximately 2 points of unfavorable foreign exchange at current spot rates. We expect 2025 Clear Aligner volume growth to be up approximately mid-single-digits year-over-year compared to up 3.5% year-over-year in 2025. We expect 2025 Clear Aligner ASPs to be down year-over-year due to unfavorable foreign exchange at current spot rates and continued product mix shift to noncompetitive, non-comprehensive Clear Aligners. We expect 2025 Systems and Services year-over-year revenues to grow faster than Clear Aligner revenues. We expect 2025 GAAP operating margin to be approximately 2 points above 2024 GAAP operating margin, and we expect 2025 non-GAAP operating margin to be approximately 22.5%, which both reflect the impact of unfavorable foreign exchange at current spot rates, partially offset by the benefits from restructuring actions we took in Q4 to improve profitability and give us margin accretion in 2025, even as we scale our next-generation direct 3D printing fabrication manufacturing. We expect our investments in capital expenditures for fiscal 2025 to be between $100 million and $150 million. Capital expenditures primarily relate to building construction and improvements, as well as manufacturing capacity in support of our continued expansion. Overall, I am pleased with our fourth quarter and fiscal 2024 results, particularly the year-over-year Clear Aligner volume growth, the record number of submitters, the continued momentum from our Systems and Services business, and our operating margin improvement. After repurchasing $353 million of our Align common stock during 2024, we continued -- we concluded the year with no debt and approximately $1.044 billion in cash and cash equivalents. Our goal, as always, is to deliver value to our shareholders. Now, I'll turn the call -- now I'll turn it back over to Joe for final comments. Joe?"
},
{
"speaker": "Joe Hogan",
"text": "Thanks John. In closing, 2024 was a year of solid progress across the business. Record full year total worldwide revenues of $4 billion, record full year total worldwide System and Services revenue of $769 million, record teen shipments and growth in both teens and adult markets, record 130,400 doctors shipped to, 19.5 million total patients treated, with 5.6 million teens in kids. We ended the year with over $1 billion in cash and equivalents after repurchasing 1.5 million shares for $353 million. In another year where the dental industry is down and we continue to grow, I feel good about where we ended the year, and I'm excited to kick off 2025 with a team focused on building the innovations introduced in 2024 that drive efficiency and growth for practices and that are committed in delivering the best customer and patient experiences in the industry. I want to highlight just a few of the Align innovations that we introduced in 2024 that we believe will continue to drive adoption and utilization. In January 2024, we unveiled a breakthrough technology, the iTero Lumina intraoral scanner with 3x wider field of capture and a 50% smaller wand that delivers faster scanning, higher accuracy and superior visualization for greater practice efficiency and with orthodontic workflows. We look forward to introducing at the end of Q1 2025, the iTero Lumina intraoral scanner with software capabilities to enable efficient restorative and ortho restorative workloads to help general practitioner dentists deliver exceptional restorative outcomes. The iTero scanner is the front end of Align digital platform, designed to give doctors the capability to run simulations and communicate with patients, so the patients can see their smiles and the time that it would take them to get that outcome. It's also a big part of our growth algorithm, and we've had good accretive margin on the iTero Lumina scanner product since its launch. We also started rolling out ClinCheck in minutes, delivering treatment plans based on doctors building personalized treatment preferences for almost touchless digital workflows, which we'll expand to more doctors this year, bringing an unprecedented level of speed and customization to digital treatment planning. Changing the paradigm for how doctors can treat growing patients is one of our biggest opportunities. As we continue to deliver innovations that help doctors achieve more of a treatment at younger ages, potentially decreasing the amount of orthodontic treatment that younger and teen patients need overall. As we continue to commercialize the Invisalign Palatal Expander system, Align's first direct 3D-printed device that provides doctors with a solution set to treat the most common skeletal and dental malocclusions in growing children, we anticipate introducing the next in a series of direct 3D-printed devices with a pilot for Invisalign First direct printed retainers in the first half of 2025. We have also Invisalign mandibular advancement with the occlusal blocks now in limited market release, giving doctors and patients a better option for Class II correction in younger patients while simultaneously strengthening their team. We're also excited about the future of digital orthodontics focused on growth opportunities as a company while driving margin improvement and our unique ability to leverage aggregated and anonymized data from approximately 19.5 million Invisalign cases to continue to gain more knowledge about the science of orthodontics to move the industry forward. And while we're now in our 28th year, in the same way, we're just at the beginning. It's that motivating and exciting for the whole Align team. With that, I thank you for your time today. I look forward to updating you on our continued progress over the coming quarters. Now I'll turn the call back to the operator for your questions. Operator?"
},
{
"speaker": "Operator",
"text": "At this time, we will be conducting a question-and-answer session. [Operator Instructions] And our first question will come from the line of Michael Cherny from Leerink Partners. Your line is open."
},
{
"speaker": "Michael Cherny",
"text": "Good afternoon, and thank you for a ton of detail already. Maybe if I could just dive in a bit to the guidance, especially on the Clear Aligner side. Is there any way to give a little bit more of a breakdown as you think about the dynamics on volume versus price? Hear you loud and clear on the ASP impact from FX. But curious how to the growth dynamics on aligners as a whole, especially coming off of the mix of, obviously, easier comps in 2024 versus what's still an uncertain macro environment? Thank you."
},
{
"speaker": "John Morici",
"text": "Yeah. Michael, this is John. When we talk about the -- kind of give picture for the total year, we're looking at volume for Clear Aligners at up mid-single digits, and that's how we look at that. It varies like it does across different regions and different times of the year and so on. But we've looked at it that way, and that's the perspective that we have for year. We were pleased with how we exited in 2024 with the volumes that we had, and that's the overall guidance that we have for the year."
},
{
"speaker": "Michael Cherny",
"text": "And just along those lines and the volumes, mid-single digits, obviously, a really solid number. How do you think about the competitive dynamics in the market now? And are there opportunities either in terms of other competitors exiting? Or how do you think about the components of what drives that in terms of market dynamics, competitive dynamics, share gains, anything more to break down that obviously strong number would be great as well. Thank you so much."
},
{
"speaker": "Joe Hogan",
"text": "Yeah. And Michael, it's Joe. I think on the competitive dynamics, I don't see a big change in the dynamics when you look at 2024 and 2025. Overall, we feel our new innovation all continues to put us ahead. Obviously, the Minute ClinCheck really drives our super users to a level of productivity they haven't had before. So I feel really good about our competitive ability all around the world, including China, including some specific areas about it. So as we move into 2025, I really feel that we're gaining momentum in that sense."
},
{
"speaker": "Operator",
"text": "Thank you. One moment for next question. Our next question will come from the line of Elizabeth Anderson from Evercore ISI. Your line is open."
},
{
"speaker": "Elizabeth Anderson",
"text": "Hi, guys. Congrats on the quarter, and thanks so much for the question. I was wondering, if you could talk about two things. Maybe as regards to the Lumina and the scanner business more broadly, it looked like you were -- you obviously have the launch coming up in the first quarter. So if you could talk a little bit on your expectations for that, maybe given what you've learned on the ortho side for Lumina? And then two, you talked about sort of the impact, obviously, of more leases and things like that versus perhaps capital equipment sales. Can you talk about, sort of, help us understand maybe on a unit basis, how you're thinking about the growth in that business? I think that would be one thing that would be helpful. And then maybe if you could also help us understand a little bit better that maybe some of the growth dynamics, particularly in North America, DSO versus non-DSO customers? Thank you."
},
{
"speaker": "Joe Hogan",
"text": "Elizabeth, it's Joe. I'll take the first part of your question. When you look at what we learned in the orthodontic release of Lumina was a product was everything we hoped it would be. I talked about the wider field of view, the speed. I didn't talk a lot the optics. So image quality is fantastic on the product line. The lightness of the one and all that was really important for the technicians that that use wand day in and day out because in the past, we had a lot of complaints in the sense of the heaviness and kind of bulkiness of the wands that are in the marketplace right now, particularly on the confocal imaging side. So as we move that into more of the restorative marketplace, remember, we had a good take-up of GPs using that product line last year, too. This will complete the -- the whole system for GPs because they can do the restorative work they had on it and not just the orthodontic side. So we're excited about it. We're looking forward to it. Obviously, we'll talk about it coming up at the IDS, and we look forward to launching it in March and then bringing you through the second quarter."
},
{
"speaker": "John Morici",
"text": "And as Joe said, kind of to your second part of the question, Elizabeth, look, this rounds out our portfolio. We've got a complete portfolio from the most advanced scanner and the latest with Lumina to all other types of products that we have, all the way down to certified pre-owned. And so that portfolio is rounded up, but we also, as you mentioned, the leasing and other rental, we offer a lot of options for our customers. Some customers want to buy, and they want that legacy equipment, that's great, and they'll buy that new equipment, do trade-ins or just add another scanner and so on. But some also don't want to put that capital up, especially in this environment. So we offer them a lot of different opportunities to lease that equipment to use external financing that gets them at a good rate for external financing to purchase, or some just want to rent it. And so we feel like we can offer that customer any which way that they want to be able to utilize our equipment. And as we continue to release new products, keep we surf pre-owned in and so on. We're just expanding our base, which is helpful for our overall business."
},
{
"speaker": "Shirley Stacy",
"text": "Thanks, Elizabeth. Next question,"
},
{
"speaker": "Operator",
"text": "Thank you. One moment for our next question. Next question will come from the line of Glen Santangelo from Jefferies. Your line is open."
},
{
"speaker": "Glen Santangelo",
"text": "Hi. Thanks for taking my question. Hey, Joe, I also want to follow up on this volume issue because it seems like in the fourth quarter and into 2025, you're forecasting some pretty decent volumes. And I'm kind of curious, could you put that in the context of where you think the overall ortho industry is now? Do you feel like you're kind of getting some share back because in 2024, in 2023, the theme was macro uncertainty, but you're not really talking about that anymore? And I'm just kind of curious if you think maybe the industries get a little bit better? Or is some of these DTC offerings that may be faded into the background, like what's enabling you to improve your volume, you think? And then I just had a follow-up for John."
},
{
"speaker": "Joe Hogan",
"text": "Yes, Glen, it's a good question. I think we've been talking about stability for a while now, too. And again, I think we stand on that platform also. Each one of these regions are different from what we've seen. We felt good about Europe in the fourth quarter. We saw some momentum there, felt reasonable about APAC in a sense, I mentioned China and Japan. And increases in Thailand and different in China and different -- I mean, in different parts of the APAC region. When you come to the United States, the orthodontic marketplace, Glen, has really been flat for the last three years. Now, I think we made progress, good progress with the new products that we've had. But we've been challenged in that segment. And I wouldn't call it so much competition as I would -- it's been a wires and brackets kind of regression in that marketplace because of when doctors are seeing less patient throughput, they're looking to save margin, and it's difficult to really appeal to them with clear aligners when they're not at capacity in that sense. But on the counter of that, Glen, we've seen really good progress in GPs and good growth in GPs, not just in the US but all over the world, and that's really helped us. And so remember, we changed our channel strategy years ago to make sure that we went to the GP channel with the GP sales force and ortho, with ortho sales force, too. And I think that's really helped us to give us insight into the industry and position our products properly for both those areas. So I hope that helps to answer your question. I think our new technology, too, gives us a lot of confidence. Specifically in the orthodontic channel since offering differentiation, those early patients that we talked about. We feel we have the three products I mentioned in my script, we feel we have something that's special in the orthodontic community in a sense of that younger patient piece, and you'll see us push that really hard as we move into 2025."
},
{
"speaker": "Glen Santangelo",
"text": "That's awesome. And John, maybe if I could just follow up with you on this ASP issue, right? I mean, obviously, everyone is focused on the fact that ASPs will be down. And you highlighted FX and you highlighted mix shift. I was wondering if you could just unpack that a little bit to tell us -- and I'm sorry if I missed this, exactly how much FX is playing a role here on that ASP number in 2025?"
},
{
"speaker": "John Morici",
"text": "Yes. Yes. That's a good question, Glen. Overall, when we look at 2025 in terms of how we've guided, we have about 2 points of FX headwind on a year-over-year basis. It's just the strengthening of the dollar. We saw that as it came out October and it continues to be strong November, December, January. We're basically forecasting what we see now on a spot rate standpoint and expecting it to be strong, and that impact is about 2 points unfavorable on a year-over-year basis."
},
{
"speaker": "Glen Santangelo",
"text": "Okay. Thank you very much."
},
{
"speaker": "Operator",
"text": "One moment for our next question. Our next question will come from the line of Jon Block from Stifel. Your line is open."
},
{
"speaker": "Jon Block",
"text": "Thanks, guys. Hey, Joe. First one, the 1Q 2025 revenue guidance is down around 2% at the midpoint. The full year revenue guidance is up low-single digits. And I think some of that is the 1Q comp, I believe also the scanner timing, if you would, due to the Resto launch. But I think it's an important question, Joe. Can you talk about other reasons why the rest of the year, you're arguably up, call it like low to mid-single digits versus the down 2% and 1Q 2025, again it's a guide? And then I think what people are going to be worried about is, is there an embedded assumption that things pick up in the guide? Or is it just sort of the moving parts again of the comp, the Resto launch, et cetera? And I'll sort of pause there and then I'll ask my follow-up."
},
{
"speaker": "Joe Hogan",
"text": "John, I'd say we obviously introducing the restorative scanner in March, we don't get the full benefit of that in the first quarter, and you're accurate in the sense of reflecting that in your comments overall. I would say we're not talking about a build as we go through the year. I think you have to look at exchange on a whole thing, and John can explain that in a sense of how we've baked that in overall. But obviously, you have a full year of IPE coming in this year. We have the regulatory approvals for that going into Europe and different parts of Asia, too, and we think we'll hit mainstream in that end too. And may deal with advancement with a plus of blocks too is another one that we think is going to be a specific grower for us also. So I mean, that's how I'd pretty much tackle that is that we have new technology rolling in. You have the iTero restorative coming in also. And John, what would you add?"
},
{
"speaker": "John Morici",
"text": "Yes. And we're not expecting, Jon, any overall improvement in the macro economy. If it happens, great, that will be good for the entire business. But we're not expecting an overall improvement there. We did see as we came out of Q4, I mean, just the 6% growth in volume in Q4, that's the highest growth that we've seen in three years on a year-over-year basis. So that's good to see. We want to continue to see that that momentum. And like Joe said, we're doing everything we can with new products, new innovations, new ways to go to market to be able to continue that."
},
{
"speaker": "Jon Block",
"text": "Yes. No, beat on balance, got it ahead on balance for 1Q, I get that. And then just second question is, I think, Joe, this one is for you. But for a couple of quarters now, at least two, maybe more, we've heard you detail, call it, the faster growth from the DSOs. And so a couple of questions here. Joe, what is are the DSOs, call it, as a part of your North American business, if you could just give us a rough number? But more importantly, the plays that you run with the DSOs -- and we've heard of some those, the marketing support -- pardon -- this is my language, not your -- they might be more sophisticated with your help. Are those transferable to the fragmented GP market? And if so, how long does that take to go ahead and manifest on your part? Because clearly, if you could extrapolate that faster growth to the individual practices, that would be -- certainly, I'm positive and something to get excited about. So, maybe your comments on, again, the percent of their weighting of your bids? And more importantly, can you see yourself running the same plays with the individual practices?"
},
{
"speaker": "Joe Hogan",
"text": "Hey Jon, it's a great question. Really, first of all, I look at -- I talk about it internally, too. I look at DSOs as a force multiplier. They can actually take our technology, what we learned in a sense of a sense of efficiency, what we learned from brand, from a demographic zone brand you can apply to. And they just have an ability to be able to disseminate that within their teams. Much better than doing that individually door-to-door like we do with our normal sales force, which is kind of obvious. But that doesn't preclude us from what we're taking to the DSOs in the sense of what we know and what they incorporate. Our salespeople are -- many of them have been with us many years, they understand that also. They just have to find the right orthodontists and the right general dentists to really want to implement those procedures in their marketplace. That's why I -- talking about the sales kickoff the other day down in Dallas. And it said that we have the longest or the hardest last mile of any company I've ever worked with because you are calling on these individual family-driven practices. And not that they're stupid or anything, they are very smart. But they're very -- not necessarily business minded always. They're clinically minded, and it takes a while to gain their confidence and move it forward. DSOs help to accelerate that, Jon, is the best way I can explain that. Jon, you've got--"
},
{
"speaker": "Jon Block",
"text": "Thanks for the color guys."
},
{
"speaker": "Joe Hogan",
"text": "Jon, thank you."
},
{
"speaker": "Operator",
"text": "Our next question comes from the line of David Saxon from Needham. Your line is open."
},
{
"speaker": "David Saxon",
"text": "Great. Good afternoon Jon and John. Thanks for taking my questions. Yes, I had a couple of follow-ups on the guide for Clear Aligner. So, mid-single-digit volume growth for Clear Aligners. Joe, based on your answer to a previous question, it sounds like U.S. volume growth should probably be slower than international, but I just wanted to confirm that's how you're thinking about it? And then on the ASP side, to down year-on-year for the full year, first quarter ASPs look be to down high single-digits year-on-year based off of the first quarter ASP guidance. But you have this price increase starting in second quarter. So, just I'd love to hear how we should think about pricing in quarters two through four on a year-over-year basis?"
},
{
"speaker": "Joe Hogan",
"text": "Hey David, I'll take the first part of your question, which, yes, our forecast for next year does imply a slower U.S. than the rest of the world. And that's -- to me, that's -- we're just projecting what we saw in 2024 into 2025. But we don't have any data right now that would make us change that in some way from a consumer confidence. And to see or any kind of change in the last several quarters, I would say that it would be different going. As far as ASPs go..."
},
{
"speaker": "John Morici",
"text": "Look, ASPs, they're heavily impacted with our business, over 50% of it outside the U.S. They're impacted by a stronger dollar. And I just tried to make it very clear in terms of our guidance based on what those spot rates are as of now and saying this is how it's going to play out in the future. Obviously, it changes. And -- but at least give you a reference point to jump off of. So when you look at Q1, you'd see that ASPs will be down. It's a reflection of the foreign exchange, and that's the primary driver of that. It will change as it goes through each of the quarters. I mean, by the end of the year, it kind of catches up, and that strength of the dollar that we saw in November and December won't have as much a year-over-year impact. But in Q1, it has that impact."
},
{
"speaker": "David Saxon",
"text": "Okay. All right. That's helpful. And then maybe sticking with you, John. So operating margin down year-on-year in the first quarter, but guiding to expansion for the full year. So I'd love to just hear kind of the puts and takes that drive that ramp? And maybe it would be great if you could talk about quarterly cadence. Thanks so much."
},
{
"speaker": "John Morici",
"text": "Yes. When you think of the op margin that we'll have, we did actions last year to be able to get our op margin in a place from a cost standpoint to be able to provide that margin accretion. The first quarter is one where, as you start to ramp up, usually first quarter op margin is and at a rate standpoint, the lowest or one of the lowest for the quarters as you -- it builds as you go through year. It's based on volume. As we have more volume coming through our facilities, we generate additional productivity, and that shows up. We have new products, as Joe described, with the Lumina Restorative, different products where we're expanding out and so on that help us drive additional margin as we go through. So we've got the levers that we can pull and adjust as we go through the year to be able to generate that margin accretion on a year-over-year basis. And that is margin accretion that we talked about at 22.5%, that's despite unfavorable FX on a year-over-year basis. So you can tell some of that margin accretion that that we're talking about. But it's -- it's all about driving productivity through volume you have and being smart about the other investments that you're making."
},
{
"speaker": "David Saxon",
"text": "Great. Thanks so much."
},
{
"speaker": "John Morici",
"text": "Thanks, David."
},
{
"speaker": "Operator",
"text": "One moment for next question. Our next question will come from the line of Jeff Johnson from Baird. Your line is open."
},
{
"speaker": "Joe Hogan",
"text": "Hi, Jeff."
},
{
"speaker": "Jeff Johnson",
"text": "Hi, thanks. Hi, Joe, how are you? Good afternoon, guys. So look, we're all going around kind of this 1Q, trying to understand it relative to the rest of the year. The one thing I haven't heard and maybe I just missed it, but you guys are talking about a 200 basis point headwind for the year from currency. I think that is pretty much flow through to ASP as to ASP as well, about a two-point headwind for the year well on the Clear Aligner side. But I haven't heard you quantify Q1. My math and my currency math is terrible, but my math would put currency at almost a 3, 3.5 point headwind in 1Q to both ASPs and global revenue. Am I close on that? Is it bigger in 1Q?"
},
{
"speaker": "John Morici",
"text": "Yes. That's the right way to phrase it, Jeff. It is bigger just based on what the dollar was doing last year compared to this year. So there is a bigger currency effect in Q1 than on average for the year."
},
{
"speaker": "Jeff Johnson",
"text": "Ballpark, am I close on that 3, 3.5?"
},
{
"speaker": "John Morici",
"text": "Yes. You're close on that."
},
{
"speaker": "Jeff Johnson",
"text": "Okay. And then just my other question is really kind of the same kind of FX question, but on the gross margin side -- sorry, on the company margin side, on the operating margin side. You're guiding to 70 basis points of year-over-year improvement at the op margin line on a non-GAAP basis. How much is currency weighing on, I don't care if it's gross margin or operating margin, however you want to provide the answer. But how much is currency weighing there? And then how much of the incremental direct fab investments potentially weighing this year on gross or overall margin? It seems like this could have been a year if currency neutral and you didn't have the direct fab incremental investments that we really would have started to see a recapture back towards those pre-COVID numbers. So just trying to understand all those moving pieces? Thank you."
},
{
"speaker": "John Morici",
"text": "Yeah. Jeff, when you talk about the FX impact on op margins, its over one point, you're right, it's two points at revenue on a year-over-year basis, falls to just over one point on an op margin basis. So a large part of that falls through. So, you're right, calling 70 basis point improvement year-over-year. That's despite having one point of op margin pressure from an FX standpoint. And then, of course, all the other things that we're doing to invest in. So and there's some offsets to that in terms of scaling up our growth platforms and so on. But that's all in the number that we have at the 22.5%. So if FX was going the other way, you would see even more margin accretion, and we'll see how that foreign exchange plays out as we go through the rest of the year."
},
{
"speaker": "Jeff Johnson",
"text": "Understood. Thank you guys."
},
{
"speaker": "Joe Hogan",
"text": "Thanks Jeff."
},
{
"speaker": "Operator",
"text": "One moment for next question. Our next question will come from the line of Brandon Vazquez from William Blair. Your line is open."
},
{
"speaker": "Brandon Vazquez",
"text": "Hi, everyone. Thanks. Hey guys, thanks for taking the question. Joe, maybe for you on the IPE side, I think we're a little bit over year after the launch of that product now. Curious if you could comment on maybe two things. One, what's the adoption curve looking like relative to your expectations now that we're about a year in? And then two, is this a product that could maybe be a catalyst within the teen market to let you get that next incremental leg of adoption given that that's kind of the third year end market that you guys are underpenetrated in?"
},
{
"speaker": "Joe Hogan",
"text": "Yeah. Brad, first of all, I mean, the adoption curve has been good, as I mentioned in my script, it follows Invisalign First. Invisalign First is what we call a dental expansion product. It's kind of moving your teeth, but it's not moving bone in that sense. In this case with IP, we're moving bone. And so that's why the regulatory things and all that I mentioned that we have to go through each region in order to move that through. I feel really good about it. It's such a breakthrough product and a different product. It takes doctors a while in a number of cases to become comfortable with it. We have a wonderful feedback from patients in the sense of the comfort of the product line. And many of the patients or parents have gone through the Hi-Res [ph] device and the wrench and those kind of things. And that makes parents a little more susceptible to wanting Invisalign Palatal Expander too. So I feel good about it. We've had some things too on the release. We didn't have full visualization from a scanning standpoint when we first started. There were some attachment pieces that we had to improve in the sense of how you attach. And then there's also some just wearability aspects about how long you wear this. But we've come over those and we're making good progress in it. So I'm very optimistic about it. And it's great to see it really go from a regional standpoint to a global standpoint now. But we have a great one, two punch in that marketplace with Invisalign First. And that's also worth mentioning, too, we're seeing many doctors, as they do the upper palate expansion, they use Invisalign First on the bottom in order to expand the teeth to be -- to make sure that they're in line with the sense of the bite as they're setting in their upper arch, too. So it's good to see a synergistic effect on those two products. I hope I answered your question, but that's the momentum that we're talking about."
},
{
"speaker": "Brandon Vazquez",
"text": "Yeah. Maybe as a quick follow-up on a separate note. International has been more durable for you guys in the Americas these days. Is that simply a result of just being earlier in the adoption curve and so things are doing a little bit better there? Or is macro and international just doing a little bit better than the Americas? Just trying to understand how durable international outperforming should be as we go into 2025 even if macro and Americas stays relatively muted? Thanks."
},
{
"speaker": "Joe Hogan",
"text": "It's hard to be discrete on that answer. Overall, Brandon, I would say there are certain areas where, obviously, it's the initial penetration of our product line in certain area, but I certainly wouldn't say that about Latin America. We've been now for many years and we see continued growth in that sense. Middle East, Africa in those areas too, some of the places of Africa are new, and they'll hit a certain inflection point. But overall, I feel like we face better economies in those regions. They didn't necessarily, I think, overextend their economies, the way we saw in the Western world and which has affected a large part of Western Europe and also in the United States. And specifically in Asia, outside of China, the other countries in Asia just came back out of COVID in a better position than we were before. But some of those countries are penetration. Some of those countries are just expansion too. So I think overall, it's just a good mix there, Brandon. And I like that. It's good to have. And then as you roll out these new technologies, remember it offers you new opportunities in those countries, too. So that expansion piece can continue."
},
{
"speaker": "Shirley Stacy",
"text": "Thanks, Brandon. Operator, we want to try and get through the covering analysts that are still on the line. So -- and if I can ask folks to limit to one question so we can get through everyone's questions, please."
},
{
"speaker": "Operator",
"text": "Thank you. One moment for our next question. Our next question will come from the line of Jason Bednar from Piper Sandler. Your line is open."
},
{
"speaker": "Jason Bednar",
"text": "Hey, good afternoon. Thanks for taking the question. I'll try be an quick here. I really want to ask on just maybe thematically reducing frictions -- I'm sorry, trailing to pack kind of a combo in here, but this is -- is there a way to reduce frictions within the teen channel and really address what has been maybe a bit of a challenge or sluggish ortho environment? Anything that you can do from a marketing initiative to really create better demand pull effect? And then also on the friction side, maybe help with the business rationale, removing that $10 to $15 process, and you see you all neutralizing it with price increases. Is that -- have you had pushback on the processing fees? Has this caused friction with doctors that you're trying to remove? Thank you."
},
{
"speaker": "Joe Hogan",
"text": "Yeah, Jason, that's a good question. First of all, the friction in teen channel is -- a lot of it has to do with the economics in the orthodontists office today. We talked about the orthodontic offices in the United States haven't really -- in North America haven't seen really any substantial growth in the last three years. And so again, there are individual practices, and I think they're trying to maximize their bottom line as much as they can. And so I think they've been very cautious from a business standpoint. The friction you talked about with our processing fees and all, those are real. We have a pushback, not as much in Asia. We had a lot of pushback in Europe and in the US on that. And we decided to roll that back with that aggregate price increase. And we have a good response from our doctors in order to do that. And that is a friction piece. And it was -- to me, it was an annoyance to the sales team to have to kind of fight through that when they had to talk to doctors in either joining what we were doing or having been with us for a while and explaining those things. So I think that's very helpful. John, I'm sure you have some ideas to it."
},
{
"speaker": "John Morici",
"text": "I mean, in the end, we want to focus on driving this driving this business, category, driving our products too and less about some of the other minor things like this with processing fees and so on. So this is a good opportunity to kind of put this together, get it in the right place and talk about the future of the business versus some of the other past expenses like this."
},
{
"speaker": "Shirley Stacy",
"text": "Yes. Thanks."
},
{
"speaker": "Jason Bednar",
"text": "Thank you."
},
{
"speaker": "Operator",
"text": "One moment for our next question. Our next question will come from the line of Steven Valiquette from Mizuho. Your line is open."
},
{
"speaker": "Steven Valiquette",
"text": "Thanks everyone. Thanks for taking the question. So obviously, there's a lot of puts and takes related to the evolving tariff situation. But one area I was just hoping to get your thoughts on is given that there's a large competitor Chinese base as some investors are watching closely as that competitor tries to establish a larger market share in the US market, really, with this new political backdrop for the next four years under the new administration, I'm wondering whether some practitioners in the US may be a little more hesitant to want to buy into the ecosystem of really any competitors that are headquartered or based outside the US, just given the heightened risk of trade wars, et cetera. So perhaps I could play into your hands favorably, at least in the US market, which I think it's still your biggest market. So just a high level, just curious to get your thoughts on that potential dynamic? Thanks."
},
{
"speaker": "Joe Hogan",
"text": "Hi, Steven, it is, just to confirm, US is still our biggest market in the world in that sense. Remember, I just talked about the orthodontic market not really growing for the last three years, too. So we have had competition. Obviously, we know that your comments really refer to Angel Aligner or maybe some other Chinese suppliers coming in. I think overall, you first win with customer service and you win with technology, you win with relationships, and that's what our sales force is really talking about. We felt that the Chinese have come in on unsustainable prices. When you look at -- we kind of know the prices you have to charge in order to have a decent return. And we think that always takes care of itself one way or another, and we've seen that with other competitors in the marketplace also. So I don't – I can't really speak for 10,000 orthos or GPs that are around the United States and how they feel about international politics or anything they do. But our job is to make sure that we keep our heads down. We deliver the best technology, best productivity, the best brand, all those things to make sure we win in the marketplace, and we'll let that other piece decide for itself."
},
{
"speaker": "Steven Valiquette",
"text": "Okay. Got it. Thanks."
},
{
"speaker": "Operator",
"text": "One moment for our next question. Our next question comes from the line of Kevin Caliendo from UBS. Your line is open."
},
{
"speaker": "Q – Unidentified Analyst",
"text": "Thanks for the question. This is Dylan on from – Dylan Kim on for Kevin. Thanks for the question. A quick question on direct fabrication. You guys previously have talked to potentially commercializing products this year, I believe, starting with the retainer product. So any update there on commercialization of products? And maybe detail on the P&L too into both revenue and investment into costs, into the manufacturing capabilities that you can call out?"
},
{
"speaker": "Joe Hogan",
"text": "First of all, I'd say our IPE device is 3D printed, but it's not the Cubicure process and it's not the resin that we'll used in the Cubicure process. So as I mentioned in my script, we will begin to -- just with limited release, an Invisalign First retainer. Invisalign First retainer is a very complicated. It has to have a high modulus. It has to have a huge amount of variability in the sense of how you structure that depending on where that person's arch is at that point in time. And it's the perfect fit for us as we try to ramp up and we ramp up our new our new Cubicure process with resin too. So again, like I mentioned, you'll see just the beginning of that in the first half of this year. And in the second half of this year, we should begin to get ourselves more ready for general release in third and fourth quarters of that product line. That's the beginning. After that, we'll move into what we call mandibular advancement. But any kind of aligners that have auxiliary types of things that you would have to have printed on those or difficult cases where wall thicknesses need to be different in some ways. So, we're really excited about the efficiency of that particular technology, but also the design and incredible design capability and design freedom orthodontists will have in order to do that. So, that's about as well as I can do for you now."
},
{
"speaker": "Shirley Stacy",
"text": "Thanks. Next question please."
},
{
"speaker": "Operator",
"text": "Our next question from the line of Michael Ryskin from Bank of America. Your line is open."
},
{
"speaker": "Michael Ryskin",
"text": "Hey, thanks for squeezing me in guys. Just one quick one for me, hopefully. John, I appreciate the commentary you had on tariffs to Mexico and realize there's still a lot of moving pieces, but I just want to make sure I understood that. Just a comment on transfer prices. I mean, I hear you on overhead and freight cost, treatment planning not being included. How should we think of it as a percent of your COGS? I think if you just go through the P&L with something like $375 COGS per case roughly? Is the transfer -- like how much would be impacted? Is it 50% to 75% of that? And just walk us through the transfer price math, just so we can--?"
},
{
"speaker": "John Morici",
"text": "No, it's a good question, Mike. And you're right. I tried to give a perspective of, look, you start with COGS and then there's some hard COGS that have nothing to do with what we're doing in Mexico freight and treatment planning and other things, specifically the value add and the work that's being done there than that transfer price. I guess to put it in perspective in terms of -- there's been a lot of people thinking about what this could be, just based on your question and so on. But like on an average month, that tariff, if it's that 25%, might impact us $4 million to $5 million of cost or that might be the cost perspective of this. So, that gives you an idea of like how this kind of fits into this. This is something, as I said in my prepared remarks -- look, if at that amount of tariffs, 25%, if that ever was implemented, it's not a big enough cost on tariff for us to switch some of the manufacturing and move from perhaps manufacturing in Mexico to Poland. But we'll evaluate that as we go forward. But I just want to kind of size that for you. We'll evaluate as we go forward, we'll understand more as these days come about. We hope there's not anything, but we have a perspective in terms of what it means from a cost standpoint, and we will make decisions based on that. And that will impact us what we do in the short and long-term."
},
{
"speaker": "Michael Ryskin",
"text": "Thank you. Thanks."
},
{
"speaker": "Shirley Stacy",
"text": "Operator, we'll take one last question."
},
{
"speaker": "Operator",
"text": "And our last question will come from the line of Erin Wright from Morgan Stanley. Your line is open."
},
{
"speaker": "Erin Wright",
"text": "Great. Thanks for squeezing me in. Just a follow-up on that last one. Just to clarify, so there's no buffer kind of embedded in your guidance as it stands today from a tariff perspective? And just on China, just the environment there, not necessarily from a tariff perspective, but just more so from demand trends? And even China from a competitive standpoint, I guess, expectations for the balance of the year, if you could touch on those? Thanks."
},
{
"speaker": "John Morici",
"text": "That's great, Erin. I'll take the first one on tariffs. So we're not in our forecast and what we've given for guidance at that margin of 22.5%. There's no additional new tariffs that we've contemplated in that number. So, we'll see how things come about. But in the framework, if there is a tariff, and it should be 25% from Mexico to the U.S., it's $4 million to $5 million depending on volume per month from an expense standpoint. And then on China, I don't know if you want to give -- Joe, any other perspective on the kind of the market there?"
},
{
"speaker": "Joe Hogan",
"text": "I'd say the China market, we were pleased with the third quarter. The fourth quarter, obviously, is always less in China what the third quarter was. There was nothing in that that quarter made me think that anything was different in China and since its trajected the business, from what we've seen. So overall, I'd call China stable right now."
},
{
"speaker": "Erin Wright",
"text": "Okay. Thank you."
},
{
"speaker": "John Morici",
"text": "Thank you."
},
{
"speaker": "Joe Hogan",
"text": "You’re welcome."
},
{
"speaker": "Operator",
"text": "And I will now turn the call over back to Shirley Stacy for any closing remarks."
},
{
"speaker": "Shirley Stacy",
"text": "Well, thank you, everyone, for joining our call today. We appreciate it. If you have any follow-up questions, please reach out to Investor Relations. We look forward to seeing you at our next industry events, including the Chicago Midwinter Dental Show coming up here later in February. I hope everyone has a great day."
},
{
"speaker": "Operator",
"text": "This concludes today's conference. You may now disconnect your lines at this time. Thank you for your participation. Everyone, have a great day."
}
] | Align Technology, Inc. | 24,568 |
ALGN | 3 | 2,024 | 2024-10-23 16:30:00 | Operator: Greetings. Welcome to the Align Third Quarter 2024 Earnings Call. At this time, all participants are in a listen-only mode. A question-and-answer session will follow the formal presentation. Please note, this conference is being recorded. I will now turn the conference over to your host, Shirley Stacy with Align Technology. You may begin.
Shirley Stacy: Good afternoon, and thank you for joining us. I'm Shirley Stacy, Vice President of Corporate Communications and Investor Relations. Joining me for today's call is Joe Hogan, President and CEO, and John Morici, CFO. We issued third quarter 2024 financial results today via Business Wire, which is available on our website at investor.aligntech.com. Today's conference call is being audio webcast and will be archived on our website for approximately one month. As a reminder, the information provided and discussed today will include forward-looking statements, including statements about Align's future events and product outlook. These forward-looking statements are only predictions and involve risks and uncertainties that are described in more detail in our most recent periodic reports filed with the Securities and Exchange Commission available on our website and at sec.gov. Actual results may vary significantly, and Align expressly assumes no obligation to update any forward-looking statement. We've posted historical financial statements with corresponding reconciliations, including our GAAP to non-GAAP reconciliation, if applicable, and our third quarter 2024 conference call slides on our website under Quarterly Results. Please refer to these files for more detailed information. With that, I'll turn the call over to Align Technology's President and CEO, Joe Hogan. Joe?
Joe Hogan: Thanks, Shirley. Good afternoon, and thanks for joining us today. On our call today, I'll provide an overview of our third quarter results and discuss a few highlights from our two operating segments, Systems and Services and Clear Aligners. John will provide more detail on our Q3 financial performance and comment on views for the remainder of the year. Following that, I'll come back and summarize a few key points and open the call to questions. Overall, Q3 '24 results were mixed and reflect strong Systems and Services year-over-year revenue growth, as well as good Clear Aligner volume in the Asia Pacific, EMEA and Latin America regions, partially offset by declines in the U.S. As recently reported by many analysts and third-party research firms, the underlying dental market in the United States remains sluggish and our doctor customers cite similar trends. Q3 '24 revenues of $978 million increased 1.8% year-over-year and Clear Aligner volumes of 617,000 were up 2.5% year-over-year. Despite strong growth from Systems and Services revenues, a record [87,400] (ph) doctor submitters, a record 236,000 teens starting treatment, driven by record teen case starts in China, and a record 25,000 of DSP Invisalign Touch-Up cases, total revenues for Q3 were slightly below our Q3 revenue outlook in part due to more pronounced seasonality for Clear Aligners than expected, as well as continued weak consumer sentiment and a soft dental market, especially in the U.S. Q3 '24 non-GAAP operating margin of 22.1% was better than expected and increased year-over-year compared to 21.8% in Q3 of '23. For Clear Aligners, Q3 volumes were up year-over-year and down slightly sequentially. Year-over-year volumes were driven by strong growth in APAC, especially China, as well as growth from the EMEA and Latin American regions. On a sequential basis, Clear Aligner volumes were down from Q2, reflecting more pronounced seasonality and soft dental markets in the U.S., offset somewhat by strength in APAC and Latin American regions. In the teen and growing kids' segment, a record 236,000 teens and younger patients started treatment with Invisalign clear aligners during the third quarter, an increase of 9.1% sequentially and up 6.7% year-over-year, reflecting growth across regions, especially from Invisalign First in the APAC and EMEA regions. In Q3, the number of doctors submitting teen or younger patient case starts was up over 6% year-over-year, led by continued strength from doctors treating young kids, also known as growing patients. During the quarter, we continued to commercialize the Invisalign Palatal Expander, Align's first direct 3D printed orthodontic appliance. Q3 reflected steady momentum for doctor submitters and shipments in the United States and Canada. We recently announced commercial availability in Singapore, and we're excited to extend the availability of the transformative Invisalign Palatal Expander System to even more doctors and their patients in markets across the Asia Pacific region. We expect it to be available in other markets, pending future applicable regulatory approvals. Non-case revenues include our Vivera retainers, retention aligners ordered through our Doctor Subscription Program, or DSP, clinical training and education, accessories and ecommerce. In Q3, non-case revenues were up year-over-year, primarily due to continued growth in retainers and the DSP program, including non-Invisalign patients getting retainers. DSP includes Invisalign Touch-Up cases up to 14 stages and is currently available in North America and certain countries in Europe. For Q3, total Invisalign DSP Touch-Up cases were up nearly 30% year-over-year to more than 25,000 cases. Q3 '24 Clear Aligner volume from DSO customers increased sequentially and year-over-year, reflecting growth across all regions. The DSO business in United States continues to outpace our retail doctors, driven by our largest DSO partners, Smile Doctors and Heartland Dental. We also had strong growth in iTero scanner sales from DSOs investing in their member practices and end-to-end digital workflows. Q3 was another strong quarter for our Systems and Services business, and year-over-year revenue growth was up 15.6%, reflecting higher scanner ASPs and non-systems revenues, driven by iTero Lumina, wand upgrades, increased scanner rentals and certified pre-owned or CPO leasing programs, as well as increased services revenues, partially offset by lower scanner volumes. On a sequential basis, Q3 Systems and Services revenues were down 2.9%, reflecting lower scanner ASPs and non-systems revenues, particularly offset by higher scanner volumes. The iTero Lumina's new Multi-Direct Capture technology replaces the confocal imaging technology in earlier models and has a 3x wider field of capture and a 50% smaller and 45% lighter wand, delivering faster scanning speed, higher accuracy, super visualization and a more comfortable scanning experience. Lumina is currently available with orthodontic workflows as new standalone scanner or as a wand upgrade from the iTero Element 5D Plus scanner. Overall, for Q3, we continue to be very pleased with the ongoing adoption of iTero Lumina scanner, with ortho workflow and response from customers. We currently expect to begin a limited market release for the restorative software on the iTero Lumina scanner in Q1 '25, followed by full commercialization by the end of Q1. Today, we announced new iTero scanner products innovations to further enhance digital dentistry workflows and integrated treatment options in oral health, restorative and aesthetic treatment in general dentistry. Align Oral Healthcare Suite with new comparison tools that aid in multimodality assessments and personalized oral health records and reports. Invisalign Outcome Simulator Pro in multiple treatment simulation to drive chairside patient education about treatment options, and iTero Design Suite with intuitive design capabilities for in-practice 3D printing now commercially available in selected markets. We believe the iTero intraoral scanner innovations introduced today enable doctors to present a variety of treatment options to their patients, supporting chairside education and communications. That helps deliver a great patient experience and supports patients in making more informed choices about their dental treatment and consultation with their doctors. We're also pleased to share that Invisalign Japan was recently awarded the [Golden] (ph) Design Award for 2024 for the iTero Lumina Intraoral scanner, making this the second time we received this prestigious award in the past two years. The Good Design Award is globally known and recognized by domestic and international designers and is the only comprehensive evaluation and recommendation system of design in Japan. The award designation increases the recognition and reliability of awarded works of -- and companies, promotes problem solving through design and focuses on the significance of design to people and society. Before I turn the call over to John, I want to comment on the employment actions we announced today resulting from a global reorganization and restructuring. As part of Align's 2025 annual operating plan process, we identified positions to be eliminated or transferred to other locations. These are difficult actions, and valuable employees will leave the company. As part of this restructuring, Raj Pudipeddi's position as EVP and MD Americas and Chief Marketing Officer has been eliminated and he will leave in the fourth quarter. We thank Raj for his contributions to Align over the past five-plus years in leading our marketing and product innovation and management as well as overseeing the APAC and Americas regions. We wish Raj well. I'm pleased to welcome Frank Quinn back to Align. He is a well-established leader with a customer focus and proven track record in orthodontics and digital dentistry. Frank's deep experience, understanding and insights into what digital means for our doctor customers is key and he is excited to be rejoining Align. With that, I'll now turn the call over to John.
John Morici: Thanks, Joe. Now, for our Q3 financial results. Total revenues for the third quarter were $977.9 million, down 4.9% from the prior quarter and up 1.8% from the corresponding quarter a year ago. On a constant currency basis, Q3 '24 revenues were not significantly impacted by foreign exchange sequentially and were unfavorably impacted by approximately $14.6 million year-over-year or approximately 1.5%. For Clear Aligners, Q3 '24 revenues of $786.8 million were down 5.4% sequentially, primarily from lower volume, higher discounts, product mix shift to lower-priced products and geographic mix, partially offset by lower net revenue deferrals. Q3 Clear Aligner revenues were not significantly impacted by foreign exchange sequentially. Q3 '24 Clear Aligners per case shipment of $1,275 was lower by $20 on a sequential basis due to higher discounts, product and geographic mix, partially offset by lower net revenue deferrals. On a year-over-year basis, Q3 Clear Aligner revenues were down 1%, primarily from lower ASPs, reflecting the impact from unfavorable foreign exchange of $11.7 million or approximately 1.5%, a 20% price reduction in the UK to offset a 2024 ruling by the UK tax authorities in Q1 of '24 that requires a 20% VAT be applied to Clear Aligner sales in the UK, product mix shift to lower-priced products, geographic mix and higher discounts. This decrease was partially offset by lower net deferrals and price increases, along with higher volumes and higher non-case revenues. Q3 '24 Clear Aligner per case shipment of $1,275 was down $45 on a year-over-year basis due to unfavorable foreign exchange of $18, impact of UK VAT of $12, product and geographic mix, higher discounts and partially offset by lower net revenue deferrals and price increases. Our Invisalign Comprehensive [3-and-3] (ph) product is available in North America, EMEA and in certain markets across APAC. We are pleased with the continued adoption of the Invisalign Comprehensive 3-and-3 product and anticipate adoption will continue. Comprehensive 3-and-3 provides doctors the flexibility they want while allowing us to recognize more revenue upfront, with deferred revenue being recognized over a shorter period compared to our traditional Invisalign Comprehensive product, which in turn allows us to benefit from a more favorable gross margin. Clear Aligner deferred revenues on the balance sheet decreased $6.2 million or 0.5% sequentially and decreased $25.8 million or 2% year-over-year and will be recognized as additional aligners are shipped under each sales contract. Q3 '24 Systems and Services revenue of $191 million were down 2.9% sequentially, primarily due to lower ASP and decreased non-system revenues mostly related to fewer upgrades, partially offset by higher scanner volumes. Q3 '24 Systems and Services revenue were up 15.6% year-over-year, primarily due to higher ASPs, increased non-system revenues, mostly related to upgrades in our leasing rental programs, and higher services revenue, partially offset by lower scanner volumes. Q3 '24 Systems and Services revenues impact by foreign exchange was approximately flat sequentially. On a year-over-year basis, Systems and Services revenues were unfavorably impacted by foreign exchange of approximately $2.9 million or approximately 1.5%. The Systems and Services deferred revenues on the balance sheet was down $1.5 million or 0.7% sequentially and down $40.6 million or 15.4% year-over-year, primarily due to the recognition of services revenue, which are recognized ratably over the service period. The decline in deferred revenues, both sequentially and year-over-year, primarily reflects the shorter duration of service contracts applicable to initial scanner purchases. Moving on to gross margin. Third quarter overall gross margin was 69.7%, down 0.5 points sequentially and up 0.7 points year-over-year. Overall gross margin was not significantly impacted by foreign exchange sequentially and was unfavorably impacted by approximately 0.4 points on a year-over-year basis. Clear Aligner gross margin for the third quarter was 70.3%, down 0.5 points sequentially due primarily to lower ASPs and higher mix of additional aligners, partially offset by lower manufacturing spend. Clear Aligner gross margin for the third quarter was down 0.5 points year-over-year due primarily -- due to lower ASPs, partially offset by lower manufacturing spend. On a constant currency basis, Clear Aligner gross margin was unfavorably impacted by foreign exchange by 0.4 points year-over-year. Systems and Services gross margin for the third quarter was 67.5%, down 0.7 points sequentially due primarily to mix, partially offset by lower manufacturing spend and freight costs. Systems and Services gross margin for the third quarter was up 6.5 points year-over-year due primarily to higher ASPs, partially offset by higher service and freight costs. On a constant currency basis, Systems and Services gross margin was unfavorably impacted by foreign exchange by 0.5 points year-over-year. Q3 operating expenses were $519.5 million, down 9.7% sequentially and up 4.6% year-over-year. On a sequential basis, operating expenses were down $56.1 million due primarily to non-recurring legal settlements, advertising and marketing and employee compensation. Year-over-year, operating expenses increased by $22.7 million, primarily due to employee compensation. On a non-GAAP basis, excluding stock-based compensation, amortization of acquired intangibles related to certain acquisitions, restructuring, legal settlements and other charges, operating expenses were $472.7 million, down 5.4% sequentially and up 3.1% year-over-year. Our third quarter operating income of $162.3 million resulted in an operating margin of 16.6%, up 2.3 points sequentially and down 0.7 points year-over-year. Operating margin was favorably impacted from foreign exchange of approximately 0.1 point sequentially and unfavorably impacted by 0.8 points year-over-year. On a non-GAAP basis, which excludes stock-based compensation, amortization of intangibles related to certain acquisitions, restructuring, legal settlements and other charges, operating margin for the third quarter was 22.1%, down 0.2 points sequentially and up 0.3 points year-over-year. Interest and other income and expense net for the third quarter was an income of $3.6 million, primarily due to foreign exchange compared to an expense of $3.2 million in Q2 of '24 and an expense of $4.2 million in Q3 of '23. The GAAP effective tax rate in the third quarter was 30.1% compared to 32.9% in the second quarter and 25.1% in the third quarter of the prior year. The third quarter GAAP effective tax rate was lower than the second quarter effective tax rate primarily due to adjustments related to tax return filings, partially offset by a small increase in uncertain tax position reserves. The third quarter GAAP effective tax rate was higher in the third quarter -- than the third quarter effective tax rate in the prior year primarily due to recognizing a one-time benefit related to the application of tax guidance issued during the third quarter of the prior year. Our non-GAAP effective tax rate in the third quarter was 20%, which reflects our long-term projected tax rate. The third quarter net income per diluted share was $1.55, up sequentially $0.27 and down $0.03 compared to the prior year. Our EPS was favorably impacted due -- primarily due to foreign exchange by $0.03 on a sequential basis and unfavorably impacted by $0.08 on a year-over-year basis. On a non-GAAP basis, net income per diluted share was $2.35 for the third quarter, down $0.06 sequentially and up $0.21 year-over-year. Moving on to the balance sheet. As of September 30, 2024, cash and cash equivalents were $1,041.9 million, up sequentially $280.5 million and down $197.1 million year-over-year. Of our $1,041.9 million balance, $285 million was held in the U.S. and $756.5 million was held by our international entities. We have $500 million available for repurchase of our common stock under our January 2023 repurchase program. Beginning in Q4 2024 and continued into Q1 '25, we expect to repurchase up to $275 million of our common stock through either a combination of open market repurchases or an accelerated stock repurchase agreement. Q3 accounts receivable balance was $1,010.6 million, down sequentially. Our overall day sales outstanding was 93 days, up approximately four days sequentially and up approximately eight days as compared to Q3 last year. Cash flow from operations for the third quarter was $263.7 million. Capital expenditures for the third quarter were $29.8 million, primarily related to investments in our manufacturing capacity and facilities. Free cash flow, defined as cash flow from operations less capital expenditures, amounted to $233.9 million. Turning to our 2024 outlook. Assuming no circumstances occur beyond our control, including foreign exchange, we expect the following business outlook for the fourth quarter. We expect Q4 '24 worldwide revenues to be in the range of $995 million to $1,015 million. We expect Q4 '24 Clear Aligner volume and ASPs to be slightly up sequentially. We expect Q4 '24 Systems and Services revenues to be up sequentially, consistent with typical Q4 seasonality. We expect Q4 '24 GAAP operating margin to be slightly lower than 14%, primarily due to restructuring charges related to severance for impacted employees. We estimate these restructuring charges will impact Q4 '24 GAAP operating margin by approximately 3 points. We anticipate Q4 '24 non-GAAP operating margin to be slightly up sequentially. For fiscal 2024, we expect investments in capital expenditures to be above $100 million. Capital expenditures primarily relate to building construction and improvements as well as manufacturing capacity in support of continued expansion. As we have said many times, we continually evaluate and evolve our business model to provide doctors with the best tools and resources that they need to help them treat their patients while managing our operations responsibly. Today's restructuring action is designed to adjust our business to more closely align with the existing business environment. We expect the restructuring actions we announced today will give us margin accretion for full year in 2025 even as we scale up our next-generation direct 3D printing fabrication manufacturing. With that, I'll turn it back over to Joe for final comments. Joe?
Joe Hogan: Thanks, John. In closing, for Q3, I was pleased to report another strong Systems and Services quarter, and I'm excited about our next-generation Lumina scanner and its continued positive impact on our customers' digital workflow, with ortho software today and restorative software expected to be released in Q1 of next year. Q3 was also strong for our Invisalign Clear Aligner business in the Asia Pacific, EMEA and Latin America regions. For -- those markets are our fastest-growing regions and help to balance outperformance in other geographies. We understand that operating environment is more challenging, and we are adapting and driving our growth strategy despite continued weak consumer demand trends. especially in the United States and a sluggish dental market. In the face of inflation, high interest rates, less patient traffic and longer conversion cycles, especially for adult patients, orthodontists and dentists are facing challenges in practice growth and profitability that impacts the way many of them approach orthodontic treatment. It is more important than ever that we differentiate our products and services and become the best partner for our customers by creating solutions that drive more patients to their practices, accelerates treatment conversion and improves their experience and bottom line. As the innovation leader in digital dentistry technology, it's our job to ensure we have the organizational structure, focus and rigor to help doctors realize the full potential of this opportunity by doing more to engage our doctor customers and support their practice growth and to help consumers and potential patients connect with these practices to get to smiles that they love. We continue to evaluate and evolve our business to provide doctors with the best tools and resources they deserve. Align is the leader in digital orthodontics, and we are committed to supporting doctor customers and the future of digital innovation. We're committed to supporting doctor customers and the future of the digital innovation and are excited the next wave of growth drivers that we believe will revolutionize the orthodontic industry in scanning software and direct 3D printing. We're in the midst of several key technology developments that are critical for the business. We will take the needed actions to get us through this, while at the same time investing in the key areas that we know will transform our industry and our business. The restructuring actions we announced today focused on ROI investments and activities that drive revenue and enable margin expansion, while making room for investments in critical future technologies, including scaling our direct 3D printing operations. With that, I thank you for your time today. I look forward to updating you on our continued progress over the coming quarters. Now, I'll turn the call back over to the operator for questions. Operator?
Operator: Thank you. At this time, we'll be conducting a question-and-answer session. [Operator Instructions] Our first question comes from Brandon Vazquez with William Blair. You may proceed.
Brandon Vazquez: Hey everyone. Thanks for taking the question. I wanted to start on a little bit just the macro backdrop. Last year, the year-over-year comp also had a little bit of weakness in the September period, if I remember, in 2023. So, things are a little bit worse now. I'm just curious if you can talk about did things get worse from last year, which was already a little bit of -- a little weak. And in case that doesn't make sense, the crux of the question is essentially just talk to us about where macro is going into year-end? Is it stable? I think you guys have used that phrase before. Is it worsening? Just any thoughts you guys are seeing on end markets?
Joe Hogan: Yeah, Brandon, it's Joe. I'd say, first of all, third quarter is always a tough quarter because of the discontinuities we have with Europe shutting down and different countries being on vacation at different times. So, I wouldn't say that the third quarter this year was worse in some way than the third quarter last year. I'd just say that it was the kind of seasonality in a difficult market. What we try to call out, as you could see, is that United States market seems to be one of our the most affected and it's really one of our largest markets, too. And so that's been a challenge in that sense also. John, do you want to add anything?
John Morici: No, that's accurate.
Brandon Vazquez: Okay. And then, as my follow-up just quickly, as we look towards 2025, right, and if we just assume end markets are stable, right, let's say things remain stable, how should we think about what the top-line on this business could do and what the P&L could look like in a year where things are stable, right? You guys are somewhat macro hindered right now. So, is it a continuation of what we're seeing in '24? Are there reasons to get a little bit more excited and accelerate the business? Any expectations around that would be helpful. Thank you.
Joe Hogan: Hey, Joe, again. I'd just say we'd like to see some increased consumer confidence obviously in the United States and just an economy that feels better to consumers. We feel that this is more of an external issue than it is an internal issue when you look at Align overall in our growth rates, particularly in United States. And so, any kind of increase in economic activity and increase in consumer confidence, we think would be really positive for our customers and then for Align in turn.
Shirley Stacy: Thanks, Brandon. Next question, please?
Operator: Thank you. Our next question comes from Jon Block with Stifel. You may proceed.
Joe Hogan: Hey, Jon.
Jon Block: Hey, guys. Good afternoon, Joe. Joe, maybe just to start with you, and it sort of picks up on that last question, anything to call out with the different results in the U.S. versus international? In other words, I think I've got this right, but cases up 2.5% globally, but as you mentioned, down in the U.S. So, is it just the consumer? Is there anything to focus on from a go to market strategy? Do we have to think about incremental competition that might be more acute in the U.S. versus OUS? Just would love your thoughts on that dynamic.
Joe Hogan: Yeah, Jon, it's a good question. I'd say it's mainly external when I look at it. I don't think there's been any dramatic changes from a competitive standpoint in the marketplace. If I look at our ortho channel and our dental channels, they're both challenged in the sense of patient throughput and their ability to close. I was just talking to some of our largest DSOs this morning and the comparison is similar. This is -- and these are -- the close rates at our customers are more difficult, too. It's customers come in, we know they want teeth treatment, but they're not really confident in the sense of their ability to pay for it or wanting to pay for it right now in the economic situation. So, I wouldn't call out anything externally from a competitive standpoint or whatever. This is more what we feel is external economics and consumer confidence issue in the United States. Look, we see, Jon, the same thing in Europe, but Europe has been a little better and a little different, because all those countries have different situations, but it's more pronounced in the United States because it's so large and so uniform in that sense.
Jon Block: Got it. Okay, thanks. And then, second question will be sort of a famous two-parter, but John, just to start, I just want to be crystal clear, you guys are committing to overall op margin expansion in '25. If that's correct, it will be somewhat neutered by the direct 3D printing fabrication initiative. Maybe if you can verify that? And then, any thoughts on the top-line? That would just be first question or I'll call it Part A. And Part B -- sorry go ahead, John.
John Morici: I was going to give the op margin. The op margin, yes, we made the restructuring actions, given us room, so that we can get the year-over-year margin accretion, while still investing in all the things that we've talked about with direct fab and five-minute ClinCheck and Lumina and so on. So, we're going to continue making those investments. The restructuring gives us some room to show that margin accretion.
Jon Block: Okay. And again, the other part of that question was, any thoughts on the top-line? If you're committing to the OM expansion, what does that mean from a top-line perspective? And the second one, Joe, just if I can pivot and if you can talk to some of the initiatives out there? In other words, it seems like Costco is off to a slow start, [per our] (ph) checks. Do you need to be in the store? And then, more recently, we picked up on a new financing initiative that it seems like you're rolling out and sort of guarantees the case approval, denials have been a problem. Where are you with that initiative? And when do you expect it to have a more sort of prominent impact on the overall P&L? Thanks, guys.
Joe Hogan: Yeah. Hey, Jon, I'll just kind of just frame your question. The first one like Costco, we've had some success in Costco, but it's nothing as material for the business right now, but I think you have to look at that as we do internally. It's a brand strategy. We have the number one brand in the world. We're looking at different areas of how we can leverage that brand to try to encourage consumers more in the sense of entertaining Invisalign treatment. As far as financing, we know that customers right now are challenged in the sense that they do want a treatment from an orthodontic standpoint, but they're really challenged from a financial standpoint. And John and the team are doing all they can. And also our DSO -- big DSO partners are doing what we can to offer the type of financing that would give consumers more confidence to move forward.
John Morici: And on overall revenue, Jon, we'll give more of an update as we get closer into 2025. But as we've said and as we've made the adjustments, we're committed to driving growth, investing where we can find that growth, balancing our investments on some of the new technologies that we have that we know will transform this business. So that's all at stake now and things that we're mindful of, but we'll give more of an update on 2025 as we get closer.
Jon Block: Thank you.
Joe Hogan: Yeah, you're welcome, Jon.
Operator: Thank you. Our next question comes from Elizabeth Anderson with Evercore ISI. You may proceed.
Elizabeth Anderson: Hi, guys.
Joe Hogan: Hi, Elizabeth.
Elizabeth Anderson: Hi. I'm also going to try my hand at a two-parter as well, [since that's the theme] (ph). One, I mean, as you talk about the restructuring and sort of Frank coming back to the organization, I think you hinted at it a little bit. I know it's obviously a little bit early, so just sort of high-level quality of thought would be fine on this too. Like, what do you mean when you're -- what are you sort of -- like, what is he going to sort of drive or what do you -- is there sort of like an inflection that you're thinking about how he operates the business differently? And sort of as a corollary to that, like, I think you talked about getting closer to the consumer. If you could talk maybe about that portion of it? And then secondarily, it was nice to hear the positive commentary about China. So, I'd love to hear a little bit more about that market and sort of how you're thinking about the consumer outlook for that market as well. Thank you.
Joe Hogan: Hey, Elizabeth, it's Joe. On Frank coming back, Frank was -- had been in the business from 2013. I think he left us in 2022 for another type of venture. Look, this business is about -- it's about three things. One is relationships. This is not a transactional business. This is one where you want to have good relationships and good trust with doctors, and Frank really brings that from a leadership standpoint. Secondly is, you would need a good understanding of the technology and types of programs that can help to drive growth. Frank is really an expert in that area. He's shown that over the years. When you look at our DSO program today, it's been really effective. Frank happened to put that together back when I first arrived, back in 2015, 2016 and really made that happen. Thirdly is, you need someone with scope in the sense of understands the industries, understands the competition, knows what really makes doctors make decisions, and orthodontists and how they make decisions versus the general practitioners. Frank has all that, and he's a trusted commodity within the business. So, we're excited to have him back.
John Morici: And then, the last part of your question, Elizabeth, on China, we're pleased with China results, sold to more doctors, pleased with the utilization. It's a great teen season for us in China. We saw good adoption of various products, including Invisalign First and others, where we saw good utilization there. So, China, for us, from a teen standpoint, especially, played out really well for us.
Elizabeth Anderson: Got it. Thank you.
Joe Hogan: You're welcome.
Operator: Thank you. Our next question comes from Jason Bednar with Piper Sandler. You may proceed.
Joe Hogan: Hi, Jason.
Jason Bednar: Hey there. Yeah, good afternoon. I'm going to come back and follow-up on one of Jon's questions. I know a lot of us have been trying to estimate the margin upside or the margin impact from 3D printing over time, just given the cost benefits you can realize from the initiative. But the comment today here with the restructuring offsetting some of the -- maybe some of the investments you're making, it would seem like that this initiative may be dilutive to gross margins in '25. So, maybe just help us bridge the thinking that you're making in these comments today, reconcile some of those comments, and if you can, quantify kind of the puts and takes?
John Morici: Yeah. I'll take my best at this. So, overall, we're talking op margin. We think that the restructuring that we're making is going to be op margin accretive on a year-over-year basis despite all the investments. You're right, from a gross margin standpoint, as we scale things, the direct fab printing, while gives us a lot of capability and a lot of benefits for our doctors, there is a higher cost initially until we start to scale that. But we're committed to that op margin accretion on a year-over-year basis for next year despite that. And then, as we have new products that come and we know the doctors are going to love what we're bringing to market, that will scale up. And as that scales up, then that really drives the overall productivity that we will see on the gross margin side, primarily from the materials and the less material that we need to go into the product.
Jason Bednar: All right, understood. And I guess maybe one follow-up to there and then another separate follow-up. But just any timeline on when we might see the gross margin benefits or expansion off of historical norms once that 3D printing does scale? And then, just with the teen season maybe now mostly complete, just what's your assessment of that part of the market, Joe, inside the U.S., outside the U.S.? The data we see has been a bit more mixed between kind of the clear aligner and bracket and wire part of the markets the past several months. Your business has grown decently the past year and a half. So, just -- do you have better visibility on this part of the market? I'm just trying to understand this again in the context of the broader comments you're making on the U.S. being a little bit softer. Thanks.
John Morici: So, Jason, this is John. I'll take the first part of your question on gross margin. Look, we've talked about it being like a two- to three-year journey to be able to help scale this up. I can say this, we're very pleased with the progress that we're making around resin and being able to scale that and get it at the right cost. So that's good progress there. As well as on the equipment side, we're making good progress around being able to scale up the actual manufacturing of this. But in terms of when you scale this and get it to a larger extent, it's really two to three years, but you will see some new products that we have on the direct fab showing up next year and in doctors' hands to give them those capabilities.
Joe Hogan: Jason, on the teen market, I mean, when you look at the international teen market, obviously, we had really good success in Asia in the quarter. We have really a terrific portfolio when you think about our Invisalign First product. Now, we have Invisalign Palatal Expander. With that also, it's what we call mandibular advancement with occlusal blocks, which are used for Class IIs, usually for patients between 10 and 11 years old. So, when you look at those pre-teen ages, we have a really good portfolio to line up in that sense. So, I think you're seeing that come through with our sales overall. When you reflect back on the United States, obviously, our orthodontic customers are really challenged. And 80% on an average, 75% of what they do are teens. And some of the close rates on teens, just talking to some of the DSOs and different doctors that we have on the orthodontic side, the close rates are even tougher on the teen segment than what it's been in the past, too. And so, times like this, where they're pressed for traffic and they're pressed for margin, they will reflect back to wires and brackets to support the profitability of their practice. We know that. We understand it. It's our job to communicate to consumers and to orthodontists what the benefits are, particularly this early treatment and what we can do. And so, this is a doctor-to-doctor situation, but again, it's an external environment where consumers are concerned with their pocketbooks right now, and they're reluctant to make decisions and close at times. And obviously, the orthodontists are responding from an individual practice standpoint accordingly.
Jason Bednar: All right. Very helpful. Thank you.
Operator: Thank you. Our next question comes from David Saxon with Needham & Company. You may proceed.
David Saxon: Great. Good afternoon, and thanks for taking my questions. I'd like to start on iTero actually. I'd love to get some color around how we should think about iTero growth with the ongoing Lumina rollout, particularly with the restorative workflow coming out early next year, but then in the context of interest rates remaining high and then lapping comps from the initial ortho launch?
Joe Hogan: Yeah, David, I think you have to start with, and I think I get the gist of your question, there's a lot of pressure on capital equipment sales in the marketplace given what we're talking about with customers being challenged in that way. I think what you have to do with the Lumina and think about it, it's truly a brand new platform. It's not an iteration of old technology like the next phase of our older technology. It's something that's really new, and it's captured doctors' attention. And I think it's the size of our sales and how well we've done, particularly in a traditional third quarter, it's a little bit slower, I think it surprised a lot of people. So, I think this is a testimony to the technology we've brought forward and the uniqueness of that technology, why we've been able -- to be able to have those kinds of sales at this point in time. We're excited about the restorative coming on in the first quarter. The team is making good progress on that. So, overall, it's just a great foundation to grow from. And what's wonderful about that platform, too, is we'll iterate from that platform going forward in different areas that will really help us to diversify the product line and target certain applications in the future.
John Morici: And two things that really have helped iTero and kind of go through this, especially with the new product and so on, it's really given us a lot of opportunity on other products that we sell within the iTero kind of family. So, all the way from CPOs that we have certified pre-owned, all the way to the 5D. We actually sold a lot of 5Ds this past quarter. So, that really helps us. And then, the added part, in a tougher economy, we're giving a lot more flexibility to doctors to kind of sell the way they want to buy. Some don't want to purchase outright because of the economic conditions and so on. So, we see a lot more leasing or in other places we see more rental. And for us, that's a great trade. It will get that recurring revenue off of those different selling options, but then it's great when a doctor uses iTero because we know they'll do use more Invisalign.
David Saxon: Great. Thanks for that. And then, on the U.S. side, on the Clear Aligners, can you give more color on kind of where that weakness is actually coming from? Is it the ortho channel or is it with GPs? And then, anywhere specifically from a portfolio perspective? Thanks so much.
Joe Hogan: Yeah. I mean, it's almost equal in both. We see pressure on the ortho side. I mean, if you look at any kind of industrial data right now as far as patients entering the dental industry right now, the GP space, it's challenged overall. So, we see pressure in both of those areas for the same reasons we talked about before.
Shirley Stacy: Yeah. Thanks, David. Next question, please?
Operator: Thank you. Our next question comes from Jeff Johnson with Baird. You may proceed.
Joe Hogan: Hey, Jeff.
Jeff Johnson: Thank you. Hey, Joe. How are you? Good afternoon, guys. So, Joe, let me ask one high-level question and then maybe just a modeling question for John. But from a high level, your R&D was down 4% year-over-year this quarter. You're making the headcount reductions. CapEx at $100 million is well below even the last couple of years, closer to $250 million those years. You're talking about increasing the buyback margin improvement next year. All of these comments kind of just point to a more mature company and that's not a critique at all. I think that's where we all know you are and see where you are. So, I guess my question is, how does this change your management style, your management objectives over the next few years? Obviously, you came into this business really pushing the top-line, but is there an evolution that's happening to go on with how you lead this company and lead this organization as well?
Joe Hogan: Hey, Jeff. I think it's a really good question. I'd say we're responding to the times here. Don't make it a reflection on what the opportunity the company is at all. We're so underpenetrated, not just in United States or North America or whatever, but all over the world. And there's hundreds of millions of people that need to have their teeth straightened. And the only way you could ever do that in a broad sense is with digital orthodontics. So, don't miss that point, Jeff. We are going through a spell right now. And what you see with the R&D down and CapEx and different things like that, CapEx is, you know we're not putting on any more manufacturing right now. We have enough manufacturing, and we're still bringing up our Poland plant, right? We're being responsible from a business leadership standpoint for our shareholders in this specific situation, but at the same time, Jeff, we're pouring a lot of money into 3D printing, five-minute ClinCheck, next phases of Lumina. All these things will really enter into just another growth cycle when this market starts to come back with brand new tech. This is the technology of the future if you really want to play in digital orthodontics. So, what we're doing is funding that, being responsible to our shareholders, but not losing our enthusiasm and what we think our opportunity is in the future.
Jeff Johnson: Yeah. No, that's all fair. You are holding a sell-side event or at least an investor event a week from Saturday. Would that be a time to evaluate though that LRP, that 20% to 30% intermediate longer-term top-line growth expectation?
Joe Hogan: I think until we get a better read on what the economy is going to do, Jeff, I think that 20% to 30% represents how we feel that market could grow in the future, but we have to have the right economic conditions, particularly in the biggest markets in the world like the United States that we participate in.
Jeff Johnson: Okay. And John, one modeling question. Just when I listen to the ASPs, I think the quick math on that is, it sounds like between the VAT issue that should anniversary at the start of next year, just remind me if I've got the timing on that correct, but should anniversary at the start of next year, currency headwinds should be -- we'll see what the U.S. dollar does post-election year, but should be reasonably moderating from here? So, I think ex currency and ex VAT, you had about 1.1% down ASP year-over-year. One, is that math correct? And two, is that about what we should be thinking about as we head kind of into '25 once VAT and hopefully FX normalizes a bit?
John Morici: You're right about FX hopefully normalizes, it's hard to predict. VAT does anniversary at the beginning of next year. And what we've said in the past that that ASPs would be flat to slightly down. So, your percentage you're talking about is in that range.
Jeff Johnson: Thank you.
Shirley Stacy: Thanks, Jeff.
Joe Hogan: Thanks, Jeff.
Operator: Thank you. Our next question comes from Kevin Caliendo with UBS. You may proceed.
Joe Hogan: Hi, Kevin.
Kevin Caliendo: Hey, thanks. Hi, Joe. Thanks for taking my question. This is maybe a little bit off, but just wondering if you guys have ever done this analysis in terms of thinking about the Venn diagram between people purchasing GLP-1s and people going and getting Invisalign treatments, because the cost for adults anyways might be close. And I'm just wondering if there's any -- if you guys have seen any correlation to maybe that's part of the weakness in the adult market as the shortages have -- in GLP-1s have come down or people may be investing $5,000 that way as opposed to into Clear Aligners. Have you done that analysis or seen anything?
Joe Hogan: I can't say that we've been -- we've overly quantified it, Kevin. We hear that a lot. There's a lot of medical device companies that kind of talk about that that might be corollaries in the sense of what you're seeing with the GLP marketplace overall. I can't say that it's not a factor because it's obviously a high expense and something that's kind of on an annual basis in line to what it would cost to do an Invisalign treatment. But I haven't wanted to lean into that as one of the drivers here. I think it's just overwhelmed by an economy right now where consumers don't have a lot of money in their pocket or confidence about what it's going to be in the future. And GLP might play a role in it, it might not. I think also you can look around the world also in some of the markets, like Continental Europe, that's not necessarily as affected by it as maybe United States is. And I can't say I've seen that piece, too. So, there's an old saying that correlation doesn't mean causation, right? And so, I would stay with that right now.
Kevin Caliendo: Fair enough. That's helpful. And just I know you don't want to talk about '25, but let's just think about the fourth quarter and sort of what you're implying for your guide in exiting the year sort of a midpoint of like 5%. Should we just sort of take that as a starting point, adjust for whatever we think the economy might do that might impact the adult side of the marketplace more and then think about Lumina as an add on to that? I mean, is that sort of how you're thinking about the business?
John Morici: Yeah. I think we'll obviously give more as we get closer to this, Kevin, but I think -- look, you come out of the year, that's probably a good starting point to be able to build off of that and say, look, what do you think is going to happen to the economy, we're going to know more, maybe about interest rates and election and other things will kind of come about and we'll have a better view of that. But I think it's a good starting point as you think about next year, you're going to add in some of the things that we've talked about with, Lumina restorative and other things and then build off of that, but we'll give more details as we get closer, obviously.
Kevin Caliendo: Appreciate it guys. Thank you.
Shirley Stacy: Thank you.
Joe Hogan: Yeah, thanks, Kevin.
Operator: Thank you. Our next question comes from Michael Cherny with Leerink Partners. You may proceed.
Michael Cherny: Hi, good afternoon. Maybe just one, following up on a question earlier on the some of the 3D printing work in the fab-related products that you're going to be pushing out. As you think about the potential for introduction to those products, how are you thinking, given that this is a bit of a obviously different manufacturing approach that you've taken before, about what the rollout will look like? Will it look any different in terms of the types of beta customers that you're going to be pursuing? How should we think about tracking -- I mean, tracking is not the right word, but making sure that you're hitting on the right customer experience, the right overlap, the right introduction process as you get what obviously could be a very scalable set of products, set of new opportunities out to market?
Joe Hogan: Hey, Michael, it's Joe. Just taking your question is, as you think about it, when you think of what we do today, when you [indiscernible], obviously, you lose a huge amount of opportunity to differentiate the geometry of that particular product and how it can help a doctor. The one sector of our business that would I think will appreciate this the most will be the orthodontic community that do a lot of Class IIs, difficult cases, young teens, and we'll be able to produce products that are more and more tailored to consumers in that specific condition than what we could do today. And so, we would offer the product that way, and we think it'd be very appealing to them. Secondly, from a general dentistry standpoint, it's a big part of our marketplace, too, there's a lot that we can do to help them with this product line also. So, I hope I'm answering your question, but the design freedom that we have here in the end and we have to prove it when you can use relatively different thicknesses, you can do different configurations for different kinds of clinical issues that a patient might have, we expect to have more predictability in the sense of how fast you can move those teeth and more certainty and how long those cases will take. And I think doctors are going to appreciate that, but I think as we're certain of that, patients will appreciate that too, and we certainly would communicate that to patients.
Michael Cherny: No, that certainly does help. And then maybe just one quick question, I promise it's not an attempt to go at '25 guidance specifically, but obviously, you've mentioned numerous times the UK VAT that's impacting ASPs internationally this year. Is there any outliers or one-time dynamics that we should be thinking about or contemplating relative to next year, something that like the UK VAT or anything else that could factor into the modeling that's non-normal?
John Morici: Michael, this is John. Nothing that we would say is non-normal. I mean, the nice thing about the anniversary of the UK VAT is, it does anniversary. Obviously, we're doing things to try to work with that government there to explain and ideally not have a VAT on our products, because it affects what goes to doctors and how much they pay and then passing it on to potential patients. But there's nothing like that, that we would see on the horizon as that type of impact.
Shirley Stacy: Thanks, Michael. Next question, please?
Operator: Thank you. Our next question comes from Erin Wright with Morgan Stanley. You may proceed.
Erin Wright: Great. Thanks. Can you speak a little bit more on just the nature of the restructuring outside of the executive change today, I guess the timeline, scope, magnitude and anything that you can give us in terms of quantifying that benefit from a profit perspective into 2025 and what that translates into just broadly speaking, but also just what -- how this kind of came about in terms of what's on the table, what were your changes that you were thinking about in terms of the business outlook or backdrop that really changed in your view since it's been a sluggish kind of consumer backdrop for some time? Now, I guess what else has changed? Thanks.
John Morici: Yeah, Erin, I could try to give you kind of an overview of where things are at. Just as part of a normal AOP process, you're always evaluating where you're going to make investments, where you're going to fund it, how you're going to fund it and so on. So, this is part of our process that we go through where we're planning out where we're going to end up for the year and what does it mean for next year and how do we grow and do all the things that we want to talk through. This type of restructuring, this is about 2x of what we did last year. Last year, we did about 350 or so, just over 300. This is close to 700 people. There's some restructuring charges, we've talked about that, this year. But really what it does and what -- I'll go back to what Joe was talking about, we want to be focused in on what we can drive as our business, what we can do from a growth platform standpoint, whether it's the direct fab, five-minute ClinCheck, Lumina restorative. We want to fund those, but we've got to also show some margin accretion and we want to be margin accretive on a year-over-year basis. So, we can fund what we need to fund to really be driving our business and we'll fund it based on some of these changes here, but it really set us up for a position to be able to show that margin accretion next year.
Erin Wright: Okay, great. And then, as we head into the fourth quarter, I guess, does your guidance assume a continuation of the same in terms of the sluggish environment in the U.S.? Or does it have any sort of changes across other regions that you anticipate either continued acceleration or deterioration across other kind of markets or geographies here? Thanks.
John Morici: Yeah, Erin, it just kind of assumes what we've seen. I mean, like as we pointed out, U.S., North America not great, we kind of assume the same. Other places we actually saw good improvement, in parts of Asia, Latin America, Middle East, other places, and we continue to invest and expect to grow in those areas. So, like any forecast, you take the best information you have at the time, you try to translate to what that's going to mean for the upcoming quarter, and that's what we did for fourth quarter.
Shirley Stacy: Thanks, Erin. Next question, please?
Operator: Thank you. [Operator Instructions] Our next question comes from Mike Ryskin with Bank of America. You may proceed.
Mike Ryskin: Hey, thanks, guys. Just a couple of cleanup follow-up questions. One, I think just kind of following up on what Erin touched there and John you touched on this as well. Two years in a row now, and again part of that is just natural attrition, natural cleanup of the business, but should we expect this to be sort of the normal going forward in terms of the restructuring? You guys famously kind of held off on that for a while. And very famously during COVID, you actually reinvested and you refused to cut when others were cutting. So, just help us think in terms of how we should factor that in going forward.
Joe Hogan: Hey, comparing this time with COVID is a stretch, Michael, overall. When we didn't lay anybody off during COVID, our expectation was that wouldn't last as long as it did, but fortunately, that was a decision to pay off well when the market came back so strongly. Right now, we're looking at just a sustained economic malaise, I would call it, in the United States, and we're responding accordingly. We haven't lost our enthusiasm and our belief in how this business can grow and this market potential of this business. What you're seeing in the restructuring is we're responding to external pressures that we see and being responsible from a business standpoint and being sure that we fund these key three technologies that we know will lead into the future from an overall digital orthodontic standpoint.
John Morici: And that's the key point of it now. It's being able to make space and have a budget to be able to fund these key technologies, because we know that's going to drive the future and it's doing things that we know no one else can do, no other company can do what we're trying to do with this. So, it's really important for us now to keep that focus through these budget changes and so on. It's what companies do to be able to push the future and do it in a responsible way where we could show margin accretion. We know we always talk about levers that we could pull or not pull. This is a part of it, and it just comes about it on a more annual basis as you assess the current environment.
Mike Ryskin: Okay. And then, quick cleanup, if I could, on the ASPs. You talked about earlier, I think, in the Q&A, you touched on some of the factors that impacted you in the quarter and your thoughts about next year, but just on 4Q, I think you guided up ASP sequentially, and you've had some of these mixed dynamics, some of the discounting and FX for a number of quarters in a row. Just what are you seeing so far through October that's giving you confidence that you'll be able to reverse that? Because I think some of those headwinds don't fade till next year.
John Morici: Yeah. Well, I think part of -- really all our Advantage programs kind of go from -- they end in at the end of June and then they reset as you come into that second half. So, third quarter kind of took the Advantage changes. So, that shows up in discount. So, I don't expect that to continue. And then, where you do have the benefit and in our case where Europe becomes a bigger part of our business in the fourth quarter and China and some of the other businesses become less, that's good from a mix standpoint. We have a higher ASP in Europe and a lower ASP in China. So, whereas that mix hurt us from a country standpoint, in a lower ASP in the third quarter, we actually get the benefit on that in the fourth quarter based on seasonality.
Mike Ryskin: Okay. That's helpful. Thanks.
Shirley Stacy: Thank you, Michael.
Joe Hogan: Yeah. Thanks, Mike.
Operator: Thank you. And we have reached the end of our Q&A session. I'll now turn the call back over to Shirley Stacy for closing remarks.
Shirley Stacy: Great. Thank you, operator, and thanks, everyone, for joining us on the call today. We look forward to speaking to you at upcoming financial conferences and for those of you who we'll see at the Invisalign Ortho Summit in Las Vegas next week. If you have any other questions, please feel free to contact Investor Relations, and have a great day.
Operator: Thank you. This concludes today's conference, and you may disconnect your lines at this time. Thank you for your participation. | [
{
"speaker": "Operator",
"text": "Greetings. Welcome to the Align Third Quarter 2024 Earnings Call. At this time, all participants are in a listen-only mode. A question-and-answer session will follow the formal presentation. Please note, this conference is being recorded. I will now turn the conference over to your host, Shirley Stacy with Align Technology. You may begin."
},
{
"speaker": "Shirley Stacy",
"text": "Good afternoon, and thank you for joining us. I'm Shirley Stacy, Vice President of Corporate Communications and Investor Relations. Joining me for today's call is Joe Hogan, President and CEO, and John Morici, CFO. We issued third quarter 2024 financial results today via Business Wire, which is available on our website at investor.aligntech.com. Today's conference call is being audio webcast and will be archived on our website for approximately one month. As a reminder, the information provided and discussed today will include forward-looking statements, including statements about Align's future events and product outlook. These forward-looking statements are only predictions and involve risks and uncertainties that are described in more detail in our most recent periodic reports filed with the Securities and Exchange Commission available on our website and at sec.gov. Actual results may vary significantly, and Align expressly assumes no obligation to update any forward-looking statement. We've posted historical financial statements with corresponding reconciliations, including our GAAP to non-GAAP reconciliation, if applicable, and our third quarter 2024 conference call slides on our website under Quarterly Results. Please refer to these files for more detailed information. With that, I'll turn the call over to Align Technology's President and CEO, Joe Hogan. Joe?"
},
{
"speaker": "Joe Hogan",
"text": "Thanks, Shirley. Good afternoon, and thanks for joining us today. On our call today, I'll provide an overview of our third quarter results and discuss a few highlights from our two operating segments, Systems and Services and Clear Aligners. John will provide more detail on our Q3 financial performance and comment on views for the remainder of the year. Following that, I'll come back and summarize a few key points and open the call to questions. Overall, Q3 '24 results were mixed and reflect strong Systems and Services year-over-year revenue growth, as well as good Clear Aligner volume in the Asia Pacific, EMEA and Latin America regions, partially offset by declines in the U.S. As recently reported by many analysts and third-party research firms, the underlying dental market in the United States remains sluggish and our doctor customers cite similar trends. Q3 '24 revenues of $978 million increased 1.8% year-over-year and Clear Aligner volumes of 617,000 were up 2.5% year-over-year. Despite strong growth from Systems and Services revenues, a record [87,400] (ph) doctor submitters, a record 236,000 teens starting treatment, driven by record teen case starts in China, and a record 25,000 of DSP Invisalign Touch-Up cases, total revenues for Q3 were slightly below our Q3 revenue outlook in part due to more pronounced seasonality for Clear Aligners than expected, as well as continued weak consumer sentiment and a soft dental market, especially in the U.S. Q3 '24 non-GAAP operating margin of 22.1% was better than expected and increased year-over-year compared to 21.8% in Q3 of '23. For Clear Aligners, Q3 volumes were up year-over-year and down slightly sequentially. Year-over-year volumes were driven by strong growth in APAC, especially China, as well as growth from the EMEA and Latin American regions. On a sequential basis, Clear Aligner volumes were down from Q2, reflecting more pronounced seasonality and soft dental markets in the U.S., offset somewhat by strength in APAC and Latin American regions. In the teen and growing kids' segment, a record 236,000 teens and younger patients started treatment with Invisalign clear aligners during the third quarter, an increase of 9.1% sequentially and up 6.7% year-over-year, reflecting growth across regions, especially from Invisalign First in the APAC and EMEA regions. In Q3, the number of doctors submitting teen or younger patient case starts was up over 6% year-over-year, led by continued strength from doctors treating young kids, also known as growing patients. During the quarter, we continued to commercialize the Invisalign Palatal Expander, Align's first direct 3D printed orthodontic appliance. Q3 reflected steady momentum for doctor submitters and shipments in the United States and Canada. We recently announced commercial availability in Singapore, and we're excited to extend the availability of the transformative Invisalign Palatal Expander System to even more doctors and their patients in markets across the Asia Pacific region. We expect it to be available in other markets, pending future applicable regulatory approvals. Non-case revenues include our Vivera retainers, retention aligners ordered through our Doctor Subscription Program, or DSP, clinical training and education, accessories and ecommerce. In Q3, non-case revenues were up year-over-year, primarily due to continued growth in retainers and the DSP program, including non-Invisalign patients getting retainers. DSP includes Invisalign Touch-Up cases up to 14 stages and is currently available in North America and certain countries in Europe. For Q3, total Invisalign DSP Touch-Up cases were up nearly 30% year-over-year to more than 25,000 cases. Q3 '24 Clear Aligner volume from DSO customers increased sequentially and year-over-year, reflecting growth across all regions. The DSO business in United States continues to outpace our retail doctors, driven by our largest DSO partners, Smile Doctors and Heartland Dental. We also had strong growth in iTero scanner sales from DSOs investing in their member practices and end-to-end digital workflows. Q3 was another strong quarter for our Systems and Services business, and year-over-year revenue growth was up 15.6%, reflecting higher scanner ASPs and non-systems revenues, driven by iTero Lumina, wand upgrades, increased scanner rentals and certified pre-owned or CPO leasing programs, as well as increased services revenues, partially offset by lower scanner volumes. On a sequential basis, Q3 Systems and Services revenues were down 2.9%, reflecting lower scanner ASPs and non-systems revenues, particularly offset by higher scanner volumes. The iTero Lumina's new Multi-Direct Capture technology replaces the confocal imaging technology in earlier models and has a 3x wider field of capture and a 50% smaller and 45% lighter wand, delivering faster scanning speed, higher accuracy, super visualization and a more comfortable scanning experience. Lumina is currently available with orthodontic workflows as new standalone scanner or as a wand upgrade from the iTero Element 5D Plus scanner. Overall, for Q3, we continue to be very pleased with the ongoing adoption of iTero Lumina scanner, with ortho workflow and response from customers. We currently expect to begin a limited market release for the restorative software on the iTero Lumina scanner in Q1 '25, followed by full commercialization by the end of Q1. Today, we announced new iTero scanner products innovations to further enhance digital dentistry workflows and integrated treatment options in oral health, restorative and aesthetic treatment in general dentistry. Align Oral Healthcare Suite with new comparison tools that aid in multimodality assessments and personalized oral health records and reports. Invisalign Outcome Simulator Pro in multiple treatment simulation to drive chairside patient education about treatment options, and iTero Design Suite with intuitive design capabilities for in-practice 3D printing now commercially available in selected markets. We believe the iTero intraoral scanner innovations introduced today enable doctors to present a variety of treatment options to their patients, supporting chairside education and communications. That helps deliver a great patient experience and supports patients in making more informed choices about their dental treatment and consultation with their doctors. We're also pleased to share that Invisalign Japan was recently awarded the [Golden] (ph) Design Award for 2024 for the iTero Lumina Intraoral scanner, making this the second time we received this prestigious award in the past two years. The Good Design Award is globally known and recognized by domestic and international designers and is the only comprehensive evaluation and recommendation system of design in Japan. The award designation increases the recognition and reliability of awarded works of -- and companies, promotes problem solving through design and focuses on the significance of design to people and society. Before I turn the call over to John, I want to comment on the employment actions we announced today resulting from a global reorganization and restructuring. As part of Align's 2025 annual operating plan process, we identified positions to be eliminated or transferred to other locations. These are difficult actions, and valuable employees will leave the company. As part of this restructuring, Raj Pudipeddi's position as EVP and MD Americas and Chief Marketing Officer has been eliminated and he will leave in the fourth quarter. We thank Raj for his contributions to Align over the past five-plus years in leading our marketing and product innovation and management as well as overseeing the APAC and Americas regions. We wish Raj well. I'm pleased to welcome Frank Quinn back to Align. He is a well-established leader with a customer focus and proven track record in orthodontics and digital dentistry. Frank's deep experience, understanding and insights into what digital means for our doctor customers is key and he is excited to be rejoining Align. With that, I'll now turn the call over to John."
},
{
"speaker": "John Morici",
"text": "Thanks, Joe. Now, for our Q3 financial results. Total revenues for the third quarter were $977.9 million, down 4.9% from the prior quarter and up 1.8% from the corresponding quarter a year ago. On a constant currency basis, Q3 '24 revenues were not significantly impacted by foreign exchange sequentially and were unfavorably impacted by approximately $14.6 million year-over-year or approximately 1.5%. For Clear Aligners, Q3 '24 revenues of $786.8 million were down 5.4% sequentially, primarily from lower volume, higher discounts, product mix shift to lower-priced products and geographic mix, partially offset by lower net revenue deferrals. Q3 Clear Aligner revenues were not significantly impacted by foreign exchange sequentially. Q3 '24 Clear Aligners per case shipment of $1,275 was lower by $20 on a sequential basis due to higher discounts, product and geographic mix, partially offset by lower net revenue deferrals. On a year-over-year basis, Q3 Clear Aligner revenues were down 1%, primarily from lower ASPs, reflecting the impact from unfavorable foreign exchange of $11.7 million or approximately 1.5%, a 20% price reduction in the UK to offset a 2024 ruling by the UK tax authorities in Q1 of '24 that requires a 20% VAT be applied to Clear Aligner sales in the UK, product mix shift to lower-priced products, geographic mix and higher discounts. This decrease was partially offset by lower net deferrals and price increases, along with higher volumes and higher non-case revenues. Q3 '24 Clear Aligner per case shipment of $1,275 was down $45 on a year-over-year basis due to unfavorable foreign exchange of $18, impact of UK VAT of $12, product and geographic mix, higher discounts and partially offset by lower net revenue deferrals and price increases. Our Invisalign Comprehensive [3-and-3] (ph) product is available in North America, EMEA and in certain markets across APAC. We are pleased with the continued adoption of the Invisalign Comprehensive 3-and-3 product and anticipate adoption will continue. Comprehensive 3-and-3 provides doctors the flexibility they want while allowing us to recognize more revenue upfront, with deferred revenue being recognized over a shorter period compared to our traditional Invisalign Comprehensive product, which in turn allows us to benefit from a more favorable gross margin. Clear Aligner deferred revenues on the balance sheet decreased $6.2 million or 0.5% sequentially and decreased $25.8 million or 2% year-over-year and will be recognized as additional aligners are shipped under each sales contract. Q3 '24 Systems and Services revenue of $191 million were down 2.9% sequentially, primarily due to lower ASP and decreased non-system revenues mostly related to fewer upgrades, partially offset by higher scanner volumes. Q3 '24 Systems and Services revenue were up 15.6% year-over-year, primarily due to higher ASPs, increased non-system revenues, mostly related to upgrades in our leasing rental programs, and higher services revenue, partially offset by lower scanner volumes. Q3 '24 Systems and Services revenues impact by foreign exchange was approximately flat sequentially. On a year-over-year basis, Systems and Services revenues were unfavorably impacted by foreign exchange of approximately $2.9 million or approximately 1.5%. The Systems and Services deferred revenues on the balance sheet was down $1.5 million or 0.7% sequentially and down $40.6 million or 15.4% year-over-year, primarily due to the recognition of services revenue, which are recognized ratably over the service period. The decline in deferred revenues, both sequentially and year-over-year, primarily reflects the shorter duration of service contracts applicable to initial scanner purchases. Moving on to gross margin. Third quarter overall gross margin was 69.7%, down 0.5 points sequentially and up 0.7 points year-over-year. Overall gross margin was not significantly impacted by foreign exchange sequentially and was unfavorably impacted by approximately 0.4 points on a year-over-year basis. Clear Aligner gross margin for the third quarter was 70.3%, down 0.5 points sequentially due primarily to lower ASPs and higher mix of additional aligners, partially offset by lower manufacturing spend. Clear Aligner gross margin for the third quarter was down 0.5 points year-over-year due primarily -- due to lower ASPs, partially offset by lower manufacturing spend. On a constant currency basis, Clear Aligner gross margin was unfavorably impacted by foreign exchange by 0.4 points year-over-year. Systems and Services gross margin for the third quarter was 67.5%, down 0.7 points sequentially due primarily to mix, partially offset by lower manufacturing spend and freight costs. Systems and Services gross margin for the third quarter was up 6.5 points year-over-year due primarily to higher ASPs, partially offset by higher service and freight costs. On a constant currency basis, Systems and Services gross margin was unfavorably impacted by foreign exchange by 0.5 points year-over-year. Q3 operating expenses were $519.5 million, down 9.7% sequentially and up 4.6% year-over-year. On a sequential basis, operating expenses were down $56.1 million due primarily to non-recurring legal settlements, advertising and marketing and employee compensation. Year-over-year, operating expenses increased by $22.7 million, primarily due to employee compensation. On a non-GAAP basis, excluding stock-based compensation, amortization of acquired intangibles related to certain acquisitions, restructuring, legal settlements and other charges, operating expenses were $472.7 million, down 5.4% sequentially and up 3.1% year-over-year. Our third quarter operating income of $162.3 million resulted in an operating margin of 16.6%, up 2.3 points sequentially and down 0.7 points year-over-year. Operating margin was favorably impacted from foreign exchange of approximately 0.1 point sequentially and unfavorably impacted by 0.8 points year-over-year. On a non-GAAP basis, which excludes stock-based compensation, amortization of intangibles related to certain acquisitions, restructuring, legal settlements and other charges, operating margin for the third quarter was 22.1%, down 0.2 points sequentially and up 0.3 points year-over-year. Interest and other income and expense net for the third quarter was an income of $3.6 million, primarily due to foreign exchange compared to an expense of $3.2 million in Q2 of '24 and an expense of $4.2 million in Q3 of '23. The GAAP effective tax rate in the third quarter was 30.1% compared to 32.9% in the second quarter and 25.1% in the third quarter of the prior year. The third quarter GAAP effective tax rate was lower than the second quarter effective tax rate primarily due to adjustments related to tax return filings, partially offset by a small increase in uncertain tax position reserves. The third quarter GAAP effective tax rate was higher in the third quarter -- than the third quarter effective tax rate in the prior year primarily due to recognizing a one-time benefit related to the application of tax guidance issued during the third quarter of the prior year. Our non-GAAP effective tax rate in the third quarter was 20%, which reflects our long-term projected tax rate. The third quarter net income per diluted share was $1.55, up sequentially $0.27 and down $0.03 compared to the prior year. Our EPS was favorably impacted due -- primarily due to foreign exchange by $0.03 on a sequential basis and unfavorably impacted by $0.08 on a year-over-year basis. On a non-GAAP basis, net income per diluted share was $2.35 for the third quarter, down $0.06 sequentially and up $0.21 year-over-year. Moving on to the balance sheet. As of September 30, 2024, cash and cash equivalents were $1,041.9 million, up sequentially $280.5 million and down $197.1 million year-over-year. Of our $1,041.9 million balance, $285 million was held in the U.S. and $756.5 million was held by our international entities. We have $500 million available for repurchase of our common stock under our January 2023 repurchase program. Beginning in Q4 2024 and continued into Q1 '25, we expect to repurchase up to $275 million of our common stock through either a combination of open market repurchases or an accelerated stock repurchase agreement. Q3 accounts receivable balance was $1,010.6 million, down sequentially. Our overall day sales outstanding was 93 days, up approximately four days sequentially and up approximately eight days as compared to Q3 last year. Cash flow from operations for the third quarter was $263.7 million. Capital expenditures for the third quarter were $29.8 million, primarily related to investments in our manufacturing capacity and facilities. Free cash flow, defined as cash flow from operations less capital expenditures, amounted to $233.9 million. Turning to our 2024 outlook. Assuming no circumstances occur beyond our control, including foreign exchange, we expect the following business outlook for the fourth quarter. We expect Q4 '24 worldwide revenues to be in the range of $995 million to $1,015 million. We expect Q4 '24 Clear Aligner volume and ASPs to be slightly up sequentially. We expect Q4 '24 Systems and Services revenues to be up sequentially, consistent with typical Q4 seasonality. We expect Q4 '24 GAAP operating margin to be slightly lower than 14%, primarily due to restructuring charges related to severance for impacted employees. We estimate these restructuring charges will impact Q4 '24 GAAP operating margin by approximately 3 points. We anticipate Q4 '24 non-GAAP operating margin to be slightly up sequentially. For fiscal 2024, we expect investments in capital expenditures to be above $100 million. Capital expenditures primarily relate to building construction and improvements as well as manufacturing capacity in support of continued expansion. As we have said many times, we continually evaluate and evolve our business model to provide doctors with the best tools and resources that they need to help them treat their patients while managing our operations responsibly. Today's restructuring action is designed to adjust our business to more closely align with the existing business environment. We expect the restructuring actions we announced today will give us margin accretion for full year in 2025 even as we scale up our next-generation direct 3D printing fabrication manufacturing. With that, I'll turn it back over to Joe for final comments. Joe?"
},
{
"speaker": "Joe Hogan",
"text": "Thanks, John. In closing, for Q3, I was pleased to report another strong Systems and Services quarter, and I'm excited about our next-generation Lumina scanner and its continued positive impact on our customers' digital workflow, with ortho software today and restorative software expected to be released in Q1 of next year. Q3 was also strong for our Invisalign Clear Aligner business in the Asia Pacific, EMEA and Latin America regions. For -- those markets are our fastest-growing regions and help to balance outperformance in other geographies. We understand that operating environment is more challenging, and we are adapting and driving our growth strategy despite continued weak consumer demand trends. especially in the United States and a sluggish dental market. In the face of inflation, high interest rates, less patient traffic and longer conversion cycles, especially for adult patients, orthodontists and dentists are facing challenges in practice growth and profitability that impacts the way many of them approach orthodontic treatment. It is more important than ever that we differentiate our products and services and become the best partner for our customers by creating solutions that drive more patients to their practices, accelerates treatment conversion and improves their experience and bottom line. As the innovation leader in digital dentistry technology, it's our job to ensure we have the organizational structure, focus and rigor to help doctors realize the full potential of this opportunity by doing more to engage our doctor customers and support their practice growth and to help consumers and potential patients connect with these practices to get to smiles that they love. We continue to evaluate and evolve our business to provide doctors with the best tools and resources they deserve. Align is the leader in digital orthodontics, and we are committed to supporting doctor customers and the future of digital innovation. We're committed to supporting doctor customers and the future of the digital innovation and are excited the next wave of growth drivers that we believe will revolutionize the orthodontic industry in scanning software and direct 3D printing. We're in the midst of several key technology developments that are critical for the business. We will take the needed actions to get us through this, while at the same time investing in the key areas that we know will transform our industry and our business. The restructuring actions we announced today focused on ROI investments and activities that drive revenue and enable margin expansion, while making room for investments in critical future technologies, including scaling our direct 3D printing operations. With that, I thank you for your time today. I look forward to updating you on our continued progress over the coming quarters. Now, I'll turn the call back over to the operator for questions. Operator?"
},
{
"speaker": "Operator",
"text": "Thank you. At this time, we'll be conducting a question-and-answer session. [Operator Instructions] Our first question comes from Brandon Vazquez with William Blair. You may proceed."
},
{
"speaker": "Brandon Vazquez",
"text": "Hey everyone. Thanks for taking the question. I wanted to start on a little bit just the macro backdrop. Last year, the year-over-year comp also had a little bit of weakness in the September period, if I remember, in 2023. So, things are a little bit worse now. I'm just curious if you can talk about did things get worse from last year, which was already a little bit of -- a little weak. And in case that doesn't make sense, the crux of the question is essentially just talk to us about where macro is going into year-end? Is it stable? I think you guys have used that phrase before. Is it worsening? Just any thoughts you guys are seeing on end markets?"
},
{
"speaker": "Joe Hogan",
"text": "Yeah, Brandon, it's Joe. I'd say, first of all, third quarter is always a tough quarter because of the discontinuities we have with Europe shutting down and different countries being on vacation at different times. So, I wouldn't say that the third quarter this year was worse in some way than the third quarter last year. I'd just say that it was the kind of seasonality in a difficult market. What we try to call out, as you could see, is that United States market seems to be one of our the most affected and it's really one of our largest markets, too. And so that's been a challenge in that sense also. John, do you want to add anything?"
},
{
"speaker": "John Morici",
"text": "No, that's accurate."
},
{
"speaker": "Brandon Vazquez",
"text": "Okay. And then, as my follow-up just quickly, as we look towards 2025, right, and if we just assume end markets are stable, right, let's say things remain stable, how should we think about what the top-line on this business could do and what the P&L could look like in a year where things are stable, right? You guys are somewhat macro hindered right now. So, is it a continuation of what we're seeing in '24? Are there reasons to get a little bit more excited and accelerate the business? Any expectations around that would be helpful. Thank you."
},
{
"speaker": "Joe Hogan",
"text": "Hey, Joe, again. I'd just say we'd like to see some increased consumer confidence obviously in the United States and just an economy that feels better to consumers. We feel that this is more of an external issue than it is an internal issue when you look at Align overall in our growth rates, particularly in United States. And so, any kind of increase in economic activity and increase in consumer confidence, we think would be really positive for our customers and then for Align in turn."
},
{
"speaker": "Shirley Stacy",
"text": "Thanks, Brandon. Next question, please?"
},
{
"speaker": "Operator",
"text": "Thank you. Our next question comes from Jon Block with Stifel. You may proceed."
},
{
"speaker": "Joe Hogan",
"text": "Hey, Jon."
},
{
"speaker": "Jon Block",
"text": "Hey, guys. Good afternoon, Joe. Joe, maybe just to start with you, and it sort of picks up on that last question, anything to call out with the different results in the U.S. versus international? In other words, I think I've got this right, but cases up 2.5% globally, but as you mentioned, down in the U.S. So, is it just the consumer? Is there anything to focus on from a go to market strategy? Do we have to think about incremental competition that might be more acute in the U.S. versus OUS? Just would love your thoughts on that dynamic."
},
{
"speaker": "Joe Hogan",
"text": "Yeah, Jon, it's a good question. I'd say it's mainly external when I look at it. I don't think there's been any dramatic changes from a competitive standpoint in the marketplace. If I look at our ortho channel and our dental channels, they're both challenged in the sense of patient throughput and their ability to close. I was just talking to some of our largest DSOs this morning and the comparison is similar. This is -- and these are -- the close rates at our customers are more difficult, too. It's customers come in, we know they want teeth treatment, but they're not really confident in the sense of their ability to pay for it or wanting to pay for it right now in the economic situation. So, I wouldn't call out anything externally from a competitive standpoint or whatever. This is more what we feel is external economics and consumer confidence issue in the United States. Look, we see, Jon, the same thing in Europe, but Europe has been a little better and a little different, because all those countries have different situations, but it's more pronounced in the United States because it's so large and so uniform in that sense."
},
{
"speaker": "Jon Block",
"text": "Got it. Okay, thanks. And then, second question will be sort of a famous two-parter, but John, just to start, I just want to be crystal clear, you guys are committing to overall op margin expansion in '25. If that's correct, it will be somewhat neutered by the direct 3D printing fabrication initiative. Maybe if you can verify that? And then, any thoughts on the top-line? That would just be first question or I'll call it Part A. And Part B -- sorry go ahead, John."
},
{
"speaker": "John Morici",
"text": "I was going to give the op margin. The op margin, yes, we made the restructuring actions, given us room, so that we can get the year-over-year margin accretion, while still investing in all the things that we've talked about with direct fab and five-minute ClinCheck and Lumina and so on. So, we're going to continue making those investments. The restructuring gives us some room to show that margin accretion."
},
{
"speaker": "Jon Block",
"text": "Okay. And again, the other part of that question was, any thoughts on the top-line? If you're committing to the OM expansion, what does that mean from a top-line perspective? And the second one, Joe, just if I can pivot and if you can talk to some of the initiatives out there? In other words, it seems like Costco is off to a slow start, [per our] (ph) checks. Do you need to be in the store? And then, more recently, we picked up on a new financing initiative that it seems like you're rolling out and sort of guarantees the case approval, denials have been a problem. Where are you with that initiative? And when do you expect it to have a more sort of prominent impact on the overall P&L? Thanks, guys."
},
{
"speaker": "Joe Hogan",
"text": "Yeah. Hey, Jon, I'll just kind of just frame your question. The first one like Costco, we've had some success in Costco, but it's nothing as material for the business right now, but I think you have to look at that as we do internally. It's a brand strategy. We have the number one brand in the world. We're looking at different areas of how we can leverage that brand to try to encourage consumers more in the sense of entertaining Invisalign treatment. As far as financing, we know that customers right now are challenged in the sense that they do want a treatment from an orthodontic standpoint, but they're really challenged from a financial standpoint. And John and the team are doing all they can. And also our DSO -- big DSO partners are doing what we can to offer the type of financing that would give consumers more confidence to move forward."
},
{
"speaker": "John Morici",
"text": "And on overall revenue, Jon, we'll give more of an update as we get closer into 2025. But as we've said and as we've made the adjustments, we're committed to driving growth, investing where we can find that growth, balancing our investments on some of the new technologies that we have that we know will transform this business. So that's all at stake now and things that we're mindful of, but we'll give more of an update on 2025 as we get closer."
},
{
"speaker": "Jon Block",
"text": "Thank you."
},
{
"speaker": "Joe Hogan",
"text": "Yeah, you're welcome, Jon."
},
{
"speaker": "Operator",
"text": "Thank you. Our next question comes from Elizabeth Anderson with Evercore ISI. You may proceed."
},
{
"speaker": "Elizabeth Anderson",
"text": "Hi, guys."
},
{
"speaker": "Joe Hogan",
"text": "Hi, Elizabeth."
},
{
"speaker": "Elizabeth Anderson",
"text": "Hi. I'm also going to try my hand at a two-parter as well, [since that's the theme] (ph). One, I mean, as you talk about the restructuring and sort of Frank coming back to the organization, I think you hinted at it a little bit. I know it's obviously a little bit early, so just sort of high-level quality of thought would be fine on this too. Like, what do you mean when you're -- what are you sort of -- like, what is he going to sort of drive or what do you -- is there sort of like an inflection that you're thinking about how he operates the business differently? And sort of as a corollary to that, like, I think you talked about getting closer to the consumer. If you could talk maybe about that portion of it? And then secondarily, it was nice to hear the positive commentary about China. So, I'd love to hear a little bit more about that market and sort of how you're thinking about the consumer outlook for that market as well. Thank you."
},
{
"speaker": "Joe Hogan",
"text": "Hey, Elizabeth, it's Joe. On Frank coming back, Frank was -- had been in the business from 2013. I think he left us in 2022 for another type of venture. Look, this business is about -- it's about three things. One is relationships. This is not a transactional business. This is one where you want to have good relationships and good trust with doctors, and Frank really brings that from a leadership standpoint. Secondly is, you would need a good understanding of the technology and types of programs that can help to drive growth. Frank is really an expert in that area. He's shown that over the years. When you look at our DSO program today, it's been really effective. Frank happened to put that together back when I first arrived, back in 2015, 2016 and really made that happen. Thirdly is, you need someone with scope in the sense of understands the industries, understands the competition, knows what really makes doctors make decisions, and orthodontists and how they make decisions versus the general practitioners. Frank has all that, and he's a trusted commodity within the business. So, we're excited to have him back."
},
{
"speaker": "John Morici",
"text": "And then, the last part of your question, Elizabeth, on China, we're pleased with China results, sold to more doctors, pleased with the utilization. It's a great teen season for us in China. We saw good adoption of various products, including Invisalign First and others, where we saw good utilization there. So, China, for us, from a teen standpoint, especially, played out really well for us."
},
{
"speaker": "Elizabeth Anderson",
"text": "Got it. Thank you."
},
{
"speaker": "Joe Hogan",
"text": "You're welcome."
},
{
"speaker": "Operator",
"text": "Thank you. Our next question comes from Jason Bednar with Piper Sandler. You may proceed."
},
{
"speaker": "Joe Hogan",
"text": "Hi, Jason."
},
{
"speaker": "Jason Bednar",
"text": "Hey there. Yeah, good afternoon. I'm going to come back and follow-up on one of Jon's questions. I know a lot of us have been trying to estimate the margin upside or the margin impact from 3D printing over time, just given the cost benefits you can realize from the initiative. But the comment today here with the restructuring offsetting some of the -- maybe some of the investments you're making, it would seem like that this initiative may be dilutive to gross margins in '25. So, maybe just help us bridge the thinking that you're making in these comments today, reconcile some of those comments, and if you can, quantify kind of the puts and takes?"
},
{
"speaker": "John Morici",
"text": "Yeah. I'll take my best at this. So, overall, we're talking op margin. We think that the restructuring that we're making is going to be op margin accretive on a year-over-year basis despite all the investments. You're right, from a gross margin standpoint, as we scale things, the direct fab printing, while gives us a lot of capability and a lot of benefits for our doctors, there is a higher cost initially until we start to scale that. But we're committed to that op margin accretion on a year-over-year basis for next year despite that. And then, as we have new products that come and we know the doctors are going to love what we're bringing to market, that will scale up. And as that scales up, then that really drives the overall productivity that we will see on the gross margin side, primarily from the materials and the less material that we need to go into the product."
},
{
"speaker": "Jason Bednar",
"text": "All right, understood. And I guess maybe one follow-up to there and then another separate follow-up. But just any timeline on when we might see the gross margin benefits or expansion off of historical norms once that 3D printing does scale? And then, just with the teen season maybe now mostly complete, just what's your assessment of that part of the market, Joe, inside the U.S., outside the U.S.? The data we see has been a bit more mixed between kind of the clear aligner and bracket and wire part of the markets the past several months. Your business has grown decently the past year and a half. So, just -- do you have better visibility on this part of the market? I'm just trying to understand this again in the context of the broader comments you're making on the U.S. being a little bit softer. Thanks."
},
{
"speaker": "John Morici",
"text": "So, Jason, this is John. I'll take the first part of your question on gross margin. Look, we've talked about it being like a two- to three-year journey to be able to help scale this up. I can say this, we're very pleased with the progress that we're making around resin and being able to scale that and get it at the right cost. So that's good progress there. As well as on the equipment side, we're making good progress around being able to scale up the actual manufacturing of this. But in terms of when you scale this and get it to a larger extent, it's really two to three years, but you will see some new products that we have on the direct fab showing up next year and in doctors' hands to give them those capabilities."
},
{
"speaker": "Joe Hogan",
"text": "Jason, on the teen market, I mean, when you look at the international teen market, obviously, we had really good success in Asia in the quarter. We have really a terrific portfolio when you think about our Invisalign First product. Now, we have Invisalign Palatal Expander. With that also, it's what we call mandibular advancement with occlusal blocks, which are used for Class IIs, usually for patients between 10 and 11 years old. So, when you look at those pre-teen ages, we have a really good portfolio to line up in that sense. So, I think you're seeing that come through with our sales overall. When you reflect back on the United States, obviously, our orthodontic customers are really challenged. And 80% on an average, 75% of what they do are teens. And some of the close rates on teens, just talking to some of the DSOs and different doctors that we have on the orthodontic side, the close rates are even tougher on the teen segment than what it's been in the past, too. And so, times like this, where they're pressed for traffic and they're pressed for margin, they will reflect back to wires and brackets to support the profitability of their practice. We know that. We understand it. It's our job to communicate to consumers and to orthodontists what the benefits are, particularly this early treatment and what we can do. And so, this is a doctor-to-doctor situation, but again, it's an external environment where consumers are concerned with their pocketbooks right now, and they're reluctant to make decisions and close at times. And obviously, the orthodontists are responding from an individual practice standpoint accordingly."
},
{
"speaker": "Jason Bednar",
"text": "All right. Very helpful. Thank you."
},
{
"speaker": "Operator",
"text": "Thank you. Our next question comes from David Saxon with Needham & Company. You may proceed."
},
{
"speaker": "David Saxon",
"text": "Great. Good afternoon, and thanks for taking my questions. I'd like to start on iTero actually. I'd love to get some color around how we should think about iTero growth with the ongoing Lumina rollout, particularly with the restorative workflow coming out early next year, but then in the context of interest rates remaining high and then lapping comps from the initial ortho launch?"
},
{
"speaker": "Joe Hogan",
"text": "Yeah, David, I think you have to start with, and I think I get the gist of your question, there's a lot of pressure on capital equipment sales in the marketplace given what we're talking about with customers being challenged in that way. I think what you have to do with the Lumina and think about it, it's truly a brand new platform. It's not an iteration of old technology like the next phase of our older technology. It's something that's really new, and it's captured doctors' attention. And I think it's the size of our sales and how well we've done, particularly in a traditional third quarter, it's a little bit slower, I think it surprised a lot of people. So, I think this is a testimony to the technology we've brought forward and the uniqueness of that technology, why we've been able -- to be able to have those kinds of sales at this point in time. We're excited about the restorative coming on in the first quarter. The team is making good progress on that. So, overall, it's just a great foundation to grow from. And what's wonderful about that platform, too, is we'll iterate from that platform going forward in different areas that will really help us to diversify the product line and target certain applications in the future."
},
{
"speaker": "John Morici",
"text": "And two things that really have helped iTero and kind of go through this, especially with the new product and so on, it's really given us a lot of opportunity on other products that we sell within the iTero kind of family. So, all the way from CPOs that we have certified pre-owned, all the way to the 5D. We actually sold a lot of 5Ds this past quarter. So, that really helps us. And then, the added part, in a tougher economy, we're giving a lot more flexibility to doctors to kind of sell the way they want to buy. Some don't want to purchase outright because of the economic conditions and so on. So, we see a lot more leasing or in other places we see more rental. And for us, that's a great trade. It will get that recurring revenue off of those different selling options, but then it's great when a doctor uses iTero because we know they'll do use more Invisalign."
},
{
"speaker": "David Saxon",
"text": "Great. Thanks for that. And then, on the U.S. side, on the Clear Aligners, can you give more color on kind of where that weakness is actually coming from? Is it the ortho channel or is it with GPs? And then, anywhere specifically from a portfolio perspective? Thanks so much."
},
{
"speaker": "Joe Hogan",
"text": "Yeah. I mean, it's almost equal in both. We see pressure on the ortho side. I mean, if you look at any kind of industrial data right now as far as patients entering the dental industry right now, the GP space, it's challenged overall. So, we see pressure in both of those areas for the same reasons we talked about before."
},
{
"speaker": "Shirley Stacy",
"text": "Yeah. Thanks, David. Next question, please?"
},
{
"speaker": "Operator",
"text": "Thank you. Our next question comes from Jeff Johnson with Baird. You may proceed."
},
{
"speaker": "Joe Hogan",
"text": "Hey, Jeff."
},
{
"speaker": "Jeff Johnson",
"text": "Thank you. Hey, Joe. How are you? Good afternoon, guys. So, Joe, let me ask one high-level question and then maybe just a modeling question for John. But from a high level, your R&D was down 4% year-over-year this quarter. You're making the headcount reductions. CapEx at $100 million is well below even the last couple of years, closer to $250 million those years. You're talking about increasing the buyback margin improvement next year. All of these comments kind of just point to a more mature company and that's not a critique at all. I think that's where we all know you are and see where you are. So, I guess my question is, how does this change your management style, your management objectives over the next few years? Obviously, you came into this business really pushing the top-line, but is there an evolution that's happening to go on with how you lead this company and lead this organization as well?"
},
{
"speaker": "Joe Hogan",
"text": "Hey, Jeff. I think it's a really good question. I'd say we're responding to the times here. Don't make it a reflection on what the opportunity the company is at all. We're so underpenetrated, not just in United States or North America or whatever, but all over the world. And there's hundreds of millions of people that need to have their teeth straightened. And the only way you could ever do that in a broad sense is with digital orthodontics. So, don't miss that point, Jeff. We are going through a spell right now. And what you see with the R&D down and CapEx and different things like that, CapEx is, you know we're not putting on any more manufacturing right now. We have enough manufacturing, and we're still bringing up our Poland plant, right? We're being responsible from a business leadership standpoint for our shareholders in this specific situation, but at the same time, Jeff, we're pouring a lot of money into 3D printing, five-minute ClinCheck, next phases of Lumina. All these things will really enter into just another growth cycle when this market starts to come back with brand new tech. This is the technology of the future if you really want to play in digital orthodontics. So, what we're doing is funding that, being responsible to our shareholders, but not losing our enthusiasm and what we think our opportunity is in the future."
},
{
"speaker": "Jeff Johnson",
"text": "Yeah. No, that's all fair. You are holding a sell-side event or at least an investor event a week from Saturday. Would that be a time to evaluate though that LRP, that 20% to 30% intermediate longer-term top-line growth expectation?"
},
{
"speaker": "Joe Hogan",
"text": "I think until we get a better read on what the economy is going to do, Jeff, I think that 20% to 30% represents how we feel that market could grow in the future, but we have to have the right economic conditions, particularly in the biggest markets in the world like the United States that we participate in."
},
{
"speaker": "Jeff Johnson",
"text": "Okay. And John, one modeling question. Just when I listen to the ASPs, I think the quick math on that is, it sounds like between the VAT issue that should anniversary at the start of next year, just remind me if I've got the timing on that correct, but should anniversary at the start of next year, currency headwinds should be -- we'll see what the U.S. dollar does post-election year, but should be reasonably moderating from here? So, I think ex currency and ex VAT, you had about 1.1% down ASP year-over-year. One, is that math correct? And two, is that about what we should be thinking about as we head kind of into '25 once VAT and hopefully FX normalizes a bit?"
},
{
"speaker": "John Morici",
"text": "You're right about FX hopefully normalizes, it's hard to predict. VAT does anniversary at the beginning of next year. And what we've said in the past that that ASPs would be flat to slightly down. So, your percentage you're talking about is in that range."
},
{
"speaker": "Jeff Johnson",
"text": "Thank you."
},
{
"speaker": "Shirley Stacy",
"text": "Thanks, Jeff."
},
{
"speaker": "Joe Hogan",
"text": "Thanks, Jeff."
},
{
"speaker": "Operator",
"text": "Thank you. Our next question comes from Kevin Caliendo with UBS. You may proceed."
},
{
"speaker": "Joe Hogan",
"text": "Hi, Kevin."
},
{
"speaker": "Kevin Caliendo",
"text": "Hey, thanks. Hi, Joe. Thanks for taking my question. This is maybe a little bit off, but just wondering if you guys have ever done this analysis in terms of thinking about the Venn diagram between people purchasing GLP-1s and people going and getting Invisalign treatments, because the cost for adults anyways might be close. And I'm just wondering if there's any -- if you guys have seen any correlation to maybe that's part of the weakness in the adult market as the shortages have -- in GLP-1s have come down or people may be investing $5,000 that way as opposed to into Clear Aligners. Have you done that analysis or seen anything?"
},
{
"speaker": "Joe Hogan",
"text": "I can't say that we've been -- we've overly quantified it, Kevin. We hear that a lot. There's a lot of medical device companies that kind of talk about that that might be corollaries in the sense of what you're seeing with the GLP marketplace overall. I can't say that it's not a factor because it's obviously a high expense and something that's kind of on an annual basis in line to what it would cost to do an Invisalign treatment. But I haven't wanted to lean into that as one of the drivers here. I think it's just overwhelmed by an economy right now where consumers don't have a lot of money in their pocket or confidence about what it's going to be in the future. And GLP might play a role in it, it might not. I think also you can look around the world also in some of the markets, like Continental Europe, that's not necessarily as affected by it as maybe United States is. And I can't say I've seen that piece, too. So, there's an old saying that correlation doesn't mean causation, right? And so, I would stay with that right now."
},
{
"speaker": "Kevin Caliendo",
"text": "Fair enough. That's helpful. And just I know you don't want to talk about '25, but let's just think about the fourth quarter and sort of what you're implying for your guide in exiting the year sort of a midpoint of like 5%. Should we just sort of take that as a starting point, adjust for whatever we think the economy might do that might impact the adult side of the marketplace more and then think about Lumina as an add on to that? I mean, is that sort of how you're thinking about the business?"
},
{
"speaker": "John Morici",
"text": "Yeah. I think we'll obviously give more as we get closer to this, Kevin, but I think -- look, you come out of the year, that's probably a good starting point to be able to build off of that and say, look, what do you think is going to happen to the economy, we're going to know more, maybe about interest rates and election and other things will kind of come about and we'll have a better view of that. But I think it's a good starting point as you think about next year, you're going to add in some of the things that we've talked about with, Lumina restorative and other things and then build off of that, but we'll give more details as we get closer, obviously."
},
{
"speaker": "Kevin Caliendo",
"text": "Appreciate it guys. Thank you."
},
{
"speaker": "Shirley Stacy",
"text": "Thank you."
},
{
"speaker": "Joe Hogan",
"text": "Yeah, thanks, Kevin."
},
{
"speaker": "Operator",
"text": "Thank you. Our next question comes from Michael Cherny with Leerink Partners. You may proceed."
},
{
"speaker": "Michael Cherny",
"text": "Hi, good afternoon. Maybe just one, following up on a question earlier on the some of the 3D printing work in the fab-related products that you're going to be pushing out. As you think about the potential for introduction to those products, how are you thinking, given that this is a bit of a obviously different manufacturing approach that you've taken before, about what the rollout will look like? Will it look any different in terms of the types of beta customers that you're going to be pursuing? How should we think about tracking -- I mean, tracking is not the right word, but making sure that you're hitting on the right customer experience, the right overlap, the right introduction process as you get what obviously could be a very scalable set of products, set of new opportunities out to market?"
},
{
"speaker": "Joe Hogan",
"text": "Hey, Michael, it's Joe. Just taking your question is, as you think about it, when you think of what we do today, when you [indiscernible], obviously, you lose a huge amount of opportunity to differentiate the geometry of that particular product and how it can help a doctor. The one sector of our business that would I think will appreciate this the most will be the orthodontic community that do a lot of Class IIs, difficult cases, young teens, and we'll be able to produce products that are more and more tailored to consumers in that specific condition than what we could do today. And so, we would offer the product that way, and we think it'd be very appealing to them. Secondly, from a general dentistry standpoint, it's a big part of our marketplace, too, there's a lot that we can do to help them with this product line also. So, I hope I'm answering your question, but the design freedom that we have here in the end and we have to prove it when you can use relatively different thicknesses, you can do different configurations for different kinds of clinical issues that a patient might have, we expect to have more predictability in the sense of how fast you can move those teeth and more certainty and how long those cases will take. And I think doctors are going to appreciate that, but I think as we're certain of that, patients will appreciate that too, and we certainly would communicate that to patients."
},
{
"speaker": "Michael Cherny",
"text": "No, that certainly does help. And then maybe just one quick question, I promise it's not an attempt to go at '25 guidance specifically, but obviously, you've mentioned numerous times the UK VAT that's impacting ASPs internationally this year. Is there any outliers or one-time dynamics that we should be thinking about or contemplating relative to next year, something that like the UK VAT or anything else that could factor into the modeling that's non-normal?"
},
{
"speaker": "John Morici",
"text": "Michael, this is John. Nothing that we would say is non-normal. I mean, the nice thing about the anniversary of the UK VAT is, it does anniversary. Obviously, we're doing things to try to work with that government there to explain and ideally not have a VAT on our products, because it affects what goes to doctors and how much they pay and then passing it on to potential patients. But there's nothing like that, that we would see on the horizon as that type of impact."
},
{
"speaker": "Shirley Stacy",
"text": "Thanks, Michael. Next question, please?"
},
{
"speaker": "Operator",
"text": "Thank you. Our next question comes from Erin Wright with Morgan Stanley. You may proceed."
},
{
"speaker": "Erin Wright",
"text": "Great. Thanks. Can you speak a little bit more on just the nature of the restructuring outside of the executive change today, I guess the timeline, scope, magnitude and anything that you can give us in terms of quantifying that benefit from a profit perspective into 2025 and what that translates into just broadly speaking, but also just what -- how this kind of came about in terms of what's on the table, what were your changes that you were thinking about in terms of the business outlook or backdrop that really changed in your view since it's been a sluggish kind of consumer backdrop for some time? Now, I guess what else has changed? Thanks."
},
{
"speaker": "John Morici",
"text": "Yeah, Erin, I could try to give you kind of an overview of where things are at. Just as part of a normal AOP process, you're always evaluating where you're going to make investments, where you're going to fund it, how you're going to fund it and so on. So, this is part of our process that we go through where we're planning out where we're going to end up for the year and what does it mean for next year and how do we grow and do all the things that we want to talk through. This type of restructuring, this is about 2x of what we did last year. Last year, we did about 350 or so, just over 300. This is close to 700 people. There's some restructuring charges, we've talked about that, this year. But really what it does and what -- I'll go back to what Joe was talking about, we want to be focused in on what we can drive as our business, what we can do from a growth platform standpoint, whether it's the direct fab, five-minute ClinCheck, Lumina restorative. We want to fund those, but we've got to also show some margin accretion and we want to be margin accretive on a year-over-year basis. So, we can fund what we need to fund to really be driving our business and we'll fund it based on some of these changes here, but it really set us up for a position to be able to show that margin accretion next year."
},
{
"speaker": "Erin Wright",
"text": "Okay, great. And then, as we head into the fourth quarter, I guess, does your guidance assume a continuation of the same in terms of the sluggish environment in the U.S.? Or does it have any sort of changes across other regions that you anticipate either continued acceleration or deterioration across other kind of markets or geographies here? Thanks."
},
{
"speaker": "John Morici",
"text": "Yeah, Erin, it just kind of assumes what we've seen. I mean, like as we pointed out, U.S., North America not great, we kind of assume the same. Other places we actually saw good improvement, in parts of Asia, Latin America, Middle East, other places, and we continue to invest and expect to grow in those areas. So, like any forecast, you take the best information you have at the time, you try to translate to what that's going to mean for the upcoming quarter, and that's what we did for fourth quarter."
},
{
"speaker": "Shirley Stacy",
"text": "Thanks, Erin. Next question, please?"
},
{
"speaker": "Operator",
"text": "Thank you. [Operator Instructions] Our next question comes from Mike Ryskin with Bank of America. You may proceed."
},
{
"speaker": "Mike Ryskin",
"text": "Hey, thanks, guys. Just a couple of cleanup follow-up questions. One, I think just kind of following up on what Erin touched there and John you touched on this as well. Two years in a row now, and again part of that is just natural attrition, natural cleanup of the business, but should we expect this to be sort of the normal going forward in terms of the restructuring? You guys famously kind of held off on that for a while. And very famously during COVID, you actually reinvested and you refused to cut when others were cutting. So, just help us think in terms of how we should factor that in going forward."
},
{
"speaker": "Joe Hogan",
"text": "Hey, comparing this time with COVID is a stretch, Michael, overall. When we didn't lay anybody off during COVID, our expectation was that wouldn't last as long as it did, but fortunately, that was a decision to pay off well when the market came back so strongly. Right now, we're looking at just a sustained economic malaise, I would call it, in the United States, and we're responding accordingly. We haven't lost our enthusiasm and our belief in how this business can grow and this market potential of this business. What you're seeing in the restructuring is we're responding to external pressures that we see and being responsible from a business standpoint and being sure that we fund these key three technologies that we know will lead into the future from an overall digital orthodontic standpoint."
},
{
"speaker": "John Morici",
"text": "And that's the key point of it now. It's being able to make space and have a budget to be able to fund these key technologies, because we know that's going to drive the future and it's doing things that we know no one else can do, no other company can do what we're trying to do with this. So, it's really important for us now to keep that focus through these budget changes and so on. It's what companies do to be able to push the future and do it in a responsible way where we could show margin accretion. We know we always talk about levers that we could pull or not pull. This is a part of it, and it just comes about it on a more annual basis as you assess the current environment."
},
{
"speaker": "Mike Ryskin",
"text": "Okay. And then, quick cleanup, if I could, on the ASPs. You talked about earlier, I think, in the Q&A, you touched on some of the factors that impacted you in the quarter and your thoughts about next year, but just on 4Q, I think you guided up ASP sequentially, and you've had some of these mixed dynamics, some of the discounting and FX for a number of quarters in a row. Just what are you seeing so far through October that's giving you confidence that you'll be able to reverse that? Because I think some of those headwinds don't fade till next year."
},
{
"speaker": "John Morici",
"text": "Yeah. Well, I think part of -- really all our Advantage programs kind of go from -- they end in at the end of June and then they reset as you come into that second half. So, third quarter kind of took the Advantage changes. So, that shows up in discount. So, I don't expect that to continue. And then, where you do have the benefit and in our case where Europe becomes a bigger part of our business in the fourth quarter and China and some of the other businesses become less, that's good from a mix standpoint. We have a higher ASP in Europe and a lower ASP in China. So, whereas that mix hurt us from a country standpoint, in a lower ASP in the third quarter, we actually get the benefit on that in the fourth quarter based on seasonality."
},
{
"speaker": "Mike Ryskin",
"text": "Okay. That's helpful. Thanks."
},
{
"speaker": "Shirley Stacy",
"text": "Thank you, Michael."
},
{
"speaker": "Joe Hogan",
"text": "Yeah. Thanks, Mike."
},
{
"speaker": "Operator",
"text": "Thank you. And we have reached the end of our Q&A session. I'll now turn the call back over to Shirley Stacy for closing remarks."
},
{
"speaker": "Shirley Stacy",
"text": "Great. Thank you, operator, and thanks, everyone, for joining us on the call today. We look forward to speaking to you at upcoming financial conferences and for those of you who we'll see at the Invisalign Ortho Summit in Las Vegas next week. If you have any other questions, please feel free to contact Investor Relations, and have a great day."
},
{
"speaker": "Operator",
"text": "Thank you. This concludes today's conference, and you may disconnect your lines at this time. Thank you for your participation."
}
] | Align Technology, Inc. | 24,568 |
ALGN | 2 | 2,024 | 2024-07-24 16:30:00 | Operator: Greetings. Welcome to the Align Technology Second Quarter 2024 Earnings Call. At this time, all participants are in a listen-only mode. A question-and-answer session will follow the formal presentation. Please note, this conference is being recorded. I would now like to turn the conference over to your host, Shirley Stacy with Align Technology. You may begin.
Shirley Stacy: Good afternoon, and thank you for joining us. I'm Shirley Stacy, Vice President of Corporate Communications and Investor Relations. Joining me for today's call is Joe Hogan, President and CEO, and John Morici, CFO. We issued second quarter 2024 financial results today via Business Wire, which is available on our website at investor.aligntech.com. Today's conference call is being audio webcast and will be archived on our website for approximately 1 month. As a reminder, the information provided and discussed today will include forward-looking statements, including statements about Align's future events and product outlook. These forward-looking statements are only predictions and involve risks and uncertainties that are described in more detail in our most recent periodic reports filed with the Securities and Exchange Commission available on our website and at sec.gov. Actual results may vary significantly and Align expressly assumes no obligation to update any forward-looking statement. We have posted historical financial statements with corresponding reconciliations, including our GAAP to non-GAAP reconciliation, if applicable, and our second quarter 2024 conference call slides on our website under Quarterly Results. Please refer to these files for more detailed information. With that, I would like to turn the call over to Align Technology's President and CEO, Joe Hogan. Joe?
Joe Hogan: Thanks, Shirley. Good afternoon, and thanks for joining us on our call today. I'll provide an overview of our second quarter results and discuss a few highlights from our two operating segments, System and Services and Clear Aligners. John will provide more detail on our Q2 financial performance and comment on our views for the third quarter and for 2024 in total. Following that, I'll come back and summarize a few key points and open the call to questions. Overall, I’m pleased to report solid second quarter results. Total Q2 '24 revenues of $1,028.5 million were up 3.1% sequentially and 2.6% year-over-year, reflecting growth in both Clear Aligner volumes and Imaging Systems and CAD/CAM Services revenues. Q2 '24 total revenues were unfavorably impacted by foreign exchange of approximately $11.6 million or 1.1% sequentially and unfavorably impacted by approximately $18.1 million or 1.7% year-over-year. For Clear Aligners, Q2 '24 volumes increased 6.2% sequentially and 3.2% year-over-year, driven by growth from adult patients, and strong teen case starts across the regions, led by strength in Asia Pacific, EEMA, and Latin America. Our Q2 results also reflect a record number of doctors submitting cases, and record doctors shipped to for the quarter. Q2 '24 Clear Aligner ASPs were down sequentially and lower than anticipated in our second quarter outlook, due in part to greater impact of unfavorable foreign exchange across multiple currencies, especially the Japanese yen, Euro, and Brazilian real, as well as discounts, and product mix shift to lower ASP products. As a result, total Q2 revenues were slightly below the expected range for our Q2 quarterly revenues. Notwithstanding these factors, non-GAAP operating margin for the second quarter was 22.3%, up 2.5 points sequentially, and up 1.0 point year-over-year. For Imaging Systems and CAD/CAM Services, Q2 '24 revenues increased 9.2% sequentially and 16.1% year-over-year reflecting continued adoption of our next-generation iTero Lumina scanner, which made up the majority of our equipment sales, iTero Lumina wand upgrades, iTero Element scanner trade-ins, as well as increased iTero scanner leases. For Q2 '24, adult patient case starts were up 5% sequentially and 1% year-over-year, reflecting our highest number of adult shipments in 8 quarters, driven by strength in the GP channel, led by North America and APAC dentists. In teen and growing kids’ segment, over 216,000 teens and younger patients started treatment with Invisalign clear aligners during the second quarter, an increase of 8.8% sequentially and up 8% year-over-year, reflecting growth across regions, especially from Invisalign First in the EMEA and APAC regions. In Q2, the number of doctors submitting teen or younger patient case starts was up 8% year-over-year, led by continued strength from doctors treating young kids also known as "growing patients. The response from doctors and their patients to Invisalign Palatal Expander System continues to be positive. We believe that Invisalign Palatal Expander System is a better option for expanding a growing patient's narrow palate compared to traditional appliances used today. The Invisalign Palatal Expander System is currently available in the U.S., Canada, Australia, and New Zealand. We expect it to be available in other markets pending future applicable regulatory approval. Non-Case revenues include our Vivera retainers, which include retention aligners ordered through our Doctor Subscription Program or DSP, as well as clinical training and education accessories in eCommerce. Q2 Non-Case revenues were up 3.5% sequentially and up 5.1% year-over-year, primarily due to continued growth in retainers and DSP. For Q2, total Clear Aligner shipments include approximately 25,000 Invisalign DSP touchup cases, a record high quarter of 37% year-over-year. DSP continues to drive growth and is currently available in North America and certain EMEA countries. During the quarter, we extended DSP into more countries in Europe and we anticipate expanding into additional markets going forward. DSP is also now available in 14 stage touch up aligner offering across all markets where it's available. As a result, Touch-Up cases increased significantly in Q2. Q2 '24 Clear Aligner volume and DSO customers increased sequentially year-over-year reflecting growth across all regions. DSOs represent a large and growing opportunity to help drive adoption of digital technology across the dental industry. We have well-established relationships in many DSOs globally that recognize the benefits of digital workflows enabled by our portfolio of products and services that make up the digital platform. Including increased practice efficiency and profitability, as well as delivering a better patient experience from shorter cycle times and customer proximity. Smile Docs and Heartland Dental are two of our largest DSO partners. We are continuously exploring collaboration with the DSOs that can further the adoption of digital dentistry. Each DSO has a different strategy and business model, and our focus is working and encouraging DSOs aligned with our vision strategy and business model goals. Today, Invisalign is the most recognized orthodontic plan globally and Invisalign, Clear Aligner treatment is faster and more effective than traditional metal braces. Yet the underlying market opportunity to remains huge and untapped. We continue to invest in consumer marketing and demand creation initiatives that raise awareness and drive potential patients to Invisalign practices globally. In Q2, we had more than 17 billion impressions in 50 million visitors to our websites globally. Below are additional highlights from Q2 and more information is available in our Q2 '24 earnings webcast slides. To increase awareness and educate young adults, parents and teens about the benefits of Invisalign brand, we continue to invest and create campaigns in social media platforms such as TikTok, Instagram, U2, Snapchat, WeChat, [indiscernible] across the markets. Reaching young adults as well as teens and their parents also requires the right engagement through Invisalign Influencers and creator-centric campaign. In the Americas, our influence in social media campaigns, featured Olympic athletes such as Rebeca Andrade from Brazil, Andre De Grasse from Canada, Jordan Chiles from the United States and Paralympic athlete Lizzi Smith from the United States. To bolster T demand -- teen demand, we launched new activations with teen high school sports, social media platform, Over Time, including several programs focused on showcasing elite high school athletes across boys' football, girls' basketball, girls' soccer. We highlighted why they chose to transform their smile with Invisalign aligners and showcase their results. In the EMEA region, we partnered with influencers to reach consumers across social media platforms, including TikTok and Meta, and launched our global consumer campaigns for teens and parents. In APAC, we continue to invest in consumer advertising across the region and expanded our reach in Japan and India via meta and YouTube and partner with key social media influencers. Finally, adoption of my Invisalign consumer patient app continued to increase with over 4 million downloads to date and over 384,000 monthly active users and 8% year-over-year increase. Usage of our other digital tools also continued to increase. ClinCheck live update was used by almost 50,000 doctors on more than 692,000 cases, reducing time spent and modifying treatment plans by an average of 16.3%. Invisalign practice app is increasing in its adoption with 85,000 doctors who actively are using the app and 5.9 million photographs were uploaded in Q2 via the Invisalign practice app. Year-over-year growth in Q2 system and services revenue were up 16.1%, reflect higher scanner ASPs and non-system revenues driven by a terra luminal wand upgrades increased service revenues in a larger basis, scanner sold. On a sequential basis, Q2 systems and services revenues were up 9.2%, reflecting higher scanner volumes, higher scanner ASPs and higher non-system revenues driven by a iTero Lumina terra wand luminal wand upgrades. The iTero Lumina is new multi direct capture technology replaces the confocal imaging technology in earlier models and has a 3x wider field of capture and a 50% smaller and 45% lighter wand, delivering faster scanning speed, higher accuracy, superior visualization, and a more comfortable scanning experience. Lumina is currently available with orthodontic workflows as a new standalone scanner or as a wand upgrade from iTera element 5D Plus scanner. During the second quarter, we had a record number of competitive trade-ins demonstrating the continued success of the iTera Luminous Scanner in the marketplace. We're also seeing a halo effect with Invisalign scans. We're pleased to see more doctors coming into the digital ecosystem with an increase in first time Invisalign case submitters as well as return of lapse submitters. Overall, Q2 we're very pleased with the continued uptake of iTero Lumina Scanner with ortho workflow and response from customers. We're looking forward to a limited market release for the restorative software on Lumina in Q4, followed by full commercialization in Q1 '25. Today we introduced the iTero design suite, offering doctors an intuitive way to facilitate designs for 3D printing of models, bite splints, and restore restorations and practice. This software innovation is designed to help doctors increase their practice efficiencies and elevate patient experiences by shortening the time to treatment through an intuitive way to design for in-practice 3D printing. The Align digital platform provides an innovative portfolio of customer-focused technologies that enable seamless end-to-end workflows for dental professionals. iTero Design Suite is now available through an early access program. Doctors using an iTero scanner can submit their interest via their scanner, or my iTero portal. Software is expected to be available later this year in selected markets. With that, I'll turn it over to John.
John Morici: Thanks, Joe. Now for our Q2 financial results. Total revenues for the second quarter were $1,028.5 million, up 3.1% from the prior quarter and up 2.6% from the corresponding quarter a year ago. On a constant currency basis, Q2 '24 revenues were impacted by unfavorable foreign exchange of approximately $11.6 million or approximately 1.1% sequentially and were unfavorably impacted by approximately $18.1 million year-over-year or approximately 1.7%. For clear aligners, Q2 revenues of $831.7 million were up 1.8% sequentially, primarily from higher volumes, partially offset by lower ASPs. On a year-over-year basis, Q2 Clear Aligner revenues were flat, primarily due to higher discounts. A product mix shift to lower ASP products and the unfavorable impact from foreign exchange offset by lower net revenue deferrals, higher volumes and price increases. Q2 '24, Clear Aligner revenues were unfavorably impacted by foreign exchange of approximately $9.5 million or approximately 1.1% sequentially. On a year-over-year basis, Clear Aligner revenues were unfavorably impacted by foreign exchange of approximately $14.7 million or approximately 1.7%. For Q2 Invisalign ASPs for comprehensive treatment were down sequentially and year-over-year. On a sequential basis, the decline in a SP primarily reflects higher discounts, a product mix shift to lower a SP products and the unfavorable impact of foreign exchange. On a year-over-year basis, the decline in comprehensive ASPs primarily reflects higher discounts, a product mix shift to lower ASP products and the unfavorable impact from foreign exchange, mostly offset by lower net revenue deferrals and price increases. For Q2, Invisalign ASPs for non comprehensive treatment were down sequentially and year-over-year. On a sequential basis, the decline in ASPs reflects the unfavorable impact from foreign exchange, higher net revenue deferrals, and a product mix shift to lower ASP products partially offset by price increases. On a year-over-year basis, the decrease in non-comprehensive ASPs reflects higher discounts, a product mix shift to lower ASP products, the unfavorable impact of foreign exchange and the unfavorable impact of a price adjustment in the UK to make the recently mandatory application of VAT to our liners cost neutral to customers. Our Invisalign comprehensive three and three product and anticipate adoption will continue to increase is available in North America, EMEA and its certain markets across APAC. We are pleased with the continued adoption of the Invisalign comprehensive [3-in-3] product and anticipate an adoption will continue to increase. Comprehensive [3-and 3] provides doctors the flexibility they want while allowing us to recognize more revenue upfront with deferred revenue being recognized over a shorter period compared to our traditional Invisalign comprehensive product and benefiting us with a more favorable gross margin. Clear Aligner deferred revenues on the balance sheet decreased $7.8 million or 0.6% sequentially and decreased $5.2 million or 0.4% year-over-year. Ambo will be recognized as the additional aligners are shipped. Q2 '24 systems and services revenues up $196.8 million were up 9.2% sequentially, primarily due to higher volumes, higher ASPs and non-system revenues mostly related to upgrades Q2 24 systems and services revenues were up 16.1% year-over-year, primarily due to higher ASPs, increased non-system revenues, mostly related to upgrades and our leasing rental programs and higher service revenues. We are pleased to be able to leverage our operational and financial capabilities to provide different types of go-to-market models for our customers such as leasing and rental options. In the end, we are focused on selling the way our customers want to buy. Q2 24 systems and services revenues were unfavorably impacted by foreign exchange of approximately $2.1 million or approximately 1% sequentially. On a year-over-year basis, systems and services revenues were unfavorably impacted by foreign exchange of approximately $3.4 million or approximately 1.7%. Systems and services deferred revenues on the balance sheet was down $20.4 million or 8.3% sequentially and down $43.4 million or 16.2% year-over-year, primarily due to the recognition of services revenues, which are recognized ratably over the service period. The decline in deferred revenues both sequentially and year-over-year primarily reflects the shorter duration of service contracts applicable to initial scanner purchases. As our scanner portfolio expands and we introduce new products, we are increasing the opportunities for customers to upgrade and make trade-ins. In addition to our scanning, leasing and rental programs. Developing new capital equipment opportunities to meet the digital transformation needs of our customers and our DSO partners is a natural progression for our equipment business with a large and growing base of scanners sold. The structural programs we have implemented across both of our operating segment benefit our customers by providing them with more options to choose what they need. In some cases at a reduced price that may impact our ASPs, but the cost of service for us is, is lower and the benefit is then reflected in our gross margins. Moving to gross margin. Second quarter overall gross margin was 70.3%, up 0.3 points sequentially and down 0.9 points year-over-year. Overall gross margin was unfavorably impacted by foreign exchange by approximately 0.3 point sequentially and unfavorably impacted by approximately 0.5 points on a year-over-year basis. Clear aligner gross margin for the second quarter was 70.8%, down 0.1 point sequentially due primarily to lower ASPs, partially offset by lower additional aligners and leverage manufacturing spend. Clear aligner gross margin for the second quarter was down 1.7 points year-over-year due primarily to lower ASPs and higher manufactured spend as we continue to ramp up Poland manufacturing facility and the impact of unfavorable foreign an exchange. Systems and Services gross margin for the second quarter was a record 68.2% up 2.3 points sequentially, primarily due to higher ASPs and manufacturing efficiencies. Systems and services gross margin for the second quarter was up three points year-over-year for the reasons stated above. Q2 operating expenses were $575.6 million, up 5.9% sequentially and 6.3% year-over-year. On a sequential basis, operating expenses were up by $31.9 million due primarily to about $31 million in legal settlements year-over-year. Operating expenses increased by $33.9 million, primarily due to legal settlements and higher employee compensation, partially offset by lower outside services, advertising and marketing expenses. On a non-GAAP basis, excluding stock-based compensation. Amortization of acquired intangibles related to certain acquisitions, restructuring, legal settlements and other charges, operating expenses were $499.5 million, down 1.3% sequentially and down 1.1% year-over-year. Our second quarter operating income of $147 million resulted in an operating margin of 14.3% down 1.2 point sequentially and down 2.9% year-over-year. Operating margin was unfavorably impacted from foreign exchange of approximately 0.6 points sequentially and unfavorable impacted by 1.2 points year-over-year. On a non-GAAP basis, which excludes stock-based compensation, Amortization of intangibles related to certain acquisitions, restructuring legal settlements and other charges. Operating margin for the second quarter was 22.3%, up 2.5 points sequentially and up 1 point year-over-year. Interest and other income expense net for the second quarter was an expense of $3.2 million, primarily due to unfavorable foreign exchange compared to an income of $4.3 million in Q1 of '24, and an expense of $0.3 million in Q2 of '23. Recall that Q1 '24 included a non-recurring gain on our equity investments. The GAAP effective tax rate in the second quarter was 32.9% compared to 33.7% in the first quarter, and 34.8% in the second quarter of the prior year. The second quarter GAAP effective tax rate was lower than the first quarter effective tax rate, primarily due to discrete tax events is recognized in Q1 of '24 that did not reoccur in Q2 of '24, and that benefit was partially offset by an increase in non-deductible expenses. Our non-GAAP effective tax rate in the second quarter was 20%, which reflects our long-term projected tax rate. Second quarter net income per diluted share was $1.28, down sequentially $0.11 and down $0.18 compared to the prior year. Our EPS was unfavorably impacted by $0.11 on a sequential basis, and $0.17 on a year-over-year basis due to foreign exchange. On a non-GAAP basis, net income per diluted share was $2.41 for the second quarter, up $0.27 sequentially and up $0.19 year-over-year. Moving on to the balance sheet. As of June 30, 2024, cash, cash equivalents and short and long-term marketable securities were $782.1 million, down sequentially, $120.4 million, and down $251.7 million year-over-year. Of our $782.1 million balance, $140 million was held in the U.S and $642.1 million was held by our international entities. During Q2 '24, we repurchase approximately 0.6 million shares of our common stock at an average price of $250.73 through $150 million of open market repurchases. As of June 30, 2024, $500 million remains available for repurchases of our common stock under the January 2023 big purchase program. During the quarter, we completed a $75 million equity investment in Heartland Dental, a multidisciplinary DSO with GP and Ortho practices across the United States. Q2 accounts receivable balance was $1,020.1 million, up sequentially. Our overall day sales outstanding was 89 days, up approximately 3 days sequentially and up approximately eight days as compared to Q2 last year. Cash flow from operations for the second quarter was $159.8 million. Capital expenditures for the second quarter were $53.5 million, primarily related to our continued investments to increase aligner manufacturing capacity and facilities. Free cash flow defined as cash flow from operations, less capital expenditures amounted to $106.4 million. Now turning to our outlook, assuming those circumstances occur beyond our control, we provide the following business outlook for Q3 and fiscal 2024. For Q3 2024, we expect our Q3 worldwide revenues to be in a range of $980 million to $1 billion. We expect Clear Aligner volume to be down sequentially as a result of Q3 seasonality and clear aligner ASPs to be down sequentially, primarily due to foreign exchange and product mix. We also expect systems and services revenues to be down sequentially because of Q3 seasonality. We expect our Q3, 2024 GAAP operating margin to be below Q3, 2023, GAAP operating margin and Q3' 2024 non-GAAP operating margin to be flat to Q3 2023 -- non-GAAP operating margin For fiscal 2024, we expect fiscal 2024 total revenue growth to be up 4% to 6% year-over-year. Doing part to lower Clear Aligner ASPs year-over-year from continued unfavorable foreign exchange and product mix. In addition, our revised revenue outlook reflects our anticipated commercial launch of iTero Lumina with restorative capabilities to occur in Q1 of 2025 instead of 2024 as previously of 2025 instead of 2024 as previously anticipated? We expect fiscal 2024 GAAP operating margin to be slightly below 2023 GAAP operating margin and 2024 non-GAAP operating margin to be above 2023. non-GAAP operating margin, we expect investments in capital expenditures for fiscal '24 2024 to be approximately $100 million. Capital expenditures primarily relate to building construction and improvements as well as manufacturing capacity in support of continued expansion. With that, I'll turn it back over to Joe for final comments, Joe. Thanks.
Joe Hogan: Thanks, John. In summary, I'm pleased with our overall performance for Q2 and the growth we delivered across the business for clear aligner volumes as well as strong revenues from scanners and services. Notwithstanding the impact of unfavorable foreign exchange on our revenues, we believe the end markets are stable overall and we're committed to supporting our doctor customers in the future of digital innovation. Our purpose is to transform smiles and change lives with the goal of being the standard of care and orthodontics with Invisalign Clear Align of treatment. Clinically, we believe that we can treat the vast majority of orthodontic cases today. From the simplest to the most complex clinical efficacy is no longer a question. We now focus on the treatment experience for patients and on efficiency and growth for our doctor customers. The orthodontic case start market is vastly underpenetrated and there are millions of consumers who would benefit from digital orthodontics. We continue to evolve to better meet the needs of doctors, potential patients who increasingly seek convenient, elevated digital experiences. Our digital platform of integrated technologies, software and services has helped improve orthodontic treatment from millions by delivering seamless workflows and dental practices on mobile devices and through remote monitoring, and are designed to help doctors and patients realize the benefits of a truly seamless end-to-end digital workflows and patient experiences. But the journey from analog to digital has proven difficult for practices. The orthodontic practice of the future requires full digital transformation to truly realize the promise of digital. And there is no other med tech company in the world that can help practices meet this challenge. With that, I thank you for your time today. We look forward to sharing our continued progress as we move the industry forward through digital orthodontics. Now I'll turn the call over to the operator for your questions. Operator?
Operator: [Operator Instructions] Our first question comes from the line of Michael Cherny from Leerink Partners. Your question please.
Michael Cherny: Good afternoon. Thank you for taking all the question. Maybe if I can just dive in a little bit on the guidance change and some of the moving pieces. In particular, I want to get a sense from you of what you view as within your control versus outside. Obviously, FX is something that management can't control, but you think about the guidance in particular on the ASP side, how do you think about the flow through of what isn't within your control on mix? Is there something you do on promotion? Is there anything else that can come from a pricing competition that you should be worried about? Just want to dive a little bit more into that number given that it seems to be the biggest fulcrum point relative to the guidance change.
John Morici: Yes, it's a good question, Michael. This is John. Look, when we looked at the total year when and based on what we're seeing now, we see the unfavorable foreign exchange impact. We saw it in Q2 and we continue to see and project that that will continue for the rest of this year. So that's in our outlook. Just over a point of our reduction in our total year is related to foreign exchange. The mix effect that you talked about, that's really the way our customers want to buy. In some cases, they're buying lower price products, it's part of our portfolio. We see that as incremental in cases like doctor subscription program. They're just at a lower ASP. But what we end up seeing then is a better gross margin. Our cost to serve in many cases is lower than that, but it really is a reflection of what doctors want to do with the cases that they buy.
Michael Cherny: Okay. Thank you.
John Morici: Thanks, Mike.
Operator: Thank you. And our next question comes from the line of Elizabeth Anderson from Evercore ISI.
Elizabeth Anderson: Hi guys. Thanks so much for the question. I was wondering if you had just regarding the guidance, if you had any insights that you could share on whether any of the iTero restorative scan revenue was originally contemplated in the 2024 guidance and now with the push out on the launch, if that was sort of an impact on the guidance as well? And then as a follow-up, if you could talk a little bit more about the acceleration in the teen revenue, or sorry, in the teen cases, which accelerated off a tougher comp, that would be helpful to also get some more additional perspective there. Thanks.
John Morici: Yes. Hi, Elizabeth. Yes, you're right. The Lumina restorative that we expected to launch in the fourth quarter, now the full launch in -- into next year. That revenue was expected for this year. So that's part of the reasoning for taking down our overall guidance, in addition to the FX as I said on the previous question. And then your question on teen, look, we're pleased with our teen growth. We saw good over 8% growth on a quarter-over-quarter basis, 8% growth on a year-over-year basis. We saw good adoption in many places around the world. And it's a further reflection of the various products that we have, the adoption that doctors have. A lot of new doctors coming into the ecosystem to get trained and then actually become customers of ours. So we're pleased with the progress that we're seeing within teen.
Elizabeth Anderson: Great. And any chance you want to quantify that iTero restorative contribution change or no?
John Morici: Yes, We're not getting it directly, but its less than a 1%, slightly less than a percentage of the total.
Elizabeth Anderson: That's helpful. Thank you.
Operator: Thank you. And our next question comes from the line of Jon Block from Stifel. Your question please.
Jonathan Block: Hey, Joe, good afternoon. Yes, where to start? Everyone was nervous about cases and then you come in and you beat cases handling, and obviously the focus is going to be on the ASP. So John, maybe let me know if I have these numbers right. But it looks like the aligner ASP was down roughly 4% Q-over-Q. The FX hit was about a 1%. So can you talk in detail as much as possible, the other 3% decline in the ASP Q-over-Q, if I've got that right, it seems like a big deviation from where your head was at 3 months ago. How much of it was mix versus discounts? And if it was a lot of mix, why did mix become so pronounced over the past 3 months? And maybe we can start there please.
John Morici: Yes, Jon, when you look at mix that we have, we see doctors utilizing DSP more and more as a record amount of DSP that we had in a quarter that's at a lower ASP. We saw a lot of GP growth. We talked about adult cases being up, and the best volumes that we've seen in several quarters, and many times that's lower stage products, that we end up seeing come through. And so when we see the ASP, it's just a reflection of the different products that are being sold and those doctors are taking those up, at that. But you also know, and we've talked about where margins in many cases are better at those lower stage products, and we end up seeing this as a benefit to be able to see show up in gross margins and also off margins.
Jonathan Block: Okay. So I, I guess to maybe just as a follow-up to that, are you saying that discounts weren't more aggressive, call it in 2Q '24 than maybe what we've seen historical? And just tack on to that follow-up, you brought down the midpoint of the rev guide from about 7% to 5%. You said FX was a 1%, you said the GP restorative push on Lumina was slightly less than 1%. I mean, are you sort of implying that clear aligner revenue by and large for 2024 is somewhat unchanged or maybe down a smidge and, and then I'll ask my quicker follow-up. Thanks.
John Morici: Yes, Clear Aligner revenue down a little bit for the total year because of the ASPs that we spoke about not necessarily due to any volume changes. Like you said, we are pleased with the Q2 volume that we have. But that’s how we’ve look at the change. Mostly the FX for the total year as we've described, and then some mix, but then the rest of it due to iTero changes from this year to next year.
Jonathan Block: Okay. And last question for me. I guess online, just John, if I've got this right, it looks like the revenue comes down a little bit, the midpoint, but I believe the non-GAAP EBIT margins came up slightly, I think before it was like flat to slightly up, and now you're saying slightly up. So maybe just talk through the dynamics where you're able to arguably increase the non-GAAP EBITDA margin assumption for '24 even off the more modest revenue base. And thanks for the time, guys.
John Morici: Yes, no, it's a good question. And so as we looked at and as we talk about some of the -- I know ASP gets a focus, but really when you look at the margin that we get on all of these products is as they go to some of the lower stage products, we end up with a better margin. Our cost to serve is lower, which shows up in gross margin and flows its way to op margin. And I think the rest of it as you saw with this quarter from an OpEx standpoint and how we think about the levers that we could pull or not pull, we're very mindful of that in this environment and want to be able to deliver as much volume and as much top line as we can, but be very mindful of the operating profit that we need to deliver.
Operator: Thank you. And our next question comes from the line of Jeff Johnson with Baird. Your question please.
Joe Hogan: Hey Jeff.
Jeff Johnson: Hey Joe. Good afternoon, guys. Wanted to start maybe on your doctor ship to number in the quarter. You shipped to a little over 86,000 docs this quarter. I think for 3 straight years you've kind of been in that 82,000 to 85,000 range. So maybe not a big breakout, but at least some of these underlying numbers on utilization is doctors ship to and that are starting to perk up a little bit. So I guess what I'm trying to understand on that doctor ship to number, are you starting to see some benefits of some of the investments Jon has been talking about the last couple quarters on getting that doctor prescribing base to expand? Is it expanding that base? Is it slowing the outflow of that base? As we know you've had some competitive losses here over the last couple years. Just maybe help us understand the inflow and the outflow rates and what's moving between those two pieces. Thanks.
Joe Hogan: Hey Jeff, Joe. First of all, we're pleased with that. It's good to see a utilization go up. It's also great to see the doctors go up too. And obviously there's a strong concerted effort. We talk about that underserved marketplace out there and we know there's still a lot of doctors to train and there's still doctors do a lot more cases. So it's a big focus for the business. When you ask that question, are we loser in fewer or gaining few? There's always a mix and a change in those kinds of things, Jeff. But overall you can see here that we're gaining, it's not saying that we don't lose some docs sometimes, but you know, we often bring them back too. The whole story with what we've been through as competitors have entered the marketplaces, sometimes we'll lose some doctors, they often come back and one of the things about our business too, sometimes it takes 18 months for doctors to figure out if those competitive cases are actually going to work. And obviously I think we’re -- we're making good progress in the sense of convincing doctors to move ahead with us. And this growth in doctors and utilization occurred across the globe, which is great. It wasn't like it just came out of one region.
Jeff Johnson: Yes, understood. All right. And then maybe just a follow-up on the manufacturing side. We saw the news maybe a couple months ago of Emory's new role leading Direct Fab. He's going to stay in that role it sounds like through 2026 when he is going to write off into the sunset. So does that tell us anything about timelines on Direct Fab? I mean, Emory just doesn't seem like the kind of guy that would want to walk away in the middle of something. So is that kind of drawing a line in the sand that by 2026 you should be up and running fairly well, fairly maybe not efficiently, but fairly completely in getting that Direct Fab plans all put together and rolling out some of that 3D printed stuff in a bigger way?
John Morici: Hey Jeff, it's a good question. We have a lot of faith in Emory. He's been here for so long and he's the only guy that's ever scaled, aligners to the point, that he has. And so it's really fun to have him in this role because he gives us great feedback in a sense of where we are. Jeff, the best I can say what we've talked about with the analyst is we're looking at 2 to 3 years on this scale. And don't think of it as a linear line. This is one where you have to do a lot of equipment work at first to get the efficiencies, to have this equipment work 24/7. And then secondly, this is a brand new resin [ph], it's never been sourced before. And so finding the source of the resin, making sure you have the reactor capacity, all those things take time. So I look at over the next year, we do a lot of that groundwork and then you'll start to see products and different things that will roll from that. So, but it's best to fix in your mind that it's a 2 to 3 year kind of a rollup.
Jeff Johnson: Understood. Thank you.
John Morici: Okay.
Operator: Thank you. One moment for our next question. And our next question comes from the line of Brandon Vazquez from William Blair. Your question please.
Brandon Vazquez: Hi everyone. Thanks for taking the question. I'll ask two upfront because it's kind of guidance related. One a little near-term, which is basically, I think if you do the sequentials and the implied numbers on the guidance that you've given us, there's maybe like a high single digits revenue increase going into Q4. I think, correct me if I'm wrong, but that's kind of like pre-COVID levels of seasonality, back when the business was a little more normal. So the question near-term being, given the uncertainty in the market, what kind of gives you the confidence that you guys can kind of return normal seasonality within this year? And then the follow-up to that on kind of a long-term guidance question is like, okay, we look with [indiscernible] three years out, what's kind of the growth expectations of this business sort of growth algorithm? Any color you can give us around that, assuming that, we're, it seems like we're stuck in somewhat of a an uncertain end market stable, but not exactly where you want it. So talk about the opportunity to accelerate if even possible, in an end market like this over the couple plus three plus years. Thank you.
John Morici: Yes, Brandon, this is John. I could take the question kind of on the remaining part of this year and so on. So we've guided to what we can see, based on how the quarter played out. We actually saw in the second quarter. I mean, I'm not saying it's a return to normal seasonality, but it was much more seasonal in the second quarter in terms of how our volume progressed and how it changed quarter-over-quarter to more normal seasonality. And so our reflection of what we tried to do for the rest of this year based on what we see. In terms of volume, takeout FX and some of that noise that gets caught into Q2. But from a underlying volume standpoint, we saw, um, more normal seasonality. And as we play out the rest of this year, we expect that to continue with teen season that comes in, that we're in now. China in the third quarter is a strong quarter for them because of team season, Europe, not so much. We expect that to, uh, play out more normally as it moves from Q3 to Q4. When we think of the total and looking out into 3 years, and so look, we're in an underpenetrated market and we've talked about a lot about that. We think we have the products and the go-to-market capabilities to really move this market forward. And it's up to us to be able to help drive this market forward. And when we look out and we look out in our long-term model, we believe in, in the opportunity revenue growth is 25% plus percent and up margin 25% plus. And that's how we are positioning things for growth, for whether it's Direct Fab, and the growth opportunities that we have there and the efficiencies that we can drive as well as the standard production that we have now. That's how we're building from an investment standpoint. We're mindful of changes that can happen short-term and economy and so on. And that's why we give you kind of the guidance that we have, at least now in short term, but in longer term we believe in, in our model. And, and that's how we're investing in the future.
Operator: Thank you. [Operator Instructions] Our next question comes from the line of Jason Bednar from Piper Sandler. Your question please?
Q - Jason Bednar: Good afternoon everyone.
Joe Hogan: Hey, Jason,
Jason Bednar: Hey, there, I wanted to touch on one near-term item with third quarter guidance, some of the spend discussed already, but clearly over the -- lower than where you'd probably model things out internally 3 to 6 months ago. And I guess I'm just reminded of maybe where we were a year ago in the third quarter, you had higher expectations than where ended up finishing. So I guess I'm curious maybe how much of that experience from last year informed your view on volumes and product mix versus, say, the trends and macro data points that you've seen develop the last few months? And then maybe include here if you could just how you're seeing that team season develop since we are in the thick of that right now.
John Morici: Yes, Jason, I can take that on, on the Q3. Some of those specifics, certainly we look at last year, we look at the 2022, you know, you got into those COVID years, they're tough to call and then you have to jump before COVID. So now you're talking almost 5 years ago. So, you look at what you see at the time knowing that most recently you have, we know we have Europe, has a summer kind of shutdown, comes back into September. We want to be able to see in September that they do come back. USS is in team season, China to get into the teen season as well. And we want to see how that plays out. So we call based on based on what we expect, both from a volume standpoint and we are really trying to give the foreign exchange that we see, that started the quarter, in July, where that FX is and not make an assumption as to whether things are going to get better or worse. We want to put that out there and really try to give you more of the underlying performance for the business. Joe, you want to talk about purchase?
Joe Hogan: Yes, on the teen side, Jason as I said in my script, and we were pleased with the team growth. It was over 8%, which is great to see. A lot of that was supported by Asia and also Europe when you really got to get into team numbers. Again, IPE is part of that. It's -- we look at that as obviously pre-teen and we watching the ramp up of that, that is obviously pre-teen and we were watching the ramp up of that and the acceptance in the marketplace. So hope I'm answering your question, but overall, we feel good about the team now. There's a big team season in China in the third quarter, we're watching it closely. We expect be able to perform in that side too. So I'm optimistic as it stands.
Jason Bednar: Okay, great. Then just for my follow-up, I'm going to pack a few in here. Maybe bigger picture, if we step back and look at some of the recent developments. I know there's a lot of initiatives, different initiatives, marketing programs, menu expansion, customer incentives, so on and so forth. Those all help contribute to expanding that utilization line, improving doctor productivity. You've got the Costco relationship that's been discussed. We uncovered what looks to be one of the larger changes to your advantage program in at least a few years. So I'm curious how you'd have us think about these in the broader context of your commercial efforts. Would you consider things like the Costco and Advantage changes, either are both more impactful than what you typically do? Have you seen any change maybe in doc behavior, just in response to these advantage changes? And then what's the right way to think about each of these influencing that ASP line that's now coming to focus more significantly with today's results? Thank you.
John Morici: Yes, that's a good, great question, Jason. I look at -- just to answer it a couple different ways, because I think one is like on the advantage you brought up, that's really a reflection of trying to put some structure, a little added structure to our Advantage program where many of our promotions we're trying to get to. And in the end for an Advantage program is trying to get new doctors in, give them a progression of, how they can get discounts as they do more and more cases drive utilization. So that's, that's good for new doctors, that's good for existing doctors. So the Advantage changes really we're trying to put more structure into that, into the second half and then carrying forward because they really had better refreshed, like, what we've got now. But it's all about driving utilization, getting doctors to do more and more cases. Programs like we're testing or piloting with a Costco is really just trying to drive more conversion. Find ways where those consumers or those potential patients are out there, they're shopping around, they're looking at, you see the economy, you see inflation, you see other things. We know those potential patients are out there. We just have to find ways to be able to connect them with a great product that we have with our customers, with our doctors. And Costco is an example of that, that we'll test and we'll see. But it's really that specifically is designed around conversion drive as much conversion as we can.
Jason Bednar: Thank you.
Operator: Thank you. And our next question comes from the line of Michael Ryskin from Bank of America. Your question please.
Michael Ryskin: Hey, thanks for taking the question, guys. Joe or John, I want to follow-up on a point that you touched on a couple times already in terms of the ASPs. You talked about part of it is the mix shift and a lot of it is how your customers want to buy, whether that's different products within portfolio, whether or DSP, things like that. But what I want to get at is, are you concerned by that trend itself at all? Is that, that customers want the lower products? I guess that gives you the option to still meet them in the air and that still drives the volume, but is that something that you expected. This shift down? As you say, the market's still very unpenetrated. It's a big untapped market, so you'd think that you wouldn't be seeing the demand elasticity type of price that you are. So is this temporary because of the current macro environment and consumer sensitivity, or does it say something deeper that the rest of the market that's out there really doesn't exist at that, 1,300 plus ASP maybe it's lower and lower and lower.
Joe Hogan: Hey Michael, it's Joe. Look, I think the ASP piece to try to explain as much as we can is, we're always staring at the margin side to make sure that our margins are good. We find out that all over the world, I mean, if you're in India, they ask for a different product and they ask in the United States at different areas, and some people want a 5x5, someone want 3x3, all these things are different products for different kinds of applications. And GPs [indiscernible] at times too. So what we're seeing and there's varying ASPs on it, but we always have -- you see, our margins have actually moved up on that. So you're seeing not necessarily the market just driving price down, you're just seeing us having a variation of options that customers or doctors want around the world and making sure that we supply those well. One -- we talk about 25,000 cases came through DSP. Remember, those are cases that, that doctors used to mold these things in their offices in order to address those, right. And now they're buying three or four of ours now, yes, we're getting great margin on that product line, but overall it's a lower ASP in that sense as part of the DSP program. So what you're seeing is just us responding to a market. It's a good market out there with varying degrees of price and value, and you'll see us continue to do that in order to grow the marketplace.
Michael Ryskin: Okay. And then much quicker follow-up hopefully, sorry if I missed it, but did you call up why the Lumina restorative was pushed out to 1Q '25? Was this commercial decision or something on the development side?
Joe Hogan: Yes, Michael, well, there's like five areas of restorative that you have to be very good at as you go through this. And truth of reviews, we made extremely good progress on most of them. But we just -- we wanted to take a little extra time to make sure we get this right and we want to make sure that we run it through our doctors who are actually going to use it, the luminaries out there that help to promote the product and make sure that they're comfortable with it too. So we just feel it's diligent and responsible to make sure that we take a few more months here, launch it in the first quarter so that we have the world's best product.
Michael Ryskin: Okay. Thanks. Makes sense.
Operator: Thank you. And one moment for our next question. And our next question comes from the line of Erin Wright from Morgan Stanley. Your question please.
Erin Wright: Thanks for taking my question. So did you see any recent changes, for instance, in the adult case volume dynamics throughout the quarter? And just what are you seeing so far in the third quarter in terms of adult cases? I guess, has anything changed in terms of your view on the macro environment and for the remainder of the year? And I hate to belabor this, but also for the Americas too, but on the macro question, are you generally expecting stability in your guidance or are you anticipating a range of outcomes from a consumer and macro environment standpoint for the remainder of the year?
Joe Hogan: Aaron, we -- I mean, we had that in our script and we talk about it as we're expecting stability. I mean, obviously not stability and exchange rates, right? We can't, we're not that smart. We'd be working somewhere else if we knew exchange that well. But as far as the market overall and how we want to go about it, we still feel we're dealing in a stable environment. The last thing I'll say about this, this is a very global business. You saw that the Japanese yen, Brazilian real, the business is growing substantially that way, and there's a certain amount of stability that we have that plays across geographies too.
John Morici: And that adult piece we saw growth. We saw highest quarter in many quarters. So we're pleased with it. I think it's a reflection of our GP business, growing GPs, growing with DSOs and so on being able to, to get some of that volume through. Like Joe said, it's more of a stability that we're seeing, but we're pleased with that adult growth. And some of that contributes to some of that lower ASP product. It's great if that's how doctors want to buy to be able to treat those adults, we're happy to sell it to them. And as Joe said, it -- it's a better margin for us.
Erin Wright: And you mentioned China too and the key market there, but just generally speaking, can you give us an update on kind of China, the underlying demand trends and market dynamics there?
Joe Hogan: It's Joe again, Erin. China performed the way we wanted China to perform, just as we predicted. Overall, I mean, the market is challenging. I think that Tier 3 and 4 cities are actually challenged more than the private and one and twos. But overall there's no surprise we have a good team there. Juno [ph] is a great leader for us there and we like the results and we're looking forward to a good team quarter there, which is third quarter is always the biggest quarter for China.
Erin Wright: Okay. Thank you.
Joe Hogan: You're welcome.
Operator: Thank you. This does conclude the question-and-answer session of today's program. I'd like to hand the program back to Shirley Stacy for any closing comments.
Shirley Stacy: Thank you, operator, and thank you everyone for joining us on the call today. We look forward to speaking to you at upcoming financial conferences and industry events. If you have any questions, please follow-up with our investor relations team. Have a great day.
Operator: Thank you, ladies and gentlemen, for your participation at today's conference. This does conclude the program. You may now disconnect. Good day. | [
{
"speaker": "Operator",
"text": "Greetings. Welcome to the Align Technology Second Quarter 2024 Earnings Call. At this time, all participants are in a listen-only mode. A question-and-answer session will follow the formal presentation. Please note, this conference is being recorded. I would now like to turn the conference over to your host, Shirley Stacy with Align Technology. You may begin."
},
{
"speaker": "Shirley Stacy",
"text": "Good afternoon, and thank you for joining us. I'm Shirley Stacy, Vice President of Corporate Communications and Investor Relations. Joining me for today's call is Joe Hogan, President and CEO, and John Morici, CFO. We issued second quarter 2024 financial results today via Business Wire, which is available on our website at investor.aligntech.com. Today's conference call is being audio webcast and will be archived on our website for approximately 1 month. As a reminder, the information provided and discussed today will include forward-looking statements, including statements about Align's future events and product outlook. These forward-looking statements are only predictions and involve risks and uncertainties that are described in more detail in our most recent periodic reports filed with the Securities and Exchange Commission available on our website and at sec.gov. Actual results may vary significantly and Align expressly assumes no obligation to update any forward-looking statement. We have posted historical financial statements with corresponding reconciliations, including our GAAP to non-GAAP reconciliation, if applicable, and our second quarter 2024 conference call slides on our website under Quarterly Results. Please refer to these files for more detailed information. With that, I would like to turn the call over to Align Technology's President and CEO, Joe Hogan. Joe?"
},
{
"speaker": "Joe Hogan",
"text": "Thanks, Shirley. Good afternoon, and thanks for joining us on our call today. I'll provide an overview of our second quarter results and discuss a few highlights from our two operating segments, System and Services and Clear Aligners. John will provide more detail on our Q2 financial performance and comment on our views for the third quarter and for 2024 in total. Following that, I'll come back and summarize a few key points and open the call to questions. Overall, I’m pleased to report solid second quarter results. Total Q2 '24 revenues of $1,028.5 million were up 3.1% sequentially and 2.6% year-over-year, reflecting growth in both Clear Aligner volumes and Imaging Systems and CAD/CAM Services revenues. Q2 '24 total revenues were unfavorably impacted by foreign exchange of approximately $11.6 million or 1.1% sequentially and unfavorably impacted by approximately $18.1 million or 1.7% year-over-year. For Clear Aligners, Q2 '24 volumes increased 6.2% sequentially and 3.2% year-over-year, driven by growth from adult patients, and strong teen case starts across the regions, led by strength in Asia Pacific, EEMA, and Latin America. Our Q2 results also reflect a record number of doctors submitting cases, and record doctors shipped to for the quarter. Q2 '24 Clear Aligner ASPs were down sequentially and lower than anticipated in our second quarter outlook, due in part to greater impact of unfavorable foreign exchange across multiple currencies, especially the Japanese yen, Euro, and Brazilian real, as well as discounts, and product mix shift to lower ASP products. As a result, total Q2 revenues were slightly below the expected range for our Q2 quarterly revenues. Notwithstanding these factors, non-GAAP operating margin for the second quarter was 22.3%, up 2.5 points sequentially, and up 1.0 point year-over-year. For Imaging Systems and CAD/CAM Services, Q2 '24 revenues increased 9.2% sequentially and 16.1% year-over-year reflecting continued adoption of our next-generation iTero Lumina scanner, which made up the majority of our equipment sales, iTero Lumina wand upgrades, iTero Element scanner trade-ins, as well as increased iTero scanner leases. For Q2 '24, adult patient case starts were up 5% sequentially and 1% year-over-year, reflecting our highest number of adult shipments in 8 quarters, driven by strength in the GP channel, led by North America and APAC dentists. In teen and growing kids’ segment, over 216,000 teens and younger patients started treatment with Invisalign clear aligners during the second quarter, an increase of 8.8% sequentially and up 8% year-over-year, reflecting growth across regions, especially from Invisalign First in the EMEA and APAC regions. In Q2, the number of doctors submitting teen or younger patient case starts was up 8% year-over-year, led by continued strength from doctors treating young kids also known as \"growing patients. The response from doctors and their patients to Invisalign Palatal Expander System continues to be positive. We believe that Invisalign Palatal Expander System is a better option for expanding a growing patient's narrow palate compared to traditional appliances used today. The Invisalign Palatal Expander System is currently available in the U.S., Canada, Australia, and New Zealand. We expect it to be available in other markets pending future applicable regulatory approval. Non-Case revenues include our Vivera retainers, which include retention aligners ordered through our Doctor Subscription Program or DSP, as well as clinical training and education accessories in eCommerce. Q2 Non-Case revenues were up 3.5% sequentially and up 5.1% year-over-year, primarily due to continued growth in retainers and DSP. For Q2, total Clear Aligner shipments include approximately 25,000 Invisalign DSP touchup cases, a record high quarter of 37% year-over-year. DSP continues to drive growth and is currently available in North America and certain EMEA countries. During the quarter, we extended DSP into more countries in Europe and we anticipate expanding into additional markets going forward. DSP is also now available in 14 stage touch up aligner offering across all markets where it's available. As a result, Touch-Up cases increased significantly in Q2. Q2 '24 Clear Aligner volume and DSO customers increased sequentially year-over-year reflecting growth across all regions. DSOs represent a large and growing opportunity to help drive adoption of digital technology across the dental industry. We have well-established relationships in many DSOs globally that recognize the benefits of digital workflows enabled by our portfolio of products and services that make up the digital platform. Including increased practice efficiency and profitability, as well as delivering a better patient experience from shorter cycle times and customer proximity. Smile Docs and Heartland Dental are two of our largest DSO partners. We are continuously exploring collaboration with the DSOs that can further the adoption of digital dentistry. Each DSO has a different strategy and business model, and our focus is working and encouraging DSOs aligned with our vision strategy and business model goals. Today, Invisalign is the most recognized orthodontic plan globally and Invisalign, Clear Aligner treatment is faster and more effective than traditional metal braces. Yet the underlying market opportunity to remains huge and untapped. We continue to invest in consumer marketing and demand creation initiatives that raise awareness and drive potential patients to Invisalign practices globally. In Q2, we had more than 17 billion impressions in 50 million visitors to our websites globally. Below are additional highlights from Q2 and more information is available in our Q2 '24 earnings webcast slides. To increase awareness and educate young adults, parents and teens about the benefits of Invisalign brand, we continue to invest and create campaigns in social media platforms such as TikTok, Instagram, U2, Snapchat, WeChat, [indiscernible] across the markets. Reaching young adults as well as teens and their parents also requires the right engagement through Invisalign Influencers and creator-centric campaign. In the Americas, our influence in social media campaigns, featured Olympic athletes such as Rebeca Andrade from Brazil, Andre De Grasse from Canada, Jordan Chiles from the United States and Paralympic athlete Lizzi Smith from the United States. To bolster T demand -- teen demand, we launched new activations with teen high school sports, social media platform, Over Time, including several programs focused on showcasing elite high school athletes across boys' football, girls' basketball, girls' soccer. We highlighted why they chose to transform their smile with Invisalign aligners and showcase their results. In the EMEA region, we partnered with influencers to reach consumers across social media platforms, including TikTok and Meta, and launched our global consumer campaigns for teens and parents. In APAC, we continue to invest in consumer advertising across the region and expanded our reach in Japan and India via meta and YouTube and partner with key social media influencers. Finally, adoption of my Invisalign consumer patient app continued to increase with over 4 million downloads to date and over 384,000 monthly active users and 8% year-over-year increase. Usage of our other digital tools also continued to increase. ClinCheck live update was used by almost 50,000 doctors on more than 692,000 cases, reducing time spent and modifying treatment plans by an average of 16.3%. Invisalign practice app is increasing in its adoption with 85,000 doctors who actively are using the app and 5.9 million photographs were uploaded in Q2 via the Invisalign practice app. Year-over-year growth in Q2 system and services revenue were up 16.1%, reflect higher scanner ASPs and non-system revenues driven by a terra luminal wand upgrades increased service revenues in a larger basis, scanner sold. On a sequential basis, Q2 systems and services revenues were up 9.2%, reflecting higher scanner volumes, higher scanner ASPs and higher non-system revenues driven by a iTero Lumina terra wand luminal wand upgrades. The iTero Lumina is new multi direct capture technology replaces the confocal imaging technology in earlier models and has a 3x wider field of capture and a 50% smaller and 45% lighter wand, delivering faster scanning speed, higher accuracy, superior visualization, and a more comfortable scanning experience. Lumina is currently available with orthodontic workflows as a new standalone scanner or as a wand upgrade from iTera element 5D Plus scanner. During the second quarter, we had a record number of competitive trade-ins demonstrating the continued success of the iTera Luminous Scanner in the marketplace. We're also seeing a halo effect with Invisalign scans. We're pleased to see more doctors coming into the digital ecosystem with an increase in first time Invisalign case submitters as well as return of lapse submitters. Overall, Q2 we're very pleased with the continued uptake of iTero Lumina Scanner with ortho workflow and response from customers. We're looking forward to a limited market release for the restorative software on Lumina in Q4, followed by full commercialization in Q1 '25. Today we introduced the iTero design suite, offering doctors an intuitive way to facilitate designs for 3D printing of models, bite splints, and restore restorations and practice. This software innovation is designed to help doctors increase their practice efficiencies and elevate patient experiences by shortening the time to treatment through an intuitive way to design for in-practice 3D printing. The Align digital platform provides an innovative portfolio of customer-focused technologies that enable seamless end-to-end workflows for dental professionals. iTero Design Suite is now available through an early access program. Doctors using an iTero scanner can submit their interest via their scanner, or my iTero portal. Software is expected to be available later this year in selected markets. With that, I'll turn it over to John."
},
{
"speaker": "John Morici",
"text": "Thanks, Joe. Now for our Q2 financial results. Total revenues for the second quarter were $1,028.5 million, up 3.1% from the prior quarter and up 2.6% from the corresponding quarter a year ago. On a constant currency basis, Q2 '24 revenues were impacted by unfavorable foreign exchange of approximately $11.6 million or approximately 1.1% sequentially and were unfavorably impacted by approximately $18.1 million year-over-year or approximately 1.7%. For clear aligners, Q2 revenues of $831.7 million were up 1.8% sequentially, primarily from higher volumes, partially offset by lower ASPs. On a year-over-year basis, Q2 Clear Aligner revenues were flat, primarily due to higher discounts. A product mix shift to lower ASP products and the unfavorable impact from foreign exchange offset by lower net revenue deferrals, higher volumes and price increases. Q2 '24, Clear Aligner revenues were unfavorably impacted by foreign exchange of approximately $9.5 million or approximately 1.1% sequentially. On a year-over-year basis, Clear Aligner revenues were unfavorably impacted by foreign exchange of approximately $14.7 million or approximately 1.7%. For Q2 Invisalign ASPs for comprehensive treatment were down sequentially and year-over-year. On a sequential basis, the decline in a SP primarily reflects higher discounts, a product mix shift to lower a SP products and the unfavorable impact of foreign exchange. On a year-over-year basis, the decline in comprehensive ASPs primarily reflects higher discounts, a product mix shift to lower ASP products and the unfavorable impact from foreign exchange, mostly offset by lower net revenue deferrals and price increases. For Q2, Invisalign ASPs for non comprehensive treatment were down sequentially and year-over-year. On a sequential basis, the decline in ASPs reflects the unfavorable impact from foreign exchange, higher net revenue deferrals, and a product mix shift to lower ASP products partially offset by price increases. On a year-over-year basis, the decrease in non-comprehensive ASPs reflects higher discounts, a product mix shift to lower ASP products, the unfavorable impact of foreign exchange and the unfavorable impact of a price adjustment in the UK to make the recently mandatory application of VAT to our liners cost neutral to customers. Our Invisalign comprehensive three and three product and anticipate adoption will continue to increase is available in North America, EMEA and its certain markets across APAC. We are pleased with the continued adoption of the Invisalign comprehensive [3-in-3] product and anticipate an adoption will continue to increase. Comprehensive [3-and 3] provides doctors the flexibility they want while allowing us to recognize more revenue upfront with deferred revenue being recognized over a shorter period compared to our traditional Invisalign comprehensive product and benefiting us with a more favorable gross margin. Clear Aligner deferred revenues on the balance sheet decreased $7.8 million or 0.6% sequentially and decreased $5.2 million or 0.4% year-over-year. Ambo will be recognized as the additional aligners are shipped. Q2 '24 systems and services revenues up $196.8 million were up 9.2% sequentially, primarily due to higher volumes, higher ASPs and non-system revenues mostly related to upgrades Q2 24 systems and services revenues were up 16.1% year-over-year, primarily due to higher ASPs, increased non-system revenues, mostly related to upgrades and our leasing rental programs and higher service revenues. We are pleased to be able to leverage our operational and financial capabilities to provide different types of go-to-market models for our customers such as leasing and rental options. In the end, we are focused on selling the way our customers want to buy. Q2 24 systems and services revenues were unfavorably impacted by foreign exchange of approximately $2.1 million or approximately 1% sequentially. On a year-over-year basis, systems and services revenues were unfavorably impacted by foreign exchange of approximately $3.4 million or approximately 1.7%. Systems and services deferred revenues on the balance sheet was down $20.4 million or 8.3% sequentially and down $43.4 million or 16.2% year-over-year, primarily due to the recognition of services revenues, which are recognized ratably over the service period. The decline in deferred revenues both sequentially and year-over-year primarily reflects the shorter duration of service contracts applicable to initial scanner purchases. As our scanner portfolio expands and we introduce new products, we are increasing the opportunities for customers to upgrade and make trade-ins. In addition to our scanning, leasing and rental programs. Developing new capital equipment opportunities to meet the digital transformation needs of our customers and our DSO partners is a natural progression for our equipment business with a large and growing base of scanners sold. The structural programs we have implemented across both of our operating segment benefit our customers by providing them with more options to choose what they need. In some cases at a reduced price that may impact our ASPs, but the cost of service for us is, is lower and the benefit is then reflected in our gross margins. Moving to gross margin. Second quarter overall gross margin was 70.3%, up 0.3 points sequentially and down 0.9 points year-over-year. Overall gross margin was unfavorably impacted by foreign exchange by approximately 0.3 point sequentially and unfavorably impacted by approximately 0.5 points on a year-over-year basis. Clear aligner gross margin for the second quarter was 70.8%, down 0.1 point sequentially due primarily to lower ASPs, partially offset by lower additional aligners and leverage manufacturing spend. Clear aligner gross margin for the second quarter was down 1.7 points year-over-year due primarily to lower ASPs and higher manufactured spend as we continue to ramp up Poland manufacturing facility and the impact of unfavorable foreign an exchange. Systems and Services gross margin for the second quarter was a record 68.2% up 2.3 points sequentially, primarily due to higher ASPs and manufacturing efficiencies. Systems and services gross margin for the second quarter was up three points year-over-year for the reasons stated above. Q2 operating expenses were $575.6 million, up 5.9% sequentially and 6.3% year-over-year. On a sequential basis, operating expenses were up by $31.9 million due primarily to about $31 million in legal settlements year-over-year. Operating expenses increased by $33.9 million, primarily due to legal settlements and higher employee compensation, partially offset by lower outside services, advertising and marketing expenses. On a non-GAAP basis, excluding stock-based compensation. Amortization of acquired intangibles related to certain acquisitions, restructuring, legal settlements and other charges, operating expenses were $499.5 million, down 1.3% sequentially and down 1.1% year-over-year. Our second quarter operating income of $147 million resulted in an operating margin of 14.3% down 1.2 point sequentially and down 2.9% year-over-year. Operating margin was unfavorably impacted from foreign exchange of approximately 0.6 points sequentially and unfavorable impacted by 1.2 points year-over-year. On a non-GAAP basis, which excludes stock-based compensation, Amortization of intangibles related to certain acquisitions, restructuring legal settlements and other charges. Operating margin for the second quarter was 22.3%, up 2.5 points sequentially and up 1 point year-over-year. Interest and other income expense net for the second quarter was an expense of $3.2 million, primarily due to unfavorable foreign exchange compared to an income of $4.3 million in Q1 of '24, and an expense of $0.3 million in Q2 of '23. Recall that Q1 '24 included a non-recurring gain on our equity investments. The GAAP effective tax rate in the second quarter was 32.9% compared to 33.7% in the first quarter, and 34.8% in the second quarter of the prior year. The second quarter GAAP effective tax rate was lower than the first quarter effective tax rate, primarily due to discrete tax events is recognized in Q1 of '24 that did not reoccur in Q2 of '24, and that benefit was partially offset by an increase in non-deductible expenses. Our non-GAAP effective tax rate in the second quarter was 20%, which reflects our long-term projected tax rate. Second quarter net income per diluted share was $1.28, down sequentially $0.11 and down $0.18 compared to the prior year. Our EPS was unfavorably impacted by $0.11 on a sequential basis, and $0.17 on a year-over-year basis due to foreign exchange. On a non-GAAP basis, net income per diluted share was $2.41 for the second quarter, up $0.27 sequentially and up $0.19 year-over-year. Moving on to the balance sheet. As of June 30, 2024, cash, cash equivalents and short and long-term marketable securities were $782.1 million, down sequentially, $120.4 million, and down $251.7 million year-over-year. Of our $782.1 million balance, $140 million was held in the U.S and $642.1 million was held by our international entities. During Q2 '24, we repurchase approximately 0.6 million shares of our common stock at an average price of $250.73 through $150 million of open market repurchases. As of June 30, 2024, $500 million remains available for repurchases of our common stock under the January 2023 big purchase program. During the quarter, we completed a $75 million equity investment in Heartland Dental, a multidisciplinary DSO with GP and Ortho practices across the United States. Q2 accounts receivable balance was $1,020.1 million, up sequentially. Our overall day sales outstanding was 89 days, up approximately 3 days sequentially and up approximately eight days as compared to Q2 last year. Cash flow from operations for the second quarter was $159.8 million. Capital expenditures for the second quarter were $53.5 million, primarily related to our continued investments to increase aligner manufacturing capacity and facilities. Free cash flow defined as cash flow from operations, less capital expenditures amounted to $106.4 million. Now turning to our outlook, assuming those circumstances occur beyond our control, we provide the following business outlook for Q3 and fiscal 2024. For Q3 2024, we expect our Q3 worldwide revenues to be in a range of $980 million to $1 billion. We expect Clear Aligner volume to be down sequentially as a result of Q3 seasonality and clear aligner ASPs to be down sequentially, primarily due to foreign exchange and product mix. We also expect systems and services revenues to be down sequentially because of Q3 seasonality. We expect our Q3, 2024 GAAP operating margin to be below Q3, 2023, GAAP operating margin and Q3' 2024 non-GAAP operating margin to be flat to Q3 2023 -- non-GAAP operating margin For fiscal 2024, we expect fiscal 2024 total revenue growth to be up 4% to 6% year-over-year. Doing part to lower Clear Aligner ASPs year-over-year from continued unfavorable foreign exchange and product mix. In addition, our revised revenue outlook reflects our anticipated commercial launch of iTero Lumina with restorative capabilities to occur in Q1 of 2025 instead of 2024 as previously of 2025 instead of 2024 as previously anticipated? We expect fiscal 2024 GAAP operating margin to be slightly below 2023 GAAP operating margin and 2024 non-GAAP operating margin to be above 2023. non-GAAP operating margin, we expect investments in capital expenditures for fiscal '24 2024 to be approximately $100 million. Capital expenditures primarily relate to building construction and improvements as well as manufacturing capacity in support of continued expansion. With that, I'll turn it back over to Joe for final comments, Joe. Thanks."
},
{
"speaker": "Joe Hogan",
"text": "Thanks, John. In summary, I'm pleased with our overall performance for Q2 and the growth we delivered across the business for clear aligner volumes as well as strong revenues from scanners and services. Notwithstanding the impact of unfavorable foreign exchange on our revenues, we believe the end markets are stable overall and we're committed to supporting our doctor customers in the future of digital innovation. Our purpose is to transform smiles and change lives with the goal of being the standard of care and orthodontics with Invisalign Clear Align of treatment. Clinically, we believe that we can treat the vast majority of orthodontic cases today. From the simplest to the most complex clinical efficacy is no longer a question. We now focus on the treatment experience for patients and on efficiency and growth for our doctor customers. The orthodontic case start market is vastly underpenetrated and there are millions of consumers who would benefit from digital orthodontics. We continue to evolve to better meet the needs of doctors, potential patients who increasingly seek convenient, elevated digital experiences. Our digital platform of integrated technologies, software and services has helped improve orthodontic treatment from millions by delivering seamless workflows and dental practices on mobile devices and through remote monitoring, and are designed to help doctors and patients realize the benefits of a truly seamless end-to-end digital workflows and patient experiences. But the journey from analog to digital has proven difficult for practices. The orthodontic practice of the future requires full digital transformation to truly realize the promise of digital. And there is no other med tech company in the world that can help practices meet this challenge. With that, I thank you for your time today. We look forward to sharing our continued progress as we move the industry forward through digital orthodontics. Now I'll turn the call over to the operator for your questions. Operator?"
},
{
"speaker": "Operator",
"text": "[Operator Instructions] Our first question comes from the line of Michael Cherny from Leerink Partners. Your question please."
},
{
"speaker": "Michael Cherny",
"text": "Good afternoon. Thank you for taking all the question. Maybe if I can just dive in a little bit on the guidance change and some of the moving pieces. In particular, I want to get a sense from you of what you view as within your control versus outside. Obviously, FX is something that management can't control, but you think about the guidance in particular on the ASP side, how do you think about the flow through of what isn't within your control on mix? Is there something you do on promotion? Is there anything else that can come from a pricing competition that you should be worried about? Just want to dive a little bit more into that number given that it seems to be the biggest fulcrum point relative to the guidance change."
},
{
"speaker": "John Morici",
"text": "Yes, it's a good question, Michael. This is John. Look, when we looked at the total year when and based on what we're seeing now, we see the unfavorable foreign exchange impact. We saw it in Q2 and we continue to see and project that that will continue for the rest of this year. So that's in our outlook. Just over a point of our reduction in our total year is related to foreign exchange. The mix effect that you talked about, that's really the way our customers want to buy. In some cases, they're buying lower price products, it's part of our portfolio. We see that as incremental in cases like doctor subscription program. They're just at a lower ASP. But what we end up seeing then is a better gross margin. Our cost to serve in many cases is lower than that, but it really is a reflection of what doctors want to do with the cases that they buy."
},
{
"speaker": "Michael Cherny",
"text": "Okay. Thank you."
},
{
"speaker": "John Morici",
"text": "Thanks, Mike."
},
{
"speaker": "Operator",
"text": "Thank you. And our next question comes from the line of Elizabeth Anderson from Evercore ISI."
},
{
"speaker": "Elizabeth Anderson",
"text": "Hi guys. Thanks so much for the question. I was wondering if you had just regarding the guidance, if you had any insights that you could share on whether any of the iTero restorative scan revenue was originally contemplated in the 2024 guidance and now with the push out on the launch, if that was sort of an impact on the guidance as well? And then as a follow-up, if you could talk a little bit more about the acceleration in the teen revenue, or sorry, in the teen cases, which accelerated off a tougher comp, that would be helpful to also get some more additional perspective there. Thanks."
},
{
"speaker": "John Morici",
"text": "Yes. Hi, Elizabeth. Yes, you're right. The Lumina restorative that we expected to launch in the fourth quarter, now the full launch in -- into next year. That revenue was expected for this year. So that's part of the reasoning for taking down our overall guidance, in addition to the FX as I said on the previous question. And then your question on teen, look, we're pleased with our teen growth. We saw good over 8% growth on a quarter-over-quarter basis, 8% growth on a year-over-year basis. We saw good adoption in many places around the world. And it's a further reflection of the various products that we have, the adoption that doctors have. A lot of new doctors coming into the ecosystem to get trained and then actually become customers of ours. So we're pleased with the progress that we're seeing within teen."
},
{
"speaker": "Elizabeth Anderson",
"text": "Great. And any chance you want to quantify that iTero restorative contribution change or no?"
},
{
"speaker": "John Morici",
"text": "Yes, We're not getting it directly, but its less than a 1%, slightly less than a percentage of the total."
},
{
"speaker": "Elizabeth Anderson",
"text": "That's helpful. Thank you."
},
{
"speaker": "Operator",
"text": "Thank you. And our next question comes from the line of Jon Block from Stifel. Your question please."
},
{
"speaker": "Jonathan Block",
"text": "Hey, Joe, good afternoon. Yes, where to start? Everyone was nervous about cases and then you come in and you beat cases handling, and obviously the focus is going to be on the ASP. So John, maybe let me know if I have these numbers right. But it looks like the aligner ASP was down roughly 4% Q-over-Q. The FX hit was about a 1%. So can you talk in detail as much as possible, the other 3% decline in the ASP Q-over-Q, if I've got that right, it seems like a big deviation from where your head was at 3 months ago. How much of it was mix versus discounts? And if it was a lot of mix, why did mix become so pronounced over the past 3 months? And maybe we can start there please."
},
{
"speaker": "John Morici",
"text": "Yes, Jon, when you look at mix that we have, we see doctors utilizing DSP more and more as a record amount of DSP that we had in a quarter that's at a lower ASP. We saw a lot of GP growth. We talked about adult cases being up, and the best volumes that we've seen in several quarters, and many times that's lower stage products, that we end up seeing come through. And so when we see the ASP, it's just a reflection of the different products that are being sold and those doctors are taking those up, at that. But you also know, and we've talked about where margins in many cases are better at those lower stage products, and we end up seeing this as a benefit to be able to see show up in gross margins and also off margins."
},
{
"speaker": "Jonathan Block",
"text": "Okay. So I, I guess to maybe just as a follow-up to that, are you saying that discounts weren't more aggressive, call it in 2Q '24 than maybe what we've seen historical? And just tack on to that follow-up, you brought down the midpoint of the rev guide from about 7% to 5%. You said FX was a 1%, you said the GP restorative push on Lumina was slightly less than 1%. I mean, are you sort of implying that clear aligner revenue by and large for 2024 is somewhat unchanged or maybe down a smidge and, and then I'll ask my quicker follow-up. Thanks."
},
{
"speaker": "John Morici",
"text": "Yes, Clear Aligner revenue down a little bit for the total year because of the ASPs that we spoke about not necessarily due to any volume changes. Like you said, we are pleased with the Q2 volume that we have. But that’s how we’ve look at the change. Mostly the FX for the total year as we've described, and then some mix, but then the rest of it due to iTero changes from this year to next year."
},
{
"speaker": "Jonathan Block",
"text": "Okay. And last question for me. I guess online, just John, if I've got this right, it looks like the revenue comes down a little bit, the midpoint, but I believe the non-GAAP EBIT margins came up slightly, I think before it was like flat to slightly up, and now you're saying slightly up. So maybe just talk through the dynamics where you're able to arguably increase the non-GAAP EBITDA margin assumption for '24 even off the more modest revenue base. And thanks for the time, guys."
},
{
"speaker": "John Morici",
"text": "Yes, no, it's a good question. And so as we looked at and as we talk about some of the -- I know ASP gets a focus, but really when you look at the margin that we get on all of these products is as they go to some of the lower stage products, we end up with a better margin. Our cost to serve is lower, which shows up in gross margin and flows its way to op margin. And I think the rest of it as you saw with this quarter from an OpEx standpoint and how we think about the levers that we could pull or not pull, we're very mindful of that in this environment and want to be able to deliver as much volume and as much top line as we can, but be very mindful of the operating profit that we need to deliver."
},
{
"speaker": "Operator",
"text": "Thank you. And our next question comes from the line of Jeff Johnson with Baird. Your question please."
},
{
"speaker": "Joe Hogan",
"text": "Hey Jeff."
},
{
"speaker": "Jeff Johnson",
"text": "Hey Joe. Good afternoon, guys. Wanted to start maybe on your doctor ship to number in the quarter. You shipped to a little over 86,000 docs this quarter. I think for 3 straight years you've kind of been in that 82,000 to 85,000 range. So maybe not a big breakout, but at least some of these underlying numbers on utilization is doctors ship to and that are starting to perk up a little bit. So I guess what I'm trying to understand on that doctor ship to number, are you starting to see some benefits of some of the investments Jon has been talking about the last couple quarters on getting that doctor prescribing base to expand? Is it expanding that base? Is it slowing the outflow of that base? As we know you've had some competitive losses here over the last couple years. Just maybe help us understand the inflow and the outflow rates and what's moving between those two pieces. Thanks."
},
{
"speaker": "Joe Hogan",
"text": "Hey Jeff, Joe. First of all, we're pleased with that. It's good to see a utilization go up. It's also great to see the doctors go up too. And obviously there's a strong concerted effort. We talk about that underserved marketplace out there and we know there's still a lot of doctors to train and there's still doctors do a lot more cases. So it's a big focus for the business. When you ask that question, are we loser in fewer or gaining few? There's always a mix and a change in those kinds of things, Jeff. But overall you can see here that we're gaining, it's not saying that we don't lose some docs sometimes, but you know, we often bring them back too. The whole story with what we've been through as competitors have entered the marketplaces, sometimes we'll lose some doctors, they often come back and one of the things about our business too, sometimes it takes 18 months for doctors to figure out if those competitive cases are actually going to work. And obviously I think we’re -- we're making good progress in the sense of convincing doctors to move ahead with us. And this growth in doctors and utilization occurred across the globe, which is great. It wasn't like it just came out of one region."
},
{
"speaker": "Jeff Johnson",
"text": "Yes, understood. All right. And then maybe just a follow-up on the manufacturing side. We saw the news maybe a couple months ago of Emory's new role leading Direct Fab. He's going to stay in that role it sounds like through 2026 when he is going to write off into the sunset. So does that tell us anything about timelines on Direct Fab? I mean, Emory just doesn't seem like the kind of guy that would want to walk away in the middle of something. So is that kind of drawing a line in the sand that by 2026 you should be up and running fairly well, fairly maybe not efficiently, but fairly completely in getting that Direct Fab plans all put together and rolling out some of that 3D printed stuff in a bigger way?"
},
{
"speaker": "John Morici",
"text": "Hey Jeff, it's a good question. We have a lot of faith in Emory. He's been here for so long and he's the only guy that's ever scaled, aligners to the point, that he has. And so it's really fun to have him in this role because he gives us great feedback in a sense of where we are. Jeff, the best I can say what we've talked about with the analyst is we're looking at 2 to 3 years on this scale. And don't think of it as a linear line. This is one where you have to do a lot of equipment work at first to get the efficiencies, to have this equipment work 24/7. And then secondly, this is a brand new resin [ph], it's never been sourced before. And so finding the source of the resin, making sure you have the reactor capacity, all those things take time. So I look at over the next year, we do a lot of that groundwork and then you'll start to see products and different things that will roll from that. So, but it's best to fix in your mind that it's a 2 to 3 year kind of a rollup."
},
{
"speaker": "Jeff Johnson",
"text": "Understood. Thank you."
},
{
"speaker": "John Morici",
"text": "Okay."
},
{
"speaker": "Operator",
"text": "Thank you. One moment for our next question. And our next question comes from the line of Brandon Vazquez from William Blair. Your question please."
},
{
"speaker": "Brandon Vazquez",
"text": "Hi everyone. Thanks for taking the question. I'll ask two upfront because it's kind of guidance related. One a little near-term, which is basically, I think if you do the sequentials and the implied numbers on the guidance that you've given us, there's maybe like a high single digits revenue increase going into Q4. I think, correct me if I'm wrong, but that's kind of like pre-COVID levels of seasonality, back when the business was a little more normal. So the question near-term being, given the uncertainty in the market, what kind of gives you the confidence that you guys can kind of return normal seasonality within this year? And then the follow-up to that on kind of a long-term guidance question is like, okay, we look with [indiscernible] three years out, what's kind of the growth expectations of this business sort of growth algorithm? Any color you can give us around that, assuming that, we're, it seems like we're stuck in somewhat of a an uncertain end market stable, but not exactly where you want it. So talk about the opportunity to accelerate if even possible, in an end market like this over the couple plus three plus years. Thank you."
},
{
"speaker": "John Morici",
"text": "Yes, Brandon, this is John. I could take the question kind of on the remaining part of this year and so on. So we've guided to what we can see, based on how the quarter played out. We actually saw in the second quarter. I mean, I'm not saying it's a return to normal seasonality, but it was much more seasonal in the second quarter in terms of how our volume progressed and how it changed quarter-over-quarter to more normal seasonality. And so our reflection of what we tried to do for the rest of this year based on what we see. In terms of volume, takeout FX and some of that noise that gets caught into Q2. But from a underlying volume standpoint, we saw, um, more normal seasonality. And as we play out the rest of this year, we expect that to continue with teen season that comes in, that we're in now. China in the third quarter is a strong quarter for them because of team season, Europe, not so much. We expect that to, uh, play out more normally as it moves from Q3 to Q4. When we think of the total and looking out into 3 years, and so look, we're in an underpenetrated market and we've talked about a lot about that. We think we have the products and the go-to-market capabilities to really move this market forward. And it's up to us to be able to help drive this market forward. And when we look out and we look out in our long-term model, we believe in, in the opportunity revenue growth is 25% plus percent and up margin 25% plus. And that's how we are positioning things for growth, for whether it's Direct Fab, and the growth opportunities that we have there and the efficiencies that we can drive as well as the standard production that we have now. That's how we're building from an investment standpoint. We're mindful of changes that can happen short-term and economy and so on. And that's why we give you kind of the guidance that we have, at least now in short term, but in longer term we believe in, in our model. And, and that's how we're investing in the future."
},
{
"speaker": "Operator",
"text": "Thank you. [Operator Instructions] Our next question comes from the line of Jason Bednar from Piper Sandler. Your question please?"
},
{
"speaker": "Q - Jason Bednar",
"text": "Good afternoon everyone."
},
{
"speaker": "Joe Hogan",
"text": "Hey, Jason,"
},
{
"speaker": "Jason Bednar",
"text": "Hey, there, I wanted to touch on one near-term item with third quarter guidance, some of the spend discussed already, but clearly over the -- lower than where you'd probably model things out internally 3 to 6 months ago. And I guess I'm just reminded of maybe where we were a year ago in the third quarter, you had higher expectations than where ended up finishing. So I guess I'm curious maybe how much of that experience from last year informed your view on volumes and product mix versus, say, the trends and macro data points that you've seen develop the last few months? And then maybe include here if you could just how you're seeing that team season develop since we are in the thick of that right now."
},
{
"speaker": "John Morici",
"text": "Yes, Jason, I can take that on, on the Q3. Some of those specifics, certainly we look at last year, we look at the 2022, you know, you got into those COVID years, they're tough to call and then you have to jump before COVID. So now you're talking almost 5 years ago. So, you look at what you see at the time knowing that most recently you have, we know we have Europe, has a summer kind of shutdown, comes back into September. We want to be able to see in September that they do come back. USS is in team season, China to get into the teen season as well. And we want to see how that plays out. So we call based on based on what we expect, both from a volume standpoint and we are really trying to give the foreign exchange that we see, that started the quarter, in July, where that FX is and not make an assumption as to whether things are going to get better or worse. We want to put that out there and really try to give you more of the underlying performance for the business. Joe, you want to talk about purchase?"
},
{
"speaker": "Joe Hogan",
"text": "Yes, on the teen side, Jason as I said in my script, and we were pleased with the team growth. It was over 8%, which is great to see. A lot of that was supported by Asia and also Europe when you really got to get into team numbers. Again, IPE is part of that. It's -- we look at that as obviously pre-teen and we watching the ramp up of that, that is obviously pre-teen and we were watching the ramp up of that and the acceptance in the marketplace. So hope I'm answering your question, but overall, we feel good about the team now. There's a big team season in China in the third quarter, we're watching it closely. We expect be able to perform in that side too. So I'm optimistic as it stands."
},
{
"speaker": "Jason Bednar",
"text": "Okay, great. Then just for my follow-up, I'm going to pack a few in here. Maybe bigger picture, if we step back and look at some of the recent developments. I know there's a lot of initiatives, different initiatives, marketing programs, menu expansion, customer incentives, so on and so forth. Those all help contribute to expanding that utilization line, improving doctor productivity. You've got the Costco relationship that's been discussed. We uncovered what looks to be one of the larger changes to your advantage program in at least a few years. So I'm curious how you'd have us think about these in the broader context of your commercial efforts. Would you consider things like the Costco and Advantage changes, either are both more impactful than what you typically do? Have you seen any change maybe in doc behavior, just in response to these advantage changes? And then what's the right way to think about each of these influencing that ASP line that's now coming to focus more significantly with today's results? Thank you."
},
{
"speaker": "John Morici",
"text": "Yes, that's a good, great question, Jason. I look at -- just to answer it a couple different ways, because I think one is like on the advantage you brought up, that's really a reflection of trying to put some structure, a little added structure to our Advantage program where many of our promotions we're trying to get to. And in the end for an Advantage program is trying to get new doctors in, give them a progression of, how they can get discounts as they do more and more cases drive utilization. So that's, that's good for new doctors, that's good for existing doctors. So the Advantage changes really we're trying to put more structure into that, into the second half and then carrying forward because they really had better refreshed, like, what we've got now. But it's all about driving utilization, getting doctors to do more and more cases. Programs like we're testing or piloting with a Costco is really just trying to drive more conversion. Find ways where those consumers or those potential patients are out there, they're shopping around, they're looking at, you see the economy, you see inflation, you see other things. We know those potential patients are out there. We just have to find ways to be able to connect them with a great product that we have with our customers, with our doctors. And Costco is an example of that, that we'll test and we'll see. But it's really that specifically is designed around conversion drive as much conversion as we can."
},
{
"speaker": "Jason Bednar",
"text": "Thank you."
},
{
"speaker": "Operator",
"text": "Thank you. And our next question comes from the line of Michael Ryskin from Bank of America. Your question please."
},
{
"speaker": "Michael Ryskin",
"text": "Hey, thanks for taking the question, guys. Joe or John, I want to follow-up on a point that you touched on a couple times already in terms of the ASPs. You talked about part of it is the mix shift and a lot of it is how your customers want to buy, whether that's different products within portfolio, whether or DSP, things like that. But what I want to get at is, are you concerned by that trend itself at all? Is that, that customers want the lower products? I guess that gives you the option to still meet them in the air and that still drives the volume, but is that something that you expected. This shift down? As you say, the market's still very unpenetrated. It's a big untapped market, so you'd think that you wouldn't be seeing the demand elasticity type of price that you are. So is this temporary because of the current macro environment and consumer sensitivity, or does it say something deeper that the rest of the market that's out there really doesn't exist at that, 1,300 plus ASP maybe it's lower and lower and lower."
},
{
"speaker": "Joe Hogan",
"text": "Hey Michael, it's Joe. Look, I think the ASP piece to try to explain as much as we can is, we're always staring at the margin side to make sure that our margins are good. We find out that all over the world, I mean, if you're in India, they ask for a different product and they ask in the United States at different areas, and some people want a 5x5, someone want 3x3, all these things are different products for different kinds of applications. And GPs [indiscernible] at times too. So what we're seeing and there's varying ASPs on it, but we always have -- you see, our margins have actually moved up on that. So you're seeing not necessarily the market just driving price down, you're just seeing us having a variation of options that customers or doctors want around the world and making sure that we supply those well. One -- we talk about 25,000 cases came through DSP. Remember, those are cases that, that doctors used to mold these things in their offices in order to address those, right. And now they're buying three or four of ours now, yes, we're getting great margin on that product line, but overall it's a lower ASP in that sense as part of the DSP program. So what you're seeing is just us responding to a market. It's a good market out there with varying degrees of price and value, and you'll see us continue to do that in order to grow the marketplace."
},
{
"speaker": "Michael Ryskin",
"text": "Okay. And then much quicker follow-up hopefully, sorry if I missed it, but did you call up why the Lumina restorative was pushed out to 1Q '25? Was this commercial decision or something on the development side?"
},
{
"speaker": "Joe Hogan",
"text": "Yes, Michael, well, there's like five areas of restorative that you have to be very good at as you go through this. And truth of reviews, we made extremely good progress on most of them. But we just -- we wanted to take a little extra time to make sure we get this right and we want to make sure that we run it through our doctors who are actually going to use it, the luminaries out there that help to promote the product and make sure that they're comfortable with it too. So we just feel it's diligent and responsible to make sure that we take a few more months here, launch it in the first quarter so that we have the world's best product."
},
{
"speaker": "Michael Ryskin",
"text": "Okay. Thanks. Makes sense."
},
{
"speaker": "Operator",
"text": "Thank you. And one moment for our next question. And our next question comes from the line of Erin Wright from Morgan Stanley. Your question please."
},
{
"speaker": "Erin Wright",
"text": "Thanks for taking my question. So did you see any recent changes, for instance, in the adult case volume dynamics throughout the quarter? And just what are you seeing so far in the third quarter in terms of adult cases? I guess, has anything changed in terms of your view on the macro environment and for the remainder of the year? And I hate to belabor this, but also for the Americas too, but on the macro question, are you generally expecting stability in your guidance or are you anticipating a range of outcomes from a consumer and macro environment standpoint for the remainder of the year?"
},
{
"speaker": "Joe Hogan",
"text": "Aaron, we -- I mean, we had that in our script and we talk about it as we're expecting stability. I mean, obviously not stability and exchange rates, right? We can't, we're not that smart. We'd be working somewhere else if we knew exchange that well. But as far as the market overall and how we want to go about it, we still feel we're dealing in a stable environment. The last thing I'll say about this, this is a very global business. You saw that the Japanese yen, Brazilian real, the business is growing substantially that way, and there's a certain amount of stability that we have that plays across geographies too."
},
{
"speaker": "John Morici",
"text": "And that adult piece we saw growth. We saw highest quarter in many quarters. So we're pleased with it. I think it's a reflection of our GP business, growing GPs, growing with DSOs and so on being able to, to get some of that volume through. Like Joe said, it's more of a stability that we're seeing, but we're pleased with that adult growth. And some of that contributes to some of that lower ASP product. It's great if that's how doctors want to buy to be able to treat those adults, we're happy to sell it to them. And as Joe said, it -- it's a better margin for us."
},
{
"speaker": "Erin Wright",
"text": "And you mentioned China too and the key market there, but just generally speaking, can you give us an update on kind of China, the underlying demand trends and market dynamics there?"
},
{
"speaker": "Joe Hogan",
"text": "It's Joe again, Erin. China performed the way we wanted China to perform, just as we predicted. Overall, I mean, the market is challenging. I think that Tier 3 and 4 cities are actually challenged more than the private and one and twos. But overall there's no surprise we have a good team there. Juno [ph] is a great leader for us there and we like the results and we're looking forward to a good team quarter there, which is third quarter is always the biggest quarter for China."
},
{
"speaker": "Erin Wright",
"text": "Okay. Thank you."
},
{
"speaker": "Joe Hogan",
"text": "You're welcome."
},
{
"speaker": "Operator",
"text": "Thank you. This does conclude the question-and-answer session of today's program. I'd like to hand the program back to Shirley Stacy for any closing comments."
},
{
"speaker": "Shirley Stacy",
"text": "Thank you, operator, and thank you everyone for joining us on the call today. We look forward to speaking to you at upcoming financial conferences and industry events. If you have any questions, please follow-up with our investor relations team. Have a great day."
},
{
"speaker": "Operator",
"text": "Thank you, ladies and gentlemen, for your participation at today's conference. This does conclude the program. You may now disconnect. Good day."
}
] | Align Technology, Inc. | 24,568 |
ALGN | 1 | 2,024 | 2024-04-24 16:30:00 | Operator: Greetings. Welcome to the Align First Quarter 2024 Earnings Call. [Operator Instructions] Please note, this conference is being recorded.
I will now turn the conference over to your host, Shirley Stacy, with Align Technology. You may begin.
Shirley Stacy: Good afternoon, and thank you for joining us.
I'm Shirley Stacy, Vice President of Corporate Communications and Investor Relations. Joining me for today's call is Joe Hogan, President and CEO; and John Morici, CFO.
We issued first quarter 2024 financial results today via Business Wire, which is available on our website at investor.aligntech.com. Today's conference call is being audio webcast and will be archived on our website for approximately 1 month.
As a reminder, the information provided and discussed today will include forward-looking statements, including statements about Align's future events and product outlook. These forward-looking statements are only predictions and involve risks and uncertainties that are described in more detail in our most recent periodic reports filed with the Securities and Exchange Commission available on our website at sec.gov. Actual results may vary significantly and Align expressly assumes no obligation to update any forward-looking statement.
We have posted historical financial statements with corresponding reconciliations, including our GAAP to non-GAAP reconciliation, if applicable, and our first quarter 2024 conference call slides on our website under Quarterly Results. Please refer to these files for more detailed information.
With that, I'll turn the call over to Align Technology's President and CEO, Joe Hogan. Joe?
Joseph Hogan: Thanks, Shirley. Good afternoon, and thanks for joining us on our call today.
I'll provide an overview of our first quarter results and discuss a few highlights from our 2 operating segments, System Services and Clear Aligners. John will provide more detail on our Q1 financial performance and comment on our views for the second quarter and 2024 in total. Following that, I'll come back and summarize a few key points and open the call to questions.
I'm pleased to report better-than-expected revenue and earnings for the first quarter and a solid start to the year. For Q1, total worldwide revenues were up 5.8% year-over-year, reflecting 3.5% growth from our Clear Aligner segment and 17.5% growth from Systems and Services. On a year-over-year basis, Q1 revenue growth was up across all regions and was driven by strong Clear Aligner volumes, primarily in the Asia Pacific region. Year-over-year growth also reflects strength in the orthodontic channel with total Invisalign case starts from teens and younger patients up 5.8% year-over-year, driven by continued momentum across all regions from Invisalign First, as well as Invisalign DSP touch-up cases.
On a sequential basis, Q1 total revenues were up 4.3%, reflecting a sequential increase in Clear Aligner revenues. Especially for North American orthodontists, as well as strong Systems and Services revenues, primarily driven by iTero Lumina wand upgrades in North America. During the quarter, we achieved several significant milestones. We completed the acquisition of Cubicure, a leader in direct 3D printing solutions, which is the foundation for our next generational aligner manufacturing. We successfully launched the iTero Lumina intraoral scanner, our next generation of digital scanning technology. We launched the Invisalign Palatal Expander or IPE system in the U.S. and Canada and received regulatory approval for the Invisalign Palatal Expander in Australia and New Zealand.
Q1 Systems and Services revenue year-over-year growth reflects nonsystems revenues driven by iTero Lumina wand upgrades and higher scanner volumes and increased services revenue from a larger base of scanners sold. On a sequential basis, Q1 Systems and Services revenue were up 3.1%, reflecting growth from nonsystems revenues and higher scanner ASPs, partially offset by lower volumes due to seasonality, a strong fourth quarter. The iTero Lumina intraoral scanner is available now with orthodontic workflows as a new standalone scanner or as a wand upgrade to iTero Element 5D Plus. The restorative workflow is expected to be available in the fourth quarter of 2024.
In the meantime, GP practices can benefit from the iTero Lumina's new multi-direct capture technology that replaces the confocal imaging technology in earlier models. The iTero Lumina intraoral scanner has a 3x wider field of capture and a 50% smaller and 45% lighter wand, delivering faster scanning speed, higher accuracy, super visualization and more comfortable scanning experience.
Overall, we're really pleased with the launch of iTero Lumina scanner. Customer feedback has been positive, and we're really excited about the feedback from doctors. So we've included some great verbatims in our webcast slides.
Q1 total Clear Aligner revenues were up year-over-year reflecting revenue growth across the regions from strong year-over-year volume growth across APAC markets, as well as the EMEA region. For the Americas region, Q1 Clear Aligner volume was consistent with prior year. For Q1, total Clear Aligner shipments were up 2.1% sequentially, reflecting seasonality with increased volumes in the Americas regions, offset somewhat by EMEA and APAC regions.
For Q1, Clear Aligner shipments include over 23,000 Invisalign Doctor subscription cases or DSP touch-up cases, primarily from North America ortho channel, an increase of approximately 49% year-over-year from Q1 '23.
The DSP touch-up cases are a component of the overall DSP program, which consists of retainers and touch up cases or aligners, and it continues to be an important offering for our customers and their patients. DSP is currently available in the United States, Canada, Iberia, Nordics, the U.K. and most recently, in Italy, France and Poland. We expect to continue expanding DSP into other country markets and EMEA in Q2 including a 14-stage touch-up aligner offering.
For non-case revenues, Q1 was up 7.5% year-over-year, primarily due to continued growth from Vivera Retainers along with Invisalign DSP retainer revenues. In a teen market, nearly 200,000 teens and younger patients started treatment with Invisalign Clear Aligners in Q1, up 5.8% year-over-year. This represents a record number of teen cases shipped as compared to prior quarters, reflecting strength in APAC and EMEA. Teen starts were up sequentially 1.2%, reflecting strength in EMEA and North America, offset by seasonally fewer teen starts in China. While the teen market tends to be less susceptible to consumer demand around discretionary spending and more resilient than adult orthodontic case starts, we're pleased that in Q1, our Clear Aligner volumes for both adults and teens were up sequentially and year-over-year.
We believe the Invisalign Palatal Expander system is one of the most exciting innovations we've developed in our 27-year history and is a better option for expanding a growing patient's narrow pallet. Initial response from doctors and patients for Invisalign Palatal Expander system is positive. The Invisalign Palatal Expander system is not a traditional Invisalign aligner. It's a series of direct 3D-printed orthodontic appliances based on proprietary and patented technology that has 4 systems designed for skeletal expansion. Clinical data shows that Invisalign Palatal Expander system is safe, effective and proven to deliver skeletal expansion.
Specifically, our clinical data is based on 49 patients across the United States and Canada between the ages of 6.9 and 11 with a mean age of 8.8 years. In this group, the mean expansion of 6 millimeters was achieved with minimal tipping with ranges between 3.4 and 10.7 millimeters as measured using the change in intermodal width between the initial and post-expansion scans with a mean expansion efficacy of 97%.
In addition, we found that survey doctors agree the Invisalign Palatal Expander is less painful than traditional expanders and facilitates better oral hygiene compared to traditional metal expanders. Phase I or early intercepted treatment includes both skeletal, orthopedic and dental orthodontic arch expansion and makes up to 20% of the orthodontic case starts each year. Combined with Invisalign First aligner treatment, Invisalign Palatal Expanders provide doctors with a full early interceptive treatment solution that allows doctors to treat all Phase I patients. We expect Invisalign Palatal Expander to be available in other markets pending future applicable regulatory approvals.
Today, Invisalign is the most recognized orthodontic brand globally, and Invisalign Clear Aligner treatment is faster and more effective than traditional metal braces. Yet the underlying market opportunity remains huge and untapped. We continue to invest in consumer marketing and demand creation initiatives to raise awareness and drive potential patients to Invisalign practices globally. Below are several highlights from Q1 and more information is available in our Q1, '24 earnings webcast slides.
In Q1 '24, we delivered 14.5 billion impressions and had 43 million visits to our websites globally. To increase awareness and educate young adults, parents and teens about the benefits of the Invisalign brand, we continue to invest and create campaigns in top media platforms such as TikTok, Instagram, YouTube, Snapchat and WeChat across markets, reaching young adults as well as teens and their parents also requires the right engagement to Invisalign influencers and creator-centric campaigns.
Our teen Invis is Drama Free campaign was recently recognized by the Association of National Advertisers with a silver award in the REGGIE Awards for creative and strategic excellence. In the U.S., in addition to our ongoing influencer campaigns, we partner with athletes such as Maxx Crosby, TikTok Gen Z influencer, Overtime Meg and the famous fashion designer, Kristin Juszczyk to create a compelling brand activation at the Super Bowl. Our campaigns delivered more than 6.1 billion impressions and 18.1 million unique visitors to our consumer websites across the Americas. In the EMEA region, we partner with influencers to reach consumers across social media platforms, including TikTok and Meta, and launched our global consumer campaigns for teens and parents. Our campaigns delivered more than 1.6 billion media impressions and 8.9 million visitors to our website.
We continue to invest in consumer advertising across the APAC region, resulting in more than 6.6 billion impressions and 16 million visitors to our websites, a 195% increase year-over-year. We expanded our reach in Japan and India via Meta and YouTube and partnered with key influencers to reach consumers across social media. We saw increased brand interest from consumers as evidenced by a 285% year-over-year increase in unique visitors to our website in India and a 129% increase in Japan.
Finally, digital tools such as My Invisalign consumer and patient app continue to increase with 4 million downloads to date and over 381,000 monthly active users, 15% year-over-year growth rate. Q1 '24 Clear Aligner volume from DSO customers increased sequentially, reflecting growth in the Americas and the EMEA regions and increased year-over-year reflecting growth across international regions.
Dental service organizations, or DSOs, represent a large and growing opportunity to help drive adoption of digital technology across the dental industry. We have established relationships with many DSOs globally, that recognize the benefits of digital workflows enabled by our portfolio of products and services that make up the Align digital platform, including increased practice efficiency and profitability, as well as delivering a better patient experience from shorter cycle times and proximity to their customers.
Smile Docs and Heartland Dental are some of the largest DSO partners and are continuously exploring collaboration with DSOs that can further adoption of digital dentistry. Each DSO has a different strategy and business model and our focus is on working with the encouraging DSOs aligned with our vision, strategy and business model goals.
Today, we announced an additional $75 million equity increase in Heartland, following the previous $75 million equity investment a year ago. Heartland is a multidisciplinary DSO with GP and ortho practices across the United States. Their growth strategy includes Heartland's de novo dental practices, which feature modern technology, located in areas with a strong community need for dentistry where Heartland provides practices with opportunities for mentorship, leadership training and continuing education. In the last 4 years, Heartland opened 240 state-of-the-art de novo practices across the U.S. and are planning to continue investing through more de novo openings. We have a shared sense of purpose with Heartland. Their mission is to help doctors and their teams deliver the highest quality digital dental care to the communities they serve.
With that, I'll now turn it over to John.
John Morici: Thanks, Joe.
Now for our Q1 financial results. Total revenues for the first quarter were $997.4 million, up 4.3% from the prior quarter and up 5.8% from the corresponding quarter a year ago. On a constant currency basis, Q1 '24 revenues were impacted by favorable foreign exchange of approximately $10 million or approximately 1% sequentially and were unfavorably impacted by approximately $4.8 million year-over-year or approximately 0.5%.
For Clear Aligners, Q1 revenues of $817.3 million were up 4.5% sequentially, primarily from higher ASPs and higher volumes. On a year-over-year basis, Q1 Clear Aligner revenues were up 3.5%, primarily due to higher volumes and ASPs and increased non-case revenues. For Q1, Invisalign ASPs for comprehensive treatment were up sequentially and up year-over-year.
On a sequential basis, ASPs primarily reflect higher additional aligners and price increases and the variable impact of foreign exchange partially offset by a product mix shift to lower ASP products. On a year-over-year basis, the increase in comprehensive ASPs primarily reflect higher additional aligners and price increases partially offset by a product mix shift to lower ASP products and higher discounts and the unfavorable impact from foreign exchange.
For Q1, Invisalign ASPs for non-comprehensive treatment were down sequentially and year-over-year. On a sequential basis, the decline in ASPs reflect unfavorable country mix shift and higher discounts, partially offset by the favorable impact from foreign exchange. On a year-over-year basis, the decrease in non-comprehensive ASPs reflect the product mix shift to lower ASP products, unfavorable country mix shift and higher discounts, partially offset by lower net revenue deferrals.
As a reminder, we announced about a 5% global price increase for some Invisalign products across most markets effective January 1, 2024. This price increase did not include Invisalign Comprehensive Three and Three products. Invisalign Comprehensive Three and Three product is available in North America and in certain markets in EMEA and APAC, most recently launching in French territories and in the Middle East.
We are pleased with the continued adoption of the Invisalign Comprehensive Three and Three product and anticipate it will continue increasing, providing doctors the flexibility they want and allowing us to recognize more revenue upfront with deferred revenue being recognized over a shorter period of time compared to our traditional Invisalign Comprehensive product.
Q1 '24 Clear Aligner revenues were impacted by a favorable foreign exchange of approximately $8.4 million or approximately 1% sequentially. On a year-over-year basis, Clear Aligner revenues were unfavorably impacted by foreign exchange of approximately $3.9 million or approximately 0.5%.
Clear Aligner deferred revenues on the balance sheet decreased $26.7 million or 2% sequentially and increased $15.8 million or 1.2% year-over-year and will be recognized as the additional aligners are shipped. Q1 '24 Systems and Services revenue of $180.2 million were up 3.1% sequentially, primarily due to increased nonsystems revenues, mostly related to upgrades and higher ASPs, partially offset by lower volumes.
Q1 '24 systems and Services revenue were up 17.5% year-over-year primarily due to increased nonsystems revenues, mostly related to upgrades, higher scanner volumes and higher services revenues from our larger base of scanners sold. CAD/CAM and Services revenue for Q1 represents approximately 51% of our Systems and Services business.
Q1 '24 Systems and Services revenues were favorably impacted by foreign exchange of approximately $1.5 million or approximately 0.9% sequentially. On a year-over-year basis, Systems and Services revenues were unfavorably impacted by foreign exchange of approximately $0.9 million or approximately 0.5%. Systems and Services deferred revenues on the balance sheet was down $14.3 million or 5.5% sequentially and down $25.3 million or 9.4% year-over-year primarily due to the recognition of services revenues, which will -- which is recognized ratably over the service period. The decline in deferred revenues both sequentially and year-over-year reflects the shorter duration of service contracts with initial scanner purchases.
As our scanner portfolio expands and we introduce new products, we increased the opportunities for customers to upgrade and make trade, in addition to other scanner leasing and rental programs. Developing new capital equipment opportunities to meet the digital transformation needs of our customers and our DSO partners is a natural progression for our equipment business with a large and growing base of scanners sold. We're pleased to be able to leverage our technological innovations and operational capabilities and efficiencies to provide different types of go-to-market models to our customers, such as rentals and leasing, selling the way that our customers want to buy.
Moving on to gross margin. First quarter overall gross margin was 70%, approximately flat sequentially and year-over-year. Overall gross margin was favorably impacted by foreign exchange by approximately 0.3 points sequentially and unfavorably impacted by approximately 0.1 points on a year-over-year basis.
Clear Aligner gross margin for the first quarter was 70.9%, down 0.3 points sequentially due -- primarily due to higher manufacturing spend, partially offset by higher ASP. Clear Aligner gross margin for the first quarter was down 0.8 points year-over-year, primarily due to higher manufacturing spend, partially offset by favorable ASP.
Systems and Services gross margin for the first quarter was 65.9%, up 1.1 points sequentially due to higher ASP partially offset by manufacturing variances. Systems and Services gross margin for the first quarter was up 4.3 points year-over-year, primarily due to higher ASP, lower service and manufacturing costs.
Q1 operating expenses were $543.7 million, up 9.2% sequentially and 3.1% year-over-year. On a sequential basis, operating expenses were up by $45.7 million from higher incentive compensation and consumer marketing spend, partially offset by restructuring and other charges not recurring in Q1. Year-over-year, operating expenses increased by $16.5 million, primarily due to our continued investments in sales and R&D activities and higher incentive compensation.
On a non-GAAP basis, excluding stock-based compensation, amortization of acquired intangibles related to certain acquisitions and restructuring and other charges, operating expenses were $506.1 million, up 13.3% sequentially and up 3.2% year-over-year. Our first quarter operating income of $154.1 million resulted in an operating margin of 15.5% down 2.5 points sequentially and up 1.3 points year-over-year.
The sequential decrease in operating margin is primarily attributed to investments in our go-to-market teams and higher incentive compensation. The year-over-year increase in operating margin is primarily attributed to operating leverage and proactively managing our costs, partially offset by unfavorable impact from foreign exchange of approximately 0.7 points.
On a non-GAAP basis, which excludes stock-based compensation, amortization of intangibles related to certain acquisitions and restructuring and other charges, operating margin for the first quarter was 19.8%, down 4 points sequentially and up 1.3 points year-over-year. Interest and other income expense net for the first quarter was an income of $4.3 million, compared to an income of $1.3 million in Q4 of '23 and an income of $1.1 million in Q1 of '23, primarily driven by a gain on our equity investments and net interest income and offset by unfavorable foreign exchange.
The GAAP effective tax rate in the first quarter was 33.7% compared to 28.3% in the fourth quarter and 34.8% in the first quarter of the prior year. The first quarter GAAP effective tax rate was higher than the fourth quarter effective tax rate, primarily due to discrete tax benefits recognized in Q4 of '23, partially offset by increased earnings in low tax jurisdictions in Q1 of '24. Our non-GAAP effective tax rate in the first quarter was 20%, which reflects our long-term projected tax rate.
First quarter net income per diluted share was $1.39, down sequentially $0.24 and up $0.26, compared to the prior year. Our EPS was not impacted on a sequential basis from foreign exchange. Our EPS was unfavorably impacted by $0.09 on a year-over-year basis due to foreign exchange. On a non-GAAP basis, net income per diluted share was $2.14 for the first quarter, down $0.28 sequentially and up $0.32 year-over-year.
Moving on to the balance sheet. As of March 31, 2024, cash, cash equivalents and short term and long-term marketable securities were $902.5 million, down sequentially $78.2 million and down $18.9 million year-over-year. Of our $902.5 million balance, $217.5 million was held in the U.S. and $685 million was held by our international entities.
In January 2024, we received approximately 37,000 shares of our common stock upon final settlement of the $250 million accelerated share repurchase from Q4 of '23. In total, we repurchased approximately 1.1 million shares at an average price per share of $230.13 under the Q4 ASR contract. We have $650 million available for repurchase of our common stock under our January 2023 repurchase program. During Q2 '24, we expect to repurchase up to $150 million of our common stock through either a combination of open market repurchase or an accelerated stock repurchase agreement. Q1 accounts receivable balance was $950.7 million, up sequentially.
Our overall days sales outstanding was 86 days up approximately 1 day sequentially and up approximately 3 days as compared to Q1 last year. Cash flow from operations for the first quarter was $28.7 million. Capital expenditures for the first quarter were $9.4 million, primarily related to our continued investments to increase aligner manufacturing capacity and facilities. Free cash flow, defined as cash flow from operations less capital expenditures, amounted to $19.3 million.
We're continuing to use our healthy balance sheet to drive growth and profitability. During the quarter, we continued to make disciplined investments in our strategic growth drivers. We completed the acquisition of Cubicure, which will enable us to scale our 3D printing operations to eventually direct print millions of custom appliances per day, and we exited the quarter with a healthy cash flow position and no long-term debt, maintaining a strong position to support our additional $75 million investment in our DSO partner Heartland Dental and our $150 million stock buyback.
Now turning to our outlook. Assuming no circumstances occur beyond our control, we provide the following framework for Q2 and fiscal 2024. For Q2 '24, we provide the following business outlook. For Q2 '24, we expect worldwide revenues to be in the range of $1.030 billion to $1.050 billion. We expect Clear Aligner volume to be up sequentially and Clear Aligner ASP to be down slightly sequentially, primarily as a result of unfavorable foreign exchange. We expect Systems and Services revenue to be up sequentially as we continue to ramp iTero Lumina in Q2 2024. We expect Q2 '24 GAAP operating margin and non-GAAP operating margin to be slightly above Q1 '24 GAAP and non-GAAP operating margins, respectively.
For fiscal '24, we provide the following business outlook. We expect fiscal '24 total revenue to be up 6% to 8% versus 2023, which is higher than our prior outlook of up mid-single-digit growth compared to 2023. The increase in our 2024 revenue outlook reflects our Q1 results, Q2 outlook and continued execution of our growth strategies. We anticipate that the incremental revenue reflected in our 2024 outlook will be roughly split 50-50 between our 2 operating segments.
We expect fiscal 2024 Clear Aligner ASPs to be slightly up year-over-year. We expect fiscal 2024 GAAP operating margin and non-GAAP operating margin to be slightly above the 2023 GAAP operating margin and non-GAAP operating margin, respectively. We expect our capital -- our investments in capital expenditures for fiscal 2024 to be approximately $100 million. Capital expenditures primarily relate to building construction and improvements as well as manufacturing capacity in support of our continued expansion.
With that, I'll turn it back over to Joe for final comments. Joe?
Joseph Hogan: Thanks, John.
In summary, Q1 was a good start for the year. While I'm pleased with our results, I'm even more excited about Align's innovation in 2024 on our next wave of growth drivers that we believe will continue to revolutionize the orthodontic and dental industry in scanning software and direct 3D printing.
Our focused execution of our product road map and innovation pipeline has resulted in the largest introduction of new products and technologies in our history, further advancing our software scanning and 3D printing capabilities. We're excited about the potential for these strategic investments to enable a new phase of growth to transform the orthodontic industry again.
The iTero Lumina intraoral scanner has the potential to set a new standard of care for dental practices by simplifying the scanning of complex oral regions while offering superior chairside visualization and a more comfortable experience for patients, especially kids. The Invisalign Palatal Expander increases the clinical applicability of the Invisalign system to nearly 100% of orthodontic case starts. It is a revolutionary removable 3D-printed appliance that is clinically proven to be safe and effective. It is less painful than traditional metal expanders and promotes better oral hygiene.
And our recent acquisition of Cubicure, a pioneer of 3D printing solutions for polymer additive manufacturing, brings a talented team and unique cutting-edge technology into Align to help us scale our 3D printing operations, providing ultimate design freedom and highly customized outcomes from a customer and patient standpoint as well as operational benefits to the business.
We see incredible opportunities in this business and continue to make the Invisalign system the standard of care in orthodontics. By continually innovating and developing digital technologies and services that enable more doctors to easily diagnose and treat patients with crooked teeth and help them retain their healthy beautiful smiles. We're increasing access to care for millions of people, who might not otherwise receive orthodontic treatment.
With that, I thank you for your time today. We look forward to sharing our continued progress in leading the digital transformation of the orthodontic and restorative dental industry.
I'll now turn the call over to the operator for your questions. Operator?
Operator: [Operator Instructions] Our first question comes from Elizabeth Anderson with Evercore ISI.
Elizabeth Anderson: I was wondering if you could talk about how you're seeing the overall demand environment? I guess, I'm particularly curious about the U.S. sort of how you're seeing it from like a consumer demand perspective, especially and any comments you could make on the SmileDirect impact on volumes in the quarter? And then secondarily, if you could comment a little bit more on the broader demand environment in China, that would be super helpful.
Joseph Hogan: Elizabeth, I'll start off and have John jump in on anything. First of all, we describe the business right now as stable. The same things that we talked about as we came out of the fourth quarter, and we see that stability broadly around the globe. And you saw in our script that we just read to, that it's good from an adult standpoint and also a teen standpoint, too, which, again, led to that kind of stability that we talk about.
If I look around the world, I mean we've -- that stability exists, whether it's in Asia, whether we've seen it in parts of Europe and we see it in the United States and the Americas also. So I -- it's hard for us to call out a particular region or whatever that is dramatically down or dramatically up. We just see them moving pretty much in unison in the first quarter.
John, would you add anything?
John Morici: No, I agree. And that's -- we're driving the growth strategies. As we've said, we've seen that stability in the environment and we're executing against that.
Joseph Hogan: And Elizabeth, last thing on your SmileDirectClub comment, them not being advertising like they were before or whatever, we can't attribute any part of the demand equation up or down as part of that. And obviously, that was more pronounced in the United States than it was anywhere else in the world, but I can't attribute any change in the marketplace because of them not advertising at this point in time.
Operator: Our next question comes from Brandon Vazquez with William Blair.
Brandon Vazquez: I wanted to focus for a second on the -- on the teen side, you have the Palatal Expander out there now getting great reviews, and it seems like it closes, if I'm understanding the numbers correctly, maybe 20% of that market that you haven't been able to hit before. This is such a big opportunity. I'm curious if you can just reflect on like how does commercialization within teens look in the next couple of years now that you have kind of a broader and more fuller portfolio here compared to the prior couple of years? And what does that mean for growth rates within that teen section and adoption within teen that's underpenetrated relative to teens as we look forward the next couple of years?
Joseph Hogan: That's a good question, Ben. I think we -- as we mentioned, it's 20%. And there's -- we don't -- we call them tweens, really. They're young students before they really hit the teen years and have a mature dentition. With Invisalign First and now with IPE, we can handle the 20% that's out there on the Phase I. And some teens just need -- tweens just need dental expansion and some of you really have to split the suture and widen the pallet overall. We feel in both those cases, with IPE and Invisalign First, these are very unique products specific to that area. And we think it will actually make doctors that aren't comfortable with the Phase I, may be even more comfortable now because of the impact on patients is not what it was before when you tried to work these kinds of cases with wires and brackets or higher risk expanders and those kinds of things.
But like anything in the orthodontic community, it takes time. It takes time for acceptance. And the good thing about this is IPE is about a 30- to 35-day kind of an episode. So our feedback loop is really good. You can tell from my transcript also is right now, we're approved in the United States and Canada and recently in ANZ. And right now, we're throttled by the regulatory procedures we have to go throughout the world. So we'll be able to give you more specificity on this brand as we go forward. But as I mentioned in my closing too, we're really excited about that technology. And we didn't tie together the new Lumina scanner has such a broad kind of a bandwidth from a scanning standpoint, it scans that palate that you have to cover with Invisalign First extremely well. So those technologies thread together very well out there. So we're excited about it and more to come.
Operator: Next question comes from Jon Block with Stifel.
Jonathan Block: Hoping to ask 2, maybe just the first one, throughout the quarter, there was sort of like an obsession or a big focus from investors on month-to-month trends. There was talk about February strength, March weakness. I don't think if anyone really knew if it was the consumer or the calendar or both. So maybe you guys can talk a little bit about how it played out for you guys, elaborate on February and March? And as much as you can, just touch on April here for the first 2 to 3 weeks. And then I'll ask my follow-up.
John Morici: Yes, Jon, this is John. Look, from -- as we talk about the quarter and think about -- we're very pleased with our results in Q1, we saw stability, as Joe mentioned, and that really continued from the end of the year into the quarter, less about month-to-month. I mean it was the stability and then the execution that we had throughout the quarter with our products.
Jonathan Block: Okay. And then I'll just shift gears. John, I might stick with you. I believe the wording is slightly above the 2023 OM, which I think is 21.4% unchanged. Despite the higher revenues, the midpoint going from roughly 5% to 7%. So can you talk about where that extra spend is going? Do we see the returns on that this year? Or will that aid and give you some more tailwinds into 2025?
And then just to tack on to that, the new higher guidance doesn't -- implies at a 6% in the back part of this year, year-over-year growth, which isn't too dissimilar from 1H, but the comps get more difficult. So the stacks need to accelerate. Why should we be comfortable with that? Is that just an accelerating contribution from some of those new products like Lumina and IPE?
John Morici: I think that latter point is how I would look at it, Jon. We're making investments. We make investments throughout the year. We get the shorter longer-term investments that we make different returns on whether they're short or long term. But what we see is a stable environment, continued investments in go-to-market activities, we have new products coming. So that helps us accelerate with things that we'll have on the iTero side, as well as IPE and others that Joe talked about, where we really get the approval later in the year. So it's about a stable environment, making investments into that environment and then executing on our growth strategies, and that should give us the benefits that you described in the second half.
Operator: Our next question comes from Jeff Johnson with Baird.
Jeffrey Johnson: John, maybe following up on Jon's question there and just a little finer point on the guidance itself. You've taken that guidance from mid-single digits to 6 to 8 scanner and CAD/CAM services came in obviously strongly in the double digits, upper teens. Should we think about kind of that double digits, maybe not in the upper teens, but double digits is kind of where the scanner and services continues this year? And your Clear Aligner revenue guidance kind of still in the mid-single digits. I think last quarter, we were talking about both those segments being mid-single-digit growers. It seems like to me now, maybe the raise here is being driven more by the scanner and CAD/CAM services. And as Joe calls the market stable, then maybe the Clear Aligner revenue still kind of expected to be in that mid-ish single digits. Is that a fair kind of way to look at guidance?
John Morici: That's a fair way to look at it, Jeff. I mean, you would see, given the new products that we have with Lumina and iTero, we'll see a little bit faster growth. We're very pleased with what we saw in the first quarter. Typically in the first quarter, you don't have a sequential gain in revenue from the fourth quarter being an equipment business. So we're very pleased with what we saw there. But then we also look at the Clear Aligner business, and we expect to be able to grow and continue to grow there, both in terms of the investments that we're making in a relatively stable environment and some of the new products that should help supplement that growth.
Jeffrey Johnson: Yes, that's helpful. And then one other follow-up. I think it's been asked in the past maybe at an Analyst Day or something. I don't remember if you've given a clear answer. But it's something I keep getting asked here more recently, and that's a percentage of your patient base of maybe orthodontic cases that get financed through some sort of third-party patient financing company. We have seen in areas like full arch implants, some of the aesthetic procedures outside of dental, where lending standards have gone up, FICO scores have gone from the 500 to 700, something like that to qualify for patient financing in this cost of capital and tougher capital environment. So what percentage -- do you know a percentage or round about of what cases get financed? And if those lending standards have changed at all and put an incremental pressure on patients here more recently?
John Morici: Yes. What we see, Jeff, is it varies country by control say U.S. is maybe the most -- and I'll combine ortho and GP together, roughly 1/3 of the cases that we see get some type of external financing. Remember, many patients or parents will pay in advance. That's great for doctors. Many doctors, especially orthos will do some type of kind of internal financing where you kind of pay as you go and so on. And many doctors are continuing to do that, especially in the tougher environment. And we're doing things to help doctors to try to give them a little bit more extension in payments so that they can provide and pass that on to their patients as well. And we'll work with DSO partners to really try to help them work with these external companies to try to give better financing rates to try to get these patients to go into treatment.
So we're well aware. We know we can help. We have the balance sheet and the cash to be able to help with our customers, so that they can pass that on. And that's something that we want to keep working towards.
Jeffrey Johnson: John, any change to note over just the past few months even in those lending standards getting tougher? Or do you feel like that's stable as well as just kind of the overall environment as you've described that way?
John Morici: I look at that as more stable. I think there was a lot of things. If you go back to last year, people are really getting a bit of sticker shock in terms of the higher interest rates, when they came to try to go into treatment. I think people are past that.
I think when I see this or what I hear from doctors or see from our customers that it's a little bit more stable. There's not a big change.
Operator: Our next question comes from Michael Cherny with Leerink Partners.
Michael Cherny: Can you hear me okay?
Shirley Stacy: Yes, we can hear you fine.
Michael Cherny: Okay. So just relative to the spend, I want to dive in a little bit more, if possible. You talked about the investment growth. Can you delineate relative to that investment, how you're thinking about the growth into, call it, your core markets or some of the new product launches? And especially with regards to the ramp on the printing side, how much incremental printing spend, so to speak, is coming now versus where you think it's going to grow, what the run rate should be on ramping that over time?
John Morici: Yes. I think we have a core business that we're running. And obviously, there's a certain amount of investment that you have to be able to grow around sales, sales and marketing and the go-to-market activities that we have.
There's also R&D spending that we've had throughout the time. And now as that R&D in the case of acquiring Cubicure and now turning this into more of a platform to be able to build our 3D printing. There's a certain amount of spend that we have. How that lays out, it varies over time that we'll have. But rest assured, we know how to scale products. We know how to scale 3D printing. We'll make the right investments to be able to start scaling up that direct fab printing while making sure that the core business has the right investments for growth, and we'll balance that as we go forward.
Operator: Our next question comes from Jason Bednar with Piper Sandler.
Jason Bednar: First I want to build on some of the macro questions that have been asked. I don't want to belabor the point, but other consumer discretionary companies called out a downtick in March. It doesn't sound like you saw any of that, but just wanted to confirm that's the case with respect to Invisalign demand. And maybe speak to your confidence to drive Clear Aligner volumes going forward, now that comps turn a little bit tougher. How much do you think you might need to fund that growth with investments to drive more traffic into the office?
Joseph Hogan: Jason, on the first part is, we talk about the stable environment that we've seen that stability of it. We read and I read, what's going on there with the consumer investment, some concerns, particularly in the luxury goods or what's going on out there.
But honestly, I think often what we see and analysts who follow us here just really pick up the U.S. data. And what we see is differences all around the world, and that's what's great about having an international business. You have some counter cycling in the sense of the demand patterns and what goes on out there. But I would say there's nothing that we would highlight right now. I would say that we think something has changed in what we saw in the second half of 2023, to what we saw in the first quarter of this year.
John, you?
John Morici: And in terms of investments, we make the investments that we need go to market and manufacture and other expansion as we continue to grow. We'll continue those investments. But as we've talked about, not only for the -- now the second quarter when we're talking about that sequential improvement in op margin and what we've talked about in total year where we expect the year-over-year improvement in margin. We're making sure that we're investing with that right amount of profitability. To still be able to grow into our market and expand the opportunity -- expand on the opportunities that we have, but then being respectful in terms of what margin we need to be able to deliver for the company.
Jason Bednar: All right. Very helpful, Joe and John. And maybe one follow-up here to maybe a multi-partner on teen. So bear with me. But this might be a nuanced look. It seems like a lot of emphasis here just recently in product development and marketing that's really trying to tap into that much younger market, that Phase I opportunity. IPE fits in there, your new marketing branding plans and emphasis there. There seems to be some benefits for younger patients with Lumina. So it's really -- it seems intentional, but wondering if you could bifurcate for us, how your Invisalign business is performing in this younger patient population relative to the teen as a whole? Where does your penetration sit in those younger patients versus the broader teen channel? And maybe what kind of outsized growth you're expecting from this part of the channel as we look out over the near to intermediate term?
Joseph Hogan: Jason, just I'll back up on your question, just to give you a kind of a conceptual view. When you think of Phase I, it's actually been controversial in the orthodontic market for years, some orthodontists don't want to do Phase I because as I mentioned before, the kind of devices that have been used, have been kind of difficult from a consumer standpoint. And so those wait for all permanent dentition and move on to there.
We feel confident that within this Invisalign First now for dental expansion and then for palate expansion or a morphological change, IPE will do that. And we think a little track more orthodontists to begin Phase I treatment, but this is an industry that takes a while for things to bake in and for them to gain confidence and I understand it because you're working with kids' teeth and mouths and their dentition.
But we actually think that a significant amount of growth could come from this area, but we think it will take time, but it's been a great focus for us. And it's going to be interesting to watch how orthodontists in the future actually focus on Phase I, Phase II because these kinds of devices make it simpler for them and for patients in the future. So right now, I can just kind of give you the ground rules on that, that we've changed those roles. In a sense, but I can't project exactly where it's going.
Jason Bednar: Any sense penetration-wise or maybe where you're at relative to the broader teen market?
Joseph Hogan: I'd say we're just in that story. I mean even Invisalign First is used sometimes on more permanent dentition too. So it's hard -- we'd have to split our cases out of Invisalign First is what the age of patients are or whatever. But as we get more data and we really get through with IPE and some more specificity around this, we'll share it with you and the rest of the....
Shirley Stacy: The only thing that -- I mean if you've tracked us for a while, you know that our average age of teen patients gets younger and younger, I think we're 14 now versus 15 plus before. So I mean that's a reflection of just being able to go after those younger patients with First.
Operator: Our next question comes from Nathan Rich with Goldman Sachs.
Nathan Rich: Great. I wanted to go back to the guidance. I know it's kind of been touched on a few different times. But I wanted to ask on the Clear Aligner revenue outlook. It looks like you're raising the outlook for the full year by about 1%. I guess could you maybe just touch on what changed specifically with respect to that outlook? It sounds like maybe it's expectations around IPE and DSP versus market improvement. But I'd be curious, any color you could share there? And maybe anything on teen versus adult within the updated guidance would be great.
John Morici: Yes, I'll start, Nate. So overall, we went from -- we had talked about mid-single digits, so call it 5% to raising it to the midpoint of 7% on a year-over-year, so up 2 points. And really, that's a reflection of a few things. One is the continued stability that we're seeing. We're operating in an environment that's more stable. We saw that coming into the fourth quarter and now into this quarter as well. So that's good if we want that stability there.
And then you look at the execution that we have about -- on our core business to be able to grow with a lot of the innovations that we have, the promotions and other things that we have as we get into further into teen season, supplemented with the various new products that we talked about. We feel really good about Lumina and the launch that we have on iTero and the further expansion that that can drive as well as some of the new products like IPE and others to really not only help those unit sales there, but then as Joe described, we had to pull in other products around Invisalign First and others to really help drive some of that growth that we can see in the teen business.
So it's a combination of things, Nate, but it's what we're seeing in stability, how we're executing on our core strategies and then some of the new products really supplementing the extended growth to help us. And that's why we adjusted our total year.
Nathan Rich: Okay. That's helpful. And then, John, maybe just sticking with you. The 2Q operating margin, I know up slightly sequentially, but down year-over-year. And I think historically, it's been a little bit variable, but you've seen more of a step-up in the second quarter than I think what the guidance implies. Anything to call out with respect to FX? Or I think you mentioned some manufacturing cost spend, but just anything there that we should keep in mind as it regards the margin cadence?
John Morici: Well, and certainly, we are seeing a stronger dollar. So that's something that we talked about when we think about our guide too, we see a stronger dollar coming out of -- out of the first quarter into the second quarter. Our guide reflects that as well.
But then you look at the continued investments that we're making to be able to drive more submitters, more doctors into our ecosystem and then ultimately drive more and more utilization. Some of it's that core business that we have to be able to drive growth. And some of it's some of the new products where there's a certain amount of OpEx spend that we have with that.
But we're being very mindful of what we can do to be able to drive growth. And then what it also means from an operating margin standpoint. And we're delivering that sequential improvement from 1Q to 2Q in operating margin and then talk to the total year of being up on a year-over-year basis.
Operator: Our next question comes from Erin Wright with Morgan Stanley.
Erin Wilson Wright: Great. I'll ask me 2 upfront here, but follow up on the guidance, and I don't want to belabor this too much, but do you think you have better visibility now just on the underlying demand trends globally? Or would you say that there's still an element or a healthy element of macro uncertainty that's still embedded in your guidance and some conservatism there?
And then second would be on Lumina and the launch. And just can you talk about where you're seeing the most success with the launch in the target markets and promotions that where you're focused in terms of expanding share and upgrades as well?
John Morici: Erin, this is John. I'll talk a little bit about visibility and guidance. I think what we -- what we enjoy now and what we want to be able to have in an operating environment is more stability, and that stability is there. Markets are open. There's a higher overall higher inflation and interest rates, but people are operating in that environment.
That stability transcends it to other things that we have. We see the Michigan index or other indices that kind of point to that stability. Based on that stability, the investments that we're making, how we're going to market, some of the new products that we have, other things that we know that could, on a core basis, drive our business as well as the new products and initiatives that we have, that's what gives us confidence to be able to have a guidance that we gave for Q2 and what it means for the total year.
Joseph Hogan: And Erin, on the Lumina piece, it's Joe, obviously, is -- as I mentioned in the closing of my script, we're really excited about that technology. We've been working on it for 6 years. It is a true new platform. It's not a derivative of the old confocal imaging platform. And there's really no other scanner in the world that's like that and how we've built it.
So -- and it will take a while for the, I think, the market to absorb that as you have to do this doctor by doctor and place by place. But we've had a very enthusiastic response from the orthodontic community, but also the general dentistry community too, even though we're not completely ready for the restorative piece, and we mentioned it will be the fourth quarter this year we'll have that capability out. It's just the speed of that one, the simplicity of being able to scan, the dimensional tolerances and all that's used in the sense of both comprehensive and orthodontic cases are really unmatched.
So we're excited about that, but we just have to take this thing. We've only had it out now for roughly a couple of months, but we are expecting to have a really strong year, but more importantly, to have that really be the set of standard from a scanner standpoint for the industry going forward.
Operator: [Operator Instructions] Our next question comes from Michael Ryskin with Bank of America.
Michael Ryskin: Congrats on the quarter. I want to follow up on something, I think, Joe, you touched on in the prepared remarks. If I caught it correctly, you kind of pointed to a little bit of strength in U.S. ortho or Americas ortho in the quarter stood out for us.
It seems like it's one of the stronger results in a number of quarters. Just wondering if you could expand on that a little bit. Is it the Lumina launch? Is the fact that you're moving into younger teens and younger kids, which obviously is going to be a little bit more ortho-focused? Just any structural change you're seeing there with that group of dentists? Or am I just reading too much?
Joseph Hogan: Michael, I understand your question. I'd say it's -- we feel it's -- we've seen more stability in that market this year than we have last year. We've always known that the teen segment of that much more solid than the adult segment, but the adult segment held up for us in the quarter 2. And so that aspect of the adults was good for us also.
But I'm very cautious about projecting this market going forward because as you can see with a lot of the surveys that are done, this moves pretty dramatically from month to month. But again, it's not just the United States market we're focused on, the global market has been good for us too in that sense.
So we're going to take this thing a month at a time, but we're confident enough to say this is stable, that we have products in here that are very helpful from an orthodontic standpoint in new, like you mentioned, Lumina and also IPE that gives us more ground to stand on the sense of those orthos. And so we're excited about that. But in no way do I think there's a phase change between what we saw last year and this year in ortho. It's just more stable and we have more continuity is another word that I'd use to describe it.
Michael Ryskin: Okay. And if I could squeeze in a follow-up if there's time. Again, also impressed by the DSP touch-up progress. You called it out in the deck. You got some additional launches later this year. You got the 14-stage touch-up aligner offering you're talking about. Any way you can start framing in terms of would you incorporate that into guidance at some point in terms of where you think that can go in terms of volumes and revenues or any update longer term, how you see DSP and touch up evolving over time?
John Morici: Yes, Mike, I'll take that one. Look, DSP is very popular because it really serves the needs that doctors have. They want to be able to buy things kind of the way they want to buy. They want to be able to instead of making things or doing things themselves, they can use our aligners as part of that DSP and be able to treat those touch-up cases.
And we like that, that's incremental for us in terms of what we see there. And they can also then use a lot of the aligners that they have for retention. And that's great too because that's typically incremental volume that we have. So I think when we see us rolling this out, like we said a few years ago, it was U.S. and North America and now into Europe, it continues to do what we expect it to do.
Doctors start. They adopt it more and more because part of their workflow and we see positive volume from that. And in success for projects -- programs like that, we'll continue to expand those out.
Shirley Stacy: Operator, we can take one more question.
Operator: And our last question comes from Kevin Caliendo with UBS.
Kevin Caliendo: I have 2 questions. So the first one is on Heartland. Can you talk a little bit about the benefits of the Heartland investment operationally? And also Heartland is -- my understanding is a pretty profitable business and now with 2 separate investments there, how does their profits or how does the accounting work for that from your perspective at this point? .
And then secondly, if you can provide -- I guess, with regards to the guidance, I think we understand it. But was that in any way based on the trends that you've seen so far in April? Or if you can elaborate on those in any way, that would be great.
John Morici: I can start with the guidance part of that, Kevin. Look, we use a lot of factors to look at where our guidance is. So we're using data from Q1 and the most recent information. But it goes back to the stability that we've seen. You can see it in a lot of the surveys and other things that a lot of people do, but what we see is that stability, coupled with what we're trying to do to go to market to drive the initiatives we have and the new products that we have. So that's a key part of what we factor in into our guidance. No change from what we normally do. This is how we've come together in terms of a guidance standpoint.
In terms of Heartland, we look at Heartland as this is a great investment from investing in a company that shares a digital orthodontic mindset that we have, to be able to do things in a similar mindset, to be able to expand like they're expanding, to be able to get into markets that in some cases, we don't have much market share with or a big presence there. And they share that same mindset, that expansion.
They've been around for a lot of years as well. With this investment, it's less than 5%. There's no consolidation or anything else that's required. And we'll evaluate going forward on whether there's any mark-to-market that we have to do going forward. But it's a continuation of that investment the expansion that they're doing, and we're pleased with the results that we've seen over the last year.
Shirley Stacy: That actually concludes -- sorry, go ahead, operator.
Operator: And we have reached the end of our question-and-answer session. I will now turn the call back over to Shirley Stacy for closing remarks.
Shirley Stacy: Thank you so much, and thank you, everyone, for joining us today. We look forward to speaking to you at upcoming financial conferences and industry meetings, including the American Association of Orthodontics meeting in New Orleans, May 4 and 5. If you have any questions, please give us a call. Thank you.
Operator: Thank you. This concludes today's conference, and you may disconnect your lines at this time. Thank you for your participation. | [
{
"speaker": "Operator",
"text": "Greetings. Welcome to the Align First Quarter 2024 Earnings Call. [Operator Instructions] Please note, this conference is being recorded."
},
{
"speaker": "Shirley Stacy",
"text": "Good afternoon, and thank you for joining us."
},
{
"speaker": "Joseph Hogan",
"text": "Thanks, Shirley. Good afternoon, and thanks for joining us on our call today."
},
{
"speaker": "John Morici",
"text": "Thanks, Joe."
},
{
"speaker": "Joseph Hogan",
"text": "Thanks, John."
},
{
"speaker": "Operator",
"text": "[Operator Instructions] Our first question comes from Elizabeth Anderson with Evercore ISI."
},
{
"speaker": "Elizabeth Anderson",
"text": "I was wondering if you could talk about how you're seeing the overall demand environment? I guess, I'm particularly curious about the U.S. sort of how you're seeing it from like a consumer demand perspective, especially and any comments you could make on the SmileDirect impact on volumes in the quarter? And then secondarily, if you could comment a little bit more on the broader demand environment in China, that would be super helpful."
},
{
"speaker": "Joseph Hogan",
"text": "Elizabeth, I'll start off and have John jump in on anything. First of all, we describe the business right now as stable. The same things that we talked about as we came out of the fourth quarter, and we see that stability broadly around the globe. And you saw in our script that we just read to, that it's good from an adult standpoint and also a teen standpoint, too, which, again, led to that kind of stability that we talk about."
},
{
"speaker": "John Morici",
"text": "No, I agree. And that's -- we're driving the growth strategies. As we've said, we've seen that stability in the environment and we're executing against that."
},
{
"speaker": "Joseph Hogan",
"text": "And Elizabeth, last thing on your SmileDirectClub comment, them not being advertising like they were before or whatever, we can't attribute any part of the demand equation up or down as part of that. And obviously, that was more pronounced in the United States than it was anywhere else in the world, but I can't attribute any change in the marketplace because of them not advertising at this point in time."
},
{
"speaker": "Operator",
"text": "Our next question comes from Brandon Vazquez with William Blair."
},
{
"speaker": "Brandon Vazquez",
"text": "I wanted to focus for a second on the -- on the teen side, you have the Palatal Expander out there now getting great reviews, and it seems like it closes, if I'm understanding the numbers correctly, maybe 20% of that market that you haven't been able to hit before. This is such a big opportunity. I'm curious if you can just reflect on like how does commercialization within teens look in the next couple of years now that you have kind of a broader and more fuller portfolio here compared to the prior couple of years? And what does that mean for growth rates within that teen section and adoption within teen that's underpenetrated relative to teens as we look forward the next couple of years?"
},
{
"speaker": "Joseph Hogan",
"text": "That's a good question, Ben. I think we -- as we mentioned, it's 20%. And there's -- we don't -- we call them tweens, really. They're young students before they really hit the teen years and have a mature dentition. With Invisalign First and now with IPE, we can handle the 20% that's out there on the Phase I. And some teens just need -- tweens just need dental expansion and some of you really have to split the suture and widen the pallet overall. We feel in both those cases, with IPE and Invisalign First, these are very unique products specific to that area. And we think it will actually make doctors that aren't comfortable with the Phase I, may be even more comfortable now because of the impact on patients is not what it was before when you tried to work these kinds of cases with wires and brackets or higher risk expanders and those kinds of things."
},
{
"speaker": "Operator",
"text": "Next question comes from Jon Block with Stifel."
},
{
"speaker": "Jonathan Block",
"text": "Hoping to ask 2, maybe just the first one, throughout the quarter, there was sort of like an obsession or a big focus from investors on month-to-month trends. There was talk about February strength, March weakness. I don't think if anyone really knew if it was the consumer or the calendar or both. So maybe you guys can talk a little bit about how it played out for you guys, elaborate on February and March? And as much as you can, just touch on April here for the first 2 to 3 weeks. And then I'll ask my follow-up."
},
{
"speaker": "John Morici",
"text": "Yes, Jon, this is John. Look, from -- as we talk about the quarter and think about -- we're very pleased with our results in Q1, we saw stability, as Joe mentioned, and that really continued from the end of the year into the quarter, less about month-to-month. I mean it was the stability and then the execution that we had throughout the quarter with our products."
},
{
"speaker": "Jonathan Block",
"text": "Okay. And then I'll just shift gears. John, I might stick with you. I believe the wording is slightly above the 2023 OM, which I think is 21.4% unchanged. Despite the higher revenues, the midpoint going from roughly 5% to 7%. So can you talk about where that extra spend is going? Do we see the returns on that this year? Or will that aid and give you some more tailwinds into 2025?"
},
{
"speaker": "John Morici",
"text": "I think that latter point is how I would look at it, Jon. We're making investments. We make investments throughout the year. We get the shorter longer-term investments that we make different returns on whether they're short or long term. But what we see is a stable environment, continued investments in go-to-market activities, we have new products coming. So that helps us accelerate with things that we'll have on the iTero side, as well as IPE and others that Joe talked about, where we really get the approval later in the year. So it's about a stable environment, making investments into that environment and then executing on our growth strategies, and that should give us the benefits that you described in the second half."
},
{
"speaker": "Operator",
"text": "Our next question comes from Jeff Johnson with Baird."
},
{
"speaker": "Jeffrey Johnson",
"text": "John, maybe following up on Jon's question there and just a little finer point on the guidance itself. You've taken that guidance from mid-single digits to 6 to 8 scanner and CAD/CAM services came in obviously strongly in the double digits, upper teens. Should we think about kind of that double digits, maybe not in the upper teens, but double digits is kind of where the scanner and services continues this year? And your Clear Aligner revenue guidance kind of still in the mid-single digits. I think last quarter, we were talking about both those segments being mid-single-digit growers. It seems like to me now, maybe the raise here is being driven more by the scanner and CAD/CAM services. And as Joe calls the market stable, then maybe the Clear Aligner revenue still kind of expected to be in that mid-ish single digits. Is that a fair kind of way to look at guidance?"
},
{
"speaker": "John Morici",
"text": "That's a fair way to look at it, Jeff. I mean, you would see, given the new products that we have with Lumina and iTero, we'll see a little bit faster growth. We're very pleased with what we saw in the first quarter. Typically in the first quarter, you don't have a sequential gain in revenue from the fourth quarter being an equipment business. So we're very pleased with what we saw there. But then we also look at the Clear Aligner business, and we expect to be able to grow and continue to grow there, both in terms of the investments that we're making in a relatively stable environment and some of the new products that should help supplement that growth."
},
{
"speaker": "Jeffrey Johnson",
"text": "Yes, that's helpful. And then one other follow-up. I think it's been asked in the past maybe at an Analyst Day or something. I don't remember if you've given a clear answer. But it's something I keep getting asked here more recently, and that's a percentage of your patient base of maybe orthodontic cases that get financed through some sort of third-party patient financing company. We have seen in areas like full arch implants, some of the aesthetic procedures outside of dental, where lending standards have gone up, FICO scores have gone from the 500 to 700, something like that to qualify for patient financing in this cost of capital and tougher capital environment. So what percentage -- do you know a percentage or round about of what cases get financed? And if those lending standards have changed at all and put an incremental pressure on patients here more recently?"
},
{
"speaker": "John Morici",
"text": "Yes. What we see, Jeff, is it varies country by control say U.S. is maybe the most -- and I'll combine ortho and GP together, roughly 1/3 of the cases that we see get some type of external financing. Remember, many patients or parents will pay in advance. That's great for doctors. Many doctors, especially orthos will do some type of kind of internal financing where you kind of pay as you go and so on. And many doctors are continuing to do that, especially in the tougher environment. And we're doing things to help doctors to try to give them a little bit more extension in payments so that they can provide and pass that on to their patients as well. And we'll work with DSO partners to really try to help them work with these external companies to try to give better financing rates to try to get these patients to go into treatment."
},
{
"speaker": "Jeffrey Johnson",
"text": "John, any change to note over just the past few months even in those lending standards getting tougher? Or do you feel like that's stable as well as just kind of the overall environment as you've described that way?"
},
{
"speaker": "John Morici",
"text": "I look at that as more stable. I think there was a lot of things. If you go back to last year, people are really getting a bit of sticker shock in terms of the higher interest rates, when they came to try to go into treatment. I think people are past that."
},
{
"speaker": "Operator",
"text": "Our next question comes from Michael Cherny with Leerink Partners."
},
{
"speaker": "Michael Cherny",
"text": "Can you hear me okay?"
},
{
"speaker": "Shirley Stacy",
"text": "Yes, we can hear you fine."
},
{
"speaker": "Michael Cherny",
"text": "Okay. So just relative to the spend, I want to dive in a little bit more, if possible. You talked about the investment growth. Can you delineate relative to that investment, how you're thinking about the growth into, call it, your core markets or some of the new product launches? And especially with regards to the ramp on the printing side, how much incremental printing spend, so to speak, is coming now versus where you think it's going to grow, what the run rate should be on ramping that over time?"
},
{
"speaker": "John Morici",
"text": "Yes. I think we have a core business that we're running. And obviously, there's a certain amount of investment that you have to be able to grow around sales, sales and marketing and the go-to-market activities that we have."
},
{
"speaker": "Operator",
"text": "Our next question comes from Jason Bednar with Piper Sandler."
},
{
"speaker": "Jason Bednar",
"text": "First I want to build on some of the macro questions that have been asked. I don't want to belabor the point, but other consumer discretionary companies called out a downtick in March. It doesn't sound like you saw any of that, but just wanted to confirm that's the case with respect to Invisalign demand. And maybe speak to your confidence to drive Clear Aligner volumes going forward, now that comps turn a little bit tougher. How much do you think you might need to fund that growth with investments to drive more traffic into the office?"
},
{
"speaker": "Joseph Hogan",
"text": "Jason, on the first part is, we talk about the stable environment that we've seen that stability of it. We read and I read, what's going on there with the consumer investment, some concerns, particularly in the luxury goods or what's going on out there."
},
{
"speaker": "John Morici",
"text": "And in terms of investments, we make the investments that we need go to market and manufacture and other expansion as we continue to grow. We'll continue those investments. But as we've talked about, not only for the -- now the second quarter when we're talking about that sequential improvement in op margin and what we've talked about in total year where we expect the year-over-year improvement in margin. We're making sure that we're investing with that right amount of profitability. To still be able to grow into our market and expand the opportunity -- expand on the opportunities that we have, but then being respectful in terms of what margin we need to be able to deliver for the company."
},
{
"speaker": "Jason Bednar",
"text": "All right. Very helpful, Joe and John. And maybe one follow-up here to maybe a multi-partner on teen. So bear with me. But this might be a nuanced look. It seems like a lot of emphasis here just recently in product development and marketing that's really trying to tap into that much younger market, that Phase I opportunity. IPE fits in there, your new marketing branding plans and emphasis there. There seems to be some benefits for younger patients with Lumina. So it's really -- it seems intentional, but wondering if you could bifurcate for us, how your Invisalign business is performing in this younger patient population relative to the teen as a whole? Where does your penetration sit in those younger patients versus the broader teen channel? And maybe what kind of outsized growth you're expecting from this part of the channel as we look out over the near to intermediate term?"
},
{
"speaker": "Joseph Hogan",
"text": "Jason, just I'll back up on your question, just to give you a kind of a conceptual view. When you think of Phase I, it's actually been controversial in the orthodontic market for years, some orthodontists don't want to do Phase I because as I mentioned before, the kind of devices that have been used, have been kind of difficult from a consumer standpoint. And so those wait for all permanent dentition and move on to there."
},
{
"speaker": "Jason Bednar",
"text": "Any sense penetration-wise or maybe where you're at relative to the broader teen market?"
},
{
"speaker": "Joseph Hogan",
"text": "I'd say we're just in that story. I mean even Invisalign First is used sometimes on more permanent dentition too. So it's hard -- we'd have to split our cases out of Invisalign First is what the age of patients are or whatever. But as we get more data and we really get through with IPE and some more specificity around this, we'll share it with you and the rest of the...."
},
{
"speaker": "Shirley Stacy",
"text": "The only thing that -- I mean if you've tracked us for a while, you know that our average age of teen patients gets younger and younger, I think we're 14 now versus 15 plus before. So I mean that's a reflection of just being able to go after those younger patients with First."
},
{
"speaker": "Operator",
"text": "Our next question comes from Nathan Rich with Goldman Sachs."
},
{
"speaker": "Nathan Rich",
"text": "Great. I wanted to go back to the guidance. I know it's kind of been touched on a few different times. But I wanted to ask on the Clear Aligner revenue outlook. It looks like you're raising the outlook for the full year by about 1%. I guess could you maybe just touch on what changed specifically with respect to that outlook? It sounds like maybe it's expectations around IPE and DSP versus market improvement. But I'd be curious, any color you could share there? And maybe anything on teen versus adult within the updated guidance would be great."
},
{
"speaker": "John Morici",
"text": "Yes, I'll start, Nate. So overall, we went from -- we had talked about mid-single digits, so call it 5% to raising it to the midpoint of 7% on a year-over-year, so up 2 points. And really, that's a reflection of a few things. One is the continued stability that we're seeing. We're operating in an environment that's more stable. We saw that coming into the fourth quarter and now into this quarter as well. So that's good if we want that stability there."
},
{
"speaker": "Nathan Rich",
"text": "Okay. That's helpful. And then, John, maybe just sticking with you. The 2Q operating margin, I know up slightly sequentially, but down year-over-year. And I think historically, it's been a little bit variable, but you've seen more of a step-up in the second quarter than I think what the guidance implies. Anything to call out with respect to FX? Or I think you mentioned some manufacturing cost spend, but just anything there that we should keep in mind as it regards the margin cadence?"
},
{
"speaker": "John Morici",
"text": "Well, and certainly, we are seeing a stronger dollar. So that's something that we talked about when we think about our guide too, we see a stronger dollar coming out of -- out of the first quarter into the second quarter. Our guide reflects that as well."
},
{
"speaker": "Operator",
"text": "Our next question comes from Erin Wright with Morgan Stanley."
},
{
"speaker": "Erin Wilson Wright",
"text": "Great. I'll ask me 2 upfront here, but follow up on the guidance, and I don't want to belabor this too much, but do you think you have better visibility now just on the underlying demand trends globally? Or would you say that there's still an element or a healthy element of macro uncertainty that's still embedded in your guidance and some conservatism there?"
},
{
"speaker": "John Morici",
"text": "Erin, this is John. I'll talk a little bit about visibility and guidance. I think what we -- what we enjoy now and what we want to be able to have in an operating environment is more stability, and that stability is there. Markets are open. There's a higher overall higher inflation and interest rates, but people are operating in that environment."
},
{
"speaker": "Joseph Hogan",
"text": "And Erin, on the Lumina piece, it's Joe, obviously, is -- as I mentioned in the closing of my script, we're really excited about that technology. We've been working on it for 6 years. It is a true new platform. It's not a derivative of the old confocal imaging platform. And there's really no other scanner in the world that's like that and how we've built it."
},
{
"speaker": "Operator",
"text": "[Operator Instructions] Our next question comes from Michael Ryskin with Bank of America."
},
{
"speaker": "Michael Ryskin",
"text": "Congrats on the quarter. I want to follow up on something, I think, Joe, you touched on in the prepared remarks. If I caught it correctly, you kind of pointed to a little bit of strength in U.S. ortho or Americas ortho in the quarter stood out for us."
},
{
"speaker": "Joseph Hogan",
"text": "Michael, I understand your question. I'd say it's -- we feel it's -- we've seen more stability in that market this year than we have last year. We've always known that the teen segment of that much more solid than the adult segment, but the adult segment held up for us in the quarter 2. And so that aspect of the adults was good for us also."
},
{
"speaker": "Michael Ryskin",
"text": "Okay. And if I could squeeze in a follow-up if there's time. Again, also impressed by the DSP touch-up progress. You called it out in the deck. You got some additional launches later this year. You got the 14-stage touch-up aligner offering you're talking about. Any way you can start framing in terms of would you incorporate that into guidance at some point in terms of where you think that can go in terms of volumes and revenues or any update longer term, how you see DSP and touch up evolving over time?"
},
{
"speaker": "John Morici",
"text": "Yes, Mike, I'll take that one. Look, DSP is very popular because it really serves the needs that doctors have. They want to be able to buy things kind of the way they want to buy. They want to be able to instead of making things or doing things themselves, they can use our aligners as part of that DSP and be able to treat those touch-up cases."
},
{
"speaker": "Shirley Stacy",
"text": "Operator, we can take one more question."
},
{
"speaker": "Operator",
"text": "And our last question comes from Kevin Caliendo with UBS."
},
{
"speaker": "Kevin Caliendo",
"text": "I have 2 questions. So the first one is on Heartland. Can you talk a little bit about the benefits of the Heartland investment operationally? And also Heartland is -- my understanding is a pretty profitable business and now with 2 separate investments there, how does their profits or how does the accounting work for that from your perspective at this point? ."
},
{
"speaker": "John Morici",
"text": "I can start with the guidance part of that, Kevin. Look, we use a lot of factors to look at where our guidance is. So we're using data from Q1 and the most recent information. But it goes back to the stability that we've seen. You can see it in a lot of the surveys and other things that a lot of people do, but what we see is that stability, coupled with what we're trying to do to go to market to drive the initiatives we have and the new products that we have. So that's a key part of what we factor in into our guidance. No change from what we normally do. This is how we've come together in terms of a guidance standpoint."
},
{
"speaker": "Shirley Stacy",
"text": "That actually concludes -- sorry, go ahead, operator."
},
{
"speaker": "Operator",
"text": "And we have reached the end of our question-and-answer session. I will now turn the call back over to Shirley Stacy for closing remarks."
},
{
"speaker": "Shirley Stacy",
"text": "Thank you so much, and thank you, everyone, for joining us today. We look forward to speaking to you at upcoming financial conferences and industry meetings, including the American Association of Orthodontics meeting in New Orleans, May 4 and 5. If you have any questions, please give us a call. Thank you."
},
{
"speaker": "Operator",
"text": "Thank you. This concludes today's conference, and you may disconnect your lines at this time. Thank you for your participation."
}
] | Align Technology, Inc. | 24,568 |
ALGN | 1 | 2,025 | 2025-04-30 16:30:00 | Operator: Good day, and thank you for standing by. Welcome to the Align Technology First Quarter 2025 Earnings Call. [Operator Instructions] Please be advised that today's conference is being recorded. I would now like to hand the conference over to your speaker today, Shirley Stacy, Vice President of Corporate Communications and Investor Relations. Please go ahead.
Shirley Stacy: Good afternoon, and thank you for joining us. Joining me on today's call is Joe Hogan, President and CEO; and John Morici, CFO. We issued first quarter 2025 financial results today via Business Wire, which is available on our website at investor.aligntech.com. Today's conference call is being audio webcast and will be archived on our website for approximately 1 month. As a reminder, the information provided and discussed today will include forward-looking statements, including statements about Align's future events and product outlook. These forward-looking statements are only predictions and involve risks and uncertainties that are described in more detail in our most recent periodic reports filed with the Securities and Exchange Commission available on our website and at sec.gov. Actual results may vary significantly, and Align expressly assumes no obligation to update any forward-looking statement. We provided historical financial statements with corresponding reconciliations, including our GAAP to non-GAAP reconciliation, if applicable, and our first quarter 2025 conference call slides on our website under Quarterly Results. Please refer to these files for more detailed information. With that, I'd like to turn the call over to Align Technology's President and CEO, Joe Hogan. Joe?
Joseph Hogan: Thanks, Shirley. Good afternoon, and thanks for joining us today. On our call, I'll provide an overview of our first quarter results and discuss a few highlights from our 2 operating segments: Systems and Services and Clear Aligners. John will provide more detail on our financial performance and comment on our views for Q2 and full year 2025. Following that, I'll come back and summarize a few key points and open the call to questions. I'm pleased to report first quarter revenues, operating margin and earnings in line with our outlook. Fiscal 2025 is off to a good start with Q1 Clear Aligner volumes, up both sequentially and year-over-year, reflecting strength in both the teens and adult patient segments across all regions, driven year-over-year strength across the Asia Pacific and EMEA regions and growth in North America. It's also worth noting that Q1 was the highest year-over-year growth rate for both adult and teen patients since 2021. From a channel perspective, Q1 Clear Aligner volumes in the orthodontic and GP dentist channels increased year-over-year with a record number of total submitters and utilization for GP dentists for the first quarter. For our Systems and Services business, Q1 revenues were down sequentially, reflecting Q1 seasonality as well as unfavorable foreign exchange. On a year-over-year basis, Q1 Systems and Services revenues were up slightly, reflecting continued adoption of iTero Lumina scanner platform, as well as the launch of iTero Lumina with restorative software at the end of month. On a year-over-year basis, Q1 Clear Aligner volumes grew 6.2%, driven primarily by continued strength across EMEA and APAC regions as well as growth in North America, offset by lower volumes in Latin America region. For North America, Q1 year-over-year increase in Clear Aligner volumes reflects continued adoption of Invisalign First for teens and kids, Invisalign DSP touch-up cases and Invisalign Comprehensive Three and Three. On a sequential basis, Q1 North America Clear Aligner volumes primarily reflect growth from Invisalign DSP touch-up cases, Invisalign Palate Expander system, as well as Invisalign Comprehensive Three and Three. For the EMEA region, Q1 year-over-year Clear Aligner volume growth primarily reflects strength across the region in both the ortho and GP channels across teens, kids and adult patients. On a year-over-year basis, Q1 EMEA volumes reflect continued adoption of Invisalign noncomprehensive cases, primarily driven by Invisalign Moderate, Invisalign DSP touch-up cases, as well as the initial launch of the Invisalign Palate Expander across EMEA region in Q1. On a sequential basis, Q1 EMEA growth was driven primarily by Invisalign DSP touch-up cases. For the APAC region, Q1 year-over-year Clear Aligner volume growth reflects increased utilization and submitters in both ortho and GP channels across teen, kid and adult patients in nearly all country markets. On a sequential basis, Q1 growth reflects strength from China and many of our emerging markets, led by India and Korea. From a product perspective in Invisalign First, Invisalign Standard and Adult products drove Q1 growth in APAC, both on a year-over-year and sequential basis. For Q1, we had over 85,000 doctors submitters worldwide for a record total for first quarter, primarily reflecting a sequential increase in Clear Aligner volume for teens, kids and adults in both noncomprehensive and comprehensive cases. In the teen and growing kids segment, approximately 226,000 teens and kids started treatment with Invisalign Clear Aligners during the first quarter, an increase of 4.5% sequentially and an increase of 13.3% year-over-year, reflecting growth across regions, especially from Invisalign First in the APAC and EMEA regions in North America, as well as growth from the Invisalign Palate Expander system in North America. For Q1, the number of doctors submitting case starts for teens and kids was up 2.1% year-over-year, led by continued strength from doctors treating young kids and growing patients. During the quarter, we continued to commercialize the Invisalign Palate Expander system with continued momentum for doctor submitters and shipments. In Q1, we announced that Align's Invisalign Palate Expander system was commercially available in Turkey, and today, we received confirmation of regulatory clearance in China. Along with Turkey and China, the Invisalign Palate Expander is available in the U.S., Canada, Brazil, Australia, New Zealand, Hong Kong, Japan, Singapore, Thailand, EU, U.K., UAE and Switzerland, and is expected to be available in additional markets following regulatory clearances. This month, we announced the commercial availability of the Invisalign system with Mandibular Advancement featuring Occlusal Blocks designed specifically to address Class II skeletal and dental correction by simultaneously advancing the mandible while aligning the teeth. Class II malocclusion is one of the most common orthodontic issues, characterized by a discrepancy and jaw alignment, where the lower jaw is positioned too far back relative to the upper jaw. It represents approximately 30% to 45% of malocclusions globally. Left untreated, this condition can lead to functional, aesthetic and other challenges for patients. The Invisalign system with Mandibular Advancement featuring Occlusal Blocks is a direct response to the needs of orthodontic practices and underscores Align's ongoing commitment to innovation in orthodontics that enhances clinical outcomes and the patient experience. By integrating occlusal blocks into the Mandibular Advancement feature, we are providing doctors with a powerful new tool that they have asked for to effectively treat growing patients with Class II malocclusions while maintaining the aesthetic and comfort benefits of Clear Aligner therapy. The Invisalign system with Mandibular Advancement featuring Occlusal Blocks is available to Invisalign trained doctors in the United States, Canada, Australia and New Zealand. It was just launched in most EMEA countries this week, and we expect to be introduced in additional markets through 2025 pending regulatory clearance. Along with the Invisalign Palate Expander system and Invisalign First, the latest innovation supports the commitment to establishing a unique and differentiated portfolio that supports growing patients throughout their continuum of care. Dental service organizations, or DSOs, continue to present 1 of the fastest-growing channels in digital dentistry as they recognize the practice and patient experience benefits of digital workflows, enabled by our portfolio of products and services that make up the Align digital platform. This includes increased practice efficiency and profitability, as well as delivering a shorter treatment appointment cycle times for their patients. In short, DSOs are a force multiplier for practice growth in Invisalign adoption. For Q1, Clear Aligner volume from DSO customers worldwide increased sequentially and year-over-year, reflecting growth across all regions. Q1 iTero scanner sales growth was also strong with DSOs as they continue to investing in their member practices and end-to-end digital workflows. The DSO business growth continues to outpace that of our retail doctors, driven primarily by some of the largest DSOs in each region. Turning to Systems and Services. For Q1, year-over-year revenue growth primarily reflects scanner and wand revenue driven by iTero Lumina, wand upgrades, partially offset by lower scanner revenues and the impact of unfavorable foreign exchange. For Q1, we delivered more scanner systems and wands in a quarter than ever before. On a sequential basis, Q1 Systems and Services revenues were down, reflecting capital equipment seasonality, partially offset by higher iTero Lumina scanner wand upgrades. In Q1, we launched new restorative capabilities and our next-generation iTero Lumina intraoral scanner and a new iTero Lumina Pro dental imaging system with iTero NIRI technology to enable efficient restorative and multidisciplinary workflows and support the diagnosis of interproximal carries above the gingiva. The new storage capabilities of iTero Lumina improves GP dentists' ability to diagnose and develop treatment plans that deliver exceptional clinical outcomes while concurrently helping GPs collaborate more effectively with their restorative lab, deliver incredible precise, custom-fitting restorations and reach new levels of practice efficiency and growth. The iTero Lumina intraoral scanner with iTero Multi-Direct Capture or MDC technology sets a new standard with effortless scanning and superior visualizations, and feedback from doctors, labs and other stakeholders regarding our Lumina portfolio has been positive. It's intuitive design and ease of scanning is appealing, is making everyday scanning more viable, especially when compared to other scanners. Like any breakthrough technology, it's important to ensure that doctors and their staffs are properly trained on scanning. Even the most experienced iTero users may indeed to unlearn previous scanning techniques. We are working closely with our teams to offer follow-up training for our customers and their staff. The iTero Lumina intraoral scanner delivers faster scanning speed, higher accuracy, superior visualization, and a more comfortable scanning experience. The iTero Lumina solutions include superior 3D and 2D visualizations that augment and amplify oral health assessment and patient communication using the Align Oral Health suite designed to increase patient engagement with greater visual understanding of their oral health conditions. Following regulatory clearances in applicable countries starting earlier this month, existing iTero Lumina scanner owners began upgrading to the new software, which includes restorative and diagnostic capabilities. We're excited about the continued technology evolution we deliver with iTero Lumina system and the depth of tools and features that it offers for imaging, diagnostics, treatment planning, visualization restorations and so much more. iTero has always been much more than a PBS replacement, and with iTero Lumina has truly become the gateway to digital treatment for orthodontics and any type of GP practice from family dentistry to high-end aesthetic practices. With that, I'll now turn the call over to John.
John Morici: Thanks, Joe. Now for our Q1 financial results. Total revenues for the first quarter were $979.3 million, down 1.6% from the prior quarter and down 1.8% from the corresponding quarter a year ago. On a constant currency basis, Q1 revenues were unfavorably impacted by approximately $21.4 million or approximately 2.1% sequentially and were unfavorably impacted by approximately $31.1 million year-over-year or approximately 3.1%. For Clear Aligners, Q1 revenues of $796.8 million were up 0.3% sequentially, primarily from higher volumes, partially offset by the impact of unfavorable foreign exchange. Unfavorable foreign exchange impacted Q1 Clear Aligner revenues by approximately $17.9 million or approximately 2.2% sequentially. Q1 Clear Aligner average per case shipment price of $1,240 decreased by $25 on a sequential basis, primarily due to the impact of unfavorable foreign exchange. On a year-over-year basis, Q1 Clear Aligner revenues were down 2.5%, primarily due to unfavorable foreign exchange of $25.8 million or approximately 3.1% and lower ASPs due to product mix shift to lower-priced products and discounts, partially offset by higher volumes. Q1 Clear Aligner average per case shipment price of $1,240 was down $110 on a year-over-year basis, primarily due to higher discounts, product mix shift to lower-priced products and the impact from unfavorable foreign exchange, partially offset by price increases. Clear Aligner deferred revenues on the balance sheet as of March 31, 2025 decreased $9.3 million or 0.8% sequentially and decreased $74.7 million or 5.8% year-over-year and will be recognized as additional aligners are shipped under the -- each sales contract. Q1 Systems and Services revenue of $182.4 million were down 9.2% sequentially, primarily due to lower scanner systems revenue -- revenues and unfavorable foreign exchange. This was partially offset by increased scanner wand revenues, mostly due to iTero Lumina wand upgrades. Q1 Systems and Services revenue were up 1.2% year-over-year, primarily due to higher iTero Lumina scanner wand revenues, partially offset by lower scanner systems revenues and unfavorable foreign exchange. Foreign exchange negatively impacted Q1 Systems and Services revenues by approximately $3.5 million or approximately 1.9% sequentially. On a year-over-year basis, System and Services revenues were unfavorably impacted by foreign exchange of approximately $5.3 million or approximately 2.8%. Systems and Services deferred revenues decreased $11.3 million or 5.1% sequentially and decreased $37.2 million or 15.2% year-over-year, primarily due to decline in deferred revenues due in part to shorter duration of service contracts applicable to initial scanner system purchases. Moving on to gross margin. First quarter overall gross margin was 69.5%, down 0.6 points sequentially and down 0.5 points year-over-year. Foreign exchange negatively impacted the overall gross margin by 0.7 points sequentially and 0.9 points on a year-over-year. Clear Aligner gross margin for the first quarter was 70.5%, up 0.4 points sequentially due primarily to lower manufacturing costs and lower restructuring expenses, partially offset by unfavorable foreign exchange of 0.6 points. Clear Aligner gross margin for the first quarter was down 0.3 points year-over-year, primarily due to unfavorable foreign exchange, partially offset by lower manufacturing spend. Foreign exchange negatively impacted Clear Aligner gross margin by 0.9 points year-over-year. Systems and Services gross margin for the first quarter was 64.7%, down 4.7 points sequentially, primarily due to lower wand ASPs and unfavorable foreign exchange, partially offset by manufacturing efficiencies. Foreign exchange negatively impacted the Systems and Services gross margin by 0.7 points sequentially. Systems and Services gross margin for the first quarter was down 1.2 points year-over-year primarily due to lower scanner and wand ASPs and unfavorable foreign exchange, partially offset by manufacturing and services efficiencies. Foreign exchange negatively impacted the Systems and Services gross margin by 1.0 points year-over-year. Q1 operating expenses were $549 million, down 0.7% sequentially and up 1% year-over-year. On a sequential basis, we saw a $3.8 million decrease in operating expenses, primarily due to lower restructuring and other nonrecurring charges in Q1, which were partially offset by consumer marketing spend. Year-over-year, operating expenses increased by $5.3 million, primarily due to our continued investments in R&D activities. On a non-GAAP basis, excluding stock-based compensation, restructuring and other charges and amortization of acquired intangibles related to certain acquisitions and legal settlement loss, operating expenses were $500.7 million, up 5.5% sequentially and down 1.1% year-over-year. Our first quarter operating income of $131.1 million resulted in an operating margin of 13.4%, down 1.1 points sequentially and down 2.1 points year-over-year. Foreign exchange negatively impacted operating margin by approximately 1.1 points sequentially and 1.4 points year-over-year. On a non-GAAP basis, which excludes stock-based compensation, restructuring and other charges, amortization of intangibles related to certain acquisitions and legal settlement loss, operating margin for the first quarter was 19.1%, down 4.1 points sequentially and down 0.7 points year-over-year. Interest and other income expense, net for the first quarter, was an income of $9.3 million compared to an expense of $3.4 million in Q4 '24, driven by favorable foreign exchange movements, partially offset by lower interest income and gain on investments from last quarter. On a year-over-year basis, Q1 interest and other income and expense were favorable compared to income of $4.3 million in Q1 '24, primarily driven by favorable foreign exchange movements, partially offset by gain on investments in the first quarter of the prior year. The GAAP effective tax rate in the first quarter was 33.6% compared to 26.3% in the fourth quarter of last year and 33.7% in the first quarter of the prior year. The first quarter GAAP effective tax rate was higher than the fourth quarter effective tax rate, primarily due to the tax expense recognized related to stock-based compensation and the release of uncertain tax provision reserves in Q4 of '24, partially offset by a onetime tax deferred tax adjustment in foreign jurisdictions in Q4 of '24. The first quarter GAAP effective tax rate was roughly in line with the first quarter effective tax rate of the prior year. Our non-GAAP effective tax rate in the first quarter was 20%, which reflects our long-term projected tax rate. First quarter net income per diluted share was $1.27, down $0.13 sequentially and down $0.13 compared to the prior year. Foreign exchange negatively impacted our EPS by $0.08 on a sequential basis and $0.12 on a year-over-year basis due to foreign exchange. On a non-GAAP basis, net income per diluted share was $2.13 for the first quarter, down $0.31 sequentially and down $0.01 year-over-year. Moving on to the balance sheet. As of March 31, 2025, cash and cash equivalents were $873 million, down sequentially $170.9 million and up $7.2 million year-over-year. Of our $873 million balance, $133.1 million was held in the U.S. and $739.9 million was held by our international entities. During Q1, we repurchased the remaining $72.1 million of the $270 million -- $275 million open market repurchase initiated in Q4 of '24. In Q1, we initiated a new plan to repurchase the remaining $225 million of our common stock under the -- our January 2023 approved stock repurchase program of $1 billion through open market repurchases. As of March 31, 2025, we had repurchased $129 million. Once completed, this open market repurchase will complete our $1 billion stock repurchase program approved in January of 2023. Q1 accounts receivable balance was $1.062 billion, up sequentially. Our overall days sales outstanding was 97 days, up approximately 7 days sequentially and up approximately 11 days as compared to Q1 last year and primarily reflects flexible payment terms we have extended as part of our ongoing efforts to support Invisalign practices. Cash flow from operations for the first quarter was $52.7 million. Capital expenditures for the first quarter were $25.3 million, primarily related to investments in our manufacturing capacity and facilities. Free cash flow, defined as cash flow from operations minus capital expenditures, amounted to $27.4 million. Before I turn to our Q2 and fiscal 2025 outlook, I'd like to provide the following remarks regarding the U.K. VAT and U.S. tariffs as of April 30. As previously disclosed in our Q4 '24 earnings release and conference call, we anticipated receiving a ruling regarding the applicability of VAT to our Clear Aligner sales in the U.K. On April 24, 2025, we received a favorable ruling in which the tribunal determined that our Clear Aligners are dental prosthesis for the purposes of VAT in the U.K., which is key condition to be considered exempt from VAT. This outcome reaffirms our commitment to enhancing patient access to oral health, leveraging digital technology. HMRC has until June 19 to appeal the tribunal's ruling. HMRC may also attempt to challenge the applicability of VAT on a different basis. Moving on to tariffs. Align Technology has Clear Aligner manufacturing operations in Mexico, Poland and China. For the U.S. domestic market, we currently manufacture clear aligners in Mexico prior to shipment to the U.S. Align does not currently ship clear aligners from Poland or China to the U.S. We currently manufacture clear aligners for the Chinese market in China. Our clear aligners and intraoral scanners made in Mexico that are imported into the U.S. are compliant with the United States-Mexico-Canada agreement, USMCA. As noted in President Trump's Executive Order dated April 2, 2025, USMCA-compliant goods are exempt from tariffs under the Executive Order. However, the U.S.-Mexico tariff situation remains fluid, and we are unable to predict whether USMCA-compliant products will remain exempt, whether there will be other changes to the announced Executive Order or if other tariffs will be imposed in the future. We expect an incremental tariff, if implemented, to be applied to the transfer price on goods shipped for Mexico. With respect to our clear aligners made in China, all manufacturing for China takes place in China. We have assessed the potential impact of China's retaliatory tariffs and believe that we are able to mitigate most of the tariff exposure through adjustments in our supply chain. Based on the current situation, we do not expect a significant impact to our costs from these retaliatory tariffs. We have also assessed the potential direct impact of additional U.S. tariffs on China on our business and currently do not expect to realize a significant impact from these retaliatory tariffs. Our intraoral scanner manufacturing primarily occurs in Israel, with scanners shipped from there to worldwide locations. We produce a small number of scanners in China primarily for the market. Regarding tariffs on Israel goods imported into the U.S., at the current 10% baseline tariff, we estimate the average monthly potential impact to be approximately $1 million, which we have considered in our guidance for Q2 and fiscal 2025. Moving on to 2025 business outlook. Assuming no circumstances occur beyond our control, such as foreign exchange, macroeconomic conditions and changes to our currently known tariffs that could impact our business, we expect Q2 2025 worldwide revenues to be in the range of $1.05 billion to $1.07 billion, up sequentially from Q1 2025. We expect Q2 '25 Clear Aligner volume to be up sequentially and Q2 '25 Clear Aligner ASPs to also be up sequentially due to favorable foreign exchange at current spot rates, partially offset by the continued product mix shift to noncomprehensive Clear Aligner products with lower list prices. We expect Q2 '25 Systems and Services revenue to be up sequentially as we continue to ramp up the iTero Lumina scanner with restorative software. We expect Q2 '25 worldwide gross margin to be up sequentially, primarily from higher ASPs and Clear Aligner volume. We expect our Q2 '25 GAAP operating margin and Q2 '25 non-GAAP operating margin to be up sequentially by approximately 3 points for each GAAP and non-GAAP operating margins. For fiscal 2025, we expect -- 2025 Clear Aligner volume growth to be up approximately mid-single digits year-over-year. We expect 2025 Clear Aligner ASPs to be down year-over-year due to continued product mix shift to noncomprehensive Clear Aligner products with lower list prices and continued growth in our emerging markets where those products may carry lower list prices. We expect 2025 Systems and Services revenues -- Systems and Services year-over-year revenues to grow faster than Clear Aligner revenues. We expect 2025 year-over-year revenue growth to be in the range of 3.5% to 5.5% at current spot rates. We expect fiscal 2025 GAAP operating margin to be approximately 2 points above the 2024 GAAP operating margin. And we expect 2025 non-GAAP operating margin to be approximately 22.5%. We expect our investments in capital expenditures for fiscal 2025 to be between $100 million and $150 million. Capital expenditures primarily relate to technology upgrades as well as manufacturing capacity in support of our ongoing business. With that, I'll turn it back over to Joe for final comments. Joe?
Joseph Hogan: Thanks, John. I'm pleased with the results of our first quarter, the strength of our Clear Aligner business, including the return to stability in the United States and the response to our recent innovations such as Invisalign Palate Expander system at iTero Lumina. All of us are aware of the global economic uncertainty and the headwinds that tariffs or changes in the consumer sentiment might bring. Align is focused on what we can control. As I mentioned last quarter, that means building on the innovations introduced in 2024 that drive efficiency and growth for our customers' practices while delivering the best customer and patient experiences in the industry. First, through our digital scanning technology. While iTero has long been valued in the orthodontic and GP practices as much more than a replacement for PBS impressions, our next-generation iTero Lumina solution with comprehensive dentistry capabilities provides transformative solutions for GP dental practices to enable diagnostics, restorative and multidisciplinary ortho restorative workflows, including NIRI technology and the iTero Lumina Pro dental imaging system. With iTero Lumina, we truly have a gateway to any type of digital orthodontic and dental treatment. Second, driving practice transformation to fully digital practices must address 2 key variables: Doctor and patient efficiency. Less patient chair time and fewer patient visits increases practice profitability. We're helping customers drive efficiency and create more time and capacity in their practices with our digital treatment planning software, delivering ClinCheck in minutes for most treatment plans. The latest innovations in the ClinCheck Signature experience combines automation of each doctor's clinical preferences with AI-powered tools that deliver customized treatment plans in near real time. Based on doctors' building personalized treatment preferences or prepopulated templates, a doctor chooses our almost touchless digital workflows, ClinCheck in minutes technology, which is revolutionizing treatment planning for doctors and enabling chair side treatment planning, improving patient conversion and getting patients started in treatments within days. Next, we're building on the world's most advanced Clear Aligner system to make it even more effective and efficient for all patients with innovations such as the Invisalign system with Mandibular Advancement featuring Occlusal Blocks, that expands Align's Class II treatment portfolio for growing patients with a comprehensive solution for treating growing patients in Class II malocclusions caused by mandibular retrusion. Finally, we're delivering on the promise of 3D technology that is part of Align's DNA with direct 3D-printed orthodontic devices, demonstrating our commitment to pushing the boundaries of digital orthodontics. The first example is the Invisalign Palate Expander system, a series of removable devices that expand a patient's palate without traditional metal expanders and screws in a way that is both effective clinically and comfortable and easy to use for kids and parents. This is the first direct 3D-printed appliance Align has commercialized. With others in development, we believe direct 3D printing will give doctors new levels of precision and appliance fit and shape and deliver the best possible outcome for patients. As we celebrate 28 years of digital innovation this year, we're also proud to be grateful and highlight that we've met a significant milestone with over 20 million Invisalign patients treated globally, representing 20 million smiles, 20 million stories and 20 million lives transformed, a testament to the passion and purpose of our employees, our doctor customers and their patients. With that, I thank you for your time today. I look forward to speaking with you at our Investor Day meeting next week. Now I'll turn the call over to the operator for questions. Operator?
Operator: [Operator Instructions] Our first question will come from the line of Brandon Vazquez from William Blair.
Brandon Vazquez: Congrats on nice start of the year here. I thought maybe just to start, I was pleasantly surprised that kind of the strength in the quarter and the strength of the guide, given historically, we've relied a lot on -- and we've talked a lot about the ties of consumer sentiment and to the dental space. So again, kind of a nice surprise in this quarter. I was hoping you guys can just spend a little time talking -- we saw consumer sentiment come down, but it seems like the business is doing well. So talk a little bit about maybe why that's decoupling and what kind of confidence that gives you in the guidance on a go-forward basis, even though in April, we were seeing sentiment go down?
Joseph Hogan: Brandon, it's Joe. Thanks for the question. We saw good volume. It's great to see North America grow again. It's been a while, as I mentioned. We have good strength in APAC overall, including China. And Europe, really across the board in Europe, we saw good demand also. And obviously, the Lumina scanner coming out now with restorative capability gives us a tailwind in that sense, too. So -- and what I would love also was the teen, you saw teens grow, but you also saw adults grow also. So when I just end that comment by saying we saw breadth in the sense of the growth, whether it was product line or whether it's by country or region and also by our different segments, including iTero.
Operator: Our next question comes from the line of Vik Chopra from Wells Fargo.
Vik Chopra: Can you hear me? Thanks for taking the question, and congrats on a nice quarter. Maybe just 2 for me. I appreciate all the color you provided on the tariff front. But can you just talk about plans to potentially mitigate this by moving production to different locations or putting in some price increases? And then I had a quick follow-up.
Joseph Hogan: Vik, it's Joe. Look, obviously, we're, I think, pretty well situated right now when you look at how the tariffs would affect us. We're in China for China. And as John said, there's some material movements in all that we'll take care of it. We don't see much of an impact there, if anything. We're good with Mexico right now. We feel pretty solid on that. And our Poland plant is fully operational and working well in Europe. I guess the only issue we really have is iTero, a lot of the shipments are coming out of Israel, but we have some plans, we'll be able to address that. But as you can see in our forecast, we're planning on holding our margin that we've committed to. And so we think we'll be able to mitigate that. So overall, I feel fortunate. I think we positioned ourselves as a truly global business, meaning we have global supply lines in each 1 of those specific regions that we can maximize and work through. And so we feel good about the situation right now. But as I mentioned in my comments, too, is there's a lot of volatility out there, but we feel we're well positioned in the sense of what we've seen so far.
Vik Chopra: Got it. That's super helpful. And you're hosting a much anticipated Investor Day next week. I'm just wondering if you can just provide some insight as to what we can expect next week?
Joseph Hogan: I think what you can expect is we'll give you a good portfolio look at the company, a good demand, what we think the next few years look like in a sense of how we're positioned overall from a technology standpoint and also a commercial standpoint. It's been a while since we've been with our investors. So we're really excited to share with you. We've developed a lot since the last meeting, and we look forward to the time in New York.
Operator: [Operator Instructions] Our next question will come from the line of Jon Block from Stifel.
Jon Block: The first one, John, will have some sort of detailed questions on the 2025 revenue guidance. So I think I got it right. You raised it from low single digits to 4.5% at the midpoint. The language around ASPs didn't change. I still expect it to be down low single digits year-over-year. The Clear Aligner language didn't change. The ball is still expected to be up mid-single digits year-over-year. So maybe it's a pretty straightforward question. But like any more color on the ASPs? Are the ASP thoughts basically, call it unchanged from 3 months ago, but now we should be thinking like down 1 and the prior was down 3, that both fits the LSD narrative with that 200 basis point delta sort of specific to just updating for the spot rate? And let me know if that came across well.
John Morici: Yes. That is accurate, the way you phrased that, John.
Jon Block: Okay. That was an easy one, concise. So I'll get another one. Joe, I'd love to spend time on teen. I mean, this was always sort of like the holy grail and it went to the moon during COVID and then you had some tough comps and here you are with new products and the double-digit growth of 13%, it was a pretty good beat on teen versus where we were. The 2-year stack is mid-20s. It wasn't up against an easy comp. So the 13 off the 12. Maybe just elaborate on that? Like what are you seeing with IPE? Clearly, that's helping the balls, but are you seeing the IPE to alignment pull-through, which I think we would still be in the early stages of that? And maybe I'm getting a little bit aggressive here, but can we think about teen as this low double-digit plus grower going forward as long as the innovation continues to step up and you got MA with occlusal blocks first hitting the market?
Joseph Hogan: Yes. Jon, first of all, I like the breadth of what you saw in teen. We saw it across each geography, too. Obviously, IPE is a big part of that, but it combines well with Invisalign First. We see that. Some doctors specified immediately, some in sequence. But overall, that's just a great -- we call it kids' product. We have it in the teen segment. But those 2 products function very well together. You're right about Mandibular Advancement with the occlusal blocks. It addresses the twin block kind of a system that's been out there for years is kind of an invasive system. And we've done that before, Mandibular Advancement, but not to the extent that these strong occlusal blocks will be able to address the Class II, like I mentioned before. So I feel -- and I feel good about our distribution capability in each geography to take that kind of technology forward. There's a lot of specificity in stuff like IPE. And obviously, occlusal blocks is you need a great distribution team to be able to explain and help to integrate in doctors' offices. So I hope I have answered your question, Jon. But overall, it's not just like 1 region or 1 product. It's really good synergy in our portfolio across the different regions.
Operator: Our next question will come from the line of Jeff Johnson from Baird.
Jeff Johnson: So let me ask, I guess, Jon's ASP question, but let me kind of dig down a little bit more. If I can ask 1 question about ASPs this quarter and then 1 question about ASPs going forward. Hopefully, that's all blended, it counts as 1 question. But John, I think ASPs were down 8.2% year-over-year, not sequentially, 8.2% year-over-year this quarter. Can you just remind us how much the VAT, the price discount you had to give to normalize that VAT impact to the U.K. got, how much that contributed out of that 8.2% and how much FX contributed as a negative headwind? I think that was 200 basis points by my math, but just trying to confirm that?
John Morici: Yes. The FX is that impact that we have on a year-over-year basis. So we have unfavorable FX. I mean, on a year-over-year basis, the FX on the overall company is 3.1 points. And then remember, we started the VAT -- withholding the VAT a year ago in Q1. So on a year-over-year basis, it's already in the baseline numbers from last year.
Jeff Johnson: Okay. And then on going forward, currency should switch to a positive contributor to ASPs. You mentioned the 310, I thought that was the top line impact, but just is that the flow-through impact ASPs as well, the 310 headwind in the first quarter? But going forward, FX switches to a positive tailwind. Any -- at spot rates, can you just kind of put us in the ballpark there? I can do my math later tonight, but I would love to hear your opinion there. And then if the HMRC doesn't appeal, can you reraise those U.K. prices? Would that actually be a contributor? Or do you stick at these prices? You just don't have to pay that VAT -- the providers don't have to pay that VAT tax. I guess, does that -- could that potentially switch to an ASP tailwind? And then lastly, just MAOB, the Mandibular Advancement blocks. I think I was hearing that that's going to be $100 add-on charge. If we start mixing more and more MA cases, does that theoretically then drive a little bit of ASP tailwind the way IPE and DSP is creating a little bit of ASP headwind right now?
John Morici: Okay. Let me try to take these 3 ASP questions, Jeff, on this. So MAOB, yes, slightly higher price, that would help our overall ASP as we sell more of that premium product on our comprehensive cases, and we'd add to that for the pricing on that. Regarding the U.K., we have to hear back on whether HMRC will appeal and what they do. We have a lot of flexibility to that if we win. Either they don't appeal or win an appeal, we can always make changes to our discount and not discount as much. And if we do that, then that gives us a benefit in ASP going forward. That has not been contemplated in our forward-looking ASP. I'm just kind of taking the U.K. VAT impact completely out from a forecast. But it does give us flexibility, depending on what HMRC decides to do or if it gets -- works its way through. And then regarding overall FX, yes, it turns into now at current spot rates, a slight benefit on a year-over-year basis. And then you still have what we've talked about before, just that list price, lower list price products, which would be comprehensive as well as some of the other growth in certain countries just at a lower list price. But gross margin, as you know, is in many cases, favorable as a result of those lower-stage products because the cost to serve for us is less. But that's how the dynamics shape up for ASPs.
Operator: [Operator Instructions] Next question comes from the line of Michael Cherny from Leerink Partners.
Michael Cherny: Congrats on a really nice quarter in the guidance. I just want to make sure we have all the pieces right. I'm not going to do as much mental math as Jeff, names a little slower there. But in terms of the margin uptick that you now expect, nice margin expansion of the year, how much of it do you -- would you accrue to kind of better revenue expectations on an organic basis for operational changes? I know we've spent a lot of time talking about the ASP regarding the impact from FX there, but anything else you can allude to relative to the operating margin drop down, how much of it has been within your control versus how much is market conditions would be great.
John Morici: I think when you look at our margin expansion -- and like I said in the prepared remarks, that's still net -- so 70 basis point improvement in op margin from 2024 to 2025 with the known tariff impact that we would have now. And where we're seeing the expansion and improvements is continuing to improve our manufacturing efficiencies with volume, with material savings, logistical savings, things that we talk about from an innovation standpoint when we do touchless ClinCheck, a lot of less activity for us, as well as some of the new products that we have that are at good margins. Some of them higher ASP like we talked about with MAOB and so on. So it's really a host of initiatives that we have. It's what we continue to do in the business. And with this forecast, we're pleased to report that as we know tariffs now, we can still get to our margin targets that we have because we're seeing productivity in other areas.
Michael Cherny: Got it. Just 1 really quick last follow-up. Could you give the DSP number for the quarter? I apologize if I missed it in the slides or anywhere else.
John Morici: No, we did not give the DSP. But as we've said in our prepared remarks and what we see is this helps grow the low stage part of our portfolio. It's rolling out in other areas, and we're pleased with the performance.
Operator: Our next question will come from the line of Jason Bednar from Piper Sandler.
Jason Bednar: I wanted to first start on two financing topics. We saw higher rates, credit denials were an issue over the past year or so. You've got a new preferred financing partner in HFD. Just curious if you're seeing that help resolve any of the challenges with consumers early on in that relationship? And then on the provider side, John, I think you said that you attributed the rise in DSOs to expanding financing or better favorable terms to practices. I just want to understand what's going on there, if you could double-click, just -- to be blunt, it's a pretty big increase in DSOs for a policy you've had in place for multiple years. So just wondering what's changed just in the last few months that would materially shift that line higher?
John Morici: Yes. I think really, you highlighted kind of the components about how people pay in general. So you have some patients that just paid directly, and they paid 100% of the cases that -- the treatment that they want. So that happens in many markets, and that continues. Maybe it's less of that because of some of the pressures that they might be facing. So the other two ways that HFD patients will pay is some will utilize some of the doctor financing. So they'll kind of pay as you go through the doctor. That's where really it helps to have favorable terms with those doctors so that we can provide a little bit a longer time for them to pay. And we continue that effort so that those doctors can take a little bit more time to pay us back so that they can use their balance sheet or their working capital to help kind of that patient financing that they'll provide. And then the third way is external, and HFD is 1 of them. There's many different companies that provide this, but we're seeing a good combination of finding the right way to get to HFD, meeting the requirements that they have. Or others that are providing this and getting those potential patients into financing. So we're seeing a good combination of this, but we know that how much things cost and how much they have to pay over a monthly basis is important. And this is a good way to offset that.
Jason Bednar: Okay. All right. Understood. And then just maybe real quick on some of the tariff dynamics and not necessarily as it influences what you have to pay, but more so from a competitive standpoint, it seems like you might have some competitors that may get dislocated or may have -- may be facing higher costs as they have to import or reconfigure their supply chains. It seems like this is a good opportunity to lean in with your business. But I want to ask, are you seeing any dislocation with doctor customers? Is that happening where you're now, call it, relatively more favorable from a cost perspective than maybe what you were pre-tariffs?
Joseph Hogan: It's Joe. I'd say we haven't seen anything material in that sense it changed so far. And I can't really speak of our -- most of our competitors' supply lines. It's a lot of intricacies in the sense of manufacturing whatever. But obviously, some of them are going to be very disadvantaged. We don't know to what extent. But we just continue to operate in the marketplace, focus on what we can focus on, like I mentioned, our product capability, our digital platform, iTero Lumina and just the efficiencies that we really can gain with doctors. So we'll let the tariffs kind of take care of themselves. We'll see how that goes. But we really feel good about our position in it, and we'll continue to execute.
Operator: [Operator Instructions] Our next question will come from the line of Steve Valiquette from Mizuho Securities.
Steve Valiquette: So one of my questions was just answered on the tariffs. I think I'll just hold off on that one. But one of the things that you mentioned, you said that you assessed the potential impact of China's retaliatory tariffs and you believe you're able to mitigate the tariff exposure through adjustments in your supply chain. I guess my high level thought was that if you're manufacturing in China for the Chinese market, you would essentially have 0 impact from tariffs. But -- so I'm not sure if I'm reading too much into your wording there, but just hoping that you can provide a little more color on the dynamics on making adjustments to your supply chain?
John Morici: Yes, you're right, Steve. From a product movement between China and the U.S. and vice versa, there's no movement across it. There are some raw materials that -- for our China manufacturing location, there are some raw materials that come from U.S. as well as other places. That's the piece that we're adjusting from a supply standpoint so that it should not impact us from a tariff standpoint.
Operator: [Operator Instructions] Next question will come from the line of Elizabeth Anderson from Evercore ISI.
Elizabeth Anderson: Thanks so much for the question. So I see what you're saying about the 2Q guidance, and I understand what you've been saying in some of the math about the FX slip in things. You're talking about in the 2Q guidance, cases, volume being up sequentially. Can you set us -- but obviously, a lot of the 1Q results happened sort of BT, before tariffs. Can you sort of talk about the demand? Are you starting to see any impact on demand? Would you characterize the demand since sort of the tariff announcement as broadly stable? Like, I guess, any sort of color you could help provide on that would be helpful just as people kind of put through the puts and takes of the current macro choppiness. And then I have a follow-up.
John Morici: Yes. No, Elizabeth, this is John. Look, we were pleased with our volume and our performance in Q1 despite some of the choppiness that people allude to and so on. When we look at how we're guiding and what we're using, it's the normal process that we go through to be able to come up with guidance. And we're showing that we expect that sequential improvement from Q1 to Q2. I think I would just remind everybody that it's a global business. There's a lot of different parts to our business and various products as well that I think sometimes gets a little bit lost. So I think if you look at the global breadth of our business, the strength that we saw in EMEA and APAC and the stability that we saw in the Americas, there's always something about tariffs and some of the noise around that, but we're guiding for that increase in and it's based on the data that we see.
Elizabeth Anderson: Got it. And as a follow-up, obviously, you've launched the restorative iTero at IDS, you're at lead in the quarter. So I would assume that there's almost no benefit in the first quarter from that. Can you sort of help us think through sort of the uptake for that and sort of how you expect that based on sort of prior launches to come across as you sort of launch the new products like the -- with the Lumina ortho version last year?
Joseph Hogan: The second version is a restorative scanner. Obviously, as you know, Elizabeth, and so it's broadening a GP segment that we're focused on right now. Obviously, we'll deliver to our channels, so it will deliver globally. We feel really good about some of the capability of that from a storage standpoint. It's -- we're seeing images right now that -- most of these images will go to labs, and it's a restorative procedure. And we're pretty excited about the degree of detail and specificity that Lumina has because of its multiprojection type of a system. So I can't tell you what the exact growth is going to be. I can tell you we'll take it to the marketplace. We'll take it from the lab side and the GP side. And we feel really good about our competitive positioning. Much stronger we feel in the restorative way than some of our scanners in the past. I hope that helps.
Operator: [Operator Instructions] Our next question will come from the line of Erin Wright from Morgan Stanley.
Erin Wright: I'll ask them both upfront here. On teen, I guess, any metrics that you have on the actual conversion rates of Invisalign First and Palate Expander and how you're seeing that translate into growth there? I know it was asked earlier at a more higher level, but curious if we are hitting that inflection point and what some of those metrics may be? And maybe it's just too early. And then the second question I have is just on direct fab and your latest thoughts on contributions, where you're at with sort of the initiative and how that should progress? And maybe we wait for Investor Day on that, but the potential contributions there?
Joseph Hogan: First of all, from a teen conversion standpoint, I wouldn't say we're hitting critical mass or something like that. But I mean, what you see is in that preteen or kids stage, we do have a very strong portfolio in that Phase I area that orthodontists talk about. Obviously, they're excited about it because there's a group of products that are much simpler from a patient standpoint, a lot less painstaking, I'd say, than before. And so we see, really all over the world, a good uptake and interest in those product lines as we expected. And I'd say that includes Mandibular Advancement, that also happens. So it will take time for that penetration piece. There's nothing about this market that moves really quickly in the sense it's an individual doctor's office piece by piece all over the world, but we certainly feel really good with the momentum of those 3 products in general in kids. Overall, from a -- when I look around a world right now, I just think from a -- we have good momentum, like I mentioned before, in every region that we've had. We haven't seen this since 2021. The teen growth overall being double digits is terrific. So the penetration rate is improving. But I think we have to take this thing quarter-to-quarter and report to you on it. I hope that helps.
Operator: [Operator Instructions] Our next question will come from the line of Mike Ryskin from Bank of America Merrill Lynch.
Mike Ryskin: Appreciate you squeezing me in. A couple of small ones, just kind of following up on prior points people brought up, so I'm shooting real quick. You talked about tariffs, you talked about China. I kind of want to talk about the indirect impact of tariffs, the trade war. There's a lot of thoughts of maybe indirectly, China will try to punish American companies by sort of pushing people towards local brands even more, the question, how much they can really do that. But just from that perspective, are you seeing anything? Obviously, you've got a local competitor there. So just thoughts on that? And what have you kind of assumed for rest of the year if that trade war continues to escalate?
Joseph Hogan: Yes, Mike, based on what we saw in the first quarter, obviously, we're looking for that is there's some kind of consumer backlash. We haven't really experienced that at all. We had a good quarter in China across the board. And so as far as where we stand today, we haven't seen that kind of an issue. And again, I think we're -- we're an in-China, for-China type of company there, too. And then obviously, we're a Western company, but we don't deliver from a Western sense. We deliver within that country, the technology, the manufacturing, the treatment planning and all those things. And so it's very local in the sense of how we operate there.
Mike Ryskin: Okay. Great. And then you talked about FX on revenues in ASP. What about on margins? I mean, it's just a pretty big swing in terms of how rates have gone. Is there any impact on margins? I see that you're keeping your full year op non-GAAP up the same. So just anything we should keep in mind in terms of how that flows through the P&L?
John Morici: Yes. There's -- with the FX, favorable FX, there's a slight improvement in our op margin as a result of that. But we have that as well as being able to offset some of the tariffs and so on. So that's the components that show up in op margin. But we're pleased with the start of the year in terms of our op margin. We're showing -- guiding to sequential improvement into the second quarter. And if FX rates stay stable as they are now, we will end up with a good accretive op margin for 2025.
Mike Ryskin: Okay. And then a quick one, if I could squeeze in a third, just sort of a technical question. Some of the disclosures, you mentioned you're not giving DSP anymore. It looks like -- unless I'm missing it, you're not giving Americas versus international Clear Aligner net revenues. Is it just sort of the new disclosure going forward? Is that something we'll find in the 10-Q? Or just sort of what's the rationale behind that?
John Morici: We're always looking to simplify and provide information. We get a lot of feedback that we provide so much information and it gets a bit confusing as to what's really driving things. So we try to give the best information that helps you and others be able to understand and analyze the business. And we look to make changes that make the most sense to help provide more clarity to the business.
Operator: [Operator Instructions] The next question is come from the line of Kevin Caliendo from UBS.
Kevin Caliendo: Thanks for getting me in, I appreciate it. I want to go back -- I want to go back to the ASP question. It was down 8%. 3% FX, I think, is how to think about it, which would imply that between discounting and mix, it was down sort of 5%, right? And I don't think that any of your expectations are going forward that ASPs are going to decline 5% to perpetuity. So what gets better, in your minds, between either mix, either customer mix or product mix or discounting programs? Or are you anticipating -- and I don't know that I've contemplated this until right now. But is there -- it used to be every July, there would be price increases. Are you thinking that you have the ability to do that, broadly speaking? And that helps. And I guess it's a short-term question, but it's also sort of a long-term question when we think about the ASPs because if we're going to get back to sort of the kind of growth that we think the business can do it, we don't want ASP to be a huge overhang in that on the Clear Aligner side?
John Morici: Yes, I think you have to look at it when you think about it, Kevin, where we're growing. Certain countries grow faster. They're just at a lower list price product that they have there or some of the product growth that we have is lower. And we certainly saw some of the shift where we starting this year, have introduced DSP in several markets and other new products with IPE and some of the other clubs that we've had, whereas we didn't have those in the past. So I think some of it is just the products and the locations that impacts the mix. And then you see as doctors, we sell to more and more doctors, record number of first quarter doctors that we sell to. Many of these doctors that come in are just -- they're at an ASP product, a list price that are -- maybe not the comprehensive and they're lower list price type products. But that's the expectation that you have. We have things that we can be able to mitigate with some of the new products we have, some of the additional pricing like we have on MAOB and others to be able to get us to that stability in ASP. And then, of course, as you work your way down the P&L, we're very mindful of making sure that gross margin is accretive and being able to drive the gross margin and ultimately, to op margin. And that's what we look at as we work our way down the P&L.
Operator: Thank you. I'm not showing any further questions in the queue. I would now like to turn the call back over to Shirley for closing remarks.
Shirley Stacy: Thank you, and thank you, everyone, for joining us today. As a reminder, we are hosting an Investor Day meeting next Tuesday, May 6, in New York City. If you would like more information about that or to register, you visit our website, aligntech.com, and that -- or you can contact Investor Relations. If you have any other questions, we look forward to hearing from you. Thanks, and have a great day.
Operator: Thank you for your participation in today's conference. This does conclude the program. You may now disconnect. Everyone, have a great day. | [
{
"speaker": "Operator",
"text": "Good day, and thank you for standing by. Welcome to the Align Technology First Quarter 2025 Earnings Call. [Operator Instructions] Please be advised that today's conference is being recorded. I would now like to hand the conference over to your speaker today, Shirley Stacy, Vice President of Corporate Communications and Investor Relations. Please go ahead."
},
{
"speaker": "Shirley Stacy",
"text": "Good afternoon, and thank you for joining us. Joining me on today's call is Joe Hogan, President and CEO; and John Morici, CFO. We issued first quarter 2025 financial results today via Business Wire, which is available on our website at investor.aligntech.com. Today's conference call is being audio webcast and will be archived on our website for approximately 1 month. As a reminder, the information provided and discussed today will include forward-looking statements, including statements about Align's future events and product outlook. These forward-looking statements are only predictions and involve risks and uncertainties that are described in more detail in our most recent periodic reports filed with the Securities and Exchange Commission available on our website and at sec.gov. Actual results may vary significantly, and Align expressly assumes no obligation to update any forward-looking statement. We provided historical financial statements with corresponding reconciliations, including our GAAP to non-GAAP reconciliation, if applicable, and our first quarter 2025 conference call slides on our website under Quarterly Results. Please refer to these files for more detailed information. With that, I'd like to turn the call over to Align Technology's President and CEO, Joe Hogan. Joe?"
},
{
"speaker": "Joseph Hogan",
"text": "Thanks, Shirley. Good afternoon, and thanks for joining us today. On our call, I'll provide an overview of our first quarter results and discuss a few highlights from our 2 operating segments: Systems and Services and Clear Aligners. John will provide more detail on our financial performance and comment on our views for Q2 and full year 2025. Following that, I'll come back and summarize a few key points and open the call to questions. I'm pleased to report first quarter revenues, operating margin and earnings in line with our outlook. Fiscal 2025 is off to a good start with Q1 Clear Aligner volumes, up both sequentially and year-over-year, reflecting strength in both the teens and adult patient segments across all regions, driven year-over-year strength across the Asia Pacific and EMEA regions and growth in North America. It's also worth noting that Q1 was the highest year-over-year growth rate for both adult and teen patients since 2021. From a channel perspective, Q1 Clear Aligner volumes in the orthodontic and GP dentist channels increased year-over-year with a record number of total submitters and utilization for GP dentists for the first quarter. For our Systems and Services business, Q1 revenues were down sequentially, reflecting Q1 seasonality as well as unfavorable foreign exchange. On a year-over-year basis, Q1 Systems and Services revenues were up slightly, reflecting continued adoption of iTero Lumina scanner platform, as well as the launch of iTero Lumina with restorative software at the end of month. On a year-over-year basis, Q1 Clear Aligner volumes grew 6.2%, driven primarily by continued strength across EMEA and APAC regions as well as growth in North America, offset by lower volumes in Latin America region. For North America, Q1 year-over-year increase in Clear Aligner volumes reflects continued adoption of Invisalign First for teens and kids, Invisalign DSP touch-up cases and Invisalign Comprehensive Three and Three. On a sequential basis, Q1 North America Clear Aligner volumes primarily reflect growth from Invisalign DSP touch-up cases, Invisalign Palate Expander system, as well as Invisalign Comprehensive Three and Three. For the EMEA region, Q1 year-over-year Clear Aligner volume growth primarily reflects strength across the region in both the ortho and GP channels across teens, kids and adult patients. On a year-over-year basis, Q1 EMEA volumes reflect continued adoption of Invisalign noncomprehensive cases, primarily driven by Invisalign Moderate, Invisalign DSP touch-up cases, as well as the initial launch of the Invisalign Palate Expander across EMEA region in Q1. On a sequential basis, Q1 EMEA growth was driven primarily by Invisalign DSP touch-up cases. For the APAC region, Q1 year-over-year Clear Aligner volume growth reflects increased utilization and submitters in both ortho and GP channels across teen, kid and adult patients in nearly all country markets. On a sequential basis, Q1 growth reflects strength from China and many of our emerging markets, led by India and Korea. From a product perspective in Invisalign First, Invisalign Standard and Adult products drove Q1 growth in APAC, both on a year-over-year and sequential basis. For Q1, we had over 85,000 doctors submitters worldwide for a record total for first quarter, primarily reflecting a sequential increase in Clear Aligner volume for teens, kids and adults in both noncomprehensive and comprehensive cases. In the teen and growing kids segment, approximately 226,000 teens and kids started treatment with Invisalign Clear Aligners during the first quarter, an increase of 4.5% sequentially and an increase of 13.3% year-over-year, reflecting growth across regions, especially from Invisalign First in the APAC and EMEA regions in North America, as well as growth from the Invisalign Palate Expander system in North America. For Q1, the number of doctors submitting case starts for teens and kids was up 2.1% year-over-year, led by continued strength from doctors treating young kids and growing patients. During the quarter, we continued to commercialize the Invisalign Palate Expander system with continued momentum for doctor submitters and shipments. In Q1, we announced that Align's Invisalign Palate Expander system was commercially available in Turkey, and today, we received confirmation of regulatory clearance in China. Along with Turkey and China, the Invisalign Palate Expander is available in the U.S., Canada, Brazil, Australia, New Zealand, Hong Kong, Japan, Singapore, Thailand, EU, U.K., UAE and Switzerland, and is expected to be available in additional markets following regulatory clearances. This month, we announced the commercial availability of the Invisalign system with Mandibular Advancement featuring Occlusal Blocks designed specifically to address Class II skeletal and dental correction by simultaneously advancing the mandible while aligning the teeth. Class II malocclusion is one of the most common orthodontic issues, characterized by a discrepancy and jaw alignment, where the lower jaw is positioned too far back relative to the upper jaw. It represents approximately 30% to 45% of malocclusions globally. Left untreated, this condition can lead to functional, aesthetic and other challenges for patients. The Invisalign system with Mandibular Advancement featuring Occlusal Blocks is a direct response to the needs of orthodontic practices and underscores Align's ongoing commitment to innovation in orthodontics that enhances clinical outcomes and the patient experience. By integrating occlusal blocks into the Mandibular Advancement feature, we are providing doctors with a powerful new tool that they have asked for to effectively treat growing patients with Class II malocclusions while maintaining the aesthetic and comfort benefits of Clear Aligner therapy. The Invisalign system with Mandibular Advancement featuring Occlusal Blocks is available to Invisalign trained doctors in the United States, Canada, Australia and New Zealand. It was just launched in most EMEA countries this week, and we expect to be introduced in additional markets through 2025 pending regulatory clearance. Along with the Invisalign Palate Expander system and Invisalign First, the latest innovation supports the commitment to establishing a unique and differentiated portfolio that supports growing patients throughout their continuum of care. Dental service organizations, or DSOs, continue to present 1 of the fastest-growing channels in digital dentistry as they recognize the practice and patient experience benefits of digital workflows, enabled by our portfolio of products and services that make up the Align digital platform. This includes increased practice efficiency and profitability, as well as delivering a shorter treatment appointment cycle times for their patients. In short, DSOs are a force multiplier for practice growth in Invisalign adoption. For Q1, Clear Aligner volume from DSO customers worldwide increased sequentially and year-over-year, reflecting growth across all regions. Q1 iTero scanner sales growth was also strong with DSOs as they continue to investing in their member practices and end-to-end digital workflows. The DSO business growth continues to outpace that of our retail doctors, driven primarily by some of the largest DSOs in each region. Turning to Systems and Services. For Q1, year-over-year revenue growth primarily reflects scanner and wand revenue driven by iTero Lumina, wand upgrades, partially offset by lower scanner revenues and the impact of unfavorable foreign exchange. For Q1, we delivered more scanner systems and wands in a quarter than ever before. On a sequential basis, Q1 Systems and Services revenues were down, reflecting capital equipment seasonality, partially offset by higher iTero Lumina scanner wand upgrades. In Q1, we launched new restorative capabilities and our next-generation iTero Lumina intraoral scanner and a new iTero Lumina Pro dental imaging system with iTero NIRI technology to enable efficient restorative and multidisciplinary workflows and support the diagnosis of interproximal carries above the gingiva. The new storage capabilities of iTero Lumina improves GP dentists' ability to diagnose and develop treatment plans that deliver exceptional clinical outcomes while concurrently helping GPs collaborate more effectively with their restorative lab, deliver incredible precise, custom-fitting restorations and reach new levels of practice efficiency and growth. The iTero Lumina intraoral scanner with iTero Multi-Direct Capture or MDC technology sets a new standard with effortless scanning and superior visualizations, and feedback from doctors, labs and other stakeholders regarding our Lumina portfolio has been positive. It's intuitive design and ease of scanning is appealing, is making everyday scanning more viable, especially when compared to other scanners. Like any breakthrough technology, it's important to ensure that doctors and their staffs are properly trained on scanning. Even the most experienced iTero users may indeed to unlearn previous scanning techniques. We are working closely with our teams to offer follow-up training for our customers and their staff. The iTero Lumina intraoral scanner delivers faster scanning speed, higher accuracy, superior visualization, and a more comfortable scanning experience. The iTero Lumina solutions include superior 3D and 2D visualizations that augment and amplify oral health assessment and patient communication using the Align Oral Health suite designed to increase patient engagement with greater visual understanding of their oral health conditions. Following regulatory clearances in applicable countries starting earlier this month, existing iTero Lumina scanner owners began upgrading to the new software, which includes restorative and diagnostic capabilities. We're excited about the continued technology evolution we deliver with iTero Lumina system and the depth of tools and features that it offers for imaging, diagnostics, treatment planning, visualization restorations and so much more. iTero has always been much more than a PBS replacement, and with iTero Lumina has truly become the gateway to digital treatment for orthodontics and any type of GP practice from family dentistry to high-end aesthetic practices. With that, I'll now turn the call over to John."
},
{
"speaker": "John Morici",
"text": "Thanks, Joe. Now for our Q1 financial results. Total revenues for the first quarter were $979.3 million, down 1.6% from the prior quarter and down 1.8% from the corresponding quarter a year ago. On a constant currency basis, Q1 revenues were unfavorably impacted by approximately $21.4 million or approximately 2.1% sequentially and were unfavorably impacted by approximately $31.1 million year-over-year or approximately 3.1%. For Clear Aligners, Q1 revenues of $796.8 million were up 0.3% sequentially, primarily from higher volumes, partially offset by the impact of unfavorable foreign exchange. Unfavorable foreign exchange impacted Q1 Clear Aligner revenues by approximately $17.9 million or approximately 2.2% sequentially. Q1 Clear Aligner average per case shipment price of $1,240 decreased by $25 on a sequential basis, primarily due to the impact of unfavorable foreign exchange. On a year-over-year basis, Q1 Clear Aligner revenues were down 2.5%, primarily due to unfavorable foreign exchange of $25.8 million or approximately 3.1% and lower ASPs due to product mix shift to lower-priced products and discounts, partially offset by higher volumes. Q1 Clear Aligner average per case shipment price of $1,240 was down $110 on a year-over-year basis, primarily due to higher discounts, product mix shift to lower-priced products and the impact from unfavorable foreign exchange, partially offset by price increases. Clear Aligner deferred revenues on the balance sheet as of March 31, 2025 decreased $9.3 million or 0.8% sequentially and decreased $74.7 million or 5.8% year-over-year and will be recognized as additional aligners are shipped under the -- each sales contract. Q1 Systems and Services revenue of $182.4 million were down 9.2% sequentially, primarily due to lower scanner systems revenue -- revenues and unfavorable foreign exchange. This was partially offset by increased scanner wand revenues, mostly due to iTero Lumina wand upgrades. Q1 Systems and Services revenue were up 1.2% year-over-year, primarily due to higher iTero Lumina scanner wand revenues, partially offset by lower scanner systems revenues and unfavorable foreign exchange. Foreign exchange negatively impacted Q1 Systems and Services revenues by approximately $3.5 million or approximately 1.9% sequentially. On a year-over-year basis, System and Services revenues were unfavorably impacted by foreign exchange of approximately $5.3 million or approximately 2.8%. Systems and Services deferred revenues decreased $11.3 million or 5.1% sequentially and decreased $37.2 million or 15.2% year-over-year, primarily due to decline in deferred revenues due in part to shorter duration of service contracts applicable to initial scanner system purchases. Moving on to gross margin. First quarter overall gross margin was 69.5%, down 0.6 points sequentially and down 0.5 points year-over-year. Foreign exchange negatively impacted the overall gross margin by 0.7 points sequentially and 0.9 points on a year-over-year. Clear Aligner gross margin for the first quarter was 70.5%, up 0.4 points sequentially due primarily to lower manufacturing costs and lower restructuring expenses, partially offset by unfavorable foreign exchange of 0.6 points. Clear Aligner gross margin for the first quarter was down 0.3 points year-over-year, primarily due to unfavorable foreign exchange, partially offset by lower manufacturing spend. Foreign exchange negatively impacted Clear Aligner gross margin by 0.9 points year-over-year. Systems and Services gross margin for the first quarter was 64.7%, down 4.7 points sequentially, primarily due to lower wand ASPs and unfavorable foreign exchange, partially offset by manufacturing efficiencies. Foreign exchange negatively impacted the Systems and Services gross margin by 0.7 points sequentially. Systems and Services gross margin for the first quarter was down 1.2 points year-over-year primarily due to lower scanner and wand ASPs and unfavorable foreign exchange, partially offset by manufacturing and services efficiencies. Foreign exchange negatively impacted the Systems and Services gross margin by 1.0 points year-over-year. Q1 operating expenses were $549 million, down 0.7% sequentially and up 1% year-over-year. On a sequential basis, we saw a $3.8 million decrease in operating expenses, primarily due to lower restructuring and other nonrecurring charges in Q1, which were partially offset by consumer marketing spend. Year-over-year, operating expenses increased by $5.3 million, primarily due to our continued investments in R&D activities. On a non-GAAP basis, excluding stock-based compensation, restructuring and other charges and amortization of acquired intangibles related to certain acquisitions and legal settlement loss, operating expenses were $500.7 million, up 5.5% sequentially and down 1.1% year-over-year. Our first quarter operating income of $131.1 million resulted in an operating margin of 13.4%, down 1.1 points sequentially and down 2.1 points year-over-year. Foreign exchange negatively impacted operating margin by approximately 1.1 points sequentially and 1.4 points year-over-year. On a non-GAAP basis, which excludes stock-based compensation, restructuring and other charges, amortization of intangibles related to certain acquisitions and legal settlement loss, operating margin for the first quarter was 19.1%, down 4.1 points sequentially and down 0.7 points year-over-year. Interest and other income expense, net for the first quarter, was an income of $9.3 million compared to an expense of $3.4 million in Q4 '24, driven by favorable foreign exchange movements, partially offset by lower interest income and gain on investments from last quarter. On a year-over-year basis, Q1 interest and other income and expense were favorable compared to income of $4.3 million in Q1 '24, primarily driven by favorable foreign exchange movements, partially offset by gain on investments in the first quarter of the prior year. The GAAP effective tax rate in the first quarter was 33.6% compared to 26.3% in the fourth quarter of last year and 33.7% in the first quarter of the prior year. The first quarter GAAP effective tax rate was higher than the fourth quarter effective tax rate, primarily due to the tax expense recognized related to stock-based compensation and the release of uncertain tax provision reserves in Q4 of '24, partially offset by a onetime tax deferred tax adjustment in foreign jurisdictions in Q4 of '24. The first quarter GAAP effective tax rate was roughly in line with the first quarter effective tax rate of the prior year. Our non-GAAP effective tax rate in the first quarter was 20%, which reflects our long-term projected tax rate. First quarter net income per diluted share was $1.27, down $0.13 sequentially and down $0.13 compared to the prior year. Foreign exchange negatively impacted our EPS by $0.08 on a sequential basis and $0.12 on a year-over-year basis due to foreign exchange. On a non-GAAP basis, net income per diluted share was $2.13 for the first quarter, down $0.31 sequentially and down $0.01 year-over-year. Moving on to the balance sheet. As of March 31, 2025, cash and cash equivalents were $873 million, down sequentially $170.9 million and up $7.2 million year-over-year. Of our $873 million balance, $133.1 million was held in the U.S. and $739.9 million was held by our international entities. During Q1, we repurchased the remaining $72.1 million of the $270 million -- $275 million open market repurchase initiated in Q4 of '24. In Q1, we initiated a new plan to repurchase the remaining $225 million of our common stock under the -- our January 2023 approved stock repurchase program of $1 billion through open market repurchases. As of March 31, 2025, we had repurchased $129 million. Once completed, this open market repurchase will complete our $1 billion stock repurchase program approved in January of 2023. Q1 accounts receivable balance was $1.062 billion, up sequentially. Our overall days sales outstanding was 97 days, up approximately 7 days sequentially and up approximately 11 days as compared to Q1 last year and primarily reflects flexible payment terms we have extended as part of our ongoing efforts to support Invisalign practices. Cash flow from operations for the first quarter was $52.7 million. Capital expenditures for the first quarter were $25.3 million, primarily related to investments in our manufacturing capacity and facilities. Free cash flow, defined as cash flow from operations minus capital expenditures, amounted to $27.4 million. Before I turn to our Q2 and fiscal 2025 outlook, I'd like to provide the following remarks regarding the U.K. VAT and U.S. tariffs as of April 30. As previously disclosed in our Q4 '24 earnings release and conference call, we anticipated receiving a ruling regarding the applicability of VAT to our Clear Aligner sales in the U.K. On April 24, 2025, we received a favorable ruling in which the tribunal determined that our Clear Aligners are dental prosthesis for the purposes of VAT in the U.K., which is key condition to be considered exempt from VAT. This outcome reaffirms our commitment to enhancing patient access to oral health, leveraging digital technology. HMRC has until June 19 to appeal the tribunal's ruling. HMRC may also attempt to challenge the applicability of VAT on a different basis. Moving on to tariffs. Align Technology has Clear Aligner manufacturing operations in Mexico, Poland and China. For the U.S. domestic market, we currently manufacture clear aligners in Mexico prior to shipment to the U.S. Align does not currently ship clear aligners from Poland or China to the U.S. We currently manufacture clear aligners for the Chinese market in China. Our clear aligners and intraoral scanners made in Mexico that are imported into the U.S. are compliant with the United States-Mexico-Canada agreement, USMCA. As noted in President Trump's Executive Order dated April 2, 2025, USMCA-compliant goods are exempt from tariffs under the Executive Order. However, the U.S.-Mexico tariff situation remains fluid, and we are unable to predict whether USMCA-compliant products will remain exempt, whether there will be other changes to the announced Executive Order or if other tariffs will be imposed in the future. We expect an incremental tariff, if implemented, to be applied to the transfer price on goods shipped for Mexico. With respect to our clear aligners made in China, all manufacturing for China takes place in China. We have assessed the potential impact of China's retaliatory tariffs and believe that we are able to mitigate most of the tariff exposure through adjustments in our supply chain. Based on the current situation, we do not expect a significant impact to our costs from these retaliatory tariffs. We have also assessed the potential direct impact of additional U.S. tariffs on China on our business and currently do not expect to realize a significant impact from these retaliatory tariffs. Our intraoral scanner manufacturing primarily occurs in Israel, with scanners shipped from there to worldwide locations. We produce a small number of scanners in China primarily for the market. Regarding tariffs on Israel goods imported into the U.S., at the current 10% baseline tariff, we estimate the average monthly potential impact to be approximately $1 million, which we have considered in our guidance for Q2 and fiscal 2025. Moving on to 2025 business outlook. Assuming no circumstances occur beyond our control, such as foreign exchange, macroeconomic conditions and changes to our currently known tariffs that could impact our business, we expect Q2 2025 worldwide revenues to be in the range of $1.05 billion to $1.07 billion, up sequentially from Q1 2025. We expect Q2 '25 Clear Aligner volume to be up sequentially and Q2 '25 Clear Aligner ASPs to also be up sequentially due to favorable foreign exchange at current spot rates, partially offset by the continued product mix shift to noncomprehensive Clear Aligner products with lower list prices. We expect Q2 '25 Systems and Services revenue to be up sequentially as we continue to ramp up the iTero Lumina scanner with restorative software. We expect Q2 '25 worldwide gross margin to be up sequentially, primarily from higher ASPs and Clear Aligner volume. We expect our Q2 '25 GAAP operating margin and Q2 '25 non-GAAP operating margin to be up sequentially by approximately 3 points for each GAAP and non-GAAP operating margins. For fiscal 2025, we expect -- 2025 Clear Aligner volume growth to be up approximately mid-single digits year-over-year. We expect 2025 Clear Aligner ASPs to be down year-over-year due to continued product mix shift to noncomprehensive Clear Aligner products with lower list prices and continued growth in our emerging markets where those products may carry lower list prices. We expect 2025 Systems and Services revenues -- Systems and Services year-over-year revenues to grow faster than Clear Aligner revenues. We expect 2025 year-over-year revenue growth to be in the range of 3.5% to 5.5% at current spot rates. We expect fiscal 2025 GAAP operating margin to be approximately 2 points above the 2024 GAAP operating margin. And we expect 2025 non-GAAP operating margin to be approximately 22.5%. We expect our investments in capital expenditures for fiscal 2025 to be between $100 million and $150 million. Capital expenditures primarily relate to technology upgrades as well as manufacturing capacity in support of our ongoing business. With that, I'll turn it back over to Joe for final comments. Joe?"
},
{
"speaker": "Joseph Hogan",
"text": "Thanks, John. I'm pleased with the results of our first quarter, the strength of our Clear Aligner business, including the return to stability in the United States and the response to our recent innovations such as Invisalign Palate Expander system at iTero Lumina. All of us are aware of the global economic uncertainty and the headwinds that tariffs or changes in the consumer sentiment might bring. Align is focused on what we can control. As I mentioned last quarter, that means building on the innovations introduced in 2024 that drive efficiency and growth for our customers' practices while delivering the best customer and patient experiences in the industry. First, through our digital scanning technology. While iTero has long been valued in the orthodontic and GP practices as much more than a replacement for PBS impressions, our next-generation iTero Lumina solution with comprehensive dentistry capabilities provides transformative solutions for GP dental practices to enable diagnostics, restorative and multidisciplinary ortho restorative workflows, including NIRI technology and the iTero Lumina Pro dental imaging system. With iTero Lumina, we truly have a gateway to any type of digital orthodontic and dental treatment. Second, driving practice transformation to fully digital practices must address 2 key variables: Doctor and patient efficiency. Less patient chair time and fewer patient visits increases practice profitability. We're helping customers drive efficiency and create more time and capacity in their practices with our digital treatment planning software, delivering ClinCheck in minutes for most treatment plans. The latest innovations in the ClinCheck Signature experience combines automation of each doctor's clinical preferences with AI-powered tools that deliver customized treatment plans in near real time. Based on doctors' building personalized treatment preferences or prepopulated templates, a doctor chooses our almost touchless digital workflows, ClinCheck in minutes technology, which is revolutionizing treatment planning for doctors and enabling chair side treatment planning, improving patient conversion and getting patients started in treatments within days. Next, we're building on the world's most advanced Clear Aligner system to make it even more effective and efficient for all patients with innovations such as the Invisalign system with Mandibular Advancement featuring Occlusal Blocks, that expands Align's Class II treatment portfolio for growing patients with a comprehensive solution for treating growing patients in Class II malocclusions caused by mandibular retrusion. Finally, we're delivering on the promise of 3D technology that is part of Align's DNA with direct 3D-printed orthodontic devices, demonstrating our commitment to pushing the boundaries of digital orthodontics. The first example is the Invisalign Palate Expander system, a series of removable devices that expand a patient's palate without traditional metal expanders and screws in a way that is both effective clinically and comfortable and easy to use for kids and parents. This is the first direct 3D-printed appliance Align has commercialized. With others in development, we believe direct 3D printing will give doctors new levels of precision and appliance fit and shape and deliver the best possible outcome for patients. As we celebrate 28 years of digital innovation this year, we're also proud to be grateful and highlight that we've met a significant milestone with over 20 million Invisalign patients treated globally, representing 20 million smiles, 20 million stories and 20 million lives transformed, a testament to the passion and purpose of our employees, our doctor customers and their patients. With that, I thank you for your time today. I look forward to speaking with you at our Investor Day meeting next week. Now I'll turn the call over to the operator for questions. Operator?"
},
{
"speaker": "Operator",
"text": "[Operator Instructions] Our first question will come from the line of Brandon Vazquez from William Blair."
},
{
"speaker": "Brandon Vazquez",
"text": "Congrats on nice start of the year here. I thought maybe just to start, I was pleasantly surprised that kind of the strength in the quarter and the strength of the guide, given historically, we've relied a lot on -- and we've talked a lot about the ties of consumer sentiment and to the dental space. So again, kind of a nice surprise in this quarter. I was hoping you guys can just spend a little time talking -- we saw consumer sentiment come down, but it seems like the business is doing well. So talk a little bit about maybe why that's decoupling and what kind of confidence that gives you in the guidance on a go-forward basis, even though in April, we were seeing sentiment go down?"
},
{
"speaker": "Joseph Hogan",
"text": "Brandon, it's Joe. Thanks for the question. We saw good volume. It's great to see North America grow again. It's been a while, as I mentioned. We have good strength in APAC overall, including China. And Europe, really across the board in Europe, we saw good demand also. And obviously, the Lumina scanner coming out now with restorative capability gives us a tailwind in that sense, too. So -- and what I would love also was the teen, you saw teens grow, but you also saw adults grow also. So when I just end that comment by saying we saw breadth in the sense of the growth, whether it was product line or whether it's by country or region and also by our different segments, including iTero."
},
{
"speaker": "Operator",
"text": "Our next question comes from the line of Vik Chopra from Wells Fargo."
},
{
"speaker": "Vik Chopra",
"text": "Can you hear me? Thanks for taking the question, and congrats on a nice quarter. Maybe just 2 for me. I appreciate all the color you provided on the tariff front. But can you just talk about plans to potentially mitigate this by moving production to different locations or putting in some price increases? And then I had a quick follow-up."
},
{
"speaker": "Joseph Hogan",
"text": "Vik, it's Joe. Look, obviously, we're, I think, pretty well situated right now when you look at how the tariffs would affect us. We're in China for China. And as John said, there's some material movements in all that we'll take care of it. We don't see much of an impact there, if anything. We're good with Mexico right now. We feel pretty solid on that. And our Poland plant is fully operational and working well in Europe. I guess the only issue we really have is iTero, a lot of the shipments are coming out of Israel, but we have some plans, we'll be able to address that. But as you can see in our forecast, we're planning on holding our margin that we've committed to. And so we think we'll be able to mitigate that. So overall, I feel fortunate. I think we positioned ourselves as a truly global business, meaning we have global supply lines in each 1 of those specific regions that we can maximize and work through. And so we feel good about the situation right now. But as I mentioned in my comments, too, is there's a lot of volatility out there, but we feel we're well positioned in the sense of what we've seen so far."
},
{
"speaker": "Vik Chopra",
"text": "Got it. That's super helpful. And you're hosting a much anticipated Investor Day next week. I'm just wondering if you can just provide some insight as to what we can expect next week?"
},
{
"speaker": "Joseph Hogan",
"text": "I think what you can expect is we'll give you a good portfolio look at the company, a good demand, what we think the next few years look like in a sense of how we're positioned overall from a technology standpoint and also a commercial standpoint. It's been a while since we've been with our investors. So we're really excited to share with you. We've developed a lot since the last meeting, and we look forward to the time in New York."
},
{
"speaker": "Operator",
"text": "[Operator Instructions] Our next question will come from the line of Jon Block from Stifel."
},
{
"speaker": "Jon Block",
"text": "The first one, John, will have some sort of detailed questions on the 2025 revenue guidance. So I think I got it right. You raised it from low single digits to 4.5% at the midpoint. The language around ASPs didn't change. I still expect it to be down low single digits year-over-year. The Clear Aligner language didn't change. The ball is still expected to be up mid-single digits year-over-year. So maybe it's a pretty straightforward question. But like any more color on the ASPs? Are the ASP thoughts basically, call it unchanged from 3 months ago, but now we should be thinking like down 1 and the prior was down 3, that both fits the LSD narrative with that 200 basis point delta sort of specific to just updating for the spot rate? And let me know if that came across well."
},
{
"speaker": "John Morici",
"text": "Yes. That is accurate, the way you phrased that, John."
},
{
"speaker": "Jon Block",
"text": "Okay. That was an easy one, concise. So I'll get another one. Joe, I'd love to spend time on teen. I mean, this was always sort of like the holy grail and it went to the moon during COVID and then you had some tough comps and here you are with new products and the double-digit growth of 13%, it was a pretty good beat on teen versus where we were. The 2-year stack is mid-20s. It wasn't up against an easy comp. So the 13 off the 12. Maybe just elaborate on that? Like what are you seeing with IPE? Clearly, that's helping the balls, but are you seeing the IPE to alignment pull-through, which I think we would still be in the early stages of that? And maybe I'm getting a little bit aggressive here, but can we think about teen as this low double-digit plus grower going forward as long as the innovation continues to step up and you got MA with occlusal blocks first hitting the market?"
},
{
"speaker": "Joseph Hogan",
"text": "Yes. Jon, first of all, I like the breadth of what you saw in teen. We saw it across each geography, too. Obviously, IPE is a big part of that, but it combines well with Invisalign First. We see that. Some doctors specified immediately, some in sequence. But overall, that's just a great -- we call it kids' product. We have it in the teen segment. But those 2 products function very well together. You're right about Mandibular Advancement with the occlusal blocks. It addresses the twin block kind of a system that's been out there for years is kind of an invasive system. And we've done that before, Mandibular Advancement, but not to the extent that these strong occlusal blocks will be able to address the Class II, like I mentioned before. So I feel -- and I feel good about our distribution capability in each geography to take that kind of technology forward. There's a lot of specificity in stuff like IPE. And obviously, occlusal blocks is you need a great distribution team to be able to explain and help to integrate in doctors' offices. So I hope I have answered your question, Jon. But overall, it's not just like 1 region or 1 product. It's really good synergy in our portfolio across the different regions."
},
{
"speaker": "Operator",
"text": "Our next question will come from the line of Jeff Johnson from Baird."
},
{
"speaker": "Jeff Johnson",
"text": "So let me ask, I guess, Jon's ASP question, but let me kind of dig down a little bit more. If I can ask 1 question about ASPs this quarter and then 1 question about ASPs going forward. Hopefully, that's all blended, it counts as 1 question. But John, I think ASPs were down 8.2% year-over-year, not sequentially, 8.2% year-over-year this quarter. Can you just remind us how much the VAT, the price discount you had to give to normalize that VAT impact to the U.K. got, how much that contributed out of that 8.2% and how much FX contributed as a negative headwind? I think that was 200 basis points by my math, but just trying to confirm that?"
},
{
"speaker": "John Morici",
"text": "Yes. The FX is that impact that we have on a year-over-year basis. So we have unfavorable FX. I mean, on a year-over-year basis, the FX on the overall company is 3.1 points. And then remember, we started the VAT -- withholding the VAT a year ago in Q1. So on a year-over-year basis, it's already in the baseline numbers from last year."
},
{
"speaker": "Jeff Johnson",
"text": "Okay. And then on going forward, currency should switch to a positive contributor to ASPs. You mentioned the 310, I thought that was the top line impact, but just is that the flow-through impact ASPs as well, the 310 headwind in the first quarter? But going forward, FX switches to a positive tailwind. Any -- at spot rates, can you just kind of put us in the ballpark there? I can do my math later tonight, but I would love to hear your opinion there. And then if the HMRC doesn't appeal, can you reraise those U.K. prices? Would that actually be a contributor? Or do you stick at these prices? You just don't have to pay that VAT -- the providers don't have to pay that VAT tax. I guess, does that -- could that potentially switch to an ASP tailwind? And then lastly, just MAOB, the Mandibular Advancement blocks. I think I was hearing that that's going to be $100 add-on charge. If we start mixing more and more MA cases, does that theoretically then drive a little bit of ASP tailwind the way IPE and DSP is creating a little bit of ASP headwind right now?"
},
{
"speaker": "John Morici",
"text": "Okay. Let me try to take these 3 ASP questions, Jeff, on this. So MAOB, yes, slightly higher price, that would help our overall ASP as we sell more of that premium product on our comprehensive cases, and we'd add to that for the pricing on that. Regarding the U.K., we have to hear back on whether HMRC will appeal and what they do. We have a lot of flexibility to that if we win. Either they don't appeal or win an appeal, we can always make changes to our discount and not discount as much. And if we do that, then that gives us a benefit in ASP going forward. That has not been contemplated in our forward-looking ASP. I'm just kind of taking the U.K. VAT impact completely out from a forecast. But it does give us flexibility, depending on what HMRC decides to do or if it gets -- works its way through. And then regarding overall FX, yes, it turns into now at current spot rates, a slight benefit on a year-over-year basis. And then you still have what we've talked about before, just that list price, lower list price products, which would be comprehensive as well as some of the other growth in certain countries just at a lower list price. But gross margin, as you know, is in many cases, favorable as a result of those lower-stage products because the cost to serve for us is less. But that's how the dynamics shape up for ASPs."
},
{
"speaker": "Operator",
"text": "[Operator Instructions] Next question comes from the line of Michael Cherny from Leerink Partners."
},
{
"speaker": "Michael Cherny",
"text": "Congrats on a really nice quarter in the guidance. I just want to make sure we have all the pieces right. I'm not going to do as much mental math as Jeff, names a little slower there. But in terms of the margin uptick that you now expect, nice margin expansion of the year, how much of it do you -- would you accrue to kind of better revenue expectations on an organic basis for operational changes? I know we've spent a lot of time talking about the ASP regarding the impact from FX there, but anything else you can allude to relative to the operating margin drop down, how much of it has been within your control versus how much is market conditions would be great."
},
{
"speaker": "John Morici",
"text": "I think when you look at our margin expansion -- and like I said in the prepared remarks, that's still net -- so 70 basis point improvement in op margin from 2024 to 2025 with the known tariff impact that we would have now. And where we're seeing the expansion and improvements is continuing to improve our manufacturing efficiencies with volume, with material savings, logistical savings, things that we talk about from an innovation standpoint when we do touchless ClinCheck, a lot of less activity for us, as well as some of the new products that we have that are at good margins. Some of them higher ASP like we talked about with MAOB and so on. So it's really a host of initiatives that we have. It's what we continue to do in the business. And with this forecast, we're pleased to report that as we know tariffs now, we can still get to our margin targets that we have because we're seeing productivity in other areas."
},
{
"speaker": "Michael Cherny",
"text": "Got it. Just 1 really quick last follow-up. Could you give the DSP number for the quarter? I apologize if I missed it in the slides or anywhere else."
},
{
"speaker": "John Morici",
"text": "No, we did not give the DSP. But as we've said in our prepared remarks and what we see is this helps grow the low stage part of our portfolio. It's rolling out in other areas, and we're pleased with the performance."
},
{
"speaker": "Operator",
"text": "Our next question will come from the line of Jason Bednar from Piper Sandler."
},
{
"speaker": "Jason Bednar",
"text": "I wanted to first start on two financing topics. We saw higher rates, credit denials were an issue over the past year or so. You've got a new preferred financing partner in HFD. Just curious if you're seeing that help resolve any of the challenges with consumers early on in that relationship? And then on the provider side, John, I think you said that you attributed the rise in DSOs to expanding financing or better favorable terms to practices. I just want to understand what's going on there, if you could double-click, just -- to be blunt, it's a pretty big increase in DSOs for a policy you've had in place for multiple years. So just wondering what's changed just in the last few months that would materially shift that line higher?"
},
{
"speaker": "John Morici",
"text": "Yes. I think really, you highlighted kind of the components about how people pay in general. So you have some patients that just paid directly, and they paid 100% of the cases that -- the treatment that they want. So that happens in many markets, and that continues. Maybe it's less of that because of some of the pressures that they might be facing. So the other two ways that HFD patients will pay is some will utilize some of the doctor financing. So they'll kind of pay as you go through the doctor. That's where really it helps to have favorable terms with those doctors so that we can provide a little bit a longer time for them to pay. And we continue that effort so that those doctors can take a little bit more time to pay us back so that they can use their balance sheet or their working capital to help kind of that patient financing that they'll provide. And then the third way is external, and HFD is 1 of them. There's many different companies that provide this, but we're seeing a good combination of finding the right way to get to HFD, meeting the requirements that they have. Or others that are providing this and getting those potential patients into financing. So we're seeing a good combination of this, but we know that how much things cost and how much they have to pay over a monthly basis is important. And this is a good way to offset that."
},
{
"speaker": "Jason Bednar",
"text": "Okay. All right. Understood. And then just maybe real quick on some of the tariff dynamics and not necessarily as it influences what you have to pay, but more so from a competitive standpoint, it seems like you might have some competitors that may get dislocated or may have -- may be facing higher costs as they have to import or reconfigure their supply chains. It seems like this is a good opportunity to lean in with your business. But I want to ask, are you seeing any dislocation with doctor customers? Is that happening where you're now, call it, relatively more favorable from a cost perspective than maybe what you were pre-tariffs?"
},
{
"speaker": "Joseph Hogan",
"text": "It's Joe. I'd say we haven't seen anything material in that sense it changed so far. And I can't really speak of our -- most of our competitors' supply lines. It's a lot of intricacies in the sense of manufacturing whatever. But obviously, some of them are going to be very disadvantaged. We don't know to what extent. But we just continue to operate in the marketplace, focus on what we can focus on, like I mentioned, our product capability, our digital platform, iTero Lumina and just the efficiencies that we really can gain with doctors. So we'll let the tariffs kind of take care of themselves. We'll see how that goes. But we really feel good about our position in it, and we'll continue to execute."
},
{
"speaker": "Operator",
"text": "[Operator Instructions] Our next question will come from the line of Steve Valiquette from Mizuho Securities."
},
{
"speaker": "Steve Valiquette",
"text": "So one of my questions was just answered on the tariffs. I think I'll just hold off on that one. But one of the things that you mentioned, you said that you assessed the potential impact of China's retaliatory tariffs and you believe you're able to mitigate the tariff exposure through adjustments in your supply chain. I guess my high level thought was that if you're manufacturing in China for the Chinese market, you would essentially have 0 impact from tariffs. But -- so I'm not sure if I'm reading too much into your wording there, but just hoping that you can provide a little more color on the dynamics on making adjustments to your supply chain?"
},
{
"speaker": "John Morici",
"text": "Yes, you're right, Steve. From a product movement between China and the U.S. and vice versa, there's no movement across it. There are some raw materials that -- for our China manufacturing location, there are some raw materials that come from U.S. as well as other places. That's the piece that we're adjusting from a supply standpoint so that it should not impact us from a tariff standpoint."
},
{
"speaker": "Operator",
"text": "[Operator Instructions] Next question will come from the line of Elizabeth Anderson from Evercore ISI."
},
{
"speaker": "Elizabeth Anderson",
"text": "Thanks so much for the question. So I see what you're saying about the 2Q guidance, and I understand what you've been saying in some of the math about the FX slip in things. You're talking about in the 2Q guidance, cases, volume being up sequentially. Can you set us -- but obviously, a lot of the 1Q results happened sort of BT, before tariffs. Can you sort of talk about the demand? Are you starting to see any impact on demand? Would you characterize the demand since sort of the tariff announcement as broadly stable? Like, I guess, any sort of color you could help provide on that would be helpful just as people kind of put through the puts and takes of the current macro choppiness. And then I have a follow-up."
},
{
"speaker": "John Morici",
"text": "Yes. No, Elizabeth, this is John. Look, we were pleased with our volume and our performance in Q1 despite some of the choppiness that people allude to and so on. When we look at how we're guiding and what we're using, it's the normal process that we go through to be able to come up with guidance. And we're showing that we expect that sequential improvement from Q1 to Q2. I think I would just remind everybody that it's a global business. There's a lot of different parts to our business and various products as well that I think sometimes gets a little bit lost. So I think if you look at the global breadth of our business, the strength that we saw in EMEA and APAC and the stability that we saw in the Americas, there's always something about tariffs and some of the noise around that, but we're guiding for that increase in and it's based on the data that we see."
},
{
"speaker": "Elizabeth Anderson",
"text": "Got it. And as a follow-up, obviously, you've launched the restorative iTero at IDS, you're at lead in the quarter. So I would assume that there's almost no benefit in the first quarter from that. Can you sort of help us think through sort of the uptake for that and sort of how you expect that based on sort of prior launches to come across as you sort of launch the new products like the -- with the Lumina ortho version last year?"
},
{
"speaker": "Joseph Hogan",
"text": "The second version is a restorative scanner. Obviously, as you know, Elizabeth, and so it's broadening a GP segment that we're focused on right now. Obviously, we'll deliver to our channels, so it will deliver globally. We feel really good about some of the capability of that from a storage standpoint. It's -- we're seeing images right now that -- most of these images will go to labs, and it's a restorative procedure. And we're pretty excited about the degree of detail and specificity that Lumina has because of its multiprojection type of a system. So I can't tell you what the exact growth is going to be. I can tell you we'll take it to the marketplace. We'll take it from the lab side and the GP side. And we feel really good about our competitive positioning. Much stronger we feel in the restorative way than some of our scanners in the past. I hope that helps."
},
{
"speaker": "Operator",
"text": "[Operator Instructions] Our next question will come from the line of Erin Wright from Morgan Stanley."
},
{
"speaker": "Erin Wright",
"text": "I'll ask them both upfront here. On teen, I guess, any metrics that you have on the actual conversion rates of Invisalign First and Palate Expander and how you're seeing that translate into growth there? I know it was asked earlier at a more higher level, but curious if we are hitting that inflection point and what some of those metrics may be? And maybe it's just too early. And then the second question I have is just on direct fab and your latest thoughts on contributions, where you're at with sort of the initiative and how that should progress? And maybe we wait for Investor Day on that, but the potential contributions there?"
},
{
"speaker": "Joseph Hogan",
"text": "First of all, from a teen conversion standpoint, I wouldn't say we're hitting critical mass or something like that. But I mean, what you see is in that preteen or kids stage, we do have a very strong portfolio in that Phase I area that orthodontists talk about. Obviously, they're excited about it because there's a group of products that are much simpler from a patient standpoint, a lot less painstaking, I'd say, than before. And so we see, really all over the world, a good uptake and interest in those product lines as we expected. And I'd say that includes Mandibular Advancement, that also happens. So it will take time for that penetration piece. There's nothing about this market that moves really quickly in the sense it's an individual doctor's office piece by piece all over the world, but we certainly feel really good with the momentum of those 3 products in general in kids. Overall, from a -- when I look around a world right now, I just think from a -- we have good momentum, like I mentioned before, in every region that we've had. We haven't seen this since 2021. The teen growth overall being double digits is terrific. So the penetration rate is improving. But I think we have to take this thing quarter-to-quarter and report to you on it. I hope that helps."
},
{
"speaker": "Operator",
"text": "[Operator Instructions] Our next question will come from the line of Mike Ryskin from Bank of America Merrill Lynch."
},
{
"speaker": "Mike Ryskin",
"text": "Appreciate you squeezing me in. A couple of small ones, just kind of following up on prior points people brought up, so I'm shooting real quick. You talked about tariffs, you talked about China. I kind of want to talk about the indirect impact of tariffs, the trade war. There's a lot of thoughts of maybe indirectly, China will try to punish American companies by sort of pushing people towards local brands even more, the question, how much they can really do that. But just from that perspective, are you seeing anything? Obviously, you've got a local competitor there. So just thoughts on that? And what have you kind of assumed for rest of the year if that trade war continues to escalate?"
},
{
"speaker": "Joseph Hogan",
"text": "Yes, Mike, based on what we saw in the first quarter, obviously, we're looking for that is there's some kind of consumer backlash. We haven't really experienced that at all. We had a good quarter in China across the board. And so as far as where we stand today, we haven't seen that kind of an issue. And again, I think we're -- we're an in-China, for-China type of company there, too. And then obviously, we're a Western company, but we don't deliver from a Western sense. We deliver within that country, the technology, the manufacturing, the treatment planning and all those things. And so it's very local in the sense of how we operate there."
},
{
"speaker": "Mike Ryskin",
"text": "Okay. Great. And then you talked about FX on revenues in ASP. What about on margins? I mean, it's just a pretty big swing in terms of how rates have gone. Is there any impact on margins? I see that you're keeping your full year op non-GAAP up the same. So just anything we should keep in mind in terms of how that flows through the P&L?"
},
{
"speaker": "John Morici",
"text": "Yes. There's -- with the FX, favorable FX, there's a slight improvement in our op margin as a result of that. But we have that as well as being able to offset some of the tariffs and so on. So that's the components that show up in op margin. But we're pleased with the start of the year in terms of our op margin. We're showing -- guiding to sequential improvement into the second quarter. And if FX rates stay stable as they are now, we will end up with a good accretive op margin for 2025."
},
{
"speaker": "Mike Ryskin",
"text": "Okay. And then a quick one, if I could squeeze in a third, just sort of a technical question. Some of the disclosures, you mentioned you're not giving DSP anymore. It looks like -- unless I'm missing it, you're not giving Americas versus international Clear Aligner net revenues. Is it just sort of the new disclosure going forward? Is that something we'll find in the 10-Q? Or just sort of what's the rationale behind that?"
},
{
"speaker": "John Morici",
"text": "We're always looking to simplify and provide information. We get a lot of feedback that we provide so much information and it gets a bit confusing as to what's really driving things. So we try to give the best information that helps you and others be able to understand and analyze the business. And we look to make changes that make the most sense to help provide more clarity to the business."
},
{
"speaker": "Operator",
"text": "[Operator Instructions] The next question is come from the line of Kevin Caliendo from UBS."
},
{
"speaker": "Kevin Caliendo",
"text": "Thanks for getting me in, I appreciate it. I want to go back -- I want to go back to the ASP question. It was down 8%. 3% FX, I think, is how to think about it, which would imply that between discounting and mix, it was down sort of 5%, right? And I don't think that any of your expectations are going forward that ASPs are going to decline 5% to perpetuity. So what gets better, in your minds, between either mix, either customer mix or product mix or discounting programs? Or are you anticipating -- and I don't know that I've contemplated this until right now. But is there -- it used to be every July, there would be price increases. Are you thinking that you have the ability to do that, broadly speaking? And that helps. And I guess it's a short-term question, but it's also sort of a long-term question when we think about the ASPs because if we're going to get back to sort of the kind of growth that we think the business can do it, we don't want ASP to be a huge overhang in that on the Clear Aligner side?"
},
{
"speaker": "John Morici",
"text": "Yes, I think you have to look at it when you think about it, Kevin, where we're growing. Certain countries grow faster. They're just at a lower list price product that they have there or some of the product growth that we have is lower. And we certainly saw some of the shift where we starting this year, have introduced DSP in several markets and other new products with IPE and some of the other clubs that we've had, whereas we didn't have those in the past. So I think some of it is just the products and the locations that impacts the mix. And then you see as doctors, we sell to more and more doctors, record number of first quarter doctors that we sell to. Many of these doctors that come in are just -- they're at an ASP product, a list price that are -- maybe not the comprehensive and they're lower list price type products. But that's the expectation that you have. We have things that we can be able to mitigate with some of the new products we have, some of the additional pricing like we have on MAOB and others to be able to get us to that stability in ASP. And then, of course, as you work your way down the P&L, we're very mindful of making sure that gross margin is accretive and being able to drive the gross margin and ultimately, to op margin. And that's what we look at as we work our way down the P&L."
},
{
"speaker": "Operator",
"text": "Thank you. I'm not showing any further questions in the queue. I would now like to turn the call back over to Shirley for closing remarks."
},
{
"speaker": "Shirley Stacy",
"text": "Thank you, and thank you, everyone, for joining us today. As a reminder, we are hosting an Investor Day meeting next Tuesday, May 6, in New York City. If you would like more information about that or to register, you visit our website, aligntech.com, and that -- or you can contact Investor Relations. If you have any other questions, we look forward to hearing from you. Thanks, and have a great day."
},
{
"speaker": "Operator",
"text": "Thank you for your participation in today's conference. This does conclude the program. You may now disconnect. Everyone, have a great day."
}
] | Align Technology, Inc. | 24,568 |
ALL | 4 | 2,020 | 2021-02-04 09:00:00 | Operator: Ladies and gentleman, thank you for standing by, and welcome to The Allstate Fourth Quarter 2020 Earnings Conference Call. At this time, all participants are in listen-only mode. After the speakers' presentation, there will be a question-and-answer session [Operator Instructions]. As a reminder, today's program is being recorded. And now, I'd like to introduce your host for today's program, Mark Nogal. Please go ahead, sir.
Mark Nogal: Thank you, Jonathan. Good morning, everyone, and welcome to Allstate's fourth quarter 2020 earnings conference call. After prepared remarks, we'll have a question-and-answer session. Yesterday, following the close of the market, we issued our news release and investor supplement and posted today's presentation on our Web site at allstateinvestors.com. Our management team is here to provide perspective on these results. As noted on the first slide of the presentation, our discussion will contain non-GAAP measures for which there are reconciliations in the news release and investor supplement and forward-looking statements about Allstate's operations. Allstate's results may differ materially from these statements so please refer to the 10-K for 2019 and other public documents for information on potential risks. And now, I'll turn it over to Tom.
Tom Wilson: Good morning, and thank you for joining us. Amidst the pandemic Allstate delivered really attractive returns while building higher growth business models in 2020, exceptional progress has made building higher growth business models to execute our strategy of increasing market share in personal property liability, and expanding protections offered to its customers. And as you know, one of our key focuses this year was transitioning the personal property liability business to higher growth. We took decisive actions and despite the operational complexity of these actions maintained Allstate brand property liability policies in force. We'll take you through a reconciliation of the various components of this and you'll see the path to growth. We've made excellent progress in expanding protection offered to customers with total policies in force increasing by 20.5% to nearly 176 million. We took advantage of the decline in auto accident frequency and our cost reductions to improve our competitive price position in auto insurance while maintaining attractive returns. The acquisition of National General is expected to increase auto insurers market share by 1 percentage point in 2021 and provides another platform for growth as we expand its product breadth. These changes position Allstate have sustainable long term growth. At the same time, Allstate generated strong profitability and returns in 2020. Net income was $2.6 billion in the fourth quarter and adjusted net income was $1.8 billion or $5.87 per diluted share. This was driven by lower frequency of auto accident, continued strong profitability of homeowners insurance and higher performance based investment income. Net income was $5.5 billion and adjusted net income was $4.6 billion for the year. This represents a 19.8% return on equity far in excess of most insurance companies. Our strategy is to increase market share in personal property liability while expanding protection services to customers will increase shareholder value. Higher property liability growth with attractive returns, rapidly growing protection services expand our total addressable market. And this growth, combined with our proactive capital deployment strategy, supports returns on equity above the insurance industry and are comparable to the S&P 500. Slide 3 is there to touch base on the strategy and so we're not going to spend time on that. So let's move to Slide 4 and discuss this strategy as it relates to the property liability business. A transformative growth has become more than a [plan], it's about creating a business model, capabilities and culture that continually transform to deliver market share growth. This is done by focusing on the customer, expanding access and improving value. Expanding access includes all the ways customers choose to interact, exclusive agents directly through call centers to the web and independent agents. The largest part of this change was transitioning our exclusive agent and direct businesses that operate under the Allstate brand. This gave us the ability to lower costs, leverage scale and increase advertising. This transaction is successfully being implemented, and we achieved key milestones in 2020. We were pleased with new business growth from existing Allstate agents who remain key to serving our customers and growing. Property liability business from existing agents met our goals, except for the pandemic slowdown in March and April where, of course, nobody was buying anything, as we shifted commission to new sales from retention. We're testing new agent models with less real estate and more efficient service enabled by technology with the goal of having strong local personal relationships with customers. These models will also create learnings to enable existing agents to achieve higher growth. As a result of that, we did stop appointing new Allstate agents in early 2020 while a higher growth in lower cost models being developed. This had a negative impact on points of presence and new business sales. At the same time, we increased direct sales. The net was that overall policies in force remained the same through the transition despite a drop in retention, which was concurrent with the ending of the special payment plans related to the pandemic. Glenn will take you through that reconciliation in a couple of minutes. The acquisition of National General in January also improves growth prospects. And as you know, this is essentially a reverse merger. The National General team is joining Allstate and they're consolidating our independent agent businesses, encompassing AIA into their operational and technology platform. Then we're going to be able to broaden National General's product portfolio using Allstate standard auto and homeowners insurance capabilities, which will create growth through independent agents. We also made great progress at improving customer value last year. From a customer value standpoint, we've maintained attractive margins through cost reductions while investing in growth. This includes improving the competitive price position of auto insurance through targeted rate reductions and a direct pricing discount. And while most of these changes are due to the lower frequency of auto actions, we are also reducing cost to ensure we continue to generate attractive margins. We're also expanding our industry leading telematics offerings, Drivewise and Milewise, to further improve our value proposition and improving its pricing expectations. We're the only company that major companies selling Milewise, which is very attractive to customers today because they're not driving as much. Our goal is not just to execute this plan but to continually generate transformational growth. We have the brand, market position, resources, capabilities and strategy to deliver this for shareholders. An extensive Allstate agent platform delivers more value per dollar to customers and competitors; a direct business utilizing the Allstate brand, competitive prices, broad product offerings and our insurance expertise; an independent agent business with national distribution and strong position in both auto and homeowners insurance; and protection services with innovative business models and expanding total addressable markets. We're well on our way to achieving this goal after putting the foundational elements into place last year. Let's move to Slide 4 to discuss Allstate's excellent financial performance in 2020. Revenues of $12 billion in the fourth quarter increased 4.8% to the prior year quarter, with total revenues for the year reaching $44.8 billion, which is primarily driven by higher premiums earned, which is partially offset then by lower net investment income. Net income was $2.6 billion for the fourth quarter and $5.5 billion for the full year 2020. Adjusted net income was $1.8 billion or $5.87 per diluted share in the fourth quarter. For the full year, adjusted net income increased to $4.6 billion or $14.73 per diluted share. We had strong profitability in both auto and homeowners insurance. Adjusted net income return on equity is 19.8% over the last 12 months, exceeding our range of 14% to 17%, which is near the top of the insurance industry. Now I'll turn it over to Glenn to discuss the transition of the property liability businesses to higher growth.
Glenn Shapiro: Thanks, Tom. Let's go to Slide 6. We'll discuss how Allstate is increasing property liability market share while maintaining attractive returns. With the foundational work completed in 2020, Allstate is positioned to grow market share in '21 while developing a leading position in all three primary distribution channels in property liability. Some of the actions taken in '20 have impacted growth in the near term but they were critical to advancing transformative growth in the longer term. Starting with Allstate exclusive agents who serve customers that value local advice and relationships, we're focused on accelerating growth and improving efficiency. Allstate agents continue to be a core strength of our organization. We're further strengthening that model by focusing on new business growth and lowering costs by improving marketing effectiveness, centralizing customer services and enhancing customer connectivity. Leveraging Esurance's direct capabilities under the Allstate brand, we've created an omnichannel experience that meets the customer where, how and when they want to interact with us. We completed the integration of direct processes and systems in 2020 and expect direct sold business to continue to accelerate. As Tom mentioned, National General is another exciting growth platform for us. I mean National General's independent agent facing technology, it's among the best in the industry and then our combined agency footprint covers the vast majority of the US market. So as we expand products on the National General platform, we're going to be in a position to grow share in the IA channel. The totality of this go to market model with strong capabilities in each distribution channel is designed to generate higher growth. Allstate's leading pricing and claims capabilities, including our strength in telematics, puts us in a strong competitive position. We're also enhancing our price competitiveness while maintaining attractive returns. The impact of the pandemic on miles driven and lower costs for auto losses gave us an opportunity to improve auto affordability through targeted rate reductions. We've also lowered underwriting expenses, as Tom mentioned. They're down 1.9 points over the last two years when excluding restructuring and coronavirus related expenses. These efficiencies and continued cost structure reductions allow us to improve pricing relative to competitors while generating excellent returns. Allstate has a strong record of profitability across lines of business and in different market conditions. The average combined ratio in auto insurance over the last five years was 94.4, and that excludes, obviously, 2020 results, which were influenced by the pandemic. We're equally strong at homeowners, where we averaged a combined ratio of 89.5 over the last five years. And that reflects the higher cost of capital or the higher capital requirements, I should say, in homeowners product versus auto. The point is we expect to grow and we expect to earn really attractive returns. So let's go to Slide 7, and we're going to discuss National General, the acquisition in a little more detail. On January 4th, Allstate closed the $4 billion acquisition of National General. We are incredibly excited about the opportunity ahead with National General and how this advances our strategy to grow personal lines. And it gives us an estimated increase of over 1 percentage point of total personal property liability market share. Allstate is now a top five personal lines carrier in the IA channel with significantly better competitive position. We utilize National General as our independent agent platform by consolidating our encompass and Allstate independent agency operations into the new entity, which will be branded National General and Allstate company. We expect to grow by rolling out new standard auto and homeowners insurance offerings starting later this year and completing countrywide deployment in less than two years. Consistent with past acquisitions, we've developed measures of success and we're showing those in the bottom of this slide. First, we expect the acquisition to be accretive with growing earnings, adding to returns and total profit. Second, we expect to achieve synergies by consolidating the three IA channel businesses into one, improving our competitive position. Third, we'll grow IA channel policies in force by broadening the product offering to fully meet customer needs for auto, home, other personal lines and from nonstandard to middle market to mass affluent. We'll continue to provide updates on our success in this channel as we report our National General brand results in the first quarter. Moving to Slide 8, let's go deeper into how we've strengthened Allstate branded property liability distribution. As we said before, some of the actions we took in 2020 negatively impacted near term growth while accelerating it in other areas. We supported Allstate agents to increase new business growth in 2020 with the exception of March and April, the beginning of the pandemic when things slowed down. At the same time, we stopped appointing new Allstate agents while higher growth and lower cost models are being developed, and that had a negative impact on new business. And as Tom mentioned earlier, we expect the new models are going to create learnings that enable our existing agents to achieve higher growth too. The chart on the lower left breaks down Allstate's personal auto new business applications compared to the prior year. If you exclude the declines in March and April due to the pandemic, Allstate brand new business increased with an improving trajectory throughout the year. The red bar on the far left of the chart shows the estimated unfavorable impact of the pandemic on new business in March and April. Moving to the right, you can see the negative impact of stopping new agent appointments during 2020, but that was partially offset by an increase in existing EA production. And that shows the viability of growth with those existing agents when we just made a slight compensation change towards new business from renewal. They just have a great opportunity to grow. Moving to the center of the chart. The total direct channel increased compared to prior year, and this is the combined Allstate and Esurance view. And it's because Allstate brand direct applications more than offset the decline in Esurance brand, that reflects the redirection of branding investments and resources from Esurance to Allstate brand. We expect continued growth in the direct channel as we optimize web and call center sales capabilities. A relatively small number of independent agents operate under the Allstate brand and had a small positive impact on overall growth but a really nice percentage increase among that group. And it highlights the growth opportunity we have going forward in the IA channel as we transition those appointments to National General over time, expand National General's product offerings upmarket and endorse the brand as an Allstate company. The overall Allstate and Esurance policies in force maintained prior year levels in 2020 as we manage through significant change in our operating model and had a small decrease in retention levels, which you can see all of that in the lower right. Total property liability policies in force declined slightly driven by the Encompass brand, which will be integrated in the National General's platform in 2021. Now I'll turn it over to Mario to discuss the rest of our quarterly results.
Mario Rizzo: Thanks, Glenn. Let's turn to Slide 9 to discuss the performance of our property liability business. Property liability results remained strong with excellent recorded and underlying profitability. Net written premium declined in the fourth quarter by 1.5%. While homeowners premium grew 3.2% from the prior year quarter due to average premium and policy growth, this was more than offset by a modest decline in auto insurance premiums, driven by premium refunds. Underwriting income of $1.4 billion in the fourth quarter and $4.4 billion for the full year increased relative to the prior year by $420 million and $1.6 billion respectively. As shown in the chart on the lower left, the recorded combined ratio of 84 in the fourth quarter improved 4.7 points compared to the prior year. This improvement was primarily attributable to a lower underlying loss ratio in auto insurance, driven by fewer auto accidents, partially offset by higher auto insurance claim severity and a slightly adverse underlying loss ratio in homeowners insurance compared to prior year. Homeowners continues to generate attractive returns with a recorded combined ratio of 78.5 in the fourth quarter and 90 for the full year 2020. Additionally, the underlying combined ratio performance has consistently achieved our low 60s target, which speaks to our expertise in managing this business. Favorable underlying loss ratios were partially offset by higher catastrophe losses along with restructuring charges related to transformative growth. The underwriting expense ratio improved 0.2 points compared to the prior year quarter, which reflects a 0.6 point improvement in the expense ratio, excluding restructuring costs, partially offset by 0.4 points of restructuring. As you can see from the chart on the bottom right, when excluding restructuring charges and impacts from actions taken as a result of coronavirus, the expense ratio improved 1 point in 2020 and 1.9 points over the past two years, demonstrating continued progress toward the goal of reducing our cost structure to maintain returns while improving the competitive price position of auto insurance. Shifting to Slide 10. Let's discuss protection services, which were formerly known as our service businesses. Protection Services revenues, excluding the impact of realized gains and losses, increased 17.5% to $497 million in the fourth quarter, reaching $1.9 billion for the full year. Allstate Protection plans continued to deliver significant growth, ending the year with nearly $1 billion in revenue. Policies in force increased 28.6% to $136 million, driven by Allstate Protection plans. As shown in the table on the bottom right, adjusted net income was $38 million in the fourth quarter and $153 million for the full year, representing increases compared to the prior year of $35 million and $115 million respectively. The increase in both periods was driven by growth of Allstate Protection plans and improved profitability at Allstate Roadside Services. Now let's turn to Slide 11, which highlights investment performance for the fourth quarter. The chart on the left shows net investment income totaled nearly $1.2 billion in the quarter, which was $502 million above the prior year quarter, driven by higher performance based income. Performance based income totaled $557 million in the fourth quarter, as shown in gray, primarily from higher private equity valuations and gains from sales of underlying investments. Market based income, shown in blue, was $63 million below the prior year quarter. With lower interest rates, our reinvestment rates remain below the average interest bearing portfolio yield, reducing income. GAAP total returns are shown in the table on the right. Our 2020 portfolio return totaled 7.1%, reflecting income generation and higher fixed income and public equity valuations. Our performance based investment return was 7% for the quarter and 4.9% for the full year. Our performance based strategy has a longer term investment horizon and higher but more volatile return expectations compared to the market based portfolio. The compound annual rate of return on the performance based portfolio is 8.8% over the past five years, as shown in the bottom right of the table, exceeding the market based portfolio return by 330 basis points. Let's move now to Slide 12 and review results for Allstate Life, Benefits and Annuities. Allstate Life, shown on the left, recorded adjusted net income of $56 million in the fourth quarter, $20 million below the prior year, primarily driven by higher contract benefits as coronavirus death claims totaled approximately $30 million in the quarter. Allstate Benefits adjusted net income of $34 million in the fourth quarter was $18 million higher than the prior year quarter, reflecting lower benefit utilization, likely due to the coronavirus and the nonrenewal of a large underperforming account in 2019. Allstate Annuities had adjusted net income of $160 million in the fourth quarter, attributable to strong investment income generated from the performance based portfolio. Starting in the first quarter of this year, the majority of the Allstate Life and Annuities business will be classified as held for sale on our balance sheet and results will be presented as discontinued operations following our recently announced agreement to sell Allstate Life Insurance company. Now let's move to Slide 13, which highlights Allstate's attractive returns and strong capital position. Allstate continued to generate returns that are among the highest in the insurance industry with an adjusted net income return on equity of 19.8%. Excellent capital management and strong cash flows have enabled Allstate to return cash to shareholders while simultaneously investing in growth, a capital deployment strategy which leads to increased shareholder value. Investing in growth opportunities remains a priority, as evidenced by our investments in building higher growth models and completing the $4 billion acquisition of National General. We also continue to provide cash returns to shareholders. In September, Allstate executed a $750 million accelerated share repurchase agreement. And upon completion on January 12, $1.45 billion remains on the $3 billion common share repurchase authorization, which we expect to complete by the end of 2021. We returned $2.4 billion to common shareholders in 2020 through a combination of $1.7 billion in share repurchases and $668 million in common stock dividends. Last week, we announced the pending sale of Allstate Life Insurance company which will enable us to redeploy up to $2.2 billion of capital out of lower growth and return businesses with minimal impact to our two part strategy. With that context, let's open up the line for questions.
Operator: [Operator Instructions] Our first question comes from the line of Josh Shanker from Bank of America.
JoshShanker: One thing that really didn't get expressed maybe you can talk about is the extent to which we're seeing buydowns to like pay per mile products and whatnot, or unbundling is going on that you're keeping the homeowners and not the auto. To what extent is it customer being shrinking their wallet with Allstate taking place in this transition?
TomWilson: Josh, this is Tom. I'll start and then get Glenn to talk a little bit about Milewise and our success there. First, we don't really see an unbundling. I know you mentioned that in your report. Our actually bundling percentage went up. That doesn't mean that it's not happening and we just don't see it, but we're seeing our bundling actually go up, as it relates to the buying down and sort of getting lower average premium. I think what you're seeing is through telematics is more accurate prices, the way I would describe it. And so if you look at the total revenues we take in and then what we pay out, we, as Glenn showed, consistently made money in auto insurance for a long period of time. That will change by customer. So if somebody gets Milewise and they only drive 2,000 miles a year and pay less, then there will be somebody else who will have to charge more. So we maintain that overall profitability. So we see it as a good thing that people get the most accurate price, particularly since we're more sophisticated than most of the industry, and we have some of the tools like telematics. Glenn, what would you add to either bundling or telematics?
GlennShapiro: I think on the bundling side, I would look at as it actually -- I'd flip it the way Tom did there, we’re actually seeing some increase in bundling, and I think that's helping our homeowners. So part of the story and the homeowners growth, it's only part because we got a lot of good parts of the story and homeowners there is bundling. In terms of Milewise and Drivewise, I'll talk about both of them, we definitely see increased demand. So right now, we have Milewise available to 45% of the market and we're continuing this year to roll out to more states. And we have Drivewise just about everybody is one state that doesn't allow it. But the demand for telematics has gone significantly up. Milewise, for example, admittedly a relatively small base, but was up 35% in terms of sales. So people are looking at the pandemic. They're not driving as much. We're advertising it a little bit. And we're getting a lot of people interested in the notion of pay by mile. From a Drivewise standpoint, most people really want to now include the telematics as part of their offering from us. So we're seeing a nice upswing on the demand post pandemic.
JoshShanker: I'm going to try and digest all that and figure out how it works. If we can go to the slides you prepared on Page 8, you have this very interesting slide about new issued applications. I'm trying to understand it a little bit better. First of all, when it says Allstate brand direct submissions were up but Esurance was down. Is that four months of Allstate brand direct and eight months of Esurance? When we should think about that, that not only is Allstate brand bring in more customers than Esurance but it's a smaller time line. Is this the right way to think about that?
TomWilson: No, those numbers are for the entire year. And what we're trying to show there is that we've successfully made the transition to the Allstate brand selling direct, both operationally, which wasn't simple, by the way, in terms of changing web flows and all kinds of other stuff. They're getting the branding changed and putting the price discount in if you buy direct under the Allstate brand because it doesn't come with an agent. So we've made that change. And what that shows is that overall, we grew. We did keep selling some under the Esurance brand those companies because they're open, people call, get on our Web site, they track their way down to it. So it's really low cost business. So we didn't completely shut off, Josh, the Esurance. So you can still buy. Over time, it will go away as we cut advertising it and quit doing and people could come into that Web site. So what it's really trying to show there is that we've made the turn indirect, and we feel good about our ability to operate under 1 brand, and there were many people who didn't think that was possible, whether that was perceived channel conflict or just operational capabilities.
JoshShanker: And then on the EA channel part, a significant portion of annual new policies coming through the EA channel coming from new appointments? If we don't do a lot of new appointments going forward, should we expect that's a multiyear issue in terms of growth in the EA channel?
TomWilson: I don't think you should think it's a multiyear issue. Obviously, Glenn mentioned we are working on creating some new higher growth models, and he can talk you through that in a second here. The part that may not be as obvious is putting Allstate agents onboarding with the old model, the commissions were substantially higher than you pay to an existing agent. And the idea being if you open an office and you got nobody coming in you sell the first policy, you need to make some money, and the commissions were quite high there. What Glenn is working on is coming up with a model where an agent can build the business and be successful without us having to incur the additional cost upfront to build it, which kind of rolled out over three to five years, it was expensive. And so what we thought -- what we made was the economic choice, which was save shareholder money, don't keep investing in a model that you think you get a better one for and then make sure the existing agents continue to grow. Glenn, do you want to talk about the new agents and then what you've done with the existing agents as well?
GlennShapiro: And I always want to emphasize on this. Our exclusive agents are a huge strategic advantage for us and a core capability for Allstate. As much as we talk about and I'm excited about the direct growth and what we can do in the independent agent channel, a large, large channel out there and a lot of customers really like to go to a local agent and a branded agent like an Allstate agent to go there. So it's a great model for us and we want those agents to keep winning. So what we've done with existing agents is, as you know, we've shifted compensation a little bit, we've motivated more on the new business side than just on the renewal side. But we're also working with them on the way we market. We're putting more money into marketing. We really want them to be successful. From a new agent standpoint, we've got a few models in market right now. And without going too detailed into it, the general theme would be, if you think about the virtual world we're operating in, can you have a local agent that doesn't really require brick and mortar? And we think the answer is yes to that. That there's an opportunity for agents to be a local point of sale, people who are active in the community, people who have relationships locally and sell through those relationships in their communities, but don't necessarily have a staff and have a brick and mortar office where we perform the back end service in a more centralized way. It's a significantly lower cost model to get started, as Tom mentioned, and one that we're pretty bullish on our ability to scale.
Operator: Our next question comes from the line of Greg Peters from Raymond James.
GregPeters: My first question is around price and competitive positioning. Obviously, we're listening to when watching the new products that you're rolling out the product enhancements and the focus on profitable growth. Your underlying combined ratio for the year is 79.3% is obviously a very excellent result. But do you think that your price for your Allstate brand auto is competitive in the marketplace considering how profitable the business is at the moment?
TomWilson: The answer is yes. That we think we can be even more competitive. It's a complicated question, of course, because with billions of price points, and some segments you're not competitive at all because you don't want to be competitive because you think that somebody else is under charging and other places you want to be competitive. And the trick is where you want to be competitive, to be competitive enough to win the business but not so competitive that you're giving away margin. And so we have a very sophisticated approach of doing that. We do think that we can change our pricing so we can be more competitive overall. But yes, we look at our close rates and we're right in the market. And that depends how we carry ourself too. So if you look at us versus other people who have exclusive agents [Technical Difficulty] in general, we're very competitive. If you look at us versus direct, I'd say we're less so, which is why we made the change to put in a direct discount on that business. So we are more competitive because people are not getting an agent, they don't want to pay for one. So I would say we're highly competitive. That said, I think we can always be better. And when you look at what drives customers’ purchase price, a lot of it's the price, now you got to make sure you make enough money. And that's the trick. Glenn, anything you would add to that?
GlennShapiro: Just a couple of things, I'll hit there. One would be, you mentioned, Tom, that close rates, like so we keep a really close eye and our close rates and our close rates have improved. Our new business is up. I mean you look at -- you're talking, Greg, auto but I'll say, auto and home, we were up 2% and 8% respectively, between on new business. So folks are buying the product and you really can't sell the product if you're out of the market from a competitive standpoint. So those are good signs that we are, but we're working to get more competitive. And the last point I'll make with it is, I always go back to this. We manage state by state. We have a talented group of state managers that like they've got their hands on the lever in each state and they're looking at the competitive position, specifically in that market. And as Tom said, on which types of business are we more or less competitive on younger drivers, older drivers, homeowners, not homeowners, married, not married all, all the different components in there, and they're pulling those levers and getting us as competitive as we can be while earning attractive returns.
GregPeters: I'd like to pivot to the expense ratio. I think the chart you put on Slide 9 of your presentation and very strong improvement from 2018 to 2019 to 2020. So two part questions with the result and then going forward. How much of the 23.2 is benefited from reduced T&E because of lockdown? Or look at a different way, I know you've been focused on integrated services platform and other tools. Is it an expectation that you can drive further improvement in '21 and the expense ratio?
TomWilson: So Mario has been our lead on cost reduction. Mario, do you want to take that?
MarioRizzo: When you look at the expense ratio for the year and the improvements we made, we came into the year really focused on taking cost out of two principal areas. One was acquisition related costs and the other one was operating costs, which your T&E component is a part of that but those are people related costs and operations and those types of items. And that's really what's driven the improvement, once you take the noise of restructuring and pandemic related costs out of the equation. The improvement we've seen this year has really come from those two principal areas. We've actually spent a little more on marketing, like we said we would as well, but our reductions in those two areas have really created the space for us to increase our growth related investments. As we go forward, as we've said on past calls, our focus is on continuing to drive our cost structure down because it is a core part of our growth strategy. It's how we're going to be able to continue to improve our competitive positioning in terms of auto insurance pricing and continuing to deliver really attractive returns. So that's a core part of our strategy and our focus is to continue to drive that ratio down.
Operator: Our next question comes from the line of David Motemaden from Evercore ISI.
DavidMotemaden: Just a question, and I believe on one of the slides, you had just talked about how you had 94.4 average combined ratio in the auto business over the last five years excluding 2020. Obviously, 2020 is an abnormal year. But is that sort of a level you're comfortable getting back to in order to return to growth? And I guess, what sort of level are you willing to let that go to in order to accelerate growth?
TomWilson: I think I would go up all the way up to the top and say that what we said is we can grow the market share on personal property liability and as a company we'll deliver 14% to 17% return on equity. And we believe that will drive lots of shareholder value, both in terms of economic value creation and valuation multiples. When you look specifically at the components of that, we have a headwind in investment income with low interest rates. We do have and have had for a long time great profitability in auto insurance. We would have put a longer period of time in there, but the pension accounting kind of changed the way we did it. But we've been earning great returns in the auto insurance business for a long time and expect to continue. At a 94, you still earn a really attractive return on equity because you don't have to put up as much capital on that line and some other lines. And so 94 would be the book -- we like to make as much money as we can and grow as fast as we can, and it's really about how do you drive net present value to the whole company. So we don't publish and have a target of safety there. But 94 would be a return I would be highly comfortable with. I'd be comfortable at 93, I'd be comfortable with 95. They're all really great returns. The other part to focus on is homeowners insurance where that's a higher capital return business and so we have a lower combined ratio there. And we're 10 to 15 points better than another large public competitor, which is somewhere between $700 million and $1 billion a year of profit. So we think all of those then add up to 14% to 17% return. So we're comfortable we can grow the business and earn good returns. And it will bounce around, as you mentioned this year, frequency went way down. So we made a bunch more money. If frequency goes back up, we'll just have to raise our prices up. And the question is are you good at it. And the point of putting those two statistics on the bottom of that page was just to give our shareholders comfort that we have a history of managing returns and profitability, and we expect to continue to do it. Not going to be the same every year because the world changes but we know how to make money.
DavidMotemaden: And I guess just maybe switching gears a little bit to the new appointed agents, and thanks for the slide on Slide 8, that was very helpful. Some encouraging trends there. I guess I just wanted to ask on the new agents and appointments. Do you expect that to still be a drag in '21 or is that something that will turn from a drag to an addition to new apps and to growth? Or is that something that you expect to still be a little bit of a drag as these new models ramp up?
Tom Wilson: I'll make some overall comments, and then Glenn, you may want to make some comments. First, I would say that when you do these year-over-year comparisons and sometimes I feel like the external view of the company, you just look one year. And so next year, obviously, we won't have had them much for this year. So I would actually be a negative versus the prior year. That said, I think the transition of Allstate agents to higher growth and lower cost will have some bumps in it. That said, as you see, when the people we focus on, the existing agents that are doing well, they know how to grow. They know their local market, their aggressive salespeople, they have aggressive salespeople working for them. And so I don't know that it's as simple as like that's now gone and we get the new one. The new one we think should add additional volume for us, and Glenn can talk about how that will roll out. And then at the same time, the beauty of our strategy is as direct grows it keeps our advertising money highly effective because if we're not closing enough because through some agent changes, we can close more in direct. So we have a fallback. We don't think we need it but we got plenty of opportunity to balance between those. Glenn, do you want to talk about the -- I think the view is on the agents, we have a ways to go to actually figure it all out, but we're making good progress.
GlennShapiro: I think if you think about that chart and you look across at the direct part, too, I think it's a similar story. I think 2020 is a story really good success. We've built the foundation in that year and actually managed to grow more on the Allstate side than we lost on the Esurance side. And so that's sort of an ideal scenario that while you're in the midst of the muck and the mire of making a change like that, that you actually are able to grow it. We absolutely are making that type of change within the EA system. As we've said, we've got a lot of agents out there that are phenomenal at what they do and they grow and we're going to invest with them and have them be successful, then we have a new model upcoming. I think the way to look at this is to across all three channels. With EAs, we will ramp up some time later this year some new models and through next year. And so there's that coming as well as work with the existing EAs that really know how to grow. With direct, we've really done a lot of the heavy lifting of making the transition and we should be able to continue to grow, and we're very confident in our ability to continue to grow it. With IA, which is really, for all intents and purposes, a bit of a new channel for us. I know we've had Encompass in the small Allstate independent agents in there. But really jumping into the top five will start like the first state will roll out in the third quarter of this year with new products going upmarket on the National General platform, National General and Allstate company platform, and then multiple states per month and like we'll be finished with the rollout across all 50 states through 2022. So you can kind of see all of these things coming together, and we're building a long term and sustainable growth platform across all of the channels.
DavidMotemaden: And I think the new agent, the new EA agent strategy is -- I mean, it sounds actually really promising. I guess one question I have is, are those new agents -- I guess, the more remote exclusive agent, are they as productive as under the old brick and mortar model?
TomWilson: I would say we don't know yet. But we do think it will be lower cost, if you want to look at it that way. You might have to have more people doing it. And then, David, you get a little bit of math because the existing agents also have salespeople in their office. So when you do it by agent but then these people might be so low producers. So net-net, we think we know over half the people want to buy from a person and having a person local is good. It's just the way we've traditionally done it hasn't given us as much growth and it's costs don't need to be as high as they are today.
Operator: Our next question comes from the line of Michael Phillips from Morgan Stanley.
MichaelPhillips: You guys mentioned the impact on the end of the payment plans and the pandemic and retention and growth in the quarter. I guess, Part A of this, is there any way to quantify that? And what I want to get at is, if so, how much -- given that the EA is still in the bulk of your business, how much of was there a drag on retention because of things that you're doing with commissions and emphasis on direct and everything else that's going on? So can we quantify that impact, one and then how much of an impact if everything else was on retention?
TomWilson: Well, Glenn can give you some detailed specifics on the year. Of course, retention is always hard to figure out, because you have a bunch of stuff going on, you have people changing lifestyle, not driving as much, some people shopping more, you have competitive moves, you have things that we did like shelter in place, payback and payment plan forgiveness -- not forgiveness, we just let you defer. And so as those things roll through the system, it's hard to do attribution on it. That said, it was down this year, which of course we're focused on. Our Net Promoter Score really peaked throughout the year. We got peaked in about July when we were doing all the shelter in place paybacks, it came down a little bit towards the end of the year, but not anything of any consequence or significance. Glenn, do you want to make a comment about the actual retention numbers?
GlennShapiro: Yes. I don't know I can add a lot to what you said, Tom. I think you hit it well. I mean the retention is in a decent range right now. So it's off of our highs that we hit. But we're within a long term window on retention of where we've operated and certainly, all the things that Tom mentioned had a drag on it. We know that the coming due of special payment plans had some drag on it, and the competitive environment. We know that there were some competitors out there that took some rate down. We also know that people facing financial hardship either shop, some people even give up a car. So all of those things have some play in it. And as you said, Tom, the attribution is next to impossible on that. But we're within a decent range of our long term retention and we're focused on it. And of course, we want to retain every customer that we work hard to get in the first place.
TomWilson: And I think if -- the underlying question there was are existing agents performing well enough to keep retention levels up or somehow made a mat or something like that, our answer there would be no. We don't see anything in there that says that existing agents are doing anything that they haven't done before, that they're not stepping up and helping their customers even more in the pandemic. I mean they really reached out tons of calls on shelter in place and the payment plans and that kind of stuff. So our agents were doing a great job. I don't think there's anything structurally in there as it relates to this transition that says we're not -- and I would point out that, that's a huge part of agent compensation. So their interests are aligned with our interest, which is keeping our customers happy.
MichaelPhillips: Second question, still on kind of channel mix, near term and longer term question. In the near term, I guess, just this year, you talked about a 1 point change in market share. Should we expect that to be kind of even throughout the year or more back half weighted in terms of that market share shift? And then longer term, more interested in maybe 10 years down the road, what does Allstate look like? How does this mix look, a third, a third, a third or something still weighted towards EA and IA?
TomWilson: We closed National General on January 4th. So that in and of itself means we'll get that revenue for the entire year. So you should expect to see total auto premiums go up throughout the year. We would expect that as we continue to roll out things in the Allstate brand that we start to see some more growth in that business over time. And yes, but we don't really give it out even do it by quarter, just as much as you can. In terms of the long term, we'll take anybody we can get. So we have one out of 10. We still got nine out of 10 to go. I'd be happy if all of them got a lot bigger and that's what we're setting up to do. So we don't have a percentage. When you look at percentages from what customers want, it's probably today, 25% of the customers really prefer self serve and it's a range. If you look at those who want an agent, it's over 50% and usually around 65% or about 60%. And then in between, you have people who are sort of -- they go with whatever is in front of them and they're indifferent. So we think there's plenty of opportunity to grow. Some of the shift you see in channels is really due to customers wanting it differently, like not feeling like they need help to buy the product. Some of the shift is just because direct companies have been advertising more. So you all loud enough and people come to you. So we think what we should do is give people exactly what they want, give them choice. And what they want with the person is really to help buy it. They need and want less help on service. And so the existing insurance agent businesses have been built on both. What we're trying to focus on is really helping them buy and then give them self serve or have computers do it or whatever to lower the cost on the service side because it's cheaper, better and faster. So we don't need to do as much local service as we do. So we'll take as many people as we can get through any channel.
Operator: Our next question comes from the line of Paul Newsome from Piper Sandler.
PaulNewsome: I was hoping you could maybe help us understand a little bit more about how the investment portfolio will look after the life sale? Will the P&C business kind of have a little bit of a different mix of assets and will that have an impact on the yield as well?
TomWilson: Paul, let me give you a slight overview from a corporate standpoint, and John can talk about the specifics. So obviously, the sale of Allstate Life Insurance company substantially reduces our investment portfolio as we exit a spread-based business. And the [Indiscernible] entity is taking almost all the assets that are used to asset liability match that business. They are not taking all of the performance based assets. So that increases the percentage relative to the overall portfolio, which also gets smaller. And we looked at it, obviously, prior to the sale. We're comfortable with the risk and return of it. You will remember that we reduced our equity holdings in February this year by $4 billion, not because of the Allstate Life sale but because we just didn't like the risk and return profile there. So we do make changes up and down. And this will still have the ability to go up and down even though this portion of the portfolio is less liquid than the public equity as a whole because we still have public equities we get high yields. We have a bunch of ways we can manage the overall risk of the portfolio, and we're very comfortable with where we'll be. John, do you want to talk specifically about [performance] basis?
JohnDugenske: When you look at performance space, too, it's part of a broader overall portfolio context. So while that percentage will go up, we look across risk and return factors across every security and every investment we hold and take it in its entirety. So as Tom mentioned, we have a lot of ways to compensate for additional risk we may take in one area. When you look at the performance space, this is a long term holding for us, we've looked at gradually growing that over multiple years. And in some ways, this just accelerates that gradual path that we're on. As we built this portfolio, we've always looked for the best partners and the best direct investments we can across private equity, real estate and other areas. And the assets that we'd be bringing on board are ones that we're already very familiar with. We already own them, obviously, and very familiar. So it accelerates our path forward in a way that we're quite comfortable with. And, I guess, I’d just finish by saying that the return on this has stood up quite well even in what's been a volatile year. We've been looking back at what our returns have been over the last five years and 10 years, and our performance based assets have fared quite well relative to public markets, and we think that it continues to be an integral part of the portfolio.
TomWilson: Jonathan, let's take one last question and then we'll wrap up to keep people on time.
Operator: Our final question for today then comes from the line of Gary Ransom from Dowling & Partners.
GaryRansom: I wanted to loop back on telematics. You mentioned increased demand for the product. A couple of questions there. Did that make any material difference to the growth in new business that you're seeing that roll forward you showed on Slide 8? And then secondly, whether the difference between your by the mile product and the standard product, whether the demand is different. And with that question, I'm really just trying to think ahead is to buy the mile product more the way of the future.
TomWilson: Gary, let me make a couple of comments. First, I don't believe it's actually driven people to us. So I think with our advertising when they get to us, and then we talk to them about it, so that's interesting. And what it enables us to is give them a more accurate price, which protects them competitively. So the more accurate the price they are -- if someone takes them away from us, and we're really accurate through a lower price, then they'll we think, lose money. And we won't lose people because we're overpriced for the risk. So it will drive more sustainability to growth as opposed to people calling us and saying, hey, I want to. That doesn't mean people don't see our ads and say, geez, I'm tired of paying this much for insurance, and I hardly drive sort cost. But I'm not seeing a big well spring of people saying cost, it tends to be more in the sale itself. In terms of a long-term basis, I think this is the way that pricing will be done. I mean insurers for a long time have been trying to get more and more accurate on the individual risk, particularly in auto insurance and home insurance for that matter, of course, going to telematics here. But as credit was a big move, I don't know, 15 or 20 years ago when we first got into that using stuff out of the credit file and is very powerful. This is very powerful, as powerful, not so much in the fat part of the curve, they're being moderate risk people. But in really low risk or really high risk people, it's very effective. So I think it will lead to more sustainable growth through better retention because we'll have a really accurate and competitive price.
GaryRansom: Can you also talk a little bit about how you might be using telematics on the claims side, whether that is developing or having much effect at this point?
TomWilson: Glenn, do you want to take that?
GlennShapiro: So we've got some capability there that is, I would call it, developing. And it's about accident notification. And I think this is -- Tom talked about it being the wave of the future for pricing, which I totally agree with from the telematics. I think it's going to be the wave of the future. When you think about connected cars, you think about our devices in OBD ports or even the mobile, there's accident detection through Arity through the mobile telematics. So early notification, emergency notification, first notice of loss taking are all areas in development, and I think will be a wave of the future.
TomWilson: Gary, I would expand on that and say, if you go to digital claims settlement, we believe we've been leading the industry, whether that's a quick photo claim, whether that's using algorithms to look at pictures and decide how you should settle the claim. I know another company is talking about going into a SPAC and raising some money. We've worked extensively with that company. We think our platform, our technology and the ability to utilize data will make us even better at settling claims. So it's not really related to telematics but it's really related to digitization of the business, which is another way that we're trying to change both our business model and really our culture, with just to drive that kind of growth. So thank you all for participating. We are trying to build really transformational growth business models. It's more than a plan. It's really a way of life. And we expect to deliver increased growth and earn good returns, which will both create economic value just because we make more money and should lead to higher valuation multiples. Thank you much. We'll talk to you next quarter.
Operator: Thank you, ladies and gentlemen, for your participation in today's conference. This does conclude the program. You may now disconnect. Good day. | [
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{
"speaker": "Mark Nogal",
"text": "Thank you, Jonathan. Good morning, everyone, and welcome to Allstate's fourth quarter 2020 earnings conference call. After prepared remarks, we'll have a question-and-answer session. Yesterday, following the close of the market, we issued our news release and investor supplement and posted today's presentation on our Web site at allstateinvestors.com. Our management team is here to provide perspective on these results. As noted on the first slide of the presentation, our discussion will contain non-GAAP measures for which there are reconciliations in the news release and investor supplement and forward-looking statements about Allstate's operations. Allstate's results may differ materially from these statements so please refer to the 10-K for 2019 and other public documents for information on potential risks. And now, I'll turn it over to Tom."
},
{
"speaker": "Tom Wilson",
"text": "Good morning, and thank you for joining us. Amidst the pandemic Allstate delivered really attractive returns while building higher growth business models in 2020, exceptional progress has made building higher growth business models to execute our strategy of increasing market share in personal property liability, and expanding protections offered to its customers. And as you know, one of our key focuses this year was transitioning the personal property liability business to higher growth. We took decisive actions and despite the operational complexity of these actions maintained Allstate brand property liability policies in force. We'll take you through a reconciliation of the various components of this and you'll see the path to growth. We've made excellent progress in expanding protection offered to customers with total policies in force increasing by 20.5% to nearly 176 million. We took advantage of the decline in auto accident frequency and our cost reductions to improve our competitive price position in auto insurance while maintaining attractive returns. The acquisition of National General is expected to increase auto insurers market share by 1 percentage point in 2021 and provides another platform for growth as we expand its product breadth. These changes position Allstate have sustainable long term growth. At the same time, Allstate generated strong profitability and returns in 2020. Net income was $2.6 billion in the fourth quarter and adjusted net income was $1.8 billion or $5.87 per diluted share. This was driven by lower frequency of auto accident, continued strong profitability of homeowners insurance and higher performance based investment income. Net income was $5.5 billion and adjusted net income was $4.6 billion for the year. This represents a 19.8% return on equity far in excess of most insurance companies. Our strategy is to increase market share in personal property liability while expanding protection services to customers will increase shareholder value. Higher property liability growth with attractive returns, rapidly growing protection services expand our total addressable market. And this growth, combined with our proactive capital deployment strategy, supports returns on equity above the insurance industry and are comparable to the S&P 500. Slide 3 is there to touch base on the strategy and so we're not going to spend time on that. So let's move to Slide 4 and discuss this strategy as it relates to the property liability business. A transformative growth has become more than a [plan], it's about creating a business model, capabilities and culture that continually transform to deliver market share growth. This is done by focusing on the customer, expanding access and improving value. Expanding access includes all the ways customers choose to interact, exclusive agents directly through call centers to the web and independent agents. The largest part of this change was transitioning our exclusive agent and direct businesses that operate under the Allstate brand. This gave us the ability to lower costs, leverage scale and increase advertising. This transaction is successfully being implemented, and we achieved key milestones in 2020. We were pleased with new business growth from existing Allstate agents who remain key to serving our customers and growing. Property liability business from existing agents met our goals, except for the pandemic slowdown in March and April where, of course, nobody was buying anything, as we shifted commission to new sales from retention. We're testing new agent models with less real estate and more efficient service enabled by technology with the goal of having strong local personal relationships with customers. These models will also create learnings to enable existing agents to achieve higher growth. As a result of that, we did stop appointing new Allstate agents in early 2020 while a higher growth in lower cost models being developed. This had a negative impact on points of presence and new business sales. At the same time, we increased direct sales. The net was that overall policies in force remained the same through the transition despite a drop in retention, which was concurrent with the ending of the special payment plans related to the pandemic. Glenn will take you through that reconciliation in a couple of minutes. The acquisition of National General in January also improves growth prospects. And as you know, this is essentially a reverse merger. The National General team is joining Allstate and they're consolidating our independent agent businesses, encompassing AIA into their operational and technology platform. Then we're going to be able to broaden National General's product portfolio using Allstate standard auto and homeowners insurance capabilities, which will create growth through independent agents. We also made great progress at improving customer value last year. From a customer value standpoint, we've maintained attractive margins through cost reductions while investing in growth. This includes improving the competitive price position of auto insurance through targeted rate reductions and a direct pricing discount. And while most of these changes are due to the lower frequency of auto actions, we are also reducing cost to ensure we continue to generate attractive margins. We're also expanding our industry leading telematics offerings, Drivewise and Milewise, to further improve our value proposition and improving its pricing expectations. We're the only company that major companies selling Milewise, which is very attractive to customers today because they're not driving as much. Our goal is not just to execute this plan but to continually generate transformational growth. We have the brand, market position, resources, capabilities and strategy to deliver this for shareholders. An extensive Allstate agent platform delivers more value per dollar to customers and competitors; a direct business utilizing the Allstate brand, competitive prices, broad product offerings and our insurance expertise; an independent agent business with national distribution and strong position in both auto and homeowners insurance; and protection services with innovative business models and expanding total addressable markets. We're well on our way to achieving this goal after putting the foundational elements into place last year. Let's move to Slide 4 to discuss Allstate's excellent financial performance in 2020. Revenues of $12 billion in the fourth quarter increased 4.8% to the prior year quarter, with total revenues for the year reaching $44.8 billion, which is primarily driven by higher premiums earned, which is partially offset then by lower net investment income. Net income was $2.6 billion for the fourth quarter and $5.5 billion for the full year 2020. Adjusted net income was $1.8 billion or $5.87 per diluted share in the fourth quarter. For the full year, adjusted net income increased to $4.6 billion or $14.73 per diluted share. We had strong profitability in both auto and homeowners insurance. Adjusted net income return on equity is 19.8% over the last 12 months, exceeding our range of 14% to 17%, which is near the top of the insurance industry. Now I'll turn it over to Glenn to discuss the transition of the property liability businesses to higher growth."
},
{
"speaker": "Glenn Shapiro",
"text": "Thanks, Tom. Let's go to Slide 6. We'll discuss how Allstate is increasing property liability market share while maintaining attractive returns. With the foundational work completed in 2020, Allstate is positioned to grow market share in '21 while developing a leading position in all three primary distribution channels in property liability. Some of the actions taken in '20 have impacted growth in the near term but they were critical to advancing transformative growth in the longer term. Starting with Allstate exclusive agents who serve customers that value local advice and relationships, we're focused on accelerating growth and improving efficiency. Allstate agents continue to be a core strength of our organization. We're further strengthening that model by focusing on new business growth and lowering costs by improving marketing effectiveness, centralizing customer services and enhancing customer connectivity. Leveraging Esurance's direct capabilities under the Allstate brand, we've created an omnichannel experience that meets the customer where, how and when they want to interact with us. We completed the integration of direct processes and systems in 2020 and expect direct sold business to continue to accelerate. As Tom mentioned, National General is another exciting growth platform for us. I mean National General's independent agent facing technology, it's among the best in the industry and then our combined agency footprint covers the vast majority of the US market. So as we expand products on the National General platform, we're going to be in a position to grow share in the IA channel. The totality of this go to market model with strong capabilities in each distribution channel is designed to generate higher growth. Allstate's leading pricing and claims capabilities, including our strength in telematics, puts us in a strong competitive position. We're also enhancing our price competitiveness while maintaining attractive returns. The impact of the pandemic on miles driven and lower costs for auto losses gave us an opportunity to improve auto affordability through targeted rate reductions. We've also lowered underwriting expenses, as Tom mentioned. They're down 1.9 points over the last two years when excluding restructuring and coronavirus related expenses. These efficiencies and continued cost structure reductions allow us to improve pricing relative to competitors while generating excellent returns. Allstate has a strong record of profitability across lines of business and in different market conditions. The average combined ratio in auto insurance over the last five years was 94.4, and that excludes, obviously, 2020 results, which were influenced by the pandemic. We're equally strong at homeowners, where we averaged a combined ratio of 89.5 over the last five years. And that reflects the higher cost of capital or the higher capital requirements, I should say, in homeowners product versus auto. The point is we expect to grow and we expect to earn really attractive returns. So let's go to Slide 7, and we're going to discuss National General, the acquisition in a little more detail. On January 4th, Allstate closed the $4 billion acquisition of National General. We are incredibly excited about the opportunity ahead with National General and how this advances our strategy to grow personal lines. And it gives us an estimated increase of over 1 percentage point of total personal property liability market share. Allstate is now a top five personal lines carrier in the IA channel with significantly better competitive position. We utilize National General as our independent agent platform by consolidating our encompass and Allstate independent agency operations into the new entity, which will be branded National General and Allstate company. We expect to grow by rolling out new standard auto and homeowners insurance offerings starting later this year and completing countrywide deployment in less than two years. Consistent with past acquisitions, we've developed measures of success and we're showing those in the bottom of this slide. First, we expect the acquisition to be accretive with growing earnings, adding to returns and total profit. Second, we expect to achieve synergies by consolidating the three IA channel businesses into one, improving our competitive position. Third, we'll grow IA channel policies in force by broadening the product offering to fully meet customer needs for auto, home, other personal lines and from nonstandard to middle market to mass affluent. We'll continue to provide updates on our success in this channel as we report our National General brand results in the first quarter. Moving to Slide 8, let's go deeper into how we've strengthened Allstate branded property liability distribution. As we said before, some of the actions we took in 2020 negatively impacted near term growth while accelerating it in other areas. We supported Allstate agents to increase new business growth in 2020 with the exception of March and April, the beginning of the pandemic when things slowed down. At the same time, we stopped appointing new Allstate agents while higher growth and lower cost models are being developed, and that had a negative impact on new business. And as Tom mentioned earlier, we expect the new models are going to create learnings that enable our existing agents to achieve higher growth too. The chart on the lower left breaks down Allstate's personal auto new business applications compared to the prior year. If you exclude the declines in March and April due to the pandemic, Allstate brand new business increased with an improving trajectory throughout the year. The red bar on the far left of the chart shows the estimated unfavorable impact of the pandemic on new business in March and April. Moving to the right, you can see the negative impact of stopping new agent appointments during 2020, but that was partially offset by an increase in existing EA production. And that shows the viability of growth with those existing agents when we just made a slight compensation change towards new business from renewal. They just have a great opportunity to grow. Moving to the center of the chart. The total direct channel increased compared to prior year, and this is the combined Allstate and Esurance view. And it's because Allstate brand direct applications more than offset the decline in Esurance brand, that reflects the redirection of branding investments and resources from Esurance to Allstate brand. We expect continued growth in the direct channel as we optimize web and call center sales capabilities. A relatively small number of independent agents operate under the Allstate brand and had a small positive impact on overall growth but a really nice percentage increase among that group. And it highlights the growth opportunity we have going forward in the IA channel as we transition those appointments to National General over time, expand National General's product offerings upmarket and endorse the brand as an Allstate company. The overall Allstate and Esurance policies in force maintained prior year levels in 2020 as we manage through significant change in our operating model and had a small decrease in retention levels, which you can see all of that in the lower right. Total property liability policies in force declined slightly driven by the Encompass brand, which will be integrated in the National General's platform in 2021. Now I'll turn it over to Mario to discuss the rest of our quarterly results."
},
{
"speaker": "Mario Rizzo",
"text": "Thanks, Glenn. Let's turn to Slide 9 to discuss the performance of our property liability business. Property liability results remained strong with excellent recorded and underlying profitability. Net written premium declined in the fourth quarter by 1.5%. While homeowners premium grew 3.2% from the prior year quarter due to average premium and policy growth, this was more than offset by a modest decline in auto insurance premiums, driven by premium refunds. Underwriting income of $1.4 billion in the fourth quarter and $4.4 billion for the full year increased relative to the prior year by $420 million and $1.6 billion respectively. As shown in the chart on the lower left, the recorded combined ratio of 84 in the fourth quarter improved 4.7 points compared to the prior year. This improvement was primarily attributable to a lower underlying loss ratio in auto insurance, driven by fewer auto accidents, partially offset by higher auto insurance claim severity and a slightly adverse underlying loss ratio in homeowners insurance compared to prior year. Homeowners continues to generate attractive returns with a recorded combined ratio of 78.5 in the fourth quarter and 90 for the full year 2020. Additionally, the underlying combined ratio performance has consistently achieved our low 60s target, which speaks to our expertise in managing this business. Favorable underlying loss ratios were partially offset by higher catastrophe losses along with restructuring charges related to transformative growth. The underwriting expense ratio improved 0.2 points compared to the prior year quarter, which reflects a 0.6 point improvement in the expense ratio, excluding restructuring costs, partially offset by 0.4 points of restructuring. As you can see from the chart on the bottom right, when excluding restructuring charges and impacts from actions taken as a result of coronavirus, the expense ratio improved 1 point in 2020 and 1.9 points over the past two years, demonstrating continued progress toward the goal of reducing our cost structure to maintain returns while improving the competitive price position of auto insurance. Shifting to Slide 10. Let's discuss protection services, which were formerly known as our service businesses. Protection Services revenues, excluding the impact of realized gains and losses, increased 17.5% to $497 million in the fourth quarter, reaching $1.9 billion for the full year. Allstate Protection plans continued to deliver significant growth, ending the year with nearly $1 billion in revenue. Policies in force increased 28.6% to $136 million, driven by Allstate Protection plans. As shown in the table on the bottom right, adjusted net income was $38 million in the fourth quarter and $153 million for the full year, representing increases compared to the prior year of $35 million and $115 million respectively. The increase in both periods was driven by growth of Allstate Protection plans and improved profitability at Allstate Roadside Services. Now let's turn to Slide 11, which highlights investment performance for the fourth quarter. The chart on the left shows net investment income totaled nearly $1.2 billion in the quarter, which was $502 million above the prior year quarter, driven by higher performance based income. Performance based income totaled $557 million in the fourth quarter, as shown in gray, primarily from higher private equity valuations and gains from sales of underlying investments. Market based income, shown in blue, was $63 million below the prior year quarter. With lower interest rates, our reinvestment rates remain below the average interest bearing portfolio yield, reducing income. GAAP total returns are shown in the table on the right. Our 2020 portfolio return totaled 7.1%, reflecting income generation and higher fixed income and public equity valuations. Our performance based investment return was 7% for the quarter and 4.9% for the full year. Our performance based strategy has a longer term investment horizon and higher but more volatile return expectations compared to the market based portfolio. The compound annual rate of return on the performance based portfolio is 8.8% over the past five years, as shown in the bottom right of the table, exceeding the market based portfolio return by 330 basis points. Let's move now to Slide 12 and review results for Allstate Life, Benefits and Annuities. Allstate Life, shown on the left, recorded adjusted net income of $56 million in the fourth quarter, $20 million below the prior year, primarily driven by higher contract benefits as coronavirus death claims totaled approximately $30 million in the quarter. Allstate Benefits adjusted net income of $34 million in the fourth quarter was $18 million higher than the prior year quarter, reflecting lower benefit utilization, likely due to the coronavirus and the nonrenewal of a large underperforming account in 2019. Allstate Annuities had adjusted net income of $160 million in the fourth quarter, attributable to strong investment income generated from the performance based portfolio. Starting in the first quarter of this year, the majority of the Allstate Life and Annuities business will be classified as held for sale on our balance sheet and results will be presented as discontinued operations following our recently announced agreement to sell Allstate Life Insurance company. Now let's move to Slide 13, which highlights Allstate's attractive returns and strong capital position. Allstate continued to generate returns that are among the highest in the insurance industry with an adjusted net income return on equity of 19.8%. Excellent capital management and strong cash flows have enabled Allstate to return cash to shareholders while simultaneously investing in growth, a capital deployment strategy which leads to increased shareholder value. Investing in growth opportunities remains a priority, as evidenced by our investments in building higher growth models and completing the $4 billion acquisition of National General. We also continue to provide cash returns to shareholders. In September, Allstate executed a $750 million accelerated share repurchase agreement. And upon completion on January 12, $1.45 billion remains on the $3 billion common share repurchase authorization, which we expect to complete by the end of 2021. We returned $2.4 billion to common shareholders in 2020 through a combination of $1.7 billion in share repurchases and $668 million in common stock dividends. Last week, we announced the pending sale of Allstate Life Insurance company which will enable us to redeploy up to $2.2 billion of capital out of lower growth and return businesses with minimal impact to our two part strategy. With that context, let's open up the line for questions."
},
{
"speaker": "Operator",
"text": "[Operator Instructions] Our first question comes from the line of Josh Shanker from Bank of America."
},
{
"speaker": "JoshShanker",
"text": "One thing that really didn't get expressed maybe you can talk about is the extent to which we're seeing buydowns to like pay per mile products and whatnot, or unbundling is going on that you're keeping the homeowners and not the auto. To what extent is it customer being shrinking their wallet with Allstate taking place in this transition?"
},
{
"speaker": "TomWilson",
"text": "Josh, this is Tom. I'll start and then get Glenn to talk a little bit about Milewise and our success there. First, we don't really see an unbundling. I know you mentioned that in your report. Our actually bundling percentage went up. That doesn't mean that it's not happening and we just don't see it, but we're seeing our bundling actually go up, as it relates to the buying down and sort of getting lower average premium. I think what you're seeing is through telematics is more accurate prices, the way I would describe it. And so if you look at the total revenues we take in and then what we pay out, we, as Glenn showed, consistently made money in auto insurance for a long period of time. That will change by customer. So if somebody gets Milewise and they only drive 2,000 miles a year and pay less, then there will be somebody else who will have to charge more. So we maintain that overall profitability. So we see it as a good thing that people get the most accurate price, particularly since we're more sophisticated than most of the industry, and we have some of the tools like telematics. Glenn, what would you add to either bundling or telematics?"
},
{
"speaker": "GlennShapiro",
"text": "I think on the bundling side, I would look at as it actually -- I'd flip it the way Tom did there, we’re actually seeing some increase in bundling, and I think that's helping our homeowners. So part of the story and the homeowners growth, it's only part because we got a lot of good parts of the story and homeowners there is bundling. In terms of Milewise and Drivewise, I'll talk about both of them, we definitely see increased demand. So right now, we have Milewise available to 45% of the market and we're continuing this year to roll out to more states. And we have Drivewise just about everybody is one state that doesn't allow it. But the demand for telematics has gone significantly up. Milewise, for example, admittedly a relatively small base, but was up 35% in terms of sales. So people are looking at the pandemic. They're not driving as much. We're advertising it a little bit. And we're getting a lot of people interested in the notion of pay by mile. From a Drivewise standpoint, most people really want to now include the telematics as part of their offering from us. So we're seeing a nice upswing on the demand post pandemic."
},
{
"speaker": "JoshShanker",
"text": "I'm going to try and digest all that and figure out how it works. If we can go to the slides you prepared on Page 8, you have this very interesting slide about new issued applications. I'm trying to understand it a little bit better. First of all, when it says Allstate brand direct submissions were up but Esurance was down. Is that four months of Allstate brand direct and eight months of Esurance? When we should think about that, that not only is Allstate brand bring in more customers than Esurance but it's a smaller time line. Is this the right way to think about that?"
},
{
"speaker": "TomWilson",
"text": "No, those numbers are for the entire year. And what we're trying to show there is that we've successfully made the transition to the Allstate brand selling direct, both operationally, which wasn't simple, by the way, in terms of changing web flows and all kinds of other stuff. They're getting the branding changed and putting the price discount in if you buy direct under the Allstate brand because it doesn't come with an agent. So we've made that change. And what that shows is that overall, we grew. We did keep selling some under the Esurance brand those companies because they're open, people call, get on our Web site, they track their way down to it. So it's really low cost business. So we didn't completely shut off, Josh, the Esurance. So you can still buy. Over time, it will go away as we cut advertising it and quit doing and people could come into that Web site. So what it's really trying to show there is that we've made the turn indirect, and we feel good about our ability to operate under 1 brand, and there were many people who didn't think that was possible, whether that was perceived channel conflict or just operational capabilities."
},
{
"speaker": "JoshShanker",
"text": "And then on the EA channel part, a significant portion of annual new policies coming through the EA channel coming from new appointments? If we don't do a lot of new appointments going forward, should we expect that's a multiyear issue in terms of growth in the EA channel?"
},
{
"speaker": "TomWilson",
"text": "I don't think you should think it's a multiyear issue. Obviously, Glenn mentioned we are working on creating some new higher growth models, and he can talk you through that in a second here. The part that may not be as obvious is putting Allstate agents onboarding with the old model, the commissions were substantially higher than you pay to an existing agent. And the idea being if you open an office and you got nobody coming in you sell the first policy, you need to make some money, and the commissions were quite high there. What Glenn is working on is coming up with a model where an agent can build the business and be successful without us having to incur the additional cost upfront to build it, which kind of rolled out over three to five years, it was expensive. And so what we thought -- what we made was the economic choice, which was save shareholder money, don't keep investing in a model that you think you get a better one for and then make sure the existing agents continue to grow. Glenn, do you want to talk about the new agents and then what you've done with the existing agents as well?"
},
{
"speaker": "GlennShapiro",
"text": "And I always want to emphasize on this. Our exclusive agents are a huge strategic advantage for us and a core capability for Allstate. As much as we talk about and I'm excited about the direct growth and what we can do in the independent agent channel, a large, large channel out there and a lot of customers really like to go to a local agent and a branded agent like an Allstate agent to go there. So it's a great model for us and we want those agents to keep winning. So what we've done with existing agents is, as you know, we've shifted compensation a little bit, we've motivated more on the new business side than just on the renewal side. But we're also working with them on the way we market. We're putting more money into marketing. We really want them to be successful. From a new agent standpoint, we've got a few models in market right now. And without going too detailed into it, the general theme would be, if you think about the virtual world we're operating in, can you have a local agent that doesn't really require brick and mortar? And we think the answer is yes to that. That there's an opportunity for agents to be a local point of sale, people who are active in the community, people who have relationships locally and sell through those relationships in their communities, but don't necessarily have a staff and have a brick and mortar office where we perform the back end service in a more centralized way. It's a significantly lower cost model to get started, as Tom mentioned, and one that we're pretty bullish on our ability to scale."
},
{
"speaker": "Operator",
"text": "Our next question comes from the line of Greg Peters from Raymond James."
},
{
"speaker": "GregPeters",
"text": "My first question is around price and competitive positioning. Obviously, we're listening to when watching the new products that you're rolling out the product enhancements and the focus on profitable growth. Your underlying combined ratio for the year is 79.3% is obviously a very excellent result. But do you think that your price for your Allstate brand auto is competitive in the marketplace considering how profitable the business is at the moment?"
},
{
"speaker": "TomWilson",
"text": "The answer is yes. That we think we can be even more competitive. It's a complicated question, of course, because with billions of price points, and some segments you're not competitive at all because you don't want to be competitive because you think that somebody else is under charging and other places you want to be competitive. And the trick is where you want to be competitive, to be competitive enough to win the business but not so competitive that you're giving away margin. And so we have a very sophisticated approach of doing that. We do think that we can change our pricing so we can be more competitive overall. But yes, we look at our close rates and we're right in the market. And that depends how we carry ourself too. So if you look at us versus other people who have exclusive agents [Technical Difficulty] in general, we're very competitive. If you look at us versus direct, I'd say we're less so, which is why we made the change to put in a direct discount on that business. So we are more competitive because people are not getting an agent, they don't want to pay for one. So I would say we're highly competitive. That said, I think we can always be better. And when you look at what drives customers’ purchase price, a lot of it's the price, now you got to make sure you make enough money. And that's the trick. Glenn, anything you would add to that?"
},
{
"speaker": "GlennShapiro",
"text": "Just a couple of things, I'll hit there. One would be, you mentioned, Tom, that close rates, like so we keep a really close eye and our close rates and our close rates have improved. Our new business is up. I mean you look at -- you're talking, Greg, auto but I'll say, auto and home, we were up 2% and 8% respectively, between on new business. So folks are buying the product and you really can't sell the product if you're out of the market from a competitive standpoint. So those are good signs that we are, but we're working to get more competitive. And the last point I'll make with it is, I always go back to this. We manage state by state. We have a talented group of state managers that like they've got their hands on the lever in each state and they're looking at the competitive position, specifically in that market. And as Tom said, on which types of business are we more or less competitive on younger drivers, older drivers, homeowners, not homeowners, married, not married all, all the different components in there, and they're pulling those levers and getting us as competitive as we can be while earning attractive returns."
},
{
"speaker": "GregPeters",
"text": "I'd like to pivot to the expense ratio. I think the chart you put on Slide 9 of your presentation and very strong improvement from 2018 to 2019 to 2020. So two part questions with the result and then going forward. How much of the 23.2 is benefited from reduced T&E because of lockdown? Or look at a different way, I know you've been focused on integrated services platform and other tools. Is it an expectation that you can drive further improvement in '21 and the expense ratio?"
},
{
"speaker": "TomWilson",
"text": "So Mario has been our lead on cost reduction. Mario, do you want to take that?"
},
{
"speaker": "MarioRizzo",
"text": "When you look at the expense ratio for the year and the improvements we made, we came into the year really focused on taking cost out of two principal areas. One was acquisition related costs and the other one was operating costs, which your T&E component is a part of that but those are people related costs and operations and those types of items. And that's really what's driven the improvement, once you take the noise of restructuring and pandemic related costs out of the equation. The improvement we've seen this year has really come from those two principal areas. We've actually spent a little more on marketing, like we said we would as well, but our reductions in those two areas have really created the space for us to increase our growth related investments. As we go forward, as we've said on past calls, our focus is on continuing to drive our cost structure down because it is a core part of our growth strategy. It's how we're going to be able to continue to improve our competitive positioning in terms of auto insurance pricing and continuing to deliver really attractive returns. So that's a core part of our strategy and our focus is to continue to drive that ratio down."
},
{
"speaker": "Operator",
"text": "Our next question comes from the line of David Motemaden from Evercore ISI."
},
{
"speaker": "DavidMotemaden",
"text": "Just a question, and I believe on one of the slides, you had just talked about how you had 94.4 average combined ratio in the auto business over the last five years excluding 2020. Obviously, 2020 is an abnormal year. But is that sort of a level you're comfortable getting back to in order to return to growth? And I guess, what sort of level are you willing to let that go to in order to accelerate growth?"
},
{
"speaker": "TomWilson",
"text": "I think I would go up all the way up to the top and say that what we said is we can grow the market share on personal property liability and as a company we'll deliver 14% to 17% return on equity. And we believe that will drive lots of shareholder value, both in terms of economic value creation and valuation multiples. When you look specifically at the components of that, we have a headwind in investment income with low interest rates. We do have and have had for a long time great profitability in auto insurance. We would have put a longer period of time in there, but the pension accounting kind of changed the way we did it. But we've been earning great returns in the auto insurance business for a long time and expect to continue. At a 94, you still earn a really attractive return on equity because you don't have to put up as much capital on that line and some other lines. And so 94 would be the book -- we like to make as much money as we can and grow as fast as we can, and it's really about how do you drive net present value to the whole company. So we don't publish and have a target of safety there. But 94 would be a return I would be highly comfortable with. I'd be comfortable at 93, I'd be comfortable with 95. They're all really great returns. The other part to focus on is homeowners insurance where that's a higher capital return business and so we have a lower combined ratio there. And we're 10 to 15 points better than another large public competitor, which is somewhere between $700 million and $1 billion a year of profit. So we think all of those then add up to 14% to 17% return. So we're comfortable we can grow the business and earn good returns. And it will bounce around, as you mentioned this year, frequency went way down. So we made a bunch more money. If frequency goes back up, we'll just have to raise our prices up. And the question is are you good at it. And the point of putting those two statistics on the bottom of that page was just to give our shareholders comfort that we have a history of managing returns and profitability, and we expect to continue to do it. Not going to be the same every year because the world changes but we know how to make money."
},
{
"speaker": "DavidMotemaden",
"text": "And I guess just maybe switching gears a little bit to the new appointed agents, and thanks for the slide on Slide 8, that was very helpful. Some encouraging trends there. I guess I just wanted to ask on the new agents and appointments. Do you expect that to still be a drag in '21 or is that something that will turn from a drag to an addition to new apps and to growth? Or is that something that you expect to still be a little bit of a drag as these new models ramp up?"
},
{
"speaker": "Tom Wilson",
"text": "I'll make some overall comments, and then Glenn, you may want to make some comments. First, I would say that when you do these year-over-year comparisons and sometimes I feel like the external view of the company, you just look one year. And so next year, obviously, we won't have had them much for this year. So I would actually be a negative versus the prior year. That said, I think the transition of Allstate agents to higher growth and lower cost will have some bumps in it. That said, as you see, when the people we focus on, the existing agents that are doing well, they know how to grow. They know their local market, their aggressive salespeople, they have aggressive salespeople working for them. And so I don't know that it's as simple as like that's now gone and we get the new one. The new one we think should add additional volume for us, and Glenn can talk about how that will roll out. And then at the same time, the beauty of our strategy is as direct grows it keeps our advertising money highly effective because if we're not closing enough because through some agent changes, we can close more in direct. So we have a fallback. We don't think we need it but we got plenty of opportunity to balance between those. Glenn, do you want to talk about the -- I think the view is on the agents, we have a ways to go to actually figure it all out, but we're making good progress."
},
{
"speaker": "GlennShapiro",
"text": "I think if you think about that chart and you look across at the direct part, too, I think it's a similar story. I think 2020 is a story really good success. We've built the foundation in that year and actually managed to grow more on the Allstate side than we lost on the Esurance side. And so that's sort of an ideal scenario that while you're in the midst of the muck and the mire of making a change like that, that you actually are able to grow it. We absolutely are making that type of change within the EA system. As we've said, we've got a lot of agents out there that are phenomenal at what they do and they grow and we're going to invest with them and have them be successful, then we have a new model upcoming. I think the way to look at this is to across all three channels. With EAs, we will ramp up some time later this year some new models and through next year. And so there's that coming as well as work with the existing EAs that really know how to grow. With direct, we've really done a lot of the heavy lifting of making the transition and we should be able to continue to grow, and we're very confident in our ability to continue to grow it. With IA, which is really, for all intents and purposes, a bit of a new channel for us. I know we've had Encompass in the small Allstate independent agents in there. But really jumping into the top five will start like the first state will roll out in the third quarter of this year with new products going upmarket on the National General platform, National General and Allstate company platform, and then multiple states per month and like we'll be finished with the rollout across all 50 states through 2022. So you can kind of see all of these things coming together, and we're building a long term and sustainable growth platform across all of the channels."
},
{
"speaker": "DavidMotemaden",
"text": "And I think the new agent, the new EA agent strategy is -- I mean, it sounds actually really promising. I guess one question I have is, are those new agents -- I guess, the more remote exclusive agent, are they as productive as under the old brick and mortar model?"
},
{
"speaker": "TomWilson",
"text": "I would say we don't know yet. But we do think it will be lower cost, if you want to look at it that way. You might have to have more people doing it. And then, David, you get a little bit of math because the existing agents also have salespeople in their office. So when you do it by agent but then these people might be so low producers. So net-net, we think we know over half the people want to buy from a person and having a person local is good. It's just the way we've traditionally done it hasn't given us as much growth and it's costs don't need to be as high as they are today."
},
{
"speaker": "Operator",
"text": "Our next question comes from the line of Michael Phillips from Morgan Stanley."
},
{
"speaker": "MichaelPhillips",
"text": "You guys mentioned the impact on the end of the payment plans and the pandemic and retention and growth in the quarter. I guess, Part A of this, is there any way to quantify that? And what I want to get at is, if so, how much -- given that the EA is still in the bulk of your business, how much of was there a drag on retention because of things that you're doing with commissions and emphasis on direct and everything else that's going on? So can we quantify that impact, one and then how much of an impact if everything else was on retention?"
},
{
"speaker": "TomWilson",
"text": "Well, Glenn can give you some detailed specifics on the year. Of course, retention is always hard to figure out, because you have a bunch of stuff going on, you have people changing lifestyle, not driving as much, some people shopping more, you have competitive moves, you have things that we did like shelter in place, payback and payment plan forgiveness -- not forgiveness, we just let you defer. And so as those things roll through the system, it's hard to do attribution on it. That said, it was down this year, which of course we're focused on. Our Net Promoter Score really peaked throughout the year. We got peaked in about July when we were doing all the shelter in place paybacks, it came down a little bit towards the end of the year, but not anything of any consequence or significance. Glenn, do you want to make a comment about the actual retention numbers?"
},
{
"speaker": "GlennShapiro",
"text": "Yes. I don't know I can add a lot to what you said, Tom. I think you hit it well. I mean the retention is in a decent range right now. So it's off of our highs that we hit. But we're within a long term window on retention of where we've operated and certainly, all the things that Tom mentioned had a drag on it. We know that the coming due of special payment plans had some drag on it, and the competitive environment. We know that there were some competitors out there that took some rate down. We also know that people facing financial hardship either shop, some people even give up a car. So all of those things have some play in it. And as you said, Tom, the attribution is next to impossible on that. But we're within a decent range of our long term retention and we're focused on it. And of course, we want to retain every customer that we work hard to get in the first place."
},
{
"speaker": "TomWilson",
"text": "And I think if -- the underlying question there was are existing agents performing well enough to keep retention levels up or somehow made a mat or something like that, our answer there would be no. We don't see anything in there that says that existing agents are doing anything that they haven't done before, that they're not stepping up and helping their customers even more in the pandemic. I mean they really reached out tons of calls on shelter in place and the payment plans and that kind of stuff. So our agents were doing a great job. I don't think there's anything structurally in there as it relates to this transition that says we're not -- and I would point out that, that's a huge part of agent compensation. So their interests are aligned with our interest, which is keeping our customers happy."
},
{
"speaker": "MichaelPhillips",
"text": "Second question, still on kind of channel mix, near term and longer term question. In the near term, I guess, just this year, you talked about a 1 point change in market share. Should we expect that to be kind of even throughout the year or more back half weighted in terms of that market share shift? And then longer term, more interested in maybe 10 years down the road, what does Allstate look like? How does this mix look, a third, a third, a third or something still weighted towards EA and IA?"
},
{
"speaker": "TomWilson",
"text": "We closed National General on January 4th. So that in and of itself means we'll get that revenue for the entire year. So you should expect to see total auto premiums go up throughout the year. We would expect that as we continue to roll out things in the Allstate brand that we start to see some more growth in that business over time. And yes, but we don't really give it out even do it by quarter, just as much as you can. In terms of the long term, we'll take anybody we can get. So we have one out of 10. We still got nine out of 10 to go. I'd be happy if all of them got a lot bigger and that's what we're setting up to do. So we don't have a percentage. When you look at percentages from what customers want, it's probably today, 25% of the customers really prefer self serve and it's a range. If you look at those who want an agent, it's over 50% and usually around 65% or about 60%. And then in between, you have people who are sort of -- they go with whatever is in front of them and they're indifferent. So we think there's plenty of opportunity to grow. Some of the shift you see in channels is really due to customers wanting it differently, like not feeling like they need help to buy the product. Some of the shift is just because direct companies have been advertising more. So you all loud enough and people come to you. So we think what we should do is give people exactly what they want, give them choice. And what they want with the person is really to help buy it. They need and want less help on service. And so the existing insurance agent businesses have been built on both. What we're trying to focus on is really helping them buy and then give them self serve or have computers do it or whatever to lower the cost on the service side because it's cheaper, better and faster. So we don't need to do as much local service as we do. So we'll take as many people as we can get through any channel."
},
{
"speaker": "Operator",
"text": "Our next question comes from the line of Paul Newsome from Piper Sandler."
},
{
"speaker": "PaulNewsome",
"text": "I was hoping you could maybe help us understand a little bit more about how the investment portfolio will look after the life sale? Will the P&C business kind of have a little bit of a different mix of assets and will that have an impact on the yield as well?"
},
{
"speaker": "TomWilson",
"text": "Paul, let me give you a slight overview from a corporate standpoint, and John can talk about the specifics. So obviously, the sale of Allstate Life Insurance company substantially reduces our investment portfolio as we exit a spread-based business. And the [Indiscernible] entity is taking almost all the assets that are used to asset liability match that business. They are not taking all of the performance based assets. So that increases the percentage relative to the overall portfolio, which also gets smaller. And we looked at it, obviously, prior to the sale. We're comfortable with the risk and return of it. You will remember that we reduced our equity holdings in February this year by $4 billion, not because of the Allstate Life sale but because we just didn't like the risk and return profile there. So we do make changes up and down. And this will still have the ability to go up and down even though this portion of the portfolio is less liquid than the public equity as a whole because we still have public equities we get high yields. We have a bunch of ways we can manage the overall risk of the portfolio, and we're very comfortable with where we'll be. John, do you want to talk specifically about [performance] basis?"
},
{
"speaker": "JohnDugenske",
"text": "When you look at performance space, too, it's part of a broader overall portfolio context. So while that percentage will go up, we look across risk and return factors across every security and every investment we hold and take it in its entirety. So as Tom mentioned, we have a lot of ways to compensate for additional risk we may take in one area. When you look at the performance space, this is a long term holding for us, we've looked at gradually growing that over multiple years. And in some ways, this just accelerates that gradual path that we're on. As we built this portfolio, we've always looked for the best partners and the best direct investments we can across private equity, real estate and other areas. And the assets that we'd be bringing on board are ones that we're already very familiar with. We already own them, obviously, and very familiar. So it accelerates our path forward in a way that we're quite comfortable with. And, I guess, I’d just finish by saying that the return on this has stood up quite well even in what's been a volatile year. We've been looking back at what our returns have been over the last five years and 10 years, and our performance based assets have fared quite well relative to public markets, and we think that it continues to be an integral part of the portfolio."
},
{
"speaker": "TomWilson",
"text": "Jonathan, let's take one last question and then we'll wrap up to keep people on time."
},
{
"speaker": "Operator",
"text": "Our final question for today then comes from the line of Gary Ransom from Dowling & Partners."
},
{
"speaker": "GaryRansom",
"text": "I wanted to loop back on telematics. You mentioned increased demand for the product. A couple of questions there. Did that make any material difference to the growth in new business that you're seeing that roll forward you showed on Slide 8? And then secondly, whether the difference between your by the mile product and the standard product, whether the demand is different. And with that question, I'm really just trying to think ahead is to buy the mile product more the way of the future."
},
{
"speaker": "TomWilson",
"text": "Gary, let me make a couple of comments. First, I don't believe it's actually driven people to us. So I think with our advertising when they get to us, and then we talk to them about it, so that's interesting. And what it enables us to is give them a more accurate price, which protects them competitively. So the more accurate the price they are -- if someone takes them away from us, and we're really accurate through a lower price, then they'll we think, lose money. And we won't lose people because we're overpriced for the risk. So it will drive more sustainability to growth as opposed to people calling us and saying, hey, I want to. That doesn't mean people don't see our ads and say, geez, I'm tired of paying this much for insurance, and I hardly drive sort cost. But I'm not seeing a big well spring of people saying cost, it tends to be more in the sale itself. In terms of a long-term basis, I think this is the way that pricing will be done. I mean insurers for a long time have been trying to get more and more accurate on the individual risk, particularly in auto insurance and home insurance for that matter, of course, going to telematics here. But as credit was a big move, I don't know, 15 or 20 years ago when we first got into that using stuff out of the credit file and is very powerful. This is very powerful, as powerful, not so much in the fat part of the curve, they're being moderate risk people. But in really low risk or really high risk people, it's very effective. So I think it will lead to more sustainable growth through better retention because we'll have a really accurate and competitive price."
},
{
"speaker": "GaryRansom",
"text": "Can you also talk a little bit about how you might be using telematics on the claims side, whether that is developing or having much effect at this point?"
},
{
"speaker": "TomWilson",
"text": "Glenn, do you want to take that?"
},
{
"speaker": "GlennShapiro",
"text": "So we've got some capability there that is, I would call it, developing. And it's about accident notification. And I think this is -- Tom talked about it being the wave of the future for pricing, which I totally agree with from the telematics. I think it's going to be the wave of the future. When you think about connected cars, you think about our devices in OBD ports or even the mobile, there's accident detection through Arity through the mobile telematics. So early notification, emergency notification, first notice of loss taking are all areas in development, and I think will be a wave of the future."
},
{
"speaker": "TomWilson",
"text": "Gary, I would expand on that and say, if you go to digital claims settlement, we believe we've been leading the industry, whether that's a quick photo claim, whether that's using algorithms to look at pictures and decide how you should settle the claim. I know another company is talking about going into a SPAC and raising some money. We've worked extensively with that company. We think our platform, our technology and the ability to utilize data will make us even better at settling claims. So it's not really related to telematics but it's really related to digitization of the business, which is another way that we're trying to change both our business model and really our culture, with just to drive that kind of growth. So thank you all for participating. We are trying to build really transformational growth business models. It's more than a plan. It's really a way of life. And we expect to deliver increased growth and earn good returns, which will both create economic value just because we make more money and should lead to higher valuation multiples. Thank you much. We'll talk to you next quarter."
},
{
"speaker": "Operator",
"text": "Thank you, ladies and gentlemen, for your participation in today's conference. This does conclude the program. You may now disconnect. Good day."
}
] | The Allstate Corporation | 18,711 |
ALL | 3 | 2,020 | 2020-11-05 09:00:00 | Operator: Ladies and gentleman, thank you for standing by. Welcome to The Allstate Third Quarter 2020 Earnings Conference Call. [Operator Instructions] As a reminder, today's program is being recorded. I would now like to introduce your host for today's program, Mr. Mark Nogal. Please go ahead, sir.
Mark Nogal: Thank you, Jonathan. Good morning, everyone, and welcome to Allstate's third quarter 2020 earnings conference call. After prepared remarks, we'll have a question-and-answer session. Yesterday, following the close of the market, we issued our news release and investor supplement, filed our 10-Q, and posted today's presentation on our website at allstateinvestors.com. Our management team is here to provide perspective on these results and further context on a Transformative Growth Plan to accelerate growth in the personal property-liability business. As noted on the first slide of the presentation, our discussion will contain non-GAAP measures for which there are reconciliations in the news release and the investor supplement and forward-looking statements about Allstate's operations. Allstate's results may differ materially from these statements, so please refer to our 10-K for 2019 and other public documents for information on potential risks. And now, I'll turn it over to Tom.
Tom Wilson: Good morning everybody. As usual, we appreciate you joining us, investing your time to learn more about Allstate. This was just an exceptional quarter. I mean, we're adapting, we're executing, we're investing for the future. We adapted to the pandemic, the wildfires, the hurricanes, record low interest rates, and despite all of that, our execution enabled us to make $1.1 billion. At the same time, our Transformative Growth is coming to light. The stock is a great value on any measure. So we executed a $750 million ASR. Our team has performed exceptionally well this year, serving customers, creating economic value, and building a stronger foundation for growth. So let's start on Slide 2, which has Allstate's strategy, which is shown by the two ovals on the left. We're going to increase market share on Personal Property-Liability with our Transformative Growth Plan, which has three components. You remember that: expand customer access; improve customer value, which includes improving our price position and launching new products; and then investing in marketing technology. You'll hear more about that from Glenn, and then we'll - and then Mario will go through the numbers, and then we'll get to your questions. We're also expanding our protection businesses to increase - which is increasing the total addressable market we serve. We have an edge in this expansion by leveraging the Allstate brand, our customer base and our operating capabilities, which you can see in between those two ovals. For a company that empowers customers that is, you know we provide affordable simple connected products. There has been plenty to protect them from this year. As I mentioned, we get all kinds of severe weather and catastrophes and there we moved with speed and efficiency, and you can see that from our third quarter results, and those are shown on the right. Our profitability was excellent. Adjusted net income was $2.94 a share, and return on equity 17.7%. Underwriting results also remain really strong, we get favorable auto insurance results which offset the elevated home insurance losses from increased catastrophes. Implementation in Transformative Growth Plan is accelerating with the initiation of cost reduction plan in the new Allstate advertising campaign. Investment income was off slightly due to lower interest rates, but the performance-based income returned to prior year levels. We did have an annual review of our actuarial assumptions for Allstate Life, Benefits and Annuity businesses which assumes that the continued low interest rate environment carries forward and reduces future investment income over the next 25 years and that resulted in several charges for the reduced net income, and Mario will go through a specific slide to show you how that works. Allstate Protection Plans has continued to grow policies, revenue and income, while expanding its total addressable market or total addressable market. So despite a tumultuous operating environment, we delivered great customer experiences, growth, excellent returns and progress on the Transformative Growth Plan. If we go to Slide 3, let's do the numbers. Total revenues of $11.5 billion increased 3.9% to the prior year quarter, and that reflects both higher net realized capital gain and growth in property-liability premiums earned. Net income of $1.1 billion increased by 26.7% to the prior year quarter, as you can see that in the table, as higher revenues more than offset Allstate Life and Annuity income in connection - which was down because in connection with those actuarial assumption. Adjusted net income of $923 million was $2.94 per share. It was $23 million lower than the prior year quarter. Its higher auto insurance underwriting income was more than offset by the elevated catastrophe losses or restructuring charges related to Transformative Growth and the lower Allstate Life and Annuities income. Our returns remained excellent, and as I said, the return on equity is well above the range that we've discussed. So let me turn it over to Glenn, who will talk about third quarter results for Personal Property-Liability.
Glenn Shapiro: Thanks Tom. So let's go to Slide 4, and we'll discuss the - as Tom said, very strong performance of our Property-Liability business. Before going deeper into the results, it's worth mentioning that consistent with how we operate under Transformative Growth, Insurance and Allstate Financial results were combined beginning in the third quarter. Property-liability results were strong with excellent recorded and underlying profitability. Growth was modest and lower than prior year quarter for auto insurance, but in the range that we expected as we build the foundation of Transformative Growth. And let me go into some detail on that before continuing on this slide. First, the three components of Transformative Growth were all making progress. The path is a bit steeper though at the beginning for several reasons. One, in our direct business, we lowered advertising for insurance brand since its being sunset, and that has a negative impact on new business there. At the same time, we've improved new business sales flows for online sales and improved our sales practices in our call centers for the Allstate brand being sold direct, which is significantly increasing volumes there but not yet enough to offset the insurance drop. Volume in our Allstate agents channel is on plan, except for the first two months of the pandemic, and we believe the shift in compensation towards new business that we start this year is working. We stopped hiring new agents under the existing commission contract early this year, since we're building a new lower cost agent model. We also increased base level production requirements coming into this year for agents as we're investing in agents who want to grow their business. This resulted in a planned and expected decline in licensed producers as we build the foundation on a high quality set of producers. We were in the right place with the right product at the right time when it comes to Milewise, which is our pay-per-mile product. That's really appealing to customers right now, because they are driving less during the pandemic, and we're the only major carrier offering a product like that. In the independent agent channel, Encompass had a small negative impact on growth, reflecting homeowners increases. National General acquisition which is pending will expand our access into the independent agent channel and we're really excited about the growth prospects there after closing. The cost reductions we're implementing will enable us to further improve our competitive position in auto insurance and drive growth while earning attractive returns. And on the homeowner side, premium grew 2.6% from the prior year quarter. This was due to policy growth of 1.2% and average premium increases. We're really well positioned for further growth in the homeowners business. In total, we believe that the foundation we are building to be a major player in both the direct space and independent agent space that will add to our great exclusive agent channel that we already have will lead to transformative growth. So now we'll go back to our slide and we've got a bullet or two here. Underwriting income was $753 million, increasing $16 million compared to the prior year. While the recorded combined ratio was equal to last year's third quarter, there were many meaningful changes underneath that, which are shown in the lower left chart. Starting on the left, the underlying loss ratio improved 7.8 points, primarily due to lower auto insurance losses from fewer accidents due to lower miles driven. Underlying loss ratio improvement was offset by elevated catastrophe losses in homeowners, unfavorable reserve development in discontinued lines, restructuring charges and Allstate's efforts to help customers during the pandemic, which are all shown in red. Catastrophe losses of $990 million in the third quarter were driven by a very active hurricane season and ongoing wildfires in the West Coast. This is partially offset by favorable prior year catastrophe development recognized in the quarter with $450 million and $45 million respectively coming from the PG&E and Southern California Edison subrogation settlements. Non-catastrophe prior year reserve re-estimates were adverse $70 million in the quarter, this includes $132 million adverse from the annual review of asbestos, environmental and other reserves in the Discontinued Line and Coverage segment, which was partially offset by favorable re-estimates in the Allstate Protection personal lines. The chart on the right breaks down the expense ratio components. Excluding the impact of restructuring charge and bad debt in the third quarter, the expense ratio was 22.6, a 1.1 point improvement compared to prior-year quarter. It also represents a 2.5 point improvement if you go back to 2018. Moving to Slide 5, let's discuss our progress on Transformative Growth. And as Tom covered, Transformative Growth is a multi-year effort to accelerate growth through three components: expanding customer access, improving customer value, and investing in marketing and technology. Customer access was expanded by combining the direct sales capabilities under the Allstate brand, which enables us to leverage insurances capabilities with a stronger brand of Allstate. We're also enhancing local agent sales models to improve effectiveness and efficiency. And customer value is being improved by implementing a cost reduction program. This enables us to offer more affordable prices while maintaining strong margins. We also continue to improve the competitive price position of auto insurance with pricing sophistication. The third component is investing in marketing and technology. In the third quarter, we launched our new advertising campaign to reposition the brand supported by increased spend. Technology investments continue to improve customer facing interactions including the launch of the Allstate OneApp which simplifies all of our digital interactions in access, including telematics offerings. Moving to Slide 6, we're still deeper into a few of the actions taken in the third quarter to advance Transformative Growth. We're executing a cost reduction plan that streamlining operations and processes across claims, sales, service and support functions to lower costs. Lower costs enable us to have more affordable price without sacrificing attractive returns. The plan impacts approximately 3,800 employees this year, which will result in a charge of $290 million, with $198 million of that recognized in the third quarter and the balance in future quarters. The bulk of the charges for employee benefits incentives, including expanded transition support, extended medical coverage and deployment search assistance. The remainder is driven by real estate exit costs. At the same time, we launched a new advertising campaign in September built on the belief that we all deserve to live life well protected, as shown on the right side of the slide. The campaign repositions our brand and updates the messaging to generate business across a broader audience by showing the breadth of product portfolio we have including identity and service protection. The campaign also emphasizes a connected experience with telematics capabilities as customers' behaviors and needs are changing. I'll now turn it over to Mario to cover the rest of our results.
Mario Rizzo: Thanks Glenn. Let's go to Slide 7, which highlights investment performance for the quarter. The chart on the left shows net investment income totaled $832 million in the quarter, which was $48 million below prior year due to a decline in market-based income. Market-based income shown in blue was $68 million below the prior year quarter. With lower interest rates, our reinvestment rates remain below the average interest-bearing portfolio yield which reduces income. Performance-based income totaled $210 million in the third quarter as shown in gray, partially reversing valuation declines recorded in the first half of the year. GAAP total returns are shown in the table on the right. Year-to-date returns were 4.4% and the latest 12 months was 5.7%, reflecting higher fixed income and public equity valuations. Performance-based investment return was 2.4% for the quarter, but remained negative year-to-date. Our performance-based strategy has a longer-term investment horizon with higher but more volatile return expectations compared to the market-based portfolio. The compound annual rate of return on the performance based portfolio is 7.2% over the past five years as is shown on the bottom right of the table, exceeding the market-based return by 220 basis points. Let's move to Slide 8 and review results for Allstate Life, Benefits and Annuities. Allstate's annual review of assumptions and the expectation of lower long-term interest rates unfavorably impacted the Allstate Life, benefits and Annuities segments in the third quarter. Allstate Life shown on the left recorded an adjusted net loss of $14 million in the third quarter. The loss was due to accelerated amortization of deferred acquisition costs, primarily from lower projected future interest rates related to the annual review of assumptions. Higher contract benefits also reduced adjusted net income, including $22 million in coronavirus death claims. Allstate Benefits adjusted net income of $33 million in the third quarter was $2 million higher than the prior year quarter, driven by a decrease in contract benefits, primarily due to lower claim experience. This decrease was driven by limited activities and the deferral of non-essential medical procedures as a result of the pandemic. The benefit from lower reported claim experience was partially offset by the acceleration of deferred acquisition cost amortization related to the annual review of assumptions. Allstate Annuities had adjusted net income of $37 million in the third quarter as contract benefits decreased primarily from favorable mortality experience compared to the prior year quarter. In the third quarter, Allstate Annuities also recorded a premium deficiency reserve of $225 million, pre-tax, given the expectation that interest rates will remain low over the long duration of these liabilities and annuitants are living longer than originally anticipated. While this reduced net income for the quarter, it did not impact adjusted net income. And let's turn to Slide 9 to discuss the Allstate Annuities and the premium deficiency reserve in a little more detail. As you can see on the chart, we've been reducing our Annuity business consistently over the last 15 years to manage risk-adjusted returns. As a result of this dynamic, we began to systematically exit these businesses. In 2006, we reinsured the variable annuity business. In 2010, we exited the broker dealer channel. In 2013, we stopped issuing structured settlements. And in 2014, we stopped issuing all remaining annuity products and sold Lincoln Benefit Life. As a result, liabilities declined from $75 billion in 2005 to $17.5 billion as of the end of the third quarter. Today, liabilities are made up of that $17.5 billion dollars of reserves and contract holder funds related to deferred and immediate annuities. Our asset liability management strategy has positioned the portfolio to cash match near term liabilities while investing in public equities and performance-based assets for longer duration liabilities to generate attractive risk-adjusted returns. Two-thirds of the payments on these annuities are expected to be made after 2030. As part of our third quarter review of actuarial assumptions we lowered our long-term return assumptions given the expectation that interest rates will remain low for an extended period. This reduces expected future investment income. Mortality assumptions were also updated to reflect the expectation that annuitant will live longer. These two changes led to a forecast where current reserves and expected returns on those reserves over the life of these annuities is less than the expected payouts, which led to the charge of $225 million pretax. So now let's go to Slide 10 and discuss the results of our service businesses. The service businesses continue to generate strong growth as policies in force increased 38.6% to $133 million in the third quarter, driven by Allstate Protection plans growth. Revenue, excluding the impact of realized gains and losses grew 16.9% to $484 million in the third quarter. Adjusted net income of $40 million reflects an increase of $32 million compared to the third quarter of 2019. The improvement continues to be driven by the growth of Allstate Protection Plans and improved profitability at Allstate roadside services. Now let's turn to Slide 11 to review the results of Allstate Protection plans in a bit more detail. So, as you remember, the acquisition in early 2017 for $1.4 billion further expanded our circle of protection for customers and continues to exceed growth and profit expectations. As you can see in the chart on the left, Allstate Protection Plan has had exceptional growth since acquisition in early 2017. Policies in force increased more than fourfold from less than 30 million policies in 2017 to 126 million in the third quarter of 2020. This represents a compound annual growth rate of 51%. In addition, net written premium of $831 million for the first nine months of 2020 increased 50% compared to the prior year period. On the right you can see that Allstate Protection plans began generating positive adjusted net income in early 2018, which is earlier than expected. The upward trajectory has continued this year, generating $105 million of adjusted net income through the first nine months of 2020. Even more important to shareholder value is the trajectory going forward from here. The team has successfully expanded the total addressable market into appliances, furniture, cellular carriers and international markets with revenues in each of these areas. The combination of attractive unit economics, scalable technology platform and the power of The Allstate brand will lead to continued profitable growth in this business. Quite simply, this is not your typical protection platform. Finally on Slide 12, we want to highlight Allstate's attractive returns and strong capital position. Allstate generated strong returns on capital with an adjusted net income return on equity of 17.7% as of the end of the third quarter. We returned $967 million to common shareholders in the third quarter. Through a combination of $798 million in share repurchases and $169 million in common stock dividends. Over the last year, we have reduced common shares outstanding by 6.4% primarily as a result of our share repurchase program. As you can see from the table. Book value per share of $82.39 increased 18% compared to the third quarter of last year, reflecting income generation and increased fixed income valuations, partially offset by cash returned to shareholders. Allstate stock valuation metrics, however, have not kept pace with this combined strength and strong operating performance. With that context we will open up the line for questions.
Operator: [Operator Instructions] Our first question comes from the line of Yaron Kinar from Goldman Sachs. Your question please.
Yaron Kinar: First question is with regards to top line growth. So I understand there are a lot of moving parts here and you're selling early to maybe the end of the beginning of the transformative growth plan. At what point do you think we actually do start seeing the initiative and the various components there resulted in top line growth?
Tom Wilson: Yaron, this is Tom. So they - we can't really give you a quarter and say here's one that turn a say you should buy the stock right before that. So that what is really reflecting the terrible pop because a number of things happening. Right? So we're trying to make sure we take care of our existing customers well, and that requires, as we change out some of the agents and the stuff Glenn talked about, we have to make sure we're doing that well with integrated service and moving people to other agencies. Second, there is obviously a competitive market in which we're in. So part of it depends what happens with our competitors and what they do, how much more they put into advertising, how much they raise homeowners prices. I think that what I would say is the focus seems to be narrowed down to just auto insurance and really transformative growth is about auto insurance is about home insurance where we're getting a growth - good growth and not as much as we think we can have, but certainly higher than auto and then the circle of protection. So I can't really call it by quarter. I would say is, you should expect as you see the components come into place. You should expect to see a trajectory up from here. But we're not giving specific guidance on here. Here's where more going to be at X percent of market share gains.
Yaron Kinar: Okay. And then my second question, somewhat related these launch of the Allstate One app. Are there any metrics you can share with us around, have the company applications have been downloaded, take-up rate in the ease of use or how long it takes to get a quote on the app?
Tom Wilson: Well we have - average that we have a whole bunch of metrics and we don't give most of them out, because we think we're starting to get in advantage versus our competitors on it and we really don't want them copying what we are doing that in both sub year on to your point, both on things like also in telematics. So we're really positive about what we got going on there. And, but we - I would tell you that the insurance industry in general is not to the level that banks are which says we have a lot of potential to increase our connectivity and lower cost at the same time. Glenn, anything you would add to that?
Glenn Shapiro: No, I think that covers it.
Operator: Our next question comes from the line of Greg Peters from Raymond James. Your question please.
Greg Peters: So I'm going to stick with the transformative growth plan. And I think in your second bullet point, you talked about improving customer value. So there's two pieces of that as we sit outside looking in, one is the expense ratio initiatives that you've highlighted. The other one would be just price to your customers. So can you give us an idea of where the expense ratio will go to or what sort of objective you have in the context of your competition? And then, on price, we have observed a number of your competitors starting to cut prices in the marketplace and in auto insurance and I'm curious about your posture with respect to that.
Tom Wilson: Greg, let me start with the overview on transformer growth and then Glenn, if you could jump into where we are on pricing these. So transformer growth has three components, right. Second one is improved customer value, that is really two components to it. But one is improve the competitive price position and with affordable products. And second is to launch new products, the things like [indiscernible]. So the second piece is really about more differentiation price the cost piece is really the way a door you go through to get to the price piece. So they are not separate. So in the reason we haven't put cost targets out there, we obviously have cost target and we also have price competitive targets. The reason we haven't put those out there is, they are tightly linked. And we don't want to signal to our competitors, where we think we're going our price. So it's not that we don't have targets we do, and we think we can reduce our costs, which enables us to give customers better value called more affordable price without sacrificing attractive margins. So that's the path we're on. Reduce expenses, if those expense is down turn that into a more affordable price, which increases your closed rate, which then drives growth. So the first - it's really one component that you're talking about. The second piece will take some time, because you have to rebuild the whole technology stack, there's just a bunch of work that has to be done to launch new products. That will take a couple of years to really get done, which is why we keep this is a multi-year initiative. Glenn, do you want to give Greg an update on pricing and your thoughts there?
Glenn Shapiro: Yes, you've covered, Tom. Well, the - going forward, how we bring the cost down and keep margins while being a better value for customers. But I don't want to leave anybody the impression that we're not moving now because sometimes you can look at a like an investor supplement and say, well, it was zero rate taken and think that that means there is zero rate action. We have made hundreds of filings over the last quarter, all across the country and I know you always hear me say it Greg, but we manage this at the market level. So we've got a really talented group of state managers, I always talk about that. They've got their hands on the lever they’re looking at, how competitive are we each competitor in this market, what's our close rate doing, what type of shifts are we seeing in customers and quoting and they're moving those levers all the time and we're working with regulators to do that. So the hundreds of filings that we've made already since the pandemic and through this time have materially changed our competitive position in spite of that 0.0, you see on total rate filing. We've done things like improved our competitive position on telematic products, increased new business discounts, changed pricing around for the type of people that are shopping. And so the average person that's out there shopping for insurance is getting a lower price rate now for us than they were six months ago or nine months ago meaningfully lower. And so this is how we stay competitive, and it goes a little bit back to Yaron's comment or question on growth, and I look at it as while we're building this foundation, like I mean we're setting up the capability for us to be a major player in direct. We are setting up the capability for us to be a major player in independent agent with the acquisition that's pending. And while we're building that foundation, I'd call it, we're holding our own. Like we actually grew policies year-over-year, policies in force, minimally in auto more so in home, but we're doing a good job of keeping the fight going and keeping our growth engine going in spite of building that foundation.
Greg Peters: Your answers makes sense. I guess the second question, and it's just going to pivot to the other source of income would be investment income and just looking over the Slide 7 and considering Mario's comments, there is obviously two pieces and it's been volatile this year. But it feels like because of the current interest rate environment there is going to be downward pressure on your market-based returns and therefore investment earnings you generate off that for the next year or two. And then also on the performance base, the volatility is interesting for us to try and model. So can you frame it for us as we think about what the future performance might be of the performance-based portfolio?
Tom Wilson: Greg, let me go up and then, John you can talk about the risk adjusted return of volatility of the performance base. So - as - when we do our investment allocations all the way at the top, we look at risk adjusted return based on economic capital per asset class and so earlier this year when we sold $4 billion of our $6 billion of public equities, it was because we saw the pandemic come in or we thought there is going to be a dip down and then a bump back up, it was - and we are going to avoid that volatility. We just - we didn't think the risk adjusted return was right. When we look at our market-based results and you're right. Interest rates are coming down there at low rates, really low rates, you're probably not going to have as much capital on those bonds as you had historically. And we looked at the risk adjusted return on the performance space, we decided it was a better risk adjusted return on the performance is now. Obviously, it comes with more volatility and particularly from quarter to quarter, as you point out, so what we did is we matched those performance space, the long-term viability is on dated annuities or capital, which we expect to have for a long time and so when you do that you can handle that in term volatility because - and that's why you get the higher risk adjusted return because you're taking on that volatility. And once you get past seven years, - you're better off owning equities and bonds, as you all know well from just looking at the pension funds. And you get past 10 years and it's like you get double the return and you actually have less risk on equity. So that's how we got to performance-based equities and we're willing to accept that volatility either because we have liabilities or capital which we know will have and will recoup the incremental economic return over time. Before I turn to John let me just - one other thing, as you look forward, what we do of course, is when we're managing our auto business in particular, we look at what underwriting margin do we need given what we think we're going to get in investment income. So to the extent investment income, it goes down, we given our power in underwriting, we're able to still make a good return for our shareholders even with slightly lower interest rates. Unlike some of the life companies who have no other way to adjust their future premiums. So John, do you want to spend a few minutes talking about performance space?
John Dugenske: Yes sure, Tom. And Greg, thanks for the question. I'll pick up where Tom left off. When you think about performance base it can be volatile for periods of time. As Tom mentioned, we really match it off versus longer liabilities that we have. If you take a longer-term view and this is information that's in the supplement, - over a 10-year period, the internal rate of return, which is a common way of measuring these assets is about 11.5% and when you look at it over 10 years or over five years relative to the public equity benchmarks that we think about owning these assets against, they are superior in terms of return. So we're willing to take some of that volatility relative to more observable public markets because we think we've got a team that has skill and expertise that can extract value out of the marketplace that it isn't easy for other people to do. I tend to think of it is we've got a lot of flash lights that we can shine in different corners of the market that maybe everyone else doesn't have to extract additional value. Now you're right to point out there has been a little bit bumpier during the course of this year and that does require some explanation. Yes, I think we'd all agree this year, it has been a pretty unique year and when you think about what releases income in performance-based assets, part of that is the deal flow itself, you need to - we invest in a particular entity, whether it's a fund or an individual investment, it improves in value over time. And then we tend to sell those investments and it generates income. During the period of time when deal flow was down because people just travel to do due-diligence and that sort of thing it's normal to understand that that income was reduced. There was also and we disclosed this earlier in the year, we did have some loss, we had about $130 million in actual losses in that place in as well. What we've seen this quarter is a beginning of returning to more normalized deal activity. So we're not going to predict the future here, but there is reason if you look back, relative to what we've experienced historically, we're starting to see a pattern that starts to fit in a little bit. So long dated liabilities matches up well versus that. We like the long run returns even though they're more volatile, but we think there is a period of what we can do in public markets. When it comes to rates you've seen us Greg, you've seen us be proactive in the way that we think about investing in our market-based portfolio. And as Tom said, that's part of a larger enterprise system where we think about risk and return across the enterprise, whether it's underwriting risk, mortality risk or investment risk and return, and we've made changes over time to address for different market environments. So a good example of that is coming out of the global financial crisis. We reduced interest rate risk as rates became lower and we took more credit risk. We thought that it was, that had a good risk return profile. As rates started to increase in recent years, we've lengthened our duration to take advantage of that and that's served us quite well as interest rates have fallen here. And we've subsequently in beginning of the year we saw less value on a risk adjusted basis for public equities and reduce that. One thing that may not be completely obvious is during the course of the year, this year we've taken further actions - we're not only are we helping buffer income by increasing duration, but we've also moved some of that equity exposure and some of our pure government exposure into almost $10 billion of investment grade credit some high quality, high yield and associated securities to help minimize the impact that lower rates we will have. I mean you're right, if rates stay this slow for a long period of time there will be a reduction of income, it's just kind of pure math that play out that way. When I look at the Slide 7 of the presentation and you see those blue lines. It just doesn't happen that rapidly part of our investments are matched off versus longer liabilities. So they're cash matched and then part of it has to happen as the portfolio tends to roll off over periods of time. So, it will happen if rates remain low for a long period of time, it won't happen overnight. And we're hopeful like most people are that interest rates will recover some ground as we pull out of the COVID-induced lower interest rate paradigm that we're currently in.
Operator: Our next question comes from the line of Mike Zaremski from Credit Suisse. Your question, please.
Mike Zaremski: First question, looking through the deck I see one of statements saying improved online and call center sales flow in Allstate direct. Can you give us a flavor for how much of your sales today I think mostly think of Allstate as a agency-based seller of insurance, but how much is coming from direct? And related, I believe in the past you've said that as part of the transformation program, you might be offering a discount to existing customers to potentially use more of the direct platform versus the agents, is that still part of the game plan?
Tom Wilson: Mike, let me first start with the overview and [indiscernible] and Glenn, if you want to talk about sort of sales flows and what you've got going on in sales. And so, we've put together the usage, so if you looked at our old stuff last quarter you would see Esurance broken out and that was 100% direct, either online or through call centers. We did also sell some business under the Allstate brand in the same manner, mostly through call centers, but a little bit online. And with the new format we have, we put those two together. And so, we're not planning on breaking out how much comes out direct and how much comes through agents. You're correct in that if you buy direct, today you get, what you paid for, so you don't pay for an agent. So you don't - the price is 7% lower if you buy direct from the company, but that's for only for new customers. We're not going back to existing customers and saying hey, how would you like the 7% price reduction because they are happy with their existing relationships. They bought from those agents, they have as we cross-sell into those agents. So there is no really need to go disrupt that were about giving it to people anyway they want. If you want an agent you can call us and get an agent and - you call center we’ll get you an agent, and you can have a local agent. If you want to do self-serve, and you want to do it online, we'll do that as well. So the strategy is to really leverage the Allstate brand and take that Esurance money which was spent - Esurance advertising money which was hundreds of millions of dollars a year and throw that at the Allstate brand. So, that, we could compete more aggressively with GEICO and Progressive in the direct space. Glenn, do you want to talk about like sales flows and how you're making that work so?
Glenn Shapiro: Yes, so the team that we've had that ran Esurance and has been put together as Allstate as Tom said, with the Allstate Group. And you would think that it would be relatively easy to flip a switch and say, hey, we're a direct company now and accordingly play big in this space. But we literally have decades of connective tissue and process built around everything is an off-ramp for an agency system. And so what we want to be and aspire to be in the near term, is a company that really goes to market in both ways. It's open access for a customer, customer that wants to click our call that we do that really effectively and we can compete with the biggest direct carriers out there. In that space and think about that as a full channel. And then it takes nothing away from the exclusive agent channel we have which is outstanding. They do an incredible job for customers. They've done a great job through the pandemic you can see it in our retention numbers and continue to grow that channel. But the work they've done is really the pick and shovel work of removing some of those pieces of connective tissue between channels and really going to market as a direct business. Esurance was set up that way because it was a separate run operation. This now is common product, its common back end service that we have, but it's a separate sales channel.
Mike Zaremski: Last question, circling back to the annuity business and we do appreciate all the color. I think we all get asked a lot whether Allstate would entertain a transaction. So I know you've answered that in the past, but maybe I'll try to ask in a different way. So you've pointed out very well that you've moved a lot of the investments into kind of longer duration hopefully higher yielding assets, which is one of the things that some of the private equity backed firms do as part of their right their special sauce? So would you say that lower interest rate environment combined with how you guys positioned the portfolio kind of makes the bid-ask spread of entering a transaction wider than it was a year or so ago?
Tom Wilson: First Mike, if you look at the one slide that we've taken annuities down some $75 billion to $17 billion over a period of time. And we've done that with a couple of objectives in mind, what we want to make sure we take care of customers do you want to get a good deal for shareholders. And so we've been kind of whittling away at it and these are the last two chunks we have left. And we're open to different ways to do that and if we look at all different ways to do it all the time so everything from reinsurance to sales, everything else. And so, I don't think lower interest - rates obviously are something you need to factor in. It's less important when you have the investment portfolio that you just mentioned in terms of what it does to the - it helps fill the gap from low interest rates because you're earning higher returns. I think we have decided so this - these are becoming more scarce properties because you've seen the asset managers go out and they like having what I would call captive asset. So there is a whole host of you are all familiar with that throughout and want to buy annuity blocks. So that they can have those assets to manage and then they separately finance the purchase of a company part with their money and part with other people's money it's a way to build a better revenue stream for themselves. We're open to that thing as long as it meets our two objectives. One, you got to take care of our customers. So some of these customers are going to get paid for 30-plus years we don't want to turn that somebody that's going to take it all and go to Las Vegas and put it on red. And then our customers are left hole in the bag. Secondly, we want to make sure it's good deal for our shareholders. So, we're always looking at opportunities to further reduce the exposure. I mean, you look at that trend line. We have a slide that is and it's - there is no reason to expect that we would try to change that trend line. It will go down by itself. So, like they do roll off people to stop collecting payments either because their term is up or they pass away. So, but you should expect it keep going down if we can find the right way to do that for shareholders and customers then we’ll do it.
Operator: Our next question comes from the line of Phil Stefano from Deutsche Bank. Your question, please.
Phil Stefano: So with the sun setting of the Esurance brand we’re down to three brands now. I guess in my mind, part of the transformative growth plan is a rally behind the Allstate brand so strategically you could talk about the importance of Encompass and answer financial. As we think about the transformative growth plan over time?
Tom Wilson: So it's Tom. I think it's really one brand. And we have some names, but right now we have one what I would call consumer brand. There is obviously some brands amongst agents. And so, you see us leveraging a brand, not just on direct, but Allstate Protection products. I don't believe we would have gotten Walmart and driven the kind of growth we have without the Allstate team on there and the Allstate backing. Same is true with Home Depot, which will be rolling out starting in January. So it's really one brand. There are - you do point out two other ways if you go to market. So Glenn, could you talk about plans or the independent agent channel Encompass with National General and then just touch on what you're doing with Answer Financial as well?
Glenn Shapiro: Yes so in the IA space, it really is National General and I won't get into the brand, because I don't know if any decisions made in terms of exactly the brand. But as Tom said, it's more of a branding with agents than it is with customers in that channel. But with National General and Encompass it's really about bringing those together in sort of a reverse integration because National General has a platform, a technology platform that the IAs love. They have 42,000 existing relationships with agency locations to go along with the 10,000 that we have with Allstate and Encompass. And between the two companies, we have a product set that goes from non-standard all the way up through high net worth and everything in between. And what I always point out on this is, I think maybe the most important part is our homeowners’ capability. The IA space they really need that the full stack and all the capabilities and we clearly have a premier homeowners capability at Allstate. So you put all of that together and we will have the most capabilities of any carrier we will be the Number 5 in size, as soon as the closing goes through in the IA space. But we will be number one in terms of overall top to bottom capabilities. That won't be the day that we go live it won't be that because we won’t been able to integrate products and everything and push it across. But in short order we will be able to bring those together and really go to that market and be a very major player in the independent agent space. And that, pertaining there was second part to that.
Phil Stefano: Answer Financial?
Glenn Shapiro: No, I'm sorry Answer Financial, thanks. Yes, so on Answer Financial, that is - it's a very different type of model. That really is taking care of customers who we can't take care of in other ways. Are they sort of fall between the cracks of - always narrowing cracks actually at this point because we cover just about all different types of customers at this point. But the narrowing cracks there and it's a way to monetize the exhaust from our expense on marketing and make sure that anybody that comes to us - we can get to at some point. And so Answer Financial from a branding standpoint is separate and they sell multiple carriers.
Phil Stefano: I think going back to the National General acquisition we noticed in the Q, that there was a note that you're currently contemplating the mix of cash and debt for that purchase. I was hoping you might be able to further find your point on what your thoughts are there. And just intertwine that into a - broader thoughts on capital management and share repurchases?
Tom Wilson: Mario you could take that.
Mario Rizzo: Sure, Phil. Thanks for the question. Yes - when we announced the National General acquisition, the financing strategy all along was part cash from our deployable capital part excess capital within the National General structure and part debt so that continues to be the strategy in terms of how we'll fund National General. So that part hasn't changed. So we fully expect it to execute across all three dimensions and the closed process is progressing on that acquisition. In terms of broader capital management - and I think Tom mentioned this early on. We continue to think the stock is undervalued. And we have ample capital and liquidity available to continue to buy back stock. We got - excuse me $2.8 billion holding company assets. We got over almost $7 billion of readily available liquidity. Our debt-to-cap ratios are below 20%. So we feel really good about the financial strength of the organization and that's one of the reasons. That combined with our view on the relative valuation of the stock is what led us to do the $750 million ASR in the fourth quarter. We got 7 million shares as part of that. We still have ways to go on the current share repurchase authorization. So we still have just under $1.6 billion left and we'll continue to execute on that. And the point that's worth mentioning is, as we've said from the beginning, the National General acquisition doesn't impact the buyback program. We fully expect to complete that by the end of the year.
Operator: Our next question comes from the line of Joshua Shanker from Bank of America. Your question, please.
Joshua Shanker: On your press release you were announcing the restructuring plan you made the comment that the cost reductions and job reductions were necessary in order to maintain underwriting ratios. I'm not really asking for guidance, but obviously COVID throws a little bit of curve on things? When we think about 2019, I guess is there actually a possibility in your long-term outlook that you think the type of underwriting margins you are achieving on a COVID-normalized basis can be maintained into the years going out given price reactions and given what your goals are?
Tom Wilson: [technical difficulty] Josh, because I'm not sure what COVID-normalized are. But I think. I think the shortest way to answer that is we are in really attractive returns on auto insurance. We have for 14-15 years, maybe longer are running and we have a system and an objective and goals that we've achieved to continue that. When I say COVID-normalized, what we don't really know is certainly of course when the pandemic ends which is beyond your normalization. But I'm not sure what it will do to consumer behavior, particularly driving, I think computing is going to be viewed as overrated. And so, given that about a third of the time people are in their cars they're driving to and from work. So if even a small portion of people so 25% of the people commute less. That's a pretty big drop, and we will react to that when we can. I think what it does, it gives us more room to maintain the kind of returns we have while getting more competitive. And so, but you should assume we’ll continue to be focused on earning attractive returns. That comment in the press release was really about saying, we didn't have to reduce cost, because we're not making money. There are a lot of people out there who today are airlines and other people were having let people go because they just in trouble. We're not in trouble. We're making really good money. And so we don't need to do it they are reason. We also as we're talking about getting more competitive in auto insurance in particular. We don't want everybody. Moving to the conclusion, which you could, if you took your question farther would be that we're going to do that by given in a way - like say anybody can give it away its talented teams that both grow and make money. And so, we were just trying to point out that the point that and Greg mentioned earlier, which is that the cost and the pricing are tightly linked. And I know a lot of you would like to have some expense ratio target that you could put into your models but trust us, we have a measure. It's a good measure, it's aggressive, but it's tied to what we're trying to do on price. So we're not willing to talk about that publicly.
Joshua Shanker: And just a quick one on square trading growth. Obviously people are stuck at their homes, they've been buying a lot of stuff on Amazon and whatnot. Do you think that 2020 was a record year for consumer electronics purchasing and that 2021 will face some headwinds in beating 2020 as a year for new policy yet square trading or Allstate protection plans?
Tom Wilson: Let me ask Don answer that and then just do a commercial before that, which is - we are stronger being together with SquareTrade than we were independently both in terms of what it does for a server protection and what we do for them in getting Walmart Home Depot leveraging the Allstate brand. But I would say you put this up against any of the recent IPOs out there. This thing is worth a whole lot more than we paid for. Don, do you want to talk about what happened?
Don Civgin: Sure. So, Josh, first, the trends have been strong for a long time. So it's not like this year, all of a sudden SquareTrade took off, they've been doing well since the acquisition. It's been a combination of things that's driven that. It's the growth in the existing customers by which they've been able to help drive with their customers. It's been additional customers that they've added B2B customers additional retailers and then this thing that Mario talked about which is just extending their total addressable market. So three years ago there were largely consumer electronics to U.S. retail. But since then it's the more than consumer electronics, it's now appliances. It's now furniture, it's now international business that's growing dramatically. It's cell carriers and so forth. So it's been kind of expansion across the board, which has been consistent for the last three years. This year's results, you're right, we're impacted by COVID, they were going to be strong regardless. So this was going to be a really great year. We got the benefit of COVID but it wasn't just people buying online, it was the customers that we have the places, people are shopping in the categories that lend themselves to warranties are the ones that customers have been purchasing. So whether it's setting up our own office or setting up consumer electronics as you said. So this year has been good and it's been positively impacted, but I think it would be a big mistake to assume it wouldn't have been good anyway. And then when you get into 2021 and those underlying trends that I talked about that have been going for three years will continue. And so, we still expect them to continue to grow and do well. I suspect at some point the lack of buying power in the economy will probably dampen retail sales across the board, more hard to predict how that's going to happen when that's going to happen. But I think that's the - that's on the margin, the underlying trends will continue in a very strong manner.
Joshua Shanker: Thank you very much.
Tom Wilson: Add to that is, when you look forward in 2021 in Allstate Protection plans, the mix of policies going to change some. So you'll see the policy growth come, but you will see the revenues continue to accelerate as particularly as we get into bigger dollar amount per policy. So just one thing to get a warranty policy on a iPad, it's another thing for a washer or dryer or for furniture. So you should still see and we expect increased revenue growth, but you may see a slight take off of drop maintaining 51% company growth and policies gets hard as you move into bigger dollar policies. Now I'll take one more question and then we'll wrap up.
Operator: Our final question then for the day comes from the line of Paul Newsome from Piper. Your question please.
Paul Newsome: I guess I was hoping you could just revisit a little bit, you've already made some comments about driving behavior that's pandemic related and what you're seeing is changing, nothing terribly specific, but you had some peers are talking about these changes in driving for example, to work or not versus regular driving. As well, I was curious if you've seen differences that were material on a state basis. Again nothing specific to state, but if there is early insights into kind of what's happening from a dynamic - from an natural behavioral perspective, I think that would be very interesting.
Tom Wilson: Glenn, why don't you answer that. I would say, Paul, the other part is with [Aire] tracking 26 million cars, we have 10 times the amount of miles driven that a company that recently went public. And so we got lots of good math on this. So, Glenn, can share with you what he is saying, just in terms of miles driven and what the impact is on frequency.
Glenn Shapiro: Yes. And thanks for the question, Paul, it is interesting getting into the data in this space. And as Tom said, with billions of miles of data we've got and the partnership with [Aire] we're able to really get into the detail. The short answer to your question is yes. There are absolutely differences state by state. There are broad trends that are true everywhere when you see some of the things about commuting and total miles driven, but you will see based on sort of where states are in the pandemic where they have either formal stay at home orders or shutdowns or anything versus when they have more informal they just have a lot of cases coming in, and just attitude differ by state in terms of how to deal with either staying home or not and so on. So we do see differences by state, but there is enough of a prevailing sort of tailwind on it that there is more similarities than difference. A couple of things, just to go deeper on the comments Tom made before, we see about 40% of our losses happen in rush hour. And so, as we're working through and we predict, again, this gets to different states because obviously in metro areas it's more of a true some of that rush hour than the non-metro areas. But we get a double effect in terms of the frequency of those accidents in rush hour in one fewer people so fewer of our drivers that we insure are actually traveling during rush hour. And so, if you're not traveling, you're not having an accident. And two, the ones who still are, because it's not zero are on less congested roads, so they have fewer accidents, and you see that in the types of accidents that remain. So it is not a pure mix of - if there were a million accidents before and you take out 10% of them. It is not a random 10%. It is a very specific 10%. And so with the mix of what's left is very different and all of these are things that we are looking at in a granular level down to state detail. So that, as I mentioned before, those the pricing actions we take, the go-to-market actions we take are highly specific.
Tom Wilson: So thank you all for participating. We had an excellent quarter. Mark is obviously available for any follow-up questions the things we didn't get to, and we'll talk to you next quarter. Thank you.
Operator: Thank you ladies and gentlemen, for your participation in today's conference This does conclude the program. You may now disconnect. Good day | [
{
"speaker": "Operator",
"text": "Ladies and gentleman, thank you for standing by. Welcome to The Allstate Third Quarter 2020 Earnings Conference Call. [Operator Instructions] As a reminder, today's program is being recorded. I would now like to introduce your host for today's program, Mr. Mark Nogal. Please go ahead, sir."
},
{
"speaker": "Mark Nogal",
"text": "Thank you, Jonathan. Good morning, everyone, and welcome to Allstate's third quarter 2020 earnings conference call. After prepared remarks, we'll have a question-and-answer session. Yesterday, following the close of the market, we issued our news release and investor supplement, filed our 10-Q, and posted today's presentation on our website at allstateinvestors.com. Our management team is here to provide perspective on these results and further context on a Transformative Growth Plan to accelerate growth in the personal property-liability business. As noted on the first slide of the presentation, our discussion will contain non-GAAP measures for which there are reconciliations in the news release and the investor supplement and forward-looking statements about Allstate's operations. Allstate's results may differ materially from these statements, so please refer to our 10-K for 2019 and other public documents for information on potential risks. And now, I'll turn it over to Tom."
},
{
"speaker": "Tom Wilson",
"text": "Good morning everybody. As usual, we appreciate you joining us, investing your time to learn more about Allstate. This was just an exceptional quarter. I mean, we're adapting, we're executing, we're investing for the future. We adapted to the pandemic, the wildfires, the hurricanes, record low interest rates, and despite all of that, our execution enabled us to make $1.1 billion. At the same time, our Transformative Growth is coming to light. The stock is a great value on any measure. So we executed a $750 million ASR. Our team has performed exceptionally well this year, serving customers, creating economic value, and building a stronger foundation for growth. So let's start on Slide 2, which has Allstate's strategy, which is shown by the two ovals on the left. We're going to increase market share on Personal Property-Liability with our Transformative Growth Plan, which has three components. You remember that: expand customer access; improve customer value, which includes improving our price position and launching new products; and then investing in marketing technology. You'll hear more about that from Glenn, and then we'll - and then Mario will go through the numbers, and then we'll get to your questions. We're also expanding our protection businesses to increase - which is increasing the total addressable market we serve. We have an edge in this expansion by leveraging the Allstate brand, our customer base and our operating capabilities, which you can see in between those two ovals. For a company that empowers customers that is, you know we provide affordable simple connected products. There has been plenty to protect them from this year. As I mentioned, we get all kinds of severe weather and catastrophes and there we moved with speed and efficiency, and you can see that from our third quarter results, and those are shown on the right. Our profitability was excellent. Adjusted net income was $2.94 a share, and return on equity 17.7%. Underwriting results also remain really strong, we get favorable auto insurance results which offset the elevated home insurance losses from increased catastrophes. Implementation in Transformative Growth Plan is accelerating with the initiation of cost reduction plan in the new Allstate advertising campaign. Investment income was off slightly due to lower interest rates, but the performance-based income returned to prior year levels. We did have an annual review of our actuarial assumptions for Allstate Life, Benefits and Annuity businesses which assumes that the continued low interest rate environment carries forward and reduces future investment income over the next 25 years and that resulted in several charges for the reduced net income, and Mario will go through a specific slide to show you how that works. Allstate Protection Plans has continued to grow policies, revenue and income, while expanding its total addressable market or total addressable market. So despite a tumultuous operating environment, we delivered great customer experiences, growth, excellent returns and progress on the Transformative Growth Plan. If we go to Slide 3, let's do the numbers. Total revenues of $11.5 billion increased 3.9% to the prior year quarter, and that reflects both higher net realized capital gain and growth in property-liability premiums earned. Net income of $1.1 billion increased by 26.7% to the prior year quarter, as you can see that in the table, as higher revenues more than offset Allstate Life and Annuity income in connection - which was down because in connection with those actuarial assumption. Adjusted net income of $923 million was $2.94 per share. It was $23 million lower than the prior year quarter. Its higher auto insurance underwriting income was more than offset by the elevated catastrophe losses or restructuring charges related to Transformative Growth and the lower Allstate Life and Annuities income. Our returns remained excellent, and as I said, the return on equity is well above the range that we've discussed. So let me turn it over to Glenn, who will talk about third quarter results for Personal Property-Liability."
},
{
"speaker": "Glenn Shapiro",
"text": "Thanks Tom. So let's go to Slide 4, and we'll discuss the - as Tom said, very strong performance of our Property-Liability business. Before going deeper into the results, it's worth mentioning that consistent with how we operate under Transformative Growth, Insurance and Allstate Financial results were combined beginning in the third quarter. Property-liability results were strong with excellent recorded and underlying profitability. Growth was modest and lower than prior year quarter for auto insurance, but in the range that we expected as we build the foundation of Transformative Growth. And let me go into some detail on that before continuing on this slide. First, the three components of Transformative Growth were all making progress. The path is a bit steeper though at the beginning for several reasons. One, in our direct business, we lowered advertising for insurance brand since its being sunset, and that has a negative impact on new business there. At the same time, we've improved new business sales flows for online sales and improved our sales practices in our call centers for the Allstate brand being sold direct, which is significantly increasing volumes there but not yet enough to offset the insurance drop. Volume in our Allstate agents channel is on plan, except for the first two months of the pandemic, and we believe the shift in compensation towards new business that we start this year is working. We stopped hiring new agents under the existing commission contract early this year, since we're building a new lower cost agent model. We also increased base level production requirements coming into this year for agents as we're investing in agents who want to grow their business. This resulted in a planned and expected decline in licensed producers as we build the foundation on a high quality set of producers. We were in the right place with the right product at the right time when it comes to Milewise, which is our pay-per-mile product. That's really appealing to customers right now, because they are driving less during the pandemic, and we're the only major carrier offering a product like that. In the independent agent channel, Encompass had a small negative impact on growth, reflecting homeowners increases. National General acquisition which is pending will expand our access into the independent agent channel and we're really excited about the growth prospects there after closing. The cost reductions we're implementing will enable us to further improve our competitive position in auto insurance and drive growth while earning attractive returns. And on the homeowner side, premium grew 2.6% from the prior year quarter. This was due to policy growth of 1.2% and average premium increases. We're really well positioned for further growth in the homeowners business. In total, we believe that the foundation we are building to be a major player in both the direct space and independent agent space that will add to our great exclusive agent channel that we already have will lead to transformative growth. So now we'll go back to our slide and we've got a bullet or two here. Underwriting income was $753 million, increasing $16 million compared to the prior year. While the recorded combined ratio was equal to last year's third quarter, there were many meaningful changes underneath that, which are shown in the lower left chart. Starting on the left, the underlying loss ratio improved 7.8 points, primarily due to lower auto insurance losses from fewer accidents due to lower miles driven. Underlying loss ratio improvement was offset by elevated catastrophe losses in homeowners, unfavorable reserve development in discontinued lines, restructuring charges and Allstate's efforts to help customers during the pandemic, which are all shown in red. Catastrophe losses of $990 million in the third quarter were driven by a very active hurricane season and ongoing wildfires in the West Coast. This is partially offset by favorable prior year catastrophe development recognized in the quarter with $450 million and $45 million respectively coming from the PG&E and Southern California Edison subrogation settlements. Non-catastrophe prior year reserve re-estimates were adverse $70 million in the quarter, this includes $132 million adverse from the annual review of asbestos, environmental and other reserves in the Discontinued Line and Coverage segment, which was partially offset by favorable re-estimates in the Allstate Protection personal lines. The chart on the right breaks down the expense ratio components. Excluding the impact of restructuring charge and bad debt in the third quarter, the expense ratio was 22.6, a 1.1 point improvement compared to prior-year quarter. It also represents a 2.5 point improvement if you go back to 2018. Moving to Slide 5, let's discuss our progress on Transformative Growth. And as Tom covered, Transformative Growth is a multi-year effort to accelerate growth through three components: expanding customer access, improving customer value, and investing in marketing and technology. Customer access was expanded by combining the direct sales capabilities under the Allstate brand, which enables us to leverage insurances capabilities with a stronger brand of Allstate. We're also enhancing local agent sales models to improve effectiveness and efficiency. And customer value is being improved by implementing a cost reduction program. This enables us to offer more affordable prices while maintaining strong margins. We also continue to improve the competitive price position of auto insurance with pricing sophistication. The third component is investing in marketing and technology. In the third quarter, we launched our new advertising campaign to reposition the brand supported by increased spend. Technology investments continue to improve customer facing interactions including the launch of the Allstate OneApp which simplifies all of our digital interactions in access, including telematics offerings. Moving to Slide 6, we're still deeper into a few of the actions taken in the third quarter to advance Transformative Growth. We're executing a cost reduction plan that streamlining operations and processes across claims, sales, service and support functions to lower costs. Lower costs enable us to have more affordable price without sacrificing attractive returns. The plan impacts approximately 3,800 employees this year, which will result in a charge of $290 million, with $198 million of that recognized in the third quarter and the balance in future quarters. The bulk of the charges for employee benefits incentives, including expanded transition support, extended medical coverage and deployment search assistance. The remainder is driven by real estate exit costs. At the same time, we launched a new advertising campaign in September built on the belief that we all deserve to live life well protected, as shown on the right side of the slide. The campaign repositions our brand and updates the messaging to generate business across a broader audience by showing the breadth of product portfolio we have including identity and service protection. The campaign also emphasizes a connected experience with telematics capabilities as customers' behaviors and needs are changing. I'll now turn it over to Mario to cover the rest of our results."
},
{
"speaker": "Mario Rizzo",
"text": "Thanks Glenn. Let's go to Slide 7, which highlights investment performance for the quarter. The chart on the left shows net investment income totaled $832 million in the quarter, which was $48 million below prior year due to a decline in market-based income. Market-based income shown in blue was $68 million below the prior year quarter. With lower interest rates, our reinvestment rates remain below the average interest-bearing portfolio yield which reduces income. Performance-based income totaled $210 million in the third quarter as shown in gray, partially reversing valuation declines recorded in the first half of the year. GAAP total returns are shown in the table on the right. Year-to-date returns were 4.4% and the latest 12 months was 5.7%, reflecting higher fixed income and public equity valuations. Performance-based investment return was 2.4% for the quarter, but remained negative year-to-date. Our performance-based strategy has a longer-term investment horizon with higher but more volatile return expectations compared to the market-based portfolio. The compound annual rate of return on the performance based portfolio is 7.2% over the past five years as is shown on the bottom right of the table, exceeding the market-based return by 220 basis points. Let's move to Slide 8 and review results for Allstate Life, Benefits and Annuities. Allstate's annual review of assumptions and the expectation of lower long-term interest rates unfavorably impacted the Allstate Life, benefits and Annuities segments in the third quarter. Allstate Life shown on the left recorded an adjusted net loss of $14 million in the third quarter. The loss was due to accelerated amortization of deferred acquisition costs, primarily from lower projected future interest rates related to the annual review of assumptions. Higher contract benefits also reduced adjusted net income, including $22 million in coronavirus death claims. Allstate Benefits adjusted net income of $33 million in the third quarter was $2 million higher than the prior year quarter, driven by a decrease in contract benefits, primarily due to lower claim experience. This decrease was driven by limited activities and the deferral of non-essential medical procedures as a result of the pandemic. The benefit from lower reported claim experience was partially offset by the acceleration of deferred acquisition cost amortization related to the annual review of assumptions. Allstate Annuities had adjusted net income of $37 million in the third quarter as contract benefits decreased primarily from favorable mortality experience compared to the prior year quarter. In the third quarter, Allstate Annuities also recorded a premium deficiency reserve of $225 million, pre-tax, given the expectation that interest rates will remain low over the long duration of these liabilities and annuitants are living longer than originally anticipated. While this reduced net income for the quarter, it did not impact adjusted net income. And let's turn to Slide 9 to discuss the Allstate Annuities and the premium deficiency reserve in a little more detail. As you can see on the chart, we've been reducing our Annuity business consistently over the last 15 years to manage risk-adjusted returns. As a result of this dynamic, we began to systematically exit these businesses. In 2006, we reinsured the variable annuity business. In 2010, we exited the broker dealer channel. In 2013, we stopped issuing structured settlements. And in 2014, we stopped issuing all remaining annuity products and sold Lincoln Benefit Life. As a result, liabilities declined from $75 billion in 2005 to $17.5 billion as of the end of the third quarter. Today, liabilities are made up of that $17.5 billion dollars of reserves and contract holder funds related to deferred and immediate annuities. Our asset liability management strategy has positioned the portfolio to cash match near term liabilities while investing in public equities and performance-based assets for longer duration liabilities to generate attractive risk-adjusted returns. Two-thirds of the payments on these annuities are expected to be made after 2030. As part of our third quarter review of actuarial assumptions we lowered our long-term return assumptions given the expectation that interest rates will remain low for an extended period. This reduces expected future investment income. Mortality assumptions were also updated to reflect the expectation that annuitant will live longer. These two changes led to a forecast where current reserves and expected returns on those reserves over the life of these annuities is less than the expected payouts, which led to the charge of $225 million pretax. So now let's go to Slide 10 and discuss the results of our service businesses. The service businesses continue to generate strong growth as policies in force increased 38.6% to $133 million in the third quarter, driven by Allstate Protection plans growth. Revenue, excluding the impact of realized gains and losses grew 16.9% to $484 million in the third quarter. Adjusted net income of $40 million reflects an increase of $32 million compared to the third quarter of 2019. The improvement continues to be driven by the growth of Allstate Protection Plans and improved profitability at Allstate roadside services. Now let's turn to Slide 11 to review the results of Allstate Protection plans in a bit more detail. So, as you remember, the acquisition in early 2017 for $1.4 billion further expanded our circle of protection for customers and continues to exceed growth and profit expectations. As you can see in the chart on the left, Allstate Protection Plan has had exceptional growth since acquisition in early 2017. Policies in force increased more than fourfold from less than 30 million policies in 2017 to 126 million in the third quarter of 2020. This represents a compound annual growth rate of 51%. In addition, net written premium of $831 million for the first nine months of 2020 increased 50% compared to the prior year period. On the right you can see that Allstate Protection plans began generating positive adjusted net income in early 2018, which is earlier than expected. The upward trajectory has continued this year, generating $105 million of adjusted net income through the first nine months of 2020. Even more important to shareholder value is the trajectory going forward from here. The team has successfully expanded the total addressable market into appliances, furniture, cellular carriers and international markets with revenues in each of these areas. The combination of attractive unit economics, scalable technology platform and the power of The Allstate brand will lead to continued profitable growth in this business. Quite simply, this is not your typical protection platform. Finally on Slide 12, we want to highlight Allstate's attractive returns and strong capital position. Allstate generated strong returns on capital with an adjusted net income return on equity of 17.7% as of the end of the third quarter. We returned $967 million to common shareholders in the third quarter. Through a combination of $798 million in share repurchases and $169 million in common stock dividends. Over the last year, we have reduced common shares outstanding by 6.4% primarily as a result of our share repurchase program. As you can see from the table. Book value per share of $82.39 increased 18% compared to the third quarter of last year, reflecting income generation and increased fixed income valuations, partially offset by cash returned to shareholders. Allstate stock valuation metrics, however, have not kept pace with this combined strength and strong operating performance. With that context we will open up the line for questions."
},
{
"speaker": "Operator",
"text": "[Operator Instructions] Our first question comes from the line of Yaron Kinar from Goldman Sachs. Your question please."
},
{
"speaker": "Yaron Kinar",
"text": "First question is with regards to top line growth. So I understand there are a lot of moving parts here and you're selling early to maybe the end of the beginning of the transformative growth plan. At what point do you think we actually do start seeing the initiative and the various components there resulted in top line growth?"
},
{
"speaker": "Tom Wilson",
"text": "Yaron, this is Tom. So they - we can't really give you a quarter and say here's one that turn a say you should buy the stock right before that. So that what is really reflecting the terrible pop because a number of things happening. Right? So we're trying to make sure we take care of our existing customers well, and that requires, as we change out some of the agents and the stuff Glenn talked about, we have to make sure we're doing that well with integrated service and moving people to other agencies. Second, there is obviously a competitive market in which we're in. So part of it depends what happens with our competitors and what they do, how much more they put into advertising, how much they raise homeowners prices. I think that what I would say is the focus seems to be narrowed down to just auto insurance and really transformative growth is about auto insurance is about home insurance where we're getting a growth - good growth and not as much as we think we can have, but certainly higher than auto and then the circle of protection. So I can't really call it by quarter. I would say is, you should expect as you see the components come into place. You should expect to see a trajectory up from here. But we're not giving specific guidance on here. Here's where more going to be at X percent of market share gains."
},
{
"speaker": "Yaron Kinar",
"text": "Okay. And then my second question, somewhat related these launch of the Allstate One app. Are there any metrics you can share with us around, have the company applications have been downloaded, take-up rate in the ease of use or how long it takes to get a quote on the app?"
},
{
"speaker": "Tom Wilson",
"text": "Well we have - average that we have a whole bunch of metrics and we don't give most of them out, because we think we're starting to get in advantage versus our competitors on it and we really don't want them copying what we are doing that in both sub year on to your point, both on things like also in telematics. So we're really positive about what we got going on there. And, but we - I would tell you that the insurance industry in general is not to the level that banks are which says we have a lot of potential to increase our connectivity and lower cost at the same time. Glenn, anything you would add to that?"
},
{
"speaker": "Glenn Shapiro",
"text": "No, I think that covers it."
},
{
"speaker": "Operator",
"text": "Our next question comes from the line of Greg Peters from Raymond James. Your question please."
},
{
"speaker": "Greg Peters",
"text": "So I'm going to stick with the transformative growth plan. And I think in your second bullet point, you talked about improving customer value. So there's two pieces of that as we sit outside looking in, one is the expense ratio initiatives that you've highlighted. The other one would be just price to your customers. So can you give us an idea of where the expense ratio will go to or what sort of objective you have in the context of your competition? And then, on price, we have observed a number of your competitors starting to cut prices in the marketplace and in auto insurance and I'm curious about your posture with respect to that."
},
{
"speaker": "Tom Wilson",
"text": "Greg, let me start with the overview on transformer growth and then Glenn, if you could jump into where we are on pricing these. So transformer growth has three components, right. Second one is improved customer value, that is really two components to it. But one is improve the competitive price position and with affordable products. And second is to launch new products, the things like [indiscernible]. So the second piece is really about more differentiation price the cost piece is really the way a door you go through to get to the price piece. So they are not separate. So in the reason we haven't put cost targets out there, we obviously have cost target and we also have price competitive targets. The reason we haven't put those out there is, they are tightly linked. And we don't want to signal to our competitors, where we think we're going our price. So it's not that we don't have targets we do, and we think we can reduce our costs, which enables us to give customers better value called more affordable price without sacrificing attractive margins. So that's the path we're on. Reduce expenses, if those expense is down turn that into a more affordable price, which increases your closed rate, which then drives growth. So the first - it's really one component that you're talking about. The second piece will take some time, because you have to rebuild the whole technology stack, there's just a bunch of work that has to be done to launch new products. That will take a couple of years to really get done, which is why we keep this is a multi-year initiative. Glenn, do you want to give Greg an update on pricing and your thoughts there?"
},
{
"speaker": "Glenn Shapiro",
"text": "Yes, you've covered, Tom. Well, the - going forward, how we bring the cost down and keep margins while being a better value for customers. But I don't want to leave anybody the impression that we're not moving now because sometimes you can look at a like an investor supplement and say, well, it was zero rate taken and think that that means there is zero rate action. We have made hundreds of filings over the last quarter, all across the country and I know you always hear me say it Greg, but we manage this at the market level. So we've got a really talented group of state managers, I always talk about that. They've got their hands on the lever they’re looking at, how competitive are we each competitor in this market, what's our close rate doing, what type of shifts are we seeing in customers and quoting and they're moving those levers all the time and we're working with regulators to do that. So the hundreds of filings that we've made already since the pandemic and through this time have materially changed our competitive position in spite of that 0.0, you see on total rate filing. We've done things like improved our competitive position on telematic products, increased new business discounts, changed pricing around for the type of people that are shopping. And so the average person that's out there shopping for insurance is getting a lower price rate now for us than they were six months ago or nine months ago meaningfully lower. And so this is how we stay competitive, and it goes a little bit back to Yaron's comment or question on growth, and I look at it as while we're building this foundation, like I mean we're setting up the capability for us to be a major player in direct. We are setting up the capability for us to be a major player in independent agent with the acquisition that's pending. And while we're building that foundation, I'd call it, we're holding our own. Like we actually grew policies year-over-year, policies in force, minimally in auto more so in home, but we're doing a good job of keeping the fight going and keeping our growth engine going in spite of building that foundation."
},
{
"speaker": "Greg Peters",
"text": "Your answers makes sense. I guess the second question, and it's just going to pivot to the other source of income would be investment income and just looking over the Slide 7 and considering Mario's comments, there is obviously two pieces and it's been volatile this year. But it feels like because of the current interest rate environment there is going to be downward pressure on your market-based returns and therefore investment earnings you generate off that for the next year or two. And then also on the performance base, the volatility is interesting for us to try and model. So can you frame it for us as we think about what the future performance might be of the performance-based portfolio?"
},
{
"speaker": "Tom Wilson",
"text": "Greg, let me go up and then, John you can talk about the risk adjusted return of volatility of the performance base. So - as - when we do our investment allocations all the way at the top, we look at risk adjusted return based on economic capital per asset class and so earlier this year when we sold $4 billion of our $6 billion of public equities, it was because we saw the pandemic come in or we thought there is going to be a dip down and then a bump back up, it was - and we are going to avoid that volatility. We just - we didn't think the risk adjusted return was right. When we look at our market-based results and you're right. Interest rates are coming down there at low rates, really low rates, you're probably not going to have as much capital on those bonds as you had historically. And we looked at the risk adjusted return on the performance space, we decided it was a better risk adjusted return on the performance is now. Obviously, it comes with more volatility and particularly from quarter to quarter, as you point out, so what we did is we matched those performance space, the long-term viability is on dated annuities or capital, which we expect to have for a long time and so when you do that you can handle that in term volatility because - and that's why you get the higher risk adjusted return because you're taking on that volatility. And once you get past seven years, - you're better off owning equities and bonds, as you all know well from just looking at the pension funds. And you get past 10 years and it's like you get double the return and you actually have less risk on equity. So that's how we got to performance-based equities and we're willing to accept that volatility either because we have liabilities or capital which we know will have and will recoup the incremental economic return over time. Before I turn to John let me just - one other thing, as you look forward, what we do of course, is when we're managing our auto business in particular, we look at what underwriting margin do we need given what we think we're going to get in investment income. So to the extent investment income, it goes down, we given our power in underwriting, we're able to still make a good return for our shareholders even with slightly lower interest rates. Unlike some of the life companies who have no other way to adjust their future premiums. So John, do you want to spend a few minutes talking about performance space?"
},
{
"speaker": "John Dugenske",
"text": "Yes sure, Tom. And Greg, thanks for the question. I'll pick up where Tom left off. When you think about performance base it can be volatile for periods of time. As Tom mentioned, we really match it off versus longer liabilities that we have. If you take a longer-term view and this is information that's in the supplement, - over a 10-year period, the internal rate of return, which is a common way of measuring these assets is about 11.5% and when you look at it over 10 years or over five years relative to the public equity benchmarks that we think about owning these assets against, they are superior in terms of return. So we're willing to take some of that volatility relative to more observable public markets because we think we've got a team that has skill and expertise that can extract value out of the marketplace that it isn't easy for other people to do. I tend to think of it is we've got a lot of flash lights that we can shine in different corners of the market that maybe everyone else doesn't have to extract additional value. Now you're right to point out there has been a little bit bumpier during the course of this year and that does require some explanation. Yes, I think we'd all agree this year, it has been a pretty unique year and when you think about what releases income in performance-based assets, part of that is the deal flow itself, you need to - we invest in a particular entity, whether it's a fund or an individual investment, it improves in value over time. And then we tend to sell those investments and it generates income. During the period of time when deal flow was down because people just travel to do due-diligence and that sort of thing it's normal to understand that that income was reduced. There was also and we disclosed this earlier in the year, we did have some loss, we had about $130 million in actual losses in that place in as well. What we've seen this quarter is a beginning of returning to more normalized deal activity. So we're not going to predict the future here, but there is reason if you look back, relative to what we've experienced historically, we're starting to see a pattern that starts to fit in a little bit. So long dated liabilities matches up well versus that. We like the long run returns even though they're more volatile, but we think there is a period of what we can do in public markets. When it comes to rates you've seen us Greg, you've seen us be proactive in the way that we think about investing in our market-based portfolio. And as Tom said, that's part of a larger enterprise system where we think about risk and return across the enterprise, whether it's underwriting risk, mortality risk or investment risk and return, and we've made changes over time to address for different market environments. So a good example of that is coming out of the global financial crisis. We reduced interest rate risk as rates became lower and we took more credit risk. We thought that it was, that had a good risk return profile. As rates started to increase in recent years, we've lengthened our duration to take advantage of that and that's served us quite well as interest rates have fallen here. And we've subsequently in beginning of the year we saw less value on a risk adjusted basis for public equities and reduce that. One thing that may not be completely obvious is during the course of the year, this year we've taken further actions - we're not only are we helping buffer income by increasing duration, but we've also moved some of that equity exposure and some of our pure government exposure into almost $10 billion of investment grade credit some high quality, high yield and associated securities to help minimize the impact that lower rates we will have. I mean you're right, if rates stay this slow for a long period of time there will be a reduction of income, it's just kind of pure math that play out that way. When I look at the Slide 7 of the presentation and you see those blue lines. It just doesn't happen that rapidly part of our investments are matched off versus longer liabilities. So they're cash matched and then part of it has to happen as the portfolio tends to roll off over periods of time. So, it will happen if rates remain low for a long period of time, it won't happen overnight. And we're hopeful like most people are that interest rates will recover some ground as we pull out of the COVID-induced lower interest rate paradigm that we're currently in."
},
{
"speaker": "Operator",
"text": "Our next question comes from the line of Mike Zaremski from Credit Suisse. Your question, please."
},
{
"speaker": "Mike Zaremski",
"text": "First question, looking through the deck I see one of statements saying improved online and call center sales flow in Allstate direct. Can you give us a flavor for how much of your sales today I think mostly think of Allstate as a agency-based seller of insurance, but how much is coming from direct? And related, I believe in the past you've said that as part of the transformation program, you might be offering a discount to existing customers to potentially use more of the direct platform versus the agents, is that still part of the game plan?"
},
{
"speaker": "Tom Wilson",
"text": "Mike, let me first start with the overview and [indiscernible] and Glenn, if you want to talk about sort of sales flows and what you've got going on in sales. And so, we've put together the usage, so if you looked at our old stuff last quarter you would see Esurance broken out and that was 100% direct, either online or through call centers. We did also sell some business under the Allstate brand in the same manner, mostly through call centers, but a little bit online. And with the new format we have, we put those two together. And so, we're not planning on breaking out how much comes out direct and how much comes through agents. You're correct in that if you buy direct, today you get, what you paid for, so you don't pay for an agent. So you don't - the price is 7% lower if you buy direct from the company, but that's for only for new customers. We're not going back to existing customers and saying hey, how would you like the 7% price reduction because they are happy with their existing relationships. They bought from those agents, they have as we cross-sell into those agents. So there is no really need to go disrupt that were about giving it to people anyway they want. If you want an agent you can call us and get an agent and - you call center we’ll get you an agent, and you can have a local agent. If you want to do self-serve, and you want to do it online, we'll do that as well. So the strategy is to really leverage the Allstate brand and take that Esurance money which was spent - Esurance advertising money which was hundreds of millions of dollars a year and throw that at the Allstate brand. So, that, we could compete more aggressively with GEICO and Progressive in the direct space. Glenn, do you want to talk about like sales flows and how you're making that work so?"
},
{
"speaker": "Glenn Shapiro",
"text": "Yes, so the team that we've had that ran Esurance and has been put together as Allstate as Tom said, with the Allstate Group. And you would think that it would be relatively easy to flip a switch and say, hey, we're a direct company now and accordingly play big in this space. But we literally have decades of connective tissue and process built around everything is an off-ramp for an agency system. And so what we want to be and aspire to be in the near term, is a company that really goes to market in both ways. It's open access for a customer, customer that wants to click our call that we do that really effectively and we can compete with the biggest direct carriers out there. In that space and think about that as a full channel. And then it takes nothing away from the exclusive agent channel we have which is outstanding. They do an incredible job for customers. They've done a great job through the pandemic you can see it in our retention numbers and continue to grow that channel. But the work they've done is really the pick and shovel work of removing some of those pieces of connective tissue between channels and really going to market as a direct business. Esurance was set up that way because it was a separate run operation. This now is common product, its common back end service that we have, but it's a separate sales channel."
},
{
"speaker": "Mike Zaremski",
"text": "Last question, circling back to the annuity business and we do appreciate all the color. I think we all get asked a lot whether Allstate would entertain a transaction. So I know you've answered that in the past, but maybe I'll try to ask in a different way. So you've pointed out very well that you've moved a lot of the investments into kind of longer duration hopefully higher yielding assets, which is one of the things that some of the private equity backed firms do as part of their right their special sauce? So would you say that lower interest rate environment combined with how you guys positioned the portfolio kind of makes the bid-ask spread of entering a transaction wider than it was a year or so ago?"
},
{
"speaker": "Tom Wilson",
"text": "First Mike, if you look at the one slide that we've taken annuities down some $75 billion to $17 billion over a period of time. And we've done that with a couple of objectives in mind, what we want to make sure we take care of customers do you want to get a good deal for shareholders. And so we've been kind of whittling away at it and these are the last two chunks we have left. And we're open to different ways to do that and if we look at all different ways to do it all the time so everything from reinsurance to sales, everything else. And so, I don't think lower interest - rates obviously are something you need to factor in. It's less important when you have the investment portfolio that you just mentioned in terms of what it does to the - it helps fill the gap from low interest rates because you're earning higher returns. I think we have decided so this - these are becoming more scarce properties because you've seen the asset managers go out and they like having what I would call captive asset. So there is a whole host of you are all familiar with that throughout and want to buy annuity blocks. So that they can have those assets to manage and then they separately finance the purchase of a company part with their money and part with other people's money it's a way to build a better revenue stream for themselves. We're open to that thing as long as it meets our two objectives. One, you got to take care of our customers. So some of these customers are going to get paid for 30-plus years we don't want to turn that somebody that's going to take it all and go to Las Vegas and put it on red. And then our customers are left hole in the bag. Secondly, we want to make sure it's good deal for our shareholders. So, we're always looking at opportunities to further reduce the exposure. I mean, you look at that trend line. We have a slide that is and it's - there is no reason to expect that we would try to change that trend line. It will go down by itself. So, like they do roll off people to stop collecting payments either because their term is up or they pass away. So, but you should expect it keep going down if we can find the right way to do that for shareholders and customers then we’ll do it."
},
{
"speaker": "Operator",
"text": "Our next question comes from the line of Phil Stefano from Deutsche Bank. Your question, please."
},
{
"speaker": "Phil Stefano",
"text": "So with the sun setting of the Esurance brand we’re down to three brands now. I guess in my mind, part of the transformative growth plan is a rally behind the Allstate brand so strategically you could talk about the importance of Encompass and answer financial. As we think about the transformative growth plan over time?"
},
{
"speaker": "Tom Wilson",
"text": "So it's Tom. I think it's really one brand. And we have some names, but right now we have one what I would call consumer brand. There is obviously some brands amongst agents. And so, you see us leveraging a brand, not just on direct, but Allstate Protection products. I don't believe we would have gotten Walmart and driven the kind of growth we have without the Allstate team on there and the Allstate backing. Same is true with Home Depot, which will be rolling out starting in January. So it's really one brand. There are - you do point out two other ways if you go to market. So Glenn, could you talk about plans or the independent agent channel Encompass with National General and then just touch on what you're doing with Answer Financial as well?"
},
{
"speaker": "Glenn Shapiro",
"text": "Yes so in the IA space, it really is National General and I won't get into the brand, because I don't know if any decisions made in terms of exactly the brand. But as Tom said, it's more of a branding with agents than it is with customers in that channel. But with National General and Encompass it's really about bringing those together in sort of a reverse integration because National General has a platform, a technology platform that the IAs love. They have 42,000 existing relationships with agency locations to go along with the 10,000 that we have with Allstate and Encompass. And between the two companies, we have a product set that goes from non-standard all the way up through high net worth and everything in between. And what I always point out on this is, I think maybe the most important part is our homeowners’ capability. The IA space they really need that the full stack and all the capabilities and we clearly have a premier homeowners capability at Allstate. So you put all of that together and we will have the most capabilities of any carrier we will be the Number 5 in size, as soon as the closing goes through in the IA space. But we will be number one in terms of overall top to bottom capabilities. That won't be the day that we go live it won't be that because we won’t been able to integrate products and everything and push it across. But in short order we will be able to bring those together and really go to that market and be a very major player in the independent agent space. And that, pertaining there was second part to that."
},
{
"speaker": "Phil Stefano",
"text": "Answer Financial?"
},
{
"speaker": "Glenn Shapiro",
"text": "No, I'm sorry Answer Financial, thanks. Yes, so on Answer Financial, that is - it's a very different type of model. That really is taking care of customers who we can't take care of in other ways. Are they sort of fall between the cracks of - always narrowing cracks actually at this point because we cover just about all different types of customers at this point. But the narrowing cracks there and it's a way to monetize the exhaust from our expense on marketing and make sure that anybody that comes to us - we can get to at some point. And so Answer Financial from a branding standpoint is separate and they sell multiple carriers."
},
{
"speaker": "Phil Stefano",
"text": "I think going back to the National General acquisition we noticed in the Q, that there was a note that you're currently contemplating the mix of cash and debt for that purchase. I was hoping you might be able to further find your point on what your thoughts are there. And just intertwine that into a - broader thoughts on capital management and share repurchases?"
},
{
"speaker": "Tom Wilson",
"text": "Mario you could take that."
},
{
"speaker": "Mario Rizzo",
"text": "Sure, Phil. Thanks for the question. Yes - when we announced the National General acquisition, the financing strategy all along was part cash from our deployable capital part excess capital within the National General structure and part debt so that continues to be the strategy in terms of how we'll fund National General. So that part hasn't changed. So we fully expect it to execute across all three dimensions and the closed process is progressing on that acquisition. In terms of broader capital management - and I think Tom mentioned this early on. We continue to think the stock is undervalued. And we have ample capital and liquidity available to continue to buy back stock. We got - excuse me $2.8 billion holding company assets. We got over almost $7 billion of readily available liquidity. Our debt-to-cap ratios are below 20%. So we feel really good about the financial strength of the organization and that's one of the reasons. That combined with our view on the relative valuation of the stock is what led us to do the $750 million ASR in the fourth quarter. We got 7 million shares as part of that. We still have ways to go on the current share repurchase authorization. So we still have just under $1.6 billion left and we'll continue to execute on that. And the point that's worth mentioning is, as we've said from the beginning, the National General acquisition doesn't impact the buyback program. We fully expect to complete that by the end of the year."
},
{
"speaker": "Operator",
"text": "Our next question comes from the line of Joshua Shanker from Bank of America. Your question, please."
},
{
"speaker": "Joshua Shanker",
"text": "On your press release you were announcing the restructuring plan you made the comment that the cost reductions and job reductions were necessary in order to maintain underwriting ratios. I'm not really asking for guidance, but obviously COVID throws a little bit of curve on things? When we think about 2019, I guess is there actually a possibility in your long-term outlook that you think the type of underwriting margins you are achieving on a COVID-normalized basis can be maintained into the years going out given price reactions and given what your goals are?"
},
{
"speaker": "Tom Wilson",
"text": "[technical difficulty] Josh, because I'm not sure what COVID-normalized are. But I think. I think the shortest way to answer that is we are in really attractive returns on auto insurance. We have for 14-15 years, maybe longer are running and we have a system and an objective and goals that we've achieved to continue that. When I say COVID-normalized, what we don't really know is certainly of course when the pandemic ends which is beyond your normalization. But I'm not sure what it will do to consumer behavior, particularly driving, I think computing is going to be viewed as overrated. And so, given that about a third of the time people are in their cars they're driving to and from work. So if even a small portion of people so 25% of the people commute less. That's a pretty big drop, and we will react to that when we can. I think what it does, it gives us more room to maintain the kind of returns we have while getting more competitive. And so, but you should assume we’ll continue to be focused on earning attractive returns. That comment in the press release was really about saying, we didn't have to reduce cost, because we're not making money. There are a lot of people out there who today are airlines and other people were having let people go because they just in trouble. We're not in trouble. We're making really good money. And so we don't need to do it they are reason. We also as we're talking about getting more competitive in auto insurance in particular. We don't want everybody. Moving to the conclusion, which you could, if you took your question farther would be that we're going to do that by given in a way - like say anybody can give it away its talented teams that both grow and make money. And so, we were just trying to point out that the point that and Greg mentioned earlier, which is that the cost and the pricing are tightly linked. And I know a lot of you would like to have some expense ratio target that you could put into your models but trust us, we have a measure. It's a good measure, it's aggressive, but it's tied to what we're trying to do on price. So we're not willing to talk about that publicly."
},
{
"speaker": "Joshua Shanker",
"text": "And just a quick one on square trading growth. Obviously people are stuck at their homes, they've been buying a lot of stuff on Amazon and whatnot. Do you think that 2020 was a record year for consumer electronics purchasing and that 2021 will face some headwinds in beating 2020 as a year for new policy yet square trading or Allstate protection plans?"
},
{
"speaker": "Tom Wilson",
"text": "Let me ask Don answer that and then just do a commercial before that, which is - we are stronger being together with SquareTrade than we were independently both in terms of what it does for a server protection and what we do for them in getting Walmart Home Depot leveraging the Allstate brand. But I would say you put this up against any of the recent IPOs out there. This thing is worth a whole lot more than we paid for. Don, do you want to talk about what happened?"
},
{
"speaker": "Don Civgin",
"text": "Sure. So, Josh, first, the trends have been strong for a long time. So it's not like this year, all of a sudden SquareTrade took off, they've been doing well since the acquisition. It's been a combination of things that's driven that. It's the growth in the existing customers by which they've been able to help drive with their customers. It's been additional customers that they've added B2B customers additional retailers and then this thing that Mario talked about which is just extending their total addressable market. So three years ago there were largely consumer electronics to U.S. retail. But since then it's the more than consumer electronics, it's now appliances. It's now furniture, it's now international business that's growing dramatically. It's cell carriers and so forth. So it's been kind of expansion across the board, which has been consistent for the last three years. This year's results, you're right, we're impacted by COVID, they were going to be strong regardless. So this was going to be a really great year. We got the benefit of COVID but it wasn't just people buying online, it was the customers that we have the places, people are shopping in the categories that lend themselves to warranties are the ones that customers have been purchasing. So whether it's setting up our own office or setting up consumer electronics as you said. So this year has been good and it's been positively impacted, but I think it would be a big mistake to assume it wouldn't have been good anyway. And then when you get into 2021 and those underlying trends that I talked about that have been going for three years will continue. And so, we still expect them to continue to grow and do well. I suspect at some point the lack of buying power in the economy will probably dampen retail sales across the board, more hard to predict how that's going to happen when that's going to happen. But I think that's the - that's on the margin, the underlying trends will continue in a very strong manner."
},
{
"speaker": "Joshua Shanker",
"text": "Thank you very much."
},
{
"speaker": "Tom Wilson",
"text": "Add to that is, when you look forward in 2021 in Allstate Protection plans, the mix of policies going to change some. So you'll see the policy growth come, but you will see the revenues continue to accelerate as particularly as we get into bigger dollar amount per policy. So just one thing to get a warranty policy on a iPad, it's another thing for a washer or dryer or for furniture. So you should still see and we expect increased revenue growth, but you may see a slight take off of drop maintaining 51% company growth and policies gets hard as you move into bigger dollar policies. Now I'll take one more question and then we'll wrap up."
},
{
"speaker": "Operator",
"text": "Our final question then for the day comes from the line of Paul Newsome from Piper. Your question please."
},
{
"speaker": "Paul Newsome",
"text": "I guess I was hoping you could just revisit a little bit, you've already made some comments about driving behavior that's pandemic related and what you're seeing is changing, nothing terribly specific, but you had some peers are talking about these changes in driving for example, to work or not versus regular driving. As well, I was curious if you've seen differences that were material on a state basis. Again nothing specific to state, but if there is early insights into kind of what's happening from a dynamic - from an natural behavioral perspective, I think that would be very interesting."
},
{
"speaker": "Tom Wilson",
"text": "Glenn, why don't you answer that. I would say, Paul, the other part is with [Aire] tracking 26 million cars, we have 10 times the amount of miles driven that a company that recently went public. And so we got lots of good math on this. So, Glenn, can share with you what he is saying, just in terms of miles driven and what the impact is on frequency."
},
{
"speaker": "Glenn Shapiro",
"text": "Yes. And thanks for the question, Paul, it is interesting getting into the data in this space. And as Tom said, with billions of miles of data we've got and the partnership with [Aire] we're able to really get into the detail. The short answer to your question is yes. There are absolutely differences state by state. There are broad trends that are true everywhere when you see some of the things about commuting and total miles driven, but you will see based on sort of where states are in the pandemic where they have either formal stay at home orders or shutdowns or anything versus when they have more informal they just have a lot of cases coming in, and just attitude differ by state in terms of how to deal with either staying home or not and so on. So we do see differences by state, but there is enough of a prevailing sort of tailwind on it that there is more similarities than difference. A couple of things, just to go deeper on the comments Tom made before, we see about 40% of our losses happen in rush hour. And so, as we're working through and we predict, again, this gets to different states because obviously in metro areas it's more of a true some of that rush hour than the non-metro areas. But we get a double effect in terms of the frequency of those accidents in rush hour in one fewer people so fewer of our drivers that we insure are actually traveling during rush hour. And so, if you're not traveling, you're not having an accident. And two, the ones who still are, because it's not zero are on less congested roads, so they have fewer accidents, and you see that in the types of accidents that remain. So it is not a pure mix of - if there were a million accidents before and you take out 10% of them. It is not a random 10%. It is a very specific 10%. And so with the mix of what's left is very different and all of these are things that we are looking at in a granular level down to state detail. So that, as I mentioned before, those the pricing actions we take, the go-to-market actions we take are highly specific."
},
{
"speaker": "Tom Wilson",
"text": "So thank you all for participating. We had an excellent quarter. Mark is obviously available for any follow-up questions the things we didn't get to, and we'll talk to you next quarter. Thank you."
},
{
"speaker": "Operator",
"text": "Thank you ladies and gentlemen, for your participation in today's conference This does conclude the program. You may now disconnect. Good day"
}
] | The Allstate Corporation | 18,711 |
ALL | 2 | 2,020 | 2020-08-05 09:00:00 | Operator: Ladies and gentlemen, thank you for standing by, and welcome to the Allstate Second Quarter 2020 Earnings Conference Call. At this time, all participants are in a listen-only mode. After the speakers’ presentation, there will be a question-and-answer session. [Operator Instructions] As a reminder, today's program is being recorded. I would now like to introduce your host for today's program, Mark Nogal, Director of Investor Relations. Please go ahead, sir.
Mark Nogal: Thank you, Jonathan. Good morning. Welcome, everyone, to Allstate's Second Quarter 2020 Earnings Conference Call. After prepared remarks, we'll have a question-and-answer session. Yesterday, following the close of the market, we issued our news release and investor supplement, filed our 10-Q and posted today's presentation along with our reinsurance update on our website at allstateinvestors.com. Our management team is here to provide perspective on these results and further context on our strategy to grow personal property-liability market share. As noted on the first slide of the presentation, our discussion will contain non-GAAP measures for which there are reconciliations in the news release and investor supplement and forward-looking statements about Allstate's operations. Allstate's results may differ materially from these statements, so please refer to our 10-K for 2019 and other public documents for information on potential risks. And now I'll turn it over to Tom.
Tom Wilson: Good morning. Thank you for joining us this day on Allstate. So let's start on slide 2 of its Allstate's strategy and our second quarter highlights. So our purpose is to protect people from life's uncertainties and to be a positive personal good. And as you know, our strategy has two components: increase personal proper liability and market share and expand into other protection businesses, which are shown in those two ovals. Richest Allstate brands, customers and capabilities to both of those components. This strategy is an adaption the coronavirus pandemic led to excellent operating in the second quarter, as shown on the right hand. The enterprise customer experience score increased as employees and agencies did an excellent job of working remote, and we benefited from leading on the shelter-in-place payback and helping customers in other ways. Profitability was good with adjusted net income of $2.46 per share. We also made progress at our multiyear transformative growth plan by leveraging the direct sales capabilities of Esurance and lowering expenses. Allstate Protection Plans, which, as you know, we acquired 3.5 years ago for $1.4 billion and high-growth and high returns, section plans [Technical Difficulty] at the end of 2017 and estimated adjusted net income of $35 million in the quarter and $69 million for the first six months of 2020. The performance-based core losses in the quarter reduced reported net investment income despite solid total loan growth. Our profitable growth it depends overall [Technical Difficulty]. We move to slide 3. I'll say quickly excellent operating results, total revenues of $11.2 billion increased 0.5% of the prior year for gain and growth in the property-liability premium earned were -- that more than offset the decline in investment income for performance-based losses. Net income of $1.2 billion increased 49% to the prior year quarter, as you can see from the middle of the table market value in just $380 million 2019, $2.46 per share, 12.8% of other than repurchase program. With adjusted net income mature line at 17.8%. [Technical Difficulty]
Glenn Shapiro: Thanks, Tom. Let's go to slide 4, where we'll discuss the strong performance of our Property-Liability segment. Premium and policy growth continued with excellent recorded and underlying profitability. Policies in force were $33.8 million at the end of the quarter, and Allstate brand policies reaching an all-time high for auto at $20.5 million. Underwriting income of $904 million increased by $537 million compared to the prior year quarter. The chart on the lower left shows the second quarter combined ratio of 89.8% and the impacts driving the 6-point improvement over the prior year quarter. Starting on the left the underlying loss ratio improved by 15.9 points on lower auto insurance losses from fewer accidents, due to significant reduction in miles driven. The underlying loss ratio on homeowners insurance also improved due to increased premiums and lower non-catastrophe losses. The underlying loss ratio improvements were partially offset by Allstate's efforts to help customers during the pandemic. This included the 15% shelter in place payback on auto, which totaled 8.3% of premiums across all lines of on business, plus a 0.5% of premiums from increased bad debt expense, due to billing flexibility related to the Allstate special payment plan. The chart on the right breaks down the expense ratio components. The expense ratio was 23.0 and improved 0.5 point compared to the prior year quarter, excluding the $738 million shelter-in-place payback and bad debt expenses in the quarter. As you know, one portion of our transformative growth plan is to deliver better value to customers, in part by reducing operating expenses. While expenses vary by quarter, as you can see from this quarter, the long-term trend has been down as you look at the adjusted numbers, which are 2.1 points below 2018 expense ration. So let's now move to slide 5 and discuss transformative growth in more detail. The transformative growth plan will accelerate growth through three key levers: expanding customer access, enhancing customer value and investing in technology and marketing. We're expanding customer access and increasing product availability by leveraging Esurance's direct sales capabilities under the Allstate brand. The Esurance brand will be sunset over time, and the advertising spend will be concentrated on the Allstate brand. This also includes improving online and call center sales flows. We're enhancing customer value through continued cost structure improvements, which will make prices more competitive without reducing underwriting margins. We recently announced changes in the personal Property-Liability organization, which included combining our direct operations as well as consolidating Allstate brand field operations to further lower costs. To improve customer value, we're also expanding telematics offerings and promoting our unique Milewise pay-by-mile product, which is appealing to customers right now as they're driving less during the pandemic. The third component is investing in technology and marketing. Technology investments are improving our customer experience, including the recent launch of Allstate One app that simplifies and combines digital access and telematics offerings in one place. Launching the transformative growth plan also enhances our ability to adapt to a post coronavirus operating environment. We'll have lower cost structure and more competitive prices. We're also building the capacity to invest in new products, marketing and technology while maintaining strong margins. The new technology platform will allow us to be more connected with customers and give us greater flexibility to change products and processes going forward. Now, I'll turn it over to Mario to discuss the rest of our second quarter results.
Mario Rizzo: Thanks, Glenn. Let's go to slide 6, which highlights investment performance for the second quarter. We take a proactive and holistic approach to managing the investment portfolio. After reducing public equity in the first quarter, we increased our allocation to investment-grade corporate bonds this quarter. The chart at the left shows net investment income totaled $409 million in the quarter, which was $533 million below prior year, due to a decline in market-based income and losses in the performance-based portfolio. Market-based income, shown in blue, was below the prior year quarter by $77 million. As interest rates have declined, reinvestment rates are below the average interest-bearing portfolio yield, reducing portfolio income. We recorded $211 million loss on our performance-based investments in the second quarter, as shown in gray. As you know, we proactively adjusted valuations in the first quarter in response to the significant decline in equity markets. In the second quarter, we followed our standard process for recording performance-based results, which generally recognizes valuations on a one-quarter lag. Given this lag in income recognition, the second quarter improvement in public equity markets did not have a positive impact on this portfolio in the quarter. GAAP total returns are shown in the table on the right. The second quarter return of 5% primarily reflects tighter credit spreads and the impact of higher equity valuations on the $2.8 billion public equity portfolio. Year-to-date returns were 2.7% and the latest 12 months was 5.9%. Performance-based investments had a 2.4% and 4.5% loss for the quarter and first half of 2020, respectively. These investments are expected to generate higher returns than the market-based portfolio, and consequently, typically have higher volatility. This portfolio has generated an annualized rate of return of 7.4% over the past five years, as shown in the bottom right of the table. Let's move to slide seven and review results for Allstate Life, Benefits, and Annuities. Allstate Life, shown on the left, generated adjusted net income of $72 million in the second quarter, an increase of $4 million compared to the prior year quarter. Life insurance mortality was elevated in the second quarter, driven by $25 million in identified coronavirus death claims. Excluding these claims, mortality experience was favorable relative to expected levels. Despite higher mortality from the pandemic, Allstate Life generated attractive returns as lower operating expenses supported an increase in adjusted net income for the second quarter. Allstate Benefits premiums declined 7.4% compared to the prior year quarter, reflecting the non-renewal of a large underperforming account in the fourth quarter of 2019, lower sales from increased competition, and the economic impact of the coronavirus, including higher employee turnover, business closures, and furloughs. Allstate Benefits adjusted net income of $5 million in the second quarter was $32 million below the prior year quarter, reflecting a $32 million after-tax write-off for software associated with the billing system. We are developing a technology strategy to build an end-to-end digital platform over time that modernizes more than just our billing system and enables us to maintain our strong position in the voluntary Benefits marketplace. Allstate Annuities, shown in the bottom right, had an adjusted net loss of $111 million in the second quarter, primarily due to the lower performance-based investment results that I discussed earlier. Let's turn to slide eight to discuss the results of the Service Businesses. Service Businesses revenue, excluding the impact of realized gains and losses, grew 15.4% to $457 million in the second quarter. Policies in force continued to grow, increasing 41.2% and to $127.3 million in the second quarter, largely due to growth in Allstate Protection Plans. Allstate Identity Protection policies in force increased $1.1 million from the prior year quarter to $2.3 million and includes subscribers accepting our free service offer through the remainder of the year as a result of the pandemic. Adjusted net income improved to $38 million in the second quarter of 2020, reflecting an increase of $22 million compared to the second quarter of last year, driven by growth of Allstate Protection Plans and improved profitability at Allstate Roadside Services. Allstate Protection Plans has outperformed expectations across each acquisition measure of success established following the $1.4 billion acquisition in 2017. Those measures of success include rapidly growing new and existing domestic customers, raising profitability and returns on capital deployed, and creating sustainable growth beyond U.S. retail. As you can see in the chart on the right, Allstate Protection Plans has grown rapidly. Policies in force increased fourfold over the last three and a half years from less than 30 million policies in 2017 to more than $120 million in the second quarter of 2020, representing a compound annual growth rate of 53%. This growth trajectory reflects expansion within both the U.S. and international markets. Allstate Protection Plans also began generating positive adjusted net income in the first quarter of 2018 and continues to experience upward trajectory with added scale, generating $35 million of adjusted net income in the second quarter of 2020 and $96 million over the latest 12 months. As you can see, Allstate Protection Plans has consistently grown customers, revenue, and profits since the acquisition. Slide nine highlights Allstate's attractive returns and strong capital position. Allstate's capital position remains strong, due to our diversified business model, substantial earnings capacity and proactive capital management. We continue to generate strong returns on capital with an adjusted net income return on equity of 17.9% as of the end of the second quarter. We returned $563 million to common shareholders in the second quarter through a combination of $391 million in share repurchases and $172 million in common stock dividends. Over the last year, we have repurchased 5.2% of outstanding shares as you can see from the table. And as of June 30, there was $2.4 billion remaining on the $3 billion share repurchase authorization that is expected to be completed by the end of 2021. Book value per share of $79.21 was 17.7% higher than the second quarter of 2019, reflecting strong net income and an increase in fixed income unrealized capital gains, partially offset by cash return to shareholders. Allstate's stock valuation metrics, however, have not kept pace with this continued strength and strong operating performance. Moving to Slide 10. This quarter, we also entered into an agreement to acquire National General. This acquisition is financially attractive and will create a platform to drive profitable growth in the independent agent channel. National General will become Allstate's independent agent platform. We will essentially do a reverse merger of our Encompass and Allstate independent agent businesses into National General, which has a good technology platform, broad distribution and a management team that has substantial acquisition integration experience. The deal will increase Allstate's total personalized market share by over one point and create a top five competitor in the independent agent channel personal lines market. It also generates opportunities for growth and expense efficiencies. It gives us a strong presence in higher risk, nonstandard auto insurance, Allstate's expertise in standard auto and home insurance will be used to leverage national General's independent agent relationships by broadening the product offering. The acquisition is expected to be accretive to earnings and returns in the first year. We expect high single-digit earnings accretion in the first year post close, and adjusted net income return on equity is expected to increase by about 100 basis points. These impacts anticipate cost synergies but do not include the incremental revenue growth opportunity. The transaction will have no impact on Allstate's existing share repurchase program. The second quarter was a busy one, where we continued to address the impact of the pandemic earned good returns for shareholders and position Allstate for long-term profitable growth. With that context, let's open up the line for questions.
Operator: [Operator Instructions] Our first question comes from the line of Yaron Kinar from Goldman Sachs. Your question please.
Yaron Kinar: Thank you very much. Good morning, everybody. So my first question is just looking at the expense ratio, adjusted for bad debt and the payback improving by 50 basis points, maybe a little more with – when you adjust for the ad spend. How much of that is from the transformative growth program? And how much is just simply COVID-driven?
Tom Wilson: Yaron?
Yaron Kinar: Yes. Can you hear me?
Tom Wilson: Yes.
Yaron Kinar: So Tom, I think we're having difficulties hearing you. I was able to hear Mario and the others on the call, but I've not been able to really hear you. I'm not sure if there's somebody on the line – if my line is open. I can't hear.
Glenn Shapiro: Your line is open. His line is definitely – the phone is definitely not coming through clearly.
Don Civgin: Mario, do you want to jump in on that one?
Mark Nogal: Why don't we have this? And then let's – Tom, maybe if you could dial back in. Go ahead, Mario.
Mario Rizzo: Oh, you want me – okay. Thanks, Yaron. So, I guess, what I'd say is, as we've talked about transformative growth, I'll just remind you, there's three core elements, as Glenn talked about. There's expanding customer access, enhancing the customer value proposition and continuing to invest in technology and marketing to support the broader transformative growth program. And improving our cost structure is a key part of how we're going to achieve that second objective of enhancing customer value. We continue to make really good progress on this front. Our underwriting expense ratio, as you indicated, is down 0.5 point once you adjust out the coronavirus impacts to 23 in the quarter, and it's down eight-tenths of a point compared to last year. And when you look at where the improvement came from, it's in acquisition-related expenses and operating costs. And that's an area that, as we've talked about, those are two of the areas that we're obviously focused on taking cost out. So we've been at this now for over a year. And I'd say our cost reductions, again, are a core part of transformative growth. So I'd say that's really what we're focused on doing as part of the plan. And we're – we would expect to continue to take costs out over time. And we'll continue to look for ways to improve processes and enhance efficiency and through a variety of means that support the transformative growth program.
Yaron Kinar: I guess, what I was trying to get at is, how much of the improvement this quarter is sticky? And how this quarter is just reduction in T&E and in office costs, given that we were in a shelter-in-place environment?
Mario Rizzo: Yeah. And, I guess, what I'd say, Yaron, is we're going to look to continue to drive cost out of the system. So I don't think – the expense ratio may bounce around a little bit going forward, as we invest in technology. You saw us – we invested more in marketing in the quarter. But I guess the way we're thinking about it is, our intent is to drive the expense ratio down over time, and that's what we're going to do.
Yaron Kinar: Okay. My second question, I think in the past, you've said that you're not looking to cut rates, but we are seeing some of your competitors starting to cut more meaningfully here. Favorable frequency experience probably also helps. Are you holding to your decision?
Glenn Shapiro: Yes. So I'll jump in and take that one. This is Glenn, but thanks for the question, Yaron. I think, first of all, we're seeing – there's one competitor that took some meaningful action more broadly. I don't think we're seeing a huge rush in direction, for one. Our competitors have been aggressive. And it's a competitive environment, but not irrational. And the second point I'd make is we manage this on a local level. And I know I'm a broken record, I say this every quarter when we talk about how we manage the – both the margins and our pricing. Over the course of the last 60 days, this could look like, with our flat rate environment, that our product people have just sort of been hanging around and waiting for something. We've actually made 180 filings over the last over the last two months. And what we do is we're constantly, in each state and each market, looking at how we pull and push levers to be competitive in the environment. It's why we saw sequential growth. And we've continued to grow in spite of a tough environment. And those filings were things like, making new business more competitive, making our telematics offering more competitive with some incentives in that area and across all 50 states, pulling different levers like that. So I would say that, while we don't favor, as you said, sort of a broad base like we're just going to cut X amount everywhere. We do favor being very surgical, very detailed and very thoughtful about how we manage our competitive position and our margin in each market. And I think you know from over time that we react quickly, whether it was the frequency spike back in 2015, or it's the frequency decline now of 2020 that we move really quickly on these things, and we have a very responsive system. And we react market-by-market and make sure that we return a very good return to our shareholders. But at the same time, we stay competitive and we're able to grow profitably.
Yaron Kinar: Thank you and best of luck.
Operator: Thank you. Our next question comes from the line of Elyse Greenspan from Wells Fargo. Your question please.
Elyse Greenspan: Hi. Thank you. Given the strong results that you've been seeing, obviously, pretty favorable frequency results in the quarter, are there any plans for further rebates within your auto insurance book?
Glenn Shapiro: So, this is Glenn. Thanks, Elyse. I'll take that as well. I think what we're looking at now, and as I mentioned in the last question to Yaron, we're looking at sustainable and more sophisticated instruments. We're looking at how we get competitive with those as opposed to what I think was the right decision and a good way to go about it with the shelter-in-place payback at the moment. It needed a broad and blunt instrument because of the big move in frequency at that time. But when you wrap-in frequency and then the mix shift that moves severity and the expansion of coverage, the increase of bad debt because we get more flexible for customers in need, put all of those things together, I think the go-forward approach is going to be more in the lines of allowing our losses to flow into our rating as we always do, and to be more precise on a state-by-state and market-by-market basis versus a broad shelter-in-place payback. Things could change because depending on how the frequency and how the virus moves and all of that, but our thinking right now is to be more -- look at more sustainable tools than a shelter-in-place payback going forward.
Elyse Greenspan: Okay. That's helpful. And then my second question, could you give us a sense of how frequency and severity trends have trended in July versus what you saw in the second quarter as we kind of -- as folks that started to go back to work and, et cetera, we've seen a change in loss trends?
Mario Rizzo: This is Mario. Glenn, can talk about the second quarter, but we're not going to talk about July trends at this point.
Glenn Shapiro: Yeah. So I'll talk about the second quarter a little bit and to say, first of all, thanks for mentioning frequency and severity because they do tend to move in opposite directions with one another. And one thing, I'll just proactively address is that I know some of our competitors report a recorded number on severity. We report a paid number and paid calendar quarter is, I think, a more transparent and better metric to use in normal times, but we're in anything but normal times. So it's much, much more volatile and subject to mix shifts. So you'll see the number move more just because of the mix of what's being paid inside the quarter where you have fewer short-tail, small claims being paid in the period and everything, so that you'll see the two things move a little bit opposite one another. But what we saw throughout the quarter, and we did disclose that June was less of a difference in gross severity -- frequency, excuse me, than the other months in the quarter -- is that it has come down. It's starting to normalize in some places. There's a lot more variation by state early on like what we would see in April and May is that while there was some variation, pretty much all the states were down within a relatively close tolerance to one another. That has started to diverge more with a really rural state like Montana, for example, was actually up slightly in the year-over-year. And then you've got places that are more significantly down, particularly states that are more heavily concentrated with metro areas and that have had more spikes of the virus. So we're watching things on a very local level into how they're moving.
Elyse Greenspan: Okay. Thank you. I appreciate the color.
Operator: Thank you. Our next question comes from the line of Greg Peters from Raymond James.
Greg Peters: Good morning. I'm going to pivot and I'd like to get an update on your homeowners business. I was looking at some of the statistics that you provide, like on page 17 of your supplement. And I was struck by the improvements in frequency, both gross claim and paid claim frequency, not just in the first and second quarters of this year, but it seems to be a longer term trend. And I would be curious about your impressions about what's driving that and how we should think about those trends as we look beyond just this year and think about next year.
Don Civgin: Greg, it's Don Civgin. I'll ask Glenn to answer it in more detail. And we've obviously worked hard on our homeowners business over the last number of years, and so we're pleased with the returns we're getting from that business. But Glenn, do you want to get into more specifics?
Glenn Shapiro: Yes. Yes, absolutely. Thanks, Don. So yes, as Don said, I'm always -- I always preach that -- look at the long term and look at the reported combined on home. We've got year-to-date and 88.6% combined ratio recorded. Our 12 months is 83%, and our 5-year is 87%. So we've sustained that. I think, Greg, your point on the frequency is a tough one because it changes almost every quarter because the weather drives so much of it. So you'll have more caught up in catastrophes, and so it's sort of a lower underlying frequency, and then you'll have maybe a good weather quarter and you have few weather-driven and fewer cats. They move around a lot. What I would say recently, and this is probably an underreported part of the COVID impact, is that we've seen a shift in frequency severity on the home side because -- and it's pretty logical is we're seeing fewer like death claims and break-ins because everybody's home. And those tend to be lower severity claims, and yet we're seeing about the same number of fire points, and those tend to be higher severity claims. So we saw our frequency go down in the quarter. Our severity average go up because the ones that went away were smaller claims. And so we get into the details, and we look at all of those components, but I wouldn't necessarily draw a conclusion that there's something in home driving long-term frequency down that will be sustainable. I think it's been different factors each quarter.
Greg Peters: Got it. Thanks for that answer. And then I guess I'll circle back your transformative growth plan and the integrated services platform. And as you guys know, I always like to track your agency data that you provide on page 9 of your supplement. And so I was wondering if you could just, from a big picture perspective, we're watching some directional changes in some of the numbers, whether it's a slight decrease in total Allstate agencies and LSPs, but we're also seeing an increase in the independent agencies and Encompass independent agencies, can you walk us through what your view is on how that's going to change further as we continue to roll out these plans that you've mentioned previously?
Mario Rizzo: Yes. Glenn, why don't you go ahead?
Glenn Shapiro: Okay, great. So you're always into the detail, Greg. So you definitely picked up on the right trends there. We're focused on growing with agencies looking to invest, and this ties back to something Mario talked about the expenses. It's not that our acquisition costs have gone down because we don't want to grow and we don't want to invest in agents looking to grow. They've gone down because we've moved the money really in a way that incentivizes growth and it's more efficient to do it that way. So coming into this year, we moved some money that was incentivizing retention, and we moved it to incentivize new business. And -- or I should say renewal versus new business as opposed to retention because how it gets paid. That's one change. And that changed some agents, who wanted to invest in that way, and some that didn't and perhaps voted themselves out on that one. We also increased our baseline performance requirements for, I'll call it, our lowest producing agency and required that folks sort of be more open for business than they have been. And so that has driven the number down a little bit. And the other thing is integrated service, which you mentioned in the question. That number will start to look strange over time. We have about 500 agents in there right now. So those agents won't show staff members that are being augmented or provided by Allstate. And so it kind of moves the number to a different place because we don't report it in as part of the agency staff as licensed sales professionals because we're doing the work on the back end for them in those centers. So there's a number of pieces moving it. But I think the headline to take away is that we've grown in the agency plan. I mentioned in the prepared remarks that we've all-time high in Allstate brand auto policies in force. So the agency force has grown, and we want to grow in all of our lines. We want to grow all state agents. We want to grow our independent agent channel, which is the pending acquisition that we've got with National general, and we want to grow in direct, which is the combination of Esurance and Allstate Direct.
Tom Wilson: Hey, Greg, this is Tom Wilson. I'm – hopefully, I've reconnected.
Mark Nogal: We can hear you.
Tom Wilson: All right. Let me highlight what Glenn just said. So, transformative growth, so we're going to sell as much as we can through everybody as we can. So we want to have more Allstate agents. We want to have independent agents. We want to sell more. You will see, over time, some increases decreases and how much goes through each of those channels as we transition to or a profit model. So – and Glenn explained what we're doing on new business versus a retention. But we're really working on different ways we can get to customers. We may not need as much real estate in the future as we have today. That means local offices are different. So you'll see changes, and you're seeing some of that change now because we're not new Allstate agents at this point as we build out these new models. So it's really about very distribution force.
Greg Peters: Got it. Thank you for the answers.
Operator: Thank you. Our next question comes from the line of Mike Zaremski from Credit Suisse. Your question please.
Mike Zaremski: Hey, good morning. Thanks. Could you guys – and maybe I missed it, did you guys touch on auto severity? I think, we – investors have expected it to increase during COVID. Maybe you can discuss whether we should expect the severity or you could talk about it, so we can maybe better understand whether it should continue? And I'm curious whether, like, the underlying severity trend is still kind of higher for longer due to issues we talked about pre-COVID? Or is there a change to that potentially post-COVID?
Tom Wilson: Mike, let me have Glenn answer that, but give you an overview first. In a time like this, where the numbers are changing rapidly in terms of the number of claims, they – the statistics in the method you use for any individual component of loss costs bounce around a lot. So it's – the best thing to do is to look at overall loss costs and say, are your loss costs still the right percentage of your premiums? We obviously have done attribution on severity, and Glenn can talk about that.
Glenn Shapiro: Yeah. So it's a great question because, as Tom said, I mean, they do bounce around a lot. Overall, we feel very comfortable and confident with where we are on severity. PD severity, paid severity was reported at 20% up, which number jumps off the page. Let me give you just an example of why that is on a paid severity number like that. So paid severity is – as you'd expect, it's a number of claims you settled and closed during that calendar period divided by the total number of claims, and you get your average. Well, during the second quarter, we settled just as many six-month-old claims as we would in any normal quarter, because six months earlier, there was no COVID and there was no drop in frequency. We settled just as many five-month-old claims and four-month old-claims and three-month-old claims, but we settled a lot fewer three-day-old claims. And one-week-old claims, because they just weren't there. They weren't happening with the same frequency and as you'd expect, the claims you settle in three, four and five days are lower severity on average. They're quick. They're easy, and they're low cost. The ones that are six months are typically ones that have like they've gone through their own carrier. The segregation comes over from that carrier, they average a much higher severity type of claim, or they've been a total loss, and so they take longer to process and so on. So it's just a pure mix issue that drives that type of number. When we get down underneath that, and we're able to look at the things that come in, in the quarter and how they're resolving and are estimating practices and what the true severity looks like, it feels like normal inflation that we've seen in the single digits that we're very comfortable with. And the claims team has done and the finance team a terrific job of getting underneath the data so that we understand where and if we have any pressures, but we've seen it run very predictably.
Mike Zaremski: Okay. That's very helpful. And lastly, my follow-up. Services segment, it feels like, driven by Allstate Protection continues to do, I think, better than expected, and it's actually kind of moving the needle a little bit these days. You talked about diversifying into – outside of the U.S. I mean, just since it's growing so fast, should we expect the rate of growth to temper? Any additional color there would be around what's going on would be helpful.
Tom Wilson: Let me provide just overview like why we talked about it, and then Don can talk about its future. So, when we bought it, one of the things we said was, we'll come back and talk to you about how we're doing every so often. And that's what we wanted to do here. And it's meeting and exceeding our expectations. I think there are a number of people. We're trying to understand why we were into that space, and you can see it's a huge growth. And we've had huge growth both domestically, and we're starting to get some good growth internationally. So, it was really about coming back to you and saying, we told you we'd come back, and here we are. And it happens to be a good news story, which Don can talk about.
Don Civgin: Yes. Thank you. So, first, thanks for noticing. The service businesses, I think, in total, have made a lot of progress and has improved the values that they provide to customers. And so I think across the Board, they're doing really good work, more specifically around the Allstate Protection Plans. I mean, Mario laid out the three goals that we set and how we're doing against them. But I'd remind you, we set those goals the first quarter after we did the acquisition, and we communicated those, and we've been consistent about them. And we have had a really strong trajectory since we acquired SquareTrade, both on the topline and improvements in profitability all along the way. This particular quarter was good, but I'd remind you we expected to have a good 2020 to begin with. And that's because we were continuing to pick up new customers. We were doing a really good job working with our partners to make the product more available and accessible to their customers. And so we expect the growth not only for new business-to-business customers, but also more availability in existing customers and our international business continues to grow substantially. So, we expected 2020 to be good. We have benefited from the virus in some ways, and topline is one of them. When you look at the partners that we do our largest business with, they tend to be the larger one-stop shops. Which, as you would know, have been in favor in the retail world -- retail is doing mix these days. But if you're a large one-stop shop, we've done quite well. In the categories that we are particularly in consumer electronics and so forth and home office, have also done very well. So, we benefited because of the virus with the topline. And then, obviously, the topline has a benefit to the bottom-line with respect to scale of the expenses and so forth. So, we're very happy with the results. The results would have been strong even without the virus. They have clearly been helped to buy the virus, both on the topline and the bottom-line. But we're still very happy with the underlying performance as well. The only thing I'd add is, it's hard to tell what the impact of the virus is going to be going forward. And that's just going to depend on consumer behavior, where they buy, what they buy. So, while we benefited from impacts from the virus at this point, it's hard to tell what's going to happen in the future. But all that said, the underlying business has been and continues to be quite strong and we're quite bullish on it.
Mike Zaremski: Thank you.
Operator: Thank you. Our next question comes from the line of Paul Newsome from Piper Sandler.
Paul Newsome: Good morning. I wanted to ask about bad debt trends within the quarter itself. And I guess I'm wondering whether or not we could see more when the Federal subsidies for unemployment go away or if maybe the bad debt is more tied to some of the state level moratoriums on -- that were in place. Just your thoughts on that would be great.
Tom Wilson: Mario, do you want to take that?
Mario Rizzo: Sure. Paul, this is Mario. So, just to give you a little context of the driver of bad debt, as we mentioned earlier, one of the ways that we provided additional benefits to our customers during the pandemic was to offer them the opportunity to opt into a special payment plan, which essentially gives them 60 days of coverage without having to make a payment on the policy. That started in March. And we've – as we've worked our way through the quarter, we've gotten more and more experience relative to how that subset of customers has performed and then the bad debt activity within that customer segment, because as much as we had historical context around offering similar-type programs during catastrophes, this was obviously much more widespread and different. And you see the impact in the quarter where bad debt was $44 million. We'll continue to get more and more experience on that customer set going forward. We'll continue to update our analysis, and then we'll update the numbers in the third quarter, if we need to. But based on the experience we've seen so far through the end of Q2, that's what we recorded in the P&L.
Tom Wilson: And Paul, I would wrap that into just the overall pandemic impact, right? So we've obviously had lower frequency, which we've talked a lot about. This is another cost associated with the pandemic. And when we're thinking about what we're going to do in the future, we factor all this stuff in.
Paul Newsome: Makes sense. Second question, I wanted to ask about whether or not you think the regulators will take into account sort of the, hopefully, one-time nature of the pandemic? Or if we put through – when you put through rate filings in the future, will you kind of have this middle of the Python kind of situation where the unusual low frequency is embedded in what you can file for rates prospectively until that kind of rolls off through the system.
Tom Wilson: Well, it's always hard for us, of course, to speak for somebody else as to what they will do. And of course, it varies by state, which oftentimes relates to the political environment in that state. What I can say is, we were out early, no regulator forces to do shelter-in-place payback or expand coverage and all the other things we did. And so we got out ahead of it. I think we got positive feedback from people that we were doing what was not required, like no one had to come in and say, you must do this. And so I feel like we're on a good basis to work through like what's the right price. And if frequency were to stay at these abnormal lows, obviously, regulators, customers in the competitive market wouldn't have you charge the same amount. The good news is our loss cost would be a lot better. So our focus, really, Paul, is on maintaining our overall competitive position and our margins. And we've been able to do that with regulators. I think there'll be a whole bunch of stories. But the good news is we have good math, an operating model that adjusts locally in a way in which we can continue then grow profitably. Glenn, anything you would add to that?
Glenn Shapiro: No. I think that covered it well.
Paul Newsome: Thanks for your help. Everyone, stay safe, guys.
Operator: Our next question comes from the line of David Motemaden from Evercore. Your question please.
David Motemaden: Hi, good morning. Just a question for Tom and Glenn. Just thinking bigger picture, I'm just wondering how you guys are thinking about miles driven and accident frequency over the longer term. And I know there's a lot of uncertainty, but are you guys thinking -- how are you guys thinking about miles driven and accident frequency? Do you think that we'll ever get back to levels that we were at pre-COVID, especially given what seems like increasingly prevalent adoption of remote working arrangements? And relatedly, how are you guys going to adjust to potential lower frequency levels on a more sustained basis?
Tom Wilson: Let me start, Glenn and then jump in. I'm going to start, David, the most macro which is of course, our strategy includes a couple of different components, the top over Property-Liability and then the bottom of other stuff. In the Property-Liability stuff, there's auto, big driver of that. And as -- and that's a key part of our both revenue and profitability. But the other thing is, we have a really profitable homeowners business, much more profitable than other people. We're good at it. We're precise at it. We sell a bunch of other stuff. And then the circle protection selling things like the service plans and everything is about making sure the company has multiple things we can sell to customers to protect them from whatever goes wrong in their life and leverage those customer bases. So we're dealing with -- because you had the same question that was about the same question about the future of auto was really around autonomous vehicles 3 or 4 years ago. And so we've been on that path from a strategic standpoint as to how to deal with that. And, of course, what's happened is, actually, premiums have gone up, not down in the last 4 or 5 years, which people were afraid nobody was going to drive. So it's really hard to predict. What you can do is have multiple options and take advantage of those options and leverage your skills and capabilities. As it relates to the auto insurance business, you want to have a broad-based approach. And that's what transformative growth really is. It's improve the customer value proposes, give people lots of access, connect to more, make your products more simple. And so we still have a lot of the share of that market we can pick up. And so even if you were to say fewer miles driven, lower average premium, we still think we can grow that business. Glenn, you might want to have some -- that was obvious sort of macro and longer term. How would you react to the question on more really as it relates to personal Profit-Liability in the shorter term?
Glenn Shapiro: Yes. And it's a great question because, obviously, we think a lot about this. Let me take you into how the team works on this. And I'll go -- like Tom did, I'll go before even the virus. We had built out a model and assumptions for the change in frequency driven purely by the change in the car fleet out in the market. What does each component of ADAS, safety equipment on cars, what does each component do to change each type of loss, like how many fewer sideswipes or rear ends or intersection actions are we going to have based on the blind spot warning or based on this autonomous feature or so on? And you add those up and you apply them to your fleet and how the fleet is changing over time, and we actually -- we've built into the model, our assumptions were what changes. But at the same time, we built the other side of it, which is the severity. Because all those cars getting into fewer accidents are a heck of a lot more expensive to fix when they have all that equipment on it. And so it goes to what Tom said about, really, it's hard to predict, but we go after it and we look at with as much specificity as we can, the component parts. So now take that into the current scenario and the question you're asking. And we're looking at, so what percentage of the market works in jobs that don't have to commute? If you work in a restaurant or your dental hygienist or like -- but you're going to have to commute because those things cannot be done remotely. But there are a lot of jobs, most of us have jobs that can be done more remotely than they have been historically. So you get that percentage. And then you look at, well, what percentage of people will do it, and then what percentage of your accidents occur in like high drive time, and you start making your assumptions and picks over what's going to change. And similarly, that then changes severity because one of the things we've learned is that the losses that go away quickest are the bumper-to-bumper accidents in high traffic, and those tend to be low severity. So while a 10% decrease in frequency is great, it's not necessarily a 10% decrease in loss costs. And the reason I'm getting into or micro, since Tom took the macro on this and laid it out, is hopefully just to give you confidence that we look at this in a very detailed way and a thoughtful way, and our teams work through what the expectations are, and then we're able to move quickly on the fly when we're either above or below it with what our prediction is.
David Motemaden: Great. Thanks for that comprehensive answer. I appreciate that. And if I could just sneak in just one more on just a quick numbers question. If I think about that 50 basis point improvement in the expense ratio, if I take out the one-time-ish items in 2Q, and then it was roughly 80 basis points in the first half versus the first half last year, is that -- and I know there are a lot of different moving pieces there, but is that the sort of level of year-over-year improvement that we should expect to see going forward?
Tom Wilson: Yes. I would say transformative growth is about reducing expenses. In part, it's just one component, but it's about reducing expenses, so we can improve our customer value proposition with better prices, without impacting our margins. But it's going to bounce around a lot by quarter. You got advertising. We're going to have – we have new advertising. We're going to launch – you have some technology spend. But you should expect the overall trend going down. I don't think we could predict how much it will change by every quarter because – or set a target that way, because then it leaves unnatural consequences. So – but you should expect it to keep going down, yes.
David Motemaden: No. Thanks fair. Thank you.
Operator: Thank you. Our next question comes from the line of Suneet Kamath from Citi. Your question, please.
Suneet Kamath: Thanks. Good morning. I wanted to go back to the frequency benefit issue, if I could. I get that you want to be more surgical in terms of how you're approaching this, as opposed to more broad-based, which makes sense, but, I guess, the question is, do you – are you comfortable or confident that you won't see an impact on policy growth to the extent that some of your competitors actually stick with much more of a broad-based approach?
Tom Wilson: Well, it's always hard to tell what customers will do. We've always found that precision works for us on the long term, and that those people who rush to grow and not have precision to it, end up having to fix it later. So if you look at homeowners, people trying to grow in homeowners are taking huge losses. Like, we just don't think that's the right way to build the business, because you get the customer for a price that's not appropriate, and then you either have to lose them or manage them to a much higher price. So, all I can say is, what we'll do. But it's a reasonably – it's a highly competitive market, but it's a thoughtful market, right? Like people are not crazy in this market and trying to use bad economics. So all of our major competitors understand their business well and why they might make different bets at different times. I feel like, the basis of competition is still going to stay the same. Whoever is the smartest, win.
Suneet Kamath: Got it. Okay. And then I just wanted to ask one on the National General deal, if I could. I see that you're still guiding to this, I guess, high single-digit accretion, I think, was the original guidance. But when we were running the math, just based on where expectations were for Allstate and Nat General based on consensus, we were getting something close to high single digit or in a high single digits EPS accretion, without factoring in any cost synergies. So I'm just trying to understand, is there any help that you can give us in terms of what you're building in with respect to cost synergies? I don't think you talked about on the last call, but any help there would be appreciated.
Tom Wilson: What, I would say is, we don't own it yet. So our projections haven't really changed. We do have cost saves in the middle of it that we figured out in terms of what we factored in when we bought – when we agreed to pay the price we did. And it did lead to accretion, as you point out. But right now, we're working on -- Glenn and Barry are working hard on what is the transition program. So as we get more specifics on things that we can lay out for you that are, here's our measurable goals, we'll do that. But, right now, we're just like a month into it.
Suneet Kamath: All right. Thanks, Tom.
Operator: Thank you.
Mark Nogal: Jonathan, I think we have time for one more question.
Operator: Certainly. Then our final question for today comes from the line Ryan Tunis from Autonomous Research. Your question, please.
Ryan Tunis: Good morning. This might be a question for Glenn, but it seems like there's some decoupling between trends in miles driven and trends in frequency with, I guess, the latter declining quite a bit more. I guess my question is, what indicators that you're seeing in your book do you think are actually the best predictive indicators of what frequency is doing in this current environment?
Tom Wilson: That's a tough question. I will let Glenn do that one.
Glenn Shapiro: Thanks. So it's a good question. And you're right about the decoupling, so I'll give you a little background on that. Not all miles are created equal. If you're driving in a high-traffic environment, you are much more likely to get an accident because it's less forgiving. You take your eyes off the road. You're distracted driving, which, by the way, I don't recommend at any time. But if you're doing it in loose traffic and you make a mistake, you're less likely to bump into somebody than when you're doing it in high traffic. So what we're seeing is with commuting miles being way down, that has a little bit of an exponential effect on frequency. So if miles came back to a new normal for non-commuting, but were lower only on commuting, it would have a disproportionate effect on the frequency. So hopefully, that answers your question. It's – we're looking at the data in that way. And our – with the partnership with Arity and the partnerships they have with a lot of the non-insurance companies out there, and they get a lot of miles-driven data on those, and that what they do for us with our own data, is extremely helpful in that.
Tom Wilson: And Ryan – and Glenn's example also is goes for rural and urban too, right? So think of the same thing, not just time and day also. So Montana, the frequency is not down as much as it is in urban areas because there's fewer people. There's always less congestion. So it is a difficult question. But the good news is we're on top of it. I know you all have another call. Thank you for participating and listening to our story. We'll talk to you next quarter.
Operator: Thank you, ladies and gentlemen, for your participation in today's conference. This does conclude the program. You may now disconnect. Good day. | [
{
"speaker": "Operator",
"text": "Ladies and gentlemen, thank you for standing by, and welcome to the Allstate Second Quarter 2020 Earnings Conference Call. At this time, all participants are in a listen-only mode. After the speakers’ presentation, there will be a question-and-answer session. [Operator Instructions] As a reminder, today's program is being recorded. I would now like to introduce your host for today's program, Mark Nogal, Director of Investor Relations. Please go ahead, sir."
},
{
"speaker": "Mark Nogal",
"text": "Thank you, Jonathan. Good morning. Welcome, everyone, to Allstate's Second Quarter 2020 Earnings Conference Call. After prepared remarks, we'll have a question-and-answer session. Yesterday, following the close of the market, we issued our news release and investor supplement, filed our 10-Q and posted today's presentation along with our reinsurance update on our website at allstateinvestors.com. Our management team is here to provide perspective on these results and further context on our strategy to grow personal property-liability market share. As noted on the first slide of the presentation, our discussion will contain non-GAAP measures for which there are reconciliations in the news release and investor supplement and forward-looking statements about Allstate's operations. Allstate's results may differ materially from these statements, so please refer to our 10-K for 2019 and other public documents for information on potential risks. And now I'll turn it over to Tom."
},
{
"speaker": "Tom Wilson",
"text": "Good morning. Thank you for joining us this day on Allstate. So let's start on slide 2 of its Allstate's strategy and our second quarter highlights. So our purpose is to protect people from life's uncertainties and to be a positive personal good. And as you know, our strategy has two components: increase personal proper liability and market share and expand into other protection businesses, which are shown in those two ovals. Richest Allstate brands, customers and capabilities to both of those components. This strategy is an adaption the coronavirus pandemic led to excellent operating in the second quarter, as shown on the right hand. The enterprise customer experience score increased as employees and agencies did an excellent job of working remote, and we benefited from leading on the shelter-in-place payback and helping customers in other ways. Profitability was good with adjusted net income of $2.46 per share. We also made progress at our multiyear transformative growth plan by leveraging the direct sales capabilities of Esurance and lowering expenses. Allstate Protection Plans, which, as you know, we acquired 3.5 years ago for $1.4 billion and high-growth and high returns, section plans [Technical Difficulty] at the end of 2017 and estimated adjusted net income of $35 million in the quarter and $69 million for the first six months of 2020. The performance-based core losses in the quarter reduced reported net investment income despite solid total loan growth. Our profitable growth it depends overall [Technical Difficulty]. We move to slide 3. I'll say quickly excellent operating results, total revenues of $11.2 billion increased 0.5% of the prior year for gain and growth in the property-liability premium earned were -- that more than offset the decline in investment income for performance-based losses. Net income of $1.2 billion increased 49% to the prior year quarter, as you can see from the middle of the table market value in just $380 million 2019, $2.46 per share, 12.8% of other than repurchase program. With adjusted net income mature line at 17.8%. [Technical Difficulty]"
},
{
"speaker": "Glenn Shapiro",
"text": "Thanks, Tom. Let's go to slide 4, where we'll discuss the strong performance of our Property-Liability segment. Premium and policy growth continued with excellent recorded and underlying profitability. Policies in force were $33.8 million at the end of the quarter, and Allstate brand policies reaching an all-time high for auto at $20.5 million. Underwriting income of $904 million increased by $537 million compared to the prior year quarter. The chart on the lower left shows the second quarter combined ratio of 89.8% and the impacts driving the 6-point improvement over the prior year quarter. Starting on the left the underlying loss ratio improved by 15.9 points on lower auto insurance losses from fewer accidents, due to significant reduction in miles driven. The underlying loss ratio on homeowners insurance also improved due to increased premiums and lower non-catastrophe losses. The underlying loss ratio improvements were partially offset by Allstate's efforts to help customers during the pandemic. This included the 15% shelter in place payback on auto, which totaled 8.3% of premiums across all lines of on business, plus a 0.5% of premiums from increased bad debt expense, due to billing flexibility related to the Allstate special payment plan. The chart on the right breaks down the expense ratio components. The expense ratio was 23.0 and improved 0.5 point compared to the prior year quarter, excluding the $738 million shelter-in-place payback and bad debt expenses in the quarter. As you know, one portion of our transformative growth plan is to deliver better value to customers, in part by reducing operating expenses. While expenses vary by quarter, as you can see from this quarter, the long-term trend has been down as you look at the adjusted numbers, which are 2.1 points below 2018 expense ration. So let's now move to slide 5 and discuss transformative growth in more detail. The transformative growth plan will accelerate growth through three key levers: expanding customer access, enhancing customer value and investing in technology and marketing. We're expanding customer access and increasing product availability by leveraging Esurance's direct sales capabilities under the Allstate brand. The Esurance brand will be sunset over time, and the advertising spend will be concentrated on the Allstate brand. This also includes improving online and call center sales flows. We're enhancing customer value through continued cost structure improvements, which will make prices more competitive without reducing underwriting margins. We recently announced changes in the personal Property-Liability organization, which included combining our direct operations as well as consolidating Allstate brand field operations to further lower costs. To improve customer value, we're also expanding telematics offerings and promoting our unique Milewise pay-by-mile product, which is appealing to customers right now as they're driving less during the pandemic. The third component is investing in technology and marketing. Technology investments are improving our customer experience, including the recent launch of Allstate One app that simplifies and combines digital access and telematics offerings in one place. Launching the transformative growth plan also enhances our ability to adapt to a post coronavirus operating environment. We'll have lower cost structure and more competitive prices. We're also building the capacity to invest in new products, marketing and technology while maintaining strong margins. The new technology platform will allow us to be more connected with customers and give us greater flexibility to change products and processes going forward. Now, I'll turn it over to Mario to discuss the rest of our second quarter results."
},
{
"speaker": "Mario Rizzo",
"text": "Thanks, Glenn. Let's go to slide 6, which highlights investment performance for the second quarter. We take a proactive and holistic approach to managing the investment portfolio. After reducing public equity in the first quarter, we increased our allocation to investment-grade corporate bonds this quarter. The chart at the left shows net investment income totaled $409 million in the quarter, which was $533 million below prior year, due to a decline in market-based income and losses in the performance-based portfolio. Market-based income, shown in blue, was below the prior year quarter by $77 million. As interest rates have declined, reinvestment rates are below the average interest-bearing portfolio yield, reducing portfolio income. We recorded $211 million loss on our performance-based investments in the second quarter, as shown in gray. As you know, we proactively adjusted valuations in the first quarter in response to the significant decline in equity markets. In the second quarter, we followed our standard process for recording performance-based results, which generally recognizes valuations on a one-quarter lag. Given this lag in income recognition, the second quarter improvement in public equity markets did not have a positive impact on this portfolio in the quarter. GAAP total returns are shown in the table on the right. The second quarter return of 5% primarily reflects tighter credit spreads and the impact of higher equity valuations on the $2.8 billion public equity portfolio. Year-to-date returns were 2.7% and the latest 12 months was 5.9%. Performance-based investments had a 2.4% and 4.5% loss for the quarter and first half of 2020, respectively. These investments are expected to generate higher returns than the market-based portfolio, and consequently, typically have higher volatility. This portfolio has generated an annualized rate of return of 7.4% over the past five years, as shown in the bottom right of the table. Let's move to slide seven and review results for Allstate Life, Benefits, and Annuities. Allstate Life, shown on the left, generated adjusted net income of $72 million in the second quarter, an increase of $4 million compared to the prior year quarter. Life insurance mortality was elevated in the second quarter, driven by $25 million in identified coronavirus death claims. Excluding these claims, mortality experience was favorable relative to expected levels. Despite higher mortality from the pandemic, Allstate Life generated attractive returns as lower operating expenses supported an increase in adjusted net income for the second quarter. Allstate Benefits premiums declined 7.4% compared to the prior year quarter, reflecting the non-renewal of a large underperforming account in the fourth quarter of 2019, lower sales from increased competition, and the economic impact of the coronavirus, including higher employee turnover, business closures, and furloughs. Allstate Benefits adjusted net income of $5 million in the second quarter was $32 million below the prior year quarter, reflecting a $32 million after-tax write-off for software associated with the billing system. We are developing a technology strategy to build an end-to-end digital platform over time that modernizes more than just our billing system and enables us to maintain our strong position in the voluntary Benefits marketplace. Allstate Annuities, shown in the bottom right, had an adjusted net loss of $111 million in the second quarter, primarily due to the lower performance-based investment results that I discussed earlier. Let's turn to slide eight to discuss the results of the Service Businesses. Service Businesses revenue, excluding the impact of realized gains and losses, grew 15.4% to $457 million in the second quarter. Policies in force continued to grow, increasing 41.2% and to $127.3 million in the second quarter, largely due to growth in Allstate Protection Plans. Allstate Identity Protection policies in force increased $1.1 million from the prior year quarter to $2.3 million and includes subscribers accepting our free service offer through the remainder of the year as a result of the pandemic. Adjusted net income improved to $38 million in the second quarter of 2020, reflecting an increase of $22 million compared to the second quarter of last year, driven by growth of Allstate Protection Plans and improved profitability at Allstate Roadside Services. Allstate Protection Plans has outperformed expectations across each acquisition measure of success established following the $1.4 billion acquisition in 2017. Those measures of success include rapidly growing new and existing domestic customers, raising profitability and returns on capital deployed, and creating sustainable growth beyond U.S. retail. As you can see in the chart on the right, Allstate Protection Plans has grown rapidly. Policies in force increased fourfold over the last three and a half years from less than 30 million policies in 2017 to more than $120 million in the second quarter of 2020, representing a compound annual growth rate of 53%. This growth trajectory reflects expansion within both the U.S. and international markets. Allstate Protection Plans also began generating positive adjusted net income in the first quarter of 2018 and continues to experience upward trajectory with added scale, generating $35 million of adjusted net income in the second quarter of 2020 and $96 million over the latest 12 months. As you can see, Allstate Protection Plans has consistently grown customers, revenue, and profits since the acquisition. Slide nine highlights Allstate's attractive returns and strong capital position. Allstate's capital position remains strong, due to our diversified business model, substantial earnings capacity and proactive capital management. We continue to generate strong returns on capital with an adjusted net income return on equity of 17.9% as of the end of the second quarter. We returned $563 million to common shareholders in the second quarter through a combination of $391 million in share repurchases and $172 million in common stock dividends. Over the last year, we have repurchased 5.2% of outstanding shares as you can see from the table. And as of June 30, there was $2.4 billion remaining on the $3 billion share repurchase authorization that is expected to be completed by the end of 2021. Book value per share of $79.21 was 17.7% higher than the second quarter of 2019, reflecting strong net income and an increase in fixed income unrealized capital gains, partially offset by cash return to shareholders. Allstate's stock valuation metrics, however, have not kept pace with this continued strength and strong operating performance. Moving to Slide 10. This quarter, we also entered into an agreement to acquire National General. This acquisition is financially attractive and will create a platform to drive profitable growth in the independent agent channel. National General will become Allstate's independent agent platform. We will essentially do a reverse merger of our Encompass and Allstate independent agent businesses into National General, which has a good technology platform, broad distribution and a management team that has substantial acquisition integration experience. The deal will increase Allstate's total personalized market share by over one point and create a top five competitor in the independent agent channel personal lines market. It also generates opportunities for growth and expense efficiencies. It gives us a strong presence in higher risk, nonstandard auto insurance, Allstate's expertise in standard auto and home insurance will be used to leverage national General's independent agent relationships by broadening the product offering. The acquisition is expected to be accretive to earnings and returns in the first year. We expect high single-digit earnings accretion in the first year post close, and adjusted net income return on equity is expected to increase by about 100 basis points. These impacts anticipate cost synergies but do not include the incremental revenue growth opportunity. The transaction will have no impact on Allstate's existing share repurchase program. The second quarter was a busy one, where we continued to address the impact of the pandemic earned good returns for shareholders and position Allstate for long-term profitable growth. With that context, let's open up the line for questions."
},
{
"speaker": "Operator",
"text": "[Operator Instructions] Our first question comes from the line of Yaron Kinar from Goldman Sachs. Your question please."
},
{
"speaker": "Yaron Kinar",
"text": "Thank you very much. Good morning, everybody. So my first question is just looking at the expense ratio, adjusted for bad debt and the payback improving by 50 basis points, maybe a little more with – when you adjust for the ad spend. How much of that is from the transformative growth program? And how much is just simply COVID-driven?"
},
{
"speaker": "Tom Wilson",
"text": "Yaron?"
},
{
"speaker": "Yaron Kinar",
"text": "Yes. Can you hear me?"
},
{
"speaker": "Tom Wilson",
"text": "Yes."
},
{
"speaker": "Yaron Kinar",
"text": "So Tom, I think we're having difficulties hearing you. I was able to hear Mario and the others on the call, but I've not been able to really hear you. I'm not sure if there's somebody on the line – if my line is open. I can't hear."
},
{
"speaker": "Glenn Shapiro",
"text": "Your line is open. His line is definitely – the phone is definitely not coming through clearly."
},
{
"speaker": "Don Civgin",
"text": "Mario, do you want to jump in on that one?"
},
{
"speaker": "Mark Nogal",
"text": "Why don't we have this? And then let's – Tom, maybe if you could dial back in. Go ahead, Mario."
},
{
"speaker": "Mario Rizzo",
"text": "Oh, you want me – okay. Thanks, Yaron. So, I guess, what I'd say is, as we've talked about transformative growth, I'll just remind you, there's three core elements, as Glenn talked about. There's expanding customer access, enhancing the customer value proposition and continuing to invest in technology and marketing to support the broader transformative growth program. And improving our cost structure is a key part of how we're going to achieve that second objective of enhancing customer value. We continue to make really good progress on this front. Our underwriting expense ratio, as you indicated, is down 0.5 point once you adjust out the coronavirus impacts to 23 in the quarter, and it's down eight-tenths of a point compared to last year. And when you look at where the improvement came from, it's in acquisition-related expenses and operating costs. And that's an area that, as we've talked about, those are two of the areas that we're obviously focused on taking cost out. So we've been at this now for over a year. And I'd say our cost reductions, again, are a core part of transformative growth. So I'd say that's really what we're focused on doing as part of the plan. And we're – we would expect to continue to take costs out over time. And we'll continue to look for ways to improve processes and enhance efficiency and through a variety of means that support the transformative growth program."
},
{
"speaker": "Yaron Kinar",
"text": "I guess, what I was trying to get at is, how much of the improvement this quarter is sticky? And how this quarter is just reduction in T&E and in office costs, given that we were in a shelter-in-place environment?"
},
{
"speaker": "Mario Rizzo",
"text": "Yeah. And, I guess, what I'd say, Yaron, is we're going to look to continue to drive cost out of the system. So I don't think – the expense ratio may bounce around a little bit going forward, as we invest in technology. You saw us – we invested more in marketing in the quarter. But I guess the way we're thinking about it is, our intent is to drive the expense ratio down over time, and that's what we're going to do."
},
{
"speaker": "Yaron Kinar",
"text": "Okay. My second question, I think in the past, you've said that you're not looking to cut rates, but we are seeing some of your competitors starting to cut more meaningfully here. Favorable frequency experience probably also helps. Are you holding to your decision?"
},
{
"speaker": "Glenn Shapiro",
"text": "Yes. So I'll jump in and take that one. This is Glenn, but thanks for the question, Yaron. I think, first of all, we're seeing – there's one competitor that took some meaningful action more broadly. I don't think we're seeing a huge rush in direction, for one. Our competitors have been aggressive. And it's a competitive environment, but not irrational. And the second point I'd make is we manage this on a local level. And I know I'm a broken record, I say this every quarter when we talk about how we manage the – both the margins and our pricing. Over the course of the last 60 days, this could look like, with our flat rate environment, that our product people have just sort of been hanging around and waiting for something. We've actually made 180 filings over the last over the last two months. And what we do is we're constantly, in each state and each market, looking at how we pull and push levers to be competitive in the environment. It's why we saw sequential growth. And we've continued to grow in spite of a tough environment. And those filings were things like, making new business more competitive, making our telematics offering more competitive with some incentives in that area and across all 50 states, pulling different levers like that. So I would say that, while we don't favor, as you said, sort of a broad base like we're just going to cut X amount everywhere. We do favor being very surgical, very detailed and very thoughtful about how we manage our competitive position and our margin in each market. And I think you know from over time that we react quickly, whether it was the frequency spike back in 2015, or it's the frequency decline now of 2020 that we move really quickly on these things, and we have a very responsive system. And we react market-by-market and make sure that we return a very good return to our shareholders. But at the same time, we stay competitive and we're able to grow profitably."
},
{
"speaker": "Yaron Kinar",
"text": "Thank you and best of luck."
},
{
"speaker": "Operator",
"text": "Thank you. Our next question comes from the line of Elyse Greenspan from Wells Fargo. Your question please."
},
{
"speaker": "Elyse Greenspan",
"text": "Hi. Thank you. Given the strong results that you've been seeing, obviously, pretty favorable frequency results in the quarter, are there any plans for further rebates within your auto insurance book?"
},
{
"speaker": "Glenn Shapiro",
"text": "So, this is Glenn. Thanks, Elyse. I'll take that as well. I think what we're looking at now, and as I mentioned in the last question to Yaron, we're looking at sustainable and more sophisticated instruments. We're looking at how we get competitive with those as opposed to what I think was the right decision and a good way to go about it with the shelter-in-place payback at the moment. It needed a broad and blunt instrument because of the big move in frequency at that time. But when you wrap-in frequency and then the mix shift that moves severity and the expansion of coverage, the increase of bad debt because we get more flexible for customers in need, put all of those things together, I think the go-forward approach is going to be more in the lines of allowing our losses to flow into our rating as we always do, and to be more precise on a state-by-state and market-by-market basis versus a broad shelter-in-place payback. Things could change because depending on how the frequency and how the virus moves and all of that, but our thinking right now is to be more -- look at more sustainable tools than a shelter-in-place payback going forward."
},
{
"speaker": "Elyse Greenspan",
"text": "Okay. That's helpful. And then my second question, could you give us a sense of how frequency and severity trends have trended in July versus what you saw in the second quarter as we kind of -- as folks that started to go back to work and, et cetera, we've seen a change in loss trends?"
},
{
"speaker": "Mario Rizzo",
"text": "This is Mario. Glenn, can talk about the second quarter, but we're not going to talk about July trends at this point."
},
{
"speaker": "Glenn Shapiro",
"text": "Yeah. So I'll talk about the second quarter a little bit and to say, first of all, thanks for mentioning frequency and severity because they do tend to move in opposite directions with one another. And one thing, I'll just proactively address is that I know some of our competitors report a recorded number on severity. We report a paid number and paid calendar quarter is, I think, a more transparent and better metric to use in normal times, but we're in anything but normal times. So it's much, much more volatile and subject to mix shifts. So you'll see the number move more just because of the mix of what's being paid inside the quarter where you have fewer short-tail, small claims being paid in the period and everything, so that you'll see the two things move a little bit opposite one another. But what we saw throughout the quarter, and we did disclose that June was less of a difference in gross severity -- frequency, excuse me, than the other months in the quarter -- is that it has come down. It's starting to normalize in some places. There's a lot more variation by state early on like what we would see in April and May is that while there was some variation, pretty much all the states were down within a relatively close tolerance to one another. That has started to diverge more with a really rural state like Montana, for example, was actually up slightly in the year-over-year. And then you've got places that are more significantly down, particularly states that are more heavily concentrated with metro areas and that have had more spikes of the virus. So we're watching things on a very local level into how they're moving."
},
{
"speaker": "Elyse Greenspan",
"text": "Okay. Thank you. I appreciate the color."
},
{
"speaker": "Operator",
"text": "Thank you. Our next question comes from the line of Greg Peters from Raymond James."
},
{
"speaker": "Greg Peters",
"text": "Good morning. I'm going to pivot and I'd like to get an update on your homeowners business. I was looking at some of the statistics that you provide, like on page 17 of your supplement. And I was struck by the improvements in frequency, both gross claim and paid claim frequency, not just in the first and second quarters of this year, but it seems to be a longer term trend. And I would be curious about your impressions about what's driving that and how we should think about those trends as we look beyond just this year and think about next year."
},
{
"speaker": "Don Civgin",
"text": "Greg, it's Don Civgin. I'll ask Glenn to answer it in more detail. And we've obviously worked hard on our homeowners business over the last number of years, and so we're pleased with the returns we're getting from that business. But Glenn, do you want to get into more specifics?"
},
{
"speaker": "Glenn Shapiro",
"text": "Yes. Yes, absolutely. Thanks, Don. So yes, as Don said, I'm always -- I always preach that -- look at the long term and look at the reported combined on home. We've got year-to-date and 88.6% combined ratio recorded. Our 12 months is 83%, and our 5-year is 87%. So we've sustained that. I think, Greg, your point on the frequency is a tough one because it changes almost every quarter because the weather drives so much of it. So you'll have more caught up in catastrophes, and so it's sort of a lower underlying frequency, and then you'll have maybe a good weather quarter and you have few weather-driven and fewer cats. They move around a lot. What I would say recently, and this is probably an underreported part of the COVID impact, is that we've seen a shift in frequency severity on the home side because -- and it's pretty logical is we're seeing fewer like death claims and break-ins because everybody's home. And those tend to be lower severity claims, and yet we're seeing about the same number of fire points, and those tend to be higher severity claims. So we saw our frequency go down in the quarter. Our severity average go up because the ones that went away were smaller claims. And so we get into the details, and we look at all of those components, but I wouldn't necessarily draw a conclusion that there's something in home driving long-term frequency down that will be sustainable. I think it's been different factors each quarter."
},
{
"speaker": "Greg Peters",
"text": "Got it. Thanks for that answer. And then I guess I'll circle back your transformative growth plan and the integrated services platform. And as you guys know, I always like to track your agency data that you provide on page 9 of your supplement. And so I was wondering if you could just, from a big picture perspective, we're watching some directional changes in some of the numbers, whether it's a slight decrease in total Allstate agencies and LSPs, but we're also seeing an increase in the independent agencies and Encompass independent agencies, can you walk us through what your view is on how that's going to change further as we continue to roll out these plans that you've mentioned previously?"
},
{
"speaker": "Mario Rizzo",
"text": "Yes. Glenn, why don't you go ahead?"
},
{
"speaker": "Glenn Shapiro",
"text": "Okay, great. So you're always into the detail, Greg. So you definitely picked up on the right trends there. We're focused on growing with agencies looking to invest, and this ties back to something Mario talked about the expenses. It's not that our acquisition costs have gone down because we don't want to grow and we don't want to invest in agents looking to grow. They've gone down because we've moved the money really in a way that incentivizes growth and it's more efficient to do it that way. So coming into this year, we moved some money that was incentivizing retention, and we moved it to incentivize new business. And -- or I should say renewal versus new business as opposed to retention because how it gets paid. That's one change. And that changed some agents, who wanted to invest in that way, and some that didn't and perhaps voted themselves out on that one. We also increased our baseline performance requirements for, I'll call it, our lowest producing agency and required that folks sort of be more open for business than they have been. And so that has driven the number down a little bit. And the other thing is integrated service, which you mentioned in the question. That number will start to look strange over time. We have about 500 agents in there right now. So those agents won't show staff members that are being augmented or provided by Allstate. And so it kind of moves the number to a different place because we don't report it in as part of the agency staff as licensed sales professionals because we're doing the work on the back end for them in those centers. So there's a number of pieces moving it. But I think the headline to take away is that we've grown in the agency plan. I mentioned in the prepared remarks that we've all-time high in Allstate brand auto policies in force. So the agency force has grown, and we want to grow in all of our lines. We want to grow all state agents. We want to grow our independent agent channel, which is the pending acquisition that we've got with National general, and we want to grow in direct, which is the combination of Esurance and Allstate Direct."
},
{
"speaker": "Tom Wilson",
"text": "Hey, Greg, this is Tom Wilson. I'm – hopefully, I've reconnected."
},
{
"speaker": "Mark Nogal",
"text": "We can hear you."
},
{
"speaker": "Tom Wilson",
"text": "All right. Let me highlight what Glenn just said. So, transformative growth, so we're going to sell as much as we can through everybody as we can. So we want to have more Allstate agents. We want to have independent agents. We want to sell more. You will see, over time, some increases decreases and how much goes through each of those channels as we transition to or a profit model. So – and Glenn explained what we're doing on new business versus a retention. But we're really working on different ways we can get to customers. We may not need as much real estate in the future as we have today. That means local offices are different. So you'll see changes, and you're seeing some of that change now because we're not new Allstate agents at this point as we build out these new models. So it's really about very distribution force."
},
{
"speaker": "Greg Peters",
"text": "Got it. Thank you for the answers."
},
{
"speaker": "Operator",
"text": "Thank you. Our next question comes from the line of Mike Zaremski from Credit Suisse. Your question please."
},
{
"speaker": "Mike Zaremski",
"text": "Hey, good morning. Thanks. Could you guys – and maybe I missed it, did you guys touch on auto severity? I think, we – investors have expected it to increase during COVID. Maybe you can discuss whether we should expect the severity or you could talk about it, so we can maybe better understand whether it should continue? And I'm curious whether, like, the underlying severity trend is still kind of higher for longer due to issues we talked about pre-COVID? Or is there a change to that potentially post-COVID?"
},
{
"speaker": "Tom Wilson",
"text": "Mike, let me have Glenn answer that, but give you an overview first. In a time like this, where the numbers are changing rapidly in terms of the number of claims, they – the statistics in the method you use for any individual component of loss costs bounce around a lot. So it's – the best thing to do is to look at overall loss costs and say, are your loss costs still the right percentage of your premiums? We obviously have done attribution on severity, and Glenn can talk about that."
},
{
"speaker": "Glenn Shapiro",
"text": "Yeah. So it's a great question because, as Tom said, I mean, they do bounce around a lot. Overall, we feel very comfortable and confident with where we are on severity. PD severity, paid severity was reported at 20% up, which number jumps off the page. Let me give you just an example of why that is on a paid severity number like that. So paid severity is – as you'd expect, it's a number of claims you settled and closed during that calendar period divided by the total number of claims, and you get your average. Well, during the second quarter, we settled just as many six-month-old claims as we would in any normal quarter, because six months earlier, there was no COVID and there was no drop in frequency. We settled just as many five-month-old claims and four-month old-claims and three-month-old claims, but we settled a lot fewer three-day-old claims. And one-week-old claims, because they just weren't there. They weren't happening with the same frequency and as you'd expect, the claims you settle in three, four and five days are lower severity on average. They're quick. They're easy, and they're low cost. The ones that are six months are typically ones that have like they've gone through their own carrier. The segregation comes over from that carrier, they average a much higher severity type of claim, or they've been a total loss, and so they take longer to process and so on. So it's just a pure mix issue that drives that type of number. When we get down underneath that, and we're able to look at the things that come in, in the quarter and how they're resolving and are estimating practices and what the true severity looks like, it feels like normal inflation that we've seen in the single digits that we're very comfortable with. And the claims team has done and the finance team a terrific job of getting underneath the data so that we understand where and if we have any pressures, but we've seen it run very predictably."
},
{
"speaker": "Mike Zaremski",
"text": "Okay. That's very helpful. And lastly, my follow-up. Services segment, it feels like, driven by Allstate Protection continues to do, I think, better than expected, and it's actually kind of moving the needle a little bit these days. You talked about diversifying into – outside of the U.S. I mean, just since it's growing so fast, should we expect the rate of growth to temper? Any additional color there would be around what's going on would be helpful."
},
{
"speaker": "Tom Wilson",
"text": "Let me provide just overview like why we talked about it, and then Don can talk about its future. So, when we bought it, one of the things we said was, we'll come back and talk to you about how we're doing every so often. And that's what we wanted to do here. And it's meeting and exceeding our expectations. I think there are a number of people. We're trying to understand why we were into that space, and you can see it's a huge growth. And we've had huge growth both domestically, and we're starting to get some good growth internationally. So, it was really about coming back to you and saying, we told you we'd come back, and here we are. And it happens to be a good news story, which Don can talk about."
},
{
"speaker": "Don Civgin",
"text": "Yes. Thank you. So, first, thanks for noticing. The service businesses, I think, in total, have made a lot of progress and has improved the values that they provide to customers. And so I think across the Board, they're doing really good work, more specifically around the Allstate Protection Plans. I mean, Mario laid out the three goals that we set and how we're doing against them. But I'd remind you, we set those goals the first quarter after we did the acquisition, and we communicated those, and we've been consistent about them. And we have had a really strong trajectory since we acquired SquareTrade, both on the topline and improvements in profitability all along the way. This particular quarter was good, but I'd remind you we expected to have a good 2020 to begin with. And that's because we were continuing to pick up new customers. We were doing a really good job working with our partners to make the product more available and accessible to their customers. And so we expect the growth not only for new business-to-business customers, but also more availability in existing customers and our international business continues to grow substantially. So, we expected 2020 to be good. We have benefited from the virus in some ways, and topline is one of them. When you look at the partners that we do our largest business with, they tend to be the larger one-stop shops. Which, as you would know, have been in favor in the retail world -- retail is doing mix these days. But if you're a large one-stop shop, we've done quite well. In the categories that we are particularly in consumer electronics and so forth and home office, have also done very well. So, we benefited because of the virus with the topline. And then, obviously, the topline has a benefit to the bottom-line with respect to scale of the expenses and so forth. So, we're very happy with the results. The results would have been strong even without the virus. They have clearly been helped to buy the virus, both on the topline and the bottom-line. But we're still very happy with the underlying performance as well. The only thing I'd add is, it's hard to tell what the impact of the virus is going to be going forward. And that's just going to depend on consumer behavior, where they buy, what they buy. So, while we benefited from impacts from the virus at this point, it's hard to tell what's going to happen in the future. But all that said, the underlying business has been and continues to be quite strong and we're quite bullish on it."
},
{
"speaker": "Mike Zaremski",
"text": "Thank you."
},
{
"speaker": "Operator",
"text": "Thank you. Our next question comes from the line of Paul Newsome from Piper Sandler."
},
{
"speaker": "Paul Newsome",
"text": "Good morning. I wanted to ask about bad debt trends within the quarter itself. And I guess I'm wondering whether or not we could see more when the Federal subsidies for unemployment go away or if maybe the bad debt is more tied to some of the state level moratoriums on -- that were in place. Just your thoughts on that would be great."
},
{
"speaker": "Tom Wilson",
"text": "Mario, do you want to take that?"
},
{
"speaker": "Mario Rizzo",
"text": "Sure. Paul, this is Mario. So, just to give you a little context of the driver of bad debt, as we mentioned earlier, one of the ways that we provided additional benefits to our customers during the pandemic was to offer them the opportunity to opt into a special payment plan, which essentially gives them 60 days of coverage without having to make a payment on the policy. That started in March. And we've – as we've worked our way through the quarter, we've gotten more and more experience relative to how that subset of customers has performed and then the bad debt activity within that customer segment, because as much as we had historical context around offering similar-type programs during catastrophes, this was obviously much more widespread and different. And you see the impact in the quarter where bad debt was $44 million. We'll continue to get more and more experience on that customer set going forward. We'll continue to update our analysis, and then we'll update the numbers in the third quarter, if we need to. But based on the experience we've seen so far through the end of Q2, that's what we recorded in the P&L."
},
{
"speaker": "Tom Wilson",
"text": "And Paul, I would wrap that into just the overall pandemic impact, right? So we've obviously had lower frequency, which we've talked a lot about. This is another cost associated with the pandemic. And when we're thinking about what we're going to do in the future, we factor all this stuff in."
},
{
"speaker": "Paul Newsome",
"text": "Makes sense. Second question, I wanted to ask about whether or not you think the regulators will take into account sort of the, hopefully, one-time nature of the pandemic? Or if we put through – when you put through rate filings in the future, will you kind of have this middle of the Python kind of situation where the unusual low frequency is embedded in what you can file for rates prospectively until that kind of rolls off through the system."
},
{
"speaker": "Tom Wilson",
"text": "Well, it's always hard for us, of course, to speak for somebody else as to what they will do. And of course, it varies by state, which oftentimes relates to the political environment in that state. What I can say is, we were out early, no regulator forces to do shelter-in-place payback or expand coverage and all the other things we did. And so we got out ahead of it. I think we got positive feedback from people that we were doing what was not required, like no one had to come in and say, you must do this. And so I feel like we're on a good basis to work through like what's the right price. And if frequency were to stay at these abnormal lows, obviously, regulators, customers in the competitive market wouldn't have you charge the same amount. The good news is our loss cost would be a lot better. So our focus, really, Paul, is on maintaining our overall competitive position and our margins. And we've been able to do that with regulators. I think there'll be a whole bunch of stories. But the good news is we have good math, an operating model that adjusts locally in a way in which we can continue then grow profitably. Glenn, anything you would add to that?"
},
{
"speaker": "Glenn Shapiro",
"text": "No. I think that covered it well."
},
{
"speaker": "Paul Newsome",
"text": "Thanks for your help. Everyone, stay safe, guys."
},
{
"speaker": "Operator",
"text": "Our next question comes from the line of David Motemaden from Evercore. Your question please."
},
{
"speaker": "David Motemaden",
"text": "Hi, good morning. Just a question for Tom and Glenn. Just thinking bigger picture, I'm just wondering how you guys are thinking about miles driven and accident frequency over the longer term. And I know there's a lot of uncertainty, but are you guys thinking -- how are you guys thinking about miles driven and accident frequency? Do you think that we'll ever get back to levels that we were at pre-COVID, especially given what seems like increasingly prevalent adoption of remote working arrangements? And relatedly, how are you guys going to adjust to potential lower frequency levels on a more sustained basis?"
},
{
"speaker": "Tom Wilson",
"text": "Let me start, Glenn and then jump in. I'm going to start, David, the most macro which is of course, our strategy includes a couple of different components, the top over Property-Liability and then the bottom of other stuff. In the Property-Liability stuff, there's auto, big driver of that. And as -- and that's a key part of our both revenue and profitability. But the other thing is, we have a really profitable homeowners business, much more profitable than other people. We're good at it. We're precise at it. We sell a bunch of other stuff. And then the circle protection selling things like the service plans and everything is about making sure the company has multiple things we can sell to customers to protect them from whatever goes wrong in their life and leverage those customer bases. So we're dealing with -- because you had the same question that was about the same question about the future of auto was really around autonomous vehicles 3 or 4 years ago. And so we've been on that path from a strategic standpoint as to how to deal with that. And, of course, what's happened is, actually, premiums have gone up, not down in the last 4 or 5 years, which people were afraid nobody was going to drive. So it's really hard to predict. What you can do is have multiple options and take advantage of those options and leverage your skills and capabilities. As it relates to the auto insurance business, you want to have a broad-based approach. And that's what transformative growth really is. It's improve the customer value proposes, give people lots of access, connect to more, make your products more simple. And so we still have a lot of the share of that market we can pick up. And so even if you were to say fewer miles driven, lower average premium, we still think we can grow that business. Glenn, you might want to have some -- that was obvious sort of macro and longer term. How would you react to the question on more really as it relates to personal Profit-Liability in the shorter term?"
},
{
"speaker": "Glenn Shapiro",
"text": "Yes. And it's a great question because, obviously, we think a lot about this. Let me take you into how the team works on this. And I'll go -- like Tom did, I'll go before even the virus. We had built out a model and assumptions for the change in frequency driven purely by the change in the car fleet out in the market. What does each component of ADAS, safety equipment on cars, what does each component do to change each type of loss, like how many fewer sideswipes or rear ends or intersection actions are we going to have based on the blind spot warning or based on this autonomous feature or so on? And you add those up and you apply them to your fleet and how the fleet is changing over time, and we actually -- we've built into the model, our assumptions were what changes. But at the same time, we built the other side of it, which is the severity. Because all those cars getting into fewer accidents are a heck of a lot more expensive to fix when they have all that equipment on it. And so it goes to what Tom said about, really, it's hard to predict, but we go after it and we look at with as much specificity as we can, the component parts. So now take that into the current scenario and the question you're asking. And we're looking at, so what percentage of the market works in jobs that don't have to commute? If you work in a restaurant or your dental hygienist or like -- but you're going to have to commute because those things cannot be done remotely. But there are a lot of jobs, most of us have jobs that can be done more remotely than they have been historically. So you get that percentage. And then you look at, well, what percentage of people will do it, and then what percentage of your accidents occur in like high drive time, and you start making your assumptions and picks over what's going to change. And similarly, that then changes severity because one of the things we've learned is that the losses that go away quickest are the bumper-to-bumper accidents in high traffic, and those tend to be low severity. So while a 10% decrease in frequency is great, it's not necessarily a 10% decrease in loss costs. And the reason I'm getting into or micro, since Tom took the macro on this and laid it out, is hopefully just to give you confidence that we look at this in a very detailed way and a thoughtful way, and our teams work through what the expectations are, and then we're able to move quickly on the fly when we're either above or below it with what our prediction is."
},
{
"speaker": "David Motemaden",
"text": "Great. Thanks for that comprehensive answer. I appreciate that. And if I could just sneak in just one more on just a quick numbers question. If I think about that 50 basis point improvement in the expense ratio, if I take out the one-time-ish items in 2Q, and then it was roughly 80 basis points in the first half versus the first half last year, is that -- and I know there are a lot of different moving pieces there, but is that the sort of level of year-over-year improvement that we should expect to see going forward?"
},
{
"speaker": "Tom Wilson",
"text": "Yes. I would say transformative growth is about reducing expenses. In part, it's just one component, but it's about reducing expenses, so we can improve our customer value proposition with better prices, without impacting our margins. But it's going to bounce around a lot by quarter. You got advertising. We're going to have – we have new advertising. We're going to launch – you have some technology spend. But you should expect the overall trend going down. I don't think we could predict how much it will change by every quarter because – or set a target that way, because then it leaves unnatural consequences. So – but you should expect it to keep going down, yes."
},
{
"speaker": "David Motemaden",
"text": "No. Thanks fair. Thank you."
},
{
"speaker": "Operator",
"text": "Thank you. Our next question comes from the line of Suneet Kamath from Citi. Your question, please."
},
{
"speaker": "Suneet Kamath",
"text": "Thanks. Good morning. I wanted to go back to the frequency benefit issue, if I could. I get that you want to be more surgical in terms of how you're approaching this, as opposed to more broad-based, which makes sense, but, I guess, the question is, do you – are you comfortable or confident that you won't see an impact on policy growth to the extent that some of your competitors actually stick with much more of a broad-based approach?"
},
{
"speaker": "Tom Wilson",
"text": "Well, it's always hard to tell what customers will do. We've always found that precision works for us on the long term, and that those people who rush to grow and not have precision to it, end up having to fix it later. So if you look at homeowners, people trying to grow in homeowners are taking huge losses. Like, we just don't think that's the right way to build the business, because you get the customer for a price that's not appropriate, and then you either have to lose them or manage them to a much higher price. So, all I can say is, what we'll do. But it's a reasonably – it's a highly competitive market, but it's a thoughtful market, right? Like people are not crazy in this market and trying to use bad economics. So all of our major competitors understand their business well and why they might make different bets at different times. I feel like, the basis of competition is still going to stay the same. Whoever is the smartest, win."
},
{
"speaker": "Suneet Kamath",
"text": "Got it. Okay. And then I just wanted to ask one on the National General deal, if I could. I see that you're still guiding to this, I guess, high single-digit accretion, I think, was the original guidance. But when we were running the math, just based on where expectations were for Allstate and Nat General based on consensus, we were getting something close to high single digit or in a high single digits EPS accretion, without factoring in any cost synergies. So I'm just trying to understand, is there any help that you can give us in terms of what you're building in with respect to cost synergies? I don't think you talked about on the last call, but any help there would be appreciated."
},
{
"speaker": "Tom Wilson",
"text": "What, I would say is, we don't own it yet. So our projections haven't really changed. We do have cost saves in the middle of it that we figured out in terms of what we factored in when we bought – when we agreed to pay the price we did. And it did lead to accretion, as you point out. But right now, we're working on -- Glenn and Barry are working hard on what is the transition program. So as we get more specifics on things that we can lay out for you that are, here's our measurable goals, we'll do that. But, right now, we're just like a month into it."
},
{
"speaker": "Suneet Kamath",
"text": "All right. Thanks, Tom."
},
{
"speaker": "Operator",
"text": "Thank you."
},
{
"speaker": "Mark Nogal",
"text": "Jonathan, I think we have time for one more question."
},
{
"speaker": "Operator",
"text": "Certainly. Then our final question for today comes from the line Ryan Tunis from Autonomous Research. Your question, please."
},
{
"speaker": "Ryan Tunis",
"text": "Good morning. This might be a question for Glenn, but it seems like there's some decoupling between trends in miles driven and trends in frequency with, I guess, the latter declining quite a bit more. I guess my question is, what indicators that you're seeing in your book do you think are actually the best predictive indicators of what frequency is doing in this current environment?"
},
{
"speaker": "Tom Wilson",
"text": "That's a tough question. I will let Glenn do that one."
},
{
"speaker": "Glenn Shapiro",
"text": "Thanks. So it's a good question. And you're right about the decoupling, so I'll give you a little background on that. Not all miles are created equal. If you're driving in a high-traffic environment, you are much more likely to get an accident because it's less forgiving. You take your eyes off the road. You're distracted driving, which, by the way, I don't recommend at any time. But if you're doing it in loose traffic and you make a mistake, you're less likely to bump into somebody than when you're doing it in high traffic. So what we're seeing is with commuting miles being way down, that has a little bit of an exponential effect on frequency. So if miles came back to a new normal for non-commuting, but were lower only on commuting, it would have a disproportionate effect on the frequency. So hopefully, that answers your question. It's – we're looking at the data in that way. And our – with the partnership with Arity and the partnerships they have with a lot of the non-insurance companies out there, and they get a lot of miles-driven data on those, and that what they do for us with our own data, is extremely helpful in that."
},
{
"speaker": "Tom Wilson",
"text": "And Ryan – and Glenn's example also is goes for rural and urban too, right? So think of the same thing, not just time and day also. So Montana, the frequency is not down as much as it is in urban areas because there's fewer people. There's always less congestion. So it is a difficult question. But the good news is we're on top of it. I know you all have another call. Thank you for participating and listening to our story. We'll talk to you next quarter."
},
{
"speaker": "Operator",
"text": "Thank you, ladies and gentlemen, for your participation in today's conference. This does conclude the program. You may now disconnect. Good day."
}
] | The Allstate Corporation | 18,711 |
ALL | 1 | 2,020 | 2020-05-06 09:00:00 | Operator: Ladies and gentlemen, thank you for standing by, and welcome to The Allstate First Quarter 2020 Earnings Conference Call. [Operator Instructions]. And now I'd like to introduce your host for today's program, Mark Nogal, Head of Investor Relations. Please go ahead, sir.
Mark Nogal: Thank you, Jonathan. Good morning, and welcome, everyone, to Allstate's First Quarter 2020 Earnings Conference Call. After prepared remarks, we will have a question-and-answer session. Yesterday, following the close of the market, we issued our news release and investor supplement, filed our 10-Q and posted today's presentation, along with our reinsurance update on our website at allstateinvestors.com. Our management team is here to provide perspective on these results and further context on our response to the coronavirus pandemic. As noted on the first slide of the presentation, our discussion will contain non-GAAP measures for which there are reconciliations in the news release and investor supplement and forward-looking statements throughout Allstate's operations. Allstate's results may differ materially from these statements, so please refer to our 10-K for 2019 and other public documents for information on potential risks. And now I'll turn it over to Tom.
Thomas Wilson: Good morning. Thank you for joining us from wherever you are sheltered in place. Let's jump right in with Allstate's response to the coronavirus pandemic on Slide 2. Allstate has been helping customers overcome catastrophes for 89 years, and we've learned to act decisively, quickly and put customers first. As a result, we've led the industry in helping customers. We created a Shelter-in-Place Payback program of more than $600 million. Special payment plans are being used for customers experiencing financial challenges. Auto insurance coverage was expanded to cover the use of personal vehicles to deliver food, medicine and other goods for commercial purposes. Allstate Identity Protection is being offered for free for the rest of the year to all U.S. residents, given the increased exposure to cybercrime. Business continuity plans were executed. Virtual sales and support capabilities were expanded. We leveraged our digital innovations, such as QuickFoto Claim and Virtual Assist, to better protect our customers, employees and agents. Employees and Allstate agents moved to more than 95% working remotely, and we altered a number of business practices to support our agents and employees. At the same time, Allstate is financially strong with significant capital and liquidity. In February, we reduced our public equity holdings by $4 billion to reduce the amount of economic capital back in the investment portfolio. But this turned out to be good timing because it enabled us to reduce the impact of the market downturn in March. And as Mario will cover later, we will maintain our share repurchase program given the strong capital position. For our communities, the Allstate Foundation announced an additional $5 million. That's on top of the money we normally grant every year, which is substantial to help deal with the pandemic and double demand for Allstate employees' need. Move to Slide 3. Let's touch base with Allstate's strategy. As you know, our strategy has two components: increase personal Property-Liability market share and expand into other protection businesses. This 2-part strategy leads to our 5 annual operating priorities, which is shown on the right side of this page, and we made good progress around all five. If you move to Slide 4, Allstate had strong operating and financial results in the first quarter. Total revenues of $10.1 billion declined 8.3% for the prior year quarter due to capital losses instead of capital gains in the prior year. If you exclude the impact of the realized capital losses, revenues increased 2%, driven by a 4.4% increase in Property-Liability insurance premiums, which you can see from the table. Net income of $513 million declined to the prior year quarter's increased underwriting income, was more than offset by capital losses and charges for pension and postretirement benefits. Adjusted net income, shown in the middle of the table, was $1.1 billion in the quarter or $3.54 per diluted share, which was significantly above the prior year, reflecting lower catastrophe losses. Returns were excellent with adjusted net income return on equity improving to 18.2%. Mario will now discuss the first quarter results in more detail.
Mario Rizzo: Thanks, Tom, and good morning, everybody. Let's go to Slide 5 to discuss the strong performance of our Property-Liability segment. Starting with the chart on the left, policy and premium growth continued, with excellent recorded and underlying profitability. Underwriting income of $1.35 billion in the first quarter was $645 million higher than the prior year quarter with a combined ratio of 84.9. The improvement to prior year was driven by several factors, including lower catastrophe losses, increased premiums earned and lower auto accident frequency from the decline in miles driven. Auto accident frequency was significantly lower in the quarter, with property damage gross frequency down 12% compared to the prior year quarter. For the month of March, property damage gross frequency declined 27% compared to the prior year, as miles driven dropped significantly, as states began implementing social distancing measures. These benefits were partially offset by increased severity and the Shelter-in-Place Payback expense. The chart on the right shows our Property-Liability expense ratio over time and specifically highlights the $210 million Shelter-in-Place Payback expense we recorded in the first quarter, which increased the expense ratio by 2.4 points. Excluding this impact, the expense ratio improved by 1 point compared to the prior year quarter, reflecting continued progress on enhancing the customer value proposition, which is one of the key components of our Transformative Growth Plan. Let's go to Slide 6, which highlights investment performance for the first quarter. As you'd expect, our first quarter investment portfolio results reflect the impact of the market volatility caused by the coronavirus. As shown in the table in the middle of the page, total return for the first quarter was a negative 2.4%, largely reflecting lower portfolio valuation. While the decline in treasury rates supported fixed income prices, the significant widening of credit spreads more than offset that benefit, and interest-bearing valuation decline reduced return by 1.9%. Lower equity valuations further decreased returns by another 1%. The chart shows net investment income of $421 million in the quarter, which was $227 million lower than the prior year. We recorded a loss of $208 million for performance-based results in the first quarter, as shown in gray. As you may recall, the income on our limited partnership is typically booked on a 1-quarter lag. Performance-based income related to fourth quarter 2019 sponsored financial statement was $176 million. We also recorded write-downs of $137 million on 4 underperforming private equity investments. In a typical quarter, this is where our process would have ended. However, given market volatility and economic disruption, we also recognized declines in the value of limited partnership interest, where we had enough information to make informed estimates rather than solely relying on sponsored financial statement as of December 31. This included updating publicly traded investments held within limited partnership to their March 31 market pricing, which reduced investment income by $52 million. We also did not recognize $195 million of unrealized valuation increases reported in sponsor's fourth quarter financial statements. The sum total of these 4 items generated the $208 million performance-based loss in Q1. Because these investments exhibit idiosyncratic risk and return, future gains and losses are uncertain. But we believe utilizing this approach in the quarter is a better indication of current value. Income from the market-based portfolio, shown in blue, was lower than the prior year quarter by $19 million, reflecting the impact of lower reinvestment rates. We expect this trend to continue to the extent reinvestment rates remain below average interest-bearing portfolio yield. Let's turn to Slide 7 to discuss our portfolio positioning. We take a disciplined and proactive approach to managing the investment portfolio risk and return profile, and our positioning has mitigated the impact of the current crisis. As you can see in the chart on the left of the page, the portfolio is largely made up of high-quality fixed income securities with substantial liquidity. We extended the duration of our Property-Liability portfolio last year, which was -- which has supported both income and returns in the lower rate environment. We are conservatively positioned in sectors more susceptible to the pandemic and continue to monitor those exposures closely. To provide transparency into these exposures, we have enhanced our Form 10-Q disclosures. We also have a 13% allocation to performance-based investments and public equity securities, down from 18% at year-end 2019, which backed long-dated liabilities and capital. As you can see in the chart at the bottom right, in February, we reduced our equity exposure by $4 billion, primarily through the sale of public equity securities with proceeds invested in high-quality fixed income. These trades were executed at an average price equivalent of 3,281 on the S&P 500 compared to the March month end level of 2,585. We continue to proactively employ a disciplined risk and return framework to the portfolio as economic conditions evolve. Now let's turn to Slide 8 to review results for the Life, Benefits and Annuities segment. Allstate Life, shown on the left, generated adjusted net income of $80 million in the first quarter, an increase of $7 million compared to the prior year quarter, driven by lower operating costs and expenses. Allstate Benefits' adjusted net income of $24 million in the first quarter was $7 million below the prior year quarter. The decline was due to higher operating costs and expenses, driven by increased investments in technology and higher DAC amortization. Allstate Annuities, shown on the bottom right, had an adjusted net loss of $139 million in the first quarter, primarily due to the performance-based investment results we discussed earlier. Coronavirus claims did not appear to materially impact any of these businesses in the first quarter, though we continue to monitor developments closely. Now let's turn to Slide 9 to talk about our Service Businesses. The Service Businesses continued to increase the number of customers protected with policy in-force growth of 35.4% to $113.7 million. This is largely due to the increase in Allstate Protection Plans. Revenues, excluding the impact of realized gains and losses, grew 18.2% to $454 million in the first quarter. Adjusted net income improved to $37 million in the first quarter, reflecting an increase of $26 million compared to the first quarter of 2019, driven by growth of Allstate Protection Plans and improved profitability at Allstate Roadside Services. Slide 10 highlights Allstate's attractive returns and strong capital position. While the impact of the coronavirus drove financial market instability and led to a decline in shareholders' equity, Allstate's diversified business model, substantial earnings capacity and strong capital and liquidity enables us to manage effectively through this pandemic. We have $3.4 billion in parent company holding deployable assets and $8.8 billion of highly liquid securities saleable within 1 week. We continued to generate strong returns on capital with an adjusted net income return on equity of 18.2% as of the end of the first quarter while returning $670 million to common shareholders in the quarter through a combination of $511 million in share repurchases and $159 million in common stock dividends. We plan to continue share repurchases under our current $3 billion program, which is expected to be completed by the end of 2021. And now I'll turn it over to Glenn to discuss the coronavirus impact on auto insurance and how we're leveraging data and insights to make decisions.
Glenn Shapiro: Thanks, Mario, and good morning, everyone. Let's go to Slide 11, which looks at the potential impacts of coronavirus on auto insurance. Profit has been, and will be, impacted by a reduction in miles driven, which will lower overall loss costs. While this has been significant, it will decline over time as the economy begins to reopen, and there are several offsets. First, the reduction of drivers on the road has increased driving speeds, which can lead to increased severity per claim. We'll also likely incur additional bad debt from some customers who have chosen to take extended payment terms. On a longer-term basis, if the global auto parts supply chain is disrupted or parts prices are raised by auto manufacturers, this could increase repair costs. The pandemic and economic slowdown will also impact growth. If loss costs continue to be below prior year, the lower required rate increases will limit average premium growth. On the positive side, the Shelter-in-Place payment could have a favorable impact on retention. The impact on new business is unclear since reduced vehicle sales can lower new business, but economic conditions may increase shopping levels. And we've seen an increased customer interest in telematics, and we're well positioned with both Drivewise and Milewise, the latter of which charges customers' insurance by mile. Getting ahead of these trends will be important to grow profitably as we continue to manage profitability and competitive position on a market-by-market basis and will enable us to be precise in our responses. Let's now move to Slide 12. As a customer of Arity, we have access not only to our data, but insights from a much broader data set, some of which is shown on this slide. Telematics-based pricing allows you to factor in things like how much someone drives, where they drive and how they drive. Our telematics products enable us to do that for individual customers, which when combined with a broader set of data, enables us to make better judgments market by market. For example, based on 3.5 billion trips from February through April, the upper-left graph shows that miles driven declined sharply in mid-March and then began a slow increase since then. You can also see that those states that had stay-at-home orders had a bigger decline in driving. In the upper right, you can see there's also a difference between rural areas at the top of the chart, which declined by about 20%, and urban areas at the bottom, which declined by about 50%. The bottom-left graph shows that while some drivers are not driving at all, those are the bars to the left, about 20% of drivers are actually driving more than they did before mid-March. Arity also provides a Drivesight score, which is a measure of driving risk. The lower the score, the higher the risk. As you can see on the bottom right, the mean risk has increased despite fewer cars on the road, which correlates to the data that shows some drivers are driving faster. The net of all of this is that Allstate has the data and business processes to proactively adjust to a changing operating environment. I'll now pass it back to Tom.
Thomas Wilson: Thank you, Glenn. To move to Slide 13, we want to discuss how we've moved past the emergency of moving people to work from home to the immediate of creating a Shelter-in-Place Payback to implementing intermediate-term actions. In this type of environment, you obviously have to look where you step, but you also have to decide where you want to walk. And as we look into the future, there's not that much clarity, right? Who will move back into offices? Will as many people still need to commute to work? What happens to the investment market? And of course, the answer is nobody knows. There are so many possibilities you can get frozen into inaction. So we used scenario planning to see what the future path look like under alternative assumptions. This came out of Royal Dutch Shell in the '70s, and it works kind of like this. You find 2 things that will be the primary drivers of change. In this case, we selected the length and depth of the health crisis, which is shown at the top of the box on the bottom of that page, and the severity of the economic downturn from disruptive to severe, which is shown on the vertical axis. You then create 4 scenarios to represent a range of possible outcomes. As you can see from the slide, the best case in the upper right, we've labeled sigh of relief. The health care crisis is over relatively quickly and the economy is disrupted, but government support enables us to bounce back with them. In the worst case, in the lower right, is distracted by the virus. It reflects a significant health impact with repeated lockdowns over the next couple of years. The decline in GDP is greater than the Great Depression, but it doesn't last as long because of the government fiscal monetary action. For each scenario then, we look at a range of outcomes, including consumer behavior, auto insurance accidents and investment returns. This helps us decide what actions we should do, even though we do not know what the ultimate outcome will be. It also helps inform what not to do. And it enables us to establish road signs for each scenario, which improves our ability to forecast the direction we're headed. There are, of course, similar consequences in the scenarios, which help determine what actions to take, which is shown on Slide 14. In many of the outcomes, revenue growth is constrained because of fewer auto accidents, deteriorating incomes, increased unemployment or lower interest rates. As a result, we are accelerating our Transformative Growth Plan, which will improve customer value with increased utilization of new technologies, lower costs in new auto insurance products. And as you know well, the investment markets will be more volatile in many of these scenarios. As a result, we're evaluating our strategic asset allocation. Many of us have found that we can adopt new technologies pretty quickly. Like who knew you can have so many Zoom or Teams or Skype meetings in one day? As a result, we're going to maintain a strong commitment to telematics and expanding the Integrated Digital Enterprise. Consumer behavior is also likely to change to focus on the quality and breadth of their protection. And this is where Allstate is headed, with the second part of our strategy, is to provide a broader array of protection offerings from auto insurance to include things like your phone and your identity. Now we'll open the line for questions.
Operator: [Operator Instructions]. Our first question comes from the line of Elyse Greenspan from Wells Fargo.
Elyse Greenspan: My first question on is -- I think is just on frequency. You guys provided some pretty good disclosure on the drop in miles driven, and I believe you said it started to bounce back from the COVID woes. So as we're thinking about Q2, so April and May kind of to date, how do you think about the frequency benefit that we might see over that period compared to what you saw towards the later stages of March?
Thomas Wilson: Elyse, let me start, and then toss it over to Glenn. Well, it is -- obviously, as people start to drive more, they'll get in more accidents. So we expect that to head up. Where it will end up is hard to predict at this point because you don't really know when people are going to go back to the office and how many people will even go back to the office site. As I talk to other companies, it's pretty clear to me that we found that we've built the infrastructure to do remote workforce. At Allstate, we've already had about 15% of our people remote before this. We think we can probably do more. So that would obviously lead to fewer people driving to and from work, but it's hard to predict exactly where the number comes out. Glenn, do you have anything you want to add to that?
Glenn Shapiro: Not too much. I think, Tom -- as Tom said, you've got some unknowns in there, which would include, if you go on the other side of it, some pent-up demand. If you think about people who postponed trips, who postponed visiting relatives and want to catch up on it, so you could have some sort of fits and starts with some of the long-lasting, as Tom described, downward pressure on driving and, therefore, frequency, but also some potential short-term bubbles where people want to get out there because they're a little bit stir-crazy.
Elyse Greenspan: Okay. That's helpful. And then my second question is on buybacks. I know you guys have said you expect to maintain your buyback program. So as we think about the completion of that program, I believe it runs through the end of 2021, should we think about kind of an even pace of buybacks from here? Would there be some slowdown over the next couple of quarters? Or just given the capital position, you kind of expect that to be evenly maintained as we work our way through 2021?
Thomas Wilson: Mario, will you take that question?
Mario Rizzo: Sure. Elyse, thanks for the questions. So I think the place I'd start, Elyse, is we feel really good about our capital and liquidity position, $3.4 billion of holding company assets, $8.8 billion of readily available liquidity, $3.7 billion of dividend capacity out of our insurance companies into the holding company for the year. And our businesses are performing really well. So I think I'd say we expect to complete the program by the end of next year just like our Board authorized. And we've got a lot of flexibility in terms of how we execute it, but we would expect to just continue to buy back shares over that time period.
Operator: Our next question comes from the line of Greg Peters from Raymond James.
Charles Peters: First question will be on the expense ratio, the underlying expense ratio improvement. Can you talk about what -- and you provided just a basic comment on it in your prepared remarks. Can you give us more color on that? And maybe talk about maybe how that fits with the sequential decline in Allstate Agency's LSPs? And is that part of your integrated services platform rollout?
Thomas Wilson: Mario, why don't you take expenses? And Glenn, will you take the agent?
Mario Rizzo: Yes, sure. So when you look at the expense ratio in the quarter, you saw a 1 point sequential decline year-over-year in the expense ratio. And first thing I'd say is, reducing our cost continues to be a core part of our transformative growth strategy. And when you kind of deconstruct where the improvement came from, it's about 50-50, not quite between acquisition costs and operating costs. And obviously, those are two core parts of our cost structure, and we saw improvement in both. And we're going to continue to be focused on reducing those costs going forward to enhance our competitive position to still take growth and be a core part of transformative growth for us. We're also going to continue to invest in the things we need to invest in for transformative growth, things like technology and marketing. But we're focused going forward on continuing to reduce costs over time. I'll turn it over to Glenn to talk a little bit about the agency part of it.
Glenn Shapiro: Yes. Greg, thanks for the question. In terms of the LSP count and agent count, you hit on part of it in your question with integrated service. When you look at licensed sales professionals, and in spite of the word sales being the operative word there, they spend only about 40% of their time on sales, about 60% on service. That's been a historic number. And one of the things we're committed to is taking a lot of the transactional work out, both through self-service capabilities as well as integrated service, over time, so that they're increasing that percentage of time they're selling and not having to do as much of that transactional work. So we'll probably see that change over time. And that's really part of our overall transformative growth work that we're doing. And in terms of the agency count, we're really focused on growth and growing with quality in terms of the agency force. So coming into this year, I think everybody knew we changed compensation a little bit, where we moved variable compensation from renewal to new, part of it. And we also increased expectations for production on our agency force because we really want to grow with those agents that are looking to invest and grow in their business.
Charles Peters: The next -- my follow-up question is on the investment portfolio. First of all, as an observer, I have to acknowledge the brilliance of your decision to sell the public equities in February. It's stunning. But as I look at the adjustments you made to the limited partnerships, do you think that this is a permanent change to your valuation approach on a quarterly basis? Or -- and I guess the other adjacent question was -- would be that in your adjustments to the first quarter results on LPs, did it include an assessment for all of the LPs or 100% of the portfolio? Or what percentage of the portfolio wasn't covered by your valuation reassessments?
Thomas Wilson: Greg, thank you for the comment on equity. I just want to be clear. It was done on a risk and return basis. So we just looked at the capital up on it. We looked at the prospective outlook, and we decided that wasn't as good a return on those -- on the amount of capital we had to have up on equity. We obviously -- it was good timing, but it wasn't like we knew the market crash was coming. But it also shows the benefit of having business processes that are metric driven that you stick to them, whether that's the way you invest or what Glenn was talking about in terms of how our business processes and our metrics were for changing frequency by state and doing pricing by state. Mario, will you take the question on accounting on this performance-based investment?
Mario Rizzo: Sure. So Greg, I guess where I'd start is, as we've said in the past, generally, we record performance-based income on a 1-quarter lag based on the partner financial statements as of the prior quarter end. So for example, in the first quarter, we would have relied on year-end partner financial statements. And that's typically how we would approach the accounting. However, our accounting policy does require that when a material market event occurs, and we have information available to make informed estimates, that we need to take that information into account. And that's what we did this quarter. So we made the two adjustments, the -- marking the public equity holdings in some of the partnership holdings to March 31 levels, and then suppressing the increases in unrealized valuation on securities that were reflected in the year-end financial statement. We did that because that's part of the accounting policy because there was a material market event in the quarter. The other piece was the -- just our normal watchlist process where we go through every holding. And to the extent we believe we need to impair a holding, we do that. And that was worth $137 million in the quarter on four specific holdings. So absent another market disruption event, let's say, hopefully, we avoid one this quarter, we'll go back to what our typical process would be. But because there was this disruption event in the first quarter, our policy required that if we had additional information that we could make good estimates based on, we should do that. And that's exactly what we did.
Operator: Our next question comes from the line of Paul Newsome from Piper Sandler.
Jon Newsome: I was hoping you could talk a little bit about or give us some color on where the acceleration will come in the Transformative Growth Plan. What will change? You mentioned you're thinking of accelerating it.
Thomas Wilson: Thanks, Paul. Obviously, it's a multifaceted program, right? The idea is to increase customer access. And that was putting together the -- using the Esurance capabilities on direct under the Allstate brand to expand there. It's to reduce our cost structure, and it's to use technology to enable us to launch new products and lower our cost structure. So the -- Glenn can talk about the progress on Esurance and the Allstate brand, and that's been great. And we're headed down the path to have start operating under the Allstate brand on a direct basis this year. On the cost reduction, it will accelerate some of the stuff we do on cost reduction, and it will also accelerate some of the work we're doing on building new technologies, particularly as it looks things like Milewise and Drivewise. Before, when you sold insurance by the mile, we're, I think, one of the few large companies that do that. The people didn't really know what it's about today with Shelter-in-Place Payback from us or the actions of our competitors. People are paying attention now and saying, "Oh, maybe I do want to pay by the mile." So we will push harder on the new product efforts as well. Glenn, do you want to pick up the Esurance and Allstate brand part? And maybe talk as well about the Esurance growth in the first quarter since that may be on people's mind as it relates to transformative growth.
Glenn Shapiro: Yes. So I'll start with the Esurance growth piece, and then I'll go into the -- what we're doing as far as the transformation. Because really transformative growth and the brand changes had nothing to do with the growth in the first quarter. It was actually a 3-part story. Esurance was having increased loss trends in the latter part of last year. We needed to take some pricing and underwriting actions. We did, which is good, because we've gotten the profitability in line as a result. But what typically happens with that is you take a little bit of a hit on your retention and your new business as that happens. And that was happening towards the very end of the year and into January. Now once those prices have worked their way through, we actually reinvested some marketing. We were doing pretty well in February and early March when quoting kind of fell off the table in the middle of March. So you have these sort of 3 windows to like a slow start in January, some really nice momentum in February, early March, and then everything fell off the table there for a few weeks. Fortunately, as we've seen from external indices, shopping has returned and is expected to actually accelerate going forward. So we've got some good optimism there as to how it moves forward in terms of Esurance growth. In terms of transformative growth and where we're going, Jonathan Adkisson, who's the President of Esurance and took over now as our head of the direct business, has been working with both teams and bringing it together in such a way that we increase or improve our sales process under the Allstate brand. We improve our online quote flow. And so those are already in process and happening on a day-by-day basis. It's a continuous improvement effort. What is still to come is our pivot on branding and how we invest in marketing for the Allstate brand to go to market as both a direct and agency-driven brand as well as our work with online leads.
Jon Newsome: Somewhat relatedly, could you talk a little bit about what happened with retention? Did it also have a kind of similar 3 different periods like the sales did during the quarter?
Thomas Wilson: Glenn, will you take that?
Glenn Shapiro: Sure. Retention, I would say no. Retention really -- there's no impact yet from coronavirus because it's kind of a lagging metric. It includes midterm cancellations that you're measuring at the point of when they would have renewed. So to the extent that we see impact, whether favorable or unfavorable from coronavirus, I think we'll see that on a go-forward basis from a retention standpoint. We still are in a pretty good space from a retention standpoint. We're down year-over-year, but off of a fairly high watermark, still running 88% retention in auto and feel fairly good about where we are. And we continue to work hard to do well for our customers. I think our response to coronavirus and the multiple areas that we were very quick to respond for customers can and, hopefully should, help us from a retention standpoint, and it's something we continue to work at.
Operator: Our next question comes from the line of David Motemaden from Evercore.
David Motemaden: Just a question for Tom on investments. And you mentioned -- just in terms of reducing the equity allocation during the quarter, you mentioned you looked at the return and the capital required and decided to reduce it. I guess are there -- I guess, how are you thinking about the allocation to equities and LPs at 13% of the portfolio going forward? Do you expect to do more of this? And maybe if you could help me understand how much capital that freed up by reducing the $4 billion worth of equities.
Thomas Wilson: Okay, David. Thank you for the growth time question. I'll talk about the logic for the equity. John can then talk about the process we're looking at in terms of going forward, which you talked about at the end is -- which is really your question, where should you invest in this kind of environment? And the answer is we don't know, but we've got a pretty good process, going to figure out what we think is the best option. First, the equities. A large portion of the equity portfolio back to payout annuities, which are long-dated liabilities, think of them like a pension plan. And so you don't want to be invested in fixed income for annuities that are going to pay out in 10, 20, 30 years. So that's appropriately at the liability match. And that's sort of a bottom. We don't want to move away from that matching because it would be bad long term economically. And you don't want to start to be picking when you trade in or out. On the other hand, some of our equities just are capital that we use to support the business and that we are a little more flexible with. And we brought down the -- when we look at economic capital, which is amount of capital, we think we need to put up for risk. We thought we had -- it wasn't a good enough return for us. So that was why we reduced it, which is really related to sort of the equity portfolio of the overall entity, not specific asset liability matching. As it relates to the amount of freed up capital, David, from a statutory capital standpoint, it obviously reduces your capital a little bit. But we're long capital as it is. And so we don't look at it as though we had to free up capital to buy shares back or anything like that. We just look at it pure economics. What's the right thing to do for shareholders on a long-term basis? And it did free up some economic capital, some statutory capital, but it doesn't really make a difference in the amount of capital we have available to either do share repurchases or buy something like that. John, do you want to spend a minute on what we're doing on the strategic asset allocation?
John Dugenske: Yes. Thanks, Tom. And David, thank you for your question. As a regular matter of course, we take a disciplined approach to investing and thoroughly look at the -- managing both the risk and return trade-offs. We do that both directly in the investment department, but then that's highly integrated with the way we think about return and risk opportunities across the firm, as Tom had mentioned. One of the key things that we do is, first, we have a -- what I believe to be a strong team of about 400 investment professionals and -- that are deeply experienced. And we are in a number of different markets and look at price action, fundamental, economic drivers, technical observations across those markets. We also bring in, on a regular basis, keen insight from people from the outside, whether that's from our dealer relationships, whether that's via specific consultants or economic research teams that we have subscriptions to and try and formulate, at any point in time, the best risk return trade-off for the portfolio, especially given the business lines that we're associated with. As Tom mentioned, if you -- candidly, if you go back a little more than a year ago, we started to see that the return per unit of risk, as we perceived it in the marketplace, was flattening out, and we became a little bit more concerned about whether investment markets offer the best opportunity. What transpired since then is that the Fed became pretty active last year, as we've all seen. We took that as an opportunity to add duration to the portfolio, which is paying benefits today. So it's tantamount to our desire to be proactive with our investment portfolio and integrate it to the rest of the firm. As we moved into the end of this year, one of the things that we noticed is that there was a limit to what the central banks could do to continue to push on returns of growth assets or risky assets. We thought that what we had observed in 2019 is not much earnings growth, and there is a fair amount of multiple growth. And we just thought that, that was likely coming into the end. As Tom said, we really didn't predict that there's going to be an event. But the one thing we all recognize as an enterprise that if there was an event, we weren't really giving much compensation for that. So we incorporated this equity trade in February, albeit at very good levels. The way that we accomplish this on a daily -- on a regular basis and quarterly, we sit down in an investment group and we go through what we call a capital allocation process. And we spend 2, 3 days deeply looking at markets, and then we share that with the rest of the enterprise.
David Motemaden: Got it. And if I could, just one follow-up. Just on the expense ratio, the 23.4 in the quarter. How should I think about that for the rest of the year, just given potential top line pressure, offset by what sounds like ramp-up of the transformative growth as the year progresses?
Thomas Wilson: Mario, do you want to take that?
Mario Rizzo: Sure. Again, what I'd say is I'd reiterate. Look, a core part of our strategy is to continue to look to take costs out of the system and the general downward view of our expense ratio to improve competitive position. Having said that, you did say, you articulated a couple of the items that are going to cause some choppiness in that. Number one is the outlook on revenue, which there's uncertainty around that, but also, we're going to continue to make investments in things, like I said, technology and marketing. So I guess what I'd say is, look, our focus is still on reducing costs and driving the expense ratio down over time. I'm not going to sit here today and give you an exact trajectory of what that's going to look like. But strategically, that continues to be a core part of what we're trying to do.
Thomas Wilson: So what we try to do is manage it down, but not do it stupidly, right? So like, as Glenn mentioned, we have to reposition the Allstate brand to go even more aggressive into driving the direct growth. And that's going to cost some money. So we'll do what we think is economic for shareholders. And then we think if we do it on an upfront, it works out so we achieve our overall objective.
Operator: Our next question comes from the line of Jimmy Bhullar from JPMorgan.
Jamminder Bhullar: So I had a couple of questions. First, maybe just on the auto business, if you could talk about competition as you're looking at the business through the rest of the year. Everyone's margins are actually obviously pretty strong. Do you see, at some point, companies start to adjust pricing based on sort of whatever the new normal is in terms of driving behavior? And have you seen any indication of companies getting a little bit looser on renewal terms recently?
Thomas Wilson: Let me start, maybe talk about process, Jimmy, and Glenn can fill in some specific thoughts he has. So it's -- obviously, we did the Shelter-in-Place Payback, and everybody followed relatively quickly. That doesn't mean that we really only have the idea. It just means that everybody thought that with margins where they were, it was fair to give it back to customers or at least that was our view. And whether that people will continue to do that or not, it's hard to tell. What I do know is that because we have a business model which is run by market, by line, by coverage, with all kinds of data, both our telematics data, our own historical data, our claim data and the information we get from Arity, will be incredibly precise and surgical about the way we react. I can't speak to what other people do. Glenn, is there anything in the competitive environment that is clearer today than -- and has been kind of murky, is I would say. But anything you would add to that?
Glenn Shapiro: Yes. What I would say is we're clearly going to be in a very benign rate environment. That might be an understatement, and -- for some period of time. What I haven't seen is, in the competitive environment, anybody making a more durable or permanent change to their premiums, meaning a rate reduction that is over a permanent price filing for rate reduction. Because I think, like us, I'm sure others see that like this came on fast. Like I don't think anybody predicted that when we came into this year, we were going to have an event that would drive mileage down by 50% or whatever the numbers are by state. And it can go away fast, too. So I think everybody's looking at this, I know we are, from the standpoint of how do we react in real time, make good decisions, doing the right thing by market with precision, as Tom said, with our customers in mind, but not do anything that we then have to rebound on. And it wouldn't be good for anybody to overplay it a hand and then have to go take rate increases afterwards. So I think what you're going to see is a very benign, flat rate environment as opposed to a negative one.
Jamminder Bhullar: And then on the sales or top line growth environment in sort of the Services, Benefits or Life businesses, should we assume that because the COVID and sort of Shelter-in-Place, that you'll see a drop-off in sales in some of these businesses in the near term?
Thomas Wilson: Let me have Don answer about the Services Business, particularly Allstate Protection plans, which, as you saw, is just continuing to grow incredibly rapidly. And I hate for that story to get lost amongst the coronavirus part. And then I would just -- I think I could summarize it to say, in Life, that we haven't had much growth there in the last couple of years, and we're really trying to still reboot that growth strategy. Don, do you want to...
Dogan Civgin: Sure. So I think, obviously, each of the businesses are going to be impacted by different trends. Some of them will be driven by frequency such as our roadside business. Some will be driven by auto sales and kind of general economic conditions like a dealer services and so forth. So I think every business will be impacted by some different factors. Allstate Protection Plans, which has continued to have terrific growth, first, on a broader level, they've been growing for a number of quarters. So this is not unique to the first quarter of 2020. And so we've been really pleased with the overall growth and overall improvement in profitability that they've been able to exhibit. Now when you look at the first quarter, you might look and say, "Well, their -- most of their sales are through retail." And retail is suffering, which is maybe true in general, but you have to get a little bit more nuanced and look at the types of customers they have, the types of retailers we do business with and, to some extent, what's being purchased at retail right now. So when you look at SquareTrade's kind of largest B2B customers, they tend to be the larger one-stop shops, where people have been going to shop more frequently since coronavirus hit because they want to get all of their purchases done with one stop if they can do so. Second, a lot of what's been purchased, as people have been adapting to the home environment, has been kind of getting home offices set up, to some extent, entertainment setup because they're going to be stuck in their houses for some period of time, which obviously come with the opportunity for extended warranties as well as the stimulus check impact which put funds in people's pockets to be able to then go out and spend. So when you look at what their particular type of customer was looking for, the first quarter after coronavirus saw a nice increase. It's hard to tell whether that will last and how long that will last. I think at some point, the overall trends in retail will be a headwind for Allstate Protection Plans. But at least in the short term, it's actually been a nice tailwind. I would also say that new business, which they've picked up a number of large accounts recently, both domestically and overseas, rollouts of those programs have slowed down a little bit as people have been trying to figure out how they're going to get those stores open. And there was a slight, I would say in the first quarter, benefit from claims dip as people submitted fewer claims after the virus hit for some period of time. So overall, trends continue to be really strong. Hard to tell what the impact is going to be on Allstate Protection Plans long term from the virus. But in kind of the immediate term, it's been good for their top line.
Jamminder Bhullar: Okay. And just lastly, any comments you have on long-term strategy for the annuity block and the likelihood of a sale or reinsurance of that business?
Thomas Wilson: Sure. Let me jump at that, Jimmy. First, on the -- I should also point out on more longitudinal perspective, Allstate Protection Plans now has over 100 million policies in force. Don, I think it was about 30-plus million when we bought it, right? 30 million plus.
Dogan Civgin: Yes.
Thomas Wilson: So it's had a tremendous run not to be swept under the carpet. It's really a great team. As it relates to annuities, it's a huge drag on our ROE because we -- as I mentioned earlier, we have a lot of equities behind that portfolio because we believe that's the right thing to do. So our 18.2% includes a large drag on it from the annuities. If we could find a way to eliminate that drag, we would do so. But we only want to do it with some place where our customers will be well taken care of because this is largely written on our paper. And we don't want to give somebody a whole bunch of investments and say, "Good luck, and we hope you pay the people off when you get there." And they do something stupid. So we are managing it well as it is today. Either we will find a solution, that could be a reinsurance solution, it could be a sale, it could be we just keep it, we run it differently. In any event, it will go away in terms of its drag on ROE when the new long-dated accounting -- long-dated annuity accounting comes in place where you'll have to mark that to market. We don't -- we think that, that accounting is a little rough. On the other end, it will eliminate the drag on overall ROE.
Operator: Our next question comes from the line of Mike Zaremski from Crédit Suisse.
Charles Lederer: This is actually Charlie on for Mike. Can you talk about your commercial lines exposures outside of commercial auto? And specifically, can you talk about business interruption exposure in general, whether you've seen claims and if your policies have virus exclusions?
Thomas Wilson: Don, in your report?
Dogan Civgin: Okay. Charlie, so in our business insurance, we do actually have exclusions for disruption caused by the pandemic and so we -- like many others do. And so there's a lot of noise out there about implementing requirements for insurance companies to go back and provide coverages that were not only excluded explicitly, but were also not priced for. And so we would be against obviously that. Having said that, our exposure is relatively small. There's about 60,000 policies in total that we have that sort of exposure, which as I said, is explicitly excluded. So it's a relatively small number for a company like Allstate.
Charles Lederer: Got it. And then on the Shelter-in-Place Payback included in the expense ratio in the first quarter, does that imply the charge for the second quarter will be the balance to get to the $600 million you guys have talked about? And is there a potential for further premium reductions, either larger discounts per month or an extension of the duration of the discounts?
Thomas Wilson: Mario, if you'll take the second -- the first piece and then make sure we talk about all the other things, whether it's bad debts or anything else coming up in the quarter. As it -- Charlie, as it relates to another Shelter-in-Place program, what we said is we're always going to treat our customers fairly. This came along quickly. We moved within 10 days to get people what was a relatively easier to implement in terms of it ubiquitous across the country, ubiquitous by customer. Everybody got 15% in April and May. And we felt we needed to do that because they were all struggling. The government money had not yet come into people's home. So we even provided the opportunity for them to get cash, even though they might have gone on a deferred payment plan with us. And so that was -- it was done because we need -- knew our customers needed help, and we need to do it fast. If frequency were to stay down because of something that was not continuous, so we thought it was Shelter-in-Place for a longer period of time, those graphs that Glenn showed. If it stayed down there, we may want to do something else for our customers to reflect the fact that they're not driving as much. This time though, it will be much more precise. And so we'll use all the data we have to -- as Glenn talked about, some people are driving more, but it doesn't feel like they should get a Shelter-in-Place Payback, right? It doesn't seem as fair to somebody who's not driving their car at all. The same thing about which area you live in, you live in an urban area or rural area. Is your -- what kind of driving? Are you a really fast driver? Now not everybody's on telematics, so we can't get it as precise as we would like. But we are working on a more comprehensive approach should frequency stay down, and we will do what we think is fair for our customers. Mario, do you want to take the second quarter impact from what we've already done?
Mario Rizzo: Sure. So on -- with respect to the SIPP payment, we saw we recorded a portion of it in the first quarter. The balance will be recorded in the second quarter. So that one's pretty straightforward. That will happen. When we kind of decided on the SIPP payment, one of the things we explicitly factored in was the potential for bad debt expense associated with the special payment plan that we're allowing our customers to opt into. As we evaluated the number of customers that had opted into that as of the end of March, along with our historical bad debt experience, the impact in the first quarter from a bad debt perspective was pretty immaterial. Obviously, we will look at the number of customers that have signed up as well as the exposure going forward. And we'll take that into account in the second quarter in terms of establishing bad debt prospectively. But first quarter was reasonably immaterial. Second quarter, we'll take a look at the analysis. We'll update it appropriately, and then we'll record something incremental in the second quarter.
Operator: Our final question then for today comes from the line of Yaron Kinar from Goldman Sachs.
Yaron Kinar: Just want to go back to distribution a little bit. Can you maybe talk about how the agency channel is impacted by Shelter-in-Place environment and the -- with customers potentially looking for lower price options as well? And with that, maybe also touch on kind of the timing of shifting the agent variable compensation to a -- more to a new business generation and how that has been impacting the sales force.
Thomas Wilson: Glenn will be the best person to answer that question.
Glenn Shapiro: All right. Thanks, Yaron. First of all, when you think about the impacts of coronavirus, I think it's important, there's all different types of businesses that have to close down all the way up through businesses that actually benefit because they're in the type of business that wins in this type of new environment. The agents kind of fall in the middle of that because if you think about their revenue stream, it is still significantly renewal compensation. Our total compensation to the agency force, and if you break down to any individual agent, will range somewhere between 90% and 100% or, in some cases, even above 100%. Some are growing more post middle of March versus before. So the core of their income remains. So you've got that piece. In terms of how it impacts their business, I think that, that will be something to watch and something to see. I agree that people will be looking for value as they go forward. But I also think our agents have really been able to show their value in this process. I don't think there's another time in our company history where I could make the following statement. Over the course of the last 6 weeks, almost all of our agents have called almost all of their customers. So you've got this really unique period of time where, a, people are more available to be reached; b, they have more questions, and they really want to hear from their trusted adviser; and c, our folks are just committed to that because of a national crisis. And so I think that there's this moment in time where at least some portion of our customer base will really see the value of what they've gotten out of their agency relationship and having a trusted adviser. That said, everything Mario and Tom and others have talked about on this call about transformative growth is, we've got to keep taking costs out of our system and be a more affordable and more competitive value for consumers going forward, which is why we're accelerating the Transformative Growth Plan.
Yaron Kinar: Got it and understood. And then maybe one quick follow-up. Milewise, you talked about potentially accelerating it. I think as of year-end, you were in 14 states. Any thoughts as to how quickly you can really expand the program to all 50 states?
Thomas Wilson: Glenn, do you want to give an update on that?
Glenn Shapiro: Yes. So we're in 16 states and moving as quickly as we can on it. Certainly, the pandemic has shown a light on the value of a pay-per-mile product, and we're seeing a nice uptick in the demand for it. You see kind of 2 effects in the public right now. One is just the acceptance of the notion that telematics is going up as a result of all of this, and two is actually the over-demand for something like Milewise is going up. We have some states up 30% in terms of their sales since the middle of March and seeing double-digit percentages regularly on a week-by-week basis of the new business being sold in Milewise versus other products. So we think it's a great opportunity. It will absolutely be part of our filings that we're doing broadly across the country to try to expand and do more for consumers as a result of the pandemic.
Thomas Wilson: Okay. Thank you all. Allstate is in a strong position. We know how to protect our customers from life's uncertainties, and we'll continue to do that as we navigate through this crisis. So thank you for participating, and we'll talk to you next quarter.
Operator: Thank you, ladies and gentlemen, for your participation in today's conference. This does conclude the program. You may now disconnect. Good day. | [
{
"speaker": "Operator",
"text": "Ladies and gentlemen, thank you for standing by, and welcome to The Allstate First Quarter 2020 Earnings Conference Call. [Operator Instructions]. And now I'd like to introduce your host for today's program, Mark Nogal, Head of Investor Relations. Please go ahead, sir."
},
{
"speaker": "Mark Nogal",
"text": "Thank you, Jonathan. Good morning, and welcome, everyone, to Allstate's First Quarter 2020 Earnings Conference Call. After prepared remarks, we will have a question-and-answer session. Yesterday, following the close of the market, we issued our news release and investor supplement, filed our 10-Q and posted today's presentation, along with our reinsurance update on our website at allstateinvestors.com. Our management team is here to provide perspective on these results and further context on our response to the coronavirus pandemic. As noted on the first slide of the presentation, our discussion will contain non-GAAP measures for which there are reconciliations in the news release and investor supplement and forward-looking statements throughout Allstate's operations. Allstate's results may differ materially from these statements, so please refer to our 10-K for 2019 and other public documents for information on potential risks. And now I'll turn it over to Tom."
},
{
"speaker": "Thomas Wilson",
"text": "Good morning. Thank you for joining us from wherever you are sheltered in place. Let's jump right in with Allstate's response to the coronavirus pandemic on Slide 2. Allstate has been helping customers overcome catastrophes for 89 years, and we've learned to act decisively, quickly and put customers first. As a result, we've led the industry in helping customers. We created a Shelter-in-Place Payback program of more than $600 million. Special payment plans are being used for customers experiencing financial challenges. Auto insurance coverage was expanded to cover the use of personal vehicles to deliver food, medicine and other goods for commercial purposes. Allstate Identity Protection is being offered for free for the rest of the year to all U.S. residents, given the increased exposure to cybercrime. Business continuity plans were executed. Virtual sales and support capabilities were expanded. We leveraged our digital innovations, such as QuickFoto Claim and Virtual Assist, to better protect our customers, employees and agents. Employees and Allstate agents moved to more than 95% working remotely, and we altered a number of business practices to support our agents and employees. At the same time, Allstate is financially strong with significant capital and liquidity. In February, we reduced our public equity holdings by $4 billion to reduce the amount of economic capital back in the investment portfolio. But this turned out to be good timing because it enabled us to reduce the impact of the market downturn in March. And as Mario will cover later, we will maintain our share repurchase program given the strong capital position. For our communities, the Allstate Foundation announced an additional $5 million. That's on top of the money we normally grant every year, which is substantial to help deal with the pandemic and double demand for Allstate employees' need. Move to Slide 3. Let's touch base with Allstate's strategy. As you know, our strategy has two components: increase personal Property-Liability market share and expand into other protection businesses. This 2-part strategy leads to our 5 annual operating priorities, which is shown on the right side of this page, and we made good progress around all five. If you move to Slide 4, Allstate had strong operating and financial results in the first quarter. Total revenues of $10.1 billion declined 8.3% for the prior year quarter due to capital losses instead of capital gains in the prior year. If you exclude the impact of the realized capital losses, revenues increased 2%, driven by a 4.4% increase in Property-Liability insurance premiums, which you can see from the table. Net income of $513 million declined to the prior year quarter's increased underwriting income, was more than offset by capital losses and charges for pension and postretirement benefits. Adjusted net income, shown in the middle of the table, was $1.1 billion in the quarter or $3.54 per diluted share, which was significantly above the prior year, reflecting lower catastrophe losses. Returns were excellent with adjusted net income return on equity improving to 18.2%. Mario will now discuss the first quarter results in more detail."
},
{
"speaker": "Mario Rizzo",
"text": "Thanks, Tom, and good morning, everybody. Let's go to Slide 5 to discuss the strong performance of our Property-Liability segment. Starting with the chart on the left, policy and premium growth continued, with excellent recorded and underlying profitability. Underwriting income of $1.35 billion in the first quarter was $645 million higher than the prior year quarter with a combined ratio of 84.9. The improvement to prior year was driven by several factors, including lower catastrophe losses, increased premiums earned and lower auto accident frequency from the decline in miles driven. Auto accident frequency was significantly lower in the quarter, with property damage gross frequency down 12% compared to the prior year quarter. For the month of March, property damage gross frequency declined 27% compared to the prior year, as miles driven dropped significantly, as states began implementing social distancing measures. These benefits were partially offset by increased severity and the Shelter-in-Place Payback expense. The chart on the right shows our Property-Liability expense ratio over time and specifically highlights the $210 million Shelter-in-Place Payback expense we recorded in the first quarter, which increased the expense ratio by 2.4 points. Excluding this impact, the expense ratio improved by 1 point compared to the prior year quarter, reflecting continued progress on enhancing the customer value proposition, which is one of the key components of our Transformative Growth Plan. Let's go to Slide 6, which highlights investment performance for the first quarter. As you'd expect, our first quarter investment portfolio results reflect the impact of the market volatility caused by the coronavirus. As shown in the table in the middle of the page, total return for the first quarter was a negative 2.4%, largely reflecting lower portfolio valuation. While the decline in treasury rates supported fixed income prices, the significant widening of credit spreads more than offset that benefit, and interest-bearing valuation decline reduced return by 1.9%. Lower equity valuations further decreased returns by another 1%. The chart shows net investment income of $421 million in the quarter, which was $227 million lower than the prior year. We recorded a loss of $208 million for performance-based results in the first quarter, as shown in gray. As you may recall, the income on our limited partnership is typically booked on a 1-quarter lag. Performance-based income related to fourth quarter 2019 sponsored financial statement was $176 million. We also recorded write-downs of $137 million on 4 underperforming private equity investments. In a typical quarter, this is where our process would have ended. However, given market volatility and economic disruption, we also recognized declines in the value of limited partnership interest, where we had enough information to make informed estimates rather than solely relying on sponsored financial statement as of December 31. This included updating publicly traded investments held within limited partnership to their March 31 market pricing, which reduced investment income by $52 million. We also did not recognize $195 million of unrealized valuation increases reported in sponsor's fourth quarter financial statements. The sum total of these 4 items generated the $208 million performance-based loss in Q1. Because these investments exhibit idiosyncratic risk and return, future gains and losses are uncertain. But we believe utilizing this approach in the quarter is a better indication of current value. Income from the market-based portfolio, shown in blue, was lower than the prior year quarter by $19 million, reflecting the impact of lower reinvestment rates. We expect this trend to continue to the extent reinvestment rates remain below average interest-bearing portfolio yield. Let's turn to Slide 7 to discuss our portfolio positioning. We take a disciplined and proactive approach to managing the investment portfolio risk and return profile, and our positioning has mitigated the impact of the current crisis. As you can see in the chart on the left of the page, the portfolio is largely made up of high-quality fixed income securities with substantial liquidity. We extended the duration of our Property-Liability portfolio last year, which was -- which has supported both income and returns in the lower rate environment. We are conservatively positioned in sectors more susceptible to the pandemic and continue to monitor those exposures closely. To provide transparency into these exposures, we have enhanced our Form 10-Q disclosures. We also have a 13% allocation to performance-based investments and public equity securities, down from 18% at year-end 2019, which backed long-dated liabilities and capital. As you can see in the chart at the bottom right, in February, we reduced our equity exposure by $4 billion, primarily through the sale of public equity securities with proceeds invested in high-quality fixed income. These trades were executed at an average price equivalent of 3,281 on the S&P 500 compared to the March month end level of 2,585. We continue to proactively employ a disciplined risk and return framework to the portfolio as economic conditions evolve. Now let's turn to Slide 8 to review results for the Life, Benefits and Annuities segment. Allstate Life, shown on the left, generated adjusted net income of $80 million in the first quarter, an increase of $7 million compared to the prior year quarter, driven by lower operating costs and expenses. Allstate Benefits' adjusted net income of $24 million in the first quarter was $7 million below the prior year quarter. The decline was due to higher operating costs and expenses, driven by increased investments in technology and higher DAC amortization. Allstate Annuities, shown on the bottom right, had an adjusted net loss of $139 million in the first quarter, primarily due to the performance-based investment results we discussed earlier. Coronavirus claims did not appear to materially impact any of these businesses in the first quarter, though we continue to monitor developments closely. Now let's turn to Slide 9 to talk about our Service Businesses. The Service Businesses continued to increase the number of customers protected with policy in-force growth of 35.4% to $113.7 million. This is largely due to the increase in Allstate Protection Plans. Revenues, excluding the impact of realized gains and losses, grew 18.2% to $454 million in the first quarter. Adjusted net income improved to $37 million in the first quarter, reflecting an increase of $26 million compared to the first quarter of 2019, driven by growth of Allstate Protection Plans and improved profitability at Allstate Roadside Services. Slide 10 highlights Allstate's attractive returns and strong capital position. While the impact of the coronavirus drove financial market instability and led to a decline in shareholders' equity, Allstate's diversified business model, substantial earnings capacity and strong capital and liquidity enables us to manage effectively through this pandemic. We have $3.4 billion in parent company holding deployable assets and $8.8 billion of highly liquid securities saleable within 1 week. We continued to generate strong returns on capital with an adjusted net income return on equity of 18.2% as of the end of the first quarter while returning $670 million to common shareholders in the quarter through a combination of $511 million in share repurchases and $159 million in common stock dividends. We plan to continue share repurchases under our current $3 billion program, which is expected to be completed by the end of 2021. And now I'll turn it over to Glenn to discuss the coronavirus impact on auto insurance and how we're leveraging data and insights to make decisions."
},
{
"speaker": "Glenn Shapiro",
"text": "Thanks, Mario, and good morning, everyone. Let's go to Slide 11, which looks at the potential impacts of coronavirus on auto insurance. Profit has been, and will be, impacted by a reduction in miles driven, which will lower overall loss costs. While this has been significant, it will decline over time as the economy begins to reopen, and there are several offsets. First, the reduction of drivers on the road has increased driving speeds, which can lead to increased severity per claim. We'll also likely incur additional bad debt from some customers who have chosen to take extended payment terms. On a longer-term basis, if the global auto parts supply chain is disrupted or parts prices are raised by auto manufacturers, this could increase repair costs. The pandemic and economic slowdown will also impact growth. If loss costs continue to be below prior year, the lower required rate increases will limit average premium growth. On the positive side, the Shelter-in-Place payment could have a favorable impact on retention. The impact on new business is unclear since reduced vehicle sales can lower new business, but economic conditions may increase shopping levels. And we've seen an increased customer interest in telematics, and we're well positioned with both Drivewise and Milewise, the latter of which charges customers' insurance by mile. Getting ahead of these trends will be important to grow profitably as we continue to manage profitability and competitive position on a market-by-market basis and will enable us to be precise in our responses. Let's now move to Slide 12. As a customer of Arity, we have access not only to our data, but insights from a much broader data set, some of which is shown on this slide. Telematics-based pricing allows you to factor in things like how much someone drives, where they drive and how they drive. Our telematics products enable us to do that for individual customers, which when combined with a broader set of data, enables us to make better judgments market by market. For example, based on 3.5 billion trips from February through April, the upper-left graph shows that miles driven declined sharply in mid-March and then began a slow increase since then. You can also see that those states that had stay-at-home orders had a bigger decline in driving. In the upper right, you can see there's also a difference between rural areas at the top of the chart, which declined by about 20%, and urban areas at the bottom, which declined by about 50%. The bottom-left graph shows that while some drivers are not driving at all, those are the bars to the left, about 20% of drivers are actually driving more than they did before mid-March. Arity also provides a Drivesight score, which is a measure of driving risk. The lower the score, the higher the risk. As you can see on the bottom right, the mean risk has increased despite fewer cars on the road, which correlates to the data that shows some drivers are driving faster. The net of all of this is that Allstate has the data and business processes to proactively adjust to a changing operating environment. I'll now pass it back to Tom."
},
{
"speaker": "Thomas Wilson",
"text": "Thank you, Glenn. To move to Slide 13, we want to discuss how we've moved past the emergency of moving people to work from home to the immediate of creating a Shelter-in-Place Payback to implementing intermediate-term actions. In this type of environment, you obviously have to look where you step, but you also have to decide where you want to walk. And as we look into the future, there's not that much clarity, right? Who will move back into offices? Will as many people still need to commute to work? What happens to the investment market? And of course, the answer is nobody knows. There are so many possibilities you can get frozen into inaction. So we used scenario planning to see what the future path look like under alternative assumptions. This came out of Royal Dutch Shell in the '70s, and it works kind of like this. You find 2 things that will be the primary drivers of change. In this case, we selected the length and depth of the health crisis, which is shown at the top of the box on the bottom of that page, and the severity of the economic downturn from disruptive to severe, which is shown on the vertical axis. You then create 4 scenarios to represent a range of possible outcomes. As you can see from the slide, the best case in the upper right, we've labeled sigh of relief. The health care crisis is over relatively quickly and the economy is disrupted, but government support enables us to bounce back with them. In the worst case, in the lower right, is distracted by the virus. It reflects a significant health impact with repeated lockdowns over the next couple of years. The decline in GDP is greater than the Great Depression, but it doesn't last as long because of the government fiscal monetary action. For each scenario then, we look at a range of outcomes, including consumer behavior, auto insurance accidents and investment returns. This helps us decide what actions we should do, even though we do not know what the ultimate outcome will be. It also helps inform what not to do. And it enables us to establish road signs for each scenario, which improves our ability to forecast the direction we're headed. There are, of course, similar consequences in the scenarios, which help determine what actions to take, which is shown on Slide 14. In many of the outcomes, revenue growth is constrained because of fewer auto accidents, deteriorating incomes, increased unemployment or lower interest rates. As a result, we are accelerating our Transformative Growth Plan, which will improve customer value with increased utilization of new technologies, lower costs in new auto insurance products. And as you know well, the investment markets will be more volatile in many of these scenarios. As a result, we're evaluating our strategic asset allocation. Many of us have found that we can adopt new technologies pretty quickly. Like who knew you can have so many Zoom or Teams or Skype meetings in one day? As a result, we're going to maintain a strong commitment to telematics and expanding the Integrated Digital Enterprise. Consumer behavior is also likely to change to focus on the quality and breadth of their protection. And this is where Allstate is headed, with the second part of our strategy, is to provide a broader array of protection offerings from auto insurance to include things like your phone and your identity. Now we'll open the line for questions."
},
{
"speaker": "Operator",
"text": "[Operator Instructions]. Our first question comes from the line of Elyse Greenspan from Wells Fargo."
},
{
"speaker": "Elyse Greenspan",
"text": "My first question on is -- I think is just on frequency. You guys provided some pretty good disclosure on the drop in miles driven, and I believe you said it started to bounce back from the COVID woes. So as we're thinking about Q2, so April and May kind of to date, how do you think about the frequency benefit that we might see over that period compared to what you saw towards the later stages of March?"
},
{
"speaker": "Thomas Wilson",
"text": "Elyse, let me start, and then toss it over to Glenn. Well, it is -- obviously, as people start to drive more, they'll get in more accidents. So we expect that to head up. Where it will end up is hard to predict at this point because you don't really know when people are going to go back to the office and how many people will even go back to the office site. As I talk to other companies, it's pretty clear to me that we found that we've built the infrastructure to do remote workforce. At Allstate, we've already had about 15% of our people remote before this. We think we can probably do more. So that would obviously lead to fewer people driving to and from work, but it's hard to predict exactly where the number comes out. Glenn, do you have anything you want to add to that?"
},
{
"speaker": "Glenn Shapiro",
"text": "Not too much. I think, Tom -- as Tom said, you've got some unknowns in there, which would include, if you go on the other side of it, some pent-up demand. If you think about people who postponed trips, who postponed visiting relatives and want to catch up on it, so you could have some sort of fits and starts with some of the long-lasting, as Tom described, downward pressure on driving and, therefore, frequency, but also some potential short-term bubbles where people want to get out there because they're a little bit stir-crazy."
},
{
"speaker": "Elyse Greenspan",
"text": "Okay. That's helpful. And then my second question is on buybacks. I know you guys have said you expect to maintain your buyback program. So as we think about the completion of that program, I believe it runs through the end of 2021, should we think about kind of an even pace of buybacks from here? Would there be some slowdown over the next couple of quarters? Or just given the capital position, you kind of expect that to be evenly maintained as we work our way through 2021?"
},
{
"speaker": "Thomas Wilson",
"text": "Mario, will you take that question?"
},
{
"speaker": "Mario Rizzo",
"text": "Sure. Elyse, thanks for the questions. So I think the place I'd start, Elyse, is we feel really good about our capital and liquidity position, $3.4 billion of holding company assets, $8.8 billion of readily available liquidity, $3.7 billion of dividend capacity out of our insurance companies into the holding company for the year. And our businesses are performing really well. So I think I'd say we expect to complete the program by the end of next year just like our Board authorized. And we've got a lot of flexibility in terms of how we execute it, but we would expect to just continue to buy back shares over that time period."
},
{
"speaker": "Operator",
"text": "Our next question comes from the line of Greg Peters from Raymond James."
},
{
"speaker": "Charles Peters",
"text": "First question will be on the expense ratio, the underlying expense ratio improvement. Can you talk about what -- and you provided just a basic comment on it in your prepared remarks. Can you give us more color on that? And maybe talk about maybe how that fits with the sequential decline in Allstate Agency's LSPs? And is that part of your integrated services platform rollout?"
},
{
"speaker": "Thomas Wilson",
"text": "Mario, why don't you take expenses? And Glenn, will you take the agent?"
},
{
"speaker": "Mario Rizzo",
"text": "Yes, sure. So when you look at the expense ratio in the quarter, you saw a 1 point sequential decline year-over-year in the expense ratio. And first thing I'd say is, reducing our cost continues to be a core part of our transformative growth strategy. And when you kind of deconstruct where the improvement came from, it's about 50-50, not quite between acquisition costs and operating costs. And obviously, those are two core parts of our cost structure, and we saw improvement in both. And we're going to continue to be focused on reducing those costs going forward to enhance our competitive position to still take growth and be a core part of transformative growth for us. We're also going to continue to invest in the things we need to invest in for transformative growth, things like technology and marketing. But we're focused going forward on continuing to reduce costs over time. I'll turn it over to Glenn to talk a little bit about the agency part of it."
},
{
"speaker": "Glenn Shapiro",
"text": "Yes. Greg, thanks for the question. In terms of the LSP count and agent count, you hit on part of it in your question with integrated service. When you look at licensed sales professionals, and in spite of the word sales being the operative word there, they spend only about 40% of their time on sales, about 60% on service. That's been a historic number. And one of the things we're committed to is taking a lot of the transactional work out, both through self-service capabilities as well as integrated service, over time, so that they're increasing that percentage of time they're selling and not having to do as much of that transactional work. So we'll probably see that change over time. And that's really part of our overall transformative growth work that we're doing. And in terms of the agency count, we're really focused on growth and growing with quality in terms of the agency force. So coming into this year, I think everybody knew we changed compensation a little bit, where we moved variable compensation from renewal to new, part of it. And we also increased expectations for production on our agency force because we really want to grow with those agents that are looking to invest and grow in their business."
},
{
"speaker": "Charles Peters",
"text": "The next -- my follow-up question is on the investment portfolio. First of all, as an observer, I have to acknowledge the brilliance of your decision to sell the public equities in February. It's stunning. But as I look at the adjustments you made to the limited partnerships, do you think that this is a permanent change to your valuation approach on a quarterly basis? Or -- and I guess the other adjacent question was -- would be that in your adjustments to the first quarter results on LPs, did it include an assessment for all of the LPs or 100% of the portfolio? Or what percentage of the portfolio wasn't covered by your valuation reassessments?"
},
{
"speaker": "Thomas Wilson",
"text": "Greg, thank you for the comment on equity. I just want to be clear. It was done on a risk and return basis. So we just looked at the capital up on it. We looked at the prospective outlook, and we decided that wasn't as good a return on those -- on the amount of capital we had to have up on equity. We obviously -- it was good timing, but it wasn't like we knew the market crash was coming. But it also shows the benefit of having business processes that are metric driven that you stick to them, whether that's the way you invest or what Glenn was talking about in terms of how our business processes and our metrics were for changing frequency by state and doing pricing by state. Mario, will you take the question on accounting on this performance-based investment?"
},
{
"speaker": "Mario Rizzo",
"text": "Sure. So Greg, I guess where I'd start is, as we've said in the past, generally, we record performance-based income on a 1-quarter lag based on the partner financial statements as of the prior quarter end. So for example, in the first quarter, we would have relied on year-end partner financial statements. And that's typically how we would approach the accounting. However, our accounting policy does require that when a material market event occurs, and we have information available to make informed estimates, that we need to take that information into account. And that's what we did this quarter. So we made the two adjustments, the -- marking the public equity holdings in some of the partnership holdings to March 31 levels, and then suppressing the increases in unrealized valuation on securities that were reflected in the year-end financial statement. We did that because that's part of the accounting policy because there was a material market event in the quarter. The other piece was the -- just our normal watchlist process where we go through every holding. And to the extent we believe we need to impair a holding, we do that. And that was worth $137 million in the quarter on four specific holdings. So absent another market disruption event, let's say, hopefully, we avoid one this quarter, we'll go back to what our typical process would be. But because there was this disruption event in the first quarter, our policy required that if we had additional information that we could make good estimates based on, we should do that. And that's exactly what we did."
},
{
"speaker": "Operator",
"text": "Our next question comes from the line of Paul Newsome from Piper Sandler."
},
{
"speaker": "Jon Newsome",
"text": "I was hoping you could talk a little bit about or give us some color on where the acceleration will come in the Transformative Growth Plan. What will change? You mentioned you're thinking of accelerating it."
},
{
"speaker": "Thomas Wilson",
"text": "Thanks, Paul. Obviously, it's a multifaceted program, right? The idea is to increase customer access. And that was putting together the -- using the Esurance capabilities on direct under the Allstate brand to expand there. It's to reduce our cost structure, and it's to use technology to enable us to launch new products and lower our cost structure. So the -- Glenn can talk about the progress on Esurance and the Allstate brand, and that's been great. And we're headed down the path to have start operating under the Allstate brand on a direct basis this year. On the cost reduction, it will accelerate some of the stuff we do on cost reduction, and it will also accelerate some of the work we're doing on building new technologies, particularly as it looks things like Milewise and Drivewise. Before, when you sold insurance by the mile, we're, I think, one of the few large companies that do that. The people didn't really know what it's about today with Shelter-in-Place Payback from us or the actions of our competitors. People are paying attention now and saying, \"Oh, maybe I do want to pay by the mile.\" So we will push harder on the new product efforts as well. Glenn, do you want to pick up the Esurance and Allstate brand part? And maybe talk as well about the Esurance growth in the first quarter since that may be on people's mind as it relates to transformative growth."
},
{
"speaker": "Glenn Shapiro",
"text": "Yes. So I'll start with the Esurance growth piece, and then I'll go into the -- what we're doing as far as the transformation. Because really transformative growth and the brand changes had nothing to do with the growth in the first quarter. It was actually a 3-part story. Esurance was having increased loss trends in the latter part of last year. We needed to take some pricing and underwriting actions. We did, which is good, because we've gotten the profitability in line as a result. But what typically happens with that is you take a little bit of a hit on your retention and your new business as that happens. And that was happening towards the very end of the year and into January. Now once those prices have worked their way through, we actually reinvested some marketing. We were doing pretty well in February and early March when quoting kind of fell off the table in the middle of March. So you have these sort of 3 windows to like a slow start in January, some really nice momentum in February, early March, and then everything fell off the table there for a few weeks. Fortunately, as we've seen from external indices, shopping has returned and is expected to actually accelerate going forward. So we've got some good optimism there as to how it moves forward in terms of Esurance growth. In terms of transformative growth and where we're going, Jonathan Adkisson, who's the President of Esurance and took over now as our head of the direct business, has been working with both teams and bringing it together in such a way that we increase or improve our sales process under the Allstate brand. We improve our online quote flow. And so those are already in process and happening on a day-by-day basis. It's a continuous improvement effort. What is still to come is our pivot on branding and how we invest in marketing for the Allstate brand to go to market as both a direct and agency-driven brand as well as our work with online leads."
},
{
"speaker": "Jon Newsome",
"text": "Somewhat relatedly, could you talk a little bit about what happened with retention? Did it also have a kind of similar 3 different periods like the sales did during the quarter?"
},
{
"speaker": "Thomas Wilson",
"text": "Glenn, will you take that?"
},
{
"speaker": "Glenn Shapiro",
"text": "Sure. Retention, I would say no. Retention really -- there's no impact yet from coronavirus because it's kind of a lagging metric. It includes midterm cancellations that you're measuring at the point of when they would have renewed. So to the extent that we see impact, whether favorable or unfavorable from coronavirus, I think we'll see that on a go-forward basis from a retention standpoint. We still are in a pretty good space from a retention standpoint. We're down year-over-year, but off of a fairly high watermark, still running 88% retention in auto and feel fairly good about where we are. And we continue to work hard to do well for our customers. I think our response to coronavirus and the multiple areas that we were very quick to respond for customers can and, hopefully should, help us from a retention standpoint, and it's something we continue to work at."
},
{
"speaker": "Operator",
"text": "Our next question comes from the line of David Motemaden from Evercore."
},
{
"speaker": "David Motemaden",
"text": "Just a question for Tom on investments. And you mentioned -- just in terms of reducing the equity allocation during the quarter, you mentioned you looked at the return and the capital required and decided to reduce it. I guess are there -- I guess, how are you thinking about the allocation to equities and LPs at 13% of the portfolio going forward? Do you expect to do more of this? And maybe if you could help me understand how much capital that freed up by reducing the $4 billion worth of equities."
},
{
"speaker": "Thomas Wilson",
"text": "Okay, David. Thank you for the growth time question. I'll talk about the logic for the equity. John can then talk about the process we're looking at in terms of going forward, which you talked about at the end is -- which is really your question, where should you invest in this kind of environment? And the answer is we don't know, but we've got a pretty good process, going to figure out what we think is the best option. First, the equities. A large portion of the equity portfolio back to payout annuities, which are long-dated liabilities, think of them like a pension plan. And so you don't want to be invested in fixed income for annuities that are going to pay out in 10, 20, 30 years. So that's appropriately at the liability match. And that's sort of a bottom. We don't want to move away from that matching because it would be bad long term economically. And you don't want to start to be picking when you trade in or out. On the other hand, some of our equities just are capital that we use to support the business and that we are a little more flexible with. And we brought down the -- when we look at economic capital, which is amount of capital, we think we need to put up for risk. We thought we had -- it wasn't a good enough return for us. So that was why we reduced it, which is really related to sort of the equity portfolio of the overall entity, not specific asset liability matching. As it relates to the amount of freed up capital, David, from a statutory capital standpoint, it obviously reduces your capital a little bit. But we're long capital as it is. And so we don't look at it as though we had to free up capital to buy shares back or anything like that. We just look at it pure economics. What's the right thing to do for shareholders on a long-term basis? And it did free up some economic capital, some statutory capital, but it doesn't really make a difference in the amount of capital we have available to either do share repurchases or buy something like that. John, do you want to spend a minute on what we're doing on the strategic asset allocation?"
},
{
"speaker": "John Dugenske",
"text": "Yes. Thanks, Tom. And David, thank you for your question. As a regular matter of course, we take a disciplined approach to investing and thoroughly look at the -- managing both the risk and return trade-offs. We do that both directly in the investment department, but then that's highly integrated with the way we think about return and risk opportunities across the firm, as Tom had mentioned. One of the key things that we do is, first, we have a -- what I believe to be a strong team of about 400 investment professionals and -- that are deeply experienced. And we are in a number of different markets and look at price action, fundamental, economic drivers, technical observations across those markets. We also bring in, on a regular basis, keen insight from people from the outside, whether that's from our dealer relationships, whether that's via specific consultants or economic research teams that we have subscriptions to and try and formulate, at any point in time, the best risk return trade-off for the portfolio, especially given the business lines that we're associated with. As Tom mentioned, if you -- candidly, if you go back a little more than a year ago, we started to see that the return per unit of risk, as we perceived it in the marketplace, was flattening out, and we became a little bit more concerned about whether investment markets offer the best opportunity. What transpired since then is that the Fed became pretty active last year, as we've all seen. We took that as an opportunity to add duration to the portfolio, which is paying benefits today. So it's tantamount to our desire to be proactive with our investment portfolio and integrate it to the rest of the firm. As we moved into the end of this year, one of the things that we noticed is that there was a limit to what the central banks could do to continue to push on returns of growth assets or risky assets. We thought that what we had observed in 2019 is not much earnings growth, and there is a fair amount of multiple growth. And we just thought that, that was likely coming into the end. As Tom said, we really didn't predict that there's going to be an event. But the one thing we all recognize as an enterprise that if there was an event, we weren't really giving much compensation for that. So we incorporated this equity trade in February, albeit at very good levels. The way that we accomplish this on a daily -- on a regular basis and quarterly, we sit down in an investment group and we go through what we call a capital allocation process. And we spend 2, 3 days deeply looking at markets, and then we share that with the rest of the enterprise."
},
{
"speaker": "David Motemaden",
"text": "Got it. And if I could, just one follow-up. Just on the expense ratio, the 23.4 in the quarter. How should I think about that for the rest of the year, just given potential top line pressure, offset by what sounds like ramp-up of the transformative growth as the year progresses?"
},
{
"speaker": "Thomas Wilson",
"text": "Mario, do you want to take that?"
},
{
"speaker": "Mario Rizzo",
"text": "Sure. Again, what I'd say is I'd reiterate. Look, a core part of our strategy is to continue to look to take costs out of the system and the general downward view of our expense ratio to improve competitive position. Having said that, you did say, you articulated a couple of the items that are going to cause some choppiness in that. Number one is the outlook on revenue, which there's uncertainty around that, but also, we're going to continue to make investments in things, like I said, technology and marketing. So I guess what I'd say is, look, our focus is still on reducing costs and driving the expense ratio down over time. I'm not going to sit here today and give you an exact trajectory of what that's going to look like. But strategically, that continues to be a core part of what we're trying to do."
},
{
"speaker": "Thomas Wilson",
"text": "So what we try to do is manage it down, but not do it stupidly, right? So like, as Glenn mentioned, we have to reposition the Allstate brand to go even more aggressive into driving the direct growth. And that's going to cost some money. So we'll do what we think is economic for shareholders. And then we think if we do it on an upfront, it works out so we achieve our overall objective."
},
{
"speaker": "Operator",
"text": "Our next question comes from the line of Jimmy Bhullar from JPMorgan."
},
{
"speaker": "Jamminder Bhullar",
"text": "So I had a couple of questions. First, maybe just on the auto business, if you could talk about competition as you're looking at the business through the rest of the year. Everyone's margins are actually obviously pretty strong. Do you see, at some point, companies start to adjust pricing based on sort of whatever the new normal is in terms of driving behavior? And have you seen any indication of companies getting a little bit looser on renewal terms recently?"
},
{
"speaker": "Thomas Wilson",
"text": "Let me start, maybe talk about process, Jimmy, and Glenn can fill in some specific thoughts he has. So it's -- obviously, we did the Shelter-in-Place Payback, and everybody followed relatively quickly. That doesn't mean that we really only have the idea. It just means that everybody thought that with margins where they were, it was fair to give it back to customers or at least that was our view. And whether that people will continue to do that or not, it's hard to tell. What I do know is that because we have a business model which is run by market, by line, by coverage, with all kinds of data, both our telematics data, our own historical data, our claim data and the information we get from Arity, will be incredibly precise and surgical about the way we react. I can't speak to what other people do. Glenn, is there anything in the competitive environment that is clearer today than -- and has been kind of murky, is I would say. But anything you would add to that?"
},
{
"speaker": "Glenn Shapiro",
"text": "Yes. What I would say is we're clearly going to be in a very benign rate environment. That might be an understatement, and -- for some period of time. What I haven't seen is, in the competitive environment, anybody making a more durable or permanent change to their premiums, meaning a rate reduction that is over a permanent price filing for rate reduction. Because I think, like us, I'm sure others see that like this came on fast. Like I don't think anybody predicted that when we came into this year, we were going to have an event that would drive mileage down by 50% or whatever the numbers are by state. And it can go away fast, too. So I think everybody's looking at this, I know we are, from the standpoint of how do we react in real time, make good decisions, doing the right thing by market with precision, as Tom said, with our customers in mind, but not do anything that we then have to rebound on. And it wouldn't be good for anybody to overplay it a hand and then have to go take rate increases afterwards. So I think what you're going to see is a very benign, flat rate environment as opposed to a negative one."
},
{
"speaker": "Jamminder Bhullar",
"text": "And then on the sales or top line growth environment in sort of the Services, Benefits or Life businesses, should we assume that because the COVID and sort of Shelter-in-Place, that you'll see a drop-off in sales in some of these businesses in the near term?"
},
{
"speaker": "Thomas Wilson",
"text": "Let me have Don answer about the Services Business, particularly Allstate Protection plans, which, as you saw, is just continuing to grow incredibly rapidly. And I hate for that story to get lost amongst the coronavirus part. And then I would just -- I think I could summarize it to say, in Life, that we haven't had much growth there in the last couple of years, and we're really trying to still reboot that growth strategy. Don, do you want to..."
},
{
"speaker": "Dogan Civgin",
"text": "Sure. So I think, obviously, each of the businesses are going to be impacted by different trends. Some of them will be driven by frequency such as our roadside business. Some will be driven by auto sales and kind of general economic conditions like a dealer services and so forth. So I think every business will be impacted by some different factors. Allstate Protection Plans, which has continued to have terrific growth, first, on a broader level, they've been growing for a number of quarters. So this is not unique to the first quarter of 2020. And so we've been really pleased with the overall growth and overall improvement in profitability that they've been able to exhibit. Now when you look at the first quarter, you might look and say, \"Well, their -- most of their sales are through retail.\" And retail is suffering, which is maybe true in general, but you have to get a little bit more nuanced and look at the types of customers they have, the types of retailers we do business with and, to some extent, what's being purchased at retail right now. So when you look at SquareTrade's kind of largest B2B customers, they tend to be the larger one-stop shops, where people have been going to shop more frequently since coronavirus hit because they want to get all of their purchases done with one stop if they can do so. Second, a lot of what's been purchased, as people have been adapting to the home environment, has been kind of getting home offices set up, to some extent, entertainment setup because they're going to be stuck in their houses for some period of time, which obviously come with the opportunity for extended warranties as well as the stimulus check impact which put funds in people's pockets to be able to then go out and spend. So when you look at what their particular type of customer was looking for, the first quarter after coronavirus saw a nice increase. It's hard to tell whether that will last and how long that will last. I think at some point, the overall trends in retail will be a headwind for Allstate Protection Plans. But at least in the short term, it's actually been a nice tailwind. I would also say that new business, which they've picked up a number of large accounts recently, both domestically and overseas, rollouts of those programs have slowed down a little bit as people have been trying to figure out how they're going to get those stores open. And there was a slight, I would say in the first quarter, benefit from claims dip as people submitted fewer claims after the virus hit for some period of time. So overall, trends continue to be really strong. Hard to tell what the impact is going to be on Allstate Protection Plans long term from the virus. But in kind of the immediate term, it's been good for their top line."
},
{
"speaker": "Jamminder Bhullar",
"text": "Okay. And just lastly, any comments you have on long-term strategy for the annuity block and the likelihood of a sale or reinsurance of that business?"
},
{
"speaker": "Thomas Wilson",
"text": "Sure. Let me jump at that, Jimmy. First, on the -- I should also point out on more longitudinal perspective, Allstate Protection Plans now has over 100 million policies in force. Don, I think it was about 30-plus million when we bought it, right? 30 million plus."
},
{
"speaker": "Dogan Civgin",
"text": "Yes."
},
{
"speaker": "Thomas Wilson",
"text": "So it's had a tremendous run not to be swept under the carpet. It's really a great team. As it relates to annuities, it's a huge drag on our ROE because we -- as I mentioned earlier, we have a lot of equities behind that portfolio because we believe that's the right thing to do. So our 18.2% includes a large drag on it from the annuities. If we could find a way to eliminate that drag, we would do so. But we only want to do it with some place where our customers will be well taken care of because this is largely written on our paper. And we don't want to give somebody a whole bunch of investments and say, \"Good luck, and we hope you pay the people off when you get there.\" And they do something stupid. So we are managing it well as it is today. Either we will find a solution, that could be a reinsurance solution, it could be a sale, it could be we just keep it, we run it differently. In any event, it will go away in terms of its drag on ROE when the new long-dated accounting -- long-dated annuity accounting comes in place where you'll have to mark that to market. We don't -- we think that, that accounting is a little rough. On the other end, it will eliminate the drag on overall ROE."
},
{
"speaker": "Operator",
"text": "Our next question comes from the line of Mike Zaremski from Crédit Suisse."
},
{
"speaker": "Charles Lederer",
"text": "This is actually Charlie on for Mike. Can you talk about your commercial lines exposures outside of commercial auto? And specifically, can you talk about business interruption exposure in general, whether you've seen claims and if your policies have virus exclusions?"
},
{
"speaker": "Thomas Wilson",
"text": "Don, in your report?"
},
{
"speaker": "Dogan Civgin",
"text": "Okay. Charlie, so in our business insurance, we do actually have exclusions for disruption caused by the pandemic and so we -- like many others do. And so there's a lot of noise out there about implementing requirements for insurance companies to go back and provide coverages that were not only excluded explicitly, but were also not priced for. And so we would be against obviously that. Having said that, our exposure is relatively small. There's about 60,000 policies in total that we have that sort of exposure, which as I said, is explicitly excluded. So it's a relatively small number for a company like Allstate."
},
{
"speaker": "Charles Lederer",
"text": "Got it. And then on the Shelter-in-Place Payback included in the expense ratio in the first quarter, does that imply the charge for the second quarter will be the balance to get to the $600 million you guys have talked about? And is there a potential for further premium reductions, either larger discounts per month or an extension of the duration of the discounts?"
},
{
"speaker": "Thomas Wilson",
"text": "Mario, if you'll take the second -- the first piece and then make sure we talk about all the other things, whether it's bad debts or anything else coming up in the quarter. As it -- Charlie, as it relates to another Shelter-in-Place program, what we said is we're always going to treat our customers fairly. This came along quickly. We moved within 10 days to get people what was a relatively easier to implement in terms of it ubiquitous across the country, ubiquitous by customer. Everybody got 15% in April and May. And we felt we needed to do that because they were all struggling. The government money had not yet come into people's home. So we even provided the opportunity for them to get cash, even though they might have gone on a deferred payment plan with us. And so that was -- it was done because we need -- knew our customers needed help, and we need to do it fast. If frequency were to stay down because of something that was not continuous, so we thought it was Shelter-in-Place for a longer period of time, those graphs that Glenn showed. If it stayed down there, we may want to do something else for our customers to reflect the fact that they're not driving as much. This time though, it will be much more precise. And so we'll use all the data we have to -- as Glenn talked about, some people are driving more, but it doesn't feel like they should get a Shelter-in-Place Payback, right? It doesn't seem as fair to somebody who's not driving their car at all. The same thing about which area you live in, you live in an urban area or rural area. Is your -- what kind of driving? Are you a really fast driver? Now not everybody's on telematics, so we can't get it as precise as we would like. But we are working on a more comprehensive approach should frequency stay down, and we will do what we think is fair for our customers. Mario, do you want to take the second quarter impact from what we've already done?"
},
{
"speaker": "Mario Rizzo",
"text": "Sure. So on -- with respect to the SIPP payment, we saw we recorded a portion of it in the first quarter. The balance will be recorded in the second quarter. So that one's pretty straightforward. That will happen. When we kind of decided on the SIPP payment, one of the things we explicitly factored in was the potential for bad debt expense associated with the special payment plan that we're allowing our customers to opt into. As we evaluated the number of customers that had opted into that as of the end of March, along with our historical bad debt experience, the impact in the first quarter from a bad debt perspective was pretty immaterial. Obviously, we will look at the number of customers that have signed up as well as the exposure going forward. And we'll take that into account in the second quarter in terms of establishing bad debt prospectively. But first quarter was reasonably immaterial. Second quarter, we'll take a look at the analysis. We'll update it appropriately, and then we'll record something incremental in the second quarter."
},
{
"speaker": "Operator",
"text": "Our final question then for today comes from the line of Yaron Kinar from Goldman Sachs."
},
{
"speaker": "Yaron Kinar",
"text": "Just want to go back to distribution a little bit. Can you maybe talk about how the agency channel is impacted by Shelter-in-Place environment and the -- with customers potentially looking for lower price options as well? And with that, maybe also touch on kind of the timing of shifting the agent variable compensation to a -- more to a new business generation and how that has been impacting the sales force."
},
{
"speaker": "Thomas Wilson",
"text": "Glenn will be the best person to answer that question."
},
{
"speaker": "Glenn Shapiro",
"text": "All right. Thanks, Yaron. First of all, when you think about the impacts of coronavirus, I think it's important, there's all different types of businesses that have to close down all the way up through businesses that actually benefit because they're in the type of business that wins in this type of new environment. The agents kind of fall in the middle of that because if you think about their revenue stream, it is still significantly renewal compensation. Our total compensation to the agency force, and if you break down to any individual agent, will range somewhere between 90% and 100% or, in some cases, even above 100%. Some are growing more post middle of March versus before. So the core of their income remains. So you've got that piece. In terms of how it impacts their business, I think that, that will be something to watch and something to see. I agree that people will be looking for value as they go forward. But I also think our agents have really been able to show their value in this process. I don't think there's another time in our company history where I could make the following statement. Over the course of the last 6 weeks, almost all of our agents have called almost all of their customers. So you've got this really unique period of time where, a, people are more available to be reached; b, they have more questions, and they really want to hear from their trusted adviser; and c, our folks are just committed to that because of a national crisis. And so I think that there's this moment in time where at least some portion of our customer base will really see the value of what they've gotten out of their agency relationship and having a trusted adviser. That said, everything Mario and Tom and others have talked about on this call about transformative growth is, we've got to keep taking costs out of our system and be a more affordable and more competitive value for consumers going forward, which is why we're accelerating the Transformative Growth Plan."
},
{
"speaker": "Yaron Kinar",
"text": "Got it and understood. And then maybe one quick follow-up. Milewise, you talked about potentially accelerating it. I think as of year-end, you were in 14 states. Any thoughts as to how quickly you can really expand the program to all 50 states?"
},
{
"speaker": "Thomas Wilson",
"text": "Glenn, do you want to give an update on that?"
},
{
"speaker": "Glenn Shapiro",
"text": "Yes. So we're in 16 states and moving as quickly as we can on it. Certainly, the pandemic has shown a light on the value of a pay-per-mile product, and we're seeing a nice uptick in the demand for it. You see kind of 2 effects in the public right now. One is just the acceptance of the notion that telematics is going up as a result of all of this, and two is actually the over-demand for something like Milewise is going up. We have some states up 30% in terms of their sales since the middle of March and seeing double-digit percentages regularly on a week-by-week basis of the new business being sold in Milewise versus other products. So we think it's a great opportunity. It will absolutely be part of our filings that we're doing broadly across the country to try to expand and do more for consumers as a result of the pandemic."
},
{
"speaker": "Thomas Wilson",
"text": "Okay. Thank you all. Allstate is in a strong position. We know how to protect our customers from life's uncertainties, and we'll continue to do that as we navigate through this crisis. So thank you for participating, and we'll talk to you next quarter."
},
{
"speaker": "Operator",
"text": "Thank you, ladies and gentlemen, for your participation in today's conference. This does conclude the program. You may now disconnect. Good day."
}
] | The Allstate Corporation | 18,711 |
ALL | 4 | 2,021 | 2022-02-03 09:00:00 | Operator: Good day and thank you for standing by. Welcome to the Allstate's Fourth Quarter 2021 Earnings Conference Call. At this time all participants are in a listen-only mode. After the prepared remarks there will be a question-and-answer session. [Operator Instructions] As a reminder, please be aware that this call is being recorded. And now I would like to introduce your host for today's program, Mr. Mark Nogal, Head of Investor Relations. Please go ahead, sir.
Mark Nogal: Thank you, Jerome. Good morning. Welcome to Allstate's fourth quarter 2021 earnings conference call. After prepared remarks, we will have a question-and-answer session. Yesterday, following the close of the market, we issued our news release and investor supplement and posted related materials on our website at allstateinvestors.com. Our management team is here to provide perspective on these results. As noted on the first slide of the presentation, our discussion will contain non-GAAP measures for which there are reconciliations in the news release and investor supplement and forward-looking statements about Allstate's operations. Allstate's results may differ materially from these statements, so please refer to our 10-K for 2020 and other public documents for information on potential risks. Before I hand it off to Tom, I would like to turn to Slide 2 and discuss the expansion of Allstate's Investor Communications. Beginning this year, instead of a traditional Investor Day, we will be conducting a series of 60 minute investor calls to provide deeper insights into significant strategic or operational topics. These calls will be in addition to our quarterly earnings calls. Our first call will focus on the current auto insurance operating environment and will be scheduled to take place in March. Topics on future calls may include homeowners insurance, independent agent channel strategy, expansion of protection services and investments. In addition to investor calls, we will also begin disclosing the company's auto insurance implemented rate actions from the prior month on our Investor Relations website to provide additional information on premium growth. Rate disclosures will be posted on the third Thursday of every month, like our monthly catastrophe loss disclosures, though the rate postings will occur regardless of whether there is a catastrophe loss release in the month. I look forward to the additional engagement these changes will bring. And now I'll turn it over to Tom.
Tom Wilson: Good morning and thank you for joining us today. Let's start on Slide 3. As you know, Allstate refocus on execution and innovation as ways to create shareholder value. And our strategy has two components: increase personal property-liability market share and then expand protection solutions, which are shown on the two ovals on the left. If you start with the upper oval, we've been a leader in product innovation a multichannel distribution and leveraging technology in telematics and claims settlement. So we're now building a low-cost digital insurer with broad distribution through transformative growth. We're also diversifying our businesses by expanding protection options as shown in the bottom oval. We offer customers a wide range of protection, good workplace benefits, commercial insurance, roadside services, car warranties, protection plans and identity protection. Avail is a leading innovator in telematics and Avail – sorry, Arity is leading entity in telematics, and Avail is a start-up, which is basically an Airbnb model for Parisien. We leverage the Allstate brand, customer base and capabilities to drive growth in those businesses as well. On the right panel, you can see our five annual operating priorities, which focus on both near-term performance and long-term value currency. So let's move to Slide 4 and go through those operating priorities for the fourth quarter and the full year. Our revenues of $13 billion in the quarter increased 18.7% compared to the prior year quarter, resulting in over $50 billion of revenue for the full year 2021, then reflected by a 1 percentage point increase in auto insurance market share through the National General acquisition, growth in homeowners premiums and then we also had strong growth at Allstate Protection Plans and higher investment income. Property-Liability premiums increased 17%. Net investment income of $847 million in the fourth quarter of 2021 increased to $187 million compared to 2020, which reflects really strong results from the performance-based portfolio. Net income was $790 million in the quarter compared to $2.6 billion in the prior year as lower underwriting income and a loss related to the sale of the life and annuities business was only partially offset by the higher investment income. Adjusted net income, remember that our measure takes out some of the things that we think are not related to the current economics, was $796 million or $2.75 per diluted share, a decline compared to the $1.6 billion generated in the prior year quarter reflecting lower underwriting income. You'll remember that 2020 had low auto accident frequency, reflecting the impact of the pandemic. 2021 was a year of – really a two distinct halves as it related to profitability of auto insurance. In the first half of 2021, auto insurance underwriting income benefited as lower accident frequency, offset increased claims severity. As a result, underwriting income for auto insurance totaled over $1.7 billion in the first two quarters. In the second half of the year, auto claim frequency continued to increase towards pre-pandemic levels and the cost of repairing cars and settling bodily injury claims accelerated. We began increasing auto insurance rates in the third quarter and this accelerated in the fourth quarter. These rate increases, however, are earned as policies renew so that the cost increase has resulted in an underwriting loss of slightly over $450 million in the last two quarters. The underlying combined ratio for auto insurance was 92.5 for the full year and 100.2 for the fourth quarter of 2021. And while that generates good underwriting income for the year and a good economic return, the results of the last two quarters are not acceptable, so we're highly focused on raising returns in the auto insurance, as Glenn will discuss in a few minutes. Adjusted net income of $4 billion for the full year was $13.48 per share, which generated a return on common shareholders' equity of 16.9%. Let's go to Slide 5 to go through the operating priority results in more detail. To better serve customers, we lowered expenses to improve the competitive price position of auto insurance. The enterprise Net Promoter Score finished slightly below the prior year, but in part, that reflects the absence of the beneficial impact in 2020 of the pandemic-related customer accommodations. You'll remember, it included $1 billion of shelter-in-place program payments, expanded coverage of longer payment term. This year, we expanded protection offerings in group and health individual products with the acquisition of National General. We significantly grew our customer base in 2021, with total policies in force increasing 9.8% to $190.9 million. Property-Liability policies of course, increased by 13.7% as due to the acquisition of National General, expansion of our direct distribution in the Allstate brand and increased insurance provided through Allstate agents. Protection Services policies also continued to grow, increasing 8.9% to $148.4 million. On the third priority, achieve target returns on capital that was accomplished. We completed the year with adjusted net income of $4 billion and a return on shareholders' equity of 16.9%. Despite the rising loss costs environment, the property-liability combined ratio finished 2021 at 95.9. Protection Services continues to grow profitably, it's really driven by Allstate Protection Plans. And then net investment income was $3.3 billion in 2021 reflecting proactive portfolio management and exceptional performance-based income, as Mario will take you through later as well. The total return on our portfolio was 4.4%, so sustainable value creation refers not only strong execution on the first four items, but long-term growth platform. In 2021, we sold life and annuities business for $4.4 billion. We acquired National General for $4 billion to capture expense savings, leveraging independent agent technology platform and improve our strategic position in this distribution channel. Significant progress was made on transformative growth to build a low-cost digital insurer with broad distribution. Allstate Protection Plans continued its rapid growth with written premiums of $1.8 billion that's 5x greater than when the company was acquired five years ago. Arity, our telematics company continues to expand its services and launch highly innovative products. Execution and innovation lead to sustainable value creation. Now let me turn it over to Glenn to discuss property liability results in more detail.
Glenn Shapiro: Thank you, Tom, and good morning, everyone. Let's start by reviewing property-liability profitability in the fourth quarter on Slide 6. The recorded combined ratio of 98.9 increased 14.9 points compared to the prior year quarter, primarily driven by higher underwriting losses as well as prior year reserve strengthening. The chart on the bottom left takes you through the impact of each component compared to the prior year quarter. Auto insurance underwriting loss ratio drove most of the increase driven by the impact of rising inflation on auto severity and higher auto accident frequency compared to the prior year. Prior year reserve were strengthening of $182 million had a 1.8 point impact on the combined ratio in the quarter, primarily due to adverse loss development in auto insurance casualty coverage. There was also a sizable impact relative to the premium in shared economy business, which was primarily driven in states we no longer insure with transportation network carriers. This was partially offset by lower underwriting expense ratio, mostly due to lower advertising expenses in the quarter. We continue to focus on cost reductions, which improve our operational flexibility and competitive position. The chart on the lower right shows Allstate's adjusted expense ratio over the last few years. And the adjusted expense ratio as a measure we're using to track our progress on improving value for customers through cost reductions. The measure starts with our underwriting expense ratio, excludes restructuring, coronavirus-related expenses, amortization and impairment of purchase intangibles and investment in advertising. It then adds our claim expense ratio, excluding catastrophe claims costs. The adjusted expense ratio improved to 26 in the full year 2021, which is 0.6 point better than prior year and 3.2 lower than 2018. Our long-term objective is a further reduction of 3 points over the next three years, which would represent a 6 point reduction over the six years following 2018, allowing us to improve competitive price position while maintaining attractive returns. Slide 7 provides further insight into the drivers of rising auto insurance loss costs. Allstate Protection auto insurance underlying combined ratio was 100.2 in the fourth quarter and 92.5 through the full year 2021, representing increases of 15.3 and 7.4 points, respectively. The increases reflect higher loss costs due to severity and accident frequency, partially offset by lower expenses. While claim frequency increased relative to prior year, reflecting a return to more normal driving environment, we continue to see favorability compared to pre-pandemic levels. Allstate brand auto property damage frequency was up 21.5% in the fourth quarter of 2021 compared to 2020, but it was down 13.3% compared to 2019. While we've seen miles driven approach pre-pandemic levels, we've seen a meaningful change in time of day driving, which continues to impact both frequency and severity. Increases in auto severity reflect inflationary pressure across coverages with a number of underlying components of severity rising faster than core inflation. Chart on the lower left shows used car values began increasing in late 2020 and accelerated in mid-2021 in a total increase of 68% beginning in 2019. OEM parts and labor rates have also accelerated in 2021, resulting in higher severities and coverages like collision and property damage. The impact of inflation is also influencing our casualty coverage. During 2020, at the onset of the pandemic, when there was less road congestion and higher speeds, a higher proportion of accidents were more severe. That resulted in more severe injuries per claim and higher average casualty severity. And as 2021 developed, casualty costs continue to rise with more severe injuries, medical inflation and higher medical consumption and higher attorney representation rates. The chart on the lower right breaks down auto report year losses, excluding catastrophe over the past two years. The impact of frequency was favorable in 2020 compared to 2019 with the pandemic. And as you shift into 2021, that favorability is partially reversed, creating a negative year-over-year frequency impact, but still favorable over two years. The impact from higher severities on the other hand were compounded over the two year period and put pressure on both physical damage and casualty coverages. The combination of these factors led to the auto insurance margin pressure that we've seen in the second half of 2021. So let's move to Slide 8 and go deeper into the steps we're taking to improve auto profitability. Allstate has, as you all know, have generated strong auto insurance margins over a long period of time. This is a core capability of ours and we are taking a comprehensive and prescriptive approach to respond to the inflationary pressure and return to our auto margin targets in the mid-90s combined ratio. There are three areas of focus: reducing expenses, which we've talked about, raising rates and managing loss costs through claim effectiveness. Since we already talked about the expenses, I'll start with the rates. And the chart on the lower left, it provides a view into 2021 rate actions. We implemented rate decreases in early 2021 to reflect, in part, Allstate's lower expense ratio and the reduced frequency we were experiencing from the pandemic. But as the year progressed and inflation escalated, we responded with rate increases that began in the third quarter and continued into the fourth quarter. As those continued, you see in the fourth quarter, we took rate in 25 locations at an average increase of 7.1% and a weighted Allstate brand auto premium impact of 2.9%. We'll continue to take rate increases to restore auto profitability at targeted levels, and we'll keep you posted monthly, as Mark mentioned earlier, so that you know where we are on the rates. The chart on the right shows the estimated annual impact of the premium from the implemented rate in each quarter. To relate these two views together that large 2.9% increase implemented in the fourth quarter that you see on the left table, relates directly to the rightmost bar of $702 million in estimated annual written premium. While the rate will obviously help our margin, it takes a little time to be realized, as Tom mentioned, there's an inherent lag between when rates are implemented and when they're reflected in written premium and then ultimately in earned premium. As auto insurance policies generally have a six month term, it takes that time for all of the policies to have renewed at the new rate. And then the annualized written premium impact is fully reflected after 10 months – after 12 months. As we take more price increases in 2022, the incremental rate will be combined and drive higher levels of written premium first and then average earned premium second as the year progresses and we favorably impact auto margins. Beyond expense reductions and rate increases, we're also leveraging advanced claim capabilities to mitigate loss cost pressure for our customers. We're broadening strategic partnerships with part suppliers and repair facilities to mitigate repair costs. We're using advanced claim analytics and predictive modeling tools to optimize repair versus total loss decisions and to assess the likelihood for injury and attorney representation on casualty claims. The bottom line is we are highly confident in our ability to restore auto profitability to targeted levels. And while auto results tend to dominate discussions around the personal lines industry, it's really important to recognize that broad product suite we offer, as Tom mentioned earlier, and in particular, our homeowners insurance product. So moving to Slide 9, I want to spend a few minutes on our industry-leading homeowners business. A majority of our customers bundle home and auto insurance, which improves retention and overall economics of both lines. And simply put, we have a differentiated homeowners ecosystem including product, underwriting, reinsurance, claims capabilities that are unique in the industry. As a proof point to that, since 2017, we've earned $3.3 billion or an average of $667 million a year in underwriting income, while the industry has generated close to an $18 billion underwriting loss from 2017 to 2020. The graph at the bottom left shows homeowners insurance combined ratios for Allstate select competitors and the industry overall since 2011 and you can see there that Allstate's consistently outperformed. We're well positioned to maintain our margins in homeowners and to continue growing it. Our House & Home product is designed to address severe weather risks and has sophisticated pricing features and inflation factors that respond to changes in replacement values, which is particularly important during an inflationary environment like the one we're in. The chart on the lower right shows Allstate homeowners net written premium over time as well as policies in force. We've grown policies in force steadily, increasing to 1.5% up at year-end, and our Allstate agents are in a great position to continue to broaden customer relationships with homeowners products. Net written premium has really taken off through 2021 reaching 13.8% variance by the fourth quarter. Now the increasing spread between those two lines, the net written premium and the policies in force, is due to an increased average in premium per policy, which has steadily grown through 2021. That is mostly due to the premium rising with the increases we saw in replacement costs and to a lesser extent rate increases. That view that difference that I just illustrated really helps show how our product reacts quickly to inflationary forces and allows us to better match price and risk. On the claims side, we've made investments in technology with photo, video and aerial imagery for timely and accurate loss cost management. Shifting to National General's homeowners book. It provides us an awesome opportunity to grow in the independent agent channel, and we're really optimistic about the ability to bundle there with independent agents when we're deploying new middle-market products on the National General ecosystem. But in the near-term, we're focused on improving their profitability in homeowners by leveraging Allstate's expertise in data, pricing sophistication and underwriting capabilities. Our ultimate goal is to meet customers' protection needs while optimizing shareholder risk and return. We underwrite risk directly in homeowners where we can achieve targeted returns. We also broker other insurers property policies where we can meet protection needs for customers, but we can't achieve the adequate returns that we require, and this allows us to maintain an auto relationship with them. We also shift a lot of our catastrophe risk to reinsurance markets, including traditional reinsurance and alternative capital covering both individual large events and an annual aggregate cover. All in, as I said at the start of this, we have a differentiated homeowners insurance capability in the market, and it operates as a really strong diversifying book of business while we improve auto margins. So with that, let me turn it over to Mario to cover the remainder of our results before we move to questions.
Mario Rizzo: Thanks, Glenn. Let's move to Slide 10 and discuss how transformative growth positions us for long-term success. So as we've discussed on past calls, transformative growth is a multiyear initiative to increase personal property-liability market share by building a low-cost digital insurer with broad distribution. This will be accomplished by delivering on four-key objectives: improving customer value, expanding customer access, increasing both the sophistication and investment in customer acquisition and deploying a new technology ecosystem. We made significant progress across each objective in 2021. Our commitment to further lower our costs, improves customer value and enables a more competitive price position while maintaining attractive returns. By leveraging our industry-leading telematics offering as well as advanced data and analytics, we are able to redesign products to create competitively differentiated offerings for our customers. We have transformed our Allstate agent model to increase growth and decrease distribution costs. We've improved the strength of our direct channel through lower pricing and enhanced capabilities, and the acquisition of National General further improved our strategic position in the independent agent channel. Customer acquisition costs relative to lifetime value have improved with higher close rates and increased use of analytics to improve marketing effectiveness. As a result, we invested more in marketing in 2021. We also made progress on deploying the technology necessary to achieve transformative growth. New customer and product management ecosystems will improve ease of use and self-service capabilities at lower costs. We are using both purchased and proprietary software, which is currently in dark deployment before it is operationally tested this year. Delivering on each objective in an integrated way enables us to increase market share and create additional shareholder value. Turning to Slide 11. Let's look how transformative growth has already begun to successfully drive results in our Property-Liability business. In the chart on the left, you will see Property-Liability policies in force grew by 13.7% compared to the prior year quarter, driven predominantly by the National General acquisition. National General, which includes Encompass, contributed growth of 4.2 million policies and Allstate brand Property-Liability policies increased 374,000, reflecting enhanced direct channel capabilities and growth in homeowners sold through Allstate agents. Property-Liability policies in force also grew organically by 1.5% from 37.5 million to 38.3 million in 2021, driven by contributions from growth in both the Allstate and National General brands, reflecting enhanced direct and independent agent capabilities. The chart on the right shows a breakdown of new issued applications for personal auto, which grew 61% compared to the prior year. The middle section of the chart shows Allstate brand impacts by channel, which grew 4.3% compared to the prior year. Existing exclusive agents increased new business compared to the prior year, but that increase was offset by fewer appointments of new agents. As you know, we significantly reduced the number of new Allstate agents being appointed beginning in early 2020 as we've been developing and deploying a new agent model to drive higher growth at a lower cost. The direct channel now represents 30% of new auto policies and grew by 28% compared to the prior year. This more than offset a slight decline from existing agents and volume that would historically have been generated by newly appointed agents. On the far right of the chart, you can see the significant impact of National General, which added 2 million applications in 2021. Slide 12 shows how Protection Services continues to generate profitable growth. Revenues, which exclude the impact of net gains and losses on investments and derivatives, increased 21.9% to $606 million in the quarter and increased 23.5% to $2.3 billion for the full-year 2021. The increase in revenues was driven by continued growth at Allstate Protection Plans and Arity. Allstate Protection Plans grew revenue by 23.8% and written premium by 49.1% for the full year 2021 compared to the prior year, driven by expanded products and partnerships, including the successful launch of the Home Depot relationship earlier in 2021. As written premium is earned over policy periods that can range from one to five years, it will continue to generate future revenue growth as we earn the $2 billion of unearned premium associated with Allstate Protection Plans on our balance sheet as of year-end. Arity expanded revenues by integrating lead cloud and transparently into its customer offerings, which were acquired as part of the National General acquisition as well as increased device revenue, driven by growth in the Milewise product. Policies in force increased 8.9% to 148 million, primarily due to growth at Allstate Protection Plans. Adjusted net income of $179 million for the full year 2021 represented an increase of $26 million compared to the prior year, driven by growth at Allstate Protection Plans. We will continue to invest in growing these businesses as they provide an attractive opportunity to both meet customer needs and create economic value for our shareholders. Let's move to Slide 13 and talk about the Allstate Health and Benefits segment, which generated growth and increased profit reflecting the National General acquisition. We've been offering voluntary benefits through the employer channel for over 20 years, and the acquisition of National General added both group and individual health products to our portfolio. These additions drove a significant increase in revenue with premiums and contract charges increasing 66.5% to the prior year. It also brought in a stream of $359 million of additional revenue, shown as other revenue on this slide, primarily from administrative fees and commissions from sales of nonproprietary health products. Adjusted net income more than doubled to $208 million in 2021 and as higher income from the National General acquisition was partially offset by a higher benefit ratio, reflecting higher life mortality in 2021 and lower benefit utilization in the prior year. Now let's move to Slide 14, which highlights our investment performance. Net investment income totaled $847 million in the quarter, which was $187 million above the prior year quarter, driven by higher performance-based income as shown in the chart on the left. Performance-based income totaled $516 million in the quarter, as shown in gray, reflecting private equity appreciation and direct asset sales. As in prior quarters, we experienced broad-based private equity valuation increases. Several large idiosyncratic contributions – contributors meaningfully impacted results in the quarter with about 50% of performance-based investment income generated by 10 individual investments. Market-based income, shown in blue, was $7 million below the prior year quarter. The impact of reinvestment rates below the average interest-bearing yield was largely mitigated in the quarter by higher average assets under management and prepayment fee income. During 2021, the portfolio also generated more than $1 billion in net gains on investments and derivative instruments, including $428 million from valuation of market-based equity investments and $167 million of net gains from the performance-based portfolio, primarily from gains on sales of direct real estate investments. Our total portfolio return was 1.1% in the fourth quarter and 4.4% year-to-date, reflecting income and higher equity valuations, partially offset by higher interest rates. On the right, we've provided our annualized portfolio return in total and by strategy over various time horizons. Our total portfolio returns have been strong across these time periods with contributions from both our market-based and performance-based portfolios. The market-based portfolio delivers predictable earnings to support business needs with returns highly influenced by public markets. The performance-based portfolio is deployed against capital and longer liabilities and supplements market risk with idiosyncratic risk. Equity investments have higher long-term returns, which compensate investors for higher volatility, and we have sufficient capital to hold these assets through the full investment cycle. Our performance-based portfolio has experienced returns above our historical trend over the last several quarters. While prospective returns will depend on future economic and market conditions, we do expect these returns to moderate from last year's level. Now let's go to Slide 15 to discuss our proactive portfolio management. Our investment portfolio is a key contributor to shareholder value and is highly integrated into our overall enterprise risk and return processes. The divestiture of the life and annuity businesses reduced our portfolio from $94 billion at year-end 2020 to $65 billion today and provided us an opportunity to shift our asset allocation to increase risk-adjusted returns. Since most of these – of the assets backing our life and annuity business were fixed income securities, the divestiture lowered overall enterprise interest rate and credit risk. As a result, we increased our allocation to higher returning equity investments while maintaining the total amount of capital backing investment risks. As you can see from the bottom left, higher return public equity and performance-based investments now account for 23% of the overall portfolio. These investments do have more volatility than fixed income securities, so we allocate more capital to support them, but the higher return more than offset – more than offsets the risk of increased volatility, creating additional shareholder value. Over three-fourth of the portfolio is still fixed income securities, which generates consistent cash flow. The result is a higher returning portfolio with lower interest rate risk overall. We actively manage interest rate risk and consider how it impacts overall enterprise risk and return. As you can see in the blue bars on the right chart, we extended duration from 2018 to 2020 when interest rates shown in the orange line were declining. This mitigated the impact of lower interest rates on auto insurance prices and was a balanced risk and return position from an enterprise perspective. In 2021, we concluded that interest rates were not sufficiently compensating us for the risk that interest rates would rise, which would have a negative impact on the valuation of our bond portfolio. As you know, the consumer price index increased throughout 2021, shown by the light blue line on the chart, and we've discussed at length the impact that inflation has had on auto insurance margins. As a result, we shortened the duration of the fixed income portfolio through the sale of long corporate and municipal bonds and to a lesser extent, the use of derivatives. We are taking additional actions in 2022 to further reduce the negative impact higher interest rates would have on fixed income valuation. This will lower fixed income portfolio yield and investment income for the near term, but positions the portfolio to reinvest into higher rates if they continue to rise. Finally, let's move to Slide 16, which highlights Allstate's strong capital position. Allstate's capital position remains strong and enables significant cash returns to shareholders while investing in growth. We returned $4.1 billion through a combination of share repurchases and common stock dividends in 2021. The common dividend was increased 50% compared to 2020, and common shares outstanding were reduced by 7.8% over the last 12 months. So if you held a share of stock at the beginning of 2020, you now own 7.8% more of the enterprise. As of year-end 2021, we had $3.3 billion remaining on the current $5 billion share repurchase program, which is expected to be completed by March 31, 2023. With that, let's open the line for questions.
Operator: [Operator Instructions] Your first question comes from the line of Joshua Shanker with Bank of America. Your line is open.
Joshua Shanker: Yeah, thank you. My first question, in the prepared statements in the press release, you mentioned the idea of rationalizing expenses in order to get back to profitability. You also have a goal of reducing your expense ratio by 300 basis points through transforming growth over the next three-years. Are you accelerating the process? Are you going to be taking some costs out that will return in 2023, but be offset by some more restructuring? How do the different parts of that play together? Hello? Hello?
Glenn Shapiro: Hello. Tom, did you want to start?
Joshua Shanker: Maybe we lost Tom.
Glenn Shapiro: Mario, you should start.
Mario Rizzo: Okay. All right.
Tom Wilson: It sounds like – Josh, can you hear me?
Joshua Shanker: Yes, yes. Go ahead.
Tom Wilson: Okay Great. It only took me five tries with hash six or star six. First, I don't think you should think about – there are obviously things you do in the short term like we reduced advertising a little bit in the fourth quarter because we don't want to go get a bunch of customers and then end up with a large price increase in the next six months. So you manage that. But in general, when you look at our expense reduction program, it's well laid out. I think it's another three years. It includes everything from using digital processes and getting rid of extra labor to using more outsourcing and cleaning up our processes and reducing our technology costs with the new platform. So those things will roll out. You can't really accelerate those because it has impact on customers. So we're not doing anything for 2022 to just get to our number that then you're going to turn around and look at 2023 and say, jeez, I thought you were profitable and now you're not. So we take a longer-term view of that. That's a little different in pricing and that we will be more aggressive early on in pricing and try to get ahead of the curve as opposed to trying to smooth that out over a multiyear period. Mario or Glenn, anything you would add to that?
Mario Rizzo: Yes, Josh, this is Mario. Thanks for the question. I would agree with Tom, I think what we're focused on is permanent cost reductions that will on a sustained basis improve our competitive position and improve customer value and really enable profitable growth. And we're going to continue to focus on things like operating costs and distribution costs that we can permanently take out of the system. And as Tom mentioned, leveraging tools like automation, process redesign off-shoring where we can and really kind of implement plans that do take time and aren't the kinds of things that I think you can accelerate the execution of. But we're also not focused on ripping a bunch of costs out, that's just going to come back into the system. We want to make the cost reductions permanent, achieve the three points over time because that will really position us to grow and grow at really attractive returns going forward.
Joshua Shanker: So the expense ratio was a little high obviously in the quarter, and I'm actually referring to in the press release where you said that you're going to drive down expenses it seemed like it was more reactive to what's going on right now, there's a short-term benefit. At least I'm trying to find the wording in the press release. In response, Allstate is reducing expenses and claims loss management, reducing expenses here in response. I mean, obviously, you have the transformative growth plan, but is there an initiative on top of that to reduce expenses to get you to a healthy underwriting profit in the near-term associated with the spike in losses?
Tom Wilson: Josh, I don't – we did not mean for it to have that interpretation. When you look at improving profitability in auto insurance, number one thing will be increased our rates. As the lowering expenses, as part of Mario said, the growth objective or transformed growth plan, that will obviously help, but we would have done that anyway. In fact, we started at like two or three years ago, and we're really glad we did it because we came into this year with, as Glenn pointed out, about 3 points lower than we would have been had we not started. But that's ongoing piece, but it's a component of improving profitability, but it's just not – not like we started in claim loss cost management is somewhere in between the two, you're always using data analytics and new claim processes, new relationships with vendors to try to reduce your cost. But as the cost change in the locus of those cost changes. Sometimes you have to adjust the programs you have in place – so I would say that the primary thing to focus on is rate increases in terms of the near-term improvement in auto profitability.
Operator: Your next question comes from the line of Greg Peters with Raymond James. Your line is open.
Greg Peters: Good morning, everyone. I would like to turn our attention to Slide 8 of your investor presentation and where you roll through the details about the rate increases that you're – that you've achieved and your expectations going forward. I guess just in the chart that's in the bottom left, just a further clarification on that. It's this number of locations, 25. Is locations the same thing as states? Or are we dealing with 100 locations? And then when we see an Allstate brand increase of 2.9%, is that a quarterly increase that we can annualize? And I guess where this is going is just trying to figure out the rate you're getting versus where the loss cost trend is and if you're catching up exceeding it or still behind?
Tom Wilson: Greg, I understand the need and desire to get to the math, and that's why we've added the monthly disclosure. Glenn, do you want to take the specifics on the slide?
Glenn Shapiro: Sure. So directly answering the question, the 2.9% is an annualized and the 25 states. So this truly is like if we stopped, if all we did was the fourth quarter, we got 2.9% rate increase across our book of business. We're not stopping in the fourth quarter, and we did a little bit in the third quarter, we took about $800 million in rate increases between the two quarters and we'll continue to. But that amount of money, when you look at the right side, you look at the 81 and the 702 that is the full impact of the rate increase.
Tom Wilson: Greg, when we get to the – when we do the auto call in March, we'll give you a little more specifics on how to calculate that because the 2.9% is based on the – it's a dollar, right? We have a dollar number of what we think we're going to get. It's 2.9% is 2.9% times the prior year premiums. As the prior year premiums, if you look at the total, of course, when you're raising rates, it keeps going up, too. So the full year number is not the annualized number of December. So we'll help you figure out how to do that in March.
Greg Peters: Got it. I appreciate the color. And by the way, the increased disclosure, I think, is appropriate, considering where you guys are, so applaud that change. I guess the other – the big picture question around the slide and just the market environment. Obviously, the auto market is under a lot of duress right now with inflation issues. And there's been news reports from different states and different regulators about pushback on rate increase filings. And I thought maybe you could give us an update of – I don't want to go state by state, but some of the big target states, how the regulators are responding to the data that you're showing them, is it a process that's going to take a while? Or do you think they're receptive immediately? Just if you could give us sort of a state of the union on the regulatory front, that would be helpful.
Tom Wilson: Glenn, could you handle that?
Glenn Shapiro: Sure, will. So Greg, it's a great question. And I know we've been the last couple of quarters. So the conversation has been a lot about will it be pushback? How do we do it? I think the evidence – this page that you pointed us back to, Page 8, the evidence is pretty clear. 25 states implemented at a 7.1% average increase. We are continuing to go at a very fast pace across other states and even in some cases, the same states, again, with rate increases as we get new data and new trends. And to this point, we have – you're always going to experience some discussions, some push on the data, some negotiation, if you will, and some back and forth. But we've – you can see it there, those are implemented rates. And we've been successful. And our people, and I give a ton of credit to our state managers and our product team who've done over years, an incredible job of building relationships because they provide a lot of detail when they do a rate increase or a decrease, any type of rate change we make. And we get great responses because ultimately, these are numbers people talking to numbers people. It is less – most often anyway, is less a political issue than it is a reality issue of looking at the numbers and what is the justifiable and supportable rate increase. And again, we've been very successful so far. We have no reason to believe we won't continue to be. We'll have pushback in places, and we'll have discussions and give and take. But overall, we're getting the rates that we need, and we're going to continue to do that.
Tom Wilson: Greg, it's – the regulators come out of when they want to treat customers fairly. And as Glenn pointed out, the first thing they want is transparency, and our team spends a tremendous amount of time trying to be transparent with the regulators. It's also about what's your history with them. So we did a shelter and place payback of $1 billion. No regulator asked us or forces to do it. We did it proactively within my 10 days of noticing this guy here and his team got organized on it. So it's not like they do everything we want, but it's about treating customers fairly. And then in addition, when you're going in on the physical damage coverages, it's paid in 90 days. So there's not a great debate over whether the money went out or not. It just does. And then finally, injury, can be a little more discussion around it because there are longer-term trends, but we have good math on that as well. So we're confident we can get our combined ratio into the target level that Glenn talked about, which is in mid-90s.
Operator: Your next question comes from the line of Paul Newsome with Piper Sandler. Your line is open.
Paul Newsome: Good morning. Thanks for all the help. I was hoping you could talk a little bit more about auto claim severity on sort of an ongoing basis because maybe the Manheim used car prices don't do this incredible increase again. And so I think if there's anything you can do to help us kind of figure out what that trend would be if you pull out some of the real extraordinary things that happened over the last six months. So I think that might help us get to a better kind of ongoing run rate.
Tom Wilson: Glenn have some good math on that.
Glenn Shapiro: Yes. So as we look at severity, a significant majority on the physical damage lines, which you were pointing to, Paul, is driven by the price of cars. It's – I think I said this last quarter, but I really like the example of if you were – if you had a life insurance company and all your policy limits went up by 50% or something, with no premium change, you'd have an issue. And really, the value of the car is the policy limit. That's the capitation method for property damage and collision. So that moving up has driven, call it, 80-ish percent of the overall severity issue. So as I look at that, there are a couple of ways you can look at it going forward, and this is not just Allstate, this is looking at the world around us that we operate in. One is when will supply chain issues and chip shortages be corrected, most of what you see externally is that, that will last through 2022. The other one is, is that there's likely some sort of structural maximum that used car prices go to because they probably won't end up exceeding new cars prices. And as we get to a year-over-year comparison, where in Q2 of 2021 was the largest single quarter of increase where there was that really steep uphill climb, at some point, you're not going to have those same type of increases on a year-over-year basis, but you may stabilize at a higher level for some period of time. And that's what we've factored in to the way we're looking at our incurred losses, and it's in there in terms of the way we've reported our results and our severities and how we're looking at it going forward.
Paul Newsome: What about the inflation on that the non – sort of the nonlimit piece, that 20%? What do you think that's doing today?
Glenn Shapiro: Yes. That is – so when you look at the – whether it's repair parts costs are accelerating labor like most industries, labor costs going up, that's continuing to move up. But I think an important way to look at it is if you removed the cost of cars, the used car price that limit going up, everything else combined would be in line with sort of our normal trend for severity, that mid-single-digit trend that you'd expect to see. Now then that's completely excluding one major factor, so I understand that it has a little bias to it because car prices do go up a little bit over time. But it is driving the lion's share of it because it's not like you expect severities to be flat year-over-year. They've moved up. Every year over long, long periods of time, there's just normal inflationary movement that happens in there, wherever it's low single digits, some years, mid-single digits or even higher single digits, other years. what is so extreme right now driving the double-digit increases is that change in car prices, but the 20% that I referred to is labor and repair costs, which we're really looking to tackle by increasing our use of direct repair and leveraging our scale in parts purchasing.
Paul Newsome: Thank you. Very helpful.
Operator: Your next question comes from the line of Yaron Kinar with Jefferies. Your line is open.
Yaron Kinar: Thank you. Good morning. First question. Slide 7 shows that auto frequency is still at a $1.4 billion good guy relative to 2019. So my question is, do you expect that frequency to normalize? And if so, is the 7% rate increase that you show on Slide 8, already contemplating that normalized frequency?
Tom Wilson: Glenn, do you want to take that?
Glenn Shapiro: I will. Yes. So I give a ton of credit to our team that does all our math and our modeling, they've done a really nice job on frequency, and we're sitting just about right on top of where we expected to be a year ago on it. So will it normalize to some degree probably? While we can't predict different things can happen in the world, we can't predict and won't give a forward-looking prediction of frequency, you'd expect there to be some normalization to pre-pandemic levels. But as we've said for a while now that we believe that there is some durable structural change. People aren't going to be commuting to office buildings as frequently as they did before the pandemic. We probably all know many people, including some of ourselves, that don't do that and won't do that even on an ongoing basis. And 40% of our losses occur in rush hour. So the commuting time, Monday to Friday mornings and afternoons, so when you got significantly fewer drivers on 40% of your last time period and that shift in when people drive, it makes changes to both frequency and severity. So we think that there's some durable reduction there that barring all the other things that change around it, would be consistent in the way frequency stays a bit lower. But as I mentioned earlier in the prepared remarks, we also see some severity increase from that because the driving has shifted to more leisure times to times where the roads are more open, people are driving faster. It creates harder hits with greater severity, that's hitting us both on the physical damage and the casualty side. So there's just a lot of pieces and parts in there. But to summarize with your question, are we contemplating that in our rate plan? The answer is absolutely yes. We are contemplating in the rate plan, our expectations for frequency, our expectations for severity. And we're going hard after rate, as you can see, and we're not done.
Yaron Kinar: That’s very helpful. I appreciate that. Maybe shifting to homeowners for a second. Look, I fully recognize that you have a tremendous track record there and certainly have earned your fair share of income there over the years. That said, if I look at the specific quarter, it seems like you saw some year-over-year deterioration, which seems to be a bit of an outlier relative to some of your earlier reporting peers. I'm just curious as to why this book maybe saw a different trend? I know you called out higher inflationary impact, but was there anything specific to the Allstate book?
Tom Wilson: Yes. It's hard to compare us to other people. If you're talking about Progressive, I'd say our combined ratio is 15 to 20 points better than theirs on a billions of dollars of either theirs or ours, but I don't even think there's a comparison. But – so we – the business bounces around a little bit. We get a good return on capital on it. Was it in the high 90s? Is that where we want it to be on a long-term basis? No. There's a bounce around by year, yes. And so we feel highly confident we can continue to differentiate ourselves in this space in that business.
Operator: Your next question comes from the line of David Motemaden with Evercore ISI. Your line is open.
David Motemaden: Hi, thanks. Just a question on when you think you'll be able to get to that mid-90s combined ratio in auto? Glenn, I think you've talked about some of the – I guess, your thinking around some of the moving parts around physical damage or severity. So wondering if you can maybe – we can zoom out and think your timing when you guys think you guys can get back to that mid-90s targeted combined ratio in personal auto.
Tom Wilson: Good question. I understand why it's important because everybody is trying to figure out the turn and when will it be in the P&L so you can get in early. And I understand the same thing is when people are looking at sort of various rate increases. The headline would be, we're not going to give a projection as to when because you can't predict what will happen to frequency, severity, rate increases. What you can do is look on a longer-term basis and say, when you look at auto insurance and you look at the broad competitive set, Allstate Progressive and GEICO tend to outperform the industry and have combined ratios, which generate attractive returns and just – you can just graph it out over five or 10 years we all sort of hover in the same place. There are other people like some of the large mutuals and stuff which don't operate at that level, but we've proven an ability to get there. So we think that we'll continue to get there as to the speed of it. Sometimes people ask about the speed, is very idiosyncratic. Like, if your frequency moved up to near – closer to pre-pandemic levels, earlier than ours did, then you should have been taking price earlier and severities, the same thing, people manage their loss costs differently. So we tend to look at it and say, with the long term, we know how to make money in this business on how we're confident we'll get there. But we've not put a date out which we said we'll be in the mid-90s.
David Motemaden: Okay. Thanks. That's fair. And then for my second – or my follow-up question just on I just wanted to focus a little bit on the bodily injury severity and some of the casualty changes, some of the charges you took this quarter. Maybe you could help me understand where that's been running. What specifically happened this quarter that made you realize that charge? And I think the last time you spoke about this. You had said that it was more or less in line with medical cost inflation. I think this was a few years ago. And that was notably below your peers back then. So I guess it's sort of a long way of asking, how are you thinking about the BI severity now given the changes that you've made? And how are you reflecting that in your picks going forward?
Tom Wilson: Yes, it's a good question. And the percentage is sometimes get a little confusing because it's a percentage, in other words, it's absolute dollars is the way we reserve to it. Mario, do you want to talk about the reserve changes?
Mario Rizzo: Sure, Tom. So I guess the play side start is we have really strong reserving processes, and we're continually looking at our reserve levels, both for the current report year but also for prior years. And we're taking into account things that we're seeing, both in terms of inflationary trends as well as other phenomenon. And we talked a little bit earlier around things like medical inflation, consumption, attorney representation, those all factor in. So I think, David, the thing we saw this quarter was we continued to see upward development in prior years and some of the casualty coverages. And we took that into account this quarter in terms of raising our ultimate report year expectations for bodily injury in a couple of the prior years. But it was really in reaction to the continuation of some of those trends that I talked about that are causing bodily injury and other casualty severities to increase to levels that were beyond kind of the range of outcomes that we had established earlier on for those prior years. So we reacted to it. We tend to be conservative when we set reserves. But in this particular instance, we saw those trends develop out, and we reacted to it and increased the prior year reserves on auto casualty.
Tom Wilson: So – and we do it by state and by coverage. I mean so if we – there's a fair amount of granularity to it, is market is not always as precise as you like because you're trying to guess what it's going to cost us settle to something. Well, thank you for participating. Let me just close by saying, there's two stories here. The narrower story is, it's about the insurance industry and Allstate dealing with auto insurance of profitability caused by inflation in fixing cars and then also fixing bodies. Great longer longitudinal story is, which I don't want to let it on the cutting of the floor is about a significant repositioning of the company while dealing with that issue. So we sold our life business. We spent $4 billion success with our National General into the fold increase our market share by 1%, which different position in the independent agent channel for transformation of the Allstate branded business is going quite well, whether that's expanding direct lowering costs or building out new products and improving our competitive position. And then our Protection Services business is really reached a substantive multibillion dollar level with large source of future revenue growth to come because of the way the time works. And at the same time, we're continuing to buy back shares and pay great dividends. So thank you all for participating, and we'll talk to the next quarter. Actually, we'll talk to you in March when we come back to auto reels.
Operator: This concludes fourth quarter conference call. You can now disconnect. | [
{
"speaker": "Operator",
"text": "Good day and thank you for standing by. Welcome to the Allstate's Fourth Quarter 2021 Earnings Conference Call. At this time all participants are in a listen-only mode. After the prepared remarks there will be a question-and-answer session. [Operator Instructions] As a reminder, please be aware that this call is being recorded. And now I would like to introduce your host for today's program, Mr. Mark Nogal, Head of Investor Relations. Please go ahead, sir."
},
{
"speaker": "Mark Nogal",
"text": "Thank you, Jerome. Good morning. Welcome to Allstate's fourth quarter 2021 earnings conference call. After prepared remarks, we will have a question-and-answer session. Yesterday, following the close of the market, we issued our news release and investor supplement and posted related materials on our website at allstateinvestors.com. Our management team is here to provide perspective on these results. As noted on the first slide of the presentation, our discussion will contain non-GAAP measures for which there are reconciliations in the news release and investor supplement and forward-looking statements about Allstate's operations. Allstate's results may differ materially from these statements, so please refer to our 10-K for 2020 and other public documents for information on potential risks. Before I hand it off to Tom, I would like to turn to Slide 2 and discuss the expansion of Allstate's Investor Communications. Beginning this year, instead of a traditional Investor Day, we will be conducting a series of 60 minute investor calls to provide deeper insights into significant strategic or operational topics. These calls will be in addition to our quarterly earnings calls. Our first call will focus on the current auto insurance operating environment and will be scheduled to take place in March. Topics on future calls may include homeowners insurance, independent agent channel strategy, expansion of protection services and investments. In addition to investor calls, we will also begin disclosing the company's auto insurance implemented rate actions from the prior month on our Investor Relations website to provide additional information on premium growth. Rate disclosures will be posted on the third Thursday of every month, like our monthly catastrophe loss disclosures, though the rate postings will occur regardless of whether there is a catastrophe loss release in the month. I look forward to the additional engagement these changes will bring. And now I'll turn it over to Tom."
},
{
"speaker": "Tom Wilson",
"text": "Good morning and thank you for joining us today. Let's start on Slide 3. As you know, Allstate refocus on execution and innovation as ways to create shareholder value. And our strategy has two components: increase personal property-liability market share and then expand protection solutions, which are shown on the two ovals on the left. If you start with the upper oval, we've been a leader in product innovation a multichannel distribution and leveraging technology in telematics and claims settlement. So we're now building a low-cost digital insurer with broad distribution through transformative growth. We're also diversifying our businesses by expanding protection options as shown in the bottom oval. We offer customers a wide range of protection, good workplace benefits, commercial insurance, roadside services, car warranties, protection plans and identity protection. Avail is a leading innovator in telematics and Avail – sorry, Arity is leading entity in telematics, and Avail is a start-up, which is basically an Airbnb model for Parisien. We leverage the Allstate brand, customer base and capabilities to drive growth in those businesses as well. On the right panel, you can see our five annual operating priorities, which focus on both near-term performance and long-term value currency. So let's move to Slide 4 and go through those operating priorities for the fourth quarter and the full year. Our revenues of $13 billion in the quarter increased 18.7% compared to the prior year quarter, resulting in over $50 billion of revenue for the full year 2021, then reflected by a 1 percentage point increase in auto insurance market share through the National General acquisition, growth in homeowners premiums and then we also had strong growth at Allstate Protection Plans and higher investment income. Property-Liability premiums increased 17%. Net investment income of $847 million in the fourth quarter of 2021 increased to $187 million compared to 2020, which reflects really strong results from the performance-based portfolio. Net income was $790 million in the quarter compared to $2.6 billion in the prior year as lower underwriting income and a loss related to the sale of the life and annuities business was only partially offset by the higher investment income. Adjusted net income, remember that our measure takes out some of the things that we think are not related to the current economics, was $796 million or $2.75 per diluted share, a decline compared to the $1.6 billion generated in the prior year quarter reflecting lower underwriting income. You'll remember that 2020 had low auto accident frequency, reflecting the impact of the pandemic. 2021 was a year of – really a two distinct halves as it related to profitability of auto insurance. In the first half of 2021, auto insurance underwriting income benefited as lower accident frequency, offset increased claims severity. As a result, underwriting income for auto insurance totaled over $1.7 billion in the first two quarters. In the second half of the year, auto claim frequency continued to increase towards pre-pandemic levels and the cost of repairing cars and settling bodily injury claims accelerated. We began increasing auto insurance rates in the third quarter and this accelerated in the fourth quarter. These rate increases, however, are earned as policies renew so that the cost increase has resulted in an underwriting loss of slightly over $450 million in the last two quarters. The underlying combined ratio for auto insurance was 92.5 for the full year and 100.2 for the fourth quarter of 2021. And while that generates good underwriting income for the year and a good economic return, the results of the last two quarters are not acceptable, so we're highly focused on raising returns in the auto insurance, as Glenn will discuss in a few minutes. Adjusted net income of $4 billion for the full year was $13.48 per share, which generated a return on common shareholders' equity of 16.9%. Let's go to Slide 5 to go through the operating priority results in more detail. To better serve customers, we lowered expenses to improve the competitive price position of auto insurance. The enterprise Net Promoter Score finished slightly below the prior year, but in part, that reflects the absence of the beneficial impact in 2020 of the pandemic-related customer accommodations. You'll remember, it included $1 billion of shelter-in-place program payments, expanded coverage of longer payment term. This year, we expanded protection offerings in group and health individual products with the acquisition of National General. We significantly grew our customer base in 2021, with total policies in force increasing 9.8% to $190.9 million. Property-Liability policies of course, increased by 13.7% as due to the acquisition of National General, expansion of our direct distribution in the Allstate brand and increased insurance provided through Allstate agents. Protection Services policies also continued to grow, increasing 8.9% to $148.4 million. On the third priority, achieve target returns on capital that was accomplished. We completed the year with adjusted net income of $4 billion and a return on shareholders' equity of 16.9%. Despite the rising loss costs environment, the property-liability combined ratio finished 2021 at 95.9. Protection Services continues to grow profitably, it's really driven by Allstate Protection Plans. And then net investment income was $3.3 billion in 2021 reflecting proactive portfolio management and exceptional performance-based income, as Mario will take you through later as well. The total return on our portfolio was 4.4%, so sustainable value creation refers not only strong execution on the first four items, but long-term growth platform. In 2021, we sold life and annuities business for $4.4 billion. We acquired National General for $4 billion to capture expense savings, leveraging independent agent technology platform and improve our strategic position in this distribution channel. Significant progress was made on transformative growth to build a low-cost digital insurer with broad distribution. Allstate Protection Plans continued its rapid growth with written premiums of $1.8 billion that's 5x greater than when the company was acquired five years ago. Arity, our telematics company continues to expand its services and launch highly innovative products. Execution and innovation lead to sustainable value creation. Now let me turn it over to Glenn to discuss property liability results in more detail."
},
{
"speaker": "Glenn Shapiro",
"text": "Thank you, Tom, and good morning, everyone. Let's start by reviewing property-liability profitability in the fourth quarter on Slide 6. The recorded combined ratio of 98.9 increased 14.9 points compared to the prior year quarter, primarily driven by higher underwriting losses as well as prior year reserve strengthening. The chart on the bottom left takes you through the impact of each component compared to the prior year quarter. Auto insurance underwriting loss ratio drove most of the increase driven by the impact of rising inflation on auto severity and higher auto accident frequency compared to the prior year. Prior year reserve were strengthening of $182 million had a 1.8 point impact on the combined ratio in the quarter, primarily due to adverse loss development in auto insurance casualty coverage. There was also a sizable impact relative to the premium in shared economy business, which was primarily driven in states we no longer insure with transportation network carriers. This was partially offset by lower underwriting expense ratio, mostly due to lower advertising expenses in the quarter. We continue to focus on cost reductions, which improve our operational flexibility and competitive position. The chart on the lower right shows Allstate's adjusted expense ratio over the last few years. And the adjusted expense ratio as a measure we're using to track our progress on improving value for customers through cost reductions. The measure starts with our underwriting expense ratio, excludes restructuring, coronavirus-related expenses, amortization and impairment of purchase intangibles and investment in advertising. It then adds our claim expense ratio, excluding catastrophe claims costs. The adjusted expense ratio improved to 26 in the full year 2021, which is 0.6 point better than prior year and 3.2 lower than 2018. Our long-term objective is a further reduction of 3 points over the next three years, which would represent a 6 point reduction over the six years following 2018, allowing us to improve competitive price position while maintaining attractive returns. Slide 7 provides further insight into the drivers of rising auto insurance loss costs. Allstate Protection auto insurance underlying combined ratio was 100.2 in the fourth quarter and 92.5 through the full year 2021, representing increases of 15.3 and 7.4 points, respectively. The increases reflect higher loss costs due to severity and accident frequency, partially offset by lower expenses. While claim frequency increased relative to prior year, reflecting a return to more normal driving environment, we continue to see favorability compared to pre-pandemic levels. Allstate brand auto property damage frequency was up 21.5% in the fourth quarter of 2021 compared to 2020, but it was down 13.3% compared to 2019. While we've seen miles driven approach pre-pandemic levels, we've seen a meaningful change in time of day driving, which continues to impact both frequency and severity. Increases in auto severity reflect inflationary pressure across coverages with a number of underlying components of severity rising faster than core inflation. Chart on the lower left shows used car values began increasing in late 2020 and accelerated in mid-2021 in a total increase of 68% beginning in 2019. OEM parts and labor rates have also accelerated in 2021, resulting in higher severities and coverages like collision and property damage. The impact of inflation is also influencing our casualty coverage. During 2020, at the onset of the pandemic, when there was less road congestion and higher speeds, a higher proportion of accidents were more severe. That resulted in more severe injuries per claim and higher average casualty severity. And as 2021 developed, casualty costs continue to rise with more severe injuries, medical inflation and higher medical consumption and higher attorney representation rates. The chart on the lower right breaks down auto report year losses, excluding catastrophe over the past two years. The impact of frequency was favorable in 2020 compared to 2019 with the pandemic. And as you shift into 2021, that favorability is partially reversed, creating a negative year-over-year frequency impact, but still favorable over two years. The impact from higher severities on the other hand were compounded over the two year period and put pressure on both physical damage and casualty coverages. The combination of these factors led to the auto insurance margin pressure that we've seen in the second half of 2021. So let's move to Slide 8 and go deeper into the steps we're taking to improve auto profitability. Allstate has, as you all know, have generated strong auto insurance margins over a long period of time. This is a core capability of ours and we are taking a comprehensive and prescriptive approach to respond to the inflationary pressure and return to our auto margin targets in the mid-90s combined ratio. There are three areas of focus: reducing expenses, which we've talked about, raising rates and managing loss costs through claim effectiveness. Since we already talked about the expenses, I'll start with the rates. And the chart on the lower left, it provides a view into 2021 rate actions. We implemented rate decreases in early 2021 to reflect, in part, Allstate's lower expense ratio and the reduced frequency we were experiencing from the pandemic. But as the year progressed and inflation escalated, we responded with rate increases that began in the third quarter and continued into the fourth quarter. As those continued, you see in the fourth quarter, we took rate in 25 locations at an average increase of 7.1% and a weighted Allstate brand auto premium impact of 2.9%. We'll continue to take rate increases to restore auto profitability at targeted levels, and we'll keep you posted monthly, as Mark mentioned earlier, so that you know where we are on the rates. The chart on the right shows the estimated annual impact of the premium from the implemented rate in each quarter. To relate these two views together that large 2.9% increase implemented in the fourth quarter that you see on the left table, relates directly to the rightmost bar of $702 million in estimated annual written premium. While the rate will obviously help our margin, it takes a little time to be realized, as Tom mentioned, there's an inherent lag between when rates are implemented and when they're reflected in written premium and then ultimately in earned premium. As auto insurance policies generally have a six month term, it takes that time for all of the policies to have renewed at the new rate. And then the annualized written premium impact is fully reflected after 10 months – after 12 months. As we take more price increases in 2022, the incremental rate will be combined and drive higher levels of written premium first and then average earned premium second as the year progresses and we favorably impact auto margins. Beyond expense reductions and rate increases, we're also leveraging advanced claim capabilities to mitigate loss cost pressure for our customers. We're broadening strategic partnerships with part suppliers and repair facilities to mitigate repair costs. We're using advanced claim analytics and predictive modeling tools to optimize repair versus total loss decisions and to assess the likelihood for injury and attorney representation on casualty claims. The bottom line is we are highly confident in our ability to restore auto profitability to targeted levels. And while auto results tend to dominate discussions around the personal lines industry, it's really important to recognize that broad product suite we offer, as Tom mentioned earlier, and in particular, our homeowners insurance product. So moving to Slide 9, I want to spend a few minutes on our industry-leading homeowners business. A majority of our customers bundle home and auto insurance, which improves retention and overall economics of both lines. And simply put, we have a differentiated homeowners ecosystem including product, underwriting, reinsurance, claims capabilities that are unique in the industry. As a proof point to that, since 2017, we've earned $3.3 billion or an average of $667 million a year in underwriting income, while the industry has generated close to an $18 billion underwriting loss from 2017 to 2020. The graph at the bottom left shows homeowners insurance combined ratios for Allstate select competitors and the industry overall since 2011 and you can see there that Allstate's consistently outperformed. We're well positioned to maintain our margins in homeowners and to continue growing it. Our House & Home product is designed to address severe weather risks and has sophisticated pricing features and inflation factors that respond to changes in replacement values, which is particularly important during an inflationary environment like the one we're in. The chart on the lower right shows Allstate homeowners net written premium over time as well as policies in force. We've grown policies in force steadily, increasing to 1.5% up at year-end, and our Allstate agents are in a great position to continue to broaden customer relationships with homeowners products. Net written premium has really taken off through 2021 reaching 13.8% variance by the fourth quarter. Now the increasing spread between those two lines, the net written premium and the policies in force, is due to an increased average in premium per policy, which has steadily grown through 2021. That is mostly due to the premium rising with the increases we saw in replacement costs and to a lesser extent rate increases. That view that difference that I just illustrated really helps show how our product reacts quickly to inflationary forces and allows us to better match price and risk. On the claims side, we've made investments in technology with photo, video and aerial imagery for timely and accurate loss cost management. Shifting to National General's homeowners book. It provides us an awesome opportunity to grow in the independent agent channel, and we're really optimistic about the ability to bundle there with independent agents when we're deploying new middle-market products on the National General ecosystem. But in the near-term, we're focused on improving their profitability in homeowners by leveraging Allstate's expertise in data, pricing sophistication and underwriting capabilities. Our ultimate goal is to meet customers' protection needs while optimizing shareholder risk and return. We underwrite risk directly in homeowners where we can achieve targeted returns. We also broker other insurers property policies where we can meet protection needs for customers, but we can't achieve the adequate returns that we require, and this allows us to maintain an auto relationship with them. We also shift a lot of our catastrophe risk to reinsurance markets, including traditional reinsurance and alternative capital covering both individual large events and an annual aggregate cover. All in, as I said at the start of this, we have a differentiated homeowners insurance capability in the market, and it operates as a really strong diversifying book of business while we improve auto margins. So with that, let me turn it over to Mario to cover the remainder of our results before we move to questions."
},
{
"speaker": "Mario Rizzo",
"text": "Thanks, Glenn. Let's move to Slide 10 and discuss how transformative growth positions us for long-term success. So as we've discussed on past calls, transformative growth is a multiyear initiative to increase personal property-liability market share by building a low-cost digital insurer with broad distribution. This will be accomplished by delivering on four-key objectives: improving customer value, expanding customer access, increasing both the sophistication and investment in customer acquisition and deploying a new technology ecosystem. We made significant progress across each objective in 2021. Our commitment to further lower our costs, improves customer value and enables a more competitive price position while maintaining attractive returns. By leveraging our industry-leading telematics offering as well as advanced data and analytics, we are able to redesign products to create competitively differentiated offerings for our customers. We have transformed our Allstate agent model to increase growth and decrease distribution costs. We've improved the strength of our direct channel through lower pricing and enhanced capabilities, and the acquisition of National General further improved our strategic position in the independent agent channel. Customer acquisition costs relative to lifetime value have improved with higher close rates and increased use of analytics to improve marketing effectiveness. As a result, we invested more in marketing in 2021. We also made progress on deploying the technology necessary to achieve transformative growth. New customer and product management ecosystems will improve ease of use and self-service capabilities at lower costs. We are using both purchased and proprietary software, which is currently in dark deployment before it is operationally tested this year. Delivering on each objective in an integrated way enables us to increase market share and create additional shareholder value. Turning to Slide 11. Let's look how transformative growth has already begun to successfully drive results in our Property-Liability business. In the chart on the left, you will see Property-Liability policies in force grew by 13.7% compared to the prior year quarter, driven predominantly by the National General acquisition. National General, which includes Encompass, contributed growth of 4.2 million policies and Allstate brand Property-Liability policies increased 374,000, reflecting enhanced direct channel capabilities and growth in homeowners sold through Allstate agents. Property-Liability policies in force also grew organically by 1.5% from 37.5 million to 38.3 million in 2021, driven by contributions from growth in both the Allstate and National General brands, reflecting enhanced direct and independent agent capabilities. The chart on the right shows a breakdown of new issued applications for personal auto, which grew 61% compared to the prior year. The middle section of the chart shows Allstate brand impacts by channel, which grew 4.3% compared to the prior year. Existing exclusive agents increased new business compared to the prior year, but that increase was offset by fewer appointments of new agents. As you know, we significantly reduced the number of new Allstate agents being appointed beginning in early 2020 as we've been developing and deploying a new agent model to drive higher growth at a lower cost. The direct channel now represents 30% of new auto policies and grew by 28% compared to the prior year. This more than offset a slight decline from existing agents and volume that would historically have been generated by newly appointed agents. On the far right of the chart, you can see the significant impact of National General, which added 2 million applications in 2021. Slide 12 shows how Protection Services continues to generate profitable growth. Revenues, which exclude the impact of net gains and losses on investments and derivatives, increased 21.9% to $606 million in the quarter and increased 23.5% to $2.3 billion for the full-year 2021. The increase in revenues was driven by continued growth at Allstate Protection Plans and Arity. Allstate Protection Plans grew revenue by 23.8% and written premium by 49.1% for the full year 2021 compared to the prior year, driven by expanded products and partnerships, including the successful launch of the Home Depot relationship earlier in 2021. As written premium is earned over policy periods that can range from one to five years, it will continue to generate future revenue growth as we earn the $2 billion of unearned premium associated with Allstate Protection Plans on our balance sheet as of year-end. Arity expanded revenues by integrating lead cloud and transparently into its customer offerings, which were acquired as part of the National General acquisition as well as increased device revenue, driven by growth in the Milewise product. Policies in force increased 8.9% to 148 million, primarily due to growth at Allstate Protection Plans. Adjusted net income of $179 million for the full year 2021 represented an increase of $26 million compared to the prior year, driven by growth at Allstate Protection Plans. We will continue to invest in growing these businesses as they provide an attractive opportunity to both meet customer needs and create economic value for our shareholders. Let's move to Slide 13 and talk about the Allstate Health and Benefits segment, which generated growth and increased profit reflecting the National General acquisition. We've been offering voluntary benefits through the employer channel for over 20 years, and the acquisition of National General added both group and individual health products to our portfolio. These additions drove a significant increase in revenue with premiums and contract charges increasing 66.5% to the prior year. It also brought in a stream of $359 million of additional revenue, shown as other revenue on this slide, primarily from administrative fees and commissions from sales of nonproprietary health products. Adjusted net income more than doubled to $208 million in 2021 and as higher income from the National General acquisition was partially offset by a higher benefit ratio, reflecting higher life mortality in 2021 and lower benefit utilization in the prior year. Now let's move to Slide 14, which highlights our investment performance. Net investment income totaled $847 million in the quarter, which was $187 million above the prior year quarter, driven by higher performance-based income as shown in the chart on the left. Performance-based income totaled $516 million in the quarter, as shown in gray, reflecting private equity appreciation and direct asset sales. As in prior quarters, we experienced broad-based private equity valuation increases. Several large idiosyncratic contributions – contributors meaningfully impacted results in the quarter with about 50% of performance-based investment income generated by 10 individual investments. Market-based income, shown in blue, was $7 million below the prior year quarter. The impact of reinvestment rates below the average interest-bearing yield was largely mitigated in the quarter by higher average assets under management and prepayment fee income. During 2021, the portfolio also generated more than $1 billion in net gains on investments and derivative instruments, including $428 million from valuation of market-based equity investments and $167 million of net gains from the performance-based portfolio, primarily from gains on sales of direct real estate investments. Our total portfolio return was 1.1% in the fourth quarter and 4.4% year-to-date, reflecting income and higher equity valuations, partially offset by higher interest rates. On the right, we've provided our annualized portfolio return in total and by strategy over various time horizons. Our total portfolio returns have been strong across these time periods with contributions from both our market-based and performance-based portfolios. The market-based portfolio delivers predictable earnings to support business needs with returns highly influenced by public markets. The performance-based portfolio is deployed against capital and longer liabilities and supplements market risk with idiosyncratic risk. Equity investments have higher long-term returns, which compensate investors for higher volatility, and we have sufficient capital to hold these assets through the full investment cycle. Our performance-based portfolio has experienced returns above our historical trend over the last several quarters. While prospective returns will depend on future economic and market conditions, we do expect these returns to moderate from last year's level. Now let's go to Slide 15 to discuss our proactive portfolio management. Our investment portfolio is a key contributor to shareholder value and is highly integrated into our overall enterprise risk and return processes. The divestiture of the life and annuity businesses reduced our portfolio from $94 billion at year-end 2020 to $65 billion today and provided us an opportunity to shift our asset allocation to increase risk-adjusted returns. Since most of these – of the assets backing our life and annuity business were fixed income securities, the divestiture lowered overall enterprise interest rate and credit risk. As a result, we increased our allocation to higher returning equity investments while maintaining the total amount of capital backing investment risks. As you can see from the bottom left, higher return public equity and performance-based investments now account for 23% of the overall portfolio. These investments do have more volatility than fixed income securities, so we allocate more capital to support them, but the higher return more than offset – more than offsets the risk of increased volatility, creating additional shareholder value. Over three-fourth of the portfolio is still fixed income securities, which generates consistent cash flow. The result is a higher returning portfolio with lower interest rate risk overall. We actively manage interest rate risk and consider how it impacts overall enterprise risk and return. As you can see in the blue bars on the right chart, we extended duration from 2018 to 2020 when interest rates shown in the orange line were declining. This mitigated the impact of lower interest rates on auto insurance prices and was a balanced risk and return position from an enterprise perspective. In 2021, we concluded that interest rates were not sufficiently compensating us for the risk that interest rates would rise, which would have a negative impact on the valuation of our bond portfolio. As you know, the consumer price index increased throughout 2021, shown by the light blue line on the chart, and we've discussed at length the impact that inflation has had on auto insurance margins. As a result, we shortened the duration of the fixed income portfolio through the sale of long corporate and municipal bonds and to a lesser extent, the use of derivatives. We are taking additional actions in 2022 to further reduce the negative impact higher interest rates would have on fixed income valuation. This will lower fixed income portfolio yield and investment income for the near term, but positions the portfolio to reinvest into higher rates if they continue to rise. Finally, let's move to Slide 16, which highlights Allstate's strong capital position. Allstate's capital position remains strong and enables significant cash returns to shareholders while investing in growth. We returned $4.1 billion through a combination of share repurchases and common stock dividends in 2021. The common dividend was increased 50% compared to 2020, and common shares outstanding were reduced by 7.8% over the last 12 months. So if you held a share of stock at the beginning of 2020, you now own 7.8% more of the enterprise. As of year-end 2021, we had $3.3 billion remaining on the current $5 billion share repurchase program, which is expected to be completed by March 31, 2023. With that, let's open the line for questions."
},
{
"speaker": "Operator",
"text": "[Operator Instructions] Your first question comes from the line of Joshua Shanker with Bank of America. Your line is open."
},
{
"speaker": "Joshua Shanker",
"text": "Yeah, thank you. My first question, in the prepared statements in the press release, you mentioned the idea of rationalizing expenses in order to get back to profitability. You also have a goal of reducing your expense ratio by 300 basis points through transforming growth over the next three-years. Are you accelerating the process? Are you going to be taking some costs out that will return in 2023, but be offset by some more restructuring? How do the different parts of that play together? Hello? Hello?"
},
{
"speaker": "Glenn Shapiro",
"text": "Hello. Tom, did you want to start?"
},
{
"speaker": "Joshua Shanker",
"text": "Maybe we lost Tom."
},
{
"speaker": "Glenn Shapiro",
"text": "Mario, you should start."
},
{
"speaker": "Mario Rizzo",
"text": "Okay. All right."
},
{
"speaker": "Tom Wilson",
"text": "It sounds like – Josh, can you hear me?"
},
{
"speaker": "Joshua Shanker",
"text": "Yes, yes. Go ahead."
},
{
"speaker": "Tom Wilson",
"text": "Okay Great. It only took me five tries with hash six or star six. First, I don't think you should think about – there are obviously things you do in the short term like we reduced advertising a little bit in the fourth quarter because we don't want to go get a bunch of customers and then end up with a large price increase in the next six months. So you manage that. But in general, when you look at our expense reduction program, it's well laid out. I think it's another three years. It includes everything from using digital processes and getting rid of extra labor to using more outsourcing and cleaning up our processes and reducing our technology costs with the new platform. So those things will roll out. You can't really accelerate those because it has impact on customers. So we're not doing anything for 2022 to just get to our number that then you're going to turn around and look at 2023 and say, jeez, I thought you were profitable and now you're not. So we take a longer-term view of that. That's a little different in pricing and that we will be more aggressive early on in pricing and try to get ahead of the curve as opposed to trying to smooth that out over a multiyear period. Mario or Glenn, anything you would add to that?"
},
{
"speaker": "Mario Rizzo",
"text": "Yes, Josh, this is Mario. Thanks for the question. I would agree with Tom, I think what we're focused on is permanent cost reductions that will on a sustained basis improve our competitive position and improve customer value and really enable profitable growth. And we're going to continue to focus on things like operating costs and distribution costs that we can permanently take out of the system. And as Tom mentioned, leveraging tools like automation, process redesign off-shoring where we can and really kind of implement plans that do take time and aren't the kinds of things that I think you can accelerate the execution of. But we're also not focused on ripping a bunch of costs out, that's just going to come back into the system. We want to make the cost reductions permanent, achieve the three points over time because that will really position us to grow and grow at really attractive returns going forward."
},
{
"speaker": "Joshua Shanker",
"text": "So the expense ratio was a little high obviously in the quarter, and I'm actually referring to in the press release where you said that you're going to drive down expenses it seemed like it was more reactive to what's going on right now, there's a short-term benefit. At least I'm trying to find the wording in the press release. In response, Allstate is reducing expenses and claims loss management, reducing expenses here in response. I mean, obviously, you have the transformative growth plan, but is there an initiative on top of that to reduce expenses to get you to a healthy underwriting profit in the near-term associated with the spike in losses?"
},
{
"speaker": "Tom Wilson",
"text": "Josh, I don't – we did not mean for it to have that interpretation. When you look at improving profitability in auto insurance, number one thing will be increased our rates. As the lowering expenses, as part of Mario said, the growth objective or transformed growth plan, that will obviously help, but we would have done that anyway. In fact, we started at like two or three years ago, and we're really glad we did it because we came into this year with, as Glenn pointed out, about 3 points lower than we would have been had we not started. But that's ongoing piece, but it's a component of improving profitability, but it's just not – not like we started in claim loss cost management is somewhere in between the two, you're always using data analytics and new claim processes, new relationships with vendors to try to reduce your cost. But as the cost change in the locus of those cost changes. Sometimes you have to adjust the programs you have in place – so I would say that the primary thing to focus on is rate increases in terms of the near-term improvement in auto profitability."
},
{
"speaker": "Operator",
"text": "Your next question comes from the line of Greg Peters with Raymond James. Your line is open."
},
{
"speaker": "Greg Peters",
"text": "Good morning, everyone. I would like to turn our attention to Slide 8 of your investor presentation and where you roll through the details about the rate increases that you're – that you've achieved and your expectations going forward. I guess just in the chart that's in the bottom left, just a further clarification on that. It's this number of locations, 25. Is locations the same thing as states? Or are we dealing with 100 locations? And then when we see an Allstate brand increase of 2.9%, is that a quarterly increase that we can annualize? And I guess where this is going is just trying to figure out the rate you're getting versus where the loss cost trend is and if you're catching up exceeding it or still behind?"
},
{
"speaker": "Tom Wilson",
"text": "Greg, I understand the need and desire to get to the math, and that's why we've added the monthly disclosure. Glenn, do you want to take the specifics on the slide?"
},
{
"speaker": "Glenn Shapiro",
"text": "Sure. So directly answering the question, the 2.9% is an annualized and the 25 states. So this truly is like if we stopped, if all we did was the fourth quarter, we got 2.9% rate increase across our book of business. We're not stopping in the fourth quarter, and we did a little bit in the third quarter, we took about $800 million in rate increases between the two quarters and we'll continue to. But that amount of money, when you look at the right side, you look at the 81 and the 702 that is the full impact of the rate increase."
},
{
"speaker": "Tom Wilson",
"text": "Greg, when we get to the – when we do the auto call in March, we'll give you a little more specifics on how to calculate that because the 2.9% is based on the – it's a dollar, right? We have a dollar number of what we think we're going to get. It's 2.9% is 2.9% times the prior year premiums. As the prior year premiums, if you look at the total, of course, when you're raising rates, it keeps going up, too. So the full year number is not the annualized number of December. So we'll help you figure out how to do that in March."
},
{
"speaker": "Greg Peters",
"text": "Got it. I appreciate the color. And by the way, the increased disclosure, I think, is appropriate, considering where you guys are, so applaud that change. I guess the other – the big picture question around the slide and just the market environment. Obviously, the auto market is under a lot of duress right now with inflation issues. And there's been news reports from different states and different regulators about pushback on rate increase filings. And I thought maybe you could give us an update of – I don't want to go state by state, but some of the big target states, how the regulators are responding to the data that you're showing them, is it a process that's going to take a while? Or do you think they're receptive immediately? Just if you could give us sort of a state of the union on the regulatory front, that would be helpful."
},
{
"speaker": "Tom Wilson",
"text": "Glenn, could you handle that?"
},
{
"speaker": "Glenn Shapiro",
"text": "Sure, will. So Greg, it's a great question. And I know we've been the last couple of quarters. So the conversation has been a lot about will it be pushback? How do we do it? I think the evidence – this page that you pointed us back to, Page 8, the evidence is pretty clear. 25 states implemented at a 7.1% average increase. We are continuing to go at a very fast pace across other states and even in some cases, the same states, again, with rate increases as we get new data and new trends. And to this point, we have – you're always going to experience some discussions, some push on the data, some negotiation, if you will, and some back and forth. But we've – you can see it there, those are implemented rates. And we've been successful. And our people, and I give a ton of credit to our state managers and our product team who've done over years, an incredible job of building relationships because they provide a lot of detail when they do a rate increase or a decrease, any type of rate change we make. And we get great responses because ultimately, these are numbers people talking to numbers people. It is less – most often anyway, is less a political issue than it is a reality issue of looking at the numbers and what is the justifiable and supportable rate increase. And again, we've been very successful so far. We have no reason to believe we won't continue to be. We'll have pushback in places, and we'll have discussions and give and take. But overall, we're getting the rates that we need, and we're going to continue to do that."
},
{
"speaker": "Tom Wilson",
"text": "Greg, it's – the regulators come out of when they want to treat customers fairly. And as Glenn pointed out, the first thing they want is transparency, and our team spends a tremendous amount of time trying to be transparent with the regulators. It's also about what's your history with them. So we did a shelter and place payback of $1 billion. No regulator asked us or forces to do it. We did it proactively within my 10 days of noticing this guy here and his team got organized on it. So it's not like they do everything we want, but it's about treating customers fairly. And then in addition, when you're going in on the physical damage coverages, it's paid in 90 days. So there's not a great debate over whether the money went out or not. It just does. And then finally, injury, can be a little more discussion around it because there are longer-term trends, but we have good math on that as well. So we're confident we can get our combined ratio into the target level that Glenn talked about, which is in mid-90s."
},
{
"speaker": "Operator",
"text": "Your next question comes from the line of Paul Newsome with Piper Sandler. Your line is open."
},
{
"speaker": "Paul Newsome",
"text": "Good morning. Thanks for all the help. I was hoping you could talk a little bit more about auto claim severity on sort of an ongoing basis because maybe the Manheim used car prices don't do this incredible increase again. And so I think if there's anything you can do to help us kind of figure out what that trend would be if you pull out some of the real extraordinary things that happened over the last six months. So I think that might help us get to a better kind of ongoing run rate."
},
{
"speaker": "Tom Wilson",
"text": "Glenn have some good math on that."
},
{
"speaker": "Glenn Shapiro",
"text": "Yes. So as we look at severity, a significant majority on the physical damage lines, which you were pointing to, Paul, is driven by the price of cars. It's – I think I said this last quarter, but I really like the example of if you were – if you had a life insurance company and all your policy limits went up by 50% or something, with no premium change, you'd have an issue. And really, the value of the car is the policy limit. That's the capitation method for property damage and collision. So that moving up has driven, call it, 80-ish percent of the overall severity issue. So as I look at that, there are a couple of ways you can look at it going forward, and this is not just Allstate, this is looking at the world around us that we operate in. One is when will supply chain issues and chip shortages be corrected, most of what you see externally is that, that will last through 2022. The other one is, is that there's likely some sort of structural maximum that used car prices go to because they probably won't end up exceeding new cars prices. And as we get to a year-over-year comparison, where in Q2 of 2021 was the largest single quarter of increase where there was that really steep uphill climb, at some point, you're not going to have those same type of increases on a year-over-year basis, but you may stabilize at a higher level for some period of time. And that's what we've factored in to the way we're looking at our incurred losses, and it's in there in terms of the way we've reported our results and our severities and how we're looking at it going forward."
},
{
"speaker": "Paul Newsome",
"text": "What about the inflation on that the non – sort of the nonlimit piece, that 20%? What do you think that's doing today?"
},
{
"speaker": "Glenn Shapiro",
"text": "Yes. That is – so when you look at the – whether it's repair parts costs are accelerating labor like most industries, labor costs going up, that's continuing to move up. But I think an important way to look at it is if you removed the cost of cars, the used car price that limit going up, everything else combined would be in line with sort of our normal trend for severity, that mid-single-digit trend that you'd expect to see. Now then that's completely excluding one major factor, so I understand that it has a little bias to it because car prices do go up a little bit over time. But it is driving the lion's share of it because it's not like you expect severities to be flat year-over-year. They've moved up. Every year over long, long periods of time, there's just normal inflationary movement that happens in there, wherever it's low single digits, some years, mid-single digits or even higher single digits, other years. what is so extreme right now driving the double-digit increases is that change in car prices, but the 20% that I referred to is labor and repair costs, which we're really looking to tackle by increasing our use of direct repair and leveraging our scale in parts purchasing."
},
{
"speaker": "Paul Newsome",
"text": "Thank you. Very helpful."
},
{
"speaker": "Operator",
"text": "Your next question comes from the line of Yaron Kinar with Jefferies. Your line is open."
},
{
"speaker": "Yaron Kinar",
"text": "Thank you. Good morning. First question. Slide 7 shows that auto frequency is still at a $1.4 billion good guy relative to 2019. So my question is, do you expect that frequency to normalize? And if so, is the 7% rate increase that you show on Slide 8, already contemplating that normalized frequency?"
},
{
"speaker": "Tom Wilson",
"text": "Glenn, do you want to take that?"
},
{
"speaker": "Glenn Shapiro",
"text": "I will. Yes. So I give a ton of credit to our team that does all our math and our modeling, they've done a really nice job on frequency, and we're sitting just about right on top of where we expected to be a year ago on it. So will it normalize to some degree probably? While we can't predict different things can happen in the world, we can't predict and won't give a forward-looking prediction of frequency, you'd expect there to be some normalization to pre-pandemic levels. But as we've said for a while now that we believe that there is some durable structural change. People aren't going to be commuting to office buildings as frequently as they did before the pandemic. We probably all know many people, including some of ourselves, that don't do that and won't do that even on an ongoing basis. And 40% of our losses occur in rush hour. So the commuting time, Monday to Friday mornings and afternoons, so when you got significantly fewer drivers on 40% of your last time period and that shift in when people drive, it makes changes to both frequency and severity. So we think that there's some durable reduction there that barring all the other things that change around it, would be consistent in the way frequency stays a bit lower. But as I mentioned earlier in the prepared remarks, we also see some severity increase from that because the driving has shifted to more leisure times to times where the roads are more open, people are driving faster. It creates harder hits with greater severity, that's hitting us both on the physical damage and the casualty side. So there's just a lot of pieces and parts in there. But to summarize with your question, are we contemplating that in our rate plan? The answer is absolutely yes. We are contemplating in the rate plan, our expectations for frequency, our expectations for severity. And we're going hard after rate, as you can see, and we're not done."
},
{
"speaker": "Yaron Kinar",
"text": "That’s very helpful. I appreciate that. Maybe shifting to homeowners for a second. Look, I fully recognize that you have a tremendous track record there and certainly have earned your fair share of income there over the years. That said, if I look at the specific quarter, it seems like you saw some year-over-year deterioration, which seems to be a bit of an outlier relative to some of your earlier reporting peers. I'm just curious as to why this book maybe saw a different trend? I know you called out higher inflationary impact, but was there anything specific to the Allstate book?"
},
{
"speaker": "Tom Wilson",
"text": "Yes. It's hard to compare us to other people. If you're talking about Progressive, I'd say our combined ratio is 15 to 20 points better than theirs on a billions of dollars of either theirs or ours, but I don't even think there's a comparison. But – so we – the business bounces around a little bit. We get a good return on capital on it. Was it in the high 90s? Is that where we want it to be on a long-term basis? No. There's a bounce around by year, yes. And so we feel highly confident we can continue to differentiate ourselves in this space in that business."
},
{
"speaker": "Operator",
"text": "Your next question comes from the line of David Motemaden with Evercore ISI. Your line is open."
},
{
"speaker": "David Motemaden",
"text": "Hi, thanks. Just a question on when you think you'll be able to get to that mid-90s combined ratio in auto? Glenn, I think you've talked about some of the – I guess, your thinking around some of the moving parts around physical damage or severity. So wondering if you can maybe – we can zoom out and think your timing when you guys think you guys can get back to that mid-90s targeted combined ratio in personal auto."
},
{
"speaker": "Tom Wilson",
"text": "Good question. I understand why it's important because everybody is trying to figure out the turn and when will it be in the P&L so you can get in early. And I understand the same thing is when people are looking at sort of various rate increases. The headline would be, we're not going to give a projection as to when because you can't predict what will happen to frequency, severity, rate increases. What you can do is look on a longer-term basis and say, when you look at auto insurance and you look at the broad competitive set, Allstate Progressive and GEICO tend to outperform the industry and have combined ratios, which generate attractive returns and just – you can just graph it out over five or 10 years we all sort of hover in the same place. There are other people like some of the large mutuals and stuff which don't operate at that level, but we've proven an ability to get there. So we think that we'll continue to get there as to the speed of it. Sometimes people ask about the speed, is very idiosyncratic. Like, if your frequency moved up to near – closer to pre-pandemic levels, earlier than ours did, then you should have been taking price earlier and severities, the same thing, people manage their loss costs differently. So we tend to look at it and say, with the long term, we know how to make money in this business on how we're confident we'll get there. But we've not put a date out which we said we'll be in the mid-90s."
},
{
"speaker": "David Motemaden",
"text": "Okay. Thanks. That's fair. And then for my second – or my follow-up question just on I just wanted to focus a little bit on the bodily injury severity and some of the casualty changes, some of the charges you took this quarter. Maybe you could help me understand where that's been running. What specifically happened this quarter that made you realize that charge? And I think the last time you spoke about this. You had said that it was more or less in line with medical cost inflation. I think this was a few years ago. And that was notably below your peers back then. So I guess it's sort of a long way of asking, how are you thinking about the BI severity now given the changes that you've made? And how are you reflecting that in your picks going forward?"
},
{
"speaker": "Tom Wilson",
"text": "Yes, it's a good question. And the percentage is sometimes get a little confusing because it's a percentage, in other words, it's absolute dollars is the way we reserve to it. Mario, do you want to talk about the reserve changes?"
},
{
"speaker": "Mario Rizzo",
"text": "Sure, Tom. So I guess the play side start is we have really strong reserving processes, and we're continually looking at our reserve levels, both for the current report year but also for prior years. And we're taking into account things that we're seeing, both in terms of inflationary trends as well as other phenomenon. And we talked a little bit earlier around things like medical inflation, consumption, attorney representation, those all factor in. So I think, David, the thing we saw this quarter was we continued to see upward development in prior years and some of the casualty coverages. And we took that into account this quarter in terms of raising our ultimate report year expectations for bodily injury in a couple of the prior years. But it was really in reaction to the continuation of some of those trends that I talked about that are causing bodily injury and other casualty severities to increase to levels that were beyond kind of the range of outcomes that we had established earlier on for those prior years. So we reacted to it. We tend to be conservative when we set reserves. But in this particular instance, we saw those trends develop out, and we reacted to it and increased the prior year reserves on auto casualty."
},
{
"speaker": "Tom Wilson",
"text": "So – and we do it by state and by coverage. I mean so if we – there's a fair amount of granularity to it, is market is not always as precise as you like because you're trying to guess what it's going to cost us settle to something. Well, thank you for participating. Let me just close by saying, there's two stories here. The narrower story is, it's about the insurance industry and Allstate dealing with auto insurance of profitability caused by inflation in fixing cars and then also fixing bodies. Great longer longitudinal story is, which I don't want to let it on the cutting of the floor is about a significant repositioning of the company while dealing with that issue. So we sold our life business. We spent $4 billion success with our National General into the fold increase our market share by 1%, which different position in the independent agent channel for transformation of the Allstate branded business is going quite well, whether that's expanding direct lowering costs or building out new products and improving our competitive position. And then our Protection Services business is really reached a substantive multibillion dollar level with large source of future revenue growth to come because of the way the time works. And at the same time, we're continuing to buy back shares and pay great dividends. So thank you all for participating, and we'll talk to the next quarter. Actually, we'll talk to you in March when we come back to auto reels."
},
{
"speaker": "Operator",
"text": "This concludes fourth quarter conference call. You can now disconnect."
}
] | The Allstate Corporation | 18,711 |
ALL | 3 | 2,021 | 2021-11-04 09:00:00 | Operator: Thank you for standing by and welcome to the Allstate Third Quarter 2021Eearnings Conference Call. At this time, all participants are in a listen-only mode. After the speakers presentation, there will be a question-and-answer session. [Operator Instructions] As a reminder, today's program is being recorded. I would now like to introduce your host for today's program, Mark Nogal, Head of Investor Relations. Please go ahead, sir.
Mark Nogal: Thank you, Jonathan. Good morning. Welcome to Allstate's Third Quarter 2021 Earnings Conference Call. After prepared remarks, we will have a question-and-answer session. Yesterday following the close of the market, we issued our news release and investor supplement and we posted related materials to our website @allstateinvestors.com. our management team is here to provide perspective on these results. As noted on the first slide of the presentation, our discussion will contain non-GAAP measures for which there are reconciliations in the news release and the investor supplement and forward-looking statements on Allstate's operations. Allstate's results may differ materially from these statements, so please refer to our 10-K for 2020 and other public documents for information on potential risks. And now, I'll turn it over to Tom.
Tom Wilson: Well, good morning and thank you for investing your time with us today. Let's start on Slide 2. This is Allstate strategy on the left-hand side, which we've talked about before. We have two components; increased personal profit liability market share, and expanded protection solutions. And those are the two ovals you see on the left with the intersection between. The key third quarter results are highlighted on the right-hand panel. Property-liability policies and force increased by 12.5%. Allstate Protection Plans continue to grow rapidly by both broadening its product offering and expanding the network of retail providers. As a result, we now have almost a 192 million policies force across the [Indiscernible]. Financially, the results were more mixed. Revenues were up substantially, but net income and adjusted net income declined from the prior year quarter. Underwriting income declined primarily due to higher loss costs of settling auto insurance claims. We've implemented price increases to proactively respond to the sharp rise in loss costs and transformative growth continues to position us for long-term success, both of which we'll talk about in a couple of minutes. This was partially offset by the benefits from our long-term risk and return program that includes significant reinsurance recoverable, they were primarily related to Hurricane Ida, and a substantial increase in performance-based investment income. Capital deployment results were excellent with a billion-and-a-half dollars in cash return to shareholders in the quarter. We also completed the divestitures of our two largest life and annuity businesses, one in October and then one just earlier this week. So let's go to Slide 3. Revenues of $12.5 billion in the quarter increased 16.9% compared to the prior-year quarter. And that reflects both the higher earned premiums in National General acquisition. Allstate brand homeowners premium growth, and higher net investment income, property liability premiums, and policies and force increased 13.5%, and 12.5% respectively. Net investment income was $764 million, and that's up almost [Indiscernible] by $300 million compared to the prior-year quarter, reflecting strong results from the performance-based portfolio. Net Income was $508 million in the quarter. And that's compared to a billion 1 in the prior quarter as lower underwriting income was partially offset by the higher investment income. Adjusted net income was $217 million or $0.73 per diluted share and decreased $683 million compared to the prior-year quarter, reflecting the lower underwriting income due to the higher auto and homeowners insurance loss costs. Net income for the first 9 months of 2021 was below the prior year, and it's largely due to the loss on the sale of the life annuity business which we recorded earlier in the year. Adjusted net income was $10.70 per share for the first nine months. That was above the prior year as higher investment income and lower expenses, more than offset higher loss costs. Let's turn to slide 4. How I would do is put the pandemic in the longitudinal perspective because this created volatility for our results. And it obviously requires us to adapt quickly, which we do. But before we go through the impact on the third quarter results of the supply chain disruptions, let's talk about the initial and subsequent impact of the pandemic. So in 2020, the economic lockdown resulted in fewer miles being driven and promoted -- and prompted an aggressive economic support response from really governments around the world. The impact on auto insurance was a dramatic drop in the number of accidents. And of course, due to this unprecedented driving frequency, we've proactively provided our customers with some money back which increased customer retention. Since then, and since there was less road congestion and fewer accidents that occurred during commuting hours, the average speed in severity of auto claims increased, offsetting some of the frequency benefits. Nevertheless, underwriting margins improved dramatically, so we introduced a temporary shelter in place payback rather than take a permanent rate reduction, and took some modest overall reductions in rate level. This year, as you can see from the right-hand column, the story has been just the opposite as it relates to frequency, with large percentage increases. And while the overall level of accident frequency for the Allstate brand is still below pre -pandemic levels, the national and general non-standard business is back to the levels before the pandemic. Auto severity this year, however, has been dramatically impacted by the supply chain disruption and price increases on used cars and original equipment parts in Mario will take you through that in a couple of slides. From a pricing perspective, this results in moving from modest rate reductions to significant increases on auto insurance prices. From a growth standpoint at the off set of the pandemic, we begin to see material increase in the consumer acceptance to telematics. And we've really leaned into that with our Milewise product, which is really the only national product out there to pay for the mile. And that's led to substantial increase in debt telematics products. Now, the pandemic has also had a significant impact on the investment portfolio and this is a tale of the beginning of the end as well. So early in the crisis, equity valuations were down and it had a negative impact on investment results. Then of course, we have a broad-based long-term spread out over a decade, really investing in these kinds of funds. And so we do it on a long-term basis, whether that's 3, 5, or 10 years. But so what's happened this year, of course, is we've had the opposite happen, which is with the economic stimulus, we've had equity evaluations going after and our returns have come back strongly. In the market-based portfolio, lower interest rates at the onset of this pandemic did lead to an increase in the unrealized gains in the portfolio. But of course, what that does is reduce future interest rate income, which you see slight decline in this quarter. And many of our other businesses that have been impacted, some positively, some negatively. But it's our ability to adapt and seize the opportunities that are presented that create shareholder result So Mario will now go through the third quarter results in more detail and how transformative growth positions Allstate for continued success.
Mario Rizzo: Thanks, Tom. Let's move to Slide 5 to review property-liability margin results in the third quarter. The recorded combined ratio of 105.3 increased 13.7 points compared to the prior year quarter. This was primarily driven by increased underlying losses, as well as higher catastrophe losses and non-catastrophe prior year reserve re-estimates. The chart at the bottom of the slide quantifies the impact of each component in the third quarter compared to the prior year quarter. As you can see, the personal auto underlying loss ratio drove most of the increase, due to higher auto accident frequency and the inflationary impacts on auto severity. Higher catastrophe losses shown in the middle of the chart, had a negative 1.4 impact on the combined ratio, as favorable reserve re-estimates recorded in 2020 from wildfires subrogation settlements, positively impacted the prior year quarter. Gross catastrophe losses were higher, but were reduced by nearly $1 billion of net reinsurance recoveries following Hurricane Ida, demonstrated the benefits of our long-term approach to risk and return management of the homeowners insurance business and our comprehensive reinsurance program. Non-catastrophe prior-year reserve strengthening of a $162 million in the quarter drove an adverse impact of 0.8 points, primarily from increases in auto and commercial lines. This also included $111 million of strengthening in the quarter related to asbestos, environmental, and other reserves in the runoff property-liability segment, following our annual comprehensive reserve review. This was partially offset by a lower expense ratio when excluding the impact of amortization of purchased intangibles, primarily due to lower restructuring and related charges compared to the prior-year quarter. Moving to Slide 6, let's go a bit deeper on auto insurance profitability. Allstate brand auto insurance underlying combined ratio finished at 97.5 for the quarter and 89.7 over the first 9 months of 2021. The increase to the prior year quarter reflects higher loss -- loss costs due to higher accident frequency, increased severity, and competitive pricing enhancements implemented in late 2020 and earlier this year. While claim frequency increased relative to prior year, we continue to experience favorable trends relative to pre -pandemic levels. Allstate brand auto property damage frequency increased 16.6% compared to 2020, but decreased 16.8% relative to 2019. The chart on the lower left compares the underlying combined ratio for the third quarter of 2019 to this quarter, to remove some of the short-term pandemic volatility. The underlying combined ratio was 93.1 in 2019, which generates an attractive return on capital. Favorable auto frequency in the third quarter of 2021, lowered the combined ratio by 6.4 points compared to 2019. Increased auto claim severity, however, increased the combined ratio by 12 points versus 2 years ago, as you can see from the red bar. The cost reductions implemented as part of transformative growth, reduced expenses by 1.3 points, which favorably impacted 2021 results. As Tom mentioned, early in the pandemic, the severity increases were driven by higher average losses due to a reduction in low severity claims. This year, the increase reflects the impact of supply chain disruptions in the auto markets, which has increased used car prices and enabled original equipment manufacturers to significantly increased part prices. The chart on the lower right, shows used car values began increasing above the CPI in late 2020, which accelerated in 2021, resulting in an increase of 44% since the beginning of 2019. Similarly, OEM parts have also increased in 2021, roughly twice as much as core CPI. This has resulted in higher severities for both total loss vehicles and repairable vehicles. Since these increases were accelerating throughout the second and third quarters of the year, we Increased expected loss costs for the first 2 quarters of 2021. And this prior quarter strengthening shows up in the combined ratio for the third quarter. Increases in report year severities for auto insurance claims during the first two quarters of 2021, increased the third quarter combined ratio by 2.6 points, as you can see by the green bar on the lower left. So let's flip to Slide 7, which lays out the steps we're taking to improve auto profitability. As you can see from the chart on the top, Allstate has maintained industry-leading auto insurance margins over a long period of time with a combined ratio operating range in the mid-90s, exhibiting strong execution and operational expertise. To maintain industry-leading results, we are increasing rates, improving claims effectiveness, and continuing to lower costs. After lowering prices in early 2021 to reflect in part Allstate 's lower expense ratio, we have proactively been responding with increases in the third quarter with actions continuing into the fourth quarter and into 2022. The chart on the right provides selected rate increases already implemented in the third and Fourth Quarter, as well as publicly filed rates that have yet to be implemented in the Fourth Quarter. Those states denoted with a carrot, our top ten states in terms of written premium as of year-end 2020 in the third quarter we received rate approvals for increases in 12 states, primarily in September. We adapted quickly to higher severities in the Fourth Quarter with plans to file rates in an additional 20 states. We have already implemented rate increases in 8 states during the Fourth Quarter with an average increase of 6.7% 7% as of November first, looking ahead, we expect to pursue price increases in an additional 12 locations by year-end. We are working closely with state regulators to provide detailed support and decrease the lag time between filing, implementation, and premium generation. As we move into next year, it is likely auto insurance prices will continue to be increased to reflect higher severities. We also continue to leverage advanced claims capabilities and process efficiencies. Cost reductions as part of transformative growth will also continue to be implemented. Let's turn to slide 8 and discuss our expectations and commitment to further improve our cost structure through transformative growth. As you can see by the chart on the bottom of the slide, we've defined a new non-GAAP measure this quarter, referred to as the adjusted expense ratio. This starts with our underwriting expense ratio excluding restructuring, coronavirus related expenses, amortization, and impairment of purchased intangibles, and investments in advertising. It then also adds in our claim expense ratio, excluding costs associated with settling catastrophe claims, which tend to be more variable. We believe this measure provides the best insight into the underlying expense trends within our Property-liability business. Through innovation and strong execution, we achieved 2.6 points of improvement when comparing 2020 to 2018 with further improvement occurring through the first 9 months of 2021. Over time, we expect to drive an additional three points of improvement from current levels achieving an adjusted expense ratio of approximately 23 by year-end 2024. This represents about a 6 point reduction relative to 2018 or an average of 1 point per year over 6 years, enabling an improved price position relative to our competitors. While maintaining attractive returns. Future cost reductions center around continued digital enhancements to automate processes enabling the retirement of legacy technology. Operating efficiency gains from combining organization, combining organizations and transforming the distribute -- the distribution model to higher growth and lower cost. Transitioning to slide 9, let's go up a level to show how transformative growth positions us for long-term success and how the components of transformative growth work together to create a flywheel of profitable growth. As you know, transformative growth is a multiyear initiative to increase personal property - liability market share, by building a low cost digital insurer with broad distribution. This will be accomplished by improving customer value, expanding customer access, increasing sophistication and investment in customer acquisition, and deploying a new technology ecosystem. We've made significant progress to date, across each component. Starting at the top of the flywheel visual, our commitment to further lower our costs, improves customer value and enables a more competitive price position while maintaining attractive returns. Enhancing and expanding distribution puts us in a position to take advantage of more affordable pricing. Increasing the analytical sophistication of new customer acquisitions let's cus -- let's consumers know about this better value proposition. New technology platforms' lower costs, has enable us to further broaden the solutions offered to property-liability customers. This flywheel will enable us to increase market share and create additional shareholder value. Turning to Slide 10, let's look at the changes to the distribution system, which are also underway. As you can see in the chart on the left side of the slide, Property-liability policies in force grew by 12.5% compared to the prior-year quarter. National General, which includes Encompass, contributed growth of 4 million policies and Allstate brand property liability policies increased by 231,000, driven by growth across personal lines. Allstate brand auto policies enforce increased slightly compared to the prior-year quarter. And sequentially for the third consecutive quarter, including growth of 142,000 policies compared to prior year-end. As you can see by the table on the lower left. The chart on the right shows a breakdown of personal auto new issued applications compared to the prior year. The middle section of the right chart shows Allstate brand impacts by channel, which in total generated a 5% increase in new business growth compared to the prior year. A 38% increase in the direct channel more than offset a slight decline from existing agents and volume that would have normally been generated by newly appointed agents. As you know, we significantly reduced the number of new Allstate agents being appointed beginning in early 2020, since we are developing a new agent model to drive higher growth at lower-cost. The addition of National General also added 502 thousand new auto applications in the quarter. Let me now turn it over to Mark to cover the remainder of the slides before we move to Q&A.
Mark Nogal: Thanks Mario. Moving to Slide 11, protection services continues to grow revenue and profit. Revenues, excluding the impact of realized gains and losses, increased 23.3% to $597 million in the third quarter. Protection Plans, net written premium increased by a $139 million due to the launch of the Home Depot relationships, focusing on appliances. Our quarterly net written premium is now 5.5 times the level of when the Company was acquired in 2017. Already expanded revenues due to the integration of LeadCloud and Transparently., which were acquired as part of the national general acquisition, as well as increased device sales driven by growth in the milewest product. Policies and force increased 12.5% to a 150 million driven by growth in Allstate Protection Plans and Allstate identity protection. Adjusted net income was $45 million in the third quarter, representing an increase of $5 million compared to the prior-year quarter, driven by higher profitability at Allstate identity protection in Arity. This was partially offset by higher operating costs and expenses related to investments and growth. Now let's shift to Slide 12, which highlights our investment performance. Net investment income totaled $764 million in the quarter, which was $300 million above the prior year quarter, driven by higher performance-based income as shown in the chart on the left. Performance-based income totaled $437 million in the quarter, as shown in gray, reflecting increases in private equity investments. As in prior quarters, several large idiosyncratic contributors had a meaningful impact on our results. These results represent a long-term and broad approach to growth investing, with nearly 90% of year-to-date performance-based income coming from assets with inception years of 2018 and prior. Market-based income, shown in blue, was $6 million below the prior-year quarter. The impact of reinvestment rates below the average interest-bearing portfolio yield, was somewhat mitigated in the quarter by higher average assets under management and prepayments fee income. Our total portfolio return was 1% in the third quarter and 3.3% year-to-date, reflecting income and changes in equity valuations partially offset by higher interest rates. We take an active approach to optimizing our returns per unit risk for appropriate investment horizons. Our investment activities are integrated into our overall enterprise risk and return process, and play an important role in generating shareholder value. While the performance-based investment results continued to be strong in the third quarter, we manage the portfolio with a longer-term view on returns. On the right, we have provided our annualized portfolio return in total, and by strategy over various time horizons. Consistent with broader public and private equity markets, our portfolio has experienced returns above our historical trend over the last several quarters. While prospective returns will depend on future economic and market conditions, we do expect our performance-based returns to moderate in line with our longer-term results. Now let's move to Slide 13, which highlights Allstate strong capital position. Allstate's balance sheet strength and excellent cash flow generation, provides strong cash returns to shareholders while investing in growth. Significant cash returns to shareholders, including $1.5 billion through a combination of share repurchases and common stock dividends occurred during the third quarter. Common shares outstanding have been reduced by 5% over the last 12 months. Already in the fourth quarter we successfully completed the acquisition of safe auto on October 1st for $262 million to leverage National General's integration capabilities and further increased personal lines market share. We also recently closed on the divestitures of Allstate Life Insurance Company in New York. These divestitures free up approximately $1.7 billion of deployable capital, which was factored into the $5 billion share repurchase program currently being executed. Turning to Slide 14, let's finish with a longer-term view of Allstate's focus on execution, innovation, and sustainable value creation. Allstate has an excellent track record of serving customers, earning attractive returns on risks, and delivering for shareholders, as you can see by the industry-leading statistics on the upper right. Innovation is also critical to the execution, and our proactive implementation of transformative growth has positioned us well to address the macroeconomic challenges facing our business today and in the future. Sustainable value creation also requires excellent capital management and governance. As an example, Allstate is in the top 15% of S&P 500 companies and cash returns to shareholders by providing an attractive dividend and repurchasing 25% and 50% of outstanding shares over the last 5 and 10 years respectively. Execution, innovation, and long-term value creation will continue to drive increased shareholder value. With that context, let's open the line for your questions.
Operator: [Operator Instructions]
Operator: Our first question comes from the line of Josh Inc. from Bank of America. Your question, please.
Joshua Shanker: Yes. Thank you. I want to talk about bundles and homeowners in the pricing of the dual engine of homeowners and auto together. I guess there's two things I want to understand. One is when a customer sees their overall bundled price going up, what does the conversation like, especially if you're trying to more centralized your business with a greater direct relationship with your customers. And 2, given Allstate's geographic footprint, can Allstate add incoming customers for homeowners without changing its cap footprint.
Tom Wilson: Good morning, Josh is Tom, I'll start and then Glenn can jump in first as you know, we've long been focused on bundling auto and homeowners because those are good, stable, long-term customers. You do get a discount for putting those two together. So there's an advantage to the customer from buying it and putting it all in one place besides just having 1 point of contact. And we've been good at that. If you look at our growth in Homeowners this year. It's higher than our growth in auto insurance. And data appears to be because we are doing more bundling of individual customers, it a little hard to get the exact attribution, but we feel good about what our agents are doing to drive that. As it relates to the Gross event. We've been we've repositioned as business over multiple years back in the middle -- late 2 thousand decade of 2,000, we've made of course a bunch of money since over the last eight or nine years, I think almost $9 billion of underwriting income on homeowners which you need to do because we don't believe that a 4 point margin is attractive for homeowners for a couple of reasons. One is you don't get much investment income. Secondly, you got to put up more capital because the results are more volatile and you have the big tail losses. So as we seek to grow it, we bring all of that math to bear. On individual states is where we grow. And so if there's a state where even if there's a fair amount of catastrophe exposure but we think we can get a good return, that's got a margin on it that compensates us for the capital we have to put up and the reinsurance we have to buy, then we'll do that. And we're highly sophisticated in the way we run it. So the geographic focus is really -- we have a much highly sophisticated model into it. On the direct business, you don't sell as much direct homeowners right now, we still need to crack the code on that. Before I -- Glenn will have some view on how we can continue to run the table in homeowners as we have so far. But the -- an upcoming thing that Glenn might want to touch on, is what we're doing in the independent agent channel because of the National General platform gives us, with our products, our expertise, our pricing, our claims management. And our reinsurance programs gives us the ability to really serve a lot of customers. [Indiscernible]
Joshua Shanker: Glenn, where [Indiscernible] I just want to say, can you address retention and cat footprints as well?
Tom Wilson: Yeah. Glenn, mind if you take both of those?
Glenn Shapiro: Sure. So a few comments on homeowners leading into it, but we got a really strong home care business and so we want to grow it, and we want to handle it as Tom said. So, over the course of the past year, we've deepened bundling discounts. So we've made it more attractive for customers across 30 states. We've shifted our agency competition over the last couple of years to where it's more attractive for them to bundle. And the same is true in direct, as Tom said, we're looking to crack the code right board there. Were writing some, We want to write more, and so some of the incentives for our direct team around cross quoting and bundling. To the point around that footprint, We're in good shape. Like, if you look at our ability to write business, we can write it pretty broadly. We can write in some CAT-prone areas, but we tend to offset it and create the diversity of our book by writing in other areas. I mean, right now, we're on a 12-month view right now, we're at 93.8 combined ratio made about $400 million underwriting profit in the last 12 months, in spite of having some really big CAT quarters. Though it's a good business that we're able to consistently make money in, and so we're looking to grow it. But as Tom said, we have -- we have pretty stringent guidelines, that where we write, how we write so that we don't overgrown in CAT prone areas. But we're able to grow without that and Tom mentioned something that I want to come back to. In terms of the breadth of our distribution and growing and that would be into our IA channel. You know, the IA channel is a huge opportunity. Independent agents where a lot of homeowners and our National General and Allstate's Company, as it will be branded, is adding our middle market products, both auto and home. And we have sort of a whole new Greenfield there to run in. And that would be a broad geographic spread, not just the cat prone areas.
Tom Wilson: Hey [Indiscernible] let me just ask that because I think I understand why you're trying to triangulate between what's going on in the industry. First, we don't have a catastrophe exposure problem. We don't have a profitability problem. We believe in homeowners. We only made about -- we lost about $16 million bucks and $7.3 billion so far this year. So we'd like to make more money, but as Glenn pointed out, when you look over a longer period of time, we've had a fair amount of ups and downs, but we still make underwriting profit sense of 12-month basis. So we don't have a catastrophe problem. So we don't have to restrict stuff and end up with -- what you're poking at is retention issues. We have been there and done that though And it was called the repositioning we did in the latter part of the decade I mentioned. And when you call a customer and say, I used to have -- you used to be insured with us and now I am not going to insure your thoughts and we were one of the biggest brokers have homeowners insurance products. I think in the country and maybe Vegas. And through our advantage in even when you say to people, here's another Company. It has some impact on your auto business. So because people are like, Well, I'll take my business someplace else or competitors decide they want to, they want to bundle and they'll go get those customers as well. We had some issues with auto growth when we were downsizing. We went down by 2 million policies in the homeowner's business over a 4, 5 year-period. It does hurt. It's manageable. I can't speak for what our competitors are going to do. What I do know is what Glenn said, which is we got a good business, we know how to run it. We have growth opportunities, and we're looking forward to serving more customers and make more money for our shareholders along the way.
Joshua Shanker: Thank you.
Operator: Thank you. Our next question comes from the line of Greg Peters from Raymond James. Your question, please.
Greg Peters: Good morning. I'd like to turn your attention to Page 7, and I was particularly struck by your chart where you've identified the rate increases you've deployed, and then ones that you're going to be implementing. And I was wondering if you could provide us some perspective on -- given the fact that severity has been so substantial, where you think that's going to go with other states? It feels like this is going to be an ongoing reset of pricing as we go through most of next year. And against that backdrop, just how you think about your competitive positioning when most of the industry is going to be raising rates.
Tom Wilson: Let me -- maybe -- let me start and then, Glenn, why don't you jump in on what you are doing individually. I think you are right about that. There seems to be this -- a threat going through the markets today. And this is kind of a once and done. And we don't necessarily see it that way. I mean, I think there's never bold enough to decide in claim, we're ahead or of anybody else. Because firstly, I'd assumes everybody is in the same place. Secondly, assumes the same trends are going to happen and third is that those trends are going to end and the answer is we don't know when they will do. What we do know is what we can do differently. And we do know that some of our competitors had frequency increases sooner than we did so that you would expect them to raise prices sooner than we did. We do think that we have a good plan in place and Glenn can take you through that, which is to make sure we get attractive returns in auto insurance, which is a key component of what we do in terms of delivering value for shareholders. We are all over that and we will go -- where -- how that will move forward in terms of competitive position. And that's also hard to tell, what I do know is that I'm really glad we started transformative growth 2 years ago. And the cost reductions we already have in place certainly have benefited us. It's positioned us to be able to grow through many different venues, so we can dial growth up if we choose to do that. I'm really glad we are where we are and we're positioned to take share in the future, which of course, our strategy. But we want to do that profitably. Glenn, do you want to talk about your plans getting the auto insurance returns back to where they have been historically?
Glenn Shapiro: Yes. Absolutely. So thanks, Greg. And you hit a couple of important points that you're right about that everyone or close to everyone is going to have to take rate. When you talk about competitive position. So we think about that as part of process. But this is broad and this is going to be around for a while, like everything you look at in terms of what the root causes of severity, which is in its simplest terms, is the price of used cars. I would like to talk about collision coverage as it's a coverage that doesn't really have a policy limit that's dated other than the value of the vehicle itself. So in real turn, our policy limit on that coverage went up by 40% plus with no change in premium. And that experience happened to everybody across the industry. So it's a rarity where you have something is Clean and clean as that that is a root cause to your severity changes. So we think it will be around for a bit and we're going after rate to address that has one of the levers and we've talked about our claims capabilities and certainly our expense reductions as other ones. So in the third quarter, we took 12 price increases that went effective in the third quarter and other 8 in the fourth quarter so far with more to come. So this is broad and we'll be doing it just about everywhere. And I think the key from a competitive position is that we made a lot progress. So our starting point, we made significant progress over the last year with the expenses we've taken out, and therefore the competitive position we were in improved significantly. Our close rates improved significantly, leading to some of the greater new business that you saw. And so as we take rates and other due. It's our goal certainly keep that competitive position gain that we've made. But the primary goal is to get our margins back to where they need to be. And that's why we're going after rate, we're doing it pretty proactively.
Greg Peters: Great. Thanks for the color on that. I wanted to pivot to Slide 8, which is, I think another really important slide in your presentation. And just to step back and recognize the long-term objective that you've introduced is pretty striking. I feel like when we get to 2024, if you've achieved that objective, that will put you clearly among the leaders in terms of a lowest adjusted expense ratio in the marketplace. I'm sure a lot of thought went into this. Can you give us some more color on where the improvement, where you're going to get the most leverage in terms of the expense ratio improvements, where it's going to come from. And then maybe also include some comments on the advertising expense because that's not included in this.
Tom Wilson: Mario, do you want to start with the components of the cost reduction and now come back to advertisement?
Mario Rizzo: Sure. So Greg, thanks for the question and the acknowledgement of the progress we've made. I guess, why it start is maybe to just kind of go up a level and reiterate again what our objective in reducing costs really is, which is to enhance customer value by improving our competitive price position. And we're going to do that by continuing to drive down the expense component of our combined ratio, which is inclusive of both underwriting and claim expenses and to your point, we've made really good progress over the past several years. And in addition to the progress we've made, we've created plans and have line of sight to the additional 3-point objective that we've got by 2024, by focusing on things like digitizing processes to improve efficiency by continuing -- as we do that, create opportunity to retire legacy technology to capture the synergies associated with the National General acquisition, to continue to drive down distribution costs as we've talked about creating a more productive but lower-cost distribution model. So we've got opportunity in both the -- from an operating cost perspective and both the underwriting and the claim side. And we've got a plan on how to get there, and that's why we established a goal and we think once we can get the additional 3 points out of our cost structure, it's really going to position us well relative to our competitors, to have a more competitive price point, to deliver higher customer value and really position ourselves to accelerate growth.
Tom Wilson: So let me go to advertising then. Let me start with we didn't do transformative growth because of the pandemic, but boy, I am sure glad we got started on transformative growth when we did because we were able to reposition the brand. We invested over $250 million in repositioning the brand, do advertising, testing out new, more sophisticated ways to do it. And we did it when frequency was low, so we were able to use some of that reduction in frequency, the margin it's created, to invest in long-term growth by repositioning the brand. When you look at transfer on breast for a simple right, you get a more competitive price, you have more places to buy it. You let people know about that the increase in advertising, that or restocking that. What we do in the future will be depending how much we want to grow. So as we move forward, I think our advertising will be flat or come down some, because we want to make sure we've got the pricing right. The point that came up earlier about the longevity of the how long will severity keep come up. You want to make sure you've got that pricing right before you go out and get that flywheel going by doing more advertising. That said, we're always going to do a lot of advertising because as you know, it is a marketing war really out there between some of the large players. But the other part that's not as well known is it's getting every bit as sophisticated as auto insurance in home prices. You really got to be good with your math and whether it's upper funnel, lower funnel, getting the right price to the right customer, at the right time, in the right space is complicated. And so the other thing we've been working on is building out the sophistication, so that every dollar of advertising investment we spend is well done. The reason we took it out of the expense ratio guidance was because it is more volatile and it has penned down on what kind of growth we're looking to achieve in that quarter. And this is a measure of really how effectively running the business, like how are you keeping your costs down for your customers see can't hit at competitive price.
Greg Peters: Thank you for your answers.
Operator: Thank you. Our next question comes from the line of a Elyse Greenspan from Wells Fargo. Your question, please.
Elyse Greenspan: All right, thanks. Good morning. My first question was on the growth in new business that you guys saw in direct in the quarter. I know from commentary, you guys started to take price during the quarter and then more is on the [Indiscernible], but I was a little bit surprised with the level of growth you saw there, given the increase, the loss trend that you're mentioning. Can you expand upon that? And would you expect a new business growth on the direct side to slow as you push for additional ways through this system?
Tom Wilson: Elyse, let me give that to Glenn and just -- but Glenn and his team have done a fabulous job in getting us better at direct. Some of the growth that you see is because of the advertisement we talked about, some of the growth you see is we're just getting a lot better at it. And so once we put the Allstate brand on in Glenn study to combine capabilities. We've just -- we're getting much more effective at what we've closed on, and what we've closed in the cost. Glenn when you want to talk about the prospects for address?
Glenn Shapiro: Yeah. I agree there any Tom just said I think we've got really nice prospect because I would say we're making up ground in dog years because we have what we're 20 years newer at doing directed the Allstate brands and some of our competitors. But we're making up chunks of that capability as we move a year-and-a-half into the launching with Allstate brand in direct. The effectiveness of our sales, whether it be our call centers, or on the web, etc., our marketing sophistication, our partners with marketing, all of those things getting better and that helps move it up. The other thing is, actually in this price environment that's going to be disrupted, we're really likely to see some tailwind in new business, but some headwind in retention. Because if we were in a situation where we're the only ones taking rate, you might expect the opposite. But with a whole bunch of people having to take rate that will create a lot of shoppers, we'll create shoppers of our own too, because it disrupts our own customers. And when people shop, they often find a better price for situation. Even in a rising environment like this. So there will be a lot of customers shopping, ours, and other companies. And so, it's an opportunity as Tom said, to leverage what we did and say we're really happy we did transformative growth when we did because we have more ways for customers to buy when that disruptive market happens.
Elyse Greenspan: Thanks. And then my second question on, just in terms of rate, I believe the majority of your auto policies is six months, so correct me if I'm wrong there, but as we think about the rate going to this system, what you've done in the third quarter, the fourth quarter, and expectations for next year. How long would you -- do you think it will take to get back to your target margins, is it kind of a 6 month to 12 months situation? I know you don't have a specific target margins for Property-liability. We've gone to an overall awry, but we think about putting your margins at an acceptable level that we think that that would come over the next 6 to 12 months or can you give us the time range there?
Tom Wilson: I don't think you can do a time range on it, because I don't think we can predict what's going to happen in the future on the inflationary pressures. What we can do is say, we're going to go at this aggressively as soon as we can get there. That will be -- we're going to hustle as Glenn to get it. Well, as he said, his priority is auto insurance margins on that part of the business. We got lots of other priorities to look at. But when you look at inflation, I'm not in the camp that the inflationary, like used car prices are suddenly going to go back down. I think you buy a car for $14,000 and use a cost of $10,000, Like, you're not thinking it's worth $10,000 no matter what the Fed and everybody else thinks about it being transitory. I think the same thing is true with when you look at parts prices. Parts prices, it's not like the oil market where prices are -- the system is built to go up and down everyday, it gets embedded in there. The dealers buy inventories, people, distributors buy inventory, they price that. So we don't really see that being transitory and coming down. How long it will take to work all the way through the system, what opportunities the OEs will take to push prices farther up Is really unknown at this part. So it's hard to determine when they will cross, what you do know is at least in it's half-life, just going to keep going up. As long as we see movement in the bottom line. And it will keep going up until the bottom-line plans out, that being the bottom line is being lost cost. And that top-line then will keep going past their point in time until we get back to the margins. But when we get back to the same underwriting margin on a dollar basis, or a percentage basis on auto insurance. You can't really predict until you can have a better handle on where frequency [Indiscernible]. Glenn, anything you would add to that?
Glenn Shapiro: I know that the only thing I would add would be that the tactical answer on the rates, because completely agree. We don't know what the bottom line will do exactly, so we'll have to keep moving those and adjust. But the tactical answer on the rates, you're correct, Elyse, its 6 months in almost all of our states and all of our policy. So it's about 6 months from the effective date to get all customers paying that. And then another 6 months from the point they start paying it to where the full premium has been earnings for one policy period. So you really start to see the effect of the rates starting at the beginning of the year, but more impactfully in the second and third quarters of next year.
Elyse Greenspan: Okay. Thanks for the color.
Operator: Thank you, our next question comes from the line of Michael Phillips from Morgan Stanley. Your question, please.
Michael Phillips: Thanks, good morning, everybody. I think Glenn answered this question, but just want to be sure. I'm going to ask First Quarter, Second Quarter you were taking some targeted rate costs and now you're not. And I think Glenn said rate increases that are going to continue are going to be I think you said just about everywhere. I Just want to confirm that because I guess the question would be, how much of an overlap would there be in states where you took previous rate cuts -- pretty recent rate cuts, and now moving upward in those same states, is there overlap there in those states? I'm asking because of what that means to consumer impact on maybe retentions, seeing gyrations down and back up again. And then also if there is overlap there, what it means for, just something that Tom said, make sure we have pricing rates to confidence around our current rates.
Tom Wilson: Glenn do you want to take that?
Glenn Shapiro: Sure. So the short answer to your question would be yes, there will be increases in places where there were modest decreases. I do think we waited a little while to really see what was happening with the frequency and ensure that it was long-standing and has remained a long-standing benefit before taking them. And we were modest and we've done some pretty significant givebacks into shelter in place, get it back, which were one-time and not sort of durable discount. Actually changing rates and moving them down, we were more subtle with and more modest with. I don't think people will see a wild swing down and backup, but they will see it in same-state. And the simple fact is, as you saw on the chart, I believe just on page -- bottom page 7, that used car prices spiked dramatically in the second quarter. And those spike, and then people start having claims. And then those claims start to be paid, working their way into the loss costs, and you have this hyper inflationary environment on auto physical damage lines. So it's just the appropriate response at the appropriate time for it. And we'll do everything we can to maintain our retention. It's one of the wonderful things -- one of the many wonderful things about our agency force. Our agency force do a really good job of building relationships and talking customers through changes in their policies, and helping us through things like this.
Michael Phillips: Okay. Thank you very much for that. The second question, a different one on Arity. I guess I'm curious how you think about Arity. Do you think of it as either a more of a use it for our own pricing and telematics business, or that plus [Indiscernible] it off to others and having more of a income-generating machine? It's still not giving you a lot of lift on that second piece, but do you think of it more that way longer-term? And we've seen more and more Companies go the route. You are about the only one that isn't. the go the route of farming that business off, Hartford just announced that recently were they farmed it off, and more and more companies are doing that. So how do you think about Arity? Is it more just for your own pricing or do you want to have it be more of a, again, an income generating machine as well?
Tom Wilson: Michael, thank you for asking about something other than auto insurance margins, because we have a lot of good things going on, one of which is Arity, which a significant value has been created with Arity, both in the insurance business and outside the insurance business. And I don't think that's been reviewed by any analysts as if it was a separate Company. I mean, we have 600 billion miles of data. We risk scoring the operation. We help people do marketing, more effectively and efficiently. And so we're really building quite a platform that will do a number of things. One is it does exactly what you've talked about, which is -- and the way we started, it was telematics as a service for us. We needed somebody to collect the data. We needed to get a mobile app up. We needed to put it in files and be able to do something with it. And so rather than do that inside the insurance Company, we decided to do it outside the insurance Company because we said this is -- at the point, we said this is Basically a service at other insurance companies will need and we can provide to them and we do. So. Arity provides that service to some other insurance companies, and we're working to try to expand that effort for them. But it moved beyond what I would just call telematics as a service, help me pull data in to figure out all my customers are doing too. We started collecting more data from ourselves and built a rating service organization so that we can help other insurance companies use telematics to price the insurance. We believe that they're going to get their capability anyway. So we think that we might as well do it through Arity, and capture addition -- additional margin, rather than just assumed that we can take over a 100% of the insurance industry. But being a leader in telematics, which we are, but we don't think we can get the entire market share. So we created a rating services organization around that. It's then been expanded to include really lead generation. As we started collecting more data. So we have data from the Allstate customers, we have data because we have our SDK embedded in other people's thoughts. We have had data and I think it's over 25 million cars were pulling every day, really high fidelity data that's in the same format. We also buy data that we're able to combine with that 25 million on an over another 75 million current. So we're pulling data on a 100 million cars per day right now. And so we're building this rating services organization for all state and other insurers so that we can not only do telematics to the servers. We can do that. We think we can actually work to help people pre -qualify buyers and it's called the Arity IQ. So significant value has been created. I don't think that shows up in shareholder value today because I don't really see any of the analysts really looking hard and saying what's it worth, but we think it's substantial value and we expect to continue to grow their business and expand its total addressable market.
Michael Phillips: Okay Tom. Thank you very much.
Operator: Thank you. Our next question comes from the line of David Motemaden from Evercore ISI. Your question, please.
David Motemaden: Hi, thanks. Good morning. I had a question on, I think it was Slide 7, where you show the around a 7% rate increase that you are asking for. I guess that feels high to me, especially considering that the loss ratio, if I take out the reserve charge, was only about 1.5 points higher than the third quarter of 2019. And then also, considering the expense initiatives that you guys have taken to-date, I guess my thought was -- I thought that the expense plan would maybe help reduce the amount of rate that you guys would need to take. I guess -- is that the right way of thinking about it or is it too uncertain at this time and you guys just want to get in front of what might be coming down the road in terms of future loss cost increases?
Tom Wilson: Well, it's an accurate call-out, David, that the future expense reductions will certainly help us manage profitability. But we're increasing the price is now because we do want to grow profitably. But being unclear as to where this inflation will sort out, we're being what we think is fair and appropriate, as opposed to overlay aggressive in increasing prices now. As to the extent in the future, we don't need that as much in our expenses come down. Then we can improve our competitive position, which we've been -- we've improved our competitive position pretty significantly in 2021. and we don't want to give that up. And we'd like to continue to improve it as so we get that flywheel of growth going. But in this case, we're using the expense reductions for future competitive price improvement as opposed to saying, we don't need to raise prices because loss costs are [Indiscernible] Glenn or Mario anything you would add to that?
Glenn Shapiro: The only thing I'd add is, it is -- it is pretty easy to get negative rates in approved and in market very quickly. And as we talked about in one of the prior answers, it takes time for them to earn in. So we're projecting future loss costs out over the course of the next year and years and taking rate that we think best reflects our best estimates of what we're going to need to deliver the right returns. So it would be a good situation to get into to where we were we slightly overshot and could dial it back. But as Tom said, there's a lot of questions still on where this severity will -- Inflation for severity will end.
Tom Wilson: At some point, Glenn. Look, we need to make money in auto insurance, David, and we're going to do that. I think we're out of time, so let me just say as we move forward, you should expect us, as you've heard throughout this call, to focus on improving returns in auto insurance. At the same time, we're not letting up on any of the components of increasing our market share and personal property-liability, or expanding circle of protection. All of which we've had really good progress and success on this year and in this quarter, so you should expect us to continue to focus on a broad-based approach to increasing shareholder value. So thank you for your engagement with us again, and we will talk to you next quarter.
Operator: Thank you, ladies and gentlemen for your participation at today's conference. This does conclude the program. You may now disconnect. Good day. | [
{
"speaker": "Operator",
"text": "Thank you for standing by and welcome to the Allstate Third Quarter 2021Eearnings Conference Call. At this time, all participants are in a listen-only mode. After the speakers presentation, there will be a question-and-answer session. [Operator Instructions] As a reminder, today's program is being recorded. I would now like to introduce your host for today's program, Mark Nogal, Head of Investor Relations. Please go ahead, sir."
},
{
"speaker": "Mark Nogal",
"text": "Thank you, Jonathan. Good morning. Welcome to Allstate's Third Quarter 2021 Earnings Conference Call. After prepared remarks, we will have a question-and-answer session. Yesterday following the close of the market, we issued our news release and investor supplement and we posted related materials to our website @allstateinvestors.com. our management team is here to provide perspective on these results. As noted on the first slide of the presentation, our discussion will contain non-GAAP measures for which there are reconciliations in the news release and the investor supplement and forward-looking statements on Allstate's operations. Allstate's results may differ materially from these statements, so please refer to our 10-K for 2020 and other public documents for information on potential risks. And now, I'll turn it over to Tom."
},
{
"speaker": "Tom Wilson",
"text": "Well, good morning and thank you for investing your time with us today. Let's start on Slide 2. This is Allstate strategy on the left-hand side, which we've talked about before. We have two components; increased personal profit liability market share, and expanded protection solutions. And those are the two ovals you see on the left with the intersection between. The key third quarter results are highlighted on the right-hand panel. Property-liability policies and force increased by 12.5%. Allstate Protection Plans continue to grow rapidly by both broadening its product offering and expanding the network of retail providers. As a result, we now have almost a 192 million policies force across the [Indiscernible]. Financially, the results were more mixed. Revenues were up substantially, but net income and adjusted net income declined from the prior year quarter. Underwriting income declined primarily due to higher loss costs of settling auto insurance claims. We've implemented price increases to proactively respond to the sharp rise in loss costs and transformative growth continues to position us for long-term success, both of which we'll talk about in a couple of minutes. This was partially offset by the benefits from our long-term risk and return program that includes significant reinsurance recoverable, they were primarily related to Hurricane Ida, and a substantial increase in performance-based investment income. Capital deployment results were excellent with a billion-and-a-half dollars in cash return to shareholders in the quarter. We also completed the divestitures of our two largest life and annuity businesses, one in October and then one just earlier this week. So let's go to Slide 3. Revenues of $12.5 billion in the quarter increased 16.9% compared to the prior-year quarter. And that reflects both the higher earned premiums in National General acquisition. Allstate brand homeowners premium growth, and higher net investment income, property liability premiums, and policies and force increased 13.5%, and 12.5% respectively. Net investment income was $764 million, and that's up almost [Indiscernible] by $300 million compared to the prior-year quarter, reflecting strong results from the performance-based portfolio. Net Income was $508 million in the quarter. And that's compared to a billion 1 in the prior quarter as lower underwriting income was partially offset by the higher investment income. Adjusted net income was $217 million or $0.73 per diluted share and decreased $683 million compared to the prior-year quarter, reflecting the lower underwriting income due to the higher auto and homeowners insurance loss costs. Net income for the first 9 months of 2021 was below the prior year, and it's largely due to the loss on the sale of the life annuity business which we recorded earlier in the year. Adjusted net income was $10.70 per share for the first nine months. That was above the prior year as higher investment income and lower expenses, more than offset higher loss costs. Let's turn to slide 4. How I would do is put the pandemic in the longitudinal perspective because this created volatility for our results. And it obviously requires us to adapt quickly, which we do. But before we go through the impact on the third quarter results of the supply chain disruptions, let's talk about the initial and subsequent impact of the pandemic. So in 2020, the economic lockdown resulted in fewer miles being driven and promoted -- and prompted an aggressive economic support response from really governments around the world. The impact on auto insurance was a dramatic drop in the number of accidents. And of course, due to this unprecedented driving frequency, we've proactively provided our customers with some money back which increased customer retention. Since then, and since there was less road congestion and fewer accidents that occurred during commuting hours, the average speed in severity of auto claims increased, offsetting some of the frequency benefits. Nevertheless, underwriting margins improved dramatically, so we introduced a temporary shelter in place payback rather than take a permanent rate reduction, and took some modest overall reductions in rate level. This year, as you can see from the right-hand column, the story has been just the opposite as it relates to frequency, with large percentage increases. And while the overall level of accident frequency for the Allstate brand is still below pre -pandemic levels, the national and general non-standard business is back to the levels before the pandemic. Auto severity this year, however, has been dramatically impacted by the supply chain disruption and price increases on used cars and original equipment parts in Mario will take you through that in a couple of slides. From a pricing perspective, this results in moving from modest rate reductions to significant increases on auto insurance prices. From a growth standpoint at the off set of the pandemic, we begin to see material increase in the consumer acceptance to telematics. And we've really leaned into that with our Milewise product, which is really the only national product out there to pay for the mile. And that's led to substantial increase in debt telematics products. Now, the pandemic has also had a significant impact on the investment portfolio and this is a tale of the beginning of the end as well. So early in the crisis, equity valuations were down and it had a negative impact on investment results. Then of course, we have a broad-based long-term spread out over a decade, really investing in these kinds of funds. And so we do it on a long-term basis, whether that's 3, 5, or 10 years. But so what's happened this year, of course, is we've had the opposite happen, which is with the economic stimulus, we've had equity evaluations going after and our returns have come back strongly. In the market-based portfolio, lower interest rates at the onset of this pandemic did lead to an increase in the unrealized gains in the portfolio. But of course, what that does is reduce future interest rate income, which you see slight decline in this quarter. And many of our other businesses that have been impacted, some positively, some negatively. But it's our ability to adapt and seize the opportunities that are presented that create shareholder result So Mario will now go through the third quarter results in more detail and how transformative growth positions Allstate for continued success."
},
{
"speaker": "Mario Rizzo",
"text": "Thanks, Tom. Let's move to Slide 5 to review property-liability margin results in the third quarter. The recorded combined ratio of 105.3 increased 13.7 points compared to the prior year quarter. This was primarily driven by increased underlying losses, as well as higher catastrophe losses and non-catastrophe prior year reserve re-estimates. The chart at the bottom of the slide quantifies the impact of each component in the third quarter compared to the prior year quarter. As you can see, the personal auto underlying loss ratio drove most of the increase, due to higher auto accident frequency and the inflationary impacts on auto severity. Higher catastrophe losses shown in the middle of the chart, had a negative 1.4 impact on the combined ratio, as favorable reserve re-estimates recorded in 2020 from wildfires subrogation settlements, positively impacted the prior year quarter. Gross catastrophe losses were higher, but were reduced by nearly $1 billion of net reinsurance recoveries following Hurricane Ida, demonstrated the benefits of our long-term approach to risk and return management of the homeowners insurance business and our comprehensive reinsurance program. Non-catastrophe prior-year reserve strengthening of a $162 million in the quarter drove an adverse impact of 0.8 points, primarily from increases in auto and commercial lines. This also included $111 million of strengthening in the quarter related to asbestos, environmental, and other reserves in the runoff property-liability segment, following our annual comprehensive reserve review. This was partially offset by a lower expense ratio when excluding the impact of amortization of purchased intangibles, primarily due to lower restructuring and related charges compared to the prior-year quarter. Moving to Slide 6, let's go a bit deeper on auto insurance profitability. Allstate brand auto insurance underlying combined ratio finished at 97.5 for the quarter and 89.7 over the first 9 months of 2021. The increase to the prior year quarter reflects higher loss -- loss costs due to higher accident frequency, increased severity, and competitive pricing enhancements implemented in late 2020 and earlier this year. While claim frequency increased relative to prior year, we continue to experience favorable trends relative to pre -pandemic levels. Allstate brand auto property damage frequency increased 16.6% compared to 2020, but decreased 16.8% relative to 2019. The chart on the lower left compares the underlying combined ratio for the third quarter of 2019 to this quarter, to remove some of the short-term pandemic volatility. The underlying combined ratio was 93.1 in 2019, which generates an attractive return on capital. Favorable auto frequency in the third quarter of 2021, lowered the combined ratio by 6.4 points compared to 2019. Increased auto claim severity, however, increased the combined ratio by 12 points versus 2 years ago, as you can see from the red bar. The cost reductions implemented as part of transformative growth, reduced expenses by 1.3 points, which favorably impacted 2021 results. As Tom mentioned, early in the pandemic, the severity increases were driven by higher average losses due to a reduction in low severity claims. This year, the increase reflects the impact of supply chain disruptions in the auto markets, which has increased used car prices and enabled original equipment manufacturers to significantly increased part prices. The chart on the lower right, shows used car values began increasing above the CPI in late 2020, which accelerated in 2021, resulting in an increase of 44% since the beginning of 2019. Similarly, OEM parts have also increased in 2021, roughly twice as much as core CPI. This has resulted in higher severities for both total loss vehicles and repairable vehicles. Since these increases were accelerating throughout the second and third quarters of the year, we Increased expected loss costs for the first 2 quarters of 2021. And this prior quarter strengthening shows up in the combined ratio for the third quarter. Increases in report year severities for auto insurance claims during the first two quarters of 2021, increased the third quarter combined ratio by 2.6 points, as you can see by the green bar on the lower left. So let's flip to Slide 7, which lays out the steps we're taking to improve auto profitability. As you can see from the chart on the top, Allstate has maintained industry-leading auto insurance margins over a long period of time with a combined ratio operating range in the mid-90s, exhibiting strong execution and operational expertise. To maintain industry-leading results, we are increasing rates, improving claims effectiveness, and continuing to lower costs. After lowering prices in early 2021 to reflect in part Allstate 's lower expense ratio, we have proactively been responding with increases in the third quarter with actions continuing into the fourth quarter and into 2022. The chart on the right provides selected rate increases already implemented in the third and Fourth Quarter, as well as publicly filed rates that have yet to be implemented in the Fourth Quarter. Those states denoted with a carrot, our top ten states in terms of written premium as of year-end 2020 in the third quarter we received rate approvals for increases in 12 states, primarily in September. We adapted quickly to higher severities in the Fourth Quarter with plans to file rates in an additional 20 states. We have already implemented rate increases in 8 states during the Fourth Quarter with an average increase of 6.7% 7% as of November first, looking ahead, we expect to pursue price increases in an additional 12 locations by year-end. We are working closely with state regulators to provide detailed support and decrease the lag time between filing, implementation, and premium generation. As we move into next year, it is likely auto insurance prices will continue to be increased to reflect higher severities. We also continue to leverage advanced claims capabilities and process efficiencies. Cost reductions as part of transformative growth will also continue to be implemented. Let's turn to slide 8 and discuss our expectations and commitment to further improve our cost structure through transformative growth. As you can see by the chart on the bottom of the slide, we've defined a new non-GAAP measure this quarter, referred to as the adjusted expense ratio. This starts with our underwriting expense ratio excluding restructuring, coronavirus related expenses, amortization, and impairment of purchased intangibles, and investments in advertising. It then also adds in our claim expense ratio, excluding costs associated with settling catastrophe claims, which tend to be more variable. We believe this measure provides the best insight into the underlying expense trends within our Property-liability business. Through innovation and strong execution, we achieved 2.6 points of improvement when comparing 2020 to 2018 with further improvement occurring through the first 9 months of 2021. Over time, we expect to drive an additional three points of improvement from current levels achieving an adjusted expense ratio of approximately 23 by year-end 2024. This represents about a 6 point reduction relative to 2018 or an average of 1 point per year over 6 years, enabling an improved price position relative to our competitors. While maintaining attractive returns. Future cost reductions center around continued digital enhancements to automate processes enabling the retirement of legacy technology. Operating efficiency gains from combining organization, combining organizations and transforming the distribute -- the distribution model to higher growth and lower cost. Transitioning to slide 9, let's go up a level to show how transformative growth positions us for long-term success and how the components of transformative growth work together to create a flywheel of profitable growth. As you know, transformative growth is a multiyear initiative to increase personal property - liability market share, by building a low cost digital insurer with broad distribution. This will be accomplished by improving customer value, expanding customer access, increasing sophistication and investment in customer acquisition, and deploying a new technology ecosystem. We've made significant progress to date, across each component. Starting at the top of the flywheel visual, our commitment to further lower our costs, improves customer value and enables a more competitive price position while maintaining attractive returns. Enhancing and expanding distribution puts us in a position to take advantage of more affordable pricing. Increasing the analytical sophistication of new customer acquisitions let's cus -- let's consumers know about this better value proposition. New technology platforms' lower costs, has enable us to further broaden the solutions offered to property-liability customers. This flywheel will enable us to increase market share and create additional shareholder value. Turning to Slide 10, let's look at the changes to the distribution system, which are also underway. As you can see in the chart on the left side of the slide, Property-liability policies in force grew by 12.5% compared to the prior-year quarter. National General, which includes Encompass, contributed growth of 4 million policies and Allstate brand property liability policies increased by 231,000, driven by growth across personal lines. Allstate brand auto policies enforce increased slightly compared to the prior-year quarter. And sequentially for the third consecutive quarter, including growth of 142,000 policies compared to prior year-end. As you can see by the table on the lower left. The chart on the right shows a breakdown of personal auto new issued applications compared to the prior year. The middle section of the right chart shows Allstate brand impacts by channel, which in total generated a 5% increase in new business growth compared to the prior year. A 38% increase in the direct channel more than offset a slight decline from existing agents and volume that would have normally been generated by newly appointed agents. As you know, we significantly reduced the number of new Allstate agents being appointed beginning in early 2020, since we are developing a new agent model to drive higher growth at lower-cost. The addition of National General also added 502 thousand new auto applications in the quarter. Let me now turn it over to Mark to cover the remainder of the slides before we move to Q&A."
},
{
"speaker": "Mark Nogal",
"text": "Thanks Mario. Moving to Slide 11, protection services continues to grow revenue and profit. Revenues, excluding the impact of realized gains and losses, increased 23.3% to $597 million in the third quarter. Protection Plans, net written premium increased by a $139 million due to the launch of the Home Depot relationships, focusing on appliances. Our quarterly net written premium is now 5.5 times the level of when the Company was acquired in 2017. Already expanded revenues due to the integration of LeadCloud and Transparently., which were acquired as part of the national general acquisition, as well as increased device sales driven by growth in the milewest product. Policies and force increased 12.5% to a 150 million driven by growth in Allstate Protection Plans and Allstate identity protection. Adjusted net income was $45 million in the third quarter, representing an increase of $5 million compared to the prior-year quarter, driven by higher profitability at Allstate identity protection in Arity. This was partially offset by higher operating costs and expenses related to investments and growth. Now let's shift to Slide 12, which highlights our investment performance. Net investment income totaled $764 million in the quarter, which was $300 million above the prior year quarter, driven by higher performance-based income as shown in the chart on the left. Performance-based income totaled $437 million in the quarter, as shown in gray, reflecting increases in private equity investments. As in prior quarters, several large idiosyncratic contributors had a meaningful impact on our results. These results represent a long-term and broad approach to growth investing, with nearly 90% of year-to-date performance-based income coming from assets with inception years of 2018 and prior. Market-based income, shown in blue, was $6 million below the prior-year quarter. The impact of reinvestment rates below the average interest-bearing portfolio yield, was somewhat mitigated in the quarter by higher average assets under management and prepayments fee income. Our total portfolio return was 1% in the third quarter and 3.3% year-to-date, reflecting income and changes in equity valuations partially offset by higher interest rates. We take an active approach to optimizing our returns per unit risk for appropriate investment horizons. Our investment activities are integrated into our overall enterprise risk and return process, and play an important role in generating shareholder value. While the performance-based investment results continued to be strong in the third quarter, we manage the portfolio with a longer-term view on returns. On the right, we have provided our annualized portfolio return in total, and by strategy over various time horizons. Consistent with broader public and private equity markets, our portfolio has experienced returns above our historical trend over the last several quarters. While prospective returns will depend on future economic and market conditions, we do expect our performance-based returns to moderate in line with our longer-term results. Now let's move to Slide 13, which highlights Allstate strong capital position. Allstate's balance sheet strength and excellent cash flow generation, provides strong cash returns to shareholders while investing in growth. Significant cash returns to shareholders, including $1.5 billion through a combination of share repurchases and common stock dividends occurred during the third quarter. Common shares outstanding have been reduced by 5% over the last 12 months. Already in the fourth quarter we successfully completed the acquisition of safe auto on October 1st for $262 million to leverage National General's integration capabilities and further increased personal lines market share. We also recently closed on the divestitures of Allstate Life Insurance Company in New York. These divestitures free up approximately $1.7 billion of deployable capital, which was factored into the $5 billion share repurchase program currently being executed. Turning to Slide 14, let's finish with a longer-term view of Allstate's focus on execution, innovation, and sustainable value creation. Allstate has an excellent track record of serving customers, earning attractive returns on risks, and delivering for shareholders, as you can see by the industry-leading statistics on the upper right. Innovation is also critical to the execution, and our proactive implementation of transformative growth has positioned us well to address the macroeconomic challenges facing our business today and in the future. Sustainable value creation also requires excellent capital management and governance. As an example, Allstate is in the top 15% of S&P 500 companies and cash returns to shareholders by providing an attractive dividend and repurchasing 25% and 50% of outstanding shares over the last 5 and 10 years respectively. Execution, innovation, and long-term value creation will continue to drive increased shareholder value. With that context, let's open the line for your questions."
},
{
"speaker": "Operator",
"text": "[Operator Instructions]"
},
{
"speaker": "Operator",
"text": "Our first question comes from the line of Josh Inc. from Bank of America. Your question, please."
},
{
"speaker": "Joshua Shanker",
"text": "Yes. Thank you. I want to talk about bundles and homeowners in the pricing of the dual engine of homeowners and auto together. I guess there's two things I want to understand. One is when a customer sees their overall bundled price going up, what does the conversation like, especially if you're trying to more centralized your business with a greater direct relationship with your customers. And 2, given Allstate's geographic footprint, can Allstate add incoming customers for homeowners without changing its cap footprint."
},
{
"speaker": "Tom Wilson",
"text": "Good morning, Josh is Tom, I'll start and then Glenn can jump in first as you know, we've long been focused on bundling auto and homeowners because those are good, stable, long-term customers. You do get a discount for putting those two together. So there's an advantage to the customer from buying it and putting it all in one place besides just having 1 point of contact. And we've been good at that. If you look at our growth in Homeowners this year. It's higher than our growth in auto insurance. And data appears to be because we are doing more bundling of individual customers, it a little hard to get the exact attribution, but we feel good about what our agents are doing to drive that. As it relates to the Gross event. We've been we've repositioned as business over multiple years back in the middle -- late 2 thousand decade of 2,000, we've made of course a bunch of money since over the last eight or nine years, I think almost $9 billion of underwriting income on homeowners which you need to do because we don't believe that a 4 point margin is attractive for homeowners for a couple of reasons. One is you don't get much investment income. Secondly, you got to put up more capital because the results are more volatile and you have the big tail losses. So as we seek to grow it, we bring all of that math to bear. On individual states is where we grow. And so if there's a state where even if there's a fair amount of catastrophe exposure but we think we can get a good return, that's got a margin on it that compensates us for the capital we have to put up and the reinsurance we have to buy, then we'll do that. And we're highly sophisticated in the way we run it. So the geographic focus is really -- we have a much highly sophisticated model into it. On the direct business, you don't sell as much direct homeowners right now, we still need to crack the code on that. Before I -- Glenn will have some view on how we can continue to run the table in homeowners as we have so far. But the -- an upcoming thing that Glenn might want to touch on, is what we're doing in the independent agent channel because of the National General platform gives us, with our products, our expertise, our pricing, our claims management. And our reinsurance programs gives us the ability to really serve a lot of customers. [Indiscernible]"
},
{
"speaker": "Joshua Shanker",
"text": "Glenn, where [Indiscernible] I just want to say, can you address retention and cat footprints as well?"
},
{
"speaker": "Tom Wilson",
"text": "Yeah. Glenn, mind if you take both of those?"
},
{
"speaker": "Glenn Shapiro",
"text": "Sure. So a few comments on homeowners leading into it, but we got a really strong home care business and so we want to grow it, and we want to handle it as Tom said. So, over the course of the past year, we've deepened bundling discounts. So we've made it more attractive for customers across 30 states. We've shifted our agency competition over the last couple of years to where it's more attractive for them to bundle. And the same is true in direct, as Tom said, we're looking to crack the code right board there. Were writing some, We want to write more, and so some of the incentives for our direct team around cross quoting and bundling. To the point around that footprint, We're in good shape. Like, if you look at our ability to write business, we can write it pretty broadly. We can write in some CAT-prone areas, but we tend to offset it and create the diversity of our book by writing in other areas. I mean, right now, we're on a 12-month view right now, we're at 93.8 combined ratio made about $400 million underwriting profit in the last 12 months, in spite of having some really big CAT quarters. Though it's a good business that we're able to consistently make money in, and so we're looking to grow it. But as Tom said, we have -- we have pretty stringent guidelines, that where we write, how we write so that we don't overgrown in CAT prone areas. But we're able to grow without that and Tom mentioned something that I want to come back to. In terms of the breadth of our distribution and growing and that would be into our IA channel. You know, the IA channel is a huge opportunity. Independent agents where a lot of homeowners and our National General and Allstate's Company, as it will be branded, is adding our middle market products, both auto and home. And we have sort of a whole new Greenfield there to run in. And that would be a broad geographic spread, not just the cat prone areas."
},
{
"speaker": "Tom Wilson",
"text": "Hey [Indiscernible] let me just ask that because I think I understand why you're trying to triangulate between what's going on in the industry. First, we don't have a catastrophe exposure problem. We don't have a profitability problem. We believe in homeowners. We only made about -- we lost about $16 million bucks and $7.3 billion so far this year. So we'd like to make more money, but as Glenn pointed out, when you look over a longer period of time, we've had a fair amount of ups and downs, but we still make underwriting profit sense of 12-month basis. So we don't have a catastrophe problem. So we don't have to restrict stuff and end up with -- what you're poking at is retention issues. We have been there and done that though And it was called the repositioning we did in the latter part of the decade I mentioned. And when you call a customer and say, I used to have -- you used to be insured with us and now I am not going to insure your thoughts and we were one of the biggest brokers have homeowners insurance products. I think in the country and maybe Vegas. And through our advantage in even when you say to people, here's another Company. It has some impact on your auto business. So because people are like, Well, I'll take my business someplace else or competitors decide they want to, they want to bundle and they'll go get those customers as well. We had some issues with auto growth when we were downsizing. We went down by 2 million policies in the homeowner's business over a 4, 5 year-period. It does hurt. It's manageable. I can't speak for what our competitors are going to do. What I do know is what Glenn said, which is we got a good business, we know how to run it. We have growth opportunities, and we're looking forward to serving more customers and make more money for our shareholders along the way."
},
{
"speaker": "Joshua Shanker",
"text": "Thank you."
},
{
"speaker": "Operator",
"text": "Thank you. Our next question comes from the line of Greg Peters from Raymond James. Your question, please."
},
{
"speaker": "Greg Peters",
"text": "Good morning. I'd like to turn your attention to Page 7, and I was particularly struck by your chart where you've identified the rate increases you've deployed, and then ones that you're going to be implementing. And I was wondering if you could provide us some perspective on -- given the fact that severity has been so substantial, where you think that's going to go with other states? It feels like this is going to be an ongoing reset of pricing as we go through most of next year. And against that backdrop, just how you think about your competitive positioning when most of the industry is going to be raising rates."
},
{
"speaker": "Tom Wilson",
"text": "Let me -- maybe -- let me start and then, Glenn, why don't you jump in on what you are doing individually. I think you are right about that. There seems to be this -- a threat going through the markets today. And this is kind of a once and done. And we don't necessarily see it that way. I mean, I think there's never bold enough to decide in claim, we're ahead or of anybody else. Because firstly, I'd assumes everybody is in the same place. Secondly, assumes the same trends are going to happen and third is that those trends are going to end and the answer is we don't know when they will do. What we do know is what we can do differently. And we do know that some of our competitors had frequency increases sooner than we did so that you would expect them to raise prices sooner than we did. We do think that we have a good plan in place and Glenn can take you through that, which is to make sure we get attractive returns in auto insurance, which is a key component of what we do in terms of delivering value for shareholders. We are all over that and we will go -- where -- how that will move forward in terms of competitive position. And that's also hard to tell, what I do know is that I'm really glad we started transformative growth 2 years ago. And the cost reductions we already have in place certainly have benefited us. It's positioned us to be able to grow through many different venues, so we can dial growth up if we choose to do that. I'm really glad we are where we are and we're positioned to take share in the future, which of course, our strategy. But we want to do that profitably. Glenn, do you want to talk about your plans getting the auto insurance returns back to where they have been historically?"
},
{
"speaker": "Glenn Shapiro",
"text": "Yes. Absolutely. So thanks, Greg. And you hit a couple of important points that you're right about that everyone or close to everyone is going to have to take rate. When you talk about competitive position. So we think about that as part of process. But this is broad and this is going to be around for a while, like everything you look at in terms of what the root causes of severity, which is in its simplest terms, is the price of used cars. I would like to talk about collision coverage as it's a coverage that doesn't really have a policy limit that's dated other than the value of the vehicle itself. So in real turn, our policy limit on that coverage went up by 40% plus with no change in premium. And that experience happened to everybody across the industry. So it's a rarity where you have something is Clean and clean as that that is a root cause to your severity changes. So we think it will be around for a bit and we're going after rate to address that has one of the levers and we've talked about our claims capabilities and certainly our expense reductions as other ones. So in the third quarter, we took 12 price increases that went effective in the third quarter and other 8 in the fourth quarter so far with more to come. So this is broad and we'll be doing it just about everywhere. And I think the key from a competitive position is that we made a lot progress. So our starting point, we made significant progress over the last year with the expenses we've taken out, and therefore the competitive position we were in improved significantly. Our close rates improved significantly, leading to some of the greater new business that you saw. And so as we take rates and other due. It's our goal certainly keep that competitive position gain that we've made. But the primary goal is to get our margins back to where they need to be. And that's why we're going after rate, we're doing it pretty proactively."
},
{
"speaker": "Greg Peters",
"text": "Great. Thanks for the color on that. I wanted to pivot to Slide 8, which is, I think another really important slide in your presentation. And just to step back and recognize the long-term objective that you've introduced is pretty striking. I feel like when we get to 2024, if you've achieved that objective, that will put you clearly among the leaders in terms of a lowest adjusted expense ratio in the marketplace. I'm sure a lot of thought went into this. Can you give us some more color on where the improvement, where you're going to get the most leverage in terms of the expense ratio improvements, where it's going to come from. And then maybe also include some comments on the advertising expense because that's not included in this."
},
{
"speaker": "Tom Wilson",
"text": "Mario, do you want to start with the components of the cost reduction and now come back to advertisement?"
},
{
"speaker": "Mario Rizzo",
"text": "Sure. So Greg, thanks for the question and the acknowledgement of the progress we've made. I guess, why it start is maybe to just kind of go up a level and reiterate again what our objective in reducing costs really is, which is to enhance customer value by improving our competitive price position. And we're going to do that by continuing to drive down the expense component of our combined ratio, which is inclusive of both underwriting and claim expenses and to your point, we've made really good progress over the past several years. And in addition to the progress we've made, we've created plans and have line of sight to the additional 3-point objective that we've got by 2024, by focusing on things like digitizing processes to improve efficiency by continuing -- as we do that, create opportunity to retire legacy technology to capture the synergies associated with the National General acquisition, to continue to drive down distribution costs as we've talked about creating a more productive but lower-cost distribution model. So we've got opportunity in both the -- from an operating cost perspective and both the underwriting and the claim side. And we've got a plan on how to get there, and that's why we established a goal and we think once we can get the additional 3 points out of our cost structure, it's really going to position us well relative to our competitors, to have a more competitive price point, to deliver higher customer value and really position ourselves to accelerate growth."
},
{
"speaker": "Tom Wilson",
"text": "So let me go to advertising then. Let me start with we didn't do transformative growth because of the pandemic, but boy, I am sure glad we got started on transformative growth when we did because we were able to reposition the brand. We invested over $250 million in repositioning the brand, do advertising, testing out new, more sophisticated ways to do it. And we did it when frequency was low, so we were able to use some of that reduction in frequency, the margin it's created, to invest in long-term growth by repositioning the brand. When you look at transfer on breast for a simple right, you get a more competitive price, you have more places to buy it. You let people know about that the increase in advertising, that or restocking that. What we do in the future will be depending how much we want to grow. So as we move forward, I think our advertising will be flat or come down some, because we want to make sure we've got the pricing right. The point that came up earlier about the longevity of the how long will severity keep come up. You want to make sure you've got that pricing right before you go out and get that flywheel going by doing more advertising. That said, we're always going to do a lot of advertising because as you know, it is a marketing war really out there between some of the large players. But the other part that's not as well known is it's getting every bit as sophisticated as auto insurance in home prices. You really got to be good with your math and whether it's upper funnel, lower funnel, getting the right price to the right customer, at the right time, in the right space is complicated. And so the other thing we've been working on is building out the sophistication, so that every dollar of advertising investment we spend is well done. The reason we took it out of the expense ratio guidance was because it is more volatile and it has penned down on what kind of growth we're looking to achieve in that quarter. And this is a measure of really how effectively running the business, like how are you keeping your costs down for your customers see can't hit at competitive price."
},
{
"speaker": "Greg Peters",
"text": "Thank you for your answers."
},
{
"speaker": "Operator",
"text": "Thank you. Our next question comes from the line of a Elyse Greenspan from Wells Fargo. Your question, please."
},
{
"speaker": "Elyse Greenspan",
"text": "All right, thanks. Good morning. My first question was on the growth in new business that you guys saw in direct in the quarter. I know from commentary, you guys started to take price during the quarter and then more is on the [Indiscernible], but I was a little bit surprised with the level of growth you saw there, given the increase, the loss trend that you're mentioning. Can you expand upon that? And would you expect a new business growth on the direct side to slow as you push for additional ways through this system?"
},
{
"speaker": "Tom Wilson",
"text": "Elyse, let me give that to Glenn and just -- but Glenn and his team have done a fabulous job in getting us better at direct. Some of the growth that you see is because of the advertisement we talked about, some of the growth you see is we're just getting a lot better at it. And so once we put the Allstate brand on in Glenn study to combine capabilities. We've just -- we're getting much more effective at what we've closed on, and what we've closed in the cost. Glenn when you want to talk about the prospects for address?"
},
{
"speaker": "Glenn Shapiro",
"text": "Yeah. I agree there any Tom just said I think we've got really nice prospect because I would say we're making up ground in dog years because we have what we're 20 years newer at doing directed the Allstate brands and some of our competitors. But we're making up chunks of that capability as we move a year-and-a-half into the launching with Allstate brand in direct. The effectiveness of our sales, whether it be our call centers, or on the web, etc., our marketing sophistication, our partners with marketing, all of those things getting better and that helps move it up. The other thing is, actually in this price environment that's going to be disrupted, we're really likely to see some tailwind in new business, but some headwind in retention. Because if we were in a situation where we're the only ones taking rate, you might expect the opposite. But with a whole bunch of people having to take rate that will create a lot of shoppers, we'll create shoppers of our own too, because it disrupts our own customers. And when people shop, they often find a better price for situation. Even in a rising environment like this. So there will be a lot of customers shopping, ours, and other companies. And so, it's an opportunity as Tom said, to leverage what we did and say we're really happy we did transformative growth when we did because we have more ways for customers to buy when that disruptive market happens."
},
{
"speaker": "Elyse Greenspan",
"text": "Thanks. And then my second question on, just in terms of rate, I believe the majority of your auto policies is six months, so correct me if I'm wrong there, but as we think about the rate going to this system, what you've done in the third quarter, the fourth quarter, and expectations for next year. How long would you -- do you think it will take to get back to your target margins, is it kind of a 6 month to 12 months situation? I know you don't have a specific target margins for Property-liability. We've gone to an overall awry, but we think about putting your margins at an acceptable level that we think that that would come over the next 6 to 12 months or can you give us the time range there?"
},
{
"speaker": "Tom Wilson",
"text": "I don't think you can do a time range on it, because I don't think we can predict what's going to happen in the future on the inflationary pressures. What we can do is say, we're going to go at this aggressively as soon as we can get there. That will be -- we're going to hustle as Glenn to get it. Well, as he said, his priority is auto insurance margins on that part of the business. We got lots of other priorities to look at. But when you look at inflation, I'm not in the camp that the inflationary, like used car prices are suddenly going to go back down. I think you buy a car for $14,000 and use a cost of $10,000, Like, you're not thinking it's worth $10,000 no matter what the Fed and everybody else thinks about it being transitory. I think the same thing is true with when you look at parts prices. Parts prices, it's not like the oil market where prices are -- the system is built to go up and down everyday, it gets embedded in there. The dealers buy inventories, people, distributors buy inventory, they price that. So we don't really see that being transitory and coming down. How long it will take to work all the way through the system, what opportunities the OEs will take to push prices farther up Is really unknown at this part. So it's hard to determine when they will cross, what you do know is at least in it's half-life, just going to keep going up. As long as we see movement in the bottom line. And it will keep going up until the bottom-line plans out, that being the bottom line is being lost cost. And that top-line then will keep going past their point in time until we get back to the margins. But when we get back to the same underwriting margin on a dollar basis, or a percentage basis on auto insurance. You can't really predict until you can have a better handle on where frequency [Indiscernible]. Glenn, anything you would add to that?"
},
{
"speaker": "Glenn Shapiro",
"text": "I know that the only thing I would add would be that the tactical answer on the rates, because completely agree. We don't know what the bottom line will do exactly, so we'll have to keep moving those and adjust. But the tactical answer on the rates, you're correct, Elyse, its 6 months in almost all of our states and all of our policy. So it's about 6 months from the effective date to get all customers paying that. And then another 6 months from the point they start paying it to where the full premium has been earnings for one policy period. So you really start to see the effect of the rates starting at the beginning of the year, but more impactfully in the second and third quarters of next year."
},
{
"speaker": "Elyse Greenspan",
"text": "Okay. Thanks for the color."
},
{
"speaker": "Operator",
"text": "Thank you, our next question comes from the line of Michael Phillips from Morgan Stanley. Your question, please."
},
{
"speaker": "Michael Phillips",
"text": "Thanks, good morning, everybody. I think Glenn answered this question, but just want to be sure. I'm going to ask First Quarter, Second Quarter you were taking some targeted rate costs and now you're not. And I think Glenn said rate increases that are going to continue are going to be I think you said just about everywhere. I Just want to confirm that because I guess the question would be, how much of an overlap would there be in states where you took previous rate cuts -- pretty recent rate cuts, and now moving upward in those same states, is there overlap there in those states? I'm asking because of what that means to consumer impact on maybe retentions, seeing gyrations down and back up again. And then also if there is overlap there, what it means for, just something that Tom said, make sure we have pricing rates to confidence around our current rates."
},
{
"speaker": "Tom Wilson",
"text": "Glenn do you want to take that?"
},
{
"speaker": "Glenn Shapiro",
"text": "Sure. So the short answer to your question would be yes, there will be increases in places where there were modest decreases. I do think we waited a little while to really see what was happening with the frequency and ensure that it was long-standing and has remained a long-standing benefit before taking them. And we were modest and we've done some pretty significant givebacks into shelter in place, get it back, which were one-time and not sort of durable discount. Actually changing rates and moving them down, we were more subtle with and more modest with. I don't think people will see a wild swing down and backup, but they will see it in same-state. And the simple fact is, as you saw on the chart, I believe just on page -- bottom page 7, that used car prices spiked dramatically in the second quarter. And those spike, and then people start having claims. And then those claims start to be paid, working their way into the loss costs, and you have this hyper inflationary environment on auto physical damage lines. So it's just the appropriate response at the appropriate time for it. And we'll do everything we can to maintain our retention. It's one of the wonderful things -- one of the many wonderful things about our agency force. Our agency force do a really good job of building relationships and talking customers through changes in their policies, and helping us through things like this."
},
{
"speaker": "Michael Phillips",
"text": "Okay. Thank you very much for that. The second question, a different one on Arity. I guess I'm curious how you think about Arity. Do you think of it as either a more of a use it for our own pricing and telematics business, or that plus [Indiscernible] it off to others and having more of a income-generating machine? It's still not giving you a lot of lift on that second piece, but do you think of it more that way longer-term? And we've seen more and more Companies go the route. You are about the only one that isn't. the go the route of farming that business off, Hartford just announced that recently were they farmed it off, and more and more companies are doing that. So how do you think about Arity? Is it more just for your own pricing or do you want to have it be more of a, again, an income generating machine as well?"
},
{
"speaker": "Tom Wilson",
"text": "Michael, thank you for asking about something other than auto insurance margins, because we have a lot of good things going on, one of which is Arity, which a significant value has been created with Arity, both in the insurance business and outside the insurance business. And I don't think that's been reviewed by any analysts as if it was a separate Company. I mean, we have 600 billion miles of data. We risk scoring the operation. We help people do marketing, more effectively and efficiently. And so we're really building quite a platform that will do a number of things. One is it does exactly what you've talked about, which is -- and the way we started, it was telematics as a service for us. We needed somebody to collect the data. We needed to get a mobile app up. We needed to put it in files and be able to do something with it. And so rather than do that inside the insurance Company, we decided to do it outside the insurance Company because we said this is -- at the point, we said this is Basically a service at other insurance companies will need and we can provide to them and we do. So. Arity provides that service to some other insurance companies, and we're working to try to expand that effort for them. But it moved beyond what I would just call telematics as a service, help me pull data in to figure out all my customers are doing too. We started collecting more data from ourselves and built a rating service organization so that we can help other insurance companies use telematics to price the insurance. We believe that they're going to get their capability anyway. So we think that we might as well do it through Arity, and capture addition -- additional margin, rather than just assumed that we can take over a 100% of the insurance industry. But being a leader in telematics, which we are, but we don't think we can get the entire market share. So we created a rating services organization around that. It's then been expanded to include really lead generation. As we started collecting more data. So we have data from the Allstate customers, we have data because we have our SDK embedded in other people's thoughts. We have had data and I think it's over 25 million cars were pulling every day, really high fidelity data that's in the same format. We also buy data that we're able to combine with that 25 million on an over another 75 million current. So we're pulling data on a 100 million cars per day right now. And so we're building this rating services organization for all state and other insurers so that we can not only do telematics to the servers. We can do that. We think we can actually work to help people pre -qualify buyers and it's called the Arity IQ. So significant value has been created. I don't think that shows up in shareholder value today because I don't really see any of the analysts really looking hard and saying what's it worth, but we think it's substantial value and we expect to continue to grow their business and expand its total addressable market."
},
{
"speaker": "Michael Phillips",
"text": "Okay Tom. Thank you very much."
},
{
"speaker": "Operator",
"text": "Thank you. Our next question comes from the line of David Motemaden from Evercore ISI. Your question, please."
},
{
"speaker": "David Motemaden",
"text": "Hi, thanks. Good morning. I had a question on, I think it was Slide 7, where you show the around a 7% rate increase that you are asking for. I guess that feels high to me, especially considering that the loss ratio, if I take out the reserve charge, was only about 1.5 points higher than the third quarter of 2019. And then also, considering the expense initiatives that you guys have taken to-date, I guess my thought was -- I thought that the expense plan would maybe help reduce the amount of rate that you guys would need to take. I guess -- is that the right way of thinking about it or is it too uncertain at this time and you guys just want to get in front of what might be coming down the road in terms of future loss cost increases?"
},
{
"speaker": "Tom Wilson",
"text": "Well, it's an accurate call-out, David, that the future expense reductions will certainly help us manage profitability. But we're increasing the price is now because we do want to grow profitably. But being unclear as to where this inflation will sort out, we're being what we think is fair and appropriate, as opposed to overlay aggressive in increasing prices now. As to the extent in the future, we don't need that as much in our expenses come down. Then we can improve our competitive position, which we've been -- we've improved our competitive position pretty significantly in 2021. and we don't want to give that up. And we'd like to continue to improve it as so we get that flywheel of growth going. But in this case, we're using the expense reductions for future competitive price improvement as opposed to saying, we don't need to raise prices because loss costs are [Indiscernible] Glenn or Mario anything you would add to that?"
},
{
"speaker": "Glenn Shapiro",
"text": "The only thing I'd add is, it is -- it is pretty easy to get negative rates in approved and in market very quickly. And as we talked about in one of the prior answers, it takes time for them to earn in. So we're projecting future loss costs out over the course of the next year and years and taking rate that we think best reflects our best estimates of what we're going to need to deliver the right returns. So it would be a good situation to get into to where we were we slightly overshot and could dial it back. But as Tom said, there's a lot of questions still on where this severity will -- Inflation for severity will end."
},
{
"speaker": "Tom Wilson",
"text": "At some point, Glenn. Look, we need to make money in auto insurance, David, and we're going to do that. I think we're out of time, so let me just say as we move forward, you should expect us, as you've heard throughout this call, to focus on improving returns in auto insurance. At the same time, we're not letting up on any of the components of increasing our market share and personal property-liability, or expanding circle of protection. All of which we've had really good progress and success on this year and in this quarter, so you should expect us to continue to focus on a broad-based approach to increasing shareholder value. So thank you for your engagement with us again, and we will talk to you next quarter."
},
{
"speaker": "Operator",
"text": "Thank you, ladies and gentlemen for your participation at today's conference. This does conclude the program. You may now disconnect. Good day."
}
] | The Allstate Corporation | 18,711 |
ALL | 2 | 2,021 | 2021-08-05 09:00:00 | Operator: Thank you for standing by, and welcome to the Allstate's Second Quarter 2021 Earnings Conference Call. At this time, all participants are in a listen-only mode. After the speaker's presentation there will be a question-and-answer session. [Operator Instructions] As a reminder, today's program is being recorded. And now I'd like to introduce your host for today's program, Mr. Mark Nogal, Head of Investor Relations. Please go ahead, sir.
Mark Nogal: Thank you, Jonathan. Good morning. Welcome to Allstate's second quarter 2021 earnings conference call. After prepared remarks, we'll have a question-and-answer session. Yesterday, following the close of the market, we issued our news release and investor supplement and posted related materials on our website at allstateinvestors.com. Our management team is here to provide perspective on these results. As noted on the first slide of the presentation, our discussion will contain non-GAAP measures for which there are reconciliations in the news release and investor supplement and forward-looking statements about Allstate's operations. Allstate's results may differ materially from these statements. So please refer to our 10-K for 2020 and other public documents for information on potential risks. And now I'll turn it over to Tom.
Tom Wilson: Good morning and thank you for joining us today. Let's start on Slide 2. Today, we're going to link operating results to strategy in order to show how we expect to continue to generate shareholder value. So Allstate’s strategy has two components; increased personal property-liability market share and expand protection solutions, which are shown in the two ovals on the left. The transformative growth plan to increase market share and personal property-liability has four components. This strategy would drive market valuation by executing, innovating, and focusing on long-term value creation. So in the first half of the year, we executed well for customers, we executed well financially and for shareholders as you can see on the right hand panel. Property-liability market share increased by approximately one percentage point through the acquisition of National General. Allstate Protection Plans continued to grow rapidly by broadening the product offering to include appliances and furniture and expanding availability through Home Depot stores. Strong execution generated excellent financial results with revenues increasing 23.8% compared to the prior year, adjusted net income of $3 billion, and a return on equity of 23.8% for the last 12 months. Shareholders benefited from a 50% increase in the quarterly common dividend and a reduction in outstanding shares by 2.4% just this year, under the current $3 billion share repurchase program. Yesterday, the Board approved a new $5 billion common share repurchase program, which represents approximately 13% of current market capitalization, and we expect to complete that by the end of March of 2023. Let's continue on Slide 3. In addition to operating execution, we're innovating to create long-term value. The transformative growth plan to create a digital insurance company is making good progress. Today, we're going to spend time talking about the distribution component of that plan. Allstate is amongst the leaders in telematics capabilities with Drivewise in the industry's largest pay-per-mile product Milewise, which offers customers unique value. Arity, our telematics service platform company recently launched Arity IQ, which when combined with LeadCloud and Transparent.ly platforms will integrate telematics information into pricing at the time of quote, rather than at the time after the sale. We enhanced our competitive position in independent agent channel by using National General to consolidate and improve our IA business model. We executed agreements to sell Allstate Life Insurance Company and Allstate Life Insurance Company New York, to redeploy capital out of lower growth and return businesses and reduce exposure to interest rates. Increasing market share, while maintaining attractive returns and expanding protection solutions through transformation, targeted acquisitions, and divestitures will create shareholder value. Slide 4 lays out the Allstate's strong second quarter performance. Revenues of 12.6 billion in the quarter increased 21.6% compared to the prior year, largely reflects the National General acquisition and higher net investment income. Property-liability premiums earned and policies in force increased by 12.9% and 12.1% respectively. Net investment income of $974 million increased by over $0.75 billion compared to the prior year quarter, reflecting $649 million of income from the performance-based portfolio. Net income of 1.6 billion was reported in the second quarter compared to $1.2 billion in the prior year. Adjusted net income was $1.1 billion or $3.79 per diluted share as you can see from the table on the bottom, that's a 40% increase from the prior year quarter. Allstate's excellent execution and strong operating results in the quarter contributed to that return on equity, which I just mentioned of 23.8% over the last 12 months. Let's move to Slide 5 to discuss our progress on building transformative growth business models. So, transformative growth is a multiyear initiative and what we're working to do is build a low cost digital insurer with broad distribution, and that's going to be accomplished through four areas; expanding customer access, improving customer value, increasing sophistication and investment in customer acquisition, and deploying new technology ecosystems. And in transformative growth - you wouldn't do it all in one day of course, it's got five phases, and substantial progress has been made in phases two and three. Phase two successes include improving the competitive price position of auto insurance, protecting margins by reducing costs, new advertising was launched with increased investment. We also are off to an excellent start with National General. And of course the phases overlap, so progress has also been made in Phase three. So we're transforming the distribution platform, including supporting transition of Allstate agents to higher growth and lower cost models, which we'll discuss on the next slide. Improving customer acquisition sophistication will lower costs relative to lifetime value. We continue to focus on lowering underwriting and claims expenses to deliver lower cost protection to customers, and we’ve designed the new technology architecture. We've coded much of the new applications. The next step for us is to launch an integrated system with one product in one state. Turning to Slide 6, let's review how we're transforming the Allstate agent, Allstate direct sales, and independent agent distribution platforms to grow market share. The illustrative on the right side of the slide provides a view into our growth expectations by channel over time. Starting with Allstate exclusive agents, we're making progress transitioning to a higher growth and lower cost model. This year, we changed agent compensation by increasing their business compensation opportunity and reducing a bonus paid on policy renewals. We expect to continue this shift from renewal compensation to new sale because it aligns with what consumers want. Consumers want assistance with purchasing insurance more than they want routine policy service. To lower cost for agents, we're digitizing processes, redesigning products to increase self-service, and expanding centralized service support. We're also working to reduce agent operating expenses and real estate costs. These changes will improve the customer value proposition with lower cost and easier service. Now, of course, you're not going to do this in one day either, so a multiyear transformation - transition program is in place to support existing agents, we've initiated it and it has different levels of support based on agent performance. Given this transition, we reduced new agent appointments last year, which has had a negative impact on new business levels. But as Mario will discuss next, this has been offset by higher productivity from existing agents. At the same time, we have two new agent models in market, which have a personal touch, but a lower cost structure. All of these changes are supported by more competitive auto insurance pricing and increased marketing spending, which is designed to continue to grow. But as you can see on the right, the net impact of these changes for the Allstate agent channel is to be flat to a slight decline in sales in the short-term, but increased growth thereafter. The Allstate direct sales effort leverages the capabilities that we built for the insurance brand, and we've shifted our advertising focus away from insurance to be totally focused on the Allstate brand and utilizing the direct channel for Allstate brand sales as well. The pricing is lower than the Allstate agent model since it doesn't come with the help of an agent. And as this business grows, we're improving our operational and marketing effectiveness. Direct sales now represent 29% of new auto business sales. And we expect that to continue to grow rapidly as you can see on the right. Independent agent distribution also represents an attractive growth opportunity. The acquisition National General enhanced our capabilities in this channel and they added 4 million policies in force. Additional growth is expected by broadening the product portfolio from high risk drivers to middle market auto and home insurance through the existing agent relationships. We also expect to increase the number of agents actively engaged in selling National General products. So when you combine this effective and efficient distribution, with more competitive auto insurance pricing, enhanced marketing, advanced pricing and telematics and the digital experience, that's the transformative growth plan that'll drive property-liability market share growth. So Mario will now discuss the second quarter results in more detail.
Mario Rizzo: Thanks Tom. Turning to Slide 7, let's dive deeper into near-term results on our multifaceted approach to grow property-liability market share. As you can see in the chart on the left side of the slide, property-liability policies in force grew by 12.1% compared to the prior year quarter, primarily driven by National General and growth in Allstate brand new business. National General, which includes Encompass, contributed growth of 4 million policies, and Allstate brand property-liability policies increased in the quarter driven by growth in homeowners and other personal lines. Allstate brand auto policies in force declined slightly compared to the prior year quarter, but increased sequentially for the second consecutive quarter, including growth of 111,000 policies compared to prior year and as you can see by the table on the lower left. The chart on the right shows a breakdown of personal auto new issued applications compared to prior year. We continue to make progress in building higher growth business models, as we look to achieve leading positions in all three primary distribution channels. The middle section of the chart on the right shows Allstate brand impacts by channel, which in total generated a 6.7% increase in new business growth compared to the prior year. Modest increases from existing agents excluding new appointments, and a 31% increase in the direct channel more than offset the volume that would normally have been generated by newly appointed agents as we pilot new agent models with higher growth and lower costs. The addition of National General also added 481,000 new auto applications in the quarter. Let's turn to Slide 8 to review property-liability margin results in the second quarter. The recorded combined ratio of 95.7 increased 5.9 points compared to the prior year quarter. This was primarily driven by increased losses relative to the historically low auto accident frequency experienced in the prior year quarter due to the pandemic. Increased losses were partially offset by lower pandemic related expenses, primarily shelter in place paybacks in 2020, as well as lower catastrophe losses. These are represented by the green bars in the combined ratio reconciliation chart on the lower left of the slide. Shifting to the chart on the bottom right, we continue to make progress in reducing our cost structure. This enables improvement in the competitive price position of auto insurance, and investments in marketing and technology while maintaining strong returns. The total property-liability expense ratio of 24.7 in the second quarter decreased by 7.1 points compared to the prior year, again, driven by lower Coronavirus related expenses. This was partially offset by the amortization of purchased intangibles associated with the acquisition of National General, restructuring charges, and a 0.7 point increase from higher investment in advertising. Excluding these items as shown by the dark blue bars, the expense ratio decreased by 0.4 points in the second quarter, compared to the prior year period, decreased 1.7 points below year end 2019 and 2.5 points below year end 2018 reflecting continued progress and improving cost efficiencies. Claims expenses have also been reduced through innovations such as QuickFoto Claim, Virtual Assist and aerial imagery, which also improves the customer experience. These claim improvements are not reflected in the expense ratio, but are in the loss ratio and also helped maintain margins. Moving to Slide 9, let's discuss how our auto insurance profitability which remains very strong, and is still favorable to pre-pandemic levels, despite pandemic driven volatility. Allstate protection auto underlying combined ratio finished at 91.8. As you can see from the chart, the level remains favorable to 2017 through 2019 historical second quarter and year end levels despite increasing by 9.4 points compared to the prior year quarter. The increase to the prior year quarter reflects a comparison to a period with historically low auto accident frequencies. The improvement relative to historical levels is driven by auto accident frequency remaining below pre-pandemic levels, partly offset by auto severity increases and competitive pricing enhancements. To illustrate the pandemic driven volatility, Allstate brand auto property damage gross frequency increased 47.3% from the prior year quarter, but is 21% lower than the same period in 2019. Auto severity increases persisted relative to the prior year quarter and pre-pandemic periods across coverages largely driven by the shift in mix to more severe higher speed auto accidents and rising inflationary impacts in both used car values and replacement part costs. The incurred severity increases are running higher than general inflation, which are reflected in the reported combined ratio. To counteract rising severity we are leveraging advanced claim capabilities, predictive modeling, advanced photo and video utilization and deep expertise in repair process management to enable a scaled response to inflation and supply constraints. Targeted price increases will also be implemented as necessary to maintain attractive auto insurance returns. Now let's shift to Slide 10, which highlights investment performance for the second quarter. Net investment income totaled $974 million in the quarter, which was $754 million above the prior year quarter driven by higher performance based income as shown in the chart on the left Performance-based income totaled $649 million in the second quarter, as shown in grey, reflecting both idiosyncratic and broad based valuation increases in private equity investments, and to a lesser extent gains from the sale of real estate equity. Market-based income shown in blue was $3 million above the prior year quarter. The impact of reinvestment rates below the average interest bearing portfolio yield was mitigated in the quarter by higher average assets under management and prepayment fee income. Our total portfolio return in the second quarter totaled 2.6% reflecting income as well as higher fixed income and equity valuations. We take an active approach to optimizing our returns per unit of risk over appropriate investment horizons. Our investment activities are integrated into our overall enterprise risk and return process and play an important role in generating shareholder value. We draw upon a deep and experienced team of roughly 350 professionals to leverage expertise and asset allocation, portfolio construction, fundamental research, field leadership, quantitative methods, manager selection and risk management. While the results for this quarter were exceptionally strong, particularly for the performance-based investments, we manage the portfolio with a longer term view on returns. At the right we have provided our annualized portfolio returns over a three, five and 10 year horizon. As disclosed in our investors supplement our performance based portfolio has delivered an attractive 12% IRR over the last 10 years, which compares favorably to relevant public and private market comparisons. Our performance-based strategy takes a longer term view, where we seek to deliver attractive, absolute and risk adjusted returns and supplement market risk with idiosyncratic risk. Moving to Slide 11, protection services continues to grow revenue and profit. Revenues excluding the impact of realized0 gains and losses increased 27.1% to $581 million in the second quarter. The increase was driven by continued rapid growth in Allstate protection plans, and expanding marketing services at Arity due to the integration of LeadCloud and Transparent.ly, which were acquired as part of the National General acquisition. Policies in force increased 15.5% to 147 million, also driven by Allstate protection plans, and supported by the successful launch with the Home Depot in the first quarter. Adjusted net income was $56 million in the second quarter, representing an increase of $18 million compared to the prior year quarter, driven by profitable growth at Allstate protection plans and profits at Arity and Allstate identity protection. Allstate protection plans generated adjusted net income of $42 million in the second quarter and $155 million over the past 12 months. Now, let's move to Slide 12, which highlights Allstate's attractive returns and strong capital position. Allstate continued to generate attractive returns in the second quarter, with adjusted net income return on equity of 23.8% for the last 12 months, which was 5.8 points higher than the prior year. Excellent capital management and strong financial results have enabled Allstate to return cash to shareholders while simultaneously investing in growth. We continue to provide significant cash returns to shareholders in the second quarter through a combination of $562 million in share repurchases and $245 million in common stock dividends. We announced the acquisition of SafeAuto in June, leveraging National General's success in integrating companies to accelerate growth. The current $3 billion share repurchase program is expected to be completed in the third quarter. And yesterday the Board approved a new $5 billion share repurchase authorization to be completed by March 31, 2023. This represents approximately 13% of our current market capitalization. This new authorization continues Allstate's strong track record of providing cash returns to shareholders and reflects in part, the deployable capital generated by the sale of our life and annuity businesses. Moving to Slide 13, it should be clear that Allstate is an attractive investment opportunity. When you invest in Allstate you get ownership of a company with advanced capabilities and a clear strategy, delivering superior financial results relative to peers and the broader market. The table below shows Allstate across key financial metrics over the past five years compared to the S&P 500 and property casualty insurance peers with a market cap of $4 billion or more. As you can see by the four measures on the top operating EPS, operating return on average equity, cash yield and total shareholder return, Allstate is consistently ranked in the top two or three amongst its peers. In the case of operating EPS and cash yield to common shareholders, Allstate is in the top 10% and top 15% respectively, compared to the S&P 500. Moving down one row, Allstate's top line revenue growth relative to peers and the S&P 500 is in the middle of the pack. We are committed to accelerating top line performance through transformative growth and innovating protection while continuing to deliver excellent financial results. Moving down to the price to earnings ratio, Allstate is well below average, eight out of 10 P&C peers and in the 10th percentile amongst the S&P 500. This is an attractive valuation, given our market leading capabilities, excellent returns, future growth prospects and commitment to accelerate growth. Now, let me turn it back over to Tom.
Tom Wilson: Let's turn to Slide 14. Let's finish where we started with a more macro and longer term view of Allstate's execution, innovation and long-term value creation as this is a whole report card as his is what you get by investing in Allstate. Empowering customers with protection is a core part of our purpose. We provide a broad set of protection solutions with over 180 million protection policies in force. You see our name while you're watching TV, you're in Walmart, you're in Target, You're in Casco, you're in Home Depot, Allstate is ubiquitous out there protecting customers. We constantly achieve industry leading margins on auto and home insurance, and have attractive risk adjusted investment returns. As a result, the adjusted net income return on equities averaged 15.6% from 2016 to 2020, ranking number two in our peer group. This has led to a 14.9% annualized total shareholder return over the last five years. We have a history of innovation. Transformative growth is a multiyear personal property-liability strategy to build a digital platform that offers low cost affordable, simple and connected protection solutions. We're simultaneously innovating protection by expanding through telematics, product warranties and identity protection. In telematics we've taken a broad and aggressive approach, the insurance offerings and the creation of Arity leading telematics business. Allstate is also innovating new corporate citizenship, focusing on climate change, privacy and equity. For example, we used an underwriting syndicate for $1.2 billion bond offering last year that was exclusively minority women and veteran owned banking enterprises. Long-term value is also being created through proactive capital management, and strong governance. Over the past five and 10 years we've repurchased 25% and 50% respectively of outstanding shares. Among the S&P 500, Allstate is in the top 15% of cash provided to shareholders. At the same time, we've successfully invested over $6 billion in acquisitions, including Allstate protection plans, Allstate identity protection and National General. And of course, strong governance is key to delivering those results. Allstate has an experienced and first management team and Board with relevant expertise. This is acknowledged by the leading proxy advisory firm that has awarded Allstate the top score for governance. Execution, innovation and long-term value creation will continue to drive increased shareholder value. With that context, let's open the line for your questions.
Operator: Certainly. [Operator Instructions] Our first question comes from the line of Greg Peters from Raymond James, your question please.
Greg Peters: Good morning. So I'd like to go back to Slide 5 Tom, and where you lay out the transformative growth strategy, and in the phase two area, you report on substantial progress being made in terms of improved competitive price position in auto insurance. When I went to your supplement, I observed that the average gross premium in the auto brand continued to be lower relative to prior quarters. And I'm just curious how you think about pricing today given the increase in frequency and certainly the increase in severity in the context of your strategy to have an improved competitive price position.
Tom Wilson: Okay, let me start and then I'll get Glenn to jump in. First, in terms of transformative growth, we made a conscious strategic decision to improve the competitive position of auto insurance. When we looked at our cost structure and we looked at where other people were, we decided we needed to be more competitive on pricing. And so, we've been working on that. We've reduced our costs. We've reduced price. We know we're more competitive in the market. And actually you can't really look at the average prices Greg because everybody starts in a different place. So, if you're at 100 and I'm at 95 and you go down 2%, it doesn't make you - really it makes you more competitive [ph], but not competitive, so we look at close rates and we know - we looked at the - when people come to us, they quote what percentage do we close, and when the close rate goes up, you assume you're price competitive and you have a better value proposition. And in fact, that's been true this year, and it's one of the reasons why our new business is up. Now we do that, of course, with great surgical precision. So let me maybe provide an overview of auto insurance profitability because it was the focus of so many of the reports issued last night, and Glenn can jump into what he's got going forward. And I'll start with the analytical structure that I use to evaluate our performance in ways that hopefully will be helpful from an investment perspective. The headline would be to evaluate starting with the current absolute number, don't use one analytical method to assess the future and build on your margin for error. So, the current combined ratio for auto insurance this quarter generated an attractive return on capital. When you look at the number, it's a good return on capital. Looking forward of course is what I need to do and investors need to do, and the forecasting challenge is that the volatility of the components is so high that it's hard to do a quarterly forecast that’s accurate enough to make an important decision. So for example, let's say the percentage is up and down, they're really hard to evaluate, the outcome of 50% decrease, and a 30% increase is a 65%. A 45%, decrease and a 35% increase, it sounds pretty similar, right, but it's the 74%. That small 5 point difference on each side creates a 9 point difference on margins. They're typically less than that. So given the volatility of the percentage changes, we build in margins for error. So as it relates to our projections and forecast so far this year has been pretty good. Severity was higher than expected. But given the volatility of those percentages in the environment, we made sure there was enough margin in pricing and reduced expenses. So as a result, our absolute level of profitability was good and better than many of our competitors' reported results. So the overall goal, of course, is profitable growth. And the best way to manage that total is then you focus on the components, whether that's state-by-state, line by line, or inside the actual cost structure, so Glenn has established goals for the rest of the year on price increases, severity control, and expense reductions. And we have the processes, the math, and state managers that enable us to achieve and adapt, which is we have a consistent track record of doing. So I think when I see people making percentage changes over each quarter and looking at the percentage change of us versus the percentage change of competitors, I'm like when you got the numbers moving around this fast, you really have to go back to the absolute and say, “did you make money? How did you make money? And how do you make sure you keep making money going forward?” With that let me turn it over Glenn, who can talk a little bit about what he's going to get planned for the rest of the year.
Glenn Shapiro: Great. Thanks Tom. And Greg, if I go to the first part of your question on price position, the best measure of price competitiveness are close rates, and our closed rates are up. So we've seen a good result on the fact that for a few years, as Mario covered earlier, we've taken expenses out of the system, we've taken those expenses, and essentially allowed customers to get better value from us. And that's improving our close rates, which has helped. The second part, when you talked about going forward with frequency and severity, as Tom said, we have a pretty good forecast on frequency, and it's continued to be lower when you go on a two-year basis. The one-year comparisons right now are interesting on just about everything, but on a two-year basis to pre-pandemic, they continue to be meaningfully lower. Some of that will be just the new different world that we're in with fewer people working in office buildings and travelling in rush hour. Some of that will revert back over time, but we've had really good forecasts on that. The frequency has been higher. Sorry, the severity has been higher with inflationary factors. And so, we're looking at that and where we have to take pricing we will. And I guess, when you put them together the key is in how we've been forecasting, and when we look at when the line will cross. And what I mean by that is, we knew that look, severity compounds over time. So once you're a couple years in which we are now when you're comparing to 2019, you've got a couple of years of severity increases. At some point, it's going to be greater than the benefit that is persisting on frequency and you cross that line. And so, we're pretty good at forecasting about the time we're crossing that line. We moved prices slightly down. In some places, we're still good with those and we still have opportunity to even be more competitive. In other places, we're going to have to take them up. But we don't have wild swings happening in terms of our pricing. We've been pretty careful and cautious to do things that we thought were sustainable, and we're going to continue to do things that we think are sustainable. So as we take expenses out, continuing to do for the remainder of the year, the loss cost management that the claims team is doing and our pricing actions, we think there's more ground we can make up from a competitive position standpoint.
Greg Peters: That was a very thorough answer. And I was going to ask a question on expenses. But I got to just follow up on your point on severity, and crossing the line. As you know, there's so much oxygen going on around inflationary pressures in the marketplace. And some of its viewed maybe perhaps being transitory, some of it being structural and longer term in nature. And I guess what I'm looking for from you guys is what's your view on the severity trends and can you give us some perspective on that crossing the line analogy that you used Glenn?
Tom Wilson: Well Greg, we don't do forecasts of combined ratio, or the components of the combined ratio. But I think when you look at - it's interesting though, when you look at the supplement, you'll see the paid on property damages is down, that's not related to the way we're booking, they just happen to be paid and there's some timing. So when you look at severity has to be clear difference between what you pay, and what you think you're going to pay eventually. And so we think severity - we know severity is up this year, we booked it up both first quarter and second quarter, even a little more. But so Glenn's got factored into this pricing. Glenn, anything you want to say about the client, maybe talk a little bit about severity control.
Glenn Shapiro: Yeah. And just to the point about what's transitory and what's in there. I think if you look at both frequency and severity in that way, like they're components of frequency, like we get really detailed into looking at the miles driven, it isn't just what was the total miles driven out there. It's, by state, it's urban versus rural, it's commuting time versus not, it's weekend versus week day and night day. So when we look at all of this, we have a view on what we believe is transitory and what is more sustainable on frequency as well as on severity. But the controls that we have, from a claims standpoint, we have a really strong claims team and they use first of all proprietary models that we have to escalate claims that either need to be expedited, moved faster or need to be prepared for defense in terms of injury claims. Tell us the likelihood of litigation, the likelihood of representation, things like that, we leverage our scale really well and that we have long-term pricing deals on a lot of the parts and labor that are out there for whether it's auto or home, so some of that acts as a hedge towards inflation. And it's not perfect, because we're in the same inflationary environment that others are in. But we do with our buying power have had good long-term deals that we've negotiated that help to hedge that to some degree and then really strong quality process that we manage across the system. So we feel good about our ability to manage within the environment, but also we have to price for it as it moves. And I guess I'll close by saying, if anything, our history is been proven, I would say, we do a really good job managing to our returns. And Mario and Tom talked about those in the opening quite a bit. We will manage to produce the right returns and when we need to take price to do that we do it.
Greg Peters: Makes sense. Thank you for the answers.
Operator: Thank you. Our next question comes from line Paul Newsome from Piper Sandler, your question, please.
Paul Newsome: Good morning. A little bit more of a key off of those last questions. But one of the questions I'm getting a lot is whether or not there'll be sort of regulatory issues with auto in particular if we need to get more rate and I'd love to hear your thoughts on how that gets managed at Allstate.
Tom Wilson: I'll maybe start with a little macro and then Glenn can talk about anything we're doing specifically. Paul, I think the first place I would start is the regulatory reaction tends to start with what consumers think. And consumers are in a pretty good place. Our customers are in pretty good place getting a billion dollars back last year. There's plenty - if you look at savings rates and cash and bank accounts and all kinds of stuff, consumers are not - have some pricing ability - there not a lot of pricing pressure coming from consumers each day, so again the count of percentage increases that we need or not so large, you're not talking about double digit price increases that cause everybody to call the insurance regulator and say I don't like this world. So we don't see a lot of consumer pushback. When you look at the regulators we have a good relationship with our regulators. I mean, we were 10 days in last year, I mean, Glenn, I think it was like 10 days into March, we were like we got to do something about this. So we went out proactively to regulators and said, we don't have a requirement to do this, we have no contractual requirement to do it. But we know you'll want us to do it. So we're going to do it in advance upfront and we led the industry in doing that. So we feel like we have good relationships with them, we've been balanced as to how we approach it. And we've been able to earn the economic rents in the marketplace and compete successfully. And Glenn anything, you want to talk about in terms of specifics.
Glenn Shapiro: First, I think is a really good point with some of the credibility we earned last year, because it's not only the shift the return of the money, but the fact that we went out there and proactively had the idea to say, we're just going to waive the requirement that you have an endorsement to do deliveries, let's say with your car and turn your car into an economic vehicle for you, for people that were out of work. They appreciate the fact that we were thinking about the way people were having to live their lives and not having to go buy an endorsement to do it. And we just gave it away for free and filed that across 50 states and in a matter of days, and special payment plans, allowing people more time to pay. So I think we did build a lot of credibility with that. But I think the core of this is the regulators have actuaries. And we have actuaries, and they are math based. So this is - sometimes you get into some emotion with it, but it's really a fact based and math based situation. So when severities go up or loss ratios move their actuaries with our actuaries and we have great relationships working to that one.
Tom Wilson: Yeah, when rental cars go from 50 bucks a day to $100 a day or used car prices go up 40%, regulators know you got to make - you got to collect more money to take care of that.
Paul Newsome: Makes sense and I'd like to ask homeowners question. I tend to think that people underestimate the durability and impact of the home business. Can you just talk a little bit about what's going on there from a pricing and competitive perspective? And whether or not the outlook is more favorable overtime? But it does seem to be - if anything, it seems like you're selling more of it and seems like it's a lead product for you at the moment?
Tom Wilson: Well, Paul, thank you for recognizing how successful we've been at home. Like there are days, when I feel like people think the only thing we sell is auto insurance. And like we make a lot of money in homeowners insurance, we're really good at it. It does require lower margins than auto insurance, because you got to put up a lot more capital because of the volatility. And you don't get a lot of investment income. So we've been very good at it. Glenn, do you want to talk about how we're doing this?
Glenn Shapiro: Yeah, boy, do I. Yeah, I appreciate that Paul. We feel really good about where we are in homeowners. So I'll give you a quick number on the last five years, 89 combined ratio, that's recorded combined ratio not underlying, and we've made just over $4 billion in the past five years of underwriting profit. So we're good at this, I don't mind being bold enough to say that we - I think we have a sustained and systemic advantage in homeowners that we've proven over a long period of time. And it goes to the claims capabilities, the cap management capabilities, our reinsurance system that we have, our risk selection, our product capability and pricing. So it's a pretty deep skill that's been honed over a long period of time that we're able to leverage. And so when you look at there's no question that inflation is hitting the homeowner side hard and you got weather events. And you look at what it's doing to the industry more broadly than us. And there's going to be folks taking a lot of rate out there. And I think you've heard that from them. And our product is such that like, year-over-year, we're at 6% up on average premium, even though we took only three and a half points a rate because built into it, there's some inflationary factor. So we're really well positioned to continue to make money at it, protect a lot of people. And last point is it goes to what Tom talked about earlier about transformative growth. You look at the independent agent system. We bought National General primarily to really have a ticket into that system, where they have great systems, a lot of appointments, great relationships and they're good at some products. Well, we're really good at home. You get that home product into the IA channel. And I think it's going to sell well, we're going protect a lot of people we're going to help IAs grow.
Paul Newsome: Thank you, I appreciate it.
Operator: Thank you. Our next question comes from wine of David Motemaden from Evercore ISI, your question, please.
David Motemaden: Hi, good morning. I had a question just on frequency. And I guess it's a question maybe you can clarify how that trended throughout the quarter by month? And maybe just talk about what you're seeing today. And should we be thinking about frequency being more flat with 2019, combined with 14% to 15% severity increase versus '19 that you guys called out in the 10-Q?
Tom Wilson: David, I'll get Glenn to answer the question on frequency. I'm not sure where that 14% to 15% came from, but and how you've factored. What period of time you're focused, is that two years and then one year? Because you can't take a two year trend and extrapolate it onto annual trends is, maybe that's what I heard. But Glenn do you want to talk just about frequency?
Glenn Shapiro: Sure. Yeah. No, I would not - the short answer would be I would not say you should just expect a zero frequency trend relative to 2019. Well, we don't publish any forecasting on frequency. I think, broadly people in the industry have talked about the fact that safer cars have tended to have a little bit of a tailwind for frequency, even take away the pandemic for a moment that year-over-year we've had a long-term steady decline in frequency. And so you've got a couple of years of data as you compare to 2019. On top of that, we see and I alluded to this a little bit before, we see a really material change in the way people are driving. So even when you see the aggregate number of miles driven coming back still lower, but closer to 2019 levels. Who is driving, when they're driving and how they're driving is changing materially? So you see about a four or five point difference between the net change of urban driving being down more than rural driving. So you look at an Allstate book of business where we sell predominantly through exclusive agents or solicit agents or in more populated markets that tends to favor the way the frequency comes through. You look at the type of driving that's done, I mentioned before commuting is down significantly more than non-commuting. So quick stat for us, we look at a lot of these details. Weekend driving is actually higher right now than 2019 was. People just want to get out. Weekday driving is materially lower and particularly in rush hour. So when you see less congested roads in the time period, when the predominance of accidents happen in those morning and afternoon commutes that is helpful to particularly in our book of business, the way frequency comes through. So there are elements that will come back, it will come back differently and it is the only thing I'm confident in saying is that the world will look exactly the same after the pandemic than before. And that will mean that people drive and move differently. We see some non-transitory or temporary impacts to frequency.
David Motemaden: Got it, okay, thanks and Tom, yes, yeah, I was referring to just Page 63 of the 10-Q, which is, yeah, that 14% to 15% is over two years. So you're right. It's about 7% on average per year. I guess, just a follow up just on the rate actions that you're thinking about taking? I just saw, I think it was like a 5% rate increase that you filed in Georgia recently. Maybe could you just talk about how widespread the rate increases are that you want to put in and maybe just talk a bit more about how you think that might impact the growth trajectory going forward?
Tom Wilson: Well, we don't - we've got - we got plans for the rest of the year is where we think we need to increase price. But we don't give those out for competitive reasons. And we also need to bring traders to agree. So I would just say that we think we will. You should rely on the fact David that we know how to make money and we're focused on making money. As to the competitive business I think it depends what other people do. So you heard yesterday if you listen to the Progressive call they're all in on raising prices, cutting advertising, changing underwriting stuff. So we think that gives us room to adapt and continue to grow, and make money and make sure that we can recover costs as they go up. Other competitors are in different places. But we feel good about where we're at, like trades for growth. Like if you start off and said, would you want to - have a pandemic and a huge drop in frequency for a year to do transformative growth? You probably would say, I don't know, like it's a lot of volatility to manage. On the other hand, I think in our particular case, it's worked well for us.
David Motemaden: Got it. Thank you. Is it your sense that the rest of the industry is going to start raising prices?
Tom Wilson: If you look at what they've done then we can really focus on and there have been more rate increases this year than I think probably people would have predicted if you asked them in the fourth quarter of last year. And that would include us, like if you just said, what do we think everybody was going to do this year? We wouldn't have thought they had to go up as much as they did. But we also didn't think severity was going to be as high as it is. So we're increasing ours, and they're increasing theirs. But we think our relative advantage, given our sophistication in pricing, given our reduction in expenses, given what we're doing on the long-term basis to get expenses down even farther, puts us in good place. So we don't see anything happening that tells us we can't still be on the path to grow market share. The specific roads we go down might be a little different. But we're still feeling like that goal is still there or the objective is still achievable.
David Motemaden: Okay, thank you.
Operator: Thank you. Our next question comes from line of Meyer Shields from KBW, your question, please.
Meyer Shields: Thanks. I wanted to dig in a little bit to Allstate direct, I just want understand the thought on the pricing strategy. And what I mean by that is I think we've got demographic trends favoring direct distribution, but also to massive competitors and I wanted to know whether the competitive posture is that you have to be in line with where Progressive and GEICO are? Or can you benefit enough from these demographic trends to achieve your growth goals.
Tom Wilson: I'm trying to sort through Meyer - the first direct should be priced for what you get like you should get what you pay for. So when you buy Allstate direct, it's I think on average, about 7% lower than if you buy from an agent because it doesn't come with health, and so it's you get what you pay for. And there are people - there are some demographic shifts there. But some of it's not - there are some young people who want help and some older people who don't want help. And so where their focus is not as much on demographics of those channels, but it is the customer value. As it relates to our competitive position in each channel, we believe you should have a competitive price position in each channel, like-for-like, so if you're buying from GEICO or Progressive and you're buying direct and you're buying from Allstate, you're buying direct, you should - it should be the same kind of value. Now, it gets a little dicier when you figure out prices because what the limits are and all kinds of - it's complicated fast. But the conceptual approach would be, be competitive in channel based on the value you deliver to shareholders, or the customers. Glenn how would you - is there other things you'd add to that?
Glenn Shapiro: Yeah. Going to the point about what do we get out just the demographic shift versus being more competitive? Clearly, it's a growing channel. So if you are - if you're sitting in the boat and the current is taking you in a certain direction, so that there's something to, you really should be there, and that's why we're there. It's why transformative growth, why we wanted to be in all channels and where customers want to buy. So I think there's some benefit to that. But the bigger benefit is two other things. One would be being competitively priced, why we're going after expenses, why we did the pricing differential that Tom talked about. And then the third one, which frankly, maybe even the most important is just your execution in it and it's the fact that it we have used the capabilities of insurance, but we're still newer at being a large national player with the brand we've got of Allstate doing this is building the capabilities whether it's web, our sales processes, marketing sophistication, integration of marketing into it. So that we are winning our fair share there because you got to get the price to be competitive, but you also have to be great at the process itself.
Tom Wilson: So as we go back to that slide where we showed the three different channels, direct is up, as we said it's not 29% of sales, we expected to continue to go up as Glenn said, as we get better. There are some shifts to that channel if you just look globally, some of that's because more people feel comfortable buying over the web and not going through some of that. Some of it is just because direct is a whole bunch of advertising and it drives people to it. But we're, as Glenn pointed out in that boat and increasing our capabilities. But that doesn't mean we're waving the flag on people-to-people exchange. And so the key part of transformer growth is, there are people who want help. We just need to give it them at a lower cost. And that's what we're working on. So people were more than happy to pay a lot of money - not lot, but to be paid for help to buy the insurance, they just don't want to pay you 10% for ongoing service when they can do self-service, it is not much to be done or you can do at a lower cost centrally. So that's our shift and transformer. We're not waving the flag on person-to-person sales. In fact, we're leaning in and saying we have a great position here, we have a great brand, people know us, we just need to do it more effectively and create higher growth models. So that will take us some time to transition. As we talked about, like I don't expect the Allstate agent business to jump up the way you'll see the direct business increase over the next 12 months. But I do think it's got great long-term potential. And we're investing heavily in making sure those agents can deliver what people want if they want help buying products.
Meyer Shields: Okay, that was quite helpful. Thank you. A quick follow up if I can, has the - I guess recent severity issues in both auto and home, have those changed the timeline for rolling out the standard products on National General's platform?
Tom Wilson: Short answer would be no, we think we can be really competitive in that market. And we're excited to get into the independent agent channel and do it as quickly as we can. We'll have some of our middle market products this year on the NatGen platform branded as National General and Allstate Company. So we'll get the benefit of the endorsed brand. And then over the next two years, we'll be rolling that out as quickly as we can.
Meyer Shields: Perfect. Thank you so much.
Operator: Thank you. Our next question comes from the line of Michael Phillips from Morgan Stanley, your question please.
Michael Phillips: Hey, thanks. Good morning. In your introductory comments on severity, you talked about some other ways to counter it besides the target price increases, could you expand upon maybe how those will help severity issues, I didn't really get all the lists you were talking about maybe go through those little more detail and talk about how they can help you counter severity besides price?
Tom Wilson: Sure. Thanks, Michael. It really is about claims capabilities and paying what you owe, in being fair to folks. But making sure you don't pay more than you owe as things move. So we have inflationary factors, for example, say on materials for homeowners, having purchasing power, and having really good deals in place over the long-term on flooring, on roofing, and other products used in home repair, helps hedge that inflation. And with our size, with our buying power and with the capabilities of our claims team, we've been able to do that helps hedge it. Again, I'm not suggesting it eliminates the problem of inflation. But it does help mitigate it so that not all of that cost is passed through to your customers. Because in our view the job to our customers, obviously we got to put them back to where they were. We've got to charge people an appropriate price and give them the best value possible. And part of that is mitigating the cost of claims. So that was in the purchasing power. The proprietary models I mentioned before, is we've just invested a lot in our analytics and data capabilities over the years in order to flag claims that were at risk for accelerating costs so that we could get it into the right experts hands at the right time and it allows us to do a better quality job on those and also manage the costs.
Michael Phillips: Okay, thank you for that. One other quick one if I could then, you had a lot of talk on the direct to consumer channel for auto and clearly that's a growth area. What's your view on that channel longer term for the homeowners market?
Tom Wilson: We think it's good. I mean, I think people do want sometimes a little more help on their home because they care more about their home. But we think that those people who are comfortable using advanced technology, bots, chat on assets you can get online should be able to buy more homes direct.
Michael Phillips: Okay, cool. Thank you.
Tom Wilson: Thank you for taking the time. Maybe just close on a few things first on investment results. I totally understand the view that one would not fully count the huge increase in performance spacing. But when I read some of the reports, I'm like I think it's fair to say it was an outsize quarter. But that doesn't mean that our long-term results should be ignored. We're good in investments we had good results. Our acquisitions are performing well, whether that be Allstate protection plans, which we didn't really get questions on today. I just want to remind you we bought that company four years ago at $1.4 billion. It's now over a billion dollars in revenue. It's growing at 27% a year. It made $155 million, which means we paid nine times earnings for business that is growing 27%. So we think it's worth a lot more than that. National General, we also think will be highly successful. But we're off to a really good start there. You can see that in the current numbers. And it's not just the 4 million policies we added. By the way, when you look at the net cash, we had the layout after a stretch to our capital. I do not believe we could have acquired 1% market share by putting a couple of billion dollars into advertising. So we think it was also just an economic growth opportunity straight up, forget the strategic potential for the growth. And then share repurchases we continue to really do well. This is the biggest share repurchase program we've ever announced both in dollars and percentage of market capitalization that's build up. So, thank you for participating today. We had great results this quarter. We look forward to talking to you next quarter.
Operator: Thank you, ladies and gentlemen, for your participation in today's conference. This does conclude the program. You may now disconnect. Good day. | [
{
"speaker": "Operator",
"text": "Thank you for standing by, and welcome to the Allstate's Second Quarter 2021 Earnings Conference Call. At this time, all participants are in a listen-only mode. After the speaker's presentation there will be a question-and-answer session. [Operator Instructions] As a reminder, today's program is being recorded. And now I'd like to introduce your host for today's program, Mr. Mark Nogal, Head of Investor Relations. Please go ahead, sir."
},
{
"speaker": "Mark Nogal",
"text": "Thank you, Jonathan. Good morning. Welcome to Allstate's second quarter 2021 earnings conference call. After prepared remarks, we'll have a question-and-answer session. Yesterday, following the close of the market, we issued our news release and investor supplement and posted related materials on our website at allstateinvestors.com. Our management team is here to provide perspective on these results. As noted on the first slide of the presentation, our discussion will contain non-GAAP measures for which there are reconciliations in the news release and investor supplement and forward-looking statements about Allstate's operations. Allstate's results may differ materially from these statements. So please refer to our 10-K for 2020 and other public documents for information on potential risks. And now I'll turn it over to Tom."
},
{
"speaker": "Tom Wilson",
"text": "Good morning and thank you for joining us today. Let's start on Slide 2. Today, we're going to link operating results to strategy in order to show how we expect to continue to generate shareholder value. So Allstate’s strategy has two components; increased personal property-liability market share and expand protection solutions, which are shown in the two ovals on the left. The transformative growth plan to increase market share and personal property-liability has four components. This strategy would drive market valuation by executing, innovating, and focusing on long-term value creation. So in the first half of the year, we executed well for customers, we executed well financially and for shareholders as you can see on the right hand panel. Property-liability market share increased by approximately one percentage point through the acquisition of National General. Allstate Protection Plans continued to grow rapidly by broadening the product offering to include appliances and furniture and expanding availability through Home Depot stores. Strong execution generated excellent financial results with revenues increasing 23.8% compared to the prior year, adjusted net income of $3 billion, and a return on equity of 23.8% for the last 12 months. Shareholders benefited from a 50% increase in the quarterly common dividend and a reduction in outstanding shares by 2.4% just this year, under the current $3 billion share repurchase program. Yesterday, the Board approved a new $5 billion common share repurchase program, which represents approximately 13% of current market capitalization, and we expect to complete that by the end of March of 2023. Let's continue on Slide 3. In addition to operating execution, we're innovating to create long-term value. The transformative growth plan to create a digital insurance company is making good progress. Today, we're going to spend time talking about the distribution component of that plan. Allstate is amongst the leaders in telematics capabilities with Drivewise in the industry's largest pay-per-mile product Milewise, which offers customers unique value. Arity, our telematics service platform company recently launched Arity IQ, which when combined with LeadCloud and Transparent.ly platforms will integrate telematics information into pricing at the time of quote, rather than at the time after the sale. We enhanced our competitive position in independent agent channel by using National General to consolidate and improve our IA business model. We executed agreements to sell Allstate Life Insurance Company and Allstate Life Insurance Company New York, to redeploy capital out of lower growth and return businesses and reduce exposure to interest rates. Increasing market share, while maintaining attractive returns and expanding protection solutions through transformation, targeted acquisitions, and divestitures will create shareholder value. Slide 4 lays out the Allstate's strong second quarter performance. Revenues of 12.6 billion in the quarter increased 21.6% compared to the prior year, largely reflects the National General acquisition and higher net investment income. Property-liability premiums earned and policies in force increased by 12.9% and 12.1% respectively. Net investment income of $974 million increased by over $0.75 billion compared to the prior year quarter, reflecting $649 million of income from the performance-based portfolio. Net income of 1.6 billion was reported in the second quarter compared to $1.2 billion in the prior year. Adjusted net income was $1.1 billion or $3.79 per diluted share as you can see from the table on the bottom, that's a 40% increase from the prior year quarter. Allstate's excellent execution and strong operating results in the quarter contributed to that return on equity, which I just mentioned of 23.8% over the last 12 months. Let's move to Slide 5 to discuss our progress on building transformative growth business models. So, transformative growth is a multiyear initiative and what we're working to do is build a low cost digital insurer with broad distribution, and that's going to be accomplished through four areas; expanding customer access, improving customer value, increasing sophistication and investment in customer acquisition, and deploying new technology ecosystems. And in transformative growth - you wouldn't do it all in one day of course, it's got five phases, and substantial progress has been made in phases two and three. Phase two successes include improving the competitive price position of auto insurance, protecting margins by reducing costs, new advertising was launched with increased investment. We also are off to an excellent start with National General. And of course the phases overlap, so progress has also been made in Phase three. So we're transforming the distribution platform, including supporting transition of Allstate agents to higher growth and lower cost models, which we'll discuss on the next slide. Improving customer acquisition sophistication will lower costs relative to lifetime value. We continue to focus on lowering underwriting and claims expenses to deliver lower cost protection to customers, and we’ve designed the new technology architecture. We've coded much of the new applications. The next step for us is to launch an integrated system with one product in one state. Turning to Slide 6, let's review how we're transforming the Allstate agent, Allstate direct sales, and independent agent distribution platforms to grow market share. The illustrative on the right side of the slide provides a view into our growth expectations by channel over time. Starting with Allstate exclusive agents, we're making progress transitioning to a higher growth and lower cost model. This year, we changed agent compensation by increasing their business compensation opportunity and reducing a bonus paid on policy renewals. We expect to continue this shift from renewal compensation to new sale because it aligns with what consumers want. Consumers want assistance with purchasing insurance more than they want routine policy service. To lower cost for agents, we're digitizing processes, redesigning products to increase self-service, and expanding centralized service support. We're also working to reduce agent operating expenses and real estate costs. These changes will improve the customer value proposition with lower cost and easier service. Now, of course, you're not going to do this in one day either, so a multiyear transformation - transition program is in place to support existing agents, we've initiated it and it has different levels of support based on agent performance. Given this transition, we reduced new agent appointments last year, which has had a negative impact on new business levels. But as Mario will discuss next, this has been offset by higher productivity from existing agents. At the same time, we have two new agent models in market, which have a personal touch, but a lower cost structure. All of these changes are supported by more competitive auto insurance pricing and increased marketing spending, which is designed to continue to grow. But as you can see on the right, the net impact of these changes for the Allstate agent channel is to be flat to a slight decline in sales in the short-term, but increased growth thereafter. The Allstate direct sales effort leverages the capabilities that we built for the insurance brand, and we've shifted our advertising focus away from insurance to be totally focused on the Allstate brand and utilizing the direct channel for Allstate brand sales as well. The pricing is lower than the Allstate agent model since it doesn't come with the help of an agent. And as this business grows, we're improving our operational and marketing effectiveness. Direct sales now represent 29% of new auto business sales. And we expect that to continue to grow rapidly as you can see on the right. Independent agent distribution also represents an attractive growth opportunity. The acquisition National General enhanced our capabilities in this channel and they added 4 million policies in force. Additional growth is expected by broadening the product portfolio from high risk drivers to middle market auto and home insurance through the existing agent relationships. We also expect to increase the number of agents actively engaged in selling National General products. So when you combine this effective and efficient distribution, with more competitive auto insurance pricing, enhanced marketing, advanced pricing and telematics and the digital experience, that's the transformative growth plan that'll drive property-liability market share growth. So Mario will now discuss the second quarter results in more detail."
},
{
"speaker": "Mario Rizzo",
"text": "Thanks Tom. Turning to Slide 7, let's dive deeper into near-term results on our multifaceted approach to grow property-liability market share. As you can see in the chart on the left side of the slide, property-liability policies in force grew by 12.1% compared to the prior year quarter, primarily driven by National General and growth in Allstate brand new business. National General, which includes Encompass, contributed growth of 4 million policies, and Allstate brand property-liability policies increased in the quarter driven by growth in homeowners and other personal lines. Allstate brand auto policies in force declined slightly compared to the prior year quarter, but increased sequentially for the second consecutive quarter, including growth of 111,000 policies compared to prior year and as you can see by the table on the lower left. The chart on the right shows a breakdown of personal auto new issued applications compared to prior year. We continue to make progress in building higher growth business models, as we look to achieve leading positions in all three primary distribution channels. The middle section of the chart on the right shows Allstate brand impacts by channel, which in total generated a 6.7% increase in new business growth compared to the prior year. Modest increases from existing agents excluding new appointments, and a 31% increase in the direct channel more than offset the volume that would normally have been generated by newly appointed agents as we pilot new agent models with higher growth and lower costs. The addition of National General also added 481,000 new auto applications in the quarter. Let's turn to Slide 8 to review property-liability margin results in the second quarter. The recorded combined ratio of 95.7 increased 5.9 points compared to the prior year quarter. This was primarily driven by increased losses relative to the historically low auto accident frequency experienced in the prior year quarter due to the pandemic. Increased losses were partially offset by lower pandemic related expenses, primarily shelter in place paybacks in 2020, as well as lower catastrophe losses. These are represented by the green bars in the combined ratio reconciliation chart on the lower left of the slide. Shifting to the chart on the bottom right, we continue to make progress in reducing our cost structure. This enables improvement in the competitive price position of auto insurance, and investments in marketing and technology while maintaining strong returns. The total property-liability expense ratio of 24.7 in the second quarter decreased by 7.1 points compared to the prior year, again, driven by lower Coronavirus related expenses. This was partially offset by the amortization of purchased intangibles associated with the acquisition of National General, restructuring charges, and a 0.7 point increase from higher investment in advertising. Excluding these items as shown by the dark blue bars, the expense ratio decreased by 0.4 points in the second quarter, compared to the prior year period, decreased 1.7 points below year end 2019 and 2.5 points below year end 2018 reflecting continued progress and improving cost efficiencies. Claims expenses have also been reduced through innovations such as QuickFoto Claim, Virtual Assist and aerial imagery, which also improves the customer experience. These claim improvements are not reflected in the expense ratio, but are in the loss ratio and also helped maintain margins. Moving to Slide 9, let's discuss how our auto insurance profitability which remains very strong, and is still favorable to pre-pandemic levels, despite pandemic driven volatility. Allstate protection auto underlying combined ratio finished at 91.8. As you can see from the chart, the level remains favorable to 2017 through 2019 historical second quarter and year end levels despite increasing by 9.4 points compared to the prior year quarter. The increase to the prior year quarter reflects a comparison to a period with historically low auto accident frequencies. The improvement relative to historical levels is driven by auto accident frequency remaining below pre-pandemic levels, partly offset by auto severity increases and competitive pricing enhancements. To illustrate the pandemic driven volatility, Allstate brand auto property damage gross frequency increased 47.3% from the prior year quarter, but is 21% lower than the same period in 2019. Auto severity increases persisted relative to the prior year quarter and pre-pandemic periods across coverages largely driven by the shift in mix to more severe higher speed auto accidents and rising inflationary impacts in both used car values and replacement part costs. The incurred severity increases are running higher than general inflation, which are reflected in the reported combined ratio. To counteract rising severity we are leveraging advanced claim capabilities, predictive modeling, advanced photo and video utilization and deep expertise in repair process management to enable a scaled response to inflation and supply constraints. Targeted price increases will also be implemented as necessary to maintain attractive auto insurance returns. Now let's shift to Slide 10, which highlights investment performance for the second quarter. Net investment income totaled $974 million in the quarter, which was $754 million above the prior year quarter driven by higher performance based income as shown in the chart on the left Performance-based income totaled $649 million in the second quarter, as shown in grey, reflecting both idiosyncratic and broad based valuation increases in private equity investments, and to a lesser extent gains from the sale of real estate equity. Market-based income shown in blue was $3 million above the prior year quarter. The impact of reinvestment rates below the average interest bearing portfolio yield was mitigated in the quarter by higher average assets under management and prepayment fee income. Our total portfolio return in the second quarter totaled 2.6% reflecting income as well as higher fixed income and equity valuations. We take an active approach to optimizing our returns per unit of risk over appropriate investment horizons. Our investment activities are integrated into our overall enterprise risk and return process and play an important role in generating shareholder value. We draw upon a deep and experienced team of roughly 350 professionals to leverage expertise and asset allocation, portfolio construction, fundamental research, field leadership, quantitative methods, manager selection and risk management. While the results for this quarter were exceptionally strong, particularly for the performance-based investments, we manage the portfolio with a longer term view on returns. At the right we have provided our annualized portfolio returns over a three, five and 10 year horizon. As disclosed in our investors supplement our performance based portfolio has delivered an attractive 12% IRR over the last 10 years, which compares favorably to relevant public and private market comparisons. Our performance-based strategy takes a longer term view, where we seek to deliver attractive, absolute and risk adjusted returns and supplement market risk with idiosyncratic risk. Moving to Slide 11, protection services continues to grow revenue and profit. Revenues excluding the impact of realized0 gains and losses increased 27.1% to $581 million in the second quarter. The increase was driven by continued rapid growth in Allstate protection plans, and expanding marketing services at Arity due to the integration of LeadCloud and Transparent.ly, which were acquired as part of the National General acquisition. Policies in force increased 15.5% to 147 million, also driven by Allstate protection plans, and supported by the successful launch with the Home Depot in the first quarter. Adjusted net income was $56 million in the second quarter, representing an increase of $18 million compared to the prior year quarter, driven by profitable growth at Allstate protection plans and profits at Arity and Allstate identity protection. Allstate protection plans generated adjusted net income of $42 million in the second quarter and $155 million over the past 12 months. Now, let's move to Slide 12, which highlights Allstate's attractive returns and strong capital position. Allstate continued to generate attractive returns in the second quarter, with adjusted net income return on equity of 23.8% for the last 12 months, which was 5.8 points higher than the prior year. Excellent capital management and strong financial results have enabled Allstate to return cash to shareholders while simultaneously investing in growth. We continue to provide significant cash returns to shareholders in the second quarter through a combination of $562 million in share repurchases and $245 million in common stock dividends. We announced the acquisition of SafeAuto in June, leveraging National General's success in integrating companies to accelerate growth. The current $3 billion share repurchase program is expected to be completed in the third quarter. And yesterday the Board approved a new $5 billion share repurchase authorization to be completed by March 31, 2023. This represents approximately 13% of our current market capitalization. This new authorization continues Allstate's strong track record of providing cash returns to shareholders and reflects in part, the deployable capital generated by the sale of our life and annuity businesses. Moving to Slide 13, it should be clear that Allstate is an attractive investment opportunity. When you invest in Allstate you get ownership of a company with advanced capabilities and a clear strategy, delivering superior financial results relative to peers and the broader market. The table below shows Allstate across key financial metrics over the past five years compared to the S&P 500 and property casualty insurance peers with a market cap of $4 billion or more. As you can see by the four measures on the top operating EPS, operating return on average equity, cash yield and total shareholder return, Allstate is consistently ranked in the top two or three amongst its peers. In the case of operating EPS and cash yield to common shareholders, Allstate is in the top 10% and top 15% respectively, compared to the S&P 500. Moving down one row, Allstate's top line revenue growth relative to peers and the S&P 500 is in the middle of the pack. We are committed to accelerating top line performance through transformative growth and innovating protection while continuing to deliver excellent financial results. Moving down to the price to earnings ratio, Allstate is well below average, eight out of 10 P&C peers and in the 10th percentile amongst the S&P 500. This is an attractive valuation, given our market leading capabilities, excellent returns, future growth prospects and commitment to accelerate growth. Now, let me turn it back over to Tom."
},
{
"speaker": "Tom Wilson",
"text": "Let's turn to Slide 14. Let's finish where we started with a more macro and longer term view of Allstate's execution, innovation and long-term value creation as this is a whole report card as his is what you get by investing in Allstate. Empowering customers with protection is a core part of our purpose. We provide a broad set of protection solutions with over 180 million protection policies in force. You see our name while you're watching TV, you're in Walmart, you're in Target, You're in Casco, you're in Home Depot, Allstate is ubiquitous out there protecting customers. We constantly achieve industry leading margins on auto and home insurance, and have attractive risk adjusted investment returns. As a result, the adjusted net income return on equities averaged 15.6% from 2016 to 2020, ranking number two in our peer group. This has led to a 14.9% annualized total shareholder return over the last five years. We have a history of innovation. Transformative growth is a multiyear personal property-liability strategy to build a digital platform that offers low cost affordable, simple and connected protection solutions. We're simultaneously innovating protection by expanding through telematics, product warranties and identity protection. In telematics we've taken a broad and aggressive approach, the insurance offerings and the creation of Arity leading telematics business. Allstate is also innovating new corporate citizenship, focusing on climate change, privacy and equity. For example, we used an underwriting syndicate for $1.2 billion bond offering last year that was exclusively minority women and veteran owned banking enterprises. Long-term value is also being created through proactive capital management, and strong governance. Over the past five and 10 years we've repurchased 25% and 50% respectively of outstanding shares. Among the S&P 500, Allstate is in the top 15% of cash provided to shareholders. At the same time, we've successfully invested over $6 billion in acquisitions, including Allstate protection plans, Allstate identity protection and National General. And of course, strong governance is key to delivering those results. Allstate has an experienced and first management team and Board with relevant expertise. This is acknowledged by the leading proxy advisory firm that has awarded Allstate the top score for governance. Execution, innovation and long-term value creation will continue to drive increased shareholder value. With that context, let's open the line for your questions."
},
{
"speaker": "Operator",
"text": "Certainly. [Operator Instructions] Our first question comes from the line of Greg Peters from Raymond James, your question please."
},
{
"speaker": "Greg Peters",
"text": "Good morning. So I'd like to go back to Slide 5 Tom, and where you lay out the transformative growth strategy, and in the phase two area, you report on substantial progress being made in terms of improved competitive price position in auto insurance. When I went to your supplement, I observed that the average gross premium in the auto brand continued to be lower relative to prior quarters. And I'm just curious how you think about pricing today given the increase in frequency and certainly the increase in severity in the context of your strategy to have an improved competitive price position."
},
{
"speaker": "Tom Wilson",
"text": "Okay, let me start and then I'll get Glenn to jump in. First, in terms of transformative growth, we made a conscious strategic decision to improve the competitive position of auto insurance. When we looked at our cost structure and we looked at where other people were, we decided we needed to be more competitive on pricing. And so, we've been working on that. We've reduced our costs. We've reduced price. We know we're more competitive in the market. And actually you can't really look at the average prices Greg because everybody starts in a different place. So, if you're at 100 and I'm at 95 and you go down 2%, it doesn't make you - really it makes you more competitive [ph], but not competitive, so we look at close rates and we know - we looked at the - when people come to us, they quote what percentage do we close, and when the close rate goes up, you assume you're price competitive and you have a better value proposition. And in fact, that's been true this year, and it's one of the reasons why our new business is up. Now we do that, of course, with great surgical precision. So let me maybe provide an overview of auto insurance profitability because it was the focus of so many of the reports issued last night, and Glenn can jump into what he's got going forward. And I'll start with the analytical structure that I use to evaluate our performance in ways that hopefully will be helpful from an investment perspective. The headline would be to evaluate starting with the current absolute number, don't use one analytical method to assess the future and build on your margin for error. So, the current combined ratio for auto insurance this quarter generated an attractive return on capital. When you look at the number, it's a good return on capital. Looking forward of course is what I need to do and investors need to do, and the forecasting challenge is that the volatility of the components is so high that it's hard to do a quarterly forecast that’s accurate enough to make an important decision. So for example, let's say the percentage is up and down, they're really hard to evaluate, the outcome of 50% decrease, and a 30% increase is a 65%. A 45%, decrease and a 35% increase, it sounds pretty similar, right, but it's the 74%. That small 5 point difference on each side creates a 9 point difference on margins. They're typically less than that. So given the volatility of the percentage changes, we build in margins for error. So as it relates to our projections and forecast so far this year has been pretty good. Severity was higher than expected. But given the volatility of those percentages in the environment, we made sure there was enough margin in pricing and reduced expenses. So as a result, our absolute level of profitability was good and better than many of our competitors' reported results. So the overall goal, of course, is profitable growth. And the best way to manage that total is then you focus on the components, whether that's state-by-state, line by line, or inside the actual cost structure, so Glenn has established goals for the rest of the year on price increases, severity control, and expense reductions. And we have the processes, the math, and state managers that enable us to achieve and adapt, which is we have a consistent track record of doing. So I think when I see people making percentage changes over each quarter and looking at the percentage change of us versus the percentage change of competitors, I'm like when you got the numbers moving around this fast, you really have to go back to the absolute and say, “did you make money? How did you make money? And how do you make sure you keep making money going forward?” With that let me turn it over Glenn, who can talk a little bit about what he's going to get planned for the rest of the year."
},
{
"speaker": "Glenn Shapiro",
"text": "Great. Thanks Tom. And Greg, if I go to the first part of your question on price position, the best measure of price competitiveness are close rates, and our closed rates are up. So we've seen a good result on the fact that for a few years, as Mario covered earlier, we've taken expenses out of the system, we've taken those expenses, and essentially allowed customers to get better value from us. And that's improving our close rates, which has helped. The second part, when you talked about going forward with frequency and severity, as Tom said, we have a pretty good forecast on frequency, and it's continued to be lower when you go on a two-year basis. The one-year comparisons right now are interesting on just about everything, but on a two-year basis to pre-pandemic, they continue to be meaningfully lower. Some of that will be just the new different world that we're in with fewer people working in office buildings and travelling in rush hour. Some of that will revert back over time, but we've had really good forecasts on that. The frequency has been higher. Sorry, the severity has been higher with inflationary factors. And so, we're looking at that and where we have to take pricing we will. And I guess, when you put them together the key is in how we've been forecasting, and when we look at when the line will cross. And what I mean by that is, we knew that look, severity compounds over time. So once you're a couple years in which we are now when you're comparing to 2019, you've got a couple of years of severity increases. At some point, it's going to be greater than the benefit that is persisting on frequency and you cross that line. And so, we're pretty good at forecasting about the time we're crossing that line. We moved prices slightly down. In some places, we're still good with those and we still have opportunity to even be more competitive. In other places, we're going to have to take them up. But we don't have wild swings happening in terms of our pricing. We've been pretty careful and cautious to do things that we thought were sustainable, and we're going to continue to do things that we think are sustainable. So as we take expenses out, continuing to do for the remainder of the year, the loss cost management that the claims team is doing and our pricing actions, we think there's more ground we can make up from a competitive position standpoint."
},
{
"speaker": "Greg Peters",
"text": "That was a very thorough answer. And I was going to ask a question on expenses. But I got to just follow up on your point on severity, and crossing the line. As you know, there's so much oxygen going on around inflationary pressures in the marketplace. And some of its viewed maybe perhaps being transitory, some of it being structural and longer term in nature. And I guess what I'm looking for from you guys is what's your view on the severity trends and can you give us some perspective on that crossing the line analogy that you used Glenn?"
},
{
"speaker": "Tom Wilson",
"text": "Well Greg, we don't do forecasts of combined ratio, or the components of the combined ratio. But I think when you look at - it's interesting though, when you look at the supplement, you'll see the paid on property damages is down, that's not related to the way we're booking, they just happen to be paid and there's some timing. So when you look at severity has to be clear difference between what you pay, and what you think you're going to pay eventually. And so we think severity - we know severity is up this year, we booked it up both first quarter and second quarter, even a little more. But so Glenn's got factored into this pricing. Glenn, anything you want to say about the client, maybe talk a little bit about severity control."
},
{
"speaker": "Glenn Shapiro",
"text": "Yeah. And just to the point about what's transitory and what's in there. I think if you look at both frequency and severity in that way, like they're components of frequency, like we get really detailed into looking at the miles driven, it isn't just what was the total miles driven out there. It's, by state, it's urban versus rural, it's commuting time versus not, it's weekend versus week day and night day. So when we look at all of this, we have a view on what we believe is transitory and what is more sustainable on frequency as well as on severity. But the controls that we have, from a claims standpoint, we have a really strong claims team and they use first of all proprietary models that we have to escalate claims that either need to be expedited, moved faster or need to be prepared for defense in terms of injury claims. Tell us the likelihood of litigation, the likelihood of representation, things like that, we leverage our scale really well and that we have long-term pricing deals on a lot of the parts and labor that are out there for whether it's auto or home, so some of that acts as a hedge towards inflation. And it's not perfect, because we're in the same inflationary environment that others are in. But we do with our buying power have had good long-term deals that we've negotiated that help to hedge that to some degree and then really strong quality process that we manage across the system. So we feel good about our ability to manage within the environment, but also we have to price for it as it moves. And I guess I'll close by saying, if anything, our history is been proven, I would say, we do a really good job managing to our returns. And Mario and Tom talked about those in the opening quite a bit. We will manage to produce the right returns and when we need to take price to do that we do it."
},
{
"speaker": "Greg Peters",
"text": "Makes sense. Thank you for the answers."
},
{
"speaker": "Operator",
"text": "Thank you. Our next question comes from line Paul Newsome from Piper Sandler, your question, please."
},
{
"speaker": "Paul Newsome",
"text": "Good morning. A little bit more of a key off of those last questions. But one of the questions I'm getting a lot is whether or not there'll be sort of regulatory issues with auto in particular if we need to get more rate and I'd love to hear your thoughts on how that gets managed at Allstate."
},
{
"speaker": "Tom Wilson",
"text": "I'll maybe start with a little macro and then Glenn can talk about anything we're doing specifically. Paul, I think the first place I would start is the regulatory reaction tends to start with what consumers think. And consumers are in a pretty good place. Our customers are in pretty good place getting a billion dollars back last year. There's plenty - if you look at savings rates and cash and bank accounts and all kinds of stuff, consumers are not - have some pricing ability - there not a lot of pricing pressure coming from consumers each day, so again the count of percentage increases that we need or not so large, you're not talking about double digit price increases that cause everybody to call the insurance regulator and say I don't like this world. So we don't see a lot of consumer pushback. When you look at the regulators we have a good relationship with our regulators. I mean, we were 10 days in last year, I mean, Glenn, I think it was like 10 days into March, we were like we got to do something about this. So we went out proactively to regulators and said, we don't have a requirement to do this, we have no contractual requirement to do it. But we know you'll want us to do it. So we're going to do it in advance upfront and we led the industry in doing that. So we feel like we have good relationships with them, we've been balanced as to how we approach it. And we've been able to earn the economic rents in the marketplace and compete successfully. And Glenn anything, you want to talk about in terms of specifics."
},
{
"speaker": "Glenn Shapiro",
"text": "First, I think is a really good point with some of the credibility we earned last year, because it's not only the shift the return of the money, but the fact that we went out there and proactively had the idea to say, we're just going to waive the requirement that you have an endorsement to do deliveries, let's say with your car and turn your car into an economic vehicle for you, for people that were out of work. They appreciate the fact that we were thinking about the way people were having to live their lives and not having to go buy an endorsement to do it. And we just gave it away for free and filed that across 50 states and in a matter of days, and special payment plans, allowing people more time to pay. So I think we did build a lot of credibility with that. But I think the core of this is the regulators have actuaries. And we have actuaries, and they are math based. So this is - sometimes you get into some emotion with it, but it's really a fact based and math based situation. So when severities go up or loss ratios move their actuaries with our actuaries and we have great relationships working to that one."
},
{
"speaker": "Tom Wilson",
"text": "Yeah, when rental cars go from 50 bucks a day to $100 a day or used car prices go up 40%, regulators know you got to make - you got to collect more money to take care of that."
},
{
"speaker": "Paul Newsome",
"text": "Makes sense and I'd like to ask homeowners question. I tend to think that people underestimate the durability and impact of the home business. Can you just talk a little bit about what's going on there from a pricing and competitive perspective? And whether or not the outlook is more favorable overtime? But it does seem to be - if anything, it seems like you're selling more of it and seems like it's a lead product for you at the moment?"
},
{
"speaker": "Tom Wilson",
"text": "Well, Paul, thank you for recognizing how successful we've been at home. Like there are days, when I feel like people think the only thing we sell is auto insurance. And like we make a lot of money in homeowners insurance, we're really good at it. It does require lower margins than auto insurance, because you got to put up a lot more capital because of the volatility. And you don't get a lot of investment income. So we've been very good at it. Glenn, do you want to talk about how we're doing this?"
},
{
"speaker": "Glenn Shapiro",
"text": "Yeah, boy, do I. Yeah, I appreciate that Paul. We feel really good about where we are in homeowners. So I'll give you a quick number on the last five years, 89 combined ratio, that's recorded combined ratio not underlying, and we've made just over $4 billion in the past five years of underwriting profit. So we're good at this, I don't mind being bold enough to say that we - I think we have a sustained and systemic advantage in homeowners that we've proven over a long period of time. And it goes to the claims capabilities, the cap management capabilities, our reinsurance system that we have, our risk selection, our product capability and pricing. So it's a pretty deep skill that's been honed over a long period of time that we're able to leverage. And so when you look at there's no question that inflation is hitting the homeowner side hard and you got weather events. And you look at what it's doing to the industry more broadly than us. And there's going to be folks taking a lot of rate out there. And I think you've heard that from them. And our product is such that like, year-over-year, we're at 6% up on average premium, even though we took only three and a half points a rate because built into it, there's some inflationary factor. So we're really well positioned to continue to make money at it, protect a lot of people. And last point is it goes to what Tom talked about earlier about transformative growth. You look at the independent agent system. We bought National General primarily to really have a ticket into that system, where they have great systems, a lot of appointments, great relationships and they're good at some products. Well, we're really good at home. You get that home product into the IA channel. And I think it's going to sell well, we're going protect a lot of people we're going to help IAs grow."
},
{
"speaker": "Paul Newsome",
"text": "Thank you, I appreciate it."
},
{
"speaker": "Operator",
"text": "Thank you. Our next question comes from wine of David Motemaden from Evercore ISI, your question, please."
},
{
"speaker": "David Motemaden",
"text": "Hi, good morning. I had a question just on frequency. And I guess it's a question maybe you can clarify how that trended throughout the quarter by month? And maybe just talk about what you're seeing today. And should we be thinking about frequency being more flat with 2019, combined with 14% to 15% severity increase versus '19 that you guys called out in the 10-Q?"
},
{
"speaker": "Tom Wilson",
"text": "David, I'll get Glenn to answer the question on frequency. I'm not sure where that 14% to 15% came from, but and how you've factored. What period of time you're focused, is that two years and then one year? Because you can't take a two year trend and extrapolate it onto annual trends is, maybe that's what I heard. But Glenn do you want to talk just about frequency?"
},
{
"speaker": "Glenn Shapiro",
"text": "Sure. Yeah. No, I would not - the short answer would be I would not say you should just expect a zero frequency trend relative to 2019. Well, we don't publish any forecasting on frequency. I think, broadly people in the industry have talked about the fact that safer cars have tended to have a little bit of a tailwind for frequency, even take away the pandemic for a moment that year-over-year we've had a long-term steady decline in frequency. And so you've got a couple of years of data as you compare to 2019. On top of that, we see and I alluded to this a little bit before, we see a really material change in the way people are driving. So even when you see the aggregate number of miles driven coming back still lower, but closer to 2019 levels. Who is driving, when they're driving and how they're driving is changing materially? So you see about a four or five point difference between the net change of urban driving being down more than rural driving. So you look at an Allstate book of business where we sell predominantly through exclusive agents or solicit agents or in more populated markets that tends to favor the way the frequency comes through. You look at the type of driving that's done, I mentioned before commuting is down significantly more than non-commuting. So quick stat for us, we look at a lot of these details. Weekend driving is actually higher right now than 2019 was. People just want to get out. Weekday driving is materially lower and particularly in rush hour. So when you see less congested roads in the time period, when the predominance of accidents happen in those morning and afternoon commutes that is helpful to particularly in our book of business, the way frequency comes through. So there are elements that will come back, it will come back differently and it is the only thing I'm confident in saying is that the world will look exactly the same after the pandemic than before. And that will mean that people drive and move differently. We see some non-transitory or temporary impacts to frequency."
},
{
"speaker": "David Motemaden",
"text": "Got it, okay, thanks and Tom, yes, yeah, I was referring to just Page 63 of the 10-Q, which is, yeah, that 14% to 15% is over two years. So you're right. It's about 7% on average per year. I guess, just a follow up just on the rate actions that you're thinking about taking? I just saw, I think it was like a 5% rate increase that you filed in Georgia recently. Maybe could you just talk about how widespread the rate increases are that you want to put in and maybe just talk a bit more about how you think that might impact the growth trajectory going forward?"
},
{
"speaker": "Tom Wilson",
"text": "Well, we don't - we've got - we got plans for the rest of the year is where we think we need to increase price. But we don't give those out for competitive reasons. And we also need to bring traders to agree. So I would just say that we think we will. You should rely on the fact David that we know how to make money and we're focused on making money. As to the competitive business I think it depends what other people do. So you heard yesterday if you listen to the Progressive call they're all in on raising prices, cutting advertising, changing underwriting stuff. So we think that gives us room to adapt and continue to grow, and make money and make sure that we can recover costs as they go up. Other competitors are in different places. But we feel good about where we're at, like trades for growth. Like if you start off and said, would you want to - have a pandemic and a huge drop in frequency for a year to do transformative growth? You probably would say, I don't know, like it's a lot of volatility to manage. On the other hand, I think in our particular case, it's worked well for us."
},
{
"speaker": "David Motemaden",
"text": "Got it. Thank you. Is it your sense that the rest of the industry is going to start raising prices?"
},
{
"speaker": "Tom Wilson",
"text": "If you look at what they've done then we can really focus on and there have been more rate increases this year than I think probably people would have predicted if you asked them in the fourth quarter of last year. And that would include us, like if you just said, what do we think everybody was going to do this year? We wouldn't have thought they had to go up as much as they did. But we also didn't think severity was going to be as high as it is. So we're increasing ours, and they're increasing theirs. But we think our relative advantage, given our sophistication in pricing, given our reduction in expenses, given what we're doing on the long-term basis to get expenses down even farther, puts us in good place. So we don't see anything happening that tells us we can't still be on the path to grow market share. The specific roads we go down might be a little different. But we're still feeling like that goal is still there or the objective is still achievable."
},
{
"speaker": "David Motemaden",
"text": "Okay, thank you."
},
{
"speaker": "Operator",
"text": "Thank you. Our next question comes from line of Meyer Shields from KBW, your question, please."
},
{
"speaker": "Meyer Shields",
"text": "Thanks. I wanted to dig in a little bit to Allstate direct, I just want understand the thought on the pricing strategy. And what I mean by that is I think we've got demographic trends favoring direct distribution, but also to massive competitors and I wanted to know whether the competitive posture is that you have to be in line with where Progressive and GEICO are? Or can you benefit enough from these demographic trends to achieve your growth goals."
},
{
"speaker": "Tom Wilson",
"text": "I'm trying to sort through Meyer - the first direct should be priced for what you get like you should get what you pay for. So when you buy Allstate direct, it's I think on average, about 7% lower than if you buy from an agent because it doesn't come with health, and so it's you get what you pay for. And there are people - there are some demographic shifts there. But some of it's not - there are some young people who want help and some older people who don't want help. And so where their focus is not as much on demographics of those channels, but it is the customer value. As it relates to our competitive position in each channel, we believe you should have a competitive price position in each channel, like-for-like, so if you're buying from GEICO or Progressive and you're buying direct and you're buying from Allstate, you're buying direct, you should - it should be the same kind of value. Now, it gets a little dicier when you figure out prices because what the limits are and all kinds of - it's complicated fast. But the conceptual approach would be, be competitive in channel based on the value you deliver to shareholders, or the customers. Glenn how would you - is there other things you'd add to that?"
},
{
"speaker": "Glenn Shapiro",
"text": "Yeah. Going to the point about what do we get out just the demographic shift versus being more competitive? Clearly, it's a growing channel. So if you are - if you're sitting in the boat and the current is taking you in a certain direction, so that there's something to, you really should be there, and that's why we're there. It's why transformative growth, why we wanted to be in all channels and where customers want to buy. So I think there's some benefit to that. But the bigger benefit is two other things. One would be being competitively priced, why we're going after expenses, why we did the pricing differential that Tom talked about. And then the third one, which frankly, maybe even the most important is just your execution in it and it's the fact that it we have used the capabilities of insurance, but we're still newer at being a large national player with the brand we've got of Allstate doing this is building the capabilities whether it's web, our sales processes, marketing sophistication, integration of marketing into it. So that we are winning our fair share there because you got to get the price to be competitive, but you also have to be great at the process itself."
},
{
"speaker": "Tom Wilson",
"text": "So as we go back to that slide where we showed the three different channels, direct is up, as we said it's not 29% of sales, we expected to continue to go up as Glenn said, as we get better. There are some shifts to that channel if you just look globally, some of that's because more people feel comfortable buying over the web and not going through some of that. Some of it is just because direct is a whole bunch of advertising and it drives people to it. But we're, as Glenn pointed out in that boat and increasing our capabilities. But that doesn't mean we're waving the flag on people-to-people exchange. And so the key part of transformer growth is, there are people who want help. We just need to give it them at a lower cost. And that's what we're working on. So people were more than happy to pay a lot of money - not lot, but to be paid for help to buy the insurance, they just don't want to pay you 10% for ongoing service when they can do self-service, it is not much to be done or you can do at a lower cost centrally. So that's our shift and transformer. We're not waving the flag on person-to-person sales. In fact, we're leaning in and saying we have a great position here, we have a great brand, people know us, we just need to do it more effectively and create higher growth models. So that will take us some time to transition. As we talked about, like I don't expect the Allstate agent business to jump up the way you'll see the direct business increase over the next 12 months. But I do think it's got great long-term potential. And we're investing heavily in making sure those agents can deliver what people want if they want help buying products."
},
{
"speaker": "Meyer Shields",
"text": "Okay, that was quite helpful. Thank you. A quick follow up if I can, has the - I guess recent severity issues in both auto and home, have those changed the timeline for rolling out the standard products on National General's platform?"
},
{
"speaker": "Tom Wilson",
"text": "Short answer would be no, we think we can be really competitive in that market. And we're excited to get into the independent agent channel and do it as quickly as we can. We'll have some of our middle market products this year on the NatGen platform branded as National General and Allstate Company. So we'll get the benefit of the endorsed brand. And then over the next two years, we'll be rolling that out as quickly as we can."
},
{
"speaker": "Meyer Shields",
"text": "Perfect. Thank you so much."
},
{
"speaker": "Operator",
"text": "Thank you. Our next question comes from the line of Michael Phillips from Morgan Stanley, your question please."
},
{
"speaker": "Michael Phillips",
"text": "Hey, thanks. Good morning. In your introductory comments on severity, you talked about some other ways to counter it besides the target price increases, could you expand upon maybe how those will help severity issues, I didn't really get all the lists you were talking about maybe go through those little more detail and talk about how they can help you counter severity besides price?"
},
{
"speaker": "Tom Wilson",
"text": "Sure. Thanks, Michael. It really is about claims capabilities and paying what you owe, in being fair to folks. But making sure you don't pay more than you owe as things move. So we have inflationary factors, for example, say on materials for homeowners, having purchasing power, and having really good deals in place over the long-term on flooring, on roofing, and other products used in home repair, helps hedge that inflation. And with our size, with our buying power and with the capabilities of our claims team, we've been able to do that helps hedge it. Again, I'm not suggesting it eliminates the problem of inflation. But it does help mitigate it so that not all of that cost is passed through to your customers. Because in our view the job to our customers, obviously we got to put them back to where they were. We've got to charge people an appropriate price and give them the best value possible. And part of that is mitigating the cost of claims. So that was in the purchasing power. The proprietary models I mentioned before, is we've just invested a lot in our analytics and data capabilities over the years in order to flag claims that were at risk for accelerating costs so that we could get it into the right experts hands at the right time and it allows us to do a better quality job on those and also manage the costs."
},
{
"speaker": "Michael Phillips",
"text": "Okay, thank you for that. One other quick one if I could then, you had a lot of talk on the direct to consumer channel for auto and clearly that's a growth area. What's your view on that channel longer term for the homeowners market?"
},
{
"speaker": "Tom Wilson",
"text": "We think it's good. I mean, I think people do want sometimes a little more help on their home because they care more about their home. But we think that those people who are comfortable using advanced technology, bots, chat on assets you can get online should be able to buy more homes direct."
},
{
"speaker": "Michael Phillips",
"text": "Okay, cool. Thank you."
},
{
"speaker": "Tom Wilson",
"text": "Thank you for taking the time. Maybe just close on a few things first on investment results. I totally understand the view that one would not fully count the huge increase in performance spacing. But when I read some of the reports, I'm like I think it's fair to say it was an outsize quarter. But that doesn't mean that our long-term results should be ignored. We're good in investments we had good results. Our acquisitions are performing well, whether that be Allstate protection plans, which we didn't really get questions on today. I just want to remind you we bought that company four years ago at $1.4 billion. It's now over a billion dollars in revenue. It's growing at 27% a year. It made $155 million, which means we paid nine times earnings for business that is growing 27%. So we think it's worth a lot more than that. National General, we also think will be highly successful. But we're off to a really good start there. You can see that in the current numbers. And it's not just the 4 million policies we added. By the way, when you look at the net cash, we had the layout after a stretch to our capital. I do not believe we could have acquired 1% market share by putting a couple of billion dollars into advertising. So we think it was also just an economic growth opportunity straight up, forget the strategic potential for the growth. And then share repurchases we continue to really do well. This is the biggest share repurchase program we've ever announced both in dollars and percentage of market capitalization that's build up. So, thank you for participating today. We had great results this quarter. We look forward to talking to you next quarter."
},
{
"speaker": "Operator",
"text": "Thank you, ladies and gentlemen, for your participation in today's conference. This does conclude the program. You may now disconnect. Good day."
}
] | The Allstate Corporation | 18,711 |
ALL | 1 | 2,021 | 2021-05-06 09:00:00 | Operator: Thank you for standing by. And welcome to the Allstate First Quarter 2021 Earnings Conference Call. At this time, all participants are in a listen-only mode. After the speaker's presentation, there will be a question-and-answer session. [Operator Instructions] As a reminder, today's program is being recorded. And now I'd like to introduce your host for today's program, Mark Nogal, Head of Investor Relations. Please go ahead, sir.
Mark Nogal: Thank you, Jonathan. Good morning. Welcome to Allstate’s first quarter 2021 earnings conference call. After prepared remarks, we'll have a question-and-answer session. Yesterday, following the close of the market, we issued our news release, investor supplement and posted related materials on our website at allstateinvestors.com. Our management team is here to provide perspective on these results. As noted on the first slide of the presentation, our discussion will contain non-GAAP measures for which there are reconciliations in the news release and investor supplement and forward-looking statements about Allstate's operations. Allstate's results may differ materially from these statements. So please refer to our 10-K for 2020 and other public documents for information on potential risks. And now I'll turn it over to Tom.
Tom Wilson: Thanks, Mark. Good morning everybody. We appreciate you making the time to follow-up on Allstate to see how we're doing. Let's start on Slide 2. On the left our strategy has two components, which is to increase personal property liability market share, and then secondly, to expand protection services, which are shown in those two logos. And we made substantial progress in executing that this quarter. Many of those things that we'll talk about on the right-hand side, were really a year plus in the making, but you see it all coming together this quarter. So, we closed on the acquisition National General in January enhancing our competitive position in the independent agent distribution. We executed agreement to sell Allstate Life Insurance Company and Allstate Life Insurance Company at New York, two separate deals there and that will redeploy capital out of the lower growth and return businesses and reduces our exposure to interest rate risk. We also can make continued progress on getting higher growth in our personal property liability business, moving into Phase 3 of Transformative Growth. Total revenues increased by 26.2% at quarter, which is an outstanding number. Policies in force increased by 20.6%. And of course, that's driven in large part by the National General acquisition. And we'll talk a little bit more about that in the call. A long-term approach to creating shareholder value in both investing and using reinsurance also benefited results this quarter. We hit substantial increase in performance-based income and reinsurance recoveries. Allstate Protection Plans continues its rapid growth. We launched Home Depot earlier this quarter. We had strong operating results with adjusted net income of $1.9 billion or $6.11 a share and it generated a return on equity over the last 12 months of 23.2%. And then shareholders also benefited with a $765 million of dividends in share repurchases. Let’s turn to Slide 3 and go through the first quarter financial results. Our revenues of $12.5 billion in the quarter increased 26.2% to the prior year quarter. And that reflects both the National General acquisition, higher investment income and realized capital gains. Property-liability premiums earned and policies in force increased by 11.4% and 12.1% respectively. Our performance-based income was $378 million versus a loss in the first quarter of 2020. We did have a net loss of $1.4 billion that was recorded in a quarter, which there was a $4 billion loss on the dispositions on those announced sales of the two life insurance companies. And that was not fully offset by the strong operating performance. The strong operating performance charter did create that adjusted net income of about $1.9 billion, as you can see from the table on the bottom. And that's 55.7% higher than the prior year quarter as reduced auto claim frequency and higher net investment income, more than offset increased catastrophe losses. Let's go to Slide 4 digging a little on National General, which is an excellent growth platform for us. We acquired the business for $4 billion in January and that's to grow market share within the independent agent channel. And National General has appointments with over 42,000 independent agents. That expands our product portfolio as well includes non-standard auto insurance, where we had a very small presence, lender-placed homeowners insurance, accident and health insurance and two digital marketing platforms. National General’s agency-facing technology is effective, efficient and scalable. So we're a better owner for National General, since it improves the independent agent business, it lowers costs and it will generate incremental growth from here. It will become a top five independent agent carrier. And then the combination of Allstate's standard auto and homeowners insurance expertise with National General's expertise in non-standard auto insurance, will give us a really broad portfolio of products to provide to independent agents. Significant expense reductions are expected by consolidating Allstate’s to independent agent businesses onto National General's technology and operating platform. And the cost to acquire these in force policies, which is about one point of our market share at the net acquisition price is comparable to doing this organically. Now we have three measures of success through these acquisitions. You can see in the bottom of the table, accretion to earnings, achieve expense synergies and grow IA channel policies in force. We’re only a quarter into it, but we had a really strong start on these goals. We put Glenn and the team, [indiscernible] have been working on this really since the six months we started the deal in July six months before we bought it. So we came into this first quarter with a head of steam. And the Allstate protection segment added $1.3 billion in net written premiums, $138 million in underwriting income this quarter. Allstate Health and Benefits increase adjusted net income by $35 million. We are integrating Encompass onto the National General platform and are on pace to achieve our expense synergies. We also expect to grow policies enforced by broadening that product portfolio in IA channel. And of course, that represents about a third of the total person lines market. The IA channel policies in force are approximately six times larger after this transaction, as we add standard auto and homeowners insurance products to National General’s offering later this year that will drive even more growth. Let me now turn it over to Mario to go through the first quarter results in more detail.
Mario Rizzo: Thanks, Tom. And good morning everybody. Let's go to Slide five and delve a little deeper into Property Liability growth. Property Liability policies in force grew by 12.1%, compared to the prior year quarter. National General, which includes Encompass, contributed growth of 3.9 million policies. The Allstate brand grew policies by 0.5% due to growth in homeowners and other personal lines as you can see by the table on the left. Allstate brand auto insurance was flat to the prior year, as increased new business was offset by lower retention. The chart on the lower right shows a breakdown of personal auto, new issued applications compared to the prior year, which increased 64% in total, primarily due to the incremental 526,000 applications generated by National General. The middle section of the chart shows Allstate brand impacts by channel, which in total generated a 5.4% increase in new business growth, compared to the prior year. Modest increases from existing agents and a large increase in direct channel sales, more than offset the volume that would normally have been generated by newly appointed agents, as we pilot new agent models with higher growth and lower costs. As a result, property liability net written premium grew 13.7% in the first quarter compared to prior year, driven by a 12.9% increase in auto insurance and a 20.3% increase in homeowners insurance. The auto insurance net written premium increase was driven by a 14.1% increase in policies in force due to National General and increased new business – new issued applications across all brands. These favorable impacts were partially offset by lower average auto insurance premiums from approved rate decreases and lower retention, partially driven by the impact of special payment plans that were implemented during the pandemic. If you flip to Slide 6, you see property-liability margins remain strong. The recorded combined ratio of 83.3, improved 1.5 points compared to the prior year quarter, primarily from a lower underlying loss ratio driven by reduced auto frequency and continued cost savings. The auto insurance recorded combined ratio of 80.5, was 8.8 points below the prior year, primarily due to lower accident frequency in the quarter. Allstate brand auto property damage gross frequency remained below prior year levels in 47 of 51 geographies, which includes the District of Columbia. The chart on the lower left shows the impact of the pandemic on Allstate brand auto property damage gross frequency. As you can see the onset of the pandemic and efforts to slow the spread of the virus had a large impact on frequency beginning at the end of the first quarter of last year, and then extending into the second quarter when auto frequency was at its lows. This timeframe coincided with Allstate's shelter in place payback. Following the second quarter of 2020 property damage frequency has trended below pre-pandemic levels by approximately 28%, as you can see by the third and fourth quarter variances to 2019. And first quarter of 2021 frequency showed a comparable decline relative to 2019. As you can see from the chart on the bottom right, we continue to make progress in reducing our cost structure, enabling us to improve the competitive position of auto insurance, while maintaining strong returns. The property liability expense ratio improved 2.5 points in the first quarter of 2021, compared to the prior year due to the absence of coronavirus-related expenses incurred in 2020, such as the shelter in place payback as well as continued cost reductions. This was partially offset by a significant increase in advertising investment. The expense ratio, excluding coronavirus-related expenses, restructuring charges, and the amortization of purchased intangibles associated with the acquisition of National General was 22.8, an improvement of 0.5 points compared to the prior year quarter. In connection with the anticipated benefits associated with the future work environment, we expect to incur approximately $110 million in restructuring costs during 2021 with $33 million recognized in the first quarter, primarily related to real estate exit costs. These restructuring costs and their future benefits are incremental to the $290 million of aggregate restructuring costs related to transformative growth, which we announced in the third quarter of 2020 and of which we've recognized $256 million to date including $17 million this quarter. Let's move to Slide 7 to discuss our progress on building transformative growth business models. So transformative growth is a multi-year initiative to build a low cost digital insurer with broad distribution. This will be accomplished by expanding customer access, improving customer value, increasing marketing sophistication and investment and building new technology ecosystems. A longitudinal plan segments transformative growth into five phases, starting with the conceptual design and ending with the retirement of the old business model. We've completed Phase 1 and much of Phase 2. In Phase 2, the auto insurance competitive position has been improved leading to higher close rates. This was supported by cost reductions. Direct capabilities have been expanded and sales volumes are increasing. New branding has been launched and marketing investment has been increased. This combined with industry-leading telematics capabilities will increase growth. We believe Allstate is among the leaders in telematics and is the largest pay-per-mile provider through Milewise, which offers lower costs for customers who drive less. We've also expanded independent agent distribution through the National General acquisition. Looking forward, we are now into Phase 3 in building the new operating model. We will support the transition of Allstate agents to higher growth and lower cost models. New agent models are also being tested to serve customers who want a local agent. Improving customer acquisition costs relative to lifetime value will lower costs. Expense reductions will support increased investment in growth and technology. The new customer experience and product management technology ecosystems also get deployed in this phase. Now let's go to Slide 8, which highlights investment performance for the first quarter. Net investment income totaled $708 million in the quarter, which was $462 million above the prior year quarter driven by a higher performance based income as shown in the chart on the left. Performance-based income totaled $378 million in the first quarter as shown in gray, reflecting broad based valuation increases in private equity investments and sales of underlying real estate investments. Market-based income shown in blue was $6 million below the prior year quarter with lower interest rates, our reinvestment rates remain below the average interest bearing portfolio yield reducing income. Our first quarter GAAP total portfolio return was minus 0.2% as you can see on the bottom of the left chart, reflecting lower fixed income valuations. Over the last 12 months, the total return was 8.8%. As discussed previously, our performance-based strategy has a longer-term investment horizon with higher, but more volatile return expectations. This volatility can be seen by the chart on the lower right. It highlights the one, five and 10-year performance-based internal rates of return. The one year trends has been volatile throughout the pandemic with the two most recent quarters, significantly higher than the returns experienced during the middle of 2020. Conversely, the five and 10-year trends are stable and closer to our expected returns. Moving to Slide 9. Allstate Protection Plans continues to grow revenue and profit. As you recall, we purchased Allstate Protection Plans for $1.4 billion in 2017 to broaden the protection solutions offered to customers. It provides low cost protection with excellent service. Products are primarily sold for U.S. retailers and leverage the Allstate brand. Since acquisition, Allstate Protection Plans has experienced rapid top-line growth and improved profitability. Revenues have grown at a compound annual rate of 48% over the last three years, as you can see on the bottom left. And we're more than $1 billion over the latest 12 months. Adjusted net income went from a loss of $22 million in 2017 to income of $148 million over the last 12 months. Additional growth will be achieved by further expanding appliance furniture and mobile phone protection, expanding the geographic footprint outside the U.S. and creating new innovative services such as two-day appliance repair. This acquisition has been an incredible success for us. Now let's move to Slide 10, which highlights Allstate attractive returns and strong capital position. Allstate continued to generate attractive returns with adjusted net income return on equity of 23.2% for the last 12 months, which was 5.7 points higher than the prior year. Excellent capital management and strong cash flows have enabled Allstate to return cash to shareholders while simultaneously investing in growth. We provided significant cash returns to shareholders in the first quarter through a combination of $601 million in share repurchases and $164 million in common stock dividends. The current $3 billion share repurchase program is expected to be completed by the end of 2021. Given our growth strategy and sustainable earnings potential, we announced a 50% increase in the quarterly common shareholder dividend to $0.81 paid to shareholders on April 1. The total cash return provided to shareholders was 7.8% of average market capitalization over the last 12 months. With that context, let's open up the line for questions.
Operator: Certainly. [Operator Instructions] Our first question comes from the line of Josh Shanker from Bank of America. Your question, please.
Josh Shanker: Yes. Thank you very much for taking my question. So it looks like there's very good success in the allstate.com direct model. Can we talk a little about whether we shuttered the purchasing through Esurance and the sort of flows we're seeing on the new policy apps on the allstate.com site?
Tom Wilson: Glenn, do you want to take that?
Glenn Shapiro: Sure. Yes. So we have not completely shuttered Esurance. What we've done is we've redirected our marketing dollars from the Esurance brand to the Allstate brand. And in addition to that, we've invested more in the Allstate brand as well. So – but part of that was being able to move that marketing. So while Esurance has trailed down, we're still taking advantage of the goodwill that we've paid for over years of that brand. And the fact that people recognize it, still find the Esurance out there and they have good products for a portion of our market. So we're still selling some there, but the growth is absolutely being driven by the Allstate brand. As you saw in the supplement that or the Q, we've got 33% increase in direct sold business. So it's really taking off and we've got more capacity going into that system, because a direct system is – I won't say only limited, but a main limiter would be your capacity, your sales capacity in there. So we're growing the contact center, improving web flows and really growing the Allstate branded direct sold business. [Indiscernible] as you know, is part of transformative growth, we're also building a new technology ecosystem, a product management system and a customer experience system. As that gets rolled out, we will shutdown the Esurance system and then we will stop selling products under the Esurance thing. But we have some time to do that.
Josh Shanker: And the 278,000 new policy apps at Allstate direct, are those apples-to-apples with the 200 or so that you sold one year ago, or was that part of a joint direct captive sort of relationship where we're directly the lead generator or are they complete apples-to-apples those two types of new applications?
Tom Wilson: Glenn, do you want to take?
Glenn Shapiro: Yes. Sure. Yes, it would be an apples-to-apples. It's basically just think about customers that come to us by either clicking or calling directly into an 800 number as opposed to the customers that come to us through an agent. So it would be an apples-to-apples comparison.
Josh Shanker: And can we talk about National General, Encompass and Allstate brand through independent agents, is Encompass going to be called National General, even though the National General and Encompass products are kind of a different target customer and what would be wrong with calling the product Allstate?
Tom Wilson: Well, let me take the branding question then Glenn can fill in how we're doing the transition, because it's different for Encompass than it is for the Allstate independent agent. So first from a branding standpoint, we've decided that the Allstate brand and personal property liability will be on business that we control both the sales and the service on it. So that's both the Allstate agents and then direct whether that's a web or call center. For the independent agent business, we've rebranded National General. So it's National General and Allstate company and we launch it, I think beginning of January. So that you get the relationship with Allstate, but that everybody understands that it's separate than that, which you would get from an Allstate agent. We do not do that with the Allstate brand in the circle of protection. So for example, we sell under the Allstate name at Walmart, sell under the Allstate name at Home Depot, at target, which gives us both increased exposure to customers, enables us to further leverage that capability. And quite honestly, it's helped us dramatically expand Allstate protection products because of the power of their brand. So slightly different strategy from a branding standpoint, inside the personal property liability markets and outside, but we try to leverage it everywhere we can, but provide, make sure that that brand stands for certain things in different areas. Glenn, do you want to talk about your plans to both integrate Encompass and Allstate independent agents into National General and then Josh’s question on branding at the same time.
Glenn Shapiro: Yes. So thanks Josh, because I think it's an interesting question because I think if you take from a legacy standpoint, National General and what it was best that known for in Encompass and what is best that known for, it would be different as we suggested. But as Tom just pointed out National General and Allstate company, that's going to be a different story. We're launching middle market products. So think about basically the Allstate product capability in the middle market auto and home and other personal lines. On the National General platform and branded as National General and Allstate company starting in the second half of this year and then really fast expansion. So it would be to all 50 States within 18 months of the start of that. So before the end of next year. So really National General and Allstate company is going to be a company that is serving from nonstandard up through a mass affluent, and everything in between. It really is another national player in the independent agent space. And we've gotten a phenomenal reaction from independent agents and they are genuinely excited to have another significant player and with the capabilities of Allstate, National General combined in that market. And so we're positioned really well to grow with a lot of greenfield ahead of us in the independent agent space.
Josh Shanker: The Encompass name will disappear?
Tom Wilson: It will be at part of National General and Allstate company, correct. Whether we grow the policies to a new policy or leave the policy outstanding under the Encompass name and basically put National General stuff on top of it, it would just depend on the cost of it. And Encompass, it goes first and the Allstate independent agent, which is Allstate brand products sold through independent agents in rural spaces where it was not economic to have a captive agent, mostly there's a few places where it didn't work that way, but mostly that will transition over time as well.
Josh Shanker: Excellent. Thank you very much.
Operator: Thank you. Our next question comes from the line of Jimmy Bhullar from JPMorgan. Your question, please.
Jimmy Bhullar: Hi, good morning. So first I guess for Glenn or Mario, but the question on just auto –the auto business. How do you see the interplay between the frequency and pricing? And it seems like everybody's had very good margins in personal auto over the last several quarters. At what point do you see sort of pricing catch up to that? And in that environment, do you think if the market stays competitive; are you still in a position to grow your discount?
Tom Wilson: Let me provide an overview and then Glenn if you want to jump onto this one. So first I'm going to go up a little bit. First, it's about how do we think about increasing market share and we'll use two words together profitable growth. We put them together because that's what we want. We do not believe that growth with no profit is good for shareholders. So the objective of course is maximize shareholder value. Our expected outcomes for our team are that they will balance between growth and profitability. Our strategy of course is as Mario talked about in the first phase, second phase of transforming growth is getting more competitive auto insurance product. And we supported that, of course in worse being successful by reducing our costs. So the first thing would be we can control our costs and we can make sure that if we reduce prices to get more competitive, we still maintain our margins. Obviously, we want to be smarter whether that be how we price or how we acquire business and our marketing and we're also using telematics. And then as we go forward with transformative growth, it'll be by being faster with better technology and having new products affordable, simple and connected that are sold through that broad range of distribution that Glenn was just talking about from direct to Allstate agents. So Glenn, do you want to jump in on the specifics?
Glenn Shapiro: Yes. So first I'll talk about frequency a little bit and then go to competitive position. So from frequency standpoint, what we're – everybody has benefited from some lower frequency. But we've also looked at a deeper level at it, but then just sort of miles driven and the number of accidents coming out, because there are differences by books and you see differences in competitors as to how much tailwind that's providing. So, we look at the fact that commuter driven or take it from rush hour losses are down about three points more than overall losses. And we look at rural driving is down about four or five points less than urban driving. And so we look at these that are pretty deep level, and we we're fortunate to work with Arity and have a lot of data on this with 10 years plus of telematics that we get pretty granular into how we're looking at it and understanding the frequency picture. So we've got a tailwind with that, which takes me into competitive position because we've been moving our competitive position pretty aggressively. Like you see a minus 1.5 on average premium, and that might feel or seem slight, but there's a lot underneath that. We've moved new business pricing. We've moved telematic pricing. We've reduced the cost of our Milewise program. That's grown really nicely and all of that is inside of there. So our competitive position on the price changes we've made and that are still going into market have really improved. And our close rates are up. We're starting to see those really positive signs of momentum across multiple states. And then you put on top of that, the fact that some of our competitors have already taken price increases, some of those out there. We've heard others say that they're going to start taking bites at the apple in terms of price increases. And you look at our position and obviously we're in a position right now. We continue to invest in growth. We can still put money into marketing. We could still put money into competitive price position because of where we're positioned, which really puts us in a great spot to grow going forward.
Jimmy Bhullar: And then just any comments on your views on if growth to the extent you're able to quantify or give a range on how I'm assuming it should trend higher later this year and into next year as you're implementing some of these initiatives in direct and independent agency, but to whatever extent you can quantify or give us an idea do you expect it to be?
Tom Wilson: Well, we're not – we don't give forecast on if growth or frequency or case tasks, these things you can't predict. Let me talk about growth a little bit, because it is really an important question that many analysts have. And of course it drives huge value in the market today. And so we were starting to have first actuals matter and we had a great quarter. I mean, over 25% revenue growth, our fifth growth was in the low teens. And we're headed towards increasing our market share pretty significantly in personal lines this year, which is consistent with our strategy. I guess what we set out to do? Now, you'd have some naysayers and say, well, you bought it with the acquisition of National General. And that's of course true. But you always have to investigate market share. In this case, it is real growth. And we look at it and said, if we had taken the net price that we paid for National General and thrown it into marketing or higher commissions or some kind of spiff. It likely would have given us less growth than we got. And certainly not the kind of profitability we're getting from it. The same thing, but we did buy it. But we did the same thing with Allstate protection plans, right? We bought SquareTrade. We repositioned it with our brands and that acquired growth and turned into an organic growth platform. We expect the same thing to happen with National General. The difference is we paid a slightly higher premium for SquareTrade than we did for National General. As it relates to the Allstate brand, we have multiple ways to grow, right. We got the Allstate agents and we're making – helping them transition to a new model. We have the direct business, which we've launched in is so by the way, at a different price than through an agent, because we believe customers should pay for what they get. And if you get an agent and get that help, you should be willing to pay for that. And so overall we feel like the Allstate brand is positioned for long-term growth as well. And so we feel like we've got an overall plan to move forward, has got transformative growth in it. It's got real growth this quarter and it's got – we're building platforms and we'll continue that growth going forward.
Jimmy Bhullar: Okay. Thank you.
Operator: Thank you. Our next question comes from the line of Greg Peters from Raymond James. Your question, please.
Greg Peters: Good morning. My first question will be on reinsurance. Tom, I was hoping you could just give us an overview of how reinsurance helps the company this quarter. And then I know you did file your reinsurance update piece and maybe talk about what's changing going forward. I did note that the costs in the first quarter about 14% higher versus a year ago is that the type of cost or increase we should expect for the full year.
Tom Wilson: Greg, let me start with this strategic perspective on it, and then either Maria or Glenn, if you want to talk about the first quarter. So I'm going to go back a long way. But in 2004 and 2005 we had huge catastrophe losses. We weren't earning any money on the homeowner's business. We'd make some money one year and we would lose money the next year. When you looked at over time, I think this is not a really good business. So we looked at getting out and we said what – if we were out, we'd want to be in, because it does, our customers do want it. So maybe it's just this catastrophe risk they don't want. So we created a very comprehensive catastrophe reinsurance program to basically divest certain portions of the risk we took on. And that's evolved over time. We have a very sophisticated multi-year program. It's got – it's by stated got different by event. It's got the aggregate in it. And we bear that cost each and every quarter, obviously that comes through. And then sometimes it pays off. And what you saw this quarter was the aggregate kicked in. And so from losses, some of the losses, which were last year showed up as reducing our catastrophe losses this quarter, which were upgraded significantly. And that helps smooth it out. And we've looked at that from what kind of return on capital do we give up to the reinsurers and we're quite comfortable giving up the return that they get to avoid the volatility that comes from it. And so it's helped us reposition the homeowners business, so that now it's a very consistent source of profitability for us. As I was saying to the prior question, we don't believe in growth with like running homeowners above a 100 is not a good plan and you're destroying value at that point with growth. And we don't believe in that. So we've used reinsurance to help reposition the business. We did a whole bunch of other stuff including changing the product and changing the way we price and how we underwrite it, where – how we do our segmentation by down to specific risks codes. So how we pay for roofs, there's a whole bunch of stuff we've changed underneath that over the last decade. But it's a really good business. In reinsurance, using that reinsurers helped us get there. So what you saw this quarter was a benefit, which is more than was earned in this quarter, but it was paid for in the prior quarter. So if you – some people want to exclude it from this year's quarter, totally get that. Unlike that's fine. But then you should not be counting all the costs from the other time. Mario, Glenn, do you want to talk about the cost of reinsurance and the program going forward?
Mario Rizzo: Sure. I can jump in on that Tom. And just to give you a little color, Greg, on the benefits in the quarter. We recovered about $955 million in the quarter on a net basis. Part of that was from our per occurrence nationwide program where we retain the first $500 million of an event. And then we have coverage up – in our current program up to $5 billion. And then as Tom mentioned, we also have an aggregate cover, which is about $1 billion, which spans a 12-month period. We also had recoveries under that. So combined, it was about $955 million. That's net of reinstatement premiums in the quarter, and it was principally on the freeze event in Texas. So the freeze event on a net basis cost us $586 million in the quarter. Once you start peeling back the prior year component of that reinsurance recovery, which was about $150 million. You get to a gross loss in Texas north of $1.3 billion. So we've benefited pretty significantly in the quarter from our reinsurance program. As you mentioned, we posted on our website – we placed most of the nationwide program this quarter and we still have a component of the nationwide program to do. And then remember we have a separate Florida program. The costs year-over-year, because we've included National General in this year's program. It’s going to be slightly higher than it was a year ago when you add up what we were spending on reinsurance and what National General was spending on reinsurance. But in terms of what you saw in the first quarter, you got to remember, that's still last year's program that was placed May 1. And what we saw last year was the increase we experienced was mainly in the Florida program. And you're seeing that kind of cycle through in the first quarter. We will start incurring the cost of this year's program when it incepts which is on June 1.
Greg Peters: That was a thorough answer. I appreciate it. I'd like to pivot to the expense ratio on Page 6 of the presentation slide deck you are continuing every quarter to show improvement in almost every quarter and show improvement in your expense ratio. And I guess when we think about the sustainability or more importantly, is this a trend that we should continue to expect forever? Obviously, I don't think your expense ratio is going to zero, but the improvement is noteworthy. And then just as in the slide, I did notice that the expense ratio was up in the Allstate protection home business. So, I'm curious if there was something unusual on that?
Tom Wilson: So, overall, Greg you are right our strategy to get a more competitive in auto insurance pricing, which was Phase 2 [indiscernible] transformed to growth, included taking down costs. And as you know, we did a large reduction in force last year, did about 3,800 people starting to see that come through this year. At the same time, our advertising was way up. And so, we try to balance between those two. I don't think you could expect it to come down half a point every quarter from now till an infinite item. You should know that our strategy is to both keep reducing cost every place we can so that we can have a more affordable product for our customers and therefore a better price. So, we get more of them. But not invest in growth, because if the kind of a return on capital we're getting in these businesses, we should definitely be seeking more growth. Mario, do you want to talk more about what you – this current quarter and what the ins and outs were?
Mario Rizzo: Yes. Thanks Craig. So, I guess, it's not mentioned. We're going to continue to focus on reducing our cost structure. And like we said, really all along, our focus on reducing our cost structure is not a margin expansion focus, it's a growth focus. And it's a growth focus because reducing our costs enables us to invest more in growth. And you saw it this quarter where we invested more in marketing and the component of our underwriting expense ratio related to marketing actually increased by nine tenths of a point. Yet it was more than offset by the operating cost reductions that Tom referenced from last year. So, real ins and outs were more investment in advertising, more than offset by cost reductions and net-net a half a point improvement in kind of the underlying expense ratio in the quarter. And we're going to continue to focus on moving that number down. The other thing I'd mentioned on expenses, and it's not obvious in our numbers is, part of our focus on cost reduction has been on getting more efficient in claim handling. And we've improved the efficiency in our loss adjustment expense, which comes through the loss ratio. But again, we consider it as a core part of our cost reduction efforts to improve the combine – improve the cost structure, creates a path we need to invest and be able to grow more and continue to deliver excellent return. So, I think what you saw in the quarter was really kind of proof of, of how that strategy is playing out. In terms of the homeowner expense ratio specifically, Greg, I'd have to go back and take a look at what components of it – whether it came through distribution costs, or underwriting costs, whether it was like inspections, and so on. So let me take that one offline and I'll get back to you on that one.
Greg Peters: Got it. Thank you for the answers.
Operator: Thank you. Our next question comes from a lot of Paul Newsome from Piper Sandler. Your question, please.
Paul Newsome: Good morning. Thanks for the call. Congratulations on the quarter. I was hoping you could expand a little bit more about what it means to transition the existing through agents to a different model. We get emails from agents all the time. Usually, they are worried about this or that. Is this a transition that's really towards more of an independent agent type structure with equations, or are we talking to something that's completely out of book? Or if it's sort of to be determined?
Tom Wilson: Let me provide a little view and then Glenn can tell you some of the specifics of what we're doing. But Paul first thing I would say is now we're not going to do the nationwide deal and turn them all into independent agents. We don't think that makes sense from a customer standpoint. Customers come to us because they love the Allstate brand. We have a really strong brand, long relationships, so we're not planning on turning them into something else. And obviously the fast pace of change has all of this on it, whether you're a retailer or anybody what's going on in the world. And the good news for our agents is that still a majority of consumers want an insurance professional help them buy insurance. And our agents are really good at it. That said, people are more comfortable with self-service, simple items and the technology enables a computer to do some of the work that used to be handled in by people and stellar in some cases handle the local offices. So we have to transition their model and go where the customer is going. And so that includes maybe we don't have to use as much real estate as we use today. We certainly do not need to do as much service work in agent offices. So, we have a little over 10,000 Allstate agents. There's probably 26,000 to 27,000 people working in those agencies. Some of those people are doing service work. And we think we can do that either centrally at a lower cost and be more effective for our customers, or just get the computer to do it. Nobody does it at all. So, we have to figure out how do we transition those people in those offices to doing service work, to doing sales work. Or if they can't transition those licensed sales professionals, have the agents build up staff, they can move into that. So last year, one of the things that Glenn and team did was they raised new business commissions to incent, to give people the opportunity to invest more, and sell more things to more people and get more people selling for them. To offset that and continue to make sure we're meeting our customers’ cost needs, we slightly reduced renewal commissions to reflect that. So, if you're an agent and you're focused on new sales, that's a good thing. You're excited about it, you are off and ready to go. If you've been focused more on service and not on growth, then you are not going to be as excited about that change because it changes your business model. So, we have to help them transition from where they are to the place where the customers want us to go, which is they want help, but they want to do it in technologically efficient, low-cost way. And we think that there's a good way to do it. Glenn can give you some examples of what we're doing with our existing agents. We've already talked about what we're doing direct to serve our customers. And then we're also trying some new models that Glenn can talk about, that do the same thing, which is use people to help people buy insurance in a local space, but at a lower cost. Glenn, do you want to give them some more specifics on that?
Glenn Shapiro: Yes, absolutely. And Paul, Tom hit a lot of the really important points here. But a couple bear repeating, so no harm being repetitive, but it's really important. So, it's a hard no on the IAP. So, I'll just reiterate, as Tom said, we are dedicated to our exclusive agent model completely. And we believe that there is a not only a meaningful place, but a huge place for our exclusive agents to grow in the market because as Tom said, most consumers still want to work with an agent. So, in the presentation materials that talked about higher growth, lower cost models, so, I'll just hit a couple of things. Lower cost, we've been really reticent in the past to allow agents to consolidate locations or to even go in some cases without real estate or reduce their real estate footprint. We've been very focused on a model that is how many signs do you have up across the countryside. And we're going to really lean in to allowing agents to reduce costs in the way they run their business. And Tom talked a bit about the service. We started that in 2019 and we built it up a bit and everything, but we really have to get to a centralized, and more efficient and effective way of serving customers than separately across 10,000 different locations. And we can take a lot of cost out of the system and reduce the cost for the agents so that they can focus on growth. From a higher growth standpoint, it's about leaning in, on the marketing that they do, that we can help them do more effectively and efficiently as a large enterprise, the lead management that they do, compensating them more for new business, as Tom mentioned also. That's the existing agents and how we want to transition that to higher growth, lower costs. The new models, for example, and we have several hundred of these already in place actually where we are learning from our Canadian operation. Actually, in Canada we have Allstate agents who operate sort of independently from one another. It's not an agent with multiple staff, they are independent workers and producers. And they work on sort of a balance between being in communities, and driving leads themselves and getting leads from the company. And it's been very successful. We're growing very fast in Canada. So, we're leveraging that model and looking at models with no real estate in local markets that are part of the community and are able to take leads and also generate their own leads in that community and grow. So, it's early in the process, but in the second half of the year, we're looking to ramp those up significantly.
Paul Newsome: I guess, relatedly, could you talk a little bit about any early looks on the pilot programs for new agent recruitment? And if there's some different things that will be happening there in the near future?
Tom Wilson: Glenn, do I take that? Hey Glenn, do you want to take that or maybe you are on mute.
Glenn Shapiro: My apologies, I did go on mute there. Yes, so we're focused on those new models. I just mentioned in terms of our recruitment right now. And so we have been, I think, – we have several hundred already and we have a lot more in the pipeline. So, we're looking to grow with those new models. What we're really focused on with the existing agent group, well we’re recruiting sung into the compensation programs that we have as opposed to what we called enhanced compensation program, which was a higher cost model before we're recruiting some into that as more of what you had refer to as a traditional exclusive agent. But the heavier emphasis on our recruiting is on those new models, where with our existing agents, we are really focused on investing to get more of those agents growing and wanting to grow. The good news is they are growing right now. We have increased new business production with our existing established agents. So, when you see the total that somebody referenced earlier, it's slightly down on the overall agency force that is driven by sort of a lack of new appointments, the existing agents, new businesses up year-over-year
Tom Wilson: And Glenn, let me just add last point which is when you see that little red bar on our graph, that was an intentional choice on our part, not a flaw in the system. So, it's not like we decided that, you know what, we were hiring these new agents, we required them to have their own office, we require that they have support staff. To make that work when you have no customers, we're paying 30% upfront commissions which then stayed high for it, not at 30%, but stayed higher than customers should have to pay for them for about five years. And we said what, but this is not the model of the future. We could have kept that going while we develop these new models. And the system would look like it would have been generating more growth than it is today. But we say, economically, that's just not the smart thing to do. Like we're not using shareholders money, right. And that's where we get into which the conversation we’re talking about before is profitable growth. If you're going to [indiscernible] profitable long-term growth, and so you have some bumps, but that's not about a flaw in the system. That's about an intentional choice.
Paul Newsome: Appreciate it. Thank you very much.
Operator: Thank you. Our next question comes from the line of David Motemaden from Evercore. Your question, please.
David Motemaden: Hi, good morning. I guess I wanted to just touch on retention. I was surprised it fell a little bit here again also, especially, given some of the rate actions that you guys have taken. I guess, could you maybe just talk about how much of an impact the lapsing of any billing leniency may have had on the retention, and what your expectations are for retention going forward, like, should we see a snapback here in the second quarter? Yes, I guess that's just my question on retention.
Tom Wilson: David let me provide an overview and Glenn, you can take the impact of the pandemic billing stuff. First, I would say retention is really hard to do attribution on. People leave for all different reasons. And sometimes it's for price, sometimes it's because they move, sometimes it's they bought a new car. And so, it's difficult to get it down to precision to, in a point. What you do know is if your net promoter score is good and you are doing a better job for customers, they should stay around longer. And if you are competitive in price and you are changing your price not only for new business, which we've done, but also for your existing customers, which we've done, so they have a better price and that should also keep them. But there's lots of different variations. So it's kind of really hard to predict it. Glenn, do you want to talk about how you're feeling about retention this quarter? And again, we have a hard time, nobody really knows how to predict retention.
Glenn Shapiro: Yes, absolutely. So, retention is a lagging metric, first of all I’ll start there. Wherever or whenever a customer decides to cancel, move, shift we record it and report it at the point of what would have been the renewal. So, there's a bit of a lag to that. So, while we stopped the special payment plans during last year, there's still some of that trick going in. So as Tom said, attribution is difficult on this. But there's a portion of it that's related to that. No question. Secondly though it is a highly competitive market right now, shopping is up, advertising is up and there is some impact from that. It's interesting. When you look at National General, as an example, if you saw in some of our disclosures, like National General’s, new business, it's really eye-popping, because National General writes a lot more new business to grow because they have a shorter cycle time. As our business shifts and we look at overall protection business and we're writing in more markets, and we're writing direct and not just through our exclusive agents, that number will move around a little bit on retention, but our focus is to create a lot of new business. We're going to do that. That's what transformative growth is about. We're going to create a lot of new business so that the undulations of retention don't mute our overall growth.
David Motemaden: Got it. Thanks. That's helpful. And then maybe just on the new business side, obviously great growth, especially on the direct side in new apps. I guess I'm wondering maybe if you could just – you had kind of mentioned it in your script, but want to just a bit more details on the Milewise offering and how that did this quarter? How big that is as a percentage of the entire book? And was that really the driver behind the direct growth that we saw in the quarter?
Mario Rizzo: Glenn, you can take where we are with Milewise, and number of states and how [indiscernible] you got the done pricing. I would say though, when you just step all the way back, we're about building a digital insurer. And sometimes that gets lost into how big and how successful we are given the size and scale of our company. [Indiscernible] sometimes people look at people who only do that and assume that, they are about to take over the market. We're happy to compete. We feel like we're really doing well in here. We’re early in telematics. We think we're a leader in telematics. And this is an example of a product where we were out early, we're aggressively advertising it and it's resonating. Glenn, do you want to talk about, what you've done to help it grow?
Glenn Shapiro: Yes, absolutely. And to the question of, is it driving the direct growth, I would say, no. Direct growth a majority of that is not Milewise. It's an interesting thing to look at, as Tom said, when you look at it inside a company like Allstate, Milewise will look relatively small. It's up, this year it's something close to in autos. Policies, I think, are foreign change times, autos are six in change times what they were a year prior. So significant growth. If this was a standalone startup sitting outside of a large insurance company like Allstate, it is the largest in the industry pay by mile program. And it would look really big, and really fast growing and really attractive. Inside of Allstate, it is helping our growth, but it is not driving our growth, is the way I'd say that. We're looking to expand over time on Milewise. Right now, it's available to about 50% of consumers across the country. And we have more states lined up for that. It does require the OBD port, which, I think, everybody knows there are chip shortages out there. We have not run into a problem where we have to slow down our – Milewise at this point. But we are actively managing our supply chain on it because it is a popular product. And we're managing our state expansion and looking at that so that we don't run into a supply chain issues.
Tom Wilson: Thank you for the questions, I think, we're out of time here, it’s top of the hour, and we try to be respectful of your time. Obviously, we appreciate you coming to spend time with us in here about us. We had an excellent quarter the work and you saw from that first slide, the amount of expertise and effort that went into delivering all that for the quarter. It wasn't just this quarter, it's what we do over time, but we feel good about where we're at. So, we've had great operating results as well. So, thank you for your participation. And we'll see you next quarter.
Operator: Thank you, ladies and gentlemen, for your participation in today's conference. This does conclude the program. You may now disconnect. Good day. | [
{
"speaker": "Operator",
"text": "Thank you for standing by. And welcome to the Allstate First Quarter 2021 Earnings Conference Call. At this time, all participants are in a listen-only mode. After the speaker's presentation, there will be a question-and-answer session. [Operator Instructions] As a reminder, today's program is being recorded. And now I'd like to introduce your host for today's program, Mark Nogal, Head of Investor Relations. Please go ahead, sir."
},
{
"speaker": "Mark Nogal",
"text": "Thank you, Jonathan. Good morning. Welcome to Allstate’s first quarter 2021 earnings conference call. After prepared remarks, we'll have a question-and-answer session. Yesterday, following the close of the market, we issued our news release, investor supplement and posted related materials on our website at allstateinvestors.com. Our management team is here to provide perspective on these results. As noted on the first slide of the presentation, our discussion will contain non-GAAP measures for which there are reconciliations in the news release and investor supplement and forward-looking statements about Allstate's operations. Allstate's results may differ materially from these statements. So please refer to our 10-K for 2020 and other public documents for information on potential risks. And now I'll turn it over to Tom."
},
{
"speaker": "Tom Wilson",
"text": "Thanks, Mark. Good morning everybody. We appreciate you making the time to follow-up on Allstate to see how we're doing. Let's start on Slide 2. On the left our strategy has two components, which is to increase personal property liability market share, and then secondly, to expand protection services, which are shown in those two logos. And we made substantial progress in executing that this quarter. Many of those things that we'll talk about on the right-hand side, were really a year plus in the making, but you see it all coming together this quarter. So, we closed on the acquisition National General in January enhancing our competitive position in the independent agent distribution. We executed agreement to sell Allstate Life Insurance Company and Allstate Life Insurance Company at New York, two separate deals there and that will redeploy capital out of the lower growth and return businesses and reduces our exposure to interest rate risk. We also can make continued progress on getting higher growth in our personal property liability business, moving into Phase 3 of Transformative Growth. Total revenues increased by 26.2% at quarter, which is an outstanding number. Policies in force increased by 20.6%. And of course, that's driven in large part by the National General acquisition. And we'll talk a little bit more about that in the call. A long-term approach to creating shareholder value in both investing and using reinsurance also benefited results this quarter. We hit substantial increase in performance-based income and reinsurance recoveries. Allstate Protection Plans continues its rapid growth. We launched Home Depot earlier this quarter. We had strong operating results with adjusted net income of $1.9 billion or $6.11 a share and it generated a return on equity over the last 12 months of 23.2%. And then shareholders also benefited with a $765 million of dividends in share repurchases. Let’s turn to Slide 3 and go through the first quarter financial results. Our revenues of $12.5 billion in the quarter increased 26.2% to the prior year quarter. And that reflects both the National General acquisition, higher investment income and realized capital gains. Property-liability premiums earned and policies in force increased by 11.4% and 12.1% respectively. Our performance-based income was $378 million versus a loss in the first quarter of 2020. We did have a net loss of $1.4 billion that was recorded in a quarter, which there was a $4 billion loss on the dispositions on those announced sales of the two life insurance companies. And that was not fully offset by the strong operating performance. The strong operating performance charter did create that adjusted net income of about $1.9 billion, as you can see from the table on the bottom. And that's 55.7% higher than the prior year quarter as reduced auto claim frequency and higher net investment income, more than offset increased catastrophe losses. Let's go to Slide 4 digging a little on National General, which is an excellent growth platform for us. We acquired the business for $4 billion in January and that's to grow market share within the independent agent channel. And National General has appointments with over 42,000 independent agents. That expands our product portfolio as well includes non-standard auto insurance, where we had a very small presence, lender-placed homeowners insurance, accident and health insurance and two digital marketing platforms. National General’s agency-facing technology is effective, efficient and scalable. So we're a better owner for National General, since it improves the independent agent business, it lowers costs and it will generate incremental growth from here. It will become a top five independent agent carrier. And then the combination of Allstate's standard auto and homeowners insurance expertise with National General's expertise in non-standard auto insurance, will give us a really broad portfolio of products to provide to independent agents. Significant expense reductions are expected by consolidating Allstate’s to independent agent businesses onto National General's technology and operating platform. And the cost to acquire these in force policies, which is about one point of our market share at the net acquisition price is comparable to doing this organically. Now we have three measures of success through these acquisitions. You can see in the bottom of the table, accretion to earnings, achieve expense synergies and grow IA channel policies in force. We’re only a quarter into it, but we had a really strong start on these goals. We put Glenn and the team, [indiscernible] have been working on this really since the six months we started the deal in July six months before we bought it. So we came into this first quarter with a head of steam. And the Allstate protection segment added $1.3 billion in net written premiums, $138 million in underwriting income this quarter. Allstate Health and Benefits increase adjusted net income by $35 million. We are integrating Encompass onto the National General platform and are on pace to achieve our expense synergies. We also expect to grow policies enforced by broadening that product portfolio in IA channel. And of course, that represents about a third of the total person lines market. The IA channel policies in force are approximately six times larger after this transaction, as we add standard auto and homeowners insurance products to National General’s offering later this year that will drive even more growth. Let me now turn it over to Mario to go through the first quarter results in more detail."
},
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"speaker": "Mario Rizzo",
"text": "Thanks, Tom. And good morning everybody. Let's go to Slide five and delve a little deeper into Property Liability growth. Property Liability policies in force grew by 12.1%, compared to the prior year quarter. National General, which includes Encompass, contributed growth of 3.9 million policies. The Allstate brand grew policies by 0.5% due to growth in homeowners and other personal lines as you can see by the table on the left. Allstate brand auto insurance was flat to the prior year, as increased new business was offset by lower retention. The chart on the lower right shows a breakdown of personal auto, new issued applications compared to the prior year, which increased 64% in total, primarily due to the incremental 526,000 applications generated by National General. The middle section of the chart shows Allstate brand impacts by channel, which in total generated a 5.4% increase in new business growth, compared to the prior year. Modest increases from existing agents and a large increase in direct channel sales, more than offset the volume that would normally have been generated by newly appointed agents, as we pilot new agent models with higher growth and lower costs. As a result, property liability net written premium grew 13.7% in the first quarter compared to prior year, driven by a 12.9% increase in auto insurance and a 20.3% increase in homeowners insurance. The auto insurance net written premium increase was driven by a 14.1% increase in policies in force due to National General and increased new business – new issued applications across all brands. These favorable impacts were partially offset by lower average auto insurance premiums from approved rate decreases and lower retention, partially driven by the impact of special payment plans that were implemented during the pandemic. If you flip to Slide 6, you see property-liability margins remain strong. The recorded combined ratio of 83.3, improved 1.5 points compared to the prior year quarter, primarily from a lower underlying loss ratio driven by reduced auto frequency and continued cost savings. The auto insurance recorded combined ratio of 80.5, was 8.8 points below the prior year, primarily due to lower accident frequency in the quarter. Allstate brand auto property damage gross frequency remained below prior year levels in 47 of 51 geographies, which includes the District of Columbia. The chart on the lower left shows the impact of the pandemic on Allstate brand auto property damage gross frequency. As you can see the onset of the pandemic and efforts to slow the spread of the virus had a large impact on frequency beginning at the end of the first quarter of last year, and then extending into the second quarter when auto frequency was at its lows. This timeframe coincided with Allstate's shelter in place payback. Following the second quarter of 2020 property damage frequency has trended below pre-pandemic levels by approximately 28%, as you can see by the third and fourth quarter variances to 2019. And first quarter of 2021 frequency showed a comparable decline relative to 2019. As you can see from the chart on the bottom right, we continue to make progress in reducing our cost structure, enabling us to improve the competitive position of auto insurance, while maintaining strong returns. The property liability expense ratio improved 2.5 points in the first quarter of 2021, compared to the prior year due to the absence of coronavirus-related expenses incurred in 2020, such as the shelter in place payback as well as continued cost reductions. This was partially offset by a significant increase in advertising investment. The expense ratio, excluding coronavirus-related expenses, restructuring charges, and the amortization of purchased intangibles associated with the acquisition of National General was 22.8, an improvement of 0.5 points compared to the prior year quarter. In connection with the anticipated benefits associated with the future work environment, we expect to incur approximately $110 million in restructuring costs during 2021 with $33 million recognized in the first quarter, primarily related to real estate exit costs. These restructuring costs and their future benefits are incremental to the $290 million of aggregate restructuring costs related to transformative growth, which we announced in the third quarter of 2020 and of which we've recognized $256 million to date including $17 million this quarter. Let's move to Slide 7 to discuss our progress on building transformative growth business models. So transformative growth is a multi-year initiative to build a low cost digital insurer with broad distribution. This will be accomplished by expanding customer access, improving customer value, increasing marketing sophistication and investment and building new technology ecosystems. A longitudinal plan segments transformative growth into five phases, starting with the conceptual design and ending with the retirement of the old business model. We've completed Phase 1 and much of Phase 2. In Phase 2, the auto insurance competitive position has been improved leading to higher close rates. This was supported by cost reductions. Direct capabilities have been expanded and sales volumes are increasing. New branding has been launched and marketing investment has been increased. This combined with industry-leading telematics capabilities will increase growth. We believe Allstate is among the leaders in telematics and is the largest pay-per-mile provider through Milewise, which offers lower costs for customers who drive less. We've also expanded independent agent distribution through the National General acquisition. Looking forward, we are now into Phase 3 in building the new operating model. We will support the transition of Allstate agents to higher growth and lower cost models. New agent models are also being tested to serve customers who want a local agent. Improving customer acquisition costs relative to lifetime value will lower costs. Expense reductions will support increased investment in growth and technology. The new customer experience and product management technology ecosystems also get deployed in this phase. Now let's go to Slide 8, which highlights investment performance for the first quarter. Net investment income totaled $708 million in the quarter, which was $462 million above the prior year quarter driven by a higher performance based income as shown in the chart on the left. Performance-based income totaled $378 million in the first quarter as shown in gray, reflecting broad based valuation increases in private equity investments and sales of underlying real estate investments. Market-based income shown in blue was $6 million below the prior year quarter with lower interest rates, our reinvestment rates remain below the average interest bearing portfolio yield reducing income. Our first quarter GAAP total portfolio return was minus 0.2% as you can see on the bottom of the left chart, reflecting lower fixed income valuations. Over the last 12 months, the total return was 8.8%. As discussed previously, our performance-based strategy has a longer-term investment horizon with higher, but more volatile return expectations. This volatility can be seen by the chart on the lower right. It highlights the one, five and 10-year performance-based internal rates of return. The one year trends has been volatile throughout the pandemic with the two most recent quarters, significantly higher than the returns experienced during the middle of 2020. Conversely, the five and 10-year trends are stable and closer to our expected returns. Moving to Slide 9. Allstate Protection Plans continues to grow revenue and profit. As you recall, we purchased Allstate Protection Plans for $1.4 billion in 2017 to broaden the protection solutions offered to customers. It provides low cost protection with excellent service. Products are primarily sold for U.S. retailers and leverage the Allstate brand. Since acquisition, Allstate Protection Plans has experienced rapid top-line growth and improved profitability. Revenues have grown at a compound annual rate of 48% over the last three years, as you can see on the bottom left. And we're more than $1 billion over the latest 12 months. Adjusted net income went from a loss of $22 million in 2017 to income of $148 million over the last 12 months. Additional growth will be achieved by further expanding appliance furniture and mobile phone protection, expanding the geographic footprint outside the U.S. and creating new innovative services such as two-day appliance repair. This acquisition has been an incredible success for us. Now let's move to Slide 10, which highlights Allstate attractive returns and strong capital position. Allstate continued to generate attractive returns with adjusted net income return on equity of 23.2% for the last 12 months, which was 5.7 points higher than the prior year. Excellent capital management and strong cash flows have enabled Allstate to return cash to shareholders while simultaneously investing in growth. We provided significant cash returns to shareholders in the first quarter through a combination of $601 million in share repurchases and $164 million in common stock dividends. The current $3 billion share repurchase program is expected to be completed by the end of 2021. Given our growth strategy and sustainable earnings potential, we announced a 50% increase in the quarterly common shareholder dividend to $0.81 paid to shareholders on April 1. The total cash return provided to shareholders was 7.8% of average market capitalization over the last 12 months. With that context, let's open up the line for questions."
},
{
"speaker": "Operator",
"text": "Certainly. [Operator Instructions] Our first question comes from the line of Josh Shanker from Bank of America. Your question, please."
},
{
"speaker": "Josh Shanker",
"text": "Yes. Thank you very much for taking my question. So it looks like there's very good success in the allstate.com direct model. Can we talk a little about whether we shuttered the purchasing through Esurance and the sort of flows we're seeing on the new policy apps on the allstate.com site?"
},
{
"speaker": "Tom Wilson",
"text": "Glenn, do you want to take that?"
},
{
"speaker": "Glenn Shapiro",
"text": "Sure. Yes. So we have not completely shuttered Esurance. What we've done is we've redirected our marketing dollars from the Esurance brand to the Allstate brand. And in addition to that, we've invested more in the Allstate brand as well. So – but part of that was being able to move that marketing. So while Esurance has trailed down, we're still taking advantage of the goodwill that we've paid for over years of that brand. And the fact that people recognize it, still find the Esurance out there and they have good products for a portion of our market. So we're still selling some there, but the growth is absolutely being driven by the Allstate brand. As you saw in the supplement that or the Q, we've got 33% increase in direct sold business. So it's really taking off and we've got more capacity going into that system, because a direct system is – I won't say only limited, but a main limiter would be your capacity, your sales capacity in there. So we're growing the contact center, improving web flows and really growing the Allstate branded direct sold business. [Indiscernible] as you know, is part of transformative growth, we're also building a new technology ecosystem, a product management system and a customer experience system. As that gets rolled out, we will shutdown the Esurance system and then we will stop selling products under the Esurance thing. But we have some time to do that."
},
{
"speaker": "Josh Shanker",
"text": "And the 278,000 new policy apps at Allstate direct, are those apples-to-apples with the 200 or so that you sold one year ago, or was that part of a joint direct captive sort of relationship where we're directly the lead generator or are they complete apples-to-apples those two types of new applications?"
},
{
"speaker": "Tom Wilson",
"text": "Glenn, do you want to take?"
},
{
"speaker": "Glenn Shapiro",
"text": "Yes. Sure. Yes, it would be an apples-to-apples. It's basically just think about customers that come to us by either clicking or calling directly into an 800 number as opposed to the customers that come to us through an agent. So it would be an apples-to-apples comparison."
},
{
"speaker": "Josh Shanker",
"text": "And can we talk about National General, Encompass and Allstate brand through independent agents, is Encompass going to be called National General, even though the National General and Encompass products are kind of a different target customer and what would be wrong with calling the product Allstate?"
},
{
"speaker": "Tom Wilson",
"text": "Well, let me take the branding question then Glenn can fill in how we're doing the transition, because it's different for Encompass than it is for the Allstate independent agent. So first from a branding standpoint, we've decided that the Allstate brand and personal property liability will be on business that we control both the sales and the service on it. So that's both the Allstate agents and then direct whether that's a web or call center. For the independent agent business, we've rebranded National General. So it's National General and Allstate company and we launch it, I think beginning of January. So that you get the relationship with Allstate, but that everybody understands that it's separate than that, which you would get from an Allstate agent. We do not do that with the Allstate brand in the circle of protection. So for example, we sell under the Allstate name at Walmart, sell under the Allstate name at Home Depot, at target, which gives us both increased exposure to customers, enables us to further leverage that capability. And quite honestly, it's helped us dramatically expand Allstate protection products because of the power of their brand. So slightly different strategy from a branding standpoint, inside the personal property liability markets and outside, but we try to leverage it everywhere we can, but provide, make sure that that brand stands for certain things in different areas. Glenn, do you want to talk about your plans to both integrate Encompass and Allstate independent agents into National General and then Josh’s question on branding at the same time."
},
{
"speaker": "Glenn Shapiro",
"text": "Yes. So thanks Josh, because I think it's an interesting question because I think if you take from a legacy standpoint, National General and what it was best that known for in Encompass and what is best that known for, it would be different as we suggested. But as Tom just pointed out National General and Allstate company, that's going to be a different story. We're launching middle market products. So think about basically the Allstate product capability in the middle market auto and home and other personal lines. On the National General platform and branded as National General and Allstate company starting in the second half of this year and then really fast expansion. So it would be to all 50 States within 18 months of the start of that. So before the end of next year. So really National General and Allstate company is going to be a company that is serving from nonstandard up through a mass affluent, and everything in between. It really is another national player in the independent agent space. And we've gotten a phenomenal reaction from independent agents and they are genuinely excited to have another significant player and with the capabilities of Allstate, National General combined in that market. And so we're positioned really well to grow with a lot of greenfield ahead of us in the independent agent space."
},
{
"speaker": "Josh Shanker",
"text": "The Encompass name will disappear?"
},
{
"speaker": "Tom Wilson",
"text": "It will be at part of National General and Allstate company, correct. Whether we grow the policies to a new policy or leave the policy outstanding under the Encompass name and basically put National General stuff on top of it, it would just depend on the cost of it. And Encompass, it goes first and the Allstate independent agent, which is Allstate brand products sold through independent agents in rural spaces where it was not economic to have a captive agent, mostly there's a few places where it didn't work that way, but mostly that will transition over time as well."
},
{
"speaker": "Josh Shanker",
"text": "Excellent. Thank you very much."
},
{
"speaker": "Operator",
"text": "Thank you. Our next question comes from the line of Jimmy Bhullar from JPMorgan. Your question, please."
},
{
"speaker": "Jimmy Bhullar",
"text": "Hi, good morning. So first I guess for Glenn or Mario, but the question on just auto –the auto business. How do you see the interplay between the frequency and pricing? And it seems like everybody's had very good margins in personal auto over the last several quarters. At what point do you see sort of pricing catch up to that? And in that environment, do you think if the market stays competitive; are you still in a position to grow your discount?"
},
{
"speaker": "Tom Wilson",
"text": "Let me provide an overview and then Glenn if you want to jump onto this one. So first I'm going to go up a little bit. First, it's about how do we think about increasing market share and we'll use two words together profitable growth. We put them together because that's what we want. We do not believe that growth with no profit is good for shareholders. So the objective of course is maximize shareholder value. Our expected outcomes for our team are that they will balance between growth and profitability. Our strategy of course is as Mario talked about in the first phase, second phase of transforming growth is getting more competitive auto insurance product. And we supported that, of course in worse being successful by reducing our costs. So the first thing would be we can control our costs and we can make sure that if we reduce prices to get more competitive, we still maintain our margins. Obviously, we want to be smarter whether that be how we price or how we acquire business and our marketing and we're also using telematics. And then as we go forward with transformative growth, it'll be by being faster with better technology and having new products affordable, simple and connected that are sold through that broad range of distribution that Glenn was just talking about from direct to Allstate agents. So Glenn, do you want to jump in on the specifics?"
},
{
"speaker": "Glenn Shapiro",
"text": "Yes. So first I'll talk about frequency a little bit and then go to competitive position. So from frequency standpoint, what we're – everybody has benefited from some lower frequency. But we've also looked at a deeper level at it, but then just sort of miles driven and the number of accidents coming out, because there are differences by books and you see differences in competitors as to how much tailwind that's providing. So, we look at the fact that commuter driven or take it from rush hour losses are down about three points more than overall losses. And we look at rural driving is down about four or five points less than urban driving. And so we look at these that are pretty deep level, and we we're fortunate to work with Arity and have a lot of data on this with 10 years plus of telematics that we get pretty granular into how we're looking at it and understanding the frequency picture. So we've got a tailwind with that, which takes me into competitive position because we've been moving our competitive position pretty aggressively. Like you see a minus 1.5 on average premium, and that might feel or seem slight, but there's a lot underneath that. We've moved new business pricing. We've moved telematic pricing. We've reduced the cost of our Milewise program. That's grown really nicely and all of that is inside of there. So our competitive position on the price changes we've made and that are still going into market have really improved. And our close rates are up. We're starting to see those really positive signs of momentum across multiple states. And then you put on top of that, the fact that some of our competitors have already taken price increases, some of those out there. We've heard others say that they're going to start taking bites at the apple in terms of price increases. And you look at our position and obviously we're in a position right now. We continue to invest in growth. We can still put money into marketing. We could still put money into competitive price position because of where we're positioned, which really puts us in a great spot to grow going forward."
},
{
"speaker": "Jimmy Bhullar",
"text": "And then just any comments on your views on if growth to the extent you're able to quantify or give a range on how I'm assuming it should trend higher later this year and into next year as you're implementing some of these initiatives in direct and independent agency, but to whatever extent you can quantify or give us an idea do you expect it to be?"
},
{
"speaker": "Tom Wilson",
"text": "Well, we're not – we don't give forecast on if growth or frequency or case tasks, these things you can't predict. Let me talk about growth a little bit, because it is really an important question that many analysts have. And of course it drives huge value in the market today. And so we were starting to have first actuals matter and we had a great quarter. I mean, over 25% revenue growth, our fifth growth was in the low teens. And we're headed towards increasing our market share pretty significantly in personal lines this year, which is consistent with our strategy. I guess what we set out to do? Now, you'd have some naysayers and say, well, you bought it with the acquisition of National General. And that's of course true. But you always have to investigate market share. In this case, it is real growth. And we look at it and said, if we had taken the net price that we paid for National General and thrown it into marketing or higher commissions or some kind of spiff. It likely would have given us less growth than we got. And certainly not the kind of profitability we're getting from it. The same thing, but we did buy it. But we did the same thing with Allstate protection plans, right? We bought SquareTrade. We repositioned it with our brands and that acquired growth and turned into an organic growth platform. We expect the same thing to happen with National General. The difference is we paid a slightly higher premium for SquareTrade than we did for National General. As it relates to the Allstate brand, we have multiple ways to grow, right. We got the Allstate agents and we're making – helping them transition to a new model. We have the direct business, which we've launched in is so by the way, at a different price than through an agent, because we believe customers should pay for what they get. And if you get an agent and get that help, you should be willing to pay for that. And so overall we feel like the Allstate brand is positioned for long-term growth as well. And so we feel like we've got an overall plan to move forward, has got transformative growth in it. It's got real growth this quarter and it's got – we're building platforms and we'll continue that growth going forward."
},
{
"speaker": "Jimmy Bhullar",
"text": "Okay. Thank you."
},
{
"speaker": "Operator",
"text": "Thank you. Our next question comes from the line of Greg Peters from Raymond James. Your question, please."
},
{
"speaker": "Greg Peters",
"text": "Good morning. My first question will be on reinsurance. Tom, I was hoping you could just give us an overview of how reinsurance helps the company this quarter. And then I know you did file your reinsurance update piece and maybe talk about what's changing going forward. I did note that the costs in the first quarter about 14% higher versus a year ago is that the type of cost or increase we should expect for the full year."
},
{
"speaker": "Tom Wilson",
"text": "Greg, let me start with this strategic perspective on it, and then either Maria or Glenn, if you want to talk about the first quarter. So I'm going to go back a long way. But in 2004 and 2005 we had huge catastrophe losses. We weren't earning any money on the homeowner's business. We'd make some money one year and we would lose money the next year. When you looked at over time, I think this is not a really good business. So we looked at getting out and we said what – if we were out, we'd want to be in, because it does, our customers do want it. So maybe it's just this catastrophe risk they don't want. So we created a very comprehensive catastrophe reinsurance program to basically divest certain portions of the risk we took on. And that's evolved over time. We have a very sophisticated multi-year program. It's got – it's by stated got different by event. It's got the aggregate in it. And we bear that cost each and every quarter, obviously that comes through. And then sometimes it pays off. And what you saw this quarter was the aggregate kicked in. And so from losses, some of the losses, which were last year showed up as reducing our catastrophe losses this quarter, which were upgraded significantly. And that helps smooth it out. And we've looked at that from what kind of return on capital do we give up to the reinsurers and we're quite comfortable giving up the return that they get to avoid the volatility that comes from it. And so it's helped us reposition the homeowners business, so that now it's a very consistent source of profitability for us. As I was saying to the prior question, we don't believe in growth with like running homeowners above a 100 is not a good plan and you're destroying value at that point with growth. And we don't believe in that. So we've used reinsurance to help reposition the business. We did a whole bunch of other stuff including changing the product and changing the way we price and how we underwrite it, where – how we do our segmentation by down to specific risks codes. So how we pay for roofs, there's a whole bunch of stuff we've changed underneath that over the last decade. But it's a really good business. In reinsurance, using that reinsurers helped us get there. So what you saw this quarter was a benefit, which is more than was earned in this quarter, but it was paid for in the prior quarter. So if you – some people want to exclude it from this year's quarter, totally get that. Unlike that's fine. But then you should not be counting all the costs from the other time. Mario, Glenn, do you want to talk about the cost of reinsurance and the program going forward?"
},
{
"speaker": "Mario Rizzo",
"text": "Sure. I can jump in on that Tom. And just to give you a little color, Greg, on the benefits in the quarter. We recovered about $955 million in the quarter on a net basis. Part of that was from our per occurrence nationwide program where we retain the first $500 million of an event. And then we have coverage up – in our current program up to $5 billion. And then as Tom mentioned, we also have an aggregate cover, which is about $1 billion, which spans a 12-month period. We also had recoveries under that. So combined, it was about $955 million. That's net of reinstatement premiums in the quarter, and it was principally on the freeze event in Texas. So the freeze event on a net basis cost us $586 million in the quarter. Once you start peeling back the prior year component of that reinsurance recovery, which was about $150 million. You get to a gross loss in Texas north of $1.3 billion. So we've benefited pretty significantly in the quarter from our reinsurance program. As you mentioned, we posted on our website – we placed most of the nationwide program this quarter and we still have a component of the nationwide program to do. And then remember we have a separate Florida program. The costs year-over-year, because we've included National General in this year's program. It’s going to be slightly higher than it was a year ago when you add up what we were spending on reinsurance and what National General was spending on reinsurance. But in terms of what you saw in the first quarter, you got to remember, that's still last year's program that was placed May 1. And what we saw last year was the increase we experienced was mainly in the Florida program. And you're seeing that kind of cycle through in the first quarter. We will start incurring the cost of this year's program when it incepts which is on June 1."
},
{
"speaker": "Greg Peters",
"text": "That was a thorough answer. I appreciate it. I'd like to pivot to the expense ratio on Page 6 of the presentation slide deck you are continuing every quarter to show improvement in almost every quarter and show improvement in your expense ratio. And I guess when we think about the sustainability or more importantly, is this a trend that we should continue to expect forever? Obviously, I don't think your expense ratio is going to zero, but the improvement is noteworthy. And then just as in the slide, I did notice that the expense ratio was up in the Allstate protection home business. So, I'm curious if there was something unusual on that?"
},
{
"speaker": "Tom Wilson",
"text": "So, overall, Greg you are right our strategy to get a more competitive in auto insurance pricing, which was Phase 2 [indiscernible] transformed to growth, included taking down costs. And as you know, we did a large reduction in force last year, did about 3,800 people starting to see that come through this year. At the same time, our advertising was way up. And so, we try to balance between those two. I don't think you could expect it to come down half a point every quarter from now till an infinite item. You should know that our strategy is to both keep reducing cost every place we can so that we can have a more affordable product for our customers and therefore a better price. So, we get more of them. But not invest in growth, because if the kind of a return on capital we're getting in these businesses, we should definitely be seeking more growth. Mario, do you want to talk more about what you – this current quarter and what the ins and outs were?"
},
{
"speaker": "Mario Rizzo",
"text": "Yes. Thanks Craig. So, I guess, it's not mentioned. We're going to continue to focus on reducing our cost structure. And like we said, really all along, our focus on reducing our cost structure is not a margin expansion focus, it's a growth focus. And it's a growth focus because reducing our costs enables us to invest more in growth. And you saw it this quarter where we invested more in marketing and the component of our underwriting expense ratio related to marketing actually increased by nine tenths of a point. Yet it was more than offset by the operating cost reductions that Tom referenced from last year. So, real ins and outs were more investment in advertising, more than offset by cost reductions and net-net a half a point improvement in kind of the underlying expense ratio in the quarter. And we're going to continue to focus on moving that number down. The other thing I'd mentioned on expenses, and it's not obvious in our numbers is, part of our focus on cost reduction has been on getting more efficient in claim handling. And we've improved the efficiency in our loss adjustment expense, which comes through the loss ratio. But again, we consider it as a core part of our cost reduction efforts to improve the combine – improve the cost structure, creates a path we need to invest and be able to grow more and continue to deliver excellent return. So, I think what you saw in the quarter was really kind of proof of, of how that strategy is playing out. In terms of the homeowner expense ratio specifically, Greg, I'd have to go back and take a look at what components of it – whether it came through distribution costs, or underwriting costs, whether it was like inspections, and so on. So let me take that one offline and I'll get back to you on that one."
},
{
"speaker": "Greg Peters",
"text": "Got it. Thank you for the answers."
},
{
"speaker": "Operator",
"text": "Thank you. Our next question comes from a lot of Paul Newsome from Piper Sandler. Your question, please."
},
{
"speaker": "Paul Newsome",
"text": "Good morning. Thanks for the call. Congratulations on the quarter. I was hoping you could expand a little bit more about what it means to transition the existing through agents to a different model. We get emails from agents all the time. Usually, they are worried about this or that. Is this a transition that's really towards more of an independent agent type structure with equations, or are we talking to something that's completely out of book? Or if it's sort of to be determined?"
},
{
"speaker": "Tom Wilson",
"text": "Let me provide a little view and then Glenn can tell you some of the specifics of what we're doing. But Paul first thing I would say is now we're not going to do the nationwide deal and turn them all into independent agents. We don't think that makes sense from a customer standpoint. Customers come to us because they love the Allstate brand. We have a really strong brand, long relationships, so we're not planning on turning them into something else. And obviously the fast pace of change has all of this on it, whether you're a retailer or anybody what's going on in the world. And the good news for our agents is that still a majority of consumers want an insurance professional help them buy insurance. And our agents are really good at it. That said, people are more comfortable with self-service, simple items and the technology enables a computer to do some of the work that used to be handled in by people and stellar in some cases handle the local offices. So we have to transition their model and go where the customer is going. And so that includes maybe we don't have to use as much real estate as we use today. We certainly do not need to do as much service work in agent offices. So, we have a little over 10,000 Allstate agents. There's probably 26,000 to 27,000 people working in those agencies. Some of those people are doing service work. And we think we can do that either centrally at a lower cost and be more effective for our customers, or just get the computer to do it. Nobody does it at all. So, we have to figure out how do we transition those people in those offices to doing service work, to doing sales work. Or if they can't transition those licensed sales professionals, have the agents build up staff, they can move into that. So last year, one of the things that Glenn and team did was they raised new business commissions to incent, to give people the opportunity to invest more, and sell more things to more people and get more people selling for them. To offset that and continue to make sure we're meeting our customers’ cost needs, we slightly reduced renewal commissions to reflect that. So, if you're an agent and you're focused on new sales, that's a good thing. You're excited about it, you are off and ready to go. If you've been focused more on service and not on growth, then you are not going to be as excited about that change because it changes your business model. So, we have to help them transition from where they are to the place where the customers want us to go, which is they want help, but they want to do it in technologically efficient, low-cost way. And we think that there's a good way to do it. Glenn can give you some examples of what we're doing with our existing agents. We've already talked about what we're doing direct to serve our customers. And then we're also trying some new models that Glenn can talk about, that do the same thing, which is use people to help people buy insurance in a local space, but at a lower cost. Glenn, do you want to give them some more specifics on that?"
},
{
"speaker": "Glenn Shapiro",
"text": "Yes, absolutely. And Paul, Tom hit a lot of the really important points here. But a couple bear repeating, so no harm being repetitive, but it's really important. So, it's a hard no on the IAP. So, I'll just reiterate, as Tom said, we are dedicated to our exclusive agent model completely. And we believe that there is a not only a meaningful place, but a huge place for our exclusive agents to grow in the market because as Tom said, most consumers still want to work with an agent. So, in the presentation materials that talked about higher growth, lower cost models, so, I'll just hit a couple of things. Lower cost, we've been really reticent in the past to allow agents to consolidate locations or to even go in some cases without real estate or reduce their real estate footprint. We've been very focused on a model that is how many signs do you have up across the countryside. And we're going to really lean in to allowing agents to reduce costs in the way they run their business. And Tom talked a bit about the service. We started that in 2019 and we built it up a bit and everything, but we really have to get to a centralized, and more efficient and effective way of serving customers than separately across 10,000 different locations. And we can take a lot of cost out of the system and reduce the cost for the agents so that they can focus on growth. From a higher growth standpoint, it's about leaning in, on the marketing that they do, that we can help them do more effectively and efficiently as a large enterprise, the lead management that they do, compensating them more for new business, as Tom mentioned also. That's the existing agents and how we want to transition that to higher growth, lower costs. The new models, for example, and we have several hundred of these already in place actually where we are learning from our Canadian operation. Actually, in Canada we have Allstate agents who operate sort of independently from one another. It's not an agent with multiple staff, they are independent workers and producers. And they work on sort of a balance between being in communities, and driving leads themselves and getting leads from the company. And it's been very successful. We're growing very fast in Canada. So, we're leveraging that model and looking at models with no real estate in local markets that are part of the community and are able to take leads and also generate their own leads in that community and grow. So, it's early in the process, but in the second half of the year, we're looking to ramp those up significantly."
},
{
"speaker": "Paul Newsome",
"text": "I guess, relatedly, could you talk a little bit about any early looks on the pilot programs for new agent recruitment? And if there's some different things that will be happening there in the near future?"
},
{
"speaker": "Tom Wilson",
"text": "Glenn, do I take that? Hey Glenn, do you want to take that or maybe you are on mute."
},
{
"speaker": "Glenn Shapiro",
"text": "My apologies, I did go on mute there. Yes, so we're focused on those new models. I just mentioned in terms of our recruitment right now. And so we have been, I think, – we have several hundred already and we have a lot more in the pipeline. So, we're looking to grow with those new models. What we're really focused on with the existing agent group, well we’re recruiting sung into the compensation programs that we have as opposed to what we called enhanced compensation program, which was a higher cost model before we're recruiting some into that as more of what you had refer to as a traditional exclusive agent. But the heavier emphasis on our recruiting is on those new models, where with our existing agents, we are really focused on investing to get more of those agents growing and wanting to grow. The good news is they are growing right now. We have increased new business production with our existing established agents. So, when you see the total that somebody referenced earlier, it's slightly down on the overall agency force that is driven by sort of a lack of new appointments, the existing agents, new businesses up year-over-year"
},
{
"speaker": "Tom Wilson",
"text": "And Glenn, let me just add last point which is when you see that little red bar on our graph, that was an intentional choice on our part, not a flaw in the system. So, it's not like we decided that, you know what, we were hiring these new agents, we required them to have their own office, we require that they have support staff. To make that work when you have no customers, we're paying 30% upfront commissions which then stayed high for it, not at 30%, but stayed higher than customers should have to pay for them for about five years. And we said what, but this is not the model of the future. We could have kept that going while we develop these new models. And the system would look like it would have been generating more growth than it is today. But we say, economically, that's just not the smart thing to do. Like we're not using shareholders money, right. And that's where we get into which the conversation we’re talking about before is profitable growth. If you're going to [indiscernible] profitable long-term growth, and so you have some bumps, but that's not about a flaw in the system. That's about an intentional choice."
},
{
"speaker": "Paul Newsome",
"text": "Appreciate it. Thank you very much."
},
{
"speaker": "Operator",
"text": "Thank you. Our next question comes from the line of David Motemaden from Evercore. Your question, please."
},
{
"speaker": "David Motemaden",
"text": "Hi, good morning. I guess I wanted to just touch on retention. I was surprised it fell a little bit here again also, especially, given some of the rate actions that you guys have taken. I guess, could you maybe just talk about how much of an impact the lapsing of any billing leniency may have had on the retention, and what your expectations are for retention going forward, like, should we see a snapback here in the second quarter? Yes, I guess that's just my question on retention."
},
{
"speaker": "Tom Wilson",
"text": "David let me provide an overview and Glenn, you can take the impact of the pandemic billing stuff. First, I would say retention is really hard to do attribution on. People leave for all different reasons. And sometimes it's for price, sometimes it's because they move, sometimes it's they bought a new car. And so, it's difficult to get it down to precision to, in a point. What you do know is if your net promoter score is good and you are doing a better job for customers, they should stay around longer. And if you are competitive in price and you are changing your price not only for new business, which we've done, but also for your existing customers, which we've done, so they have a better price and that should also keep them. But there's lots of different variations. So it's kind of really hard to predict it. Glenn, do you want to talk about how you're feeling about retention this quarter? And again, we have a hard time, nobody really knows how to predict retention."
},
{
"speaker": "Glenn Shapiro",
"text": "Yes, absolutely. So, retention is a lagging metric, first of all I’ll start there. Wherever or whenever a customer decides to cancel, move, shift we record it and report it at the point of what would have been the renewal. So, there's a bit of a lag to that. So, while we stopped the special payment plans during last year, there's still some of that trick going in. So as Tom said, attribution is difficult on this. But there's a portion of it that's related to that. No question. Secondly though it is a highly competitive market right now, shopping is up, advertising is up and there is some impact from that. It's interesting. When you look at National General, as an example, if you saw in some of our disclosures, like National General’s, new business, it's really eye-popping, because National General writes a lot more new business to grow because they have a shorter cycle time. As our business shifts and we look at overall protection business and we're writing in more markets, and we're writing direct and not just through our exclusive agents, that number will move around a little bit on retention, but our focus is to create a lot of new business. We're going to do that. That's what transformative growth is about. We're going to create a lot of new business so that the undulations of retention don't mute our overall growth."
},
{
"speaker": "David Motemaden",
"text": "Got it. Thanks. That's helpful. And then maybe just on the new business side, obviously great growth, especially on the direct side in new apps. I guess I'm wondering maybe if you could just – you had kind of mentioned it in your script, but want to just a bit more details on the Milewise offering and how that did this quarter? How big that is as a percentage of the entire book? And was that really the driver behind the direct growth that we saw in the quarter?"
},
{
"speaker": "Mario Rizzo",
"text": "Glenn, you can take where we are with Milewise, and number of states and how [indiscernible] you got the done pricing. I would say though, when you just step all the way back, we're about building a digital insurer. And sometimes that gets lost into how big and how successful we are given the size and scale of our company. [Indiscernible] sometimes people look at people who only do that and assume that, they are about to take over the market. We're happy to compete. We feel like we're really doing well in here. We’re early in telematics. We think we're a leader in telematics. And this is an example of a product where we were out early, we're aggressively advertising it and it's resonating. Glenn, do you want to talk about, what you've done to help it grow?"
},
{
"speaker": "Glenn Shapiro",
"text": "Yes, absolutely. And to the question of, is it driving the direct growth, I would say, no. Direct growth a majority of that is not Milewise. It's an interesting thing to look at, as Tom said, when you look at it inside a company like Allstate, Milewise will look relatively small. It's up, this year it's something close to in autos. Policies, I think, are foreign change times, autos are six in change times what they were a year prior. So significant growth. If this was a standalone startup sitting outside of a large insurance company like Allstate, it is the largest in the industry pay by mile program. And it would look really big, and really fast growing and really attractive. Inside of Allstate, it is helping our growth, but it is not driving our growth, is the way I'd say that. We're looking to expand over time on Milewise. Right now, it's available to about 50% of consumers across the country. And we have more states lined up for that. It does require the OBD port, which, I think, everybody knows there are chip shortages out there. We have not run into a problem where we have to slow down our – Milewise at this point. But we are actively managing our supply chain on it because it is a popular product. And we're managing our state expansion and looking at that so that we don't run into a supply chain issues."
},
{
"speaker": "Tom Wilson",
"text": "Thank you for the questions, I think, we're out of time here, it’s top of the hour, and we try to be respectful of your time. Obviously, we appreciate you coming to spend time with us in here about us. We had an excellent quarter the work and you saw from that first slide, the amount of expertise and effort that went into delivering all that for the quarter. It wasn't just this quarter, it's what we do over time, but we feel good about where we're at. So, we've had great operating results as well. So, thank you for your participation. And we'll see you next quarter."
},
{
"speaker": "Operator",
"text": "Thank you, ladies and gentlemen, for your participation in today's conference. This does conclude the program. You may now disconnect. Good day."
}
] | The Allstate Corporation | 18,711 |
ALL | 4 | 2,022 | 2023-02-02 09:00:00 | Operator: Good day and thank you for standing by. Welcome to Allstate’s Fourth Quarter Investor Call. At this time, all participants are in a listen-only mode. After the prepared remarks, there will be a question-and-answer session. [Operator instructions] As a reminder, please be aware that this call is being recorded. And now I’d like to introduce your host for today’s program, Mr. Mark Nogal, Head of Investor Relations. Please go ahead, sir.
Mark Nogal: Thank you, Jonathan. Good morning. Welcome to Allstate’s fourth quarter 2022 earnings conference call. After prepared remarks, we’ll have a question-and-answer session. Yesterday following the close of the market, we issued our news release and investor supplement and posted related material on our website at allstateinvestors.com. Our management team is here to provide perspective on these results. As noted on the first slide of the presentation, our discussion will contain non-GAAP measures for which there are reconciliations in the news release and investor supplement and forward-looking statements about Allstate’s operations. Allstate’s results may differ materially from these statements, so please refer to our 10-K for 2021 and other public documents for information on potential risks. And now I’ll turn it over to Tom.
Tom Wilson: Well, good morning. Thank you for investing your time in Allstate today. I’ll start by setting context and then Mario and Jess would provide additional perspective on operating results and the actions being taken to improve auto profitability and increase shareholder value. So let’s begin on Slide 2. So as you know, Allstate strategy has two components: increase personal Property-Liability market share and expand Protection Services, which is shown in the two ovals on the left. On the right hand side, you can see our results for the year. Earnings were disappointing with a net loss of $1.4 billion, largely reflecting an underwriting loss on auto insurance and mark-to-market losses on the equity portfolio. Strong results from homeowners insurance, protection services and fixed income investments were not enough to offset the losses on auto and commercial insurance. The most important driver of near-term shareholder value will be successfully executing our comprehensive plan to improve auto profitability. That includes broadly raising auto insurance rates, reducing expenses including temporary moves such as less advertising and permanent reductions including digitizing and outsourcing work and lowering distribution costs. Underwriting restrictions have been implemented to reduce new business volume until profitability is acceptable. Claims operating processes are also being modified to manage our loss costs. This plan is being implemented, but earned premiums from auto insurance rates have not increased enough to offset higher loss costs. And while the number one priority is to improve auto insurance margins, implementation of the transformative growth strategies make great progress in 2022, and we validated that this will drive personal Property-Liability market share growth. Proactive investment risk and return management mitigated approximately $2 billion of loss this year. And while the total return on the portfolio was a negative 4%, that compares very favorably to the performance of the S&P 500 and intermediate bond indices. We also had another great year at Allstate Protection Plans. Moving to Slide 3, let’s discuss financial results. Starting at the top, revenues of $13.6 billion in the fourth quarter were 4.9% higher than the prior year quarter, increasing the full year total to $51.4 billion. Property-Liability premiums earned increased by 9.5% in the fourth quarter compared to the prior year and 8.5% for the full year due to higher average premiums in auto and homeowners insurance. Moving down the table, an adjusted net loss of $359 million was incurred in the fourth quarter reflecting an auto insurance underwriting loss, which is impacted by reserve increases for the current and prior years. Now let me turn it over to Mario to discuss our Property-Liability results and then Jess will cover the other components of earnings.
Mario Rizzo: Thanks, Tom. Let’s start by reviewing underwriting profitability for the Property-Liability business in total on Slide 4. The overall message is that the underwriting loss was a result of auto insurance operating at a combined ratio above our targets, but homeowners insurance continued to be a strong source of profit. On the left chart, the recorded combined ratio of 109.1 in the fourth quarter was primarily driven by higher auto loss costs, unfavorable reserve development and higher catastrophes. This led to a full year recorded combined ratio of 106.6, which was 10.7 points higher than the prior year. The table on the right shows the combined ratio and underwriting income by line of business for the quarter and the year. Auto insurance had a combined ratio of 112.6 in the quarter and 110.1 for the year, substantially worse than our targets given rapidly increasing loss costs throughout the year. This result was an underwriting loss of $974 million in the quarter and over $3 billion for the year. Hence, you can see why Tom has said executing our auto profit improvement plan is the number one priority going forward. Homeowners insurance, on the other hand, had excellent results with the combined – with combined ratios in the low 90s, which generated $681 million of underwriting income for the year. This reflects industry-leading underwriting and risk management in this line of business. Commercial insurance was negatively impacted by the same auto insurance cost pressures, along with inadequate pricing for the coverage provided to the large transportation network companies. The result was an underwriting loss for the year of $464 million. This led to the decision discussed last quarter to not provide insurance to transportation network companies unless telematics-based pricing is implemented and to exit five states in the Allstate traditional commercial business. These actions are expected to reduce commercial business premiums by over 50% in 2023. Now let’s move to Slide 5 and discuss auto margin in more detail. As you can see from the chart on the left, which shows the auto insurance combined ratio and underlying combined ratio from 2017 through the current year, we have a long history of sustained profitability in auto insurance due to pricing sophistication, underwriting and claims expertise and expense management. In 2020, the combined ratio dropped to 86 even though we provided customers with over $1 billion of shelter-in-place payments. This was due to historically low accident frequency in the early stages of the pandemic. In 2021, frequency increased as mileage driven increased, but it did not reach pre-pandemic levels. Claims severity, however, increased above historical levels because of more severe increasing costs to settle claims with third parties, who are injured in accidents with our customers. In addition, used car prices were increasing at unprecedented levels, eventually peaking in December, reflecting an approximate 50% increase over the prior year. We had a reported combined ratio of 95 for the year despite all these pressures. This year, the combined ratio increased 14.7 points to 110.1, the drivers of which are shown in the right-hand chart. The red bars reflect the impact of increasing loss costs, including a 3.6 point impact from prior year reserve additions and a 16.7 point impact from current year underlying losses, excluding catastrophes, which include increases in both frequency and more significantly, severity compared to last year. As we discussed, the core component of the profit improvement plan is to raise auto insurance rates and substantial progress was made on this front starting in the fourth quarter of 2021 and throughout last year. In 2022, the impact of higher average earned premium drove a benefit of 3.6 points, which is shown in green. As I will cover in a minute, there is much more benefit to be realized in earned premiums based on what was implemented in 2022. Another part of the profit improvement plan is to reduce expenses and this contributed a favorable 2 point benefit this year. Moving to Slide 6. Let’s discuss prior year reserve re-estimates before we look forward. Our loss estimates and reserve liabilities use consistent practices, multiple analytical methods and two external actuarial reviews to ensure reserve adequacy. These processes led us to increase the reserve liability for prior years throughout 2022 by amounts that are larger than recent years. Property-Liability prior year reserve strengthening, excluding catastrophes totaled $1.7 billion or 3.9 points on the combined ratio for the full year 2022. The pie chart on the left breaks down the impact by line and coverage with $1.1 billion driven by Allstate Brand personal auto largely related to bodily injury claims. In addition $295 million was related to Allstate Brand commercial insurance, also mostly related to auto. The table on the right breaks down the Allstate Brand auto prior year reserve strengthening of $1.1 billion in 2022 by report year. Let me orient you to the table. Reserve increases are shown by coverage in total and then for the report here to which they apply. The reserve liability for physical damage coverages was increased by $211 million, which was entirely attributable to 2021. This primarily related to adverse development and elongated repair time frames, which were primarily addressed in the first and second quarter. Injury reserves were the largest component at $676 million, which was spread across many report years. Incurred but not reported was increased by $226 million as late reported claim counts have exceeded prior estimates. This reserve balance was increased in each of the first three quarters of 2022, but a larger amount was recorded in the fourth quarter. In total for all coverages about 63% of the increases were for 2021 and 2020. At the bottom of the table, the reported combined ratio for the calendar year is shown and compared to the reserve changes. For example in 2021, the reported combined ratios for Allstate Brand auto insurance was 95. The reserve additions indicate that costs were 2.1 points above this reported number. Estimating reserve liability utilizes multiple reserving techniques, but is always subject to strengthening or releasing reserves over time. This variability increases with changes in the underlying data, such as claim counts, settlement times, or cost increases and as has been the case over the past three years. While reserves could change going forward, based on the 2022 claim statistics and data, reserves are appropriately established at year-end 2022. Moving to Slide 7. Let’s provide some clarity on what the auto insurance combined ratio trend was by quarter in 2022. As you can see on the left-hand chart, the recorded combined ratio peaked in the third quarter at 117.4, largely reflecting prior year reserve changes and catastrophe losses shown in light blue. The dark blue bars are the underlying combined ratio, as reported, which increased each quarter. Included in this dark blue bar is the impact of increasing claim severities within the year. We update the forecast on claim severities as the year progresses. As 2022 developed, loss cost trends resulted in increases to current report year ultimate severity expectations. As shown in the call out on the left chart, 2022 incurred severities for collision, property damage and bodily injury was 17%, 21% and 14%, respectively, above the full report year 2021 level. This estimate, however, increased throughout the year. The impact of increasing current report year on incurred severities as the year progressed influences the quarter underlying combined ratio trend. This impact from increasing full year severities from claims occurring in prior quarters is reflected in the financial results of the period where severities were increased. For example, the fourth quarter of 2022 reflects the impact of higher severity expectations in the auto physical damage coverage, not just for claims reported in Q4 but also for claims that were reported throughout the prior three quarters as well. The chart on the right adjusts the quarterly underlying combined ratio to reflect full year average severity levels, which removes the influence of intra-year severity changes. As you can see, after adjusting for the timing of severity increases in the current year, the quarterly underlying combined ratio trend was essentially flat throughout 2022 and close to the full year level of 103.6. Slide 8 outlines our comprehensive approach to restore auto margins. There are four areas of focus: raising rates; a continued focus on reducing expenses; implementing stricter underwriting requirements; and modifying claim practices to manage loss costs. Starting with rates, since the beginning of this year, we’ve implemented rate increases of 16.9% in the Allstate Brand, including 6.1% in the fourth quarter, which significantly increased written premium. We expect to continue to pursue significant rate increases into 2023 to improve auto insurance margins to target levels. We are also reducing operating expenses as part of transformative growth and have temporarily reduced advertising spend to manage new business volume. We are implementing more restrictive underwriting actions on new business in locations or risk segments where we cannot achieve adequate prices for the risk. Increased restrictions have been implemented in 37 states including California, New York and New Jersey, which account for a large portion of underwriting losses. Claim practices have been modified to deal with the higher loss cost environment. For example, we have strategic partnerships with part suppliers and repair facilities to mitigate the cost of repair and use predictive modeling to optimize repair versus total loss decisions and likelihood of injury and attorney representation. Moving to Slide 9, let’s discuss a key component of our multifaceted plan raising auto insurance prices. Growth in average premium per policy is accelerating due to implemented rate increases, but the impact to average earned premium per policy is on a lag due to the six-month policy term. The chart on the left depicts the year-over-year growth in auto average gross written premium in orange, reaching 14.4% in the fourth quarter of 2022. The auto average earned premium growth of 9.7% in the fourth quarter, represented in blue, continues to increase, but on a lag due to the six-month policy term. The chart on the right is an estimation of when the rate increase is implemented will be earned into premiums. Of course, actual earned premium growth will be influenced by changes in the number of policies in force and absolute levels of new business and retention. This illustrative example assumes 85% of the annualized written premium will be earned since customers modify policy terms such as deductibles or limits where they may not renew. Starting on the left, over the last 15 months, we’ve implemented Allstate brand auto rate increases of 19.8% for an estimated annualized written premium impact of approximately $4.8 billion. Using the historical 85% effectiveness assumption nets a total of $4.1 billion in expected earned premium, represented by the second blue bar. Approximately $1.2 billion has been earned through the fourth quarter. Of the remaining $2.9 billion of premium yet to be earned, roughly $2.6 billion will be earned in 2023 and $300 million in 2024 as shown in green. As I mentioned earlier, we expect to implement additional rate increases in 2023, which will be additive to the figures shown on this chart. Slide 10 illustrates the drivers that will determine the timing of improved auto profitability. The chart on this page is an illustrative view we’ve shown in the past on our path to target profitability along with the magnitude of actions already taken and required prospectively. Starting on the left, the first blue bar shows the year-end 2022 auto insurance reported combined ratio 110.1. To start with the normalized base, we removed the impact of prior year reserve increases and normalized the catastrophe loss ratio for our five-year historical average. This improves the combined ratio by roughly 4.5 points. The second green bar reflects the estimated impact of rate actions already implemented when fully earned into premium, which we discussed on the prior slide. The impact on the combined ratio is approximately 10.5 points when combining the Allstate brand and the National General brand actions. Those two adjustments would improve the combined ratio to target levels. Now of course, we know that loss costs will increase, whether from severity or accident frequency, which would increase the combined ratio. So prospective rate increases and other margin improvement actions must meet or exceed loss cost increases to achieve historical returns. We continue to manage the auto insurance business with the expectation to achieve an auto insurance combined ratio target in the mid-90s. Moving to Slide 11, the table shows Allstate brand auto results in three major states: California, New York and New Jersey combined contributed approximately a quarter of the Allstate brand auto written premiums in 2022 but accounted for approximately 45% of the underwriting loss. While rates were increased in 2022 by 7% to 10%, this is not enough to achieve target margins. As a result, we have more work to do, some of which is listed on the right-hand side. The right-hand side of the slide is a list of actions we are taking in each of these states to improve margins. In California, we filed for an additional 6.9% rate increase in January after getting approval for an initial 6.9% rate increase and are significantly increasing down payment requirements. In New York, while multiple rate filings were requested, only partial approval of the increases requires us to make additional rate filings in early 2023, increased down payment requirements, allowable prior incidents and channel restrictions means fewer choices for consumers until an adequate rate is approved. In New Jersey, additional rate filings will also be made and similar underwriting actions will be implemented as those taken in New York. Moving to Slide 12. Let’s look at a continued good performance story in homeowners insurance. As you know a significant portion of our customers bundle home and auto insurance, which improves retention and the overall economics of both product lines. We have a differentiated homeowners product, underwriting, reinsurance and claims ecosystem that is unique in the industry. Net written premium has increased significantly throughout 2021 and into 2022, increasing 9.3% from the prior year quarter and 12% for the full year, predominantly driven by higher average gross written premium per policy and a 1.4% increase in policies in force. National general written premiums also increased as we improved underwriting margins closer to targeted levels. The fourth quarter combined ratio for homeowners of 92.6 increased by 5.5 points compared to the prior year quarter, while full year combined ratio of 93.8 and declined by 3 points compared to 2021. For the year, this line generated $681 million of underwriting income. The increase in the fourth quarter is shown on the right side. The increased combined ratio was driven by elevated catastrophe losses, primarily due to winter storm Elliot. Homeowners insurance was also impacted by the higher loss cost environment as we continue to experience higher severities due to increasing labor and material costs. To address the inflationary environment, our products have sophisticated pricing features that respond to changes in home replacement values. And now I’ll turn it over to Jess to discuss the remainder of our results.
Jess Merten: All right. Thank you, Mario. Well, property liability is a core business for us. There are other important drivers of financial performance to discuss, starting with investment income on Slide 13. As shown in the table at the bottom left, the total return of our portfolio is 2.5% in the fourth quarter and negative 4% for the year. These returns for our broadly diversified portfolio compare favorably to the full year performance for the S&P 500 of negative 18%, and to the Bloomberg Intermediate Bond Index return of negative 9%. Net investment income shown in the chart on the left totaled $557 million in the quarter, which is $290 million below fourth quarter last year. Market-based income of $464 million, which is shown in blue, was $101 million above the prior year quarter. This is the third consecutive quarter of increase as we benefit from reinvestment at higher market yields. Performance-based income of $147 million shown in black was $369 million below a strong prior year quarter. Income this quarter included in negative contribution from valuation of private equity fund investments that was more than offset by positive contributions from direct investments along with positive returns for infrastructure in real estate. The chart on the right shows the fixed income yield is rising and was 3.2% at quarter end, but is still below the current intermediate corporate bond yield at 5.3%. Also shown is that duration increased modestly to 3.4 in the fourth quarter, primarily by removing approximately half of our duration shortening interest rate derivatives. The migration of the portfolio to higher yield and the corresponding increase in income will happen over time as we reinvest portfolio cash flows into higher interest rates. With the portfolio in unrealized loss positions accelerating this shift by selling bonds to generate capital losses but will be pursued if it optimizes enterprise risk and return. Now let’s turn to Slide 14 and talk more about how enterprise risk and return management impacts investment allocations and results. Proactive investment management is highly integrated with risk adjusted return opportunities across the enterprise. We discussed this in detail on our September 1 Special Topic call on investments. In 2021, we decided to lower overall risk levels given the declines in auto insurance profitability. We also expected that sustained inflation would lead to higher interest rates. As a result, the economic capital deployed to investments was reduced. This led to a shortening of the bond portfolio through the sale of long corporate and municipal bonds and the use of derivatives. While adverse market conditions negatively impacted our portfolio, these actions mitigated losses by approximately $2 billion. In 2022, giving continued auto insurance losses, we decided to lower the potential for investment losses as the U.S. economy went into recession. At the same time, interest rates were increasing, offering a better risk adjusted return from fixed income. Consequently, holdings and below investment grade bonds were cut almost in half, and public equity holdings were lowered by 40%. Late in the year, interest rates had increased in the duration of the bond portfolio was extended as shown on the previous slide. About half the duration shortening derivative position was removed in the fourth quarter, at the same time, this lowered the amount of economic capital deployed to investments. These actions optimize enterprise risk and return and provide flexibility to take advantage of investment opportunities as economic conditions evolve. The Protection Services businesses also create shareholder value, as shown on Slide 15. Revenues, excluding the impact of net gains and losses on investments and derivatives, increased 6.1% to $643 million in the quarter and 8.7% to $2.5 billion for the full year 2022. The increase in revenue for the fourth quarter and full year was primarily driven by Allstate Protection Plans growth of 16.9% and 15.7% respectively. As you can see from the table on the right, Allstate Protection Plans continues to rapidly expand with written premium of $1.9 billion for the year. Allstate Protection Plans expansion in 2022 is primarily driven by our investment in appliance and furniture product coverages. We continue to believe there’s a significant growth opportunity in these areas and in our continued expansion of European consumer electronics and other international growth. Given, the longer policy term compared to auto and homeowner’s insurance products, the unearned premium balance continues to significantly grow as well, reaching $2.6 billion at the end of the year. For the segment, adjusted net income of $38 million in the quarter, increased $9 million compared to the prior year due to a one-time net tax benefit in Allstate Protection Plans. Full year adjusted net income of $169 million, decreased $10 million compared to the prior year, primarily due to the lower revenue in Arity as a result of decreased insurer client advertising. We’ll continue to invest in growing these businesses as they provide an attractive opportunity to meet customers’ needs and create economic value for our shareholders. Moving on to Slide 16, Allstate Health and Benefits is growing an attractive set of businesses that protects more than 4 million policy holders. The acquisition of National General in 2021 added both group and individual products to our portfolio as you can see on the left. Revenues of $579 million in the fourth quarter of 2022, excluding the impact of net gains and losses on investments and derivatives, decreased 1.5% to the prior year quarter as a reduction in individual health was partially offset by an increase in group health and other revenue. Adjusted net income of $50 million, increased $2 million compared to the prior year quarter, resulting in a full year 2022 income of $222 million. The full year 2022 result was $14 million above prior year and reflects increases in group health revenues partially offset by higher operating costs and expenses on group health contract benefits. Let’s close by highlighting Allstate’s strong financial condition and proactive approach to capital management, which you can see on Slide 17. We ended the year with $4 billion in holding company assets, which represents an increase of $700 million compared to year end 2021. We believe holding company assets and capital resources available from statutory operating companies provide financial flexibility as we continue to implement profit proven actions, invest in Transformative Growth and return capital to shareholders. As you can see, our adjusted net loss in 2022 resulted in a negative adjusted net income return on equity. Executing our comprehensive plan in achieving target combined ratios for auto and homeowners insurance will bring adjusted net income returns and equity back to our long-term target range of 14% to 17%. In 2022, we returned $3.4 billion to shareholders through $2.5 billion in share repurchases and $926 million in common shareholder dividends. This resulted in common shares outstanding being reduced by 6.1%, reflecting the repurchase of 19.7 million shares in 2022. With that as context, let’s open the line for your questions.
Operator: Certainly. [Operator Instructions] And our first question comes from the line of Paul Newsome from Piper Sandler. Your question, please.
Paul Newsome: Good morning. I wanted to ask about claims management process that over the course of the last couple of years, I think of Allstate is having a superior claims management in auto and home and that is being kind of one of the core advantages. But you’ve also been implementing a lot of cost cuts and laying off folks over the last couple years. So how are you sort of balancing that? And are there some core metrics that we can see as outsiders that suggest that advantage relative to your peers still exists?
Tom Wilson: Thank you, Paul. Good morning. Let me make a few overview comments and then Mario can jump in. You’re correct that one of our competitive advantages really claim [indiscernible] settling what are millions of claims a year. And we really look at like a – it’s a systems approach. It’s not the result of adding one person process or vendor arrangement. But like for example, if you look at auto insurance, we have this network of auto body repair facilities enables us to both source high quality costs, high quality repairs, good costs and in timely stuff. So cutting down things like car, rental use and stuff like that. At the same time, we have extensive use of analytics, whether that’s the value of an individual car in a local market with specific options to settlements of complicated multi-year bodily injury claims or fraud detection. Part sourcing and buying that Mario talked about enables us to both control the price of those parts by buying them in bulk. But also deciding which part you use. You use an OE [ph] part or an aftermarket part, what’s available in the local market. So the reason I’m going through that is it’s a really complicated system that works really well. We’ve got good employee training, got good technology, we have good quality control processes. And we do have metrics that you can look at to determine how we’re doing versus the outside. There’s first call reporting and there’s some other external reporting which shows, for example, that we have. We buy – we pay less per claim for parts and labor than other people. So some of that information like first call you guys could have access to others – we get from other sources. But it – what it tells us is that we’re good. Now, anytime you’re good, the only reason – the only way you stay good is you keep changing and getting better and updating processes. And so as we’ve dealt with these dramatic swings and frequency and costs, we continue to implement changes to improve the effectiveness and efficiency and Mario can talk about those. Are we perfect? No. Are we constantly reassessing everything we do to make sure we’re getting the right price for parts and we’re settling at the right value for customers of course. Do we believe it’s still a continued competitive advantage for Allstate? Yes. So Mario, would you want to talk about some of the things you worked on last year and what you have looking forward this year?
Mario Rizzo: Yes, thanks Tom, and thanks for the question, Paul. First thing, I would reiterate what Tom said. We continue to view our claims capabilities as a competitive differentiator and a source of real value for Allstate. We think that’s been – certainly been true in the past and it’ll continue to be true going forward. The reality is given the environment we’re operating in, both from a casualty perspective as well as physical damage, we’ve talked a lot throughout the year around the drivers of inflation and the things that are driving up loss costs at such a rapid pace. And I think what that does is it really forces us and the industry to continue to evolve those practices. And it’s certainly something we’ve done overtime to continue to maintain in our leadership position and our edge when it comes to claims. So let me just spend a minute and I’ll break out casualty versus physical damage. In terms of the action plans, we talk a lot about changing operational processes. I’ll say a couple things starting with casualty first. One of the things we’ve done over the past 12 plus months is we’ve meaningfully reduced the volume of pending bodily injury claims by about 20%. And what that does is it reduces risk of both of inflation impacting those claims that certainly that we’ve settled and remediated going forward. But also reduces we think reserve uncertainty on those claims going forward. And to just give you a sense of context, the current level of bodily injury pending claims in aggregate is at its lowest level that it’s been since before 2016. So we’ve looked to de-risk the bodily injury pending portfolio by leaning in and settling claims. We’re also focusing on a strategy that I would characterize as an earlier strategy when it comes to bodily injury. Things like earlier recognition of injury claims, earlier claimant contact and earlier settlement of claims that we should settle quickly again to avoid the inflationary risk in the current environment. And what we’re doing is we’re leveraging our advanced data and analytics capabilities to execute on all components of that strategy to continue to evolve and get better in casualty claim handling. On the physical damage side, I think it’s really around, broadly continuing to focus on estimation accuracy cycle time and leveraging – further leveraging our scale to the fullest extent. It’s continuing to increase the utilization of our good hands repair network to reduce costs, both in terms of parts and labor costs and improve cycle time while continuing to improve or provide a high quality customer experience. Enhancing total loss processes to reduce cycle time and reduce costs around things like storage and rental costs and identification of preexisting damage on vehicles, again, to move total losses through the system more rapidly. And then continuing to look to leverage our scale additionally when it comes to sourcing parts and getting as efficient as we can from a process perspective. So we’re really attacking claims across a number of fronts. Again, feel really good about where we’re positioned with claims. And this is all about continuing to get better and maintain that industry leading capability on the claim side.
Operator: Thank you. One moment…
Paul Newsome: Is there any difference in how you handle claims across the distribution systems at this point that would vary the execution of claims?
Mario Rizzo: This is Mario. Yes, sure. I’ll jump in. Process wise, we adopt consistent processes across claims. There’s certainly unique processes. For example, in National General, given the non-standard auto mix, there’s just a different approach to those claims because they potentially have a higher risk of fraud. So there’s some unique processes there. But in terms of claim handling consistency for similar types of claims, we tend to leverage best practices across brands.
Paul Newsome: Great. Thank you for your help as always. Really appreciate it.
Operator: Thank you. One moment for our next question. And our next question comes from the line of C. Gregory Peters from Raymond James. Your question please.
C. Gregory Peters: Good morning everyone. Tough quarter and a tough year for the company. I was looking at Slide 11 in the supplement. And this is the slide that talks about the Allstate brand auto state profitability. And if we look at the number of states that have a combined ratio above 100, it steadily increased through the fourth quarter and it kind of a contrary to the comments you made about the rate that you applied and achieved in the year. So my question is what type of expectation do you have for that category of states above 100 as we move through 2023? Is it kind of peak here at 41? Do you think it could get worse? Or what’s your expectation going forward of how that might trend?
Tom Wilson: Greg, let me provide an overview, then Mario can jump in on it. First, as we said and you know well that improving auto profitability will be a key to driving shareholder value. So we’re all over that. We’ve made a lot of progress. Mario showed about the rate increases. And so of the $4.1 billion that we think will still come true, or that will come through from the rate increases we’ve already implemented, we’ve got $1.2 billion, $2.6 billion of that should show up in 2023. And I would point out that, that’s not in those combined ratio numbers. So our objective is to make money in every line in every state. So no cross subsidies between states, no cross-subsidies between lines. Now, of course, that’s hard to do with as many lines as many states we’re in, but that’s our objective. And so the amount – that amount that’s not reflected in the – some of those states. We think some of those states are probably adequately priced today. There are many that are not, and so we’ll continue to drive those. But I would expect to see that number come down. But we don’t have a target of – we’re at 41 at the end of the year. We want to be at some XX at the end of the first quarter. It’s every state, every line, make money every year. Mario, would you want to add some additional color to that?
Mario Rizzo: Sure. And thanks for the question, Greg. Look, I think when you look at that trend of states above 100 and the increase throughout the year, I think what I’d point you to is when you just – you look at our underlying auto combined ratio as we reported it, increasing throughout the year and being driven by increases in our severity expectations quarter-over-quarter as the year played out, as well as increasing frequency between Q1 through Q4, only partially being offset by the rate that we took. So I think that chart mirrors what we show you in aggregate in terms of the reported underlying combined ratio. But when you look at our business from a state perspective, I think it’s important to really categorize states into a couple of different buckets. I think there’s a group of states that while we certainly are pleased with the outcome of an underwriting loss, given the actions we’ve taken, particularly from a rate perspective as well as underwriting actions, we feel like we’re positioned in a good place. Now you can’t predict the future in terms of the path of inflation or severity going forward. But given the actions we’ve taken, we feel good about where we’re positioned and what the outlook looks like for 2023. I put states like Texas, Georgia, a couple of large states for us where we’ve implemented significant rates and have been successful in doing so. And so we feel good about the outlook. Again, we’ll have to adapt to what changes in the future, but I think there is a lot of states that falls into that category. Unfortunately, there is a number of, for us, pretty meaningful states, three of which we highlighted in the presentation: California, New York, New Jersey, where they’re much more challenging regulatory environments. And we need to continue to execute on both rate increases and underwriting restrictions to curb growth to really bend the line in aggregate. And just using California as one example. So as you all know, we got a 6.9% rate approved late in the year, but we immediately filed another 6.9% increase pending with the department. We took down paid requirements up pretty dramatically. We have not changed those down paid requirements even with the first rate. We’re working with the department on getting approval for the second 6.9%. But then we’re going to come back with another rate increase because we need more rate in California. So that’s a big state for us where we’re going to have to continue to really lean in and take – continue to take dramatic and aggressive actions to improve margins. And I put New York in that same category. We got a 5% flex rate in New York. Middle of the year, we got approval for a 9.4% rate in New York towards the end of the year, while we’re prepared to do additional – an additional round of rate filings in New York early in 2023, because loss trends are not where they need to be. And in the interim, we’ve taken underwriting actions around prior incidents, down pay and other actions to curb new business growth, and we’re going to continue to lean into those actions because we can’t afford to write the new business at the current rate levels and we’ll continue to take the appropriate actions there. So I think you got to look at the states in a different way. I think we’ve made a lot of progress in a number of states, but we still have some work to do. And as we said, we expect to take some pretty significant rate increases in 2023, particularly leaning into some of those states where we haven’t, really for regulatory reasons been able to make the kind of progress that we would have liked.
C. Gregory Peters: That’s good detail. Just the follow-up question on those three states, California, New York and New Jersey. And I know you’re not going to start negotiating with the Departments of Insurance on an earnings conference call. But when I look at California, for example, you yourself said 6.9% is not going to be enough. One of your competitors recently got, just last month got a rate increase improved that was in the teens. Why not pivot and get more aggressive with rate filings in some of these challenging states? It seems like some of your peers might be doing that and getting – having some success.
Tom Wilson: Greg, I would just maybe provide – I think we’ve been very aggressive when you look at how much we’ve raised rates in total for the year across the country. We’ve been very aggressive. And depending whose measures you want to use, more aggressive. As you never really know where people start and what they finish and what their losses are. Mario, do you want to talk specifically about California?
Mario Rizzo: Yes. Sure. So, Greg, I think we’ve been working really closely with the Department of Insurance in California. We were able to pretty rapidly get approval of our first 6.9%, and we’re in active dialogue around the second 6.9%. And as I mentioned, when we get that one behind us, there’ll be a third one coming. We always have the option of going down the path of filing a larger rate increase. California generally takes a longer time period to get approvals for rates as it is. And the one you mentioned specifically, I think, have been pending with the department for over a year. So we’re – as we look at the map, we want to get approval, we want to get approval as rapidly as we can, so we can implement the rates and move on. So the approach we’ve taken so far in California, we’re comfortable with. We’re going to continue to lean in. We always have the option to change course if things change. But so far, we’ve had success with the path we’ve taken, and we’re going to continue to push on that.
C. Gregory Peters: Thank you for the answers.
Operator: Thank you, one moment for our next question. And our next question comes from the line of Elyse Greenspan from Wells Fargo. Your question please.
Elyse Greenspan: Hi, thanks. Good morning. My first question is just on capital, right? You guys said you expect to complete the buyback program by the – still by the end of the third quarter of 2023. Can you just help us understand what metrics you’re looking at to judge the capital adequacy of Allstate Insurance Company at the end of 2022? I think in the past, you’ve said you look at RBC ratios there. Can you give us a sense of where you ended 2022 your RBC was, and where you would like that to be over time?
Tom Wilson: Elyse, I’ll let Jess give you some specifics, but we obviously have a long history of managing capital that both balances our financial strength, growth returns to shareholders. We have plenty of capital to grow our business and pursue attractive risk and return opportunities. We do it in a much more sophisticated way than RBC. So for example, when Jess talked about the things we had done in the investment portfolio, that we allocate specific amounts of capital to different investment allocations. So when we dial up interest rate risk, we put a little more capital up for it. If we dial down equities, we put up less capital, and we believe we’re really well capitalized and don’t have any issues. Jess, do you want to go from there?
Jess Merten: Yes. Thanks, Tom. So Elyse, I think as it relates to your question on RBC, we haven’t disclosed the RBC for the year. That will come out in due course as it relates to the actual RBC in insurance company, and we don’t publish a target. I think Tom hit on the right point, because you asked what are the metrics that we look at as we think about the repurchases. And we really do focus on our sophisticated economic capital model that looks at a comprehensive view of risk across types around the enterprise. And we use that as the basis for capital management. We obviously focus on RBC rating agency metrics, a variety of other things. But we don’t have specific targets that we published as it relates to risk-based capital. So – and I really like to take it up a level and just think about how we manage it overall using our sophisticated, risk-based capital framework. We remain confident in our overall capital position and the capital position of the insurance subsidiaries.
Elyse Greenspan: Thanks. And then my second question is going back to some of what you guys have been discussing with modifying your claims practices. Have you guys tested the predictive modeling on an external data against your own internal data and seeing a meaningful benefit? And should we – how – over what time period should we think about the rollout of the program over the next year, 12 months to 24 months, on what type of time frame should we be thinking about?
Tom Wilson: Elyse, I’m not sure which predictive models are you talking about the – I mean we use predictive models for a lot in claims. Was there one specifically you were interested in?
Elyse Greenspan: Well, I was talking about some of the kind of changes you guys have stressed that you’re kind of looking to make on the claims side of things.
Tom Wilson: Okay. Yes. Let me – I’ll take a shot at it and Mario, you can jump in. So we use – I mean we’re a data-driven company, so we use predictive models as you know well, for just about everything. That could be fraud. There could be – do we think this claim might end up being severe enough where it gets represented by a lawyer? So it’s important for us to establish a relationship with the customers as possible. It might be, do we think there’s a better way to settle this claim, whether it gets – the car gets totaled or we send it to a body shop. So there’s we use predictive analytics throughout the business and obviously largely in claims as well. So we’re always tuning those. We think we’re pretty good at it. You can’t really take one specific algorithm. But when you look at our claims severities, you can look at them externally. And when you look at absolute dollars, we think we did really well. It’s easier on physical damage, obviously, because you’re just fixing a car bodily injury, it’s like, okay, well, what was the case worth? What’s the average case? That gets a little harder to do. But when in – the only weakness in the external stuff is it tends to be a percentage increase over the prior year, which is, of course, we work in absolute dollars. And our models are done in absolute dollars. And so even though it all depends where you start – but we like our overall position. Mario, do you want to talk specifically about any models that you’re using now that think you can point to where we’ve updated and increased the value-added?
Mario Rizzo: Yes. The one I’d point to, and I think generally, the statement Tom made about like leveraging all the data and the capabilities we have, but also looking to tune those models and evolve over time. The example I would use would be around bodily injury, both potential loss identification and attorney representation. Given, obviously, the environment around us has evolved pretty significantly over the past couple of years in terms of higher levels of attorney representation and bodily injury claims and just medical inflation, medical consumption and treatment, those kinds of things. So what we’ve been doing is tuning the models to be able to use the components and the data that we gather early on in the claims process, to identify claims where there is, first of all, the potential for an injury. More importantly, the potential for a major injury given it’s a higher impact accident or things like that. So we can get out ahead of the claim, make contact earlier and manage the claim much more effectively. The same would be true around claims that have the potential, ultimately to be represented by an attorney. Again, creating contact with a third-party claimant and establishing dialogue and communication and leveraging the tools and the models at our disposal to better manage the claim process through the bodily injury claims. So those are just a couple of examples of how we tuned models that we’ve had to adapt to the current environment. And we’re going to have to continue to, as I mentioned earlier, evolve our processes and those models to adapt to the environment over time. So this is not a static process, and we’re always looking to get better based on the most current information as well as the external environment that we’re operating in.
Elyse Greenspan: Okay. Thank you.
Operator: Thank you. [Operator Instructions] And our next question comes from the line of Andrew Kligerman from Credit Suisse. Your question, please.
Andrew Kligerman: Hey, thanks a lot for getting me in. First question is around social inflation, and in particular, bad price point. And in 2022, I think the court up a lot. And we – I would – I suspect that had a big impact. As we move into 2023, what’s your thinking about further social inflation issues? Do you think it will get materially worse? Could you give us some measurement around that? And that’s the question.
Tom Wilson: Mario, do you want to take that?
Mario Rizzo: Yes. Certainly, social inflation is a phenomenon that we and the industry have been dealing with for an extended period of time. I think in our business, we certainly see it in the personal auto side, in casualty coverages. We’ve also seen it on commercial auto and in the shared economy, just given the higher limits that we tend to write on that business. It’s hard for me to predict whether it will get better or get worse going forward. I think it’s a reality of what we’re experiencing right now. And as I talked about some of the analytics and the processes we’re putting in place, to identify and manage injury claims more effectively. That’s a big reason why we’re doing it is in response to the social inflationary impacts we’ve seen. I’d also go back to something I said earlier around quickly not only identifying but settling claims earlier in the process where we can to mitigate the potential exposure to social inflation going forward. And the reduction in pending claims across a variety of segments that we’ve already executed on and are going to continue to focus on going forward. So I think our approach has been to modify our processes and take appropriate actions to offset the impacts of social inflation. And again, I don’t want to predict whether it will get better or get worse, but we know it’s a reality and we’ve adapted in response to it.
Andrew Kligerman: Was there a big pickup in bad faith claims?
Mario Rizzo: I wouldn’t say there’s a big pickup in bad faith claims now.
Andrew Kligerman: Okay. And then the next question is around the rate increase. So I think Greg was touching on how your competitor got in the teens. I think it was 17.4% and you got 6.9%. My question there is should we worry that there will be anti-selection? If other players are getting these big rate increases, will that drive more consumers to Allstate as the pricing appears better in California?
Tom Wilson: Mario, do you want to take that?
Mario Rizzo: Yes. Look, as I mentioned earlier, even with the rate that we were approved for – we didn’t change the actions we took around down pay requirements. So our risk appetite is not – has not changed in California, and it won’t until we get to a point where we believe we’re adequately priced, and that will take at least a couple more rates. Will we get anti-selected against? I think if we keep the restrictions in place or down pay requirements in place, we mitigate that risk. And it’s all relative. The rate increase that was approved was on a much larger indication than the one we filed. So it’s hard to tell what the relative price position is. But again, we’re not going to change our stance. Our focus in California is to reduce growth as much as we can until we get to rate-adequate levels, and that’s the way we’re going to manage the business.
Andrew Kligerman: Thanks a lot.
Operator: Thank you. [Operator Instructions] And our next question comes from the line of Josh Shanker from Bank of America. Question, please.
Josh Shanker: Yes, thank you. I was looking at the new policy application, and I was trying to tease out Allstate, National General and agency versus exclusive agency versus direct. And I noticed that there was a non-significant amount of independent agency, new policy applications coming from non-National General sources. And so I’m wondering, is Allstate brand being sold through independent agencies? And the reason why I asked this is also I noticed that new policy applications from Allstate exclusive agents are up, but Allstate branded new policy applications are down overall. Meaning that it feels like there’s a channel shift that you’re excited about getting business from Allstate exclusive agents, but not from the other sources where you sold Allstate branded products last year.
Tom Wilson: Let me provide a little overview. And then Mario you can take it. So Josh, first, we’ll take business from anybody’s, not just for price. You are correct in that you see – remember, National General, we took – when we acquired National General, we gave them both the Encompass business, which was straight up independent agents under the Encompass brand. There’s also an Allstate independent agent channel that we’re transitioning to National General products and services over time. So the National General has both of those. On the direct versus agent piece, we’ve been shutting down growth and reducing expenses. We went first to the direct channel because it was faster, and we got more dollars out of it. That doesn’t mean that we have a preference for Allstate agent versus direct. We’ll serve customers any way they want to be served. Mario, do you want to add some additional perspective on that?
Mario Rizzo: Yes. And maybe I’ll focus on – first on the Allstate brand, Josh, in terms of the shift, the mix shift between direct and exclusive agents. So you’ll remember a couple of things. One of the things we did this year was we reduced the amount of advertising spend, particularly lower funnel advertising spend, which directly impacts both volume through the direct channel. And I think you’ve seen a decline in the direct Allstate branded production as a result of that. I think the other thing you’ve seen is the phenomenon we’re experiencing in the exclusive agent channel with Allstate. And I’ll take you back to one of the core tenets of transformative growth was to reduce costs. But one of the components of it was to reduce distribution costs by changing how we compensated our exclusive agents, and also introducing lower cost, higher productive new models. And I think what you see in 2022 is that the model that we put in, that shifts agency compensation more to new customer acquisition has driven a level of engagement and behavior change on behalf of our exclusive agents that’s resulted in an increase in new business production, despite the rate actions that we’ve taken. I think as we go forward, we’re going to continue to evolve the agency model. We’ll continue to shift commission away from renewal to new business. And while at the same time, continue to enhance our direct capabilities so that when we do lean back into growth, we’re willing to accept the grow through any channel that we can write it. But I don’t think it’s unreasonable to assume that the first place you’d see kind of sequential growth would be in the direct channel, just given that when we turn advertising back on, that will be where a lot of the claim volume is driven through. But at the same time, we are pleased with the – again, the engagement and the behavior shift of our exclusive agents and the performance of the new agency models in terms of their levels of productivity, which I think bode well for us from a long-term growth perspective.
Josh Shanker: Is there a difference in profitability over the lifetime of the customer, depending on the brand and the channel it’s sourced? And long-term, should there be any difference?
Mario Rizzo: Yes, I can jump in. Any Allstate brand, I think over time, it should be the same, right? Because we’re targeting and marketing to the same customer segment and looking to drive the same lifetime value, whether we write it in the agency channel or we write it in the direct channel. And you’ll remember, we’ve gone to differentiated pricing to match the cost of the channel with the price that the consumer is paying. So that kind of normalizes for the acquisition cost or the distribution cost. So we’d be getting the same lifetime value. I think in the National General brand, what we’ve got today is predominantly still a non-standard mix, which has a very different lifetime value than the standard and preferred products that we write in the Allstate brands. But we price for that. We have the fee structure in place for that where – and we manage that business very effectively to drive value for a much shorter policy life expectancy for those non-standard risks. As we roll out more middle market products in National General, we’ve really started on that process, but we’ve got a ways to go there. The value – the lifetime value expectancy for that policy group should look and feel a lot like the Allstate brand because we’re leveraging the same data, the same capabilities to expand our capabilities in that market. So I think from a customer segment perspective, it should be very similar across channels, given the same risk profile. Different in non-standard auto, but we’ve got a really effective model in National General to manage that business.
Josh Shanker: Thank you for answering my overly belabor questions.
Tom Wilson: I know that’s very helpful. So thank you all for tuning in. Allstate’s obviously focused on using our extensive system operating expertise to improve auto insurance margins. And at the same time, as Mario just mentioned, we’re investing in transforming growth to increase our profit liability business. We have upside in front of us on the investment portfolio, and we’re having a good successful expansion of our circle of protection. So thank you all, and we will talk to you next quarter.
Operator: Thank you ladies and gentlemen for your participation on today’s conference. This does conclude the program. You may now disconnect. Good day. | [
{
"speaker": "Operator",
"text": "Good day and thank you for standing by. Welcome to Allstate’s Fourth Quarter Investor Call. At this time, all participants are in a listen-only mode. After the prepared remarks, there will be a question-and-answer session. [Operator instructions] As a reminder, please be aware that this call is being recorded. And now I’d like to introduce your host for today’s program, Mr. Mark Nogal, Head of Investor Relations. Please go ahead, sir."
},
{
"speaker": "Mark Nogal",
"text": "Thank you, Jonathan. Good morning. Welcome to Allstate’s fourth quarter 2022 earnings conference call. After prepared remarks, we’ll have a question-and-answer session. Yesterday following the close of the market, we issued our news release and investor supplement and posted related material on our website at allstateinvestors.com. Our management team is here to provide perspective on these results. As noted on the first slide of the presentation, our discussion will contain non-GAAP measures for which there are reconciliations in the news release and investor supplement and forward-looking statements about Allstate’s operations. Allstate’s results may differ materially from these statements, so please refer to our 10-K for 2021 and other public documents for information on potential risks. And now I’ll turn it over to Tom."
},
{
"speaker": "Tom Wilson",
"text": "Well, good morning. Thank you for investing your time in Allstate today. I’ll start by setting context and then Mario and Jess would provide additional perspective on operating results and the actions being taken to improve auto profitability and increase shareholder value. So let’s begin on Slide 2. So as you know, Allstate strategy has two components: increase personal Property-Liability market share and expand Protection Services, which is shown in the two ovals on the left. On the right hand side, you can see our results for the year. Earnings were disappointing with a net loss of $1.4 billion, largely reflecting an underwriting loss on auto insurance and mark-to-market losses on the equity portfolio. Strong results from homeowners insurance, protection services and fixed income investments were not enough to offset the losses on auto and commercial insurance. The most important driver of near-term shareholder value will be successfully executing our comprehensive plan to improve auto profitability. That includes broadly raising auto insurance rates, reducing expenses including temporary moves such as less advertising and permanent reductions including digitizing and outsourcing work and lowering distribution costs. Underwriting restrictions have been implemented to reduce new business volume until profitability is acceptable. Claims operating processes are also being modified to manage our loss costs. This plan is being implemented, but earned premiums from auto insurance rates have not increased enough to offset higher loss costs. And while the number one priority is to improve auto insurance margins, implementation of the transformative growth strategies make great progress in 2022, and we validated that this will drive personal Property-Liability market share growth. Proactive investment risk and return management mitigated approximately $2 billion of loss this year. And while the total return on the portfolio was a negative 4%, that compares very favorably to the performance of the S&P 500 and intermediate bond indices. We also had another great year at Allstate Protection Plans. Moving to Slide 3, let’s discuss financial results. Starting at the top, revenues of $13.6 billion in the fourth quarter were 4.9% higher than the prior year quarter, increasing the full year total to $51.4 billion. Property-Liability premiums earned increased by 9.5% in the fourth quarter compared to the prior year and 8.5% for the full year due to higher average premiums in auto and homeowners insurance. Moving down the table, an adjusted net loss of $359 million was incurred in the fourth quarter reflecting an auto insurance underwriting loss, which is impacted by reserve increases for the current and prior years. Now let me turn it over to Mario to discuss our Property-Liability results and then Jess will cover the other components of earnings."
},
{
"speaker": "Mario Rizzo",
"text": "Thanks, Tom. Let’s start by reviewing underwriting profitability for the Property-Liability business in total on Slide 4. The overall message is that the underwriting loss was a result of auto insurance operating at a combined ratio above our targets, but homeowners insurance continued to be a strong source of profit. On the left chart, the recorded combined ratio of 109.1 in the fourth quarter was primarily driven by higher auto loss costs, unfavorable reserve development and higher catastrophes. This led to a full year recorded combined ratio of 106.6, which was 10.7 points higher than the prior year. The table on the right shows the combined ratio and underwriting income by line of business for the quarter and the year. Auto insurance had a combined ratio of 112.6 in the quarter and 110.1 for the year, substantially worse than our targets given rapidly increasing loss costs throughout the year. This result was an underwriting loss of $974 million in the quarter and over $3 billion for the year. Hence, you can see why Tom has said executing our auto profit improvement plan is the number one priority going forward. Homeowners insurance, on the other hand, had excellent results with the combined – with combined ratios in the low 90s, which generated $681 million of underwriting income for the year. This reflects industry-leading underwriting and risk management in this line of business. Commercial insurance was negatively impacted by the same auto insurance cost pressures, along with inadequate pricing for the coverage provided to the large transportation network companies. The result was an underwriting loss for the year of $464 million. This led to the decision discussed last quarter to not provide insurance to transportation network companies unless telematics-based pricing is implemented and to exit five states in the Allstate traditional commercial business. These actions are expected to reduce commercial business premiums by over 50% in 2023. Now let’s move to Slide 5 and discuss auto margin in more detail. As you can see from the chart on the left, which shows the auto insurance combined ratio and underlying combined ratio from 2017 through the current year, we have a long history of sustained profitability in auto insurance due to pricing sophistication, underwriting and claims expertise and expense management. In 2020, the combined ratio dropped to 86 even though we provided customers with over $1 billion of shelter-in-place payments. This was due to historically low accident frequency in the early stages of the pandemic. In 2021, frequency increased as mileage driven increased, but it did not reach pre-pandemic levels. Claims severity, however, increased above historical levels because of more severe increasing costs to settle claims with third parties, who are injured in accidents with our customers. In addition, used car prices were increasing at unprecedented levels, eventually peaking in December, reflecting an approximate 50% increase over the prior year. We had a reported combined ratio of 95 for the year despite all these pressures. This year, the combined ratio increased 14.7 points to 110.1, the drivers of which are shown in the right-hand chart. The red bars reflect the impact of increasing loss costs, including a 3.6 point impact from prior year reserve additions and a 16.7 point impact from current year underlying losses, excluding catastrophes, which include increases in both frequency and more significantly, severity compared to last year. As we discussed, the core component of the profit improvement plan is to raise auto insurance rates and substantial progress was made on this front starting in the fourth quarter of 2021 and throughout last year. In 2022, the impact of higher average earned premium drove a benefit of 3.6 points, which is shown in green. As I will cover in a minute, there is much more benefit to be realized in earned premiums based on what was implemented in 2022. Another part of the profit improvement plan is to reduce expenses and this contributed a favorable 2 point benefit this year. Moving to Slide 6. Let’s discuss prior year reserve re-estimates before we look forward. Our loss estimates and reserve liabilities use consistent practices, multiple analytical methods and two external actuarial reviews to ensure reserve adequacy. These processes led us to increase the reserve liability for prior years throughout 2022 by amounts that are larger than recent years. Property-Liability prior year reserve strengthening, excluding catastrophes totaled $1.7 billion or 3.9 points on the combined ratio for the full year 2022. The pie chart on the left breaks down the impact by line and coverage with $1.1 billion driven by Allstate Brand personal auto largely related to bodily injury claims. In addition $295 million was related to Allstate Brand commercial insurance, also mostly related to auto. The table on the right breaks down the Allstate Brand auto prior year reserve strengthening of $1.1 billion in 2022 by report year. Let me orient you to the table. Reserve increases are shown by coverage in total and then for the report here to which they apply. The reserve liability for physical damage coverages was increased by $211 million, which was entirely attributable to 2021. This primarily related to adverse development and elongated repair time frames, which were primarily addressed in the first and second quarter. Injury reserves were the largest component at $676 million, which was spread across many report years. Incurred but not reported was increased by $226 million as late reported claim counts have exceeded prior estimates. This reserve balance was increased in each of the first three quarters of 2022, but a larger amount was recorded in the fourth quarter. In total for all coverages about 63% of the increases were for 2021 and 2020. At the bottom of the table, the reported combined ratio for the calendar year is shown and compared to the reserve changes. For example in 2021, the reported combined ratios for Allstate Brand auto insurance was 95. The reserve additions indicate that costs were 2.1 points above this reported number. Estimating reserve liability utilizes multiple reserving techniques, but is always subject to strengthening or releasing reserves over time. This variability increases with changes in the underlying data, such as claim counts, settlement times, or cost increases and as has been the case over the past three years. While reserves could change going forward, based on the 2022 claim statistics and data, reserves are appropriately established at year-end 2022. Moving to Slide 7. Let’s provide some clarity on what the auto insurance combined ratio trend was by quarter in 2022. As you can see on the left-hand chart, the recorded combined ratio peaked in the third quarter at 117.4, largely reflecting prior year reserve changes and catastrophe losses shown in light blue. The dark blue bars are the underlying combined ratio, as reported, which increased each quarter. Included in this dark blue bar is the impact of increasing claim severities within the year. We update the forecast on claim severities as the year progresses. As 2022 developed, loss cost trends resulted in increases to current report year ultimate severity expectations. As shown in the call out on the left chart, 2022 incurred severities for collision, property damage and bodily injury was 17%, 21% and 14%, respectively, above the full report year 2021 level. This estimate, however, increased throughout the year. The impact of increasing current report year on incurred severities as the year progressed influences the quarter underlying combined ratio trend. This impact from increasing full year severities from claims occurring in prior quarters is reflected in the financial results of the period where severities were increased. For example, the fourth quarter of 2022 reflects the impact of higher severity expectations in the auto physical damage coverage, not just for claims reported in Q4 but also for claims that were reported throughout the prior three quarters as well. The chart on the right adjusts the quarterly underlying combined ratio to reflect full year average severity levels, which removes the influence of intra-year severity changes. As you can see, after adjusting for the timing of severity increases in the current year, the quarterly underlying combined ratio trend was essentially flat throughout 2022 and close to the full year level of 103.6. Slide 8 outlines our comprehensive approach to restore auto margins. There are four areas of focus: raising rates; a continued focus on reducing expenses; implementing stricter underwriting requirements; and modifying claim practices to manage loss costs. Starting with rates, since the beginning of this year, we’ve implemented rate increases of 16.9% in the Allstate Brand, including 6.1% in the fourth quarter, which significantly increased written premium. We expect to continue to pursue significant rate increases into 2023 to improve auto insurance margins to target levels. We are also reducing operating expenses as part of transformative growth and have temporarily reduced advertising spend to manage new business volume. We are implementing more restrictive underwriting actions on new business in locations or risk segments where we cannot achieve adequate prices for the risk. Increased restrictions have been implemented in 37 states including California, New York and New Jersey, which account for a large portion of underwriting losses. Claim practices have been modified to deal with the higher loss cost environment. For example, we have strategic partnerships with part suppliers and repair facilities to mitigate the cost of repair and use predictive modeling to optimize repair versus total loss decisions and likelihood of injury and attorney representation. Moving to Slide 9, let’s discuss a key component of our multifaceted plan raising auto insurance prices. Growth in average premium per policy is accelerating due to implemented rate increases, but the impact to average earned premium per policy is on a lag due to the six-month policy term. The chart on the left depicts the year-over-year growth in auto average gross written premium in orange, reaching 14.4% in the fourth quarter of 2022. The auto average earned premium growth of 9.7% in the fourth quarter, represented in blue, continues to increase, but on a lag due to the six-month policy term. The chart on the right is an estimation of when the rate increase is implemented will be earned into premiums. Of course, actual earned premium growth will be influenced by changes in the number of policies in force and absolute levels of new business and retention. This illustrative example assumes 85% of the annualized written premium will be earned since customers modify policy terms such as deductibles or limits where they may not renew. Starting on the left, over the last 15 months, we’ve implemented Allstate brand auto rate increases of 19.8% for an estimated annualized written premium impact of approximately $4.8 billion. Using the historical 85% effectiveness assumption nets a total of $4.1 billion in expected earned premium, represented by the second blue bar. Approximately $1.2 billion has been earned through the fourth quarter. Of the remaining $2.9 billion of premium yet to be earned, roughly $2.6 billion will be earned in 2023 and $300 million in 2024 as shown in green. As I mentioned earlier, we expect to implement additional rate increases in 2023, which will be additive to the figures shown on this chart. Slide 10 illustrates the drivers that will determine the timing of improved auto profitability. The chart on this page is an illustrative view we’ve shown in the past on our path to target profitability along with the magnitude of actions already taken and required prospectively. Starting on the left, the first blue bar shows the year-end 2022 auto insurance reported combined ratio 110.1. To start with the normalized base, we removed the impact of prior year reserve increases and normalized the catastrophe loss ratio for our five-year historical average. This improves the combined ratio by roughly 4.5 points. The second green bar reflects the estimated impact of rate actions already implemented when fully earned into premium, which we discussed on the prior slide. The impact on the combined ratio is approximately 10.5 points when combining the Allstate brand and the National General brand actions. Those two adjustments would improve the combined ratio to target levels. Now of course, we know that loss costs will increase, whether from severity or accident frequency, which would increase the combined ratio. So prospective rate increases and other margin improvement actions must meet or exceed loss cost increases to achieve historical returns. We continue to manage the auto insurance business with the expectation to achieve an auto insurance combined ratio target in the mid-90s. Moving to Slide 11, the table shows Allstate brand auto results in three major states: California, New York and New Jersey combined contributed approximately a quarter of the Allstate brand auto written premiums in 2022 but accounted for approximately 45% of the underwriting loss. While rates were increased in 2022 by 7% to 10%, this is not enough to achieve target margins. As a result, we have more work to do, some of which is listed on the right-hand side. The right-hand side of the slide is a list of actions we are taking in each of these states to improve margins. In California, we filed for an additional 6.9% rate increase in January after getting approval for an initial 6.9% rate increase and are significantly increasing down payment requirements. In New York, while multiple rate filings were requested, only partial approval of the increases requires us to make additional rate filings in early 2023, increased down payment requirements, allowable prior incidents and channel restrictions means fewer choices for consumers until an adequate rate is approved. In New Jersey, additional rate filings will also be made and similar underwriting actions will be implemented as those taken in New York. Moving to Slide 12. Let’s look at a continued good performance story in homeowners insurance. As you know a significant portion of our customers bundle home and auto insurance, which improves retention and the overall economics of both product lines. We have a differentiated homeowners product, underwriting, reinsurance and claims ecosystem that is unique in the industry. Net written premium has increased significantly throughout 2021 and into 2022, increasing 9.3% from the prior year quarter and 12% for the full year, predominantly driven by higher average gross written premium per policy and a 1.4% increase in policies in force. National general written premiums also increased as we improved underwriting margins closer to targeted levels. The fourth quarter combined ratio for homeowners of 92.6 increased by 5.5 points compared to the prior year quarter, while full year combined ratio of 93.8 and declined by 3 points compared to 2021. For the year, this line generated $681 million of underwriting income. The increase in the fourth quarter is shown on the right side. The increased combined ratio was driven by elevated catastrophe losses, primarily due to winter storm Elliot. Homeowners insurance was also impacted by the higher loss cost environment as we continue to experience higher severities due to increasing labor and material costs. To address the inflationary environment, our products have sophisticated pricing features that respond to changes in home replacement values. And now I’ll turn it over to Jess to discuss the remainder of our results."
},
{
"speaker": "Jess Merten",
"text": "All right. Thank you, Mario. Well, property liability is a core business for us. There are other important drivers of financial performance to discuss, starting with investment income on Slide 13. As shown in the table at the bottom left, the total return of our portfolio is 2.5% in the fourth quarter and negative 4% for the year. These returns for our broadly diversified portfolio compare favorably to the full year performance for the S&P 500 of negative 18%, and to the Bloomberg Intermediate Bond Index return of negative 9%. Net investment income shown in the chart on the left totaled $557 million in the quarter, which is $290 million below fourth quarter last year. Market-based income of $464 million, which is shown in blue, was $101 million above the prior year quarter. This is the third consecutive quarter of increase as we benefit from reinvestment at higher market yields. Performance-based income of $147 million shown in black was $369 million below a strong prior year quarter. Income this quarter included in negative contribution from valuation of private equity fund investments that was more than offset by positive contributions from direct investments along with positive returns for infrastructure in real estate. The chart on the right shows the fixed income yield is rising and was 3.2% at quarter end, but is still below the current intermediate corporate bond yield at 5.3%. Also shown is that duration increased modestly to 3.4 in the fourth quarter, primarily by removing approximately half of our duration shortening interest rate derivatives. The migration of the portfolio to higher yield and the corresponding increase in income will happen over time as we reinvest portfolio cash flows into higher interest rates. With the portfolio in unrealized loss positions accelerating this shift by selling bonds to generate capital losses but will be pursued if it optimizes enterprise risk and return. Now let’s turn to Slide 14 and talk more about how enterprise risk and return management impacts investment allocations and results. Proactive investment management is highly integrated with risk adjusted return opportunities across the enterprise. We discussed this in detail on our September 1 Special Topic call on investments. In 2021, we decided to lower overall risk levels given the declines in auto insurance profitability. We also expected that sustained inflation would lead to higher interest rates. As a result, the economic capital deployed to investments was reduced. This led to a shortening of the bond portfolio through the sale of long corporate and municipal bonds and the use of derivatives. While adverse market conditions negatively impacted our portfolio, these actions mitigated losses by approximately $2 billion. In 2022, giving continued auto insurance losses, we decided to lower the potential for investment losses as the U.S. economy went into recession. At the same time, interest rates were increasing, offering a better risk adjusted return from fixed income. Consequently, holdings and below investment grade bonds were cut almost in half, and public equity holdings were lowered by 40%. Late in the year, interest rates had increased in the duration of the bond portfolio was extended as shown on the previous slide. About half the duration shortening derivative position was removed in the fourth quarter, at the same time, this lowered the amount of economic capital deployed to investments. These actions optimize enterprise risk and return and provide flexibility to take advantage of investment opportunities as economic conditions evolve. The Protection Services businesses also create shareholder value, as shown on Slide 15. Revenues, excluding the impact of net gains and losses on investments and derivatives, increased 6.1% to $643 million in the quarter and 8.7% to $2.5 billion for the full year 2022. The increase in revenue for the fourth quarter and full year was primarily driven by Allstate Protection Plans growth of 16.9% and 15.7% respectively. As you can see from the table on the right, Allstate Protection Plans continues to rapidly expand with written premium of $1.9 billion for the year. Allstate Protection Plans expansion in 2022 is primarily driven by our investment in appliance and furniture product coverages. We continue to believe there’s a significant growth opportunity in these areas and in our continued expansion of European consumer electronics and other international growth. Given, the longer policy term compared to auto and homeowner’s insurance products, the unearned premium balance continues to significantly grow as well, reaching $2.6 billion at the end of the year. For the segment, adjusted net income of $38 million in the quarter, increased $9 million compared to the prior year due to a one-time net tax benefit in Allstate Protection Plans. Full year adjusted net income of $169 million, decreased $10 million compared to the prior year, primarily due to the lower revenue in Arity as a result of decreased insurer client advertising. We’ll continue to invest in growing these businesses as they provide an attractive opportunity to meet customers’ needs and create economic value for our shareholders. Moving on to Slide 16, Allstate Health and Benefits is growing an attractive set of businesses that protects more than 4 million policy holders. The acquisition of National General in 2021 added both group and individual products to our portfolio as you can see on the left. Revenues of $579 million in the fourth quarter of 2022, excluding the impact of net gains and losses on investments and derivatives, decreased 1.5% to the prior year quarter as a reduction in individual health was partially offset by an increase in group health and other revenue. Adjusted net income of $50 million, increased $2 million compared to the prior year quarter, resulting in a full year 2022 income of $222 million. The full year 2022 result was $14 million above prior year and reflects increases in group health revenues partially offset by higher operating costs and expenses on group health contract benefits. Let’s close by highlighting Allstate’s strong financial condition and proactive approach to capital management, which you can see on Slide 17. We ended the year with $4 billion in holding company assets, which represents an increase of $700 million compared to year end 2021. We believe holding company assets and capital resources available from statutory operating companies provide financial flexibility as we continue to implement profit proven actions, invest in Transformative Growth and return capital to shareholders. As you can see, our adjusted net loss in 2022 resulted in a negative adjusted net income return on equity. Executing our comprehensive plan in achieving target combined ratios for auto and homeowners insurance will bring adjusted net income returns and equity back to our long-term target range of 14% to 17%. In 2022, we returned $3.4 billion to shareholders through $2.5 billion in share repurchases and $926 million in common shareholder dividends. This resulted in common shares outstanding being reduced by 6.1%, reflecting the repurchase of 19.7 million shares in 2022. With that as context, let’s open the line for your questions."
},
{
"speaker": "Operator",
"text": "Certainly. [Operator Instructions] And our first question comes from the line of Paul Newsome from Piper Sandler. Your question, please."
},
{
"speaker": "Paul Newsome",
"text": "Good morning. I wanted to ask about claims management process that over the course of the last couple of years, I think of Allstate is having a superior claims management in auto and home and that is being kind of one of the core advantages. But you’ve also been implementing a lot of cost cuts and laying off folks over the last couple years. So how are you sort of balancing that? And are there some core metrics that we can see as outsiders that suggest that advantage relative to your peers still exists?"
},
{
"speaker": "Tom Wilson",
"text": "Thank you, Paul. Good morning. Let me make a few overview comments and then Mario can jump in. You’re correct that one of our competitive advantages really claim [indiscernible] settling what are millions of claims a year. And we really look at like a – it’s a systems approach. It’s not the result of adding one person process or vendor arrangement. But like for example, if you look at auto insurance, we have this network of auto body repair facilities enables us to both source high quality costs, high quality repairs, good costs and in timely stuff. So cutting down things like car, rental use and stuff like that. At the same time, we have extensive use of analytics, whether that’s the value of an individual car in a local market with specific options to settlements of complicated multi-year bodily injury claims or fraud detection. Part sourcing and buying that Mario talked about enables us to both control the price of those parts by buying them in bulk. But also deciding which part you use. You use an OE [ph] part or an aftermarket part, what’s available in the local market. So the reason I’m going through that is it’s a really complicated system that works really well. We’ve got good employee training, got good technology, we have good quality control processes. And we do have metrics that you can look at to determine how we’re doing versus the outside. There’s first call reporting and there’s some other external reporting which shows, for example, that we have. We buy – we pay less per claim for parts and labor than other people. So some of that information like first call you guys could have access to others – we get from other sources. But it – what it tells us is that we’re good. Now, anytime you’re good, the only reason – the only way you stay good is you keep changing and getting better and updating processes. And so as we’ve dealt with these dramatic swings and frequency and costs, we continue to implement changes to improve the effectiveness and efficiency and Mario can talk about those. Are we perfect? No. Are we constantly reassessing everything we do to make sure we’re getting the right price for parts and we’re settling at the right value for customers of course. Do we believe it’s still a continued competitive advantage for Allstate? Yes. So Mario, would you want to talk about some of the things you worked on last year and what you have looking forward this year?"
},
{
"speaker": "Mario Rizzo",
"text": "Yes, thanks Tom, and thanks for the question, Paul. First thing, I would reiterate what Tom said. We continue to view our claims capabilities as a competitive differentiator and a source of real value for Allstate. We think that’s been – certainly been true in the past and it’ll continue to be true going forward. The reality is given the environment we’re operating in, both from a casualty perspective as well as physical damage, we’ve talked a lot throughout the year around the drivers of inflation and the things that are driving up loss costs at such a rapid pace. And I think what that does is it really forces us and the industry to continue to evolve those practices. And it’s certainly something we’ve done overtime to continue to maintain in our leadership position and our edge when it comes to claims. So let me just spend a minute and I’ll break out casualty versus physical damage. In terms of the action plans, we talk a lot about changing operational processes. I’ll say a couple things starting with casualty first. One of the things we’ve done over the past 12 plus months is we’ve meaningfully reduced the volume of pending bodily injury claims by about 20%. And what that does is it reduces risk of both of inflation impacting those claims that certainly that we’ve settled and remediated going forward. But also reduces we think reserve uncertainty on those claims going forward. And to just give you a sense of context, the current level of bodily injury pending claims in aggregate is at its lowest level that it’s been since before 2016. So we’ve looked to de-risk the bodily injury pending portfolio by leaning in and settling claims. We’re also focusing on a strategy that I would characterize as an earlier strategy when it comes to bodily injury. Things like earlier recognition of injury claims, earlier claimant contact and earlier settlement of claims that we should settle quickly again to avoid the inflationary risk in the current environment. And what we’re doing is we’re leveraging our advanced data and analytics capabilities to execute on all components of that strategy to continue to evolve and get better in casualty claim handling. On the physical damage side, I think it’s really around, broadly continuing to focus on estimation accuracy cycle time and leveraging – further leveraging our scale to the fullest extent. It’s continuing to increase the utilization of our good hands repair network to reduce costs, both in terms of parts and labor costs and improve cycle time while continuing to improve or provide a high quality customer experience. Enhancing total loss processes to reduce cycle time and reduce costs around things like storage and rental costs and identification of preexisting damage on vehicles, again, to move total losses through the system more rapidly. And then continuing to look to leverage our scale additionally when it comes to sourcing parts and getting as efficient as we can from a process perspective. So we’re really attacking claims across a number of fronts. Again, feel really good about where we’re positioned with claims. And this is all about continuing to get better and maintain that industry leading capability on the claim side."
},
{
"speaker": "Operator",
"text": "Thank you. One moment…"
},
{
"speaker": "Paul Newsome",
"text": "Is there any difference in how you handle claims across the distribution systems at this point that would vary the execution of claims?"
},
{
"speaker": "Mario Rizzo",
"text": "This is Mario. Yes, sure. I’ll jump in. Process wise, we adopt consistent processes across claims. There’s certainly unique processes. For example, in National General, given the non-standard auto mix, there’s just a different approach to those claims because they potentially have a higher risk of fraud. So there’s some unique processes there. But in terms of claim handling consistency for similar types of claims, we tend to leverage best practices across brands."
},
{
"speaker": "Paul Newsome",
"text": "Great. Thank you for your help as always. Really appreciate it."
},
{
"speaker": "Operator",
"text": "Thank you. One moment for our next question. And our next question comes from the line of C. Gregory Peters from Raymond James. Your question please."
},
{
"speaker": "C. Gregory Peters",
"text": "Good morning everyone. Tough quarter and a tough year for the company. I was looking at Slide 11 in the supplement. And this is the slide that talks about the Allstate brand auto state profitability. And if we look at the number of states that have a combined ratio above 100, it steadily increased through the fourth quarter and it kind of a contrary to the comments you made about the rate that you applied and achieved in the year. So my question is what type of expectation do you have for that category of states above 100 as we move through 2023? Is it kind of peak here at 41? Do you think it could get worse? Or what’s your expectation going forward of how that might trend?"
},
{
"speaker": "Tom Wilson",
"text": "Greg, let me provide an overview, then Mario can jump in on it. First, as we said and you know well that improving auto profitability will be a key to driving shareholder value. So we’re all over that. We’ve made a lot of progress. Mario showed about the rate increases. And so of the $4.1 billion that we think will still come true, or that will come through from the rate increases we’ve already implemented, we’ve got $1.2 billion, $2.6 billion of that should show up in 2023. And I would point out that, that’s not in those combined ratio numbers. So our objective is to make money in every line in every state. So no cross subsidies between states, no cross-subsidies between lines. Now, of course, that’s hard to do with as many lines as many states we’re in, but that’s our objective. And so the amount – that amount that’s not reflected in the – some of those states. We think some of those states are probably adequately priced today. There are many that are not, and so we’ll continue to drive those. But I would expect to see that number come down. But we don’t have a target of – we’re at 41 at the end of the year. We want to be at some XX at the end of the first quarter. It’s every state, every line, make money every year. Mario, would you want to add some additional color to that?"
},
{
"speaker": "Mario Rizzo",
"text": "Sure. And thanks for the question, Greg. Look, I think when you look at that trend of states above 100 and the increase throughout the year, I think what I’d point you to is when you just – you look at our underlying auto combined ratio as we reported it, increasing throughout the year and being driven by increases in our severity expectations quarter-over-quarter as the year played out, as well as increasing frequency between Q1 through Q4, only partially being offset by the rate that we took. So I think that chart mirrors what we show you in aggregate in terms of the reported underlying combined ratio. But when you look at our business from a state perspective, I think it’s important to really categorize states into a couple of different buckets. I think there’s a group of states that while we certainly are pleased with the outcome of an underwriting loss, given the actions we’ve taken, particularly from a rate perspective as well as underwriting actions, we feel like we’re positioned in a good place. Now you can’t predict the future in terms of the path of inflation or severity going forward. But given the actions we’ve taken, we feel good about where we’re positioned and what the outlook looks like for 2023. I put states like Texas, Georgia, a couple of large states for us where we’ve implemented significant rates and have been successful in doing so. And so we feel good about the outlook. Again, we’ll have to adapt to what changes in the future, but I think there is a lot of states that falls into that category. Unfortunately, there is a number of, for us, pretty meaningful states, three of which we highlighted in the presentation: California, New York, New Jersey, where they’re much more challenging regulatory environments. And we need to continue to execute on both rate increases and underwriting restrictions to curb growth to really bend the line in aggregate. And just using California as one example. So as you all know, we got a 6.9% rate approved late in the year, but we immediately filed another 6.9% increase pending with the department. We took down paid requirements up pretty dramatically. We have not changed those down paid requirements even with the first rate. We’re working with the department on getting approval for the second 6.9%. But then we’re going to come back with another rate increase because we need more rate in California. So that’s a big state for us where we’re going to have to continue to really lean in and take – continue to take dramatic and aggressive actions to improve margins. And I put New York in that same category. We got a 5% flex rate in New York. Middle of the year, we got approval for a 9.4% rate in New York towards the end of the year, while we’re prepared to do additional – an additional round of rate filings in New York early in 2023, because loss trends are not where they need to be. And in the interim, we’ve taken underwriting actions around prior incidents, down pay and other actions to curb new business growth, and we’re going to continue to lean into those actions because we can’t afford to write the new business at the current rate levels and we’ll continue to take the appropriate actions there. So I think you got to look at the states in a different way. I think we’ve made a lot of progress in a number of states, but we still have some work to do. And as we said, we expect to take some pretty significant rate increases in 2023, particularly leaning into some of those states where we haven’t, really for regulatory reasons been able to make the kind of progress that we would have liked."
},
{
"speaker": "C. Gregory Peters",
"text": "That’s good detail. Just the follow-up question on those three states, California, New York and New Jersey. And I know you’re not going to start negotiating with the Departments of Insurance on an earnings conference call. But when I look at California, for example, you yourself said 6.9% is not going to be enough. One of your competitors recently got, just last month got a rate increase improved that was in the teens. Why not pivot and get more aggressive with rate filings in some of these challenging states? It seems like some of your peers might be doing that and getting – having some success."
},
{
"speaker": "Tom Wilson",
"text": "Greg, I would just maybe provide – I think we’ve been very aggressive when you look at how much we’ve raised rates in total for the year across the country. We’ve been very aggressive. And depending whose measures you want to use, more aggressive. As you never really know where people start and what they finish and what their losses are. Mario, do you want to talk specifically about California?"
},
{
"speaker": "Mario Rizzo",
"text": "Yes. Sure. So, Greg, I think we’ve been working really closely with the Department of Insurance in California. We were able to pretty rapidly get approval of our first 6.9%, and we’re in active dialogue around the second 6.9%. And as I mentioned, when we get that one behind us, there’ll be a third one coming. We always have the option of going down the path of filing a larger rate increase. California generally takes a longer time period to get approvals for rates as it is. And the one you mentioned specifically, I think, have been pending with the department for over a year. So we’re – as we look at the map, we want to get approval, we want to get approval as rapidly as we can, so we can implement the rates and move on. So the approach we’ve taken so far in California, we’re comfortable with. We’re going to continue to lean in. We always have the option to change course if things change. But so far, we’ve had success with the path we’ve taken, and we’re going to continue to push on that."
},
{
"speaker": "C. Gregory Peters",
"text": "Thank you for the answers."
},
{
"speaker": "Operator",
"text": "Thank you, one moment for our next question. And our next question comes from the line of Elyse Greenspan from Wells Fargo. Your question please."
},
{
"speaker": "Elyse Greenspan",
"text": "Hi, thanks. Good morning. My first question is just on capital, right? You guys said you expect to complete the buyback program by the – still by the end of the third quarter of 2023. Can you just help us understand what metrics you’re looking at to judge the capital adequacy of Allstate Insurance Company at the end of 2022? I think in the past, you’ve said you look at RBC ratios there. Can you give us a sense of where you ended 2022 your RBC was, and where you would like that to be over time?"
},
{
"speaker": "Tom Wilson",
"text": "Elyse, I’ll let Jess give you some specifics, but we obviously have a long history of managing capital that both balances our financial strength, growth returns to shareholders. We have plenty of capital to grow our business and pursue attractive risk and return opportunities. We do it in a much more sophisticated way than RBC. So for example, when Jess talked about the things we had done in the investment portfolio, that we allocate specific amounts of capital to different investment allocations. So when we dial up interest rate risk, we put a little more capital up for it. If we dial down equities, we put up less capital, and we believe we’re really well capitalized and don’t have any issues. Jess, do you want to go from there?"
},
{
"speaker": "Jess Merten",
"text": "Yes. Thanks, Tom. So Elyse, I think as it relates to your question on RBC, we haven’t disclosed the RBC for the year. That will come out in due course as it relates to the actual RBC in insurance company, and we don’t publish a target. I think Tom hit on the right point, because you asked what are the metrics that we look at as we think about the repurchases. And we really do focus on our sophisticated economic capital model that looks at a comprehensive view of risk across types around the enterprise. And we use that as the basis for capital management. We obviously focus on RBC rating agency metrics, a variety of other things. But we don’t have specific targets that we published as it relates to risk-based capital. So – and I really like to take it up a level and just think about how we manage it overall using our sophisticated, risk-based capital framework. We remain confident in our overall capital position and the capital position of the insurance subsidiaries."
},
{
"speaker": "Elyse Greenspan",
"text": "Thanks. And then my second question is going back to some of what you guys have been discussing with modifying your claims practices. Have you guys tested the predictive modeling on an external data against your own internal data and seeing a meaningful benefit? And should we – how – over what time period should we think about the rollout of the program over the next year, 12 months to 24 months, on what type of time frame should we be thinking about?"
},
{
"speaker": "Tom Wilson",
"text": "Elyse, I’m not sure which predictive models are you talking about the – I mean we use predictive models for a lot in claims. Was there one specifically you were interested in?"
},
{
"speaker": "Elyse Greenspan",
"text": "Well, I was talking about some of the kind of changes you guys have stressed that you’re kind of looking to make on the claims side of things."
},
{
"speaker": "Tom Wilson",
"text": "Okay. Yes. Let me – I’ll take a shot at it and Mario, you can jump in. So we use – I mean we’re a data-driven company, so we use predictive models as you know well, for just about everything. That could be fraud. There could be – do we think this claim might end up being severe enough where it gets represented by a lawyer? So it’s important for us to establish a relationship with the customers as possible. It might be, do we think there’s a better way to settle this claim, whether it gets – the car gets totaled or we send it to a body shop. So there’s we use predictive analytics throughout the business and obviously largely in claims as well. So we’re always tuning those. We think we’re pretty good at it. You can’t really take one specific algorithm. But when you look at our claims severities, you can look at them externally. And when you look at absolute dollars, we think we did really well. It’s easier on physical damage, obviously, because you’re just fixing a car bodily injury, it’s like, okay, well, what was the case worth? What’s the average case? That gets a little harder to do. But when in – the only weakness in the external stuff is it tends to be a percentage increase over the prior year, which is, of course, we work in absolute dollars. And our models are done in absolute dollars. And so even though it all depends where you start – but we like our overall position. Mario, do you want to talk specifically about any models that you’re using now that think you can point to where we’ve updated and increased the value-added?"
},
{
"speaker": "Mario Rizzo",
"text": "Yes. The one I’d point to, and I think generally, the statement Tom made about like leveraging all the data and the capabilities we have, but also looking to tune those models and evolve over time. The example I would use would be around bodily injury, both potential loss identification and attorney representation. Given, obviously, the environment around us has evolved pretty significantly over the past couple of years in terms of higher levels of attorney representation and bodily injury claims and just medical inflation, medical consumption and treatment, those kinds of things. So what we’ve been doing is tuning the models to be able to use the components and the data that we gather early on in the claims process, to identify claims where there is, first of all, the potential for an injury. More importantly, the potential for a major injury given it’s a higher impact accident or things like that. So we can get out ahead of the claim, make contact earlier and manage the claim much more effectively. The same would be true around claims that have the potential, ultimately to be represented by an attorney. Again, creating contact with a third-party claimant and establishing dialogue and communication and leveraging the tools and the models at our disposal to better manage the claim process through the bodily injury claims. So those are just a couple of examples of how we tuned models that we’ve had to adapt to the current environment. And we’re going to have to continue to, as I mentioned earlier, evolve our processes and those models to adapt to the environment over time. So this is not a static process, and we’re always looking to get better based on the most current information as well as the external environment that we’re operating in."
},
{
"speaker": "Elyse Greenspan",
"text": "Okay. Thank you."
},
{
"speaker": "Operator",
"text": "Thank you. [Operator Instructions] And our next question comes from the line of Andrew Kligerman from Credit Suisse. Your question, please."
},
{
"speaker": "Andrew Kligerman",
"text": "Hey, thanks a lot for getting me in. First question is around social inflation, and in particular, bad price point. And in 2022, I think the court up a lot. And we – I would – I suspect that had a big impact. As we move into 2023, what’s your thinking about further social inflation issues? Do you think it will get materially worse? Could you give us some measurement around that? And that’s the question."
},
{
"speaker": "Tom Wilson",
"text": "Mario, do you want to take that?"
},
{
"speaker": "Mario Rizzo",
"text": "Yes. Certainly, social inflation is a phenomenon that we and the industry have been dealing with for an extended period of time. I think in our business, we certainly see it in the personal auto side, in casualty coverages. We’ve also seen it on commercial auto and in the shared economy, just given the higher limits that we tend to write on that business. It’s hard for me to predict whether it will get better or get worse going forward. I think it’s a reality of what we’re experiencing right now. And as I talked about some of the analytics and the processes we’re putting in place, to identify and manage injury claims more effectively. That’s a big reason why we’re doing it is in response to the social inflationary impacts we’ve seen. I’d also go back to something I said earlier around quickly not only identifying but settling claims earlier in the process where we can to mitigate the potential exposure to social inflation going forward. And the reduction in pending claims across a variety of segments that we’ve already executed on and are going to continue to focus on going forward. So I think our approach has been to modify our processes and take appropriate actions to offset the impacts of social inflation. And again, I don’t want to predict whether it will get better or get worse, but we know it’s a reality and we’ve adapted in response to it."
},
{
"speaker": "Andrew Kligerman",
"text": "Was there a big pickup in bad faith claims?"
},
{
"speaker": "Mario Rizzo",
"text": "I wouldn’t say there’s a big pickup in bad faith claims now."
},
{
"speaker": "Andrew Kligerman",
"text": "Okay. And then the next question is around the rate increase. So I think Greg was touching on how your competitor got in the teens. I think it was 17.4% and you got 6.9%. My question there is should we worry that there will be anti-selection? If other players are getting these big rate increases, will that drive more consumers to Allstate as the pricing appears better in California?"
},
{
"speaker": "Tom Wilson",
"text": "Mario, do you want to take that?"
},
{
"speaker": "Mario Rizzo",
"text": "Yes. Look, as I mentioned earlier, even with the rate that we were approved for – we didn’t change the actions we took around down pay requirements. So our risk appetite is not – has not changed in California, and it won’t until we get to a point where we believe we’re adequately priced, and that will take at least a couple more rates. Will we get anti-selected against? I think if we keep the restrictions in place or down pay requirements in place, we mitigate that risk. And it’s all relative. The rate increase that was approved was on a much larger indication than the one we filed. So it’s hard to tell what the relative price position is. But again, we’re not going to change our stance. Our focus in California is to reduce growth as much as we can until we get to rate-adequate levels, and that’s the way we’re going to manage the business."
},
{
"speaker": "Andrew Kligerman",
"text": "Thanks a lot."
},
{
"speaker": "Operator",
"text": "Thank you. [Operator Instructions] And our next question comes from the line of Josh Shanker from Bank of America. Question, please."
},
{
"speaker": "Josh Shanker",
"text": "Yes, thank you. I was looking at the new policy application, and I was trying to tease out Allstate, National General and agency versus exclusive agency versus direct. And I noticed that there was a non-significant amount of independent agency, new policy applications coming from non-National General sources. And so I’m wondering, is Allstate brand being sold through independent agencies? And the reason why I asked this is also I noticed that new policy applications from Allstate exclusive agents are up, but Allstate branded new policy applications are down overall. Meaning that it feels like there’s a channel shift that you’re excited about getting business from Allstate exclusive agents, but not from the other sources where you sold Allstate branded products last year."
},
{
"speaker": "Tom Wilson",
"text": "Let me provide a little overview. And then Mario you can take it. So Josh, first, we’ll take business from anybody’s, not just for price. You are correct in that you see – remember, National General, we took – when we acquired National General, we gave them both the Encompass business, which was straight up independent agents under the Encompass brand. There’s also an Allstate independent agent channel that we’re transitioning to National General products and services over time. So the National General has both of those. On the direct versus agent piece, we’ve been shutting down growth and reducing expenses. We went first to the direct channel because it was faster, and we got more dollars out of it. That doesn’t mean that we have a preference for Allstate agent versus direct. We’ll serve customers any way they want to be served. Mario, do you want to add some additional perspective on that?"
},
{
"speaker": "Mario Rizzo",
"text": "Yes. And maybe I’ll focus on – first on the Allstate brand, Josh, in terms of the shift, the mix shift between direct and exclusive agents. So you’ll remember a couple of things. One of the things we did this year was we reduced the amount of advertising spend, particularly lower funnel advertising spend, which directly impacts both volume through the direct channel. And I think you’ve seen a decline in the direct Allstate branded production as a result of that. I think the other thing you’ve seen is the phenomenon we’re experiencing in the exclusive agent channel with Allstate. And I’ll take you back to one of the core tenets of transformative growth was to reduce costs. But one of the components of it was to reduce distribution costs by changing how we compensated our exclusive agents, and also introducing lower cost, higher productive new models. And I think what you see in 2022 is that the model that we put in, that shifts agency compensation more to new customer acquisition has driven a level of engagement and behavior change on behalf of our exclusive agents that’s resulted in an increase in new business production, despite the rate actions that we’ve taken. I think as we go forward, we’re going to continue to evolve the agency model. We’ll continue to shift commission away from renewal to new business. And while at the same time, continue to enhance our direct capabilities so that when we do lean back into growth, we’re willing to accept the grow through any channel that we can write it. But I don’t think it’s unreasonable to assume that the first place you’d see kind of sequential growth would be in the direct channel, just given that when we turn advertising back on, that will be where a lot of the claim volume is driven through. But at the same time, we are pleased with the – again, the engagement and the behavior shift of our exclusive agents and the performance of the new agency models in terms of their levels of productivity, which I think bode well for us from a long-term growth perspective."
},
{
"speaker": "Josh Shanker",
"text": "Is there a difference in profitability over the lifetime of the customer, depending on the brand and the channel it’s sourced? And long-term, should there be any difference?"
},
{
"speaker": "Mario Rizzo",
"text": "Yes, I can jump in. Any Allstate brand, I think over time, it should be the same, right? Because we’re targeting and marketing to the same customer segment and looking to drive the same lifetime value, whether we write it in the agency channel or we write it in the direct channel. And you’ll remember, we’ve gone to differentiated pricing to match the cost of the channel with the price that the consumer is paying. So that kind of normalizes for the acquisition cost or the distribution cost. So we’d be getting the same lifetime value. I think in the National General brand, what we’ve got today is predominantly still a non-standard mix, which has a very different lifetime value than the standard and preferred products that we write in the Allstate brands. But we price for that. We have the fee structure in place for that where – and we manage that business very effectively to drive value for a much shorter policy life expectancy for those non-standard risks. As we roll out more middle market products in National General, we’ve really started on that process, but we’ve got a ways to go there. The value – the lifetime value expectancy for that policy group should look and feel a lot like the Allstate brand because we’re leveraging the same data, the same capabilities to expand our capabilities in that market. So I think from a customer segment perspective, it should be very similar across channels, given the same risk profile. Different in non-standard auto, but we’ve got a really effective model in National General to manage that business."
},
{
"speaker": "Josh Shanker",
"text": "Thank you for answering my overly belabor questions."
},
{
"speaker": "Tom Wilson",
"text": "I know that’s very helpful. So thank you all for tuning in. Allstate’s obviously focused on using our extensive system operating expertise to improve auto insurance margins. And at the same time, as Mario just mentioned, we’re investing in transforming growth to increase our profit liability business. We have upside in front of us on the investment portfolio, and we’re having a good successful expansion of our circle of protection. So thank you all, and we will talk to you next quarter."
},
{
"speaker": "Operator",
"text": "Thank you ladies and gentlemen for your participation on today’s conference. This does conclude the program. You may now disconnect. Good day."
}
] | The Allstate Corporation | 18,711 |
ALL | 3 | 2,022 | 2022-11-03 09:00:00 | Operator: Good day and thank you for standing by. Welcome to Allstate's Third Quarter Investor Call. At this time, all participants are in a listen-only mode. After prepared remarks, there will be a question-and-answer session. [Operator instructions] As a reminder, please be aware that this call is being recorded. And now I'd like to introduce your host for today's program, Mr. Mark Nogal, Head of Investor Relations. Please go ahead, sir.
Mark Nogal: Thank you, Jonathan. Good morning and welcome to Allstate's third quarter 2022 earnings conference call. After prepared remarks, we'll have a question-and-answer session. Yesterday following the close of the market, we issued our news release and investor supplement filed our 10-Q and posted today's presentation on our website allstateinvestors.com. Our management team is here to provide perspective on these results. As noted on the first slide of the presentation, our discussion will contain non-GAAP measures for which there are reconciliations in the news release and investor supplement and forward-looking statements about Allstate's operations. Allstate's results may differ materially from these statements, so please refer to our 10-K for 2021 and other public documents for information on potential risks. Additionally, we will be hosting our next special topic investor call on December 2, focusing on Allstate's auto and home insurance claims practices and reserving process. And now I'll turn it over to Tom.
Thomas Wilson: Well, good morning. Thank you for investing your time with Allstate today. As you know, we pre-released earnings several weeks ago and reported the net loss for the quarter. That reflected a small underlying, underwriting margin that was offset by increases in reserves for prior years and a mark-to-market loss on public equity securities. . Mario and Jeff will go through the details of the quarter and the reserve changes after I set some context. So let's start on Slide 2. Allstate's strategy to increase shareholder value has two components: increase personal profit liability market share and expand protection services, which are shown in the two ovals on the left. We're building a low-cost digital insurer with broad distribution through transfer onto growth to increase market share. We're also broadening protection offerings and leveraging the Allstate brand, customer base and capabilities with expanded distribution. In the third quarter, we made progress executing this strategy, while we continue to implement a comprehensive approach to improve auto profitability, which is shown in the right-hand panel, that includes broadly raising auto insurance rates, which you've seen in our disclosures. Operating expenses were lowered, including advertising and more permanent reductions in the operating cost structure. Underwriting guidelines have been adjusted to reduce new business volume where we're not earning adequate returns. Our claims operating processes are being modified to manage loss cost in a high inflation environment. And we believe this plan will return auto insurance profitability to historical levels. While the current environment requires focus on improving margins, we continue to advance and transform our growth strategy to gain market share when profitability improves. In addition, the protection services businesses is generating profitable growth. Investment returns were negative for the quarter and year-to-date, but better than the overall declines in the bond and equity markets. This reflects risk reductions implemented late last year. So you'll remember, we reduced the bond portfolio duration to lower exposure to high interest rates, which enabled us to avoid about $2 billion in losses in the bond portfolio. Our capital position is strong, and as a result, we were able to deliver attractive returns to shareholders. And Jess is going to discuss capital in his section, but let me provide a few summary points since this was covered in some of the reports issued last night. First, we have plenty of capital, and there's $4.5 billion of deployable capital at the holding. Secondly, the significant reduction in risk with the sale of the life and annuity operations occurred last October and that needs to be considered. This divestiture reduced assets by $34 billion and freed up capital. Thirdly, we use a really sophisticated approach to determining our capital that goes far beyond statutory capital and premium to surplus ratios. For example, if you just use statutory capital measure, the life company equity would be included in capital historically, which we did not believe was appropriate, so we never included it. So our methodology has led to strong results. We did decide to complete the remaining $1.4 billion stock repurchase over more than the next six months, which was our prior target we had disclosed to, but we still expect to complete it in the second or third quarter of next year. So in summary, we're really well capitalized, and this year's results have not changed our strategy or earnings power. Now let's move to Slide 3 to go through the third quarter performance in detail. Total revenues of $13.2 billion or 5.8% over the prior year quarter as property liability premiums earned increased by $5 billion or 9.8%, which reflected higher average premiums and policy growth. Lower net investment income and net losses on investments and derivatives negatively impacted the year-over-year considering our comparison there. A net loss of $694 million and an adjusted net loss of $420 million in the third quarter reflected a decline in underwriting income due to an increase in profit liability, prior year reserve estimates, which was $875 million that excludes catastrophes and increased loss costs in the current year. Looking forward, beyond improving profits in auto insurance, if you go to Slide 4, you'll see the flywheel of growth that will increase personal profit liability market share. So this is a multiyear initiative designed to build a low-cost digital insurer with broad distribution, that will be accomplished by delivering on five key objectives: improving customer value, expanding customer access, increasing sophistication and investment in customer acquisition, deploying new technology ecosystems and enhancing organizational capabilities. We made significant progress on all these components, and we're well on the way to having really being in a position where we can dial up growth quite rapidly when profitability improves. Now let me turn it over to Mario, and he'll go through our property-liability results.
Mario Rizzo: Thanks, Tom. Let's start by reviewing underwriting profitability for the Property Liability business in total on Slide 5. Our underwriting results reflect the high level of inflation and the impact of reserve strengthening in the quarter with a third quarter recorded combined ratio of 117.4% for auto, 91.2% for homeowners, 126.6% for all other lines and 111.6% for total property liability, which is shown on the left chart. Remember, our goal is to run the auto business with a combined ratio in the mid-90s and homeowners at around 90, while homeowners was close to our target in the quarter, we continue to focus on improving auto margins through a comprehensive plan that is being implemented to get us back to our mid-90s objective. The third quarter underlying combined ratio for auto insurance was 104, as you can see on the right. So we're raising auto insurance prices, reducing growth investments, lowering operating expenses and adapting claims practices to a high inflationary environment. While the homeowners business generated $245 million of underwriting profit, higher severity resulted in an underlying combined ratio of 74.6%, which is above where we manage it to, and we are increasing prices through both rates and the inflationary adjustment factor embedded in our homeowners product to improve underlying margins going forward. One of the reasons that we have an industry-leading homeowners business is because we proactively manage the risk and return profile of each market that we operate in. Based on this approach, we have decided to stop writing new homeowners and condo insurance in California at this time, given our inability to fully reflect the cost of providing these products in the state, including both loss and reinsurance costs. We intend to continue protecting our existing California property customers by offering ongoing coverage to them. Other lines are mainly traditional small commercial auto and shared economy insurance, both of which have recorded and underlying combined ratios above target levels. As a result, we made the decision to exit 5 states in the traditional small commercial business and no longer provide insurance to transportation network companies unless pricing begins to utilize a telematics-based framework for pricing. These actions are expected to reduce commercial business premiums by over 50% next year. Let's move to Slide 6 and discuss auto profitability in more detail. As you can see from the chart on the left, which shows the auto insurance combined ratio and underlying combined ratio over time. We have a long history of meeting or outperforming our mid- combined ratio target, supported by our pricing sophistication, underwriting and claims equities and expense management. 2020 is an outlier with much better than target results due to reduced accident frequency in the early stages of the pandemic. In 2021 and again this year, we have experienced both higher frequency than 2020 and the impacts of inflation, which have dramatically increased the cost to repair or replace cars and raise the cost of settling injury claims with third parties who are injured in accidents with our customers. In addition, this quarter, we strengthened prior year reserves by $643 million, which Jeff will discuss in more detail in a few minutes and experienced higher catastrophe losses mainly from flooding associated with Hurricane in. As a result, the auto insurance recorded combined ratio was 117.4% with reserve strengthening and catastrophes contributing 8.5 and 4.4 points, respectively, to this result. The right chart quantifies the drivers in the year-over-year change in the underlying combined ratio, which increased from 97.6 to 104 and excludes catastrophes and the reserve changes. The red bar reflects the increase in underlying losses, primarily due to current report year incurred severity strengthening across major coverages and moderately higher frequency than last year. The increase to underlying loss costs were partially offset by 4.3 points of average earned premiums from implemented rate increases and a 3.1 point reduction in underwriting expenses to get to the 104. To add more clarity to the current quarter results, we also highlight the 2.6 point impact of increasing full year claim severities in the third quarter for claims that were reported in the first and second quarter of this year. This impact is noted by the green bar on the right-hand chart. Excluding this intra-year strengthening, the third quarter underlying combined ratio would have been 101.4. Current report year incurred severity for collision and property damage claims were increased to 17% above the level reported for the full year 2021, and bodily injury severity was increased to 12%. Moving to Slide 7, let's discuss key components of our multifaceted plan to deal with inflation, raising auto insurance prices. Growth in average premium per policy is accelerating due to implemented rate increases over the last 12 months, but the impact to average earned premium per policy is on a lag due to the 6-month policy term. Over the last 12 months, we've implemented Allstate brand auto rate increases across 53 locations for an annualized written premium impact of approximately 13.7% or nearly $3.3 billion, including 4.7% in the third quarter. The chart on the page is an estimation of when the rate increases implemented in the last 12 months will be earned into premiums. This illustrative example assumes only 85% of the annualized written premium will be earned to account for retention and the fact that some customers modify policy terms, such as deductibles or limits when faced with price increases. As you can see, looking back at Q3 2022, the estimated impact of the $3.3 billion in annualized implemented rate had only an estimated impact of $660 million on earned premium, which is expected to grow by over $2.1 billion through the end of next year. Given the ongoing loss cost inflation, we expect to implement additional rate increases in the fourth quarter of this year and into 2023, and those will be on top of increases implemented since Q4 of last year and additive to the increases shown here. Moving to Slide 8, let's discuss the timing of how these rate increases will impact the combined ratio for auto insurance. The chart on this page is an illustrative view to show our path to target profitability, along with the magnitude of actions already taken and required prospectively. Starting on the left, through the first nine months of the year, the auto insurance recorded combined ratio is 109.3% as shown by the first blue bar. From this starting point, we removed the impact of prior year reserve increases and normalize the catastrophe loss ratio to our 5-year historical average. This improves the combined ratio by approximately 6 points represented by the first green bar. The second green bar reflects the estimated impact of rate actions already implemented when fully earned in the premium which is an additional $2.3 billion of premium across the Allstate and National General brands or approximately 8 points. These amounts will be mostly earned by the end of 2023. Of course, loss costs will likely continue to increase, whether from inflationary impacts on severity or higher accident frequency, which would increase the combined ratio. Prospective rate increases must meet or exceed loss cost increases to achieve historical returns. Combined with other non-rate actions such as reducing new business and expenses, we expect to achieve an auto insurance combined ratio target in the mid-90s. The timing of reaching this goal will be largely dependent on the relative increase in premiums and future loss cost trends. Moving to Slide 9. Let's now take a look at our industry-leading homeowners business. As you know, a significant portion of our customers bundle home and auto insurance, which improves retention and the overall economics of both product lines. We have a differentiated homeowners product, underwriting, reinsurance and claims ecosystem that is unique in the industry. Our long-term under result -- underwriting results reflect this dynamic with a 5-year average recorded combined ratio of 91.9%. The third quarter combined ratio for homeowners improved to 91.2%, primarily driven by lower catastrophe losses compared to the prior year quarter, as you can see by the chart on the left. Enterprise risk and return management actions reduced our Florida personal property market share to 2.6%, which, combined with a comprehensive reinsurance program, including our stand-alone Florida property coverage, significantly mitigated net losses from Hurricane Ian. Estimated gross catastrophe losses due to the hurricane totaled $671 million and were reduced by $305 million in expected reinsurance recoveries, primarily related to property reinsurance for our stand-alone Florida property insurance company, . Of the $366 million net loss from Ian, only approximately 25% was from property lines. Homeowners insurance is certainly not immune to the rising inflationary environment as we continue to be impacted by increasing labor and material costs. In the third quarter, non-catastrophe prior year reserves were strengthened by $51 million, and current report year incurred severity was increased primarily as a result of increasing inflation in both labor and material costs. The resulting impact to the underlying combined ratio from current year severity strengthening was 3.8 points in the third quarter, partially offset by slightly lower non-catastrophe frequency. Similar to auto insurance, there was an intra-year impact of 2.4 points related to claims reported in the first and second quarter of this year, which was reflected in the underlying combined ratio for the third quarter of 2022. To combat inflation challenges, our products have sophisticated pricing features that respond to changes in replacement values. The chart on the right shows key homeowners insurance operating statistics. Net written premium has grown sharply throughout 2021 and into 2022, increasing 9.4% from the prior year quarter and 12.9% year-to-date, primarily driven by a more than 13% increase in Allstate brand average gross premium per policy and a 1.4% increase in policies in force. The Allstate brand increases are partially offset by lower National General premiums and policies in force as we improve underwriting margins to targeted levels in this brand. We are continuing to raise homeowners' prices to address inflationary pressures, both through the impact of inflation on insured home valuations and filed rate increases. Beyond these pricing actions, we have also decided to limit new business where margin targets cannot be achieved in the near term, including the action I previously noted of suspending the sale of new homeowners insurance policies to consumers in California. Let's delve deeper into improving customer value through expense reductions on Slide 10. Let me start by saying we remain on pace and committed to our long-term objective to reduce our adjusted expense ratio which is a metric we introduced about a year ago to track our underlying progress to improve customer value. This metric starts with our underwriting expense ratio, excluding things like restructuring, coronavirus-related expenses amortization and impairment of purchased intangibles and investments in advertising. It then adds in our claims expense ratio, excluding costs associated with settling catastrophe claims because catastrophe-related costs tend to bounce around quarter-to-quarter. Through innovation and strong execution, we've achieved almost three points of improvement since 2018. Over time, we expect to drive more than three points of additional improvements from current levels, achieving an adjusted expense ratio of approximately 23 by year-end 2024, and which represents a 6-point reduction compared to 2018. The chart on the slide shows the Allstate Protection underwriting expense ratio since 2018 and quantifies the impacts from third quarter 2022 compared to the prior year quarter, reflecting actions we've taken to address the current operating environment. The first green bar on the left shows the decline in advertising spend as growth investments have been reduced given our focus on improving margins. The next green bar shows a decline in the amortization of deferred acquisition costs, primarily driven by the phaseout of enhanced compensation models for new agents. Our future cost reduction efforts are focused on digitization, sourcing and operating efficiency and continuing to reduce distribution costs. Let me now turn it over to Jess to discuss our reserving actions in the quarter and the remainder of our business results in more detail.
Jess Merten: Thank you, Mario, and good morning, everyone. On Slide 11, let's begin with our prior year reserve development, property liability, prior year reserve strengthening, excluding catastrophes totaled $875 million in the third quarter. The pie chart on the left breaks down the impact by line with $643 million, driven by personal auto, $120 million one-off property liability from our annual reserve review related to environmental and asbestos exposures, $63 million in commercial, largely related to auto bodily injury and $51 million in homeowners. . The chart on the right breaks down Allstate Protection auto prior year reserve strengthening of $643 million in the third quarter, which was primarily driven by noncustomer claim and bodily injury claims. The total cost to settle these claims continues to be impacted by more severe accidents and higher medical and litigation costs. Increases to commercial and homeowners insurance can also be attributed to these factors. Physical damage prior year reserve increases in the third quarter from property damage collision and comprehensive coverages, excluding catastrophes, were largely offset by higher subrogation collection estimates. Now let's move to Slide 12 to discuss the drivers of bodily injury development and our claims operating actions to manage loss costs. Bodily injury severities have increased as the mix of claims shifted to more costly claim segments. The chart on the left shows the relative severity of bodily injury claims by type of treatment, major versus non-major and whether the claim is unrepresented, attorney represented or litigated. Major injuries have more expensive medical treatments, greater nonmedical related damages and often more attorney involvement. As a result, paid severity for major injury claims and litigation represented by the first bar on the left costs approximately 3.9x the average paid bodily injury claim. Non-major claims shown on the right-hand side of the chart, have less medical and other related costs intend not to have attorney costs, so unrepresented nonmajor injury claims are roughly 10% of the average cost. Let me be clear, in all cases, we settled the cases for what is fair and equitable regardless of attorney involvement. The table below the chart shows a significant shift from nonmajor claims that have below average cost to major injuries that are represented or in litigation in comparison to historical levels. This shift is partially attributable to more severe accidents. This shift to larger and more complex cases has also resulted in greater variability in paid and case reserve development patterns. As part of our actuarial process, we review changes in claim development patterns to define an appropriate range of estimated outcomes based on weighing historical and more recent trends in the data. The chart on the right side depicts the value of two standard deviations to the average paid in case severity development over the last six report years. As you can see, this measure of variability has almost doubled over the last two years, resulting in a wider range of estimated outcomes. The third quarter reserving process showed a continuation of these development patterns. Therefore, we increased reserves for prior years to reflect the persistence of the trends in major injuries, increased settlement costs and greater variability in case reserves. We're proactively responding to these trends by leveraging sophisticated models, increasing medical expertise, reviewing settlement processes and assessing litigation risks. Now let's move to Slide 13 and briefly discuss physical damage loss costs, which continue to pressure profitability. Rising inflation and delays in third-party carriers subrogation demands are driving higher expected severity in the property damage coverage leading to an increase in the current year -- the current report year variance from 12% to 17% when compared to 2021. The left side of the slide includes a chart we have shown before, which indexes inflation to year-end 2018 for a few of the main inputs to physical damage severity. While used car values are below their recent peak, which is a positive indicator to continue to run more than 50% above pre-pandemic levels. Conversely, labor and parts prices continue to accelerate from the prior peak levels seen just last quarter. This continues to put upward pressure on severities in the near term. The right-hand side of the page shows third-party subrogation demand dollars paid, again, indexed to the year-end 2018. Third-party demands are when our insured isn't an accident and the claimant files a claim to their carrier rather than us. As the other carrier evaluates the claim, the Allstate insured is wholly or partially at fault, they will reach out to us with subrogation demand. We have recently experienced an uptick in the volume of severity -- volume and severity of these demands compared to prior year trends and expectations. It's worth noting that a similar dynamic is also impacting our first-party collision coverages. We are demanding and receiving elevated subrogation collections from other carriers following the declines during the pandemic and backlog and claim settlements due to delayed repairs. Shifting gears now on Slide 14. The Protection Services businesses in the lower strategic growing revenues and increasing shareholder value as we invest in future expansion. Revenues, excluding the impact of net gains and losses on investments and derivatives increased 7.2% to $640 million in the quarter, primarily driven by a 12.2% increase in Allstate Protection Plans. Adjusted net income of $35 million for the third quarter of 2022 decreased $10 million compared to the prior year quarter due to increased severity on appliance repair for Allstate protection plans, in the absence of onetime restructuring expense at Allstate Identity Protection in the prior year quarter as well as investments in growth. Policies in force declined 5%, reflecting the expiration of protection plan warranties primarily due to the -- to a high volume, low premium per policy retail account and overall decline in retail sales. Moving now to Slide 15. Allstate Health and Benefits is also growing an attractive set of businesses that protect millions of policyholders. The acquisition of National General in 2021 added both group and individual health products to our portfolio, as you can see on the left. Revenues of $570 million in the third quarter of 2022 increased 1.2% to the prior year quarter as growth in group health and employer voluntary benefits was partially offset by a reduction in individual health. Adjusted net income of $54 million increased $21 million from the prior year quarter, reflecting a lower benefit ratio, lower restructuring charges and increased revenue. Shifting now to investments on Slide 16. We'll review the performance and the portfolio risk and return position that we've taken given higher inflation and the possibility of a recession. As you may recall, we reduced our portfolio risk beginning in the fourth quarter of 2021. This included shortening the fixed income duration from 4.6 years to three years through the sale of bonds and use of derivatives, which resulted in a reduction to the portfolio's sensitivity to higher interest rates caused by increasing inflation. We also reduced our exposure to recession-sensitive assets through the sales of high-yield bonds, bank loans and public equity. We maintained this defensive positioning in the third quarter, which continued to preserve portfolio value given ongoing market volatility, rising interest rates and a further decline in public equity markets. As shown in the table, at the bottom left, our total return for the quarter was negative 0.8% and year-to-date is negative 6.4%, while adverse market conditions negatively impacted the portfolio, we estimate our duration shortening mitigated portfolio losses of approximately $2 billion. These proactive actions and the broad diversification of our portfolio produced results that were better than the S&P 500 index which is down 23.9% this year and the Bloomberg Intermediate corporate bond index, which has declined 11.8%. Our net investment income, shown in the chart on the left, totaled $690 million in the quarter, which was $74 million below the third quarter of last year. Performance-based income of $335 million shown in dark blue, was $102 million below a strong quarter in 2021. Three individual investments generated approximately 97% of the performance-based investment income in the quarter, including two sizable cash realizations. Excluding those assets, results of the broader performance-based portfolio were largely flat with negative valuations in our private equity fund investments, which have a higher correlation to public equity markets, offset by increased valuations on other asset classes such as real estate and infrastructure. Our market-based income, which is shown in blue, was $50 million above the prior year quarter, benefiting from reinvestment into market yields that are significantly higher than the overall portfolio's current yield. The table on the right demonstrates how our shorter duration fixed income portfolio is positioned to generate higher levels of investment income as we reinvest into higher interest rates. Our fixed income yield has begun to rise and was 2.9% at quarter end, but is well below the current intermediate corporate bond yield of 5.6%. Now let's take a few minutes to discuss Allstate's financial condition and capital position, starting with Slide 17. Allstate's corporate organizational structure provides sources of capital to the holding company from multiple reporting entities and intermediate holding companies. We manage capital at all levels using economic capital, rating agency models and regulatory requirements to guide decisions and maximize flexibility. We commonly report a view of capital that includes both statutory surplus and parent company -- parent holding company assets. We prefer to dividend money up from subsidiaries to the holding company when possible as it provides more financial flexibility for the organization while maintaining adequate capital levels from subsidiaries to support operations. The chart on the left shows an overview of our capital position since 2016. As you can see, it grew substantially beginning in 2019 following strong results leading up to and during the pandemic. While the current level of $19.8 billion is approximately $6 billion lower than a year ago, this was largely made up of two specific items. First, $3 billion or roughly half is related to the sale of the Life and Annuity business, as represented by the first red bar on the chart. This transaction reduced our statutory capital as we sold the legal entities and significantly reduced our overall risk profile, freeing up an additional $1.7 billion of capital. We returned this capital to shareholders as part of the current $5 billion share repurchase authorization. The second bar reflects our cash returns to shareholders, excluding the impact of the life and annuity sale. Together, these factors reduced capital by $5.4 billion with more than $4 billion going back to shareholders. The last red bar primarily reflects the impact of current auto insurance profitability challenges, which have resulted in a statutory loss and then changes in unrealized gains and losses on equity investments due to recent market volatility. We also added a line to this chart that represents our average capital from year-end 2016 through Q3 of 2021, excluding surplus related to the life and annuity businesses. Our current capital position of $19.8 billion is approximately $1 billion higher than this average, demonstrating that returning cash to shareholders after adjusting our risk profile in recent years of profitability has left us in a strong capital position. The right-hand side of this page isolates holding company assets, a key component of our capital relative to the remaining authorized repurchases and fixed charges. At the end of the third quarter, we had $4.5 billion in holding company assets with $1.2 billion remaining on the current share repurchase authorization, we would still have $3.3 billion remaining in comparison to our annual fixed charges of $1.3 billion. We believe holding company assets and capital resources available from statutory operating companies provide significant financial flexibility as we continue to implement profit improvement actions and invest in transformative growth. Now let's move to Slide 18 to discuss Allstate's strong cash return to shareholders. Adjusted net income return on equity of 4.3% was below the prior year, primarily due to lower underwriting income. Achieving our targeted combined ratios for auto and homeowners insurance will bring adjusted net income returns on equity back to our long-term targeted range of 14% to 17%. Through the first three quarters of 2022, we've returned $2.8 billion to shareholders through $2.1 billion in share repurchases and $698 million in common shareholder dividends. Over the last year, shares outstanding have been reduced by 7.7%, providing more upside per share as profitability has improved. There's $1.2 billion remaining on the current $5 billion share repurchase authorization as of September 30, which we expect to be completed in the second or third quarter of 2023 and as we moderately slow the pace of our repurchases. With that context, we're going to open up the line for your questions.
Operator: [Operator Instructions] Our first question comes from the line of Greg Peters from Raymond.
Charles Peters: I'm going to focus the first question on reserves. And I was looking at the information you provided on Slide 12 and some of the earlier slides. And I guess what we're trying to do is reconcile the charge that you took in the third quarter with the information we're getting from some of your peers? And then additionally, trying to understand why the data that you're showing now here for the third quarter results, so you can start to see it in the second quarter and make adjustments then. And I mean it's a long-winded question, but ultimately, we're trying to get at is there a risk of additional reserve charges going forward?
Thomas Wilson: Greg, thank you for your question. Let me provide just a quick overview, and then Jesse can give you some more specifics. First, of course, obviously, we estimate the what's going to happen that depends on trends for the numbers. And we can't make a comment as to what other people's numbers look. People do reserving all sorts of different ways. And we believe ours is highly precise, specific, and we have external people look at it, and we put up the numbers when we think we need to put them up. And of course, this quarter, we did increase it for prior years and that's largely due to the injury trends that just saw, which have really been unfolding over the last couple of years. And these are claims that take 4 years before you get 80% paid. It takes a while before it developed. Jesse what would -- how do you want to address that?
Jess Merten: Yes. Thanks, Tom. Greg, what I would start with is, I think it's important to be clear on one thing. At the end of every quarter, we record reserves at an appropriate level based on all the information that we have in front of us. We did that at the end of Q3 and every quarter leading up to Q3. We followed the same process that we have in the past. It's a rigorous process. It leverages internal actuarial expertise, close collaboration with our claims team and third-party reviews to analyze the most current data and assess the impact on that data on our reserves. . As I look at the quarter, the variability that we've seen continue to come through in the data that we reviewed as part of our actual process. So Q3 data supported more recent trends and continued variability in reserve development. And while these trends weren't new, an additional quarter of data did provide new insights into the persistent nature of the trends that have been emerging. So insights from actual claims development in the quarter, led us to strengthen both prior year reserves and increase our report year 2022 ultimate severities. So as I take a step back and think about where we're at from a reserve perspective, we record appropriate reserves based on what we know at the time. We used current data and all known factors to establish the reserves. So I'm confident in what we set up. And I think that the new insights that we cleaned in Q3 caused us to make the move.
Charles Peters: Okay, makes sense. I guess my follow-up question is on capital. And just looking at it from a macro perspective, I really don't remember in recent history, a time where you guys have been growing your top line almost at a double-digit rate. And that by itself puts pressure on capital resources. And then if we look at your capital position outlined in the statistical supplement, and we see total capital resources having declined year-over-year due to a variety of issues. Just wondering if you can help frame how we should think about traditional metrics around premiums to surplus in the context of all the different moving parts?
Thomas Wilson: I'll start and then Jesse can add as well. So Greg, first, we don't use the traditional -- when we look at the traditional metrics like premium surplus and as we go, but we're much more sophisticated than that. And it goes -- in the way we allocate capital is from an enterprise standpoint and looks at specificity on risk levels down to the state-based level by line. So for example, some people would blend their premium to surplus ratio for all property liability products, auto and home at the same. We don't do that. We think capital is much higher for homeowners insurance. And that's why when Mario went through our target ratios for home insurance, they're lower than they are for auto insurance. Other people just assume that same. So we're much -- we're very sophisticated in the way we do it. We manage it from an enterprise standpoint. So when we -- the answer would be we have plenty of capital, like we've got tons of money, and it's not going to do anything to our strategy. It has no impact on our future earnings power, which is, of course, what drives the company. And we're in the middle of a massive share repurchase program, and we don't feel like we have to back off on it based on what we know about our business at the granular level. So we feel very good about where we're at. We've generated good returns for shareholders by doing it that way. And so there's really -- I feel like using broad measures like that doesn't really reflect the economic reality that we're managing to. Jesse, where would you go from there?
Jess Merten: That's a pretty complete answer, Tom. But I think the important point is that the proactive capital management that really relies on our robust economic capital approach, which looks at risk on a granular basis and takes that information to understand capital needs in an enterprise level. Premium surplus only looks at one dimension of risk and capital, and we use a more complete set of measures and metrics to establish capital levels, as Tom laid out. So I just think it's important. We're cognizant of and we monitor regulatory capital requirements, rating agency capital benchmarks, all in our proactive capital management process. But I feel the same way that Tom does it that we certainly have plenty of money to execute on our strategies and continue to implement our profit improvement plan. So nothing more to add, Tom.
Operator: And our next question comes from the line of Elyse Greenspan from Wells Fargo.
Elyse Greenspan: My first question is on the capital side of things. So as you guys came to the decision, I guess, to more moderate your buyback, are you assuming that there's any dividends that you're going to take out of Allstate Insurance company over the next year? And then within that question, I guess, did you guys think about pausing the buyback program completely just to have more capital flexibility within that subsidiary?
Thomas Wilson: Elyse, let me answer that and Jesse can jump in. First, in terms of the dividends, we move -- first, we make sure that each of the insurance subsidiaries that large ones are appropriately capitalized based on what we think economic capital is just that with the rating agencies, whether it's an investor, others, think we should have in those and then what regulators want. So -- and we're really well capitalized at those. To the extent there is extra capital in those, we then move that out of the insurance companies into the holding company is just point out because that gives us more flexibility. As we look forward next year, it will depend how much money we make. I think in some of the announcements, like we have really strong earnings power and when you look at our profitability of our auto insurance, we think it's headed up. So we think there's plenty of earnings power. Whether that and where we think risk is and what we need to do with risk will depend on the overall enterprise risk portfolio. So for example, not covered in some of these things, we dialled down the risk for our investment portfolio late last year as a percentage of our total enterprise capital because we didn't think it was a good risk return trade-off. So we're constantly managing where do we want to move capital where do we want to make sure we get a good return on it. So we don't feel like we are capital constrained at all. Did we consider shutting the program down in total? No. We think we have plenty of moments of $5 billion of massive share repurchase program, a large 4 of which a portion of which was funded because we sold the life insurance company. and we said we should get that money back to the cat shareholders. So we have a historical track record of doing this extremely well. We're a top decile amongst the S&P of providing cash returns to shareholders. And we do that without putting our customers at risk of the company is. So we feel like we're in really good shape.
Elyse Greenspan: Okay. And then my follow-up, I guess, would be right. You talked about that you don't manage your premium to surplus, but I know one of your peers has mentioned looking to write their all business to a 3:1 home to 1.5:1. So I'm not sure if you have frames of references that you look at for your businesses? And then if rating agencies and regulators, what are they looking at? Are they holding you to a 3:1? Or is there other metrics that they're holding you to relative to premium to surplus or something else?
Thomas Wilson: We've had -- essentially to say, from certainly my standpoint, no conversations with regulators about our cap levels because we're so well capitalized -- I might start there. And that's been true forever and it will be true far into the future. And so the regulators really were so far above their standards. It's not really been a conversation. I can't speak to how other people look at their premium surplus ratio. I think some of our competitors who don't make money in homeowners should have even more than we do. Because when you look at your capital it's -- okay, what do we think the risk is? What is the risk of loss. But you also want to factor in your earnings power. And so if you're losing $0.10 on a dollar, on a line of business, then you have to hold more capital than if you're making $0.10 on the line of business. So I think it's all very idiosyncratic to a specific company. . We factor all of those things in by state really and even sometimes looking down at different components of the state to decide what price we should get per customer from customers, how much business we want to write and then how much capital we have to keep in the company. So I feel very good about where we're at.
Operator: And our next question comes from the line of Brian Meredith from UBS.
Brian Meredith: A couple of them here for you. First, Tom, I'm just curious, this is the, I think, first quarter a little while that we've seen auto PIF actually declined somewhat sequentially. Is that due to some of the actions you're taking in California? Or is it just in general, the price increases you're taking should we expect the PIFs to kind of decline here for a couple of quarters.
Thomas Wilson: Well, the PIF decline was, of course, in the Allstate brand versus in total because we went up in the independent agent channel, but it's intentional. And I would tell you that it's actually the decline was less than we thought it would be. When you look at historical price sensitivities on what your customer retention is, our retention is held up better than you would think from historical trends. It's hard to do attribution down to the specific item, but when you look at it, we'd say, first, the competitive position -- our competitors are also raising rates. So as we raise rates, we thought more people would leave, but less did. It could be because our competitors are also raising rates. Consumers still have a fair amount of cash in their bank accounts, so that helps. They also know that their houses and cars are worth more. So it makes sense to them that they should have to pay more for insurance, when explained to them. And I think that's the value of our Allstate agents at this point. they're out working hard to make sure our customers understand why the prices are going up. And then as Mario mentioned, they'll help them work to figure out how do they get the right price. So this is a case where like our mile-wise product is really helpful for people because if you're, say your senior citizen, you don't drive much and you should go to Milewise and save a bunch of money by not paying more. So when you look through all those together, we expected our auto PIF to go down more in the Allstate brand than it did. But we're happy that we're keeping the customers because with the price increases we've put through that will be good shareholder value creation when we start earning the rates.
Brian Meredith: Great. That's helpful. And then my next question, I'm just curious, and I think this question will be asked in prior quarters, but when you're pricing your auto insurance and homeowners insurance now, what type of loss trend are you expecting in the future expecting inflationary trends to moderate here? Or do you think they're going to stay relatively high here for a while?
Thomas Wilson: Mario, will you take that?
Mario Rizzo: Yes, sure. Brian. Yes, I think, Brian, in terms of what we're seeing, we're factoring in, obviously, the inflation we're experiencing currently, but also projecting it going forward so that we can reflect the full cost of loss costs prospectively into our prices. And so yes, we're not making any kind of significant assumptions around a deceleration in inflation going forward given the current inflationary environment, that's why we made the statement that we expect to continue to take rate increases certainly for the balance of this year but into next year, and that's really a reflection of the environment we're operating right now and the continued elevated level of inflation, which we need to kind of catch up with and then surpass going forward. So we're not assuming, as I said, any significant reduction in inflationary trends going forward.
Operator: And our next question comes from the line of Tracy Benguigui from Barclays.
Tracy Benguigui: All right. So used ask this question for casualty line writers. Given the consecutive adverse reserve development charges, have you worked with any external actuaries to review reserves? And if so, what is your management estimate relative to central estimates?
Thomas Wilson: Tracy, we always work with external people and looking at our reserves. So we obviously have Deloitte & Touche to our auditors, but we also have an external actuary in called -- which is KPMG, which provides the statutory reports for our regulators. We look at all of their stuff. We just had a detailed review with Deloitte & Touche a couple of weeks ago, and their view ties closely to ours. .
Tracy Benguigui: Do you have a management estimate above the central estimate at the moment? Or is it closer to the central?
Thomas Wilson: We don't put ranges in the financials. We put up what we -- as Jesse said, like we put up what we think the future liability is and we pick a number, and that's where we do it. And we're comfortable with the number and that number is very close to what our external participants or external health thinks and thought historically, by the way. So it isn't like we were in -- we built a very similar views at the end of the second quarter, end of the first quarter and end of the third quarter, and they are -- they believe that the actions we've taken are appropriate.
Tracy Benguigui: Got it. And just going back to capital management, given you manage capital more efficiently at the OpCo level and the way you like to hold cash at the holdco level if you could flex that up and down. I'm just curious, when was the last time you downstream capital to the operating company. How do you lever often.
Thomas Wilson: It's a good question. I don't remember certainly in the last decade, I don't remember having done that at all from -- down to the Allstate insurance company. Would we move money into the health and benefits companies because they were growing or do we have to -- so we do move money around. But if you said if you really talk about Allstate insurance company as the largest business we have, I don't remember anything in the last 10 years. But Jesse or Mario, do you have any other perspective on that?
Jess Merten: I don't have anything more than that. I think we did move some capital down into the Life company. at 1 point, Tom. But I think that certainly is no longer an issue, but that's the last thing that I remember. Mario? .
Mario Rizzo: Yes, I would concur the last time I remember any meaningful movement of capital down into an operating company. would have been during the financial crisis, which obviously was a while ago. But as Tom mentioned, we moved capital around but nothing in terms of shortfalls within any of the insurance companies.
Tracy Benguigui: Right. but I'm not thinking about this the right way where you have capital at the parent company that you could flex it up and down in your slide when you talk about your fixed charges, is there a multiple that you want to keep like 2x minimum level?
Thomas Wilson: We don't manage it that way. I just showed the level of cash we would have after we used deployable capital to finish the share repurchase program, you can see it's still well above our fixed charges, which we intentionally managed to keep at a modest level, which is even though we increased the dividend by about 50% a year ago, we tried to give a lot of money back to shareholders through share repurchases. So we don't have a multiple -- if you had a multiple and you also have to factor in how much money you're going to make over the next 12 months. And obviously, our fixed charge coverages historically have been terrific. So we don't have a -- like don't go below this because we've never even been close.
Operator: And our next question comes from the line of David Motemaden from Evercore ISI.
David Motemaden: I think it was Jesse, who spoke about just the mix shift that you're experiencing on the BI claims side to more expensive claims. And as part of the reserving process, you weight both historical and more recent trends in the claim development patterns in the data. So I guess I'm wondering after the changes that you've made this quarter, are you -- I guess, how much are you waiting more recent experience? Is it 100% weight on these trends that you're seeing? Or is there still some weight being placed on more historical experience?
Thomas Wilson: David, let me answer that, and Jesse, you can add anything else to it. So first, the reserving process uses all types of statistical analysis, triangles, link ratios, all sorts of different things. So there's no real like just 1 percentage. I think we look at it by state, by line of business, by coverage. And so it's slice and dice a whole bunch of way. So there's no really simple way to answer that. I think what I would say about you're trying to get comfortable with the reserves. It really starts -- you got to go back to say, well, what's happening in the world. And during the pandemic, we noticed when people weren't on the roads, people were driving a lot faster because there is -- they could zip around and there was no traffic and off they went. Once we get through the pandemic, at least in our data, we see people still driving pretty fast, but as a result of that, you have more severe accidents, and that trend appears to be holding. We thought that, that trend might come down because when the little ones are sort of bumps in scratches and stuff, which happen in congested traffic. Today, those, as you saw from Jesse's numbers have not gone back up and the major ones have not gone down. So people are just driving faster and hurting people more. So you have to figure out, okay, well, what are you going to do take care of it. Those are really complicated cases. I mean people have surgery, they have all kinds of services, and those services are more expensive, and they take longer to develop. So if you really severely injured, it could take 6 months, nine months, two years before you really figure out how you get back to where you should be, and it costs a lot of money and takes a lot of time. And so those cases develop over a longer period of time. So it isn't so much that it's just -- we use the same process as procedures, but as these things develop, it really comes back to -- our customers are just in a lot more severe actions and people are getting hurt, and we need to make sure we have the liability up to cover that. And that's what we did this quarter. So we said, okay, this is really continuing. Most of these are still severe. And as they develop, then you have to put the money up.
David Motemaden: Got it. Okay. So it sounds like you had assumed that the mix which normalize somewhat away from some of these more severe accidents, and I guess now the assumption is that there is going to be no mix away from these more severe accidents and that's sort of the new normal. Is that correct?
Thomas Wilson: Yes. But it's not just 1 item, I would say. So you can't pin it on just those now more majors. There's more majors. The majors are harder to estimate. They're taking longer to settle. There's more legal costs associated with settling those, and so you have to factor that in. So there's a whole bunch of factors that relate to it. So we look at it. We're comfortable we've put up the right amount of money. And what other companies do and what they're reserving are -- some people use less specific processes that we do, some processes react faster or slower to trends in the marketplace. But the important thing is we use the same process is have external views, and we all think this is the right amount of money.
David Motemaden: Got it. Okay. And then maybe just a quick numbers follow-up here. So see that you guys are now assuming a bodily injury severity of 12%, I guess I'm just wondering what was the report year incurred severity on bodily injury for 2021 after the changes that you've made?
Thomas Wilson: We have not broken out the reserve -- after the reserve changes by prior years. We won't break those out until we publish the 10-K. I mean, is that right -- correct, Jess?
Jess Merten: That's right, Tom. We don't disclose the split, so we don't have that.
Thomas Wilson: But suffice it to say, David, that is higher than it was before.
David Motemaden: Yes. I was looking at a -- I'm just trying to get a sense for the compound if we say, okay, up 12%, but the base does matter. And so I think the base was set at 5% in the first quarter for all of 2021, which has since been changed. So I was just trying to get a sense for where that's gone. But I guess I'll look in the K for that.
Thomas Wilson: Why don't we take 1 more question and then...
Operator: Our final question comes from the line of Yaron Kinar from Jefferies.
Yaron Kinar: I'm going to go to my specialty of beating dead horses here, if I can. On capital, do you expect to deploy some of the hold liquidity into AIC over the coming year?
Thomas Wilson: No.
Yaron Kinar: Okay. And then shifting more just to the auto and home side. So I think you guys shifted the exclusive agent comp structure to be more weighted to new business. Now that you're kind of maybe taking a little bit of a step back on growth and really focusing more on fixing the margins, how is that playing out with the agent comp structure with your conversations with them? I'm assuming that can be a little bit of murmurings and rumblings around that. How are you handling that?
Thomas Wilson: Well, I'm address embedded in all of this, there's a lot of good news on transformative growth that we really don't have a chance to talk about it. One is that which you talked about, which was expanding customer access is the second key lever. And that included selling direct under the Allstate brand at 7% less than it was sold through Allstate agents. And there was some concern amongst investors as to would the agents walk away and would you have a decline in volume there? And the answer is no. That is the underlying assumption that they would continue to be focused on getting more new customers given what we did to the compensation plan was true. . If you look at new business from the Allstate agents, you can see that's where it was a year ago, even though there are fewer Allstate agents out there. And then if you look at the retention numbers, as I mentioned, I think our agents are doing a great job for us talking to customers whose price changes. And so we feel good that, that part of the expanding access, all of our underlying assumptions prove to. We also have really improved our web-based and the call center close processes. So we're getting much better at selling through those two vehicles. We obviously dialled the advertising way down this year because we don't want to take on new business and then have to raise the price 15% or 20% the first time. So while you don't see the benefit of those improved processes come through new business, but when we get auto profitability improved, we feel good about the underlying assumptions we made in transformative growth and our progress in making those realities. So we're feeling good about where that's headed.
Thomas Wilson: So thank you all for dialing in. As we move forward, we have a couple of things in front of us. One, we have to improve auto insurance margins, while making sure we continue to invest and transform the growth so that we can grow market share and then continuing to expand our other protection services businesses, which also had a great quarter. So thank you and we will talk to you in December.
Operator: Thank you, ladies and gentlemen, for your participation in today's conference. This does conclude the program. You may now disconnect at today's conference. | [
{
"speaker": "Operator",
"text": "Good day and thank you for standing by. Welcome to Allstate's Third Quarter Investor Call. At this time, all participants are in a listen-only mode. After prepared remarks, there will be a question-and-answer session. [Operator instructions] As a reminder, please be aware that this call is being recorded. And now I'd like to introduce your host for today's program, Mr. Mark Nogal, Head of Investor Relations. Please go ahead, sir."
},
{
"speaker": "Mark Nogal",
"text": "Thank you, Jonathan. Good morning and welcome to Allstate's third quarter 2022 earnings conference call. After prepared remarks, we'll have a question-and-answer session. Yesterday following the close of the market, we issued our news release and investor supplement filed our 10-Q and posted today's presentation on our website allstateinvestors.com. Our management team is here to provide perspective on these results. As noted on the first slide of the presentation, our discussion will contain non-GAAP measures for which there are reconciliations in the news release and investor supplement and forward-looking statements about Allstate's operations. Allstate's results may differ materially from these statements, so please refer to our 10-K for 2021 and other public documents for information on potential risks. Additionally, we will be hosting our next special topic investor call on December 2, focusing on Allstate's auto and home insurance claims practices and reserving process. And now I'll turn it over to Tom."
},
{
"speaker": "Thomas Wilson",
"text": "Well, good morning. Thank you for investing your time with Allstate today. As you know, we pre-released earnings several weeks ago and reported the net loss for the quarter. That reflected a small underlying, underwriting margin that was offset by increases in reserves for prior years and a mark-to-market loss on public equity securities. . Mario and Jeff will go through the details of the quarter and the reserve changes after I set some context. So let's start on Slide 2. Allstate's strategy to increase shareholder value has two components: increase personal profit liability market share and expand protection services, which are shown in the two ovals on the left. We're building a low-cost digital insurer with broad distribution through transfer onto growth to increase market share. We're also broadening protection offerings and leveraging the Allstate brand, customer base and capabilities with expanded distribution. In the third quarter, we made progress executing this strategy, while we continue to implement a comprehensive approach to improve auto profitability, which is shown in the right-hand panel, that includes broadly raising auto insurance rates, which you've seen in our disclosures. Operating expenses were lowered, including advertising and more permanent reductions in the operating cost structure. Underwriting guidelines have been adjusted to reduce new business volume where we're not earning adequate returns. Our claims operating processes are being modified to manage loss cost in a high inflation environment. And we believe this plan will return auto insurance profitability to historical levels. While the current environment requires focus on improving margins, we continue to advance and transform our growth strategy to gain market share when profitability improves. In addition, the protection services businesses is generating profitable growth. Investment returns were negative for the quarter and year-to-date, but better than the overall declines in the bond and equity markets. This reflects risk reductions implemented late last year. So you'll remember, we reduced the bond portfolio duration to lower exposure to high interest rates, which enabled us to avoid about $2 billion in losses in the bond portfolio. Our capital position is strong, and as a result, we were able to deliver attractive returns to shareholders. And Jess is going to discuss capital in his section, but let me provide a few summary points since this was covered in some of the reports issued last night. First, we have plenty of capital, and there's $4.5 billion of deployable capital at the holding. Secondly, the significant reduction in risk with the sale of the life and annuity operations occurred last October and that needs to be considered. This divestiture reduced assets by $34 billion and freed up capital. Thirdly, we use a really sophisticated approach to determining our capital that goes far beyond statutory capital and premium to surplus ratios. For example, if you just use statutory capital measure, the life company equity would be included in capital historically, which we did not believe was appropriate, so we never included it. So our methodology has led to strong results. We did decide to complete the remaining $1.4 billion stock repurchase over more than the next six months, which was our prior target we had disclosed to, but we still expect to complete it in the second or third quarter of next year. So in summary, we're really well capitalized, and this year's results have not changed our strategy or earnings power. Now let's move to Slide 3 to go through the third quarter performance in detail. Total revenues of $13.2 billion or 5.8% over the prior year quarter as property liability premiums earned increased by $5 billion or 9.8%, which reflected higher average premiums and policy growth. Lower net investment income and net losses on investments and derivatives negatively impacted the year-over-year considering our comparison there. A net loss of $694 million and an adjusted net loss of $420 million in the third quarter reflected a decline in underwriting income due to an increase in profit liability, prior year reserve estimates, which was $875 million that excludes catastrophes and increased loss costs in the current year. Looking forward, beyond improving profits in auto insurance, if you go to Slide 4, you'll see the flywheel of growth that will increase personal profit liability market share. So this is a multiyear initiative designed to build a low-cost digital insurer with broad distribution, that will be accomplished by delivering on five key objectives: improving customer value, expanding customer access, increasing sophistication and investment in customer acquisition, deploying new technology ecosystems and enhancing organizational capabilities. We made significant progress on all these components, and we're well on the way to having really being in a position where we can dial up growth quite rapidly when profitability improves. Now let me turn it over to Mario, and he'll go through our property-liability results."
},
{
"speaker": "Mario Rizzo",
"text": "Thanks, Tom. Let's start by reviewing underwriting profitability for the Property Liability business in total on Slide 5. Our underwriting results reflect the high level of inflation and the impact of reserve strengthening in the quarter with a third quarter recorded combined ratio of 117.4% for auto, 91.2% for homeowners, 126.6% for all other lines and 111.6% for total property liability, which is shown on the left chart. Remember, our goal is to run the auto business with a combined ratio in the mid-90s and homeowners at around 90, while homeowners was close to our target in the quarter, we continue to focus on improving auto margins through a comprehensive plan that is being implemented to get us back to our mid-90s objective. The third quarter underlying combined ratio for auto insurance was 104, as you can see on the right. So we're raising auto insurance prices, reducing growth investments, lowering operating expenses and adapting claims practices to a high inflationary environment. While the homeowners business generated $245 million of underwriting profit, higher severity resulted in an underlying combined ratio of 74.6%, which is above where we manage it to, and we are increasing prices through both rates and the inflationary adjustment factor embedded in our homeowners product to improve underlying margins going forward. One of the reasons that we have an industry-leading homeowners business is because we proactively manage the risk and return profile of each market that we operate in. Based on this approach, we have decided to stop writing new homeowners and condo insurance in California at this time, given our inability to fully reflect the cost of providing these products in the state, including both loss and reinsurance costs. We intend to continue protecting our existing California property customers by offering ongoing coverage to them. Other lines are mainly traditional small commercial auto and shared economy insurance, both of which have recorded and underlying combined ratios above target levels. As a result, we made the decision to exit 5 states in the traditional small commercial business and no longer provide insurance to transportation network companies unless pricing begins to utilize a telematics-based framework for pricing. These actions are expected to reduce commercial business premiums by over 50% next year. Let's move to Slide 6 and discuss auto profitability in more detail. As you can see from the chart on the left, which shows the auto insurance combined ratio and underlying combined ratio over time. We have a long history of meeting or outperforming our mid- combined ratio target, supported by our pricing sophistication, underwriting and claims equities and expense management. 2020 is an outlier with much better than target results due to reduced accident frequency in the early stages of the pandemic. In 2021 and again this year, we have experienced both higher frequency than 2020 and the impacts of inflation, which have dramatically increased the cost to repair or replace cars and raise the cost of settling injury claims with third parties who are injured in accidents with our customers. In addition, this quarter, we strengthened prior year reserves by $643 million, which Jeff will discuss in more detail in a few minutes and experienced higher catastrophe losses mainly from flooding associated with Hurricane in. As a result, the auto insurance recorded combined ratio was 117.4% with reserve strengthening and catastrophes contributing 8.5 and 4.4 points, respectively, to this result. The right chart quantifies the drivers in the year-over-year change in the underlying combined ratio, which increased from 97.6 to 104 and excludes catastrophes and the reserve changes. The red bar reflects the increase in underlying losses, primarily due to current report year incurred severity strengthening across major coverages and moderately higher frequency than last year. The increase to underlying loss costs were partially offset by 4.3 points of average earned premiums from implemented rate increases and a 3.1 point reduction in underwriting expenses to get to the 104. To add more clarity to the current quarter results, we also highlight the 2.6 point impact of increasing full year claim severities in the third quarter for claims that were reported in the first and second quarter of this year. This impact is noted by the green bar on the right-hand chart. Excluding this intra-year strengthening, the third quarter underlying combined ratio would have been 101.4. Current report year incurred severity for collision and property damage claims were increased to 17% above the level reported for the full year 2021, and bodily injury severity was increased to 12%. Moving to Slide 7, let's discuss key components of our multifaceted plan to deal with inflation, raising auto insurance prices. Growth in average premium per policy is accelerating due to implemented rate increases over the last 12 months, but the impact to average earned premium per policy is on a lag due to the 6-month policy term. Over the last 12 months, we've implemented Allstate brand auto rate increases across 53 locations for an annualized written premium impact of approximately 13.7% or nearly $3.3 billion, including 4.7% in the third quarter. The chart on the page is an estimation of when the rate increases implemented in the last 12 months will be earned into premiums. This illustrative example assumes only 85% of the annualized written premium will be earned to account for retention and the fact that some customers modify policy terms, such as deductibles or limits when faced with price increases. As you can see, looking back at Q3 2022, the estimated impact of the $3.3 billion in annualized implemented rate had only an estimated impact of $660 million on earned premium, which is expected to grow by over $2.1 billion through the end of next year. Given the ongoing loss cost inflation, we expect to implement additional rate increases in the fourth quarter of this year and into 2023, and those will be on top of increases implemented since Q4 of last year and additive to the increases shown here. Moving to Slide 8, let's discuss the timing of how these rate increases will impact the combined ratio for auto insurance. The chart on this page is an illustrative view to show our path to target profitability, along with the magnitude of actions already taken and required prospectively. Starting on the left, through the first nine months of the year, the auto insurance recorded combined ratio is 109.3% as shown by the first blue bar. From this starting point, we removed the impact of prior year reserve increases and normalize the catastrophe loss ratio to our 5-year historical average. This improves the combined ratio by approximately 6 points represented by the first green bar. The second green bar reflects the estimated impact of rate actions already implemented when fully earned in the premium which is an additional $2.3 billion of premium across the Allstate and National General brands or approximately 8 points. These amounts will be mostly earned by the end of 2023. Of course, loss costs will likely continue to increase, whether from inflationary impacts on severity or higher accident frequency, which would increase the combined ratio. Prospective rate increases must meet or exceed loss cost increases to achieve historical returns. Combined with other non-rate actions such as reducing new business and expenses, we expect to achieve an auto insurance combined ratio target in the mid-90s. The timing of reaching this goal will be largely dependent on the relative increase in premiums and future loss cost trends. Moving to Slide 9. Let's now take a look at our industry-leading homeowners business. As you know, a significant portion of our customers bundle home and auto insurance, which improves retention and the overall economics of both product lines. We have a differentiated homeowners product, underwriting, reinsurance and claims ecosystem that is unique in the industry. Our long-term under result -- underwriting results reflect this dynamic with a 5-year average recorded combined ratio of 91.9%. The third quarter combined ratio for homeowners improved to 91.2%, primarily driven by lower catastrophe losses compared to the prior year quarter, as you can see by the chart on the left. Enterprise risk and return management actions reduced our Florida personal property market share to 2.6%, which, combined with a comprehensive reinsurance program, including our stand-alone Florida property coverage, significantly mitigated net losses from Hurricane Ian. Estimated gross catastrophe losses due to the hurricane totaled $671 million and were reduced by $305 million in expected reinsurance recoveries, primarily related to property reinsurance for our stand-alone Florida property insurance company, . Of the $366 million net loss from Ian, only approximately 25% was from property lines. Homeowners insurance is certainly not immune to the rising inflationary environment as we continue to be impacted by increasing labor and material costs. In the third quarter, non-catastrophe prior year reserves were strengthened by $51 million, and current report year incurred severity was increased primarily as a result of increasing inflation in both labor and material costs. The resulting impact to the underlying combined ratio from current year severity strengthening was 3.8 points in the third quarter, partially offset by slightly lower non-catastrophe frequency. Similar to auto insurance, there was an intra-year impact of 2.4 points related to claims reported in the first and second quarter of this year, which was reflected in the underlying combined ratio for the third quarter of 2022. To combat inflation challenges, our products have sophisticated pricing features that respond to changes in replacement values. The chart on the right shows key homeowners insurance operating statistics. Net written premium has grown sharply throughout 2021 and into 2022, increasing 9.4% from the prior year quarter and 12.9% year-to-date, primarily driven by a more than 13% increase in Allstate brand average gross premium per policy and a 1.4% increase in policies in force. The Allstate brand increases are partially offset by lower National General premiums and policies in force as we improve underwriting margins to targeted levels in this brand. We are continuing to raise homeowners' prices to address inflationary pressures, both through the impact of inflation on insured home valuations and filed rate increases. Beyond these pricing actions, we have also decided to limit new business where margin targets cannot be achieved in the near term, including the action I previously noted of suspending the sale of new homeowners insurance policies to consumers in California. Let's delve deeper into improving customer value through expense reductions on Slide 10. Let me start by saying we remain on pace and committed to our long-term objective to reduce our adjusted expense ratio which is a metric we introduced about a year ago to track our underlying progress to improve customer value. This metric starts with our underwriting expense ratio, excluding things like restructuring, coronavirus-related expenses amortization and impairment of purchased intangibles and investments in advertising. It then adds in our claims expense ratio, excluding costs associated with settling catastrophe claims because catastrophe-related costs tend to bounce around quarter-to-quarter. Through innovation and strong execution, we've achieved almost three points of improvement since 2018. Over time, we expect to drive more than three points of additional improvements from current levels, achieving an adjusted expense ratio of approximately 23 by year-end 2024, and which represents a 6-point reduction compared to 2018. The chart on the slide shows the Allstate Protection underwriting expense ratio since 2018 and quantifies the impacts from third quarter 2022 compared to the prior year quarter, reflecting actions we've taken to address the current operating environment. The first green bar on the left shows the decline in advertising spend as growth investments have been reduced given our focus on improving margins. The next green bar shows a decline in the amortization of deferred acquisition costs, primarily driven by the phaseout of enhanced compensation models for new agents. Our future cost reduction efforts are focused on digitization, sourcing and operating efficiency and continuing to reduce distribution costs. Let me now turn it over to Jess to discuss our reserving actions in the quarter and the remainder of our business results in more detail."
},
{
"speaker": "Jess Merten",
"text": "Thank you, Mario, and good morning, everyone. On Slide 11, let's begin with our prior year reserve development, property liability, prior year reserve strengthening, excluding catastrophes totaled $875 million in the third quarter. The pie chart on the left breaks down the impact by line with $643 million, driven by personal auto, $120 million one-off property liability from our annual reserve review related to environmental and asbestos exposures, $63 million in commercial, largely related to auto bodily injury and $51 million in homeowners. . The chart on the right breaks down Allstate Protection auto prior year reserve strengthening of $643 million in the third quarter, which was primarily driven by noncustomer claim and bodily injury claims. The total cost to settle these claims continues to be impacted by more severe accidents and higher medical and litigation costs. Increases to commercial and homeowners insurance can also be attributed to these factors. Physical damage prior year reserve increases in the third quarter from property damage collision and comprehensive coverages, excluding catastrophes, were largely offset by higher subrogation collection estimates. Now let's move to Slide 12 to discuss the drivers of bodily injury development and our claims operating actions to manage loss costs. Bodily injury severities have increased as the mix of claims shifted to more costly claim segments. The chart on the left shows the relative severity of bodily injury claims by type of treatment, major versus non-major and whether the claim is unrepresented, attorney represented or litigated. Major injuries have more expensive medical treatments, greater nonmedical related damages and often more attorney involvement. As a result, paid severity for major injury claims and litigation represented by the first bar on the left costs approximately 3.9x the average paid bodily injury claim. Non-major claims shown on the right-hand side of the chart, have less medical and other related costs intend not to have attorney costs, so unrepresented nonmajor injury claims are roughly 10% of the average cost. Let me be clear, in all cases, we settled the cases for what is fair and equitable regardless of attorney involvement. The table below the chart shows a significant shift from nonmajor claims that have below average cost to major injuries that are represented or in litigation in comparison to historical levels. This shift is partially attributable to more severe accidents. This shift to larger and more complex cases has also resulted in greater variability in paid and case reserve development patterns. As part of our actuarial process, we review changes in claim development patterns to define an appropriate range of estimated outcomes based on weighing historical and more recent trends in the data. The chart on the right side depicts the value of two standard deviations to the average paid in case severity development over the last six report years. As you can see, this measure of variability has almost doubled over the last two years, resulting in a wider range of estimated outcomes. The third quarter reserving process showed a continuation of these development patterns. Therefore, we increased reserves for prior years to reflect the persistence of the trends in major injuries, increased settlement costs and greater variability in case reserves. We're proactively responding to these trends by leveraging sophisticated models, increasing medical expertise, reviewing settlement processes and assessing litigation risks. Now let's move to Slide 13 and briefly discuss physical damage loss costs, which continue to pressure profitability. Rising inflation and delays in third-party carriers subrogation demands are driving higher expected severity in the property damage coverage leading to an increase in the current year -- the current report year variance from 12% to 17% when compared to 2021. The left side of the slide includes a chart we have shown before, which indexes inflation to year-end 2018 for a few of the main inputs to physical damage severity. While used car values are below their recent peak, which is a positive indicator to continue to run more than 50% above pre-pandemic levels. Conversely, labor and parts prices continue to accelerate from the prior peak levels seen just last quarter. This continues to put upward pressure on severities in the near term. The right-hand side of the page shows third-party subrogation demand dollars paid, again, indexed to the year-end 2018. Third-party demands are when our insured isn't an accident and the claimant files a claim to their carrier rather than us. As the other carrier evaluates the claim, the Allstate insured is wholly or partially at fault, they will reach out to us with subrogation demand. We have recently experienced an uptick in the volume of severity -- volume and severity of these demands compared to prior year trends and expectations. It's worth noting that a similar dynamic is also impacting our first-party collision coverages. We are demanding and receiving elevated subrogation collections from other carriers following the declines during the pandemic and backlog and claim settlements due to delayed repairs. Shifting gears now on Slide 14. The Protection Services businesses in the lower strategic growing revenues and increasing shareholder value as we invest in future expansion. Revenues, excluding the impact of net gains and losses on investments and derivatives increased 7.2% to $640 million in the quarter, primarily driven by a 12.2% increase in Allstate Protection Plans. Adjusted net income of $35 million for the third quarter of 2022 decreased $10 million compared to the prior year quarter due to increased severity on appliance repair for Allstate protection plans, in the absence of onetime restructuring expense at Allstate Identity Protection in the prior year quarter as well as investments in growth. Policies in force declined 5%, reflecting the expiration of protection plan warranties primarily due to the -- to a high volume, low premium per policy retail account and overall decline in retail sales. Moving now to Slide 15. Allstate Health and Benefits is also growing an attractive set of businesses that protect millions of policyholders. The acquisition of National General in 2021 added both group and individual health products to our portfolio, as you can see on the left. Revenues of $570 million in the third quarter of 2022 increased 1.2% to the prior year quarter as growth in group health and employer voluntary benefits was partially offset by a reduction in individual health. Adjusted net income of $54 million increased $21 million from the prior year quarter, reflecting a lower benefit ratio, lower restructuring charges and increased revenue. Shifting now to investments on Slide 16. We'll review the performance and the portfolio risk and return position that we've taken given higher inflation and the possibility of a recession. As you may recall, we reduced our portfolio risk beginning in the fourth quarter of 2021. This included shortening the fixed income duration from 4.6 years to three years through the sale of bonds and use of derivatives, which resulted in a reduction to the portfolio's sensitivity to higher interest rates caused by increasing inflation. We also reduced our exposure to recession-sensitive assets through the sales of high-yield bonds, bank loans and public equity. We maintained this defensive positioning in the third quarter, which continued to preserve portfolio value given ongoing market volatility, rising interest rates and a further decline in public equity markets. As shown in the table, at the bottom left, our total return for the quarter was negative 0.8% and year-to-date is negative 6.4%, while adverse market conditions negatively impacted the portfolio, we estimate our duration shortening mitigated portfolio losses of approximately $2 billion. These proactive actions and the broad diversification of our portfolio produced results that were better than the S&P 500 index which is down 23.9% this year and the Bloomberg Intermediate corporate bond index, which has declined 11.8%. Our net investment income, shown in the chart on the left, totaled $690 million in the quarter, which was $74 million below the third quarter of last year. Performance-based income of $335 million shown in dark blue, was $102 million below a strong quarter in 2021. Three individual investments generated approximately 97% of the performance-based investment income in the quarter, including two sizable cash realizations. Excluding those assets, results of the broader performance-based portfolio were largely flat with negative valuations in our private equity fund investments, which have a higher correlation to public equity markets, offset by increased valuations on other asset classes such as real estate and infrastructure. Our market-based income, which is shown in blue, was $50 million above the prior year quarter, benefiting from reinvestment into market yields that are significantly higher than the overall portfolio's current yield. The table on the right demonstrates how our shorter duration fixed income portfolio is positioned to generate higher levels of investment income as we reinvest into higher interest rates. Our fixed income yield has begun to rise and was 2.9% at quarter end, but is well below the current intermediate corporate bond yield of 5.6%. Now let's take a few minutes to discuss Allstate's financial condition and capital position, starting with Slide 17. Allstate's corporate organizational structure provides sources of capital to the holding company from multiple reporting entities and intermediate holding companies. We manage capital at all levels using economic capital, rating agency models and regulatory requirements to guide decisions and maximize flexibility. We commonly report a view of capital that includes both statutory surplus and parent company -- parent holding company assets. We prefer to dividend money up from subsidiaries to the holding company when possible as it provides more financial flexibility for the organization while maintaining adequate capital levels from subsidiaries to support operations. The chart on the left shows an overview of our capital position since 2016. As you can see, it grew substantially beginning in 2019 following strong results leading up to and during the pandemic. While the current level of $19.8 billion is approximately $6 billion lower than a year ago, this was largely made up of two specific items. First, $3 billion or roughly half is related to the sale of the Life and Annuity business, as represented by the first red bar on the chart. This transaction reduced our statutory capital as we sold the legal entities and significantly reduced our overall risk profile, freeing up an additional $1.7 billion of capital. We returned this capital to shareholders as part of the current $5 billion share repurchase authorization. The second bar reflects our cash returns to shareholders, excluding the impact of the life and annuity sale. Together, these factors reduced capital by $5.4 billion with more than $4 billion going back to shareholders. The last red bar primarily reflects the impact of current auto insurance profitability challenges, which have resulted in a statutory loss and then changes in unrealized gains and losses on equity investments due to recent market volatility. We also added a line to this chart that represents our average capital from year-end 2016 through Q3 of 2021, excluding surplus related to the life and annuity businesses. Our current capital position of $19.8 billion is approximately $1 billion higher than this average, demonstrating that returning cash to shareholders after adjusting our risk profile in recent years of profitability has left us in a strong capital position. The right-hand side of this page isolates holding company assets, a key component of our capital relative to the remaining authorized repurchases and fixed charges. At the end of the third quarter, we had $4.5 billion in holding company assets with $1.2 billion remaining on the current share repurchase authorization, we would still have $3.3 billion remaining in comparison to our annual fixed charges of $1.3 billion. We believe holding company assets and capital resources available from statutory operating companies provide significant financial flexibility as we continue to implement profit improvement actions and invest in transformative growth. Now let's move to Slide 18 to discuss Allstate's strong cash return to shareholders. Adjusted net income return on equity of 4.3% was below the prior year, primarily due to lower underwriting income. Achieving our targeted combined ratios for auto and homeowners insurance will bring adjusted net income returns on equity back to our long-term targeted range of 14% to 17%. Through the first three quarters of 2022, we've returned $2.8 billion to shareholders through $2.1 billion in share repurchases and $698 million in common shareholder dividends. Over the last year, shares outstanding have been reduced by 7.7%, providing more upside per share as profitability has improved. There's $1.2 billion remaining on the current $5 billion share repurchase authorization as of September 30, which we expect to be completed in the second or third quarter of 2023 and as we moderately slow the pace of our repurchases. With that context, we're going to open up the line for your questions."
},
{
"speaker": "Operator",
"text": "[Operator Instructions] Our first question comes from the line of Greg Peters from Raymond."
},
{
"speaker": "Charles Peters",
"text": "I'm going to focus the first question on reserves. And I was looking at the information you provided on Slide 12 and some of the earlier slides. And I guess what we're trying to do is reconcile the charge that you took in the third quarter with the information we're getting from some of your peers? And then additionally, trying to understand why the data that you're showing now here for the third quarter results, so you can start to see it in the second quarter and make adjustments then. And I mean it's a long-winded question, but ultimately, we're trying to get at is there a risk of additional reserve charges going forward?"
},
{
"speaker": "Thomas Wilson",
"text": "Greg, thank you for your question. Let me provide just a quick overview, and then Jesse can give you some more specifics. First, of course, obviously, we estimate the what's going to happen that depends on trends for the numbers. And we can't make a comment as to what other people's numbers look. People do reserving all sorts of different ways. And we believe ours is highly precise, specific, and we have external people look at it, and we put up the numbers when we think we need to put them up. And of course, this quarter, we did increase it for prior years and that's largely due to the injury trends that just saw, which have really been unfolding over the last couple of years. And these are claims that take 4 years before you get 80% paid. It takes a while before it developed. Jesse what would -- how do you want to address that?"
},
{
"speaker": "Jess Merten",
"text": "Yes. Thanks, Tom. Greg, what I would start with is, I think it's important to be clear on one thing. At the end of every quarter, we record reserves at an appropriate level based on all the information that we have in front of us. We did that at the end of Q3 and every quarter leading up to Q3. We followed the same process that we have in the past. It's a rigorous process. It leverages internal actuarial expertise, close collaboration with our claims team and third-party reviews to analyze the most current data and assess the impact on that data on our reserves. . As I look at the quarter, the variability that we've seen continue to come through in the data that we reviewed as part of our actual process. So Q3 data supported more recent trends and continued variability in reserve development. And while these trends weren't new, an additional quarter of data did provide new insights into the persistent nature of the trends that have been emerging. So insights from actual claims development in the quarter, led us to strengthen both prior year reserves and increase our report year 2022 ultimate severities. So as I take a step back and think about where we're at from a reserve perspective, we record appropriate reserves based on what we know at the time. We used current data and all known factors to establish the reserves. So I'm confident in what we set up. And I think that the new insights that we cleaned in Q3 caused us to make the move."
},
{
"speaker": "Charles Peters",
"text": "Okay, makes sense. I guess my follow-up question is on capital. And just looking at it from a macro perspective, I really don't remember in recent history, a time where you guys have been growing your top line almost at a double-digit rate. And that by itself puts pressure on capital resources. And then if we look at your capital position outlined in the statistical supplement, and we see total capital resources having declined year-over-year due to a variety of issues. Just wondering if you can help frame how we should think about traditional metrics around premiums to surplus in the context of all the different moving parts?"
},
{
"speaker": "Thomas Wilson",
"text": "I'll start and then Jesse can add as well. So Greg, first, we don't use the traditional -- when we look at the traditional metrics like premium surplus and as we go, but we're much more sophisticated than that. And it goes -- in the way we allocate capital is from an enterprise standpoint and looks at specificity on risk levels down to the state-based level by line. So for example, some people would blend their premium to surplus ratio for all property liability products, auto and home at the same. We don't do that. We think capital is much higher for homeowners insurance. And that's why when Mario went through our target ratios for home insurance, they're lower than they are for auto insurance. Other people just assume that same. So we're much -- we're very sophisticated in the way we do it. We manage it from an enterprise standpoint. So when we -- the answer would be we have plenty of capital, like we've got tons of money, and it's not going to do anything to our strategy. It has no impact on our future earnings power, which is, of course, what drives the company. And we're in the middle of a massive share repurchase program, and we don't feel like we have to back off on it based on what we know about our business at the granular level. So we feel very good about where we're at. We've generated good returns for shareholders by doing it that way. And so there's really -- I feel like using broad measures like that doesn't really reflect the economic reality that we're managing to. Jesse, where would you go from there?"
},
{
"speaker": "Jess Merten",
"text": "That's a pretty complete answer, Tom. But I think the important point is that the proactive capital management that really relies on our robust economic capital approach, which looks at risk on a granular basis and takes that information to understand capital needs in an enterprise level. Premium surplus only looks at one dimension of risk and capital, and we use a more complete set of measures and metrics to establish capital levels, as Tom laid out. So I just think it's important. We're cognizant of and we monitor regulatory capital requirements, rating agency capital benchmarks, all in our proactive capital management process. But I feel the same way that Tom does it that we certainly have plenty of money to execute on our strategies and continue to implement our profit improvement plan. So nothing more to add, Tom."
},
{
"speaker": "Operator",
"text": "And our next question comes from the line of Elyse Greenspan from Wells Fargo."
},
{
"speaker": "Elyse Greenspan",
"text": "My first question is on the capital side of things. So as you guys came to the decision, I guess, to more moderate your buyback, are you assuming that there's any dividends that you're going to take out of Allstate Insurance company over the next year? And then within that question, I guess, did you guys think about pausing the buyback program completely just to have more capital flexibility within that subsidiary?"
},
{
"speaker": "Thomas Wilson",
"text": "Elyse, let me answer that and Jesse can jump in. First, in terms of the dividends, we move -- first, we make sure that each of the insurance subsidiaries that large ones are appropriately capitalized based on what we think economic capital is just that with the rating agencies, whether it's an investor, others, think we should have in those and then what regulators want. So -- and we're really well capitalized at those. To the extent there is extra capital in those, we then move that out of the insurance companies into the holding company is just point out because that gives us more flexibility. As we look forward next year, it will depend how much money we make. I think in some of the announcements, like we have really strong earnings power and when you look at our profitability of our auto insurance, we think it's headed up. So we think there's plenty of earnings power. Whether that and where we think risk is and what we need to do with risk will depend on the overall enterprise risk portfolio. So for example, not covered in some of these things, we dialled down the risk for our investment portfolio late last year as a percentage of our total enterprise capital because we didn't think it was a good risk return trade-off. So we're constantly managing where do we want to move capital where do we want to make sure we get a good return on it. So we don't feel like we are capital constrained at all. Did we consider shutting the program down in total? No. We think we have plenty of moments of $5 billion of massive share repurchase program, a large 4 of which a portion of which was funded because we sold the life insurance company. and we said we should get that money back to the cat shareholders. So we have a historical track record of doing this extremely well. We're a top decile amongst the S&P of providing cash returns to shareholders. And we do that without putting our customers at risk of the company is. So we feel like we're in really good shape."
},
{
"speaker": "Elyse Greenspan",
"text": "Okay. And then my follow-up, I guess, would be right. You talked about that you don't manage your premium to surplus, but I know one of your peers has mentioned looking to write their all business to a 3:1 home to 1.5:1. So I'm not sure if you have frames of references that you look at for your businesses? And then if rating agencies and regulators, what are they looking at? Are they holding you to a 3:1? Or is there other metrics that they're holding you to relative to premium to surplus or something else?"
},
{
"speaker": "Thomas Wilson",
"text": "We've had -- essentially to say, from certainly my standpoint, no conversations with regulators about our cap levels because we're so well capitalized -- I might start there. And that's been true forever and it will be true far into the future. And so the regulators really were so far above their standards. It's not really been a conversation. I can't speak to how other people look at their premium surplus ratio. I think some of our competitors who don't make money in homeowners should have even more than we do. Because when you look at your capital it's -- okay, what do we think the risk is? What is the risk of loss. But you also want to factor in your earnings power. And so if you're losing $0.10 on a dollar, on a line of business, then you have to hold more capital than if you're making $0.10 on the line of business. So I think it's all very idiosyncratic to a specific company. . We factor all of those things in by state really and even sometimes looking down at different components of the state to decide what price we should get per customer from customers, how much business we want to write and then how much capital we have to keep in the company. So I feel very good about where we're at."
},
{
"speaker": "Operator",
"text": "And our next question comes from the line of Brian Meredith from UBS."
},
{
"speaker": "Brian Meredith",
"text": "A couple of them here for you. First, Tom, I'm just curious, this is the, I think, first quarter a little while that we've seen auto PIF actually declined somewhat sequentially. Is that due to some of the actions you're taking in California? Or is it just in general, the price increases you're taking should we expect the PIFs to kind of decline here for a couple of quarters."
},
{
"speaker": "Thomas Wilson",
"text": "Well, the PIF decline was, of course, in the Allstate brand versus in total because we went up in the independent agent channel, but it's intentional. And I would tell you that it's actually the decline was less than we thought it would be. When you look at historical price sensitivities on what your customer retention is, our retention is held up better than you would think from historical trends. It's hard to do attribution down to the specific item, but when you look at it, we'd say, first, the competitive position -- our competitors are also raising rates. So as we raise rates, we thought more people would leave, but less did. It could be because our competitors are also raising rates. Consumers still have a fair amount of cash in their bank accounts, so that helps. They also know that their houses and cars are worth more. So it makes sense to them that they should have to pay more for insurance, when explained to them. And I think that's the value of our Allstate agents at this point. they're out working hard to make sure our customers understand why the prices are going up. And then as Mario mentioned, they'll help them work to figure out how do they get the right price. So this is a case where like our mile-wise product is really helpful for people because if you're, say your senior citizen, you don't drive much and you should go to Milewise and save a bunch of money by not paying more. So when you look through all those together, we expected our auto PIF to go down more in the Allstate brand than it did. But we're happy that we're keeping the customers because with the price increases we've put through that will be good shareholder value creation when we start earning the rates."
},
{
"speaker": "Brian Meredith",
"text": "Great. That's helpful. And then my next question, I'm just curious, and I think this question will be asked in prior quarters, but when you're pricing your auto insurance and homeowners insurance now, what type of loss trend are you expecting in the future expecting inflationary trends to moderate here? Or do you think they're going to stay relatively high here for a while?"
},
{
"speaker": "Thomas Wilson",
"text": "Mario, will you take that?"
},
{
"speaker": "Mario Rizzo",
"text": "Yes, sure. Brian. Yes, I think, Brian, in terms of what we're seeing, we're factoring in, obviously, the inflation we're experiencing currently, but also projecting it going forward so that we can reflect the full cost of loss costs prospectively into our prices. And so yes, we're not making any kind of significant assumptions around a deceleration in inflation going forward given the current inflationary environment, that's why we made the statement that we expect to continue to take rate increases certainly for the balance of this year but into next year, and that's really a reflection of the environment we're operating right now and the continued elevated level of inflation, which we need to kind of catch up with and then surpass going forward. So we're not assuming, as I said, any significant reduction in inflationary trends going forward."
},
{
"speaker": "Operator",
"text": "And our next question comes from the line of Tracy Benguigui from Barclays."
},
{
"speaker": "Tracy Benguigui",
"text": "All right. So used ask this question for casualty line writers. Given the consecutive adverse reserve development charges, have you worked with any external actuaries to review reserves? And if so, what is your management estimate relative to central estimates?"
},
{
"speaker": "Thomas Wilson",
"text": "Tracy, we always work with external people and looking at our reserves. So we obviously have Deloitte & Touche to our auditors, but we also have an external actuary in called -- which is KPMG, which provides the statutory reports for our regulators. We look at all of their stuff. We just had a detailed review with Deloitte & Touche a couple of weeks ago, and their view ties closely to ours. ."
},
{
"speaker": "Tracy Benguigui",
"text": "Do you have a management estimate above the central estimate at the moment? Or is it closer to the central?"
},
{
"speaker": "Thomas Wilson",
"text": "We don't put ranges in the financials. We put up what we -- as Jesse said, like we put up what we think the future liability is and we pick a number, and that's where we do it. And we're comfortable with the number and that number is very close to what our external participants or external health thinks and thought historically, by the way. So it isn't like we were in -- we built a very similar views at the end of the second quarter, end of the first quarter and end of the third quarter, and they are -- they believe that the actions we've taken are appropriate."
},
{
"speaker": "Tracy Benguigui",
"text": "Got it. And just going back to capital management, given you manage capital more efficiently at the OpCo level and the way you like to hold cash at the holdco level if you could flex that up and down. I'm just curious, when was the last time you downstream capital to the operating company. How do you lever often."
},
{
"speaker": "Thomas Wilson",
"text": "It's a good question. I don't remember certainly in the last decade, I don't remember having done that at all from -- down to the Allstate insurance company. Would we move money into the health and benefits companies because they were growing or do we have to -- so we do move money around. But if you said if you really talk about Allstate insurance company as the largest business we have, I don't remember anything in the last 10 years. But Jesse or Mario, do you have any other perspective on that?"
},
{
"speaker": "Jess Merten",
"text": "I don't have anything more than that. I think we did move some capital down into the Life company. at 1 point, Tom. But I think that certainly is no longer an issue, but that's the last thing that I remember. Mario? ."
},
{
"speaker": "Mario Rizzo",
"text": "Yes, I would concur the last time I remember any meaningful movement of capital down into an operating company. would have been during the financial crisis, which obviously was a while ago. But as Tom mentioned, we moved capital around but nothing in terms of shortfalls within any of the insurance companies."
},
{
"speaker": "Tracy Benguigui",
"text": "Right. but I'm not thinking about this the right way where you have capital at the parent company that you could flex it up and down in your slide when you talk about your fixed charges, is there a multiple that you want to keep like 2x minimum level?"
},
{
"speaker": "Thomas Wilson",
"text": "We don't manage it that way. I just showed the level of cash we would have after we used deployable capital to finish the share repurchase program, you can see it's still well above our fixed charges, which we intentionally managed to keep at a modest level, which is even though we increased the dividend by about 50% a year ago, we tried to give a lot of money back to shareholders through share repurchases. So we don't have a multiple -- if you had a multiple and you also have to factor in how much money you're going to make over the next 12 months. And obviously, our fixed charge coverages historically have been terrific. So we don't have a -- like don't go below this because we've never even been close."
},
{
"speaker": "Operator",
"text": "And our next question comes from the line of David Motemaden from Evercore ISI."
},
{
"speaker": "David Motemaden",
"text": "I think it was Jesse, who spoke about just the mix shift that you're experiencing on the BI claims side to more expensive claims. And as part of the reserving process, you weight both historical and more recent trends in the claim development patterns in the data. So I guess I'm wondering after the changes that you've made this quarter, are you -- I guess, how much are you waiting more recent experience? Is it 100% weight on these trends that you're seeing? Or is there still some weight being placed on more historical experience?"
},
{
"speaker": "Thomas Wilson",
"text": "David, let me answer that, and Jesse, you can add anything else to it. So first, the reserving process uses all types of statistical analysis, triangles, link ratios, all sorts of different things. So there's no real like just 1 percentage. I think we look at it by state, by line of business, by coverage. And so it's slice and dice a whole bunch of way. So there's no really simple way to answer that. I think what I would say about you're trying to get comfortable with the reserves. It really starts -- you got to go back to say, well, what's happening in the world. And during the pandemic, we noticed when people weren't on the roads, people were driving a lot faster because there is -- they could zip around and there was no traffic and off they went. Once we get through the pandemic, at least in our data, we see people still driving pretty fast, but as a result of that, you have more severe accidents, and that trend appears to be holding. We thought that, that trend might come down because when the little ones are sort of bumps in scratches and stuff, which happen in congested traffic. Today, those, as you saw from Jesse's numbers have not gone back up and the major ones have not gone down. So people are just driving faster and hurting people more. So you have to figure out, okay, well, what are you going to do take care of it. Those are really complicated cases. I mean people have surgery, they have all kinds of services, and those services are more expensive, and they take longer to develop. So if you really severely injured, it could take 6 months, nine months, two years before you really figure out how you get back to where you should be, and it costs a lot of money and takes a lot of time. And so those cases develop over a longer period of time. So it isn't so much that it's just -- we use the same process as procedures, but as these things develop, it really comes back to -- our customers are just in a lot more severe actions and people are getting hurt, and we need to make sure we have the liability up to cover that. And that's what we did this quarter. So we said, okay, this is really continuing. Most of these are still severe. And as they develop, then you have to put the money up."
},
{
"speaker": "David Motemaden",
"text": "Got it. Okay. So it sounds like you had assumed that the mix which normalize somewhat away from some of these more severe accidents, and I guess now the assumption is that there is going to be no mix away from these more severe accidents and that's sort of the new normal. Is that correct?"
},
{
"speaker": "Thomas Wilson",
"text": "Yes. But it's not just 1 item, I would say. So you can't pin it on just those now more majors. There's more majors. The majors are harder to estimate. They're taking longer to settle. There's more legal costs associated with settling those, and so you have to factor that in. So there's a whole bunch of factors that relate to it. So we look at it. We're comfortable we've put up the right amount of money. And what other companies do and what they're reserving are -- some people use less specific processes that we do, some processes react faster or slower to trends in the marketplace. But the important thing is we use the same process is have external views, and we all think this is the right amount of money."
},
{
"speaker": "David Motemaden",
"text": "Got it. Okay. And then maybe just a quick numbers follow-up here. So see that you guys are now assuming a bodily injury severity of 12%, I guess I'm just wondering what was the report year incurred severity on bodily injury for 2021 after the changes that you've made?"
},
{
"speaker": "Thomas Wilson",
"text": "We have not broken out the reserve -- after the reserve changes by prior years. We won't break those out until we publish the 10-K. I mean, is that right -- correct, Jess?"
},
{
"speaker": "Jess Merten",
"text": "That's right, Tom. We don't disclose the split, so we don't have that."
},
{
"speaker": "Thomas Wilson",
"text": "But suffice it to say, David, that is higher than it was before."
},
{
"speaker": "David Motemaden",
"text": "Yes. I was looking at a -- I'm just trying to get a sense for the compound if we say, okay, up 12%, but the base does matter. And so I think the base was set at 5% in the first quarter for all of 2021, which has since been changed. So I was just trying to get a sense for where that's gone. But I guess I'll look in the K for that."
},
{
"speaker": "Thomas Wilson",
"text": "Why don't we take 1 more question and then..."
},
{
"speaker": "Operator",
"text": "Our final question comes from the line of Yaron Kinar from Jefferies."
},
{
"speaker": "Yaron Kinar",
"text": "I'm going to go to my specialty of beating dead horses here, if I can. On capital, do you expect to deploy some of the hold liquidity into AIC over the coming year?"
},
{
"speaker": "Thomas Wilson",
"text": "No."
},
{
"speaker": "Yaron Kinar",
"text": "Okay. And then shifting more just to the auto and home side. So I think you guys shifted the exclusive agent comp structure to be more weighted to new business. Now that you're kind of maybe taking a little bit of a step back on growth and really focusing more on fixing the margins, how is that playing out with the agent comp structure with your conversations with them? I'm assuming that can be a little bit of murmurings and rumblings around that. How are you handling that?"
},
{
"speaker": "Thomas Wilson",
"text": "Well, I'm address embedded in all of this, there's a lot of good news on transformative growth that we really don't have a chance to talk about it. One is that which you talked about, which was expanding customer access is the second key lever. And that included selling direct under the Allstate brand at 7% less than it was sold through Allstate agents. And there was some concern amongst investors as to would the agents walk away and would you have a decline in volume there? And the answer is no. That is the underlying assumption that they would continue to be focused on getting more new customers given what we did to the compensation plan was true. . If you look at new business from the Allstate agents, you can see that's where it was a year ago, even though there are fewer Allstate agents out there. And then if you look at the retention numbers, as I mentioned, I think our agents are doing a great job for us talking to customers whose price changes. And so we feel good that, that part of the expanding access, all of our underlying assumptions prove to. We also have really improved our web-based and the call center close processes. So we're getting much better at selling through those two vehicles. We obviously dialled the advertising way down this year because we don't want to take on new business and then have to raise the price 15% or 20% the first time. So while you don't see the benefit of those improved processes come through new business, but when we get auto profitability improved, we feel good about the underlying assumptions we made in transformative growth and our progress in making those realities. So we're feeling good about where that's headed."
},
{
"speaker": "Thomas Wilson",
"text": "So thank you all for dialing in. As we move forward, we have a couple of things in front of us. One, we have to improve auto insurance margins, while making sure we continue to invest and transform the growth so that we can grow market share and then continuing to expand our other protection services businesses, which also had a great quarter. So thank you and we will talk to you in December."
},
{
"speaker": "Operator",
"text": "Thank you, ladies and gentlemen, for your participation in today's conference. This does conclude the program. You may now disconnect at today's conference."
}
] | The Allstate Corporation | 18,711 |
ALL | 2 | 2,022 | 2022-08-04 09:00:00 | Operator: Thank you for standing by, and welcome to the Allstate Second Quarter 2022 Earnings Conference Call. [Operator Instructions]. And now I'd like to introduce your host for today's program, Mark Nogal, Head of Investor Relations. Please go ahead, sir.
Mark Nogal: Thank you, Jonathan. Good morning. Welcome to Allstate's Second Quarter 2022 Earnings Conference Call. After prepared remarks, we will have a question-and-answer session. Yesterday, following the close of the market, we issued our news release and investor supplement, filed our 10-Q and posted today's presentation on our website at allstateinvestors.com. Our management team is here to provide perspective on these results. As noted on the first slide of the presentation, our discussion will contain non-GAAP measures, for which there are reconciliations in the news release and investor supplement and forward-looking statements about Allstate's operations. Allstate's results may differ materially from these statements, so please refer to our 10-K for 2021 and other public documents for information on potential risks. Additionally, we will be hosting our next special topic investor call on September 1, focusing on Allstate's investment strategy. Now I'll turn it over to Tom.
Thomas Wilson: Well, good morning. Thank you for investing your time with Allstate today. Let's start on Slide 2. So Allstate's strategy to increase shareholder value has 2 components: increase personal property-liability market share and expand Protection services, which are shown in the 2 ovals on the left. We're building a low-cost digital insurer with broad distribution we transformed the growth. We're also diversifying our business by expanding protection offers and by leveraging the Allstate brand, customer base capabilities and expanding distribution. On the panel on the right, in the second quarter, we made progress executing this strategy, while we continue to implement a comprehensive strategy to improve profitability. That includes broadly raising auto and home insurance rates. In the second half of 2022, we plan to file for rate increases in excess of the increases implemented in the first half of this year, which were 6.1% of Allstate brand countrywide premiums. We're also reducing expenses on advertising and growth investments. Underwriting guidelines have been and will be changed to reduce new business volume, where we're not earning adequate returns. And we're also executing claims operating actions to manage loss cost in a high inflationary environment. These actions will likely have a negative impact on policy growth. And now while the current environment requires a huge focus on margin improvement, we continue to advance our transformative growth strategy where profitability -- when profitability levels are acceptable we'll have a business model to capture market share. The Protection Services businesses are generating profitable growth, although earnings declined slightly this quarter as we invest in that growth. Given the negative impact of inflation on the auto insurance business, as you know, beginning late last year, we reduced the bond portfolio duration to lower exposure to higher interest rates, which helped mitigate the reduction in bond valuations by approximately $1.3 billion in the first half of 2022. Our strong capital position enabled us to maintain high cash returns to shareholders in this environment. Moving to Slide 3, let's review second quarter performance in more detail. Total revenues decreased 3.4% in the prior year quarter, despite property liability premiums earned increasing 8.6%, which reflected higher average premiums and policy growth. Higher loss costs in the current report year and upward loss reserve development of $411 million in the prior report years resulted in a property liability recorded combined ratio of 107.9 in the second quarter. Net investment income of $562 million was 42% below the prior year quarter since performance-based income was exceptional in the prior year. Net losses on investments and derivatives were $733 million in the quarter as lower valuations and equity investments and losses on fixed income sales, which were only partially offset by the derivative gains associated with the bond portfolio duration shortening. The combination of these factors led to a net loss of $1.4 billion in the second quarter and an adjusted net loss of $209 million or $0.76 per diluted share. The adjusted net income return on equity was 6.9% over the last 12 months, which is obviously unacceptable from our standpoint. It's substantially below the levels we achieved at this time last year, but we remain committed to achieving our long-term returns on equity of between 14% and 17%. Now let me turn it over to Glenn to talk -- walk through our property liability results in more detail.
Glenn Shapiro: Thank you, Tom. Let's start by reviewing underwriting profitability on Slide 4. The underwriting results reflect the high level of inflation, which is increasing severity leading to an underlying combined ratio of 93.4 for the second quarter and a recorded combined ratio of 107.9, which is shown in the chart on the left. The chart on the right compares last year's recorded combined ratio of 95.7 to this year's second quarter. A higher auto insurance underlying loss ratio drove 8.6 of the 12.2 point increase as claims severity has been increasing faster than earned rate increases. The other large negative impact was from prior year reserve strengthening this quarter, which I'll cover in a few minutes. The one positive impact on there was the 1.7 points from expense reductions. Let's move to Slide 5 and talk about profitability and rising loss costs in more detail. As you know, we have a target combined ratio for auto insurance in the mid-90s. And you can see on the chart, which shows the combined ratio by year and then the first 2 quarters of this year, that we have a long history of meeting or exceeding those targets, which is supported by our pricing sophistication, underwriting, claims expertise and expense management. Now in there, you'll see 2020 was an outlier because we had much better than target results than due to some of the early pandemic frequency impacts. And as we move from that environment to the high inflationary environment we're in today, incurred claims severities increased the underlying auto combined ratio of 102.1 for the quarter and 100.5 year-to-date. Auto non-catastrophe prior year reserve strengthening in the second quarter totaled $275 million, which is primarily physical damage and injury coverages. The most significant impact, though, on the combined ratio was report year incurred severity for collision, property damage and bodily injury claims, which increased by 16%, 12% and 9%, respectively, over the average of the full year 2021 incurred. Because the costs were rising rapidly during 2021, the quarter-to-quarter increase comparison is even greater. And frequency also went up about 5 to 7 points, but it's still well below pre-pandemic levels. So let's go to Slide 6, and we'll go deeper into the prior year physical damage for reserve development. The chart on the left shows used car values. They began to rise in 2020. And if you go back looking from the beginning of 2019 to current, used car prices have gone up more than 60% and continue to stay at an elevated level. At the same time, OEM parts and labor rates have increased during the first half of this year, which causes severity increases for coverages like collision and property damage. Now we anticipated that those trends and the delays that are taking cars a long time to be repaired right now would increase the amount of claim payments we made on 2021 losses after the end of the year, even though these are relatively short-duration claims. The chart on the right shows gross paid losses for physical damage coverages for the 6 months after the end of the calendar year. Now our expectation for paid losses for 2021 claims from months 13 to 18 was that it would be about $1.25 billion, which you can see from the chart is about 40% above the prior year. You can see that from the dash line on the far right bar compared to the bars to the left of it. But at the end of the second quarter, the actual paid losses were $1.48 billion, which exceeded even our higher estimate by $230 million and is a large driver of the prior year reserve increases. All other non-catastrophe prior year development, primarily from injury, commercial auto and homeowners, totaled $268 million in the quarter. Let's go to Slide 7 and discuss how higher auto insurance rates have been and will be implemented to improve profitability. Since the beginning of the year, we've implemented broad rate increases across the country, as shown on the map, at 9 states where we had increases over 10%, and auto rates have been increased in 48 locations, inclusive of Canadian provinces. Those rate increases are expected to increase Allstate brand annualized written premium by 6.1%. Now we have not been able to get adequate rate in New York or any increase in rate in California. New York represents about 9% of our auto premium. And the implemented rate there was, we leveraged the annual flex filings process there. And it gave us less than 5% rate in our current indicated indication there is significantly higher than that to get to an adequate return. Similarly, in California, which represents about 12% of our auto premium, we recently filed in the second quarter, a 6.9% increase, which again is significantly below the overall rate need there. In states markets, risk segments or channels where we cannot achieve an adequate price for the risk, we're implementing more restrictive underwriting actions and reducing new business as needed until adequate levels of rate are approved. Let's move to Slide 8, and we'll look at how these rate increases are impacting and will impact the combined ratio for auto insurance. What you see here illustrates our path to target profitability, along with the magnitude of actions we've already taken and what's required prospectively. Starting on the left. Through the first 6 months of the year, our auto insurance recorded combined ratio is 105, and that's shown in the blue bar. To start with, we normalized that by removing the impact of prior year reserve increases and going to a 5-year average on catastrophe losses, that improves the combined ratio by 2.5 points represented by the first green bar. The second green bar reflects the estimated impact of rate actions already implemented when fully earned into premium. So these are already implemented actions that are in market and renewing on policies. They total an additional $1.7 billion of effective premium across Allstate and national general brands. Those will be earned over the coming quarters and fully earned by the end of 2023. Now of course, loss costs will continue to increase, whether it's inflationary impacts on severity or higher frequency, which would increase the combined ratio from what I just described there. So prospective rate increases must exceed the loss cost increases that come to achieve our target returns. Now everything I just described, combined with our non-rate actions such as reducing new business and expenses, gives us a track where we expect to achieve our target combined ratio in the mid-90s in auto insurance. Now the timing of that will be largely dependent on the relative increases and pace of these increases in premium and loss costs. So on Page 9, we'll take a look again at our industry-leading homeowners business. As you know, a significant portion of our customers, bundle home and auto insurance, and that improves the retention and the overall economics of both products. We have a differentiated ecosystem in homeowners. That includes a differentiated product, underwriting, reinsurance, claim capabilities, and we discussed a lot of those capabilities in our last special topic call. Our long-term underwriting results show the strength of the system. Our 5-year average reported combined ratio is 91.9, as shown in the chart on the left. And that produced $3.3 billion of underwriting profit since 2017, while the industry lost over $20 billion in that same period. Now our second quarter combined ratio and most second quarter combined ratios have historically been higher than full year results, primarily due to catastrophes. And second quarter this year was at 106.9, which reflected again higher catastrophes and 1.7 points of unfavorable non-catastrophe prior year reserve estimates. Our year-to-date recorded combined ratio for home is 95.8. Now homeowners insurance is certainly not immune to the inflationary environment we're in, and we continue to see increases in labor and material costs. To combat that, our product has sophisticated pricing features that respond to changes in replacement values, and we've taken rate. If you see on the chart on the right that shows some of the key Allstate brand homeowners operating statistics, we've grown net written premium by 15.2% from the prior year. And that's on a policy base that we grew of 1.2% in the second quarter, where our Allstate agents remain in a really good position to broaden customer relationships. So as you've heard me say several times and certainly in our last special topic call, we're really well positioned at homeowners to not only maintain the competitive advantage we have, but to grow that line of business. And with that, I'd like to turn it over to Mario.
Mario Rizzo: Thanks, Glenn. As Tom mentioned, while we are improving profitability, we also continue to invest in the core components of the transformative growth strategy to increase market share in the personal property-liability business. Slide 10 is the flywheel of growth that we have discussed on earlier calls. Transformative growth is a multiyear initiative designed to increase personal property-liability market share by building a low-cost digital insurer with broad distribution. I won't get into all the pieces today, but I want to highlight 2 specific items: first, we remain committed to achieving our adjusted expense ratio goal of 23 by year-end 2024, which represents a 6-point improvement compared to year-end 2018; secondly, in the quarter, we launched beta versions of a new fully digital auto insurance product and sales experience made possible with new technology for relationship initiation and product delivery. Building these foundational elements will enable us to scale growth when adequate insurance pricing is a tank. At the same time, the Protection Services businesses, in the lower strategic oval, are growing and increasing shareholder value, as shown on Slide 11. Revenues, excluding the impact of net gains and losses on investments and derivatives, increased 8.3% to $629 million in the quarter, primarily driven by Allstate Protection Plans. Adjusted net income of $43 million for the second quarter of 2022 decreased $13 million compared to the prior year quarter as ongoing investments and growth are being made to position these businesses for future success. Policies in force did decrease by 1.6%, reflecting expiring Protection Plan warranties and lower retail sales compared to the favorable environment in the prior year quarter. Moving to Slide 12. Allstate Health and Benefits is also growing. It is also growing an attractive set of businesses that protect millions of policyholders. The acquisition of National General in 2021 added both group and individual health products to our portfolio, as you can see on the left. Revenues of $574 million in the second quarter of 2022 increased to 4.6% for the prior year quarter, driven primarily by growth in group and individual health businesses. Adjusted net income of $65 million increased $3 million from the prior year quarter, driven by increased revenue, which was partially offset by a higher benefit ratio, primarily in individual health. Now let's shift to investments on Slide 13 to review investment performance and the portfolio risk and return position we have taken given higher inflation and the possibility of a recession. Net investment income totaled $562 million in the quarter, which is $412 million below the prior year quarter, as shown in the chart on the left. Market-based income, shown in blue, was $13 million above the prior year quarter, reflecting an increase in the fixed income portfolio yields, which are now benefiting from investing in yields that are higher than the overall portfolio's current yield. Performance-based income of $236 million, shown in dark blue, was $413 million below with an exceptional quarter in 2021. The performance-based internal rate of return over the last 12 months was 24.6%, which remains above our long-term return expectations. The performance-based portfolio includes private equity as well as a mix of other asset types such as real estate and infrastructure, which diversify our performance in this segment. In the second quarter, real estate investments had strong performance, including gains on asset sales, while private equity results were lower. As a reminder, our performance-based results are reported based on a 1 quarter lag, so second quarter results reflect March 31 sponsored financial statements, and future returns will reflect market and economic conditions from the prior quarter. The total portfolio return was negative 2.8% for the quarter and negative 5.6% year-to-date due to higher interest rates and credit spreads, lowering the market value of bonds and a decline in public equity valuations. While these market conditions negatively impacted the market value of the portfolio, it continues to generate operating income. And because of proactive portfolio actions, the results are better than the broad indices with the S&P 500 Index 20% lower and the Bloomberg U.S. Aggregate Bond Index 10% lower. The chart on the right illustrates the shift in risk positioning we have executed to protect portfolio value and position us to take advantage of opportunities as conditions evolve. We reduced interest rate risk towards the end of 2021 and into the first quarter through the sale of longer-duration bonds and the use of derivatives. The portfolio duration is shorter than our long-term targets, which has mitigated the negative impact of higher market rates by approximately $1.3 billion this year. With recession concerns rising, the exposure to recession risk-sensitive assets was also reduced through sales of high-yield bonds, bank loans and public equity. These sales were largely executed prior to the most significant credit spread widening and equity market decline for the end of the quarter, further preserving portfolio value. Now let's move to Slide 14 to discuss Allstate's strong cash returns to shareholders of $1.9 billion in the first 2 quarters. Over the last year, shares outstanding have been reduced by 8.7%, providing more upside per share as profitability has improved. In addition, there is another $1.8 billion remaining on the current $5 billion share repurchase authorization. Adjusted net income return on equity of 6.9% was below the prior year period, primarily due to lower underwriting income. Achieving our target combined ratios for both auto and homeowners insurance will bring adjusted net income returns on equity back to our long-term target range of 14% to 17%. With that context, let's open up the line for questions.
Operator: [Operator Instructions]. And our first question comes from the line of Greg Peters from Raymond James.
Charles Peters: I would like to go back to Slide 8 for my first question. And I guess the 2 areas that caught my attention as you were running through them, Glenn, were the future loss costs arrow and the rate and other actions. And then in the box, you say you're pursuing larger rate increases in the second half of 2022 relative to the first half. So maybe you can give us some additional detail around what you guys are thinking on those 2 areas in that chart?
Thomas Wilson: Greg, this is Tom. I'll do a bit of overviewing. Glenn, you can jump right in. First, Greg, as you know, we don't give perspective -- earnings estimates in order to give perspective line-by-line. We would expect future loss costs to go up, like we don't -- and we're booking to have them go up in the future. And we also, as we mentioned, expect to take increase in rates. With that, Glenn, do you want to provide some more perspective on both the trends you're seeing historically in loss cost and then what you're -- where we're thinking about -- how you're thinking about rate increases.
Glenn Shapiro: Sure. Greg, on the loss cost piece of it, I know there's been some opinion out there that maybe the worst is behind us and the inflation will slow or just listening to other calls out there. We're not sure of that, and we certainly want to have the rate outpace the loss trends. One thing I'll say is when you look at our frequency trend, I think this is a unique time in history where typically frequency is harder to predict than severity. And I think the opposite is true right now. Our frequency has been really, really steady. You look at it from the low points of the pandemic up to where it is now, it is just steadily crept back up but has leveled out in that creep, and we have good data and expectation that it remains below the pre-pandemic levels, but continues to rise slightly as it has. And on the other side, severity, it's a big wild card out there, I think, in all industries right now as to how long and how severe inflation runs with the actions of the Fed and anything else out there, we're taking the conservative viewpoint that we need a lot more rate in order to offset that. So I mentioned in the prepared remarks, a couple of places where we're having trouble on it, and we're working through it. But broadly, I will tell you, it's gone very well in that the regulators we work with, good relationships across the country, and we're getting some meaningful rates going through the pipeline right now, and they understand. I mean the math is on our side, and we need to get those rates in to offset those future rate trends because as the slide depicts, if you froze time and loss costs didn't move, we would earn our way right to the mid-90s combined ratio over the coming quarters, but that isn't the case. We need additional rate to offset those loss trends.
Charles Peters: Got it. You slipped in the reference to Slide 7 in your answer, Glenn, which was going to be my other area of focus, which is you talk about reducing new business in states without appropriate rates. In the slide, I think you -- well, you do call out California, New York, are there other states where you're having some problems getting the rate approved that you need? Or are just those the 2 principal states?
Thomas Wilson: Greg, I'll let Glenn give you the specifics there. But it isn't just to like negotiate. And I'm reading into your statement. I know you're not really saying that, but it's also to just maintain our loss cost. Like we just -- even if we get a rate increase, there may be certain cells or certain segments of the state that are less -- where we have less profitability than we want. So it's also about managing profitability. Glenn, why don't you give some specifics on that?
Glenn Shapiro: Yes. And I'll just build on that because it's exactly right. It really is -- it's segments within states, it's markets within states, and it's even channels. I mean look at the fact that right now, National General is performing quite well, both from a growth and a profit standpoint. And so we can position based on where we can be profitable, whether it's channel, market, segment of risk, and that's kind of how we're thinking about new business. We -- to put it very simply, we don't want to write new business that we're not profitable on. And it's not as simple as looking at, you can see in our disclosures, the number of states where we're above 100 or above 96. And because it's -- that's the rearview mirror. The prospective view is where we've already gotten rates. And in some of the states that we feel good about the price we're putting on for new business and we'll grow in those. To answer your specific question, New Jersey would be another place that we're working hard on and need to get more rate. But the vast majority of states across the country, we've been working through, and we're in good shape in.
Operator: And our next question comes from the line of Andrew Kligerman from Credit Suisse.
Thomas Wilson: Jonathan, we didn't hear him. I don't know if you did or I don't know, Andrew, if you're on mute or not, but we didn't hear him.
Operator: You couldn't hear him?
Thomas Wilson: Now we can hear you. Now we can't.
Mark Nogal: Jonathan, I think we move to the next question. We can' hear...
Thomas Wilson: Andrew, maybe you want to question to Mark, and he can ask it for you, if you want. But let's move on.
Operator: Our next question comes from the line of David Motemaden from Evercore ISI.
David Motemaden: I guess I'm just looking through what rates you're submitting, and that slowed down. And I'm specifically talking about auto insurance rate increase filings. It looks like the amount of the rate increase that you guys submitted during the second quarter slowed materially versus the first quarter. I'm just wondering why that was?
Thomas Wilson: David, I'll make a comment and then Glenn can -- if there's anything you want to add, you might jump in. First, we are fully committed to increasing rates necessary to get our combined ratio down to the target levels that Glenn talked about, that obviously bounces around by quarter. And what you saw is what we got implemented in the second quarter, in the early part of your question, you said submitting as in forward-looking, that's not what we're submitting. What you saw in that release is just what got implemented. We're obviously in conversations with regulators when you have these kind of increases continuously. So there are some states where Glenn's team chooses to go down and meet with the regulators, explain the numbers and then submit it and so we feel good about where we're headed there. Glenn, anything you want to add to that?
Glenn Shapiro: Yes. I would just add, it really is about timing and about which states go through. So like if you look at the amount we filed per state, we really haven't backed off at all, David, it is the states that went through in that cycle. It just -- they aren't as large. And so the countrywide impact when you do a medium or smaller state population-wise is lesser than the big states. We have some very large states going through the pipeline right now. And I think you'll see that timing level itself out, and it's why we're able to say to you that we are seeking more rate in the second half of the year than the first half of the year. We have some very large states with meaningful rate increases going through.
David Motemaden: Got it. Yes. I was referring to -- I obviously can see the implemented rate. I was referring to submitted, which I guess is something that's -- they're not approved or disapproved yet. It's just more kind of a leading indicator that I track, and it just looked like you guys had slowed a little bit in the second quarter versus the first quarter. But it does sound like that is more timing related as well. Maybe for just another question, I was just looking through the businesses in auto specifically, and I noticed that the Allstate brand combined ratio was 9 points above the NatGen combined ratio for the quarter and has been trending -- it's been higher for the last few quarters. Could you just -- yes, that's kind of counterintuitive to me just given the differences in those books of business. So could you just maybe talk about what's going on between those two?
Thomas Wilson: David, it's an astute question, and let me -- but let me take it up a level and then get Glenn to jump into NatGen versus the Allstate brand. Because many of you have also written and asked about like how do you stand versus competitors and stuff on that? So let me just take it up and deal with that, and then we'll go into the specifics. So like you, we always look at different comparisons, whether it's internal or external, to get a sense for our performance. That said, when it's external, it tends to be more directional versus our variance analysis because of the differences in strategies and particularly it gives you got different strategies, different risk profiles, different state mix. It's better if you look at the long-term results rather than quarterly numbers, particularly when you're using percentage changes on a quarter-by-quarter. That said, the numbers are the numbers, and you need to understand them and evaluate them. First thing I would say is when you look at -- most of you have asked about Progressive, they're a really strong competitors, so we have great respect to them. As it relates to auto insurance over a long period of time, Allstate, Progressive and GEICO have all had attractive returns. And we're all dealing with the impact of what I would say, a wide swings in frequency and severity for auto claims, in particular that's driven by the pandemic and then the related inflationary impacts on tower repairs and prices. They did report, that is Progressive, a better combined ratio than us this quarter as they began raising prices earlier in 2021. But again, we don't know why, like we're not them. But they did have different trends in frequency both last year and this year. So and of course, claims statistics are different for everybody and sometimes people change them how they count them over time. But the numbers I see are that in 2020, we both had frequency declines from 2019, that was reflecting the impact of shutting down the economy. So we were down -- in collision, we were down 26%, and they were down, I think, about 23%, 24%. Last year, their collision frequency increased by 26%, whereas ours increased by only 18%. So you would expect them to raise prices more than we raise them. This year, they're down in frequency, and we're up. So you would expect our combined ratio to be higher than theirs. It's hard to say why these short-term trends are different. But Glenn will talk, it may be that they have a relatively small share of the customer statement that they call the Robinson. And so the comparison to NatGen will be helpful for you to see how that's different. It could be state mix. It could be a whole bunch of other things. So I can't intuit exactly the results. And so Glenn will go through that risk mix and show you how that impacts the different results. As it relates to the strength of the business model, though, and your strategy, I think it's also worthwhile looking at other lines. And as we talked about on our last call, Allstate is an industry leader in homeowners with very attractive combined ratios. The reported combined ratio this quarter, again, is higher, as Glenn talked about, than it typically is in the second quarter. On a longer-term basis, though, we've obviously done quite well. To put that in perspective, if we had 112.5 combined ratio on our homeowners business, last year, our underwriting income would have been about $1.6 billion lower than it actually was, and that's particularly hard on a business that requires twice as much capital as auto insurance. As it relates to commitment to profitability, speed, precision, we dramatically reshaped that business, which we took you through. So our business models tend to be good and precise, we tend to look at both lines of business and see how we're doing. With that, Glenn, do you want to talk about NatGen versus the Allstate rate?
Glenn Shapiro: Yes, I will. Well, David, you're getting a good detailed answer there from Tom and after me, you like hit the daily double here because it is a really good question and an important one. I want to take you back and kind of look at it over the 18 months that we've owned NatGen and since the closing of that deal, and it's a good time frame to use because 18 months is the time it takes to earn out the full annualized premium changes also. So you go back to first quarter 2021, and this would be true, by the way, not only of comparison of Allstate brand and NatGen but Allstate to other competitors, like Tom was talking about. Allstate was running a combined ratio about 10 points lower. And the reason for that was the frequency was lower, frequency on more nonstandard or near nonstandard business came back much quicker as people needed to use their cars to make a living, and there was just a difference between different books of business. And so as a result, the good news was for the Allstate brand was that is a really low combined ratio. It's around 80. The bad news is in the current state would be to say that, well, when you're running at that level, you need to take rates now. I mean you can't sustain and even in some places, require you to refile your rates, you can't sustain that level that far below target combined ratios. And National General, on the other hand, was still taking a maintenance level of rates up over that period of time. So now flash forward to today, their frequency down while all states is up. And then you've got a higher average earned premium going through. And I mentioned before the $1.7 billion of premium that we have already in the system, not only filed but approved and already like renewing on policies that hasn't been earned yet, we've actually only earned 15% of the premium that's been raised through this cycle. So we get 85% of it out there still left to be earned, whereas National General is earning off of a base, plus they didn't have the hole to fill, so to speak, of the negative rates that, again, we appropriately took because when you're running an 80 combined ratio, but you got to fill that up to get back to par and then go up from there. So there's a difference in the average earned premium that's a few points to the differences, one. Two, there's a few points difference on the frequency levels right now. Three, and this is a really important one when you're looking across companies is the risks are different and the policies are different. So as you think about the inflationary factors and how they're hitting different policies, National General, even inside their own book, it's really fascinating. If you look at their full coverage policies versus their liability-only policies, they're running about 10 points different on trend in their combined ratio. Because if you think about a liability-only policy, you don't have collision, which is the highest inflationary trend of any coverage right now, one. Two, you tend to have very low liability limits, so on things like, let's say, property damage. If you have a state minimum of $10,000 of property-liability coverage and you hit somebody's car and you total it, whether it's before the inflation factors that were hitting us or after, you're probably just going to pay that $10,000. And the inflation, there's a computation to that inflation. Whereas when you typically have $100,000 limits, you're bearing the full weight of the change in the value of vehicles. So looking at all these components, we see just a lot of different ways, and I didn't even get into state mix, which is another one, a lot of different ways that the trends move differently. The nice thing is having acquired NatGen, and it's performing really well, it's growing nicely, it's profitable, is that it's really acting right now as a bit of a diversification on that auto trend and gives us a place where we are able and willing to grow.
Operator: [Operator Instructions]. Our next question comes from the line of Andrew Kligerman from Credit Suisse.
Andrew Kligerman: Can you hear me this time?
Thomas Wilson: We can.
Andrew Kligerman: I'm sorry about that before. First question is around non-rate actions. Could you give a little color on some of the more material non-rate actions that you could take and the potential magnitude we might be able to see in the back half of the year on loss ratio? How much potential improvement could that offer?
Thomas Wilson: Glenn can give you the items. I think we probably won't be able to give you an attribution on what that will do for this year's combined ratio. Glenn, what do you -- do you want to take that?
Glenn Shapiro: Yes. So I'll give you a few like you've got underwriting actions where we segment the business and we segment our pricing to where, as Tom said earlier, it isn't just about, geez, we're going to not write new business in this market, let's say, it's, well, we're profitable in these segments and not those other ones. So we're going to change the segmentation of our pricing, would be one. Another would be, we changed the down payment on policies and expect that there's a change in the flow of business at times with that. Certainly, the targeting of marketing is a really big one that I think can be underplayed, but we're pretty sophisticated in how we go to market. So when and where are we putting up banner ads when people are searching for auto insurance, which risk categories, which markets? And flat out, we've taken a lot of marketing dollars out right now. We're just reducing the marketing that we're doing: one, it will improve expense; two, it will lower the new business flow and allow us to more quickly get back to profitability; and then the last one I'll say is the sales incentives that are out there with our agents about how we're incentivizing people to grow and in which places. So when you put all of that together and you look at how you're going to market, you're really limiting in some places, the ability to grow your business with your intent of being not growing in nonprofitable segments.
Andrew Kligerman: Got it. That's helpful. And I should assume then that, that would be a very material impact on loss ratio as we go into the back half of the year?
Thomas Wilson: I don't think you should assume very material. I mean, the first, it's subject to anybody's -- underwriting actions, Andrew, won't get us to where we need to go. We need to raise prices, cut our expenses. Those are the big drivers. This is helpful. And I'd like to say to our team, look, anybody can give it away, so like there's no sense writing business and knowing you're going to lose money out whatever. So this is more about managing long-term profitability than what it would do for the combined ratio in the second half of the year.
Andrew Kligerman: Got it. And then just looking backwards a little bit and a lot of your competitors that their rate increases have been all over the place, and I think you got what about 2.5% across the whole book last quarter. What was the thinking going into that? Why not a lot more rate? Was it precluded by the fact that 20% of the book is in California and New York, and it's a lot more difficult? But maybe just rewinding back a little bit, why not pushing for a lot more rate 4 or 5 months ago?
Thomas Wilson: Well, I address part of that with the comparison of Progressive, but let me just address that first, the philosophical concept. We are raising prices as fast as we can, everywhere we can. So we're up 6.1% in 6 months of this year, which is -- would have been equal to maybe even our highest year in a long period of time. So we're -- and we expect to get at least that much in the second half. So there wasn't any thinking of let's dial down to 2.5%. It's let's get everything we can, everywhere we can. It obviously does depend on -- if you don't get anything in California, as Glenn said, that's 12% of your stuff of your total book, so that you got to pick it up by getting the right price in other places or just getting smaller in those places. So it doesn't impact your profitability as much. As it relates to our competitors, I think, again, everyone's got their own story. We have our own story inside National General is different than the Allstate brand is -- it's related to Progressive. Their frequency was up about 10 -- almost 10 points more than ours in 2021. So you would expect them to raise their prices faster and higher than we did because at the beginning of the year, we were still earning a very attractive combined ratio. So I think everyone has their own story. What I would leave you with is that like we're completely committed to getting a combined ratio consistent with where we've been in the past. We've been able to run our business for a long time in the mid-90s, and even when the industry has been a lot higher than that and we see no change in the competitive situation, the regulatory environment or our capabilities that lead us to conclude that, that's not possible.
Operator: And our next question comes from the line of Tracy Benguigui from Barclays.
Tracy Benguigui: I want to touch on your higher physical damage loss development, Slide 6. Just wondering, in your transformative growth initiative, I presume you cut clean staff. Do you feel like you're adequate staff in claims where you can close claims in a timely fashion? Maybe you could talk about how you're trying to speed up close rates?
Thomas Wilson: Let me -- Glenn, if you'll talk about what we're doing in claims from an operating standpoint to deal with a higher inflationary environment, leveraging our relationships and getting purchase contracts, and then Mario can talk about the difference between property damage, which is amounts that we have to pay to other people for accidents that our customers help create to how we look at collision. And Tracy, the change in the prior year reserve stuff was really on that first category. And so Mario can talk about how that flows through the system.
Glenn Shapiro: So yes. So I'll start with -- let me just emphatically say we are not behind on claims staff, and we are not behind on claims. Our pending looks good. And we're in good shape there. The expenses that we took out of the claims process, the team has done a really terrific job of automating processes, creating good self-service capabilities, using a lot of virtual estimating capability. With the slowdown we talked about in the system is really external, and everybody is dealing with this part of it. And this would be uniform across the industry. So, for example, shop capacity is way down. The staffing level in body shops across the repair industry is down to the point where there's been a 33% decline in the number of hours worked per car per day. So you think about a car sitting in a shop and historically is 4 hours a day, it got work done, now it's 3 hours a day or a little less than 3 hours a day. So it's moved materially on that. Not surprisingly, the converse of that is that the average car time in a shop has doubled, and the average time to get a car into a shop has more than doubled. So you put all of those together and consumers are, frankly, just choosing to hold on to the check and wait to fix their drivable car until a time they think they can get it back in some reasonable time. And so we're seeing a way elongated repair cycle that then you get your supplements later and you just have a different dynamic in the way the financials are coming through. And it's -- like I said in the prepared remarks, we had planned for it being about 40% greater than any point prior, and it turned out to be even higher than that with the way it delayed coming through. So I just didn't want the question to miss the chance to tell you, it is not claim staffing. We've got plenty of staff, and our team does a terrific job on it.
Thomas Wilson: Well, in fact, Glenn, you're also doing some stuff and parts buying and other things that mitigate the inflationary aspects, right?
Glenn Shapiro: Yes, absolutely. So using our scale as a company, we've doubled down on some of our parts suppliers, and this is both in home and auto, by the way, where we become a large and in some cases, the largest in the industry buyer of certain materials, whether it's parts in auto or roofing and homeowners or flooring, and we get the benefit of those broader relationships and trends. We've also doubled down on our direct repair shop, network in auto, so that we can get our customers access to more shops that can take their car and we have a better one-to-one relationship with that network and are able to control costs in that way.
Thomas Wilson: And Mario, why don't you talk about a reserve release piece?
Mario Rizzo: Yes. So I guess -- just a couple of points I think are worth making before I jump into -- to that. First of all, at the end of any reporting period, we believe, based on our processes that our reserves are adequate. That's certainly the case at the end of the second quarter as we work our way what are very comprehensive and thorough processes to estimate reserves, taking into account all the data and inputs both in terms of internal and external data that we have. So I guess that's the place I'd start. Well, Tracy, your question was on physical damage development specifically, which is different than historically because these tend to be pretty short-tail claims in the past. And as Tom mentioned, they're really -- they show up principally in 2 coverages: collision and property damage. Collision is first-party coverage. There are customers. We're fixing their cars. A claim gets reported, it's open. It may be subject to the same delays that Glenn talked about in terms of body shops, waiting periods, certainly the same inflationary factors. But we have the claim, we pay the claim, we move on. Property damage is a third-party coverage. So just to remind you, it's another carrier's customer. And oftentimes, we get notice of that claim and the payout on that claim are subrogation demands we get from a third-party carrier. And what we've seen is, as Glenn talked about, lack of capacity and auto repair shops, coupled with the inflation factors we've been talking about as well as changes in consumer claiming behavior. A lot of consumers are waiting oftentimes months to get their cars repaired whether that's because they can't get in the queue or they can't get an appointment to get it repaired, but it's just taking longer. And what that -- what all those factors are showing up as is a much longer tail and property damage on those third-party sub road demand from other carriers. And that is the physical damage strengthening that we reported in the quarter, much of that was in PD, and you see that on the chart that we showed on Page 6 of the presentation. In terms of the dollar amounts getting paid after the end of the calendar year are much more significant than we've seen in the past. The thing I'd leave you with is because we have this information on kind of longer tail expectations, we're taking that into account as we establish 2022 severity levels. So we're certainly factoring that into the severity increases that we talked about earlier.
Tracy Benguigui: So just a follow-up on that. Your auto underlying loss ratio of 79.6% was up 4.7 points sequentially. So should I think that part of that was raising your loss picks from everything you said, but was there also a component that you trued up your first quarter loss ratio since that will show up as a prior year, it's in the same accident year?
Mario Rizzo: Yes, Tracy. So as you know, when we increased severity, which we did slightly this quarter relative to where we talked about our severity trends last quarter, that gets applied to claim counts for the entire year. So there is a catch-up component that would have been reflected in the first quarter, had we had perfect information in the first quarter.
Tracy Benguigui: And would you be able to quantify what that first quarter true-up would have looked like, just so we have a better sense of what's the right starting point when thinking about your loss ratio?
Thomas Wilson: Tracy, I think you should just think about looking at the combined ratio by quarter, it does bounce around. There's seasonality, there's driving in the summer, there's all kinds of stuff. So I would -- I think look at it on a year basis. We did it 1 year -- 1 quarter last year when it was a pretty big number. It's not that big as we're looking at this quarter.
Operator: And our next question comes from the line of Paul Newsome from Piper Sandler.
Paul Newsome: I was wondering thinking about on the home insurance side of the house. Do we see the same sort of regulatory pressure in the home insurance business that we do in the auto because presumably, we have inflationary issues there and presumably, you need to get rate there as well to offset those issues?
Thomas Wilson: Paul, the increase in home insurance, you saw is 15% year-over-year. So we don't -- we're getting the rates we think we need in those areas. The underlying assumption there is we have regulatory pressure in auto insurance. And as Glenn mentioned, we have good relationships with the regulation when the price of picking cars, they got it. So there are a few states. And so we've been waiting to get a rate increase that was agreed to with State of California over a year ago on homeowners, and that has yet to come through. So it tends to be more of a state-specific issue than a broad-based regulatory pushback. Glenn, anything you want to add?
Glenn Shapiro: Yes. The only thing I would add there is it's that base level of premium we're getting that isn't great. It's the inflationary factors that really keeps us going in that space. It's just a different type of products. Home values go up, and replacement costs go up. Cars, other than recent history, tend to not go up. So it's a different type of product in that way. So when you look at an average premium up over 13% year-over-year, it's a mix of rate in that. But to your point, Paul, like we've got to get rate there, it's not as heavy as it is in auto, but we deal with the same regulators. And I always go back to, it's the math. Like we're not making up these rates, and they're not looking to make up a reason not to do the rates in most cases. It's the math. Does the math support a trend that says you need rate? And we've been successful in that space.
Paul Newsome: No, I was just curious because obviously getting rate in home is different than auto is that inflation factors there and such. I just want to know if the dynamics is -- so really any different in the improvement of the rate there as well. And on the home side, is -- are you implementing some of the same underwriting criteria changes? Or are they materially different than what we've talked about from that volumes changes this quarter on the auto side?
Thomas Wilson: Glenn, do you want to take that?
Glenn Shapiro: Yes. No, we're -- I would say it is materially different. We like where we are in homeowners. That's obviously not universal. I mean, there's -- from a risk standpoint, from a catastrophe-prone standpoint, everything, there's obviously a lot of underwriting we do. It's one of the strengths we have. And homeowners is that we know how to underwrite this business to make money over time and protect a good balance set of customers in such a way that, that portfolio works. But we are not in an equal or even that similar position in homeowners as auto right now in spite of the inflation. We're in a very good position to continue to write and grow homeowners.
Thomas Wilson: Jonathan, let's just do 1 last question.
Operator: Certainly. And our final question for today comes from the line of Josh Shanker from Bank of America.
Joshua Shanker: When I think of Allstate, I think you guys are second to none understanding the long-term value bundler that the Progressive people call the Robinson. And when anyone says they're going after that Allstate customer, I'm very skeptical at the level of success they'll have. On the other hand, you guys bought NatGen to go into nonstandard in a bigger way. You guys have come back and forth over 20 years in that a number of times. And if you look at Progressive, they're losing their SAMs at this point in time. Whether they're unprofitable or whatnot, that they are going somewhere. And when you talk about having 1,000 basis points of better margin in NatGen and it's growing, how confident are you given that that's not your legacy business that you understand that those aren't Progressive customers that they can't make work coming onto your books?
Thomas Wilson: Let me see if I can deal with that. So I'm going to go up in a minute. So it's really the question of we. And so who is we, Josh? So we as now Allstate and NatGen, as opposed to we was Allstate without experience in nonstandard. So you may remember when we got started on NatGen, I went to Barry Karfunkel and said, hey, Barry, I got this problem, I'm not making any money in the independent agent business, and I'm not really in the nonstandard business. So I either have to get out of the business or try to fix it, I had trouble fixing it. So I've decided I'd like to get out of it, but I'm going to get out of it first by buying you, and then your team can fix our business, and that's exactly what's played out. Peter Randell and that team are really good at nonstandard. They know their business well. They run separately. They have separate pricing, separate claims, they know that business well. And then they took our Encompass business, which was more a standard business, and they're folding that in. And so we think we have a great opportunity to expand in the independent agent channel, not just for the nonstandard piece but in what's affectionately called, I guess, the Robinson is quite progressive because we're really in that segment. And we think there's a great opportunity for us to compete there.
Joshua Shanker: And so I just -- I'll make this the last part of the question. You say who as we, and you're making it seeing that National General is running separately in some ways from Allstate. Of course, you're in charge and the buck stops with you, Tom, how comp are you that you understand the underwriting going on there that you know that what we see right now is results that you're very comfortable and proud of?
Thomas Wilson: Yes. It's not that hard to understand, Josh. It's more difficult to build a set of business processes, policy documents, procedures and relationships with agents to note. So they -- for example, they were on something called the WAR Score where they look at every individual agent and see what kind of business they're getting for them. So it isn't -- like if it's got wheels on it, and it's got losses and that stuff is not that complicated. What's really complicated is building the business model to do it. And we are highly confident that they know what they're doing. All right. First, as we move forward, we clearly, based on your comments and the amount of time, we're focused on auto insurance. We're going to get those margins up. We still got to make sure we make good money in homeowners, expand on our Protection services and at the same time, rebuild its digital insurer called transformer growth of that when we get margins where we are, we can hit the accelerator hard on profitable growth and drive more shareholder value. So thank you all, and we'll talk to you on investments in September.
Operator: Thank you, ladies and gentlemen, for your participation in today's conference. This does conclude the program. You may now disconnect. Good day. | [
{
"speaker": "Operator",
"text": "Thank you for standing by, and welcome to the Allstate Second Quarter 2022 Earnings Conference Call. [Operator Instructions]. And now I'd like to introduce your host for today's program, Mark Nogal, Head of Investor Relations. Please go ahead, sir."
},
{
"speaker": "Mark Nogal",
"text": "Thank you, Jonathan. Good morning. Welcome to Allstate's Second Quarter 2022 Earnings Conference Call. After prepared remarks, we will have a question-and-answer session. Yesterday, following the close of the market, we issued our news release and investor supplement, filed our 10-Q and posted today's presentation on our website at allstateinvestors.com. Our management team is here to provide perspective on these results. As noted on the first slide of the presentation, our discussion will contain non-GAAP measures, for which there are reconciliations in the news release and investor supplement and forward-looking statements about Allstate's operations. Allstate's results may differ materially from these statements, so please refer to our 10-K for 2021 and other public documents for information on potential risks. Additionally, we will be hosting our next special topic investor call on September 1, focusing on Allstate's investment strategy. Now I'll turn it over to Tom."
},
{
"speaker": "Thomas Wilson",
"text": "Well, good morning. Thank you for investing your time with Allstate today. Let's start on Slide 2. So Allstate's strategy to increase shareholder value has 2 components: increase personal property-liability market share and expand Protection services, which are shown in the 2 ovals on the left. We're building a low-cost digital insurer with broad distribution we transformed the growth. We're also diversifying our business by expanding protection offers and by leveraging the Allstate brand, customer base capabilities and expanding distribution. On the panel on the right, in the second quarter, we made progress executing this strategy, while we continue to implement a comprehensive strategy to improve profitability. That includes broadly raising auto and home insurance rates. In the second half of 2022, we plan to file for rate increases in excess of the increases implemented in the first half of this year, which were 6.1% of Allstate brand countrywide premiums. We're also reducing expenses on advertising and growth investments. Underwriting guidelines have been and will be changed to reduce new business volume, where we're not earning adequate returns. And we're also executing claims operating actions to manage loss cost in a high inflationary environment. These actions will likely have a negative impact on policy growth. And now while the current environment requires a huge focus on margin improvement, we continue to advance our transformative growth strategy where profitability -- when profitability levels are acceptable we'll have a business model to capture market share. The Protection Services businesses are generating profitable growth, although earnings declined slightly this quarter as we invest in that growth. Given the negative impact of inflation on the auto insurance business, as you know, beginning late last year, we reduced the bond portfolio duration to lower exposure to higher interest rates, which helped mitigate the reduction in bond valuations by approximately $1.3 billion in the first half of 2022. Our strong capital position enabled us to maintain high cash returns to shareholders in this environment. Moving to Slide 3, let's review second quarter performance in more detail. Total revenues decreased 3.4% in the prior year quarter, despite property liability premiums earned increasing 8.6%, which reflected higher average premiums and policy growth. Higher loss costs in the current report year and upward loss reserve development of $411 million in the prior report years resulted in a property liability recorded combined ratio of 107.9 in the second quarter. Net investment income of $562 million was 42% below the prior year quarter since performance-based income was exceptional in the prior year. Net losses on investments and derivatives were $733 million in the quarter as lower valuations and equity investments and losses on fixed income sales, which were only partially offset by the derivative gains associated with the bond portfolio duration shortening. The combination of these factors led to a net loss of $1.4 billion in the second quarter and an adjusted net loss of $209 million or $0.76 per diluted share. The adjusted net income return on equity was 6.9% over the last 12 months, which is obviously unacceptable from our standpoint. It's substantially below the levels we achieved at this time last year, but we remain committed to achieving our long-term returns on equity of between 14% and 17%. Now let me turn it over to Glenn to talk -- walk through our property liability results in more detail."
},
{
"speaker": "Glenn Shapiro",
"text": "Thank you, Tom. Let's start by reviewing underwriting profitability on Slide 4. The underwriting results reflect the high level of inflation, which is increasing severity leading to an underlying combined ratio of 93.4 for the second quarter and a recorded combined ratio of 107.9, which is shown in the chart on the left. The chart on the right compares last year's recorded combined ratio of 95.7 to this year's second quarter. A higher auto insurance underlying loss ratio drove 8.6 of the 12.2 point increase as claims severity has been increasing faster than earned rate increases. The other large negative impact was from prior year reserve strengthening this quarter, which I'll cover in a few minutes. The one positive impact on there was the 1.7 points from expense reductions. Let's move to Slide 5 and talk about profitability and rising loss costs in more detail. As you know, we have a target combined ratio for auto insurance in the mid-90s. And you can see on the chart, which shows the combined ratio by year and then the first 2 quarters of this year, that we have a long history of meeting or exceeding those targets, which is supported by our pricing sophistication, underwriting, claims expertise and expense management. Now in there, you'll see 2020 was an outlier because we had much better than target results than due to some of the early pandemic frequency impacts. And as we move from that environment to the high inflationary environment we're in today, incurred claims severities increased the underlying auto combined ratio of 102.1 for the quarter and 100.5 year-to-date. Auto non-catastrophe prior year reserve strengthening in the second quarter totaled $275 million, which is primarily physical damage and injury coverages. The most significant impact, though, on the combined ratio was report year incurred severity for collision, property damage and bodily injury claims, which increased by 16%, 12% and 9%, respectively, over the average of the full year 2021 incurred. Because the costs were rising rapidly during 2021, the quarter-to-quarter increase comparison is even greater. And frequency also went up about 5 to 7 points, but it's still well below pre-pandemic levels. So let's go to Slide 6, and we'll go deeper into the prior year physical damage for reserve development. The chart on the left shows used car values. They began to rise in 2020. And if you go back looking from the beginning of 2019 to current, used car prices have gone up more than 60% and continue to stay at an elevated level. At the same time, OEM parts and labor rates have increased during the first half of this year, which causes severity increases for coverages like collision and property damage. Now we anticipated that those trends and the delays that are taking cars a long time to be repaired right now would increase the amount of claim payments we made on 2021 losses after the end of the year, even though these are relatively short-duration claims. The chart on the right shows gross paid losses for physical damage coverages for the 6 months after the end of the calendar year. Now our expectation for paid losses for 2021 claims from months 13 to 18 was that it would be about $1.25 billion, which you can see from the chart is about 40% above the prior year. You can see that from the dash line on the far right bar compared to the bars to the left of it. But at the end of the second quarter, the actual paid losses were $1.48 billion, which exceeded even our higher estimate by $230 million and is a large driver of the prior year reserve increases. All other non-catastrophe prior year development, primarily from injury, commercial auto and homeowners, totaled $268 million in the quarter. Let's go to Slide 7 and discuss how higher auto insurance rates have been and will be implemented to improve profitability. Since the beginning of the year, we've implemented broad rate increases across the country, as shown on the map, at 9 states where we had increases over 10%, and auto rates have been increased in 48 locations, inclusive of Canadian provinces. Those rate increases are expected to increase Allstate brand annualized written premium by 6.1%. Now we have not been able to get adequate rate in New York or any increase in rate in California. New York represents about 9% of our auto premium. And the implemented rate there was, we leveraged the annual flex filings process there. And it gave us less than 5% rate in our current indicated indication there is significantly higher than that to get to an adequate return. Similarly, in California, which represents about 12% of our auto premium, we recently filed in the second quarter, a 6.9% increase, which again is significantly below the overall rate need there. In states markets, risk segments or channels where we cannot achieve an adequate price for the risk, we're implementing more restrictive underwriting actions and reducing new business as needed until adequate levels of rate are approved. Let's move to Slide 8, and we'll look at how these rate increases are impacting and will impact the combined ratio for auto insurance. What you see here illustrates our path to target profitability, along with the magnitude of actions we've already taken and what's required prospectively. Starting on the left. Through the first 6 months of the year, our auto insurance recorded combined ratio is 105, and that's shown in the blue bar. To start with, we normalized that by removing the impact of prior year reserve increases and going to a 5-year average on catastrophe losses, that improves the combined ratio by 2.5 points represented by the first green bar. The second green bar reflects the estimated impact of rate actions already implemented when fully earned into premium. So these are already implemented actions that are in market and renewing on policies. They total an additional $1.7 billion of effective premium across Allstate and national general brands. Those will be earned over the coming quarters and fully earned by the end of 2023. Now of course, loss costs will continue to increase, whether it's inflationary impacts on severity or higher frequency, which would increase the combined ratio from what I just described there. So prospective rate increases must exceed the loss cost increases that come to achieve our target returns. Now everything I just described, combined with our non-rate actions such as reducing new business and expenses, gives us a track where we expect to achieve our target combined ratio in the mid-90s in auto insurance. Now the timing of that will be largely dependent on the relative increases and pace of these increases in premium and loss costs. So on Page 9, we'll take a look again at our industry-leading homeowners business. As you know, a significant portion of our customers, bundle home and auto insurance, and that improves the retention and the overall economics of both products. We have a differentiated ecosystem in homeowners. That includes a differentiated product, underwriting, reinsurance, claim capabilities, and we discussed a lot of those capabilities in our last special topic call. Our long-term underwriting results show the strength of the system. Our 5-year average reported combined ratio is 91.9, as shown in the chart on the left. And that produced $3.3 billion of underwriting profit since 2017, while the industry lost over $20 billion in that same period. Now our second quarter combined ratio and most second quarter combined ratios have historically been higher than full year results, primarily due to catastrophes. And second quarter this year was at 106.9, which reflected again higher catastrophes and 1.7 points of unfavorable non-catastrophe prior year reserve estimates. Our year-to-date recorded combined ratio for home is 95.8. Now homeowners insurance is certainly not immune to the inflationary environment we're in, and we continue to see increases in labor and material costs. To combat that, our product has sophisticated pricing features that respond to changes in replacement values, and we've taken rate. If you see on the chart on the right that shows some of the key Allstate brand homeowners operating statistics, we've grown net written premium by 15.2% from the prior year. And that's on a policy base that we grew of 1.2% in the second quarter, where our Allstate agents remain in a really good position to broaden customer relationships. So as you've heard me say several times and certainly in our last special topic call, we're really well positioned at homeowners to not only maintain the competitive advantage we have, but to grow that line of business. And with that, I'd like to turn it over to Mario."
},
{
"speaker": "Mario Rizzo",
"text": "Thanks, Glenn. As Tom mentioned, while we are improving profitability, we also continue to invest in the core components of the transformative growth strategy to increase market share in the personal property-liability business. Slide 10 is the flywheel of growth that we have discussed on earlier calls. Transformative growth is a multiyear initiative designed to increase personal property-liability market share by building a low-cost digital insurer with broad distribution. I won't get into all the pieces today, but I want to highlight 2 specific items: first, we remain committed to achieving our adjusted expense ratio goal of 23 by year-end 2024, which represents a 6-point improvement compared to year-end 2018; secondly, in the quarter, we launched beta versions of a new fully digital auto insurance product and sales experience made possible with new technology for relationship initiation and product delivery. Building these foundational elements will enable us to scale growth when adequate insurance pricing is a tank. At the same time, the Protection Services businesses, in the lower strategic oval, are growing and increasing shareholder value, as shown on Slide 11. Revenues, excluding the impact of net gains and losses on investments and derivatives, increased 8.3% to $629 million in the quarter, primarily driven by Allstate Protection Plans. Adjusted net income of $43 million for the second quarter of 2022 decreased $13 million compared to the prior year quarter as ongoing investments and growth are being made to position these businesses for future success. Policies in force did decrease by 1.6%, reflecting expiring Protection Plan warranties and lower retail sales compared to the favorable environment in the prior year quarter. Moving to Slide 12. Allstate Health and Benefits is also growing. It is also growing an attractive set of businesses that protect millions of policyholders. The acquisition of National General in 2021 added both group and individual health products to our portfolio, as you can see on the left. Revenues of $574 million in the second quarter of 2022 increased to 4.6% for the prior year quarter, driven primarily by growth in group and individual health businesses. Adjusted net income of $65 million increased $3 million from the prior year quarter, driven by increased revenue, which was partially offset by a higher benefit ratio, primarily in individual health. Now let's shift to investments on Slide 13 to review investment performance and the portfolio risk and return position we have taken given higher inflation and the possibility of a recession. Net investment income totaled $562 million in the quarter, which is $412 million below the prior year quarter, as shown in the chart on the left. Market-based income, shown in blue, was $13 million above the prior year quarter, reflecting an increase in the fixed income portfolio yields, which are now benefiting from investing in yields that are higher than the overall portfolio's current yield. Performance-based income of $236 million, shown in dark blue, was $413 million below with an exceptional quarter in 2021. The performance-based internal rate of return over the last 12 months was 24.6%, which remains above our long-term return expectations. The performance-based portfolio includes private equity as well as a mix of other asset types such as real estate and infrastructure, which diversify our performance in this segment. In the second quarter, real estate investments had strong performance, including gains on asset sales, while private equity results were lower. As a reminder, our performance-based results are reported based on a 1 quarter lag, so second quarter results reflect March 31 sponsored financial statements, and future returns will reflect market and economic conditions from the prior quarter. The total portfolio return was negative 2.8% for the quarter and negative 5.6% year-to-date due to higher interest rates and credit spreads, lowering the market value of bonds and a decline in public equity valuations. While these market conditions negatively impacted the market value of the portfolio, it continues to generate operating income. And because of proactive portfolio actions, the results are better than the broad indices with the S&P 500 Index 20% lower and the Bloomberg U.S. Aggregate Bond Index 10% lower. The chart on the right illustrates the shift in risk positioning we have executed to protect portfolio value and position us to take advantage of opportunities as conditions evolve. We reduced interest rate risk towards the end of 2021 and into the first quarter through the sale of longer-duration bonds and the use of derivatives. The portfolio duration is shorter than our long-term targets, which has mitigated the negative impact of higher market rates by approximately $1.3 billion this year. With recession concerns rising, the exposure to recession risk-sensitive assets was also reduced through sales of high-yield bonds, bank loans and public equity. These sales were largely executed prior to the most significant credit spread widening and equity market decline for the end of the quarter, further preserving portfolio value. Now let's move to Slide 14 to discuss Allstate's strong cash returns to shareholders of $1.9 billion in the first 2 quarters. Over the last year, shares outstanding have been reduced by 8.7%, providing more upside per share as profitability has improved. In addition, there is another $1.8 billion remaining on the current $5 billion share repurchase authorization. Adjusted net income return on equity of 6.9% was below the prior year period, primarily due to lower underwriting income. Achieving our target combined ratios for both auto and homeowners insurance will bring adjusted net income returns on equity back to our long-term target range of 14% to 17%. With that context, let's open up the line for questions."
},
{
"speaker": "Operator",
"text": "[Operator Instructions]. And our first question comes from the line of Greg Peters from Raymond James."
},
{
"speaker": "Charles Peters",
"text": "I would like to go back to Slide 8 for my first question. And I guess the 2 areas that caught my attention as you were running through them, Glenn, were the future loss costs arrow and the rate and other actions. And then in the box, you say you're pursuing larger rate increases in the second half of 2022 relative to the first half. So maybe you can give us some additional detail around what you guys are thinking on those 2 areas in that chart?"
},
{
"speaker": "Thomas Wilson",
"text": "Greg, this is Tom. I'll do a bit of overviewing. Glenn, you can jump right in. First, Greg, as you know, we don't give perspective -- earnings estimates in order to give perspective line-by-line. We would expect future loss costs to go up, like we don't -- and we're booking to have them go up in the future. And we also, as we mentioned, expect to take increase in rates. With that, Glenn, do you want to provide some more perspective on both the trends you're seeing historically in loss cost and then what you're -- where we're thinking about -- how you're thinking about rate increases."
},
{
"speaker": "Glenn Shapiro",
"text": "Sure. Greg, on the loss cost piece of it, I know there's been some opinion out there that maybe the worst is behind us and the inflation will slow or just listening to other calls out there. We're not sure of that, and we certainly want to have the rate outpace the loss trends. One thing I'll say is when you look at our frequency trend, I think this is a unique time in history where typically frequency is harder to predict than severity. And I think the opposite is true right now. Our frequency has been really, really steady. You look at it from the low points of the pandemic up to where it is now, it is just steadily crept back up but has leveled out in that creep, and we have good data and expectation that it remains below the pre-pandemic levels, but continues to rise slightly as it has. And on the other side, severity, it's a big wild card out there, I think, in all industries right now as to how long and how severe inflation runs with the actions of the Fed and anything else out there, we're taking the conservative viewpoint that we need a lot more rate in order to offset that. So I mentioned in the prepared remarks, a couple of places where we're having trouble on it, and we're working through it. But broadly, I will tell you, it's gone very well in that the regulators we work with, good relationships across the country, and we're getting some meaningful rates going through the pipeline right now, and they understand. I mean the math is on our side, and we need to get those rates in to offset those future rate trends because as the slide depicts, if you froze time and loss costs didn't move, we would earn our way right to the mid-90s combined ratio over the coming quarters, but that isn't the case. We need additional rate to offset those loss trends."
},
{
"speaker": "Charles Peters",
"text": "Got it. You slipped in the reference to Slide 7 in your answer, Glenn, which was going to be my other area of focus, which is you talk about reducing new business in states without appropriate rates. In the slide, I think you -- well, you do call out California, New York, are there other states where you're having some problems getting the rate approved that you need? Or are just those the 2 principal states?"
},
{
"speaker": "Thomas Wilson",
"text": "Greg, I'll let Glenn give you the specifics there. But it isn't just to like negotiate. And I'm reading into your statement. I know you're not really saying that, but it's also to just maintain our loss cost. Like we just -- even if we get a rate increase, there may be certain cells or certain segments of the state that are less -- where we have less profitability than we want. So it's also about managing profitability. Glenn, why don't you give some specifics on that?"
},
{
"speaker": "Glenn Shapiro",
"text": "Yes. And I'll just build on that because it's exactly right. It really is -- it's segments within states, it's markets within states, and it's even channels. I mean look at the fact that right now, National General is performing quite well, both from a growth and a profit standpoint. And so we can position based on where we can be profitable, whether it's channel, market, segment of risk, and that's kind of how we're thinking about new business. We -- to put it very simply, we don't want to write new business that we're not profitable on. And it's not as simple as looking at, you can see in our disclosures, the number of states where we're above 100 or above 96. And because it's -- that's the rearview mirror. The prospective view is where we've already gotten rates. And in some of the states that we feel good about the price we're putting on for new business and we'll grow in those. To answer your specific question, New Jersey would be another place that we're working hard on and need to get more rate. But the vast majority of states across the country, we've been working through, and we're in good shape in."
},
{
"speaker": "Operator",
"text": "And our next question comes from the line of Andrew Kligerman from Credit Suisse."
},
{
"speaker": "Thomas Wilson",
"text": "Jonathan, we didn't hear him. I don't know if you did or I don't know, Andrew, if you're on mute or not, but we didn't hear him."
},
{
"speaker": "Operator",
"text": "You couldn't hear him?"
},
{
"speaker": "Thomas Wilson",
"text": "Now we can hear you. Now we can't."
},
{
"speaker": "Mark Nogal",
"text": "Jonathan, I think we move to the next question. We can' hear..."
},
{
"speaker": "Thomas Wilson",
"text": "Andrew, maybe you want to question to Mark, and he can ask it for you, if you want. But let's move on."
},
{
"speaker": "Operator",
"text": "Our next question comes from the line of David Motemaden from Evercore ISI."
},
{
"speaker": "David Motemaden",
"text": "I guess I'm just looking through what rates you're submitting, and that slowed down. And I'm specifically talking about auto insurance rate increase filings. It looks like the amount of the rate increase that you guys submitted during the second quarter slowed materially versus the first quarter. I'm just wondering why that was?"
},
{
"speaker": "Thomas Wilson",
"text": "David, I'll make a comment and then Glenn can -- if there's anything you want to add, you might jump in. First, we are fully committed to increasing rates necessary to get our combined ratio down to the target levels that Glenn talked about, that obviously bounces around by quarter. And what you saw is what we got implemented in the second quarter, in the early part of your question, you said submitting as in forward-looking, that's not what we're submitting. What you saw in that release is just what got implemented. We're obviously in conversations with regulators when you have these kind of increases continuously. So there are some states where Glenn's team chooses to go down and meet with the regulators, explain the numbers and then submit it and so we feel good about where we're headed there. Glenn, anything you want to add to that?"
},
{
"speaker": "Glenn Shapiro",
"text": "Yes. I would just add, it really is about timing and about which states go through. So like if you look at the amount we filed per state, we really haven't backed off at all, David, it is the states that went through in that cycle. It just -- they aren't as large. And so the countrywide impact when you do a medium or smaller state population-wise is lesser than the big states. We have some very large states going through the pipeline right now. And I think you'll see that timing level itself out, and it's why we're able to say to you that we are seeking more rate in the second half of the year than the first half of the year. We have some very large states with meaningful rate increases going through."
},
{
"speaker": "David Motemaden",
"text": "Got it. Yes. I was referring to -- I obviously can see the implemented rate. I was referring to submitted, which I guess is something that's -- they're not approved or disapproved yet. It's just more kind of a leading indicator that I track, and it just looked like you guys had slowed a little bit in the second quarter versus the first quarter. But it does sound like that is more timing related as well. Maybe for just another question, I was just looking through the businesses in auto specifically, and I noticed that the Allstate brand combined ratio was 9 points above the NatGen combined ratio for the quarter and has been trending -- it's been higher for the last few quarters. Could you just -- yes, that's kind of counterintuitive to me just given the differences in those books of business. So could you just maybe talk about what's going on between those two?"
},
{
"speaker": "Thomas Wilson",
"text": "David, it's an astute question, and let me -- but let me take it up a level and then get Glenn to jump into NatGen versus the Allstate brand. Because many of you have also written and asked about like how do you stand versus competitors and stuff on that? So let me just take it up and deal with that, and then we'll go into the specifics. So like you, we always look at different comparisons, whether it's internal or external, to get a sense for our performance. That said, when it's external, it tends to be more directional versus our variance analysis because of the differences in strategies and particularly it gives you got different strategies, different risk profiles, different state mix. It's better if you look at the long-term results rather than quarterly numbers, particularly when you're using percentage changes on a quarter-by-quarter. That said, the numbers are the numbers, and you need to understand them and evaluate them. First thing I would say is when you look at -- most of you have asked about Progressive, they're a really strong competitors, so we have great respect to them. As it relates to auto insurance over a long period of time, Allstate, Progressive and GEICO have all had attractive returns. And we're all dealing with the impact of what I would say, a wide swings in frequency and severity for auto claims, in particular that's driven by the pandemic and then the related inflationary impacts on tower repairs and prices. They did report, that is Progressive, a better combined ratio than us this quarter as they began raising prices earlier in 2021. But again, we don't know why, like we're not them. But they did have different trends in frequency both last year and this year. So and of course, claims statistics are different for everybody and sometimes people change them how they count them over time. But the numbers I see are that in 2020, we both had frequency declines from 2019, that was reflecting the impact of shutting down the economy. So we were down -- in collision, we were down 26%, and they were down, I think, about 23%, 24%. Last year, their collision frequency increased by 26%, whereas ours increased by only 18%. So you would expect them to raise prices more than we raise them. This year, they're down in frequency, and we're up. So you would expect our combined ratio to be higher than theirs. It's hard to say why these short-term trends are different. But Glenn will talk, it may be that they have a relatively small share of the customer statement that they call the Robinson. And so the comparison to NatGen will be helpful for you to see how that's different. It could be state mix. It could be a whole bunch of other things. So I can't intuit exactly the results. And so Glenn will go through that risk mix and show you how that impacts the different results. As it relates to the strength of the business model, though, and your strategy, I think it's also worthwhile looking at other lines. And as we talked about on our last call, Allstate is an industry leader in homeowners with very attractive combined ratios. The reported combined ratio this quarter, again, is higher, as Glenn talked about, than it typically is in the second quarter. On a longer-term basis, though, we've obviously done quite well. To put that in perspective, if we had 112.5 combined ratio on our homeowners business, last year, our underwriting income would have been about $1.6 billion lower than it actually was, and that's particularly hard on a business that requires twice as much capital as auto insurance. As it relates to commitment to profitability, speed, precision, we dramatically reshaped that business, which we took you through. So our business models tend to be good and precise, we tend to look at both lines of business and see how we're doing. With that, Glenn, do you want to talk about NatGen versus the Allstate rate?"
},
{
"speaker": "Glenn Shapiro",
"text": "Yes, I will. Well, David, you're getting a good detailed answer there from Tom and after me, you like hit the daily double here because it is a really good question and an important one. I want to take you back and kind of look at it over the 18 months that we've owned NatGen and since the closing of that deal, and it's a good time frame to use because 18 months is the time it takes to earn out the full annualized premium changes also. So you go back to first quarter 2021, and this would be true, by the way, not only of comparison of Allstate brand and NatGen but Allstate to other competitors, like Tom was talking about. Allstate was running a combined ratio about 10 points lower. And the reason for that was the frequency was lower, frequency on more nonstandard or near nonstandard business came back much quicker as people needed to use their cars to make a living, and there was just a difference between different books of business. And so as a result, the good news was for the Allstate brand was that is a really low combined ratio. It's around 80. The bad news is in the current state would be to say that, well, when you're running at that level, you need to take rates now. I mean you can't sustain and even in some places, require you to refile your rates, you can't sustain that level that far below target combined ratios. And National General, on the other hand, was still taking a maintenance level of rates up over that period of time. So now flash forward to today, their frequency down while all states is up. And then you've got a higher average earned premium going through. And I mentioned before the $1.7 billion of premium that we have already in the system, not only filed but approved and already like renewing on policies that hasn't been earned yet, we've actually only earned 15% of the premium that's been raised through this cycle. So we get 85% of it out there still left to be earned, whereas National General is earning off of a base, plus they didn't have the hole to fill, so to speak, of the negative rates that, again, we appropriately took because when you're running an 80 combined ratio, but you got to fill that up to get back to par and then go up from there. So there's a difference in the average earned premium that's a few points to the differences, one. Two, there's a few points difference on the frequency levels right now. Three, and this is a really important one when you're looking across companies is the risks are different and the policies are different. So as you think about the inflationary factors and how they're hitting different policies, National General, even inside their own book, it's really fascinating. If you look at their full coverage policies versus their liability-only policies, they're running about 10 points different on trend in their combined ratio. Because if you think about a liability-only policy, you don't have collision, which is the highest inflationary trend of any coverage right now, one. Two, you tend to have very low liability limits, so on things like, let's say, property damage. If you have a state minimum of $10,000 of property-liability coverage and you hit somebody's car and you total it, whether it's before the inflation factors that were hitting us or after, you're probably just going to pay that $10,000. And the inflation, there's a computation to that inflation. Whereas when you typically have $100,000 limits, you're bearing the full weight of the change in the value of vehicles. So looking at all these components, we see just a lot of different ways, and I didn't even get into state mix, which is another one, a lot of different ways that the trends move differently. The nice thing is having acquired NatGen, and it's performing really well, it's growing nicely, it's profitable, is that it's really acting right now as a bit of a diversification on that auto trend and gives us a place where we are able and willing to grow."
},
{
"speaker": "Operator",
"text": "[Operator Instructions]. Our next question comes from the line of Andrew Kligerman from Credit Suisse."
},
{
"speaker": "Andrew Kligerman",
"text": "Can you hear me this time?"
},
{
"speaker": "Thomas Wilson",
"text": "We can."
},
{
"speaker": "Andrew Kligerman",
"text": "I'm sorry about that before. First question is around non-rate actions. Could you give a little color on some of the more material non-rate actions that you could take and the potential magnitude we might be able to see in the back half of the year on loss ratio? How much potential improvement could that offer?"
},
{
"speaker": "Thomas Wilson",
"text": "Glenn can give you the items. I think we probably won't be able to give you an attribution on what that will do for this year's combined ratio. Glenn, what do you -- do you want to take that?"
},
{
"speaker": "Glenn Shapiro",
"text": "Yes. So I'll give you a few like you've got underwriting actions where we segment the business and we segment our pricing to where, as Tom said earlier, it isn't just about, geez, we're going to not write new business in this market, let's say, it's, well, we're profitable in these segments and not those other ones. So we're going to change the segmentation of our pricing, would be one. Another would be, we changed the down payment on policies and expect that there's a change in the flow of business at times with that. Certainly, the targeting of marketing is a really big one that I think can be underplayed, but we're pretty sophisticated in how we go to market. So when and where are we putting up banner ads when people are searching for auto insurance, which risk categories, which markets? And flat out, we've taken a lot of marketing dollars out right now. We're just reducing the marketing that we're doing: one, it will improve expense; two, it will lower the new business flow and allow us to more quickly get back to profitability; and then the last one I'll say is the sales incentives that are out there with our agents about how we're incentivizing people to grow and in which places. So when you put all of that together and you look at how you're going to market, you're really limiting in some places, the ability to grow your business with your intent of being not growing in nonprofitable segments."
},
{
"speaker": "Andrew Kligerman",
"text": "Got it. That's helpful. And I should assume then that, that would be a very material impact on loss ratio as we go into the back half of the year?"
},
{
"speaker": "Thomas Wilson",
"text": "I don't think you should assume very material. I mean, the first, it's subject to anybody's -- underwriting actions, Andrew, won't get us to where we need to go. We need to raise prices, cut our expenses. Those are the big drivers. This is helpful. And I'd like to say to our team, look, anybody can give it away, so like there's no sense writing business and knowing you're going to lose money out whatever. So this is more about managing long-term profitability than what it would do for the combined ratio in the second half of the year."
},
{
"speaker": "Andrew Kligerman",
"text": "Got it. And then just looking backwards a little bit and a lot of your competitors that their rate increases have been all over the place, and I think you got what about 2.5% across the whole book last quarter. What was the thinking going into that? Why not a lot more rate? Was it precluded by the fact that 20% of the book is in California and New York, and it's a lot more difficult? But maybe just rewinding back a little bit, why not pushing for a lot more rate 4 or 5 months ago?"
},
{
"speaker": "Thomas Wilson",
"text": "Well, I address part of that with the comparison of Progressive, but let me just address that first, the philosophical concept. We are raising prices as fast as we can, everywhere we can. So we're up 6.1% in 6 months of this year, which is -- would have been equal to maybe even our highest year in a long period of time. So we're -- and we expect to get at least that much in the second half. So there wasn't any thinking of let's dial down to 2.5%. It's let's get everything we can, everywhere we can. It obviously does depend on -- if you don't get anything in California, as Glenn said, that's 12% of your stuff of your total book, so that you got to pick it up by getting the right price in other places or just getting smaller in those places. So it doesn't impact your profitability as much. As it relates to our competitors, I think, again, everyone's got their own story. We have our own story inside National General is different than the Allstate brand is -- it's related to Progressive. Their frequency was up about 10 -- almost 10 points more than ours in 2021. So you would expect them to raise their prices faster and higher than we did because at the beginning of the year, we were still earning a very attractive combined ratio. So I think everyone has their own story. What I would leave you with is that like we're completely committed to getting a combined ratio consistent with where we've been in the past. We've been able to run our business for a long time in the mid-90s, and even when the industry has been a lot higher than that and we see no change in the competitive situation, the regulatory environment or our capabilities that lead us to conclude that, that's not possible."
},
{
"speaker": "Operator",
"text": "And our next question comes from the line of Tracy Benguigui from Barclays."
},
{
"speaker": "Tracy Benguigui",
"text": "I want to touch on your higher physical damage loss development, Slide 6. Just wondering, in your transformative growth initiative, I presume you cut clean staff. Do you feel like you're adequate staff in claims where you can close claims in a timely fashion? Maybe you could talk about how you're trying to speed up close rates?"
},
{
"speaker": "Thomas Wilson",
"text": "Let me -- Glenn, if you'll talk about what we're doing in claims from an operating standpoint to deal with a higher inflationary environment, leveraging our relationships and getting purchase contracts, and then Mario can talk about the difference between property damage, which is amounts that we have to pay to other people for accidents that our customers help create to how we look at collision. And Tracy, the change in the prior year reserve stuff was really on that first category. And so Mario can talk about how that flows through the system."
},
{
"speaker": "Glenn Shapiro",
"text": "So yes. So I'll start with -- let me just emphatically say we are not behind on claims staff, and we are not behind on claims. Our pending looks good. And we're in good shape there. The expenses that we took out of the claims process, the team has done a really terrific job of automating processes, creating good self-service capabilities, using a lot of virtual estimating capability. With the slowdown we talked about in the system is really external, and everybody is dealing with this part of it. And this would be uniform across the industry. So, for example, shop capacity is way down. The staffing level in body shops across the repair industry is down to the point where there's been a 33% decline in the number of hours worked per car per day. So you think about a car sitting in a shop and historically is 4 hours a day, it got work done, now it's 3 hours a day or a little less than 3 hours a day. So it's moved materially on that. Not surprisingly, the converse of that is that the average car time in a shop has doubled, and the average time to get a car into a shop has more than doubled. So you put all of those together and consumers are, frankly, just choosing to hold on to the check and wait to fix their drivable car until a time they think they can get it back in some reasonable time. And so we're seeing a way elongated repair cycle that then you get your supplements later and you just have a different dynamic in the way the financials are coming through. And it's -- like I said in the prepared remarks, we had planned for it being about 40% greater than any point prior, and it turned out to be even higher than that with the way it delayed coming through. So I just didn't want the question to miss the chance to tell you, it is not claim staffing. We've got plenty of staff, and our team does a terrific job on it."
},
{
"speaker": "Thomas Wilson",
"text": "Well, in fact, Glenn, you're also doing some stuff and parts buying and other things that mitigate the inflationary aspects, right?"
},
{
"speaker": "Glenn Shapiro",
"text": "Yes, absolutely. So using our scale as a company, we've doubled down on some of our parts suppliers, and this is both in home and auto, by the way, where we become a large and in some cases, the largest in the industry buyer of certain materials, whether it's parts in auto or roofing and homeowners or flooring, and we get the benefit of those broader relationships and trends. We've also doubled down on our direct repair shop, network in auto, so that we can get our customers access to more shops that can take their car and we have a better one-to-one relationship with that network and are able to control costs in that way."
},
{
"speaker": "Thomas Wilson",
"text": "And Mario, why don't you talk about a reserve release piece?"
},
{
"speaker": "Mario Rizzo",
"text": "Yes. So I guess -- just a couple of points I think are worth making before I jump into -- to that. First of all, at the end of any reporting period, we believe, based on our processes that our reserves are adequate. That's certainly the case at the end of the second quarter as we work our way what are very comprehensive and thorough processes to estimate reserves, taking into account all the data and inputs both in terms of internal and external data that we have. So I guess that's the place I'd start. Well, Tracy, your question was on physical damage development specifically, which is different than historically because these tend to be pretty short-tail claims in the past. And as Tom mentioned, they're really -- they show up principally in 2 coverages: collision and property damage. Collision is first-party coverage. There are customers. We're fixing their cars. A claim gets reported, it's open. It may be subject to the same delays that Glenn talked about in terms of body shops, waiting periods, certainly the same inflationary factors. But we have the claim, we pay the claim, we move on. Property damage is a third-party coverage. So just to remind you, it's another carrier's customer. And oftentimes, we get notice of that claim and the payout on that claim are subrogation demands we get from a third-party carrier. And what we've seen is, as Glenn talked about, lack of capacity and auto repair shops, coupled with the inflation factors we've been talking about as well as changes in consumer claiming behavior. A lot of consumers are waiting oftentimes months to get their cars repaired whether that's because they can't get in the queue or they can't get an appointment to get it repaired, but it's just taking longer. And what that -- what all those factors are showing up as is a much longer tail and property damage on those third-party sub road demand from other carriers. And that is the physical damage strengthening that we reported in the quarter, much of that was in PD, and you see that on the chart that we showed on Page 6 of the presentation. In terms of the dollar amounts getting paid after the end of the calendar year are much more significant than we've seen in the past. The thing I'd leave you with is because we have this information on kind of longer tail expectations, we're taking that into account as we establish 2022 severity levels. So we're certainly factoring that into the severity increases that we talked about earlier."
},
{
"speaker": "Tracy Benguigui",
"text": "So just a follow-up on that. Your auto underlying loss ratio of 79.6% was up 4.7 points sequentially. So should I think that part of that was raising your loss picks from everything you said, but was there also a component that you trued up your first quarter loss ratio since that will show up as a prior year, it's in the same accident year?"
},
{
"speaker": "Mario Rizzo",
"text": "Yes, Tracy. So as you know, when we increased severity, which we did slightly this quarter relative to where we talked about our severity trends last quarter, that gets applied to claim counts for the entire year. So there is a catch-up component that would have been reflected in the first quarter, had we had perfect information in the first quarter."
},
{
"speaker": "Tracy Benguigui",
"text": "And would you be able to quantify what that first quarter true-up would have looked like, just so we have a better sense of what's the right starting point when thinking about your loss ratio?"
},
{
"speaker": "Thomas Wilson",
"text": "Tracy, I think you should just think about looking at the combined ratio by quarter, it does bounce around. There's seasonality, there's driving in the summer, there's all kinds of stuff. So I would -- I think look at it on a year basis. We did it 1 year -- 1 quarter last year when it was a pretty big number. It's not that big as we're looking at this quarter."
},
{
"speaker": "Operator",
"text": "And our next question comes from the line of Paul Newsome from Piper Sandler."
},
{
"speaker": "Paul Newsome",
"text": "I was wondering thinking about on the home insurance side of the house. Do we see the same sort of regulatory pressure in the home insurance business that we do in the auto because presumably, we have inflationary issues there and presumably, you need to get rate there as well to offset those issues?"
},
{
"speaker": "Thomas Wilson",
"text": "Paul, the increase in home insurance, you saw is 15% year-over-year. So we don't -- we're getting the rates we think we need in those areas. The underlying assumption there is we have regulatory pressure in auto insurance. And as Glenn mentioned, we have good relationships with the regulation when the price of picking cars, they got it. So there are a few states. And so we've been waiting to get a rate increase that was agreed to with State of California over a year ago on homeowners, and that has yet to come through. So it tends to be more of a state-specific issue than a broad-based regulatory pushback. Glenn, anything you want to add?"
},
{
"speaker": "Glenn Shapiro",
"text": "Yes. The only thing I would add there is it's that base level of premium we're getting that isn't great. It's the inflationary factors that really keeps us going in that space. It's just a different type of products. Home values go up, and replacement costs go up. Cars, other than recent history, tend to not go up. So it's a different type of product in that way. So when you look at an average premium up over 13% year-over-year, it's a mix of rate in that. But to your point, Paul, like we've got to get rate there, it's not as heavy as it is in auto, but we deal with the same regulators. And I always go back to, it's the math. Like we're not making up these rates, and they're not looking to make up a reason not to do the rates in most cases. It's the math. Does the math support a trend that says you need rate? And we've been successful in that space."
},
{
"speaker": "Paul Newsome",
"text": "No, I was just curious because obviously getting rate in home is different than auto is that inflation factors there and such. I just want to know if the dynamics is -- so really any different in the improvement of the rate there as well. And on the home side, is -- are you implementing some of the same underwriting criteria changes? Or are they materially different than what we've talked about from that volumes changes this quarter on the auto side?"
},
{
"speaker": "Thomas Wilson",
"text": "Glenn, do you want to take that?"
},
{
"speaker": "Glenn Shapiro",
"text": "Yes. No, we're -- I would say it is materially different. We like where we are in homeowners. That's obviously not universal. I mean, there's -- from a risk standpoint, from a catastrophe-prone standpoint, everything, there's obviously a lot of underwriting we do. It's one of the strengths we have. And homeowners is that we know how to underwrite this business to make money over time and protect a good balance set of customers in such a way that, that portfolio works. But we are not in an equal or even that similar position in homeowners as auto right now in spite of the inflation. We're in a very good position to continue to write and grow homeowners."
},
{
"speaker": "Thomas Wilson",
"text": "Jonathan, let's just do 1 last question."
},
{
"speaker": "Operator",
"text": "Certainly. And our final question for today comes from the line of Josh Shanker from Bank of America."
},
{
"speaker": "Joshua Shanker",
"text": "When I think of Allstate, I think you guys are second to none understanding the long-term value bundler that the Progressive people call the Robinson. And when anyone says they're going after that Allstate customer, I'm very skeptical at the level of success they'll have. On the other hand, you guys bought NatGen to go into nonstandard in a bigger way. You guys have come back and forth over 20 years in that a number of times. And if you look at Progressive, they're losing their SAMs at this point in time. Whether they're unprofitable or whatnot, that they are going somewhere. And when you talk about having 1,000 basis points of better margin in NatGen and it's growing, how confident are you given that that's not your legacy business that you understand that those aren't Progressive customers that they can't make work coming onto your books?"
},
{
"speaker": "Thomas Wilson",
"text": "Let me see if I can deal with that. So I'm going to go up in a minute. So it's really the question of we. And so who is we, Josh? So we as now Allstate and NatGen, as opposed to we was Allstate without experience in nonstandard. So you may remember when we got started on NatGen, I went to Barry Karfunkel and said, hey, Barry, I got this problem, I'm not making any money in the independent agent business, and I'm not really in the nonstandard business. So I either have to get out of the business or try to fix it, I had trouble fixing it. So I've decided I'd like to get out of it, but I'm going to get out of it first by buying you, and then your team can fix our business, and that's exactly what's played out. Peter Randell and that team are really good at nonstandard. They know their business well. They run separately. They have separate pricing, separate claims, they know that business well. And then they took our Encompass business, which was more a standard business, and they're folding that in. And so we think we have a great opportunity to expand in the independent agent channel, not just for the nonstandard piece but in what's affectionately called, I guess, the Robinson is quite progressive because we're really in that segment. And we think there's a great opportunity for us to compete there."
},
{
"speaker": "Joshua Shanker",
"text": "And so I just -- I'll make this the last part of the question. You say who as we, and you're making it seeing that National General is running separately in some ways from Allstate. Of course, you're in charge and the buck stops with you, Tom, how comp are you that you understand the underwriting going on there that you know that what we see right now is results that you're very comfortable and proud of?"
},
{
"speaker": "Thomas Wilson",
"text": "Yes. It's not that hard to understand, Josh. It's more difficult to build a set of business processes, policy documents, procedures and relationships with agents to note. So they -- for example, they were on something called the WAR Score where they look at every individual agent and see what kind of business they're getting for them. So it isn't -- like if it's got wheels on it, and it's got losses and that stuff is not that complicated. What's really complicated is building the business model to do it. And we are highly confident that they know what they're doing. All right. First, as we move forward, we clearly, based on your comments and the amount of time, we're focused on auto insurance. We're going to get those margins up. We still got to make sure we make good money in homeowners, expand on our Protection services and at the same time, rebuild its digital insurer called transformer growth of that when we get margins where we are, we can hit the accelerator hard on profitable growth and drive more shareholder value. So thank you all, and we'll talk to you on investments in September."
},
{
"speaker": "Operator",
"text": "Thank you, ladies and gentlemen, for your participation in today's conference. This does conclude the program. You may now disconnect. Good day."
}
] | The Allstate Corporation | 18,711 |
ALL | 1 | 2,022 | 2022-05-05 09:00:00 | Operator: Good morning, everyone. Thank you for standing by, and welcome to the Allstate First Quarter 2020 Earnings Conference Call. [Operator Instructions]. I would now like to hand the conference over to your speaker today, Mr. Mark Nogal.
Mark Nogal: Thank you, Kirby. Good morning, and welcome to Allstate's First Quarter 2022 Earnings Conference Call. After prepared remarks, we'll have a question-and-answer session. Yesterday, following the close of the market, we issued our news release and investor supplement, filed our 10-Q and posted today's presentation, along with our reinsurance update on our website at allstateinvestors.com. Our management team is here to provide perspective on these results. As noted on the first slide of the presentation, our discussion will contain non-GAAP measures, for which there are reconciliations in the news release and investor supplement and forward-looking statements about Allstate operations. Allstate's results could differ materially from these statements, so please refer to our 10-K for 2021 and other public documents for information on potential risks. Before I hand it off to Tom, I want to share that we will be hosting our second special topic investor call on June 16, focusing on the value of homeowners. We look forward to the additional engagement later this quarter, and we'll share further information soon. And now I'll turn it over to Tom.
Thomas Wilson: Well, good morning, and thank you for investing your time in Allstate today. Now let's start on Slide 2. So Allstate's strategy to deliver Transformative Growth and higher valuation has two components: increase personal profit liability market share and expand protection services, which are shown in the 2 ovals on the left. We're building a low-cost digital insurer with broad distribution to a Transformative Growth. We're also diversifying our business by expanding protection offerings as shown in the bottom. In the first quarter, we made progress in 3 key areas to execute this strategy. We're 6 months into a multifaceted plan to address the negative impact of inflation, which is largely in auto insurance. This begins with aggressively raising prices. We're doing this surgically and raising prices more for new or shorter tenured customers with less profitability and less for longer tenured profitable customers. Progress was also made in executing programs to reduce expenses and manage loss costs. We also shifted our asset allocations by reducing the interest rate exposure of our bond portfolio in the fourth quarter of last year, which lowered the overall enterprise impact from higher inflation by $800 million. Secondly, we continue to make progress on transformative growth by expanding customer access increasing pricing sophistication and building new technology ecosystems. Protection Services also continues its profitable growth trajectory with revenue growth of almost 14% above the prior year. Moving to Slide 3, let's discuss first quarter performance in more detail. Property liability premiums earned increased 6.1% due to higher average premiums and a 2.1% growth in policies in force. Net investment income of $594 million was 16.1% below the prior year quarter, reflecting lower fixed income reinvestment rates, the impact of reducing the bond portfolio duration and strong performance-based portfolio income that was in comparison to an exceptional prior year quarter. Net income of $630 million in the first quarter compares to a $1.4 billion loss in the prior year, which included losses related to the disposition of the life and annuity businesses. Adjusted net income of $726 million or $2.58 per diluted share declined compared to the nearly $1.9 billion generated in the prior year quarter due to lower underwriting income. You'll remember, last year's first quarter reflected low auto accident frequency because of the pandemic and inflation and loss costs had not yet been realized. We provided over $1 billion in cash returns to shareholders in the quarter and reduced outstanding shares by 8.1% over the last 12 months. Moving to Slide 4. You can see how income from homeowners insurance, investments, Protection Services and health and benefits mitigated the negative impact as inflation had on auto insurance. Insurance underwriting margins provided $267 million of after-tax adjusted net income or $0.95 a share. Auto insurance generated a slight underwriting loss with a recorded combined ratio of B. Our industry-leading homeowners insurance business generated underwriting income that contributed $335 million of adjusted net income or $1.19 per share. And although performance-based investment income declined from record highs in 2021, results were still strong in the first quarter, with property liability net investment income contributing $1.56 per share. Protection Services and Health and Benefits income more than offset the losses in auto insurance. Now let me turn it over to Glenn to discuss the property liability results in more detail.
Glenn Shapiro: Thanks, Tom. Starting on Page 5, we'll talk about profitability in Allstate Brand auto insurance. We target mid-90s combined ratio in auto insurance. And as you could see from the chart on the left, we have a long history of meeting or exceeding that target, supported by our pricing sophistication, underwriting, claims expertise, expense management. And of course, when you look at 2020 in that chart, it's an outlier in terms of the view because we had much better than target results due to the early pandemic impacts. On the chart on the right breaks down the 5 most recent quarters, highlighting the significant increase in combined ratio that occurred in 2021, as we transitioned from those favorable pandemic impacts to the high inflation environment that we're in today. . In late 2020 and early 2021, as Tom just mentioned, while we were running a combined ratio around 80 and benefiting from frequency and the improved cost structure changes we've made, we took price decreases. And then as inflation spiked in Q2 and Q3 of last year, we shifted towards rate increases, which ramped up significantly in the last 6 months. The recorded and underlying combined ratios improved sequentially in the first quarter of '22, though inflationary trends continue to pressure margins with increasing severity. And frequency is obviously higher year-over-year from that low point, but it's been very stable in terms of maintaining lower level frequency compared to pre-pandemic levels. We'll go deeper into severity and pricing for auto insurance in the next few pages. So let's move to Slide 6 and talk about Allstate auto physical damage claims severity in more detail. The story of higher severity has continued into 2022, and it's across the country, as you can see from the map on the left. Allstate Brand report year 2022 incurred severity for property damage increased about 11% compared to report year '21. Now recall that we shifted to report year incurred severity to give you a better view directly into what's recorded in our financials. And it's really important to note on this that when you look at paid severities, it's typically shared as a comparison to the prior year quarter or year-to-date or some prior period, whereas our new disclosure is an estimate of the full change in the fully developed report year severities year-over-year. So the 11% in this case, is the expected severity in '22 over all of 2021, inclusive of the inflation seen in quarters 2 through 4. On the chart on the right, you can see that Allstate has a higher distribution of total loss claims involving newer vehicles compared to the industry. And while those vehicles come with higher premiums, they also can adversely impact total loss severity when vehicle values rise. We're adjusting pricing and using our strong claim capabilities to mitigate rising costs, and that includes leveraging our scale, our operating processes, experienced claim professionals, technology, broad repair relationships that we have and our investments in data and analytics to help contain costs for customers. Moving to Slide 7. Let's talk about bodily injury severity increases because they've also contributed to auto insurance cost and price increases. Like property damage, casualty loss trends have been elevated for the past few years and continued into '22. But the bodily injury pressure isn't quite as wide spread. Allstate brand report year '22 incurred severity for bodily injury increased about 8% compared to report year '21. Higher-speed accidents and less congested roads are leading to harder impact crashes and more severe injuries, and an evolving legal environment is also a factor in casualty costs. If you look at the chart on the left, you'll see that claims resulting in a nondrivable vehicle, which would mean kind of a harder hit and claims resulting in bodily injury claims with a major injury designation have increased compared to pre-pandemic levels. That's driving a shift to more complex and costly treatments and contributing to higher medical consumption. In terms of the legal environment, trial attorney advertising for claimants has doubled over the past decade and exceeds $1 billion annually now. That results in higher attorney representation rates, and ultimately, higher costs for consumers. The chart on the right shows the severity variance to prior years trending higher in some of our more populous states like Texas, Florida, Georgia, New York and California. And Texas actually accounted for about 80% of the prior report year strengthening within bodily injury in the first quarter. Here again, our scale, our investments in technology and in data and analytics and our claim expertise are helping us resolve claims fairly, accurately and efficiently. Moving to Slide 8, let's talk about another key component to our multifaceted plan to deal with inflation, and that's raising auto insurance prices. The table on the left provides a view into 2021 in the first quarter of '22 rate actions in Allstate Brand Auto. We implemented rate decreases as we talked about earlier, in early '21 to reflect our continued lower frequency and expense reductions. In the second quarter, as inflation picked up, we pulled back on any reductions and began increasing rates by the third quarter, and then those rate actions accelerated in the fourth quarter and then further accelerate in the first quarter this year. In the first quarter of '22, we implemented rate in 28 states with an average increase of 9.3% and a weighted Allstate Brand Auto premium impact of 3.6%. When you combine that with the fourth quarter actions, we've increased weighted rates by 6.5% over the last 6 months, and that equates to a gross annualized written premium impact of $1.6 billion within the Allstate brand. About 95% of our premiums in the U.S. are coming from 6-month term policies. So the rates will improve margins, but there's a lag between when the rates are implemented and they're ultimately earned, which you can see in the chart on the right, which estimates when the rate increases taken in the last 6 months will be earned into premium. That illustration assumes only 85% of the annualized premium will be earned to account for things like retention and the fact that customers modify their policy terms when faced with a price increase, like changing deductibles or limits. As you can see, looking at Q1 2022, the rate increases we've taken didn't have a whole lot of impact yet, but you can see it coming in the coming quarters, and it really accelerates. We expect to see significant increases in earned premium beginning in the second half, reaching over $1.1 billion by the first quarter of next year based on the implemented rate so far. And keep in mind that additional rates and increases that we take through this year will be additive and compound on those rate increases. And given the ongoing inflationary pressure, we have increased the magnitude of rate increases we expect to take in the rest of 2022. We remain very confident in our ability to restore auto profitability to targeted levels, and we'll keep you posted on that in our new monthly disclosures of rate filings. So let's move to Slide 9 and take a look at something that I think is an undervalued strength at Allstate. It's our industry-leading homeowners business. As you know, a significant portion of our customers bundle home and auto, and that improves the retention and overall economics of both lines of business. We've differentiated our homeowners product and our homeowners capability really, and that goes to our product, our underwriting, our reinsurance, our claims ecosystem. It is a unique entire business model and system in the industry. The graph on the left shows the history of Allstate brand combined ratio in homeowners versus the industry and competitors. And we believe that in order to achieve an adequate return on the capital that's required in this particular line of business, you have to achieve a recorded combined ratio over time at a target of 90% or better. And as you can see from the Allstate dots on that chart, we have a long history of doing exactly that. You can also see that some of our large competitors and the industry as a whole consistently generate combined ratios that don't meet what we find as a definition of needed for a return on capital. We've repositioned the homeowners business over a multiyear period by reducing exposure to unprofitable geographies, designing new products, creating highly sophisticated pricing plans, improving home inspection and risk selection process and sourcing capital through multiyear reinsurance programs. As a result of all of that, we've consistently generated excellent underwriting results. Since 2017, we've earned $3.3 billion or about $667 million annually in underwriting income with the industry generating an underwriting loss over that same period. Homeowners Insurance and Allstate's Homeowners Insurance is certainly not immune to the rising inflationary environment right now, though. And we see that in the form of higher labor costs and higher material costs. But our products have the sophisticated pricing features needed to respond to those changes and replacement values and help offset the impact. The chart on the right shows key Allstate Brand Homeowners Insurance operating statistics. And there, you'll see that our net written premium has grown sharply through 2021 and into 2022, increasing 17% from the prior year. We grew policies in force by 1.7% in the first quarter. And our Allstate agents continue to be in a really good spot to broaden customer relationships with homeowners. And our average premiums rose 14.3%, mostly driven by increasing property values, as I mentioned earlier. The first quarter combined ratio of 83.3% generated $368 million of underwriting income for the Allstate brand. In short, our property insurance business is a competitive advantage, and we aim to continue to leverage that advantage and grow it. And we look forward to sharing additional insights on homeowners with you during our upcoming special topic call on June 16. And with that, I will turn it over to Mario.
Mario Rizzo: Thanks, Glenn. Let's move to Slide 10, where we'll discuss how we're improving customer value through cost reductions. The chart on the slide shows the adjusted expense ratio, which is a metric we introduced a couple of quarters ago. This starts with our underwriting expense ratio, excluding restructuring, coronavirus-related expenses, amortization and impairment of purchased intangibles and investments in advertising. It then adds in our claims expense ratio, excluding costs associated with settling catastrophe claims because catastrophe-related costs tend to bounce around quarter-to-quarter. We believe this measure provides the best insight into the underlying expense trends within our Property-Liability business. Through innovation and strong execution, we've achieved more than 3 points of improvement since 2018. Over time, we expect to drive an additional 2 points of improvement from rent levels, achieving an adjusted expense ratio of approximately 23 by year-end 2024. This represents approximately a 6-point reduction compared to 2018, enabling an improved competitive position relative to our competitors while maintaining attractive returns. While the adjusted expense ratio increased compared to the prior year quarter, primarily due to higher employee-related costs, we remain committed to our 3-year reduction goals. Not included in this measure, but in the reported expense ratio was an increase in advertising expenses versus the prior year quarter as we took advantage of a drop in advertising costs and a seasonal increase in direct shopping to ship spending earlier in the year. Advertising will fluctuate throughout the year as we implement auto price increases and could impact near-term growth. Our future cost reduction efforts are focused on digitization, sourcing and operating efficiency and distribution-related costs. Slide 11, diagrams Transformative Growth with increase market share. This multiyear initiative is designed to increase personal property-liability market share by building a low-cost digital insurer with broad distribution. This will be accomplished by delivering on 5 key objectives: improving customer value, expanding customer access, increasing sophistication and investment in customer acquisition, deploying new technology ecosystems and enhancing organizational capabilities. We made significant progress across each objective in 2021 and are continuing the momentum in 2022. While the current auto operating environment required rapid price increases, we are confident this plan will generate long-term growth. Starting at the top of the flywheel, we have reduced expenses to improve customer value with more competitive prices while earning target returns. We are building simple, affordable and connected protection solutions that are competitively differentiated. We have enhanced and expanded distribution, including modifying the Allstate agent model to increase growth and decrease distribution costs. We also improved the strength of our direct channel capabilities by leveraging the Allstate brand and significantly expanded in the independent agent channel through National General. Differentiated products and expanded distribution are supported by increased marketing sophistication and investment. New technology ecosystems lower cost, support protection offerings and improved service and speed to market. This comprehensive approach is like a flywheel that creates sustainable competitive advantage, leading to market share growth. At the bottom of the page, you can see the 5 cases of Transformative Growth. We continue to make meaningful progress as we execute on building the new model in Phase III and begin to scale the new model in Phase 4. Moving to Slide 12. You can see how expanding customer access better meets customer demand. Starting on the bar on the lower left, you can see the auto insurance industry written premium distribution by channel in 2020 was roughly 1/3 exclusive agency, 1/3 direct and 1/3 independent agency. Allstate's pre Transformative Growth distribution auto new business as of year-end 2019 is shown in the middle bar in Allstate's first quarter 2022 distribution is shown on the right. As you can see, today, the distribution of new business more closely mirrors the industry due to Transformative Growth and the acquisition of National General. The National General acquisition significantly increased our presence in the independent agent channel and offers future growth potential by expanding middle-market product offerings. Direct sales capabilities were improved and expanded from the Esurance base, including the use of the Allstate Brand with lower pricing in this channel. Allstate agents are and will continue to be the competitive strength as an incentive shift to growth and costs are reduced. Today, the source of new business matches customer preferences and drove a 14% increase in new business applications in the first quarter compared to the prior year quarter. Slide 13 shows the profitable growth of Protection Services. Revenues, which exclude the impact of net gains and losses on investments and derivatives increased 13.6% to $627 million in the quarter. The increase in revenues was driven by continued growth at Allstate Protection Plans, generating a 19.6% increase in revenues to $329 million compared to the prior year quarter. Policies in force also increased 4.7%, reflecting growth in Allstate Protection Plans and Allstate Identity Protection. Protection Services policies in force of $147 million are approximately 4x that of property liability, showing how ubiquitous the Allstate brand is becoming. Adjusted net income of $53 million for the first quarter of 2022 increased $4 million compared to the prior year quarter after generating $179 million of adjusted net income for all of 2021. Moving to Slide 14. Allstate Health and Benefits standing product offering generated growth and income. The acquisition of National General in 2021 added both group and individual health products to our portfolio, as you can see on the left. Revenues of $581 million in the first quarter of 2022 increased 4.9% to the prior year quarter, driven by higher premiums and contract charges and other revenue, primarily in Group Hub. Adjusted net income of $53 million decreased $12 million from the prior year quarter, driven by increased individual and group health lifes. Now let's shift to Slide 15, which highlights our investment performance in the reduction of fixed income duration to reduce enterprise exposure to inflation. Net investment income totaled $594 million in the quarter, which is $114 million below the prior year quarter as shown in the chart on the left. Performance-based income, shown in dark blue, was $72 million below the prior year quarter, but 2021 was an exceptional year for private equity markets and reported income. While results are lower compared to a strong prior year, the performance-based annualized yield of 14% in the first quarter is above long-term average performance. Market-based income, shown in blue, was $31 million below the prior year quarter. As we've discussed, our market-based portfolio yield has declined in the lower interest rate environment over the last few years, with reinvestment rates below our average fixed income portfolio yield. The fixed income yield was further reduced by actions we took in the fourth quarter of 2021 to lower portfolio duration and reduce the negative impact higher inflation and interest rates would have on our fixed income portfolio valuations. The chart on the right illustrates our proactive management of interest rate exposure over the interest rate cycle. After shortening duration late in the fourth quarter of 2021, we further reduced duration by 0.7 years in the first quarter. The increase in interest rates in the quarter decreased our fixed income valuations by $2 billion, resulting in a negative portfolio return of 2.8%. However, our interest rate risk mitigation lowered the negative impact of higher interest rates by approximately $800 million versus our position at the end of the third quarter of last year. The shorter duration portfolio also positions us to reinvest in higher market yields as interest rates continue to rise. Now let's move to Slide 16, which highlights Allstate's strong capital position. Adjusted net income return on equity of 12.8% was below the prior year period due to lower auto insurance underwriting income. Allstate's strong capital position continues to enable significant cash returns to shareholders. We returned $1 billion through a combination of share repurchases and common stock dividends in the first quarter of 2022. Common shares outstanding were reduced by 8.1% over the last 12 months, 16.9% since 2018 and 45% since 2011, reflecting our history of providing strong cash returns to shareholders. As of March 31, 2022, we had $2.5 million remaining on the current $5 billion share repurchase program, which is expected to be completed by early 2023. With that context, let's open up the line for questions.
Operator: [Operator Instructions]. And the first question comes from the line of Josh Shanker of Bank of America.
Joshua Shanker: I guess, the Agency segment, you guys added 159,000 auto policies in the quarter net and lost 5,000 homeowners policies. I don't know if those are our encompass policies or if those are net gen policies. But it does seem like you're adding a lot of monoline auto, which is a lower persistency than the overall Allstate book. Given where your pricing is in the net gen book, how comfortable are you with the monoline drivers you're adding right now? And what is the strategy there on April of 2022 versus where it will be in 1.5 years?
Thomas Wilson: Josh, let me go up and then I'll let Glenn take the specific part. So we bought National General in part to get into the monoline stuff you're talking about. So we wanted -- we needed a stronger presence in the nonstandard business, particularly designed with the products and the pricing on it. We also thought we had -- and see great potential with the independent agent business. And so our goal is to take that strength in nonstandard, add our standard auto insurance and our homeowners product to that portfolio and really leverage the distribution. So you should -- we expect to see not only just growth from picking up new product line but also by expanding our existing product line through that distribution. . The homeowners piece is basically we got to make them us. We're really good at homeowners. I think they were okay at homeowners. And so you see some of the reduction being us getting their profit targets to where they need to be. Glenn, why don't you take the specifics of how that works?
Glenn Shapiro: Great. And thanks for the question, Josh. So it is definitely 2 different stories on the auto and home, as Tom mentioned. So auto, the first quarter is the shopping quarter in nonstandard auto. It's by far the biggest shopping quarter and our National General team did a really nice job of being in the market in the right places in the places they felt they had good profitability and the right pricing and growing effectively. So think of that one as -- and you're right, it's shorter duration business in terms of lifetime value, but that is their business model and they make a good return on those policies. So they grew auto in that way. . As Tom just mentioned, on the homeowner side, this has been a shift to the homeowner strategy in NatGen time that we're in we're really taking the Allstate strength and making it a strength of NatGen. So they've had to get some pricing in there. They haven't -- they've shrunk a bit in homeowners, but that's setting ourselves up for than the strategy part of this, which is as we get our middle-market products based on that Allstate data and the Allstate capabilities into the independent agent channel marketed as National General and Allstate company, the endorsed branding, that we think we have a really great opportunity to grow homeowners with the Allstate level of sophistication and pricing and all the things I talked about in the opening remarks. But in a channel, we really haven't meaningfully been in before. So that's the path forward. But as we sit from a 1-quarter basis, we're still in, I guess, correction mode of the homeowners business there, but in a really good quarter and in a really good place from a nonstandard auto standpoint.
Joshua Shanker: Okay. And [indiscernible] reputation is the only person who asked a question is about Allstate Protection Plans. I want to go to another area that never gets any questions. Allstate Commercial, as I calculated, it seems like you guys are running at about 120% combined ratio in that business, but growing very quickly. What is it and what exactly is going on there? And maybe I'm wrong.
Thomas Wilson: No. We always appreciate your precision, Josh. First, I am not pleased -- none of us are pleased with the results of Allstate Business Insurance. So we review -- we've done a bunch of work to improve the profitability in that line. There's really 2 parts to the business. And one is the, what I would just call traditional commercial insurers, small contract or stuff like that, that we sell through Allstate agents. And then there's the shared economy business. And it's a shared economy business that has been trouble for us from a profitability standpoint, particularly a home-sharing company and then some states in the transportation network companies. . And we made a decision last year that we weren't going to chase revenue if we didn't think that the states were profitable. So we exited a number of states. I think 3 big states, in particular, in the transportation network piece because they were not profitable. And then the home-sharing business, we just got out of that contract altogether. Glenn, do you want to -- what would you like to add to that?
Glenn Shapiro: I would just add that if you look at -- when you're talking about the premium growth there, it is 2 things in large part. One is, we've raised rates in sort of the traditional small commercial business we have. So rates are materially up, units are not. The other is that a year ago, transportation business is -- because we have -- the charge by mile and we pay them for the usage. A year ago, there was very little usage still in those transportation networks, and there's a lot more usage and therefore, a lot more premium right now. And we have raised, as Tom said, we've gotten out of some states and we've raised rates on those. So we think the profitability go forward is better. So it's not growth in that we're piling on business as we've gotten a lot more revenue coming through.
Operator: Next question comes from the line of Greg Peters of Raymond James.
Charles Peters: I appreciate the new information and your updated investor slide deck, just FYI. So I'm going to focus my one question on Slide 8. And I'm just trying to put the pieces together of the information you provided us around pricing. Tom, you mentioned in your opening remarks, surgical pricing, and you talked about how you're differentiating between lower lifetime value customers and longer lifetime values. Glenn, you talked about a lot of rate in the pipeline that's going to affect earned premium going forward. And I was trying to reconcile the language difference from your February cat and pricing report to your March cat and pricing report. And the difference between the 2, just 1 month later in the March pricing report, you said that that effectively lost cost inflations were exceeding your targets and you were going to have to raise prices even more, just 1 month later from your February pricing report. So I was hoping maybe you could put all those pieces together for us and sort of map out what's going on.
Glenn Shapiro: Tom, did you want to start on that? Or do you want me to?
Thomas Wilson: Yes, sorry, I was on mute. It was quite articulate but -- great. Let me start off and then I'll get Glenn and Mario to give you more specifics. So first, obviously, increasing price is really important to getting our auto insurance possibility. We've been aggressive, but we believe smart about spreading it between newer less profitable customers and profitable longer-tenure customers. And so obviously, let's say you have a customer who's been with you 10 years and you're making a 95% combined ratio, and you have one that's new and you're losing money on it. And you have to raise your rates to cover the higher inflation, which impacts both customers. If you give them both the same amount, you run the risk of losing that long-tenured profitable customer. So we've put less rate into our, what we would call, older closed books and more into our newer books with shorter-term customers. And we believe that, that protects lifetime value and will help with retention. In this new space, retention is going to be a challenge for all companies. And so we're -- but we're trying to make sure we manage our way through it. So the numbers that you see on Slide 8 are the total between all the customers, whether new old profitable, unprofitable to help us get there. But it's more surgical than it appears. I would say the other part is what we're doing auto profitability back to Glenn's earlier slide was like we know how to make money in auto insurance, and we're going to make money in auto insurance. But we want to make sure it's sustainable. One is the way we're taking those prices. Two is make sure the expense reductions are permanent, not just temporary, making sure you manage your loss costs differently, and just make sure you're being -- continuing to invest in sophistication and new products. So we feel good about this, but then hopefully, that provides some insight. As to the change in the outlook, that maybe be more what we said than just sort of like waking up in the month of March and deciding we're going to say something different. Glenn, do you want to talk about how this has unfolded. And Mario, if you're going to go onto closures, that would be helpful.
Glenn Shapiro: Yes. So I'll start with how it unfolded. I mean -- I would say, we continue to see inflation run like a lot of people continue to see. We continue to see elongated time frames for development, including prior year development. And so we're taking, I think, an appropriately conservative view and saying that like we're going to need more rate on that part of it. The other part on the precision, I want to build on what Tom said, because it's an important point because we do use a lot of precision. And I think that there some folks who talk more -- or some companies talk more or less about their level of segmentation and precision. We maybe don't do a good enough job talking about the depth that we have in terms of our segmentation, which is highly sophisticated and that's what Tom is going into. But it's sophistication at that level, but also on the go-to-market level. Because clearly, we kept marketing open, and we took an opportunity to grow some business that the economics were good on. We did that because the marketing cost itself was down with others leaving that area. There were a lot of shoppers and first quarter tends to be a time that a lot of people shop. . Now we also did that with a lot of precision. It's the entire go-to-market system because we're not just -- to sort of have the open sign everywhere. It is -- we're marketing precisely where we know we have a lifetime value return based on risk type based on market within state level. And it's a combination of underwriting, marketing, pricing that all comes together -- and distribution that all comes together with how we go to market and drive where we want to grow and how we want to grow that I think goes into the need for rate as well.
Mario Rizzo: Yes. If I can just add, Greg, this is Mario. First, I guess, where I'd start is, the objective of providing that rate information monthly that we started this year was really to create a level of transparency into what we were doing with auto profitability with rates being such a significant lever and provide you all with a view of the progress we're making but also some color around what we're seeing on a forward-looking basis. So that's the objective. And the language we used in the most recent disclosure provided, I think, some additional context. In terms of what's happening, I think we continue to look at loss trends month-in and month-out, both in terms of reserve levels, severe trends and just loss trends overall. And the statement we made in our most recent release was really a reflection of what we were seeing in loss trends in severity development both in terms of what we saw in last year, we strengthened reserves by $151 million in auto this quarter and what we were seeing in terms of the physical damage severity escalation as well as what -- how that translated into current year severity. So we're taking that data. We're looking at it. We're working with the pricing team and factoring it into our outlook and the purpose of the disclosure again is to tell you what we did, but also provide a little more texture around what we're seeing in the market. .
Operator: Next question comes from the line of Andrew Kligerman of Credit Suisse.
Andrew Kligerman: Yes, great answer to the prior question. I guess you didn't mention anything about non-rate actions. Would it be possible to discuss nonrate actions as as maybe a percent of the business that you're able to get that on and maybe how much that might be contributing to improved performance?
Thomas Wilson: Glenn, do you want to take that for both the Allstate Brand and National General?
Glenn Shapiro: Yes. So one, and if you saw the -- I'll go to the National General first, we saw that National General underlying combined ratio looked pretty good in the first quarter. And one of the things that they have that's really stable is fee structure. The fee structure is a nonrate element that turns out to be really stable over time and helps them predict and plan for their combined ratio. When I think about nonrate actions across the Allstate book, it really goes back to what I was talking about where it's about -- I don't like to isolate it to the word underwriting because then it sounds like you're sort of deciding to write or not to write as opposed to getting the right level of rate for each type of risk, but that also goes into with underwriting and marketing and distribution how you go to market. And where we've really built our sophistication is in how our marketing team, our underwriting and product teams and pricing and our distribution organization deploy resources quickly and nimbly to where and how we're looking to grow. And I think that in itself generates a lot of the long-term economic value that we drive.
Andrew Kligerman: Okay. So really not any real actions to -- okay, makes a lot of sense. And then if I could just quickly sneak one in. The buyback of $794 million that's pretty fast in terms of the pace. I thought you had about $3.3 billion left, and this implies you're going at a quicker pace. Is there a chance that you could complete that authorization by the end of this year or do more than you anticipated because it seems pretty robust and I was curious about the thinking there.
Thomas Wilson: Andrew, it's Tom. First, on the actions. You will see though -- I know you will see some things like down-pay requirements and stuff like that, that we will change going forward to help manage the selection of the business. So Glenn is absolutely right that we're being very precise in which stuff we want, but if we feel like there are certain policy terms and things we can change or payment terms that we can change that will help us, we will put those in place. . On the buyback Mario is committed to have it done early in the first quarter of next year. Mario, anything you want to add to that?
Mario Rizzo: No, I think that's right, Tom. So I wouldn't read too much into any one quarter. We still have $2.5 billion left to buy. We said we'll complete it by early next year, and that's the point.
Operator: Next question comes from the line of David Motemaden of Evercore ISI. .
David Motemaden: I had a question on Slide 8. It says that you guys have a higher mix of newer, more expensive vehicles. Glenn, I believe you said that those vehicles come with higher premiums, and they can adversely impact total loss severity when vehicle values rise. Does the fact that you have more of a mix of more expensive vehicles, does that increase -- or does that mean that you need to take more rate relative to peers? Or I guess, how should I interpret this mix difference that you guys have versus peers?
Thomas Wilson: Glenn, do you want to do that?
Glenn Shapiro: Yes. So there's a few parts to that because I'll talk more macro about the auto -- the car park out there and like the whole system. With every new model year newer that we get and every year that passes, we've done the math through what's in our book of business, what type of safety elements are in cars, accident avoidance, technology and everything. And we know 2 things: one, that we get a little bit of a tailwind with every year that passes on frequency, and we get a little bit of a headwind on severity because they're more expensive to fix, more sensors and so on. And the reason I started there is that would be true of this example as well. The fact that our book of business tends to trend that way more, it will give us a little bit of a sustainable benefit on frequency in comparison to others, and it will give us a little bit of a sustainable headwind on the severity. But we do charge premium based on make and model year and you get a higher premium for it. It was more of a statement in that opening that as we look at and we try to put our trends, whether we're looking at Fast Track or looking at public disclosures, when we look at our trends on bodily injury or property damage, which are third-party vehicles, and then collision first-party vehicles, we see some of that difference come through and then have to like do the math back to our premium and ensure that we're getting the right rates for all of that.
Operator: Next question comes from the line of Meyer Shields of KBW.
Meyer Shields: Fantastic. I wanted to dig in a little more to your comments on homeowners and the automatic lift because we've seen a little bit of deterioration in the underlying loss ratio all of last year into the first quarter. Is the automatic, I guess, inflation guard changing? Are there other steps that are necessary in homeowners?
Thomas Wilson: Well, the first, we're really happy with where the homeowners business is today in terms of its profitability. As you know, sometimes it bounces around because catastrophes -- we had slightly lower catastrophes this quarter than the prior year quarter, but still earn a really good return. The underlying combined ratio, as you point out, which excludes catastrophes, ticked up a little bit. We feel comfortable with where that is in part because of the inflation parts that you mentioned that come through, what we call PIA, Property Insurance Adjustment. It really raises average premium. And as that burns in to earn premium just like it does burn through in auto that cover some of those increased costs. If it doesn't, we have plenty of room to go in and continue to prices. Glenn, what would you add about severity in the combined ratio in [indiscernible]?
Glenn Shapiro: Yes. So first, I always start with I think we're accountable for the recorded combined ratio because ultimately, if we always had a good underlying but like we hadn't gotten the right reinsurance or we hadn't been in the right locations, and we hadn't done good risk mapping for wildfire or hail or hurricane or any other exposure and we were constantly running what the industry or key competitors run. I think you would rightfully hold us accountable for that. So I always go back to the recorded combined ratio. That said, the underlying, as Tom said, it moves up and down a little bit, and we do watch that primarily though we watch the recorded combined ratio. Right now, like Tom, I feel really good about where we are. Severity ran hot in the first quarter. It's tough to look at one quarter in homeowners and draw a lot of conclusions because there's a decent amount of volatility between the mix of perils in homeowners. It's not nearly as stable as auto in that way. And so we're watching that, that was a high number, but we got an average price increase, average earned premium of 14.3% burning through, which really ticked up in the latter part of the year last year. So we'll continue to give us benefit as that earns through. And we're in -- obviously, we're really good shape in homeowners, and I feel good about it.
Meyer Shields: Okay. That's helpful. Second question on the auto side. I just want to make sure that I'm understanding the commentary on the surgical application of rate increases, should we expect, I guess, suppressed new business as the strategy works its way through to the extent that rate increases are being focused on lower tenured customers? .
Thomas Wilson: I'll start off and then Glenn, you can jump in. I think a lot of this premier depends on what happens in the competitive environment. So as other people are taking rents, it depends where they're spreading their rates. So if you buy on the renewal book, then that will create more shoppers because those tend to be people who shop less than just putting it all on the new business. But part of it depends what happens, how people do it. That said we feel pretty good about where we track our competitive position, the LTI index with our LTI Index at this point. So we're hopeful that as we move through this, we'll still continue to grow. With Transformative Growth on top of that, we think that it all still hangs together in terms of increasing market share. Glenn, what would you add to that?
Glenn Shapiro: I'll just add if you take the long term and the short term, the long term first, as Tom said, our expanded customer access, our work on improving value as we get the 3 points at cost that Mario talked about out and we've got access into all these systems, and we get middle market products into the IA channel and our exclusive agents are humming, we've got a really good long-term prognosis on that. . With your question, you were asking, I think, some about the short term. So as you think about what we did early this year, we pulled marketing dollars forward, and we've talked about the fact that we pulled them forward. That's not the same as increasing them. It did increase in the quarter, but it's pulling it forward. That means it does have to come out of somewhere, too. We decided to do that because there were good economics on the marketing. A number of companies publicly talked about pulling back from marketing that left from the supply and demand curve of marketing costs that left it reasonable, and there was good economics on it, plus a lot of business gets sold in the first quarter. So we thought with a lot of shoppers in the market with rates out there, that it would be a good time to be in the market where we had our prices in, and we felt good about the lifetime value. That said, inflation is continuing to run and we're taking more rate, and we pulled that money forward from later. So marketing will reduce from this point and that could have a short-term impact on new business growth, plus we've got -- everybody will have headwinds on retention with the amount of rate that's in the system across the industry.
Thomas Wilson: Yes. I think when you go back to Glenn's long term. Bottom we like prospects for sustainable profitable growth. I mean, auto insurance, we know how to buy money and with transformative growth, we really grow that business. You add homeowners on top of that, which is really a growth business. And just like price and value are important to auto insurance customers, it's also important in investing. And when you look at the price of Allstate, it's essentially less than your other options. That's why we think transformative growth is going to increase nation multiples. .
Operator: Next question comes from the line of Brian Meredith of UBS.
Brian Meredith: A quick question here. On Slide 11 of your supplement, you've got an interesting chart here that looks at auto state profitability. Just my question is, is this based on an earned kind of basis? Or is on a written basis. And if it's on an earned basis, how would this chart look on a written basis, as far as what states do you think are currently pretty close to rate adequate?
Thomas Wilson: Well, that's a tough question. I don't know if we -- Glenn, do you want to take the forward looking.
Glenn Shapiro: Yes, I'll take it. Yes. So it's definitely earned basis in that we look at our when you look at combined ratios, it's on an earned basis. So you're hitting a really important point. So it's an astute observation. Because I think about that disclosure and you could look at -- when you look at the percentage of states that are above 100, for example, that is not the same as looking at the way we look at where do we want to grow. Because the state could be above 100 right now, but we've just gotten in the rate we feel we need to be adequate. So any new business we put on is going to be at a rate adequate level that we like, and we would want to grow there. So it really does lag and you have to go back to Page 8 and see where that -- which we don't -- because that's an estimate. We don't estimate every state and disclose based on when we'll earn the premiums and what percentage will earn by state and what that will do. But the point is, while that's a snapshot of where we are today, that does not reflect all of the written premiums and increases that we've got. .
Thomas Wilson: Okay. Well, thank you all for engaging with us today. As we go forward, we look forward to in the next month or so talking about homeowners -- and then we continue to execute in the meantime our multi-facet fan, both to improve profitability of auto insurance and to get Transformative Growth because that's a key component to sustainable growth, and both of those will improve shareholder value. So thank you for your engagement, and we'll talk to you soon.
Operator: Thank you so much to our presenters and to everyone who participated. This concludes today's conference call. You may now disconnect. Have a great day. | [
{
"speaker": "Operator",
"text": "Good morning, everyone. Thank you for standing by, and welcome to the Allstate First Quarter 2020 Earnings Conference Call. [Operator Instructions]. I would now like to hand the conference over to your speaker today, Mr. Mark Nogal."
},
{
"speaker": "Mark Nogal",
"text": "Thank you, Kirby. Good morning, and welcome to Allstate's First Quarter 2022 Earnings Conference Call. After prepared remarks, we'll have a question-and-answer session. Yesterday, following the close of the market, we issued our news release and investor supplement, filed our 10-Q and posted today's presentation, along with our reinsurance update on our website at allstateinvestors.com. Our management team is here to provide perspective on these results. As noted on the first slide of the presentation, our discussion will contain non-GAAP measures, for which there are reconciliations in the news release and investor supplement and forward-looking statements about Allstate operations. Allstate's results could differ materially from these statements, so please refer to our 10-K for 2021 and other public documents for information on potential risks. Before I hand it off to Tom, I want to share that we will be hosting our second special topic investor call on June 16, focusing on the value of homeowners. We look forward to the additional engagement later this quarter, and we'll share further information soon. And now I'll turn it over to Tom."
},
{
"speaker": "Thomas Wilson",
"text": "Well, good morning, and thank you for investing your time in Allstate today. Now let's start on Slide 2. So Allstate's strategy to deliver Transformative Growth and higher valuation has two components: increase personal profit liability market share and expand protection services, which are shown in the 2 ovals on the left. We're building a low-cost digital insurer with broad distribution to a Transformative Growth. We're also diversifying our business by expanding protection offerings as shown in the bottom. In the first quarter, we made progress in 3 key areas to execute this strategy. We're 6 months into a multifaceted plan to address the negative impact of inflation, which is largely in auto insurance. This begins with aggressively raising prices. We're doing this surgically and raising prices more for new or shorter tenured customers with less profitability and less for longer tenured profitable customers. Progress was also made in executing programs to reduce expenses and manage loss costs. We also shifted our asset allocations by reducing the interest rate exposure of our bond portfolio in the fourth quarter of last year, which lowered the overall enterprise impact from higher inflation by $800 million. Secondly, we continue to make progress on transformative growth by expanding customer access increasing pricing sophistication and building new technology ecosystems. Protection Services also continues its profitable growth trajectory with revenue growth of almost 14% above the prior year. Moving to Slide 3, let's discuss first quarter performance in more detail. Property liability premiums earned increased 6.1% due to higher average premiums and a 2.1% growth in policies in force. Net investment income of $594 million was 16.1% below the prior year quarter, reflecting lower fixed income reinvestment rates, the impact of reducing the bond portfolio duration and strong performance-based portfolio income that was in comparison to an exceptional prior year quarter. Net income of $630 million in the first quarter compares to a $1.4 billion loss in the prior year, which included losses related to the disposition of the life and annuity businesses. Adjusted net income of $726 million or $2.58 per diluted share declined compared to the nearly $1.9 billion generated in the prior year quarter due to lower underwriting income. You'll remember, last year's first quarter reflected low auto accident frequency because of the pandemic and inflation and loss costs had not yet been realized. We provided over $1 billion in cash returns to shareholders in the quarter and reduced outstanding shares by 8.1% over the last 12 months. Moving to Slide 4. You can see how income from homeowners insurance, investments, Protection Services and health and benefits mitigated the negative impact as inflation had on auto insurance. Insurance underwriting margins provided $267 million of after-tax adjusted net income or $0.95 a share. Auto insurance generated a slight underwriting loss with a recorded combined ratio of B. Our industry-leading homeowners insurance business generated underwriting income that contributed $335 million of adjusted net income or $1.19 per share. And although performance-based investment income declined from record highs in 2021, results were still strong in the first quarter, with property liability net investment income contributing $1.56 per share. Protection Services and Health and Benefits income more than offset the losses in auto insurance. Now let me turn it over to Glenn to discuss the property liability results in more detail."
},
{
"speaker": "Glenn Shapiro",
"text": "Thanks, Tom. Starting on Page 5, we'll talk about profitability in Allstate Brand auto insurance. We target mid-90s combined ratio in auto insurance. And as you could see from the chart on the left, we have a long history of meeting or exceeding that target, supported by our pricing sophistication, underwriting, claims expertise, expense management. And of course, when you look at 2020 in that chart, it's an outlier in terms of the view because we had much better than target results due to the early pandemic impacts. On the chart on the right breaks down the 5 most recent quarters, highlighting the significant increase in combined ratio that occurred in 2021, as we transitioned from those favorable pandemic impacts to the high inflation environment that we're in today. . In late 2020 and early 2021, as Tom just mentioned, while we were running a combined ratio around 80 and benefiting from frequency and the improved cost structure changes we've made, we took price decreases. And then as inflation spiked in Q2 and Q3 of last year, we shifted towards rate increases, which ramped up significantly in the last 6 months. The recorded and underlying combined ratios improved sequentially in the first quarter of '22, though inflationary trends continue to pressure margins with increasing severity. And frequency is obviously higher year-over-year from that low point, but it's been very stable in terms of maintaining lower level frequency compared to pre-pandemic levels. We'll go deeper into severity and pricing for auto insurance in the next few pages. So let's move to Slide 6 and talk about Allstate auto physical damage claims severity in more detail. The story of higher severity has continued into 2022, and it's across the country, as you can see from the map on the left. Allstate Brand report year 2022 incurred severity for property damage increased about 11% compared to report year '21. Now recall that we shifted to report year incurred severity to give you a better view directly into what's recorded in our financials. And it's really important to note on this that when you look at paid severities, it's typically shared as a comparison to the prior year quarter or year-to-date or some prior period, whereas our new disclosure is an estimate of the full change in the fully developed report year severities year-over-year. So the 11% in this case, is the expected severity in '22 over all of 2021, inclusive of the inflation seen in quarters 2 through 4. On the chart on the right, you can see that Allstate has a higher distribution of total loss claims involving newer vehicles compared to the industry. And while those vehicles come with higher premiums, they also can adversely impact total loss severity when vehicle values rise. We're adjusting pricing and using our strong claim capabilities to mitigate rising costs, and that includes leveraging our scale, our operating processes, experienced claim professionals, technology, broad repair relationships that we have and our investments in data and analytics to help contain costs for customers. Moving to Slide 7. Let's talk about bodily injury severity increases because they've also contributed to auto insurance cost and price increases. Like property damage, casualty loss trends have been elevated for the past few years and continued into '22. But the bodily injury pressure isn't quite as wide spread. Allstate brand report year '22 incurred severity for bodily injury increased about 8% compared to report year '21. Higher-speed accidents and less congested roads are leading to harder impact crashes and more severe injuries, and an evolving legal environment is also a factor in casualty costs. If you look at the chart on the left, you'll see that claims resulting in a nondrivable vehicle, which would mean kind of a harder hit and claims resulting in bodily injury claims with a major injury designation have increased compared to pre-pandemic levels. That's driving a shift to more complex and costly treatments and contributing to higher medical consumption. In terms of the legal environment, trial attorney advertising for claimants has doubled over the past decade and exceeds $1 billion annually now. That results in higher attorney representation rates, and ultimately, higher costs for consumers. The chart on the right shows the severity variance to prior years trending higher in some of our more populous states like Texas, Florida, Georgia, New York and California. And Texas actually accounted for about 80% of the prior report year strengthening within bodily injury in the first quarter. Here again, our scale, our investments in technology and in data and analytics and our claim expertise are helping us resolve claims fairly, accurately and efficiently. Moving to Slide 8, let's talk about another key component to our multifaceted plan to deal with inflation, and that's raising auto insurance prices. The table on the left provides a view into 2021 in the first quarter of '22 rate actions in Allstate Brand Auto. We implemented rate decreases as we talked about earlier, in early '21 to reflect our continued lower frequency and expense reductions. In the second quarter, as inflation picked up, we pulled back on any reductions and began increasing rates by the third quarter, and then those rate actions accelerated in the fourth quarter and then further accelerate in the first quarter this year. In the first quarter of '22, we implemented rate in 28 states with an average increase of 9.3% and a weighted Allstate Brand Auto premium impact of 3.6%. When you combine that with the fourth quarter actions, we've increased weighted rates by 6.5% over the last 6 months, and that equates to a gross annualized written premium impact of $1.6 billion within the Allstate brand. About 95% of our premiums in the U.S. are coming from 6-month term policies. So the rates will improve margins, but there's a lag between when the rates are implemented and they're ultimately earned, which you can see in the chart on the right, which estimates when the rate increases taken in the last 6 months will be earned into premium. That illustration assumes only 85% of the annualized premium will be earned to account for things like retention and the fact that customers modify their policy terms when faced with a price increase, like changing deductibles or limits. As you can see, looking at Q1 2022, the rate increases we've taken didn't have a whole lot of impact yet, but you can see it coming in the coming quarters, and it really accelerates. We expect to see significant increases in earned premium beginning in the second half, reaching over $1.1 billion by the first quarter of next year based on the implemented rate so far. And keep in mind that additional rates and increases that we take through this year will be additive and compound on those rate increases. And given the ongoing inflationary pressure, we have increased the magnitude of rate increases we expect to take in the rest of 2022. We remain very confident in our ability to restore auto profitability to targeted levels, and we'll keep you posted on that in our new monthly disclosures of rate filings. So let's move to Slide 9 and take a look at something that I think is an undervalued strength at Allstate. It's our industry-leading homeowners business. As you know, a significant portion of our customers bundle home and auto, and that improves the retention and overall economics of both lines of business. We've differentiated our homeowners product and our homeowners capability really, and that goes to our product, our underwriting, our reinsurance, our claims ecosystem. It is a unique entire business model and system in the industry. The graph on the left shows the history of Allstate brand combined ratio in homeowners versus the industry and competitors. And we believe that in order to achieve an adequate return on the capital that's required in this particular line of business, you have to achieve a recorded combined ratio over time at a target of 90% or better. And as you can see from the Allstate dots on that chart, we have a long history of doing exactly that. You can also see that some of our large competitors and the industry as a whole consistently generate combined ratios that don't meet what we find as a definition of needed for a return on capital. We've repositioned the homeowners business over a multiyear period by reducing exposure to unprofitable geographies, designing new products, creating highly sophisticated pricing plans, improving home inspection and risk selection process and sourcing capital through multiyear reinsurance programs. As a result of all of that, we've consistently generated excellent underwriting results. Since 2017, we've earned $3.3 billion or about $667 million annually in underwriting income with the industry generating an underwriting loss over that same period. Homeowners Insurance and Allstate's Homeowners Insurance is certainly not immune to the rising inflationary environment right now, though. And we see that in the form of higher labor costs and higher material costs. But our products have the sophisticated pricing features needed to respond to those changes and replacement values and help offset the impact. The chart on the right shows key Allstate Brand Homeowners Insurance operating statistics. And there, you'll see that our net written premium has grown sharply through 2021 and into 2022, increasing 17% from the prior year. We grew policies in force by 1.7% in the first quarter. And our Allstate agents continue to be in a really good spot to broaden customer relationships with homeowners. And our average premiums rose 14.3%, mostly driven by increasing property values, as I mentioned earlier. The first quarter combined ratio of 83.3% generated $368 million of underwriting income for the Allstate brand. In short, our property insurance business is a competitive advantage, and we aim to continue to leverage that advantage and grow it. And we look forward to sharing additional insights on homeowners with you during our upcoming special topic call on June 16. And with that, I will turn it over to Mario."
},
{
"speaker": "Mario Rizzo",
"text": "Thanks, Glenn. Let's move to Slide 10, where we'll discuss how we're improving customer value through cost reductions. The chart on the slide shows the adjusted expense ratio, which is a metric we introduced a couple of quarters ago. This starts with our underwriting expense ratio, excluding restructuring, coronavirus-related expenses, amortization and impairment of purchased intangibles and investments in advertising. It then adds in our claims expense ratio, excluding costs associated with settling catastrophe claims because catastrophe-related costs tend to bounce around quarter-to-quarter. We believe this measure provides the best insight into the underlying expense trends within our Property-Liability business. Through innovation and strong execution, we've achieved more than 3 points of improvement since 2018. Over time, we expect to drive an additional 2 points of improvement from rent levels, achieving an adjusted expense ratio of approximately 23 by year-end 2024. This represents approximately a 6-point reduction compared to 2018, enabling an improved competitive position relative to our competitors while maintaining attractive returns. While the adjusted expense ratio increased compared to the prior year quarter, primarily due to higher employee-related costs, we remain committed to our 3-year reduction goals. Not included in this measure, but in the reported expense ratio was an increase in advertising expenses versus the prior year quarter as we took advantage of a drop in advertising costs and a seasonal increase in direct shopping to ship spending earlier in the year. Advertising will fluctuate throughout the year as we implement auto price increases and could impact near-term growth. Our future cost reduction efforts are focused on digitization, sourcing and operating efficiency and distribution-related costs. Slide 11, diagrams Transformative Growth with increase market share. This multiyear initiative is designed to increase personal property-liability market share by building a low-cost digital insurer with broad distribution. This will be accomplished by delivering on 5 key objectives: improving customer value, expanding customer access, increasing sophistication and investment in customer acquisition, deploying new technology ecosystems and enhancing organizational capabilities. We made significant progress across each objective in 2021 and are continuing the momentum in 2022. While the current auto operating environment required rapid price increases, we are confident this plan will generate long-term growth. Starting at the top of the flywheel, we have reduced expenses to improve customer value with more competitive prices while earning target returns. We are building simple, affordable and connected protection solutions that are competitively differentiated. We have enhanced and expanded distribution, including modifying the Allstate agent model to increase growth and decrease distribution costs. We also improved the strength of our direct channel capabilities by leveraging the Allstate brand and significantly expanded in the independent agent channel through National General. Differentiated products and expanded distribution are supported by increased marketing sophistication and investment. New technology ecosystems lower cost, support protection offerings and improved service and speed to market. This comprehensive approach is like a flywheel that creates sustainable competitive advantage, leading to market share growth. At the bottom of the page, you can see the 5 cases of Transformative Growth. We continue to make meaningful progress as we execute on building the new model in Phase III and begin to scale the new model in Phase 4. Moving to Slide 12. You can see how expanding customer access better meets customer demand. Starting on the bar on the lower left, you can see the auto insurance industry written premium distribution by channel in 2020 was roughly 1/3 exclusive agency, 1/3 direct and 1/3 independent agency. Allstate's pre Transformative Growth distribution auto new business as of year-end 2019 is shown in the middle bar in Allstate's first quarter 2022 distribution is shown on the right. As you can see, today, the distribution of new business more closely mirrors the industry due to Transformative Growth and the acquisition of National General. The National General acquisition significantly increased our presence in the independent agent channel and offers future growth potential by expanding middle-market product offerings. Direct sales capabilities were improved and expanded from the Esurance base, including the use of the Allstate Brand with lower pricing in this channel. Allstate agents are and will continue to be the competitive strength as an incentive shift to growth and costs are reduced. Today, the source of new business matches customer preferences and drove a 14% increase in new business applications in the first quarter compared to the prior year quarter. Slide 13 shows the profitable growth of Protection Services. Revenues, which exclude the impact of net gains and losses on investments and derivatives increased 13.6% to $627 million in the quarter. The increase in revenues was driven by continued growth at Allstate Protection Plans, generating a 19.6% increase in revenues to $329 million compared to the prior year quarter. Policies in force also increased 4.7%, reflecting growth in Allstate Protection Plans and Allstate Identity Protection. Protection Services policies in force of $147 million are approximately 4x that of property liability, showing how ubiquitous the Allstate brand is becoming. Adjusted net income of $53 million for the first quarter of 2022 increased $4 million compared to the prior year quarter after generating $179 million of adjusted net income for all of 2021. Moving to Slide 14. Allstate Health and Benefits standing product offering generated growth and income. The acquisition of National General in 2021 added both group and individual health products to our portfolio, as you can see on the left. Revenues of $581 million in the first quarter of 2022 increased 4.9% to the prior year quarter, driven by higher premiums and contract charges and other revenue, primarily in Group Hub. Adjusted net income of $53 million decreased $12 million from the prior year quarter, driven by increased individual and group health lifes. Now let's shift to Slide 15, which highlights our investment performance in the reduction of fixed income duration to reduce enterprise exposure to inflation. Net investment income totaled $594 million in the quarter, which is $114 million below the prior year quarter as shown in the chart on the left. Performance-based income, shown in dark blue, was $72 million below the prior year quarter, but 2021 was an exceptional year for private equity markets and reported income. While results are lower compared to a strong prior year, the performance-based annualized yield of 14% in the first quarter is above long-term average performance. Market-based income, shown in blue, was $31 million below the prior year quarter. As we've discussed, our market-based portfolio yield has declined in the lower interest rate environment over the last few years, with reinvestment rates below our average fixed income portfolio yield. The fixed income yield was further reduced by actions we took in the fourth quarter of 2021 to lower portfolio duration and reduce the negative impact higher inflation and interest rates would have on our fixed income portfolio valuations. The chart on the right illustrates our proactive management of interest rate exposure over the interest rate cycle. After shortening duration late in the fourth quarter of 2021, we further reduced duration by 0.7 years in the first quarter. The increase in interest rates in the quarter decreased our fixed income valuations by $2 billion, resulting in a negative portfolio return of 2.8%. However, our interest rate risk mitigation lowered the negative impact of higher interest rates by approximately $800 million versus our position at the end of the third quarter of last year. The shorter duration portfolio also positions us to reinvest in higher market yields as interest rates continue to rise. Now let's move to Slide 16, which highlights Allstate's strong capital position. Adjusted net income return on equity of 12.8% was below the prior year period due to lower auto insurance underwriting income. Allstate's strong capital position continues to enable significant cash returns to shareholders. We returned $1 billion through a combination of share repurchases and common stock dividends in the first quarter of 2022. Common shares outstanding were reduced by 8.1% over the last 12 months, 16.9% since 2018 and 45% since 2011, reflecting our history of providing strong cash returns to shareholders. As of March 31, 2022, we had $2.5 million remaining on the current $5 billion share repurchase program, which is expected to be completed by early 2023. With that context, let's open up the line for questions."
},
{
"speaker": "Operator",
"text": "[Operator Instructions]. And the first question comes from the line of Josh Shanker of Bank of America."
},
{
"speaker": "Joshua Shanker",
"text": "I guess, the Agency segment, you guys added 159,000 auto policies in the quarter net and lost 5,000 homeowners policies. I don't know if those are our encompass policies or if those are net gen policies. But it does seem like you're adding a lot of monoline auto, which is a lower persistency than the overall Allstate book. Given where your pricing is in the net gen book, how comfortable are you with the monoline drivers you're adding right now? And what is the strategy there on April of 2022 versus where it will be in 1.5 years?"
},
{
"speaker": "Thomas Wilson",
"text": "Josh, let me go up and then I'll let Glenn take the specific part. So we bought National General in part to get into the monoline stuff you're talking about. So we wanted -- we needed a stronger presence in the nonstandard business, particularly designed with the products and the pricing on it. We also thought we had -- and see great potential with the independent agent business. And so our goal is to take that strength in nonstandard, add our standard auto insurance and our homeowners product to that portfolio and really leverage the distribution. So you should -- we expect to see not only just growth from picking up new product line but also by expanding our existing product line through that distribution. . The homeowners piece is basically we got to make them us. We're really good at homeowners. I think they were okay at homeowners. And so you see some of the reduction being us getting their profit targets to where they need to be. Glenn, why don't you take the specifics of how that works?"
},
{
"speaker": "Glenn Shapiro",
"text": "Great. And thanks for the question, Josh. So it is definitely 2 different stories on the auto and home, as Tom mentioned. So auto, the first quarter is the shopping quarter in nonstandard auto. It's by far the biggest shopping quarter and our National General team did a really nice job of being in the market in the right places in the places they felt they had good profitability and the right pricing and growing effectively. So think of that one as -- and you're right, it's shorter duration business in terms of lifetime value, but that is their business model and they make a good return on those policies. So they grew auto in that way. . As Tom just mentioned, on the homeowner side, this has been a shift to the homeowner strategy in NatGen time that we're in we're really taking the Allstate strength and making it a strength of NatGen. So they've had to get some pricing in there. They haven't -- they've shrunk a bit in homeowners, but that's setting ourselves up for than the strategy part of this, which is as we get our middle-market products based on that Allstate data and the Allstate capabilities into the independent agent channel marketed as National General and Allstate company, the endorsed branding, that we think we have a really great opportunity to grow homeowners with the Allstate level of sophistication and pricing and all the things I talked about in the opening remarks. But in a channel, we really haven't meaningfully been in before. So that's the path forward. But as we sit from a 1-quarter basis, we're still in, I guess, correction mode of the homeowners business there, but in a really good quarter and in a really good place from a nonstandard auto standpoint."
},
{
"speaker": "Joshua Shanker",
"text": "Okay. And [indiscernible] reputation is the only person who asked a question is about Allstate Protection Plans. I want to go to another area that never gets any questions. Allstate Commercial, as I calculated, it seems like you guys are running at about 120% combined ratio in that business, but growing very quickly. What is it and what exactly is going on there? And maybe I'm wrong."
},
{
"speaker": "Thomas Wilson",
"text": "No. We always appreciate your precision, Josh. First, I am not pleased -- none of us are pleased with the results of Allstate Business Insurance. So we review -- we've done a bunch of work to improve the profitability in that line. There's really 2 parts to the business. And one is the, what I would just call traditional commercial insurers, small contract or stuff like that, that we sell through Allstate agents. And then there's the shared economy business. And it's a shared economy business that has been trouble for us from a profitability standpoint, particularly a home-sharing company and then some states in the transportation network companies. . And we made a decision last year that we weren't going to chase revenue if we didn't think that the states were profitable. So we exited a number of states. I think 3 big states, in particular, in the transportation network piece because they were not profitable. And then the home-sharing business, we just got out of that contract altogether. Glenn, do you want to -- what would you like to add to that?"
},
{
"speaker": "Glenn Shapiro",
"text": "I would just add that if you look at -- when you're talking about the premium growth there, it is 2 things in large part. One is, we've raised rates in sort of the traditional small commercial business we have. So rates are materially up, units are not. The other is that a year ago, transportation business is -- because we have -- the charge by mile and we pay them for the usage. A year ago, there was very little usage still in those transportation networks, and there's a lot more usage and therefore, a lot more premium right now. And we have raised, as Tom said, we've gotten out of some states and we've raised rates on those. So we think the profitability go forward is better. So it's not growth in that we're piling on business as we've gotten a lot more revenue coming through."
},
{
"speaker": "Operator",
"text": "Next question comes from the line of Greg Peters of Raymond James."
},
{
"speaker": "Charles Peters",
"text": "I appreciate the new information and your updated investor slide deck, just FYI. So I'm going to focus my one question on Slide 8. And I'm just trying to put the pieces together of the information you provided us around pricing. Tom, you mentioned in your opening remarks, surgical pricing, and you talked about how you're differentiating between lower lifetime value customers and longer lifetime values. Glenn, you talked about a lot of rate in the pipeline that's going to affect earned premium going forward. And I was trying to reconcile the language difference from your February cat and pricing report to your March cat and pricing report. And the difference between the 2, just 1 month later in the March pricing report, you said that that effectively lost cost inflations were exceeding your targets and you were going to have to raise prices even more, just 1 month later from your February pricing report. So I was hoping maybe you could put all those pieces together for us and sort of map out what's going on."
},
{
"speaker": "Glenn Shapiro",
"text": "Tom, did you want to start on that? Or do you want me to?"
},
{
"speaker": "Thomas Wilson",
"text": "Yes, sorry, I was on mute. It was quite articulate but -- great. Let me start off and then I'll get Glenn and Mario to give you more specifics. So first, obviously, increasing price is really important to getting our auto insurance possibility. We've been aggressive, but we believe smart about spreading it between newer less profitable customers and profitable longer-tenure customers. And so obviously, let's say you have a customer who's been with you 10 years and you're making a 95% combined ratio, and you have one that's new and you're losing money on it. And you have to raise your rates to cover the higher inflation, which impacts both customers. If you give them both the same amount, you run the risk of losing that long-tenured profitable customer. So we've put less rate into our, what we would call, older closed books and more into our newer books with shorter-term customers. And we believe that, that protects lifetime value and will help with retention. In this new space, retention is going to be a challenge for all companies. And so we're -- but we're trying to make sure we manage our way through it. So the numbers that you see on Slide 8 are the total between all the customers, whether new old profitable, unprofitable to help us get there. But it's more surgical than it appears. I would say the other part is what we're doing auto profitability back to Glenn's earlier slide was like we know how to make money in auto insurance, and we're going to make money in auto insurance. But we want to make sure it's sustainable. One is the way we're taking those prices. Two is make sure the expense reductions are permanent, not just temporary, making sure you manage your loss costs differently, and just make sure you're being -- continuing to invest in sophistication and new products. So we feel good about this, but then hopefully, that provides some insight. As to the change in the outlook, that maybe be more what we said than just sort of like waking up in the month of March and deciding we're going to say something different. Glenn, do you want to talk about how this has unfolded. And Mario, if you're going to go onto closures, that would be helpful."
},
{
"speaker": "Glenn Shapiro",
"text": "Yes. So I'll start with how it unfolded. I mean -- I would say, we continue to see inflation run like a lot of people continue to see. We continue to see elongated time frames for development, including prior year development. And so we're taking, I think, an appropriately conservative view and saying that like we're going to need more rate on that part of it. The other part on the precision, I want to build on what Tom said, because it's an important point because we do use a lot of precision. And I think that there some folks who talk more -- or some companies talk more or less about their level of segmentation and precision. We maybe don't do a good enough job talking about the depth that we have in terms of our segmentation, which is highly sophisticated and that's what Tom is going into. But it's sophistication at that level, but also on the go-to-market level. Because clearly, we kept marketing open, and we took an opportunity to grow some business that the economics were good on. We did that because the marketing cost itself was down with others leaving that area. There were a lot of shoppers and first quarter tends to be a time that a lot of people shop. . Now we also did that with a lot of precision. It's the entire go-to-market system because we're not just -- to sort of have the open sign everywhere. It is -- we're marketing precisely where we know we have a lifetime value return based on risk type based on market within state level. And it's a combination of underwriting, marketing, pricing that all comes together -- and distribution that all comes together with how we go to market and drive where we want to grow and how we want to grow that I think goes into the need for rate as well."
},
{
"speaker": "Mario Rizzo",
"text": "Yes. If I can just add, Greg, this is Mario. First, I guess, where I'd start is, the objective of providing that rate information monthly that we started this year was really to create a level of transparency into what we were doing with auto profitability with rates being such a significant lever and provide you all with a view of the progress we're making but also some color around what we're seeing on a forward-looking basis. So that's the objective. And the language we used in the most recent disclosure provided, I think, some additional context. In terms of what's happening, I think we continue to look at loss trends month-in and month-out, both in terms of reserve levels, severe trends and just loss trends overall. And the statement we made in our most recent release was really a reflection of what we were seeing in loss trends in severity development both in terms of what we saw in last year, we strengthened reserves by $151 million in auto this quarter and what we were seeing in terms of the physical damage severity escalation as well as what -- how that translated into current year severity. So we're taking that data. We're looking at it. We're working with the pricing team and factoring it into our outlook and the purpose of the disclosure again is to tell you what we did, but also provide a little more texture around what we're seeing in the market. ."
},
{
"speaker": "Operator",
"text": "Next question comes from the line of Andrew Kligerman of Credit Suisse."
},
{
"speaker": "Andrew Kligerman",
"text": "Yes, great answer to the prior question. I guess you didn't mention anything about non-rate actions. Would it be possible to discuss nonrate actions as as maybe a percent of the business that you're able to get that on and maybe how much that might be contributing to improved performance?"
},
{
"speaker": "Thomas Wilson",
"text": "Glenn, do you want to take that for both the Allstate Brand and National General?"
},
{
"speaker": "Glenn Shapiro",
"text": "Yes. So one, and if you saw the -- I'll go to the National General first, we saw that National General underlying combined ratio looked pretty good in the first quarter. And one of the things that they have that's really stable is fee structure. The fee structure is a nonrate element that turns out to be really stable over time and helps them predict and plan for their combined ratio. When I think about nonrate actions across the Allstate book, it really goes back to what I was talking about where it's about -- I don't like to isolate it to the word underwriting because then it sounds like you're sort of deciding to write or not to write as opposed to getting the right level of rate for each type of risk, but that also goes into with underwriting and marketing and distribution how you go to market. And where we've really built our sophistication is in how our marketing team, our underwriting and product teams and pricing and our distribution organization deploy resources quickly and nimbly to where and how we're looking to grow. And I think that in itself generates a lot of the long-term economic value that we drive."
},
{
"speaker": "Andrew Kligerman",
"text": "Okay. So really not any real actions to -- okay, makes a lot of sense. And then if I could just quickly sneak one in. The buyback of $794 million that's pretty fast in terms of the pace. I thought you had about $3.3 billion left, and this implies you're going at a quicker pace. Is there a chance that you could complete that authorization by the end of this year or do more than you anticipated because it seems pretty robust and I was curious about the thinking there."
},
{
"speaker": "Thomas Wilson",
"text": "Andrew, it's Tom. First, on the actions. You will see though -- I know you will see some things like down-pay requirements and stuff like that, that we will change going forward to help manage the selection of the business. So Glenn is absolutely right that we're being very precise in which stuff we want, but if we feel like there are certain policy terms and things we can change or payment terms that we can change that will help us, we will put those in place. . On the buyback Mario is committed to have it done early in the first quarter of next year. Mario, anything you want to add to that?"
},
{
"speaker": "Mario Rizzo",
"text": "No, I think that's right, Tom. So I wouldn't read too much into any one quarter. We still have $2.5 billion left to buy. We said we'll complete it by early next year, and that's the point."
},
{
"speaker": "Operator",
"text": "Next question comes from the line of David Motemaden of Evercore ISI. ."
},
{
"speaker": "David Motemaden",
"text": "I had a question on Slide 8. It says that you guys have a higher mix of newer, more expensive vehicles. Glenn, I believe you said that those vehicles come with higher premiums, and they can adversely impact total loss severity when vehicle values rise. Does the fact that you have more of a mix of more expensive vehicles, does that increase -- or does that mean that you need to take more rate relative to peers? Or I guess, how should I interpret this mix difference that you guys have versus peers?"
},
{
"speaker": "Thomas Wilson",
"text": "Glenn, do you want to do that?"
},
{
"speaker": "Glenn Shapiro",
"text": "Yes. So there's a few parts to that because I'll talk more macro about the auto -- the car park out there and like the whole system. With every new model year newer that we get and every year that passes, we've done the math through what's in our book of business, what type of safety elements are in cars, accident avoidance, technology and everything. And we know 2 things: one, that we get a little bit of a tailwind with every year that passes on frequency, and we get a little bit of a headwind on severity because they're more expensive to fix, more sensors and so on. And the reason I started there is that would be true of this example as well. The fact that our book of business tends to trend that way more, it will give us a little bit of a sustainable benefit on frequency in comparison to others, and it will give us a little bit of a sustainable headwind on the severity. But we do charge premium based on make and model year and you get a higher premium for it. It was more of a statement in that opening that as we look at and we try to put our trends, whether we're looking at Fast Track or looking at public disclosures, when we look at our trends on bodily injury or property damage, which are third-party vehicles, and then collision first-party vehicles, we see some of that difference come through and then have to like do the math back to our premium and ensure that we're getting the right rates for all of that."
},
{
"speaker": "Operator",
"text": "Next question comes from the line of Meyer Shields of KBW."
},
{
"speaker": "Meyer Shields",
"text": "Fantastic. I wanted to dig in a little more to your comments on homeowners and the automatic lift because we've seen a little bit of deterioration in the underlying loss ratio all of last year into the first quarter. Is the automatic, I guess, inflation guard changing? Are there other steps that are necessary in homeowners?"
},
{
"speaker": "Thomas Wilson",
"text": "Well, the first, we're really happy with where the homeowners business is today in terms of its profitability. As you know, sometimes it bounces around because catastrophes -- we had slightly lower catastrophes this quarter than the prior year quarter, but still earn a really good return. The underlying combined ratio, as you point out, which excludes catastrophes, ticked up a little bit. We feel comfortable with where that is in part because of the inflation parts that you mentioned that come through, what we call PIA, Property Insurance Adjustment. It really raises average premium. And as that burns in to earn premium just like it does burn through in auto that cover some of those increased costs. If it doesn't, we have plenty of room to go in and continue to prices. Glenn, what would you add about severity in the combined ratio in [indiscernible]?"
},
{
"speaker": "Glenn Shapiro",
"text": "Yes. So first, I always start with I think we're accountable for the recorded combined ratio because ultimately, if we always had a good underlying but like we hadn't gotten the right reinsurance or we hadn't been in the right locations, and we hadn't done good risk mapping for wildfire or hail or hurricane or any other exposure and we were constantly running what the industry or key competitors run. I think you would rightfully hold us accountable for that. So I always go back to the recorded combined ratio. That said, the underlying, as Tom said, it moves up and down a little bit, and we do watch that primarily though we watch the recorded combined ratio. Right now, like Tom, I feel really good about where we are. Severity ran hot in the first quarter. It's tough to look at one quarter in homeowners and draw a lot of conclusions because there's a decent amount of volatility between the mix of perils in homeowners. It's not nearly as stable as auto in that way. And so we're watching that, that was a high number, but we got an average price increase, average earned premium of 14.3% burning through, which really ticked up in the latter part of the year last year. So we'll continue to give us benefit as that earns through. And we're in -- obviously, we're really good shape in homeowners, and I feel good about it."
},
{
"speaker": "Meyer Shields",
"text": "Okay. That's helpful. Second question on the auto side. I just want to make sure that I'm understanding the commentary on the surgical application of rate increases, should we expect, I guess, suppressed new business as the strategy works its way through to the extent that rate increases are being focused on lower tenured customers? ."
},
{
"speaker": "Thomas Wilson",
"text": "I'll start off and then Glenn, you can jump in. I think a lot of this premier depends on what happens in the competitive environment. So as other people are taking rents, it depends where they're spreading their rates. So if you buy on the renewal book, then that will create more shoppers because those tend to be people who shop less than just putting it all on the new business. But part of it depends what happens, how people do it. That said we feel pretty good about where we track our competitive position, the LTI index with our LTI Index at this point. So we're hopeful that as we move through this, we'll still continue to grow. With Transformative Growth on top of that, we think that it all still hangs together in terms of increasing market share. Glenn, what would you add to that?"
},
{
"speaker": "Glenn Shapiro",
"text": "I'll just add if you take the long term and the short term, the long term first, as Tom said, our expanded customer access, our work on improving value as we get the 3 points at cost that Mario talked about out and we've got access into all these systems, and we get middle market products into the IA channel and our exclusive agents are humming, we've got a really good long-term prognosis on that. . With your question, you were asking, I think, some about the short term. So as you think about what we did early this year, we pulled marketing dollars forward, and we've talked about the fact that we pulled them forward. That's not the same as increasing them. It did increase in the quarter, but it's pulling it forward. That means it does have to come out of somewhere, too. We decided to do that because there were good economics on the marketing. A number of companies publicly talked about pulling back from marketing that left from the supply and demand curve of marketing costs that left it reasonable, and there was good economics on it, plus a lot of business gets sold in the first quarter. So we thought with a lot of shoppers in the market with rates out there, that it would be a good time to be in the market where we had our prices in, and we felt good about the lifetime value. That said, inflation is continuing to run and we're taking more rate, and we pulled that money forward from later. So marketing will reduce from this point and that could have a short-term impact on new business growth, plus we've got -- everybody will have headwinds on retention with the amount of rate that's in the system across the industry."
},
{
"speaker": "Thomas Wilson",
"text": "Yes. I think when you go back to Glenn's long term. Bottom we like prospects for sustainable profitable growth. I mean, auto insurance, we know how to buy money and with transformative growth, we really grow that business. You add homeowners on top of that, which is really a growth business. And just like price and value are important to auto insurance customers, it's also important in investing. And when you look at the price of Allstate, it's essentially less than your other options. That's why we think transformative growth is going to increase nation multiples. ."
},
{
"speaker": "Operator",
"text": "Next question comes from the line of Brian Meredith of UBS."
},
{
"speaker": "Brian Meredith",
"text": "A quick question here. On Slide 11 of your supplement, you've got an interesting chart here that looks at auto state profitability. Just my question is, is this based on an earned kind of basis? Or is on a written basis. And if it's on an earned basis, how would this chart look on a written basis, as far as what states do you think are currently pretty close to rate adequate?"
},
{
"speaker": "Thomas Wilson",
"text": "Well, that's a tough question. I don't know if we -- Glenn, do you want to take the forward looking."
},
{
"speaker": "Glenn Shapiro",
"text": "Yes, I'll take it. Yes. So it's definitely earned basis in that we look at our when you look at combined ratios, it's on an earned basis. So you're hitting a really important point. So it's an astute observation. Because I think about that disclosure and you could look at -- when you look at the percentage of states that are above 100, for example, that is not the same as looking at the way we look at where do we want to grow. Because the state could be above 100 right now, but we've just gotten in the rate we feel we need to be adequate. So any new business we put on is going to be at a rate adequate level that we like, and we would want to grow there. So it really does lag and you have to go back to Page 8 and see where that -- which we don't -- because that's an estimate. We don't estimate every state and disclose based on when we'll earn the premiums and what percentage will earn by state and what that will do. But the point is, while that's a snapshot of where we are today, that does not reflect all of the written premiums and increases that we've got. ."
},
{
"speaker": "Thomas Wilson",
"text": "Okay. Well, thank you all for engaging with us today. As we go forward, we look forward to in the next month or so talking about homeowners -- and then we continue to execute in the meantime our multi-facet fan, both to improve profitability of auto insurance and to get Transformative Growth because that's a key component to sustainable growth, and both of those will improve shareholder value. So thank you for your engagement, and we'll talk to you soon."
},
{
"speaker": "Operator",
"text": "Thank you so much to our presenters and to everyone who participated. This concludes today's conference call. You may now disconnect. Have a great day."
}
] | The Allstate Corporation | 18,711 |
ALL | 4 | 2,023 | 2024-02-08 09:00:00 | Operator: Good day and thank you for standing by. Welcome to Allstate’s Fourth Quarter Earnings Conference Call. Currently, all participants are in a listen-only mode. After prepared remarks, there will be a question-and-answer session. [Operator Instructions] As a reminder, please be aware this call is being recorded. And now, I’d like to introduce your host for today’s program, Brent Vandermause, Head of Investor Relations. Please go ahead, sir.
Brent Vandermause: Thank you, Jonathan. Good morning. And welcome to Allstate’s fourth quarter 2023 earnings conference call. After prepared remarks, we will have a question-and-answer session. Yesterday, following the close of market, we issued our news release and investor supplement and posted related material on our website at allstateinvestors.com. Our management team is here to provide perspective on these results and our strategy. As noted on the first slide of the presentation, our discussion will contain non-GAAP measures for which there are reconciliations in the news release and investor supplement, and forward-looking statements about Allstate’s operations. Allstate’s results may differ materially from these statements. So please refer to our 10-K for 2022 and other public documents for information on potential risks. And now, I will turn it over to Tom.
Tom Wilson: Good morning. And we appreciate you taking the time and spending your efforts to explore why Allstate is an attractive investment. So I will begin with an overview of our strategy and results, and Mario and Jess, can go through the operating performance. Then we will have time for your questions at the end. Let’s begin on slide two, which depicts Allstate’s strategy to increase shareholder value. So we have two components to this strategy, increase personal Property-Liability market share and expand protection provided to customers, which are shown in the two ovals on the left. On the right-hand side, you can see the highlights for the fourth quarter. We generated net income of $1.5 billion. The strong results reflect our actions to improve auto insurance profitability and mild weather conditions, which was a welcome reprieve from the elevated level of weather related losses in the first three quarters of the year. The proactive approach to increasing bond duration also contributed to strong results with higher income from the market based portfolio. To further increase shareholder value this year, we remain focused on improving auto insurance profitability. There is more work to be done, but we are well on our way. Additional shareholder value will then be increased by increasing policies in-force across all of our businesses. The transformative growth initiatives to drive Property-Liability market share growth can be implemented in more states this year now as auto margins have been improved. We are also focusing on expanding protection offerings to Protection Services businesses, which is shown in the lower oval as Protection Plans, Identity Protection, Roadside and Arity, all have good growth prospects. As you know, we started the process to sell the Health and Benefits business and that process is proceeding on schedule. Let’s review the financial results on slide three. Revenues of $14.8 billion in the fourth quarter increased by 8.7%. That reflects a 10.7% increase in Property-Liability earned premium and that was due to rate increases in 2022 and -- mostly in 2022, and in 2023 in both the auto and homeowners’ insurances. Net investment income in the quarter was $604 million, an 8.4% increase, reflecting higher fixed-income yields and duration extension, which is partially offset by lower performance based income. The strong profitability in the quarter generated adjusted net income of $1.5 billion or $5.82 per diluted share. Annual revenues of $57 billion were up $5.7 billion or 11.1% over the prior year. Strong fourth quarter earnings resulted in positive adjusted net income for the year. Slide four summarizes the status of the four-part auto insurance profit improvement plan. Strong execution resulted in 6.7% point improvement in the combined ratio in 2023. Starting with rates. Since 2022, the Allstate brand implemented rate increases 33.3%, which included 16.4% in 2023 and 6.9% in the fourth quarter, driven by the recent approvals in California, New York and New Jersey. National General implemented rate increases of 10% in 2022 and an additional 12.8% in 2023. Looking forward, we will pursue rate increases in 10 states to improve margins and in other states to keep pace with increases in loss costs. Expense reductions were initiated in 2019 as part of the transformative growth plan to become a low cost provider of protections, being early in this effort helped offset the rapid inflation in loss costs. The underwriting expense ratio decreased 1.1 points in 2023 compared to the prior year when you exclude the large decline in advertising that was directly linked to lower profitability. Looking forward, further cost reductions will improve efficiencies and our competitive price position. Given the significant improvement in perspective, auto margins will increase advertising investment this year. In addition, we implemented underwriting actions to restrict new business, where we were not achieving target returns. We are moving some underwriting restrictions as rate adequacy is achieved. Finally, enhancing claim practices in a high inflation and increasingly litigious environment are required to deliver good customer value. This includes accelerating the settlement of injury claims and increasing in-person inspections. This program has positioned us to increase new business levels and begin to grow policies in-force in sales where acceptable margins have been restored. Now I will turn it over to Mario to discuss Property-Liability.
Mario Rizzo: Thanks, Tom. Let’s start on slide five. Property-Liability earned premium increased 10.7% in the fourth quarter, primarily driven by, excuse me, higher average premiums from rate increases, partially offset by a 2% decline in policies in-force. Underwriting income of $1.3 billion in the quarter improved $2.4 billion compared to the prior year quarter due to increased premiums earned, improved underlying loss experience, lower catastrophe losses and operating efficiencies. The chart on the right highlights the components of the 89.5 combined ratio in the quarter, which improved 19.6 points from the prior year quarter. The impact of catastrophe losses and prior year reserve re-estimates on the combined ratio as shown in light blue and gray materially improved compared to the prior year. Catastrophe losses of $68 million were $711 million or 6.3 points lower than prior year due to the mild weather conditions experienced in the quarter and favorable loss development from prior period events. Prior year reserve re-estimates, excluding catastrophes, were unfavorable and totaled $199 million, representing a 1.6-point adverse combined ratio impact in the quarter and a 0.9-point favorable impact compared to the prior year quarter. Approximately $148 million related to personal auto driven in part by costs related to claims in litigation and adverse development in National General. The underlying combined ratio of 86.9, improved by 12.3 points compared to the prior year quarter, due to higher average premium and the favorable influence of milder weather conditions on accident frequency. Despite the favorable results in the quarter, the full year combined ratio of 104.5 was significantly impacted by elevated catastrophe losses primarily from events in the first three quarters, resulting in a catastrophe loss ratio that was 4 points above the 10-year average from 2013 to 2022. Now let’s move to slide six to review Allstate’s auto insurance profit trends. The fourth quarter recorded auto insurance combined ratio of 98.9 improved by 13.7 points compared to the prior year quarter, reflecting higher earned premium, lower underlying losses, lower adverse prior year reserve re-estimates and expense efficiencies. The chart shows the underlying combined ratios from 2022 and 2023 with quarterly reported figures adjusted to reflect the estimated average severity level as of year-end for each year. As you can see, the underlying combined ratio decreased each quarter in 2023, reflecting the benefits of the profit improvement plan, Tom discussed earlier. As a reminder, we continually reassess claim severity expectations as the year progresses. If the current year expected severity increases or decreases, the year-to-date impact of that change is recorded in the current quarter, despite a portion of that impact being driven by reassessment of the prior quarters. In 2023, the full year estimate of claim severity decreased in the fourth quarter. So there was a benefit from prior quarters included in reported results in the fourth quarter. When you adjust for this, the reported underlying combined ratio of 96.4, as shown in the table would be 98.2 as shown in the bar on the graph. The three preceding quarters all benefit from the adjustments, including Q3, which improved from 100.5 in the presentation shown last quarter to 99.9, reflecting the latest severity estimates. While loss cost trends remain historically elevated, the rate of increase moderated in the second half of the year, mainly in physical damage coverages. Allstate brand weighted-average major coverage severity expectations improved from 11% as of the end of the second quarter to 9% in the third quarter and now that 8% to 9% at the end of the year. As a reminder, this trend reflects our current best estimate for the year-over-year increase in average severity. Slide seven shows the impact of our profit improvement actions across the country. As shown on the left, Allstate’s brand rate increases have exceeded 33% over the last eight quarters, including larger increases in California, New York, New Jersey and Texas, reflective of the elevated loss trends in these states. These four states comprised 36% of Allstate brand auto total written premiums in the U.S. during 2023. As you know, increases were approved in California, New York and New Jersey in December. So we have yet to see this in earned premiums. The chart on the right shows states with an underlying combined ratio below 100, shown in the light and dark blue bars were 65% of the total in 2023, more than doubling from the percentage at year-end 2022. Excluding California, New York, and New Jersey, the Allstate brand auto insurance underlying combined ratio was 95.9 in 2023. Slide eight shows improving profitability had a negative impact on policies in-force during 2023. On the left, you can see that total Protection Auto policies in-force, decreased by 2.9% compared to prior year, as the Allstate brand decline of 6.2% more than offset a 13.3% increase at National General. Allstate brand auto policies in-force decreased due to reduced new business volumes and lower retention. National General growth of 581,000 policies in-force was mostly driven by non-standard auto insurance and to a lesser extent, the rollout of new middle-market standard and preferred auto insurance product launches for the Custom 360 products. The chart on the right shows total personal auto new issued applications for 2023 decreased 6% compared to the prior year and the accompanying drivers. Targeted profitability actions within the Allstate brand resulted in a decline in new auto issued applications of 20% compared to the prior year. The first two red bars reflect the impact of lower new business volume in California, New York and New Jersey, as well as the direct channel decline in the remainder of the country, which was most directly impacted by the reduction in marketing investment last year. Outside of the three states where profit actions significantly reduced new business, Allstate exclusive agents increased production by 6%, driven by higher productivity, showing the response of Allstate agents to the changes we have made to incent growth and the opportunity to continue to grow with our agency owners as part of transformative growth. The acquisition of National General strategically positioned Allstate to grow in the independent agent channel with new business applications, increasing 12% in 2023. National General continues to grow non-standard auto and generate higher volume from the Custom 360 product launches. Slide nine covers homeowners’ insurance results, which generated significant profits for the quarter, while full year results were impacted by elevated catastrophe losses in the first three quarters of the year. On the left you can see net written premium increased 13.3% from the prior year quarter, primarily driven by higher average gross written premium per policy in both the National General and Allstate Brands, and a 1.1% increase in policies in-force. National General net written premium grew 19.6% compared to the prior year quarter, primarily due to policy in-force growth, driven by the Custom 360 offering and higher average premiums from implemented rate increases. Allstate brand net written premiums increased 12.5%, driven by average gross written premium per policy increases of 12.2% compared to the prior year quarter and a small increase in policies in-force. Allstate agents continue to bundle auto and homeowners’ insurance at historically high levels. Catastrophe losses of $21 million in the fourth quarter were low by historical standards, reflecting milder weather conditions and favorable development from prior events contributing to a 62 combined ratio and $1.2 billion of underwriting income for the quarter. Milder weather in the fourth quarter also favorably influenced the underlying combined ratio due to lower non-catastrophe claim frequency. For the full year, higher catastrophe losses drove the combined ratio increase in 2023 compared to 2022. Full year catastrophe losses of $4.5 billion were higher than our historical experience and translated to a catastrophe loss ratio that was 17 points higher than prior year and roughly 14 points above the 10-year average from 2013 to 2022. As you can see from the chart on the right, the full year underlying combined ratio declined from 70.3 in 2022 to 67.3 in 2023, reflecting higher average premiums from rate increases, partially offset by higher claims severity due to materials and labor costs. With an industry-leading product, advanced pricing, underwriting and analytics, broad distribution capabilities and a comprehensive reinsurance program, we will continue to leverage homeowners as a growth opportunity and remain confident in our ability to generate attractive risk-adjusted returns in this line. Moving to slide 10, let’s discuss how we are advancing transformative growth to provide customers low-cost protection through broad distribution. We remain focused on four key elements of this multiyear initiative, as you can see on this slide. We have improved our cost structure to enhance our competitive price position. In the current environment with most competitors taking large rate increases, it’s difficult to pinpoint competitive position. That said, our relative competitive position likely deteriorated in 2023. But as many of our competitors continue to implement rate increases and our expenses decline, we believe our competitive position will improve enhancing growth opportunities as part of transformative growth. Redesigned, affordable, simple and connected products currently available for auto insurance in seven states with plans for further expansion this year, both improve customer value and deliver a differentiated customer experience. National General independent agent growth prospects will be further enhanced by expanding Custom 360 products, which were live in 16 states as of year-end 2023 and expect to be in nearly every state by the end of 2024. Expanding customer access will also support market share growth and we have made good progress in all three channels. Increasing sophistication and customer acquisition continues to advance and will improve the effectiveness of increased advertising spend in 2024, as we look to grow in more states. A new technology ecosystem is also being deployed to improve the customer experience, speed-to-market and reduce costs for legacy technology platforms. Let me turn it over to Jess now to talk about expense reductions and other operating results.
Jesse Merten: All right. Thank you, Mario. On slide 11 we delve deeper into how we are improving customer value through expense reductions. As shown in the chart on the left, the Property-Liability underwriting expense ratio decreased two points from 2022 to 2023 as we continue to focus on lowering costs to provide more value to customers and some of the benefits of higher earned premium growth relative to fixed costs. The right half of the chart provides additional context on the drivers of the 1.3-point improvement in the fourth quarter compared to the prior year quarter. The first red bar shows the two-tenth of a point impact from increased advertising spend, reflecting the slight increase was driven by seasonal investment changes and growth investments in rate adequacy states. The second green bar shows the 1.4 -- 1.4-point decline in operating costs, which was mainly driven by lower employee-related costs and the impact of higher premiums relative to fixed costs in the quarter. Shifting to the longer term trend in the chart on the right, we remain committed to reducing the adjusted expense ratio as part of transformative growth. As a reminder, the adjusted expense ratio starts with our underwriting expense ratio, which I just covered and excludes restructuring COVID-related expenses, amortization and impairment of purchased intangibles and advertising expense. It then adds our claims expense ratio, excluding costs associated with settling catastrophe claims. Those expenses are excluded because catastrophe-related costs tend to fluctuate. Through innovation, process improvement and strong execution, we have driven significant improvement in expenses for the fourth quarter and year-end 2023 adjusted expense ratio of 24.7. This reflects decreases in both the underwriting expense and non-cat claims expense ratio compared to the prior year quarter. Now moving to slide 12, I will cover investment results. This quarter showed how our proactive approach to duration management benefits results. The chart on the left shows changes we made in the duration of the bond portfolio in comparison to bond market yields, from the fourth quarter of 2021 through the third quarter of 2022, lowering fixed-income duration, mitigated losses as rates rose. Beginning in Q4 of 2022, we began to extend duration which when combined with higher yields has increased market-based income. Our fixed income yield, shown in the table below the chart, remains below the current intermediate corporate bond yield, reflecting an additional opportunity to increase yields as we continue to reinvest portfolio cash flows into higher interest rates. The bar chart on the right shows the income and total return benefits of these decisions. As you can see in the table on the chart, the total return of our portfolio was 4.6% in the fourth quarter and 6.7% for the year. Portfolio returns in both periods reflect income earned, as well as higher fixed income valuations due to the decline in market yields in the fourth quarter. Net investment income totaled $604 million in the quarter, which was $47 million above the fourth quarter of last year. Market based income of $604 million shown in blue, was $140 million above the prior year quarter, reflecting the repositioning of the fixed income portfolio into longer duration and the benefit from higher yielding assets that sustainably increase income. Market based income also benefit -- benefited from higher fixed-income balances. Performance based income of $60 million shown in black, was 87 million below the prior year quarter due to lower valuation increases and fewer sales of underlying assets. As we have stated previously, the performance based portfolio is expected to enhance long-term returns as demonstrated through our five-year and 10-year internal rates of return of 12% and volatility in these assets from quarter-to-quarter is expected. Slide 13 covers results for our Protection Services businesses. Revenue in these businesses increased 11.8% to $719 million in the fourth quarter compared to the prior year quarter. This result is mainly driven by growth in Allstate Protection Plans, which increased 19.6% compared to the prior year quarter, reflecting expanded product breadth and international growth. In the table on the right, you will see adjusted net income of $4 million in the fourth quarter decreased $34 million as compared to the prior year quarter. This decrease is attributable to the results of a state income tax examination that increased the effective state tax rate that we apply, which increased deferred income taxes by $43 million in the quarter for future tax payments and Protection Services, largely related to dealer services. The impact of the tax change on the enterprise was a net benefit of $6 million. We do not anticipate that these tax adjustments will have a significant impact on our ongoing operations. Shifting now to slide 14, our Health and Benefits businesses continue to generate profitable growth. From the fourth quarter of 2023, revenue of $630 million increased by $50 million compared to the prior-year quarter, driven by growth in individual health, group health, as well as fees and other revenue. Adjusted net income of $60 million in the fourth quarter of 2023, increased $2 million compared to the prior year quarter as individual health revenue growth partially offset higher benefit ratios in group health. As you know, late last year, we announced a decision to pursue the divestiture of our Health and Benefits business following the successful integration of Allstate’s voluntary benefits business in National General’s Group and individual health businesses. We continue to anticipate a transaction will be completed in 2024. We will close on slide 15 by reviewing Allstate’s financial condition and capital position. Allstate’s proactive capital management approach provides the financial flexibility, liquidity and capital resources necessary to navigate a challenging operating environment, while providing support for long-term value creation. Fourth quarter results demonstrated the company’s capital generation capabilities with a statutory surplus in holding company assets of $18 billion, increasing by $1.6 billion compared to the prior quarter. Assets held at the holding company also increased to $3.4 billion. The increase to the prior quarter primarily reflects a return of capital from National General statutory entities, partially offset by common shareholder dividends. Additionally, GAAP shareholders’ equity of $17.8 billion increased $3.2 billion compared to the prior quarter, reflecting $1.5 billion of GAAP net income and the improved unrealized position on fixed income securities of $1.9 billion. We continue to proactively manage capital, make progress on the comprehensive profit improvement plan and invest in transformative growth. We remain confident that these strategic actions will generate attractive shareholder returns. With that as context, let’s open it up for your questions.
Operator: Certainly. One moment for our first question. And our first question comes from the line of Jimmy Bhullar from JPMorgan. Your question please.
Jimmy Bhullar: Hey. Good morning. So I had a couple of questions. First, can you talk about rate adequacy in California, New York, New Jersey, the new business that you are issuing there now is that adequate price for normal profitability or are you assuming that you are going to need another sort of stab at it in 2024 to get the normal profits?
Tom Wilson: Thank you, Jimmy. I will let, Mario, really three different stories, Mario will take you through those in, then we will do a follow-up question, and I would just remind everybody, we like -- ask one question with a follow-up, hopefully, related to the first question. But so we can make sure we get through everybody’s call. So, Mario, you...
Mario Rizzo: Yeah. So, Jimmy, first thing I’d say is, we have talked a lot last quarter about the actions we needed to take in the three states, California, New York and New Jersey. I will start with a view that says, look our objective is to meet the protection needs of as many customers in as many states as possible. When that can happen, we think customers are served well, markets operate effectively and we can operate our business to achieve the appropriate levels of returns. We had rate pending in all three of those states and I will just spend a minute kind of giving you the story in each one of those, because I think it’s slightly different. In California, you will remember we filed a 35% rate. We got approval for 30 %. But we got approval earlier than our expected effective date. So, effectively, we filed our full rate need and got approval for our full rate need. As of yesterday, we are writing business in California, again across all channels and we feel comfortable writing business in California given the rate level that we are operating. Now, of course, having said that, we have got to stay on top of loss trends going forward and we will do that, but we are comfortable with the rate level, we have gotten California that have opened up that market. In New Jersey, it’s kind of the opposite story we filed for 29 points of rate, we got approval for just under 17%. And as a result of that, we are going to continue to take the more restrictive underwriting actions that we have been taking in New Jersey, which means we will continue to get smaller in New Jersey, while we plan on filing additional rate as a matter of fact, we have two rates pending with the New Jersey Department and depending on how those things shake out that that will inform future actions we take in New Jersey. But as of right now, we will continue to get smaller in New Jersey, just given the lack of rate adequacy. And New York is kind of somewhere in between, we got approval for a 14.6% rate in December. We have implemented that, that helps. But we still need more rate. We are actively engaged with the department and intend to file our full rate need going forward and do that in reasonably short order. And again, depending on how that plays out, that will inform the next set of actions we have taken in New York.
Jimmy Bhullar: Okay. And then just a follow-up, maybe slightly related and slightly unrelated, in those three states, if you are raising prices a lot, it’s reasonable to assume that you would suffer in terms of discount or at least at a minimum, it wouldn’t grow. But how is your PIF faring in the states where you are not taking any outsized rate actions versus what some of your peers are taking and just trying to assess whether you think it’s reasonable to assume that your overall PIF count stabilizes at some point this year for the company as a whole and potentially grows this year, later in the year or next year.
Tom Wilson: Jimmy, this is Tom. I will start and then Mario can give -- can add on to that. I would say that the current competitive environment is still in flux. So, we raise our rates 30 points in California. State Farm gets another increase somewhere after that. So it’s too early to tell what impact that will have on volume in 2024. We do -- our goal, though, is obviously to, one, make good money for our shareholders as first part, and as Jess said, the other part is, we need to grow. So we are -- we think we have got transformative growth in place, which is differentiated in a long-term growth plan, as well as some of the short-term things you are talking about here. Mario, what would you add to that?
Mario Rizzo: Yeah. I think, specifically, on retention, Jimmy, as Tom mentioned, in the three states we talked about, those markets are still in a bit of a state of flux. One state I’d point to, to kind of tell the story about retention and how taking outsized rates and then kind of lapping that impacts retention is Texas. We took significant rates in Texas in 2022 and earlier in 2023 and we showed you last quarter there was a pretty substantial hit to retention in Texas. As we have lapped those rates, we have seen a nice bounce back which contributed to the sequential improvement in the fourth quarter retention level in auto relative to Q3. So, once the rate need stabilizes, that certainly has a positive impact on retention going forward. And hopefully, as we in more and more states are really just keeping on top of loss trend, we would expect the headwind that we faced in retention to diminish going forward.
Jimmy Bhullar: Thank you.
Operator: Thank you. One moment for our next question. And our next question comes from the line of Gregory Peters from Raymond James. Your question please.
Gregory Peters: Okay. Good morning, everyone. I -- for my first question, I’d like to focus on transformative growth and it’s kind of counter intuitive, right, because you are talking about lowering expenses at the same time growing your policy count. So when I think of some of the headwinds going forward on expenses, I think, of increased agent commission because profitability is going up. I see maybe the potential for increased advertising expense. So maybe you can help us pull together on how you see growth emerging at a lower expense base?
Tom Wilson: Greg, I will start and Mario can jump in. So I don’t know that, I think, there is counterintuitive that as you grow your expenses can’t go down, and I would point out, if you look at National General, its growth has helped drive more scale and has brought its expenses down. So that’s just a scale-related comment to it. As you relate -- you look at the programs we have in place on transformative growth, it’s really across the Board. Everywhere we are at where programs that are -- we have been working on for three plus years and they are rolling out as we go. For example, we are cutting costs by becoming more digital. By becoming more digital, we can move more jobs either get rid of the jobs or move them offshore. That’s a multiyear thing. You don’t just take first notice of loss and change it in three months. So the benefits of those programs, which we have been working and rolling those out for the last 18 months really still will get more of those benefits as we go forward in 2024 just based on the work we have already done. In terms of agent commission, Mario mentioned this, we have changed the agent commission structure such that it pays more for new business and less for renewals and that was one of the core parts of transformative growth was how do we distribute our products at a lower price and still give people the value of an agent. And people want an agent to buy the stuff, they don’t necessarily want to pay as much for attention. One of the underlying assumptions we validated with transformer growth, which quite honestly, a number of analysts and other people were not so sure, but you are going to keep agents head in the game? And the answer is, yes. Look at the productivity numbers that Mario showed. Do they like having renewal compensation go down? No. Do our customers like having a better priced product? Yes. And so we choose to do what our customers want and they have worked through that. So we have a series of things that go on. Now, we do spend money, but like -- we are doing our expenses to, first, take care of our customers, second, build long-term value. We are not running our expenses to make a particular P&L number in a quarter. We just don’t do that. We cut advertising, as you pointed out, because there was no sense growing if you are losing money on the product. It wasn’t because we were trying to make some combined ratio target. It certainly helped that. But we are like, why go out and advertise if you are going to write it at 105 combined ratio. So we think about it economically first and in terms of creating long-term value. Mario, do you want to talk about how you are thinking about expenses and where you go this year?
Mario Rizzo: Yeah. So, Greg, I think, when you combine the pieces that Tom talked about, I think, you can get comfortable that we can continue to improve our expense ratio and our cost structure to get more competitively priced and invest in marketing at the same time. So when I think about the broad areas where we are looking to get more efficient and where we have gotten more efficient over the last several years, first, distribution costs. So when you look at the progress we have made on creating a lower cost but more productive Allstate agency distribution system. We are really happy with the progress we have made there. And I have talked a little bit earlier about the increases in overall production. But underneath that, the even more significant increases in average productivity as we have fewer agents producing more volume today than was the case a couple of years ago. And within our expense ratio, the distribution cost component of our expense ratio has continued to come down while we have been able to do that. So I am really optimistic that as we move forward and look to grow in more states that our Allstate agency force is going to be a core part of that and we will continue to be able to do that, but do that at a lower distribution cost overall. On the operating cost side through the combination of becoming more digital, outsourcing, offshoring, just improving processes, we have seen pretty significant reduction in operating costs going forward and we are going to continue to hammer on that one. We have also seen similar improvements on the claim side. Although I will say we are going to continue to invest in claims as part of profit improvement plan to get more effective on a number of processes. And I think the combination of the efficiencies we will get in those three areas will help fund the marketing investments that we want to make and will make as we look to accelerate growth.
Gregory Peters: Okay.
Tom Wilson: But if we need to spend money to grow on advertising and we like the profitability, we are going to spend more money on advertising.
Gregory Peters: That makes sense. Can you just help remind me how the transformative growth plan moves over and touches National General or is National General sort of in its own ecosystem in terms of how you are thinking about expenses?
Mario Rizzo: No. National General is a core part of transformative growth. The reason we acquired National General was to, first and foremost improve our competitive positioning in the independent agent channel and we have done that. With the business, we got a very well run non-standard auto business that we have continued to grow and grow profitably over the last several years. We are in the, I will say, early stages of rolling out what we call Custom 360. As I mentioned, that’s the standard and preferred auto and homeowners offering. So we think there’s significant opportunity in the independent agent space. When you look at the size of the National General business when we bought it compared to what it is now, our total IA presence, say, at the beginning of 2021 was a little over $5 billion, which included National General plus the Allstate independent agent business, as well as the encompass business. It’s over $9 billion currently. So we have had a lot of success in that channel and we think there’s just a ton of opportunity both in non-standard auto, but in standard preferred homeowners in the IA channel, and we expect to continue to capture that opportunity and that’s a core part of how we are going to grow and a core part of the transformative growth strategy.
Gregory Peters: Got it. Thank you for the answers.
Operator: Thank you. One moment for our next question. And our next question comes from the line of Yaron Kinar from Jefferies. Your question please.
Yaron Kinar: Thank you. Good morning. I want to stay on the line of growth, if I can. So based on the expectation that Allstate will be better competitively positioned in 2024? Like, how quickly and aggressively can you pivot a growth and is it more a matter of improving the retention rates, which I would think would be pretty quick or is it more about the ability to pivot to new business?
Tom Wilson: Well, how quickly will depend what happens in the marketplace, Yaron. So, I fully expect that Progressive and GEICO are going to spend more money in advertising and seeking to grow this year based on where their profitability is. State Farm has also been aggressive in trying to grow. Although they still have to improve their price position so that they are earning profit. But I expect it to continue to be a competitive environment. But you are right about the -- and then, it will just be how effective are we versus them. We feel -- Mario showed you the numbers, where two-thirds of the country were like all systems go. When you add in California, that’s another big chunk. So we think we have got plenty of open fields, so to speak, to run in and to compete with transformative growth. We have validated a lot of the underlying assumptions, but we have yet to bring it to market in a consolidated way in particular states with all of our channels, that’s on Mario’s list to do this year. So we feel good about those opportunities. So we will grow as fast as we can and still make sure we have a good combined ratio. Mario, what would you add to that?
Mario Rizzo: Yeah. I think that’s a comprehensive answer, Tom. And I think the short answer, Yaron, is it’s going to be both through retention and new business acquisition. And certainly, as we said earlier, as more states get into the right zone from a margin perspective, we would expect the amount of rate we need to take in those states to diminish. That’s really, again, as Tom said earlier, is going to be a function of what the future loss trend looks like, but having to take less rate is a good thing from a retention perspective and we will continue to focus on that. And then in terms of new business, as we begin to invest in more states and do things like unwinding some of the restrictive underwriting actions we had to take to limit growth, invest in marketing and take full advantage of the broad distribution capabilities we have built across the Allstate exclusive agency system, direct and independent agent. We think we can fully leverage all the things we have been building with a better competitive position to help drive growth. But timing will be dependent on state-by-state, market-by-market, and influenced in large part by the competitive marketplace we are going to be operating in.
Yaron Kinar: Thanks. And then maybe as my follow-up, tying the appetite to grow as much as you can profitably to the question of capital. You talked in the past and even on this call, about the -- about maybe selling the Health and Benefits business, you talked about the stop loss that you were looking to maybe purchase last year. Do you need to take any of these actions or other strategic actions in order to satisfy the growth appetite or do you have all the capital you need to grow as much as you want today?
Mario Rizzo: No. We don’t have to take any of those actions, we have plenty of capital and we have plenty of capital today. When you look at our earnings power, we will have plenty of capital to fund whatever growth we think we can achieve.
Yaron Kinar: Thank you.
Operator: Thank you. One moment for our next question. And our next question comes from the line of Elyse Greenspan from Wells Fargo. Your question please.
Elyse Greenspan: Hi. Thanks. Good morning. My first question is on the holdco cash. It did go up in the quarter. Did you guys take a dividend out of AIC or another entity in the third quarter.
Jesse Merten: Good morning, Elyse. It’s Jess. So as it relates to holdco cash, you can see that it went up from the prior quarter and this was really in accordance with our normal practice of moving capital around to maximize flexibility. So what we did do is move some capital up from a statutory legal entity was not AIC. But we moved some money out from statutory legal entities, as well as a few dividends out of non-insurance companies into the holding company. I know when we have talked in prior quarters, we had a few insurance companies that had fair amount of capital in them and didn’t have risk, because the risk was all reinsured into the Allstate Insurance Company, so sort of in the normal-course of creating flexibility, we looked at those entities and move some of that surplus up to the holdco in the quarter.
Elyse Greenspan: Thanks. And then my second question is on policy growth, but on the Nat Gen side, right? You guys have been showing on as growth slow within Allstate brand. You have been showing pretty strong growth within Nat Gen policies in-force. Just hoping to get some color there as you have kind of put way through books like what’s been driving the growth within NAT Gen and how should we think about that continuing from here?
Mario Rizzo: Yeah. Hi, Elyse. It’s Mario. So most of the growth that we have been experience in the National General has been in the non-standard auto space. And as you know, that’s a part of the market that’s had a lot of disruption competitively where a lot of carriers have really pulled out or certainly slowed their growth. With National General, we have taken the same approach from a profit improvement perspective as we have in Allstate, we have taken almost 23 points of rate over the last two years in National General. The non-standard auto book intends to turnover quickly, so you can reprice the book on a continual basis. And so we have stayed in that market, we generated meaningful growth in non-standard auto and we are comfortable with the margins that we are experiencing in that in that book of business and look to continue to grow that. On top of that, as I said earlier, we are rolling out the Customer 360, which is going up market. In the IA channel to write standard preferred auto and homeowners. Again, early stages there. The good news is, that product is in 16 states, we are getting good traction and it accounts for in the fourth quarter, it was about 70% of our standard auto and preferred new business production in the IA channel. We will expand that into additional states throughout the course of 2024 and into 2025. So we think that will be an additive opportunity in the IA space. But we are comfortable with what we have been writing non-standard auto and National General, we think there’s an additive opportunity as we look to really leverage Allstate’s capabilities in the middle-market to expand National General in that space in the IA channel.
Operator: Thank you. One moment for our next question. And our next question comes from the line of Bob Huang from Morgan Stanley. Your question please.
Bob Huang: Hi. Good morning. Just a quick question on the capital side, obviously, your capital now, it seems to be very sufficient. Curious as to how you think about the path to resuming buybacks, especially given the material rebound in capital levels so far?
Tom Wilson: So -- hi. This is Tom. I am going to start. Our capital is always been sufficient. So it should like reiterate what the position we have had. As it relates to buybacks when we are looking at capital regenerate. We start with, first, making sure we have enough capital to run the business and to grow the business and we have -- had put aside more capital for growth, given the dramatic increase in premiums and the risk and we think by transformative growth. We will continue to have opportunities to deploying capital and high ROEs in fact growth. So that’s the first thing we do is like how do you drive shareholder value. And so, I think, looking forward with those opportunities, we will have less capital than it’s for share buybacks that we had historically. That said, we have a strong track record of buying shares back. I think, I don’t know, since I have been CEO, maybe it’s $30 billion worth of shares we bought back. Like, if we don’t have a good use for the capital. Then we will give it back to shareholders, because there’s no sense holding onto extra capital. But between growth in the Property-Liability business, growth in some of our Protection Services, they tend to be a little lighter in terms of capital needs. And then our investment portfolio we derisked our investment portfolio last year, because of what we didn’t see as great market opportunities and if we saw there was opportunities to put more risk into that portfolio that would be another use of capital. So I think -- the think about capital we are always trying to manage and maximize shareholder value and we will do that -- do whatever form that is best.
Bob Huang: All right. Thank you. That’s very helpful and apologies for misstating the capital side of things.
Tom Wilson: Okay. That’s fine. So my second question really is on the expense. So one thing we hear typically from litigation lawyers is that, well, social inflation is an issue because insurance companies, carriers tend to under underfunded claims departments and often have inexperienced claim staffing. As you think about expense save going forward and as we think about re-pivoting back to growth, can you maybe help us think about what areas within expenses are you cutting and what are the areas where it is very critical and then things that are you are not going to cut on the expense side, is it possible to provide some colors?
Tom Wilson: Let me maybe address the litigation fees. Mario, can talk about expenses in claims. And then if you want, we can go above that in claims, already share just folks on claims. I am not shocked that lawyers would say that the only reason they exist is because we don’t have good people settling claims. That’s just not true. We -- bodily injury claims are where our customers get into an accident and hurt somebody else, we take those very seriously. We try to resolve those quickly. We try to make sure people get a fair amount. So I don’t think I have seen any systemic changes either in the way we do it or the way the industry does it. I will say there have been a couple of things that have led to increased number of suits and litigation. First is, there’s just more severe accidents. So during the pandemic, people started driving faster. They keep driving faster. And so when you look at the severity of the accidents, severity is up, and when severity is up, people tend to get hurt more, and when people get hurt more, they tend to have more damages, and that leads to a greater increase in the use of lawyers to help them resolve their claims. So that part seems completely natural to me. There’s, obviously, been a big change in the way those litigation firms go to market. I don’t know, obviously, but if you look at their advertising spend today, it’s over $1 billion a year. So they are out looking for customers. Some of those are people who need their help because they have been in severe accidents and there are more of them. Some of them are people that maybe don’t need as much help. They have also gotten much more sophisticated in the use of data and analytics, and trying to hunt down claimants and possible clients. Some of that would be good. Some of that -- we are not so sure they are actually doing what they are supposed to be doing. So I think it’s just a process, like, we want to make sure people get the right amount, we don’t want them to get too little and we don’t want them to get too much, we work to do that. You saw, we mentioned in the release for sure that we have also been settling claims faster. I guess we mentioned it in a presentation as well. So to counter that, what we have found is that if we can put more resources on a claim, settle it faster, then people are less likely to feel they need to go get a lawyer. They are happy, we are happy and it’s cheaper for everybody because nobody has to pay the 30% to attorneys. Mario, do you want to talk more about claims, maybe bodily injury, other claim expenses?
Mario Rizzo: Yeah. I guess where I start is, as we talked over the last really couple of years about our profit improvement plan, it’s multidimensional, and one dimension that we have continued to focus on is just improving claim operational execution. The fact is, as much as continuing to reduce our cost structure improves our competitive position, really operational excellence and claims is another way to make sure that, we pay what we owe, but that also will translate into better competitive position over time. So we are focused on really, I would say, all elements of the claim process. It’s people, it’s process, it’s technology, analytics. And we are going to invest in the claims process moving forward across all those dimensions to just continue to invest in terms of people, making sure we have the right adjuster capacity. We went through a pretty significant turnover. It was really in 2022. That has largely subsided. So we have much more stability in terms of claim staffing, but we are focused on training claim staff and providing them the tools, both in bodily injury and in physical damage to operate in a way that, again, we pay what we owe, but we ensure that we eliminate any leakage in the system and again, that’s been a core part of the profit improvement plan going forward. We are investing in people to provide more oversight, get more eyes on cars in the physical damage side, do a much more effective job in terms of total loss evaluation on the injury side. Tom mentioned we are paying claims faster. We have reduced our pending inventory on the casualty side to the lowest level it’s been since well before the pandemic. We think that continues to reduce reserve risk going forward. So I would say, really, the answer is, we are going to continue to invest in claims broadly, because we just do believe it’s a core part of enabling us to be more competitive and ultimately translate into growth.
Tom Wilson: Let me link this to Greg’s question as well, because I think sometimes when we set goals out there and we talk about specific line items in the P&L, we don’t always show the subtleties of how they are linked together. So we clearly have a goal to reduce expenses related to transformative growth so we can be a low cost provider. That said, we -- that’s not our primary goal. Our primary goal is to treat our customers really well, to build a great long-term business platform and to settle our claims and run our business properly. So if it means we have to spend more money on claims personnel, so that we lower, so loss costs come down and we think that’s in the best interest of our shareholders and our customers, then we are going to do that even if the expense number goes up. So we put those numbers out there to help you say we are let you know we are managing them, but we are not captured by just that one-line item.
Bob Huang: Got it. Thank you very much.
Operator: Thank you. One moment for our next question. And our next question comes from the line of Josh Shanker from Bank of America. Your question please.
Josh Shanker: Yeah. Thank you for taking my question. Once upon a time you think about combined ratio guidance and now you talk more about ROE guidance, which is sensible. But I look at the results in homeowners and they are quite volatile and good this quarter. I want to know where we stand in terms of pricing adequacy broadly for the homeowners’ line. But more importantly, I want to see pricing adequacy for bundlers, I assume that you have a pricing adequacy for monoline drivers and it’s different for the bundlers. Are we at a point where you are very happy to take unbundles at a nice level of profitability today?
Tom Wilson: I will let Mario take on the bundling question, because we are really happy about that. Let me just -- in terms of the homeowners’ business, we really like the business. It’s -- you see -- look at our six-year combined ratio before this year, it was 92 and so really high return on equity, it’s a great combined ratio. If you look at our underlying combined ratio this year, which excludes catastrophes, it’s come down from last year. Obviously, we had a bad two quarters -- bad two quarters doesn’t make a bad business. So we still really like the business, we have raised prices in the low-teens this year from a variety of different ways. So we like that business. If cats is the first two quarters are indicative of where we go in the future, our cats were up $2.5 billion this year versus the prior year. So if that’s the case. I am confident we have the business model, which will adapt to it. We might not catch it before it, you won’t catch it before it happens, but we haven’t really great go-to-market business, so we are really happy with the homeowners’ business. Mario, do you want to talk about returns in the homeowners’ business and then the bundling question.
Mario Rizzo: Yes. So, Josh. On -- in terms of overall rate adequacy. Obviously, through the combination of the rates we have taken over the last couple of years, plus the inflation and replacement values in homes, that’s really fueling a pretty consistent and significant low-teens increase in average premiums. So this quarter that was about 12.5%, so we are seeing price flow through the system. And that doesn’t include, because as you know, with a 12-month policy, it takes 24 months to earn it all that rate. So a lot of the rate we took in 2023 we have yet to earn and we are going to we are going to keep at it in terms of staying on top of loss cost. The underlying combined ratio for the year was 67 improved by about 3 points, mid 60s is where we would like that number to be. So we are getting closer to that, we have more rate that’s going to earn in, and as Tom mentioned, we feel really good about our capabilities in homeowners and we are going to continue to lean-in and look to grow that business. From a bundling perspective, just 80% of our homeowners’ customers have a supporting line are bundled. That’s a pretty meaningful number and it happens at discount, it’s upwards of 15%. And again, what we think with that pricing the lifetime value of that bundled segment is substantial and we will write bundled customers all day long. Our agents are writing bundled business at an all-time high level north of 70% of new business we are incenting agents to write that, we are seeing more bundled business come through our call centers and our direct business. And as I talked earlier Custom 360 going up market is both in auto and home offering. So we think we are well-positioned across all three channels to continue to attract bundled business that we can be even more competitively priced and because of the discounting element, but also it’s a segment that we think generates substantial lifetime value and we are good at it, so we are going to keep that.
Tom Wilson: Hey, Josh. I know you are a student of our competitors. So you see both GEICO and Progressive talking more about bundling in their advertising. They obviously see also good customers there. Our difference is we expect to make money in homeowners.
Josh Shanker: And if I just close upon that, even though we are going to see some modest decline in auto policy count due to price increases and turning the book a little bit, are you net growing bundlers every day?
Tom Wilson: I think we probably don’t give that number out, but let’s just say, we have a high focus on bundling, our agents are doing more bundling these days because we changed the way in which we reward and compensate them. So we are continuing to hunt down.
Brent Vandermause: I think we have time for one more question, is that.
Operator: Certainly. One moment for our final question then. And our final question for today comes from the line of Andrew Kligerman from TD Cowen. Your question please.
Andrew Kligerman: Hey. Thanks for sweeping me in at the end. Quick -- maybe some quick questions here. With regard to the impacts of unwinding the restrictions and increasing advertising, could you give us a sense of the impacts of each on the combined ratio?
Tom Wilson: Well, I think, the first -- the principal impact of unwinding underwriting restrictions will be to kind of increase the aperture of the types of risks that we will be willing to write. Again, now that in the states that we are going to do that, we feel better and good about our rate adequacy and that’s true across segments. So we have a pretty sophisticated approach to pricing where the prices accurately reflect the specific risks of each individual segment. So as we write more business, it’s going to be written at what we believe to be a rate adequate level. Now, from a new business perspective, as we increase the volume of new business, that does tend to write or run a higher loss ratio due to renewal relativity going forward. So it will have some impact on our overall combined ratio going forward. But we take that into account in terms of how we manage the business. But we don’t open the underwriting restrictions until we are comfortable with the rate level we are at. We price each risk according to its unique characteristics. Having said that, there is a new business penalty associated with higher new business volume. But again, we factor that in in terms of how we manage the overall combined ratio in the business.
Andrew Kligerman: Got it. And then with regard to severity, just to make sure I am clear on it, you talked about 8% to 9% in 2023. Is that what you are anticipating for 2024 and how are you thinking about frequency as well going into the year?
Mario Rizzo: We don’t do a forecast for either frequency or severity on a go-forward basis. I would say it’s whatever it is, we will make sure we get priced for it.
Andrew Kligerman: Okay. Thank you.
Tom Wilson: Okay. Thank you all for spending time with us this quarter. Obviously, with the sun shining a little bit and a few less cats, it gave you the opportunity to see the benefits of all the hard work the team’s been doing to improve profitability in auto insurance and making sure we keep our homeowner business strong. We didn’t really get to our other businesses, but they also continue to do quite well and our investment portfolio and team had a great year when you look at our total returns. So we feel good about where we are going forward. Thank you and we will see you next quarter.
Operator: Thank you, ladies and gentlemen, for your participation in today’s conference. This does conclude the program. You may now disconnect. Good day. | [
{
"speaker": "Operator",
"text": "Good day and thank you for standing by. Welcome to Allstate’s Fourth Quarter Earnings Conference Call. Currently, all participants are in a listen-only mode. After prepared remarks, there will be a question-and-answer session. [Operator Instructions] As a reminder, please be aware this call is being recorded. And now, I’d like to introduce your host for today’s program, Brent Vandermause, Head of Investor Relations. Please go ahead, sir."
},
{
"speaker": "Brent Vandermause",
"text": "Thank you, Jonathan. Good morning. And welcome to Allstate’s fourth quarter 2023 earnings conference call. After prepared remarks, we will have a question-and-answer session. Yesterday, following the close of market, we issued our news release and investor supplement and posted related material on our website at allstateinvestors.com. Our management team is here to provide perspective on these results and our strategy. As noted on the first slide of the presentation, our discussion will contain non-GAAP measures for which there are reconciliations in the news release and investor supplement, and forward-looking statements about Allstate’s operations. Allstate’s results may differ materially from these statements. So please refer to our 10-K for 2022 and other public documents for information on potential risks. And now, I will turn it over to Tom."
},
{
"speaker": "Tom Wilson",
"text": "Good morning. And we appreciate you taking the time and spending your efforts to explore why Allstate is an attractive investment. So I will begin with an overview of our strategy and results, and Mario and Jess, can go through the operating performance. Then we will have time for your questions at the end. Let’s begin on slide two, which depicts Allstate’s strategy to increase shareholder value. So we have two components to this strategy, increase personal Property-Liability market share and expand protection provided to customers, which are shown in the two ovals on the left. On the right-hand side, you can see the highlights for the fourth quarter. We generated net income of $1.5 billion. The strong results reflect our actions to improve auto insurance profitability and mild weather conditions, which was a welcome reprieve from the elevated level of weather related losses in the first three quarters of the year. The proactive approach to increasing bond duration also contributed to strong results with higher income from the market based portfolio. To further increase shareholder value this year, we remain focused on improving auto insurance profitability. There is more work to be done, but we are well on our way. Additional shareholder value will then be increased by increasing policies in-force across all of our businesses. The transformative growth initiatives to drive Property-Liability market share growth can be implemented in more states this year now as auto margins have been improved. We are also focusing on expanding protection offerings to Protection Services businesses, which is shown in the lower oval as Protection Plans, Identity Protection, Roadside and Arity, all have good growth prospects. As you know, we started the process to sell the Health and Benefits business and that process is proceeding on schedule. Let’s review the financial results on slide three. Revenues of $14.8 billion in the fourth quarter increased by 8.7%. That reflects a 10.7% increase in Property-Liability earned premium and that was due to rate increases in 2022 and -- mostly in 2022, and in 2023 in both the auto and homeowners’ insurances. Net investment income in the quarter was $604 million, an 8.4% increase, reflecting higher fixed-income yields and duration extension, which is partially offset by lower performance based income. The strong profitability in the quarter generated adjusted net income of $1.5 billion or $5.82 per diluted share. Annual revenues of $57 billion were up $5.7 billion or 11.1% over the prior year. Strong fourth quarter earnings resulted in positive adjusted net income for the year. Slide four summarizes the status of the four-part auto insurance profit improvement plan. Strong execution resulted in 6.7% point improvement in the combined ratio in 2023. Starting with rates. Since 2022, the Allstate brand implemented rate increases 33.3%, which included 16.4% in 2023 and 6.9% in the fourth quarter, driven by the recent approvals in California, New York and New Jersey. National General implemented rate increases of 10% in 2022 and an additional 12.8% in 2023. Looking forward, we will pursue rate increases in 10 states to improve margins and in other states to keep pace with increases in loss costs. Expense reductions were initiated in 2019 as part of the transformative growth plan to become a low cost provider of protections, being early in this effort helped offset the rapid inflation in loss costs. The underwriting expense ratio decreased 1.1 points in 2023 compared to the prior year when you exclude the large decline in advertising that was directly linked to lower profitability. Looking forward, further cost reductions will improve efficiencies and our competitive price position. Given the significant improvement in perspective, auto margins will increase advertising investment this year. In addition, we implemented underwriting actions to restrict new business, where we were not achieving target returns. We are moving some underwriting restrictions as rate adequacy is achieved. Finally, enhancing claim practices in a high inflation and increasingly litigious environment are required to deliver good customer value. This includes accelerating the settlement of injury claims and increasing in-person inspections. This program has positioned us to increase new business levels and begin to grow policies in-force in sales where acceptable margins have been restored. Now I will turn it over to Mario to discuss Property-Liability."
},
{
"speaker": "Mario Rizzo",
"text": "Thanks, Tom. Let’s start on slide five. Property-Liability earned premium increased 10.7% in the fourth quarter, primarily driven by, excuse me, higher average premiums from rate increases, partially offset by a 2% decline in policies in-force. Underwriting income of $1.3 billion in the quarter improved $2.4 billion compared to the prior year quarter due to increased premiums earned, improved underlying loss experience, lower catastrophe losses and operating efficiencies. The chart on the right highlights the components of the 89.5 combined ratio in the quarter, which improved 19.6 points from the prior year quarter. The impact of catastrophe losses and prior year reserve re-estimates on the combined ratio as shown in light blue and gray materially improved compared to the prior year. Catastrophe losses of $68 million were $711 million or 6.3 points lower than prior year due to the mild weather conditions experienced in the quarter and favorable loss development from prior period events. Prior year reserve re-estimates, excluding catastrophes, were unfavorable and totaled $199 million, representing a 1.6-point adverse combined ratio impact in the quarter and a 0.9-point favorable impact compared to the prior year quarter. Approximately $148 million related to personal auto driven in part by costs related to claims in litigation and adverse development in National General. The underlying combined ratio of 86.9, improved by 12.3 points compared to the prior year quarter, due to higher average premium and the favorable influence of milder weather conditions on accident frequency. Despite the favorable results in the quarter, the full year combined ratio of 104.5 was significantly impacted by elevated catastrophe losses primarily from events in the first three quarters, resulting in a catastrophe loss ratio that was 4 points above the 10-year average from 2013 to 2022. Now let’s move to slide six to review Allstate’s auto insurance profit trends. The fourth quarter recorded auto insurance combined ratio of 98.9 improved by 13.7 points compared to the prior year quarter, reflecting higher earned premium, lower underlying losses, lower adverse prior year reserve re-estimates and expense efficiencies. The chart shows the underlying combined ratios from 2022 and 2023 with quarterly reported figures adjusted to reflect the estimated average severity level as of year-end for each year. As you can see, the underlying combined ratio decreased each quarter in 2023, reflecting the benefits of the profit improvement plan, Tom discussed earlier. As a reminder, we continually reassess claim severity expectations as the year progresses. If the current year expected severity increases or decreases, the year-to-date impact of that change is recorded in the current quarter, despite a portion of that impact being driven by reassessment of the prior quarters. In 2023, the full year estimate of claim severity decreased in the fourth quarter. So there was a benefit from prior quarters included in reported results in the fourth quarter. When you adjust for this, the reported underlying combined ratio of 96.4, as shown in the table would be 98.2 as shown in the bar on the graph. The three preceding quarters all benefit from the adjustments, including Q3, which improved from 100.5 in the presentation shown last quarter to 99.9, reflecting the latest severity estimates. While loss cost trends remain historically elevated, the rate of increase moderated in the second half of the year, mainly in physical damage coverages. Allstate brand weighted-average major coverage severity expectations improved from 11% as of the end of the second quarter to 9% in the third quarter and now that 8% to 9% at the end of the year. As a reminder, this trend reflects our current best estimate for the year-over-year increase in average severity. Slide seven shows the impact of our profit improvement actions across the country. As shown on the left, Allstate’s brand rate increases have exceeded 33% over the last eight quarters, including larger increases in California, New York, New Jersey and Texas, reflective of the elevated loss trends in these states. These four states comprised 36% of Allstate brand auto total written premiums in the U.S. during 2023. As you know, increases were approved in California, New York and New Jersey in December. So we have yet to see this in earned premiums. The chart on the right shows states with an underlying combined ratio below 100, shown in the light and dark blue bars were 65% of the total in 2023, more than doubling from the percentage at year-end 2022. Excluding California, New York, and New Jersey, the Allstate brand auto insurance underlying combined ratio was 95.9 in 2023. Slide eight shows improving profitability had a negative impact on policies in-force during 2023. On the left, you can see that total Protection Auto policies in-force, decreased by 2.9% compared to prior year, as the Allstate brand decline of 6.2% more than offset a 13.3% increase at National General. Allstate brand auto policies in-force decreased due to reduced new business volumes and lower retention. National General growth of 581,000 policies in-force was mostly driven by non-standard auto insurance and to a lesser extent, the rollout of new middle-market standard and preferred auto insurance product launches for the Custom 360 products. The chart on the right shows total personal auto new issued applications for 2023 decreased 6% compared to the prior year and the accompanying drivers. Targeted profitability actions within the Allstate brand resulted in a decline in new auto issued applications of 20% compared to the prior year. The first two red bars reflect the impact of lower new business volume in California, New York and New Jersey, as well as the direct channel decline in the remainder of the country, which was most directly impacted by the reduction in marketing investment last year. Outside of the three states where profit actions significantly reduced new business, Allstate exclusive agents increased production by 6%, driven by higher productivity, showing the response of Allstate agents to the changes we have made to incent growth and the opportunity to continue to grow with our agency owners as part of transformative growth. The acquisition of National General strategically positioned Allstate to grow in the independent agent channel with new business applications, increasing 12% in 2023. National General continues to grow non-standard auto and generate higher volume from the Custom 360 product launches. Slide nine covers homeowners’ insurance results, which generated significant profits for the quarter, while full year results were impacted by elevated catastrophe losses in the first three quarters of the year. On the left you can see net written premium increased 13.3% from the prior year quarter, primarily driven by higher average gross written premium per policy in both the National General and Allstate Brands, and a 1.1% increase in policies in-force. National General net written premium grew 19.6% compared to the prior year quarter, primarily due to policy in-force growth, driven by the Custom 360 offering and higher average premiums from implemented rate increases. Allstate brand net written premiums increased 12.5%, driven by average gross written premium per policy increases of 12.2% compared to the prior year quarter and a small increase in policies in-force. Allstate agents continue to bundle auto and homeowners’ insurance at historically high levels. Catastrophe losses of $21 million in the fourth quarter were low by historical standards, reflecting milder weather conditions and favorable development from prior events contributing to a 62 combined ratio and $1.2 billion of underwriting income for the quarter. Milder weather in the fourth quarter also favorably influenced the underlying combined ratio due to lower non-catastrophe claim frequency. For the full year, higher catastrophe losses drove the combined ratio increase in 2023 compared to 2022. Full year catastrophe losses of $4.5 billion were higher than our historical experience and translated to a catastrophe loss ratio that was 17 points higher than prior year and roughly 14 points above the 10-year average from 2013 to 2022. As you can see from the chart on the right, the full year underlying combined ratio declined from 70.3 in 2022 to 67.3 in 2023, reflecting higher average premiums from rate increases, partially offset by higher claims severity due to materials and labor costs. With an industry-leading product, advanced pricing, underwriting and analytics, broad distribution capabilities and a comprehensive reinsurance program, we will continue to leverage homeowners as a growth opportunity and remain confident in our ability to generate attractive risk-adjusted returns in this line. Moving to slide 10, let’s discuss how we are advancing transformative growth to provide customers low-cost protection through broad distribution. We remain focused on four key elements of this multiyear initiative, as you can see on this slide. We have improved our cost structure to enhance our competitive price position. In the current environment with most competitors taking large rate increases, it’s difficult to pinpoint competitive position. That said, our relative competitive position likely deteriorated in 2023. But as many of our competitors continue to implement rate increases and our expenses decline, we believe our competitive position will improve enhancing growth opportunities as part of transformative growth. Redesigned, affordable, simple and connected products currently available for auto insurance in seven states with plans for further expansion this year, both improve customer value and deliver a differentiated customer experience. National General independent agent growth prospects will be further enhanced by expanding Custom 360 products, which were live in 16 states as of year-end 2023 and expect to be in nearly every state by the end of 2024. Expanding customer access will also support market share growth and we have made good progress in all three channels. Increasing sophistication and customer acquisition continues to advance and will improve the effectiveness of increased advertising spend in 2024, as we look to grow in more states. A new technology ecosystem is also being deployed to improve the customer experience, speed-to-market and reduce costs for legacy technology platforms. Let me turn it over to Jess now to talk about expense reductions and other operating results."
},
{
"speaker": "Jesse Merten",
"text": "All right. Thank you, Mario. On slide 11 we delve deeper into how we are improving customer value through expense reductions. As shown in the chart on the left, the Property-Liability underwriting expense ratio decreased two points from 2022 to 2023 as we continue to focus on lowering costs to provide more value to customers and some of the benefits of higher earned premium growth relative to fixed costs. The right half of the chart provides additional context on the drivers of the 1.3-point improvement in the fourth quarter compared to the prior year quarter. The first red bar shows the two-tenth of a point impact from increased advertising spend, reflecting the slight increase was driven by seasonal investment changes and growth investments in rate adequacy states. The second green bar shows the 1.4 -- 1.4-point decline in operating costs, which was mainly driven by lower employee-related costs and the impact of higher premiums relative to fixed costs in the quarter. Shifting to the longer term trend in the chart on the right, we remain committed to reducing the adjusted expense ratio as part of transformative growth. As a reminder, the adjusted expense ratio starts with our underwriting expense ratio, which I just covered and excludes restructuring COVID-related expenses, amortization and impairment of purchased intangibles and advertising expense. It then adds our claims expense ratio, excluding costs associated with settling catastrophe claims. Those expenses are excluded because catastrophe-related costs tend to fluctuate. Through innovation, process improvement and strong execution, we have driven significant improvement in expenses for the fourth quarter and year-end 2023 adjusted expense ratio of 24.7. This reflects decreases in both the underwriting expense and non-cat claims expense ratio compared to the prior year quarter. Now moving to slide 12, I will cover investment results. This quarter showed how our proactive approach to duration management benefits results. The chart on the left shows changes we made in the duration of the bond portfolio in comparison to bond market yields, from the fourth quarter of 2021 through the third quarter of 2022, lowering fixed-income duration, mitigated losses as rates rose. Beginning in Q4 of 2022, we began to extend duration which when combined with higher yields has increased market-based income. Our fixed income yield, shown in the table below the chart, remains below the current intermediate corporate bond yield, reflecting an additional opportunity to increase yields as we continue to reinvest portfolio cash flows into higher interest rates. The bar chart on the right shows the income and total return benefits of these decisions. As you can see in the table on the chart, the total return of our portfolio was 4.6% in the fourth quarter and 6.7% for the year. Portfolio returns in both periods reflect income earned, as well as higher fixed income valuations due to the decline in market yields in the fourth quarter. Net investment income totaled $604 million in the quarter, which was $47 million above the fourth quarter of last year. Market based income of $604 million shown in blue, was $140 million above the prior year quarter, reflecting the repositioning of the fixed income portfolio into longer duration and the benefit from higher yielding assets that sustainably increase income. Market based income also benefit -- benefited from higher fixed-income balances. Performance based income of $60 million shown in black, was 87 million below the prior year quarter due to lower valuation increases and fewer sales of underlying assets. As we have stated previously, the performance based portfolio is expected to enhance long-term returns as demonstrated through our five-year and 10-year internal rates of return of 12% and volatility in these assets from quarter-to-quarter is expected. Slide 13 covers results for our Protection Services businesses. Revenue in these businesses increased 11.8% to $719 million in the fourth quarter compared to the prior year quarter. This result is mainly driven by growth in Allstate Protection Plans, which increased 19.6% compared to the prior year quarter, reflecting expanded product breadth and international growth. In the table on the right, you will see adjusted net income of $4 million in the fourth quarter decreased $34 million as compared to the prior year quarter. This decrease is attributable to the results of a state income tax examination that increased the effective state tax rate that we apply, which increased deferred income taxes by $43 million in the quarter for future tax payments and Protection Services, largely related to dealer services. The impact of the tax change on the enterprise was a net benefit of $6 million. We do not anticipate that these tax adjustments will have a significant impact on our ongoing operations. Shifting now to slide 14, our Health and Benefits businesses continue to generate profitable growth. From the fourth quarter of 2023, revenue of $630 million increased by $50 million compared to the prior-year quarter, driven by growth in individual health, group health, as well as fees and other revenue. Adjusted net income of $60 million in the fourth quarter of 2023, increased $2 million compared to the prior year quarter as individual health revenue growth partially offset higher benefit ratios in group health. As you know, late last year, we announced a decision to pursue the divestiture of our Health and Benefits business following the successful integration of Allstate’s voluntary benefits business in National General’s Group and individual health businesses. We continue to anticipate a transaction will be completed in 2024. We will close on slide 15 by reviewing Allstate’s financial condition and capital position. Allstate’s proactive capital management approach provides the financial flexibility, liquidity and capital resources necessary to navigate a challenging operating environment, while providing support for long-term value creation. Fourth quarter results demonstrated the company’s capital generation capabilities with a statutory surplus in holding company assets of $18 billion, increasing by $1.6 billion compared to the prior quarter. Assets held at the holding company also increased to $3.4 billion. The increase to the prior quarter primarily reflects a return of capital from National General statutory entities, partially offset by common shareholder dividends. Additionally, GAAP shareholders’ equity of $17.8 billion increased $3.2 billion compared to the prior quarter, reflecting $1.5 billion of GAAP net income and the improved unrealized position on fixed income securities of $1.9 billion. We continue to proactively manage capital, make progress on the comprehensive profit improvement plan and invest in transformative growth. We remain confident that these strategic actions will generate attractive shareholder returns. With that as context, let’s open it up for your questions."
},
{
"speaker": "Operator",
"text": "Certainly. One moment for our first question. And our first question comes from the line of Jimmy Bhullar from JPMorgan. Your question please."
},
{
"speaker": "Jimmy Bhullar",
"text": "Hey. Good morning. So I had a couple of questions. First, can you talk about rate adequacy in California, New York, New Jersey, the new business that you are issuing there now is that adequate price for normal profitability or are you assuming that you are going to need another sort of stab at it in 2024 to get the normal profits?"
},
{
"speaker": "Tom Wilson",
"text": "Thank you, Jimmy. I will let, Mario, really three different stories, Mario will take you through those in, then we will do a follow-up question, and I would just remind everybody, we like -- ask one question with a follow-up, hopefully, related to the first question. But so we can make sure we get through everybody’s call. So, Mario, you..."
},
{
"speaker": "Mario Rizzo",
"text": "Yeah. So, Jimmy, first thing I’d say is, we have talked a lot last quarter about the actions we needed to take in the three states, California, New York and New Jersey. I will start with a view that says, look our objective is to meet the protection needs of as many customers in as many states as possible. When that can happen, we think customers are served well, markets operate effectively and we can operate our business to achieve the appropriate levels of returns. We had rate pending in all three of those states and I will just spend a minute kind of giving you the story in each one of those, because I think it’s slightly different. In California, you will remember we filed a 35% rate. We got approval for 30 %. But we got approval earlier than our expected effective date. So, effectively, we filed our full rate need and got approval for our full rate need. As of yesterday, we are writing business in California, again across all channels and we feel comfortable writing business in California given the rate level that we are operating. Now, of course, having said that, we have got to stay on top of loss trends going forward and we will do that, but we are comfortable with the rate level, we have gotten California that have opened up that market. In New Jersey, it’s kind of the opposite story we filed for 29 points of rate, we got approval for just under 17%. And as a result of that, we are going to continue to take the more restrictive underwriting actions that we have been taking in New Jersey, which means we will continue to get smaller in New Jersey, while we plan on filing additional rate as a matter of fact, we have two rates pending with the New Jersey Department and depending on how those things shake out that that will inform future actions we take in New Jersey. But as of right now, we will continue to get smaller in New Jersey, just given the lack of rate adequacy. And New York is kind of somewhere in between, we got approval for a 14.6% rate in December. We have implemented that, that helps. But we still need more rate. We are actively engaged with the department and intend to file our full rate need going forward and do that in reasonably short order. And again, depending on how that plays out, that will inform the next set of actions we have taken in New York."
},
{
"speaker": "Jimmy Bhullar",
"text": "Okay. And then just a follow-up, maybe slightly related and slightly unrelated, in those three states, if you are raising prices a lot, it’s reasonable to assume that you would suffer in terms of discount or at least at a minimum, it wouldn’t grow. But how is your PIF faring in the states where you are not taking any outsized rate actions versus what some of your peers are taking and just trying to assess whether you think it’s reasonable to assume that your overall PIF count stabilizes at some point this year for the company as a whole and potentially grows this year, later in the year or next year."
},
{
"speaker": "Tom Wilson",
"text": "Jimmy, this is Tom. I will start and then Mario can give -- can add on to that. I would say that the current competitive environment is still in flux. So, we raise our rates 30 points in California. State Farm gets another increase somewhere after that. So it’s too early to tell what impact that will have on volume in 2024. We do -- our goal, though, is obviously to, one, make good money for our shareholders as first part, and as Jess said, the other part is, we need to grow. So we are -- we think we have got transformative growth in place, which is differentiated in a long-term growth plan, as well as some of the short-term things you are talking about here. Mario, what would you add to that?"
},
{
"speaker": "Mario Rizzo",
"text": "Yeah. I think, specifically, on retention, Jimmy, as Tom mentioned, in the three states we talked about, those markets are still in a bit of a state of flux. One state I’d point to, to kind of tell the story about retention and how taking outsized rates and then kind of lapping that impacts retention is Texas. We took significant rates in Texas in 2022 and earlier in 2023 and we showed you last quarter there was a pretty substantial hit to retention in Texas. As we have lapped those rates, we have seen a nice bounce back which contributed to the sequential improvement in the fourth quarter retention level in auto relative to Q3. So, once the rate need stabilizes, that certainly has a positive impact on retention going forward. And hopefully, as we in more and more states are really just keeping on top of loss trend, we would expect the headwind that we faced in retention to diminish going forward."
},
{
"speaker": "Jimmy Bhullar",
"text": "Thank you."
},
{
"speaker": "Operator",
"text": "Thank you. One moment for our next question. And our next question comes from the line of Gregory Peters from Raymond James. Your question please."
},
{
"speaker": "Gregory Peters",
"text": "Okay. Good morning, everyone. I -- for my first question, I’d like to focus on transformative growth and it’s kind of counter intuitive, right, because you are talking about lowering expenses at the same time growing your policy count. So when I think of some of the headwinds going forward on expenses, I think, of increased agent commission because profitability is going up. I see maybe the potential for increased advertising expense. So maybe you can help us pull together on how you see growth emerging at a lower expense base?"
},
{
"speaker": "Tom Wilson",
"text": "Greg, I will start and Mario can jump in. So I don’t know that, I think, there is counterintuitive that as you grow your expenses can’t go down, and I would point out, if you look at National General, its growth has helped drive more scale and has brought its expenses down. So that’s just a scale-related comment to it. As you relate -- you look at the programs we have in place on transformative growth, it’s really across the Board. Everywhere we are at where programs that are -- we have been working on for three plus years and they are rolling out as we go. For example, we are cutting costs by becoming more digital. By becoming more digital, we can move more jobs either get rid of the jobs or move them offshore. That’s a multiyear thing. You don’t just take first notice of loss and change it in three months. So the benefits of those programs, which we have been working and rolling those out for the last 18 months really still will get more of those benefits as we go forward in 2024 just based on the work we have already done. In terms of agent commission, Mario mentioned this, we have changed the agent commission structure such that it pays more for new business and less for renewals and that was one of the core parts of transformative growth was how do we distribute our products at a lower price and still give people the value of an agent. And people want an agent to buy the stuff, they don’t necessarily want to pay as much for attention. One of the underlying assumptions we validated with transformer growth, which quite honestly, a number of analysts and other people were not so sure, but you are going to keep agents head in the game? And the answer is, yes. Look at the productivity numbers that Mario showed. Do they like having renewal compensation go down? No. Do our customers like having a better priced product? Yes. And so we choose to do what our customers want and they have worked through that. So we have a series of things that go on. Now, we do spend money, but like -- we are doing our expenses to, first, take care of our customers, second, build long-term value. We are not running our expenses to make a particular P&L number in a quarter. We just don’t do that. We cut advertising, as you pointed out, because there was no sense growing if you are losing money on the product. It wasn’t because we were trying to make some combined ratio target. It certainly helped that. But we are like, why go out and advertise if you are going to write it at 105 combined ratio. So we think about it economically first and in terms of creating long-term value. Mario, do you want to talk about how you are thinking about expenses and where you go this year?"
},
{
"speaker": "Mario Rizzo",
"text": "Yeah. So, Greg, I think, when you combine the pieces that Tom talked about, I think, you can get comfortable that we can continue to improve our expense ratio and our cost structure to get more competitively priced and invest in marketing at the same time. So when I think about the broad areas where we are looking to get more efficient and where we have gotten more efficient over the last several years, first, distribution costs. So when you look at the progress we have made on creating a lower cost but more productive Allstate agency distribution system. We are really happy with the progress we have made there. And I have talked a little bit earlier about the increases in overall production. But underneath that, the even more significant increases in average productivity as we have fewer agents producing more volume today than was the case a couple of years ago. And within our expense ratio, the distribution cost component of our expense ratio has continued to come down while we have been able to do that. So I am really optimistic that as we move forward and look to grow in more states that our Allstate agency force is going to be a core part of that and we will continue to be able to do that, but do that at a lower distribution cost overall. On the operating cost side through the combination of becoming more digital, outsourcing, offshoring, just improving processes, we have seen pretty significant reduction in operating costs going forward and we are going to continue to hammer on that one. We have also seen similar improvements on the claim side. Although I will say we are going to continue to invest in claims as part of profit improvement plan to get more effective on a number of processes. And I think the combination of the efficiencies we will get in those three areas will help fund the marketing investments that we want to make and will make as we look to accelerate growth."
},
{
"speaker": "Gregory Peters",
"text": "Okay."
},
{
"speaker": "Tom Wilson",
"text": "But if we need to spend money to grow on advertising and we like the profitability, we are going to spend more money on advertising."
},
{
"speaker": "Gregory Peters",
"text": "That makes sense. Can you just help remind me how the transformative growth plan moves over and touches National General or is National General sort of in its own ecosystem in terms of how you are thinking about expenses?"
},
{
"speaker": "Mario Rizzo",
"text": "No. National General is a core part of transformative growth. The reason we acquired National General was to, first and foremost improve our competitive positioning in the independent agent channel and we have done that. With the business, we got a very well run non-standard auto business that we have continued to grow and grow profitably over the last several years. We are in the, I will say, early stages of rolling out what we call Custom 360. As I mentioned, that’s the standard and preferred auto and homeowners offering. So we think there’s significant opportunity in the independent agent space. When you look at the size of the National General business when we bought it compared to what it is now, our total IA presence, say, at the beginning of 2021 was a little over $5 billion, which included National General plus the Allstate independent agent business, as well as the encompass business. It’s over $9 billion currently. So we have had a lot of success in that channel and we think there’s just a ton of opportunity both in non-standard auto, but in standard preferred homeowners in the IA channel, and we expect to continue to capture that opportunity and that’s a core part of how we are going to grow and a core part of the transformative growth strategy."
},
{
"speaker": "Gregory Peters",
"text": "Got it. Thank you for the answers."
},
{
"speaker": "Operator",
"text": "Thank you. One moment for our next question. And our next question comes from the line of Yaron Kinar from Jefferies. Your question please."
},
{
"speaker": "Yaron Kinar",
"text": "Thank you. Good morning. I want to stay on the line of growth, if I can. So based on the expectation that Allstate will be better competitively positioned in 2024? Like, how quickly and aggressively can you pivot a growth and is it more a matter of improving the retention rates, which I would think would be pretty quick or is it more about the ability to pivot to new business?"
},
{
"speaker": "Tom Wilson",
"text": "Well, how quickly will depend what happens in the marketplace, Yaron. So, I fully expect that Progressive and GEICO are going to spend more money in advertising and seeking to grow this year based on where their profitability is. State Farm has also been aggressive in trying to grow. Although they still have to improve their price position so that they are earning profit. But I expect it to continue to be a competitive environment. But you are right about the -- and then, it will just be how effective are we versus them. We feel -- Mario showed you the numbers, where two-thirds of the country were like all systems go. When you add in California, that’s another big chunk. So we think we have got plenty of open fields, so to speak, to run in and to compete with transformative growth. We have validated a lot of the underlying assumptions, but we have yet to bring it to market in a consolidated way in particular states with all of our channels, that’s on Mario’s list to do this year. So we feel good about those opportunities. So we will grow as fast as we can and still make sure we have a good combined ratio. Mario, what would you add to that?"
},
{
"speaker": "Mario Rizzo",
"text": "Yeah. I think that’s a comprehensive answer, Tom. And I think the short answer, Yaron, is it’s going to be both through retention and new business acquisition. And certainly, as we said earlier, as more states get into the right zone from a margin perspective, we would expect the amount of rate we need to take in those states to diminish. That’s really, again, as Tom said earlier, is going to be a function of what the future loss trend looks like, but having to take less rate is a good thing from a retention perspective and we will continue to focus on that. And then in terms of new business, as we begin to invest in more states and do things like unwinding some of the restrictive underwriting actions we had to take to limit growth, invest in marketing and take full advantage of the broad distribution capabilities we have built across the Allstate exclusive agency system, direct and independent agent. We think we can fully leverage all the things we have been building with a better competitive position to help drive growth. But timing will be dependent on state-by-state, market-by-market, and influenced in large part by the competitive marketplace we are going to be operating in."
},
{
"speaker": "Yaron Kinar",
"text": "Thanks. And then maybe as my follow-up, tying the appetite to grow as much as you can profitably to the question of capital. You talked in the past and even on this call, about the -- about maybe selling the Health and Benefits business, you talked about the stop loss that you were looking to maybe purchase last year. Do you need to take any of these actions or other strategic actions in order to satisfy the growth appetite or do you have all the capital you need to grow as much as you want today?"
},
{
"speaker": "Mario Rizzo",
"text": "No. We don’t have to take any of those actions, we have plenty of capital and we have plenty of capital today. When you look at our earnings power, we will have plenty of capital to fund whatever growth we think we can achieve."
},
{
"speaker": "Yaron Kinar",
"text": "Thank you."
},
{
"speaker": "Operator",
"text": "Thank you. One moment for our next question. And our next question comes from the line of Elyse Greenspan from Wells Fargo. Your question please."
},
{
"speaker": "Elyse Greenspan",
"text": "Hi. Thanks. Good morning. My first question is on the holdco cash. It did go up in the quarter. Did you guys take a dividend out of AIC or another entity in the third quarter."
},
{
"speaker": "Jesse Merten",
"text": "Good morning, Elyse. It’s Jess. So as it relates to holdco cash, you can see that it went up from the prior quarter and this was really in accordance with our normal practice of moving capital around to maximize flexibility. So what we did do is move some capital up from a statutory legal entity was not AIC. But we moved some money out from statutory legal entities, as well as a few dividends out of non-insurance companies into the holding company. I know when we have talked in prior quarters, we had a few insurance companies that had fair amount of capital in them and didn’t have risk, because the risk was all reinsured into the Allstate Insurance Company, so sort of in the normal-course of creating flexibility, we looked at those entities and move some of that surplus up to the holdco in the quarter."
},
{
"speaker": "Elyse Greenspan",
"text": "Thanks. And then my second question is on policy growth, but on the Nat Gen side, right? You guys have been showing on as growth slow within Allstate brand. You have been showing pretty strong growth within Nat Gen policies in-force. Just hoping to get some color there as you have kind of put way through books like what’s been driving the growth within NAT Gen and how should we think about that continuing from here?"
},
{
"speaker": "Mario Rizzo",
"text": "Yeah. Hi, Elyse. It’s Mario. So most of the growth that we have been experience in the National General has been in the non-standard auto space. And as you know, that’s a part of the market that’s had a lot of disruption competitively where a lot of carriers have really pulled out or certainly slowed their growth. With National General, we have taken the same approach from a profit improvement perspective as we have in Allstate, we have taken almost 23 points of rate over the last two years in National General. The non-standard auto book intends to turnover quickly, so you can reprice the book on a continual basis. And so we have stayed in that market, we generated meaningful growth in non-standard auto and we are comfortable with the margins that we are experiencing in that in that book of business and look to continue to grow that. On top of that, as I said earlier, we are rolling out the Customer 360, which is going up market. In the IA channel to write standard preferred auto and homeowners. Again, early stages there. The good news is, that product is in 16 states, we are getting good traction and it accounts for in the fourth quarter, it was about 70% of our standard auto and preferred new business production in the IA channel. We will expand that into additional states throughout the course of 2024 and into 2025. So we think that will be an additive opportunity in the IA space. But we are comfortable with what we have been writing non-standard auto and National General, we think there’s an additive opportunity as we look to really leverage Allstate’s capabilities in the middle-market to expand National General in that space in the IA channel."
},
{
"speaker": "Operator",
"text": "Thank you. One moment for our next question. And our next question comes from the line of Bob Huang from Morgan Stanley. Your question please."
},
{
"speaker": "Bob Huang",
"text": "Hi. Good morning. Just a quick question on the capital side, obviously, your capital now, it seems to be very sufficient. Curious as to how you think about the path to resuming buybacks, especially given the material rebound in capital levels so far?"
},
{
"speaker": "Tom Wilson",
"text": "So -- hi. This is Tom. I am going to start. Our capital is always been sufficient. So it should like reiterate what the position we have had. As it relates to buybacks when we are looking at capital regenerate. We start with, first, making sure we have enough capital to run the business and to grow the business and we have -- had put aside more capital for growth, given the dramatic increase in premiums and the risk and we think by transformative growth. We will continue to have opportunities to deploying capital and high ROEs in fact growth. So that’s the first thing we do is like how do you drive shareholder value. And so, I think, looking forward with those opportunities, we will have less capital than it’s for share buybacks that we had historically. That said, we have a strong track record of buying shares back. I think, I don’t know, since I have been CEO, maybe it’s $30 billion worth of shares we bought back. Like, if we don’t have a good use for the capital. Then we will give it back to shareholders, because there’s no sense holding onto extra capital. But between growth in the Property-Liability business, growth in some of our Protection Services, they tend to be a little lighter in terms of capital needs. And then our investment portfolio we derisked our investment portfolio last year, because of what we didn’t see as great market opportunities and if we saw there was opportunities to put more risk into that portfolio that would be another use of capital. So I think -- the think about capital we are always trying to manage and maximize shareholder value and we will do that -- do whatever form that is best."
},
{
"speaker": "Bob Huang",
"text": "All right. Thank you. That’s very helpful and apologies for misstating the capital side of things."
},
{
"speaker": "Tom Wilson",
"text": "Okay. That’s fine. So my second question really is on the expense. So one thing we hear typically from litigation lawyers is that, well, social inflation is an issue because insurance companies, carriers tend to under underfunded claims departments and often have inexperienced claim staffing. As you think about expense save going forward and as we think about re-pivoting back to growth, can you maybe help us think about what areas within expenses are you cutting and what are the areas where it is very critical and then things that are you are not going to cut on the expense side, is it possible to provide some colors?"
},
{
"speaker": "Tom Wilson",
"text": "Let me maybe address the litigation fees. Mario, can talk about expenses in claims. And then if you want, we can go above that in claims, already share just folks on claims. I am not shocked that lawyers would say that the only reason they exist is because we don’t have good people settling claims. That’s just not true. We -- bodily injury claims are where our customers get into an accident and hurt somebody else, we take those very seriously. We try to resolve those quickly. We try to make sure people get a fair amount. So I don’t think I have seen any systemic changes either in the way we do it or the way the industry does it. I will say there have been a couple of things that have led to increased number of suits and litigation. First is, there’s just more severe accidents. So during the pandemic, people started driving faster. They keep driving faster. And so when you look at the severity of the accidents, severity is up, and when severity is up, people tend to get hurt more, and when people get hurt more, they tend to have more damages, and that leads to a greater increase in the use of lawyers to help them resolve their claims. So that part seems completely natural to me. There’s, obviously, been a big change in the way those litigation firms go to market. I don’t know, obviously, but if you look at their advertising spend today, it’s over $1 billion a year. So they are out looking for customers. Some of those are people who need their help because they have been in severe accidents and there are more of them. Some of them are people that maybe don’t need as much help. They have also gotten much more sophisticated in the use of data and analytics, and trying to hunt down claimants and possible clients. Some of that would be good. Some of that -- we are not so sure they are actually doing what they are supposed to be doing. So I think it’s just a process, like, we want to make sure people get the right amount, we don’t want them to get too little and we don’t want them to get too much, we work to do that. You saw, we mentioned in the release for sure that we have also been settling claims faster. I guess we mentioned it in a presentation as well. So to counter that, what we have found is that if we can put more resources on a claim, settle it faster, then people are less likely to feel they need to go get a lawyer. They are happy, we are happy and it’s cheaper for everybody because nobody has to pay the 30% to attorneys. Mario, do you want to talk more about claims, maybe bodily injury, other claim expenses?"
},
{
"speaker": "Mario Rizzo",
"text": "Yeah. I guess where I start is, as we talked over the last really couple of years about our profit improvement plan, it’s multidimensional, and one dimension that we have continued to focus on is just improving claim operational execution. The fact is, as much as continuing to reduce our cost structure improves our competitive position, really operational excellence and claims is another way to make sure that, we pay what we owe, but that also will translate into better competitive position over time. So we are focused on really, I would say, all elements of the claim process. It’s people, it’s process, it’s technology, analytics. And we are going to invest in the claims process moving forward across all those dimensions to just continue to invest in terms of people, making sure we have the right adjuster capacity. We went through a pretty significant turnover. It was really in 2022. That has largely subsided. So we have much more stability in terms of claim staffing, but we are focused on training claim staff and providing them the tools, both in bodily injury and in physical damage to operate in a way that, again, we pay what we owe, but we ensure that we eliminate any leakage in the system and again, that’s been a core part of the profit improvement plan going forward. We are investing in people to provide more oversight, get more eyes on cars in the physical damage side, do a much more effective job in terms of total loss evaluation on the injury side. Tom mentioned we are paying claims faster. We have reduced our pending inventory on the casualty side to the lowest level it’s been since well before the pandemic. We think that continues to reduce reserve risk going forward. So I would say, really, the answer is, we are going to continue to invest in claims broadly, because we just do believe it’s a core part of enabling us to be more competitive and ultimately translate into growth."
},
{
"speaker": "Tom Wilson",
"text": "Let me link this to Greg’s question as well, because I think sometimes when we set goals out there and we talk about specific line items in the P&L, we don’t always show the subtleties of how they are linked together. So we clearly have a goal to reduce expenses related to transformative growth so we can be a low cost provider. That said, we -- that’s not our primary goal. Our primary goal is to treat our customers really well, to build a great long-term business platform and to settle our claims and run our business properly. So if it means we have to spend more money on claims personnel, so that we lower, so loss costs come down and we think that’s in the best interest of our shareholders and our customers, then we are going to do that even if the expense number goes up. So we put those numbers out there to help you say we are let you know we are managing them, but we are not captured by just that one-line item."
},
{
"speaker": "Bob Huang",
"text": "Got it. Thank you very much."
},
{
"speaker": "Operator",
"text": "Thank you. One moment for our next question. And our next question comes from the line of Josh Shanker from Bank of America. Your question please."
},
{
"speaker": "Josh Shanker",
"text": "Yeah. Thank you for taking my question. Once upon a time you think about combined ratio guidance and now you talk more about ROE guidance, which is sensible. But I look at the results in homeowners and they are quite volatile and good this quarter. I want to know where we stand in terms of pricing adequacy broadly for the homeowners’ line. But more importantly, I want to see pricing adequacy for bundlers, I assume that you have a pricing adequacy for monoline drivers and it’s different for the bundlers. Are we at a point where you are very happy to take unbundles at a nice level of profitability today?"
},
{
"speaker": "Tom Wilson",
"text": "I will let Mario take on the bundling question, because we are really happy about that. Let me just -- in terms of the homeowners’ business, we really like the business. It’s -- you see -- look at our six-year combined ratio before this year, it was 92 and so really high return on equity, it’s a great combined ratio. If you look at our underlying combined ratio this year, which excludes catastrophes, it’s come down from last year. Obviously, we had a bad two quarters -- bad two quarters doesn’t make a bad business. So we still really like the business, we have raised prices in the low-teens this year from a variety of different ways. So we like that business. If cats is the first two quarters are indicative of where we go in the future, our cats were up $2.5 billion this year versus the prior year. So if that’s the case. I am confident we have the business model, which will adapt to it. We might not catch it before it, you won’t catch it before it happens, but we haven’t really great go-to-market business, so we are really happy with the homeowners’ business. Mario, do you want to talk about returns in the homeowners’ business and then the bundling question."
},
{
"speaker": "Mario Rizzo",
"text": "Yes. So, Josh. On -- in terms of overall rate adequacy. Obviously, through the combination of the rates we have taken over the last couple of years, plus the inflation and replacement values in homes, that’s really fueling a pretty consistent and significant low-teens increase in average premiums. So this quarter that was about 12.5%, so we are seeing price flow through the system. And that doesn’t include, because as you know, with a 12-month policy, it takes 24 months to earn it all that rate. So a lot of the rate we took in 2023 we have yet to earn and we are going to we are going to keep at it in terms of staying on top of loss cost. The underlying combined ratio for the year was 67 improved by about 3 points, mid 60s is where we would like that number to be. So we are getting closer to that, we have more rate that’s going to earn in, and as Tom mentioned, we feel really good about our capabilities in homeowners and we are going to continue to lean-in and look to grow that business. From a bundling perspective, just 80% of our homeowners’ customers have a supporting line are bundled. That’s a pretty meaningful number and it happens at discount, it’s upwards of 15%. And again, what we think with that pricing the lifetime value of that bundled segment is substantial and we will write bundled customers all day long. Our agents are writing bundled business at an all-time high level north of 70% of new business we are incenting agents to write that, we are seeing more bundled business come through our call centers and our direct business. And as I talked earlier Custom 360 going up market is both in auto and home offering. So we think we are well-positioned across all three channels to continue to attract bundled business that we can be even more competitively priced and because of the discounting element, but also it’s a segment that we think generates substantial lifetime value and we are good at it, so we are going to keep that."
},
{
"speaker": "Tom Wilson",
"text": "Hey, Josh. I know you are a student of our competitors. So you see both GEICO and Progressive talking more about bundling in their advertising. They obviously see also good customers there. Our difference is we expect to make money in homeowners."
},
{
"speaker": "Josh Shanker",
"text": "And if I just close upon that, even though we are going to see some modest decline in auto policy count due to price increases and turning the book a little bit, are you net growing bundlers every day?"
},
{
"speaker": "Tom Wilson",
"text": "I think we probably don’t give that number out, but let’s just say, we have a high focus on bundling, our agents are doing more bundling these days because we changed the way in which we reward and compensate them. So we are continuing to hunt down."
},
{
"speaker": "Brent Vandermause",
"text": "I think we have time for one more question, is that."
},
{
"speaker": "Operator",
"text": "Certainly. One moment for our final question then. And our final question for today comes from the line of Andrew Kligerman from TD Cowen. Your question please."
},
{
"speaker": "Andrew Kligerman",
"text": "Hey. Thanks for sweeping me in at the end. Quick -- maybe some quick questions here. With regard to the impacts of unwinding the restrictions and increasing advertising, could you give us a sense of the impacts of each on the combined ratio?"
},
{
"speaker": "Tom Wilson",
"text": "Well, I think, the first -- the principal impact of unwinding underwriting restrictions will be to kind of increase the aperture of the types of risks that we will be willing to write. Again, now that in the states that we are going to do that, we feel better and good about our rate adequacy and that’s true across segments. So we have a pretty sophisticated approach to pricing where the prices accurately reflect the specific risks of each individual segment. So as we write more business, it’s going to be written at what we believe to be a rate adequate level. Now, from a new business perspective, as we increase the volume of new business, that does tend to write or run a higher loss ratio due to renewal relativity going forward. So it will have some impact on our overall combined ratio going forward. But we take that into account in terms of how we manage the business. But we don’t open the underwriting restrictions until we are comfortable with the rate level we are at. We price each risk according to its unique characteristics. Having said that, there is a new business penalty associated with higher new business volume. But again, we factor that in in terms of how we manage the overall combined ratio in the business."
},
{
"speaker": "Andrew Kligerman",
"text": "Got it. And then with regard to severity, just to make sure I am clear on it, you talked about 8% to 9% in 2023. Is that what you are anticipating for 2024 and how are you thinking about frequency as well going into the year?"
},
{
"speaker": "Mario Rizzo",
"text": "We don’t do a forecast for either frequency or severity on a go-forward basis. I would say it’s whatever it is, we will make sure we get priced for it."
},
{
"speaker": "Andrew Kligerman",
"text": "Okay. Thank you."
},
{
"speaker": "Tom Wilson",
"text": "Okay. Thank you all for spending time with us this quarter. Obviously, with the sun shining a little bit and a few less cats, it gave you the opportunity to see the benefits of all the hard work the team’s been doing to improve profitability in auto insurance and making sure we keep our homeowner business strong. We didn’t really get to our other businesses, but they also continue to do quite well and our investment portfolio and team had a great year when you look at our total returns. So we feel good about where we are going forward. Thank you and we will see you next quarter."
},
{
"speaker": "Operator",
"text": "Thank you, ladies and gentlemen, for your participation in today’s conference. This does conclude the program. You may now disconnect. Good day."
}
] | The Allstate Corporation | 18,711 |
ALL | 3 | 2,023 | 2023-11-02 09:00:00 | Operator: Thank you for standing by and welcome to Allstate's Third Quarter 2023 Earnings Conference Call. [Operator Instructions] As a reminder, today's program is being recorded. And now, I'd like to introduce your host for today's program, Brent Vandermause, Head of Investor Relations. Please go ahead, sir.
Brent Vandermause: Thank you, Jonathan. Good morning. Welcome to Allstate's third quarter 2023 earnings conference call. After prepared remarks, we will have a question-and-answer session. Yesterday, following the close of market, we issued our news release and investor supplement, filed our 10-Q and posted related material on our website at allstateinvestors.com. Our management team is here to provide perspective on these results and our strategy. As noted on the first slide of the presentation, our discussion will contain non-GAAP measures for which there are reconciliations in the news release and investor supplement and forward-looking statements about Allstate's operations. Allstate's results may differ materially from these statements, so please refer to our 10-K for 2022 and other public documents for information on potential risks. And now, I'll turn it over to Tom.
Tom Wilson: Good morning. We appreciate your investment in time in Allstate. Let's start with an overview of results and then Mario and Jess will walk through our operating performance. Let's begin on Slide 2. So our strategy's 2 components: increase personal Property-Liability market share. And expand protection provided to customers which are shown in the 2 over on the left. On the right-hand side, you can see the highlights for the quarter. We made good progress on improving auto insurance profitability. There is more to be done but you can see the improving trend again this quarter. We decided to pursue our sale of Allstate's Health and Benefits businesses. After successful integration of Allstate's voluntary benefits business, with National General's group and individual health businesses, we've created a really well-positioned benefits platform and that strategy was part of the National General acquisition plan. Our success now positions us to achieve additional growth that potential could be maximized by aligning this platform with a broader set of complementary products, distribution channels and capabilities. We anticipate completing a transaction in 2024. We also made progress in executing and transformative growth initiatives to set the stage for personal profit liability market share growth as margins improve. The second part of our strategy to broaden protection offerings also progressed with Allstate Protection Plans growth. Let's review the financial results on Slide 3. Revenues of $14.5 billion in the third quarter increased 9.8% above the prior year at $1.3 billion. The increase was driven by higher property liability earned premiums in auto and homeowners insurance, primarily reflecting the 2022 and 2023 rate increases. Which has resulted in Property-Liability earned premium growth of 10%. Net investment income of $689 million reflects proactive portfolio actions, including extending fixed income duration and lowering public equity holdings to take advantage of higher fixed income yields. Net loss of $41 million and adjusted net income of $214 million that's $0.81 per diluted share reflects improved profit liability underwriting performance. Property-Liability recorded an underwriting loss of $414 million which compares to $1.3 billion loss in the third quarter of 2022. While the improvement was encouraging, loss cost trends remain elevated and require continued execution of auto insurance profit improvement plan, particularly in California, New York and New Jersey. Slide 4 provides an update on the execution of the 4 components of that plan. Starting with rates; the Allstate brand has implemented 26.4% of rates since 2022, including 9.5% through the first 3 quarters of 2023. National General implemented rate increases of 10% in 2022 and an additional 8.8% through the first 9 months in 2023. We will continue to pursue rate increases to restore auto insurance margins back to target levels. Second, reducing operating expenses is core to both the profit improvement plan. And importantly, the transformative growth plan to become a low-cost provider of protection. Expenses are down and we have a path to further reductions. Third, we've restricted new business growth in areas and classes of business where we are not achieving target returns. Given the success we've had in some areas, we're selectively removing these restrictions in some states and segments; fourth, enhancing claim practices in a high inflationary and increasingly litigious environment are required to deliver customer value. That includes accelerating the settlement of injury claims and increasing in-person inspections. Turning to Slide 5. Let's touch base on why we believe this profit improvement will work in the current competitive environment. Allstate's capabilities and business model have generated industry-leading auto insurance margins over the last 10 years with an average combined ratio of roughly 96.5% and an average underwriting income of $800 million. That represents approximately a 5-point outperformance in the industry which generates an incremental profit of about $1.3 billion annually. Only a few of the other top 10 insurance companies have a similar record. In the current competitive environment, these same capabilities will enable us to continue the progress made in improving auto insurance margins. The rapid rise in auto claim severities eroded profits for the industry with most carriers responding by increasing auto insurance prices and lowering expenses. Allstate Progressive and GEICO has significantly raised auto insurance prices since 2019. State Farms increased its prices to a lesser degree but as a result, appears to be incurring large underwriting losses. Expense reductions are also being pursued by many companies, including lowering advertising spending which has moderated competition for new customers. The impact on policies in force is dependent on each company's individual profit and growth plan. As Mario will discuss, the Allstate brand policies in force has declined, particularly in 4 large states. GEICO's policies in force have declined by a larger amount, while Progressive has grown. Allstate's capabilities will enable achievement of the profit improvement plan in its competitive environment. Now let's review the potential sale of the Health and Benefits business on Slide 6. We acquired National General was primarily to improve our position in independent agent channel for Property-Liability insurance and we've exceeded our goals in that integration. The acquisition also gave us the opportunity to combine Allstate's voluntary benefits business with National General's group and individual health businesses. Successfully combining these into 1 business unit has created a strong benefits platform with substantial additional value can be realized by aligning with a broader set of product offerings, distribution and capabilities such as medical network management. Allstate Health and Benefits separates 3 successful businesses which is shown in the middle there and the $1 trillion employer benefit markets group and individual health when you add those all up. We've been the preeminent voluntary benefits provided for 24 years. With a comprehensive product offering that generates annualized premiums and contract charges of $1 billion and $300 million of new sales. National General's group health business targets the small case size market. And has $700 million of premium in fee revenue. And $400 million in new sales. The individual health protection is provided through both proprietary and third-party products which generates both underwriting and fee income. The Health and Benefits businesses have revenues of $2.3 billion which is 4% of total corporate revenues and adjusted net income of $240 million for the trailing 12 months which you can see in the 2 pie charts in the bottom and it's kind of spread between all the businesses. The employer voluntary benefits and group health businesses when you add them up, have roughly 48,000 relationships ranging from Fortune 50 companies to small businesses and over $4.3 million policies in force. The growth potential of these businesses can be accelerated with greater alignment with a wide range of companies in the market that are shown on the right-hand side. With its attractive business profile and financial results, we expect the transaction to be completed in 2024. In addition to improving profitability and strategically allocating capital, we continue to implement the transformative growth initiative to position the Property-Liability market share gains as margins improve. The fine components initiative was shown as top of Slide 7. Affordable simple connected protection is at the heart of the strategy to further improve customer value. Customers will have access to high-quality protection that better meets your needs at a low cost with hassle-free experiences. However, they choose to access our broad distribution network. We're live in the market with a new business experience and further enhance the connectivity of the Allstate at this week. Mario will discuss our success in expanding customer access. While each transformative growth element is at various stages of maturity. We're moving from Phase III of building new model towards scaling it in Phase IV. Now, I'll turn it over to Mario to go through the Property-Liability results.
Mario Rizzo: Thanks, Tom. Let's start on Slide 8. Our comprehensive auto profit improvement plan is improving margins. Property-Liability earned premium increased 10% compared to the prior year quarter, driven by higher average premiums which were partially offset by a decline in policies in force. The underwriting loss of $414 million in the quarter improved $878 million compared to the prior year quarter due to the improvement in our auto loss ratio. The chart on the right highlights the components of the 103.4 [ph] combined ratio in the quarter which improved 8.2 points despite a 2.8 point increase in the catastrophe loss ratio compared to prior year. Prior year reserve estimates, excluding catastrophes, were $166 million unfavorable or at 1.4 point [ph] adverse impact on the combined ratio in the quarter. $82 million was attributable to the runoff property liability annual reserve review. And $84 million in Allstate Protection primarily driven by national general personal auto injury coverages. The underlying combined ratio of 91.9 improved by 4.5 points compared to the prior year quarter and 1 point sequentially versus the second quarter of 2023 despite continued elevated severity inflation. Now let's move to Slide 9 to review Allstate's auto insurance profit trends. The third quarter recorded auto insurance combined ratio of 102.1 was 15.3 points [ph] favorable to the prior year quarter, reflecting higher earned premium, lower adverse prior year reserve reestimates and expense efficiencies. As a reminder, we continuously assess claim severities as the year progresses. For example, last year, as 2022 developed, we increased current report year ultimate severity expectations which influenced the quarterly reported trends. While loss cost trends remain historically elevated, the pace of increase moderated in the third quarter. As Allstate brand weighted average major coverage severity improved to 9% compared to the 11% estimate as of the end of last quarter. The chart on the left shows the sequential improvement in quarterly underlying combined ratios from 2022 through the current quarter with quarterly reported figures adjusted to the full year severity level for 2022 and 2023 adjusted for current severity estimates as of the third quarter. Higher average premium and the continued execution of our profit improvement plan drove the sequential improvement in underlying combined ratio to 98.8 as reported or a 100.5 in the bar graph when removing the 1.7 point [ph] favorable impact on the third quarter from improved severity for claims reported in the first 2 quarters of the year. The chart on the right portrays how our comprehensive actions are resulting in a higher proportion of the portfolio progressing towards or achieving target levels of profitability. Excluding the 3 large states which generated 45% of Allstate brand auto underwriting loss in 2022, Allstate brand auto insurance underlying combined ratio was 97.2. The Premiums from states with an underlying combined ratio below 100 improved to 59% of the portfolio in the third quarter, doubling from the percentage at year-end 2022 and up almost 10 points from 50% in the second quarter. Slide 10 shows the impact on policies in force from actions to improve profitability. Allstate brand rate increases have exceeded 26% over the last 7 quarters. New issued applications shown in the middle chart, declined 19.5% compared to the prior year quarter, largely driven by actions to reduce growth in unprofitable states. California, New York and New Jersey combined declined 75% compared to the prior year. Allstate brand auto policies in force decreased by 6% in the third quarter compared to the prior year, partially driven by the lower new business and also driven by lower retention due to rate increases. Elevated loss trends in Texas required implementation of rate increases of over 50% in the last 21 months. As a result, retention has declined, while profitability has improved. Policies in force in these 4 large states combined decreased by 8.7%, whereas the remaining states declined by 4.7% compared to the prior year through the third quarter. On Slide 11, we take a deeper look at the National General Auto book. While third quarter margins were impacted by $95 million of unfavorable non-catastrophe prior year reserve reestimates primarily across liability coverages. The underlying combined ratio of 96.8 in the quarter and 95.7 year-to-date remains largely consistent with the prior year periods. Reflecting higher loss cost expectations given the reserve strengthening to date, offset by higher average premiums and expense efficiencies. The National General business as product, including fee-based revenue features and claims capabilities to accept in the nonstandard auto insurance market. As you can see in the chart on the right, 75% of the written premium growth in the third quarter of 2023 is coming from nonstandard auto which is more profitable than the overall national general auto insurance business. Our new middle-market product, Custom 360, is now available in nearly 1/3 of the U.S. market and is also contributing to growth. While the legacy National General and Encompass businesses which will be run off as we implement custom 360, are having the lowest impact on growth. Slide 12 covers homeowners insurance results which incurred an underwriting loss in Q3, driven by higher catastrophe losses. On the left, you can see net written premium increased 12.1% from the prior year quarter. primarily driven by higher average gross written premium per policy in both the Allstate and National General brands and a 0.8% increase in policies in force. Allstate Brand average gross written premium per policy increased by 13.2% compared to the prior year quarter, driven by implemented rate increases throughout 2022 and an additional 9.5 points implemented through the first 9 months of 2023. As well as inflation and insurance home replacement costs. The underlying combined ratio of 72.9 improved by 1.2 points compared to the prior year quarter, driven by higher earned premium, lower frequency and a lower expense ratio, partially offset by higher severity. We remain confident in our ability to generate attractive risk-adjusted returns in the homeowners business. Slide 13 highlights progress on expanding customer access as part of transformative growth. We continue to enhance capabilities across distribution channels and are the only major carrier with competitive offerings and branded agent, independent agent and direct distribution. The exclusive agent channel represents the majority of Allstate's U.S. personal lines premium at approximately $32 billion or roughly 22% market share in this channel. Our exclusive agents continue to be a strength, offering personalized local advice customers value in this $145 billion market. While exclusive agent auto new business decreased by 5% overall, applications per agency, excluding California, New York and New Jersey has increased by 13.4% so far this year. In addition, modifications to compensation have driven bundling at point of sale to an all-time high of over 75%. Agent performance continues to improve as they adapt to new compensation programs. We also have great growth potential through independent agents. The acquisition of National General strategically positioned Allstate to grow in the independent agent channel. National General continues to profitably grow nonstandard auto, while converting legacy Encompass and Allstate independent agent business onto their platform. Expanded nonstandard auto presence in 12 states represented 9% of National General's 12.9% increase in policies in force during 2023. As we leverage Allstate's expertise in standard auto and homeowners, this channel should represent another source of profitable growth. The direct channel had a significant decline in new business volume this year since this was the most effective place to reduce new business volume and was the most impacted by the reduction in advertising. We have improved our capabilities in this channel, so it will be another source of growth moving forward. And now, I'll hand it over to Jess to discuss the remainder of our results.
Jesse Merten: All right. Thank you, Mario. I'll start on Slide 14 to discuss investment results. We proactively repositioned our investment portfolio based on continuous monitoring of changes in the economic environment, current market conditions and enterprise risk and return considerations. As shown in the chart on the left, net investment income totaled $689 million in the quarter, relatively flat to the third quarter of last year but with a higher contribution from the market-based portfolio. Market-based income of $567 million shown in blue, was $165 million above the prior year quarter, reflecting repositioning of the fixed income portfolio into longer duration bonds, a reduction of public equity holdings and higher interest rates. The chart on the right shows changes we made to the duration of the bond portfolio in comparison to interest rates. In 2021, we began reducing duration to reflect the belief that interest rates would rise. This not only reduced some losses as rates increased but it provided flexibility to reposition as yields increased. Starting in the middle of last year, we began increasing duration as rates increased which has increased market-based income. On Slide 15, let's take a closer look at our performance-based portfolio which offers diversification and enhances longer-term returns. The portfolio is anchored in private equity and real estate is diversified across infrastructure, energy, agriculture and timber investments. We hold more than 400 names, including funds with multiple underlying positions across diversified vintage years. These investments are focused on long-term value creation and we expect quarter-to-quarter income volatility as seen in the bars on the chart to the left, where quarterly returns have ranged from a negative 2.3% and to positive 8.6% over the last 5 years. The benefit from accepting this volatility is shown on the right with 3- and 5-year annualized returns of 19% and 12%. The private equity portion of the portfolio has outperformed public equity benchmarks over 3, 5 and 10 years. Slide 16 covers the results of our Protection Services businesses. Revenues in these businesses increased 8.9% to $697 million in the third quarter compared to prior year quarter. Increase is mainly driven by growth in Allstate Protection Plans which increased 19.2% compared to the prior year quarter, reflecting expanded products and international growth. In the table on the right, you will see that adjusted net income of $27 million in the third quarter decreased $8 million compared to the prior year quarter, primarily due to the higher appliance and furniture claims severity and a higher mix of lower-margin business as we invest in growth at Allstate Protection Plans. These were partially offset by improved margins at Allstate Roadside and lower expenses at Allstate Identity Protection. Shifting to Slide 17. Our Health and Benefits business also had good results. Both revenues and income increased significantly with the National General acquisition in 2021 as we added scale and capabilities. For the third quarter of 2023, revenues of $587 million increased by $17 million compared to the prior year quarter, driven by an increase in premiums, contract charges and other revenue in group health which was partially offset by a reduction in individual health and employer voluntary benefits. Adjusted net income of $69 million in the third quarter of 2023 increased $6 million compared to the prior year quarter primarily due to increases in group and individual health revenue and lower operating expenses. Now let's move to Slide 18 and discuss Allstate's approach to capital management to clarify how this differs from traditional methods used to evaluate capital such as the ratio of premiums to statutory surplus. On the left hand of the slide, we summarized 3 discrete components we evaluate to establish target capital which is the basis of our capital management framework. Base capital at the bottom is the capital required to meet ongoing operating requirements. Stress Capital is an additional layer of capital needed to cover tail events for the occurrence of multiple negative impacts, such as lower auto profitability and high catastrophe losses. The contingent reserve is for extremely low frequency and high severity events, a severe breakdown in diversification benefits and also provide strategic flexibility. We use a highly sophisticated model that breaks out individual risk types incorporates regulatory and rating agency considerations and uses extensive simulations to determine the right amount of capital for each component. This is more sophisticated and comprehensive than the ratio of premiums to surplus to determine the right amount of capital. For example, when calculating the premium to surplus ratio for the Allstate Insurance Company, the premiums for many of our subsidiary companies are included but over $1.6 billion of statutory capital is not included in the denominator. This framework also better assesses the use of catastrophe reinsurance particularly for large tail events then a simple ratio. Our sophisticated model and proactive actions provide flexibility to manage capital to maximize shareholder value creation. To close, let's turn to Slide 19 and recap all state strategic priorities. We continue making progress on our plan to return auto insurance profitability to targeted levels. We will pursue the divestiture of our Health and Benefits business, we're continuing to advance on our transformative growth initiatives. Proactive investment management has increased income. Allstate Protection Plans is expanding and these strategic priorities support value creation for Allstate shareholders. With that context, let's open the line to your questions.
Operator: [Operator Instructions] And our first question comes from the line of Gregory Peters from Raymond James.
Gregory Peters: I guess for the first question and there was a lot to unpack in your release and slide deck. I'm going to focus on Slide 7 which is the transformative growth strategy. I was looking at your slide and it talks about building the new model and scaling the new model. And I'm just curious if you're running elevated expenses at this point because you're running 2 separate models. And as you roll out the model, I'm curious about how it's accounting for the nuances of different customers. And I'm thinking about the needs of preferred customers versus standard versus nonstandard?
Tom Wilson: Greg, good question. Let me -- so first, the transformative growth is about increasing market share in personal profit liability. It's got a couple of components at the core of that is being low-cost insurance but also about raising customer value and also about being available to people however they want to get to a specter segment and the customers. So I would say at this point, we've proven out that the underlying assumptions that we had made going into it work. So we know that lower price raises close right. We know that's true. We know that being available through more people, whether that's through different bundling with exclusive agents through independent agents or direct also works and we can do that. We know we can raise customer value, as you saw on the slide there, I didn't dig go into it but the new sales process is really slick. I mean it pops up with offers that are specifically for you, you don't have to pick your deductible, you don't have to go through a bunch of questions. People don't pick the deductible for you. It's fast, it's slick, then the renters piece which is in the middle one, takes less than a minute and we're finding great ways to attach more protection by making it simpler for customers. We're also making it more connected which is in the right-hand side. And so we relaunched the. We think that people are going to have fewer apps on their phone going forward. So having an app where people could just access either look at their bill or get their ID card is helpful but it's not compelling. So we are expanding that. So you'll see on their gas body. You can get figure out how to save money on buying gas which is, of course, directly related to what we do. We have a whole bunch of other things that we've either added or going to add. For example, we are really terrific on crash detection with our telematics experience through Arty and do that through Light 360 and it's a terrific product. So there's a variety of things we're doing to expand that. As it relates to expenses, we're continuing to invest in this. I don't know that I would say it's over expense it's just we have an objective. We have to lower our overall expenses. We're after that but we're not backing off on investing in the new technology. One of the things that we've proved out the underlying assumptions was can we build the technology to do what you see on that screen. And the answer is yes. We've built it, it's out -- it's working, it's rolling. We need to scale it but we have high confidence that it's scalable. So -- you should expect us to continue to find ways to reduce cost to live into this. But I don't think like there's like -- we're running hot in expenses today because of that. As it relates to the various segments of customers, we want to sell as many people as we can as much stuff as we can. However they want to come. If you want an agent, we'll give you an agent. We just have to make sure it's cost is what you're prepared to pay and they do what you want. -- whether that's an exclusive agent or an independent agent. And if you want to buy direct for the company, you want to buy to call so you want to buy on the web. We just want to make it as simple and easy as you can which we think is differentiated in the marketplace.
Gregory Peters: Well, that makes sense. I guess for my follow-up, I'm going to pivot to the pricing slides. I'm thinking Slides 9 and 10. And was wondering if you could -- I know you provided detail in your comments but if you could give us an update on the problematic states. I think in Slide 9, you said 41% of the -- of your business in auto is running above 100. If we look forward to 2024, how do you think this chart might look?
Tom Wilson: Which chart are you referring to, Greg?
Gregory Peters: [Indiscernible].
Tom Wilson: Yes. I mean, of course, it all depends. Mario can give you some color as well. But it all depends what happens in California, New York and New Jersey. But let me be very clear, we are not going to continue to lose -- 4 digits in millions in those 3 states. So far, Mario has talked about us getting smaller by not growing we've executed that. The next step is to not be able to serve customers who we want to serve because we can't afford to those $0.20 on the dollar. Mario, do you want to comment on? Like we've been talking -- it's not like this as we just figured this out or they're not aware of.
Mario Rizzo: Just to give you a little additional color across the 3 states. And Tom is right, we've been talking about this all year and we've taken pretty significant actions to restrict new business volumes and it's down like we talked about earlier, about 75%. We've got 3 significant rates pending rate pending across all 3 states. We have an auto rate in California that we filed back in May, I believe, 35% we've got a 29% filing pending in New Jersey. We implemented rates in New York ranging from high single digits to low double digits or low teens across our opening closed books middle of the year. We just filed for another 18.3% in New York auto. So we've got significant rates pending with the department. As Tom mentioned, where we're at now is we need action those filings in the fourth quarter. And if we can't, then we believe the right thing to do for the customers in the other 47 states as well as for our shareholders is to take additional action to get smaller across all 3 of those states and that's what we would do beginning next year if we can't get resolution on the rate filings that are currently pending.
Operator: [Operator Instructions] And our next question comes from the line of Alex Scott from Goldman Sachs.
Unidentified Analyst: It's Marley [ph] on for Alex. So you mentioned in the prepared remarks that you were increasing in-person inspections to reduce overall claim costs. Could you touch on this a little bit more? How impactful is this? And then maybe how many of the current accidents are assessed now in person versus remote? And then how should we think about this for near-term changes to loss LAE?
Mario Rizzo: Marley, this is Mario. I'll answer your question. So I would -- where I would start is going back to the different components of our auto profit improvement plan, taking rate increases, reducing costs, restricting new business in states where we aren't achieving target levels of profitability and improving operational processes and claims what you're describing around more in-person inspections is a component of that fourth piece of improving operational processes. We believe that by doing more physical inspections doing more oversight broadly of both in-network and out-of-network shops as well as doing the same thing on the property side as well that we'll be able to identify opportunities pay what we owe but also not pay for, say, things like pre-existing damage or in total loss cases, cars that could be repaired versus replace. So we think doing more in-person physical inspections in addition to continuing to leverage quick photo claim capabilities is the right thing to do to best manage loss cost going forward and that's what we intend to do to ensure that we're operationally excellent in claims and again, paying what we owe but eliminating any leakage in the system and we're prepared to invest in the claims organization to be able to execute on that. So in terms of the expense ratio, the LAE ratio as part of our adjusted expense ratio. We're still committed to hitting the 23 by the end of next year. The investments we'll make in claims are inclusive of that goal. We think we can do both.
Unidentified Analyst: Got it. And then I just wanted to get your thoughts on longer-term severity drivers that you're seeing in terms of medical inflation and any impacts from the UAW strike?
Mario Rizzo: Sure. So we'll start with medical inflation. And you'll note that we talked about our severity expectations in auto being about 9% currently which has improved from the 11% we talked about last quarter. All that improvement came from physical damage coverages. Our outlook on casualty and injury severity is unchanged. It didn't get worse but it's consistent with where we were last quarter. And the drivers behind that continue to be medical inflation more attorney representation, higher levels of treatment being pursued kind of all the components of both kind of economic and social inflation that have driven injury severities up. Overtime, those will continue to be headwinds for us. But as we -- again, as I talked about on the physical damage side, as we've adapted our claims processes to take into account those inflationary trends, we've seen some good progress. So we're looking to settle claims earlier in the cycle and we've seen a real improvement in terms of reduction in pending injury claims as well as faster settlement times on injury claims. We're using things like analytics and testing AI models to identify accidents where injuries are likely and those that have a higher likelihood of potentially being represented by attorney so that we can further accelerate claimant contact time and get out ahead of the process and manage the overall claim process. So we're doing things proactively to help mitigate some of those inflationary impacts. And we'll continue to do that. And like I said, we did see some stability in injury severity trends during the quarter.
Operator: [Operator Instructions] And our next question comes from the line of Elyse Greenspan from Wells Fargo.
Elyse Greenspan: My first question, during the quarter, you guys spoke about looking to buy some additional aggregate stop-loss reinsurance. Do you have any update on what you're doing on the reinsurance side in terms of looking to protect your capital position?
Jesse Merten: Yes, Elyse. Thanks. This is Jess. We have talked a lot about our reinsurance program in general. As you know, we have a robust reinsurance program that reduces our overall capital levels. We've talked more recently about the aggregate cover. At this point, we don't have specific updates about the potential transaction. As I've talked about a number of times, we're looking at whether or not we can economically reduce overall risk and target capital. And to the extent we find a structure where we can get that done, we'll do it. And to the extent we can't get it done economically we'll move on and look at other options. So I would say, as it relates to this quarter, no updates. We continue to be interested in understanding what might be available to attract some new capital. sources into the industry and make them available. But we don't have anything firm to talk about at this point on that.
Elyse Greenspan: And then my second question, you guys highlighted that you're looking into a potential transaction with the benefits business. Were there any diversification credits that you guys got from a capital perspective by owning the benefits business?
Tom Wilson: Of course, yes. So they're there but we factor that into our overall position here.
Operator: [Operator Instructions] And our next question comes from the line of Michael Zaremski from BMO.
Unidentified Analyst: This is Jack [ph] on for Mike. Just one question on changes to Allstate's captive distribution commission and fee structure. I think you mentioned earlier, how it has driven greater bundling rates. I'm just wondering does also expect this change to impact overall organic growth levels? And do you expect a meaningful benefit to the company's expense ratio?
Tom Wilson: Well, I think when you go all the way up to transformative growth. Yes, we think that the whole package of stuff will drive market share growth. That includes making sure that the agents do what customers want them to do and that they're supported in doing that with technology and everything else in marketing and that they're well compensated for what they do. But yes, so there's various pieces on Mario, do you want to talk specifically about the account changes?
Mario Rizzo: Yes. So again, I would characterize the most recent set of changes as a continuation of what we started really several years ago which was intended to drive higher levels of productivity in the exclusive agent distribution system but also reduced distribution costs over time. And I think what we're seeing if you -- particularly if you take out the impacts of the 3 large states where we're purposely driving reduced volume is exactly what we had hoped would happen. So from an expense standpoint, you see in the quarter, we benefited by 2 or 3 from [ph] the distribution cost perspective. So we're continuing to see the impacts and benefits of lower distribution costs. but more importantly, the productivity of the exclusive agency system continues to improve. So I can take out those 3 states, overall production was up 7.6%. Average productivity was up over 13%. And when you look at our top tier of agents, we segment agents into 3 categories, emerging Pro and Elite, that elite group, their level of production was up 15%. So that shows that agents continue to invest in their businesses and take advantage of increased shopping levels in the marketplace but they're focused on driving the kind of growth that will certainly become a real asset for us as we begin to lean back into growth as different states hit target levels of profitability. So we're really encouraged, both in terms of the performance of our agency channel, how they've adapted and the fact that we've been able to take cost out of the distribution system at the same time.
Operator: And our next question comes from the line of Joshua Shanker from Bank of America.
Joshua Shanker: I have a model that goes pretty far back. And historically, if you look at reserves and try and analyze that -- it's hard in short-tail lines. Historically, Allstate run at about a 95% paid to incurred loss ratio. For every dollar of loss you put 5 in the reserves for future losses. And that's true in 3Q '23. But for the previous 5 quarters, it ran at an astonishingly low 83%. I know that you try and get the reserves right. But it does feel over this period of elevated loss ratio that the company put a lot more of its reserves of losses into reserve than any time in my model. Is there something different that had gone on over the past 5 quarters now that you're resuming a normal sort of pay to incur trend? Or is it just -- that was unusual period in you needed to put more reserve?
Tom Wilson: Maybe I'll start and then Jess can fill in here. First, Josh but we think the reserves are right and we put up what we think we need to put up when we need to put it up as painful as that was last year. We felt we needed to put it up. When you look at the -- I don't know -- I'm not looking at specific numbers you have but I've been through reserves enough to the paid bounce around a lot. It depends what happened in the pandemic with impending levels and we adjust for all that. So, I would say just may have Jess may have some answer for it. I think Jess and Brent could walk through your model with you and help you see it. But I don't -- like we just think the reserves are right and we put them up when we believe Jess, anything to?
Jesse Merten: No, I would agree with that. I also think you should keep in mind that, that same period was a period of extreme acceleration in the loss cost trend which you wouldn't see over the historical periods, right? So you're going to get a different pay-to-incurred ratio when you have acceleration, the way that we've seen and you saw what our severity trend was last year, you've seen what it is this year. So I think a component of that clearly is just the time period that you're looking at and the acceleration of the underlying trend.
Joshua Shanker: And if you'll indulge me another question, Allstate over the next 20 years has really changed its geographic footprint away from catastrophe. And obviously, with climate change, people have seen a lot of losses and maybe the severity trend over the long term for cat-exposed properties up. But how does the -- severity trend compare between the trend in generally non-cat-exposed property versus cat exposed property, are states like Illinois and a lot of the Midwest seeing a very different trend than severity trends longer term from weather along the coast?
Tom Wilson: Let me start and then Mario just if you guys want to jump in. First, I would start with saying we've built a really great business model in homeowners just like we make more money than the industry on auto insurance were even better in homeowners. And you see those results over 10 years. You do see this year a lot of catastrophes which is like to have an underwriting loss which we prefer not to have that said, catastrophes happen and that's why people buy insurance. So we're comfortable that, that worked. When you look underneath that and say, okay, what's driving those cat losses storms are more severe now. So just the fact you have a more severe storm will increase the severity of the losses that you have one on a strong, whether that's hail storm or a tornado or a hurricane, it just causes more damage. Underneath both that and a traditional loss are just the normal inflationary pressures. And so the cost of lumber goes up, whether you burn your house down or get knocked down by a hurricane, it's that underlying it. So you have kind of a compounding impact on catastrophes. That said, we're good at it. We manage it by state. So you're correct, Illinois would have less pressure because it would have less catastrophe losses than perhaps a state along the East Coast or in the Southwest on the coast. So -- we factored that all in and both of those things there. We do think though that we -- you've seen the raise in prices that spend both of those factors have increased it. So the dramatic increase in homeowners insurance prices has been driven by both those factors. Anything to add, Mario [ph]?
Mario Rizzo: Yes. The only thing I'd add, Josh, I think you take a step back and say, what are the underlying drivers of the increase in homeowner severity -- and it's principally, as Tom mentioned, it's labor costs and its material cost to repair homes. And to the extent the rates of inflation vary across different parts of the country. Obviously, that will have an influence on state-specific severity. I think it's more driven by that. Than any -- whether it's cat exposed or not cat exposed because those costs just get amplified when there's a large event and we just have to repair a larger volume of homes.
Operator: [Operator Instructions] And our next question comes from the line of Tracy Benguigui from Barclays.
Tracy Benguigui: Is the impetus selling the Health and Benefits business really to unlock capital and to restore some of your contingency capital? Or was the impetus to become a more lean organization and focus more on core offerings?
Tom Wilson: Neither. And nor was it in relationship to any shareholder asking us to pursue a sale. I know a few of you wrote about. Let me just tell you what it is. So -- we're selling the businesses because it's the best way to capture the value credit. They're terrific businesses. I mean we make almost $0.25 billion a year. And we get a good platform, they have low capital requirements. We like the businesses. When we look forward to the future, though, we said we think we can harvest more growth from it if we had more complementary distribution, a broader set of products, capabilities such as network management of a health network like manage that. Those are things that we don't have today. We said we can build those it would take us time and money. On the other hand, we could access those that already exist. But that requires us to let go the success we've created. So we decided to choose the latter path. It had nothing to do with a shareholder coming to us and saying, you should sell this had nothing to do with needing the money, it has everything to do with this is the right way to manage your company to optimize shareholder value which is sometimes you have to let go of the success you've created.
Tracy Benguigui: Okay. But maybe as a byproduct, assuming you could hit whatever valuation target range you have in mind might be early but would you have any kind of implied capital relief from your internal model from the sale?
Tom Wilson: These are low capital businesses. So this First, I would say, on the price high would be the appropriate message I'd like you to carry out there because we do like the businesses a lot. Secondly, they're pretty low capital businesses. So whatever the sale price is, will generate additional capital. And then we'll decide what we want to do when we get there. We've got plenty of other growth opportunities. We're doing a lot with to grow market share and profit liability. We don't need to make that decision right now, so we're not going to.
Tracy Benguigui: Okay. Or could it potentially move down to AIC or accelerate your path to resume buybacks down the road?
Tom Wilson: There's -- we have all the options that you would have to use capital. Organic growth to buying shares back. All those options are out there. We have no set plans for the capital. Right now, we're focused on -- this is a great business. We can help it be an even greater business by letting go of it. So that's what we're going to do.
Jesse Merten: And I would add, Tracy, we -- our capitalization philosophy, as you know, we tend to keep the capital at the holding company to the extent that we can. So I don't believe we have a capital need at AIC that would cause us to want to do that. So I think we would remain with the philosophy of keeping the capital where it's at the holding company level to the extent we have capital management decisions to make, as Tom said, we'll make him when the time comes. But I don't think we have a need for capital in AIC. So I don't know why we would go away from the philosophy of keeping it up and holding company.
Tracy Benguigui: Got it. And just quickly on your commentary of extending your asset duration now at 4.6 years. I mean you don't have a life business anymore. You plan to divest the Health and Benefits business. How you think about the optimal asset duration relative to your pro forma duration of your remaining liabilities?
Tom Wilson: Well, we look at it from an enterprise risk and return standpoint. So the first thing we do is say, how much capital do we want to allocate to the investment portfolio. And then John and his team figure out how they best want to allocate that amongst various asset classes. So John may want to make a comment on where we are at today. I would point out that if you look at Slide 14, we made the right calls at the right time.
Mario Rizzo: Yes. I'd just add that -- another thing to consider when one lengthens out duration is just that you keep the appropriate amount of liquidity and flexibility in the portfolio. And I can assure you that we are doing that between the cash that we hold short-term position to other things that we can turn into cash in short order and just maturities by year-end, we're close to $10 billion. So we believe that we're both capturing the additional income that the market is giving us. lengthening out to preserve the capture of that income for a longer period of time, building some resilience into the portfolio in case the economic environment would change, while also providing adequate liquidity.
Tracy Benguigui: Okay. So it sounds like you feel comfortable with durational mismatch because of your strong liquidity position. Is that fair?
Tom Wilson: Well, the Property-Liability business is a little different than the life business in terms of matching to liabilities. In the life business scores, we have a set maturity date and you can factor in some stuff and you figure out let's match that off. In the Property-Liability business, of course, the liabilities are much shorter but then they're naturally recurring. So you pay off 1 claim and you get another one. Is that a separate claim or -- and so if you match it to that, you'd be having here for 90 days for a physical damage claims. So it's really more about liquidity and overall risk management. And I would also point out a large part of our set capital is there in case we mess up on underwriting income. And so that has a really long duration on it.
Mario Rizzo: Yes. Tracy, 1 other thing to add, if you look at the slide, the blue line depicts the duration, we've really just reverted back to what's been more of a long-term average for us. So we were at a point in time where we were in a lower level of duration, a lower level of interest rate exposure. We thought that was right given what was happening with the Fed and interest rates in general. Now that rates have climbed back up pretty aggressively. We want to go back to what has been a longer run central tendency for us.
Operator: Our next question comes from the line of David Motemaden from Evercore ISI.
David Motemaden: I just had a question on the frequency trends that you guys saw in the third quarter. Could you just describe what you guys are seeing. It sounded like that was up a little bit. I was hoping you could put some numbers around it and sort of what you're seeing, especially as it looks like you're shrinking units. I would think that there would be some benefit from improving the mix of business. But I was hoping you could maybe just touch on that.
Mario Rizzo: David, it's Mario. Thanks for the question. I'll talk a little more qualitatively about frequency since we now are disclosing more pure premium trends which combine the overall loss trend. We just think it's a better way for you all to look at and think about auto profitability. But in terms of auto frequency, the headline is it continues to revert back to pre-pandemic levels but remains below where it was in 2019. There continues to be a tailwind when you think about the safety features embedded in vehicles that will continue to help improve frequency, we think, from a long-term trend going forward. And then when you look at the other driver which is driving activity. When we look at our telematics data, we look at the number of miles that a person is driving each day. It's up mid-single digits compared to last year, still skewing less to rush hour times which benefit frequency and more to nonpeak hours. But that trend has been pretty stable over the last several quarters and we feel like we're in a period of stability in terms of driving behavior. So net-net frequency is up modestly. It's a small component of pure premium. So just to give you a couple of numbers. When you adjust out the intra-year impact in pure premium, it's up about 9.7% year-over-year in the quarter and we said severity was up 9% [ph]. So you can see the modest impact that frequency is having, again, as people drive a bit more than they were a year ago.
David Motemaden: Got it. And you're saying it's a little bit more stable now, so maybe flattens out there at those levels?
Mario Rizzo: Yes, David, the trend has been pretty stable over the last several quarters in terms of when we look at miles driven for our book.
David Motemaden: Got it. And then for my follow-up, just to add a question on Slide 13 and I appreciate this information on the distribution channels. I was hoping -- it looks like you guys track the TAM by channel pretty closely. Within the exclusive agent channel, how has that TAM been growing -- and I guess, I'm under the impression that it's been shrinking at the expense of the direct and independent agent channels. So just given that backdrop, I'm wondering if you're seeing signs that you think you can sort of buck that trend and start to grow within your exclusive agency channel?
Tom Wilson: Let me David maybe a couple of thoughts. First, there's a lot of analysis on it. People want to tend to like assume that it's a straight line. And actually, there's competition for the customer amongst all of those. So our effort to reduce the cost that Mario talked about in providing an agent is to give customers better value which should take share away from some of the other 2. The independent agents also are a good place people want to come where they don't want to just buy from an insurance company. They want somebody to shop around for them and want them to do the work for it. On the direct channel, obviously, with increased connectivity, the direct channel has certainly grown. But it's also growing a lot because billions of dollars of advertising going to it. So it's an overall ecosystem, I guess, I would say. And so we look at it and like, we want to be there. People want to have buy from a company like Allstate. Allstate brand name, want to go to that agent. We want to be there for that person with everything they have. The same thing if they want someone to shop or on them, don't want to do the work. We want to be in that independent agent channel. And then in a direct channel, if they want to buy directly then. And what we are doing is using the technology between those various things make it an even better value proposition. So we showed you that cell phone which had the 3 offers in it. Imagine an agent now being able to not have to ask you a whole bunch of stuff; what's your deductible, what kind of stuff. But we pre-populate it with, here's what we think David's deductible should be, offer David this package you put them in a different position. So we look at it really as sort of organic and it moves between there. And we want to be there for all of our customers. So it's not like we think 1 is going to win and the other is going to lose. It's just a constant competition to just do a better job for the customers that want to buy it that way. Jonathan, we'll take one more question.
Operator: [Operator Instructions] Our final question for today comes from the line of Meyer Shields from KBW.
Unidentified Analyst: It's Jen [ph] on for me. Most of my questions are answered just 1 on the growth in 2024. So what is your expectation and plan for next year? Is the nonstandard auto still be the key growth driver -- any color on that would be great?
Tom Wilson: Mario will give you some specifics. I would say that the biggest impact -- so first, we're starting to grow in the Allstate brand. Mario has got a number of states where he's starting to roll out, transform growth in a more aggressive way to capture the market share growth. So we comfortable there. The independent Asian business, we think, will grow through continued expansion of the nonstandard and the Custom 360 Mario talked about, I would say that the biggest driver. The biggest thing we're unclear on right now is what happens in New York, New Jersey and California. That will be the biggest impact on policies in force. May be different than the growth measure you're talking about but certainly, we need to get properly priced in those states. Or else will get smaller in those states. And given that they're a large percentage for our book of business, it will impact overall policy. Mario thing you would add to that?
Mario Rizzo: Yes. The only thing I'd add as we look ahead is -- I think it's important to recognize that we manage the business on a local level. That means state by state, market by market, risk segment by risk segment; that's been the approach we've taken to improve profitability and we're taking that same approach as we look forward in terms of growth. And I think it's -- where we're at is really 2 groupings of states emerging. Tom talked about the 3 that we've just got to get more rate and get more profitable. And before we can even begin to think about growing and investing in growth because it just economically doesn't make sense for us and that's California, New York, New Jersey. The rest of the states that if you divide them, there's a number of states that are already at target levels of profitability and we're beginning to do things like make local marketing investments, leverage a lot of the capabilities we've been building with transformative growth, the momentum we've got in the exclusive agent channel, the improvements we've made in direct and the capabilities we've built there and what we're building in the independent agent channels with things like Custom 360 and nonstandard auto. So we feel like as a system we are much more effectively positioned to grow when the time is right for us to grow. And as we look out into 2024, we think more states will fall into that ready-to-grow category in terms of target levels of profitability. And we look forward to continuing to invest in growth in those states and leverage the capabilities we've been building with transformative growth.
Tom Wilson: So let me close with 4 points which summarize kind of the conversation we had. What's going to drive shareholder back profitability increases, strategic capital allocation great investment returns and then transform growth long-term sustainable growth. We think those 4 things combined make this a great opportunity. Thank you very much. We'll see you next quarter.
Operator: Thank you, ladies and gentlemen, for your participation in today's conference. This does conclude the program. You may now disconnect. Good day. | [
{
"speaker": "Operator",
"text": "Thank you for standing by and welcome to Allstate's Third Quarter 2023 Earnings Conference Call. [Operator Instructions] As a reminder, today's program is being recorded. And now, I'd like to introduce your host for today's program, Brent Vandermause, Head of Investor Relations. Please go ahead, sir."
},
{
"speaker": "Brent Vandermause",
"text": "Thank you, Jonathan. Good morning. Welcome to Allstate's third quarter 2023 earnings conference call. After prepared remarks, we will have a question-and-answer session. Yesterday, following the close of market, we issued our news release and investor supplement, filed our 10-Q and posted related material on our website at allstateinvestors.com. Our management team is here to provide perspective on these results and our strategy. As noted on the first slide of the presentation, our discussion will contain non-GAAP measures for which there are reconciliations in the news release and investor supplement and forward-looking statements about Allstate's operations. Allstate's results may differ materially from these statements, so please refer to our 10-K for 2022 and other public documents for information on potential risks. And now, I'll turn it over to Tom."
},
{
"speaker": "Tom Wilson",
"text": "Good morning. We appreciate your investment in time in Allstate. Let's start with an overview of results and then Mario and Jess will walk through our operating performance. Let's begin on Slide 2. So our strategy's 2 components: increase personal Property-Liability market share. And expand protection provided to customers which are shown in the 2 over on the left. On the right-hand side, you can see the highlights for the quarter. We made good progress on improving auto insurance profitability. There is more to be done but you can see the improving trend again this quarter. We decided to pursue our sale of Allstate's Health and Benefits businesses. After successful integration of Allstate's voluntary benefits business, with National General's group and individual health businesses, we've created a really well-positioned benefits platform and that strategy was part of the National General acquisition plan. Our success now positions us to achieve additional growth that potential could be maximized by aligning this platform with a broader set of complementary products, distribution channels and capabilities. We anticipate completing a transaction in 2024. We also made progress in executing and transformative growth initiatives to set the stage for personal profit liability market share growth as margins improve. The second part of our strategy to broaden protection offerings also progressed with Allstate Protection Plans growth. Let's review the financial results on Slide 3. Revenues of $14.5 billion in the third quarter increased 9.8% above the prior year at $1.3 billion. The increase was driven by higher property liability earned premiums in auto and homeowners insurance, primarily reflecting the 2022 and 2023 rate increases. Which has resulted in Property-Liability earned premium growth of 10%. Net investment income of $689 million reflects proactive portfolio actions, including extending fixed income duration and lowering public equity holdings to take advantage of higher fixed income yields. Net loss of $41 million and adjusted net income of $214 million that's $0.81 per diluted share reflects improved profit liability underwriting performance. Property-Liability recorded an underwriting loss of $414 million which compares to $1.3 billion loss in the third quarter of 2022. While the improvement was encouraging, loss cost trends remain elevated and require continued execution of auto insurance profit improvement plan, particularly in California, New York and New Jersey. Slide 4 provides an update on the execution of the 4 components of that plan. Starting with rates; the Allstate brand has implemented 26.4% of rates since 2022, including 9.5% through the first 3 quarters of 2023. National General implemented rate increases of 10% in 2022 and an additional 8.8% through the first 9 months in 2023. We will continue to pursue rate increases to restore auto insurance margins back to target levels. Second, reducing operating expenses is core to both the profit improvement plan. And importantly, the transformative growth plan to become a low-cost provider of protection. Expenses are down and we have a path to further reductions. Third, we've restricted new business growth in areas and classes of business where we are not achieving target returns. Given the success we've had in some areas, we're selectively removing these restrictions in some states and segments; fourth, enhancing claim practices in a high inflationary and increasingly litigious environment are required to deliver customer value. That includes accelerating the settlement of injury claims and increasing in-person inspections. Turning to Slide 5. Let's touch base on why we believe this profit improvement will work in the current competitive environment. Allstate's capabilities and business model have generated industry-leading auto insurance margins over the last 10 years with an average combined ratio of roughly 96.5% and an average underwriting income of $800 million. That represents approximately a 5-point outperformance in the industry which generates an incremental profit of about $1.3 billion annually. Only a few of the other top 10 insurance companies have a similar record. In the current competitive environment, these same capabilities will enable us to continue the progress made in improving auto insurance margins. The rapid rise in auto claim severities eroded profits for the industry with most carriers responding by increasing auto insurance prices and lowering expenses. Allstate Progressive and GEICO has significantly raised auto insurance prices since 2019. State Farms increased its prices to a lesser degree but as a result, appears to be incurring large underwriting losses. Expense reductions are also being pursued by many companies, including lowering advertising spending which has moderated competition for new customers. The impact on policies in force is dependent on each company's individual profit and growth plan. As Mario will discuss, the Allstate brand policies in force has declined, particularly in 4 large states. GEICO's policies in force have declined by a larger amount, while Progressive has grown. Allstate's capabilities will enable achievement of the profit improvement plan in its competitive environment. Now let's review the potential sale of the Health and Benefits business on Slide 6. We acquired National General was primarily to improve our position in independent agent channel for Property-Liability insurance and we've exceeded our goals in that integration. The acquisition also gave us the opportunity to combine Allstate's voluntary benefits business with National General's group and individual health businesses. Successfully combining these into 1 business unit has created a strong benefits platform with substantial additional value can be realized by aligning with a broader set of product offerings, distribution and capabilities such as medical network management. Allstate Health and Benefits separates 3 successful businesses which is shown in the middle there and the $1 trillion employer benefit markets group and individual health when you add those all up. We've been the preeminent voluntary benefits provided for 24 years. With a comprehensive product offering that generates annualized premiums and contract charges of $1 billion and $300 million of new sales. National General's group health business targets the small case size market. And has $700 million of premium in fee revenue. And $400 million in new sales. The individual health protection is provided through both proprietary and third-party products which generates both underwriting and fee income. The Health and Benefits businesses have revenues of $2.3 billion which is 4% of total corporate revenues and adjusted net income of $240 million for the trailing 12 months which you can see in the 2 pie charts in the bottom and it's kind of spread between all the businesses. The employer voluntary benefits and group health businesses when you add them up, have roughly 48,000 relationships ranging from Fortune 50 companies to small businesses and over $4.3 million policies in force. The growth potential of these businesses can be accelerated with greater alignment with a wide range of companies in the market that are shown on the right-hand side. With its attractive business profile and financial results, we expect the transaction to be completed in 2024. In addition to improving profitability and strategically allocating capital, we continue to implement the transformative growth initiative to position the Property-Liability market share gains as margins improve. The fine components initiative was shown as top of Slide 7. Affordable simple connected protection is at the heart of the strategy to further improve customer value. Customers will have access to high-quality protection that better meets your needs at a low cost with hassle-free experiences. However, they choose to access our broad distribution network. We're live in the market with a new business experience and further enhance the connectivity of the Allstate at this week. Mario will discuss our success in expanding customer access. While each transformative growth element is at various stages of maturity. We're moving from Phase III of building new model towards scaling it in Phase IV. Now, I'll turn it over to Mario to go through the Property-Liability results."
},
{
"speaker": "Mario Rizzo",
"text": "Thanks, Tom. Let's start on Slide 8. Our comprehensive auto profit improvement plan is improving margins. Property-Liability earned premium increased 10% compared to the prior year quarter, driven by higher average premiums which were partially offset by a decline in policies in force. The underwriting loss of $414 million in the quarter improved $878 million compared to the prior year quarter due to the improvement in our auto loss ratio. The chart on the right highlights the components of the 103.4 [ph] combined ratio in the quarter which improved 8.2 points despite a 2.8 point increase in the catastrophe loss ratio compared to prior year. Prior year reserve estimates, excluding catastrophes, were $166 million unfavorable or at 1.4 point [ph] adverse impact on the combined ratio in the quarter. $82 million was attributable to the runoff property liability annual reserve review. And $84 million in Allstate Protection primarily driven by national general personal auto injury coverages. The underlying combined ratio of 91.9 improved by 4.5 points compared to the prior year quarter and 1 point sequentially versus the second quarter of 2023 despite continued elevated severity inflation. Now let's move to Slide 9 to review Allstate's auto insurance profit trends. The third quarter recorded auto insurance combined ratio of 102.1 was 15.3 points [ph] favorable to the prior year quarter, reflecting higher earned premium, lower adverse prior year reserve reestimates and expense efficiencies. As a reminder, we continuously assess claim severities as the year progresses. For example, last year, as 2022 developed, we increased current report year ultimate severity expectations which influenced the quarterly reported trends. While loss cost trends remain historically elevated, the pace of increase moderated in the third quarter. As Allstate brand weighted average major coverage severity improved to 9% compared to the 11% estimate as of the end of last quarter. The chart on the left shows the sequential improvement in quarterly underlying combined ratios from 2022 through the current quarter with quarterly reported figures adjusted to the full year severity level for 2022 and 2023 adjusted for current severity estimates as of the third quarter. Higher average premium and the continued execution of our profit improvement plan drove the sequential improvement in underlying combined ratio to 98.8 as reported or a 100.5 in the bar graph when removing the 1.7 point [ph] favorable impact on the third quarter from improved severity for claims reported in the first 2 quarters of the year. The chart on the right portrays how our comprehensive actions are resulting in a higher proportion of the portfolio progressing towards or achieving target levels of profitability. Excluding the 3 large states which generated 45% of Allstate brand auto underwriting loss in 2022, Allstate brand auto insurance underlying combined ratio was 97.2. The Premiums from states with an underlying combined ratio below 100 improved to 59% of the portfolio in the third quarter, doubling from the percentage at year-end 2022 and up almost 10 points from 50% in the second quarter. Slide 10 shows the impact on policies in force from actions to improve profitability. Allstate brand rate increases have exceeded 26% over the last 7 quarters. New issued applications shown in the middle chart, declined 19.5% compared to the prior year quarter, largely driven by actions to reduce growth in unprofitable states. California, New York and New Jersey combined declined 75% compared to the prior year. Allstate brand auto policies in force decreased by 6% in the third quarter compared to the prior year, partially driven by the lower new business and also driven by lower retention due to rate increases. Elevated loss trends in Texas required implementation of rate increases of over 50% in the last 21 months. As a result, retention has declined, while profitability has improved. Policies in force in these 4 large states combined decreased by 8.7%, whereas the remaining states declined by 4.7% compared to the prior year through the third quarter. On Slide 11, we take a deeper look at the National General Auto book. While third quarter margins were impacted by $95 million of unfavorable non-catastrophe prior year reserve reestimates primarily across liability coverages. The underlying combined ratio of 96.8 in the quarter and 95.7 year-to-date remains largely consistent with the prior year periods. Reflecting higher loss cost expectations given the reserve strengthening to date, offset by higher average premiums and expense efficiencies. The National General business as product, including fee-based revenue features and claims capabilities to accept in the nonstandard auto insurance market. As you can see in the chart on the right, 75% of the written premium growth in the third quarter of 2023 is coming from nonstandard auto which is more profitable than the overall national general auto insurance business. Our new middle-market product, Custom 360, is now available in nearly 1/3 of the U.S. market and is also contributing to growth. While the legacy National General and Encompass businesses which will be run off as we implement custom 360, are having the lowest impact on growth. Slide 12 covers homeowners insurance results which incurred an underwriting loss in Q3, driven by higher catastrophe losses. On the left, you can see net written premium increased 12.1% from the prior year quarter. primarily driven by higher average gross written premium per policy in both the Allstate and National General brands and a 0.8% increase in policies in force. Allstate Brand average gross written premium per policy increased by 13.2% compared to the prior year quarter, driven by implemented rate increases throughout 2022 and an additional 9.5 points implemented through the first 9 months of 2023. As well as inflation and insurance home replacement costs. The underlying combined ratio of 72.9 improved by 1.2 points compared to the prior year quarter, driven by higher earned premium, lower frequency and a lower expense ratio, partially offset by higher severity. We remain confident in our ability to generate attractive risk-adjusted returns in the homeowners business. Slide 13 highlights progress on expanding customer access as part of transformative growth. We continue to enhance capabilities across distribution channels and are the only major carrier with competitive offerings and branded agent, independent agent and direct distribution. The exclusive agent channel represents the majority of Allstate's U.S. personal lines premium at approximately $32 billion or roughly 22% market share in this channel. Our exclusive agents continue to be a strength, offering personalized local advice customers value in this $145 billion market. While exclusive agent auto new business decreased by 5% overall, applications per agency, excluding California, New York and New Jersey has increased by 13.4% so far this year. In addition, modifications to compensation have driven bundling at point of sale to an all-time high of over 75%. Agent performance continues to improve as they adapt to new compensation programs. We also have great growth potential through independent agents. The acquisition of National General strategically positioned Allstate to grow in the independent agent channel. National General continues to profitably grow nonstandard auto, while converting legacy Encompass and Allstate independent agent business onto their platform. Expanded nonstandard auto presence in 12 states represented 9% of National General's 12.9% increase in policies in force during 2023. As we leverage Allstate's expertise in standard auto and homeowners, this channel should represent another source of profitable growth. The direct channel had a significant decline in new business volume this year since this was the most effective place to reduce new business volume and was the most impacted by the reduction in advertising. We have improved our capabilities in this channel, so it will be another source of growth moving forward. And now, I'll hand it over to Jess to discuss the remainder of our results."
},
{
"speaker": "Jesse Merten",
"text": "All right. Thank you, Mario. I'll start on Slide 14 to discuss investment results. We proactively repositioned our investment portfolio based on continuous monitoring of changes in the economic environment, current market conditions and enterprise risk and return considerations. As shown in the chart on the left, net investment income totaled $689 million in the quarter, relatively flat to the third quarter of last year but with a higher contribution from the market-based portfolio. Market-based income of $567 million shown in blue, was $165 million above the prior year quarter, reflecting repositioning of the fixed income portfolio into longer duration bonds, a reduction of public equity holdings and higher interest rates. The chart on the right shows changes we made to the duration of the bond portfolio in comparison to interest rates. In 2021, we began reducing duration to reflect the belief that interest rates would rise. This not only reduced some losses as rates increased but it provided flexibility to reposition as yields increased. Starting in the middle of last year, we began increasing duration as rates increased which has increased market-based income. On Slide 15, let's take a closer look at our performance-based portfolio which offers diversification and enhances longer-term returns. The portfolio is anchored in private equity and real estate is diversified across infrastructure, energy, agriculture and timber investments. We hold more than 400 names, including funds with multiple underlying positions across diversified vintage years. These investments are focused on long-term value creation and we expect quarter-to-quarter income volatility as seen in the bars on the chart to the left, where quarterly returns have ranged from a negative 2.3% and to positive 8.6% over the last 5 years. The benefit from accepting this volatility is shown on the right with 3- and 5-year annualized returns of 19% and 12%. The private equity portion of the portfolio has outperformed public equity benchmarks over 3, 5 and 10 years. Slide 16 covers the results of our Protection Services businesses. Revenues in these businesses increased 8.9% to $697 million in the third quarter compared to prior year quarter. Increase is mainly driven by growth in Allstate Protection Plans which increased 19.2% compared to the prior year quarter, reflecting expanded products and international growth. In the table on the right, you will see that adjusted net income of $27 million in the third quarter decreased $8 million compared to the prior year quarter, primarily due to the higher appliance and furniture claims severity and a higher mix of lower-margin business as we invest in growth at Allstate Protection Plans. These were partially offset by improved margins at Allstate Roadside and lower expenses at Allstate Identity Protection. Shifting to Slide 17. Our Health and Benefits business also had good results. Both revenues and income increased significantly with the National General acquisition in 2021 as we added scale and capabilities. For the third quarter of 2023, revenues of $587 million increased by $17 million compared to the prior year quarter, driven by an increase in premiums, contract charges and other revenue in group health which was partially offset by a reduction in individual health and employer voluntary benefits. Adjusted net income of $69 million in the third quarter of 2023 increased $6 million compared to the prior year quarter primarily due to increases in group and individual health revenue and lower operating expenses. Now let's move to Slide 18 and discuss Allstate's approach to capital management to clarify how this differs from traditional methods used to evaluate capital such as the ratio of premiums to statutory surplus. On the left hand of the slide, we summarized 3 discrete components we evaluate to establish target capital which is the basis of our capital management framework. Base capital at the bottom is the capital required to meet ongoing operating requirements. Stress Capital is an additional layer of capital needed to cover tail events for the occurrence of multiple negative impacts, such as lower auto profitability and high catastrophe losses. The contingent reserve is for extremely low frequency and high severity events, a severe breakdown in diversification benefits and also provide strategic flexibility. We use a highly sophisticated model that breaks out individual risk types incorporates regulatory and rating agency considerations and uses extensive simulations to determine the right amount of capital for each component. This is more sophisticated and comprehensive than the ratio of premiums to surplus to determine the right amount of capital. For example, when calculating the premium to surplus ratio for the Allstate Insurance Company, the premiums for many of our subsidiary companies are included but over $1.6 billion of statutory capital is not included in the denominator. This framework also better assesses the use of catastrophe reinsurance particularly for large tail events then a simple ratio. Our sophisticated model and proactive actions provide flexibility to manage capital to maximize shareholder value creation. To close, let's turn to Slide 19 and recap all state strategic priorities. We continue making progress on our plan to return auto insurance profitability to targeted levels. We will pursue the divestiture of our Health and Benefits business, we're continuing to advance on our transformative growth initiatives. Proactive investment management has increased income. Allstate Protection Plans is expanding and these strategic priorities support value creation for Allstate shareholders. With that context, let's open the line to your questions."
},
{
"speaker": "Operator",
"text": "[Operator Instructions] And our first question comes from the line of Gregory Peters from Raymond James."
},
{
"speaker": "Gregory Peters",
"text": "I guess for the first question and there was a lot to unpack in your release and slide deck. I'm going to focus on Slide 7 which is the transformative growth strategy. I was looking at your slide and it talks about building the new model and scaling the new model. And I'm just curious if you're running elevated expenses at this point because you're running 2 separate models. And as you roll out the model, I'm curious about how it's accounting for the nuances of different customers. And I'm thinking about the needs of preferred customers versus standard versus nonstandard?"
},
{
"speaker": "Tom Wilson",
"text": "Greg, good question. Let me -- so first, the transformative growth is about increasing market share in personal profit liability. It's got a couple of components at the core of that is being low-cost insurance but also about raising customer value and also about being available to people however they want to get to a specter segment and the customers. So I would say at this point, we've proven out that the underlying assumptions that we had made going into it work. So we know that lower price raises close right. We know that's true. We know that being available through more people, whether that's through different bundling with exclusive agents through independent agents or direct also works and we can do that. We know we can raise customer value, as you saw on the slide there, I didn't dig go into it but the new sales process is really slick. I mean it pops up with offers that are specifically for you, you don't have to pick your deductible, you don't have to go through a bunch of questions. People don't pick the deductible for you. It's fast, it's slick, then the renters piece which is in the middle one, takes less than a minute and we're finding great ways to attach more protection by making it simpler for customers. We're also making it more connected which is in the right-hand side. And so we relaunched the. We think that people are going to have fewer apps on their phone going forward. So having an app where people could just access either look at their bill or get their ID card is helpful but it's not compelling. So we are expanding that. So you'll see on their gas body. You can get figure out how to save money on buying gas which is, of course, directly related to what we do. We have a whole bunch of other things that we've either added or going to add. For example, we are really terrific on crash detection with our telematics experience through Arty and do that through Light 360 and it's a terrific product. So there's a variety of things we're doing to expand that. As it relates to expenses, we're continuing to invest in this. I don't know that I would say it's over expense it's just we have an objective. We have to lower our overall expenses. We're after that but we're not backing off on investing in the new technology. One of the things that we've proved out the underlying assumptions was can we build the technology to do what you see on that screen. And the answer is yes. We've built it, it's out -- it's working, it's rolling. We need to scale it but we have high confidence that it's scalable. So -- you should expect us to continue to find ways to reduce cost to live into this. But I don't think like there's like -- we're running hot in expenses today because of that. As it relates to the various segments of customers, we want to sell as many people as we can as much stuff as we can. However they want to come. If you want an agent, we'll give you an agent. We just have to make sure it's cost is what you're prepared to pay and they do what you want. -- whether that's an exclusive agent or an independent agent. And if you want to buy direct for the company, you want to buy to call so you want to buy on the web. We just want to make it as simple and easy as you can which we think is differentiated in the marketplace."
},
{
"speaker": "Gregory Peters",
"text": "Well, that makes sense. I guess for my follow-up, I'm going to pivot to the pricing slides. I'm thinking Slides 9 and 10. And was wondering if you could -- I know you provided detail in your comments but if you could give us an update on the problematic states. I think in Slide 9, you said 41% of the -- of your business in auto is running above 100. If we look forward to 2024, how do you think this chart might look?"
},
{
"speaker": "Tom Wilson",
"text": "Which chart are you referring to, Greg?"
},
{
"speaker": "Gregory Peters",
"text": "[Indiscernible]."
},
{
"speaker": "Tom Wilson",
"text": "Yes. I mean, of course, it all depends. Mario can give you some color as well. But it all depends what happens in California, New York and New Jersey. But let me be very clear, we are not going to continue to lose -- 4 digits in millions in those 3 states. So far, Mario has talked about us getting smaller by not growing we've executed that. The next step is to not be able to serve customers who we want to serve because we can't afford to those $0.20 on the dollar. Mario, do you want to comment on? Like we've been talking -- it's not like this as we just figured this out or they're not aware of."
},
{
"speaker": "Mario Rizzo",
"text": "Just to give you a little additional color across the 3 states. And Tom is right, we've been talking about this all year and we've taken pretty significant actions to restrict new business volumes and it's down like we talked about earlier, about 75%. We've got 3 significant rates pending rate pending across all 3 states. We have an auto rate in California that we filed back in May, I believe, 35% we've got a 29% filing pending in New Jersey. We implemented rates in New York ranging from high single digits to low double digits or low teens across our opening closed books middle of the year. We just filed for another 18.3% in New York auto. So we've got significant rates pending with the department. As Tom mentioned, where we're at now is we need action those filings in the fourth quarter. And if we can't, then we believe the right thing to do for the customers in the other 47 states as well as for our shareholders is to take additional action to get smaller across all 3 of those states and that's what we would do beginning next year if we can't get resolution on the rate filings that are currently pending."
},
{
"speaker": "Operator",
"text": "[Operator Instructions] And our next question comes from the line of Alex Scott from Goldman Sachs."
},
{
"speaker": "Unidentified Analyst",
"text": "It's Marley [ph] on for Alex. So you mentioned in the prepared remarks that you were increasing in-person inspections to reduce overall claim costs. Could you touch on this a little bit more? How impactful is this? And then maybe how many of the current accidents are assessed now in person versus remote? And then how should we think about this for near-term changes to loss LAE?"
},
{
"speaker": "Mario Rizzo",
"text": "Marley, this is Mario. I'll answer your question. So I would -- where I would start is going back to the different components of our auto profit improvement plan, taking rate increases, reducing costs, restricting new business in states where we aren't achieving target levels of profitability and improving operational processes and claims what you're describing around more in-person inspections is a component of that fourth piece of improving operational processes. We believe that by doing more physical inspections doing more oversight broadly of both in-network and out-of-network shops as well as doing the same thing on the property side as well that we'll be able to identify opportunities pay what we owe but also not pay for, say, things like pre-existing damage or in total loss cases, cars that could be repaired versus replace. So we think doing more in-person physical inspections in addition to continuing to leverage quick photo claim capabilities is the right thing to do to best manage loss cost going forward and that's what we intend to do to ensure that we're operationally excellent in claims and again, paying what we owe but eliminating any leakage in the system and we're prepared to invest in the claims organization to be able to execute on that. So in terms of the expense ratio, the LAE ratio as part of our adjusted expense ratio. We're still committed to hitting the 23 by the end of next year. The investments we'll make in claims are inclusive of that goal. We think we can do both."
},
{
"speaker": "Unidentified Analyst",
"text": "Got it. And then I just wanted to get your thoughts on longer-term severity drivers that you're seeing in terms of medical inflation and any impacts from the UAW strike?"
},
{
"speaker": "Mario Rizzo",
"text": "Sure. So we'll start with medical inflation. And you'll note that we talked about our severity expectations in auto being about 9% currently which has improved from the 11% we talked about last quarter. All that improvement came from physical damage coverages. Our outlook on casualty and injury severity is unchanged. It didn't get worse but it's consistent with where we were last quarter. And the drivers behind that continue to be medical inflation more attorney representation, higher levels of treatment being pursued kind of all the components of both kind of economic and social inflation that have driven injury severities up. Overtime, those will continue to be headwinds for us. But as we -- again, as I talked about on the physical damage side, as we've adapted our claims processes to take into account those inflationary trends, we've seen some good progress. So we're looking to settle claims earlier in the cycle and we've seen a real improvement in terms of reduction in pending injury claims as well as faster settlement times on injury claims. We're using things like analytics and testing AI models to identify accidents where injuries are likely and those that have a higher likelihood of potentially being represented by attorney so that we can further accelerate claimant contact time and get out ahead of the process and manage the overall claim process. So we're doing things proactively to help mitigate some of those inflationary impacts. And we'll continue to do that. And like I said, we did see some stability in injury severity trends during the quarter."
},
{
"speaker": "Operator",
"text": "[Operator Instructions] And our next question comes from the line of Elyse Greenspan from Wells Fargo."
},
{
"speaker": "Elyse Greenspan",
"text": "My first question, during the quarter, you guys spoke about looking to buy some additional aggregate stop-loss reinsurance. Do you have any update on what you're doing on the reinsurance side in terms of looking to protect your capital position?"
},
{
"speaker": "Jesse Merten",
"text": "Yes, Elyse. Thanks. This is Jess. We have talked a lot about our reinsurance program in general. As you know, we have a robust reinsurance program that reduces our overall capital levels. We've talked more recently about the aggregate cover. At this point, we don't have specific updates about the potential transaction. As I've talked about a number of times, we're looking at whether or not we can economically reduce overall risk and target capital. And to the extent we find a structure where we can get that done, we'll do it. And to the extent we can't get it done economically we'll move on and look at other options. So I would say, as it relates to this quarter, no updates. We continue to be interested in understanding what might be available to attract some new capital. sources into the industry and make them available. But we don't have anything firm to talk about at this point on that."
},
{
"speaker": "Elyse Greenspan",
"text": "And then my second question, you guys highlighted that you're looking into a potential transaction with the benefits business. Were there any diversification credits that you guys got from a capital perspective by owning the benefits business?"
},
{
"speaker": "Tom Wilson",
"text": "Of course, yes. So they're there but we factor that into our overall position here."
},
{
"speaker": "Operator",
"text": "[Operator Instructions] And our next question comes from the line of Michael Zaremski from BMO."
},
{
"speaker": "Unidentified Analyst",
"text": "This is Jack [ph] on for Mike. Just one question on changes to Allstate's captive distribution commission and fee structure. I think you mentioned earlier, how it has driven greater bundling rates. I'm just wondering does also expect this change to impact overall organic growth levels? And do you expect a meaningful benefit to the company's expense ratio?"
},
{
"speaker": "Tom Wilson",
"text": "Well, I think when you go all the way up to transformative growth. Yes, we think that the whole package of stuff will drive market share growth. That includes making sure that the agents do what customers want them to do and that they're supported in doing that with technology and everything else in marketing and that they're well compensated for what they do. But yes, so there's various pieces on Mario, do you want to talk specifically about the account changes?"
},
{
"speaker": "Mario Rizzo",
"text": "Yes. So again, I would characterize the most recent set of changes as a continuation of what we started really several years ago which was intended to drive higher levels of productivity in the exclusive agent distribution system but also reduced distribution costs over time. And I think what we're seeing if you -- particularly if you take out the impacts of the 3 large states where we're purposely driving reduced volume is exactly what we had hoped would happen. So from an expense standpoint, you see in the quarter, we benefited by 2 or 3 from [ph] the distribution cost perspective. So we're continuing to see the impacts and benefits of lower distribution costs. but more importantly, the productivity of the exclusive agency system continues to improve. So I can take out those 3 states, overall production was up 7.6%. Average productivity was up over 13%. And when you look at our top tier of agents, we segment agents into 3 categories, emerging Pro and Elite, that elite group, their level of production was up 15%. So that shows that agents continue to invest in their businesses and take advantage of increased shopping levels in the marketplace but they're focused on driving the kind of growth that will certainly become a real asset for us as we begin to lean back into growth as different states hit target levels of profitability. So we're really encouraged, both in terms of the performance of our agency channel, how they've adapted and the fact that we've been able to take cost out of the distribution system at the same time."
},
{
"speaker": "Operator",
"text": "And our next question comes from the line of Joshua Shanker from Bank of America."
},
{
"speaker": "Joshua Shanker",
"text": "I have a model that goes pretty far back. And historically, if you look at reserves and try and analyze that -- it's hard in short-tail lines. Historically, Allstate run at about a 95% paid to incurred loss ratio. For every dollar of loss you put 5 in the reserves for future losses. And that's true in 3Q '23. But for the previous 5 quarters, it ran at an astonishingly low 83%. I know that you try and get the reserves right. But it does feel over this period of elevated loss ratio that the company put a lot more of its reserves of losses into reserve than any time in my model. Is there something different that had gone on over the past 5 quarters now that you're resuming a normal sort of pay to incur trend? Or is it just -- that was unusual period in you needed to put more reserve?"
},
{
"speaker": "Tom Wilson",
"text": "Maybe I'll start and then Jess can fill in here. First, Josh but we think the reserves are right and we put up what we think we need to put up when we need to put it up as painful as that was last year. We felt we needed to put it up. When you look at the -- I don't know -- I'm not looking at specific numbers you have but I've been through reserves enough to the paid bounce around a lot. It depends what happened in the pandemic with impending levels and we adjust for all that. So, I would say just may have Jess may have some answer for it. I think Jess and Brent could walk through your model with you and help you see it. But I don't -- like we just think the reserves are right and we put them up when we believe Jess, anything to?"
},
{
"speaker": "Jesse Merten",
"text": "No, I would agree with that. I also think you should keep in mind that, that same period was a period of extreme acceleration in the loss cost trend which you wouldn't see over the historical periods, right? So you're going to get a different pay-to-incurred ratio when you have acceleration, the way that we've seen and you saw what our severity trend was last year, you've seen what it is this year. So I think a component of that clearly is just the time period that you're looking at and the acceleration of the underlying trend."
},
{
"speaker": "Joshua Shanker",
"text": "And if you'll indulge me another question, Allstate over the next 20 years has really changed its geographic footprint away from catastrophe. And obviously, with climate change, people have seen a lot of losses and maybe the severity trend over the long term for cat-exposed properties up. But how does the -- severity trend compare between the trend in generally non-cat-exposed property versus cat exposed property, are states like Illinois and a lot of the Midwest seeing a very different trend than severity trends longer term from weather along the coast?"
},
{
"speaker": "Tom Wilson",
"text": "Let me start and then Mario just if you guys want to jump in. First, I would start with saying we've built a really great business model in homeowners just like we make more money than the industry on auto insurance were even better in homeowners. And you see those results over 10 years. You do see this year a lot of catastrophes which is like to have an underwriting loss which we prefer not to have that said, catastrophes happen and that's why people buy insurance. So we're comfortable that, that worked. When you look underneath that and say, okay, what's driving those cat losses storms are more severe now. So just the fact you have a more severe storm will increase the severity of the losses that you have one on a strong, whether that's hail storm or a tornado or a hurricane, it just causes more damage. Underneath both that and a traditional loss are just the normal inflationary pressures. And so the cost of lumber goes up, whether you burn your house down or get knocked down by a hurricane, it's that underlying it. So you have kind of a compounding impact on catastrophes. That said, we're good at it. We manage it by state. So you're correct, Illinois would have less pressure because it would have less catastrophe losses than perhaps a state along the East Coast or in the Southwest on the coast. So -- we factored that all in and both of those things there. We do think though that we -- you've seen the raise in prices that spend both of those factors have increased it. So the dramatic increase in homeowners insurance prices has been driven by both those factors. Anything to add, Mario [ph]?"
},
{
"speaker": "Mario Rizzo",
"text": "Yes. The only thing I'd add, Josh, I think you take a step back and say, what are the underlying drivers of the increase in homeowner severity -- and it's principally, as Tom mentioned, it's labor costs and its material cost to repair homes. And to the extent the rates of inflation vary across different parts of the country. Obviously, that will have an influence on state-specific severity. I think it's more driven by that. Than any -- whether it's cat exposed or not cat exposed because those costs just get amplified when there's a large event and we just have to repair a larger volume of homes."
},
{
"speaker": "Operator",
"text": "[Operator Instructions] And our next question comes from the line of Tracy Benguigui from Barclays."
},
{
"speaker": "Tracy Benguigui",
"text": "Is the impetus selling the Health and Benefits business really to unlock capital and to restore some of your contingency capital? Or was the impetus to become a more lean organization and focus more on core offerings?"
},
{
"speaker": "Tom Wilson",
"text": "Neither. And nor was it in relationship to any shareholder asking us to pursue a sale. I know a few of you wrote about. Let me just tell you what it is. So -- we're selling the businesses because it's the best way to capture the value credit. They're terrific businesses. I mean we make almost $0.25 billion a year. And we get a good platform, they have low capital requirements. We like the businesses. When we look forward to the future, though, we said we think we can harvest more growth from it if we had more complementary distribution, a broader set of products, capabilities such as network management of a health network like manage that. Those are things that we don't have today. We said we can build those it would take us time and money. On the other hand, we could access those that already exist. But that requires us to let go the success we've created. So we decided to choose the latter path. It had nothing to do with a shareholder coming to us and saying, you should sell this had nothing to do with needing the money, it has everything to do with this is the right way to manage your company to optimize shareholder value which is sometimes you have to let go of the success you've created."
},
{
"speaker": "Tracy Benguigui",
"text": "Okay. But maybe as a byproduct, assuming you could hit whatever valuation target range you have in mind might be early but would you have any kind of implied capital relief from your internal model from the sale?"
},
{
"speaker": "Tom Wilson",
"text": "These are low capital businesses. So this First, I would say, on the price high would be the appropriate message I'd like you to carry out there because we do like the businesses a lot. Secondly, they're pretty low capital businesses. So whatever the sale price is, will generate additional capital. And then we'll decide what we want to do when we get there. We've got plenty of other growth opportunities. We're doing a lot with to grow market share and profit liability. We don't need to make that decision right now, so we're not going to."
},
{
"speaker": "Tracy Benguigui",
"text": "Okay. Or could it potentially move down to AIC or accelerate your path to resume buybacks down the road?"
},
{
"speaker": "Tom Wilson",
"text": "There's -- we have all the options that you would have to use capital. Organic growth to buying shares back. All those options are out there. We have no set plans for the capital. Right now, we're focused on -- this is a great business. We can help it be an even greater business by letting go of it. So that's what we're going to do."
},
{
"speaker": "Jesse Merten",
"text": "And I would add, Tracy, we -- our capitalization philosophy, as you know, we tend to keep the capital at the holding company to the extent that we can. So I don't believe we have a capital need at AIC that would cause us to want to do that. So I think we would remain with the philosophy of keeping the capital where it's at the holding company level to the extent we have capital management decisions to make, as Tom said, we'll make him when the time comes. But I don't think we have a need for capital in AIC. So I don't know why we would go away from the philosophy of keeping it up and holding company."
},
{
"speaker": "Tracy Benguigui",
"text": "Got it. And just quickly on your commentary of extending your asset duration now at 4.6 years. I mean you don't have a life business anymore. You plan to divest the Health and Benefits business. How you think about the optimal asset duration relative to your pro forma duration of your remaining liabilities?"
},
{
"speaker": "Tom Wilson",
"text": "Well, we look at it from an enterprise risk and return standpoint. So the first thing we do is say, how much capital do we want to allocate to the investment portfolio. And then John and his team figure out how they best want to allocate that amongst various asset classes. So John may want to make a comment on where we are at today. I would point out that if you look at Slide 14, we made the right calls at the right time."
},
{
"speaker": "Mario Rizzo",
"text": "Yes. I'd just add that -- another thing to consider when one lengthens out duration is just that you keep the appropriate amount of liquidity and flexibility in the portfolio. And I can assure you that we are doing that between the cash that we hold short-term position to other things that we can turn into cash in short order and just maturities by year-end, we're close to $10 billion. So we believe that we're both capturing the additional income that the market is giving us. lengthening out to preserve the capture of that income for a longer period of time, building some resilience into the portfolio in case the economic environment would change, while also providing adequate liquidity."
},
{
"speaker": "Tracy Benguigui",
"text": "Okay. So it sounds like you feel comfortable with durational mismatch because of your strong liquidity position. Is that fair?"
},
{
"speaker": "Tom Wilson",
"text": "Well, the Property-Liability business is a little different than the life business in terms of matching to liabilities. In the life business scores, we have a set maturity date and you can factor in some stuff and you figure out let's match that off. In the Property-Liability business, of course, the liabilities are much shorter but then they're naturally recurring. So you pay off 1 claim and you get another one. Is that a separate claim or -- and so if you match it to that, you'd be having here for 90 days for a physical damage claims. So it's really more about liquidity and overall risk management. And I would also point out a large part of our set capital is there in case we mess up on underwriting income. And so that has a really long duration on it."
},
{
"speaker": "Mario Rizzo",
"text": "Yes. Tracy, 1 other thing to add, if you look at the slide, the blue line depicts the duration, we've really just reverted back to what's been more of a long-term average for us. So we were at a point in time where we were in a lower level of duration, a lower level of interest rate exposure. We thought that was right given what was happening with the Fed and interest rates in general. Now that rates have climbed back up pretty aggressively. We want to go back to what has been a longer run central tendency for us."
},
{
"speaker": "Operator",
"text": "Our next question comes from the line of David Motemaden from Evercore ISI."
},
{
"speaker": "David Motemaden",
"text": "I just had a question on the frequency trends that you guys saw in the third quarter. Could you just describe what you guys are seeing. It sounded like that was up a little bit. I was hoping you could put some numbers around it and sort of what you're seeing, especially as it looks like you're shrinking units. I would think that there would be some benefit from improving the mix of business. But I was hoping you could maybe just touch on that."
},
{
"speaker": "Mario Rizzo",
"text": "David, it's Mario. Thanks for the question. I'll talk a little more qualitatively about frequency since we now are disclosing more pure premium trends which combine the overall loss trend. We just think it's a better way for you all to look at and think about auto profitability. But in terms of auto frequency, the headline is it continues to revert back to pre-pandemic levels but remains below where it was in 2019. There continues to be a tailwind when you think about the safety features embedded in vehicles that will continue to help improve frequency, we think, from a long-term trend going forward. And then when you look at the other driver which is driving activity. When we look at our telematics data, we look at the number of miles that a person is driving each day. It's up mid-single digits compared to last year, still skewing less to rush hour times which benefit frequency and more to nonpeak hours. But that trend has been pretty stable over the last several quarters and we feel like we're in a period of stability in terms of driving behavior. So net-net frequency is up modestly. It's a small component of pure premium. So just to give you a couple of numbers. When you adjust out the intra-year impact in pure premium, it's up about 9.7% year-over-year in the quarter and we said severity was up 9% [ph]. So you can see the modest impact that frequency is having, again, as people drive a bit more than they were a year ago."
},
{
"speaker": "David Motemaden",
"text": "Got it. And you're saying it's a little bit more stable now, so maybe flattens out there at those levels?"
},
{
"speaker": "Mario Rizzo",
"text": "Yes, David, the trend has been pretty stable over the last several quarters in terms of when we look at miles driven for our book."
},
{
"speaker": "David Motemaden",
"text": "Got it. And then for my follow-up, just to add a question on Slide 13 and I appreciate this information on the distribution channels. I was hoping -- it looks like you guys track the TAM by channel pretty closely. Within the exclusive agent channel, how has that TAM been growing -- and I guess, I'm under the impression that it's been shrinking at the expense of the direct and independent agent channels. So just given that backdrop, I'm wondering if you're seeing signs that you think you can sort of buck that trend and start to grow within your exclusive agency channel?"
},
{
"speaker": "Tom Wilson",
"text": "Let me David maybe a couple of thoughts. First, there's a lot of analysis on it. People want to tend to like assume that it's a straight line. And actually, there's competition for the customer amongst all of those. So our effort to reduce the cost that Mario talked about in providing an agent is to give customers better value which should take share away from some of the other 2. The independent agents also are a good place people want to come where they don't want to just buy from an insurance company. They want somebody to shop around for them and want them to do the work for it. On the direct channel, obviously, with increased connectivity, the direct channel has certainly grown. But it's also growing a lot because billions of dollars of advertising going to it. So it's an overall ecosystem, I guess, I would say. And so we look at it and like, we want to be there. People want to have buy from a company like Allstate. Allstate brand name, want to go to that agent. We want to be there for that person with everything they have. The same thing if they want someone to shop or on them, don't want to do the work. We want to be in that independent agent channel. And then in a direct channel, if they want to buy directly then. And what we are doing is using the technology between those various things make it an even better value proposition. So we showed you that cell phone which had the 3 offers in it. Imagine an agent now being able to not have to ask you a whole bunch of stuff; what's your deductible, what kind of stuff. But we pre-populate it with, here's what we think David's deductible should be, offer David this package you put them in a different position. So we look at it really as sort of organic and it moves between there. And we want to be there for all of our customers. So it's not like we think 1 is going to win and the other is going to lose. It's just a constant competition to just do a better job for the customers that want to buy it that way. Jonathan, we'll take one more question."
},
{
"speaker": "Operator",
"text": "[Operator Instructions] Our final question for today comes from the line of Meyer Shields from KBW."
},
{
"speaker": "Unidentified Analyst",
"text": "It's Jen [ph] on for me. Most of my questions are answered just 1 on the growth in 2024. So what is your expectation and plan for next year? Is the nonstandard auto still be the key growth driver -- any color on that would be great?"
},
{
"speaker": "Tom Wilson",
"text": "Mario will give you some specifics. I would say that the biggest impact -- so first, we're starting to grow in the Allstate brand. Mario has got a number of states where he's starting to roll out, transform growth in a more aggressive way to capture the market share growth. So we comfortable there. The independent Asian business, we think, will grow through continued expansion of the nonstandard and the Custom 360 Mario talked about, I would say that the biggest driver. The biggest thing we're unclear on right now is what happens in New York, New Jersey and California. That will be the biggest impact on policies in force. May be different than the growth measure you're talking about but certainly, we need to get properly priced in those states. Or else will get smaller in those states. And given that they're a large percentage for our book of business, it will impact overall policy. Mario thing you would add to that?"
},
{
"speaker": "Mario Rizzo",
"text": "Yes. The only thing I'd add as we look ahead is -- I think it's important to recognize that we manage the business on a local level. That means state by state, market by market, risk segment by risk segment; that's been the approach we've taken to improve profitability and we're taking that same approach as we look forward in terms of growth. And I think it's -- where we're at is really 2 groupings of states emerging. Tom talked about the 3 that we've just got to get more rate and get more profitable. And before we can even begin to think about growing and investing in growth because it just economically doesn't make sense for us and that's California, New York, New Jersey. The rest of the states that if you divide them, there's a number of states that are already at target levels of profitability and we're beginning to do things like make local marketing investments, leverage a lot of the capabilities we've been building with transformative growth, the momentum we've got in the exclusive agent channel, the improvements we've made in direct and the capabilities we've built there and what we're building in the independent agent channels with things like Custom 360 and nonstandard auto. So we feel like as a system we are much more effectively positioned to grow when the time is right for us to grow. And as we look out into 2024, we think more states will fall into that ready-to-grow category in terms of target levels of profitability. And we look forward to continuing to invest in growth in those states and leverage the capabilities we've been building with transformative growth."
},
{
"speaker": "Tom Wilson",
"text": "So let me close with 4 points which summarize kind of the conversation we had. What's going to drive shareholder back profitability increases, strategic capital allocation great investment returns and then transform growth long-term sustainable growth. We think those 4 things combined make this a great opportunity. Thank you very much. We'll see you next quarter."
},
{
"speaker": "Operator",
"text": "Thank you, ladies and gentlemen, for your participation in today's conference. This does conclude the program. You may now disconnect. Good day."
}
] | The Allstate Corporation | 18,711 |
ALL | 2 | 2,023 | 2023-08-02 11:00:00 | Operator: Good day, and thank you for standing by. Welcome to Allstate’s Second Quarter Investor Call. At this time, all participants are in a listen-only mode. After the prepared remarks, there will be a question-and-answer session. [Operator Instructions] Please limit your enquiry to one question and one follow-up. As a reminder, please be aware that today’s call is being recorded. And now, I’d like to introduce your host for today’s program, Brent Vandermause, Head of Investor Relations. Please go ahead, sir.
Brent Vandermause: Thank you, Jonathan. Good morning. Welcome to Allstate’s second quarter 2023 earnings conference call. After prepared remarks, we’ll have a question-and-answer session. Yesterday, following the close of the market, we issued our news release and investor supplement, filed our 10-Q and posted related material on our website at allstateinvestors.com. Our management team is here to provide perspective on these results. As noted on the first slide of the presentation, our discussion will contain non-GAAP measures for which are reconciliations in the news release and investor supplement, and forward-looking statements about Allstate’s operations. Allstate’s results may differ materially from these statements, so please refer to our 10-K for 2022 and other public documents for information on potential risks. And now, I’ll turn it over to Tom.
Tom Wilson: Good morning. We appreciate you investing your time in Allstate. Let's start with an overview of results and then Mario and Jesse will walk through operating results and the actions being taken to increase shareholder value. Let's begin on Slide 2. Allstate's strategy has two components; increase personal profit liability market share, and expand protection services, which are shown in the two with on the left. On the right-hand side, you can see a summary of results for the second quarter. Progress is being made on the comprehensive plan to improve auto insurance profitability, which includes raising rates, reducing expenses, limiting growth and enhancing claim processes. While auto insurance margins are not at target levels, the proportion of premium associated with states operating and that underlying -- underwriting profit has gone from just under 30% in 2022 to 50% for the first half of this year. Mario will discuss the actions being taken to continue this trend and importantly, improved results in New York, New Jersey and California. Severe weather in the quarter contributed to a net loss of $1.4 billion, 42 catastrophe events impacted 160,000 customers and resulted in $2.7 billion of catastrophe losses and a property liability underwriting loss of $2.1 billion. Strong fixed income results from higher bond yields generated $610 million of investment income and Protection Services and Health and Benefits generated $98 million of profits in the quarter. The transformative growth plan to become the lowest cost protection provider is making continued progress. This both helps current results with lower costs and positions Allstate for sustainable growth when auto margins return to acceptable levels. Affordable, simple and connected property liability products with sophisticated telematics pricing and differentiated direct-to-consumer capabilities are being introduced under the Allstate brand through a new technology platform. National General was growing, which will also increase market share. Specialty auto expertise, along with leveraging auto’s Allstate strength in preferred auto and homeowners insurance products are expected to drive sustainable growth. Allstate Protection Plans is expanding its embedded protection through new products and retail relationships and in international markets. Allstate has a strong capital position with $16.9 billion of statutory surplus and holding company assets, as Jesse will discuss later. And as you know, we have a long history of providing cash returns to shareholders through dividends and share repurchases. Over the last 12 months, we've repurchased 3.9% of outstanding shares for $1.3 billion. We suspended this is repurchase program in July, as we had a net loss for the six months of the year. Improving profitability, increasing property liability, organic growth and broadening protection offered to customers through an extensive distribution platform will increase shareholder value. Let's review financial results on Slide 3. Revenues of $14 billion in the second quarter increased 14.4% above the prior year quarter of $1.8 billion. The increase was driven by higher average premiums in auto and homeowners insurance from rates taken in 2022 and 2023, resulting in property-liability earned premium growth of 9.6%. Net investment income of $610 million reflects the impact of higher fixed income yields and extended duration, which will substantially increase income. This growth more than offset a decline from performance-based investments in the quarter. The net loss of $1.4 billion and an adjusted net loss of $1.2 billion reflects a profit liability underwriting loss of $2.1 billion due to the $2.7 billion in catastrophe losses and increased auto insurance loss costs. In auto insurance, higher insurance pros and lower expenses were largely offset by higher catastrophe losses and increased claim frequency and severity. The underlying auto insurance combined ratio did improve slightly for the first six months of 2023 compared to the year-end 2022. Auto insurance had an underwriting loss of $678 million. In homeowners insurance, catastrophe losses were substantially over the 15-year average, resulting in a combined ratio of 145, generating an underwriting loss of $1.3 billion. The underlying combined ratio on homeowners improved 1.9 points to 67.6% as higher average premiums more than offset increased severity. Adjusted net income of $98 million from protection services and health and benefits when combined with the $610 million of investment income offset a portion of the underwriting loss. The target for enterprise adjusted net income return on equity remains at 14% to 17%. I'll now turn it over to Mario to discuss profit liability results.
Mario Rizzo: Thanks, Tom. Let's turn to Slide 4. We are seeing the impact of our comprehensive auto profit improvement plan in our financial results, starting with the rate increases we have implemented to date. The chart on the left shows Property-Liability earned premium increased 9.6% above the prior year quarter, driven by higher average premiums in auto and homeowners insurance, which were partially offset by a decline in policies in force. Price increases and cost reductions were largely offset by severe weather events and increased accident frequency and claim severity. The underwriting loss of $2.1 billion in the quarter was $1.2 billion worse than the prior year quarter due to the $1.6 billion increase in catastrophe losses. The chart on the right highlights the components of the combined ratio, including 22.6 points from catastrophe losses. Prior year reserve reestimates, excluding catastrophes, had a 1.6 point adverse impact on the combined ratio in the quarter. Of the $182 million of strengthening in the second quarter, $148 million was in National General, primarily driven by personal auto injury coverages in the 2022 accident year. In addition, prior years were strengthened by approximately $31 million for litigation activity in the state of Florida related to torque reform that was passed in March of this year. We've been closely monitoring the increase in filed suits on existing claims and the charge reflects a combination of higher legal defense costs and a modest loss reserve adjustment. Despite continuing pressure on the loss side, the underlying combined ratio of 92.9 improved modestly by 0.5 points compared to the prior year quarter and 0.4 points sequentially versus the first quarter of 2023. Now, let's move to slide five to discuss Allstate's auto insurance profitability in more detail. The second quarter recorded auto insurance combined ratio of 108.3% was 0.4 points higher than the prior year quarter, reflecting higher catastrophe losses and increased current report year accident frequency and severity, which were largely offset by higher earned premium, expense reductions, and lower adverse non-catastrophe prior year reserve re-estimates. We continue to raise rates, reduce expenses, restrict growth, and enhanced claim processes as part of our comprehensive plan to improve auto insurance margins. This slide depicts the impact of our profit improvement actions on underlying auto insurance profitability trends. As a reminder, we continually assess claim severities as the year progresses. And last year, as 2022 developed, we continue to increase report year ultimate severity expectations. The chart on the left shows the quarterly underlying combined ratios from 2022 through the current quarter with 2022 quarters adjusted to account for full year average severity assumptions, which removes the effect that intra-year severity changes had on recorded quarterly results. After adjusting for the timing of higher severity expectations, the quarterly underlying combined ratio trend was essentially flat throughout 2022. As we move into 2023, the underlying combined ratio has improved modestly in each of the first two quarters, reflecting both the impact of our profitability actions and the continued persistently high levels of loss cost inflation. The chart on the right depicts the percent change at annualized average earned premium shown by the blue line and the average underlying loss and expense per policy shown by the light blue bars compared to prior year-end. Rapid increases in claim severity and higher accident frequency since mid-2021, resulted in significant increases in the underlying loss and expense per policy which outpaced the change in average earned premium and drove a higher underlying combined ratio in both 2021 and 2022. As we've implemented rate increases, the annualized earned premium trend line continues to increase and has begun to outpace the still elevated underlying cost per policy in the first two quarters of 2023, resulting in a modest improvement in the underlying combined ratio. Slide six provides an update on the execution of our comprehensive approach to increase returns in auto insurance. There are four areas of focus; raising rates, reducing expenses, implementing underwriting actions, and enhancing claim practices to manage loss costs. Starting with rates, you remember the Allstate brand implemented 16.9% of rate in 2022. In the first six months of 2023, we have implemented an additional 7.5% across the book, including 5.8% in the second quarter. National General implemented rate increases of 10% in 2022, an additional 5.5% through the first six months of 2023. We will continue to pursue rate increases in 2023 to restore auto insurance margins back to the mid-90s target levels. Reducing operating expenses is core to transformative growth, and we also temporarily reduced advertising to reflect the lower appetite for new business. We continue to have more restrictive underwriting actions on new business in locations and risk segments where we have not yet achieved adequate prices for the risk, but are beginning to selectively remove these restrictions in states and segments that are achieving target margins. To this point, the number of states achieving an underlying combined ratio better than 100 increased from 23 states, which represented just under 30% of Allstate brand auto insurance premium at the end of 2022 and to 36 states, representing approximately 50% of premium at the end of the second quarter. Ensuring that our claim practices are operating effectively and enhancing those practices where necessary, is key to delivering customer value, particularly in this high inflation environment. This includes modifying claim processes in both physical damage and injury coverages by doing things like increasing resources, expanding reinspections and accelerating the settlement of injury claims to mitigate the risk of continued loss development. We are also negotiating improved vendor service and parts agreements to offset some of the inflation associated with repairing vehicles. Slide 7 provides an update on progress in three large states with a disproportionate impact on profitability. The table on the left provides rate increases either implemented so far this year are currently pending with the respective insurance department in California, New York and New Jersey. Because our current prices are not adequate to cover our costs in these states, we have had to take actions to restrict new business volumes. As a result, new issued applications from the combination of California, New York and New Jersey declined by approximately 62% compared to the prior year quarter. In California, we implemented a second 6.9% rate increase in April and also filed for a 35% increase in the second quarter that is currently pending with the Department of Insurance. We continue to work closely with the California Department to secure approval of this filing and restore auto rates to an adequate level. In New York, we implemented approximately three points of weighted rate in June, driven by approved increases in two closed companies. And subsequently received approval for a 6.7% increase in the larger open companies, which was implemented in July, we will continue to make further filings in 2023 that will be additive to their -- to the rates approved so far this year. In New Jersey, we received approval for a 6.9% rate increase in the first quarter and filed a subsequent 29% increase in the second quarter. As mentioned earlier, we anticipate implementing additional rate increases for the balance of 2023 to counteract persistent loss cost increases. Slide 8 dives deeper into how we are improving customer value through expense reductions. The chart on the left shows the property liability underwriting expense ratio and highlights drivers of the 2.5 point improvement in the second quarter compared to the prior year quarter. The first green bar shows the 1.4 point impact from advertising spend, which has been temporarily reduced, given a more limited appetite for new business. The second green bar shows the decline in operating costs, mainly driven by lower agent and employee-related costs and the impact of higher premiums relative to fixed costs. Shifting to our longer-term trend on the right, we remain committed to reducing the adjusted expense ratio as part of transformative growth. This metric starts with our underwriting expense ratio, excluding restructuring, coronavirus-related expenses, amortization and impairment of purchased intangibles and advertising. It then adds in our claims expense ratio, excluding costs associated with settling catastrophe claims because catastrophe-related costs tend to fluctuate. Through innovation and strong execution, we've driven significant improvement with a second quarter adjusted expense ratio of 24.7%. We expect to drive additional improvement, achieving an adjusted expense ratio of approximately 23 by year-end 2024, which represents a 6-point reduction compared to our starting point in 2018. While increasing average premiums certainly represent a tailwind, our intent in establishing the goal is to become more price competitive. This requires a sustainable improvement in our cost structure with our future focus on three primary areas, including enhancing digitization and automation capabilities, improving operating efficiency through outsourcing, business model rationalization and centralized support and enabling higher growth distribution at lower cost through changes in agency compensation structure and new agent models. Now, let's move to slide 9 to review homeowner insurance results, which despite improving underlying performance, incurred an underwriting loss in the quarter driven by elevated catastrophe losses. Our business model incorporates a differentiated product, underwriting, reinsurance and claims ecosystem that is unique in the industry. Our approach has consistently generated industry-leading underwriting results despite quarterly or yearly fluctuations in catastrophe losses. Our homeowners insurance combined ratio, including the impact of catastrophes, has outperformed the industry by 12 points from 2017 through 2022. During that same time period, we generated annual average underwriting income of approximately $650 million. The chart on the left shows key Allstate Protection homeowners insurance operating statistics for the quarter. Net written premium increased 12.4% from the prior year quarter, predominantly driven by higher average gross premium per policy in both the Allstate and National General brands and a 1% increase in policies in force. Allstate brand average gross written premium per policy increased by 13.2% compared to the prior year quarter driven by implemented rate increases throughout 2022 and an additional 7.4 points implemented through the first six months of 2023 as well as inflation in insured home replacement costs. While the second quarter homeowners combined ratio is typically higher than full year results, primarily due to seasonally high severe weather-related catastrophe losses, the second quarter of 2023 combined ratio of 145.3% was among the highest in Allstate's history and increased by 37.8 points compared to last year's second quarter due to a 40.3 point increase in the catastrophe loss ratio. The underlying combined ratio of 67.6% improved by 1.9 points compared to the prior year quarter, driven by higher earned premium, lower frequency and a lower expense ratio, partially offset by higher severity. The chart on the right provides a historical perspective on the second quarter property liability catastrophe loss ratio of 75.9 points, which was elevated compared to historical experience, reflecting an increased number of catastrophe events and larger losses per event. While the second quarter result was 33.9 points above the 15-year second quarter average of 42 points, it is not unprecedented and filled within modeled outcomes contemplated in our economic capital framework. We remain confident in our ability to generate attractive risk-adjusted returns in the homeowners business and continue to respond to loss trends by implementing rate increases to address higher repair costs and limiting exposures in geographies where we cannot achieve adequate returns for our shareholders. And now I'll hand it over to Jesse to discuss the remainder of our results.
Jesse Merten: Thank you, Mario. I'd like to start on Slide 10, which covers results for our Protection Services and Health and Benefits businesses. The chart on the left shows Protection Services where we continue to broaden the protection provided to an increasing number of customers largely through embedded distribution programs. Revenues in these businesses, excluding the impact of net gains and losses on investments and derivatives increased 9.1% to $686 million in the second quarter compared to the prior year quarter. Increase reflects growth in Allstate Protection Plans and Allstate Dealer Services, partially offset by a decline in parity. By leveraging the Allstate brand, excellent customer service and expanded products and partnerships with leading retailers, Allstate Protection Plans continues to generate profitable growth, resulting in an 18% increase in the second quarter compared to the prior year quarter. In the table below the chart, you will see that adjusted net income of $41 million in the second quarter decreased $2 million compared to the prior year quarter, primarily due to higher appliance and furniture claims severity and a higher mix of lower-margin business as we invest in growth at Allstate Protection Plans. We'll continue to invest in these businesses, which provide an attractive opportunity to broaden distribution protection offerings that meet customers' needs and create value for shareholders. Shifting to the chart on the right, Health and Benefits continues to provide stable revenues while protecting more than four million policyholders. Revenues of $575 million in the second quarter of 2023 increased by $2 million compared to the prior year quarter, driven by an increase in premiums, contract charges and other revenues in group health, which was partially offset by a reduction in individual health and employer voluntary benefits. Health and Benefits continues to make progress on rebuilding core operating systems to drive down costs, improve the customer experience and support growth that generates shareholder value. Adjusted net income of $57 million in the second quarter of 2023 decreased $10 million, compared to the prior year quarter, primarily due to the decline in employer voluntary benefits, individual health and higher expenses related to system investments. Now let's move to Slide 11 to discuss investment results and portfolio positioning. Active portfolio management includes comprehensive monitoring of economic conditions, market opportunities, enterprise risk and return and capital, as well as interest rates and credit spreads by rating, sector and individual name. As you'll recall, last year, exposure to below investment grade bonds in public equity was reduced. We maintained this portfolio allocation in the second quarter, which enabled us to extend duration of the fixed income portfolio and increased market-based income levels. As shown in the chart on the left, net investment income totaled $610 million in the quarter, which was $48 million above the second quarter of last year. Market-based income of $536 million, shown in blue was $168 million above the prior year quarter, reflecting repositioning of the fixed income portfolio into longer duration and higher yielding assets that sustainably increased income. Market-based income has also benefited from higher yields for short-term investments in floating rate assets, such as bank loans. Performance-based income of $127 million shown in black, was $109 million below the prior year quarter due to lower valuation increases and fewer sales of underlying assets. Our performance-based portfolio is expected to enhance long-term returns and volatility on these assets from quarter-to-quarter as expected. The chart on the right shows the fixed income earned yield continues to rise and was 3.6% at quarter end compared to 2.8% for the prior year quarter and 3.4% in the first quarter of 2023. This chart also shows that from the fourth quarter of 2021 through the third quarter of 2022, lowering fixed income duration mitigated losses as rates rose. Beginning in Q4 of 2022, we began to extend duration, which locks in higher yields for longer. In the second quarter, we further extended duration to 4.4 years, increasing from 4 years in the first quarter. Our fixed income portfolio yield is still below the current intermediate corporate bond yield of approximately 5.5%, reflecting an additional opportunity to increase yields. To close, I'd like to turn to Slide 12 to discuss how Allstate proactively manages capital to provide the financial flexibility, liquidity and capital resources necessary to navigate the challenging operating environment. Capital management is based on a sophisticated framework that quantifies capital targets by business, product, geography, investment type and for the overall enterprise. Targets include a base level of capital for expected volatility and earnings as well as additional capital for stress events, situations where correlations between risks are higher than modeled and other contingencies. This model enables us to proactively manage capital in a dynamic and uncertain environment. Utilization of reinsurance, both by event and in aggregate is assessed relative to overall enterprise risk levels. A robust reinsurance program is in place with multiyear contracts to mitigate losses from large catastrophes. Homeowners insurance geographic exposures are managed to generate appropriate risk-adjusted returns, including lowering exposure to California and Florida property markets. This framework was used to decide to purchase additional aggregate program coverage this year. Reducing high-yield bonds and public equities in the investment portfolio significantly reduced the amount of enterprise capital required for investments. This decision was based on market conditions and the decline in auto profitability as well as the desire to reduce volatility and statutory results. It also provides a sustainable source of increased income in capital generation. The decline in auto insurance profitability is also captured by our framework, which increased capital requirements for auto insurance from pre-pandemic levels to reflect recent results. The capital management framework ensures Allstate has the financial flexibility, liquidity and capital resources necessary to operate in challenging environments and be positioned for growth. Allstate's capital position is sound with estimated statutory surplus and holding company assets totaling $16.9 billion at the end of the second quarter, as shown on the table to the left. Holding company assets of $3.3 billion represent approximately 2.5x our annual fixed charges with no debt maturities for the remainder of 2023 and a modest amount maturing in 2024. Senior debt and preferred stock refinancing in the first and second quarters of this year demonstrate our ability to readily access capital markets to address maturities as they arise. In response to the loss this quarter, we have suspended share repurchases under the $5 billion authorization, which is 90% complete. This authorization expires in March of 2024. In addition to having a strong capital base, Allstate has a history of generating capital and statutory net income in our largest underwriting company, Allstate Insurance Company, as you can see on the chart on the right. Statutory net income averaged $1.9 billion annually in the 10 years prior to the onset of COVID. You can also see the impact of the rapid increase in auto insurance claim severity and recent catastrophe loss experience on 2022 and 2023 statutory net income. We're confident that the auto insurance profit improvement plan will restore profitability. The homeowner's insurance business is designed to generate underwriting profits, and proactive investment management will create additional capital to grow market share, expand protection offerings and provide cash return to shareholders. Allstate will continue to proactively manage capital to navigate the current operating environment and be well positioned for growth to increase its shareholder value. With that as context, let's open up the line for your questions.
Operator: Certainly, one moment for our first question. [Operator Instructions] Our first question comes from the line of Gregory Peters from Raymond James. Your question, please.
Gregory Peters: Well, good morning, everyone. I guess, I'm going to focus on auto insurance profitability for my first question. And obviously, there's a bunch of slides in your presentation, the one where you identified the three states. I guess from a bigger picture perspective, though, -- do you have updated views on frequency and severity for the second half of this year or for next year versus what you were thinking at the beginning of the year I guess what I'm ultimately getting is how much more rate do we need to get that underlying combined ratio number that you use on the slide 6 -- excuse me, slide 5 to get it down to the low to mid-90s.
Tom Wilson: Greg, this is Tom. Let me start, and then Mario can jump in. First, as it relates to frequency and severity, of course, it's hard to predict what's going to happen in the second half of the year. What we do know is that the severity was increased in the second -- first half of this year from what we thought it would be when we looked at it last year. So we're really glad we took the rates that we did, and we've been accelerating rates, as Mario talked about. I think when you look at it, it's really -- of course, it's hard to predict, right? What you're really looking at is that slide that Mario showed that had the line with the average premiums going up and then the bar with the severities and you want that line to be above the bar, of course. What you know going forward is that the line is going to keep going up, right? Like we filed those rates, we've got those rates. We put them in the computer, we're collecting the cash. And so you know that's going to happen. What you don't know is whether severity will go up from the 11% or whether it will be down from the 11%. It's come down this year from last year. We'd like to think that all the work we're doing will have it come down even further. And so that gap will get you back to the mid-90s that we talked about in terms of targeted combined ratio. When that exactly happens, of course, is dependent on what happens to the second bar, which is not known. What we do know is we'll continue to take increased rates and make that line continue to go up. Mario, any specifics you want to add on the three states that you mentioned or?
Mario Rizzo: I think, Greg, the thing I'd add is less about to Tom's point, what we expect going forward and more about what we're seeing and maybe just give you a little more color underneath the loss cost trend. So as you remember, last quarter, we started giving you pure premium trends as opposed to coverage specific frequency and severity because we just think it's a better way for you to evaluate where overall profitability is going. And the point I'd make is if you look on Slide 5, as Tom pointed out, for the first couple of quarters this year, we've seen the average earned premium trend begin to outpace the increases in loss and expense. It's hard to predict what the future will hold, but that's an encouraging development. Underneath that loss trend, if you look at where we're at in the second quarter compared to where we were for the full year last year, the increase in pure premium is about 12.5%, and we told you that severity is up on average across all coverages by about 11%. So what we're seeing still is persistently high severity across coverages with a lesser impact from overall frequency increases. The point being we're going to continue to aggressively implement our profit improvement plan, you've seen what we've done with rates. We've done 7.5 points through the first half of this year in the Allstate brand, 5.5 points on National General. We're going to continue to do that. You see the benefit that the cost reductions is having on the combined ratio while that rate earns in. And we've talked a lot about those three states, which make up about one-quarter of our book, California, New York and New Jersey. We want to keep pushing on continuing to drive rate increases into the book. We've gotten some approvals so far this year, but there's rates pending, pretty significant rates pending in California and New Jersey, and we're prepared to file another rate in New York. So we're going to keep pushing really hard on that. And in the meantime, we've scaled way back on new business production in those states. And while it's having a reasonably small impact on the loss ratio so far this year, because new business just tends to be a smaller proportion of our overall book, it will continue to have a favorable impact on our loss ratio going forward. And until we get to adequate rates in those three states, we're going to keep restricting the volume of business we're willing to write.
Gregory Peters: Okay. Thanks for the color. Maybe just keeping on auto as my follow-up question on NatGen, you spoke about the reserve strengthening in the quarter, and I guess you also mentioned Florida in your comments. Can you give us any perspective on the reserve strengthening that happened inside NatGen? Is it a true-up and that you're comfortable where the trends are with matching reserves at this point in time, or is this going to be another situation where we have a couple of quarters of catch-up that we're having to deal with?
Tom Wilson: Mario can answer how we feel about the growth and the profitability of the growth in National General, Greg, let me just settle up context. So first, the acquisition of National General is exceeding our expectations. As, you know, we bought the company so that we could consolidate our Encompass business into it that would reduce the cost and create a stronger business that we're serving independent agents. We like what we got there. The consolidation and the cost reductions are exceeding our expectations. And that was the basis under which we agreed to where the economics of the acquisition made at. The upside from there was growing in the IA channel, both through the specialty vehicle product and by building new products for preferred auto and homeowners insurance using Allstate's expertise, both of which are also becoming reality. Mario, do you want to talk about, I guess, both reserves. But I think Greg's underlying question there was like you're growing, is that a good thing?
Mario Rizzo: Yes. So, Greg, the place I'd start with National General, you're right. We're growing in National General that's principally in the specialty vehicle or the non-standard auto part of the business, which that market continues to experience pretty significant disruption. A couple of things I'd say on NatGen. First of all, the underlying combined ratio in the quarter was 96%, and 96% is slightly higher than we want to run it at, but it's pretty close to our target margin. And that 96% includes the kind of roll-forward impact of increasing reserves principally in the 2022 accident year and therefore, increasing our loss expectations in the 2023 year. So, that's all embedded in the 96%. A couple of things in addition to that, that I mentioned. We've talked a lot about the profit improvement plan, we're implementing that same approach in that same plan in National General across the same levers we're using in the Allstate brand. We've taken 5.5 points of rate this year, 11 points of rate over the last 12 months in NatGen. And given that it's predominantly a non-standard auto book, the book tends to turn over and get repriced pretty rapidly. So, we're comfortable that the rate we've taken so far this year is working its way into the system. And I would say in response to a higher loss trend that we've seen in 2023, we've accelerated our plan to take rate in 2023. So, we're ahead of that 5.5 points is ahead of where we expected to be at this point during the year. We've also restricted underwriting guidelines in a number of states, we're writing more liability-only less full coverage. So, we're being really selective about what we're writing. And the other benefit, as Tom mentioned, part of the rationale around acquiring National General was the opportunity to lower costs and improve the expense ratio, and we're benefiting from that inside that 96% underlying combined ratio. We've seen a pretty significant improvement year-over-year in the underwriting expense ratio as we essentially take advantage of scale through the growth we're getting. So, comfortable where we're positioned. We're taking the appropriate actions from a profitability perspective. And so we're comfortable with what we're writing in NatGen right now.
Gregory Peters: Got it. Thank you for the detail and your answers.
Operator: Thank you. And our next question comes from the line of Josh Shanker from Bank of America. Your question please.
Josh Shanker: Thank you very much for taking my question. Yes. Tom, there's the amount of rate that you need and the amount that you can get over a certain period of time, but when you look back to the beginning of the year and you had your plan for taking rates and you've learned about some changes in frequency and severity over the past six, seven months. Has that changed the perspective on how much rate you need and want to ask for? And does that change the 2023 plan, or does that mean that the regulators will give you only so much and you have get that rate in 2024 and beyond?
Tom Wilson: Of course, it's -- I would say, Josh, it's a good question, but I would say it's not like not like every quarter or every 6 months, we adapt it is like every day. So Mario and Guy are constantly looking at our pricing, and we're going to maximum file rates everywhere we can, and we're not getting as much pushback from goes because the numbers are pretty clear. Like it's not like we're making it up, you pay for the cars and they see the cash go out so you -- and they do have to pay attention to what the rules are in the rating. Now we have 3 states, which are a problem, and we're working aggressively with them. so that we can get the right amount of it. But yes, so our -- the rate expectation for the year has gone up from the beginning of the year. And it will keep going up until we get to our target combined ratio. We have -- we've talked about some of the issues we have in some of those states, you see us agreeing to lower amounts than we actually need because the time value of money and the multiplication works for you. So why take a 6.9 when you need 35 in California because you can get 6.9 right away as opposed you could wait 18 months to get 35. So we've we're very sophisticated and have good relationships with them, so we can manage it so that it meets our needs. So and we'll just keep rate that's on auto, which I assume where you're going, Josh. Same thing applies in homeowners and our price increases are up a little bit, but not up as much as what we thought they were going to be. but they're still from where we set out where we thought would be in the beginning. Mario, add anything you would add?
A – Mario Rizzo: Yes. Just a couple of additional data points, Josh. As Tom mentioned, our data is immediately -- our indications are immediately responsive to the data we're seeing. So we're constantly updating rate indications and filing for what we need based on what we're actually experiencing versus what we thought we would have needed going into the year. And the other point I'd make is, and this is on a couple of the states that we've spiked out for you. We're evaluating trade-offs and leaning in where we think it just makes sense. So for example, in California, got the 2 6.9% rate and we turned around and filed for essentially our full indication at 35, knowing that, that was likely to require a longer review period. There was a little more risk there, but we thought it was the right thing to do. In New Jersey, we did the same thing. We got the 6.9% rate approved, which is essentially the cap that the state hold you to, but then we opted to utilize an administrative provision and file for a 29% rate. So again, we're aggressively pushing on the amount of rate we need based on the loss experience where we've got in real time. And we're going to keep doing that. and keep pushing rate through and working with all the departments and each of the regulators to get those rates approved as quickly as we can to continue to bend the line on that loss trend.
Q – Joshua Shanker: And outside of the 3 problem states, when you are submitting the filing, does the filing need to be audit financial statements or financial data in arrears, or can you pretty much file new rate with current data as it's coming into the systems?
A – Mario Rizzo: Yes. I mean for filing used state, certainly, we're filing based on current data as opposed to relying on prior year-end or any of that information. So what we're doing is, Josh, is reacting to the loss trends we're seeing incorporating that into the filing, and that's what kept submitted.
Josh Shanker: Okay. Thank you for the answers to the question.
Operator: One moment for our next question. And our next question comes from the line of Elyse Greenspan from Wells Fargo. Your question, please.
Elyse Greenspan : Hi. Thanks. Good morning. My first question, I wanted to go back to the capital discussion and the decision you guys made to pull the buyback program. Can you just give us a sense of what you're looking for when you return to buybacks? I sense maybe some of this is also dependent going into wind season, right, which could bring additional cat losses to Allstate and you guys are still working on improving the profitability of your auto business. So what would you need to see to turn back on the buyback at some point next year?
Tom Wilson : Elyse, let me start macro and then ask Jesse to maybe dig in even a little more. I know you spend a lot of time on capital, so we can help you show you what we believe to be true. First, we have a long history of proactive managing capital, whether that's how we deploy it at the individual risk level or what we do with different investments, as Jesse talked about, whether it's selling businesses like life and annuities or using alternative capital like reinsurance or cat bonds or providing cash to shareholders through dividends and share repurchases. As you point out, I think if you look at the Q, we bought back about $37 billion of stock since we went public. And so that's because we're -- we got good math, which Jesse will talk about, and we do a proactively. I think the suspending the share repurchase we just sound judgment. If you're not making money, don't buy shares back. It's really not a lot more complicated than that. I mean, it obviously helps you preserve capital, but just sort of good logic always serves the right kind of capital plan, which is you got to make money to be buying shares back. Jesse, do you want to talk about maybe give at least some more specifics on this whole capital?
Jesse Merten : Yes. Good morning, Elyse. I think to build on Tom's point, and I think it's easiest to just think about not the specific question, but more how we think about capital management more broadly. So you focus as many others do on RBC. RBC is a great measure for insurance companies, it's common. We look at it as well. So we certainly understand why there's a focus at times on RBC. It's a measure that served the industry well in good times and in bad times. But I think as you know, RBC has some limitations. So we use it as an input in our capital management process, but not a primary driver, right? RBC is focused on statutory legal entities, but it doesn't incorporate the risk across the enterprise or correlation in those types of risks. It doesn't include sources of capital outside of regulated entities. Protection plans would be an example there. But those aspects are important to our overall capital management framework.
eyes: Now that capital is all available to us and our comprehensive and more precise capital management framework considers those facets. So -- and I think it's important to go back to really how we're managing capital through what we consider to be a very detailed and sophisticated economic capital framework that quantifies enterprise risk and establishes our targets. As we've talked, that includes inputs from regulatory capital models, rating agencies and then our own risk models to help to quantify stress events, and we built those models really off of their risk models that are used to regulate banks. We feel very good about the output of our overall economic capital model. So we use that then as we've discussed, to determine a level of base capital that we need to operate our business while continuing to meet customer needs and amounts that are well above triggering any regulatory involvement. So you've got base capital. On top of that, we hold stress capital for unexpected on frequent outcomes. And then we have a contingent reserve that we use and included in our target capital range, that's really meant to incorporate extreme stress events, extreme low frequency events and just basically things that are beyond the standard probabilities that we apply to our stressed capital calculations. So high catastrophes this quarter used some of the contingent capital reserve, but we continue to hold stress capital that's above our base capital level, and we remain confident in our capital position and our ability to execute on strategy, we look ahead. I think your question gets to the future, right? So I wanted to build a base for reminding everyone how we think about it. But as we look to the future, it's more than just a question of the buybacks, it's what is their capital perspective look like. And we continue to believe we're well capitalized even if it takes longer than we expect to get auto profitability back to targeted levels and even if catastrophes come in at more expected levels, for the rest of the year in 2023. Even at more normal levels of catastrophes for the rest of the year, 2023 will be the highest year for catastrophe losses on a pure dollar basis in about 25 years. So it's a high cap quarter. We continue to feel good about capital, liquidity is not an issue, as we've talked about. We have a strong source of cash through interest payments and maturities that come over the next 12 months, and we have about $5 billion that comes off the portfolio that selling everything in the next 12 months, and we have a highly liquid investment portfolio. We also have a number of capital options that we're continuously evaluating given our proactive approach to capital management, as Tom mentioned. So that includes additional reinsurance options that could allow us to lower the volatility of our earnings at an attractive cost of capital, and we continue to look at those things. I think we've also proven in the last couple of quarters, we have open access to financial markets where we showed that through our -- some of our refinancing activity. So we have a lot of options. I want to kind of close out with -- as it relates to capital options and capital strength, issuing common stock at this point is not something that we're considering. It's not an option that's on the table given how we feel about our overall capital position. So maybe that -- I know it's more than just when you're going to turn back on buybacks. But I want to -- I think the context around how we think about capital management is more important to how we might answer that question in the future. So hopefully, that was helpful.
Elyse Greenspan: That was helpful. And then maybe just one more, right? You did mention reinsurance and some other options that you have. And you did make -- you did in the first quarter, right, you choose to monetize part of your equity portfolio. Is it safe to assume that you think about prospect going forward on the capital side, you're not looking to make any significant changes to investments? And on the same thinking about your current businesses, you're not -- you wouldn't be thinking about monetizing any assets as a way to free up capital?
Tom Wilson: Elyse, so on the investment side, that decision was primarily made from a risk and return standpoint, first starting at the markets. And we thought -- when we made the decision, we thought there is greater opportunity to make money by lengthening duration than by staying in equities. It had the benefit of reducing the volatility of equities. And in our models, the capital charges for equities is a lot higher the bot. So it has that capital benefit. If we felt like the time was right to go back long in public equities, then we would look at it at the time and then we'd say, okay, how much capital do we have and how do we feel about it? But we don't have a date in mind for that. I think when you just look at the economic environment, it's somewhat balanced.
Jesse Merten: And I think as it relates to monetizing assets, Elyse, in that component of the question. I think we certainly understand all the range of options but we don't believe we're in a position right now where we have to be considering things like monetizing assets to bolster capital. Again, we feel good about our capital position. We have options in place, and we understand the full range of options of what we could do in the event we believe that we had a need.
Tom Wilson: We have the capital to make our strategy is, of course, the way we're going to increase shareholder value. One, get profit up. Two, get growth up. And three, broaden the portfolio, which those lands to will lead to a higher multiple, and that's what we're trying to drive to.
Elyse Greenspan: Thanks for all the color.
Operator: Thank you, one moment for our next question. And our next question comes from the line of Michael Zaremski from BMO. Your question, please.
Michael Zaremski: I guess, my first is a quick follow-up on the capital discussion, you said bolstering capital. So I just want to clarify, you reiterated the 14% to 17% ROE targets, which I believe you've been talking about since I believe 2019 could be prior looking at my notes. It seems like there's a disconnect, though, because the shareholders' equity levels ex OCI are down meaningfully since 2019. There's an element of where -- it seems like this is why this company is coming up, investors are expecting that the consensus ROEs look like they're well above the 14% to 17% because people aren't bolstering their capital assumptions, I guess, in the model. So I just want to make sure I'm thinking about this correctly. It's 14% to 17% is still the target. And so we directionally should be making sure we don't turn on the buyback until Cereal's equity levels are bolstered a bit.
Tom Wilson: So first, the 14% to 17% confirmation was just really our way saying we don't see anything that diminishes the ultimate earning power of the company. What the equity base is and what the earnings are, of course, but we -- so we're really just trying to say we don't see anything that diminishes the earning power of the building company. We never said it was a cap. And as I just mentioned, our strategy is really get returns up to where they've been historically, which will increase shareholder value. And then the big differential we have versus progressive and others is we need higher growth to drive the multiple of and we're going to get that two ways to increase market share, personal profit liability to transformative growth. And then secondly, by expanding our protection offerings, which will drive the multiple up. So it's like step 1, step 2. We think they can both hit at the same time, to be honest, but that's what we're driving to.
Michael Zaremski: Okay. That's okay. That's very helpful. My last question is just thinking through all the actions you're taking in terms of expense ratio, pulling back in certain states. I guess it seems clear that in the near term, we should be thinking about PIF [ph] growth remaining under pressure. I'm just curious, too, is that one the right way to think about it? And two, is there -- for your capital model, does PIF growth being negative with total revenue growth still being very positive because of pricing power? Is it -- does it help that you're shrinking PIF, but growing top line because of pricing, or is every dollar of growth still seems the revenue still seem the same way within your capital model?
Tom Wilscon: Capital models are really driven on risk, which are tied to premium. So PIF doesn't really impact it. So -- which is the right economically, we believe the right way to do it. In terms of growth, we think we can -- Mario talked about growth in National General. We talked about growth in 50% of the markets were working there. When those 3 states that we need higher prices on get to the right level, we can grow there as we continue to roll out transformative growth and we'll be in -- we expect to be in 10 states with our new product this year, which will just be in the states and that we drive a lot of growth. but we're using machine-based learning some really cool direct stuff. So we think there's plenty of opportunity to grow. And so we're not concerned about it. The reason we're reducing the growth in those states like if you're not making any money, it doesn't make sense to sell it. Like I don't really understand the logic of we're losing money. Let's go out and spend a bunch of money to get business, and we'll continue to lose money until we can raise the prices later. That just raises your -- if you include those losses in your acquisition cost, it's hard to make the lifetime value work. So we chose not to write the business it's not quite really, as Mario said, it's not really a combined ratio impact. It's just like why do something that's uneconomic.
Michael Zaremski: Understood
Operator: Thank you. One moment for our next question. And our next question comes from the line of Alex Scott from Goldman Sachs. Your questions please.
Alex Scott: Hi. First one I had is on the prior year development. One of the things we noticed from last quarter was just that I think 2022 accident year actually looked like it developed favorably and 2021 was still a bit unfavorable. And I guess I'm just interested what was the mix of that this quarter? And how do we think about sort of the speed up of kind of reaching settlements to reduce volatility on some of the older claims and the impact that's having? And where are you in the process of doing that? Like is there still a good amount of wood to chop there? Have you sort of, gone through the 2021 claims to the extent you're going to do it already. Just any color around all that to help us think through what development could look like through the rest of the year?
A – Jesse Merten: And I'll take that quickly. I think the first thing I would highlight is that the development this quarter was related to National General, so a little bit different than what we went through last year. And we don't separately disclose which prior years, it's attributable to. But it's safe to say -- given the nature of that business, some of the near and years, we continually, Alex, move reserves between years and coverages and prior year reserves and coming up with these estimates. And so it's safe to say that we're really focused on settling -- getting some of those older claims settled, getting the reserves right. And, sort of, again, I'm a broken record on this, but getting the aggregate reserve recorded properly. So this was really -- again, this was -- this quarter is certainly a story of the National General reserve levels. And the movement between prior years and coverage is just normal course this quarter.
Alex Scott: Got it. Thanks. And the second one I had is just a follow-up on, there was a comment earlier related to, I think it was the 35% filing where it was mentioned that, that can take up to 18 months. I mean that one, I think, was filed in late May. So that would suggest would be like all the way towards the end of 2024, if I just take that comment at face value as to like when you potentially get the California approval. I'm just trying to weigh thinking through that versus some of the comments that suggested the regulatory environment may be getting a little better, I mean that seems like a pretty long time line. Can you help us think through and maybe I'm just trying to take that a little to cut and dry?
Tom Wilson: I think I'm probably the one that said 18 months that was not to imply that we think it's right to wait 18 months or it should take 18 months. We just said sometimes it takes a long time, the California department stayed on all rate increases for a couple of years. They're not in that mode anymore, and we're working actively with them because they know that's not a good place to be and it doesn't create a good market. So I think what you can do is just look at the monthly numbers we've put out on rate increases. You can factor that in. You can -- we've given some math on how it rolls into the P&L. And that will give you a good look 12 months forward at what that blue line is that Mario talked about and at what rate is going up. They will tell you what's going to come in. And then you can make your own judgment on what you think severity and frequency will be.
Alex Scott: Got it. That’s helpful. Thanks for clarifying.
Brent Vandermause: Hey, Jonathan, we’ll take one more question.
Operator: Certainly. One moment for our final question then. And our final question for today comes from the line of Yaron Kinar from Jefferies. Your question please.
Yaron Kinar: Thank you. Good morning. Thanks for first allowing me in here. I want to go back to the capital question and the decision to stop the buybacks, if I may. And Tom, I'm certainly -- I appreciate the thought of it doesn't really make sense to buy back stock when we're generating a loss. That said, I think we have seen about $2 billion of buybacks since I think, the second quarter of last year in a loss environment. I think everything you're showing on -- and presenting in the slides would suggest that we are hopefully inflecting in the auto margins. I think even a quarter ago, you were still talking about over $4 billion of holdco liquidity. So I'd just love to better understand what changed or shifted in the thinking here to make you decide to stop here, especially when stock seems to be attractively valued relative to previous buybacks?
Tom Wilson: Let me go back to the genesis of the buyback program and then roll it forward. So it was a $5 billion program, about $3 billion of which was because we're returning capital that was generated by sale of the life and annuity businesses. So it was really a $2 billion net program. We tended to have that program -- that buyback program was usually sized by how much money we made the prior year and we weren't using in growth. So it was in arrears kind of share repurchase program. And that's how we got to $5 billion. So we're 90% of the way there on $5 billon, we couldn't complete it, for sure, and we just decided you're losing money, don't buy stock back. It's just sometimes good capital management is just a common sense as opposed to a specific formula because it's formulas change, correlations change and all that sort of stuff. So from our standpoint, it was really no more complicated. I mean, Jess and I talked for like five minutes were like, okay, another quarter of a loss. A lot of -- lot catastrophes are a lot higher, almost two standard deviations away. We factored that in when we decided on the $5 billion. We factored that in when we looked at last year, keeping the program going. And it was a sensitivity, but it was a sensitivity, not a reality when insurance into a reality, you say, okay, let's just stop buying it back. And if we feel like getting back to it, we will. And we have a strong track record of buying stock back, but what will drive the value of our stock, and I can close on this is not share repurchases. Like we've looked at share repurchases. As I said, we bought $37 billion back. The return on share repurchases, if you take the price that you bought it at and the price of the stock at any point in time. Of course, it varies like it's cheap now, in my opinion. And so it would be good to buyback. But when you look at it over an extended period of time, it kind of turns into the cost of capital, which makes some sense. Sometimes you get a 20% return because you buyback cheap and the stock went on to run. Sometimes you buy it and it stacks up and you get lower return. But when you look at it over a long period of time, so you don't really create shareholder value by doing share buybacks. If you don't do share buybacks, you destroy shareholder value. That's a bad thing. But -- so the way we're going to create shareholder value is get profitability up, execute transformer growth and broaden our -- the product offering to people and things like protection plans, which are low capital, high growth, high-return businesses, health and benefits in the same way. So that's our plan. We look -- thank you for tuning in this quarter, and we'll talk to you next quarter.
Operator: Thank you, ladies and gentlemen, for your participation in today's conference. This does conclude the program. You may now disconnect. Good day. | [
{
"speaker": "Operator",
"text": "Good day, and thank you for standing by. Welcome to Allstate’s Second Quarter Investor Call. At this time, all participants are in a listen-only mode. After the prepared remarks, there will be a question-and-answer session. [Operator Instructions] Please limit your enquiry to one question and one follow-up. As a reminder, please be aware that today’s call is being recorded. And now, I’d like to introduce your host for today’s program, Brent Vandermause, Head of Investor Relations. Please go ahead, sir."
},
{
"speaker": "Brent Vandermause",
"text": "Thank you, Jonathan. Good morning. Welcome to Allstate’s second quarter 2023 earnings conference call. After prepared remarks, we’ll have a question-and-answer session. Yesterday, following the close of the market, we issued our news release and investor supplement, filed our 10-Q and posted related material on our website at allstateinvestors.com. Our management team is here to provide perspective on these results. As noted on the first slide of the presentation, our discussion will contain non-GAAP measures for which are reconciliations in the news release and investor supplement, and forward-looking statements about Allstate’s operations. Allstate’s results may differ materially from these statements, so please refer to our 10-K for 2022 and other public documents for information on potential risks. And now, I’ll turn it over to Tom."
},
{
"speaker": "Tom Wilson",
"text": "Good morning. We appreciate you investing your time in Allstate. Let's start with an overview of results and then Mario and Jesse will walk through operating results and the actions being taken to increase shareholder value. Let's begin on Slide 2. Allstate's strategy has two components; increase personal profit liability market share, and expand protection services, which are shown in the two with on the left. On the right-hand side, you can see a summary of results for the second quarter. Progress is being made on the comprehensive plan to improve auto insurance profitability, which includes raising rates, reducing expenses, limiting growth and enhancing claim processes. While auto insurance margins are not at target levels, the proportion of premium associated with states operating and that underlying -- underwriting profit has gone from just under 30% in 2022 to 50% for the first half of this year. Mario will discuss the actions being taken to continue this trend and importantly, improved results in New York, New Jersey and California. Severe weather in the quarter contributed to a net loss of $1.4 billion, 42 catastrophe events impacted 160,000 customers and resulted in $2.7 billion of catastrophe losses and a property liability underwriting loss of $2.1 billion. Strong fixed income results from higher bond yields generated $610 million of investment income and Protection Services and Health and Benefits generated $98 million of profits in the quarter. The transformative growth plan to become the lowest cost protection provider is making continued progress. This both helps current results with lower costs and positions Allstate for sustainable growth when auto margins return to acceptable levels. Affordable, simple and connected property liability products with sophisticated telematics pricing and differentiated direct-to-consumer capabilities are being introduced under the Allstate brand through a new technology platform. National General was growing, which will also increase market share. Specialty auto expertise, along with leveraging auto’s Allstate strength in preferred auto and homeowners insurance products are expected to drive sustainable growth. Allstate Protection Plans is expanding its embedded protection through new products and retail relationships and in international markets. Allstate has a strong capital position with $16.9 billion of statutory surplus and holding company assets, as Jesse will discuss later. And as you know, we have a long history of providing cash returns to shareholders through dividends and share repurchases. Over the last 12 months, we've repurchased 3.9% of outstanding shares for $1.3 billion. We suspended this is repurchase program in July, as we had a net loss for the six months of the year. Improving profitability, increasing property liability, organic growth and broadening protection offered to customers through an extensive distribution platform will increase shareholder value. Let's review financial results on Slide 3. Revenues of $14 billion in the second quarter increased 14.4% above the prior year quarter of $1.8 billion. The increase was driven by higher average premiums in auto and homeowners insurance from rates taken in 2022 and 2023, resulting in property-liability earned premium growth of 9.6%. Net investment income of $610 million reflects the impact of higher fixed income yields and extended duration, which will substantially increase income. This growth more than offset a decline from performance-based investments in the quarter. The net loss of $1.4 billion and an adjusted net loss of $1.2 billion reflects a profit liability underwriting loss of $2.1 billion due to the $2.7 billion in catastrophe losses and increased auto insurance loss costs. In auto insurance, higher insurance pros and lower expenses were largely offset by higher catastrophe losses and increased claim frequency and severity. The underlying auto insurance combined ratio did improve slightly for the first six months of 2023 compared to the year-end 2022. Auto insurance had an underwriting loss of $678 million. In homeowners insurance, catastrophe losses were substantially over the 15-year average, resulting in a combined ratio of 145, generating an underwriting loss of $1.3 billion. The underlying combined ratio on homeowners improved 1.9 points to 67.6% as higher average premiums more than offset increased severity. Adjusted net income of $98 million from protection services and health and benefits when combined with the $610 million of investment income offset a portion of the underwriting loss. The target for enterprise adjusted net income return on equity remains at 14% to 17%. I'll now turn it over to Mario to discuss profit liability results."
},
{
"speaker": "Mario Rizzo",
"text": "Thanks, Tom. Let's turn to Slide 4. We are seeing the impact of our comprehensive auto profit improvement plan in our financial results, starting with the rate increases we have implemented to date. The chart on the left shows Property-Liability earned premium increased 9.6% above the prior year quarter, driven by higher average premiums in auto and homeowners insurance, which were partially offset by a decline in policies in force. Price increases and cost reductions were largely offset by severe weather events and increased accident frequency and claim severity. The underwriting loss of $2.1 billion in the quarter was $1.2 billion worse than the prior year quarter due to the $1.6 billion increase in catastrophe losses. The chart on the right highlights the components of the combined ratio, including 22.6 points from catastrophe losses. Prior year reserve reestimates, excluding catastrophes, had a 1.6 point adverse impact on the combined ratio in the quarter. Of the $182 million of strengthening in the second quarter, $148 million was in National General, primarily driven by personal auto injury coverages in the 2022 accident year. In addition, prior years were strengthened by approximately $31 million for litigation activity in the state of Florida related to torque reform that was passed in March of this year. We've been closely monitoring the increase in filed suits on existing claims and the charge reflects a combination of higher legal defense costs and a modest loss reserve adjustment. Despite continuing pressure on the loss side, the underlying combined ratio of 92.9 improved modestly by 0.5 points compared to the prior year quarter and 0.4 points sequentially versus the first quarter of 2023. Now, let's move to slide five to discuss Allstate's auto insurance profitability in more detail. The second quarter recorded auto insurance combined ratio of 108.3% was 0.4 points higher than the prior year quarter, reflecting higher catastrophe losses and increased current report year accident frequency and severity, which were largely offset by higher earned premium, expense reductions, and lower adverse non-catastrophe prior year reserve re-estimates. We continue to raise rates, reduce expenses, restrict growth, and enhanced claim processes as part of our comprehensive plan to improve auto insurance margins. This slide depicts the impact of our profit improvement actions on underlying auto insurance profitability trends. As a reminder, we continually assess claim severities as the year progresses. And last year, as 2022 developed, we continue to increase report year ultimate severity expectations. The chart on the left shows the quarterly underlying combined ratios from 2022 through the current quarter with 2022 quarters adjusted to account for full year average severity assumptions, which removes the effect that intra-year severity changes had on recorded quarterly results. After adjusting for the timing of higher severity expectations, the quarterly underlying combined ratio trend was essentially flat throughout 2022. As we move into 2023, the underlying combined ratio has improved modestly in each of the first two quarters, reflecting both the impact of our profitability actions and the continued persistently high levels of loss cost inflation. The chart on the right depicts the percent change at annualized average earned premium shown by the blue line and the average underlying loss and expense per policy shown by the light blue bars compared to prior year-end. Rapid increases in claim severity and higher accident frequency since mid-2021, resulted in significant increases in the underlying loss and expense per policy which outpaced the change in average earned premium and drove a higher underlying combined ratio in both 2021 and 2022. As we've implemented rate increases, the annualized earned premium trend line continues to increase and has begun to outpace the still elevated underlying cost per policy in the first two quarters of 2023, resulting in a modest improvement in the underlying combined ratio. Slide six provides an update on the execution of our comprehensive approach to increase returns in auto insurance. There are four areas of focus; raising rates, reducing expenses, implementing underwriting actions, and enhancing claim practices to manage loss costs. Starting with rates, you remember the Allstate brand implemented 16.9% of rate in 2022. In the first six months of 2023, we have implemented an additional 7.5% across the book, including 5.8% in the second quarter. National General implemented rate increases of 10% in 2022, an additional 5.5% through the first six months of 2023. We will continue to pursue rate increases in 2023 to restore auto insurance margins back to the mid-90s target levels. Reducing operating expenses is core to transformative growth, and we also temporarily reduced advertising to reflect the lower appetite for new business. We continue to have more restrictive underwriting actions on new business in locations and risk segments where we have not yet achieved adequate prices for the risk, but are beginning to selectively remove these restrictions in states and segments that are achieving target margins. To this point, the number of states achieving an underlying combined ratio better than 100 increased from 23 states, which represented just under 30% of Allstate brand auto insurance premium at the end of 2022 and to 36 states, representing approximately 50% of premium at the end of the second quarter. Ensuring that our claim practices are operating effectively and enhancing those practices where necessary, is key to delivering customer value, particularly in this high inflation environment. This includes modifying claim processes in both physical damage and injury coverages by doing things like increasing resources, expanding reinspections and accelerating the settlement of injury claims to mitigate the risk of continued loss development. We are also negotiating improved vendor service and parts agreements to offset some of the inflation associated with repairing vehicles. Slide 7 provides an update on progress in three large states with a disproportionate impact on profitability. The table on the left provides rate increases either implemented so far this year are currently pending with the respective insurance department in California, New York and New Jersey. Because our current prices are not adequate to cover our costs in these states, we have had to take actions to restrict new business volumes. As a result, new issued applications from the combination of California, New York and New Jersey declined by approximately 62% compared to the prior year quarter. In California, we implemented a second 6.9% rate increase in April and also filed for a 35% increase in the second quarter that is currently pending with the Department of Insurance. We continue to work closely with the California Department to secure approval of this filing and restore auto rates to an adequate level. In New York, we implemented approximately three points of weighted rate in June, driven by approved increases in two closed companies. And subsequently received approval for a 6.7% increase in the larger open companies, which was implemented in July, we will continue to make further filings in 2023 that will be additive to their -- to the rates approved so far this year. In New Jersey, we received approval for a 6.9% rate increase in the first quarter and filed a subsequent 29% increase in the second quarter. As mentioned earlier, we anticipate implementing additional rate increases for the balance of 2023 to counteract persistent loss cost increases. Slide 8 dives deeper into how we are improving customer value through expense reductions. The chart on the left shows the property liability underwriting expense ratio and highlights drivers of the 2.5 point improvement in the second quarter compared to the prior year quarter. The first green bar shows the 1.4 point impact from advertising spend, which has been temporarily reduced, given a more limited appetite for new business. The second green bar shows the decline in operating costs, mainly driven by lower agent and employee-related costs and the impact of higher premiums relative to fixed costs. Shifting to our longer-term trend on the right, we remain committed to reducing the adjusted expense ratio as part of transformative growth. This metric starts with our underwriting expense ratio, excluding restructuring, coronavirus-related expenses, amortization and impairment of purchased intangibles and advertising. It then adds in our claims expense ratio, excluding costs associated with settling catastrophe claims because catastrophe-related costs tend to fluctuate. Through innovation and strong execution, we've driven significant improvement with a second quarter adjusted expense ratio of 24.7%. We expect to drive additional improvement, achieving an adjusted expense ratio of approximately 23 by year-end 2024, which represents a 6-point reduction compared to our starting point in 2018. While increasing average premiums certainly represent a tailwind, our intent in establishing the goal is to become more price competitive. This requires a sustainable improvement in our cost structure with our future focus on three primary areas, including enhancing digitization and automation capabilities, improving operating efficiency through outsourcing, business model rationalization and centralized support and enabling higher growth distribution at lower cost through changes in agency compensation structure and new agent models. Now, let's move to slide 9 to review homeowner insurance results, which despite improving underlying performance, incurred an underwriting loss in the quarter driven by elevated catastrophe losses. Our business model incorporates a differentiated product, underwriting, reinsurance and claims ecosystem that is unique in the industry. Our approach has consistently generated industry-leading underwriting results despite quarterly or yearly fluctuations in catastrophe losses. Our homeowners insurance combined ratio, including the impact of catastrophes, has outperformed the industry by 12 points from 2017 through 2022. During that same time period, we generated annual average underwriting income of approximately $650 million. The chart on the left shows key Allstate Protection homeowners insurance operating statistics for the quarter. Net written premium increased 12.4% from the prior year quarter, predominantly driven by higher average gross premium per policy in both the Allstate and National General brands and a 1% increase in policies in force. Allstate brand average gross written premium per policy increased by 13.2% compared to the prior year quarter driven by implemented rate increases throughout 2022 and an additional 7.4 points implemented through the first six months of 2023 as well as inflation in insured home replacement costs. While the second quarter homeowners combined ratio is typically higher than full year results, primarily due to seasonally high severe weather-related catastrophe losses, the second quarter of 2023 combined ratio of 145.3% was among the highest in Allstate's history and increased by 37.8 points compared to last year's second quarter due to a 40.3 point increase in the catastrophe loss ratio. The underlying combined ratio of 67.6% improved by 1.9 points compared to the prior year quarter, driven by higher earned premium, lower frequency and a lower expense ratio, partially offset by higher severity. The chart on the right provides a historical perspective on the second quarter property liability catastrophe loss ratio of 75.9 points, which was elevated compared to historical experience, reflecting an increased number of catastrophe events and larger losses per event. While the second quarter result was 33.9 points above the 15-year second quarter average of 42 points, it is not unprecedented and filled within modeled outcomes contemplated in our economic capital framework. We remain confident in our ability to generate attractive risk-adjusted returns in the homeowners business and continue to respond to loss trends by implementing rate increases to address higher repair costs and limiting exposures in geographies where we cannot achieve adequate returns for our shareholders. And now I'll hand it over to Jesse to discuss the remainder of our results."
},
{
"speaker": "Jesse Merten",
"text": "Thank you, Mario. I'd like to start on Slide 10, which covers results for our Protection Services and Health and Benefits businesses. The chart on the left shows Protection Services where we continue to broaden the protection provided to an increasing number of customers largely through embedded distribution programs. Revenues in these businesses, excluding the impact of net gains and losses on investments and derivatives increased 9.1% to $686 million in the second quarter compared to the prior year quarter. Increase reflects growth in Allstate Protection Plans and Allstate Dealer Services, partially offset by a decline in parity. By leveraging the Allstate brand, excellent customer service and expanded products and partnerships with leading retailers, Allstate Protection Plans continues to generate profitable growth, resulting in an 18% increase in the second quarter compared to the prior year quarter. In the table below the chart, you will see that adjusted net income of $41 million in the second quarter decreased $2 million compared to the prior year quarter, primarily due to higher appliance and furniture claims severity and a higher mix of lower-margin business as we invest in growth at Allstate Protection Plans. We'll continue to invest in these businesses, which provide an attractive opportunity to broaden distribution protection offerings that meet customers' needs and create value for shareholders. Shifting to the chart on the right, Health and Benefits continues to provide stable revenues while protecting more than four million policyholders. Revenues of $575 million in the second quarter of 2023 increased by $2 million compared to the prior year quarter, driven by an increase in premiums, contract charges and other revenues in group health, which was partially offset by a reduction in individual health and employer voluntary benefits. Health and Benefits continues to make progress on rebuilding core operating systems to drive down costs, improve the customer experience and support growth that generates shareholder value. Adjusted net income of $57 million in the second quarter of 2023 decreased $10 million, compared to the prior year quarter, primarily due to the decline in employer voluntary benefits, individual health and higher expenses related to system investments. Now let's move to Slide 11 to discuss investment results and portfolio positioning. Active portfolio management includes comprehensive monitoring of economic conditions, market opportunities, enterprise risk and return and capital, as well as interest rates and credit spreads by rating, sector and individual name. As you'll recall, last year, exposure to below investment grade bonds in public equity was reduced. We maintained this portfolio allocation in the second quarter, which enabled us to extend duration of the fixed income portfolio and increased market-based income levels. As shown in the chart on the left, net investment income totaled $610 million in the quarter, which was $48 million above the second quarter of last year. Market-based income of $536 million, shown in blue was $168 million above the prior year quarter, reflecting repositioning of the fixed income portfolio into longer duration and higher yielding assets that sustainably increased income. Market-based income has also benefited from higher yields for short-term investments in floating rate assets, such as bank loans. Performance-based income of $127 million shown in black, was $109 million below the prior year quarter due to lower valuation increases and fewer sales of underlying assets. Our performance-based portfolio is expected to enhance long-term returns and volatility on these assets from quarter-to-quarter as expected. The chart on the right shows the fixed income earned yield continues to rise and was 3.6% at quarter end compared to 2.8% for the prior year quarter and 3.4% in the first quarter of 2023. This chart also shows that from the fourth quarter of 2021 through the third quarter of 2022, lowering fixed income duration mitigated losses as rates rose. Beginning in Q4 of 2022, we began to extend duration, which locks in higher yields for longer. In the second quarter, we further extended duration to 4.4 years, increasing from 4 years in the first quarter. Our fixed income portfolio yield is still below the current intermediate corporate bond yield of approximately 5.5%, reflecting an additional opportunity to increase yields. To close, I'd like to turn to Slide 12 to discuss how Allstate proactively manages capital to provide the financial flexibility, liquidity and capital resources necessary to navigate the challenging operating environment. Capital management is based on a sophisticated framework that quantifies capital targets by business, product, geography, investment type and for the overall enterprise. Targets include a base level of capital for expected volatility and earnings as well as additional capital for stress events, situations where correlations between risks are higher than modeled and other contingencies. This model enables us to proactively manage capital in a dynamic and uncertain environment. Utilization of reinsurance, both by event and in aggregate is assessed relative to overall enterprise risk levels. A robust reinsurance program is in place with multiyear contracts to mitigate losses from large catastrophes. Homeowners insurance geographic exposures are managed to generate appropriate risk-adjusted returns, including lowering exposure to California and Florida property markets. This framework was used to decide to purchase additional aggregate program coverage this year. Reducing high-yield bonds and public equities in the investment portfolio significantly reduced the amount of enterprise capital required for investments. This decision was based on market conditions and the decline in auto profitability as well as the desire to reduce volatility and statutory results. It also provides a sustainable source of increased income in capital generation. The decline in auto insurance profitability is also captured by our framework, which increased capital requirements for auto insurance from pre-pandemic levels to reflect recent results. The capital management framework ensures Allstate has the financial flexibility, liquidity and capital resources necessary to operate in challenging environments and be positioned for growth. Allstate's capital position is sound with estimated statutory surplus and holding company assets totaling $16.9 billion at the end of the second quarter, as shown on the table to the left. Holding company assets of $3.3 billion represent approximately 2.5x our annual fixed charges with no debt maturities for the remainder of 2023 and a modest amount maturing in 2024. Senior debt and preferred stock refinancing in the first and second quarters of this year demonstrate our ability to readily access capital markets to address maturities as they arise. In response to the loss this quarter, we have suspended share repurchases under the $5 billion authorization, which is 90% complete. This authorization expires in March of 2024. In addition to having a strong capital base, Allstate has a history of generating capital and statutory net income in our largest underwriting company, Allstate Insurance Company, as you can see on the chart on the right. Statutory net income averaged $1.9 billion annually in the 10 years prior to the onset of COVID. You can also see the impact of the rapid increase in auto insurance claim severity and recent catastrophe loss experience on 2022 and 2023 statutory net income. We're confident that the auto insurance profit improvement plan will restore profitability. The homeowner's insurance business is designed to generate underwriting profits, and proactive investment management will create additional capital to grow market share, expand protection offerings and provide cash return to shareholders. Allstate will continue to proactively manage capital to navigate the current operating environment and be well positioned for growth to increase its shareholder value. With that as context, let's open up the line for your questions."
},
{
"speaker": "Operator",
"text": "Certainly, one moment for our first question. [Operator Instructions] Our first question comes from the line of Gregory Peters from Raymond James. Your question, please."
},
{
"speaker": "Gregory Peters",
"text": "Well, good morning, everyone. I guess, I'm going to focus on auto insurance profitability for my first question. And obviously, there's a bunch of slides in your presentation, the one where you identified the three states. I guess from a bigger picture perspective, though, -- do you have updated views on frequency and severity for the second half of this year or for next year versus what you were thinking at the beginning of the year I guess what I'm ultimately getting is how much more rate do we need to get that underlying combined ratio number that you use on the slide 6 -- excuse me, slide 5 to get it down to the low to mid-90s."
},
{
"speaker": "Tom Wilson",
"text": "Greg, this is Tom. Let me start, and then Mario can jump in. First, as it relates to frequency and severity, of course, it's hard to predict what's going to happen in the second half of the year. What we do know is that the severity was increased in the second -- first half of this year from what we thought it would be when we looked at it last year. So we're really glad we took the rates that we did, and we've been accelerating rates, as Mario talked about. I think when you look at it, it's really -- of course, it's hard to predict, right? What you're really looking at is that slide that Mario showed that had the line with the average premiums going up and then the bar with the severities and you want that line to be above the bar, of course. What you know going forward is that the line is going to keep going up, right? Like we filed those rates, we've got those rates. We put them in the computer, we're collecting the cash. And so you know that's going to happen. What you don't know is whether severity will go up from the 11% or whether it will be down from the 11%. It's come down this year from last year. We'd like to think that all the work we're doing will have it come down even further. And so that gap will get you back to the mid-90s that we talked about in terms of targeted combined ratio. When that exactly happens, of course, is dependent on what happens to the second bar, which is not known. What we do know is we'll continue to take increased rates and make that line continue to go up. Mario, any specifics you want to add on the three states that you mentioned or?"
},
{
"speaker": "Mario Rizzo",
"text": "I think, Greg, the thing I'd add is less about to Tom's point, what we expect going forward and more about what we're seeing and maybe just give you a little more color underneath the loss cost trend. So as you remember, last quarter, we started giving you pure premium trends as opposed to coverage specific frequency and severity because we just think it's a better way for you to evaluate where overall profitability is going. And the point I'd make is if you look on Slide 5, as Tom pointed out, for the first couple of quarters this year, we've seen the average earned premium trend begin to outpace the increases in loss and expense. It's hard to predict what the future will hold, but that's an encouraging development. Underneath that loss trend, if you look at where we're at in the second quarter compared to where we were for the full year last year, the increase in pure premium is about 12.5%, and we told you that severity is up on average across all coverages by about 11%. So what we're seeing still is persistently high severity across coverages with a lesser impact from overall frequency increases. The point being we're going to continue to aggressively implement our profit improvement plan, you've seen what we've done with rates. We've done 7.5 points through the first half of this year in the Allstate brand, 5.5 points on National General. We're going to continue to do that. You see the benefit that the cost reductions is having on the combined ratio while that rate earns in. And we've talked a lot about those three states, which make up about one-quarter of our book, California, New York and New Jersey. We want to keep pushing on continuing to drive rate increases into the book. We've gotten some approvals so far this year, but there's rates pending, pretty significant rates pending in California and New Jersey, and we're prepared to file another rate in New York. So we're going to keep pushing really hard on that. And in the meantime, we've scaled way back on new business production in those states. And while it's having a reasonably small impact on the loss ratio so far this year, because new business just tends to be a smaller proportion of our overall book, it will continue to have a favorable impact on our loss ratio going forward. And until we get to adequate rates in those three states, we're going to keep restricting the volume of business we're willing to write."
},
{
"speaker": "Gregory Peters",
"text": "Okay. Thanks for the color. Maybe just keeping on auto as my follow-up question on NatGen, you spoke about the reserve strengthening in the quarter, and I guess you also mentioned Florida in your comments. Can you give us any perspective on the reserve strengthening that happened inside NatGen? Is it a true-up and that you're comfortable where the trends are with matching reserves at this point in time, or is this going to be another situation where we have a couple of quarters of catch-up that we're having to deal with?"
},
{
"speaker": "Tom Wilson",
"text": "Mario can answer how we feel about the growth and the profitability of the growth in National General, Greg, let me just settle up context. So first, the acquisition of National General is exceeding our expectations. As, you know, we bought the company so that we could consolidate our Encompass business into it that would reduce the cost and create a stronger business that we're serving independent agents. We like what we got there. The consolidation and the cost reductions are exceeding our expectations. And that was the basis under which we agreed to where the economics of the acquisition made at. The upside from there was growing in the IA channel, both through the specialty vehicle product and by building new products for preferred auto and homeowners insurance using Allstate's expertise, both of which are also becoming reality. Mario, do you want to talk about, I guess, both reserves. But I think Greg's underlying question there was like you're growing, is that a good thing?"
},
{
"speaker": "Mario Rizzo",
"text": "Yes. So, Greg, the place I'd start with National General, you're right. We're growing in National General that's principally in the specialty vehicle or the non-standard auto part of the business, which that market continues to experience pretty significant disruption. A couple of things I'd say on NatGen. First of all, the underlying combined ratio in the quarter was 96%, and 96% is slightly higher than we want to run it at, but it's pretty close to our target margin. And that 96% includes the kind of roll-forward impact of increasing reserves principally in the 2022 accident year and therefore, increasing our loss expectations in the 2023 year. So, that's all embedded in the 96%. A couple of things in addition to that, that I mentioned. We've talked a lot about the profit improvement plan, we're implementing that same approach in that same plan in National General across the same levers we're using in the Allstate brand. We've taken 5.5 points of rate this year, 11 points of rate over the last 12 months in NatGen. And given that it's predominantly a non-standard auto book, the book tends to turn over and get repriced pretty rapidly. So, we're comfortable that the rate we've taken so far this year is working its way into the system. And I would say in response to a higher loss trend that we've seen in 2023, we've accelerated our plan to take rate in 2023. So, we're ahead of that 5.5 points is ahead of where we expected to be at this point during the year. We've also restricted underwriting guidelines in a number of states, we're writing more liability-only less full coverage. So, we're being really selective about what we're writing. And the other benefit, as Tom mentioned, part of the rationale around acquiring National General was the opportunity to lower costs and improve the expense ratio, and we're benefiting from that inside that 96% underlying combined ratio. We've seen a pretty significant improvement year-over-year in the underwriting expense ratio as we essentially take advantage of scale through the growth we're getting. So, comfortable where we're positioned. We're taking the appropriate actions from a profitability perspective. And so we're comfortable with what we're writing in NatGen right now."
},
{
"speaker": "Gregory Peters",
"text": "Got it. Thank you for the detail and your answers."
},
{
"speaker": "Operator",
"text": "Thank you. And our next question comes from the line of Josh Shanker from Bank of America. Your question please."
},
{
"speaker": "Josh Shanker",
"text": "Thank you very much for taking my question. Yes. Tom, there's the amount of rate that you need and the amount that you can get over a certain period of time, but when you look back to the beginning of the year and you had your plan for taking rates and you've learned about some changes in frequency and severity over the past six, seven months. Has that changed the perspective on how much rate you need and want to ask for? And does that change the 2023 plan, or does that mean that the regulators will give you only so much and you have get that rate in 2024 and beyond?"
},
{
"speaker": "Tom Wilson",
"text": "Of course, it's -- I would say, Josh, it's a good question, but I would say it's not like not like every quarter or every 6 months, we adapt it is like every day. So Mario and Guy are constantly looking at our pricing, and we're going to maximum file rates everywhere we can, and we're not getting as much pushback from goes because the numbers are pretty clear. Like it's not like we're making it up, you pay for the cars and they see the cash go out so you -- and they do have to pay attention to what the rules are in the rating. Now we have 3 states, which are a problem, and we're working aggressively with them. so that we can get the right amount of it. But yes, so our -- the rate expectation for the year has gone up from the beginning of the year. And it will keep going up until we get to our target combined ratio. We have -- we've talked about some of the issues we have in some of those states, you see us agreeing to lower amounts than we actually need because the time value of money and the multiplication works for you. So why take a 6.9 when you need 35 in California because you can get 6.9 right away as opposed you could wait 18 months to get 35. So we've we're very sophisticated and have good relationships with them, so we can manage it so that it meets our needs. So and we'll just keep rate that's on auto, which I assume where you're going, Josh. Same thing applies in homeowners and our price increases are up a little bit, but not up as much as what we thought they were going to be. but they're still from where we set out where we thought would be in the beginning. Mario, add anything you would add?"
},
{
"speaker": "A – Mario Rizzo",
"text": "Yes. Just a couple of additional data points, Josh. As Tom mentioned, our data is immediately -- our indications are immediately responsive to the data we're seeing. So we're constantly updating rate indications and filing for what we need based on what we're actually experiencing versus what we thought we would have needed going into the year. And the other point I'd make is, and this is on a couple of the states that we've spiked out for you. We're evaluating trade-offs and leaning in where we think it just makes sense. So for example, in California, got the 2 6.9% rate and we turned around and filed for essentially our full indication at 35, knowing that, that was likely to require a longer review period. There was a little more risk there, but we thought it was the right thing to do. In New Jersey, we did the same thing. We got the 6.9% rate approved, which is essentially the cap that the state hold you to, but then we opted to utilize an administrative provision and file for a 29% rate. So again, we're aggressively pushing on the amount of rate we need based on the loss experience where we've got in real time. And we're going to keep doing that. and keep pushing rate through and working with all the departments and each of the regulators to get those rates approved as quickly as we can to continue to bend the line on that loss trend."
},
{
"speaker": "Q – Joshua Shanker",
"text": "And outside of the 3 problem states, when you are submitting the filing, does the filing need to be audit financial statements or financial data in arrears, or can you pretty much file new rate with current data as it's coming into the systems?"
},
{
"speaker": "A – Mario Rizzo",
"text": "Yes. I mean for filing used state, certainly, we're filing based on current data as opposed to relying on prior year-end or any of that information. So what we're doing is, Josh, is reacting to the loss trends we're seeing incorporating that into the filing, and that's what kept submitted."
},
{
"speaker": "Josh Shanker",
"text": "Okay. Thank you for the answers to the question."
},
{
"speaker": "Operator",
"text": "One moment for our next question. And our next question comes from the line of Elyse Greenspan from Wells Fargo. Your question, please."
},
{
"speaker": "Elyse Greenspan",
"text": "Hi. Thanks. Good morning. My first question, I wanted to go back to the capital discussion and the decision you guys made to pull the buyback program. Can you just give us a sense of what you're looking for when you return to buybacks? I sense maybe some of this is also dependent going into wind season, right, which could bring additional cat losses to Allstate and you guys are still working on improving the profitability of your auto business. So what would you need to see to turn back on the buyback at some point next year?"
},
{
"speaker": "Tom Wilson",
"text": "Elyse, let me start macro and then ask Jesse to maybe dig in even a little more. I know you spend a lot of time on capital, so we can help you show you what we believe to be true. First, we have a long history of proactive managing capital, whether that's how we deploy it at the individual risk level or what we do with different investments, as Jesse talked about, whether it's selling businesses like life and annuities or using alternative capital like reinsurance or cat bonds or providing cash to shareholders through dividends and share repurchases. As you point out, I think if you look at the Q, we bought back about $37 billion of stock since we went public. And so that's because we're -- we got good math, which Jesse will talk about, and we do a proactively. I think the suspending the share repurchase we just sound judgment. If you're not making money, don't buy shares back. It's really not a lot more complicated than that. I mean, it obviously helps you preserve capital, but just sort of good logic always serves the right kind of capital plan, which is you got to make money to be buying shares back. Jesse, do you want to talk about maybe give at least some more specifics on this whole capital?"
},
{
"speaker": "Jesse Merten",
"text": "Yes. Good morning, Elyse. I think to build on Tom's point, and I think it's easiest to just think about not the specific question, but more how we think about capital management more broadly. So you focus as many others do on RBC. RBC is a great measure for insurance companies, it's common. We look at it as well. So we certainly understand why there's a focus at times on RBC. It's a measure that served the industry well in good times and in bad times. But I think as you know, RBC has some limitations. So we use it as an input in our capital management process, but not a primary driver, right? RBC is focused on statutory legal entities, but it doesn't incorporate the risk across the enterprise or correlation in those types of risks. It doesn't include sources of capital outside of regulated entities. Protection plans would be an example there. But those aspects are important to our overall capital management framework."
},
{
"speaker": "eyes",
"text": "Now that capital is all available to us and our comprehensive and more precise capital management framework considers those facets. So -- and I think it's important to go back to really how we're managing capital through what we consider to be a very detailed and sophisticated economic capital framework that quantifies enterprise risk and establishes our targets. As we've talked, that includes inputs from regulatory capital models, rating agencies and then our own risk models to help to quantify stress events, and we built those models really off of their risk models that are used to regulate banks. We feel very good about the output of our overall economic capital model. So we use that then as we've discussed, to determine a level of base capital that we need to operate our business while continuing to meet customer needs and amounts that are well above triggering any regulatory involvement. So you've got base capital. On top of that, we hold stress capital for unexpected on frequent outcomes. And then we have a contingent reserve that we use and included in our target capital range, that's really meant to incorporate extreme stress events, extreme low frequency events and just basically things that are beyond the standard probabilities that we apply to our stressed capital calculations. So high catastrophes this quarter used some of the contingent capital reserve, but we continue to hold stress capital that's above our base capital level, and we remain confident in our capital position and our ability to execute on strategy, we look ahead. I think your question gets to the future, right? So I wanted to build a base for reminding everyone how we think about it. But as we look to the future, it's more than just a question of the buybacks, it's what is their capital perspective look like. And we continue to believe we're well capitalized even if it takes longer than we expect to get auto profitability back to targeted levels and even if catastrophes come in at more expected levels, for the rest of the year in 2023. Even at more normal levels of catastrophes for the rest of the year, 2023 will be the highest year for catastrophe losses on a pure dollar basis in about 25 years. So it's a high cap quarter. We continue to feel good about capital, liquidity is not an issue, as we've talked about. We have a strong source of cash through interest payments and maturities that come over the next 12 months, and we have about $5 billion that comes off the portfolio that selling everything in the next 12 months, and we have a highly liquid investment portfolio. We also have a number of capital options that we're continuously evaluating given our proactive approach to capital management, as Tom mentioned. So that includes additional reinsurance options that could allow us to lower the volatility of our earnings at an attractive cost of capital, and we continue to look at those things. I think we've also proven in the last couple of quarters, we have open access to financial markets where we showed that through our -- some of our refinancing activity. So we have a lot of options. I want to kind of close out with -- as it relates to capital options and capital strength, issuing common stock at this point is not something that we're considering. It's not an option that's on the table given how we feel about our overall capital position. So maybe that -- I know it's more than just when you're going to turn back on buybacks. But I want to -- I think the context around how we think about capital management is more important to how we might answer that question in the future. So hopefully, that was helpful."
},
{
"speaker": "Elyse Greenspan",
"text": "That was helpful. And then maybe just one more, right? You did mention reinsurance and some other options that you have. And you did make -- you did in the first quarter, right, you choose to monetize part of your equity portfolio. Is it safe to assume that you think about prospect going forward on the capital side, you're not looking to make any significant changes to investments? And on the same thinking about your current businesses, you're not -- you wouldn't be thinking about monetizing any assets as a way to free up capital?"
},
{
"speaker": "Tom Wilson",
"text": "Elyse, so on the investment side, that decision was primarily made from a risk and return standpoint, first starting at the markets. And we thought -- when we made the decision, we thought there is greater opportunity to make money by lengthening duration than by staying in equities. It had the benefit of reducing the volatility of equities. And in our models, the capital charges for equities is a lot higher the bot. So it has that capital benefit. If we felt like the time was right to go back long in public equities, then we would look at it at the time and then we'd say, okay, how much capital do we have and how do we feel about it? But we don't have a date in mind for that. I think when you just look at the economic environment, it's somewhat balanced."
},
{
"speaker": "Jesse Merten",
"text": "And I think as it relates to monetizing assets, Elyse, in that component of the question. I think we certainly understand all the range of options but we don't believe we're in a position right now where we have to be considering things like monetizing assets to bolster capital. Again, we feel good about our capital position. We have options in place, and we understand the full range of options of what we could do in the event we believe that we had a need."
},
{
"speaker": "Tom Wilson",
"text": "We have the capital to make our strategy is, of course, the way we're going to increase shareholder value. One, get profit up. Two, get growth up. And three, broaden the portfolio, which those lands to will lead to a higher multiple, and that's what we're trying to drive to."
},
{
"speaker": "Elyse Greenspan",
"text": "Thanks for all the color."
},
{
"speaker": "Operator",
"text": "Thank you, one moment for our next question. And our next question comes from the line of Michael Zaremski from BMO. Your question, please."
},
{
"speaker": "Michael Zaremski",
"text": "I guess, my first is a quick follow-up on the capital discussion, you said bolstering capital. So I just want to clarify, you reiterated the 14% to 17% ROE targets, which I believe you've been talking about since I believe 2019 could be prior looking at my notes. It seems like there's a disconnect, though, because the shareholders' equity levels ex OCI are down meaningfully since 2019. There's an element of where -- it seems like this is why this company is coming up, investors are expecting that the consensus ROEs look like they're well above the 14% to 17% because people aren't bolstering their capital assumptions, I guess, in the model. So I just want to make sure I'm thinking about this correctly. It's 14% to 17% is still the target. And so we directionally should be making sure we don't turn on the buyback until Cereal's equity levels are bolstered a bit."
},
{
"speaker": "Tom Wilson",
"text": "So first, the 14% to 17% confirmation was just really our way saying we don't see anything that diminishes the ultimate earning power of the company. What the equity base is and what the earnings are, of course, but we -- so we're really just trying to say we don't see anything that diminishes the earning power of the building company. We never said it was a cap. And as I just mentioned, our strategy is really get returns up to where they've been historically, which will increase shareholder value. And then the big differential we have versus progressive and others is we need higher growth to drive the multiple of and we're going to get that two ways to increase market share, personal profit liability to transformative growth. And then secondly, by expanding our protection offerings, which will drive the multiple up. So it's like step 1, step 2. We think they can both hit at the same time, to be honest, but that's what we're driving to."
},
{
"speaker": "Michael Zaremski",
"text": "Okay. That's okay. That's very helpful. My last question is just thinking through all the actions you're taking in terms of expense ratio, pulling back in certain states. I guess it seems clear that in the near term, we should be thinking about PIF [ph] growth remaining under pressure. I'm just curious, too, is that one the right way to think about it? And two, is there -- for your capital model, does PIF growth being negative with total revenue growth still being very positive because of pricing power? Is it -- does it help that you're shrinking PIF, but growing top line because of pricing, or is every dollar of growth still seems the revenue still seem the same way within your capital model?"
},
{
"speaker": "Tom Wilscon",
"text": "Capital models are really driven on risk, which are tied to premium. So PIF doesn't really impact it. So -- which is the right economically, we believe the right way to do it. In terms of growth, we think we can -- Mario talked about growth in National General. We talked about growth in 50% of the markets were working there. When those 3 states that we need higher prices on get to the right level, we can grow there as we continue to roll out transformative growth and we'll be in -- we expect to be in 10 states with our new product this year, which will just be in the states and that we drive a lot of growth. but we're using machine-based learning some really cool direct stuff. So we think there's plenty of opportunity to grow. And so we're not concerned about it. The reason we're reducing the growth in those states like if you're not making any money, it doesn't make sense to sell it. Like I don't really understand the logic of we're losing money. Let's go out and spend a bunch of money to get business, and we'll continue to lose money until we can raise the prices later. That just raises your -- if you include those losses in your acquisition cost, it's hard to make the lifetime value work. So we chose not to write the business it's not quite really, as Mario said, it's not really a combined ratio impact. It's just like why do something that's uneconomic."
},
{
"speaker": "Michael Zaremski",
"text": "Understood"
},
{
"speaker": "Operator",
"text": "Thank you. One moment for our next question. And our next question comes from the line of Alex Scott from Goldman Sachs. Your questions please."
},
{
"speaker": "Alex Scott",
"text": "Hi. First one I had is on the prior year development. One of the things we noticed from last quarter was just that I think 2022 accident year actually looked like it developed favorably and 2021 was still a bit unfavorable. And I guess I'm just interested what was the mix of that this quarter? And how do we think about sort of the speed up of kind of reaching settlements to reduce volatility on some of the older claims and the impact that's having? And where are you in the process of doing that? Like is there still a good amount of wood to chop there? Have you sort of, gone through the 2021 claims to the extent you're going to do it already. Just any color around all that to help us think through what development could look like through the rest of the year?"
},
{
"speaker": "A – Jesse Merten",
"text": "And I'll take that quickly. I think the first thing I would highlight is that the development this quarter was related to National General, so a little bit different than what we went through last year. And we don't separately disclose which prior years, it's attributable to. But it's safe to say -- given the nature of that business, some of the near and years, we continually, Alex, move reserves between years and coverages and prior year reserves and coming up with these estimates. And so it's safe to say that we're really focused on settling -- getting some of those older claims settled, getting the reserves right. And, sort of, again, I'm a broken record on this, but getting the aggregate reserve recorded properly. So this was really -- again, this was -- this quarter is certainly a story of the National General reserve levels. And the movement between prior years and coverage is just normal course this quarter."
},
{
"speaker": "Alex Scott",
"text": "Got it. Thanks. And the second one I had is just a follow-up on, there was a comment earlier related to, I think it was the 35% filing where it was mentioned that, that can take up to 18 months. I mean that one, I think, was filed in late May. So that would suggest would be like all the way towards the end of 2024, if I just take that comment at face value as to like when you potentially get the California approval. I'm just trying to weigh thinking through that versus some of the comments that suggested the regulatory environment may be getting a little better, I mean that seems like a pretty long time line. Can you help us think through and maybe I'm just trying to take that a little to cut and dry?"
},
{
"speaker": "Tom Wilson",
"text": "I think I'm probably the one that said 18 months that was not to imply that we think it's right to wait 18 months or it should take 18 months. We just said sometimes it takes a long time, the California department stayed on all rate increases for a couple of years. They're not in that mode anymore, and we're working actively with them because they know that's not a good place to be and it doesn't create a good market. So I think what you can do is just look at the monthly numbers we've put out on rate increases. You can factor that in. You can -- we've given some math on how it rolls into the P&L. And that will give you a good look 12 months forward at what that blue line is that Mario talked about and at what rate is going up. They will tell you what's going to come in. And then you can make your own judgment on what you think severity and frequency will be."
},
{
"speaker": "Alex Scott",
"text": "Got it. That’s helpful. Thanks for clarifying."
},
{
"speaker": "Brent Vandermause",
"text": "Hey, Jonathan, we’ll take one more question."
},
{
"speaker": "Operator",
"text": "Certainly. One moment for our final question then. And our final question for today comes from the line of Yaron Kinar from Jefferies. Your question please."
},
{
"speaker": "Yaron Kinar",
"text": "Thank you. Good morning. Thanks for first allowing me in here. I want to go back to the capital question and the decision to stop the buybacks, if I may. And Tom, I'm certainly -- I appreciate the thought of it doesn't really make sense to buy back stock when we're generating a loss. That said, I think we have seen about $2 billion of buybacks since I think, the second quarter of last year in a loss environment. I think everything you're showing on -- and presenting in the slides would suggest that we are hopefully inflecting in the auto margins. I think even a quarter ago, you were still talking about over $4 billion of holdco liquidity. So I'd just love to better understand what changed or shifted in the thinking here to make you decide to stop here, especially when stock seems to be attractively valued relative to previous buybacks?"
},
{
"speaker": "Tom Wilson",
"text": "Let me go back to the genesis of the buyback program and then roll it forward. So it was a $5 billion program, about $3 billion of which was because we're returning capital that was generated by sale of the life and annuity businesses. So it was really a $2 billion net program. We tended to have that program -- that buyback program was usually sized by how much money we made the prior year and we weren't using in growth. So it was in arrears kind of share repurchase program. And that's how we got to $5 billion. So we're 90% of the way there on $5 billon, we couldn't complete it, for sure, and we just decided you're losing money, don't buy stock back. It's just sometimes good capital management is just a common sense as opposed to a specific formula because it's formulas change, correlations change and all that sort of stuff. So from our standpoint, it was really no more complicated. I mean, Jess and I talked for like five minutes were like, okay, another quarter of a loss. A lot of -- lot catastrophes are a lot higher, almost two standard deviations away. We factored that in when we decided on the $5 billion. We factored that in when we looked at last year, keeping the program going. And it was a sensitivity, but it was a sensitivity, not a reality when insurance into a reality, you say, okay, let's just stop buying it back. And if we feel like getting back to it, we will. And we have a strong track record of buying stock back, but what will drive the value of our stock, and I can close on this is not share repurchases. Like we've looked at share repurchases. As I said, we bought $37 billion back. The return on share repurchases, if you take the price that you bought it at and the price of the stock at any point in time. Of course, it varies like it's cheap now, in my opinion. And so it would be good to buyback. But when you look at it over an extended period of time, it kind of turns into the cost of capital, which makes some sense. Sometimes you get a 20% return because you buyback cheap and the stock went on to run. Sometimes you buy it and it stacks up and you get lower return. But when you look at it over a long period of time, so you don't really create shareholder value by doing share buybacks. If you don't do share buybacks, you destroy shareholder value. That's a bad thing. But -- so the way we're going to create shareholder value is get profitability up, execute transformer growth and broaden our -- the product offering to people and things like protection plans, which are low capital, high growth, high-return businesses, health and benefits in the same way. So that's our plan. We look -- thank you for tuning in this quarter, and we'll talk to you next quarter."
},
{
"speaker": "Operator",
"text": "Thank you, ladies and gentlemen, for your participation in today's conference. This does conclude the program. You may now disconnect. Good day."
}
] | The Allstate Corporation | 18,711 |
ALL | 1 | 2,023 | 2023-05-04 09:00:00 | Operator: Thank you for standing by, and welcome to Allstate's First Quarter 2023 Earnings Conference Call. [Operator Instructions] As a reminder, today's program is being recorded. And now, I'd like to introduce your host for today's program, Mr. Mark Nogal, Head of Investor Relations. Please go ahead, sir.
Mark Nogal: Thank you, Jonathan. Good morning. Welcome to Allstate's first quarter 2023 earnings conference call. After prepared remarks, we'll have a question-and-answer session. Yesterday, following the close of the market, we issued our news release and investor supplement, filed our 10-Q and posted related material on our website at allstateinvestors.com. Our management team is here to provide perspective on these results. As noted on the first slide of the presentation, our discussion will contain non-GAAP measures for which there are reconciliations in the news release and investor supplement, and forward-looking statements about Allstate's operations. Allstate's results may differ materially from these statements, so please refer to our 10-K for 2022 and other public documents for information on potential risks. As some of you know, this will be my final earnings call as the leader of our Investor Relations team, and I will be transitioning to a new role in our P&C finance area supporting National General. I'm leaving Investor Relations in the capable hands of Brent Vandermause, who will be a great partner for all of you going forward. And now, I'll turn it over to Tom.
Tom Wilson: Good morning. We're excited for Mark, and we're completely confident that Brent is going to give you everything you need to help you decide how and why you want to invest in Allstate. So good morning. We appreciate the investment of your time in Allstate today. Let's start with an overview results, and then Mario and Jess are going to walk through the operating results and the actions that we're taking to increase shareholder value. So let's start on Slide 2. Allstate's strategy, as you know, has two components, increased personal property-liability market share and expand protection services. Those are shown in the two ovals on the left. If you go to the right-hand side of the slide, you can see a summary of the results for the first quarter. We had a net loss of $346 million in the first quarter, which reflects a property liability underwriting loss which was only partially offset by strong investment income and profits from protection services and health and benefits. We're making good progress on executing the comprehensive plans to improve auto insurance profitability, and of course, we'll have a substantive discussion on that today. Not to be overlooked, we also continue to advance Transformative Growth plan, which is to execute the top oval there, which is to increase Property-Liability market share. At the same time, Allstate Protection Plans in the lower oval continues to expand its product offering and geographic footprint. Let's review the financial results on Slide 3. Revenues of $13.8 billion in the first quarter increased 11.8% or nearly $1.5 billion as compared to the prior year quarter. The increase was driven by higher average premiums in auto and homeowners insurance, resulting in Property-Liability earned premium growth of 10.8%. In the auto insurance line, higher insurance premiums and lower expenses were essentially offset by increased loss costs, so the profit improvement plan has not yet returned margins to historical levels. The auto insurance line had an underwriting loss of $346 million in the quarter. In homeowners, the story is really about $1.7 billion of catastrophes, which led to an underwriting loss of $534 million. The total underwriting loss was just under $1 billion. Net investment income of $575 million benefited from higher yields, which mostly offset an income decline from performance-based investments. Protection Services and Health and Benefits generated adjusted net income of $90 million in the quarter. As a result, the adjusted net loss was $342 million or $1.30 a share. Now let me turn it over to Mario to discuss Property-Liability results.
Mario Rizzo: Thanks, Tom, and good morning, everybody. Let's flip to Slide 4. The chart on the left shows the Property-Liability recorded and underlying combined ratio since 2017. As you can see, Allstate has a long history of generating strong underwriting results though the current operating environment is challenging, with combined ratios over 100 last year and into the first quarter. The underlying combined ratio of 93.3 for the first quarter was slightly below the full year 2022. The second chart compares the full year 2022 recorded combined ratio for all lines of business to the first quarter of this year, which removes the influence of intra-year severity changes that occurred throughout 2022. The first red bar shows the underlying loss ratio was essentially unchanged as higher premiums were offset by increased loss costs. The second red bar on the left shows most of the increase in the combined ratio was driven by higher catastrophe losses, reflecting the widespread severe weather in the first quarter of this year. Expenses were lower by 1.9 points of premiums and minimal non-catastrophe prior year reserve reestimates also had a positive impact. Let's move to Slide 5 to review Allstate's auto insurance profitability in more detail. As you can see from the chart on the left, which shows the auto insurance recorded and underlying combined ratios from 2017 through the current quarter, we have a long history of sustained profitability in auto insurance as we successfully leveraged our capabilities and pricing sophistication, underwriting and claims expertise and expense management to generate excellent returns in the auto insurance business. Since mid-2021, loss costs have increased rapidly, driving combined ratios above our mid-90s target. The profit improvement plan is designed to address these significant loss cost increases, and we're making good progress. The chart on the right compares the recorded combined ratio of 104.4 in the first quarter to full year 2022 results. Starting on the left, higher average earned premiums drove a 5.7 point favorable impact, which is shown in the first green bar. The first red bar reflects a 6.5 point increase in underlying loss cost due to increased accident frequency and severity for the 2023 report year, with severity currently projected in the 9% to 11% range above the full prior report year. A lower expense ratio reflects expense reductions and higher earned premiums. The remaining difference was due to catastrophes and prior year reserve reestimates. All in, both the recorded and underlying combined ratios of 104.4 and 102.6, respectively, improved in the first quarter of 2023 compared to the full year of 2022. Slide 6 provides an update on the execution of our comprehensive approach to increase returns in auto insurance. There are four focus areas, raising rates, reducing expenses, implementing underwriting actions and enhancing claim practices to manage loss costs. Starting with rates. Following increases of 16.9% in 2022, the Allstate brand implemented an additional 1.7% of rate increases in the first quarter. We will continue to pursue rate increases in 2023 to restore auto insurance margins. Reducing operating expenses is core to Transformative Growth. We have also temporarily reduced advertising to reflect a lower appetite for new business. We implemented more restrictive underwriting actions on new business in locations and risk segments where we have not yet achieved adequate prices for the risk. As we move through 2023, it is likely that some of these restrictions will be removed where there are profitable growth opportunities. Enhancing claim practices in a high inflation environment is key to delivering customer value. This includes leveraging strategic partnerships and scale with repair facilities and parts suppliers to mitigate the cost of repairing vehicles. In addition, settlement of pending bodily injury claims has been accelerated to avoid continued increases in costs and settlements. Transitioning to Slide 7. Let's discuss progress in three large states with a disproportionate impact on auto profitability. The table depicts Allstate brand auto new business production and rate actions for California, New York and New Jersey. As a result of implemented profitability actions, new issued applications from the combination of California, New York and New Jersey declined by 40% compared to the prior year quarter. The decline in these three states meaningfully contributed to the 22% decline countrywide. The right-hand portion of the table provides rate increases either taken or needed to improve margins. In California, we just received approval for a second 6.9% rate increase implemented in April, which will be effective in June. We continue to work closely with the California Department on the best path forward to getting rates to an adequate level and expect to file for an additional increase in the second quarter, which will reflect the balance of our full rate need. In New York, we filed for additional rate in the first quarter that is currently pending with the Department of Financial Services. In New Jersey, we attained a 6.9% rate increase in the first quarter and expect to pursue additional filings in the second quarter. As mentioned earlier, we anticipate implementing additional rates across the country into 2023 to counteract persistent loss cost increases. Slide 8 dives deeper into how we are improving customer value through expense reductions. The chart on the left shows the property liability underwriting expense ratio over time and highlights drivers of the 2.9 points of improvement in the first quarter compared to the prior year quarter. The first green bar on the left shows the 2 point improvement impact from advertising spend, which has been reduced given a limited interest in new business at current rate levels. The last two green bars show a decline in operating and distribution costs mainly driven by lower agent and employee-related costs and the impact of higher premiums. Shifting to our longer-term target on the right, we remain on pace to reducing the adjusted expense ratio to 23 by year-end 2024 as part of transformative growth. This metric starts with our underwriting expense ratio excluding restructuring, coronavirus-related expenses, amortization and impairment of purchased intangibles and advertising. It then adds in our claims expense ratio, excluding costs associated with settling catastrophe claims because catastrophe-related costs tend to fluctuate. Through innovation and strong execution, we've driven significant improvement relative to 2018, with first quarter adjusted expense ratio of 24.9. We expect to drive additional improvement, achieving an adjusted expense ratio of approximately 23 by the end of next year by represents a 6-point reduction compared to 2018. The increase in average premiums certainly represents a tailwind, however, our intent in establishing the goal is to become more price competitive. This requires a sustainable reduction in our cost structure, with future focus on three principal areas, including enhancing digitization and automation capabilities, improving operating efficiency through outsourcing, business model rationalization and centralized support, and enabling higher growth distribution at lower costs through changes in agency compensation structure and new agent models. Now let's move to Slide 9 to review homeowner insurance results, which incurred an underwriting loss in the quarter despite favorable underlying performance due to elevated catastrophe losses. We have a superior business model that includes differentiated product, underwriting, reinsurance and a claims ecosystem that is unique in the industry. As you can see by the chart on the left, this approach consistently generates industry-leading underwriting results despite quarterly or yearly fluctuations in catastrophe losses. The chart on the right shows key Allstate Protection homeowners insurance operating statistics for the first quarter. Net written premium increased 11.1% from the prior year quarter, predominantly driven by higher average gross written premium per policy in both the Allstate and National General brands and a 1.4% increase in policies in force. The first quarter homeowners combined ratio of 119 increased by 35.1 points compared to the prior year quarter, reflecting higher catastrophe losses primarily related to five large wind events in March. These accounted for more than 70% of catastrophe losses in the quarter. The first quarter catastrophe loss ratio was significantly elevated compared to the prior year and 10-year historical average by 36.2 and 30.5 points, respectively. The underlying combined ratio of 67.6 improved 0.4 points compared to the prior year quarter, driven by higher earned premium and a lower expense ratio partially offset by higher claim severity. Slide 10 provides an update on Transformative Growth. Transformative Growth remains a focus and is being executed in parallel with our profit improvement actions. We continue to make good progress on this multiyear initiative that spans five main components: improving customer value, expanding customer access, increasing sophistication and investment in customer acquisition, modernizing the technology ecosystem and driving organizational transformation. The bottom half of the slide highlights recent progress by intended outcome. Providing the lowest cost insurance through expense reductions, broad distribution and pricing sophistication is key to growth. Our Allstate brand relative competitive position has deteriorated recently as rate increases have exceeded some competitors. We expect that those competitors will eventually raise rates, improving our competitive position and growth prospects. Distribution has been expanded by launching middle market and preferred products through independent agents under the National General brand. These products are currently available in approximately 25% of the U.S. market, with a plan to be in nearly every market by the end of next year. Our new affordable, simple and connected auto product creates a differentiated customer experience, which is expected to become available in approximately one-third of the U.S. through the direct distribution channel by the end of this year, deploying a new technology stack, integrating technology across brands and retiring legacy technology applications provides increased agility and lowers costs. This will be reflected in the sunset of the Esurance and Encompass technology platforms next year. We believe transformative growth will lead to increased market share, and hence, higher company valuation multiples. And now, I'll turn it over to Jess to discuss the remainder of our results.
Jess Merten: All right. Thank you, Mario. Let's start with Slide 11, which covers results for our Protection Services and Health and Benefits businesses. Chart on the left shows Protection Services revenues excluding the impact of net gains and losses on investments and derivatives, which increased 7% to $671 million in the first quarter compared to the prior year quarter. Increase reflects growth in Allstate Protection Plans and Allstate Dealer Services, partially offset by a decline in Arity. By leveraging the Allstate brand, excellent customer service, expanded product offerings and partnerships with leading retailers, Protection Plans continues to generate profitable growth, resulting in a 17% increase in the first quarter compared to the prior year quarter. In the table below the chart, you will see that adjusted net income of $34 million in the first quarter decreased $19 million compared to the prior year, primarily due to higher appliance and furniture claim severity and a higher mix of lower-margin business as we invest in growth at Allstate Protection Plans. We will continue to invest in these businesses which provide an attractive opportunity to meet our customers' needs and create value for shareholders. Shifting to the chart on the right, Health and Benefits provide stable revenues and is consistently profitable while protecting more than 4 million customers. Revenues of $583 million in the first quarter of 2023 increased by $3 million compared to the prior year quarter as an increase in group health and other revenue was partially offset by a reduction in individual health and employee benefits. Health and Benefits operating systems are being rebuilt to lower costs and support growth, which will leverage the Allstate brand and customer base to generate shareholder value. Adjusted net income of $56 million was in line with the prior year quarter. Effective January 1, 2023, we adopted the FASB guidance, revising the accounting for certain long-duration insurance contracts in the Allstate Health and Benefits segment using the modified retrospective approach to the transition date of January 1, 2021. This had an immaterial impact on our results. Now let's move to Slide 12, which depicts trends in our investment portfolio allocation. Our active portfolio management includes comprehensive monitoring of markets, sectors and individual names, and we proactively reposition based on our views of economic conditions, market opportunities and the risk return trade-off. Asset class holdings are shown on the left. Our $63.5 billion investment portfolio includes a large allocation to high quality interest bearing assets, which has increased in recent years. In response to increasing recession risks, we defensively position the portfolio in 2022 by reducing our exposure to below investment grade bonds and public equity. We maintain this defensive position in the first quarter with additional reductions in our public equity exposure. Our performance based portfolio shown in green and gray enhances long-term returns and is broadly diversified with more than 400 assets. The portfolio is largely U.S. exposure that span vintage years, sponsors and sectors. Exposure to real estate and commercial mortgage loans is modest at $2.8 billion or 4% of the portfolio and is focused on more resilient sectors such as industrial and multifamily. We hold only $230 million in office properties for mortgages. In addition to real estate, we have selective exposure to the banking sector totaling about $4.5 billion and consists primarily of investment-grade, fixed income securities issued by large financial institutions. We hold $240 million of exposure to regional banks, primarily larger regional banks, and we did not realize significant losses related to recent bank failures. Our high-quality portfolio provides flexibility to take advantage of investment opportunities as economic conditions evolve while providing substantial liquidity to protect our customers. Let's shift from investment allocation to performance on Slide 13. As shown in the table at the bottom of the chart on the left, total return on our portfolio was 2.4% in the first quarter and 1.2% over the last 12 months. Net investment income, shown in the chart on the left, totaled $575 million in the quarter, which is $19 million below the first quarter of last year. Market-based income of $507 million, shown in blue, was $184 million above the prior year quarter following the proactive decision to reposition the market-based portfolio into higher market yields and an increase in fixed income funded by our reduction in public equity. Performance-based income of $126 million, shown in black, was $180 million below a strong prior year quarter. Volatility from quarter-to-quarter on these assets is expected. Our portfolio management and the allocation of risk capital to investments is highly integrated with the assessment of risk-adjusted return opportunities across the enterprise. As you'll recall, in response to declines in auto insurance profitability, last year, we defensively positioned the portfolio against rising rates and reduced our exposure to recession sensitive assets. As market rate grows, we began to increase the duration in the fourth quarter and ended the first quarter at four years. This duration extension locks in higher yields and income for longer while positioning the portfolio to benefit from potential future reductions in interest rates. The chart on the right shows the fixed income earned yield continues to rise and was 3.4% at quarter end. Our portfolio yield is still below the current intermediate corporate bond yield of approximately 5.1%, reflecting an additional opportunity to increase yields if rates stay at these levels. To close, let's turn to Slide 14 to discuss Allstate's strong financial position and prudent approach to capital management. In light of recent financial events impacting the banking industry, let's start with an overview of Allstate's liabilities. As you can see in the chart on the left, our liabilities primarily consist of property casualty claim reserves and unearned premiums that are not subject to unpredictable or immediate demand for repayment. Our sophisticated economic capital framework quantifies enterprise risk to establish capital targets by business, product, geography and investment while also providing additional capital for stress events or contingencies. The framework incorporates regulatory capital standards, proprietary econometric modeling, I struggled with that, rating agency criteria and other external assessments. It's used through the company from individual product and state-based decisions to establishing the appropriate amount of capital for each company and the overall corporation. Allstate's capital of $19.2 billion exceeds our target capital based on this framework. Our ratings remain strong, with S&P and Moody's assigning an issuer credit rating of A minus and A3, respectively, to our recent senior debt offering. Holding company assets of $4.2 billion as of the end of the first quarter represent approximately 2.5x our annual fixed charges. We returned $377 million to shareholders in the quarter through dividends and share repurchases. As a sign of our financial strength and commitment to shareholder returns, the common dividend was increased by 4.7% in the first quarter and paid in early April. With that as context, let's open up the line for questions.
Operator: [Operator Instructions] And our first question comes from the line of Gregory Peters from Raymond James. Your question please.
Gregory Peters: Well, good morning, everyone. A lot to unpack in your comments. I think what I'd like to do for my question and follow-up would be to focus on, first, Slide 5. And I was interested in your comments about the average underlying loss ratio, I think, up 6.5% in first quarter versus the average earned premium being a good guide for 5.7%. I guess the question would be, is the expectation that 6.5% is going to continue? And when will the average earned premium go beyond where the underlying loss ratio deterioration is?
Tom Wilson: I'll get Mario to dig in on claim expenses. When you look at the 5.7%, I'll remind you -- first, good morning, Greg. I'll remind you that remember, this is a number that's been trending up as the rates that we took in '21 and '22 start to be earned in. So we would expect that number to continue to increase as we earn in the rates we've already implemented, and so we think this. In terms of claims severity, I'll let Mario give you an update on where we are and what we're thinking about.
Mario Rizzo: Yes. Good morning, Greg. So in terms of claims severity, what we disclosed this quarter was across major coverages. We're running in the 9% to 11% range in both physical damage and in injury coverages. Really, the drivers of those costs, if you start with physical damage, we continue to see pretty persistent inflation particularly in parts and labor costs to repair cars. Actually, used car prices or total values for used cars actually came down a little bit in the first quarter in our numbers, but we had a higher percentage of total loss frequency which impacted the mix, so those are really the drivers. And on bodily injury, it's the same things we've been talking about. Medical inflation, medical consumption and attorney representation. So I think the drivers of severity continue to persist. In terms of where they're going forward, it's really anybody's guess, but I think our perspective is, and we've been pretty consistent on this point, we're going to continue to take prices up. We've been doing that really since the fourth quarter of 2021 throughout last year. That continued into the first quarter. We're going to continue to, on a forward-looking basis, implement rate increases to first catch up and then outpace loss cost trends. But our perspective on rates as we continue to need to push more price through the system, and we intend to do that throughout the balance of 2023.
Gregory Peters: Right. On Slide 7, you -- in your comments, you talked about those three states. And I guess a follow-up question would be, where do you think that's going to go from a rate perspective? I think you said in your comment, Mario, that you expect to file the balance of your full rate need in California, and won't that trigger a different process causing a delay in potential rate approvals? So give us some color on that slide, please.
Mario Rizzo: Sure. So first I'll start with -- as we talked about, we just got approval for a second 6.9% auto rate increase in California, so we're -- going back to the fourth quarter of last year, we've got approval for 2 6.9% rates, and we've done that by working closely with the department to lay out our data and our loss costs. In those conversations, and I think you've seen some of this across the industry, the department is really encouraging carriers to file for the rate need that they have in their book as opposed to going forward with 6.9% rate increase filings, and it's really based on just the volume of rate filings they're getting. So as we talk to the commissioner and the department, we got -- we're able to secure approval for the two 6.9% rate increases, and we intend on filing the balance of our rate need going forward. Does that create risk in intervention? It does. But I think we need to get California auto prices back to where they need to be so that we can create the kind of availability for consumers, really, that they deserve in California. So we're going to work with the department closely, we're going to make that filing, and then we'll see where that takes us going forward.
Tom Wilson: So Greg, I think embedded in your question is, will you be challenged on something above 6.9%? The strategy that [Guy Hill] and team put into place was take 6.9% -- get 6.9%, don't have to have a consumer advocate come in and look at it, get another 6.9% and then go for the full rate. So what you're seeing us do it in three chunks. Other people have tried to do it other ways. We think this is the right way for us.
Gregory Peters: Got it. In New York, New Jersey?
Mario Rizzo: Yes. We got some rate filings pending with the New York department that hopefully will get resolved soon. And then New Jersey, you see, we were able to implement a rate increase and we're going to come back and file another rate increase. So we're working hard to get these three states off of this page.
Gregory Peters: Got it. Thank you for the answers.
Operator: Thank you. One moment for our next question. And our next question comes from the line of Paul Newsome from Piper Sandler. Your question please.
Paul Newsome: Good morning. I was hoping you could give us a little bit more additional color on the risk inflation rate. Is it fair to say that what we saw in the first quarter was an acceleration of frequency or severity trends that was unexpected? And if so, maybe you could talk about a little bit more of the pieces that were that much worse that may have seemed to have caught some people in the industry off guard.
Tom Wilson: Paul, you're breaking up a little bit, so let me just make sure I get it. So we're talking about auto insurance severity trends first quarter versus -- is that a tick up from what you saw last year? Or is it the level on? If that's the question, I'll just -- Mario can jump into that.
Mario Rizzo: Yes. I guess what I would say about severity, again, in that 9% to 11% range is it just remains persistently high, I think, is how I would describe it, and that's true across coverages. It's certainly lower than what our expectations were for severity last year, what our ultimate forecast is for 2022. But it still remains at elevated levels, which is why I go back to we're going to need to continue to push rate through the system through the balance of this year to combat that inflation.
Paul Newsome: Is that -- should we interpret that as a further acceleration of rate? I mean, I think you were expecting to put rate -- more rate anyway, right? I guess the question is do we have a step function up a little bit from where we would have been?
Tom Wilson: Yes. Paul, I think there's a little bit of -- I mean, when you're looking at the percentages, it gets a little confusing when you're in a high increase environment. So if you looked at the numbers that Mario was talking about, are the percentages up versus the full year of 2022, not versus the first quarter of last year. As you know, the percentages kept going up as we move throughout the year and we adjusted our results, so what we've decided to do is to talk about the percentages up versus the full year. And I think, Mario, it is -- said it well, which is it continues to be high. And so we're trying to -- if you look at the percentage up versus what we thought it was in the first quarter, it would be higher than 10% to 11%, but it's not higher than what we thought the first quarter was at the end of last year. So as it relates to pricing, we're looking at just total loss cost frequency and severity, and we have to -- we believe we have to continue to increase prices this year. As Mario talked about, we were up almost 17% in the Allstate brand last year. I don't know. We don't have a target for what it will be this year. As Mario said, it's going to be what it needs to be.
Paul Newsome: No, that's helpful. I always appreciate the help, and I'll let some other folks ask questions. Thank you very much.
Operator: Thank you. One moment for our next question. And our next question comes from the line of Elyse Greenspan from Wells Fargo. Your question please.
Elyse Greenspan: Hi, thanks. Good morning. My first question, I just wanted to talk about your RBC ratio. I mean, we see the cat losses and we can see the impact that that would have had on statutory income in the quarter. But you guys also did cut your equity investments in half, which I think could have maybe a 20-point benefit in RBC. Is there a way for you guys to walk through the moving components of RBC in the quarter and give us a sense of where your RBC ratio would be within AIC at the end of the Q1?
Tom Wilson: Elyse thanks for the question. Let me provide a little overview and then Jess will jump into the specifics. The headline would be, we don't just look at RBC. And so as Jess said, so -- I mean, if you step back and say, what are the learnings from the recent bank failures? Having a capital problem is not something that just happens to you like an auto accident [ph], right? It's a result of a series of choices made over time. So in terms of our series of choices, we had this really comprehensive set of processes around those choices that are highly analytical. We look at all kinds of scenarios. We look at it frequently, and as a result of that, we come up with what we think the right amount of capital. It includes things like RBC it includes things, like the rating agencies it includes. In some cases, we are more restrictive in terms of the amount of capital we think we need than other people. So we don't play the game of RBC arbitrage, so to speak, and fool ourselves. With that, Jess, do you want to talk about how you think about capital and where we're at?
Jess Merten: Yes. Thanks, Tom. I mean I think, as you and I have talked before at least, we try and take a look at our capital position using our sophisticated economic capital I know it's not just the RBC ratios. We don't - just to be clear to your specific question. We don't publish and have not published the RBC ratio for this quarter, and so I'm not in a position to take you through the bits and pieces on this call. I think directionally, you and others have noted what the RBC impacts would be. But I think it's more important to think about the way that we manage capital and the way that we look at it on a comprehensive basis, not just and RBC basis. And I think you've seen reflected in the results that we continue to proactively manage our overall capital position. So again, I go back to our economic capital model, the sophisticated and comprehensive way that we look at capital, including all different sources and uses, and feel confident in our capital position being, as I said in my prepared remarks, above our internal targeted levels.
Tom Wilson: But you shouldn't take the fact that we have less equity as a statement that we thought we needed to save capital. We have less public equity holdings, because we didn't think it was a good risk return trade-off, which John [ph] will be happy to talk about it if somebody wants to go through. But we think we have plenty of capital on this business.
Elyse Greenspan: Thanks. And then my second question, your personal auto underlying loss ratio did improve sequentially, right? There are some noise, right, as there were some true-ups in the fourth quarter last year. And also, I thought that seasonally, Q1 for auto tends to be better. But I guess when we put this altogether and you guys you are talking about taking - still earning in some - a good amount of rate increases. Do you think that the personal auto loss ratio peaked in the first quarter and should we expect it to improve from here?
Tom Wilson: Well, first, we think the profit improvement plan is working. I would say, Elyse, that if you just summarize the first quarter, I would say we held serve, we held serve in the face of, if you're a tennis fan, 120-mile an hour serve, which was called continued high increase in severity. How will - we'll return the ball, and as you point out, it's about where it was last year. It is improved sequentially in the fourth quarter, but you're absolutely right. Yes, there were some other things going around in the fourth quarter related to the first, second and third quarter of last year. So it's not quite fair to say that it improved. I would just say we held serve. We feel good about where we're going. In our mind, it's a question of when, not if we will get back to how we make profitability. And that's, of course, dependent on what happens with inflation and costs.
Elyse Greenspan: Thank you.
Operator: Thank you. One moment for our next question and our next question comes from the line of Yaron Kinar from Jefferies. Your question please.
Yaron Kinar: Thank you. Good morning. May be starting with the current capital position, the reallocation of some of the investments, can you maybe talk about how you see the capital in maybe capital market stress scenarios? And I'm sure you run those internally, any color you can offer around that would be much appreciated?
Tom Wilson: Yaron, I'm not exactly sure. Maybe you can give me another layer down in the question so we can get specific for you?
Yaron Kinar: Sure. So I think you're talking about, what, roughly $4 billion of liquidity or access about the holdco and I think, $16 billion of liquidity. What happens to those - we find capital markets stressed? I don't know if there's another 25% decrease in the equity market, maybe a credit cycle. I'm not exactly sure what kind of scenario to paint, because I don't want to put you on the spot with a specific set of declines. But I'm sure you do test, this excess capital availability against stresses in the system?
Tom Wilson: Yes. No, it's a good point. Let me get John to answer that. I'll give you a little overview [ph]. First, I would just say analytics everywhere. It counts for everyone despite. So whether that's using sophisticated models is that where they toll the car or extending duration or what we're doing with capital. And so, when we look at the extension of duration, I think John ran like nine different scenarios, how to do it, what to do it, what and - so we're all over that. When it comes to stress events in the capital markets, we look at all kinds of alternatives there. Everything from -- and what do we do with the government defaults to what do we do if there's more bank failures. And so we have - and John can tell you sort, of how he's thinking about how we allocate assets in the portfolio relative to stress events in today's market. I would say from an overall capital standpoint, which is we got plenty of money. Like you saw our liabilities, they're very predictable, and so nobody is going to run in and say give us back our $10 billion and we don't have it. At the same time, we have a really highly liquid portfolio, because so much of it's in investment-grade fixed income. If it's fixed - investment-grade fixed income market is completely shut down, we would still probably be fine. Right now probably we would be fine, because we're having cash come in terms of unearned premiums every day, so we don't really have any overall liquidity issues. But in terms of capital market stress and how you think about that from an investment decisions and where we're invested today, John can give you some perspective.
John Dugenske: Yes, Yaron, thank you so much for the question. Just a piece of data, if we can trade a security, we've had $5 billion of cash coming in the next year just by things that are rolling off. It's highly integrated into the overall data and analytics quantitative framework across the enterprise. So I answered this question, I feel confident that scores of people on the investment team could answer too, because it's part of the way that we think. We're not managing an investment portfolio separate from the way that we think about the enterprise. Tom talked a little bit about the duration trade that we did that was highlighted in the materials. That's not taken in isolation of how all the other securities in the portfolio would perform and it's not taken in isolation on how we think about the entire enterprise, what happens in underwriting and other areas. We run probably 100 different scenarios on a daily basis that look back at things that have happened in the past, things that could happen in the future, what that means for returns and what that means for capital. And we subscribe to getting the order of ready, aim and fire, right? So we really aim a lot as we think about our investment profile.
Yaron Kinar: Thanks. And then maybe shifting back to the auto book, is the piece or the cadence of rate increases that you expect to file in auto kind of similar to where it was when we ended in 2022 or do you see maybe additional rate increases are necessary today relative to the plan at the beginning of the year?
Tom Wilson: Where is, the plan at the beginning of the year. So maybe I'll give an overview, Mario, with an analogy and you can bear. We're running as fast and as hard as we can on rates everywhere. If we need them, we're really running fast and hard. If we think, we're actually adequately priced in some states where we are today, we're still paying attention. We're still on the track. We're so warmed up and ready to run if we need to be.
Mario Rizzo: Yes. What I would add Yaron, I'm going to go back to a comment I made earlier, which is we've been pretty consistent on this point of the need to take prices up going back to last year, and that hasn't changed. Now obviously, we react to new data, new information in real-time and the absolute amount of rate we take is going to be dependent on that updated data. As Tom mentioned earlier, we rely on heavy-duty analytics to manage the business and we respond to what's happening in real time, so the amount of rate we need will be dependent on how loss costs play out over time for us. But we're going to continue to push rate through the system. We've been successful at that. I wouldn't get too hung up on quarter-to-quarter fluctuations because that quarterly number is going to bounce around in terms of the rates that were approved in a particular state, and the size of those rates. But I think thematically, I'm going to go back to what we've been saying now for -- over the last year, which is we're going to continue to take the rate that we need to get auto margins back to where they need to be, which is in the mid-90s targets that we have.
Yaron Kinar: Thanks and good luck, Mark, with the new role.
Mario Rizzo: Thank you.
Operator: Thank you. One moment for our next question, and our next question comes from the line of Andrew Kligerman from Credit Suisse. Your question please.
Andrew Kligerman: Thank you and good morning. I'm trying to unpack the earlier comment about used car prices coming down a bit, because the Manheim Index was up about 8.6%, and that's kind of a forward-looking indicator. So maybe you could kind of give a little color on what your expectation there is for used car prices? Does that kind of fit in your 9% to 11% or could - of projected severity increase or could it be materially higher as we look out in the year?
Mario Rizzo: Hi Andrew, it's Mario. Thanks for the question. I guess what I'd start with, there's, a number of indices for used car prices. I think you mentioned one with Manheim that tends to focus on wholesale prices. And I think as we all know, that metric was coming down most of last year. Certainly in the back half of last year, and then it started to tick up in the end of the fourth quarter and has continued into this year. What I was referring to earlier is actual total loss severity, which tends to lag the Manheim Index and is more a function of retail used car prices, which have improved, and that's what I was referring to in the quarter. What we saw was actually used car - or I'm sorry, total loss severity actually improved a little bit year-over-year. In terms of the risk going forward, I think, yes. If you look at what's happening with the Manheim Index and other indices. Certainly, they're headed in a different direction than they were headed for much of last year, which adds risk. We've tried to factor that into our severity expectations in terms of what we're recording that 9% to 11% range. But what we actually saw in the first quarter of this year was a modest improvement in total loss severity.
Andrew Kligerman: Got it, all right. Thank you on that. And then it was interesting following National General with auto policies in force now of about $4.6 million off pretty significantly from $4.1 million last year. It looks like you're getting good rate increases. Your combined underlying was 94%, so which is pretty decent. So looking forward, it sounds like you haven't fully rolled it out. Is this something that could really catapult your policy in force at a very responsible return? I mean, maybe a little color on how that - what your expectations over the next year to -- for policy growth and doing so profitably?
Tom Wilson: Andrew thanks for focusing in on National General. For summary, we feel really good about the acquisition of National General. If you just start with the math, the numbers, it's exceeded our expectations and assumptions, because as you'll remember, we've mostly bought that so we could reduce our expenses in the independent agent channel by folding, basically having them reverse acquire Encompass, we just happen to buy them first. And so they've - and that's ahead of plan and the numbers are bigger. So, we're feeling really good about that, and that's the way we price the deal. You're - strategically, which is where you're after, we're also getting the benefit of now having a solid plan for an independent agent channel, which we did not before. We've been struggling to get a good platform so they have good technology, good relationships, as you point out, mostly in the nonstandard stuffing. Mario, I think in his comments, mentioned how we're now taking those relationships and that technology platform and we're putting what we call mid-market, which is basically standard auto and homeowners, on that platform, and that's going to give us great growth opportunities because we're using the Allstate expertise in both standard auto and - not to be underestimated, one bit really is our business model and homeowners. We think that's a great growth opportunity and which is basically icing on the cake relative to the acquisition. So, we feel really good about we're in that channel. It's part of Transformative Growth. It's part of increasing market share and personal profit liability, and we're pleased with the results.
Andrew Kligerman: Awesome, thank you.
Operator: Thank you. One moment for our next question and our next question comes from the line of Josh Shanker from Bank of America. Your question please.
Josh Shanker: Yes, thank you. I want to talk about segmentation and policy count. Obviously, the net decline in the auto policy count was quite high this quarter. Do you have some sort of advice or thoughts to think about how much policy count will decline over this repricing period? But two, I also note that homeowners policy count was flat which suggests in the segmentation, there's different policyholders you're keeping versus different policyholders you're losing. So I thought you might be able to touch on both things?
Tom Wilson: Good. Mario, why don't you talk about homeowners and what we're doing there to drive growth? As it relates to auto insurance, we just talked about sort of the Allstate brand, I think, which may be the numbers you're referring to, which is down versus Andrew's comment about National General, which is off. On the Allstate piece, there's, obviously two components. One is, are you selling more new business? And then the second is what's happening with retention. And as it relates to new business, we've taken the approach that a prospective rate increase is like a new business penalty. So as you know, when you sell a business, you're going to have - you got expenses. It is getting the customers more to get them right in front, and then the loss ratio is typically higher for new business than it is for existing business. If you need 10 points of rate on top of what you're currently selling it to, we've factored that into our growth projections on new business and said, well this -- at the very least, it's an additional 10 points of new business penalty. The worst is that when you raise your prices by 10%, all the money you spent getting the customer is wasted, because they go away and you churn it. So we've dialed back new business and advertising not so much, because we're trying to manage the P&L, but because we're managing the economic growth. And we think needing rate increases and going out and getting a new customer and saying, it's great, you bought it for $1,000. And then six months later saying, well, it was really $1,100 is not a good plan. So we've dialed back new business, and you see that really across the board. And Mario showed in some places, even more aggressively, like New York, New Jersey, and California have kidded Mario that like, you'll know every new business customer we get in New York if we keep this up personally. So that's basically an economic choice. On retention, of course, that's the customer's choice and it depends what happens in the marketplace and what other people are doing. Our retention has gone down. We do model that out. It's really very difficult to take those old models, so -- and give yourself any kind of good estimate on the current view because a couple of things have changed. One, these are much bigger increases than those models had in them. So those models are based on 5%, 6%, 7%, not on 10%, 12% or 15% or 14% [ph] in Texas. And at the same time, those models don't have the kind of competitive environment you're operating in where everybody else is raising rates at the same time. So we've shutdown new business, because we think it's economic and there's an increased new business penalty associated with being underpriced, and then we're managing to. What we want to do, of course, is we're highly focused on improving customer value, because people pay more, you got to do more for them. And so, we're working hard on making sure we do insurance reviews, get our agents for them [ph] homeowners is another great story that I think we've kind of - we get so focused on auto. We haven't really put - it's a great business model. Mario can talk about what we're doing to grow that business.
Mario Rizzo: Yes. Thanks for the question, Josh. And homeowners, again, as I talked about in the prepared remarks, is a business that we continue to feel really good about in terms of where it's positioned from a profitable growth perspective. And what you saw in the quarter is that we actually increased policy count by about 1.4%. Retention actually picked up by a temp. And I think there's a couple of things when you kind of unpack what's happening with retention in homeowners because much -- as Tom talked about, we're having to take prices up in auto. The way we're taking price increases is in a highly segmented and targeted way, and that's helping from a retention perspective on homeowners because those bundled customers tend to be our longest-tenured, most profitable customers. We also bundle about 80% of homeowners' policies have on supporting auto line and the retention on a bundled customer where a homeowner that has an auto policy is meaningfully higher than a monoline homeowners, and we're continuing to see the benefit of that. And we've put processes in place both in terms of economic incentives for our agents and sales processes in the call centers on the direct side to incent additional bundling. And we're seeing some nice trends in terms of bundling rates, which is certainly helping homeowner growth through homeowner retention. We're going to continue to look for ways to grow the homeowner business. We think it provides a really compelling risk and return opportunity for us. The results are going to bounce around because there's volatility. This quarter is an example of that with catastrophe losses, but we continue to see our underlying combined ratio and loss ratio improve, and both through leveraging the tactics I talked about for retention production, particularly with bundled customers, we think we can continue to grow that line.
Josh Shanker: Are the bundlers having the same problem that they get quoted or rate an entire six months later? Or is your pricing such that you can comfortably quote a bundle right now and think that you're going to retain them for 12 months?
Mario Rizzo: Yes, we're obviously quoting bundled customers right now. And when you look at the business we are writing, we're seeing really nice improvements in terms of quality and lifetime value, which is indicative of that bundling rate. And so yes, we're quoting it. And the other thing you got to remember, and this is true both from a retention and a new business perspective. Bundling, it's an easier experience and a more streamlined experience for customers. There's discounts associated with bundling as well that can help offset higher auto rates and incent customers to stay with us.
Josh Shanker: Thank you for the detailed answers.
Operator: Thank you. One moment for our next question. Our next question comes from the line of Brian Meredith from UBS. Your question please.
Brian Meredith: Thanks. A couple of questions here for you. First one, I'm just curious, I saw your expense ratio is down about 1 point x ad spend. Where are we in this Transformational Growth as far as the expense ratio reduction? How much can we potentially see here additional going forward? And then maybe on the -- an add on to that, what kind of a normalized ad spend as a percentage of earned premium, so we can kind of get a view on what our expense ratio should ultimately end up?
Mario Rizzo: Yes, Brian, this is Mario. Thanks for the question. Again, expenses as much as Tom talked earlier about, earned premium and loss ratio, we kind of held serve there. We did see the benefit of a lower expense ratio both in terms of the underwriting expense ratio and the adjusted expense ratio. Where we're at in the kind of continuum on the adjusted expense ratio, we set a goal to get that adjusted ratio down to about 23 by the end of 2024. And we're making really good progress on that, you saw continued progress on that this quarter. We certainly are being helped by higher earned premium which leveraged our cost. But we're continuing to see reductions in both operating costs and distribution-related costs, which are helping the expense ratio. And I talked a little bit earlier about the areas we're focused on, whether it's automation, digitization, sourcing and continuing to drive both operating and distribution costs down. We're going to -- those are really going to be the levers we pull to push the expense ratio ultimately to that goal that we set with Transformative Growth. So we're making good progress, feel really good about that. In terms of the level of marketing spend, certainly, we spent less this quarter on marketing than we did a year ago, and we've pulled that back. I think as Tom said earlier, really from an economic risk and return perspective, it doesn't make a lot of sense for us to invest aggressively in marketing at a time when our prices aren't adequate. But what we will do over time has more rates and -- or, I'm sorry, more states and more markets get to a rate level that we're comfortable with, we're going to surgically lean in. And as one of the components of Transformative Growth, we're going to look to both increase the level and the sophistication of the marketing investment that we make. And that will be commensurate with what we think the opportunity is to grow, so I can't sit here today and give you a specific dollar amount or our target that we're focused on. That's why we gave you the adjusted expense ratio, which excludes marketing costs because we're going to continue to invest in marketing when it makes economic sense and where it makes economic sense for us to lean in.
Tom Wilson: So let me just double click on the Transformative Growth piece. So the third piece of Transformative Growth is to increase the sophistication and investment in customer acquisition. We think we can and should be able to get new customers cheaper than we do today. There's lots of math we have around that. One of those is telematics, so we were the first out there with continuous telematics. We've been at it for over a decade. We're now taking telematics, and with Arity, we now think we can take telematics into new business, Brian. And actually, not have to have them download our app or put a device in their car to figure out how good a drive they are. We think we can use our sophisticated analytics to price them using telematics ahead of time, which will maybe -- to better manage your acquisition cost. So lots of work to go there, so plenty of opportunity to grow.
Brian Meredith: Can I just -- one quick follow-up here. If I think of kind of going forward here, when you're looking at putting rate increases through for the remainder of the year, what's your kind of base case with respect to how you're thinking about inflation here? Are you assuming that the current inflationary environment in persisting through the remainder of 2023 as you're filing for rates?
Tom Wilson: Let me finish and make sure we respect for people's time on that question. So first, when you look at overall inflation, the numbers Fed and everybody else sees, that's one set of numbers. If you look at the inflation in what we do, it's of course, dramatically higher. And those are subject to different things. So whether the Fed tightens the economy, it doesn't tighten economy, probably isn't going to do a lot to keep people from having severe accidents, hurting themselves and needing a lot of medical care or then more lawyers getting involved in the case, nor will it have a huge impact on what the OEs charge on parts. They tend to charge more in parts based on what they're doing to overall profitability and how many new cars are selling. So if we go into a recession, they sell new cars, I don't expect they're going to cut car's prices. So we think inflation will persist in this business at a higher level than you see from the overall CPI, and that's why we're having to raise prices for our customers.
Tom Wilson: Thank you all for participating today. Thank you for being generous with your time. We're going a few minutes over. Our priorities, make sure we're going to make money in auto insurance and continue to leverage our superior position in homeowners as start to grow and execute Transformative Growth, whether that's by getting our costs down, rolling out new products, expanding our National General platform. And then we didn't spend any time today on the great stories we have in the lower oval, which is expanding Protection Services. So a lot of things we're working on hard to create more value for you. Thank you, and we'll see you next quarter.
Operator: Thank you, ladies and gentlemen, for your participation in today's conference. This does conclude the program. You may now disconnect. Good day. | [
{
"speaker": "Operator",
"text": "Thank you for standing by, and welcome to Allstate's First Quarter 2023 Earnings Conference Call. [Operator Instructions] As a reminder, today's program is being recorded. And now, I'd like to introduce your host for today's program, Mr. Mark Nogal, Head of Investor Relations. Please go ahead, sir."
},
{
"speaker": "Mark Nogal",
"text": "Thank you, Jonathan. Good morning. Welcome to Allstate's first quarter 2023 earnings conference call. After prepared remarks, we'll have a question-and-answer session. Yesterday, following the close of the market, we issued our news release and investor supplement, filed our 10-Q and posted related material on our website at allstateinvestors.com. Our management team is here to provide perspective on these results. As noted on the first slide of the presentation, our discussion will contain non-GAAP measures for which there are reconciliations in the news release and investor supplement, and forward-looking statements about Allstate's operations. Allstate's results may differ materially from these statements, so please refer to our 10-K for 2022 and other public documents for information on potential risks. As some of you know, this will be my final earnings call as the leader of our Investor Relations team, and I will be transitioning to a new role in our P&C finance area supporting National General. I'm leaving Investor Relations in the capable hands of Brent Vandermause, who will be a great partner for all of you going forward. And now, I'll turn it over to Tom."
},
{
"speaker": "Tom Wilson",
"text": "Good morning. We're excited for Mark, and we're completely confident that Brent is going to give you everything you need to help you decide how and why you want to invest in Allstate. So good morning. We appreciate the investment of your time in Allstate today. Let's start with an overview results, and then Mario and Jess are going to walk through the operating results and the actions that we're taking to increase shareholder value. So let's start on Slide 2. Allstate's strategy, as you know, has two components, increased personal property-liability market share and expand protection services. Those are shown in the two ovals on the left. If you go to the right-hand side of the slide, you can see a summary of the results for the first quarter. We had a net loss of $346 million in the first quarter, which reflects a property liability underwriting loss which was only partially offset by strong investment income and profits from protection services and health and benefits. We're making good progress on executing the comprehensive plans to improve auto insurance profitability, and of course, we'll have a substantive discussion on that today. Not to be overlooked, we also continue to advance Transformative Growth plan, which is to execute the top oval there, which is to increase Property-Liability market share. At the same time, Allstate Protection Plans in the lower oval continues to expand its product offering and geographic footprint. Let's review the financial results on Slide 3. Revenues of $13.8 billion in the first quarter increased 11.8% or nearly $1.5 billion as compared to the prior year quarter. The increase was driven by higher average premiums in auto and homeowners insurance, resulting in Property-Liability earned premium growth of 10.8%. In the auto insurance line, higher insurance premiums and lower expenses were essentially offset by increased loss costs, so the profit improvement plan has not yet returned margins to historical levels. The auto insurance line had an underwriting loss of $346 million in the quarter. In homeowners, the story is really about $1.7 billion of catastrophes, which led to an underwriting loss of $534 million. The total underwriting loss was just under $1 billion. Net investment income of $575 million benefited from higher yields, which mostly offset an income decline from performance-based investments. Protection Services and Health and Benefits generated adjusted net income of $90 million in the quarter. As a result, the adjusted net loss was $342 million or $1.30 a share. Now let me turn it over to Mario to discuss Property-Liability results."
},
{
"speaker": "Mario Rizzo",
"text": "Thanks, Tom, and good morning, everybody. Let's flip to Slide 4. The chart on the left shows the Property-Liability recorded and underlying combined ratio since 2017. As you can see, Allstate has a long history of generating strong underwriting results though the current operating environment is challenging, with combined ratios over 100 last year and into the first quarter. The underlying combined ratio of 93.3 for the first quarter was slightly below the full year 2022. The second chart compares the full year 2022 recorded combined ratio for all lines of business to the first quarter of this year, which removes the influence of intra-year severity changes that occurred throughout 2022. The first red bar shows the underlying loss ratio was essentially unchanged as higher premiums were offset by increased loss costs. The second red bar on the left shows most of the increase in the combined ratio was driven by higher catastrophe losses, reflecting the widespread severe weather in the first quarter of this year. Expenses were lower by 1.9 points of premiums and minimal non-catastrophe prior year reserve reestimates also had a positive impact. Let's move to Slide 5 to review Allstate's auto insurance profitability in more detail. As you can see from the chart on the left, which shows the auto insurance recorded and underlying combined ratios from 2017 through the current quarter, we have a long history of sustained profitability in auto insurance as we successfully leveraged our capabilities and pricing sophistication, underwriting and claims expertise and expense management to generate excellent returns in the auto insurance business. Since mid-2021, loss costs have increased rapidly, driving combined ratios above our mid-90s target. The profit improvement plan is designed to address these significant loss cost increases, and we're making good progress. The chart on the right compares the recorded combined ratio of 104.4 in the first quarter to full year 2022 results. Starting on the left, higher average earned premiums drove a 5.7 point favorable impact, which is shown in the first green bar. The first red bar reflects a 6.5 point increase in underlying loss cost due to increased accident frequency and severity for the 2023 report year, with severity currently projected in the 9% to 11% range above the full prior report year. A lower expense ratio reflects expense reductions and higher earned premiums. The remaining difference was due to catastrophes and prior year reserve reestimates. All in, both the recorded and underlying combined ratios of 104.4 and 102.6, respectively, improved in the first quarter of 2023 compared to the full year of 2022. Slide 6 provides an update on the execution of our comprehensive approach to increase returns in auto insurance. There are four focus areas, raising rates, reducing expenses, implementing underwriting actions and enhancing claim practices to manage loss costs. Starting with rates. Following increases of 16.9% in 2022, the Allstate brand implemented an additional 1.7% of rate increases in the first quarter. We will continue to pursue rate increases in 2023 to restore auto insurance margins. Reducing operating expenses is core to Transformative Growth. We have also temporarily reduced advertising to reflect a lower appetite for new business. We implemented more restrictive underwriting actions on new business in locations and risk segments where we have not yet achieved adequate prices for the risk. As we move through 2023, it is likely that some of these restrictions will be removed where there are profitable growth opportunities. Enhancing claim practices in a high inflation environment is key to delivering customer value. This includes leveraging strategic partnerships and scale with repair facilities and parts suppliers to mitigate the cost of repairing vehicles. In addition, settlement of pending bodily injury claims has been accelerated to avoid continued increases in costs and settlements. Transitioning to Slide 7. Let's discuss progress in three large states with a disproportionate impact on auto profitability. The table depicts Allstate brand auto new business production and rate actions for California, New York and New Jersey. As a result of implemented profitability actions, new issued applications from the combination of California, New York and New Jersey declined by 40% compared to the prior year quarter. The decline in these three states meaningfully contributed to the 22% decline countrywide. The right-hand portion of the table provides rate increases either taken or needed to improve margins. In California, we just received approval for a second 6.9% rate increase implemented in April, which will be effective in June. We continue to work closely with the California Department on the best path forward to getting rates to an adequate level and expect to file for an additional increase in the second quarter, which will reflect the balance of our full rate need. In New York, we filed for additional rate in the first quarter that is currently pending with the Department of Financial Services. In New Jersey, we attained a 6.9% rate increase in the first quarter and expect to pursue additional filings in the second quarter. As mentioned earlier, we anticipate implementing additional rates across the country into 2023 to counteract persistent loss cost increases. Slide 8 dives deeper into how we are improving customer value through expense reductions. The chart on the left shows the property liability underwriting expense ratio over time and highlights drivers of the 2.9 points of improvement in the first quarter compared to the prior year quarter. The first green bar on the left shows the 2 point improvement impact from advertising spend, which has been reduced given a limited interest in new business at current rate levels. The last two green bars show a decline in operating and distribution costs mainly driven by lower agent and employee-related costs and the impact of higher premiums. Shifting to our longer-term target on the right, we remain on pace to reducing the adjusted expense ratio to 23 by year-end 2024 as part of transformative growth. This metric starts with our underwriting expense ratio excluding restructuring, coronavirus-related expenses, amortization and impairment of purchased intangibles and advertising. It then adds in our claims expense ratio, excluding costs associated with settling catastrophe claims because catastrophe-related costs tend to fluctuate. Through innovation and strong execution, we've driven significant improvement relative to 2018, with first quarter adjusted expense ratio of 24.9. We expect to drive additional improvement, achieving an adjusted expense ratio of approximately 23 by the end of next year by represents a 6-point reduction compared to 2018. The increase in average premiums certainly represents a tailwind, however, our intent in establishing the goal is to become more price competitive. This requires a sustainable reduction in our cost structure, with future focus on three principal areas, including enhancing digitization and automation capabilities, improving operating efficiency through outsourcing, business model rationalization and centralized support, and enabling higher growth distribution at lower costs through changes in agency compensation structure and new agent models. Now let's move to Slide 9 to review homeowner insurance results, which incurred an underwriting loss in the quarter despite favorable underlying performance due to elevated catastrophe losses. We have a superior business model that includes differentiated product, underwriting, reinsurance and a claims ecosystem that is unique in the industry. As you can see by the chart on the left, this approach consistently generates industry-leading underwriting results despite quarterly or yearly fluctuations in catastrophe losses. The chart on the right shows key Allstate Protection homeowners insurance operating statistics for the first quarter. Net written premium increased 11.1% from the prior year quarter, predominantly driven by higher average gross written premium per policy in both the Allstate and National General brands and a 1.4% increase in policies in force. The first quarter homeowners combined ratio of 119 increased by 35.1 points compared to the prior year quarter, reflecting higher catastrophe losses primarily related to five large wind events in March. These accounted for more than 70% of catastrophe losses in the quarter. The first quarter catastrophe loss ratio was significantly elevated compared to the prior year and 10-year historical average by 36.2 and 30.5 points, respectively. The underlying combined ratio of 67.6 improved 0.4 points compared to the prior year quarter, driven by higher earned premium and a lower expense ratio partially offset by higher claim severity. Slide 10 provides an update on Transformative Growth. Transformative Growth remains a focus and is being executed in parallel with our profit improvement actions. We continue to make good progress on this multiyear initiative that spans five main components: improving customer value, expanding customer access, increasing sophistication and investment in customer acquisition, modernizing the technology ecosystem and driving organizational transformation. The bottom half of the slide highlights recent progress by intended outcome. Providing the lowest cost insurance through expense reductions, broad distribution and pricing sophistication is key to growth. Our Allstate brand relative competitive position has deteriorated recently as rate increases have exceeded some competitors. We expect that those competitors will eventually raise rates, improving our competitive position and growth prospects. Distribution has been expanded by launching middle market and preferred products through independent agents under the National General brand. These products are currently available in approximately 25% of the U.S. market, with a plan to be in nearly every market by the end of next year. Our new affordable, simple and connected auto product creates a differentiated customer experience, which is expected to become available in approximately one-third of the U.S. through the direct distribution channel by the end of this year, deploying a new technology stack, integrating technology across brands and retiring legacy technology applications provides increased agility and lowers costs. This will be reflected in the sunset of the Esurance and Encompass technology platforms next year. We believe transformative growth will lead to increased market share, and hence, higher company valuation multiples. And now, I'll turn it over to Jess to discuss the remainder of our results."
},
{
"speaker": "Jess Merten",
"text": "All right. Thank you, Mario. Let's start with Slide 11, which covers results for our Protection Services and Health and Benefits businesses. Chart on the left shows Protection Services revenues excluding the impact of net gains and losses on investments and derivatives, which increased 7% to $671 million in the first quarter compared to the prior year quarter. Increase reflects growth in Allstate Protection Plans and Allstate Dealer Services, partially offset by a decline in Arity. By leveraging the Allstate brand, excellent customer service, expanded product offerings and partnerships with leading retailers, Protection Plans continues to generate profitable growth, resulting in a 17% increase in the first quarter compared to the prior year quarter. In the table below the chart, you will see that adjusted net income of $34 million in the first quarter decreased $19 million compared to the prior year, primarily due to higher appliance and furniture claim severity and a higher mix of lower-margin business as we invest in growth at Allstate Protection Plans. We will continue to invest in these businesses which provide an attractive opportunity to meet our customers' needs and create value for shareholders. Shifting to the chart on the right, Health and Benefits provide stable revenues and is consistently profitable while protecting more than 4 million customers. Revenues of $583 million in the first quarter of 2023 increased by $3 million compared to the prior year quarter as an increase in group health and other revenue was partially offset by a reduction in individual health and employee benefits. Health and Benefits operating systems are being rebuilt to lower costs and support growth, which will leverage the Allstate brand and customer base to generate shareholder value. Adjusted net income of $56 million was in line with the prior year quarter. Effective January 1, 2023, we adopted the FASB guidance, revising the accounting for certain long-duration insurance contracts in the Allstate Health and Benefits segment using the modified retrospective approach to the transition date of January 1, 2021. This had an immaterial impact on our results. Now let's move to Slide 12, which depicts trends in our investment portfolio allocation. Our active portfolio management includes comprehensive monitoring of markets, sectors and individual names, and we proactively reposition based on our views of economic conditions, market opportunities and the risk return trade-off. Asset class holdings are shown on the left. Our $63.5 billion investment portfolio includes a large allocation to high quality interest bearing assets, which has increased in recent years. In response to increasing recession risks, we defensively position the portfolio in 2022 by reducing our exposure to below investment grade bonds and public equity. We maintain this defensive position in the first quarter with additional reductions in our public equity exposure. Our performance based portfolio shown in green and gray enhances long-term returns and is broadly diversified with more than 400 assets. The portfolio is largely U.S. exposure that span vintage years, sponsors and sectors. Exposure to real estate and commercial mortgage loans is modest at $2.8 billion or 4% of the portfolio and is focused on more resilient sectors such as industrial and multifamily. We hold only $230 million in office properties for mortgages. In addition to real estate, we have selective exposure to the banking sector totaling about $4.5 billion and consists primarily of investment-grade, fixed income securities issued by large financial institutions. We hold $240 million of exposure to regional banks, primarily larger regional banks, and we did not realize significant losses related to recent bank failures. Our high-quality portfolio provides flexibility to take advantage of investment opportunities as economic conditions evolve while providing substantial liquidity to protect our customers. Let's shift from investment allocation to performance on Slide 13. As shown in the table at the bottom of the chart on the left, total return on our portfolio was 2.4% in the first quarter and 1.2% over the last 12 months. Net investment income, shown in the chart on the left, totaled $575 million in the quarter, which is $19 million below the first quarter of last year. Market-based income of $507 million, shown in blue, was $184 million above the prior year quarter following the proactive decision to reposition the market-based portfolio into higher market yields and an increase in fixed income funded by our reduction in public equity. Performance-based income of $126 million, shown in black, was $180 million below a strong prior year quarter. Volatility from quarter-to-quarter on these assets is expected. Our portfolio management and the allocation of risk capital to investments is highly integrated with the assessment of risk-adjusted return opportunities across the enterprise. As you'll recall, in response to declines in auto insurance profitability, last year, we defensively positioned the portfolio against rising rates and reduced our exposure to recession sensitive assets. As market rate grows, we began to increase the duration in the fourth quarter and ended the first quarter at four years. This duration extension locks in higher yields and income for longer while positioning the portfolio to benefit from potential future reductions in interest rates. The chart on the right shows the fixed income earned yield continues to rise and was 3.4% at quarter end. Our portfolio yield is still below the current intermediate corporate bond yield of approximately 5.1%, reflecting an additional opportunity to increase yields if rates stay at these levels. To close, let's turn to Slide 14 to discuss Allstate's strong financial position and prudent approach to capital management. In light of recent financial events impacting the banking industry, let's start with an overview of Allstate's liabilities. As you can see in the chart on the left, our liabilities primarily consist of property casualty claim reserves and unearned premiums that are not subject to unpredictable or immediate demand for repayment. Our sophisticated economic capital framework quantifies enterprise risk to establish capital targets by business, product, geography and investment while also providing additional capital for stress events or contingencies. The framework incorporates regulatory capital standards, proprietary econometric modeling, I struggled with that, rating agency criteria and other external assessments. It's used through the company from individual product and state-based decisions to establishing the appropriate amount of capital for each company and the overall corporation. Allstate's capital of $19.2 billion exceeds our target capital based on this framework. Our ratings remain strong, with S&P and Moody's assigning an issuer credit rating of A minus and A3, respectively, to our recent senior debt offering. Holding company assets of $4.2 billion as of the end of the first quarter represent approximately 2.5x our annual fixed charges. We returned $377 million to shareholders in the quarter through dividends and share repurchases. As a sign of our financial strength and commitment to shareholder returns, the common dividend was increased by 4.7% in the first quarter and paid in early April. With that as context, let's open up the line for questions."
},
{
"speaker": "Operator",
"text": "[Operator Instructions] And our first question comes from the line of Gregory Peters from Raymond James. Your question please."
},
{
"speaker": "Gregory Peters",
"text": "Well, good morning, everyone. A lot to unpack in your comments. I think what I'd like to do for my question and follow-up would be to focus on, first, Slide 5. And I was interested in your comments about the average underlying loss ratio, I think, up 6.5% in first quarter versus the average earned premium being a good guide for 5.7%. I guess the question would be, is the expectation that 6.5% is going to continue? And when will the average earned premium go beyond where the underlying loss ratio deterioration is?"
},
{
"speaker": "Tom Wilson",
"text": "I'll get Mario to dig in on claim expenses. When you look at the 5.7%, I'll remind you -- first, good morning, Greg. I'll remind you that remember, this is a number that's been trending up as the rates that we took in '21 and '22 start to be earned in. So we would expect that number to continue to increase as we earn in the rates we've already implemented, and so we think this. In terms of claims severity, I'll let Mario give you an update on where we are and what we're thinking about."
},
{
"speaker": "Mario Rizzo",
"text": "Yes. Good morning, Greg. So in terms of claims severity, what we disclosed this quarter was across major coverages. We're running in the 9% to 11% range in both physical damage and in injury coverages. Really, the drivers of those costs, if you start with physical damage, we continue to see pretty persistent inflation particularly in parts and labor costs to repair cars. Actually, used car prices or total values for used cars actually came down a little bit in the first quarter in our numbers, but we had a higher percentage of total loss frequency which impacted the mix, so those are really the drivers. And on bodily injury, it's the same things we've been talking about. Medical inflation, medical consumption and attorney representation. So I think the drivers of severity continue to persist. In terms of where they're going forward, it's really anybody's guess, but I think our perspective is, and we've been pretty consistent on this point, we're going to continue to take prices up. We've been doing that really since the fourth quarter of 2021 throughout last year. That continued into the first quarter. We're going to continue to, on a forward-looking basis, implement rate increases to first catch up and then outpace loss cost trends. But our perspective on rates as we continue to need to push more price through the system, and we intend to do that throughout the balance of 2023."
},
{
"speaker": "Gregory Peters",
"text": "Right. On Slide 7, you -- in your comments, you talked about those three states. And I guess a follow-up question would be, where do you think that's going to go from a rate perspective? I think you said in your comment, Mario, that you expect to file the balance of your full rate need in California, and won't that trigger a different process causing a delay in potential rate approvals? So give us some color on that slide, please."
},
{
"speaker": "Mario Rizzo",
"text": "Sure. So first I'll start with -- as we talked about, we just got approval for a second 6.9% auto rate increase in California, so we're -- going back to the fourth quarter of last year, we've got approval for 2 6.9% rates, and we've done that by working closely with the department to lay out our data and our loss costs. In those conversations, and I think you've seen some of this across the industry, the department is really encouraging carriers to file for the rate need that they have in their book as opposed to going forward with 6.9% rate increase filings, and it's really based on just the volume of rate filings they're getting. So as we talk to the commissioner and the department, we got -- we're able to secure approval for the two 6.9% rate increases, and we intend on filing the balance of our rate need going forward. Does that create risk in intervention? It does. But I think we need to get California auto prices back to where they need to be so that we can create the kind of availability for consumers, really, that they deserve in California. So we're going to work with the department closely, we're going to make that filing, and then we'll see where that takes us going forward."
},
{
"speaker": "Tom Wilson",
"text": "So Greg, I think embedded in your question is, will you be challenged on something above 6.9%? The strategy that [Guy Hill] and team put into place was take 6.9% -- get 6.9%, don't have to have a consumer advocate come in and look at it, get another 6.9% and then go for the full rate. So what you're seeing us do it in three chunks. Other people have tried to do it other ways. We think this is the right way for us."
},
{
"speaker": "Gregory Peters",
"text": "Got it. In New York, New Jersey?"
},
{
"speaker": "Mario Rizzo",
"text": "Yes. We got some rate filings pending with the New York department that hopefully will get resolved soon. And then New Jersey, you see, we were able to implement a rate increase and we're going to come back and file another rate increase. So we're working hard to get these three states off of this page."
},
{
"speaker": "Gregory Peters",
"text": "Got it. Thank you for the answers."
},
{
"speaker": "Operator",
"text": "Thank you. One moment for our next question. And our next question comes from the line of Paul Newsome from Piper Sandler. Your question please."
},
{
"speaker": "Paul Newsome",
"text": "Good morning. I was hoping you could give us a little bit more additional color on the risk inflation rate. Is it fair to say that what we saw in the first quarter was an acceleration of frequency or severity trends that was unexpected? And if so, maybe you could talk about a little bit more of the pieces that were that much worse that may have seemed to have caught some people in the industry off guard."
},
{
"speaker": "Tom Wilson",
"text": "Paul, you're breaking up a little bit, so let me just make sure I get it. So we're talking about auto insurance severity trends first quarter versus -- is that a tick up from what you saw last year? Or is it the level on? If that's the question, I'll just -- Mario can jump into that."
},
{
"speaker": "Mario Rizzo",
"text": "Yes. I guess what I would say about severity, again, in that 9% to 11% range is it just remains persistently high, I think, is how I would describe it, and that's true across coverages. It's certainly lower than what our expectations were for severity last year, what our ultimate forecast is for 2022. But it still remains at elevated levels, which is why I go back to we're going to need to continue to push rate through the system through the balance of this year to combat that inflation."
},
{
"speaker": "Paul Newsome",
"text": "Is that -- should we interpret that as a further acceleration of rate? I mean, I think you were expecting to put rate -- more rate anyway, right? I guess the question is do we have a step function up a little bit from where we would have been?"
},
{
"speaker": "Tom Wilson",
"text": "Yes. Paul, I think there's a little bit of -- I mean, when you're looking at the percentages, it gets a little confusing when you're in a high increase environment. So if you looked at the numbers that Mario was talking about, are the percentages up versus the full year of 2022, not versus the first quarter of last year. As you know, the percentages kept going up as we move throughout the year and we adjusted our results, so what we've decided to do is to talk about the percentages up versus the full year. And I think, Mario, it is -- said it well, which is it continues to be high. And so we're trying to -- if you look at the percentage up versus what we thought it was in the first quarter, it would be higher than 10% to 11%, but it's not higher than what we thought the first quarter was at the end of last year. So as it relates to pricing, we're looking at just total loss cost frequency and severity, and we have to -- we believe we have to continue to increase prices this year. As Mario talked about, we were up almost 17% in the Allstate brand last year. I don't know. We don't have a target for what it will be this year. As Mario said, it's going to be what it needs to be."
},
{
"speaker": "Paul Newsome",
"text": "No, that's helpful. I always appreciate the help, and I'll let some other folks ask questions. Thank you very much."
},
{
"speaker": "Operator",
"text": "Thank you. One moment for our next question. And our next question comes from the line of Elyse Greenspan from Wells Fargo. Your question please."
},
{
"speaker": "Elyse Greenspan",
"text": "Hi, thanks. Good morning. My first question, I just wanted to talk about your RBC ratio. I mean, we see the cat losses and we can see the impact that that would have had on statutory income in the quarter. But you guys also did cut your equity investments in half, which I think could have maybe a 20-point benefit in RBC. Is there a way for you guys to walk through the moving components of RBC in the quarter and give us a sense of where your RBC ratio would be within AIC at the end of the Q1?"
},
{
"speaker": "Tom Wilson",
"text": "Elyse thanks for the question. Let me provide a little overview and then Jess will jump into the specifics. The headline would be, we don't just look at RBC. And so as Jess said, so -- I mean, if you step back and say, what are the learnings from the recent bank failures? Having a capital problem is not something that just happens to you like an auto accident [ph], right? It's a result of a series of choices made over time. So in terms of our series of choices, we had this really comprehensive set of processes around those choices that are highly analytical. We look at all kinds of scenarios. We look at it frequently, and as a result of that, we come up with what we think the right amount of capital. It includes things like RBC it includes things, like the rating agencies it includes. In some cases, we are more restrictive in terms of the amount of capital we think we need than other people. So we don't play the game of RBC arbitrage, so to speak, and fool ourselves. With that, Jess, do you want to talk about how you think about capital and where we're at?"
},
{
"speaker": "Jess Merten",
"text": "Yes. Thanks, Tom. I mean I think, as you and I have talked before at least, we try and take a look at our capital position using our sophisticated economic capital I know it's not just the RBC ratios. We don't - just to be clear to your specific question. We don't publish and have not published the RBC ratio for this quarter, and so I'm not in a position to take you through the bits and pieces on this call. I think directionally, you and others have noted what the RBC impacts would be. But I think it's more important to think about the way that we manage capital and the way that we look at it on a comprehensive basis, not just and RBC basis. And I think you've seen reflected in the results that we continue to proactively manage our overall capital position. So again, I go back to our economic capital model, the sophisticated and comprehensive way that we look at capital, including all different sources and uses, and feel confident in our capital position being, as I said in my prepared remarks, above our internal targeted levels."
},
{
"speaker": "Tom Wilson",
"text": "But you shouldn't take the fact that we have less equity as a statement that we thought we needed to save capital. We have less public equity holdings, because we didn't think it was a good risk return trade-off, which John [ph] will be happy to talk about it if somebody wants to go through. But we think we have plenty of capital on this business."
},
{
"speaker": "Elyse Greenspan",
"text": "Thanks. And then my second question, your personal auto underlying loss ratio did improve sequentially, right? There are some noise, right, as there were some true-ups in the fourth quarter last year. And also, I thought that seasonally, Q1 for auto tends to be better. But I guess when we put this altogether and you guys you are talking about taking - still earning in some - a good amount of rate increases. Do you think that the personal auto loss ratio peaked in the first quarter and should we expect it to improve from here?"
},
{
"speaker": "Tom Wilson",
"text": "Well, first, we think the profit improvement plan is working. I would say, Elyse, that if you just summarize the first quarter, I would say we held serve, we held serve in the face of, if you're a tennis fan, 120-mile an hour serve, which was called continued high increase in severity. How will - we'll return the ball, and as you point out, it's about where it was last year. It is improved sequentially in the fourth quarter, but you're absolutely right. Yes, there were some other things going around in the fourth quarter related to the first, second and third quarter of last year. So it's not quite fair to say that it improved. I would just say we held serve. We feel good about where we're going. In our mind, it's a question of when, not if we will get back to how we make profitability. And that's, of course, dependent on what happens with inflation and costs."
},
{
"speaker": "Elyse Greenspan",
"text": "Thank you."
},
{
"speaker": "Operator",
"text": "Thank you. One moment for our next question and our next question comes from the line of Yaron Kinar from Jefferies. Your question please."
},
{
"speaker": "Yaron Kinar",
"text": "Thank you. Good morning. May be starting with the current capital position, the reallocation of some of the investments, can you maybe talk about how you see the capital in maybe capital market stress scenarios? And I'm sure you run those internally, any color you can offer around that would be much appreciated?"
},
{
"speaker": "Tom Wilson",
"text": "Yaron, I'm not exactly sure. Maybe you can give me another layer down in the question so we can get specific for you?"
},
{
"speaker": "Yaron Kinar",
"text": "Sure. So I think you're talking about, what, roughly $4 billion of liquidity or access about the holdco and I think, $16 billion of liquidity. What happens to those - we find capital markets stressed? I don't know if there's another 25% decrease in the equity market, maybe a credit cycle. I'm not exactly sure what kind of scenario to paint, because I don't want to put you on the spot with a specific set of declines. But I'm sure you do test, this excess capital availability against stresses in the system?"
},
{
"speaker": "Tom Wilson",
"text": "Yes. No, it's a good point. Let me get John to answer that. I'll give you a little overview [ph]. First, I would just say analytics everywhere. It counts for everyone despite. So whether that's using sophisticated models is that where they toll the car or extending duration or what we're doing with capital. And so, when we look at the extension of duration, I think John ran like nine different scenarios, how to do it, what to do it, what and - so we're all over that. When it comes to stress events in the capital markets, we look at all kinds of alternatives there. Everything from -- and what do we do with the government defaults to what do we do if there's more bank failures. And so we have - and John can tell you sort, of how he's thinking about how we allocate assets in the portfolio relative to stress events in today's market. I would say from an overall capital standpoint, which is we got plenty of money. Like you saw our liabilities, they're very predictable, and so nobody is going to run in and say give us back our $10 billion and we don't have it. At the same time, we have a really highly liquid portfolio, because so much of it's in investment-grade fixed income. If it's fixed - investment-grade fixed income market is completely shut down, we would still probably be fine. Right now probably we would be fine, because we're having cash come in terms of unearned premiums every day, so we don't really have any overall liquidity issues. But in terms of capital market stress and how you think about that from an investment decisions and where we're invested today, John can give you some perspective."
},
{
"speaker": "John Dugenske",
"text": "Yes, Yaron, thank you so much for the question. Just a piece of data, if we can trade a security, we've had $5 billion of cash coming in the next year just by things that are rolling off. It's highly integrated into the overall data and analytics quantitative framework across the enterprise. So I answered this question, I feel confident that scores of people on the investment team could answer too, because it's part of the way that we think. We're not managing an investment portfolio separate from the way that we think about the enterprise. Tom talked a little bit about the duration trade that we did that was highlighted in the materials. That's not taken in isolation of how all the other securities in the portfolio would perform and it's not taken in isolation on how we think about the entire enterprise, what happens in underwriting and other areas. We run probably 100 different scenarios on a daily basis that look back at things that have happened in the past, things that could happen in the future, what that means for returns and what that means for capital. And we subscribe to getting the order of ready, aim and fire, right? So we really aim a lot as we think about our investment profile."
},
{
"speaker": "Yaron Kinar",
"text": "Thanks. And then maybe shifting back to the auto book, is the piece or the cadence of rate increases that you expect to file in auto kind of similar to where it was when we ended in 2022 or do you see maybe additional rate increases are necessary today relative to the plan at the beginning of the year?"
},
{
"speaker": "Tom Wilson",
"text": "Where is, the plan at the beginning of the year. So maybe I'll give an overview, Mario, with an analogy and you can bear. We're running as fast and as hard as we can on rates everywhere. If we need them, we're really running fast and hard. If we think, we're actually adequately priced in some states where we are today, we're still paying attention. We're still on the track. We're so warmed up and ready to run if we need to be."
},
{
"speaker": "Mario Rizzo",
"text": "Yes. What I would add Yaron, I'm going to go back to a comment I made earlier, which is we've been pretty consistent on this point of the need to take prices up going back to last year, and that hasn't changed. Now obviously, we react to new data, new information in real-time and the absolute amount of rate we take is going to be dependent on that updated data. As Tom mentioned earlier, we rely on heavy-duty analytics to manage the business and we respond to what's happening in real time, so the amount of rate we need will be dependent on how loss costs play out over time for us. But we're going to continue to push rate through the system. We've been successful at that. I wouldn't get too hung up on quarter-to-quarter fluctuations because that quarterly number is going to bounce around in terms of the rates that were approved in a particular state, and the size of those rates. But I think thematically, I'm going to go back to what we've been saying now for -- over the last year, which is we're going to continue to take the rate that we need to get auto margins back to where they need to be, which is in the mid-90s targets that we have."
},
{
"speaker": "Yaron Kinar",
"text": "Thanks and good luck, Mark, with the new role."
},
{
"speaker": "Mario Rizzo",
"text": "Thank you."
},
{
"speaker": "Operator",
"text": "Thank you. One moment for our next question, and our next question comes from the line of Andrew Kligerman from Credit Suisse. Your question please."
},
{
"speaker": "Andrew Kligerman",
"text": "Thank you and good morning. I'm trying to unpack the earlier comment about used car prices coming down a bit, because the Manheim Index was up about 8.6%, and that's kind of a forward-looking indicator. So maybe you could kind of give a little color on what your expectation there is for used car prices? Does that kind of fit in your 9% to 11% or could - of projected severity increase or could it be materially higher as we look out in the year?"
},
{
"speaker": "Mario Rizzo",
"text": "Hi Andrew, it's Mario. Thanks for the question. I guess what I'd start with, there's, a number of indices for used car prices. I think you mentioned one with Manheim that tends to focus on wholesale prices. And I think as we all know, that metric was coming down most of last year. Certainly in the back half of last year, and then it started to tick up in the end of the fourth quarter and has continued into this year. What I was referring to earlier is actual total loss severity, which tends to lag the Manheim Index and is more a function of retail used car prices, which have improved, and that's what I was referring to in the quarter. What we saw was actually used car - or I'm sorry, total loss severity actually improved a little bit year-over-year. In terms of the risk going forward, I think, yes. If you look at what's happening with the Manheim Index and other indices. Certainly, they're headed in a different direction than they were headed for much of last year, which adds risk. We've tried to factor that into our severity expectations in terms of what we're recording that 9% to 11% range. But what we actually saw in the first quarter of this year was a modest improvement in total loss severity."
},
{
"speaker": "Andrew Kligerman",
"text": "Got it, all right. Thank you on that. And then it was interesting following National General with auto policies in force now of about $4.6 million off pretty significantly from $4.1 million last year. It looks like you're getting good rate increases. Your combined underlying was 94%, so which is pretty decent. So looking forward, it sounds like you haven't fully rolled it out. Is this something that could really catapult your policy in force at a very responsible return? I mean, maybe a little color on how that - what your expectations over the next year to -- for policy growth and doing so profitably?"
},
{
"speaker": "Tom Wilson",
"text": "Andrew thanks for focusing in on National General. For summary, we feel really good about the acquisition of National General. If you just start with the math, the numbers, it's exceeded our expectations and assumptions, because as you'll remember, we've mostly bought that so we could reduce our expenses in the independent agent channel by folding, basically having them reverse acquire Encompass, we just happen to buy them first. And so they've - and that's ahead of plan and the numbers are bigger. So, we're feeling really good about that, and that's the way we price the deal. You're - strategically, which is where you're after, we're also getting the benefit of now having a solid plan for an independent agent channel, which we did not before. We've been struggling to get a good platform so they have good technology, good relationships, as you point out, mostly in the nonstandard stuffing. Mario, I think in his comments, mentioned how we're now taking those relationships and that technology platform and we're putting what we call mid-market, which is basically standard auto and homeowners, on that platform, and that's going to give us great growth opportunities because we're using the Allstate expertise in both standard auto and - not to be underestimated, one bit really is our business model and homeowners. We think that's a great growth opportunity and which is basically icing on the cake relative to the acquisition. So, we feel really good about we're in that channel. It's part of Transformative Growth. It's part of increasing market share and personal profit liability, and we're pleased with the results."
},
{
"speaker": "Andrew Kligerman",
"text": "Awesome, thank you."
},
{
"speaker": "Operator",
"text": "Thank you. One moment for our next question and our next question comes from the line of Josh Shanker from Bank of America. Your question please."
},
{
"speaker": "Josh Shanker",
"text": "Yes, thank you. I want to talk about segmentation and policy count. Obviously, the net decline in the auto policy count was quite high this quarter. Do you have some sort of advice or thoughts to think about how much policy count will decline over this repricing period? But two, I also note that homeowners policy count was flat which suggests in the segmentation, there's different policyholders you're keeping versus different policyholders you're losing. So I thought you might be able to touch on both things?"
},
{
"speaker": "Tom Wilson",
"text": "Good. Mario, why don't you talk about homeowners and what we're doing there to drive growth? As it relates to auto insurance, we just talked about sort of the Allstate brand, I think, which may be the numbers you're referring to, which is down versus Andrew's comment about National General, which is off. On the Allstate piece, there's, obviously two components. One is, are you selling more new business? And then the second is what's happening with retention. And as it relates to new business, we've taken the approach that a prospective rate increase is like a new business penalty. So as you know, when you sell a business, you're going to have - you got expenses. It is getting the customers more to get them right in front, and then the loss ratio is typically higher for new business than it is for existing business. If you need 10 points of rate on top of what you're currently selling it to, we've factored that into our growth projections on new business and said, well this -- at the very least, it's an additional 10 points of new business penalty. The worst is that when you raise your prices by 10%, all the money you spent getting the customer is wasted, because they go away and you churn it. So we've dialed back new business and advertising not so much, because we're trying to manage the P&L, but because we're managing the economic growth. And we think needing rate increases and going out and getting a new customer and saying, it's great, you bought it for $1,000. And then six months later saying, well, it was really $1,100 is not a good plan. So we've dialed back new business, and you see that really across the board. And Mario showed in some places, even more aggressively, like New York, New Jersey, and California have kidded Mario that like, you'll know every new business customer we get in New York if we keep this up personally. So that's basically an economic choice. On retention, of course, that's the customer's choice and it depends what happens in the marketplace and what other people are doing. Our retention has gone down. We do model that out. It's really very difficult to take those old models, so -- and give yourself any kind of good estimate on the current view because a couple of things have changed. One, these are much bigger increases than those models had in them. So those models are based on 5%, 6%, 7%, not on 10%, 12% or 15% or 14% [ph] in Texas. And at the same time, those models don't have the kind of competitive environment you're operating in where everybody else is raising rates at the same time. So we've shutdown new business, because we think it's economic and there's an increased new business penalty associated with being underpriced, and then we're managing to. What we want to do, of course, is we're highly focused on improving customer value, because people pay more, you got to do more for them. And so, we're working hard on making sure we do insurance reviews, get our agents for them [ph] homeowners is another great story that I think we've kind of - we get so focused on auto. We haven't really put - it's a great business model. Mario can talk about what we're doing to grow that business."
},
{
"speaker": "Mario Rizzo",
"text": "Yes. Thanks for the question, Josh. And homeowners, again, as I talked about in the prepared remarks, is a business that we continue to feel really good about in terms of where it's positioned from a profitable growth perspective. And what you saw in the quarter is that we actually increased policy count by about 1.4%. Retention actually picked up by a temp. And I think there's a couple of things when you kind of unpack what's happening with retention in homeowners because much -- as Tom talked about, we're having to take prices up in auto. The way we're taking price increases is in a highly segmented and targeted way, and that's helping from a retention perspective on homeowners because those bundled customers tend to be our longest-tenured, most profitable customers. We also bundle about 80% of homeowners' policies have on supporting auto line and the retention on a bundled customer where a homeowner that has an auto policy is meaningfully higher than a monoline homeowners, and we're continuing to see the benefit of that. And we've put processes in place both in terms of economic incentives for our agents and sales processes in the call centers on the direct side to incent additional bundling. And we're seeing some nice trends in terms of bundling rates, which is certainly helping homeowner growth through homeowner retention. We're going to continue to look for ways to grow the homeowner business. We think it provides a really compelling risk and return opportunity for us. The results are going to bounce around because there's volatility. This quarter is an example of that with catastrophe losses, but we continue to see our underlying combined ratio and loss ratio improve, and both through leveraging the tactics I talked about for retention production, particularly with bundled customers, we think we can continue to grow that line."
},
{
"speaker": "Josh Shanker",
"text": "Are the bundlers having the same problem that they get quoted or rate an entire six months later? Or is your pricing such that you can comfortably quote a bundle right now and think that you're going to retain them for 12 months?"
},
{
"speaker": "Mario Rizzo",
"text": "Yes, we're obviously quoting bundled customers right now. And when you look at the business we are writing, we're seeing really nice improvements in terms of quality and lifetime value, which is indicative of that bundling rate. And so yes, we're quoting it. And the other thing you got to remember, and this is true both from a retention and a new business perspective. Bundling, it's an easier experience and a more streamlined experience for customers. There's discounts associated with bundling as well that can help offset higher auto rates and incent customers to stay with us."
},
{
"speaker": "Josh Shanker",
"text": "Thank you for the detailed answers."
},
{
"speaker": "Operator",
"text": "Thank you. One moment for our next question. Our next question comes from the line of Brian Meredith from UBS. Your question please."
},
{
"speaker": "Brian Meredith",
"text": "Thanks. A couple of questions here for you. First one, I'm just curious, I saw your expense ratio is down about 1 point x ad spend. Where are we in this Transformational Growth as far as the expense ratio reduction? How much can we potentially see here additional going forward? And then maybe on the -- an add on to that, what kind of a normalized ad spend as a percentage of earned premium, so we can kind of get a view on what our expense ratio should ultimately end up?"
},
{
"speaker": "Mario Rizzo",
"text": "Yes, Brian, this is Mario. Thanks for the question. Again, expenses as much as Tom talked earlier about, earned premium and loss ratio, we kind of held serve there. We did see the benefit of a lower expense ratio both in terms of the underwriting expense ratio and the adjusted expense ratio. Where we're at in the kind of continuum on the adjusted expense ratio, we set a goal to get that adjusted ratio down to about 23 by the end of 2024. And we're making really good progress on that, you saw continued progress on that this quarter. We certainly are being helped by higher earned premium which leveraged our cost. But we're continuing to see reductions in both operating costs and distribution-related costs, which are helping the expense ratio. And I talked a little bit earlier about the areas we're focused on, whether it's automation, digitization, sourcing and continuing to drive both operating and distribution costs down. We're going to -- those are really going to be the levers we pull to push the expense ratio ultimately to that goal that we set with Transformative Growth. So we're making good progress, feel really good about that. In terms of the level of marketing spend, certainly, we spent less this quarter on marketing than we did a year ago, and we've pulled that back. I think as Tom said earlier, really from an economic risk and return perspective, it doesn't make a lot of sense for us to invest aggressively in marketing at a time when our prices aren't adequate. But what we will do over time has more rates and -- or, I'm sorry, more states and more markets get to a rate level that we're comfortable with, we're going to surgically lean in. And as one of the components of Transformative Growth, we're going to look to both increase the level and the sophistication of the marketing investment that we make. And that will be commensurate with what we think the opportunity is to grow, so I can't sit here today and give you a specific dollar amount or our target that we're focused on. That's why we gave you the adjusted expense ratio, which excludes marketing costs because we're going to continue to invest in marketing when it makes economic sense and where it makes economic sense for us to lean in."
},
{
"speaker": "Tom Wilson",
"text": "So let me just double click on the Transformative Growth piece. So the third piece of Transformative Growth is to increase the sophistication and investment in customer acquisition. We think we can and should be able to get new customers cheaper than we do today. There's lots of math we have around that. One of those is telematics, so we were the first out there with continuous telematics. We've been at it for over a decade. We're now taking telematics, and with Arity, we now think we can take telematics into new business, Brian. And actually, not have to have them download our app or put a device in their car to figure out how good a drive they are. We think we can use our sophisticated analytics to price them using telematics ahead of time, which will maybe -- to better manage your acquisition cost. So lots of work to go there, so plenty of opportunity to grow."
},
{
"speaker": "Brian Meredith",
"text": "Can I just -- one quick follow-up here. If I think of kind of going forward here, when you're looking at putting rate increases through for the remainder of the year, what's your kind of base case with respect to how you're thinking about inflation here? Are you assuming that the current inflationary environment in persisting through the remainder of 2023 as you're filing for rates?"
},
{
"speaker": "Tom Wilson",
"text": "Let me finish and make sure we respect for people's time on that question. So first, when you look at overall inflation, the numbers Fed and everybody else sees, that's one set of numbers. If you look at the inflation in what we do, it's of course, dramatically higher. And those are subject to different things. So whether the Fed tightens the economy, it doesn't tighten economy, probably isn't going to do a lot to keep people from having severe accidents, hurting themselves and needing a lot of medical care or then more lawyers getting involved in the case, nor will it have a huge impact on what the OEs charge on parts. They tend to charge more in parts based on what they're doing to overall profitability and how many new cars are selling. So if we go into a recession, they sell new cars, I don't expect they're going to cut car's prices. So we think inflation will persist in this business at a higher level than you see from the overall CPI, and that's why we're having to raise prices for our customers."
},
{
"speaker": "Tom Wilson",
"text": "Thank you all for participating today. Thank you for being generous with your time. We're going a few minutes over. Our priorities, make sure we're going to make money in auto insurance and continue to leverage our superior position in homeowners as start to grow and execute Transformative Growth, whether that's by getting our costs down, rolling out new products, expanding our National General platform. And then we didn't spend any time today on the great stories we have in the lower oval, which is expanding Protection Services. So a lot of things we're working on hard to create more value for you. Thank you, and we'll see you next quarter."
},
{
"speaker": "Operator",
"text": "Thank you, ladies and gentlemen, for your participation in today's conference. This does conclude the program. You may now disconnect. Good day."
}
] | The Allstate Corporation | 18,711 |
ALL | 4 | 2,024 | 2025-02-06 09:00:00 | Operator: And thank you for standing by. Welcome to The Allstate Corporation's third quarter earnings investor call. At this time, all participants are in a listen-only mode. To ask a question during this session, you'll need to press star one one on your phone. If your question has been answered and you wish to remove yourself from the program, it is being recorded. And now I'd like to introduce your host for today's program, Alastair Gobin of investor relations. Please go ahead, sir.
Alastair Gobin: Thank you, Jonathan. Good morning. Welcome to The Allstate Corporation's fourth quarter 2024 earnings conference call. Yesterday, following the close of the market, we issued our news release and investor supplement and posted related material on our website at allstateinvestors.com. Our management team will provide perspective on our strategy and an update on results. After prepared remarks, we will have a question and answer session. As noted on the first slide of the presentation, our discussion will contain non-GAAP measures for which there are reconciliations in the news release and investor supplement, and forward-looking statements about The Allstate Corporation's operations. Allstate's results may differ materially from these statements, so please refer to our 10-K for 2023 and other public documents for information on potential risks. Our 10-K for 2024 will be published later this month. And now, I'll turn it over to Tom.
Tom Wilson: Good morning. We appreciate you investing time at The Allstate Corporation. I'll start with an overview, and then Mario and Jess will go through the operating sales. Let's begin on slide two. So as you know, Allstate's strategy has two components: increased personal property liability market share and then expand protection provided to customers, which is shown in the two o's on the left-hand side. On the right hand, you can see Allstate's strong performance in 2024 and the topics we're gonna cover this morning. Total revenues were $16.5 billion in the fourth quarter, up 11.3% compared to the prior year quarter. Allstate generated net income of $1.9 billion in the fourth quarter, and $4.6 billion for the full year. Adjusted net income return on equity was 26.8%. Let me just repeat that, 26.8% over the last twelve months. Successful risk return management resulted in excellent underwriting and investment. Transformative growth has strengthened our competitive position. We'll spend a few minutes on that today. The sale of our group health and employee voluntary benefits to companies with greater strategic alignment will generate $3.25 billion of expected proceeds representing attractive valuation multiples. Let's move on to slide three. That shows the operational execution produced excellent financial results in the quarter and for the full year. Revenues increased to $64.1 billion in 2024. Property liability earned premiums were up 10.6% in the quarter and 11.2% for the full year. Net investment income was up 37.9% about the prior year.
Tom Wilson: And up almost 25% for the full year. Income was $1.9 billion in the quarter and $4.6 billion for the full year. Adjusted net income, which, you know, we make a few changes on amortization of intangibles, things we just can walk you through. The amount was $7.67 per share for the fourth quarter. On the lower right, you can see the adjusted net income return to that equity was 26.8%. So 2024 was an excellent year for Allstate both financially and strategically. Let's move on and talk strategically about transformative growth at slide four. We launched this project in December of 2019. So five years have gone by, so that'd be a good time to give you a five-year look as to where we are. And as you know, there's five components at the plan to increase market share and property liability, two of which we'll cover today. Improving customer value requires us to lower our cost and provide differentiated products. As you can see on the right-hand side, the adjusted expense ratio, which excludes advertising cost, has improved almost five points since 2019 by eliminating work outsourcing and digitizing activity using less real estate and lowering distribution. That's just lower cost enable us to offer more competitive prices.
Tom Wilson: Without impacting margins. Substantial progress has also been made in introducing products. New products. So affordable simple connected auto insurance is now in thirty-one states. And the new homeowners product is in four states. Differentiated custom three sixty middle market standard and preferred auto and homeowners price have also been introduced to the independent agent channel in thirty states. One of the most significant changes is the expansion of customer access to improve growth. So this effort has three components. Improve Allstate agent productivity, expand direct sales, and increase independent agent distribution, all of which have been successful. Allstate agency productivity has increased. Enhancement to direct capabilities, lower pricing, and increased advertising is attracting more self-directed customers. The National General acquisition significantly expanded our presence in and capabilities in the independent agent channel. As you can see on the right, in 2019, more than three out of four new business policies came from the Allstate agent. Last year, new business was 9.7 million items. Seventy-six percent higher than 2019, significant contributions from each channel. Policies in force have increased from thirty to set from the two thirty-seven point three million despite the negative impact of those pandemic price increases. Transformative growth has positioned us for personal profit liability, market share growth, you'll hear more about from Mario. So now let me move on to Mario on property liability.
Mario Rizzo: Thanks, Tom. Let's turn to slide five. At the top of the table, you can see fourth quarter property liability underwriting income of $1.8 billion improved by $507 million compared to the prior year. Auto insurance generated $603 million of underwriting income, an improvement of $510 million compared to the prior year quarter and reflecting the successful execution of the profit improvement plan. Homeowners insurance underwriting income was also strong at $1.1 billion. This was $99 million lower than the prior year quarter due to increased catastrophe losses. The bottom half of the table, you see the strong margins delivered during the quarter. With the total property liability recorded combined ratio of 86.9 reflecting a 2.6 point improvement compared to the prior year. Auto and homeowner combined ratios in the quarter were both better than the targets for those businesses of mid-nineties for auto and low nineties for homeowners. Now we'll expand on the auto insurance margins on slide six. We you can see how successful execution of the auto profit improvement plan has restored profitability back to target levels. The fourth quarter auto insurance recorded combined ratio of 93.5 was 5.4 points below prior year quarter as average earned premium outpaced loss cost. As a reminder, we regularly review claims severity expectations throughout the year. If the expected severity for the current year changes, we record the year to date impact in the current quarter even though a portion of that impact is attributable to previous quarters. For 2022 through 2024, the bars in the graph reflect the updated average severity estimates as of the end of each of those years to remove the volatility related to entry year severity adjustments. The table at the bottom of the graph shows actual reported combined ratios. In the fourth quarter of 2024, the full year claims severity estimate went down there was a benefit from prior quarters included in the fourth quarter's reported results. This benefit was worth 1.5 points in the fourth quarter with the adjusted quarterly combined ratio of 95 shown in the furthest bar to the right. Let's turn to slide seven where you can see that homeowners insurance produced attractive returns and group policies in force in 2024. With an industry leading product, advanced pricing, underwriting, and analytics, broad distribution capabilities, and a comprehensive reinsurance program we will continue to win the homeowner's business. On the left, you can see some of the key factors that contributed to strong results. Including increased written premium of 15.3% in the fourth quarter compared to prior year. Reflecting higher average gross written premium per policy and policy enforced growth of 2.4%. For the full year 2024, the homeowners insurance business recorded a combined ratio of 90.1 in line with our low nineties target, while generating total underwriting profit of $1.3 billion.
Mario Rizzo: So the combined ratio for 2024 improved by 16.7 points primarily driven by lower catastrophe losses and strong underlying loss performance. The chart on the right shows Allstate's strong track record of profitability in homeowners insurance. Allstate produced a recorded combined ratio of 92 over the past ten years which compares favorably to the industry which experienced an underwriting loss a combined ratio of 103 over that same time period. Now let's go to a homeowner pertinent topic on slide eight. And discuss the California wildfires. So Allstate responded quickly empathetically to help customers and communities after the tragic wildfires in Southern California. Deployed mobile claim centers and over nine hundred team members to assist customers. Helping our customers recover from the fires, is our principal priority. The financial impact of the wildfires reflects the comprehensive risk and return approach we've taken to managing the homeowners insurance business. Allstate made the decision to reduce California exposure beginning in 2007. Our homeowners market share has been reduced by over fifty percent since that time, as you can see on the chart on the left. While it is early and we have not been able to adjust many claims, current gross losses are estimated at $2 billion which includes loss adjustment expenses, and an estimated California fair plan assessment. Reinsurance recoveries of $900 million net of reinstatement premiums would reduce the net loss to $1.1 billion which will be reflected in first quarter 2025 earnings. Each additional $100 million in gross losses above our current estimate would result in $10 million of net losses since we are above the reinsurance attachment point of $1 billion. We will continue to monitor the development of this event and provide any updates with our January catastrophe release which we'll make on February twentieth. Looking forward, let's discuss policy and force trends in the property liability business on slide nine. The chart to the left shows the composition of property liabilities thirty-seven point five million policies in force. Auto is the largest at twenty-four point nine million. Homeowners represents approximately twenty percent of policies enforced. As you can see on the right side of the page, auto insurance policies in force declined by 1.4%. A decline in customer retention particularly in states with large recent rate increases more than offset a nearly thirty percent increase in new business applications in the quarter. Auto policies enforced did increase in thirty-one states representing approximately sixty percent of countrywide written premium on a year over year basis.
Mario Rizzo: In the middle column on the right, you can see that homeowners insurance policy is enforced increased by one hundred and seventy-three thousand or 2.4% driven by strong retention and a 20.5% increase in new business. We view homeowners as a growth opportunity across all distribution channels. Our objective in 2025 is to grow property liability policy and continuing strong new business sales. We are proactively contacting customers to lower the cost of protection to increase retention. Completing the rollout of affordable simple, and connected auto and homeowners products will also enable growth. In addition to improving the customer experience, these products contain our most sophisticated rating plans and telematics offerings. Which will deliver profitable growth and position us to compete effectively in a market where more carriers are looking to grow. We will also continue to invest in marketing and leverage broad distribution to grow property liability market share. To provide transparency to investors on our progress on growth, monthly disclosure of policies in force will be provided beginning with our next monthly release in a couple of weeks. Now I'll turn it over to Jess.
Jess Merten: Alright. Thank you, Mario. Slide ten provides insights on performance and asset allocation. By taking a proactive approach to portfolio management, Allstate optimizes return for you to the risk across the enterprise. This disciplined approach includes comprehensive monitoring of economic conditions, market opportunities, interest rates, and credit spreads. The chart on the left shows a quarterly trend of net investment income our fixed income earned yield. Market based income of $727 million, which is shown in blue, was $123 million above the prior year quarter, reflecting a higher fixed income yield and increased assets under management. Fixed income yields shown below the chart has steadily increased as we repositioned into higher yielding longer duration assets. Increasing forty basis points from point zero percent to 4.4% over the past year. Performance based income of $167 million shown in black was $107 million above the prior year quarter where reflecting higher private equity and real estate investment results. We've mentioned previously, our performance based portfolio is intended to provide long term value creation and volatility on these assets from quarter to quarter is expected. Pie chart on the right shows our asset allocation as of year end 2024. As you can see, our portfolio is largely comprised of high quality, liquid, interest bearing assets. Public equity holdings were increased by $2.4 billion in the fourth quarter and now comprised $3.3 billion or approximately 5% of the total portfolio. Fixed income duration was 5.3 years, which is in line with prior year quarter and up from 4.8 years at the end of last year. Let's turn to slide eleven and discuss protection plans business which is a key component of protection services and advance our strategy to expand protection while generating profitable growth.
Jess Merten: Protection plans offers protection that prepares or replaces a wide range of consumer products, including electronics, computers and tablets, TVs, mobile phones, major appliances, and furniture that are either damaged or broken. The products are distributed through strong retail relationships. Revenues of $528 million in the fourth quarter grew 20.3% prior year, driven by both domestic and international expansion. Profitable growth resulted in adjusted net income for the quarter of $37 million, which is consistent with the prior year quarter, and an increase for the full year of $40 million to $157 million reflecting the benefit of higher revenues and claims cost improvements. The business has profitably grown to approximately 160 million policies adding 60 million since 2019 through broad distribution and protection offerings as well as geographic expansion. Additionally, revenue has increased to nearly $2 billion in 2024, reflecting 23.9% in annual compounded growth since 2019 while generating more than three quarters of a billion dollars in adjusted net income 2019 to 2024 as growth offsets expansion investments. We continue to invest in this driving business as evidenced by the recent acquisition of Kingfisher, which enhances our mobile phone protection capabilities. I would like to transition slide twelve into discuss how the sale of the employer voluntary benefits and group health businesses create shareholder value. As a reminder, the decision to pursue the sale of health and benefit was based on the assumption that these businesses would have greater strategic value to other companies and selling them would maximize shareholder value. The transactions we've announced support this assumption. In August, we agreed to sell the employer voluntary benefits business to Stancorp Financial for $2 billion. We expect to close that in the first half of 2025. Last week, we marked another major milestone with our agreement to sell the group health business to Nationwide for $1.25 billion which we expect to close sometime in 2025. Both of these transactions are economically and financially attractive for our shareholders, The combined proceeds of these sales are $3.25 billion with an expected book gain of approximately $1 billion. Using trailing twelve months adjusted net income, the combined estimated impact of the transactions on adjusted net income return on equity then a decrease of about 180 basis points due to lower income and higher equity resulting from the gains on sale. As a reminder, the Group Health business is part of National General, which we acquired in January of 2021 for $4 billion. The proceeds from this divestiture combined with about a billion dollars in dividends that we received from National General statutory legal entities represents a return of more than half of the original purchase price while the sides with the National General Property Liability business approximately doubled. Touching briefly on the results of health and benefits for the quarter. Premium and contract charges for the segment increased 3.2% or $15 million compared to the prior year quarter, Individual and group health business saw strong growth with premiums and contract charges up 8% and 9.8% respectively. This growth was partially offset by a modest decrease in employer voluntary benefits. Adjusted net income for the segment of $35 million in the third quarter was $25 million lower than the prior year quarter as increased benefit utilization across all three businesses impacted profitability. Underwriting and rate actions are being taken to quickly address benefit ratio trends and restore margins to historical levels. Options for the individual health business, which has adjusted an income of $30 million for 2024, are being evaluated and the business will either be retained or combined with another company. Let's close on slide thirteen by reviewing Allstate's strategy to create shareholder value. As you can see on this page, we create value by delivering attractive financial returns executing transformative growth to increase property liability market share, expanding protection offerings, completing the sales of employee voluntary benefits and group health businesses. So with that context, I'd like to open up the line for your questions.
Operator: Certainly. And our first question for today comes from the line of Rob Cox from Goldman Sachs. Your question, please?
Rob Cox: Hi. Good morning. Thanks for taking my question. So first question for you, I had on advertising. I think you all had previously said that you were pretty comfortable with the 3Q 2024 level of advertising spend. Was hoping you could talk about the decision to ramp it up here in the fourth quarter. And I'm curious, what your measures of ad spend efficiency are telling you in the current environment, and how does that compare to history?
Tom Wilson: So, Rob, we're comfortable with our advertised spending. We adjusted obviously, by quarter to point out, and it also depends which markets we're after. Sometimes we do some heavy up tests in particular months to see what the sense is. I can assure you we have state of the art analytics on that. It's everything every kind of lead we bid on leads automatically. We just to make sure we were good last year, we had a number of outside people come in and look at our analytics. And we appear to be at least contemporary, if not industry leading. Now, you know, some of these are people you're buying ads from, they're not gonna come tell you stupid. But when we look at it in total, we think we're really good at it. And we have all kinds of allowable acquisition cost measures that look at everything from quote to close ratios to lifetime value.
Rob Cox: Got it. Thank you. Secondly, I wanted to ask a question on the comment in the press release about expecting growth in total property liability PIF in 2025. You know, we've been thinking that you could certainly grow PIF in both home and auto in 2025. Is there any reason why you would be hesitant to commit to growing in both of the segments, or am I looking too deeply into that statement? Let me make a comment and then turn it over to Mario.
Tom Wilson: So first, as you know, we don't give forward-looking projections on PIF growth. So what we've said to help bring some clarity to it is we're just gonna give you the numbers every month like we do with cats, and you can decide what you wanna do with that. We're obviously already growing at home, and we have plans we talked a little bit in the press release on where we're growing at auto. But in total, we're not growing in auto. So Mario is working on that. Mario, you wanna talk about what you got going?
Mario Rizzo: Yeah. Thanks for the question, Rob. Look, I'd say look, the objective of transformative growth is to grow policies in force and gain market share in the property liability business. That's our goal. That's our objective. Having said that, as Tom mentioned, we're currently growing the homeowners business. We think there's a real opportunity in the market. We're gonna continue to lean in on that one. A, because we've got really strong capabilities. B, there's disruption in the market that we can take advantage of, and we like the prospects of continuing to grow homeowners. On the auto side, we think despite the fact that policies are declining, we're really well positioned to lean into growth going forward for a variety of reasons. I think the first is, you've seen the new business momentum build over the course of 2024. In part due to your first question, our advertising investment that we've increased throughout the year, but we've also been doing things like unwinding underwriting restrictions and looking to accelerate growth across all distribution channels. We're gonna continue to fully leverage our broad distribution capabilities alongside that marketing investment continue to roll out new affordable, simple, and connected product. We are currently in thirty-one states. We'll continue to expand that. Over the course of this year. That has our most sophisticated pricing our most contemporary telematics offerings included in that. We're gonna continue to leverage capabilities on the Allstate side. International General just talked about the growth that we've seen in National General. We're gonna leverage middle market capabilities in Allstate to grow National General in a part of the market that they have less penetration in. We're also gonna use National General's capabilities in the nonstandard auto space and leverage the Allstate brand to begin to accelerate growth in that space. So we've got a lot of things that we've both been doing and expect to do in 2025 to accelerate growth and, really, that was the genesis of the statement. Oh, yeah. One last point I should have brought up is retention. Yeah. Everything I talked about was on the new business side. You know, we've seen the adverse impact of retention as we've been having to raise prices over the last couple of years. To improve margins. The good news is auto margins are back where we would want them to be in the mid-nineties range. The downside of that is, retention. Has taken a hit. Some of that will come back as we are less active in taking prices going forward because of where margin sits. But additionally, and more importantly, we're gonna proactively lean into reaching out to customers, helping them save money, by making sure they're getting all the appropriate discounts, they've got the right coverage levels that meet their specific needs, and the objective there is to improve affordability, improve customer satisfaction, and retention and that will be added into our growth trends.
Rob Cox: Very much for the answers.
Operator: Thank you. And our next question comes from the line of Gregory Peters from Raymond James. Your question, please.
Gregory Peters: Good morning, everyone. So for my first question, feedback on the last answer there, Mario. And you know, you said on slide nine here for the auto policies, you said that you're proactively contacting existing customers. You mentioned that in your answer. Can you give us an updated perspective on how you think your pricing is on a competitive positioning basis versus your peer group and as you shift gears and proactively contact existing customers, does that mean that there's gonna be some sort of corresponding adjustment in agent compensation that's gonna give more weighting to retention versus just flat out new sales?
Tom Wilson: Right. Let me the pricing was complicated, so I'm gonna let Mario do that one. But I would make one point on the retention part. I think having branded agents who work exclusively with you is the best channel to be able to do what we're talking about. So, you know, we've raised some people's prices thirty, forty percent. We had to do it quickly because we're losing money. Now we can go back in and help them get the absolute right coverage. That could be deductibles. It could be coverage limits. It could be using telematics. It could be paying differently. So there's lots of different ways we can help them do that. And that would be very difficult to do in through an independent agent channel. It would be harder to do with a direct channel because you don't have the skills and capabilities built in your call centers necessarily do that. Our agents the Allstate agents are used to doing this all the time. They certainly did it when we were raising rates. But now Mario has a new program going on, which is a safe program to which has specific goals, numbers. We are not planning on changing agent comp. Margaret, do you wanna talk about competitive position in?
Mario Rizzo: Yes. Thanks, Greg. The and competitive position, I'd say a couple of things. First, when you look at the ramp up in new business over the course of the year, and, you know, we made a comment that we're growing in thirty-one states currently. I think that's indicative of having competitive prices and being able to, you know, fully leverage the marketing investment that we're making. It is a complicated question. It's hard to answer it on a national basis because, obviously, we compete market by market, state by state, and we're constantly looking at our competitive position and making tweaks to, you know, the tiers within our pricing plan to adjust prices when we think it's appropriate to adjust prices. Good news is, you know, we've achieved target margins. So we're comfortable with where our rate level is currently. And we would expect that we would need to take less price going forward. But when you look at our new business trends, we feel good about competitive prices. We've taken a lot of cost out of the system over the past several years, as Tom mentioned earlier, which is helpful. We're gonna continue to pull that lever going forward. But we think we're priced competitively and we have the broad distribution capabilities to continue to grow in the auto space. The only other point I'd make on your second question about the proactively contacting customers and agency compensation a meaningful portion of the agent compensation currently relates to renewal. So they've got a strong economic vested interest in retaining as many customers as they possibly can. And as Tom mentioned, they've been doing that. This is a way through the same program where we're gonna really scale it and do it much more broadly. To help drive retention proactively versus just relying on less instability in the market from rate increases.
Gregory Peters: Thanks for that information. Tom, in as my follow-up question, Tom, in your opening comments, when you were going through the information on slide two, you emphasized the ROE of 26.8%, which I could believe is one of the best results I've seen from your company in recent history. Can you provide some view of how you are thinking about the ROE going forward and maybe what the board how the board's viewing it. I guess the reason why I'm asking is, you know, you've disposed of some underperforming assets, you know, over the last decade, and it feels like there's just a natural migration that the ROE objectives for the organization can be moving up certainly this result for last year sort of puts an explanation point on that.
Tom Wilson: Good question, Greg. And with longitudinal perspective on it. So as you remember, I don't remember how many years ago it was. At one time, we put out a target of fourteen to seventeen percent. But I would say that was a different company and a different time. It was a different company and that we had a life business. It was a different time and that interest rates were a lot lower. People were thinking it was low for bond. Since then, of course, as you point out, we've made a bunch of changes. We've sold the life business. We bought back a substantial amount of stock, which takes some of our investment earnings down. Our premiums are up substantially. Not just because we've grown total policies, but also because there's just higher cost per policy which I think the market isn't really affected and that that includes requires more capital. So when you look all through it, we feel really good about where we're at. When we put that fourteen to seventeen percent out there, it was really because investors were not sure given the time and given the nature of the company where our returns would be and would they be acceptable. We never said it was capped. And so, obviously, now we're doing better than that. I would say the most important thing for us to do now is to increase growth. So increasing returns won't drive that much more shareholder value. What will drive more shareholder value is growth. And we've obviously growing and are growing a bunch of our other businesses. So whether that's our homeowners business, whether that's for growing premiums, which people kind of get all focused in on auto pay, and AutoPIP is important, and we're gonna grow AutoPIP. But when you look at just growth in premiums, you know, we're up double digit single low low teens percent depending which measure you wanna look at last year. So we feel good about overall growth think and the key to unlocking the value we've already created through growth is to get auto unit growth up.
Gregory Peters: Got it. Thanks for the answers.
Operator: Thank you. And our next question comes from the line of Michael Zaremski from BMO. Your question please.
Michael Zaremski: Hey. Thanks. Good morning. And my first question is on the expense ratio and kudos to to kinda, you know, lowering it over time and and meeting your goal. Curious. I think in the in the past, Tom, recent past, you said that you have plans to to improve it even further. Maybe I'm maybe that's the expense ratio x add expense. If that's the case, are you able to kind of elaborate on what the building blocks are going forward to to to continue the improvements.
Tom Wilson: So yeah. So the answer is yes. We always expect to keep reducing expenses, and we think we have an opportunity to even lower them farther from where they are now. We're not done. I would say, you know, maybe we're sixty percent of the way done. And, you know, and I but I wouldn't, like, take that and multiply that by some percentage change because part of that percentage change just to be completely transparent is because premiums have gone up faster than general inflation. So you kinda can't count can't count that as as much. So we are constantly work I think the where is we're after will be digitization. Leveraging the new technology platform we built the affordable simple connected is all designed around doing that increasing our marketing effectiveness. So even though we carve marketing out from that number, that doesn't mean, like, we're just gonna spend wild on marketing. It needs to have the same level of precision and to it that everything else does. And we also still need to lower distribution cost. You know, the distribution costs are still higher than we would like them to be, so we have work to do there as well.
Michael Zaremski: Great. And my final follow-up is just more high level on the devastating tragedy in California. I know it's kinda still a fluid situation, but I think a few of your competitors have, you know, expressed as a vet they might need to retrench even more in California given the payback the potential payback on the losses are going to be many, many, many years. Curious if you think this could cause Allstate to also rethink its ambitions of growing or or just just overall growth in in California might might My My a different direction. Thanks.
Tom Wilson: Well, every state's different. We don't have any growth aspirations in homeowners in California at this point. And we haven't since 2007, really. We had a small window in there where we thought we had some arrangements where it would make sense for us to grow, that didn't turn out to be the case. So we had turned off the spigot for new customers. We didn't go nav for new people, but we just said we're not gonna take add new customers. Starting in 2007. Then in about 2017, eighteen, I'm looking at my here. Yeah. We said, you know, we think we can take on a few new customers to That didn't turn out to be true, so we stopped that then in 2022. But we've been at this a long time. And so we don't have any growth aspirations in California right now. That said, we're really good at homeowners. We make more than half of the industry's profits. We've got a good business model. We think it's a great growth opportunity. And it doesn't have to be the way it is in California. So Texas has just as many types and dollar amount of losses as California does, yet the homeowners market works there. And so we believe that there's a way to make that work. We'd like to work with a state to make it work because people want to insure their homes. They need to ensure their homes. And we just need to make sure it's done on a basis that is fair to consumers, but also gives our shareholders an appropriate return for the risk. So example, we don't wanna have to do things like in California. Mario talked about the numbers. We have a substantial amount of reinsurance recoveries. We're a cost plus business. We did not the cost for that reinsurance that we just now got back to with lower losses. Which means that, you know, we need to have a structure. The departments talked about that. They're open to that. So I would say that these things you know, they happen over a long time, and it takes a while for them to get. So I don't think anything's gonna change in the next you know, it's not like in twelve months. Everybody's gonna be rushing into California to write homeowners. It just doesn't happen that fast.
Michael Zaremski: Thank you.
Operator: Thank you. And our next question comes from the line of Christian Getzoff from Wells Fargo. Your question, please.
Christian Getzoff: Hi. Good morning. My first question is on retention. I didn't see any retention numbers in the press release for supplements. I was wondering if you could provide that. And then you say the majority of the headwinds on retention just from, like, know you guys called out Esurance migration and then the New York, California, New Jersey rate hikes. Are those is the majority of that headwind paid it by now, or do you expect some further headwinds kind of in the first half?
Tom Wilson: I'll make a couple comments then, Jess. May wanna comment. So at first, we've paid a lot of attention to attention in it. In more granularity than you just even mentioned, whether it's this book of business, this state, his risk cover, his whatever, you know, his price changes. We're like, we're all over retention. Just made the decision that rather than give you the components which are complicated and we spend a bunch of time helping you spend a bunch of time trying to figure out retention on this much and how much policy too. Just just so why don't I just give you the numbers? I'll just give you the fifth numbers every month. You'll know what the numbers are. You don't have to get caught up into what's your projections on new business, what's your projection on retention, presurience policy. So the our goal was to increase transparency and give you more information you can use to make your investment in recommendation decisions rather than less into an So that that's what we've set out to do. Maybe Jess or Mario, you guys wanna talk about the retention and how you're feeling about it and other ways to measure it. Maybe I'll just touch on this round out the disclosure, and then, Mario, you can talk about your thoughts. You know, I think the other thing, you know, to keep in mind is, as Tom mentioned, we gave you component a component. We didn't even give you all of the components. We believe by giving you tip on a monthly basis, you'll have more transparency. Recall, what we gave you was Allstate brand, gift or Allstate brand retention rather. So it was a piece of the puzzle and we spent a lot of time explaining movements between brands which we wanted to move away from. So I really believe that that what we're giving you now on a monthly basis will be much clearer and actually, you know, reduce a lot of the complication that came from our disclosure. And as Tom said, put you in a better position to understand new business and retention trends and frankly with the total policy in force trend is. So it was definitely a move to increase transparency by taking away and really completing that move away from brand to line of business and distribution channel.
Mario Rizzo: Yeah. The only thing I'd add on on retention, I think it's important to take a step back and look at what we've really been saying over the last several years, which our principal focus would say, you know, heading into 2024, was to improve auto margins. I think we were pretty clear on that. That was our principal priority. We had to take prices up a lot to do that over forty percent when you look over the past several years. The good news is, you know, margins are back to where we want them to be and where they need to be. And as from a new business perspective, as best kind of played out, you've seen us kind of lean back into the market and really accelerate new business growth over the course of last year. The downside to that approach and that strategy with retention as you mentioned, which has stabilized in a number of states as we've cycled through what we needed to do to improve profitability. But as we talked about before, there were a handful states that were a little later to the game in terms of getting margins back to where they needed to be. We talked extensively about California, New York, New Jersey, The good news is we've been making good progress in those three states. We've been making it by implementing some pretty meaningful rate increases. That is having a drag on retention as we cycle our way through that. We should see that stabilize. I will say though, New York and New Jersey, we still got some work to do. We're our margins are better, but they're not where we'd like them to be. We're gonna continue to pursue rate in those states. But we, you know, believe we can overcome that. Because we got a lot of growth opportunity in the rest of the country.
Christian Getzoff: Gotcha. Thank you. And going back to the California wild losses, I know you provided a $2 billion gross s You provided some sensitivity, but what are you assuming in terms of the industry losses so we could, like, flex that sensitivity up or down depending on how the losses develop.
Mario Rizzo: Yeah. Look. And the this is Mario. The way I'd answer that question is, obviously, there's a lot of moving parts in in our estimate. We know our data with a lot of specificity because we have that. We've made assumptions around a fair plan assessment just given the, you know, the the the magnitude of the of the losses we've seen and also when you when you look at the fare plan surplus level as of the end of the third quarter, their reinsurance and their co participation in that, we think it's pretty likely that they're gonna you know, kind of exceed their their surplus levels and there will likely be an assessment. We've got that in there. And we you know, our our our number includes a view of what the industry loss is. I really don't wanna to kind of disclose what our view on that is, but there's I will say we've made certain assumptions to come up with our number both in terms of ourselves and the fair plan. We'll keep looking at those because it's a pretty fluid process and we'll update it as we get more information. If we need to update.
Tom Wilson: So here's if you want a sensitivity. For every hundred million, it's ten million bucks. So for every five percent or often total, it costs us ten million dollars. So if we're off by fifty percent, so it's another billion dollars, it costs us a hundred million. Right? So the I don't think you need to worry about sensitivity on the gross loss.
Christian Getzoff: Thank you.
Operator: Thank you. And our next question comes from the line of Timmy Peller from JPMorgan. Your question please.
Timmy Peller: Hey. Good morning. I had a question first on just the auto business. You mentioned PIF turning positive in thirty-one states, I think. And I'm assuming what's unique about those states is just the fact that you're not raising prices as much. And advertising more. So if that is true, then could you talk about of the remaining that you're not growing in, should that begin, happen throughout the year gradually, or is there more of a cliff event? Some point later in the year? When you will lap those comps and you're not gonna be raising prices just to sort of be able to assess when those stocks, states will begin to show better growth.
Tom Wilson: Timmy, I'll let Mario talk about the pace, but I don't think he's gonna give you an answer by quarter. Alright. I got it. It's more complicated though than just those two factors. Alright? So it's not just, are we not taking price? And how much are we advertising is what's everybody else doing? What kind of coverage are we offering, where are we with our ASC roll out, where are we with our custom three c. So it's a really complicated machine that Mario's running. And but the goal is sometimes attribution helps explain why you are you're on Sometimes attribution leads to excuses. And we're not interested in excuses. We're interested in results, which grows. So Mario can talk about how these thinking about that maybe you wanna talk about both the impact of retention and the impact of new business over the course there, but we can't give you, obviously, a per quarter PIP number. Just watch for Jess's monthly number.
Mario Rizzo: Yeah. Timmy, thanks for the question. Look, at lower where I'd say is like, we wanna grow in every state where it makes economic sense for us to grow and where we believe we can grow profitably. That happens to be thirty-one states now. We think the opportunity is beyond that level. And as Tom mentioned, there's a lot of components that factor into our ability to grow price is part of it, competitive position, and where our price hits relative to competition. The growth investments we're making, our risk appetite, there's a lot of factors that play into that. Retention is a key component of our ability to grow. Right? So what you saw in total this year was we had really good new business trends, and in the quarter, they kind of peaked in 2024. At almost thirty percent. Yet despite that, our units declined year over year. Because of the drag of retention. So we're focused through the same program on not just waiting for retention to bounce back because of less rate disruption in the system, gonna proactively do things to work with customers help them save money, improve affordability, and drive retention up. We think doing that well alongside all the other things I mentioned earlier new product rollout, new technology, distribution, and continued investments in marketing and all the things that helped us drive new business volume. That's the key that will drive growth broadly, and that's the plan we're executing on.
Timmy Peller: And then maybe just following up on capital. Like, the business is obviously profitable now. I think you'll make money even with the California buyers. In one queue, and then you've got the money coming in through the sales of the benefits and the health business. So how should we think And I'm assuming capital is not a constraint for growth given how much money you're gonna get from the sales, but should we think about capital deployment between growth, m and a, and share buybacks. And is it unreasonable to assume that you wouldn't be in the market buying back stock at some point assuming results come in as expected over the course of the CVA.
Tom Wilson: Timmy, if we consider proactive capital management to be a significant strength of Allstate. And it's added tremendous amounts of shareholder value. So and you're right. Share repurchase are obviously one of those. And we've used that extensively. But would encourage you to hold us accountable as you started to mention on really a broader basis. Right? So there's organic growth, there's risk and return on economic capital, there's inorganic growth, and then there's capital structure, which includes the share repurchases. And so let me just go through each of those. First, organic growth is a twofer. And based on the returns we're getting in our business today? It generates absolute dollar growth in earnings. Secondly, with that higher growth rate and we should have a higher PE, because if you look at our price earnings ratio versus any other insurer, and you look at our top line growth, the average premium growth is getting discounted, and it's basically all hung on auto unicorns. You can start whether that's right or wrong, but we think that that the unlock of in deploying capital to grow the property liability business both in units and premiums is will drive growth. So we think that's really important. Marketing, we talked a lot about that this morning, so I don't wanna And We don't need to go back through that. If you look at risk and return on economic capital, we have a really sophisticated way in just talked about this a lot within the last couple of years of how we manage capital, and associate a risk and return on that. That helps us do things like leverage our investment our investments, and that capability generates good returns. And I think it needs to be valued in its own right. It's but for example, the duration calls we made used additional economic capital. We knew that. We decided on it. It was part of the enterprise decision, and it's clearly generated good returns. Same thing is true with the reinsurance in California. We look at all those things economically. I think acquisitions also need to be assessed on the actual return on capital. So National in general and Square screen, both both both on the standpoint. When you look at National General, it's more than double its size on apples to apples basis from when we bought three years ago. SquareTrade is substantially bigger as maybe ten times bigger and making a hundred and fifty million bucks a year when we paid a billion four four nine. Just when you look at what was the net cost of National General and SquareTrade?
Jess Merten: Tell me, you take a look at you know, both of them, the net cost is about half of what we paid. So as I mentioned in my prepared remarks, we paid $4 billion for National General. When you add up the recently announced group health transaction, and the dividends we've been able to take out of the statutory entities which are about a billion dollars, we've reduced that purchase price by about $2.25 billion. So to $1.75 or less than half. The same will be true if you look at SquareTrade in the $1.4 billion acquisition. Since owning it, we've taken about half that back in, dividends based on earnings. While also and this is important, investing in growth, doing acquisitions. So we've gotten about half of it back and still invested. In growth on SquareTrade.
Tom Wilson: So and and then, of course, share repurchase is is an also thing, but you have to really look at how you manage your capital. Stack better. So for example, We issued a perpetual preferred stock. I don't remember how many years ago. We we issued two billion of stock. We bought back two billion in common, swapped fixed equity cost and left all the remaining upside with our common equity. Today. Preferred just has a what's current cost on the preferred?
Jess Merten: Oh, we have three different issuances, Tom. So we're our lowest is about 4.75% and then we have a tranche that was more recently issued at 7.375%. So we've got a range, but most of it the largest issuance actually is a 5.1%. Fixed for life. So, you know, obviously, and it the math is not exactly right because you got gap, capital, and gap. But if you look at our returns, On equity, on just actual market equity, it's substantially above that. So that's a that's a good trade. The we also look obviously, look at dividends and everything else. Share repurchases, we've done a lot of. And so so just you wanna just go through the numbers of what we've done on share repurchases. We have been a lot of time. So I took a look back and went all the way back to when Allstate went public. Since going public, we've repurchased about $41.5 billion of our stock, and that represents about 83% of the outstanding shares. If you bring that time frame in a little bit, I have over the last ten years, the number is closer to $17.5 billion. And about half of the outstanding shares over the last ten years. Bringing in again five year period, $7.8 billion of repurchase is about 25% of our outstanding shares and in all cases, at an average cost, it's very attractive. We even go through and look at the returns in all cases over any period, whether it's thirty years, five years, the return is significantly above our cost to cap. So we've had really good returns. And to your point, Tom, you know, buying back 83% since going publish public just shows our commitment to reverse.
Tom Wilson: Yeah. So, I mean, we've got plenty of things we do. And I would just you know, like, don't like, yes, share repurchases are important. I know it's a number of analysts wrote that up over the evening of, like, when you're gonna be back. I'm like, you should hold us accountable for manager and capital to drive shareholder value. And if that means growing faster, and using our capital to grow faster, then holds accountable for that. If we if we have extra capital, we don't hold on to it. And we buy back stock because we think, you know, when you look at our our value relative to our growth potential, the size of our business, our our PE. We still think it's cheap.
Timmy Peller: Yeah. Still better to get those questions and questions about adequacy of capital, I guess. So
Tom Wilson: And I thought those those were those were thoughts for sure.
Timmy Peller: Thank you.
Operator: Thank you. And our next question comes from the line of Bob Huang from Morgan Stanley. Your question please.
Bob Huang: Yeah. Good morning. I'm gonna stay away from capital. So the first question is on auto. And I mean, an investor astutely pointed out that on your first quarter 2024 slide, you talked about 64% of your total premiums were profitable. So fast forward today to today, then we're talking about about 60% of that premium is now growing. Is this fair to kind of make some type of causal correlation between the time you achieve profitability and the time that you you start to grow the business? In other words, is it fair to say that six to nine months from now, essentially, California, New York, New Jersey, they're only state you're unable to grow and everything else should be growing and that rather than the 60% of total premium is growing. Probably call it eighty or ninety percent of it should be. Is that a fair way to think about this?
Tom Wilson: I think the construct is right. I don't know if I would automatically extrapolate that extrapolate that into the future. I mean, it is true when we were losing money, we shut down advertising, shut down growth, be intentionally, because we said there's really no sense going to get a bunch of new customers we're gonna have to raise their price by fifteen percent relatively quickly, and it maybe then lose them. So what's the point to spend the money to getting a new customer to lose a bunch of money on, and you know you're gonna lose money on. So that is was true, and that's what we did. We also know that by driving that and going your crush we that it was going to her retention. And so now we're about so there it is a there are, you know, pieces you rolled in. I don't think you could automatically go to say, like, like, do an analysis of two line lines on a graph going up, and they would follow each you know, each sit each state's different, each position's different. You know, if if if if Mario wish to get adequate prices in New York, tomorrow, we have a great agency plant there. We have we got pretty we got huge share down in the in the New York area. And we could really leverage it to grow fast. When that will happen, who knows? So I think you should just hold us accountable for growing auto units, and I keep coming back to auto units is the unlocked A lot everything else is growing and it's like, so let's you know, it is it is an important part of our business. But we've got we got higher premiums, the reserve balances are up, the investment balances are up. That's all driving increase you know, protection plans is back in and out of the park. So we got lots of growth. We are focused on the unlock of auto unit growth.
Bob Huang: Got it. No. That's that's helpful. If I can just have a follow-up on that. I I I don't know if you'll address this, so apologies if you did. The question is really around adverse selection. Right? As we go into 2025. More and more auto carriers are profitable, and more and more auto carriers are talking about growth. Should we expect your current level of combined ratio to hold for auto as you head into a environment where everyone is looking for growth? Like, how do you feel about the the broader competitive environment as a whole?
Tom Wilson: Well, you're you're talking well, the auto market has obviously been competitive. And both Progressive, GEICO, State Farm, the big carriers that we compete with all the time have been out in the market and competitive this year. So people are advertising. It's it's last year, 2024. So it's not like it wasn't competitive and it's suddenly turning into competition. We think we have the capabilities to compete and grow. I would say that's a different market in homeowners where most people are backing out. There is a secular trend there. Where we have an opportunity to grow, and as we look at capital, one of the things we like to do is get a higher valuation on our homeowners growth. So when you look at our homeowner business and I said, jeez, if you have a business that's growing, you know, revenues in the mid-teens, it's it's picking up, not huge market share, but it's got you real unit growth. It's an industry leading model. It's earned money good money eleven out of twelve years. And and it has high returns on capital you probably wouldn't put it at the kind of PE that we have for our overall enterprise. And I suspect that if you actually looked at analysts, they might even give it a lower p e than our total. So we need to figure out how to have that fully recognized in our valuation. And it might mean doing something differently in reinsurance and lowering the volatility of that line. But just know that our goal is to increase shareholder value. Maybe we're close. I think we're in time. Our goal is to increase shareholder value, whether that's buy shares back grow, manage our capital structure differently, figure out how to compete differently, do more advertising. We're all about driving growth for shareholders. We think we have the tools and capabilities to do that, and we have a track record that shows we know how to get. Got So thank you all. We'll see you next quarter.
Operator: Thank you, ladies and gentlemen, for your participation in today's conference. This does conclude the program. You may now disconnect. Good day. | [
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"speaker": "Operator",
"text": "And thank you for standing by. Welcome to The Allstate Corporation's third quarter earnings investor call. At this time, all participants are in a listen-only mode. To ask a question during this session, you'll need to press star one one on your phone. If your question has been answered and you wish to remove yourself from the program, it is being recorded. And now I'd like to introduce your host for today's program, Alastair Gobin of investor relations. Please go ahead, sir."
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"speaker": "Alastair Gobin",
"text": "Thank you, Jonathan. Good morning. Welcome to The Allstate Corporation's fourth quarter 2024 earnings conference call. Yesterday, following the close of the market, we issued our news release and investor supplement and posted related material on our website at allstateinvestors.com. Our management team will provide perspective on our strategy and an update on results. After prepared remarks, we will have a question and answer session. As noted on the first slide of the presentation, our discussion will contain non-GAAP measures for which there are reconciliations in the news release and investor supplement, and forward-looking statements about The Allstate Corporation's operations. Allstate's results may differ materially from these statements, so please refer to our 10-K for 2023 and other public documents for information on potential risks. Our 10-K for 2024 will be published later this month. And now, I'll turn it over to Tom."
},
{
"speaker": "Tom Wilson",
"text": "Good morning. We appreciate you investing time at The Allstate Corporation. I'll start with an overview, and then Mario and Jess will go through the operating sales. Let's begin on slide two. So as you know, Allstate's strategy has two components: increased personal property liability market share and then expand protection provided to customers, which is shown in the two o's on the left-hand side. On the right hand, you can see Allstate's strong performance in 2024 and the topics we're gonna cover this morning. Total revenues were $16.5 billion in the fourth quarter, up 11.3% compared to the prior year quarter. Allstate generated net income of $1.9 billion in the fourth quarter, and $4.6 billion for the full year. Adjusted net income return on equity was 26.8%. Let me just repeat that, 26.8% over the last twelve months. Successful risk return management resulted in excellent underwriting and investment. Transformative growth has strengthened our competitive position. We'll spend a few minutes on that today. The sale of our group health and employee voluntary benefits to companies with greater strategic alignment will generate $3.25 billion of expected proceeds representing attractive valuation multiples. Let's move on to slide three. That shows the operational execution produced excellent financial results in the quarter and for the full year. Revenues increased to $64.1 billion in 2024. Property liability earned premiums were up 10.6% in the quarter and 11.2% for the full year. Net investment income was up 37.9% about the prior year."
},
{
"speaker": "Tom Wilson",
"text": "And up almost 25% for the full year. Income was $1.9 billion in the quarter and $4.6 billion for the full year. Adjusted net income, which, you know, we make a few changes on amortization of intangibles, things we just can walk you through. The amount was $7.67 per share for the fourth quarter. On the lower right, you can see the adjusted net income return to that equity was 26.8%. So 2024 was an excellent year for Allstate both financially and strategically. Let's move on and talk strategically about transformative growth at slide four. We launched this project in December of 2019. So five years have gone by, so that'd be a good time to give you a five-year look as to where we are. And as you know, there's five components at the plan to increase market share and property liability, two of which we'll cover today. Improving customer value requires us to lower our cost and provide differentiated products. As you can see on the right-hand side, the adjusted expense ratio, which excludes advertising cost, has improved almost five points since 2019 by eliminating work outsourcing and digitizing activity using less real estate and lowering distribution. That's just lower cost enable us to offer more competitive prices."
},
{
"speaker": "Tom Wilson",
"text": "Without impacting margins. Substantial progress has also been made in introducing products. New products. So affordable simple connected auto insurance is now in thirty-one states. And the new homeowners product is in four states. Differentiated custom three sixty middle market standard and preferred auto and homeowners price have also been introduced to the independent agent channel in thirty states. One of the most significant changes is the expansion of customer access to improve growth. So this effort has three components. Improve Allstate agent productivity, expand direct sales, and increase independent agent distribution, all of which have been successful. Allstate agency productivity has increased. Enhancement to direct capabilities, lower pricing, and increased advertising is attracting more self-directed customers. The National General acquisition significantly expanded our presence in and capabilities in the independent agent channel. As you can see on the right, in 2019, more than three out of four new business policies came from the Allstate agent. Last year, new business was 9.7 million items. Seventy-six percent higher than 2019, significant contributions from each channel. Policies in force have increased from thirty to set from the two thirty-seven point three million despite the negative impact of those pandemic price increases. Transformative growth has positioned us for personal profit liability, market share growth, you'll hear more about from Mario. So now let me move on to Mario on property liability."
},
{
"speaker": "Mario Rizzo",
"text": "Thanks, Tom. Let's turn to slide five. At the top of the table, you can see fourth quarter property liability underwriting income of $1.8 billion improved by $507 million compared to the prior year. Auto insurance generated $603 million of underwriting income, an improvement of $510 million compared to the prior year quarter and reflecting the successful execution of the profit improvement plan. Homeowners insurance underwriting income was also strong at $1.1 billion. This was $99 million lower than the prior year quarter due to increased catastrophe losses. The bottom half of the table, you see the strong margins delivered during the quarter. With the total property liability recorded combined ratio of 86.9 reflecting a 2.6 point improvement compared to the prior year. Auto and homeowner combined ratios in the quarter were both better than the targets for those businesses of mid-nineties for auto and low nineties for homeowners. Now we'll expand on the auto insurance margins on slide six. We you can see how successful execution of the auto profit improvement plan has restored profitability back to target levels. The fourth quarter auto insurance recorded combined ratio of 93.5 was 5.4 points below prior year quarter as average earned premium outpaced loss cost. As a reminder, we regularly review claims severity expectations throughout the year. If the expected severity for the current year changes, we record the year to date impact in the current quarter even though a portion of that impact is attributable to previous quarters. For 2022 through 2024, the bars in the graph reflect the updated average severity estimates as of the end of each of those years to remove the volatility related to entry year severity adjustments. The table at the bottom of the graph shows actual reported combined ratios. In the fourth quarter of 2024, the full year claims severity estimate went down there was a benefit from prior quarters included in the fourth quarter's reported results. This benefit was worth 1.5 points in the fourth quarter with the adjusted quarterly combined ratio of 95 shown in the furthest bar to the right. Let's turn to slide seven where you can see that homeowners insurance produced attractive returns and group policies in force in 2024. With an industry leading product, advanced pricing, underwriting, and analytics, broad distribution capabilities, and a comprehensive reinsurance program we will continue to win the homeowner's business. On the left, you can see some of the key factors that contributed to strong results. Including increased written premium of 15.3% in the fourth quarter compared to prior year. Reflecting higher average gross written premium per policy and policy enforced growth of 2.4%. For the full year 2024, the homeowners insurance business recorded a combined ratio of 90.1 in line with our low nineties target, while generating total underwriting profit of $1.3 billion."
},
{
"speaker": "Mario Rizzo",
"text": "So the combined ratio for 2024 improved by 16.7 points primarily driven by lower catastrophe losses and strong underlying loss performance. The chart on the right shows Allstate's strong track record of profitability in homeowners insurance. Allstate produced a recorded combined ratio of 92 over the past ten years which compares favorably to the industry which experienced an underwriting loss a combined ratio of 103 over that same time period. Now let's go to a homeowner pertinent topic on slide eight. And discuss the California wildfires. So Allstate responded quickly empathetically to help customers and communities after the tragic wildfires in Southern California. Deployed mobile claim centers and over nine hundred team members to assist customers. Helping our customers recover from the fires, is our principal priority. The financial impact of the wildfires reflects the comprehensive risk and return approach we've taken to managing the homeowners insurance business. Allstate made the decision to reduce California exposure beginning in 2007. Our homeowners market share has been reduced by over fifty percent since that time, as you can see on the chart on the left. While it is early and we have not been able to adjust many claims, current gross losses are estimated at $2 billion which includes loss adjustment expenses, and an estimated California fair plan assessment. Reinsurance recoveries of $900 million net of reinstatement premiums would reduce the net loss to $1.1 billion which will be reflected in first quarter 2025 earnings. Each additional $100 million in gross losses above our current estimate would result in $10 million of net losses since we are above the reinsurance attachment point of $1 billion. We will continue to monitor the development of this event and provide any updates with our January catastrophe release which we'll make on February twentieth. Looking forward, let's discuss policy and force trends in the property liability business on slide nine. The chart to the left shows the composition of property liabilities thirty-seven point five million policies in force. Auto is the largest at twenty-four point nine million. Homeowners represents approximately twenty percent of policies enforced. As you can see on the right side of the page, auto insurance policies in force declined by 1.4%. A decline in customer retention particularly in states with large recent rate increases more than offset a nearly thirty percent increase in new business applications in the quarter. Auto policies enforced did increase in thirty-one states representing approximately sixty percent of countrywide written premium on a year over year basis."
},
{
"speaker": "Mario Rizzo",
"text": "In the middle column on the right, you can see that homeowners insurance policy is enforced increased by one hundred and seventy-three thousand or 2.4% driven by strong retention and a 20.5% increase in new business. We view homeowners as a growth opportunity across all distribution channels. Our objective in 2025 is to grow property liability policy and continuing strong new business sales. We are proactively contacting customers to lower the cost of protection to increase retention. Completing the rollout of affordable simple, and connected auto and homeowners products will also enable growth. In addition to improving the customer experience, these products contain our most sophisticated rating plans and telematics offerings. Which will deliver profitable growth and position us to compete effectively in a market where more carriers are looking to grow. We will also continue to invest in marketing and leverage broad distribution to grow property liability market share. To provide transparency to investors on our progress on growth, monthly disclosure of policies in force will be provided beginning with our next monthly release in a couple of weeks. Now I'll turn it over to Jess."
},
{
"speaker": "Jess Merten",
"text": "Alright. Thank you, Mario. Slide ten provides insights on performance and asset allocation. By taking a proactive approach to portfolio management, Allstate optimizes return for you to the risk across the enterprise. This disciplined approach includes comprehensive monitoring of economic conditions, market opportunities, interest rates, and credit spreads. The chart on the left shows a quarterly trend of net investment income our fixed income earned yield. Market based income of $727 million, which is shown in blue, was $123 million above the prior year quarter, reflecting a higher fixed income yield and increased assets under management. Fixed income yields shown below the chart has steadily increased as we repositioned into higher yielding longer duration assets. Increasing forty basis points from point zero percent to 4.4% over the past year. Performance based income of $167 million shown in black was $107 million above the prior year quarter where reflecting higher private equity and real estate investment results. We've mentioned previously, our performance based portfolio is intended to provide long term value creation and volatility on these assets from quarter to quarter is expected. Pie chart on the right shows our asset allocation as of year end 2024. As you can see, our portfolio is largely comprised of high quality, liquid, interest bearing assets. Public equity holdings were increased by $2.4 billion in the fourth quarter and now comprised $3.3 billion or approximately 5% of the total portfolio. Fixed income duration was 5.3 years, which is in line with prior year quarter and up from 4.8 years at the end of last year. Let's turn to slide eleven and discuss protection plans business which is a key component of protection services and advance our strategy to expand protection while generating profitable growth."
},
{
"speaker": "Jess Merten",
"text": "Protection plans offers protection that prepares or replaces a wide range of consumer products, including electronics, computers and tablets, TVs, mobile phones, major appliances, and furniture that are either damaged or broken. The products are distributed through strong retail relationships. Revenues of $528 million in the fourth quarter grew 20.3% prior year, driven by both domestic and international expansion. Profitable growth resulted in adjusted net income for the quarter of $37 million, which is consistent with the prior year quarter, and an increase for the full year of $40 million to $157 million reflecting the benefit of higher revenues and claims cost improvements. The business has profitably grown to approximately 160 million policies adding 60 million since 2019 through broad distribution and protection offerings as well as geographic expansion. Additionally, revenue has increased to nearly $2 billion in 2024, reflecting 23.9% in annual compounded growth since 2019 while generating more than three quarters of a billion dollars in adjusted net income 2019 to 2024 as growth offsets expansion investments. We continue to invest in this driving business as evidenced by the recent acquisition of Kingfisher, which enhances our mobile phone protection capabilities. I would like to transition slide twelve into discuss how the sale of the employer voluntary benefits and group health businesses create shareholder value. As a reminder, the decision to pursue the sale of health and benefit was based on the assumption that these businesses would have greater strategic value to other companies and selling them would maximize shareholder value. The transactions we've announced support this assumption. In August, we agreed to sell the employer voluntary benefits business to Stancorp Financial for $2 billion. We expect to close that in the first half of 2025. Last week, we marked another major milestone with our agreement to sell the group health business to Nationwide for $1.25 billion which we expect to close sometime in 2025. Both of these transactions are economically and financially attractive for our shareholders, The combined proceeds of these sales are $3.25 billion with an expected book gain of approximately $1 billion. Using trailing twelve months adjusted net income, the combined estimated impact of the transactions on adjusted net income return on equity then a decrease of about 180 basis points due to lower income and higher equity resulting from the gains on sale. As a reminder, the Group Health business is part of National General, which we acquired in January of 2021 for $4 billion. The proceeds from this divestiture combined with about a billion dollars in dividends that we received from National General statutory legal entities represents a return of more than half of the original purchase price while the sides with the National General Property Liability business approximately doubled. Touching briefly on the results of health and benefits for the quarter. Premium and contract charges for the segment increased 3.2% or $15 million compared to the prior year quarter, Individual and group health business saw strong growth with premiums and contract charges up 8% and 9.8% respectively. This growth was partially offset by a modest decrease in employer voluntary benefits. Adjusted net income for the segment of $35 million in the third quarter was $25 million lower than the prior year quarter as increased benefit utilization across all three businesses impacted profitability. Underwriting and rate actions are being taken to quickly address benefit ratio trends and restore margins to historical levels. Options for the individual health business, which has adjusted an income of $30 million for 2024, are being evaluated and the business will either be retained or combined with another company. Let's close on slide thirteen by reviewing Allstate's strategy to create shareholder value. As you can see on this page, we create value by delivering attractive financial returns executing transformative growth to increase property liability market share, expanding protection offerings, completing the sales of employee voluntary benefits and group health businesses. So with that context, I'd like to open up the line for your questions."
},
{
"speaker": "Operator",
"text": "Certainly. And our first question for today comes from the line of Rob Cox from Goldman Sachs. Your question, please?"
},
{
"speaker": "Rob Cox",
"text": "Hi. Good morning. Thanks for taking my question. So first question for you, I had on advertising. I think you all had previously said that you were pretty comfortable with the 3Q 2024 level of advertising spend. Was hoping you could talk about the decision to ramp it up here in the fourth quarter. And I'm curious, what your measures of ad spend efficiency are telling you in the current environment, and how does that compare to history?"
},
{
"speaker": "Tom Wilson",
"text": "So, Rob, we're comfortable with our advertised spending. We adjusted obviously, by quarter to point out, and it also depends which markets we're after. Sometimes we do some heavy up tests in particular months to see what the sense is. I can assure you we have state of the art analytics on that. It's everything every kind of lead we bid on leads automatically. We just to make sure we were good last year, we had a number of outside people come in and look at our analytics. And we appear to be at least contemporary, if not industry leading. Now, you know, some of these are people you're buying ads from, they're not gonna come tell you stupid. But when we look at it in total, we think we're really good at it. And we have all kinds of allowable acquisition cost measures that look at everything from quote to close ratios to lifetime value."
},
{
"speaker": "Rob Cox",
"text": "Got it. Thank you. Secondly, I wanted to ask a question on the comment in the press release about expecting growth in total property liability PIF in 2025. You know, we've been thinking that you could certainly grow PIF in both home and auto in 2025. Is there any reason why you would be hesitant to commit to growing in both of the segments, or am I looking too deeply into that statement? Let me make a comment and then turn it over to Mario."
},
{
"speaker": "Tom Wilson",
"text": "So first, as you know, we don't give forward-looking projections on PIF growth. So what we've said to help bring some clarity to it is we're just gonna give you the numbers every month like we do with cats, and you can decide what you wanna do with that. We're obviously already growing at home, and we have plans we talked a little bit in the press release on where we're growing at auto. But in total, we're not growing in auto. So Mario is working on that. Mario, you wanna talk about what you got going?"
},
{
"speaker": "Mario Rizzo",
"text": "Yeah. Thanks for the question, Rob. Look, I'd say look, the objective of transformative growth is to grow policies in force and gain market share in the property liability business. That's our goal. That's our objective. Having said that, as Tom mentioned, we're currently growing the homeowners business. We think there's a real opportunity in the market. We're gonna continue to lean in on that one. A, because we've got really strong capabilities. B, there's disruption in the market that we can take advantage of, and we like the prospects of continuing to grow homeowners. On the auto side, we think despite the fact that policies are declining, we're really well positioned to lean into growth going forward for a variety of reasons. I think the first is, you've seen the new business momentum build over the course of 2024. In part due to your first question, our advertising investment that we've increased throughout the year, but we've also been doing things like unwinding underwriting restrictions and looking to accelerate growth across all distribution channels. We're gonna continue to fully leverage our broad distribution capabilities alongside that marketing investment continue to roll out new affordable, simple, and connected product. We are currently in thirty-one states. We'll continue to expand that. Over the course of this year. That has our most sophisticated pricing our most contemporary telematics offerings included in that. We're gonna continue to leverage capabilities on the Allstate side. International General just talked about the growth that we've seen in National General. We're gonna leverage middle market capabilities in Allstate to grow National General in a part of the market that they have less penetration in. We're also gonna use National General's capabilities in the nonstandard auto space and leverage the Allstate brand to begin to accelerate growth in that space. So we've got a lot of things that we've both been doing and expect to do in 2025 to accelerate growth and, really, that was the genesis of the statement. Oh, yeah. One last point I should have brought up is retention. Yeah. Everything I talked about was on the new business side. You know, we've seen the adverse impact of retention as we've been having to raise prices over the last couple of years. To improve margins. The good news is auto margins are back where we would want them to be in the mid-nineties range. The downside of that is, retention. Has taken a hit. Some of that will come back as we are less active in taking prices going forward because of where margin sits. But additionally, and more importantly, we're gonna proactively lean into reaching out to customers, helping them save money, by making sure they're getting all the appropriate discounts, they've got the right coverage levels that meet their specific needs, and the objective there is to improve affordability, improve customer satisfaction, and retention and that will be added into our growth trends."
},
{
"speaker": "Rob Cox",
"text": "Very much for the answers."
},
{
"speaker": "Operator",
"text": "Thank you. And our next question comes from the line of Gregory Peters from Raymond James. Your question, please."
},
{
"speaker": "Gregory Peters",
"text": "Good morning, everyone. So for my first question, feedback on the last answer there, Mario. And you know, you said on slide nine here for the auto policies, you said that you're proactively contacting existing customers. You mentioned that in your answer. Can you give us an updated perspective on how you think your pricing is on a competitive positioning basis versus your peer group and as you shift gears and proactively contact existing customers, does that mean that there's gonna be some sort of corresponding adjustment in agent compensation that's gonna give more weighting to retention versus just flat out new sales?"
},
{
"speaker": "Tom Wilson",
"text": "Right. Let me the pricing was complicated, so I'm gonna let Mario do that one. But I would make one point on the retention part. I think having branded agents who work exclusively with you is the best channel to be able to do what we're talking about. So, you know, we've raised some people's prices thirty, forty percent. We had to do it quickly because we're losing money. Now we can go back in and help them get the absolute right coverage. That could be deductibles. It could be coverage limits. It could be using telematics. It could be paying differently. So there's lots of different ways we can help them do that. And that would be very difficult to do in through an independent agent channel. It would be harder to do with a direct channel because you don't have the skills and capabilities built in your call centers necessarily do that. Our agents the Allstate agents are used to doing this all the time. They certainly did it when we were raising rates. But now Mario has a new program going on, which is a safe program to which has specific goals, numbers. We are not planning on changing agent comp. Margaret, do you wanna talk about competitive position in?"
},
{
"speaker": "Mario Rizzo",
"text": "Yes. Thanks, Greg. The and competitive position, I'd say a couple of things. First, when you look at the ramp up in new business over the course of the year, and, you know, we made a comment that we're growing in thirty-one states currently. I think that's indicative of having competitive prices and being able to, you know, fully leverage the marketing investment that we're making. It is a complicated question. It's hard to answer it on a national basis because, obviously, we compete market by market, state by state, and we're constantly looking at our competitive position and making tweaks to, you know, the tiers within our pricing plan to adjust prices when we think it's appropriate to adjust prices. Good news is, you know, we've achieved target margins. So we're comfortable with where our rate level is currently. And we would expect that we would need to take less price going forward. But when you look at our new business trends, we feel good about competitive prices. We've taken a lot of cost out of the system over the past several years, as Tom mentioned earlier, which is helpful. We're gonna continue to pull that lever going forward. But we think we're priced competitively and we have the broad distribution capabilities to continue to grow in the auto space. The only other point I'd make on your second question about the proactively contacting customers and agency compensation a meaningful portion of the agent compensation currently relates to renewal. So they've got a strong economic vested interest in retaining as many customers as they possibly can. And as Tom mentioned, they've been doing that. This is a way through the same program where we're gonna really scale it and do it much more broadly. To help drive retention proactively versus just relying on less instability in the market from rate increases."
},
{
"speaker": "Gregory Peters",
"text": "Thanks for that information. Tom, in as my follow-up question, Tom, in your opening comments, when you were going through the information on slide two, you emphasized the ROE of 26.8%, which I could believe is one of the best results I've seen from your company in recent history. Can you provide some view of how you are thinking about the ROE going forward and maybe what the board how the board's viewing it. I guess the reason why I'm asking is, you know, you've disposed of some underperforming assets, you know, over the last decade, and it feels like there's just a natural migration that the ROE objectives for the organization can be moving up certainly this result for last year sort of puts an explanation point on that."
},
{
"speaker": "Tom Wilson",
"text": "Good question, Greg. And with longitudinal perspective on it. So as you remember, I don't remember how many years ago it was. At one time, we put out a target of fourteen to seventeen percent. But I would say that was a different company and a different time. It was a different company and that we had a life business. It was a different time and that interest rates were a lot lower. People were thinking it was low for bond. Since then, of course, as you point out, we've made a bunch of changes. We've sold the life business. We bought back a substantial amount of stock, which takes some of our investment earnings down. Our premiums are up substantially. Not just because we've grown total policies, but also because there's just higher cost per policy which I think the market isn't really affected and that that includes requires more capital. So when you look all through it, we feel really good about where we're at. When we put that fourteen to seventeen percent out there, it was really because investors were not sure given the time and given the nature of the company where our returns would be and would they be acceptable. We never said it was capped. And so, obviously, now we're doing better than that. I would say the most important thing for us to do now is to increase growth. So increasing returns won't drive that much more shareholder value. What will drive more shareholder value is growth. And we've obviously growing and are growing a bunch of our other businesses. So whether that's our homeowners business, whether that's for growing premiums, which people kind of get all focused in on auto pay, and AutoPIP is important, and we're gonna grow AutoPIP. But when you look at just growth in premiums, you know, we're up double digit single low low teens percent depending which measure you wanna look at last year. So we feel good about overall growth think and the key to unlocking the value we've already created through growth is to get auto unit growth up."
},
{
"speaker": "Gregory Peters",
"text": "Got it. Thanks for the answers."
},
{
"speaker": "Operator",
"text": "Thank you. And our next question comes from the line of Michael Zaremski from BMO. Your question please."
},
{
"speaker": "Michael Zaremski",
"text": "Hey. Thanks. Good morning. And my first question is on the expense ratio and kudos to to kinda, you know, lowering it over time and and meeting your goal. Curious. I think in the in the past, Tom, recent past, you said that you have plans to to improve it even further. Maybe I'm maybe that's the expense ratio x add expense. If that's the case, are you able to kind of elaborate on what the building blocks are going forward to to to continue the improvements."
},
{
"speaker": "Tom Wilson",
"text": "So yeah. So the answer is yes. We always expect to keep reducing expenses, and we think we have an opportunity to even lower them farther from where they are now. We're not done. I would say, you know, maybe we're sixty percent of the way done. And, you know, and I but I wouldn't, like, take that and multiply that by some percentage change because part of that percentage change just to be completely transparent is because premiums have gone up faster than general inflation. So you kinda can't count can't count that as as much. So we are constantly work I think the where is we're after will be digitization. Leveraging the new technology platform we built the affordable simple connected is all designed around doing that increasing our marketing effectiveness. So even though we carve marketing out from that number, that doesn't mean, like, we're just gonna spend wild on marketing. It needs to have the same level of precision and to it that everything else does. And we also still need to lower distribution cost. You know, the distribution costs are still higher than we would like them to be, so we have work to do there as well."
},
{
"speaker": "Michael Zaremski",
"text": "Great. And my final follow-up is just more high level on the devastating tragedy in California. I know it's kinda still a fluid situation, but I think a few of your competitors have, you know, expressed as a vet they might need to retrench even more in California given the payback the potential payback on the losses are going to be many, many, many years. Curious if you think this could cause Allstate to also rethink its ambitions of growing or or just just overall growth in in California might might My My a different direction. Thanks."
},
{
"speaker": "Tom Wilson",
"text": "Well, every state's different. We don't have any growth aspirations in homeowners in California at this point. And we haven't since 2007, really. We had a small window in there where we thought we had some arrangements where it would make sense for us to grow, that didn't turn out to be the case. So we had turned off the spigot for new customers. We didn't go nav for new people, but we just said we're not gonna take add new customers. Starting in 2007. Then in about 2017, eighteen, I'm looking at my here. Yeah. We said, you know, we think we can take on a few new customers to That didn't turn out to be true, so we stopped that then in 2022. But we've been at this a long time. And so we don't have any growth aspirations in California right now. That said, we're really good at homeowners. We make more than half of the industry's profits. We've got a good business model. We think it's a great growth opportunity. And it doesn't have to be the way it is in California. So Texas has just as many types and dollar amount of losses as California does, yet the homeowners market works there. And so we believe that there's a way to make that work. We'd like to work with a state to make it work because people want to insure their homes. They need to ensure their homes. And we just need to make sure it's done on a basis that is fair to consumers, but also gives our shareholders an appropriate return for the risk. So example, we don't wanna have to do things like in California. Mario talked about the numbers. We have a substantial amount of reinsurance recoveries. We're a cost plus business. We did not the cost for that reinsurance that we just now got back to with lower losses. Which means that, you know, we need to have a structure. The departments talked about that. They're open to that. So I would say that these things you know, they happen over a long time, and it takes a while for them to get. So I don't think anything's gonna change in the next you know, it's not like in twelve months. Everybody's gonna be rushing into California to write homeowners. It just doesn't happen that fast."
},
{
"speaker": "Michael Zaremski",
"text": "Thank you."
},
{
"speaker": "Operator",
"text": "Thank you. And our next question comes from the line of Christian Getzoff from Wells Fargo. Your question, please."
},
{
"speaker": "Christian Getzoff",
"text": "Hi. Good morning. My first question is on retention. I didn't see any retention numbers in the press release for supplements. I was wondering if you could provide that. And then you say the majority of the headwinds on retention just from, like, know you guys called out Esurance migration and then the New York, California, New Jersey rate hikes. Are those is the majority of that headwind paid it by now, or do you expect some further headwinds kind of in the first half?"
},
{
"speaker": "Tom Wilson",
"text": "I'll make a couple comments then, Jess. May wanna comment. So at first, we've paid a lot of attention to attention in it. In more granularity than you just even mentioned, whether it's this book of business, this state, his risk cover, his whatever, you know, his price changes. We're like, we're all over retention. Just made the decision that rather than give you the components which are complicated and we spend a bunch of time helping you spend a bunch of time trying to figure out retention on this much and how much policy too. Just just so why don't I just give you the numbers? I'll just give you the fifth numbers every month. You'll know what the numbers are. You don't have to get caught up into what's your projections on new business, what's your projection on retention, presurience policy. So the our goal was to increase transparency and give you more information you can use to make your investment in recommendation decisions rather than less into an So that that's what we've set out to do. Maybe Jess or Mario, you guys wanna talk about the retention and how you're feeling about it and other ways to measure it. Maybe I'll just touch on this round out the disclosure, and then, Mario, you can talk about your thoughts. You know, I think the other thing, you know, to keep in mind is, as Tom mentioned, we gave you component a component. We didn't even give you all of the components. We believe by giving you tip on a monthly basis, you'll have more transparency. Recall, what we gave you was Allstate brand, gift or Allstate brand retention rather. So it was a piece of the puzzle and we spent a lot of time explaining movements between brands which we wanted to move away from. So I really believe that that what we're giving you now on a monthly basis will be much clearer and actually, you know, reduce a lot of the complication that came from our disclosure. And as Tom said, put you in a better position to understand new business and retention trends and frankly with the total policy in force trend is. So it was definitely a move to increase transparency by taking away and really completing that move away from brand to line of business and distribution channel."
},
{
"speaker": "Mario Rizzo",
"text": "Yeah. The only thing I'd add on on retention, I think it's important to take a step back and look at what we've really been saying over the last several years, which our principal focus would say, you know, heading into 2024, was to improve auto margins. I think we were pretty clear on that. That was our principal priority. We had to take prices up a lot to do that over forty percent when you look over the past several years. The good news is, you know, margins are back to where we want them to be and where they need to be. And as from a new business perspective, as best kind of played out, you've seen us kind of lean back into the market and really accelerate new business growth over the course of last year. The downside to that approach and that strategy with retention as you mentioned, which has stabilized in a number of states as we've cycled through what we needed to do to improve profitability. But as we talked about before, there were a handful states that were a little later to the game in terms of getting margins back to where they needed to be. We talked extensively about California, New York, New Jersey, The good news is we've been making good progress in those three states. We've been making it by implementing some pretty meaningful rate increases. That is having a drag on retention as we cycle our way through that. We should see that stabilize. I will say though, New York and New Jersey, we still got some work to do. We're our margins are better, but they're not where we'd like them to be. We're gonna continue to pursue rate in those states. But we, you know, believe we can overcome that. Because we got a lot of growth opportunity in the rest of the country."
},
{
"speaker": "Christian Getzoff",
"text": "Gotcha. Thank you. And going back to the California wild losses, I know you provided a $2 billion gross s You provided some sensitivity, but what are you assuming in terms of the industry losses so we could, like, flex that sensitivity up or down depending on how the losses develop."
},
{
"speaker": "Mario Rizzo",
"text": "Yeah. Look. And the this is Mario. The way I'd answer that question is, obviously, there's a lot of moving parts in in our estimate. We know our data with a lot of specificity because we have that. We've made assumptions around a fair plan assessment just given the, you know, the the the magnitude of the of the losses we've seen and also when you when you look at the fare plan surplus level as of the end of the third quarter, their reinsurance and their co participation in that, we think it's pretty likely that they're gonna you know, kind of exceed their their surplus levels and there will likely be an assessment. We've got that in there. And we you know, our our our number includes a view of what the industry loss is. I really don't wanna to kind of disclose what our view on that is, but there's I will say we've made certain assumptions to come up with our number both in terms of ourselves and the fair plan. We'll keep looking at those because it's a pretty fluid process and we'll update it as we get more information. If we need to update."
},
{
"speaker": "Tom Wilson",
"text": "So here's if you want a sensitivity. For every hundred million, it's ten million bucks. So for every five percent or often total, it costs us ten million dollars. So if we're off by fifty percent, so it's another billion dollars, it costs us a hundred million. Right? So the I don't think you need to worry about sensitivity on the gross loss."
},
{
"speaker": "Christian Getzoff",
"text": "Thank you."
},
{
"speaker": "Operator",
"text": "Thank you. And our next question comes from the line of Timmy Peller from JPMorgan. Your question please."
},
{
"speaker": "Timmy Peller",
"text": "Hey. Good morning. I had a question first on just the auto business. You mentioned PIF turning positive in thirty-one states, I think. And I'm assuming what's unique about those states is just the fact that you're not raising prices as much. And advertising more. So if that is true, then could you talk about of the remaining that you're not growing in, should that begin, happen throughout the year gradually, or is there more of a cliff event? Some point later in the year? When you will lap those comps and you're not gonna be raising prices just to sort of be able to assess when those stocks, states will begin to show better growth."
},
{
"speaker": "Tom Wilson",
"text": "Timmy, I'll let Mario talk about the pace, but I don't think he's gonna give you an answer by quarter. Alright. I got it. It's more complicated though than just those two factors. Alright? So it's not just, are we not taking price? And how much are we advertising is what's everybody else doing? What kind of coverage are we offering, where are we with our ASC roll out, where are we with our custom three c. So it's a really complicated machine that Mario's running. And but the goal is sometimes attribution helps explain why you are you're on Sometimes attribution leads to excuses. And we're not interested in excuses. We're interested in results, which grows. So Mario can talk about how these thinking about that maybe you wanna talk about both the impact of retention and the impact of new business over the course there, but we can't give you, obviously, a per quarter PIP number. Just watch for Jess's monthly number."
},
{
"speaker": "Mario Rizzo",
"text": "Yeah. Timmy, thanks for the question. Look, at lower where I'd say is like, we wanna grow in every state where it makes economic sense for us to grow and where we believe we can grow profitably. That happens to be thirty-one states now. We think the opportunity is beyond that level. And as Tom mentioned, there's a lot of components that factor into our ability to grow price is part of it, competitive position, and where our price hits relative to competition. The growth investments we're making, our risk appetite, there's a lot of factors that play into that. Retention is a key component of our ability to grow. Right? So what you saw in total this year was we had really good new business trends, and in the quarter, they kind of peaked in 2024. At almost thirty percent. Yet despite that, our units declined year over year. Because of the drag of retention. So we're focused through the same program on not just waiting for retention to bounce back because of less rate disruption in the system, gonna proactively do things to work with customers help them save money, improve affordability, and drive retention up. We think doing that well alongside all the other things I mentioned earlier new product rollout, new technology, distribution, and continued investments in marketing and all the things that helped us drive new business volume. That's the key that will drive growth broadly, and that's the plan we're executing on."
},
{
"speaker": "Timmy Peller",
"text": "And then maybe just following up on capital. Like, the business is obviously profitable now. I think you'll make money even with the California buyers. In one queue, and then you've got the money coming in through the sales of the benefits and the health business. So how should we think And I'm assuming capital is not a constraint for growth given how much money you're gonna get from the sales, but should we think about capital deployment between growth, m and a, and share buybacks. And is it unreasonable to assume that you wouldn't be in the market buying back stock at some point assuming results come in as expected over the course of the CVA."
},
{
"speaker": "Tom Wilson",
"text": "Timmy, if we consider proactive capital management to be a significant strength of Allstate. And it's added tremendous amounts of shareholder value. So and you're right. Share repurchase are obviously one of those. And we've used that extensively. But would encourage you to hold us accountable as you started to mention on really a broader basis. Right? So there's organic growth, there's risk and return on economic capital, there's inorganic growth, and then there's capital structure, which includes the share repurchases. And so let me just go through each of those. First, organic growth is a twofer. And based on the returns we're getting in our business today? It generates absolute dollar growth in earnings. Secondly, with that higher growth rate and we should have a higher PE, because if you look at our price earnings ratio versus any other insurer, and you look at our top line growth, the average premium growth is getting discounted, and it's basically all hung on auto unicorns. You can start whether that's right or wrong, but we think that that the unlock of in deploying capital to grow the property liability business both in units and premiums is will drive growth. So we think that's really important. Marketing, we talked a lot about that this morning, so I don't wanna And We don't need to go back through that. If you look at risk and return on economic capital, we have a really sophisticated way in just talked about this a lot within the last couple of years of how we manage capital, and associate a risk and return on that. That helps us do things like leverage our investment our investments, and that capability generates good returns. And I think it needs to be valued in its own right. It's but for example, the duration calls we made used additional economic capital. We knew that. We decided on it. It was part of the enterprise decision, and it's clearly generated good returns. Same thing is true with the reinsurance in California. We look at all those things economically. I think acquisitions also need to be assessed on the actual return on capital. So National in general and Square screen, both both both on the standpoint. When you look at National General, it's more than double its size on apples to apples basis from when we bought three years ago. SquareTrade is substantially bigger as maybe ten times bigger and making a hundred and fifty million bucks a year when we paid a billion four four nine. Just when you look at what was the net cost of National General and SquareTrade?"
},
{
"speaker": "Jess Merten",
"text": "Tell me, you take a look at you know, both of them, the net cost is about half of what we paid. So as I mentioned in my prepared remarks, we paid $4 billion for National General. When you add up the recently announced group health transaction, and the dividends we've been able to take out of the statutory entities which are about a billion dollars, we've reduced that purchase price by about $2.25 billion. So to $1.75 or less than half. The same will be true if you look at SquareTrade in the $1.4 billion acquisition. Since owning it, we've taken about half that back in, dividends based on earnings. While also and this is important, investing in growth, doing acquisitions. So we've gotten about half of it back and still invested. In growth on SquareTrade."
},
{
"speaker": "Tom Wilson",
"text": "So and and then, of course, share repurchase is is an also thing, but you have to really look at how you manage your capital. Stack better. So for example, We issued a perpetual preferred stock. I don't remember how many years ago. We we issued two billion of stock. We bought back two billion in common, swapped fixed equity cost and left all the remaining upside with our common equity. Today. Preferred just has a what's current cost on the preferred?"
},
{
"speaker": "Jess Merten",
"text": "Oh, we have three different issuances, Tom. So we're our lowest is about 4.75% and then we have a tranche that was more recently issued at 7.375%. So we've got a range, but most of it the largest issuance actually is a 5.1%. Fixed for life. So, you know, obviously, and it the math is not exactly right because you got gap, capital, and gap. But if you look at our returns, On equity, on just actual market equity, it's substantially above that. So that's a that's a good trade. The we also look obviously, look at dividends and everything else. Share repurchases, we've done a lot of. And so so just you wanna just go through the numbers of what we've done on share repurchases. We have been a lot of time. So I took a look back and went all the way back to when Allstate went public. Since going public, we've repurchased about $41.5 billion of our stock, and that represents about 83% of the outstanding shares. If you bring that time frame in a little bit, I have over the last ten years, the number is closer to $17.5 billion. And about half of the outstanding shares over the last ten years. Bringing in again five year period, $7.8 billion of repurchase is about 25% of our outstanding shares and in all cases, at an average cost, it's very attractive. We even go through and look at the returns in all cases over any period, whether it's thirty years, five years, the return is significantly above our cost to cap. So we've had really good returns. And to your point, Tom, you know, buying back 83% since going publish public just shows our commitment to reverse."
},
{
"speaker": "Tom Wilson",
"text": "Yeah. So, I mean, we've got plenty of things we do. And I would just you know, like, don't like, yes, share repurchases are important. I know it's a number of analysts wrote that up over the evening of, like, when you're gonna be back. I'm like, you should hold us accountable for manager and capital to drive shareholder value. And if that means growing faster, and using our capital to grow faster, then holds accountable for that. If we if we have extra capital, we don't hold on to it. And we buy back stock because we think, you know, when you look at our our value relative to our growth potential, the size of our business, our our PE. We still think it's cheap."
},
{
"speaker": "Timmy Peller",
"text": "Yeah. Still better to get those questions and questions about adequacy of capital, I guess. So"
},
{
"speaker": "Tom Wilson",
"text": "And I thought those those were those were thoughts for sure."
},
{
"speaker": "Timmy Peller",
"text": "Thank you."
},
{
"speaker": "Operator",
"text": "Thank you. And our next question comes from the line of Bob Huang from Morgan Stanley. Your question please."
},
{
"speaker": "Bob Huang",
"text": "Yeah. Good morning. I'm gonna stay away from capital. So the first question is on auto. And I mean, an investor astutely pointed out that on your first quarter 2024 slide, you talked about 64% of your total premiums were profitable. So fast forward today to today, then we're talking about about 60% of that premium is now growing. Is this fair to kind of make some type of causal correlation between the time you achieve profitability and the time that you you start to grow the business? In other words, is it fair to say that six to nine months from now, essentially, California, New York, New Jersey, they're only state you're unable to grow and everything else should be growing and that rather than the 60% of total premium is growing. Probably call it eighty or ninety percent of it should be. Is that a fair way to think about this?"
},
{
"speaker": "Tom Wilson",
"text": "I think the construct is right. I don't know if I would automatically extrapolate that extrapolate that into the future. I mean, it is true when we were losing money, we shut down advertising, shut down growth, be intentionally, because we said there's really no sense going to get a bunch of new customers we're gonna have to raise their price by fifteen percent relatively quickly, and it maybe then lose them. So what's the point to spend the money to getting a new customer to lose a bunch of money on, and you know you're gonna lose money on. So that is was true, and that's what we did. We also know that by driving that and going your crush we that it was going to her retention. And so now we're about so there it is a there are, you know, pieces you rolled in. I don't think you could automatically go to say, like, like, do an analysis of two line lines on a graph going up, and they would follow each you know, each sit each state's different, each position's different. You know, if if if if Mario wish to get adequate prices in New York, tomorrow, we have a great agency plant there. We have we got pretty we got huge share down in the in the New York area. And we could really leverage it to grow fast. When that will happen, who knows? So I think you should just hold us accountable for growing auto units, and I keep coming back to auto units is the unlocked A lot everything else is growing and it's like, so let's you know, it is it is an important part of our business. But we've got we got higher premiums, the reserve balances are up, the investment balances are up. That's all driving increase you know, protection plans is back in and out of the park. So we got lots of growth. We are focused on the unlock of auto unit growth."
},
{
"speaker": "Bob Huang",
"text": "Got it. No. That's that's helpful. If I can just have a follow-up on that. I I I don't know if you'll address this, so apologies if you did. The question is really around adverse selection. Right? As we go into 2025. More and more auto carriers are profitable, and more and more auto carriers are talking about growth. Should we expect your current level of combined ratio to hold for auto as you head into a environment where everyone is looking for growth? Like, how do you feel about the the broader competitive environment as a whole?"
},
{
"speaker": "Tom Wilson",
"text": "Well, you're you're talking well, the auto market has obviously been competitive. And both Progressive, GEICO, State Farm, the big carriers that we compete with all the time have been out in the market and competitive this year. So people are advertising. It's it's last year, 2024. So it's not like it wasn't competitive and it's suddenly turning into competition. We think we have the capabilities to compete and grow. I would say that's a different market in homeowners where most people are backing out. There is a secular trend there. Where we have an opportunity to grow, and as we look at capital, one of the things we like to do is get a higher valuation on our homeowners growth. So when you look at our homeowner business and I said, jeez, if you have a business that's growing, you know, revenues in the mid-teens, it's it's picking up, not huge market share, but it's got you real unit growth. It's an industry leading model. It's earned money good money eleven out of twelve years. And and it has high returns on capital you probably wouldn't put it at the kind of PE that we have for our overall enterprise. And I suspect that if you actually looked at analysts, they might even give it a lower p e than our total. So we need to figure out how to have that fully recognized in our valuation. And it might mean doing something differently in reinsurance and lowering the volatility of that line. But just know that our goal is to increase shareholder value. Maybe we're close. I think we're in time. Our goal is to increase shareholder value, whether that's buy shares back grow, manage our capital structure differently, figure out how to compete differently, do more advertising. We're all about driving growth for shareholders. We think we have the tools and capabilities to do that, and we have a track record that shows we know how to get. Got So thank you all. We'll see you next quarter."
},
{
"speaker": "Operator",
"text": "Thank you, ladies and gentlemen, for your participation in today's conference. This does conclude the program. You may now disconnect. Good day."
}
] | The Allstate Corporation | 18,711 |
ALL | 3 | 2,024 | 2024-10-31 09:00:00 | Operator: Good day, and thank you for standing by. Welcome to Allstate's Third Quarter Investor Call. At this time, all participants are in listen-only mode. After the prepared remarks, there will be a question-and-answer session. [Operator Instructions] As a reminder, please be aware this call is being recorded. And now, I'd like to introduce your host for today's program, Alastair Gobin, Head of Investor Relations. Please go ahead, sir.
Alastair Gobin: Thank you, Jonathan. Good morning. Welcome to Allstate's third quarter 2024 earnings conference call. Yesterday, following the close of the market, we issued our news release and investor supplement, filed our 10-Q and posted related material on our website at allstateinvestors.com. Our management team will provide perspective on our strategy and an update on our results. After prepared remarks, we will have a question-and-answer session. As noted on the first slide of the presentation, our discussion will contain non-GAAP measures, for which there are reconciliations in the news release and investor supplement and forward-looking statements about Allstate's operations. Allstate's results may differ materially from these statements, so please refer to our 10-K for 2023 and other public documents for information on potential risks. And now, I'll turn it over to Tom.
Tom Wilson: Good morning. We appreciate you investing your time in understanding the value creation potential at Allstate. I'm going to provide an overview of results. Mario and Jess will walk through the operating performance, and then we'll address your questions. So let's begin on Slide 2. Allstate's strategy has two components, increased personal Property-Liability market share, and expand protection provided to customers, which are shown in the two ovals on the left. We now have more than 200 million policies in force. On the right hand side, you can see Allstate's performance for the third quarter. Total revenues of $16.6 billion were up 14.7%, compared to the prior year quarter. Allstate generated net income of $1.2 billion and adjusted net income of $3.91 per share. Return on equity was 26.1% over the last 12 months. The Property-Liability business, is now positioned for growth. Execution of the auto profit improvement plan has restored auto margins, near term auto insurance policy growth will require us to improve customer retention and increase new business levels, both of which Mario will discuss. The homeowners business had good returns and is growing. The transformative growth initiatives, to build a low cost digital insurer with affordable, simple and connected protection, will ensure that this growth is sustainable. Proactive investing also benefited income as the decision to lengthen duration at the right time increased portfolio yields. In addition, higher insurance prices, and increased reserve levels create a much larger investment portfolio, which also raises income. Protection plans continues to profitably grow, and we recently did a small acquisition to expand mobile device protection capabilities. Let's move to Slide 3. Here you can see the operational execution generated excellent financial results. Revenues increased to $16.6 billion. As you can see in the upper left, Property-Liability earned premiums were up 11.6%. Net investment income for the quarter was $783 million that's 13.6% higher than the prior year quarter. Net income was $1.16 billion. Adjusted net income as I mentioned was $3.91 per share. And then, you can see in the lower right that the return on equity was 26.1%. This shows that Allstate's operational excellence enabled us to dramatically improve results from last year. Now let's hear from Mario on Property-Liability results.
Mario Rizzo: Thanks, Tom. Before I go into my remarks on the quarter, I want to call out a change we made to our disclosures. You'll notice that we simplified our Protection segment disclosures this quarter, to focus on product and channel instead of brand. For the past several years, we've provided detail on both the Allstate and National General brands separately, to create transparency into National General's performance and allow you to evaluate the acquisition. National General has been a highly successful acquisition, since it is now twice its size, generates excellent returns and gives us strong competitive positions in both independent agent distribution and non-standard auto risk. We're now building on this success by combining operations, such as expanding the sale of non-standard business under the Allstate brand. As a result, performance should be evaluated for the protection business in total, and by distribution channel versus by brand and that's why we made the change. So in keeping with this approach, my commentary today will be focused on performance on total auto and homeowner lines, and production by distribution channel. With that as background, let's start on Slide 4. On the top of the table on the left, you can see Property-Liability premiums of $13.7 billion, increased 11.6% in the third quarter driven by higher average premiums. Underwriting income of $495 million improved by $909 million, compared to the prior year quarter, as improved underlying margins more than offset higher catastrophes. The expense ratio of 21.5 was 0.3 points higher than prior year, due to increased advertising. As we continue to accelerate growth investments in rate adequate states and risk segments. The chart on the right depicts the components of the 96.4 combined ratio. The loss ratio shown in light blue includes losses of $1.7 billion and was 2.8 points higher than the prior year quarter. The underlying combined ratio of 83.2 in dark blue improved by 8.7 points, compared to the prior year quarter. The improvement was driven by higher average earned premium, and improved loss cost strengths. Prior year reserve reestimates excluding catastrophes had only a minor impact on current quarter results, as favorable development in personal auto and homeowners insurance, was more than offset by increases in personal umbrella and runoff business, primarily related to asbestos related claims, which was recorded this quarter, as a result of our annual third quarter discontinued lines reserve review. Now let's dive deeper into auto insurance margins on Slide 5, where you can see the success of the auto profit improvement plan. The third quarter recorded auto insurance combined ratio of 94.8 improved by 7.3 points, compared to the prior year quarter as average earned premiums outpaced loss costs. Average underlying loss in expense was 4.8% above prior year quarter, reflecting higher current year incurred severity estimates, primarily driven by bodily injury coverage offset by lower accident frequency, as well as higher advertising investments to drive new business growth. Physical damage severity increases continue to moderate, while bodily injury severity continues to trend above broader inflation indices. Our claims team continues to focus on operational actions, to mitigate the impact of inflationary trends. As a reminder, we regularly review claim severity expectations throughout the year. If the expected severity for the current year changes, we record the year-to-date impact in the current quarter, even though a portion of that impact is attributable to previous quarters. For 2022 and 2023, the bars in the graph reflect the updated average severity estimates, as of the end of each of those years to remove the volatility, related to intra-year severity adjustments. Similarly, in the third quarter of 2024, the full year claim severity estimate went down, so there was a benefit from prior quarters included in the third quarter's reported results. This benefit was worth 0.8 points in the third quarter, with the adjusted quarterly combined ratio of 95.6 as shown on the far right bar. Now let's review homeowners insurance on Slide 6, which generates attractive returns and growth opportunities. Allstate is an industry leader in homeowners insurance, generating a low 90s combined ratio over the last 10 years. As you can see in the chart on the left, this performance compares favorably to the industry, which experienced an underwriting loss and a combined ratio of 103 over the same time period. Moving to the table on the right, Allstate Protection homeowners written premium increased by 10.8%, compared to prior year reflecting higher average gross written premium per policy, and policy enforced growth of 2.5%. The third quarter combined ratio of 98.2 resulted in $60 million of underwriting income, compared to a $131 million loss in the prior year quarter. The underlying combined ratio of 62.1 improved by 10.8 points, due to higher average premium and lower non-catastrophe loss costs. For the first nine months of 2024, homeowners insurance generated an underwriting profit of $249 million, despite $1.2 billion of catastrophe losses in in the third quarter. Let me provide insight into the growth potential of the Property-Liability business starting on Slide 7. In the chart on the left, you see the composition of the Property-Liability book. Homeowners in medium blue represents approximately 20% of policies in force. Homeowners' insurance policies in force increased by 2.5% as retention has improved by close to half a point, compared to last year and new issued applications are close to 20% above prior year. As you can see in the right hand column. We view homeowners as a growth opportunity. Auto policies in the dark blue account for approximately two-thirds of Property-Liability policies enforced. As you can see on the right side of the page, overall policies enforce declined by 1.5%. This reflects a decline in customer retention to 84.7%, which is 2/10th of a point below the prior year quarter, but much lower than historical levels. We did have a 26% increase in new issued applications, which offset some of the retention losses. Now let's go through each of these components to give you insight into how to assess growth prospects. Let's start with customer retention on Slide 8. This chart shows Allstate brand auto insurance retention over a 10-year period which is primarily standard auto insurance risks. There is a couple of key points I want to make on this slide. First, raising prices leads to lower retentions as customers shop for other options. Second, the large increases in the last several years have led to a significant decline in retention since 2022, which has negatively impacted policies in force. This has, however, recently leveled off as price increases have moderated. Let's look at the three periods with the arrows. In 2015 and 2016, we raised auto insurance prices, which you can see from the dotted line because of an increase in the frequency of accidents. The graph shows how this led to lag declines in retention from 88.2 in 2014 to 86.7 in 2017. Over the next three years, price increases were relatively modest and retention recovered reaching 88.3 by 2019. Now, there are lots of factors impacting retention, such as the amount of new business you write, the risk type of that business, number of bundled policies and specific actions taken in big states like California and Florida, as well as customer satisfaction levels. But the biggest driver is price. Increased advertising and price competition had a modest negative impact over the next several years with retention hovering around 87%. You can see this in the most recent period where retention has declined by 2.7 points over the last 10 quarters, which reflected rate increases of 36% on a cumulative basis. Looking forward, we expect lower rate increases given the profitability of auto insurance. This year, for example, Allstate brand rates have been increased by 6.3% compared to 9.5% in the first nine months of last year. Lower price increases should translate into higher retention. To help you model this out, every point of retention is worth approximately 350,000 policies enforced each and every year, or 1.4% of the current policy count. Moving to Slide 9, let's discuss the success we've had in increasing new business levels this year. We continue to invest in transformative growth while we executed the profit improvement plan. These foundational investments enable us to go to market with a multichannel distribution strategy that serves customers based on their personal preferences and has resulted in a 26% increase in new business in the third quarter shown in the far right column at the bottom. While profit actions previously restricted our new business appetite, rate adequacy has now been achieved in the vast majority of states. Third quarter advertising spend was roughly 60% higher than the same quarter in 2021. In the Allstate agency channel, the compensation structure was also changed to improve growth and agent productivity at lower distribution costs. Allstate Agency new business was up 16% over the prior year quarter with bundling rates at point of sale at all-time highs. The national general acquisition enabled us to grow independent agency new business by 14% over the prior year quarter. In the direct channel, we are back to 2022 levels with fewer underwriting restrictions, increased advertising and the new affordable, simple and connected auto product which is currently available in 25 states. New business is 56% over prior year and we expect to increase to continue increasing volume in this channel which now represents 31% of total auto new business. This level of new business will drive future growth. Every 5% increase in new issued applications above the current run rate increases policies enforce by approximately 250,000 items or 1% of policies in force. Looking forward, the property liabilities business is positioned for growth. Margins are attractive, fewer rate increases should improve retention and the components of transformative growth are working, including new products, increased advertising, lower expenses and expanded distribution. This will enable us to achieve our strategic goal of increased Property-Liability market share. And now, I'll turn it over to Jess.
Jess Merten: Thank you, Mario. Let's shift to Slide 10 to review investment performance. A proactive approach to portfolio management that optimizes return per unit of risk across the enterprise generated strong returns this quarter. Our disciplined approach includes comprehensive monitoring of economic conditions, market opportunities, interest rates and credit spreads. The chart on the left shows the fixed income, portfolio yield and assets under management trend over the last several years. Fixed income yield shown with the orange line has steadily increased as we repositioned into higher yielding longer duration assets. Based on interest rates in the third quarter our fixed income yield is now generally in line with market yields. In the gray bars you can see growth in the portfolio book value. Since the fourth quarter of 2021, book value has increased by 14% or $9.1 billion, reflecting the impact of higher underwriting cash flows attributable to increased premiums and reserve levels as well as portfolio cash flows that increased because of higher coupon rates. Growth in assets and higher yields benefited net investment income as shown in the chart on the right. Net Investment income totaled $783 million in the quarter, which is $94 million above the third quarter of last year. Market based income of $708 million, which is shown in blue, was $141 million above the prior year quarter, reflecting the impact of a fixed income yield that is 60 basis points above the third quarter last year. Performance based income of $143 million shown in black was $43 million below the prior year quarter, reflecting lower real estate investment results. While this quarter's result is lower than our long term expectation, our returns continue to be strong and volatility on these assets from quarter-to-quarter is expected. Slide 11 highlights strong results in the protection plans business, which is one of the five companies in the protection services segment that also includes Arity, Roadside, dealer Services and identity protection. The Protection Plans business provides warranties for consumer electronics, computers and tablets, TVs, mobile phones, major appliances and furniture through strong domestic and international retail distribution relationships. Revenues for this business totaled $512 million in the third quarter and increased 23.1% compared to the prior year, reflecting growth in international markets. Profitable growth resulted in adjusted net income of $39 million, a $19 million increase compared to the prior year quarter, as strong operational execution increased margins and enabled successful implementation of the strategy to expand distribution relationships and product offerings. We continue to invest in this fast growing business. In October, Allstate Protection Plans acquired Kingfisher to enhance capabilities in mobile phone protection. Now let's Transition to Slide 12 to focus on the terms and accounting treatment of the sale of the Employer Voluntary Benefits business. As we announced in August, Allstate finalized an agreement to sell the Employer Voluntary Benefits business, which I will also refer to as the EVB business for a purchase price of $2 billion to StanCorp Financial. The transaction is expected to close in the first half of 2025, pending regulatory approvals. As a reminder, the EVB sale is the first step in a strategic decision to pursue divestiture of the Employer Voluntary Benefits, group health and individual health businesses to capture value through greater strategic alignment. The EVB transaction is economically and financially attractive for shareholders. Allstate retains the economics of the business until closing and results continue to be reflected in net income and adjusted net income. In the quarter $3.2 billion of assets and $2.2 billion of liabilities related to the EVB business have been classified as held for sale. As you can see on the right of the slide, we're estimating a $600 million gain and had previously disclosed that we expect the transaction to generate approximately $1.6 billion of capital. Moving to health and benefits results for the quarter, Premium and contract charges for the segment increased 5.2% for $24 million compared to the prior year quarter. The individual and group health businesses saw strong growth with premiums and contract charges up by 8.1% and 20.2% respectively. This growth was partially offset by a modest decrease in the EVB business. Adjusted net income for the segment of $37 million in the quarter was $32 million lower than the prior year quarter as increased benefit utilization across all three businesses impacted profitability, underwriting and rate actions are being taken to quickly address the benefit ratio trends and restore margins to historical levels. The process to evaluate disposition of the group and individual businesses is progressing. Let's wrap up with Slide 13 to recap Allstate's strategy and path to value creation. Operational excellence ensures that we react to changing business conditions and maintain margins at target levels. Transformative growth investments are being made to create sustainable growth and Allstate delivers attractive returns. With that as context, let's open the line for questions.
Operator: Certainly. And our first question for today comes from the line of Jimmy Bhullar from JPMorgan. Your question, please.
Jimmy Bhullar: Hi, good morning. So first, just had a question around your confidence and outlook for PIF growth in the auto business, and what you're seeing in terms of competitor behavior, both on prices and on advertising. Seems like most competitors are - shifting to a growth mode now that margins have recovered. But are you confident that we can see PIF growth turn positive over the next few quarters?
Tom Wilson: Jimmy, let me make a couple of comments and Mario can jump in. First, we don't give growth projections, so we're not going to comment on that. We gave you. We put the numbers in there, so you can do your own analysis of how you think we'll do in retention, and how you think we'll do in new business. We obviously believe we can grow market share, which is what our whole strategy is about. When you look at the competitive environment, you continue to see progressive advertising aggressively GEICO has gotten back into the market, but perhaps not as aggressively as they have in the past. And State Farm continues to try to grow, but as you know, they have an underwriting profitability challenge that they're I suspect they will take out, but we'll only see. But I would also not just focus on those big players, but there's a whole bunch of other players that are more moderate size or smaller that either don't have the firepower in advertising to compete, or don't have the pricing sophistication. Mario, do you want to make comments about how you're feeling about growth?
Mario Rizzo: Yes, thanks for the question, Jimmy. At its highest level, obviously to turn positive, PIF growth requires that we keep more of our existing customers, which is the retention component, and then we drive increased levels of new business. Maybe I'll talk about each of the pieces individually. Like we pointed out in the presentation, obviously a lot of the rate actions in the profit improvement plan that we've implemented over the last couple of years has had a pretty negative impact on customer retention. Now going forward, we would expect, just given where our margins are in auto, all other things being equal, we would expect to take less rate going forward, which will have a positive impact on retention, as it has in the past as we create less disruption in the book. But the other side of it is, we're not just going to rely on that. We've got actions in place in a number of areas, both in terms of improving the customer experience. Working with our customers, both through our agents, and our contact centers to help identify opportunities to improve affordability, and really kind of mitigate shopping activity from our own customers. So, we're focused on retention improving going forward, both kind of organically, I'll say through less rate, but we're also not sitting back. We're taking proactive actions to help offset some of the headwind that we've seen in retention. On the other side. On the new business standpoint, just to give you some context, we talked about the vast majority of markets being open for business somewhere between 75% and 80% of our premium volume. When you look at it nationally, those are markets that we are open for business. We're accelerating investments, and we've really seen some good production trends across all distribution channels. Our agents are productive, they're bundling at all-time high levels, which also will help retention. We believe over time we're continuing to see really good traction on the direct business and we think there's ongoing opportunity there. And then as I mentioned earlier, the National General acquisition and what we've been able to do both in the non-standard auto market, as well as in the independent agent space more broadly, is generating some good production trends. So, we feel good about that. We're focused on improving retention, while continuing to build on the growth momentum from a new business perspective, which has improved sequentially over the course of the year. And when those two things come together, that that's what will drive positive growth.
Tom Wilson: Jimmy, let me add just a couple of things. On a longer term perspective, what Mario talked about. So when auto profitability went negative, we said first priority, get the rate, don't be too specific about it. And what Mario is talking about is going back in now and saying, okay, well we got the total rate. How many more people should be using Milewise? How many more people should be using telematics? Those are great opportunities for us to leverage our innovation and keep more customers. So there's a bunch of good work going on there. So the priority that we gave to the team was we need to make money in auto insurance. We've done that. Now we're ready to go back in and, which should drive retention. The other thing I would say is on distribution. If you look at our historical growth, this is the first time really we have three fully functioning channels. Like, we've got three horses here, all ready to run. You can see the growth. And direct is up a lot this versus last year. But that's, because direct was the first place we shutdown, too. When it came to how do we get profitability up in auto insurance, we said well, first, if we're losing money on it, we shouldn't write it. Rather than take that hit in volume to the Allstate aging channel, which needs to be maintained in terms of its revenue and growth, we said, let's just do it to direct. So the direct bounce back, is just where we are now. But in that pause, we really built out our capability. So, we're feeling good about having three horses to drive growth.
Jimmy Bhullar: Okay. And then on capital, obviously, your balance sheet's a lot stronger with the improved profitability. You've got the pending sale of the benefits business as well. How should we think about uses of capital, as profitability continues to recover and once the sale closes between sort of your priorities for acquisitions, potential buybacks, dividends?
Tom Wilson: A very appropriate question. I'll channel Jess for a minute here, and just say, we've always had a lot of capital. So I know not everybody believed that, but we've always been financially very strong. But as we think about capital, it is something we take very seriously. It's really one of the key things we do for shareholders, and we feel like we've been good stewards of that. As you look forward, we think the best and first place to put our money, is organic growth. Particularly when you look at the kind of ROEs we're running at. And if you look at our growth in premiums, you look at the growth potential, we think that will be the first and best place to maximize shareholder value. There's lots of other ways we use it, right. So share repurchases. I know a number of analysts brought that question up. Let me just go right to that. So we're no stranger to share repurchases. Since we went public, we bought back 83% of our shares outstanding for about $42 billion. Last 10 years, it was $20 billion in the last five years it was about $10 billion and a quarter of the shares outstanding. So we know how to and do share repurchases, when it makes sense. In this particular case, we think the growth opportunities outweigh the value of doing share repurchases. And that's because the returns are so high on that. Now if we don't, if you're keeping extra money around and you put it in the bond portfolio, and you're getting 5%, then obviously you should not be doing it. We do have other places we've used the money historically, and places we might use it in the future. So as we dialed down our equity allocation back when, we didn't think the risk and return was right. If we feel like that's appropriate, we'll dial that equity allocation up again. That uses capital. If we've also looked at acquiring growth. So the National General acquisition, Mario talked about it. And the reason we kept breaking it out so you could all see it, is that business just rocked it's twice its size. And the same thing is true with our protection plans business, which is nine or 10 times its size since we bought. And that was a little longer ago, it was seven years, but we paid $1 billion for it, and it's making over $120 million a year. So, we're feeling really good about that business, and its growth potential. So just know we always have our shareholders best interest in mind. We think about it broadly and we'll continue to do that.
Jimmy Bhullar: Thanks.
Operator: Thank you. And our next question comes from the line of Greg Peters from Raymond James. Your question please.
Gregory Peters: Good morning, everyone. I'd like to, for my first question, focus on Slide 8, which is your retention slide. And in your comments you mentioned changing of agent compensation. If I'm not mistaken, some time ago you lowered agent compensation on renewals. And I'm wondering if that's having any spillover effect on retention. Obviously, the new shoe daps are doing strong, so your competitive position looks good. Also, as part of transformative growth, I think you've been streamlining some claims costs, some claims functions. Curious if you're seeing any impact of that on retention?
Mario Rizzo: Thanks, Greg. This is Mario. Let me take your questions in order. First, on retention, when we isolate and look at, we look at retention a whole bunch of different ways. When we look at retention in the agency channel, it's actually up year-over-year. So what's happening and what you see on Page 8 is predominantly a function of price increases, which I think have the biggest impact on retention. Just from an agent compensation perspective as you mentioned, we kind of changed and have been transforming the model for them to really align with what both we want to do strategically, but also the value that customers see from agent. So we've incented agents to drive more new business, deepen relationships with customers and we see that with kind of all-time high levels of bundling. And agents, we're really pleased with the performance of our agency force and how productive they are and they're going to be a key part of our growth plan going forward. But that's really not the driver of retention that you see on the page. In terms of the claims organization, that's an area where even though the -- when you look at the ratio, it's pretty flat, that's a function of just having higher average premium. We're investing in claims. We actually have been adding staff so that we can continue to build on our claims capabilities, pay what we owe, drive a higher level of customer satisfaction. And again, we look at those as growth levers every bit as much as profit and severity management levers, but nothing really from a claim standpoint driving the retention numbers. And as I said, as a matter of fact, we're adding resources and dollars in claims to help both support the growth that we want to achieve going forward, but enhance customer satisfaction and effectively continue to manage severity levels.
Gregory Peters: Thanks for that additional information. I guess as my follow up question, just looking at the homeowners business, it looks like it's really performing well at a 62.1% underlying combined ratio. You're growing that business. I assume you're not growing just your standalone homeowners business with the policy force growth. It's part of a bundle. But maybe you can provide us some perspective on how you're able to grow that business considering all the rates you've thrown in that line of business?
Tom Wilson: I'll start and then Mario can jump in. So first, you're right and Mario called that we're just really good in homeowners. And we've made a lot of money at it. And because we've repositioned the business really over almost a 10-year period, everything from how do we underwrite to what's covered by the policy, to how we price, to our specificity and sophistication and pricing and the way we settle claims. So we're doing quite well there. You see, we are growing. Some of that is, as Mario talked about, our agents are really good at bundling and that leads to better lifetime value for us and cheaper prices for customers. So that's good on both sides. We do think that there's more growth potential there. Some of that is many people, because of the industry numbers that Mario quoted, have now decided not to grow in homeowners. And that gives us more opportunity, not just through the Allstate agents, but in particular through the independent agents. And I think we should be able to crack the code on direct. Nobody's really cracked the code on direct yet in selling homeowners, but I think there's great potential there. So I think there's growth in homeowners across all three channels. Obviously Allstate agents are doing well. The independent agent business, Mario might want to talk about what we're doing with custom 360. And then direct, I think we could be an industry leader. And my logic is, people buy houses off the web. Like if you buy a house off the web, you should buy your homeowners insurance off the web. So we'll have to sort that one out. So we're feeling good about it. I would just -- the other thing I would say is not really yet in market, but coming soon is ASC Affordable Simple Connected Homeowners. Mario has talked about Affordable Simple Connected Auto, which is in market in 25 states.
Mario Rizzo: Yes, 25 states now.
Tom Wilson: And ASC homeowners is even better. And it's got some really nice features to it, sophistication which will leave us behind in our classic product. And our classic product is far ahead of the industry. So we think it's another leap forward. You want to talk about like 360 or how you view homeowners, maybe by state or something?
Mario Rizzo: Yes. So Greg, again I just reiterate where Tom started. We're really good at homeowners and we think there is a real opportunity for us to grow homeowners in part right now because of the disruption that exists in the market. There's just fewer competitors out there that are wanting to write new business and we want to take advantage of that opportunity. We feel good about where our pricing is. As you mentioned, average premiums have gone up pretty consistently at a double digit clip over the last several years to keep pace with inflation. But when you look at our profit trends and you pointed out our underlying combined ratio which is currently in the low 60s, I think that's reflective of our ability to stay on top of loss trends and write new homeowners business at an attractive margin. We target low 90s which generates really strong returns on capital. We think we can do that and grow the business across all the distribution channels. And I'll just end with the opportunity with Custom360 in the independent agent channel because I think that becomes additive to our Allstate agents and our ability to grow direct in the Allstate brand. We're in I believe 24 states with Custom360. Currently, that's a standard and preferred auto offering along with homeowners that leverages Allstate's data and mid-market capabilities to price and really design that product. So it's intended to be the same product that we go to market with in the Allstate brand. As you can imagine, in the independent agent space we're getting really good traction on our ability to lead with homeowners which enables us to not just write the homeowners but also capture the auto opportunity from a packaged perspective. So we feel really good about the go forward opportunity in the independent agent space, which I think from a National General perspective becomes additive to the great success we've had in growing the nonstandard auto business and is really another way that we can leverage our homeowner capabilities broadly across all three horses, I'll use Tom's term, to really grow that business and generate really attractive returns going forward.
Tom Wilson: And Greg, let me make sure we fully answer your question. Price sensitivity, you referenced the rate of increase and it is high, it's higher than auto insurance right at this point. Not necessarily over the last three years, but pretty high. But that's -- it's just less price sensitive than auto insurance is. There are a whole bunch of reasons. Some of the people like their house a lot. Second, people know their house is actually worth more and so when we're charging more, they know their house is worth more.
Mario Rizzo: Not so much on cars. So, we had to raise auto insurance prices because the houses or the cars became worth. But people didn't really think about it that way. They do think about their home value. So we're comfortable with where we're at.
Gregory Peters: Thanks for the additional information.
Operator: Thank you. And our next question comes from the line of Yaron Kinar from Jefferies. Your question please.
Yaron Kinar: Thank you. Good morning. I actually have two on renewal ratios. First, maybe conceptually just looking at the slide eight, as the company grows in nonstandard auto and in direct, two areas where I think, and then correct me if I'm wrong, renewal rates for the industry have tended to be a bit lower. Is it fair to think of a run rate renewal rate that would be a bit lower than the call it through cycle 87.5 or so that I see in the slide?
Tom Wilson: Insightful question, Mara, you want to take that?
Mario Rizzo: Yes. The first just to be clear, the numbers you see on the page are Allstate brand. So there's just not that much nonstandard auto. There's more direct, but at least currently, again, not a meaningful impact in the trends. On a go forward basis, I guess, I'd broaden the statement a little bit, Yaron and say, the more new business we write, that first renewal period or the first policy period tends to be lower than the book overall. So the more new business volume we write, there will be some downward pressure on the overall retention rate. Current volumes aren't meaningful enough to really drive a significant impact. But you're right from that perspective. And then certainly in the non-standard auto space, we've seen it with National General as we broaden the risk appetite in the Allstate brand and kind of do the opposite of what we're doing in homeowners, take advantage and leverage National General's non-standard auto capabilities in the Allstate brand that will have an impact on retention. Again, magnitude, we'll have to call that out for you when we see it. But certainly that business tends to retain at lower levels because those customers just tend to shop more. So those things will have an impact on retention going forward. But I would say what you see in Page 8, pretty much a muted impact on those items at this point.
Yaron Kinar: Great. And then just think about the renewal ratio from here on. I think at times you see a little bit of a breakdown of that inverse correlation between rate increases and the renewal ratio. And we saw a little bit of that a bit earlier in this current cycle. Obviously we're seeing that pick up now. But I guess bottom line, is there a bit of a lag currently between the rate increases and the renewal ratio? One that we -- I don't think we was as pronounced in prior years?
Mario Rizzo: Yes. Yaron, it's Mario, again. There is almost certainly a lag when you think about implementing a rate increase in auto. It takes six months for that to be implemented across the entirety of the book and then you'll earn it over the six months after that. So there is a lag in terms of the rate we've taken or the industry takes and the impact on retention. And you see that in our numbers. One of the things though that I point out is and we've been clear on this. We believe we will need to take less rate given where profitability is. But again, this is a state-by-state, market-by-market business. So when we need to take prices up to keep pace with loss trends, we're going to do that. And what you saw in the third quarter, about 70% of the rate that we took was in three states. It was in New York, New Jersey, and an increase we implemented in Texas. So we're going to continue to take rate where we need to. We just think there's going to be less of it. And again, we'll look to manage retention alongside that.
Yaron Kinar: But I guess what I'm trying to get at here is I think the big rate increases that we saw in the beginning of the year were really first quarter weighted. California, New York, New Jersey. I would have thought that the full impact of those rates taking effect in the first quarter would have been in the second quarter. And by the time we came out of the third quarter, call it August, September, we'd see a little less of that pressure?
Mario Rizzo: Yes, the California rate was in the first quarter. New York and New Jersey were actually implemented in the third quarter. So -- and I believe it was over 18% in New York and 13.7 or 13.4 in New Jersey. So again, there's some pretty meaningful rates that we've implemented currently, again, to get those markets back to where they need to be from a margin perspective so we can open up to right new business.
Tom Wilson: So, Yaron, I would just say that the leg is muted and it kind of goes up and goes down, right? Like, not everybody shops, the minute they get the price, it's late, they get the bill, they just pay the bill. Then they decide after a couple of months, geez, I should really think about this. So it's not a simple on renewal that happens.
Yaron Kinar: Got it. Thank you.
Operator: Thank you. And our next question comes from the line of Bob Huang from Morgan Stanley. Your question, please.
Bob Huang: Good morning. My question also kind of follows around that line of business. So if we think about your combined ratio and growth, right. In auto, you typically target a mid-90 combined ratio, understanding that pricing has a lagging effect and then retention and growth also does. But if we just look at the combined ratio, is the current level good enough for you to really step on the gas for growth? Or do you feel you probably need a one or two point more on the auto combined ratio side before you're fully comfortable with fully ramping up that growth going forward?
Tom Wilson: We think that the auto profit improvement plan has been successfully completed. That's why we dialed up advertising by 60% from 2021. That's not just up, that's way up over last year. It's like we're not even in the same zip code. So yes, we spend the money and are investing the money because we think it will -- there are good returns. And there's like things happen in every state. So, Bob, sometimes you got a state, sometimes you back off. Mario's team is constantly doing that. But when you just look in total, we're feeling good about it in total. If you look at a couple of states, yeah, there's still some work to do.
Bob Huang: Okay. That's super helpful. Thank you for that. Second question is around the homeowner side. Understand that you kind of said there are a few competitors now. The technology really makes it easier potentially for homeowner insurance to really grow from here. But isn't it fair to say that the states where there are opportunities, there are also states where people are trying to pull out. So growth, wouldn't that be geography related? Can you maybe talk about what regions do you think is more attractive on the homeowner front or where do you think the opportunity lies in the growth on that space?
Tom Wilson: So let me go up a minute and then turn it over to Mario. First, we think homeowners is a good business. There is the challenge of increased severe weather and what it does to increase catastrophe losses, which you referenced. Like why go right where there's a bunch of catastrophes? I mean if you can get the right price, its fine. And then you just buy reinsurance for a risk you don't want. And when you look at increased losses from weather related events, there are three drivers. One just more storms and more severe -- mostly more severe storms actually. Two is houses are worth more and three people are building houses in places that are risk. To your other point, those latter two you can know, like those are known knowns. You can factor those into your pricing effect. You can factor those into your growth opportunities. You can factor that into where you try to get new customers. It's the third one. But the third one tends to be the -- is the smallest according to a couple of external studies of the dry attribution on increased catastrophe losses. So the unknown known of what will happen to the severity of storms is the smallest driver of the increase in catastrophe losses. So we feel good about it in total from a macro standpoint. And then we execute it obviously at a not even at a much below a state level. You get east of Sunrise Highway, we get different standards and if you're west of Sunrise Highway on Long Island. So Mario, do you want to talk about where you see growth opportunities?
Mario Rizzo: Yes. Maybe I'll start with where we don't, because I think it gets to the first part of your question. And two states in particular, Florida and California obviously really challenged homeowner markets that there's been a lot of pullback across the industry. Those are not states that we're looking to get bigger in. So certainly those would not be where we focus our growth efforts and then we'll continue to manage PML and coastal exposure to be within our risk appetite. But then once you kind of get away from that, really the rest of the country, particularly the middle part of the country is -- there's real opportunity for us to continue to grow homeowners. And that's not where you get the hurricanes or necessarily the wildfires. It's more severe weather, tornadoes, hail and so on. And what we found is a lot of competitors have pulled back in those states given severe weather experience. I think that's where our capabilities from a product, a pricing, a risk management perspective really enable us to take advantage of the disruption in the market and grow pretty broadly geographically and not have to kind of grow where, I guess where we can, because nobody else wants it, but actually grow where we think we can generate attractive returns. And that geographically is the vast majority of the country. And again, that's why I think being good at homeowners and having an effective system and operating model to write it and write it profitably is a real competitive advantage for us. And I think you see that in the growth trends really over the course of this year.
Tom Wilson: And I just said, we grew 2.5% from the last year, and we did grow in two giant markets that Mario talked about, which I'm going to guess are 15% to 20% of the homes in the United States. So, we did quite well there.
Bob Huang: Excellent. Really appreciate the answer. Thank you very much.
Operator: Thank you. And our next question comes from the line of [Christian Gitzoff] from Wells Fargo. Your question, please.
Unidentified Analyst: Hi, good morning, Mario. You said a 75% to 80% of your auto premiums are currently open for new business. So is it safe to assume that auto policies grew quarter-over-quarter in those states in the Q3?
Mario Rizzo: Yes. I won't go into any state specific detail, but what I will say is we're open broadly. The 26% increase in new business that you saw was not concentrated in a handful of states. It was pretty broad as well, but so -- were the retention decline. So really it's a combination of all those things kind of working together. There's markets that grew in total. There's others that did not. But we're focused on having all of them turn positive at some point.
Unidentified Analyst: Got you. And then so with the auto retention being down a point sequentially, and then PIFs were down 50bps, this is auto. Like, is the majority of the declines in those metrics driven by California, New York, New Jersey, just given, like the big rate increases we saw, that were implement, I guess approved in December. They were kind of implemented throughout the year. And then when would you kind of expect in, I guess excluding those three states, right? That PIF improved quarter-over-quarter. Trying to get a sense of how big of a drag those three states have?
Tom Wilson: Yes. The quarter-over-quarter change in retention, I know came up across a number of reports that came out. Let me just comment on that because there's really two things going on. Some of the decline, probably about 40% of the decline is attributable to a handful of states. It's California as well as New York and New Jersey that are having a meaningful impact quarter-over-quarter. And again that's driven by some of the larger rate increases that we've implemented this year. There's another portion of it that I think reinforces why we made the disclosure change. We did, which is about 60% of that sequential decline in retention is attributed to -- we're migrating some legacy encompass books of business in some reasonably large states to National General. One of those states is California. And what that does is it drags down the Allstate brand renewal ratio. But as those policies -- as those customers opt to take a National General policy, it shows up in National General's numbers. So that's where looking at it by brand is -- I'm sorry, it was insurance. I misspoke. I said encompass, their legacy assurance customers. But that's why looking at it by brand, you just see -- as we operate the business in total with multiple brands, some of those brand metrics get distorted. So we just think it's more constructive to look at the total.
Mario Rizzo: And I think look at the long term number. We're down 2.7 points. We think it should be able to go up from there. So quarter-to-quarter we'll do full attribution on it. We're happy to talk about it. But it's the real drivers who just raise prices a lot, so a lot of people wouldn't shop.
Unidentified Analyst: Thank you.
Operator: Thank you. And our next question comes from the line of David Motemaden from Evercore ISI. Your question please.
David Motemaden: Hi, thanks. Good morning. I was wondering if you could just comment on your expectations for the timing of the retention ratio improvements. I know that you mentioned leveling off of rate increases should help retention. So I'm wondering, are you seeing any evidence of that here in October or is it still too early to tell?
Tom Wilson: First, obviously sooner is better than later. So we're all on it. The whole team's on it. There's a whole bunch of stuff we're doing that Mario mentioned to make it move and you can see benefits in individual states. So we have some pretty large states that it's actually up. So we have confidence that we know how to manage our way through this. But we haven't really done a projection on that. We're comfortable giving to everybody to say here's the number you should count on. What we do know is as Mario pointed out is we expect to grow market share and personal profit liability and that's by doing transformative growth. In the near term we have to get retention up and continue to expand our new business. But then longer term all the work we're doing there is just even more sustainable. So rolling out ASC auto, ASC homeowners, all that work will drive long term growth.
David Motemaden: Got it, thanks. It definitely feels like you guys are pretty confident around just the -- or feel optimistic that the tempering rate increases should help improve that retention. I mean from your standpoint is it really just -- we're sort of just having this timing impact from these three big states that need to just sort of work their way through, and like we're on the cusp here of a turn, or I mean I'm just trying to understand how you guys are thinking about it internally?
Tom Wilson: We're thinking about we need to do a better job for our customers. So, we're charging them a lot more, they expect more, they deserve more. Some of that's because their cars and stuff and Bob the injury claims are higher, but like we need to do a good job for them. So it's not just oh let's wait this out and not take a bunch of price increases and it'll bounce back. We're actively working on this year alone we have a goal on double-digit millions of improving the customer experience individual transactions. We'll have another goal for next year that will be similar, but different. We're working on how do, we get more precise on the price. So if you're an elderly person, you don't drive much, you should have Milewise you'll cut your price in half. So we're not, we're not, it's not like we just think oh we're through this. I think this is just provide our - we use our operational excellence and capabilities, to go back in now and fine tune the fact that we had to raise prices a lot, so we can keep more customers.
David Motemaden: Great, thank you.
Operator: Thank you. And our next question comes from the line of Josh Shanker from Bank of America. Your question, please.
Josh Shanker: Yes, thank you for getting me at the end. Two questions, one whimsical and one numbers. You talked about sort of cracking the code, on how to get people to buy homeowners insurance online. How far away are we from being able to call Allstate and getting into an AI conversation with Dennis Haysbert or Dean Winters that knowledgeable about what you can do to save money, by switching to Allstate and what you can do for your policy?
Tom Wilson: I love whimsical questions, but I would say that one's probably not whimsical really. We have a - I'd say let's call sales sidekick, which will help people do a better job of interacting with customers. It's going to dramatically change the way that the people interact with other people, which is why Mario was talking about how we have to reposition the off-site agents. It gives us an opportunity to do that at lower cost. So work they had to do before where they couldn't do, or they had lower close rates, because they didn't know some stuff will increase their productivity, and make them even better. So, we're feeling really good about where that might go. And I think, if you look at our web stuff on ASC, that's quite sophisticated too. So Mario, what would you add?
Mario Rizzo: Yes, the only other thing I'd add, Josh, that makes it not as whimsical as you might think, is we have a lot of data on homeowners, both in terms of customers we've insured in the past and just on the homes across the country in general, which I think facilitates our ability to do what you described, and be really efficient - intelligently being able to price and manage the homeowner risk. So that's the other component I think that gets us and creates the ability to do what you, what you suggested
Josh Shanker: And then numbers look, ad spend is way up as you look to grow the business. I'm multiplying your number on that buy premium and seeing it up substantially. You also gave us a lot of data around new issued applications, and we can make some guesses around gross new customers. The ad spend is up significantly more than the new customer acquisition. Can you talk a little about what is sensible acquisition cost per customer, how we should think about it. And clearly are you getting the kind of pack on new business that you can make a return over a two or three year period on that investment?
Tom Wilson: A bunch of questions in this, and let me end on this one first. Advertising is a little bit like driving a car when you first, when you hit the gas pedal it doesn't take off right away. It takes a while to get to 60. So you've seen us do that. We like the performance we see in terms of brand consideration. We like the number of quotes that have gone up, and we like our close rate. So but if you said, did we get back every dollar we spent economically as we're ramping it up? No you, you're kind of investing some for the future. That said, we have highly sophisticated metrics around it and it's both upper and lower funnel. If you break it into upper funnel being, kind of brand image stuff, lower funnel being, I send you, I got a specific lead and I buy that lead and I know you're shopping. So we have highly sophisticated math around that. It continues to be a sophistication game. We think we're pretty good at it. Outside people tell us we're pretty good at it. That said, you can always be better. And when you're spending billions of dollars, you ought to be really good at it. So, we're feeling good about the investment to-date. We think we can continue to spend more, and that will drive economic growth. But if it doesn't, we have the ability to just dial it down whenever we want. It's not really that complicated. So thank you all for this. Our goal, of course, is to increase personal profit, liability and market share, which we talked a lot about today. Also broaden our Protection offerings, well capitalized, we have good shareholder returns, and we look forward to seeing you next quarter.
Operator: Thank you, ladies and gentlemen for your participation in today's conference. This does conclude the program. You may now disconnect. Good day. | [
{
"speaker": "Operator",
"text": "Good day, and thank you for standing by. Welcome to Allstate's Third Quarter Investor Call. At this time, all participants are in listen-only mode. After the prepared remarks, there will be a question-and-answer session. [Operator Instructions] As a reminder, please be aware this call is being recorded. And now, I'd like to introduce your host for today's program, Alastair Gobin, Head of Investor Relations. Please go ahead, sir."
},
{
"speaker": "Alastair Gobin",
"text": "Thank you, Jonathan. Good morning. Welcome to Allstate's third quarter 2024 earnings conference call. Yesterday, following the close of the market, we issued our news release and investor supplement, filed our 10-Q and posted related material on our website at allstateinvestors.com. Our management team will provide perspective on our strategy and an update on our results. After prepared remarks, we will have a question-and-answer session. As noted on the first slide of the presentation, our discussion will contain non-GAAP measures, for which there are reconciliations in the news release and investor supplement and forward-looking statements about Allstate's operations. Allstate's results may differ materially from these statements, so please refer to our 10-K for 2023 and other public documents for information on potential risks. And now, I'll turn it over to Tom."
},
{
"speaker": "Tom Wilson",
"text": "Good morning. We appreciate you investing your time in understanding the value creation potential at Allstate. I'm going to provide an overview of results. Mario and Jess will walk through the operating performance, and then we'll address your questions. So let's begin on Slide 2. Allstate's strategy has two components, increased personal Property-Liability market share, and expand protection provided to customers, which are shown in the two ovals on the left. We now have more than 200 million policies in force. On the right hand side, you can see Allstate's performance for the third quarter. Total revenues of $16.6 billion were up 14.7%, compared to the prior year quarter. Allstate generated net income of $1.2 billion and adjusted net income of $3.91 per share. Return on equity was 26.1% over the last 12 months. The Property-Liability business, is now positioned for growth. Execution of the auto profit improvement plan has restored auto margins, near term auto insurance policy growth will require us to improve customer retention and increase new business levels, both of which Mario will discuss. The homeowners business had good returns and is growing. The transformative growth initiatives, to build a low cost digital insurer with affordable, simple and connected protection, will ensure that this growth is sustainable. Proactive investing also benefited income as the decision to lengthen duration at the right time increased portfolio yields. In addition, higher insurance prices, and increased reserve levels create a much larger investment portfolio, which also raises income. Protection plans continues to profitably grow, and we recently did a small acquisition to expand mobile device protection capabilities. Let's move to Slide 3. Here you can see the operational execution generated excellent financial results. Revenues increased to $16.6 billion. As you can see in the upper left, Property-Liability earned premiums were up 11.6%. Net investment income for the quarter was $783 million that's 13.6% higher than the prior year quarter. Net income was $1.16 billion. Adjusted net income as I mentioned was $3.91 per share. And then, you can see in the lower right that the return on equity was 26.1%. This shows that Allstate's operational excellence enabled us to dramatically improve results from last year. Now let's hear from Mario on Property-Liability results."
},
{
"speaker": "Mario Rizzo",
"text": "Thanks, Tom. Before I go into my remarks on the quarter, I want to call out a change we made to our disclosures. You'll notice that we simplified our Protection segment disclosures this quarter, to focus on product and channel instead of brand. For the past several years, we've provided detail on both the Allstate and National General brands separately, to create transparency into National General's performance and allow you to evaluate the acquisition. National General has been a highly successful acquisition, since it is now twice its size, generates excellent returns and gives us strong competitive positions in both independent agent distribution and non-standard auto risk. We're now building on this success by combining operations, such as expanding the sale of non-standard business under the Allstate brand. As a result, performance should be evaluated for the protection business in total, and by distribution channel versus by brand and that's why we made the change. So in keeping with this approach, my commentary today will be focused on performance on total auto and homeowner lines, and production by distribution channel. With that as background, let's start on Slide 4. On the top of the table on the left, you can see Property-Liability premiums of $13.7 billion, increased 11.6% in the third quarter driven by higher average premiums. Underwriting income of $495 million improved by $909 million, compared to the prior year quarter, as improved underlying margins more than offset higher catastrophes. The expense ratio of 21.5 was 0.3 points higher than prior year, due to increased advertising. As we continue to accelerate growth investments in rate adequate states and risk segments. The chart on the right depicts the components of the 96.4 combined ratio. The loss ratio shown in light blue includes losses of $1.7 billion and was 2.8 points higher than the prior year quarter. The underlying combined ratio of 83.2 in dark blue improved by 8.7 points, compared to the prior year quarter. The improvement was driven by higher average earned premium, and improved loss cost strengths. Prior year reserve reestimates excluding catastrophes had only a minor impact on current quarter results, as favorable development in personal auto and homeowners insurance, was more than offset by increases in personal umbrella and runoff business, primarily related to asbestos related claims, which was recorded this quarter, as a result of our annual third quarter discontinued lines reserve review. Now let's dive deeper into auto insurance margins on Slide 5, where you can see the success of the auto profit improvement plan. The third quarter recorded auto insurance combined ratio of 94.8 improved by 7.3 points, compared to the prior year quarter as average earned premiums outpaced loss costs. Average underlying loss in expense was 4.8% above prior year quarter, reflecting higher current year incurred severity estimates, primarily driven by bodily injury coverage offset by lower accident frequency, as well as higher advertising investments to drive new business growth. Physical damage severity increases continue to moderate, while bodily injury severity continues to trend above broader inflation indices. Our claims team continues to focus on operational actions, to mitigate the impact of inflationary trends. As a reminder, we regularly review claim severity expectations throughout the year. If the expected severity for the current year changes, we record the year-to-date impact in the current quarter, even though a portion of that impact is attributable to previous quarters. For 2022 and 2023, the bars in the graph reflect the updated average severity estimates, as of the end of each of those years to remove the volatility, related to intra-year severity adjustments. Similarly, in the third quarter of 2024, the full year claim severity estimate went down, so there was a benefit from prior quarters included in the third quarter's reported results. This benefit was worth 0.8 points in the third quarter, with the adjusted quarterly combined ratio of 95.6 as shown on the far right bar. Now let's review homeowners insurance on Slide 6, which generates attractive returns and growth opportunities. Allstate is an industry leader in homeowners insurance, generating a low 90s combined ratio over the last 10 years. As you can see in the chart on the left, this performance compares favorably to the industry, which experienced an underwriting loss and a combined ratio of 103 over the same time period. Moving to the table on the right, Allstate Protection homeowners written premium increased by 10.8%, compared to prior year reflecting higher average gross written premium per policy, and policy enforced growth of 2.5%. The third quarter combined ratio of 98.2 resulted in $60 million of underwriting income, compared to a $131 million loss in the prior year quarter. The underlying combined ratio of 62.1 improved by 10.8 points, due to higher average premium and lower non-catastrophe loss costs. For the first nine months of 2024, homeowners insurance generated an underwriting profit of $249 million, despite $1.2 billion of catastrophe losses in in the third quarter. Let me provide insight into the growth potential of the Property-Liability business starting on Slide 7. In the chart on the left, you see the composition of the Property-Liability book. Homeowners in medium blue represents approximately 20% of policies in force. Homeowners' insurance policies in force increased by 2.5% as retention has improved by close to half a point, compared to last year and new issued applications are close to 20% above prior year. As you can see in the right hand column. We view homeowners as a growth opportunity. Auto policies in the dark blue account for approximately two-thirds of Property-Liability policies enforced. As you can see on the right side of the page, overall policies enforce declined by 1.5%. This reflects a decline in customer retention to 84.7%, which is 2/10th of a point below the prior year quarter, but much lower than historical levels. We did have a 26% increase in new issued applications, which offset some of the retention losses. Now let's go through each of these components to give you insight into how to assess growth prospects. Let's start with customer retention on Slide 8. This chart shows Allstate brand auto insurance retention over a 10-year period which is primarily standard auto insurance risks. There is a couple of key points I want to make on this slide. First, raising prices leads to lower retentions as customers shop for other options. Second, the large increases in the last several years have led to a significant decline in retention since 2022, which has negatively impacted policies in force. This has, however, recently leveled off as price increases have moderated. Let's look at the three periods with the arrows. In 2015 and 2016, we raised auto insurance prices, which you can see from the dotted line because of an increase in the frequency of accidents. The graph shows how this led to lag declines in retention from 88.2 in 2014 to 86.7 in 2017. Over the next three years, price increases were relatively modest and retention recovered reaching 88.3 by 2019. Now, there are lots of factors impacting retention, such as the amount of new business you write, the risk type of that business, number of bundled policies and specific actions taken in big states like California and Florida, as well as customer satisfaction levels. But the biggest driver is price. Increased advertising and price competition had a modest negative impact over the next several years with retention hovering around 87%. You can see this in the most recent period where retention has declined by 2.7 points over the last 10 quarters, which reflected rate increases of 36% on a cumulative basis. Looking forward, we expect lower rate increases given the profitability of auto insurance. This year, for example, Allstate brand rates have been increased by 6.3% compared to 9.5% in the first nine months of last year. Lower price increases should translate into higher retention. To help you model this out, every point of retention is worth approximately 350,000 policies enforced each and every year, or 1.4% of the current policy count. Moving to Slide 9, let's discuss the success we've had in increasing new business levels this year. We continue to invest in transformative growth while we executed the profit improvement plan. These foundational investments enable us to go to market with a multichannel distribution strategy that serves customers based on their personal preferences and has resulted in a 26% increase in new business in the third quarter shown in the far right column at the bottom. While profit actions previously restricted our new business appetite, rate adequacy has now been achieved in the vast majority of states. Third quarter advertising spend was roughly 60% higher than the same quarter in 2021. In the Allstate agency channel, the compensation structure was also changed to improve growth and agent productivity at lower distribution costs. Allstate Agency new business was up 16% over the prior year quarter with bundling rates at point of sale at all-time highs. The national general acquisition enabled us to grow independent agency new business by 14% over the prior year quarter. In the direct channel, we are back to 2022 levels with fewer underwriting restrictions, increased advertising and the new affordable, simple and connected auto product which is currently available in 25 states. New business is 56% over prior year and we expect to increase to continue increasing volume in this channel which now represents 31% of total auto new business. This level of new business will drive future growth. Every 5% increase in new issued applications above the current run rate increases policies enforce by approximately 250,000 items or 1% of policies in force. Looking forward, the property liabilities business is positioned for growth. Margins are attractive, fewer rate increases should improve retention and the components of transformative growth are working, including new products, increased advertising, lower expenses and expanded distribution. This will enable us to achieve our strategic goal of increased Property-Liability market share. And now, I'll turn it over to Jess."
},
{
"speaker": "Jess Merten",
"text": "Thank you, Mario. Let's shift to Slide 10 to review investment performance. A proactive approach to portfolio management that optimizes return per unit of risk across the enterprise generated strong returns this quarter. Our disciplined approach includes comprehensive monitoring of economic conditions, market opportunities, interest rates and credit spreads. The chart on the left shows the fixed income, portfolio yield and assets under management trend over the last several years. Fixed income yield shown with the orange line has steadily increased as we repositioned into higher yielding longer duration assets. Based on interest rates in the third quarter our fixed income yield is now generally in line with market yields. In the gray bars you can see growth in the portfolio book value. Since the fourth quarter of 2021, book value has increased by 14% or $9.1 billion, reflecting the impact of higher underwriting cash flows attributable to increased premiums and reserve levels as well as portfolio cash flows that increased because of higher coupon rates. Growth in assets and higher yields benefited net investment income as shown in the chart on the right. Net Investment income totaled $783 million in the quarter, which is $94 million above the third quarter of last year. Market based income of $708 million, which is shown in blue, was $141 million above the prior year quarter, reflecting the impact of a fixed income yield that is 60 basis points above the third quarter last year. Performance based income of $143 million shown in black was $43 million below the prior year quarter, reflecting lower real estate investment results. While this quarter's result is lower than our long term expectation, our returns continue to be strong and volatility on these assets from quarter-to-quarter is expected. Slide 11 highlights strong results in the protection plans business, which is one of the five companies in the protection services segment that also includes Arity, Roadside, dealer Services and identity protection. The Protection Plans business provides warranties for consumer electronics, computers and tablets, TVs, mobile phones, major appliances and furniture through strong domestic and international retail distribution relationships. Revenues for this business totaled $512 million in the third quarter and increased 23.1% compared to the prior year, reflecting growth in international markets. Profitable growth resulted in adjusted net income of $39 million, a $19 million increase compared to the prior year quarter, as strong operational execution increased margins and enabled successful implementation of the strategy to expand distribution relationships and product offerings. We continue to invest in this fast growing business. In October, Allstate Protection Plans acquired Kingfisher to enhance capabilities in mobile phone protection. Now let's Transition to Slide 12 to focus on the terms and accounting treatment of the sale of the Employer Voluntary Benefits business. As we announced in August, Allstate finalized an agreement to sell the Employer Voluntary Benefits business, which I will also refer to as the EVB business for a purchase price of $2 billion to StanCorp Financial. The transaction is expected to close in the first half of 2025, pending regulatory approvals. As a reminder, the EVB sale is the first step in a strategic decision to pursue divestiture of the Employer Voluntary Benefits, group health and individual health businesses to capture value through greater strategic alignment. The EVB transaction is economically and financially attractive for shareholders. Allstate retains the economics of the business until closing and results continue to be reflected in net income and adjusted net income. In the quarter $3.2 billion of assets and $2.2 billion of liabilities related to the EVB business have been classified as held for sale. As you can see on the right of the slide, we're estimating a $600 million gain and had previously disclosed that we expect the transaction to generate approximately $1.6 billion of capital. Moving to health and benefits results for the quarter, Premium and contract charges for the segment increased 5.2% for $24 million compared to the prior year quarter. The individual and group health businesses saw strong growth with premiums and contract charges up by 8.1% and 20.2% respectively. This growth was partially offset by a modest decrease in the EVB business. Adjusted net income for the segment of $37 million in the quarter was $32 million lower than the prior year quarter as increased benefit utilization across all three businesses impacted profitability, underwriting and rate actions are being taken to quickly address the benefit ratio trends and restore margins to historical levels. The process to evaluate disposition of the group and individual businesses is progressing. Let's wrap up with Slide 13 to recap Allstate's strategy and path to value creation. Operational excellence ensures that we react to changing business conditions and maintain margins at target levels. Transformative growth investments are being made to create sustainable growth and Allstate delivers attractive returns. With that as context, let's open the line for questions."
},
{
"speaker": "Operator",
"text": "Certainly. And our first question for today comes from the line of Jimmy Bhullar from JPMorgan. Your question, please."
},
{
"speaker": "Jimmy Bhullar",
"text": "Hi, good morning. So first, just had a question around your confidence and outlook for PIF growth in the auto business, and what you're seeing in terms of competitor behavior, both on prices and on advertising. Seems like most competitors are - shifting to a growth mode now that margins have recovered. But are you confident that we can see PIF growth turn positive over the next few quarters?"
},
{
"speaker": "Tom Wilson",
"text": "Jimmy, let me make a couple of comments and Mario can jump in. First, we don't give growth projections, so we're not going to comment on that. We gave you. We put the numbers in there, so you can do your own analysis of how you think we'll do in retention, and how you think we'll do in new business. We obviously believe we can grow market share, which is what our whole strategy is about. When you look at the competitive environment, you continue to see progressive advertising aggressively GEICO has gotten back into the market, but perhaps not as aggressively as they have in the past. And State Farm continues to try to grow, but as you know, they have an underwriting profitability challenge that they're I suspect they will take out, but we'll only see. But I would also not just focus on those big players, but there's a whole bunch of other players that are more moderate size or smaller that either don't have the firepower in advertising to compete, or don't have the pricing sophistication. Mario, do you want to make comments about how you're feeling about growth?"
},
{
"speaker": "Mario Rizzo",
"text": "Yes, thanks for the question, Jimmy. At its highest level, obviously to turn positive, PIF growth requires that we keep more of our existing customers, which is the retention component, and then we drive increased levels of new business. Maybe I'll talk about each of the pieces individually. Like we pointed out in the presentation, obviously a lot of the rate actions in the profit improvement plan that we've implemented over the last couple of years has had a pretty negative impact on customer retention. Now going forward, we would expect, just given where our margins are in auto, all other things being equal, we would expect to take less rate going forward, which will have a positive impact on retention, as it has in the past as we create less disruption in the book. But the other side of it is, we're not just going to rely on that. We've got actions in place in a number of areas, both in terms of improving the customer experience. Working with our customers, both through our agents, and our contact centers to help identify opportunities to improve affordability, and really kind of mitigate shopping activity from our own customers. So, we're focused on retention improving going forward, both kind of organically, I'll say through less rate, but we're also not sitting back. We're taking proactive actions to help offset some of the headwind that we've seen in retention. On the other side. On the new business standpoint, just to give you some context, we talked about the vast majority of markets being open for business somewhere between 75% and 80% of our premium volume. When you look at it nationally, those are markets that we are open for business. We're accelerating investments, and we've really seen some good production trends across all distribution channels. Our agents are productive, they're bundling at all-time high levels, which also will help retention. We believe over time we're continuing to see really good traction on the direct business and we think there's ongoing opportunity there. And then as I mentioned earlier, the National General acquisition and what we've been able to do both in the non-standard auto market, as well as in the independent agent space more broadly, is generating some good production trends. So, we feel good about that. We're focused on improving retention, while continuing to build on the growth momentum from a new business perspective, which has improved sequentially over the course of the year. And when those two things come together, that that's what will drive positive growth."
},
{
"speaker": "Tom Wilson",
"text": "Jimmy, let me add just a couple of things. On a longer term perspective, what Mario talked about. So when auto profitability went negative, we said first priority, get the rate, don't be too specific about it. And what Mario is talking about is going back in now and saying, okay, well we got the total rate. How many more people should be using Milewise? How many more people should be using telematics? Those are great opportunities for us to leverage our innovation and keep more customers. So there's a bunch of good work going on there. So the priority that we gave to the team was we need to make money in auto insurance. We've done that. Now we're ready to go back in and, which should drive retention. The other thing I would say is on distribution. If you look at our historical growth, this is the first time really we have three fully functioning channels. Like, we've got three horses here, all ready to run. You can see the growth. And direct is up a lot this versus last year. But that's, because direct was the first place we shutdown, too. When it came to how do we get profitability up in auto insurance, we said well, first, if we're losing money on it, we shouldn't write it. Rather than take that hit in volume to the Allstate aging channel, which needs to be maintained in terms of its revenue and growth, we said, let's just do it to direct. So the direct bounce back, is just where we are now. But in that pause, we really built out our capability. So, we're feeling good about having three horses to drive growth."
},
{
"speaker": "Jimmy Bhullar",
"text": "Okay. And then on capital, obviously, your balance sheet's a lot stronger with the improved profitability. You've got the pending sale of the benefits business as well. How should we think about uses of capital, as profitability continues to recover and once the sale closes between sort of your priorities for acquisitions, potential buybacks, dividends?"
},
{
"speaker": "Tom Wilson",
"text": "A very appropriate question. I'll channel Jess for a minute here, and just say, we've always had a lot of capital. So I know not everybody believed that, but we've always been financially very strong. But as we think about capital, it is something we take very seriously. It's really one of the key things we do for shareholders, and we feel like we've been good stewards of that. As you look forward, we think the best and first place to put our money, is organic growth. Particularly when you look at the kind of ROEs we're running at. And if you look at our growth in premiums, you look at the growth potential, we think that will be the first and best place to maximize shareholder value. There's lots of other ways we use it, right. So share repurchases. I know a number of analysts brought that question up. Let me just go right to that. So we're no stranger to share repurchases. Since we went public, we bought back 83% of our shares outstanding for about $42 billion. Last 10 years, it was $20 billion in the last five years it was about $10 billion and a quarter of the shares outstanding. So we know how to and do share repurchases, when it makes sense. In this particular case, we think the growth opportunities outweigh the value of doing share repurchases. And that's because the returns are so high on that. Now if we don't, if you're keeping extra money around and you put it in the bond portfolio, and you're getting 5%, then obviously you should not be doing it. We do have other places we've used the money historically, and places we might use it in the future. So as we dialed down our equity allocation back when, we didn't think the risk and return was right. If we feel like that's appropriate, we'll dial that equity allocation up again. That uses capital. If we've also looked at acquiring growth. So the National General acquisition, Mario talked about it. And the reason we kept breaking it out so you could all see it, is that business just rocked it's twice its size. And the same thing is true with our protection plans business, which is nine or 10 times its size since we bought. And that was a little longer ago, it was seven years, but we paid $1 billion for it, and it's making over $120 million a year. So, we're feeling really good about that business, and its growth potential. So just know we always have our shareholders best interest in mind. We think about it broadly and we'll continue to do that."
},
{
"speaker": "Jimmy Bhullar",
"text": "Thanks."
},
{
"speaker": "Operator",
"text": "Thank you. And our next question comes from the line of Greg Peters from Raymond James. Your question please."
},
{
"speaker": "Gregory Peters",
"text": "Good morning, everyone. I'd like to, for my first question, focus on Slide 8, which is your retention slide. And in your comments you mentioned changing of agent compensation. If I'm not mistaken, some time ago you lowered agent compensation on renewals. And I'm wondering if that's having any spillover effect on retention. Obviously, the new shoe daps are doing strong, so your competitive position looks good. Also, as part of transformative growth, I think you've been streamlining some claims costs, some claims functions. Curious if you're seeing any impact of that on retention?"
},
{
"speaker": "Mario Rizzo",
"text": "Thanks, Greg. This is Mario. Let me take your questions in order. First, on retention, when we isolate and look at, we look at retention a whole bunch of different ways. When we look at retention in the agency channel, it's actually up year-over-year. So what's happening and what you see on Page 8 is predominantly a function of price increases, which I think have the biggest impact on retention. Just from an agent compensation perspective as you mentioned, we kind of changed and have been transforming the model for them to really align with what both we want to do strategically, but also the value that customers see from agent. So we've incented agents to drive more new business, deepen relationships with customers and we see that with kind of all-time high levels of bundling. And agents, we're really pleased with the performance of our agency force and how productive they are and they're going to be a key part of our growth plan going forward. But that's really not the driver of retention that you see on the page. In terms of the claims organization, that's an area where even though the -- when you look at the ratio, it's pretty flat, that's a function of just having higher average premium. We're investing in claims. We actually have been adding staff so that we can continue to build on our claims capabilities, pay what we owe, drive a higher level of customer satisfaction. And again, we look at those as growth levers every bit as much as profit and severity management levers, but nothing really from a claim standpoint driving the retention numbers. And as I said, as a matter of fact, we're adding resources and dollars in claims to help both support the growth that we want to achieve going forward, but enhance customer satisfaction and effectively continue to manage severity levels."
},
{
"speaker": "Gregory Peters",
"text": "Thanks for that additional information. I guess as my follow up question, just looking at the homeowners business, it looks like it's really performing well at a 62.1% underlying combined ratio. You're growing that business. I assume you're not growing just your standalone homeowners business with the policy force growth. It's part of a bundle. But maybe you can provide us some perspective on how you're able to grow that business considering all the rates you've thrown in that line of business?"
},
{
"speaker": "Tom Wilson",
"text": "I'll start and then Mario can jump in. So first, you're right and Mario called that we're just really good in homeowners. And we've made a lot of money at it. And because we've repositioned the business really over almost a 10-year period, everything from how do we underwrite to what's covered by the policy, to how we price, to our specificity and sophistication and pricing and the way we settle claims. So we're doing quite well there. You see, we are growing. Some of that is, as Mario talked about, our agents are really good at bundling and that leads to better lifetime value for us and cheaper prices for customers. So that's good on both sides. We do think that there's more growth potential there. Some of that is many people, because of the industry numbers that Mario quoted, have now decided not to grow in homeowners. And that gives us more opportunity, not just through the Allstate agents, but in particular through the independent agents. And I think we should be able to crack the code on direct. Nobody's really cracked the code on direct yet in selling homeowners, but I think there's great potential there. So I think there's growth in homeowners across all three channels. Obviously Allstate agents are doing well. The independent agent business, Mario might want to talk about what we're doing with custom 360. And then direct, I think we could be an industry leader. And my logic is, people buy houses off the web. Like if you buy a house off the web, you should buy your homeowners insurance off the web. So we'll have to sort that one out. So we're feeling good about it. I would just -- the other thing I would say is not really yet in market, but coming soon is ASC Affordable Simple Connected Homeowners. Mario has talked about Affordable Simple Connected Auto, which is in market in 25 states."
},
{
"speaker": "Mario Rizzo",
"text": "Yes, 25 states now."
},
{
"speaker": "Tom Wilson",
"text": "And ASC homeowners is even better. And it's got some really nice features to it, sophistication which will leave us behind in our classic product. And our classic product is far ahead of the industry. So we think it's another leap forward. You want to talk about like 360 or how you view homeowners, maybe by state or something?"
},
{
"speaker": "Mario Rizzo",
"text": "Yes. So Greg, again I just reiterate where Tom started. We're really good at homeowners and we think there is a real opportunity for us to grow homeowners in part right now because of the disruption that exists in the market. There's just fewer competitors out there that are wanting to write new business and we want to take advantage of that opportunity. We feel good about where our pricing is. As you mentioned, average premiums have gone up pretty consistently at a double digit clip over the last several years to keep pace with inflation. But when you look at our profit trends and you pointed out our underlying combined ratio which is currently in the low 60s, I think that's reflective of our ability to stay on top of loss trends and write new homeowners business at an attractive margin. We target low 90s which generates really strong returns on capital. We think we can do that and grow the business across all the distribution channels. And I'll just end with the opportunity with Custom360 in the independent agent channel because I think that becomes additive to our Allstate agents and our ability to grow direct in the Allstate brand. We're in I believe 24 states with Custom360. Currently, that's a standard and preferred auto offering along with homeowners that leverages Allstate's data and mid-market capabilities to price and really design that product. So it's intended to be the same product that we go to market with in the Allstate brand. As you can imagine, in the independent agent space we're getting really good traction on our ability to lead with homeowners which enables us to not just write the homeowners but also capture the auto opportunity from a packaged perspective. So we feel really good about the go forward opportunity in the independent agent space, which I think from a National General perspective becomes additive to the great success we've had in growing the nonstandard auto business and is really another way that we can leverage our homeowner capabilities broadly across all three horses, I'll use Tom's term, to really grow that business and generate really attractive returns going forward."
},
{
"speaker": "Tom Wilson",
"text": "And Greg, let me make sure we fully answer your question. Price sensitivity, you referenced the rate of increase and it is high, it's higher than auto insurance right at this point. Not necessarily over the last three years, but pretty high. But that's -- it's just less price sensitive than auto insurance is. There are a whole bunch of reasons. Some of the people like their house a lot. Second, people know their house is actually worth more and so when we're charging more, they know their house is worth more."
},
{
"speaker": "Mario Rizzo",
"text": "Not so much on cars. So, we had to raise auto insurance prices because the houses or the cars became worth. But people didn't really think about it that way. They do think about their home value. So we're comfortable with where we're at."
},
{
"speaker": "Gregory Peters",
"text": "Thanks for the additional information."
},
{
"speaker": "Operator",
"text": "Thank you. And our next question comes from the line of Yaron Kinar from Jefferies. Your question please."
},
{
"speaker": "Yaron Kinar",
"text": "Thank you. Good morning. I actually have two on renewal ratios. First, maybe conceptually just looking at the slide eight, as the company grows in nonstandard auto and in direct, two areas where I think, and then correct me if I'm wrong, renewal rates for the industry have tended to be a bit lower. Is it fair to think of a run rate renewal rate that would be a bit lower than the call it through cycle 87.5 or so that I see in the slide?"
},
{
"speaker": "Tom Wilson",
"text": "Insightful question, Mara, you want to take that?"
},
{
"speaker": "Mario Rizzo",
"text": "Yes. The first just to be clear, the numbers you see on the page are Allstate brand. So there's just not that much nonstandard auto. There's more direct, but at least currently, again, not a meaningful impact in the trends. On a go forward basis, I guess, I'd broaden the statement a little bit, Yaron and say, the more new business we write, that first renewal period or the first policy period tends to be lower than the book overall. So the more new business volume we write, there will be some downward pressure on the overall retention rate. Current volumes aren't meaningful enough to really drive a significant impact. But you're right from that perspective. And then certainly in the non-standard auto space, we've seen it with National General as we broaden the risk appetite in the Allstate brand and kind of do the opposite of what we're doing in homeowners, take advantage and leverage National General's non-standard auto capabilities in the Allstate brand that will have an impact on retention. Again, magnitude, we'll have to call that out for you when we see it. But certainly that business tends to retain at lower levels because those customers just tend to shop more. So those things will have an impact on retention going forward. But I would say what you see in Page 8, pretty much a muted impact on those items at this point."
},
{
"speaker": "Yaron Kinar",
"text": "Great. And then just think about the renewal ratio from here on. I think at times you see a little bit of a breakdown of that inverse correlation between rate increases and the renewal ratio. And we saw a little bit of that a bit earlier in this current cycle. Obviously we're seeing that pick up now. But I guess bottom line, is there a bit of a lag currently between the rate increases and the renewal ratio? One that we -- I don't think we was as pronounced in prior years?"
},
{
"speaker": "Mario Rizzo",
"text": "Yes. Yaron, it's Mario, again. There is almost certainly a lag when you think about implementing a rate increase in auto. It takes six months for that to be implemented across the entirety of the book and then you'll earn it over the six months after that. So there is a lag in terms of the rate we've taken or the industry takes and the impact on retention. And you see that in our numbers. One of the things though that I point out is and we've been clear on this. We believe we will need to take less rate given where profitability is. But again, this is a state-by-state, market-by-market business. So when we need to take prices up to keep pace with loss trends, we're going to do that. And what you saw in the third quarter, about 70% of the rate that we took was in three states. It was in New York, New Jersey, and an increase we implemented in Texas. So we're going to continue to take rate where we need to. We just think there's going to be less of it. And again, we'll look to manage retention alongside that."
},
{
"speaker": "Yaron Kinar",
"text": "But I guess what I'm trying to get at here is I think the big rate increases that we saw in the beginning of the year were really first quarter weighted. California, New York, New Jersey. I would have thought that the full impact of those rates taking effect in the first quarter would have been in the second quarter. And by the time we came out of the third quarter, call it August, September, we'd see a little less of that pressure?"
},
{
"speaker": "Mario Rizzo",
"text": "Yes, the California rate was in the first quarter. New York and New Jersey were actually implemented in the third quarter. So -- and I believe it was over 18% in New York and 13.7 or 13.4 in New Jersey. So again, there's some pretty meaningful rates that we've implemented currently, again, to get those markets back to where they need to be from a margin perspective so we can open up to right new business."
},
{
"speaker": "Tom Wilson",
"text": "So, Yaron, I would just say that the leg is muted and it kind of goes up and goes down, right? Like, not everybody shops, the minute they get the price, it's late, they get the bill, they just pay the bill. Then they decide after a couple of months, geez, I should really think about this. So it's not a simple on renewal that happens."
},
{
"speaker": "Yaron Kinar",
"text": "Got it. Thank you."
},
{
"speaker": "Operator",
"text": "Thank you. And our next question comes from the line of Bob Huang from Morgan Stanley. Your question, please."
},
{
"speaker": "Bob Huang",
"text": "Good morning. My question also kind of follows around that line of business. So if we think about your combined ratio and growth, right. In auto, you typically target a mid-90 combined ratio, understanding that pricing has a lagging effect and then retention and growth also does. But if we just look at the combined ratio, is the current level good enough for you to really step on the gas for growth? Or do you feel you probably need a one or two point more on the auto combined ratio side before you're fully comfortable with fully ramping up that growth going forward?"
},
{
"speaker": "Tom Wilson",
"text": "We think that the auto profit improvement plan has been successfully completed. That's why we dialed up advertising by 60% from 2021. That's not just up, that's way up over last year. It's like we're not even in the same zip code. So yes, we spend the money and are investing the money because we think it will -- there are good returns. And there's like things happen in every state. So, Bob, sometimes you got a state, sometimes you back off. Mario's team is constantly doing that. But when you just look in total, we're feeling good about it in total. If you look at a couple of states, yeah, there's still some work to do."
},
{
"speaker": "Bob Huang",
"text": "Okay. That's super helpful. Thank you for that. Second question is around the homeowner side. Understand that you kind of said there are a few competitors now. The technology really makes it easier potentially for homeowner insurance to really grow from here. But isn't it fair to say that the states where there are opportunities, there are also states where people are trying to pull out. So growth, wouldn't that be geography related? Can you maybe talk about what regions do you think is more attractive on the homeowner front or where do you think the opportunity lies in the growth on that space?"
},
{
"speaker": "Tom Wilson",
"text": "So let me go up a minute and then turn it over to Mario. First, we think homeowners is a good business. There is the challenge of increased severe weather and what it does to increase catastrophe losses, which you referenced. Like why go right where there's a bunch of catastrophes? I mean if you can get the right price, its fine. And then you just buy reinsurance for a risk you don't want. And when you look at increased losses from weather related events, there are three drivers. One just more storms and more severe -- mostly more severe storms actually. Two is houses are worth more and three people are building houses in places that are risk. To your other point, those latter two you can know, like those are known knowns. You can factor those into your pricing effect. You can factor those into your growth opportunities. You can factor that into where you try to get new customers. It's the third one. But the third one tends to be the -- is the smallest according to a couple of external studies of the dry attribution on increased catastrophe losses. So the unknown known of what will happen to the severity of storms is the smallest driver of the increase in catastrophe losses. So we feel good about it in total from a macro standpoint. And then we execute it obviously at a not even at a much below a state level. You get east of Sunrise Highway, we get different standards and if you're west of Sunrise Highway on Long Island. So Mario, do you want to talk about where you see growth opportunities?"
},
{
"speaker": "Mario Rizzo",
"text": "Yes. Maybe I'll start with where we don't, because I think it gets to the first part of your question. And two states in particular, Florida and California obviously really challenged homeowner markets that there's been a lot of pullback across the industry. Those are not states that we're looking to get bigger in. So certainly those would not be where we focus our growth efforts and then we'll continue to manage PML and coastal exposure to be within our risk appetite. But then once you kind of get away from that, really the rest of the country, particularly the middle part of the country is -- there's real opportunity for us to continue to grow homeowners. And that's not where you get the hurricanes or necessarily the wildfires. It's more severe weather, tornadoes, hail and so on. And what we found is a lot of competitors have pulled back in those states given severe weather experience. I think that's where our capabilities from a product, a pricing, a risk management perspective really enable us to take advantage of the disruption in the market and grow pretty broadly geographically and not have to kind of grow where, I guess where we can, because nobody else wants it, but actually grow where we think we can generate attractive returns. And that geographically is the vast majority of the country. And again, that's why I think being good at homeowners and having an effective system and operating model to write it and write it profitably is a real competitive advantage for us. And I think you see that in the growth trends really over the course of this year."
},
{
"speaker": "Tom Wilson",
"text": "And I just said, we grew 2.5% from the last year, and we did grow in two giant markets that Mario talked about, which I'm going to guess are 15% to 20% of the homes in the United States. So, we did quite well there."
},
{
"speaker": "Bob Huang",
"text": "Excellent. Really appreciate the answer. Thank you very much."
},
{
"speaker": "Operator",
"text": "Thank you. And our next question comes from the line of [Christian Gitzoff] from Wells Fargo. Your question, please."
},
{
"speaker": "Unidentified Analyst",
"text": "Hi, good morning, Mario. You said a 75% to 80% of your auto premiums are currently open for new business. So is it safe to assume that auto policies grew quarter-over-quarter in those states in the Q3?"
},
{
"speaker": "Mario Rizzo",
"text": "Yes. I won't go into any state specific detail, but what I will say is we're open broadly. The 26% increase in new business that you saw was not concentrated in a handful of states. It was pretty broad as well, but so -- were the retention decline. So really it's a combination of all those things kind of working together. There's markets that grew in total. There's others that did not. But we're focused on having all of them turn positive at some point."
},
{
"speaker": "Unidentified Analyst",
"text": "Got you. And then so with the auto retention being down a point sequentially, and then PIFs were down 50bps, this is auto. Like, is the majority of the declines in those metrics driven by California, New York, New Jersey, just given, like the big rate increases we saw, that were implement, I guess approved in December. They were kind of implemented throughout the year. And then when would you kind of expect in, I guess excluding those three states, right? That PIF improved quarter-over-quarter. Trying to get a sense of how big of a drag those three states have?"
},
{
"speaker": "Tom Wilson",
"text": "Yes. The quarter-over-quarter change in retention, I know came up across a number of reports that came out. Let me just comment on that because there's really two things going on. Some of the decline, probably about 40% of the decline is attributable to a handful of states. It's California as well as New York and New Jersey that are having a meaningful impact quarter-over-quarter. And again that's driven by some of the larger rate increases that we've implemented this year. There's another portion of it that I think reinforces why we made the disclosure change. We did, which is about 60% of that sequential decline in retention is attributed to -- we're migrating some legacy encompass books of business in some reasonably large states to National General. One of those states is California. And what that does is it drags down the Allstate brand renewal ratio. But as those policies -- as those customers opt to take a National General policy, it shows up in National General's numbers. So that's where looking at it by brand is -- I'm sorry, it was insurance. I misspoke. I said encompass, their legacy assurance customers. But that's why looking at it by brand, you just see -- as we operate the business in total with multiple brands, some of those brand metrics get distorted. So we just think it's more constructive to look at the total."
},
{
"speaker": "Mario Rizzo",
"text": "And I think look at the long term number. We're down 2.7 points. We think it should be able to go up from there. So quarter-to-quarter we'll do full attribution on it. We're happy to talk about it. But it's the real drivers who just raise prices a lot, so a lot of people wouldn't shop."
},
{
"speaker": "Unidentified Analyst",
"text": "Thank you."
},
{
"speaker": "Operator",
"text": "Thank you. And our next question comes from the line of David Motemaden from Evercore ISI. Your question please."
},
{
"speaker": "David Motemaden",
"text": "Hi, thanks. Good morning. I was wondering if you could just comment on your expectations for the timing of the retention ratio improvements. I know that you mentioned leveling off of rate increases should help retention. So I'm wondering, are you seeing any evidence of that here in October or is it still too early to tell?"
},
{
"speaker": "Tom Wilson",
"text": "First, obviously sooner is better than later. So we're all on it. The whole team's on it. There's a whole bunch of stuff we're doing that Mario mentioned to make it move and you can see benefits in individual states. So we have some pretty large states that it's actually up. So we have confidence that we know how to manage our way through this. But we haven't really done a projection on that. We're comfortable giving to everybody to say here's the number you should count on. What we do know is as Mario pointed out is we expect to grow market share and personal profit liability and that's by doing transformative growth. In the near term we have to get retention up and continue to expand our new business. But then longer term all the work we're doing there is just even more sustainable. So rolling out ASC auto, ASC homeowners, all that work will drive long term growth."
},
{
"speaker": "David Motemaden",
"text": "Got it, thanks. It definitely feels like you guys are pretty confident around just the -- or feel optimistic that the tempering rate increases should help improve that retention. I mean from your standpoint is it really just -- we're sort of just having this timing impact from these three big states that need to just sort of work their way through, and like we're on the cusp here of a turn, or I mean I'm just trying to understand how you guys are thinking about it internally?"
},
{
"speaker": "Tom Wilson",
"text": "We're thinking about we need to do a better job for our customers. So, we're charging them a lot more, they expect more, they deserve more. Some of that's because their cars and stuff and Bob the injury claims are higher, but like we need to do a good job for them. So it's not just oh let's wait this out and not take a bunch of price increases and it'll bounce back. We're actively working on this year alone we have a goal on double-digit millions of improving the customer experience individual transactions. We'll have another goal for next year that will be similar, but different. We're working on how do, we get more precise on the price. So if you're an elderly person, you don't drive much, you should have Milewise you'll cut your price in half. So we're not, we're not, it's not like we just think oh we're through this. I think this is just provide our - we use our operational excellence and capabilities, to go back in now and fine tune the fact that we had to raise prices a lot, so we can keep more customers."
},
{
"speaker": "David Motemaden",
"text": "Great, thank you."
},
{
"speaker": "Operator",
"text": "Thank you. And our next question comes from the line of Josh Shanker from Bank of America. Your question, please."
},
{
"speaker": "Josh Shanker",
"text": "Yes, thank you for getting me at the end. Two questions, one whimsical and one numbers. You talked about sort of cracking the code, on how to get people to buy homeowners insurance online. How far away are we from being able to call Allstate and getting into an AI conversation with Dennis Haysbert or Dean Winters that knowledgeable about what you can do to save money, by switching to Allstate and what you can do for your policy?"
},
{
"speaker": "Tom Wilson",
"text": "I love whimsical questions, but I would say that one's probably not whimsical really. We have a - I'd say let's call sales sidekick, which will help people do a better job of interacting with customers. It's going to dramatically change the way that the people interact with other people, which is why Mario was talking about how we have to reposition the off-site agents. It gives us an opportunity to do that at lower cost. So work they had to do before where they couldn't do, or they had lower close rates, because they didn't know some stuff will increase their productivity, and make them even better. So, we're feeling really good about where that might go. And I think, if you look at our web stuff on ASC, that's quite sophisticated too. So Mario, what would you add?"
},
{
"speaker": "Mario Rizzo",
"text": "Yes, the only other thing I'd add, Josh, that makes it not as whimsical as you might think, is we have a lot of data on homeowners, both in terms of customers we've insured in the past and just on the homes across the country in general, which I think facilitates our ability to do what you described, and be really efficient - intelligently being able to price and manage the homeowner risk. So that's the other component I think that gets us and creates the ability to do what you, what you suggested"
},
{
"speaker": "Josh Shanker",
"text": "And then numbers look, ad spend is way up as you look to grow the business. I'm multiplying your number on that buy premium and seeing it up substantially. You also gave us a lot of data around new issued applications, and we can make some guesses around gross new customers. The ad spend is up significantly more than the new customer acquisition. Can you talk a little about what is sensible acquisition cost per customer, how we should think about it. And clearly are you getting the kind of pack on new business that you can make a return over a two or three year period on that investment?"
},
{
"speaker": "Tom Wilson",
"text": "A bunch of questions in this, and let me end on this one first. Advertising is a little bit like driving a car when you first, when you hit the gas pedal it doesn't take off right away. It takes a while to get to 60. So you've seen us do that. We like the performance we see in terms of brand consideration. We like the number of quotes that have gone up, and we like our close rate. So but if you said, did we get back every dollar we spent economically as we're ramping it up? No you, you're kind of investing some for the future. That said, we have highly sophisticated metrics around it and it's both upper and lower funnel. If you break it into upper funnel being, kind of brand image stuff, lower funnel being, I send you, I got a specific lead and I buy that lead and I know you're shopping. So we have highly sophisticated math around that. It continues to be a sophistication game. We think we're pretty good at it. Outside people tell us we're pretty good at it. That said, you can always be better. And when you're spending billions of dollars, you ought to be really good at it. So, we're feeling good about the investment to-date. We think we can continue to spend more, and that will drive economic growth. But if it doesn't, we have the ability to just dial it down whenever we want. It's not really that complicated. So thank you all for this. Our goal, of course, is to increase personal profit, liability and market share, which we talked a lot about today. Also broaden our Protection offerings, well capitalized, we have good shareholder returns, and we look forward to seeing you next quarter."
},
{
"speaker": "Operator",
"text": "Thank you, ladies and gentlemen for your participation in today's conference. This does conclude the program. You may now disconnect. Good day."
}
] | The Allstate Corporation | 18,711 |
ALL | 2 | 2,024 | 2024-08-01 09:00:00 | Operator: Good day, and thank you for standing by. Welcome to Allstate's Second Quarter Earnings Investor Call. [Operator Instructions] As a reminder, please be aware that this call is being recorded. And now, I'd like to introduce your host for today's program, Brent Vandermause, Head of Investor Relations. Please go ahead, sir.
Brent Vandermause: Thank you, Jonathan. Good morning. Welcome to Allstate's second quarter 2024 earnings conference call. Yesterday, following the close of the market, we issued our news release and investor supplement, filed our 10-Q and posted related material on our website at allstateinvestors.com. Our management team will provide perspective on our strategy and an update on our results. After prepared remarks, we will have a question-and-answer session. As noted on the first slide of the presentation, our discussion will contain non-GAAP measures, for which there are reconciliations in the news release and investor supplement and forward-looking statements about Allstate's operations. Allstate's results may differ materially from these statements, so please refer to our 10-K for 2023 and other public documents for information on potential risks. As some of you know, this will be my final earnings call as the leader of our Investor Relations team since I will be transitioning to a new role. Investor Relations will be in the capable hands of Alastair Gobin, who will be a great partner for you all. And now, I'll turn it over to Tom.
Tom Wilson: Well, good morning. Thank you for investing your time at Allstate. I'll provide an overview of results. Mario and Jess will go through operating performance, and then we'll address questions. Let's start on Slide 2. Allstate strategy has two components: increase personal property-liability market share and expand protection provided to customers, which are shown in the two ovals on the left. On the right-hand side, you could see highlights in the second quarter. Net income was $301 million in a quarter with elevated catastrophes. The auto profit improvement plan is being successfully executed. National General continues on a 4-year profitable growth trajectory. The Homeowners business had good results with an improved underlying combined ratio and underwriting profit for the first six months of the year. Net investment income was up almost 17% over the prior year quarter as the fixed income portfolio continues to benefit from repositioning into longer duration and higher yielding assets. Protection Services has had another good quarter led by profitable growth in protection plans. Let's move to Slide 3 and show how that operational execution improved underlying results in the quarter. Revenues increased to $15.7 billion, reflecting higher average property liability earned premiums and that was mostly from rate increases in auto and homeowners insurance and increased net investment income. Net investment income for the second quarter was $712 million higher than the prior year quarter, reflecting that fixed income duration extension in 2022 and 2023. And then which also included lowering public equity holdings to take advantage of higher fixed income yields. Adjusted net income was $429 million or $1.61 per diluted share. Now, I'll turn it over to Mario for Property-Liability results.
Mario Rizzo: Thanks, Tom. I'll start by covering Slide 4. On the top left of the table, you can see Property-Liability earned premiums of $13.3 billion increased 11.9% in the second quarter, driven by higher average premiums. The underwriting loss of $145 million improved by $1.9 billion compared to the prior year quarter due to improved underlying margins and lower catastrophes. The expense ratio of 21.3 was 0.8 points higher than prior year due to increased advertising as we continue to accelerate growth investments in rate adequate states and risk segments. The adjusted expense ratio, which excludes advertising costs and other non-core expenses was down 1.6 points in the quarter. The chart on the right depicts components of the 101.1 combined ratio. Catastrophe losses of $2.1 billion were 6.7 points favorable to the prior year quarter. The underlying combined ratio of 85.3 improved by 7.6 points compared to the prior year quarter with the improvement driven by higher average earned premium and moderating loss cost trends. Prior year reserve re-estimates, excluding catastrophes, had only a minor impact on current quarter results as favorable development in personal auto and homeowners insurance offset increases in personal umbrella liabilities and commercial auto reserves related to the transportation network contracts we began exiting in late 2022. Turning to Slide 5. You can see that we continue to successfully execute our profit improvement plan. The second quarter recorded auto insurance combined ratio of 95.9 improved by 12.4 points compared to the prior year quarter. The bars in the chart show consistent improvement in the quarter underlying combined ratio. I will note that we have adjusted 2022 and 2023 reported quarterly figures to reflect the updated average severity estimates as of the end of each of those years to remove the volatility related to intra-year severity adjustments. You can see that the auto business has seen six sequential quarters of underlying combined ratio improvement with an underlying combined ratio of 93.5 in the second quarter of 2024. The dark blue line in the chart shows how rate increases throughout 2022 and 2023 pushed average premiums above underlying losses and expenses represented by the light blue line starting in the second half of 2023. As average premium increases have outpaced loss and expense profitability has improved. Relative to the prior year quarter, average underlying loss and expense was 5.5% higher, as you can see in the second row of the table. This reflects higher current year incurred severity estimates primarily driven by bodily injury coverage, offset by lower accident frequency as well as higher advertising investments. Physical damage severity increases continue to moderate, while bodily injury continues to trend above inflation. Our claims team is focused on operational actions to mitigate the impact of inflationary trends, including identifying injuries earlier in the claims process to improve overall cycle time and focus on fast and fair resolution. Let's review Homeowners insurance on Slide 6 which had improved underlying performance. Allstate is an industry leader in Homeowners insurance, generating low 90s combined ratios over the last 10 years, as you can see in the chart on the right. This performance compares favorably to the industry, which experienced an underwriting loss and a 103 combined ratio over that same time period. Moving to the table on the left. Allstate Protection homeowners written premium increased by 13.7% compared to prior year, reflecting both higher average gross written premium per policy and policy in force growth of 2.2%. The second quarter combined ratio of 111.5% resulted in $375 million of underwriting losses compared to the $1.3 billion loss in the prior year. The underlying combined ratio of 63.5 improved by 4.1 points due to higher average premium and lower non-catastrophe claim frequency, which more than offset modest increases in non-catastrophe severity. For the first six months of 2024, Homeowners insurance generated an underwriting profit of $189 million. Moving to Slide 7. Let's discuss Transformative Growth our multiyear strategy to create a low-cost digital insurer with broad distribution. The 5 components of Transformative Growth are shown in the blue panels on the left side of the page, and we continue to make good progress on all of them. On the right-hand side, we show the tangible outcomes and proof points that we're delivering through this transformation, which improve the customer experience and support our objective to profitably grow market share over time. Two examples of those tangible outcomes that I'd highlight are the new affordable, simple and connected auto insurance product that was built on our new technology platform is now available in 19 states. And that in the second quarter, we increased our advertising investment by approximately $300 million to support growth efforts in states with attractive returns. Moving to Slide 8. We'll double-click on the multichannel distribution strategy, which enables us to serve customers based on their personal preferences. Our exclusive agents are available for local customers seeking personalized advice to fulfill broad insurance needs. Agency productivity has increased and bundling rates at point of sale are at all-time highs. Enhancements to direct capabilities and increased advertising attract more self-directed customers with new business production in the direct channel in the second quarter, nearly double that of the prior year. The National General acquisition significantly expanded the independent agent channel. If you look at the distribution of new business we write, shown in the pie charts on the bottom of slide, you can see the power of expanded customer access. The combination of broader distribution capabilities, increased advertising greater pricing sophistication and product expansion has resulted in a 90% increase in new business applications since 2020 with a much more balanced split across distribution channels. Now let's turn to Slide 9 to delve deeper into how the National General acquisition has allowed us to better serve customers who prefer to engage with independent agents. The $4 billion acquisition included a number of businesses, including personal auto insurance, group health, individual accident and health, and digital marketing platforms. Prior to the acquisition, we offered insurance in the independent agent channel through both the Allstate and Encompass brands, with the Encompass brand solely dedicated to selling through IAs. With the acquisition of National General, we now go to market in the independent agency channel, primarily through the National General brand. Through the ownership of National General since January of 2021, we have significantly increased the number of customers we protect through independent agents, having added almost 1.7 million policies in force reflecting a compound annual growth rate of 8% in policies over the past four years and bringing premiums written to over $5.1 billion for the first six months of this year. Underwriting margins remain attractive and National General is now one of the largest independent agent personal lines insurers with expansion into lower risk customer segments supporting additional growth going forward in the IA channel. Slide 10 reviews property liability policies in force for all brands. Given the successful execution of the Auto Insurance profit improvement plan, investments in growth will made in Allstate that offer attractive return opportunities. These higher growth investments led to a 17% increase in Personal Auto new business applications in the second quarter, as you can see at the top of the chart on the left. The green bars show the components of that growth in new policy sales. The first two bars reflect the drivers of the 23% increase in new business volume in the Allstate brand. Higher productivity per exclusive agents drove a 9% new business increase compared to prior year and advertising investments and enhancements to direct operations resulted in a 92% increase in the direct channel compared to the prior year. The last two green bars reflect national general growth in both the non-standard auto business and higher sales volume from the Custom360 middle market offering that we continue to roll out. On the right, you can see that total protection auto policies enforced decreased by 1.6% compared to prior year as the Allstate brand decrease was partially offset by growth at National General. Allstate brand auto policies in force decreased by 4.5% compared to prior year as policies lost from customer defections more than offset the increase in new policy sales. Allstate brand auto retention of 85.7 did improve by 0.2 points compared to prior year as the negative impact of large rate increases in 2022 and 2023 continues to moderate. National General growth of 548,000 policies in force offset almost 60% of the Allstate brand decrease. While margin improvement actions have negatively impacted policy growth, the were necessary to mitigate loss cost trends during a period of rapid loss cost inflation. And now I'll turn it over to Jess.
Jess Merten: All right. Thank you, Mario. Slide 11 details profitable growth in Protection Services. In the second quarter, revenues in these businesses increased to $773 million, which was 12.7% higher than the prior year quarter. This result was primarily driven by growth in Allstate Protection Plans. Revenues in our Roadside business decreased 22.7% compared to the prior year quarter, reflecting the impact of exiting a large unprofitable wholesale account. In the table on the right, you will see adjusted net income of $55 million in the second quarter increased $14 million compared to the prior year quarter, with most businesses showing improvements. Profitable growth in Allstate Protection plans resulted in adjusted net income of $41 million, a $10 million increase compared to the prior year quarter as revenue growth and improved claims trends continue to benefit the bottom-line. Slide 12 provides additional insight into the shareholder value created by protection plans. Since acquiring SquareTrade in 2017 for $1.4 billion, this has become a significant growth platform with scale and attractive profitability. Protection Plans provides warranties for a wide range of products, including consumer electronics, computers and tablets, TVs, mobile phones, major appliances and furniture. The power of the Allstate brand has helped to secure partnerships with large retailers in North America. We sell Allstate Protection Plans at point of sale through successful retailers such as Costco, Home Depot, Sam's Club, Target and Walmart, all under the Allstate brand. We're also expanding internationally into Europe and Asia. As you can see from the charts to the right, broad distribution and customer-focused operational execution has resulted in rapid growth in this business. Revenue grown 20% compared to the same 12-month period in 2023, while returns have been strong. Adjusted net income over the last 12 months totaled $139 million and almost $700 million cumulatively since 2017. Now let's shift to Slide 13 to discuss investment results. Result again benefited from active portfolio management that seeks to optimize return per unit of risk across the enterprise. Net investment income, shown in the chart on the left, totaled $712 million in the quarter, which is $102 million above the second quarter of last year. Market-based income of $667 million, which is shown in blue, was $131 million above the prior year quarter as the fixed income portfolio continues to benefit from repositioning into longer duration and higher yielding assets. Performance-based income of $107 million, shown in black, was $20 million below the prior year quarter due to lower real estate investment results. The performance-based portfolio is constructed to enhance long-term returns and volatility on these assets from quarter-to-quarter is expected. On the right, you can see our annualized portfolio return in total and by strategy over a short-term and long-term horizon. The market-based portfolio delivers predictable earnings while the performance-based portfolio enhances risk and return and diversifies the $71 billion investment portfolio. Moving to Slide 14. The Health and Benefits business continues to perform well. Revenues of $620 million increased by $45 million compared to the prior year quarter, driven by premium growth in group and individual health. Adjusted net income of $58 million in the second quarter was slightly higher than the prior year quarter, reflecting increased group health and employee benefits adjusted net income that was partially offset by a decrease in individual health. As a reminder, the decision to pursue a divestiture of these businesses was based on a belief that potential buyers with complementary products and capabilities will unlock value beyond what is achievable by Allstate. The process is progressing well and has confirmed our strategic logic. Slide 15 recaps Allstate strategy in this quarter's results. Auto and Homeowners insurance profitability has improved. National General is profitably growing policies in force. We're accelerating transformative growth to increase auto and homeowners' policies in force. Proactive risk and return management of the investment portfolio continues to generate value. And Protection Plans is expanding with broadened product offerings and distribution. We're confident that this strategy will continue to create value for our shareholders. And with that context, let's open the line for your questions.
Operator: Certainly. And our first question for today comes from the line of Gregory Peters from Raymond James. Your question, please.
Gregory Peters: Good morning, everyone. So for my first question, I'll focus on growth. And Tom, I know you've been talking about transformational growth now for several years. And we're seeing this strong increase in new issued applications. So I'm wondering if you might help us understand how you think that new issued application result is going to drive increased policies in force in the auto stats that we see in some of your supplements.
Tom Wilson: Good morning Greg. Thank you for both being here and paying attention over years, appreciate it. Mario talked about the growth by channel. And we highlighted National General this quarter because it's a $10 billion business on an annual basis. And we feel like the market is really not looking through that one in terms of growth as much. Transformative growth includes what we're doing in National General. But to your point, it really also includes remaking a lot of the business processes inside the Allstate brand. So let me make a couple of comments about that. And give it to Mario to talk about specific things he's doing in various geographies. It's just the most macro view growth driven by two factors, sell more, as you point out and keep more. And so we spent a bunch of time Mario talked about selling more. We feel good about the trajectory there. You can see the benefits of the increased advertising and direct volume Mario talked about. And that also will translate into increased growth in productivity in the Allstate agent channel as we roll it out. So the other question then is, of course, how many do you keep? And retention was up slightly in the quarter versus the prior year quarter. If you kind of look over the last 12 months, it's been reasonably flat in Auto Insurance. I assume you're talking about Auto Insurance, by the way, we can talk about Home as well because I think that's a great opportunity for us. But on Auto Insurance, it's been relatively flat and normally, you would expect as rate increases come down, you would expect retention to increase. It's not clear what that trend will be at this point in time. And the reason I say that is not that I think traditional economics of don't ask me to pay a lot more and more likely to stay breakdown. It's just that the price elasticity curves broke down when we raised prices over the last couple of years. So it's a little hard to tell what the tail on that will be because it's hard to figure out attribution of why did in the face of 33% increase in rates we were able to hold retention pretty well. Some have been -- maybe car people understood the cars worth more, maybe they had a bunch of cash the government gave them. Some of it's competitors were also raising rates. So you can't really do attribution as to why we are where we are. So looking forward, we said it's a little hard to tell exactly what retention will do in the future. I take Senate goes up because we are taking fewer price increases. That's almost -- it's pretty close to one to one in terms of movement retention rate and growth, which is really a good thing, obviously. But we're not waiting around to see what happens there. We're working on improving the customer experience. We have a goal of growing 20 million customer interactions on an annual basis by next year, and we're well along the goal on that. So we're doing a whole bunch of continuous improvement. We've got new tech tools out there, new products, all of which are designed around improving retention and growth. Mario, do you want to talk about specific aspects of growth in terms of states or something?
Mario Rizzo: Sure. Thanks for the question, Greg. So maybe the place I'd start like Tom said, retention is obviously critically important to growth, and we're pleased with the fact that retention is stabilizing. But we also recognize there's a handful of states that we have taken some pretty significant rate increases more recently, California, New York, New Jersey. Those are going to continue to have an impact on retention going forward. But absent those three states, we kind of like the trends that are emerging. But I want to talk a little bit about new business production and get at your question. So Greg, where I would start would be kind of how did we get here? And the reality is, as we've been implementing the auto profit improvement plan over the past couple of years, that's obviously being executed on a state-by-state, market-by-market basis. But as states have gotten to a rate adequate level, we've begun to lean in and invest more in growth to drive production in those states. And that would include things like unwinding underwriting guidelines to restrict business, increasing advertising spend, both nationally and locally. And as where we sit right now, as I'd say, about two-thirds of our states, the premium volume represented like two-thirds of our states, are what we would consider at profit target levels. And then there's about another 10% or so that are kind of on the path to getting there. So overall, we feel really good about the vast majority of country in terms of geographically where we're comfortable investing. And you see the momentum that's really been building over the course of the year. Last quarter, production was up about 9% in total. This quarter, it was up 17% as we further ramped up growth investments. And we're going to continue to do that. At the same time, you've seen us take less rate, which, as Tom mentioned, helps retention. But we're going to continue to be diligent about staying on top of loss cost trends really broadly across states. And as I mentioned, there are some states that aren't in that growth category right now that we've got to get to target levels of profitability. We're going to continue to focus on taking rates that are necessary there. And when we're successful, those will become additive to the parts of the country where we can invest. So that kind of got us to where we're at in terms of geography and new business and the good news is we're seeing the growth across brands and across channels.
Gregory Peters: Great. I guess in a related question as a follow-up -- my follow-up would be on the expense ratio side. You called out the increased advertising expense in the second quarter. I think it was 3 points of your property liability combined ratio. When we look forward, what kind of expectation do you have about how maybe the adjusted expense ratio is going to move through the balance of this year and sort of what your longer-term objectives are there?
Tom Wilson: Let me answer that both by first by going up and then coming down a little bit. So Transform Growth had 5 components that Mario walked through. We've -- on each of those, the underlying assumptions between whether that was a good thing to do or not, we've proven out. We haven't -- they all are not working all at the same time right now so that you're seeing the growth we think we can get, which is to increase market share. So we're confident we're going to increase market share in personal property liability. When you get into what's retention next quarter, what happens in new business exporter, we're confident that all of those things will work in the same direction. As it relates to expenses, we think we need to continue. I mean we wanted to affordable simple, connected protection. Affordable means low price. That means we're going to continue to reduce costs. And so we've got a whole bunch of things we're working on now that are -- we've been working on for a couple of years as you point out, that are starting to generate benefits. But we have more to go. Like we don't -- we think there's with the age of digitization and the things we can do in our business, we can still drive cost on. As it relates to advertising, the reason we broke that out separately is that, that does relate to the fact of we don't want people to be to miscommunicate to people that we think taking advertising down and making that lower is a good idea, because we think growth creates value for shareholders as long we're operating at attractive returns. We've got a good set of capabilities there. And I'd be happy to talk about that. If anybody wants to get there, but we're comfortable that we can continue to invest in growth, get good returns, lower expenses at the same time, increased market share, which then will lead to a re-rating of the earnings multiple.
Gregory Peters: Thank you.
Operator: Thank you. And our next question comes from the line of Jimmy Bhullar from JPMorgan. Your question please.
Jimmy Bhullar: Hi. Good morning. I just had a question on, what you're seeing in terms of competitive trends in the Personal Auto market, both in terms of pricing and advertising. It seems like margins for most of the companies are getting closer to normal. So wondering if that, if you're starting to see some of them, get aggressive on price? I know certainly advertising spending has been going up a lot. But what are you seeing out there?
Tom Wilson: Let me talk about advertising and Mario, can jump in on pricing. And of course, there's a lot of competitors, but let's focus on the biggest competitors for time being a business is the ones that are mostly in play here. So from a -- as we were just talking about, growth is good for shareholders. It's good, because we're earning good returns. Secondly, we're leveraging capabilities over a broader capital base, which drives more shareholder value creation, and then that should lead to a re-rating other multiple. And then you say, what needs to be true for you to do good advertising and to head into a fight on that one. And first, you got to have a product that's differentiated and appeals to customers. So we have that with our new ASC Auto product. We know it from the close to quote ratios higher with product you've got to have -- you got to be getting attractive returns when we talked about that at length. You got to have a great brand because that increases consideration like if people view the first time people have heard of you your dollar advertisings done is effective, obviously, we a great brand and great consideration. You have to have broad access, and this, ties together with transforming growth. We advertise, you can go to exclusive agent, you can go on our website, you can go to a direct. So you want to make sure that however they want to come to, they had advertising dollars effectively used. Now I would say advertising today, though, is a game of precision, much as Auto Insurance pricing went through this great push on sophistication, those who are good at sophistication win. And you can see that when you look at the combined ratios of people like Allstate Progressive, Geico, we all have really good combined ratios, because we're sophisticated in how we price product. Same thing is true in advertising today. So you have to be good at search. And we don't just listen to ourselves. We had external reviews, and we're really good at search. You have to be good at a bidding strategy. How much you're bidding for Elite? We're good at bidding for Elite. It's not like we're perfect. We got other stuff we need to do. You got figure out how you're using different kind of messaging for different groups. And you can imagine with the refrain of number of media channels, number of messages you can do now, particularly with AI, the number of segments you have, your pricing sophistication, it gets complicated really fast. And we're really good at it. So when we go into this, and we're thinking about us increasing the advertising versus other people, you're like, well, how good are you? And we think we're good at it. If you look at where we are with Arity and our Telematics work, that's to really end run around having more information on who you bid on because we track 15% of the U.S. population they're driving. So we can decide how good a driver you are without even sticking a device on you or an app on your phone or a device in your car. So will competition increase in advertising, probably. Do I -- it will be from those carriers who have the same kind of capabilities we do. So we're fully up to winning that game. I think there will be some other people who hold back or even drop out because they can't -- they don't have the capabilities and expertise to do it. So that's where we are in the advertising, good for shareholders because it's good for growth. And we use the money effectively. Mario, do you want talk about pricing environment?
Mario Rizzo: Yes. And Jimmy, thanks for the question. I'll answer the question broadly, but I'd put a caveat around it that, obviously, what I'm going to say is going to vary by company and it's going to vary geographically because the business has just operated that way, and there's a lot of competitors in the market. But I would say, by and large, as we discussed this morning and as many of our competitors have reported profitability in auto is improving as loss cost trends have improved. And all of the things being equal, when that happens and margins are better. There's just less rate activity in the system, and that's what we're saying -- companies generally taking less rate than they were over the last couple of years. Again, that will vary by company. Some started later than others and are still catching up. Others are a little further along. But generally, we see less rate getting pushed through. And then certainly, that varies geographically as well. Having said that, I would just take that along with what Tom talked about in terms of advertising and say that when you take the totality of where we're positioned and what we're building with transformative Growth, we like where we're positioned in our ability to be able to increase growth investments and be successful in a competitive marketplace. That's what we're building, and we like our chances.
Jimmy Bhullar: And then just on the benefit sale, we're late in the year, and there hasn't been an announcement, but maybe talk a little bit about how the process is going. And I'm assuming it's probably not going to close this year, but are you still assuming the close within the next few months, even if it drags on to next year?
Jess Merten: Hi, Jimmy, it's Jess. First, I guess I would start by reminding everyone, the third great businesses. You saw it in the results that I covered. So we're really happy to continue to focus on execution in the operations. It might be helpful if I give you a little bit of a window into the process to help you understand of where we're at and where we're going. So if you think about our process, we started out with a preference for single transaction. But in the same note, we were unwilling to compromise value for that preference, right? So we spent a lot of time with a single transaction buyer that thought they could, in the end, change the terms and/or that we didn't have better options, quite frankly. So we spent a lot of time on a process there, and ultimately, what we decided was to work with other buyers. And that has created a delay in things, it just has. But we're confident that by making that switch, we'll get a better outcome. A better outcome for our shareholders, a better outcome for the businesses. So what I would say right now, and I don't want to get into timing of announcements to close, what I would say is that we're likely to be in a position to announce transactions this year, and you'll get more details about the what and the how, when those announcements come. But that's just a little bit of window into the process and why you still haven't heard anything, if that's helpful.
Jimmy Bhullar: And do you intend to sell a disposal of the entire unit eventually, even if it goes into pieces? Or are there some pieces you might decide to retain?
Jess Merte: We still intend to make the divestiture of the Health and Benefits segment.
Jimmy Bhullar: Thank you.
Operator: Thank you. And our next question comes from the line of Bob Huang from Morgan Stanley. Your question please.
Bob Huang: Hi. Good morning. Maybe one on homeowner. I think last year, when it comes to cat losses, severe convective storm was a one in 2018 event, if I remember correctly, which obviously was a headwind to your cat numbers. Just given how things are developing so far, curious how is it tracking this year? Is it going to be more of a worse than one in 2018 event? Just pace on what we have in the first half, curious in terms of like how are the weathers are developing for the Homeowner side.
Tom Wilson: Bob, it's Tom. Thanks for the question on Homeowners. I would look at Homeowners on a longer-term basis than one year. So if you look over the last 11 years, we've made three-quarter of the profit that whole industry has made because we have a pretty sophisticated business model, we've talked about before and be happy to go into, but we're good at homeowners. It's currently turning into a, I guess, what we do domestically, we called the hard market, but a lot of people are bailing on growth in that market because they were either part of the 25% or they were part of the negative amount that led to us every three quarters. So that entire profit pool when we have less than 10% of the total business. So we think that is a great growth opportunity. As it relates to this year, too hard to predict whether. It comes and goes. For the first six months, we made money on an underwriting basis. That makes me feel better than last year, where we didn't make money for the whole year, prior 10 years. We've made money in each of those 10 years. So I feel good about our business model. As it relates to any individual quarter, they're keeping for us is be there for our customers. Like when I got a problem and we're good at getting there fast. We want to be there to take care of their claims. They tell their friends. Our Homeowners as you saw the unit growth is up. It's particularly -- we're doing extremely well in our Allstate agents with bundling customers. So other people are interested in that segment. We're just killing it right now on cross line sales. So we feel good about that. Some of that is the hard market. Some of it's great relationships. Some of it is the product and the pricing we have it all kind of comes together. So we like the business. We think it's got good long-term growth potential. And we -- on a quarterly basis, I wouldn't get too focused on whether it's up or down this second quarter is -- you can decide it's either higher or lower depending on which period of time you wanted to evaluate it against. And so I would just say focus on the long-term results from it.
Bob Huang: Okay. Thanks. My second question, a little bit of a shot in the dark here. For the DOJ lawsuit for National General, there has been precedent where under FIRREA Civil Enforcement Actions, where SEC can potentially get involved under the current litigation environment, do you expect that the National General case should get SEC involved at some point down the road? I'm not sure if that's the question you can answer at this point.
Tom Wilson: Well, we don't give a lot of specifics on active litigation, obviously. And I certainly can't speak for what other people want to do when we have -- I don't know what the SEC will or will not choose to do. What I can give us a little bit of information. This is -- the lawsuit is in reference to a lender-placed insurance program, so that stuff sold through agents. It's focused on auto insurance. Our program was transparent. We borrowers are treated fairly. And we're confident that we will prevail in this and at the lawsuits will have no impact on our ongoing business.
Bob Huang: Okay. Thank you.
Operator: Thank you. And our next question comes from the line of Michael Zaremski from BMO. Your question, please.
Jack Matten: Hi. Good morning. This is Jack on for Mike. Just a follow-up on the advertising spend strategy. I'm curious how your strategy and focus today compares to the last cycle? And more specifically, how much of your ad spend has historically been geared toward direct-to-consumer targeted sales versus supporting your agents? And then how is that evolving today given the success of your transformative growth strategy in your lower expense base?
Tom Wilson: Jack, I would say that the third component of transformative growth was increase the sophistication and investment in new customer acquisition. We didn't talk about it here much, but we've gotten much more sophisticated versus the last time we did this. But I think other people have too. So I'm not -- like I don't want conclude we're 5 miles ahead of everybody else but we're good. And so we feel much better about our sophistication. The way in which we go through the allocation of investment is think about it as upper and lower funnel, upper funnel being get the brand out there, do some TV advertisements to make sure people are considering you when they're getting insurance. So you'll notice that more advertising on TV. Then there's what we call lower funnel, which is you're on the website, you're cruising around for a new car, and we pop something into your web browsing that says, hey, what about Allstate or we use addressable TV to do it. So there's lots of different ways we try to do, what I would call, lower funnel. And the first one, you do because we are off a little bit for the last couple of years in terms of down in advertising, we've increased our upper funnel some just because we want people to remember there, got a great brand because we've been investing in it forever. It's got great unaided recognition, and we want to keep investing in that. The biggest portion of our increase would be in the lower funnel piece. That gets tightly tied to what Mario described, which is really by state by market, by risk class, and it's highly sophisticated in terms of how we do that. As it relates to both of those upper and lower funnel work for both all of our -- all of the Allstate brand channels, so agents and direct. Our agents also do some of their own lead generation, whether they go to mortgage brokers or other people in their local areas and buy leads. I think there is an area where we need to bring increased sophistication to it because we're just better at doing it globally than you would be if you live it to Boeing or something like that. So there's increased sophistication there. But think of it as a large machine has got a number of different levers we can pull, and we have -- it has got good gauges on it, so we can tell what's coming out on the other end. And so we're constantly turning and dialing those levers and watching the gauges so that we beat our current competition.
Jack Matten: That's helpful. Thank you. And then maybe switching gears to auto loss cost trends. If you look at the average underlying loss you disclosed, it's now running slightly lower compared to 2023. I guess does that mean you're now seeing frequency benefits more than offsetting higher severity. And I'm curious how you view the sustainability of current favorable frequency trends. I know last quarter, you mentioned favorable weather. Just curious how those pieces are moving.
Tom Wilson: Jack, I'll let Mario jump into both frequency and severity and by coverage. I can just say it's nice to have it be about halfway through the call on loss costs and be talking about growth, which is much more optimistic. A year ago that would have been in the first, second and third question. So it's a good question. Mario will go to it, but I'm happy we're talking about growth because we think that's where we're going to create a lot of shareholder value. So Mario over to you.
Mario Rizzo: Sure. Thanks, Jack. I guess the place I'd start is as much as we dig into the components of profitability. They're all important, but we should lose sight of the fact that the way we manage the auto business is to generate mid-90s combined ratios across the entirety of the system. And we use levers like rates and we look at pure premium, whether that's frequency and severity and expenses, they all matter. And certainly, the loss trend helps inform what we need to do with some of the other levers. What I would say, as I mentioned, the negative trend, the negative 0.8% that you see in the supplement as I mentioned in my prepared remarks, there's a little bit of noise in in there terms of year-over-year comparisons because we were moving severity targets around intra-quarter last year. So the adjusted numbers, it's slightly positive, it's about 1%. So not all that different. But I would say it's -- favorable frequency has continued through the first half of the year has been offset by higher severity predominantly in bodily injury, which continues to run above inflation and on the physical damage side, we continue see some good tailwinds with things like used car prices and stabilizing repair costs and so on. But that's kind of the overall loss trend that we're reacting to. In terms of the sustainability of frequency, it's a really difficult question to answer. Things like weather and geography risk segments all come into play. Frequency has been better than it was a year ago. When we look at our telematics data, which gives us a lot of rich information, miles driven per operators up a little bit but trips are shorter. So that could be having an impact on frequency. Weather favorably impacted frequency in the first quarter. And the other thing I'd say is as we've been looking to improve profitability over the last couple of years and not growing, the risk segmentation and the mix of our auto book has shifted around a bit to higher lifetime value, let lower frequency type business, that's having an impact as well. So there's a lot of moving parts in there. One thing I will say is as we go forward and write more new business, that will impact prospective frequency trends, but I'll go back to where I started. We manage the system in its entirety to generate mid-90s combined ratio profitability, and we're going to continue to do that despite however frequency bounces around.
Jack Matten: Thank you.
Operator: Thank you. And our next question comes from the line of Yaron Kinar from Jefferies. Your question please.
Yaron Kinar: Thank you, good morning. I wanted to go back to growth or continue to focus on growth. I think ever since the Transformative Growth program was announced and launched. Clearly, you've had some issues with COVID and the aftermath of COVID. But now that we're hopefully starting to come out of that transitionary period and all the levers from Transformative Growth are kind of kicking in. Can you maybe help us think through -- I'm not even asking about a one or two-year horizon, but maybe over the cycle, what you think reasonable growth expectations should be on a PIF basis for Allstate. And I say this also in the context of I think we see some of industry leaders in growth, achieving pretty consistent, call it, high -- mid-to-high single-digit growth in PIF. Do you think that you can be at that level?
Tom Wilson: So we haven't given out a target for PIF growth, but it's the right way to think about it. Because when you're looking at market share, a lot of times, market share is done in the industry by premiums. Also charge, more have fewer customers and presumably could increase your market share on that basis, that's not our goal. Our goal is PIF growth. If you want to assume that, if you said okay, the U.S. economy in terms of number of cars, house and stuff like that, it's going to be a low single-digit increase, I don't know. So 1% there's not going to be a whole bunch of more new cars in houses in the United States. And so obviously, PIF growth has got to be higher than that. And it is higher than that you can see right now in Homeowners because we're winning in that business. When you look at how far up is up, we don't have a limit on that, if you look at National General, which is one of the reasons we called it out, it's got every bit as good a growth as some of those our competitors who get much higher valuations than we do. And it's got really good profitability. So we know how to do it. And the question is how do you translate it into? And what is the timing? We think there's great growth potential here. And that when you put on, just call it, -- if you take 1% for the overall growth in assets in the United States. You put on top of that what would be modest increases in premiums then you should get revenue growth which is above 5%. And so what does that turn into? You can do the math as well as we can. But we think there's great potential here. When you look at other people, we don't think they figured out how to turn lead into gold. They're just really good at what they do. We think we can be every bit, as good in the Allstate brand and growing that business. Particularly now that we've gotten direct, what I would say is improved and unleashed that. And you can see that from Mario's charts on how much new business we're writing there. So we think there's lots of potential, like we're very optimistic, but we don't have -- here's our magic number that we're going to get to. But whatever the number is, it would lead a higher valuation of earnings than we currently have.
Yaron Kinar: Same question. Does the company have reps and warranties insurance associated with the NatGen acquisition that's still in effect?
Tom Wilson: If you're relating to the DOJ lawsuit, I don't think that will impact what eventually happens. But let me just reiterate, we're really confident in where we are with that claim, we put it that way.
Yaron Kinar: Okay. Thank you.
Operator: Thank you. And our next question comes from the line of David Motemaden from Evercore ISI. Your question please.
David Motemaden: Hi thanks. Good morning. I was wondering if you could just talk about within the auto underlying loss ratio. If there's any way to size if there was any one time or unsustainable benefit from frequency in there, one of your peers had called out, I think it was a 2.5 point benefit from unsustainable factors the quarter. I wonder if you could give us any insight in terms of, if any, of the improvement was driven by something that is unsustainable within the auto business?
Tom Wilson: No. Let me give you a little -- I'll give you the summary and then go through Mario you can jump in here front. I don't know how you determine what's sustainable or not sustainable in frequency. Examples, if it -- in the winter, if it snows at 3 p.m., and it's kind of wet and then the temperature drops quickly and it turns the ice by time you get to 5:30 rush hour, a bunch of cars getting accidents. If it snows at 2 a.m., it doesn't matter so much. So I'm not really sure how you -- and that's just one example of the myriad of things that Mario talked about how far are you driving? How often do you drive? How fast you drive? What city driving? Who else drives? Like I don't know how you -- I don't know if they -- I don't know who it was on that remember said that, but I'm not sure how we would be able to with our math and the precision that we were being able to determine what's sustainable or unsustainable. What I would come back to is what Mario said, we price on what it is. So what it is, is what we factor in. Just the frequency goes down in a quarter, we don't suddenly decrease rates. Just like if it goes up in a quarter, we don't suddenly increase rates. We price to get a mid-90s combined ratio in auto insurance, and that's what we'll keep doing.
David Motemaden: Got it. That's helpful. Understood. It is pretty complex to do that. So that's fair. My follow-up question is just on the ad spend? And just I think in the past, you've shown -- I think it was the states that are under a 96 combined. I guess, I'm assuming that clearly went up this quarter. And I guess I'm wondering, are there any states where you're holding back on ad spend? And if so, could you just size how big those are as a percentage of the total book?
Tom Wilson: I'll let Mario answer the percentage question. I would say in hold back -- I was trying -- think of it as a lever that dialed you turned. Some states were wide open and testing really high levels. Other states were at what we think is appropriate there. So we're constantly managing and testing learning in a live market on how much we bid on stuff. I mean there's just -- it's very sophisticated. So it's not like there's a go or no go level. But there is, to your point, important from a macro standpoint, like how many states you're making money.
Mario Rizzo: Yes. And David, what I'd say -- I'd go back to what I said earlier, as we look at that kind of same mix of states, about two-thirds in terms of premium volume of states are at or below our target combined ratio. And I'd say about another 10% or so are on the path to getting there with rate that we've already approved. I guess there's a handful of states that that we're not leaning in, and that's true beyond just the advertising spend, but it would be around things like underwriting guidelines and so on. As much as we've talked about California, New York, New Jersey. California, we got approval for a 30% rate. We are writing new business across all channels in California. As a matter of fact, we filed an additional 6.9% rate to stay ahead of the loss trend because you don't want to get behind in California. But we are now writing in California, and we're spending some marketing dollars there. The two that on the other side of the country, New York and New Jersey are ones that we're still effectively managing what we write. And we're writing very low volumes of business. Having said that, we've gotten rate approvals in New York. We're in active conversations with the department on a 24% rate that we filed that we hope to get resolution on hopefully reasonably soon. And then we'll revisit that stance. And in New Jersey, we got rate approved at the end of last year. We just implemented another low teens rate in July, and we've got another one coming in December. And as we evaluate where that positions us we'll reassess our risk appetite and how much we want to invest. And I'll go back to saying what I've said multiple times is our objective function is to be able to write in every state. But the reality is we need to see a path to attractive returns and profitability to be able to do that once we get there, then we'll expand our appetite across geographies.
Tom Wilson: I would just add a couple of things. First, I don't think we'll ever be at 100%. But I also that that the high-growth competitors that your competitor, I guess, you're comparing us to, it probably has the same situation. Like not everything goes well in every state in this business. So I can see what people are trying to do. You're trying to triangulate between the gap of a small decrease in auto insurance to what's the increase is going to be and how does that translate into the increase in valuation multiple. Appropriate thing, we're focused on it as well. I would just say that the gap between the current growth and what potential is probably narrower than the gap that between the valuation, like our valuation multiple could be substantially higher even with small moves in the growth rate. You have to decide what you think that's worth and whether you want to pay for it or not. But I think that focusing -- it's not going to be a one-to-one thing, and it's not all going to happen at the same time. But we're confident we can grow like we know how to run this business.
David Motemaden: Great. Thank you.
Operator: Thank you. And our next question comes from the line of Vikram Gandhi from HSBC. Your question, please. Vikram, you might have your phone on mute. We're still not hearing you. Would you like me to…
Tom Wilson: Why don't we go to the next question?
Operator: All right. Our question then comes from the line of Charles Lederer from Citi. Your question please.
Charles Lederer: Hi, can you talk about the new issued app mix on Slide 8, I guess how does your customer appetite differ across channels as you open things back up? And how do you see that impacting your margins given direct tends to have a higher upfront expense ratio as I understand it?
Tom Wilson: First, I would say we want all customers all locations or most locations, but all risk levels. Mario, do you want to talk about maybe specialist, not general or non-standard.
Mario Rizzo: Yes, Charlie, I'd say from a channel perspective, like in the Allstate brand, we have differentiated pricing between agency and direct. So we have we have the ability to do that to match the cost of doing business in the channel with the price that we charge. In terms of underwriting risk appetite, we write in standard and preferred across the entirety of the risk segment. And if we have the right price in the agent channel, we're right in the agent channel, and we'll also write it indirect. So there's very few exceptions in terms of different underwriting standards across channels. In terms of brands, the one risk segment that I think is new in the sense of we acquired it when we acquired National General is the nonstandard auto business, which historically Allstate really didn't participate in, in a meaningful way. That's a very well-run business. That's the lion's share currently of the nonstandard auto premium, generating really strong growth unit growth just under 12% with really strong profitability. And the one thing I'd say on that segment of business, there tend to be a lot of shoppers in that segment. So you can turn growth on and off a lot more rapidly. You tend to be able to reprice the book pretty quickly because the retention is lower. And I think that's become a real growth lever for us. As you can see in our numbers, we've been able to grow that business grow it profitably because we now have the right capabilities to write in that segment, which we didn't have when we started transformative growth. So but we're -- as Tom mentioned, we're positioned to write across channels, across brand and equally importantly, risk segments through National General in nonstandard Auto. But now, as I've talked about, Custom360 and rolling out middle market standard preferred and homeowner product, we can go upmarket in the independent agent channel as well. But we're positioned to write across the entirety of system.
Tom Wilson: Okay. Thank you all for spending your time with us as we move forward, we'll keep doing what do well, which is to serve our customers. We're going work on accelerating our growth in the profit liability business, making sure we're proactively investing and we didn't have spent a lot of time on that today, but we've had really great results in our investment portfolio. And then expanding protection offerings through great platforms like Protection Plans. Thank you all. We'll see you next quarter.
Operator: Thank you, ladies and gentlemen, for your participation in today's conference. This does conclude the program. You may now disconnect. Good day. | [
{
"speaker": "Operator",
"text": "Good day, and thank you for standing by. Welcome to Allstate's Second Quarter Earnings Investor Call. [Operator Instructions] As a reminder, please be aware that this call is being recorded. And now, I'd like to introduce your host for today's program, Brent Vandermause, Head of Investor Relations. Please go ahead, sir."
},
{
"speaker": "Brent Vandermause",
"text": "Thank you, Jonathan. Good morning. Welcome to Allstate's second quarter 2024 earnings conference call. Yesterday, following the close of the market, we issued our news release and investor supplement, filed our 10-Q and posted related material on our website at allstateinvestors.com. Our management team will provide perspective on our strategy and an update on our results. After prepared remarks, we will have a question-and-answer session. As noted on the first slide of the presentation, our discussion will contain non-GAAP measures, for which there are reconciliations in the news release and investor supplement and forward-looking statements about Allstate's operations. Allstate's results may differ materially from these statements, so please refer to our 10-K for 2023 and other public documents for information on potential risks. As some of you know, this will be my final earnings call as the leader of our Investor Relations team since I will be transitioning to a new role. Investor Relations will be in the capable hands of Alastair Gobin, who will be a great partner for you all. And now, I'll turn it over to Tom."
},
{
"speaker": "Tom Wilson",
"text": "Well, good morning. Thank you for investing your time at Allstate. I'll provide an overview of results. Mario and Jess will go through operating performance, and then we'll address questions. Let's start on Slide 2. Allstate strategy has two components: increase personal property-liability market share and expand protection provided to customers, which are shown in the two ovals on the left. On the right-hand side, you could see highlights in the second quarter. Net income was $301 million in a quarter with elevated catastrophes. The auto profit improvement plan is being successfully executed. National General continues on a 4-year profitable growth trajectory. The Homeowners business had good results with an improved underlying combined ratio and underwriting profit for the first six months of the year. Net investment income was up almost 17% over the prior year quarter as the fixed income portfolio continues to benefit from repositioning into longer duration and higher yielding assets. Protection Services has had another good quarter led by profitable growth in protection plans. Let's move to Slide 3 and show how that operational execution improved underlying results in the quarter. Revenues increased to $15.7 billion, reflecting higher average property liability earned premiums and that was mostly from rate increases in auto and homeowners insurance and increased net investment income. Net investment income for the second quarter was $712 million higher than the prior year quarter, reflecting that fixed income duration extension in 2022 and 2023. And then which also included lowering public equity holdings to take advantage of higher fixed income yields. Adjusted net income was $429 million or $1.61 per diluted share. Now, I'll turn it over to Mario for Property-Liability results."
},
{
"speaker": "Mario Rizzo",
"text": "Thanks, Tom. I'll start by covering Slide 4. On the top left of the table, you can see Property-Liability earned premiums of $13.3 billion increased 11.9% in the second quarter, driven by higher average premiums. The underwriting loss of $145 million improved by $1.9 billion compared to the prior year quarter due to improved underlying margins and lower catastrophes. The expense ratio of 21.3 was 0.8 points higher than prior year due to increased advertising as we continue to accelerate growth investments in rate adequate states and risk segments. The adjusted expense ratio, which excludes advertising costs and other non-core expenses was down 1.6 points in the quarter. The chart on the right depicts components of the 101.1 combined ratio. Catastrophe losses of $2.1 billion were 6.7 points favorable to the prior year quarter. The underlying combined ratio of 85.3 improved by 7.6 points compared to the prior year quarter with the improvement driven by higher average earned premium and moderating loss cost trends. Prior year reserve re-estimates, excluding catastrophes, had only a minor impact on current quarter results as favorable development in personal auto and homeowners insurance offset increases in personal umbrella liabilities and commercial auto reserves related to the transportation network contracts we began exiting in late 2022. Turning to Slide 5. You can see that we continue to successfully execute our profit improvement plan. The second quarter recorded auto insurance combined ratio of 95.9 improved by 12.4 points compared to the prior year quarter. The bars in the chart show consistent improvement in the quarter underlying combined ratio. I will note that we have adjusted 2022 and 2023 reported quarterly figures to reflect the updated average severity estimates as of the end of each of those years to remove the volatility related to intra-year severity adjustments. You can see that the auto business has seen six sequential quarters of underlying combined ratio improvement with an underlying combined ratio of 93.5 in the second quarter of 2024. The dark blue line in the chart shows how rate increases throughout 2022 and 2023 pushed average premiums above underlying losses and expenses represented by the light blue line starting in the second half of 2023. As average premium increases have outpaced loss and expense profitability has improved. Relative to the prior year quarter, average underlying loss and expense was 5.5% higher, as you can see in the second row of the table. This reflects higher current year incurred severity estimates primarily driven by bodily injury coverage, offset by lower accident frequency as well as higher advertising investments. Physical damage severity increases continue to moderate, while bodily injury continues to trend above inflation. Our claims team is focused on operational actions to mitigate the impact of inflationary trends, including identifying injuries earlier in the claims process to improve overall cycle time and focus on fast and fair resolution. Let's review Homeowners insurance on Slide 6 which had improved underlying performance. Allstate is an industry leader in Homeowners insurance, generating low 90s combined ratios over the last 10 years, as you can see in the chart on the right. This performance compares favorably to the industry, which experienced an underwriting loss and a 103 combined ratio over that same time period. Moving to the table on the left. Allstate Protection homeowners written premium increased by 13.7% compared to prior year, reflecting both higher average gross written premium per policy and policy in force growth of 2.2%. The second quarter combined ratio of 111.5% resulted in $375 million of underwriting losses compared to the $1.3 billion loss in the prior year. The underlying combined ratio of 63.5 improved by 4.1 points due to higher average premium and lower non-catastrophe claim frequency, which more than offset modest increases in non-catastrophe severity. For the first six months of 2024, Homeowners insurance generated an underwriting profit of $189 million. Moving to Slide 7. Let's discuss Transformative Growth our multiyear strategy to create a low-cost digital insurer with broad distribution. The 5 components of Transformative Growth are shown in the blue panels on the left side of the page, and we continue to make good progress on all of them. On the right-hand side, we show the tangible outcomes and proof points that we're delivering through this transformation, which improve the customer experience and support our objective to profitably grow market share over time. Two examples of those tangible outcomes that I'd highlight are the new affordable, simple and connected auto insurance product that was built on our new technology platform is now available in 19 states. And that in the second quarter, we increased our advertising investment by approximately $300 million to support growth efforts in states with attractive returns. Moving to Slide 8. We'll double-click on the multichannel distribution strategy, which enables us to serve customers based on their personal preferences. Our exclusive agents are available for local customers seeking personalized advice to fulfill broad insurance needs. Agency productivity has increased and bundling rates at point of sale are at all-time highs. Enhancements to direct capabilities and increased advertising attract more self-directed customers with new business production in the direct channel in the second quarter, nearly double that of the prior year. The National General acquisition significantly expanded the independent agent channel. If you look at the distribution of new business we write, shown in the pie charts on the bottom of slide, you can see the power of expanded customer access. The combination of broader distribution capabilities, increased advertising greater pricing sophistication and product expansion has resulted in a 90% increase in new business applications since 2020 with a much more balanced split across distribution channels. Now let's turn to Slide 9 to delve deeper into how the National General acquisition has allowed us to better serve customers who prefer to engage with independent agents. The $4 billion acquisition included a number of businesses, including personal auto insurance, group health, individual accident and health, and digital marketing platforms. Prior to the acquisition, we offered insurance in the independent agent channel through both the Allstate and Encompass brands, with the Encompass brand solely dedicated to selling through IAs. With the acquisition of National General, we now go to market in the independent agency channel, primarily through the National General brand. Through the ownership of National General since January of 2021, we have significantly increased the number of customers we protect through independent agents, having added almost 1.7 million policies in force reflecting a compound annual growth rate of 8% in policies over the past four years and bringing premiums written to over $5.1 billion for the first six months of this year. Underwriting margins remain attractive and National General is now one of the largest independent agent personal lines insurers with expansion into lower risk customer segments supporting additional growth going forward in the IA channel. Slide 10 reviews property liability policies in force for all brands. Given the successful execution of the Auto Insurance profit improvement plan, investments in growth will made in Allstate that offer attractive return opportunities. These higher growth investments led to a 17% increase in Personal Auto new business applications in the second quarter, as you can see at the top of the chart on the left. The green bars show the components of that growth in new policy sales. The first two bars reflect the drivers of the 23% increase in new business volume in the Allstate brand. Higher productivity per exclusive agents drove a 9% new business increase compared to prior year and advertising investments and enhancements to direct operations resulted in a 92% increase in the direct channel compared to the prior year. The last two green bars reflect national general growth in both the non-standard auto business and higher sales volume from the Custom360 middle market offering that we continue to roll out. On the right, you can see that total protection auto policies enforced decreased by 1.6% compared to prior year as the Allstate brand decrease was partially offset by growth at National General. Allstate brand auto policies in force decreased by 4.5% compared to prior year as policies lost from customer defections more than offset the increase in new policy sales. Allstate brand auto retention of 85.7 did improve by 0.2 points compared to prior year as the negative impact of large rate increases in 2022 and 2023 continues to moderate. National General growth of 548,000 policies in force offset almost 60% of the Allstate brand decrease. While margin improvement actions have negatively impacted policy growth, the were necessary to mitigate loss cost trends during a period of rapid loss cost inflation. And now I'll turn it over to Jess."
},
{
"speaker": "Jess Merten",
"text": "All right. Thank you, Mario. Slide 11 details profitable growth in Protection Services. In the second quarter, revenues in these businesses increased to $773 million, which was 12.7% higher than the prior year quarter. This result was primarily driven by growth in Allstate Protection Plans. Revenues in our Roadside business decreased 22.7% compared to the prior year quarter, reflecting the impact of exiting a large unprofitable wholesale account. In the table on the right, you will see adjusted net income of $55 million in the second quarter increased $14 million compared to the prior year quarter, with most businesses showing improvements. Profitable growth in Allstate Protection plans resulted in adjusted net income of $41 million, a $10 million increase compared to the prior year quarter as revenue growth and improved claims trends continue to benefit the bottom-line. Slide 12 provides additional insight into the shareholder value created by protection plans. Since acquiring SquareTrade in 2017 for $1.4 billion, this has become a significant growth platform with scale and attractive profitability. Protection Plans provides warranties for a wide range of products, including consumer electronics, computers and tablets, TVs, mobile phones, major appliances and furniture. The power of the Allstate brand has helped to secure partnerships with large retailers in North America. We sell Allstate Protection Plans at point of sale through successful retailers such as Costco, Home Depot, Sam's Club, Target and Walmart, all under the Allstate brand. We're also expanding internationally into Europe and Asia. As you can see from the charts to the right, broad distribution and customer-focused operational execution has resulted in rapid growth in this business. Revenue grown 20% compared to the same 12-month period in 2023, while returns have been strong. Adjusted net income over the last 12 months totaled $139 million and almost $700 million cumulatively since 2017. Now let's shift to Slide 13 to discuss investment results. Result again benefited from active portfolio management that seeks to optimize return per unit of risk across the enterprise. Net investment income, shown in the chart on the left, totaled $712 million in the quarter, which is $102 million above the second quarter of last year. Market-based income of $667 million, which is shown in blue, was $131 million above the prior year quarter as the fixed income portfolio continues to benefit from repositioning into longer duration and higher yielding assets. Performance-based income of $107 million, shown in black, was $20 million below the prior year quarter due to lower real estate investment results. The performance-based portfolio is constructed to enhance long-term returns and volatility on these assets from quarter-to-quarter is expected. On the right, you can see our annualized portfolio return in total and by strategy over a short-term and long-term horizon. The market-based portfolio delivers predictable earnings while the performance-based portfolio enhances risk and return and diversifies the $71 billion investment portfolio. Moving to Slide 14. The Health and Benefits business continues to perform well. Revenues of $620 million increased by $45 million compared to the prior year quarter, driven by premium growth in group and individual health. Adjusted net income of $58 million in the second quarter was slightly higher than the prior year quarter, reflecting increased group health and employee benefits adjusted net income that was partially offset by a decrease in individual health. As a reminder, the decision to pursue a divestiture of these businesses was based on a belief that potential buyers with complementary products and capabilities will unlock value beyond what is achievable by Allstate. The process is progressing well and has confirmed our strategic logic. Slide 15 recaps Allstate strategy in this quarter's results. Auto and Homeowners insurance profitability has improved. National General is profitably growing policies in force. We're accelerating transformative growth to increase auto and homeowners' policies in force. Proactive risk and return management of the investment portfolio continues to generate value. And Protection Plans is expanding with broadened product offerings and distribution. We're confident that this strategy will continue to create value for our shareholders. And with that context, let's open the line for your questions."
},
{
"speaker": "Operator",
"text": "Certainly. And our first question for today comes from the line of Gregory Peters from Raymond James. Your question, please."
},
{
"speaker": "Gregory Peters",
"text": "Good morning, everyone. So for my first question, I'll focus on growth. And Tom, I know you've been talking about transformational growth now for several years. And we're seeing this strong increase in new issued applications. So I'm wondering if you might help us understand how you think that new issued application result is going to drive increased policies in force in the auto stats that we see in some of your supplements."
},
{
"speaker": "Tom Wilson",
"text": "Good morning Greg. Thank you for both being here and paying attention over years, appreciate it. Mario talked about the growth by channel. And we highlighted National General this quarter because it's a $10 billion business on an annual basis. And we feel like the market is really not looking through that one in terms of growth as much. Transformative growth includes what we're doing in National General. But to your point, it really also includes remaking a lot of the business processes inside the Allstate brand. So let me make a couple of comments about that. And give it to Mario to talk about specific things he's doing in various geographies. It's just the most macro view growth driven by two factors, sell more, as you point out and keep more. And so we spent a bunch of time Mario talked about selling more. We feel good about the trajectory there. You can see the benefits of the increased advertising and direct volume Mario talked about. And that also will translate into increased growth in productivity in the Allstate agent channel as we roll it out. So the other question then is, of course, how many do you keep? And retention was up slightly in the quarter versus the prior year quarter. If you kind of look over the last 12 months, it's been reasonably flat in Auto Insurance. I assume you're talking about Auto Insurance, by the way, we can talk about Home as well because I think that's a great opportunity for us. But on Auto Insurance, it's been relatively flat and normally, you would expect as rate increases come down, you would expect retention to increase. It's not clear what that trend will be at this point in time. And the reason I say that is not that I think traditional economics of don't ask me to pay a lot more and more likely to stay breakdown. It's just that the price elasticity curves broke down when we raised prices over the last couple of years. So it's a little hard to tell what the tail on that will be because it's hard to figure out attribution of why did in the face of 33% increase in rates we were able to hold retention pretty well. Some have been -- maybe car people understood the cars worth more, maybe they had a bunch of cash the government gave them. Some of it's competitors were also raising rates. So you can't really do attribution as to why we are where we are. So looking forward, we said it's a little hard to tell exactly what retention will do in the future. I take Senate goes up because we are taking fewer price increases. That's almost -- it's pretty close to one to one in terms of movement retention rate and growth, which is really a good thing, obviously. But we're not waiting around to see what happens there. We're working on improving the customer experience. We have a goal of growing 20 million customer interactions on an annual basis by next year, and we're well along the goal on that. So we're doing a whole bunch of continuous improvement. We've got new tech tools out there, new products, all of which are designed around improving retention and growth. Mario, do you want to talk about specific aspects of growth in terms of states or something?"
},
{
"speaker": "Mario Rizzo",
"text": "Sure. Thanks for the question, Greg. So maybe the place I'd start like Tom said, retention is obviously critically important to growth, and we're pleased with the fact that retention is stabilizing. But we also recognize there's a handful of states that we have taken some pretty significant rate increases more recently, California, New York, New Jersey. Those are going to continue to have an impact on retention going forward. But absent those three states, we kind of like the trends that are emerging. But I want to talk a little bit about new business production and get at your question. So Greg, where I would start would be kind of how did we get here? And the reality is, as we've been implementing the auto profit improvement plan over the past couple of years, that's obviously being executed on a state-by-state, market-by-market basis. But as states have gotten to a rate adequate level, we've begun to lean in and invest more in growth to drive production in those states. And that would include things like unwinding underwriting guidelines to restrict business, increasing advertising spend, both nationally and locally. And as where we sit right now, as I'd say, about two-thirds of our states, the premium volume represented like two-thirds of our states, are what we would consider at profit target levels. And then there's about another 10% or so that are kind of on the path to getting there. So overall, we feel really good about the vast majority of country in terms of geographically where we're comfortable investing. And you see the momentum that's really been building over the course of the year. Last quarter, production was up about 9% in total. This quarter, it was up 17% as we further ramped up growth investments. And we're going to continue to do that. At the same time, you've seen us take less rate, which, as Tom mentioned, helps retention. But we're going to continue to be diligent about staying on top of loss cost trends really broadly across states. And as I mentioned, there are some states that aren't in that growth category right now that we've got to get to target levels of profitability. We're going to continue to focus on taking rates that are necessary there. And when we're successful, those will become additive to the parts of the country where we can invest. So that kind of got us to where we're at in terms of geography and new business and the good news is we're seeing the growth across brands and across channels."
},
{
"speaker": "Gregory Peters",
"text": "Great. I guess in a related question as a follow-up -- my follow-up would be on the expense ratio side. You called out the increased advertising expense in the second quarter. I think it was 3 points of your property liability combined ratio. When we look forward, what kind of expectation do you have about how maybe the adjusted expense ratio is going to move through the balance of this year and sort of what your longer-term objectives are there?"
},
{
"speaker": "Tom Wilson",
"text": "Let me answer that both by first by going up and then coming down a little bit. So Transform Growth had 5 components that Mario walked through. We've -- on each of those, the underlying assumptions between whether that was a good thing to do or not, we've proven out. We haven't -- they all are not working all at the same time right now so that you're seeing the growth we think we can get, which is to increase market share. So we're confident we're going to increase market share in personal property liability. When you get into what's retention next quarter, what happens in new business exporter, we're confident that all of those things will work in the same direction. As it relates to expenses, we think we need to continue. I mean we wanted to affordable simple, connected protection. Affordable means low price. That means we're going to continue to reduce costs. And so we've got a whole bunch of things we're working on now that are -- we've been working on for a couple of years as you point out, that are starting to generate benefits. But we have more to go. Like we don't -- we think there's with the age of digitization and the things we can do in our business, we can still drive cost on. As it relates to advertising, the reason we broke that out separately is that, that does relate to the fact of we don't want people to be to miscommunicate to people that we think taking advertising down and making that lower is a good idea, because we think growth creates value for shareholders as long we're operating at attractive returns. We've got a good set of capabilities there. And I'd be happy to talk about that. If anybody wants to get there, but we're comfortable that we can continue to invest in growth, get good returns, lower expenses at the same time, increased market share, which then will lead to a re-rating of the earnings multiple."
},
{
"speaker": "Gregory Peters",
"text": "Thank you."
},
{
"speaker": "Operator",
"text": "Thank you. And our next question comes from the line of Jimmy Bhullar from JPMorgan. Your question please."
},
{
"speaker": "Jimmy Bhullar",
"text": "Hi. Good morning. I just had a question on, what you're seeing in terms of competitive trends in the Personal Auto market, both in terms of pricing and advertising. It seems like margins for most of the companies are getting closer to normal. So wondering if that, if you're starting to see some of them, get aggressive on price? I know certainly advertising spending has been going up a lot. But what are you seeing out there?"
},
{
"speaker": "Tom Wilson",
"text": "Let me talk about advertising and Mario, can jump in on pricing. And of course, there's a lot of competitors, but let's focus on the biggest competitors for time being a business is the ones that are mostly in play here. So from a -- as we were just talking about, growth is good for shareholders. It's good, because we're earning good returns. Secondly, we're leveraging capabilities over a broader capital base, which drives more shareholder value creation, and then that should lead to a re-rating other multiple. And then you say, what needs to be true for you to do good advertising and to head into a fight on that one. And first, you got to have a product that's differentiated and appeals to customers. So we have that with our new ASC Auto product. We know it from the close to quote ratios higher with product you've got to have -- you got to be getting attractive returns when we talked about that at length. You got to have a great brand because that increases consideration like if people view the first time people have heard of you your dollar advertisings done is effective, obviously, we a great brand and great consideration. You have to have broad access, and this, ties together with transforming growth. We advertise, you can go to exclusive agent, you can go on our website, you can go to a direct. So you want to make sure that however they want to come to, they had advertising dollars effectively used. Now I would say advertising today, though, is a game of precision, much as Auto Insurance pricing went through this great push on sophistication, those who are good at sophistication win. And you can see that when you look at the combined ratios of people like Allstate Progressive, Geico, we all have really good combined ratios, because we're sophisticated in how we price product. Same thing is true in advertising today. So you have to be good at search. And we don't just listen to ourselves. We had external reviews, and we're really good at search. You have to be good at a bidding strategy. How much you're bidding for Elite? We're good at bidding for Elite. It's not like we're perfect. We got other stuff we need to do. You got figure out how you're using different kind of messaging for different groups. And you can imagine with the refrain of number of media channels, number of messages you can do now, particularly with AI, the number of segments you have, your pricing sophistication, it gets complicated really fast. And we're really good at it. So when we go into this, and we're thinking about us increasing the advertising versus other people, you're like, well, how good are you? And we think we're good at it. If you look at where we are with Arity and our Telematics work, that's to really end run around having more information on who you bid on because we track 15% of the U.S. population they're driving. So we can decide how good a driver you are without even sticking a device on you or an app on your phone or a device in your car. So will competition increase in advertising, probably. Do I -- it will be from those carriers who have the same kind of capabilities we do. So we're fully up to winning that game. I think there will be some other people who hold back or even drop out because they can't -- they don't have the capabilities and expertise to do it. So that's where we are in the advertising, good for shareholders because it's good for growth. And we use the money effectively. Mario, do you want talk about pricing environment?"
},
{
"speaker": "Mario Rizzo",
"text": "Yes. And Jimmy, thanks for the question. I'll answer the question broadly, but I'd put a caveat around it that, obviously, what I'm going to say is going to vary by company and it's going to vary geographically because the business has just operated that way, and there's a lot of competitors in the market. But I would say, by and large, as we discussed this morning and as many of our competitors have reported profitability in auto is improving as loss cost trends have improved. And all of the things being equal, when that happens and margins are better. There's just less rate activity in the system, and that's what we're saying -- companies generally taking less rate than they were over the last couple of years. Again, that will vary by company. Some started later than others and are still catching up. Others are a little further along. But generally, we see less rate getting pushed through. And then certainly, that varies geographically as well. Having said that, I would just take that along with what Tom talked about in terms of advertising and say that when you take the totality of where we're positioned and what we're building with transformative Growth, we like where we're positioned in our ability to be able to increase growth investments and be successful in a competitive marketplace. That's what we're building, and we like our chances."
},
{
"speaker": "Jimmy Bhullar",
"text": "And then just on the benefit sale, we're late in the year, and there hasn't been an announcement, but maybe talk a little bit about how the process is going. And I'm assuming it's probably not going to close this year, but are you still assuming the close within the next few months, even if it drags on to next year?"
},
{
"speaker": "Jess Merten",
"text": "Hi, Jimmy, it's Jess. First, I guess I would start by reminding everyone, the third great businesses. You saw it in the results that I covered. So we're really happy to continue to focus on execution in the operations. It might be helpful if I give you a little bit of a window into the process to help you understand of where we're at and where we're going. So if you think about our process, we started out with a preference for single transaction. But in the same note, we were unwilling to compromise value for that preference, right? So we spent a lot of time with a single transaction buyer that thought they could, in the end, change the terms and/or that we didn't have better options, quite frankly. So we spent a lot of time on a process there, and ultimately, what we decided was to work with other buyers. And that has created a delay in things, it just has. But we're confident that by making that switch, we'll get a better outcome. A better outcome for our shareholders, a better outcome for the businesses. So what I would say right now, and I don't want to get into timing of announcements to close, what I would say is that we're likely to be in a position to announce transactions this year, and you'll get more details about the what and the how, when those announcements come. But that's just a little bit of window into the process and why you still haven't heard anything, if that's helpful."
},
{
"speaker": "Jimmy Bhullar",
"text": "And do you intend to sell a disposal of the entire unit eventually, even if it goes into pieces? Or are there some pieces you might decide to retain?"
},
{
"speaker": "Jess Merte",
"text": "We still intend to make the divestiture of the Health and Benefits segment."
},
{
"speaker": "Jimmy Bhullar",
"text": "Thank you."
},
{
"speaker": "Operator",
"text": "Thank you. And our next question comes from the line of Bob Huang from Morgan Stanley. Your question please."
},
{
"speaker": "Bob Huang",
"text": "Hi. Good morning. Maybe one on homeowner. I think last year, when it comes to cat losses, severe convective storm was a one in 2018 event, if I remember correctly, which obviously was a headwind to your cat numbers. Just given how things are developing so far, curious how is it tracking this year? Is it going to be more of a worse than one in 2018 event? Just pace on what we have in the first half, curious in terms of like how are the weathers are developing for the Homeowner side."
},
{
"speaker": "Tom Wilson",
"text": "Bob, it's Tom. Thanks for the question on Homeowners. I would look at Homeowners on a longer-term basis than one year. So if you look over the last 11 years, we've made three-quarter of the profit that whole industry has made because we have a pretty sophisticated business model, we've talked about before and be happy to go into, but we're good at homeowners. It's currently turning into a, I guess, what we do domestically, we called the hard market, but a lot of people are bailing on growth in that market because they were either part of the 25% or they were part of the negative amount that led to us every three quarters. So that entire profit pool when we have less than 10% of the total business. So we think that is a great growth opportunity. As it relates to this year, too hard to predict whether. It comes and goes. For the first six months, we made money on an underwriting basis. That makes me feel better than last year, where we didn't make money for the whole year, prior 10 years. We've made money in each of those 10 years. So I feel good about our business model. As it relates to any individual quarter, they're keeping for us is be there for our customers. Like when I got a problem and we're good at getting there fast. We want to be there to take care of their claims. They tell their friends. Our Homeowners as you saw the unit growth is up. It's particularly -- we're doing extremely well in our Allstate agents with bundling customers. So other people are interested in that segment. We're just killing it right now on cross line sales. So we feel good about that. Some of that is the hard market. Some of it's great relationships. Some of it is the product and the pricing we have it all kind of comes together. So we like the business. We think it's got good long-term growth potential. And we -- on a quarterly basis, I wouldn't get too focused on whether it's up or down this second quarter is -- you can decide it's either higher or lower depending on which period of time you wanted to evaluate it against. And so I would just say focus on the long-term results from it."
},
{
"speaker": "Bob Huang",
"text": "Okay. Thanks. My second question, a little bit of a shot in the dark here. For the DOJ lawsuit for National General, there has been precedent where under FIRREA Civil Enforcement Actions, where SEC can potentially get involved under the current litigation environment, do you expect that the National General case should get SEC involved at some point down the road? I'm not sure if that's the question you can answer at this point."
},
{
"speaker": "Tom Wilson",
"text": "Well, we don't give a lot of specifics on active litigation, obviously. And I certainly can't speak for what other people want to do when we have -- I don't know what the SEC will or will not choose to do. What I can give us a little bit of information. This is -- the lawsuit is in reference to a lender-placed insurance program, so that stuff sold through agents. It's focused on auto insurance. Our program was transparent. We borrowers are treated fairly. And we're confident that we will prevail in this and at the lawsuits will have no impact on our ongoing business."
},
{
"speaker": "Bob Huang",
"text": "Okay. Thank you."
},
{
"speaker": "Operator",
"text": "Thank you. And our next question comes from the line of Michael Zaremski from BMO. Your question, please."
},
{
"speaker": "Jack Matten",
"text": "Hi. Good morning. This is Jack on for Mike. Just a follow-up on the advertising spend strategy. I'm curious how your strategy and focus today compares to the last cycle? And more specifically, how much of your ad spend has historically been geared toward direct-to-consumer targeted sales versus supporting your agents? And then how is that evolving today given the success of your transformative growth strategy in your lower expense base?"
},
{
"speaker": "Tom Wilson",
"text": "Jack, I would say that the third component of transformative growth was increase the sophistication and investment in new customer acquisition. We didn't talk about it here much, but we've gotten much more sophisticated versus the last time we did this. But I think other people have too. So I'm not -- like I don't want conclude we're 5 miles ahead of everybody else but we're good. And so we feel much better about our sophistication. The way in which we go through the allocation of investment is think about it as upper and lower funnel, upper funnel being get the brand out there, do some TV advertisements to make sure people are considering you when they're getting insurance. So you'll notice that more advertising on TV. Then there's what we call lower funnel, which is you're on the website, you're cruising around for a new car, and we pop something into your web browsing that says, hey, what about Allstate or we use addressable TV to do it. So there's lots of different ways we try to do, what I would call, lower funnel. And the first one, you do because we are off a little bit for the last couple of years in terms of down in advertising, we've increased our upper funnel some just because we want people to remember there, got a great brand because we've been investing in it forever. It's got great unaided recognition, and we want to keep investing in that. The biggest portion of our increase would be in the lower funnel piece. That gets tightly tied to what Mario described, which is really by state by market, by risk class, and it's highly sophisticated in terms of how we do that. As it relates to both of those upper and lower funnel work for both all of our -- all of the Allstate brand channels, so agents and direct. Our agents also do some of their own lead generation, whether they go to mortgage brokers or other people in their local areas and buy leads. I think there is an area where we need to bring increased sophistication to it because we're just better at doing it globally than you would be if you live it to Boeing or something like that. So there's increased sophistication there. But think of it as a large machine has got a number of different levers we can pull, and we have -- it has got good gauges on it, so we can tell what's coming out on the other end. And so we're constantly turning and dialing those levers and watching the gauges so that we beat our current competition."
},
{
"speaker": "Jack Matten",
"text": "That's helpful. Thank you. And then maybe switching gears to auto loss cost trends. If you look at the average underlying loss you disclosed, it's now running slightly lower compared to 2023. I guess does that mean you're now seeing frequency benefits more than offsetting higher severity. And I'm curious how you view the sustainability of current favorable frequency trends. I know last quarter, you mentioned favorable weather. Just curious how those pieces are moving."
},
{
"speaker": "Tom Wilson",
"text": "Jack, I'll let Mario jump into both frequency and severity and by coverage. I can just say it's nice to have it be about halfway through the call on loss costs and be talking about growth, which is much more optimistic. A year ago that would have been in the first, second and third question. So it's a good question. Mario will go to it, but I'm happy we're talking about growth because we think that's where we're going to create a lot of shareholder value. So Mario over to you."
},
{
"speaker": "Mario Rizzo",
"text": "Sure. Thanks, Jack. I guess the place I'd start is as much as we dig into the components of profitability. They're all important, but we should lose sight of the fact that the way we manage the auto business is to generate mid-90s combined ratios across the entirety of the system. And we use levers like rates and we look at pure premium, whether that's frequency and severity and expenses, they all matter. And certainly, the loss trend helps inform what we need to do with some of the other levers. What I would say, as I mentioned, the negative trend, the negative 0.8% that you see in the supplement as I mentioned in my prepared remarks, there's a little bit of noise in in there terms of year-over-year comparisons because we were moving severity targets around intra-quarter last year. So the adjusted numbers, it's slightly positive, it's about 1%. So not all that different. But I would say it's -- favorable frequency has continued through the first half of the year has been offset by higher severity predominantly in bodily injury, which continues to run above inflation and on the physical damage side, we continue see some good tailwinds with things like used car prices and stabilizing repair costs and so on. But that's kind of the overall loss trend that we're reacting to. In terms of the sustainability of frequency, it's a really difficult question to answer. Things like weather and geography risk segments all come into play. Frequency has been better than it was a year ago. When we look at our telematics data, which gives us a lot of rich information, miles driven per operators up a little bit but trips are shorter. So that could be having an impact on frequency. Weather favorably impacted frequency in the first quarter. And the other thing I'd say is as we've been looking to improve profitability over the last couple of years and not growing, the risk segmentation and the mix of our auto book has shifted around a bit to higher lifetime value, let lower frequency type business, that's having an impact as well. So there's a lot of moving parts in there. One thing I will say is as we go forward and write more new business, that will impact prospective frequency trends, but I'll go back to where I started. We manage the system in its entirety to generate mid-90s combined ratio profitability, and we're going to continue to do that despite however frequency bounces around."
},
{
"speaker": "Jack Matten",
"text": "Thank you."
},
{
"speaker": "Operator",
"text": "Thank you. And our next question comes from the line of Yaron Kinar from Jefferies. Your question please."
},
{
"speaker": "Yaron Kinar",
"text": "Thank you, good morning. I wanted to go back to growth or continue to focus on growth. I think ever since the Transformative Growth program was announced and launched. Clearly, you've had some issues with COVID and the aftermath of COVID. But now that we're hopefully starting to come out of that transitionary period and all the levers from Transformative Growth are kind of kicking in. Can you maybe help us think through -- I'm not even asking about a one or two-year horizon, but maybe over the cycle, what you think reasonable growth expectations should be on a PIF basis for Allstate. And I say this also in the context of I think we see some of industry leaders in growth, achieving pretty consistent, call it, high -- mid-to-high single-digit growth in PIF. Do you think that you can be at that level?"
},
{
"speaker": "Tom Wilson",
"text": "So we haven't given out a target for PIF growth, but it's the right way to think about it. Because when you're looking at market share, a lot of times, market share is done in the industry by premiums. Also charge, more have fewer customers and presumably could increase your market share on that basis, that's not our goal. Our goal is PIF growth. If you want to assume that, if you said okay, the U.S. economy in terms of number of cars, house and stuff like that, it's going to be a low single-digit increase, I don't know. So 1% there's not going to be a whole bunch of more new cars in houses in the United States. And so obviously, PIF growth has got to be higher than that. And it is higher than that you can see right now in Homeowners because we're winning in that business. When you look at how far up is up, we don't have a limit on that, if you look at National General, which is one of the reasons we called it out, it's got every bit as good a growth as some of those our competitors who get much higher valuations than we do. And it's got really good profitability. So we know how to do it. And the question is how do you translate it into? And what is the timing? We think there's great growth potential here. And that when you put on, just call it, -- if you take 1% for the overall growth in assets in the United States. You put on top of that what would be modest increases in premiums then you should get revenue growth which is above 5%. And so what does that turn into? You can do the math as well as we can. But we think there's great potential here. When you look at other people, we don't think they figured out how to turn lead into gold. They're just really good at what they do. We think we can be every bit, as good in the Allstate brand and growing that business. Particularly now that we've gotten direct, what I would say is improved and unleashed that. And you can see that from Mario's charts on how much new business we're writing there. So we think there's lots of potential, like we're very optimistic, but we don't have -- here's our magic number that we're going to get to. But whatever the number is, it would lead a higher valuation of earnings than we currently have."
},
{
"speaker": "Yaron Kinar",
"text": "Same question. Does the company have reps and warranties insurance associated with the NatGen acquisition that's still in effect?"
},
{
"speaker": "Tom Wilson",
"text": "If you're relating to the DOJ lawsuit, I don't think that will impact what eventually happens. But let me just reiterate, we're really confident in where we are with that claim, we put it that way."
},
{
"speaker": "Yaron Kinar",
"text": "Okay. Thank you."
},
{
"speaker": "Operator",
"text": "Thank you. And our next question comes from the line of David Motemaden from Evercore ISI. Your question please."
},
{
"speaker": "David Motemaden",
"text": "Hi thanks. Good morning. I was wondering if you could just talk about within the auto underlying loss ratio. If there's any way to size if there was any one time or unsustainable benefit from frequency in there, one of your peers had called out, I think it was a 2.5 point benefit from unsustainable factors the quarter. I wonder if you could give us any insight in terms of, if any, of the improvement was driven by something that is unsustainable within the auto business?"
},
{
"speaker": "Tom Wilson",
"text": "No. Let me give you a little -- I'll give you the summary and then go through Mario you can jump in here front. I don't know how you determine what's sustainable or not sustainable in frequency. Examples, if it -- in the winter, if it snows at 3 p.m., and it's kind of wet and then the temperature drops quickly and it turns the ice by time you get to 5:30 rush hour, a bunch of cars getting accidents. If it snows at 2 a.m., it doesn't matter so much. So I'm not really sure how you -- and that's just one example of the myriad of things that Mario talked about how far are you driving? How often do you drive? How fast you drive? What city driving? Who else drives? Like I don't know how you -- I don't know if they -- I don't know who it was on that remember said that, but I'm not sure how we would be able to with our math and the precision that we were being able to determine what's sustainable or unsustainable. What I would come back to is what Mario said, we price on what it is. So what it is, is what we factor in. Just the frequency goes down in a quarter, we don't suddenly decrease rates. Just like if it goes up in a quarter, we don't suddenly increase rates. We price to get a mid-90s combined ratio in auto insurance, and that's what we'll keep doing."
},
{
"speaker": "David Motemaden",
"text": "Got it. That's helpful. Understood. It is pretty complex to do that. So that's fair. My follow-up question is just on the ad spend? And just I think in the past, you've shown -- I think it was the states that are under a 96 combined. I guess, I'm assuming that clearly went up this quarter. And I guess I'm wondering, are there any states where you're holding back on ad spend? And if so, could you just size how big those are as a percentage of the total book?"
},
{
"speaker": "Tom Wilson",
"text": "I'll let Mario answer the percentage question. I would say in hold back -- I was trying -- think of it as a lever that dialed you turned. Some states were wide open and testing really high levels. Other states were at what we think is appropriate there. So we're constantly managing and testing learning in a live market on how much we bid on stuff. I mean there's just -- it's very sophisticated. So it's not like there's a go or no go level. But there is, to your point, important from a macro standpoint, like how many states you're making money."
},
{
"speaker": "Mario Rizzo",
"text": "Yes. And David, what I'd say -- I'd go back to what I said earlier, as we look at that kind of same mix of states, about two-thirds in terms of premium volume of states are at or below our target combined ratio. And I'd say about another 10% or so are on the path to getting there with rate that we've already approved. I guess there's a handful of states that that we're not leaning in, and that's true beyond just the advertising spend, but it would be around things like underwriting guidelines and so on. As much as we've talked about California, New York, New Jersey. California, we got approval for a 30% rate. We are writing new business across all channels in California. As a matter of fact, we filed an additional 6.9% rate to stay ahead of the loss trend because you don't want to get behind in California. But we are now writing in California, and we're spending some marketing dollars there. The two that on the other side of the country, New York and New Jersey are ones that we're still effectively managing what we write. And we're writing very low volumes of business. Having said that, we've gotten rate approvals in New York. We're in active conversations with the department on a 24% rate that we filed that we hope to get resolution on hopefully reasonably soon. And then we'll revisit that stance. And in New Jersey, we got rate approved at the end of last year. We just implemented another low teens rate in July, and we've got another one coming in December. And as we evaluate where that positions us we'll reassess our risk appetite and how much we want to invest. And I'll go back to saying what I've said multiple times is our objective function is to be able to write in every state. But the reality is we need to see a path to attractive returns and profitability to be able to do that once we get there, then we'll expand our appetite across geographies."
},
{
"speaker": "Tom Wilson",
"text": "I would just add a couple of things. First, I don't think we'll ever be at 100%. But I also that that the high-growth competitors that your competitor, I guess, you're comparing us to, it probably has the same situation. Like not everything goes well in every state in this business. So I can see what people are trying to do. You're trying to triangulate between the gap of a small decrease in auto insurance to what's the increase is going to be and how does that translate into the increase in valuation multiple. Appropriate thing, we're focused on it as well. I would just say that the gap between the current growth and what potential is probably narrower than the gap that between the valuation, like our valuation multiple could be substantially higher even with small moves in the growth rate. You have to decide what you think that's worth and whether you want to pay for it or not. But I think that focusing -- it's not going to be a one-to-one thing, and it's not all going to happen at the same time. But we're confident we can grow like we know how to run this business."
},
{
"speaker": "David Motemaden",
"text": "Great. Thank you."
},
{
"speaker": "Operator",
"text": "Thank you. And our next question comes from the line of Vikram Gandhi from HSBC. Your question, please. Vikram, you might have your phone on mute. We're still not hearing you. Would you like me to…"
},
{
"speaker": "Tom Wilson",
"text": "Why don't we go to the next question?"
},
{
"speaker": "Operator",
"text": "All right. Our question then comes from the line of Charles Lederer from Citi. Your question please."
},
{
"speaker": "Charles Lederer",
"text": "Hi, can you talk about the new issued app mix on Slide 8, I guess how does your customer appetite differ across channels as you open things back up? And how do you see that impacting your margins given direct tends to have a higher upfront expense ratio as I understand it?"
},
{
"speaker": "Tom Wilson",
"text": "First, I would say we want all customers all locations or most locations, but all risk levels. Mario, do you want to talk about maybe specialist, not general or non-standard."
},
{
"speaker": "Mario Rizzo",
"text": "Yes, Charlie, I'd say from a channel perspective, like in the Allstate brand, we have differentiated pricing between agency and direct. So we have we have the ability to do that to match the cost of doing business in the channel with the price that we charge. In terms of underwriting risk appetite, we write in standard and preferred across the entirety of the risk segment. And if we have the right price in the agent channel, we're right in the agent channel, and we'll also write it indirect. So there's very few exceptions in terms of different underwriting standards across channels. In terms of brands, the one risk segment that I think is new in the sense of we acquired it when we acquired National General is the nonstandard auto business, which historically Allstate really didn't participate in, in a meaningful way. That's a very well-run business. That's the lion's share currently of the nonstandard auto premium, generating really strong growth unit growth just under 12% with really strong profitability. And the one thing I'd say on that segment of business, there tend to be a lot of shoppers in that segment. So you can turn growth on and off a lot more rapidly. You tend to be able to reprice the book pretty quickly because the retention is lower. And I think that's become a real growth lever for us. As you can see in our numbers, we've been able to grow that business grow it profitably because we now have the right capabilities to write in that segment, which we didn't have when we started transformative growth. So but we're -- as Tom mentioned, we're positioned to write across channels, across brand and equally importantly, risk segments through National General in nonstandard Auto. But now, as I've talked about, Custom360 and rolling out middle market standard preferred and homeowner product, we can go upmarket in the independent agent channel as well. But we're positioned to write across the entirety of system."
},
{
"speaker": "Tom Wilson",
"text": "Okay. Thank you all for spending your time with us as we move forward, we'll keep doing what do well, which is to serve our customers. We're going work on accelerating our growth in the profit liability business, making sure we're proactively investing and we didn't have spent a lot of time on that today, but we've had really great results in our investment portfolio. And then expanding protection offerings through great platforms like Protection Plans. Thank you all. We'll see you next quarter."
},
{
"speaker": "Operator",
"text": "Thank you, ladies and gentlemen, for your participation in today's conference. This does conclude the program. You may now disconnect. Good day."
}
] | The Allstate Corporation | 18,711 |
ALL | 1 | 2,024 | 2024-05-02 09:00:00 | Operator: Good day, and thank you for standing by. Welcome to Allstate's First Quarter Earnings Investor Call. [Operator Instructions] As a reminder, please be aware that this call is being recorded.
And now I'd like to introduce your host for today's program, Brent Vandermause, Head of Investor Relations. Please go ahead, sir.
Brent Vandermause: Thank you, Jonathan. Good morning, and welcome to Allstate's First Quarter 2021 Earnings Conference Call. Yesterday, following the close of market, we issued our news release and investor supplement, filed our 10-Q and posted today's presentation, along with our reinsurance update on to our website at allstateinvestors.com. Our management team is here to provide perspective on these results and our strategy. After prepared remarks, we will have a question-and-answer session.
As noted on the first slide of the presentation, our discussion will contain non-GAAP measures for which there are reconciliations in the news release and investor supplement and forward-looking statements about Allstate's operations. Allstate's results may differ materially from these statements, so please refer to our 10-K for 2023 and other public documents for information on potential risks.
Before I turn the call over to Tom, I would also like to provide an update on our monthly financial disclosures since early 2022, and implemented rate actions from the prior month have been included in our monthly release and disclosed on our Investor Relations website to provide additional transparency on our proactive response to the rapid rise in loss costs. Going forward, our implemented rate disclosures for auto and homeowners insurance will be disclosed on a quarterly basis instead of monthly within our investor supplement.
And now I'll turn the call over to Tom.
Thomas Wilson: Good morning. Thank you for investing your time and have interest in explaining why Allstate's such an attractive [indiscernible]. And then Mario and Jesse are going to walk through the operating performance. And then as Brent mentioned, as there we'll have time for Q&A.
Let's begin on Slide 2. Allstate strategy has 2 components, which is shown on the left there, increased personal property-liability market share and expand protection provided to customers. On the right-hand side, you can see the highlights for the quarter. So we generated net income of $1.2 billion in the first quarter. The profit improvement was broad-based. It reflects successful execution of the auto insurance profit improvement plan, attractive homeowners' insurance margins, and they also benefited from lower catastrophe losses in this quarter.
Net investment income was up almost 33%, reflecting the 2022 and 2023 repositioning into longer duration, higher fixed income yields and then yields also went up some. And We had good performance-based valuations this quarter as well. Protection Services also had a good quarter, and that was led by Protection Plans and Roadside Services; if you go; down to the bottom, what do we do from here, we have a broad approach to further increase shareholder value.
First improving auto profitability in underperforming states will increase returns. Secondly, we're focused on increasing policies in force under the Allstate brand while continuing to expand National General. Mario is going to talk about that in a few minutes. Allstate's integrated approach to investing has and will continue to create value for shareholders. Expanding protection services will benefit both our customers and shareholders. And then the sale of the Health and Benefits business to a buyer that can further leverage our success will create more shareholder value. Although I'd point out, it will have a short-term negative impact on return on equity.
Let's review the broad-based profit improvement on Slide 3. So revenues were $15.3 billion in the first quarter, reflecting a 10.9% increase in Property-Liability earned premium and that, of course, was primarily due to kick rate increases in both auto and homeowners insurance. Over the last 12 months, property-liability written premiums have increased by almost $5 billion on an annual basis. Net investment income in the quarter was $764 million, or $32.9 for the prior year, and that reflects those higher fixed income yields and the duration extension I just mentioned. The strong profitability in the quarter generated adjusted net income of $1.4 billion or $5.13 per diluted share.
Now let me turn it over to Mario to go through property liability results.
Mario Rizzo: Thanks, Tom. Let's start on Slide 4. Property-Liability earned premium increased 10.9% in the first quarter, driven by higher average premiums. Underwriting income was $89 million, the combined ratio of 93%, which improved by 15.6 points compared to prior year was driven by higher premiums earned, improved underlying loss cost trends, lower catastrophe losses and operating efficiencies. The chart on the right depicts the components of the 93 combined ratio. Lower catastrophe losses of $731 million were 8.8 points favorable to the prior year quarter, reflecting milder winter weather.
The underlying combined ratio of 86.9% improved by 6.4 points compared to the prior year quarter. The improvement was driven by higher average premium and moderating loss cost increases. Expense reduction programs also benefited results more than offsetting higher advertising spend. Prior year reserve reestimates, excluding catastrophes, had only a small impact on results. Favorable development in personal auto and homeowners insurance largely offset increases in personal umbrella liabilities and commercial auto reserves for the transportation network contracts we began exiting in late 2022.
Now let's take a closer look at auto insurance profitability on Slide 5. The first quarter recorded auto insurance combined ratio of 96 improved by 8.4 points compared to the prior year quarter, showing that our profit improvement plan is working. The left chart shows quarterly underlying combined ratios. You will remember, we showed this chart last year, which adjusts 2022 and 2023 quarterly reported figures to reflect the updated average severity estimates as of the end of each respective year. As you can see, the underlying combined ratio improved sequentially in each of the last 5 quarters to 95.1% in the first quarter of 2024.
The chart on the right shows that in the first half of 2023, premium increases in dark blue were being offset by higher underlying losses and expenses. Profits began to improve in the third quarter of 2023 as premiums outpaced loss and expense increases and this continued in this year's first quarter. The slight first quarter drop in underlying loss and expense reflects lower claim frequency that benefited from milder weather and improved operating efficiencies, partially offset by higher severity.
Relative to the prior year quarter, average underlying loss and expense in the first quarter of 2024 was 6.7% higher as you can see at the top of the table. This reflects higher current year incurred severity estimates, primarily driven by bodily injury coverage, which was partially offset by lower accident frequency and the favorable impact on current year severity of favorable prior year reserve development in the Allstate brand.
Given the impact that good weather had on frequency in the quarter, favorable frequency may not persist as the year progresses. While auto margins have improved due to our price improvement actions we remain focused on ensuring that rate levels continue to keep pace with underlying cost trends driving improved profitability in those states not yet achieving target margins.
Slide 6 shows how auto profit improvement supports pursuing policy growth. As shown on the left, Allstate brand implemented rate increases exceeding 16% in both 2022 and 2023. In the first quarter of 2024, we implemented rate increases of 2.4% to keep up with the cost trends and improve margins in states not achieving target margins. The chart on the right depicts the Allstate brand auto proportion of premium in states with an underlying combined ratio of below 96%, shown by the dark blue bars. As more states have achieved target returns, we have started to increase marketing investment, both nationally and in those states. Slide 7 shows that while Allstate brand policies in force decreased compared to prior year, albeit at a slower rate than last quarter, over half that decline was offset by growth at National General.
On the left, you can see that total protection auto policies in force decreased by 2% and compared to prior year due to a decline of 5.2% in the Allstate brand, reflecting the continued impact of auto insurance profit improvement actions. Underneath this decline is the positive impact of higher Allstate agent productivity and direct channel sales. Customer retention in the Allstate brand also continued to improve, and that improvement has a significant impact on growth trends. Allstate brand auto retention of 86% improved by 0.3 points compared to prior year, as the negative impact of large rate increases in 2022 and 2023 begins to moderate.
As we discussed last quarter, we received approval for rate increases in the profit challenge states of California, New York and New Jersey, which were affected this quarter. Renewal trends in those states were stable in the first quarter, but the full impact on customer retention had not yet impacted growth. Allstate brand new business also increased 7% versus the prior year, reflecting more advertising and increased Allstate agent productivity and direct sales.
National General was another positive to growth. Policies in force increased by 12.6% over the prior year due to an increase in nonstandard auto insurance and the continued rollout of a new middle market standard and preferred auto insurance product, also known as Custom360.
Slide 8 summarizes homeowners insurance profitability, which generated strong returns in the quarter. Homeowners insurance provides a differentiated customer experience and represents an additional growth opportunity across channels. The chart shows the homeowners combined ratio over time, achieving a 10-year average of approximately 92. The first quarter combined ratio of 82.1 translated to $564 million of underwriting income and improved 36.9 points compared to prior year, primarily driven by lower catastrophe losses. The underlying combined ratio of 65.5 also improved by 2.1 points due to higher average premium and lower noncatastrophe claim frequency.
Allstate Protection homeowners generated double-digit written premium growth compared to prior year, reflecting higher average gross written premium per policy and policies in force growth of 1.4%. Allstate agents continue to bundle auto and homeowners insurance at historically high levels. And National General's Custom360 product offers additional growth opportunities in the independent agent channel. Allstate has created an industry-leading business model, and we remain confident in our ability to generate attractive risk-adjusted returns.
Moving to Slide 9, let's discuss the property liability growth opportunities. Starting on the first row. Improving customer retention remains key to improving our growth trajectory. Auto retention levels have stabilized and sequentially improved over the last two quarters and homeowners retention improved 0.8 points to the prior year quarter. Our agents and employees continue to guide customers through the renewal process by offering coverage options and ways to save through innovative programs and discounts like Drivewise and Milewise telematics offerings.
Growth can also be increased by easing new business restrictions. As rate adequacy has been achieved in more states, restrictive underwriting policies have been unwound in states representing more than 75% of Allstate brand auto premium. Increased Allstate brand advertising is also expected to increase growth. The components of transformative growth are being implemented to create sustainable growth. An improved competitive position will result from further expense reductions.
Expanded customer access comes from increased Allstate agent productivity, enhanced direct distribution and the expansion of Custom360 to more independent agents. A new Allstate brand, affordable, simple and connected auto insurance product is available in 9 states on the direct sales side. Online quote completion time has been reduced by 40% to less than 3 minutes within the new technology ecosystem. This platform will be expanded to the Allstate agent channel this year into more states and homeowners over the next several years. With these growth levers, Allstate is positioned to generate sustainable, profitable growth.
Now I'll turn it over to Jesse to talk about other operating results.
Jesse Merten: Thank you, Mario. I'm moving to Slide 10, let's discuss the increase in investment income. Before we dig into specifics, let me reiterate that our active portfolio management includes comprehensive monitoring of economic conditions, market opportunities, interest rates and credit spreads by rating, sector and individual names. We seek to optimize return per unit of risk across the enterprise. This approach to portfolio management continued to benefit results in the quarter. Net investment income shown in the chart on the left totaled $764 million in the quarter, which is $189 million above the first quarter of last year.
Market-based income of $626 million shown in blue was $119 million above the prior year quarter as the fixed income portfolio continues to benefit from repositioning into longer duration and higher yielding assets that have sustainably increased income. Performance-based income of $201 million shown in black was $75 million above the prior year quarter due to higher valuation increases and was above the trend that we have seen in recent quarters but lower than 2022.
The performance-based portfolio is constructed to enhance long-term returns and volatility on these assets from quarter-to-quarter as expected. Total portfolio return of 0.5% for the quarter and 4.8% for the last 12 months which is shown in the table below the left chart indicates that a balanced approach to risk and return creates shareholder value. The chart on the right shows changes made to the bond portfolio duration in comparison to interest rates over time. Higher income this quarter reflects increases in duration as inter rates rose in 2022 and 2023. The table below the chart shows fixed income portfolio earned yield was 4.1% at quarter end, but 0.7 point increase compared to 3.4% for the prior year quarter.
Slide 11 breaks down the growth and profit performance of the Protection Service businesses. Revenues in these businesses increased 12.2% to $753 million in the first quarter compared to the prior year quarter. This result is mainly driven by growth in Allstate Protection Plans, which increased 20.5% compared to the prior year quarter, reflecting expanded product breadth and international growth. In the table on the right, you will see adjusted net income of $54 million in the first quarter increased $20 million compared to the prior year quarter. The increase was primarily attributable to 2 businesses. Profitable growth in Allstate Protection plans resulted in adjusted net income of $40 million, representing an increase of $12 million compared to the prior year quarter, higher revenue and improved claims trends benefited the bottom line. Allstate Roadside had adjusted net income of $11 million, driven by increased pricing, improved provider capacity and lower costs.
Shifting to Slide 12, the Health and Benefits business continued to perform well. For the first quarter of 2024, revenues of $635 million increased by $52 million compared to the prior year quarter, driven by premium growth in individual and group health in addition to higher fees and other revenue in those businesses. Adjusted net income of $56 million in the first quarter was consistent with the prior year quarter as individual health fee income growth was offset by lower employer voluntary benefit income.
On Slide 13, we'll wrap up our prepared remarks where we started by reiterating Allstate's strategy and opportunities to increase shareholder value; improving auto insurance profitability, pivoting to growing auto and homeowners' policies in force, proactive risk and return management of the investment portfolio, expanding Protection Services and completing the sale of Health and Benefits, which we expect to occur in 2024.
With that context, let's open up the line for your questions.
Operator: [Operator Instructions] Our first question comes from the line of Jimmy Bhullar from JPMorgan.
Jamminder Bhullar: So my first question was just on your views on PIF growth. And I realize it's going to be challenging in the near term, just given price increases. But with the expense cuts and coming through and once you're done with repricing, do you think that it's reasonable to assume that you'll have positive growth beginning sometime later this year or early next year in the auto business?
Thomas Wilson: Jimmy, we do believe that it's time to pivot to growth that we has had restrict growth so we could get profitability up in the auto insurance business. We're not done with it yet, but we feel that the trajectory is good and we get a path forward on that. Mario went through the long list of various ways we can do it. First, of course, you just keep more of your existing customers. And then we have a bunch of other ways that we think we can grow new business.
When that will actually turn by quarter will be dependent on what happens in the marketplace. But it is, we believe, the really great opportunity to increase shareholder value because when you look at our valuation relative to a higher growth company like Progressive, it's -- there's a substantial discount. And we believe that this pivot to growth will drive more shareholder value. Mario, anything you want to add to that?
Mario Rizzo: No, I think that covers it in. The only thing I'd say is in the Allstate brand, obviously, we continue to see the impacts of the profit improvement plan that we've implemented over the last couple of years. But we're starting to see, as Tom mentioned, some positive signs on retention as well as an uptick in production. And first, we need to see sequential growth before we'll get to annual year-over-year growth. And I think it's important to point out in National General. We continue to see really strong growth in that business, along with really strong profitability that we're encouraged by. And we think there's -- most of that growth in National General is coming in the nonstandard auto insurance business, we think there's an additive opportunity that we're going to continue to go after, as I mentioned, with Custom360. So opportunity across all brands and all channels going forward.
Jamminder Bhullar: And can you talk about progress on the benefit sale? Obviously, from the outside, we haven't seen any movement. But -- and then just how you think about the deployment of the proceeds that come out of that sale?
Jesse Merten: Jimmy, this is Jesse. So as it relates to the process, I would say things are progressing as expected on the pursuit of the divestiture. You'll remember we announced the intention to pursue the sale about 6 months ago, almost to the day. And as you might expect, there was robust interest from a large group of quality potential buyers on both strategic and financial. So diligence on a large complex business takes some time in so to selecting the right potential buyers to stay involved in the process. At this point, we're pleased with how the process is progressing, and we're confident that we'll be in a position to select a buyer that sees the same potential in the business that we do and is aligned with our strategic rationale for the sale. So we continue to pursue the divestiture as we said. And obviously, we'll let you all know as soon as we have a definitive agreement in place and offer more details at that time.
Thomas Wilson: Jim, let me make a comment about the capital since it came up -- you mentioned that it came up at a number of the analyst write-ups last night. So first, we're very well capitalized. We've made that point consistently over the last couple of years. Obviously, the divestiture of health and benefits would free up additional capital. We're doing it because we believe it's the right way to harvest value, as Jesse pointed out. We think this is a great business that's shown up in the people who have been interested in buying it, but we also think that somebody else could do more with it than we can do with.it.
When you look at capital utilization, I would say that it's embedded in kind of a like from our strategy to enterprise risk and return to reinsurance to how we price homeowners insurance in a local market. And a couple of things I would say all those decisions are made with math, highly sophisticated math. So sometimes I think that confuses some people when we have more sophisticated math than things like premium surplus ratios.
But when we do that, we're looking at what the impact is economically and what the impact is on shareholder value. And we look at a really wide range of alternatives. First -- the first best opportunities of organic growth, given the high returns in our auto home protection plan businesses, we get really good returns there. And as I mentioned, we think that will drive increased valuation in the stock without earnings. After that, you said, well, share repurchase, a number of people asked about share repurchases. It's another thing that we look at.
We've -- as you know, we bought back a lot of stock since we went public we've bought back almost $42 billion worth of stock, which is 83% of shares outstanding. If you look over the last 10 years, it's about half the shares and about $20 billion, you look over 5 years, that's 1/4 of the shares and about $10 billion. So we have no aversion to that. When you say, well, what kind of return do you get on that? Of course, it depends on what price you bought it at and what day you're marking it to market.
It is low point, it tends to look like cost of capital. Today, it looks like it's in the 10% to 14% range, depending on what period of time we look at. So that's a good return, one that we think benefits shareholders. On the other hand, it's not as good as at which we get from deploying it in those businesses. So deploying getting growth is why we believe that we have a whole bunch of other things we look at. We could increase the equity allocation and investment portfolio.
As we've told you, we're -- we have a bimodal approach there. About 60% is illiquid. We hang on to over ups and downs and 40%, it's liquid, we're down at the lowest level we've ever been in liquid equity securities. And we did it because we didn't like the risk in return. We're not trying to be a hedge fund, but we thought we had better places to put the money. We could decide we want to dial up there. Sometimes we put opportunity money in new capabilities, Arity.
If you look at Arity, we've now got 1.5 trillion miles of driving data. We're getting over $1 billion a week. We're expanding that from just pricing people who are our customers to pricing people before they become customers, which makes you be more efficient in marketing and advertising. Sometimes we acquire companies. So if you look at our protection plans business, it's like 10x its size and we bought it for $1.4 billion. We look at National General, we paid $4.1 billion, I think just -- and that's like double its size.
So we did -- haven't done as well harvesting the value out of our identity protection business yet, but we're confident we got the right pick there that people are at greater risk, recently figure out how to grow it faster and make more money. So we have a whole bunch of opportunities that we look at. So I don't think you should just automatically default to something that falls into an easy analysis if you got the extra money to do share repurchases. No, we'll think about it hard. We'll do the right thing for shareholders, and then we'll make sure we're communicating with people.
Operator: And our next question comes from the line of Andrew Kligerman from TD Cowen.
Andrew Kligerman: Yes, it seems like your PIF growth is right around the corner of pivoting down only 1.4% year-over-year. So I'm wondering on the Allstate brand your expense ratio on advertising was 2.2%. Historically, if I look back at 2017 to '19, it was roughly 2.5%. So is there First question, is there much to go in terms of your ad campaigns? Or do you feel like you're kind of at a level where you need to be?
Thomas Wilson: I'll let Mario talk about how he's reorganizing the business and really going to market in an integrated fashion to drive growth. As it relates to advertising, we don't like to give those numbers out just because we've got other people out there doing their advertising as well. What I will point out is one of the key components of transformative growth was improving our sophistication of customer acquisition. So no matter what percentage it is we want it to be more effective. But Mario, maybe you should talk about how you're changing your go-to-market.
Mario Rizzo: Yes. Thanks for the question, Andrew. I guess where I start. First, the good news, as we pointed out, in the presentation as more and more states are achieving rate adequacy. And right now, in about 75% of the states we operate in, we've began to unwind underwriting restrictions. And to your point, begin investing in marketing to look to grow.
The other thing we've done in anticipation of that opportunity, not only being there, but continuing to expand, is we're organizing ourselves in what we call go-to-market teams that are local market focused that are really intended to drive kind of bottoms-up opportunity, identification and capture again, at the local market level so that we can get the highest possible return on things like the marketing investments we're making, the continued expansion, up distribution as well as the growth opportunity that exists across channels in those states.
So we're early days in that, but we are putting behind our organization structure to be more focused on local market growth. And you remember, we manage this business state by state, market by market. So having local market insight, intelligence and the ability to move rapidly to capture opportunities is really going to be critical. And we think that alongside the expanded investment we're making in growth, will create significant growth opportunity for us going forward.
Thomas Wilson: And we know that it works because we've used it for a long time. So -- and we dismantled some of it about 2 or 3 years ago when we were cutting expenses that didn't want to grow. And now that we're back into growth mode, we're just expanding what we know works.
Adam Klauber: That's very helpful. And then the second question with regard to National General, just trying to get my arms around, how much growth potential there? How much of the book right now is nonstandard versus the Custom360s. The Custom360 relatively very small. And are those the right agents to generate big time growth on the more traditional or more standard products?
Thomas Wilson: Well, we wouldn't give out that percentage in each, but you're correct. And then it's -- when we bought National General, it was mostly a nonstandard company. And we bought it for the strategic opportunity to leverage our capabilities in, which is called preferred auto and home insurance, and that's turning out to be true. Mario, maybe you want to talk about the success you're having with Custom360.
Mario Rizzo: Yes. So Andrew, I guess the place I'd start is, first of all, we're really happy with the acquisition of National General. As Tom mentioned, we've effectively doubled the size of our independent agent business since we bought it in early 2021. And there's really 3 pieces to the business. There's the nonstandard auto piece, which is the by far the biggest component. And then there's what we call the legacy household business, which is think about our Encompass business that we integrated into it along with the legacy National General Standard Auto, Preferred and home business. And then there's Custom360.
And Custom360 is the new product offering. We're in about 17 states currently with the intent to expand pretty much into every state by the end of this year or into 2025. And we think that really represents an additive growth opportunity. The product offering itself is built on the Allstate product chassis. So think about the sophisticated rating plans that we have in standard and preferred auto in Allstate, the host and home product that we have in Allstate.
So those are the products that we're launching in the independent agent channel. And really, to your point, there's a different distribution, a different segment of the independent agent distribution system that we're looking to engage with to really grow that product portfolio. We're early stages. As I said, we're in 17 states. We're really encouraged by the early growth that we're seeing in the states that we've rolled out and more importantly, the agency engagement we're seeing on the IA side. We're going to continue to look to expand on that and leverage that going forward, but we're really optimistic around Custom360 and the opportunity beyond nonstandard auto and the IA channel.
Operator: And our next question comes from the line of Gregory Peters from Raymond James.
Charles Peters: So for the first question, I'd like to just have you comment on both frequency and severity, frequency trends through the first quarter and sort of how you're thinking about severity for 2024, both inside the Allstate brand and also at NatGen.
Mario Rizzo: Thanks, Greg. This is Mario. I'm going to make some comments off the slide -- off of Slide 5 that we showed you in the presentation, which really shows the -- starts with the average underlying loss and expense trend that we saw in the quarter. That number is about 6.7%. If you take out the expense component, it drops by over 1 point. So I'd say the loss trend we're seeing in the protection business in the mid-5s, and that's made up of both frequency and severity. As we indicated, frequency relative to last year, just given the milder weather was favorable. And then the other component of it is severity. So it's, I'd say, favorable frequency more than offset by higher severity. But severity is continuing to moderate in terms of the rate of increase that we're seeing.
Maybe a little bit of color underneath severity broadly because really, there's 2 different emerging stories both in physical damage and in injury. And physical damage, we continue to see the benefit of things like lower used car prices. Total loss severity continues to drop. But it continues to cost more to fixed cars, and that's made up of continually increasing parts prices and labor costs. So we've seen increasing severity and physical damage repairable -- for repairable vehicles, but not at the same rate we have been seeing before. That has moderated.
The real ongoing severity pressure is in beyond the injury side, which continues to run at higher than historical levels. That's driven by a lot of the things we've been talking about, medical treatments, medical consumption, inflation. It's also being driven by the fact that more of our customers continue to get sued and attorney representation levels continue to increase and that's putting pressure on severity. It's also resulting in higher cost for consumers ultimately. The cost to settle injury claims going up at the level that it is translating into higher insurance prices for consumers.
I'd point out a state like Florida, where last year, they passed meaningful tort reform, and we're starting to see some positive impacts of that tort reform, which I think will bode well for consumers going forward.
Georgia just -- the Georgia legislature just passed some tort reform, which, again, can be a positive for consumers going forward. And obviously, we're a strong proponent of that kind of reform broadening across more states going forward. But Greg, to your question, positive frequency in the quarter, hard to quantify with any degree of precision what the weather was worth, but it was favorable, offset with severity levels that are running lower than they have been running, but still at positive levels, which is why we're going to stay on top of pricing to make sure that our rates fully reflect loss trends and keep pace with loss trends in the states that we've reopened for growth and continue to pursue rates in states where we haven't achieved target profitability yet. And that would be true both in the Allstate brand and National General.
Charles Peters: I guess in conjunction with that answer, you brought up rate. And I know you mentioned that you're not going to provide us updates on pricing going forward because you're rate adequate. I know -- if you go back to previous presentations, you've called out 3 states. And even after you reported fourth quarter, you still were I think New Jersey and New York were kind of still in the question mark period. Has there been some updates there in those 2 states that you want to give us that leads you to believe that they are rate adequate now too as well?
Thomas Wilson: I'll let Mario go into the 3 states, but I just want to clarify. We decided not to give it to you every month because -- we don't -- we think you get to drill, you know what we're doing, and we don't need to do it. We didn't say we're very adequate so don't worry about it. We're always focused on it. We just didn't think we needed to like burden people sending out every month.
Mario Rizzo: Yes, Greg, it's Mario. I'll just give you a little more color on those 3 states. Remember, last quarter, we told you we had just got an approval in the fourth quarter for auto rate increases in all 3 of those states. In California -- and we implemented those rate increases this past quarter. In California, we feel comfortable of where the rate level is with the increase, and we've reopened California for new business. really no change in New York and New Jersey in terms of our underwriting risk appetite, even with the rate approvals that we got late last year.
We still don't feel like we're at the appropriate rate level to want to grow in those two states. The only update I'd give you on one of the states is, New Jersey recently approved a 13.9% auto rate increase, which was one of the filings we had pending. That will be effective in the second half of this year. We're still going to need more rate beyond that before we would look to reopen that market. And in New York, we're having ongoing conversations around a pending rate that's with the department, but really nothing new to report at this point. And in those two states, in particular, we have not lifted any of the underwriting restrictions that we have in place.
Operator: And our next question comes from the line of Bob Jian Huang from Morgan Stanley.
Jian Huang: Maybe just going back to the PIF growth and rates -- for Slide 6, if we look at the states that are above 96% combined ratio, I know that you talked about New York, New Jersey, California, but are there any other reasonably large states where you continue to need rates? And in those states, are you -- like comparing to your peers, is your loss ratio significantly above everyone else? Or in other words, if you were to raise rates in those states, do the customers have anywhere else to go?
Thomas Wilson: Well, that's a complicated question. Let's see if I can address it. So in all states, when you have severities going up the way Mario described it. You're going to be increasing rates at levels above what is the general inflation rate. So we expect to continue to have to do that. If our customers quick and sued every time they get an access, then maybe it will back off some. But -- so we're always moving rate up. You're really get into where is your competitive position.
And I think it's difficult right now to determine where one's competitive position is in any individual state given how rapidly rates are moving and how they're moving through books of business, given how -- and so that said, we're confident that with transformative growth by reducing our expenses will end up in a lower cost, more competitive position than when we started this 4 years ago whatever place. It's just this blip in here where everyone is raising prices a lot, including us, as Mario pointed out, in auto alone, it was 16% in each of the last 2 years.
Homeowners is not -- it's slightly lower, but also has the same trends to it. So -- we feel confident that the product offering we have, the technology we have, the agents we have, the broad set of distribution that will enable us to grow. Price is clearly an important part of that. And we're focused on making sure we're competitive, but we're not going to not take rate so that we can grow. One of our big competitors, State Farm's picked up almost a couple of points of market share over the last couple of years because they chose to run fairly large underwriting losses that won't be us.
Jian Huang: Okay. That's very helpful. But just curious, are there any other relatively large states outside of New York, New Jersey, California, where you still need rate at this point in time?
Mario Rizzo: No. Like if you go back to Page 6 that you mentioned that the top bar on the right, the 26%, the vast majority of that is those 3 states: California, New York and New Jersey. And then the -- both the light blue and the dark blue, when you kind of add those together, and we talked about unwinding underwriting restrictions in about 3/4 of the states. Again, we base those decisions on rate adequacy versus kind of a backward-looking combined ratio.
And we feel good about where we're positioned the growth opportunity, and as we said a couple of times, we're going to stay on top of the loss trend in those states. But the states that are in that top section are the ones that we're going to continue to push incremental rate through because we're not at target margins yet.
Operator: And our next question comes from the line of Elyse Greenspan from Wells Fargo.
Elyse Greenspan: My first question is on the auto. I guess it's more on the underlying loss ratio. I thought in the past, right, the first quarter would seasonally be a better quarter for just an auto book in general, but understanding rate increases that can earn in can kind of mask that as we go through the year. And then I'm also not sure if there was maybe some favorable non-cat weather in the Q1 numbers. So just can you give us a sense of the cadence would you expect on the underlying loss ratio within auto to improve as we go through the year given the rate to earn in? Or is there some seasonality or other factors that we need to consider?
Thomas Wilson: Let me start, and Mario, you can jump in. First, you're correct in that first quarter is usually a better quarter in combined ratio in auto insurance than like the summer months when everybody is driving. To be able to do attribution of this current quarter versus other quarters and weather and how much -- what the sustainable [indiscernible] is really difficult to get it with any sort of precision. It's not that we don't try and we look at it when we come up with numbers, but they're not numbers that I would say would be for public consumption.
What I would say is we feel really good about the trend in auto insurance profitability. As you point out, we got a lot more rates still coming through. We've gotten good control over our expenses. We're working hard on claims to try to deal with a high inflationary environment. Make, sure we keep costs down and not just accept that they have to go up at high single digits. So we feel really good about the trend, at least I don't know that I feel like one quarter makes a trend in that, I would say, this first quarter x percent was due to just some [indiscernible]. Mario, anything you would add to that?
Mario Rizzo: Yes. I think, Elyse, the components you mentioned are the right ones. And while I can't -- I'm not going to give you the guidance on continually improving loss ratio going forward. What we do know are a handful of things. Number one, we took over 16 points of rate last year and another 2.4 points in the first quarter. That's going to continue to earn through the book, and you're going to continue to see average earned premium growth going forward. That's just based on the actions we've taken so far.
I talked a little bit about the loss trend earlier and where that was running -- we'll see how that plays out over the duration of the year. The only other piece I'd give you is the frequency component of that, there clearly is a weather benefit we got difficult to quantify. So the frequency benefit may or may not persist going forward. That would be the only thing in addition to just the Q1 seasonality that exists. But we feel good about where the earned premium trend is going and then we're obviously going to watch both components of the loss trend, and we're going to continue to push hard on expenses to drive cost out of the system, which will also help from a margin perspective.
Elyse Greenspan: And then my second question, going back to earlier comments on the Health and Benefits transaction, is your plan still to expect to announce and close the transaction this year? And then I think based on your comments to a prior question, you implied right, that there was conversations with parties. It sounds like you're going down the route of one counterparty instead of perhaps maybe multiple. But can you just confirm, I guess, that that's the thought as well just to find one counterparty to buy the entirety of the business?
Jesse Merten: It's a normal process, Elyse. We're not going to go through [indiscernible] it. We still think we'll sell it this year. A lot of people are interested in the business, and we're confident we made the right choice.
Operator: And our next question comes from the line of Yaron Kinar from Jefferies.
Yaron Kinar: Most of my questions have been asked, but I did want to dig a little deeper into NatGen, if I could, in the PIF growth there. So I understand you have the Custom360 that should drive further growth. At the same time, we also see maybe some competitive pressures rising in nonstandard auto, which may actually result in a little bit of a decrease in that segment's growth? Maybe you can help us think through the two combined.
Thomas Wilson: I'll let Mario jump in, I know you're probably referring to Klauber's numbers. I'll let Mario jump in on state. But let me just mentioned something, I think kind of we talk about, but I'm not sure if it gets as much focus as I think it should, which is homeowners. The homeowners business is a really attractive business for us. We're really good at it. We have an integrated business model that you can see Mario showed the slide where we've earned a 92 combined ratio over a 10-year period. The industry dynamics today. A lot of that business is sold through independent agents, about half of it.
And industry dynamics are right for us to leverage that position. There's a great interest in independent agents and having what they call markets or we would call availability. And when you look at why that is, this is -- the first customer risks are increasing, right, whether that's inflation in home values, whether it's demographic trends, people moving in the way of where there's severe weather or just increased severe weather. So there's increased need for risks. And then at the same time, the industry has lost money.
So the industry lost money over the last 3 years, last 5 years, over the last 10 years, it made money but we made about 3/4 of that money. So the industry made about $10 billion over a 10-year period, and we made about 75% of that. So we're really good at it. And so we think that one of the ways to grow there is in the independent agent channel is by leveraging our homeowners. So we obviously can grow in homeowners in the Allstate agent channel. You see that our bundling stuff, whether you look at any of the industry reports, we're really good at bundling there.
And you see the PIF growth there even when auto growth is going down, which wasn't always the case. They used to trend more together, but we've got so much better at bundling. So that's -- I don't want to leave homeowners on the cutting-room floor, as it relates to growth, both in the National General channel and the Allstate channel. Mario, do you want to talk about that.
Mario Rizzo: Yes. Thanks for the question, Yaron. Look, where I start is the National General nonstandard auto business is a really well-run business for us. And when we acquired NatGen several years ago, it allowed us to get into a business that Allstate was not in at that time in a particularly meaningful way. And we've been able to grow that pretty aggressively and grow it profitably. Over the last several years. Some of the ways we've been able to expand is we've expanded geographically, so we're in a lot more states with nonstandard auto now than when we bought the business.
We've also expanded from a channel perspective, we allow Allstate agents to sell nonstandard auto through National General for business that's outside of Allstate's risk appetite. We sell it direct to consumer. So we've been able to expand the business, both geographically as well as across channels.
And the business has been subject to the same inflationary pressures that the standard and preferred auto business has been subject to. But we've stayed on top of rate need. We've taken a lot of rate over the last couple of years, I believe, over 15 points in the last 12 months. So we've stayed on top of the rate need. It's a business that you can effectively reprice most of the book almost every policy period, just given the deflection rates. And we've been able to, over the last couple of years, take advantage of the competitive dislocation in nonstandard auto as a number of carriers have backed off from that business.
We've taken advantage of that opportunity and taking advantage of by leveraging our capabilities in that space. And as much as the competition might be heating up there, we feel really good about our capabilities, and we're going to continue to look to grow that business as well as the standard preferred and homeowners that Tom talked about with Custom360.
Operator: And our next question comes from the line of David Motemaden from Evercore ISI.
David Motemaden: I had a question just on the brand auto PIF. So the brand auto PIF was down about 1.5% compared to the fourth quarter. And I guess I'm wondering how. And now is for the entire book, the entire brand auto book. I guess I'm wondering how that PIF growth trended versus the fourth quarter in the 64% of the book that is at target margins that you showed on Slide 6, are you guys growing PIF in that part of the book?
Thomas Wilson: We wouldn't break those numbers out for competitive reasons. When it's big enough, so David, you could do math on it. So you could say, okay, here's when the churn is going to come. We would say it. But obviously, there are some markets, we're growing in other markets, we're not growing in. Some of those are markets. Some of those are states. When we get to the point where you can do the math to show when -- I know you -- I totally get where you're going because you want to figure out when the turn is. But we don't like to show what states were growing in at higher rates than others because then they get our competitors interested in going to those states. And we'd rather grow without having them be aware of where we're growing.
David Motemaden: No, understood. It was worth a shot anyway. Just another question, just on the agent productivity. You gave some interesting stats last quarter that agent productivity was up 6% excluding California, New York, New Jersey. I'm just wondering how the productivity looked this quarter. Did that improve significantly? Or just how to think about that as a potential growth driver?
Thomas Wilson: Let me go up to transformative growth and get Mario to talk about the specifics of your question. So as part of transformative growth, we said we want to improve customer value. And that meant getting our agents to really focus on there were those things that customers really want them to do for them, which includes helping them buy insurance. It doesn't necessarily include having them there when they have to pay a bill for retention.
They will pay for that, but they won't pay as much as they will for when they get to new business. So we shifted our compensation program to move to lower our cost for customers and better align it with what customers want to pay for. As a result of that, we both lowered distribution expense and we've had some agents who had the word -- had built business models on higher retention [indiscernible]. So our overall agent capacity in the Allstate brand has gone down. That said, to your point, productivity has gone up, and so our overall volume has been even better when you adjust for those 3 states that are not to be named. So Mario, do you want to go there?
Mario Rizzo: Yes. Thanks for the question. So I think the short answer to your question is yes. We -- when you look at overall Allstate brand new business production is up about 6.5%. It was up both in the Allstate exclusive agent channel as well as direct. And then if you kind of carve out California, New York and New Jersey. Because you have to remember, the California rate wasn't effective until February. So we really didn't start opening things back up until the really the latter part of the quarter.
We're really pleased with how our agents are responding to the changes we've made that Tom talked about continue to invest in their businesses, continuing to drive higher levels of average productivity. And despite the fact that we have fewer agents and have restricted -- or have been restricting grown in 3 pretty significant states.
Overall productivity is increasing and absolute production is up. So we're really happy with the productivity levels of our agents. And as we look to accelerate growth going forward, they're going to be a core part of how we grow prospectively in addition to things we've been talking about with independent agents and the direct channel.
Brent Vandermause: We'll take one more question.
Operator: Certainly. And our final question for today comes from the line of Mike Zaremski from BMO.
Michael Zaremski: I guess just I know there's been a lot of talk about growth. And the strategy has been clear you guys have successfully kind of transformed your expense ratio lower, which should help grow direct-to-consumer channel specifically. And I know Allstate has a ton of marketing expertise. But I'm just kind of curious, the direct-to-consumer -- customer, my understanding is a bit different than the average current Allstate customer. So is there -- are there any different strategies or maybe you kind of -- or just go slow to learn as you kind of grow into DC? Or anything you'd like to -- you think we should be thinking about there?
Thomas Wilson: Yes. The first -- the direct customer does have different needs. So they necessarily want to pay for someone to help them buy insurance, which is why we price our direct insurance under the Allstate brand, cheaper than Allstate-branded insurance bought through an agent. Because we're trying to do exactly what our customers want. They also have different ways they want to interact with us. And so we've -- with our new Transformer growth and new tech stack, it's really everything from what's prepopulated into the thing to the offers it presents to the questions you required to.
As Mario talked about, we're down 40% in the time. We've been able to add other products to that flow and so increase things like roadside services and sell more products, which lowers our acquisition costs. So it is different. We're good at it, we could be better at it. And so we're working at getting better at it. About 2 years ago, we really reformed the business, put some new leadership in place and then are updating everything from the technology I talked about to also who you market to.
So you mentioned they're direct, but some of the customers directly, that's where you go to. Like if you go to people who are shopping all time, then you will get higher risk drivers because they shop all the time as opposed to lower risk drivers don't shop as much. So it costs more to get the lower risk drivers on board. So we're working through how do we expand that. We believe that the direct channel has tremendous upside with us to serve those customers who want it that way not just on auto insurance, but things like home insurance and whether it's protection plans or what we're doing in. We get some stuff going on in the commercial space with direct.
So we think it's just another way the customer would interact. Often -- not a lot of homeowners is sold over direct. We'll see how successful we are. I believe we can. I mean, people buy houses direct. So like if your buyouts or probably buy a home insurance from us. And so there's a great upside. You will notice that when you look over the last couple of years, One of the first places we dialed down new business was in the direct channel. So it was down like 50% or 60%, I think in '23 or something.
Because we wanted to make sure we maintained our agent force levels of compensation because they have businesses right and this is the revenue that comes into their business. We said, okay, well, this is a temporary window it's easier for us to concentrate that reduction in new business in the direct channel than it is to spread it amongst a bunch of agents who are now also trying to get through a new comp plan. That turned out to be a good choice. It gave us the opportunity to build new capabilities. And now we're hitting the gas side expanding direct. So you should expect to see our direct volume is go up higher as a percentage of new business than it has better in the past. Thank you all for joining us and investing your time in Allstate. We'll talk to you next quarter.
Operator: This concludes the investor call. You can now disconnect. Good day. | [
{
"speaker": "Operator",
"text": "Good day, and thank you for standing by. Welcome to Allstate's First Quarter Earnings Investor Call. [Operator Instructions] As a reminder, please be aware that this call is being recorded."
},
{
"speaker": "Brent Vandermause",
"text": "Thank you, Jonathan. Good morning, and welcome to Allstate's First Quarter 2021 Earnings Conference Call. Yesterday, following the close of market, we issued our news release and investor supplement, filed our 10-Q and posted today's presentation, along with our reinsurance update on to our website at allstateinvestors.com. Our management team is here to provide perspective on these results and our strategy. After prepared remarks, we will have a question-and-answer session."
},
{
"speaker": "Thomas Wilson",
"text": "Good morning. Thank you for investing your time and have interest in explaining why Allstate's such an attractive [indiscernible]. And then Mario and Jesse are going to walk through the operating performance. And then as Brent mentioned, as there we'll have time for Q&A."
},
{
"speaker": "Mario Rizzo",
"text": "Thanks, Tom. Let's start on Slide 4. Property-Liability earned premium increased 10.9% in the first quarter, driven by higher average premiums. Underwriting income was $89 million, the combined ratio of 93%, which improved by 15.6 points compared to prior year was driven by higher premiums earned, improved underlying loss cost trends, lower catastrophe losses and operating efficiencies. The chart on the right depicts the components of the 93 combined ratio. Lower catastrophe losses of $731 million were 8.8 points favorable to the prior year quarter, reflecting milder winter weather."
},
{
"speaker": "Jesse Merten",
"text": "Thank you, Mario. I'm moving to Slide 10, let's discuss the increase in investment income. Before we dig into specifics, let me reiterate that our active portfolio management includes comprehensive monitoring of economic conditions, market opportunities, interest rates and credit spreads by rating, sector and individual names. We seek to optimize return per unit of risk across the enterprise. This approach to portfolio management continued to benefit results in the quarter. Net investment income shown in the chart on the left totaled $764 million in the quarter, which is $189 million above the first quarter of last year."
},
{
"speaker": "Operator",
"text": "[Operator Instructions] Our first question comes from the line of Jimmy Bhullar from JPMorgan."
},
{
"speaker": "Jamminder Bhullar",
"text": "So my first question was just on your views on PIF growth. And I realize it's going to be challenging in the near term, just given price increases. But with the expense cuts and coming through and once you're done with repricing, do you think that it's reasonable to assume that you'll have positive growth beginning sometime later this year or early next year in the auto business?"
},
{
"speaker": "Thomas Wilson",
"text": "Jimmy, we do believe that it's time to pivot to growth that we has had restrict growth so we could get profitability up in the auto insurance business. We're not done with it yet, but we feel that the trajectory is good and we get a path forward on that. Mario went through the long list of various ways we can do it. First, of course, you just keep more of your existing customers. And then we have a bunch of other ways that we think we can grow new business."
},
{
"speaker": "Mario Rizzo",
"text": "No, I think that covers it in. The only thing I'd say is in the Allstate brand, obviously, we continue to see the impacts of the profit improvement plan that we've implemented over the last couple of years. But we're starting to see, as Tom mentioned, some positive signs on retention as well as an uptick in production. And first, we need to see sequential growth before we'll get to annual year-over-year growth. And I think it's important to point out in National General. We continue to see really strong growth in that business, along with really strong profitability that we're encouraged by. And we think there's -- most of that growth in National General is coming in the nonstandard auto insurance business, we think there's an additive opportunity that we're going to continue to go after, as I mentioned, with Custom360. So opportunity across all brands and all channels going forward."
},
{
"speaker": "Jamminder Bhullar",
"text": "And can you talk about progress on the benefit sale? Obviously, from the outside, we haven't seen any movement. But -- and then just how you think about the deployment of the proceeds that come out of that sale?"
},
{
"speaker": "Jesse Merten",
"text": "Jimmy, this is Jesse. So as it relates to the process, I would say things are progressing as expected on the pursuit of the divestiture. You'll remember we announced the intention to pursue the sale about 6 months ago, almost to the day. And as you might expect, there was robust interest from a large group of quality potential buyers on both strategic and financial. So diligence on a large complex business takes some time in so to selecting the right potential buyers to stay involved in the process. At this point, we're pleased with how the process is progressing, and we're confident that we'll be in a position to select a buyer that sees the same potential in the business that we do and is aligned with our strategic rationale for the sale. So we continue to pursue the divestiture as we said. And obviously, we'll let you all know as soon as we have a definitive agreement in place and offer more details at that time."
},
{
"speaker": "Thomas Wilson",
"text": "Jim, let me make a comment about the capital since it came up -- you mentioned that it came up at a number of the analyst write-ups last night. So first, we're very well capitalized. We've made that point consistently over the last couple of years. Obviously, the divestiture of health and benefits would free up additional capital. We're doing it because we believe it's the right way to harvest value, as Jesse pointed out. We think this is a great business that's shown up in the people who have been interested in buying it, but we also think that somebody else could do more with it than we can do with.it."
},
{
"speaker": "Operator",
"text": "And our next question comes from the line of Andrew Kligerman from TD Cowen."
},
{
"speaker": "Andrew Kligerman",
"text": "Yes, it seems like your PIF growth is right around the corner of pivoting down only 1.4% year-over-year. So I'm wondering on the Allstate brand your expense ratio on advertising was 2.2%. Historically, if I look back at 2017 to '19, it was roughly 2.5%. So is there First question, is there much to go in terms of your ad campaigns? Or do you feel like you're kind of at a level where you need to be?"
},
{
"speaker": "Thomas Wilson",
"text": "I'll let Mario talk about how he's reorganizing the business and really going to market in an integrated fashion to drive growth. As it relates to advertising, we don't like to give those numbers out just because we've got other people out there doing their advertising as well. What I will point out is one of the key components of transformative growth was improving our sophistication of customer acquisition. So no matter what percentage it is we want it to be more effective. But Mario, maybe you should talk about how you're changing your go-to-market."
},
{
"speaker": "Mario Rizzo",
"text": "Yes. Thanks for the question, Andrew. I guess where I start. First, the good news, as we pointed out, in the presentation as more and more states are achieving rate adequacy. And right now, in about 75% of the states we operate in, we've began to unwind underwriting restrictions. And to your point, begin investing in marketing to look to grow."
},
{
"speaker": "Thomas Wilson",
"text": "And we know that it works because we've used it for a long time. So -- and we dismantled some of it about 2 or 3 years ago when we were cutting expenses that didn't want to grow. And now that we're back into growth mode, we're just expanding what we know works."
},
{
"speaker": "Adam Klauber",
"text": "That's very helpful. And then the second question with regard to National General, just trying to get my arms around, how much growth potential there? How much of the book right now is nonstandard versus the Custom360s. The Custom360 relatively very small. And are those the right agents to generate big time growth on the more traditional or more standard products?"
},
{
"speaker": "Thomas Wilson",
"text": "Well, we wouldn't give out that percentage in each, but you're correct. And then it's -- when we bought National General, it was mostly a nonstandard company. And we bought it for the strategic opportunity to leverage our capabilities in, which is called preferred auto and home insurance, and that's turning out to be true. Mario, maybe you want to talk about the success you're having with Custom360."
},
{
"speaker": "Mario Rizzo",
"text": "Yes. So Andrew, I guess the place I'd start is, first of all, we're really happy with the acquisition of National General. As Tom mentioned, we've effectively doubled the size of our independent agent business since we bought it in early 2021. And there's really 3 pieces to the business. There's the nonstandard auto piece, which is the by far the biggest component. And then there's what we call the legacy household business, which is think about our Encompass business that we integrated into it along with the legacy National General Standard Auto, Preferred and home business. And then there's Custom360."
},
{
"speaker": "Operator",
"text": "And our next question comes from the line of Gregory Peters from Raymond James."
},
{
"speaker": "Charles Peters",
"text": "So for the first question, I'd like to just have you comment on both frequency and severity, frequency trends through the first quarter and sort of how you're thinking about severity for 2024, both inside the Allstate brand and also at NatGen."
},
{
"speaker": "Mario Rizzo",
"text": "Thanks, Greg. This is Mario. I'm going to make some comments off the slide -- off of Slide 5 that we showed you in the presentation, which really shows the -- starts with the average underlying loss and expense trend that we saw in the quarter. That number is about 6.7%. If you take out the expense component, it drops by over 1 point. So I'd say the loss trend we're seeing in the protection business in the mid-5s, and that's made up of both frequency and severity. As we indicated, frequency relative to last year, just given the milder weather was favorable. And then the other component of it is severity. So it's, I'd say, favorable frequency more than offset by higher severity. But severity is continuing to moderate in terms of the rate of increase that we're seeing."
},
{
"speaker": "Charles Peters",
"text": "I guess in conjunction with that answer, you brought up rate. And I know you mentioned that you're not going to provide us updates on pricing going forward because you're rate adequate. I know -- if you go back to previous presentations, you've called out 3 states. And even after you reported fourth quarter, you still were I think New Jersey and New York were kind of still in the question mark period. Has there been some updates there in those 2 states that you want to give us that leads you to believe that they are rate adequate now too as well?"
},
{
"speaker": "Thomas Wilson",
"text": "I'll let Mario go into the 3 states, but I just want to clarify. We decided not to give it to you every month because -- we don't -- we think you get to drill, you know what we're doing, and we don't need to do it. We didn't say we're very adequate so don't worry about it. We're always focused on it. We just didn't think we needed to like burden people sending out every month."
},
{
"speaker": "Mario Rizzo",
"text": "Yes, Greg, it's Mario. I'll just give you a little more color on those 3 states. Remember, last quarter, we told you we had just got an approval in the fourth quarter for auto rate increases in all 3 of those states. In California -- and we implemented those rate increases this past quarter. In California, we feel comfortable of where the rate level is with the increase, and we've reopened California for new business. really no change in New York and New Jersey in terms of our underwriting risk appetite, even with the rate approvals that we got late last year."
},
{
"speaker": "Operator",
"text": "And our next question comes from the line of Bob Jian Huang from Morgan Stanley."
},
{
"speaker": "Jian Huang",
"text": "Maybe just going back to the PIF growth and rates -- for Slide 6, if we look at the states that are above 96% combined ratio, I know that you talked about New York, New Jersey, California, but are there any other reasonably large states where you continue to need rates? And in those states, are you -- like comparing to your peers, is your loss ratio significantly above everyone else? Or in other words, if you were to raise rates in those states, do the customers have anywhere else to go?"
},
{
"speaker": "Thomas Wilson",
"text": "Well, that's a complicated question. Let's see if I can address it. So in all states, when you have severities going up the way Mario described it. You're going to be increasing rates at levels above what is the general inflation rate. So we expect to continue to have to do that. If our customers quick and sued every time they get an access, then maybe it will back off some. But -- so we're always moving rate up. You're really get into where is your competitive position."
},
{
"speaker": "Jian Huang",
"text": "Okay. That's very helpful. But just curious, are there any other relatively large states outside of New York, New Jersey, California, where you still need rate at this point in time?"
},
{
"speaker": "Mario Rizzo",
"text": "No. Like if you go back to Page 6 that you mentioned that the top bar on the right, the 26%, the vast majority of that is those 3 states: California, New York and New Jersey. And then the -- both the light blue and the dark blue, when you kind of add those together, and we talked about unwinding underwriting restrictions in about 3/4 of the states. Again, we base those decisions on rate adequacy versus kind of a backward-looking combined ratio."
},
{
"speaker": "Operator",
"text": "And our next question comes from the line of Elyse Greenspan from Wells Fargo."
},
{
"speaker": "Elyse Greenspan",
"text": "My first question is on the auto. I guess it's more on the underlying loss ratio. I thought in the past, right, the first quarter would seasonally be a better quarter for just an auto book in general, but understanding rate increases that can earn in can kind of mask that as we go through the year. And then I'm also not sure if there was maybe some favorable non-cat weather in the Q1 numbers. So just can you give us a sense of the cadence would you expect on the underlying loss ratio within auto to improve as we go through the year given the rate to earn in? Or is there some seasonality or other factors that we need to consider?"
},
{
"speaker": "Thomas Wilson",
"text": "Let me start, and Mario, you can jump in. First, you're correct in that first quarter is usually a better quarter in combined ratio in auto insurance than like the summer months when everybody is driving. To be able to do attribution of this current quarter versus other quarters and weather and how much -- what the sustainable [indiscernible] is really difficult to get it with any sort of precision. It's not that we don't try and we look at it when we come up with numbers, but they're not numbers that I would say would be for public consumption."
},
{
"speaker": "Mario Rizzo",
"text": "Yes. I think, Elyse, the components you mentioned are the right ones. And while I can't -- I'm not going to give you the guidance on continually improving loss ratio going forward. What we do know are a handful of things. Number one, we took over 16 points of rate last year and another 2.4 points in the first quarter. That's going to continue to earn through the book, and you're going to continue to see average earned premium growth going forward. That's just based on the actions we've taken so far."
},
{
"speaker": "Elyse Greenspan",
"text": "And then my second question, going back to earlier comments on the Health and Benefits transaction, is your plan still to expect to announce and close the transaction this year? And then I think based on your comments to a prior question, you implied right, that there was conversations with parties. It sounds like you're going down the route of one counterparty instead of perhaps maybe multiple. But can you just confirm, I guess, that that's the thought as well just to find one counterparty to buy the entirety of the business?"
},
{
"speaker": "Jesse Merten",
"text": "It's a normal process, Elyse. We're not going to go through [indiscernible] it. We still think we'll sell it this year. A lot of people are interested in the business, and we're confident we made the right choice."
},
{
"speaker": "Operator",
"text": "And our next question comes from the line of Yaron Kinar from Jefferies."
},
{
"speaker": "Yaron Kinar",
"text": "Most of my questions have been asked, but I did want to dig a little deeper into NatGen, if I could, in the PIF growth there. So I understand you have the Custom360 that should drive further growth. At the same time, we also see maybe some competitive pressures rising in nonstandard auto, which may actually result in a little bit of a decrease in that segment's growth? Maybe you can help us think through the two combined."
},
{
"speaker": "Thomas Wilson",
"text": "I'll let Mario jump in, I know you're probably referring to Klauber's numbers. I'll let Mario jump in on state. But let me just mentioned something, I think kind of we talk about, but I'm not sure if it gets as much focus as I think it should, which is homeowners. The homeowners business is a really attractive business for us. We're really good at it. We have an integrated business model that you can see Mario showed the slide where we've earned a 92 combined ratio over a 10-year period. The industry dynamics today. A lot of that business is sold through independent agents, about half of it."
},
{
"speaker": "Mario Rizzo",
"text": "Yes. Thanks for the question, Yaron. Look, where I start is the National General nonstandard auto business is a really well-run business for us. And when we acquired NatGen several years ago, it allowed us to get into a business that Allstate was not in at that time in a particularly meaningful way. And we've been able to grow that pretty aggressively and grow it profitably. Over the last several years. Some of the ways we've been able to expand is we've expanded geographically, so we're in a lot more states with nonstandard auto now than when we bought the business."
},
{
"speaker": "Operator",
"text": "And our next question comes from the line of David Motemaden from Evercore ISI."
},
{
"speaker": "David Motemaden",
"text": "I had a question just on the brand auto PIF. So the brand auto PIF was down about 1.5% compared to the fourth quarter. And I guess I'm wondering how. And now is for the entire book, the entire brand auto book. I guess I'm wondering how that PIF growth trended versus the fourth quarter in the 64% of the book that is at target margins that you showed on Slide 6, are you guys growing PIF in that part of the book?"
},
{
"speaker": "Thomas Wilson",
"text": "We wouldn't break those numbers out for competitive reasons. When it's big enough, so David, you could do math on it. So you could say, okay, here's when the churn is going to come. We would say it. But obviously, there are some markets, we're growing in other markets, we're not growing in. Some of those are markets. Some of those are states. When we get to the point where you can do the math to show when -- I know you -- I totally get where you're going because you want to figure out when the turn is. But we don't like to show what states were growing in at higher rates than others because then they get our competitors interested in going to those states. And we'd rather grow without having them be aware of where we're growing."
},
{
"speaker": "David Motemaden",
"text": "No, understood. It was worth a shot anyway. Just another question, just on the agent productivity. You gave some interesting stats last quarter that agent productivity was up 6% excluding California, New York, New Jersey. I'm just wondering how the productivity looked this quarter. Did that improve significantly? Or just how to think about that as a potential growth driver?"
},
{
"speaker": "Thomas Wilson",
"text": "Let me go up to transformative growth and get Mario to talk about the specifics of your question. So as part of transformative growth, we said we want to improve customer value. And that meant getting our agents to really focus on there were those things that customers really want them to do for them, which includes helping them buy insurance. It doesn't necessarily include having them there when they have to pay a bill for retention."
},
{
"speaker": "Mario Rizzo",
"text": "Yes. Thanks for the question. So I think the short answer to your question is yes. We -- when you look at overall Allstate brand new business production is up about 6.5%. It was up both in the Allstate exclusive agent channel as well as direct. And then if you kind of carve out California, New York and New Jersey. Because you have to remember, the California rate wasn't effective until February. So we really didn't start opening things back up until the really the latter part of the quarter."
},
{
"speaker": "Brent Vandermause",
"text": "We'll take one more question."
},
{
"speaker": "Operator",
"text": "Certainly. And our final question for today comes from the line of Mike Zaremski from BMO."
},
{
"speaker": "Michael Zaremski",
"text": "I guess just I know there's been a lot of talk about growth. And the strategy has been clear you guys have successfully kind of transformed your expense ratio lower, which should help grow direct-to-consumer channel specifically. And I know Allstate has a ton of marketing expertise. But I'm just kind of curious, the direct-to-consumer -- customer, my understanding is a bit different than the average current Allstate customer. So is there -- are there any different strategies or maybe you kind of -- or just go slow to learn as you kind of grow into DC? Or anything you'd like to -- you think we should be thinking about there?"
},
{
"speaker": "Thomas Wilson",
"text": "Yes. The first -- the direct customer does have different needs. So they necessarily want to pay for someone to help them buy insurance, which is why we price our direct insurance under the Allstate brand, cheaper than Allstate-branded insurance bought through an agent. Because we're trying to do exactly what our customers want. They also have different ways they want to interact with us. And so we've -- with our new Transformer growth and new tech stack, it's really everything from what's prepopulated into the thing to the offers it presents to the questions you required to."
},
{
"speaker": "Operator",
"text": "This concludes the investor call. You can now disconnect. Good day."
}
] | The Allstate Corporation | 18,711 |
ALL | 1 | 2,025 | 2025-05-01 09:00:00 | Operator: Good day, and thank you for standing by. Welcome to Allstate’s First Quarter Earnings Investor Call. At this time, all participants are in a listen-only mode. After prepared remarks, there will be a question-and-answer. [Operator Instructions] As a reminder, please be aware that this call is being recorded. And now, I’d like to introduce your host for today’s program, Allister Gobin, Head of Investor Relations. Please go ahead, sir.
Allister Gobin: Good morning, everyone. Welcome to Allstate’s first quarter 2025 earnings call. Yesterday, following close of the market, we issued our news release and investor supplement, filed our 10-Q and posted related materials on our website at allstateinvestors.com. Today, our management team will share perspective on our strategy and how Allstate is creating shareholder value. Then we will have a question-and-answer session. As noted on the first slide of the presentation, our discussion will contain non-GAAP measures for which there are reconciliations in the news release and investor supplement and forward-looking statements about Allstate’s operations. Allstate’s results may differ materially from these statements, so please refer to our 10-K for 2024 and other public documents for information on potential risks. And now, I’ll turn it over to, Tom.
Tom Wilson: Good morning. Thank you for investing your time with Allstate. I’m going to start with an overview of results and then the progress we’re making on transformative growth. Mario, will then cover Property-Liability results. John, will go through investments, and Jess, can talk about Protection Services. Then we’ll, as Allister said, deal with any questions that you have. So, let’s start on Slide 2, which has Allstate’s strategy and first quarter results. Allstate’s strategy, of course, has two components, increased personal Property-Liability market share and expand protection provided to customers, which are shown in this two ovals on the left. On the right hand side, you can see Allstate’s strong performance in the first quarter. Revenues were $16.5 billion in the first quarter, up 7.8% compared to the first quarter of 2024. Allstate generated net income of $566 million in the quarter and adjusted net income of $949 million which is $3.53 per diluted share. Adjusted net income return on equity was 23.7% over the last 12 months. So, we work on shareholder value with a balanced set of priorities. First, generating attractive returns on capital, which you can see from this year this quarter’s results. Growing policies enforced in the Property-Liability and Protection Services businesses will both generate increased earnings and should improve Allstate’s valuation multiples. A diversified investment portfolio generates attractive returns on capital, which John will cover. Proactive enterprise risk and return management is also important and that includes whether that’s utilization of reinsurance, our capital transactions or cash returns to shareholders. Mario will discuss the benefits of our approach to reinsurance when we go through Property-Liability. Jess’ team closed the sale of Employer Voluntary Benefits business for $2 billion on April 1. So, the results of that are not in this quarter, but it’s because it happened shortly thereafter, we want to make sure we call it out for you. And, that’s the first of two large sales from that business segment. As you know, we increased quarterly dividend to $1 a share and instituted $1.5 billion share repurchase program. Slide 3 is an update on the execution of transformative growth strategy in the Property-Liability business. So, there are five integrated components to this strategy to increase market share, one of which is to improve customers’ value and one of the key parts of it is lowering costs. As you can see on the left hand side, the adjusted expense ratio, which excludes advertising costs has improved by 6.7%, so its 6.7 points really, by eliminating outsourcing digitizing work, using less real estate and aligning our distribution expenses with customer value. And, those lower costs enable us to offer more competitive prices without impacting margins. Substantial progress has also been made on other components, several of which are listed on the right. New Allstate branded affordable, simple and connected auto insurance are now available in 36 states and we have the companion homeowners product is now available in six states. Differentiated Custom360 middle market standard and preferred auto for independent agents is shown is now in 31 states. One of the most significant changes is expansion of customer access to improved growth, which resulted in increased new business from all channels this quarter versus the first quarter 2024. This effort has three components, right, improve Allstate agent productivity, expand our direct sales and then increase independent agent distribution, all of which have been successful. Allstate agent productivity has increased, enhancements to direct capabilities are lower pricing and increased advertising are attracting more self-directed customers. The National General acquisition significantly expanded our presence and capabilities in the independent agent channel. So, this quarter personalized new business was 2.8 million items, a 27% increase over the prior year. The S.A.V.E. program, which stands for Show Allstate Customers Value Every Day, following our acronyms, is being embraced by employees and agents with a goal of improving 25 million interactions this year, which builds on last year’s success, which was over 20 million. Our objective is to increase customer retention, an important driver of growth. The combination of strong new business levels and an improvement of retention is a path to market share growth. We’re beginning to see signs of growth. So, property liability policies enforced on a year-over-year business has stopped declining. And of course, that was due to the significant auto price increases and the economic decision to reduce new business in 2022 and 2023. Sequential growth over the end of 2024 was 0.5 point. So, Allstate remains focused on increasing market share and Property-Liability and expanding protection provided to customers. Now, let me turn it over to, Mario.
Mario Rizzo: Thanks, Tom. Let’s take a look at first quarter Property-Liability and underwriting results on Slide 4. As you can see from the table on the left, the Property-Liability business generated $360 million of underwriting income this quarter. The combined ratio of 97.4 was 4.4 points above the prior year quarter, primarily due to $3.3 billion in gross catastrophe losses during the quarter, which was significantly higher than the first quarter of last year. This was partially offset by recoveries from a comprehensive reinsurance program, higher average earned premiums, favorable non-catastrophe prior year reserve reestimates and favorable underlying loss trends. The auto combined ratio was 91.3 in the quarter as average earned premium increases outpaced losses, driven by favorable physical damage loss cost trends. The underlying homeowners combined ratio, which excludes the impact of catastrophes and prior year reserve reestimates, remained in our targeted low-60s range. While there may be fluctuations and catastrophe losses, the homeowners business consistently generates profits with a 10 year recorded combined ratio of 91.5. Now, let’s move to Slide 5, to discuss first quarter catastrophe results in more detail. Our claims team worked tirelessly to support over 70,000 customers as they recovered from the devastating California wildfires and a series of severe weather events that impacted multiple regions across the country in the first quarter. The chart on the left depicts gross catastrophe losses as a percent of earned premium for the last 10-years. As you can see, 2025 represents an outlier year that was more than three standard deviations above the mean driven by the California wildfires represented by the orange bar. We generally do not see wildfire activity in the first quarter of the year. Wind and hail events represented by the dark gray bars were above the 5-year and 10-year averages, but there is no clear pattern over the last 10-years for these barrels. In the table on the right, you can see this quarter’s catastrophe loss ratio and number of events by peril compared to 5-year and 10-year averages. On the second to the last row of the table, you can see the impact of our approach to risk and return management, which includes a comprehensive reinsurance program that reduces capital requirements by lowering catastrophe loss tail risk and earnings volatility. In the quarter, we had reinsurance recoveries of $1.1 billion primarily due to the California wildfires, but recoveries were also generated from aggregate catastrophe losses from events over $50 million that occurred over the past 12 months. As I said earlier, while we expect some quarter-to-quarter volatility in the homeowners line of business, our industry-leading capabilities remain a competitive advantage and we view homeowners insurance as a growth opportunity. Turning to Slide 6, let’s discuss how expanded access under transformative growth is starting to increase growth. In the chart to the left, you can see the composition of Property-Liabilities 37.7 million policies in force. Auto insurance in the dark blue makes up two-thirds of total policies and ended the quarter with $25.1 million policies in force, which was down 0.4% compared to last year. Homeowners with 7.5 million policies is about 20% of the total and continued to grow this quarter increasing 2.5% versus prior year. Total Property-Liabilities policies grew by 0.1% in the quarter. As Tom discussed, expanding distribution to include capabilities across the exclusive agent, direct and independent agent channels is a key component of transformative growth. The stacked bars in the chart on the right demonstrate the impact of those expanded capabilities. Auto new business applications were 31.2% above prior year with strong growth across all three distribution channels. And while relatively evenly distributed across channels, the direct channel generated the most auto new business volume this past quarter. The increase in new business applications was offset by lower retention, resulting in an overall slight decline in auto policies in force. We continue to focus on improving retention trends by both increasing value and improving interactions with existing customers, which Tom described previously. Homeowners new business also continued to increase, growing by 10% this quarter. Exclusive agents who produce the highest volume of Homeowners business continue to bundle at historically high rates, and we’re making strong progress in the direct channel. Transformative growth is building momentum and we are confident that expanded distribution, differentiated products and increased customer value will lead to Property-Liability market share growth. Now, I’ll turn it over to, John.
John Dugenske: Thanks, Mario. Turning to investments on Slide 7, I’ll cover how our proactive investment management approach creates value. First, I’d like to point out that our portfolio has been designed for resiliency in varying market conditions, and it is built to support enterprise risk and return objectives at all times. As you can see from the pie chart, the portfolio is well-diversified allocated largely to public interest-bearing assets with some allocation to performance based assets including private equity, private real estate, infrastructure and opportunistic. About 85% of the portfolio is in publicly traded securities affording us the flexibility to dynamically adjust exposures to manage risk and seize opportunity. We use a proprietary dynamic asset allocation process, which uses an enterprise-wide risk and return lens. Additionally, we lever both internal and external asset class experts to deliver performance that exceeds a passive approach and builds resiliency into the strategy. Our active management has helped us preserve capital in down markets without sacrificing long-term gains. On the bottom left of the slide, you’ll see proof points of our success in active portfolio management. Let me describe how this has worked by focusing on late 2021. Auto insurance margins were beginning to decline because of inflation in used car prices and parts, and we felt equity valuations were relatively high. As a result, we took down risk in the portfolio by reducing public equity exposure. Additionally, we mitigated the adverse valuation impacts of rising inflation and rising rates by decreasing the portfolio’s fixed income duration. As bond yields rose, we extended our duration capturing higher market yields for longer and positioning the portfolio to benefit from rate declines. This is a prime example of our enterprise approach to portfolio. The portfolio is well-positioned to face market uncertainties with over 81% in income generating assets. On the bottom right, you can see our active allocations, including performance based strategies. Our team of asset managers has delivered performance consistent with upper quartile managers. Proactive investment management has consistently enhanced shareholder value and we continue to work to deliver similarly strong results moving forward. Now, I’ll pass it over to Jess.
Jess Merten: Thank you, John. Let’s move to Slide 8, to cover how Protection Services is providing additional growth platforms for Allstate. Allstate events protection in the flow of commerce through a range of strategic partnerships that include retailers, auto dealers, mobile phone carriers, benefit brokers and financial institutions. We deliver protection to customers through product warranties to cover important purchases like automobiles, furniture and consumer electronics. Other examples of the protection we provide include identity protection and recovery services as well as roadside assistance. The largest business in this segment is Allstate Protection Plans, which we acquired as SquareTrade in 2017 for $1.4 billion. This business provides protection against broken or damaged consumer products including computers, tablets, TVs, mobile phones, major devices and furniture. On the right side of the slide, you can see the excellent progress we’ve made in profitably growing Allstate Protection Plans business. Since the acquisition, our customer base has grown over four times and we now serve 162 million customers in 18 countries. The Allstate brand has helped to secure distribution partnerships with large retailers in North America, providing access to a broader customer base through traditional retail channels and e-commerce platforms. Allstate’s partnered with five Fortune 40 companies and customers can now purchase Protection Plans at several major retailers. In the past 12 months, the business has generated $162 million in adjusted net income, which is seven times greater than 2018, which was the year after we acquired the business in the first year that it was profitable. The Protection Services segment allows Allstate to build for the future with a broad protection offering suite that provides a diversified source of profitable growth. Now, I want to wrap up on Slide 9. Allstate remains focused on creating shareholder value. Strong underwriting capabilities position Allstate for continued success. Transformative growth is positively impacting Property-Liability policies in force. We remain focused on execution. We take a balanced approach to investment risk and return and we’re building for the future with expanded protection offerings. Excellent capital management will continue to create lasting shareholder value. We remain confident in our strategy and ability to deliver value for shareholders and protection to our customers. Our first quarter results were strong and we’re entering the remainder of 2025 with a solid foundation. With that, I’d like to open it up for your questions.
Operator: Certainly. [Operator Instructions] And, our first question comes from the line of Jimmy Bhullar from JP Morgan. Your question please.
Jimmy Bhullar: Hey, good morning. So, I had a couple of questions, but maybe first starting with just your views on competition in personal auto. Frequency has been pretty favorable for you guys, for many of your peers as well. And, are you seeing that result in companies getting a little bit more aggressive on pricing, or do you feel competition is fairly rational overall?
Tom Wilson: Jimmy, I’ll start and then Mario can jump in. First, you’re seeing a reduction in the rate of increases in auto insurance this year versus 2022, 2023 and then it started to come down in 2024 and it’s a little bit lower this year. So, which says that people are operating in basic kind of where they want to be from a profitability standpoint. One of the large competitors is still a little bit lagging, taking larger price increases, but they’ll catch up. So, I think what you can say is the industry is operating good profitability. All of those competitors have the objectives of profitable growth. So, I don’t see us headed into sometimes what you see in the commercial market, soft markets where people are chasing volume by lowering rates. So, I don’t see us moving into an aggressive rate reduction, right, particularly when you look going forward in the possible impact. Mario, anything you want to add to that?
Mario Rizzo: Yes. Jimmy, I would say that it’s really the combination of favorable frequency, which I think we and the industry have experienced and the moderation of physical damage severities really that’s been the story. I think that’s improved margins broadly. And to Tom’s point, I think the competition has leaned into growth more heavily certainly as margins have improved. We still think it’s a rational market. We like our capabilities and our ability to lean into what we’ve been doing with transformative growth to grow going forward. But, I would still characterize it as a rational market from a pricing perspective.
Tom Wilson: And Jimmy, I would say in that market, we wrote 2.8 million new piece to business in Property-Liability last quarter. Yes. That’s one point.
Jimmy Bhullar: And then on the [fifth] (ph) count, obviously, you’re not raising prices to the same extent as you were before, which means that your persistency should remain good or get better. And then, just with more marketing spending, that should help new business volume, which sort of implies that the sort of turn that you’ve seen in this should sustain, but any reasons to believe that recent improvement would not continue?
Tom Wilson: Well, there’s two pieces to that. Let me address it, and Mario can jump in here. First, to grow, you’re right, we need to write more new business and then we also need to keep more of the existing customers we have, persistency or in our vernacular retention. So, new business levels were way up at a percentage versus the first quarter of last year, but they’re kind of where we were at the end of last year, which is we’re able to sustain this kind of new business volume on an ongoing basis because of the breadth of our distribution, our competitive pricing, our advertising, all the things you mentioned. So, we feel good about where we’re at in new business. In retention, it lags much as the way it lagged on price going up. So, when we were raising rates, we used to, remember showing you the chart that said, oh, here is what we did this quarter, but keep in mind it takes about 12 months to 18 months to really come into the P&L. The same thing happens to customers and because they don’t pay it right away. And, even when they do pay it right away, sometimes they don’t shift right away. So, your retention lags just as it would on the price increase. So, our retention is flattened out and maybe Mario wants to talk about that. And, our efforts in the S.A.V.E. program are to drive it up, besides just not taking more rate. We ought to be giving people more for what they’re paying.
Mario Rizzo: Yes. Let me just maybe do a quick double click on retention because I think the new business volume that we disclosed is pretty self-explanatory. On retention, Jimmy, qualitatively, what I would say is it’s down year-over-year, so Q1 to Q1. But, as Tom indicated, it’s stabilized in the same zone really that it’s been over the past couple of quarters in Q1. And, some of that is because there’s less rate activity in the system, but I think our view is while less rate will help, we’re not waiting for that to improve retention. The S.A.V.E. program is intended to favorably impact customer interactions across at least 25 million customers. One of the components is to improve affordability for customers by proactively engaging with them to make sure that they’ve got the right coverage, the right discounts, things like deductibles and so on, and they can get the best possible price from us, which we believe will help retention. The other part of it is just to improve the overall customer experience and how they interact with us. So, we’re leaning into that as Tom mentioned earlier both through our employees, our agency owners to really proactively engage with customers, improve the experience, improve affordability. And that along with a more stable rate environment, our intent is to have that drive improved retention.
Jimmy Bhullar: Okay. Thank you.
Operator: Thank you. And, our next question comes from the line of Rob Cox from Goldman Sachs. Your question please.
Rob Cox: Hey, thanks. For my first question, maybe a similar line of questioning, but the new issued applications, as you mentioned, accelerated meaningfully in the quarter. I’m just curious if you think this level of new apps is being flattered by an unusually high amount of shopping or if you think this level or higher can actually be maintained with further advertising investment and product rollout?
Tom Wilson: Well, first, as I mentioned, Rob, that it’s the new business levels this quarter were similar to what we had towards the end of last year. So, we are maintaining it and we’re comfortable there. Our appetite depends on what states we’re in advertising. So, we want to grow as fast as we can. We don’t really have any capacity constraints right now, in terms of number of agents, number of people in direct, in the call centers or on the web or independent agents. So, rolling out affordable simple connected products are what really drives most of the growth. We mentioned we’re not in all the states yet. So, as we roll that out in the rest of the auto states and we get homeowners to go with it, it’s a much better experience, better product. So, we think we still have upward potential. Do I think it’s going to be 27%? No, because it wasn’t 27% over the fourth quarter. So, do I think we have a great distribution system that’s scalable 100%.
Rob Cox: Got it. Thank you. And, then maybe following up on the auto underlying loss ratio. I was just wondering if there’s anything unusual, embedded, maybe any tariff impacts or anything like that contemplated in the loss ratio. I noticed it was kind of one of the first quarters in a long time that the underlying loss ratio actually went up in the first quarter versus the fourth quarter.
Tom Wilson: Let me, on auto insurance property, I’ll make comments. Mario, can jump in here. First, when you evaluate it at the absolute level, it’s outstanding. We are getting really strong returns on capital. We’re better than our targets. Its broad based across the country and by risk level inside the auto book. So, we’re feeling really good about where it is. I think quarterly comparisons are really not that meaningful, to be honest. You got all kinds of things happening. Fourth quarter has got different kind of weather than the first quarter. So, you have frequency bounces and then you have, of course, just weather changes, not even inside individual quarters. And then, the type of weather and the type of accidents also changes the mix of your claims, which has some impact on severity. And, those can easily move a combined ratio by one point to two points. So, I don’t get that focused on that. If you want to look at it on a longer basis, first quarter looks great. We’d like them where we’re at. Mario, what would you add about like breadth and depth of it?
Mario Rizzo: Yes. Look, I think when we look at auto profitability, certainly in absolute terms, the combined ratio is performing exceptionally well. And, when we look at a state level, with literally a handful of exceptions, we like where our price position is and our rate adequacy and feel really good about profit levels across the vast majority of states that we operate in. The trend on profitability is really unchanged from the last couple of quarters. We continue to earn the rate that we implemented over the last 12 months. And then, we look at loss cost, the combination of favorable frequency and physical damage severity and loss cost kind of flattening out. We actually saw a drop in pure premium year-over-year, and that drove a pretty substantial improvement in the underlying combined ratio in auto, but we feel good about auto profitability. And, that’s one of the things that as margins improved over the course of last year, we opened up markets and we started to expand our risk appetite for new business, and we’re going to continue to do that because we feel good about where we’re positioned from a margin perspective.
Rob Cox: Great. Thank you.
Operator: Thank you. And, our next question comes from the line of Gregory Peters from Raymond James. Your question please.
Gregory Peters: Good morning, everyone. I would like to pivot to Slide 3 of your presentation, where you highlight the improvement in the adjusted expense ratio since 2018. And, I’m just trying to understand what your objective will be, say, for the next five years. Do you anticipate bringing this down below 20%? And, inside the expense ratio for the first quarter, we did note that the, it looks like the advertising expense was down sequentially a little bit. So, I know that’s outside of the adjusted expense ratio, but maybe you can tie in with your answer or perspective on advertising expense?
Tom Wilson: So, good morning, Greg. We haven’t put a target out for expenses, but our goal should always be lower expenses. And, that’s both as a percentage and in an absolute dollar basis. So, some of the decline, of course, as you raise prices faster than the cost of inflation than your expense ratio goes on. That’s not the way to really get there for your customers. So, but we’ve made some substantial cuts in absolute expenses and we’re going back at it again. Just as now just starting to lead a new effort to go back and so we don’t have a goal, but expect it to keep coming down. We think with our new technology platform and new technologies available out there that there is the opportunity to digitize and eliminate a number of processes that are done by people today, which will be faster, better and cheaper for customers. So, we’re back at it again. We’re excited about it. We think there’s good opportunity there. On advertising, it depends how good we think the opportunities are to grow, where we’re trying to get into markets, whether we’re launching new products. So, the fourth quarter was a high watermark for us. We were testing some new stuff. I don’t expect it to stay at that fourth quarter level really at any time this year that that we were really learning to lean in to see how much we could drive in growth. And, it’s workforce and we what we’ll do is to extend its economic, we’ll continue to spend. If it’s not economic, then we won’t. And, that means both are you getting a good return of people shopping, buying new products, you have a competitive price. And, how do you feel about your margins going forward? We feel really good about our margins going forward in both auto and home. So, you should expect to see us do more there.
Gregory Peters: Okay. I guess for my follow-up question, I’ll pivot to the Slide 5, which is the catastrophe loss slide. I thought your chart there on the left is interesting in the context of framing what goes beyond one standard deviation and two standard deviations. So, inside that disclosure, a couple of things. First of all, it looks like there could be some material subrogation event for you on the wildfire. So, I’m just curious how that might change your perspective on whether this is a two standard deviation or three standard deviation event? And then secondly, in your first quarter supplement, you provided a reinsurance update and it looks like you raised some of the limits. So, maybe you can talk a little bit about that.
Tom Wilson: Well, thank you for liking our slide. We work hard on them. Mario, do you want to take the first part and Jess, do you want to take the reinsurance one?
Mario Rizzo: Yes. So Greg, the first thing I’d say is that obviously, the chart on Page 5, those are gross losses, so they’re not net of reinsurance. And, the reinsurance recoveries we did disclose in the first quarter, the $1.1 billion the bulk of which was California wildfire related, and the net loss does not consider any sub row recoveries. Having said that, to the extent there are potential sub-row recoveries from at fault parties, we would certainly want to pursue those. And, there is that new wildfire fund that was established by the utilities in California. I think it’s funded at about $15 billion or so with additional capacity beyond that. So, to the extent there is sub-row that we can pursue, we would certainly do that, but we have not reflected any of that in our numbers. And ultimately, the dollars would recover given that we’re into the reinsurance layers will go to reinsurers. It’s also our customers’ money as well. And I think to the extent it provides relief from our breeding perspective, it’s the right thing to do for our customers.
Jess Merten: And, on the reinsurance program, just a reminder to everyone, we do post a very robust disclosure on the changes so that you can find on our investor website. We did place the bulk of the national program this quarter and so we’ve announced that. You can see and I’m sure this is what you saw, Greg. Reinsurance limit purchase was up $1.5 billion, so that’s about 21% and that now we have single event protection up to $9.5 billion up from just under $8 billion last year on a per occurrence basis. We’re doing that really to reflect the change in the risk profile, right? We buy reinsurance based on our risk and return framework and our economic capital model. And, the market in the placement went very well. We split it evenly between traditional markets and the catastrophe bond or the ILS market and had good support for the program this year. On a risk adjusted basis, the cost will be down, which I think is a really good outcome and it helps protect us from single event risk like we saw recently. We’ll announce the remainder of the program that gets placed in Q2 at the end of next quarter. And, that’s just as a reminder that’s the Florida program and then the National General Lender price program reinsurance gets done this quarter. So, all-in-all, again, we have very detailed disclosure that we put out, but in general, we increased the total limit that we bought this year to reflect the expansion of the homeowners both on the expansion of risk.
Tom Wilson: Hey, Greg, let me I’ll just add on to it. So, it’s really the homeowners business is growing. I mean, there’s a lot of conversation appropriately on auto insurance growth and we’re of course highly focused on that. But, the home insurance business, it just units for 2.5 points. And as far as I know, we’re not adding 2.5% to the housing stock in United States, which means we’re picking up unit share. And then, it’s mid-teens growth in revenue. That’s a growth business and I feel like it’s been overlooked by some people. We’ve had some shareholders recently say, no, that’s a story not being told. So, I’m trying to tell the story on their behalf and our behalf. It is a good growth business, which is why we need more reinsurance.
Gregory Peters: Thanks for the additional detail.
Operator: Thank you. And, our next question comes from the line of Bob Huang from Morgan Stanley. Your question please.
Bob Huang: Hey, yes, good morning. So, maybe one real quick on how we should think about essentially the capital position, right? So, you bought back about $100 million of stock this quarter. Just given the market volatility, you’re fairly stable capital position. Curious how you should think about capital allocation, but also capital return at this point of the junction given market has been volatile, your shares have been moving around?
Tom Wilson: I’ll start and maybe Jess, you want to jump in. First, we’re very comfortable where we’re at. We’ve got plenty of capital. We’ve got -- it’s in the right places. We’re earning good returns. We’ve got the right risk profile. As John talked about, we look in our capital position relative to the whole enterprise thing in terms of our investment risk as well as our insurance risk. And we’re really comfortable with where we’re at there. We’re also comfortable with our program of how we’re deploying it, first into growth and because that generates the kind of ROEs that we talked about earlier in the conversation. Secondly, to the extent we have cash, we can give it to investors, then we do and we have a great track record of doing that. We’re comfortable with $1.5 billion share repurchase program. We’re $100 million in, so it’s a little early to start talking about what else we’re going to do. Jess, anything else you want to?
Jess Merten: No, I think you hit it, Tom. We’ve talked about this, Bob. We use a sophisticated economic capital framework to look at our capital position. We’re doing that continually and looking at priorities the way that Tom laid out. So, you saw the announced repurchase, as Tom said, we’re $100 million into $1.5 billion, so we’ve got a little bit of time on that. We’ll continue to watch where we sit relative to our target.
Bob Huang: Okay. No, that’s very helpful. So, you’re not front loading April for buybacks, I guess is what I’m trying to say, right?
Jess Merten: From a pace perspective, we don’t put forward guidance out on how we’re going to buy repurchase stock. What we do is we like to have a continual presence in the market with our repurchases, Bob. So, you can see what we did in Q1 and sort of project out the meeting where we announced was the February, right. So, we effectively did the $100 million over about a month and we like to have that consistent presence in the market. So, I would say on a go forward basis, we’ll continue to evaluate and adjust as needed, but that gives you some sense for the pace of what we did in the first quarter.
Bob Huang: Okay. Thank you. So, my second question, just maybe thinking about California, obviously some competitors are facing more challenges in the homeowner environment. If homeowner competitors were to pull back, does that disrupt their bundling strategy in your view? Do you think the current environment in California changes the competitive environment there and then a consequently maybe makes an opening for you? I understand that California previously had been a challenge, but maybe just any color there.
Tom Wilson: Yes, and partly. How about that? And Marco, you’re drilling there. So, yes, it will impact their auto business, that’s what you referred to. And so in particular, State Farm is struggling given their losses there. And so as they have to restrict the amount of business, it will impact our audit. We know it, we went through it and we went through it in California from 2007. And but for a couple of years, right up until this year, which is why our market share is so low. We went through it in Florida when we went from a 13% or 12% share to like 2% in homeowners and we felt it in our auto book. Now we recovered and we have great share in Florida and we’re growing in Florida. So, they’re not down and out. It will just be a bump that they have to deal with. So yes, it will be something that will change the competitive dynamics. Is it going to change our interest in writing homeowners in California? I doubt it. And we’ll see what happens in the subsequent reforms. But we recovered billion dollars of reinsurance and we got none of that back in rates. And we paid for all of that from our shareholders. So until we get to a place where our costs are actually reflected in what we can charge, we’re not going to be interested in selling homeowners at a loss for our shareholders. On the auto business, Mario, maybe you want to talk about the auto business?
Mario Rizzo: Yes. In terms of auto, we’ve talked a lot over the past, call it, 12 to 18 months about three states in particular California, New York, New Jersey and the profit challenges we had. With California, I think we’ve largely cycled our way through that. Our California auto insurance is actually generating an underwriting profit. We are open across all channels to write new auto business in California. We got a significant rate approved early last year. We also recently got approval for another 6.9%, which we’ll implement in May. So, our approach in California has always been to try to stay ahead of loss costs as best we can, and the team is doing a really good job of doing that. And we’re operating in California, just like we are in other states that we’re open because we like more position from a profit standpoint and we’re open for business and looking to grow the auto business in California.
Bob Huang: Excellent. Really appreciate it and congrats on the quarter.
Operator: Thank you. Our next question comes from the line of Elyse Greenspan from Wells Fargo. Your question please.
Elyse Greenspan: Hi, thanks. Good morning. My first question is, I guess, on the March policy growth, right, you guys obviously turned the corner with growth in the first quarter. My question is specific to auto. Did you guys observe perhaps any pull forward? Were there perhaps cars being purchased in advance of tariffs? And did that impact any of the numbers in March, from a policy growth perspective?
Tom Wilson: Elyse, I don’t think we would be able to tell. So, shopping is obviously up in total. It’s up in part because what the industry had to do to raise rates to deal with the pandemic related inflation. It’s unclear that it’s really moved a lot of people to buy cars. You have seen a slight uptick in used car prices recently. Whether that’s in anticipation, who knows?
Elyse Greenspan: Okay. And then, my follow-up, I guess, is on the tariff, right. It seems like it’ll be about a mid-single digit, increase to severity. As you guys think about that potential increase, and my sense is probably we’ll start to see it over the summer. Correct me if I’m wrong. But as you guys think about that increase and where your margins are today in your auto book, are you going to either absorb it with potentially absorb it in your margins, Or would you look to take additional price to offset any increase that we potentially see from the tariffs?
Tom Wilson: So, we’re going to manage through whatever the impacts of tariffs are just as we did the inflation that came through the pandemic. So, our objectives are to give customers a good competitive price, make sure we get a return for our shareholders and to grow. So, those are our objectives. Right now, of course, it’s unclear when the actual impact will be to your point. It takes a while to rattle through new car prices, used car prices, dealers, people fixing cars, who else replacing cars. And the pandemic, of course, it happened incredibly rapidly. So, we had 60% increase in used car prices in about less than two years, I think, March or something like that. And so we are factoring in the fact that we think there will be increases in costs, but we don’t know what those are yet. So, it’s difficult to say exactly what we would do in prices or even what the percentage is. You quoted about mid-single digits. I think you were like five points. There are industry estimates that are higher than that and the answer is nobody really knows. So, I’ll just describe what we’re likely to do. So, our costs are likely to be higher. I agree with that. Particularly auto repair and replacement costs are likely to increase. The cost to repair homes is also likely to increase, but our analysis, which we’ve done tons of, is that it’s probably less maybe it’s half of what will happen in auto insurance. So, we’re feeling we’re more focused on auto than we are at home. We are hopeful that the trends reduce what I would call the ramping costs of fender bender losses will take hold. So that should offset some of the increases. So, you saw in Florida Tort reform really helped on the, what I’ll just call, opportunistic If somebody gets an offender bender accident and they just decide, well, I’m going to sue somebody, so I can get some money from because of the way litigation. So, Georgia just passed some tort reform. So, we’re hopeful that, that will work. As in obviously, as Greg asked us, we’re still taking cost down. So, we’re not sticking where we are. And all of that fixed into the mix of where we are. And if we need to raise prices, we will raise prices just like we did in the pandemic because with our margins, we don’t have a lot of room to absorb. I’d like to sell like we’re selling software with 80% margins, we’re in a relatively thin margin business. So, we need to raise our prices. On the Protection Services businesses, some costs are likely to go up as well, but we factored that into the way we’re pricing our product as we go forward and then it adjusts and spreads over time. On a growth standpoint, I think it just is a level playing field. Like I think the advantages you have today or the advantages you’re going to have tomorrow are car prices are x percent higher. And so I don’t really see much difference in the growth side on Property-Liability. On the Protection Services businesses, to the extent that there’s consumer demand goes down because inflation is up or people start buying fewer TVs or washers or stuff like that, that could impact our growth a little bit there. But we’ve got great international growth we’re doing there. So, I’m comfortable with our growth numbers in the tariff. From the investment standpoint, John talked about how balanced our portfolio is, how proactive we are. So, we factor all of this into the mix. From an enterprise standpoint, tariffs are manageable for us. They will be manageable for our customers, and we’ll just do whatever we need to do to make sure we serve both our customers well and keep making money for shareholders.
Elyse Greenspan: Thank you.
Operator: Thank you.
Operator: And our next question comes from the line of Alex Scott from Barclays. Your question please.
Alex Scott: Hey, good morning. First one I had is just on retention, see if you could dig a little more into what you’re seeing and also the S.A.V.E. program. And I guess, specifically, we don’t have the exact numbers necessarily, but we can kind of calculate proxies and so forth. I mean, it looks like it’s still about as bad as it’s got in terms of retention. How much of that is associated with package business, maybe still some, shed in a business versus more competition in the auto market in certain states and versus running through price in certain states. Can you help me think about like, how quickly you expect that to come back and what this S.A.V.E. initiative will do to help that?
Tom Wilson: Okay. Let me talk about some of the specifics in the various areas. I know it might be frustrating to you that we don’t give you the retention number for the Allstate brand for auto insurance. But we did that on purpose because we found that as we delve into the individual pieces, it gets a little confusing and it’s hard to tell the story. The story is, are we growing total PIF? I guess the story. And some of that’s new business, which we show you numbers on, some of that is retention, which you’re right, you can back into the total number. The specific percentage though bounces around by risk by the number of type of customers you’re writing. So, we’ve gotten much more aggressive in the non-standard market. So, if you look at our internally the way we look at that risk class, we’re doing much better in that segment than we were a couple of years ago, which is where we think one of our big competitors has had a lot of growth. Now that comes with lower retention. So you’re like, oh, well, it’s you feel good on new business, not so good on retention. So, we decided rather than take everybody through the third derivative, we would focus on are we growing total PIF. Now so rather than going into the specific numbers. That said, it’s a good question because retention is really important and we’re doing a lot of work on it. So Mario, do you want to talk about the various programs you have going on retention?
Mario Rizzo: Yes. So, it is a good question because retention is obviously a core way that we’re going to grow. And you’re right, as I said earlier, it remains in the same zone relative to where it’s been the last couple of quarters. Maybe the way I would think about it, Alex, is actually kind of flip it and rather than talk about retentions, talk about defection, which are the customers that leave us because our actions are really focused on those customers. So, as you think about what we’re doing, the things that cause customers to defect, there are certain triggers. It could be price increase, which obviously we and the industry have had to raise pretty significantly over the last couple of years. Those things trigger shopping. But also poor customer experience or a negative customer experience, those things matter as well. And with S.A.V.E. we’re really going after those triggers. So, we’re looking to improve affordability by making sure, again, customers have the best possible coverage, the best possible price that’s based on their personal circumstances to help alleviate that shopping trigger related to the price of insurance. But it’s also focused on improving our customer interactions broadly to make sure that customers have the best possible and an industry leading customer experience when they engage with Allstate, again, to reduce the number of defections. Along with that, bundling helps the stickiness of the relationship. And our agents on the Allstate side continue to bundle at historically high levels around 80% for new business. That helps retention because it improves the depth of the relationship. And then finally, the fact that we’ve had to be less active from a rate perspective creates more stability in the book, which also will help in terms of reducing defections. But we’re focused principally proactively on those first couple, which is improving the customer experience, improving affordability, continuing to drive bundling at the point of sale and through cross sell where we can to help improve the retention trends going forward.
Alex Scott: Got it. Okay. That’s all really helpful. Next question I had is sort of a follow-up on some of the lost trend comments you made around tariffs and appreciate there’s a ton of uncertainty right now and there’s a wide range of outcomes. But when I think about your financial position in terms of just like premium to equity leverage, which I know is very crude, not necessarily the way you look at it. But, at a high level, you’re sort of sitting at a much higher level than you were prior to the 2021 inflationary period. You’re still buying back stock. I’m just trying to understand how do you think about your capital capacity to deal with the more adverse outcomes that you described? And are there sort of offsets or things I’m not thinking about that are more finetuned than just looking at that premium to equity now versus then?
Mario Rizzo: So, we’re in a really strong capital position. Depending which equity you’re looking at, you’re looking at statutory capital, you got to add back in what’s at the holding company, which just at the end of the first quarter was about $3 billion. So, there’s a lot of capital there. We think we have plenty of money, even if it means really high increases in average premiums because inflation takes up. We have capital that is positioned so that we can -- we went into this with capital thinking we’re going to grow market share. We plan on growing market share, so we’ve got capital to grow market share and we have plenty of capital to do that. And if it means that average premium scope, we’ve got plenty of capital to do that. So, we’re feeling really good about where our capital position is. And we never really thought we had an issue that a couple of people did, but we’re in great shape. And I do think that the premium to surplus ratio that you’re measuring is too crude to measure, but that’s not a good way to look at capital. We don’t drag you down into the middle of it because we’ve always had good capital and it gets very sophisticated. But we do have lots of scenarios we run. So, we run what if we’re in stagflation, what happens with stagflation and market share growth and how we’re feeling about overall capital. And we’re just in a really good place. The only thing I would add to what Tom said is, you’ll recall as we went through and talked about capital over the last few years, we have the way that we construct our economic capital is we have a base capital layer and then we put stress capital on top of that. So, the stress is to absorb times like what we’re talking about, right? So, we have stressed capital to absorb the volatility that comes with changing market conditions. And to the extent where we have a repurchase program in place, that means that we’ve rebuilt that stress layer from the previous years because as we talk through capital in the last few years, we said there’s sort of an order of operations, you have to get the target and target means you’ve rebuilt a stress layer. So, as you think about going forward, we as Tom said, are in a very strong capital position and we’ve got capital in place to absorb uncertainty and changing market conditions.
Tom Wilson: I think one of the things that didn’t get as much focus as we came through the pandemic was that higher prices led to was based on higher loss costs, higher loss costs led to higher reserves, higher reserves leads to more investments and that leads to more investment income, which keeps going on forever. So, there is a growth aspect to investment income that comes out of this as well besides just making sure you have good combined ratio.
Alex Scott: All good points. Thank you.
Operator: Thank you. And our next question comes from the line of Mike Zaremski from BMO. Your question please.
Mike Zaremski: Hey, great. Thanks for fitting me in. My first question is a high level question. So, looking at consensus, not saying this is necessarily correct, but expected to earn Allstate is a 23% ROE in the coming years. That’s obviously well above Allstate’s long-term average and your cost of equity. You spent significant time and effort building out additional sales channels in recent years. So, I guess just why not write it a slightly worse combined ratio, trade off some ROE for enable more sustainable organic growth since it seems growth has been all the focus on a go forward basis?
Tom Wilson: Well, we think we can do both. When we look at our if you just go to auto insurance, if you look at our combined ratio relative to the industry, we’ve always been able to operate at, let’s call it, five points better than the industry average. And which means we’ve been able to extract economic rents and still be competitive in marketplace. We haven’t grown as fast as one of our competitors have. We’d like to grow that fast. And so we’re working on that. Their model shows that they have about the same level of combined ratio and they can grow. So, we’re like, yes, we should be able to do both. In homeowners, we have an industry leading position and we are growing. So, we think we can do both. And I do think that growth -- I think you’re absolutely right growth is the unlock to the valuation multiples. If you look at our valuation multiples to anybody else in the industry, they’re substantially below. We obviously don’t like that because we think that we got great businesses and it’s all focused on auto insurance as well as how you doing at home insurance and our protection plans businesses and services businesses are killing it. But like the market will tell us when they’re ready to pay more, but we’re working on it. We’ll do one more question.
Operator: Certainly. Then our final question for today comes from the line of Josh Shanker from Bank of America. Your question please.
Joshua Shanker: Well, thank you for fitting me in. I appreciate it. In terms of the cadence of advertising spend, I noticed you spent less money in the first quarter, than you did in the fourth quarter. And historically looking at when GEICO and Progressive added business, they were more first half of your weighted policy addition businesses. I don’t know if something has changed about the industry. But has the ad spend already peaked? And you talked in this back half of last year about ad spending for future growth. Can you talk about how that works and whether it’s all playing out as the design sets up?
Tom Wilson: It hasn’t peaked in the first quarter for us. Everybody else will have to decide what they do. I can’t speak to them. Josh, I could speculate, but it is just speculation that the direct business this I know, the direct business does write more new business in the first quarter than other quarters. And they’re heavier in direct than we are. Certainly, GEICO is all direct other than a small little piece of their agency business to kind of build out and progress is a good half direct and we’re not quite there. So, I would guess that their advertising by quarter lines up with where their opportunities are by distribution channel by quarter. But that’s me outside looking in. As it relates to us, as long as we’re getting a good combiner show and we’re writing new business in our economics on advertising, which are very granular these days, not quite as granular as the billion price points in the state in auto insurance, but pretty down close. As long as we’re driving positive ROE on that advertising stuff, we’ll keep doing it. And it’s not all just average, like we do look at the incremental advertising spend as well to make sure we’re getting good returns. So, our goal is increase market share and sell more protection of people. So, there’s other places we can grow besides auto insurance too. I think we should be growing faster than renters and some other stuff. It’s not going to make a huge deal in terms of actual revenues. But one of the things we’re also focused on is we’ve crossed a couple of hundred million dollars in policies in force and that’s substantial presence in America. And so we’re focused on not just every other auto policy, but everything else we sell as well.
Tom Wilson: Thank you all for tuning in. We do have the capabilities of brand, the distribution, the resources to help us accomplish that strategy, which is grow market share in Property-Liability and expand the protection we offer to everybody else. So, thank you for your ongoing engagement. We’ll talk to you next quarter.
Operator: Thank you, ladies and gentlemen, for your participation in today’s conference. This does conclude the program. You may now disconnect. Good day. | [
{
"speaker": "Operator",
"text": "Good day, and thank you for standing by. Welcome to Allstate’s First Quarter Earnings Investor Call. At this time, all participants are in a listen-only mode. After prepared remarks, there will be a question-and-answer. [Operator Instructions] As a reminder, please be aware that this call is being recorded. And now, I’d like to introduce your host for today’s program, Allister Gobin, Head of Investor Relations. Please go ahead, sir."
},
{
"speaker": "Allister Gobin",
"text": "Good morning, everyone. Welcome to Allstate’s first quarter 2025 earnings call. Yesterday, following close of the market, we issued our news release and investor supplement, filed our 10-Q and posted related materials on our website at allstateinvestors.com. Today, our management team will share perspective on our strategy and how Allstate is creating shareholder value. Then we will have a question-and-answer session. As noted on the first slide of the presentation, our discussion will contain non-GAAP measures for which there are reconciliations in the news release and investor supplement and forward-looking statements about Allstate’s operations. Allstate’s results may differ materially from these statements, so please refer to our 10-K for 2024 and other public documents for information on potential risks. And now, I’ll turn it over to, Tom."
},
{
"speaker": "Tom Wilson",
"text": "Good morning. Thank you for investing your time with Allstate. I’m going to start with an overview of results and then the progress we’re making on transformative growth. Mario, will then cover Property-Liability results. John, will go through investments, and Jess, can talk about Protection Services. Then we’ll, as Allister said, deal with any questions that you have. So, let’s start on Slide 2, which has Allstate’s strategy and first quarter results. Allstate’s strategy, of course, has two components, increased personal Property-Liability market share and expand protection provided to customers, which are shown in this two ovals on the left. On the right hand side, you can see Allstate’s strong performance in the first quarter. Revenues were $16.5 billion in the first quarter, up 7.8% compared to the first quarter of 2024. Allstate generated net income of $566 million in the quarter and adjusted net income of $949 million which is $3.53 per diluted share. Adjusted net income return on equity was 23.7% over the last 12 months. So, we work on shareholder value with a balanced set of priorities. First, generating attractive returns on capital, which you can see from this year this quarter’s results. Growing policies enforced in the Property-Liability and Protection Services businesses will both generate increased earnings and should improve Allstate’s valuation multiples. A diversified investment portfolio generates attractive returns on capital, which John will cover. Proactive enterprise risk and return management is also important and that includes whether that’s utilization of reinsurance, our capital transactions or cash returns to shareholders. Mario will discuss the benefits of our approach to reinsurance when we go through Property-Liability. Jess’ team closed the sale of Employer Voluntary Benefits business for $2 billion on April 1. So, the results of that are not in this quarter, but it’s because it happened shortly thereafter, we want to make sure we call it out for you. And, that’s the first of two large sales from that business segment. As you know, we increased quarterly dividend to $1 a share and instituted $1.5 billion share repurchase program. Slide 3 is an update on the execution of transformative growth strategy in the Property-Liability business. So, there are five integrated components to this strategy to increase market share, one of which is to improve customers’ value and one of the key parts of it is lowering costs. As you can see on the left hand side, the adjusted expense ratio, which excludes advertising costs has improved by 6.7%, so its 6.7 points really, by eliminating outsourcing digitizing work, using less real estate and aligning our distribution expenses with customer value. And, those lower costs enable us to offer more competitive prices without impacting margins. Substantial progress has also been made on other components, several of which are listed on the right. New Allstate branded affordable, simple and connected auto insurance are now available in 36 states and we have the companion homeowners product is now available in six states. Differentiated Custom360 middle market standard and preferred auto for independent agents is shown is now in 31 states. One of the most significant changes is expansion of customer access to improved growth, which resulted in increased new business from all channels this quarter versus the first quarter 2024. This effort has three components, right, improve Allstate agent productivity, expand our direct sales and then increase independent agent distribution, all of which have been successful. Allstate agent productivity has increased, enhancements to direct capabilities are lower pricing and increased advertising are attracting more self-directed customers. The National General acquisition significantly expanded our presence and capabilities in the independent agent channel. So, this quarter personalized new business was 2.8 million items, a 27% increase over the prior year. The S.A.V.E. program, which stands for Show Allstate Customers Value Every Day, following our acronyms, is being embraced by employees and agents with a goal of improving 25 million interactions this year, which builds on last year’s success, which was over 20 million. Our objective is to increase customer retention, an important driver of growth. The combination of strong new business levels and an improvement of retention is a path to market share growth. We’re beginning to see signs of growth. So, property liability policies enforced on a year-over-year business has stopped declining. And of course, that was due to the significant auto price increases and the economic decision to reduce new business in 2022 and 2023. Sequential growth over the end of 2024 was 0.5 point. So, Allstate remains focused on increasing market share and Property-Liability and expanding protection provided to customers. Now, let me turn it over to, Mario."
},
{
"speaker": "Mario Rizzo",
"text": "Thanks, Tom. Let’s take a look at first quarter Property-Liability and underwriting results on Slide 4. As you can see from the table on the left, the Property-Liability business generated $360 million of underwriting income this quarter. The combined ratio of 97.4 was 4.4 points above the prior year quarter, primarily due to $3.3 billion in gross catastrophe losses during the quarter, which was significantly higher than the first quarter of last year. This was partially offset by recoveries from a comprehensive reinsurance program, higher average earned premiums, favorable non-catastrophe prior year reserve reestimates and favorable underlying loss trends. The auto combined ratio was 91.3 in the quarter as average earned premium increases outpaced losses, driven by favorable physical damage loss cost trends. The underlying homeowners combined ratio, which excludes the impact of catastrophes and prior year reserve reestimates, remained in our targeted low-60s range. While there may be fluctuations and catastrophe losses, the homeowners business consistently generates profits with a 10 year recorded combined ratio of 91.5. Now, let’s move to Slide 5, to discuss first quarter catastrophe results in more detail. Our claims team worked tirelessly to support over 70,000 customers as they recovered from the devastating California wildfires and a series of severe weather events that impacted multiple regions across the country in the first quarter. The chart on the left depicts gross catastrophe losses as a percent of earned premium for the last 10-years. As you can see, 2025 represents an outlier year that was more than three standard deviations above the mean driven by the California wildfires represented by the orange bar. We generally do not see wildfire activity in the first quarter of the year. Wind and hail events represented by the dark gray bars were above the 5-year and 10-year averages, but there is no clear pattern over the last 10-years for these barrels. In the table on the right, you can see this quarter’s catastrophe loss ratio and number of events by peril compared to 5-year and 10-year averages. On the second to the last row of the table, you can see the impact of our approach to risk and return management, which includes a comprehensive reinsurance program that reduces capital requirements by lowering catastrophe loss tail risk and earnings volatility. In the quarter, we had reinsurance recoveries of $1.1 billion primarily due to the California wildfires, but recoveries were also generated from aggregate catastrophe losses from events over $50 million that occurred over the past 12 months. As I said earlier, while we expect some quarter-to-quarter volatility in the homeowners line of business, our industry-leading capabilities remain a competitive advantage and we view homeowners insurance as a growth opportunity. Turning to Slide 6, let’s discuss how expanded access under transformative growth is starting to increase growth. In the chart to the left, you can see the composition of Property-Liabilities 37.7 million policies in force. Auto insurance in the dark blue makes up two-thirds of total policies and ended the quarter with $25.1 million policies in force, which was down 0.4% compared to last year. Homeowners with 7.5 million policies is about 20% of the total and continued to grow this quarter increasing 2.5% versus prior year. Total Property-Liabilities policies grew by 0.1% in the quarter. As Tom discussed, expanding distribution to include capabilities across the exclusive agent, direct and independent agent channels is a key component of transformative growth. The stacked bars in the chart on the right demonstrate the impact of those expanded capabilities. Auto new business applications were 31.2% above prior year with strong growth across all three distribution channels. And while relatively evenly distributed across channels, the direct channel generated the most auto new business volume this past quarter. The increase in new business applications was offset by lower retention, resulting in an overall slight decline in auto policies in force. We continue to focus on improving retention trends by both increasing value and improving interactions with existing customers, which Tom described previously. Homeowners new business also continued to increase, growing by 10% this quarter. Exclusive agents who produce the highest volume of Homeowners business continue to bundle at historically high rates, and we’re making strong progress in the direct channel. Transformative growth is building momentum and we are confident that expanded distribution, differentiated products and increased customer value will lead to Property-Liability market share growth. Now, I’ll turn it over to, John."
},
{
"speaker": "John Dugenske",
"text": "Thanks, Mario. Turning to investments on Slide 7, I’ll cover how our proactive investment management approach creates value. First, I’d like to point out that our portfolio has been designed for resiliency in varying market conditions, and it is built to support enterprise risk and return objectives at all times. As you can see from the pie chart, the portfolio is well-diversified allocated largely to public interest-bearing assets with some allocation to performance based assets including private equity, private real estate, infrastructure and opportunistic. About 85% of the portfolio is in publicly traded securities affording us the flexibility to dynamically adjust exposures to manage risk and seize opportunity. We use a proprietary dynamic asset allocation process, which uses an enterprise-wide risk and return lens. Additionally, we lever both internal and external asset class experts to deliver performance that exceeds a passive approach and builds resiliency into the strategy. Our active management has helped us preserve capital in down markets without sacrificing long-term gains. On the bottom left of the slide, you’ll see proof points of our success in active portfolio management. Let me describe how this has worked by focusing on late 2021. Auto insurance margins were beginning to decline because of inflation in used car prices and parts, and we felt equity valuations were relatively high. As a result, we took down risk in the portfolio by reducing public equity exposure. Additionally, we mitigated the adverse valuation impacts of rising inflation and rising rates by decreasing the portfolio’s fixed income duration. As bond yields rose, we extended our duration capturing higher market yields for longer and positioning the portfolio to benefit from rate declines. This is a prime example of our enterprise approach to portfolio. The portfolio is well-positioned to face market uncertainties with over 81% in income generating assets. On the bottom right, you can see our active allocations, including performance based strategies. Our team of asset managers has delivered performance consistent with upper quartile managers. Proactive investment management has consistently enhanced shareholder value and we continue to work to deliver similarly strong results moving forward. Now, I’ll pass it over to Jess."
},
{
"speaker": "Jess Merten",
"text": "Thank you, John. Let’s move to Slide 8, to cover how Protection Services is providing additional growth platforms for Allstate. Allstate events protection in the flow of commerce through a range of strategic partnerships that include retailers, auto dealers, mobile phone carriers, benefit brokers and financial institutions. We deliver protection to customers through product warranties to cover important purchases like automobiles, furniture and consumer electronics. Other examples of the protection we provide include identity protection and recovery services as well as roadside assistance. The largest business in this segment is Allstate Protection Plans, which we acquired as SquareTrade in 2017 for $1.4 billion. This business provides protection against broken or damaged consumer products including computers, tablets, TVs, mobile phones, major devices and furniture. On the right side of the slide, you can see the excellent progress we’ve made in profitably growing Allstate Protection Plans business. Since the acquisition, our customer base has grown over four times and we now serve 162 million customers in 18 countries. The Allstate brand has helped to secure distribution partnerships with large retailers in North America, providing access to a broader customer base through traditional retail channels and e-commerce platforms. Allstate’s partnered with five Fortune 40 companies and customers can now purchase Protection Plans at several major retailers. In the past 12 months, the business has generated $162 million in adjusted net income, which is seven times greater than 2018, which was the year after we acquired the business in the first year that it was profitable. The Protection Services segment allows Allstate to build for the future with a broad protection offering suite that provides a diversified source of profitable growth. Now, I want to wrap up on Slide 9. Allstate remains focused on creating shareholder value. Strong underwriting capabilities position Allstate for continued success. Transformative growth is positively impacting Property-Liability policies in force. We remain focused on execution. We take a balanced approach to investment risk and return and we’re building for the future with expanded protection offerings. Excellent capital management will continue to create lasting shareholder value. We remain confident in our strategy and ability to deliver value for shareholders and protection to our customers. Our first quarter results were strong and we’re entering the remainder of 2025 with a solid foundation. With that, I’d like to open it up for your questions."
},
{
"speaker": "Operator",
"text": "Certainly. [Operator Instructions] And, our first question comes from the line of Jimmy Bhullar from JP Morgan. Your question please."
},
{
"speaker": "Jimmy Bhullar",
"text": "Hey, good morning. So, I had a couple of questions, but maybe first starting with just your views on competition in personal auto. Frequency has been pretty favorable for you guys, for many of your peers as well. And, are you seeing that result in companies getting a little bit more aggressive on pricing, or do you feel competition is fairly rational overall?"
},
{
"speaker": "Tom Wilson",
"text": "Jimmy, I’ll start and then Mario can jump in. First, you’re seeing a reduction in the rate of increases in auto insurance this year versus 2022, 2023 and then it started to come down in 2024 and it’s a little bit lower this year. So, which says that people are operating in basic kind of where they want to be from a profitability standpoint. One of the large competitors is still a little bit lagging, taking larger price increases, but they’ll catch up. So, I think what you can say is the industry is operating good profitability. All of those competitors have the objectives of profitable growth. So, I don’t see us headed into sometimes what you see in the commercial market, soft markets where people are chasing volume by lowering rates. So, I don’t see us moving into an aggressive rate reduction, right, particularly when you look going forward in the possible impact. Mario, anything you want to add to that?"
},
{
"speaker": "Mario Rizzo",
"text": "Yes. Jimmy, I would say that it’s really the combination of favorable frequency, which I think we and the industry have experienced and the moderation of physical damage severities really that’s been the story. I think that’s improved margins broadly. And to Tom’s point, I think the competition has leaned into growth more heavily certainly as margins have improved. We still think it’s a rational market. We like our capabilities and our ability to lean into what we’ve been doing with transformative growth to grow going forward. But, I would still characterize it as a rational market from a pricing perspective."
},
{
"speaker": "Tom Wilson",
"text": "And Jimmy, I would say in that market, we wrote 2.8 million new piece to business in Property-Liability last quarter. Yes. That’s one point."
},
{
"speaker": "Jimmy Bhullar",
"text": "And then on the [fifth] (ph) count, obviously, you’re not raising prices to the same extent as you were before, which means that your persistency should remain good or get better. And then, just with more marketing spending, that should help new business volume, which sort of implies that the sort of turn that you’ve seen in this should sustain, but any reasons to believe that recent improvement would not continue?"
},
{
"speaker": "Tom Wilson",
"text": "Well, there’s two pieces to that. Let me address it, and Mario can jump in here. First, to grow, you’re right, we need to write more new business and then we also need to keep more of the existing customers we have, persistency or in our vernacular retention. So, new business levels were way up at a percentage versus the first quarter of last year, but they’re kind of where we were at the end of last year, which is we’re able to sustain this kind of new business volume on an ongoing basis because of the breadth of our distribution, our competitive pricing, our advertising, all the things you mentioned. So, we feel good about where we’re at in new business. In retention, it lags much as the way it lagged on price going up. So, when we were raising rates, we used to, remember showing you the chart that said, oh, here is what we did this quarter, but keep in mind it takes about 12 months to 18 months to really come into the P&L. The same thing happens to customers and because they don’t pay it right away. And, even when they do pay it right away, sometimes they don’t shift right away. So, your retention lags just as it would on the price increase. So, our retention is flattened out and maybe Mario wants to talk about that. And, our efforts in the S.A.V.E. program are to drive it up, besides just not taking more rate. We ought to be giving people more for what they’re paying."
},
{
"speaker": "Mario Rizzo",
"text": "Yes. Let me just maybe do a quick double click on retention because I think the new business volume that we disclosed is pretty self-explanatory. On retention, Jimmy, qualitatively, what I would say is it’s down year-over-year, so Q1 to Q1. But, as Tom indicated, it’s stabilized in the same zone really that it’s been over the past couple of quarters in Q1. And, some of that is because there’s less rate activity in the system, but I think our view is while less rate will help, we’re not waiting for that to improve retention. The S.A.V.E. program is intended to favorably impact customer interactions across at least 25 million customers. One of the components is to improve affordability for customers by proactively engaging with them to make sure that they’ve got the right coverage, the right discounts, things like deductibles and so on, and they can get the best possible price from us, which we believe will help retention. The other part of it is just to improve the overall customer experience and how they interact with us. So, we’re leaning into that as Tom mentioned earlier both through our employees, our agency owners to really proactively engage with customers, improve the experience, improve affordability. And that along with a more stable rate environment, our intent is to have that drive improved retention."
},
{
"speaker": "Jimmy Bhullar",
"text": "Okay. Thank you."
},
{
"speaker": "Operator",
"text": "Thank you. And, our next question comes from the line of Rob Cox from Goldman Sachs. Your question please."
},
{
"speaker": "Rob Cox",
"text": "Hey, thanks. For my first question, maybe a similar line of questioning, but the new issued applications, as you mentioned, accelerated meaningfully in the quarter. I’m just curious if you think this level of new apps is being flattered by an unusually high amount of shopping or if you think this level or higher can actually be maintained with further advertising investment and product rollout?"
},
{
"speaker": "Tom Wilson",
"text": "Well, first, as I mentioned, Rob, that it’s the new business levels this quarter were similar to what we had towards the end of last year. So, we are maintaining it and we’re comfortable there. Our appetite depends on what states we’re in advertising. So, we want to grow as fast as we can. We don’t really have any capacity constraints right now, in terms of number of agents, number of people in direct, in the call centers or on the web or independent agents. So, rolling out affordable simple connected products are what really drives most of the growth. We mentioned we’re not in all the states yet. So, as we roll that out in the rest of the auto states and we get homeowners to go with it, it’s a much better experience, better product. So, we think we still have upward potential. Do I think it’s going to be 27%? No, because it wasn’t 27% over the fourth quarter. So, do I think we have a great distribution system that’s scalable 100%."
},
{
"speaker": "Rob Cox",
"text": "Got it. Thank you. And, then maybe following up on the auto underlying loss ratio. I was just wondering if there’s anything unusual, embedded, maybe any tariff impacts or anything like that contemplated in the loss ratio. I noticed it was kind of one of the first quarters in a long time that the underlying loss ratio actually went up in the first quarter versus the fourth quarter."
},
{
"speaker": "Tom Wilson",
"text": "Let me, on auto insurance property, I’ll make comments. Mario, can jump in here. First, when you evaluate it at the absolute level, it’s outstanding. We are getting really strong returns on capital. We’re better than our targets. Its broad based across the country and by risk level inside the auto book. So, we’re feeling really good about where it is. I think quarterly comparisons are really not that meaningful, to be honest. You got all kinds of things happening. Fourth quarter has got different kind of weather than the first quarter. So, you have frequency bounces and then you have, of course, just weather changes, not even inside individual quarters. And then, the type of weather and the type of accidents also changes the mix of your claims, which has some impact on severity. And, those can easily move a combined ratio by one point to two points. So, I don’t get that focused on that. If you want to look at it on a longer basis, first quarter looks great. We’d like them where we’re at. Mario, what would you add about like breadth and depth of it?"
},
{
"speaker": "Mario Rizzo",
"text": "Yes. Look, I think when we look at auto profitability, certainly in absolute terms, the combined ratio is performing exceptionally well. And, when we look at a state level, with literally a handful of exceptions, we like where our price position is and our rate adequacy and feel really good about profit levels across the vast majority of states that we operate in. The trend on profitability is really unchanged from the last couple of quarters. We continue to earn the rate that we implemented over the last 12 months. And then, we look at loss cost, the combination of favorable frequency and physical damage severity and loss cost kind of flattening out. We actually saw a drop in pure premium year-over-year, and that drove a pretty substantial improvement in the underlying combined ratio in auto, but we feel good about auto profitability. And, that’s one of the things that as margins improved over the course of last year, we opened up markets and we started to expand our risk appetite for new business, and we’re going to continue to do that because we feel good about where we’re positioned from a margin perspective."
},
{
"speaker": "Rob Cox",
"text": "Great. Thank you."
},
{
"speaker": "Operator",
"text": "Thank you. And, our next question comes from the line of Gregory Peters from Raymond James. Your question please."
},
{
"speaker": "Gregory Peters",
"text": "Good morning, everyone. I would like to pivot to Slide 3 of your presentation, where you highlight the improvement in the adjusted expense ratio since 2018. And, I’m just trying to understand what your objective will be, say, for the next five years. Do you anticipate bringing this down below 20%? And, inside the expense ratio for the first quarter, we did note that the, it looks like the advertising expense was down sequentially a little bit. So, I know that’s outside of the adjusted expense ratio, but maybe you can tie in with your answer or perspective on advertising expense?"
},
{
"speaker": "Tom Wilson",
"text": "So, good morning, Greg. We haven’t put a target out for expenses, but our goal should always be lower expenses. And, that’s both as a percentage and in an absolute dollar basis. So, some of the decline, of course, as you raise prices faster than the cost of inflation than your expense ratio goes on. That’s not the way to really get there for your customers. So, but we’ve made some substantial cuts in absolute expenses and we’re going back at it again. Just as now just starting to lead a new effort to go back and so we don’t have a goal, but expect it to keep coming down. We think with our new technology platform and new technologies available out there that there is the opportunity to digitize and eliminate a number of processes that are done by people today, which will be faster, better and cheaper for customers. So, we’re back at it again. We’re excited about it. We think there’s good opportunity there. On advertising, it depends how good we think the opportunities are to grow, where we’re trying to get into markets, whether we’re launching new products. So, the fourth quarter was a high watermark for us. We were testing some new stuff. I don’t expect it to stay at that fourth quarter level really at any time this year that that we were really learning to lean in to see how much we could drive in growth. And, it’s workforce and we what we’ll do is to extend its economic, we’ll continue to spend. If it’s not economic, then we won’t. And, that means both are you getting a good return of people shopping, buying new products, you have a competitive price. And, how do you feel about your margins going forward? We feel really good about our margins going forward in both auto and home. So, you should expect to see us do more there."
},
{
"speaker": "Gregory Peters",
"text": "Okay. I guess for my follow-up question, I’ll pivot to the Slide 5, which is the catastrophe loss slide. I thought your chart there on the left is interesting in the context of framing what goes beyond one standard deviation and two standard deviations. So, inside that disclosure, a couple of things. First of all, it looks like there could be some material subrogation event for you on the wildfire. So, I’m just curious how that might change your perspective on whether this is a two standard deviation or three standard deviation event? And then secondly, in your first quarter supplement, you provided a reinsurance update and it looks like you raised some of the limits. So, maybe you can talk a little bit about that."
},
{
"speaker": "Tom Wilson",
"text": "Well, thank you for liking our slide. We work hard on them. Mario, do you want to take the first part and Jess, do you want to take the reinsurance one?"
},
{
"speaker": "Mario Rizzo",
"text": "Yes. So Greg, the first thing I’d say is that obviously, the chart on Page 5, those are gross losses, so they’re not net of reinsurance. And, the reinsurance recoveries we did disclose in the first quarter, the $1.1 billion the bulk of which was California wildfire related, and the net loss does not consider any sub row recoveries. Having said that, to the extent there are potential sub-row recoveries from at fault parties, we would certainly want to pursue those. And, there is that new wildfire fund that was established by the utilities in California. I think it’s funded at about $15 billion or so with additional capacity beyond that. So, to the extent there is sub-row that we can pursue, we would certainly do that, but we have not reflected any of that in our numbers. And ultimately, the dollars would recover given that we’re into the reinsurance layers will go to reinsurers. It’s also our customers’ money as well. And I think to the extent it provides relief from our breeding perspective, it’s the right thing to do for our customers."
},
{
"speaker": "Jess Merten",
"text": "And, on the reinsurance program, just a reminder to everyone, we do post a very robust disclosure on the changes so that you can find on our investor website. We did place the bulk of the national program this quarter and so we’ve announced that. You can see and I’m sure this is what you saw, Greg. Reinsurance limit purchase was up $1.5 billion, so that’s about 21% and that now we have single event protection up to $9.5 billion up from just under $8 billion last year on a per occurrence basis. We’re doing that really to reflect the change in the risk profile, right? We buy reinsurance based on our risk and return framework and our economic capital model. And, the market in the placement went very well. We split it evenly between traditional markets and the catastrophe bond or the ILS market and had good support for the program this year. On a risk adjusted basis, the cost will be down, which I think is a really good outcome and it helps protect us from single event risk like we saw recently. We’ll announce the remainder of the program that gets placed in Q2 at the end of next quarter. And, that’s just as a reminder that’s the Florida program and then the National General Lender price program reinsurance gets done this quarter. So, all-in-all, again, we have very detailed disclosure that we put out, but in general, we increased the total limit that we bought this year to reflect the expansion of the homeowners both on the expansion of risk."
},
{
"speaker": "Tom Wilson",
"text": "Hey, Greg, let me I’ll just add on to it. So, it’s really the homeowners business is growing. I mean, there’s a lot of conversation appropriately on auto insurance growth and we’re of course highly focused on that. But, the home insurance business, it just units for 2.5 points. And as far as I know, we’re not adding 2.5% to the housing stock in United States, which means we’re picking up unit share. And then, it’s mid-teens growth in revenue. That’s a growth business and I feel like it’s been overlooked by some people. We’ve had some shareholders recently say, no, that’s a story not being told. So, I’m trying to tell the story on their behalf and our behalf. It is a good growth business, which is why we need more reinsurance."
},
{
"speaker": "Gregory Peters",
"text": "Thanks for the additional detail."
},
{
"speaker": "Operator",
"text": "Thank you. And, our next question comes from the line of Bob Huang from Morgan Stanley. Your question please."
},
{
"speaker": "Bob Huang",
"text": "Hey, yes, good morning. So, maybe one real quick on how we should think about essentially the capital position, right? So, you bought back about $100 million of stock this quarter. Just given the market volatility, you’re fairly stable capital position. Curious how you should think about capital allocation, but also capital return at this point of the junction given market has been volatile, your shares have been moving around?"
},
{
"speaker": "Tom Wilson",
"text": "I’ll start and maybe Jess, you want to jump in. First, we’re very comfortable where we’re at. We’ve got plenty of capital. We’ve got -- it’s in the right places. We’re earning good returns. We’ve got the right risk profile. As John talked about, we look in our capital position relative to the whole enterprise thing in terms of our investment risk as well as our insurance risk. And we’re really comfortable with where we’re at there. We’re also comfortable with our program of how we’re deploying it, first into growth and because that generates the kind of ROEs that we talked about earlier in the conversation. Secondly, to the extent we have cash, we can give it to investors, then we do and we have a great track record of doing that. We’re comfortable with $1.5 billion share repurchase program. We’re $100 million in, so it’s a little early to start talking about what else we’re going to do. Jess, anything else you want to?"
},
{
"speaker": "Jess Merten",
"text": "No, I think you hit it, Tom. We’ve talked about this, Bob. We use a sophisticated economic capital framework to look at our capital position. We’re doing that continually and looking at priorities the way that Tom laid out. So, you saw the announced repurchase, as Tom said, we’re $100 million into $1.5 billion, so we’ve got a little bit of time on that. We’ll continue to watch where we sit relative to our target."
},
{
"speaker": "Bob Huang",
"text": "Okay. No, that’s very helpful. So, you’re not front loading April for buybacks, I guess is what I’m trying to say, right?"
},
{
"speaker": "Jess Merten",
"text": "From a pace perspective, we don’t put forward guidance out on how we’re going to buy repurchase stock. What we do is we like to have a continual presence in the market with our repurchases, Bob. So, you can see what we did in Q1 and sort of project out the meeting where we announced was the February, right. So, we effectively did the $100 million over about a month and we like to have that consistent presence in the market. So, I would say on a go forward basis, we’ll continue to evaluate and adjust as needed, but that gives you some sense for the pace of what we did in the first quarter."
},
{
"speaker": "Bob Huang",
"text": "Okay. Thank you. So, my second question, just maybe thinking about California, obviously some competitors are facing more challenges in the homeowner environment. If homeowner competitors were to pull back, does that disrupt their bundling strategy in your view? Do you think the current environment in California changes the competitive environment there and then a consequently maybe makes an opening for you? I understand that California previously had been a challenge, but maybe just any color there."
},
{
"speaker": "Tom Wilson",
"text": "Yes, and partly. How about that? And Marco, you’re drilling there. So, yes, it will impact their auto business, that’s what you referred to. And so in particular, State Farm is struggling given their losses there. And so as they have to restrict the amount of business, it will impact our audit. We know it, we went through it and we went through it in California from 2007. And but for a couple of years, right up until this year, which is why our market share is so low. We went through it in Florida when we went from a 13% or 12% share to like 2% in homeowners and we felt it in our auto book. Now we recovered and we have great share in Florida and we’re growing in Florida. So, they’re not down and out. It will just be a bump that they have to deal with. So yes, it will be something that will change the competitive dynamics. Is it going to change our interest in writing homeowners in California? I doubt it. And we’ll see what happens in the subsequent reforms. But we recovered billion dollars of reinsurance and we got none of that back in rates. And we paid for all of that from our shareholders. So until we get to a place where our costs are actually reflected in what we can charge, we’re not going to be interested in selling homeowners at a loss for our shareholders. On the auto business, Mario, maybe you want to talk about the auto business?"
},
{
"speaker": "Mario Rizzo",
"text": "Yes. In terms of auto, we’ve talked a lot over the past, call it, 12 to 18 months about three states in particular California, New York, New Jersey and the profit challenges we had. With California, I think we’ve largely cycled our way through that. Our California auto insurance is actually generating an underwriting profit. We are open across all channels to write new auto business in California. We got a significant rate approved early last year. We also recently got approval for another 6.9%, which we’ll implement in May. So, our approach in California has always been to try to stay ahead of loss costs as best we can, and the team is doing a really good job of doing that. And we’re operating in California, just like we are in other states that we’re open because we like more position from a profit standpoint and we’re open for business and looking to grow the auto business in California."
},
{
"speaker": "Bob Huang",
"text": "Excellent. Really appreciate it and congrats on the quarter."
},
{
"speaker": "Operator",
"text": "Thank you. Our next question comes from the line of Elyse Greenspan from Wells Fargo. Your question please."
},
{
"speaker": "Elyse Greenspan",
"text": "Hi, thanks. Good morning. My first question is, I guess, on the March policy growth, right, you guys obviously turned the corner with growth in the first quarter. My question is specific to auto. Did you guys observe perhaps any pull forward? Were there perhaps cars being purchased in advance of tariffs? And did that impact any of the numbers in March, from a policy growth perspective?"
},
{
"speaker": "Tom Wilson",
"text": "Elyse, I don’t think we would be able to tell. So, shopping is obviously up in total. It’s up in part because what the industry had to do to raise rates to deal with the pandemic related inflation. It’s unclear that it’s really moved a lot of people to buy cars. You have seen a slight uptick in used car prices recently. Whether that’s in anticipation, who knows?"
},
{
"speaker": "Elyse Greenspan",
"text": "Okay. And then, my follow-up, I guess, is on the tariff, right. It seems like it’ll be about a mid-single digit, increase to severity. As you guys think about that potential increase, and my sense is probably we’ll start to see it over the summer. Correct me if I’m wrong. But as you guys think about that increase and where your margins are today in your auto book, are you going to either absorb it with potentially absorb it in your margins, Or would you look to take additional price to offset any increase that we potentially see from the tariffs?"
},
{
"speaker": "Tom Wilson",
"text": "So, we’re going to manage through whatever the impacts of tariffs are just as we did the inflation that came through the pandemic. So, our objectives are to give customers a good competitive price, make sure we get a return for our shareholders and to grow. So, those are our objectives. Right now, of course, it’s unclear when the actual impact will be to your point. It takes a while to rattle through new car prices, used car prices, dealers, people fixing cars, who else replacing cars. And the pandemic, of course, it happened incredibly rapidly. So, we had 60% increase in used car prices in about less than two years, I think, March or something like that. And so we are factoring in the fact that we think there will be increases in costs, but we don’t know what those are yet. So, it’s difficult to say exactly what we would do in prices or even what the percentage is. You quoted about mid-single digits. I think you were like five points. There are industry estimates that are higher than that and the answer is nobody really knows. So, I’ll just describe what we’re likely to do. So, our costs are likely to be higher. I agree with that. Particularly auto repair and replacement costs are likely to increase. The cost to repair homes is also likely to increase, but our analysis, which we’ve done tons of, is that it’s probably less maybe it’s half of what will happen in auto insurance. So, we’re feeling we’re more focused on auto than we are at home. We are hopeful that the trends reduce what I would call the ramping costs of fender bender losses will take hold. So that should offset some of the increases. So, you saw in Florida Tort reform really helped on the, what I’ll just call, opportunistic If somebody gets an offender bender accident and they just decide, well, I’m going to sue somebody, so I can get some money from because of the way litigation. So, Georgia just passed some tort reform. So, we’re hopeful that, that will work. As in obviously, as Greg asked us, we’re still taking cost down. So, we’re not sticking where we are. And all of that fixed into the mix of where we are. And if we need to raise prices, we will raise prices just like we did in the pandemic because with our margins, we don’t have a lot of room to absorb. I’d like to sell like we’re selling software with 80% margins, we’re in a relatively thin margin business. So, we need to raise our prices. On the Protection Services businesses, some costs are likely to go up as well, but we factored that into the way we’re pricing our product as we go forward and then it adjusts and spreads over time. On a growth standpoint, I think it just is a level playing field. Like I think the advantages you have today or the advantages you’re going to have tomorrow are car prices are x percent higher. And so I don’t really see much difference in the growth side on Property-Liability. On the Protection Services businesses, to the extent that there’s consumer demand goes down because inflation is up or people start buying fewer TVs or washers or stuff like that, that could impact our growth a little bit there. But we’ve got great international growth we’re doing there. So, I’m comfortable with our growth numbers in the tariff. From the investment standpoint, John talked about how balanced our portfolio is, how proactive we are. So, we factor all of this into the mix. From an enterprise standpoint, tariffs are manageable for us. They will be manageable for our customers, and we’ll just do whatever we need to do to make sure we serve both our customers well and keep making money for shareholders."
},
{
"speaker": "Elyse Greenspan",
"text": "Thank you."
},
{
"speaker": "Operator",
"text": "Thank you."
},
{
"speaker": "Operator",
"text": "And our next question comes from the line of Alex Scott from Barclays. Your question please."
},
{
"speaker": "Alex Scott",
"text": "Hey, good morning. First one I had is just on retention, see if you could dig a little more into what you’re seeing and also the S.A.V.E. program. And I guess, specifically, we don’t have the exact numbers necessarily, but we can kind of calculate proxies and so forth. I mean, it looks like it’s still about as bad as it’s got in terms of retention. How much of that is associated with package business, maybe still some, shed in a business versus more competition in the auto market in certain states and versus running through price in certain states. Can you help me think about like, how quickly you expect that to come back and what this S.A.V.E. initiative will do to help that?"
},
{
"speaker": "Tom Wilson",
"text": "Okay. Let me talk about some of the specifics in the various areas. I know it might be frustrating to you that we don’t give you the retention number for the Allstate brand for auto insurance. But we did that on purpose because we found that as we delve into the individual pieces, it gets a little confusing and it’s hard to tell the story. The story is, are we growing total PIF? I guess the story. And some of that’s new business, which we show you numbers on, some of that is retention, which you’re right, you can back into the total number. The specific percentage though bounces around by risk by the number of type of customers you’re writing. So, we’ve gotten much more aggressive in the non-standard market. So, if you look at our internally the way we look at that risk class, we’re doing much better in that segment than we were a couple of years ago, which is where we think one of our big competitors has had a lot of growth. Now that comes with lower retention. So you’re like, oh, well, it’s you feel good on new business, not so good on retention. So, we decided rather than take everybody through the third derivative, we would focus on are we growing total PIF. Now so rather than going into the specific numbers. That said, it’s a good question because retention is really important and we’re doing a lot of work on it. So Mario, do you want to talk about the various programs you have going on retention?"
},
{
"speaker": "Mario Rizzo",
"text": "Yes. So, it is a good question because retention is obviously a core way that we’re going to grow. And you’re right, as I said earlier, it remains in the same zone relative to where it’s been the last couple of quarters. Maybe the way I would think about it, Alex, is actually kind of flip it and rather than talk about retentions, talk about defection, which are the customers that leave us because our actions are really focused on those customers. So, as you think about what we’re doing, the things that cause customers to defect, there are certain triggers. It could be price increase, which obviously we and the industry have had to raise pretty significantly over the last couple of years. Those things trigger shopping. But also poor customer experience or a negative customer experience, those things matter as well. And with S.A.V.E. we’re really going after those triggers. So, we’re looking to improve affordability by making sure, again, customers have the best possible coverage, the best possible price that’s based on their personal circumstances to help alleviate that shopping trigger related to the price of insurance. But it’s also focused on improving our customer interactions broadly to make sure that customers have the best possible and an industry leading customer experience when they engage with Allstate, again, to reduce the number of defections. Along with that, bundling helps the stickiness of the relationship. And our agents on the Allstate side continue to bundle at historically high levels around 80% for new business. That helps retention because it improves the depth of the relationship. And then finally, the fact that we’ve had to be less active from a rate perspective creates more stability in the book, which also will help in terms of reducing defections. But we’re focused principally proactively on those first couple, which is improving the customer experience, improving affordability, continuing to drive bundling at the point of sale and through cross sell where we can to help improve the retention trends going forward."
},
{
"speaker": "Alex Scott",
"text": "Got it. Okay. That’s all really helpful. Next question I had is sort of a follow-up on some of the lost trend comments you made around tariffs and appreciate there’s a ton of uncertainty right now and there’s a wide range of outcomes. But when I think about your financial position in terms of just like premium to equity leverage, which I know is very crude, not necessarily the way you look at it. But, at a high level, you’re sort of sitting at a much higher level than you were prior to the 2021 inflationary period. You’re still buying back stock. I’m just trying to understand how do you think about your capital capacity to deal with the more adverse outcomes that you described? And are there sort of offsets or things I’m not thinking about that are more finetuned than just looking at that premium to equity now versus then?"
},
{
"speaker": "Mario Rizzo",
"text": "So, we’re in a really strong capital position. Depending which equity you’re looking at, you’re looking at statutory capital, you got to add back in what’s at the holding company, which just at the end of the first quarter was about $3 billion. So, there’s a lot of capital there. We think we have plenty of money, even if it means really high increases in average premiums because inflation takes up. We have capital that is positioned so that we can -- we went into this with capital thinking we’re going to grow market share. We plan on growing market share, so we’ve got capital to grow market share and we have plenty of capital to do that. And if it means that average premium scope, we’ve got plenty of capital to do that. So, we’re feeling really good about where our capital position is. And we never really thought we had an issue that a couple of people did, but we’re in great shape. And I do think that the premium to surplus ratio that you’re measuring is too crude to measure, but that’s not a good way to look at capital. We don’t drag you down into the middle of it because we’ve always had good capital and it gets very sophisticated. But we do have lots of scenarios we run. So, we run what if we’re in stagflation, what happens with stagflation and market share growth and how we’re feeling about overall capital. And we’re just in a really good place. The only thing I would add to what Tom said is, you’ll recall as we went through and talked about capital over the last few years, we have the way that we construct our economic capital is we have a base capital layer and then we put stress capital on top of that. So, the stress is to absorb times like what we’re talking about, right? So, we have stressed capital to absorb the volatility that comes with changing market conditions. And to the extent where we have a repurchase program in place, that means that we’ve rebuilt that stress layer from the previous years because as we talk through capital in the last few years, we said there’s sort of an order of operations, you have to get the target and target means you’ve rebuilt a stress layer. So, as you think about going forward, we as Tom said, are in a very strong capital position and we’ve got capital in place to absorb uncertainty and changing market conditions."
},
{
"speaker": "Tom Wilson",
"text": "I think one of the things that didn’t get as much focus as we came through the pandemic was that higher prices led to was based on higher loss costs, higher loss costs led to higher reserves, higher reserves leads to more investments and that leads to more investment income, which keeps going on forever. So, there is a growth aspect to investment income that comes out of this as well besides just making sure you have good combined ratio."
},
{
"speaker": "Alex Scott",
"text": "All good points. Thank you."
},
{
"speaker": "Operator",
"text": "Thank you. And our next question comes from the line of Mike Zaremski from BMO. Your question please."
},
{
"speaker": "Mike Zaremski",
"text": "Hey, great. Thanks for fitting me in. My first question is a high level question. So, looking at consensus, not saying this is necessarily correct, but expected to earn Allstate is a 23% ROE in the coming years. That’s obviously well above Allstate’s long-term average and your cost of equity. You spent significant time and effort building out additional sales channels in recent years. So, I guess just why not write it a slightly worse combined ratio, trade off some ROE for enable more sustainable organic growth since it seems growth has been all the focus on a go forward basis?"
},
{
"speaker": "Tom Wilson",
"text": "Well, we think we can do both. When we look at our if you just go to auto insurance, if you look at our combined ratio relative to the industry, we’ve always been able to operate at, let’s call it, five points better than the industry average. And which means we’ve been able to extract economic rents and still be competitive in marketplace. We haven’t grown as fast as one of our competitors have. We’d like to grow that fast. And so we’re working on that. Their model shows that they have about the same level of combined ratio and they can grow. So, we’re like, yes, we should be able to do both. In homeowners, we have an industry leading position and we are growing. So, we think we can do both. And I do think that growth -- I think you’re absolutely right growth is the unlock to the valuation multiples. If you look at our valuation multiples to anybody else in the industry, they’re substantially below. We obviously don’t like that because we think that we got great businesses and it’s all focused on auto insurance as well as how you doing at home insurance and our protection plans businesses and services businesses are killing it. But like the market will tell us when they’re ready to pay more, but we’re working on it. We’ll do one more question."
},
{
"speaker": "Operator",
"text": "Certainly. Then our final question for today comes from the line of Josh Shanker from Bank of America. Your question please."
},
{
"speaker": "Joshua Shanker",
"text": "Well, thank you for fitting me in. I appreciate it. In terms of the cadence of advertising spend, I noticed you spent less money in the first quarter, than you did in the fourth quarter. And historically looking at when GEICO and Progressive added business, they were more first half of your weighted policy addition businesses. I don’t know if something has changed about the industry. But has the ad spend already peaked? And you talked in this back half of last year about ad spending for future growth. Can you talk about how that works and whether it’s all playing out as the design sets up?"
},
{
"speaker": "Tom Wilson",
"text": "It hasn’t peaked in the first quarter for us. Everybody else will have to decide what they do. I can’t speak to them. Josh, I could speculate, but it is just speculation that the direct business this I know, the direct business does write more new business in the first quarter than other quarters. And they’re heavier in direct than we are. Certainly, GEICO is all direct other than a small little piece of their agency business to kind of build out and progress is a good half direct and we’re not quite there. So, I would guess that their advertising by quarter lines up with where their opportunities are by distribution channel by quarter. But that’s me outside looking in. As it relates to us, as long as we’re getting a good combiner show and we’re writing new business in our economics on advertising, which are very granular these days, not quite as granular as the billion price points in the state in auto insurance, but pretty down close. As long as we’re driving positive ROE on that advertising stuff, we’ll keep doing it. And it’s not all just average, like we do look at the incremental advertising spend as well to make sure we’re getting good returns. So, our goal is increase market share and sell more protection of people. So, there’s other places we can grow besides auto insurance too. I think we should be growing faster than renters and some other stuff. It’s not going to make a huge deal in terms of actual revenues. But one of the things we’re also focused on is we’ve crossed a couple of hundred million dollars in policies in force and that’s substantial presence in America. And so we’re focused on not just every other auto policy, but everything else we sell as well."
},
{
"speaker": "Tom Wilson",
"text": "Thank you all for tuning in. We do have the capabilities of brand, the distribution, the resources to help us accomplish that strategy, which is grow market share in Property-Liability and expand the protection we offer to everybody else. So, thank you for your ongoing engagement. We’ll talk to you next quarter."
},
{
"speaker": "Operator",
"text": "Thank you, ladies and gentlemen, for your participation in today’s conference. This does conclude the program. You may now disconnect. Good day."
}
] | The Allstate Corporation | 18,711 |
ALLE | 4 | 2,020 | 2021-02-16 08:00:00 | Operator: Good day and welcome to the Allegion Fourth Quarter and Full Year 2020 Earnings Conference Call. All participants will be in listen-only mode. After today’s presentation there will be an opportunity to ask questions. [Operator Instructions]. Please note this event is being recorded. I would now like to turn the conference over to Tom Martineau, Vice President, Investor Relations and Treasurer. Please go ahead.
Tom Martineau: Thank you, Alyssa. Good morning, everyone. Welcome and thank you for joining us for Allegion's fourth quarter and full year 2020 earnings call. With me today are Dave Petratis, Chairman President and Chief Executive Officer; and Patrick Shannon, Senior Vice President and Chief Financial Officer of Allegion. Our earnings release, which was issued earlier this morning and the presentation which we will refer to in today's call are available on our website at investor.allegion.com. This call will be recorded and archived on our website. Please go to Slides 2 and 3. Statements made in today's call that are not historical facts are considered forward-looking statements and are made pursuant to the Safe Harbor provisions of Federal Securities Law. Please see our most recent SEC filings for description of some of the factors that may cause actual results to differ materially from our projections. The company assumes no obligation to update these forward-looking statements. Today's presentation and commentary include non-GAAP financial measures. Please refer to the reconciliation in the financial tables of our press release for further details. Dave and Patrick will now discuss our fourth quarter and full year 2020 results and provide an outlook for 2021, which will be followed by a Q&A session. For the Q&A, we would like to ask each caller to limit themselves to one question and one follow-up and then re-enter the queue. We would like to give everyone an opportunity given the time allotted. Now I would like to turn the call over to Dave.
David D. Petratis: Thanks Tom. Good morning and thank you for joining us today. 2020 was an extremely difficult year, perhaps the most challenging that I have encountered during my career. I want to take the time to acknowledge the sacrifice and hard work of our employees in helping Allegion deliver strong results in the face of the obstacles presented by the COVID-19 pandemic. Thank you for your diligence, flexibility, and perseverance. Please go to Slide 4. Despite the pressures posed by the global pandemic, Allegion experienced only a modest topline revenue decline in 2020 and we saw pockets of strength during the year. The business, as you may remember, performed extremely well in the first quarter and in the second half of the year the Americas residential business, SimonsVoss business, Interflex, and global portable security businesses in Europe realized good growth. Although revenue was down modestly for the year, we expanded adjusted operating margins by 20 basis points, aided by quickly implementing restructuring and cost management actions to mitigate the volume related COVID-19 impacts. Allegion produced record adjusted earnings per share and increased available cash flow by more than 20 million versus the prior year. We strengthened foundational elements of Allegion’s culture around safety, sustainability, inclusion, diversity, and engagement, which will help drive our continued success as a company. I'm very proud of our commitment to employee safety and customer excellence, which remain top priorities. In 2020 we made improvements in all of our employee safety metrics, which are already industry leading. This has and will be our North Star. I believe that the time and resources we have invested in safety since then paid us back in 2020. We were able to keep our essential employees working and took extra protections to keep people safe, whether they were on the sites or working remotely and our dedication to customer excellence allowed us to better serve our customers. Today, Allegion is greener and cleaner, reducing greenhouse gases and water usage throughout the year. We paid considerable attention to drive progress on inclusion and diversity, creating a strategic framework and leadership commitment to our action agenda. Our team is significantly more engaged, meaning our global employees are more committed to our vision and our workforce than ever before. All Allegion employees are surveyed annually by Gallup in their native language. Our engagement has seen solid improvements since we have been a standalone company. Please go to Slide 5 and I'll walk you through the fourth quarter financial summary. Revenue for the fourth quarter was 727.3 million, an increase of 1.1%. Organic revenue declined six tenths of a percent. Currency tailwinds more than offset the organic revenue decline and the impact of divestitures. Organic revenue in the quarter included Americas residential, SimonsVoss, Interflex, and global portable security in Europe and Australia and New Zealand in the Asia Pacific. These gains were offset by expected headwinds experienced in our Americas non-residential business. Patrick will share more detail on the regions in a moment. Adjusted operating margin increased by 150 basis point in the fourth quarter as we saw the benefits from restructuring and cost reduction actions mitigate deleverage from volume declines. Adjusted earnings per share of a $1.49 increased $0.21, more than 16% versus the prior year. High operating income, favorable share count, and year-over-year tax rates accounted for the increase. Available cash flow for the year came in at 443.2 million, an increase of over 20 million versus the prior year. Higher adjusted earnings and lower capital expenditures were the driving forces for the increase. I encourage all of you to review the body of work and execution of the Allegion team globally versus our competitors and peers in 2020. Solid top line performance in a pandemic, margin expansion, and record cash flows. During the year we leaned out our structure, increased our investment in technology, and retained our go to market resources and strengthened the engagement of our worldwide team in a pandemic, positioning Allegion to exit the COVID plague as a stronger company. Patrick will now walk you through the financial results, and I'll be back to discuss our strategic agenda and 2021 outlook.
Patrick Shannon: Thanks, Dave and good morning, everyone. Thank you for joining today's call. Please go to Slide Number 6. This slide reflects our earnings per share reconciliation for the fourth quarter. For the fourth quarter 2019 reported earnings per share was $0.86, adjusting $0.42 for charges related to restructuring, trade name impairments, as well as loss on divestitures in Turkey and Colombia, the 2019 adjusted earnings per share was a $1.28. Operational earnings were the primary driver for the year-over-year increase. As indicated, operational results increased earnings per share by $0.13 as favorable price, productivity, and material deflationary impacts more than offset reduced volume, related deleverage, as well as plant inefficiencies due to COVID-19. Favorable year-over-year, tax rate and share count drove another $0.06 and $0.02 increase respectively. Interest and other income were slightly positive and offset the slight reduction associated with incremental investments during the quarter. This results in adjusted fourth quarter 2020 earnings per share of a $1.49, an increase of $0.21, or 16.4% compared to the prior year. Lastly, we have a $0.48 per share reduction for charges related to restructuring, M&A costs, impairments, as well as a loss on health for sale assets. This is related to our decision to divest the QMI door business in the Middle East, which is expected to close in Q1 subject to normal regulatory approvals. After giving effect to these items, you arrive at the fourth quarter. 2020 reported earnings per share of $1.01. Please go to Slide Number 7. This slide depicts the components of our revenue growth for the fourth quarter, as well as for the full year 2020. I'll focus on the total Allegion results and cover the regions on their respective slides. As indicated, we experienced a 0.6% organic revenue decline in the fourth quarter. As shown in the trending chart, we saw sequential improvement in the organic revenue decline, as well as positive total growth of 1.1%, with currency tailwinds mitigating the organic decline and divestitures. Price continued to remain strong and helped to offset some of the volume decline. With the fourth quarter performance, you can see that total revenue was down 4.7% for the full year with organic revenue decline of 4.8%. All three regions ended the year down organically with Americas down 4.2%, EMEA lower by 5.1%, and Asia Pacific off 10.6%. All regions experienced organic revenue declines from the prior year as a result of the COVID-19 pandemic. Please go to Slide Number 8. Fourth quarter revenues for the Americas region were 521.2 million, down 1% and 0.7% on an organic basis. The region continued to deliver solid price realization. On volume Americas residential was outstanding, experiencing mid 20% growth boosted by robust retail point of sale, new home construction and electronics growth, which nearly offset the expected decline in the non-residential business caused by lower new construction and discretionary project delays. Electronics revenue was slightly down with good growth in residential offset by reduced commercial electronics, driven by delays in discretionary projects. We continue to see electronics and touchless solutions as long-term growth drivers and expected electronics accelerated growth to resume when market conditions normalize. Americas adjusted operating income of 148.5 million decreased 3.5% versus the prior year period and adjusted operating margin for the quarter was down 70 basis points. The decrease was driven primarily by volume deleverage, plant inefficiencies due to the challenges from COVID-19, and unfavorable mix partially offset by benefits from cost reduction actions, restructuring benefits, and material deflation. Please go to Slide Number 9. Fourth quarter revenues for the EMEA region were 165.3 million, up 10.5% in total and up 3.1% on an organic basis. The organic growth was driven by good price realization and strength in our SimonsVoss, Interflex, and global portable security businesses. These businesses demonstrated resiliency throughout the year and are well-positioned to continue profitable growth in 2021. Currency tailwinds added to the total growth. EMEA adjusted operating income of 24.9 million increased 49.1% versus the prior year period, and adjusted operating margin for the quarter was up 390 basis points. Also note that these results absorbed a 5.1 million environmental remediation charge, which had a 310 basis point negative impact on adjusted operating margins. The margin expansion was primarily driven by the organic growth leverage and the benefits of the restructuring and cost control actions taken throughout the year. Please go to Slide Number 10. Fourth quarter revenues for the Asia Pacific region were 40.8 million, down 6.4% versus the prior year. Organic revenue was down 11.9%. The decline was driven by continued weakness in Korea and slightly offset by growth in Australia and New Zealand, particularly in the residential business. Currency tailwinds muted some of the organic revenue decline. Asia Pacific adjusted operating income for the quarter was 8.2 million, an increase of 6.3 million, with adjusted operating margins up 1570 basis points versus the prior year period. Approximately 4 million of the income increase was attributable to a gain on the sale of a building. Even excluding that, the benefits realized from restructuring and cost control actions drove substantial margin expansion. Please go to Slide Number 11. Available cash flow for 2020 came in at 443.2 million, which is an increase of 20.6 million compared to the prior year period. The increase was driven by higher adjusted net earnings and lower capital expenditures. Looking at the chart to the right, it shows working capital as a percent of revenues decreased based on a four-point quarter average. This was driven by reduced working capital needs from the lower volume. The business continues to generate strong cash flow and conversion of net earnings. Liquidity and our capital structure are in a great position and we will continue to evaluate opportunities to optimize working capital and drive effective cash flow conversion. We resumed share repurchases and acquired approximately 1.1 million shares for approximately $115 million during the fourth quarter. We also announced a 13% increase in our dividend payout later in March. I will now hand the call back over to Dave.
David D. Petratis: Thank you, Patrick. Please go to Slide Number 12. There's no doubt that throughout the fourth quarter and 2020 as a whole, our vision of seamless access and a safer world continued to drive our business forward. Despite the pandemic and resulting market headwinds, our vision and strategy are progressing on many fronts. We continued our commitments and investments to R&D in 2020, creating a robust pipeline of new product development projects across both our core brands and new electronic product offerings. Our recent acquisition of Yonomi is an example of it's infusing outside thinking, and yet in another way we're making digital and software investments to meet customer needs now and in the future. Yonomi, will accelerate Allegion’s digital journey and product offerings. And our vision remains anchored and are strategic pillars, delivering new value and access and to be the partner of choice, but also in the strength of our historic brands. In fact, throughout the pandemic's Schlage, Von Duprin, SimonsVoss, and Interflex among others in our portfolio, demonstrated both flexibility and creativity to meet customers immediate and changing needs. I couldn't be prouder of how the team grounded our company in sound business practices, while strategic…
Operator: Forgive me, ladies and gentlemen, it appears we are having technical difficulties with the speaker location. Please standby while we try to reconnect. Pardon me ladies and gentlemen, thank you for your patience. I would now like to turn the call back over to Dave Petratis. Please go ahead.
David D. Petratis: Okay, I apologize for that audience. We will go to Slide 12. There's no doubt throughout the fourth quarter and 2020 as a whole, our vision of seamless access and a safer world continue to drive our business forward. Despite the pandemic and resulting market headwinds, our vision and strategy are progressing on many fronts. We continued our commitment and investments to R&D in 2020, creating a robust pipeline of new product and development projects across both our core brands and new electronic product offerings. Our recent acquisition of Yonomi is an example of infusing outside thinking and yet, in another way, we're making digital and software investments to meet customer needs now and in the future. Yonomi will accelerate Allegion’s digital journey and product offerings. And our vision remains anchored in our strategic pillars, delivering new value and access and to be the partner of choice, but also on the strength of our historic brands. In fact, throughout the pandemic Schlage, Von Duprin, SimonsVoss, and Interflex among others in our portfolio demonstrated both flexibility and creativity to meet customers immediate and changing needs. I couldn't be prouder of our team grounded our company in sound business practices was strategically investing for our future to position Allegion for growth as markets rebound. I have said this before and I'll say it again, because of how we've managed our business and how we are investing and because of the engagement, commitment, and resiliency of our employees I believe we'll exit the pandemic stronger than when we started and we are committed to advancing environmental, social, and governance topics. They are important to the company and the communities where we live. Please go to slide 13. Another example from the quarter that demonstrates our focus on Allegion’s future and our vision of seamless access is the creation of Allegion International. As we announced in December, Allegion International officially launched this year on January 1 as a consolidation of the former EMEA and Asia Pacific operating segments. Tim Eckersley is now leading Allegion International, and we are excited to leverage his broad experiences there. As a veteran of the security industry and high growth technologies, and as a longtime leader within our business. Creating Allegion International is designed to drive speed and efficiency by moving decision closer to the customer, simplifying our operating segments, and by reducing overhead in our non-U.S. operations. With this updated operating model in place, we expect to accelerate momentum in electronics growth, software and seamless access in those international markets. Again, we have elite brands with rich histories in Europe and Asia Pacific. While Tim is now leading the way for Allegion International, I want to welcome Luis Orbegoso as Senior Vice President of the Americas. If you haven't already, I encourage you to read our press release or look up Luis's bio on allegion.com. Luis brings a wealth of diverse leadership experiences spanning multiple industries, geographies, and cultures and has a track record of managing through teams through transformation with a focus on operational and customer excellence. He possesses a deep understanding of smart home security, cloud technology, consumer access solutions, as well as commercial and institutional safety, which support our strategic priorities. Needless to say, Tim and Luis are both dedicated to our leadership commitments, delivering value to our customer and shareholders and driving our strategy forward. We are focused and disciplined heading into 2021. Please go to Slide 14. Looking ahead at the 2021 non-residential business, it's important to understand the cyclical nature of this market and where we fit in. In general, we are a late cycle, meaning our products are installed up to a year, sometimes longer after new construction projects start. Our views on commercial institutional markets have not changed. I expect new construction to remain soft this year with institutional markets recovering faster than commercial. I also believe that this recovery will be faster than the 2008 downturn and thus we have maintained our sales and specification capability and capacity while continuing to invest in innovation. Relative to the broader market and competitors Allegion continues to perform well. We continue to provide innovative solutions in our core markets, as well as underserved market opportunities to drive profitable growth. As K through 12 schools, college campuses, and healthcare begin to normalize with regard to the pandemic, we would expect discretionary projects on the non-residential side to pick up in the back half of the year as pent up demand begins to break loose. The residential piece of the Americas business continues to be a bright spot and is expected to grow in 2021 as the undersupply of single family homes continues to be corrected. In addition to the builder channel, DIY projects will continue to drive opportunities as consumers invest in their homes and adopt electronic solutions. We anticipate strength in residential to persist in the foreseeable future. Seamless access, software, and electronics continue to be a long-term growth driver and will remain our top investment priority. They are the future of Allegion. With a strengthened residential and softness in commercial and institutional, we project total organic revenue in the Americas to be down 3% to 4% in 2021. In the Allegion International segments, markets continue to recover and we expect growth in our electronics and system integration businesses, SimonsVoss, Interflex, as well as global portable security business. Currency tailwinds more than offset the expected divestiture of our QMI business and contribute to total growth. For the region, we project total growth of 6% to 7% with organic growth of 2% to 3%. All in for total Allegion we are projecting total revenues to be down a 0.5% to 1.5% and organic revenue decline 1.5% to 2.5%. Please go to Slide 15. Our 2021 outlook for adjusted earnings per share is $4.70 to $4.85. As indicated adjusted operating earnings are expected to decrease 5% to 8%, driven by reduced volumes as a result of the non-residential end markets, incremental investments, and inflationary impacts. We are not immune to the macro-inflationary headwinds especially from steel and electronics components, as well as with freight and transportation. For 2021, we expect an EPS headwind of $0.25 to $0.30 related to direct material input costs and freight inflation alone. We will continue to drive price and productivity to offset but the net benefit will be less than prior years. Incremental investments continue to be a priority as we remain focused on accelerating electronics and seamless access, growth and support of our vision and strategy. These incremental investments predominantly relate to added R&D and engineering capabilities to further develop, enhance, and accelerate new product development. The combination of interest and other expense is expected to be a headwind as some of the more formidable items that we experience in 2020 are non-recurring. Our outlook assumes a full adjusted effective tax rate of approximately 12% and an increase from 11.2% in 2020. It also assumes outstanding weighted average diluted shares of approximately 91 million. The outlook additionally includes $0.10 to $0.15 per share for restructuring charges during the year. As a result, reported EPS is projected to be $4.55 to $4.75. We are projecting our available cash flow for 2021 to be in the $400 million to $420 million range. Please go to Slide 16. We are pleased with our 2020 performance in a pandemic. We saw expanded -- we expanded our operating margins, increased adjustable earnings per share, and delivered higher available cash flow in a difficult macro environment in which we were operating. We have taken actions that will allow Allegion to be leaner and more focused on 2021 as we and the rest of the world navigate and emerge from the pandemic, Allegion will be a stronger company and we are positioned for long-term success. As always, our execution and commitment to driving solid results will remain high. Allegion’s future is bright. Patrick will now -- Patrick and I will now take your questions.
Operator: [Operator Instructions]. The first question today comes from Andrew Obin of Bank of America. Please go ahead.
Andrew Obin: Yes, good morning. Can you hear me?
David D. Petratis: I can hear you perfect. Sorry for the break in our delivery.
Andrew Obin: Oh no, don't worry about it. So first question I have is just how you think about North America comps, because if I look at the revenue it's just -- it's a highly unusual year and that Q1 was super strong last year, Q2 very weak, and then things sort of flattened out. So as I think about comps getting positive into the second half, is the issue really first quarter being very strong and then second quarter you resume positive growth in the second quarter or there is any sort of specific dynamic in the second quarter that you see, sorry to get so granular but it was just highly unusual year and I just want to understand your sort of view on second half recovery in 2021?
David D. Petratis: So I'll jump in here and Patrick can clean up. I'd say as we reflected on 2019 and 2020, I actually saw some softening in the broader building markets as we exited the first half of 2019. Again, we're a late cycle and we carried extremely strong backlog that really helped us through Q1. Then you had the blow up and again we used that strong backlog and the wrap up of projects to really put up, I think, a respectable 2020 for Allegion as we navigated through that. As we go into 2021 and 2022, the backlogs are softened, the new project pipeline is down, and we've got to reposition that. Patrick can talk more about the comps on a quarter-to-quarter basis.
Patrick Shannon: Yeah, so Andrew as you have highlighted, I mean you got it right, Q1 is going to be a difficult comparison because we had really good growth, particularly in the non-residential business. So that's going to be a really tough comp for us. Q2 obviously becomes much easier, particularly on the residential business where we had a plant closure in our Mexico facilities, and we're kind of playing catch up when they reopen, the back half of the quarter. And then, kind of things return I'd say more on a normalized basis in the back half of the year. So, first half it is going to be say down, Q1, up Q2, and then kind of more of a normalized basis, but continued strength in a residential business. Non-residential challenged first half of the year, but getting better as we progress throughout the year, particularly as it relates to discretionary project based business. And, when people start returning to work relative to the easing of the COVID impact, we should start seeing some improvement on that side of the business. Hopefully, that answers what you're looking for.
Andrew Obin: Yeah, and just a follow-up question, bigger picture question. I think the market we've seen some companies going public that are sort of trying to address building management software and sort of integrate software with hardware, you have some of you larger sort of competitors who do building systems also focus on building management software. And if you look at the numbers, the end market growth opportunity just seems very, very attractive. And I know you guys have thought about it, but I was just wondering, how do you think about Allegion’s ability to participate in what seems to be a very exciting growth, not just in hardware, electronic hardware, but also the software market that goes together with it that seems to be growing quite fast over the next several years? Thank you. And I know you guys have thought about it, but we'd love to get more color.
David D. Petratis: So I think, Andrew, we have thought very deeply about it, as we rolled out our vision of seamless access almost three years ago. We see the opportunity, we began to venture investments which was amplified by our full acquisition of Yonomi. But we think through the cloud and connect -- great connected products, there's a key role here for Allegion to play. And we continue to invest in position. I would also say the success that we're having in SimonsVoss and Interflex as an indicator of the attractiveness in the market, where both software and really cool hardware comes together. We're pointed right at that market and think that we can carve out a very attractive position for the company.
Andrew Obin: Alright, thank you.
Operator: Our next question comes from Josh Chan of Baird. Please go ahead.
Josh Chan: Hi, good morning Dave, Patrick, and Tom.
David D. Petratis: Good morning.
Josh Chan: My first -- good morning, my first question has to do with sort of a combination of international under Tim. I was just wondering if, under his leadership are you anticipating any change in strategy or at least focus, areas of focus versus the historical pattern there in their respective businesses?
David D. Petratis: So, first, the creation of Allegion International, we've got great confidence in our General Managers. To start there one of the key moves was to simplify and reduce the overall cost of running the international segment. Two is, within those portfolios we think we're well positioned to move ahead, especially as electronic as a driver. Our Gainsborough offerings are being up to date in terms of electronics and we continue to drive the SimonsVoss and Interflex with new products and a supply chain that I think has helped us grow during the pandemic. Third is global portable security with kryptonite, AXA, and Trelock has performed into a nice operating position as demand for bikes and demand for growth as an OEM supplier have been nice. So we expect Tim to advance that and lean into the electronics growth and potentially further acquisitions in that space.
Patrick Shannon: And Josh, I would just add too, you saw it in the numbers we exited 2020 in really good shape. Good organic growth as Dave mentioned on the SimonsVoss and Interflex and global portable security. We would expect that to continue obviously in 2021 leveraging the good work that was done in the back half of 2020. And then on the operational margin performance outstanding Q4 and our outline has always been to continue to improve our margin profile associated with our international region and we would expect that to continue going forward. Again relative to some of the cost actions we took early in 2020 you saw that come through in the year, and we expect that momentum to continue in 2021.
Josh Chan: Yeah, that's great -- thank you. And my follow-up is on the non-res specification business recognizing that that's a longer cycle business. Are you seeing any sort of uptick in the early stages of the design process and where in terms of verticals might you be seeing any types of movement or improvement there in terms of the early stages of the design?
David D. Petratis: So our specification levels have remained strong, and we have continued to invest in digital capability and keeping that specifying capability strong. So we're in a good position. We expect to see a rebound in the second half. There's not been a lot of activity on the campuses of the world, especially the campuses of North America. And as we normalize, we expect some pickup in the second half. As we look at the overall project load, we see positive traction as does institutional products -- projects reload, but also in the hospital sector, where we're very nicely positioned. That whole structure has been severely tested and clearly the economics would suggest that that will be a continued opportunity when we get to the other side of that pandemic, Josh.
Josh Chan: Great, thanks for the color and thanks for the time.
David D. Petratis: Thank you.
Operator: The next question is from David MacGregor of Longbow Research. Please go ahead.
David MacGregor: Yes, good morning everyone. Thanks for all the color on the outlook and as you pointed out your cyclical business, organic growth is going to be soft this year. So I guess that raises the question, given the strength of your cash flow with inorganic growth and so on I am just wondering if you could talk a little bit about how you're thinking about the acquisition growth opportunity in 2021, do we see any departure from the pattern of more bolt-on transactions, do we start leaning into perhaps larger deals as a way to support that acquisition growth? And I guess I'll -- overall just how confident are you in your ability to deliver growth by acquisitions?
David D. Petratis: I'd say number one strong message from our Board of Directors pulled this lever. Two, we've been active and it's -- we continue to have a pipeline of assets that we aspire for and sometimes you got to be patient. I've always felt that our execution as a company puts pressure on that acquisition pipeline that we aspire for. And I would say the pandemic will force decisions among some of those targets that we acquire that move up into the mid major range. We certainly have made numerous acquisitions here, more a string of pearls. We tend to like things that look more like SimonsVoss and Interflex technology that can help enable our capabilities. And as we think about this world of seamless access, going in with accretive targets that will solve new problems for multifamily, for college campuses where we have a unique position on the door that must be connected. Dave, I remind myself, that hardware is hard and we're doing a great job of connecting that. And we've got the opportunity to come in there with connected devices that will be accelerated through Yonomi, thin cloud opportunities that open up opportunities for growth for Allegion.
David MacGregor: Thanks for that. Just a second question, I guess a two part, what's your tax rate risk around Biden's rate increases if those two come to pass? And then secondly, are you kind of -- is there any aspect of your story that you consider to be an infrastructure play such that if we get infrastructure stimulus and infrastructure support legislation, there could be growth drivers there that are not currently reflected in your guidance? Thank you.
Patrick Shannon: So on the tax rates, like any company, multi-industrial company we would be exposed to a rate increase legislative change. We will have to see what happens but that would put obviously pressure on the rate going up. And so we'll just have to kind of see where that goes. Right now our guidance assumes no legislative changes. On the infrastructure spending, obviously, with any money kind of kicking back to the state, local government, so those types of things, I think, would benefit Allegion down the road.
David D. Petratis: I would say in particular, they're still great or large infrastructure needs K through 12 schools. I think the average school in the United States about 40 years. The security needs, certainly are always there and state municipal government will be investing in that, as well as rethinking some of the challenges that they face during the pandemic. We clearly have the ability to control capacity inside a building, increase the security through electronics, and we think we're in a great position as a company and infrastructure investment I think will naturally follow in those public spaces.
David MacGregor: Okay, thank you very much.
David D. Petratis: Thank you.
Operator: The next question comes from Josh Pokrzywinski of Morgan Stanley. Please go ahead.
Joshua Pokrzywinski: Hi, good morning guys.
David D. Petratis: Hey, Josh.
Joshua Pokrzywinski: Just a couple questions here. I guess first on the residential side. I know there's some inventory fill that's still going on, clearly strong growth in the quarter. Where do we sit on that and I guess, when do you expect to get back to normal, Dave, I think you said it was going to run through mid-year and I know Patrick reminded us earlier that it was going to be particularly easy comps on resi. So anything we should keep in mind on channel fell or anything else that would kind of add some lumpiness to the resi growth profile here?
David D. Petratis: I think the mid-year target to normalize backlogs was still the aspiration. We saw our backlog shrink a little bit in December. But we've got work to do in terms of replenishing that channel. We sent a very strong message to our building partners that are non-standard product lead times have been reduced dramatically. We think that will help us grow versus the competition. And we've got new electronic offerings coming out in the second half of the year to match our industry leading Schlage encode products. So, feel good about it but normalization, Josh, certainly by mid-summer barring any blow ups. And, I'd say there's pressure on all manufacturers, especially around the chip thing, our supply chain navigating that wealth, but if -- I don't see it getting materially worse but the pandemic still is having an effect on global supply chains. And again, our strength shines pretty brightly there but mid-year we'll be out of this in a normal way.
Joshua Pokrzywinski: Okay, perfect. And then just a follow-up here. Obviously, decrementals have a lot of things going on between inflation mix, you mentioned freight as well. Maybe some way to kind of give some sensitivity because they look pretty heavy, especially including the investment. But we're also talking about small declines and below our mixed business growing and higher mixed business declining. If non-resi does show some upside through the year, what sort of incremental should we put on that growth, is it kind of the 40% to 50%, that we've kind of grown accustomed to since that number is already fully loaded for investments or is there something else working here because, again, small numbers on the top line in terms of movement can distort the margin line?
David D. Petratis: So I would characterize it this way and hopefully this is helpful as you think about the margin profile for next year or 2021 as it relates to Americas. So a couple things and you touched on one specific relative to our investments that are incremental, associated with R&D and engineering to really push forward the electronics, enhance our product offering going forward. Most of that incremental spend is attached to Americas and so that alone will put pressure on the margin profile associated with Americas. In addition to that you have the incremental inflation that we have highlighted, $0.25 to $0.30 pressure on material input cost. We will do our best to offset that with pricing. But if we break even just the -- math would suggests you're going to have margin pressure attached to that, and then you layer on top of that the mix component, i.e. residential growing faster than non-residential and the non-residential business profile having a higher margin profile, which suggests some additional mix there. So Americas margins will be under pressure in 2021 associated with those three things. We will continue to drive productivity and those types of things to help mitigate that, but there's going to be margin pressure. To come to your second question relative to any growth in the increments associates non-residential, yes. There's going to be some improvement, if we can experience growth in the back half of the year. And you know how we've leveraged historically, I would expect that to continue. And let me make one more point, the margin profile for 2021 being under pressure I view is temporary. Okay, this is a market dynamic, it's not a structural issue associated with Allegion. When business comes back and it will, margin profiles will get better, okay. We will continue to grow margin and we're not in a situation where we've maximized our margin going forward.
Patrick Shannon: I would also add, we certainly got cost out in 2020 and I consciously kept my foot on the accelerator on our specifying and revenue generating resources. We've taken care of these teams through the downturn, and I expect us to get more than our fair share on the upside.
Joshua Pokrzywinski: Alright, thanks for the color Dave and Patrick.
David D. Petratis: Thank you.
Operator: The next question comes from Chris Snyder with UBS. Please go ahead.
Chris Snyder: Thank you for the question. Good morning. So just following up on the 2021 Americas seasonality, is it fair to think that the first half of the year could be up year-on-year just given the easy Q2 comp and then typically you get some level of positive seasonality into the quarter or is that just going to be overwhelmed by the cyclical pressure? And if the first half of the year is up year-on-year, the guidance would suggest pretty material declines in the back half, so hoping you could provide a little bit of color on that?
David D. Petratis: Yeah, so it is -- so yes, to answer your question succinctly. First, that can be up relative to 2020. Why? It's because of Q2 kind of given the easy comps there. And as Dave mentioned earlier, we're still working off the backlog if you will associated with the residential business. The residential business in Q2 2020 was severely depressed because of our plant closures. And as we progress throughout 2020 and the markets POS continue to accelerate, we're having a hard time catching up with demand. That's going to be worked off if you will in the first half and so the residential business in of itself will be up significantly. Non-resi top comp in Q1, but it kind of normalizes in the back half of the year.
Chris Snyder: So appreciate all of that color and then just kind of following up. So, for the Americans the guidance of down 300 to 400 bps year-on-year would suggest pretty material duration for Q4 which was down 70 bps organically in the Americas. Is this the result of deeper declines for non-resi from the low double-digit level we saw in Q4 or is it just that residential is normalizing from a mid-20% growth realized in Q4?
David D. Petratis: I will take the latter so, the double stack on 25% growth year-over-year, much harder comp if you will. Keep in mind Q4 working down backlog, fulfilling stock orders, getting inventory into the channel, that our assumption is not going to repeat itself for 2021 and consequently you have a much difficult comp. Non-res I would expect the rate of decline to improve as we progress during the course of 2021 because of the discretionary business should begin to recover in the back half.
Chris Snyder: Very helpful. Thank you.
Operator: The next question is from Ryan Merkel of William Blair. Please go ahead.
Ryan Merkel: Hey everyone, I guess first off, I had a question on mix and price cost. So what does 2021 guidance assume for the mix headwind and then just clarify, did you say that you expect price to cover costs in 2021?
David D. Petratis: So on the price cost dynamic, we would expect price to offset material costs in outbound freight, but we're going to be under pressure to mitigate other inflationary impacts, i.e. packaging and those type of things that are also escalating and some of the carry over cost that kind of boomeranged back in 2021, relative to 2020. But as it relates to the price, direct material, expect to be neutral there. I'm sorry, what was your other question?
Ryan Merkel: Mix headwind, what are you assuming guidance for mix headwind?
Patrick Shannon: Yeah. So, we don't give specific guidance on that. But there's going to be headwinds, again, the non-res business being our most profitable segments. That being down residential up will create kind of a mixed headwind. That is a component of the margin degradation as realized Americas for 2021.
Ryan Merkel: Alright, fair enough. And then secondly, just high level. Dave, as you think about 2021, what is the biggest variable, is it vaccine timing or is it how customers respond to building investments in a post COVID world?
David D. Petratis: I think we need to continue to accelerate the vaccine delivery. The faster we can get campuses to normalize, hospitals to normalize that pent up demand of discretionary projects bows back, I think it puts confidence into our channel which is restocking. And people will get back thinking about the management of their facilities long term. So it's -- we can see that. Actually feel better about state and local budgets than I did a few months ago and have done a lot of looking into the drivers of our business coming out of the last downturn, the financial crisis. Overall, macro economies are in better shape. The commercial will go through certainly a churn, what do we do with the retail space, not necessarily our sweet spot, but there'll be opportunities as those spaces are reconfigured.
Ryan Merkel: Thanks for the color.
David D. Petratis: Thank you.
Operator: The next question is from Julian Mitchell with Barclays. Please go ahead.
Trish Gorman: Hey, good morning. This is Trish Gorman on for Julian. Hey, so maybe just first question on the QMI sale, can you guys talk a little bit more about the rationale behind this, was this function of the financial profile, was it a function of the end market exposure product line, and then maybe any financial impacts you would expect from that near-term?
Patrick Shannon: So I'd say one, as you look at the market for oil and gas and things are going to drive that part of the world. Clearly a question mark and soft. I'd say two, where did we want to spend our human capital? Clearly, there was pressure in those end markets and our ability to bring together hardware and door solutions didn't feel it was the optimal time. And during the downturn as part of our strategic review, that came up on the portfolio and we chose to exit. So that's how I would describe that situation.
Trish Gorman: Got it. That makes sense. And then maybe just one on the free cash flow guide down kind of high single-digits for 2021. Can you talk about the moving pieces there, how we should think about CAPEX and then maybe working capital through the year?
Patrick Shannon: Yeah, so down it's really down to commensurate with the earnings guide. And CAPEX is up a little bit year-over-year. We can kind of hover around this 2% of revenue. Working capital don't see any significant movement there. I mean, we will be under a little pressure, we did benefit from the CARES Act. And there'll be some payments coming and some deferrals we had in 2020. So, net-net I still think pretty good conversion and we'll continue to drive that and maximize it to the extent we can.
Trish Gorman: Got it. Thanks, guys.
Patrick Shannon: Thank you.
Operator: The next question is from Jeff Kessler of Imperial Capital. Please go ahead.
Jeffrey Kessler: Thank you. And I want to give a quick shout out to Luis who I know from his ADT days, so hello Luis and welcome aboard. [Multiple Speakers] Yeah, UTC as well, right. First question is specific to -- can you go back over, give some of divergences between major divergence between GAAP and non-GAAP reporting that you're expecting for 2021?
Patrick Shannon: Yes, predominantly restructuring. So, it's a continuation of some of the programs we announced, but you just can't book the charge until it's actually incurred. And so we have some continuation of those type of things, and expect some continuation of perhaps one or two kind of new smaller type programs going forward.
Jeffrey Kessler: Right. And then I want to get back to that question of COVID, general question of becoming more seamless into, along with some of the core building software, in my travels and obviously in some of the presentations that I am involved with, we've been talking a lot and this is internationally, this is not just here in the U.S. about -- you can't help but run into now hundreds of companies, some small, some tiny, but some real mid, almost mid-size now that are stressing that. While hardware is the mainstay and software is the tool that it uses, this may reverse in the course of the next, let's call it five to eight years. I'm not going to say two to three, five to eight years probably in which the analytics and visitor management and the entire -- lets just call it the entire the entire realm of software being used is going to be what perhaps drives value and what drives margin for the -- when the end user, particularly when they may start making discretionary decisions. Can you just elaborate on that, I know you have talked about the Yonomi acquisition, that's one step without obviously naming names, what are the types of adjacencies, what are the types of reaches you're looking for here?
Patrick Shannon: So I'd say number one, I looked at companies, Rockwell Automation, Roper, Schneider, where I spent a part, a clear opportunity to take our legacy positions and thrust them into the new world of connectivity, cloud management, to solve customer needs. So, I think that's important. There clearly will be people coming at it from different angles and levels, so I think, our aspiration will be the partner of choice to have open platforms, important here. With that said, I think there's new problems to be solved in the access and security arena. And I think our unique position on the door, along with partners, investment, and further development, we can go in and solve new problems like why does a building have to be open 16 hours a day, why don't I allow that access through as device or, think about how people move through complex buildings. And I know you have Jeff, I think our unique position with connectivity, API's, and SDKs that connect into thin cloud opportunity that we can get more than our share of the growth in these markets.
Jeffrey Kessler: And this is -- you are basing the same, this is worldwide, I'm assuming.
Patrick Shannon: Absolutely. I think, particularly look at our success with SimonsVoss and Interflex versus some pretty strong players in that space, incredible for Allegion, and those trends are going to continue.
Jeffrey Kessler: Right, great. Thank you very much. Appreciate it.
Patrick Shannon: Alright, good to hear you.
Operator: This concludes our question-and-answer session. I would like to turn the conference back over to Tom Martineau for any closing remarks.
Tom Martineau: Thank you. We'd like to thank everyone for participating in today's call. Have a safe day.
Operator: The conference is now concluded. Thank you for attending today's presentation. You may now disconnect. | [
{
"speaker": "Operator",
"text": "Good day and welcome to the Allegion Fourth Quarter and Full Year 2020 Earnings Conference Call. All participants will be in listen-only mode. After today’s presentation there will be an opportunity to ask questions. [Operator Instructions]. Please note this event is being recorded. I would now like to turn the conference over to Tom Martineau, Vice President, Investor Relations and Treasurer. Please go ahead."
},
{
"speaker": "Tom Martineau",
"text": "Thank you, Alyssa. Good morning, everyone. Welcome and thank you for joining us for Allegion's fourth quarter and full year 2020 earnings call. With me today are Dave Petratis, Chairman President and Chief Executive Officer; and Patrick Shannon, Senior Vice President and Chief Financial Officer of Allegion. Our earnings release, which was issued earlier this morning and the presentation which we will refer to in today's call are available on our website at investor.allegion.com. This call will be recorded and archived on our website. Please go to Slides 2 and 3. Statements made in today's call that are not historical facts are considered forward-looking statements and are made pursuant to the Safe Harbor provisions of Federal Securities Law. Please see our most recent SEC filings for description of some of the factors that may cause actual results to differ materially from our projections. The company assumes no obligation to update these forward-looking statements. Today's presentation and commentary include non-GAAP financial measures. Please refer to the reconciliation in the financial tables of our press release for further details. Dave and Patrick will now discuss our fourth quarter and full year 2020 results and provide an outlook for 2021, which will be followed by a Q&A session. For the Q&A, we would like to ask each caller to limit themselves to one question and one follow-up and then re-enter the queue. We would like to give everyone an opportunity given the time allotted. Now I would like to turn the call over to Dave."
},
{
"speaker": "David D. Petratis",
"text": "Thanks Tom. Good morning and thank you for joining us today. 2020 was an extremely difficult year, perhaps the most challenging that I have encountered during my career. I want to take the time to acknowledge the sacrifice and hard work of our employees in helping Allegion deliver strong results in the face of the obstacles presented by the COVID-19 pandemic. Thank you for your diligence, flexibility, and perseverance. Please go to Slide 4. Despite the pressures posed by the global pandemic, Allegion experienced only a modest topline revenue decline in 2020 and we saw pockets of strength during the year. The business, as you may remember, performed extremely well in the first quarter and in the second half of the year the Americas residential business, SimonsVoss business, Interflex, and global portable security businesses in Europe realized good growth. Although revenue was down modestly for the year, we expanded adjusted operating margins by 20 basis points, aided by quickly implementing restructuring and cost management actions to mitigate the volume related COVID-19 impacts. Allegion produced record adjusted earnings per share and increased available cash flow by more than 20 million versus the prior year. We strengthened foundational elements of Allegion’s culture around safety, sustainability, inclusion, diversity, and engagement, which will help drive our continued success as a company. I'm very proud of our commitment to employee safety and customer excellence, which remain top priorities. In 2020 we made improvements in all of our employee safety metrics, which are already industry leading. This has and will be our North Star. I believe that the time and resources we have invested in safety since then paid us back in 2020. We were able to keep our essential employees working and took extra protections to keep people safe, whether they were on the sites or working remotely and our dedication to customer excellence allowed us to better serve our customers. Today, Allegion is greener and cleaner, reducing greenhouse gases and water usage throughout the year. We paid considerable attention to drive progress on inclusion and diversity, creating a strategic framework and leadership commitment to our action agenda. Our team is significantly more engaged, meaning our global employees are more committed to our vision and our workforce than ever before. All Allegion employees are surveyed annually by Gallup in their native language. Our engagement has seen solid improvements since we have been a standalone company. Please go to Slide 5 and I'll walk you through the fourth quarter financial summary. Revenue for the fourth quarter was 727.3 million, an increase of 1.1%. Organic revenue declined six tenths of a percent. Currency tailwinds more than offset the organic revenue decline and the impact of divestitures. Organic revenue in the quarter included Americas residential, SimonsVoss, Interflex, and global portable security in Europe and Australia and New Zealand in the Asia Pacific. These gains were offset by expected headwinds experienced in our Americas non-residential business. Patrick will share more detail on the regions in a moment. Adjusted operating margin increased by 150 basis point in the fourth quarter as we saw the benefits from restructuring and cost reduction actions mitigate deleverage from volume declines. Adjusted earnings per share of a $1.49 increased $0.21, more than 16% versus the prior year. High operating income, favorable share count, and year-over-year tax rates accounted for the increase. Available cash flow for the year came in at 443.2 million, an increase of over 20 million versus the prior year. Higher adjusted earnings and lower capital expenditures were the driving forces for the increase. I encourage all of you to review the body of work and execution of the Allegion team globally versus our competitors and peers in 2020. Solid top line performance in a pandemic, margin expansion, and record cash flows. During the year we leaned out our structure, increased our investment in technology, and retained our go to market resources and strengthened the engagement of our worldwide team in a pandemic, positioning Allegion to exit the COVID plague as a stronger company. Patrick will now walk you through the financial results, and I'll be back to discuss our strategic agenda and 2021 outlook."
},
{
"speaker": "Patrick Shannon",
"text": "Thanks, Dave and good morning, everyone. Thank you for joining today's call. Please go to Slide Number 6. This slide reflects our earnings per share reconciliation for the fourth quarter. For the fourth quarter 2019 reported earnings per share was $0.86, adjusting $0.42 for charges related to restructuring, trade name impairments, as well as loss on divestitures in Turkey and Colombia, the 2019 adjusted earnings per share was a $1.28. Operational earnings were the primary driver for the year-over-year increase. As indicated, operational results increased earnings per share by $0.13 as favorable price, productivity, and material deflationary impacts more than offset reduced volume, related deleverage, as well as plant inefficiencies due to COVID-19. Favorable year-over-year, tax rate and share count drove another $0.06 and $0.02 increase respectively. Interest and other income were slightly positive and offset the slight reduction associated with incremental investments during the quarter. This results in adjusted fourth quarter 2020 earnings per share of a $1.49, an increase of $0.21, or 16.4% compared to the prior year. Lastly, we have a $0.48 per share reduction for charges related to restructuring, M&A costs, impairments, as well as a loss on health for sale assets. This is related to our decision to divest the QMI door business in the Middle East, which is expected to close in Q1 subject to normal regulatory approvals. After giving effect to these items, you arrive at the fourth quarter. 2020 reported earnings per share of $1.01. Please go to Slide Number 7. This slide depicts the components of our revenue growth for the fourth quarter, as well as for the full year 2020. I'll focus on the total Allegion results and cover the regions on their respective slides. As indicated, we experienced a 0.6% organic revenue decline in the fourth quarter. As shown in the trending chart, we saw sequential improvement in the organic revenue decline, as well as positive total growth of 1.1%, with currency tailwinds mitigating the organic decline and divestitures. Price continued to remain strong and helped to offset some of the volume decline. With the fourth quarter performance, you can see that total revenue was down 4.7% for the full year with organic revenue decline of 4.8%. All three regions ended the year down organically with Americas down 4.2%, EMEA lower by 5.1%, and Asia Pacific off 10.6%. All regions experienced organic revenue declines from the prior year as a result of the COVID-19 pandemic. Please go to Slide Number 8. Fourth quarter revenues for the Americas region were 521.2 million, down 1% and 0.7% on an organic basis. The region continued to deliver solid price realization. On volume Americas residential was outstanding, experiencing mid 20% growth boosted by robust retail point of sale, new home construction and electronics growth, which nearly offset the expected decline in the non-residential business caused by lower new construction and discretionary project delays. Electronics revenue was slightly down with good growth in residential offset by reduced commercial electronics, driven by delays in discretionary projects. We continue to see electronics and touchless solutions as long-term growth drivers and expected electronics accelerated growth to resume when market conditions normalize. Americas adjusted operating income of 148.5 million decreased 3.5% versus the prior year period and adjusted operating margin for the quarter was down 70 basis points. The decrease was driven primarily by volume deleverage, plant inefficiencies due to the challenges from COVID-19, and unfavorable mix partially offset by benefits from cost reduction actions, restructuring benefits, and material deflation. Please go to Slide Number 9. Fourth quarter revenues for the EMEA region were 165.3 million, up 10.5% in total and up 3.1% on an organic basis. The organic growth was driven by good price realization and strength in our SimonsVoss, Interflex, and global portable security businesses. These businesses demonstrated resiliency throughout the year and are well-positioned to continue profitable growth in 2021. Currency tailwinds added to the total growth. EMEA adjusted operating income of 24.9 million increased 49.1% versus the prior year period, and adjusted operating margin for the quarter was up 390 basis points. Also note that these results absorbed a 5.1 million environmental remediation charge, which had a 310 basis point negative impact on adjusted operating margins. The margin expansion was primarily driven by the organic growth leverage and the benefits of the restructuring and cost control actions taken throughout the year. Please go to Slide Number 10. Fourth quarter revenues for the Asia Pacific region were 40.8 million, down 6.4% versus the prior year. Organic revenue was down 11.9%. The decline was driven by continued weakness in Korea and slightly offset by growth in Australia and New Zealand, particularly in the residential business. Currency tailwinds muted some of the organic revenue decline. Asia Pacific adjusted operating income for the quarter was 8.2 million, an increase of 6.3 million, with adjusted operating margins up 1570 basis points versus the prior year period. Approximately 4 million of the income increase was attributable to a gain on the sale of a building. Even excluding that, the benefits realized from restructuring and cost control actions drove substantial margin expansion. Please go to Slide Number 11. Available cash flow for 2020 came in at 443.2 million, which is an increase of 20.6 million compared to the prior year period. The increase was driven by higher adjusted net earnings and lower capital expenditures. Looking at the chart to the right, it shows working capital as a percent of revenues decreased based on a four-point quarter average. This was driven by reduced working capital needs from the lower volume. The business continues to generate strong cash flow and conversion of net earnings. Liquidity and our capital structure are in a great position and we will continue to evaluate opportunities to optimize working capital and drive effective cash flow conversion. We resumed share repurchases and acquired approximately 1.1 million shares for approximately $115 million during the fourth quarter. We also announced a 13% increase in our dividend payout later in March. I will now hand the call back over to Dave."
},
{
"speaker": "David D. Petratis",
"text": "Thank you, Patrick. Please go to Slide Number 12. There's no doubt that throughout the fourth quarter and 2020 as a whole, our vision of seamless access and a safer world continued to drive our business forward. Despite the pandemic and resulting market headwinds, our vision and strategy are progressing on many fronts. We continued our commitments and investments to R&D in 2020, creating a robust pipeline of new product development projects across both our core brands and new electronic product offerings. Our recent acquisition of Yonomi is an example of it's infusing outside thinking, and yet in another way we're making digital and software investments to meet customer needs now and in the future. Yonomi, will accelerate Allegion’s digital journey and product offerings. And our vision remains anchored and are strategic pillars, delivering new value and access and to be the partner of choice, but also in the strength of our historic brands. In fact, throughout the pandemic's Schlage, Von Duprin, SimonsVoss, and Interflex among others in our portfolio, demonstrated both flexibility and creativity to meet customers immediate and changing needs. I couldn't be prouder of how the team grounded our company in sound business practices, while strategic…"
},
{
"speaker": "Operator",
"text": "Forgive me, ladies and gentlemen, it appears we are having technical difficulties with the speaker location. Please standby while we try to reconnect. Pardon me ladies and gentlemen, thank you for your patience. I would now like to turn the call back over to Dave Petratis. Please go ahead."
},
{
"speaker": "David D. Petratis",
"text": "Okay, I apologize for that audience. We will go to Slide 12. There's no doubt throughout the fourth quarter and 2020 as a whole, our vision of seamless access and a safer world continue to drive our business forward. Despite the pandemic and resulting market headwinds, our vision and strategy are progressing on many fronts. We continued our commitment and investments to R&D in 2020, creating a robust pipeline of new product and development projects across both our core brands and new electronic product offerings. Our recent acquisition of Yonomi is an example of infusing outside thinking and yet, in another way, we're making digital and software investments to meet customer needs now and in the future. Yonomi will accelerate Allegion’s digital journey and product offerings. And our vision remains anchored in our strategic pillars, delivering new value and access and to be the partner of choice, but also on the strength of our historic brands. In fact, throughout the pandemic Schlage, Von Duprin, SimonsVoss, and Interflex among others in our portfolio demonstrated both flexibility and creativity to meet customers immediate and changing needs. I couldn't be prouder of our team grounded our company in sound business practices was strategically investing for our future to position Allegion for growth as markets rebound. I have said this before and I'll say it again, because of how we've managed our business and how we are investing and because of the engagement, commitment, and resiliency of our employees I believe we'll exit the pandemic stronger than when we started and we are committed to advancing environmental, social, and governance topics. They are important to the company and the communities where we live. Please go to slide 13. Another example from the quarter that demonstrates our focus on Allegion’s future and our vision of seamless access is the creation of Allegion International. As we announced in December, Allegion International officially launched this year on January 1 as a consolidation of the former EMEA and Asia Pacific operating segments. Tim Eckersley is now leading Allegion International, and we are excited to leverage his broad experiences there. As a veteran of the security industry and high growth technologies, and as a longtime leader within our business. Creating Allegion International is designed to drive speed and efficiency by moving decision closer to the customer, simplifying our operating segments, and by reducing overhead in our non-U.S. operations. With this updated operating model in place, we expect to accelerate momentum in electronics growth, software and seamless access in those international markets. Again, we have elite brands with rich histories in Europe and Asia Pacific. While Tim is now leading the way for Allegion International, I want to welcome Luis Orbegoso as Senior Vice President of the Americas. If you haven't already, I encourage you to read our press release or look up Luis's bio on allegion.com. Luis brings a wealth of diverse leadership experiences spanning multiple industries, geographies, and cultures and has a track record of managing through teams through transformation with a focus on operational and customer excellence. He possesses a deep understanding of smart home security, cloud technology, consumer access solutions, as well as commercial and institutional safety, which support our strategic priorities. Needless to say, Tim and Luis are both dedicated to our leadership commitments, delivering value to our customer and shareholders and driving our strategy forward. We are focused and disciplined heading into 2021. Please go to Slide 14. Looking ahead at the 2021 non-residential business, it's important to understand the cyclical nature of this market and where we fit in. In general, we are a late cycle, meaning our products are installed up to a year, sometimes longer after new construction projects start. Our views on commercial institutional markets have not changed. I expect new construction to remain soft this year with institutional markets recovering faster than commercial. I also believe that this recovery will be faster than the 2008 downturn and thus we have maintained our sales and specification capability and capacity while continuing to invest in innovation. Relative to the broader market and competitors Allegion continues to perform well. We continue to provide innovative solutions in our core markets, as well as underserved market opportunities to drive profitable growth. As K through 12 schools, college campuses, and healthcare begin to normalize with regard to the pandemic, we would expect discretionary projects on the non-residential side to pick up in the back half of the year as pent up demand begins to break loose. The residential piece of the Americas business continues to be a bright spot and is expected to grow in 2021 as the undersupply of single family homes continues to be corrected. In addition to the builder channel, DIY projects will continue to drive opportunities as consumers invest in their homes and adopt electronic solutions. We anticipate strength in residential to persist in the foreseeable future. Seamless access, software, and electronics continue to be a long-term growth driver and will remain our top investment priority. They are the future of Allegion. With a strengthened residential and softness in commercial and institutional, we project total organic revenue in the Americas to be down 3% to 4% in 2021. In the Allegion International segments, markets continue to recover and we expect growth in our electronics and system integration businesses, SimonsVoss, Interflex, as well as global portable security business. Currency tailwinds more than offset the expected divestiture of our QMI business and contribute to total growth. For the region, we project total growth of 6% to 7% with organic growth of 2% to 3%. All in for total Allegion we are projecting total revenues to be down a 0.5% to 1.5% and organic revenue decline 1.5% to 2.5%. Please go to Slide 15. Our 2021 outlook for adjusted earnings per share is $4.70 to $4.85. As indicated adjusted operating earnings are expected to decrease 5% to 8%, driven by reduced volumes as a result of the non-residential end markets, incremental investments, and inflationary impacts. We are not immune to the macro-inflationary headwinds especially from steel and electronics components, as well as with freight and transportation. For 2021, we expect an EPS headwind of $0.25 to $0.30 related to direct material input costs and freight inflation alone. We will continue to drive price and productivity to offset but the net benefit will be less than prior years. Incremental investments continue to be a priority as we remain focused on accelerating electronics and seamless access, growth and support of our vision and strategy. These incremental investments predominantly relate to added R&D and engineering capabilities to further develop, enhance, and accelerate new product development. The combination of interest and other expense is expected to be a headwind as some of the more formidable items that we experience in 2020 are non-recurring. Our outlook assumes a full adjusted effective tax rate of approximately 12% and an increase from 11.2% in 2020. It also assumes outstanding weighted average diluted shares of approximately 91 million. The outlook additionally includes $0.10 to $0.15 per share for restructuring charges during the year. As a result, reported EPS is projected to be $4.55 to $4.75. We are projecting our available cash flow for 2021 to be in the $400 million to $420 million range. Please go to Slide 16. We are pleased with our 2020 performance in a pandemic. We saw expanded -- we expanded our operating margins, increased adjustable earnings per share, and delivered higher available cash flow in a difficult macro environment in which we were operating. We have taken actions that will allow Allegion to be leaner and more focused on 2021 as we and the rest of the world navigate and emerge from the pandemic, Allegion will be a stronger company and we are positioned for long-term success. As always, our execution and commitment to driving solid results will remain high. Allegion’s future is bright. Patrick will now -- Patrick and I will now take your questions."
},
{
"speaker": "Operator",
"text": "[Operator Instructions]. The first question today comes from Andrew Obin of Bank of America. Please go ahead."
},
{
"speaker": "Andrew Obin",
"text": "Yes, good morning. Can you hear me?"
},
{
"speaker": "David D. Petratis",
"text": "I can hear you perfect. Sorry for the break in our delivery."
},
{
"speaker": "Andrew Obin",
"text": "Oh no, don't worry about it. So first question I have is just how you think about North America comps, because if I look at the revenue it's just -- it's a highly unusual year and that Q1 was super strong last year, Q2 very weak, and then things sort of flattened out. So as I think about comps getting positive into the second half, is the issue really first quarter being very strong and then second quarter you resume positive growth in the second quarter or there is any sort of specific dynamic in the second quarter that you see, sorry to get so granular but it was just highly unusual year and I just want to understand your sort of view on second half recovery in 2021?"
},
{
"speaker": "David D. Petratis",
"text": "So I'll jump in here and Patrick can clean up. I'd say as we reflected on 2019 and 2020, I actually saw some softening in the broader building markets as we exited the first half of 2019. Again, we're a late cycle and we carried extremely strong backlog that really helped us through Q1. Then you had the blow up and again we used that strong backlog and the wrap up of projects to really put up, I think, a respectable 2020 for Allegion as we navigated through that. As we go into 2021 and 2022, the backlogs are softened, the new project pipeline is down, and we've got to reposition that. Patrick can talk more about the comps on a quarter-to-quarter basis."
},
{
"speaker": "Patrick Shannon",
"text": "Yeah, so Andrew as you have highlighted, I mean you got it right, Q1 is going to be a difficult comparison because we had really good growth, particularly in the non-residential business. So that's going to be a really tough comp for us. Q2 obviously becomes much easier, particularly on the residential business where we had a plant closure in our Mexico facilities, and we're kind of playing catch up when they reopen, the back half of the quarter. And then, kind of things return I'd say more on a normalized basis in the back half of the year. So, first half it is going to be say down, Q1, up Q2, and then kind of more of a normalized basis, but continued strength in a residential business. Non-residential challenged first half of the year, but getting better as we progress throughout the year, particularly as it relates to discretionary project based business. And, when people start returning to work relative to the easing of the COVID impact, we should start seeing some improvement on that side of the business. Hopefully, that answers what you're looking for."
},
{
"speaker": "Andrew Obin",
"text": "Yeah, and just a follow-up question, bigger picture question. I think the market we've seen some companies going public that are sort of trying to address building management software and sort of integrate software with hardware, you have some of you larger sort of competitors who do building systems also focus on building management software. And if you look at the numbers, the end market growth opportunity just seems very, very attractive. And I know you guys have thought about it, but I was just wondering, how do you think about Allegion’s ability to participate in what seems to be a very exciting growth, not just in hardware, electronic hardware, but also the software market that goes together with it that seems to be growing quite fast over the next several years? Thank you. And I know you guys have thought about it, but we'd love to get more color."
},
{
"speaker": "David D. Petratis",
"text": "So I think, Andrew, we have thought very deeply about it, as we rolled out our vision of seamless access almost three years ago. We see the opportunity, we began to venture investments which was amplified by our full acquisition of Yonomi. But we think through the cloud and connect -- great connected products, there's a key role here for Allegion to play. And we continue to invest in position. I would also say the success that we're having in SimonsVoss and Interflex as an indicator of the attractiveness in the market, where both software and really cool hardware comes together. We're pointed right at that market and think that we can carve out a very attractive position for the company."
},
{
"speaker": "Andrew Obin",
"text": "Alright, thank you."
},
{
"speaker": "Operator",
"text": "Our next question comes from Josh Chan of Baird. Please go ahead."
},
{
"speaker": "Josh Chan",
"text": "Hi, good morning Dave, Patrick, and Tom."
},
{
"speaker": "David D. Petratis",
"text": "Good morning."
},
{
"speaker": "Josh Chan",
"text": "My first -- good morning, my first question has to do with sort of a combination of international under Tim. I was just wondering if, under his leadership are you anticipating any change in strategy or at least focus, areas of focus versus the historical pattern there in their respective businesses?"
},
{
"speaker": "David D. Petratis",
"text": "So, first, the creation of Allegion International, we've got great confidence in our General Managers. To start there one of the key moves was to simplify and reduce the overall cost of running the international segment. Two is, within those portfolios we think we're well positioned to move ahead, especially as electronic as a driver. Our Gainsborough offerings are being up to date in terms of electronics and we continue to drive the SimonsVoss and Interflex with new products and a supply chain that I think has helped us grow during the pandemic. Third is global portable security with kryptonite, AXA, and Trelock has performed into a nice operating position as demand for bikes and demand for growth as an OEM supplier have been nice. So we expect Tim to advance that and lean into the electronics growth and potentially further acquisitions in that space."
},
{
"speaker": "Patrick Shannon",
"text": "And Josh, I would just add too, you saw it in the numbers we exited 2020 in really good shape. Good organic growth as Dave mentioned on the SimonsVoss and Interflex and global portable security. We would expect that to continue obviously in 2021 leveraging the good work that was done in the back half of 2020. And then on the operational margin performance outstanding Q4 and our outline has always been to continue to improve our margin profile associated with our international region and we would expect that to continue going forward. Again relative to some of the cost actions we took early in 2020 you saw that come through in the year, and we expect that momentum to continue in 2021."
},
{
"speaker": "Josh Chan",
"text": "Yeah, that's great -- thank you. And my follow-up is on the non-res specification business recognizing that that's a longer cycle business. Are you seeing any sort of uptick in the early stages of the design process and where in terms of verticals might you be seeing any types of movement or improvement there in terms of the early stages of the design?"
},
{
"speaker": "David D. Petratis",
"text": "So our specification levels have remained strong, and we have continued to invest in digital capability and keeping that specifying capability strong. So we're in a good position. We expect to see a rebound in the second half. There's not been a lot of activity on the campuses of the world, especially the campuses of North America. And as we normalize, we expect some pickup in the second half. As we look at the overall project load, we see positive traction as does institutional products -- projects reload, but also in the hospital sector, where we're very nicely positioned. That whole structure has been severely tested and clearly the economics would suggest that that will be a continued opportunity when we get to the other side of that pandemic, Josh."
},
{
"speaker": "Josh Chan",
"text": "Great, thanks for the color and thanks for the time."
},
{
"speaker": "David D. Petratis",
"text": "Thank you."
},
{
"speaker": "Operator",
"text": "The next question is from David MacGregor of Longbow Research. Please go ahead."
},
{
"speaker": "David MacGregor",
"text": "Yes, good morning everyone. Thanks for all the color on the outlook and as you pointed out your cyclical business, organic growth is going to be soft this year. So I guess that raises the question, given the strength of your cash flow with inorganic growth and so on I am just wondering if you could talk a little bit about how you're thinking about the acquisition growth opportunity in 2021, do we see any departure from the pattern of more bolt-on transactions, do we start leaning into perhaps larger deals as a way to support that acquisition growth? And I guess I'll -- overall just how confident are you in your ability to deliver growth by acquisitions?"
},
{
"speaker": "David D. Petratis",
"text": "I'd say number one strong message from our Board of Directors pulled this lever. Two, we've been active and it's -- we continue to have a pipeline of assets that we aspire for and sometimes you got to be patient. I've always felt that our execution as a company puts pressure on that acquisition pipeline that we aspire for. And I would say the pandemic will force decisions among some of those targets that we acquire that move up into the mid major range. We certainly have made numerous acquisitions here, more a string of pearls. We tend to like things that look more like SimonsVoss and Interflex technology that can help enable our capabilities. And as we think about this world of seamless access, going in with accretive targets that will solve new problems for multifamily, for college campuses where we have a unique position on the door that must be connected. Dave, I remind myself, that hardware is hard and we're doing a great job of connecting that. And we've got the opportunity to come in there with connected devices that will be accelerated through Yonomi, thin cloud opportunities that open up opportunities for growth for Allegion."
},
{
"speaker": "David MacGregor",
"text": "Thanks for that. Just a second question, I guess a two part, what's your tax rate risk around Biden's rate increases if those two come to pass? And then secondly, are you kind of -- is there any aspect of your story that you consider to be an infrastructure play such that if we get infrastructure stimulus and infrastructure support legislation, there could be growth drivers there that are not currently reflected in your guidance? Thank you."
},
{
"speaker": "Patrick Shannon",
"text": "So on the tax rates, like any company, multi-industrial company we would be exposed to a rate increase legislative change. We will have to see what happens but that would put obviously pressure on the rate going up. And so we'll just have to kind of see where that goes. Right now our guidance assumes no legislative changes. On the infrastructure spending, obviously, with any money kind of kicking back to the state, local government, so those types of things, I think, would benefit Allegion down the road."
},
{
"speaker": "David D. Petratis",
"text": "I would say in particular, they're still great or large infrastructure needs K through 12 schools. I think the average school in the United States about 40 years. The security needs, certainly are always there and state municipal government will be investing in that, as well as rethinking some of the challenges that they face during the pandemic. We clearly have the ability to control capacity inside a building, increase the security through electronics, and we think we're in a great position as a company and infrastructure investment I think will naturally follow in those public spaces."
},
{
"speaker": "David MacGregor",
"text": "Okay, thank you very much."
},
{
"speaker": "David D. Petratis",
"text": "Thank you."
},
{
"speaker": "Operator",
"text": "The next question comes from Josh Pokrzywinski of Morgan Stanley. Please go ahead."
},
{
"speaker": "Joshua Pokrzywinski",
"text": "Hi, good morning guys."
},
{
"speaker": "David D. Petratis",
"text": "Hey, Josh."
},
{
"speaker": "Joshua Pokrzywinski",
"text": "Just a couple questions here. I guess first on the residential side. I know there's some inventory fill that's still going on, clearly strong growth in the quarter. Where do we sit on that and I guess, when do you expect to get back to normal, Dave, I think you said it was going to run through mid-year and I know Patrick reminded us earlier that it was going to be particularly easy comps on resi. So anything we should keep in mind on channel fell or anything else that would kind of add some lumpiness to the resi growth profile here?"
},
{
"speaker": "David D. Petratis",
"text": "I think the mid-year target to normalize backlogs was still the aspiration. We saw our backlog shrink a little bit in December. But we've got work to do in terms of replenishing that channel. We sent a very strong message to our building partners that are non-standard product lead times have been reduced dramatically. We think that will help us grow versus the competition. And we've got new electronic offerings coming out in the second half of the year to match our industry leading Schlage encode products. So, feel good about it but normalization, Josh, certainly by mid-summer barring any blow ups. And, I'd say there's pressure on all manufacturers, especially around the chip thing, our supply chain navigating that wealth, but if -- I don't see it getting materially worse but the pandemic still is having an effect on global supply chains. And again, our strength shines pretty brightly there but mid-year we'll be out of this in a normal way."
},
{
"speaker": "Joshua Pokrzywinski",
"text": "Okay, perfect. And then just a follow-up here. Obviously, decrementals have a lot of things going on between inflation mix, you mentioned freight as well. Maybe some way to kind of give some sensitivity because they look pretty heavy, especially including the investment. But we're also talking about small declines and below our mixed business growing and higher mixed business declining. If non-resi does show some upside through the year, what sort of incremental should we put on that growth, is it kind of the 40% to 50%, that we've kind of grown accustomed to since that number is already fully loaded for investments or is there something else working here because, again, small numbers on the top line in terms of movement can distort the margin line?"
},
{
"speaker": "David D. Petratis",
"text": "So I would characterize it this way and hopefully this is helpful as you think about the margin profile for next year or 2021 as it relates to Americas. So a couple things and you touched on one specific relative to our investments that are incremental, associated with R&D and engineering to really push forward the electronics, enhance our product offering going forward. Most of that incremental spend is attached to Americas and so that alone will put pressure on the margin profile associated with Americas. In addition to that you have the incremental inflation that we have highlighted, $0.25 to $0.30 pressure on material input cost. We will do our best to offset that with pricing. But if we break even just the -- math would suggests you're going to have margin pressure attached to that, and then you layer on top of that the mix component, i.e. residential growing faster than non-residential and the non-residential business profile having a higher margin profile, which suggests some additional mix there. So Americas margins will be under pressure in 2021 associated with those three things. We will continue to drive productivity and those types of things to help mitigate that, but there's going to be margin pressure. To come to your second question relative to any growth in the increments associates non-residential, yes. There's going to be some improvement, if we can experience growth in the back half of the year. And you know how we've leveraged historically, I would expect that to continue. And let me make one more point, the margin profile for 2021 being under pressure I view is temporary. Okay, this is a market dynamic, it's not a structural issue associated with Allegion. When business comes back and it will, margin profiles will get better, okay. We will continue to grow margin and we're not in a situation where we've maximized our margin going forward."
},
{
"speaker": "Patrick Shannon",
"text": "I would also add, we certainly got cost out in 2020 and I consciously kept my foot on the accelerator on our specifying and revenue generating resources. We've taken care of these teams through the downturn, and I expect us to get more than our fair share on the upside."
},
{
"speaker": "Joshua Pokrzywinski",
"text": "Alright, thanks for the color Dave and Patrick."
},
{
"speaker": "David D. Petratis",
"text": "Thank you."
},
{
"speaker": "Operator",
"text": "The next question comes from Chris Snyder with UBS. Please go ahead."
},
{
"speaker": "Chris Snyder",
"text": "Thank you for the question. Good morning. So just following up on the 2021 Americas seasonality, is it fair to think that the first half of the year could be up year-on-year just given the easy Q2 comp and then typically you get some level of positive seasonality into the quarter or is that just going to be overwhelmed by the cyclical pressure? And if the first half of the year is up year-on-year, the guidance would suggest pretty material declines in the back half, so hoping you could provide a little bit of color on that?"
},
{
"speaker": "David D. Petratis",
"text": "Yeah, so it is -- so yes, to answer your question succinctly. First, that can be up relative to 2020. Why? It's because of Q2 kind of given the easy comps there. And as Dave mentioned earlier, we're still working off the backlog if you will associated with the residential business. The residential business in Q2 2020 was severely depressed because of our plant closures. And as we progress throughout 2020 and the markets POS continue to accelerate, we're having a hard time catching up with demand. That's going to be worked off if you will in the first half and so the residential business in of itself will be up significantly. Non-resi top comp in Q1, but it kind of normalizes in the back half of the year."
},
{
"speaker": "Chris Snyder",
"text": "So appreciate all of that color and then just kind of following up. So, for the Americans the guidance of down 300 to 400 bps year-on-year would suggest pretty material duration for Q4 which was down 70 bps organically in the Americas. Is this the result of deeper declines for non-resi from the low double-digit level we saw in Q4 or is it just that residential is normalizing from a mid-20% growth realized in Q4?"
},
{
"speaker": "David D. Petratis",
"text": "I will take the latter so, the double stack on 25% growth year-over-year, much harder comp if you will. Keep in mind Q4 working down backlog, fulfilling stock orders, getting inventory into the channel, that our assumption is not going to repeat itself for 2021 and consequently you have a much difficult comp. Non-res I would expect the rate of decline to improve as we progress during the course of 2021 because of the discretionary business should begin to recover in the back half."
},
{
"speaker": "Chris Snyder",
"text": "Very helpful. Thank you."
},
{
"speaker": "Operator",
"text": "The next question is from Ryan Merkel of William Blair. Please go ahead."
},
{
"speaker": "Ryan Merkel",
"text": "Hey everyone, I guess first off, I had a question on mix and price cost. So what does 2021 guidance assume for the mix headwind and then just clarify, did you say that you expect price to cover costs in 2021?"
},
{
"speaker": "David D. Petratis",
"text": "So on the price cost dynamic, we would expect price to offset material costs in outbound freight, but we're going to be under pressure to mitigate other inflationary impacts, i.e. packaging and those type of things that are also escalating and some of the carry over cost that kind of boomeranged back in 2021, relative to 2020. But as it relates to the price, direct material, expect to be neutral there. I'm sorry, what was your other question?"
},
{
"speaker": "Ryan Merkel",
"text": "Mix headwind, what are you assuming guidance for mix headwind?"
},
{
"speaker": "Patrick Shannon",
"text": "Yeah. So, we don't give specific guidance on that. But there's going to be headwinds, again, the non-res business being our most profitable segments. That being down residential up will create kind of a mixed headwind. That is a component of the margin degradation as realized Americas for 2021."
},
{
"speaker": "Ryan Merkel",
"text": "Alright, fair enough. And then secondly, just high level. Dave, as you think about 2021, what is the biggest variable, is it vaccine timing or is it how customers respond to building investments in a post COVID world?"
},
{
"speaker": "David D. Petratis",
"text": "I think we need to continue to accelerate the vaccine delivery. The faster we can get campuses to normalize, hospitals to normalize that pent up demand of discretionary projects bows back, I think it puts confidence into our channel which is restocking. And people will get back thinking about the management of their facilities long term. So it's -- we can see that. Actually feel better about state and local budgets than I did a few months ago and have done a lot of looking into the drivers of our business coming out of the last downturn, the financial crisis. Overall, macro economies are in better shape. The commercial will go through certainly a churn, what do we do with the retail space, not necessarily our sweet spot, but there'll be opportunities as those spaces are reconfigured."
},
{
"speaker": "Ryan Merkel",
"text": "Thanks for the color."
},
{
"speaker": "David D. Petratis",
"text": "Thank you."
},
{
"speaker": "Operator",
"text": "The next question is from Julian Mitchell with Barclays. Please go ahead."
},
{
"speaker": "Trish Gorman",
"text": "Hey, good morning. This is Trish Gorman on for Julian. Hey, so maybe just first question on the QMI sale, can you guys talk a little bit more about the rationale behind this, was this function of the financial profile, was it a function of the end market exposure product line, and then maybe any financial impacts you would expect from that near-term?"
},
{
"speaker": "Patrick Shannon",
"text": "So I'd say one, as you look at the market for oil and gas and things are going to drive that part of the world. Clearly a question mark and soft. I'd say two, where did we want to spend our human capital? Clearly, there was pressure in those end markets and our ability to bring together hardware and door solutions didn't feel it was the optimal time. And during the downturn as part of our strategic review, that came up on the portfolio and we chose to exit. So that's how I would describe that situation."
},
{
"speaker": "Trish Gorman",
"text": "Got it. That makes sense. And then maybe just one on the free cash flow guide down kind of high single-digits for 2021. Can you talk about the moving pieces there, how we should think about CAPEX and then maybe working capital through the year?"
},
{
"speaker": "Patrick Shannon",
"text": "Yeah, so down it's really down to commensurate with the earnings guide. And CAPEX is up a little bit year-over-year. We can kind of hover around this 2% of revenue. Working capital don't see any significant movement there. I mean, we will be under a little pressure, we did benefit from the CARES Act. And there'll be some payments coming and some deferrals we had in 2020. So, net-net I still think pretty good conversion and we'll continue to drive that and maximize it to the extent we can."
},
{
"speaker": "Trish Gorman",
"text": "Got it. Thanks, guys."
},
{
"speaker": "Patrick Shannon",
"text": "Thank you."
},
{
"speaker": "Operator",
"text": "The next question is from Jeff Kessler of Imperial Capital. Please go ahead."
},
{
"speaker": "Jeffrey Kessler",
"text": "Thank you. And I want to give a quick shout out to Luis who I know from his ADT days, so hello Luis and welcome aboard. [Multiple Speakers] Yeah, UTC as well, right. First question is specific to -- can you go back over, give some of divergences between major divergence between GAAP and non-GAAP reporting that you're expecting for 2021?"
},
{
"speaker": "Patrick Shannon",
"text": "Yes, predominantly restructuring. So, it's a continuation of some of the programs we announced, but you just can't book the charge until it's actually incurred. And so we have some continuation of those type of things, and expect some continuation of perhaps one or two kind of new smaller type programs going forward."
},
{
"speaker": "Jeffrey Kessler",
"text": "Right. And then I want to get back to that question of COVID, general question of becoming more seamless into, along with some of the core building software, in my travels and obviously in some of the presentations that I am involved with, we've been talking a lot and this is internationally, this is not just here in the U.S. about -- you can't help but run into now hundreds of companies, some small, some tiny, but some real mid, almost mid-size now that are stressing that. While hardware is the mainstay and software is the tool that it uses, this may reverse in the course of the next, let's call it five to eight years. I'm not going to say two to three, five to eight years probably in which the analytics and visitor management and the entire -- lets just call it the entire the entire realm of software being used is going to be what perhaps drives value and what drives margin for the -- when the end user, particularly when they may start making discretionary decisions. Can you just elaborate on that, I know you have talked about the Yonomi acquisition, that's one step without obviously naming names, what are the types of adjacencies, what are the types of reaches you're looking for here?"
},
{
"speaker": "Patrick Shannon",
"text": "So I'd say number one, I looked at companies, Rockwell Automation, Roper, Schneider, where I spent a part, a clear opportunity to take our legacy positions and thrust them into the new world of connectivity, cloud management, to solve customer needs. So, I think that's important. There clearly will be people coming at it from different angles and levels, so I think, our aspiration will be the partner of choice to have open platforms, important here. With that said, I think there's new problems to be solved in the access and security arena. And I think our unique position on the door, along with partners, investment, and further development, we can go in and solve new problems like why does a building have to be open 16 hours a day, why don't I allow that access through as device or, think about how people move through complex buildings. And I know you have Jeff, I think our unique position with connectivity, API's, and SDKs that connect into thin cloud opportunity that we can get more than our share of the growth in these markets."
},
{
"speaker": "Jeffrey Kessler",
"text": "And this is -- you are basing the same, this is worldwide, I'm assuming."
},
{
"speaker": "Patrick Shannon",
"text": "Absolutely. I think, particularly look at our success with SimonsVoss and Interflex versus some pretty strong players in that space, incredible for Allegion, and those trends are going to continue."
},
{
"speaker": "Jeffrey Kessler",
"text": "Right, great. Thank you very much. Appreciate it."
},
{
"speaker": "Patrick Shannon",
"text": "Alright, good to hear you."
},
{
"speaker": "Operator",
"text": "This concludes our question-and-answer session. I would like to turn the conference back over to Tom Martineau for any closing remarks."
},
{
"speaker": "Tom Martineau",
"text": "Thank you. We'd like to thank everyone for participating in today's call. Have a safe day."
},
{
"speaker": "Operator",
"text": "The conference is now concluded. Thank you for attending today's presentation. You may now disconnect."
}
] | Allegion plc | 241,782,379 |
ALLE | 3 | 2,020 | 2020-10-22 08:00:00 | Operator: Good day and welcome to the Allegion Third Quarter 2020 Earnings Conference Call. All participants will be in listen-only mode. [Operator Instructions] Please note this event is being recorded. I would now like to turn the conference over to Tom Martineau, Vice President of Investor Relations and Treasury. Please go ahead.
Tom Martineau: Thank you, Andrew. Good morning, everyone. Welcome and thank you for joining us for Allegion's third quarter 2020 earnings call. With me today are Dave Petratis, Chairman President and Chief Executive Officer; and Patrick Shannon, Senior Vice President and Chief Financial Officer of Allegion. Our earnings release, which was issued earlier this morning and the presentation which we will refer to in today's call are available on our website at investor.allegion.com. This call will be recorded and archived on our website. Please go to slide number two and three. Statements made in today's call that are not historical facts are considered forward-looking statements and are made pursuant to the Safe Harbor provisions of federal securities law. Please see our most recent SEC filings for description of some of the factors that may cause actual results to differ materially from our projections. The company assumes no obligation to update these forward-looking statements. Today's presentation and commentary include non-GAAP financial measures. Please refer to the reconciliation in the financial tables of our press release for further details. Dave and Patrick will now discuss our third quarter 2020 results, which will be followed by a Q&A session. Please for the Q&A, we would like to ask each caller to limit themselves to one question and one short follow-up and then re-enter the queue. We will like to give everyone an opportunity given the time allotted. Please go to slide four and I'll turn the call over to Dave.
Dave Petratis: Thanks, Tom. Good morning and thank you for joining us today. I'll start by walking through the third quarter financial summary. Revenue for the third quarter was $728.4 million, a decrease of 2.7% or 3.4% organically, which shows sequential improvement from Q2 to Q3. The organic revenue decrease was driven by continued economic challenges stemming from the COVID-19 pandemic. Currency tailwinds provided a boost to total revenue and more than offset the impact of divestitures of our business in Colombia and Turkey. Patrick will share more detail on the regions in a moment. Adjusted operating margin increased by 20 basis points in the third quarter. I'm extremely proud of the resiliency shown by the Allegion team. We executed extremely well and the cost management actions taken during the year helped mitigate the deleverage from volume declines. Positive price and muted inflation also helped deliver the operating margin increase. Adjusted earnings per share of $1.67 increased $0.20 or approximately 14% versus the prior year. The increase was driven primarily by favorable other income, tax cite rate and share count offset the lower operating income. Year-to-date available cash flow came in at $256.1 million, an increase of just over $26 million versus the prior year. Improvement in networking capital and reduce capital expenditures more than offset the lower net earnings. Please go to slide five. Access has been part of our company's heritage for more than a 100 years, and our vision of seamless access and a safer world are providing a sound foundation for our future. In the realities of a post COVID world, customers have new concerns and new needs for healthy environments. The importance of making home, work and institutions safer has never been so important to our customers and the needs for touchless access is not going away. Our business is disciplined and focused, prioritizing investments in our seamless access strategy. As a result, Allegion continues to deliver leadership and innovation across the portfolio. Our Schlage brand is 100 year old powerhouse that spans the globe. In the building channel, our mix of Schlage mechanical and electronic solutions continue to help us win projects, including the new development community in Florida with over 3000 homes. Allegion is further advancing seamless access for builders with electronic solutions that provide contactless home showings, and the Schlage Encode Smart Deadbolt continues to gain momentum in both residential, new construction and retail markets. On university campuses, among the first schools to adopt Schlage security solutions for Apple Wallet are the University of Tennessee, University of Vermont and the University of San Francisco. Allegion now supports contactless student IDs across Apple Wallet, Android and Google Pay. For commercial and institutional markets, we have a full suite of mobile-enabled Schlage locks and readers. In a post-COVID environment mobile technology, contactless hardware and readers in combination with wave-to-open actuators now extend our touchless options for interior and perimeter security. Seamless access also getting grabbed outside the Americas in Q3. SimonsVoss is celebrating its 25th year as an electronic access innovator, and was recently recognized in Germany as the number one electronic locking system manufacturer. In Australia, we just delivered the Gainsborough Freestyle Electronic Trilock for single family and short term rentals, giving the owner full control of access from a mobile approximately. And in Australia and in New Zealand, we introduced the Schlage Omnia fire-rated smart lock for multi-family and office settings. In the quarter we booked over 4 million in orders to support and provide seamless access touchless [ph] solutions to a global leader in social media to be delivered in ‘21. Our investments in seamless access are bolstered by global accelerators. Allegion's partner of choice and open credential strategy is an important accelerator. More than 45 physical access control software providers already integrate with Schlage electronic locks and devices. Many of them are moving to integrate to our mobile credential ecosystem as well. Our global accelerators include e-commerce, touchless access, and increased focus on visitor management and occupancy monitoring. Seamless access is providing to be a strong foundation for our future. Patrick, will now talk to you - walk you through the financial results. And I'll be back to later discuss our 2020 outlook and wrap up.
Patrick Shannon: Thanks, Dave. Good morning, everyone. Thank you for joining today's call. And please go to slide number six. This slide reflects our earnings per share reconciliation for the third quarter. For the third quarter of 2019 reported earnings per share was $1.40. Adjusting $0.07 for the prior year restructuring expenses, integration cost related acquisitions and debt refinancing costs, the 2019 adjusted earnings per share was $1.47. Favorable other income and interest expense increased earnings per share by $0.15. The increase was driven by an approximately $14 million non-cash currency translation gain related to the liquidation of a legal entity in our EMEA region. This benefit would not be expected to recur in 2021. Favorable year-over-year tax rate and share count combined to provide another positive $0.08 per share impact. Operational results decreased earnings per share by $0.03, driven by volume deleverage that was nearly offset by favorable price and productivity exceeding inflationary impacts, as well as favorable currency. This results in adjusted third quarter 2020 earnings per share of $1.67, an increase of $0.20 or approximately 14% compared to the prior year. Lastly, we have a $0.09 per share reduction for charges related to restructuring and impairment costs. After giving effect to these items you arrive at the third quarter 2020 reported earnings per share of $1.58. Please go to slide number seven. This slide depicts the components of our revenue performance for the third quarter, I'll focus on the total Allegion results and cover the regions on their respective slides. As indicated, we experienced a 3.4% organic revenue decline in the third quarter. The COVID-19 pandemic continued to have an impact on the top line number, although we did realize the benefit of delayed projects from the prior quarter. As shown in the trending chart, revenues rebounded nicely, but were short of the very strong quarterly results in the prior year. Despite the difficult and uncertain times we are operating in, the overall business performed very well, particularly in the supply chain and meeting customer requirements. It is also important to note that price remained solid in the quarter, which slightly offset the volume pressure. Currency also provided a tailwind to total growth, and more than offset the impact of the divestiture of our businesses in Colombia and Turkey. Please go to slide number eight. Third quarter revenues for the Americas region were $539.1 million, down 5.1% on a reported basis and down 4.6% organically. The decline was driven by volume challenges on the non-residential business due to the COVID-19 pandemic and was partially offset by good price realization and strength in the residential business. The non-residential business was down low double digits. Conversely, residential bounced back nicely and grew at a low double digit rate. The Americas electronics revenue declined in the mid single digit range, as discretionary commercial projects are delayed. We see electronics and touchless solutions continuing to be a long-term growth drivers and expect electronics accelerated growth to resume when market conditions normalize. America's adjusted operating income of $166.6 million decreased 5.1% versus the prior year period and adjusted operating margin for the quarter was flat. Discretionary cost actions, restructuring benefits and material deflation mitigated the impacts of volume deleverage and unfavorable mix. Please go to slide number nine. Third quarter revenues for the EMEA region were $148.4 million up 7.7% and up 2.9% on an organic basis. The organic growth was driven by strength in a Global Portable Security and SimonsVoss businesses, as well as solid price realization. Favorable currency impacts contributed to total revenue growth and was slightly offset by the impact of the divestiture in the business in Turkey. EMEA adjusted operating income of $17.1 million increased 42.5% versus the prior year period. Adjusted operating margin for the quarter increased by 280 basis points. The margin increase was driven primarily by price and productivity exceeding inflation. Productivity was bolstered by benefits from lower operating costs from the restructuring actions taken earlier in the year and discretionary and variable cost reductions. Please go to slide number 10. Third quarter revenues for Asia Pacific region were $40.9 million down 4.2% versus the prior year, with an organic revenue decline of 6.8%. The decline was driven by continued COVID-19 related impacts and weakness in Korea. Our Australia business performed quite well despite the ongoing pressure in Australian end markets. Currency tailwinds offset some of the organic revenue decline. Asia Pacific adjusted operating income for the quarter was $3.2 million, a decrease of $1.2 million with adjusted operating margins down 250 basis points versus the prior year period. Of note, the prior year operating income includes a $1.1 million favorable one-time item related to the recovery of previously remitted non-income taxes. This had a 260 basis point favorable impact on Asia Pacific margins in Q3 of 2019. Excluding that, margins were essentially flat year-over-year, with the volume deleverage and unfavorable mix being offset by favorable price and productivity exceeding inflation. Please go to slide number 11. Year-to-date available cash flow for the third quarter 2020 came in at $256.1 million, which is an increase of just over $26 million compared to the prior year period. The increase was driven by improvements in net working capital and reduced capital expenditures, which more than offset lower net earnings. Our strong cash flow generation has been an asset to the company. This was evident in the third quarter and will continue to serve us well during the current market environment. Looking at the chart to the right, it shows working capital as a percentage of revenues decreased based on a 4 point quarter average. This was driven by reduced working capital needs from the lower volume, as well as strong collections performance. The business continues to generate strong cash flow and we remain committed to an effective and efficient use of working capital. We will continue to evaluate opportunities to optimize working capital and drive effective cash flow conversion. Please go to slide number 12. Our financial and liquidity position remains extremely solid. Our net debt to EBITDA ratio is 1.6, based on the last 12 months performance. Our debt covenants are well within the required limits. And we have no near term debt maturities. Our $500 million credit facility remains untapped. Our quarterly dividend in 2020 increased 18.5% through the third quarter. This is the sixth consecutive year of annual increases. In addition, with a strong operational execution and cash generation, the increased cash position since the beginning of the year, and better visibility into business conditions, we have resumed share repurchases under our previously authorized $800 million program. As you have heard us say numerous times, we've put our excess cash to use as part of our commitment to a flexible and balanced capital allocation strategy. I will now hand it back over to Dave for an update on our full year 2020 outlook.
Dave Petratis: Thank you, Patrick. Please go to slide number 13. As you know, we were one of the handful of companies who provided an outlook following Q2. With another quarter being behind us, and a bit more clarity, we are updating our outlook for 2020. In the Americas, we expect to see continued pressure on the non-residential business, as discretionary spending and commercial markets remain tough due to the people continuing to work from home. In institutional markets, the projects are restarted will continue to finish. The rate of completion may be slowed as restrictions for the number of people on job sites remain in place, and supply chain issues to the construction site. Residential markets are expected to remain strong in all channels we serve, Big Box retail, e-commerce and new construction. With these expectations, we are improving the organic revenue outlook in the Americas to be down 5.5% to 6% for the full year. We are projecting America's total revenue decline to be 6% to 6.5%, with a slight impact from the divestiture of the business in Colombia. In Europe, we saw sequential improvement in Q3 and we expect Q4 to be better than the year-to-date performance we have experienced. For the region, we now project organic revenue to be down 6.5% to 7.5%. Total Revenue includes currency tailwinds in the latter part of the year, as well as the impacts from the divestiture of the businesses in Turkey and is projected to be down 4.5% to 5.5% for the full year. In Asia Pacific markets were weak before COVID-19, especially in Australia. We expect that along with the weakness we are experiencing Korea to continue. With this backdrop, we expect 2020 organic revenue decline of 12% to 13%. In 2020, total revenue to be down 12.5% to 13.5%, with a slight impact from currency. We are projecting total and organic revenue for the company to be down 6% to 6.5%. We are raising our outlook for adjusted earnings per share to a range of $4.75 to $4.80. Although net investments are assumed to be relatively small in the revised outlook, we remain committed to investing in innovation that supports our seamless access strategy. This outlook reflects the reprioritization of investment to support the expected future of electronics growth. Our revised outlook assumes a full year adjusted effective tax rate of approximately 13%, as well as outstanding weighted average diluted shares of approximately 93 million. The outlook additionally includes approximately $1.30 to $1.35 per share impact from impairment and restructuring charge during the year, most of which have already occurred. As a result, reported EPS is estimated at $3.40 to $3.50. Finally, our revised available cash flow outlook for 2020 has increased and is now projected to be in the $400 million to $420 million range. Please go to slide 14. Allegion has strong business fundamentals and a proven ability to execute and adapt to a changing and uncertain market conditions. We have managed the business extremely well to mitigate the impacts of the ongoing pandemic. We remain ready to serve our customers and meet their needs for touchless access and healthy environments with our market leading brands. We will provide an official outlook for 2021 during our Q4 full year call early next year. But as we think about the remainder of the year, and begin to look at 2021, some key observations that we see are, as previously expected, commercial and institutional markets will continue to be soft in Q4 and in the first half of 2021, with a snapback in repair, retrofit and small projects beginning in the second half of next year. US state and local bond issues continue to be - moved ahead and supported by local communities. Residential end markets are expected to remain strong for the long term, as an under supply of single family homes is corrected. We will continue to manage our cost base to help aggressively mitigate any volume reductions. Seamless access software and electronics will drive growth and continue to be among our top investment priorities, they are our future. Strong cash flow generation will remain a focus with capital deployment to enhance shareholder returns. Going forward, Allegion will be leaner and more focused as we navigate the coming months and emerge from the pandemic. We have implemented restructuring actions during the year that have addressed the cost base in order to right-size the business. We will continue to evaluate business going forward and make necessary changes. Our execution and commitment to driving solid results will remain high. In closing, Allegion’s future is bright. We thank you. And we'll now take your questions.
Operator: [Operator Instructions] The first question comes from Chris Snyder of UBS. Please go ahead.
Chris Snyder: Thank you for the question. Could you, you know, just maybe unpack the Q4 guidance a little bit? Just I guess specifically as it relates to the resi and the non-resi piece in the Americas?
Dave Petratis: So we don't provide specific guidance by quarter, you can obviously back into that relative to our full year guide. I would say, you know, basis of our Q3 performance, strong, both in terms of top line and operating income margin performance, you know, relative to the backdrop of what's going on around the globe. I would say you can kind of see similar type of patterns, in terms of both the non-residential and residential businesses and in terms of what you saw in Q3. But, you know, we'll continue to manage the costs to help mitigate any shortfall relative to the non-residential business and the margin impact. We do have a mix impact that's going on here relative to growth in residential, and, softness in non-residential business.
Chris Snyder: Appreciate that. And then maybe just following up on the resi piece, and I certainly understand your comments on, you know, the resi new construction cycle picking up and we've had low household formations for a long time now. So certainly, you know, see that view. But I guess specifically as it relates to, maybe the restocking cycle, I know there was the Q2 supply chain disruption, like, you know, has that restocking stuff cycle fully been realized at this point? Maybe what's kind of like the runway there that you see growth just on that end?
Dave Petratis: I would say, as we look at the res segment and the pause that, you know, was taken by all suppliers in Q2. We're at record backlogs and normalizing that will take certainly into early Q2.
Chris Snyder: Thank you for that color. Very much appreciate it.
Operator: The next question comes from Ryan Merkel of William Blair. Please go ahead.
Ryan Merkel: Hey, thanks. Good morning and nice quarter.
Dave Petratis: Thank you.
Ryan Merkel: So first off, America's electronics revenue down mid single digits is much improved. You gave some remarks that the trend of touchless access is real and happening. Do you expect this business to turn positive in the fourth quarter? And could electronics provide some offset to weaker underlying commercial trends in 2021 or is that a bit of a reach at this point?
Dave Petratis: Electronics will be positive in Q4. As you look at the year, our electronics, especially electronics mirrors our res and commercial performance, extremely strong and electronics res extremely strong, somewhat muted in commercial and institutional. Two reasons for that. The strength in residential electronics is driven by supply chain strength and an extremely strong position in the portfolio of our products. The Schlage Encode, the Schlage Connect, our KPL locks are some of the best products on the market. So where was the growth in the quarter? In Q3, we had a supplier affected by COVID. And we lost a couple weeks with that. The demand did not stop it, it affected our ability. And if you normalize that through the balance of the year, our growth in electronics, you know, led by res continues. So you know, feel good about that.
Ryan Merkel: That's super helpful. Thanks for that. And then I want to follow up on the 4Q guide and maybe ask it a little differently. It seems to imply America's you know, revenue down mid single digits year-over-year, with flattish margins, just like this quarter. So if I have that, right, why is there not more improvement in the Americas business in 4Q?
Dave Petratis: So, you know, I would characterize it this way, entering into Q3, we had stronger backlogs, particularly in the non-residential business, some of the projects were delayed in the catch-up and that type of thing. And so we were able to maybe operate more efficiently from a manufacturing perspective that helped the margin profile and the business. Two would be, in Q4 maybe a stronger negative mix component, relative to the residential, non-residential sales in the quarter, as well as within the channel and product segments within the non-residential business. So there is a lot of things going on there. But quite frankly, we will, as I said earlier, continue to manage the margin. Well, I was very happy with the progress we made relative to some of the mitigation on the cost side. And you saw that with strong overall margin improvement relative to the prior year.
Ryan Merkel: Yeah. Thanks. I’ll pass it on.
Operator: The next question comes from Josh Pokrzywinski of Morgan Stanley. Please go ahead.
Josh Pokrzywinski: Hi. Good morning, guys.
Dave Petratis: Good morning, Josh.
Josh Pokrzywinski: Dave, just coming back first to some of your comments on the channel replenishment that's necessary in res and appreciate that kind of side point on the - on maybe some of the interruptions on the electronic side that kept fulfillment, you know, maybe cap there. Would you mind quantifying how big of a replenishment still needs to happen? If I remember your comments last time, it was kind of through 1Q. Now it sounds like early 2Q. So maybe a bit of a push out there. But how many weeks of inventory or points of demand, however you want to put it, does the channel need to kind of get back to normal levels on the res side?
Dave Petratis: So, Josh, you know, I would - you know, sorted out in my mind is we leave Q3 with record residential backlog, number one. As I think about bringing that backlog down to normal, it pushes us into Q2. It's not inhibited by our ability for throughput, you know, just with the small disruption. We have had - we have expanded capacity of our residential capability significantly. Demand is good. We've done a good job picking up builders, expanding space at big box. E-commerce remains extremely red hot, and I believe it's our ability to keep our customers in product that has built that backlog. I would say gaining share and a strong suite of electronics that has enhanced our position.
Josh Pokrzywinski: Got it…
Dave Petratis: I'd add one other comment. I'd add one other comment, Allegion’s ability to flex that supply chain is impressive, as is impressive of anything that I've seen in my 40 years of manufacturing.
Josh Pokrzywinski: Got it. Appreciate that color. And then just a follow up. Dave, I appreciate that you even going back to April that you've been cognizant that the current environment probably doesn't support an awesome 2021 for non-res, I think that's now much more apparent to a broader range of folks. If I kind of take some of your comments as a time series, you know, starting from the first quarter earnings, it doesn't really sound like much has changed in the outlook, as you guys have seen more data come through and have gotten closer to next year, if anything, if some of the bond issuance commentary sounds a bit more supportive than what we would have known back then. Is that reading it, right? I mean, I guess, you know, how do you feel versus some of those early observations when we were in the first half of the year, and this is all still fresh?
Dave Petratis: So barring a rupture, I believe, you know, we're lifting off the bottom. I was extremely encouraged by the ABI lift from 40 to 47. Our spec levels are just slightly lighter than last year. So I think that's a net positive. But I've also got to be cognizant, in our key markets, commercial, institutional, especially institutional, the priority is around keeping people safe, keeping people socially distanced, keeping people capacities properly managed. So in my mind, they're small projects, break fix, preventive maintenance that gets delayed, and I believe as COVID winds down in Q2, we're going to see a snapback in those types of projects. And, you know, things will move back towards normal as we get to ‘22.
Josh Pokrzywinski: Got it. Great color. Thanks, Dave.
Operator: The next question comes from Joe Ritchie of Goldman Sachs. Please go ahead.
Joe Ritchie: Thanks. Good morning, everybody.
Dave Petratis: Good morning.
Joe Ritchie: Hey, Dave, just to you know, I hate to harp on the 4Q commentary, but I just want to make sure I understand it, particularly in America. So it sounds like on the residential side of things, things are very strong, right. Your backlogs at record levels, electronics is supposed to be up in the fourth quarter. So the implied step down then in 4Q, is that just non-res is going to get worse in 4Q versus 3Q? And maybe just any color intra-quarter on how trends played out in non-res would be helpful?
Dave Petratis: I would say, you know, getting back to Patrick's comments, the slowdown, in some cases shut down in Q2 set us up for a nice backlog to saw through in Q3. We did a good job in that. Primarily commercial institutional demand has softened And we see that in Q4. That's how I describe it from a demand standpoint. As you look at the margin profile in that, the res demand is extremely strong, but we - you know, it creates a mix issue. Our commercial institutional is significantly more profitable. And those factors work through the fourth quarter.
Joe Ritchie: Okay, great. I appreciate the clarification. And then I guess, you know, just the follow on question, thinking about this, you know, a little bit longer term. You know, ahead of the pandemic, you guys were pretty front-footed and discussing some of the, you know, not just like supply constraints, but really labor constraints in some of these projects, moving to completion. I guess, as you think about the institutional or non-res markets, and what you have in your backlog? Like, how much more visibility do you have, I guess, into 2021? And how much more backlog do you have to complete? I'm just trying to understand, like, how much we've worked through versus what's left to complete before we kind of head into 2021?
Dave Petratis: So as I think at 2021, you know, I talked about spec writing, we're looking at, you know, at incoming order demand, especially, you know, project related, and the backlog. You know, incoming project quotes, again, muted. Our backlog, if you look at it over 36 months, is in the low end of the range, it's not unhealthy. But we would typically go into a softer backlog this time of a year, but again it's on the low range, then, you know, you've got - you know, to get your crystal ball out and my crystal ball, the economics that we continue to look at, suggest softness, and that's what we suggest.
Joe Ritchie: Okay, great. Thank you. Thank you, all.
Operator: The next question comes from Julian Mitchell of Barclays. Please go ahead.
Julian Mitchell: Hi, good morning.
Dave Petratis: Good morning.
Julian Mitchell: Maybe just moving away from the top line for a second, very good productivity performance in the quarter with the margins up, year-on-year you booked some more restructuring charges. So maybe as we look at 2021, is there any way that you could describe the sort of carryover fixed cost savings into next year that should support margins? And any sense around, perhaps temporary costs that might flow back into the P&L? Really just trying to get a sense of any major moving parts? The margins next year, aside from volumes?
Patrick Shannon: Yeah, Julian. I would characterize it this way. You may recall, in the last quarter conference call, we kind of outlined what we are doing this year, you know, there's $80 million kind of cost reduction take out for 2020. And we characterize that as kind of three components, which was the discretionary, variable, structural, permanent type of cost savings. And if you look at those specifically on the permanent structural cost savings, to answer your question, we've been added, you know, pretty solidly, I'd say, over the last couple of quarters. We're now hitting, I'd say a full stride, in terms of the cost takeout associated with that. We've identified some additional measures as well, that will help us into 2021. So there's carryover benefit, particularly in the first half of 2021, that will help mitigate some of these variable components that Boomerang back next year. So I look at those, you know, maybe we're a little upside down. If you kind of look at those two independently and sum them up. We will continue to evaluate our cost structure going forward and adjust as necessary. Basis of future demands are always looking at that. However, we will continue to invest in the business, that's a core part of our strategy, particularly on the seamless access and growth opportunities associated with that, to really position us well on the growth prospects associated with that going forward, as we exit COVID-19. So there's going to be some pressure there relative to those components, and then you're going to have unfortunately, unfavorable mix associated with strength in residential, better than anticipated and some continued softness associated with the no-residential markets.
Julian Mitchell: Very helpful. Thank you, Patrick. And maybe my follow up would be also away from the top line, just on the balance sheet. I think in the prepared remarks around cash usage, you mentioned that the buyback may be resuming. So maybe just help us understand the appetite for share buybacks, how quickly you want to get underway on that. And how attractive M&A opportunities are today?
Patrick Shannon: So first on the M&A, I would say, you know, core part of our strategy to continue to evaluate opportunities that are core in our business, expanding product or our market presence, important, continue to evaluate where we can look at assets that help us from a technology perspective, particularly around this whole connectivity, and seamless access, and then participating in that growth. So we're active, looking at various opportunities. I would say, there's fewer assets on the market, specific and core to our business. And, so kind of if you assume that there's limited M&A activity, we would pivot more toward shareholder distribution, which we - I just want to clarify, we are in the market, and will be in Q4 to help, you know, continue to put cash to use for the benefit of our shareholders, enhance shareholder returns. We think it's a good investment, relative to where we trade today. And so we'll continue to be active in the market.
Dave Petratis: I would add to it from an M&A position, we can go where we need to go. We've got, you know, the dry powder and firepower, I think it's an, you know, an enviable position, leaning harder towards electronics, software that accelerate and add capabilities to our value proposition.
Julian Mitchell: Great. Thanks, Dave and Patrick.
Operator: The next question comes from Andrew Obin of Bank of America. Please go ahead.
Andrew Obin: Hi, guys. Good morning.
Dave Petratis: Good morning, Andrew.
Andrew Obin: I just want to dive in a little bit in institutional markets, specifically education and healthcare. If I look at the bond issuance year-to-date, I think as of end of September, education bond issuance was up almost 40%, and healthcare, I think was down 2%, effectively flat. So within those dynamics, so you know, in education, the pushback were getting is that, okay, so we are going to have bond - you know, we are going to have new bond issuance in November, I guess people will vote for it. But how - what are you hearing from your customers on the education side about the fact is that, I guess some people, they are getting tuition, but maybe they're not getting rents for the dorm rooms. So how much pressure is education sector under? And then for healthcare, right, the issue there is elective surgeries, which are coming back, but how are the conversations going with the healthcare providers in terms of whether they get back to normal? So that's sort of part one, education and healthcare? You know, what are you seeing in those two verticals into next year?
Dave Petratis: So I've had more dialogue on the educational side, and I'd say generally optimistic, and in line with the Bank of America research. As I've had new dialogues, you know, with a few university presidents, their capital projects continue to move forward and have funding at the state level or the private level, depending on the institution. I think there's something to recognize within that, though, Andrew, is the small projects, the break fix, the preventive maintenance, those facility teams are inundated [ph] by just the problems of the day in dealing with students at all levels. So I tend to be net positive and in that college campus K through 12, Allegion will get more than its fair share of the business. On the hospital side. I see the opportunity, the hospital system has been severely tested and investment will go back into that, but it will be second half of ‘21 and into ‘22.
Andrew Obin: And just a follow up question, can you just give us any color on what’s happening was your market share in discretionary retrofit market? I know it's been sort of a couple years ago been a big initiative, you guys have done very well, I believe you continue to do well. But any color on what's happening there?
Dave Petratis: You know, we continue to execute our ground game in terms of the discretionary working with our wholesale partners. A large partner, just shifted completely to Allegion, opening price point, mid price point project. So it continues to be a net positive.
Andrew Obin: So continue to gain market share, so I'll leave that away.
Dave Petratis: Yeah. And I would say the command of our supply chain helps us there, when things are locked up, you know, because of challenges in other parts of the world. Again, you've heard me say, Andrew, our supply chain is simpler, and it gives us opportunities to have dialogues, we can keep the flow of product going.
Andrew Obin: Fantastic. And congratulations on well executed quarter.
Dave Petratis: Thank you, Andrew.
Operator: The next question comes from Tim Wojs of Baird. Please go ahead.
Dave Petratis: Good morning, Tim.
Tim Wojs: Hey, guys. Hey, good morning. Nice job on the margins. Maybe just, really the only question I have is just on pricing. You know, as you kind of look at ‘21, maybe some choppiness in non-res continuing into next year. Any change and kind of how you guys think about pricing? You know, in kind of the out here and you know, really just asking because we are starting to see a little bit of incremental kind of raw material inflation, that's kind of popping up to here. So you just kind of commentary on how we should think about price.
Dave Petratis: So I would characterize it as you know, solid performance in Q3 in year-to-date 2020. We will continue to push and remain competitive in the market. You're correct, there's going to be some inflationary pressure associated with input costs on commodities, you know, things like steel, and aluminium. We'll continue to push the price dynamic to the extent we can, and again remain competitive. But I would think about it, as you know, we're 1%, maybe a little bit lower realize, kind of on a go forward basis.
Tim Wojs: Okay, sounds good. Thanks, guys. Good luck on the rest of the year.
Dave Petratis: Thank you.
Operator: The next question comes from John Walsh of Credit Suisse. Please go ahead.
John Walsh: Hi, good morning.
Dave Petratis: Good morning.
John Walsh: Just wanted to go back to the kind of the language you used around a snapback in the repair, retrofit and small projects activity you're looking at, or anticipating next year. You talked about that large mobile project, which will hit next year. But I'm curious today, if you're seeing your customers make those touchless upgrades in the back half of this year or if it's still more of a conversation with them anticipating doing more of the projects next year?
Dave Petratis: We can identify projects and early adopters, but the momentum of those projects will pick up once we get on the other side of COVID. Unless there's a burning need - when you go in and increase or improve your infrastructure to touchless, waveless connected, it's a bigger project than somebody wants to take on in the middle of a fire fight.
John Walsh: Got you. No, that makes sense. And then, you know, just thinking about earlier, when you were talking about the seamless opportunity, you did use the term, you know, thinking about the readers. As I kind of have historically thought about Allegion’s position in that product, it was smaller relative to one of your competitors. But how important is having the reader as part of the solution? You know, as these customers shift into that seamless world? Is that some place where you need to get bigger or just trying to understand how that works?
Dave Petratis: So when you think about readers, kind of think about light switches, they are ubiquitous, they're in every room. Is one light switch differentiate another? The answer is no. It's important in the sequence, but what we're really after is to eliminate the card and move that to your edge device, your cell phone. That is going to happen. That's the opportunity that we're going to exploit which complements the touchless environment, it complements higher security levels, because you can not only have one level, but even triple levels of authentication. And you don't ever - you get immediate, you know, what we call the arbitrator of access. With a click of a button access is granted or denied eliminating the needs of cards. That's our opportunity.
John Walsh: Great. Appreciate that color. Thank you.
Operator: The next question comes from Deepa Raghavan of Wells Fargo. Please go ahead.
Deepa Raghavan: Hi. Good morning, all.
Dave Petratis: Good morning, Deepa.
Deepa Raghavan: Hey, good quarter, by the way. Two questions for me. First one is, can you talk about the momentum or the revenue growth that you're seeing in products that are driving this post-COVID world with you know, your touchless, seamless, you talked about contactless, Apple, iPhones, et cetera. Now these look like strong renovation opportunity. So why would you not see continued tailwinds into first half of next year versus your commentary for a snapback only in second half? And also can you touch upon how accretive these tech-heavy products and software is to your margins? And I have a follow up.
Dave Petratis: I think you have to put yourself in the middle of a college campus, hospital. And you know, the prioritization of their day and their project work in a COVID reality. As I talked to school administrators, it's not – those preventative small - preventive maintenance items, small projects, unless it's severely broken, it's just not part of the priority list. It's about people flow. It's about cleaning surfaces. So, you know, when you're in a firefight, and you would be at the University of Florida today, you know, that projects, those small projects don't hit that - even the radar screen. So that's what I see in terms of this moving into the second half. Your follow up, your second question, did you hear it Patrick?
Deepa Raghavan: Yeah, sure.
Patrick Shannon: So Deepa, on the margin profile, the electronics with the similar type of margin is your traditional mechanical, but a higher selling price and therefore more EBITDA. So to the extent we can continue to push electronics, which we are and we will, that benefits us from an earnings growth perspective.
Deepa Raghavan: Great. My follow up- Patrick, was more on the residential, electronics lots performance. As I mentioned yesterday, their smart lock business in residential grew high double-digit percent in Q3. Did you see similar kind of strength?
Patrick Shannon: Deepa, I would say this, if we didn't have the supply disruption from a supplier, we would have had one of the strongest residential quarters in the company's history.
Deepa Raghavan: Got it. Great. Thanks for the color.
Operator: The next question comes from David MacGregor of Longbow Research. Please go ahead.
Colton West: Hi, good morning. It's Colton, on for David, congrats on a good quarter.
Dave Petratis: Thank you.
Colton West: I guess, can you start by walking us through how the residential point of sale growth played out in the quarter and any new trends you're seeing there?
Dave Petratis: I would say impressive strength in the e-commerce, you know would indicate share gains. If we look at point of sale, we continue to gain momentum and strength. And it's really across all sectors. I don't think that when people are spending more time in their homes, they're thinking about how do I upgrade and improve my space. I think across DIY, you see that extremely strong trend, one. I think two, the rise in demand for single family home, whether existing or new, we're benefiting from that. Remember, Allegion tends to be the replacement lock of choice. And then we have a suite of electronic products that maybe the best in the industry. And then our supply chain, we have product available, have been able to provide it. So all of those channels, in some cases, our specials, our returns are extended because of the increase in demand. But I think several factors there that are really showing off some res performance. I'd add one more to and I commented on it. Our ability to take our demand up is as good as I've seen in 40 years of manufacturing.
Colton West: That's great. I appreciate that. And then as a follow up, you mentioned some supplier headwinds in the third quarter related to electronics, can you give us an update on where your supply chain stands today for the segment? And if there are any risks that could limit growth in the near term?
Dave Petratis: With the exception of that one supplier, no disruptions. That doesn't mean the supply chains are not under pressure, but we tend to produce in region and that you know, certainly helps us just think time on the boat. But it's one of the proud points of Allegion. We've been working on that supply chain even under Ingersoll Rand. The simplicity of it, the leanness of it, some of the vertical integration that we did over the last few years as we invest in Allegion has really come back to pay dividends.
Colton West: Great. Thanks for the color.
Operator: The next question comes from Jeff Kessler of Imperial Capital. Please go ahead.
Jeff Kessler: Thank you. Thank you. Good morning, guys.
Dave Petratis: Good morning, Jeff.
Jeff Kessler: Morning. Can you can you break out EMEA and Asia Pacific just a little bit in terms of - granted, they're small, but the fact is that, you know, at some point EMEA has to grow again. Where - let's call it vertically and geographically, what was stronger and what was weaker in EMEA?
Dave Petratis: So I think a very good quarter in EMEA, number one. Number two is strengthened our SimonsVoss franchise, which would be SimonsVoss Interflex. Our leader there, Bernhard Sommer really put his foot on the pedal, as we went into the pandemic, had some supply chain strengths that winning in allowed him to capture projects. I also thought our Interflex business did extremely well, which is access software control time and attendance. That business, you know, under some pressure because of - they do a very good job at servicing large manufacturers, especially the auto, aerospace industry, you know, executed well. And I think the numbers suggest that. The other one that's hidden, Jeff is our - what we call global portable security, excellent execution and leadership by John Stanley. Think about it, you can't walk into a bike shop today and find a bike. And that demand has come right into our wheelhouse. We also have been investing in connected technologies that help the location of your bike platform. You know, won some nice business because of that connected capability in the GPS business, that'd be my comments and you know, for the Europe business.
Jeff Kessler: Okay. Great. And in the US now that and I think you alluded to, you use the word NFC, but I'm assuming that NFC becomes a key part of the touchless, wireless, three levels of authority, technology. Are there - are you going to be using multiple technologies in terms of getting those projects going? And will it be mainly around NFC or will you be adding various types of Bluetooth to it? I mean, I know I'm getting down in the weeds here. But question - the question really involves, you know, how flexible are you going to be in terms of those technologies and what is - what are you - what are people asking for or what are people negotiating with you for, they just heard the word that Apple is taking this on as well and now it's basically going to be a standard? Or are you getting different types of demand for different types of wireless technology, per either vertical or per type of end user?
Dave Petratis: NFC remains important. We're investing and partnering in technologies like thread that you're probably the only person on the phone that's aware of a thread technology And I think we continue to be very comfortable on our foundation of being open. And, you know, making good segmentation decisions that allow Allegion to grow, but also servicing our customers.
Jeff Kessler: Okay. Just as a last follow up to this. As far as getting this out there was this at the beginning going to cost you more to get these technologies. I mean, you've obviously had wireless technologies coming out into the marketplace for several years now. But is - are these new technologies going to cost you more to get out there? Or is this is as you said before, the mark - ultimate margins remain about the same, where do the innards of those margins differ from mechanical?
Dave Petratis: Again, margins consistent at a higher selling price. What fascinates me is our position in seamless access opens up new business opportunities, in terms of helping customers simplify their world. So an example of this would be at the University of Texas Austin, where we are the sole supplier on access, they manage 80,000 credentials today. I can get them out of that business and provide new value propositions, higher level of security that I think you know, customers will be more than willing to offer, create a new revenue streams and ecosystems for Allegion.
Jeff Kessler: Great. Thank you very much.
Dave Petratis: Be safe.
Operator: This concludes our question-and-answer session. I would like to turn the conference back over to Tom Martineau for any closing remarks.
Tom Martineau: Thank you. And we'd like to thank everyone for participating in today's call. Have a safe day.
Operator: The conference has now concluded. Thank you for attending today's presentation. You may now disconnect. | [
{
"speaker": "Operator",
"text": "Good day and welcome to the Allegion Third Quarter 2020 Earnings Conference Call. All participants will be in listen-only mode. [Operator Instructions] Please note this event is being recorded. I would now like to turn the conference over to Tom Martineau, Vice President of Investor Relations and Treasury. Please go ahead."
},
{
"speaker": "Tom Martineau",
"text": "Thank you, Andrew. Good morning, everyone. Welcome and thank you for joining us for Allegion's third quarter 2020 earnings call. With me today are Dave Petratis, Chairman President and Chief Executive Officer; and Patrick Shannon, Senior Vice President and Chief Financial Officer of Allegion. Our earnings release, which was issued earlier this morning and the presentation which we will refer to in today's call are available on our website at investor.allegion.com. This call will be recorded and archived on our website. Please go to slide number two and three. Statements made in today's call that are not historical facts are considered forward-looking statements and are made pursuant to the Safe Harbor provisions of federal securities law. Please see our most recent SEC filings for description of some of the factors that may cause actual results to differ materially from our projections. The company assumes no obligation to update these forward-looking statements. Today's presentation and commentary include non-GAAP financial measures. Please refer to the reconciliation in the financial tables of our press release for further details. Dave and Patrick will now discuss our third quarter 2020 results, which will be followed by a Q&A session. Please for the Q&A, we would like to ask each caller to limit themselves to one question and one short follow-up and then re-enter the queue. We will like to give everyone an opportunity given the time allotted. Please go to slide four and I'll turn the call over to Dave."
},
{
"speaker": "Dave Petratis",
"text": "Thanks, Tom. Good morning and thank you for joining us today. I'll start by walking through the third quarter financial summary. Revenue for the third quarter was $728.4 million, a decrease of 2.7% or 3.4% organically, which shows sequential improvement from Q2 to Q3. The organic revenue decrease was driven by continued economic challenges stemming from the COVID-19 pandemic. Currency tailwinds provided a boost to total revenue and more than offset the impact of divestitures of our business in Colombia and Turkey. Patrick will share more detail on the regions in a moment. Adjusted operating margin increased by 20 basis points in the third quarter. I'm extremely proud of the resiliency shown by the Allegion team. We executed extremely well and the cost management actions taken during the year helped mitigate the deleverage from volume declines. Positive price and muted inflation also helped deliver the operating margin increase. Adjusted earnings per share of $1.67 increased $0.20 or approximately 14% versus the prior year. The increase was driven primarily by favorable other income, tax cite rate and share count offset the lower operating income. Year-to-date available cash flow came in at $256.1 million, an increase of just over $26 million versus the prior year. Improvement in networking capital and reduce capital expenditures more than offset the lower net earnings. Please go to slide five. Access has been part of our company's heritage for more than a 100 years, and our vision of seamless access and a safer world are providing a sound foundation for our future. In the realities of a post COVID world, customers have new concerns and new needs for healthy environments. The importance of making home, work and institutions safer has never been so important to our customers and the needs for touchless access is not going away. Our business is disciplined and focused, prioritizing investments in our seamless access strategy. As a result, Allegion continues to deliver leadership and innovation across the portfolio. Our Schlage brand is 100 year old powerhouse that spans the globe. In the building channel, our mix of Schlage mechanical and electronic solutions continue to help us win projects, including the new development community in Florida with over 3000 homes. Allegion is further advancing seamless access for builders with electronic solutions that provide contactless home showings, and the Schlage Encode Smart Deadbolt continues to gain momentum in both residential, new construction and retail markets. On university campuses, among the first schools to adopt Schlage security solutions for Apple Wallet are the University of Tennessee, University of Vermont and the University of San Francisco. Allegion now supports contactless student IDs across Apple Wallet, Android and Google Pay. For commercial and institutional markets, we have a full suite of mobile-enabled Schlage locks and readers. In a post-COVID environment mobile technology, contactless hardware and readers in combination with wave-to-open actuators now extend our touchless options for interior and perimeter security. Seamless access also getting grabbed outside the Americas in Q3. SimonsVoss is celebrating its 25th year as an electronic access innovator, and was recently recognized in Germany as the number one electronic locking system manufacturer. In Australia, we just delivered the Gainsborough Freestyle Electronic Trilock for single family and short term rentals, giving the owner full control of access from a mobile approximately. And in Australia and in New Zealand, we introduced the Schlage Omnia fire-rated smart lock for multi-family and office settings. In the quarter we booked over 4 million in orders to support and provide seamless access touchless [ph] solutions to a global leader in social media to be delivered in ‘21. Our investments in seamless access are bolstered by global accelerators. Allegion's partner of choice and open credential strategy is an important accelerator. More than 45 physical access control software providers already integrate with Schlage electronic locks and devices. Many of them are moving to integrate to our mobile credential ecosystem as well. Our global accelerators include e-commerce, touchless access, and increased focus on visitor management and occupancy monitoring. Seamless access is providing to be a strong foundation for our future. Patrick, will now talk to you - walk you through the financial results. And I'll be back to later discuss our 2020 outlook and wrap up."
},
{
"speaker": "Patrick Shannon",
"text": "Thanks, Dave. Good morning, everyone. Thank you for joining today's call. And please go to slide number six. This slide reflects our earnings per share reconciliation for the third quarter. For the third quarter of 2019 reported earnings per share was $1.40. Adjusting $0.07 for the prior year restructuring expenses, integration cost related acquisitions and debt refinancing costs, the 2019 adjusted earnings per share was $1.47. Favorable other income and interest expense increased earnings per share by $0.15. The increase was driven by an approximately $14 million non-cash currency translation gain related to the liquidation of a legal entity in our EMEA region. This benefit would not be expected to recur in 2021. Favorable year-over-year tax rate and share count combined to provide another positive $0.08 per share impact. Operational results decreased earnings per share by $0.03, driven by volume deleverage that was nearly offset by favorable price and productivity exceeding inflationary impacts, as well as favorable currency. This results in adjusted third quarter 2020 earnings per share of $1.67, an increase of $0.20 or approximately 14% compared to the prior year. Lastly, we have a $0.09 per share reduction for charges related to restructuring and impairment costs. After giving effect to these items you arrive at the third quarter 2020 reported earnings per share of $1.58. Please go to slide number seven. This slide depicts the components of our revenue performance for the third quarter, I'll focus on the total Allegion results and cover the regions on their respective slides. As indicated, we experienced a 3.4% organic revenue decline in the third quarter. The COVID-19 pandemic continued to have an impact on the top line number, although we did realize the benefit of delayed projects from the prior quarter. As shown in the trending chart, revenues rebounded nicely, but were short of the very strong quarterly results in the prior year. Despite the difficult and uncertain times we are operating in, the overall business performed very well, particularly in the supply chain and meeting customer requirements. It is also important to note that price remained solid in the quarter, which slightly offset the volume pressure. Currency also provided a tailwind to total growth, and more than offset the impact of the divestiture of our businesses in Colombia and Turkey. Please go to slide number eight. Third quarter revenues for the Americas region were $539.1 million, down 5.1% on a reported basis and down 4.6% organically. The decline was driven by volume challenges on the non-residential business due to the COVID-19 pandemic and was partially offset by good price realization and strength in the residential business. The non-residential business was down low double digits. Conversely, residential bounced back nicely and grew at a low double digit rate. The Americas electronics revenue declined in the mid single digit range, as discretionary commercial projects are delayed. We see electronics and touchless solutions continuing to be a long-term growth drivers and expect electronics accelerated growth to resume when market conditions normalize. America's adjusted operating income of $166.6 million decreased 5.1% versus the prior year period and adjusted operating margin for the quarter was flat. Discretionary cost actions, restructuring benefits and material deflation mitigated the impacts of volume deleverage and unfavorable mix. Please go to slide number nine. Third quarter revenues for the EMEA region were $148.4 million up 7.7% and up 2.9% on an organic basis. The organic growth was driven by strength in a Global Portable Security and SimonsVoss businesses, as well as solid price realization. Favorable currency impacts contributed to total revenue growth and was slightly offset by the impact of the divestiture in the business in Turkey. EMEA adjusted operating income of $17.1 million increased 42.5% versus the prior year period. Adjusted operating margin for the quarter increased by 280 basis points. The margin increase was driven primarily by price and productivity exceeding inflation. Productivity was bolstered by benefits from lower operating costs from the restructuring actions taken earlier in the year and discretionary and variable cost reductions. Please go to slide number 10. Third quarter revenues for Asia Pacific region were $40.9 million down 4.2% versus the prior year, with an organic revenue decline of 6.8%. The decline was driven by continued COVID-19 related impacts and weakness in Korea. Our Australia business performed quite well despite the ongoing pressure in Australian end markets. Currency tailwinds offset some of the organic revenue decline. Asia Pacific adjusted operating income for the quarter was $3.2 million, a decrease of $1.2 million with adjusted operating margins down 250 basis points versus the prior year period. Of note, the prior year operating income includes a $1.1 million favorable one-time item related to the recovery of previously remitted non-income taxes. This had a 260 basis point favorable impact on Asia Pacific margins in Q3 of 2019. Excluding that, margins were essentially flat year-over-year, with the volume deleverage and unfavorable mix being offset by favorable price and productivity exceeding inflation. Please go to slide number 11. Year-to-date available cash flow for the third quarter 2020 came in at $256.1 million, which is an increase of just over $26 million compared to the prior year period. The increase was driven by improvements in net working capital and reduced capital expenditures, which more than offset lower net earnings. Our strong cash flow generation has been an asset to the company. This was evident in the third quarter and will continue to serve us well during the current market environment. Looking at the chart to the right, it shows working capital as a percentage of revenues decreased based on a 4 point quarter average. This was driven by reduced working capital needs from the lower volume, as well as strong collections performance. The business continues to generate strong cash flow and we remain committed to an effective and efficient use of working capital. We will continue to evaluate opportunities to optimize working capital and drive effective cash flow conversion. Please go to slide number 12. Our financial and liquidity position remains extremely solid. Our net debt to EBITDA ratio is 1.6, based on the last 12 months performance. Our debt covenants are well within the required limits. And we have no near term debt maturities. Our $500 million credit facility remains untapped. Our quarterly dividend in 2020 increased 18.5% through the third quarter. This is the sixth consecutive year of annual increases. In addition, with a strong operational execution and cash generation, the increased cash position since the beginning of the year, and better visibility into business conditions, we have resumed share repurchases under our previously authorized $800 million program. As you have heard us say numerous times, we've put our excess cash to use as part of our commitment to a flexible and balanced capital allocation strategy. I will now hand it back over to Dave for an update on our full year 2020 outlook."
},
{
"speaker": "Dave Petratis",
"text": "Thank you, Patrick. Please go to slide number 13. As you know, we were one of the handful of companies who provided an outlook following Q2. With another quarter being behind us, and a bit more clarity, we are updating our outlook for 2020. In the Americas, we expect to see continued pressure on the non-residential business, as discretionary spending and commercial markets remain tough due to the people continuing to work from home. In institutional markets, the projects are restarted will continue to finish. The rate of completion may be slowed as restrictions for the number of people on job sites remain in place, and supply chain issues to the construction site. Residential markets are expected to remain strong in all channels we serve, Big Box retail, e-commerce and new construction. With these expectations, we are improving the organic revenue outlook in the Americas to be down 5.5% to 6% for the full year. We are projecting America's total revenue decline to be 6% to 6.5%, with a slight impact from the divestiture of the business in Colombia. In Europe, we saw sequential improvement in Q3 and we expect Q4 to be better than the year-to-date performance we have experienced. For the region, we now project organic revenue to be down 6.5% to 7.5%. Total Revenue includes currency tailwinds in the latter part of the year, as well as the impacts from the divestiture of the businesses in Turkey and is projected to be down 4.5% to 5.5% for the full year. In Asia Pacific markets were weak before COVID-19, especially in Australia. We expect that along with the weakness we are experiencing Korea to continue. With this backdrop, we expect 2020 organic revenue decline of 12% to 13%. In 2020, total revenue to be down 12.5% to 13.5%, with a slight impact from currency. We are projecting total and organic revenue for the company to be down 6% to 6.5%. We are raising our outlook for adjusted earnings per share to a range of $4.75 to $4.80. Although net investments are assumed to be relatively small in the revised outlook, we remain committed to investing in innovation that supports our seamless access strategy. This outlook reflects the reprioritization of investment to support the expected future of electronics growth. Our revised outlook assumes a full year adjusted effective tax rate of approximately 13%, as well as outstanding weighted average diluted shares of approximately 93 million. The outlook additionally includes approximately $1.30 to $1.35 per share impact from impairment and restructuring charge during the year, most of which have already occurred. As a result, reported EPS is estimated at $3.40 to $3.50. Finally, our revised available cash flow outlook for 2020 has increased and is now projected to be in the $400 million to $420 million range. Please go to slide 14. Allegion has strong business fundamentals and a proven ability to execute and adapt to a changing and uncertain market conditions. We have managed the business extremely well to mitigate the impacts of the ongoing pandemic. We remain ready to serve our customers and meet their needs for touchless access and healthy environments with our market leading brands. We will provide an official outlook for 2021 during our Q4 full year call early next year. But as we think about the remainder of the year, and begin to look at 2021, some key observations that we see are, as previously expected, commercial and institutional markets will continue to be soft in Q4 and in the first half of 2021, with a snapback in repair, retrofit and small projects beginning in the second half of next year. US state and local bond issues continue to be - moved ahead and supported by local communities. Residential end markets are expected to remain strong for the long term, as an under supply of single family homes is corrected. We will continue to manage our cost base to help aggressively mitigate any volume reductions. Seamless access software and electronics will drive growth and continue to be among our top investment priorities, they are our future. Strong cash flow generation will remain a focus with capital deployment to enhance shareholder returns. Going forward, Allegion will be leaner and more focused as we navigate the coming months and emerge from the pandemic. We have implemented restructuring actions during the year that have addressed the cost base in order to right-size the business. We will continue to evaluate business going forward and make necessary changes. Our execution and commitment to driving solid results will remain high. In closing, Allegion’s future is bright. We thank you. And we'll now take your questions."
},
{
"speaker": "Operator",
"text": "[Operator Instructions] The first question comes from Chris Snyder of UBS. Please go ahead."
},
{
"speaker": "Chris Snyder",
"text": "Thank you for the question. Could you, you know, just maybe unpack the Q4 guidance a little bit? Just I guess specifically as it relates to the resi and the non-resi piece in the Americas?"
},
{
"speaker": "Dave Petratis",
"text": "So we don't provide specific guidance by quarter, you can obviously back into that relative to our full year guide. I would say, you know, basis of our Q3 performance, strong, both in terms of top line and operating income margin performance, you know, relative to the backdrop of what's going on around the globe. I would say you can kind of see similar type of patterns, in terms of both the non-residential and residential businesses and in terms of what you saw in Q3. But, you know, we'll continue to manage the costs to help mitigate any shortfall relative to the non-residential business and the margin impact. We do have a mix impact that's going on here relative to growth in residential, and, softness in non-residential business."
},
{
"speaker": "Chris Snyder",
"text": "Appreciate that. And then maybe just following up on the resi piece, and I certainly understand your comments on, you know, the resi new construction cycle picking up and we've had low household formations for a long time now. So certainly, you know, see that view. But I guess specifically as it relates to, maybe the restocking cycle, I know there was the Q2 supply chain disruption, like, you know, has that restocking stuff cycle fully been realized at this point? Maybe what's kind of like the runway there that you see growth just on that end?"
},
{
"speaker": "Dave Petratis",
"text": "I would say, as we look at the res segment and the pause that, you know, was taken by all suppliers in Q2. We're at record backlogs and normalizing that will take certainly into early Q2."
},
{
"speaker": "Chris Snyder",
"text": "Thank you for that color. Very much appreciate it."
},
{
"speaker": "Operator",
"text": "The next question comes from Ryan Merkel of William Blair. Please go ahead."
},
{
"speaker": "Ryan Merkel",
"text": "Hey, thanks. Good morning and nice quarter."
},
{
"speaker": "Dave Petratis",
"text": "Thank you."
},
{
"speaker": "Ryan Merkel",
"text": "So first off, America's electronics revenue down mid single digits is much improved. You gave some remarks that the trend of touchless access is real and happening. Do you expect this business to turn positive in the fourth quarter? And could electronics provide some offset to weaker underlying commercial trends in 2021 or is that a bit of a reach at this point?"
},
{
"speaker": "Dave Petratis",
"text": "Electronics will be positive in Q4. As you look at the year, our electronics, especially electronics mirrors our res and commercial performance, extremely strong and electronics res extremely strong, somewhat muted in commercial and institutional. Two reasons for that. The strength in residential electronics is driven by supply chain strength and an extremely strong position in the portfolio of our products. The Schlage Encode, the Schlage Connect, our KPL locks are some of the best products on the market. So where was the growth in the quarter? In Q3, we had a supplier affected by COVID. And we lost a couple weeks with that. The demand did not stop it, it affected our ability. And if you normalize that through the balance of the year, our growth in electronics, you know, led by res continues. So you know, feel good about that."
},
{
"speaker": "Ryan Merkel",
"text": "That's super helpful. Thanks for that. And then I want to follow up on the 4Q guide and maybe ask it a little differently. It seems to imply America's you know, revenue down mid single digits year-over-year, with flattish margins, just like this quarter. So if I have that, right, why is there not more improvement in the Americas business in 4Q?"
},
{
"speaker": "Dave Petratis",
"text": "So, you know, I would characterize it this way, entering into Q3, we had stronger backlogs, particularly in the non-residential business, some of the projects were delayed in the catch-up and that type of thing. And so we were able to maybe operate more efficiently from a manufacturing perspective that helped the margin profile and the business. Two would be, in Q4 maybe a stronger negative mix component, relative to the residential, non-residential sales in the quarter, as well as within the channel and product segments within the non-residential business. So there is a lot of things going on there. But quite frankly, we will, as I said earlier, continue to manage the margin. Well, I was very happy with the progress we made relative to some of the mitigation on the cost side. And you saw that with strong overall margin improvement relative to the prior year."
},
{
"speaker": "Ryan Merkel",
"text": "Yeah. Thanks. I’ll pass it on."
},
{
"speaker": "Operator",
"text": "The next question comes from Josh Pokrzywinski of Morgan Stanley. Please go ahead."
},
{
"speaker": "Josh Pokrzywinski",
"text": "Hi. Good morning, guys."
},
{
"speaker": "Dave Petratis",
"text": "Good morning, Josh."
},
{
"speaker": "Josh Pokrzywinski",
"text": "Dave, just coming back first to some of your comments on the channel replenishment that's necessary in res and appreciate that kind of side point on the - on maybe some of the interruptions on the electronic side that kept fulfillment, you know, maybe cap there. Would you mind quantifying how big of a replenishment still needs to happen? If I remember your comments last time, it was kind of through 1Q. Now it sounds like early 2Q. So maybe a bit of a push out there. But how many weeks of inventory or points of demand, however you want to put it, does the channel need to kind of get back to normal levels on the res side?"
},
{
"speaker": "Dave Petratis",
"text": "So, Josh, you know, I would - you know, sorted out in my mind is we leave Q3 with record residential backlog, number one. As I think about bringing that backlog down to normal, it pushes us into Q2. It's not inhibited by our ability for throughput, you know, just with the small disruption. We have had - we have expanded capacity of our residential capability significantly. Demand is good. We've done a good job picking up builders, expanding space at big box. E-commerce remains extremely red hot, and I believe it's our ability to keep our customers in product that has built that backlog. I would say gaining share and a strong suite of electronics that has enhanced our position."
},
{
"speaker": "Josh Pokrzywinski",
"text": "Got it…"
},
{
"speaker": "Dave Petratis",
"text": "I'd add one other comment. I'd add one other comment, Allegion’s ability to flex that supply chain is impressive, as is impressive of anything that I've seen in my 40 years of manufacturing."
},
{
"speaker": "Josh Pokrzywinski",
"text": "Got it. Appreciate that color. And then just a follow up. Dave, I appreciate that you even going back to April that you've been cognizant that the current environment probably doesn't support an awesome 2021 for non-res, I think that's now much more apparent to a broader range of folks. If I kind of take some of your comments as a time series, you know, starting from the first quarter earnings, it doesn't really sound like much has changed in the outlook, as you guys have seen more data come through and have gotten closer to next year, if anything, if some of the bond issuance commentary sounds a bit more supportive than what we would have known back then. Is that reading it, right? I mean, I guess, you know, how do you feel versus some of those early observations when we were in the first half of the year, and this is all still fresh?"
},
{
"speaker": "Dave Petratis",
"text": "So barring a rupture, I believe, you know, we're lifting off the bottom. I was extremely encouraged by the ABI lift from 40 to 47. Our spec levels are just slightly lighter than last year. So I think that's a net positive. But I've also got to be cognizant, in our key markets, commercial, institutional, especially institutional, the priority is around keeping people safe, keeping people socially distanced, keeping people capacities properly managed. So in my mind, they're small projects, break fix, preventive maintenance that gets delayed, and I believe as COVID winds down in Q2, we're going to see a snapback in those types of projects. And, you know, things will move back towards normal as we get to ‘22."
},
{
"speaker": "Josh Pokrzywinski",
"text": "Got it. Great color. Thanks, Dave."
},
{
"speaker": "Operator",
"text": "The next question comes from Joe Ritchie of Goldman Sachs. Please go ahead."
},
{
"speaker": "Joe Ritchie",
"text": "Thanks. Good morning, everybody."
},
{
"speaker": "Dave Petratis",
"text": "Good morning."
},
{
"speaker": "Joe Ritchie",
"text": "Hey, Dave, just to you know, I hate to harp on the 4Q commentary, but I just want to make sure I understand it, particularly in America. So it sounds like on the residential side of things, things are very strong, right. Your backlogs at record levels, electronics is supposed to be up in the fourth quarter. So the implied step down then in 4Q, is that just non-res is going to get worse in 4Q versus 3Q? And maybe just any color intra-quarter on how trends played out in non-res would be helpful?"
},
{
"speaker": "Dave Petratis",
"text": "I would say, you know, getting back to Patrick's comments, the slowdown, in some cases shut down in Q2 set us up for a nice backlog to saw through in Q3. We did a good job in that. Primarily commercial institutional demand has softened And we see that in Q4. That's how I describe it from a demand standpoint. As you look at the margin profile in that, the res demand is extremely strong, but we - you know, it creates a mix issue. Our commercial institutional is significantly more profitable. And those factors work through the fourth quarter."
},
{
"speaker": "Joe Ritchie",
"text": "Okay, great. I appreciate the clarification. And then I guess, you know, just the follow on question, thinking about this, you know, a little bit longer term. You know, ahead of the pandemic, you guys were pretty front-footed and discussing some of the, you know, not just like supply constraints, but really labor constraints in some of these projects, moving to completion. I guess, as you think about the institutional or non-res markets, and what you have in your backlog? Like, how much more visibility do you have, I guess, into 2021? And how much more backlog do you have to complete? I'm just trying to understand, like, how much we've worked through versus what's left to complete before we kind of head into 2021?"
},
{
"speaker": "Dave Petratis",
"text": "So as I think at 2021, you know, I talked about spec writing, we're looking at, you know, at incoming order demand, especially, you know, project related, and the backlog. You know, incoming project quotes, again, muted. Our backlog, if you look at it over 36 months, is in the low end of the range, it's not unhealthy. But we would typically go into a softer backlog this time of a year, but again it's on the low range, then, you know, you've got - you know, to get your crystal ball out and my crystal ball, the economics that we continue to look at, suggest softness, and that's what we suggest."
},
{
"speaker": "Joe Ritchie",
"text": "Okay, great. Thank you. Thank you, all."
},
{
"speaker": "Operator",
"text": "The next question comes from Julian Mitchell of Barclays. Please go ahead."
},
{
"speaker": "Julian Mitchell",
"text": "Hi, good morning."
},
{
"speaker": "Dave Petratis",
"text": "Good morning."
},
{
"speaker": "Julian Mitchell",
"text": "Maybe just moving away from the top line for a second, very good productivity performance in the quarter with the margins up, year-on-year you booked some more restructuring charges. So maybe as we look at 2021, is there any way that you could describe the sort of carryover fixed cost savings into next year that should support margins? And any sense around, perhaps temporary costs that might flow back into the P&L? Really just trying to get a sense of any major moving parts? The margins next year, aside from volumes?"
},
{
"speaker": "Patrick Shannon",
"text": "Yeah, Julian. I would characterize it this way. You may recall, in the last quarter conference call, we kind of outlined what we are doing this year, you know, there's $80 million kind of cost reduction take out for 2020. And we characterize that as kind of three components, which was the discretionary, variable, structural, permanent type of cost savings. And if you look at those specifically on the permanent structural cost savings, to answer your question, we've been added, you know, pretty solidly, I'd say, over the last couple of quarters. We're now hitting, I'd say a full stride, in terms of the cost takeout associated with that. We've identified some additional measures as well, that will help us into 2021. So there's carryover benefit, particularly in the first half of 2021, that will help mitigate some of these variable components that Boomerang back next year. So I look at those, you know, maybe we're a little upside down. If you kind of look at those two independently and sum them up. We will continue to evaluate our cost structure going forward and adjust as necessary. Basis of future demands are always looking at that. However, we will continue to invest in the business, that's a core part of our strategy, particularly on the seamless access and growth opportunities associated with that, to really position us well on the growth prospects associated with that going forward, as we exit COVID-19. So there's going to be some pressure there relative to those components, and then you're going to have unfortunately, unfavorable mix associated with strength in residential, better than anticipated and some continued softness associated with the no-residential markets."
},
{
"speaker": "Julian Mitchell",
"text": "Very helpful. Thank you, Patrick. And maybe my follow up would be also away from the top line, just on the balance sheet. I think in the prepared remarks around cash usage, you mentioned that the buyback may be resuming. So maybe just help us understand the appetite for share buybacks, how quickly you want to get underway on that. And how attractive M&A opportunities are today?"
},
{
"speaker": "Patrick Shannon",
"text": "So first on the M&A, I would say, you know, core part of our strategy to continue to evaluate opportunities that are core in our business, expanding product or our market presence, important, continue to evaluate where we can look at assets that help us from a technology perspective, particularly around this whole connectivity, and seamless access, and then participating in that growth. So we're active, looking at various opportunities. I would say, there's fewer assets on the market, specific and core to our business. And, so kind of if you assume that there's limited M&A activity, we would pivot more toward shareholder distribution, which we - I just want to clarify, we are in the market, and will be in Q4 to help, you know, continue to put cash to use for the benefit of our shareholders, enhance shareholder returns. We think it's a good investment, relative to where we trade today. And so we'll continue to be active in the market."
},
{
"speaker": "Dave Petratis",
"text": "I would add to it from an M&A position, we can go where we need to go. We've got, you know, the dry powder and firepower, I think it's an, you know, an enviable position, leaning harder towards electronics, software that accelerate and add capabilities to our value proposition."
},
{
"speaker": "Julian Mitchell",
"text": "Great. Thanks, Dave and Patrick."
},
{
"speaker": "Operator",
"text": "The next question comes from Andrew Obin of Bank of America. Please go ahead."
},
{
"speaker": "Andrew Obin",
"text": "Hi, guys. Good morning."
},
{
"speaker": "Dave Petratis",
"text": "Good morning, Andrew."
},
{
"speaker": "Andrew Obin",
"text": "I just want to dive in a little bit in institutional markets, specifically education and healthcare. If I look at the bond issuance year-to-date, I think as of end of September, education bond issuance was up almost 40%, and healthcare, I think was down 2%, effectively flat. So within those dynamics, so you know, in education, the pushback were getting is that, okay, so we are going to have bond - you know, we are going to have new bond issuance in November, I guess people will vote for it. But how - what are you hearing from your customers on the education side about the fact is that, I guess some people, they are getting tuition, but maybe they're not getting rents for the dorm rooms. So how much pressure is education sector under? And then for healthcare, right, the issue there is elective surgeries, which are coming back, but how are the conversations going with the healthcare providers in terms of whether they get back to normal? So that's sort of part one, education and healthcare? You know, what are you seeing in those two verticals into next year?"
},
{
"speaker": "Dave Petratis",
"text": "So I've had more dialogue on the educational side, and I'd say generally optimistic, and in line with the Bank of America research. As I've had new dialogues, you know, with a few university presidents, their capital projects continue to move forward and have funding at the state level or the private level, depending on the institution. I think there's something to recognize within that, though, Andrew, is the small projects, the break fix, the preventive maintenance, those facility teams are inundated [ph] by just the problems of the day in dealing with students at all levels. So I tend to be net positive and in that college campus K through 12, Allegion will get more than its fair share of the business. On the hospital side. I see the opportunity, the hospital system has been severely tested and investment will go back into that, but it will be second half of ‘21 and into ‘22."
},
{
"speaker": "Andrew Obin",
"text": "And just a follow up question, can you just give us any color on what’s happening was your market share in discretionary retrofit market? I know it's been sort of a couple years ago been a big initiative, you guys have done very well, I believe you continue to do well. But any color on what's happening there?"
},
{
"speaker": "Dave Petratis",
"text": "You know, we continue to execute our ground game in terms of the discretionary working with our wholesale partners. A large partner, just shifted completely to Allegion, opening price point, mid price point project. So it continues to be a net positive."
},
{
"speaker": "Andrew Obin",
"text": "So continue to gain market share, so I'll leave that away."
},
{
"speaker": "Dave Petratis",
"text": "Yeah. And I would say the command of our supply chain helps us there, when things are locked up, you know, because of challenges in other parts of the world. Again, you've heard me say, Andrew, our supply chain is simpler, and it gives us opportunities to have dialogues, we can keep the flow of product going."
},
{
"speaker": "Andrew Obin",
"text": "Fantastic. And congratulations on well executed quarter."
},
{
"speaker": "Dave Petratis",
"text": "Thank you, Andrew."
},
{
"speaker": "Operator",
"text": "The next question comes from Tim Wojs of Baird. Please go ahead."
},
{
"speaker": "Dave Petratis",
"text": "Good morning, Tim."
},
{
"speaker": "Tim Wojs",
"text": "Hey, guys. Hey, good morning. Nice job on the margins. Maybe just, really the only question I have is just on pricing. You know, as you kind of look at ‘21, maybe some choppiness in non-res continuing into next year. Any change and kind of how you guys think about pricing? You know, in kind of the out here and you know, really just asking because we are starting to see a little bit of incremental kind of raw material inflation, that's kind of popping up to here. So you just kind of commentary on how we should think about price."
},
{
"speaker": "Dave Petratis",
"text": "So I would characterize it as you know, solid performance in Q3 in year-to-date 2020. We will continue to push and remain competitive in the market. You're correct, there's going to be some inflationary pressure associated with input costs on commodities, you know, things like steel, and aluminium. We'll continue to push the price dynamic to the extent we can, and again remain competitive. But I would think about it, as you know, we're 1%, maybe a little bit lower realize, kind of on a go forward basis."
},
{
"speaker": "Tim Wojs",
"text": "Okay, sounds good. Thanks, guys. Good luck on the rest of the year."
},
{
"speaker": "Dave Petratis",
"text": "Thank you."
},
{
"speaker": "Operator",
"text": "The next question comes from John Walsh of Credit Suisse. Please go ahead."
},
{
"speaker": "John Walsh",
"text": "Hi, good morning."
},
{
"speaker": "Dave Petratis",
"text": "Good morning."
},
{
"speaker": "John Walsh",
"text": "Just wanted to go back to the kind of the language you used around a snapback in the repair, retrofit and small projects activity you're looking at, or anticipating next year. You talked about that large mobile project, which will hit next year. But I'm curious today, if you're seeing your customers make those touchless upgrades in the back half of this year or if it's still more of a conversation with them anticipating doing more of the projects next year?"
},
{
"speaker": "Dave Petratis",
"text": "We can identify projects and early adopters, but the momentum of those projects will pick up once we get on the other side of COVID. Unless there's a burning need - when you go in and increase or improve your infrastructure to touchless, waveless connected, it's a bigger project than somebody wants to take on in the middle of a fire fight."
},
{
"speaker": "John Walsh",
"text": "Got you. No, that makes sense. And then, you know, just thinking about earlier, when you were talking about the seamless opportunity, you did use the term, you know, thinking about the readers. As I kind of have historically thought about Allegion’s position in that product, it was smaller relative to one of your competitors. But how important is having the reader as part of the solution? You know, as these customers shift into that seamless world? Is that some place where you need to get bigger or just trying to understand how that works?"
},
{
"speaker": "Dave Petratis",
"text": "So when you think about readers, kind of think about light switches, they are ubiquitous, they're in every room. Is one light switch differentiate another? The answer is no. It's important in the sequence, but what we're really after is to eliminate the card and move that to your edge device, your cell phone. That is going to happen. That's the opportunity that we're going to exploit which complements the touchless environment, it complements higher security levels, because you can not only have one level, but even triple levels of authentication. And you don't ever - you get immediate, you know, what we call the arbitrator of access. With a click of a button access is granted or denied eliminating the needs of cards. That's our opportunity."
},
{
"speaker": "John Walsh",
"text": "Great. Appreciate that color. Thank you."
},
{
"speaker": "Operator",
"text": "The next question comes from Deepa Raghavan of Wells Fargo. Please go ahead."
},
{
"speaker": "Deepa Raghavan",
"text": "Hi. Good morning, all."
},
{
"speaker": "Dave Petratis",
"text": "Good morning, Deepa."
},
{
"speaker": "Deepa Raghavan",
"text": "Hey, good quarter, by the way. Two questions for me. First one is, can you talk about the momentum or the revenue growth that you're seeing in products that are driving this post-COVID world with you know, your touchless, seamless, you talked about contactless, Apple, iPhones, et cetera. Now these look like strong renovation opportunity. So why would you not see continued tailwinds into first half of next year versus your commentary for a snapback only in second half? And also can you touch upon how accretive these tech-heavy products and software is to your margins? And I have a follow up."
},
{
"speaker": "Dave Petratis",
"text": "I think you have to put yourself in the middle of a college campus, hospital. And you know, the prioritization of their day and their project work in a COVID reality. As I talked to school administrators, it's not – those preventative small - preventive maintenance items, small projects, unless it's severely broken, it's just not part of the priority list. It's about people flow. It's about cleaning surfaces. So, you know, when you're in a firefight, and you would be at the University of Florida today, you know, that projects, those small projects don't hit that - even the radar screen. So that's what I see in terms of this moving into the second half. Your follow up, your second question, did you hear it Patrick?"
},
{
"speaker": "Deepa Raghavan",
"text": "Yeah, sure."
},
{
"speaker": "Patrick Shannon",
"text": "So Deepa, on the margin profile, the electronics with the similar type of margin is your traditional mechanical, but a higher selling price and therefore more EBITDA. So to the extent we can continue to push electronics, which we are and we will, that benefits us from an earnings growth perspective."
},
{
"speaker": "Deepa Raghavan",
"text": "Great. My follow up- Patrick, was more on the residential, electronics lots performance. As I mentioned yesterday, their smart lock business in residential grew high double-digit percent in Q3. Did you see similar kind of strength?"
},
{
"speaker": "Patrick Shannon",
"text": "Deepa, I would say this, if we didn't have the supply disruption from a supplier, we would have had one of the strongest residential quarters in the company's history."
},
{
"speaker": "Deepa Raghavan",
"text": "Got it. Great. Thanks for the color."
},
{
"speaker": "Operator",
"text": "The next question comes from David MacGregor of Longbow Research. Please go ahead."
},
{
"speaker": "Colton West",
"text": "Hi, good morning. It's Colton, on for David, congrats on a good quarter."
},
{
"speaker": "Dave Petratis",
"text": "Thank you."
},
{
"speaker": "Colton West",
"text": "I guess, can you start by walking us through how the residential point of sale growth played out in the quarter and any new trends you're seeing there?"
},
{
"speaker": "Dave Petratis",
"text": "I would say impressive strength in the e-commerce, you know would indicate share gains. If we look at point of sale, we continue to gain momentum and strength. And it's really across all sectors. I don't think that when people are spending more time in their homes, they're thinking about how do I upgrade and improve my space. I think across DIY, you see that extremely strong trend, one. I think two, the rise in demand for single family home, whether existing or new, we're benefiting from that. Remember, Allegion tends to be the replacement lock of choice. And then we have a suite of electronic products that maybe the best in the industry. And then our supply chain, we have product available, have been able to provide it. So all of those channels, in some cases, our specials, our returns are extended because of the increase in demand. But I think several factors there that are really showing off some res performance. I'd add one more to and I commented on it. Our ability to take our demand up is as good as I've seen in 40 years of manufacturing."
},
{
"speaker": "Colton West",
"text": "That's great. I appreciate that. And then as a follow up, you mentioned some supplier headwinds in the third quarter related to electronics, can you give us an update on where your supply chain stands today for the segment? And if there are any risks that could limit growth in the near term?"
},
{
"speaker": "Dave Petratis",
"text": "With the exception of that one supplier, no disruptions. That doesn't mean the supply chains are not under pressure, but we tend to produce in region and that you know, certainly helps us just think time on the boat. But it's one of the proud points of Allegion. We've been working on that supply chain even under Ingersoll Rand. The simplicity of it, the leanness of it, some of the vertical integration that we did over the last few years as we invest in Allegion has really come back to pay dividends."
},
{
"speaker": "Colton West",
"text": "Great. Thanks for the color."
},
{
"speaker": "Operator",
"text": "The next question comes from Jeff Kessler of Imperial Capital. Please go ahead."
},
{
"speaker": "Jeff Kessler",
"text": "Thank you. Thank you. Good morning, guys."
},
{
"speaker": "Dave Petratis",
"text": "Good morning, Jeff."
},
{
"speaker": "Jeff Kessler",
"text": "Morning. Can you can you break out EMEA and Asia Pacific just a little bit in terms of - granted, they're small, but the fact is that, you know, at some point EMEA has to grow again. Where - let's call it vertically and geographically, what was stronger and what was weaker in EMEA?"
},
{
"speaker": "Dave Petratis",
"text": "So I think a very good quarter in EMEA, number one. Number two is strengthened our SimonsVoss franchise, which would be SimonsVoss Interflex. Our leader there, Bernhard Sommer really put his foot on the pedal, as we went into the pandemic, had some supply chain strengths that winning in allowed him to capture projects. I also thought our Interflex business did extremely well, which is access software control time and attendance. That business, you know, under some pressure because of - they do a very good job at servicing large manufacturers, especially the auto, aerospace industry, you know, executed well. And I think the numbers suggest that. The other one that's hidden, Jeff is our - what we call global portable security, excellent execution and leadership by John Stanley. Think about it, you can't walk into a bike shop today and find a bike. And that demand has come right into our wheelhouse. We also have been investing in connected technologies that help the location of your bike platform. You know, won some nice business because of that connected capability in the GPS business, that'd be my comments and you know, for the Europe business."
},
{
"speaker": "Jeff Kessler",
"text": "Okay. Great. And in the US now that and I think you alluded to, you use the word NFC, but I'm assuming that NFC becomes a key part of the touchless, wireless, three levels of authority, technology. Are there - are you going to be using multiple technologies in terms of getting those projects going? And will it be mainly around NFC or will you be adding various types of Bluetooth to it? I mean, I know I'm getting down in the weeds here. But question - the question really involves, you know, how flexible are you going to be in terms of those technologies and what is - what are you - what are people asking for or what are people negotiating with you for, they just heard the word that Apple is taking this on as well and now it's basically going to be a standard? Or are you getting different types of demand for different types of wireless technology, per either vertical or per type of end user?"
},
{
"speaker": "Dave Petratis",
"text": "NFC remains important. We're investing and partnering in technologies like thread that you're probably the only person on the phone that's aware of a thread technology And I think we continue to be very comfortable on our foundation of being open. And, you know, making good segmentation decisions that allow Allegion to grow, but also servicing our customers."
},
{
"speaker": "Jeff Kessler",
"text": "Okay. Just as a last follow up to this. As far as getting this out there was this at the beginning going to cost you more to get these technologies. I mean, you've obviously had wireless technologies coming out into the marketplace for several years now. But is - are these new technologies going to cost you more to get out there? Or is this is as you said before, the mark - ultimate margins remain about the same, where do the innards of those margins differ from mechanical?"
},
{
"speaker": "Dave Petratis",
"text": "Again, margins consistent at a higher selling price. What fascinates me is our position in seamless access opens up new business opportunities, in terms of helping customers simplify their world. So an example of this would be at the University of Texas Austin, where we are the sole supplier on access, they manage 80,000 credentials today. I can get them out of that business and provide new value propositions, higher level of security that I think you know, customers will be more than willing to offer, create a new revenue streams and ecosystems for Allegion."
},
{
"speaker": "Jeff Kessler",
"text": "Great. Thank you very much."
},
{
"speaker": "Dave Petratis",
"text": "Be safe."
},
{
"speaker": "Operator",
"text": "This concludes our question-and-answer session. I would like to turn the conference back over to Tom Martineau for any closing remarks."
},
{
"speaker": "Tom Martineau",
"text": "Thank you. And we'd like to thank everyone for participating in today's call. Have a safe day."
},
{
"speaker": "Operator",
"text": "The conference has now concluded. Thank you for attending today's presentation. You may now disconnect."
}
] | Allegion plc | 241,782,379 |
ALLE | 2 | 2,020 | 2020-07-23 08:00:00 | Operator: Good day and welcome to the Allegion Second Quarter 2020 Financial Results Conference Call. All participants will be in listen-only mode. [Operator Instructions] Please note this event is being recorded. I would now like to turn the conference over to Tom Martineau, Vice President, Vice President, Investor Relations and Treasurer. Please go ahead.
Tom Martineau: Thank you, Andrew. Good morning everyone. Welcome and thank you for joining us for Allegion's second quarter 2020 earnings call. With me today are Dave Petratis, Chairman President and Chief Executive Officer; and Patrick Shannon, Senior Vice President and Chief Financial Officer of Allegion. Our earnings release, which was issued earlier this morning and the presentation which we will refer to in today's call are available on our website at investor.allegion.com. This call will be recorded and archived on our website. Please go to slides two and three. Statements made in today's call that are not historical facts are considered forward-looking statements and are made pursuant to the Safe Harbor provisions of federal securities law. Please see our most recent SEC filings for a description of some of the factors that may cause actual results to differ materially from our projections. The company has no obligation to update these forward-looking statements. Today's presentation and commentary include non-GAAP financial measures. Please refer to the reconciliation in the financial tables of our press release for further details. Dave and Patrick will now discuss our second quarter 2020 results, which will be followed by a Q&A session. We have a very tight meeting today. Please for the Q&A, we would like to ask each caller to limit themselves to one question and short follow-up and then reenter the queue. We will like to give everyone an opportunity given the time allotted. Please go to slide 4 and I'll turn the call over to Dave.
Dave Petratis: Thanks Tom. Good morning thank you for joining us today. 2020 will go down as a year of dramatic change. The health and economic impact of COVID-19 will take the head one along side the social concerns related to inclusion and diversity. With these challenges comes needed reflection. Before I turn to business results, I'd like to address these events and Allegion's response to them. The tragedy of George Floyd's death has been on my mind, as well as the deaths of many who have preceded him. Black lives matter, black lives matter and we must level the playing field, understand bias and work for equality. Prejudice and racism are intolerable and we can and must do better. My executive leadership team has joined me in a journey of listening, learning and reflection and will continue building the right roadmap for Allegion. With our employees, we must also help build a better world with our voices, our minds, our hands and our hearts. I expect the people of the Allegion in our businesses to be involved to create positive change in our community and our company. And you can expect the same of me. This is the spirit and culture of Allegion. And determining how we respond to social concerns our value and code of conduct has been our lighthouse since the creation of Allegion. And they will help us to improve inclusion and diversity at the company. In a similar way, our values and corporate business strategy has provided the foundation to respond to COVID-19 pandemic, which will be with us for some time to come Please go to Slide 5. You can equip with a culture of safety and resilient supply chain and operational discipline, Allegion was in a position of strength facing the pandemic. Keeping our employees safe and healthy continues to be top of mind, and we're effectively leveraging safety and health as our true number throughout these uncertain times. My leadership team led the COVID-19 effort to ensure our company was responding in real time to considerable global complexity. And to meet the needs of our employees, customers, communities and other stakeholders, as well as requests from public health officials. Cross-functional teams guided our health and safety efforts, production and operational decisions, work from home infrastructure and best practices. We also created an Allegion safety net program giving production workers an extra day of pay per month to cover unexpected illnesses or family needs. I'm proud of the collaboration and communication between functions which has been key to working productively and safely wherever we are. At the same time, Allegion has turned his attention to giving back to communities across the world while ensuring our employees had mask, we've also been able to donate thousands of mask to healthcare workers across the U.S, Mexico and Italy, knowing that people have a safe place to live is perhaps more important than ever. We've also continued our substantial commitment to habitat for humanity in 2020. There is no doubt our team members across the world are dedicated to serving others and doing the right thing. And taking care of our team members' means they can in turn take care of their communities. Please go to Slide 6. Our enterprise excellence and discipline capital allocation strategies have served us well to weather the COVID-19 storm. We are delivering new value in access and safety as people deal with the realities of daily life in a pandemic. Our vision of seamless access and a safer world has never been more important. As an expert in security, Allegion customers look for us to support specific guidance when faced with new challenges. In the age of COVID-19 for example new attention was brought to their need for a healthy environment in a variety of ways. First, proper cleaning and disinfecting procedures for door hardware. Second, surface technologies like silver ion antimicrobial coatings and new technologies with antibacterial and antiviral properties. Third, our touchless solutions are at the forefront of helping prevent the spread of viruses and reducing common physical touch points. From automatic door opening solutions and contactless readers to innovative door poles, our products can help avoid hand to surface contact. Further by integrating our wave to open and other innovations with identity management partners, we're able to enable seamless access through our partners of choice strategy. Fourth, our keyless solutions around the world are often are offering mobile and remote capabilities for access control and workforce management. In brief, customers around the world are looking for new practical and convenient solutions that help promote healthy environments and provide peace of mind. Our leading brands like Schlage, LCN, VON Duprin, interflex and Simons Voss paired with the strength of our supply chain and integration partners are meeting those needs. As we continue to navigate COVID-19 and other challenges, we will focus on our customers, our strategy and the health and safety of our people. Our business has strong fundamentals and has proven the ability to execute. We will continue to monitor, evaluate and adapt to market dynamics. Please go to Slide 7. And I'll walk you through the second quarter financial summary. Revenues for the second quarter were $589.5 million, a decrease of 19.4% or 18.5% organically. The organic revenue decrease was driven by the economic challenges that arose as a result of the COVID-19 pandemic, currency headwinds and the impact of divestitures of our businesses in Colombia and Turkey also contributed to the total revenue weakening. All regions experience substantial revenue declines. Patrick will share more detail on the regions at a moment. Adjusted operating margins decreased by 260 basis points in the second quarter. The significant vol e declines drove the margin reduction. We did see positive price, productivity, inflation dynamic, which helped -- which was help by reductions in variable and share based compensation, non-US government incentives, plus the impact of cost actions including reductions in discretionary spending, a freeze on non-essential investments and hiring, restructuring and re-prioritization of capital expenditures. Due to these actions, we saw sequential improvement during the quarter. Adjusted earnings per share of $0.92 decreased $0.34 or 27% versus the prior year. The decrease was driven primarily by lowering operating income as a result of reduced revenue. Favorable share count and other income offset some of the operational decline. Year-to-date available cash flow came in at $103.6 million, an increase of approximately $26 million versus the prior year. Improvement in networking capital and reduced capital expenditures more than offset the lower net earnings. Patrick will now walk you through the financial results. And I'll be back later to discuss our 2020 outlook and a wrap-up.
Patrick Shannon: Thanks Dave. Good morning, everyone. Thank you for joining today's call. If you would please go to Slide 8. This slide reflects our earnings per share reconciliation for the second quarter. For the second quarter 2019 reported earnings per share was a $1.16, adjusting $0.10 for prior year restructuring expenses and integration cost related acquisitions, the 2019 adjusted earnings per share was a $1.26. Operational results decreased earnings per share by $0.42 driven by vol e deleverage that was offset slightly by favorable price and productivity exceeding inflationary impacts and unfavorable currency. The impact of decreased investments in the quarter was a $0.01 increase and an increase in other income drove another positive $0.05 per share impact. Favorable year-over-year share count increased adjusted earnings per share by $0.02. These results in adjusted second quarter 2020 earnings per share of $0.92, a decrease of $0.34 or approximately 27% compared to the prior year. Lastly, we have $0.12 per share reduction for charges related to restructuring costs. After giving effect to these items you arrive at second quarter 2020 reported earnings per share of $0.80. Please go to Slide 9. This slide depicts the components of our revenue performance for the second quarter. I'll focus on the total Allegion results and cover the regions on their respective slides. As indicated, we experienced an 18.5% organic revenue decline in the second quarter. All three regions saw substantial revenue declines. The COVID-19 pandemic drove the decreases across the globe as there were many government mandated shutdowns across all industries where our products are sold. We did see modest price realization which slightly offsets some of the precipitous vol e declines. The impact of the divestiture of our businesses in Colombia and Turkey along with continued currency pressure was headwinds of total growth. Please go to Slide 10. Second quarter revenues for the Americas region were $444.3 million down 18.5% on a reported basis and down 18.1% organically. The decline was driven by vol e challenges posed by the COVID-19 pandemic; both the non-residential and residential businesses were down significantly. Early in the quarter, our factories in the Baja region of Mexico were shutdown by a broad government decree related to COVID-19 which had a significant impact on shipments. The Americas electronics revenue declined more than 20% in the quarter as that segment was adversely affected due to its discretionary nature. We see electronics continuing to be a long-term growth driver and expect growth to res e when market conditions normalize. On the positive side, the region generated modest price realization and experienced sequential month-over-month improvements in revenue as COVID restrictions began to ease. Through the Mexico plant closures early in the quarter and improving residential markets, we enter the third quarter with a healthy backlog for a residential business. Although the non-residential business orders are below the prior year activity has begun to stabilize. Americas' adjusted operating income of $124.1 million decreased 23.6% versus the prior year period. And adjusted operating margin for the quarter decreased 190 basis points. Vol e deleverage drove the decline and was offset slightly by price and productivity exceeding inflation. The region has implemented necessary cost control measures in the quarter including headcount reductions, investment delays and cancellations and reductions in discretionary spending. In addition, manufacturing expenses have been adjusted to reduce impacts on lower volumes. Please go to Slide 11. Second quarter revenues for the EMEA region were $111 million, down 21.9% and down 20.4% on an organic basis. The lower vol e was driven by COVID-19 and the widespread government mandated closures throughout the continent. The impact of the divestiture of the business in Turkey and currency headwinds also contributed to the reported revenue decline and was partially offset by modest price realization. EMEA adjusted operating income of $1.5 million decreased 87% versus the prior year period. Adjusted operating margin for the quarter decreased by 660 basis points. The margin degradation was driven by the significant vol e declines associated with government mandated closures in several countries where the company operates. Price and productivity exceeding inflation helped mitigate some of the margin decline. Similar to the Americas, reductions in variable compensation and other discretionary spending helped the productivity performance as did assistance received through government incentives. As previously announced in Q1, restructuring programs are underway in the region and we expect benefits to accelerate in the second half of the year. Please go to Slide 12. Second quarter revenues for the Asia-Pacific region were $34.2 million, down 22.1% versus the prior year. Organic revenue was down 18%. The decline was driven by COVID-19 related impacts and continued weakness in China residential, in Australian end markets. Total revenue continued to be affected by currency headwinds. Asia-Pacific adjusted operating loss for the quarter was $1.2 million, a decrease of $3 million with adjusted operating margins down 760 basis points versus the prior year period. The operating loss includes a $1.8 million charge related to a specific product quality dispute in China. Significant vol e declines and unfavorable mix also had a large impact on the reduced income and margin. As with the other regions, the price, productivity inflation dynamic was positive and was aided by reductions in variable compensation, other discretionary spending. As with the EMEA, Asia-Pacific also benefited from government incentives related to COVID-19. And as previously announced in Q1, restructuring programs are underway in the region and we expect benefits to accelerate in the second half of the year. Please go to Slide 13. Year-to-date available cash flow for the second quarter came in at $103.6 million which is an increase of approximately $26 million compared to the prior year period. The increase was driven by improvements in networking capital and reduced capital expenditures which more than offset lower adjusted net earnings. Our ability for cash flow generation has been strength of the company that was evident in the second quarter and will continue to serve us well during the current market environment. Looking at the chart to the right, it shows working capital as a percent of revenues decreased based on a 4 point quarter average. This was driven by reduced working capital needs, lower vol e as well as better turnover on accounts receivable. The business continues to generate strong cash flow and we remain committed to an effective and efficient use of working capital. We will continue to evaluate opportunities, optimize working capital to continue driving substantial cash flow conversion. Our financial and liquidity position remains extremely solid. Our net debt to EBITDA ratio is 1.8 based on the last 12-months performance, we have close to $500 million available under a revolving credit facility. We also remain committed to a flexible and balanced capital allocation strategy. Although, we've communicated a pause in share buybacks in order to focus on liquidity during this time of market volatility, we intend to put excess cash to use as we continue to see market improvement and stabilization. I will now hand it back over to Dave review on our full year 2020 outlook.
Dave Petratis: Thank you, Patrick. Please go to Slide 14. As you know, we previously withdrew our outlook for 2020. This morning we reissued an outlook. The n beers we provided ass e there is no additional COVID-19 impacts including government decrees, supply chain disruptions and safety and health issues. The pandemic has already driven much change in the market dynamic across the world for 2020. With that said, Allegion's sound fundamental business strength provides some resiliency in times of economic downturn and our long-term investment thesis remains unchanged. In the Americas, we expect to see continued year-over-year organic revenue declines in the second half. Residential markets are expected to rebound more quickly than the non-residential. We have seen sequential increases in home builder demand and point-of-sale metrics have improved in the big box and e-commerce channels. We expect commercial markets to be tough as the pandemic had forced many to work from home. In institutional markets, projects already started will continue and finish. With these expectations, we project organic revenue in the Americas to be down 7.5% to 8.5% for the full year. We're projecting Americas total revenue decline to be 8% to 9% with a slight impact from the divestiture of the business in Colombia. In Europe, markets have softened prior to the COVID-19 outbreak and revenue declines are expected to continue in the second half. However, we are projecting sequential improvement as we go through the back half. For the region, we project our organic growth to be down 9% to 10%. Total revenue includes the impact of currency pressure in the first half, as well as the divestiture of the business in Turkey and is projected to be down 10 % to 11% for the full year. In Asia- Pacific, markets were weak before COVID-19 and we expect that to continue especially in the China residential and Australian markets. With that backdrop, we expect an organic revenue decline in 2020 of 10.5% to 12.5% and total revenue will be down 14% to 16% as currency pressures continue. We are projecting total organic revenues for the company to be down 8% to 9% and total revenues to decline 9% to 10%. Please go to slide 15. Our new 2020 outlook for adjusted earnings per share is $4.15 to $4.30. As indicated, the earnings decline is driven by lower volumes related to COVID-1. We have made significant cost reduction in the business and our work will continue to streamline our structure as needed, while prioritizing critical investments as we remain focused on driving our strategy of seamless access. The combination of interest and other expense is expected to be a positive to earnings per share. Our outlook ass es full adjusted effective tax rates of approximately 13.5% to 14.5%, as well as outstanding weighted average diluted shares of approximately 93 million. The outlook additionally includes approximately $1.35 to $1.45 per share impact from impairment and restructuring charges during the year, most of which has already occurred. As a result, reported EPS is estimated to be at $2.70 to $2.95. Our revised available cash flow outlook for 2020 is now projected to be in the $350 million to $370 million range. Please go to Slide 16. Allegion has strong fundamentals and has proven the ability to execute and adjust to market dynamics as demonstrated during the first half of 2020. We had strong moment in the first quarter particularly in the Americas, while the pandemic was unforeseen and its effects were immediate, we managed the business extremely well to restructure and manage costs. We also move quickly to address new customer needs for touchless solutions and remote management. As we go into the second half of the year, we start from our core strengths in health and safety, supply chain and financial discipline. We will take the necessary and often difficult actions needed to adjust quickly to evolving market dynamics. The strategy of adding value through seamless access in a safer world drives the right focus for the long term. And it puts us on solid footing for the post pandemic world. Thank you. Now Patrick and I will be happy to take your questions.
Operator: [Operator Instructions] First question comes from Ryan Merkel of William Blair. Please go ahead.
RyanMerkel: Thanks and good morning, everyone. So two questions, First off, in Americas the year-over-year decline in electronics was a little more than I thought. Just looking forward do you expect electronics mix to continue to mix down? And then second question are you seeing more interest in touchless access and mobile keys in this environment?
DavePetratis: I would say we do not expect a mix down. I think our key growth has been stronger in the residential and I think last mile delivery, the growth of e-commerce, people's connectivity that trend will continue. We've got one of the best locks on the market with our encode lock, the favorability ratings I looked this morning 37,000 comments on Amazon at about a 4.8, so feel extremely good about that. I think the weakness in the quarter really driven by the overall lockdowns but in terms of integrators ability to enter college campuses, none of us wanted people coming on site and that work to see, so we like the long-term trends and I believe it's a key factor going forward. I think two, when you think about some of the capabilities that we're putting together, the ability to seamlessly travel without touch whether there's the wave at hand, your edge device, these things will continue to be drivers. Add things like our investment in the need to be able to understand how many people are in a room, in an area, in a building; these are things that will continue to expand as we go forward.
Operator: The next question comes from John Walsh of Credit Suisse. Please go ahead.
JohnWalsh: Hi, good morning. I wondered if we could just touch a little bit on investments and tax I guess maybe first on the investments, obviously, you put a hard number around it not surprising it's lower than the initial expectations given the way demands played out, tax this is kind of the second year in a row. We'll have this lower rate, how should we think about the investment spending going forward in the sustainability of the tax rate from here?
PatrickShannon: So as we indicated in our full year guide, we're looking at some incremental investments although it's lower than what we'd originally anticipated, but nonetheless higher than last year. And that's predominantly around this whole movement in electronics and trying to drive that market for faster adoption. Some specific initiatives around the IoT platform and those types of things that will help us, in particular as we begin to kind of come out of this pandemic. So feel good about those investments and the ability to be able to drive incremental revenue and as we've indicated historically those investments have enabled us to drive revenue faster than the overall market. And I think we get good return on those in terms of invested capital. So going forward will kind of continue to monitor the markets and the needs in our business, and we'll continue to invest for the long-term future in our business. As it relates to the tax rate, we are anticipating a lower rate again than what was originally provided at the beginning of the year. Some of that is due to some favorable items that kind of came through FIN48 reserves those type of things. Some of it is quite frankly we've been able to implement some new tax planning strategies that will take effect and feel good about the work that the team is implemented there. As we go forward beyond 2020, we had historically given some guidance that the tax rate would migrate upwards to kind of like the high teens area, more guidance to come when we come out with the 2021 information, but I feel fairly confident it will be better than that maybe mid-teens type of thing at least in the near term and that's all because of where we find ourselves today and some of the great tax planning strategy work that's been going on.
JohnWalsh: Great. Thank you for that color. And then maybe just a follow-up here. You talked about in the Americas exiting with some strength and resi and stabilization and non-resi. Can you put any numbers around that either what the exit rate was in June or what you're seeing here in July?
DavePetratis: So, first, I'd go to the backlogs, we've got effectively record backlogs between commercial institutional and res, the res demand extremely strong as we look at point of sale. If you look May, June and July the 12% increase in dollars, 7% in units really like that trend this morning's Wall Street Journal about strength in housing I think the other thing as you think about our res performance especially in the first half, there was a mandate in the country of Mexico to shutdown that's about 25% of our workforce and a big supplier of our res supply chain. We deleted inventories in a situation where demand was accelerating that point of sale that I referred to. Record backlogs in residential I think we've got a great set of product capabilities and I think our supply chain is stronger than the people that we're competing against. So I like our opportunities as we go through the next -- the second half and early in the next year.
Operator: The next question comes from Jeff Sprague of Vertical Research. Please go ahead.
JeffSprague: Thank you. Good morning. Two from me also, David, I'd be interested in just your kind of forward opinion here now on the non-res cycle overall. You introduced on the Q1 call the very logical possibility that 2021 could be down given the later cycle nature for some of these end markets. Based on what you're seeing in the channels now and just pipeline work and other folks on the ground what's your thought around that large question on everyone's mind?
DavePetratis: So I think when you think about the institution of commercial verticals, everybody caution, right. I think clearly there's shifts going on there I think we saw the ABI come out it, doesn't drive optimism I think as I look at Allegion healthy backlogs, our commercial institutional backlogs as we exited June high but I think the other thing that we look at specs written, we saw some disruption and spec writing and demand from architectural firms that's to be expected. I think we'll have a better call on specs written which is an early demand level as we exit Q3. If I looked at spec written today it's improved every week as we've gone through the crisis, but this is more of a long-term trend but as I would look at educational, healthcare, total commercial we anticipate softer markets. We will put our foot on to drive seamless access and we believe we can outperform in a weaker position because of our installed base. The strength of our spec writing and the capability of the Allegion.
JeffSprague: Thanks and then second question perhaps for Patrick, just around kind of the cost reduction actions Patrick can you just provide a little bit more granularity on kind of what's kind of been done structurally from a cost-saving standpoint and what perhaps is temporary and I'm sure you like a lot of companies also some of these temporary actions are feeling like maybe they're at least semi-permanent as folks think about travel budgets and the like. But if you could kind of frame that up for us it would be helpful.
PatrickShannon: Yes. sure. So good question. Let me try to provide a framework around that. First of all, we've identified and we are executing on a plan of about $80 million of cost reduction year-over-year reduction. And I would bucket that into three categories. The first of which would be the structural, more fixed cost predominantly headcount reduction that for this year is about 30% of the $80 million. Then you've got another bucket what I call the discretionary type of expenditures i.e. T&E, contractor spent, consulting those type of things, the things that you control in a down market, that's another probably 30% of the $80 million for this year and then the variable type of items, the things that are compensation related that a large portion of which will probably boomerang back next year is the balance of the $80 million or 40% of the total that I think the key point here is that offsetting the variable stuff i.e. the things that are expected to come back next year. We do have and we'll have carryforward benefit associated with some of the permanent cost reductions that will carry into next year. We won't be in a full year run rate level on some of those identified costs until Q4. So we have that as Dave mentioned in a script we will continue to work on further cost reductions to help mitigate that as well. So TBD onfurther actions that will be identified for the second half of the year.
DavePetratis: I'd just add a little color as well. I think we got after this early even before Covid-19 you could see that in our in-flight restructuring plans and I think it's important that we continue to accelerate investments around electronics and seamless access, while transforming the company into a leaner structure.
Operator: The next question comes from David MacGregor of Longbow Research. Please go ahead.
ColtonWest: HI. Good morning. It's Colton West on for David MacGregor. I guess you pointed out sequential improvement on a month-to-month basis in the Americas in the quarter. Are you seeing those trends continue into July now?
DavePetratis: Absolutely. As you can feel the pulse of the economy coming back and I put cautions around that because in some cases they've gone too fast, but we feel it I think if you're in the wholesale retail channel on shelf inventories are down and we're seeing that in terms of specs quotes, point of sale and our own shipment.
ColtonWest: Okay and then I guess as follow-up non-res came in better than res, sounds like for the quarter. How much of that was volumes versus price mix? If I recall correctly you guys implemented 3% pricing on commercial hardware back in April?
PatrickShannon: Yes, majority volume related but as we kind of saw in Q1 pricing relative to non-res better than the residential performance. We will continue to push that dynamic to the extent we can and so far here year-to-date have been fairly successful in getting solid price realization in the non-residential segment.
Operator: Next question comes from Joe Ritchie of Goldman Sachs. Please go ahead.
JoeRitchie: Thanks. Good morning, everyone. So, Dave, my first question maybe just trying to unpack the impact that you had from the Mexico decree. I know last quarter you guys had talked about having inventory on hand, but it sounds like you kind of depleted that inventory fairly quickly as the quarter went out. I'm just trying to understand, one, kind of like the impact that you had in the first quarter from maybe running out of inventory. And then secondly like how we should be potentially thinking about a restock as you get back online in Mexico.
DavePetratis: So we deep dive this in terms of the performance second quarter, there was a decree from Mexico that mandated a 30-day shutdown. We were open well ahead of that and it was our ability to point out that we were essential, but more importantly our ability to keep our people safe. If you dig into it the governor of the Baja highlighted Allegion in a press conference in our safe practices and the confidence that we could do that, so that was important. I think if you look at the whole region we got restarted quicker. Second, the government mandated that anybody over the age of 55 immune compromised, pregnant could not work for us that was about 300 to 400 employees. We had this and some of our most experienced, we have reloaded on that and are producing at a higher -- we're producing out of the Baja today at the highest level since I've been at Allegion or we created the company. So if you think about that we've got 42 discrete manufacturing lines in Enemata if you have ever visited, there the ability to bring on that number of employees, pull that lever and replenish the supply chain is, and I think, few companies in the world could do it. So extremely proud the team, our ability to reinvent. I think a second thing that important here, you don't see the point of sale data but our teams did an extremely good job to drive our -- se our inventory to keep customers and products, as well as other partners in the supply chain. When you think about a situation where you're trying to maximize inventory, we reached out into our partners supply chains to be able to optimize that. Again, I thought they did a better job of it. And I believe the last point your question, we will be well into the first quarter of next year getting the supply chain in terms of finished inventories normalized with the increasing demand.
JoeRitchie: Got it. Okay. That's helpful color, Dave. I guess my one follow-up question here in just thinking about what's happening from a commodity perspective and how your business mix is perhaps expected to change over the next four months, your copper prices right now are surging and notice that while pricing was still positive this quarter I think it's 70 bps from the Americas, it was still you saw a tick down versus Q1. So I'm just trying to understand I guess as we kind of move forward in this environment where volumes really aren't at normal levels like how are you guys feeling about your ability to offset inflation and your ability to get price in this environment. Also in the context of kind of the mixed shift that you're seeing in your business.
DavePetratis: I'm always confident on price. I would say the market is discipline. Our first cautionary is always steel. We purchase a lot of steel more and then I think brass, but we're continue -- we'll continue to be aggressive on price realization, try to offset the effects of inflation, but I'm net positive and I'm that way every day. Patrick will bring some realization to it.
PatrickShannon: Well, Joe, you're right. I mean the commodity prices have continued rise here over the last 90 days or so. I'd say for the balance of the year is you kind of look at the margin profile, think about sequential improvement as we progress throughout the course of the year, just through more efficiency and some of the cost measures we're taking will help us navigate for the balance of the year. Next year, another question will kind of monitor and see how progresses during the course of this year, but as Dave mentioned we will continue to push price to the extent we can and if we're unable to offset the inflationary impact will drive productivity, we'll make the appropriate investments to do whatever we can to mitigate the inflationary impact.
Operator: The next question comes from Andrew Obin of Bank of America. Please go ahead.
AndrewObin: Hi, guys. Good morning. Question, can you just comment on regional trends in the US? How is California trending versus Texas versus Florida versus Northeast? I mean frankly just trying to figure out how COVID and the second wave is just impact has been impacting demand, and if there is close correlation between what we see with hospitalizations and demand trends by region? Thank you.
DavePetratis: I would say the stoppage in New York, the Northeast, you have some pretty strong governor mandates and decrees especially Boston, no public construction. We do very well in those big metro markets and so we're seeing that recovery as North East gets better. Again, you look to California, the construction and Allegion was able to operate during the first shutdown. We'll see how it drives if as they move, I guess, towards a second shutdown. I think you really dig in the data the COVID, Andrew, you're seeing growing pockets in construction workers of infection and how government will mandate around it. We've got to keep an eye on it, but construction has been considered essential in most areas of the country. And I think it will continue.
AndrewObin: And then just a follow up just sort of talked about seamless access, but how do you think how you rethinking access business post COVID? Do you expect any structural changes and what the customers will demand in terms of being able to sort of get an out of the building without touching things?
DavePetratis: So I absolutely believe it, the number of enquiries on our antimicrobial products would be a clear example, but Andrew, I really believe that your edge device is how we'll navigate through society. The long-term trend I think positive. We've got the ability exist today to be able to through your edge device monitor your temperature as you approach the door, if you're out of it accepted range, are you going to get a temperature check, do we allow access. Those are things that are going to continue to develop as a result of Covid-19 and trying to keep people healthy.
Operator: The next question comes from Tim Wojs of Baird. Please go ahead.
TimWojs: Hey, guys. Good morning. Just maybe going back to Americas and just some of the cadence through the quarter, is there any way to just think about how June kind of finished up relative to the quarter in both resi and non-resi?
PatrickShannon: Yes, Tim, I would say again during the course of the quarter sequential improvement is a quarter progressed, June much stronger than May, May stronger than April, feel pretty good relative to the visibility and the strengths relative to the backlog and the order intake. Resi, as Dave indicated POS really strong demand improving significantly on non-resi, I'd say it's more stabilized kind of going into Q2 and exiting out of Q2 now much better and so relative commensurate was kind of the guidance we gave that's kind of how we're seeing things right now, maybe a little conservatism there but okay.
DavePetratis: I'd also say we look at a variety of indicators on non-resi bookings, frame sales, hardware quotes, specs written, wholesale sell-through, every week as we exited April got better. You could see things coming back through.
TimWojs: Okay. Perfect. Thank you. And then I guess bigger picture if the end markets maybe over the next 12 to 18 months are choppy. I'm just wanted to gauge your appetite on just M&A and I guess your appetite change at all? I mean is just a time where maybe you'd purposely get more aggressive to just add good assets and maybe a time of more stress.
DavePetratis: We'll certainly be watching the stress movements on a set of selected assets that we always keep an eye on. I don't expect a lot of change in those things that we would aspire to; the jewels that could help redefine Allegion. I don't expect that to change, but look for us to increase our activity around tools that will help us expand seamless access, both internally and externally.
Operator: The next question comes from Josh Pokrzywinski of Morgan Stanley. Please go ahead.
JoshPokrzywinski: Hey. Good morning, guys. Just before my question, Dave, thanks for your leadership on employee, safety, health, societal awareness all that. I think it's very clear those aren't just talking points, so really appreciate that. Just a couple questions on the non-resi business. First on backlog visibility, how far does that stretch out, does that get you through your end? As I get into 2021 and then any comments that you would make on some of the retrofit side of the business versus new as you see activity or quotes in the market today because I think maybe relative to some other products that's out there security retrofit is either completely non-discretionary because you're locked out or it's broken or a lot more discretionary around aesthetics or upgrades. So just maybe some comments on how that retrofit side looks. Thanks.
DavePetratis: I'd say in terms of the backlog in commercial, institutional. I'd say you look at that with a six month lens but there are a couple filters. What we have in the actual backlog then you start looking at quote specs, job awards like let's just take a -- if we look at the city of Washington DC, job awards that could go out 18-24 months do we have the contractor, the architect, the wholesaler? There are things that go beyond just our book of business and generally we're going to get more than our fair share there. So I think good indicators but then you got to go to the broader macro. So I feel pretty good sitting here. I feel very good on 2020, it's as you look at I put those caution lines. Second question on the discretionary. I would -- I believe in terms of break fix, the discretionary side of the market especially the day that money gets spent especially with rising crime rates. I live in the downtown areas of Indianapolis; you're going to get your doors locked. And I think you also got to think about shutdowns. Our place is secure, so the discretionary break part of this market tends to roll it up and down economies and generally if you've got LCN, VON Duprin, interflex installed you're going like-for-like.
Operator: The next question comes from Jeff Kessler of Imperial Capital. Please go ahead.
JeffreyKessler: Thank you. In terms of timing on the regions it seems that in the US and particularly the southern -- in the southern tier is going to ask -- is going to continue to have some problems although the Northeast is obviously done a lot better. Europe seems to have rolled over its COVID problems much more quickly than we have. Are you seeing any impact on your business in Europe because of perhaps there -- them coming out of pandemic a little bit earlier than the US?
DavePetratis: We see -- let me say this. We've got our electronics, our Simons Voss and VON Duprin and interflex, that are mechanical business in Europe, the electronic business has performed well during the COVID-19 in lockdowns and it's -- you got to look at that as a key strength maybe better geographical position, but it's that continued trend of electronic conversion, software capabilities that is leading the way there. So we like that. We're going to continue to invest in that and we were driving some restructuring before COVID-19 was either mentioned. The world has got a challenge in terms of overall GDP, but we -- the dark regions, the Nordic regions are going to be a bit better than the southern and the electronic trends, we think will continue to operate nicely anywhere we're at in the world.
JeffreyKessler: Follow-up is you've talked a good amount of seamless and touchless of electronics. Are you seeing any move within the sub sectors and when you got some Bluetooth connectivity, but obviously NFC has been on the tip of your tongue now for since you guys were before the company was even spun out of and now that Apple has brought into NFC wholly at this point. The entire NFC world seems to be growing. The question is looking at other companies some smaller companies who are moving very quickly into NFC access, are you seeing the same type of -- are you seeing more competition area? Are you seeing your own business of improving in that area? And if so, what are the areas that you're going to be focusing on with regard to some of these new -- some of these technologies have been around but have been suppressed for one reason or another.
DavePetratis: So I look back --I look backward to try and understand what our strength is. I think in the 18 or last 22 quarters, we have grown double digits in electronics, so we like that trend. Two is I think it's all about your edge device and that is the tool that will allow the free flow of people. I think the problems to be solved are outstanding. Remember, we were the first company in the world, hey, open the door. Our relationships with Apple are outstanding. And I think these technologies are going to continue to drive and shape the marketplace and I like the position of Allegion.
Operator: The next question comes from Deepa Raghavan of Wells Fargo. Please go ahead.
DeepaRaghavan: Hi. Good morning. Question for me is for Americas fiscal year 2020 revenues, it doesn't look like the revenue outlook assumes Q4 exits with positive growth, but it definitely looks like you're planning for continued sequential improvement throughout the second half. Now if we continue to extrapolate that trend, it appears spring could be the likely bottom. I mean and by next construction season we could be talking positive non-res in Americas. Now is that a reasonable way to think about trends if economy stabilizes here or is the air pocket and quotation activities that you're currently seeing push the time-life -- timeline out materially?
DavePetratis: Great question, not easy answers. I went back and looked at contraction in the architectural indexes and these tend to snap back quickly. Now is this the pandemic will follow that? I think it's a function of how long the pandemic drags on, the real damage that's been done to institutional budgets, but as we move in to the construction season there is naturally an improvement and spring could be given us life here, but I think we'll have a better view of that 90 -days.
DeepaRaghavan: Got it. Can you talk about inventory in the system and if you can split that between resi and non-residential inventory commentary that will be helpful? Thank you very much.
DavePetratis: Inventory and the residential channel have been depleted. I'm looking for some numbers here but think about it 16 days of no replenishment, we tend to try and optimize those inventories so the shelves aren't bare, we're in a replenishment cycle, but it will take well in the first quarter at the significant demand levels to get that back to normal. If there's any weakness in competitive supply chain, and if you think about some of our competitors the supply chains get pretty complex, we could have more opportunity and could take longer. We'll take on that challenge. In terms of the non-res commercial institutional supply chains, those are responding back quickly, I think, some of the leverage that we had was we built backlog and some of our institutional products. We're able to fill that but that's normalizing much quicker.
Operator: Our last question from Julian Mitchell of Barclays. Please go ahead.
JulianMitchell: Hi. Good morning. Maybe just the first question around circling back to residential just trying to understand when you put everything together around the Mexico impact and inventories and so forth. And the point-of-sale data, how likely is it you think that the residential revenues in the Americas can grow in the second half? It's certainly something that we're seeing at other resi related products. And any color you could give on the differing outlooks you have within resi of new construction versus the replacement site.
PatrickShannon: I would characterize it this way, Julian, as we look at the residential business and you kind of look at all the factors you mentioned. Clearly, the second half sequential improvement as we progress throughout the year. Growth is year-over-year will be dependent upon our ability to get the labor in place to produce the product and get it through the channel to the end customer. And so a little bit constrained there from a capacity perspective is kind of going to be the driver whether we can show year-over-year growth, but nonetheless we'll kind of continue to drive that like the overall trend in electronics that's going to rebound as well to provide some additional growth as well.
DavePetratis: So I'd be maybe a little bit more aggressive in that. I believe Allegion has a better supply chain than our competitor. And I believe that is going to allow us to take some advantages here in the marketplace. And you think about that. These products come from South East Asia, the complexity can get pretty hard, where our tends to be is more North American centric even though we had to take a pause to keep our people healthy. I think I've got a better supply chain. I'd say second, the point-of-sale orders are reflecting that we're creating opportunities. Our electronics are some of the highest regarded and highest quality in the marketplace. And then some of the builder activity that part of the market is growing today in The Wall Street Journal. And if you've got a question, are my suppliers going to be able to support me as that market expands, if you're any of the big builders who you're going to look to. And I like our opportunities to have the discussions when you've got to depend on products coming halfway around the world to support your home building effort in an environment of uncertainty this pandemic. I like our opportunities.
JulianMitchell: Thank you. And any color on replacement trends in particular. I think as you said new home building very strong using replacements perhaps growing at an equal pace in the second half or similar revenue trajectory as OE?
DavePetratis: Amazing as I work from home, the amount of activity in the do-it-yourself centers then think about more frequent deliveries of point-of- sale. And then people just investing back in your home, Schlage is the number one replacement brand. It's a nice spot of the market. So I like our opportunity.
Operator: This concludes our question-and-answer session. I would like to turn the conference back over to Tom Martineau for any closing remarks.
Tom Martineau: Thanks. We'd like to thank everyone for participating in today's call. Please have a safe day.
Operator: The conference has now concluded. Thank you for attending today's presentation. You may now disconnect. | [
{
"speaker": "Operator",
"text": "Good day and welcome to the Allegion Second Quarter 2020 Financial Results Conference Call. All participants will be in listen-only mode. [Operator Instructions] Please note this event is being recorded. I would now like to turn the conference over to Tom Martineau, Vice President, Vice President, Investor Relations and Treasurer. Please go ahead."
},
{
"speaker": "Tom Martineau",
"text": "Thank you, Andrew. Good morning everyone. Welcome and thank you for joining us for Allegion's second quarter 2020 earnings call. With me today are Dave Petratis, Chairman President and Chief Executive Officer; and Patrick Shannon, Senior Vice President and Chief Financial Officer of Allegion. Our earnings release, which was issued earlier this morning and the presentation which we will refer to in today's call are available on our website at investor.allegion.com. This call will be recorded and archived on our website. Please go to slides two and three. Statements made in today's call that are not historical facts are considered forward-looking statements and are made pursuant to the Safe Harbor provisions of federal securities law. Please see our most recent SEC filings for a description of some of the factors that may cause actual results to differ materially from our projections. The company has no obligation to update these forward-looking statements. Today's presentation and commentary include non-GAAP financial measures. Please refer to the reconciliation in the financial tables of our press release for further details. Dave and Patrick will now discuss our second quarter 2020 results, which will be followed by a Q&A session. We have a very tight meeting today. Please for the Q&A, we would like to ask each caller to limit themselves to one question and short follow-up and then reenter the queue. We will like to give everyone an opportunity given the time allotted. Please go to slide 4 and I'll turn the call over to Dave."
},
{
"speaker": "Dave Petratis",
"text": "Thanks Tom. Good morning thank you for joining us today. 2020 will go down as a year of dramatic change. The health and economic impact of COVID-19 will take the head one along side the social concerns related to inclusion and diversity. With these challenges comes needed reflection. Before I turn to business results, I'd like to address these events and Allegion's response to them. The tragedy of George Floyd's death has been on my mind, as well as the deaths of many who have preceded him. Black lives matter, black lives matter and we must level the playing field, understand bias and work for equality. Prejudice and racism are intolerable and we can and must do better. My executive leadership team has joined me in a journey of listening, learning and reflection and will continue building the right roadmap for Allegion. With our employees, we must also help build a better world with our voices, our minds, our hands and our hearts. I expect the people of the Allegion in our businesses to be involved to create positive change in our community and our company. And you can expect the same of me. This is the spirit and culture of Allegion. And determining how we respond to social concerns our value and code of conduct has been our lighthouse since the creation of Allegion. And they will help us to improve inclusion and diversity at the company. In a similar way, our values and corporate business strategy has provided the foundation to respond to COVID-19 pandemic, which will be with us for some time to come Please go to Slide 5. You can equip with a culture of safety and resilient supply chain and operational discipline, Allegion was in a position of strength facing the pandemic. Keeping our employees safe and healthy continues to be top of mind, and we're effectively leveraging safety and health as our true number throughout these uncertain times. My leadership team led the COVID-19 effort to ensure our company was responding in real time to considerable global complexity. And to meet the needs of our employees, customers, communities and other stakeholders, as well as requests from public health officials. Cross-functional teams guided our health and safety efforts, production and operational decisions, work from home infrastructure and best practices. We also created an Allegion safety net program giving production workers an extra day of pay per month to cover unexpected illnesses or family needs. I'm proud of the collaboration and communication between functions which has been key to working productively and safely wherever we are. At the same time, Allegion has turned his attention to giving back to communities across the world while ensuring our employees had mask, we've also been able to donate thousands of mask to healthcare workers across the U.S, Mexico and Italy, knowing that people have a safe place to live is perhaps more important than ever. We've also continued our substantial commitment to habitat for humanity in 2020. There is no doubt our team members across the world are dedicated to serving others and doing the right thing. And taking care of our team members' means they can in turn take care of their communities. Please go to Slide 6. Our enterprise excellence and discipline capital allocation strategies have served us well to weather the COVID-19 storm. We are delivering new value in access and safety as people deal with the realities of daily life in a pandemic. Our vision of seamless access and a safer world has never been more important. As an expert in security, Allegion customers look for us to support specific guidance when faced with new challenges. In the age of COVID-19 for example new attention was brought to their need for a healthy environment in a variety of ways. First, proper cleaning and disinfecting procedures for door hardware. Second, surface technologies like silver ion antimicrobial coatings and new technologies with antibacterial and antiviral properties. Third, our touchless solutions are at the forefront of helping prevent the spread of viruses and reducing common physical touch points. From automatic door opening solutions and contactless readers to innovative door poles, our products can help avoid hand to surface contact. Further by integrating our wave to open and other innovations with identity management partners, we're able to enable seamless access through our partners of choice strategy. Fourth, our keyless solutions around the world are often are offering mobile and remote capabilities for access control and workforce management. In brief, customers around the world are looking for new practical and convenient solutions that help promote healthy environments and provide peace of mind. Our leading brands like Schlage, LCN, VON Duprin, interflex and Simons Voss paired with the strength of our supply chain and integration partners are meeting those needs. As we continue to navigate COVID-19 and other challenges, we will focus on our customers, our strategy and the health and safety of our people. Our business has strong fundamentals and has proven the ability to execute. We will continue to monitor, evaluate and adapt to market dynamics. Please go to Slide 7. And I'll walk you through the second quarter financial summary. Revenues for the second quarter were $589.5 million, a decrease of 19.4% or 18.5% organically. The organic revenue decrease was driven by the economic challenges that arose as a result of the COVID-19 pandemic, currency headwinds and the impact of divestitures of our businesses in Colombia and Turkey also contributed to the total revenue weakening. All regions experience substantial revenue declines. Patrick will share more detail on the regions at a moment. Adjusted operating margins decreased by 260 basis points in the second quarter. The significant vol e declines drove the margin reduction. We did see positive price, productivity, inflation dynamic, which helped -- which was help by reductions in variable and share based compensation, non-US government incentives, plus the impact of cost actions including reductions in discretionary spending, a freeze on non-essential investments and hiring, restructuring and re-prioritization of capital expenditures. Due to these actions, we saw sequential improvement during the quarter. Adjusted earnings per share of $0.92 decreased $0.34 or 27% versus the prior year. The decrease was driven primarily by lowering operating income as a result of reduced revenue. Favorable share count and other income offset some of the operational decline. Year-to-date available cash flow came in at $103.6 million, an increase of approximately $26 million versus the prior year. Improvement in networking capital and reduced capital expenditures more than offset the lower net earnings. Patrick will now walk you through the financial results. And I'll be back later to discuss our 2020 outlook and a wrap-up."
},
{
"speaker": "Patrick Shannon",
"text": "Thanks Dave. Good morning, everyone. Thank you for joining today's call. If you would please go to Slide 8. This slide reflects our earnings per share reconciliation for the second quarter. For the second quarter 2019 reported earnings per share was a $1.16, adjusting $0.10 for prior year restructuring expenses and integration cost related acquisitions, the 2019 adjusted earnings per share was a $1.26. Operational results decreased earnings per share by $0.42 driven by vol e deleverage that was offset slightly by favorable price and productivity exceeding inflationary impacts and unfavorable currency. The impact of decreased investments in the quarter was a $0.01 increase and an increase in other income drove another positive $0.05 per share impact. Favorable year-over-year share count increased adjusted earnings per share by $0.02. These results in adjusted second quarter 2020 earnings per share of $0.92, a decrease of $0.34 or approximately 27% compared to the prior year. Lastly, we have $0.12 per share reduction for charges related to restructuring costs. After giving effect to these items you arrive at second quarter 2020 reported earnings per share of $0.80. Please go to Slide 9. This slide depicts the components of our revenue performance for the second quarter. I'll focus on the total Allegion results and cover the regions on their respective slides. As indicated, we experienced an 18.5% organic revenue decline in the second quarter. All three regions saw substantial revenue declines. The COVID-19 pandemic drove the decreases across the globe as there were many government mandated shutdowns across all industries where our products are sold. We did see modest price realization which slightly offsets some of the precipitous vol e declines. The impact of the divestiture of our businesses in Colombia and Turkey along with continued currency pressure was headwinds of total growth. Please go to Slide 10. Second quarter revenues for the Americas region were $444.3 million down 18.5% on a reported basis and down 18.1% organically. The decline was driven by vol e challenges posed by the COVID-19 pandemic; both the non-residential and residential businesses were down significantly. Early in the quarter, our factories in the Baja region of Mexico were shutdown by a broad government decree related to COVID-19 which had a significant impact on shipments. The Americas electronics revenue declined more than 20% in the quarter as that segment was adversely affected due to its discretionary nature. We see electronics continuing to be a long-term growth driver and expect growth to res e when market conditions normalize. On the positive side, the region generated modest price realization and experienced sequential month-over-month improvements in revenue as COVID restrictions began to ease. Through the Mexico plant closures early in the quarter and improving residential markets, we enter the third quarter with a healthy backlog for a residential business. Although the non-residential business orders are below the prior year activity has begun to stabilize. Americas' adjusted operating income of $124.1 million decreased 23.6% versus the prior year period. And adjusted operating margin for the quarter decreased 190 basis points. Vol e deleverage drove the decline and was offset slightly by price and productivity exceeding inflation. The region has implemented necessary cost control measures in the quarter including headcount reductions, investment delays and cancellations and reductions in discretionary spending. In addition, manufacturing expenses have been adjusted to reduce impacts on lower volumes. Please go to Slide 11. Second quarter revenues for the EMEA region were $111 million, down 21.9% and down 20.4% on an organic basis. The lower vol e was driven by COVID-19 and the widespread government mandated closures throughout the continent. The impact of the divestiture of the business in Turkey and currency headwinds also contributed to the reported revenue decline and was partially offset by modest price realization. EMEA adjusted operating income of $1.5 million decreased 87% versus the prior year period. Adjusted operating margin for the quarter decreased by 660 basis points. The margin degradation was driven by the significant vol e declines associated with government mandated closures in several countries where the company operates. Price and productivity exceeding inflation helped mitigate some of the margin decline. Similar to the Americas, reductions in variable compensation and other discretionary spending helped the productivity performance as did assistance received through government incentives. As previously announced in Q1, restructuring programs are underway in the region and we expect benefits to accelerate in the second half of the year. Please go to Slide 12. Second quarter revenues for the Asia-Pacific region were $34.2 million, down 22.1% versus the prior year. Organic revenue was down 18%. The decline was driven by COVID-19 related impacts and continued weakness in China residential, in Australian end markets. Total revenue continued to be affected by currency headwinds. Asia-Pacific adjusted operating loss for the quarter was $1.2 million, a decrease of $3 million with adjusted operating margins down 760 basis points versus the prior year period. The operating loss includes a $1.8 million charge related to a specific product quality dispute in China. Significant vol e declines and unfavorable mix also had a large impact on the reduced income and margin. As with the other regions, the price, productivity inflation dynamic was positive and was aided by reductions in variable compensation, other discretionary spending. As with the EMEA, Asia-Pacific also benefited from government incentives related to COVID-19. And as previously announced in Q1, restructuring programs are underway in the region and we expect benefits to accelerate in the second half of the year. Please go to Slide 13. Year-to-date available cash flow for the second quarter came in at $103.6 million which is an increase of approximately $26 million compared to the prior year period. The increase was driven by improvements in networking capital and reduced capital expenditures which more than offset lower adjusted net earnings. Our ability for cash flow generation has been strength of the company that was evident in the second quarter and will continue to serve us well during the current market environment. Looking at the chart to the right, it shows working capital as a percent of revenues decreased based on a 4 point quarter average. This was driven by reduced working capital needs, lower vol e as well as better turnover on accounts receivable. The business continues to generate strong cash flow and we remain committed to an effective and efficient use of working capital. We will continue to evaluate opportunities, optimize working capital to continue driving substantial cash flow conversion. Our financial and liquidity position remains extremely solid. Our net debt to EBITDA ratio is 1.8 based on the last 12-months performance, we have close to $500 million available under a revolving credit facility. We also remain committed to a flexible and balanced capital allocation strategy. Although, we've communicated a pause in share buybacks in order to focus on liquidity during this time of market volatility, we intend to put excess cash to use as we continue to see market improvement and stabilization. I will now hand it back over to Dave review on our full year 2020 outlook."
},
{
"speaker": "Dave Petratis",
"text": "Thank you, Patrick. Please go to Slide 14. As you know, we previously withdrew our outlook for 2020. This morning we reissued an outlook. The n beers we provided ass e there is no additional COVID-19 impacts including government decrees, supply chain disruptions and safety and health issues. The pandemic has already driven much change in the market dynamic across the world for 2020. With that said, Allegion's sound fundamental business strength provides some resiliency in times of economic downturn and our long-term investment thesis remains unchanged. In the Americas, we expect to see continued year-over-year organic revenue declines in the second half. Residential markets are expected to rebound more quickly than the non-residential. We have seen sequential increases in home builder demand and point-of-sale metrics have improved in the big box and e-commerce channels. We expect commercial markets to be tough as the pandemic had forced many to work from home. In institutional markets, projects already started will continue and finish. With these expectations, we project organic revenue in the Americas to be down 7.5% to 8.5% for the full year. We're projecting Americas total revenue decline to be 8% to 9% with a slight impact from the divestiture of the business in Colombia. In Europe, markets have softened prior to the COVID-19 outbreak and revenue declines are expected to continue in the second half. However, we are projecting sequential improvement as we go through the back half. For the region, we project our organic growth to be down 9% to 10%. Total revenue includes the impact of currency pressure in the first half, as well as the divestiture of the business in Turkey and is projected to be down 10 % to 11% for the full year. In Asia- Pacific, markets were weak before COVID-19 and we expect that to continue especially in the China residential and Australian markets. With that backdrop, we expect an organic revenue decline in 2020 of 10.5% to 12.5% and total revenue will be down 14% to 16% as currency pressures continue. We are projecting total organic revenues for the company to be down 8% to 9% and total revenues to decline 9% to 10%. Please go to slide 15. Our new 2020 outlook for adjusted earnings per share is $4.15 to $4.30. As indicated, the earnings decline is driven by lower volumes related to COVID-1. We have made significant cost reduction in the business and our work will continue to streamline our structure as needed, while prioritizing critical investments as we remain focused on driving our strategy of seamless access. The combination of interest and other expense is expected to be a positive to earnings per share. Our outlook ass es full adjusted effective tax rates of approximately 13.5% to 14.5%, as well as outstanding weighted average diluted shares of approximately 93 million. The outlook additionally includes approximately $1.35 to $1.45 per share impact from impairment and restructuring charges during the year, most of which has already occurred. As a result, reported EPS is estimated to be at $2.70 to $2.95. Our revised available cash flow outlook for 2020 is now projected to be in the $350 million to $370 million range. Please go to Slide 16. Allegion has strong fundamentals and has proven the ability to execute and adjust to market dynamics as demonstrated during the first half of 2020. We had strong moment in the first quarter particularly in the Americas, while the pandemic was unforeseen and its effects were immediate, we managed the business extremely well to restructure and manage costs. We also move quickly to address new customer needs for touchless solutions and remote management. As we go into the second half of the year, we start from our core strengths in health and safety, supply chain and financial discipline. We will take the necessary and often difficult actions needed to adjust quickly to evolving market dynamics. The strategy of adding value through seamless access in a safer world drives the right focus for the long term. And it puts us on solid footing for the post pandemic world. Thank you. Now Patrick and I will be happy to take your questions."
},
{
"speaker": "Operator",
"text": "[Operator Instructions] First question comes from Ryan Merkel of William Blair. Please go ahead."
},
{
"speaker": "RyanMerkel",
"text": "Thanks and good morning, everyone. So two questions, First off, in Americas the year-over-year decline in electronics was a little more than I thought. Just looking forward do you expect electronics mix to continue to mix down? And then second question are you seeing more interest in touchless access and mobile keys in this environment?"
},
{
"speaker": "DavePetratis",
"text": "I would say we do not expect a mix down. I think our key growth has been stronger in the residential and I think last mile delivery, the growth of e-commerce, people's connectivity that trend will continue. We've got one of the best locks on the market with our encode lock, the favorability ratings I looked this morning 37,000 comments on Amazon at about a 4.8, so feel extremely good about that. I think the weakness in the quarter really driven by the overall lockdowns but in terms of integrators ability to enter college campuses, none of us wanted people coming on site and that work to see, so we like the long-term trends and I believe it's a key factor going forward. I think two, when you think about some of the capabilities that we're putting together, the ability to seamlessly travel without touch whether there's the wave at hand, your edge device, these things will continue to be drivers. Add things like our investment in the need to be able to understand how many people are in a room, in an area, in a building; these are things that will continue to expand as we go forward."
},
{
"speaker": "Operator",
"text": "The next question comes from John Walsh of Credit Suisse. Please go ahead."
},
{
"speaker": "JohnWalsh",
"text": "Hi, good morning. I wondered if we could just touch a little bit on investments and tax I guess maybe first on the investments, obviously, you put a hard number around it not surprising it's lower than the initial expectations given the way demands played out, tax this is kind of the second year in a row. We'll have this lower rate, how should we think about the investment spending going forward in the sustainability of the tax rate from here?"
},
{
"speaker": "PatrickShannon",
"text": "So as we indicated in our full year guide, we're looking at some incremental investments although it's lower than what we'd originally anticipated, but nonetheless higher than last year. And that's predominantly around this whole movement in electronics and trying to drive that market for faster adoption. Some specific initiatives around the IoT platform and those types of things that will help us, in particular as we begin to kind of come out of this pandemic. So feel good about those investments and the ability to be able to drive incremental revenue and as we've indicated historically those investments have enabled us to drive revenue faster than the overall market. And I think we get good return on those in terms of invested capital. So going forward will kind of continue to monitor the markets and the needs in our business, and we'll continue to invest for the long-term future in our business. As it relates to the tax rate, we are anticipating a lower rate again than what was originally provided at the beginning of the year. Some of that is due to some favorable items that kind of came through FIN48 reserves those type of things. Some of it is quite frankly we've been able to implement some new tax planning strategies that will take effect and feel good about the work that the team is implemented there. As we go forward beyond 2020, we had historically given some guidance that the tax rate would migrate upwards to kind of like the high teens area, more guidance to come when we come out with the 2021 information, but I feel fairly confident it will be better than that maybe mid-teens type of thing at least in the near term and that's all because of where we find ourselves today and some of the great tax planning strategy work that's been going on."
},
{
"speaker": "JohnWalsh",
"text": "Great. Thank you for that color. And then maybe just a follow-up here. You talked about in the Americas exiting with some strength and resi and stabilization and non-resi. Can you put any numbers around that either what the exit rate was in June or what you're seeing here in July?"
},
{
"speaker": "DavePetratis",
"text": "So, first, I'd go to the backlogs, we've got effectively record backlogs between commercial institutional and res, the res demand extremely strong as we look at point of sale. If you look May, June and July the 12% increase in dollars, 7% in units really like that trend this morning's Wall Street Journal about strength in housing I think the other thing as you think about our res performance especially in the first half, there was a mandate in the country of Mexico to shutdown that's about 25% of our workforce and a big supplier of our res supply chain. We deleted inventories in a situation where demand was accelerating that point of sale that I referred to. Record backlogs in residential I think we've got a great set of product capabilities and I think our supply chain is stronger than the people that we're competing against. So I like our opportunities as we go through the next -- the second half and early in the next year."
},
{
"speaker": "Operator",
"text": "The next question comes from Jeff Sprague of Vertical Research. Please go ahead."
},
{
"speaker": "JeffSprague",
"text": "Thank you. Good morning. Two from me also, David, I'd be interested in just your kind of forward opinion here now on the non-res cycle overall. You introduced on the Q1 call the very logical possibility that 2021 could be down given the later cycle nature for some of these end markets. Based on what you're seeing in the channels now and just pipeline work and other folks on the ground what's your thought around that large question on everyone's mind?"
},
{
"speaker": "DavePetratis",
"text": "So I think when you think about the institution of commercial verticals, everybody caution, right. I think clearly there's shifts going on there I think we saw the ABI come out it, doesn't drive optimism I think as I look at Allegion healthy backlogs, our commercial institutional backlogs as we exited June high but I think the other thing that we look at specs written, we saw some disruption and spec writing and demand from architectural firms that's to be expected. I think we'll have a better call on specs written which is an early demand level as we exit Q3. If I looked at spec written today it's improved every week as we've gone through the crisis, but this is more of a long-term trend but as I would look at educational, healthcare, total commercial we anticipate softer markets. We will put our foot on to drive seamless access and we believe we can outperform in a weaker position because of our installed base. The strength of our spec writing and the capability of the Allegion."
},
{
"speaker": "JeffSprague",
"text": "Thanks and then second question perhaps for Patrick, just around kind of the cost reduction actions Patrick can you just provide a little bit more granularity on kind of what's kind of been done structurally from a cost-saving standpoint and what perhaps is temporary and I'm sure you like a lot of companies also some of these temporary actions are feeling like maybe they're at least semi-permanent as folks think about travel budgets and the like. But if you could kind of frame that up for us it would be helpful."
},
{
"speaker": "PatrickShannon",
"text": "Yes. sure. So good question. Let me try to provide a framework around that. First of all, we've identified and we are executing on a plan of about $80 million of cost reduction year-over-year reduction. And I would bucket that into three categories. The first of which would be the structural, more fixed cost predominantly headcount reduction that for this year is about 30% of the $80 million. Then you've got another bucket what I call the discretionary type of expenditures i.e. T&E, contractor spent, consulting those type of things, the things that you control in a down market, that's another probably 30% of the $80 million for this year and then the variable type of items, the things that are compensation related that a large portion of which will probably boomerang back next year is the balance of the $80 million or 40% of the total that I think the key point here is that offsetting the variable stuff i.e. the things that are expected to come back next year. We do have and we'll have carryforward benefit associated with some of the permanent cost reductions that will carry into next year. We won't be in a full year run rate level on some of those identified costs until Q4. So we have that as Dave mentioned in a script we will continue to work on further cost reductions to help mitigate that as well. So TBD onfurther actions that will be identified for the second half of the year."
},
{
"speaker": "DavePetratis",
"text": "I'd just add a little color as well. I think we got after this early even before Covid-19 you could see that in our in-flight restructuring plans and I think it's important that we continue to accelerate investments around electronics and seamless access, while transforming the company into a leaner structure."
},
{
"speaker": "Operator",
"text": "The next question comes from David MacGregor of Longbow Research. Please go ahead."
},
{
"speaker": "ColtonWest",
"text": "HI. Good morning. It's Colton West on for David MacGregor. I guess you pointed out sequential improvement on a month-to-month basis in the Americas in the quarter. Are you seeing those trends continue into July now?"
},
{
"speaker": "DavePetratis",
"text": "Absolutely. As you can feel the pulse of the economy coming back and I put cautions around that because in some cases they've gone too fast, but we feel it I think if you're in the wholesale retail channel on shelf inventories are down and we're seeing that in terms of specs quotes, point of sale and our own shipment."
},
{
"speaker": "ColtonWest",
"text": "Okay and then I guess as follow-up non-res came in better than res, sounds like for the quarter. How much of that was volumes versus price mix? If I recall correctly you guys implemented 3% pricing on commercial hardware back in April?"
},
{
"speaker": "PatrickShannon",
"text": "Yes, majority volume related but as we kind of saw in Q1 pricing relative to non-res better than the residential performance. We will continue to push that dynamic to the extent we can and so far here year-to-date have been fairly successful in getting solid price realization in the non-residential segment."
},
{
"speaker": "Operator",
"text": "Next question comes from Joe Ritchie of Goldman Sachs. Please go ahead."
},
{
"speaker": "JoeRitchie",
"text": "Thanks. Good morning, everyone. So, Dave, my first question maybe just trying to unpack the impact that you had from the Mexico decree. I know last quarter you guys had talked about having inventory on hand, but it sounds like you kind of depleted that inventory fairly quickly as the quarter went out. I'm just trying to understand, one, kind of like the impact that you had in the first quarter from maybe running out of inventory. And then secondly like how we should be potentially thinking about a restock as you get back online in Mexico."
},
{
"speaker": "DavePetratis",
"text": "So we deep dive this in terms of the performance second quarter, there was a decree from Mexico that mandated a 30-day shutdown. We were open well ahead of that and it was our ability to point out that we were essential, but more importantly our ability to keep our people safe. If you dig into it the governor of the Baja highlighted Allegion in a press conference in our safe practices and the confidence that we could do that, so that was important. I think if you look at the whole region we got restarted quicker. Second, the government mandated that anybody over the age of 55 immune compromised, pregnant could not work for us that was about 300 to 400 employees. We had this and some of our most experienced, we have reloaded on that and are producing at a higher -- we're producing out of the Baja today at the highest level since I've been at Allegion or we created the company. So if you think about that we've got 42 discrete manufacturing lines in Enemata if you have ever visited, there the ability to bring on that number of employees, pull that lever and replenish the supply chain is, and I think, few companies in the world could do it. So extremely proud the team, our ability to reinvent. I think a second thing that important here, you don't see the point of sale data but our teams did an extremely good job to drive our -- se our inventory to keep customers and products, as well as other partners in the supply chain. When you think about a situation where you're trying to maximize inventory, we reached out into our partners supply chains to be able to optimize that. Again, I thought they did a better job of it. And I believe the last point your question, we will be well into the first quarter of next year getting the supply chain in terms of finished inventories normalized with the increasing demand."
},
{
"speaker": "JoeRitchie",
"text": "Got it. Okay. That's helpful color, Dave. I guess my one follow-up question here in just thinking about what's happening from a commodity perspective and how your business mix is perhaps expected to change over the next four months, your copper prices right now are surging and notice that while pricing was still positive this quarter I think it's 70 bps from the Americas, it was still you saw a tick down versus Q1. So I'm just trying to understand I guess as we kind of move forward in this environment where volumes really aren't at normal levels like how are you guys feeling about your ability to offset inflation and your ability to get price in this environment. Also in the context of kind of the mixed shift that you're seeing in your business."
},
{
"speaker": "DavePetratis",
"text": "I'm always confident on price. I would say the market is discipline. Our first cautionary is always steel. We purchase a lot of steel more and then I think brass, but we're continue -- we'll continue to be aggressive on price realization, try to offset the effects of inflation, but I'm net positive and I'm that way every day. Patrick will bring some realization to it."
},
{
"speaker": "PatrickShannon",
"text": "Well, Joe, you're right. I mean the commodity prices have continued rise here over the last 90 days or so. I'd say for the balance of the year is you kind of look at the margin profile, think about sequential improvement as we progress throughout the course of the year, just through more efficiency and some of the cost measures we're taking will help us navigate for the balance of the year. Next year, another question will kind of monitor and see how progresses during the course of this year, but as Dave mentioned we will continue to push price to the extent we can and if we're unable to offset the inflationary impact will drive productivity, we'll make the appropriate investments to do whatever we can to mitigate the inflationary impact."
},
{
"speaker": "Operator",
"text": "The next question comes from Andrew Obin of Bank of America. Please go ahead."
},
{
"speaker": "AndrewObin",
"text": "Hi, guys. Good morning. Question, can you just comment on regional trends in the US? How is California trending versus Texas versus Florida versus Northeast? I mean frankly just trying to figure out how COVID and the second wave is just impact has been impacting demand, and if there is close correlation between what we see with hospitalizations and demand trends by region? Thank you."
},
{
"speaker": "DavePetratis",
"text": "I would say the stoppage in New York, the Northeast, you have some pretty strong governor mandates and decrees especially Boston, no public construction. We do very well in those big metro markets and so we're seeing that recovery as North East gets better. Again, you look to California, the construction and Allegion was able to operate during the first shutdown. We'll see how it drives if as they move, I guess, towards a second shutdown. I think you really dig in the data the COVID, Andrew, you're seeing growing pockets in construction workers of infection and how government will mandate around it. We've got to keep an eye on it, but construction has been considered essential in most areas of the country. And I think it will continue."
},
{
"speaker": "AndrewObin",
"text": "And then just a follow up just sort of talked about seamless access, but how do you think how you rethinking access business post COVID? Do you expect any structural changes and what the customers will demand in terms of being able to sort of get an out of the building without touching things?"
},
{
"speaker": "DavePetratis",
"text": "So I absolutely believe it, the number of enquiries on our antimicrobial products would be a clear example, but Andrew, I really believe that your edge device is how we'll navigate through society. The long-term trend I think positive. We've got the ability exist today to be able to through your edge device monitor your temperature as you approach the door, if you're out of it accepted range, are you going to get a temperature check, do we allow access. Those are things that are going to continue to develop as a result of Covid-19 and trying to keep people healthy."
},
{
"speaker": "Operator",
"text": "The next question comes from Tim Wojs of Baird. Please go ahead."
},
{
"speaker": "TimWojs",
"text": "Hey, guys. Good morning. Just maybe going back to Americas and just some of the cadence through the quarter, is there any way to just think about how June kind of finished up relative to the quarter in both resi and non-resi?"
},
{
"speaker": "PatrickShannon",
"text": "Yes, Tim, I would say again during the course of the quarter sequential improvement is a quarter progressed, June much stronger than May, May stronger than April, feel pretty good relative to the visibility and the strengths relative to the backlog and the order intake. Resi, as Dave indicated POS really strong demand improving significantly on non-resi, I'd say it's more stabilized kind of going into Q2 and exiting out of Q2 now much better and so relative commensurate was kind of the guidance we gave that's kind of how we're seeing things right now, maybe a little conservatism there but okay."
},
{
"speaker": "DavePetratis",
"text": "I'd also say we look at a variety of indicators on non-resi bookings, frame sales, hardware quotes, specs written, wholesale sell-through, every week as we exited April got better. You could see things coming back through."
},
{
"speaker": "TimWojs",
"text": "Okay. Perfect. Thank you. And then I guess bigger picture if the end markets maybe over the next 12 to 18 months are choppy. I'm just wanted to gauge your appetite on just M&A and I guess your appetite change at all? I mean is just a time where maybe you'd purposely get more aggressive to just add good assets and maybe a time of more stress."
},
{
"speaker": "DavePetratis",
"text": "We'll certainly be watching the stress movements on a set of selected assets that we always keep an eye on. I don't expect a lot of change in those things that we would aspire to; the jewels that could help redefine Allegion. I don't expect that to change, but look for us to increase our activity around tools that will help us expand seamless access, both internally and externally."
},
{
"speaker": "Operator",
"text": "The next question comes from Josh Pokrzywinski of Morgan Stanley. Please go ahead."
},
{
"speaker": "JoshPokrzywinski",
"text": "Hey. Good morning, guys. Just before my question, Dave, thanks for your leadership on employee, safety, health, societal awareness all that. I think it's very clear those aren't just talking points, so really appreciate that. Just a couple questions on the non-resi business. First on backlog visibility, how far does that stretch out, does that get you through your end? As I get into 2021 and then any comments that you would make on some of the retrofit side of the business versus new as you see activity or quotes in the market today because I think maybe relative to some other products that's out there security retrofit is either completely non-discretionary because you're locked out or it's broken or a lot more discretionary around aesthetics or upgrades. So just maybe some comments on how that retrofit side looks. Thanks."
},
{
"speaker": "DavePetratis",
"text": "I'd say in terms of the backlog in commercial, institutional. I'd say you look at that with a six month lens but there are a couple filters. What we have in the actual backlog then you start looking at quote specs, job awards like let's just take a -- if we look at the city of Washington DC, job awards that could go out 18-24 months do we have the contractor, the architect, the wholesaler? There are things that go beyond just our book of business and generally we're going to get more than our fair share there. So I think good indicators but then you got to go to the broader macro. So I feel pretty good sitting here. I feel very good on 2020, it's as you look at I put those caution lines. Second question on the discretionary. I would -- I believe in terms of break fix, the discretionary side of the market especially the day that money gets spent especially with rising crime rates. I live in the downtown areas of Indianapolis; you're going to get your doors locked. And I think you also got to think about shutdowns. Our place is secure, so the discretionary break part of this market tends to roll it up and down economies and generally if you've got LCN, VON Duprin, interflex installed you're going like-for-like."
},
{
"speaker": "Operator",
"text": "The next question comes from Jeff Kessler of Imperial Capital. Please go ahead."
},
{
"speaker": "JeffreyKessler",
"text": "Thank you. In terms of timing on the regions it seems that in the US and particularly the southern -- in the southern tier is going to ask -- is going to continue to have some problems although the Northeast is obviously done a lot better. Europe seems to have rolled over its COVID problems much more quickly than we have. Are you seeing any impact on your business in Europe because of perhaps there -- them coming out of pandemic a little bit earlier than the US?"
},
{
"speaker": "DavePetratis",
"text": "We see -- let me say this. We've got our electronics, our Simons Voss and VON Duprin and interflex, that are mechanical business in Europe, the electronic business has performed well during the COVID-19 in lockdowns and it's -- you got to look at that as a key strength maybe better geographical position, but it's that continued trend of electronic conversion, software capabilities that is leading the way there. So we like that. We're going to continue to invest in that and we were driving some restructuring before COVID-19 was either mentioned. The world has got a challenge in terms of overall GDP, but we -- the dark regions, the Nordic regions are going to be a bit better than the southern and the electronic trends, we think will continue to operate nicely anywhere we're at in the world."
},
{
"speaker": "JeffreyKessler",
"text": "Follow-up is you've talked a good amount of seamless and touchless of electronics. Are you seeing any move within the sub sectors and when you got some Bluetooth connectivity, but obviously NFC has been on the tip of your tongue now for since you guys were before the company was even spun out of and now that Apple has brought into NFC wholly at this point. The entire NFC world seems to be growing. The question is looking at other companies some smaller companies who are moving very quickly into NFC access, are you seeing the same type of -- are you seeing more competition area? Are you seeing your own business of improving in that area? And if so, what are the areas that you're going to be focusing on with regard to some of these new -- some of these technologies have been around but have been suppressed for one reason or another."
},
{
"speaker": "DavePetratis",
"text": "So I look back --I look backward to try and understand what our strength is. I think in the 18 or last 22 quarters, we have grown double digits in electronics, so we like that trend. Two is I think it's all about your edge device and that is the tool that will allow the free flow of people. I think the problems to be solved are outstanding. Remember, we were the first company in the world, hey, open the door. Our relationships with Apple are outstanding. And I think these technologies are going to continue to drive and shape the marketplace and I like the position of Allegion."
},
{
"speaker": "Operator",
"text": "The next question comes from Deepa Raghavan of Wells Fargo. Please go ahead."
},
{
"speaker": "DeepaRaghavan",
"text": "Hi. Good morning. Question for me is for Americas fiscal year 2020 revenues, it doesn't look like the revenue outlook assumes Q4 exits with positive growth, but it definitely looks like you're planning for continued sequential improvement throughout the second half. Now if we continue to extrapolate that trend, it appears spring could be the likely bottom. I mean and by next construction season we could be talking positive non-res in Americas. Now is that a reasonable way to think about trends if economy stabilizes here or is the air pocket and quotation activities that you're currently seeing push the time-life -- timeline out materially?"
},
{
"speaker": "DavePetratis",
"text": "Great question, not easy answers. I went back and looked at contraction in the architectural indexes and these tend to snap back quickly. Now is this the pandemic will follow that? I think it's a function of how long the pandemic drags on, the real damage that's been done to institutional budgets, but as we move in to the construction season there is naturally an improvement and spring could be given us life here, but I think we'll have a better view of that 90 -days."
},
{
"speaker": "DeepaRaghavan",
"text": "Got it. Can you talk about inventory in the system and if you can split that between resi and non-residential inventory commentary that will be helpful? Thank you very much."
},
{
"speaker": "DavePetratis",
"text": "Inventory and the residential channel have been depleted. I'm looking for some numbers here but think about it 16 days of no replenishment, we tend to try and optimize those inventories so the shelves aren't bare, we're in a replenishment cycle, but it will take well in the first quarter at the significant demand levels to get that back to normal. If there's any weakness in competitive supply chain, and if you think about some of our competitors the supply chains get pretty complex, we could have more opportunity and could take longer. We'll take on that challenge. In terms of the non-res commercial institutional supply chains, those are responding back quickly, I think, some of the leverage that we had was we built backlog and some of our institutional products. We're able to fill that but that's normalizing much quicker."
},
{
"speaker": "Operator",
"text": "Our last question from Julian Mitchell of Barclays. Please go ahead."
},
{
"speaker": "JulianMitchell",
"text": "Hi. Good morning. Maybe just the first question around circling back to residential just trying to understand when you put everything together around the Mexico impact and inventories and so forth. And the point-of-sale data, how likely is it you think that the residential revenues in the Americas can grow in the second half? It's certainly something that we're seeing at other resi related products. And any color you could give on the differing outlooks you have within resi of new construction versus the replacement site."
},
{
"speaker": "PatrickShannon",
"text": "I would characterize it this way, Julian, as we look at the residential business and you kind of look at all the factors you mentioned. Clearly, the second half sequential improvement as we progress throughout the year. Growth is year-over-year will be dependent upon our ability to get the labor in place to produce the product and get it through the channel to the end customer. And so a little bit constrained there from a capacity perspective is kind of going to be the driver whether we can show year-over-year growth, but nonetheless we'll kind of continue to drive that like the overall trend in electronics that's going to rebound as well to provide some additional growth as well."
},
{
"speaker": "DavePetratis",
"text": "So I'd be maybe a little bit more aggressive in that. I believe Allegion has a better supply chain than our competitor. And I believe that is going to allow us to take some advantages here in the marketplace. And you think about that. These products come from South East Asia, the complexity can get pretty hard, where our tends to be is more North American centric even though we had to take a pause to keep our people healthy. I think I've got a better supply chain. I'd say second, the point-of-sale orders are reflecting that we're creating opportunities. Our electronics are some of the highest regarded and highest quality in the marketplace. And then some of the builder activity that part of the market is growing today in The Wall Street Journal. And if you've got a question, are my suppliers going to be able to support me as that market expands, if you're any of the big builders who you're going to look to. And I like our opportunities to have the discussions when you've got to depend on products coming halfway around the world to support your home building effort in an environment of uncertainty this pandemic. I like our opportunities."
},
{
"speaker": "JulianMitchell",
"text": "Thank you. And any color on replacement trends in particular. I think as you said new home building very strong using replacements perhaps growing at an equal pace in the second half or similar revenue trajectory as OE?"
},
{
"speaker": "DavePetratis",
"text": "Amazing as I work from home, the amount of activity in the do-it-yourself centers then think about more frequent deliveries of point-of- sale. And then people just investing back in your home, Schlage is the number one replacement brand. It's a nice spot of the market. So I like our opportunity."
},
{
"speaker": "Operator",
"text": "This concludes our question-and-answer session. I would like to turn the conference back over to Tom Martineau for any closing remarks."
},
{
"speaker": "Tom Martineau",
"text": "Thanks. We'd like to thank everyone for participating in today's call. Please have a safe day."
},
{
"speaker": "Operator",
"text": "The conference has now concluded. Thank you for attending today's presentation. You may now disconnect."
}
] | Allegion plc | 241,782,379 |
ALLE | 1 | 2,020 | 2020-04-23 08:00:00 | Operator: Good day and welcome to the Allegion First Quarter Earnings Call. All participants will be in listen-only mode. [Operator Instructions] After today's presentation, there will be an opportunity to ask question. Please note this event is being recorded. I would now like to turn the conference over to Thomas Martineau, Vice President, Treasurer and Investor Relations. Please go ahead.
Thomas Martineau: Thank you, Jason. Good morning everyone. Welcome and thank you for joining us for Allegion's first quarter 2020 earnings call. With me today are Dave Petratis, Chairman President and Chief Executive Officer; and Patrick Shannon, Senior Vice President and Chief Financial Officer of Allegion. Our earnings release, which was issued earlier this morning and the presentation which we will refer to in today's call are available on our website at investor.allegion.com. This call will be recorded and archived on our website. Please go to slides two and three. Statements made in today's call that are not historical facts are considered forward-looking statements and are made pursuant to the Safe Harbor provisions of federal securities law. Please see our most recent SEC filings for a description of some of the factors that may cause actual results to differ materially from our projections. The company assumes no obligation to update these forward-looking statements. Today's presentation and commentary include non-GAAP financial measures. Please refer to the reconciliation in the financial tables of our press release for further details. Dave and Patrick will now discuss our first quarter 2020 results, which will be followed by a Q&A session. Given the high uncertainty around the duration and severity of the COVID-19 pandemic, we had previously pulled our outlook for 2020 and will not be providing an update during this call. For the Q&A, we would like to ask each caller to limit themselves to one question and one follow-up and then reenter the queue. We will do our best to get to everyone given the time allotted. Please go to slide 4 and I'll turn the call over to Dave.
Dave Petratis: Thanks Tom. Good morning, and thank you for joining us today. Like all responsible global companies, Allegion is closely monitoring and assessing the COVID-19 outbreak, which continues to evolve. We are focused on doing what's right for our employees, customers and communities. We're also maintaining our business health and supporting a central critical infrastructure around the world. Allegion operates within several different critical infrastructure sectors, making our work essential to our customers, and in many cases, their customers. Our people create the security and life safety devices so many others depend on, whether for private homes, government buildings, or medical facilities. We are regularly called on to provide our products and solutions for hospitals and health care facilities, most recently new construction for laboratories that will support the fight against COVID-19. This work gives us clear purpose, especially in these unprecedented times. With the exception of Italy and Mexico, where government health decrees have temporarily paused production, our manufacturing sites may operate. We monitor for demand and material shortages related to COVID-19, taking necessary short-term actions such as adjustments to production to protect the long-term future of Allegion. Such majors are being implemented in a way that minimizes disruption to customers and the overall business. In the case of Italy, we are shipping orders for finished goods with government approval and continue to engage in dialogue with Mexican authorities to open prior to the lifting of its general decree. In the meantime, we are working with our supply chain, existing inventory, and channel partners to fulfill customer requirements for goods normally coming out of Mexico. It remains our intention to continue to serve our customers to the best of our abilities. You've heard me say before, but it bears repeating. We have one of the safest workforces in the world. I could not be prouder of our company of experts who have leveraged our strength and safety to adapt to the current reality. We have faced COVID-19 since mid-January in China and developed operational practices that keep our people safe. We're modeling best practice safe hygiene guidelines based on standards from the World Health Organization and the Centers for Disease Control and Prevention. We're conducting deep cleaning of our facilities on a regular basis. We're social distancing where we were and we're limiting crowds. We've increased our personal protective equipment and supplies. There's additional cleaning solution, wipes, hand sanitizers throughout our facilities. Employees can ask for PPE supplies like gloves and who're requiring face masks in manufacturing and distribution facilities. We paused all nonessential meetings and visitors, as well as air travel early in the crisis. Essential meetings are encouraged in virtual ways. We're adhering to government decrees and orders and monitoring health conditions, and wherever possible and where necessary, employees are working from home. The strength of Allegion's global supply chain is a major asset and allows us to continue servicing our customers. We have many levers to pull from utilizing safety stocks and inventories to leveraging dual and alternate supply to sharing components across our own facilities and regions. Without doubt, these options that our team have in place are increasing Allegion's credibility and customer loyalty in the marketplace. Of course, our business must be healthy to continue to support our employees, customers, and communities. We have proactively taken actions to mitigate financial implications associated with COVID-19. These actions include reductions in discretionary spending, elimination of nonessential investments, a hiring freeze and reprioritization of all capital expenditures, including a temporary suspension of share repurchases. Importantly, we believe Allegion has an extremely strong balance sheet and liquidity that provides flexibility and positions us well throughout this time. Our net debt-to-adjusted EBITDA ratio was 1.6 times at December 31, 2019. We have an undrawn credit facility of up to $500 million if needed and no principal payments due on an outstanding debt until September 22. Our business generates significant cash flow due to industry-leading EBITDA margins and low capital intensity. Allegion's available cash flow conversion to earnings ratio has averaged over 100% as a stand-alone company. Yet there will be challenges ahead. The start of 2020 has made that clear. Allegion can take on great challenges with an engaged, safe, and healthy workforce, financial strength, legacy brands that have stood the test of time, and a steady focus. Allegion will remain true to our values and strong business fundamentals. Please go to Slide 5. Let's turn to the results for the first quarter. We have a strong disciplined supply chain, and our team did an outstanding job navigating the early challenges posed by COVID-19 pandemic as evidenced by the revenue growth we experienced in the quarter. In particular, the Americas had a stellar quarter offset by weakness in Europe and Asia Pacific. The Americas region had reported growth of 7.7% and organic growth of 8.2% in the quarter, driven by both nonresidential and residential businesses. EMEIA markets continue to be soft through the quarter, and our business was further impacted by the COVID-19 pandemic impact beginning in March. For Asia-Pacific, Asian markets remained weak, and the region as a whole experienced the COVID-19 impacts as well. Electronics growth in the Americas came in at 12% in the quarter. We continue to see electronics as a long-term positive trend as more and more products become connected for ease of access. The underlying fundamentals of the business are strong and will serve us well as the global pandemic subsides. Adjusted operating margin were up a 190 basis points in the quarter. Margin expansion led by the Americas region, which saw adjusted margins up 270 basis points. EMEIA and Asia-Pacific margins were down due to volume declines in both regions. EMEIA margins were further pressured by continued operational inefficiencies from the move of our operations from Turkey to Poland. We highlighted last quarter our expectation that the impact would carry over in the first half of this year. In the first quarter, adjusted EPS growth came in at a robust 18% and available cash flow was up nearly $44 million versus the prior quarter – prior year. Overall, I'm very pleased with our Q1 2020 results. That said, the near-term future will be more difficult as we continue to navigate the uncertainty brought on by the COVID-19 pandemic, and I expect financial headwinds. Beyond the expense and cash management actions previously discussed, we are implementing cost reduction actions to optimize and simplify the European and Asia-Pacific regions. These actions are intended to address weaker end market fundamentals, enable enhanced customer focus, and will help position these regions for future success. And there's one accounting item to mention. We recognized a $96.3 million non-cash charge related to goodwill and indefinite-lived trade name impairments for our non-U.S. operations predominantly related to the COVID-19 and the expected future impacts. Please go to Slide 6, and I'll take you through the first quarter financial summary. Revenue for the first quarter was $674.7 million, an increase of 3%, inclusive of 4.3% organic growth. Currency headwinds and the impact of the divestitures of our business in Colombia and Turkey offset some of the organic growth. Americas led the way on revenue growth, offsetting the weakness we experienced in EMEIA and Asia Pacific. Patrick will share more detail on the regions in a moment. Adjusted operating margin increased by 190 basis points in the first quarter. As I stated earlier, we saw a significant margin expansion in the Americas with declines in Europe and Asia. Adjusted earnings per share of $1.04 increased $0.16 or just over 18% versus the prior year. The increase was driven primarily by higher operating income, favorable share count and tax rate offset the increase in other expense. Available cash flow came in at $19 million, an increase of nearly $44 million versus the prior year. Increased adjusted earnings and improvement in net working capital were the driving factors for the increase. Patrick will now walk you through the financial results, and I'll be back to wrap-up.
Patrick Shannon: Thanks, Dave and good morning, everyone. Thank you for joining today's call. Please go to slide number 7. This slide depicts the components of our revenue growth for the first quarter. I'll focus on the total Allegion results and cover the regions on their respective slides. As indicated, we delivered 4.3% organic growth in the first quarter led by the Americas region with strong growth in both the non-residential and residential businesses. Price realization was again solid in the quarter more than offsetting material inflation. The impact of the divestiture of our businesses in Colombia and Turkey along with continued currency pressure in EMEIA and Asia-Pacific were headwinds of total growth. Please go to slide number 8. Reported net revenues for the first quarter were $674.7 million. As stated earlier, this reflects an increase of 3% versus the prior year up 4.3% on an organic basis. We delivered good price realization and saw a solid volume driven by the Americas region. We experienced an estimated $10 million revenue loss related to COVID-19 during the quarter primarily in our international regions as a result of business closures. Adjusted operating income of $128.2 million increased more than 14% over the same timeframe from last year. Adjusted operating margin of 19% increased 190 basis points. The margin expansion was primarily driven by solid operating leverage on incremental volumes in the Americas along with pricing and productivity outpacing inflation. Headwinds of margin performance include incremental investments which had a 30 basis point impact on adjusted operating margins and an estimated $4 million impact to adjusted operating income related to COVID-19. Please go to slide number 9. This slide reflects our earnings per share reconciliation for the first quarter. For the first quarter of 2019 reported earnings per share was $0.84. Adjusting $0.04 for the prior year restructuring expenses and integration costs related to acquisitions, the 2019 adjusted earnings per share was $0.88. Operational results increased earnings per share by $0.16 as favorable price. Operating leverage on incremental volume and productivity more than offset inflationary impacts and unfavorable currency. A year-over-year decrease in the adjusted effective tax rate drove another $0.04 increase. Favorable year-over-year share count increased adjusted earnings per share by another $0.02. The impact of incremental investments in the quarter was a $0.02 reduction and an increase in other expense drove another negative $0.04 per share impact. This results in adjusted first quarter 2020 earnings per share of $1.04 an increase of $0.16 or 18.2% compared to the prior year. Lastly, we had a $1.04 per share reduction for charges primarily related to goodwill and indefinite-live trade name impairments. These charges were related to COVID-19 and its impact on expected future results. After giving effect to these onetime items you arrive at first quarter 2020 reported earnings per share of $0. Please go to slide number 10. First quarter revenues for the Americas region were $502.1 million up 7.7% on a reported basis and up 8.2% organically. The growth was driven by solid price realization and strong volume. Both the non-residential and residential businesses grew high single-digits. The business saw a growth across all product segments and verticals particularly in institutional end markets. The electronics growth for the quarter was 12%. Electronic products continue to be a long-term growth driver as consumers and end users value the connectivity and convenience they offer over their mechanical counterparts. The overall growth in the Americas reflects the company's strong position in the market as well as the returns associated with incremental investments in new product development and channel strategies. Americas adjusted operating income of $146.6 million increased 19.1% versus the prior year period and adjusted operating margin for the quarter increased 270 basis points. Volume leverage on the revenue increase along with price and productivity significantly exceeding inflation drove the substantial margin expansion. The team continues to deliver solid cost leverage and productivity to further improve operating performance in our competitive position. Lastly, incremental investments were a 40 basis point decrease on margins. Please go to slide number 11. First quarter revenues for the EMEIA region were $129.9 million down 9.1% and down 6.2% on an organic basis. The lower volume was driven by continued weakening in end markets across the region and COVID-19 impacts, primarily, in the southern region. The impact of the divestiture of the business in Turkey and currency headwinds also contributed to the reported revenue decline. EMEIA adjusted operating income of $3.3 million decreased 71.8% versus the prior year period. Adjusted operating margin for the quarter decreased by 570 basis points. Also, during the quarter inflation exceeded price plus productivity. Revenue declines had a negative impact on operating margin, and we continue to experience cost pressure associated with the plant relocation from Turkey to Poland. Earlier in April, we announced cost reduction initiatives aimed at optimizing and simplifying our operations, improving our customer service, as well as addressing the cost structure in our non-U.S. locations. These are not specific to the COVID-19 pandemic, but part of our long-range business planning process. Please go to slide number 12. First quarter revenues for the Asia-Pacific region were $32.7 million, down 11.1% versus the prior year. Organic revenue was down 4.9%. The decline was driven by continued weakness in Australian end markets, primarily residential as well as impacts related to COVID 19. Total revenue continued to be affected by currency headwinds. Asia-Pacific adjusted operating loss for the quarter was $1.6 million, a decrease of $0.9 million with adjusted operating margins down 300 basis points versus the prior year period. Significant volume declines and unfavorable mix had a large impact on the reduced income and margin. Of note, we did have approximately $95 million in impairment charges for goodwill and indefinite live trade names. These charges were related to COVID-19 and its impact to expected future results. As with the EMEIA region, the cost reduction actions announced earlier in April will have a favorable impact on operations in Asia-Pacific. These actions are also the result of our long-range business planning and not specific to COVID-19 impacts. Please go to slide number 13. Year-to-date available cash flow for the first quarter of 2020 came in at $19 million, which is an increase of nearly $44 million compared to the prior year period. The increase was driven by higher adjusted net earnings and improvements in net working capital. Looking at the chart at the bottom of the slide, it shows working capital as a percent of revenues decreased based on a four point quarter average. On a year-over-year point in time basis, working capital as a percent of revenue is down 220 basis points. This was driven by accelerated turnover in both inventory and receivables. As always, we remain committed to an effective and efficient use of working capital. We will continue to evaluate opportunities to minimize investments in working capital in order to continue to drive substantial cash flow conversion. Please go to slide number 14. This slide provides an update on our capital structure. As you can see, our leverage has dropped steadily over the past five years and we ended 2019 at 2.1 times gross leverage and 1.6 times net leverage to adjusted EBITDA. In looking at our debt maturity profile, we do not have any loans maturing until September 2022. We also have a $500 million untapped credit facility should we need additional liquidity. Our balance sheet is in a strong position and our high level cash flow conversion provides us flexibility and optionality to run the business going forward. These same strengths have led Allegion to six consecutive years of annual increase in dividends and our most recent dividend increase of nearly 19% announced in February remains intact. During the first quarter, the company repurchased approximately $94 million of stock. Due to the uncertainties related to the pandemic, we have placed repurchase plans on hold and we will review further as the year progresses. I will now hand it back over to Dave to wrap-up.
Dave Petratis: Thank you, Patrick. Please go to slide number 15. We recently announced that we were withdrawing our outlook for 2020 based on the magnitude and uncertainties surrounding the COVID-19 pandemic. We respect the need for financial guidance for the analyst community and shareholders. However, the COVID-19 pandemic is ongoing. Health care experts are still learning about the virus and there is tremendous speculation on the economic recovery and the path it will take. The many unknowns include the scope and effect of further government regulatory, fiscal monetary and public health responses. Our update will come when we release Q2 2020 results. The fundamentals of Allegion are strong. And as the world adapts to the new normal, we should have more clarity on the rest of 2020 at that time. We do expect that COVID-19 will have a near-term negative financial impact on the business, including the reduction in year-over-year revenues, operating profit and cash flow due to government decrees and softening demand. With that said, Allegion's sound fundamental business strength provides some resiliency in times of economic downturn, and our long-term investment thesis remains unchanged. For the past several years, we have delivered above-market organic growth, the strength of our channel relationships, new product development, large installed base brand and market positions have helped us continually drive higher organic growth than the market. Since spin, Allegion has delivered a 5.4% organic revenue CAGR. In the first quarter, the company grew organically at 4.3% with the Americas at 8.2%. Our strategy of seamless access takes full advantage of the keyless and connected technologies increasingly demanded in our industry. The electronic products needed to facilitate these demands continue to be a long-term growth driver for the company. The Americas business experienced 12% growth in electronics in Q1. Even with the growth we have seen in these products, since we became a stand-alone company, adoption is still in the early stages. Therefore, the industry conversion opportunity remains robust. Although, Allegion has industry-leading EBIT margins, our focus on price realization productivity and cost management allows us to expand margins when volumes are up like the 170 basis point increase we produced in Q1, but also facilitates the margin profile to be resilient through economic cycles. Our strong balance sheet, low capital requirements in tandem with a high level of cash flow conversion our business generates allows us to have capital allocation optionality. We are well within our debt covenants and have no near-term debt repayments. For the six full years, that Allegion has been a stand-alone company, the conversion of net income to available cash flow has on average exceeded 100%. The COVID pandemic has caused worldwide disruption in economic markets, whether haltering growing economies or furthering softening ones that were in decline. Nonetheless, we feel that our company is set up well to weather the storm and our strong fundamentals will serve us well when the pandemic subsides. Allegion has the right people in place to help ensure this. Our employees have shown a great deal of adaptability during these uncertain times. I could not be prouder of our people. Our management acted early to mitigate the economic impact. Our supply chain has proven itself to be flexible, proficient and dependable and we are positioned to continue leveraging as a strength moving forward. And of course, our legacy brands have stood the test of time and delivered incredible value. Allegion is strong, its people are resilient and we remain focused and disciplined. I do want to thank every member of the Allegion team on a successful Q1 2020. Everyone stay safe and healthy. And now Patrick and I will be happy to take your questions.
Operator: [Operator Instructions] First question comes from Tim Wojs from Baird. Please go ahead.
Tim Wojs: Hey, gentlemen, good morning. Hope everybody is well.
Dave Petratis: Good morning.
Patrick Shannon: Good morning.
Tim Wojs: Maybe if -- just my first question. Maybe if we can just add a little bit color particularly in Americas of how the demand trajectory you saw kind of trended through the quarter? And maybe, if you could give us just some flavor of how April has trended here, just to give us an idea what Q2 and kind of the near-term may look like?
Dave Petratis: Glad to do that. I would say first, the company got on to COVID-19 response early with a focus on our supply chain and protecting our people with a strategy for us to gain market share in Q1. So, we went extremely strong through the first quarter. I think that's reflected in our Americas results, and the strength, our ability to keep our supply chain strong. As we got into March, we saw a slight decline in the last two weeks. But again, we had our foot on the gas, and we communicated that. As we moved into April, we're 17 days into this. I think the things that we're seeing are rather predictable. We see some softness in the overall residential. I would say we have a view into point-of-sale in the bid box, and I'd say it's off low-teens. And as I look at that, I'd say, yes, that probably makes sense. Second, I think from a positive standpoint, our -- we see softness in bookings in the commercial and institutional. Our backlog is strong. We see the continuation of construction projects and we think if ground's broken, if permits are issued, these projects are going to roll in. As I came into work this morning, I see construction continue to move forward. The last thing I'd add Tim is our specs and quotes continue to be very positive. I know you can spec yourself and quote yourself right off a cliff, but it's a positive indicator. That work continues to roll.
Tim Wojs: Okay. Okay. Is that -- as you guys look into maybe the back half of this year and into 2021, is that really the part of your leading indicator or what might give you confidence that COVID is really more of kind of a temporary issue as opposed to something maybe more cyclical for non-residential construction in general?
Dave Petratis: I think you've got to be more critical than people would call it a V. I think the construction pipeline that we have today again, projects that are approved and are in progress will roll. I've got uncertainty about 2021 commercial and institutional. Commercial is going to be soft. I think that's where the strength of our spec writing, our wholesale channels, whatever the market gives us at Allegion, we expect to do better than the market.
Patrick Shannon: Thanks, Tim.
Operator: The next question comes from Jeff Sprague from Vertical Research. Please go ahead.
Jeff Sprague: Thank you. Good morning everyone. Hope everyone is well. Thanks for that color and also just trying to now kind of think about -- since we're all going to make our assumptions here, could you give us a little additional thought on decrementals and how linear or not linear the relationship is in other words, if revenues are down 10, what do you think the decrementals might be? And if they're down 20, what they might be and frame it however you like, but we've all got to kind of take a shot here at what's coming at us and try to put a stake in the ground in terms of an earnings estimate.
Patrick Shannon: Yes. So, the big question mark, I think Jeff relates to what's on the demand horizon. And as we've highlighted, very difficult to predict just kind of given the government decrees, and as we've highlighted we have a couple of plant closures today that will inhibit us a little bit on the top side and also will provide some cost pressure just from an under absorption perspective near term. As I think about it, and you try to run some correlations to prior cycles that type of thing, I mean, everyone knows a way it was pretty drastic, I think it's too early to make some comparisons to that. Right now, we're still -- as everyone else is collecting data from economists and a lot of people have different opinions, but as I think about it related to Allegion, some couple of points I'd like to highlight why I think we're better positioned than perhaps we were at the last downturn for several reasons. Number one, we have a much stronger business franchise, a lot better stronger portfolio of businesses. As you know, we've divested poor-performing businesses. We added businesses to our portfolio that I think are more resilient in a downturn and less susceptible to market downturns. This whole convergence of electronics is a -- you kind of look back 10 years ago, it wasn't a big driver in the business and whereas today it is a driver, it's growing at 1.5 times to 2 times the market today, and as you know we continue to put up really good numbers related to that. So, I think that's an item that needs to -- or will continue to grow and will be a continued focus for us going forward. And as you know, it's a higher average selling price similar margin, which means more EBIT dollars. The channel investments we've made, particularly in the repair retrofit market discretionary markets, we have a much broader product portfolio to serve our customers in that segment. And I think we're better positioned to participate in that market segment, whereas at time of spin we weren't, I think that will be good for us going forward. And then to your question on the margin profile, we would say historically, we've been able to adjust our cost profile. We can react pretty quickly. We historically have shown some margin decrements related to the last cycles, if you kind of go back to 2008, small margin deterioration. We adjusted our cost position fairly aggressively. Pricing we will continue to push that lever. It was a good driver for us in the quarter. So, I would say maybe some margin pressure, but not substantial relative to where we are. And if you think about where we are today, we're at a high watermark. Again, we had another record Q1 performance, up 190 basis points. And so, we're coming from peak margin performance, and we'll continue to take the actions necessary to address our cost base. We talked about those eliminating the discretionary spend, hiring freeze kind of re-prioritization of essential investments, you will see a reduction in some of the incremental investment, but we'll be focused on long-term areas. And so I just -- we'll see how things kind of pan out here, but I think it's going to be more demand-driven and we'll adjust our cost profile to meet future demand both at the factory and SG&A level.
Jeff Sprague: Thanks. And as an unrelated second question. Just on the good will, it's awful early in the COVID. It sounds like you're kind of using that as a kind of a justification for knocking out that goodwill. It sounds like -- but you've really beyond kind of COVID made a clear judgment that those acquisitions just have not lived up the snuff. And I just wonder if any of the other acquisitions in Europe or anything as you've gone through this goodwill testing are kind of close to being on the bubble here?
Dave Petratis: So Asia-Pacific as we indicated a write-down there goodwill and indefinite-live assets which pretty much releases the entire balance there. I think there's a de-minimis amount that remains. As we kind of talked about in Q4 the pressure there really given from the Australian market and just weak end-market fundamentals. And so we re-looked at that particularly given the COVID-19 which really accelerated the market decline, kind of as we look at it going forward and so put us in a position to kind of do that analysis which is kind of a discounted cash flow et cetera. When we look at Europe there is some cushion left there. We didn't need to take an impairment. I think hopefully, we took a conservative view on the discounted cash flow and hopefully, we're okay. But time will tell and we'll see where this pans out going forward. But again end markets continued weakness particularly in Southern Europe. But I feel really good about our electronics business there in the Germanic area. You mentioned acquisitions. SimonsVoss has been a home run for us. And I think there's some good growth opportunity there going forward. So again we'll kind of reevaluate as the year progresses and we'll see what happens when the fog lifts.
Patrick Shannon: I'd add one other comment. If you think about the Asia-Pacific, our acquisition profile has been Australia and one acquisition in Korea. All of those markets were in free fall in the second half of 2019 through the COVID-19 and it's hard to retain that goodwill on the books.
Jeff Sprague: Okay. Thanks for the color. Thanks a lot.
Patrick Shannon: Thank you.
Operator: The next question comes from Andrew Obin Bank of America.
Andrew Obin: Hi, good morning.
Patrick Shannon: Good morning, Andrew.
Andrew Obin: I'm just wondering so the first question I have, how should I think about your ability to release working capital in this environment because a lot of companies are telling us that they're going to run-off inventories run for cash. But my understanding also is that a lot of your product in the U.S. is highly customized. So how should I think about your ability to release working capital in second and third quarter as the COVID-19 sort of sweeps through the U.S. as well I guess?
Patrick Shannon: Yes. Most companies with downturns would show a higher cash conversion net earnings because of the runoff in working capital. I think we'll be no different in that situation. However, I just remind everyone our working capital as a percent of revenue is fairly low; 4-point average, we're at like 6% of revenue. So there's not a lot of room there for significant cash flow conversion on further reductions in working capital. And actually, Q1 we made substantial progress in both inventory turns and receivable DSO. So there's probably a little improvement there, but I wouldn't look at it as a significant opportunity and further cash flow generation for us, just kind of given where we are relative to maybe other industrial companies.
Dave Petratis: I'd add to that too. That one of our objectives coming through the first quarter was to have the right inventory. And we made some investments there. As we go through the summer here, we'll probably run a little stronger on finished good inventories as an opportunity. The strength of our supply chain and the ability to get the component parts into the right products where we need them, I think gives us an advantage. And then I'll use that advantage in some inventories to try and get orders to help the business.
Andrew Obin: And the second question, I have sort of unrelated. But given that a lot of municipalities are shut down, how do you deal with the whole -- how does the industry deal with the whole permitting process? And what does it mean for the construction activity in the summer both in residential and institutional space? Thank you.
Dave Petratis: I think you've got to keep an eye on permits. You've got to assume that that will -- the permitting processes that run through government will slow down. I think though two -- when -- whether it's institutional or commercial housing when people want to commit capital, they'll force that process to move forward. But as you well know permits is a key indicator for us, we'll keep an eye on it. And see where that trend goes. I think today Andrew, from a -- you could think about, if we in fact do go into recovery, the permit process the ability to do that will loosen up. It's been how is, capital deployed to be able to go out and drive this industry.
Andrew Obin: So, you think its economic activity driving permitting process. And if economy improves permitting logjam will improve as well.
Dave Petratis: Yeah.
Andrew Obin: Thank you very much.
Operator: The next question comes from David MacGregor from Longbow Research. Please go ahead.
David MacGregor: Hey, good morning, everyone. Just -- hope you're well. Just wanted to ask about the strength of the North American volume here in the first quarter and there's been various observations for different people in the industry about, pull forward particularly in the case of education, but maybe in some healthcare applications as well. And I'm just wondering if you're able to characterize the degree to which you may have pulled forward revenue from the summer quarters here in 1Q?
Dave Petratis: We announced a price increase. So we would get some natural pull through, as a result of that. But I'd say, generally if you look could across North America a rather mild winter, I think and we executed, at a high level. And we picked up opportunities, in the quarter that others could not serve. So I'd say a robust market, really in Q4 and Q1, you've got the electronics driver. And I think the strength of Allegion is shown hard. And the price increase pulled forward slight demand which I like, as we go through Q2 to be able to serve the local markets.
David MacGregor: Okay. I guess, just as a follow-up, you're undertaking restructuring in Europe. I know you've been working on Turkey for a while now. We talked about that last quarter, again this quarter. And those things never happen quickly, I understand. But when you think about sort of the disparate nature of -- from scale and a profitability and a growth standpoint between the North American business, and what you're doing now or what you have been doing recently, in Europe and in Asia, I guess, the question at a high level is do you need to be in Asia and Europe? Or would this be a stronger business if you were just solely in North American business? And as a part of that, maybe if you could talk about the extent to which North American results may benefit to some degree from being in Europe and Asia? Thank you.
Dave Petratis: I would say, it again the adjustments that we made in the quarter with the restructuring announcement will strengthen those franchises. I think, both regions -- I'd also emphasize I've been very clear that we lack scale outside of North America. I think the moves that we're making allow us to focus, where we can win rip out cost that we think will simplify the business. And continue to sharpen our focus on, what we call seamless access. There is some complementary nature to the Australia/New Zealand business, especially along residential which is still developing. And I think our, SimonsVoss, Interflex business, which we've been extremely pleased with gives us a looking glass into a seamless access. And again, I think we look to Allegion to have more focus on where this business is going deploy more human and financial capital into that seamless access experienced as we compete wherever, we're at in the world.
David MacGregor: Great, thanks very much gentlemen. Stay well.
Operator: The next question comes from Josh Pokrzywinski from Morgan Stanley. Please go ahead.
Josh Pokrzywinski: Hi. Good morning, guys.
Dave Petratis: Good morning.
Josh Pokrzywinski: Dave, just on the pipeline of spec writing that you mentioned was fairly strong. Did folks use this opportunity, or if you look back at other points in time where we've had kind of pauses in activity? Is there kind of a natural lag where, everyone says, okay, here's something I was working on. But I'm going to rethink it and maybe that adds, three or six months to kind of the recovery time frame where there is just an air pocket. Is that the way you guys have experienced it in the past? And how should we think about kind of like a natural delay as folks kind of get back to work. And the economy reopens, or does activity continue throughout on the spec writing side?
Dave Petratis: So Josh, this is my seventh little disruption in the economy, since I began my career in 1980. So I think the experiences give you some strength as you go through this. There will be an air pocket. And that's what we're trying to understand. Our bids our quote activity specs we track that in terms of the dollar level of activity. But you can actually have specs kick back and say, "Hey let's revalue engineer this." You can't look at this current situation and say, "Hey there's going to be an air pocket of demand activity because of all supply chain factors, spec writing quotation, wholesale activity, construction, other supply challenges on the construction side. So, it's a part of our thinking. But I think as a lead indicator that spec writing is a clear strength of Allegion and it will help us as we navigate through this.
Josh Pokrzywinski: That's helpful. And then unrelated and kind of back to the Jeff's question on decrementals. If I look back to the same business or at least most of it under Ingersoll ownership back in 2009, the margin expansion during that timeframe on a pretty significant revenue decline was pretty phenomenal hundreds of basis points. Obviously, a higher starting point today. So, not all those levers are available. Can -- but Dave or Patrick, can you just remind us some of what happened since then? And maybe what if those actions can be revisited or reexamined today versus stuff that was maybe more of kind of a one-time realignment of the cost base?
Patrick Shannon: I would characterize it this way entering the 2008 financial crisis there was probably more options to reduce the cost profile particularly on manufacturing footprint. I think IR at the time was fairly aggressive in closing certain factories related to the security technologies business at that time that helped protect the margin profile. Pricing was another lever I think was pushed pretty hard. You kind of have to look at it over the 2008-2010 timeframe. And if I remember correctly, it showed a slight margin decrement over that time period. I would characterize today relative to going into the situation where a better franchise stronger portfolio of businesses that you can maybe protect ourselves more on the topline side. And again we are taking the appropriate actions to reduce our cost structure. Dave talked about actions we're taking in international arena. Yes, we're doing things here to tighten the belt. Obviously, in Americas, we'll continue to do that and adjust to future demand. I would say quite frankly we don't maybe have as many levers to pull. But having said that, I wouldn't expect a significant margin degradation relative to where we are today. So, dollars will come down basis of demand, i.e. topline, but margin percent we'll do what we can to try to maintain that.
Josh Pokrzywinski: Got it. Appreciate the color and best of luck guys.
Patrick Shannon: And let me -- so one other quick thing is probably worth noting is that short-term again given the governmental decrees and the fact that some of our facilities are closed, I mean you're going to have it's going to be a lot more choppy right? I mean you kind of have to -- if you're talking about margin profile; you need to really look at it over a 12-month period. You're always going to get hit initially. Immediately you make adjustments and then you start to kind of level out. And so just kind of keep that in mind as you're thinking through this.
Josh Pokrzywinski: Got it. Will do. Appreciate that.
Operator: The next question comes from John Walsh from Credit Suisse. Please go ahead.
Dave Petratis: Good morning John.
John Walsh: Hi, good morning and glad to hear everyone is well. Wanted to follow-up on to that question. Clearly, you're getting ahead on the cost action. Is there a way to quantify how much is kind of structural? You did make the comment that some of it would have been done regardless of COVID-19 and then kind of those variable cost actions. Just wondering what might come back if -- as volume returns paying employees et cetera things like that?
Patrick Shannon: So, there are variable components relative to our cost structure as you would expect in any business and it could be anything from the way that we have our pricing structure kind of volume rebates, for example, you can look at things like salesmen commissions those type of things naturally will come down and correspond with the volume decrease. The things that we're adjusting now some of the discretionary spend really relooking at some of our things relative to investments. And making sure that we went through a re-prioritization of those that's really focused on things that matter so that we're coming out of this stronger particularly on revenue growth opportunities associated with electronics. So, we're taking that into consideration. But collectively these variable costs I mean it's tens of millions is how I would -- if you're looking for a type of a magnitude. We will give you more color as in Q2 as Dave mentioned when we have a better kind of outlook on revenue but it's fairly significant.
Dave Petratis: I would add the announced restructuring we saw significant softening in Asia Pacific and in areas of Europe as we exited the second half of 2019. We were not pleased with our position and we took actions regardless of the COVID-19 and a pandemic does not. The other thing I would say, when you're in the construction-related industries you do have variation in demand and Allegion's ability to adjust our cost structure, I think can be seen over the last 20 years and we'll be making the moves that help keep this business strong.
John Walsh: Great. And then maybe one about end markets. So I guess the Cares Act fixed somewhat of a bonus depreciation glitch that wasn't part of the tax plan. Wondering if you're hearing from folks that with the QIP adjustment that they're more willing to do interior improvements or if that's something that's nice, but just given the severity of what's happening right now it's not enough to kind of offset some of the demand?
Dave Petratis: I'm not aware of that feature of the Cares Act. I'm sure that the people here at Allegion if we feel that's an opportunity we'll go after it. So I can't give you a good response to that one.
John Walsh: Okay. Thanks for the color. I appreciate it.
Dave Petratis: Okay, John. Thank you.
Operator: The next question comes from Joe Ritchie from Goldman Sachs. Please go ahead.
Joe Ritchie: Thanks. Good morning, everyone.
Patrick Shannon: Good morning.
Joe Ritchie: Yeah. Just -- maybe just starting off I know a lot of the questions so far have been on the forward. But maybe just going back to 1Q for a second, clearly the margins in Americas I mean this is your best 1Q margins by a long shot. I'm just wondering was there anything either like one-time-ish that came through in the quarter, or maybe you can elaborate a little bit more on like pricing this quarter? And how you expect that to hold up as the year progresses?
Patrick Shannon: Yeah. So nothing unusual in the quarter that accelerated the margin improvement. It's the old blocking and tackling and execution. The team did a great job. We went into the year, I'd say with a really healthy pipeline of productivity activity around both material and the factory. We got great volume leverage on the incremental volume. And then you add on top of that price was good particularly in the commercial segment we're going to continue to drive that. And so everything played out, and again no real big surprises, but the team really kind of continued to drive good execution all around.
Dave Petratis: I'd go back even farther Joe. As we exited 2018 as a leadership team, we felt we left margin on the table. We put a pipeline of activities and in 2019 that we worked on throughout the year and we picked up strength as we went into the second half of 2019 and 2020 that strengthened the business.
Patrick Shannon: The other comment I just mentioned too on the input costs. So think about commodity prices, they've come down. So year-over-year there was some benefit there where we didn't have any inflation on the material side.
Joe Ritchie: Got it. No, that makes sense. But Patrick is that something that's going to continue as the year progresses as well? I mean it can -- and how sticky you think the pricing will be?
Patrick Shannon: Yeah. Basis of the current cost for steel, zinc, copper, brass et cetera that will continue throughout the course of the year, yes.
Joe Ritchie: Okay. That's helpful. And then maybe my one follow-up. Going back into several years, several quarters, the level of outgrowth you saw this quarter relative to your biggest competitor based in Europe in the Americas was I think like higher than any other quarter that we've seen. I guess, I'm curious if maybe you can elaborate what you're doing or the effect of the share gains that you're seeing specifically this quarter? And if -- I know we're all trying to figure out what the demand environment is going to be like, but should you continue to outpace your peers in this downturn?
Dave Petratis: So, I think number one, I'll give you a sports analogy. Why did the Patriots roll up six championship, six rooms same head coach, great quarterback, good offensive strategy. If you look at our competitors over the last 24 months, quite a bit of turnover at the top. A lot of management change. One of the strengths of Allegion is our experience. We have a system of management here that we're pretty disciplined to. It doesn't mean it's perfect. But I think the strength of the leadership team the knowledge that cascades through our business and some favorable markets regionally in the country helped us to continue to put up growth that we have built on over the last six years. So a combination of things there. I think the electronics as well is another -- this is an industry trend and we continue to prioritize our investments to take advantage of that opportunity. And I think it will continue to reward us Joe.
Patrick Shannon: And I'll add Joe too, to be fair on the analysis. So we did have a little bit easier comparison on residential. You may recall, we had some channel difficulties in Q1 last year. Those obviously have been worked through. We continue to get really good electronics growth. And we added a substantial customer on the new construction Lennar that helped our year-over-year comparisons as well.
Joe Ritchie: Yeah. That makes a lot of sense. Thanks guys.
Patrick Shannon: Thank you.
Operator: The next question comes from Julian Mitchell from Barclays. Please go ahead.
Julian Mitchell: Hi, good morning. Maybe just wanted to double check again the mix of business. So within the Americas, if you could just remind us in terms of 2019 split, let's say how much -- within the resi and non-resi pieces of the business, how much of each of those was related to new build versus aftermarket or replacement activity for Allegion?
Dave Petratis: So we would say, it's around 50-50 collectively across the entire portfolio.
Julian Mitchell: I see.
Patrick Shannon: Hey, Julian, you'd want to think that the non-residential is a little heavier I think on the new construction versus the aftermarket and then it's flipped on the residential, but then it nets out to about 50-50.
Julian Mitchell: Thank you. And how much related to that of your resi sales are going via the big box channel nowadays?
Patrick Shannon: So it's a about a third 40% of the business 50% maybe up to 50%.
Julian Mitchell: Thanks very much. And then my second question would following up on that question from Joe around pricing and productivity. So those items were I think almost a 200-point tailwind to margins in the first quarter year-on-year. Based on your comments, should we assume that that remains a very strong tailwind for the next nine months, perhaps not quite at the level of Q1, but should be a material contributor?
Patrick Shannon: Yes. I think we'll have -- we'll continue to have a tailwind there. But again, some of the issues associated with the closure reduced demand et cetera we'll put some pressure on those comparisons.
Julian Mitchell: Understood. Thank you very much.
Operator: The next question comes from Jeffrey Kessler from Imperial Capital. Please go ahead.
Jeffrey Kessler: Thank you. Hope you guys are doing well.
Patrick Shannon: And you too.
Jeffrey Kessler: A quick question on the -- looking at the channel, the integration and the installation channel, we've been seeing that there is continuation of big projects going on. There are some problems in getting people on to sites at some of the midsized projects. And obviously when they get on, they have to be wearing the types of PPE and things like that that are mandated by the local ordinances. And in some places, the smaller SMB market seems to be shut down completely. Can you make some comments on how your -- what you're getting back from your installers and integrators with regard to their ability to do work on projects what's continuing where -- what's out there where there's some restriction on their ability to get to the site and what's out there which is completely closed down?
Dave Petratis: I think it's clearly a step back in terms of being able to go in service install. Here at Allegion, we have a policy. Visitors are highly controlled. We don't want infection. With that said, it depends on where you're at. The Dallas market continues to be very active. We are moving around college campuses, but it's not going to happen in New York City. It certainly could happen in Denver. So again, it depends on where you're at and it puts an air pocket into the work. So I actually think if things straighten themselves out, there'll be a pickup in intensity short term. And over time, it schedules itself out. I do think the normal project activity that we have typically that goes on college campuses will roll to schedule, which is really May through August. It's an important driver for us. Could be moved up a little early, if access is there, but it depends on where you're at geographically Jeff.
Jeffrey Kessler: Okay.
Dave Petratis: Higher infection rates, more difficult access.
Jeffrey Kessler: I see. We'll see what happens at West over the next few weeks. Second thing is, do you -- what investments have you made? And I know you've made some in the past with regard to obviously collaborative spec writing, if you want to call that in the cloud, touchless access NFC things like that. Are you in a position to take market share because of number one touchless access. Number two, some of the – let's just call it, some of the newer investments that you've made in trying to – in trying to just make the process easier for your customers. Is that something that that can continue a market share gain in the – at least in the Americas for the moment because it seems to have been – have worked at least over the last year or so?
Dave Petratis: I believe if you look at our overall growth, the investments that we're making in collaborative tools Overture, which we'll continue to invest and develop. Overture has been rolled out in the bulk of the world as a collaborative working tool and it's been extremely well received by our partners, spec writers architects and they have been collaborative in the creation of Overture. So I really give Tim Eckersley credit to creating that. We continue to invest in the electronics side of this. I think you may have seen Jeff our investment in open path as a partnership and investment that we think will help expand the world of seamless access. Schlage Sense [ph] would be another and our continued investment in electronics and new products. We also brought together SimonsVoss and Interflex under one leadership team, because we believe that that's a looking glass into seamless access. And our growth there in electronics in the DAC region is gaining share. So I think you've got the right sense in that collaborative tools, electronics and seamless access is going to help us as we go through this crisis and come out the other end.
Jeffrey Kessler: Is that at the margin, or is that something that can actually really move the needle as we come out of this recession?
Dave Petratis: I think the drivers of seamless access keyless activity simplifying the world that our customers live in eliminating master keys and intelligence that goes with seamless access is going to be a driver for the next two decades.
Jeffrey Kessler: Thank you very much. Appreciate it.
Dave Petratis: Thank you.
Operator: The next question comes from Deepa Raghavan from Wells Fargo Securities. Please go ahead.
Deepa Raghavan: Hey, good morning. Dave you touched a little bit on the restrictions on construction site actually impacting project activity, especially you mentioned institutional. Now institutionally we've always considered it long tail in nature and more defensive as we go into a down cycle. Now, does that dynamic now make it less defensive this down cycle? And the other – extending that question, if site access continue to be restricted through this construction selling season, does it mean you can – you're able to recover beyond fall or in winter season, or you think that's been now pushed to the next construction season which is next summer?
Dave Petratis: So I like our position in institutional. I was looking last night. 22 of the states have – are generally in pretty good financial shape. Infrastructure has aged. We still have the driver of security in public settings. So you got to like that. And then our spec activity would also suggest that that this whole market continued to develop. With that said, an earlier question described an air pocket, we're going to have to have our eyes wide open and understand that air pocket. Part of it is you get some immediate shock. Second is it's that snowplow effect that we've talked about in the past, projects will get pushed out but we may see that air pocket again as we moved into 2021 because budgets are a little bit tighter. So to be seen, I like our institutional position. It's been – in my 40 years, the institutional markets have always been a good place to operate and we'll try and get more than our share out of whatever market is there.
Deepa Raghavan: Got it. So can you talk about your Mexico and the Italy plant closures, I mean what percent of sales is coming from those two regions? And when you talk about working with your channel partners to ensure demand is wholesale, does it entail higher costs?
Patrick Shannon: So, I'll take a stab at the revenue base. I mean just to kind of put it into perspective on Mexico. That's predominantly the supplier for our residential business. Here in Americas, which we've characterized it's about a third of the overall Americas portfolio. Keep in mind, the decree was extended through the end of May. However, we are -- we've got inventory on hand. We're working with our distribution partners to ensure customers can be served. When that comes back online there will be a restocking in the channels for the depletion of the inventory. So we're kind of working that. But I think that the message is near term you're going to see a decline and obviously in revenue for some piece of that certainly in Q2. Italy, again, the data I think on that is May three is the current decree. We will see that is subject to change based on what the government dictates. That might be kind of call it 20% of our portfolio in Europe. We are shipping finished goods inventory out of the warehouse there in Italy today. So that activity is taking place. It's just the production, manufacturing, et cetera right now that were inhibited from producing anything. However, it doesn't necessarily mean we're losing business. I think it just means delays deferrals that type of thing because the reality is the customers are closed also. And so they don't have the ability to be able to receive inventory. And so this is just going to be a deferral, and we'll see how quickly that may or may not pick up in the back half of this year.
Dave Petratis: Pete, I have to give a shout out to our Italian teams. We operated safely longer there than many manufacturers. Same in Mexico. We got a few extra days until that decree came down working hard to petition the government now to consider it's essential. I believe in Mexico we can keep our people safer than they are on the streets. And so we're pushing that. Again, we've got a good supply of residential inventory on the shelf. And if we can cut through this, we're going to be in good shape.
Patrick Shannon: All right, Jason?
Operator: Yeah. There are no more questions in the queue. And this concludes our question-and-answer session. I would like to turn the conference back over to Tom Martineau for any closing remarks.
Thomas Martineau: I appreciate it. So we'd like to thank everyone for participating in today's call. And today more than ever please have a safe day.
Operator: The conference has now concluded. Thank you for attending today's presentation. You may now disconnect. | [
{
"speaker": "Operator",
"text": "Good day and welcome to the Allegion First Quarter Earnings Call. All participants will be in listen-only mode. [Operator Instructions] After today's presentation, there will be an opportunity to ask question. Please note this event is being recorded. I would now like to turn the conference over to Thomas Martineau, Vice President, Treasurer and Investor Relations. Please go ahead."
},
{
"speaker": "Thomas Martineau",
"text": "Thank you, Jason. Good morning everyone. Welcome and thank you for joining us for Allegion's first quarter 2020 earnings call. With me today are Dave Petratis, Chairman President and Chief Executive Officer; and Patrick Shannon, Senior Vice President and Chief Financial Officer of Allegion. Our earnings release, which was issued earlier this morning and the presentation which we will refer to in today's call are available on our website at investor.allegion.com. This call will be recorded and archived on our website. Please go to slides two and three. Statements made in today's call that are not historical facts are considered forward-looking statements and are made pursuant to the Safe Harbor provisions of federal securities law. Please see our most recent SEC filings for a description of some of the factors that may cause actual results to differ materially from our projections. The company assumes no obligation to update these forward-looking statements. Today's presentation and commentary include non-GAAP financial measures. Please refer to the reconciliation in the financial tables of our press release for further details. Dave and Patrick will now discuss our first quarter 2020 results, which will be followed by a Q&A session. Given the high uncertainty around the duration and severity of the COVID-19 pandemic, we had previously pulled our outlook for 2020 and will not be providing an update during this call. For the Q&A, we would like to ask each caller to limit themselves to one question and one follow-up and then reenter the queue. We will do our best to get to everyone given the time allotted. Please go to slide 4 and I'll turn the call over to Dave."
},
{
"speaker": "Dave Petratis",
"text": "Thanks Tom. Good morning, and thank you for joining us today. Like all responsible global companies, Allegion is closely monitoring and assessing the COVID-19 outbreak, which continues to evolve. We are focused on doing what's right for our employees, customers and communities. We're also maintaining our business health and supporting a central critical infrastructure around the world. Allegion operates within several different critical infrastructure sectors, making our work essential to our customers, and in many cases, their customers. Our people create the security and life safety devices so many others depend on, whether for private homes, government buildings, or medical facilities. We are regularly called on to provide our products and solutions for hospitals and health care facilities, most recently new construction for laboratories that will support the fight against COVID-19. This work gives us clear purpose, especially in these unprecedented times. With the exception of Italy and Mexico, where government health decrees have temporarily paused production, our manufacturing sites may operate. We monitor for demand and material shortages related to COVID-19, taking necessary short-term actions such as adjustments to production to protect the long-term future of Allegion. Such majors are being implemented in a way that minimizes disruption to customers and the overall business. In the case of Italy, we are shipping orders for finished goods with government approval and continue to engage in dialogue with Mexican authorities to open prior to the lifting of its general decree. In the meantime, we are working with our supply chain, existing inventory, and channel partners to fulfill customer requirements for goods normally coming out of Mexico. It remains our intention to continue to serve our customers to the best of our abilities. You've heard me say before, but it bears repeating. We have one of the safest workforces in the world. I could not be prouder of our company of experts who have leveraged our strength and safety to adapt to the current reality. We have faced COVID-19 since mid-January in China and developed operational practices that keep our people safe. We're modeling best practice safe hygiene guidelines based on standards from the World Health Organization and the Centers for Disease Control and Prevention. We're conducting deep cleaning of our facilities on a regular basis. We're social distancing where we were and we're limiting crowds. We've increased our personal protective equipment and supplies. There's additional cleaning solution, wipes, hand sanitizers throughout our facilities. Employees can ask for PPE supplies like gloves and who're requiring face masks in manufacturing and distribution facilities. We paused all nonessential meetings and visitors, as well as air travel early in the crisis. Essential meetings are encouraged in virtual ways. We're adhering to government decrees and orders and monitoring health conditions, and wherever possible and where necessary, employees are working from home. The strength of Allegion's global supply chain is a major asset and allows us to continue servicing our customers. We have many levers to pull from utilizing safety stocks and inventories to leveraging dual and alternate supply to sharing components across our own facilities and regions. Without doubt, these options that our team have in place are increasing Allegion's credibility and customer loyalty in the marketplace. Of course, our business must be healthy to continue to support our employees, customers, and communities. We have proactively taken actions to mitigate financial implications associated with COVID-19. These actions include reductions in discretionary spending, elimination of nonessential investments, a hiring freeze and reprioritization of all capital expenditures, including a temporary suspension of share repurchases. Importantly, we believe Allegion has an extremely strong balance sheet and liquidity that provides flexibility and positions us well throughout this time. Our net debt-to-adjusted EBITDA ratio was 1.6 times at December 31, 2019. We have an undrawn credit facility of up to $500 million if needed and no principal payments due on an outstanding debt until September 22. Our business generates significant cash flow due to industry-leading EBITDA margins and low capital intensity. Allegion's available cash flow conversion to earnings ratio has averaged over 100% as a stand-alone company. Yet there will be challenges ahead. The start of 2020 has made that clear. Allegion can take on great challenges with an engaged, safe, and healthy workforce, financial strength, legacy brands that have stood the test of time, and a steady focus. Allegion will remain true to our values and strong business fundamentals. Please go to Slide 5. Let's turn to the results for the first quarter. We have a strong disciplined supply chain, and our team did an outstanding job navigating the early challenges posed by COVID-19 pandemic as evidenced by the revenue growth we experienced in the quarter. In particular, the Americas had a stellar quarter offset by weakness in Europe and Asia Pacific. The Americas region had reported growth of 7.7% and organic growth of 8.2% in the quarter, driven by both nonresidential and residential businesses. EMEIA markets continue to be soft through the quarter, and our business was further impacted by the COVID-19 pandemic impact beginning in March. For Asia-Pacific, Asian markets remained weak, and the region as a whole experienced the COVID-19 impacts as well. Electronics growth in the Americas came in at 12% in the quarter. We continue to see electronics as a long-term positive trend as more and more products become connected for ease of access. The underlying fundamentals of the business are strong and will serve us well as the global pandemic subsides. Adjusted operating margin were up a 190 basis points in the quarter. Margin expansion led by the Americas region, which saw adjusted margins up 270 basis points. EMEIA and Asia-Pacific margins were down due to volume declines in both regions. EMEIA margins were further pressured by continued operational inefficiencies from the move of our operations from Turkey to Poland. We highlighted last quarter our expectation that the impact would carry over in the first half of this year. In the first quarter, adjusted EPS growth came in at a robust 18% and available cash flow was up nearly $44 million versus the prior quarter – prior year. Overall, I'm very pleased with our Q1 2020 results. That said, the near-term future will be more difficult as we continue to navigate the uncertainty brought on by the COVID-19 pandemic, and I expect financial headwinds. Beyond the expense and cash management actions previously discussed, we are implementing cost reduction actions to optimize and simplify the European and Asia-Pacific regions. These actions are intended to address weaker end market fundamentals, enable enhanced customer focus, and will help position these regions for future success. And there's one accounting item to mention. We recognized a $96.3 million non-cash charge related to goodwill and indefinite-lived trade name impairments for our non-U.S. operations predominantly related to the COVID-19 and the expected future impacts. Please go to Slide 6, and I'll take you through the first quarter financial summary. Revenue for the first quarter was $674.7 million, an increase of 3%, inclusive of 4.3% organic growth. Currency headwinds and the impact of the divestitures of our business in Colombia and Turkey offset some of the organic growth. Americas led the way on revenue growth, offsetting the weakness we experienced in EMEIA and Asia Pacific. Patrick will share more detail on the regions in a moment. Adjusted operating margin increased by 190 basis points in the first quarter. As I stated earlier, we saw a significant margin expansion in the Americas with declines in Europe and Asia. Adjusted earnings per share of $1.04 increased $0.16 or just over 18% versus the prior year. The increase was driven primarily by higher operating income, favorable share count and tax rate offset the increase in other expense. Available cash flow came in at $19 million, an increase of nearly $44 million versus the prior year. Increased adjusted earnings and improvement in net working capital were the driving factors for the increase. Patrick will now walk you through the financial results, and I'll be back to wrap-up."
},
{
"speaker": "Patrick Shannon",
"text": "Thanks, Dave and good morning, everyone. Thank you for joining today's call. Please go to slide number 7. This slide depicts the components of our revenue growth for the first quarter. I'll focus on the total Allegion results and cover the regions on their respective slides. As indicated, we delivered 4.3% organic growth in the first quarter led by the Americas region with strong growth in both the non-residential and residential businesses. Price realization was again solid in the quarter more than offsetting material inflation. The impact of the divestiture of our businesses in Colombia and Turkey along with continued currency pressure in EMEIA and Asia-Pacific were headwinds of total growth. Please go to slide number 8. Reported net revenues for the first quarter were $674.7 million. As stated earlier, this reflects an increase of 3% versus the prior year up 4.3% on an organic basis. We delivered good price realization and saw a solid volume driven by the Americas region. We experienced an estimated $10 million revenue loss related to COVID-19 during the quarter primarily in our international regions as a result of business closures. Adjusted operating income of $128.2 million increased more than 14% over the same timeframe from last year. Adjusted operating margin of 19% increased 190 basis points. The margin expansion was primarily driven by solid operating leverage on incremental volumes in the Americas along with pricing and productivity outpacing inflation. Headwinds of margin performance include incremental investments which had a 30 basis point impact on adjusted operating margins and an estimated $4 million impact to adjusted operating income related to COVID-19. Please go to slide number 9. This slide reflects our earnings per share reconciliation for the first quarter. For the first quarter of 2019 reported earnings per share was $0.84. Adjusting $0.04 for the prior year restructuring expenses and integration costs related to acquisitions, the 2019 adjusted earnings per share was $0.88. Operational results increased earnings per share by $0.16 as favorable price. Operating leverage on incremental volume and productivity more than offset inflationary impacts and unfavorable currency. A year-over-year decrease in the adjusted effective tax rate drove another $0.04 increase. Favorable year-over-year share count increased adjusted earnings per share by another $0.02. The impact of incremental investments in the quarter was a $0.02 reduction and an increase in other expense drove another negative $0.04 per share impact. This results in adjusted first quarter 2020 earnings per share of $1.04 an increase of $0.16 or 18.2% compared to the prior year. Lastly, we had a $1.04 per share reduction for charges primarily related to goodwill and indefinite-live trade name impairments. These charges were related to COVID-19 and its impact on expected future results. After giving effect to these onetime items you arrive at first quarter 2020 reported earnings per share of $0. Please go to slide number 10. First quarter revenues for the Americas region were $502.1 million up 7.7% on a reported basis and up 8.2% organically. The growth was driven by solid price realization and strong volume. Both the non-residential and residential businesses grew high single-digits. The business saw a growth across all product segments and verticals particularly in institutional end markets. The electronics growth for the quarter was 12%. Electronic products continue to be a long-term growth driver as consumers and end users value the connectivity and convenience they offer over their mechanical counterparts. The overall growth in the Americas reflects the company's strong position in the market as well as the returns associated with incremental investments in new product development and channel strategies. Americas adjusted operating income of $146.6 million increased 19.1% versus the prior year period and adjusted operating margin for the quarter increased 270 basis points. Volume leverage on the revenue increase along with price and productivity significantly exceeding inflation drove the substantial margin expansion. The team continues to deliver solid cost leverage and productivity to further improve operating performance in our competitive position. Lastly, incremental investments were a 40 basis point decrease on margins. Please go to slide number 11. First quarter revenues for the EMEIA region were $129.9 million down 9.1% and down 6.2% on an organic basis. The lower volume was driven by continued weakening in end markets across the region and COVID-19 impacts, primarily, in the southern region. The impact of the divestiture of the business in Turkey and currency headwinds also contributed to the reported revenue decline. EMEIA adjusted operating income of $3.3 million decreased 71.8% versus the prior year period. Adjusted operating margin for the quarter decreased by 570 basis points. Also, during the quarter inflation exceeded price plus productivity. Revenue declines had a negative impact on operating margin, and we continue to experience cost pressure associated with the plant relocation from Turkey to Poland. Earlier in April, we announced cost reduction initiatives aimed at optimizing and simplifying our operations, improving our customer service, as well as addressing the cost structure in our non-U.S. locations. These are not specific to the COVID-19 pandemic, but part of our long-range business planning process. Please go to slide number 12. First quarter revenues for the Asia-Pacific region were $32.7 million, down 11.1% versus the prior year. Organic revenue was down 4.9%. The decline was driven by continued weakness in Australian end markets, primarily residential as well as impacts related to COVID 19. Total revenue continued to be affected by currency headwinds. Asia-Pacific adjusted operating loss for the quarter was $1.6 million, a decrease of $0.9 million with adjusted operating margins down 300 basis points versus the prior year period. Significant volume declines and unfavorable mix had a large impact on the reduced income and margin. Of note, we did have approximately $95 million in impairment charges for goodwill and indefinite live trade names. These charges were related to COVID-19 and its impact to expected future results. As with the EMEIA region, the cost reduction actions announced earlier in April will have a favorable impact on operations in Asia-Pacific. These actions are also the result of our long-range business planning and not specific to COVID-19 impacts. Please go to slide number 13. Year-to-date available cash flow for the first quarter of 2020 came in at $19 million, which is an increase of nearly $44 million compared to the prior year period. The increase was driven by higher adjusted net earnings and improvements in net working capital. Looking at the chart at the bottom of the slide, it shows working capital as a percent of revenues decreased based on a four point quarter average. On a year-over-year point in time basis, working capital as a percent of revenue is down 220 basis points. This was driven by accelerated turnover in both inventory and receivables. As always, we remain committed to an effective and efficient use of working capital. We will continue to evaluate opportunities to minimize investments in working capital in order to continue to drive substantial cash flow conversion. Please go to slide number 14. This slide provides an update on our capital structure. As you can see, our leverage has dropped steadily over the past five years and we ended 2019 at 2.1 times gross leverage and 1.6 times net leverage to adjusted EBITDA. In looking at our debt maturity profile, we do not have any loans maturing until September 2022. We also have a $500 million untapped credit facility should we need additional liquidity. Our balance sheet is in a strong position and our high level cash flow conversion provides us flexibility and optionality to run the business going forward. These same strengths have led Allegion to six consecutive years of annual increase in dividends and our most recent dividend increase of nearly 19% announced in February remains intact. During the first quarter, the company repurchased approximately $94 million of stock. Due to the uncertainties related to the pandemic, we have placed repurchase plans on hold and we will review further as the year progresses. I will now hand it back over to Dave to wrap-up."
},
{
"speaker": "Dave Petratis",
"text": "Thank you, Patrick. Please go to slide number 15. We recently announced that we were withdrawing our outlook for 2020 based on the magnitude and uncertainties surrounding the COVID-19 pandemic. We respect the need for financial guidance for the analyst community and shareholders. However, the COVID-19 pandemic is ongoing. Health care experts are still learning about the virus and there is tremendous speculation on the economic recovery and the path it will take. The many unknowns include the scope and effect of further government regulatory, fiscal monetary and public health responses. Our update will come when we release Q2 2020 results. The fundamentals of Allegion are strong. And as the world adapts to the new normal, we should have more clarity on the rest of 2020 at that time. We do expect that COVID-19 will have a near-term negative financial impact on the business, including the reduction in year-over-year revenues, operating profit and cash flow due to government decrees and softening demand. With that said, Allegion's sound fundamental business strength provides some resiliency in times of economic downturn, and our long-term investment thesis remains unchanged. For the past several years, we have delivered above-market organic growth, the strength of our channel relationships, new product development, large installed base brand and market positions have helped us continually drive higher organic growth than the market. Since spin, Allegion has delivered a 5.4% organic revenue CAGR. In the first quarter, the company grew organically at 4.3% with the Americas at 8.2%. Our strategy of seamless access takes full advantage of the keyless and connected technologies increasingly demanded in our industry. The electronic products needed to facilitate these demands continue to be a long-term growth driver for the company. The Americas business experienced 12% growth in electronics in Q1. Even with the growth we have seen in these products, since we became a stand-alone company, adoption is still in the early stages. Therefore, the industry conversion opportunity remains robust. Although, Allegion has industry-leading EBIT margins, our focus on price realization productivity and cost management allows us to expand margins when volumes are up like the 170 basis point increase we produced in Q1, but also facilitates the margin profile to be resilient through economic cycles. Our strong balance sheet, low capital requirements in tandem with a high level of cash flow conversion our business generates allows us to have capital allocation optionality. We are well within our debt covenants and have no near-term debt repayments. For the six full years, that Allegion has been a stand-alone company, the conversion of net income to available cash flow has on average exceeded 100%. The COVID pandemic has caused worldwide disruption in economic markets, whether haltering growing economies or furthering softening ones that were in decline. Nonetheless, we feel that our company is set up well to weather the storm and our strong fundamentals will serve us well when the pandemic subsides. Allegion has the right people in place to help ensure this. Our employees have shown a great deal of adaptability during these uncertain times. I could not be prouder of our people. Our management acted early to mitigate the economic impact. Our supply chain has proven itself to be flexible, proficient and dependable and we are positioned to continue leveraging as a strength moving forward. And of course, our legacy brands have stood the test of time and delivered incredible value. Allegion is strong, its people are resilient and we remain focused and disciplined. I do want to thank every member of the Allegion team on a successful Q1 2020. Everyone stay safe and healthy. And now Patrick and I will be happy to take your questions."
},
{
"speaker": "Operator",
"text": "[Operator Instructions] First question comes from Tim Wojs from Baird. Please go ahead."
},
{
"speaker": "Tim Wojs",
"text": "Hey, gentlemen, good morning. Hope everybody is well."
},
{
"speaker": "Dave Petratis",
"text": "Good morning."
},
{
"speaker": "Patrick Shannon",
"text": "Good morning."
},
{
"speaker": "Tim Wojs",
"text": "Maybe if -- just my first question. Maybe if we can just add a little bit color particularly in Americas of how the demand trajectory you saw kind of trended through the quarter? And maybe, if you could give us just some flavor of how April has trended here, just to give us an idea what Q2 and kind of the near-term may look like?"
},
{
"speaker": "Dave Petratis",
"text": "Glad to do that. I would say first, the company got on to COVID-19 response early with a focus on our supply chain and protecting our people with a strategy for us to gain market share in Q1. So, we went extremely strong through the first quarter. I think that's reflected in our Americas results, and the strength, our ability to keep our supply chain strong. As we got into March, we saw a slight decline in the last two weeks. But again, we had our foot on the gas, and we communicated that. As we moved into April, we're 17 days into this. I think the things that we're seeing are rather predictable. We see some softness in the overall residential. I would say we have a view into point-of-sale in the bid box, and I'd say it's off low-teens. And as I look at that, I'd say, yes, that probably makes sense. Second, I think from a positive standpoint, our -- we see softness in bookings in the commercial and institutional. Our backlog is strong. We see the continuation of construction projects and we think if ground's broken, if permits are issued, these projects are going to roll in. As I came into work this morning, I see construction continue to move forward. The last thing I'd add Tim is our specs and quotes continue to be very positive. I know you can spec yourself and quote yourself right off a cliff, but it's a positive indicator. That work continues to roll."
},
{
"speaker": "Tim Wojs",
"text": "Okay. Okay. Is that -- as you guys look into maybe the back half of this year and into 2021, is that really the part of your leading indicator or what might give you confidence that COVID is really more of kind of a temporary issue as opposed to something maybe more cyclical for non-residential construction in general?"
},
{
"speaker": "Dave Petratis",
"text": "I think you've got to be more critical than people would call it a V. I think the construction pipeline that we have today again, projects that are approved and are in progress will roll. I've got uncertainty about 2021 commercial and institutional. Commercial is going to be soft. I think that's where the strength of our spec writing, our wholesale channels, whatever the market gives us at Allegion, we expect to do better than the market."
},
{
"speaker": "Patrick Shannon",
"text": "Thanks, Tim."
},
{
"speaker": "Operator",
"text": "The next question comes from Jeff Sprague from Vertical Research. Please go ahead."
},
{
"speaker": "Jeff Sprague",
"text": "Thank you. Good morning everyone. Hope everyone is well. Thanks for that color and also just trying to now kind of think about -- since we're all going to make our assumptions here, could you give us a little additional thought on decrementals and how linear or not linear the relationship is in other words, if revenues are down 10, what do you think the decrementals might be? And if they're down 20, what they might be and frame it however you like, but we've all got to kind of take a shot here at what's coming at us and try to put a stake in the ground in terms of an earnings estimate."
},
{
"speaker": "Patrick Shannon",
"text": "Yes. So, the big question mark, I think Jeff relates to what's on the demand horizon. And as we've highlighted, very difficult to predict just kind of given the government decrees, and as we've highlighted we have a couple of plant closures today that will inhibit us a little bit on the top side and also will provide some cost pressure just from an under absorption perspective near term. As I think about it, and you try to run some correlations to prior cycles that type of thing, I mean, everyone knows a way it was pretty drastic, I think it's too early to make some comparisons to that. Right now, we're still -- as everyone else is collecting data from economists and a lot of people have different opinions, but as I think about it related to Allegion, some couple of points I'd like to highlight why I think we're better positioned than perhaps we were at the last downturn for several reasons. Number one, we have a much stronger business franchise, a lot better stronger portfolio of businesses. As you know, we've divested poor-performing businesses. We added businesses to our portfolio that I think are more resilient in a downturn and less susceptible to market downturns. This whole convergence of electronics is a -- you kind of look back 10 years ago, it wasn't a big driver in the business and whereas today it is a driver, it's growing at 1.5 times to 2 times the market today, and as you know we continue to put up really good numbers related to that. So, I think that's an item that needs to -- or will continue to grow and will be a continued focus for us going forward. And as you know, it's a higher average selling price similar margin, which means more EBIT dollars. The channel investments we've made, particularly in the repair retrofit market discretionary markets, we have a much broader product portfolio to serve our customers in that segment. And I think we're better positioned to participate in that market segment, whereas at time of spin we weren't, I think that will be good for us going forward. And then to your question on the margin profile, we would say historically, we've been able to adjust our cost profile. We can react pretty quickly. We historically have shown some margin decrements related to the last cycles, if you kind of go back to 2008, small margin deterioration. We adjusted our cost position fairly aggressively. Pricing we will continue to push that lever. It was a good driver for us in the quarter. So, I would say maybe some margin pressure, but not substantial relative to where we are. And if you think about where we are today, we're at a high watermark. Again, we had another record Q1 performance, up 190 basis points. And so, we're coming from peak margin performance, and we'll continue to take the actions necessary to address our cost base. We talked about those eliminating the discretionary spend, hiring freeze kind of re-prioritization of essential investments, you will see a reduction in some of the incremental investment, but we'll be focused on long-term areas. And so I just -- we'll see how things kind of pan out here, but I think it's going to be more demand-driven and we'll adjust our cost profile to meet future demand both at the factory and SG&A level."
},
{
"speaker": "Jeff Sprague",
"text": "Thanks. And as an unrelated second question. Just on the good will, it's awful early in the COVID. It sounds like you're kind of using that as a kind of a justification for knocking out that goodwill. It sounds like -- but you've really beyond kind of COVID made a clear judgment that those acquisitions just have not lived up the snuff. And I just wonder if any of the other acquisitions in Europe or anything as you've gone through this goodwill testing are kind of close to being on the bubble here?"
},
{
"speaker": "Dave Petratis",
"text": "So Asia-Pacific as we indicated a write-down there goodwill and indefinite-live assets which pretty much releases the entire balance there. I think there's a de-minimis amount that remains. As we kind of talked about in Q4 the pressure there really given from the Australian market and just weak end-market fundamentals. And so we re-looked at that particularly given the COVID-19 which really accelerated the market decline, kind of as we look at it going forward and so put us in a position to kind of do that analysis which is kind of a discounted cash flow et cetera. When we look at Europe there is some cushion left there. We didn't need to take an impairment. I think hopefully, we took a conservative view on the discounted cash flow and hopefully, we're okay. But time will tell and we'll see where this pans out going forward. But again end markets continued weakness particularly in Southern Europe. But I feel really good about our electronics business there in the Germanic area. You mentioned acquisitions. SimonsVoss has been a home run for us. And I think there's some good growth opportunity there going forward. So again we'll kind of reevaluate as the year progresses and we'll see what happens when the fog lifts."
},
{
"speaker": "Patrick Shannon",
"text": "I'd add one other comment. If you think about the Asia-Pacific, our acquisition profile has been Australia and one acquisition in Korea. All of those markets were in free fall in the second half of 2019 through the COVID-19 and it's hard to retain that goodwill on the books."
},
{
"speaker": "Jeff Sprague",
"text": "Okay. Thanks for the color. Thanks a lot."
},
{
"speaker": "Patrick Shannon",
"text": "Thank you."
},
{
"speaker": "Operator",
"text": "The next question comes from Andrew Obin Bank of America."
},
{
"speaker": "Andrew Obin",
"text": "Hi, good morning."
},
{
"speaker": "Patrick Shannon",
"text": "Good morning, Andrew."
},
{
"speaker": "Andrew Obin",
"text": "I'm just wondering so the first question I have, how should I think about your ability to release working capital in this environment because a lot of companies are telling us that they're going to run-off inventories run for cash. But my understanding also is that a lot of your product in the U.S. is highly customized. So how should I think about your ability to release working capital in second and third quarter as the COVID-19 sort of sweeps through the U.S. as well I guess?"
},
{
"speaker": "Patrick Shannon",
"text": "Yes. Most companies with downturns would show a higher cash conversion net earnings because of the runoff in working capital. I think we'll be no different in that situation. However, I just remind everyone our working capital as a percent of revenue is fairly low; 4-point average, we're at like 6% of revenue. So there's not a lot of room there for significant cash flow conversion on further reductions in working capital. And actually, Q1 we made substantial progress in both inventory turns and receivable DSO. So there's probably a little improvement there, but I wouldn't look at it as a significant opportunity and further cash flow generation for us, just kind of given where we are relative to maybe other industrial companies."
},
{
"speaker": "Dave Petratis",
"text": "I'd add to that too. That one of our objectives coming through the first quarter was to have the right inventory. And we made some investments there. As we go through the summer here, we'll probably run a little stronger on finished good inventories as an opportunity. The strength of our supply chain and the ability to get the component parts into the right products where we need them, I think gives us an advantage. And then I'll use that advantage in some inventories to try and get orders to help the business."
},
{
"speaker": "Andrew Obin",
"text": "And the second question, I have sort of unrelated. But given that a lot of municipalities are shut down, how do you deal with the whole -- how does the industry deal with the whole permitting process? And what does it mean for the construction activity in the summer both in residential and institutional space? Thank you."
},
{
"speaker": "Dave Petratis",
"text": "I think you've got to keep an eye on permits. You've got to assume that that will -- the permitting processes that run through government will slow down. I think though two -- when -- whether it's institutional or commercial housing when people want to commit capital, they'll force that process to move forward. But as you well know permits is a key indicator for us, we'll keep an eye on it. And see where that trend goes. I think today Andrew, from a -- you could think about, if we in fact do go into recovery, the permit process the ability to do that will loosen up. It's been how is, capital deployed to be able to go out and drive this industry."
},
{
"speaker": "Andrew Obin",
"text": "So, you think its economic activity driving permitting process. And if economy improves permitting logjam will improve as well."
},
{
"speaker": "Dave Petratis",
"text": "Yeah."
},
{
"speaker": "Andrew Obin",
"text": "Thank you very much."
},
{
"speaker": "Operator",
"text": "The next question comes from David MacGregor from Longbow Research. Please go ahead."
},
{
"speaker": "David MacGregor",
"text": "Hey, good morning, everyone. Just -- hope you're well. Just wanted to ask about the strength of the North American volume here in the first quarter and there's been various observations for different people in the industry about, pull forward particularly in the case of education, but maybe in some healthcare applications as well. And I'm just wondering if you're able to characterize the degree to which you may have pulled forward revenue from the summer quarters here in 1Q?"
},
{
"speaker": "Dave Petratis",
"text": "We announced a price increase. So we would get some natural pull through, as a result of that. But I'd say, generally if you look could across North America a rather mild winter, I think and we executed, at a high level. And we picked up opportunities, in the quarter that others could not serve. So I'd say a robust market, really in Q4 and Q1, you've got the electronics driver. And I think the strength of Allegion is shown hard. And the price increase pulled forward slight demand which I like, as we go through Q2 to be able to serve the local markets."
},
{
"speaker": "David MacGregor",
"text": "Okay. I guess, just as a follow-up, you're undertaking restructuring in Europe. I know you've been working on Turkey for a while now. We talked about that last quarter, again this quarter. And those things never happen quickly, I understand. But when you think about sort of the disparate nature of -- from scale and a profitability and a growth standpoint between the North American business, and what you're doing now or what you have been doing recently, in Europe and in Asia, I guess, the question at a high level is do you need to be in Asia and Europe? Or would this be a stronger business if you were just solely in North American business? And as a part of that, maybe if you could talk about the extent to which North American results may benefit to some degree from being in Europe and Asia? Thank you."
},
{
"speaker": "Dave Petratis",
"text": "I would say, it again the adjustments that we made in the quarter with the restructuring announcement will strengthen those franchises. I think, both regions -- I'd also emphasize I've been very clear that we lack scale outside of North America. I think the moves that we're making allow us to focus, where we can win rip out cost that we think will simplify the business. And continue to sharpen our focus on, what we call seamless access. There is some complementary nature to the Australia/New Zealand business, especially along residential which is still developing. And I think our, SimonsVoss, Interflex business, which we've been extremely pleased with gives us a looking glass into a seamless access. And again, I think we look to Allegion to have more focus on where this business is going deploy more human and financial capital into that seamless access experienced as we compete wherever, we're at in the world."
},
{
"speaker": "David MacGregor",
"text": "Great, thanks very much gentlemen. Stay well."
},
{
"speaker": "Operator",
"text": "The next question comes from Josh Pokrzywinski from Morgan Stanley. Please go ahead."
},
{
"speaker": "Josh Pokrzywinski",
"text": "Hi. Good morning, guys."
},
{
"speaker": "Dave Petratis",
"text": "Good morning."
},
{
"speaker": "Josh Pokrzywinski",
"text": "Dave, just on the pipeline of spec writing that you mentioned was fairly strong. Did folks use this opportunity, or if you look back at other points in time where we've had kind of pauses in activity? Is there kind of a natural lag where, everyone says, okay, here's something I was working on. But I'm going to rethink it and maybe that adds, three or six months to kind of the recovery time frame where there is just an air pocket. Is that the way you guys have experienced it in the past? And how should we think about kind of like a natural delay as folks kind of get back to work. And the economy reopens, or does activity continue throughout on the spec writing side?"
},
{
"speaker": "Dave Petratis",
"text": "So Josh, this is my seventh little disruption in the economy, since I began my career in 1980. So I think the experiences give you some strength as you go through this. There will be an air pocket. And that's what we're trying to understand. Our bids our quote activity specs we track that in terms of the dollar level of activity. But you can actually have specs kick back and say, \"Hey let's revalue engineer this.\" You can't look at this current situation and say, \"Hey there's going to be an air pocket of demand activity because of all supply chain factors, spec writing quotation, wholesale activity, construction, other supply challenges on the construction side. So, it's a part of our thinking. But I think as a lead indicator that spec writing is a clear strength of Allegion and it will help us as we navigate through this."
},
{
"speaker": "Josh Pokrzywinski",
"text": "That's helpful. And then unrelated and kind of back to the Jeff's question on decrementals. If I look back to the same business or at least most of it under Ingersoll ownership back in 2009, the margin expansion during that timeframe on a pretty significant revenue decline was pretty phenomenal hundreds of basis points. Obviously, a higher starting point today. So, not all those levers are available. Can -- but Dave or Patrick, can you just remind us some of what happened since then? And maybe what if those actions can be revisited or reexamined today versus stuff that was maybe more of kind of a one-time realignment of the cost base?"
},
{
"speaker": "Patrick Shannon",
"text": "I would characterize it this way entering the 2008 financial crisis there was probably more options to reduce the cost profile particularly on manufacturing footprint. I think IR at the time was fairly aggressive in closing certain factories related to the security technologies business at that time that helped protect the margin profile. Pricing was another lever I think was pushed pretty hard. You kind of have to look at it over the 2008-2010 timeframe. And if I remember correctly, it showed a slight margin decrement over that time period. I would characterize today relative to going into the situation where a better franchise stronger portfolio of businesses that you can maybe protect ourselves more on the topline side. And again we are taking the appropriate actions to reduce our cost structure. Dave talked about actions we're taking in international arena. Yes, we're doing things here to tighten the belt. Obviously, in Americas, we'll continue to do that and adjust to future demand. I would say quite frankly we don't maybe have as many levers to pull. But having said that, I wouldn't expect a significant margin degradation relative to where we are today. So, dollars will come down basis of demand, i.e. topline, but margin percent we'll do what we can to try to maintain that."
},
{
"speaker": "Josh Pokrzywinski",
"text": "Got it. Appreciate the color and best of luck guys."
},
{
"speaker": "Patrick Shannon",
"text": "And let me -- so one other quick thing is probably worth noting is that short-term again given the governmental decrees and the fact that some of our facilities are closed, I mean you're going to have it's going to be a lot more choppy right? I mean you kind of have to -- if you're talking about margin profile; you need to really look at it over a 12-month period. You're always going to get hit initially. Immediately you make adjustments and then you start to kind of level out. And so just kind of keep that in mind as you're thinking through this."
},
{
"speaker": "Josh Pokrzywinski",
"text": "Got it. Will do. Appreciate that."
},
{
"speaker": "Operator",
"text": "The next question comes from John Walsh from Credit Suisse. Please go ahead."
},
{
"speaker": "Dave Petratis",
"text": "Good morning John."
},
{
"speaker": "John Walsh",
"text": "Hi, good morning and glad to hear everyone is well. Wanted to follow-up on to that question. Clearly, you're getting ahead on the cost action. Is there a way to quantify how much is kind of structural? You did make the comment that some of it would have been done regardless of COVID-19 and then kind of those variable cost actions. Just wondering what might come back if -- as volume returns paying employees et cetera things like that?"
},
{
"speaker": "Patrick Shannon",
"text": "So, there are variable components relative to our cost structure as you would expect in any business and it could be anything from the way that we have our pricing structure kind of volume rebates, for example, you can look at things like salesmen commissions those type of things naturally will come down and correspond with the volume decrease. The things that we're adjusting now some of the discretionary spend really relooking at some of our things relative to investments. And making sure that we went through a re-prioritization of those that's really focused on things that matter so that we're coming out of this stronger particularly on revenue growth opportunities associated with electronics. So, we're taking that into consideration. But collectively these variable costs I mean it's tens of millions is how I would -- if you're looking for a type of a magnitude. We will give you more color as in Q2 as Dave mentioned when we have a better kind of outlook on revenue but it's fairly significant."
},
{
"speaker": "Dave Petratis",
"text": "I would add the announced restructuring we saw significant softening in Asia Pacific and in areas of Europe as we exited the second half of 2019. We were not pleased with our position and we took actions regardless of the COVID-19 and a pandemic does not. The other thing I would say, when you're in the construction-related industries you do have variation in demand and Allegion's ability to adjust our cost structure, I think can be seen over the last 20 years and we'll be making the moves that help keep this business strong."
},
{
"speaker": "John Walsh",
"text": "Great. And then maybe one about end markets. So I guess the Cares Act fixed somewhat of a bonus depreciation glitch that wasn't part of the tax plan. Wondering if you're hearing from folks that with the QIP adjustment that they're more willing to do interior improvements or if that's something that's nice, but just given the severity of what's happening right now it's not enough to kind of offset some of the demand?"
},
{
"speaker": "Dave Petratis",
"text": "I'm not aware of that feature of the Cares Act. I'm sure that the people here at Allegion if we feel that's an opportunity we'll go after it. So I can't give you a good response to that one."
},
{
"speaker": "John Walsh",
"text": "Okay. Thanks for the color. I appreciate it."
},
{
"speaker": "Dave Petratis",
"text": "Okay, John. Thank you."
},
{
"speaker": "Operator",
"text": "The next question comes from Joe Ritchie from Goldman Sachs. Please go ahead."
},
{
"speaker": "Joe Ritchie",
"text": "Thanks. Good morning, everyone."
},
{
"speaker": "Patrick Shannon",
"text": "Good morning."
},
{
"speaker": "Joe Ritchie",
"text": "Yeah. Just -- maybe just starting off I know a lot of the questions so far have been on the forward. But maybe just going back to 1Q for a second, clearly the margins in Americas I mean this is your best 1Q margins by a long shot. I'm just wondering was there anything either like one-time-ish that came through in the quarter, or maybe you can elaborate a little bit more on like pricing this quarter? And how you expect that to hold up as the year progresses?"
},
{
"speaker": "Patrick Shannon",
"text": "Yeah. So nothing unusual in the quarter that accelerated the margin improvement. It's the old blocking and tackling and execution. The team did a great job. We went into the year, I'd say with a really healthy pipeline of productivity activity around both material and the factory. We got great volume leverage on the incremental volume. And then you add on top of that price was good particularly in the commercial segment we're going to continue to drive that. And so everything played out, and again no real big surprises, but the team really kind of continued to drive good execution all around."
},
{
"speaker": "Dave Petratis",
"text": "I'd go back even farther Joe. As we exited 2018 as a leadership team, we felt we left margin on the table. We put a pipeline of activities and in 2019 that we worked on throughout the year and we picked up strength as we went into the second half of 2019 and 2020 that strengthened the business."
},
{
"speaker": "Patrick Shannon",
"text": "The other comment I just mentioned too on the input costs. So think about commodity prices, they've come down. So year-over-year there was some benefit there where we didn't have any inflation on the material side."
},
{
"speaker": "Joe Ritchie",
"text": "Got it. No, that makes sense. But Patrick is that something that's going to continue as the year progresses as well? I mean it can -- and how sticky you think the pricing will be?"
},
{
"speaker": "Patrick Shannon",
"text": "Yeah. Basis of the current cost for steel, zinc, copper, brass et cetera that will continue throughout the course of the year, yes."
},
{
"speaker": "Joe Ritchie",
"text": "Okay. That's helpful. And then maybe my one follow-up. Going back into several years, several quarters, the level of outgrowth you saw this quarter relative to your biggest competitor based in Europe in the Americas was I think like higher than any other quarter that we've seen. I guess, I'm curious if maybe you can elaborate what you're doing or the effect of the share gains that you're seeing specifically this quarter? And if -- I know we're all trying to figure out what the demand environment is going to be like, but should you continue to outpace your peers in this downturn?"
},
{
"speaker": "Dave Petratis",
"text": "So, I think number one, I'll give you a sports analogy. Why did the Patriots roll up six championship, six rooms same head coach, great quarterback, good offensive strategy. If you look at our competitors over the last 24 months, quite a bit of turnover at the top. A lot of management change. One of the strengths of Allegion is our experience. We have a system of management here that we're pretty disciplined to. It doesn't mean it's perfect. But I think the strength of the leadership team the knowledge that cascades through our business and some favorable markets regionally in the country helped us to continue to put up growth that we have built on over the last six years. So a combination of things there. I think the electronics as well is another -- this is an industry trend and we continue to prioritize our investments to take advantage of that opportunity. And I think it will continue to reward us Joe."
},
{
"speaker": "Patrick Shannon",
"text": "And I'll add Joe too, to be fair on the analysis. So we did have a little bit easier comparison on residential. You may recall, we had some channel difficulties in Q1 last year. Those obviously have been worked through. We continue to get really good electronics growth. And we added a substantial customer on the new construction Lennar that helped our year-over-year comparisons as well."
},
{
"speaker": "Joe Ritchie",
"text": "Yeah. That makes a lot of sense. Thanks guys."
},
{
"speaker": "Patrick Shannon",
"text": "Thank you."
},
{
"speaker": "Operator",
"text": "The next question comes from Julian Mitchell from Barclays. Please go ahead."
},
{
"speaker": "Julian Mitchell",
"text": "Hi, good morning. Maybe just wanted to double check again the mix of business. So within the Americas, if you could just remind us in terms of 2019 split, let's say how much -- within the resi and non-resi pieces of the business, how much of each of those was related to new build versus aftermarket or replacement activity for Allegion?"
},
{
"speaker": "Dave Petratis",
"text": "So we would say, it's around 50-50 collectively across the entire portfolio."
},
{
"speaker": "Julian Mitchell",
"text": "I see."
},
{
"speaker": "Patrick Shannon",
"text": "Hey, Julian, you'd want to think that the non-residential is a little heavier I think on the new construction versus the aftermarket and then it's flipped on the residential, but then it nets out to about 50-50."
},
{
"speaker": "Julian Mitchell",
"text": "Thank you. And how much related to that of your resi sales are going via the big box channel nowadays?"
},
{
"speaker": "Patrick Shannon",
"text": "So it's a about a third 40% of the business 50% maybe up to 50%."
},
{
"speaker": "Julian Mitchell",
"text": "Thanks very much. And then my second question would following up on that question from Joe around pricing and productivity. So those items were I think almost a 200-point tailwind to margins in the first quarter year-on-year. Based on your comments, should we assume that that remains a very strong tailwind for the next nine months, perhaps not quite at the level of Q1, but should be a material contributor?"
},
{
"speaker": "Patrick Shannon",
"text": "Yes. I think we'll have -- we'll continue to have a tailwind there. But again, some of the issues associated with the closure reduced demand et cetera we'll put some pressure on those comparisons."
},
{
"speaker": "Julian Mitchell",
"text": "Understood. Thank you very much."
},
{
"speaker": "Operator",
"text": "The next question comes from Jeffrey Kessler from Imperial Capital. Please go ahead."
},
{
"speaker": "Jeffrey Kessler",
"text": "Thank you. Hope you guys are doing well."
},
{
"speaker": "Patrick Shannon",
"text": "And you too."
},
{
"speaker": "Jeffrey Kessler",
"text": "A quick question on the -- looking at the channel, the integration and the installation channel, we've been seeing that there is continuation of big projects going on. There are some problems in getting people on to sites at some of the midsized projects. And obviously when they get on, they have to be wearing the types of PPE and things like that that are mandated by the local ordinances. And in some places, the smaller SMB market seems to be shut down completely. Can you make some comments on how your -- what you're getting back from your installers and integrators with regard to their ability to do work on projects what's continuing where -- what's out there where there's some restriction on their ability to get to the site and what's out there which is completely closed down?"
},
{
"speaker": "Dave Petratis",
"text": "I think it's clearly a step back in terms of being able to go in service install. Here at Allegion, we have a policy. Visitors are highly controlled. We don't want infection. With that said, it depends on where you're at. The Dallas market continues to be very active. We are moving around college campuses, but it's not going to happen in New York City. It certainly could happen in Denver. So again, it depends on where you're at and it puts an air pocket into the work. So I actually think if things straighten themselves out, there'll be a pickup in intensity short term. And over time, it schedules itself out. I do think the normal project activity that we have typically that goes on college campuses will roll to schedule, which is really May through August. It's an important driver for us. Could be moved up a little early, if access is there, but it depends on where you're at geographically Jeff."
},
{
"speaker": "Jeffrey Kessler",
"text": "Okay."
},
{
"speaker": "Dave Petratis",
"text": "Higher infection rates, more difficult access."
},
{
"speaker": "Jeffrey Kessler",
"text": "I see. We'll see what happens at West over the next few weeks. Second thing is, do you -- what investments have you made? And I know you've made some in the past with regard to obviously collaborative spec writing, if you want to call that in the cloud, touchless access NFC things like that. Are you in a position to take market share because of number one touchless access. Number two, some of the – let's just call it, some of the newer investments that you've made in trying to – in trying to just make the process easier for your customers. Is that something that that can continue a market share gain in the – at least in the Americas for the moment because it seems to have been – have worked at least over the last year or so?"
},
{
"speaker": "Dave Petratis",
"text": "I believe if you look at our overall growth, the investments that we're making in collaborative tools Overture, which we'll continue to invest and develop. Overture has been rolled out in the bulk of the world as a collaborative working tool and it's been extremely well received by our partners, spec writers architects and they have been collaborative in the creation of Overture. So I really give Tim Eckersley credit to creating that. We continue to invest in the electronics side of this. I think you may have seen Jeff our investment in open path as a partnership and investment that we think will help expand the world of seamless access. Schlage Sense [ph] would be another and our continued investment in electronics and new products. We also brought together SimonsVoss and Interflex under one leadership team, because we believe that that's a looking glass into seamless access. And our growth there in electronics in the DAC region is gaining share. So I think you've got the right sense in that collaborative tools, electronics and seamless access is going to help us as we go through this crisis and come out the other end."
},
{
"speaker": "Jeffrey Kessler",
"text": "Is that at the margin, or is that something that can actually really move the needle as we come out of this recession?"
},
{
"speaker": "Dave Petratis",
"text": "I think the drivers of seamless access keyless activity simplifying the world that our customers live in eliminating master keys and intelligence that goes with seamless access is going to be a driver for the next two decades."
},
{
"speaker": "Jeffrey Kessler",
"text": "Thank you very much. Appreciate it."
},
{
"speaker": "Dave Petratis",
"text": "Thank you."
},
{
"speaker": "Operator",
"text": "The next question comes from Deepa Raghavan from Wells Fargo Securities. Please go ahead."
},
{
"speaker": "Deepa Raghavan",
"text": "Hey, good morning. Dave you touched a little bit on the restrictions on construction site actually impacting project activity, especially you mentioned institutional. Now institutionally we've always considered it long tail in nature and more defensive as we go into a down cycle. Now, does that dynamic now make it less defensive this down cycle? And the other – extending that question, if site access continue to be restricted through this construction selling season, does it mean you can – you're able to recover beyond fall or in winter season, or you think that's been now pushed to the next construction season which is next summer?"
},
{
"speaker": "Dave Petratis",
"text": "So I like our position in institutional. I was looking last night. 22 of the states have – are generally in pretty good financial shape. Infrastructure has aged. We still have the driver of security in public settings. So you got to like that. And then our spec activity would also suggest that that this whole market continued to develop. With that said, an earlier question described an air pocket, we're going to have to have our eyes wide open and understand that air pocket. Part of it is you get some immediate shock. Second is it's that snowplow effect that we've talked about in the past, projects will get pushed out but we may see that air pocket again as we moved into 2021 because budgets are a little bit tighter. So to be seen, I like our institutional position. It's been – in my 40 years, the institutional markets have always been a good place to operate and we'll try and get more than our share out of whatever market is there."
},
{
"speaker": "Deepa Raghavan",
"text": "Got it. So can you talk about your Mexico and the Italy plant closures, I mean what percent of sales is coming from those two regions? And when you talk about working with your channel partners to ensure demand is wholesale, does it entail higher costs?"
},
{
"speaker": "Patrick Shannon",
"text": "So, I'll take a stab at the revenue base. I mean just to kind of put it into perspective on Mexico. That's predominantly the supplier for our residential business. Here in Americas, which we've characterized it's about a third of the overall Americas portfolio. Keep in mind, the decree was extended through the end of May. However, we are -- we've got inventory on hand. We're working with our distribution partners to ensure customers can be served. When that comes back online there will be a restocking in the channels for the depletion of the inventory. So we're kind of working that. But I think that the message is near term you're going to see a decline and obviously in revenue for some piece of that certainly in Q2. Italy, again, the data I think on that is May three is the current decree. We will see that is subject to change based on what the government dictates. That might be kind of call it 20% of our portfolio in Europe. We are shipping finished goods inventory out of the warehouse there in Italy today. So that activity is taking place. It's just the production, manufacturing, et cetera right now that were inhibited from producing anything. However, it doesn't necessarily mean we're losing business. I think it just means delays deferrals that type of thing because the reality is the customers are closed also. And so they don't have the ability to be able to receive inventory. And so this is just going to be a deferral, and we'll see how quickly that may or may not pick up in the back half of this year."
},
{
"speaker": "Dave Petratis",
"text": "Pete, I have to give a shout out to our Italian teams. We operated safely longer there than many manufacturers. Same in Mexico. We got a few extra days until that decree came down working hard to petition the government now to consider it's essential. I believe in Mexico we can keep our people safer than they are on the streets. And so we're pushing that. Again, we've got a good supply of residential inventory on the shelf. And if we can cut through this, we're going to be in good shape."
},
{
"speaker": "Patrick Shannon",
"text": "All right, Jason?"
},
{
"speaker": "Operator",
"text": "Yeah. There are no more questions in the queue. And this concludes our question-and-answer session. I would like to turn the conference back over to Tom Martineau for any closing remarks."
},
{
"speaker": "Thomas Martineau",
"text": "I appreciate it. So we'd like to thank everyone for participating in today's call. And today more than ever please have a safe day."
},
{
"speaker": "Operator",
"text": "The conference has now concluded. Thank you for attending today's presentation. You may now disconnect."
}
] | Allegion plc | 241,782,379 |
ALLE | 4 | 2,021 | 2022-02-15 08:00:00 | Disclaimer*: This transcript is designed to be used alongside the freely available audio recording on this page. Timestamps within the transcript are designed to help you navigate the audio should the corresponding text be unclear. The machine-assisted output provided is partly edited and is designed as a guide.:
Operator: 00:05 Good day and welcome to the Allegion’s Fourth Quarter 2021 Earnings Call. All participants will be in listen-only mode. [Operator Instructions] After today's presentation, there will be an opportunity to ask questions. Please note this event is being recorded. 00:24 I would now like to turn the conference over to Tom Martineau. Please go ahead.
Tom Martineau: 00:29 Thank you, Jason. Good morning, everyone. Welcome and thank you for joining us for Allegion's fourth quarter and full-year 2021 earnings call. With me today are Dave Petratis, Chairman, President, and Chief Executive Officer; and Patrick Shannon, Senior Vice President, and Chief Financial Officer of Allegion. 00:48 Our earnings release, which was issued earlier this morning and the presentation, which we will refer to in today's call, are available on our website at investor.allegion.com. This call will be recorded and archived on our website. 01:02 Please go to Slides 2 and 3. Statements made in today's call that are not historical facts are considered forward-looking statements and are made pursuant to the Safe Harbor provisions of federal securities law. Please see our most recent SEC filings for a description of some of the factors that may cause actual results to differ materially from our projections. The company assumes no obligation to update these forward-looking statements. 01:28 Today's presentation and commentary includes non-GAAP financial measures. Please refer to the reconciliation in the financial tables of our press release for further details. Dave and Patrick will now discuss our fourth quarter and full-year 2021 results and provide an outlook for 2022, which will be followed by a Q&A session. 01:48 For the Q&A, we would like to ask each caller to limit themselves to one question and then re-enter the queue. We would like to give everyone an opportunity given the time allotted. 01:57 Now, I’d like to turn the call over to Dave.
Dave Petratis: 02:00 Thanks, Tom. Good morning and thank you for joining us today. Please go to Slide number 4. Q4 was tough for Allegion and although we achieved the expected results, we discussed last quarter, I was disappointed that we were unable to fully meet the market opportunity presented. 02:22 The strength and demand, particularly in America’s non-residential end markets continued. And as I said last quarter, this trend began softly in Q1, accelerated in Q2, and continued throughout the back half of the year. 02:40 Leading indicators like specs written for Allegion America’s, ABI, and Dodge new construction indices, retail point of sales, and macroeconomic indicators in our Allegion International segment all remained positive. These indicators suggest continued strength in all end markets for the foreseeable future. 03:02 However, with supply chain challenges, we continue to experience difficulty converting that demand into revenue. Typically, we’d be able to gear up our supply base in short fashion, but the accelerated increase in demand occurred during an unprecedented time when suppliers where experiencing labor, raw material, transportation, and electronic component shortages creating tremendous global disruption. 03:32 What we typically resolve in a quarter is now taking much longer. We are making good progress on product redesigns and alternative sourcing, which should alleviate some of the supply chain pressure, but we do expect revenue to continue to be constrained in the near-term. 03:53 Even with the supply chain improvements we are making, it’s important to note that the pressures in electronic components are expected to continue throughout 2022. Looking at price versus cost, we continue to experience high inflationary impacts for material cost, labor, and freight. The pricing that we put in place last year is currently lagging inflation. That coupled with productivity challenges is a major contributor to margin declines in Q4. 04:25 We implemented additional price increases during the fourth quarter and have already announced another price increase for Q1 2022 that goes into effect this month. We are aggressively pursuing price across all products and in all channels to offset unprecedented inflation and expect price to exceed inflation in 2022. 04:52 I do want to highlight our Allegion International business, which had another good quarter and closed out a strong year. The segment delivered robust organic revenue growth and solid margin expansion in 2021. 05:09 Looking forward, the increased demand and supply chain shortages have led to record backlog in our American non-residential business and coupled with the progress we are making on redesigns and alternative sourcing, we expect solid revenue growth in 2022 and into 2023. 05:30 As supply chain pressures ease, operational efficiencies will improve, which along with accelerated pricing will allow us to expand margins in 2022 and exit the year on a glide path back to peak performance. 05:47 Now, let's turn to the quarter’s performance for more details. Please go to Slide 5. Revenue for the fourth quarter was 709 million, a decrease of 2.5%, compared to last year. Organic revenue declined 1.4%. The organic revenue decline in the quarter was driven by Allegion Americas, which experienced continued supply chain pressures that led to electronic and other component shortages. 06:17 Also embedded in the decline is a tough comparable to last year. During the fourth quarter of 2020, we had a large residential channel loading that was necessary to catch up from the shutdowns experienced earlier that year. The Americas volume declines more than [offset] [ph] the sequential improvements in price realization and the growth that the Allegion International segment delivered. Patrick will share more details on the business segments in a moment. 06:50 Adjusted operating margin decreased by 610 basis points in the fourth quarter. Continued inflationary pressures, productivity challenges, and volume de-leverage drove most of the decrease. Incremental investments for future growth cost 80 basis points of the decline. 07:10 Adjusted earnings per share of $1.11 decreased $0.38 or approximately 26% versus the prior year. Lower operating income was partially offset by favorable share count, year-over-year tax rate reduction, and other income. Available cash flow for the year came in at 443 million, which was flat to 2020. 07:36 Slightly lower adjusted earnings were offset by slightly lower capital expenditures. The cash flow impact of working capital was nearly neutral as well with increased inventory offset by other components of working capital. 07:52 As I think about the road ahead, I firmly believe our vision strategy and support of our seamless access is more relevant than ever. I also believe we have the right team and an engaged workforce that will respond to the challenges we face today. 08:09 We are bullish on construction and DIY markets for 2022 and continue to expect the IoT trends of electronic adoption and smart buildings to fuel growth for many years. Allegion’s future is bright and we will return to the peak performance and profitability that you expect. 08:30 Patrick will now walk you through the financial results and I'll be back to discuss our 2022 outlook.
Patrick Shannon: 08:37 Thanks, Dave and good morning, everyone. Thank you for joining today's call. Please go to Slide number 6. This slide reflects our earnings per share reconciliation for the fourth quarter. 08:49 For the fourth quarter of 2020 reported earnings per share was $1.01, adjusting $0.48 for charges related to restructuring, M&A costs, impairments, as well as a loss on held for sale assets, the 2020 adjusted earnings per share was $1.49. 09:08 Favorable year-over-year tax rate and share count drove another $0.04 and $0.03 increase respectively. Interest and other income were slightly positive as were the impact of acquisitions and divestitures, both at $0.01 per share. 09:24 The story for the quarter is reflected in the operational results, which decreased earnings per share by $0.41. The inflation of productivity headwinds were predominantly driven from higher input costs, wage increases, and efficiencies from supply chain challenges and the bounce back of variable related costs, which were not as high in the prior year. 09:46 These added costs were partially offset by price. Pricing sequentially improved in the quarter and will continue to accelerate in 2022. Investment spending increased during the quarter and reduced earnings per share by $0.06 [when we] [ph] remain committed to investing in new product innovation and technology that will accelerate future growth and deliver solutions that enhance customer and end user experiences and connectivity. 10:15 This results in adjusted fourth quarter 2021 earnings per share of $1.11, a decrease of $0.38 or 25.5%, compared to the prior year. 10:25 Lastly, we have a $0.15 per share increase for the combination of a non-cash gain on a remeasurement of an Allegion Ventures investment offset by charges related to restructuring, M&A and debt refinancing. After giving effect to these items, you arrive at the fourth quarter of 2021 reported earnings per share of $1.26. 10:48 Please go to Slide number 7. This slide depicts the components of our revenue growth for the fourth quarter, as well as for the full-year of 2021. As indicated, we experienced a 1.4% organic revenue decline in the fourth quarter. Like Q3, the electronics and other component shortages, primarily in the Americas region, had an impact our ability to meet continued strong demand. 11:15 We achieved the highest quarter price realization in the year, which offset some of the volume decline. For the full-year, you can see that total revenue was up 5.4% with organic revenue growth of 4.5%. Both segments of the business delivered organic growth for the year with the international segment at 10.4% and Americas at 2.4%. 11:39 As mentioned, end-market demand increased considerably faster than we anticipated in 2021. And although we were able to deliver significantly more than our initial outlook, we were unable to meet the full market opportunity currently. However, our record backlogs will enable accelerated revenue in the future once the supply chain constraints are mitigated. 12:03 Please go to Slide number 8. Fourth quarter revenues for the Allegion Americas segment were 499.5 million, down 4.2% on a reported basis and 4.3% organically. The organic decline was driven by continued supply chain pressures for both mechanical and electronic products. 12:23 On the plus side, we did see sequential improvement in price and the Americas has announced another increase that goes into effect this month. We're driving price in all channels and products and our expectation is that pricing will exceed inflation in 2022. 12:40 The Americas non-residential business was up low single digits as strong price was offset by delayed volume, related to electronic allocations and other component shortages. These supply chain constraints paired with robust market demand, slowed the pace of revenue realization that led to historic levels of backlogs at the end of the year. 13:00 Americas residential was down mid-teens. Similar to last quarter and mentioned previously, the main drivers of the decrease are the prior year being inflated by channel refill coming out of the pandemic shutdowns experienced in Q2 2020, and the shortage of electronic components that primarily impact us in the DIY space of big box retail and e-commerce. 13:23 Electronics revenue was down low 20%, driven by continued shortages of electronic components in both the non-residential and residential businesses. The prior year residential channel refill also had an impact on year-over-year electronics performance. 13:39 Allegion Americas adjusted operating income of 105.5 million decreased 29% versus the prior year period and adjusted operating margin for the quarter was down 740 basis points. The decrease was driven by inflationary pressures, productivity challenges related to supply chain, and volume de-leverage. Incremental investments had a 90 basis points dilutive impact on adjusted markets. 14:05 Although margins were down significantly in the quarter, down 370 basis points for the full-year, margins will improve in 2022, compared with 2021 from increased price realization, volume leverage, and improved business mix. 14:21 Please go to Slide number 9. The Allegion International segment had another solid quarter. Fourth quarter revenues were 209.7 million, up 1.7% and up 5.8% on an organic basis. The organic growth was driven by strength in our global portable security business along with good price realization. Reported growth reflecting impacts at currency headwinds and divestitures. 14:48 Allegion International adjusted operating income of 29.4 million decreased 11.2% versus the prior year period. Adjusted operating margin for the quarter decreased by 200 basis points. The margin decrease was driven primarily by inflation exceeding price and productivity along with negative product mix, which more than offset the positive volume leverage. Incremental investments reduced margins by 50 basis points. 15:16 I would also note the full-year performance of the International segment, double-digit organic growth, and achievement of 11% operating margin. This was a record year for the segment and reflects a tremendous amount of effort and dedication by the entire team. 15:32 Please go to Slide number 10. Available cash flow for 2021 came in at 443 million, which is flat compared to the prior year period. The adjusted net earnings were slightly lower and was offset by slightly lower capital expenditures. In total, the working capital impact was near neutral with increased inventories offset by other components of working capital. 15:58 Looking at the working capital chart, it shows working capital as a percentage of revenues and the cash conversion cycle decreased based on a [4.25] [ph] average. 16:09 Last chart on the slide shows our net leverage. The net debt-to-EBITDA ratio increased from 1.5 last year to 1.7 this year. The increase in the ratio was driven primarily by reduced cash position from shareholder distributions for the year. 16:27 The business continues to generate strong cash flow and conversion of net earnings. We have a healthy balance sheet and we executed 542 million and shareholder distributions were 413 million in share repurchases and 129 million of dividends. We also recently announced a 14% increase in our dividend coming later in March. 16:51 During the quarter, we entered into a new 750 million unsecured credit agreement, consisting of a 250 million term facility, and a 500 million revolving facility. We obtained a rating upgrade with Moody's and a move to positive outlook by Fitch. Our capital structure is an asset of the company and we continue to execute on our balanced capital allocation strategy that will deploy capital through incremental, high returning organic investments, CapEx, M&A, or shareholder distributions. 17:25 I’ll now hand it back over to Dave for some comments on 2022.
Dave Petratis: 17:29 Thank you, Patrick. Please go to Slide 11. Before I get into our outlook for the year, I want to highlight actions we are taking to mitigate constraints and drive growth and profitability in 2022. 17:47 Our expectation is to fully cover inflation with price. We are in the midst of executing aggressive pricing actions across the globe in all product categories and all channels. We will remain vigilant during the year and we will not hesitate to pull the pricing lever if inflation headwinds increase further. 18:12 With regard to timing, we expect net margin pressures during the first half with the price versus cost dynamic improving sequentially throughout the year and turning positive in the middle of the year. 18:26 Our product redesigned and alternative sourcing work is expected to be completed by the end of Q2. This will help alleviate the supply chain pressures related to our mechanical business and provide access to additional electronic component solutions. However, electronic chip allocations will continue to be choppy throughout the year. As the supply chain normalizes, we will continuously improve our lead times and reduce our record backlog. 18:58 Our greatest strength lies in the people of Allegion. With broad tightness in the labor market, we are protecting our labor pipeline. We have implemented pay increases and are not flexing labor to the degree we normally would. This is operationally inefficient in the short-term, but when supply chains pressure ease, we want to be sure we have the labor in place to move product out of the factories and reduce backlogs. 19:30 We expect return to margin expansion this year. Second half margins are anticipated to perform stronger than first half, and we will exit the year on a path back to peak margin performance. We continue to invest in R&D and software development that progresses our seamless access strategy and to build critical talent capabilities and innovation. 19:55 Please go to Slide 12. For the 2022 outlook on revenue, the Americas is expected to strengthen our non-residential businesses with the continued recovery in those end markets, particularly education, healthcare, and commercial. All leading indicators are positive and the level of institutional specification for our business had continued to be strong. 20:22 Residential indicators are positive as well and we expect that business have continued growing in 2022. The under supply of single family homes continues to be corrected and the builder channel and retail point of sale has been strong for quite some time. Electronic and smart home adoption continues to be long-term growth drivers. 20:48 As underscored earlier, we are aggressively pursuing pricing in all channels, products in the Americas, and around the globe. Given the supply chain challenges that persist, we expect the revenue performance to be better in the second half than in the first, but still project organic revenue growth in all quarters. 21:09 With the strength in non-residential constructions, continued growth in residential, our expectation for electronic chip allocation and redesign work to ease supply chain pressures, we project total organic revenue in the Americas to be up 8.5% to 10% in 2022. 21:29 In the Allegion International segment, we expect growth, but we are starting to see some electronic supply chain issues in that region as well. Currency headwinds are projected to offset organic growth. 21:44 For Allegion International, we project total revenue to be in the minus 1% to plus 1% range with organic growth of 3% to 5%. All in for Allegion, we are projecting total revenue to be up 6% to 7.5% and organic revenue growth of 7% to 8.5%. Our 2022 outlook for adjusted earnings per share is $5.55 to $5.75. Timing [warrants] [ph], we expect to realize approximately 60% of the adjusted EPS in the second half of the year. 22:24 As indicated, adjusted operational earnings are expected to increase 14% to 18% driven by volume leverage and price exceeding inflation. Incremental investments continue to be a priority as we remain focused on accelerating electronics and seamless access growth in support of our vision and strategy. These incremental investments predominantly relate to added R&D and engineering to further develop, enhance, and accelerate new product development and software capabilities. 23:01 The combination of interest and other expenses is expected to be a headwind as some of the more favorable items that we experienced in 2021 are non-recurring. Our outlook assumes a full-year adjusted effective tax rate of approximately 13%. It also assumes outstanding weighted average diluted shares of approximately 88 million. 23:23 The outlook additionally includes approximately $0.05 per share for restructuring charges during the year. As a result, reporting EPS is projected to be $5.50 to $5.70. We are expecting our available cash flow for 2022 to be in the $465 million to $485 million range. 23:45 Please go to Slide 13. In summary, end market demand remains strong in the fourth quarter and we expect that to continue. The supply chain issues we are experiencing have hindered our ability to meet that demand, and as a result, we have built record backlogs that will support growth in 2022 and 2023. 24:10 The product redesigns and alternative sourcing should begin to alleviate some of the supply chain pressures by mid-year, primarily on the mechanical side of the business. We are projecting solid organic revenue growth of 7% to 805% in 2022, even with the expectation that chip allocations will continue to be tight. 24:33 We expect year-over-year growth in electronics and acceleration in that growth throughout the year. We are aggressively going after price across the globe and in all products and channels. For the calendar year, pricing will exceed inflation. This will help Allegion to deliver margin improvement, which we expect will progress as we go throughout the year. 24:58 Please go to Slide 14. A final note on some key leadership announcements before we move into Q&A. Mike Wagnes, who leads the Commercial Americas strategic business unit will be transitioning to the role of Chief Financial Officer on March 1. He succeeds Patrick Shannon, who will be retiring later this year. 25:22 As CFO, Mike brings significant financial experience and a deep understanding of our global business in the markets we serve. He has been with Allegion for 15 years and many of you know him from his time as Treasurer and leading Investor Relations. The Board of Directors and I have the utmost confident that he is the right person to step into this important role. 25:46 Dave Ilardi has been promoted to Senior Vice President of the Americas Segment effective March 1. Dave currently leads Allegion Home and is responsible for the flagship Schlage portfolio of residential solutions. He been at the company for 20 years and is highly respected, an industry veteran with extensive knowledge of our customers, channel partners, and vertical markets. We are thrilled to welcome him to the senior leadership team. 26:16 Allegion is equally fortunate to have a strong bench of talented leaders throughout the globe. They are well prepared to execute on our strategy and capitalize on growth opportunities as we emerge from the pandemic. And I want to thank our entire team for their commitment and dedication. 26:34 Last, a few remarks for Patrick Shannon. It has been a privilege to work alongside Patrick, who has been a partner, a friend for me, and an outstanding business leader. And as a family member of the leadership team, Patrick has been instrumental in refreshing our business strategy, building a world-class finance organization, and creating a strong foundation that will serve us well in the years ahead. I speak for all of the employees of Allegion, when I say that it has been an honor and a pleasure to [serve with] [ph] Patrick Shannon. 27:11 We'll now take your questions.
Operator: 27:14 [Operator Instructions] Our first question comes from [Brett Lindsay] [ph] from [indiscernible]. Please go ahead.
Unidentified Analyst: 27:41 Hi, good morning all and congrats to Patrick.
Patrick Shannon: 27:44 Thank you.
Unidentified Analyst: 27:45 Good. A strong outlook overall. I'm just curious what level of price are you expecting within the guide for the full-year? And any directional color you can give us between how you're thinking about the residential and non-residential piece within the Americas business for 2022?
Patrick Shannon: 28:05 Yes. So, I would characterize as you look at price, again, good sequential improvement in Q4 of 2021. You will see continued improvement as we progress throughout 2022, both on the non-residential and residential side of business. It is a large component of our overall revenue growth kind of reaching a peak, if you will, in terms of price realization in Q3 as we realize the full implementation of all the price increases, including both list prices and surcharges on certain products. 28:43 So, a big part of the revenue growth and if you, kind of look at it relative to non-res, res, the non-resi in terms of our guide, full-year revenue growth, you'd be looking at the high-end, kind of low-double-digits, residential mid-single digit type of growth for 2022.
Unidentified Analyst: 29:09 Okay, great. And then just to come back to the electronics, you noted growth year-over-year on a full-year basis, I'm just curious, what's the pacing look like through the year? Is it really Q3 until that turns positive again or does it happen earlier? Just curious what’s your planning processes looks like there?
Dave Petratis: 29:28 We've spent a lot of time looking at electronic chip and component allocations. And as you think about our guide, it will be – it will improve sequentially quarter-to-quarter in terms of the flow of electronic blocks and be strongest in the second half and as we move into 2023.
Unidentified Analyst: 29:50 Okay, great. I'll pass it along. Thanks.
Dave Petratis: 29:52 Thank you.
Operator: 29:54 The next question comes from Julian Mitchell from Barclays. Please go ahead.
Julian Mitchell: 29:59 Hi, good morning and thanks for all the help Patrick and wish you all the best. In terms of – my question would be around the underperformance of, sort of the volumes Allegion in the Americas relative to some of its biggest peers, that's clearly been a point of focus for investors for a few months now. So just wondered what you thought the main factors were behind that seeming share loss, particularly from a non-resi side, if it’s simply a difference in kind of procurement and sourcing strategies? And is there anything else perhaps doing on more on the commercial or customer facing front as well?
Dave Petratis: 30:46 I think you've got to call our second half as of is. Number 1, markets are incredibly strong. Number 2, our loss in opportunity by the company, because of supply chain difficulties. Our supply chains tend to be in region. They perform incredibly well giving high inventory turnover, high return on invested capital when they're working well. 31:16 The pandemic, especially as we move through 2022 was severely impacted by chips and labor shortages that affected our very complex supply chain within region. And when I say complex, you've heard me say Julian, complexity is our friend at Allegion, but when you throw that – those challenges in supply chain, you're really working a variety of issues, which I'd say stabilized as we ended December and will get sequentially better as we go on. 31:57 I would also say, some of the moves that we made pre-pandemic to vertically integrate actually helped us. And I think, I'm confident that we'll get the mechanical side of the Americas business straighten out its things like investing, investment capping that make the Von Duprin exit device what it is. And as we move through the year, the pacing item will be electronics. 32:30 We build our plan based on the allocations that we believe that we will get, and I believe in the electronics, the supply chain disruptions there have pulled demand forward and will benefit in the secondary markets that will help us exceed our plan in 2022, if that in fact impacts. So, a lot into that answer. I hope that gives you some color.
Patrick Shannon: 33:00 Julian, I would also just add real quickly, when you look at, kind of the order activity on non-res, really strong, we're kind of giving indication, maybe similar what we're seeing from our peer set, just this inability to be able to ship and realize of revenue. So, we'll call it, kind of differed or delayed revenue, it will come. They’re definitive orders. We're not seeing any cancellations. And that's why we're going to anticipate 2022 to have accelerated revenues we progress throughout the course of the year with the resolution of some of these supply chain difficulties. 33:40 The other thing is, on the residential side, keep in mind, we got a large channel load last year that's impacting negatively the comparisons year-over-year. So that has kind of the distortion. I mean, if you look at it on a two-year stack basis, it's not as pronounced as what you saw perhaps in Q4 2021. So, just kind of keep those things in mind if you would.
Julian Mitchell: 34:08 Thanks a lot. That's very helpful. And then just one very quick follow-up. Just [on kind of] [ph] final point on the, sort of the price volume split within the organic sales guide for total company 2022, is this the sort of rough assumption that the organic sales growth is split sort of 50/50 price and volume?
Patrick Shannon: 34:28 Yes, I'd say that's pretty much in the ballpark. Again, we're going to push the price lever and because right now, as the numbers would indicate, underwater relative to the inflation we've seen, but I think that's a decent assumption.
Julian Mitchell: 34:49 Great. Thank you.
Operator: 34:52 The next question comes from Joe O'Dea from Wells Fargo. Please go ahead.
Joe O'Dea: 34:57 Hi, good morning. First, just a cadence question. You gave some helpful details in terms of how you're thinking about the back half of the year, but I think with the fluidity of the current environment, just anything that you're able to talk about in terms of the first half? I think, first quarter EPS tends to be maybe a high teens percentage of the full-year. Just trying to understand based on the visibility you have on supply chain, what kind of progression we should be thinking about, kind of as we go first quarter and the second quarter if you're able to talk about that?
Patrick Shannon : 35:31 I think, we gave you a [nugget] [ph] there, 60% of the EPS will be in the second half of the year. Second, you know you think about the labor ramp up that I think is happening for us [Technical Difficulty] see people are coming back to work, back into the factories, that momentum is important for us to drive the supply chain to meet this, you know the demand and backlog that we've got to drive through. 36:03 The second would be chip supplies, sequentially they'll get better quarter-to-quarter and it leads to that back half being stronger.
Dave Petratis: 36:12 I would just add, seasonally, Q1 normally our weakest quarter from a revenue perspective and earnings. The year-over-year decline in margin not as pronounced. Obviously is what you saw in Q4, but yet margin down relative to Q4 just from a seasonal perspective, that's kind of normal course of business, but as we progress throughout the course of the year, the price cost dynamic, you will see continuous improvement beginning in Q1, relative to Q4, and that will progress throughout the course of the year, as we get more price realization and our assumption is, on inflation that, we've kind of plateaued where we are and actually steel is, if you kind of look at on a [cold role] [ph] per ton basis has come down a little bit, maybe a little opportunity there. But margin expansion really back-end loaded where that price cost dynamic becomes very favorable. 37:20 And obviously, we have easier comps, back half of this year, compared to 2021. So, that's kind of how we see it playing out sequentially.
Joe O'Dea: 37:32 I appreciate that. And then I wanted to ask about some of the commentary 2022, but also constructive on 2023 in terms of the conversations that you're having with customers and the amount of backlog that's even scheduled for 2023, but you can just expand on that a little bit in terms of, kind of what you're seeing to help kind of build what would be, kind of a two year constructive outlook on improving demand?
Patrick Shannon: 38:03 So, we certainly filtered through the macroeconomic indicators, which we feel all positive all levels. I think as you travel around the country, you see the strength in construction markets. You've got stimulus coming from the top, you also are working through the backlog of work that was disrupted by the pandemic. So, as I think about [K through 12] [ph] hospitals, multi-family, and the overall res, which drives expansion, I feel very good about the next couple of years.
Dave Petratis: 38:47 I would also add, we've talked about this record backlog, both on the mechanical electronics, we’ll have an opportunity to work through a lot of the mechanical backlog in 2022. There's still going to be an overhang, if you will, or excess elevated backlog associated with electronic products going into 2023. And so, with that backdrop and their continued strength and market demand, would expect 2023 to be – have a pretty robust organic revenue growth as well for the Americas region on non-res and really good electronics growth year-over-year. So, would expect that to, kind of continue on, compared to 2022.
Joe O'Dea: 39:35 Thank you.
Operator: 39:37 The next question comes from David MacGregor from Longbow. Please go ahead.
David MacGregor: 39:43 Good morning, everyone. Just a couple of quick ones, maybe Dave, you could talk about the backlogs and in the past, you've indicated a disinclination to want to put through pricing on backlogs as you protect some of the spec business that you've [booked] [ph]. I'm just wondering if that's changing now as you think about becoming more aggressive on pricing into 2022? And then obviously great results from Europe under some pretty difficult circumstances there as well, clearly Tim and his team are executing well there. Can you just talk about one of the biggest pieces of the 2022, 2023 margin progression opportunity in Europe? Thank you.
Dave Petratis: 40:20 So, I'll talk about international first. I think Tim, our Allegion Home, Europe, SimonsVoss, Interflex, the [Australian business] [ph], great focus of execution in 2021 in the phase of the pandemic. The consolidation that we drove a year ago and announced in combining that did a couple of things. One, simplify their structure. We cleaned up some bits of the portfolio, but Tim's knowledge of the capabilities of America accelerated capabilities that we have here into those markets. It's things like diligence. 41:02 It's things like our electronic software platforms and a belief that some of that product platforms that we're having advanced development can be extended and help us compete. So, I think, when I think about Allegion International that we pulled that off in a pandemic year, is some work that's been going on at Allegion for a couple of years, and it came to our head, and I think our best days are ahead of us. 41:31 I think, in terms of margin expansion, I think the long-term goal would be to be a margin equal or better than [ASSA] in the competitive markets. We're not apples to apples in terms of how we compete, extremely strong in the electronics and then you get more into the regional market forces and what those markets allow where we're competing. 41:59 The second part of the question was?
Patrick Shannon: 42:00 Yes. So, David, on the pricing associated with the backlog, keep in mind, industry standard normally when you give a quote, on a project based job or and/or you have an order in-house prior to the price going into effect, you kind of honor that. 42:24 So, normally, there's a time lag between when you announce a price increase and the realization and that could be, we'll call it on average, 90 days to 120 days type of time timeframe. And so, that's why relative to the price increases, we've already implemented and are executing. You don't get to a full run rate realization that we'll call at Q3, but normally you don't go back and reprice quotes and backlog. 42:55 Okay. That's a consistency, kind of in our industry. Now, we have looked at other parts of the business and doing that, but predominantly it’s protected.
David MacGregor: 43:09 Is there any way you can update that 80 million to 100 million of backlog number that you gave us last quarter, just to indicate where you think that is today?
Patrick Shannon: 43:16 So, it exceeded or increased compared to Q3, just kind of given the surge and order activity. Now, some of that and it's difficult to characterize would be a pull forward from 2022 activity when customers are just trying to get to orders at and get in-line for the products, but increased and I would say, if you're, kind of looking at the full-year revenue impact on Allegion north of 100 million would be how to think about it.
David MacGregor: 43:53 Thanks very much, gentlemen.
Patrick Shannon: 43:55 Thank you.
Operator: 43:56 The next question comes from Andrew Obin from Bank of America. Please go ahead.
Andrew Obin: 44:02 Good morning.
Dave Petratis: 44:03 Good morning.
Andrew Obin: 44:04 Hey, guys. Just trying to understand how much overlap is there between your supply chain and the supply chain of your competitors? i.e. just sort of ability to compensate for the fact that it sounds you underestimated the strength of the demand and sort of catch up when the competitors already have sort of slots [on the line] [ph] or is that not an issue?
Patrick Shannon: 44:26 I don't believe there's little overlap. You know, look at Von Duprin devices and look at [indiscernible] whatever brand go market with, significant differences on the mechanical side, different [indiscernible] came out of San Francisco. I mean, there's just differences. I think there's also advantages, disadvantages, also out of scale, something we're not shy of. 45:00 A bigger electronic expense would may give us some advantage. I think when I look at the performance of [ourself] [ph] in 2021, I’m humbled and I would say, it's a strong reflection of the opportunity out there in the marketplace for approach.
Andrew Obin: 45:16 Yes, we can figure up, I was seeing more on the electronics side, but that makes a lot of sense. And another question, sort of, look you guys have been fairly conservative with the balance sheet usage, particularly on the technology side, you have a lot of, sort of things incubating inside, but the valuations out there are a lot more favorable than they were a year ago. How do you think about strategic opportunities post the sell-off, and I would imagine there are more sort of desperate buyers/sellers than they were a year ago? How does that look for you?
Dave Petratis: 45:51 So, I'd say, number one, on the software electronic seamless access side of this, our software stacks that support expanding access, capabilities to customers have never been stronger. We've invested through the pandemic and our ability to bring in visitor management and schools or capacity flow through a building or solving problems and verticals where there's multifamily K through 12, those software stacks are critical, and I believe we're in a leadership position. 46:32 Two is, the valuations are softening. We will be opportunistic on both. You've got to have one leg in the mechanical world and one foot at least in the seamless access world, and we're ready to deploy capital in both that in areas that extend our value proposition and advance our position and seamless access around K through 12 multifamily and hospitals, and we’ve never have been in a better position to do it Andrew.
Andrew Obin: 47:06 Great and congratulations to Patrick. Thanks a lot.
Operator: 47:10 The next question comes from Jeff Sprague from Vertical Research. Please go ahead.
Jeff Sprague: 47:17 Thank you. Good morning, everyone.
Dave Petratis: 47:19 Good morning.
Jeff Sprague: 47:21 Just kind of come back to price cost and also Dave your comment about, kind of glide back to prior peak. When you're talking about recovering inflations fully in 2022, is that kind of accumulative inflation burden that you've taken through this entire episode or are we just speaking about 2022 specifically? And really the nature of my question ties back to the glide path comment, you know your revenues here in 2022 look like there'll be 12% or 13% above 2020 and the margins are 100 bps below 2020, 100 bps below 2019. So, maybe you could just kind of bridge us a little bit more back to where you think you're [normally] [ph] heading here?
Patrick Shannon: 48:10 Yes. So, on the price cost dynamic, the commentary relative to 2022 is margin accretive, obviously. Pricing exceeding inflation cost. And then when you add productivity, we're in the positive territory there, margin accretive. If you look at it over a two-year basis, net positive, okay, but down on margin, and you understand obviously the math on this. You can offset inflation, but it's not enough to, kind of cover your normal margin profile. So, pressure there. 48:51 When I look forward to 2023, you've got continued growth in the business. So, you can have volume leverage there. Assuming inflation is normalized, we carryover a price improvement there, plus any incremental pricing improvements would be additive. And then, you just have the normal leverage on the business, plus business mix should be favorable as well. 49:18 So, kind of looking forward, past 2022, glide path to peak margin performance from an overall Allegion perspective, you heard Dave talk about the improvement in the international segment, leveraging corporate spend etcetera, I think it puts Allegion in a good position to be a peak margin performance, and hopefully by the end of 2023 and going into 2024.
Dave Petratis: 49:45 I'd add one other, as I think about pricing versus pre-pandemic, we are increasing product – pricing on our residential products and we'll make sure that we true that element of our portfolio as well.
Jeff Sprague: 50:03 And could you just speak to, I mean, obviously everyone is dealing with supply chain issues, but the key competitor does seem to be fairing a little bit better, is there any, kind of dis-slippage in, kind of distribution posture with key distributors or in retail, where you're kind of, for like a better term, I guess stocking out and kind of losing shelf space?
Dave Petratis: 50:32 I'd say, my reaction is no, not losing shelf space. I think, one is, when I think about ASSA, they would run with significantly more inventory Allegion versus ASSA. It's a different model, but if we would typically run with $400 million, $500 hundred worth of inventory, they are 4x or 5x bigger on that. So, you got to bigger math. They have to drive that on a global basis. 51:02 I think their electronics position is particularly driven by HID [indiscernible] advantage there. With that said, we worked extremely hard to adapt our supply chain. Again, I talked about the velocity we get through that supply chain in a normal time. We were hit by the electronics, investment casting some extrusion, the mechanical side easier for us to go in effect. The electronics as we think about our guide, allocations equal to the guide, if electronics improved, which I see some bricks. 51:42 We're going to sell more electronic [indiscernible] to be good for Allegion. As I think about lack of shelf space, Jeff, you know as well as I do. If you're – if the installer needs it today, and you can't provide that, it goes to the competition. And I'm confident we have faced some of that. I'm confident that we will regain whatever we lost.
Jeff Sprague: 52:09 Great. And maybe just one housekeeping question. Wages came up a couple of times. Can you just give us a sense of, kind of labor – direct labor as a percent of COGS or however you'd want to frame it for us just to have the perspective on that?
Patrick Shannon: 52:24 So, if you look at it relative to the gross profit, it's a low piece of the overall product manufacturing cost. Wage rates have increased here. We're competitive in the marketplace and so what you're seeing across the board, we would participate in that relative to the increases. I’m sure we're competitive and attracting and retaining good talent.
Dave Petratis : 52:50 I would just add, especially in the major sites, our goal is that, Allegion to be that shiny manufacturer on the hill, great benefits, great wages, great opportunity to develop, one of the safest workforces in the world, and a place where people can engage and grow.
Jeff Sprague: 53:08 Great. Thanks. Patrick, congratulations. Enjoy retirement. Mike, congrats.
Patrick Shannon: 53:13 Sure.
Tom Martineau: 53:14 Just a reminder, if we could just have one question and a very short follow-up if possible just to ensure we get everybody in.
Operator: 53:21 The next question comes from John Walsh from Credit Suisse. Please go ahead.
John Walsh: 53:27 Hi, good morning and congrats to Patrick and Mike both. I guess just for my one question here, as we think about the margins for the two segments and I appreciate we're not going to get, kind of quarterly detail here, but would you expect both of them to kind of lever at a normal type incremental back half of the year? Is there any kind of divergence between the two of them as we think about the margin growth opportunity for both segments in 2022? Thank you.
Dave Petratis: 54:06 Yes, I would say the international segment would be on a more normalized basis, and obviously didn't see the pressure that the Americas region in 2021. And so, your question is specific to the back half of the year. Americas would lever more than what you would normally see, again because of the price cost dynamic, becoming much more positive there, and the efficiencies from a manufacturing perspective as we work through some of these supply chain constraints. 54:38 Now, they will have much better leverage because productivity will be a lot better and then, kind of leveraging on the SG&A cost base. So, higher incrementals in the back half of the year, and you would expect that just kind of given the dynamics of where we are today.
John Walsh: 54:58 Great. I'll just leave it at the one question there. Appreciate it.
Operator: 55:03 The next question comes from Josh Chan from Baird. Please go ahead.
Josh Chan: 55:08 Good morning, Dave, Patrick, Tom. Best wishes Patrick in your retirement.
Patrick Shannon: 55:14 Thanks, Josh.
Josh Chan: 55:16 I guess my one question based on your comments about raw materials and steel maybe be coming down a little bit and your, kind of how costs flow through your P&L, when do you expect to, sort of hit peak raw material costs, if you will, prior to steal maybe benefiting you a bit later on?
Dave Petratis: 55:39 So, we're currently at peak costs right now. That will kind of carry forward into Q1, you know Q2 it starts to level off relative to prior year comparison, but just a quick reminder, even with the market costs being lower today than what it was well say in early to Q4, we don't see the benefit of that roll into our numbers, maybe 3 months to 6 months later, just kind of basis of how we manage our supply chain and entering into contracts with average prices and those type of things. 56:22 So, kind of like the pricing dynamic, there's always a lag relative to market. And so, would expect if they retain here some of that to flow through, we'll call it in Q3.
Josh Chan: 56:38 Great. And I appreciate the color and good luck in 2022.
Dave Petratis: 56:43 Thank you.
Operator: 56:44 The next question comes from Josh Pokrzywinski from Morgan Stanley. Please go ahead.
Josh Pokrzywinski: 56:50 Hi, good morning guys and congrats to Patrick and Mike both. Just maybe first question on the supply chain side, you guys had talked about a lot about chip shortage, but I guess, maybe just kind of zooming out the bulk of the portfolio really is mechanical versus electrified, like any other pieces of supply chain that are still, kind of jump [indiscernible] for 2022 that we should think about or will a lot of that throttling really be determined by chips?
Dave Petratis: 57:22 We have, what I would describe as more control over that mechanical supply chain have been able to move faster and to develop alternative sources wherever that could come from the world. Again, I'd say a lot of our U.S. mechanical supply chain is based [in region] [ph]. And again, the mitigating moves that we made, I think are substantially more operational execution than the chip side of it.
Josh Pokrzywinski: 58:00 Got it. And then just quick follow-up to want to make sure I heard you right, Patrick, on the return to prior peak margins. It was an exit rate for 2023, not a full-year comment? I know, it’s sort of silly like sitting here in early 2022, but just making sure I understood you right?
Patrick Shannon: 58:16 So, first of all, what I did mention is, exit rate 2022, kind of, if you kind of go back to, we'll call it more of a normalized margin profile, Q4 this year 2022 is going to look pretty good. So, feel good about that. As we progress throughout 2023, we could be back as a total company, Allegion peak margin. Again, a lot of inputs there and factors, kind of playing into that and things could change, but so if you were in a good trajectory for 2023 for peak margin for the full-year, Americas will still have some wood to chop, kind of get back to peak margins, but we're working at.
Dave Petratis: 59:04 I want to make one more comment to make sure I'm clear on the electronics side of this. The team, our engineering resources have done a great job adapting and developing second sources for electronic chips, particularly in some of our newest locks, those chips are in high demand in the external market. 59:31 So, things like our exit devices, those chips, maybe more options on the market than some of the things like the incurred plus that are right on the cutting edge.
Josh Pokrzywinski: 59:45 Appreciate it. Thanks.
Operator: 59:49 The next question comes from Chris Snyder from UBS. Please go ahead.
Chris Snyder: 59:54 Thank you. Actually just wanted to follow-up on those prior comments around chip procurement. Can you maybe talk where the company is in terms of sourcing alternative suppliers? And at this point, is the chip constraint more of a revenue headwind in that, you cannot get the chips or is it more of a margin headwind and that the chips can get from alternative suppliers are running at a higher cost?
Dave Petratis: 60:18 I would say, the chip constraints are our revenue headwind. If we could get more, we could some more. And I’m encouraging you take a look at our new [indiscernible] plus, it's the first touch to tap lock on the market. It's constraint. It's got some of the newest chip technologies, battery savings, energy savings, you like it, but it's constraint. 60:48 The second part of your question?
Chris Snyder: 60:53 I think that answered. I guess my follow-up question was actually, would be on pricing methodology. Obviously in the current market where availability matters more than price, you can push pretty hard, but how do you guys determine or how do you gauge like what's the sustainable level? How much can we put in Q1 2022 that that could sustain through 2022 because it sounds like the assumption is that availability across the supply chain improves throughout the year?
Dave Petratis: 61:21 I think in the [indiscernible] quote market, we're testing that market. We're testing that pricing every day. So, two price increases in 2021 in the commercial institutional, another coming out. So, we're raising list prices. We're making sure we're capturing our freight, but in the bid – in the quote bid order procurement phase of that, it’s been tested everyday by the marketplace, are you winning or losing and whether it's a bit of an auction market, but we're living that every day. On the residential side, we're going to be strong and stand-up from the inflationary forces that are impacting our products and not give away some of the furnished products on the [plan] [ph] in terms of residential security.
Patrick Shannon: 62:18 And, Chris, I'll just add to your question on the product redesign and alternative sourcing strategy, making really good progress. It impacts a lot of products throughout our product portfolio. The expectation is, the majority of it will be completed and executed by the end of the second quarter. 62:41 It’s kind of phased in throughout a little bit this quarter, most of it Q2, which will help us alleviate and start getting more product into the channel or customers, etcetera and higher growth rates organically. And so – and to start working down the backlog.
Chris Snyder: 63:03 Appreciate all the color. Thank you.
Operator: 63:06 The next question comes from Brian Ruttenbur from Imperial Capital. Please go ahead.
Brian Ruttenbur: 63:12 Yes. Just real quick. I had a number of questions. So, I'm going to hit you with, maybe the easiest one. The total price increases that you had in 2021, can you give us a range, was it on the low of 5% up to [20] [ph]? Can you give us a range on where prices went in 2021 and where you anticipate those to go in 2022, overall in terms of the ranges of price increases you had on your products?
Dave Petratis : 63:39 You know, I would say characterize it as a wide range, different product segments get different price increases, you know residential, non-residential is different. Even within non-nonresidential, our hollow metal door business for example has surcharges attached to it, which would be higher than it’s specific to steel, but list price increases maybe is what you're more at asking for. 64:07 I'd say, we're competitive with the market relative to the increases we've already announced and implemented in the market, and then another increase this month as well, pretty sizable, but remember, it's less price and as always discounts off a list price of the key item here is what you end up realizing and that number will continue to accelerate reaching a peak in Q3 of this year.
Brian Ruttenbur: 64:36 Okay. Just as a follow-up to clarify that, since you didn't mention any specific numbers, the market as I hear it is around 15% increases, is that the right markets that I'm hearing that you're talking about?
Dave Petratis: 64:50 I'd say, again, it depends what you're talking about. That to me sounds like there's a lot of surcharges baked into that number. That is not in aggregate, kind of the list price on your traditional mechanical electronic business.
Brian Ruttenbur: 65:08 Thank you.
Patrick Shannon: 65:09 So, let me – specifically with hollow metal steel doors, you could easily be in that zip code or more. But there's a wide range of SKUs here and we're in a – a lot of it's been [indiscernible] where we're competing every day, but prices are up.
Brian Ruttenbur: 65:33 Thank you.
Operator: 65:36 This concludes our question-and-answer session. I'd like to turn the conference back over to Dave Petratis for any closing remarks.
Dave Petratis: 65:46 To wrap up the main things you heard today, demand remains robust and leading indicators are positive. We're working through the supply chain challenges, which are expected to improve, but we still see some pressure in electronics. 66:01 We will get the price cost equation back to positive this year and we expect to deliver organic growth of 7% to 8.5%, adjusted EPS of 7% to 11%, and high cash conversion in 2022. The long term fundamentals of Allegion remains strong and we are well-positioned to capitalize on the opportunities and we’ll return to peak performance as conditions normalize. Thank you, and have a great day.
Operator: 66:30 The conference has now concluded. Thank you for attending today's presentation. You may now disconnect. | [
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"speaker": "Operator",
"text": "00:05 Good day and welcome to the Allegion’s Fourth Quarter 2021 Earnings Call. All participants will be in listen-only mode. [Operator Instructions] After today's presentation, there will be an opportunity to ask questions. Please note this event is being recorded. 00:24 I would now like to turn the conference over to Tom Martineau. Please go ahead."
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"speaker": "Tom Martineau",
"text": "00:29 Thank you, Jason. Good morning, everyone. Welcome and thank you for joining us for Allegion's fourth quarter and full-year 2021 earnings call. With me today are Dave Petratis, Chairman, President, and Chief Executive Officer; and Patrick Shannon, Senior Vice President, and Chief Financial Officer of Allegion. 00:48 Our earnings release, which was issued earlier this morning and the presentation, which we will refer to in today's call, are available on our website at investor.allegion.com. This call will be recorded and archived on our website. 01:02 Please go to Slides 2 and 3. Statements made in today's call that are not historical facts are considered forward-looking statements and are made pursuant to the Safe Harbor provisions of federal securities law. Please see our most recent SEC filings for a description of some of the factors that may cause actual results to differ materially from our projections. The company assumes no obligation to update these forward-looking statements. 01:28 Today's presentation and commentary includes non-GAAP financial measures. Please refer to the reconciliation in the financial tables of our press release for further details. Dave and Patrick will now discuss our fourth quarter and full-year 2021 results and provide an outlook for 2022, which will be followed by a Q&A session. 01:48 For the Q&A, we would like to ask each caller to limit themselves to one question and then re-enter the queue. We would like to give everyone an opportunity given the time allotted. 01:57 Now, I’d like to turn the call over to Dave."
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"speaker": "Dave Petratis",
"text": "02:00 Thanks, Tom. Good morning and thank you for joining us today. Please go to Slide number 4. Q4 was tough for Allegion and although we achieved the expected results, we discussed last quarter, I was disappointed that we were unable to fully meet the market opportunity presented. 02:22 The strength and demand, particularly in America’s non-residential end markets continued. And as I said last quarter, this trend began softly in Q1, accelerated in Q2, and continued throughout the back half of the year. 02:40 Leading indicators like specs written for Allegion America’s, ABI, and Dodge new construction indices, retail point of sales, and macroeconomic indicators in our Allegion International segment all remained positive. These indicators suggest continued strength in all end markets for the foreseeable future. 03:02 However, with supply chain challenges, we continue to experience difficulty converting that demand into revenue. Typically, we’d be able to gear up our supply base in short fashion, but the accelerated increase in demand occurred during an unprecedented time when suppliers where experiencing labor, raw material, transportation, and electronic component shortages creating tremendous global disruption. 03:32 What we typically resolve in a quarter is now taking much longer. We are making good progress on product redesigns and alternative sourcing, which should alleviate some of the supply chain pressure, but we do expect revenue to continue to be constrained in the near-term. 03:53 Even with the supply chain improvements we are making, it’s important to note that the pressures in electronic components are expected to continue throughout 2022. Looking at price versus cost, we continue to experience high inflationary impacts for material cost, labor, and freight. The pricing that we put in place last year is currently lagging inflation. That coupled with productivity challenges is a major contributor to margin declines in Q4. 04:25 We implemented additional price increases during the fourth quarter and have already announced another price increase for Q1 2022 that goes into effect this month. We are aggressively pursuing price across all products and in all channels to offset unprecedented inflation and expect price to exceed inflation in 2022. 04:52 I do want to highlight our Allegion International business, which had another good quarter and closed out a strong year. The segment delivered robust organic revenue growth and solid margin expansion in 2021. 05:09 Looking forward, the increased demand and supply chain shortages have led to record backlog in our American non-residential business and coupled with the progress we are making on redesigns and alternative sourcing, we expect solid revenue growth in 2022 and into 2023. 05:30 As supply chain pressures ease, operational efficiencies will improve, which along with accelerated pricing will allow us to expand margins in 2022 and exit the year on a glide path back to peak performance. 05:47 Now, let's turn to the quarter’s performance for more details. Please go to Slide 5. Revenue for the fourth quarter was 709 million, a decrease of 2.5%, compared to last year. Organic revenue declined 1.4%. The organic revenue decline in the quarter was driven by Allegion Americas, which experienced continued supply chain pressures that led to electronic and other component shortages. 06:17 Also embedded in the decline is a tough comparable to last year. During the fourth quarter of 2020, we had a large residential channel loading that was necessary to catch up from the shutdowns experienced earlier that year. The Americas volume declines more than [offset] [ph] the sequential improvements in price realization and the growth that the Allegion International segment delivered. Patrick will share more details on the business segments in a moment. 06:50 Adjusted operating margin decreased by 610 basis points in the fourth quarter. Continued inflationary pressures, productivity challenges, and volume de-leverage drove most of the decrease. Incremental investments for future growth cost 80 basis points of the decline. 07:10 Adjusted earnings per share of $1.11 decreased $0.38 or approximately 26% versus the prior year. Lower operating income was partially offset by favorable share count, year-over-year tax rate reduction, and other income. Available cash flow for the year came in at 443 million, which was flat to 2020. 07:36 Slightly lower adjusted earnings were offset by slightly lower capital expenditures. The cash flow impact of working capital was nearly neutral as well with increased inventory offset by other components of working capital. 07:52 As I think about the road ahead, I firmly believe our vision strategy and support of our seamless access is more relevant than ever. I also believe we have the right team and an engaged workforce that will respond to the challenges we face today. 08:09 We are bullish on construction and DIY markets for 2022 and continue to expect the IoT trends of electronic adoption and smart buildings to fuel growth for many years. Allegion’s future is bright and we will return to the peak performance and profitability that you expect. 08:30 Patrick will now walk you through the financial results and I'll be back to discuss our 2022 outlook."
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"speaker": "Patrick Shannon",
"text": "08:37 Thanks, Dave and good morning, everyone. Thank you for joining today's call. Please go to Slide number 6. This slide reflects our earnings per share reconciliation for the fourth quarter. 08:49 For the fourth quarter of 2020 reported earnings per share was $1.01, adjusting $0.48 for charges related to restructuring, M&A costs, impairments, as well as a loss on held for sale assets, the 2020 adjusted earnings per share was $1.49. 09:08 Favorable year-over-year tax rate and share count drove another $0.04 and $0.03 increase respectively. Interest and other income were slightly positive as were the impact of acquisitions and divestitures, both at $0.01 per share. 09:24 The story for the quarter is reflected in the operational results, which decreased earnings per share by $0.41. The inflation of productivity headwinds were predominantly driven from higher input costs, wage increases, and efficiencies from supply chain challenges and the bounce back of variable related costs, which were not as high in the prior year. 09:46 These added costs were partially offset by price. Pricing sequentially improved in the quarter and will continue to accelerate in 2022. Investment spending increased during the quarter and reduced earnings per share by $0.06 [when we] [ph] remain committed to investing in new product innovation and technology that will accelerate future growth and deliver solutions that enhance customer and end user experiences and connectivity. 10:15 This results in adjusted fourth quarter 2021 earnings per share of $1.11, a decrease of $0.38 or 25.5%, compared to the prior year. 10:25 Lastly, we have a $0.15 per share increase for the combination of a non-cash gain on a remeasurement of an Allegion Ventures investment offset by charges related to restructuring, M&A and debt refinancing. After giving effect to these items, you arrive at the fourth quarter of 2021 reported earnings per share of $1.26. 10:48 Please go to Slide number 7. This slide depicts the components of our revenue growth for the fourth quarter, as well as for the full-year of 2021. As indicated, we experienced a 1.4% organic revenue decline in the fourth quarter. Like Q3, the electronics and other component shortages, primarily in the Americas region, had an impact our ability to meet continued strong demand. 11:15 We achieved the highest quarter price realization in the year, which offset some of the volume decline. For the full-year, you can see that total revenue was up 5.4% with organic revenue growth of 4.5%. Both segments of the business delivered organic growth for the year with the international segment at 10.4% and Americas at 2.4%. 11:39 As mentioned, end-market demand increased considerably faster than we anticipated in 2021. And although we were able to deliver significantly more than our initial outlook, we were unable to meet the full market opportunity currently. However, our record backlogs will enable accelerated revenue in the future once the supply chain constraints are mitigated. 12:03 Please go to Slide number 8. Fourth quarter revenues for the Allegion Americas segment were 499.5 million, down 4.2% on a reported basis and 4.3% organically. The organic decline was driven by continued supply chain pressures for both mechanical and electronic products. 12:23 On the plus side, we did see sequential improvement in price and the Americas has announced another increase that goes into effect this month. We're driving price in all channels and products and our expectation is that pricing will exceed inflation in 2022. 12:40 The Americas non-residential business was up low single digits as strong price was offset by delayed volume, related to electronic allocations and other component shortages. These supply chain constraints paired with robust market demand, slowed the pace of revenue realization that led to historic levels of backlogs at the end of the year. 13:00 Americas residential was down mid-teens. Similar to last quarter and mentioned previously, the main drivers of the decrease are the prior year being inflated by channel refill coming out of the pandemic shutdowns experienced in Q2 2020, and the shortage of electronic components that primarily impact us in the DIY space of big box retail and e-commerce. 13:23 Electronics revenue was down low 20%, driven by continued shortages of electronic components in both the non-residential and residential businesses. The prior year residential channel refill also had an impact on year-over-year electronics performance. 13:39 Allegion Americas adjusted operating income of 105.5 million decreased 29% versus the prior year period and adjusted operating margin for the quarter was down 740 basis points. The decrease was driven by inflationary pressures, productivity challenges related to supply chain, and volume de-leverage. Incremental investments had a 90 basis points dilutive impact on adjusted markets. 14:05 Although margins were down significantly in the quarter, down 370 basis points for the full-year, margins will improve in 2022, compared with 2021 from increased price realization, volume leverage, and improved business mix. 14:21 Please go to Slide number 9. The Allegion International segment had another solid quarter. Fourth quarter revenues were 209.7 million, up 1.7% and up 5.8% on an organic basis. The organic growth was driven by strength in our global portable security business along with good price realization. Reported growth reflecting impacts at currency headwinds and divestitures. 14:48 Allegion International adjusted operating income of 29.4 million decreased 11.2% versus the prior year period. Adjusted operating margin for the quarter decreased by 200 basis points. The margin decrease was driven primarily by inflation exceeding price and productivity along with negative product mix, which more than offset the positive volume leverage. Incremental investments reduced margins by 50 basis points. 15:16 I would also note the full-year performance of the International segment, double-digit organic growth, and achievement of 11% operating margin. This was a record year for the segment and reflects a tremendous amount of effort and dedication by the entire team. 15:32 Please go to Slide number 10. Available cash flow for 2021 came in at 443 million, which is flat compared to the prior year period. The adjusted net earnings were slightly lower and was offset by slightly lower capital expenditures. In total, the working capital impact was near neutral with increased inventories offset by other components of working capital. 15:58 Looking at the working capital chart, it shows working capital as a percentage of revenues and the cash conversion cycle decreased based on a [4.25] [ph] average. 16:09 Last chart on the slide shows our net leverage. The net debt-to-EBITDA ratio increased from 1.5 last year to 1.7 this year. The increase in the ratio was driven primarily by reduced cash position from shareholder distributions for the year. 16:27 The business continues to generate strong cash flow and conversion of net earnings. We have a healthy balance sheet and we executed 542 million and shareholder distributions were 413 million in share repurchases and 129 million of dividends. We also recently announced a 14% increase in our dividend coming later in March. 16:51 During the quarter, we entered into a new 750 million unsecured credit agreement, consisting of a 250 million term facility, and a 500 million revolving facility. We obtained a rating upgrade with Moody's and a move to positive outlook by Fitch. Our capital structure is an asset of the company and we continue to execute on our balanced capital allocation strategy that will deploy capital through incremental, high returning organic investments, CapEx, M&A, or shareholder distributions. 17:25 I’ll now hand it back over to Dave for some comments on 2022."
},
{
"speaker": "Dave Petratis",
"text": "17:29 Thank you, Patrick. Please go to Slide 11. Before I get into our outlook for the year, I want to highlight actions we are taking to mitigate constraints and drive growth and profitability in 2022. 17:47 Our expectation is to fully cover inflation with price. We are in the midst of executing aggressive pricing actions across the globe in all product categories and all channels. We will remain vigilant during the year and we will not hesitate to pull the pricing lever if inflation headwinds increase further. 18:12 With regard to timing, we expect net margin pressures during the first half with the price versus cost dynamic improving sequentially throughout the year and turning positive in the middle of the year. 18:26 Our product redesigned and alternative sourcing work is expected to be completed by the end of Q2. This will help alleviate the supply chain pressures related to our mechanical business and provide access to additional electronic component solutions. However, electronic chip allocations will continue to be choppy throughout the year. As the supply chain normalizes, we will continuously improve our lead times and reduce our record backlog. 18:58 Our greatest strength lies in the people of Allegion. With broad tightness in the labor market, we are protecting our labor pipeline. We have implemented pay increases and are not flexing labor to the degree we normally would. This is operationally inefficient in the short-term, but when supply chains pressure ease, we want to be sure we have the labor in place to move product out of the factories and reduce backlogs. 19:30 We expect return to margin expansion this year. Second half margins are anticipated to perform stronger than first half, and we will exit the year on a path back to peak margin performance. We continue to invest in R&D and software development that progresses our seamless access strategy and to build critical talent capabilities and innovation. 19:55 Please go to Slide 12. For the 2022 outlook on revenue, the Americas is expected to strengthen our non-residential businesses with the continued recovery in those end markets, particularly education, healthcare, and commercial. All leading indicators are positive and the level of institutional specification for our business had continued to be strong. 20:22 Residential indicators are positive as well and we expect that business have continued growing in 2022. The under supply of single family homes continues to be corrected and the builder channel and retail point of sale has been strong for quite some time. Electronic and smart home adoption continues to be long-term growth drivers. 20:48 As underscored earlier, we are aggressively pursuing pricing in all channels, products in the Americas, and around the globe. Given the supply chain challenges that persist, we expect the revenue performance to be better in the second half than in the first, but still project organic revenue growth in all quarters. 21:09 With the strength in non-residential constructions, continued growth in residential, our expectation for electronic chip allocation and redesign work to ease supply chain pressures, we project total organic revenue in the Americas to be up 8.5% to 10% in 2022. 21:29 In the Allegion International segment, we expect growth, but we are starting to see some electronic supply chain issues in that region as well. Currency headwinds are projected to offset organic growth. 21:44 For Allegion International, we project total revenue to be in the minus 1% to plus 1% range with organic growth of 3% to 5%. All in for Allegion, we are projecting total revenue to be up 6% to 7.5% and organic revenue growth of 7% to 8.5%. Our 2022 outlook for adjusted earnings per share is $5.55 to $5.75. Timing [warrants] [ph], we expect to realize approximately 60% of the adjusted EPS in the second half of the year. 22:24 As indicated, adjusted operational earnings are expected to increase 14% to 18% driven by volume leverage and price exceeding inflation. Incremental investments continue to be a priority as we remain focused on accelerating electronics and seamless access growth in support of our vision and strategy. These incremental investments predominantly relate to added R&D and engineering to further develop, enhance, and accelerate new product development and software capabilities. 23:01 The combination of interest and other expenses is expected to be a headwind as some of the more favorable items that we experienced in 2021 are non-recurring. Our outlook assumes a full-year adjusted effective tax rate of approximately 13%. It also assumes outstanding weighted average diluted shares of approximately 88 million. 23:23 The outlook additionally includes approximately $0.05 per share for restructuring charges during the year. As a result, reporting EPS is projected to be $5.50 to $5.70. We are expecting our available cash flow for 2022 to be in the $465 million to $485 million range. 23:45 Please go to Slide 13. In summary, end market demand remains strong in the fourth quarter and we expect that to continue. The supply chain issues we are experiencing have hindered our ability to meet that demand, and as a result, we have built record backlogs that will support growth in 2022 and 2023. 24:10 The product redesigns and alternative sourcing should begin to alleviate some of the supply chain pressures by mid-year, primarily on the mechanical side of the business. We are projecting solid organic revenue growth of 7% to 805% in 2022, even with the expectation that chip allocations will continue to be tight. 24:33 We expect year-over-year growth in electronics and acceleration in that growth throughout the year. We are aggressively going after price across the globe and in all products and channels. For the calendar year, pricing will exceed inflation. This will help Allegion to deliver margin improvement, which we expect will progress as we go throughout the year. 24:58 Please go to Slide 14. A final note on some key leadership announcements before we move into Q&A. Mike Wagnes, who leads the Commercial Americas strategic business unit will be transitioning to the role of Chief Financial Officer on March 1. He succeeds Patrick Shannon, who will be retiring later this year. 25:22 As CFO, Mike brings significant financial experience and a deep understanding of our global business in the markets we serve. He has been with Allegion for 15 years and many of you know him from his time as Treasurer and leading Investor Relations. The Board of Directors and I have the utmost confident that he is the right person to step into this important role. 25:46 Dave Ilardi has been promoted to Senior Vice President of the Americas Segment effective March 1. Dave currently leads Allegion Home and is responsible for the flagship Schlage portfolio of residential solutions. He been at the company for 20 years and is highly respected, an industry veteran with extensive knowledge of our customers, channel partners, and vertical markets. We are thrilled to welcome him to the senior leadership team. 26:16 Allegion is equally fortunate to have a strong bench of talented leaders throughout the globe. They are well prepared to execute on our strategy and capitalize on growth opportunities as we emerge from the pandemic. And I want to thank our entire team for their commitment and dedication. 26:34 Last, a few remarks for Patrick Shannon. It has been a privilege to work alongside Patrick, who has been a partner, a friend for me, and an outstanding business leader. And as a family member of the leadership team, Patrick has been instrumental in refreshing our business strategy, building a world-class finance organization, and creating a strong foundation that will serve us well in the years ahead. I speak for all of the employees of Allegion, when I say that it has been an honor and a pleasure to [serve with] [ph] Patrick Shannon. 27:11 We'll now take your questions."
},
{
"speaker": "Operator",
"text": "27:14 [Operator Instructions] Our first question comes from [Brett Lindsay] [ph] from [indiscernible]. Please go ahead."
},
{
"speaker": "Unidentified Analyst",
"text": "27:41 Hi, good morning all and congrats to Patrick."
},
{
"speaker": "Patrick Shannon",
"text": "27:44 Thank you."
},
{
"speaker": "Unidentified Analyst",
"text": "27:45 Good. A strong outlook overall. I'm just curious what level of price are you expecting within the guide for the full-year? And any directional color you can give us between how you're thinking about the residential and non-residential piece within the Americas business for 2022?"
},
{
"speaker": "Patrick Shannon",
"text": "28:05 Yes. So, I would characterize as you look at price, again, good sequential improvement in Q4 of 2021. You will see continued improvement as we progress throughout 2022, both on the non-residential and residential side of business. It is a large component of our overall revenue growth kind of reaching a peak, if you will, in terms of price realization in Q3 as we realize the full implementation of all the price increases, including both list prices and surcharges on certain products. 28:43 So, a big part of the revenue growth and if you, kind of look at it relative to non-res, res, the non-resi in terms of our guide, full-year revenue growth, you'd be looking at the high-end, kind of low-double-digits, residential mid-single digit type of growth for 2022."
},
{
"speaker": "Unidentified Analyst",
"text": "29:09 Okay, great. And then just to come back to the electronics, you noted growth year-over-year on a full-year basis, I'm just curious, what's the pacing look like through the year? Is it really Q3 until that turns positive again or does it happen earlier? Just curious what’s your planning processes looks like there?"
},
{
"speaker": "Dave Petratis",
"text": "29:28 We've spent a lot of time looking at electronic chip and component allocations. And as you think about our guide, it will be – it will improve sequentially quarter-to-quarter in terms of the flow of electronic blocks and be strongest in the second half and as we move into 2023."
},
{
"speaker": "Unidentified Analyst",
"text": "29:50 Okay, great. I'll pass it along. Thanks."
},
{
"speaker": "Dave Petratis",
"text": "29:52 Thank you."
},
{
"speaker": "Operator",
"text": "29:54 The next question comes from Julian Mitchell from Barclays. Please go ahead."
},
{
"speaker": "Julian Mitchell",
"text": "29:59 Hi, good morning and thanks for all the help Patrick and wish you all the best. In terms of – my question would be around the underperformance of, sort of the volumes Allegion in the Americas relative to some of its biggest peers, that's clearly been a point of focus for investors for a few months now. So just wondered what you thought the main factors were behind that seeming share loss, particularly from a non-resi side, if it’s simply a difference in kind of procurement and sourcing strategies? And is there anything else perhaps doing on more on the commercial or customer facing front as well?"
},
{
"speaker": "Dave Petratis",
"text": "30:46 I think you've got to call our second half as of is. Number 1, markets are incredibly strong. Number 2, our loss in opportunity by the company, because of supply chain difficulties. Our supply chains tend to be in region. They perform incredibly well giving high inventory turnover, high return on invested capital when they're working well. 31:16 The pandemic, especially as we move through 2022 was severely impacted by chips and labor shortages that affected our very complex supply chain within region. And when I say complex, you've heard me say Julian, complexity is our friend at Allegion, but when you throw that – those challenges in supply chain, you're really working a variety of issues, which I'd say stabilized as we ended December and will get sequentially better as we go on. 31:57 I would also say, some of the moves that we made pre-pandemic to vertically integrate actually helped us. And I think, I'm confident that we'll get the mechanical side of the Americas business straighten out its things like investing, investment capping that make the Von Duprin exit device what it is. And as we move through the year, the pacing item will be electronics. 32:30 We build our plan based on the allocations that we believe that we will get, and I believe in the electronics, the supply chain disruptions there have pulled demand forward and will benefit in the secondary markets that will help us exceed our plan in 2022, if that in fact impacts. So, a lot into that answer. I hope that gives you some color."
},
{
"speaker": "Patrick Shannon",
"text": "33:00 Julian, I would also just add real quickly, when you look at, kind of the order activity on non-res, really strong, we're kind of giving indication, maybe similar what we're seeing from our peer set, just this inability to be able to ship and realize of revenue. So, we'll call it, kind of differed or delayed revenue, it will come. They’re definitive orders. We're not seeing any cancellations. And that's why we're going to anticipate 2022 to have accelerated revenues we progress throughout the course of the year with the resolution of some of these supply chain difficulties. 33:40 The other thing is, on the residential side, keep in mind, we got a large channel load last year that's impacting negatively the comparisons year-over-year. So that has kind of the distortion. I mean, if you look at it on a two-year stack basis, it's not as pronounced as what you saw perhaps in Q4 2021. So, just kind of keep those things in mind if you would."
},
{
"speaker": "Julian Mitchell",
"text": "34:08 Thanks a lot. That's very helpful. And then just one very quick follow-up. Just [on kind of] [ph] final point on the, sort of the price volume split within the organic sales guide for total company 2022, is this the sort of rough assumption that the organic sales growth is split sort of 50/50 price and volume?"
},
{
"speaker": "Patrick Shannon",
"text": "34:28 Yes, I'd say that's pretty much in the ballpark. Again, we're going to push the price lever and because right now, as the numbers would indicate, underwater relative to the inflation we've seen, but I think that's a decent assumption."
},
{
"speaker": "Julian Mitchell",
"text": "34:49 Great. Thank you."
},
{
"speaker": "Operator",
"text": "34:52 The next question comes from Joe O'Dea from Wells Fargo. Please go ahead."
},
{
"speaker": "Joe O'Dea",
"text": "34:57 Hi, good morning. First, just a cadence question. You gave some helpful details in terms of how you're thinking about the back half of the year, but I think with the fluidity of the current environment, just anything that you're able to talk about in terms of the first half? I think, first quarter EPS tends to be maybe a high teens percentage of the full-year. Just trying to understand based on the visibility you have on supply chain, what kind of progression we should be thinking about, kind of as we go first quarter and the second quarter if you're able to talk about that?"
},
{
"speaker": "Patrick Shannon",
"text": "35:31 I think, we gave you a [nugget] [ph] there, 60% of the EPS will be in the second half of the year. Second, you know you think about the labor ramp up that I think is happening for us [Technical Difficulty] see people are coming back to work, back into the factories, that momentum is important for us to drive the supply chain to meet this, you know the demand and backlog that we've got to drive through. 36:03 The second would be chip supplies, sequentially they'll get better quarter-to-quarter and it leads to that back half being stronger."
},
{
"speaker": "Dave Petratis",
"text": "36:12 I would just add, seasonally, Q1 normally our weakest quarter from a revenue perspective and earnings. The year-over-year decline in margin not as pronounced. Obviously is what you saw in Q4, but yet margin down relative to Q4 just from a seasonal perspective, that's kind of normal course of business, but as we progress throughout the course of the year, the price cost dynamic, you will see continuous improvement beginning in Q1, relative to Q4, and that will progress throughout the course of the year, as we get more price realization and our assumption is, on inflation that, we've kind of plateaued where we are and actually steel is, if you kind of look at on a [cold role] [ph] per ton basis has come down a little bit, maybe a little opportunity there. But margin expansion really back-end loaded where that price cost dynamic becomes very favorable. 37:20 And obviously, we have easier comps, back half of this year, compared to 2021. So, that's kind of how we see it playing out sequentially."
},
{
"speaker": "Joe O'Dea",
"text": "37:32 I appreciate that. And then I wanted to ask about some of the commentary 2022, but also constructive on 2023 in terms of the conversations that you're having with customers and the amount of backlog that's even scheduled for 2023, but you can just expand on that a little bit in terms of, kind of what you're seeing to help kind of build what would be, kind of a two year constructive outlook on improving demand?"
},
{
"speaker": "Patrick Shannon",
"text": "38:03 So, we certainly filtered through the macroeconomic indicators, which we feel all positive all levels. I think as you travel around the country, you see the strength in construction markets. You've got stimulus coming from the top, you also are working through the backlog of work that was disrupted by the pandemic. So, as I think about [K through 12] [ph] hospitals, multi-family, and the overall res, which drives expansion, I feel very good about the next couple of years."
},
{
"speaker": "Dave Petratis",
"text": "38:47 I would also add, we've talked about this record backlog, both on the mechanical electronics, we’ll have an opportunity to work through a lot of the mechanical backlog in 2022. There's still going to be an overhang, if you will, or excess elevated backlog associated with electronic products going into 2023. And so, with that backdrop and their continued strength and market demand, would expect 2023 to be – have a pretty robust organic revenue growth as well for the Americas region on non-res and really good electronics growth year-over-year. So, would expect that to, kind of continue on, compared to 2022."
},
{
"speaker": "Joe O'Dea",
"text": "39:35 Thank you."
},
{
"speaker": "Operator",
"text": "39:37 The next question comes from David MacGregor from Longbow. Please go ahead."
},
{
"speaker": "David MacGregor",
"text": "39:43 Good morning, everyone. Just a couple of quick ones, maybe Dave, you could talk about the backlogs and in the past, you've indicated a disinclination to want to put through pricing on backlogs as you protect some of the spec business that you've [booked] [ph]. I'm just wondering if that's changing now as you think about becoming more aggressive on pricing into 2022? And then obviously great results from Europe under some pretty difficult circumstances there as well, clearly Tim and his team are executing well there. Can you just talk about one of the biggest pieces of the 2022, 2023 margin progression opportunity in Europe? Thank you."
},
{
"speaker": "Dave Petratis",
"text": "40:20 So, I'll talk about international first. I think Tim, our Allegion Home, Europe, SimonsVoss, Interflex, the [Australian business] [ph], great focus of execution in 2021 in the phase of the pandemic. The consolidation that we drove a year ago and announced in combining that did a couple of things. One, simplify their structure. We cleaned up some bits of the portfolio, but Tim's knowledge of the capabilities of America accelerated capabilities that we have here into those markets. It's things like diligence. 41:02 It's things like our electronic software platforms and a belief that some of that product platforms that we're having advanced development can be extended and help us compete. So, I think, when I think about Allegion International that we pulled that off in a pandemic year, is some work that's been going on at Allegion for a couple of years, and it came to our head, and I think our best days are ahead of us. 41:31 I think, in terms of margin expansion, I think the long-term goal would be to be a margin equal or better than [ASSA] in the competitive markets. We're not apples to apples in terms of how we compete, extremely strong in the electronics and then you get more into the regional market forces and what those markets allow where we're competing. 41:59 The second part of the question was?"
},
{
"speaker": "Patrick Shannon",
"text": "42:00 Yes. So, David, on the pricing associated with the backlog, keep in mind, industry standard normally when you give a quote, on a project based job or and/or you have an order in-house prior to the price going into effect, you kind of honor that. 42:24 So, normally, there's a time lag between when you announce a price increase and the realization and that could be, we'll call it on average, 90 days to 120 days type of time timeframe. And so, that's why relative to the price increases, we've already implemented and are executing. You don't get to a full run rate realization that we'll call at Q3, but normally you don't go back and reprice quotes and backlog. 42:55 Okay. That's a consistency, kind of in our industry. Now, we have looked at other parts of the business and doing that, but predominantly it’s protected."
},
{
"speaker": "David MacGregor",
"text": "43:09 Is there any way you can update that 80 million to 100 million of backlog number that you gave us last quarter, just to indicate where you think that is today?"
},
{
"speaker": "Patrick Shannon",
"text": "43:16 So, it exceeded or increased compared to Q3, just kind of given the surge and order activity. Now, some of that and it's difficult to characterize would be a pull forward from 2022 activity when customers are just trying to get to orders at and get in-line for the products, but increased and I would say, if you're, kind of looking at the full-year revenue impact on Allegion north of 100 million would be how to think about it."
},
{
"speaker": "David MacGregor",
"text": "43:53 Thanks very much, gentlemen."
},
{
"speaker": "Patrick Shannon",
"text": "43:55 Thank you."
},
{
"speaker": "Operator",
"text": "43:56 The next question comes from Andrew Obin from Bank of America. Please go ahead."
},
{
"speaker": "Andrew Obin",
"text": "44:02 Good morning."
},
{
"speaker": "Dave Petratis",
"text": "44:03 Good morning."
},
{
"speaker": "Andrew Obin",
"text": "44:04 Hey, guys. Just trying to understand how much overlap is there between your supply chain and the supply chain of your competitors? i.e. just sort of ability to compensate for the fact that it sounds you underestimated the strength of the demand and sort of catch up when the competitors already have sort of slots [on the line] [ph] or is that not an issue?"
},
{
"speaker": "Patrick Shannon",
"text": "44:26 I don't believe there's little overlap. You know, look at Von Duprin devices and look at [indiscernible] whatever brand go market with, significant differences on the mechanical side, different [indiscernible] came out of San Francisco. I mean, there's just differences. I think there's also advantages, disadvantages, also out of scale, something we're not shy of. 45:00 A bigger electronic expense would may give us some advantage. I think when I look at the performance of [ourself] [ph] in 2021, I’m humbled and I would say, it's a strong reflection of the opportunity out there in the marketplace for approach."
},
{
"speaker": "Andrew Obin",
"text": "45:16 Yes, we can figure up, I was seeing more on the electronics side, but that makes a lot of sense. And another question, sort of, look you guys have been fairly conservative with the balance sheet usage, particularly on the technology side, you have a lot of, sort of things incubating inside, but the valuations out there are a lot more favorable than they were a year ago. How do you think about strategic opportunities post the sell-off, and I would imagine there are more sort of desperate buyers/sellers than they were a year ago? How does that look for you?"
},
{
"speaker": "Dave Petratis",
"text": "45:51 So, I'd say, number one, on the software electronic seamless access side of this, our software stacks that support expanding access, capabilities to customers have never been stronger. We've invested through the pandemic and our ability to bring in visitor management and schools or capacity flow through a building or solving problems and verticals where there's multifamily K through 12, those software stacks are critical, and I believe we're in a leadership position. 46:32 Two is, the valuations are softening. We will be opportunistic on both. You've got to have one leg in the mechanical world and one foot at least in the seamless access world, and we're ready to deploy capital in both that in areas that extend our value proposition and advance our position and seamless access around K through 12 multifamily and hospitals, and we’ve never have been in a better position to do it Andrew."
},
{
"speaker": "Andrew Obin",
"text": "47:06 Great and congratulations to Patrick. Thanks a lot."
},
{
"speaker": "Operator",
"text": "47:10 The next question comes from Jeff Sprague from Vertical Research. Please go ahead."
},
{
"speaker": "Jeff Sprague",
"text": "47:17 Thank you. Good morning, everyone."
},
{
"speaker": "Dave Petratis",
"text": "47:19 Good morning."
},
{
"speaker": "Jeff Sprague",
"text": "47:21 Just kind of come back to price cost and also Dave your comment about, kind of glide back to prior peak. When you're talking about recovering inflations fully in 2022, is that kind of accumulative inflation burden that you've taken through this entire episode or are we just speaking about 2022 specifically? And really the nature of my question ties back to the glide path comment, you know your revenues here in 2022 look like there'll be 12% or 13% above 2020 and the margins are 100 bps below 2020, 100 bps below 2019. So, maybe you could just kind of bridge us a little bit more back to where you think you're [normally] [ph] heading here?"
},
{
"speaker": "Patrick Shannon",
"text": "48:10 Yes. So, on the price cost dynamic, the commentary relative to 2022 is margin accretive, obviously. Pricing exceeding inflation cost. And then when you add productivity, we're in the positive territory there, margin accretive. If you look at it over a two-year basis, net positive, okay, but down on margin, and you understand obviously the math on this. You can offset inflation, but it's not enough to, kind of cover your normal margin profile. So, pressure there. 48:51 When I look forward to 2023, you've got continued growth in the business. So, you can have volume leverage there. Assuming inflation is normalized, we carryover a price improvement there, plus any incremental pricing improvements would be additive. And then, you just have the normal leverage on the business, plus business mix should be favorable as well. 49:18 So, kind of looking forward, past 2022, glide path to peak margin performance from an overall Allegion perspective, you heard Dave talk about the improvement in the international segment, leveraging corporate spend etcetera, I think it puts Allegion in a good position to be a peak margin performance, and hopefully by the end of 2023 and going into 2024."
},
{
"speaker": "Dave Petratis",
"text": "49:45 I'd add one other, as I think about pricing versus pre-pandemic, we are increasing product – pricing on our residential products and we'll make sure that we true that element of our portfolio as well."
},
{
"speaker": "Jeff Sprague",
"text": "50:03 And could you just speak to, I mean, obviously everyone is dealing with supply chain issues, but the key competitor does seem to be fairing a little bit better, is there any, kind of dis-slippage in, kind of distribution posture with key distributors or in retail, where you're kind of, for like a better term, I guess stocking out and kind of losing shelf space?"
},
{
"speaker": "Dave Petratis",
"text": "50:32 I'd say, my reaction is no, not losing shelf space. I think, one is, when I think about ASSA, they would run with significantly more inventory Allegion versus ASSA. It's a different model, but if we would typically run with $400 million, $500 hundred worth of inventory, they are 4x or 5x bigger on that. So, you got to bigger math. They have to drive that on a global basis. 51:02 I think their electronics position is particularly driven by HID [indiscernible] advantage there. With that said, we worked extremely hard to adapt our supply chain. Again, I talked about the velocity we get through that supply chain in a normal time. We were hit by the electronics, investment casting some extrusion, the mechanical side easier for us to go in effect. The electronics as we think about our guide, allocations equal to the guide, if electronics improved, which I see some bricks. 51:42 We're going to sell more electronic [indiscernible] to be good for Allegion. As I think about lack of shelf space, Jeff, you know as well as I do. If you're – if the installer needs it today, and you can't provide that, it goes to the competition. And I'm confident we have faced some of that. I'm confident that we will regain whatever we lost."
},
{
"speaker": "Jeff Sprague",
"text": "52:09 Great. And maybe just one housekeeping question. Wages came up a couple of times. Can you just give us a sense of, kind of labor – direct labor as a percent of COGS or however you'd want to frame it for us just to have the perspective on that?"
},
{
"speaker": "Patrick Shannon",
"text": "52:24 So, if you look at it relative to the gross profit, it's a low piece of the overall product manufacturing cost. Wage rates have increased here. We're competitive in the marketplace and so what you're seeing across the board, we would participate in that relative to the increases. I’m sure we're competitive and attracting and retaining good talent."
},
{
"speaker": "Dave Petratis",
"text": "52:50 I would just add, especially in the major sites, our goal is that, Allegion to be that shiny manufacturer on the hill, great benefits, great wages, great opportunity to develop, one of the safest workforces in the world, and a place where people can engage and grow."
},
{
"speaker": "Jeff Sprague",
"text": "53:08 Great. Thanks. Patrick, congratulations. Enjoy retirement. Mike, congrats."
},
{
"speaker": "Patrick Shannon",
"text": "53:13 Sure."
},
{
"speaker": "Tom Martineau",
"text": "53:14 Just a reminder, if we could just have one question and a very short follow-up if possible just to ensure we get everybody in."
},
{
"speaker": "Operator",
"text": "53:21 The next question comes from John Walsh from Credit Suisse. Please go ahead."
},
{
"speaker": "John Walsh",
"text": "53:27 Hi, good morning and congrats to Patrick and Mike both. I guess just for my one question here, as we think about the margins for the two segments and I appreciate we're not going to get, kind of quarterly detail here, but would you expect both of them to kind of lever at a normal type incremental back half of the year? Is there any kind of divergence between the two of them as we think about the margin growth opportunity for both segments in 2022? Thank you."
},
{
"speaker": "Dave Petratis",
"text": "54:06 Yes, I would say the international segment would be on a more normalized basis, and obviously didn't see the pressure that the Americas region in 2021. And so, your question is specific to the back half of the year. Americas would lever more than what you would normally see, again because of the price cost dynamic, becoming much more positive there, and the efficiencies from a manufacturing perspective as we work through some of these supply chain constraints. 54:38 Now, they will have much better leverage because productivity will be a lot better and then, kind of leveraging on the SG&A cost base. So, higher incrementals in the back half of the year, and you would expect that just kind of given the dynamics of where we are today."
},
{
"speaker": "John Walsh",
"text": "54:58 Great. I'll just leave it at the one question there. Appreciate it."
},
{
"speaker": "Operator",
"text": "55:03 The next question comes from Josh Chan from Baird. Please go ahead."
},
{
"speaker": "Josh Chan",
"text": "55:08 Good morning, Dave, Patrick, Tom. Best wishes Patrick in your retirement."
},
{
"speaker": "Patrick Shannon",
"text": "55:14 Thanks, Josh."
},
{
"speaker": "Josh Chan",
"text": "55:16 I guess my one question based on your comments about raw materials and steel maybe be coming down a little bit and your, kind of how costs flow through your P&L, when do you expect to, sort of hit peak raw material costs, if you will, prior to steal maybe benefiting you a bit later on?"
},
{
"speaker": "Dave Petratis",
"text": "55:39 So, we're currently at peak costs right now. That will kind of carry forward into Q1, you know Q2 it starts to level off relative to prior year comparison, but just a quick reminder, even with the market costs being lower today than what it was well say in early to Q4, we don't see the benefit of that roll into our numbers, maybe 3 months to 6 months later, just kind of basis of how we manage our supply chain and entering into contracts with average prices and those type of things. 56:22 So, kind of like the pricing dynamic, there's always a lag relative to market. And so, would expect if they retain here some of that to flow through, we'll call it in Q3."
},
{
"speaker": "Josh Chan",
"text": "56:38 Great. And I appreciate the color and good luck in 2022."
},
{
"speaker": "Dave Petratis",
"text": "56:43 Thank you."
},
{
"speaker": "Operator",
"text": "56:44 The next question comes from Josh Pokrzywinski from Morgan Stanley. Please go ahead."
},
{
"speaker": "Josh Pokrzywinski",
"text": "56:50 Hi, good morning guys and congrats to Patrick and Mike both. Just maybe first question on the supply chain side, you guys had talked about a lot about chip shortage, but I guess, maybe just kind of zooming out the bulk of the portfolio really is mechanical versus electrified, like any other pieces of supply chain that are still, kind of jump [indiscernible] for 2022 that we should think about or will a lot of that throttling really be determined by chips?"
},
{
"speaker": "Dave Petratis",
"text": "57:22 We have, what I would describe as more control over that mechanical supply chain have been able to move faster and to develop alternative sources wherever that could come from the world. Again, I'd say a lot of our U.S. mechanical supply chain is based [in region] [ph]. And again, the mitigating moves that we made, I think are substantially more operational execution than the chip side of it."
},
{
"speaker": "Josh Pokrzywinski",
"text": "58:00 Got it. And then just quick follow-up to want to make sure I heard you right, Patrick, on the return to prior peak margins. It was an exit rate for 2023, not a full-year comment? I know, it’s sort of silly like sitting here in early 2022, but just making sure I understood you right?"
},
{
"speaker": "Patrick Shannon",
"text": "58:16 So, first of all, what I did mention is, exit rate 2022, kind of, if you kind of go back to, we'll call it more of a normalized margin profile, Q4 this year 2022 is going to look pretty good. So, feel good about that. As we progress throughout 2023, we could be back as a total company, Allegion peak margin. Again, a lot of inputs there and factors, kind of playing into that and things could change, but so if you were in a good trajectory for 2023 for peak margin for the full-year, Americas will still have some wood to chop, kind of get back to peak margins, but we're working at."
},
{
"speaker": "Dave Petratis",
"text": "59:04 I want to make one more comment to make sure I'm clear on the electronics side of this. The team, our engineering resources have done a great job adapting and developing second sources for electronic chips, particularly in some of our newest locks, those chips are in high demand in the external market. 59:31 So, things like our exit devices, those chips, maybe more options on the market than some of the things like the incurred plus that are right on the cutting edge."
},
{
"speaker": "Josh Pokrzywinski",
"text": "59:45 Appreciate it. Thanks."
},
{
"speaker": "Operator",
"text": "59:49 The next question comes from Chris Snyder from UBS. Please go ahead."
},
{
"speaker": "Chris Snyder",
"text": "59:54 Thank you. Actually just wanted to follow-up on those prior comments around chip procurement. Can you maybe talk where the company is in terms of sourcing alternative suppliers? And at this point, is the chip constraint more of a revenue headwind in that, you cannot get the chips or is it more of a margin headwind and that the chips can get from alternative suppliers are running at a higher cost?"
},
{
"speaker": "Dave Petratis",
"text": "60:18 I would say, the chip constraints are our revenue headwind. If we could get more, we could some more. And I’m encouraging you take a look at our new [indiscernible] plus, it's the first touch to tap lock on the market. It's constraint. It's got some of the newest chip technologies, battery savings, energy savings, you like it, but it's constraint. 60:48 The second part of your question?"
},
{
"speaker": "Chris Snyder",
"text": "60:53 I think that answered. I guess my follow-up question was actually, would be on pricing methodology. Obviously in the current market where availability matters more than price, you can push pretty hard, but how do you guys determine or how do you gauge like what's the sustainable level? How much can we put in Q1 2022 that that could sustain through 2022 because it sounds like the assumption is that availability across the supply chain improves throughout the year?"
},
{
"speaker": "Dave Petratis",
"text": "61:21 I think in the [indiscernible] quote market, we're testing that market. We're testing that pricing every day. So, two price increases in 2021 in the commercial institutional, another coming out. So, we're raising list prices. We're making sure we're capturing our freight, but in the bid – in the quote bid order procurement phase of that, it’s been tested everyday by the marketplace, are you winning or losing and whether it's a bit of an auction market, but we're living that every day. On the residential side, we're going to be strong and stand-up from the inflationary forces that are impacting our products and not give away some of the furnished products on the [plan] [ph] in terms of residential security."
},
{
"speaker": "Patrick Shannon",
"text": "62:18 And, Chris, I'll just add to your question on the product redesign and alternative sourcing strategy, making really good progress. It impacts a lot of products throughout our product portfolio. The expectation is, the majority of it will be completed and executed by the end of the second quarter. 62:41 It’s kind of phased in throughout a little bit this quarter, most of it Q2, which will help us alleviate and start getting more product into the channel or customers, etcetera and higher growth rates organically. And so – and to start working down the backlog."
},
{
"speaker": "Chris Snyder",
"text": "63:03 Appreciate all the color. Thank you."
},
{
"speaker": "Operator",
"text": "63:06 The next question comes from Brian Ruttenbur from Imperial Capital. Please go ahead."
},
{
"speaker": "Brian Ruttenbur",
"text": "63:12 Yes. Just real quick. I had a number of questions. So, I'm going to hit you with, maybe the easiest one. The total price increases that you had in 2021, can you give us a range, was it on the low of 5% up to [20] [ph]? Can you give us a range on where prices went in 2021 and where you anticipate those to go in 2022, overall in terms of the ranges of price increases you had on your products?"
},
{
"speaker": "Dave Petratis",
"text": "63:39 You know, I would say characterize it as a wide range, different product segments get different price increases, you know residential, non-residential is different. Even within non-nonresidential, our hollow metal door business for example has surcharges attached to it, which would be higher than it’s specific to steel, but list price increases maybe is what you're more at asking for. 64:07 I'd say, we're competitive with the market relative to the increases we've already announced and implemented in the market, and then another increase this month as well, pretty sizable, but remember, it's less price and as always discounts off a list price of the key item here is what you end up realizing and that number will continue to accelerate reaching a peak in Q3 of this year."
},
{
"speaker": "Brian Ruttenbur",
"text": "64:36 Okay. Just as a follow-up to clarify that, since you didn't mention any specific numbers, the market as I hear it is around 15% increases, is that the right markets that I'm hearing that you're talking about?"
},
{
"speaker": "Dave Petratis",
"text": "64:50 I'd say, again, it depends what you're talking about. That to me sounds like there's a lot of surcharges baked into that number. That is not in aggregate, kind of the list price on your traditional mechanical electronic business."
},
{
"speaker": "Brian Ruttenbur",
"text": "65:08 Thank you."
},
{
"speaker": "Patrick Shannon",
"text": "65:09 So, let me – specifically with hollow metal steel doors, you could easily be in that zip code or more. But there's a wide range of SKUs here and we're in a – a lot of it's been [indiscernible] where we're competing every day, but prices are up."
},
{
"speaker": "Brian Ruttenbur",
"text": "65:33 Thank you."
},
{
"speaker": "Operator",
"text": "65:36 This concludes our question-and-answer session. I'd like to turn the conference back over to Dave Petratis for any closing remarks."
},
{
"speaker": "Dave Petratis",
"text": "65:46 To wrap up the main things you heard today, demand remains robust and leading indicators are positive. We're working through the supply chain challenges, which are expected to improve, but we still see some pressure in electronics. 66:01 We will get the price cost equation back to positive this year and we expect to deliver organic growth of 7% to 8.5%, adjusted EPS of 7% to 11%, and high cash conversion in 2022. The long term fundamentals of Allegion remains strong and we are well-positioned to capitalize on the opportunities and we’ll return to peak performance as conditions normalize. Thank you, and have a great day."
},
{
"speaker": "Operator",
"text": "66:30 The conference has now concluded. Thank you for attending today's presentation. You may now disconnect."
}
] | Allegion plc | 241,782,379 |
ALLE | 3 | 2,021 | 2021-10-21 08:00:00 | Operator: Good morning, and welcome to the Allegion Third Quarter 2021 Earnings Call. All participants will be in listen-only mode. [Operator Instructions] After today's presentation, there will be an opportunity to ask questions. [Operator Instructions] Please note this event is being recorded. I would now like to turn the conference over to Tom Martineau, Vice President of Investor Relations and Treasurer. Please go ahead.
Tom Martineau: Thank you, Andrew. Good morning everyone. Thank you for joining us for Allegion's third quarter 2021 earnings call. With me today are Dave Petratis, Chairman, President and Chief Executive Officer; and Patrick Shannon, Senior Vice President and Chief Financial Officer of Allegion. Our earnings release, which was issued earlier this morning and the presentation, which we will refer to in today's call, are available on our website at investor.allegion.com. This call will be recorded and archived on our website. Please go to Slides 2 and 3. Statements made in today's call that are not historical facts are considered forward-looking statements and are made pursuant to the Safe Harbor provisions of federal securities law. Please see our most recent SEC filings for a description of some of the factors that may cause actual results to differ materially from our projections. The company assumes no obligation to update these forward-looking statements. Today's presentation and commentary includes non-GAAP financial measures. Please refer to the reconciliation in the financial tables of our press release for further details. Dave and Patrick will now discuss our third quarter 2021 results, which will be followed by a Q&A session. Please, for the Q&A, we would like to ask each caller to limit themselves to one question and one short follow-up. We would like to give everyone an opportunity given the time allotted. Please go to Slide 4, and I'll turn the call over to Dave.
Dave Petratis: Thanks, Tom. Good morning and thank you for joining us today. Before we go into our third quarter results, I'd like to take a minute to acknowledge and congratulate my fellow Allegion team members for their ongoing dedication to the environment, society and governance. I'm humbled and honored to share that just last week Allegion was recognized for ESG leadership through two different awards: the Robert W. Campbell Award and the Jackson Lewis Diversity, Equity & Inclusion Champion Award. The Campbell Award is an annual recognition by The National Safety Council, America's leading non-profits safety advocate. It is the premier award for excellence in integrating environmental, health and safety management into business operating systems. Winners have strong processes and show measurable achievement over a five-year period in the EH&S performance that leads to productivity and profitability and are expected to demonstrate a long-term track record of not just the EH&S compliance, but also critical improvements. The prestigious award is also known for its rigorous application process with a systematic review and audit attached to it. Submissions are reviewed by management, labor, academic and government experts from around the world followed by a meticulous audit format at three or more of a company's global sites. With this in mind, Campbell Award winners are an elite group of organizations. Past winners include Boeing, Cummins, Dow Chemical, DuPont, Honeywell Aerospace and Johnson & Johnson. Allegion is proud to have our name added to this best-in-class list. We are also excited to have been named the Jackson Lewis Diversity, Equity & Inclusion Champion by the Indiana Chamber of Commerce. This is a statewide honor that recognizes an organization making significant strides in the workplace. The judge noted that Allegion was chosen as its first ever winner of this award because of our company's proactive and intentional diversity, equity and inclusion efforts around the globe. We have strong momentum on our diversity efforts and we know there's more work to be done. We're not asking the people of Allegion to agree on everything, but we need to be a place where racism and bias are rejected, where inclusion is a way of life and we're all employees feel they belongand can contribute to our business success. Importantly, I've shared before that Allegion's ESG commitments are vital to how our company achieves results and the way we do business. ESG excellence will give us better long-term outcomes across the board, better employee safety, better employee engagement, better productivity, better creativity, better innovation and stronger financial performance. We see this firsthand and external data points to it as well. Please go to Slide 5. During the quarter, we experienced continued strength in demand, particularly in the America's non-residential market. This trend began in Q2 and accelerated through Q3. Leading indicators like ABI and Dodge new construction indices remain positive. Increased demand is for both discretionary projects and new construction and is across all verticals and product categories. The recovery has been faster than we originally anticipated and is expected to continue in the foreseeable future. Residential end market demand is also favorable across both retail point of sale and new home construction. The strength in demand continues to constrain the global supply chain's ability to fully meet demand requirements. Similar to last quarter, this was especially prevalent in electronic components in Q3. As I'm sure you're aware this is a global issue and not isolated to Allegion or to any single industry. We have redirected resources and are taking actions such as reconfiguring and redesigning products, as well as developing alternative sources of supply to help alleviate the pressures we are experiencing in procuring electronic components. Additionally, material and freight input costs continue to accelerate during Q3. We now anticipate material and freight inflation to be approximately $60 million higher compared to last year. In addition to the supply chain pressures we're seeing for electronics, there are also widespread industry shortages of labor and other components. Once again, these issues are not Allegion specific and we expect the global constraints driving these shortages to continue beyond 2021. These challenges led to margin deterioration in the quarter. We will leverage the strength of our supply chain management capabilities as well as priced to help mitigate these impacts going forward. During the quarter, the continued robust demand coupled with the supply chain pressures resulted in record backlogs, approximately four times normal levels. We estimate that widespread shortages have delayed approximately $80 million to $100 million of 2021 revenue. We believe this impact is evenly distributed across the third and fourth quarter. We do not believe this is lost revenue, but expect it will be recovered as supply chain constraints ease. Now let's turn to the third quarter performance, for more details please go to Slide 6. Revenue for the third quarter was $717 million, a decrease of 1.6% on both a reported and organic basis. The organic revenue decrease was driven by lower volume in the Americas region related to the aforementioned electronics, components and labor shortages. Currency tailwind and acquisitions offset the impact of divestitures. Patrick will share more details on the regions in a moment. Adjusted operating margins decreased by 330 basis points in the third quarter. Higher input costs, productivity challenges and volume deleverage drove the majority of the decrease. Incremental investments important to our future growth caused 90 basis points of the decline. Adjusted earnings per share of $1.56 decreased $0.11 or 6.6% versus the prior year. The decrease was driven by reduced operating income offset by a favorable tax rate and share count. Year-to-date available cash flow came in at $327.7 million, an increase of $71.6 million, or 28% versus the prior year. The increased cash flow was driven by higher year-to-date net earnings along with improvement in net working capital and reduced capital expenditures. Patrick will now take you through the financial results and I'll be back later to discuss our 2021 outlook and wrap up.
Patrick Shannon: Thanks, Dave, and good morning everyone. Thank you for joining today's call. Please go to Slide number 7. This slide reflects our earnings per share reconciliation for the third quarter. For the third quarter 2020 reported earnings per share was $1.58. Adjusting $0.09 for charges related to restructuring and impairment, the 2020 adjusted earnings per share was $1.67. Favorable tax drove a $0.13 increase in earnings per share. The negative tax rate for the third quarter reflects favorable settlements of uncertain tax positions, a benefit of mix of income as well as the non-recurring unfavorable tax impact in 2020 related to certain valuation allowances. Reduced share count drove another favorable $0.04 per share. Acquisitions and divestitures had a positive $0.02 per share impact. Operational results decreased earnings per share by $0.21 driven by higher material and freight costs. Productivity challenges and volume deleverage which more than offset the favorable impacts of price and currency. Investment spend increased during the quarter and reduced earnings per share by $0.06. As a reminder, the incremental investment spend is predominantly related to R&D, technology and market investments to accelerate future growth. The combination of interest and other income drove another $0.03 per share reduction. This results in adjusted third quarter 2021 earnings per share with $1.56, a decrease of $0.11 or 6.6% compared to the prior year. Lastly, we have a $0.03 per share increase driven by a gain on the sale of an equity method investment offset slightly by the combination of restructuring charges and acquisition and integration expenses. After giving effect to these items, you arrive at the third quarter 2021 reported earnings per share of $1.59. Please go to Slide Number 8. This slide depicts the components of our revenue performance for the third quarter. I'll focus on the total Allegion results and cover the regions on their respective slides. As indicated, we experienced an organic revenue decline of 1.6% in the third quarter. The electronics, components and labor shortages primarily in the Americas region had an impact on our ability to meet the continued strong demand. Still we realized good price performance, which offset some of the volume decline. Currency continued to be a tailwind to total growth and offset the combined impact of acquisitions and divestitures. In total, reported revenue reduced by 1.6%. Please go to Slide Number 9. Third quarter revenues for the Allegion Americas segment were $524.4 million, down 2.7% on a reported basis and 3% organically. As previously stated, the supply chain pressures we are experiencing drove the revenue decline. We are still seeing strong market demand, which has resulted in record backlogs, particularly in the non-residential part of the business. The region continued to deliver good price realization. Our latest price increase went into effect at the beginning of October. So we expect the price realization to accelerate in the future. On volume, Americas nonresidential was down low single digits driven by the electronics, components and labor shortages. Americas residential was down high single digits. This was uniquely driven by the prior year being inflated by channel refill coming out of the pandemic shutdowns experienced in Q2 of 2020. The shortage of electronic components also had a negative impact on residential performance primarily in the DIY space, a big box retail and e-commerce. Electronics revenue was down high single digits driven by shortages of electronic components of both the nonresidential and residential businesses. Electronics and touchless solutions remain a long-term growth driver and as an integral to our investment in innovation efforts. Americas adjusted operating income of $133.7 million, decrease 19.7% versus the prior year period and adjusted operating margin for the quarter was down 540 basis points. The decrease was driven by higher material and freight costs, productivity challenges related to inconsistent supply and volume deleverage. Incremental investments had a 100 basis points dilutive impact on adjusted margins. Please go to Slide Number 10. The Allegion International segment delivered another solid quarter. Third quarter revenues were $192.6 million, up 1.7% and up 2.5% on an organic basis. We continue to see strength in our SimonsVoss, Interflex and Global Portable Security businesses, which along with good price realization drove the organic revenue growth. Favorable currency and acquisition impacts also contributed to total revenue growth and were slightly offset by divestitures. International adjusted operating income of $21.3 million, increased 4.9% versus the prior year period. Adjusted operating margin for the quarter increased by 40 basis points. The margin increase was driven primarily by volume leverage along with favorable impacts from divestitures and currency. The combination of price productivity inflation were an 80 basis point headwind to margins. Incremental investments reduced margins by 40 basis points. Please go to Slide Number 11. Year-to-date available cash flow for the third quarter 2021 came in at $327.7 million, which is an increase of $71.6 million compared to the prior year period. The increase is attributed to higher year-to-date earnings, improvements in networking capital and reduce capital expenditures. Our cash flow generation continues to be an asset to the company. Looking at the chart to the right, it shows working capital as a percentage of revenues decreased based on a four-point quarter average. The business continues to manage working capital efficiently and generate strong cash flow. I will now hand it back over to Dave for some comments on our full year of 2021 outlook.
Dave Petratis: Thank you, Patrick. Please go to Slide Number 12. On October 1, we issued a pre-release to our earnings and updated our 2021 full year outlook for revenue, earnings per share and available cash flow. We are reaffirming those updated outlooks. We have talked at length about the demand strengthened the Americans business as well as supply chain pressures that are having impact on our ability to meet that demand, which will delay an estimated $80 million to $100 million of revenue. The outlook for total revenue in the Americas is now projected to be at 1% to 1.5% with organic revenue growth at 0.5% to 1%. In the Allegion International segment, we have not seen as large of an impact from component and labor shortages. In our SimonsVoss, Interflex and Global Portable Security businesses continued to perform well. For that region, we expect total revenue growth to be between 12% and 13% with organic growth of 9% to 10%. All-in for total Allegion, total revenue is projected to be up 4% to 4.5% and organic revenue is expected to increase 3% to 3.5%. We're expecting reported EPS to come in the range of $4.95 to $5.05 per share and adjusted EPS to be between $5 and $5.10. Our outlook for available cash flow is projected to be $460 million to $480 million. The outlook assumes investment spend of approximately $0.15 to $0.20 per share. The full year adjusted effective tax rate is expected to be approximately 9%. The outlook for outstanding diluted shares is approximately $90.5 million. Please go to Slide number 13. As we close the presentation and move on to Q&A, I want to take some time to stress Allegion’s strong long-term fundamentals. First, even with the disruption caused by the global pandemic, our strategy around seamless access and electronic transformation remains strong. We expect electronic and seamless access solutions to be the future of access control and we are using multiple innovation engines to lead the industry. You've seen proactive work from Allegion through Allegion Ventures, our recent acquisitions like Yonomi and in our Interflex business, accelerating our software and tech capabilities. We're making investments and expanding partnerships with mega techs and leading access control platforms. We're making significant progress on our ESG journey. This is evident with the two awards that we received earlier this month. The Campbell Award given by the National Safety Council is a very prestigious honor and we joined an elite group of previous winners. I'm also proud of the Jackson Lewis Diversity, Equity & Inclusion Champion Award, which we received from the Indiana Chamber, which recognizes our proactive leadership in diversity, equity and inclusion. Congratulations to be Allegion team. All markets in America remain robust. We continue to see positive trends from leading indicators like ABI and the Dodge New Construction Index and expect these trends to continue into 2022. With the International segment, the strength in our SimonsVoss, Interflex and Global Portable Security business persist. We have aligned and adjusted resources to navigate and adapt to supply chain pressures that the world is experiencing. Actions taken including the redesign of products, the development of alternative supply sources and we continue to leverage our pricing power. Allegion’s supply chain will continue to differentiate us and the strength in our backlogs would indicate that our channel partners believe we will navigate through the global pressures [indiscernible]. Demand remains strong. We have implemented pricing actions that will carry forward into next year and there's substantial backlog to work down. With that backdrop and assuming supply chain pressures related to inflation and component shortages begin to ease, we expect solid revenue growth with year-over-year margin improvement and continued strong cash flow generation in the 2022. The future of Allegion remains bright. Now, Patrick and I will be happy to take your questions.
Operator: We will now begin the question-and-answer session. [Operator Instructions] The first question comes from Joe O'Dea with Wells Fargo. Please go ahead.
Joe O'Dea: Hi. Good morning everyone.
Dave Petratis: Good morning, Joe.
Joe O'Dea: First question is just related to any visibility you have around the timing of relief from supply chain constraints. You've talked about this extending into 2022, but are you seeing anything out there and based on conversations with your suppliers that gives you confidence in when you start to see some relief?
Dave Petratis: So my first observation, your past records sometimes is a predictor. Allegion performed extremely well through the first phases of this pandemic. Number two is some of the strength of our supply chain adaptability was evident. If we had not adapted, made design changes over the last couple of quarters, our backlog would even be larger. So we feel very good about the performance and the adaptability, flexibility. It's clear the electronics is going to be a problem that all companies, including Allegion, will have to adapt to through 2022. I think an important element of the rest and it's the complexity of the Allegion supply chain is the return of labor pressures to our partner suppliers. This we'll have to continue to monitor. This is everything from castings to power supplies to wire harnesses. There is a labor scarcity across the globe. And again, I believe our ability to adapt and our philosophy to produce in region will help Allegion.
Joe O'Dea: And then related to backlog and catch up and you made the comment about backlog being four times higher than normal, how do you think about managing that? So when you do start to get some relief in the supply chain, do you think about kind of ramping up to deliver to customers as fast as possible, which could then create some inefficiencies in a strained production system? Or do you think about managing that and maybe it takes longer to deliver over time, but not straining the production system in that process?
Dave Petratis: So we've got a lot of experience in production systems, including the man that runs the company, me, 41 years. I think I liked the backlog. I think if component supplies – as if that regains health, we will actually pick up efficiencies. There has been gross inefficiencies through COVID, these supply chains. An important element is our ability to bring on and flux our own labor and I've got high confidence in our ability to do that.
Joe O'Dea: Great, thank you.
Operator: The next question comes from Joe Ritchie with Goldman Sachs. Please go ahead.
Joe Ritchie: Thanks. Good morning everybody.
Dave Petratis: Good morning, Joe.
Joe Ritchie: As you guys talked about clearly lots of challenges in the marketplace today, I know that as you kind of think about the Americas margins being down 500 basis points to 600 basis points year-over-year, our investments of about 100 basis points impacting the margin. Can you maybe parse that out a little bit more for us like do we know how much of it is coming from higher material and freight costs? How much of it is more kind of like the productivity issues? Just any other additional color around that would be helpful.
Dave Petratis: Yes, Joe, so the significant portion of the margin degradation year-over-year is predominantly inflation and freight costs. And then we've got productivity challenges associated with some of the component shortages and those types of things, creating inefficiencies at our facilities. So if you think about it relative to normally we've done a good job in terms of managing the price inflation dynamic, we're underwater today as we kind of look at that price being lower than the incremental material and freight costs that will get better. As we kind of progress here, we're putting in more price increases to make up for the Delta. One of the challenges is kind of given the high backlog and the fact that a lot of the backlog today is kind of price protected. You don't see the benefit of the price increases coming through and offsetting the incremental inflation until going into 2022. So we're still going to be under pressure for the balance of the year, but inflation really accelerated particularly when you look year-over-year on steel components and those types of things. So it's just – it's one of these short-term phenomenons. If you assume that inflation has kind of peaked today, going into 2022 things will kind of continue to get better than we would expect to be in the positive end of the equation as we progress throughout 2022.
Joe Ritchie: Got it. That's helpful, Patrick. And maybe just kind of following on there, as you think about then – it sounds like you're going to be underwater again in the fourth quarter. As you think about like the pricing that you're putting through, do you typically include a fuel surcharge? Or is this kind of like stickier pricing that you expect to get in the 2022 timeframe? And then we've also gotten some questions from investors today around the fact that pricing stepped down on a year-over-year basis if you took a look at the second quarter versus 3Q. So curious like any comments around why pricing was a little bit weaker in 3Q versus 2Q.
Dave Petratis: So on your first question – so we've managed pricing broadly and it's really dependent upon product category, some of our products that are more steel related, i.e., steel doors, those types of things would carry surcharges associated with that, but mostly across the product portfolio is through list price increases is kind of how we manage it, so it's more permanent in nature. The year-over-year Delta, you kind of have to look at it again by product category, a little pressure and some of the discounts, residential, for example, a little bit harder to kind of pass through the price increases. So that's really what you're seeing there. If you, kind of, look at the bulk of our business, commercial, year-over-year price increase.
Patrick Shannon: I'd add to this. Our hollow metal business, list price increases and surcharges, on the general hardware business two price increases in the year and will adapt to the pressures as we go into 2022 and certainly going hard at the residential products as well. And my message here would be in the addition to freight surcharges, we're pulling all levers on price realization. And I think as we get past this momentary surge that occurred in Q2 and Q3 on inflation, we'll continue our discipline around price performance as we move into 2022.
Joe Ritchie: Thank you. That's helpful.
Operator: The next question comes from Andrew Obin with Bank of America. Please go ahead.
Andrew Obin: Yes, hi, guys.
Dave Petratis: Good morning, Andrew.
Patrick Shannon: Good morning.
Andrew Obin: Yes. Just to follow up on Joe's question on pricing, I'm just a little bit surprised by the pricing myself. We did some channel checks with electrical distributors in the markets. Dave, you would know very well, one of the largest players in North America has pricing effect I think sort of policy at this point in order to sort of cleanse out the backlog. I think HVC guys that's selling a lot of similar channels, I think have had like four price increases this year. I mean the industry structure seems to be quite favorable. Why is it so hard to get a price increase through? Or who is being aggressive, particularly you seem to highlight a residential is one player being aggressive, people out of Asia being aggressive, which was surprising because I would have expected they would have difficulties getting stuff on the boat. Just maybe a little bit more color there. Thank you.
Dave Petratis: So, I'd give a completely different perspective, Andrew. I know the electrical quite well. Think about the amount of electrical pipe, wire and distribution gear that goes in, in the first six months of a construction project, we'd submit our quotes get orders at the same time. And that – those products are delivered at the end of that cycle. When we put a quote, that's carried for a period of time, but we honor that order and so we eat that inflationary pressure. The cycle for the electrical industry is much faster than ours. We've been aggressive on the price increases as well as surcharges and it's not apples to apples. We're both in new construction. On new quotes and bids, we're really raising the levels every day. And I hope that color maybe helps you understand leading products, the electrical versus lagging products on the hardware side.
Patrick Shannon: I'll just add, Andrew. It's not a question of realization. In other words, we'll get the price increase. It's more of a timing issue. So, you will begin to see sequential improvement beginning Q4 relative to the price increases we put in the market. And that will continue to accelerate into 2022, year-over-year and sequentially.
Andrew Obin: In 2022, you'll get some of the benefit of these 2021 price increases. So you'll get it, but later.
Patrick Shannon: Yes.
Andrew Obin: Got you. And just a follow up question, just a difference in performance between North America and I guess international, which I sort of think mostly Europe, as I think about your brands, Interflex, I guess it is mostly software, but it does have electronic components if I think about I guess CISA is the one that's purely mechanical, but on SimonsVoss, which you've highlighted also has large electronic component. Why are you able to avoid the kind of disruption related to electronic components and labor in Europe that you experienced in the U.S. because I would imagine the electronic components in Europe are also getting sourced in Asia? Thank you.
Dave Petratis: So electronic components tight in all sectors of the world, the differences between SimonsVoss a lesser extent and Interflex and the core business in the Americas is pure suppliers. We had designed around the Americas Texas Instruments, NXP, Texas both have had their supply chain issues. The European products more around a different set of suppliers and it's those differences. And the adaptability important here many of the newest Allegion products that drives battery efficiency, WiFi connectivity that makes us the leading products in the world are closer to the supply chain challenges in the Americas than they are in Europe.
Andrew Obin: Got you. I appreciate it. Thanks a lot Dave.
Dave Petratis: You're welcome, Andrew.
Operator: The next question comes from Brian Ruttenbur with Imperial Capital. Please go ahead.
Brian Ruttenbur: Yes, thank you very much. My first question and I'm sorry to keep asking about price increases, but I'm going to ask one on that and one on – a follow-up on a different subject, but the first is on price increases. Can you say specifically how much you've increased prices? ASSA has gone up about 15% multiple, in total, this year. NAPCOs said that 3% they've increased. What have you increased so far this year and what do you plan to increase on the year?
Dave Petratis: I would say, again you have to look across the different product sets, so it varies. If you're looking at all price increases, i.e., what we talked about there's list price, there's surcharges, there's things related to freight those that have heavier steel related i.e., steel doors those types of things would carry a much higher price increase realization than your traditional products, locks and exits, closers, those types of things. So, list prices for the year would be with both price increases north of 6% with more to come in the future.
Patrick Shannon: I think you also got to include the surcharges on top of that, and this is a big end in our quote activities, we apply discount schemes that give us the ability to rise price based on the project. So again, I feel very good on our pricing analytics. There's that gap in the backlog that we may have quoted over a year ago. We honor those firm orders and they're delivered sometimes over the periods of years. And as we move into 2022, we'll reassess this again and be early and aggressive to make sure that price continues to cover our input cost as we've done since the creation of the company.
Brian Ruttenbur: Right. And then just as my follow-up real quick on – off just real quick maybe you make a comment about their move with HHI from Spectrum and how you anticipate competing on that. I know we've spoken offline on that, but I want to just hear what you think – how that's going to impact Allegion moving forward.
Dave Petratis: So you never want to see your number one competitor or market leader gets bigger. Rest assured that we also looked hard at the Kwikset HHI assets over the years. And I think if you really step back and study the dimensions of Kwikset and how they performed under HHI, I believe also will actually bring a level of discipline to the market. It's certainly our great Schlage brand, the Kwikset brands. There's plenty of room to compete and we've met this challenge I think credibly over the last several decades. Schlage in terms of its electronic leadership, if you look at consumer reports electronics that I think was published in April of this year, three of the top eight walks are ours. We're the number one replacement walk and it's going to be continued competition against two world leaders.
Brian Ruttenbur: Thank you, Dave.
Operator: The next question comes from Julian Mitchell with Barclays. Please go ahead.
Julian Mitchell: Hi, good morning. Maybe just my first question is perhaps on the demand outlook, which hasn't really been touched on yet. I remember in that upcycle in U.S. non-res in sort of 2006, 2007 and 2008, that upcycle in terms of projects did suffered some headwinds because of cost inflation and labor led developers to delay in projects and so forth. And so you had these kinds of rolling push outs and delays. Just wondered what your perspectives are on the risks of that type of phenomenon recurring in the current environment when you're talking to developers looking at your quote activity and so forth.
Dave Petratis: I'd say, each bust and boom cycle sets its own history. We're still living this aspect of it, but as I reviewed the macro demand factors, our backlogs and then recent travel, I would think I was in five states last week. The sentiment that I feel, see and, and living here every day at Allegion is I'm extremely positive. I think we've got three solid years ahead of us as I think about the strategic planning period, working through the supply chain issues, I think there is key infrastructure needs and we have a housing economy that's significantly under inventory for single-family homes, which also is a generator for commercial and institutional development. So, I packed out all together in borrowing another disruption. I liked to go ahead in terms of the business conditions for construction and for Allegion.
Julian Mitchell: I see. So you have not seen major projects being deferred or postponed?
Dave Petratis: We track cancellations and I'd say it's at a normal level.
Julian Mitchell: That's helpful. And then just a quick follow-up, I'm trying to wrap together your comments on pricing. If you look at your sort of your operating income bridge that line for inflation in excessive pricing and productivity, obviously it's been negative for a couple of quarters now. When you look at the margins in the backlog and the pace of completion, should we assume that that line can go back to sort of breakeven sort of third quarter of next year? Is that the rough timeline?
Dave Petratis: I would – at – Q3 next year is sort of positive is what I would anticipate basis of a constant inflation relative to what we're seeing today in terms of no further increase year-over-year. But the Delta, i.e., the gap between price inflation improving up until that point, so the rate of change will get better as we progress.
Patrick Shannon: Julian, I'd also add as we – as you and I think about that backlog, if some of the highest margin products that we produce, electronic locks and exit devices are elements, heavy elements of that backlog, the exit devices, heavy complexity, which we – the supply chain pressures create some challenges in that, but those supply chain pressures will improve. The mix of that will roll through. In addition to the price increases, I like our opportunities going forward.
Julian Mitchell: Great. Thank you.
Operator: The next question comes from John Walsh with Credit Suisse. Please go ahead.
John Walsh: Hi. Good morning.
Dave Petratis: Good morning.
John Walsh: Maybe just to follow on Julian’s last question there. If you look in your bridge, I know it's called the volume and mix, but it was a headwind year-over-year, but you actually had non-residential declining less than residential in the Americas. So maybe it has to do with the mix within non-res. And you talked about some of your higher margin products now growing backlog, but we'd just love to unpack that a little bit, why the mix was negative despite non-resi growing better than residential, at least on a relative basis?
Patrick Shannon: Yes. So you hit on it. It's really within the product portfolio of non-residential products. As Dave indicated high margin products being impacted more and that's kind of what we're seeing it in the backlog due to shortages of components. And so it's really within the non-residential business that you're seeing a mix element, given that non-resi was higher than resi for the quarter.
John Walsh: Great. And then I'm going to take a stab at this. I think earlier in the year, you kind of pointed international margins up low double digits. Obviously, you've seen really good progress there through the year. You've given us the mid point of your guide, a lot of other information. It does seem like that implies the Q4 Americas margin kind of steps down more than seasonality would assume in Q4. And also just thinking about the decremental still being pretty challenged there, any color you can help us on how to think about that from the model perspective or I'll just leave it there, however you'd like to help us out with that sequential decline implied?
Patrick Shannon: Yes. So kind of we touched on it a little bit earlier. It's predominantly given the price inflation dynamics still under pressure. Some of the inefficiencies from a productivity standpoint, we'll continue given the component challenges supply base that's really the – you are going to see some decrements sequentially. But then as we kind of continue to move into 2022, you wouldn't see obviously that a big of a change in the first part of the year and then approving certainly in the back half.
John Walsh: Okay. Thank you. Appreciate it.
Dave Petratis: Welcome.
Operator: The next question comes from David MacGregor with Longbow Research. Please go ahead.
David MacGregor: Yes. So good morning, everyone.
Dave Petratis: Good morning.
David MacGregor: Patrick, you've made reference a couple of times now to the expectation that maybe inflation is peaked. And I guess I'm just interested in what gives you confidence that would be the case. Have you provisions in place through some of your procurement agreements that lock pricing now or hedges that are in place to give you the confidence to say that. But if you just elaborate on that side, so I appreciate it?
Patrick Shannon: So that's kind of the commentary was more around kind of our assumptions right now. I mean, if there's continued pressure in the marketplace to some of the component challenges, then that would certainly put pressure on our assumptions as we look forward to 2022. But if you kind of look at some of the forecasting information relative to steel and those type of things, the expectation is, is that as we go into next year, it starts to alleviate itself and maybe trend down. And that would be positive to what we're thinking today.
David MacGregor: Can you just remind us what – how much of your businesses is walk up with annual contracts or supply agreements versus spot purchases? You can elaborate on that a little bit…
Patrick Shannon: A small portion that it's mostly on raw steel. We kind of look forward and we've got some arrangements with some of our supply base that has fixed rate agreements. Those then kind of fluctuate basis on changes in the market on a forward basis. And so it's small. A lot of our supply base is indexed to steel, if you will. And so it's really just on the purchase of raw steel, which is a small component relative to our overall purchasing.
David MacGregor: Okay. Thank you for that. And then just as a follow-up. You just talk about installation labor and the extent to which that may be a sort of frustration at this point, or how you see that developing as a potential bottleneck or impediment in 2022?
Dave Petratis: Some broad comments on labor. And it's from a general labor through the trades to professionals. Labor is tight, professional help on a worldwide basis. Second, when you look particularly at construction labor, the gap has grown. Skilled trades were a problem going into the pandemic. The problem has widened slightly. In my mind extends cycle times for construction projects and snowplows, what I think are strong business conditions well into the future.
David MacGregor: Would you consider it all investing in the development of that labor for the market, as a means of alleviating that constraint?
Dave Petratis: We are investors. I will get off the phone here today, and its manufacturing month in the United States. Allegion plays a very active role in promoting our industry, leading culture, diversity opportunities, tuition reimbursement programs, healthy lifestyle, to attract people and have done it since the creation of the company, number one. Number two, I think manufacturing, I'm extremely proud of is a great place to develop talent and we will make investments in our wage structures to continue to keep Allegion as the best employer with wages and benefits and the communities we operate around the world.
David MacGregor: Thanks David.
Operator: The next question comes from Tim Wojs with Baird. Please go ahead.
Tim Wojs: Hey guys. Good morning.
Dave Petratis: Good morning, Tim.
Tim Wojs: Maybe just dovetailing off of David's question there, could you just – when you think about the new non-resi cycle and how investors should kind of think about it? The leading indicators have obviously been really robust over the last seven or eight months. How would you think about converting those cycle? It was kind of leading interiors into revenue for you guys? I mean, are those new construction projects that could contribute to you in the second half of 2022? Or do you think at this point it's probably more prudent to think 2023?
Dave Petratis: I think you've got to take the strong cycle and as I look at the macro indicators that you did positive, you've got to lay on that backlog, which will take the better part of six, seven months for us to eat through. And I think extremely robust I see education, I see health care. I think you've also – I've always been concerned about commercial, extremely positive in terms of the macro. There's lots of money on the sidelines to go reinvent this commercial real estate and the new office of the future. So as I look at education, healthcare, commercial, even multifamily is honing longer. And I think investment is going to come in needed infrastructure. We could get an infrastructure bill. So as I look at that, Tim, I like it for the next three to five years.
Tim Wojs: Okay. Okay. And then maybe more of just a modeling question. So you guys outlined that the split on the deferred sales, I think was kind of even between Q3 and Q4, but I think if you just kind of roll that into the model, I mean, there's a bigger think you're down double digits or that's the implication in the fourth quarter versus down maybe low single digits in Americas in Q3. So, any perspective there you can kind of add as to why that is? Is it just seasonality comps?
Patrick Shannon: Yes. Seasonality comps, the component shortages plus – last year, you may recall what the rebound in a residential business and it was coming out of COVID, there was channel refill in the business, right. Restocking the shelves on retail and e-commerce and so that’s certainly had a fairly significant impact on last year. So you're getting into a difficult comp as relates to our residential business.
Tim Wojs: Okay. Okay. Got you. And then $80 million to $100 million of deferred revenue, I mean, how does that kind of come back next year? I mean, is it – is there some sort of burst that kind of happens and you kind of convert that in 2022 or is it just kind of result in a little bit of a longer cycle?
Patrick Shannon: No. I think you need to think about it depending on the flow of components and labor, it's a tailwind as we roll through the year. And in a manufacturing environment, you can step up about 20% just by working Saturdays. You need to kind of think about it. If I go to Sundays, I get 40%, people don't work seven days a week for six months. You got to think about, it will step up. It's a tailwind, barring if you get – if we get improvement in components, both electronic and general components, we're going to see that as a tailwind as we roll through the first half of next year. And if the component situation and labor improves work about and gain more share.
Tim Wojs: Okay. Okay. Good luck on the rest of the year, guys. Thanks for your time.
Dave Petratis: Thank you.
Operator: The next question comes from John [ph] Pokrzywinski with Morgan Stanley. Please go ahead.
Unidentified Analyst: Hey, good morning guys.
Dave Petratis: Good morning.
Unidentified Analyst: Dave. So electronics are 20-ish percent of the business, probably a little more than that now. The $80 million to $100 million that you talked about does sound pretty biased to 4Q and I guess what precipitates out of that is it's pretty high percentage of electronics like that virtually electronics going to zero, or how should we think about the split of that headwind between the electrified product versus the mechanical products?
Dave Petratis: I'd say 40% electronics, 60% mechanical. I'd also, I think you've been in our factories here in Indianapolis complexity when things are common right is our friend. We'll make 2200 variations of the Von Duprin exit device today. And any one of those components in shortage, whether it's a casting, a wire harness as a power supply and electronic board puts pressure on that supply chain and that's what we're living today and confident in our teams to work through it. Remember too, it's not necessarily my ability to put labor in the seat. It's also my supply chain. We pulled hard on redesign shifting over a 100 engineers to redesign predominantly boards but other components. And the second thing I’d say is our flexibility, we've offered to put our people insights to help strengthen our supply chain vendors. And I share that example just because the labor thing goes across transportation, supply chain, getting in through the ports and a level of complexity that I've maybe never seen in my 41 years.
Unidentified Analyst: And then just thinking about the – kind of the unwind of this current tightness. I think an earlier question asked about trade labor, is that the biggest governor of how much the business can grow next year to the teams like you have the ingredients, the demand is there maybe a bit more backlog than usual? It just how quick can we get, installers both on new construction and retrofit is that sort of the KPI that we should be focused on?
Dave Petratis: I think I would describe it Josh, is there's pacing constraints and labor from the design phase. We just saw a record ABI through the installation phase and I think projects will have longer lead times in an environment that's extremely positive in terms of their willingness to invest.
Unidentified Analyst: Got it. Thanks.
Dave Petratis: You're welcome.
Operator: The next question comes from Chris Snyder with UBS. Please go ahead.
Chris Snyder: Thank you. Thank you. So my first question is on the deferred $80 million to $100 million of revenue, seems like the majority of this is coming from the Americas. In your previous commentary, I think, said that it could take six to seven months to work through this elevated backlog and I think the ability to ramp manufacturing 20% by working Saturdays, I think kind of suggests that this could be realized this $80 million to $100 million in 2022. And obviously, I know there's some uncertainty around the ability to source components. But I guess is that reasonable to think that this could be realized next year, because it's a pretty substantial kind of mid single digit tailwind to the Americas segment.
Patrick Shannon: As you think about 2022, the backlog will be a tailwind, constrained by availability of electronics. That tightness will run into 2023 and then the overall labor. We see – I don't know if you ever, it's an industrial game we call the beer game, bottlenecks move. There's bottlenecks at the ports, there's bottlenecks in labor. These things are going to be moving throughout the year, but my fundamental belief is Allegion has a superior ability to navigate the nation and the world will navigate it. And we'll see these things ease as we go through. And it's a tailwind to push that backlog through.
Chris Snyder: I appreciate that. And then, second question on resi, it sounded like from the prepared remarks that there may be with some demand softening in the quarter. I think you guys called out do-it-yourself or DIY slowdown. So I guess my question is, was this maybe the resi softness part of the second half of revenue cut. And I guess, is there any reason to think that this gets better in 2022, as it seems like that could be more demand related than supply chain related?
Dave Petratis: So again, I want you to think about that demand game, the supply chains on resi for all supplier was heavily disrupted in 2020. We were shut down for 15, 16 days. You had a demand surge, and this is very evident from the Big Box, Home Depot, Lowes reports in terms of increase investments and do-it-yourself projects. And then you had also housing picking up pretty rapidly that created a demand surge as we started coming out of the lockdowns record backlog in residential, which we have worked through. So I look at overall demand for resi as we move into 2022 is net positive. Based on continued starts of new construction, solid repair and replacement and good multi-family. So that whip is going on the supply chain. Make sure you think about that in your model, because I think a year ago, I'm sitting here talking through record backlogs in residential. We worked through that and I would suggest if you look at our performance versus our competitors that we gained share throughout the last eight quarters.
Chris Snyder: I appreciate that. Thank you.
Operator: And the last questioner will be Ryan Merkel with William Blair. Please go ahead.
Ryan Merkel: Hey everyone. Good morning.
Dave Petratis: Good morning.
Ryan Merkel: So I wanted to follow up on the timing of supply chain getting better. Is it fair to say that margins are bottoming in the second half of 2021, such that as we get into next year, you could see margins increase year-over-year, or is that maybe more of a second half 2022 events?
Patrick Shannon: Probably more back-end loaded, but feel very confident. If you kind of look at the moves we're making on price, again, assuming inflation is peak. I mean, that's still a question mark, right? But I feel very confident relative to pushing through the backlog, getting some efficiencies that are factory productivity, these types of things. We will have margin incremental improvement in 2022 compared to 2021. No doubt in my mind.
Ryan Merkel: All right. That's helpful. And then just stepping back maybe this question for David, but can you discuss the adoption curve for electronic? Is it faster now and also how are your customers rethinking access control in this new environment?
Dave Petratis: Electronic access, electronic locks, the power of your edge device and its ability to interact with secured access is a powerful trend that will positively influence this industry for the coming decades. The electronic adoption is what I would describe as high single digits in normal times or pre-pandemic we've been able to deliver on that growth at mid, or excuse me, low single digit or low double digit gross of market growing high single digits. We're in a normalized time low double digits. So a clear trend you can see it in your everyday life. The overall market's still, there's 40 billion openings in the world less than 10% of those integrated. So bright for our industry and bright for Allegion.
Ryan Merkel: Thank you.
Operator: This concludes our question-and-answer session. I would like to turn the conference back over to Dave Petratis, our Chairman, President, and CEO for any closing remarks.
Dave Petratis: Thanks for your questions today. I also want to thank our employees for their continued commitment, steadfastness in navigating the challenges over the last 22 months. Some final messages. Allegion remains a white house for our safety performance and our ESG advancements. Demand in our business remains robust and leading indicators are positive. Supply chain constraints, labor availability, and inflation are challenging. I'm confident in Allegion supply capability, adaptability to be strong, and the long-term fundamentals of Allegion remains bright and strong. Thank you for your time today. Have a safe day.
Operator: The conference has now concluded. Thank you for attending today's presentation. You may now disconnect. | [
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"speaker": "Operator",
"text": "Good morning, and welcome to the Allegion Third Quarter 2021 Earnings Call. All participants will be in listen-only mode. [Operator Instructions] After today's presentation, there will be an opportunity to ask questions. [Operator Instructions] Please note this event is being recorded. I would now like to turn the conference over to Tom Martineau, Vice President of Investor Relations and Treasurer. Please go ahead."
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"speaker": "Tom Martineau",
"text": "Thank you, Andrew. Good morning everyone. Thank you for joining us for Allegion's third quarter 2021 earnings call. With me today are Dave Petratis, Chairman, President and Chief Executive Officer; and Patrick Shannon, Senior Vice President and Chief Financial Officer of Allegion. Our earnings release, which was issued earlier this morning and the presentation, which we will refer to in today's call, are available on our website at investor.allegion.com. This call will be recorded and archived on our website. Please go to Slides 2 and 3. Statements made in today's call that are not historical facts are considered forward-looking statements and are made pursuant to the Safe Harbor provisions of federal securities law. Please see our most recent SEC filings for a description of some of the factors that may cause actual results to differ materially from our projections. The company assumes no obligation to update these forward-looking statements. Today's presentation and commentary includes non-GAAP financial measures. Please refer to the reconciliation in the financial tables of our press release for further details. Dave and Patrick will now discuss our third quarter 2021 results, which will be followed by a Q&A session. Please, for the Q&A, we would like to ask each caller to limit themselves to one question and one short follow-up. We would like to give everyone an opportunity given the time allotted. Please go to Slide 4, and I'll turn the call over to Dave."
},
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"speaker": "Dave Petratis",
"text": "Thanks, Tom. Good morning and thank you for joining us today. Before we go into our third quarter results, I'd like to take a minute to acknowledge and congratulate my fellow Allegion team members for their ongoing dedication to the environment, society and governance. I'm humbled and honored to share that just last week Allegion was recognized for ESG leadership through two different awards: the Robert W. Campbell Award and the Jackson Lewis Diversity, Equity & Inclusion Champion Award. The Campbell Award is an annual recognition by The National Safety Council, America's leading non-profits safety advocate. It is the premier award for excellence in integrating environmental, health and safety management into business operating systems. Winners have strong processes and show measurable achievement over a five-year period in the EH&S performance that leads to productivity and profitability and are expected to demonstrate a long-term track record of not just the EH&S compliance, but also critical improvements. The prestigious award is also known for its rigorous application process with a systematic review and audit attached to it. Submissions are reviewed by management, labor, academic and government experts from around the world followed by a meticulous audit format at three or more of a company's global sites. With this in mind, Campbell Award winners are an elite group of organizations. Past winners include Boeing, Cummins, Dow Chemical, DuPont, Honeywell Aerospace and Johnson & Johnson. Allegion is proud to have our name added to this best-in-class list. We are also excited to have been named the Jackson Lewis Diversity, Equity & Inclusion Champion by the Indiana Chamber of Commerce. This is a statewide honor that recognizes an organization making significant strides in the workplace. The judge noted that Allegion was chosen as its first ever winner of this award because of our company's proactive and intentional diversity, equity and inclusion efforts around the globe. We have strong momentum on our diversity efforts and we know there's more work to be done. We're not asking the people of Allegion to agree on everything, but we need to be a place where racism and bias are rejected, where inclusion is a way of life and we're all employees feel they belongand can contribute to our business success. Importantly, I've shared before that Allegion's ESG commitments are vital to how our company achieves results and the way we do business. ESG excellence will give us better long-term outcomes across the board, better employee safety, better employee engagement, better productivity, better creativity, better innovation and stronger financial performance. We see this firsthand and external data points to it as well. Please go to Slide 5. During the quarter, we experienced continued strength in demand, particularly in the America's non-residential market. This trend began in Q2 and accelerated through Q3. Leading indicators like ABI and Dodge new construction indices remain positive. Increased demand is for both discretionary projects and new construction and is across all verticals and product categories. The recovery has been faster than we originally anticipated and is expected to continue in the foreseeable future. Residential end market demand is also favorable across both retail point of sale and new home construction. The strength in demand continues to constrain the global supply chain's ability to fully meet demand requirements. Similar to last quarter, this was especially prevalent in electronic components in Q3. As I'm sure you're aware this is a global issue and not isolated to Allegion or to any single industry. We have redirected resources and are taking actions such as reconfiguring and redesigning products, as well as developing alternative sources of supply to help alleviate the pressures we are experiencing in procuring electronic components. Additionally, material and freight input costs continue to accelerate during Q3. We now anticipate material and freight inflation to be approximately $60 million higher compared to last year. In addition to the supply chain pressures we're seeing for electronics, there are also widespread industry shortages of labor and other components. Once again, these issues are not Allegion specific and we expect the global constraints driving these shortages to continue beyond 2021. These challenges led to margin deterioration in the quarter. We will leverage the strength of our supply chain management capabilities as well as priced to help mitigate these impacts going forward. During the quarter, the continued robust demand coupled with the supply chain pressures resulted in record backlogs, approximately four times normal levels. We estimate that widespread shortages have delayed approximately $80 million to $100 million of 2021 revenue. We believe this impact is evenly distributed across the third and fourth quarter. We do not believe this is lost revenue, but expect it will be recovered as supply chain constraints ease. Now let's turn to the third quarter performance, for more details please go to Slide 6. Revenue for the third quarter was $717 million, a decrease of 1.6% on both a reported and organic basis. The organic revenue decrease was driven by lower volume in the Americas region related to the aforementioned electronics, components and labor shortages. Currency tailwind and acquisitions offset the impact of divestitures. Patrick will share more details on the regions in a moment. Adjusted operating margins decreased by 330 basis points in the third quarter. Higher input costs, productivity challenges and volume deleverage drove the majority of the decrease. Incremental investments important to our future growth caused 90 basis points of the decline. Adjusted earnings per share of $1.56 decreased $0.11 or 6.6% versus the prior year. The decrease was driven by reduced operating income offset by a favorable tax rate and share count. Year-to-date available cash flow came in at $327.7 million, an increase of $71.6 million, or 28% versus the prior year. The increased cash flow was driven by higher year-to-date net earnings along with improvement in net working capital and reduced capital expenditures. Patrick will now take you through the financial results and I'll be back later to discuss our 2021 outlook and wrap up."
},
{
"speaker": "Patrick Shannon",
"text": "Thanks, Dave, and good morning everyone. Thank you for joining today's call. Please go to Slide number 7. This slide reflects our earnings per share reconciliation for the third quarter. For the third quarter 2020 reported earnings per share was $1.58. Adjusting $0.09 for charges related to restructuring and impairment, the 2020 adjusted earnings per share was $1.67. Favorable tax drove a $0.13 increase in earnings per share. The negative tax rate for the third quarter reflects favorable settlements of uncertain tax positions, a benefit of mix of income as well as the non-recurring unfavorable tax impact in 2020 related to certain valuation allowances. Reduced share count drove another favorable $0.04 per share. Acquisitions and divestitures had a positive $0.02 per share impact. Operational results decreased earnings per share by $0.21 driven by higher material and freight costs. Productivity challenges and volume deleverage which more than offset the favorable impacts of price and currency. Investment spend increased during the quarter and reduced earnings per share by $0.06. As a reminder, the incremental investment spend is predominantly related to R&D, technology and market investments to accelerate future growth. The combination of interest and other income drove another $0.03 per share reduction. This results in adjusted third quarter 2021 earnings per share with $1.56, a decrease of $0.11 or 6.6% compared to the prior year. Lastly, we have a $0.03 per share increase driven by a gain on the sale of an equity method investment offset slightly by the combination of restructuring charges and acquisition and integration expenses. After giving effect to these items, you arrive at the third quarter 2021 reported earnings per share of $1.59. Please go to Slide Number 8. This slide depicts the components of our revenue performance for the third quarter. I'll focus on the total Allegion results and cover the regions on their respective slides. As indicated, we experienced an organic revenue decline of 1.6% in the third quarter. The electronics, components and labor shortages primarily in the Americas region had an impact on our ability to meet the continued strong demand. Still we realized good price performance, which offset some of the volume decline. Currency continued to be a tailwind to total growth and offset the combined impact of acquisitions and divestitures. In total, reported revenue reduced by 1.6%. Please go to Slide Number 9. Third quarter revenues for the Allegion Americas segment were $524.4 million, down 2.7% on a reported basis and 3% organically. As previously stated, the supply chain pressures we are experiencing drove the revenue decline. We are still seeing strong market demand, which has resulted in record backlogs, particularly in the non-residential part of the business. The region continued to deliver good price realization. Our latest price increase went into effect at the beginning of October. So we expect the price realization to accelerate in the future. On volume, Americas nonresidential was down low single digits driven by the electronics, components and labor shortages. Americas residential was down high single digits. This was uniquely driven by the prior year being inflated by channel refill coming out of the pandemic shutdowns experienced in Q2 of 2020. The shortage of electronic components also had a negative impact on residential performance primarily in the DIY space, a big box retail and e-commerce. Electronics revenue was down high single digits driven by shortages of electronic components of both the nonresidential and residential businesses. Electronics and touchless solutions remain a long-term growth driver and as an integral to our investment in innovation efforts. Americas adjusted operating income of $133.7 million, decrease 19.7% versus the prior year period and adjusted operating margin for the quarter was down 540 basis points. The decrease was driven by higher material and freight costs, productivity challenges related to inconsistent supply and volume deleverage. Incremental investments had a 100 basis points dilutive impact on adjusted margins. Please go to Slide Number 10. The Allegion International segment delivered another solid quarter. Third quarter revenues were $192.6 million, up 1.7% and up 2.5% on an organic basis. We continue to see strength in our SimonsVoss, Interflex and Global Portable Security businesses, which along with good price realization drove the organic revenue growth. Favorable currency and acquisition impacts also contributed to total revenue growth and were slightly offset by divestitures. International adjusted operating income of $21.3 million, increased 4.9% versus the prior year period. Adjusted operating margin for the quarter increased by 40 basis points. The margin increase was driven primarily by volume leverage along with favorable impacts from divestitures and currency. The combination of price productivity inflation were an 80 basis point headwind to margins. Incremental investments reduced margins by 40 basis points. Please go to Slide Number 11. Year-to-date available cash flow for the third quarter 2021 came in at $327.7 million, which is an increase of $71.6 million compared to the prior year period. The increase is attributed to higher year-to-date earnings, improvements in networking capital and reduce capital expenditures. Our cash flow generation continues to be an asset to the company. Looking at the chart to the right, it shows working capital as a percentage of revenues decreased based on a four-point quarter average. The business continues to manage working capital efficiently and generate strong cash flow. I will now hand it back over to Dave for some comments on our full year of 2021 outlook."
},
{
"speaker": "Dave Petratis",
"text": "Thank you, Patrick. Please go to Slide Number 12. On October 1, we issued a pre-release to our earnings and updated our 2021 full year outlook for revenue, earnings per share and available cash flow. We are reaffirming those updated outlooks. We have talked at length about the demand strengthened the Americans business as well as supply chain pressures that are having impact on our ability to meet that demand, which will delay an estimated $80 million to $100 million of revenue. The outlook for total revenue in the Americas is now projected to be at 1% to 1.5% with organic revenue growth at 0.5% to 1%. In the Allegion International segment, we have not seen as large of an impact from component and labor shortages. In our SimonsVoss, Interflex and Global Portable Security businesses continued to perform well. For that region, we expect total revenue growth to be between 12% and 13% with organic growth of 9% to 10%. All-in for total Allegion, total revenue is projected to be up 4% to 4.5% and organic revenue is expected to increase 3% to 3.5%. We're expecting reported EPS to come in the range of $4.95 to $5.05 per share and adjusted EPS to be between $5 and $5.10. Our outlook for available cash flow is projected to be $460 million to $480 million. The outlook assumes investment spend of approximately $0.15 to $0.20 per share. The full year adjusted effective tax rate is expected to be approximately 9%. The outlook for outstanding diluted shares is approximately $90.5 million. Please go to Slide number 13. As we close the presentation and move on to Q&A, I want to take some time to stress Allegion’s strong long-term fundamentals. First, even with the disruption caused by the global pandemic, our strategy around seamless access and electronic transformation remains strong. We expect electronic and seamless access solutions to be the future of access control and we are using multiple innovation engines to lead the industry. You've seen proactive work from Allegion through Allegion Ventures, our recent acquisitions like Yonomi and in our Interflex business, accelerating our software and tech capabilities. We're making investments and expanding partnerships with mega techs and leading access control platforms. We're making significant progress on our ESG journey. This is evident with the two awards that we received earlier this month. The Campbell Award given by the National Safety Council is a very prestigious honor and we joined an elite group of previous winners. I'm also proud of the Jackson Lewis Diversity, Equity & Inclusion Champion Award, which we received from the Indiana Chamber, which recognizes our proactive leadership in diversity, equity and inclusion. Congratulations to be Allegion team. All markets in America remain robust. We continue to see positive trends from leading indicators like ABI and the Dodge New Construction Index and expect these trends to continue into 2022. With the International segment, the strength in our SimonsVoss, Interflex and Global Portable Security business persist. We have aligned and adjusted resources to navigate and adapt to supply chain pressures that the world is experiencing. Actions taken including the redesign of products, the development of alternative supply sources and we continue to leverage our pricing power. Allegion’s supply chain will continue to differentiate us and the strength in our backlogs would indicate that our channel partners believe we will navigate through the global pressures [indiscernible]. Demand remains strong. We have implemented pricing actions that will carry forward into next year and there's substantial backlog to work down. With that backdrop and assuming supply chain pressures related to inflation and component shortages begin to ease, we expect solid revenue growth with year-over-year margin improvement and continued strong cash flow generation in the 2022. The future of Allegion remains bright. Now, Patrick and I will be happy to take your questions."
},
{
"speaker": "Operator",
"text": "We will now begin the question-and-answer session. [Operator Instructions] The first question comes from Joe O'Dea with Wells Fargo. Please go ahead."
},
{
"speaker": "Joe O'Dea",
"text": "Hi. Good morning everyone."
},
{
"speaker": "Dave Petratis",
"text": "Good morning, Joe."
},
{
"speaker": "Joe O'Dea",
"text": "First question is just related to any visibility you have around the timing of relief from supply chain constraints. You've talked about this extending into 2022, but are you seeing anything out there and based on conversations with your suppliers that gives you confidence in when you start to see some relief?"
},
{
"speaker": "Dave Petratis",
"text": "So my first observation, your past records sometimes is a predictor. Allegion performed extremely well through the first phases of this pandemic. Number two is some of the strength of our supply chain adaptability was evident. If we had not adapted, made design changes over the last couple of quarters, our backlog would even be larger. So we feel very good about the performance and the adaptability, flexibility. It's clear the electronics is going to be a problem that all companies, including Allegion, will have to adapt to through 2022. I think an important element of the rest and it's the complexity of the Allegion supply chain is the return of labor pressures to our partner suppliers. This we'll have to continue to monitor. This is everything from castings to power supplies to wire harnesses. There is a labor scarcity across the globe. And again, I believe our ability to adapt and our philosophy to produce in region will help Allegion."
},
{
"speaker": "Joe O'Dea",
"text": "And then related to backlog and catch up and you made the comment about backlog being four times higher than normal, how do you think about managing that? So when you do start to get some relief in the supply chain, do you think about kind of ramping up to deliver to customers as fast as possible, which could then create some inefficiencies in a strained production system? Or do you think about managing that and maybe it takes longer to deliver over time, but not straining the production system in that process?"
},
{
"speaker": "Dave Petratis",
"text": "So we've got a lot of experience in production systems, including the man that runs the company, me, 41 years. I think I liked the backlog. I think if component supplies – as if that regains health, we will actually pick up efficiencies. There has been gross inefficiencies through COVID, these supply chains. An important element is our ability to bring on and flux our own labor and I've got high confidence in our ability to do that."
},
{
"speaker": "Joe O'Dea",
"text": "Great, thank you."
},
{
"speaker": "Operator",
"text": "The next question comes from Joe Ritchie with Goldman Sachs. Please go ahead."
},
{
"speaker": "Joe Ritchie",
"text": "Thanks. Good morning everybody."
},
{
"speaker": "Dave Petratis",
"text": "Good morning, Joe."
},
{
"speaker": "Joe Ritchie",
"text": "As you guys talked about clearly lots of challenges in the marketplace today, I know that as you kind of think about the Americas margins being down 500 basis points to 600 basis points year-over-year, our investments of about 100 basis points impacting the margin. Can you maybe parse that out a little bit more for us like do we know how much of it is coming from higher material and freight costs? How much of it is more kind of like the productivity issues? Just any other additional color around that would be helpful."
},
{
"speaker": "Dave Petratis",
"text": "Yes, Joe, so the significant portion of the margin degradation year-over-year is predominantly inflation and freight costs. And then we've got productivity challenges associated with some of the component shortages and those types of things, creating inefficiencies at our facilities. So if you think about it relative to normally we've done a good job in terms of managing the price inflation dynamic, we're underwater today as we kind of look at that price being lower than the incremental material and freight costs that will get better. As we kind of progress here, we're putting in more price increases to make up for the Delta. One of the challenges is kind of given the high backlog and the fact that a lot of the backlog today is kind of price protected. You don't see the benefit of the price increases coming through and offsetting the incremental inflation until going into 2022. So we're still going to be under pressure for the balance of the year, but inflation really accelerated particularly when you look year-over-year on steel components and those types of things. So it's just – it's one of these short-term phenomenons. If you assume that inflation has kind of peaked today, going into 2022 things will kind of continue to get better than we would expect to be in the positive end of the equation as we progress throughout 2022."
},
{
"speaker": "Joe Ritchie",
"text": "Got it. That's helpful, Patrick. And maybe just kind of following on there, as you think about then – it sounds like you're going to be underwater again in the fourth quarter. As you think about like the pricing that you're putting through, do you typically include a fuel surcharge? Or is this kind of like stickier pricing that you expect to get in the 2022 timeframe? And then we've also gotten some questions from investors today around the fact that pricing stepped down on a year-over-year basis if you took a look at the second quarter versus 3Q. So curious like any comments around why pricing was a little bit weaker in 3Q versus 2Q."
},
{
"speaker": "Dave Petratis",
"text": "So on your first question – so we've managed pricing broadly and it's really dependent upon product category, some of our products that are more steel related, i.e., steel doors, those types of things would carry surcharges associated with that, but mostly across the product portfolio is through list price increases is kind of how we manage it, so it's more permanent in nature. The year-over-year Delta, you kind of have to look at it again by product category, a little pressure and some of the discounts, residential, for example, a little bit harder to kind of pass through the price increases. So that's really what you're seeing there. If you, kind of, look at the bulk of our business, commercial, year-over-year price increase."
},
{
"speaker": "Patrick Shannon",
"text": "I'd add to this. Our hollow metal business, list price increases and surcharges, on the general hardware business two price increases in the year and will adapt to the pressures as we go into 2022 and certainly going hard at the residential products as well. And my message here would be in the addition to freight surcharges, we're pulling all levers on price realization. And I think as we get past this momentary surge that occurred in Q2 and Q3 on inflation, we'll continue our discipline around price performance as we move into 2022."
},
{
"speaker": "Joe Ritchie",
"text": "Thank you. That's helpful."
},
{
"speaker": "Operator",
"text": "The next question comes from Andrew Obin with Bank of America. Please go ahead."
},
{
"speaker": "Andrew Obin",
"text": "Yes, hi, guys."
},
{
"speaker": "Dave Petratis",
"text": "Good morning, Andrew."
},
{
"speaker": "Patrick Shannon",
"text": "Good morning."
},
{
"speaker": "Andrew Obin",
"text": "Yes. Just to follow up on Joe's question on pricing, I'm just a little bit surprised by the pricing myself. We did some channel checks with electrical distributors in the markets. Dave, you would know very well, one of the largest players in North America has pricing effect I think sort of policy at this point in order to sort of cleanse out the backlog. I think HVC guys that's selling a lot of similar channels, I think have had like four price increases this year. I mean the industry structure seems to be quite favorable. Why is it so hard to get a price increase through? Or who is being aggressive, particularly you seem to highlight a residential is one player being aggressive, people out of Asia being aggressive, which was surprising because I would have expected they would have difficulties getting stuff on the boat. Just maybe a little bit more color there. Thank you."
},
{
"speaker": "Dave Petratis",
"text": "So, I'd give a completely different perspective, Andrew. I know the electrical quite well. Think about the amount of electrical pipe, wire and distribution gear that goes in, in the first six months of a construction project, we'd submit our quotes get orders at the same time. And that – those products are delivered at the end of that cycle. When we put a quote, that's carried for a period of time, but we honor that order and so we eat that inflationary pressure. The cycle for the electrical industry is much faster than ours. We've been aggressive on the price increases as well as surcharges and it's not apples to apples. We're both in new construction. On new quotes and bids, we're really raising the levels every day. And I hope that color maybe helps you understand leading products, the electrical versus lagging products on the hardware side."
},
{
"speaker": "Patrick Shannon",
"text": "I'll just add, Andrew. It's not a question of realization. In other words, we'll get the price increase. It's more of a timing issue. So, you will begin to see sequential improvement beginning Q4 relative to the price increases we put in the market. And that will continue to accelerate into 2022, year-over-year and sequentially."
},
{
"speaker": "Andrew Obin",
"text": "In 2022, you'll get some of the benefit of these 2021 price increases. So you'll get it, but later."
},
{
"speaker": "Patrick Shannon",
"text": "Yes."
},
{
"speaker": "Andrew Obin",
"text": "Got you. And just a follow up question, just a difference in performance between North America and I guess international, which I sort of think mostly Europe, as I think about your brands, Interflex, I guess it is mostly software, but it does have electronic components if I think about I guess CISA is the one that's purely mechanical, but on SimonsVoss, which you've highlighted also has large electronic component. Why are you able to avoid the kind of disruption related to electronic components and labor in Europe that you experienced in the U.S. because I would imagine the electronic components in Europe are also getting sourced in Asia? Thank you."
},
{
"speaker": "Dave Petratis",
"text": "So electronic components tight in all sectors of the world, the differences between SimonsVoss a lesser extent and Interflex and the core business in the Americas is pure suppliers. We had designed around the Americas Texas Instruments, NXP, Texas both have had their supply chain issues. The European products more around a different set of suppliers and it's those differences. And the adaptability important here many of the newest Allegion products that drives battery efficiency, WiFi connectivity that makes us the leading products in the world are closer to the supply chain challenges in the Americas than they are in Europe."
},
{
"speaker": "Andrew Obin",
"text": "Got you. I appreciate it. Thanks a lot Dave."
},
{
"speaker": "Dave Petratis",
"text": "You're welcome, Andrew."
},
{
"speaker": "Operator",
"text": "The next question comes from Brian Ruttenbur with Imperial Capital. Please go ahead."
},
{
"speaker": "Brian Ruttenbur",
"text": "Yes, thank you very much. My first question and I'm sorry to keep asking about price increases, but I'm going to ask one on that and one on – a follow-up on a different subject, but the first is on price increases. Can you say specifically how much you've increased prices? ASSA has gone up about 15% multiple, in total, this year. NAPCOs said that 3% they've increased. What have you increased so far this year and what do you plan to increase on the year?"
},
{
"speaker": "Dave Petratis",
"text": "I would say, again you have to look across the different product sets, so it varies. If you're looking at all price increases, i.e., what we talked about there's list price, there's surcharges, there's things related to freight those that have heavier steel related i.e., steel doors those types of things would carry a much higher price increase realization than your traditional products, locks and exits, closers, those types of things. So, list prices for the year would be with both price increases north of 6% with more to come in the future."
},
{
"speaker": "Patrick Shannon",
"text": "I think you also got to include the surcharges on top of that, and this is a big end in our quote activities, we apply discount schemes that give us the ability to rise price based on the project. So again, I feel very good on our pricing analytics. There's that gap in the backlog that we may have quoted over a year ago. We honor those firm orders and they're delivered sometimes over the periods of years. And as we move into 2022, we'll reassess this again and be early and aggressive to make sure that price continues to cover our input cost as we've done since the creation of the company."
},
{
"speaker": "Brian Ruttenbur",
"text": "Right. And then just as my follow-up real quick on – off just real quick maybe you make a comment about their move with HHI from Spectrum and how you anticipate competing on that. I know we've spoken offline on that, but I want to just hear what you think – how that's going to impact Allegion moving forward."
},
{
"speaker": "Dave Petratis",
"text": "So you never want to see your number one competitor or market leader gets bigger. Rest assured that we also looked hard at the Kwikset HHI assets over the years. And I think if you really step back and study the dimensions of Kwikset and how they performed under HHI, I believe also will actually bring a level of discipline to the market. It's certainly our great Schlage brand, the Kwikset brands. There's plenty of room to compete and we've met this challenge I think credibly over the last several decades. Schlage in terms of its electronic leadership, if you look at consumer reports electronics that I think was published in April of this year, three of the top eight walks are ours. We're the number one replacement walk and it's going to be continued competition against two world leaders."
},
{
"speaker": "Brian Ruttenbur",
"text": "Thank you, Dave."
},
{
"speaker": "Operator",
"text": "The next question comes from Julian Mitchell with Barclays. Please go ahead."
},
{
"speaker": "Julian Mitchell",
"text": "Hi, good morning. Maybe just my first question is perhaps on the demand outlook, which hasn't really been touched on yet. I remember in that upcycle in U.S. non-res in sort of 2006, 2007 and 2008, that upcycle in terms of projects did suffered some headwinds because of cost inflation and labor led developers to delay in projects and so forth. And so you had these kinds of rolling push outs and delays. Just wondered what your perspectives are on the risks of that type of phenomenon recurring in the current environment when you're talking to developers looking at your quote activity and so forth."
},
{
"speaker": "Dave Petratis",
"text": "I'd say, each bust and boom cycle sets its own history. We're still living this aspect of it, but as I reviewed the macro demand factors, our backlogs and then recent travel, I would think I was in five states last week. The sentiment that I feel, see and, and living here every day at Allegion is I'm extremely positive. I think we've got three solid years ahead of us as I think about the strategic planning period, working through the supply chain issues, I think there is key infrastructure needs and we have a housing economy that's significantly under inventory for single-family homes, which also is a generator for commercial and institutional development. So, I packed out all together in borrowing another disruption. I liked to go ahead in terms of the business conditions for construction and for Allegion."
},
{
"speaker": "Julian Mitchell",
"text": "I see. So you have not seen major projects being deferred or postponed?"
},
{
"speaker": "Dave Petratis",
"text": "We track cancellations and I'd say it's at a normal level."
},
{
"speaker": "Julian Mitchell",
"text": "That's helpful. And then just a quick follow-up, I'm trying to wrap together your comments on pricing. If you look at your sort of your operating income bridge that line for inflation in excessive pricing and productivity, obviously it's been negative for a couple of quarters now. When you look at the margins in the backlog and the pace of completion, should we assume that that line can go back to sort of breakeven sort of third quarter of next year? Is that the rough timeline?"
},
{
"speaker": "Dave Petratis",
"text": "I would – at – Q3 next year is sort of positive is what I would anticipate basis of a constant inflation relative to what we're seeing today in terms of no further increase year-over-year. But the Delta, i.e., the gap between price inflation improving up until that point, so the rate of change will get better as we progress."
},
{
"speaker": "Patrick Shannon",
"text": "Julian, I'd also add as we – as you and I think about that backlog, if some of the highest margin products that we produce, electronic locks and exit devices are elements, heavy elements of that backlog, the exit devices, heavy complexity, which we – the supply chain pressures create some challenges in that, but those supply chain pressures will improve. The mix of that will roll through. In addition to the price increases, I like our opportunities going forward."
},
{
"speaker": "Julian Mitchell",
"text": "Great. Thank you."
},
{
"speaker": "Operator",
"text": "The next question comes from John Walsh with Credit Suisse. Please go ahead."
},
{
"speaker": "John Walsh",
"text": "Hi. Good morning."
},
{
"speaker": "Dave Petratis",
"text": "Good morning."
},
{
"speaker": "John Walsh",
"text": "Maybe just to follow on Julian’s last question there. If you look in your bridge, I know it's called the volume and mix, but it was a headwind year-over-year, but you actually had non-residential declining less than residential in the Americas. So maybe it has to do with the mix within non-res. And you talked about some of your higher margin products now growing backlog, but we'd just love to unpack that a little bit, why the mix was negative despite non-resi growing better than residential, at least on a relative basis?"
},
{
"speaker": "Patrick Shannon",
"text": "Yes. So you hit on it. It's really within the product portfolio of non-residential products. As Dave indicated high margin products being impacted more and that's kind of what we're seeing it in the backlog due to shortages of components. And so it's really within the non-residential business that you're seeing a mix element, given that non-resi was higher than resi for the quarter."
},
{
"speaker": "John Walsh",
"text": "Great. And then I'm going to take a stab at this. I think earlier in the year, you kind of pointed international margins up low double digits. Obviously, you've seen really good progress there through the year. You've given us the mid point of your guide, a lot of other information. It does seem like that implies the Q4 Americas margin kind of steps down more than seasonality would assume in Q4. And also just thinking about the decremental still being pretty challenged there, any color you can help us on how to think about that from the model perspective or I'll just leave it there, however you'd like to help us out with that sequential decline implied?"
},
{
"speaker": "Patrick Shannon",
"text": "Yes. So kind of we touched on it a little bit earlier. It's predominantly given the price inflation dynamics still under pressure. Some of the inefficiencies from a productivity standpoint, we'll continue given the component challenges supply base that's really the – you are going to see some decrements sequentially. But then as we kind of continue to move into 2022, you wouldn't see obviously that a big of a change in the first part of the year and then approving certainly in the back half."
},
{
"speaker": "John Walsh",
"text": "Okay. Thank you. Appreciate it."
},
{
"speaker": "Dave Petratis",
"text": "Welcome."
},
{
"speaker": "Operator",
"text": "The next question comes from David MacGregor with Longbow Research. Please go ahead."
},
{
"speaker": "David MacGregor",
"text": "Yes. So good morning, everyone."
},
{
"speaker": "Dave Petratis",
"text": "Good morning."
},
{
"speaker": "David MacGregor",
"text": "Patrick, you've made reference a couple of times now to the expectation that maybe inflation is peaked. And I guess I'm just interested in what gives you confidence that would be the case. Have you provisions in place through some of your procurement agreements that lock pricing now or hedges that are in place to give you the confidence to say that. But if you just elaborate on that side, so I appreciate it?"
},
{
"speaker": "Patrick Shannon",
"text": "So that's kind of the commentary was more around kind of our assumptions right now. I mean, if there's continued pressure in the marketplace to some of the component challenges, then that would certainly put pressure on our assumptions as we look forward to 2022. But if you kind of look at some of the forecasting information relative to steel and those type of things, the expectation is, is that as we go into next year, it starts to alleviate itself and maybe trend down. And that would be positive to what we're thinking today."
},
{
"speaker": "David MacGregor",
"text": "Can you just remind us what – how much of your businesses is walk up with annual contracts or supply agreements versus spot purchases? You can elaborate on that a little bit…"
},
{
"speaker": "Patrick Shannon",
"text": "A small portion that it's mostly on raw steel. We kind of look forward and we've got some arrangements with some of our supply base that has fixed rate agreements. Those then kind of fluctuate basis on changes in the market on a forward basis. And so it's small. A lot of our supply base is indexed to steel, if you will. And so it's really just on the purchase of raw steel, which is a small component relative to our overall purchasing."
},
{
"speaker": "David MacGregor",
"text": "Okay. Thank you for that. And then just as a follow-up. You just talk about installation labor and the extent to which that may be a sort of frustration at this point, or how you see that developing as a potential bottleneck or impediment in 2022?"
},
{
"speaker": "Dave Petratis",
"text": "Some broad comments on labor. And it's from a general labor through the trades to professionals. Labor is tight, professional help on a worldwide basis. Second, when you look particularly at construction labor, the gap has grown. Skilled trades were a problem going into the pandemic. The problem has widened slightly. In my mind extends cycle times for construction projects and snowplows, what I think are strong business conditions well into the future."
},
{
"speaker": "David MacGregor",
"text": "Would you consider it all investing in the development of that labor for the market, as a means of alleviating that constraint?"
},
{
"speaker": "Dave Petratis",
"text": "We are investors. I will get off the phone here today, and its manufacturing month in the United States. Allegion plays a very active role in promoting our industry, leading culture, diversity opportunities, tuition reimbursement programs, healthy lifestyle, to attract people and have done it since the creation of the company, number one. Number two, I think manufacturing, I'm extremely proud of is a great place to develop talent and we will make investments in our wage structures to continue to keep Allegion as the best employer with wages and benefits and the communities we operate around the world."
},
{
"speaker": "David MacGregor",
"text": "Thanks David."
},
{
"speaker": "Operator",
"text": "The next question comes from Tim Wojs with Baird. Please go ahead."
},
{
"speaker": "Tim Wojs",
"text": "Hey guys. Good morning."
},
{
"speaker": "Dave Petratis",
"text": "Good morning, Tim."
},
{
"speaker": "Tim Wojs",
"text": "Maybe just dovetailing off of David's question there, could you just – when you think about the new non-resi cycle and how investors should kind of think about it? The leading indicators have obviously been really robust over the last seven or eight months. How would you think about converting those cycle? It was kind of leading interiors into revenue for you guys? I mean, are those new construction projects that could contribute to you in the second half of 2022? Or do you think at this point it's probably more prudent to think 2023?"
},
{
"speaker": "Dave Petratis",
"text": "I think you've got to take the strong cycle and as I look at the macro indicators that you did positive, you've got to lay on that backlog, which will take the better part of six, seven months for us to eat through. And I think extremely robust I see education, I see health care. I think you've also – I've always been concerned about commercial, extremely positive in terms of the macro. There's lots of money on the sidelines to go reinvent this commercial real estate and the new office of the future. So as I look at education, healthcare, commercial, even multifamily is honing longer. And I think investment is going to come in needed infrastructure. We could get an infrastructure bill. So as I look at that, Tim, I like it for the next three to five years."
},
{
"speaker": "Tim Wojs",
"text": "Okay. Okay. And then maybe more of just a modeling question. So you guys outlined that the split on the deferred sales, I think was kind of even between Q3 and Q4, but I think if you just kind of roll that into the model, I mean, there's a bigger think you're down double digits or that's the implication in the fourth quarter versus down maybe low single digits in Americas in Q3. So, any perspective there you can kind of add as to why that is? Is it just seasonality comps?"
},
{
"speaker": "Patrick Shannon",
"text": "Yes. Seasonality comps, the component shortages plus – last year, you may recall what the rebound in a residential business and it was coming out of COVID, there was channel refill in the business, right. Restocking the shelves on retail and e-commerce and so that’s certainly had a fairly significant impact on last year. So you're getting into a difficult comp as relates to our residential business."
},
{
"speaker": "Tim Wojs",
"text": "Okay. Okay. Got you. And then $80 million to $100 million of deferred revenue, I mean, how does that kind of come back next year? I mean, is it – is there some sort of burst that kind of happens and you kind of convert that in 2022 or is it just kind of result in a little bit of a longer cycle?"
},
{
"speaker": "Patrick Shannon",
"text": "No. I think you need to think about it depending on the flow of components and labor, it's a tailwind as we roll through the year. And in a manufacturing environment, you can step up about 20% just by working Saturdays. You need to kind of think about it. If I go to Sundays, I get 40%, people don't work seven days a week for six months. You got to think about, it will step up. It's a tailwind, barring if you get – if we get improvement in components, both electronic and general components, we're going to see that as a tailwind as we roll through the first half of next year. And if the component situation and labor improves work about and gain more share."
},
{
"speaker": "Tim Wojs",
"text": "Okay. Okay. Good luck on the rest of the year, guys. Thanks for your time."
},
{
"speaker": "Dave Petratis",
"text": "Thank you."
},
{
"speaker": "Operator",
"text": "The next question comes from John [ph] Pokrzywinski with Morgan Stanley. Please go ahead."
},
{
"speaker": "Unidentified Analyst",
"text": "Hey, good morning guys."
},
{
"speaker": "Dave Petratis",
"text": "Good morning."
},
{
"speaker": "Unidentified Analyst",
"text": "Dave. So electronics are 20-ish percent of the business, probably a little more than that now. The $80 million to $100 million that you talked about does sound pretty biased to 4Q and I guess what precipitates out of that is it's pretty high percentage of electronics like that virtually electronics going to zero, or how should we think about the split of that headwind between the electrified product versus the mechanical products?"
},
{
"speaker": "Dave Petratis",
"text": "I'd say 40% electronics, 60% mechanical. I'd also, I think you've been in our factories here in Indianapolis complexity when things are common right is our friend. We'll make 2200 variations of the Von Duprin exit device today. And any one of those components in shortage, whether it's a casting, a wire harness as a power supply and electronic board puts pressure on that supply chain and that's what we're living today and confident in our teams to work through it. Remember too, it's not necessarily my ability to put labor in the seat. It's also my supply chain. We pulled hard on redesign shifting over a 100 engineers to redesign predominantly boards but other components. And the second thing I’d say is our flexibility, we've offered to put our people insights to help strengthen our supply chain vendors. And I share that example just because the labor thing goes across transportation, supply chain, getting in through the ports and a level of complexity that I've maybe never seen in my 41 years."
},
{
"speaker": "Unidentified Analyst",
"text": "And then just thinking about the – kind of the unwind of this current tightness. I think an earlier question asked about trade labor, is that the biggest governor of how much the business can grow next year to the teams like you have the ingredients, the demand is there maybe a bit more backlog than usual? It just how quick can we get, installers both on new construction and retrofit is that sort of the KPI that we should be focused on?"
},
{
"speaker": "Dave Petratis",
"text": "I think I would describe it Josh, is there's pacing constraints and labor from the design phase. We just saw a record ABI through the installation phase and I think projects will have longer lead times in an environment that's extremely positive in terms of their willingness to invest."
},
{
"speaker": "Unidentified Analyst",
"text": "Got it. Thanks."
},
{
"speaker": "Dave Petratis",
"text": "You're welcome."
},
{
"speaker": "Operator",
"text": "The next question comes from Chris Snyder with UBS. Please go ahead."
},
{
"speaker": "Chris Snyder",
"text": "Thank you. Thank you. So my first question is on the deferred $80 million to $100 million of revenue, seems like the majority of this is coming from the Americas. In your previous commentary, I think, said that it could take six to seven months to work through this elevated backlog and I think the ability to ramp manufacturing 20% by working Saturdays, I think kind of suggests that this could be realized this $80 million to $100 million in 2022. And obviously, I know there's some uncertainty around the ability to source components. But I guess is that reasonable to think that this could be realized next year, because it's a pretty substantial kind of mid single digit tailwind to the Americas segment."
},
{
"speaker": "Patrick Shannon",
"text": "As you think about 2022, the backlog will be a tailwind, constrained by availability of electronics. That tightness will run into 2023 and then the overall labor. We see – I don't know if you ever, it's an industrial game we call the beer game, bottlenecks move. There's bottlenecks at the ports, there's bottlenecks in labor. These things are going to be moving throughout the year, but my fundamental belief is Allegion has a superior ability to navigate the nation and the world will navigate it. And we'll see these things ease as we go through. And it's a tailwind to push that backlog through."
},
{
"speaker": "Chris Snyder",
"text": "I appreciate that. And then, second question on resi, it sounded like from the prepared remarks that there may be with some demand softening in the quarter. I think you guys called out do-it-yourself or DIY slowdown. So I guess my question is, was this maybe the resi softness part of the second half of revenue cut. And I guess, is there any reason to think that this gets better in 2022, as it seems like that could be more demand related than supply chain related?"
},
{
"speaker": "Dave Petratis",
"text": "So again, I want you to think about that demand game, the supply chains on resi for all supplier was heavily disrupted in 2020. We were shut down for 15, 16 days. You had a demand surge, and this is very evident from the Big Box, Home Depot, Lowes reports in terms of increase investments and do-it-yourself projects. And then you had also housing picking up pretty rapidly that created a demand surge as we started coming out of the lockdowns record backlog in residential, which we have worked through. So I look at overall demand for resi as we move into 2022 is net positive. Based on continued starts of new construction, solid repair and replacement and good multi-family. So that whip is going on the supply chain. Make sure you think about that in your model, because I think a year ago, I'm sitting here talking through record backlogs in residential. We worked through that and I would suggest if you look at our performance versus our competitors that we gained share throughout the last eight quarters."
},
{
"speaker": "Chris Snyder",
"text": "I appreciate that. Thank you."
},
{
"speaker": "Operator",
"text": "And the last questioner will be Ryan Merkel with William Blair. Please go ahead."
},
{
"speaker": "Ryan Merkel",
"text": "Hey everyone. Good morning."
},
{
"speaker": "Dave Petratis",
"text": "Good morning."
},
{
"speaker": "Ryan Merkel",
"text": "So I wanted to follow up on the timing of supply chain getting better. Is it fair to say that margins are bottoming in the second half of 2021, such that as we get into next year, you could see margins increase year-over-year, or is that maybe more of a second half 2022 events?"
},
{
"speaker": "Patrick Shannon",
"text": "Probably more back-end loaded, but feel very confident. If you kind of look at the moves we're making on price, again, assuming inflation is peak. I mean, that's still a question mark, right? But I feel very confident relative to pushing through the backlog, getting some efficiencies that are factory productivity, these types of things. We will have margin incremental improvement in 2022 compared to 2021. No doubt in my mind."
},
{
"speaker": "Ryan Merkel",
"text": "All right. That's helpful. And then just stepping back maybe this question for David, but can you discuss the adoption curve for electronic? Is it faster now and also how are your customers rethinking access control in this new environment?"
},
{
"speaker": "Dave Petratis",
"text": "Electronic access, electronic locks, the power of your edge device and its ability to interact with secured access is a powerful trend that will positively influence this industry for the coming decades. The electronic adoption is what I would describe as high single digits in normal times or pre-pandemic we've been able to deliver on that growth at mid, or excuse me, low single digit or low double digit gross of market growing high single digits. We're in a normalized time low double digits. So a clear trend you can see it in your everyday life. The overall market's still, there's 40 billion openings in the world less than 10% of those integrated. So bright for our industry and bright for Allegion."
},
{
"speaker": "Ryan Merkel",
"text": "Thank you."
},
{
"speaker": "Operator",
"text": "This concludes our question-and-answer session. I would like to turn the conference back over to Dave Petratis, our Chairman, President, and CEO for any closing remarks."
},
{
"speaker": "Dave Petratis",
"text": "Thanks for your questions today. I also want to thank our employees for their continued commitment, steadfastness in navigating the challenges over the last 22 months. Some final messages. Allegion remains a white house for our safety performance and our ESG advancements. Demand in our business remains robust and leading indicators are positive. Supply chain constraints, labor availability, and inflation are challenging. I'm confident in Allegion supply capability, adaptability to be strong, and the long-term fundamentals of Allegion remains bright and strong. Thank you for your time today. Have a safe day."
},
{
"speaker": "Operator",
"text": "The conference has now concluded. Thank you for attending today's presentation. You may now disconnect."
}
] | Allegion plc | 241,782,379 |
ALLE | 2 | 2,021 | 2021-07-22 10:00:00 | Operator: Good morning, and welcome to the Allegion Second Quarter 2021 Earnings Call. All participants will be in listen-only mode. [Operator Instructions]. After today's presentation, there will be an opportunity to ask questions. [Operator Instructions]. Please ask one question and one follow up, and after that you’re welcome to enter the queue. Please note this event is being recorded. I would now like to turn the conference over to Tom Martineau. Please go ahead.
Tom Martineau: Thank you, Andrew. Good morning. Welcome and thank you for joining us for Allegion's second quarter 2021 earnings call. With me today are Dave Petratis, Chairman, President and Chief Executive Officer; and Patrick Shannon, Senior Vice President and Chief Financial Officer of Allegion. Our earnings release which was issued earlier this morning and the presentation, which we will refer to in today's call, are available on our Web site at investor.allegion.com. This call will be recorded and archived on our Web site. Please go to slides 2 and 3. Statements made in today's call that are not historical facts are considered forward-looking statements and are made pursuant to the Safe Harbor provisions of federal securities law. Please see our most recent SEC filings for a description of some of the factors that may cause actual results to differ materially from our projections. The company assumes no obligation to update these forward-looking statements. Today's presentation and commentary include non-GAAP financial measures. Please refer to the reconciliation in the financial tables of our press release for further details. Dave and Patrick will now discuss our second quarter 2021 results, which will be followed by a Q&A session. Please, for the Q&A, we would like to ask each caller to limit themselves to one question and one short follow-up and then reenter the queue. We would like to give everyone an opportunity given the time allotted. Please go to Slide 4, and I'll turn the call over to Dave.
Dave Petratis: Thanks, Tom. Good morning and thank you for joining us today. Allegion delivered a very strong quarter. And I would like to thank the employees of Allegion for their contributions and efforts. Our employees are the greatest strength of Allegion, their dedication to safety and customer excellence is outstanding, and our teams have moved quickly to adapt to opportunities in a dynamic market. Before I jump into the financials, I want to give you a high-level update on recovery trends in the business overall. The pandemic has changed our world and created volatility throughout the last 18 months, both in terms of the economic contraction last year and the current economic rebound we are seeing. Starting in Q1 and accelerating in Q2, demand surged faster and stronger than expected. This is a positive sign and provides confidence in the sustainable economic recovery. In fact, Allegion is already returning to pre-pandemic demand levels. At the same time, the robust demand is constraining the global supply chain’s ability to fully meet the poll for labor and materials, especially electronic components. Allegion has built a record non-residential backlog in 2021, which is a healthy sign of strong demand. And we believe Allegion will be well positioned for the remainder of this year, and for 2022. And another positive sign to recovery are America’s electronics grew more than 20% in the second quarter. There was strong demand for electronic residential products and in the non-residential retrofit, repair and small project opportunities. Allegion is not immune to inflation and the supply chain constraints impacting the industrial markets. Allegion navigated well during Q2, but these industry-wide constraints will persist for the remainder of the year, and put pressure on margins for the short term. We will leverage the strength of our supply chain management capabilities as well as price to mitigate these impacts. During the pandemic, we were also able to restructure the business and make it leaner, while keeping our front facing and strategic investments. Allegion is stronger exiting the pandemic than when we entered it. Now let's turn to the second quarter performance for more details. Please go to Slide 5. I'm pleased with the company's second quarter results. We delivered strong performance in all areas. Revenue for the second quarter was 746.9 million, an increase of 26.7% or 23.8% organically. The organic revenue increase was driven by the favorable comparable created by last year’s shutdowns, solid price realization from the price increase announced earlier this year, and the increased market demand which returned to pre-pandemic levels. Currency tailwinds provided a boost to total revenue and more than offset the impact of divestitures. Adjusted operating margin increased by 70 basis points in the second quarter. The restructuring and cost management actions taken during 2020 along with volume leverage have offset the accelerated inflation. We are also seeing cost creep back from reductions experienced last year during the pandemic. Mix is also a margin headwind due to our strong residential growth. Adjusted earnings per share of $1.32 increased $0.40, or 43.5% versus the prior year. The increase was driven largely by the expanded operating income, with some benefits also coming from a favorable tax rate and share count. Year-to-date available cash flow came in at 249.6 million, an increase of 146 million versus the prior year. The increased cash flow was driven by higher net earnings along with improvements in net working capital and reduced capital expenditures. Please go to Slide 6. Last quarter, I shared with you Allegion’s build-borrow-buy approach to accelerating seamless access. Today, I want to briefly focus on the borrow innovation engine in our strategic pillar to be the partner of choice. Allegion participates in recognized, secure, industry-leading platforms. We expand our reach through strategic relationships with recognized experts and tech innovators, and we leverage open standards. By doing this, we not only set up Allegion as the partner of choice and a continued leader in the IoT marketplace. We also ensure Allegion has its choice of strategic partners as well. Allegion has a growing breadth of strategic partners; mega-tech, software product integrators, our venture portfolio, and technology alliance and industry consortium. We are executing on our partnership strategic pillar and here are a few recent examples. Allegion was showcased at Apple's Worldwide Developer Conference. We're expanding our innovation with Apple in both residential and commercial marketplaces. In the smart home space, Schlage will soon be growing its connected portfolio with a new device that allows people to easily and securely unlock their doors with just a tap using home keys for the icon or the Apple Watch. At the same time, we are extending our work with student ID in the Apple Wallet to offer more access control options to universities and colleges, enterprises and their students plus employees. Allegion renewed our engagement with the Matter Work Group, a mega-tech consortium. Through this partnership, we're working to establish a secure connectivity standard for the future of the smart home that will ultimately allow more seamless connections between more IoT devices. We announced Allegion’s venture investments in both Mint House and Mapped, two startups driving new value in a post COVID world through revolutionary experiences and technology. And we completed a brand new cloud-to-cloud integration with Openpath, leveraging our engaged technology, then Schlage NDE and the LE mobile-enabled smart locks. Through these partnerships, we're investing in promising innovation. We're leveraging developer friendly APIs and open standards. Allegion is building strategic, commercial and technical relationships. We are collaborating with recognized experts who also understand and embrace how Allegion creates value by securing people and assets with seamless access wherever they reside, work and thrive. Patrick will now take you through the financial results. And I'll be back to discuss our revised '21 outlook and to wrap up.
Patrick Shannon: Thanks, Dave, and good morning, everyone. Thank you for joining today's call. Please go to Slide 7. This slide reflects our earnings per share reconciliation for the second quarter. For the second quarter 2020, reported earnings per share was $0.80. Adjusting $0.12 for charges related to restructuring expenses, the 2020 adjusted earnings per share was $0.92. Operational results increased earnings per share by $0.36 driven by volume leverage, along with continued benefits from cost control measures and restructuring actions taken in 2020. Favorable price and currency also contributed to the increase. The combination of these items offset headwinds from inflation, bounce back variable costs related to reduce volume from the COVID-19 pandemic and unfavorable mix. Favorable tax rate drove a $0.06 increase in earnings per share. Divestitures had a positive $0.01 per share impact and offset the impact of other income and interest expense. Investment spend increased during the quarter and reduced earnings per share by $0.05. As a reminder, the incremental investment spend is predominantly related to R&D, technology and market investments to accelerate future growth. This results in adjusted second quarter 2021 earnings per share of $1.32, an increase of $0.40 or 43.5% compared to the prior year. Lastly, we had a $0.01 per share reduction related to restructuring charges and acquisition integration expenses. After giving effect to these items, you arrive at the second quarter 2021 reported earnings per share of $1.31. Please go to Slide 8. This slide depicts the components of our revenue performance for the second quarter. I'll focus on the total Allegion results and cover the regions on their respective slides. As indicated, we experienced organic revenue growth of 23.8% in the second quarter, as higher demand and a favorable comparable drove significant volume increases versus the prior year. We also experienced solid price performance coming in over 2%, which is up sequentially. Currency continued to be a tailwind to total growth and more than offset the impact of divestitures. In total, reported revenue came in at 26.7% growth. Please go to Slide 9. Second quarter revenues for the Allegion Americas segment were 549.4 million, up 23.7% on a reported basis and 22.9% organically. While the strong growth reflects the impact of COVID-related shutdowns last year, it is also the result of accelerated market demand. The region continued to deliver good price realization. On volume, Americas non-residential experienced high-single digit growth driven by retrofit, repair and small projects. Americas residential was outstanding again experiencing growth of more than 70%. The significant growth from the prior year was primarily due to facility closures in 2020. However, we continue to see strength and retail point of sale in new home construction. While our products revenue was up high 20%, we experienced electronics growth in both the non-residential and residential businesses. Electronics and touchless solutions will continue to be long-term growth drivers. The accelerated demand coupled with labor and parts shortages, especially in electronic components, is resulting in elevated backlogs as we enter the third quarter, particularly in non-residential. The timing of when we see the revenue could shift as the industry works through the supply chain constraints. Americas adjusted operating income of 150.5 million increased 21.3% versus the prior year period, and adjusted operating margin for the quarter was down 50 basis points. The decrease was driven by headwinds related to inflation, bounce back costs and unfavorable mix more than offsetting the volume leverage. While the price productivity inflation dynamic was slightly positive on a dollar basis, it did have a 60-basis point dilutive impact on adjusted margins, as did the incremental investment spend. Please go to Slide 10. Second quarter revenues for the Allegion International segment were 197.5 million, up 36% and up 26.6% on an organic basis. The organic growth was driven predominantly by strength across all European countries and businesses, as markets continue to rebound. Part of the year-over-year growth was due to the comparative impact of COVID-related shutdowns in the prior year. Favorable currency impacts also contributed to total revenue growth and were slightly offset by divestiture impacts. International adjusted operating income of 18.5 million increased more than 18 million versus the prior year period. Adjusted operating margin for the quarter increased by 920 basis points. The margin increase was driven primarily by solid volume leverage, benefits from lower operating costs due to the restructuring and cost control actions taken during 2020, as well as favorable currency impacts. All of these offset the higher inflation and bounce back costs which had 150 basis point impact and incremental investments, which were a 20 basis point headwind. Please go to Slide 11. Year-to-date available cash flow for the second quarter of 2021 came in at 249.6 million, which is an increase of 146 million compared to the prior year period. The increase was driven by higher earnings, improvements in net working capital and reduced capital expenditures. Our cash flow generation continues to be a strong asset for the company. Looking at the chart to the right, it shows working capital as a percent of revenues decreased based on a 4 point quarter average. This was driven by improved asset turnover in both receivables and inventory. The business continues to generate strong cash flow and is well positioned to deliver 500 million in available cash flow for the year. I'll now hand it back over to Dave for an update for our full year 2021 outlook.
Dave Petratis: Thank you, Patrick. Please go to Slide 12. At the end of Q2, leading indicators continue to be positive. I’m increasingly optimistic on the economic recovery. The Americas residential business continues to be high. On the non-residential side of Americas, demand accelerated for retrofit, repair and small projects, and is recovering in new construction. However, labor and part charges are proving to be challenging, and we are building a strong backlog that will benefit us in the future. With these parameters in place, we are raising our outlook for total revenue in the Americas to be at 4.5% to 5% and organic revenue to be up 4% to 4.5% in 2021. In the Allegion International segment, markets continue to recover led by our Germanic and Global Portable Security businesses. Currency tailwinds more than offset the divestiture of our QMI door business and contribute to total growth. For that region, we are raising our outlook for total revenue growth to 13.5% to 14.5% with organic growth of 8.5% to 9.5%. All-in for total Allegion, we are now projecting total revenue to be up 7% to 7.5% and organic revenue to increase to 5.5% to 6%. We are also raising our earnings per share outlook with reported EPS at a range of $5.15 to $5.30 and adjusted EPS to be between $5.25 and $5.40. This guide incorporates pricing actions to mitigate the expected impact of direct material inflation. We anticipate these inflationary challenges will persist for the balance of the year, and we will continue to monitor and adapt to changing market conditions. Our outlook for available capital is also being raised and is now projected to be 490 million to 510 million. The outlook assumes investment spend of approximately $0.20 per share. The full adjusted effective tax rate is expected to be approximately 12%. The outlook for outstanding diluted shares continues to be approximately 91 million shares. Please go to Slide 13. Allegion continues its great start in 2021. We have managed the business extremely well and leading indicators of specific market indices related to our business continue to be positive. Looking forward, we are prepared to navigate the pressures related to accelerated inflation in labor and part shortages. We are encouraged by the positive resiliency of our supply chain, and we will continue to manage these challenges for the balance of the year. Thank you. Now Patrick and I will be happy to take your questions.
Operator: We will now begin the question-and-answer session. [Operator Instructions]. The first question comes from Josh Pokrzywinski with Morgan Stanley. Please go ahead.
Josh Pokrzywinski: Hi. Good morning, guys.
Dave Petratis: Good morning, Josh.
Josh Pokrzywinski: So I guess first question on the margin front. Obviously, there's kind of the tyranny of the math on price costs, even though you're positive on the dollar basis. And I would imagine a little bit of a mix headwind on the revenue side as well. But if you just kind of take a giant step back and put some of the mechanical items aside, do you feel like getting price or managing inflation and logistics and all the other kind of inflationary headwinds, labor is any different than it has been normally, or that has got gotten a little bit more challenging? It’s sort of hard to parse through some of the different moving pieces there.
Dave Petratis: Yes, I would characterize it this way. And you're right. There's a lot of tyranny in the math. But what we've seen is an acceleration of inflation, predominantly in commodity costs, material components, freight packaging, et cetera. It’s continued to be a headwind. As you know, we're pretty aggressive moving on price. And we're taking similar actions in the back half of this year. We went ahead and announced a price increase that will take effect at the beginning of Q4. So there's going to be some margin pressure, I would say, given the acceleration in inflation, particularly in Q3. I expect price to offset material inflation. The issue is really in some of the other components as it relates to packaging, freight, those type of things, will drive productivity to help mitigate those type of things, like we have previously. But it's going to be a challenge. There will be some margin pressure in the back half of the year. But I feel very confident relative to margin improvement as we go into 2022, predominantly because of the carryover price. And we'll continue to take pricing actions next year. We'll have an improved mix profile, as it relates to the non-residential business growing faster and accelerating more so than the residential business. And we're not going to have these bounce back costs, which were an issue for us in Q2, and will kind of linger during Q3, Q4 this year. So I think to answer your question, Josh, we’ll continue to manage the business. We'll get through some of the supply chain challenges. That in of itself also put a little bit of margin pressure because of some of the inefficiencies at the factories. But we'll manage through it. Margin sequentially will improve in the second half relative to the first half, still down year-over-year. But then in 2022, expect margin improvement to accelerate.
Josh Pokrzywinski: Got it. That's helpful. And then I guess just a follow up on the comment, Dave, you made on record backlog. Maybe if you could unpack that a little, because I would imagine some of that is resi where you probably don't really want a lot of backlog there and it's more indicative of lead times and supply chain stuff than it is necessarily like a long cycle business. So maybe break down the components of that of how much is non-resi, is the market getting better and reopening and retrofit versus we're just hearing more backlog in resi because the whole supply chain lengthens? Thanks.
Dave Petratis: So, I want to be clear. The backlog issue is not a residential problem. Our residential backlog is slightly above what we normally run. The backlog creation has been on the commercial side of the business and the rapid build has really happened over the last 60 to 90 days. The commercial backlog predominantly on the Americas business is double normal. And it was really driven by the acceleration of order demand that we started seeing in April. And I’ll give you some backdrop here. If you go back December, January, February, March, and we would have talked about this in the Q1 call, commercial institutional demand in the Americas business was down low double digits, and it's like someone turned on a light. And it's -- extremely pleased with that demand acceleration. We're doing a good job of I think processing that through, but there's supply constraints and it's resulted in a record backlog that I think we'll continue to see. There's been analysts out there that have said, we've done a better job of managing this. And I believe that to be true. Our supply chain is strong and we're going to benefit from that trend. I'd also share one other comment is the macroeconomic forecast on what I'd say the commercial break fix was not particularly clear. In fact, I've got economic reports that would suggest that the repair, replacement would have been soft even today. That switch came back on. We've gained that opportunity. So why couldn't we have seen it? When you shut off access to college campuses, hospitals and commercial buildings for 400 days, you get pent-up demand and that's what we're seeing reacting positively in the marketplace.
Josh Pokrzywinski: Got it, very helpful. Thanks, guys.
Dave Petratis: Thank you.
Operator: The next question comes from Chris Snyder with UBS. Please go ahead.
Chris Snyder: Good morning, guys. Thank you. And I kind of want to follow up on the margin commentary, but maybe from a bit of a different angle. So guidance implies a pretty material ramp in margins into the back half of 2021. My back of the envelope math puts margins in the low 21% range -- low to mid 19% in the first half. Can you just kind of help unpack the drivers of this step higher? Because guidance is not implying much volume leverage into the back half. So is this more price catching up the cost, freight normalizing, mix normalizing, any color on that step higher into the back half will be appreciated?
Dave Petratis: Yes, so that trend is not uncharacteristic. From a seasonality perspective, margins -- if you kind of look at it over historical time period, stronger back half of the year. So that's not unusual. I think as we characterize sequentially, margins are expected to increase. It's the year-over-year comparisons that we would expect some degradation, just kind of given some of the things we outlined relative to inflation.
Chris Snyder: I appreciate that. And then I guess following up also on the record backlogs, it sounds like revenue on some level was constrained just by the supply chain issues that everyone is feeling. And it also sounds like the back half or the full year of growth guidance is also reflecting uncertainty as to when these backlogs will be released, whether it's the back half of '21 or into '22. Could you provide any color on maybe how much or how significant revenues were maybe constrained in the quarter just because of those supply chain issues? And then how we should -- what level of maybe supply chain conservatism is baked into the full year organic growth guidance?
Dave Petratis: When we look at the demand relative to what we could ship, there is going to be a disconnect there just kind of given the supply chain constraints. And I think you're aware, Chris, we normally carry a light backlog, highly specified engineered product, quick turnover in our manufacturing facilities to the customer. That has been elevated kind of given some of the constraints. But to answer your question, specifically, it could be 1%, 1.5% kind of total revenue at Allegion that's constrained that we’ll get the revenue. So it's not a question of -- it's just a question of timing. So we look at it as a timing kind of transitory issue. And if the supply chain constraints persist, we'll get that in 2022, which means revenue in '22 would be accelerated more so than the overall market demand.
Chris Snyder: Thank you for that.
Patrick Shannon: I would add a couple other comments. Clearly, supply constraints ended the rapid acceleration of demand that we saw helped build backlogs. I would say, we will -- over this entire pandemic and downturn, the resiliency of the Allegion supply chain I believe was stronger than the competition. And we're going to come out of this better. So feel good about that. I think the other thing you've got to think about, we're not alone in this. In the retrofit community and new construction, the entire project is affected by this. And we just got to navigate in that environment.
Chris Snyder: I appreciate that. Thank you.
Operator: The next question comes from Brian Ruttenbur of Imperial Capital. Please go ahead.
Brian Ruttenbur: Yes. Thank you very much. So I have two questions. Can you talk about the commercial office performance in the quarter? How much was the sector down year-over-year? How much did commercial office represent in terms of revenue in the quarter? I'm just trying to get a data point where you are.
Dave Petratis: Yes, so we don't really provide revenue by vertical markets. But I would just say, in terms of market demand, i.e. order intake activity, what we're seeing in specification, et cetera, commercial office space is lagging institutional segment. And a lot of that is just not kind of keeping pace with what we're seeing in terms of the rebound in repair, retrofit and new construction. So hopefully that provides you with ample color there.
Patrick Shannon: Maybe to give you a little bit more, again, we don't split out that commercial segment as a standalone, but the strength that we saw in the first half was really driven by strong wholesale, small project and retrofit business. Where that business ends up, we don't have precise data on but there's -- the snapback of that volume would say, even in the commercial office space, there's definitely going in there to repurpose, to reposition and I like the opportunity for Allegion as we move through there from an electronic standpoint. You go back six months ago, I was concerned about the return to office and we're going to have a lot of vacancies out there. Capital will go in and redefine that space, and it's going to be good for our industry.
Brian Ruttenbur: Great. Well, thank you. The second question I have just coming off of ISC West and meeting with a lot of companies, private and public, we see a lot of competition coming at access control with a total solution, white and -- one of the trends I'm seeing is white labeling of hardware at a discount and integrating software. So it's all about delivering a total solution, the hardware, maybe name doesn't mean as much. That's what I'm hearing at least. So some of these companies that are investing large sums of money in this total access control solution, that's what we're seeing. Can you address what you're seeing in the industry and how you're addressing this threat?
Dave Petratis: I think in today's presentation, we try to emphasize our build-borrow-buy emphasis and our partnerships with the mega-techs. I certainly see this private labeling, white labeling phenomena. I would just suggest the core part of our business has a level of complexity and connectivity that I'll bet on over the long haul. When you get into a complex business or a complex event space, like you were at ISC West, it's easy to look at this and say, okay, I can have a small offering of white label products. But when you start adding code requirements, master key systems, the connectivity with an Apple, a Google, a Lenel, the game gets a lot tougher.
Brian Ruttenbur: Great. Well, thank you very much for addressing those. I really appreciate it. I'll get back.
Dave Petratis: You’re welcome.
Operator: The next question comes from Julian Mitchell with Barclays. Please go ahead.
Julian Mitchell: Hi. Good morning. I just wanted to circle back to the Americas revenue guide for the year. You're embedding I think maybe very low-single digit growth year-on-year in the second half in the Americas. Just trying to understand what's embedded in that for residential versus non-residential and what sort of pace of slowdown of residential growth you’re assuming?
Dave Petratis: Yes. So, Julian, just as a reminder, last year as we're coming out of the pandemic and demand started to surge for replacement demand on residential products, backlog accelerated, channel inventories were depleted. And so a lot of the revenue growth last year was channel fill; big box retail, e-commerce, et cetera. So you're getting a tough comp, particularly in the second half as it relates to the residential business. And so that's going to impact the comparability, particularly when you're looking at overall Allegion Americas business. As we indicated, non-residential business, starting to show good demand, a little bit constrained relative to the supply chain issues, but we'll start seeing some growth kind of year-over-year. So, it's really that the guide, you have to take into account last year, had a higher growth component associated with channel fill related to the residential business.
Julian Mitchell: Sure. But I guess I’m trying to understand, are you assuming that residential revenues are down year-on-year in the second half or --
Dave Petratis: No. They're still increasing.
Julian Mitchell: Okay, got it. That's just what I wanted to check. Thank you. And then on the margin front, looking at -- yes, we keep attacking it different ways. But let's look at it sort of second half margin year-on-year, because I think that makes more sense in terms of the information you provide in the 10-Q and so on. So it looks like your second half operating margins firm-wide maybe down something like 100, 200 bips year-on-year in the second half. Is the way to think about that it's about 200 bips headwind from inflation net of price productivity, and then maybe another 100 bips headwind from investment spend? Are those roughly the right orders of magnitude?
Dave Petratis: Yes. And I would -- just a little bit more color on the price productivity inflation dynamic. Included in that guide would include some of the effect of these bounce back costs that we've been highlighting. It was much more pronounced in Q2, but you've got kind of some of those costs that continue in Q3, Q4. So that's some of the pressure as well year-over-year.
Julian Mitchell: Perfect. Thank you.
Operator: The next question comes from David MacGregor with Longbow Research. Please go ahead.
Joseph Nolan: Hi. This is Joe Nolan on for David MacGregor.
Dave Petratis: Good morning, Joe.
Joseph Nolan: Good morning. I was just wondering could you talk about field inventory levels in both the residential and infomercial business. And then just how you expect the timing of the channel restock to play out?
Dave Petratis: On the residential side, big box, our res pro [ph] partners, I think the restocking of that supply chain is essentially complete. There is pressure on any type of electronic-related product, again, which we’re navigating well, but that will be a problem that moves through in the next four quarters. On the commercial wholesale side, as I talked about, the bounce back in demand, I think part of that is wholesalers seeing the confidence in the marketplace and restocking, but I think much of it is going straight through because of the availability or really green light on small projects that were delayed over a continued period. So I would suggest that the restocking of the wholesale and contract supply chain will be completed over the next two to three quarters.
Joseph Nolan: Okay. Thanks for that. And then also just on your education business, given the year-ago pull forward and the timing of seasonal maintenance into 2Q '20. Was that a growth headwind that you experienced in 2Q '21 this year, and do you think that becomes a tailwind here in 3Q?
Dave Petratis: State your question again. You broke up.
Joseph Nolan: I’m sorry. Just on the education business, given the year-ago pull forward and the timing of seasonal maintenance into 2Q '20. Was that a growth headwind this year in 2Q '21? And does that become a tailwind here in the third quarter?
Dave Petratis: I would look at the opportunity in K-12 as part of the bounce back, but more a positive as we move into '22 and '23. Americas going to continue to invest in its K-12 infrastructure for a variety of reasons; age, increased security, more automation, and Allegion will benefit from that. It's clearly a positive.
Joseph Nolan: Okay. Thanks.
Operator: The next question comes from Andrew Obin with Bank of America. Please go ahead.
Andrew Obin: Hi, guys. Good morning.
Dave Petratis: Good morning, Andrew.
Andrew Obin: For a while, I thought I would have to use the word unpack in my question. I was wondering if there was a memo that went out to use the term unpack, but --
Dave Petratis: I thought you were going to remind me that you had it right on this bounce back.
Andrew Obin: I'll take that too. Thank you. I guess the question is on pricing. Historically, your pricing has been fairly close to that of your large competitor in North America. This quarter, they seem to be ahead of you. And I was just wondering, is there a difference in approach to channel between the two of you or it’s just a matter of timing, as I said, because the industry seems to sort of move in lockstep?
Dave Petratis: I wouldn't say, they're ahead of us. My words to our leaders worldwide is use all tools required to address the extraordinary inflationary forces. We were out with a normal Q1 price increase. We've added surcharges on certain products. And we've announced an end of Q3 price increase, two price increases in a year and the other tools that we're using to mitigate price. I think the industry has been disciplined in our stewardship of making sure that we respond to the incredible inflationary forces that work for us.
Andrew Obin: Got you. Thank you. Then the second question, as you -- and I think I've asked this question a couple of times. But as you face supply chain constraints, are you rethinking either your approach to your internal supply chain, i.e., sort of more automation, or are you sort of rethinking sourcing any long-term impact from sort of current disruption in the channel, or you think once we sort of get rid of the bullwhip effect, things go back to normal fairly fast?
Dave Petratis: I think the weakened supply chain is always a strategic item, as we think about positioning the business, one. Number two, I point to our decrementals during the downturn. Our decrementals on a top line basis was softer than any of the competition, meaning as the markets collapsed, our revenues were stronger on those decrementals, and I would point to supply chain. Third is, I think clearly a lot of work going on, I'd say, managing the complexity of what we do. It's everything from boards to grommets to casting. Part of what the Allegion franchise is built on is managing this complexity. Our supply chain does an important part of -- it plays a critical part of that, but it's rethinking those partnerships, making sure that we've got the availability of any type of part to be able to move it. We've made some pretty significant industrial investments in automation. Those will continue. I think as we go through this, labor availability is going to be in scarcity on a worldwide basis. And so automation investments, investing with strong suppliers and producing in region are key drivers for Allegion, Andrew.
Andrew Obin: Okay. Thank you so much. And I appreciate the compliment. I don't get those often. Thank you.
Dave Petratis: I should have read that twice. I did read it twice.
Operator: The next question comes from Joe Ritchie with Goldman Sachs. Please go ahead.
Joe Ritchie: Thanks. Good morning, guys. And no need to fish for compliments on this one. Just a quick question here on the margins. If I take a look at the Americas margins and your commentary around pricing for 4Q, I guess when we think about the sequential change in margins in the Americas, is there kind of like embedded in your expectations that sequentially margins potentially step down in 3Q because of these inflationary pressures and then back up in 4Q? Just trying to understand the cadence a little bit better?
Dave Petratis: Yes. So you got it right. Q3 margin decrease year-over-year much more pronounced than Q4. Q4, because of the price increase and some further actions, is still down but improving. Not as far down as 2Q.
Joe Ritchie: Okay, all right. That's super helpful. And then I guess maybe just one -- maybe one broader question. I know that you guys consistently get compared to your European peer and the U.S. But if we took a step back and just thought about the industry as a whole and the potential consolidation in the locks market in the U.S., do you guys view the market as being fairly well concentrated today? Are there opportunities to continue to expand either via M&A within the market, you see future consolidation? Just curious on your broader thoughts there?
Dave Petratis: I think over the last decade, this is an industry that's consolidated. I would suggest that that's not moved at the pace that other industries have. So there's opportunities, half step adjacencies. I think the brightest growth aspect for Allegion is in the seamless access technologies. Part of the corporate spend this year is we're investing to try and better understand the future of seamless access, and where it could be 5 to 10 years out, because of our unique position in. And my message here, the industry is going to continue to consolidate it, but I believe through innovation of our unique position on the door, electronics, your edge device that it will continue to drive nice growth for Allegion.
Joe Ritchie: Okay, that's helpful, Dave. Thanks, guys.
Operator: The next question comes from Tim Wojs with Baird. Please go ahead.
Tim Wojs: Hi, guys. Good morning.
Dave Petratis: Good morning to you.
Tim Wojs: Maybe just -- so first question is on investment, and I guess it's two-part. So I guess first, could you just elaborate a little more on where you're making the actual incremental investments this year? And then secondly, could you just talk about the pipeline build for future investments and how the paybacks on those are kind of prospectively versus just history? Are they the kind of same, better or worse? Just kind of curious there?
Patrick Shannon: Yes, Tim. So the majority of the incremental investments would be centered around R&D technology type of investments centered around driving electronics, revenue growth and market segmentation, i.e., where are the opportunities where we can expand our business and leverage our franchise globally. And so think about that in relation to some of the things Dave talked about in terms of enhancing our partnerships, to have broader connectivity into electronic seamless access, ecosystems and solutions, very important for the business going forward. So we're putting monies in those that I think will position us extremely well for growth going forward and will help us continue to grow faster than the broader market is the plan there. Your question on ROIC, it's always been a really good payback, not only on investment, but on a cash-on-cash basis, and good things to do that will position us in the marketplace for further growth. And historically, you've kind of seen our revenue kind of trend probably a little bit north of our peer set, and would expect that to kind of continue given the level of investments that we're making and position our franchise going forward.
Dave Petratis: I'd build on that a bit, Tim, to say we've had -- take out the pandemic, we've had five, six years of double digit electronics growth. And clearly the market is moving that way. We've got over the next 24 months a nice pipeline of connected products coming out that it will enhance specific investments in software capabilities, what I call software stacks, that enhance the partnership that we talked about today. You have to have the APIs, SDKs that allow our locks to work in our own ecosystems and work in the complex ecosystems that may be present at a hospital, college campus. We believe this differentiates us versus one horse ponies that come in with a solution in an important part of our future growth. I'd add one other is segmenting the market and understanding the future 5, 10 years out in multifamily, K-12, college campuses and hospitals, we think we have an important role to play in our installed base in this connected environment will leverage Allegion’s growth.
Patrick Shannon: Tim, also just think about the movement in technology, how fast things are changing. And being part of a broader ecosystem where we can, our products can seamlessly plug and play into a broader set of solutions is very important, and so incremental investments will continue. It is part of our DNA in terms of how we think about accelerating growth. And things are moving quickly and we want to be a market leader in that segment.
Dave Petratis: In depth, partnerships with the mega-techs which are important, partnerships with the integrators, like Lenel, our venture arm, I think you saw the announcement on Openpath, the sale to Motorola Solutions, an excellent example of how we're playing that game, and then continuing investments in the digital players that help drive our growth.
Tim Wojs: Okay, great. I really appreciate that. It all makes sense. I guess the second question just on maybe bigger picture. Could you just frame for us how you're thinking about a recovery and maybe revenue contribution from the specification business? So you're obviously seeing an uptick on the specification side. But when do you think you could start to see that be a meaningful revenue contributor? Is that a full year benefit next year, or is it skewed towards the second half?
Dave Petratis: I think you'll see that really gaining some speed Q2 of next year and through the traditional construction season. ABI has been up for three, four consecutive months at really record high at 60. I think we were there for a peak. It takes about 12 to 18 months based on the scope of those projects for us to really start seeing the momentum.
Tim Wojs: Okay, great. Good luck, guys. Thanks for the time, guys.
Dave Petratis: Thank you.
Operator: The next question comes from John Walsh with Credit Suisse. Please go ahead.
John Walsh: Hi. Good morning.
Dave Petratis: Good morning.
John Walsh: Maybe just two follow ups here. One, you had a little bit of a discussion there on K-12. You talked about the age, the security, more automation. But one thing you didn't mention was stimulus. And just curious, we're hearing that there's a lot of stimulus already been approved for that vertical, a lot of focus on HVAC, but there is a big demand on the infrastructure side for access control. Are you seeing any of that benefit yet or is that what you're kind of talking about might come through in '22 and beyond?
Dave Petratis: As we try and unpack the stimulus package, we certainly see access control, school security as a part of that. Again, it's dominated I think by modernization, things that you talked about, HVAC. We're going to benefit as a result of that stimulus. I would also say, there will continue to be a drive in the K-12 sector to modernize. The average K-12 structure is 40 years old. Security threats persist and access into schools is becoming more sophisticated because of people's edge device, electronic locks, and Allegion is going to benefit from that.
John Walsh: Great. Thanks. And then, obviously, you've lived through several inflationary cycles. We could argue this one's a little bit different. But can you talk about your ability to hold price when you come out of these inflationary cycles? There's probably some regular pricing activity. I think you used the term surcharges for some things as well that maybe those are a little bit more transitory and go away when inflation abates. But can you just talk about your historical experience if we’re thinking about margin next year?
Patrick Shannon: Yes. Sure, John. So historically, price increases announced that are permanent in nature stick going forward, okay, i.e., even in deflationary periods, prices remain the same. And fairly disciplined industry here. We did announce some surcharges on particular products that are more heavy in steel-related components. And those, of course, go away assuming the price of steel comes down. But the majority of our price increases are permanent price increase that we expect will stick going forward, even when inflation comes down.
Dave Petratis: I would add to that. The majority of my industrial career in the electrical industry and now security, we have as a guiding management principle as our input costs go up, I expect to capture that plus. And we're very driven on the inputs as well as the pricing systems here. And it's part of our DNA. And it's never been more important as we face inflationary pressures.
John Walsh: Thanks. I appreciate you taking the questions.
Operator: The next question comes from Jeff Sprague with Vertical Research. Please go ahead.
Jeff Sprague: Thank you. Good morning, everyone. Maybe just a couple loose ends here, a lot of ground covered. First, maybe a little shout out to your international friends. Just wonder if you could give a little bit of color how you're thinking about the margins in the back half there, right? Usually we start fairly low in the first half and step up materially. I'm assuming from this kind of better run rates here in the first half, you’re not expecting the same magnitude of step up by assuming margins are going higher. Can you just elaborate on the trajectory there, the price cost dynamics in those markets collectively? And what if any other restructuring benefits you have coming through?
Dave Petratis: Yes, Jeff, so thanks for bringing that up. Outstanding performance by the international team, particularly when you're looking at not only margin increase but the top line growth, and that's been a key contributor to the margin expansion there as well. But you may recall, if you kind of look at that segment in isolation, they were probably out in front of this pandemic quicker in terms of reducing costs, managing that side of the equation, restructuring programs that kind of went through both in Europe and Asia Pacific. We also are seeing the benefit of the amalgamation of both the Asia Pacific and European segments coming together as Allegion International. All that combined has really accelerated the margin improvement year-over-year. The restructuring actions, the benefits we saw in the first half, kind of lapped, if you will, beginning in Q3. So you're not going to see the step up in margin expansion year-over-year. Seasonally, you know this Jeff that the margins expand in Q4 for that segment, in particular. We would expect the same seasonal increase. But the year-over-year margin improvement you're not going to see and there was some one-time benefits in Q4 that are non-recurring this year, bounce back in cost, higher inflation, these type of things. But a great performance first half. We would expect kind of this continuous margin improvement going into next year too. And so really like what the team has done there, how they're executing, driving top line growth, those types of things, a great performance.
Jeff Sprague: Great. Understood. And then just back to kind of the whole backlog top line calculus here. I guess your guide essentially kind of indicates revenues in Q3 and Q4 will be similar to Q2, which is not atypical for your business. But I guess I'm also hearing though that perhaps you're suggesting the top line is just governed here by the supply and other constraints. Is that really the message that they're kind of in normal circumstances, there would be more upside into the back half just unlocking this backlog, but just the physical ability to get it out the door, whether it's your own factory or inputs from suppliers, just keeping a lid on what you can actually execute on in 2021?
Dave Petratis: You read that correctly. I think we've assessed, okay, what's possible here? We'll move that backlog through. I think we are mindful of the constraints on our supply base. We're also I think grounded that labor may be the tightest element in all of this, and it affects our customers and suppliers. So you've got to kind of take a stiff view at this. When are people going to come back to work and availability improve? We think that's a long-term problem. We think the culture of Allegion, how we run our business and the strength of our supply chain will do better than the competition in that battle.
Jeff Sprague: Great. Thanks for the color.
Dave Petratis: Thank you.
Operator: This concludes our question-and-answer session. I would like to turn the conference back over to Dave Petratis for any closing remarks.
Dave Petratis: Thanks for joining today's call. Allegion’s future remains bright. And I'd like to leave you with some key highlights of our call. Market demand is robust and it has returned to pre-pandemic levels faster and stronger than anticipated. This is extremely encouraging. Inflation has accelerated and there are industry-wide supply chain pressures. These constraints are not unique to us and we will actively manage both of these dynamics. The resulting backlog we are building sets us up well for the remainder of '21 and '22. Last, Allegion is stronger, more structurally sound as we continue to invest during the pandemic. As a result, we are positioned well for profitable growth, and we'll continue to aggressively execute on our strategy of seamless access. Have a great day today. Thanks for your attendance.
Operator: The conference has now concluded. Thank you for attending today's presentation. You may now disconnect. | [
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"speaker": "Operator",
"text": "Good morning, and welcome to the Allegion Second Quarter 2021 Earnings Call. All participants will be in listen-only mode. [Operator Instructions]. After today's presentation, there will be an opportunity to ask questions. [Operator Instructions]. Please ask one question and one follow up, and after that you’re welcome to enter the queue. Please note this event is being recorded. I would now like to turn the conference over to Tom Martineau. Please go ahead."
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"speaker": "Tom Martineau",
"text": "Thank you, Andrew. Good morning. Welcome and thank you for joining us for Allegion's second quarter 2021 earnings call. With me today are Dave Petratis, Chairman, President and Chief Executive Officer; and Patrick Shannon, Senior Vice President and Chief Financial Officer of Allegion. Our earnings release which was issued earlier this morning and the presentation, which we will refer to in today's call, are available on our Web site at investor.allegion.com. This call will be recorded and archived on our Web site. Please go to slides 2 and 3. Statements made in today's call that are not historical facts are considered forward-looking statements and are made pursuant to the Safe Harbor provisions of federal securities law. Please see our most recent SEC filings for a description of some of the factors that may cause actual results to differ materially from our projections. The company assumes no obligation to update these forward-looking statements. Today's presentation and commentary include non-GAAP financial measures. Please refer to the reconciliation in the financial tables of our press release for further details. Dave and Patrick will now discuss our second quarter 2021 results, which will be followed by a Q&A session. Please, for the Q&A, we would like to ask each caller to limit themselves to one question and one short follow-up and then reenter the queue. We would like to give everyone an opportunity given the time allotted. Please go to Slide 4, and I'll turn the call over to Dave."
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"speaker": "Dave Petratis",
"text": "Thanks, Tom. Good morning and thank you for joining us today. Allegion delivered a very strong quarter. And I would like to thank the employees of Allegion for their contributions and efforts. Our employees are the greatest strength of Allegion, their dedication to safety and customer excellence is outstanding, and our teams have moved quickly to adapt to opportunities in a dynamic market. Before I jump into the financials, I want to give you a high-level update on recovery trends in the business overall. The pandemic has changed our world and created volatility throughout the last 18 months, both in terms of the economic contraction last year and the current economic rebound we are seeing. Starting in Q1 and accelerating in Q2, demand surged faster and stronger than expected. This is a positive sign and provides confidence in the sustainable economic recovery. In fact, Allegion is already returning to pre-pandemic demand levels. At the same time, the robust demand is constraining the global supply chain’s ability to fully meet the poll for labor and materials, especially electronic components. Allegion has built a record non-residential backlog in 2021, which is a healthy sign of strong demand. And we believe Allegion will be well positioned for the remainder of this year, and for 2022. And another positive sign to recovery are America’s electronics grew more than 20% in the second quarter. There was strong demand for electronic residential products and in the non-residential retrofit, repair and small project opportunities. Allegion is not immune to inflation and the supply chain constraints impacting the industrial markets. Allegion navigated well during Q2, but these industry-wide constraints will persist for the remainder of the year, and put pressure on margins for the short term. We will leverage the strength of our supply chain management capabilities as well as price to mitigate these impacts. During the pandemic, we were also able to restructure the business and make it leaner, while keeping our front facing and strategic investments. Allegion is stronger exiting the pandemic than when we entered it. Now let's turn to the second quarter performance for more details. Please go to Slide 5. I'm pleased with the company's second quarter results. We delivered strong performance in all areas. Revenue for the second quarter was 746.9 million, an increase of 26.7% or 23.8% organically. The organic revenue increase was driven by the favorable comparable created by last year’s shutdowns, solid price realization from the price increase announced earlier this year, and the increased market demand which returned to pre-pandemic levels. Currency tailwinds provided a boost to total revenue and more than offset the impact of divestitures. Adjusted operating margin increased by 70 basis points in the second quarter. The restructuring and cost management actions taken during 2020 along with volume leverage have offset the accelerated inflation. We are also seeing cost creep back from reductions experienced last year during the pandemic. Mix is also a margin headwind due to our strong residential growth. Adjusted earnings per share of $1.32 increased $0.40, or 43.5% versus the prior year. The increase was driven largely by the expanded operating income, with some benefits also coming from a favorable tax rate and share count. Year-to-date available cash flow came in at 249.6 million, an increase of 146 million versus the prior year. The increased cash flow was driven by higher net earnings along with improvements in net working capital and reduced capital expenditures. Please go to Slide 6. Last quarter, I shared with you Allegion’s build-borrow-buy approach to accelerating seamless access. Today, I want to briefly focus on the borrow innovation engine in our strategic pillar to be the partner of choice. Allegion participates in recognized, secure, industry-leading platforms. We expand our reach through strategic relationships with recognized experts and tech innovators, and we leverage open standards. By doing this, we not only set up Allegion as the partner of choice and a continued leader in the IoT marketplace. We also ensure Allegion has its choice of strategic partners as well. Allegion has a growing breadth of strategic partners; mega-tech, software product integrators, our venture portfolio, and technology alliance and industry consortium. We are executing on our partnership strategic pillar and here are a few recent examples. Allegion was showcased at Apple's Worldwide Developer Conference. We're expanding our innovation with Apple in both residential and commercial marketplaces. In the smart home space, Schlage will soon be growing its connected portfolio with a new device that allows people to easily and securely unlock their doors with just a tap using home keys for the icon or the Apple Watch. At the same time, we are extending our work with student ID in the Apple Wallet to offer more access control options to universities and colleges, enterprises and their students plus employees. Allegion renewed our engagement with the Matter Work Group, a mega-tech consortium. Through this partnership, we're working to establish a secure connectivity standard for the future of the smart home that will ultimately allow more seamless connections between more IoT devices. We announced Allegion’s venture investments in both Mint House and Mapped, two startups driving new value in a post COVID world through revolutionary experiences and technology. And we completed a brand new cloud-to-cloud integration with Openpath, leveraging our engaged technology, then Schlage NDE and the LE mobile-enabled smart locks. Through these partnerships, we're investing in promising innovation. We're leveraging developer friendly APIs and open standards. Allegion is building strategic, commercial and technical relationships. We are collaborating with recognized experts who also understand and embrace how Allegion creates value by securing people and assets with seamless access wherever they reside, work and thrive. Patrick will now take you through the financial results. And I'll be back to discuss our revised '21 outlook and to wrap up."
},
{
"speaker": "Patrick Shannon",
"text": "Thanks, Dave, and good morning, everyone. Thank you for joining today's call. Please go to Slide 7. This slide reflects our earnings per share reconciliation for the second quarter. For the second quarter 2020, reported earnings per share was $0.80. Adjusting $0.12 for charges related to restructuring expenses, the 2020 adjusted earnings per share was $0.92. Operational results increased earnings per share by $0.36 driven by volume leverage, along with continued benefits from cost control measures and restructuring actions taken in 2020. Favorable price and currency also contributed to the increase. The combination of these items offset headwinds from inflation, bounce back variable costs related to reduce volume from the COVID-19 pandemic and unfavorable mix. Favorable tax rate drove a $0.06 increase in earnings per share. Divestitures had a positive $0.01 per share impact and offset the impact of other income and interest expense. Investment spend increased during the quarter and reduced earnings per share by $0.05. As a reminder, the incremental investment spend is predominantly related to R&D, technology and market investments to accelerate future growth. This results in adjusted second quarter 2021 earnings per share of $1.32, an increase of $0.40 or 43.5% compared to the prior year. Lastly, we had a $0.01 per share reduction related to restructuring charges and acquisition integration expenses. After giving effect to these items, you arrive at the second quarter 2021 reported earnings per share of $1.31. Please go to Slide 8. This slide depicts the components of our revenue performance for the second quarter. I'll focus on the total Allegion results and cover the regions on their respective slides. As indicated, we experienced organic revenue growth of 23.8% in the second quarter, as higher demand and a favorable comparable drove significant volume increases versus the prior year. We also experienced solid price performance coming in over 2%, which is up sequentially. Currency continued to be a tailwind to total growth and more than offset the impact of divestitures. In total, reported revenue came in at 26.7% growth. Please go to Slide 9. Second quarter revenues for the Allegion Americas segment were 549.4 million, up 23.7% on a reported basis and 22.9% organically. While the strong growth reflects the impact of COVID-related shutdowns last year, it is also the result of accelerated market demand. The region continued to deliver good price realization. On volume, Americas non-residential experienced high-single digit growth driven by retrofit, repair and small projects. Americas residential was outstanding again experiencing growth of more than 70%. The significant growth from the prior year was primarily due to facility closures in 2020. However, we continue to see strength and retail point of sale in new home construction. While our products revenue was up high 20%, we experienced electronics growth in both the non-residential and residential businesses. Electronics and touchless solutions will continue to be long-term growth drivers. The accelerated demand coupled with labor and parts shortages, especially in electronic components, is resulting in elevated backlogs as we enter the third quarter, particularly in non-residential. The timing of when we see the revenue could shift as the industry works through the supply chain constraints. Americas adjusted operating income of 150.5 million increased 21.3% versus the prior year period, and adjusted operating margin for the quarter was down 50 basis points. The decrease was driven by headwinds related to inflation, bounce back costs and unfavorable mix more than offsetting the volume leverage. While the price productivity inflation dynamic was slightly positive on a dollar basis, it did have a 60-basis point dilutive impact on adjusted margins, as did the incremental investment spend. Please go to Slide 10. Second quarter revenues for the Allegion International segment were 197.5 million, up 36% and up 26.6% on an organic basis. The organic growth was driven predominantly by strength across all European countries and businesses, as markets continue to rebound. Part of the year-over-year growth was due to the comparative impact of COVID-related shutdowns in the prior year. Favorable currency impacts also contributed to total revenue growth and were slightly offset by divestiture impacts. International adjusted operating income of 18.5 million increased more than 18 million versus the prior year period. Adjusted operating margin for the quarter increased by 920 basis points. The margin increase was driven primarily by solid volume leverage, benefits from lower operating costs due to the restructuring and cost control actions taken during 2020, as well as favorable currency impacts. All of these offset the higher inflation and bounce back costs which had 150 basis point impact and incremental investments, which were a 20 basis point headwind. Please go to Slide 11. Year-to-date available cash flow for the second quarter of 2021 came in at 249.6 million, which is an increase of 146 million compared to the prior year period. The increase was driven by higher earnings, improvements in net working capital and reduced capital expenditures. Our cash flow generation continues to be a strong asset for the company. Looking at the chart to the right, it shows working capital as a percent of revenues decreased based on a 4 point quarter average. This was driven by improved asset turnover in both receivables and inventory. The business continues to generate strong cash flow and is well positioned to deliver 500 million in available cash flow for the year. I'll now hand it back over to Dave for an update for our full year 2021 outlook."
},
{
"speaker": "Dave Petratis",
"text": "Thank you, Patrick. Please go to Slide 12. At the end of Q2, leading indicators continue to be positive. I’m increasingly optimistic on the economic recovery. The Americas residential business continues to be high. On the non-residential side of Americas, demand accelerated for retrofit, repair and small projects, and is recovering in new construction. However, labor and part charges are proving to be challenging, and we are building a strong backlog that will benefit us in the future. With these parameters in place, we are raising our outlook for total revenue in the Americas to be at 4.5% to 5% and organic revenue to be up 4% to 4.5% in 2021. In the Allegion International segment, markets continue to recover led by our Germanic and Global Portable Security businesses. Currency tailwinds more than offset the divestiture of our QMI door business and contribute to total growth. For that region, we are raising our outlook for total revenue growth to 13.5% to 14.5% with organic growth of 8.5% to 9.5%. All-in for total Allegion, we are now projecting total revenue to be up 7% to 7.5% and organic revenue to increase to 5.5% to 6%. We are also raising our earnings per share outlook with reported EPS at a range of $5.15 to $5.30 and adjusted EPS to be between $5.25 and $5.40. This guide incorporates pricing actions to mitigate the expected impact of direct material inflation. We anticipate these inflationary challenges will persist for the balance of the year, and we will continue to monitor and adapt to changing market conditions. Our outlook for available capital is also being raised and is now projected to be 490 million to 510 million. The outlook assumes investment spend of approximately $0.20 per share. The full adjusted effective tax rate is expected to be approximately 12%. The outlook for outstanding diluted shares continues to be approximately 91 million shares. Please go to Slide 13. Allegion continues its great start in 2021. We have managed the business extremely well and leading indicators of specific market indices related to our business continue to be positive. Looking forward, we are prepared to navigate the pressures related to accelerated inflation in labor and part shortages. We are encouraged by the positive resiliency of our supply chain, and we will continue to manage these challenges for the balance of the year. Thank you. Now Patrick and I will be happy to take your questions."
},
{
"speaker": "Operator",
"text": "We will now begin the question-and-answer session. [Operator Instructions]. The first question comes from Josh Pokrzywinski with Morgan Stanley. Please go ahead."
},
{
"speaker": "Josh Pokrzywinski",
"text": "Hi. Good morning, guys."
},
{
"speaker": "Dave Petratis",
"text": "Good morning, Josh."
},
{
"speaker": "Josh Pokrzywinski",
"text": "So I guess first question on the margin front. Obviously, there's kind of the tyranny of the math on price costs, even though you're positive on the dollar basis. And I would imagine a little bit of a mix headwind on the revenue side as well. But if you just kind of take a giant step back and put some of the mechanical items aside, do you feel like getting price or managing inflation and logistics and all the other kind of inflationary headwinds, labor is any different than it has been normally, or that has got gotten a little bit more challenging? It’s sort of hard to parse through some of the different moving pieces there."
},
{
"speaker": "Dave Petratis",
"text": "Yes, I would characterize it this way. And you're right. There's a lot of tyranny in the math. But what we've seen is an acceleration of inflation, predominantly in commodity costs, material components, freight packaging, et cetera. It’s continued to be a headwind. As you know, we're pretty aggressive moving on price. And we're taking similar actions in the back half of this year. We went ahead and announced a price increase that will take effect at the beginning of Q4. So there's going to be some margin pressure, I would say, given the acceleration in inflation, particularly in Q3. I expect price to offset material inflation. The issue is really in some of the other components as it relates to packaging, freight, those type of things, will drive productivity to help mitigate those type of things, like we have previously. But it's going to be a challenge. There will be some margin pressure in the back half of the year. But I feel very confident relative to margin improvement as we go into 2022, predominantly because of the carryover price. And we'll continue to take pricing actions next year. We'll have an improved mix profile, as it relates to the non-residential business growing faster and accelerating more so than the residential business. And we're not going to have these bounce back costs, which were an issue for us in Q2, and will kind of linger during Q3, Q4 this year. So I think to answer your question, Josh, we’ll continue to manage the business. We'll get through some of the supply chain challenges. That in of itself also put a little bit of margin pressure because of some of the inefficiencies at the factories. But we'll manage through it. Margin sequentially will improve in the second half relative to the first half, still down year-over-year. But then in 2022, expect margin improvement to accelerate."
},
{
"speaker": "Josh Pokrzywinski",
"text": "Got it. That's helpful. And then I guess just a follow up on the comment, Dave, you made on record backlog. Maybe if you could unpack that a little, because I would imagine some of that is resi where you probably don't really want a lot of backlog there and it's more indicative of lead times and supply chain stuff than it is necessarily like a long cycle business. So maybe break down the components of that of how much is non-resi, is the market getting better and reopening and retrofit versus we're just hearing more backlog in resi because the whole supply chain lengthens? Thanks."
},
{
"speaker": "Dave Petratis",
"text": "So, I want to be clear. The backlog issue is not a residential problem. Our residential backlog is slightly above what we normally run. The backlog creation has been on the commercial side of the business and the rapid build has really happened over the last 60 to 90 days. The commercial backlog predominantly on the Americas business is double normal. And it was really driven by the acceleration of order demand that we started seeing in April. And I’ll give you some backdrop here. If you go back December, January, February, March, and we would have talked about this in the Q1 call, commercial institutional demand in the Americas business was down low double digits, and it's like someone turned on a light. And it's -- extremely pleased with that demand acceleration. We're doing a good job of I think processing that through, but there's supply constraints and it's resulted in a record backlog that I think we'll continue to see. There's been analysts out there that have said, we've done a better job of managing this. And I believe that to be true. Our supply chain is strong and we're going to benefit from that trend. I'd also share one other comment is the macroeconomic forecast on what I'd say the commercial break fix was not particularly clear. In fact, I've got economic reports that would suggest that the repair, replacement would have been soft even today. That switch came back on. We've gained that opportunity. So why couldn't we have seen it? When you shut off access to college campuses, hospitals and commercial buildings for 400 days, you get pent-up demand and that's what we're seeing reacting positively in the marketplace."
},
{
"speaker": "Josh Pokrzywinski",
"text": "Got it, very helpful. Thanks, guys."
},
{
"speaker": "Dave Petratis",
"text": "Thank you."
},
{
"speaker": "Operator",
"text": "The next question comes from Chris Snyder with UBS. Please go ahead."
},
{
"speaker": "Chris Snyder",
"text": "Good morning, guys. Thank you. And I kind of want to follow up on the margin commentary, but maybe from a bit of a different angle. So guidance implies a pretty material ramp in margins into the back half of 2021. My back of the envelope math puts margins in the low 21% range -- low to mid 19% in the first half. Can you just kind of help unpack the drivers of this step higher? Because guidance is not implying much volume leverage into the back half. So is this more price catching up the cost, freight normalizing, mix normalizing, any color on that step higher into the back half will be appreciated?"
},
{
"speaker": "Dave Petratis",
"text": "Yes, so that trend is not uncharacteristic. From a seasonality perspective, margins -- if you kind of look at it over historical time period, stronger back half of the year. So that's not unusual. I think as we characterize sequentially, margins are expected to increase. It's the year-over-year comparisons that we would expect some degradation, just kind of given some of the things we outlined relative to inflation."
},
{
"speaker": "Chris Snyder",
"text": "I appreciate that. And then I guess following up also on the record backlogs, it sounds like revenue on some level was constrained just by the supply chain issues that everyone is feeling. And it also sounds like the back half or the full year of growth guidance is also reflecting uncertainty as to when these backlogs will be released, whether it's the back half of '21 or into '22. Could you provide any color on maybe how much or how significant revenues were maybe constrained in the quarter just because of those supply chain issues? And then how we should -- what level of maybe supply chain conservatism is baked into the full year organic growth guidance?"
},
{
"speaker": "Dave Petratis",
"text": "When we look at the demand relative to what we could ship, there is going to be a disconnect there just kind of given the supply chain constraints. And I think you're aware, Chris, we normally carry a light backlog, highly specified engineered product, quick turnover in our manufacturing facilities to the customer. That has been elevated kind of given some of the constraints. But to answer your question, specifically, it could be 1%, 1.5% kind of total revenue at Allegion that's constrained that we’ll get the revenue. So it's not a question of -- it's just a question of timing. So we look at it as a timing kind of transitory issue. And if the supply chain constraints persist, we'll get that in 2022, which means revenue in '22 would be accelerated more so than the overall market demand."
},
{
"speaker": "Chris Snyder",
"text": "Thank you for that."
},
{
"speaker": "Patrick Shannon",
"text": "I would add a couple other comments. Clearly, supply constraints ended the rapid acceleration of demand that we saw helped build backlogs. I would say, we will -- over this entire pandemic and downturn, the resiliency of the Allegion supply chain I believe was stronger than the competition. And we're going to come out of this better. So feel good about that. I think the other thing you've got to think about, we're not alone in this. In the retrofit community and new construction, the entire project is affected by this. And we just got to navigate in that environment."
},
{
"speaker": "Chris Snyder",
"text": "I appreciate that. Thank you."
},
{
"speaker": "Operator",
"text": "The next question comes from Brian Ruttenbur of Imperial Capital. Please go ahead."
},
{
"speaker": "Brian Ruttenbur",
"text": "Yes. Thank you very much. So I have two questions. Can you talk about the commercial office performance in the quarter? How much was the sector down year-over-year? How much did commercial office represent in terms of revenue in the quarter? I'm just trying to get a data point where you are."
},
{
"speaker": "Dave Petratis",
"text": "Yes, so we don't really provide revenue by vertical markets. But I would just say, in terms of market demand, i.e. order intake activity, what we're seeing in specification, et cetera, commercial office space is lagging institutional segment. And a lot of that is just not kind of keeping pace with what we're seeing in terms of the rebound in repair, retrofit and new construction. So hopefully that provides you with ample color there."
},
{
"speaker": "Patrick Shannon",
"text": "Maybe to give you a little bit more, again, we don't split out that commercial segment as a standalone, but the strength that we saw in the first half was really driven by strong wholesale, small project and retrofit business. Where that business ends up, we don't have precise data on but there's -- the snapback of that volume would say, even in the commercial office space, there's definitely going in there to repurpose, to reposition and I like the opportunity for Allegion as we move through there from an electronic standpoint. You go back six months ago, I was concerned about the return to office and we're going to have a lot of vacancies out there. Capital will go in and redefine that space, and it's going to be good for our industry."
},
{
"speaker": "Brian Ruttenbur",
"text": "Great. Well, thank you. The second question I have just coming off of ISC West and meeting with a lot of companies, private and public, we see a lot of competition coming at access control with a total solution, white and -- one of the trends I'm seeing is white labeling of hardware at a discount and integrating software. So it's all about delivering a total solution, the hardware, maybe name doesn't mean as much. That's what I'm hearing at least. So some of these companies that are investing large sums of money in this total access control solution, that's what we're seeing. Can you address what you're seeing in the industry and how you're addressing this threat?"
},
{
"speaker": "Dave Petratis",
"text": "I think in today's presentation, we try to emphasize our build-borrow-buy emphasis and our partnerships with the mega-techs. I certainly see this private labeling, white labeling phenomena. I would just suggest the core part of our business has a level of complexity and connectivity that I'll bet on over the long haul. When you get into a complex business or a complex event space, like you were at ISC West, it's easy to look at this and say, okay, I can have a small offering of white label products. But when you start adding code requirements, master key systems, the connectivity with an Apple, a Google, a Lenel, the game gets a lot tougher."
},
{
"speaker": "Brian Ruttenbur",
"text": "Great. Well, thank you very much for addressing those. I really appreciate it. I'll get back."
},
{
"speaker": "Dave Petratis",
"text": "You’re welcome."
},
{
"speaker": "Operator",
"text": "The next question comes from Julian Mitchell with Barclays. Please go ahead."
},
{
"speaker": "Julian Mitchell",
"text": "Hi. Good morning. I just wanted to circle back to the Americas revenue guide for the year. You're embedding I think maybe very low-single digit growth year-on-year in the second half in the Americas. Just trying to understand what's embedded in that for residential versus non-residential and what sort of pace of slowdown of residential growth you’re assuming?"
},
{
"speaker": "Dave Petratis",
"text": "Yes. So, Julian, just as a reminder, last year as we're coming out of the pandemic and demand started to surge for replacement demand on residential products, backlog accelerated, channel inventories were depleted. And so a lot of the revenue growth last year was channel fill; big box retail, e-commerce, et cetera. So you're getting a tough comp, particularly in the second half as it relates to the residential business. And so that's going to impact the comparability, particularly when you're looking at overall Allegion Americas business. As we indicated, non-residential business, starting to show good demand, a little bit constrained relative to the supply chain issues, but we'll start seeing some growth kind of year-over-year. So, it's really that the guide, you have to take into account last year, had a higher growth component associated with channel fill related to the residential business."
},
{
"speaker": "Julian Mitchell",
"text": "Sure. But I guess I’m trying to understand, are you assuming that residential revenues are down year-on-year in the second half or --"
},
{
"speaker": "Dave Petratis",
"text": "No. They're still increasing."
},
{
"speaker": "Julian Mitchell",
"text": "Okay, got it. That's just what I wanted to check. Thank you. And then on the margin front, looking at -- yes, we keep attacking it different ways. But let's look at it sort of second half margin year-on-year, because I think that makes more sense in terms of the information you provide in the 10-Q and so on. So it looks like your second half operating margins firm-wide maybe down something like 100, 200 bips year-on-year in the second half. Is the way to think about that it's about 200 bips headwind from inflation net of price productivity, and then maybe another 100 bips headwind from investment spend? Are those roughly the right orders of magnitude?"
},
{
"speaker": "Dave Petratis",
"text": "Yes. And I would -- just a little bit more color on the price productivity inflation dynamic. Included in that guide would include some of the effect of these bounce back costs that we've been highlighting. It was much more pronounced in Q2, but you've got kind of some of those costs that continue in Q3, Q4. So that's some of the pressure as well year-over-year."
},
{
"speaker": "Julian Mitchell",
"text": "Perfect. Thank you."
},
{
"speaker": "Operator",
"text": "The next question comes from David MacGregor with Longbow Research. Please go ahead."
},
{
"speaker": "Joseph Nolan",
"text": "Hi. This is Joe Nolan on for David MacGregor."
},
{
"speaker": "Dave Petratis",
"text": "Good morning, Joe."
},
{
"speaker": "Joseph Nolan",
"text": "Good morning. I was just wondering could you talk about field inventory levels in both the residential and infomercial business. And then just how you expect the timing of the channel restock to play out?"
},
{
"speaker": "Dave Petratis",
"text": "On the residential side, big box, our res pro [ph] partners, I think the restocking of that supply chain is essentially complete. There is pressure on any type of electronic-related product, again, which we’re navigating well, but that will be a problem that moves through in the next four quarters. On the commercial wholesale side, as I talked about, the bounce back in demand, I think part of that is wholesalers seeing the confidence in the marketplace and restocking, but I think much of it is going straight through because of the availability or really green light on small projects that were delayed over a continued period. So I would suggest that the restocking of the wholesale and contract supply chain will be completed over the next two to three quarters."
},
{
"speaker": "Joseph Nolan",
"text": "Okay. Thanks for that. And then also just on your education business, given the year-ago pull forward and the timing of seasonal maintenance into 2Q '20. Was that a growth headwind that you experienced in 2Q '21 this year, and do you think that becomes a tailwind here in 3Q?"
},
{
"speaker": "Dave Petratis",
"text": "State your question again. You broke up."
},
{
"speaker": "Joseph Nolan",
"text": "I’m sorry. Just on the education business, given the year-ago pull forward and the timing of seasonal maintenance into 2Q '20. Was that a growth headwind this year in 2Q '21? And does that become a tailwind here in the third quarter?"
},
{
"speaker": "Dave Petratis",
"text": "I would look at the opportunity in K-12 as part of the bounce back, but more a positive as we move into '22 and '23. Americas going to continue to invest in its K-12 infrastructure for a variety of reasons; age, increased security, more automation, and Allegion will benefit from that. It's clearly a positive."
},
{
"speaker": "Joseph Nolan",
"text": "Okay. Thanks."
},
{
"speaker": "Operator",
"text": "The next question comes from Andrew Obin with Bank of America. Please go ahead."
},
{
"speaker": "Andrew Obin",
"text": "Hi, guys. Good morning."
},
{
"speaker": "Dave Petratis",
"text": "Good morning, Andrew."
},
{
"speaker": "Andrew Obin",
"text": "For a while, I thought I would have to use the word unpack in my question. I was wondering if there was a memo that went out to use the term unpack, but --"
},
{
"speaker": "Dave Petratis",
"text": "I thought you were going to remind me that you had it right on this bounce back."
},
{
"speaker": "Andrew Obin",
"text": "I'll take that too. Thank you. I guess the question is on pricing. Historically, your pricing has been fairly close to that of your large competitor in North America. This quarter, they seem to be ahead of you. And I was just wondering, is there a difference in approach to channel between the two of you or it’s just a matter of timing, as I said, because the industry seems to sort of move in lockstep?"
},
{
"speaker": "Dave Petratis",
"text": "I wouldn't say, they're ahead of us. My words to our leaders worldwide is use all tools required to address the extraordinary inflationary forces. We were out with a normal Q1 price increase. We've added surcharges on certain products. And we've announced an end of Q3 price increase, two price increases in a year and the other tools that we're using to mitigate price. I think the industry has been disciplined in our stewardship of making sure that we respond to the incredible inflationary forces that work for us."
},
{
"speaker": "Andrew Obin",
"text": "Got you. Thank you. Then the second question, as you -- and I think I've asked this question a couple of times. But as you face supply chain constraints, are you rethinking either your approach to your internal supply chain, i.e., sort of more automation, or are you sort of rethinking sourcing any long-term impact from sort of current disruption in the channel, or you think once we sort of get rid of the bullwhip effect, things go back to normal fairly fast?"
},
{
"speaker": "Dave Petratis",
"text": "I think the weakened supply chain is always a strategic item, as we think about positioning the business, one. Number two, I point to our decrementals during the downturn. Our decrementals on a top line basis was softer than any of the competition, meaning as the markets collapsed, our revenues were stronger on those decrementals, and I would point to supply chain. Third is, I think clearly a lot of work going on, I'd say, managing the complexity of what we do. It's everything from boards to grommets to casting. Part of what the Allegion franchise is built on is managing this complexity. Our supply chain does an important part of -- it plays a critical part of that, but it's rethinking those partnerships, making sure that we've got the availability of any type of part to be able to move it. We've made some pretty significant industrial investments in automation. Those will continue. I think as we go through this, labor availability is going to be in scarcity on a worldwide basis. And so automation investments, investing with strong suppliers and producing in region are key drivers for Allegion, Andrew."
},
{
"speaker": "Andrew Obin",
"text": "Okay. Thank you so much. And I appreciate the compliment. I don't get those often. Thank you."
},
{
"speaker": "Dave Petratis",
"text": "I should have read that twice. I did read it twice."
},
{
"speaker": "Operator",
"text": "The next question comes from Joe Ritchie with Goldman Sachs. Please go ahead."
},
{
"speaker": "Joe Ritchie",
"text": "Thanks. Good morning, guys. And no need to fish for compliments on this one. Just a quick question here on the margins. If I take a look at the Americas margins and your commentary around pricing for 4Q, I guess when we think about the sequential change in margins in the Americas, is there kind of like embedded in your expectations that sequentially margins potentially step down in 3Q because of these inflationary pressures and then back up in 4Q? Just trying to understand the cadence a little bit better?"
},
{
"speaker": "Dave Petratis",
"text": "Yes. So you got it right. Q3 margin decrease year-over-year much more pronounced than Q4. Q4, because of the price increase and some further actions, is still down but improving. Not as far down as 2Q."
},
{
"speaker": "Joe Ritchie",
"text": "Okay, all right. That's super helpful. And then I guess maybe just one -- maybe one broader question. I know that you guys consistently get compared to your European peer and the U.S. But if we took a step back and just thought about the industry as a whole and the potential consolidation in the locks market in the U.S., do you guys view the market as being fairly well concentrated today? Are there opportunities to continue to expand either via M&A within the market, you see future consolidation? Just curious on your broader thoughts there?"
},
{
"speaker": "Dave Petratis",
"text": "I think over the last decade, this is an industry that's consolidated. I would suggest that that's not moved at the pace that other industries have. So there's opportunities, half step adjacencies. I think the brightest growth aspect for Allegion is in the seamless access technologies. Part of the corporate spend this year is we're investing to try and better understand the future of seamless access, and where it could be 5 to 10 years out, because of our unique position in. And my message here, the industry is going to continue to consolidate it, but I believe through innovation of our unique position on the door, electronics, your edge device that it will continue to drive nice growth for Allegion."
},
{
"speaker": "Joe Ritchie",
"text": "Okay, that's helpful, Dave. Thanks, guys."
},
{
"speaker": "Operator",
"text": "The next question comes from Tim Wojs with Baird. Please go ahead."
},
{
"speaker": "Tim Wojs",
"text": "Hi, guys. Good morning."
},
{
"speaker": "Dave Petratis",
"text": "Good morning to you."
},
{
"speaker": "Tim Wojs",
"text": "Maybe just -- so first question is on investment, and I guess it's two-part. So I guess first, could you just elaborate a little more on where you're making the actual incremental investments this year? And then secondly, could you just talk about the pipeline build for future investments and how the paybacks on those are kind of prospectively versus just history? Are they the kind of same, better or worse? Just kind of curious there?"
},
{
"speaker": "Patrick Shannon",
"text": "Yes, Tim. So the majority of the incremental investments would be centered around R&D technology type of investments centered around driving electronics, revenue growth and market segmentation, i.e., where are the opportunities where we can expand our business and leverage our franchise globally. And so think about that in relation to some of the things Dave talked about in terms of enhancing our partnerships, to have broader connectivity into electronic seamless access, ecosystems and solutions, very important for the business going forward. So we're putting monies in those that I think will position us extremely well for growth going forward and will help us continue to grow faster than the broader market is the plan there. Your question on ROIC, it's always been a really good payback, not only on investment, but on a cash-on-cash basis, and good things to do that will position us in the marketplace for further growth. And historically, you've kind of seen our revenue kind of trend probably a little bit north of our peer set, and would expect that to kind of continue given the level of investments that we're making and position our franchise going forward."
},
{
"speaker": "Dave Petratis",
"text": "I'd build on that a bit, Tim, to say we've had -- take out the pandemic, we've had five, six years of double digit electronics growth. And clearly the market is moving that way. We've got over the next 24 months a nice pipeline of connected products coming out that it will enhance specific investments in software capabilities, what I call software stacks, that enhance the partnership that we talked about today. You have to have the APIs, SDKs that allow our locks to work in our own ecosystems and work in the complex ecosystems that may be present at a hospital, college campus. We believe this differentiates us versus one horse ponies that come in with a solution in an important part of our future growth. I'd add one other is segmenting the market and understanding the future 5, 10 years out in multifamily, K-12, college campuses and hospitals, we think we have an important role to play in our installed base in this connected environment will leverage Allegion’s growth."
},
{
"speaker": "Patrick Shannon",
"text": "Tim, also just think about the movement in technology, how fast things are changing. And being part of a broader ecosystem where we can, our products can seamlessly plug and play into a broader set of solutions is very important, and so incremental investments will continue. It is part of our DNA in terms of how we think about accelerating growth. And things are moving quickly and we want to be a market leader in that segment."
},
{
"speaker": "Dave Petratis",
"text": "In depth, partnerships with the mega-techs which are important, partnerships with the integrators, like Lenel, our venture arm, I think you saw the announcement on Openpath, the sale to Motorola Solutions, an excellent example of how we're playing that game, and then continuing investments in the digital players that help drive our growth."
},
{
"speaker": "Tim Wojs",
"text": "Okay, great. I really appreciate that. It all makes sense. I guess the second question just on maybe bigger picture. Could you just frame for us how you're thinking about a recovery and maybe revenue contribution from the specification business? So you're obviously seeing an uptick on the specification side. But when do you think you could start to see that be a meaningful revenue contributor? Is that a full year benefit next year, or is it skewed towards the second half?"
},
{
"speaker": "Dave Petratis",
"text": "I think you'll see that really gaining some speed Q2 of next year and through the traditional construction season. ABI has been up for three, four consecutive months at really record high at 60. I think we were there for a peak. It takes about 12 to 18 months based on the scope of those projects for us to really start seeing the momentum."
},
{
"speaker": "Tim Wojs",
"text": "Okay, great. Good luck, guys. Thanks for the time, guys."
},
{
"speaker": "Dave Petratis",
"text": "Thank you."
},
{
"speaker": "Operator",
"text": "The next question comes from John Walsh with Credit Suisse. Please go ahead."
},
{
"speaker": "John Walsh",
"text": "Hi. Good morning."
},
{
"speaker": "Dave Petratis",
"text": "Good morning."
},
{
"speaker": "John Walsh",
"text": "Maybe just two follow ups here. One, you had a little bit of a discussion there on K-12. You talked about the age, the security, more automation. But one thing you didn't mention was stimulus. And just curious, we're hearing that there's a lot of stimulus already been approved for that vertical, a lot of focus on HVAC, but there is a big demand on the infrastructure side for access control. Are you seeing any of that benefit yet or is that what you're kind of talking about might come through in '22 and beyond?"
},
{
"speaker": "Dave Petratis",
"text": "As we try and unpack the stimulus package, we certainly see access control, school security as a part of that. Again, it's dominated I think by modernization, things that you talked about, HVAC. We're going to benefit as a result of that stimulus. I would also say, there will continue to be a drive in the K-12 sector to modernize. The average K-12 structure is 40 years old. Security threats persist and access into schools is becoming more sophisticated because of people's edge device, electronic locks, and Allegion is going to benefit from that."
},
{
"speaker": "John Walsh",
"text": "Great. Thanks. And then, obviously, you've lived through several inflationary cycles. We could argue this one's a little bit different. But can you talk about your ability to hold price when you come out of these inflationary cycles? There's probably some regular pricing activity. I think you used the term surcharges for some things as well that maybe those are a little bit more transitory and go away when inflation abates. But can you just talk about your historical experience if we’re thinking about margin next year?"
},
{
"speaker": "Patrick Shannon",
"text": "Yes. Sure, John. So historically, price increases announced that are permanent in nature stick going forward, okay, i.e., even in deflationary periods, prices remain the same. And fairly disciplined industry here. We did announce some surcharges on particular products that are more heavy in steel-related components. And those, of course, go away assuming the price of steel comes down. But the majority of our price increases are permanent price increase that we expect will stick going forward, even when inflation comes down."
},
{
"speaker": "Dave Petratis",
"text": "I would add to that. The majority of my industrial career in the electrical industry and now security, we have as a guiding management principle as our input costs go up, I expect to capture that plus. And we're very driven on the inputs as well as the pricing systems here. And it's part of our DNA. And it's never been more important as we face inflationary pressures."
},
{
"speaker": "John Walsh",
"text": "Thanks. I appreciate you taking the questions."
},
{
"speaker": "Operator",
"text": "The next question comes from Jeff Sprague with Vertical Research. Please go ahead."
},
{
"speaker": "Jeff Sprague",
"text": "Thank you. Good morning, everyone. Maybe just a couple loose ends here, a lot of ground covered. First, maybe a little shout out to your international friends. Just wonder if you could give a little bit of color how you're thinking about the margins in the back half there, right? Usually we start fairly low in the first half and step up materially. I'm assuming from this kind of better run rates here in the first half, you’re not expecting the same magnitude of step up by assuming margins are going higher. Can you just elaborate on the trajectory there, the price cost dynamics in those markets collectively? And what if any other restructuring benefits you have coming through?"
},
{
"speaker": "Dave Petratis",
"text": "Yes, Jeff, so thanks for bringing that up. Outstanding performance by the international team, particularly when you're looking at not only margin increase but the top line growth, and that's been a key contributor to the margin expansion there as well. But you may recall, if you kind of look at that segment in isolation, they were probably out in front of this pandemic quicker in terms of reducing costs, managing that side of the equation, restructuring programs that kind of went through both in Europe and Asia Pacific. We also are seeing the benefit of the amalgamation of both the Asia Pacific and European segments coming together as Allegion International. All that combined has really accelerated the margin improvement year-over-year. The restructuring actions, the benefits we saw in the first half, kind of lapped, if you will, beginning in Q3. So you're not going to see the step up in margin expansion year-over-year. Seasonally, you know this Jeff that the margins expand in Q4 for that segment, in particular. We would expect the same seasonal increase. But the year-over-year margin improvement you're not going to see and there was some one-time benefits in Q4 that are non-recurring this year, bounce back in cost, higher inflation, these type of things. But a great performance first half. We would expect kind of this continuous margin improvement going into next year too. And so really like what the team has done there, how they're executing, driving top line growth, those types of things, a great performance."
},
{
"speaker": "Jeff Sprague",
"text": "Great. Understood. And then just back to kind of the whole backlog top line calculus here. I guess your guide essentially kind of indicates revenues in Q3 and Q4 will be similar to Q2, which is not atypical for your business. But I guess I'm also hearing though that perhaps you're suggesting the top line is just governed here by the supply and other constraints. Is that really the message that they're kind of in normal circumstances, there would be more upside into the back half just unlocking this backlog, but just the physical ability to get it out the door, whether it's your own factory or inputs from suppliers, just keeping a lid on what you can actually execute on in 2021?"
},
{
"speaker": "Dave Petratis",
"text": "You read that correctly. I think we've assessed, okay, what's possible here? We'll move that backlog through. I think we are mindful of the constraints on our supply base. We're also I think grounded that labor may be the tightest element in all of this, and it affects our customers and suppliers. So you've got to kind of take a stiff view at this. When are people going to come back to work and availability improve? We think that's a long-term problem. We think the culture of Allegion, how we run our business and the strength of our supply chain will do better than the competition in that battle."
},
{
"speaker": "Jeff Sprague",
"text": "Great. Thanks for the color."
},
{
"speaker": "Dave Petratis",
"text": "Thank you."
},
{
"speaker": "Operator",
"text": "This concludes our question-and-answer session. I would like to turn the conference back over to Dave Petratis for any closing remarks."
},
{
"speaker": "Dave Petratis",
"text": "Thanks for joining today's call. Allegion’s future remains bright. And I'd like to leave you with some key highlights of our call. Market demand is robust and it has returned to pre-pandemic levels faster and stronger than anticipated. This is extremely encouraging. Inflation has accelerated and there are industry-wide supply chain pressures. These constraints are not unique to us and we will actively manage both of these dynamics. The resulting backlog we are building sets us up well for the remainder of '21 and '22. Last, Allegion is stronger, more structurally sound as we continue to invest during the pandemic. As a result, we are positioned well for profitable growth, and we'll continue to aggressively execute on our strategy of seamless access. Have a great day today. Thanks for your attendance."
},
{
"speaker": "Operator",
"text": "The conference has now concluded. Thank you for attending today's presentation. You may now disconnect."
}
] | Allegion plc | 241,782,379 |
ALLE | 1 | 2,021 | 2021-04-22 08:00:00 | Operator: Good morning and welcome to the Allegion First Quarter 2021 Earnings Conference Call. All participants will be in a listen-only mode. [Operator Instructions] After today's presentation, there will be an opportunity to ask questions. [Operator Instructions] Please note, this event is being recorded. I would now like to turn the conference over to Tom Martineau, Vice President, Investor Relations and Treasurer. Please go ahead.
Tom Martineau: Thank you, Andrew. Good morning, everyone. Welcome and thank you for joining us for Allegion's first quarter 2021 earnings call. With me today are Dave Petratis, Chairman, President and Chief Executive Officer; and Patrick Shannon, Senior Vice President and Chief Financial Officer of Allegion. Our earnings release which was issued earlier this morning and a presentation, which we will refer to in today's call, are available on our website at investor.allegion.com. This call will be recorded and archived on our website. Please go to Slides 2 and 3. Statements made in today's call that are not historical facts are considered forward-looking statements and are made pursuant to the Safe Harbor provisions of federal securities law. Please see our most recent SEC filings for description of some of the factors that may cause actual results to differ materially from our projections. The company assumes no obligation to update these forward-looking statements. Today's presentation and commentary include non-GAAP financial measures, please refer to the reconciliation in the financial tables of our press release for further details. Dave and Patrick will now discuss our first quarter 2021 results, which will be followed by a Q&A session. Please, for the Q&A, we would like to ask each caller to limit themselves to one question and one short follow-up and then reenter the queue. We would like to give everyone an opportunity given the time allotted. Please go to Slide 4. And I'll turn the call over to Dave.
Dave Petratis: Thanks, Tom. Good morning and thank you for joining us today. I'm pleased with the company's first quarter performance. We delivered revenue growth, margin expansion, double digit earnings growth and strong available cash flow against a tough prior year comparable. We continue to make progress on our seamless access strategy, while maintaining the focus on keeping our employees safe and serving our customers efficiently. Let's begin by walking through the first quarter financial summary. Revenue for the first quarter was $694.3 million, an increase of 2.9% or 0.5% organically. The organic revenue increase was driven by strength in the Americas' residential and Allegion's international businesses, offsetting continued softness in Americas' non-residential. Currency tailwinds provided a boost to total revenue and more than offset the impact of divestitures. Patrick will share more detail on the regions in a moment. Adjusted operating margin increased by 30 basis points in the first quarter. We executed extremely well, and the restructuring and cost management actions taken during 2020 along with the volume leverage on the businesses that grew offset the mix headwinds we are experiencing. Adjusted earnings per share of $1.20 increased $0.16 or - 15.4% versus the prior year. The increase was driven by expanded operating income along with favorable other income and share count. Year-to-date available cash flow came in at $105.5 million, an increase of more than $86 million versus the prior year. The increased cash flow was driven by improvement in net working capital, growth and net earnings and reduced capital expenditures. Please go to Slide 5. As we discussed previously, reflecting on 2020 despite the ongoing pandemic, Allegion continues to invest in our future, most notably through our innovation engines. From industrial design, engineering, and IT to ventures, partnerships and acquisitions, we're building a build-borrow-buy approach to accelerate seamless access. Investing in our capabilities, partnering and integration are all core to our innovation strategy. Let's review some of Allegion's innovation and investments. Allegion's Overtur, our cloud-based ecosystem where project teams collaborate on the specification, design and construction of door security and openings expanded in multiple ways during the past year. Key and credential management was added, more functionality and integration for our billing information modeling customers and automation that helps hardware specification writers. Overtur allows digital connectivity to our customers over the life of the structure. It's - proving its value as a single source of truth for hardware requirements and decisions and to empower our partners to work more productively. Our ISONAS brand also launched a significant upgrade of its software platform in - Q1 the Pure Access Cloud 4.0 reader controllers are preconfigured to the cloud and only require a network connection on-site, making the ISONAS system truly plug and play. The software upgrade includes new front-end technology with customized dashboards gives a boost to cybersecurity and anticipate added capabilities and future new devices. Our product innovation spans the world of Allegion. SimonsVoss recently released the SmartLocker, a retrofit, no drilling lock option for lockers and furnitures in schools, hospitals and industrial facilities. This innovation was customer inspired, based on trends and needs in the market. Importantly, it integrates the existing SimonsVoss digital ecosystem, and there's additional functionality to [provide] (ph) or open each lock remotely, to display break-in attempts in the software and to send notifications. And just as our internal innovations continue to delight our customers, innovation is built through key partnerships in our early leadership in the IoT market has established us as a go-to partner. In Q1 Homebase announced that they're working with Allegion and Walmart InHome to enable direct-to-fridge grocery delivery for apartment residents starting in the Kansas City Metro. Homebase enables communities - Homebase enabled communities come with preinstalled Schlage smart locks, meaning, that the Walmart associate making the delivery gets secure, one-time access for entry during a designated timeframe for a delivery. This is a clear demonstration of seamless access adding value to people's everyday lives. Partnering with CBORD, Apple and Android has rapidly expanded seamless access use cases on higher education campuses. By enabling mobile credential technologies, we are part of the ecosystem that supports contactless student IDs for iPhones, Apple Watches and Google [Pay] (ph). CBORD also brings our Von Duprin exit devices into play, giving colleges new remote lockdown and monitoring capabilities. These integrations are good for campus securities and help universities and colleges operate more efficiently and safely. Rounding out our build-borrow-buy approach to innovation, Allegion Ventures continues to invest in companies like Kasa, Mint House, VergeSense and Openpath. We also acquired Yonomi, a technology company and leader in IoT cloud platforms. Founded in 2013, by building automation and enterprise computing experts, Yonomi was the first to create a smart home ecosystem, one that automatically discovers and coordinates devices. Allegion was an early customer and investor. Today Yonomi solutions are used in more than 150 countries connected to millions of IoT devices. IoT - excuse me, Yonomi also holds unique intellectual property that matches well to Allegion's strategic priorities for accelerating growth through seamless access, innovation and meaningful partnership. Our goal is to be the provider of choice among IoT developers and integrators. You’ll continue to see more examples of investment in innovation through our build-borrow and buy approach in '21 and we look forward to sharing more with you in the future. Patrick will now walk you through the financials, and I'll be back later to discuss our '21 outlook and wrap up.
Patrick Shannon: Thanks, Dave and good morning, everyone. Thank you for joining today's call. If you would, please go to Slide number 6. This slide reflects our earnings per share reconciliation for the first quarter. For the first quarter 2020, reported earnings per share was zero. Adjusting $1.04 for charges related to intangible asset impairments, restructuring expenses and integration costs related to acquisitions, the 2020 adjusted earnings per share was $1.04. Operational results increased earnings per share by $0.06 driven by volume leverage, along with continued benefits from cost control measures and restructuring actions taken in 2020. Favorable price and currency also contributed to the increase. The combination of these items offset the unfavorable mix. Favorable other income and interest expense increased earnings per share by $0.08 and was driven primarily by favorable unrealized investment gains in 2021 compared to unrealized investment losses experienced in 2020. Favorable share count drove another $0.03 per share impact more than offsetting the $0.01 reduction from investments. This results in adjusted first quarter 2021 earnings per share of $1.20 an increase of $0.16 cents or 15.4% compared to the prior year. Lastly, we have a $0.02 per share reduction for charges related to restructuring costs. After giving effect to these items, you arrive at the first quarter 2021 reported earnings per share of $1.18. Please go to Slide number 7. This slide depicts the components of our revenue performance for the first quarter. I'll focus on the total Allegion results and cover the regions on their respective slides. As indicated, we experienced a 0.5% organic revenue growth in the first quarter as solid price performance was able to offset lower volume. Although the total company volume was slightly down, we did see strength in the Americas residential and international businesses. Currency also provided a tailwind to total growth and more than offset the impact of divestitures. Please go to Slide number 8. First quarter revenues for the Allegion Americas segment were $498.9 million, down 2.6% on a reported basis and down 2.9% organically. The region continued to deliver good price realization. On volume, Americas residential was outstanding again, experiencing low 20% growth boosted by continued strength in retail point of sale, new home construction and electronics growth which nearly offset the anticipated decline in the non-residential business caused by lower new construction and discretionary project delays. Electronics revenue was down mid single-digits with growth in residential products that was offset by reduced commercial electronics driven by delays in discretionary projects. We continue to see electronics and touchless solutions as long-term growth drivers and expect electronics accelerated growth to resume when market conditions normalize. Americas adjusted operating income of $135.5 million decreased 7.6% versus the prior year period and adjusted operating margin for the quarter was down 140 basis points. The decrease was driven primarily by volume deleverage, negative mix and incremental investments partially offset by benefits from cost reduction actions and restructuring. Please go to Slide number 9. First quarter revenues for the Allegion International segment were $195.4 million, up 20.2% and up 11% on an organic basis. The organic growth was driven by strength across all major geographies and businesses as markets continue to rebound. Part of the year-over-year growth was due to the comparative impact of COVID related shutdowns in the prior year. Favorable currency impacts also contributed to total revenue growth and were slightly offset by divestiture impacts. International adjusted operating income of $18 million increased nearly 1000% versus the prior year period. Adjusted operating margin for the quarter increased by 820 basis points. The margin increase was driven primarily by solid volume leverage, benefits from lower operating costs from the restructuring cost control actions taken during 2020 as well as favorable currency impacts. This is also our first quarter reporting under the new Allegion International segment. The transition was seamless and made possible by having strong leadership in place to drive effective change. Please go to Slide number 10. Year-to-date available cash flow for the first quarter 2021 came in at $105.5 million, which is an increase of more than $86 million compared to the prior year period. The increase was driven by improvements in net working capital, higher earnings and reduced capital expenditures. Our strong cash flow generation continues to be an asset of the company. Looking at the chart to the right, it shows working capital as a percent of revenues decreased based on a 4-point quarter average. This was driven by reduced working capital needs from the lower volume throughout 2020, as well as strong collections performance. The business continues to generate strong cash flow and we remain committed to effective and efficient use of working capital. We will continue to evaluate opportunities to optimize working capital and drive effective cash flow conversion. I will now hand it back over to Dave for an update on our full year 2021 outlook.
Dave Petratis: Thank you, Patrick. Please go to Slide 11. We have more visibility into our markets and I am increasingly optimistic on the economic recovery. The Americas residential business continues to be hot and is expected to grow in 2021. We anticipate strength at residential to persist for the foreseeable future. DIY demand remained strong and the construction market is strengthened by a shortage of available new homes, continued low mortgage rates and improved trends in permits and starts. However, completion rates have been lagging starts due to labor and supply shortages, which should improve as we move further past the pandemic. Looking at the Americas non-residential business, we saw demand begin to increase on the repair retrofit projects sooner than we previously anticipated. We expect this trend to continue for the remainder of the year. In new constructions, we are starting to see positive movement in macroeconomic indicators, but it's important to remember the late cycle nature of this market. For 2021, I expect non-residential new construction to remain soft. But the monthly change in the architectural building index, Dodge construction starts and potential stimulus spending are trending favorable and assuming this continues, it will lead to growth in 2022 and beyond. Seamless access, software and electronics continue to be long-term growth drivers and they will remain our top investment priorities. They are the future of Allegion. With these parameters in place, we are now projecting total inorganic revenue in the Americas to be flat to up 1% in 2021. In the Allegion International segments, markets continue to recover and we expect full year growth in most of our international segments led by our Germanic and Global Portable Securities business. We continue to monitor the pace of vaccine rollouts internationally, as this will lead to sustainable improvements in the economic environment. Currency tailwinds more than offset the divestiture of our QMI door business and contribute to total growth. For the region, we are raising our outlook for total revenue growth to 12% to 13% with our organic growth of 7.5% to 8.5%. All in, for total Allegion, we are now projecting total revenue to be up 3% to 4% and organic revenue to increase 2% to 3%. We are also raising earnings per share outlook with reported EPS at a range of $4.85 to $5.05 per share and adjusted EPS to be between $5 and $5.15. This guide incorporates pricing actions to offset direct material inflation, as well as reflecting our supply chain capability to mitigate industry challenges on supply and electronic component shortages. We anticipate that these challenges will persist for the balance of the year and we will continue to monitor and adapt to changing market conditions. Our outlook for available cash flow is also being raised and now projected to be $430 million to $450 million. The outlook assumes investment spend of approximately $0.10 to $0.15 per share. The full year adjusted effective tax rate is expected to be approximately 12.5%. The outlook for outstanding diluted shares continues to be approximately 91 million. Please go to Slide 12. Allegion is off to a great start. We experienced reported and organic revenue growth, expanded operating margins and delivered strong cash flow. We have solid business fundamentals and a proven ability to execute and adapt to changing and uncertain market conditions. We have managed the business extremely well to set us up for success as markets returned to normal. Macroeconomic indicators and specific indices related to our business are trending positive and I'm increasingly confident in the recovery. The Allegion commitment to shareholders, employees and customers is to be stronger, exiting the pandemic than when we entered, our work continues. I want to take this opportunity to thank our employees for their diligence and dedication during the pandemic. It is their commitment that has driven the company to perform well and accelerated our vision of seamless access in a safer world. Allegion future is bright. Thank you. Now Patrick and I will be happy to take your questions.
Operator: We will now begin the question-and-answer session. [Operator Instructions] The first question comes from Julian Mitchell with Barclays. Please go ahead.
Julian Mitchell: Hi, good morning. Maybe just wanted to dial in on the revised Americas organic sales growth outlook. Maybe just help us understand you know how that guidance increase was split between your residential and your non-residential assumptions changing? And then within non-residential specifically, how should we think about that slope of decline shrinking over the balance of this year as you've been running at a sort of down low double-digit rate for four quarters in a row now?
Patrick Shannon: Yeah. Julian so I would characterize it this way. You know, first of all, you know, during the course of the quarter, you know, things progressively got better, particularly as we looked at our non-residential business. And by that, I mean just kind of the level of activity orders, you know, customer enthusiasm, specifically related to discretionary projects. And so that piece of information plus with the improvement and uncertain indices leading indicators relative to our business, i.e., ABI new construction starts, those types of things, which I'll remind you relative to new construction, it doesn't necessarily mean it's going to be incremental business this year, but continued improvement, particularly as we look out beyond 2021. With the improvement in non-resi, you know, really relates to discretionary projects, you know are continuing to be favorable more than what we had originally anticipated. Last time, we were on the conference call, residential continues its strength really across the board. You know, just really seeing good improvement in DIY, new build construction, et cetera, we expect that strength to continue. I would just, you know, remind you, you know, keep in mind that last year as we're coming, exiting out of Q2 after the plant shutdowns, demand started to surge, we were kind of catching our feet relative to production and kind of keeping up with demand. We didn't start kind of filling channel inventory until late Q3, Q4, that will be non-recurring right this year. And so you get into a tougher comp, if you will, in the back half of this year as it relates to the residential business, but still growth on a normalized basis.
Julian Mitchell: Thank you. And then my follow-up would be switching to the Americas margin outlook. So if I look in the 10-Q, you have that pricing and productivity in excess of inflation line, you know, that was only about a 20 bps tailwind to margins in the first quarter? How should we think about that playing out over the balance of the year, you know, both in terms of sort of what's happening with inflation and also your pricing measures?
Patrick Shannon: It's going to be more difficult. And, you know, the reason being is the inflationary item will step up, it's going to be worse as we progress kind of throughout the course of the year. Why, because of the input costs, you know, specific to commodities and material components. The other thing I would remind you of is, remember, we talked last year about some of the boomerang effect of the cost kind of coming back in into 2021, that was not there in 2020. So that's another item, plus, you know, we're going to have incremental investments, so all those are going to weigh a little bit more on margin. And will put a, you know, more pressure, if you will, on margins in the back half of the year that, you know, for '21 that we didn't experience in 2020. But let me just add something else. I think the - on the non-resi side of things is you know, relative to the reduced volume, even though things were getting better as we progressed throughout the year, we do have volume deleverage. We have taken the necessary actions to extract variable costs, okay. So it's really a volume deleverage issue. It's not a permanent item, when volumes come back margins will accelerate and - because we've taken the necessary cost control actions.
Dave Petratis: I'd add one other dimension and that would just be a slight mix shift as this - as the discretionary small project comes back and we're seeing that and applauding it, it tends to have more mid price point products versus our new build supply that's, you know, heavy in our premium products.
Julian Mitchell: Great, thank you.
Operator: The next question comes from Colton West of Longbow Research. Please go ahead.
Colton West: Hi, good morning and thanks for taking my question. It looks like some great progress was made this quarter. I guess firstly, you know, as we speak to contacts and we hear of a pickup in non-res quoting activity and in the prepared remarks, you called out an acceleration on the R&R side. With where conditions stand today, are you able to give us a more concrete sense of when we start to see orders and then the corresponding top line growth? And this is something you know, do we start to see quotes turn into orders as early as 2Q? Or is this - does this not materialize until maybe the back half for next year?
Dave Petratis: You know, we see some favorable indicators, one, the broader indicators that you all see, ABI, Dodge, you know, it's, you know, starts, not Dodge starts. But momentum. So we like what we see there too. Our own specification is up. The challenge with that is specification doesn't mean orders tomorrow or next week or even next quarter, you know, we would see that, you know, gaining momentum as we exit '21 and then into '22. I also like the, you know, where the investment is going in terms of our mix and strengths of the company, as we see end markets dynamics, you know, in major projects and in construction, hospitals, K through 12, college campuses and institutions, that's where the market is rebounding and it attends to complement the strengths of the company.
Colton West: Okay. And then my next one is from sort of a 30,000 foot view. Would you consider the current level of earnings to be trough earnings? And if so, can you walk us through the moving parts that will push earnings to the next peak?
Patrick Shannon: Yeah, so, you know, I would characterize, you know, the earnings, you know, really good performance, obviously in Q1. You know, if we look at the full year guide, you know, kind of in line with last year, in terms of where we ended up. You know, I would expect, you know, what the improvement in terms of our outlook, particularly on the non-residential business gaining momentum that will hopefully continue to accelerate in 2022. As I mentioned before, you would see continuous improvement in margins relative to that business, with the continuation of residential in the strength of the end markets, would expect growth there. So, yeah, I would characterize, you know, as long as the end markets continue to be favorable, you know, we'll see, you know, earnings growth, you know, accelerate, you know, from '22 and beyond.
Colton West: Okay, great. That's all I had. Thank you.
Operator: The next question comes from Andrew Obin of Bank of America. Please go ahead.
Andrew Obin: Yes. Good morning.
Dave Petratis: Good morning, Andrew.
Andrew Obin: Yeah, so a question in the last stimulus bill, and I think HVAC companies had been talking about it and also electrical companies have been talking about it. There's a lot of money allocated for schools. And I think, if you look in the last stimulus, I think 70% of the money was spent on capital improvement project, right. And the money seems to be like sort of $67 billion a year for the next three years. So, you know, I think HVAC companies and electrical companies are talking about the fact that they'll see an impact from this in next quarter, right, because you do a school remodeling in the summer. So institutional vertical is quite a big deal for you guys. Are you going to see any impact from it? And what's your assessment of the impact of this portion of the stimulus on your business this year and next year? Thank you.
Dave Petratis: So thanks for your question. You know we absolutely see the billions of dollars that are being allocated into K through 12's campuses. We will see benefit from that, hard to quantify each project, you know, we'll have different attributes, but it's clear, school security remains on the minds of Americans. And I think to the rise in violence, which is disturbing across the country, you know, will coupled with the stimulus, school security will get a portion of that investment and benefit Allegion.
Andrew Obin: Great. But is it in your guidance here or is it just too hard to quantify at this point?
Patrick Shannon: You know, I would say, Andrew, a little bit too hard to quantify at this point. However, you know, as we talked about earlier, a step up in terms of order activity relative to discretionary projects, we did see and that will turn into we'll call it, new business, you know, Q2, Q3 type of timeframe. But I think trying to kind of quantify a larger impact specific to the stimulus bill right now is probably premature.
Dave Petratis: I would just add, we will capture a large percentage of that security spent and we should be able to have visibility to that in our spec and quotation activity in which we also see a very large part of the market.
Andrew Obin: Got you. And just a follow-up question on international sort of starting to build impressive momentum there in terms of operating turnaround. Can you just give us more granularity you know, what's driving it? Is it Italy? Is it Poland? Is it Korea? Is it Australia? As I said, it's been all of a sudden, there's real momentum, just would love to get a better sense of what's happening there. Thank you.
Dave Petratis: So, one, remember the pandemic started, you know, internationally before it started here. So you know, Asia Pacific, particularly Italy hit hard early. So we're seeing that recovery, even though the pandemic continues to move. Number two, our continued investment in electronics and software, our Interflex and SimonsVoss businesses are performing extremely well and quite proud of the work. The leverage of investment to drive top line which we will continue. Third, success in our GPS business, you know, for those of you that have gone to try and buy a bike, there's no inventory in, and we made supply chain changes that gives us some advantages versus importers. We like that. And then we're beginning to see early recovery as well, Australia, New Zealand, remember, our Gainsborough acquisition as residential recovery drives in Australia we'll do extremely well there. I'd add something else. Over the last four to five quarters, we've been working hard to reposition that. We collapsed, you know, three divisions into two that gave us some cost efficiencies, driving more accountability down and the ability to invest back in those businesses for future growth. I like our position and the future's bright as we move through recovery.
Andrew Obin: Thank you. Really appreciate it.
Operator: The next question comes from Tim Wojs with Baird. Please go ahead.
Tim Wojs: Hey, everybody. Good morning. Nice work.
Patrick Shannon: Thanks, Tim.
Dave Petratis: Thank you, Tim.
Tim Wojs: Maybe just a bigger picture question for you guys. Just as you're seeing buildings reopened where in the budget stack is security from a priority perspective? And I guess I'm just kind of wondering if you're seeing other areas within buildings like HVAC taking focus away from security? Are you seeing kind of the interest in the budget priorities, you know, relatively unchanged relative to where they were pre-COVID?
Dave Petratis: I would describe it as this, and I think it's consistent as I have painted it. I think over the last 12 months, there's been absence of any type of preventive maintenance and small project work because the focus was on the health and safety of the occupants of buildings. I believe what we saw strongly, you know, beginning mid-March and continues on is the return of that, people going after those projects, those small projects preventive maintenance activity, particularly if it's security related, carry a pretty high priority versus other preventive maintenance aspects. Let's say the door doesn't show up properly, it's not locking, I have a security breach. You know, maintenance people are always making tradeoffs as we move into the air-conditioning season, where we don't have a heat, those tends to be a, you know, a red priority, we could fall into yellow. But, Tim, I believe there's an absence - there have been an absence of preventive maintenance, the small projects and those are moving in, I believe the budgets are there. I've also been refreshed that in larger projects that have - that were delayed, those are coming back, you know, in the mid price project level. An example would be the University of Tennessee, they had a project, you know, that was, you know, slated to go in '20, that's come back on. So, you know, was fully budgeted. I think, again, what that will naturally occur and we'll get our share of that wallet and as the new construction comes back, it will add more momentum to Allegion.
Tim Wojs: Okay. Okay, great, that's good to hear. And then maybe just my second question, just on the M&A side of things. How would you kind of characterize the development in the pipeline over the last three months to six months? And any sort of increased, you know, kind of activity or actionability there, you know, just given you know, like more of a meeting of the minds in terms of, you know, people's perspective on the end market?
Dave Petratis: I would say, the attention of the leadership team has never been stronger. You know, focused on, you know, moves that can help improve the scale of Allegion. We believe as we move harder in seamless access scale matters, we're pushing hard on moves that we think would help us participate in the connection of access, seamless access at a faster pace. I'd say less time spent on you know, smaller projects and deals. But you know, we've been working on this now for seven, eight years and we're pushing on those relationships. We believe there's further consolidation opportunities within the market. And the faster that we, you know, accelerate this convergence it's going to force some action.
Tim Wojs: Okay. Okay, great. Well, good luck on the rest of year guys. Nice job.
Dave Petratis: Thank you. Good to hear from you.
Operator: The next question comes from John Walsh with Credit Suisse. Please go ahead.
John Walsh: Hi, good morning and really impressive execution in the international business. Wanted to actually ask you about where you see the margins going for that segment now? I mean, really strong out of the gate here with that kind of high end of upper single-digits performance? What should we kind of be thinking about for the full year there in terms of margins?
Patrick Shannon: Yeah, John. So, you know, again, as you indicated, really strong performance, you know, both top line and you know, margin, you know, rates, particularly relative compared to prior year. Just as a reminder, you may recall last year, we were pretty quick out of the gate in terms of implementing cost control measures, you know, going in with the restructuring programs across the board, in Asia as well as Europe. And so you're seeing kind of the full benefit of that, if you will, reflected in the '21 results. So the restructuring actions taken last year begin to lap in the back half of the year. So you're not going to see kind of a step up in the margin performance that you saw in Q1. However, I would suggest that margins will continue to improve year-over-year, you know, as we continue throughout the year, and we should finish on an aggregate basis, i.e. the consolidation of Asia and Europe together, that kind of a record performance in terms of margin percent. And that's really reflective as Dave kind of highlighted earlier, the continued strength in electronics, which has a higher margin profile, the - all the cost reduction actions that we've taken will continue to manifest itself and the collapse and consolidation of the two segments together, we're seeing the benefits of that as well. I feel like we're in a really good position kind of going forward, not only to drive top line, but ensure that we do it in a profitable basis and we continue from here on out getting margin accretion as the business continues to grow.
John Walsh: Great, thank you. And then just as a follow-up, I think it was in response to Julian's question about residential, you called out kind of some stock orders in Q3, Q4, just curious here in Q1, if you were still seeing those stock orders or if kind of sell in is equal to sell out at this point? Yeah.
Patrick Shannon: Yeah, so we did experience some of that, not to the magnitude that we did in the latter half of last year. And I would say too, you know, quite frankly, if you kind of look at inventory levels in the channel, you know, particularly a big box like that on like a trailing kind of 12-month basis, basis of future demand, still probably lower than where it needs to be. So it's a matter of kind of, you know, trying to produce at a higher level, which is difficult right now, kind of given some of the supply constraints in our business. So there is maybe a little bit more that we could put into the channel. But you know, right now as that we're kind of assuming we're more on a normalized basis, producing, you know, basis of demand type of thing.
John Walsh: Great. Appreciate taking the questions. Thank you.
Operator: The next question comes from Jeff Sprague with Vertical Research. Please go ahead.
Jeff Sprague: Thank you. Good morning, everyone.
Dave Petratis: Good morning, Jeff.
Jeff Sprague: Yeah, I just wanted to put my finger a little bit more on kind of the cyclical trajectory also. And I thought maybe it'd be helpful to kind of discuss things a little bit sequentially, given how wild some of the year-over-year comps are with COVID and the like. Just thinking about Americas in aggregate, right, with commercial coming off the bottom and resi still strong I mean, is there any reason to think you don't have your normal sequential lift in revenues there from Q1 to Q2?
Dave Petratis: I think, you know, first, let's look at the lay of the land, you know, backwards. You know, we had the rupture of the pandemic, then let's go even back, we had a record Q1, we had the rupture of the pandemic, but as we compare to competition, I believe we were stronger, you know, quarter in, quarter out over several of the last quarter. So, you know, whether it was up or down the sequential nature of it, remember, we talked about, you know, plowing through our backlog. So with that as a backdrop, as we move through, we should expect some lift in the second and third quarters that we would normally see. I think that's why we highlight the return of the discretionary and small projects, which I think will certainly be better than it was a year ago. The but is, you know, that new construction demand is not as robust as it was going into the pandemic. So I think it takes '21 to normalize itself. And we'll see, probably a truer picture of what the markets going to be and we believe better as we go into '22.
Jeff Sprague: Yeah, the nature of my question is really, you know, I hate to just kind of play math exercise with you, right. But, you know, Q2 sales typically rise 15% to 20% sequentially, right. For that to happen, you know, you need almost 30% organic growth in Q2. And if you do 30% organic growth in Q2, you know, you're implying kind of negative 10% in the back half to get to your guide.
Dave Petratis: Patrick will have the math, I would suggest, and we are suggesting a forecast that's not going to happen. And I think one of the key drivers is new - non-residential construction starts, they had been down 28% for the last four quarters. And that is clearly a driver of our business that's got to be in place to get that type of ramp.
Patrick Shannon: So, Jeff, keep in mind, going into Q2 last year, we're coming off a record quarter Q1 2020. Backlogs were really, really healthy both on discretionary, new construction you know, projects that were started were kind of still being completed some of them may have been delayed and pushed out during the back half of the year. So you still have a real tough comp on non-res, okay, new construction, it begins to improve year-over-year and sequentially, but by Q2 is still going to be, you know, a non-resi now, okay, non-residential, a non-resi still kind of be tough, okay. We didn't have plant shutdowns like we did in residential business in Q2.
Jeff Sprague: Right, thank you.
Operator: The next question comes from Josh Pokrzywinski with Morgan Stanley. Please go ahead.
Josh Pokrzywinski: Hey, good morning, guys.
Dave Petratis: Good morning, Josh.
Patrick Shannon: Hi, Josh.
Josh Pokrzywinski: Dave, just on a bit of a snap the line update versus where you were in kind of three months or six months ago. I think the expectation was that when we get into the second half, folks will be back in, you know, some of these institutions or offices and will drive some retrofit activity. It sounds like some of that is starting to percolate a bit quicker. But I guess one, am I reading that right? And two, is that something that could show up as soon as 2Q? I know, there's still plenty of chop in the new side of the market, but you know just versus that prior expectation of a second half improvement in non-resi retrofit.
Dave Petratis: I want to be very clear. Beginning mid-March and through today, we saw an uplift in wholesale and CHD demand that we believe is part of you know, an air pocket that we saw 12 months earlier, preventive maintenance, small projects were delayed. And that's come back and we're very pleased to see that. It was a little earlier, I think the results of the vaccination success we're having here in the US has driven that and overall confidence. So you know, feel good about that. We added to Allegion's commercial - or commercial and institutional backlog in the Americas during the period. And we continue to believe that will - that demand will continue. I think the challenge is that new construction backlog which you know, the projects are complete, I think it's evident in the starts data that comes out of Dodge, and we just got to work through that. I think we've got a reasonable view on it. Again, market demand was better than we anticipated in Q1, reasonably better, it's still softer than it was a year ago.
Josh Pokrzywinski: Got it. That's helpful and maybe that just to follow-up on that. And I think this sort of gets to what Jeff was asking as well. I get the - there's still plenty of uncertainty on new construction. And you just sort of prefaced that with your answer just now that the non-res new backlog is still lower. But, is it lower than what you would have thought a few months ago? I guess that would sort of imply some higher level of conversion. So I guess that's always possible. But it sounds like the market itself is doing better from an orders' perspective just trying to balance that, you know, maybe heightened caution on the back on comment even though I don't know if anything's really changed for you.
Dave Petratis: I would say you know, the new construction activity is, you know, performing as we would anticipate and we see the benefits of that really rolling in into '22. And it's the nature of the beast. I would also emphasize this. However the market performs, on the retrofits small project and new construction, I believe that we've made the investments here that will continue to beat the market.
Josh Pokrzywinski: Great. That's helpful color and congrats on a good quarter.
Dave Petratis: Thank you.
Operator: The next question comes from Chris Snyder with UBS. Please go ahead.
Chris Snyder: Thank you. Just following-up a little bit more on the non-res comments. If starts inflect to positive here shortly when could we expect the new construction business to bottom? And then just any color you could provide on the R&R trajectory embedded in the 2021 guidance?
Dave Petratis: I would say, if starts inflect and we believe they'll gain momentum as we go through the year you really see the benefits of that in '22, because dirt in the ground today does not mean revenues for Allegion tomorrow, this is a long cycle nature, most building projects that, you know, have a 12 month to 18-month duration, especially in our sweet spots. And that's how I'd paint it. I'm extremely encouraged by the uplift of our specification activity and the broader indices. And I think, coupled that with the stimulus, you know, we feel good about where this business is going.
Chris Snyder: Appreciate that - all that color. And then, you know, just kind of following up. So non-res has been running at a low double-digit or down low double-digits for the last three quarters. Can you provide any color on the under the surface movements between new construction, which kind of based on your last comment seems like it would be continually getting worse through at least Q1, and just, you know, any mix there between new construction or just the under the surface movements?
Patrick Shannon: As you know, we don't really give specific guidance associated with a breakdown in those, you know, kind of end markets, but, you know, I would, you know, characterize it this way that, you know, continued, you know, pressure as we kind of continue to go through '21, relative to new construction, year-over-year, but getting sequentially better in the back half of the year, i.e. as we progress, the rate of decline becomes less. The repair and retrofit was the first area that kind of saw the decline, you know, last year and that will start to hopefully improve in the back half of the year, you know, year-over-year, but keep in mind, the new construction part of our non-residential business is roughly 65% relative to or compared to the discretionary total.
Dave Petratis: I would also -
Chris Snyder: Appreciate that -
Dave Petratis: …suggest you know, just a little bit more color on that. The range of capabilities that Allegion has today, opening price point, mid price point and full price point in terms of our commercial and institution offerings is it’s significantly better than it was in the last downturn. We're seeing that growth, we're flexing, you know, our strength in the channel to make sure if the dollar’s available for revenue, that we get more than our fair share of that.
Chris Snyder: Thank you.
Operator: The next question comes from Ryan Merkel with William Blair. Please go ahead.
Ryan Merkel: Hey, everyone. First off, can you just talk about the supply chain pressures you're seeing? And is this risk manageable? Or are you expecting to see a revenue impact in '21?
Dave Petratis: So, you know, our record speaks for itself here, I think the Allegion's supply chain has performed exceptionally you know, through the last five quarters. You know, it's because of this, you know, strategic choice that we make to produce, you know, in region and it's benefiting us in a lot of ways. There are clear and obvious pressures, particularly on electronics and we're certainly adapting to those. You know, there could be, you know, some shutdowns in terms of we're not able to produce specific products. With that in mind, we were very aggressive early to put in long-term orders to secure our supply chains, we've got tight, vendor relations. And again, my confidence is, yes, we can be affected, but we will navigate it better than the competition.
Patrick Shannon: And I would add that, you know, the current guide assumes that we're going to help mitigate the impact of the inefficiencies. You know, I feel good about that, where we stand today. However, you know, continued pressure there does create inefficiencies, you know, to the extent, you know, we're unable to procure the appropriate supplies needed to produce the products. And so kind of remains to be seen, but we're managing through it. Some of our product lines, you know particularly electronics are hand to mouth and it does create, you know, inefficiencies, but we're working through those issues.
Ryan Merkel: That's helpful -
Dave Petratis: I would also, you know - 40 years of dealing with this type of thing we made moves early, you know, that will help us. And we're extremely proud of our supply team. And you know, what they've done to mitigate a variety of issues and we were well out ahead of this, and I think we'll come out of it stronger.
Ryan Merkel: Got it. All right and then just quickly, you know, great to hear the non-res rentals coming back. Is that a broad-based comment? Or is it just happening in certain sectors today?
Dave Petratis: So, you know, I think if you go across the geographies, you know, we see stronger activity, particularly in the South, East Texas, you can kind of look at where COVID’s come, you know, had harder hits or, you know, where shutdowns have been harder, you know, it reflects the strength as you go into the different segments, think about, were you completing your preventive maintenance list at any hospital in the United States over the last, you know, 15 months? I would suggest the answer is no. College campuses are similar and we see confidence in our wholesale distribution orders, incoming orders. And it's going into those segments that have really been, you know, battered in their ability just to, you know, meet the needs of their customers.
Ryan Merkel: Perfect, thanks.
Dave Petratis: Thank you.
Operator: The next question comes from Jeff Kessler with Imperial Capital. Please go ahead.
Jeff Kessler: Thank you and thank you for taking the question. First, just quickly on international, again, congratulations on the numbers. You've explained them. I'd love to give Tim all the credit. But of course, I won't yet. But I do want to know, what his game plan is or what the game plan is for getting what in general for getting in International, essentially moving so that the - so that currency and other factors are not what we're going to be talking about in two or three years. But the - but gains in market share, et cetera. Because obviously, having international move forward is just another quiver in your growth cap.
Dave Petratis: So, you know, Tim does have a lot of instant talent. And, you know, we give him you know, great kudos in the first 90 days. Jeff, there - there's been a tremendous amount of work that's gone on in that business over the last couple of years. And one is, you know, I talked about the restructuring, significant investment in prioritization around Interflex and SimonsVoss really nice growth over the last six quarters, the Interflex and SimonsVoss performed exceptionally during the pandemic, and I think that momentum will continue. As you think about strategic priorities for Tim, it's to continue that growth and expand the cloud and technical capabilities. You know better than others that SimonsVoss really thrives on what we call active technologies. Driving more investment that goes into some of the passive areas will help fuel those - their growth which could include also acquisition. But we like that SimonsVoss Interflex. I think, second important for Tim, is, we acquired the Gainsborough asset, that's well positioned. We launched the first electronic tri-lock in the region. And we think we're well positioned to be with new - in the newbuild and the DIY to see nice growth as that residential market recovers in Gainsborough. I think third what has been surprising to Tim in his first 90 days, is the opportunity to export more capability from the Americas which he has more knowledge than anybody in the company, and you know, so looking forward to taking some of the real strengths we have here in the Americas and helping our international partners grow even faster.
Jeff Kessler: Okay. My follow-up question quickly is and maybe the answer may not be so quick, is, just underneath your level, I would say we're perhaps down level from where you folks operate, we're seeing a shift, some - a small shift in growth from away from video and toward we'll call it, you want to call it software-based access control, everything from obviously NFC to Bluetooth to ultrahigh frequency as well as, you know, as - just as well as the just power, you know, Power over Ethernet, which you folks know a little bit about. And what we're also seeing - is simply put a gain in software as the driver as opposed to hardware as a driver in getting into access control. And with access control, let's say becoming a faster growth area than even video, and we've seen some crazy valuations in the venture and private equity markets for some of these companies that are getting involved in areas that are either adjacent to you or actually may compete with you from intercoms all the way to you know to SaaS-based things. What is the company looking at in terms of, you know, trying to make sure that both protects its flank and grow this business?
Dave Petratis: So, I would describe it as one of the most exciting opportunities that I've seen in you know my 40 years of industrial participation. The company has been invested heavily and increased our investment as we went through the pandemic, you know, the, Yonomi acquisition would be reflective. But if you looked under the covers and saw the growth of our investments in Bangalore and our engineering capabilities, since I created - since we created Allegion, we tripled the feet on the street there to be able to position ourselves more strongly in the connectivity and the software elements. Third, Jeff, would be the venture activity you know, and you see some of the investments Kasa, Mint House, Openpath, I don't believe we - our strategy has been to be in the fast lanes to you know with new technology to be observe, learn, partner, invest potentially own, Yonomi went through that entire cycle. I think we continue to sharpen our position and I like our opportunities to be able to participate in the world of seamless access that you described.
Jeff Kessler: All right, great. Look forward to interacting with you guys in the future. Thank you.
Dave Petratis: We're always a leader in this and we appreciate your thought leadership, Jeff. Thank you.
Operator: This concludes our question-and-answer session. I would like to turn the conference back over to Tom Martineau for any closing remarks.
Tom Martineau: We'd like to thank everybody for participating in today's call and have a safe day.
Operator: The conference has now concluded. Thank you for attending today's presentation. You may now disconnect. | [
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"speaker": "Operator",
"text": "Good morning and welcome to the Allegion First Quarter 2021 Earnings Conference Call. All participants will be in a listen-only mode. [Operator Instructions] After today's presentation, there will be an opportunity to ask questions. [Operator Instructions] Please note, this event is being recorded. I would now like to turn the conference over to Tom Martineau, Vice President, Investor Relations and Treasurer. Please go ahead."
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"speaker": "Tom Martineau",
"text": "Thank you, Andrew. Good morning, everyone. Welcome and thank you for joining us for Allegion's first quarter 2021 earnings call. With me today are Dave Petratis, Chairman, President and Chief Executive Officer; and Patrick Shannon, Senior Vice President and Chief Financial Officer of Allegion. Our earnings release which was issued earlier this morning and a presentation, which we will refer to in today's call, are available on our website at investor.allegion.com. This call will be recorded and archived on our website. Please go to Slides 2 and 3. Statements made in today's call that are not historical facts are considered forward-looking statements and are made pursuant to the Safe Harbor provisions of federal securities law. Please see our most recent SEC filings for description of some of the factors that may cause actual results to differ materially from our projections. The company assumes no obligation to update these forward-looking statements. Today's presentation and commentary include non-GAAP financial measures, please refer to the reconciliation in the financial tables of our press release for further details. Dave and Patrick will now discuss our first quarter 2021 results, which will be followed by a Q&A session. Please, for the Q&A, we would like to ask each caller to limit themselves to one question and one short follow-up and then reenter the queue. We would like to give everyone an opportunity given the time allotted. Please go to Slide 4. And I'll turn the call over to Dave."
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"speaker": "Dave Petratis",
"text": "Thanks, Tom. Good morning and thank you for joining us today. I'm pleased with the company's first quarter performance. We delivered revenue growth, margin expansion, double digit earnings growth and strong available cash flow against a tough prior year comparable. We continue to make progress on our seamless access strategy, while maintaining the focus on keeping our employees safe and serving our customers efficiently. Let's begin by walking through the first quarter financial summary. Revenue for the first quarter was $694.3 million, an increase of 2.9% or 0.5% organically. The organic revenue increase was driven by strength in the Americas' residential and Allegion's international businesses, offsetting continued softness in Americas' non-residential. Currency tailwinds provided a boost to total revenue and more than offset the impact of divestitures. Patrick will share more detail on the regions in a moment. Adjusted operating margin increased by 30 basis points in the first quarter. We executed extremely well, and the restructuring and cost management actions taken during 2020 along with the volume leverage on the businesses that grew offset the mix headwinds we are experiencing. Adjusted earnings per share of $1.20 increased $0.16 or - 15.4% versus the prior year. The increase was driven by expanded operating income along with favorable other income and share count. Year-to-date available cash flow came in at $105.5 million, an increase of more than $86 million versus the prior year. The increased cash flow was driven by improvement in net working capital, growth and net earnings and reduced capital expenditures. Please go to Slide 5. As we discussed previously, reflecting on 2020 despite the ongoing pandemic, Allegion continues to invest in our future, most notably through our innovation engines. From industrial design, engineering, and IT to ventures, partnerships and acquisitions, we're building a build-borrow-buy approach to accelerate seamless access. Investing in our capabilities, partnering and integration are all core to our innovation strategy. Let's review some of Allegion's innovation and investments. Allegion's Overtur, our cloud-based ecosystem where project teams collaborate on the specification, design and construction of door security and openings expanded in multiple ways during the past year. Key and credential management was added, more functionality and integration for our billing information modeling customers and automation that helps hardware specification writers. Overtur allows digital connectivity to our customers over the life of the structure. It's - proving its value as a single source of truth for hardware requirements and decisions and to empower our partners to work more productively. Our ISONAS brand also launched a significant upgrade of its software platform in - Q1 the Pure Access Cloud 4.0 reader controllers are preconfigured to the cloud and only require a network connection on-site, making the ISONAS system truly plug and play. The software upgrade includes new front-end technology with customized dashboards gives a boost to cybersecurity and anticipate added capabilities and future new devices. Our product innovation spans the world of Allegion. SimonsVoss recently released the SmartLocker, a retrofit, no drilling lock option for lockers and furnitures in schools, hospitals and industrial facilities. This innovation was customer inspired, based on trends and needs in the market. Importantly, it integrates the existing SimonsVoss digital ecosystem, and there's additional functionality to [provide] (ph) or open each lock remotely, to display break-in attempts in the software and to send notifications. And just as our internal innovations continue to delight our customers, innovation is built through key partnerships in our early leadership in the IoT market has established us as a go-to partner. In Q1 Homebase announced that they're working with Allegion and Walmart InHome to enable direct-to-fridge grocery delivery for apartment residents starting in the Kansas City Metro. Homebase enables communities - Homebase enabled communities come with preinstalled Schlage smart locks, meaning, that the Walmart associate making the delivery gets secure, one-time access for entry during a designated timeframe for a delivery. This is a clear demonstration of seamless access adding value to people's everyday lives. Partnering with CBORD, Apple and Android has rapidly expanded seamless access use cases on higher education campuses. By enabling mobile credential technologies, we are part of the ecosystem that supports contactless student IDs for iPhones, Apple Watches and Google [Pay] (ph). CBORD also brings our Von Duprin exit devices into play, giving colleges new remote lockdown and monitoring capabilities. These integrations are good for campus securities and help universities and colleges operate more efficiently and safely. Rounding out our build-borrow-buy approach to innovation, Allegion Ventures continues to invest in companies like Kasa, Mint House, VergeSense and Openpath. We also acquired Yonomi, a technology company and leader in IoT cloud platforms. Founded in 2013, by building automation and enterprise computing experts, Yonomi was the first to create a smart home ecosystem, one that automatically discovers and coordinates devices. Allegion was an early customer and investor. Today Yonomi solutions are used in more than 150 countries connected to millions of IoT devices. IoT - excuse me, Yonomi also holds unique intellectual property that matches well to Allegion's strategic priorities for accelerating growth through seamless access, innovation and meaningful partnership. Our goal is to be the provider of choice among IoT developers and integrators. You’ll continue to see more examples of investment in innovation through our build-borrow and buy approach in '21 and we look forward to sharing more with you in the future. Patrick will now walk you through the financials, and I'll be back later to discuss our '21 outlook and wrap up."
},
{
"speaker": "Patrick Shannon",
"text": "Thanks, Dave and good morning, everyone. Thank you for joining today's call. If you would, please go to Slide number 6. This slide reflects our earnings per share reconciliation for the first quarter. For the first quarter 2020, reported earnings per share was zero. Adjusting $1.04 for charges related to intangible asset impairments, restructuring expenses and integration costs related to acquisitions, the 2020 adjusted earnings per share was $1.04. Operational results increased earnings per share by $0.06 driven by volume leverage, along with continued benefits from cost control measures and restructuring actions taken in 2020. Favorable price and currency also contributed to the increase. The combination of these items offset the unfavorable mix. Favorable other income and interest expense increased earnings per share by $0.08 and was driven primarily by favorable unrealized investment gains in 2021 compared to unrealized investment losses experienced in 2020. Favorable share count drove another $0.03 per share impact more than offsetting the $0.01 reduction from investments. This results in adjusted first quarter 2021 earnings per share of $1.20 an increase of $0.16 cents or 15.4% compared to the prior year. Lastly, we have a $0.02 per share reduction for charges related to restructuring costs. After giving effect to these items, you arrive at the first quarter 2021 reported earnings per share of $1.18. Please go to Slide number 7. This slide depicts the components of our revenue performance for the first quarter. I'll focus on the total Allegion results and cover the regions on their respective slides. As indicated, we experienced a 0.5% organic revenue growth in the first quarter as solid price performance was able to offset lower volume. Although the total company volume was slightly down, we did see strength in the Americas residential and international businesses. Currency also provided a tailwind to total growth and more than offset the impact of divestitures. Please go to Slide number 8. First quarter revenues for the Allegion Americas segment were $498.9 million, down 2.6% on a reported basis and down 2.9% organically. The region continued to deliver good price realization. On volume, Americas residential was outstanding again, experiencing low 20% growth boosted by continued strength in retail point of sale, new home construction and electronics growth which nearly offset the anticipated decline in the non-residential business caused by lower new construction and discretionary project delays. Electronics revenue was down mid single-digits with growth in residential products that was offset by reduced commercial electronics driven by delays in discretionary projects. We continue to see electronics and touchless solutions as long-term growth drivers and expect electronics accelerated growth to resume when market conditions normalize. Americas adjusted operating income of $135.5 million decreased 7.6% versus the prior year period and adjusted operating margin for the quarter was down 140 basis points. The decrease was driven primarily by volume deleverage, negative mix and incremental investments partially offset by benefits from cost reduction actions and restructuring. Please go to Slide number 9. First quarter revenues for the Allegion International segment were $195.4 million, up 20.2% and up 11% on an organic basis. The organic growth was driven by strength across all major geographies and businesses as markets continue to rebound. Part of the year-over-year growth was due to the comparative impact of COVID related shutdowns in the prior year. Favorable currency impacts also contributed to total revenue growth and were slightly offset by divestiture impacts. International adjusted operating income of $18 million increased nearly 1000% versus the prior year period. Adjusted operating margin for the quarter increased by 820 basis points. The margin increase was driven primarily by solid volume leverage, benefits from lower operating costs from the restructuring cost control actions taken during 2020 as well as favorable currency impacts. This is also our first quarter reporting under the new Allegion International segment. The transition was seamless and made possible by having strong leadership in place to drive effective change. Please go to Slide number 10. Year-to-date available cash flow for the first quarter 2021 came in at $105.5 million, which is an increase of more than $86 million compared to the prior year period. The increase was driven by improvements in net working capital, higher earnings and reduced capital expenditures. Our strong cash flow generation continues to be an asset of the company. Looking at the chart to the right, it shows working capital as a percent of revenues decreased based on a 4-point quarter average. This was driven by reduced working capital needs from the lower volume throughout 2020, as well as strong collections performance. The business continues to generate strong cash flow and we remain committed to effective and efficient use of working capital. We will continue to evaluate opportunities to optimize working capital and drive effective cash flow conversion. I will now hand it back over to Dave for an update on our full year 2021 outlook."
},
{
"speaker": "Dave Petratis",
"text": "Thank you, Patrick. Please go to Slide 11. We have more visibility into our markets and I am increasingly optimistic on the economic recovery. The Americas residential business continues to be hot and is expected to grow in 2021. We anticipate strength at residential to persist for the foreseeable future. DIY demand remained strong and the construction market is strengthened by a shortage of available new homes, continued low mortgage rates and improved trends in permits and starts. However, completion rates have been lagging starts due to labor and supply shortages, which should improve as we move further past the pandemic. Looking at the Americas non-residential business, we saw demand begin to increase on the repair retrofit projects sooner than we previously anticipated. We expect this trend to continue for the remainder of the year. In new constructions, we are starting to see positive movement in macroeconomic indicators, but it's important to remember the late cycle nature of this market. For 2021, I expect non-residential new construction to remain soft. But the monthly change in the architectural building index, Dodge construction starts and potential stimulus spending are trending favorable and assuming this continues, it will lead to growth in 2022 and beyond. Seamless access, software and electronics continue to be long-term growth drivers and they will remain our top investment priorities. They are the future of Allegion. With these parameters in place, we are now projecting total inorganic revenue in the Americas to be flat to up 1% in 2021. In the Allegion International segments, markets continue to recover and we expect full year growth in most of our international segments led by our Germanic and Global Portable Securities business. We continue to monitor the pace of vaccine rollouts internationally, as this will lead to sustainable improvements in the economic environment. Currency tailwinds more than offset the divestiture of our QMI door business and contribute to total growth. For the region, we are raising our outlook for total revenue growth to 12% to 13% with our organic growth of 7.5% to 8.5%. All in, for total Allegion, we are now projecting total revenue to be up 3% to 4% and organic revenue to increase 2% to 3%. We are also raising earnings per share outlook with reported EPS at a range of $4.85 to $5.05 per share and adjusted EPS to be between $5 and $5.15. This guide incorporates pricing actions to offset direct material inflation, as well as reflecting our supply chain capability to mitigate industry challenges on supply and electronic component shortages. We anticipate that these challenges will persist for the balance of the year and we will continue to monitor and adapt to changing market conditions. Our outlook for available cash flow is also being raised and now projected to be $430 million to $450 million. The outlook assumes investment spend of approximately $0.10 to $0.15 per share. The full year adjusted effective tax rate is expected to be approximately 12.5%. The outlook for outstanding diluted shares continues to be approximately 91 million. Please go to Slide 12. Allegion is off to a great start. We experienced reported and organic revenue growth, expanded operating margins and delivered strong cash flow. We have solid business fundamentals and a proven ability to execute and adapt to changing and uncertain market conditions. We have managed the business extremely well to set us up for success as markets returned to normal. Macroeconomic indicators and specific indices related to our business are trending positive and I'm increasingly confident in the recovery. The Allegion commitment to shareholders, employees and customers is to be stronger, exiting the pandemic than when we entered, our work continues. I want to take this opportunity to thank our employees for their diligence and dedication during the pandemic. It is their commitment that has driven the company to perform well and accelerated our vision of seamless access in a safer world. Allegion future is bright. Thank you. Now Patrick and I will be happy to take your questions."
},
{
"speaker": "Operator",
"text": "We will now begin the question-and-answer session. [Operator Instructions] The first question comes from Julian Mitchell with Barclays. Please go ahead."
},
{
"speaker": "Julian Mitchell",
"text": "Hi, good morning. Maybe just wanted to dial in on the revised Americas organic sales growth outlook. Maybe just help us understand you know how that guidance increase was split between your residential and your non-residential assumptions changing? And then within non-residential specifically, how should we think about that slope of decline shrinking over the balance of this year as you've been running at a sort of down low double-digit rate for four quarters in a row now?"
},
{
"speaker": "Patrick Shannon",
"text": "Yeah. Julian so I would characterize it this way. You know, first of all, you know, during the course of the quarter, you know, things progressively got better, particularly as we looked at our non-residential business. And by that, I mean just kind of the level of activity orders, you know, customer enthusiasm, specifically related to discretionary projects. And so that piece of information plus with the improvement and uncertain indices leading indicators relative to our business, i.e., ABI new construction starts, those types of things, which I'll remind you relative to new construction, it doesn't necessarily mean it's going to be incremental business this year, but continued improvement, particularly as we look out beyond 2021. With the improvement in non-resi, you know, really relates to discretionary projects, you know are continuing to be favorable more than what we had originally anticipated. Last time, we were on the conference call, residential continues its strength really across the board. You know, just really seeing good improvement in DIY, new build construction, et cetera, we expect that strength to continue. I would just, you know, remind you, you know, keep in mind that last year as we're coming, exiting out of Q2 after the plant shutdowns, demand started to surge, we were kind of catching our feet relative to production and kind of keeping up with demand. We didn't start kind of filling channel inventory until late Q3, Q4, that will be non-recurring right this year. And so you get into a tougher comp, if you will, in the back half of this year as it relates to the residential business, but still growth on a normalized basis."
},
{
"speaker": "Julian Mitchell",
"text": "Thank you. And then my follow-up would be switching to the Americas margin outlook. So if I look in the 10-Q, you have that pricing and productivity in excess of inflation line, you know, that was only about a 20 bps tailwind to margins in the first quarter? How should we think about that playing out over the balance of the year, you know, both in terms of sort of what's happening with inflation and also your pricing measures?"
},
{
"speaker": "Patrick Shannon",
"text": "It's going to be more difficult. And, you know, the reason being is the inflationary item will step up, it's going to be worse as we progress kind of throughout the course of the year. Why, because of the input costs, you know, specific to commodities and material components. The other thing I would remind you of is, remember, we talked last year about some of the boomerang effect of the cost kind of coming back in into 2021, that was not there in 2020. So that's another item, plus, you know, we're going to have incremental investments, so all those are going to weigh a little bit more on margin. And will put a, you know, more pressure, if you will, on margins in the back half of the year that, you know, for '21 that we didn't experience in 2020. But let me just add something else. I think the - on the non-resi side of things is you know, relative to the reduced volume, even though things were getting better as we progressed throughout the year, we do have volume deleverage. We have taken the necessary actions to extract variable costs, okay. So it's really a volume deleverage issue. It's not a permanent item, when volumes come back margins will accelerate and - because we've taken the necessary cost control actions."
},
{
"speaker": "Dave Petratis",
"text": "I'd add one other dimension and that would just be a slight mix shift as this - as the discretionary small project comes back and we're seeing that and applauding it, it tends to have more mid price point products versus our new build supply that's, you know, heavy in our premium products."
},
{
"speaker": "Julian Mitchell",
"text": "Great, thank you."
},
{
"speaker": "Operator",
"text": "The next question comes from Colton West of Longbow Research. Please go ahead."
},
{
"speaker": "Colton West",
"text": "Hi, good morning and thanks for taking my question. It looks like some great progress was made this quarter. I guess firstly, you know, as we speak to contacts and we hear of a pickup in non-res quoting activity and in the prepared remarks, you called out an acceleration on the R&R side. With where conditions stand today, are you able to give us a more concrete sense of when we start to see orders and then the corresponding top line growth? And this is something you know, do we start to see quotes turn into orders as early as 2Q? Or is this - does this not materialize until maybe the back half for next year?"
},
{
"speaker": "Dave Petratis",
"text": "You know, we see some favorable indicators, one, the broader indicators that you all see, ABI, Dodge, you know, it's, you know, starts, not Dodge starts. But momentum. So we like what we see there too. Our own specification is up. The challenge with that is specification doesn't mean orders tomorrow or next week or even next quarter, you know, we would see that, you know, gaining momentum as we exit '21 and then into '22. I also like the, you know, where the investment is going in terms of our mix and strengths of the company, as we see end markets dynamics, you know, in major projects and in construction, hospitals, K through 12, college campuses and institutions, that's where the market is rebounding and it attends to complement the strengths of the company."
},
{
"speaker": "Colton West",
"text": "Okay. And then my next one is from sort of a 30,000 foot view. Would you consider the current level of earnings to be trough earnings? And if so, can you walk us through the moving parts that will push earnings to the next peak?"
},
{
"speaker": "Patrick Shannon",
"text": "Yeah, so, you know, I would characterize, you know, the earnings, you know, really good performance, obviously in Q1. You know, if we look at the full year guide, you know, kind of in line with last year, in terms of where we ended up. You know, I would expect, you know, what the improvement in terms of our outlook, particularly on the non-residential business gaining momentum that will hopefully continue to accelerate in 2022. As I mentioned before, you would see continuous improvement in margins relative to that business, with the continuation of residential in the strength of the end markets, would expect growth there. So, yeah, I would characterize, you know, as long as the end markets continue to be favorable, you know, we'll see, you know, earnings growth, you know, accelerate, you know, from '22 and beyond."
},
{
"speaker": "Colton West",
"text": "Okay, great. That's all I had. Thank you."
},
{
"speaker": "Operator",
"text": "The next question comes from Andrew Obin of Bank of America. Please go ahead."
},
{
"speaker": "Andrew Obin",
"text": "Yes. Good morning."
},
{
"speaker": "Dave Petratis",
"text": "Good morning, Andrew."
},
{
"speaker": "Andrew Obin",
"text": "Yeah, so a question in the last stimulus bill, and I think HVAC companies had been talking about it and also electrical companies have been talking about it. There's a lot of money allocated for schools. And I think, if you look in the last stimulus, I think 70% of the money was spent on capital improvement project, right. And the money seems to be like sort of $67 billion a year for the next three years. So, you know, I think HVAC companies and electrical companies are talking about the fact that they'll see an impact from this in next quarter, right, because you do a school remodeling in the summer. So institutional vertical is quite a big deal for you guys. Are you going to see any impact from it? And what's your assessment of the impact of this portion of the stimulus on your business this year and next year? Thank you."
},
{
"speaker": "Dave Petratis",
"text": "So thanks for your question. You know we absolutely see the billions of dollars that are being allocated into K through 12's campuses. We will see benefit from that, hard to quantify each project, you know, we'll have different attributes, but it's clear, school security remains on the minds of Americans. And I think to the rise in violence, which is disturbing across the country, you know, will coupled with the stimulus, school security will get a portion of that investment and benefit Allegion."
},
{
"speaker": "Andrew Obin",
"text": "Great. But is it in your guidance here or is it just too hard to quantify at this point?"
},
{
"speaker": "Patrick Shannon",
"text": "You know, I would say, Andrew, a little bit too hard to quantify at this point. However, you know, as we talked about earlier, a step up in terms of order activity relative to discretionary projects, we did see and that will turn into we'll call it, new business, you know, Q2, Q3 type of timeframe. But I think trying to kind of quantify a larger impact specific to the stimulus bill right now is probably premature."
},
{
"speaker": "Dave Petratis",
"text": "I would just add, we will capture a large percentage of that security spent and we should be able to have visibility to that in our spec and quotation activity in which we also see a very large part of the market."
},
{
"speaker": "Andrew Obin",
"text": "Got you. And just a follow-up question on international sort of starting to build impressive momentum there in terms of operating turnaround. Can you just give us more granularity you know, what's driving it? Is it Italy? Is it Poland? Is it Korea? Is it Australia? As I said, it's been all of a sudden, there's real momentum, just would love to get a better sense of what's happening there. Thank you."
},
{
"speaker": "Dave Petratis",
"text": "So, one, remember the pandemic started, you know, internationally before it started here. So you know, Asia Pacific, particularly Italy hit hard early. So we're seeing that recovery, even though the pandemic continues to move. Number two, our continued investment in electronics and software, our Interflex and SimonsVoss businesses are performing extremely well and quite proud of the work. The leverage of investment to drive top line which we will continue. Third, success in our GPS business, you know, for those of you that have gone to try and buy a bike, there's no inventory in, and we made supply chain changes that gives us some advantages versus importers. We like that. And then we're beginning to see early recovery as well, Australia, New Zealand, remember, our Gainsborough acquisition as residential recovery drives in Australia we'll do extremely well there. I'd add something else. Over the last four to five quarters, we've been working hard to reposition that. We collapsed, you know, three divisions into two that gave us some cost efficiencies, driving more accountability down and the ability to invest back in those businesses for future growth. I like our position and the future's bright as we move through recovery."
},
{
"speaker": "Andrew Obin",
"text": "Thank you. Really appreciate it."
},
{
"speaker": "Operator",
"text": "The next question comes from Tim Wojs with Baird. Please go ahead."
},
{
"speaker": "Tim Wojs",
"text": "Hey, everybody. Good morning. Nice work."
},
{
"speaker": "Patrick Shannon",
"text": "Thanks, Tim."
},
{
"speaker": "Dave Petratis",
"text": "Thank you, Tim."
},
{
"speaker": "Tim Wojs",
"text": "Maybe just a bigger picture question for you guys. Just as you're seeing buildings reopened where in the budget stack is security from a priority perspective? And I guess I'm just kind of wondering if you're seeing other areas within buildings like HVAC taking focus away from security? Are you seeing kind of the interest in the budget priorities, you know, relatively unchanged relative to where they were pre-COVID?"
},
{
"speaker": "Dave Petratis",
"text": "I would describe it as this, and I think it's consistent as I have painted it. I think over the last 12 months, there's been absence of any type of preventive maintenance and small project work because the focus was on the health and safety of the occupants of buildings. I believe what we saw strongly, you know, beginning mid-March and continues on is the return of that, people going after those projects, those small projects preventive maintenance activity, particularly if it's security related, carry a pretty high priority versus other preventive maintenance aspects. Let's say the door doesn't show up properly, it's not locking, I have a security breach. You know, maintenance people are always making tradeoffs as we move into the air-conditioning season, where we don't have a heat, those tends to be a, you know, a red priority, we could fall into yellow. But, Tim, I believe there's an absence - there have been an absence of preventive maintenance, the small projects and those are moving in, I believe the budgets are there. I've also been refreshed that in larger projects that have - that were delayed, those are coming back, you know, in the mid price project level. An example would be the University of Tennessee, they had a project, you know, that was, you know, slated to go in '20, that's come back on. So, you know, was fully budgeted. I think, again, what that will naturally occur and we'll get our share of that wallet and as the new construction comes back, it will add more momentum to Allegion."
},
{
"speaker": "Tim Wojs",
"text": "Okay. Okay, great, that's good to hear. And then maybe just my second question, just on the M&A side of things. How would you kind of characterize the development in the pipeline over the last three months to six months? And any sort of increased, you know, kind of activity or actionability there, you know, just given you know, like more of a meeting of the minds in terms of, you know, people's perspective on the end market?"
},
{
"speaker": "Dave Petratis",
"text": "I would say, the attention of the leadership team has never been stronger. You know, focused on, you know, moves that can help improve the scale of Allegion. We believe as we move harder in seamless access scale matters, we're pushing hard on moves that we think would help us participate in the connection of access, seamless access at a faster pace. I'd say less time spent on you know, smaller projects and deals. But you know, we've been working on this now for seven, eight years and we're pushing on those relationships. We believe there's further consolidation opportunities within the market. And the faster that we, you know, accelerate this convergence it's going to force some action."
},
{
"speaker": "Tim Wojs",
"text": "Okay. Okay, great. Well, good luck on the rest of year guys. Nice job."
},
{
"speaker": "Dave Petratis",
"text": "Thank you. Good to hear from you."
},
{
"speaker": "Operator",
"text": "The next question comes from John Walsh with Credit Suisse. Please go ahead."
},
{
"speaker": "John Walsh",
"text": "Hi, good morning and really impressive execution in the international business. Wanted to actually ask you about where you see the margins going for that segment now? I mean, really strong out of the gate here with that kind of high end of upper single-digits performance? What should we kind of be thinking about for the full year there in terms of margins?"
},
{
"speaker": "Patrick Shannon",
"text": "Yeah, John. So, you know, again, as you indicated, really strong performance, you know, both top line and you know, margin, you know, rates, particularly relative compared to prior year. Just as a reminder, you may recall last year, we were pretty quick out of the gate in terms of implementing cost control measures, you know, going in with the restructuring programs across the board, in Asia as well as Europe. And so you're seeing kind of the full benefit of that, if you will, reflected in the '21 results. So the restructuring actions taken last year begin to lap in the back half of the year. So you're not going to see kind of a step up in the margin performance that you saw in Q1. However, I would suggest that margins will continue to improve year-over-year, you know, as we continue throughout the year, and we should finish on an aggregate basis, i.e. the consolidation of Asia and Europe together, that kind of a record performance in terms of margin percent. And that's really reflective as Dave kind of highlighted earlier, the continued strength in electronics, which has a higher margin profile, the - all the cost reduction actions that we've taken will continue to manifest itself and the collapse and consolidation of the two segments together, we're seeing the benefits of that as well. I feel like we're in a really good position kind of going forward, not only to drive top line, but ensure that we do it in a profitable basis and we continue from here on out getting margin accretion as the business continues to grow."
},
{
"speaker": "John Walsh",
"text": "Great, thank you. And then just as a follow-up, I think it was in response to Julian's question about residential, you called out kind of some stock orders in Q3, Q4, just curious here in Q1, if you were still seeing those stock orders or if kind of sell in is equal to sell out at this point? Yeah."
},
{
"speaker": "Patrick Shannon",
"text": "Yeah, so we did experience some of that, not to the magnitude that we did in the latter half of last year. And I would say too, you know, quite frankly, if you kind of look at inventory levels in the channel, you know, particularly a big box like that on like a trailing kind of 12-month basis, basis of future demand, still probably lower than where it needs to be. So it's a matter of kind of, you know, trying to produce at a higher level, which is difficult right now, kind of given some of the supply constraints in our business. So there is maybe a little bit more that we could put into the channel. But you know, right now as that we're kind of assuming we're more on a normalized basis, producing, you know, basis of demand type of thing."
},
{
"speaker": "John Walsh",
"text": "Great. Appreciate taking the questions. Thank you."
},
{
"speaker": "Operator",
"text": "The next question comes from Jeff Sprague with Vertical Research. Please go ahead."
},
{
"speaker": "Jeff Sprague",
"text": "Thank you. Good morning, everyone."
},
{
"speaker": "Dave Petratis",
"text": "Good morning, Jeff."
},
{
"speaker": "Jeff Sprague",
"text": "Yeah, I just wanted to put my finger a little bit more on kind of the cyclical trajectory also. And I thought maybe it'd be helpful to kind of discuss things a little bit sequentially, given how wild some of the year-over-year comps are with COVID and the like. Just thinking about Americas in aggregate, right, with commercial coming off the bottom and resi still strong I mean, is there any reason to think you don't have your normal sequential lift in revenues there from Q1 to Q2?"
},
{
"speaker": "Dave Petratis",
"text": "I think, you know, first, let's look at the lay of the land, you know, backwards. You know, we had the rupture of the pandemic, then let's go even back, we had a record Q1, we had the rupture of the pandemic, but as we compare to competition, I believe we were stronger, you know, quarter in, quarter out over several of the last quarter. So, you know, whether it was up or down the sequential nature of it, remember, we talked about, you know, plowing through our backlog. So with that as a backdrop, as we move through, we should expect some lift in the second and third quarters that we would normally see. I think that's why we highlight the return of the discretionary and small projects, which I think will certainly be better than it was a year ago. The but is, you know, that new construction demand is not as robust as it was going into the pandemic. So I think it takes '21 to normalize itself. And we'll see, probably a truer picture of what the markets going to be and we believe better as we go into '22."
},
{
"speaker": "Jeff Sprague",
"text": "Yeah, the nature of my question is really, you know, I hate to just kind of play math exercise with you, right. But, you know, Q2 sales typically rise 15% to 20% sequentially, right. For that to happen, you know, you need almost 30% organic growth in Q2. And if you do 30% organic growth in Q2, you know, you're implying kind of negative 10% in the back half to get to your guide."
},
{
"speaker": "Dave Petratis",
"text": "Patrick will have the math, I would suggest, and we are suggesting a forecast that's not going to happen. And I think one of the key drivers is new - non-residential construction starts, they had been down 28% for the last four quarters. And that is clearly a driver of our business that's got to be in place to get that type of ramp."
},
{
"speaker": "Patrick Shannon",
"text": "So, Jeff, keep in mind, going into Q2 last year, we're coming off a record quarter Q1 2020. Backlogs were really, really healthy both on discretionary, new construction you know, projects that were started were kind of still being completed some of them may have been delayed and pushed out during the back half of the year. So you still have a real tough comp on non-res, okay, new construction, it begins to improve year-over-year and sequentially, but by Q2 is still going to be, you know, a non-resi now, okay, non-residential, a non-resi still kind of be tough, okay. We didn't have plant shutdowns like we did in residential business in Q2."
},
{
"speaker": "Jeff Sprague",
"text": "Right, thank you."
},
{
"speaker": "Operator",
"text": "The next question comes from Josh Pokrzywinski with Morgan Stanley. Please go ahead."
},
{
"speaker": "Josh Pokrzywinski",
"text": "Hey, good morning, guys."
},
{
"speaker": "Dave Petratis",
"text": "Good morning, Josh."
},
{
"speaker": "Patrick Shannon",
"text": "Hi, Josh."
},
{
"speaker": "Josh Pokrzywinski",
"text": "Dave, just on a bit of a snap the line update versus where you were in kind of three months or six months ago. I think the expectation was that when we get into the second half, folks will be back in, you know, some of these institutions or offices and will drive some retrofit activity. It sounds like some of that is starting to percolate a bit quicker. But I guess one, am I reading that right? And two, is that something that could show up as soon as 2Q? I know, there's still plenty of chop in the new side of the market, but you know just versus that prior expectation of a second half improvement in non-resi retrofit."
},
{
"speaker": "Dave Petratis",
"text": "I want to be very clear. Beginning mid-March and through today, we saw an uplift in wholesale and CHD demand that we believe is part of you know, an air pocket that we saw 12 months earlier, preventive maintenance, small projects were delayed. And that's come back and we're very pleased to see that. It was a little earlier, I think the results of the vaccination success we're having here in the US has driven that and overall confidence. So you know, feel good about that. We added to Allegion's commercial - or commercial and institutional backlog in the Americas during the period. And we continue to believe that will - that demand will continue. I think the challenge is that new construction backlog which you know, the projects are complete, I think it's evident in the starts data that comes out of Dodge, and we just got to work through that. I think we've got a reasonable view on it. Again, market demand was better than we anticipated in Q1, reasonably better, it's still softer than it was a year ago."
},
{
"speaker": "Josh Pokrzywinski",
"text": "Got it. That's helpful and maybe that just to follow-up on that. And I think this sort of gets to what Jeff was asking as well. I get the - there's still plenty of uncertainty on new construction. And you just sort of prefaced that with your answer just now that the non-res new backlog is still lower. But, is it lower than what you would have thought a few months ago? I guess that would sort of imply some higher level of conversion. So I guess that's always possible. But it sounds like the market itself is doing better from an orders' perspective just trying to balance that, you know, maybe heightened caution on the back on comment even though I don't know if anything's really changed for you."
},
{
"speaker": "Dave Petratis",
"text": "I would say you know, the new construction activity is, you know, performing as we would anticipate and we see the benefits of that really rolling in into '22. And it's the nature of the beast. I would also emphasize this. However the market performs, on the retrofits small project and new construction, I believe that we've made the investments here that will continue to beat the market."
},
{
"speaker": "Josh Pokrzywinski",
"text": "Great. That's helpful color and congrats on a good quarter."
},
{
"speaker": "Dave Petratis",
"text": "Thank you."
},
{
"speaker": "Operator",
"text": "The next question comes from Chris Snyder with UBS. Please go ahead."
},
{
"speaker": "Chris Snyder",
"text": "Thank you. Just following-up a little bit more on the non-res comments. If starts inflect to positive here shortly when could we expect the new construction business to bottom? And then just any color you could provide on the R&R trajectory embedded in the 2021 guidance?"
},
{
"speaker": "Dave Petratis",
"text": "I would say, if starts inflect and we believe they'll gain momentum as we go through the year you really see the benefits of that in '22, because dirt in the ground today does not mean revenues for Allegion tomorrow, this is a long cycle nature, most building projects that, you know, have a 12 month to 18-month duration, especially in our sweet spots. And that's how I'd paint it. I'm extremely encouraged by the uplift of our specification activity and the broader indices. And I think, coupled that with the stimulus, you know, we feel good about where this business is going."
},
{
"speaker": "Chris Snyder",
"text": "Appreciate that - all that color. And then, you know, just kind of following up. So non-res has been running at a low double-digit or down low double-digits for the last three quarters. Can you provide any color on the under the surface movements between new construction, which kind of based on your last comment seems like it would be continually getting worse through at least Q1, and just, you know, any mix there between new construction or just the under the surface movements?"
},
{
"speaker": "Patrick Shannon",
"text": "As you know, we don't really give specific guidance associated with a breakdown in those, you know, kind of end markets, but, you know, I would, you know, characterize it this way that, you know, continued, you know, pressure as we kind of continue to go through '21, relative to new construction, year-over-year, but getting sequentially better in the back half of the year, i.e. as we progress, the rate of decline becomes less. The repair and retrofit was the first area that kind of saw the decline, you know, last year and that will start to hopefully improve in the back half of the year, you know, year-over-year, but keep in mind, the new construction part of our non-residential business is roughly 65% relative to or compared to the discretionary total."
},
{
"speaker": "Dave Petratis",
"text": "I would also -"
},
{
"speaker": "Chris Snyder",
"text": "Appreciate that -"
},
{
"speaker": "Dave Petratis",
"text": "…suggest you know, just a little bit more color on that. The range of capabilities that Allegion has today, opening price point, mid price point and full price point in terms of our commercial and institution offerings is it’s significantly better than it was in the last downturn. We're seeing that growth, we're flexing, you know, our strength in the channel to make sure if the dollar’s available for revenue, that we get more than our fair share of that."
},
{
"speaker": "Chris Snyder",
"text": "Thank you."
},
{
"speaker": "Operator",
"text": "The next question comes from Ryan Merkel with William Blair. Please go ahead."
},
{
"speaker": "Ryan Merkel",
"text": "Hey, everyone. First off, can you just talk about the supply chain pressures you're seeing? And is this risk manageable? Or are you expecting to see a revenue impact in '21?"
},
{
"speaker": "Dave Petratis",
"text": "So, you know, our record speaks for itself here, I think the Allegion's supply chain has performed exceptionally you know, through the last five quarters. You know, it's because of this, you know, strategic choice that we make to produce, you know, in region and it's benefiting us in a lot of ways. There are clear and obvious pressures, particularly on electronics and we're certainly adapting to those. You know, there could be, you know, some shutdowns in terms of we're not able to produce specific products. With that in mind, we were very aggressive early to put in long-term orders to secure our supply chains, we've got tight, vendor relations. And again, my confidence is, yes, we can be affected, but we will navigate it better than the competition."
},
{
"speaker": "Patrick Shannon",
"text": "And I would add that, you know, the current guide assumes that we're going to help mitigate the impact of the inefficiencies. You know, I feel good about that, where we stand today. However, you know, continued pressure there does create inefficiencies, you know, to the extent, you know, we're unable to procure the appropriate supplies needed to produce the products. And so kind of remains to be seen, but we're managing through it. Some of our product lines, you know particularly electronics are hand to mouth and it does create, you know, inefficiencies, but we're working through those issues."
},
{
"speaker": "Ryan Merkel",
"text": "That's helpful -"
},
{
"speaker": "Dave Petratis",
"text": "I would also, you know - 40 years of dealing with this type of thing we made moves early, you know, that will help us. And we're extremely proud of our supply team. And you know, what they've done to mitigate a variety of issues and we were well out ahead of this, and I think we'll come out of it stronger."
},
{
"speaker": "Ryan Merkel",
"text": "Got it. All right and then just quickly, you know, great to hear the non-res rentals coming back. Is that a broad-based comment? Or is it just happening in certain sectors today?"
},
{
"speaker": "Dave Petratis",
"text": "So, you know, I think if you go across the geographies, you know, we see stronger activity, particularly in the South, East Texas, you can kind of look at where COVID’s come, you know, had harder hits or, you know, where shutdowns have been harder, you know, it reflects the strength as you go into the different segments, think about, were you completing your preventive maintenance list at any hospital in the United States over the last, you know, 15 months? I would suggest the answer is no. College campuses are similar and we see confidence in our wholesale distribution orders, incoming orders. And it's going into those segments that have really been, you know, battered in their ability just to, you know, meet the needs of their customers."
},
{
"speaker": "Ryan Merkel",
"text": "Perfect, thanks."
},
{
"speaker": "Dave Petratis",
"text": "Thank you."
},
{
"speaker": "Operator",
"text": "The next question comes from Jeff Kessler with Imperial Capital. Please go ahead."
},
{
"speaker": "Jeff Kessler",
"text": "Thank you and thank you for taking the question. First, just quickly on international, again, congratulations on the numbers. You've explained them. I'd love to give Tim all the credit. But of course, I won't yet. But I do want to know, what his game plan is or what the game plan is for getting what in general for getting in International, essentially moving so that the - so that currency and other factors are not what we're going to be talking about in two or three years. But the - but gains in market share, et cetera. Because obviously, having international move forward is just another quiver in your growth cap."
},
{
"speaker": "Dave Petratis",
"text": "So, you know, Tim does have a lot of instant talent. And, you know, we give him you know, great kudos in the first 90 days. Jeff, there - there's been a tremendous amount of work that's gone on in that business over the last couple of years. And one is, you know, I talked about the restructuring, significant investment in prioritization around Interflex and SimonsVoss really nice growth over the last six quarters, the Interflex and SimonsVoss performed exceptionally during the pandemic, and I think that momentum will continue. As you think about strategic priorities for Tim, it's to continue that growth and expand the cloud and technical capabilities. You know better than others that SimonsVoss really thrives on what we call active technologies. Driving more investment that goes into some of the passive areas will help fuel those - their growth which could include also acquisition. But we like that SimonsVoss Interflex. I think, second important for Tim, is, we acquired the Gainsborough asset, that's well positioned. We launched the first electronic tri-lock in the region. And we think we're well positioned to be with new - in the newbuild and the DIY to see nice growth as that residential market recovers in Gainsborough. I think third what has been surprising to Tim in his first 90 days, is the opportunity to export more capability from the Americas which he has more knowledge than anybody in the company, and you know, so looking forward to taking some of the real strengths we have here in the Americas and helping our international partners grow even faster."
},
{
"speaker": "Jeff Kessler",
"text": "Okay. My follow-up question quickly is and maybe the answer may not be so quick, is, just underneath your level, I would say we're perhaps down level from where you folks operate, we're seeing a shift, some - a small shift in growth from away from video and toward we'll call it, you want to call it software-based access control, everything from obviously NFC to Bluetooth to ultrahigh frequency as well as, you know, as - just as well as the just power, you know, Power over Ethernet, which you folks know a little bit about. And what we're also seeing - is simply put a gain in software as the driver as opposed to hardware as a driver in getting into access control. And with access control, let's say becoming a faster growth area than even video, and we've seen some crazy valuations in the venture and private equity markets for some of these companies that are getting involved in areas that are either adjacent to you or actually may compete with you from intercoms all the way to you know to SaaS-based things. What is the company looking at in terms of, you know, trying to make sure that both protects its flank and grow this business?"
},
{
"speaker": "Dave Petratis",
"text": "So, I would describe it as one of the most exciting opportunities that I've seen in you know my 40 years of industrial participation. The company has been invested heavily and increased our investment as we went through the pandemic, you know, the, Yonomi acquisition would be reflective. But if you looked under the covers and saw the growth of our investments in Bangalore and our engineering capabilities, since I created - since we created Allegion, we tripled the feet on the street there to be able to position ourselves more strongly in the connectivity and the software elements. Third, Jeff, would be the venture activity you know, and you see some of the investments Kasa, Mint House, Openpath, I don't believe we - our strategy has been to be in the fast lanes to you know with new technology to be observe, learn, partner, invest potentially own, Yonomi went through that entire cycle. I think we continue to sharpen our position and I like our opportunities to be able to participate in the world of seamless access that you described."
},
{
"speaker": "Jeff Kessler",
"text": "All right, great. Look forward to interacting with you guys in the future. Thank you."
},
{
"speaker": "Dave Petratis",
"text": "We're always a leader in this and we appreciate your thought leadership, Jeff. Thank you."
},
{
"speaker": "Operator",
"text": "This concludes our question-and-answer session. I would like to turn the conference back over to Tom Martineau for any closing remarks."
},
{
"speaker": "Tom Martineau",
"text": "We'd like to thank everybody for participating in today's call and have a safe day."
},
{
"speaker": "Operator",
"text": "The conference has now concluded. Thank you for attending today's presentation. You may now disconnect."
}
] | Allegion plc | 241,782,379 |
ALLE | 4 | 2,022 | 2023-02-22 08:00:00 | Operator: Good day, and welcome to the Allegion Fourth Quarter 2022 Earnings Call. All participants will be in listen-only mode. [Operator Instructions] After today's presentation, there will be an opportunity to ask questions. Please note this event is being recorded. I would now like to turn the conference over to Tom Martineau, Vice President of Investor Relations and Treasurer. Please go ahead.
Tom Martineau: Thank you, Jason. Good morning, everyone. Thank you for joining us for Allegion's fourth quarter and full-year 2022 earnings call. With me today are John Stone, President and Chief Executive Officer; and Mike Wagnes, Senior Vice President and Chief Financial Officer of Allegion. Our earnings release, which was issued earlier this morning and the presentation, which we will refer to in today's call are available on our website at investor.allegion.com. This call will be recorded and archived on our website. Please go to slides two and three. Statements made in today's call that are not historical facts are considered forward-looking statements and are made pursuant to the safe harbor provisions of federal securities law. Please see our most recent SEC filings for a description of some of the factors that may cause actual results to differ materially from our projections. The company assumes no obligation to update these forward-looking statements. Today's presentation and commentary include non-GAAP financial measures. Please refer to the reconciliation in the financial tables of our press release for further details. Before I turn the call over to John, I have a couple of announcements to share. Kevin Sayer, who has been Allegiant's Director of Investor Relations for the past six years has been promoted to the role of Finance Director of our Commercial Americas business. This is a fantastic role for Kevin, who will now serve as our senior finance leader for that business. And I want to express my thanks and appreciation for all of Kevin's support. I'm also pleased to announce the promotion of Joby Coyle to the Director of Investor Relations role. Most recently, Joby has been leading our Americas home finance organization. Effective today, Job is the primary contact for our Investor Relations office. I will continue to lead the Investor Relations function. I would also like to share that Allegion will be hosting a 2023 Investor and Analyst Day on May 2nd of this year. The event will be at our Carmel, Indiana facility, which is in the North Indianapolis Metro area. A webcast option will also be available. Look for more details as we get closer to the event. John and Mike will now discuss our fourth quarter and full-year 2022 results, as well as provide an outlook for 2023, which will be followed by a Q&A session. [Operator Instructions] Now I'd like to turn the call over to John.
John Stone: Thanks, Tom, and let's go to slide four. And first off, congratulations to Kevin, and welcome to Joby. Allegion delivered another outstanding quarter of operational performance. As we look at market dynamics, we continue to see strong demand in the Americas non-residential segments, as well as global electronics. Residential markets continue to be soft with new construction slowing due to inflation and higher interest rates. International end markets are softening as a result of macroeconomic and geopolitical conditions. Our engineering redesigns and alternate supply actions are delivering results and lead times are normalizing on our mechanical products. We're seeing continued improvement in electronic supply, although it's still short of the very strong market demand we're seeing for our products. Price, productivity and inflation dynamic was positive again this quarter on both a dollar and a margin basis as we continue to combat inflation with pricing actions across products and channels. Consistent and efficient available cash flow generation remains a focus for our company. In 2022, we made the decision to protect our customers by investing in inventory, which resulted in a short-term increase in working capital. We're also accelerating certain strategic capital investments to deliver future growth. As a result, available cash flow in 2022 was less than expected. Lastly, to our 2023 outlook, which I'll speak to in more detail later in the presentation, shows revenue growth of 9% to 10.5% with organic growth of 2.5% to 4.5%. Adjusted EPS on a recast basis will be up 5% to 9%. Mike will provide details on the recast in a few minutes. Let's go to slide five. Revenue for the fourth quarter was $861.5 million, an increase of 21.5%, compared to 2021. Organic revenue growth was 11.4%. The organic growth was driven by strong price realization across the portfolio and favorable volume in the Americas non-residential business, offsetting weakness experienced in the Americas residential and international businesses. The Access Technologies acquisition contributed approximately 14% to total growth and currency impacts remain a headwind. Adjusted operating margin and adjusted EBITDA margins increased by 310 basis points each in the fourth quarter. The increases were attributable to favorable price, productivity and inflation dynamic, positive business mix, along with volume leverage associated with the Americas non-residential growth. These factors more than offset the expected margin dilution related to Access Technologies. Excluding the Access Technologies business, adjusted operating income margins were up 430 basis points. Adjusted EPS of $1.60 increased $0.49 or approximately 44% versus the prior year. Strong operational performance more than offset the unfavorable impact of higher interest expense and supported continued investments for growth. Please go to slide six. Building greater supply chain resiliency remains a focus for Allegion from redesigning our products to dual sourcing, we've taken the right actions to strengthen our company and capabilities over the past couple of years. Today, this work continues as we are adding a 350,000 square foot manufacturing facility in Central Mexico. This operation will boost in-region production for our Americas business with core activities like stamping, plating, die cast and assembly. Strategically, this new operation will increase our supply chain resiliency in a number of ways. The plant will be vertically integrated as we will now build components and products in-house that were previously sourced. At the same time, we're driving more efficiency in our supply chain, increasing manufacturing capacity and improving our future cost position. Production is expected to get started later this year, and we could not be more excited about this strategic investment. Mike will now walk you through the financial results, and I'll be back to discuss our 2023 outlook.
Mike Wagnes: Thanks, John, and good morning, everyone. Thank you for joining today's call. Please go to slide number seven. This slide reflects our earnings per share reconciliation for the fourth quarter. For the fourth quarter of 2021, reported earnings per share was $1.26, adjusting down $0.15 per share for a non-cash gain on an investment remeasurement offset by charges related to restructuring, M&A and debt refinancing costs, the 2021 adjusted earnings per share was $1.11. Operational results were very strong in the current quarter, adding $0.48 per share, reflecting 43.2% growth. This was driven by double-digit organic growth, favorable operating leverage and positive business mix, which more than offset currency headwinds. Access Technologies delivered $0.08 to earnings per share as operational results of $0.12 per share were offset by $0.04 of intangible amortization expense. We are pleased with the performance of Access Technologies in the first six months as the business results were in line with our expectations. A lower year-over-year tax rate increased earnings by $0.04 and favorable share count added another $0.03. Interest expense reduced earnings per share by $0.10, primarily driven by increased debt to finance the acquisition of Access Technologies. We continue to invest in the long-term strategy of the business, resulting in a $0.04 earnings per share headwind. This resulted in the fourth quarter 2022 adjusted earnings per share of $1.60, an increase of $0.49 or 44.1%, compared to the prior year. Lastly, we have a $0.07 per share reduction from adjusted EPS to arrive at reported EPS. This reduction is primarily attributed to M&A and additional non-cash purchase accounting items related to the acquisition [Technical Difficulty] of Access Technologies. After giving effect to these items, you arrive at a fourth quarter 2022 reported earnings per share of $1.53. Of note, starting in 2023, we are making a change to our adjusted operating income, earnings and EPS to exclude amortization expense related to acquired intangible assets. This change is based on the non-cash nature of those expenses and supports our growth strategy. Please go to slide number eight. This slide depicts our components of our revenue growth for the fourth quarter, as well as the full-year. As indicated, we experienced 11.4% organic revenue growth in the fourth quarter, driven by price across all segments. Volume growth in the Americas mostly offset declines in the international region. Net acquisitions and divestitures delivered 13.4% growth driven by Access Technologies. Currency pressures continued to be a headwind, primarily impacting our Allegion International segment bringing the total reported growth to 21.5% in the quarter. For the full-year, you could see the total revenue was up 14.1% with organic revenue growth of 10.7%. Both segments grew organically for the year, led by Allegion Americas, which grew 14.4%. Please go to slide number nine. Fourth quarter revenues for the Americas segment was $683.9 million, up 36.9% on a reported basis and up 18% organically. Price realization remains strong in both our residential and non-residential businesses offsetting ongoing inflationary pressure. In non-residential, we continue to see strong volume growth that when coupled with price, drove organic growth in the mid-20%. Residential was up low-single-digits with favorable price being offset by lower volumes. Electronics revenue was up approximately 50% for the quarter as we compare against supply chain headwinds in the prior year. Full-year electronics growth was approximately 20% and as our engineering and supply chain actions are yielding good results. We are pleased with the ongoing access technologies integration and results. This business contributed nearly 20% to the Americas reported growth number. Americas adjusted operating income of $164.4 million increased 55.8% versus the prior year period, while adjusted operating margins and adjusted EBITDA margins for the quarter were up 290 basis points and 320 basis points, respectively. Excluding Access Technologies, the business drove a 530-basis point improvement in operating margins versus the prior year. Pricing productivity in excess of inflation along with volume leverage on America's non-residential business and positive mix contributed to the margin improvement. Please go to slide number 10. Fourth quarter revenue for our Allegion International segment was $177.6 million, down 15.3% on a reported basis and down 4.3% organically. In the quarter, strong price realization was more than offset by lower volumes attributed to softening end markets. Notably, the demand for our electronic and software solutions remain stable. Currency headwinds persisted this quarter and reduced reported revenues by 9.9%. International adjusted operating income of $23.3 million decreased 20.7% versus the prior year period. Compared to 2021, adjusted operating margins and adjusted EBITDA margins decreased 90-basis points each. The margin decline was driven by reduced volumes and FX pressure, which more than offset the favorable impact of the combination of price, productivity and inflation. Please go to slide number 11. Available cash flow for 2022 came in at $395.5 million, down $47.7 million versus the prior year. This reduction is driven by higher capital expenditures, as well as increases in working capital. Given the inconsistencies in the supply chain and component availability, we increased inventory to protect our customers in 2022. When combined with the added working capital of the Access Technologies acquisition, there is an increase in working capital as a percent of revenue. We expect this to improve in 2023 as supply chains disruptions moderate. Capital expenditures as a percent of revenue also increased as we made strategic investments to drive future growth and improve supply chain resiliency like our new production facility in Central Mexico mentioned earlier. The last chart on the slide shows our net leverage. The net debt-to-EBITDA ratio increased from 1.7 times in 2021 to 3.3 times following the Access Technologies acquisition. We have quickly delevered post acquisition and are down to 2.5 times as of the end of the year. The business continues to generate strong cash flow, providing the opportunity for capital deployment with a focus on organic investment and acquisitions. Previously, our Board declared a dividend increase of approximately 10% in the dividend payable in March. I will now hand it back over to John for our 2023 outlook.
John Stone: Thanks, Mike. Let's go to slide 12 and take a look at full-year 2023 outlook. In the Americas, we expect to see total growth in the low to mid-teens with organic growth being approximately 4% to 6%. Electronics growth is expected to be strong as we've made significant progress working through supply chain challenges and demand and our backlogs remain robust. We do, however, expect some choppiness of component supply to continue throughout 2023. Non-residential market demand in the Americas continues to be strong heading into the year. We expect growth in the mid to high-teens for our non-res business, inclusive of our Access Technologies acquisition and high single-digits organically. Given the strength we saw in the second half of 2022, we expect stronger growth in the first-half with moderated growth in the second half, up against tougher comps. As communicated last quarter, residential markets have softened we expect our residential business to be down slightly, driven by the slowdown of single-family new construction. In the International segment, we expect relatively flat revenue as end markets continue to soften driven by macroeconomic and geopolitical factors. We project total revenue for international to be in the minus 1% to plus 1% range with organic revenue between minus 2% and flat. All in for the company, we are projecting total revenue to be up between 9% and 10.5%, organic revenue growth of 2.5% to 4.5%. Our 2023 outlook for adjusted earnings per share is expected to be between $6.30 and $6.50. This is inclusive of the reporting change effective January 1 of this year to exclude all acquisition-related amortization. Adjusted operational earnings are expected to increase 9% to 12%, driven by volume leverage and price and productivity exceeding inflation and investments. Interest is expected to be around a $0.24 per share headwind, reflecting a full-year of acquisition-related borrowings and increases to variable interest rates. Tax is expected to be a $0.20 headwind and other income is expected to be around a $0.05 headwind. The outlook assumes approximately $0.20 per share for costs related to restructuring and M&A and amortization expense related to acquired backlog. In addition, it excludes approximately $0.40 per share for acquired intangible asset amortization. As a result, reported EPS is projected to be between $5.70 and $5.90. Lastly, we're expecting available cash flow for 2023 to be in the $470 million to $490 million range. Let's go to slide 13. So in summary, we delivered significant growth in the fourth quarter, and we expect to see continued growth into 2023. Our electronic solutions are well received in the market, we continue to see very strong demand and we expect this to be a long-term growth driver for our company. As a late-cycle business, the Allegion Americas non-residential market demand is solid. We're well positioned for 2023. We're excited about a full-year with Access Technologies and love the recurring service aspect of that business. Operating margins have been improving, and we expect that trend to continue into 2023. We are accelerating investments in new product development, software capabilities and supply chain resiliency, all of which support the health of our business and the creation of long-term shareholder value. Overall, the entire team at Allegion, along with our distribution partners had a great finish to 2022, and we're headed into 2023 with the right velocity and momentum. With that, we're happy to turn to Q&A.
Operator: We will now begin our question-and-answer session. [Operator Instructions] Our first question comes from Joe O'Dea from Wells Fargo. Please go ahead.
Joe O'Dea: Hi, good morning. Thanks for taking my question.
John Stone: Good morning, Joe.
Mike Wagnes: Hi, Joe.
Joe O'Dea: I wanted to -- hi, just wanted to start on sort of Americas non-res end markets trends you've seen sort of in the year-end, the beginning of this year. If you could talk about color across verticals, I think seeing sort of ABI sub-50 for four months, looks like Dodge momentum remains pretty strong. I think we're hearing about some mix toward bigger projects. So just kind of what you're seeing kind of institutional side, commercial side with visibility into 2023.
John Stone: Yes, that's the right question, Joe. Thank you very much. This is John. What I would say is probably we're seeing the same trends on ABI as you are, and that would tend to telegraph what the market's doing 9 to 12 months from now. So we're watching that, of course, very carefully. I would say the present situation right now is there is a lot of construction activity going on. And we're pretty heavy institutional. And so what we see is, if you look at things like the association of building contractors, construction backlog, while it's sequentially down just a little bit, it's still looking at historical trends quite elevated, which means there's a lot of activity. And that index, I would tell you is quite consistent with what we hear from our distribution partners. It's what we're hearing from our folks out in the regional sales offices that there's a lot of project business out there, and we feel very well positioned to capture it.
Joe O'Dea: That's helpful. And then just wanted to touch on growth investments in 2023, just from a capability and end market perspective, where some of those growth investments are focused?
Mike Wagnes: Yes. So really good question. We'll take an organic angle at it first. And I would say we feel like we're a leader in electromechanical products. So continuing to invest on the R&D side in those products and those capabilities, continue to build that portfolio. You saw -- I hope you saw in January, we did close on our acquisition of Plano in Germany, kind of, building more of our Software-as-a-Service business there in the International segment. And I think you can continue to expect us to be more acquisitive in the future. I think that's definitely something we're interested in. Pipeline feels pretty good. But of course, these things are rather episodic in nature. So we take it as the right asset comes available at the right price. I would take you back to in the deck the facility that we're building in Central Mexico. That's essentially in-sourcing and near-shoring previously sourced product. And that facility has a lot of expansion capability to it. So as we ramp up production there, we'll have a better cost position on some of our mechanical products and then future products to be built there yet to be seen. But I think we're quite excited about that from an organic growth perspective as well.
Operator: Our next question comes from Joe Ritchie from Goldman Sachs. Please go ahead.
Vivek Srivastava : Good morning. This is Vivek Srivastava on for Joe Ritchie. Thank you for the question. My first question is on the residential pricing. It looks like this quarter pricing was basically offset by volume. If you can provide some color on how the realized pricing is progressing, especially on the big box side of the business? And how should we think about 2023 here as we think about pricing?
Mike Wagnes: Yes. Thanks for the question. As you think about our residential business historically, say, before 2022, we've struggled to get price in residential, and we made it a focus area to drive pricing due to all the inflationary pressures we had. We had the strongest price realization I can recall in my decade-plus here in residential in 2022. And we expect to see price realization next year as well. So as we deal with inflationary pressures, look for us to combat that with pricing, and we've had significant progress in that area across the entire portfolio in 2022, moving into 2023, we expect that to continue.
Vivek Srivastava: That's great to hear. And maybe just a follow-up there, especially on the any destock risk on the residential side? Any -- has any of the destock happened already? Or do you expect some in 2023?
John Stone: So I think -- this is John. Kind of two things going on there in that channel. I think on the mechanical side, again, you heard earlier in the call, our lead times are essentially back to normal. So book and ship business, retail point-of-sale pull-through. Certainly, on a volume basis, particularly on the mechanical side, it's a little softer. There is no doubt. On the electronics side, again, demand is very strong. Backlogs are still elevated. And in all honesty, we still have -- by historical values, we still have shelf space to fill with electronic products, both on the commercial side and the residential side. So I think there's -- again, electronics will continue to be a growth driver for the company in all segments.
Operator: Our next question comes from Brett Linzey from Mizuho Americas. Please go ahead.
Brett Linzey: Hey, good morning, all.
John Stone: Good morning.
Mike Wagnes: Good morning, Brett.
Brett Linzey: Yes, just wanted to come back to the pricing discussion. Mike, I think you touched on pricing expectations for residential. But thinking more broadly about the portfolio and actions into 2023. How are you thinking about additional pricing for this year? And then specifically, within the whole framework, what do you think in for price realization this year?
Mike Wagnes: Brett, as we've talked over time, we're committed to fight that inflationary pressure we see. We expect price realization -- substantial price realization in 2023 and such that, that price, productivity, inflation and investment dynamic is a net positive. You've heard me talk about this for at least 6 months now. We've made good momentum in '22, and we're set up nicely for '23 such that we have a net positive of those 4 characteristics or those 4 items.
Brett Linzey: Okay. Got it. And just wanted to follow-up on the Mexico facility for stamping, plating, et cetera. In terms of identifiable paybacks, how are you thinking about the potential cost savings as you look into ‘24 and ‘25? Or what that payback might look like?
John Stone: Yes. It's the right question. I think payback is going to be pretty quick. I mean, these are high-volume products and the cost reduction that we're looking at is substantial. I'm not going to give you the exact down to the penny number, but it's substantial. And we see, because of that, a favorable impact on margins and a favorable impact on market share in those segments. It's -- we're quite excited about getting this facility ramped up.
Mike Wagnes: And Brett, just to add, if you think about 2023 because the facility is going to come online later in the year, that margin benefit and that cost benefit, that's more of a ‘24, ‘25 benefit. If you think about ‘23, think of there is some investment in start-up costs as you bring a new facility up and running during the year, but this is a great long-term investment like John mentioned. So I just wanted to add that color.
Operator: Our next question comes from David MacGregor from Longbow Research. Please go ahead.
David MacGregor: Yes, good morning, everyone. I just wanted to continue on the pricing. And in response to the last couple of questions. You made it very clear that you're pushing much harder on pricing. But can you just talk about that in terms of price cost expectations and what you've got reflected in your full year guidance? Maybe talk about how that should phase over the 4 quarters.
Mike Wagnes: Yes. As you think about it for next year, definitely positive. Obviously, price cost will be better in the first half because of the prior year comparable. And then if you think about quarters, we try not to guide quarters. But think of it as price cost inflation and investments, ‘this is a net positive for us moving forward. We fell behind last year, right, in 2021. '22, we caught up, we made some positive traction at the end of the year, and now we're set up nicely moving forward and expect this dynamic to continue to be positive.
David MacGregor: Good. Just as a follow-up, I guess, maybe talk about Access Technologies and maybe the progress to date? And how are you reflecting that acquisition in your 2023 growth and margin guidance?
Mike Wagnes: So if you look at the first half of the year, that would be considered inorganic growth. And so on the slide in the presentation, we show a delta between reported and organic for the Americas, that inorganic would be Access Tech. The back half of the year, it will be part of organic growth and is included in that non-residential number John mentioned earlier in the prepared remarks. So it's a combination of both the first half is that inorganic growth.
John Stone: Yes. Strategically, David, it's a great fit. We've retained the key talent. We've retained the key customers. We're working very, very hard on getting these automatic doors into this very powerful Allegion spec engine. That team is super excited to be here. We're super excited to have him. And again, you've got a very robust recurring service business as a part of that acquisition that we're really excited about.
Operator: Our next question comes from Jeff Sprague from Vertical Research. Please go ahead.
Jeff Sprague: Hey, thank you. Good morning, everyone.
John Stone: Hey, Jeff.
Mike Wagnes: Hi, Jeff.
Jeff Sprague: Good morning. Just a couple for me, if I could. Just first, back to price cost and everybody has asked the question a couple of times. But I just want to be clear really on your volume expectations for the year. It would seem we could get two or pretty close to your organic revenue growth just on carryover price. And the fact that I would think you've also got some positive mix effects on revenue as electronics ramps up. So perhaps you could just give us a little bit more color on what you're expecting for volumes for the year.
Mike Wagnes: Yes. Jeff, if you think of the non-residential business in the Americas, still going to see volume growth, good end markets. If you think about international and residential, they're a little softer. So think of any form of growth coming more from the price there, all in weighted more towards pricing like you suggested than volume. But the non-res side and electronics, that's where the volume growth will be driven.
Jeff Sprague: Great. And then actually, I just wanted to ask a little bit of a philosophical question about going to ex-amort and I agree it's the right thing to do, ultimately, particularly given a lot of other folks do it. But the main premise of it is, right, that amortization is non-cash. So when I go to adjusted EPS, my earnings and my cash flow are then, in fact, similar, right? And the EPS is kind of an economic number. You're only going to convert at about 85% free cash flow to adjusted net income this year according to your guide. Do you -- and it's certainly understandable supply chain inventories elevated and the like. But do you see those numbers converging over time? And getting the organization to, I don't know, 95% to 100% conversion to adjusted net income.
Mike Wagnes: Yes. So Jeff, historically, when we looked at it at reported net income, that was in the low-90s based on the current guide on the reported net income, it's mid-90s. I would say, longer term, we do expect it to be better. We do have an increase in capital expenditures this year. So if you think of depreciation versus CapEx, CapEx is elevated. Think of it as 2.5% plus of revenue. We're building a new facility. That's not something we do every single day, so it is a little lighter, because a higher level of CapEx. But longer term, think of us as focusing on, especially as we make M&A, the cash returns of these acquisitions. We've been talking about Access Tech for almost a year now. And it's -- the ability to drive cash earnings from those acquisitions rather than a non-cash charge.
Operator: The next question comes from Chris Snyder from UBS. Please go ahead.
Chris Snyder: Thank you. I want to follow-up on the previous question around the Americas organic growth guide of 4% to 6%. Can you just, I guess, specifically talk about the split between volume and price within that? Because my math is kind of similar to Jeff. It feels like Americas can get there on just wrap around price alone, and it sounds like there is scope for incremental price as well.
Mike Wagnes: Yes. So when you think about 2023 and pricing. Clearly, we had good momentum coming into the year. We have more pricing than volume growth. Residential is when you build your models, don't forget, starts have been down considerably there in the residential space. So residential volume is going to be more challenged, right? So overall, the volume growth coming from non-res in the total segment, I don't want to give subsegment targets for volume versus price. But I would just say the total segment is more pricing than volume when you build your models.
Chris Snyder: Thank you. I appreciate that. And then maybe for my follow-up, just around the cadence of America's organic growth as the year goes on. So it certainly feels like organic growth in the first-half of the year will be stronger in the back half, just on the easier price comps. But could you just provide some more color on that trajectory? And does the guidance imply that Q4 will be negative organic for the Americas? Thank you.
Mike Wagnes: Yes. So if you look at our history, we're not going to guide quarters. I would say this 2022 very back-end loaded. Our historical norms for the Americas is probably more indicative of what you think 2023 would look like from a percent of the total. As a result, you'll see more revenue growth in the first-half than the second-half, but we do expect to see growth in the back half of the year.
Operator: The next question comes from Tim Tojs from Baird. Please go ahead.
Tim Tojs: Hey, good morning, [Indiscernible]. Maybe just on backlog. Just maybe if you can give us a little bit of flavor for where backlog is maybe versus a year ago? And I know there's some noise in there just from the supply chain, kind of, constraints. But just maybe any color on the trajectory of that backlog through the year would be helpful.
Mike Wagnes: Yes. So Tim, we ended last year very elevated backlogs, especially in electronics and mechanical, that's 2021. If you think about ‘22, we worked through the excess mechanical backlog such that lead times are normal. Demand is good, lead times are normal. So it's where we want to be from a health of a business. If you think of electronics, electronics does have elevated backlogs at the end of 2022, which is attributable to both supply challenges, but as well as really strong demand. And so we do have elevated backlogs in electronics, which will give us tailwinds for both and frankly, ‘24. This is a long-term trend moving for us.
Tim Tojs: Okay, okay. So it sounds like you've burned off most of the kind of buildup from ‘21 and now it's just stronger demand.
Mike Wagnes: On the mechanical side, yes.
Tim Tojs: Yes. Okay, okay. Got you. And then John, maybe just bigger picture. I mean, you've been CEO now for six to nine months. And now that you've gotten maybe a little bit more settle into role. Just maybe some color on any potential strategic changes or tweaks that you think you might make with the business going forward.
John Stone: Yes, absolutely. I think these last two quarters, it's really been a pleasure being here, working with the Allegion team and working with these distribution partners out there. I think what you should see is a lot of the things that built Allegion's reputation since spin of outstanding operational execution, year-over-year expanding margins. Those kind of things will continue. What we're looking to do is continue to orient the company towards growth and allocate capital towards growth. That means driving organic growth. That means continue to look for us and expect us to be acquisitive and really leading with our technology. Allegion got a fabulous electromechanical portfolio. We've got extremely talented engineers. We feel like we're a leader in that space, and we'll continue to be a leader in that space. So organic growth, inorganic growth through M&A, I think that's what you need to expect us to layer on top of the operational excellence that you're used to from Allegion. And this year-on-year ability to drive above-market growth and continue to expand margins.
Operator: Our next question comes from Josh Pokrzywinski from Morgan Stanley. Please go ahead.
Josh Pokrzywinski: Hey, good morning, guys.
John Stone: Good morning.
Mike Wagnes: Good morning, Josh.
Josh Pokrzywinski: So John, you talked a few times about the visibility in the non-res business, particularly on electronics with the elevated backlog. Just wondering if you could give us sort of any view on where backlog levels stand? Or how you think about conversion or something like book-to-bill in the framework this year?
John Stone: Yes. So I think, again, on the mechanical side of the portfolio, we're -- you put air quotes around it back to what you would expect a book and ship business. So very efficient, very lean book and ship business. Electronics demand is still very, very strong, and that's globally. And supply limited is still where we are. We've got -- and I think quarter-to-quarter, month-to-month made continuous progress on that. And that's why you see the kind of year-over-year growth numbers that you've seen in Q3, Q4 of ‘22. We're very bullish on that portfolio, and we're continuing to invest and refresh the products. So we do expect demand to continue to remain strong. We do expect conversion and adoption to continue to grow. That being said, of course, there are parts of a building. There are parts of Allegion's portfolio that will never be electrified. So it doesn't just go from some state to 100% electric. But electronics will continue to be a double-digit growth driver for the company and that gives us a pretty interesting avenue to continue to build out Software-as-a-Service, like you see with our Enerflex and our Plano acquisition. So I'd say, again, look for us to continue to be acquisitive and build on this advantage that we feel we've got with the electronic products.
Josh Pokrzywinski: Got it. That's helpful. Looking forward to hearing more about that at the Investor Day as well. On the margin guide in the Americas or I guess implicit in the guide overall, how do we think about sort of what's an easy comp and timing elements around things like either price/cost or miss shipments, productivity versus just kind of volume leverage. Is there any way you guys would sort of break down those buckets of what just comes from kind of the absence of the bad guys versus some of this healthy mix, price/cost, some of the other things you're talking about.
Mike Wagnes: Yes, Josh. Clearly, first half, we're going to see more margin expansion, due to the easier comp. Look for us, though, for all quarters to be driving pricing and productivity in excess of that inflation and investment number on a dollar basis. And when you think about expansion, Americas margin expansion will be more front half loaded year-over-year.
Operator: The next question comes from Ryan Merkel from William Blair. Please go ahead.
Ryan Merkel: Good morning. Thanks for taking the question. Wanted to pick up on the electronics demand. Can you just talk about some of the key drivers is the strength in both resi and commercial? And then what are the features and benefits that are really resonating with customers?
John Stone: Yes, it's a great question. Maybe start with residential. I think the rise of the mega tech smart home ecosystems, the two most popular products that you find connected to those systems would be thermostats and locks. People might do other things, but those two fundamental elements seem like the most popular the functionality you get with a phone connected to your smart -- excuse me, a phone connected to your lock, the visibility of the state of that lock the peace of mind aspect that, that gives you, I think that's quite attractive to a lot of folks. On the non-res side, it's -- I mean, this is a B2B environment. So here, you're talking about like real economic value add for the end user. So think about a multifamily residential setting, an apartment complex rather than the landlord managing and swapping out metal keys. You can do this all digitally now with digital credentials, mobile credentials. It's just -- there's operating cost savings there that will continue to drive adoption in spaces like that. So -- on the non-res side, this is real economic benefits that are delivered over time. Residential side, peace of mind, visibility, higher tech connected to my smart home, et cetera. Those trends are, I think, still in the early stages of a traditional S-curve of adoption and a nice long runway ahead of us.
Ryan Merkel: That's helpful. Thanks. And then on supply chain, just where are the pinch points in electronics? Do you have any visibility to when that improves and the investment in working capital. Is that primarily in electronics?
John Stone: So the supply chain, the way I described it last quarter, the same way I'll describe it this quarter of a year ago. We had 50 suppliers on the delinquent list that was shutting our assembly lines down on any given day. Today, that number is down to a handful, three or four. So that's the order of magnitude of improvement. The constraint is the semiconductors themselves, microprocessors in particular. And it's just been a matter of the industrial Internet-of-Things, that space has had extremely strong demand, while you've probably seen news headlines and other things about some foundries or chip manufacturers seeing softening demand, that’s from things like consumer goods and mobile phones, these much smaller, much more advanced, much more expensive chips. But these chips that hit the sweet spot of cost and power and performance for the industrial IoT, which is like what we use in our products. That demand has still outstripped supply and capacity all the way back to the foundries. We've been working very closely to do a couple of things. One would be expand the quantity of supply that's been improving. The other thing has also improved the visibility and the linearity of deliveries. So then our factories can run a bit more efficiently and we can bring our lead times down. So it goes all the way back to the semiconductor itself, and that's the value chain we're trying to work through and continue to make improvements. And we're happy with the improvement so far, but we're still supply constrained versus very strong demand.
Operator: The next question comes from Brian Rittenberg from Imperial Capital, please -- I'm sorry, Brian Ruttenbur from Imperial Capital.
Brian Ruttenbur: Okay, thank you very much. So one other question on the residential side in 2023. It looks like it's going to be driven by pricing. Can you talk a little bit about -- you say it's primarily driven by pricing. Will volumes actually be down? And could they be down 2% to 3%, 4% or 5% and you still hit that -- your goals for 2023 on the residential side?
Mike Wagnes: Yes. Brian, I really don't want to give the subcomponents for res, non-res, but if you think about it, I would say you're approximating a reasonable outlook for res in that it's going to be price driven and that volume will be challenged. But I don't want to give individual components between res and non-res.
Brian Ruttenbur: Okay. And then along those same lines, have you experienced on the residential side or even the international side, any debooking in the fourth quarter where you've just heard about some debooking in the residential side, and I didn't want to kind of get your color on that, if there's been any debooking and you've seen a recovery post fourth quarter?
Mike Wagnes: If you think about our residential business, electronics, clearly, there's shelf space to be filled, as John talked about. On the mechanical side, what we have seen is slowing there again to the overall numbers we talked about residential. As far as de bookings, we have not seen a lot of cancellations from customers more think of it as slowing down in the consumer making purchases there.
Operator: This concludes our question-and-answer session. I would like to turn the conference back over to John Stone for any closing remarks.
John Stone: Thanks very much. So to wrap up, what you heard today, Allegion Americas non-residential demand remains robust. Global electronics demand remains very strong. Our supply chains are improving, and our products are very well received in the market. Access Technologies acquisition is continuing to perform very well. We, along with our distribution partners had a great finish to 2022 and feel that we're favorably positioned for 2023. Thank you very much for joining the call, and have a great day.
Operator: Conference has now concluded. Thank you for attending today's presentation. You may now disconnect. | [
{
"speaker": "Operator",
"text": "Good day, and welcome to the Allegion Fourth Quarter 2022 Earnings Call. All participants will be in listen-only mode. [Operator Instructions] After today's presentation, there will be an opportunity to ask questions. Please note this event is being recorded. I would now like to turn the conference over to Tom Martineau, Vice President of Investor Relations and Treasurer. Please go ahead."
},
{
"speaker": "Tom Martineau",
"text": "Thank you, Jason. Good morning, everyone. Thank you for joining us for Allegion's fourth quarter and full-year 2022 earnings call. With me today are John Stone, President and Chief Executive Officer; and Mike Wagnes, Senior Vice President and Chief Financial Officer of Allegion. Our earnings release, which was issued earlier this morning and the presentation, which we will refer to in today's call are available on our website at investor.allegion.com. This call will be recorded and archived on our website. Please go to slides two and three. Statements made in today's call that are not historical facts are considered forward-looking statements and are made pursuant to the safe harbor provisions of federal securities law. Please see our most recent SEC filings for a description of some of the factors that may cause actual results to differ materially from our projections. The company assumes no obligation to update these forward-looking statements. Today's presentation and commentary include non-GAAP financial measures. Please refer to the reconciliation in the financial tables of our press release for further details. Before I turn the call over to John, I have a couple of announcements to share. Kevin Sayer, who has been Allegiant's Director of Investor Relations for the past six years has been promoted to the role of Finance Director of our Commercial Americas business. This is a fantastic role for Kevin, who will now serve as our senior finance leader for that business. And I want to express my thanks and appreciation for all of Kevin's support. I'm also pleased to announce the promotion of Joby Coyle to the Director of Investor Relations role. Most recently, Joby has been leading our Americas home finance organization. Effective today, Job is the primary contact for our Investor Relations office. I will continue to lead the Investor Relations function. I would also like to share that Allegion will be hosting a 2023 Investor and Analyst Day on May 2nd of this year. The event will be at our Carmel, Indiana facility, which is in the North Indianapolis Metro area. A webcast option will also be available. Look for more details as we get closer to the event. John and Mike will now discuss our fourth quarter and full-year 2022 results, as well as provide an outlook for 2023, which will be followed by a Q&A session. [Operator Instructions] Now I'd like to turn the call over to John."
},
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"speaker": "John Stone",
"text": "Thanks, Tom, and let's go to slide four. And first off, congratulations to Kevin, and welcome to Joby. Allegion delivered another outstanding quarter of operational performance. As we look at market dynamics, we continue to see strong demand in the Americas non-residential segments, as well as global electronics. Residential markets continue to be soft with new construction slowing due to inflation and higher interest rates. International end markets are softening as a result of macroeconomic and geopolitical conditions. Our engineering redesigns and alternate supply actions are delivering results and lead times are normalizing on our mechanical products. We're seeing continued improvement in electronic supply, although it's still short of the very strong market demand we're seeing for our products. Price, productivity and inflation dynamic was positive again this quarter on both a dollar and a margin basis as we continue to combat inflation with pricing actions across products and channels. Consistent and efficient available cash flow generation remains a focus for our company. In 2022, we made the decision to protect our customers by investing in inventory, which resulted in a short-term increase in working capital. We're also accelerating certain strategic capital investments to deliver future growth. As a result, available cash flow in 2022 was less than expected. Lastly, to our 2023 outlook, which I'll speak to in more detail later in the presentation, shows revenue growth of 9% to 10.5% with organic growth of 2.5% to 4.5%. Adjusted EPS on a recast basis will be up 5% to 9%. Mike will provide details on the recast in a few minutes. Let's go to slide five. Revenue for the fourth quarter was $861.5 million, an increase of 21.5%, compared to 2021. Organic revenue growth was 11.4%. The organic growth was driven by strong price realization across the portfolio and favorable volume in the Americas non-residential business, offsetting weakness experienced in the Americas residential and international businesses. The Access Technologies acquisition contributed approximately 14% to total growth and currency impacts remain a headwind. Adjusted operating margin and adjusted EBITDA margins increased by 310 basis points each in the fourth quarter. The increases were attributable to favorable price, productivity and inflation dynamic, positive business mix, along with volume leverage associated with the Americas non-residential growth. These factors more than offset the expected margin dilution related to Access Technologies. Excluding the Access Technologies business, adjusted operating income margins were up 430 basis points. Adjusted EPS of $1.60 increased $0.49 or approximately 44% versus the prior year. Strong operational performance more than offset the unfavorable impact of higher interest expense and supported continued investments for growth. Please go to slide six. Building greater supply chain resiliency remains a focus for Allegion from redesigning our products to dual sourcing, we've taken the right actions to strengthen our company and capabilities over the past couple of years. Today, this work continues as we are adding a 350,000 square foot manufacturing facility in Central Mexico. This operation will boost in-region production for our Americas business with core activities like stamping, plating, die cast and assembly. Strategically, this new operation will increase our supply chain resiliency in a number of ways. The plant will be vertically integrated as we will now build components and products in-house that were previously sourced. At the same time, we're driving more efficiency in our supply chain, increasing manufacturing capacity and improving our future cost position. Production is expected to get started later this year, and we could not be more excited about this strategic investment. Mike will now walk you through the financial results, and I'll be back to discuss our 2023 outlook."
},
{
"speaker": "Mike Wagnes",
"text": "Thanks, John, and good morning, everyone. Thank you for joining today's call. Please go to slide number seven. This slide reflects our earnings per share reconciliation for the fourth quarter. For the fourth quarter of 2021, reported earnings per share was $1.26, adjusting down $0.15 per share for a non-cash gain on an investment remeasurement offset by charges related to restructuring, M&A and debt refinancing costs, the 2021 adjusted earnings per share was $1.11. Operational results were very strong in the current quarter, adding $0.48 per share, reflecting 43.2% growth. This was driven by double-digit organic growth, favorable operating leverage and positive business mix, which more than offset currency headwinds. Access Technologies delivered $0.08 to earnings per share as operational results of $0.12 per share were offset by $0.04 of intangible amortization expense. We are pleased with the performance of Access Technologies in the first six months as the business results were in line with our expectations. A lower year-over-year tax rate increased earnings by $0.04 and favorable share count added another $0.03. Interest expense reduced earnings per share by $0.10, primarily driven by increased debt to finance the acquisition of Access Technologies. We continue to invest in the long-term strategy of the business, resulting in a $0.04 earnings per share headwind. This resulted in the fourth quarter 2022 adjusted earnings per share of $1.60, an increase of $0.49 or 44.1%, compared to the prior year. Lastly, we have a $0.07 per share reduction from adjusted EPS to arrive at reported EPS. This reduction is primarily attributed to M&A and additional non-cash purchase accounting items related to the acquisition [Technical Difficulty] of Access Technologies. After giving effect to these items, you arrive at a fourth quarter 2022 reported earnings per share of $1.53. Of note, starting in 2023, we are making a change to our adjusted operating income, earnings and EPS to exclude amortization expense related to acquired intangible assets. This change is based on the non-cash nature of those expenses and supports our growth strategy. Please go to slide number eight. This slide depicts our components of our revenue growth for the fourth quarter, as well as the full-year. As indicated, we experienced 11.4% organic revenue growth in the fourth quarter, driven by price across all segments. Volume growth in the Americas mostly offset declines in the international region. Net acquisitions and divestitures delivered 13.4% growth driven by Access Technologies. Currency pressures continued to be a headwind, primarily impacting our Allegion International segment bringing the total reported growth to 21.5% in the quarter. For the full-year, you could see the total revenue was up 14.1% with organic revenue growth of 10.7%. Both segments grew organically for the year, led by Allegion Americas, which grew 14.4%. Please go to slide number nine. Fourth quarter revenues for the Americas segment was $683.9 million, up 36.9% on a reported basis and up 18% organically. Price realization remains strong in both our residential and non-residential businesses offsetting ongoing inflationary pressure. In non-residential, we continue to see strong volume growth that when coupled with price, drove organic growth in the mid-20%. Residential was up low-single-digits with favorable price being offset by lower volumes. Electronics revenue was up approximately 50% for the quarter as we compare against supply chain headwinds in the prior year. Full-year electronics growth was approximately 20% and as our engineering and supply chain actions are yielding good results. We are pleased with the ongoing access technologies integration and results. This business contributed nearly 20% to the Americas reported growth number. Americas adjusted operating income of $164.4 million increased 55.8% versus the prior year period, while adjusted operating margins and adjusted EBITDA margins for the quarter were up 290 basis points and 320 basis points, respectively. Excluding Access Technologies, the business drove a 530-basis point improvement in operating margins versus the prior year. Pricing productivity in excess of inflation along with volume leverage on America's non-residential business and positive mix contributed to the margin improvement. Please go to slide number 10. Fourth quarter revenue for our Allegion International segment was $177.6 million, down 15.3% on a reported basis and down 4.3% organically. In the quarter, strong price realization was more than offset by lower volumes attributed to softening end markets. Notably, the demand for our electronic and software solutions remain stable. Currency headwinds persisted this quarter and reduced reported revenues by 9.9%. International adjusted operating income of $23.3 million decreased 20.7% versus the prior year period. Compared to 2021, adjusted operating margins and adjusted EBITDA margins decreased 90-basis points each. The margin decline was driven by reduced volumes and FX pressure, which more than offset the favorable impact of the combination of price, productivity and inflation. Please go to slide number 11. Available cash flow for 2022 came in at $395.5 million, down $47.7 million versus the prior year. This reduction is driven by higher capital expenditures, as well as increases in working capital. Given the inconsistencies in the supply chain and component availability, we increased inventory to protect our customers in 2022. When combined with the added working capital of the Access Technologies acquisition, there is an increase in working capital as a percent of revenue. We expect this to improve in 2023 as supply chains disruptions moderate. Capital expenditures as a percent of revenue also increased as we made strategic investments to drive future growth and improve supply chain resiliency like our new production facility in Central Mexico mentioned earlier. The last chart on the slide shows our net leverage. The net debt-to-EBITDA ratio increased from 1.7 times in 2021 to 3.3 times following the Access Technologies acquisition. We have quickly delevered post acquisition and are down to 2.5 times as of the end of the year. The business continues to generate strong cash flow, providing the opportunity for capital deployment with a focus on organic investment and acquisitions. Previously, our Board declared a dividend increase of approximately 10% in the dividend payable in March. I will now hand it back over to John for our 2023 outlook."
},
{
"speaker": "John Stone",
"text": "Thanks, Mike. Let's go to slide 12 and take a look at full-year 2023 outlook. In the Americas, we expect to see total growth in the low to mid-teens with organic growth being approximately 4% to 6%. Electronics growth is expected to be strong as we've made significant progress working through supply chain challenges and demand and our backlogs remain robust. We do, however, expect some choppiness of component supply to continue throughout 2023. Non-residential market demand in the Americas continues to be strong heading into the year. We expect growth in the mid to high-teens for our non-res business, inclusive of our Access Technologies acquisition and high single-digits organically. Given the strength we saw in the second half of 2022, we expect stronger growth in the first-half with moderated growth in the second half, up against tougher comps. As communicated last quarter, residential markets have softened we expect our residential business to be down slightly, driven by the slowdown of single-family new construction. In the International segment, we expect relatively flat revenue as end markets continue to soften driven by macroeconomic and geopolitical factors. We project total revenue for international to be in the minus 1% to plus 1% range with organic revenue between minus 2% and flat. All in for the company, we are projecting total revenue to be up between 9% and 10.5%, organic revenue growth of 2.5% to 4.5%. Our 2023 outlook for adjusted earnings per share is expected to be between $6.30 and $6.50. This is inclusive of the reporting change effective January 1 of this year to exclude all acquisition-related amortization. Adjusted operational earnings are expected to increase 9% to 12%, driven by volume leverage and price and productivity exceeding inflation and investments. Interest is expected to be around a $0.24 per share headwind, reflecting a full-year of acquisition-related borrowings and increases to variable interest rates. Tax is expected to be a $0.20 headwind and other income is expected to be around a $0.05 headwind. The outlook assumes approximately $0.20 per share for costs related to restructuring and M&A and amortization expense related to acquired backlog. In addition, it excludes approximately $0.40 per share for acquired intangible asset amortization. As a result, reported EPS is projected to be between $5.70 and $5.90. Lastly, we're expecting available cash flow for 2023 to be in the $470 million to $490 million range. Let's go to slide 13. So in summary, we delivered significant growth in the fourth quarter, and we expect to see continued growth into 2023. Our electronic solutions are well received in the market, we continue to see very strong demand and we expect this to be a long-term growth driver for our company. As a late-cycle business, the Allegion Americas non-residential market demand is solid. We're well positioned for 2023. We're excited about a full-year with Access Technologies and love the recurring service aspect of that business. Operating margins have been improving, and we expect that trend to continue into 2023. We are accelerating investments in new product development, software capabilities and supply chain resiliency, all of which support the health of our business and the creation of long-term shareholder value. Overall, the entire team at Allegion, along with our distribution partners had a great finish to 2022, and we're headed into 2023 with the right velocity and momentum. With that, we're happy to turn to Q&A."
},
{
"speaker": "Operator",
"text": "We will now begin our question-and-answer session. [Operator Instructions] Our first question comes from Joe O'Dea from Wells Fargo. Please go ahead."
},
{
"speaker": "Joe O'Dea",
"text": "Hi, good morning. Thanks for taking my question."
},
{
"speaker": "John Stone",
"text": "Good morning, Joe."
},
{
"speaker": "Mike Wagnes",
"text": "Hi, Joe."
},
{
"speaker": "Joe O'Dea",
"text": "I wanted to -- hi, just wanted to start on sort of Americas non-res end markets trends you've seen sort of in the year-end, the beginning of this year. If you could talk about color across verticals, I think seeing sort of ABI sub-50 for four months, looks like Dodge momentum remains pretty strong. I think we're hearing about some mix toward bigger projects. So just kind of what you're seeing kind of institutional side, commercial side with visibility into 2023."
},
{
"speaker": "John Stone",
"text": "Yes, that's the right question, Joe. Thank you very much. This is John. What I would say is probably we're seeing the same trends on ABI as you are, and that would tend to telegraph what the market's doing 9 to 12 months from now. So we're watching that, of course, very carefully. I would say the present situation right now is there is a lot of construction activity going on. And we're pretty heavy institutional. And so what we see is, if you look at things like the association of building contractors, construction backlog, while it's sequentially down just a little bit, it's still looking at historical trends quite elevated, which means there's a lot of activity. And that index, I would tell you is quite consistent with what we hear from our distribution partners. It's what we're hearing from our folks out in the regional sales offices that there's a lot of project business out there, and we feel very well positioned to capture it."
},
{
"speaker": "Joe O'Dea",
"text": "That's helpful. And then just wanted to touch on growth investments in 2023, just from a capability and end market perspective, where some of those growth investments are focused?"
},
{
"speaker": "Mike Wagnes",
"text": "Yes. So really good question. We'll take an organic angle at it first. And I would say we feel like we're a leader in electromechanical products. So continuing to invest on the R&D side in those products and those capabilities, continue to build that portfolio. You saw -- I hope you saw in January, we did close on our acquisition of Plano in Germany, kind of, building more of our Software-as-a-Service business there in the International segment. And I think you can continue to expect us to be more acquisitive in the future. I think that's definitely something we're interested in. Pipeline feels pretty good. But of course, these things are rather episodic in nature. So we take it as the right asset comes available at the right price. I would take you back to in the deck the facility that we're building in Central Mexico. That's essentially in-sourcing and near-shoring previously sourced product. And that facility has a lot of expansion capability to it. So as we ramp up production there, we'll have a better cost position on some of our mechanical products and then future products to be built there yet to be seen. But I think we're quite excited about that from an organic growth perspective as well."
},
{
"speaker": "Operator",
"text": "Our next question comes from Joe Ritchie from Goldman Sachs. Please go ahead."
},
{
"speaker": "Vivek Srivastava",
"text": "Good morning. This is Vivek Srivastava on for Joe Ritchie. Thank you for the question. My first question is on the residential pricing. It looks like this quarter pricing was basically offset by volume. If you can provide some color on how the realized pricing is progressing, especially on the big box side of the business? And how should we think about 2023 here as we think about pricing?"
},
{
"speaker": "Mike Wagnes",
"text": "Yes. Thanks for the question. As you think about our residential business historically, say, before 2022, we've struggled to get price in residential, and we made it a focus area to drive pricing due to all the inflationary pressures we had. We had the strongest price realization I can recall in my decade-plus here in residential in 2022. And we expect to see price realization next year as well. So as we deal with inflationary pressures, look for us to combat that with pricing, and we've had significant progress in that area across the entire portfolio in 2022, moving into 2023, we expect that to continue."
},
{
"speaker": "Vivek Srivastava",
"text": "That's great to hear. And maybe just a follow-up there, especially on the any destock risk on the residential side? Any -- has any of the destock happened already? Or do you expect some in 2023?"
},
{
"speaker": "John Stone",
"text": "So I think -- this is John. Kind of two things going on there in that channel. I think on the mechanical side, again, you heard earlier in the call, our lead times are essentially back to normal. So book and ship business, retail point-of-sale pull-through. Certainly, on a volume basis, particularly on the mechanical side, it's a little softer. There is no doubt. On the electronics side, again, demand is very strong. Backlogs are still elevated. And in all honesty, we still have -- by historical values, we still have shelf space to fill with electronic products, both on the commercial side and the residential side. So I think there's -- again, electronics will continue to be a growth driver for the company in all segments."
},
{
"speaker": "Operator",
"text": "Our next question comes from Brett Linzey from Mizuho Americas. Please go ahead."
},
{
"speaker": "Brett Linzey",
"text": "Hey, good morning, all."
},
{
"speaker": "John Stone",
"text": "Good morning."
},
{
"speaker": "Mike Wagnes",
"text": "Good morning, Brett."
},
{
"speaker": "Brett Linzey",
"text": "Yes, just wanted to come back to the pricing discussion. Mike, I think you touched on pricing expectations for residential. But thinking more broadly about the portfolio and actions into 2023. How are you thinking about additional pricing for this year? And then specifically, within the whole framework, what do you think in for price realization this year?"
},
{
"speaker": "Mike Wagnes",
"text": "Brett, as we've talked over time, we're committed to fight that inflationary pressure we see. We expect price realization -- substantial price realization in 2023 and such that, that price, productivity, inflation and investment dynamic is a net positive. You've heard me talk about this for at least 6 months now. We've made good momentum in '22, and we're set up nicely for '23 such that we have a net positive of those 4 characteristics or those 4 items."
},
{
"speaker": "Brett Linzey",
"text": "Okay. Got it. And just wanted to follow-up on the Mexico facility for stamping, plating, et cetera. In terms of identifiable paybacks, how are you thinking about the potential cost savings as you look into ‘24 and ‘25? Or what that payback might look like?"
},
{
"speaker": "John Stone",
"text": "Yes. It's the right question. I think payback is going to be pretty quick. I mean, these are high-volume products and the cost reduction that we're looking at is substantial. I'm not going to give you the exact down to the penny number, but it's substantial. And we see, because of that, a favorable impact on margins and a favorable impact on market share in those segments. It's -- we're quite excited about getting this facility ramped up."
},
{
"speaker": "Mike Wagnes",
"text": "And Brett, just to add, if you think about 2023 because the facility is going to come online later in the year, that margin benefit and that cost benefit, that's more of a ‘24, ‘25 benefit. If you think about ‘23, think of there is some investment in start-up costs as you bring a new facility up and running during the year, but this is a great long-term investment like John mentioned. So I just wanted to add that color."
},
{
"speaker": "Operator",
"text": "Our next question comes from David MacGregor from Longbow Research. Please go ahead."
},
{
"speaker": "David MacGregor",
"text": "Yes, good morning, everyone. I just wanted to continue on the pricing. And in response to the last couple of questions. You made it very clear that you're pushing much harder on pricing. But can you just talk about that in terms of price cost expectations and what you've got reflected in your full year guidance? Maybe talk about how that should phase over the 4 quarters."
},
{
"speaker": "Mike Wagnes",
"text": "Yes. As you think about it for next year, definitely positive. Obviously, price cost will be better in the first half because of the prior year comparable. And then if you think about quarters, we try not to guide quarters. But think of it as price cost inflation and investments, ‘this is a net positive for us moving forward. We fell behind last year, right, in 2021. '22, we caught up, we made some positive traction at the end of the year, and now we're set up nicely moving forward and expect this dynamic to continue to be positive."
},
{
"speaker": "David MacGregor",
"text": "Good. Just as a follow-up, I guess, maybe talk about Access Technologies and maybe the progress to date? And how are you reflecting that acquisition in your 2023 growth and margin guidance?"
},
{
"speaker": "Mike Wagnes",
"text": "So if you look at the first half of the year, that would be considered inorganic growth. And so on the slide in the presentation, we show a delta between reported and organic for the Americas, that inorganic would be Access Tech. The back half of the year, it will be part of organic growth and is included in that non-residential number John mentioned earlier in the prepared remarks. So it's a combination of both the first half is that inorganic growth."
},
{
"speaker": "John Stone",
"text": "Yes. Strategically, David, it's a great fit. We've retained the key talent. We've retained the key customers. We're working very, very hard on getting these automatic doors into this very powerful Allegion spec engine. That team is super excited to be here. We're super excited to have him. And again, you've got a very robust recurring service business as a part of that acquisition that we're really excited about."
},
{
"speaker": "Operator",
"text": "Our next question comes from Jeff Sprague from Vertical Research. Please go ahead."
},
{
"speaker": "Jeff Sprague",
"text": "Hey, thank you. Good morning, everyone."
},
{
"speaker": "John Stone",
"text": "Hey, Jeff."
},
{
"speaker": "Mike Wagnes",
"text": "Hi, Jeff."
},
{
"speaker": "Jeff Sprague",
"text": "Good morning. Just a couple for me, if I could. Just first, back to price cost and everybody has asked the question a couple of times. But I just want to be clear really on your volume expectations for the year. It would seem we could get two or pretty close to your organic revenue growth just on carryover price. And the fact that I would think you've also got some positive mix effects on revenue as electronics ramps up. So perhaps you could just give us a little bit more color on what you're expecting for volumes for the year."
},
{
"speaker": "Mike Wagnes",
"text": "Yes. Jeff, if you think of the non-residential business in the Americas, still going to see volume growth, good end markets. If you think about international and residential, they're a little softer. So think of any form of growth coming more from the price there, all in weighted more towards pricing like you suggested than volume. But the non-res side and electronics, that's where the volume growth will be driven."
},
{
"speaker": "Jeff Sprague",
"text": "Great. And then actually, I just wanted to ask a little bit of a philosophical question about going to ex-amort and I agree it's the right thing to do, ultimately, particularly given a lot of other folks do it. But the main premise of it is, right, that amortization is non-cash. So when I go to adjusted EPS, my earnings and my cash flow are then, in fact, similar, right? And the EPS is kind of an economic number. You're only going to convert at about 85% free cash flow to adjusted net income this year according to your guide. Do you -- and it's certainly understandable supply chain inventories elevated and the like. But do you see those numbers converging over time? And getting the organization to, I don't know, 95% to 100% conversion to adjusted net income."
},
{
"speaker": "Mike Wagnes",
"text": "Yes. So Jeff, historically, when we looked at it at reported net income, that was in the low-90s based on the current guide on the reported net income, it's mid-90s. I would say, longer term, we do expect it to be better. We do have an increase in capital expenditures this year. So if you think of depreciation versus CapEx, CapEx is elevated. Think of it as 2.5% plus of revenue. We're building a new facility. That's not something we do every single day, so it is a little lighter, because a higher level of CapEx. But longer term, think of us as focusing on, especially as we make M&A, the cash returns of these acquisitions. We've been talking about Access Tech for almost a year now. And it's -- the ability to drive cash earnings from those acquisitions rather than a non-cash charge."
},
{
"speaker": "Operator",
"text": "The next question comes from Chris Snyder from UBS. Please go ahead."
},
{
"speaker": "Chris Snyder",
"text": "Thank you. I want to follow-up on the previous question around the Americas organic growth guide of 4% to 6%. Can you just, I guess, specifically talk about the split between volume and price within that? Because my math is kind of similar to Jeff. It feels like Americas can get there on just wrap around price alone, and it sounds like there is scope for incremental price as well."
},
{
"speaker": "Mike Wagnes",
"text": "Yes. So when you think about 2023 and pricing. Clearly, we had good momentum coming into the year. We have more pricing than volume growth. Residential is when you build your models, don't forget, starts have been down considerably there in the residential space. So residential volume is going to be more challenged, right? So overall, the volume growth coming from non-res in the total segment, I don't want to give subsegment targets for volume versus price. But I would just say the total segment is more pricing than volume when you build your models."
},
{
"speaker": "Chris Snyder",
"text": "Thank you. I appreciate that. And then maybe for my follow-up, just around the cadence of America's organic growth as the year goes on. So it certainly feels like organic growth in the first-half of the year will be stronger in the back half, just on the easier price comps. But could you just provide some more color on that trajectory? And does the guidance imply that Q4 will be negative organic for the Americas? Thank you."
},
{
"speaker": "Mike Wagnes",
"text": "Yes. So if you look at our history, we're not going to guide quarters. I would say this 2022 very back-end loaded. Our historical norms for the Americas is probably more indicative of what you think 2023 would look like from a percent of the total. As a result, you'll see more revenue growth in the first-half than the second-half, but we do expect to see growth in the back half of the year."
},
{
"speaker": "Operator",
"text": "The next question comes from Tim Tojs from Baird. Please go ahead."
},
{
"speaker": "Tim Tojs",
"text": "Hey, good morning, [Indiscernible]. Maybe just on backlog. Just maybe if you can give us a little bit of flavor for where backlog is maybe versus a year ago? And I know there's some noise in there just from the supply chain, kind of, constraints. But just maybe any color on the trajectory of that backlog through the year would be helpful."
},
{
"speaker": "Mike Wagnes",
"text": "Yes. So Tim, we ended last year very elevated backlogs, especially in electronics and mechanical, that's 2021. If you think about ‘22, we worked through the excess mechanical backlog such that lead times are normal. Demand is good, lead times are normal. So it's where we want to be from a health of a business. If you think of electronics, electronics does have elevated backlogs at the end of 2022, which is attributable to both supply challenges, but as well as really strong demand. And so we do have elevated backlogs in electronics, which will give us tailwinds for both and frankly, ‘24. This is a long-term trend moving for us."
},
{
"speaker": "Tim Tojs",
"text": "Okay, okay. So it sounds like you've burned off most of the kind of buildup from ‘21 and now it's just stronger demand."
},
{
"speaker": "Mike Wagnes",
"text": "On the mechanical side, yes."
},
{
"speaker": "Tim Tojs",
"text": "Yes. Okay, okay. Got you. And then John, maybe just bigger picture. I mean, you've been CEO now for six to nine months. And now that you've gotten maybe a little bit more settle into role. Just maybe some color on any potential strategic changes or tweaks that you think you might make with the business going forward."
},
{
"speaker": "John Stone",
"text": "Yes, absolutely. I think these last two quarters, it's really been a pleasure being here, working with the Allegion team and working with these distribution partners out there. I think what you should see is a lot of the things that built Allegion's reputation since spin of outstanding operational execution, year-over-year expanding margins. Those kind of things will continue. What we're looking to do is continue to orient the company towards growth and allocate capital towards growth. That means driving organic growth. That means continue to look for us and expect us to be acquisitive and really leading with our technology. Allegion got a fabulous electromechanical portfolio. We've got extremely talented engineers. We feel like we're a leader in that space, and we'll continue to be a leader in that space. So organic growth, inorganic growth through M&A, I think that's what you need to expect us to layer on top of the operational excellence that you're used to from Allegion. And this year-on-year ability to drive above-market growth and continue to expand margins."
},
{
"speaker": "Operator",
"text": "Our next question comes from Josh Pokrzywinski from Morgan Stanley. Please go ahead."
},
{
"speaker": "Josh Pokrzywinski",
"text": "Hey, good morning, guys."
},
{
"speaker": "John Stone",
"text": "Good morning."
},
{
"speaker": "Mike Wagnes",
"text": "Good morning, Josh."
},
{
"speaker": "Josh Pokrzywinski",
"text": "So John, you talked a few times about the visibility in the non-res business, particularly on electronics with the elevated backlog. Just wondering if you could give us sort of any view on where backlog levels stand? Or how you think about conversion or something like book-to-bill in the framework this year?"
},
{
"speaker": "John Stone",
"text": "Yes. So I think, again, on the mechanical side of the portfolio, we're -- you put air quotes around it back to what you would expect a book and ship business. So very efficient, very lean book and ship business. Electronics demand is still very, very strong, and that's globally. And supply limited is still where we are. We've got -- and I think quarter-to-quarter, month-to-month made continuous progress on that. And that's why you see the kind of year-over-year growth numbers that you've seen in Q3, Q4 of ‘22. We're very bullish on that portfolio, and we're continuing to invest and refresh the products. So we do expect demand to continue to remain strong. We do expect conversion and adoption to continue to grow. That being said, of course, there are parts of a building. There are parts of Allegion's portfolio that will never be electrified. So it doesn't just go from some state to 100% electric. But electronics will continue to be a double-digit growth driver for the company and that gives us a pretty interesting avenue to continue to build out Software-as-a-Service, like you see with our Enerflex and our Plano acquisition. So I'd say, again, look for us to continue to be acquisitive and build on this advantage that we feel we've got with the electronic products."
},
{
"speaker": "Josh Pokrzywinski",
"text": "Got it. That's helpful. Looking forward to hearing more about that at the Investor Day as well. On the margin guide in the Americas or I guess implicit in the guide overall, how do we think about sort of what's an easy comp and timing elements around things like either price/cost or miss shipments, productivity versus just kind of volume leverage. Is there any way you guys would sort of break down those buckets of what just comes from kind of the absence of the bad guys versus some of this healthy mix, price/cost, some of the other things you're talking about."
},
{
"speaker": "Mike Wagnes",
"text": "Yes, Josh. Clearly, first half, we're going to see more margin expansion, due to the easier comp. Look for us, though, for all quarters to be driving pricing and productivity in excess of that inflation and investment number on a dollar basis. And when you think about expansion, Americas margin expansion will be more front half loaded year-over-year."
},
{
"speaker": "Operator",
"text": "The next question comes from Ryan Merkel from William Blair. Please go ahead."
},
{
"speaker": "Ryan Merkel",
"text": "Good morning. Thanks for taking the question. Wanted to pick up on the electronics demand. Can you just talk about some of the key drivers is the strength in both resi and commercial? And then what are the features and benefits that are really resonating with customers?"
},
{
"speaker": "John Stone",
"text": "Yes, it's a great question. Maybe start with residential. I think the rise of the mega tech smart home ecosystems, the two most popular products that you find connected to those systems would be thermostats and locks. People might do other things, but those two fundamental elements seem like the most popular the functionality you get with a phone connected to your smart -- excuse me, a phone connected to your lock, the visibility of the state of that lock the peace of mind aspect that, that gives you, I think that's quite attractive to a lot of folks. On the non-res side, it's -- I mean, this is a B2B environment. So here, you're talking about like real economic value add for the end user. So think about a multifamily residential setting, an apartment complex rather than the landlord managing and swapping out metal keys. You can do this all digitally now with digital credentials, mobile credentials. It's just -- there's operating cost savings there that will continue to drive adoption in spaces like that. So -- on the non-res side, this is real economic benefits that are delivered over time. Residential side, peace of mind, visibility, higher tech connected to my smart home, et cetera. Those trends are, I think, still in the early stages of a traditional S-curve of adoption and a nice long runway ahead of us."
},
{
"speaker": "Ryan Merkel",
"text": "That's helpful. Thanks. And then on supply chain, just where are the pinch points in electronics? Do you have any visibility to when that improves and the investment in working capital. Is that primarily in electronics?"
},
{
"speaker": "John Stone",
"text": "So the supply chain, the way I described it last quarter, the same way I'll describe it this quarter of a year ago. We had 50 suppliers on the delinquent list that was shutting our assembly lines down on any given day. Today, that number is down to a handful, three or four. So that's the order of magnitude of improvement. The constraint is the semiconductors themselves, microprocessors in particular. And it's just been a matter of the industrial Internet-of-Things, that space has had extremely strong demand, while you've probably seen news headlines and other things about some foundries or chip manufacturers seeing softening demand, that’s from things like consumer goods and mobile phones, these much smaller, much more advanced, much more expensive chips. But these chips that hit the sweet spot of cost and power and performance for the industrial IoT, which is like what we use in our products. That demand has still outstripped supply and capacity all the way back to the foundries. We've been working very closely to do a couple of things. One would be expand the quantity of supply that's been improving. The other thing has also improved the visibility and the linearity of deliveries. So then our factories can run a bit more efficiently and we can bring our lead times down. So it goes all the way back to the semiconductor itself, and that's the value chain we're trying to work through and continue to make improvements. And we're happy with the improvement so far, but we're still supply constrained versus very strong demand."
},
{
"speaker": "Operator",
"text": "The next question comes from Brian Rittenberg from Imperial Capital, please -- I'm sorry, Brian Ruttenbur from Imperial Capital."
},
{
"speaker": "Brian Ruttenbur",
"text": "Okay, thank you very much. So one other question on the residential side in 2023. It looks like it's going to be driven by pricing. Can you talk a little bit about -- you say it's primarily driven by pricing. Will volumes actually be down? And could they be down 2% to 3%, 4% or 5% and you still hit that -- your goals for 2023 on the residential side?"
},
{
"speaker": "Mike Wagnes",
"text": "Yes. Brian, I really don't want to give the subcomponents for res, non-res, but if you think about it, I would say you're approximating a reasonable outlook for res in that it's going to be price driven and that volume will be challenged. But I don't want to give individual components between res and non-res."
},
{
"speaker": "Brian Ruttenbur",
"text": "Okay. And then along those same lines, have you experienced on the residential side or even the international side, any debooking in the fourth quarter where you've just heard about some debooking in the residential side, and I didn't want to kind of get your color on that, if there's been any debooking and you've seen a recovery post fourth quarter?"
},
{
"speaker": "Mike Wagnes",
"text": "If you think about our residential business, electronics, clearly, there's shelf space to be filled, as John talked about. On the mechanical side, what we have seen is slowing there again to the overall numbers we talked about residential. As far as de bookings, we have not seen a lot of cancellations from customers more think of it as slowing down in the consumer making purchases there."
},
{
"speaker": "Operator",
"text": "This concludes our question-and-answer session. I would like to turn the conference back over to John Stone for any closing remarks."
},
{
"speaker": "John Stone",
"text": "Thanks very much. So to wrap up, what you heard today, Allegion Americas non-residential demand remains robust. Global electronics demand remains very strong. Our supply chains are improving, and our products are very well received in the market. Access Technologies acquisition is continuing to perform very well. We, along with our distribution partners had a great finish to 2022 and feel that we're favorably positioned for 2023. Thank you very much for joining the call, and have a great day."
},
{
"speaker": "Operator",
"text": "Conference has now concluded. Thank you for attending today's presentation. You may now disconnect."
}
] | Allegion plc | 241,782,379 |
ALLE | 3 | 2,022 | 2022-10-27 08:00:00 | Operator: Good morning, and welcome to the Allegion Q3 2022 Earnings Conference Call. All participants will be in listen-only mode. [Operator Instructions] Please note, this event is being recorded. I would like to turn the conference over to Tom Martineau, Vice President of Investor Relations and Treasurer. Please go ahead.
Tom Martineau: Thank you, [Francheska] [ph]. Good morning, everyone. Thank you for joining us for Allegion's third quarter 2022 earnings call. With me today are John Stone, President and Chief Financial Officer; and Mike Wagnes, Senior Vice President and Chief Financial Officer of Allegion. Our earnings release, which was issued earlier this morning and the presentation, which we will refer to in today's call, are available on our website at investor.allegion.com. This call will be recorded and archived on our website. Please go to Slides 2 and 3. Statements made in today's call that are not historical facts are considered forward-looking statements and are made pursuant to the Safe Harbor provisions of federal securities law. Please see our most recent SEC filings for description of some of the factors that may cause actual results to differ materially from our projections. The company assumes no obligation to update these forward-looking statements. Today's presentation and commentary include non-GAAP financial measures. Please refer to the reconciliation in the financial tables of our press release for further details. John and Mike will now discuss our third quarter 2022 results, which will be followed by a Q&A session. Please, for the Q&A, we would like to ask each caller to limit themselves to one question and one short follow-up and then re-enter the queue. We would like to give everyone an opportunity given the time allotted. Please go to Slide 4 and I’ll turn the call over to John.
John Stone: Thanks, Tom. Good morning and thank you all for joining us today. Allegion delivered a very strong third quarter and as we look at the market dynamics, we continue to see strength in the Americas non-residential sector. Leading indicators for that business like the ABI and AIA consensus are positive and continue to be in expansionary territory, particularly for institutional verticals. On the Americas residential side, our business grew nicely in the quarter, but we are seeing signs of a slowing market. Certainly new construction is impacted by rising mortgage rates and retail point of sale for our industry is returning to more normal levels. Although Allegion International is experiencing broader weakness in many of its markets, we continue to see strength and demand for our electronics and software solutions. Allegion delivered record revenue during the third quarter. This is due to the hard work and dedication of our team as we've made significant progress on product redesign and other supply chain improvements that are driving strong operational performance across the company. Top line revenue was also aided by robust price realization in the quarter across the world. I do want to highlight that while we've made some progress, there's still choppiness in the electronic supply chain, backlogs, and electronics are still elevated as demand for those products has remained strong. At the beginning of the year, we underscore our commitment to aggressively pursue price across all products and in all channels. The result of this effort is evident in the quarterly results. While we continue to experience inflationary headwinds, our price productivity inflation dynamic was positive this quarter, both on a dollar and margin basis. Allegion will continue to assess the need for future price increases. Lastly, the currency pressures impacting our international businesses persist, the reported revenues in the third quarter reflect $26 million of pressure related to foreign exchange rates. Please go to Slide 5. At the beginning of the quarter, on July 5, in fact, we officially welcome The Access Technologies business into the Allegion family. Together, we will deliver long-term value for customers, shareholders, and employees alike and we're already moving in that direction. The operational performance of the business was in-line with the expectations shared with you in last quarter's earnings call and our teams are getting well aligned on culture, vision, and strategy. Just as important, our early work together affirms that Access Technologies and Allegion are a great combination. We have unique opportunities to accelerate our seamless access strategy with innovation that will create new value around doors and entrances. This is where I get to say a picture says a thousand words, and we now have a well-established recurring service business that positions us to meet new customer needs as devices become more connected and technology advances. And we have expanded portfolio of products that fills gaps, complements our business, and takes full advantage of our demand generation specification engine in the Americas. Bottom line, Access Technologies is a strong business. It's another category market leader for Allegion. We're off to a great start and excited about the opportunities ahead. Now, let's turn to Slide 6 and take a look at the quarter performance for more details. Revenue for the third quarter was 914 million, an increase of 27.4% compared to last year. Organic revenue growth was 18.6% attributed to both significant price realization worldwide and strong volume growth in the Americas. The Access Technologies acquisition contributed approximately 12% to the total growth number and currency impacts remain a significant headwind. Mike will share more details on the segment reporting in a moment. Adjusted operating margin and adjusted EBITDA margins increased by 100 basis points each in the third quarter. The increase was driven by volume leverage in the Americas, as well as price and productivity exceeding inflation. These more than offset the margin dilution related to Access Technologies. Excluding the Access Technologies business adjusted operating income margins were up 240 basis points. Adjusted EPS of $1.64 increased $0.08 or approximately 5% versus the prior year. Robust operational performance more than offset the unfavorable tax rate impact, which is compared against the prior year that had substantial non-recurring benefits. Mike will now walk you through the financials and I'll be back later to discuss our 2022 outlook.
Mike Wagnes: Thanks, John, and good morning everyone. Thank you for joining today's call. Please go to Slide number 7. This slide reflects our earnings per share reconciliation for the third quarter. For the third quarter of 2021, reported earnings per share was $1.59 and adjusted earnings per share was $1.56. Operational results were very strong in the quarter, adding $0.49 per share, reflecting 31.4% growth. This was driven by strong pricing, volume, and operational execution, which more than offset inflationary and currency pressures. Access Technologies delivered $0.06 to earnings per share as operational results of $0.10 per share offset $0.04 of intangible amortization. The operational results were as expected and amortization was favorable. A year-over-year tax rate reduced earnings by $0.28 per share. This decline was driven by tax benefits in 2021 that were non-recurring. As anticipated, interest expense was a $0.12 per share drag on earnings, primarily driven by increased debt-to-finance the acquisition of Access Technologies. Other income was a $0.08 per share reduction as the prior year had some favorable items that did not repeat in 2022. Favorable share count offset the impact of investment spending in the quarter. This results in adjusted third quarter 2022 earnings per share of $1.64, an increase of $0.08 or 5.1%, compared to the prior year. Lastly, we have a $0.34 per share reduction from adjusted EPS to arrive at reported EPS. This reduction is attributable to M&A and additional non-purchase accounting items related to Access Technologies, along with the loss on the divestiture of our Milre business in South Korea. After giving effect to these items, you arrive at third quarter 2022 reported earnings per share of $1.30. Please go to Slide number 8. This slide depicts the components of our revenue performance for the quarter. I'll focus on total Allegion results and cover the regions on their respective slides. As indicated, we experienced a robust 18.6% organic revenue growth in the third quarter, driven by both price and volume. Strength in Allegion Americas, both non-residential and residential led to volume growth. Net acquisition and divestitures delivered 12.4% growth driven by Access Technologies. Currency pressures continue to be a significant headwind, primarily impacting our international segment, bringing the total reported growth to 27.4% in the quarter. Please go to Slide number 9. Third quarter revenues for the Americas segment was 747.2 million, up 42.5% on a reported basis and up 25.8% organically. This segment delivered significant price realization in both our non-residential and residential businesses as we remain committed to addressing inflation. Aided by substantial price and strong volume, non-residential grew approximately 30% in the quarter. Residential was up mid-teens, also driven by both price and volume. A portion of our growth was fueled by backlog reductions as the actions our team undertook helped us improve component availability and shipments in the quarter. Electronics revenue was up approximately 30% and was a significant improvement from the growth rates experienced the past few quarters. This was supported by continued strength in demand and the timing of component availability. While it is important to note that electronic component supply chains remain choppy, our reengineering and alternate supply efforts are providing improved flexibility to our supply capabilities. Access Technologies contributed mid-teens percent to the Americas reported growth numbers. Americas adjusted operating margins and adjusted EBITDA margins for the quarter were up 50 basis points and 80 basis points respectively. This includes Access Technologies, which we previously stated, would be dilutive to margins. Excluding Access Technologies, the business drove a 300 basis point improvement in operating margins versus the prior year. Volume leverage contributed to the margin increase and for the quarter. Price productivity inflation dynamic was positive both on dollars and margins. Please go to Slide number 10. Third quarter revenue for our Allegion International segment was 166.5 million, down 13.6% on a reported basis and down [0.8%] [ph] organically. In the quarter, strong price realization mostly offset lower volumes. Lower volumes are attributable to end market softening. However, demand for our electronics and software solution remained stable. Currency headwinds persisted this quarter and reduced reported revenue by 12.8%. Third quarter international adjusted operating margins decreased 180 basis points compared to last year, and adjusted EBITDA margins were down 160 basis points. The margin decline was driven by reduced volume and FX pressures, which more than offset favorable impacts of the combination of price productivity and inflation. Please go to Slide number 11. Year to date available cash flow is 225.6 million, which is a decrease of more than 102 million, compared to the prior year period. This year's available cash flow continues to be in-line with three pandemic levels. We continue to operate with a strong debt structure with 80% of our debt having fixed interest rates. We currently have 199 million outstanding on our revolving borrowings. During the third quarter, we repaid approximately 140 million from the initial draw used to help fund the acquisition of Access Technologies. We have a strong leverage profile with our net debt-to-EBITDA ratio at 2.9x at the end of the quarter. We still plan to use the excess cash generated during the remainder of the year to pay down the revolver. This would be after paying expected dividends, which are subject to Board approval and other debt payments. The 2022 full-year available cash flow outlook is unchanged from our prior outlook remaining at a range of 420 million to 440 million. I will now hand it back to John for an update on our full-year 2022 outlook.
John Stone: Thanks Mike. So, please go to Slide 12 and looking at our full-year 2022 outlook, and to reiterate a few things said earlier in the call, we see non-residential market demand in the Americas as remaining strong. Leading indicators remain favorable. Further, while demand for electronics products remain strong, residential markets in the Americas are indeed softening. As you've heard, the Allegion team has made significant progress on supply chain challenges, our electronics growth was strong this quarter, and we continue to navigate the choppiness of component supply. Long-term, we expect electronics adoption to remain a growth driver for Allegion. Given this backdrop, we're raising the outlook for Americas and are now projecting total growth to be between 22.5% and 23.5% with organic revenue to be up 13.5% to 14.5% for the year. Allegion International experienced another quarter of solid price realization and stable demand for our electronics and software solutions. However, we see the broader markets continue to soften, driven by macroeconomic and geopolitical factors and currency pressures are anticipated to remain. For the Allegion International segment, we're revising our outlook for total revenue to be down 10.5% to 11.5% with approximately flat organic growth. All-in for total Allegion, we expect revenue growth to be in the 13% to 14% range with organic revenues increasing 9.5% to 10.5%. Please go to Slide 13. We are expecting reported EPS to come in at a range of %4.90 to $5 per share and adjusted EPS to be between $5.40 to $5.50. The adjusted EPS increase from the prior outlook is driven by lower Access Technologies and tangible amortization. The revised amortization takes the outlook for the acquisition impact to negative $0.05 per share versus negative $0.10 per share we communicated last quarter. Our updated outlook assumes incremental investments of approximately $0.17 per share. And as a reminder, the incremental investment spend is predominantly related to R&D and technology investments to further accelerate our growth and support our seamless access strategy. The $0.20 per share increase in reported to non-GAAP adjustments from the previous outlook is driven by the loss on the mill rate divestiture and non-cash purchase accounting adjustments, which were primarily recorded in this quarter. Please go to Slide 14 and let's wrap this up. Here's the main themes I hope you heard today. Allegion had a very strong third quarter. Our operational performance was exceptional. The entire Allegion team deserves a lot of credit for this. The Access Technologies acquisition is off to a great start and performing as expected. We're excited to have this business and the people as a part of the Allegion family and to have automated entrance solutions in our portfolio. We've made significant progress on supply chain challenges, although choppiness in electronics components persist. America's non-residential demand is still strong, leading indicators are still positive, and we continue to see strength and demand for our global electronics products. To reiterate, we see electronics adoption as a long-term growth driver for Allegion. I'm very proud of the dedication and resiliency of our entire team and the results we've delivered this quarter. With that, Mike and I would be happy to take your questions.
Operator: [Operator Instructions] The first question comes from Josh Pokrzywinski with Morgan Stanley. Please go ahead.
Josh Pokrzywinski: Hi good morning guys.
John Stone: Good morning. Josh, good to hear you on the call.
Josh Pokrzywinski: Just wanted to begin a little bit on this, kind of non-resi backlog phenomenon, it's not really a metric you guys talked about as much, but with the growth in the quarter clearly supply chain improvement, but get some product out the door. Can you maybe contextualize how much of the excess backlog you worked off? And how should we think about, maybe kind of a normalized margin? Because I would imagine the mix on that influences things a lot once we get past that backlog period?
Mike Wagnes: Yes, Josh, as you know, we had built backlog starting the end of last year. And most of that driven by some supply chain, as well as really strong demand. As you look at the third quarter, we have better component availability as we talked about on the call. That helped drive more revenue in the Americas non-res at 30%, and not all of that obviously is demand. So, we did reduce backlog levels. We don't disclose the exact amounts, but we did have a very strong volume growth, which we provided and that's driven by both demand being strong, as well as backlog reductions. With respect to margins, the key thing about margins for us is, we're driving that price realization to offset the inflationary pressures that we've been seeing. This quarter, we finally turned the corner on the margin percent. Last quarter, it was offsetting on dollars. So, we've made significant progress here as we progressed over the last few quarters on that element. So, it's those key items, I think that have led to the margin expansion you saw.
John Stone: Josh, this is John. I would just add one thing that probably every manufacturer has dealt with. When we talk about choppiness in the supply chain, without a doubt that injects this or the other inefficiency into the factories. So, that's – there's been some cost inefficiencies over time that we've been working through and certainly that's on the way towards improvement as well, but just one other nuance there to your questions. That's a good one. Thank you.
Josh Pokrzywinski: Got it. Thanks. And then just a quick follow-up on the pricing dynamic. I know you guys and the industry in general honors exist and quotes out there. So, price kind of layers in over time. What inning are we in, in terms of being caught up on price versus having these outstanding older price quotes?
Mike Wagnes: Yes. We've been raising price pretty consistently over the last year as we've had such challenges in the inflationary environment. I would say, the dynamic of price productivity and inflation will be positive moving forward. So, I wouldn't expect a situation where we turn the other way. We’ve had the dynamic positive and expected to be positive moving forward.
Josh Pokrzywinski: Perfect. Appreciate the color. Thanks guys. Best of luck.
Operator: The next question is from Julian Mitchell with Barclays. Please go ahead.
Kiran Patel-O'Connor: Hi. This is Kiran Patel-O'Connor on for Julian Mitchell. So, I just wanted to ask on residential. So, it looks like residential growth in the Americas are inflected positively, and I just wanted to get a sense of, is this more of a function of supply chains easing versus underlying demand and to what extent do you see this growth as sustainable going forward given what we're seeing in housing market?
John Stone: Thanks for the question. This is John. I would say, you know, going back to our comments, certainly the Americas residential market is softening. We're reading the same headlines that you are. Higher mortgage rates is certainly going to have an impact there. I would say our performance in the quarter is without a doubt due to strong demand for our products. We have good products, people like them, we get good reviews. Our electronics growth, you saw, was very strong, which is quite prevalent in the residential sector, but the broader market is softening without a doubt. I think electronics remains a tailwind for us. And yes, so what more to say there. I think that's it, broader market softening a little bit, electronics is favorable, that's a tailwind, and yes, so we're still chugging along.
Kiran Patel-O'Connor : That's helpful. Thanks. And then my follow-up is, just kind of what you're seeing in the channel? Based on your results today, it doesn't seem as if you're seeing any signs of destocking, which we're seeing in some other industrial markets. So, can you give us a color of what you're seeing in channel from an inventories perspective? And what underlying demand is looking like relative to that?
John Stone: Thanks. Yes, you bet. Very, very relevant question. Thanks for that. I'd say, we'd like in it to more normal levels. I wouldn't necessarily say, de-stocking, restocking, just more normal point of sale pull-through based on retail demand. And I think that's the environment we're getting back to as lead times normalize to more of what the industry is used to. Retail demand pull-through is what's going to drive the stocking levels.
Kiran Patel-O'Connor : Appreciate it. Thank you.
Operator: The next question is from Ryan Merkel with William Blair. Please go ahead.
Ryan Merkel: Hey, good morning and thanks for taking the questions. My first question is on 4Q. It looks like guidance implies a little bit of a cut there. Can you unpack any changes you made versus prior expectations?
Mike Wagnes: Ryan, if you look at Allegion, we always guide for the full-year. In July, we put a guide out there and essentially we reiterated the guide this quarter for the full-year, because we're a full-year guiding company. With respect to Q4, you can back into some math, see strength in the Americas, right, Americas top line guide implied in the high-teens. We are seeing obviously some weakness in that guide internationally, right, which we called-out. So overall, our business is seeing strength in Americas led by obviously non-res, which we talked about and seeing some softening internationally. Full-year, in-line with what we said July. So, I don't think there's major changes from what we told you previously, but you do have some mix between the two regions.
Ryan Merkel: Got it. That's helpful. And then for my follow-up, you mentioned progress on supply chain, but still some choppiness. Where are there still issues? And when do you expect to fully catch-up?
John Stone: Yes, that's the question of the year, I think, on fully catch up. But I would think of it like this, you know if three or four quarters ago we had like 50 suppliers on the severely delinquent list, today, that would be 7 or 8. Just to kind of quantify it for you, I think the choppiness still exists primarily in semiconductors, microprocessors. Now, the redesign work that Allegion did is obviously having benefits, we're seeing strong electronics growth. Some of those suppliers are performing quite well. Some are still having a lot of issues. And it comes up both in terms of quantity that we need to fully meet retail demand, but then also linearity that we need to really have a productive manufacturing operation. So, that's kind of if we double click into what we mean by choppiness, I'd say this is definitely continuing on into 2023, but we're making progress and we feel good about the progress we've made. We feel good about the improving flexibility and resiliency of our supply base and I think the improvement trend will continue.
Ryan Merkel: Thank you.
Operator: The next question comes from Brett Linzey with Mizuho Americas. Please go ahead.
Brett Linzey: Hi, good morning all.
Mike Wagnes: Good morning.
John Stone: Good morning.
Brett Linzey: Congrats on a great quarter. Just back to the price and productivity and specifically within the Americas business did step-up nicely from what's 6 million in Q2 to [24 million] [ph] here in the third quarter. Should we see that continue to move higher into Q4? And then given the wraparound price, you should be able to get next year. I mean, should we think of 25 million in Q1 and Q2 of next year at a minimum?
Mike Wagnes: Yes. Brett, with respect to next year, we'll give an outlook when we come back in Feb, I'm certainly not on the third quarter call going to get that specific of price productivity inflation. However, in general, think of this dynamic as progressively improving to this point, right? We were weaker last year, negative, got back to positive this quarter on a substantial way. Obviously, volume drives more ability to get that price because you have more revenue, but in general, we're going to fight that inflation and have that dynamic positive moving forward.
Brett Linzey: Got it. And then just back to the backlog question. And so, you're obviously working here to [uncork] [ph] that specifically on the electronic side. As these supplier additions are ramping here, should we think of the electronics growth normalizing back to that double-digit plus level that Allegion has really observed pretty consistently for several years before the pandemic? So, going forward, kind of double-digit in that territory.
Mike Wagnes: Yes, especially long-term, this is a great growth driver for us and that be a double-digit growth business for us as you think about the long-term. We talked about choppiness, right, but long-term, this is a double-digit growth opportunity for us.
Brett Linzey: And just a quick follow-up, do you think you have enough availability to, kind of sustain that into Q4 here?
Mike Wagnes: Yes, I'm not going to guide a specific quarter, but as you looked at our results for the Americas in particular, we have a pretty healthy top line guide in Q4. So, you can draw your conclusions to that particular item, but we still see strength in Q4 as indicated in our guide.
Brett Linzey: Appreciate the color.
John Stone: Thank you.
Operator: The next question is from Joe O’Dea with Wells Fargo. Please go ahead.
Joe O’Dea: Hi, good morning. I wanted to start on the operational and FX piece of the guide. And if you could just, sort of bridge from prior guide to revised guide, I mean, the numbers didn't change, but what some of the moving parts are and given the strength we saw in the third quarter, would have expected to see that that could have moved up, but if you could just talk, kind of the Americas piece, the international piece, the FX piece in terms of what moved from last guide to this one?
John Stone: Yes. So, Joe, if you think about FX, we actually took down our guidance in July when we reported our Q2 results for currency. So, a good chunk of the currency pressure you seeing with the dollar strengthening, we anticipated and put in that guidance that we put out in July. Currency rates have gotten a little worse since that period of time, but a good chunk of the FX pressure we called out previously. And then with respect to operations, we're right online with what we said in July for the year. Obviously, like I mentioned earlier, a little more strength in Americas as we took up the revenue outlook there, and a little more pressure from the markets internationally.
Joe O’Dea: Okay. And then I wanted to ask on the Americas margin, excluding Access Tech, clearly some nice progress that we saw sequentially, but when we go back to where, kind of pre-pandemic margins were, there still now appears be some good opportunity there. So, again kind of bridging to that, I mean, what are the keys to, sort of get back to those kinds of margins pretty good volume this quarter. I'm not sure sort of mix side of things. If still from a price productivity inflation, there's room to go and you have visibility into that. It's kind of a timeline to getting back to where your margins were.
Mike Wagnes: Yes. If you think about the margin profile in Americas, the strong contribution margin those businesses have as we grow, we should get margin expansion. We've done a much better job this year driving the price realization and offset the inflation. We've been talking about this all year on these calls. We expect that to continue. So, we think that there's margin runway for the Americas and we'll continue to drive that pricing to offset inflation with an understanding that this has been the most significant inflationary environment I've ever personally experienced and we're going to have to just combat that with pricing actions.
John Stone: And Joe, this is John. I'd add that again there's an electronics angle to this as well. Electrified and connected products are delivering substantially higher value to the end customer, which then should also be not just organic growth on the top line, but also a margin expansion opportunity too as electronics adoption continues. So, that's an element as well that we're really keen to continue to grow, and deliver more value to the customer.
Joe O’Dea: Just related to that, do you think you're capturing that value proposition today or do you think there are opportunities to, sort of better capture that margin opportunity on the electronic side?
John Stone: I think both. I think we're doing very well today and I think there's continued opportunity. That's a tailwind for Allegion.
Joe O’Dea: Got it. Thank you.
Operator: Next question is from David MacGregor with Longbow Research. Please go ahead.
Joe Nolan: Hey, good morning. This is Joe Nolan on for David MacGregor.
Mike Wagnes: Hi, Joe.
Joe Nolan: First, I just wanted to ask within the Americas group, can you talk about volume versus price trends for both the non-res and residential businesses?
Mike Wagnes: Yes. Historically, we don't disclose those individual components. What we did share for the quarter was, they were both up pricing and volume for each segment, but the individual numbers historically we have not and don't anticipate disclosing that level of detail.
Joe Nolan: Okay, got it. And then just on the Access Technologies business, I realize it's still early from an integration standpoint, but can you just give any update about how that's going in terms of the integration?
John Stone: Yes, I appreciate that question. I think as we said in the prepared comments, off to a great start, our teams are gelling very well. There's this or the other small project win here and there. So – and I think the early work on some of the heavy lift in terms of systems and things like this will continue for the next many months, but off to a very good start, cultural fit is very good, strategic fit is very good, the automatic doors is an excellent complementary portfolio to the rest of Allegion. And just really excited for that team. And really excited for the services business that comes along with that. And we're quite bullish on the future there.
Joe Nolan: All right, great. Thanks for answering my questions.
Operator: Last question is from Brian Ruttenbur with Imperial Capital. Please go ahead.
Brian Ruttenbur: Yes. Thank you very much for taking my questions. Can we talk a little bit about the competitive landscape right now? What you're seeing given the ASSA ABLOY [HII Spectrum] [ph] transaction appears to be at least held up some with the DOJ, can you talk about the opportunity that you see out there with Allegion and the competitive environment? Are you gaining market share, losing market share, because of this transaction or it doesn't impact you at all?
John Stone: Yes, it's certainly not appropriate for us to comment on that particular situation. I would say we feel good about our product portfolio, about our brands, about our competitive position in the market. I think our third quarter results reflect that that as we made the supply chain improvements, we continue to talk about, we generate good results. We've been saying for several quarters now, we were supply constrained versus demand constrained. And I think that continued to prove itself out. And so, yes, we'll continue to compete vigorously in the segments where we compete. And I think Allegion's best days are still ahead.
Brian Ruttenbur: Okay. As a follow-up, I'll go in a different direction. Then can we talk about – you addressed a little bit, but price increases going forward, are you starting to see a pushback on the non-residential market yet in the Americas on price increases and that, kind of tells you when you're done? And I just want to get kind of an indication from you what you see in terms of price indication, price increases going forward if you feel like you can push more through or you feel like that you're at the top end of that market?
Mike Wagnes: Yes. We put a number of increases in. I would say it all depends on what the future inflationary environment is, but as we sit here today, we would always communicate future price increases to the channel for an earnings call, but expect us if inflation persists, expect us to pass along pricing to mitigate that, but it all depends on the inflationary environment moving forward.
Brian Ruttenbur: Great. Thank you.
Operator: This concludes our Q&A session, and we like to turn conference back over to John Stone for any closing remarks.
John Stone: Thanks very much and thanks everyone for attending today. I would just like to again reiterate; we feel like we delivered an outstanding performance this quarter. The entire Allegion team and our distribution partners deserve credit for that. Access Technologies awesome acquisition off to a great start. We are making the supply chain improvements that we've been promising for a while and you'd see that reflected in our results. And we see continued strength in the Americas non-residential end markets and global electronics demand. Allegion's best days are still ahead. Thanks very much.
Operator: The conference has now concluded. Thank you for attending today's presentation. You may now disconnect. | [
{
"speaker": "Operator",
"text": "Good morning, and welcome to the Allegion Q3 2022 Earnings Conference Call. All participants will be in listen-only mode. [Operator Instructions] Please note, this event is being recorded. I would like to turn the conference over to Tom Martineau, Vice President of Investor Relations and Treasurer. Please go ahead."
},
{
"speaker": "Tom Martineau",
"text": "Thank you, [Francheska] [ph]. Good morning, everyone. Thank you for joining us for Allegion's third quarter 2022 earnings call. With me today are John Stone, President and Chief Financial Officer; and Mike Wagnes, Senior Vice President and Chief Financial Officer of Allegion. Our earnings release, which was issued earlier this morning and the presentation, which we will refer to in today's call, are available on our website at investor.allegion.com. This call will be recorded and archived on our website. Please go to Slides 2 and 3. Statements made in today's call that are not historical facts are considered forward-looking statements and are made pursuant to the Safe Harbor provisions of federal securities law. Please see our most recent SEC filings for description of some of the factors that may cause actual results to differ materially from our projections. The company assumes no obligation to update these forward-looking statements. Today's presentation and commentary include non-GAAP financial measures. Please refer to the reconciliation in the financial tables of our press release for further details. John and Mike will now discuss our third quarter 2022 results, which will be followed by a Q&A session. Please, for the Q&A, we would like to ask each caller to limit themselves to one question and one short follow-up and then re-enter the queue. We would like to give everyone an opportunity given the time allotted. Please go to Slide 4 and I’ll turn the call over to John."
},
{
"speaker": "John Stone",
"text": "Thanks, Tom. Good morning and thank you all for joining us today. Allegion delivered a very strong third quarter and as we look at the market dynamics, we continue to see strength in the Americas non-residential sector. Leading indicators for that business like the ABI and AIA consensus are positive and continue to be in expansionary territory, particularly for institutional verticals. On the Americas residential side, our business grew nicely in the quarter, but we are seeing signs of a slowing market. Certainly new construction is impacted by rising mortgage rates and retail point of sale for our industry is returning to more normal levels. Although Allegion International is experiencing broader weakness in many of its markets, we continue to see strength and demand for our electronics and software solutions. Allegion delivered record revenue during the third quarter. This is due to the hard work and dedication of our team as we've made significant progress on product redesign and other supply chain improvements that are driving strong operational performance across the company. Top line revenue was also aided by robust price realization in the quarter across the world. I do want to highlight that while we've made some progress, there's still choppiness in the electronic supply chain, backlogs, and electronics are still elevated as demand for those products has remained strong. At the beginning of the year, we underscore our commitment to aggressively pursue price across all products and in all channels. The result of this effort is evident in the quarterly results. While we continue to experience inflationary headwinds, our price productivity inflation dynamic was positive this quarter, both on a dollar and margin basis. Allegion will continue to assess the need for future price increases. Lastly, the currency pressures impacting our international businesses persist, the reported revenues in the third quarter reflect $26 million of pressure related to foreign exchange rates. Please go to Slide 5. At the beginning of the quarter, on July 5, in fact, we officially welcome The Access Technologies business into the Allegion family. Together, we will deliver long-term value for customers, shareholders, and employees alike and we're already moving in that direction. The operational performance of the business was in-line with the expectations shared with you in last quarter's earnings call and our teams are getting well aligned on culture, vision, and strategy. Just as important, our early work together affirms that Access Technologies and Allegion are a great combination. We have unique opportunities to accelerate our seamless access strategy with innovation that will create new value around doors and entrances. This is where I get to say a picture says a thousand words, and we now have a well-established recurring service business that positions us to meet new customer needs as devices become more connected and technology advances. And we have expanded portfolio of products that fills gaps, complements our business, and takes full advantage of our demand generation specification engine in the Americas. Bottom line, Access Technologies is a strong business. It's another category market leader for Allegion. We're off to a great start and excited about the opportunities ahead. Now, let's turn to Slide 6 and take a look at the quarter performance for more details. Revenue for the third quarter was 914 million, an increase of 27.4% compared to last year. Organic revenue growth was 18.6% attributed to both significant price realization worldwide and strong volume growth in the Americas. The Access Technologies acquisition contributed approximately 12% to the total growth number and currency impacts remain a significant headwind. Mike will share more details on the segment reporting in a moment. Adjusted operating margin and adjusted EBITDA margins increased by 100 basis points each in the third quarter. The increase was driven by volume leverage in the Americas, as well as price and productivity exceeding inflation. These more than offset the margin dilution related to Access Technologies. Excluding the Access Technologies business adjusted operating income margins were up 240 basis points. Adjusted EPS of $1.64 increased $0.08 or approximately 5% versus the prior year. Robust operational performance more than offset the unfavorable tax rate impact, which is compared against the prior year that had substantial non-recurring benefits. Mike will now walk you through the financials and I'll be back later to discuss our 2022 outlook."
},
{
"speaker": "Mike Wagnes",
"text": "Thanks, John, and good morning everyone. Thank you for joining today's call. Please go to Slide number 7. This slide reflects our earnings per share reconciliation for the third quarter. For the third quarter of 2021, reported earnings per share was $1.59 and adjusted earnings per share was $1.56. Operational results were very strong in the quarter, adding $0.49 per share, reflecting 31.4% growth. This was driven by strong pricing, volume, and operational execution, which more than offset inflationary and currency pressures. Access Technologies delivered $0.06 to earnings per share as operational results of $0.10 per share offset $0.04 of intangible amortization. The operational results were as expected and amortization was favorable. A year-over-year tax rate reduced earnings by $0.28 per share. This decline was driven by tax benefits in 2021 that were non-recurring. As anticipated, interest expense was a $0.12 per share drag on earnings, primarily driven by increased debt-to-finance the acquisition of Access Technologies. Other income was a $0.08 per share reduction as the prior year had some favorable items that did not repeat in 2022. Favorable share count offset the impact of investment spending in the quarter. This results in adjusted third quarter 2022 earnings per share of $1.64, an increase of $0.08 or 5.1%, compared to the prior year. Lastly, we have a $0.34 per share reduction from adjusted EPS to arrive at reported EPS. This reduction is attributable to M&A and additional non-purchase accounting items related to Access Technologies, along with the loss on the divestiture of our Milre business in South Korea. After giving effect to these items, you arrive at third quarter 2022 reported earnings per share of $1.30. Please go to Slide number 8. This slide depicts the components of our revenue performance for the quarter. I'll focus on total Allegion results and cover the regions on their respective slides. As indicated, we experienced a robust 18.6% organic revenue growth in the third quarter, driven by both price and volume. Strength in Allegion Americas, both non-residential and residential led to volume growth. Net acquisition and divestitures delivered 12.4% growth driven by Access Technologies. Currency pressures continue to be a significant headwind, primarily impacting our international segment, bringing the total reported growth to 27.4% in the quarter. Please go to Slide number 9. Third quarter revenues for the Americas segment was 747.2 million, up 42.5% on a reported basis and up 25.8% organically. This segment delivered significant price realization in both our non-residential and residential businesses as we remain committed to addressing inflation. Aided by substantial price and strong volume, non-residential grew approximately 30% in the quarter. Residential was up mid-teens, also driven by both price and volume. A portion of our growth was fueled by backlog reductions as the actions our team undertook helped us improve component availability and shipments in the quarter. Electronics revenue was up approximately 30% and was a significant improvement from the growth rates experienced the past few quarters. This was supported by continued strength in demand and the timing of component availability. While it is important to note that electronic component supply chains remain choppy, our reengineering and alternate supply efforts are providing improved flexibility to our supply capabilities. Access Technologies contributed mid-teens percent to the Americas reported growth numbers. Americas adjusted operating margins and adjusted EBITDA margins for the quarter were up 50 basis points and 80 basis points respectively. This includes Access Technologies, which we previously stated, would be dilutive to margins. Excluding Access Technologies, the business drove a 300 basis point improvement in operating margins versus the prior year. Volume leverage contributed to the margin increase and for the quarter. Price productivity inflation dynamic was positive both on dollars and margins. Please go to Slide number 10. Third quarter revenue for our Allegion International segment was 166.5 million, down 13.6% on a reported basis and down [0.8%] [ph] organically. In the quarter, strong price realization mostly offset lower volumes. Lower volumes are attributable to end market softening. However, demand for our electronics and software solution remained stable. Currency headwinds persisted this quarter and reduced reported revenue by 12.8%. Third quarter international adjusted operating margins decreased 180 basis points compared to last year, and adjusted EBITDA margins were down 160 basis points. The margin decline was driven by reduced volume and FX pressures, which more than offset favorable impacts of the combination of price productivity and inflation. Please go to Slide number 11. Year to date available cash flow is 225.6 million, which is a decrease of more than 102 million, compared to the prior year period. This year's available cash flow continues to be in-line with three pandemic levels. We continue to operate with a strong debt structure with 80% of our debt having fixed interest rates. We currently have 199 million outstanding on our revolving borrowings. During the third quarter, we repaid approximately 140 million from the initial draw used to help fund the acquisition of Access Technologies. We have a strong leverage profile with our net debt-to-EBITDA ratio at 2.9x at the end of the quarter. We still plan to use the excess cash generated during the remainder of the year to pay down the revolver. This would be after paying expected dividends, which are subject to Board approval and other debt payments. The 2022 full-year available cash flow outlook is unchanged from our prior outlook remaining at a range of 420 million to 440 million. I will now hand it back to John for an update on our full-year 2022 outlook."
},
{
"speaker": "John Stone",
"text": "Thanks Mike. So, please go to Slide 12 and looking at our full-year 2022 outlook, and to reiterate a few things said earlier in the call, we see non-residential market demand in the Americas as remaining strong. Leading indicators remain favorable. Further, while demand for electronics products remain strong, residential markets in the Americas are indeed softening. As you've heard, the Allegion team has made significant progress on supply chain challenges, our electronics growth was strong this quarter, and we continue to navigate the choppiness of component supply. Long-term, we expect electronics adoption to remain a growth driver for Allegion. Given this backdrop, we're raising the outlook for Americas and are now projecting total growth to be between 22.5% and 23.5% with organic revenue to be up 13.5% to 14.5% for the year. Allegion International experienced another quarter of solid price realization and stable demand for our electronics and software solutions. However, we see the broader markets continue to soften, driven by macroeconomic and geopolitical factors and currency pressures are anticipated to remain. For the Allegion International segment, we're revising our outlook for total revenue to be down 10.5% to 11.5% with approximately flat organic growth. All-in for total Allegion, we expect revenue growth to be in the 13% to 14% range with organic revenues increasing 9.5% to 10.5%. Please go to Slide 13. We are expecting reported EPS to come in at a range of %4.90 to $5 per share and adjusted EPS to be between $5.40 to $5.50. The adjusted EPS increase from the prior outlook is driven by lower Access Technologies and tangible amortization. The revised amortization takes the outlook for the acquisition impact to negative $0.05 per share versus negative $0.10 per share we communicated last quarter. Our updated outlook assumes incremental investments of approximately $0.17 per share. And as a reminder, the incremental investment spend is predominantly related to R&D and technology investments to further accelerate our growth and support our seamless access strategy. The $0.20 per share increase in reported to non-GAAP adjustments from the previous outlook is driven by the loss on the mill rate divestiture and non-cash purchase accounting adjustments, which were primarily recorded in this quarter. Please go to Slide 14 and let's wrap this up. Here's the main themes I hope you heard today. Allegion had a very strong third quarter. Our operational performance was exceptional. The entire Allegion team deserves a lot of credit for this. The Access Technologies acquisition is off to a great start and performing as expected. We're excited to have this business and the people as a part of the Allegion family and to have automated entrance solutions in our portfolio. We've made significant progress on supply chain challenges, although choppiness in electronics components persist. America's non-residential demand is still strong, leading indicators are still positive, and we continue to see strength and demand for our global electronics products. To reiterate, we see electronics adoption as a long-term growth driver for Allegion. I'm very proud of the dedication and resiliency of our entire team and the results we've delivered this quarter. With that, Mike and I would be happy to take your questions."
},
{
"speaker": "Operator",
"text": "[Operator Instructions] The first question comes from Josh Pokrzywinski with Morgan Stanley. Please go ahead."
},
{
"speaker": "Josh Pokrzywinski",
"text": "Hi good morning guys."
},
{
"speaker": "John Stone",
"text": "Good morning. Josh, good to hear you on the call."
},
{
"speaker": "Josh Pokrzywinski",
"text": "Just wanted to begin a little bit on this, kind of non-resi backlog phenomenon, it's not really a metric you guys talked about as much, but with the growth in the quarter clearly supply chain improvement, but get some product out the door. Can you maybe contextualize how much of the excess backlog you worked off? And how should we think about, maybe kind of a normalized margin? Because I would imagine the mix on that influences things a lot once we get past that backlog period?"
},
{
"speaker": "Mike Wagnes",
"text": "Yes, Josh, as you know, we had built backlog starting the end of last year. And most of that driven by some supply chain, as well as really strong demand. As you look at the third quarter, we have better component availability as we talked about on the call. That helped drive more revenue in the Americas non-res at 30%, and not all of that obviously is demand. So, we did reduce backlog levels. We don't disclose the exact amounts, but we did have a very strong volume growth, which we provided and that's driven by both demand being strong, as well as backlog reductions. With respect to margins, the key thing about margins for us is, we're driving that price realization to offset the inflationary pressures that we've been seeing. This quarter, we finally turned the corner on the margin percent. Last quarter, it was offsetting on dollars. So, we've made significant progress here as we progressed over the last few quarters on that element. So, it's those key items, I think that have led to the margin expansion you saw."
},
{
"speaker": "John Stone",
"text": "Josh, this is John. I would just add one thing that probably every manufacturer has dealt with. When we talk about choppiness in the supply chain, without a doubt that injects this or the other inefficiency into the factories. So, that's – there's been some cost inefficiencies over time that we've been working through and certainly that's on the way towards improvement as well, but just one other nuance there to your questions. That's a good one. Thank you."
},
{
"speaker": "Josh Pokrzywinski",
"text": "Got it. Thanks. And then just a quick follow-up on the pricing dynamic. I know you guys and the industry in general honors exist and quotes out there. So, price kind of layers in over time. What inning are we in, in terms of being caught up on price versus having these outstanding older price quotes?"
},
{
"speaker": "Mike Wagnes",
"text": "Yes. We've been raising price pretty consistently over the last year as we've had such challenges in the inflationary environment. I would say, the dynamic of price productivity and inflation will be positive moving forward. So, I wouldn't expect a situation where we turn the other way. We’ve had the dynamic positive and expected to be positive moving forward."
},
{
"speaker": "Josh Pokrzywinski",
"text": "Perfect. Appreciate the color. Thanks guys. Best of luck."
},
{
"speaker": "Operator",
"text": "The next question is from Julian Mitchell with Barclays. Please go ahead."
},
{
"speaker": "Kiran Patel-O'Connor",
"text": "Hi. This is Kiran Patel-O'Connor on for Julian Mitchell. So, I just wanted to ask on residential. So, it looks like residential growth in the Americas are inflected positively, and I just wanted to get a sense of, is this more of a function of supply chains easing versus underlying demand and to what extent do you see this growth as sustainable going forward given what we're seeing in housing market?"
},
{
"speaker": "John Stone",
"text": "Thanks for the question. This is John. I would say, you know, going back to our comments, certainly the Americas residential market is softening. We're reading the same headlines that you are. Higher mortgage rates is certainly going to have an impact there. I would say our performance in the quarter is without a doubt due to strong demand for our products. We have good products, people like them, we get good reviews. Our electronics growth, you saw, was very strong, which is quite prevalent in the residential sector, but the broader market is softening without a doubt. I think electronics remains a tailwind for us. And yes, so what more to say there. I think that's it, broader market softening a little bit, electronics is favorable, that's a tailwind, and yes, so we're still chugging along."
},
{
"speaker": "Kiran Patel-O'Connor",
"text": "That's helpful. Thanks. And then my follow-up is, just kind of what you're seeing in the channel? Based on your results today, it doesn't seem as if you're seeing any signs of destocking, which we're seeing in some other industrial markets. So, can you give us a color of what you're seeing in channel from an inventories perspective? And what underlying demand is looking like relative to that?"
},
{
"speaker": "John Stone",
"text": "Thanks. Yes, you bet. Very, very relevant question. Thanks for that. I'd say, we'd like in it to more normal levels. I wouldn't necessarily say, de-stocking, restocking, just more normal point of sale pull-through based on retail demand. And I think that's the environment we're getting back to as lead times normalize to more of what the industry is used to. Retail demand pull-through is what's going to drive the stocking levels."
},
{
"speaker": "Kiran Patel-O'Connor",
"text": "Appreciate it. Thank you."
},
{
"speaker": "Operator",
"text": "The next question is from Ryan Merkel with William Blair. Please go ahead."
},
{
"speaker": "Ryan Merkel",
"text": "Hey, good morning and thanks for taking the questions. My first question is on 4Q. It looks like guidance implies a little bit of a cut there. Can you unpack any changes you made versus prior expectations?"
},
{
"speaker": "Mike Wagnes",
"text": "Ryan, if you look at Allegion, we always guide for the full-year. In July, we put a guide out there and essentially we reiterated the guide this quarter for the full-year, because we're a full-year guiding company. With respect to Q4, you can back into some math, see strength in the Americas, right, Americas top line guide implied in the high-teens. We are seeing obviously some weakness in that guide internationally, right, which we called-out. So overall, our business is seeing strength in Americas led by obviously non-res, which we talked about and seeing some softening internationally. Full-year, in-line with what we said July. So, I don't think there's major changes from what we told you previously, but you do have some mix between the two regions."
},
{
"speaker": "Ryan Merkel",
"text": "Got it. That's helpful. And then for my follow-up, you mentioned progress on supply chain, but still some choppiness. Where are there still issues? And when do you expect to fully catch-up?"
},
{
"speaker": "John Stone",
"text": "Yes, that's the question of the year, I think, on fully catch up. But I would think of it like this, you know if three or four quarters ago we had like 50 suppliers on the severely delinquent list, today, that would be 7 or 8. Just to kind of quantify it for you, I think the choppiness still exists primarily in semiconductors, microprocessors. Now, the redesign work that Allegion did is obviously having benefits, we're seeing strong electronics growth. Some of those suppliers are performing quite well. Some are still having a lot of issues. And it comes up both in terms of quantity that we need to fully meet retail demand, but then also linearity that we need to really have a productive manufacturing operation. So, that's kind of if we double click into what we mean by choppiness, I'd say this is definitely continuing on into 2023, but we're making progress and we feel good about the progress we've made. We feel good about the improving flexibility and resiliency of our supply base and I think the improvement trend will continue."
},
{
"speaker": "Ryan Merkel",
"text": "Thank you."
},
{
"speaker": "Operator",
"text": "The next question comes from Brett Linzey with Mizuho Americas. Please go ahead."
},
{
"speaker": "Brett Linzey",
"text": "Hi, good morning all."
},
{
"speaker": "Mike Wagnes",
"text": "Good morning."
},
{
"speaker": "John Stone",
"text": "Good morning."
},
{
"speaker": "Brett Linzey",
"text": "Congrats on a great quarter. Just back to the price and productivity and specifically within the Americas business did step-up nicely from what's 6 million in Q2 to [24 million] [ph] here in the third quarter. Should we see that continue to move higher into Q4? And then given the wraparound price, you should be able to get next year. I mean, should we think of 25 million in Q1 and Q2 of next year at a minimum?"
},
{
"speaker": "Mike Wagnes",
"text": "Yes. Brett, with respect to next year, we'll give an outlook when we come back in Feb, I'm certainly not on the third quarter call going to get that specific of price productivity inflation. However, in general, think of this dynamic as progressively improving to this point, right? We were weaker last year, negative, got back to positive this quarter on a substantial way. Obviously, volume drives more ability to get that price because you have more revenue, but in general, we're going to fight that inflation and have that dynamic positive moving forward."
},
{
"speaker": "Brett Linzey",
"text": "Got it. And then just back to the backlog question. And so, you're obviously working here to [uncork] [ph] that specifically on the electronic side. As these supplier additions are ramping here, should we think of the electronics growth normalizing back to that double-digit plus level that Allegion has really observed pretty consistently for several years before the pandemic? So, going forward, kind of double-digit in that territory."
},
{
"speaker": "Mike Wagnes",
"text": "Yes, especially long-term, this is a great growth driver for us and that be a double-digit growth business for us as you think about the long-term. We talked about choppiness, right, but long-term, this is a double-digit growth opportunity for us."
},
{
"speaker": "Brett Linzey",
"text": "And just a quick follow-up, do you think you have enough availability to, kind of sustain that into Q4 here?"
},
{
"speaker": "Mike Wagnes",
"text": "Yes, I'm not going to guide a specific quarter, but as you looked at our results for the Americas in particular, we have a pretty healthy top line guide in Q4. So, you can draw your conclusions to that particular item, but we still see strength in Q4 as indicated in our guide."
},
{
"speaker": "Brett Linzey",
"text": "Appreciate the color."
},
{
"speaker": "John Stone",
"text": "Thank you."
},
{
"speaker": "Operator",
"text": "The next question is from Joe O’Dea with Wells Fargo. Please go ahead."
},
{
"speaker": "Joe O’Dea",
"text": "Hi, good morning. I wanted to start on the operational and FX piece of the guide. And if you could just, sort of bridge from prior guide to revised guide, I mean, the numbers didn't change, but what some of the moving parts are and given the strength we saw in the third quarter, would have expected to see that that could have moved up, but if you could just talk, kind of the Americas piece, the international piece, the FX piece in terms of what moved from last guide to this one?"
},
{
"speaker": "John Stone",
"text": "Yes. So, Joe, if you think about FX, we actually took down our guidance in July when we reported our Q2 results for currency. So, a good chunk of the currency pressure you seeing with the dollar strengthening, we anticipated and put in that guidance that we put out in July. Currency rates have gotten a little worse since that period of time, but a good chunk of the FX pressure we called out previously. And then with respect to operations, we're right online with what we said in July for the year. Obviously, like I mentioned earlier, a little more strength in Americas as we took up the revenue outlook there, and a little more pressure from the markets internationally."
},
{
"speaker": "Joe O’Dea",
"text": "Okay. And then I wanted to ask on the Americas margin, excluding Access Tech, clearly some nice progress that we saw sequentially, but when we go back to where, kind of pre-pandemic margins were, there still now appears be some good opportunity there. So, again kind of bridging to that, I mean, what are the keys to, sort of get back to those kinds of margins pretty good volume this quarter. I'm not sure sort of mix side of things. If still from a price productivity inflation, there's room to go and you have visibility into that. It's kind of a timeline to getting back to where your margins were."
},
{
"speaker": "Mike Wagnes",
"text": "Yes. If you think about the margin profile in Americas, the strong contribution margin those businesses have as we grow, we should get margin expansion. We've done a much better job this year driving the price realization and offset the inflation. We've been talking about this all year on these calls. We expect that to continue. So, we think that there's margin runway for the Americas and we'll continue to drive that pricing to offset inflation with an understanding that this has been the most significant inflationary environment I've ever personally experienced and we're going to have to just combat that with pricing actions."
},
{
"speaker": "John Stone",
"text": "And Joe, this is John. I'd add that again there's an electronics angle to this as well. Electrified and connected products are delivering substantially higher value to the end customer, which then should also be not just organic growth on the top line, but also a margin expansion opportunity too as electronics adoption continues. So, that's an element as well that we're really keen to continue to grow, and deliver more value to the customer."
},
{
"speaker": "Joe O’Dea",
"text": "Just related to that, do you think you're capturing that value proposition today or do you think there are opportunities to, sort of better capture that margin opportunity on the electronic side?"
},
{
"speaker": "John Stone",
"text": "I think both. I think we're doing very well today and I think there's continued opportunity. That's a tailwind for Allegion."
},
{
"speaker": "Joe O’Dea",
"text": "Got it. Thank you."
},
{
"speaker": "Operator",
"text": "Next question is from David MacGregor with Longbow Research. Please go ahead."
},
{
"speaker": "Joe Nolan",
"text": "Hey, good morning. This is Joe Nolan on for David MacGregor."
},
{
"speaker": "Mike Wagnes",
"text": "Hi, Joe."
},
{
"speaker": "Joe Nolan",
"text": "First, I just wanted to ask within the Americas group, can you talk about volume versus price trends for both the non-res and residential businesses?"
},
{
"speaker": "Mike Wagnes",
"text": "Yes. Historically, we don't disclose those individual components. What we did share for the quarter was, they were both up pricing and volume for each segment, but the individual numbers historically we have not and don't anticipate disclosing that level of detail."
},
{
"speaker": "Joe Nolan",
"text": "Okay, got it. And then just on the Access Technologies business, I realize it's still early from an integration standpoint, but can you just give any update about how that's going in terms of the integration?"
},
{
"speaker": "John Stone",
"text": "Yes, I appreciate that question. I think as we said in the prepared comments, off to a great start, our teams are gelling very well. There's this or the other small project win here and there. So – and I think the early work on some of the heavy lift in terms of systems and things like this will continue for the next many months, but off to a very good start, cultural fit is very good, strategic fit is very good, the automatic doors is an excellent complementary portfolio to the rest of Allegion. And just really excited for that team. And really excited for the services business that comes along with that. And we're quite bullish on the future there."
},
{
"speaker": "Joe Nolan",
"text": "All right, great. Thanks for answering my questions."
},
{
"speaker": "Operator",
"text": "Last question is from Brian Ruttenbur with Imperial Capital. Please go ahead."
},
{
"speaker": "Brian Ruttenbur",
"text": "Yes. Thank you very much for taking my questions. Can we talk a little bit about the competitive landscape right now? What you're seeing given the ASSA ABLOY [HII Spectrum] [ph] transaction appears to be at least held up some with the DOJ, can you talk about the opportunity that you see out there with Allegion and the competitive environment? Are you gaining market share, losing market share, because of this transaction or it doesn't impact you at all?"
},
{
"speaker": "John Stone",
"text": "Yes, it's certainly not appropriate for us to comment on that particular situation. I would say we feel good about our product portfolio, about our brands, about our competitive position in the market. I think our third quarter results reflect that that as we made the supply chain improvements, we continue to talk about, we generate good results. We've been saying for several quarters now, we were supply constrained versus demand constrained. And I think that continued to prove itself out. And so, yes, we'll continue to compete vigorously in the segments where we compete. And I think Allegion's best days are still ahead."
},
{
"speaker": "Brian Ruttenbur",
"text": "Okay. As a follow-up, I'll go in a different direction. Then can we talk about – you addressed a little bit, but price increases going forward, are you starting to see a pushback on the non-residential market yet in the Americas on price increases and that, kind of tells you when you're done? And I just want to get kind of an indication from you what you see in terms of price indication, price increases going forward if you feel like you can push more through or you feel like that you're at the top end of that market?"
},
{
"speaker": "Mike Wagnes",
"text": "Yes. We put a number of increases in. I would say it all depends on what the future inflationary environment is, but as we sit here today, we would always communicate future price increases to the channel for an earnings call, but expect us if inflation persists, expect us to pass along pricing to mitigate that, but it all depends on the inflationary environment moving forward."
},
{
"speaker": "Brian Ruttenbur",
"text": "Great. Thank you."
},
{
"speaker": "Operator",
"text": "This concludes our Q&A session, and we like to turn conference back over to John Stone for any closing remarks."
},
{
"speaker": "John Stone",
"text": "Thanks very much and thanks everyone for attending today. I would just like to again reiterate; we feel like we delivered an outstanding performance this quarter. The entire Allegion team and our distribution partners deserve credit for that. Access Technologies awesome acquisition off to a great start. We are making the supply chain improvements that we've been promising for a while and you'd see that reflected in our results. And we see continued strength in the Americas non-residential end markets and global electronics demand. Allegion's best days are still ahead. Thanks very much."
},
{
"speaker": "Operator",
"text": "The conference has now concluded. Thank you for attending today's presentation. You may now disconnect."
}
] | Allegion plc | 241,782,379 |
ALLE | 2 | 2,022 | 2022-07-30 08:00:00 | Operator: Good morning, and welcome to the Allegion Q2 2022 Earnings Conference Call. All participants will be in listen-only mode. [Operator Instructions] Please note. this event is being recorded. I would now like to turn the conference over to Tom Martineau, Vice President of Investor Relations. Please go ahead.
Tom Martineau: Good morning, everyone. Thank you for joining us for Allegion's second quarter 2022 earnings call. With me today are Executive Chairman, Dave Petratis; President and Chief Executive Officer, John Stone; and Senior Vice President and Chief Financial Officer, Mike Wagnes. Our earnings release, which was issued earlier this morning and the presentation, which we will refer to in today's call, are available on our website at investor.allegion.com. This call will be recorded and archived on our website. Please go to Slides 2 and 3. Statements made in today's call that are not historical facts are considered forward-looking statements and are made pursuant to the Safe Harbor provisions of federal securities law. Please see our most recent SEC filings for description of some of the factors that may cause actual results to differ materially from our projections. The company assumes no obligation to update these forward-looking statements. Today's presentation and commentary include non-GAAP financial measures. Please refer to the reconciliation in the financial tables of our press release for further details. We will now discuss our second quarter 2022 results which will be followed by a Q&A session. Please, for the Q&A, we would like to ask each caller to limit themselves to one question and one short follow-up and then reenter the queue. Now, I'll turn the call over to Dave.
Dave Petratis: Thanks, Tom. Good morning and thank you for joining us today. Please go to Slide number 4. Before we provide our business and financial overview for you for the quarter, I want to start by acknowledging two significant announcements from the last few months. In May, I shared my plans to retire from Allegion announcing John Stone as the incoming President and CEO of Allegion. John is the right leader to take Allegion into its next chapter. And I'm happy to say, Allegion has the right talent, right strategy, and right foundation to successfully execute its vision of seamless access and a safer world under John's leadership. It's been a privilege for you to know John and learn about his service to our country as a West Point graduate, Army Officer and Veteran. He also has a background in engineering and manufacturing with a track record of leading sustainable profitable growth, building from the core business by layering on new innovation and technology. We are particularly impressed by John's experience, leading Deere & Company’s Intelligence Solutions Group. John is well versed in connectivity, having guiding the company through the digital transformation for agriculture. He drove value through digital tools, helping the industry become more productive through innovative technologies like automation, artificial intelligence, and machine learning. He leverages the IoT to deliver wireless data, sensing technologies, as well as innovative remote service capabilities. All of this enhanced the performance and value of traditional mechanical equipment and allowed customers to drive their own operational efficiencies. Most of all, John has experience at managing complexity. Deere & Company is a complex global business and his leadership opened an important route to precision agriculture during his time there. In many ways, John has already driven growth and success utilizing seamless access strategies. John, would you like to say a few words?
John Stone: Yes. Thank you, Dave and good morning everyone. Thank you for joining our call. I'm looking forward to getting to know each of you a lot better over the coming quarters. Dave, I am super energized to be here, highly motivated by our higher purpose of pioneering safety and motivated by our vision of seamless access for a safer world. I agree with you that Allegion has a very sound foundation. We've got great brands, great products, a strong team strong culture, and customer relationships that have stood the test of time. I'm looking forward to visiting more of our sites in the coming weeks, getting to know our employees, our investors, and our customers and learning the business at a deeper level right alongside our experts. I feel it's a really exciting time to be part of Allegion. Back to you, Dave.
Dave Petratis: Thank you, John. Leading Allegion has been an honor and one of the most rewarding experiences of my professional career. And I'm proud to turn over the reins of this incredible organization to you, John Stone. Please go to Slide number 5. In the second quarter, we shared Allegion's intent to acquire the Access Technologies business from Stanley. I'm happy to announce that of July 5, Access Technology is now a part of the Allegion family. The Access Technology business bolsters Allegion's seamless access strategy with a category market leader that has more than 90 years of history and innovation. Automatic entrance solutions is a strategic investment that addresses a gap in our portfolio. We're adding a high growth service and support network to our North American portfolio, which will position us better as devices become more connected. Importantly, bringing the Access Technologies business to Allegion also provides clear synergy and incremental revenue opportunities. And we believe we're creating a stronger long-term financial profile for our company that will deliver long-term value creation for Allegion’s shareholders. Simply put, with Access Technology as a part of Allegion, we are now able to offer our customers broader solutions and services and continuing to grow profitably. At this time, I want to go over Access Technology's expected financial impacts for the second half of 2022. We expect the business to deliver approximately 9% growth in the full-year top line number for the Americas segment. We are also projecting the business will be diluted by – to adjusted EPS by approximately $0.10 per share in 2022. Breaking down that impact further, the Access Technology’s business is expected to deliver $0.20 per share of operational earnings offset by non-cash intangible asset amortization of negative $0.13 per share and increased interest expense related to financing the deal is expected to drive a negative $0.17 per share impact. I want to reiterate that the Allegion team is proud to welcome the Access Technology's dedicated employees who bring immense talent and expertise in safety, security, and service to our Americas segment, as well as our global organization. We're excited to have you here. Please go to Slide number 6. As we look at business conditions, American non-residential market demand remains very strong and we expect that to continue. Leading indicators are showing expansionary readings. On the flip side, we are beginning to see some softening in the Allegion International segment and Americas residential markets from previous robust levels. In international, we are seeing the impacts of geopolitical instability and zero tolerance COVID policies in China that have negatively impacted volume. We continue to make progress on our supply chain actions, which have resulted in improving component availability for mechanical products. Electronic component challenges continue, however the product redesigns and alternative sourcing actions we have taken set us up better for the remainder of the year and 2023. Looking at price versus cost, we delivered strong price in the quarter across the entire portfolio. Price realization accelerated again in Q2 and was the driver of organic growth in the quarter. Price exceeded inflation in the quarter and we expect that to continue for the remainder of the year. Allegion will assess the need for future price increases. We remain vigilant to increase – to ensure that price and productivity exceeds inflation. Lastly, our Allegion International business is experiencing significant currency pressure as the dollar strengthens. In the second quarter, reported revenues reflect 22 million of currency pressure related to foreign exchange rates. And as noted in our press release, currency headwinds are driving a reduction in our full-year EPS outlook to the effect of $0.09 per share. Now, let's turn to the quarterly performance for more details. Please go to Slide 7. Revenue for the second quarter was 773 million, an increase of 3.5%, compared to last year. Organic revenue growth was 6.4%. The organic revenue increase in the quarter was driven by significant price realization of 8.4%. The negative volume was driven by the Allegion America's residential business, which was comparing against a robust to Q2 2021 growth rate associated with prior year catch up on COVID related backlog. It was also impacted by the current year electronic parts shortages. Allegion International delivered organic growth driven by price, but faced volume declines that were driven by COVID-19 lockdowns in China and softening European markets. Mike will share more detail on the business segments in a moment. Adjusted operating margin and adjusted EBITDA margins increased by 40 basis points and 30 basis points respectively in the second quarter. The increase was driven by price productivity, exceeding inflation, which include favorable corporate cost, and favorable business mix, which more than offset the negative impacts of volume deleverage and incremental investments. Adjusted earnings per share of $1.37 increased $0.05 or approximately 4% versus the prior year. Strong operational performance and favorable share count more than offset a favorable impact from FX, investments, other income, and tax rate. Mike will now walk you through the financials and our updated 2022 outlook.
Mike Wagnes: Thanks, Dave, and good morning, everyone. I want to echo Dave's comments in welcoming John as our new President and CEO and in welcoming Access Technology employees to Allegion. Please go to Slide number 8. This slide reflects our earnings per share reconciliation for the second quarter. For the second quarter of 2021, reported earnings per share was $1.31. Adjusting $0.01 per charges related to restructuring and acquisition expenses, the 2021 adjusted earnings per share was $1.32. Strong operational results increased earnings per share by $0.13, net of $0.05 per share pressure related to FX. The performance was driven by significant price, which exceeded inflation and business mix driven by the strength of the Americas non-residential business. Favorable share count increased earnings per share by $0.03 and the impact of acquisition and divestitures drove another $0.01 per share. A higher year-over-year tax rate reduced earnings by $0.02 per share and the combination of interest and other income drove another $0.05 reduction. Investment spending had a $0.05 per share drag on earnings as we continue to invest in the business to fuel long-term growth, expand our electronic capabilities, and drive our seamless access strategy. This results in an adjusted second quarter 2022 earnings per share of $1.37, an increase of $0.05 or 3.8% compared to the prior year. Lastly, we had a $0.07 per share reduction from the net of non-operating gains and charges related to restructuring, acquisitions, and debt financing costs. After giving effect to these items, you arrive at the second quarter 2022 reported earnings per share of $1.30. Please go to Slide number 9. This slide depicts the components of our revenue performance for the quarter. I’ll focus on total Allegion results and cover the regions on their respective slides. As indicated, we experienced 6.4% organic revenue growth in the second quarter, driven by strong price realization. Although the total company volume was down, we did see significant strength in our Americas non-residential business, which is starting to benefit from our supply chain actions over the last year. As mentioned previously, currency headwinds were significant in the quarter and reduced reported revenue by 3%. There was a small impact from acquisitions bringing the total reported growth to 3.5% for Q2. Please go to Slide number 10. Second quarter revenue for the Americas segment was 592.3 million, up 7.8% on a reported basis and up 8% organically. The segment delivered significant price realization coming in at 9.4% in the quarter. Both the non-residential and residential businesses delivered strong pricing. Pricing helped the non-residential business grow high teens when combined with volume growth. Residential was down mid-teens driven by a prior year catch-up on COVID related backlogs and continued pressure in electronic components availability. Electronics revenue was down low single digits, driven primarily by electronic component shortages that limit our ability to fully meet demand. Americas adjusted operating margin and adjusted EBITDA margins for the quarter were down 150 basis points and 160 basis points, respectively. The Q2 margin performance was a sequential improvement from Q1. For the quarter, price exceeded inflation and productivity headwinds on a dollar basis, but were dilutive to operating margins. Please go to Slide number 11. Second quarter revenue for our Allegion International segment was 180.8 million, down 8.5% on a reported basis and up 1.9% organically. The organic growth was driven by solid price realization, which more than offset the volume declines experienced as a result of COVID shutdowns in China and geopolitical pressures in Europe. The negative impact related to currency headwinds reduced reported revenues by 10.9% as the U.S. dollar has strengthened substantially against other foreign currencies. Second quarter international adjusted operating margins decreased 100 basis points, compared to last year and adjusted EBITDA margins were down 60 basis points. The margin decline was driven by unfavorable impacts from volume and mix, FX, and incremental investments that more than offset the favorable impact of price and productivity exceeding inflation. Please go to Slide number 12. Year to date available cash flow for the first half of 2022 came in at 84.5 million, which is a decrease of more than 165 million, compared to the prior year. The 84.5 million is more in-line with historical levels. Last year's cash flow was driven primarily by lower working capital, due to the pandemic. We are now projecting that 2022 full-year available cash flow to be between 420 million and 440 million. The reduction in ACF from the prior outlook is primarily related to investing in inventory to create supply chain resiliency and to better serve our customers. This will position us to manage backlogs, which are expected to be elevated entering 2023 due to strong non-residential demand. The revised cash flow outlook includes the impact of the Access Technologies business, inclusive of operational cash flows offset by acquisition and integration costs related to the transaction. As discussed earlier, we closed on the acquisition of Access Technologies business on July 5. The transaction was funded by issuing senior notes and utilization of our revolver. As mentioned when we announced the acquisition, we expect to use excess cash generated during the remainder of the year to pay down short-term debt to taken on to complete the transaction. This would be after paying expected dividends, which are subject to Board approval. Please go to Slide number 13. We now turn our attention to the revised revenue outlook. Non-residential markets in the Americas continues to be robust, leading indicators remain positive, and the level of specifications continues to be strong. Consistent with the broader macro industry, we are beginning to see signs of residential softening from robust COVID level peaks. However, we remain positive on the long-term growth opportunity in residential due to the undersupply of homes to meet demand and the long-term trend of electronic adoption. We've been aggressive in pursuing price in all channels and products and as a result, expect to deliver solid price realization for the remainder of the year that will more than offset substantial inflationary headwinds. As noted previously, we expect the newly acquired Access Technologies business to deliver approximately 9% growth for the full-year reported Americas revenue. With these parameters in place, we are now projecting total growth for the Americas to be up 21% to 22% and organic revenue to be up 12% to 13%. The increase in the Americas organic revenue outlook is primarily driven by price to offset the ongoing inflationary pressures. Allegion International experienced sequential improvement in price realization. However, we are beginning to see markets soften and currency pressures are anticipated to continue. For Allegion International, we are revising our outlook for total revenue to be down 7% to 8% with organic growth coming in at 2% to 3%. All in for a total Allegion, we expect revenue growth to be in the 13% to 14% range with organic revenue increasing 9% to 10%. Please go to Slide 14. For our EPS outlook, we are expecting reported EPS to come into a range of $5.05 to $5.15 per share, and adjusted EPS to be between $5.35 to $5.45. These ranges include the approximately negative 10% impact related to Access Technologies acquisition as the discussed earlier. The updated outlook also includes a $0.09 per share reduction from the prior outlook related to currency pressure. This outlook assumes incremental investments of approximately $0.20 per share. As a reminder, the incremental investment spend is predominantly related to R&D and technology investments to accelerate future growth and support our seamless access strategy. Also included in the revised outlook is a slight increase in interest expense driven by an increase in variable interest rates on the base business. This does not include the Access Technologies acquisition, which will have a $0.17 per share negative impact related to financing we secured to close the transaction. That impact is included in the overall $0.10 per share dilution from the acquisition. I will now hand it back to Dave for some closing remarks.
Dave Petratis: Thank you, Mike. Please go to Slide number 15. To wrap up the main things you heard today, Allegion is excited to welcome John Stone as President and CEO. He brings a wealth of knowledge and expertise that will help Allegion on its seamless access journey. We are also excited to welcome Access Technologies to Allegion. This is a category market leader with a strategic investment that expands our core business. Globally, Allegion is driving significant price realization and has turned the price productivity inflation dynamic positive. The supply chain actions we have taken will help efficiency and productivity in our manufacturing locations and along with ongoing price realization will continue to drive pricing and productivity to exceed inflation. Non-residential markets in the Americas continue to be robust. Leading indicators have been positive for over a year and given the late cycle nature of that business, this bodes well for the near term future, plus we are still sitting on healthy backlog levels that should fuel future growth as supply chains normalize. With that, Mike and I would now be happy to take your questions.
Operator: Thank you. [Operator Instructions] The first question is from the line of Julian Mitchell with Barclays. Please go ahead.
Julian Mitchell: Hi, good morning. Thanks very much and wish Dave all the best and thanks for your help and look forward to working with you John. In terms of – I guess the first question would probably be around – on the residential business, understand you've had, sort of several quarters of very tough comps and sort of a destock that had to happen, maybe help us understand on residential today, where are you on the inventories, kind of in the channel? The comp should get easier in the second half year-on-year, but the broader U.S. resi demand backdrop is probably worse than you had thought a few months ago. So, maybe help us understand, kind of what slope of residential revenue growth we should get in the second half of the year and the assumptions behind it?
Dave Petratis: So, thank you for your comments, Julian, and for your questions, and support over the years. When I think about the residential market. We moved through this – went through this supply chain, which has been pretty dramatic over the last 24, 36 months. I continue to be positive on residential. We still have some noise, but there's an undersupply of housing. We'll see some softening in the R&R, but we have maybe been hit harder in res because of the lack of electronic chips. We'll build momentum back over the second half and into 2023. I think the nation's got to build between 800,000 and a million single family homes. So, I think that's net opportunity as we look at the change.
Mike Wagnes: And Julian, if you think about guides, we don't guide the residential business. We do give outlooks for Americas in total, but just – I'll just agree with you. We had that prior year comp in the second quarter that went up against last year. The second half for this year is much easier comps versus last year.
Julian Mitchell: That's helpful. Thank you. And then just my second question would be around the, sort of the price cost dynamics. Any updated thoughts around how that plays out in terms of margin impact in the back half? And I suppose based on the recent declines in spot commodity prices, when do you see those perhaps rolling into your gross margins in terms of the timing of those lower costs starting to help the gross margin? And do you think you can retain those savings when they come through or they might have to be passed back to the customer?
Dave Petratis: Yes. So, Julian, as you think about price cost, we struggled at the end of last year. We got slightly behind and we put efforts to raise prices to get that price productivity inflation positive. We had improvement in Q1. In Q2, we are now positive. Like we said, we would be as we look to the back half that continues to be positive for both quarters in the back half, we'll be positive for the full-year and price productivity inflation. We do have substantial inflationary pressures in the back half and we've taken additional pricing actions to mitigate that. As a result, you'll see that price productivity inflation positive, as well as margin expansion in the back half. If you think about commodity prices, those spot prices are coming down. As you see from the public markets, they're still elevated versus, say historic norms. Any decrease in commodity prices is not something 2022 we feel because we've been putting in those purchase orders to ensure that we had adequate parts and inventory to meet that demand that we have. So, as you think about price productivity inflation, think of it as a net plus in the back half full-year and we're back to expanding margins.
Julian Mitchell: Great. Thank you.
Operator: Thank you. Next question is from the line of David MacGregor with Longbow Research. Please go ahead, sir.
Joe Nolan: Hi. This is Joe Nolan on for David. Congrats on a nice quarter, guys.
Dave Petratis : Thanks. Hi, Joe.
Joe Nolan: So, I was just wondering within the Americas non-residential business, can you just talk about how distributor inventories look? And also just wondering, are you seeing any increase in order cancellations or signs that distributors maybe getting more cautious about holding inventory in a slowing macro environment?
Dave Petratis: I would say, as we think about distributor inventory and wholesale pull through, I would say it's normalized. Remember there was a big to pull back 15 months ago as we entered COVID. I would say it's normalized. Wholesalers typically play the price increase gain intelligently. They'll bring in those orders earlier ahead of a price increase to create a margin opportunity for themselves, but I would say they are solid. There are some deficiencies within our portfolio, which would be electronics, which will improve over the second half of the year. I would say, second half of the question.
Mike Wagnes: Yes, I would say that the – if you think of our business, we've had such supply chain challenges last year. So, as we move forward to this year, our distribution base is looking for product. So, we have very healthy backlogs. Demand is very strong, elevated backlog. So, as we move forward, we feel very confident about the non-residential business.
Dave Petratis: I would also say, touch base with our teams on cancellations, not seeing it. There's a demand for product flow. There's a very strong construction backlog right at nine months and the indicators would suggest work in for a good 12 months to 18 months of non-residential activity.
Joe Nolan: Got it. Okay. Thank you. And then just as a quick follow-up on the Access Technologies business, can you just talk about what this acquisition adds revenue wise to your aftermarket business and whether it would be accretive or dilutive to margins on the existing business? Thanks.
Mike Wagnes: Yes. If you think about Access Technologies, when we announced it in April, we talked about that 38% of the business was service revenue. Our business today, we don't have service revenue to a substantial level, especially in the Americas. We have some out in the international, but in the Americas, we don't have that service capability. So, this is a great asset to add to our existing portfolio as we leverage their strengths with our Allegion Americas strengths.
Dave Petratis: I would add that in our vision of seamless access and smart connected edge devices on the doors, the service component becomes required by our customers and the ability to grow recurring revenues through services, we like the opportunity.
Mike Wagnes : And I think you also asked about margins. When you think about Access Technologies, we gave some guidance in the April call, how that business is, think of it as a mid-teen EBITDA margin.
Joe Nolan: Got it. Okay. Thank you very much. I'll pass it along.
Operator: Thank you. Next question is from the line of Brett Linzey with Mizuho. Please go ahead, sir.
Brett Linzey: Hi, good morning and congrats today, best of luck, and welcome to John.
John Stone: Thank you.
Dave Petratis: Thank you.
Brett Linzey: Just wanted to come back to the electronics activity still continues to show just kind of uneven performance here with the chip constraints. I guess as you've gotten closer to the redesigns and some of these new suppliers coming ramping up here, I mean should we see the electronic growth snap back here in the second half or do you expect this to be still uneven for the next few quarters as you kind of work through some of those new product designs?
Mike Wagnes: Brett, as you think about revenue growth, so much of it has to do with the prior year comparable. Electronics growth should be better in the back half from a growth percentage as you think about prior year. In addition, we are seeing signs of improvement related to the activity we've been driving on the product redesign. So, both those areas should lead to better second half growth than what we experienced in the first half.
Brett Linzey: Okay, got it. And just coming back to the reporting convention and thinking about the guidance framework and now rolling in Access Technologies, have you considered ever moving to ex-amortization? I mean, it is a big number, so that's question one. And just the follow-up would be, within this new framework, are there any one time items related to integration or anything that we should be thinking about maybe don't repeat, sort of the second half of the year ownership?
Mike Wagnes: Yes. So, if you think about the one-timers we backed that out of reported EPS to get to our adjusted EPS, right? So, if you look at our guide, we have that at the bottom of the schedule. With respect to amortization expense, we started the year obviously with our guide. We're using the same presentation that we have when we started the year, but clearly identifying that amortization drag because it is significant for Access Technologies. We're going to get through 2022 using this presentation. With respect to the future, we can tackle that in the future, but when you think about 2022, we're going to have that amortization in the adjusted EPS, but we're going to clearly show it to you and provide it to you so you can have all those details.
Brett Linzey: Okay, great. I will pass it along. Thanks.
Operator: Thank you. Next question is from the line of Brian Rutenberg with Imperial Capital. Please go ahead, sir.
Brian Rutenberg: Yes, thank you very much. A couple of quick questions. In your guidance for 2022, what do you assume the supply chain will do? Will it get better, worse, the same? Just want to know what are your assumptions are around the supply chain?
Mike Wagnes: Yes. As you look at our guide for the back half of 2022, we are seeing improvement, especially in the mechanical space in the non-residential business. This is attributable to all the sourcing actions we've taken over the last year. So, as we think about that non-res growth, right, that high teens that we had, part of that is attributable to a better supply chain due to our activity. Our back half is taking into account what we've known we've done and chips that our partners have committed to get to us or provided us. Chips are always fragile, as you know, that can move, but this is not seeing a [sea change] [ph] of improvement that we don't have line of sight to. So, if you think about back half, think of it as the activity we've driven is helping provide better confidence in our ability to meet our customers' needs.
Dave Petratis: I would add two. If you look at some of the macro numbers, [Institutional Supply Management] [ph], deliveries across the board to all industrial players have improved. I'd say number two, the system of all manufacturers remain fragile, a port strike, COVID surge, puts a level of uncertainty that we've grown to navigate, but it remains fragile. And I'd say, the extensive work Allegion has done on the mechanical and electronics positions us nicely for the second half. We’d factor that in. I think we're not alone. The electronic flows for chips and other components is improving and that will benefit Allegion in 2022 and nicely steps up in 2023.
Brian Rutenberg: Great. Thank you.
Operator: Thank you. This concludes our question-and-answer session. I would now like to turn the conference back to our Executive Chairman, Dave Petratis, for any closing remarks.
Dave Petratis: Thank you. This concludes my 56th earning call as a CEO. The balance here at Allegion. This will likely be my last call. I want to thank our shareholders and the financial community for their support over the years. I also want to thank Nelson Peltz and Mike Lamach for the opportunity to create and lead Allegion. I want to thank Kirk Hachigian and the Allegion Board. Kirk has been with me since the day one. Kirk and the Allegion Board has helped create this company and guide us to where we are today. Last, a heartfelt thank you to the people of Allegion worldwide. You have a great new leader in John Stone. We have done some great work together. Allegion, your best days are ahead of you. Be safe, be healthy, and thanks for all your contributions. Have a great day.
Operator: Thank you. The conference has now concluded. Thank you for attending today's presentation. You may now disconnect. | [
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"text": "Good morning, and welcome to the Allegion Q2 2022 Earnings Conference Call. All participants will be in listen-only mode. [Operator Instructions] Please note. this event is being recorded. I would now like to turn the conference over to Tom Martineau, Vice President of Investor Relations. Please go ahead."
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"speaker": "Tom Martineau",
"text": "Good morning, everyone. Thank you for joining us for Allegion's second quarter 2022 earnings call. With me today are Executive Chairman, Dave Petratis; President and Chief Executive Officer, John Stone; and Senior Vice President and Chief Financial Officer, Mike Wagnes. Our earnings release, which was issued earlier this morning and the presentation, which we will refer to in today's call, are available on our website at investor.allegion.com. This call will be recorded and archived on our website. Please go to Slides 2 and 3. Statements made in today's call that are not historical facts are considered forward-looking statements and are made pursuant to the Safe Harbor provisions of federal securities law. Please see our most recent SEC filings for description of some of the factors that may cause actual results to differ materially from our projections. The company assumes no obligation to update these forward-looking statements. Today's presentation and commentary include non-GAAP financial measures. Please refer to the reconciliation in the financial tables of our press release for further details. We will now discuss our second quarter 2022 results which will be followed by a Q&A session. Please, for the Q&A, we would like to ask each caller to limit themselves to one question and one short follow-up and then reenter the queue. Now, I'll turn the call over to Dave."
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"text": "Thanks, Tom. Good morning and thank you for joining us today. Please go to Slide number 4. Before we provide our business and financial overview for you for the quarter, I want to start by acknowledging two significant announcements from the last few months. In May, I shared my plans to retire from Allegion announcing John Stone as the incoming President and CEO of Allegion. John is the right leader to take Allegion into its next chapter. And I'm happy to say, Allegion has the right talent, right strategy, and right foundation to successfully execute its vision of seamless access and a safer world under John's leadership. It's been a privilege for you to know John and learn about his service to our country as a West Point graduate, Army Officer and Veteran. He also has a background in engineering and manufacturing with a track record of leading sustainable profitable growth, building from the core business by layering on new innovation and technology. We are particularly impressed by John's experience, leading Deere & Company’s Intelligence Solutions Group. John is well versed in connectivity, having guiding the company through the digital transformation for agriculture. He drove value through digital tools, helping the industry become more productive through innovative technologies like automation, artificial intelligence, and machine learning. He leverages the IoT to deliver wireless data, sensing technologies, as well as innovative remote service capabilities. All of this enhanced the performance and value of traditional mechanical equipment and allowed customers to drive their own operational efficiencies. Most of all, John has experience at managing complexity. Deere & Company is a complex global business and his leadership opened an important route to precision agriculture during his time there. In many ways, John has already driven growth and success utilizing seamless access strategies. John, would you like to say a few words?"
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"speaker": "John Stone",
"text": "Yes. Thank you, Dave and good morning everyone. Thank you for joining our call. I'm looking forward to getting to know each of you a lot better over the coming quarters. Dave, I am super energized to be here, highly motivated by our higher purpose of pioneering safety and motivated by our vision of seamless access for a safer world. I agree with you that Allegion has a very sound foundation. We've got great brands, great products, a strong team strong culture, and customer relationships that have stood the test of time. I'm looking forward to visiting more of our sites in the coming weeks, getting to know our employees, our investors, and our customers and learning the business at a deeper level right alongside our experts. I feel it's a really exciting time to be part of Allegion. Back to you, Dave."
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"speaker": "Dave Petratis",
"text": "Thank you, John. Leading Allegion has been an honor and one of the most rewarding experiences of my professional career. And I'm proud to turn over the reins of this incredible organization to you, John Stone. Please go to Slide number 5. In the second quarter, we shared Allegion's intent to acquire the Access Technologies business from Stanley. I'm happy to announce that of July 5, Access Technology is now a part of the Allegion family. The Access Technology business bolsters Allegion's seamless access strategy with a category market leader that has more than 90 years of history and innovation. Automatic entrance solutions is a strategic investment that addresses a gap in our portfolio. We're adding a high growth service and support network to our North American portfolio, which will position us better as devices become more connected. Importantly, bringing the Access Technologies business to Allegion also provides clear synergy and incremental revenue opportunities. And we believe we're creating a stronger long-term financial profile for our company that will deliver long-term value creation for Allegion’s shareholders. Simply put, with Access Technology as a part of Allegion, we are now able to offer our customers broader solutions and services and continuing to grow profitably. At this time, I want to go over Access Technology's expected financial impacts for the second half of 2022. We expect the business to deliver approximately 9% growth in the full-year top line number for the Americas segment. We are also projecting the business will be diluted by – to adjusted EPS by approximately $0.10 per share in 2022. Breaking down that impact further, the Access Technology’s business is expected to deliver $0.20 per share of operational earnings offset by non-cash intangible asset amortization of negative $0.13 per share and increased interest expense related to financing the deal is expected to drive a negative $0.17 per share impact. I want to reiterate that the Allegion team is proud to welcome the Access Technology's dedicated employees who bring immense talent and expertise in safety, security, and service to our Americas segment, as well as our global organization. We're excited to have you here. Please go to Slide number 6. As we look at business conditions, American non-residential market demand remains very strong and we expect that to continue. Leading indicators are showing expansionary readings. On the flip side, we are beginning to see some softening in the Allegion International segment and Americas residential markets from previous robust levels. In international, we are seeing the impacts of geopolitical instability and zero tolerance COVID policies in China that have negatively impacted volume. We continue to make progress on our supply chain actions, which have resulted in improving component availability for mechanical products. Electronic component challenges continue, however the product redesigns and alternative sourcing actions we have taken set us up better for the remainder of the year and 2023. Looking at price versus cost, we delivered strong price in the quarter across the entire portfolio. Price realization accelerated again in Q2 and was the driver of organic growth in the quarter. Price exceeded inflation in the quarter and we expect that to continue for the remainder of the year. Allegion will assess the need for future price increases. We remain vigilant to increase – to ensure that price and productivity exceeds inflation. Lastly, our Allegion International business is experiencing significant currency pressure as the dollar strengthens. In the second quarter, reported revenues reflect 22 million of currency pressure related to foreign exchange rates. And as noted in our press release, currency headwinds are driving a reduction in our full-year EPS outlook to the effect of $0.09 per share. Now, let's turn to the quarterly performance for more details. Please go to Slide 7. Revenue for the second quarter was 773 million, an increase of 3.5%, compared to last year. Organic revenue growth was 6.4%. The organic revenue increase in the quarter was driven by significant price realization of 8.4%. The negative volume was driven by the Allegion America's residential business, which was comparing against a robust to Q2 2021 growth rate associated with prior year catch up on COVID related backlog. It was also impacted by the current year electronic parts shortages. Allegion International delivered organic growth driven by price, but faced volume declines that were driven by COVID-19 lockdowns in China and softening European markets. Mike will share more detail on the business segments in a moment. Adjusted operating margin and adjusted EBITDA margins increased by 40 basis points and 30 basis points respectively in the second quarter. The increase was driven by price productivity, exceeding inflation, which include favorable corporate cost, and favorable business mix, which more than offset the negative impacts of volume deleverage and incremental investments. Adjusted earnings per share of $1.37 increased $0.05 or approximately 4% versus the prior year. Strong operational performance and favorable share count more than offset a favorable impact from FX, investments, other income, and tax rate. Mike will now walk you through the financials and our updated 2022 outlook."
},
{
"speaker": "Mike Wagnes",
"text": "Thanks, Dave, and good morning, everyone. I want to echo Dave's comments in welcoming John as our new President and CEO and in welcoming Access Technology employees to Allegion. Please go to Slide number 8. This slide reflects our earnings per share reconciliation for the second quarter. For the second quarter of 2021, reported earnings per share was $1.31. Adjusting $0.01 per charges related to restructuring and acquisition expenses, the 2021 adjusted earnings per share was $1.32. Strong operational results increased earnings per share by $0.13, net of $0.05 per share pressure related to FX. The performance was driven by significant price, which exceeded inflation and business mix driven by the strength of the Americas non-residential business. Favorable share count increased earnings per share by $0.03 and the impact of acquisition and divestitures drove another $0.01 per share. A higher year-over-year tax rate reduced earnings by $0.02 per share and the combination of interest and other income drove another $0.05 reduction. Investment spending had a $0.05 per share drag on earnings as we continue to invest in the business to fuel long-term growth, expand our electronic capabilities, and drive our seamless access strategy. This results in an adjusted second quarter 2022 earnings per share of $1.37, an increase of $0.05 or 3.8% compared to the prior year. Lastly, we had a $0.07 per share reduction from the net of non-operating gains and charges related to restructuring, acquisitions, and debt financing costs. After giving effect to these items, you arrive at the second quarter 2022 reported earnings per share of $1.30. Please go to Slide number 9. This slide depicts the components of our revenue performance for the quarter. I’ll focus on total Allegion results and cover the regions on their respective slides. As indicated, we experienced 6.4% organic revenue growth in the second quarter, driven by strong price realization. Although the total company volume was down, we did see significant strength in our Americas non-residential business, which is starting to benefit from our supply chain actions over the last year. As mentioned previously, currency headwinds were significant in the quarter and reduced reported revenue by 3%. There was a small impact from acquisitions bringing the total reported growth to 3.5% for Q2. Please go to Slide number 10. Second quarter revenue for the Americas segment was 592.3 million, up 7.8% on a reported basis and up 8% organically. The segment delivered significant price realization coming in at 9.4% in the quarter. Both the non-residential and residential businesses delivered strong pricing. Pricing helped the non-residential business grow high teens when combined with volume growth. Residential was down mid-teens driven by a prior year catch-up on COVID related backlogs and continued pressure in electronic components availability. Electronics revenue was down low single digits, driven primarily by electronic component shortages that limit our ability to fully meet demand. Americas adjusted operating margin and adjusted EBITDA margins for the quarter were down 150 basis points and 160 basis points, respectively. The Q2 margin performance was a sequential improvement from Q1. For the quarter, price exceeded inflation and productivity headwinds on a dollar basis, but were dilutive to operating margins. Please go to Slide number 11. Second quarter revenue for our Allegion International segment was 180.8 million, down 8.5% on a reported basis and up 1.9% organically. The organic growth was driven by solid price realization, which more than offset the volume declines experienced as a result of COVID shutdowns in China and geopolitical pressures in Europe. The negative impact related to currency headwinds reduced reported revenues by 10.9% as the U.S. dollar has strengthened substantially against other foreign currencies. Second quarter international adjusted operating margins decreased 100 basis points, compared to last year and adjusted EBITDA margins were down 60 basis points. The margin decline was driven by unfavorable impacts from volume and mix, FX, and incremental investments that more than offset the favorable impact of price and productivity exceeding inflation. Please go to Slide number 12. Year to date available cash flow for the first half of 2022 came in at 84.5 million, which is a decrease of more than 165 million, compared to the prior year. The 84.5 million is more in-line with historical levels. Last year's cash flow was driven primarily by lower working capital, due to the pandemic. We are now projecting that 2022 full-year available cash flow to be between 420 million and 440 million. The reduction in ACF from the prior outlook is primarily related to investing in inventory to create supply chain resiliency and to better serve our customers. This will position us to manage backlogs, which are expected to be elevated entering 2023 due to strong non-residential demand. The revised cash flow outlook includes the impact of the Access Technologies business, inclusive of operational cash flows offset by acquisition and integration costs related to the transaction. As discussed earlier, we closed on the acquisition of Access Technologies business on July 5. The transaction was funded by issuing senior notes and utilization of our revolver. As mentioned when we announced the acquisition, we expect to use excess cash generated during the remainder of the year to pay down short-term debt to taken on to complete the transaction. This would be after paying expected dividends, which are subject to Board approval. Please go to Slide number 13. We now turn our attention to the revised revenue outlook. Non-residential markets in the Americas continues to be robust, leading indicators remain positive, and the level of specifications continues to be strong. Consistent with the broader macro industry, we are beginning to see signs of residential softening from robust COVID level peaks. However, we remain positive on the long-term growth opportunity in residential due to the undersupply of homes to meet demand and the long-term trend of electronic adoption. We've been aggressive in pursuing price in all channels and products and as a result, expect to deliver solid price realization for the remainder of the year that will more than offset substantial inflationary headwinds. As noted previously, we expect the newly acquired Access Technologies business to deliver approximately 9% growth for the full-year reported Americas revenue. With these parameters in place, we are now projecting total growth for the Americas to be up 21% to 22% and organic revenue to be up 12% to 13%. The increase in the Americas organic revenue outlook is primarily driven by price to offset the ongoing inflationary pressures. Allegion International experienced sequential improvement in price realization. However, we are beginning to see markets soften and currency pressures are anticipated to continue. For Allegion International, we are revising our outlook for total revenue to be down 7% to 8% with organic growth coming in at 2% to 3%. All in for a total Allegion, we expect revenue growth to be in the 13% to 14% range with organic revenue increasing 9% to 10%. Please go to Slide 14. For our EPS outlook, we are expecting reported EPS to come into a range of $5.05 to $5.15 per share, and adjusted EPS to be between $5.35 to $5.45. These ranges include the approximately negative 10% impact related to Access Technologies acquisition as the discussed earlier. The updated outlook also includes a $0.09 per share reduction from the prior outlook related to currency pressure. This outlook assumes incremental investments of approximately $0.20 per share. As a reminder, the incremental investment spend is predominantly related to R&D and technology investments to accelerate future growth and support our seamless access strategy. Also included in the revised outlook is a slight increase in interest expense driven by an increase in variable interest rates on the base business. This does not include the Access Technologies acquisition, which will have a $0.17 per share negative impact related to financing we secured to close the transaction. That impact is included in the overall $0.10 per share dilution from the acquisition. I will now hand it back to Dave for some closing remarks."
},
{
"speaker": "Dave Petratis",
"text": "Thank you, Mike. Please go to Slide number 15. To wrap up the main things you heard today, Allegion is excited to welcome John Stone as President and CEO. He brings a wealth of knowledge and expertise that will help Allegion on its seamless access journey. We are also excited to welcome Access Technologies to Allegion. This is a category market leader with a strategic investment that expands our core business. Globally, Allegion is driving significant price realization and has turned the price productivity inflation dynamic positive. The supply chain actions we have taken will help efficiency and productivity in our manufacturing locations and along with ongoing price realization will continue to drive pricing and productivity to exceed inflation. Non-residential markets in the Americas continue to be robust. Leading indicators have been positive for over a year and given the late cycle nature of that business, this bodes well for the near term future, plus we are still sitting on healthy backlog levels that should fuel future growth as supply chains normalize. With that, Mike and I would now be happy to take your questions."
},
{
"speaker": "Operator",
"text": "Thank you. [Operator Instructions] The first question is from the line of Julian Mitchell with Barclays. Please go ahead."
},
{
"speaker": "Julian Mitchell",
"text": "Hi, good morning. Thanks very much and wish Dave all the best and thanks for your help and look forward to working with you John. In terms of – I guess the first question would probably be around – on the residential business, understand you've had, sort of several quarters of very tough comps and sort of a destock that had to happen, maybe help us understand on residential today, where are you on the inventories, kind of in the channel? The comp should get easier in the second half year-on-year, but the broader U.S. resi demand backdrop is probably worse than you had thought a few months ago. So, maybe help us understand, kind of what slope of residential revenue growth we should get in the second half of the year and the assumptions behind it?"
},
{
"speaker": "Dave Petratis",
"text": "So, thank you for your comments, Julian, and for your questions, and support over the years. When I think about the residential market. We moved through this – went through this supply chain, which has been pretty dramatic over the last 24, 36 months. I continue to be positive on residential. We still have some noise, but there's an undersupply of housing. We'll see some softening in the R&R, but we have maybe been hit harder in res because of the lack of electronic chips. We'll build momentum back over the second half and into 2023. I think the nation's got to build between 800,000 and a million single family homes. So, I think that's net opportunity as we look at the change."
},
{
"speaker": "Mike Wagnes",
"text": "And Julian, if you think about guides, we don't guide the residential business. We do give outlooks for Americas in total, but just – I'll just agree with you. We had that prior year comp in the second quarter that went up against last year. The second half for this year is much easier comps versus last year."
},
{
"speaker": "Julian Mitchell",
"text": "That's helpful. Thank you. And then just my second question would be around the, sort of the price cost dynamics. Any updated thoughts around how that plays out in terms of margin impact in the back half? And I suppose based on the recent declines in spot commodity prices, when do you see those perhaps rolling into your gross margins in terms of the timing of those lower costs starting to help the gross margin? And do you think you can retain those savings when they come through or they might have to be passed back to the customer?"
},
{
"speaker": "Dave Petratis",
"text": "Yes. So, Julian, as you think about price cost, we struggled at the end of last year. We got slightly behind and we put efforts to raise prices to get that price productivity inflation positive. We had improvement in Q1. In Q2, we are now positive. Like we said, we would be as we look to the back half that continues to be positive for both quarters in the back half, we'll be positive for the full-year and price productivity inflation. We do have substantial inflationary pressures in the back half and we've taken additional pricing actions to mitigate that. As a result, you'll see that price productivity inflation positive, as well as margin expansion in the back half. If you think about commodity prices, those spot prices are coming down. As you see from the public markets, they're still elevated versus, say historic norms. Any decrease in commodity prices is not something 2022 we feel because we've been putting in those purchase orders to ensure that we had adequate parts and inventory to meet that demand that we have. So, as you think about price productivity inflation, think of it as a net plus in the back half full-year and we're back to expanding margins."
},
{
"speaker": "Julian Mitchell",
"text": "Great. Thank you."
},
{
"speaker": "Operator",
"text": "Thank you. Next question is from the line of David MacGregor with Longbow Research. Please go ahead, sir."
},
{
"speaker": "Joe Nolan",
"text": "Hi. This is Joe Nolan on for David. Congrats on a nice quarter, guys."
},
{
"speaker": "Dave Petratis",
"text": "Thanks. Hi, Joe."
},
{
"speaker": "Joe Nolan",
"text": "So, I was just wondering within the Americas non-residential business, can you just talk about how distributor inventories look? And also just wondering, are you seeing any increase in order cancellations or signs that distributors maybe getting more cautious about holding inventory in a slowing macro environment?"
},
{
"speaker": "Dave Petratis",
"text": "I would say, as we think about distributor inventory and wholesale pull through, I would say it's normalized. Remember there was a big to pull back 15 months ago as we entered COVID. I would say it's normalized. Wholesalers typically play the price increase gain intelligently. They'll bring in those orders earlier ahead of a price increase to create a margin opportunity for themselves, but I would say they are solid. There are some deficiencies within our portfolio, which would be electronics, which will improve over the second half of the year. I would say, second half of the question."
},
{
"speaker": "Mike Wagnes",
"text": "Yes, I would say that the – if you think of our business, we've had such supply chain challenges last year. So, as we move forward to this year, our distribution base is looking for product. So, we have very healthy backlogs. Demand is very strong, elevated backlog. So, as we move forward, we feel very confident about the non-residential business."
},
{
"speaker": "Dave Petratis",
"text": "I would also say, touch base with our teams on cancellations, not seeing it. There's a demand for product flow. There's a very strong construction backlog right at nine months and the indicators would suggest work in for a good 12 months to 18 months of non-residential activity."
},
{
"speaker": "Joe Nolan",
"text": "Got it. Okay. Thank you. And then just as a quick follow-up on the Access Technologies business, can you just talk about what this acquisition adds revenue wise to your aftermarket business and whether it would be accretive or dilutive to margins on the existing business? Thanks."
},
{
"speaker": "Mike Wagnes",
"text": "Yes. If you think about Access Technologies, when we announced it in April, we talked about that 38% of the business was service revenue. Our business today, we don't have service revenue to a substantial level, especially in the Americas. We have some out in the international, but in the Americas, we don't have that service capability. So, this is a great asset to add to our existing portfolio as we leverage their strengths with our Allegion Americas strengths."
},
{
"speaker": "Dave Petratis",
"text": "I would add that in our vision of seamless access and smart connected edge devices on the doors, the service component becomes required by our customers and the ability to grow recurring revenues through services, we like the opportunity."
},
{
"speaker": "Mike Wagnes",
"text": "And I think you also asked about margins. When you think about Access Technologies, we gave some guidance in the April call, how that business is, think of it as a mid-teen EBITDA margin."
},
{
"speaker": "Joe Nolan",
"text": "Got it. Okay. Thank you very much. I'll pass it along."
},
{
"speaker": "Operator",
"text": "Thank you. Next question is from the line of Brett Linzey with Mizuho. Please go ahead, sir."
},
{
"speaker": "Brett Linzey",
"text": "Hi, good morning and congrats today, best of luck, and welcome to John."
},
{
"speaker": "John Stone",
"text": "Thank you."
},
{
"speaker": "Dave Petratis",
"text": "Thank you."
},
{
"speaker": "Brett Linzey",
"text": "Just wanted to come back to the electronics activity still continues to show just kind of uneven performance here with the chip constraints. I guess as you've gotten closer to the redesigns and some of these new suppliers coming ramping up here, I mean should we see the electronic growth snap back here in the second half or do you expect this to be still uneven for the next few quarters as you kind of work through some of those new product designs?"
},
{
"speaker": "Mike Wagnes",
"text": "Brett, as you think about revenue growth, so much of it has to do with the prior year comparable. Electronics growth should be better in the back half from a growth percentage as you think about prior year. In addition, we are seeing signs of improvement related to the activity we've been driving on the product redesign. So, both those areas should lead to better second half growth than what we experienced in the first half."
},
{
"speaker": "Brett Linzey",
"text": "Okay, got it. And just coming back to the reporting convention and thinking about the guidance framework and now rolling in Access Technologies, have you considered ever moving to ex-amortization? I mean, it is a big number, so that's question one. And just the follow-up would be, within this new framework, are there any one time items related to integration or anything that we should be thinking about maybe don't repeat, sort of the second half of the year ownership?"
},
{
"speaker": "Mike Wagnes",
"text": "Yes. So, if you think about the one-timers we backed that out of reported EPS to get to our adjusted EPS, right? So, if you look at our guide, we have that at the bottom of the schedule. With respect to amortization expense, we started the year obviously with our guide. We're using the same presentation that we have when we started the year, but clearly identifying that amortization drag because it is significant for Access Technologies. We're going to get through 2022 using this presentation. With respect to the future, we can tackle that in the future, but when you think about 2022, we're going to have that amortization in the adjusted EPS, but we're going to clearly show it to you and provide it to you so you can have all those details."
},
{
"speaker": "Brett Linzey",
"text": "Okay, great. I will pass it along. Thanks."
},
{
"speaker": "Operator",
"text": "Thank you. Next question is from the line of Brian Rutenberg with Imperial Capital. Please go ahead, sir."
},
{
"speaker": "Brian Rutenberg",
"text": "Yes, thank you very much. A couple of quick questions. In your guidance for 2022, what do you assume the supply chain will do? Will it get better, worse, the same? Just want to know what are your assumptions are around the supply chain?"
},
{
"speaker": "Mike Wagnes",
"text": "Yes. As you look at our guide for the back half of 2022, we are seeing improvement, especially in the mechanical space in the non-residential business. This is attributable to all the sourcing actions we've taken over the last year. So, as we think about that non-res growth, right, that high teens that we had, part of that is attributable to a better supply chain due to our activity. Our back half is taking into account what we've known we've done and chips that our partners have committed to get to us or provided us. Chips are always fragile, as you know, that can move, but this is not seeing a [sea change] [ph] of improvement that we don't have line of sight to. So, if you think about back half, think of it as the activity we've driven is helping provide better confidence in our ability to meet our customers' needs."
},
{
"speaker": "Dave Petratis",
"text": "I would add two. If you look at some of the macro numbers, [Institutional Supply Management] [ph], deliveries across the board to all industrial players have improved. I'd say number two, the system of all manufacturers remain fragile, a port strike, COVID surge, puts a level of uncertainty that we've grown to navigate, but it remains fragile. And I'd say, the extensive work Allegion has done on the mechanical and electronics positions us nicely for the second half. We’d factor that in. I think we're not alone. The electronic flows for chips and other components is improving and that will benefit Allegion in 2022 and nicely steps up in 2023."
},
{
"speaker": "Brian Rutenberg",
"text": "Great. Thank you."
},
{
"speaker": "Operator",
"text": "Thank you. This concludes our question-and-answer session. I would now like to turn the conference back to our Executive Chairman, Dave Petratis, for any closing remarks."
},
{
"speaker": "Dave Petratis",
"text": "Thank you. This concludes my 56th earning call as a CEO. The balance here at Allegion. This will likely be my last call. I want to thank our shareholders and the financial community for their support over the years. I also want to thank Nelson Peltz and Mike Lamach for the opportunity to create and lead Allegion. I want to thank Kirk Hachigian and the Allegion Board. Kirk has been with me since the day one. Kirk and the Allegion Board has helped create this company and guide us to where we are today. Last, a heartfelt thank you to the people of Allegion worldwide. You have a great new leader in John Stone. We have done some great work together. Allegion, your best days are ahead of you. Be safe, be healthy, and thanks for all your contributions. Have a great day."
},
{
"speaker": "Operator",
"text": "Thank you. The conference has now concluded. Thank you for attending today's presentation. You may now disconnect."
}
] | Allegion plc | 241,782,379 |
ALLE | 1 | 2,022 | 2022-04-26 08:00:00 | Operator: Good morning, and welcome to the Allegion First Quarter 2022 Earnings Call. All participants will be in listen-only mode. [Operator Instructions]. Please note this event is being recorded. I'd now like to turn the conference over to Tom Martineau, Vice President of Investor Relations and Treasurer. Please go ahead.
Tom Martineau: Thank you, Jason. Good morning, everyone. Thank you for joining us for Allegion's first quarter 2022 earnings call. With me today are Dave Petratis, Chairman, President and Chief Executive Officer, and Mike Wagnes, Senior Vice President and Chief Financial Officer of Allegion. Our earnings release, which was issued earlier this morning and the presentation which we will refer to in today's call, are available on our website at investor.allegion.com. This call will be recorded and archived on our website. Please go to slides two and three. Statements made in today's call that are not historical facts are considered forward-looking statements and are made pursuant to the Safe Harbor provisions of federal securities law. Please see our most recent SEC filings for description of some of the factors that may cause actual results to differ materially from our projections. The company assumes no obligation to update these forward-looking statements. Today's presentation and commentary include non-GAAP financial measures. Please refer to the reconciliation in the financial tables of our press release for further details. Dave and Mike will now discuss our first quarter 2022 results, which will be followed by a Q&A session. Please, for the Q&A, we would like to ask each caller to limit themselves to one question and one short follow-up and then reenter the queue. We would like to give everyone an opportunity given the time allotted. Please go to slide four and I'll turn the call over to Dave.
Dave Petratis: Thanks, Tom. Good morning. And thank you for joining us today. We had a solid start to 2022. Overall, market demand remains strong and our organic growth and pricing action accelerated. We also announced on Friday the acquisition of the Stanley Access Technologies business, a highly strategic acquisition for Allegion, which is expected to close in the third quarter of this year. During Q1, we experienced robust demand on the non-residential side of the Americas, as well as strength in SimonsVoss, Interflex, and Portable Security within the International segment. Residential markets in the Americas remain stable. We have made progress on our product redesigns and alternative sourcing similar to the last two quarters, but were not able to fully meet the strong demand due to continued supply chain constraints. We did deliver good revenue growth in the quarter, driven primarily by price. The continued strength in demand is encouraging. With regard to the supply chain constraints, we expect electronic component challenges to persist and the latest lockdowns in China are likely going to impact global supply chains even further. Looking at price versus cost, we continue to experience high inflationary impacts from material cost, labor and freight. Price realization accelerated in Q1 and was the driver of organic growth in the quarter. With the recent spike in commodity prices, we have already announced additional price increases to take effect starting in Q2 across residential and non-residential markets, and we'll assess the need for further price increases as inflationary pressures continue. As we discussed in February, we are aggressively pursuing price across all products and in all channels to offset unprecedented inflation, and we expect price to exceed inflation further for the year. We are providing an updated outlook for 2022. We're raising our revenue outlook to reflect higher price, offsetting the additional inflation we're experiencing. We're holding our prior EPS range, and I'll share more detail on the outlook later in the presentation. Last, on the business review, I want to further highlight our announcement from last Friday. We have come to an agreement to acquire Access Technologies business from Stanley Black & Decker. This is the right asset for Allegion and it progresses our seamless access strategic focus, adding a category leader with an expansive service footprint. The business has a strong financial profile and is very complementary to the Allegion Americas core business and our portfolio. Close is anticipated in Q3. And we welcome the Access Technology employees, and we look forward to all of them joining our team. Now let's turn to the quarter performance for more details. Please go to slide 5. Revenue for the first quarter was $724 million, an increase of 4.2% compared to last year. Organic revenue growth was 6.4%. The organic revenue increase in the quarter was driven by significant price realization of 6%. Allegion International and Allegion Americas non-residential business also saw volume growth, driven by robust demand highlighted earlier. Americas residential volumes were down as that business had a tough comparable to last year, a drip attributed to the large channel load during Q1 of 2021. Mike will share more detail on the business segments in a moment. Adjusted operating margin decreased by 240 basis points in the first quarter. Continued inflationary pressures, productivity challenge, and currency headwinds drove most of the decrease. Incremental investments for future growth caused 60 basis points of the decline. Adjusted earnings per share of $1.07 decreased $0.13 or approximately $0.11 versus the prior. Lower operating income, a year-over-year tax rate increase and reduced other income was partially offset by favorable share count. Year-to-date available cash flow came in at $12 million, which was down 89% versus Q1 of last year, but is in line with our historical trends. Last year's high number was driven by lower working capital requirements due to the COVID-19 pandemic. As I've stated before, I firmly believe our vision and strategy in support of seamless access is more relevant than ever, and the Access Technology acquisition will add momentum. We remain bullish on construction and DIY markets for 2022 and continue to expect the trend of electronic adaption to fuel growth for many years. Mike will now walk you through the financials, and I'll be back to discuss our 2022 outlook.
Mike Wagnes : Thanks, Dave. And good morning, everyone. Thank you for joining today's call. Please go to slide number 6. This slide reflects our earnings per share reconciliation for the first quarter. For the first quarter of 2021, reported earnings per share was $1.18. Adjusting $0.02 for charges related to restructuring expenses, the 2021 adjusted earnings per share was $1.20. Favorable share count increased earnings by $0.03 per share and the impact of acquisition and divestitures drove another $0.01 per share. Higher year-over-year tax rate reduced earnings by $0.02 per share and the combination of interest and other income drove another $0.03 reduction. Investment spending had a $0.04 per share drag on earnings as we continue to invest in the business to fuel long-term growth, expand our electronics capabilities, and drive our seamless access strategy. Operational results decreased earnings per share by $0.08, driven by significant inflation, productivity challenges associated with supply chain pressures and unfavorable currency, which more than offset the favorable impacts of price. This results in adjusted first quarter 2022 earnings per share of $1.07, a decrease of $0.13 or 10.8% compared to the prior year. Lastly, we have a $0.02 per share reduction for the net of a non-operating gain and charges related to restructuring and acquisition costs. After giving effect to these items, you arrive at the first quarter 2022 reported earnings per share of $1.05. Please go to slide 7. This slide depicts the components of our revenue performance for the quarter. I'll focus on the total Allegion results and cover the regions on their respective slides. As indicated, we had 6.4% organic revenue growth in the first quarter, driven by improved price realization. Although the company's volume was essentially flat, we did see strength in Allegion International and the Allegion Americas non-residential business. Currency headwind and divestitures more than offset the impact of acquisitions, bringing the total reported growth to 4.2% in the first quarter. Please go to slide number 8. First quarter revenue for the Americas segment was $528.2 million, up 5.9% on both a reported and an organic basis. The segment delivered significant price realization. Non-residential price was strong and residential business experience improved price realization. The price helped the non-residential business grow low-double digits. Residential was down mid-single digit against a tough comparable from last year's channel load in, which drove Q1 of 2021 to be up low 20s percent. Electronics revenue was up low-single digits as component shortages continued to dampen our growth. Americas adjusted operating income of $123.9 million decreased 8.6% versus the prior-year period and adjusted operating margin for the quarter was down 370 basis points. The Q1 margin performance was a sequential improvement for the Americas as we expect to see further improvements as we progress through the year. The decrease in margin was driven by continued inflationary pressures, productivity challenges associated with supply chain shortages and volume deleverage. Incremental investments had a 60 basis point impact on margins as well. Please go to slide 9. First quarter revenue for our International segment was $195.4 million, flat to last year and up 7.6% on an organic basis. The organic growth was driven by strength in SimonsVoss, Interflex and Global Portable Securities businesses. The segment also saw solid price realization contributing to the organic growth. The strong organic growth was offset by unfavorable currency and divestitures. International adjusted operating income of $20.4 million increased 13.3% versus the prior-year period. Adjusted operating margins for the quarter increased by 120 basis points to 10.4%. The margin increase was primarily driven by price and productivity exceeding inflation, as well as solid volume leverage, which more than offset currency and the 50 basis point headwind due to investment spending. Please go to slide 10. Year-to-date available cash flow for the first quarter of 2022 came in at $11.8 million, which is a decrease of more than $93 million compared to the prior-year period. The $11.8 million is more in line with historical trends as the business tends to have modest cash flows in the first quarter of a typical year. Last year's spike in cash flow was driven primarily by lower working capital needs due to COVID. The business continues to generate strong cash flow and we remain committed to efficient and effective use of working capital. The amount of available cash generated in the first quarter was as expected and the balance sheet continues to be in a healthy position. We expect to use excess cash generated during the remainder of the year to pay down short-term debt taken on to complete the acquisition of the Stanley Access Technologies business. I will now hand it back over to Dave for an update on our full-year 2022 outlook.
Dave Petratis : Thank you, Mike. Please go to slide number 11. Non-residential market demand in Americas continues to be robust. All leading indicators are positive and the level of institutional specifications continues to be strong. The residential business is stable and the under-supply of homes over the last decade will continue to be a factor driving growth in the residential segment. We have been aggressive in pursuing price in all channels and products and saw substantial improvement in price realization in Q1. We have announced additional price increases to go in effect starting in Q2. Given the continued supply chain challenges, we still expect the revenue performance to be better in the second half than in the first half. With these parameters in place, we are raising the outlook and are now projecting total inorganic revenue in the Americas to be up 10% to 11.5% in 2022. In Allegion International, markets have remained solid, led by our Germanic and Global Portable Security business. The International segment also experienced sequential improvement in price realization, as we are pursuing price aggressively in those markets as well. Currency headwinds will continue to reduce total growth. For Allegion International, we are raising our outlook for total revenue growth to 0.5% to 2%, with organic growth of 5% to 6.5%. All in, for total Allegion, we're raising the total revenue growth outlook to a range of 7.5% to 9% and organic revenue to increase 8.5% to 10%. These increases to prior outlook are driven primarily by higher price realization. It's important to note this updated outlook does not include any impacts from the Stanley Access Technology acquisition. Please go to slide number 12. For EPS, we are holding to the ranges provided during our last earnings call. Reported EPS is expected to be $5.50 to $5.70 per share with an adjusted EPS range of $5.55 to $5.75 as the increased revenue from the additional price realization is offset by higher inflationary cost. The outlook continues to assume a full-year adjusted tax rate of approximately 13% and the share count assumption has been updated to approximately 88.5 million. The unfavorable impact of the higher share count assumption is offset by operational improvements, leading us to hold the prior EPS outlook. Our outlook for available cash flow is being raised and it's now projected to be $470 million to $490 million. Please go to slide 14. Before we go to Q&A, I want to talk a bit more about our acquisition of the Access Technologies business. For those of you who have missed Friday's conference call, I invite you to visit our website and listen to the archived webcast. I want to repeat the benefits we saw in this acquisition. It's a highly strategic combination that expands our presence in security markets and unlocks greater values for our employees, customers, distributors and shareholders. We will bolster our geographic leadership in Allegion Americas through complementary verticals and further penetrate our markets with complementary products and service offerings. Cross-selling opportunities will create more room for mutual growth, and we will enhance and expand a service business that drives customer value in automatic entrance solutions, providing ongoing and consistent revenue streams. Allegion will significantly expand its breadth of access, egress and access control solutions. In return, the Access Technology business will gain specification and institutional market expertise, strong new end user and architectural relationships and distribution networks as well as additional resources from Allegion. Along with Allegion's strong balance sheet, significant cash flow and disciplined capital allocation, we believe it will create a stronger financial profile, a stronger value proposition and new opportunities that enhance shareholder value. Please go to slide 15. As we look at this acquisition, we believe there are many ways to deliver on our promise to create value for Allegion shareholders. We're creating value with a more comprehensive portfolio of solutions, adding a category leader and addressing a current portfolio gap in Allegion's core businesses. We're also adding North American service capabilities to grow seamless access in a connected world. The acquisition of Access Technologies business is the right opportunity for us. It expands our innovation and electronic capabilities, brings a strong business with good market fundamentals, and complements the core markets and specification expertise of our Allegion Americas segment. We believe the acquisition will strengthen our financial profile. It provides clear synergy and incremental revenue opportunities. A balanced and disciplined capital allocation strategy will continue to be a top priority for Allegion and having a strong balance sheet and cash flow to maintain financial flexibility that supports that. Ultimately, we believe the automatic entrance solution and service business are a strategic investment that supports seamless access, and the Access Technology acquisition will create value for our shareholders. We're excited to welcome the business and its people to the Allegion family. With that, Mike and I will be happy to take your questions.
Operator: [Operator Instructions]. Our first question comes from Timothy Wojs from Baird.
Timothy Wojs: Let's jump on the quarter. Maybe just to talk a little bit about what you're seeing from an order and kind of a backlog perspective. How are you kind of thinking about the revenue cadence as you kind of think through the year, I'm just trying to kind of understand the visibility that you've got to the back half of the year and what you're building in for any risks that maybe the building timelines might elongate just from a construction timeline perspective and maybe shift some revenue into 2023.
Dave Petratis: I think as we think about the path forward in terms of order activity, incoming orders, especially in the commercial business, institutional business, extremely robust. And as I've been traveling around the last few weeks, you also get that feel that construction activity across the country, extremely robust. As we look at our macroeconomics, it says, in the commercial, institutional, we're beginning the upcycle, which says we're going to get stronger as we go through the year in terms of product out the door. I would say supply chains remain under pressure, but have improved from the second half of last year. And then, I think you've got to think about res. When I think about res, it probably shows my age a little bit. Residential was extremely difficult in the last decade. And as I think about the under-supply of housing across the nation, I think we're going to continue to bang out 1.2 million to 1.6 million, even with higher interest rates. So, I feel very good about overall demand. I think about that going out four to six quarters and then we'll see.
Timothy Wojs: I think in the prior guidance, just on the EPS cadence, Mike, I think it was kind of 60% weighted to the back half. Is there any difference to that today just given kind of where you are in the first quarter or is that kind of similar?
Mike Wagnes: Tim, as you think about it, we got off to a decent start. Right? I would say it doesn't move materially from that 60% that we said at the beginning of the year. First quarter was okay or stronger than maybe the original assumption assumed. And so, it could move a percent or so or two, but it's roughly around that 60% that we gave in the beginning of the year.
Timothy Wojs: Is there any change to kind of the price cost assumptions on a dollar basis for the year?
Mike Wagnes: I would say as you look at our guide, we raised our guide on the top line, didn't raise the guide on the EPS because that is price realization that is fighting the inflationary pressures. And so, there will be a higher percentage going to price than we assumed in the beginning of the year. So, if in the beginning of the year, we said roughly 50/50, that's going to be higher by the raise of the guide. So, you're going to be looking at that 60% to 65%.
Operator: Our next question comes from John Walsh from Credit Suisse.
John Walsh: Nice quarter. Just kind of wanted to understand the change in the sales guidance. So, sounds like it's being driven by price, but what kind of gave you the confidence to take it higher, given that supply chains were still tough. You have the China COVID impacts. I understand that demand is really robust and you have the strong backlog, but kind of what gave you the confidence that you'll be able to get the parts you need to kind of hit a higher top line.
Mike Wagnes: John, as you think about our – so the price, we feel really strong. We've announced those increases already. So, they're in the marketplace. With respect to the overall market demand, even stronger than when we exited Q4. So Q1, real strong market demand in non-residential. And then lastly, we've taken actions to qualify additional suppliers and to work on bringing in new supply base. Those activities have gained traction in the first quarter. And so, that does give us confidence that, in the back half of the year, we'll get additional supply from additional suppliers that we can get more volume out.
Dave Petratis: I'd add to it as well. Versus the second half of last year, labor has improved in its availability, freight has improved modestly. And I say modestly, the rise in COVID in China, the lockdowns will have some implications. We've got some exposure, but it's not major. And I think particular on the mechanical inputs to our business, redesign, qualifying second suppliers has really strengthened our confidence. That leaves the electronics element. As we think about going forward and our guide, that's based on allocations. If chip availability gets better across the board, we'll be even stronger.
John Walsh: I guess just thinking about some of the moving pieces with the margins, I know before we were thinking Americas should see better than normal just on mix and volume recovery. Obviously, we have the higher inflation that's getting passed through. But could you just maybe help calibrate either total Allegion level or within Americas kind of what you're thinking the incremental margins will be for the year or however you'd like to talk to it?
Mike Wagnes: John, as you think about Q1, sequential improvement versus what you saw in the fourth quarter, we'll expect to see improvements each quarter sequentially, such that the back half, you start to really see that margin expansion versus the prior year. So, sequential improvement and then expansion in the back half. And then, when you model it, just take into account that there's substantial inflationary pressures. We're driving price to offset it from a dollar amount, but that raises the denominator in the margin calc without raising the numerator from the profit because it offsets it.
Operator: Our next question comes from Julian Mitchell from Barclays.
Julian Mitchell: You have Matthew Shaffer on from Julian Mitchell's team. So, you guys mentioned that pricing is expected to beat inflation in 2022. Can you maybe talk to the cadence of the price cost differential through the remaining quarters?
Mike Wagnes: As you think of the first quarter, we were slightly negative. We provide that information in our 10-Q. So, you'll see it in our 10-Q by region and in total. But, say, $7 million underwater in the first quarter. As you progress throughout the year, think of Q2 being closer to breakeven-ish and then Q3 and Q4 substantial price in excess of that inflation or price and productivity in excess of the inflation. So, gets better as the year progresses and then significantly positive in the back half.
Julian Mitchell: Just a follow-up for me. Electronics was up low-single digits in Americas Q1 after being pretty weak in 2021. Just curious the expectation is for 2022 growth for electronics.
Mike Wagnes: We don't provide individual growth rates, electronics versus mechanical. But if you think about our performance in the first quarter, substantial improvement from what you saw Q4, as you mentioned. The demand is there. The demand will be limited by the ability to get the supply. So, I would just say, take it into account when you consider our total guide for revenue, understanding that it's better than what you saw in the fourth quarter. And in the back half, we do comp against those easier comparables that we had in the back half of last year.
Operator: Our next question comes from David MacGregor from Longbow Research.
Joseph Nolan: This is Joe Nolan on for David MacGregor. On the residential business, you mentioned revenues were down mid-single digits. Are you able to talk about what units did in that business? And then I'm aware it's always been a difficult channel to get pricing in. So, if you could just talk about how the recent price increase is trending in terms of how that's gone into the channel.
Mike Wagnes: If you look at our resi business, we mentioned earlier that it had positive price realization for the quarter, not as strong as non-res. From a unit perspective then, you can see that units would be a little less than the total growth because we did have the positive price realization. More importantly, moving forward, we've taken actions in residential to drive price that has been announced to the marketplace and goes into effect in the second quarter. So, we expect to see better price realization in the second quarter and onward through 2022.
Joseph Nolan: Can you just give an update on trends in spec writing activity, just the size of projects, your content, order size, timing, that sort of stuff?
Dave Petratis: I would say spec writing activity continues to be robust. You can look at the ABI. I think the march ABI was at like a 58. I'd say a good range of projects with strength in the medical and hospital areas, which is good for Allegion. Can't really get into the size of these, but the order activity is good, and I think reflects the strength we're seeing in our incoming bookings.
Operator: Our next question comes from Brian Rutenberg from Imperial Capital.
Brian Rutenberg: Great quarter. So I'd like to break things down a little bit on gross versus operating margins. So, gross margins were down from fourth quarter and obviously down year-over-year. Do you expect gross margins to increase from first quarter to second quarter and then progress couple hundred basis points per quarter? Is that what you're saying?
Mike Wagnes: Yeah, I would say, if you think about the gross margin, that's inflation in excess of pricing that we talked about in the 10-Q. As you think about margins, in general, they'll improve as we get throughout the year. So, we should see both the gross and the operating improve as we move throughout 2022.
Brian Rutenberg: So, on the operating basis, we'll also see improvement sequentially with that because there's going to be lower SG&A or just increased leverage from the top line and more gross profit.
Mike Wagnes: As you get significant growth in the back half of the year, Q2, Q3, Q4, you leverage that SG&A base. So, that does help also the operating margins.
Dave Petratis: Volume is a very beautiful thing in this business. And as we go through the second half, the business leverage quite nicely.
Operator: The next question comes from Andrew Obin from Bank of America.
Unidentified Participant: You have Sabrina Abrams [ph] on from Andrew Obin's team. I understand that you mentioned you're sort of expecting them, but in the past month, have you been seeing worsening supply chain impacts from the COVID-related China shutdowns and from the Russia-Ukraine conflict?
Dave Petratis: I'd say we have very little exposure to Russia. I'd say the bigger effect there has been pricing of raw materials. And we'll adapt to that with price. As we think about China, it's certainly serious. We have exposure there, but it has not affected us in April. And I think we've got the adaptability to be able to work through that. We're not totally immune, but are in geographic production capabilities position us well.
Unidentified Participant: I understand that you're raising the revenue guide and maintaining the EPS range on inflation. But I guess I'm curious, you guys had a strong EPS beat in 1Q and are maintaining that guide. Are there any other headwinds we should be thinking about besides inflation in the remainder of the year?
Mike Wagnes: As we think about where we are today, we just completed the first quarter. We've got three quarters to go. Feel good that we got out to a nice start to the year. As we started the year, we had a very back half loaded plan. Getting off to a good start makes us feel even better about us hitting our EPS range.
Operator: There are no more questions in the queue. This concludes our question-and-answer session. I would like to turn the conference back over to David Petratis for any closing remarks.
Dave Petratis: To wrap up our main themes you heard today, Allegion got off to a solid start in 2022. Demand remains robust and leading indicators are positive. We continue to work through supply chain challenges that macroeconomic events in China could delay in the improvement of some of the global supply chains. It's not unique to Allegion, but it does affect us. Pressure in electronic components is expected to persist. Inflation continues. We are aggressively producing price in all channels and products and we'll get the price cost equation back to positive this year. And last, we're excited to welcome Stanley's Access Technology business to the Allegion family and portfolio of products. Thank you and have a safe day.
Operator: The conference has now concluded. Thank you for attending today's presentation. You may now disconnect. | [
{
"speaker": "Operator",
"text": "Good morning, and welcome to the Allegion First Quarter 2022 Earnings Call. All participants will be in listen-only mode. [Operator Instructions]. Please note this event is being recorded. I'd now like to turn the conference over to Tom Martineau, Vice President of Investor Relations and Treasurer. Please go ahead."
},
{
"speaker": "Tom Martineau",
"text": "Thank you, Jason. Good morning, everyone. Thank you for joining us for Allegion's first quarter 2022 earnings call. With me today are Dave Petratis, Chairman, President and Chief Executive Officer, and Mike Wagnes, Senior Vice President and Chief Financial Officer of Allegion. Our earnings release, which was issued earlier this morning and the presentation which we will refer to in today's call, are available on our website at investor.allegion.com. This call will be recorded and archived on our website. Please go to slides two and three. Statements made in today's call that are not historical facts are considered forward-looking statements and are made pursuant to the Safe Harbor provisions of federal securities law. Please see our most recent SEC filings for description of some of the factors that may cause actual results to differ materially from our projections. The company assumes no obligation to update these forward-looking statements. Today's presentation and commentary include non-GAAP financial measures. Please refer to the reconciliation in the financial tables of our press release for further details. Dave and Mike will now discuss our first quarter 2022 results, which will be followed by a Q&A session. Please, for the Q&A, we would like to ask each caller to limit themselves to one question and one short follow-up and then reenter the queue. We would like to give everyone an opportunity given the time allotted. Please go to slide four and I'll turn the call over to Dave."
},
{
"speaker": "Dave Petratis",
"text": "Thanks, Tom. Good morning. And thank you for joining us today. We had a solid start to 2022. Overall, market demand remains strong and our organic growth and pricing action accelerated. We also announced on Friday the acquisition of the Stanley Access Technologies business, a highly strategic acquisition for Allegion, which is expected to close in the third quarter of this year. During Q1, we experienced robust demand on the non-residential side of the Americas, as well as strength in SimonsVoss, Interflex, and Portable Security within the International segment. Residential markets in the Americas remain stable. We have made progress on our product redesigns and alternative sourcing similar to the last two quarters, but were not able to fully meet the strong demand due to continued supply chain constraints. We did deliver good revenue growth in the quarter, driven primarily by price. The continued strength in demand is encouraging. With regard to the supply chain constraints, we expect electronic component challenges to persist and the latest lockdowns in China are likely going to impact global supply chains even further. Looking at price versus cost, we continue to experience high inflationary impacts from material cost, labor and freight. Price realization accelerated in Q1 and was the driver of organic growth in the quarter. With the recent spike in commodity prices, we have already announced additional price increases to take effect starting in Q2 across residential and non-residential markets, and we'll assess the need for further price increases as inflationary pressures continue. As we discussed in February, we are aggressively pursuing price across all products and in all channels to offset unprecedented inflation, and we expect price to exceed inflation further for the year. We are providing an updated outlook for 2022. We're raising our revenue outlook to reflect higher price, offsetting the additional inflation we're experiencing. We're holding our prior EPS range, and I'll share more detail on the outlook later in the presentation. Last, on the business review, I want to further highlight our announcement from last Friday. We have come to an agreement to acquire Access Technologies business from Stanley Black & Decker. This is the right asset for Allegion and it progresses our seamless access strategic focus, adding a category leader with an expansive service footprint. The business has a strong financial profile and is very complementary to the Allegion Americas core business and our portfolio. Close is anticipated in Q3. And we welcome the Access Technology employees, and we look forward to all of them joining our team. Now let's turn to the quarter performance for more details. Please go to slide 5. Revenue for the first quarter was $724 million, an increase of 4.2% compared to last year. Organic revenue growth was 6.4%. The organic revenue increase in the quarter was driven by significant price realization of 6%. Allegion International and Allegion Americas non-residential business also saw volume growth, driven by robust demand highlighted earlier. Americas residential volumes were down as that business had a tough comparable to last year, a drip attributed to the large channel load during Q1 of 2021. Mike will share more detail on the business segments in a moment. Adjusted operating margin decreased by 240 basis points in the first quarter. Continued inflationary pressures, productivity challenge, and currency headwinds drove most of the decrease. Incremental investments for future growth caused 60 basis points of the decline. Adjusted earnings per share of $1.07 decreased $0.13 or approximately $0.11 versus the prior. Lower operating income, a year-over-year tax rate increase and reduced other income was partially offset by favorable share count. Year-to-date available cash flow came in at $12 million, which was down 89% versus Q1 of last year, but is in line with our historical trends. Last year's high number was driven by lower working capital requirements due to the COVID-19 pandemic. As I've stated before, I firmly believe our vision and strategy in support of seamless access is more relevant than ever, and the Access Technology acquisition will add momentum. We remain bullish on construction and DIY markets for 2022 and continue to expect the trend of electronic adaption to fuel growth for many years. Mike will now walk you through the financials, and I'll be back to discuss our 2022 outlook."
},
{
"speaker": "Mike Wagnes",
"text": "Thanks, Dave. And good morning, everyone. Thank you for joining today's call. Please go to slide number 6. This slide reflects our earnings per share reconciliation for the first quarter. For the first quarter of 2021, reported earnings per share was $1.18. Adjusting $0.02 for charges related to restructuring expenses, the 2021 adjusted earnings per share was $1.20. Favorable share count increased earnings by $0.03 per share and the impact of acquisition and divestitures drove another $0.01 per share. Higher year-over-year tax rate reduced earnings by $0.02 per share and the combination of interest and other income drove another $0.03 reduction. Investment spending had a $0.04 per share drag on earnings as we continue to invest in the business to fuel long-term growth, expand our electronics capabilities, and drive our seamless access strategy. Operational results decreased earnings per share by $0.08, driven by significant inflation, productivity challenges associated with supply chain pressures and unfavorable currency, which more than offset the favorable impacts of price. This results in adjusted first quarter 2022 earnings per share of $1.07, a decrease of $0.13 or 10.8% compared to the prior year. Lastly, we have a $0.02 per share reduction for the net of a non-operating gain and charges related to restructuring and acquisition costs. After giving effect to these items, you arrive at the first quarter 2022 reported earnings per share of $1.05. Please go to slide 7. This slide depicts the components of our revenue performance for the quarter. I'll focus on the total Allegion results and cover the regions on their respective slides. As indicated, we had 6.4% organic revenue growth in the first quarter, driven by improved price realization. Although the company's volume was essentially flat, we did see strength in Allegion International and the Allegion Americas non-residential business. Currency headwind and divestitures more than offset the impact of acquisitions, bringing the total reported growth to 4.2% in the first quarter. Please go to slide number 8. First quarter revenue for the Americas segment was $528.2 million, up 5.9% on both a reported and an organic basis. The segment delivered significant price realization. Non-residential price was strong and residential business experience improved price realization. The price helped the non-residential business grow low-double digits. Residential was down mid-single digit against a tough comparable from last year's channel load in, which drove Q1 of 2021 to be up low 20s percent. Electronics revenue was up low-single digits as component shortages continued to dampen our growth. Americas adjusted operating income of $123.9 million decreased 8.6% versus the prior-year period and adjusted operating margin for the quarter was down 370 basis points. The Q1 margin performance was a sequential improvement for the Americas as we expect to see further improvements as we progress through the year. The decrease in margin was driven by continued inflationary pressures, productivity challenges associated with supply chain shortages and volume deleverage. Incremental investments had a 60 basis point impact on margins as well. Please go to slide 9. First quarter revenue for our International segment was $195.4 million, flat to last year and up 7.6% on an organic basis. The organic growth was driven by strength in SimonsVoss, Interflex and Global Portable Securities businesses. The segment also saw solid price realization contributing to the organic growth. The strong organic growth was offset by unfavorable currency and divestitures. International adjusted operating income of $20.4 million increased 13.3% versus the prior-year period. Adjusted operating margins for the quarter increased by 120 basis points to 10.4%. The margin increase was primarily driven by price and productivity exceeding inflation, as well as solid volume leverage, which more than offset currency and the 50 basis point headwind due to investment spending. Please go to slide 10. Year-to-date available cash flow for the first quarter of 2022 came in at $11.8 million, which is a decrease of more than $93 million compared to the prior-year period. The $11.8 million is more in line with historical trends as the business tends to have modest cash flows in the first quarter of a typical year. Last year's spike in cash flow was driven primarily by lower working capital needs due to COVID. The business continues to generate strong cash flow and we remain committed to efficient and effective use of working capital. The amount of available cash generated in the first quarter was as expected and the balance sheet continues to be in a healthy position. We expect to use excess cash generated during the remainder of the year to pay down short-term debt taken on to complete the acquisition of the Stanley Access Technologies business. I will now hand it back over to Dave for an update on our full-year 2022 outlook."
},
{
"speaker": "Dave Petratis",
"text": "Thank you, Mike. Please go to slide number 11. Non-residential market demand in Americas continues to be robust. All leading indicators are positive and the level of institutional specifications continues to be strong. The residential business is stable and the under-supply of homes over the last decade will continue to be a factor driving growth in the residential segment. We have been aggressive in pursuing price in all channels and products and saw substantial improvement in price realization in Q1. We have announced additional price increases to go in effect starting in Q2. Given the continued supply chain challenges, we still expect the revenue performance to be better in the second half than in the first half. With these parameters in place, we are raising the outlook and are now projecting total inorganic revenue in the Americas to be up 10% to 11.5% in 2022. In Allegion International, markets have remained solid, led by our Germanic and Global Portable Security business. The International segment also experienced sequential improvement in price realization, as we are pursuing price aggressively in those markets as well. Currency headwinds will continue to reduce total growth. For Allegion International, we are raising our outlook for total revenue growth to 0.5% to 2%, with organic growth of 5% to 6.5%. All in, for total Allegion, we're raising the total revenue growth outlook to a range of 7.5% to 9% and organic revenue to increase 8.5% to 10%. These increases to prior outlook are driven primarily by higher price realization. It's important to note this updated outlook does not include any impacts from the Stanley Access Technology acquisition. Please go to slide number 12. For EPS, we are holding to the ranges provided during our last earnings call. Reported EPS is expected to be $5.50 to $5.70 per share with an adjusted EPS range of $5.55 to $5.75 as the increased revenue from the additional price realization is offset by higher inflationary cost. The outlook continues to assume a full-year adjusted tax rate of approximately 13% and the share count assumption has been updated to approximately 88.5 million. The unfavorable impact of the higher share count assumption is offset by operational improvements, leading us to hold the prior EPS outlook. Our outlook for available cash flow is being raised and it's now projected to be $470 million to $490 million. Please go to slide 14. Before we go to Q&A, I want to talk a bit more about our acquisition of the Access Technologies business. For those of you who have missed Friday's conference call, I invite you to visit our website and listen to the archived webcast. I want to repeat the benefits we saw in this acquisition. It's a highly strategic combination that expands our presence in security markets and unlocks greater values for our employees, customers, distributors and shareholders. We will bolster our geographic leadership in Allegion Americas through complementary verticals and further penetrate our markets with complementary products and service offerings. Cross-selling opportunities will create more room for mutual growth, and we will enhance and expand a service business that drives customer value in automatic entrance solutions, providing ongoing and consistent revenue streams. Allegion will significantly expand its breadth of access, egress and access control solutions. In return, the Access Technology business will gain specification and institutional market expertise, strong new end user and architectural relationships and distribution networks as well as additional resources from Allegion. Along with Allegion's strong balance sheet, significant cash flow and disciplined capital allocation, we believe it will create a stronger financial profile, a stronger value proposition and new opportunities that enhance shareholder value. Please go to slide 15. As we look at this acquisition, we believe there are many ways to deliver on our promise to create value for Allegion shareholders. We're creating value with a more comprehensive portfolio of solutions, adding a category leader and addressing a current portfolio gap in Allegion's core businesses. We're also adding North American service capabilities to grow seamless access in a connected world. The acquisition of Access Technologies business is the right opportunity for us. It expands our innovation and electronic capabilities, brings a strong business with good market fundamentals, and complements the core markets and specification expertise of our Allegion Americas segment. We believe the acquisition will strengthen our financial profile. It provides clear synergy and incremental revenue opportunities. A balanced and disciplined capital allocation strategy will continue to be a top priority for Allegion and having a strong balance sheet and cash flow to maintain financial flexibility that supports that. Ultimately, we believe the automatic entrance solution and service business are a strategic investment that supports seamless access, and the Access Technology acquisition will create value for our shareholders. We're excited to welcome the business and its people to the Allegion family. With that, Mike and I will be happy to take your questions."
},
{
"speaker": "Operator",
"text": "[Operator Instructions]. Our first question comes from Timothy Wojs from Baird."
},
{
"speaker": "Timothy Wojs",
"text": "Let's jump on the quarter. Maybe just to talk a little bit about what you're seeing from an order and kind of a backlog perspective. How are you kind of thinking about the revenue cadence as you kind of think through the year, I'm just trying to kind of understand the visibility that you've got to the back half of the year and what you're building in for any risks that maybe the building timelines might elongate just from a construction timeline perspective and maybe shift some revenue into 2023."
},
{
"speaker": "Dave Petratis",
"text": "I think as we think about the path forward in terms of order activity, incoming orders, especially in the commercial business, institutional business, extremely robust. And as I've been traveling around the last few weeks, you also get that feel that construction activity across the country, extremely robust. As we look at our macroeconomics, it says, in the commercial, institutional, we're beginning the upcycle, which says we're going to get stronger as we go through the year in terms of product out the door. I would say supply chains remain under pressure, but have improved from the second half of last year. And then, I think you've got to think about res. When I think about res, it probably shows my age a little bit. Residential was extremely difficult in the last decade. And as I think about the under-supply of housing across the nation, I think we're going to continue to bang out 1.2 million to 1.6 million, even with higher interest rates. So, I feel very good about overall demand. I think about that going out four to six quarters and then we'll see."
},
{
"speaker": "Timothy Wojs",
"text": "I think in the prior guidance, just on the EPS cadence, Mike, I think it was kind of 60% weighted to the back half. Is there any difference to that today just given kind of where you are in the first quarter or is that kind of similar?"
},
{
"speaker": "Mike Wagnes",
"text": "Tim, as you think about it, we got off to a decent start. Right? I would say it doesn't move materially from that 60% that we said at the beginning of the year. First quarter was okay or stronger than maybe the original assumption assumed. And so, it could move a percent or so or two, but it's roughly around that 60% that we gave in the beginning of the year."
},
{
"speaker": "Timothy Wojs",
"text": "Is there any change to kind of the price cost assumptions on a dollar basis for the year?"
},
{
"speaker": "Mike Wagnes",
"text": "I would say as you look at our guide, we raised our guide on the top line, didn't raise the guide on the EPS because that is price realization that is fighting the inflationary pressures. And so, there will be a higher percentage going to price than we assumed in the beginning of the year. So, if in the beginning of the year, we said roughly 50/50, that's going to be higher by the raise of the guide. So, you're going to be looking at that 60% to 65%."
},
{
"speaker": "Operator",
"text": "Our next question comes from John Walsh from Credit Suisse."
},
{
"speaker": "John Walsh",
"text": "Nice quarter. Just kind of wanted to understand the change in the sales guidance. So, sounds like it's being driven by price, but what kind of gave you the confidence to take it higher, given that supply chains were still tough. You have the China COVID impacts. I understand that demand is really robust and you have the strong backlog, but kind of what gave you the confidence that you'll be able to get the parts you need to kind of hit a higher top line."
},
{
"speaker": "Mike Wagnes",
"text": "John, as you think about our – so the price, we feel really strong. We've announced those increases already. So, they're in the marketplace. With respect to the overall market demand, even stronger than when we exited Q4. So Q1, real strong market demand in non-residential. And then lastly, we've taken actions to qualify additional suppliers and to work on bringing in new supply base. Those activities have gained traction in the first quarter. And so, that does give us confidence that, in the back half of the year, we'll get additional supply from additional suppliers that we can get more volume out."
},
{
"speaker": "Dave Petratis",
"text": "I'd add to it as well. Versus the second half of last year, labor has improved in its availability, freight has improved modestly. And I say modestly, the rise in COVID in China, the lockdowns will have some implications. We've got some exposure, but it's not major. And I think particular on the mechanical inputs to our business, redesign, qualifying second suppliers has really strengthened our confidence. That leaves the electronics element. As we think about going forward and our guide, that's based on allocations. If chip availability gets better across the board, we'll be even stronger."
},
{
"speaker": "John Walsh",
"text": "I guess just thinking about some of the moving pieces with the margins, I know before we were thinking Americas should see better than normal just on mix and volume recovery. Obviously, we have the higher inflation that's getting passed through. But could you just maybe help calibrate either total Allegion level or within Americas kind of what you're thinking the incremental margins will be for the year or however you'd like to talk to it?"
},
{
"speaker": "Mike Wagnes",
"text": "John, as you think about Q1, sequential improvement versus what you saw in the fourth quarter, we'll expect to see improvements each quarter sequentially, such that the back half, you start to really see that margin expansion versus the prior year. So, sequential improvement and then expansion in the back half. And then, when you model it, just take into account that there's substantial inflationary pressures. We're driving price to offset it from a dollar amount, but that raises the denominator in the margin calc without raising the numerator from the profit because it offsets it."
},
{
"speaker": "Operator",
"text": "Our next question comes from Julian Mitchell from Barclays."
},
{
"speaker": "Julian Mitchell",
"text": "You have Matthew Shaffer on from Julian Mitchell's team. So, you guys mentioned that pricing is expected to beat inflation in 2022. Can you maybe talk to the cadence of the price cost differential through the remaining quarters?"
},
{
"speaker": "Mike Wagnes",
"text": "As you think of the first quarter, we were slightly negative. We provide that information in our 10-Q. So, you'll see it in our 10-Q by region and in total. But, say, $7 million underwater in the first quarter. As you progress throughout the year, think of Q2 being closer to breakeven-ish and then Q3 and Q4 substantial price in excess of that inflation or price and productivity in excess of the inflation. So, gets better as the year progresses and then significantly positive in the back half."
},
{
"speaker": "Julian Mitchell",
"text": "Just a follow-up for me. Electronics was up low-single digits in Americas Q1 after being pretty weak in 2021. Just curious the expectation is for 2022 growth for electronics."
},
{
"speaker": "Mike Wagnes",
"text": "We don't provide individual growth rates, electronics versus mechanical. But if you think about our performance in the first quarter, substantial improvement from what you saw Q4, as you mentioned. The demand is there. The demand will be limited by the ability to get the supply. So, I would just say, take it into account when you consider our total guide for revenue, understanding that it's better than what you saw in the fourth quarter. And in the back half, we do comp against those easier comparables that we had in the back half of last year."
},
{
"speaker": "Operator",
"text": "Our next question comes from David MacGregor from Longbow Research."
},
{
"speaker": "Joseph Nolan",
"text": "This is Joe Nolan on for David MacGregor. On the residential business, you mentioned revenues were down mid-single digits. Are you able to talk about what units did in that business? And then I'm aware it's always been a difficult channel to get pricing in. So, if you could just talk about how the recent price increase is trending in terms of how that's gone into the channel."
},
{
"speaker": "Mike Wagnes",
"text": "If you look at our resi business, we mentioned earlier that it had positive price realization for the quarter, not as strong as non-res. From a unit perspective then, you can see that units would be a little less than the total growth because we did have the positive price realization. More importantly, moving forward, we've taken actions in residential to drive price that has been announced to the marketplace and goes into effect in the second quarter. So, we expect to see better price realization in the second quarter and onward through 2022."
},
{
"speaker": "Joseph Nolan",
"text": "Can you just give an update on trends in spec writing activity, just the size of projects, your content, order size, timing, that sort of stuff?"
},
{
"speaker": "Dave Petratis",
"text": "I would say spec writing activity continues to be robust. You can look at the ABI. I think the march ABI was at like a 58. I'd say a good range of projects with strength in the medical and hospital areas, which is good for Allegion. Can't really get into the size of these, but the order activity is good, and I think reflects the strength we're seeing in our incoming bookings."
},
{
"speaker": "Operator",
"text": "Our next question comes from Brian Rutenberg from Imperial Capital."
},
{
"speaker": "Brian Rutenberg",
"text": "Great quarter. So I'd like to break things down a little bit on gross versus operating margins. So, gross margins were down from fourth quarter and obviously down year-over-year. Do you expect gross margins to increase from first quarter to second quarter and then progress couple hundred basis points per quarter? Is that what you're saying?"
},
{
"speaker": "Mike Wagnes",
"text": "Yeah, I would say, if you think about the gross margin, that's inflation in excess of pricing that we talked about in the 10-Q. As you think about margins, in general, they'll improve as we get throughout the year. So, we should see both the gross and the operating improve as we move throughout 2022."
},
{
"speaker": "Brian Rutenberg",
"text": "So, on the operating basis, we'll also see improvement sequentially with that because there's going to be lower SG&A or just increased leverage from the top line and more gross profit."
},
{
"speaker": "Mike Wagnes",
"text": "As you get significant growth in the back half of the year, Q2, Q3, Q4, you leverage that SG&A base. So, that does help also the operating margins."
},
{
"speaker": "Dave Petratis",
"text": "Volume is a very beautiful thing in this business. And as we go through the second half, the business leverage quite nicely."
},
{
"speaker": "Operator",
"text": "The next question comes from Andrew Obin from Bank of America."
},
{
"speaker": "Unidentified Participant",
"text": "You have Sabrina Abrams [ph] on from Andrew Obin's team. I understand that you mentioned you're sort of expecting them, but in the past month, have you been seeing worsening supply chain impacts from the COVID-related China shutdowns and from the Russia-Ukraine conflict?"
},
{
"speaker": "Dave Petratis",
"text": "I'd say we have very little exposure to Russia. I'd say the bigger effect there has been pricing of raw materials. And we'll adapt to that with price. As we think about China, it's certainly serious. We have exposure there, but it has not affected us in April. And I think we've got the adaptability to be able to work through that. We're not totally immune, but are in geographic production capabilities position us well."
},
{
"speaker": "Unidentified Participant",
"text": "I understand that you're raising the revenue guide and maintaining the EPS range on inflation. But I guess I'm curious, you guys had a strong EPS beat in 1Q and are maintaining that guide. Are there any other headwinds we should be thinking about besides inflation in the remainder of the year?"
},
{
"speaker": "Mike Wagnes",
"text": "As we think about where we are today, we just completed the first quarter. We've got three quarters to go. Feel good that we got out to a nice start to the year. As we started the year, we had a very back half loaded plan. Getting off to a good start makes us feel even better about us hitting our EPS range."
},
{
"speaker": "Operator",
"text": "There are no more questions in the queue. This concludes our question-and-answer session. I would like to turn the conference back over to David Petratis for any closing remarks."
},
{
"speaker": "Dave Petratis",
"text": "To wrap up our main themes you heard today, Allegion got off to a solid start in 2022. Demand remains robust and leading indicators are positive. We continue to work through supply chain challenges that macroeconomic events in China could delay in the improvement of some of the global supply chains. It's not unique to Allegion, but it does affect us. Pressure in electronic components is expected to persist. Inflation continues. We are aggressively producing price in all channels and products and we'll get the price cost equation back to positive this year. And last, we're excited to welcome Stanley's Access Technology business to the Allegion family and portfolio of products. Thank you and have a safe day."
},
{
"speaker": "Operator",
"text": "The conference has now concluded. Thank you for attending today's presentation. You may now disconnect."
}
] | Allegion plc | 241,782,379 |
ALLE | 4 | 2,023 | 2024-02-20 08:00:00 | Operator: Good morning, and welcome to the Allegion Fourth Quarter 2023 Earnings Call. All participants will be in listen-only mode. [Operator Instructions] After today’s presentation, there will be an opportunity to ask questions. [Operator Instructions] Please note, this event is being recorded. I would now like to turn the conference over to Josh Pokrzywinski, Vice President of Investor Relations. Please go ahead.
Josh Pokrzywinski: Thank you, Drew. Good morning, everyone. Thank you for joining us for Allegion's fourth quarter and full year 2023 earnings call. With me today are John Stone, President and Chief Executive Officer; and Mike Wagnes, Senior Vice President and Chief Financial Officer of Allegion. Our earnings release, which was issued earlier this morning, and the presentation, which we will refer to in today's call, are available on our website at investor.allegion.com. This call will be recorded and archived on our website. Please go to Slide 2. Statements made in today's call that are not historical facts are considered forward-looking statements and are made pursuant to the safe harbor provisions of federal securities law. Please see our most recent SEC filings for a description of some of the factors that may cause actual results to differ materially from our projections. The company assumes no obligation to update these forward-looking statements. Today's presentation and commentary include non-GAAP financial measures. Please refer to the reconciliation in the financial tables of our press release for further details. Please go to Slide 3, and I'll turn the call over to John.
John Stone: Thanks, Josh. Good morning, everyone, and thanks for joining us. I'd like to start today by recognizing that 2023 was a year of strong execution by the entire Allegion team. This performance reflects the value we add for our customers, the strength of our distribution partners, as well as the quality of our brands and the capabilities and expertise of our employees. Let's walk through some highlights of the quarter and the year. After celebrating our 10th anniversary as a standalone company in December, we closed the year with record revenue, adjusted operating income, and adjusted EPS. Reinforcing the thesis behind our seamless access strategy, electronics demand remained strong. We delivered approximately 20% organic growth in electronics for the year as supply chains normalized, and that's on top of mid-teens organic growth in the prior year. We sustained a high operating cadence and expanded our industry leading margins in the quarter. And for the full year, our adjusted operating margin performance was 22.1%, up 160 basis points. Simply stated, the Allegion team delivered on price and productivity, bringing margins back to pre-pandemic levels, with room to expand further in 2024 and beyond. Our balance sheet and cash flow generation are strong. We ended the year under 2 times net debt to EBITDA, which sets up a 2024 return to the balanced capital deployment you've come to expect from Allegion. When you look at our past decade, this team has delivered solid results and executed well through a variety of macroeconomic backdrops. We've built on the strength of 100 year old brands, consistently meeting customer needs and meeting our commitments to shareholders. We've operated with excellence, sustained the highest margins in the industry, and are still pioneering safety, better securing people and their property where they live, learn, work, and connect. Driven by our vision of enabling seamless access and a safer world, we're proud of this track record, we're proud of what we delivered in 2023, and we're excited about the momentum we're carrying into 2024. Please go to Slide 4, and let's talk about our capital allocation strategy in action. Reflecting on Allegion's first 10 years, we've had a roughly even split between inorganic growth and the return of capital to shareholders through dividends and share repurchases. We remain committed to balanced, consistent capital allocation, and having quickly delevered from the Access Technologies acquisition, our balance sheet supports this strategy. As we move into 2024, we will continue investing for organic growth, prioritizing projects and solution that drive seamless access forward. One recent example in new product development is Schlage's next generation of innovative electronic locks, the XE360. This is the latest wireless lock family from Schlage, designed with flexibility and interoperability in mind. With solutions for perimeter and interior doors, this series has the security and access features most looked for by multifamily and light commercial properties at attractive price points. It leads with open architecture, supports the latest credentialed technologies, and integrates with the Allegion and our partner systems. In addition, Schlage's innovative FleX Module allows the XE360 series to be easily upgraded in the field to allow migration from an offline to a network solution and to adapt to emerging trends in security and connectivity down the road. Next, Allegion will continue to be a dividend-paying stock. You can expect our dividends to grow commensurate with earnings over the long term, and we've just announced our 10th consecutive annual increase. We also expect to grow through acquisitions. Bolt-on acquisitions that fill portfolio gaps in the hardware space and high margin, recurring revenue business in the access solutions space will remain priorities. Larger deals like Access Technologies may be more episodic, but we will be disciplined and have demonstrated the ability to quickly delever. Boss Door Controls, which we closed this month, is a classic bolt-on that both complements and expands how we go-to-market in the UK. This acquisition bolsters our local business with a strong architectural channel, flexible supply chain, and also positions us to increase our spec-driven business there in the future. Lastly, with regards to share repurchases, as we've said, at a minimum, we will continue to offset incentive compensation. And as you saw in the fourth quarter, we will make additional share repurchases as appropriate. Mike will now walk you through fourth quarter financial results, and I'll be back to discuss our full year 2024 outlook.
Mike Wagnes: Thanks, John, and good morning, everyone. Thank you for joining today's call. Please go to Slide number 5. As John shared, Allegion continued to execute at a high level and delivered another solid quarter. Revenue for the fourth quarter was $897.4 million, an increase of 4.2% compared to 2022. Organic growth of 2.6% was driven by our Americas non-residential and Access Technologies businesses, offset by declines in residential and international. Adjusted operating margin and adjusted EBITDA margin increased by 130 basis points and 120 basis points, respectively, in the fourth quarter, driven by price and productivity in excess of inflation and investment. I am pleased with the margin performance as we have recaptured the margin loss during the supply chain disruptions experienced in late 2021 and early 2022. Our operating model and strong execution have positioned us well for future margin expansion. Adjusted earnings per share of $1.68 decreased $0.01, or approximately 0.6% versus the prior year. Operational performance drove growth of $0.17 per share, with the offset coming from tax, driven by the timing of discrete items versus the prior year. John will cover the outlook later in the presentation, however, I want to note that our tax rate will migrate to between 18% and 19% in 2024, inclusive of the implementation of global minimum tax. We expect Allegion's structural tax rate will be in the high-teens over the planning horizon we laid out at our Investor Day in May. Finally, full year available cash flow for 2023 was $516.4 million, a 30.6% increase versus last year, driven by higher earnings and improved working capital performance. I will provide more details on cash flow and balance sheet a little later in the presentation. Please go to Slide number 6. This slide provides an overview of our quarterly and full year revenue. I will review our enterprise results here before turning to our respective regions. Organic growth in the quarter was 2.6%, a strong price realization offset pressure on volumes. Currency and acquisitions drove additional favorability in the quarter, bringing the total reported growth to 4.2%. On a full year basis, organic revenue growth was 5.2% overall, with Americas at 7.4%. Our international business was down 2.5% for the year. Our full year organic growth was led by our electronics and software solutions, which grew globally by approximately 20% in 2023, with both regions in double-digits. Please go to Slide number 7. Our Americas segment continues to deliver strong operating results in the fourth quarter. Revenue of $704.6 million was up 3.7% on both a reported and organic basis as favorable pricing offset lower volumes. Our Americas non-residential business was up mid-single digits against a prior-year comp that grew in the mid-20%’s. On a full year basis, this business had double-digit organic growth in 2023. Residential markets are soft, with our business down low-single digits in the quarter and for the full year, as higher interest rates continue to impact new and existing home sales. Our Access Technologies business delivered organic growth of mid-single digits in Q4. Americas electronics growth remained strong on a multi-year basis, with mid-single digit growth in the quarter on top of the nearly 50% comparison in Q4 2022. Our Americas adjusted operating income of $188.4 million increased 10.8% versus the prior year period, while adjusted operating margins and adjusted EBITDA margins for the quarter were up 170 basis points and 190 basis points, respectively. The team executed well. We are performing more efficiently, driving price and productivity, and we delivered margin expansion every quarter in 2023. Please go to Slide 8. Our International segment continues to execute well in a challenging macroeconomic environment. Revenue of $192.8 million was up 5.9% on a reported basis and down 1.3% organically. Price realization was more than offset by lower volumes associated with soft end market demand. Currency and acquisitions were a tailwind this quarter, positively impacted reported revenues by 4.4% and 2.8%, respectively. International adjusted operating income of $32.3 million increased nearly 13% versus the prior year period. We also saw improvement in adjusted operating margins and adjusted EBITDA margins of 110 basis points and 100 basis points, respectively. The team delivered margin expansion for Q4 and the full year despite a challenging topline, highlighting the healthier, more resilient business portfolio we have within our International segment. The acquisition growth I mentioned earlier is primarily driven by our plano business, a tuck-in software-as-a-service business we acquired early 2023, which is accretive to both growth rates and margins. Please go to Slide number 9. As I mentioned earlier, year-to-date available cash flow came in at $516.4 million, up nearly $121 million versus the prior year. This increase is driven by higher earnings and working capital improvements, partially offset by higher capital expenditures. You can look for Allegion to continue to invest in our business and convert earnings to cash. Next, working capital as a percent of revenue improved versus the prior year, driven by higher inventory turns as supply chains normalized. Finally, our net debt to adjusted EBITDA is down to 1.9 times as we successfully delevered following the Access Technologies acquisition. We are now back to historical leverage levels, which demonstrates our proven track record of effectively deploying capital, while maintaining both our leverage profile and our investment grade credit rating. Our business continues to generate strong cash flow and our balance sheet continues to be in a healthy position. I will now hand the call back over to John for our 2024 Outlook.
John Stone: Thanks, Mike. Please go to Slide 10. And before we get to guidance, I want to spend a moment on what we see as a couple of key drivers for 2024, including macroeconomic inputs that inform our outlook. We're expecting more modest inflation in 2024, enabling normal levels of margin expansion from net price and productivity. We report these to you as aggregate price, productivity, inflation, and investments shown in the left-hand chart. Since the beginning of 2019, we've averaged approximately 60 basis points of margin contribution annually from net price and productivity. This has been a hallmark of the business over time and it's a key driver of our 2024 outlook. We're expecting a stable non-residential environment, underpinned by healthy institutional markets. You can see Dodge starts for institutional have shown steady growth in the past few years, contrasting the higher volatility in commercial leaning verticals. As you all know, Allegion is a late-cycle business, and starts can lead our business by a year or more. We're not expecting many market tailwinds, however, we believe the visibility and stability of late-cycle institutional verticals, as well as our large installed base, will allow us to deliver organic growth. Please go to Slide 11, and let's walk through the outlook for 2024. We expect total and organic revenue growth in the Americas to be 1.5% to 3.5%. This is led by our non-residential business, forecast to grow low to mid-single digits organically. Please note, the non-residential business is inclusive of Access Technologies, starting this year. The residential business is expected to be flat to down slightly on an organic basis. Overall, for the Americas, we are expecting more normal seasonality with tough comps in the first quarter. For Allegion International, we expect total revenue to be up 1.5% to 3.5% and minus 1% to up 1% on an organic basis. Inorganic growth includes the recently announced acquisition of Boss Door Controls. While mechanical markets remain sluggish in international, I'm pleased with how the team executed to close out the year. We have a high quality portfolio and continue to see good growth potential in our international electronics and software solutions businesses. All in, for the company, we are projecting total revenue growth of 1.5% to 3.5%, with organic revenue growth of 1% to 3%. We expect to drive margin expansion consistent with our historical framework. We're confident in the execution playbook we have for 2024, given cost actions taken in '23 and a more modest inflation environment. Based on our strong operating momentum, prior cost actions, and more normalized inflation, we are projecting an adjusted EPS outlook in the range of $7 and $7.15. This represents growth of approximately 1% to 3% over the prior year period, inclusive of a $0.37 headwind from tax. Lastly, we expect our outlook on available cash flow to be in the range of $540 million to $570 million. While we are committed to balanced and consistent capital deployment, this guidance does not include future capital deployment beyond the recent acquisition of Boss Door Controls. Please go to Slide 12. Bottom line, I am very proud of the entire Allegion team's 2023 performance and grateful for the strong distribution partners and loyal customers we have. As we look ahead to 2024, we will continue to build on the Allegion legacy and deliver new value in access. Our team is focused on relentless execution of our strategy and balanced capital deployment against what we expect to be a stable market backdrop. We remain committed to putting our customers first and delivering our vision of enabling seamless access and a safer world. I look forward to updating you more in the future as we work to achieve another record year for Allegion and propel our company into its next decade of growth. With that, let's turn to Q&A.
Operator: Thank you. We will now begin the question-and-answer session. [Operator Instructions] The first question comes from Joe O'Dea with Wells Fargo. Please go ahead.
Joe O'Dea: Hi. Good morning.
John Stone: Good morning, Joe.
Mike Wagnes: Good morning, Joe.
Joe O'Dea: Wanted to start on op margin in '24. It looks like year-over-year margin expansion maybe in the 60 bps kind of range. So it would fit within the 50 bps to 100 bps, I think, medium-term target, but also comes off a pretty tough comp where you just did 160 and so, I think maybe a little bit better than anticipated. Can you just talk about the drivers of that year-over-year expansion that's embedded in terms of price, productivity, inflation, sort of how much of that is driven by it? And then also how much is already kind of in there in terms of carryover price, price that you've announced, cost actions that you've taken versus how much you still have to go get?
Mike Wagnes: Yes. Thanks for the question, Joe. You're correct in that. If you look at margin expansion, a big driver of that is the price productivity in excess of inflation and investments. As you look at our topline guide, our pricing is going to be a driver of growth. If you think about midpoint, it's going to be the biggest driver of growth. As a result, you will get margin expansion when you think about the '24 year. And in addition, when you think about the actions we've taken, biggest driver of price for us is our non-residential business in the Americas. Those pricing actions are -- have already been announced and in the marketplace. And then from cost actions, we've taken some cost actions in the fourth quarter of '23. As a result, we're positioned nicely. You should see an acceleration of productivity in 2024. So, when you think about our margin outlook, the actions have been taken and we're positioned well in order to achieve that outlook.
Joe O'Dea: That's really helpful. And then in terms of non-res and the growth outlook in Americas, can you unpack a little -- that a little bit by vertical then to talk about sort of electronics versus mechanical, but then institutional versus commercial, I think a lot of focus on sort of office and headwinds out there. But what you see on kind of new versus renovation, just trying to understand some of the moving pieces within that growth in non-res.
John Stone: Yes, Joe. This is John. I appreciate the question. I think as we showed, the institutional verticals, they're less volatile than the commercial leaning verticals and have still been flashing some positive data on starch. So we -- and our businesses, as you know, is a little bit heavily tilted to those vertical. So we feel good about that space. It's stable. The commercial, that's a wide basket of end users. So it's everything from data centers to retail to office to multifamily. We put that in the commercial bucket as well. And certainly, commercial office on the new construction side is soft and has been for quite some time. We think that will continue. Multifamily has been slowing as well. So we're not counting on a dramatic snap back there. We do see strength like everybody has been talking about in data centers, that's a highly spec application of our high end electronic products. And I'd say on balance, you add all that up, the puts and the takes, and complement that with -- again, if you think of Allegion has about 50-50 new construction to aftermarket exposure. The aftermarket is quite stable across all verticals, break fix, repair and maintenance, even some tenant turnover here in commercial office. So the aftermarket is still, I think, pretty stable and underpins the overall portfolio, that's what leads us to come up to low to mid-single digits for growth in non-res. The only other item to mention since we do include Access Technologies and non-res for this year and going forward is big retail chains with store renovations and things like that also makes for a rather stable outlook on the Access Tech, the automatic doors business, that's kind of how we would see the whole basket.
Joe O'Dea: I appreciate the details. Thanks.
John Stone: Thank you.
Operator: The next question comes from Joe Ritchie with Goldman Sachs. Please go ahead.
Vivek Srivastava: Hi. This is Vivek Srivastava on for Joe. Thanks for the question. My first question is just on the cadence of organic growth. It just looks like in first quarter '23, you had a big backlog burn, so that will be a tougher comp. Is it fair to say, you probably have a slightly negative organic growth in first quarter and then it ramps up to maybe closer to mid-single digit level in the second half?
Mike Wagnes: Yeah. Thanks for the question. Clearly, Q1 is going to be our most challenging comp when you think about the '24 year. We don't give quarterly guidance. But if you recall, we burned through that backlog Q1 of '23. So when you think about our cadence for top line, ‘23 was not a normal year, right? When we think about '24, I think there's more normal seasonality. So we're a little more back half loaded than first half loaded from a top line. Don't want to get individual quarter forecasting. As you know, we don't give quarterly guidance. But just remember, a little more back half than first half from the top line as a company and that we do have that really challenging comp in the first quarter when you model year-over-year.
Vivek Srivastava: Thanks. That's helpful. And then just a follow-up on the International segment margins. It was impressive to see that in fourth quarter despite negative organic growth, you expanded over 100 basis points of margin. Could you talk about what drove that strong margin expansion in fourth quarter and then just expectations in that segment for margins in 2024?
Mike Wagnes: Yeah. Super pleased about our international business when you think about the margin performance. If you look at our 10-year history, that business is breakeven when we spun out a decade ago. Now we’re driving good healthy margin expansion. It’s a much healthier portfolio. When you think about that electronics and software businesses, we’ve been talking about the last few years, strong – stronger businesses from a margin perspective and top line. So really doing some good work to drive productivity in the region, pricing excellence. Tim, he took the excellence we had in the Americas and brought that to International as well. So a lot of things favorable for International as we think about the business for ‘23 and more importantly, moving forward.
Vivek Srivastava: Great. Thanks.
Operator: The next question comes from Jeff Sprague with Vertical Research Partners. Please go ahead.
Jeffrey Sprague: Hi. Thank you. Good morning, everyone. Just coming back to just the seasonality comment. I know you don't do want to get into quarters, but are you comfortable with us kind of assuming kind of the pre-COVID period, call it, 2014 to 2019 is what you mean by normal seasonality as we look into Q1?
Mike Wagnes: Yeah, Jeff. If you look at half, I'd like to talk about it in halves. I think that '14 to '19 is kind of a normal seasonality when you look at the half years. And we expect to be more in line with that a little more back half weighted than first half.
Jeffrey Sprague: Okay. Great. You just give us a little more color on Boss to size the profitability, what impact, if any, it has on international margins?
Mike Wagnes: Yeah. Jeff, if you think about that business, organic -- I'm sorry, inorganic growth for International, you would assume -- about half of that inorganic growth we've highlighted in the outlook is coming from the Boss Door acquisition, the other half coming from currency. So you could see it's a pretty -- it's a smaller acquisition. It's not a massive size. So from a price now on the top line, you have an idea that it's not a huge acquisition, but it's a nice complement to our business. We're really strong at writing specifications in North America. This is bringing that spec writing capability to a large country in Europe like the U.K.
Jeffrey Sprague: Great. And then, hey, John, earlier in your opening remarks, you mentioned this new Schlage electronic product. Can you just maybe provide a little bit more color overall on what you're expecting for electronics growth in 2024? Is there a measurable impact on your investment levels to drive that, etc.?
John Stone: Yeah. It's a good question, Jeff. And I think if listen to the prepared remarks in 2022, strong electronics growth, 2023, around 20% electronics growth. So I mean, over the long haul, long term, like we said at Investor Day back in May last year, think of our electronics performance of high-single, low double-digit growth driver for Allegion. We’ve definitely given backlog burn and things in 2023, we’ll have some tough electronics comps here and there. But demand is still strong. The secular trend still remains this migration to electronic access control for better security and better convenience is still moving and underway. We’re still investing there. XE360 is just on that was very timely to highlight for us given the flexibility and interoperability that, that brings to the market. And also just to highlight the ease of upgrade of that in the field. We’re also pretty excited about that. I mean the flexibility that’s going to offer the end users is quite interesting and quite attractive for us. I think as you – as we move through 2024, you can continue to see, I think, an emphasis from us on things like product vitality, you’re going to see a steady stream of new product launches just like this, and we look forward to highlighting those for you.
Jeffrey Sprague: All right. Thank you.
Operator: The next question comes from Julian Mitchell with Barclays. Please go ahead.
Julian Mitchell: Hi. Good morning. Maybe just the first question. You talked about some of the color by end market vertical earlier. And maybe one, I guess I wanted a bit more color on was the education vertical. I think it's one of your largest. So maybe any sense of kind of scale of how much of your business is education today and how do you see the outlook there? There have been some good tailwinds depending on product types from the education stimulus three years ago or maybe 70% of the way through that spend now. So how do you see that kind of tailing off and what does it mean for your education vertical growth rates from here?
John Stone: Yeah. I think, Julien, when you look at our Americas business, we would say we're in the range around 45% of that business would be institutional. Institutional, of course, would be education, also health care, some government institutions in there. Education, K-12 and higher ed have been quite stable. I think when you see the things that Allegion invests, human capital as well as product investments and terms of helping drive safer schools. It's one, it's a really important mission. We're very active in the partner alliance for safe schools, advocate for proper standards, make sure people are aware and educated on proper standards. And then yes, that is a substantial portion of our business. But 45% of Americas is institutional -- it's a stable vertical. I think you can look around the country, you can see some big bond referendums lately. Those can lead sales by a year or two years or more in some cases. In any given year, certain portions of school budgets, of course, go to safety and security. And we want to make sure people understand proper standards and advocate for that. And if you recall, again, one of the products we highlighted at our Investor Day, these indication lots that just provide a visual indication of the lock status critically important. We've got a great portfolio there, and that's continuing to drive value into that vertical. So I think stable would be the outlook that we would see kind of consistent with the Dodge starts -- chart that we showed you. I think in that low to mid-single digit growth driver.
Julian Mitchell: That's helpful. Thank you, John. And just my second one would be following up on the operating margin outlook. So I just wanted to check, is the right way to think about it that you referenced that kind of 60 bps average on Slide 10 from price productivity inflation investment net. Is that really sort of the -- essentially the margin expansion guide for 2024 simplistically? And then we assume that things like mix and volume sort of netting off against each other? I just wanted to check that that's the right assumption. And any color you could give on the corporate cost outlook for the year.
Mike Wagnes: Yeah. So as you know, Julian, we don't guide margins per se. However, we do give top line, bottom line, other estimates. So you can back into a margin rate. I think one, Joe kind of talked to margin rates earlier in the call as well. From a business perspective, you can see corporate being flattish for us year-over-year. With that element, you can kind of back into the respective region margin rates. And the big driver to the expansion, like, I mentioned earlier, is that price productivity in excess of investments and inflation. Lastly, you asked about mix, historically, mix is not a huge mover of margin rates for us. They can move around a little, but it’s not something that drives significant changes in our margin profile for a full year.
Julian Mitchell: Understood. Thank you.
Operator: The next question comes from Brett Linzey with Mizuho. Please go ahead.
Brett Linzey: Hey. Good morning, all.
John Stone: Hi, Brett.
Mike Wagnes: Hi, Brett.
Brett Linzey: I wanted to come back just to price volume, Mike, I think you said a good portion of organic growth was price generation. I guess is it safe to assume the volumes are assumed flat to maybe negative for the year? And then, any context on the non-res versus resi volume outlook for this year as well?
Mike Wagnes: Yeah. So as you know, Brett, we don't give subsegment outlooks of volume and pricing, especially on the pricing dynamic. Don't want to share that. In general, think of us as -- at that midpoint, this is a price driven outlook from actions that have already been announced in the marketplace. And then as markets -- if markets are better than we think, we're going to be able to participate in that upside if there is market upside from a volume perspective. And then I think that answers your question, there might have been another element if there is, just remind me.
Brett Linzey: Yeah. No. Thanks for that. And then maybe just shifting to the available cash flow. I think implicitly in that 90% ZIP code, but you did have some working capital draw down last year. Is that the right type of conversion you're thinking about? And then I guess what kind of leverage you back up to that kind of 95 to 100 historical range you guys have generated in the past?
Mike Wagnes: Yeah. So you got to look at it one or two ways, either on an adjusted basis of net income, adjusted net income or on the reported – on an adjusted basis, we’re at that 90%, which is roughly historical, even a little better than historical from a business, we have improved working capital in 2023. Expect that to continue in ‘24, really focused on the inventory front, where we’re going to drive increased turns and be more efficient as we manage our inventory. But from a conversion perspective, roughly in line with historical performance.
Brett Linzey: All right. Appreciate the detail.
Operator: The next question comes from Tim Wojs with Baird. Please go ahead.
Tim Wojs: Hi, guys. Good morning. Maybe just, first one, just on investments. I know you guys don't disclose the number anymore in the 10-Qs and the 10-K. But I was just kind of curious how you kind of frame go-forward investments in terms of the incremental dollars you'd spend in any given year, if 2024 would be kind of assumed as a kind of a normal year or if there are some discrete investments around some of the software development and new products and things you want to call out?
Mike Wagnes: Tim, look for us to always continually invest in our portfolio and our business to drive organic growth, especially in software and electronics. That is something we've been talking about driving growth and investing in our business for a decade and expect that to continue.
Tim Wojs: Okay. So no changes there. Okay. And then, Mike, you said that if the market was kind of better than you thought you'd be able to participate in some upside, I guess, how would you frame your backlog kind of heading into '24 versus maybe a normal year? And if there was upside, where do you think the most likely source of that would come from?
Mike Wagnes: As you know, Tim, we're a made-to-order business predominantly. We -- if you think about '21 backlogs in '21, early '22, they got really extended because of our inability to ship efficiently. We're now back to that normal lead time book and ship business. So I would say it's a normal lead time for customers and our ability to serve them. And so backlog is not what it was two years ago when we were talking about extended backlogs and dissatisfied customers, right? It's about serving our customers, and I think we're doing a much better job today than a couple of years ago.
Tim Wojs: Okay. And I guess if there's any source of upside, I mean, as you look at the business, where do you think that most likely come from?
Mike Wagnes: We talked about it as a company, where our outlook is. We see the stability in the institutional markets. Residential, we see as soft, right, if residential is better than we think. Hey, we have a great brand that SLA (ph) brand, we'll be able to participate. But for right now, we see the strongest markets being the institutional and the non-res side, as we laid out in the prepared remarks.
Tim Wojs: Okay. Very good. Thanks, guys. Appreciate it.
Operator: The next question comes from Andrew Obin with Bank of America. Please go ahead.
Andrew Obin: Hi, guys. Good morning.
Mike Wagnes: Hi, Andrew.
Andrew Obin: Can we just go back to International because I looked at my model and it's quite fascinating, right? If you look at 2018, just year-over-year comps I think revenues have declined with the exception of one year very, very consistently, yet the margins are materially higher when they were back then sort of underscoring what you've said. So can you just give us a little bit more color because I think in the 10-K, you've also highlighted that portable securities, I think, dragging volumes in '23, and I thought that was mix helpful to the mix in international. Just can you just give us a little bit more color? Is it Europe? Is it Asia? Is it Australia and New Zealand? Is it Interflex? Because under the surface, something is going really, really well there. Just give us a little bit of color there over the long term. Thank you.
John Stone: Yeah. Andrew, really appreciate the question and the chance to highlight what we feel is just outstanding performance by the Allegion international team. I think the soft points, certainly, China is still soft, particularly on the residential side of the market, that's all over the headlines, and we felt that too. Our exposure there is rather muted. I would say, we took some portfolio absence over time to just raise the overall portfolio quality of our international business. Our teams are executing very well on productivity in international despite rather soft mechanical volume markets. And then our electronics business, the SimonsVoss and the Interflex team have really come together extremely well. They're driving growth. They're driving margin expansion, finding new customers and then performing really, really well. As one of the things that make us so excited about the Boss Door Control acquisition. And while Mike indicated, it is rather small. It's strategically significant for us because it does help us get into more of that architect, channel, more spec-driven business in the U.K. and excited about that potential from a strategic standpoint there. So I think -- the international team has been performing very well on portfolio quality overall is better and execution by the team has been outstanding.
Andrew Obin: I'll take that answer. Thanks a lot. And just to follow up on North American Residential. When do you think just the volumes to bottom out? Is it a ‘24 event or is this sort of something beyond the scope of ‘24 volumes in North American resi?
John Stone: So probably tough to call. I've seen others eager to call a bottom. I think our outlook contemplates a flat to slightly down end market and that's what we see today. If there are any meaningful changes in interest rate environments that might be a spark that starts up secondary home sales. But I'd say, we're going to remain cautious on our outlook for the residential segment in Americas.
Andrew Obin: And if I could just squeeze one more in, sorry. Pricing has been very solid, particularly on a two year stack. Would you say that pricing has been stickier than you would have expected earlier in the year. If we would go back 12 months ago, would you say the pricing is stickier than you would have expected or about where you thought it would come out. Thank you.
John Stone: I would say this, Andrew, as you know, we price for value. We had significant inflation over a multiple year period -- our industry puts in price increases. So it tends to lag a little some of the inflation dynamics. So you have to look at it on a multiyear basis. But in general, we price for value as a business and as an industry. And so pricing tends to be sticky. It's in list prices. And so from a dynamic, just don't forget, you have to look at the massive inflation we saw over a multiple year period and think of the pricing in that context.
Andrew Obin: Okay. Thanks so much.
John Stone: Thanks, Andrew.
Operator: The next question comes from Chris Snyder with UBS. Please go ahead.
Chris Snyder: Thank you. John, I believe in the prepared remarks, you talked about how Allegion is a very late cycle business and starts can lead the company by more than 12 months. So when -- and I know, I guess, Americas non-res has stated organic positive, but the growth has decelerated a lot here over the last two to three quarters. But starts only really came down maybe two quarters ago. So when we see that deceleration or softening in the non-res Americas growth rate, is it fair to assume that that's really just been the channel destock and any sort of cycle pressure that could come from those starts is still on the horizon? Just any way to help think about that. Thank you.
John Stone: Yeah. It's a fair set of questions there. And I think the channel destock that was, in our opinion, a rather unique and temporary phenomenon that just happened because of all the supply chain disruptions and the lead times got extended and backlogs got extended and ordering patterns were disrupted. I think you saw that manifest itself in late 2022 through about mid '23. We feel like most of that is in the rearview for the industry. In fact, published lead times from Allegion, from our couple of key large competitors are largely back in line with what you would expect. Book and ship business, like Mike was saying earlier. And so I think the vertical mix has been rather volatile. The institutional segment is stable, but the commercial vertical mix has been a bit volatile, right, with office being soft. Multifamily was very strong. Multifamily has been softer a little bit. Data centers have been extremely robust. Warehouses have now been very weak. So you have to kind of disaggregate to see the drivers and then reaggregate to see the total outlook that we're contemplating here for 2024, where we would still say low to mid-single digit growth for the non-res part of our business.
Chris Snyder: I appreciate that. And maybe just a follow-up on Americas margins, up about 200 basis points this year in the absence of volume growth. So it's really supportive. And I understand that price cost is recovering and productivity is getting better. But I guess my question is, is it getting increasingly difficult or is there a point where you guys kind of run up on a glass ceiling there in Americas margins until maybe the cycle gives you enough to start driving positive volume growth at some point in the coming quarters? Thank you.
Mike Wagnes: Yeah, Chris. Clearly, there was some catch up this year. As I mentioned earlier, the inflation was before the pricing a few questions ago. When we think about this business though, I think it's important to understand, we had some challenges operationally over the last few years as well that started to get better in '23. And for '24, we should be more efficient and more productive as well. So it’s not just the pricing element, you will see in ‘24, an acceleration of productivity, which should give us some tailwinds for margins. But if you think long term, clearly, long term, you have to have some volume growth to drive margin expansion. But for the 24 ‘year, you will see us operate more efficiently and accelerate productivity to help drive that margin expansion.
Chris Snyder: Thank you.
Operator: This concludes our question-and-answer session. I would like to turn the conference back over to John Stone, President and CEO for any closing remarks.
John Stone: So thanks, everyone for a great Q&A. I think when you look back on 2024 a year from now, we expect you'll see an organization that delivered on margins and continue to show proof-points on organic growth and capital allocation, along with continuing to drive forward our strategy on seamless access. I think you’ll see we’re making the right investments to reinforce our strategy and reward our shareholders through balanced and consistent capital allocation. Thank you very much. Be safe. Be healthy.
Operator: The conference has now concluded. Thank you for attending today's presentation. You may now disconnect. | [
{
"speaker": "Operator",
"text": "Good morning, and welcome to the Allegion Fourth Quarter 2023 Earnings Call. All participants will be in listen-only mode. [Operator Instructions] After today’s presentation, there will be an opportunity to ask questions. [Operator Instructions] Please note, this event is being recorded. I would now like to turn the conference over to Josh Pokrzywinski, Vice President of Investor Relations. Please go ahead."
},
{
"speaker": "Josh Pokrzywinski",
"text": "Thank you, Drew. Good morning, everyone. Thank you for joining us for Allegion's fourth quarter and full year 2023 earnings call. With me today are John Stone, President and Chief Executive Officer; and Mike Wagnes, Senior Vice President and Chief Financial Officer of Allegion. Our earnings release, which was issued earlier this morning, and the presentation, which we will refer to in today's call, are available on our website at investor.allegion.com. This call will be recorded and archived on our website. Please go to Slide 2. Statements made in today's call that are not historical facts are considered forward-looking statements and are made pursuant to the safe harbor provisions of federal securities law. Please see our most recent SEC filings for a description of some of the factors that may cause actual results to differ materially from our projections. The company assumes no obligation to update these forward-looking statements. Today's presentation and commentary include non-GAAP financial measures. Please refer to the reconciliation in the financial tables of our press release for further details. Please go to Slide 3, and I'll turn the call over to John."
},
{
"speaker": "John Stone",
"text": "Thanks, Josh. Good morning, everyone, and thanks for joining us. I'd like to start today by recognizing that 2023 was a year of strong execution by the entire Allegion team. This performance reflects the value we add for our customers, the strength of our distribution partners, as well as the quality of our brands and the capabilities and expertise of our employees. Let's walk through some highlights of the quarter and the year. After celebrating our 10th anniversary as a standalone company in December, we closed the year with record revenue, adjusted operating income, and adjusted EPS. Reinforcing the thesis behind our seamless access strategy, electronics demand remained strong. We delivered approximately 20% organic growth in electronics for the year as supply chains normalized, and that's on top of mid-teens organic growth in the prior year. We sustained a high operating cadence and expanded our industry leading margins in the quarter. And for the full year, our adjusted operating margin performance was 22.1%, up 160 basis points. Simply stated, the Allegion team delivered on price and productivity, bringing margins back to pre-pandemic levels, with room to expand further in 2024 and beyond. Our balance sheet and cash flow generation are strong. We ended the year under 2 times net debt to EBITDA, which sets up a 2024 return to the balanced capital deployment you've come to expect from Allegion. When you look at our past decade, this team has delivered solid results and executed well through a variety of macroeconomic backdrops. We've built on the strength of 100 year old brands, consistently meeting customer needs and meeting our commitments to shareholders. We've operated with excellence, sustained the highest margins in the industry, and are still pioneering safety, better securing people and their property where they live, learn, work, and connect. Driven by our vision of enabling seamless access and a safer world, we're proud of this track record, we're proud of what we delivered in 2023, and we're excited about the momentum we're carrying into 2024. Please go to Slide 4, and let's talk about our capital allocation strategy in action. Reflecting on Allegion's first 10 years, we've had a roughly even split between inorganic growth and the return of capital to shareholders through dividends and share repurchases. We remain committed to balanced, consistent capital allocation, and having quickly delevered from the Access Technologies acquisition, our balance sheet supports this strategy. As we move into 2024, we will continue investing for organic growth, prioritizing projects and solution that drive seamless access forward. One recent example in new product development is Schlage's next generation of innovative electronic locks, the XE360. This is the latest wireless lock family from Schlage, designed with flexibility and interoperability in mind. With solutions for perimeter and interior doors, this series has the security and access features most looked for by multifamily and light commercial properties at attractive price points. It leads with open architecture, supports the latest credentialed technologies, and integrates with the Allegion and our partner systems. In addition, Schlage's innovative FleX Module allows the XE360 series to be easily upgraded in the field to allow migration from an offline to a network solution and to adapt to emerging trends in security and connectivity down the road. Next, Allegion will continue to be a dividend-paying stock. You can expect our dividends to grow commensurate with earnings over the long term, and we've just announced our 10th consecutive annual increase. We also expect to grow through acquisitions. Bolt-on acquisitions that fill portfolio gaps in the hardware space and high margin, recurring revenue business in the access solutions space will remain priorities. Larger deals like Access Technologies may be more episodic, but we will be disciplined and have demonstrated the ability to quickly delever. Boss Door Controls, which we closed this month, is a classic bolt-on that both complements and expands how we go-to-market in the UK. This acquisition bolsters our local business with a strong architectural channel, flexible supply chain, and also positions us to increase our spec-driven business there in the future. Lastly, with regards to share repurchases, as we've said, at a minimum, we will continue to offset incentive compensation. And as you saw in the fourth quarter, we will make additional share repurchases as appropriate. Mike will now walk you through fourth quarter financial results, and I'll be back to discuss our full year 2024 outlook."
},
{
"speaker": "Mike Wagnes",
"text": "Thanks, John, and good morning, everyone. Thank you for joining today's call. Please go to Slide number 5. As John shared, Allegion continued to execute at a high level and delivered another solid quarter. Revenue for the fourth quarter was $897.4 million, an increase of 4.2% compared to 2022. Organic growth of 2.6% was driven by our Americas non-residential and Access Technologies businesses, offset by declines in residential and international. Adjusted operating margin and adjusted EBITDA margin increased by 130 basis points and 120 basis points, respectively, in the fourth quarter, driven by price and productivity in excess of inflation and investment. I am pleased with the margin performance as we have recaptured the margin loss during the supply chain disruptions experienced in late 2021 and early 2022. Our operating model and strong execution have positioned us well for future margin expansion. Adjusted earnings per share of $1.68 decreased $0.01, or approximately 0.6% versus the prior year. Operational performance drove growth of $0.17 per share, with the offset coming from tax, driven by the timing of discrete items versus the prior year. John will cover the outlook later in the presentation, however, I want to note that our tax rate will migrate to between 18% and 19% in 2024, inclusive of the implementation of global minimum tax. We expect Allegion's structural tax rate will be in the high-teens over the planning horizon we laid out at our Investor Day in May. Finally, full year available cash flow for 2023 was $516.4 million, a 30.6% increase versus last year, driven by higher earnings and improved working capital performance. I will provide more details on cash flow and balance sheet a little later in the presentation. Please go to Slide number 6. This slide provides an overview of our quarterly and full year revenue. I will review our enterprise results here before turning to our respective regions. Organic growth in the quarter was 2.6%, a strong price realization offset pressure on volumes. Currency and acquisitions drove additional favorability in the quarter, bringing the total reported growth to 4.2%. On a full year basis, organic revenue growth was 5.2% overall, with Americas at 7.4%. Our international business was down 2.5% for the year. Our full year organic growth was led by our electronics and software solutions, which grew globally by approximately 20% in 2023, with both regions in double-digits. Please go to Slide number 7. Our Americas segment continues to deliver strong operating results in the fourth quarter. Revenue of $704.6 million was up 3.7% on both a reported and organic basis as favorable pricing offset lower volumes. Our Americas non-residential business was up mid-single digits against a prior-year comp that grew in the mid-20%’s. On a full year basis, this business had double-digit organic growth in 2023. Residential markets are soft, with our business down low-single digits in the quarter and for the full year, as higher interest rates continue to impact new and existing home sales. Our Access Technologies business delivered organic growth of mid-single digits in Q4. Americas electronics growth remained strong on a multi-year basis, with mid-single digit growth in the quarter on top of the nearly 50% comparison in Q4 2022. Our Americas adjusted operating income of $188.4 million increased 10.8% versus the prior year period, while adjusted operating margins and adjusted EBITDA margins for the quarter were up 170 basis points and 190 basis points, respectively. The team executed well. We are performing more efficiently, driving price and productivity, and we delivered margin expansion every quarter in 2023. Please go to Slide 8. Our International segment continues to execute well in a challenging macroeconomic environment. Revenue of $192.8 million was up 5.9% on a reported basis and down 1.3% organically. Price realization was more than offset by lower volumes associated with soft end market demand. Currency and acquisitions were a tailwind this quarter, positively impacted reported revenues by 4.4% and 2.8%, respectively. International adjusted operating income of $32.3 million increased nearly 13% versus the prior year period. We also saw improvement in adjusted operating margins and adjusted EBITDA margins of 110 basis points and 100 basis points, respectively. The team delivered margin expansion for Q4 and the full year despite a challenging topline, highlighting the healthier, more resilient business portfolio we have within our International segment. The acquisition growth I mentioned earlier is primarily driven by our plano business, a tuck-in software-as-a-service business we acquired early 2023, which is accretive to both growth rates and margins. Please go to Slide number 9. As I mentioned earlier, year-to-date available cash flow came in at $516.4 million, up nearly $121 million versus the prior year. This increase is driven by higher earnings and working capital improvements, partially offset by higher capital expenditures. You can look for Allegion to continue to invest in our business and convert earnings to cash. Next, working capital as a percent of revenue improved versus the prior year, driven by higher inventory turns as supply chains normalized. Finally, our net debt to adjusted EBITDA is down to 1.9 times as we successfully delevered following the Access Technologies acquisition. We are now back to historical leverage levels, which demonstrates our proven track record of effectively deploying capital, while maintaining both our leverage profile and our investment grade credit rating. Our business continues to generate strong cash flow and our balance sheet continues to be in a healthy position. I will now hand the call back over to John for our 2024 Outlook."
},
{
"speaker": "John Stone",
"text": "Thanks, Mike. Please go to Slide 10. And before we get to guidance, I want to spend a moment on what we see as a couple of key drivers for 2024, including macroeconomic inputs that inform our outlook. We're expecting more modest inflation in 2024, enabling normal levels of margin expansion from net price and productivity. We report these to you as aggregate price, productivity, inflation, and investments shown in the left-hand chart. Since the beginning of 2019, we've averaged approximately 60 basis points of margin contribution annually from net price and productivity. This has been a hallmark of the business over time and it's a key driver of our 2024 outlook. We're expecting a stable non-residential environment, underpinned by healthy institutional markets. You can see Dodge starts for institutional have shown steady growth in the past few years, contrasting the higher volatility in commercial leaning verticals. As you all know, Allegion is a late-cycle business, and starts can lead our business by a year or more. We're not expecting many market tailwinds, however, we believe the visibility and stability of late-cycle institutional verticals, as well as our large installed base, will allow us to deliver organic growth. Please go to Slide 11, and let's walk through the outlook for 2024. We expect total and organic revenue growth in the Americas to be 1.5% to 3.5%. This is led by our non-residential business, forecast to grow low to mid-single digits organically. Please note, the non-residential business is inclusive of Access Technologies, starting this year. The residential business is expected to be flat to down slightly on an organic basis. Overall, for the Americas, we are expecting more normal seasonality with tough comps in the first quarter. For Allegion International, we expect total revenue to be up 1.5% to 3.5% and minus 1% to up 1% on an organic basis. Inorganic growth includes the recently announced acquisition of Boss Door Controls. While mechanical markets remain sluggish in international, I'm pleased with how the team executed to close out the year. We have a high quality portfolio and continue to see good growth potential in our international electronics and software solutions businesses. All in, for the company, we are projecting total revenue growth of 1.5% to 3.5%, with organic revenue growth of 1% to 3%. We expect to drive margin expansion consistent with our historical framework. We're confident in the execution playbook we have for 2024, given cost actions taken in '23 and a more modest inflation environment. Based on our strong operating momentum, prior cost actions, and more normalized inflation, we are projecting an adjusted EPS outlook in the range of $7 and $7.15. This represents growth of approximately 1% to 3% over the prior year period, inclusive of a $0.37 headwind from tax. Lastly, we expect our outlook on available cash flow to be in the range of $540 million to $570 million. While we are committed to balanced and consistent capital deployment, this guidance does not include future capital deployment beyond the recent acquisition of Boss Door Controls. Please go to Slide 12. Bottom line, I am very proud of the entire Allegion team's 2023 performance and grateful for the strong distribution partners and loyal customers we have. As we look ahead to 2024, we will continue to build on the Allegion legacy and deliver new value in access. Our team is focused on relentless execution of our strategy and balanced capital deployment against what we expect to be a stable market backdrop. We remain committed to putting our customers first and delivering our vision of enabling seamless access and a safer world. I look forward to updating you more in the future as we work to achieve another record year for Allegion and propel our company into its next decade of growth. With that, let's turn to Q&A."
},
{
"speaker": "Operator",
"text": "Thank you. We will now begin the question-and-answer session. [Operator Instructions] The first question comes from Joe O'Dea with Wells Fargo. Please go ahead."
},
{
"speaker": "Joe O'Dea",
"text": "Hi. Good morning."
},
{
"speaker": "John Stone",
"text": "Good morning, Joe."
},
{
"speaker": "Mike Wagnes",
"text": "Good morning, Joe."
},
{
"speaker": "Joe O'Dea",
"text": "Wanted to start on op margin in '24. It looks like year-over-year margin expansion maybe in the 60 bps kind of range. So it would fit within the 50 bps to 100 bps, I think, medium-term target, but also comes off a pretty tough comp where you just did 160 and so, I think maybe a little bit better than anticipated. Can you just talk about the drivers of that year-over-year expansion that's embedded in terms of price, productivity, inflation, sort of how much of that is driven by it? And then also how much is already kind of in there in terms of carryover price, price that you've announced, cost actions that you've taken versus how much you still have to go get?"
},
{
"speaker": "Mike Wagnes",
"text": "Yes. Thanks for the question, Joe. You're correct in that. If you look at margin expansion, a big driver of that is the price productivity in excess of inflation and investments. As you look at our topline guide, our pricing is going to be a driver of growth. If you think about midpoint, it's going to be the biggest driver of growth. As a result, you will get margin expansion when you think about the '24 year. And in addition, when you think about the actions we've taken, biggest driver of price for us is our non-residential business in the Americas. Those pricing actions are -- have already been announced and in the marketplace. And then from cost actions, we've taken some cost actions in the fourth quarter of '23. As a result, we're positioned nicely. You should see an acceleration of productivity in 2024. So, when you think about our margin outlook, the actions have been taken and we're positioned well in order to achieve that outlook."
},
{
"speaker": "Joe O'Dea",
"text": "That's really helpful. And then in terms of non-res and the growth outlook in Americas, can you unpack a little -- that a little bit by vertical then to talk about sort of electronics versus mechanical, but then institutional versus commercial, I think a lot of focus on sort of office and headwinds out there. But what you see on kind of new versus renovation, just trying to understand some of the moving pieces within that growth in non-res."
},
{
"speaker": "John Stone",
"text": "Yes, Joe. This is John. I appreciate the question. I think as we showed, the institutional verticals, they're less volatile than the commercial leaning verticals and have still been flashing some positive data on starch. So we -- and our businesses, as you know, is a little bit heavily tilted to those vertical. So we feel good about that space. It's stable. The commercial, that's a wide basket of end users. So it's everything from data centers to retail to office to multifamily. We put that in the commercial bucket as well. And certainly, commercial office on the new construction side is soft and has been for quite some time. We think that will continue. Multifamily has been slowing as well. So we're not counting on a dramatic snap back there. We do see strength like everybody has been talking about in data centers, that's a highly spec application of our high end electronic products. And I'd say on balance, you add all that up, the puts and the takes, and complement that with -- again, if you think of Allegion has about 50-50 new construction to aftermarket exposure. The aftermarket is quite stable across all verticals, break fix, repair and maintenance, even some tenant turnover here in commercial office. So the aftermarket is still, I think, pretty stable and underpins the overall portfolio, that's what leads us to come up to low to mid-single digits for growth in non-res. The only other item to mention since we do include Access Technologies and non-res for this year and going forward is big retail chains with store renovations and things like that also makes for a rather stable outlook on the Access Tech, the automatic doors business, that's kind of how we would see the whole basket."
},
{
"speaker": "Joe O'Dea",
"text": "I appreciate the details. Thanks."
},
{
"speaker": "John Stone",
"text": "Thank you."
},
{
"speaker": "Operator",
"text": "The next question comes from Joe Ritchie with Goldman Sachs. Please go ahead."
},
{
"speaker": "Vivek Srivastava",
"text": "Hi. This is Vivek Srivastava on for Joe. Thanks for the question. My first question is just on the cadence of organic growth. It just looks like in first quarter '23, you had a big backlog burn, so that will be a tougher comp. Is it fair to say, you probably have a slightly negative organic growth in first quarter and then it ramps up to maybe closer to mid-single digit level in the second half?"
},
{
"speaker": "Mike Wagnes",
"text": "Yeah. Thanks for the question. Clearly, Q1 is going to be our most challenging comp when you think about the '24 year. We don't give quarterly guidance. But if you recall, we burned through that backlog Q1 of '23. So when you think about our cadence for top line, ‘23 was not a normal year, right? When we think about '24, I think there's more normal seasonality. So we're a little more back half loaded than first half loaded from a top line. Don't want to get individual quarter forecasting. As you know, we don't give quarterly guidance. But just remember, a little more back half than first half from the top line as a company and that we do have that really challenging comp in the first quarter when you model year-over-year."
},
{
"speaker": "Vivek Srivastava",
"text": "Thanks. That's helpful. And then just a follow-up on the International segment margins. It was impressive to see that in fourth quarter despite negative organic growth, you expanded over 100 basis points of margin. Could you talk about what drove that strong margin expansion in fourth quarter and then just expectations in that segment for margins in 2024?"
},
{
"speaker": "Mike Wagnes",
"text": "Yeah. Super pleased about our international business when you think about the margin performance. If you look at our 10-year history, that business is breakeven when we spun out a decade ago. Now we’re driving good healthy margin expansion. It’s a much healthier portfolio. When you think about that electronics and software businesses, we’ve been talking about the last few years, strong – stronger businesses from a margin perspective and top line. So really doing some good work to drive productivity in the region, pricing excellence. Tim, he took the excellence we had in the Americas and brought that to International as well. So a lot of things favorable for International as we think about the business for ‘23 and more importantly, moving forward."
},
{
"speaker": "Vivek Srivastava",
"text": "Great. Thanks."
},
{
"speaker": "Operator",
"text": "The next question comes from Jeff Sprague with Vertical Research Partners. Please go ahead."
},
{
"speaker": "Jeffrey Sprague",
"text": "Hi. Thank you. Good morning, everyone. Just coming back to just the seasonality comment. I know you don't do want to get into quarters, but are you comfortable with us kind of assuming kind of the pre-COVID period, call it, 2014 to 2019 is what you mean by normal seasonality as we look into Q1?"
},
{
"speaker": "Mike Wagnes",
"text": "Yeah, Jeff. If you look at half, I'd like to talk about it in halves. I think that '14 to '19 is kind of a normal seasonality when you look at the half years. And we expect to be more in line with that a little more back half weighted than first half."
},
{
"speaker": "Jeffrey Sprague",
"text": "Okay. Great. You just give us a little more color on Boss to size the profitability, what impact, if any, it has on international margins?"
},
{
"speaker": "Mike Wagnes",
"text": "Yeah. Jeff, if you think about that business, organic -- I'm sorry, inorganic growth for International, you would assume -- about half of that inorganic growth we've highlighted in the outlook is coming from the Boss Door acquisition, the other half coming from currency. So you could see it's a pretty -- it's a smaller acquisition. It's not a massive size. So from a price now on the top line, you have an idea that it's not a huge acquisition, but it's a nice complement to our business. We're really strong at writing specifications in North America. This is bringing that spec writing capability to a large country in Europe like the U.K."
},
{
"speaker": "Jeffrey Sprague",
"text": "Great. And then, hey, John, earlier in your opening remarks, you mentioned this new Schlage electronic product. Can you just maybe provide a little bit more color overall on what you're expecting for electronics growth in 2024? Is there a measurable impact on your investment levels to drive that, etc.?"
},
{
"speaker": "John Stone",
"text": "Yeah. It's a good question, Jeff. And I think if listen to the prepared remarks in 2022, strong electronics growth, 2023, around 20% electronics growth. So I mean, over the long haul, long term, like we said at Investor Day back in May last year, think of our electronics performance of high-single, low double-digit growth driver for Allegion. We’ve definitely given backlog burn and things in 2023, we’ll have some tough electronics comps here and there. But demand is still strong. The secular trend still remains this migration to electronic access control for better security and better convenience is still moving and underway. We’re still investing there. XE360 is just on that was very timely to highlight for us given the flexibility and interoperability that, that brings to the market. And also just to highlight the ease of upgrade of that in the field. We’re also pretty excited about that. I mean the flexibility that’s going to offer the end users is quite interesting and quite attractive for us. I think as you – as we move through 2024, you can continue to see, I think, an emphasis from us on things like product vitality, you’re going to see a steady stream of new product launches just like this, and we look forward to highlighting those for you."
},
{
"speaker": "Jeffrey Sprague",
"text": "All right. Thank you."
},
{
"speaker": "Operator",
"text": "The next question comes from Julian Mitchell with Barclays. Please go ahead."
},
{
"speaker": "Julian Mitchell",
"text": "Hi. Good morning. Maybe just the first question. You talked about some of the color by end market vertical earlier. And maybe one, I guess I wanted a bit more color on was the education vertical. I think it's one of your largest. So maybe any sense of kind of scale of how much of your business is education today and how do you see the outlook there? There have been some good tailwinds depending on product types from the education stimulus three years ago or maybe 70% of the way through that spend now. So how do you see that kind of tailing off and what does it mean for your education vertical growth rates from here?"
},
{
"speaker": "John Stone",
"text": "Yeah. I think, Julien, when you look at our Americas business, we would say we're in the range around 45% of that business would be institutional. Institutional, of course, would be education, also health care, some government institutions in there. Education, K-12 and higher ed have been quite stable. I think when you see the things that Allegion invests, human capital as well as product investments and terms of helping drive safer schools. It's one, it's a really important mission. We're very active in the partner alliance for safe schools, advocate for proper standards, make sure people are aware and educated on proper standards. And then yes, that is a substantial portion of our business. But 45% of Americas is institutional -- it's a stable vertical. I think you can look around the country, you can see some big bond referendums lately. Those can lead sales by a year or two years or more in some cases. In any given year, certain portions of school budgets, of course, go to safety and security. And we want to make sure people understand proper standards and advocate for that. And if you recall, again, one of the products we highlighted at our Investor Day, these indication lots that just provide a visual indication of the lock status critically important. We've got a great portfolio there, and that's continuing to drive value into that vertical. So I think stable would be the outlook that we would see kind of consistent with the Dodge starts -- chart that we showed you. I think in that low to mid-single digit growth driver."
},
{
"speaker": "Julian Mitchell",
"text": "That's helpful. Thank you, John. And just my second one would be following up on the operating margin outlook. So I just wanted to check, is the right way to think about it that you referenced that kind of 60 bps average on Slide 10 from price productivity inflation investment net. Is that really sort of the -- essentially the margin expansion guide for 2024 simplistically? And then we assume that things like mix and volume sort of netting off against each other? I just wanted to check that that's the right assumption. And any color you could give on the corporate cost outlook for the year."
},
{
"speaker": "Mike Wagnes",
"text": "Yeah. So as you know, Julian, we don't guide margins per se. However, we do give top line, bottom line, other estimates. So you can back into a margin rate. I think one, Joe kind of talked to margin rates earlier in the call as well. From a business perspective, you can see corporate being flattish for us year-over-year. With that element, you can kind of back into the respective region margin rates. And the big driver to the expansion, like, I mentioned earlier, is that price productivity in excess of investments and inflation. Lastly, you asked about mix, historically, mix is not a huge mover of margin rates for us. They can move around a little, but it’s not something that drives significant changes in our margin profile for a full year."
},
{
"speaker": "Julian Mitchell",
"text": "Understood. Thank you."
},
{
"speaker": "Operator",
"text": "The next question comes from Brett Linzey with Mizuho. Please go ahead."
},
{
"speaker": "Brett Linzey",
"text": "Hey. Good morning, all."
},
{
"speaker": "John Stone",
"text": "Hi, Brett."
},
{
"speaker": "Mike Wagnes",
"text": "Hi, Brett."
},
{
"speaker": "Brett Linzey",
"text": "I wanted to come back just to price volume, Mike, I think you said a good portion of organic growth was price generation. I guess is it safe to assume the volumes are assumed flat to maybe negative for the year? And then, any context on the non-res versus resi volume outlook for this year as well?"
},
{
"speaker": "Mike Wagnes",
"text": "Yeah. So as you know, Brett, we don't give subsegment outlooks of volume and pricing, especially on the pricing dynamic. Don't want to share that. In general, think of us as -- at that midpoint, this is a price driven outlook from actions that have already been announced in the marketplace. And then as markets -- if markets are better than we think, we're going to be able to participate in that upside if there is market upside from a volume perspective. And then I think that answers your question, there might have been another element if there is, just remind me."
},
{
"speaker": "Brett Linzey",
"text": "Yeah. No. Thanks for that. And then maybe just shifting to the available cash flow. I think implicitly in that 90% ZIP code, but you did have some working capital draw down last year. Is that the right type of conversion you're thinking about? And then I guess what kind of leverage you back up to that kind of 95 to 100 historical range you guys have generated in the past?"
},
{
"speaker": "Mike Wagnes",
"text": "Yeah. So you got to look at it one or two ways, either on an adjusted basis of net income, adjusted net income or on the reported – on an adjusted basis, we’re at that 90%, which is roughly historical, even a little better than historical from a business, we have improved working capital in 2023. Expect that to continue in ‘24, really focused on the inventory front, where we’re going to drive increased turns and be more efficient as we manage our inventory. But from a conversion perspective, roughly in line with historical performance."
},
{
"speaker": "Brett Linzey",
"text": "All right. Appreciate the detail."
},
{
"speaker": "Operator",
"text": "The next question comes from Tim Wojs with Baird. Please go ahead."
},
{
"speaker": "Tim Wojs",
"text": "Hi, guys. Good morning. Maybe just, first one, just on investments. I know you guys don't disclose the number anymore in the 10-Qs and the 10-K. But I was just kind of curious how you kind of frame go-forward investments in terms of the incremental dollars you'd spend in any given year, if 2024 would be kind of assumed as a kind of a normal year or if there are some discrete investments around some of the software development and new products and things you want to call out?"
},
{
"speaker": "Mike Wagnes",
"text": "Tim, look for us to always continually invest in our portfolio and our business to drive organic growth, especially in software and electronics. That is something we've been talking about driving growth and investing in our business for a decade and expect that to continue."
},
{
"speaker": "Tim Wojs",
"text": "Okay. So no changes there. Okay. And then, Mike, you said that if the market was kind of better than you thought you'd be able to participate in some upside, I guess, how would you frame your backlog kind of heading into '24 versus maybe a normal year? And if there was upside, where do you think the most likely source of that would come from?"
},
{
"speaker": "Mike Wagnes",
"text": "As you know, Tim, we're a made-to-order business predominantly. We -- if you think about '21 backlogs in '21, early '22, they got really extended because of our inability to ship efficiently. We're now back to that normal lead time book and ship business. So I would say it's a normal lead time for customers and our ability to serve them. And so backlog is not what it was two years ago when we were talking about extended backlogs and dissatisfied customers, right? It's about serving our customers, and I think we're doing a much better job today than a couple of years ago."
},
{
"speaker": "Tim Wojs",
"text": "Okay. And I guess if there's any source of upside, I mean, as you look at the business, where do you think that most likely come from?"
},
{
"speaker": "Mike Wagnes",
"text": "We talked about it as a company, where our outlook is. We see the stability in the institutional markets. Residential, we see as soft, right, if residential is better than we think. Hey, we have a great brand that SLA (ph) brand, we'll be able to participate. But for right now, we see the strongest markets being the institutional and the non-res side, as we laid out in the prepared remarks."
},
{
"speaker": "Tim Wojs",
"text": "Okay. Very good. Thanks, guys. Appreciate it."
},
{
"speaker": "Operator",
"text": "The next question comes from Andrew Obin with Bank of America. Please go ahead."
},
{
"speaker": "Andrew Obin",
"text": "Hi, guys. Good morning."
},
{
"speaker": "Mike Wagnes",
"text": "Hi, Andrew."
},
{
"speaker": "Andrew Obin",
"text": "Can we just go back to International because I looked at my model and it's quite fascinating, right? If you look at 2018, just year-over-year comps I think revenues have declined with the exception of one year very, very consistently, yet the margins are materially higher when they were back then sort of underscoring what you've said. So can you just give us a little bit more color because I think in the 10-K, you've also highlighted that portable securities, I think, dragging volumes in '23, and I thought that was mix helpful to the mix in international. Just can you just give us a little bit more color? Is it Europe? Is it Asia? Is it Australia and New Zealand? Is it Interflex? Because under the surface, something is going really, really well there. Just give us a little bit of color there over the long term. Thank you."
},
{
"speaker": "John Stone",
"text": "Yeah. Andrew, really appreciate the question and the chance to highlight what we feel is just outstanding performance by the Allegion international team. I think the soft points, certainly, China is still soft, particularly on the residential side of the market, that's all over the headlines, and we felt that too. Our exposure there is rather muted. I would say, we took some portfolio absence over time to just raise the overall portfolio quality of our international business. Our teams are executing very well on productivity in international despite rather soft mechanical volume markets. And then our electronics business, the SimonsVoss and the Interflex team have really come together extremely well. They're driving growth. They're driving margin expansion, finding new customers and then performing really, really well. As one of the things that make us so excited about the Boss Door Control acquisition. And while Mike indicated, it is rather small. It's strategically significant for us because it does help us get into more of that architect, channel, more spec-driven business in the U.K. and excited about that potential from a strategic standpoint there. So I think -- the international team has been performing very well on portfolio quality overall is better and execution by the team has been outstanding."
},
{
"speaker": "Andrew Obin",
"text": "I'll take that answer. Thanks a lot. And just to follow up on North American Residential. When do you think just the volumes to bottom out? Is it a ‘24 event or is this sort of something beyond the scope of ‘24 volumes in North American resi?"
},
{
"speaker": "John Stone",
"text": "So probably tough to call. I've seen others eager to call a bottom. I think our outlook contemplates a flat to slightly down end market and that's what we see today. If there are any meaningful changes in interest rate environments that might be a spark that starts up secondary home sales. But I'd say, we're going to remain cautious on our outlook for the residential segment in Americas."
},
{
"speaker": "Andrew Obin",
"text": "And if I could just squeeze one more in, sorry. Pricing has been very solid, particularly on a two year stack. Would you say that pricing has been stickier than you would have expected earlier in the year. If we would go back 12 months ago, would you say the pricing is stickier than you would have expected or about where you thought it would come out. Thank you."
},
{
"speaker": "John Stone",
"text": "I would say this, Andrew, as you know, we price for value. We had significant inflation over a multiple year period -- our industry puts in price increases. So it tends to lag a little some of the inflation dynamics. So you have to look at it on a multiyear basis. But in general, we price for value as a business and as an industry. And so pricing tends to be sticky. It's in list prices. And so from a dynamic, just don't forget, you have to look at the massive inflation we saw over a multiple year period and think of the pricing in that context."
},
{
"speaker": "Andrew Obin",
"text": "Okay. Thanks so much."
},
{
"speaker": "John Stone",
"text": "Thanks, Andrew."
},
{
"speaker": "Operator",
"text": "The next question comes from Chris Snyder with UBS. Please go ahead."
},
{
"speaker": "Chris Snyder",
"text": "Thank you. John, I believe in the prepared remarks, you talked about how Allegion is a very late cycle business and starts can lead the company by more than 12 months. So when -- and I know, I guess, Americas non-res has stated organic positive, but the growth has decelerated a lot here over the last two to three quarters. But starts only really came down maybe two quarters ago. So when we see that deceleration or softening in the non-res Americas growth rate, is it fair to assume that that's really just been the channel destock and any sort of cycle pressure that could come from those starts is still on the horizon? Just any way to help think about that. Thank you."
},
{
"speaker": "John Stone",
"text": "Yeah. It's a fair set of questions there. And I think the channel destock that was, in our opinion, a rather unique and temporary phenomenon that just happened because of all the supply chain disruptions and the lead times got extended and backlogs got extended and ordering patterns were disrupted. I think you saw that manifest itself in late 2022 through about mid '23. We feel like most of that is in the rearview for the industry. In fact, published lead times from Allegion, from our couple of key large competitors are largely back in line with what you would expect. Book and ship business, like Mike was saying earlier. And so I think the vertical mix has been rather volatile. The institutional segment is stable, but the commercial vertical mix has been a bit volatile, right, with office being soft. Multifamily was very strong. Multifamily has been softer a little bit. Data centers have been extremely robust. Warehouses have now been very weak. So you have to kind of disaggregate to see the drivers and then reaggregate to see the total outlook that we're contemplating here for 2024, where we would still say low to mid-single digit growth for the non-res part of our business."
},
{
"speaker": "Chris Snyder",
"text": "I appreciate that. And maybe just a follow-up on Americas margins, up about 200 basis points this year in the absence of volume growth. So it's really supportive. And I understand that price cost is recovering and productivity is getting better. But I guess my question is, is it getting increasingly difficult or is there a point where you guys kind of run up on a glass ceiling there in Americas margins until maybe the cycle gives you enough to start driving positive volume growth at some point in the coming quarters? Thank you."
},
{
"speaker": "Mike Wagnes",
"text": "Yeah, Chris. Clearly, there was some catch up this year. As I mentioned earlier, the inflation was before the pricing a few questions ago. When we think about this business though, I think it's important to understand, we had some challenges operationally over the last few years as well that started to get better in '23. And for '24, we should be more efficient and more productive as well. So it’s not just the pricing element, you will see in ‘24, an acceleration of productivity, which should give us some tailwinds for margins. But if you think long term, clearly, long term, you have to have some volume growth to drive margin expansion. But for the 24 ‘year, you will see us operate more efficiently and accelerate productivity to help drive that margin expansion."
},
{
"speaker": "Chris Snyder",
"text": "Thank you."
},
{
"speaker": "Operator",
"text": "This concludes our question-and-answer session. I would like to turn the conference back over to John Stone, President and CEO for any closing remarks."
},
{
"speaker": "John Stone",
"text": "So thanks, everyone for a great Q&A. I think when you look back on 2024 a year from now, we expect you'll see an organization that delivered on margins and continue to show proof-points on organic growth and capital allocation, along with continuing to drive forward our strategy on seamless access. I think you’ll see we’re making the right investments to reinforce our strategy and reward our shareholders through balanced and consistent capital allocation. Thank you very much. Be safe. Be healthy."
},
{
"speaker": "Operator",
"text": "The conference has now concluded. Thank you for attending today's presentation. You may now disconnect."
}
] | Allegion plc | 241,782,379 |
ALLE | 3 | 2,023 | 2023-10-31 08:00:00 | Operator: Good morning, and welcome to the Allegion Third Quarter 2023 Earnings Call. All participants will be in listen-only mode. [Operator Instructions] After today's presentation, there will be an opportunity to ask questions. [Operator Instructions] Please note this event is being recorded. I would now like to turn the conference over to Jobi Coyle, Director of Investor Relations. Please go ahead.
Jobi Coyle: Thank you, Drew. Good morning, everyone. Thank you for joining us for Allegion's Third Quarter 2023 Earnings Call. With me today are John Stone, President and Chief Executive Officer; and Mike Wagnes, Senior Vice President and Chief Financial Officer of Allegion. Our earnings release, which was issued earlier this morning, and the presentation, which we will refer to in today's call are available on our website at investor.allegion.com. This call will be recorded and archived on our website. Please go to Slide number 2. Statements made in today's call that are not historical facts are considered forward-looking statements and are made pursuant to the Safe Harbor provisions of federal securities law. Please see our most recent SEC filings for a description of some of the factors that may cause actual results to differ materially from our projections. The company assumes no obligation to update these forward-looking statements. Today's presentation and commentary include non-GAAP financial measures. Please refer to the reconciliation in the financial tables of our press release for further details. Please go to Slide 3, and I'll turn the call over to John.
John Stone: Thanks, Jobi, and good morning, everyone. Thanks for joining us today. This current quarter was all about outstanding operational execution from the entire Allegion team, and I'm pleased with our performance. Electronics demand remains strong with in our opinion a long runway for further adoption. In the quarter, Allegion delivered mid-teens organic growth in electronics and software solutions globally, led by our Americas nonresidential business, which had another robust quarter. We already have the highest margins in our industry, and we're driving additional expansion at the gross and operating margin levels despite not having some of the mechanical volume tailwinds from a year ago. Our balance sheet is getting stronger. We delevered from the Access Technologies acquisition quickly and are now building capital to deploy for growth. Bottom-line, Allegion is poised for a record year in total revenue, adjusted operating income and adjusted earnings per share. As a result, we're raising our guidance for full year adjusted EPS. Please go to Slide 4. So Allegion's vision of enabling seamless access in a safer world remains core to our company culture, performance and results. Securing people where they live, learn and work has never been more important. We are a pure-play provider of security and access solutions. We have a great legacy of the strongest brands and the highest margins. We operate with excellence and are accelerating our year-over-year productivity with normalized lead times while still managing the massive SKU complexity that we manage in a made-to-order environment. This makes Allegion a partner of choice, and we're leveraging that unique position to promote the adoption of open ecosystems that maximize our addressable market. We're also delivering new value and access, continuing our drive to wrap software and services around our hardware solutions. This is the critical unlock of additional value for our end user customers for Allegion's growth and for long-term shareholder return. A great proof point of how our company is living this vision and strategy is the Allegion Ventures announcement we made yesterday. Allegion Ventures has made a strategic investment in Ambient AI, whose cutting-edge AI platform utilizes innovative technology to enable seamless access in a safer world. This is the largest investment in Allegion Ventures history, and it reflects the tremendous potential we see in Ambient and Allegion's collaboration to deliver new value and access. Please go to Slide 5. I'd like to turn to our capital allocation priorities. When I joined Allegion, we had just announced the acquisition of Access Technologies. And over the last year, I feel we've done a good job in quickly delevering back to pre-acquisition levels, while still investing in our business and returning cash to our shareholders. Allegion is an investment-grade company, and we expect to remain an investment-grade company. This is critically important to us. We will continue investing for above-market organic growth prioritizing projects and solutions that drive seamless access and make the world safer. We're a dividend-paying stock, and you can expect our dividends to grow commensurate with earnings over the long-term. We will also drive growth through acquisitions, considering complementary portfolios like you saw with the Access Technologies business, as well as Software-as-a-Service related to seamless access, like you saw with plano. High-margin recurring revenue businesses and bolt-on acquisitions that fill portfolio gaps in the hardware space will remain priorities. And while we may increase our debt for the right acquisitions, we've demonstrated the ability to quickly delever. Lastly, with regards to share repurchases at a minimum, we will continue to offset incentive compensation, and we will make additional share repurchases as appropriate. Mike will now walk you through third quarter financial results, and I'll be back to discuss our full year 2023 outlook.
Mike Wagnes: Thanks, John, and good morning, everyone. Thank you for joining today's call. Please go to Slide number 6. As John shared, Allegion continued to execute at a high level. We delivered another quarter of solid performance with strong electronics growth, sustained margin expansion and healthy cash flows. Revenue for the third quarter was $917.9 million, an increase of 0.5% compared to 2022. We continue to see favorable price realization along with strength in electronics and access technologies. However, ongoing pressure on our residential business, paired with a challenging prior year comparable, resulted in organic revenue decline of 0.6%. Adjusted operating margin and adjusted EBITDA margin in the third quarter both increased by 110 basis points. Price and productivity in excess of inflation and investment along with strong operational execution more than offset the volume decline impact. On a year-to-date basis, we have achieved the highest adjusted operating margin in our history. I'm pleased with the margin performance over the last 18 months as we have now recaptured the margin loss during our supply chain disruptions. Our operating model and strong execution have positioned us well for future margin expansion. Adjusted earnings per share of $1.94 increased $0.21 or approximately 12% versus the prior year. Operational performance drove nearly $0.10 per share with the remaining coming from tax driven by timing of discrete items versus the prior year. We expect our full year adjusted effective tax rate to be approximately 15%. You can find further details of our earnings per share performance in the appendix. Year-to-date available cash flow was $320.4 million, an increase of approximately $95 million versus last year, driven by higher earnings. I will provide more details on our cash flow and balance sheet a little later in the presentation. Please go to Slide number 7. This slide provides an overview of our quarterly and year-to-date revenue. I will review our enterprise results here before turning to our respective regions. As I just mentioned, we have reported growth of 0.5% with a decline in organic revenue of 0.6% in the quarter, as price realization offset pressure on mechanical volumes. As you see on the top of the slide, Q3 is comping against our prior year quarter with organic growth of more than 18%. If you recall that is when our supply chain improvement efforts allowed us to start working through backlogs and past due customer orders and represented the highest organic growth in our company's history. Currency drove some favorability in the quarter, bringing total reported growth to 5/10. On a year-to-date basis, organic revenue was 6.1% overall with Americas at nearly 9%, driven by strength in our nonresidential business. Our international business is down about 3% year-to-date. Please go to Slide number 8. Our Americas segment continues to deliver strong operating results in the third quarter, expanding margins despite lower volumes. Revenues of $740.9 million was down slightly on a reported basis and flat organically, as favorable pricing was offset by reduced volumes. Let me disaggregate the components further. The Americas non-residential business was up low single digits against the prior year comp, which grew approximately 30% driven by backlog reductions I just mentioned. On a year-to-date basis, non-residential business has grown double digits. Our Americas residential business is down low teens in the quarter as we continue to see weakness in the residential market as higher interest rates continue to impact new and existing home sales. Our Access Technologies business delivered organic growth of mid-teens, representing another strong quarter of top-line growth and demonstrating the stability that this business provides us. Demand for our electronic solutions remained strong in the Americas. We delivered high teens organic growth in electronics in the quarter, and we continue to see a long runway for further adoption as electronics remains a key growth driver for the long-term. As we discussed during our second quarter call, mechanical volumes were expected to be a little soft in the third quarter as customers adjusted to our reduced lead times. We feel the channel has worked through this adjustment, and we are back to a more normal book and ship business. Our Americas adjusted operating income of $210.6 million increased 5% versus the prior year period, while adjusted operating margin and adjusted EBITDA margin for the quarter were up 140 and 150 basis points, respectively. Pricing and productivity exceeded inflation and investments driving substantial margin expansion, demonstrating the resiliency of our Americas business model. Please go to Slide number 9. Our International segment executed well in a challenging macroeconomic environment. Revenues of $177 million was up 3% on a reported basis and down 2.8% organically. Price realization was more than offset by lower volumes, primarily associated with our global portable securities business and our China business, which are operating in challenging markets. We continue to see strength in our electronics and software solutions, which grew low double digits organically in the quarter. In addition, currency was a tailwind this quarter, positively impacting reported revenues by 5.2%. International adjusted operating income of $23.7 million increased over 18% versus the prior year period. We also saw improvements in adjusted operating margin and adjusted EBITDA margins of 180 and 190 basis points, respectively. This substantial margin expansion, despite reduced volumes, highlights the healthier portfolio within our International segment. Please go to Slide number 10. As I mentioned earlier, year-to-date available cash flow came in at $320.4 million, up nearly $95 million versus the prior year. This increase is driven by higher earnings, partially offset by higher capital expenditures related to our new facility in Mexico, which begins production later this quarter. Working capital as a percent of revenue increased versus the prior year. This was primarily driven by timing of revenue and associated receivables within the quarter as well as timing of payments to suppliers in the prior year. Working capital and inventory management remain a priority for our company as we efficiently turn earnings to cash. Our net debt to adjusted EBITDA is down to 2x as we continue to successfully delever following the Access Technologies acquisition. We repaid the final $39 million on our revolving credit facility in the quarter, completing our repayments of short-term borrowings associated with that acquisition. We are now back to pre-acquisition leverage levels, which demonstrates our proven track record of effectively deploying capital while maintaining an investment-grade credit rating. Our business continues to generate strong cash flow and our balance sheet continues to be in a healthy position. I'll now hand the call back over to John for an update on our full year 2023 outlook.
John Stone: Thanks, Mike. Please go to Slide 11. As I mentioned earlier, our company is on track for record full year revenue, adjusted operating income and adjusted EPS in 2023. We're raising our full year outlook on adjusted EPS and affirming our full year outlook on revenue and available cash flow. We continue to expect the Americas segment to be 15% to 16% for total growth, 7.5% to 8.5% organically, led by our non-residential business, which is still expected to grow high single to low double digits organically. Residential business is expected to be down slightly as markets remain challenged. For international, we continue to expect revenue to be down 1% to flat in total and down 1% to 2% organically. All in for the company, our outlook continues to reflect total revenue growth between 11.5% and 12.5% with organic revenue growth between 5.5% and 6.5%. Based on our strong operational performance in the third quarter, we're increasing our adjusted EPS outlook to the range of $6.80 to $6.90, which is approximately 13.5% to 15% growth over the prior year period. Lastly, we still expect our outlook on available cash flow to be in the range of $500 million to $520 million. I'm very proud of the work of the entire Allegion team and our distribution partners over the course of this year and the record results we're on track to achieve. Looking forward, we'll provide our full 2024 outlook to you during our fourth quarter call, as we normally do. However, given the uncertainty in the market moving into next year, we wanted to give you some insights into our view of the market dynamics today. First, we expect growth in electronics adoption to continue, driven by the convenience and added security that digital identities and mobile credentials leveraging smartphone wallets provide to our end user customers. A shift from mechanical systems to electronic access control systems with connected hardware provides efficiencies and operating cost savings for buildings and campuses, and recent channel checks and recent end user visits in the institutional segments in Education and Health Care reinforce this trend. And while small today, our software solutions portfolio is growing, and we look to accelerate this growth into 2024 and beyond. In addition, while the most recent ABI headline dipped, the institutional segment has been very resilient over the last 12 months and 5 of the last 6 months still reading above 50. Allegion's context is important here. You'll recall that we're a late-cycle business and also rather heavily weighted towards the institutional segment. We have an auto door business with strong backlogs and a blue-chip customer base and a service business that continues to grow. Our channel is in good shape on inventory and our lead times across the portfolio are now normalized. Our supply chain has improved to the point where we can regain market share in the aftermarket space. Expected headwinds are well known at this point. Commercial office in major metro areas is indeed soft. It's been soft for several months now. However, that part of our business is only a low double-digit percent of our overall Americas portfolio. Weakness in residential and certain international market is expected to continue, particularly for mechanical products, which we've highlighted for you throughout this year. We expect productivity and recent cost actions that we have taken to help drive margin expansion into next year. And before we go to Q&A, I'd like to reiterate what I said at the beginning of the call. Allegion is in a good industry, and we're well positioned, thanks to the strong execution by our team. We've navigated industry cycles very well in the past. And with the improvements we've made to our portfolio and operations, we feel confident in our ability to succeed and drive continued organic growth and margin expansion. With that, let's turn to Q&A.
Operator: We will now begin the question-and-answer session. [Operator Instructions] The first question comes from Joe O'Dea with Wells Fargo. Please go ahead.
Joe O'Dea: So John, maybe on that last point, and I'm not sure you're sort of willing to maybe elaborate a little bit more, but just the '24 kind of considerations. I mean it seems like if institutional channel checks are constructive market share gain potential in aftermarket, understandable headwinds on commercial office and resi, but then productivity and cost actions as well. I mean it seems like it's setting up for margin expansion. Is it also today setting up for top-line growth with the mix of those factors?
John Stone: Yes, Joe. I appreciate the question. I'd say again, the short answer, yes, we see organic growth in the future. I'd just keep bringing you back to Allegion as a late cycle business. We're heavily weighted towards institutional. If you look at Dodd starts, if you look at ABI, the institutional segment has been very resilient in the last 12 months or even longer. And so yes, we feel pretty good about that, both on driving organic growth as well as, just like you mentioned on the margin expansion side. So margin expansion might not be as robust as you've seen these last quarters, but we still feel well-positioned to continue to drive margin expansion productivity and as you heard and as you called out, the cost actions that we've taken here recently, still well positioned.
Joe O'Dea: All right. I appreciate that. And then, also just international and maybe level setting on your views on where things stand within that cycle, where we've got I think now 6 quarters of volume declines. It's been, I think, some time that a lot of that has been on portable security. I think electronics has been holding up quite better. But just where you think you are in that cycle? How close you are maybe to a bottom within the international trends?
John Stone: Yes. That's tough to peg, Joe, like whereas is the bottom. For international, our portfolio spans Europe and Asia Pacific. And certainly, I think we see continued weakness in China, even though that's a small part of our portfolio. I'd say continued weakness would not be ready to call a bottom. On the portable security business, it's still a challenged market. There's no doubt about it. Time to call a bottom. We're definitely flirting with the bottom, I would say, which could provide a small bit of tailwind into next year and beyond. But you called out the most important piece, and that's the continued growth around our electronics and software solutions portfolio in Europe. They've been performing extremely well. We're continuing to invest in that business, like the bolt-on acquisition of plano. That team came on board and is performing very well, integrated very well with our Interflex team. And we see a really bright future there. And in the electronic space, yes, continued growth, and we will continue to drive investments to drive that growth.
Mike Wagnes: Joe, I might also add, if you think about that global portable, we've been calling that out all year. So it's going to be a soft 2023, all 4 quarters. So if you think about next year, it's not a big headwind, I'm sorry, a big headwind versus the current year because you do have 4 soft quarters. So I think it's important to understand that dynamic about global portable.
Operator: The next question comes from Julian Mitchell with Barclays. Please go ahead.
Julian Mitchell: Maybe just wanted to circle back to the Americas organic sales outlook. So it looks like the fourth quarter implied is organic sales may be up mid-single digits year-on-year in Q4 and then sort of down mid-single digits sequentially. So just wanted to sort of make sure that's roughly correct, and any color within that on non-resi versus resi dynamics. And when we look at that plus mid-single digits entry rate into 2024 and the fact that your guidance from the Investor Day was plus mid-single digit for the Americas market, we assuming that kind of run rate can sustain into early '24?
Mike Wagnes: Yes, Julian, if you think about the current year, so much of the current year growth rates are driven by comps in the prior year. So if you think about Q3, we last year really started to ramp our plants up as we got rid of that excess backlog in mechanical. That continued into Q4 last year. So this year, obviously, back half does have lower growth rates than first half. With respect to the two businesses, I think it's fair to say that non-residential certainly is healthier or stronger than the residential end markets. So as I think about a full year, think of non-res, double digits, right? And you can do the math to back into the Q4 implied. That residential, we are going to be down slightly this year as we put in the prepared remarks, which is we’ve been saying relatively that this year, whether it's down slightly or relatively flat all year. So you do have a dynamic where resi is a little weaker, as we've been saying, and the non-res led by institutional is hanging in there. But prior year comps do impact the year-over-year quarterly growth rates.
Julian Mitchell: That's helpful. Thank you. And it sounds like you're fairly confident that, that inventory destock process by your sort of customers and channel partners is largely done. Maybe just sort of help us understand the conviction level around that. And when you're looking at your sort of forward-looking indicators, I think you mentioned backlog down a bit. But maybe any color on sort of the spec writing for the Americas business overall. How does kind of the order patterns change? Have you seen any evidence of project pushouts, that type of thing?
John Stone: Okay. That's about 5 questions in there, Julian. Well done. I'd say on the channel destock, we feel pretty good there. I think our commentary in Q2 kind of indicated we didn't view this as a real long-term issue. And channel checks kind of prove that out. I don't think it's still a big headwind at this point. We've met with our 25 largest distributors in the past few weeks, and then that would confirm that. So again, there's still certain metro areas that are a little bit soft. There are still suburban areas that are quite strong, quite robust aftermarket, et cetera. So overall, feel pretty good along with the comments that Mike just shared. Let's see what else to mention there. I think with respect to the spec activity, spec activities still remain solid, and it's still hanging in there. And so we would expect that institutional heavy business to be driven that's the spec engine that we have to still remain solid as we move forward. So spec activity still remains strong for us.
Operator: The next question comes from Joe Ritchie with Goldman Sachs. Please go ahead.
Joe Ritchie: So can we maybe just following up on the mechanical business bottoming comment. So your portfolio has gone through some change, obviously, with the Access business, the electronics business growing at a faster pace. If I think about the kind of overall level of where the mechanical business is today, what's the kind of right run rate that should be bottoming, whether that's on a quarterly basis or an annual basis? Just any color around that would be helpful.
Mike Wagnes: I'd share this with you, Joe. If you look at our revenue growth, starting in Q3 last year, we started shipping those past due orders serving our customers. That continued, if you recall, Q1 this year, real large growth that we had. So you could think of that as a kind of a 3-quarter burn through that backlog type challenge and the customers adjusting to our new lead times. I think from that point on, we're kind of more normalized. We talked in Q2 about that item. So I feel that that's behind us. It's those 3 quarters where you do have that more challenging comparable on the non-residential mechanical business we talked about.
Joe Ritchie: Okay. Great. Appreciate that, Mike. And then maybe my follow-on, John. You talked about the balance sheet getting back into investment grade, good shape. You delevered now to 2 turns. I'm curious, there are some fairly sizable assets that are out there potentially on the security side. As you're thinking about deploying capital, how are you thinking about M&A and particularly like bolt-ons versus maybe some more transformative type deals?
John Stone: Yes. Great question, Joe. And I think the teams performed very, very well. Cash flow has improved very well this year. And we did delever quite well, and I think happy with where we're positioned. And again, as in the prepared remarks, building capital to deploy for growth. And I think for us, you can look for us to be acquisitive. You can look for us to look to fill portfolio gaps with bolt-on hardware solutions, like we did with Access Technologies or SaaS businesses like we did with plano. As long as things are the right strategic asset, the right leadership team, a business model, a culture that fits with Allegion and is in the sandbox of security and Access solutions, you can look for us to be acquisitive. Certainly not right to comment on any particular transaction, but we do expect to grow through acquisition and building capital to do just that.
Operator: The next question comes from Brett Linzey with Mizuho. Please go ahead.
Brett Linzey: Just wanted to dig in on the complexion of the marketplace and really thinking about in the softer commercial pockets versus the institutional resilience. Is there any good way to think about the locker access content per building between those 2 verticals? I think you get multiples of the wallet share in school or a hospital versus a retail front, but any insight there would be helpful.
Mike Wagnes: Yes. Brett, when you think of our business, the more complex the business, a building rather, the richer the mix for us. So if you think about a higher edge school, a hospital, those are really good for us. The K-12 school, there's doors frequently and openings frequently per square foot. If you think about open floor plans like commercial office, there's clearly less openings on a commercial office floor plan than there is in an institution or a warehouse, or a warehouse, absolutely. So warehouse has been awful over the last 12 months from a starts, but we really don't have any openings in the warehouse. So when you look at our business, that institutional heavy aspect of our portfolio gives us a richer mix and gives us more openings to address. So that's a net positive for us. John?
Brett Linzey: Yes. Got it. And then just shifting back over to residential, down low teens. You will be lapping your first destock comp in the fourth quarter of '23 here. Could you just characterize where you see those categories in their destocking phase? And any visibility you have on the sellout trends within some of those resi channels?
John Stone: Yes. So I think resi mechanical, when we see our own results and we see some other industry participant results, it's a tough end market, let's just say. So I don't know that I necessarily attribute it just to destocking, but it's a soft end market with mortgage rates going up. House churn, if you will, or resale is certainly a bit depressed. Permits and starts, maybe if you look through a rose-colored lens, you see some green shoots of hope for the future. But I think that overall market is still depressed. When we think about our comps, I would just come back to there was a period of time in 2022 where we just couldn't ship our electronic locks even in the resi segment. And so the restocking phase was still going on until rather recently. And now you could say it's a more normal point-of-sale-driven business on the e-lock side. The mechanical side, I think it's just end market is depressed.
Operator: The next question comes from Chris Snyder with UBS. Please go ahead.
Chris Snyder: I wanted to ask on the Americas business into Q4. So if we look at and if my match right, if you kind of look at the Q4 or the full year organic guide, it kind of pegs Q4 revenues in the Americas anywhere from flat sequentially to maybe down 4% sequentially versus Q3. And when we look at all the pre-COVID years, it seemed like Americas was typically down anywhere from 4% to 7% into Q4. So it's calling for better-than-normal seasonality. Can you just maybe talk about what's driving that or is there Access Technologies?
Mike Wagnes: No, Chris, if you remember on an organic basis in the summertime, we talked about, hey, we're burn through this channel destock. And we said it will be a little flatter this year than historically. So what you saw, we did get through that in the third quarter, which was what we expected. Now as we just think about Q4, sequentially, we're normally down. We're just not down as much as historically we may have been on a more normalized no channel and order pattern challenges that we had in the current year. So think of it as working through that channel item we discussed in the second quarter call.
John Stone: And I think, Chris, this is John. I heard you squeeze in, a mention of Access Technologies in there. And you're right. I mean this is now considered in the organic part of the portfolio. And that business is performing very well. Again, you got strong backlogs, blue-chip customer base and a very healthy service business there. So yes, they've been performing well. Very happy with that acquisition.
Chris Snyder: Yes., I saw the organic growth come through this quarter there. I guess maybe if I could follow up. I think you kind of said earlier that when you talk to your channel partners, it sounds like the destock is largely in the rear view, if I heard that right. Like what does that assume for the cycle? Does that assume like the cycle is kind of flattening out? Are we through the destock even if the cycle kind of is going lower from here because it does feel like the amount of inventory in the channel does reflect what the outlook for the cycle is. Thank you.
John Stone: Yes. I think the way I would see that is similar to what Mike said. Given the rather dramatic volatility and upheaval that the entire industry experienced with the ramp in inflation and the pretty acute supply chain challenges in the latter half or actually, all of 2022. No parts in the first half to work over time, 6 days a week, et cetera, and over ship in second half. That is, at least in our view, normalizing. And I think you could see, as we progress on to another 2, 3, 4 quarters that cycle, Allegion's seasonality, et cetera, starts to look more normal. Our lead times across the portfolio are back to a more normal level. And so with the 9-month or so construction backlog, a lot of work still out there, book and ship business, like Mike said and a spec engine that's running all the time. Yes, I'd say we feel just normalizing is maybe the word that I would use, Chris. And that's what it starts to feel like. And again, our channel checks recently would indicate the same.
Operator: The next question comes from Tim Wojs with Baird. Please go ahead.
Tim Wojs: I have a couple of just kind of modeling questions. But I guess when you're thinking about raw material inputs, steel, copper, zinc, that set of things. I mean, what are you seeing in terms of your purchases today? And how do you think about inflation versus deflation on kind of a go-forward basis on the raw side?
Mike Wagnes: Yes, Tim. It's a great question. If you think of our business, if you remember, pure raw math, let's call that maybe 15% of our COGS, and the remaining 35% you could get have some element of metal in it from a source component. We would expect to see some favorability, as you've seen. We got some tailwinds in commodity prices versus previous peaks. However, I'd caution you, there's been significant inflation that we've experienced over the last few years in other elements of the cost base so that we're still in an inflationary environment, but you are getting some relief from the previous highs of the commodity costs. So hopefully, that kind of gives you some color for you to factor in.
Tim Wojs: Okay. Okay. No, that's helpful. And then just on pricing, if I kind of take a 3 years kind of stacked price in Americas, I think there was some acceleration kind of sequentially. And I don't think you put through like a new increase, but is there some mix dynamic kind of going in there, or did you guys put through more price?
Mike Wagnes: Yes, Tim, as you know, we put price increases in over the last 18 months because we felt so much of that inflationary pressure. We manage this equation price plus productivity to cover the inflation and the investments. If you think about pricing moving forward, think of us as a more normal business, which does our annual price increase in the kind of the beginning of the year based on an expected inflationary level. No more of the multiple price increases a year, I think that's behind us because inflation has moderated from the previous significantly elevated levels that you saw a year plus ago. And so just moving forward, just think of us, price plus productivity versus inflation and investment and most importantly, we price for value in the market that we provide our customers.
Operator: The next question comes from David MacGregor with Longbow. Please go ahead.
David MacGregor: Could you just talk a little bit about the mid-teens organic growth in the electronics and the software solutions business. I don't know to what extent you might be able to open that up for us and help us with price versus units or residential versus non-res or Americas versus international, POS versus inventory build. Any sort of granularity around that would be helpful.
John Stone: Yes, I think in aggregate, mid-teens organic growth in the electronics and software solutions globally, quite proud of those numbers between new product launches and just good execution by the team. And I'd say the end user demand is still strong. Again, recent end user visits continue to reinforce this. I've been to a couple of large universities lately. And even though they've been on the electronics adoption for a couple of years, they're still just scratching the surface. One university was, hey, I've got -- I haven't even started on the dorms yet. I've just been doing classrooms and event buildings and things like this. And as budget comes next year and putting it straight to e-locks for the dorms, I mean, that's sample size of one, but it's indicative of what we're hearing in the end user base, particularly education and health care. I would say our electronics and software business in Europe is doing very well. Blue-chip customer base, great value prop on the electronic cylinder with the SimonsVoss team. And the plano acquisition adding a bit of inorganic growth into that space as well, and that's a space we'll continue to invest in. Very proudly, it's a tiny amount, but our solution for multifamily in the United States, the Zentra platform, that's a very simple electronic access control platform designed specifically for multifamily applications is now a revenue-generating product for Allegion. So cloud-based SaaS revenue is a reality. It's very small. We're just getting started, but we do expect to accelerate that growth. I think the end-user economic benefits of electronics adoption is important and it's real. And I think the smartphone wallet and this mobile credentials and that convenience and personalized security you get out of that will continue to drive end user demand. That's the main trend, David. I'd encourage you not to get wrapped around the axle about channel build or restock, destock, anything like that. It's really, this is end user demand driven.
David MacGregor: Right. Okay. Thanks for that. And as my follow-up, I mean we're looking at a relatively strong U.S. dollar here. I'm just wondering what impact that has on your business by drawing more imported product into the marketplace?
Mike Wagnes: David, as you think about imports, they play at the very low end of the marketplace in, let's say, North America, if you think of our non-res business, we tend to be really strong in the premium space with our institutional heavy business. We've been talking about this for years. We tend to be strongest when the customer values that premium offering of complexity and solutions that we provide. So a strong dollar or a weaker dollar is not something that we view as really going to be changing the dynamics of our competitive industry.
John Stone: Yes. I would add just 1 comment there, David. Some of our flagship products, like the Von Duprin, exit devices like the [indiscernible], I mean, these are very proudly manufactured in the United States.
Operator: The next question comes from Andrew Obin with Bank of America. Please go ahead.
Andrew Obin: Congratulations on a strong quarter. So a question on Europe and sort of the margins in Europe. Can you just give us a sense of what Interflex has been doing because I know it's one of the higher profitability business. I was just trying to understand how much the mix is at play here? Or if it's not Interflex, just as I said, the performance in Europe has continued to surprise despite the headwinds from the sort of the backlog business, just sort of more insight as to what's driving the structural improvement in margins now?
John Stone: Yes, Andrew. I really appreciate that question because I am just super proud of how the international team has been on this steady march of building momentum, increasing productivity, expanding margins without a volume tailwind giving them operating leverage to lean on. They've been doing extremely well. I would say the Interflex in particular, we're not going to call out a specific margin or a P&L for them, but that's a very strong business, let's just say. And we talk about them together with the other electronics portfolio in Europe, double-digit growth for us and has been for a while. Strong margin performance as well. And I think we put our money where our mouth is with the plano acquisition. And while that was rather small, the growth potential is quite large, the margin is very attractive, and the customer value delivered there between plano and Interflex together is very compelling. And Interflex is another one of those very special businesses. Like in this call, we mentioned Access Technologies has a blue-chip customer base. Interflex really has a blue-chip customer base. And we take pride in delighting those customers with good solutions and good service, and that business continues to grow very positive for us.
Andrew Obin: Excellent. And just maybe a follow-up question. I think your predecessor, when he started used to talk quite a bit about discretionary retrofit market in North America being a source of outgrowth and then we sort of stopped talking about it. Can we just talk about where we are there? And what's the remaining opportunity for continuing to increase your market share there? Have you taken a closer look at it? Just maybe an update on this business because it used to be a big source of our growth.
John Stone: Yes, Andrew, it's a hugely important point. When the supply chain challenges hit and orders started piling up and backlog started piling up, we were in the business of just shipping everything we could to make up for orders that had been in the queue for a long while. And then, obviously, aftermarket work is going to take a backseat to whatever, 3, 4 months' worth of backlog that's just sitting there in orders that you've already got to fill for project business and other things. So I would say I'd feel like when the supply chain challenges were at their worst, we definitely lost some aftermarket share to competitors that Allegion typically doesn't and shouldn't lose share to. We're now in a position with our lead times, our published lead times back to normal. Our delivery performance improving. Our supply chain performance is vastly better. We're in a position to now compete and gain that share back, and I think that's a real opportunity for us that has been a long time coming. But getting the lead times back to where they ought to be, getting the delivery performance up and getting our internal productivity better now puts us in a better position to get out and win more of that business.
Operator: This concludes our question-and-answer session. I would like to turn the conference back over to John Stone, Chief Executive Officer, for any closing remarks.
John Stone: Well, thanks, everyone, for a great Q&A. And just to wrap up the main themes that I hope you heard today. Allegion continues to operate at a high level. Strong execution drove these Q3 results that include mid-teens organic growth in electronics and software solutions, continued margin expansion and a healthy balance sheet and cash flow, giving us good momentum going into next year. We're on track for a record year of revenue, adjusted operating income and adjusted EPS results in 2023. We will continue to drive organic growth and margin expansion, as we mentioned. In both the short term and the long term, I feel we're very well positioned to both build on our legacy and continue to invent and deliver new value and seamless access. Thank you. Be safe, be healthy. Have a great day.
Operator: The conference has now concluded. Thank you for attending today's presentation. You may now disconnect. | [
{
"speaker": "Operator",
"text": "Good morning, and welcome to the Allegion Third Quarter 2023 Earnings Call. All participants will be in listen-only mode. [Operator Instructions] After today's presentation, there will be an opportunity to ask questions. [Operator Instructions] Please note this event is being recorded. I would now like to turn the conference over to Jobi Coyle, Director of Investor Relations. Please go ahead."
},
{
"speaker": "Jobi Coyle",
"text": "Thank you, Drew. Good morning, everyone. Thank you for joining us for Allegion's Third Quarter 2023 Earnings Call. With me today are John Stone, President and Chief Executive Officer; and Mike Wagnes, Senior Vice President and Chief Financial Officer of Allegion. Our earnings release, which was issued earlier this morning, and the presentation, which we will refer to in today's call are available on our website at investor.allegion.com. This call will be recorded and archived on our website. Please go to Slide number 2. Statements made in today's call that are not historical facts are considered forward-looking statements and are made pursuant to the Safe Harbor provisions of federal securities law. Please see our most recent SEC filings for a description of some of the factors that may cause actual results to differ materially from our projections. The company assumes no obligation to update these forward-looking statements. Today's presentation and commentary include non-GAAP financial measures. Please refer to the reconciliation in the financial tables of our press release for further details. Please go to Slide 3, and I'll turn the call over to John."
},
{
"speaker": "John Stone",
"text": "Thanks, Jobi, and good morning, everyone. Thanks for joining us today. This current quarter was all about outstanding operational execution from the entire Allegion team, and I'm pleased with our performance. Electronics demand remains strong with in our opinion a long runway for further adoption. In the quarter, Allegion delivered mid-teens organic growth in electronics and software solutions globally, led by our Americas nonresidential business, which had another robust quarter. We already have the highest margins in our industry, and we're driving additional expansion at the gross and operating margin levels despite not having some of the mechanical volume tailwinds from a year ago. Our balance sheet is getting stronger. We delevered from the Access Technologies acquisition quickly and are now building capital to deploy for growth. Bottom-line, Allegion is poised for a record year in total revenue, adjusted operating income and adjusted earnings per share. As a result, we're raising our guidance for full year adjusted EPS. Please go to Slide 4. So Allegion's vision of enabling seamless access in a safer world remains core to our company culture, performance and results. Securing people where they live, learn and work has never been more important. We are a pure-play provider of security and access solutions. We have a great legacy of the strongest brands and the highest margins. We operate with excellence and are accelerating our year-over-year productivity with normalized lead times while still managing the massive SKU complexity that we manage in a made-to-order environment. This makes Allegion a partner of choice, and we're leveraging that unique position to promote the adoption of open ecosystems that maximize our addressable market. We're also delivering new value and access, continuing our drive to wrap software and services around our hardware solutions. This is the critical unlock of additional value for our end user customers for Allegion's growth and for long-term shareholder return. A great proof point of how our company is living this vision and strategy is the Allegion Ventures announcement we made yesterday. Allegion Ventures has made a strategic investment in Ambient AI, whose cutting-edge AI platform utilizes innovative technology to enable seamless access in a safer world. This is the largest investment in Allegion Ventures history, and it reflects the tremendous potential we see in Ambient and Allegion's collaboration to deliver new value and access. Please go to Slide 5. I'd like to turn to our capital allocation priorities. When I joined Allegion, we had just announced the acquisition of Access Technologies. And over the last year, I feel we've done a good job in quickly delevering back to pre-acquisition levels, while still investing in our business and returning cash to our shareholders. Allegion is an investment-grade company, and we expect to remain an investment-grade company. This is critically important to us. We will continue investing for above-market organic growth prioritizing projects and solutions that drive seamless access and make the world safer. We're a dividend-paying stock, and you can expect our dividends to grow commensurate with earnings over the long-term. We will also drive growth through acquisitions, considering complementary portfolios like you saw with the Access Technologies business, as well as Software-as-a-Service related to seamless access, like you saw with plano. High-margin recurring revenue businesses and bolt-on acquisitions that fill portfolio gaps in the hardware space will remain priorities. And while we may increase our debt for the right acquisitions, we've demonstrated the ability to quickly delever. Lastly, with regards to share repurchases at a minimum, we will continue to offset incentive compensation, and we will make additional share repurchases as appropriate. Mike will now walk you through third quarter financial results, and I'll be back to discuss our full year 2023 outlook."
},
{
"speaker": "Mike Wagnes",
"text": "Thanks, John, and good morning, everyone. Thank you for joining today's call. Please go to Slide number 6. As John shared, Allegion continued to execute at a high level. We delivered another quarter of solid performance with strong electronics growth, sustained margin expansion and healthy cash flows. Revenue for the third quarter was $917.9 million, an increase of 0.5% compared to 2022. We continue to see favorable price realization along with strength in electronics and access technologies. However, ongoing pressure on our residential business, paired with a challenging prior year comparable, resulted in organic revenue decline of 0.6%. Adjusted operating margin and adjusted EBITDA margin in the third quarter both increased by 110 basis points. Price and productivity in excess of inflation and investment along with strong operational execution more than offset the volume decline impact. On a year-to-date basis, we have achieved the highest adjusted operating margin in our history. I'm pleased with the margin performance over the last 18 months as we have now recaptured the margin loss during our supply chain disruptions. Our operating model and strong execution have positioned us well for future margin expansion. Adjusted earnings per share of $1.94 increased $0.21 or approximately 12% versus the prior year. Operational performance drove nearly $0.10 per share with the remaining coming from tax driven by timing of discrete items versus the prior year. We expect our full year adjusted effective tax rate to be approximately 15%. You can find further details of our earnings per share performance in the appendix. Year-to-date available cash flow was $320.4 million, an increase of approximately $95 million versus last year, driven by higher earnings. I will provide more details on our cash flow and balance sheet a little later in the presentation. Please go to Slide number 7. This slide provides an overview of our quarterly and year-to-date revenue. I will review our enterprise results here before turning to our respective regions. As I just mentioned, we have reported growth of 0.5% with a decline in organic revenue of 0.6% in the quarter, as price realization offset pressure on mechanical volumes. As you see on the top of the slide, Q3 is comping against our prior year quarter with organic growth of more than 18%. If you recall that is when our supply chain improvement efforts allowed us to start working through backlogs and past due customer orders and represented the highest organic growth in our company's history. Currency drove some favorability in the quarter, bringing total reported growth to 5/10. On a year-to-date basis, organic revenue was 6.1% overall with Americas at nearly 9%, driven by strength in our nonresidential business. Our international business is down about 3% year-to-date. Please go to Slide number 8. Our Americas segment continues to deliver strong operating results in the third quarter, expanding margins despite lower volumes. Revenues of $740.9 million was down slightly on a reported basis and flat organically, as favorable pricing was offset by reduced volumes. Let me disaggregate the components further. The Americas non-residential business was up low single digits against the prior year comp, which grew approximately 30% driven by backlog reductions I just mentioned. On a year-to-date basis, non-residential business has grown double digits. Our Americas residential business is down low teens in the quarter as we continue to see weakness in the residential market as higher interest rates continue to impact new and existing home sales. Our Access Technologies business delivered organic growth of mid-teens, representing another strong quarter of top-line growth and demonstrating the stability that this business provides us. Demand for our electronic solutions remained strong in the Americas. We delivered high teens organic growth in electronics in the quarter, and we continue to see a long runway for further adoption as electronics remains a key growth driver for the long-term. As we discussed during our second quarter call, mechanical volumes were expected to be a little soft in the third quarter as customers adjusted to our reduced lead times. We feel the channel has worked through this adjustment, and we are back to a more normal book and ship business. Our Americas adjusted operating income of $210.6 million increased 5% versus the prior year period, while adjusted operating margin and adjusted EBITDA margin for the quarter were up 140 and 150 basis points, respectively. Pricing and productivity exceeded inflation and investments driving substantial margin expansion, demonstrating the resiliency of our Americas business model. Please go to Slide number 9. Our International segment executed well in a challenging macroeconomic environment. Revenues of $177 million was up 3% on a reported basis and down 2.8% organically. Price realization was more than offset by lower volumes, primarily associated with our global portable securities business and our China business, which are operating in challenging markets. We continue to see strength in our electronics and software solutions, which grew low double digits organically in the quarter. In addition, currency was a tailwind this quarter, positively impacting reported revenues by 5.2%. International adjusted operating income of $23.7 million increased over 18% versus the prior year period. We also saw improvements in adjusted operating margin and adjusted EBITDA margins of 180 and 190 basis points, respectively. This substantial margin expansion, despite reduced volumes, highlights the healthier portfolio within our International segment. Please go to Slide number 10. As I mentioned earlier, year-to-date available cash flow came in at $320.4 million, up nearly $95 million versus the prior year. This increase is driven by higher earnings, partially offset by higher capital expenditures related to our new facility in Mexico, which begins production later this quarter. Working capital as a percent of revenue increased versus the prior year. This was primarily driven by timing of revenue and associated receivables within the quarter as well as timing of payments to suppliers in the prior year. Working capital and inventory management remain a priority for our company as we efficiently turn earnings to cash. Our net debt to adjusted EBITDA is down to 2x as we continue to successfully delever following the Access Technologies acquisition. We repaid the final $39 million on our revolving credit facility in the quarter, completing our repayments of short-term borrowings associated with that acquisition. We are now back to pre-acquisition leverage levels, which demonstrates our proven track record of effectively deploying capital while maintaining an investment-grade credit rating. Our business continues to generate strong cash flow and our balance sheet continues to be in a healthy position. I'll now hand the call back over to John for an update on our full year 2023 outlook."
},
{
"speaker": "John Stone",
"text": "Thanks, Mike. Please go to Slide 11. As I mentioned earlier, our company is on track for record full year revenue, adjusted operating income and adjusted EPS in 2023. We're raising our full year outlook on adjusted EPS and affirming our full year outlook on revenue and available cash flow. We continue to expect the Americas segment to be 15% to 16% for total growth, 7.5% to 8.5% organically, led by our non-residential business, which is still expected to grow high single to low double digits organically. Residential business is expected to be down slightly as markets remain challenged. For international, we continue to expect revenue to be down 1% to flat in total and down 1% to 2% organically. All in for the company, our outlook continues to reflect total revenue growth between 11.5% and 12.5% with organic revenue growth between 5.5% and 6.5%. Based on our strong operational performance in the third quarter, we're increasing our adjusted EPS outlook to the range of $6.80 to $6.90, which is approximately 13.5% to 15% growth over the prior year period. Lastly, we still expect our outlook on available cash flow to be in the range of $500 million to $520 million. I'm very proud of the work of the entire Allegion team and our distribution partners over the course of this year and the record results we're on track to achieve. Looking forward, we'll provide our full 2024 outlook to you during our fourth quarter call, as we normally do. However, given the uncertainty in the market moving into next year, we wanted to give you some insights into our view of the market dynamics today. First, we expect growth in electronics adoption to continue, driven by the convenience and added security that digital identities and mobile credentials leveraging smartphone wallets provide to our end user customers. A shift from mechanical systems to electronic access control systems with connected hardware provides efficiencies and operating cost savings for buildings and campuses, and recent channel checks and recent end user visits in the institutional segments in Education and Health Care reinforce this trend. And while small today, our software solutions portfolio is growing, and we look to accelerate this growth into 2024 and beyond. In addition, while the most recent ABI headline dipped, the institutional segment has been very resilient over the last 12 months and 5 of the last 6 months still reading above 50. Allegion's context is important here. You'll recall that we're a late-cycle business and also rather heavily weighted towards the institutional segment. We have an auto door business with strong backlogs and a blue-chip customer base and a service business that continues to grow. Our channel is in good shape on inventory and our lead times across the portfolio are now normalized. Our supply chain has improved to the point where we can regain market share in the aftermarket space. Expected headwinds are well known at this point. Commercial office in major metro areas is indeed soft. It's been soft for several months now. However, that part of our business is only a low double-digit percent of our overall Americas portfolio. Weakness in residential and certain international market is expected to continue, particularly for mechanical products, which we've highlighted for you throughout this year. We expect productivity and recent cost actions that we have taken to help drive margin expansion into next year. And before we go to Q&A, I'd like to reiterate what I said at the beginning of the call. Allegion is in a good industry, and we're well positioned, thanks to the strong execution by our team. We've navigated industry cycles very well in the past. And with the improvements we've made to our portfolio and operations, we feel confident in our ability to succeed and drive continued organic growth and margin expansion. With that, let's turn to Q&A."
},
{
"speaker": "Operator",
"text": "We will now begin the question-and-answer session. [Operator Instructions] The first question comes from Joe O'Dea with Wells Fargo. Please go ahead."
},
{
"speaker": "Joe O'Dea",
"text": "So John, maybe on that last point, and I'm not sure you're sort of willing to maybe elaborate a little bit more, but just the '24 kind of considerations. I mean it seems like if institutional channel checks are constructive market share gain potential in aftermarket, understandable headwinds on commercial office and resi, but then productivity and cost actions as well. I mean it seems like it's setting up for margin expansion. Is it also today setting up for top-line growth with the mix of those factors?"
},
{
"speaker": "John Stone",
"text": "Yes, Joe. I appreciate the question. I'd say again, the short answer, yes, we see organic growth in the future. I'd just keep bringing you back to Allegion as a late cycle business. We're heavily weighted towards institutional. If you look at Dodd starts, if you look at ABI, the institutional segment has been very resilient in the last 12 months or even longer. And so yes, we feel pretty good about that, both on driving organic growth as well as, just like you mentioned on the margin expansion side. So margin expansion might not be as robust as you've seen these last quarters, but we still feel well-positioned to continue to drive margin expansion productivity and as you heard and as you called out, the cost actions that we've taken here recently, still well positioned."
},
{
"speaker": "Joe O'Dea",
"text": "All right. I appreciate that. And then, also just international and maybe level setting on your views on where things stand within that cycle, where we've got I think now 6 quarters of volume declines. It's been, I think, some time that a lot of that has been on portable security. I think electronics has been holding up quite better. But just where you think you are in that cycle? How close you are maybe to a bottom within the international trends?"
},
{
"speaker": "John Stone",
"text": "Yes. That's tough to peg, Joe, like whereas is the bottom. For international, our portfolio spans Europe and Asia Pacific. And certainly, I think we see continued weakness in China, even though that's a small part of our portfolio. I'd say continued weakness would not be ready to call a bottom. On the portable security business, it's still a challenged market. There's no doubt about it. Time to call a bottom. We're definitely flirting with the bottom, I would say, which could provide a small bit of tailwind into next year and beyond. But you called out the most important piece, and that's the continued growth around our electronics and software solutions portfolio in Europe. They've been performing extremely well. We're continuing to invest in that business, like the bolt-on acquisition of plano. That team came on board and is performing very well, integrated very well with our Interflex team. And we see a really bright future there. And in the electronic space, yes, continued growth, and we will continue to drive investments to drive that growth."
},
{
"speaker": "Mike Wagnes",
"text": "Joe, I might also add, if you think about that global portable, we've been calling that out all year. So it's going to be a soft 2023, all 4 quarters. So if you think about next year, it's not a big headwind, I'm sorry, a big headwind versus the current year because you do have 4 soft quarters. So I think it's important to understand that dynamic about global portable."
},
{
"speaker": "Operator",
"text": "The next question comes from Julian Mitchell with Barclays. Please go ahead."
},
{
"speaker": "Julian Mitchell",
"text": "Maybe just wanted to circle back to the Americas organic sales outlook. So it looks like the fourth quarter implied is organic sales may be up mid-single digits year-on-year in Q4 and then sort of down mid-single digits sequentially. So just wanted to sort of make sure that's roughly correct, and any color within that on non-resi versus resi dynamics. And when we look at that plus mid-single digits entry rate into 2024 and the fact that your guidance from the Investor Day was plus mid-single digit for the Americas market, we assuming that kind of run rate can sustain into early '24?"
},
{
"speaker": "Mike Wagnes",
"text": "Yes, Julian, if you think about the current year, so much of the current year growth rates are driven by comps in the prior year. So if you think about Q3, we last year really started to ramp our plants up as we got rid of that excess backlog in mechanical. That continued into Q4 last year. So this year, obviously, back half does have lower growth rates than first half. With respect to the two businesses, I think it's fair to say that non-residential certainly is healthier or stronger than the residential end markets. So as I think about a full year, think of non-res, double digits, right? And you can do the math to back into the Q4 implied. That residential, we are going to be down slightly this year as we put in the prepared remarks, which is we’ve been saying relatively that this year, whether it's down slightly or relatively flat all year. So you do have a dynamic where resi is a little weaker, as we've been saying, and the non-res led by institutional is hanging in there. But prior year comps do impact the year-over-year quarterly growth rates."
},
{
"speaker": "Julian Mitchell",
"text": "That's helpful. Thank you. And it sounds like you're fairly confident that, that inventory destock process by your sort of customers and channel partners is largely done. Maybe just sort of help us understand the conviction level around that. And when you're looking at your sort of forward-looking indicators, I think you mentioned backlog down a bit. But maybe any color on sort of the spec writing for the Americas business overall. How does kind of the order patterns change? Have you seen any evidence of project pushouts, that type of thing?"
},
{
"speaker": "John Stone",
"text": "Okay. That's about 5 questions in there, Julian. Well done. I'd say on the channel destock, we feel pretty good there. I think our commentary in Q2 kind of indicated we didn't view this as a real long-term issue. And channel checks kind of prove that out. I don't think it's still a big headwind at this point. We've met with our 25 largest distributors in the past few weeks, and then that would confirm that. So again, there's still certain metro areas that are a little bit soft. There are still suburban areas that are quite strong, quite robust aftermarket, et cetera. So overall, feel pretty good along with the comments that Mike just shared. Let's see what else to mention there. I think with respect to the spec activity, spec activities still remain solid, and it's still hanging in there. And so we would expect that institutional heavy business to be driven that's the spec engine that we have to still remain solid as we move forward. So spec activity still remains strong for us."
},
{
"speaker": "Operator",
"text": "The next question comes from Joe Ritchie with Goldman Sachs. Please go ahead."
},
{
"speaker": "Joe Ritchie",
"text": "So can we maybe just following up on the mechanical business bottoming comment. So your portfolio has gone through some change, obviously, with the Access business, the electronics business growing at a faster pace. If I think about the kind of overall level of where the mechanical business is today, what's the kind of right run rate that should be bottoming, whether that's on a quarterly basis or an annual basis? Just any color around that would be helpful."
},
{
"speaker": "Mike Wagnes",
"text": "I'd share this with you, Joe. If you look at our revenue growth, starting in Q3 last year, we started shipping those past due orders serving our customers. That continued, if you recall, Q1 this year, real large growth that we had. So you could think of that as a kind of a 3-quarter burn through that backlog type challenge and the customers adjusting to our new lead times. I think from that point on, we're kind of more normalized. We talked in Q2 about that item. So I feel that that's behind us. It's those 3 quarters where you do have that more challenging comparable on the non-residential mechanical business we talked about."
},
{
"speaker": "Joe Ritchie",
"text": "Okay. Great. Appreciate that, Mike. And then maybe my follow-on, John. You talked about the balance sheet getting back into investment grade, good shape. You delevered now to 2 turns. I'm curious, there are some fairly sizable assets that are out there potentially on the security side. As you're thinking about deploying capital, how are you thinking about M&A and particularly like bolt-ons versus maybe some more transformative type deals?"
},
{
"speaker": "John Stone",
"text": "Yes. Great question, Joe. And I think the teams performed very, very well. Cash flow has improved very well this year. And we did delever quite well, and I think happy with where we're positioned. And again, as in the prepared remarks, building capital to deploy for growth. And I think for us, you can look for us to be acquisitive. You can look for us to look to fill portfolio gaps with bolt-on hardware solutions, like we did with Access Technologies or SaaS businesses like we did with plano. As long as things are the right strategic asset, the right leadership team, a business model, a culture that fits with Allegion and is in the sandbox of security and Access solutions, you can look for us to be acquisitive. Certainly not right to comment on any particular transaction, but we do expect to grow through acquisition and building capital to do just that."
},
{
"speaker": "Operator",
"text": "The next question comes from Brett Linzey with Mizuho. Please go ahead."
},
{
"speaker": "Brett Linzey",
"text": "Just wanted to dig in on the complexion of the marketplace and really thinking about in the softer commercial pockets versus the institutional resilience. Is there any good way to think about the locker access content per building between those 2 verticals? I think you get multiples of the wallet share in school or a hospital versus a retail front, but any insight there would be helpful."
},
{
"speaker": "Mike Wagnes",
"text": "Yes. Brett, when you think of our business, the more complex the business, a building rather, the richer the mix for us. So if you think about a higher edge school, a hospital, those are really good for us. The K-12 school, there's doors frequently and openings frequently per square foot. If you think about open floor plans like commercial office, there's clearly less openings on a commercial office floor plan than there is in an institution or a warehouse, or a warehouse, absolutely. So warehouse has been awful over the last 12 months from a starts, but we really don't have any openings in the warehouse. So when you look at our business, that institutional heavy aspect of our portfolio gives us a richer mix and gives us more openings to address. So that's a net positive for us. John?"
},
{
"speaker": "Brett Linzey",
"text": "Yes. Got it. And then just shifting back over to residential, down low teens. You will be lapping your first destock comp in the fourth quarter of '23 here. Could you just characterize where you see those categories in their destocking phase? And any visibility you have on the sellout trends within some of those resi channels?"
},
{
"speaker": "John Stone",
"text": "Yes. So I think resi mechanical, when we see our own results and we see some other industry participant results, it's a tough end market, let's just say. So I don't know that I necessarily attribute it just to destocking, but it's a soft end market with mortgage rates going up. House churn, if you will, or resale is certainly a bit depressed. Permits and starts, maybe if you look through a rose-colored lens, you see some green shoots of hope for the future. But I think that overall market is still depressed. When we think about our comps, I would just come back to there was a period of time in 2022 where we just couldn't ship our electronic locks even in the resi segment. And so the restocking phase was still going on until rather recently. And now you could say it's a more normal point-of-sale-driven business on the e-lock side. The mechanical side, I think it's just end market is depressed."
},
{
"speaker": "Operator",
"text": "The next question comes from Chris Snyder with UBS. Please go ahead."
},
{
"speaker": "Chris Snyder",
"text": "I wanted to ask on the Americas business into Q4. So if we look at and if my match right, if you kind of look at the Q4 or the full year organic guide, it kind of pegs Q4 revenues in the Americas anywhere from flat sequentially to maybe down 4% sequentially versus Q3. And when we look at all the pre-COVID years, it seemed like Americas was typically down anywhere from 4% to 7% into Q4. So it's calling for better-than-normal seasonality. Can you just maybe talk about what's driving that or is there Access Technologies?"
},
{
"speaker": "Mike Wagnes",
"text": "No, Chris, if you remember on an organic basis in the summertime, we talked about, hey, we're burn through this channel destock. And we said it will be a little flatter this year than historically. So what you saw, we did get through that in the third quarter, which was what we expected. Now as we just think about Q4, sequentially, we're normally down. We're just not down as much as historically we may have been on a more normalized no channel and order pattern challenges that we had in the current year. So think of it as working through that channel item we discussed in the second quarter call."
},
{
"speaker": "John Stone",
"text": "And I think, Chris, this is John. I heard you squeeze in, a mention of Access Technologies in there. And you're right. I mean this is now considered in the organic part of the portfolio. And that business is performing very well. Again, you got strong backlogs, blue-chip customer base and a very healthy service business there. So yes, they've been performing well. Very happy with that acquisition."
},
{
"speaker": "Chris Snyder",
"text": "Yes., I saw the organic growth come through this quarter there. I guess maybe if I could follow up. I think you kind of said earlier that when you talk to your channel partners, it sounds like the destock is largely in the rear view, if I heard that right. Like what does that assume for the cycle? Does that assume like the cycle is kind of flattening out? Are we through the destock even if the cycle kind of is going lower from here because it does feel like the amount of inventory in the channel does reflect what the outlook for the cycle is. Thank you."
},
{
"speaker": "John Stone",
"text": "Yes. I think the way I would see that is similar to what Mike said. Given the rather dramatic volatility and upheaval that the entire industry experienced with the ramp in inflation and the pretty acute supply chain challenges in the latter half or actually, all of 2022. No parts in the first half to work over time, 6 days a week, et cetera, and over ship in second half. That is, at least in our view, normalizing. And I think you could see, as we progress on to another 2, 3, 4 quarters that cycle, Allegion's seasonality, et cetera, starts to look more normal. Our lead times across the portfolio are back to a more normal level. And so with the 9-month or so construction backlog, a lot of work still out there, book and ship business, like Mike said and a spec engine that's running all the time. Yes, I'd say we feel just normalizing is maybe the word that I would use, Chris. And that's what it starts to feel like. And again, our channel checks recently would indicate the same."
},
{
"speaker": "Operator",
"text": "The next question comes from Tim Wojs with Baird. Please go ahead."
},
{
"speaker": "Tim Wojs",
"text": "I have a couple of just kind of modeling questions. But I guess when you're thinking about raw material inputs, steel, copper, zinc, that set of things. I mean, what are you seeing in terms of your purchases today? And how do you think about inflation versus deflation on kind of a go-forward basis on the raw side?"
},
{
"speaker": "Mike Wagnes",
"text": "Yes, Tim. It's a great question. If you think of our business, if you remember, pure raw math, let's call that maybe 15% of our COGS, and the remaining 35% you could get have some element of metal in it from a source component. We would expect to see some favorability, as you've seen. We got some tailwinds in commodity prices versus previous peaks. However, I'd caution you, there's been significant inflation that we've experienced over the last few years in other elements of the cost base so that we're still in an inflationary environment, but you are getting some relief from the previous highs of the commodity costs. So hopefully, that kind of gives you some color for you to factor in."
},
{
"speaker": "Tim Wojs",
"text": "Okay. Okay. No, that's helpful. And then just on pricing, if I kind of take a 3 years kind of stacked price in Americas, I think there was some acceleration kind of sequentially. And I don't think you put through like a new increase, but is there some mix dynamic kind of going in there, or did you guys put through more price?"
},
{
"speaker": "Mike Wagnes",
"text": "Yes, Tim, as you know, we put price increases in over the last 18 months because we felt so much of that inflationary pressure. We manage this equation price plus productivity to cover the inflation and the investments. If you think about pricing moving forward, think of us as a more normal business, which does our annual price increase in the kind of the beginning of the year based on an expected inflationary level. No more of the multiple price increases a year, I think that's behind us because inflation has moderated from the previous significantly elevated levels that you saw a year plus ago. And so just moving forward, just think of us, price plus productivity versus inflation and investment and most importantly, we price for value in the market that we provide our customers."
},
{
"speaker": "Operator",
"text": "The next question comes from David MacGregor with Longbow. Please go ahead."
},
{
"speaker": "David MacGregor",
"text": "Could you just talk a little bit about the mid-teens organic growth in the electronics and the software solutions business. I don't know to what extent you might be able to open that up for us and help us with price versus units or residential versus non-res or Americas versus international, POS versus inventory build. Any sort of granularity around that would be helpful."
},
{
"speaker": "John Stone",
"text": "Yes, I think in aggregate, mid-teens organic growth in the electronics and software solutions globally, quite proud of those numbers between new product launches and just good execution by the team. And I'd say the end user demand is still strong. Again, recent end user visits continue to reinforce this. I've been to a couple of large universities lately. And even though they've been on the electronics adoption for a couple of years, they're still just scratching the surface. One university was, hey, I've got -- I haven't even started on the dorms yet. I've just been doing classrooms and event buildings and things like this. And as budget comes next year and putting it straight to e-locks for the dorms, I mean, that's sample size of one, but it's indicative of what we're hearing in the end user base, particularly education and health care. I would say our electronics and software business in Europe is doing very well. Blue-chip customer base, great value prop on the electronic cylinder with the SimonsVoss team. And the plano acquisition adding a bit of inorganic growth into that space as well, and that's a space we'll continue to invest in. Very proudly, it's a tiny amount, but our solution for multifamily in the United States, the Zentra platform, that's a very simple electronic access control platform designed specifically for multifamily applications is now a revenue-generating product for Allegion. So cloud-based SaaS revenue is a reality. It's very small. We're just getting started, but we do expect to accelerate that growth. I think the end-user economic benefits of electronics adoption is important and it's real. And I think the smartphone wallet and this mobile credentials and that convenience and personalized security you get out of that will continue to drive end user demand. That's the main trend, David. I'd encourage you not to get wrapped around the axle about channel build or restock, destock, anything like that. It's really, this is end user demand driven."
},
{
"speaker": "David MacGregor",
"text": "Right. Okay. Thanks for that. And as my follow-up, I mean we're looking at a relatively strong U.S. dollar here. I'm just wondering what impact that has on your business by drawing more imported product into the marketplace?"
},
{
"speaker": "Mike Wagnes",
"text": "David, as you think about imports, they play at the very low end of the marketplace in, let's say, North America, if you think of our non-res business, we tend to be really strong in the premium space with our institutional heavy business. We've been talking about this for years. We tend to be strongest when the customer values that premium offering of complexity and solutions that we provide. So a strong dollar or a weaker dollar is not something that we view as really going to be changing the dynamics of our competitive industry."
},
{
"speaker": "John Stone",
"text": "Yes. I would add just 1 comment there, David. Some of our flagship products, like the Von Duprin, exit devices like the [indiscernible], I mean, these are very proudly manufactured in the United States."
},
{
"speaker": "Operator",
"text": "The next question comes from Andrew Obin with Bank of America. Please go ahead."
},
{
"speaker": "Andrew Obin",
"text": "Congratulations on a strong quarter. So a question on Europe and sort of the margins in Europe. Can you just give us a sense of what Interflex has been doing because I know it's one of the higher profitability business. I was just trying to understand how much the mix is at play here? Or if it's not Interflex, just as I said, the performance in Europe has continued to surprise despite the headwinds from the sort of the backlog business, just sort of more insight as to what's driving the structural improvement in margins now?"
},
{
"speaker": "John Stone",
"text": "Yes, Andrew. I really appreciate that question because I am just super proud of how the international team has been on this steady march of building momentum, increasing productivity, expanding margins without a volume tailwind giving them operating leverage to lean on. They've been doing extremely well. I would say the Interflex in particular, we're not going to call out a specific margin or a P&L for them, but that's a very strong business, let's just say. And we talk about them together with the other electronics portfolio in Europe, double-digit growth for us and has been for a while. Strong margin performance as well. And I think we put our money where our mouth is with the plano acquisition. And while that was rather small, the growth potential is quite large, the margin is very attractive, and the customer value delivered there between plano and Interflex together is very compelling. And Interflex is another one of those very special businesses. Like in this call, we mentioned Access Technologies has a blue-chip customer base. Interflex really has a blue-chip customer base. And we take pride in delighting those customers with good solutions and good service, and that business continues to grow very positive for us."
},
{
"speaker": "Andrew Obin",
"text": "Excellent. And just maybe a follow-up question. I think your predecessor, when he started used to talk quite a bit about discretionary retrofit market in North America being a source of outgrowth and then we sort of stopped talking about it. Can we just talk about where we are there? And what's the remaining opportunity for continuing to increase your market share there? Have you taken a closer look at it? Just maybe an update on this business because it used to be a big source of our growth."
},
{
"speaker": "John Stone",
"text": "Yes, Andrew, it's a hugely important point. When the supply chain challenges hit and orders started piling up and backlog started piling up, we were in the business of just shipping everything we could to make up for orders that had been in the queue for a long while. And then, obviously, aftermarket work is going to take a backseat to whatever, 3, 4 months' worth of backlog that's just sitting there in orders that you've already got to fill for project business and other things. So I would say I'd feel like when the supply chain challenges were at their worst, we definitely lost some aftermarket share to competitors that Allegion typically doesn't and shouldn't lose share to. We're now in a position with our lead times, our published lead times back to normal. Our delivery performance improving. Our supply chain performance is vastly better. We're in a position to now compete and gain that share back, and I think that's a real opportunity for us that has been a long time coming. But getting the lead times back to where they ought to be, getting the delivery performance up and getting our internal productivity better now puts us in a better position to get out and win more of that business."
},
{
"speaker": "Operator",
"text": "This concludes our question-and-answer session. I would like to turn the conference back over to John Stone, Chief Executive Officer, for any closing remarks."
},
{
"speaker": "John Stone",
"text": "Well, thanks, everyone, for a great Q&A. And just to wrap up the main themes that I hope you heard today. Allegion continues to operate at a high level. Strong execution drove these Q3 results that include mid-teens organic growth in electronics and software solutions, continued margin expansion and a healthy balance sheet and cash flow, giving us good momentum going into next year. We're on track for a record year of revenue, adjusted operating income and adjusted EPS results in 2023. We will continue to drive organic growth and margin expansion, as we mentioned. In both the short term and the long term, I feel we're very well positioned to both build on our legacy and continue to invent and deliver new value and seamless access. Thank you. Be safe, be healthy. Have a great day."
},
{
"speaker": "Operator",
"text": "The conference has now concluded. Thank you for attending today's presentation. You may now disconnect."
}
] | Allegion plc | 241,782,379 |
ALLE | 2 | 2,023 | 2023-07-26 08:00:00 | Operator: Good morning, and welcome to the Allegion Second Quarter 2023 Earnings Call. [Operator Instructions] Please note this event is being recorded. I would now like to turn the conference over to Jobi Coyle, Director of Investor Relations. Please, go ahead.
Jobi Coyle: Thank you, [Joe]. Good morning, everyone. Thank you for joining us for Allegion's second quarter 2023 earnings call. With me today are John Stone, President and Chief Executive Officer; and Mike Wagnes, Senior Vice President and Chief Financial Officer of Allegion. Our earnings release, which was issued earlier this morning and the presentation which we will refer to in today's call, are available on our website at investor.allegion.com. This call will be recorded and archived on our website. Please go to Slide 2. Statements made in today's call that are not historical facts are considered forward-looking statements and are made pursuant to the safe harbor provisions of federal securities law. Please see our most recent SEC filings for a description of some of the factors that may cause actual results to differ materially from our projections. The company assumes no obligation to update these forward-looking statements. Today's presentation and commentary include non-GAAP financial measures. Please refer to the reconciliation in the financial tables of our press release for further details. Please go to Slide 3, and I'll turn the call over to John.
John Stone: Thanks, Jobi. Good morning, everyone. Thanks for joining us today. My, how time flies. It's hard to believe this time last year, I was joining you for my first Allegion earnings call. I shared then my belief in our company's mission, our people, our culture, and my excitement around this chapter that we're writing in Allegion's history together. One year in, I'm even more energized about Allegion's future and even more proud of our global team who has just delivered another quarter of outstanding operational performance. Let's go to Slide 3 and talk about some of the highlights. The Allegion team delivered 18% total growth and we drove strong margin expansion. In Q2, we increased margins across the Americas and international business segments, both sequentially and year-over-year, resulting in a 130 basis-point increase in adjusted operating income margin for the quarter. We see electronics continuing to be a key growth driver for Allegion. Demand was strong for our electronic solutions in the second quarter, fueling Allegion's overall revenue growth. In Q2, strength across both residential and nonresidential business in our Americas segment totaled nearly 40% electronics growth over the prior period. We also saw a strong electronics and software solutions performance in our international segment. As we work to shape the transformation taking place in our industry, we continue to see electronics as key to our overall growth. Our nonresidential markets remained stable and electronics demand continues to be a bright spot in both Americas and international segments. However, we did see some softness in nonresidential and mechanical demand as customers and distribution partners adjust their ordering patterns to our reduced lead times due to much-improved supply chain and operational execution. The Americas residential business was bolstered by very strong electronics sales, but we're still seeing soft mechanical demand. Certain international end markets, particularly in the portable security business, also remained soft. Overall, our team delivered another strong quarter, resulting in a solid first half 2023. We are operating at a high level, and as a result, are raising our outlook for the year for adjusted EPS, which is now expected to be in a range of $6.70 to $6.80. I'm very proud of the Allegion team's operational performance. I'll provide more color on the outlook later in the presentation. Please go to Slide 4. Now let's move to our vision and strategy. This is a slide we talked through at our Investor Day and while it's a simple overview, it reflects an important foundation for our company. Our vision of enabling seamless access in a safer world. What does that mean? It means if you have the right credentials, whether that's a metal key, an encrypted proximity card, or a digital identity in a mobile wallet, we will provide you the most convenient and secure experience possible. Why is this the right strategy and why is this the right strategy now? Because our world is increasingly digital, mobile, and connected. Because touchless and contactless experiences in technology will clearly live well beyond COVID. Because digital credentials and smart hardware not only provide more seamless access experiences, they also provide more rich data to the end user customer and added layers of security. We feel this transformation has a long runway ahead. Our vision is supported by our strategy of creating value as a pure-play provider of security and access solutions. This is how we differentiate our company and drive innovation for a safer world forward. Building on our legacy, delivering new value and access, being the partner of choice, and operating with excellence. Please go to Slide 5. So, this month also reflects the first anniversary of the Stanley Access Technologies acquisition. Acquiring the Access Technologies business was a direct reflection of our seamless access strategy, making the world more accessible, expanding our presence in access and security markets and unlocking greater long-term value for our customers, our shareholders, and our employees alike. In year one, our teams have integrated very well together. We've taken very good care of our customers, and you can see this in our results, which reflects operational performance in line with the business plan. Access Technologies generated revenues of approximately $385 million, which represented approximately 10% growth. This was $0.11 accretive to adjusted EPS release in its first 12 months. In addition, when we made this acquisition, which is our largest to date, we committed to deleveraging quickly. You can see the results. Our leverage ratios are back to pre-acquisition levels. Overall, we feel great about this highly strategic combination. The automatic doors product portfolio is a hand-in-glove fit with our demand creation and specification engine. This acquisition has greatly enhanced Allegion's service capabilities and we look forward to much more long-term profitable growth opportunities together. I'll ask Mike now to walk you through second quarter financial results, and I'll be back to discuss our updated 2023 outlook.
Mike Wagnes: Thanks, John, and good morning, everyone. Thank you for joining today's call. Please go to Slide Number 6. Allegion delivered another strong quarter, with both top- and bottom-line growth as well as improving cash flows. Revenue for the second quarter was $912.5 million, an increase of 18% compared to 2022. Organic growth of 5.6% was driven by price realization along with strong growth in electronics, offsetting lower volumes in mechanical products. Our Access Technologies acquisition contributed approximately 12% to total growth. Adjusted operating margin and adjusted EBITDA margin in the second quarter increased by 130 basis points and 110 basis points, respectively. These increases were attributable to strong operational execution and favorable price and productivity, which more than offset inflation and investments. Excluding our acquisition of Access Technologies, adjusted operating margin was up 270 basis points. Adjusted earnings per share of $1.76, increased $0.33, or approximately 23%, versus the prior year. Operational performance drove 20% earnings per share growth with additional earnings per share growth coming from acquisitions, offset by the unfavorable impact of anticipated higher interest. Details of our earnings per share performance versus the prior year are in the appendix. Year-to-date available cash flow was $190.1 million, up nearly 125% versus last year. Please go to Slide Number 7. I will start by reviewing the revenue results for the enterprise here before turning to our respective regions. In Q2, we delivered 5.6% organic growth, driven by price realization across the portfolio. Strong volume growth in electronics was more than offset by volume declines in our mechanical products. Our Access Technologies acquisition served as the primary driver of our 12.5% growth in net acquisitions and divestitures. Currency pressure were minimal in the quarter, bringing total reported growth to 18%. First half organic revenue growth was 10.2% overall, driven by strength in electronics. Americas operating growth was nearly 15% and international was down 3%. Please go to Slide Number 8. Our Americas segment continued to deliver strong operating results in the second quarter, with revenues of $727.2 million, up 23.8% on a reported basis and up 7.7% organically. During the second quarter, we achieved double-digit price realization. Our electronics growth for the Americas was nearly 40% as we continue to see both improvements in our supply chain and strong demand. Electronic component availability was significantly challenged in the first half of 2022, making the quarter an easier comparison versus the prior year as our supply chains are much healthier now. In the second quarter, we saw soft mechanical volumes as customers adjust to our reduce lead times to our improve supply chain and operational execution. Organic growth was up high-single-digits for both our nonresidential and residential Americas businesses. As John mentioned earlier, Access Technologies has now been part of Allegion for just over a year, and we are pleased with the ongoing integration and results. This business had pro forma revenue growth of approximately 9.5% versus Q2 2022, and contributed over 16% to the Americas reported growth. Our adjusted operating income of $205.9 million increased 32.9% versus the prior year period, while adjusted operating margin and adjusted EBITDA margin for the quarter were up 190 basis points and 180 basis points, respectively. Excluding Access Technologies, our Americas segment drove a 460 basis-point improvement in operating margin versus the prior year. Our team is executing well and we were able to drive price and productivity in excess of inflation and investments to deliver the strong margin expansion. Please go to Slide Number 9. Our international business had a solid second quarter, with revenues of $185.3 million, flat on a reported basis and down 1% organically. In the quarter, price realization was more than offset by lower volumes, primarily associated with our Global Portable Securities business. As we've discussed previously, this business benefited from a COVID-related demand surge in the first half of last year. We expect this market will normalize and be less of a headwind to our international segment in the second half of this year. Our electronics and software solutions are performing well and continued to be a growth driver for our international segment. In addition, currency was a slight tailwind this quarter and positively impacted reported revenue by 0.6%. International adjusted operating income of $20.9 million increased 2% versus the prior-year period. We saw a significant improvement in adjusted operating margin and adjusted EBITDA margins of 30 basis points and 40 basis points, respectively, when compared to last year. The margin improvement was primarily driven by favorable price and productivity in excess of inflation and investment, reflecting strong execution by the team. Please go to Slide Number 10. Year-to-date available cash flow came in at $190.1 million, up $105.6 million versus the prior year. This increase is driven by higher earnings and lower cash used for net working capital, primarily offset by higher capital expenditures. Working capital as a percent of revenue increased versus the prior year, partially driven by our Access Technologies business, which was not owned in the first half of last year. Working capital management remains a priority of our company as we efficiently turn earnings to cash. As committed, we deleveraged following the acquisition of Access Technologies, and our net debt-to-adjusted EBITDA is back down to 2.1 times. We repaid $60 million on our revolving credit facility in the second quarter and the remaining $30 million outstanding was repaid in the month of July. This means, we have completed our repayments of short-term borrowings for the acquisition, demonstrating our ability to effectively deploy capital and maintain an investment-grade credit rating. Our business continues to generate strong cash flow and our balance sheet continues to be in a healthy position. I will now hand it back over to John for an update on our full-year 2023 outlook.
John Stone: Thanks, Mike. Please go to Slide 11. And as we look at the remainder of 2023, we're tightening our full-year revenue outlook, while also increasing our earnings per share outlook. We now expect the Americas segment to be between 15% to 16% for total growth and 7.5% to 8.5% organically. Within the Americas, we expect to see nonresidential organic growth up high-single to low-double-digits. We expect the residential business to be relatively flat as electronics growth is expected to offset mechanical weakness in that segment. As a reminder, our supply chain challenges in our Americas business began to recover in the second half of last year. So, we'll have a tougher, comparable period in the second half of 2023. Additionally, due to our improved lead times this year and their impact on our nonresidential customers' ordering patterns, seasonality is expected to be somewhat flatter than what Allegion's history would imply. For international, we expect revenue to be down 1% to flat in total and down 1% to 2% organically. The comparison for the international business is somewhat easier in the second half of 2023 as weaker market conditions really started to set in during the second half of last year. All in, for the company, our growth outlook reflects total revenue growth to be between 11.5% to 12.5%, with organic revenue growth of 5.5% to 6.5%. As a result of our team's strong operational execution and favorable first half margin performance, we're raising our adjusted EPS outlook for the year and believe it will be between $6.70 and $6.80, which is approximately 12% to 13.5% over the prior-year period. And as you heard from Mike, this is primarily driven by operations execution. Lastly, we're increasing our outlook on available cash flow for 2023 to be in the $500 million to $520 million range. Please go to Slide 12. So, in summary, Allegion delivered a solid first half of 2023. And like we said at Investor Day, we've returned to a high operating level. Our teams are executing very well. Also at Investor Day, we laid out the Allegion operating model that I'd like to go back and revisit a little bit, about driving organic growth, compounding that organic growth with both margin expansion and capital deployment, resulting in double-digit EPS growth. And I feel we're well on track to deliver all of that for 2023. Our end markets are stable, demand is steady, electronics will continue to fuel our overall revenue growth as we stay focused on our vision of enabling seamless access in a safer world. I'm confident in our outlook and very proud of what our team and our distribution partners delivered this quarter and in my first year with Allegion. So, with that, we can open up the Q&A.
Operator: We will now begin the question-and-answer session. [Operator Instructions] The first question comes from Julian Mitchell with Barclays. Please go ahead.
Julian Mitchell: Hi, good morning. Maybe just a first question to try and understand the organic sales guidance development first off. So, you raised the guidance in late April on organic sales and you've taken it down a little bit today. So, was it that you saw channel partners and customers suddenly start to destock sort of late in the second quarter? Maybe help us understand sort of what the process was behind that that guidance we vision. And then also on the nonresidential market, specifically, it seems that the macro drivers in the Americas are still very good. So, perhaps a little bit puzzled that you're not seeing new orders coming in to sort of offset the destocking that seems to be happening in some areas.
Mike Wagnes: Yes, Julian. If you think about the guide, the last few years, we really struggled with lead times and we got considerably better the end of last year. Our channel partners were maybe a little late to adjust to our reduced lead times. So, what we saw in the second quarter is they're starting to adjust that ordering pattern to our reduced lead times. Especially on the mechanical side, they're back down to normal and were, let's say, at March 31. It took a little longer for them to adjust their ordering. So, they're burning through some of the work that they previously ordered. As you know, we're mostly a made-to-order business, but channel partners will order based on what they think manufacturers can provide product at. And so, we did have some of that choppiness in the second quarter that you saw. When you think about the business in general, I talked about this at Investor Day, expect for us to be total company roughly 50-50 first half to back half. And as you look at our guide right now, you would say it's roughly 50-50 as a company. So, I do think in the second quarter, we did see that channel partners are adjusting to our improvement operationally, which is great because we put a lot of effort to get back to operating at a high level. And then second part of your question related to markets, I'll kind of let John answer that.
John Stone: Yes. Julian, thanks for the question. And we see some of those same things, and I think when I look -- if you disaggregate Americas non-res a little bit, the institutional segment in particular shows -- continues to flash signals of resilience. Healthcare, education, even airports that probably are still in the benefiting phase from the Infrastructure Bill because airport terminal renewal was one of the funding principle there of that bill. But the institutional segment continues to show good signals, positive signals. And as you know, that's where our business a bit heavily-weighted. Now that being said, are there pockets of weakness, major metro, commercial office? I mean, that's been soft for sure. That's no secret. But we're also late-cycle. We're heavily-weighted towards institutional. That segment seems pretty resilient. So, in general, yes, we feel, again, that our exposure in non-res is quite stable. The end markets are stable there.
Julian Mitchell: That's helpful. Thank you. And then just my follow-up, just to make sure we sort of calibrated properly within the second half. Clearly, seasonality is abnormal this year. Your revenues were down sequentially in Q2, which is unusual. And you talked in the prepared remarks about flatter seasonality this year. So, should we assume that you have a much narrower sort of variability between the third and fourth quarter earnings as we look at that, and maybe sort of sales and margins also not that different across the two?
Mike Wagnes: Yes. Thanks for the question, Julian. Historically, you know us, we are -- we don't guide quarters. But if you think about our business, usually we have a step-down in Q4 versus Q3 in the Americas, and it's reverse in international. If you think of the Americas this year, we would expect that to be more flatter than normal. So, the way you're thinking about without giving numbers is correct. You shouldn't see as big a drop-off from Q3 to Q4 when you model this versus, let's say, historical norms.
Julian Mitchell: That's great. Thank you.
Mike Wagnes: Thanks, Julian.
Operator: The next question comes from Joe O'Dea with Wells Fargo. Please, go ahead.
Joe O'Dea: Hi. Good morning. Thanks very much. I guess, in terms of that last point, and as we think about what's going on with channel partners and volume trends and the swing from 1Q to 2Q, as we think about the back half of the year and how you're thinking about channel inventory levels, and given maybe not as much seasonality from 3Q to 4Q, is that based on sort of an expectation that at the end of the third quarter, these channel inventories are sort of roughly normalized, or just any views on timing of when those channel inventories get to a more or less normal state?
John Stone: Yes. Joe, I think you would find -- and we find on our channel checks and customer visits, a very wide range of answers there. I think our two-step distribution partners, our wholesalers would have a different answer than some of the more traditional contract hardware distributors. And our integrated hardware distributors might have a different answer. I think, in aggregate, we still hear comments like aftermarket activity is very strong, particularly in the non-res space, again, and then the leading macros would say the institutional segment is still pretty resilient. So, we still see, I'd say, good levels of sell-through. And the inventory state of the business is going to be different within the channel. Overall, I think the best way to think about it is you just listen to what Mike said and think first half, second half, 50-50 as kind of the way we see 2023 working out.
Joe O'Dea: And then on the Americas margin ex-Access Tech, the 31%, clearly, a really strong margin level. I guess, the -- just sort of framing that relative to some of the comments at the Investor Day and targets to grow margins 50 bps to 100 bps kind of annually, is there anything about the mix that you're seeing or price-cost dynamics that make kind of growing off of this space a little bit more challenging? Just kind of want to understand some of the strength behind that margin in the quarter.
Mike Wagnes: Yes. So, Joe, a great question. As you know, obviously, the back half of the year won't have as much margin expansion year-over-year as first half just because the back half of last year was pretty strong. And so, as a result, we still expect to see margin expansion in the back half in total. But it won't be as strong as what you saw in the last two quarters just due to the prior year comp. If you think of last year, we started to really pick up operationally back half. Long-term on Investor Day, I talked about that 50 basis-point to 100 basis-point improvement, that's part of our operating model, and we still believe on a long-term basis, we can deliver margin expansion in those levels. Quarter-to-quarter, it could change by a prior-year comp. But think of the operating model where we're going to drive price and productivity to offset and fund that inflation and investment, drive some expansion with that and the volume leverage. So, in total, the operating model I talked about in length at Investor Day still holds, and we feel good about the progress we've made in our operational execution over the last four quarters.
Joe O'Dea: Thank you.
John Stone: Thanks. Joe.
Operator: The next question comes from Joe Ritchie with Goldman Sachs. Please, go ahead.
Joe Ritchie: Thanks. Good morning, everybody. And John, congrats on the one-year anniversary.
John Stone: Thank you, my friend.
Joe Ritchie: Yes. So, maybe let's just start on pricing. Obviously, very strong this quarter. Americas was, what, 10%, and you had international pricing that actually accelerated in 2Q. Maybe just tell us a little bit about what's -- what to expect as we progress through the year and whether you're putting additional pricing actions in either region.
Mike Wagnes: Yes. Joe, we've talked about this in the past. We fell behind starting in the back half of '21. And we put efforts in to catch up to that inflation dynamic that we struggled with in years past. I feel like we did a pretty good job and have caught up now. The last pricing actions we put in, in our non-res business were earlier this year as we discussed in previous earnings calls. So, as you think about back half pricing, you will see a step-down in the realization percentage, only because the prior-year comp started to accelerate last year. So, if you take a look at last year Q2 to Q3 to Q4, you get an idea of what happened, then you can model the price realization this year on, knowing that the pricing actions have been put in the marketplace. I think it's important to note. We drive pricing actions to kind of recover that inflationary pressures, coupled with productivity and investments. So, that four-item dynamic I've talked about over the last year, that still holds. But you will see a step-down in the realization percentage due to the prior-year comparable.
Joe Ritchie: Got it. That's helpful, Mike. And my follow-on since you referenced that equation. That price and productivity net of inflation and investments is the strongest, I think, we've seen in really many years. And so, can you maybe just break down a little bit what you're seeing on the productivity versus the investment side? And again, how that's expected the cadence for that going forward through the remainder of the year?
Mike Wagnes: Yes, Joe. I really don't want to give individual numbers, but I will say you are seeing an improvement in our productivity and in our efficiency, right? So, as we -- our supply chains normalize, and we operate at a higher level, we are driving a higher level of productivity than what you saw in '22, '21. And so, we're really excited about the momentum we have in productivity. We expect that to continue as an organization. And we do expect to continue to invest in our business to drive that top-line growth, thinking about the great opportunity that electronics and software provides us. So, we'll continue to invest in the business. But what you saw this quarter, you do have better operational efficiency and productivity as that has been a focus for us.
John Stone: Absolutely.
Joe Ritchie: But that's -- just to be clear, that equation is expected to remain like pretty strongly positive in the back half of the year, correct?
Mike Wagnes: Yes. I don't want to forecast or guide that dynamic. Just make sure you get the margin rate right as you look at our EPS guide and revenue. I kind of gave you the pricing as well so you can back into the -- all the dynamics you need for your model. But expect to see margin expansion in the back half. And then as you look at quarters, just be cognizant of our Q3, Q4 comparables of last year as well.
Joe Ritchie: Understood. Thank you.
Operator: The next question comes from Josh Pokrzywinski with Morgan Stanley. Please, go ahead.
Josh Pokrzywinski: Hi. Good morning, guys.
John Stone: Hi, Josh.
Josh Pokrzywinski: So, I just wanted to tease out, if we can, some of the supply versus demand signals on the mechanical side. I think we've heard elsewhere in terms of lead time normalization, some destocking, I guess, those are going to be two separate things with same concept. But any indicators that you're getting from distributors or maybe specifying architects on demand signals or sell-through in June, maybe just to kind of match up that supply versus dynamic -- demand dynamic a bit better?
John Stone: Yes. Josh, we'll segment is down a little bit. So, I think when you look at mechanical products broadly, as we indicated in the comments, residential mechanical for us is indeed soft, offset by very strong electronics performance. In the non-res side, I think that dynamic -- again, you can imagine if, for the last eight, nine, 10 months, you're placing your orders and you're not getting delivery for 15, 20 weeks, and then suddenly you're getting delivery and two to four weeks. It takes a little bit to work through that. I think channel checks have anecdotally indicated things to us, like when you look across the Americas, places like the Midwest, South, Southeast, really, really strong. And if you go to some major metro areas that are probably a bit heavy commercial losses, they're pretty light. So, it's pockets of strength and pockets of weakness. On balance, we still see good sell-through. We still see that the non-res market is stable, primarily supported by the institutional segment.
Josh Pokrzywinski: Super-helpful. And then just to pick up, some comments that you made, and I guess congrats on the quick de-levering post Access Technologies. I think at the Analyst Day, a lot more focus on growth and inorganic growth was a piece of that. How would you characterize the pipeline right now and what you guys are seeing out there, especially, with now higher interest rates and maybe some less PE competition?
John Stone: Yes. I'd say short of talking about any specific targets or anything, I would feel very good about the top of our funnel in terms of looking for acquisition targets. I think, again, think of us as a pure-play provider of security and access solutions. We've talked a lot about the importance of electronics, the importance of controlling software, really driven by the increasing use of smartphone wallets and mobile credentials. That as a macro tailwind really propelling and giving new uses for smart hardware, electronic access control solutions. We feel, again, as an industry, that's still -- all the signals we can find, that's still high-single-digit growth that we can tend to outperform by a point or two and get Allegion's performance in the low-double-digit range. And certainly acquisitions plays a part in that. And I think as we've said now, you can look for us to be acquisitive, you can look and expect us to also be a disciplined buyer. But we do see acquisitions playing a key role in our overall growth strategy.
Josh Pokrzywinski: Good color. Thanks. I'll leave it there.
John Stone: Thank you.
Operator: The next question comes from Andrew Obin with Bank of America. Please, go ahead.
Andrew Obin: Hi, guys. Good morning.
John Stone: Hi, good morning, Andrew.
Mike Wagnes: Good morning, Andrew.
Andrew Obin: Just a question on international market volumes. You highlighted portable security weakness, but it seems like underlying volumes got sequentially a little bit better. Can you just -- I know that it's a fairly diverse group of countries, but can you just highlight dynamic maybe by region, Italy, Spain, I don't know, France, Central Europe, Korea, Australia, just any granularity on what's happening there?
John Stone: Yes. I'll take a little bit different angle and hope it still answers your question, Andrew. But it's a good...
Andrew Obin: Of course.
John Stone: Thank you. So, I'd say, the portable security business, without a doubt, volume drag. No doubt about it. As Mike mentioned in the prepared comments, the post-COVID demand spike that you saw in that space was quite dramatic. We do expect that market is going to normalize as you get into 2024 and '25. But I'd say -- and we're not alone and seeing this or commenting on it, but residential in general in Europe is rather weak. And that's by and large a mechanical business. So, those volumes are under pressure. There is no doubt. Our electronics and software solutions would still be probably the low-double to mid-teens organic growth. So, we feel really good there, which is, again, more than the commercial side of our business, the non-res side of our business. APAC for us, we do have some China exposure, it's not a lot, but there's no doubt, China is under a lot of pressure. And so, our relatively small but profitable business there is certainly lower relatively speaking. Australia-New Zealand, pretty steady, pretty stable, kind of falling in line with what you'd see in the Americas, just stable end markets, our teams are performing well there.
Andrew Obin: Okay. And just maybe a follow-up question related to institutional. A, if you could sort of differentiate between what's happening hospitals and schools, because it seems that dynamic is somewhat different? And, B, a more interesting question, and you guys turned me onto this years ago, but if you look at muni bond issuance and tax receipts, what's your latest read on the environment going to second half and '24, because I know you guys have an educated view there? Thanks so much.
John Stone: You're very kind in your comments, Andrew. I'd say looking at the institutional segment, you don't see quite the amplitude of volatility that you might see in other parts of the commercial business. It's a little bit steadier. It's a little bit more stable. That is the segment that we performed very well in. That's a segment where codes, compliance, safety standards for your building really matter. And that's where Allegion differentiates and I think really excels. Healthcare has been pretty resilient, education has been pretty resilient. And that's both higher ed and K through 12. School safety is always important. Allegion has for a long time been a very proud and vocal advocate for proper standards, proper codes, and compliance. We've increased our human resources, human capital in that space, and continue to be, I think, a very positive participant in the industry for school safety there. When we look at things to the second half, to your question, like muni bonds and state tax revenues, the picture is actually pretty stable, pretty favorable, I'd say. State tax revenues look to be relatively high, like what you saw back in the '08, '09 crash. The environment is a little different this year, maybe some COVID stimulus, maybe just good economic growth, very low unemployment, etc. The tax revenues at the state level seems to be pretty good from the data that we see. Bond issuance in '21 and '22 was very high. And obviously, it has taken a bit of a dip here, but it seems to be sequentially recovering somewhat. Then also remember, Andrew, Allegion is a late-cycle. So, from bond issuance to budget development to projects being firmed up, to shovel in the dirt, so to speak, to finally, door-to-door hardware going on, that can take some time. And so, I think, in general, looking at bond issuance over the long term, drawing a trend line there, you can kind of understand why that segment we see is particularly stable. And so, I'd say, again, flashing signals of resilience in the institutional segment would be the way we see it.
Andrew Obin: Thank you.
Operator: Thank you. The next question comes from Ryan Merkel with William Blair. Please, go ahead.
Ryan Merkel: Hi, thanks. Two questions from me. Any way to quantify the impact of the order pattern adjustment for mechanical for the full year? And then on electronics, when do you see the lead times normalizing there? And could we see a similar order pattern adjustment at some point there? Thank you.
Mike Wagnes: Yes. So, I'll talk about the first one. If you think about our business, Ryan, I keep on talking about that roughly 50-50 first half to back half. We -- so if you think about it for the full-year guide, that will be completed by the end of the year. So, it really won't have an impact on full year. But you could see a flatter quarter-to-quarter variance, like we talked about earlier in the call. So, for a full year, it's really not applicable. But when you think about quarterly timing, it does result in a little more smoothing quarter-to-quarter over the last three than you would normally expect. And then remind me again, your second question?
John Stone: Electronics.
John Stone: Yes, the electronics, should we expect to see a similar ordering pattern and adjustment in lead times, etc. Lead times have been coming down. I'd say that is the portion of our business where lead times are still a little bit extended, certainly down from the peaks that we saw in the middle of last year, but maybe not yet back to normal, but have been on a pretty good glide path getting back to a more normal, say, four- to six-week kind of lead time for those products. And backlogs are still a little bit elevated there. Demand is still strong. If you see the -- our Investor Day material talking about the non-res mechanical segment being a low-single-digit growth industry, the electronics portion would be high-single-digit growth. So, I think that's the main thing, is we see that as the key growth driver. So, will that same dynamic pop up in the channel? It certainly could. Yet to be seen. And I think as we all get a little bit smarter here and having gone through these quite volatile and dynamic times of the supply chain, maybe with good work, we can we can mitigate it, but yet to be seen. I guess, I don't have a real good detailed forecast for you there. But we'll be watching out for it.
Mike Wagnes: Yes. And just add, Ryan, just remember, that electronics, we talked about it extensively at Investor Day, about what a real strong long-term growth driver that is for us. So, demand there, as John mentioned, is still really strong. So, as you think about that business moving forward, that electronics business should be a double-digit growth long-term driver for us. So, this is not a couple of quarters of growth, this is a long-term growth opportunity for us.
Ryan Merkel: Got it. Thank you.
Mike Wagnes: Thanks.
Operator: The next question comes from David MacGregor with Longbow Research. Please, go ahead.
David MacGregor: Yes. So, good morning, everyone.
John Stone: Hi, David.
David MacGregor: Hi. I just wanted to maybe build off Ryan's question on the electronics. And obviously, a 40% number is a huge number and there's a lot backlog clearance going on there. Can you -- and you talked about kind of the -- Mike, about the high-single-digit growth that's underlying that. Is there any way to sort of trifurcate that down between institutional, commercial, and residential and just give us a better feel for what the second half of this year demand in electronics is likely to look like by sort of that framework?
Mike Wagnes: Yes. What you'll see, David, a couple of dynamics in the second quarter. And I talked about it earlier in the prepared remarks. Admittedly, Q2 last year was a little weaker. So, you do have some growth here due to a weaker previous year. But still, this is now four quarters in a row, really strong growth in electronics. We saw strength in both electronics growth in resi as well as non-res. So, both were strong in the quarter. And as we look forward to the end of the year, the back half, we expect to see good growth in electronics. The one thing I'll remind you is the comps in the back half of last year get much tougher, particularly, in electronics, right? So, if you remember last year, we threw some pretty robust numbers up in the back half. So, just make sure you take that into consideration when you model your electronics. But overall, still expect to have some good growth this year and beyond this year in electronics in both res and non-res.
David MacGregor: Okay. Thanks for that. And then secondly, just a question on Access Technologies. And I wonder if you could just talk about the extent to which you've been successful building out the recurring service revenues in the first year of ownership? And maybe just also remind us on the scale the international business for AT and your growth with that business over the first year?
John Stone: Yes. A really good question, David, and we're always thrilled to talk about Access Technology. There has been a great add to the Allegion portfolio. I'd say the service side of the business has historically been about 40% of the total. It has also historically grown around the low-double-digit rate, high-single, low-double-digit rate. And so, we feel really good about that. We see lots of future opportunities and potential there as our overall, our total Allegion's service capabilities continue to expand and grow. Then, I'd say in terms of international presence with Access Technologies, it's quite small. And so, it's not zero, but it's quite small. This is mainly an Americas business, and where we really focus the investments for new product development and just really staying close to those customer requirements.
David MacGregor: Are you focused on putting more feet on the street in building this service offering in that sense, or maybe just talk about how you're investing in that business?
John Stone: Yes. So, I think, certainly, it's human capital-intensive business, right? These are very highly qualified, very highly trained, very professional service technicians that go out and do this work. I'd say it's a lot of things. We've got to put better productivity tools in their hands, better diagnostic tools in their hands. We're working on a variety of technology there. And then as we work together with certain channel partners as well, making sure we've got the right coverage and the right people to take care of those customers. So, the human element is important. Absolutely. Technology is also important there.
David MacGregor: Are you able to find those people? I mean, are you having -- I'm just wondering how much of a struggle there is to identify and recruit and retain those people.
John Stone: Okay. So, three follow-ons. All right. Yes. I'd say, obviously...
David MacGregor: You said you'd like to talk about Access Technologies.
John Stone: Yes. Don't take advantage of me. Come on. These -- again, these people are hard to find. I won't sugarcoat it. These are very highly skilled, very professional technicians. But we put a lot of investment into training and support as well. And so, we have to be very choosy, because these technicians are the ones keeping our customers up and running. So, it's not just hire as many as you can, it's hire the best. And that's what we focus on doing. Thanks very much for the questions.
David MacGregor: Thanks, John.
Operator: The next question comes from Brett Linzey with Mizuho America. Please, go ahead.
Brett Linzey: Hi, thanks. Good morning. Hi, just a question on electronics versus mechanical. I know, historically, you've said that margin profile is similar. But curious as you get more scale in that category and considering all the redesigns and the reengineering you did last year, is there headroom for the ELOC gross margin to move higher over time?
Mike Wagnes: Brett, we think about gross margins for the organization moving higher over time as we drive the price productivity in excess of the inflation and investments and we leverage volume growth. So, I don't think it's just in electronics, I think as an organization, we're going to drive margin expansion. With respect to electronics, I would say there are roughly similar percentages, but with a higher selling price, electronics will give us a little more dollars per every unit of sale. That's a dynamic we've talked about in the past. So, it's great when we can upsell to an electronic device, and it's something we're focused to drive long term.
Brett Linzey: Great. And then just on the international side. Clearly, volumes continued to be weak but margin is pretty solid in the quarter on price and productivity. Assuming the volume environment remained soft, do you think Tim and team can defend operating margins in that low-double-digit range? Just curious what the sensitivity might be on the upside to downside.
John Stone: Yes. I appreciate the question because we were really proud of what the international team put up in 2Q. Flat revenues, roughly, and still driving margin expansion, to your point. Price productivity net of inflation and investments is a positive dynamic for that group. I'd say, like previous quarters, the Allegion international business is on a much more firm foundation as a business, and we're continuing to find improvement opportunities. So, Tim and the team are performing very, very well. We're proud of what they're accomplishing. And I think we're making good progress against the goals that we've got set out for international. I appreciate you calling that out.
Brett Linzey: Yes. Thanks for taking the question.
Operator: This concludes our question-and-answer session. I would like to turn the conference back over to John Stone, President and CEO, for any closing remarks.
John Stone: Thanks very much. And thanks, everyone, for a really great Q&A. And just to really quickly wrap up the main themes you've heard today. Electronics continues to be a strong growth engine for us and we believe we're in the early innings of adoption there within the industry. The driver here is the flexibility and added layers of security that are available when you adopt smart hardware and mobile credentials. Our end markets are stable, and while we saw a softening in volumes this quarter, as customers adjusted to our improved lead times, indication from our channels show steady demand, stable end markets. The Allegion team continues to deliver outstanding operational performance. Our team is controlling the things they can control and they're executing very well, in my opinion. This is marked by strong margin expansion and increased cash flow. With this, we're confident in our performance for the remainder of the year and raising our full-year EPS outlook as a result. Thanks very much. Have a nice day.
Operator: The conference has now concluded. Thank you for attending today's presentation. You may now disconnect. | [
{
"speaker": "Operator",
"text": "Good morning, and welcome to the Allegion Second Quarter 2023 Earnings Call. [Operator Instructions] Please note this event is being recorded. I would now like to turn the conference over to Jobi Coyle, Director of Investor Relations. Please, go ahead."
},
{
"speaker": "Jobi Coyle",
"text": "Thank you, [Joe]. Good morning, everyone. Thank you for joining us for Allegion's second quarter 2023 earnings call. With me today are John Stone, President and Chief Executive Officer; and Mike Wagnes, Senior Vice President and Chief Financial Officer of Allegion. Our earnings release, which was issued earlier this morning and the presentation which we will refer to in today's call, are available on our website at investor.allegion.com. This call will be recorded and archived on our website. Please go to Slide 2. Statements made in today's call that are not historical facts are considered forward-looking statements and are made pursuant to the safe harbor provisions of federal securities law. Please see our most recent SEC filings for a description of some of the factors that may cause actual results to differ materially from our projections. The company assumes no obligation to update these forward-looking statements. Today's presentation and commentary include non-GAAP financial measures. Please refer to the reconciliation in the financial tables of our press release for further details. Please go to Slide 3, and I'll turn the call over to John."
},
{
"speaker": "John Stone",
"text": "Thanks, Jobi. Good morning, everyone. Thanks for joining us today. My, how time flies. It's hard to believe this time last year, I was joining you for my first Allegion earnings call. I shared then my belief in our company's mission, our people, our culture, and my excitement around this chapter that we're writing in Allegion's history together. One year in, I'm even more energized about Allegion's future and even more proud of our global team who has just delivered another quarter of outstanding operational performance. Let's go to Slide 3 and talk about some of the highlights. The Allegion team delivered 18% total growth and we drove strong margin expansion. In Q2, we increased margins across the Americas and international business segments, both sequentially and year-over-year, resulting in a 130 basis-point increase in adjusted operating income margin for the quarter. We see electronics continuing to be a key growth driver for Allegion. Demand was strong for our electronic solutions in the second quarter, fueling Allegion's overall revenue growth. In Q2, strength across both residential and nonresidential business in our Americas segment totaled nearly 40% electronics growth over the prior period. We also saw a strong electronics and software solutions performance in our international segment. As we work to shape the transformation taking place in our industry, we continue to see electronics as key to our overall growth. Our nonresidential markets remained stable and electronics demand continues to be a bright spot in both Americas and international segments. However, we did see some softness in nonresidential and mechanical demand as customers and distribution partners adjust their ordering patterns to our reduced lead times due to much-improved supply chain and operational execution. The Americas residential business was bolstered by very strong electronics sales, but we're still seeing soft mechanical demand. Certain international end markets, particularly in the portable security business, also remained soft. Overall, our team delivered another strong quarter, resulting in a solid first half 2023. We are operating at a high level, and as a result, are raising our outlook for the year for adjusted EPS, which is now expected to be in a range of $6.70 to $6.80. I'm very proud of the Allegion team's operational performance. I'll provide more color on the outlook later in the presentation. Please go to Slide 4. Now let's move to our vision and strategy. This is a slide we talked through at our Investor Day and while it's a simple overview, it reflects an important foundation for our company. Our vision of enabling seamless access in a safer world. What does that mean? It means if you have the right credentials, whether that's a metal key, an encrypted proximity card, or a digital identity in a mobile wallet, we will provide you the most convenient and secure experience possible. Why is this the right strategy and why is this the right strategy now? Because our world is increasingly digital, mobile, and connected. Because touchless and contactless experiences in technology will clearly live well beyond COVID. Because digital credentials and smart hardware not only provide more seamless access experiences, they also provide more rich data to the end user customer and added layers of security. We feel this transformation has a long runway ahead. Our vision is supported by our strategy of creating value as a pure-play provider of security and access solutions. This is how we differentiate our company and drive innovation for a safer world forward. Building on our legacy, delivering new value and access, being the partner of choice, and operating with excellence. Please go to Slide 5. So, this month also reflects the first anniversary of the Stanley Access Technologies acquisition. Acquiring the Access Technologies business was a direct reflection of our seamless access strategy, making the world more accessible, expanding our presence in access and security markets and unlocking greater long-term value for our customers, our shareholders, and our employees alike. In year one, our teams have integrated very well together. We've taken very good care of our customers, and you can see this in our results, which reflects operational performance in line with the business plan. Access Technologies generated revenues of approximately $385 million, which represented approximately 10% growth. This was $0.11 accretive to adjusted EPS release in its first 12 months. In addition, when we made this acquisition, which is our largest to date, we committed to deleveraging quickly. You can see the results. Our leverage ratios are back to pre-acquisition levels. Overall, we feel great about this highly strategic combination. The automatic doors product portfolio is a hand-in-glove fit with our demand creation and specification engine. This acquisition has greatly enhanced Allegion's service capabilities and we look forward to much more long-term profitable growth opportunities together. I'll ask Mike now to walk you through second quarter financial results, and I'll be back to discuss our updated 2023 outlook."
},
{
"speaker": "Mike Wagnes",
"text": "Thanks, John, and good morning, everyone. Thank you for joining today's call. Please go to Slide Number 6. Allegion delivered another strong quarter, with both top- and bottom-line growth as well as improving cash flows. Revenue for the second quarter was $912.5 million, an increase of 18% compared to 2022. Organic growth of 5.6% was driven by price realization along with strong growth in electronics, offsetting lower volumes in mechanical products. Our Access Technologies acquisition contributed approximately 12% to total growth. Adjusted operating margin and adjusted EBITDA margin in the second quarter increased by 130 basis points and 110 basis points, respectively. These increases were attributable to strong operational execution and favorable price and productivity, which more than offset inflation and investments. Excluding our acquisition of Access Technologies, adjusted operating margin was up 270 basis points. Adjusted earnings per share of $1.76, increased $0.33, or approximately 23%, versus the prior year. Operational performance drove 20% earnings per share growth with additional earnings per share growth coming from acquisitions, offset by the unfavorable impact of anticipated higher interest. Details of our earnings per share performance versus the prior year are in the appendix. Year-to-date available cash flow was $190.1 million, up nearly 125% versus last year. Please go to Slide Number 7. I will start by reviewing the revenue results for the enterprise here before turning to our respective regions. In Q2, we delivered 5.6% organic growth, driven by price realization across the portfolio. Strong volume growth in electronics was more than offset by volume declines in our mechanical products. Our Access Technologies acquisition served as the primary driver of our 12.5% growth in net acquisitions and divestitures. Currency pressure were minimal in the quarter, bringing total reported growth to 18%. First half organic revenue growth was 10.2% overall, driven by strength in electronics. Americas operating growth was nearly 15% and international was down 3%. Please go to Slide Number 8. Our Americas segment continued to deliver strong operating results in the second quarter, with revenues of $727.2 million, up 23.8% on a reported basis and up 7.7% organically. During the second quarter, we achieved double-digit price realization. Our electronics growth for the Americas was nearly 40% as we continue to see both improvements in our supply chain and strong demand. Electronic component availability was significantly challenged in the first half of 2022, making the quarter an easier comparison versus the prior year as our supply chains are much healthier now. In the second quarter, we saw soft mechanical volumes as customers adjust to our reduce lead times to our improve supply chain and operational execution. Organic growth was up high-single-digits for both our nonresidential and residential Americas businesses. As John mentioned earlier, Access Technologies has now been part of Allegion for just over a year, and we are pleased with the ongoing integration and results. This business had pro forma revenue growth of approximately 9.5% versus Q2 2022, and contributed over 16% to the Americas reported growth. Our adjusted operating income of $205.9 million increased 32.9% versus the prior year period, while adjusted operating margin and adjusted EBITDA margin for the quarter were up 190 basis points and 180 basis points, respectively. Excluding Access Technologies, our Americas segment drove a 460 basis-point improvement in operating margin versus the prior year. Our team is executing well and we were able to drive price and productivity in excess of inflation and investments to deliver the strong margin expansion. Please go to Slide Number 9. Our international business had a solid second quarter, with revenues of $185.3 million, flat on a reported basis and down 1% organically. In the quarter, price realization was more than offset by lower volumes, primarily associated with our Global Portable Securities business. As we've discussed previously, this business benefited from a COVID-related demand surge in the first half of last year. We expect this market will normalize and be less of a headwind to our international segment in the second half of this year. Our electronics and software solutions are performing well and continued to be a growth driver for our international segment. In addition, currency was a slight tailwind this quarter and positively impacted reported revenue by 0.6%. International adjusted operating income of $20.9 million increased 2% versus the prior-year period. We saw a significant improvement in adjusted operating margin and adjusted EBITDA margins of 30 basis points and 40 basis points, respectively, when compared to last year. The margin improvement was primarily driven by favorable price and productivity in excess of inflation and investment, reflecting strong execution by the team. Please go to Slide Number 10. Year-to-date available cash flow came in at $190.1 million, up $105.6 million versus the prior year. This increase is driven by higher earnings and lower cash used for net working capital, primarily offset by higher capital expenditures. Working capital as a percent of revenue increased versus the prior year, partially driven by our Access Technologies business, which was not owned in the first half of last year. Working capital management remains a priority of our company as we efficiently turn earnings to cash. As committed, we deleveraged following the acquisition of Access Technologies, and our net debt-to-adjusted EBITDA is back down to 2.1 times. We repaid $60 million on our revolving credit facility in the second quarter and the remaining $30 million outstanding was repaid in the month of July. This means, we have completed our repayments of short-term borrowings for the acquisition, demonstrating our ability to effectively deploy capital and maintain an investment-grade credit rating. Our business continues to generate strong cash flow and our balance sheet continues to be in a healthy position. I will now hand it back over to John for an update on our full-year 2023 outlook."
},
{
"speaker": "John Stone",
"text": "Thanks, Mike. Please go to Slide 11. And as we look at the remainder of 2023, we're tightening our full-year revenue outlook, while also increasing our earnings per share outlook. We now expect the Americas segment to be between 15% to 16% for total growth and 7.5% to 8.5% organically. Within the Americas, we expect to see nonresidential organic growth up high-single to low-double-digits. We expect the residential business to be relatively flat as electronics growth is expected to offset mechanical weakness in that segment. As a reminder, our supply chain challenges in our Americas business began to recover in the second half of last year. So, we'll have a tougher, comparable period in the second half of 2023. Additionally, due to our improved lead times this year and their impact on our nonresidential customers' ordering patterns, seasonality is expected to be somewhat flatter than what Allegion's history would imply. For international, we expect revenue to be down 1% to flat in total and down 1% to 2% organically. The comparison for the international business is somewhat easier in the second half of 2023 as weaker market conditions really started to set in during the second half of last year. All in, for the company, our growth outlook reflects total revenue growth to be between 11.5% to 12.5%, with organic revenue growth of 5.5% to 6.5%. As a result of our team's strong operational execution and favorable first half margin performance, we're raising our adjusted EPS outlook for the year and believe it will be between $6.70 and $6.80, which is approximately 12% to 13.5% over the prior-year period. And as you heard from Mike, this is primarily driven by operations execution. Lastly, we're increasing our outlook on available cash flow for 2023 to be in the $500 million to $520 million range. Please go to Slide 12. So, in summary, Allegion delivered a solid first half of 2023. And like we said at Investor Day, we've returned to a high operating level. Our teams are executing very well. Also at Investor Day, we laid out the Allegion operating model that I'd like to go back and revisit a little bit, about driving organic growth, compounding that organic growth with both margin expansion and capital deployment, resulting in double-digit EPS growth. And I feel we're well on track to deliver all of that for 2023. Our end markets are stable, demand is steady, electronics will continue to fuel our overall revenue growth as we stay focused on our vision of enabling seamless access in a safer world. I'm confident in our outlook and very proud of what our team and our distribution partners delivered this quarter and in my first year with Allegion. So, with that, we can open up the Q&A."
},
{
"speaker": "Operator",
"text": "We will now begin the question-and-answer session. [Operator Instructions] The first question comes from Julian Mitchell with Barclays. Please go ahead."
},
{
"speaker": "Julian Mitchell",
"text": "Hi, good morning. Maybe just a first question to try and understand the organic sales guidance development first off. So, you raised the guidance in late April on organic sales and you've taken it down a little bit today. So, was it that you saw channel partners and customers suddenly start to destock sort of late in the second quarter? Maybe help us understand sort of what the process was behind that that guidance we vision. And then also on the nonresidential market, specifically, it seems that the macro drivers in the Americas are still very good. So, perhaps a little bit puzzled that you're not seeing new orders coming in to sort of offset the destocking that seems to be happening in some areas."
},
{
"speaker": "Mike Wagnes",
"text": "Yes, Julian. If you think about the guide, the last few years, we really struggled with lead times and we got considerably better the end of last year. Our channel partners were maybe a little late to adjust to our reduced lead times. So, what we saw in the second quarter is they're starting to adjust that ordering pattern to our reduced lead times. Especially on the mechanical side, they're back down to normal and were, let's say, at March 31. It took a little longer for them to adjust their ordering. So, they're burning through some of the work that they previously ordered. As you know, we're mostly a made-to-order business, but channel partners will order based on what they think manufacturers can provide product at. And so, we did have some of that choppiness in the second quarter that you saw. When you think about the business in general, I talked about this at Investor Day, expect for us to be total company roughly 50-50 first half to back half. And as you look at our guide right now, you would say it's roughly 50-50 as a company. So, I do think in the second quarter, we did see that channel partners are adjusting to our improvement operationally, which is great because we put a lot of effort to get back to operating at a high level. And then second part of your question related to markets, I'll kind of let John answer that."
},
{
"speaker": "John Stone",
"text": "Yes. Julian, thanks for the question. And we see some of those same things, and I think when I look -- if you disaggregate Americas non-res a little bit, the institutional segment in particular shows -- continues to flash signals of resilience. Healthcare, education, even airports that probably are still in the benefiting phase from the Infrastructure Bill because airport terminal renewal was one of the funding principle there of that bill. But the institutional segment continues to show good signals, positive signals. And as you know, that's where our business a bit heavily-weighted. Now that being said, are there pockets of weakness, major metro, commercial office? I mean, that's been soft for sure. That's no secret. But we're also late-cycle. We're heavily-weighted towards institutional. That segment seems pretty resilient. So, in general, yes, we feel, again, that our exposure in non-res is quite stable. The end markets are stable there."
},
{
"speaker": "Julian Mitchell",
"text": "That's helpful. Thank you. And then just my follow-up, just to make sure we sort of calibrated properly within the second half. Clearly, seasonality is abnormal this year. Your revenues were down sequentially in Q2, which is unusual. And you talked in the prepared remarks about flatter seasonality this year. So, should we assume that you have a much narrower sort of variability between the third and fourth quarter earnings as we look at that, and maybe sort of sales and margins also not that different across the two?"
},
{
"speaker": "Mike Wagnes",
"text": "Yes. Thanks for the question, Julian. Historically, you know us, we are -- we don't guide quarters. But if you think about our business, usually we have a step-down in Q4 versus Q3 in the Americas, and it's reverse in international. If you think of the Americas this year, we would expect that to be more flatter than normal. So, the way you're thinking about without giving numbers is correct. You shouldn't see as big a drop-off from Q3 to Q4 when you model this versus, let's say, historical norms."
},
{
"speaker": "Julian Mitchell",
"text": "That's great. Thank you."
},
{
"speaker": "Mike Wagnes",
"text": "Thanks, Julian."
},
{
"speaker": "Operator",
"text": "The next question comes from Joe O'Dea with Wells Fargo. Please, go ahead."
},
{
"speaker": "Joe O'Dea",
"text": "Hi. Good morning. Thanks very much. I guess, in terms of that last point, and as we think about what's going on with channel partners and volume trends and the swing from 1Q to 2Q, as we think about the back half of the year and how you're thinking about channel inventory levels, and given maybe not as much seasonality from 3Q to 4Q, is that based on sort of an expectation that at the end of the third quarter, these channel inventories are sort of roughly normalized, or just any views on timing of when those channel inventories get to a more or less normal state?"
},
{
"speaker": "John Stone",
"text": "Yes. Joe, I think you would find -- and we find on our channel checks and customer visits, a very wide range of answers there. I think our two-step distribution partners, our wholesalers would have a different answer than some of the more traditional contract hardware distributors. And our integrated hardware distributors might have a different answer. I think, in aggregate, we still hear comments like aftermarket activity is very strong, particularly in the non-res space, again, and then the leading macros would say the institutional segment is still pretty resilient. So, we still see, I'd say, good levels of sell-through. And the inventory state of the business is going to be different within the channel. Overall, I think the best way to think about it is you just listen to what Mike said and think first half, second half, 50-50 as kind of the way we see 2023 working out."
},
{
"speaker": "Joe O'Dea",
"text": "And then on the Americas margin ex-Access Tech, the 31%, clearly, a really strong margin level. I guess, the -- just sort of framing that relative to some of the comments at the Investor Day and targets to grow margins 50 bps to 100 bps kind of annually, is there anything about the mix that you're seeing or price-cost dynamics that make kind of growing off of this space a little bit more challenging? Just kind of want to understand some of the strength behind that margin in the quarter."
},
{
"speaker": "Mike Wagnes",
"text": "Yes. So, Joe, a great question. As you know, obviously, the back half of the year won't have as much margin expansion year-over-year as first half just because the back half of last year was pretty strong. And so, as a result, we still expect to see margin expansion in the back half in total. But it won't be as strong as what you saw in the last two quarters just due to the prior year comp. If you think of last year, we started to really pick up operationally back half. Long-term on Investor Day, I talked about that 50 basis-point to 100 basis-point improvement, that's part of our operating model, and we still believe on a long-term basis, we can deliver margin expansion in those levels. Quarter-to-quarter, it could change by a prior-year comp. But think of the operating model where we're going to drive price and productivity to offset and fund that inflation and investment, drive some expansion with that and the volume leverage. So, in total, the operating model I talked about in length at Investor Day still holds, and we feel good about the progress we've made in our operational execution over the last four quarters."
},
{
"speaker": "Joe O'Dea",
"text": "Thank you."
},
{
"speaker": "John Stone",
"text": "Thanks. Joe."
},
{
"speaker": "Operator",
"text": "The next question comes from Joe Ritchie with Goldman Sachs. Please, go ahead."
},
{
"speaker": "Joe Ritchie",
"text": "Thanks. Good morning, everybody. And John, congrats on the one-year anniversary."
},
{
"speaker": "John Stone",
"text": "Thank you, my friend."
},
{
"speaker": "Joe Ritchie",
"text": "Yes. So, maybe let's just start on pricing. Obviously, very strong this quarter. Americas was, what, 10%, and you had international pricing that actually accelerated in 2Q. Maybe just tell us a little bit about what's -- what to expect as we progress through the year and whether you're putting additional pricing actions in either region."
},
{
"speaker": "Mike Wagnes",
"text": "Yes. Joe, we've talked about this in the past. We fell behind starting in the back half of '21. And we put efforts in to catch up to that inflation dynamic that we struggled with in years past. I feel like we did a pretty good job and have caught up now. The last pricing actions we put in, in our non-res business were earlier this year as we discussed in previous earnings calls. So, as you think about back half pricing, you will see a step-down in the realization percentage, only because the prior-year comp started to accelerate last year. So, if you take a look at last year Q2 to Q3 to Q4, you get an idea of what happened, then you can model the price realization this year on, knowing that the pricing actions have been put in the marketplace. I think it's important to note. We drive pricing actions to kind of recover that inflationary pressures, coupled with productivity and investments. So, that four-item dynamic I've talked about over the last year, that still holds. But you will see a step-down in the realization percentage due to the prior-year comparable."
},
{
"speaker": "Joe Ritchie",
"text": "Got it. That's helpful, Mike. And my follow-on since you referenced that equation. That price and productivity net of inflation and investments is the strongest, I think, we've seen in really many years. And so, can you maybe just break down a little bit what you're seeing on the productivity versus the investment side? And again, how that's expected the cadence for that going forward through the remainder of the year?"
},
{
"speaker": "Mike Wagnes",
"text": "Yes, Joe. I really don't want to give individual numbers, but I will say you are seeing an improvement in our productivity and in our efficiency, right? So, as we -- our supply chains normalize, and we operate at a higher level, we are driving a higher level of productivity than what you saw in '22, '21. And so, we're really excited about the momentum we have in productivity. We expect that to continue as an organization. And we do expect to continue to invest in our business to drive that top-line growth, thinking about the great opportunity that electronics and software provides us. So, we'll continue to invest in the business. But what you saw this quarter, you do have better operational efficiency and productivity as that has been a focus for us."
},
{
"speaker": "John Stone",
"text": "Absolutely."
},
{
"speaker": "Joe Ritchie",
"text": "But that's -- just to be clear, that equation is expected to remain like pretty strongly positive in the back half of the year, correct?"
},
{
"speaker": "Mike Wagnes",
"text": "Yes. I don't want to forecast or guide that dynamic. Just make sure you get the margin rate right as you look at our EPS guide and revenue. I kind of gave you the pricing as well so you can back into the -- all the dynamics you need for your model. But expect to see margin expansion in the back half. And then as you look at quarters, just be cognizant of our Q3, Q4 comparables of last year as well."
},
{
"speaker": "Joe Ritchie",
"text": "Understood. Thank you."
},
{
"speaker": "Operator",
"text": "The next question comes from Josh Pokrzywinski with Morgan Stanley. Please, go ahead."
},
{
"speaker": "Josh Pokrzywinski",
"text": "Hi. Good morning, guys."
},
{
"speaker": "John Stone",
"text": "Hi, Josh."
},
{
"speaker": "Josh Pokrzywinski",
"text": "So, I just wanted to tease out, if we can, some of the supply versus demand signals on the mechanical side. I think we've heard elsewhere in terms of lead time normalization, some destocking, I guess, those are going to be two separate things with same concept. But any indicators that you're getting from distributors or maybe specifying architects on demand signals or sell-through in June, maybe just to kind of match up that supply versus dynamic -- demand dynamic a bit better?"
},
{
"speaker": "John Stone",
"text": "Yes. Josh, we'll segment is down a little bit. So, I think when you look at mechanical products broadly, as we indicated in the comments, residential mechanical for us is indeed soft, offset by very strong electronics performance. In the non-res side, I think that dynamic -- again, you can imagine if, for the last eight, nine, 10 months, you're placing your orders and you're not getting delivery for 15, 20 weeks, and then suddenly you're getting delivery and two to four weeks. It takes a little bit to work through that. I think channel checks have anecdotally indicated things to us, like when you look across the Americas, places like the Midwest, South, Southeast, really, really strong. And if you go to some major metro areas that are probably a bit heavy commercial losses, they're pretty light. So, it's pockets of strength and pockets of weakness. On balance, we still see good sell-through. We still see that the non-res market is stable, primarily supported by the institutional segment."
},
{
"speaker": "Josh Pokrzywinski",
"text": "Super-helpful. And then just to pick up, some comments that you made, and I guess congrats on the quick de-levering post Access Technologies. I think at the Analyst Day, a lot more focus on growth and inorganic growth was a piece of that. How would you characterize the pipeline right now and what you guys are seeing out there, especially, with now higher interest rates and maybe some less PE competition?"
},
{
"speaker": "John Stone",
"text": "Yes. I'd say short of talking about any specific targets or anything, I would feel very good about the top of our funnel in terms of looking for acquisition targets. I think, again, think of us as a pure-play provider of security and access solutions. We've talked a lot about the importance of electronics, the importance of controlling software, really driven by the increasing use of smartphone wallets and mobile credentials. That as a macro tailwind really propelling and giving new uses for smart hardware, electronic access control solutions. We feel, again, as an industry, that's still -- all the signals we can find, that's still high-single-digit growth that we can tend to outperform by a point or two and get Allegion's performance in the low-double-digit range. And certainly acquisitions plays a part in that. And I think as we've said now, you can look for us to be acquisitive, you can look and expect us to also be a disciplined buyer. But we do see acquisitions playing a key role in our overall growth strategy."
},
{
"speaker": "Josh Pokrzywinski",
"text": "Good color. Thanks. I'll leave it there."
},
{
"speaker": "John Stone",
"text": "Thank you."
},
{
"speaker": "Operator",
"text": "The next question comes from Andrew Obin with Bank of America. Please, go ahead."
},
{
"speaker": "Andrew Obin",
"text": "Hi, guys. Good morning."
},
{
"speaker": "John Stone",
"text": "Hi, good morning, Andrew."
},
{
"speaker": "Mike Wagnes",
"text": "Good morning, Andrew."
},
{
"speaker": "Andrew Obin",
"text": "Just a question on international market volumes. You highlighted portable security weakness, but it seems like underlying volumes got sequentially a little bit better. Can you just -- I know that it's a fairly diverse group of countries, but can you just highlight dynamic maybe by region, Italy, Spain, I don't know, France, Central Europe, Korea, Australia, just any granularity on what's happening there?"
},
{
"speaker": "John Stone",
"text": "Yes. I'll take a little bit different angle and hope it still answers your question, Andrew. But it's a good..."
},
{
"speaker": "Andrew Obin",
"text": "Of course."
},
{
"speaker": "John Stone",
"text": "Thank you. So, I'd say, the portable security business, without a doubt, volume drag. No doubt about it. As Mike mentioned in the prepared comments, the post-COVID demand spike that you saw in that space was quite dramatic. We do expect that market is going to normalize as you get into 2024 and '25. But I'd say -- and we're not alone and seeing this or commenting on it, but residential in general in Europe is rather weak. And that's by and large a mechanical business. So, those volumes are under pressure. There is no doubt. Our electronics and software solutions would still be probably the low-double to mid-teens organic growth. So, we feel really good there, which is, again, more than the commercial side of our business, the non-res side of our business. APAC for us, we do have some China exposure, it's not a lot, but there's no doubt, China is under a lot of pressure. And so, our relatively small but profitable business there is certainly lower relatively speaking. Australia-New Zealand, pretty steady, pretty stable, kind of falling in line with what you'd see in the Americas, just stable end markets, our teams are performing well there."
},
{
"speaker": "Andrew Obin",
"text": "Okay. And just maybe a follow-up question related to institutional. A, if you could sort of differentiate between what's happening hospitals and schools, because it seems that dynamic is somewhat different? And, B, a more interesting question, and you guys turned me onto this years ago, but if you look at muni bond issuance and tax receipts, what's your latest read on the environment going to second half and '24, because I know you guys have an educated view there? Thanks so much."
},
{
"speaker": "John Stone",
"text": "You're very kind in your comments, Andrew. I'd say looking at the institutional segment, you don't see quite the amplitude of volatility that you might see in other parts of the commercial business. It's a little bit steadier. It's a little bit more stable. That is the segment that we performed very well in. That's a segment where codes, compliance, safety standards for your building really matter. And that's where Allegion differentiates and I think really excels. Healthcare has been pretty resilient, education has been pretty resilient. And that's both higher ed and K through 12. School safety is always important. Allegion has for a long time been a very proud and vocal advocate for proper standards, proper codes, and compliance. We've increased our human resources, human capital in that space, and continue to be, I think, a very positive participant in the industry for school safety there. When we look at things to the second half, to your question, like muni bonds and state tax revenues, the picture is actually pretty stable, pretty favorable, I'd say. State tax revenues look to be relatively high, like what you saw back in the '08, '09 crash. The environment is a little different this year, maybe some COVID stimulus, maybe just good economic growth, very low unemployment, etc. The tax revenues at the state level seems to be pretty good from the data that we see. Bond issuance in '21 and '22 was very high. And obviously, it has taken a bit of a dip here, but it seems to be sequentially recovering somewhat. Then also remember, Andrew, Allegion is a late-cycle. So, from bond issuance to budget development to projects being firmed up, to shovel in the dirt, so to speak, to finally, door-to-door hardware going on, that can take some time. And so, I think, in general, looking at bond issuance over the long term, drawing a trend line there, you can kind of understand why that segment we see is particularly stable. And so, I'd say, again, flashing signals of resilience in the institutional segment would be the way we see it."
},
{
"speaker": "Andrew Obin",
"text": "Thank you."
},
{
"speaker": "Operator",
"text": "Thank you. The next question comes from Ryan Merkel with William Blair. Please, go ahead."
},
{
"speaker": "Ryan Merkel",
"text": "Hi, thanks. Two questions from me. Any way to quantify the impact of the order pattern adjustment for mechanical for the full year? And then on electronics, when do you see the lead times normalizing there? And could we see a similar order pattern adjustment at some point there? Thank you."
},
{
"speaker": "Mike Wagnes",
"text": "Yes. So, I'll talk about the first one. If you think about our business, Ryan, I keep on talking about that roughly 50-50 first half to back half. We -- so if you think about it for the full-year guide, that will be completed by the end of the year. So, it really won't have an impact on full year. But you could see a flatter quarter-to-quarter variance, like we talked about earlier in the call. So, for a full year, it's really not applicable. But when you think about quarterly timing, it does result in a little more smoothing quarter-to-quarter over the last three than you would normally expect. And then remind me again, your second question?"
},
{
"speaker": "John Stone",
"text": "Electronics."
},
{
"speaker": "John Stone",
"text": "Yes, the electronics, should we expect to see a similar ordering pattern and adjustment in lead times, etc. Lead times have been coming down. I'd say that is the portion of our business where lead times are still a little bit extended, certainly down from the peaks that we saw in the middle of last year, but maybe not yet back to normal, but have been on a pretty good glide path getting back to a more normal, say, four- to six-week kind of lead time for those products. And backlogs are still a little bit elevated there. Demand is still strong. If you see the -- our Investor Day material talking about the non-res mechanical segment being a low-single-digit growth industry, the electronics portion would be high-single-digit growth. So, I think that's the main thing, is we see that as the key growth driver. So, will that same dynamic pop up in the channel? It certainly could. Yet to be seen. And I think as we all get a little bit smarter here and having gone through these quite volatile and dynamic times of the supply chain, maybe with good work, we can we can mitigate it, but yet to be seen. I guess, I don't have a real good detailed forecast for you there. But we'll be watching out for it."
},
{
"speaker": "Mike Wagnes",
"text": "Yes. And just add, Ryan, just remember, that electronics, we talked about it extensively at Investor Day, about what a real strong long-term growth driver that is for us. So, demand there, as John mentioned, is still really strong. So, as you think about that business moving forward, that electronics business should be a double-digit growth long-term driver for us. So, this is not a couple of quarters of growth, this is a long-term growth opportunity for us."
},
{
"speaker": "Ryan Merkel",
"text": "Got it. Thank you."
},
{
"speaker": "Mike Wagnes",
"text": "Thanks."
},
{
"speaker": "Operator",
"text": "The next question comes from David MacGregor with Longbow Research. Please, go ahead."
},
{
"speaker": "David MacGregor",
"text": "Yes. So, good morning, everyone."
},
{
"speaker": "John Stone",
"text": "Hi, David."
},
{
"speaker": "David MacGregor",
"text": "Hi. I just wanted to maybe build off Ryan's question on the electronics. And obviously, a 40% number is a huge number and there's a lot backlog clearance going on there. Can you -- and you talked about kind of the -- Mike, about the high-single-digit growth that's underlying that. Is there any way to sort of trifurcate that down between institutional, commercial, and residential and just give us a better feel for what the second half of this year demand in electronics is likely to look like by sort of that framework?"
},
{
"speaker": "Mike Wagnes",
"text": "Yes. What you'll see, David, a couple of dynamics in the second quarter. And I talked about it earlier in the prepared remarks. Admittedly, Q2 last year was a little weaker. So, you do have some growth here due to a weaker previous year. But still, this is now four quarters in a row, really strong growth in electronics. We saw strength in both electronics growth in resi as well as non-res. So, both were strong in the quarter. And as we look forward to the end of the year, the back half, we expect to see good growth in electronics. The one thing I'll remind you is the comps in the back half of last year get much tougher, particularly, in electronics, right? So, if you remember last year, we threw some pretty robust numbers up in the back half. So, just make sure you take that into consideration when you model your electronics. But overall, still expect to have some good growth this year and beyond this year in electronics in both res and non-res."
},
{
"speaker": "David MacGregor",
"text": "Okay. Thanks for that. And then secondly, just a question on Access Technologies. And I wonder if you could just talk about the extent to which you've been successful building out the recurring service revenues in the first year of ownership? And maybe just also remind us on the scale the international business for AT and your growth with that business over the first year?"
},
{
"speaker": "John Stone",
"text": "Yes. A really good question, David, and we're always thrilled to talk about Access Technology. There has been a great add to the Allegion portfolio. I'd say the service side of the business has historically been about 40% of the total. It has also historically grown around the low-double-digit rate, high-single, low-double-digit rate. And so, we feel really good about that. We see lots of future opportunities and potential there as our overall, our total Allegion's service capabilities continue to expand and grow. Then, I'd say in terms of international presence with Access Technologies, it's quite small. And so, it's not zero, but it's quite small. This is mainly an Americas business, and where we really focus the investments for new product development and just really staying close to those customer requirements."
},
{
"speaker": "David MacGregor",
"text": "Are you focused on putting more feet on the street in building this service offering in that sense, or maybe just talk about how you're investing in that business?"
},
{
"speaker": "John Stone",
"text": "Yes. So, I think, certainly, it's human capital-intensive business, right? These are very highly qualified, very highly trained, very professional service technicians that go out and do this work. I'd say it's a lot of things. We've got to put better productivity tools in their hands, better diagnostic tools in their hands. We're working on a variety of technology there. And then as we work together with certain channel partners as well, making sure we've got the right coverage and the right people to take care of those customers. So, the human element is important. Absolutely. Technology is also important there."
},
{
"speaker": "David MacGregor",
"text": "Are you able to find those people? I mean, are you having -- I'm just wondering how much of a struggle there is to identify and recruit and retain those people."
},
{
"speaker": "John Stone",
"text": "Okay. So, three follow-ons. All right. Yes. I'd say, obviously..."
},
{
"speaker": "David MacGregor",
"text": "You said you'd like to talk about Access Technologies."
},
{
"speaker": "John Stone",
"text": "Yes. Don't take advantage of me. Come on. These -- again, these people are hard to find. I won't sugarcoat it. These are very highly skilled, very professional technicians. But we put a lot of investment into training and support as well. And so, we have to be very choosy, because these technicians are the ones keeping our customers up and running. So, it's not just hire as many as you can, it's hire the best. And that's what we focus on doing. Thanks very much for the questions."
},
{
"speaker": "David MacGregor",
"text": "Thanks, John."
},
{
"speaker": "Operator",
"text": "The next question comes from Brett Linzey with Mizuho America. Please, go ahead."
},
{
"speaker": "Brett Linzey",
"text": "Hi, thanks. Good morning. Hi, just a question on electronics versus mechanical. I know, historically, you've said that margin profile is similar. But curious as you get more scale in that category and considering all the redesigns and the reengineering you did last year, is there headroom for the ELOC gross margin to move higher over time?"
},
{
"speaker": "Mike Wagnes",
"text": "Brett, we think about gross margins for the organization moving higher over time as we drive the price productivity in excess of the inflation and investments and we leverage volume growth. So, I don't think it's just in electronics, I think as an organization, we're going to drive margin expansion. With respect to electronics, I would say there are roughly similar percentages, but with a higher selling price, electronics will give us a little more dollars per every unit of sale. That's a dynamic we've talked about in the past. So, it's great when we can upsell to an electronic device, and it's something we're focused to drive long term."
},
{
"speaker": "Brett Linzey",
"text": "Great. And then just on the international side. Clearly, volumes continued to be weak but margin is pretty solid in the quarter on price and productivity. Assuming the volume environment remained soft, do you think Tim and team can defend operating margins in that low-double-digit range? Just curious what the sensitivity might be on the upside to downside."
},
{
"speaker": "John Stone",
"text": "Yes. I appreciate the question because we were really proud of what the international team put up in 2Q. Flat revenues, roughly, and still driving margin expansion, to your point. Price productivity net of inflation and investments is a positive dynamic for that group. I'd say, like previous quarters, the Allegion international business is on a much more firm foundation as a business, and we're continuing to find improvement opportunities. So, Tim and the team are performing very, very well. We're proud of what they're accomplishing. And I think we're making good progress against the goals that we've got set out for international. I appreciate you calling that out."
},
{
"speaker": "Brett Linzey",
"text": "Yes. Thanks for taking the question."
},
{
"speaker": "Operator",
"text": "This concludes our question-and-answer session. I would like to turn the conference back over to John Stone, President and CEO, for any closing remarks."
},
{
"speaker": "John Stone",
"text": "Thanks very much. And thanks, everyone, for a really great Q&A. And just to really quickly wrap up the main themes you've heard today. Electronics continues to be a strong growth engine for us and we believe we're in the early innings of adoption there within the industry. The driver here is the flexibility and added layers of security that are available when you adopt smart hardware and mobile credentials. Our end markets are stable, and while we saw a softening in volumes this quarter, as customers adjusted to our improved lead times, indication from our channels show steady demand, stable end markets. The Allegion team continues to deliver outstanding operational performance. Our team is controlling the things they can control and they're executing very well, in my opinion. This is marked by strong margin expansion and increased cash flow. With this, we're confident in our performance for the remainder of the year and raising our full-year EPS outlook as a result. Thanks very much. Have a nice day."
},
{
"speaker": "Operator",
"text": "The conference has now concluded. Thank you for attending today's presentation. You may now disconnect."
}
] | Allegion plc | 241,782,379 |
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